ARBA MINCH UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

Module for Financial management I.

Module Introduction
This module is prepared for the course Financial Management I offered to ACFN department
distance program students. This module includes six units that cover distinct but related topics.
Unit one explores An Overview of Financial Management and financial institution and market
chapter two provides IFRS-Based Financial Statement Analysis which covers purpose of
financial analysis and tools of financial analysis. The remaining chapter three and four that
discuss Fundamental Concepts in Financial Management about time value of money and risk
and return and the last two chapters about Long-term Investment Decision Making chapter five
deals with cost of capital and chapter six deals about capital budgeting issue.
At the beginning of each unit, you will find unit introduction and learning objectives while at
the end of each unit summary of major points of the unit and unit activities are included. After
going through each unit, you can attempt end of unit activities and check the attainment of the
learning objectives provided at the beginning of each unit.
For further examination and understanding of the topics covered in this module you can refer
to the materials cited in the reference section at the end of the module. Enjoy reading, working
and learning!

Module Learning Objectives

After successfully completing this course, students will be able to:
The course provides a sound understanding of the financial principles, theories and techniques,
and aims to give a solid basis for decision making, incorporating the different aspects of the
company. The course in general concentrates in developing a high-level understanding of the
tactical and strategic significance of the financial management function within organizations.
Chapter One
An over view of Financial Management
Chapter outline
• Finance:

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• Business Finance and The Financial Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of the Corporation
• Financial Markets and the Corporation

1.1 The nature and scope of financial management

Definition: Financial management is an art and science of managing money.
➢ As an art it requires some skills which can be used by professionals.
➢ As a science it involves some study and research used to come up with standards and
principles.
➢ Financial management includes the process and transfer of money among and between
individuals, business and government.
➢ It is also used as mediator between who want to save their money & who want to invest
money of others.
Scope of finance
A firm secures whatever capital it needs and employs it (finance activity) in activities which
generate returns on invested capital (production and marketing activities).

Financial Management Vs Economics & Accounting

Economics
➢ Financial managers need to have a good understanding of the economic environment.
➢ Some economic concepts are used by financial management such as:
o Demand & Supply concept
o Profit maximization principle (i.e. MR = MC)
o Pricing concept
Accounting
➢ Focuses on providing financial information to the user group.
➢ Accounting relies on past events, whereas the financial management focuses on the
future.
➢ Accounting deals on preparing financial statement, this must be changed to other in
understandable form by the financial manager.
Accounting Financial management
Incomes statement Analysis of F/S

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Capital statement E.g. -Ratio analysis
Exercise 1.
1. What is financial management?
2. Is financial management art or science?
1.2. Financial Markets and Institutions
The Purpose of Financial Markets
Financial assets exist in an economy because the savings of various individuals, corporations,
and governments during a period of time differ from their investment in real assets. By real
assets, we mean such things as houses, buildings, equipment, inventories, and durable goods. If
savings equaled investment in real assets for all economic units in an economy over all periods
of time, there would be no external financing, no financial assets, and no money or capital
markets. Each economic unit would be self-sufficient. Current expenditures and investment in
real assets would be paid for out of current income. A financial asset is created only when the
investment of an economic unit in real assets exceeds its savings, and it finances this excess by
borrowing or issuing stock. Of course, another economic unit must be willing to lend. This
interaction of borrowers with lenders determines interest rates. In the economy as a whole,
savings-surplus units (those whose savings exceed their investment in real assets) provide funds
to savings-deficit units (those whose investments in real assets exceed their savings). This
exchange of funds is evidenced by investment instruments, or securities, representing financial
assets to the holders and financial liabilities to the issuers. The purpose of financial markets in
an economy is to allocate savings efficiently to ultimate users. If those economic units that
saved were the same as those that engaged in capital formation, an economy could prosper
without financial markets. In modern economies, however, most nonfinancial corporations use
more than their total savings for investing in
real assets. Most households, on the other hand, have total savings in excess of total investment.
Efficiency entails bringing the ultimate investor in real assets and the ultimate saver together at
the least possible cost and inconvenience.
Financial Markets
Financial markets are not so much physical places as they are mechanisms for channeling
savings to the ultimate investors in real assets. Figure 2.1 illustrates the role of financial
markets and financial institutions in moving funds from the savings sector (savings-surplus
units) to the investment sector (savings-deficit units). From the figure we can also note the
prominent position held by certain financial institutions in channeling the flow of funds in
the economy. The secondary market, financial intermediaries, and financial brokers are the key

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institutions that enhance funds flows. We will study their unique roles as this section unfolds.
Money and Capital Markets. Financial markets can be broken into two classes – the money
market and the capital market. The money market is concerned with the buying and selling of
short-term (less than one year original maturity) government and corporate debt securities. The
capital market, on the other hand, deals with relatively long-term (greater than one year
original maturity) debt and equity instruments (e.g., bonds and stocks).
A primary market is a “new issues” market. Here, funds raised through the sale of new
securities flow from the ultimate savers to the ultimate investors in real assets. In a secondary
market, existing securities are bought and sold. Transactions in these already existing1the
existence of a secondary market encourages the purchase of new securities by individuals and
institutions. With a viable secondary market, a purchaser of financial securities achieves
marketability. If the buyer needs to sell a security in the future, he or she will be able to do so.
Thus, the existence of a strong secondary market enhances the efficiency of the primary market.
Financial Intermediaries
The flow of funds from savers to investors in real assets can be direct; if there are financial
intermediaries in an economy, the flow can also be indirect. Financial intermediaries consist
of financial institutions, such as commercial banks, savings institutions, insurance companies,
pension funds, finance companies, and mutual funds. These intermediaries come between
ultimate borrowers and lenders by transforming direct claims into indirect claims. Financial
intermediaries purchase direct (or primary) securities and, in turn, issue their own indirect (or
secondary) securities to the public. For example, the direct security that a savings and loan
association purchases is a mortgage; the indirect claim issued is a savings account or a certificate
of deposit. A life insurance company, on the other hand, purchases corporate bonds, among
other things, and issues life insurance policies.
Financial intermediation is the process of savers depositing funds with financial intermediaries
(rather than directly buying stocks and bonds) and letting the intermediaries do the lending to
the ultimate investors. We usually think of financial intermediation making the
markets more efficient by lowering the cost and/or inconvenience to consumers of financial
services. Among the various financial intermediaries, some institutions invest much more
heavily in the securities of business firms than others. In what follows, we concentrate on those
institutions involved in buying and selling corporate securities.
Deposit Institutions. Commercial banks are the most important source of funds for business
firms in the aggregate. Banks acquire demand (checking) and time (savings) deposits from
individuals, companies, and governments and, in turn, make loans and investments. Among

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the loans made to business firms are seasonal and other short-term loans, intermediate-term
loans of up to five years, and mortgage loans. Besides performing a banking function,
commercial banks affect business firms through their trust departments, which invest in
corporate bonds and stocks. They also make mortgage loans available to companies and manage
pension
funds. Other deposit institutions include savings and loan associations, mutual savings banks,
and credit unions. These institutions are primarily involved with individuals, acquiring their
savings and making home and consumer loans.
Insurance Companies. There are two types of insurance companies: property and casualty
companies and life insurance companies. These are in the business of collecting periodic
payments from those they insure in exchange for providing payouts should events, usually
adverse, occur. With the funds received in premium payments, insurance companies build
reserves. These reserves and a portion of the insurance companies’ capital are invested in
financial assets. Property and casualty companies insure against fires, thefts, car accidents, and
similar unpleasantness. Because these companies pay taxes at the full corporate income tax rate,
they invest heavily in municipal bonds, which offer tax-exempt interest income. To a lesser
extent they also invest in corporate stocks and bonds.
Life insurance companies insure against the loss of life. Because the mortality of a large
group of individuals is highly predictable, these companies are able to invest in long-term
securities. Also, the income of these institutions is partially exempt from taxes owing to the
buildup of reserves over time. They therefore seek taxable investments with yields higher
than those of tax-exempt municipal bonds. As a result, life insurance companies invest
heavily in corporate bonds. Also important are mortgages, some of which are granted to
business firms.
Other Financial Intermediaries. Pension funds and other retirement funds are established
to provide income to individuals when they retire. During their working lives, employees
usually contribute to these funds, as do employers. Funds invest these contributions and
either pay out the cumulative amounts periodically to retired workers or arrange annuities.
In the accumulation phase, monies paid into a fund are not taxed. When the benefits are paid
out in retirement, taxes are paid by the recipient. Commercial banks, through their trust
departments, and insurance companies offer pension funds, as do the federal government,
local governments, and certain other noninsurance organizations. Because of the long-term
nature of their liabilities, pension funds are able to invest in longer-term securities. As a result,
they invest heavily in corporate stocks and bonds. In fact, pension funds are the largest single

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institutional investors in corporate stocks.
Mutual investment funds also invest heavily in corporate stocks and bonds. These funds
accept monies contributed by individuals and invest them in specific types of financial assets.
The mutual fund is connected with a management company, to which the fund pays a fee
(frequently 0.5 percent of total assets per annum) for professional investment management.
Each individual owns a specified percentage of the mutual fund, which depends on that
person’s original investment. Individuals can sell their shares at any time, as the mutual
fund is required to redeem them. Though many mutual funds invest only in common stocks,
others specialize in corporate bonds; in money market instruments, including commercial
paper issued by corporations; or in municipal securities. Various stock funds have different
investment philosophies, ranging from investing for income and safety to a highly aggressive
pursuit of growth. In all cases, the individual obtains a diversified portfolio managed by
professionals.
Unfortunately, there is no evidence that such management results in consistently
superior performance.
Finance companies make consumer installment loans, personal loans, and secured loans to
business enterprises. These companies raise capital through stock issues as well as through
borrowings, some of which are long term but most of which come from commercial banks.
In turn, the finance company makes loans.
Financial Brokers
Certain financial institutions perform a necessary brokerage function. When brokers bring
together parties who need funds with those who have savings, they are not performing a direct
lending function but rather are acting as matchmakers, or middlemen.
Investment bankers are middlemen involved in the sale of corporate stocks and bonds. When
a company decides to raise funds, an investment banker will often buy the issue (at wholesale)
and then turn around and sell it to investors (at retail). Because investment bankers are
continually in the business of matching users of funds with suppliers, they can sell issues more
efficiently than can the issuing companies. For this service investment bankers receive fees in
the form of the difference between the amounts received from the sale of the securities to the
public and the amounts paid to the companies.
Mortgage bankers are involved in acquiring and placing mortgages. These mortgages come
either directly from individuals and businesses or, more typically, through builders and real
estate agents. In turn, the mortgage banker locates institutional and other investors for the

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mortgages. Although mortgage bankers do not typically hold mortgages in their own portfolios
for very long, they usually service mortgages for the ultimate investors. This
involves receiving payments and following through on delinquencies. For this service they
receive fees.
Various security exchanges and markets facilitate the smooth functioning of the financial
system. Purchases and sales of existing financial assets occur in the secondary market.
Transactions in this market do not increase the total amount of financial assets outstanding,
but the presence of a viable secondary market increases the liquidity of financial assets and
therefore enhances the primary or direct market for securities. In this regard, organized
exchanges, such as the New York Stock Exchange, the American Stock Exchange, and the
New York Bond Exchange, provide a means by which buy and sell orders can be efficiently
matched. In this matching, the forces of supply and demand determine price.
In addition, the over-the-counter (OTC) market serves as part of the secondary market for
stocks and bonds not listed on an exchange as well as for certain listed securities. It is composed
of brokers and dealers who stand ready to buy and sell securities at quoted prices. Most
corporate bonds, and a growing number of stocks, are traded OTC as opposed to being traded
on an organized exchange. The OTC market has become highly mechanized, with market
participants linked together by a telecommunications network. They do not come together in
a single place as they would on an organized exchange. The National Association of Securities
Dealers Automated Quotation Service (NASDAQ, pronounced “nas-dac”) maintains this
network, and price quotations are instantaneous. Whereas once it was considered a matter of
prestige, as well as a necessity in many cases, for a company to list its shares on a major
exchange, the electronic age has changed that. Many companies now prefer to have their shares
traded OTC, despite the fact that they qualify for listing, because they feel that they get as good
or sometimes better execution of buy and sell orders. Although there are a number of other
financial institutions, we have looked only at those interacting with business firms. As the book
continues, we will become better acquainted with many of those discussed. Our purpose here
was only to introduce you briefly to them; further
explanation will come later.
Financial Institutions:
A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and currency exchange.
Financial Market:

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Financial Markets include any place or system that provides buyers and sellers the means to
trade financial instruments, including bonds, equities, the various international currencies, and
derivatives. Financial markets facilitate the interaction between those who need capital with
those who have capital to invest
The value of financial assets
1.3.The goals of financial management
Efficient financial management requires the existence of some objective or goal, because
judgment as to whether or not a financial decision is efficient must be made in light of some
standard. Although various objectives are possible, we assume in this book that the goal of the
firm is to maximize the wealth of the firm’s present owners. Shares of common stock give
evidence of ownership in a corporation. Shareholder wealth is represented by the market price
per share of the firm’s common stock, which, in turn, is a reflection of the firm’s investment,
financing, and asset management decisions. The idea is that the success of a business decision
should be judged by the effect that it ultimately has onshare price.
The goals of managerial finance are:
• Profit maximization
• Stockholder wealth maximization
• Managerial reward maximization: when the firms make a profit management give a
bonus for their employees.
• Behavioral goal: change employees mind to think for the advancement of the
organization.
• Social responsibility: keep the environment in well manner. Avoid environmental
pollutions.
1. Profit maximization.
Objective: - to get large number of profits in short period of time.
- It is short term goal
- A firm may maximize its short-term profits at the expense of its long-term profitability and
still realize this goal. In contrast, stockholder wealth maximization is a long-term goal, since
stockholders are interested in future as well as present profits.
- You can attain maximum profit through selling a portion of your assets but you are
endangering the existence of the business.
Advantages
- Easy to calculate profits

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- Easy to determine the link between financial decisions and profits.
Disadvantages
- emphasis only on short-term
- ignores risk and uncertainty
2. Stockholder wealth maximization
Objective: is attained when highest market value of common stock is maintained.
Advantages
Wealth maximization is generally preferred because:
- Emphasis on long-term
- recognizes risks and uncertainty
Disadvantages
- offers no clear link between financial decisions and stock price
- Leads to anxiety of management and frustrations.
The roles of financial managers
The financial manager performs the following functions:
• Financial analysis, forecasting and planning
- Monitoring the firm’s financial position
- Determines the proper amount of funds to employ in the firm
• Investment decisions
- Make efficient allocations of funds to specific assets
- Make long-term capital budget & expenditure dictions
• Financing and capital structure decisions
- Determines both the mix of short-term and long-term financing and equity/debt
financing.
- Raises funds on the most favorable terms possible.
• Management of financial resources
- Manages working capital
- Maintains optimal level of investment in each of the current assets.
• Risk management
-As future is uncertain, the financial manager should consider/expectation of risk and protect
the resources.
1.4. Financial management decisions
Financial management is concerned with the acquisition, financing, and management of

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assets with some overall goal in mind. Thus the decision function of financial management
can be broken down into three major areas: the investment, financing, and asset management
decisions.
investment Decision
The investment decision is the most important of the firm’s three major decisions when it
comes to value creation. It begins with a determination of the total amount of assets needed
to be held by the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine
liabilities and owners’ equity being listed on the right side of the balance sheet and its assets
on the left. The financial manager needs to determine the dollar amount that appears above
the double lines on the left-hand side of the balance sheet – that is, the size of the firm. Even
when this number is known, the composition of the assets must still be decided. For example,
how much of the firm’s total assets should be devoted to cash or to inventory? Also, the flip
Financing Decision
The second major decision of the firm is the financing decision. Here the financial manager
is concerned with the makeup of the right-hand side of the balance sheet. If you look at the
mix of financing for firms across industries, you will see marked differences. Some firms
have relatively large amounts of debt, whereas others are almost debt free. Does the type of
financing employed make a difference? If so, why? And, in some sense, can a certain mix
of financing be thought of as best? In addition, dividend policy must be viewed as an integral
part of the firm’s financing decision.
The dividend-payout ratio determines the amount of earnings that can be retained in the firm.
Retaining a greater amount of current earnings in the firm means that fewer dollars will be
available for current dividend payments. The value of the dividends paid to stockholders must
therefore be balanced against the opportunity cost of retained earnings lost as a means of equity
financing. Once the mix of financing has been decided, the financial manager must still
determine how best to physically acquire the needed funds. The mechanics of getting a short-
term loan, entering into a long-term lease arrangement, or negotiating a sale of bonds or stock
must be understood.
Asset Management Decision
The third important decision of the firm is the asset management decision. Once assets
have been acquired and appropriate financing provided, these assets must still be managed
efficiently. The financial manager is charged with varying degrees of operating responsibility
over existing assets. These responsibilities require that the financial manager be more concerned

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with the management of current assets than with that of fixed assets. A large share of the
responsibility for the management of fixed assets would reside with the operating managers
who employ these assets.
An investment in current assets affects the firm’s profitability, liquidity and risk. A conflict
exists between liquidity and profitability while managing current assets. Example, if the firm
does not invest sufficient funds in current assets, it may become illiquid. But it would lose
profitability as idle current assets would not earn anything’s. Therefore, a proper tradeoff must
be achieved between profitability and liquidity.
In order to ensure that neither insufficient nor unnecessary funds are invested in current assets,
the financial manager should develop sound techniques of managing current assets.
Financial manager should estimate firm’s needs for current assets and make sure that funds
would be made available when needed.
1.4.Form of business organizations
There are four basic forms of business organization: sole proprietorships (one owner),
partnerships (general and limited), corporations, and limited liability companies (LLCs). Sole
proprietorships outnumber the others combined by over 2 to 1, but corporations rank first by far
when measured by sales, assets, profits, and contribution to national income. As this section
unfolds, you will discover some of the pluses and minuses of each alternative form of business
organization.
• Sole proprietorship
The sole proprietorship is the oldest form of business organization. As the title suggests, a
single person owns the business, holds title to all its assets, and is personally responsible for all
of its debts. A proprietorship pays no separate income taxes. The owner merely adds any profits
or subtracts any losses from the business when determining personal taxable income. This
business form is widely used in service industries. Because of its simplicity y, a sole
proprietorship can be established with few complications and little expense. Simplicity is its
greatest virtue. Its principal shortcoming is that the owner is personally liable for all business
obligations. If the organization is sued, the proprietor as an individual is sued and has unlimited
liability, which means that much of his or her personal property, as well as the assets of the
business, may be seized to settle claims. Another problem with a sole proprietorship is the
difficulty in raising capital. Because the life and success of the business is so dependent on a
single individual, a sole proprietorship may not be as attractive to lenders as another form of
organization. Moreover, the proprietorship has certain tax disadvantages. Fringe benefits, such
as medical coverage and group insurance, are not regarded by the Internal Revenue Service as

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expenses of the firm and therefore are not fully deductible for tax purposes. A corporation often
deducts these benefits, but the proprietor must pay for a major portion of them from income left
over after paying taxes. In addition to these drawbacks, the proprietorship form makes the
transfer of ownership more difficult than does the corporate form. In estate planning, no portion
of the enterprise can be transferred to members of the family during the proprietor’ lifetime. For
these reasons, this form of organization does not afford the flexibility that other forms do.
Partnerships
A partnership is similar to a proprietorship, except there is more than one owner. A
partnership, like a proprietorship, pays no income taxes. Instead, individual partners include
their share of profits or losses from the business as part of their personal taxable income.
One potential advantage of this business form is that, relative to a proprietorship, a greater
amount of capital can often be raised. More than one owner may now be providing personal
capital, and lenders may be more agreeable to providing funds given a larger owner
investment In a general partnership all partners have unlimited liability; they are jointly
liable for the obligations of the partnership. Because each partner can bind the partnership
with obligations, general partners should be selected with care. In most cases a formal
arrangement, or partnership agreement, sets forth the powers of each partner, the
distribution of profits, the amounts of capital to be invested by the partners, procedures for
admitting new partners, and procedures for reconstituting the partnership in the case of the
death or withdrawal of a partner. Legally, the partnership is dissolved if one of the partners
dies or withdraws. In such cases, settlements are invariably “sticky,” and reconstitution of
the partnership can be a difficult matter. In a limited partnership, limited partners
contribute capital and have liability confined to that amount of capital; they cannot lose
more than they put in. There must, however, be at least one general partner in the
partnership, whose liability is unlimited. Limited partners do not participate in the operation
of the business; this is left to the general partner(s). The limited partners are strictly
investors, and they share in the profits or losses of the partnership according to the terms of
the partnership agreement. This type of arrangement is frequently used in financing real
estate ventures.
Corporations
Because of the importance of the corporate form in the United States, the focus of this book is
on corporations. A corporation is an “artificial entity” created by law. It can own assets and
incur liabilities. In the famous Dartmouth College decision in 1819, Justice Marshall concluded
that a corporation is an artificial being, invisible, intangible, and existing only in contemplation

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of the law. Being a mere creature of law, it possesses only those properties which the charter of
its creation confers upon it, either expressly or as incidental to its very existence.1
The principal feature of this form of business organization is that the corporation exists legally
separate and apart from its owners. An owner’s liability is limited to his or her investment.
Limited liability represents an important advantage over the proprietorship and general
partnership. Capital can be raised in the corporation’s name without exposing the owners to
unlimited liability. Therefore, personal assets cannot be seized in the settlement of claims.
Ownership itself is evidenced by shares of stock, with each stockholder owning that proportion
of the enterprise represented by his or her shares in relation to the total number of shares
outstanding. These shares are easily transferable, representing another important advantage of
the corporate form. Moreover, corporations have found what the explorer Ponce de Leon could
only dream of finding – unlimited life. Because the corporation exists apart from its owners, its
life is not limited by the lives of the owners (unlike proprietorships and partnerships). The
corporation can continue even though individual owners may die or sell their stock. Because of
the advantages associated with limited liability, easy transfer of ownership through the sale of
common stock, unlimited life, and the ability of the corporation to raise capital apart from its
owners, the corporate form of business organization has grown enormously in the twentieth
century. With the large demands for capital that accompany an advanced economy, the
proprietorship and partnership have proven unsatisfactory, and the corporation has emerged as
the most important organizational form. A possible disadvantage of the corporation is tax
related. Corporate profits are subject to double taxation. The company pays tax on the income
it earns, and the stockholder
Questions
Review Exercise
1. Explain the goal of financial management
2. Discuss what financial market is and explain different types of financial
market?
3. Contrast the objective of maximizing earnings with that of maximizing wealth.
4. What is financial management all about? Is the goal of zero profits for some
finite period (three to five years, for example) ever consistent with the
maximization-of-wealth objective?
5. Explain why judging the efficiency of any financial decision requires the
existence of a goal.

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6. What are the three major functions of the financial manager? How are they
related?
7. What is the role of financial management in decision making?
8. Discuss form of business organizations?

Chapter two
IFRS-BASED FINANCIAL STATEMENT ANALAYISIS
Over view of financial statement analysis
➢ Financial statement analysis evaluates a company's performance or value through a
company's balance sheet, income statement, or statement of cash flows. By using a
number of techniques, such as horizontal, vertical, or ratio analysis, investors may
develop a more nuanced picture of a company's financial profile. The focus of financial
analysis is on key figures in the financial statements and the significant relationships that
exist between them.
➢ The analysis of financial statements is a process of evaluating relationship b/n
component parts of f/s to obtain a better understanding of the firm's financial condition
and performance.
➢ Financial analysis helps users understand the numbers presented in financial statements
and serve as a basis for financial decision making.
Financial analysis consists of three major stages. These are:
1. Preparation and selection: - the preparatory steps include establishing the objective of the
analysis and assembling the financial statements and other financial data.
❖ Objectives depend on the prospective of the financial statement user and the questions to be
answered by the analyst. For instance, management analysis financial statements to help in
planning and decision making. The analysis providing answers to such questions as:
• How has the firm performed in the past?
• What are the firm's strengths and weaknesses?
• What changes are needed to improve future performance?
2. Computation and relation: - arrange it in a way that will bring about significant relationship.
It involves the application of various tools and techniques to gain a basic understanding
of the firm's financial condition and performance. The most frequently used techniques in
analyzing f/s are:

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a. Ratio analysis: converts birr amounts in to ratios.
b. Common- size statements: express individual statement accounts as percentage of a base
amount.
3. Evaluation and interpretation: involves the determination of the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm's
performance and financial condition.
Financial statement analysis focuses primarily on the balance sheet and the income
statement. How ever, data from the following two statements may also be used:
- the statement of retained earnings, and
- the statement of changes in cash flow
2.2 ways of financial analysis:
There are three ways of financial analysis:
1. Horizontal analysis /trend analysis /: - as the name indicates in horizontal analysis, we
compare financial statement of a firm for different accounting periods.
➢ it gives an indication of the direction of change and refects whether the firm's financial
performance has improved, deteriorated or remained constsnt over time.
➢ Making use of comparative financial statement. e.g. I/S or balance sheet of period 2 with
period 1
Note
❖ It is important to show both the dollar amount of change and the percentage of change
because either one alone might be misleading.
❖ In case where analysis of financial statements of large number of years is to be made, the
horizontal analysis becomes cumbersome. As result, it is recommendable to use trends
relative to a certain base year. (the base year is 100% )
2. Vertical analysis /common size statement/
Analysis of financial statements where a significant item on a financial statement is used as
a base value and other all items are compared to it.
Example in the case of balance sheet, total asset as abases value. Each asset account
expressed in terms of total asset
In the case of income statement, net sales as abase value. All expenses and net income are
expressed in terms of net sales.
the primary objective of vertical analysis is to highlight relationship b/n components of financial
statements, not to assess trends in individuals’ components over time
it helps us to disclose the internal structure of an enterprise

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it indicates the existing relationship between each income statement account and revenue
shows the mix of assets that produce income and the mix of the source of capital
it also helps us to further assess financial status of a firm in the industry
Example
Firm A Firm B
Asset:
Current asset 40% 60%
Fixed asset 60% 40%
Total 100% 100%
Note: firm B is more liquid than firm A
3. Ratio analysis
"A single figure by itself has no meaning but when expressed in terms of a related figure, it
yields significant inferences".
❖ Ratio analysis standardizes financial data by converting birr figure in the financial
statements into ratios. A financial ratio is a mathematical relationship among several
numbers usually stated in the form of percentage or times
❖ Ratio analysis helps us to draw meaningful conclusions and make interpretations
about a firm's:
-Financial conditions, and
- Performance
2.3 Basis of comparisons:
-Ratio, as yardsticks or financial flags of a firm’s overall performance, is meaningful only when
compared with other information.
Comparisons can be made in the following ways:
1. Industry standards /comparisons: are standards used to compare a firm’s financial conditions
to that of the industry average as a whole and reflects its performance in relation to its
competitors.
E.g. Comparison of Ethiopian airlines performance with air lines industry average
2. Historical standards/trend analysis/: are standards used to compare current performance to
past trends with in the same firm and indicate the direction of change in performance. It helps
us to determine whether the firm’s financial conditions is improving or deteriorating.
3.Management goals for key ratios :are standards or plans set in advance for specific ratios or
financial statement accounts and serve as to assess the status of financial position and as a basis
for evaluating actual performance.

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Examples, Management may see a net profit margin of 20 percent at the beginning and evaluate
the actual performance.
2.4 Types of financial ratios
Financial ratio classified into five categories. These are:
1. Liquidity ratios
2. Activity ratios
3. Leverage ratios
4. Profitability ratios
5. Market value ratio
Example,

ABC Company
Balance sheet
As of December, 31
(In thousands)
yr2010 yr2009
Assets:
Current assets:
Cash 675 450
A/R 1,050 700
Marketable securities 975 650
Inventory 1,900 950
Total current asset 4,600 2,750
Plant assets (net) 3,125 1,250
Total assets 7,725 4,000
Liabilities
Current liability 900 450
Ling term liability 1,800 800
Total liabilities 2,700 1250
Stockholders’ equity
Common stock (100par) 2,000 2,000
Retained earning 3,025 750
Total liabilities &SHE 7,725 4,000

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ABC Company
Income statement
For the year ended, December 31
(in thousands)
yr2010 yr2009
Sales 2250 1800
Sales returns 375 300
Net sales 1875 1500
CGS 1000 850
GP 875 650
Operating expense:
Selling expense 300 200
General expense 105 60
Total expense 405 260
Income from operation 470 390
Other income 130 80
Earning before interest and tax (EBIT) 600 470
Interest expense 100 55
Earning before tax (EBT) 500 415
Income tax(40%) 200 166
Net income 300 249

1.liquidity ratios
“Are a firm’s current assets sufficient to pay its current liability “
Liquidity ratios measure the ability of a firm to meet its short term obligations and reflect the
short term financial strength/solvency of a firm.
Two commonly used ratios are:
A. Current ratio: - measures a firm’s ability to satisfy or cover the claims of short term creditors
by using only current assets. That is, it measures a firm’s short term solvency or liquidity.
Current ratio =Current assets

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Current liabilities
Current ratio for ABC (for yr2009) = 2750
450
=6.1 times
Interpretation: ABC has birr 6.1 in current assets available for every one birr in current
liabilities.
❖ Low ratio-suggests that a firm may face difficulty in paying its short-term
obligations.
❖ High ratio- indicates that too much capital is tied up in current assets and a firm may
be sacrificing some return.
Note: the ratio highly exceeds the industry average (i.e. 2 times) so that ABC is able to pay its
debts when they are due.

➢ A reasonable higher (moderate)the ratio,

- the larger the amount of birr availability in current assets per birr of current
liability
- the more the firm’s liquidity position
- the greater the safety of funds of short term creditors (i.e. less risk to
creditors)
➢ A very lower current ratio results opposite from current ratio out lined as above. A low
current ratio could be improved by:
-long term borrowing to increase current assets
-liquidating current liabilities using long term financing
➢ A very high current ratio may indicate,
-excessive cash due to poor cash management
-excessive A/R due to poor credit management
-excessive inventories due to poor inventory management
- A firm is not making full use of its current borrowing capacity
There fore, a firm should have a reasonable current ratio.
B. Acid –test or quick – ratio: - measures the short term liquidity by removing the least liquid
assets such as:
- Inventories: are excluded because they are not easily and readily convertible
in to cash. More over, losses are most likely to occur in the event of selling
inventories

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- Prepaid expenses: are excluded because they are not available to pay off
current debts. Prepaid expenses include prepaid rent, prepaid insurance,
prepaid advertising, supplies
Quick assets are:
➢ cash
➢ marketable securities
➢ receivables
Quick Ratio = Quick Asset
Current liabilities
Or
= Current Assets- (Inventory+ prepaid expenses)
Current liabilities
Quick Ratio for ABC (for yr.2009) = 450+700+65 = 4 times
450
Or
2750-950 = 4 times
450
Interpretation: ABC has birr 4 in quick assets for every birr in current liabilities.

➢ The current ratio is a crude measure of a firm’s liquidity position as it takes into account all
current assets with out any distinction in their composition.
2) Activity ratios
These ratios are also called.
 Efficiency ratios or
 Asset- utilization ratios
Activity ratios are employed to evaluate the efficiency with which the firm manages and
utilizes its assets. These ratios are also called turn- over ratios because they indicate the
speed with which assets are being converted or turned over into sales.

i.e. Merchandise A/R

Cash

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➢ Overall liquidity ratios generally do not give an adequate picture of company’s real liquidity
due to differences in the kinds of current assets & liabilities the company holds. Thus, it is
necessary to evaluate the activity ratio.

Example:-
ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7000
Marketable security 0 17,000
AIR 0 5,000
Inventories 35,000 6,000
Total current asset 35,000 35,000
Current Liabilities
A/P 0 6,000
N/P 14,000 6,000
Accruals 0 2,000
Total current liability 14,000 14,000
The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR = CA
CL CL
=35000 =35000
14,000 14,000
= 2.5 times = 2.5 times

Activity (Asset utilization) Ratios include

1) A/R turnover ratio
2) A/P “ “
3) Inventory “ “
4) FA “ “
5) Total Asset “ “
1) A/R turnover ratio: - measures the liquidity if a firm’s accounts receivable. That is, it
indicates how many times or how rapidly A/R is converted into cash during a year. Financial
analysts apply two tools to judge the quality or liquidity of A/R.
 A/R turnover
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 Collection period
A/R turnover = Net credit sales (Total sales)
Average A/R
A/R turnover for ABC (yr 2000) = 1500
700
= 2.14 times
AIR turnover for (yr 2001)= 1875
875*
= 2.14 times
*To compute average A/R sum up the last year A/R ( i.e. beginning of this year) and the A/R
of the current year and divide by two .

Interpretation :- ABC’s A/R are converted into cash 2.14 times in year. A reasonably high
A/R turnover is preferable.

A ratio substantially lower than the industry average may suggest that a firm has:
 More liberal credit policy (i.e. longer time credit period), poor credit selection, and
inadequate collection effort or policy which could lead.
➢ A/R to be too high
➢ Bad debts or uncorrectable Receivables
 More restrictive cash discount (i.e. no or little cash discount) that could make sales to be too
low.
A/R turnover = Net sales
A/R

Note: - As result of the above factors,

 The firm could have poor profitability position.
 The firm’s funds would be tied-up in receivable as payments by customers are
delayed.
A ratio substantially higher than the industry average may suggest that a firm has:
 More restrictive credit policy (i.e. short term credit period)
 More liberal cash discount offers (i.e. larger discount and sale increase)
 More restrictive credit selection.

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 More rigorous collection effort or policy
Note: the outcomes of a higher A/R turnover could be
 avoidance of the risk of bad debts
 Increase the firm’s profitability position.
 Small funds tied-up in A/R
 Customers pay quickly
A reasonable High ratio is required for a firm to be efficient in converting its A/R into cash.

If available, only credit sales should be used in the numerator as A/R arises only from
credit sales.

Average collocation period (ACP)

Represents the average length of time a firm must wait to receive cash after making a
sale. That is, it indicates how many days a firm takes to convert receivable into cash or
number of days sales are tied up in A/R

ACP= 360 day ACP= Receivables

A/R turnover Average sales per day

= 360 days
Net sales
Average A/R

=360 x Average A/R

Net sales
= 360 x average A/R
Net sales

= 1 X Average A/R
Net sales
360
1 X Average A/R
Average sales per day

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= Average A/R
Average sales per day
ACP= 360 days Receivable
A/R turnover or Average sales per day
= 360 days = 700 = 700
2.14 1500 4.16
=168 days 360 =168 days

Assume, the credit term of ABC is 2/10, n/75.

Interpretation: - Customer of ABC, on the average, is not paying their bills on time as the ACP
greater than the credit term (75 days). In general, a reasonably short collection period is
preferable.
ABC takes about 168 days to collect its A/R and this lengthy collection period suggests that the
firm might have potential problems in that:
 It isn’t effective in collecting its A/R
 It may give credit to marginal customers
 Thus, the firm’s profitability is adversely affected.
2) A/P turnover ratio :- measures how rapidly creditors are paid. That is, how rapidly or how
many times A/P are paid during a year.
Example, Assume for XYZ café net purchase (on credit) =150,000
A/P- Dec 31, 2000 30,000
A/P2 turnover = net purchase
A/P
= 150,000
30,000
=5 times
Interpretation: - Assume that industry average of A/P turnover is 6 times.
XYZ cafe pays its creditors lower times a year (i.e. 5 times). Thus, it may be rated a risky
borrower.
 Average payment period (APP):- measures the average length of time creditors must wait
to receive their cash or simply the average time needed by a firm to pay its A/P to creditiors
or suppliers from which purchase made.

APP= 360 days A/P

A/P turnover over Average purchase per
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APP for XYZ cafe = 360 days
5 times = 72 days

Assume, suppliers on the average extend, say 60 days credit terms.

Interpretation: - XYZ café would be given a low credit rating (low credit worthiness). That is
XYZ is a risky borrower.
3. Inventory turn over: the frequency at which inventory is converted into sales/ A/R . That is
how fast inventory is sold or turned over?
Inventory turn over= CGS
Average inventory

Inventory turnover for ABC (2010) = 1000

950 + 1900
2
= 0.7 times

Note: - The average inventory is the average of beginning and ending balances of inventory.
Interpretation: - ABC’s inventory is sold out or turned over 0.7 times per year. It general, a high
inventory turnover ratio is better than a low ratio.
➢ An Inventory turnover significantly higher than the industry average indicates:
• Superior selling practices
• Improved profitability as less money is tied-up in inventory.
Possible problems of high inventory turnover
• Very low level of inventory (i.e under investment in inventory)
• Lost sales due to insufficient inventory (i.e risk of out of stock)
• Stoppage of production process for manufacturing firms.
A very low inventory turns over suggests:
• Excessive inventory or over investment in anticipation of strike or price decreases.
• Inferior quality goods, stock of unstable / obsolete goods.
Possible problems of a very low inventory turnover
- Cost of funds locked-up or tied up in inventory (opportunely cost)

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- Deterioration
- Rental of space
- Insurance cost, property tax, and other inventory carrying costs.
Average age of inventory (AAI):- The number of days inventory is kept before it is sold to
customers.
AAI = 360 days
Inventory turnover
360 days
0.7
= 514 days
Interpretation: - ABC carries its inventory for 514 days.
The lengthening of the holding period shows a potently greater risk of obsolescence.
Operating Cycle: - is the number of days it takes to convert inventory and receivables to cash.
Inventory A/R Cash
AAI ACP
Operating cycle = AAI + ACP where, AAI, Average Age of Inventory
ACP, Average Collection Period
Operating cycle for ABC= 514 days +168 days
= 682 days

Interpretation: - ABC takes 682 days to convert inventory and receivables to cash.
A short operating cycle is desirable.
4) Fixed Asset turnover: - measures the efficiency of a business firm with which the firm has
been using its fixed assets to generate revenue
Fixed Assert turnover = Net sales
Net fixed asset.
Fixed Asset turnover = 1500
ABC (for 2000) 1250
=1.2 times
Interoperation: -ABC generated birr 1.20 in net sales for every birr invested in fixed assets.
Other things being equal, a ratio substantially below the industry average:
-Shows underutilization of available fixed assets. (i.e presence of idle capacity) relative to the
industry.
-Indicates possibility to expand activity level without requiring additional capital investment.

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➢ Shows over investment in fixed assets, low sales, or both.
-helps the financial manager to reject funds requested by production managers for new capital
investments.
Suggests that sales should be increased, some fixed assets should be disposed of, or both.
 Other things being equal, a ratio higher than the industry average:
- Requires the firm to make additional capital investments to operate a higher level of
activity.
- Shows more efficiency in managing and utilizing fixed assets.
A firm's fixed asset turnover is affected by:
- The cost of the assets.
- The time elapsed since their acquisition.
- The depreciation methods used
5. Total Asset turnover:- measures a firms efficiency in managing its total assets to generate
sales.

=Net sales

Net total assets

(For year 2000) =1500

4000

= 0.375 times

Net total assets = Net fixed assets + Current Asset.

Depreciation is excluded.

Interpretation: - ABC generates birr 0.375 in net sales for every birr invested in total assets.

➢ A high ratio suggests greater efficiency in using assets to produce sale

➢ A low ratio suggests that ABC is not generating a sufficient volume of sales for the size of
its investment in assets. Therefore, ABC should take steps to :-
-increase sales

-Dispose of some of its investment in assets or both.

Caution has to be taken in making comparison b/n Asset turnover ratio of different
organization because the initial cost of fixed asset differs. Moreover, the method of
depreciation has its own impact on total asset turnover. Inflation has an impact. Comparing

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an old firm which had acquired many of its fixed assets at low prices with a new company
which had acquired at high price may lead misleading.

Firm A (Meta Brewery) Firm B (Dashen

Brewery)

✓ Old and well established company - New company

✓ Old fixed assets recorded at lower historical cost -New fixed assets purchased at higher
prices
✓ Tend to have higher fixed asset turnover -Tend to have lower fixed
asset turnover
These differences could result from:

- Differences in net cost of fixed assets but not from differences

operational efficiencies. Thus, the analyst should consider these
facts while comparing Firm A and Firm B
2. Leverage, solvency and long term debt ratio
Solvency is a firm’s ability to pay long term debt as they come due.

Leverage shows the degree of indebt ness of a firm.

There are two debt measurement tools. These are

A. Financial leverage ratio: measures degree of indebt ness

B. Coverage ratio: measures ability to pay debt
A) Financial leverage. These ratios examine balance sheet ratios and determine the extent
to which borrowed funds have been used to finance the firm. It is the relationship of
borrowed funds and owner’s capital. This can be:

a) Debt ratio
b) Debt equity ratio
a) Debt ratio: the percentage of assets financed through debt

Debt ratio = Total Liability for ABC (yr 2010) 1250/4000=31.25%

Total Assets

Interpretation: creditors have financed ABC about 31 cents of every birr assets. It is
obviously implies that owners have financed 68.75 percent of total assets.

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Higher ratio shows- more of a firm’s asset are provided by creditors relative to owners

- The firm may face some difficulty in raising additional debt.

- Further creditors may require a higher rate of return( interest rate)
for taking higher risk
Creditors prefer moderate or low debt ratio, because low debt ratio provides creditors more
protection in case a firm experiences financial problems.

b) Debt –equity ratio: expresses the relationship between the amounts of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims
of creditors and shareholders’ against the asset of the firm/

Debt-equity ratio= Total Liability

Stockholders equity

For ABC ( yr 2000)=1250/2750=45.45%

Interpretation: Lenders’ contribution is 0.45 times of stock holders’ contributions. That is.
0.3125/0.6875=0.4545

=Debt ratio

Equity ratio

=Total liability = Total liability X Total assets = Total Liability

Total assets Total assets Stockholders equity Stockholders equity

Stock holders equity

Total assets

B) Coverage ratio: these ratio measures the risk of debt by income statement ratios designed
to determine the number of times fixed charges are covered by operating profits. Hence,
they are computed from information available in the income statement. It measures the
relationship between what is normally available from operations of the firm’s and the claims
of outsiders. The claims of a firm are normally met from the earnings or operating profits
of the firm. These claims include loan principal and interest, lease payment and preferred
stock dividends.

The coverage ratios include:

A. Times Interest Earned Ratio: measures the ability of a firm to pay interest on a timely basis.

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= EBIT

Interest expense

For ABC (yr 2001) =600/100= 6 times

Interpretation: ABC earning can cover 6 times its interest expense.

A low ratio suggests:

- Creditors are at more risk in receiving interest due.

-failure to meet interest payment can bring legal action by creditors possibly resulting in
bankruptcy.

- The firm may face difficulty in raising additional financing through debt as it is more than
similar firms.

A high ratio suggests the firm has sufficient margin of safety to cover its interest charges.

B. Fixed Charge coverage ratio: measures the firm’s ability to meet all fixed payment
obligation, such as loan principal, interest, lease payment and preferred stock dividends. It
helps to assess the business organization ability to meet all fixed payments.

Fixed charge coverage ratio= EBIT + Lease payments

Interest+ Lease Payment+ (principal pmt+ P/stock dividend)

1-T

Where, T is tax rate.

Note: a firm’s fixed charges are examined on a before tax basis. Interest payments and lease
payments are made on a before tax basis, so no need of adjustment. Principal payments and
preferred stock dividend are not tax deductible and are paid from after tax earnings, a tax
adjustment is necessary. That is, the payment grossed up by dividing (1-T) to find the before
tax income.

Example, assume, Interest expense: 100000

Lease payment: 50,000

Principal payment: 10,000

Preferred stock dividend: 20,000

Tax rate: 40 percent

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Fixed charge coverage ratio= 600+50

100+50+ (10+20/1-0.4)

3.25 times

Interpretation: ABC is able to cover its fixed charges 3.25 times.

If the ratio is lower:

- The firm may be unable to meet its fixed charges if earnings decline
and may be forced into bankruptcy.
- Creditors and preferred stockholders see the firm as more risky.
A high ratio suggests a good protection in the event of worsening financial position

3. Profitability ratio
These ratios are used to measure the management effectiveness. Besides management of the
company, creditors and owners are also interested in the profitability of the company.
Creditors want to get interest and repayment of principal regularly. Owners want to get a
required rate of return on their investment. The ratio includes:

A. Gross profit margin

B. Operating profit margin
C. Net profit margin
D. Return on investment
E. Return on equity
F. Earning per share
A. Gross profit margin
This ratio indicates management effectiveness in pricing policy, generating sales and
controlling production costs.

Gross profit margin= Gross profit

Net sales
For ABC (yr 2010) = 650/1500=43.3%
Interpretation: The company profit is 0.43 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross margin ratio may
increase by the following factors:
❖ Higher sales price, CGS remaining constant
❖ Lower CGS, sales prices remaining constant

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A low gross profit margin may reflect higher CGS due to the firm’s:
❖ Inability to purchase raw materials at favorable terms
❖ Inefficient utilization of plant and machinery
❖ Over investment in plant and machinery, resulting higher cost of production
The ratio also low due to a fall in prices in the market or marked reduction in selling by the
firm in an attempt to obtain large sales volume.
B. Operating profit margin: measures the percentage of operating profit to sales.

Operating profit margin= EBIT

Net sales

For ABC( yr 2000)=470/1500=31.3%

Interpretation: ABC generates 31 cents operating profits for each of birr sales.

C. Net profit Margin: measures the percentage of net income to sales.

Net profit margin= Net income

Net sales

For ABC (yr 2000) =249/1500=16.6%

Interpretation: ABC generates nearly 17 cents in net income for each of birr net sales.
D. Return on investment (ROI): measures the overall effectiveness of management in
utilizing assets in the process of generating revenue. It reflects how effectively and
efficiently the firm’s assets are used. This ratio is also called Return on Asset (ROA).

Or using Dupont formula: ROA= net profit margin X Total asset turnover
= Net income X Net sales
Net sales Total assets

ROA= Net income

Total assets
= 249/4000=6.225% or
=0.06225x0.375=6.225%
Interpretation: ABC generates little more than 6 cents for every birr invested in assets.

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E. Return on equity( ROE): measures the rate of return realized by stockholders on their
investment.

ROE= Net income ROE= ROA X Leverage

Or
Stockholders equity Where, Leverage= Total assets
Stockholder equity

Leverage ratio measures how the firm finances its assets. Basically, firms can finance with
either debt or equity. ROA= ROE, with only equity financing that asset is equal to
stockholders equity and leverage multiplier is 1.
For ABC (yr 20000=249/2750=9.05%
Interpretation: ABC generates about 9 cents for every birr in shareholders equity.
F. Earning per share (EPS) represents the amount of birr earned on behalf of each
outstanding shares of common stock.

EPS= Net income

No. of C/stock shares outstanding
For ABC (2000)
249/20=12.45
Interpretation: ABC earns birr 12.45 for each shares outstanding.

4. Market Value ratio: these ratio are primarily used for investment decisions and long
range planning and include:
A, Price/ Earning ratio(P/E ratio): shows the amount investors are willing to pay for each
birr of the firm’s earnings.

P/E ratio= Current Market price per share

Earning per share

Or

P/E ratio= D1/E1

k-g
Where, D1/E1, is the expected dividend payout ratio
K, is the required rate of return for the stock
g, is expected growth rate in dividends.

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Assume, that ABC year end Dec 31, 2000 market price of common stock is birr 115 per share.
P/E ratio=115/12.45=9.24 times.
Interpretation: the market is willing to pay 9.24 birr for every birr in earnings.
A high P/E multiplier often reflects the market’s perception of the firm’s growth prospects.
Thus, if investors believe that a firm’s future earnings potential is good and they may be willing
to pay a higher price for the stock.
B. Book value per share: is the value of each share of common stock based on the firm’s
accounting records.

Book value per share= Total stockholders equity- Preferred stock

No. of common shares outstanding

For ABC (yr 2000) =2750-0/20=137.50 birr/share

C. Dividend Ratios. These can be: i) Dividend payout ratio
ii) Dividend yield
i) Dividend Payout ratio: shows the percentage of earnings distributed at the end of the
accounting period. It is the birr amount of dividend paid on a share of common stock outstanding
during the reporting period.

Dividend payout ratio= Dividend Per share

Earning per share
Assume that ABC dividend per share is birr 2.49 Dividend payout ratio = 2.49/12.45=20%
Interpretation: ABC paid 20 percent of its earning as dividend. The higher the ratio may reflect
the firms lower growth opportunities.
ii) Dividend yield: shows the rate earned by shareholders from dividends relative to the current
price of the stock. Dividend yield is part of a stock’s total return.

Dividend yield= Dividend per share

Market price per share

For ABC Dividend yield = 2.49/115=2.17%

Limitation of Ratio analysis
The ratio analysis is a widely used technique to evaluate the financial position and performance
of a business. But there are certain problems in using ratios. The analysts should be aware of
these problems. The following are some of the limitations of the ratio analysis.

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1. Many large firms operate different divisions in different industries, and for such
enterprises it is difficult to develop a meaningful set industry average.
2. Most firms want to be better than industry average approximations. So merely attains
average performance is not sufficient.
3. Non recognition of inflation in financial statement makes a ratio analysis difficult
4. Firms can employ a “ window dressing” technique to make their financial statement
more stronger
5. Different accounting methods are employed by different enterprises.
End of Review questions
1. Define each of the following terms:
a. Liquidity ratios: current ratio; quick, or acid test, ratio
b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed
assets turnover ratio; total assets turnover ratio
c. financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; coverage Ratio
d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on total
assets (ROA); return on common equity (ROE)
e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/ book (M/B)
ratio; book value per share
f. what is Trend analysis; comparative ratio analysis; benchmarking
Q2.
Jimenez Corporation:
Forecasted Balance Sheet as of
December 31, 2011
Assets
Cash $ 72,000
Accounts receivable 439,000
Inventories 894,000
Total current assets $1,405,000
Fixed assets 431,000
Total assets $1,836,000
Liabilities and Equity
Accounts and notes payable 432,000
Accruals 170,000
Total current liabilities $ 602,000

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Long-term debt 404,290
Common stock 575,000
Retained earnings 254,710
Total liabilities and equity $1,836,000
Jimenez Corporation:
Forecasted Income Statement
Dec 31, 2011
Sales $4,290,000
Cost of goods sold d 3,580,000
Selling, general, and administrative expenses 370,320
Depreciation 159,000
Earnings before taxes (EBT) $ 180,680
Taxes (40%) 72,272
Net income $ 108,408
Calculate and interpreted the result
A. Current ratio
B. Quick acid ratio
C. Fixed asset ratio
E. Total asset ratio
F. Debt equity ratio

Chapter Three Time Value of Money

People generally earn money because they want to spend it. If they save it, rather than spend it
in the period in which it was earned, it is usually because they want it to spend in the future.
However, for most people present consumption is more desirable than future consumption if
only because the future is so uncertain. "Live and be merry, for tomorrow we may die," is a
rationale used over the ages to justify the urge to buy now rather than deferring gratification to
the future. For this reason, most of us would rather have a dollar today than a dollar a year from
today, and must be given something extra to get us to defer gratification.

Looking at the transaction from the borrower's perspective, there are consumers and businesses
(not to mention the deficit-ridden government) who really need that dollar today and who are
willing to promise to pay back more than that dollar in the future. Businesses can invest
borrowed funds in capital to create profits which are (hopefully) more than sufficient to repay

Complied by Abinet.E Belachew. A and Genanaw W

the borrowed funds (principal) plus interest. Consumers and governments borrow for various
reasons but are expected to have income in the future sufficient to repay principal and interest.
Simply put, the basic concept of mathematics of finance is that money has time value. That is,
a bird at hand worth two in the forest.

Interest is the price paid for the use of a sum of money over a period of time. It is the charge for
exchanging money now for money later.
A savings institution pays interest to a depositor on the money in the savings account since the
institution has use of those funds while they are on deposit. Or, a borrower pays interest to a
lending agent for use of that agent’s fund over the term of loan.

Interest can be:

1. Simple interest.
2. Compound interest.
Simple Interest
When we borrow money the money borrowed or the original sum of money lent (borrowed or
invested) is called the principal. (The principal remains fixed during the entire interest period).
Interest is usually expressed as a percentage of the principal for a specified period of time which
is generally a year. This percentage is termed the interest rate. If interest is paid on the initial
amount only and not on subsequently accrued interest, it is called simple interest.
However, if the interest for each period is added to the principal in computing the interest for
the next period, the interest is called compound interest.
The sum of the original amount (principal) and the total interest is the future amount or maturity
value or Amount. A = P + I
Simple interest is generally used only on short term notes often of duration less than one year.
Simple interest is given by the formula:
I = Prt
Where P= principal amount/ original amount borrowed or invested
r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.
If a sum of money, P is invested at a simple interest its value increases by the same amount each
year. Therefore, there is a linear relationship between amount and time.
1. I = Prt 2. A = P + I
Complied by Abinet.E Belachew. A and Genanaw W
A = P + Prt
A = P (1+rt)
I A
3. P = rt or P= 1 + rt

I
4. r = Pt

I
5. t = pr

Complied by Abinet.E Belachew. A and Genanaw W

Example: 1
1. Mr. X wanted to buy a leather sofa for his new family room. The cost of the sofa was Birr
10,000. He had short of cash and went to his local bank and borrowed Birr 10,000 for 6
months at an annual interest rate of 12%. Find the total simple interest and the maturity
value of the loan.
Solution
I = Prt A = P+I

= 10,000x 012
. x 12
= 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)
= 10,000 (1.06) = Birr 10,600
2. How long will it take if Birr 20,000 is invested at 5% simple interest to double in value?

Solution. I=A-p I
= 40,000 - 20,000 pr
P = 20,000 BIRR = 20,000 20,000
A = Birr 40,000 20,000x0.05
r = 5% t = = 20 years
t =?
A =2p =20,000x2 = 40,000

3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution
P = Birr 6,000 I
t= rP
I = Birr 900
900
t = 5 years 6000 x 5
=
r =?
= 3% annual rate

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4. How much money must Mr. Z has to invest today at 6% simple interest if he is to receive
Birr 3,100 as an amount in 4 years?

Solution. A
P=
P = Birr? 1 + rt

A = 3,100 3,100

t = 4 years = 1 + .06x 4

r = 6%
= Birr 2,500

When time over which interest is paid is given in months, t is simply the number of month
divided by 12. If time is given as a number of days, then one of two methods of computing t
may be used:
# ofdays
t=
• Ordinary interest year - uses a 360 - day year - 360
When time is determined in this way, the interest is called ordinary simple interest.
#ofdays
t=
• Exact time- uses a 365-day year = t = 365 or a 366 for leap year. Interest computed
in this way (using exact time) is called exact simple interest.

5. Find the interest on Birr 1,000 at 5% for 45 days.

Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% 45
t = 45 days = 1,000 x .05 x 360
I= Birr 6.25

2. Using exact time:

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I = Prt Always ordinary simple interest
45 is grater than exact simple
= 1,000 x .05 x 360 interest.
= Birr 6.16

Compound Interest

If the interest which is due is added to the principal at the end of each interest period, then this
interest as well as the principal will earn interest during the next period. In such a case the
interest is said to be compounded. The result of compounding interest is that starting with the
second compounding the account earns interest on interest in addition to earning interest on
principal.
The sum of the original principal and all the interest earned is the Compound Amount. The
difference between compound amount and the original principal is the Compound interest.
The compound interest method is generally used in long-term borrowing. There is usually more
than one period for computing interests during the borrowing time. The time interval between
successive conversions of interest in to principal is called the interest period or conversion
period or compounding period, and may be any convenient length of time. The interest rates
are always given as annual percentages; no matter how many times the interest is compounded
per year. Hence, interest rate must be converted in to or adjusted to the appropriate interest
rate per conversion period (i) for computational purposes; and we use the number of conversion
periods as time. The i is equal to the stated annual interest rate/nominal rate (r) divided by the
r
.
number of conversion periods in one year (m) = i = m
Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2

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Annually 1

r
A = P (1 + ) mt
m
r
A= P (1 + i) n i= m

n = mt

Where:
A = compound amount, after n conversion periods.
P = principal
r = stated annual rate of interest
m = number of conversion periods a year
t = total number of years
i = interest rate per conversion period
n =total number of conversion periods
Example:
1. What are the compound amount and compound interest at the end of one year if Birr 10,000
is borrowed at 8% compound quarterly?
Solution
P = Birr 10,000 total # of conversions = 4
r = 8% t = one year

Total number of conversion periods (m) = 4 times = quarter

r 8%
.
i = m = 4 = 2% n = mt = 1x4 = 4
A = P (1 + i) n
= 10,000 (1.02)4
= 10,824.3216 Birr
Compound interest = compound amount - original principal

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= 10,824.3216 - 10,000
= Birr 824.3216
2. Find the compound amount compound interest resulting from the investment of Birr 1000
at 6% for 10 years,
a. Compounded annually.
Solution
P = Birr 1,000 A = p(1+i)n
t = 10 years = 1,000 (1.06)10
m=1 = Birr 1,790.85
r = 6%
A =? Compound interest = Compound amount - principal
i = 6% = 1,790.85 - 1000
n = 10 = 790.85 Birr
2.2. Compounded semiannually.
Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount - principal
i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11
2.3 compounded quarterly.
Solution
P = Birr 1,000 A = 1,000 (1.015)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount - principal
i = .015 = 1814.02 - 1000
n = 40 = Birr 814.02
2.4 Compounded monthly.

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Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount - principal
i = .005 = 1,819.40 - 1000
n = 120 = 819.40 Birr

2.5. If compounded weekly

Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount - principal
i = .0012 = 1821.49 - 1000
n = 520 = Birr 821.49

3. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10% compound
quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n n
t=
m
r = 10% 1.3 = (1.025)n
10.625 2
i=2.5% log1.3= log(1.025)n = 2 years
= 4 3 or
m=4
i.e. 2.66 years
t=? log 1.3 log1.025
=n
log 1.025 log1.025
log 1.3
n = log 1.025

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= 10.625 quarters
4. Birr 2000 is deposited in an account. After one year of monthly compounding, the balance
in the account is Birr 2,166. What is the annual percentage rate for this account?
Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12
t=1 log1.083=12log1+i
log 1.083
m = 12 = log 1 + i
12

0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m = r = 8%

5. A person deposits Birr 10,000 in a savings account that pays 6% compounded semi-annually.
Three years later, this person deposits an additional Birr 8,000 in the savings account. Also, at
this time, the interest rates changes to 8% compounded quarterly. How much money is in the
account 5 years after the original Birr 10,000 is deposited?
Solution

3 years 2 years

P= Birr 10,000

10,000(1.03)6 Birr 11,940.52

8,000.00

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Birr 19,940.52

19,940.52(1.02)8
Birr 23,363.49

Present Value

Frequently it is necessary to determine the principal P which must be invested now at a given
rate of interest per conversion period in order that the compound amount “A” to be
accumulated at the end of n conversion periods. This process is called discounting and the
principal is now a discounted value of a future income A.

A = P (1+i) n dividing both sides by (1+i) n leads to

A
P = (1 + i ) = p = A (1+i)-n
n

Present values of a compound amount:

P = A (1+i)-n
Where:
p = principal / present value
A = compound amount (or future value)
i = interest rate per conversion period
n = total number of conversion periods
Example:
1. Find the present value of a loan that will amount to Birr 5,000 in four years if money is
worth 10% compounded semi annually.
Solution.
A = 5,000 Birr P = A (1+i)-n
t = 4 years = 5,000 (1.05)-8
m=2 = Birr 3,384.20

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r = 10%
P =?
3. If money worth 14% compounded semi-annually, would it be better to discharge a debt by
paying Birr 500 now or Birr 600 eighteen months from now?
Solution:
We can solve this problem in two ways:
1) By finding the PV of 600 and compare it with 500
2) By finding the FV of 500 and compare it with 600.

1) A = 600 2) P = 500
t = 18 months = 1.5years t = 1.5 years
m=2 m=2
r = 14% r = 14%
p =? A =?
P = A(1+i)-n A = P(1+i)n
= 600 (1.07)-3 = 500 (1.07)3
= Birr 489.78 = Birr 612.52

Since 489.78 < 500, it is better to pay the debt Since 612.52 > 600, it is better to pay the debt
after 18 months. after 18 months.

Annuities
An annuity is a sequence of equal, periodic payments. The payments may be made weekly,
monthly, quarterly, semi-annually, annually or for any fixed period of time. The time between
successive payments is called the payment period for an annuity. Each payment is called
periodic payment or periodic rent, and it is denoted by R. The time from the beginning of the
first payment period to the end of the last period is called the term of an annuity. If payments
are made at the end of each time interval, then the annuity is called an ordinary annuity. If
payments are made at the beginning of the payment period, it is called an annuity due.
Ordinary Annuity

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An ordinary annuity is a series of equal periodic payments in which each payment is made at
the end of the period. In an ordinary annuity the first payment is not considered in interest
calculation for the first period (because it is paid at the end of the first period for which interest
is calculated) and the last payment doesn’t qualify for interest at all since the value of the
annuity’s computed immediately after this last payment is received.
The amount (future value) of an ordinary annuity is the sum of all payments plus all interests
earned.
 (1 + i ) n − 1
R 
A=  
i

Example
1. What is the amount of an annuity if the size of each payment is Birr 100 payable at the end
of each quarter for one year at an interest rate of 4% compounded quarterly?
Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r, = 4%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of an annuity) =?
Term one year
[(1.01)4 - 1]
For the above example: A = 100 0.01 = Birr 406.04
Compound interest = Amount - R (n)
= 406.04 - 100(4) existence
= Birr 6.04
2. A newly married couple are both working and decide to have Birr 1000 at the end of a
month for a down payment on a home. The account earns 12% compound monthly. How large
a down payment will they have saved in three years?
Solution

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R = Birr 1000 (1 + i ) n − 1] Compound interest = A - R(n)
A = R 
t = 3 years. i = 43,076.88 - 36,000
[(1.01)36 − 1]
m = 12 = 1000 = 7,076,88 Birr
0.01
n = 36
= Birr 43,076.88
r = 12%
i=1%
A =?
3. A person deposits Birr 200 a month for four years in to an account that pays 7% compounded
monthly. After the four years, the person leaves the account untouched for an additional six
years. What is the balance after the 10 year period?
Solution
R = Birr 200 A4 = 200 [(1 + 0.00583)48 – 1]
t = 4years 0.00583
m = 12 = 200 (55.209)
r = 7% + = 11,041.80 Birr
After the end of the fourth year, we calculate compound interest rate taking Birr 11,041.85 as
principal compounded monthly for 6 years.
P = 11,041.85 Birr A10 = P (1+i) n
=11,041.80 (1 + .00583)72
t = 6years
m = 12 = 11,401.80 (1.5201)
r = 7% = Birr 16,780.70
A10 =?
Sinking Fund- Increasing Annuity
A Sinking fund is a fund in to which equal periodic payments are made in order to accumulate
a specified amount at some point in the future. Sinking funds are generally established in order
to satisfy some financial obligation or to reach some financial goal.
If the payments are to be made in the form of an ordinary annuity, then the required periodic
payment into the sinking fund can be determined by reference to the formula for the a mount
of an ordinary annuity. That is, if

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A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i
 i 
A 
R =  (1+ i ) − 1
n

Example:
1. What monthly deposit will produce a balance of Birr 100,000 after 10 years? Assume
that the annual percentage rate is 6% compounded monthly. What is the total amount
deposited over the 10-year period?
 i 
A 
Solution A = Birr 100,000 R=  (1 + i )n
− 1 

 0.005 
100,000  
t = 10years R=  (1.005) −1
120

m = 12
r = 6% = 100,000 (0.006102)
R =? = Birr 610.21
The total amount deposited over the 10-yr period is 120 (610.21) = Birr 73,225. The remaining
Birr 26,775 an interest.

2. XYZ Company purchased a tract of land under a purchase agreement which requires a
payment of Birr 500,000 plus 5% interest compounded annually at the end of 10 years.
The company plans to setup a sinking fund to accumulate the amount required to settle
the land purchase debt. What should the quarterly deposit into the fund be if the account
pays 15% interest, compounded quarterly?
Solution
First we have to find the total debt (future value) at the end of ten years as

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A = P (1+i) n i = mt=1x5% = 5%
= 500, 000 (1+0.05)10
= Birr 814,447.31
The amount is taken as Future Value of an Ordinary annuity with r = 15% Compounded
quarterly for 10 years
 .0375 

A40 = Birr 814,447.31
( )40 
R = 814,447.31  1.0375 −1
t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
Present Value of an Ordinary Annuity
The present value of an ordinary annuity is the amount of money today, which is equivalent to
the sum of a series of equal payment in the future. It is the sum of the present values of the
periodic payments of an annuity, each discounted to the beginning of an annuity. The present
value represents the amount that must be invested now to purchase the payment due in the
future.
In short, PV of an ordinary annuity can be computed in two ways:
(1) Discounting all periodic payment to the beginning of the term individually.
(2) Discounting the amount of an ordinary annuity to the beginning of the term.
1 − (1 + i ) − n 
P = R 
 i 
Example
1. What is the PV of an annuity if the size of each payment is Birr 200 payable at the end of each
quarter for one year and the interest rate is 8% compounded quarterly?
Solution
R = Birr 200 r = 8%
m=4 t = 1yr
P =?
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Using the above formula; the PV of the former example is computed as:

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55
Equivalently: Find the FV of the ordinary annuity using the formula A = R [(1+i)n - 1]
i
A = 200 [(1.02)4 - 1]
.02
= Birr 824.32
2. What is the cash value of a TV that can be bought for Birr 200 down payment
and Birr 82 a month for 18 months, if money is worth 12% interest compounded
monthly?
Solution
Cash Value = down payment + PV of an ordinary annuity
= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658
3. How much should you deposit in an account paying 6% compounded quarterly
in order to be able to withdraw Birr 1000 for the next 3 years?
Solution
R = Birr 1000 PV = 1000[1 – (1.015)-12]
t = 3years .015
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50

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PV =?
Amortization- Decreasing Annuity
Amortization means retiring a debt in a given length of time by equal periodic payments that
include compound interest. After the last payment, the obligation ceases to exist-it is dead-and
it is said to have been amortized by the payments.
In amortization our interest is to determine the periodic payment, R, so as to amortize (retire)
a debt at the end of the last payment. Solving the PV of ordinary annuity formula for R in terms
of the other variables, we obtain the following amortization formula:
 i 
R = P −n 
1− (1+ i ) 
Where:
R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods
Example
1. Suppose you borrow Birr 5000 from a bank and agree to repay the loan in five equal
installments including all interests due. The bank’s interest charges are 5%
compounded annually. How much should each annual payment be in order to retire the
debt including the interest in 5 years?
Solution
PV = Birr 5000 R = 5000[ .05 ]
t = 5years 1 – (1.05)-5
m=1 = 5000(.230975)
r = 5% = Birr 1,154.87 must be paid per year to amortize the
debt
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35
2. At the time of retirement, a person has Birr 200,000 in an account that pays 12%
compounded monthly. If he decides to withdraw equal monthly payments for 10 years,

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at the end of which time the account will have a zero balance, how much should he
withdraw each month?
Solution
PV = Birr 200,000 R = 200,000 [ .01 ]
t = 10years 1 – (1.01)-120
m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?
3. An employee has contributed with her employer to a retirement program for 20 years a certain
amount twice a year. The contribution earns an interest rate of 10% compounded semi annually.
At the date of her retirement the total retirement benefit is Birr 300,000. The retirement program
provides for investment of this amount at an interest rate of 10% compounded semi annually.
Semi-annual payments will be made for 20 years to the employee or her family in the event of
her death.
1. What semi-annual payment should she make?
2. What semi-annual payment should be made for her?
3. How much interest will be earned on Birr 300,000 over the 40 years?
Solution
Retirement plan
A = 300,000 PV = 300,000
t = 20 years t = 20 years
m=2 m=2
r = 10% r = 10%
R1 =? R2 =?

R = A[ i ] R2 = P20 [ i ]
(1+i) n –1 1 – (1+i)-n

= 300,000 ( .05 ) = 300,000 ( .05 )

(1.05)40 – 1 1 – (1.05)-40

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= Birr 2483.45 = Birr 17,483.45

Interest earned = (R2 x 40) - (R1 x 40)

= (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000
Mortgage Payments
In atypical house purchase transaction, the home-buyer pays part of the cost in cash and
borrows the remained needed, usually from a bank or a savings and loan association. The buyer
amortizes the indebtedness by periodic payments over a period of time. Typically, payments
are monthly and the time period is long-30 years is not unusual.

Mortgage payment and amortization are similar. The only differences are
- The time period in which the debt/loan is amortized/repaid
- The amount borrowed.
- In mortgage payments m is equal to 12 because the loan is repaid from monthly salary,
but in amortization m may take other values.
In Mortgage payments we are interested in the determination of monthly payments.
Taking A = total debt
R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t
R can be determined as follows:
 i   i 
R= A  −n  R= A  −n 
1− (1+ i )  Or 1− (1+ i ) 

1− (1+ i )− n 
A= R  
Similarly,  i 

Example:

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1. Mr. X purchased a house for Birr 115,000. He made a 20% down payment with the
balance amortized by a 30 yr mortgage at an annual interest of 12% compounded
monthly.

a. What is the amount that Mr. X should pay monthly so as to retire the debt at the
end of the 30th yr?
b. Find the interest charged.
Solution
Selling price = Birr 115,000 r = 12% i= 1%
Down payment (20%) 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?
 i 
R= A  −n 
1− (1+ i ) 
 .01 
R = 92,000  −360 
1− (1.01) 
= 92,000 (.010286125)
= Birr 946.32
Interest = Actual payment – Mortgage (loan)
= (946.32 X 360) - 92000
= Birr 340,675.20 – 92,000
= Birr 248,675.20
2. Mrs. Y purchased a house for Birr 50,000. She made an amount of down payment and
pay monthly Birr 600 to retire the mortgage for 20 years at an annual interest rate of
24% compounded monthly.
Required: Find the mortgage, down payment, interest charged, and the percentage of the
down payment to the selling price.
Solution
Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]
Down payment =? i
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Mortgage (A) =? = 600 [1- (1.02)-240]
R = Birr 600 0.02
r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87
Down payment
x100
Percentage of down payment = Selling Pr ice

20,258.87
x100
= 50,000

= 40.52%
3. Mr. Z has taken out a Birr 60,000, 20 year, 24% mortgage on his home.
a. How much will he pay each month to discharge this mortgage?
b. How much of the first payment is for interest and by how much does it reduce
the balance owed?
c. How much of the second payment is for interest and by how much does it reduce
the balance owed?
Solution
a)  i 
R= A  −n 
Mortgage (A) Birr 60,000 1− (1+ i ) 
r = 24% i = 2%
 .02 
R = 60,000  −240 
1 − (1.02) 
m = 12
t = 20 years n = 240
= 60,000(.020174
= Birr 1,210.44
b). Interest = 60,000 X .02
= Birr 1,200
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Reduction from the balance owed = Monthly payment – Interest
= 1210.44 – 1200
= Birr 10.44
c). Interest = (60,000 – 10.44) x .02
= Birr 1199.79

Reduction from Balance owed = 1210.44 – 1199.79

= Birr 10.65

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CHAPTER FOUR: RETURN AND RISK
This chapter is all about investment return and risk. It elaborate basic concept of return and
its component, as well as investment risk, component and types. Moreover, it discusses how
risk and return is computed by classifying it as historical and ex-ante risk and return. The
chapter concludes with a discussion of risk management and its tools.
2.1. Return- An Over view and component
Return is a reward and motivating force behind every investment. It is the amount or rate of
gain or profit which accrues to an investment. The rate of return required by a firm to a great
extent depends upon the risk involved, higher the risk, greater is the return expected by the
firm. Return on investment has two components, regular income in the form of interest or
dividend and capital appreciation (an increase in price.
2.1.1. Components of an Investor’s Required Rate of Return
In financial theory, the rate of return at which an investment trades is the sum different
components return. They are:
• Real Risk-Free Interest Rate: This is the rate to which all other investments are compared.
It is the rate of return an investor can earn without any risk in a world.
• Inflation Premium: This is the rate that is added to an investment return to adjust for the
market’s expectation of future inflation. For example, the inflation premium required for
a one year corporate bond might be a lot lower than a thirty year corporate bond by the
same company because investors think that inflation will be low over the short-run, but
pick up in the future as a result of the trade and budget deficits of years past.
• Liquidity Premium: Thinly traded investments such as stocks and bonds in a family
controlled company require a liquidity premium. That is, investors are not going to pay
the full value of the asset if there is a very real possibility that they will not be able to
dump the stock or bond in a short period of time. The size of the liquidity premium
depends upon an investor’s perception of how active a particular market is.
• Default Risk Premium: is premium paid to compensate faller of company to pay interest
plus principal. When signs of trouble appear, a company’s shares or bonds will collapse
as a result of investors demanding a default risk premium. If someone were able to acquire

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assets that were trading at a huge discount as a result of a default risk premium that was
too large, they could make a great deal of money.
• Maturity Premium: is the reward for greater price fluctuation when interest rates change.
It increases as maturity period of security increase.
2.2. Investment Risk-An Overview, Components and Types of Risk
Whenever you make a financing or investment decision, there is some uncertainty about the
outcome. Uncertainty means not knowing exactly what will happen in the future because of
change tax laws, consumer demand, the economy, or interest rates. Risk is how investors
characterize how much uncertainty exists on return. It is the difference between expected return
and actual return.
Components of investment risk
• Business Risk: The uncertainty of income caused by the nature of a companies business
that measured by a ratio of operating earnings (income flows of the firm). The sources
of business risk mainly arises from a companies’ products/services, ownership support,
industry environment, market position, management quality etc.
• Liquidity Risk: The uncertainty introduced by the secondary market for a company to
meet its future short term financial obligations. When an investor purchases a security,
they expect that at some future period they will be able to sell this security at a profit
and redeem this value as cash for consumption. Its ability to be redeemable for cash at
a future date.
• Financial Risk - Financial risk is the risk borne by equity holders (refer Shares section)
due to a firms use of debt. If the company raises capital by borrowing money, it must
pay back this money at some future date plus the financing charges (interest etc charged
for borrowing the money). This increases the degree of uncertainty about the company,
because it must have enough income to pay back this amount at some time in the future.
• Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency. This is particularly,
important for investors that have a large amount of over-seas investment and wish to
sell and convert their profit to their home currency. The more volatile exchange rates

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between the home and investment currency, the greater the risk of differing currency
value that eroding the investments value.
Country Risk - This is also termed political risk, because it is the risk of investing funds in
another country whereby a major change in the political or economic environment could occur.
This could devalue your investment and reduce its overall return. This type of risk is usually
restricted to emerging or developing countries that do not have stable economic or political
arenas.
Market Risk - The price fluctuations or volatility increases and decreases in the day-to-day
market. This type of risk mainly applies to both stocks and options and tends to perform well
in a bull (increasing) market and poorly in a bear (decreasing) market. Generally with stock
market risks, the more volatility within the market, the more probability of increase or decrease
investment.
Types of Risk
There are a number of risks that can affect your investments. While some of these risks can be
reduced through a number of avenues - some of them simply have to be accepted and planned
for any investment decision. Based on this, there are two main types of risk; these are
systematic risk and unsystematic risk.
Systematic risk: It is also called non-diversified risk. It is unavoidable. It may also be called a
market risk. Is the risk that cannot be reduced or predicted in any manner and it is almost
impossible to predict or protect yourself against this type of risk. Examples of this type of risk
include interest rate increases or government legislation changes recession, war, and structural
changes in the economy.
Unsystematic Risk: is also called diversifiable risk or non market risk. Unsystematic risk can
be minimized or eliminated through diversification of security holdings. The variability in
scrip’s total return that is not related to the overall market variability is called unsystematic
risk. It represents the portion of an investment risk that can be eliminated by holding diversified
stocks. This risk occurs due to management changes in the company, labor problems, strikes
etc.
2.3 Return and Risk Analysis
2.3.1. Measuring Historical Return

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Historical returns are frequently used to compare investment products or to provide an estimate
of what future returns might be. There are many ways to measure the historical rate of return
on an investment.
Total return: Defined as the percentage increase or decrease in the capital from the beginning
of the period to the end of the period.
• Assume first there are no cash flows during the period, i.e., no money is added or
withdrawn. In this case, the total return may be obtained by the formula:
Total Return = (Ending Capital / Starting Capital) – 1
• If the annual returns in each of the years are R1, R2, R3 and RN or if there is money added
or withdrawn the total return is found by compounding or "linking" the two annual returns
as follow:
Total Return = [(1+ R1)* (1+ R2)* (1+ R3)*…*(1+ RN)] –1
Average annual return: Used to compare the performance of two investments with returns on
periods of different lengths. The AR is found by taking the average of the yearly returns.
For N years with returns R1, R2, R3, and RN, the average annual return is:
Average Annual Return = (R + R2 + R3 +...+ RN) / N
Example1: A $1,000 investment portfolio grows to $1,600 at the end of one year and ends up
at $2,000 at the end of the second year. Compute:
a) Each year rate of return
b) Total rate of return and
c) Average rate of return
Solution: a) 1st year and 2nd year return is calculated as:
1st yr TR = (Ending Capital / Starting Capital) – 1 = (1600/1000)-1
= 60%
2nd yr TR= (2000/1600)-1
= 25%
b) Total Return = ($2,000 /$1,000) – 1 = 1 = 100%
Alternatively, we could use the two annual returns to get the same result:
Total Return = (1 + 60%) * (1 + 25%) – 1 = 1 = 100%
c) Average Annual Return = (60% + 25%) / 2 = 85% / 2 = 42.5%

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Example2:
A $1,000 investment appreciates 50% during the first year (to $1,500) and then loses 50% the
second year to settle at a final value of $750. Compute:
a) Each year rate of return
b) Total rate of return and
c) Average annual rate of return
Solution: a) 1st year and 2nd year return is calculated as:
1st yr TR = (Ending Capital / Starting Capital) – 1 = (1500/1000)-1
= 50%
2nd yr TR= (750/1500)-1
= -50%
b) Total Return = ($750 /$1,000) – 1 = 1 = -25%
Alternatively, we could use the two annual returns to get the same result:
Total Return = (1 + 50%) * (1 + (-50%)) – 1 = 1 = -25%
c) Average Annual Return = (50% - 50 %) / 2 = 0%
The 50% loss in the second year has a bigger effect than the 50% gain in the first year. The
general idea, which will return to later, is that one should be less impressed by positive returns
and more impressed with negative ones. As investment writers frequently mention, it takes a
100% positive return to make up for a 50% loss.
Exercise1: A $1,000 investment grows to $1,200 after one year. At that point, another $1,000
is added and then at the end of second year it appreciates to $3,300. Compute:
a) Each year rate of return
b) Total rate of return and
c) Average annual rate of return
2.3.2. Measuring historical risk
Risk refers to the possibility that the actual outcome of the investment will differ from the
expected outcome. Put differently, risk refers to variability or dispersion. If an asset return has
no variability, it is riskless. Suppose you are analyzing the total return of an equity stock over
the period of time apart from knowing the mean return, you would also like to know about the
variability of in returns. The most commonly used measures of risk in finance are variance or

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its square root the standard deviation. The variance and standard deviation of historical return
series are defined as follows:
n
Ri−R−)2
δ2 = ∑ ( )
i=1 n−1

δ =√δ2
Where: δ2 = variance of return
δ = standard deviation of return
Ri = Return from the stock in period i (=1,…., n)
R− = Arithmetic return
n = number of period
Example 3: Consider returns from the stock over a six years period.R1 = 15%, R2 =12%, R3
= 20%, R4= -10% R5 =14%and R6 =9%. Calculate the variance and standard deviation of
return.
Solution:
Period Return Ri Deviation (Ri-R− Square of deviation (Ri-
) R− )2
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
∑ni=1 Ri =60 ∑ni=1 Ri (Ri- R− )2 = 546
R− = 10
n
Ri−R−)2
δ2 = ∑ ( ) =109.2
i=1 n−1

n 6
Ri−R−)2 536
δ=∑ ( ) 1/2 =∑ (6−1) 1/2 =10.4
i=1 n−1 i=1

2.4. Measuring expected (ex ante) return and risk

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Expected rate of return: Investors estimate future rate of return based on historical return and
by assigning probability to each year rate of return. The expected rate of return is the weighted
average of all possible returns multiplied by their respective probabilities. In symbols,
E(R) = ∑ni=1 RiPi
Where: E(R) = expected return
Ri = return from the stock at year i
Pi = probability of return at year i
n = number of possible year
Expected risk: Risk refers to the dispersion of a variable. It is commonly measured by the
variance or the standard deviation. The variance of the probability distribution is the sum of
the squares of the deviations of the actual returns from the expected return, weighed by the
associated probabilities. In symbols,
σ2 = ∑ Pi (Ri –E(R))2
Where: σ2 =variance
Ri =return for the ith possible outcome
Pi =probability associated with the ith possible outcome
E(R) = expected return
Since variance is expressed as squared returns, it is some what difficult to grasp. So its square
root, the standard deviation, is employed as an equivalent measure.
σ = (σ2)1/2 Where: σ = standard deviation
Example 4: The table below provides a probability distribution for the returns on stocks A and
B. compute expected return and expected risk by using variance and standard deviation.

Year Probability Return on Stock A Return on Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

4 20% 20% -10%

Solution: Expected return for stock A and B calculated as follows:

• E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%
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• E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%,
Based on expected return stock B will perform well than stock A, so investment manager select
and invest on stock B to get future better return.
Variance and Standard deviation on Stocks A and B:
Stock A =>

Stock B =>

Based on expected risk, investor may select the second stock to minimize risk. Generally, the
above result shows that as return increase risk also increase and investors select security
based on their risk tolerance.
Exercise 2: The Probability distributions of rate of return on Bharat foods stocks and oriental
shipping stocks and rate of return is given on table below. Compute expected rate of return and
risk (variance and standard deviation) on Bharat foods stocks and oriental shipping stocks.
Which asset is best based on return and risk?
State of the prob. Of Bharat foods Rate of Oriental shipping Rate of
economy occurrence return (%) return (%)
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 -20
2.5. Management of Risk: Derivatives and hedging
Risk management is means of minimizing or avoiding risk by employing different tools of risk
management. Those tools of risk management are diversification, derivatives and hedging.
Diversification: is means of reducing security risk simply by holding combination of securities
which have correlation among each other. The process of spreading an investment across assets
is called diversification. Spreading an investment across number of assets will eliminate
unsystematic risk, but not all of the risk. Constructing a Portfolio in such a way reduces
portfolio risk without sacrificing return. Diversification strategy should take into account the
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degree of co-variance or correlation between assets return in a portfolio. The co-variance or
correlation of asset returns is the measure of the degree to which the returns two assets vary or
change together. Combine securities in a portfolio with returns that are less than perfectly
positively correlated lower portfolio risk without sacrificing return. Diversification is
impossible to unrelated securities/assets/.
Derivatives: Derivatives are those assets whose value is determined from the value of some
underlying assets. The underlying asset may be equity, commodity or currency. The
derivatives are most modern financial instruments in hedging risk. The individuals and firms
who wish to avoid or reduce risk can deal with the others who are willing to accept the risk for
a price. A common place where such transactions take place is called the ‘derivative market’.
As the financial products commonly traded in the derivatives market themselves are not
primary loans or securities but can be used to change the risk characteristics of underlying asset
or liability position, they are referred to as ‘derivative financial instruments’ or simply
‘derivatives’. These instruments are so called because they derive their value from some
underlying instrument and have no intrinsic value of their own.
Types of Derivatives
A. Forwards,
B. Futures,
C. Options,
D. Swaps
A. Forward contract: A forward contract is an agreement made today between a buyer and
seller to exchange the commodity or instrument for cash at a predetermined future date at a
price agreed upon today. The agreed upon price is called the ‘forward price’ with a forward
market the transfer of ownership occurs on the spot, but delivery of the commodity or
instrument does not occur until some future date.
In a forward contract, two parties agree to do a trade at some future date, at a stated price and
quantity. No money changes hands at the time the deal is signed. For example, a wheat farmer
may wish to contract to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such transaction would take place through a forward market.

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Forward contracts are not traded on an exchange they are said to trade over the counter (OTC).
The quantities of the underlying asset and terms of contract are fully negotiable. The secondary
markets do not exist for the forward contracts and faces the problems of liquidity and
negotiability.
Problems in Forward Contracting
• Lack of centralization of trading
• Illiquidity
• Counter party risk.
Forward markets have one basic property; the larger the time period over which the forward
contract is open, the larger are the potential price movements, and hence the larger is the
counterparty risk. Even when forward markets trade standardized contracts, and hence avoid
the problem of illiquidity, the counterparty risk remains a very real problem.
B. Futures contract: A futures contract is a financial security, issued by an organized exchange
to buy or sell a commodity, security or currency at a predetermined future date at a price agreed
upon today for future delivery at an agreed price. It is standardized contract, subject to the rules
and regulations of the exchange.
It is the standardization of the futures contract facilitates the secondary market trading. The
futures contract relates to a given quantity of the underlying asset and only whole contracts can
be traded and trading of fractional contracts is not allowed in futures contracting. A futures
contract provides both a right and an obligation to buy or sell a standard amount of a
commodity, security or currency on a specified future date at a price agreed when the contract
is entered.
The important features of futures contract is given below:
a. Standardization - Each futures contract is for a standard specified quantity, grade, coupon
rate, maturity etc. The standardization of contracts fetches the potential buyers and sellers
and increases the marketability and liquidity of the contracts.
b. Clearing House - An organization called ‘futures exchange’ will act as a clearing house. In
futures contract, the obligation of the buyer and the seller is not to each other but to the
clearing house in fulfilling the contract which ensure the elimination of the default risk on
any transaction.

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c. Margins - Since the clearing house undertakes the default risk, to protect itself from this
risk, the clearing house requires the participants to keep margin money, normally ranging
from 5% to 10% of the face value of the contract.
d. Time spreads - There is a relationship between the spot price and the futures price of
contract. The relationship also exists between prices of futures contracts which are on the
same commodity or instrument but which have different expiry dates. The differences
between the prices of two contracts is known as the ‘time spread’ is the basis of futures
market.
C. Option: An option is a contractual agreement that gives the option buyer the right, but not
the obligation, to purchase or to sell a specified instrument at a specified price at any time of
the option buyer's choosing by or before a fixed date in the future. Upon exercise of the right
by the option holder, an option seller is obliged to deliver the specified instrument at the
specified price.
Call Option: A call option give the buyer the right but not the obligation to buy a given quantity
of the underlying asset, a given price known as 'exercise price' or 'strike price' on or before a
given future date called the 'maturity date' or 'expiry date'. A call option gives the buyer the
right to buy a fixed number of shares / commodities in a particular security at the exercise price
upon the date of expiration of the contract. The seller of an option is known as 'writer'. Unlike
the buyer, the writer has no choice regarding the fulfillment of the obligations under the
contract. If the buyer wants to exercise his right, the writer must comply. For this asymmetry
of privilege, the buyer must pay the writer the option price, which is known as 'premium'.
Buying a Call: The buyer of a call option pays the premium in return for the right to buy the
underlying asset at the exercise price `C'. If at the expiry date of the option, the underlying
asset price is above the exercise price, the buyer will exercise the option, pay the exercise price
and receives the asset. This may then be sold in the market at spot price and makes profit.
Alternatively, the option may be sold immediately prior to expiry to realize a similar profit
because at expiry, its value must be equal to the difference between the exercise price and the
market price of the underlying asset. If the asset price is below the exercise price, the option
will be abandoned by the buyer and his loss will be equal to the premium paid on the purchase
of call option.

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Writing a Call: The call option writer receives the premium as consideration for bearing the
risk of having to deliver the underlying asset is return for being paid the exercise price. If at
the expiry, the asset price is above the exercise price, the writer will incur loss because he will
have to buy the asset at market price in order to deliver it to the option buyer in exchange for
the lower exercise price. If the asset price is below the exercise price, the call option will not
be exercised and the writer will make a profit equal to the option premium.
Put Option: The put option gives the buyer the right, but not the obligation, to sell a given
quantity of the underlying asset at a given price on or before a given date. The put option gives
the buyer the right to sell the underlying asset at the exercise price up to the date of the contract.
The seller of put option is known as `writer', has no choice regarding the fulfillment of the
obligations under the contract. If the buyer wants to exercise his put option, the writer must
purchase at exercise price. For this asymmetry of privilege, the buyer of put option must pay
the writer, the option price called as `premium'.
Buying a Put: The buyer of a put option pays the opinion premium to seller of the underlying
asset. If at expiry the asset price is below the exercise price, the buyer will exercise the option,
gives the asset and receive the exercise price. If the asset price is at or above the exercise price,
the put option will be abandoned and the buyer will incur a loss equal to the option premium.
Writing a Put: The put writer receives the premium for bearing the risk of having to take the
underlying asset at the exercise price. If the market price of asset is below the exercise price at
expiry, the writer will incur a loss because writer will have to pay the exercise price but will
only be able to resell the asset at the lower market price. If the asset is above the exercise price
at expiry, the buyer will abandon the put option and the writer will make a profit equal to the
option premium received.
D. Swaps: A swap can be defined as the exchange of one stream of future cash flow with
another stream of cash flows with different characteristics. A swap is an agreement between
two or more people / parties to exchange sets of cash flows over a period in future. E.g
Currency Swaps are agreements where by currencies are exchanged at specified exchange rates
and specified intervals. The basic purpose of swaps is to lock in the rate. Interest rate Swaps is
an agreement where by one party exchange one set of interest rate payments for another. Most

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common arrangement is an exchange of fixed interest rate payment for another rate over a time
period.

Hedging
Hedging is the use of the contracts to reduce risk. Risk can arise from either taking demanding
or supplying a commodity at some time in the future. The current price is known but the price
at the time of demand or supply will not be known. A strategy of hedging can be used to guard
against unfavorable movements in the product price. It is means of eliminating or reducing
risk, especially foreign exchange rate risk that result from fluctuation of exchange rate, that
result on multinational company and international trade.
PORTFOLIO MANAGEMENT
An Overview of Portfolio Theory
Portfolio is group of securities held by an individual or institutional investor, which may
contain a variety of common and preferred stocks, corporate and municipal bonds, certificates
of deposit, and treasury bills-that is, appropriate selections from the equity, capital, and money
markets. It was introduced by Harry Markowitz around 1952 by adopting modern portfolio
theory from traditional saying ‘don’t put all your eggs in one basket’. The logic is that an
investor who puts all of their funds into one investment risks everything on the performance
of that individual investment. A wiser policy would be to spread the funds over several
investments (establish a portfolio) so that the unexpected losses from one investment may be
offset to some extent by the unexpected gains from another. Thus the key motivation in
establishing a portfolio is the reduction of risk.
Portfolio is selecting combination of security that maximizes return and minimizing risk
depend up on: -
• Investors preference
• Investors objective
• Investors capacity, knowledge, and potential saving
Elements of Portfolio Management

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The basic objective of portfolio management is to maximize yield and minimize risk. To meet
this objective investment manager should consider the following elements of investment
management:
Safety of the investment: The first important objective of a portfolio, no matter who owns it,
is to ensure that the investment is absolutely safe. Other considerations like income, growth,
etc., only come into the picture after the safety of your investment is ensured.
Stable Current Return: Once investment safety is guaranteed, the portfolio should yield a
steady current income. The current returns should at least match the opportunity cost of the
funds of the investor. What we are referring to here current income by way of interest of
dividends, not capital gains.
Appreciation in the value of capital: A good portfolio should appreciate in value in order to
protect the investor from any erosion in purchasing power due to inflation. In other words, a
balanced portfolio must consist of certain investments, which tend to appreciate in real value
after adjusting for inflation.
Marketability: A good portfolio consists of investment, which can be marketed without
difficulty. If there are too many unlisted or inactive shares in your portfolio, you will face
problems in encasing them, and switching from one investment to another. It is desirable to
invest in companies listed on major stock exchanges, which are actively traded.
Liquidity: The portfolio should ensure that there are enough funds available at short notice to
take care of the investor’s liquidity requirements. It is desirable to keep a line of credit from a
bank for use in case it becomes necessary to participate in right issues, or for any other personal
needs.
Minimizing Tax liability: Since taxation is an important variable in total planning, a good
portfolio should enable its owner to enjoy a favorable tax shelter. The portfolio should be
developed considering not only income tax, but capital gains tax, and gift tax, as well. What a
good portfolio aims at is tax planning, not tax evasion or tax avoidance
3.3. Portfolio Returns and Risk
Portfolio return: The expected rate of return on a portfolio is the weighted average of the
expected rate of return on assets comprising the portfolio. Two determinants of portfolio return

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is expected rate of return on each asset/ security and relative share of each asset/ security in
the portfolio (portfolio weight). This can be expressed as follows:

Where:
• E[Rp] = the expected return on the portfolio,
• N = the number of stocks in the portfolio,
• wi = the proportion of the portfolio invested in stock i, and
• E[Ri] = the expected return on stock i.
For a portfolio consisting of two assets, the above equation can be expressed as

Example 3.1: A portfolio which value $2000 consist $1000 of stock A and $1000 stock B with
expected return of 20% and 10%, respectively.
a) Calculate portfolio return
b) Assume weight of stock A and B is 75% and 25%, respectively compute is portfolio
return.

Solution: a)
E(Rp)= 0.5(0.2)+ 0.5(0.1)= 0.1+0.05= 0.15= 15%
b) E(Rp)= 0.75(0.2)+ 0.25(0.1)= 0.15+0.025= 0.175= 17.5%
Portfolio risk: Portfolio variance is not the weighted average of variance of returns on
individual assets in the portfolio. The variance/standard deviation of a portfolio reflects not
only the variance/standard deviation of the stocks that make up the portfolio but also how the
returns on the stocks which comprise the portfolio vary together. Two measures of how the
returns on a pair of stocks vary together are the covariance and the correlation coefficient.
Covariance of Return: Covariance is a measure of the degree to which two return “move
together” relative to their individual mean values over time. In portfolio analysis, we usually
are concerned with the covariance of rates of return rather than prices or some other variable.
• A positive covariance means that the rates of return for two investments tend to move
in the same direction relative to their individual means during the same time period.
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• A negative covariance indicates that the rates of return for two investments tend to
move in different directions relative to their means during specified time intervals over
time.
• A zero co-variance shows returns on two assets could not show any patter.
The magnitude of the covariance depends on the variances of the individual return series, as
well as on the relationship between the series. For two assets, i and j, the covariance of rates
of return is defined as:
𝑛
Covij = ∑𝑖=1 Pi{[𝑅𝑖 – 𝐸(𝑅𝑖)][𝑅𝑗 – 𝐸(𝑅𝑗)]}
Where:
Covij = the covariance between the returns on stocks i and j,
N = the number of years,
pi = the probability of year i,
Ri = the return on stock i in year 1,
E[Ri] = the expected return on stock i,
Rj = the return on stock j in year i, and
E[Rj] = the expected return on stock j.
Correlation coefficient: It is a statistical tool that measures the linear relationship between two
security return. The correlation could be positive, Negative or Zero. The correlation coefficient
always ranges between -1 and +1.
A value of +1 would indicate a perfect positive linear relationship between Ri and Rj, meaning
the returns for the two stocks move together in a completely linear manner. A value of –1
indicates a perfect negative relationship between the two return series such that when one
stock’s rate of return is above its mean, the other stock’s rate of return will be below its mean
by the comparable amount. A value of zero would mean that the returns had no linear
relationship, that is, they were uncorrelated statistically or move randomly. That does not mean
that they are independent. The value of rij = 0.108 is quite low. This relatively low correlation
is not unusual for stocks in diverse industries.
For two assets, i and j, the coefficient of correlation of rates of return is defined as:

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Where:

Correlation vs. Covariance: Basically, Correlation is better than covariance because correlation
removes the effect of the variance of the variables; it provides a standardized, absolute measure
of the strength of the relationship, bounded by -1.0 and 1.0. This is good because it makes it
possible to compare any correlation to any other correlation and see which is stronger. You
cannot do this with covariance.
The squared correlation (r2) is a measure of how much of the variance in one variable is
explained by the other variable. This measure, the coefficient of determination, ranges from
0.0 to 1.0. You cannot do this with covariance.
Using either the correlation coefficient or the covariance, the Variance on a Two-Asset
Portfolio can be calculated as follows:
2 2
w w 2w1w2covij
2 2
Or, w w 2w1w2 rij, if we use correlation coefficient. For
more than two securities portfolio variance computed as follow:

3.4. Portfolio Construction

Portfolio construction refers to the allocation of funds among a variety of financial assets open
for investment. It refers to allocation of total investable funds among a wide variety of financial
instruments or assets. Portfolio theory concerns itself with the principles governing such
allocation to construct optimal portfolio.
The optimal portfolio concept falls under the modern portfolio theory. The theory assumes
(among other things) that investors fanatically try to minimize risk while striving for the
highest return possible. The theory states that investors will act rationally, always making
decisions aimed at maximizing their return for their acceptable level of risk.
The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that it is possible
for different portfolios to have varying levels of risk and return. Each investor must decide
how much risk they can handle and than allocate (or diversify) their portfolio according to this
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decision.

The chart below illustrates how the optimal portfolio works. The optimal-risk portfolio is
usually determined to be somewhere in the middle of the curve because as you go higher up
the curve, you take on proportionately more risk for a lower incremental return. On the other
end, low risk/low return portfolios are pointless because you can achieve a similar return by
investing in risk-free assets, like government securities.

3.5. Asset Pricing Model

The single Index Model
The basis of the model is the specification of a process for generating asset returns. This
process relates the returns on all the assets that are available to a single underlying variable.
This ties together the returns on different assets and by doing so simplifies the calculation of
covariances. The single variable can be thought of for now as a summary of financial
conditions.
Let there be N assets, indexed by i = 1, ...,N. The single index model assumes that the return
on asset i can be written as:
𝑟𝑖 = α𝑖𝐼 + 𝛽′𝑟𝐼 + εiI
Where:
ri is the return on asset
i and rI is the return on an index. α iI and 𝛽 'iI are constants and εiI is a random error term.
What this model is saying is that the returns on all assets can be linearly related to a single
common influence and that this influence is summarized by the return on an index.

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Furthermore, the return on the asset is not completely determined by the index so that there is
some residual variation unexplained by the index - the random error. As will be shown, if this
process for the generation of returns applies, then the calculation of portfolio variance is much
simplified.
Before proceeding to describe the further assumptions that are made, some discussion of what
is meant by the index will be helpful. The index can be an aggregate of assets such as a portfolio
of stocks for all the firms in an industry or sector. Frequently the index is taken to be the market
as a whole. When it is, the single index model is usually called the market model and rI is the
return on the market portfolio. As will be shown later the market model has additional
implications (concerning the average value of 'iI across the assets) beyond those of the general
single-index model.
The single-index model is completed by adding to the specification in (6.3) three assumptions
on the structure of the errors, (iI :
1. The expected error is zero: E [(iI ] = 0, i = 1, ...,N;
2. The error and the return on the index are uncorrelated: E [(iI (rI − ¯rI )] =0, i = 1, ...,N;
3. The errors are uncorrelated between assets: E [(iI(jI ] = 0, i = 1, ...,N, j = 1, ...,N, i _= j.
The first assumption ensures that there is no general tendency for the model to over- or under-
predict the return on the asset. The second ensures that the errors random and unexplained by
the return on the index the third assumption requires that there is no other influence that
systematically affects the assets.
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM) formulated by William Sharpe, John Lintner, and Jan
Mossin.
The CAPM is an equilibrium asset pricing model derived from a set of assumptions. Here we
demonstrate how the CAPM is derived. The CAPM is an abstraction of the real world capital
markets and, as such, is based upon some assumptions. These assumptions simplify matters a
great deal, and some of them may even seem unrealistic. However, these assumptions make
the CAPM more tractable from a mathematical standpoint. The CAPM assumptions are as
follows:
CAPM ASSUMPTIONS

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➢ Assumption 1. Investors make investment decisions based on the expected return and
variance of returns.
➢ Assumption 2. Investors are rational and risk averse.
➢ Assumption 3. Investors subscribe to the Markowitz method of portfolio
diversification.
➢ Assumption 4. Investors all invest for the same period of time.
➢ Assumption 5. Investors have the same expectations about the expected return and
variance of all assets.
➢ Assumption 6. There is a risk-free asset and investors can borrow and lend any amount
at the risk-free rate.
➢ Assumption 7. Capital markets are completely competitive and frictionless.
NB: The first five assumptions deal with the way investors make decisions. The last two
assumptions relate to characteristics of the capital market. We discuss later in this chapter each
assumption.
Because investors are risk averse, they will choose to hold a portfolio of securities to take
advantage of the benefits of Diversification. Therefore, when they are deciding whether or not
to invest in a particular stock, they want to know how the stock will contribute to the risk and
expected return of their portfolios.
The standard deviation of an individual stock does not indicate how that stock will contribute
to the risk and return of a diversified portfolio. Thus, another measure of risk is needed; a
measure of a security's systematic risk. This measure is provided by the Capital Asset Pricing
Model (CAPM).

Systematic and Unsystematic Risk

An asset's total risk consists of both systematic and unsystematic risk.

Systematic risk, which is also called market risk or undiversifiable risk, is the portion of an
asset's risk that cannot be eliminated via diversification. The systematic risk indicates how
including a particular asset in a diversified portfolio will contribute to the riskiness of the
portfolio

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Unsystematic risk, which is also called firm-specific or diversifiable risk, is the portion of an
asset's total risk that can be eliminated by including the security as part of a diversifiable
portfolio.

The Capital Asset Pricing Model (CAPM) provides an expression which relates the expected
return on an asset to its systematic risk. The relationship is known as the Security Market Line
(SML) equation and the measure of systematic risk in the CAPM is called Beta.
The Security Market Line (SML)
The SML equation is expressed as follows:

Where:
• E[Ri] = the expected return on asset i,
• Rf = the risk-free rate,
• E[Rm] = the expected return on the market portfolio,
• bi = the Beta on asset i, and
• E[Rm] - Rf = the market risk premium.
The graph below depicts the SML. Note that the slope of the SML is equal to (E[R m] - Rf)
which is the market risk premium and that the SML intercepts the y-axis at the risk-free rate.

In capital market equilibrium, the required return on an asset must equal its expected return.
Thus, the SML equation can also be used to determine an asset's required return given its Beta.
The Beta (Bi)
The beta for a stock is defined as follows:
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Where:
• sim = the Covariance between the returns on asset i and the market portfolio and
• s2m = the Variance of the market portfolio.
Note that, by definition, the beta of the market portfolio equals 1 and the beta of the risk-free
asset equals 0.
An asset's systematic risk, therefore, depends upon its covariance with the market portfolio.
The market portfolio is the most diversified portfolio possible as it consists of every asset in
the economy held according to its market portfolio weight.

Example Problems

1. Find the expected return on a stock given that the risk-free rate is 6%, the expected return on
the market portfolio is 12%, and the beta of the stock is 2.

2. Find the beta on a stock given that its expected return is 16%, the risk-free rate is 4%, and the
expected return on the market portfolio is 12%.

Critical assumptions of CAPM

The CAPM is simple and elegant. Consider the many assumptions that underlie the model. Are
they valid?
➢ Zero transaction costs. The CAPM assumes trading is costless so investments are priced
to all fall on the capital market line. If not, some investments would hover below and
above the line -- with transaction costs discouraging obvious swaps. But we know that
many investments (such as acquiring a small business) involve significant transaction
costs. Perhaps the capital market line is really a band whose width reflects trading costs.
➢ Zero taxes. The CAPM assumes investment trading is tax-free and returns are
unaffected by taxes. Yet we know this to be false: (1) many investment transactions are

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subject to capital gains taxes, thus adding transaction costs; (2) taxes reduce expected
returns for many investors, thus affecting their pricing of investments; (3) different
returns (dividends versus capital gains, taxable versus tax-deferred) are taxed
differently, thus inducing investors to choose portfolios with tax-favored assets; (4)
different investors (individuals versus pension plans) are taxed differently, thus leading
to different pricing of the same assets.
➢ Homogeneous investor expectations. The CAPM assumes investors have the same
beliefs about expected returns and risks of available investments. But we know that
there is massive trading of stocks and bonds by investors with different expectations.
We also know that investors have different risk preferences. Again, it may be that the
capital market line is a fuzzy amalgamation of many different investors' capital market
lines.
➢ Available risk-free assets. The CAPM assumes the existence of zero-risk securities, of
various maturities and sufficient quantities to allow for portfolio risk adjustments. But
we know even Treasury bills have various risks: reinvestment risk --investors may have
investment horizons beyond the T-bill maturity date; inflation risk --fixed returns may
be devalued by future inflation; currency risk -- the purchasing power of fixed returns
may diminish compared to that of other currencies. (Even if investors could sell assets
short -- by selling an asset she does not own, and buying it back later, thus profiting
from price declines -- this method of reducing portfolio risk has costs and assumes
unlimited short-selling ability.)
➢ Borrowing at risk-free rates. The CAPM assumes investors can borrow money at risk-
free rates to increase the proportion of risky assets in their portfolio. We know this is
not true for smaller, non-institutional investors. In fact, we would predict that the
capital market line should become kinked downward for riskier portfolios (ß > 1) to
reflect the higher cost of risk-free borrowing compared to risk-free lending.
➢ Beta as full measure of risk. The CAPM assumes that risk is measured by the volatility
(standard deviation) of an asset's systematic risk, relative to the volatility (standard
deviation) of the market as a whole. But we know that investors face other risks:
inflation risk -- returns may be devalued by future inflation; and liquidity risk --

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investors in need of funds or wishing to change their portfolio's risk profile may be
unable to readily sell at current market prices. Moreover, standard deviation does not
measures risk when returns are not evenly distributed around the mean (non-bell curve).
This uneven distribution describes our stock markets where winning companies, like
Dell and Walmart, have positive returns (35,000% over ten years) that greatly exceed
losing companies' negative returns (which are capped at a 100% loss).

Risk and Return Equations summary

Expected Return:

Variance:

Standard Deviation:

Covariance:

Correlation Coefficient:

Portfolio Expected Return:

Two-Asset Portfolio Variance:

Security Market Line (SML):

Beta:

Arbitrage Pricing Theory

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The capital asset pricing theory begins with an analysis of how investors construct efficient
portfolios. Stephen Ross’s arbitrage pricing theory, or APT, comes from a different family
entirely. It does not ask which portfolios are efficient. Instead, it starts by assuming that each
stock’s return depends partly on pervasive macroeconomic influences or “factors” and partly
on “noise” events that are unique to that company.
The theory doesn’t say what the factors are: There could be an oil price factor, an interest-rate
factor, and so on. The return on the market portfolio might serve as one factor, but then again
it might not.
For any individual stock there are two sources of risk. First is the risk that stems from the
pervasive macroeconomic factors which cannot be eliminated by diversification. Second is the
risk arising from possible events that are unique to the company. Diversification does eliminate
unique risk, and diversified investors can therefore ignore it when deciding whether to buy or
sell a stock. The expected risk premium on a stock is affected by factor or macroeconomic risk;
it is not affected by unique risk. Arbitrage pricing theory states that the expected risk premium
on a stock should depend on the expected risk premium associated with each factor and the
stock’s sensitivity to each of the factors (b1, b2, b3, etc.).
Arbitrage pricing theory will provide a good handle on expected returns only if we can (1)
identify a reasonably short list of macroeconomic factors, (2) measure the expected risk
premium on each of these factors, and (3) measure the sensitivity of each stock to these factors.
Although APT doesn’t tell us what the underlying economic factors are, Elton, Gruber, and
Mei identified five principal factors that could affect either the cash flows themselves or the
rate at which they are discounted. These factors are: Yield spread (the difference between two
different yields, or rates), Interest rate, Exchange rate, Real GNP (real GNP - a version of the
GNP that has been adjusted for the effects of inflation. GNP is the total market value of goods
and services produced by all citizens and capital during a given period), and Inflation. To
capture any remaining pervasive influences, Elton, Gruber, and Mei also included a sixth
factor, the portion of the market return that could not be explained by the first five.

APT states that the risk premium for any asset depends on its sensitivities to factor risks (b)
and the expected risk premium for each factor (rfactor - rf). In this case there are six factors, so

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= b1(rfactor 1 – rf) 2 + b2(rfactor2 - rf ) + b3(rfactor3 - rf ) … b6(rfactor6 - rf )
Expected return = risk-free interest rate + expected risk premium
A Comparison of the Capital Asset Pricing Model and Arbitrage Pricing Theory:
Like the capital asset pricing model, arbitrage pricing theory stresses that expected return
depends on the risk stemming from economy wide influences and is not affected by unique
risk. You can think of the factors in arbitrage pricing as representing special portfolios of stocks
that tend to be subject to a common influence.
If the expected risk premium on each of these portfolios is proportional to the portfolio’s
market beta, then the arbitrage pricing theory and the capital asset pricing model will give the
same answer. In any other case they won’t.
CAPM assumes only one source of risk (variance) while multifactor models don't. CAPM
holds that the one factor affecting returns is the market. Obviously, multifactor models allow
for more than one factor, but not necessarily the market. Arbitrage pricing theory doesn’t tell
us what the underlying factors are—unlike the capital asset pricing model, which collapses all
macroeconomic risks into a well-defined single factor, the return on the market portfolio.
The Three-Factor Model
A factor model that expands on the capital asset pricing model (CAPM) by adding size and
value factors in addition to the market risk factor in CAPM. It was introduced by Fama and
French. The three factors and there measures are given below in the following table:
Factor Measured by

Market factor Return on market index minus risk-free interest rate

Size factor Return on small-firm stocks less return on large-firm stocks
Book-to-market Return on high book-to-market-ratio stocks less return on low book-
factor to-market-ratio stocks
Thus, expected risk premium would be:
r - rf = bmarket (rmarket factor) + bsize (rsize factor) + bbook-to-market (rbook-to-market factor)
Expected return = risk-free interest rate + expected risk premium

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CHAPTER FIVE: COST OF CAPITAL
INTRODUCTION
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
❖ Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.
❖ Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of overall wealth of the
shareholders.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating
and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.
IMPORTANCE/SIGNIFICANCE/ OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to decide
the capital structure of the business concern.
❖ Importance to Capital Budgeting Decision
❖ Importance to Structure Decision
❖ Importance to Evaluation of Financial Performance
❖ Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. Hence, it plays a major part in the financial
management.
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:

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1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Specific Cost of Capital
It refers to the cost of each specific sources of finance like:
1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings

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Two important points you should bear in mind about the specific cost of capital. These are:
1. One is that it is computed on an after-tax basis. Meaning, if there would be any tax
implication on the individual source of capital, it should be considered. In almost all
circumstances, the tax implication is only on debt sources of finance.
2. The second point is that the specific cost of capital is expressed as an annual percentage or
rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birr.
1. The cost of debt
The cost of long-term debt, kd, is the after-tax cost today of raising long-term funds through
borrowing. For convenience, we typically assume that the funds are raised through the sale of
bonds.
❖ This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt.
❖ Generally, debt is the cheapest source of finance to a firm and, hence, the cost of debt is the
lowest specific cost of capital. There are two basic explanations for this:
✓ First, debt suppliers, generally, assume the lowest risk among all suppliers of capital. They
receive interest payments before preferred and common dividends are paid. Since they
assume the smallest risk, their return is the lowest. Their lowest return would be the lowest
cost of capital to the firm.
✓ Second, raising capital through debt sources entails interest expense. The interest expense
in turn reduces the firm’s income which ultimately would cause tax payment to be
reduced. So raising money in the form of debt results in the smallest tax burden, and
finally, the firm’s cost of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans.
Computing the cost of new bond issue/sale involves three steps:
i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = the net proceeds from the sale of each bond
Pd = the market price of the bond
f = Flotation costs

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ii) Compute the effective before tax cost of the bond using the following approximation formula:
Pn − NPd
I+
n
Pn + NPd
Kd = 2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = the par value of the bond
n = Length of the holding period of the bond in years.

iii) Compute the after-tax cost of debt

Kdt = Kd (1 – t)
Where:
Kdt = the after-tax cost of debt
t = the marginal tax rate
Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be incurred
in the process of issuing the bonds. The firm’s marginal tax rate is 40%.

Required: Calculate the after tax cost of Abyssinia’s new bond issue:
Solution:
Given:Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt =?
Then apply the three steps: i) NPd = Br. 1,010 – Br. 30 = Br. 980 ii) Kd =
Br.1,000 − Br.980
Br.120 +
15 = 12.26%
Br.1,000 + Br.980
2
iii) Kdt = 12.26% (1 – 40%) = 7.36%

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Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.
Class work
Ayenew Company’s financing plans for next year include the sale of long-term bonds with a 10%
coupon. The company believes it can sell the bonds at a price that will provide a yield to maturity
of 12% to investors. If its marginal tax rate is 35%, what is Ayenew’s after-tax cost of debt?
2. The cost of preferred stock
Preferred stock represents a special type of ownership interest in the firm. It gives preferred
stockholders the right to receive their stated dividends before any earnings can be distributed to
common stockholders. Because preferred stock is a form of ownership, the proceeds from its sale
are expected to be held for an infinite period of time.
❖ The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy
the required rate of return of the firm’s preferred stock investors.
❖ It is also the minimum rate of return a firm’s preferred stock investors require if they are
to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed amount of
dividends to the preferred stockholders. So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.
The cost of a new preferred stock issue can be computed by following two steps:
i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__
NPp

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Where:
Kps = the cost of preferred stock
DPs = the pre share annual dividend on the preferred stock

Example: Sefa Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition, flotation
costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.

Solution: Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50; Kps
=?
Then apply the two steps: i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50
ii) Kps = Br. 12 =12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment financed
by the new preferred stock issue. Otherwise, the firm’s value will decrease.
Class work
Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share. The issue
is expected to pay quarterly dividends of Br. 1.25 per share and to have flotation costs of 6% of
the par value. The preferred stock sells at 95% of its par. Required: Calculate the cost of preferred
stock to Satellite Share Company.
3. The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm.
➢ The cost of common stock is the cost of raising one more dollar of common equity capital,
either internally (from earnings retained in the firm) or externally (by issuing new shares
of common stock).
➢ The cost of issuing common stock is difficult to estimate because of the nature of the cash
flow streams to common shareholders.
➢ The dividend stream is not fixed, as in the case of fixed-rate preferred stock.
➢ The change in the price of shares is also difficult to estimate

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➢ Nevertheless, two methods are commonly used to estimate the cost of common stock:
✓ the dividend valuation model (DVM) and
✓ the capital asset pricing model(CAPM). Each method relies on different
assumptions regarding the cost of equity; each produces different estimates of the
cost of common equity.
1. Cost of Common Stock Using the Dividend Valuation Mode
The DVM states that the price of a share of stock is the present value of all its future cash dividends,
where the future dividends are discounted at the required rate of return on equity, r.
If these dividends are constant forever (similar to the dividends of perpetual preferred stock, as we
just covered), the cost of common stock is derived from the value of perpetuity.
➢ Let D represent the constant dividend per share of common stock that is expected next
period and each period after that forever; P0, the current price of a share of stock; and re,
the cost of common stock. The current price of a share of common stock is:

P0= D
Re We can solve for re: re= D
P0

However, C/S dividends do not usually remain constant. It’s typical for dividends to grow at a
constant rate.

If we refer to the next period’s dividend, D1, as this period’s dividend, D0, compounded one period
at the rate g,

Cost of common stock = Dividend yield + Growth rate of dividends

Example:1

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Consider a firm expected to pay a constant dividend of br.2 per share per year, forever. If the firm
issues stock at br.20 a share. Required: compute the firm’s cost of common stock is:
re= br.2
br.20 = 0.10 or 10% per year
But, if dividends are expected to be br.2 in the next period and grow at a rate of 3% per year, and
the required rate of return is 10% per year, the expected price per share (with D1 = br.2 and g =
3%) is:
P0 = br.2
0.10 – 0.03
= br. 28.57 which is more than br.8 above the price if there is no expected growth in
dividends.
Example 2: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock issue.
Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:

i) NPo = Br. 20 – Br. 1 = Br. 19

ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new common stock issue.

Class work
Repentance Corporation’s share of common stock is currently selling at Br. 75. The firm’s
projected dividend per share during the next year is Br. 3.38 and the expected dividend growth rate
is 8%. Because of competitive nature of the market a Br. 3 per share underpricing is necessary. In
addition, the sale of new common stock involves underwriting fee of Br. 0.60 per share and other
flotation costs of Br. 0.90 per share.

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Required:Calculate the cost of common stock for Repentance Corporation
❖ The DVM reflects two ideas that make some sense about the relation between the cost of
equity and the dividend payments:
✓ The greater the current dividend yield, the greater the cost of equity.
✓ The greater the growth in dividends, the greater the cost of equity.
However, the DVM has some drawbacks:
How do you deal with dividends that do not grow at a constant rate? This model does not
accommodate non-constant growth easily.
What if the firm does not pay dividends now? In that case, D1 would be zero and the
expected price would be zero. But a zero price for stock does not make any sense! And if
dividends are expected in the future, but there are no current dividends, what do you do?
What if the growth rate of dividends is greater than the required rate of return? This implies
a negative stock price, which isn’t possible.
What if the stock price is not readily available, say in the case of a privately-held firm?
This would require an estimate of the share price.
Therefore, the DVM may be appropriate to use to determine the cost of equity for companies with
stable dividend policies, but it may not applicable for all firms.
2. Cost of Common Stock Using the Capital Asset Pricing Model
The investor’s required rate of return is compensation for both the time value of money and risk.
To figure out how much compensation there should be for risk, we first have to understand what
risk we are talking about.
❖ The capital asset pricing model (CAPM) assumes an investor holds a diversified
portfolio—a collection of investments whose returns do not move in the same direction nor
at the same time nor by the same amount. The result is that the only risk left in the portfolio
as a whole is the risk related to movements in the market as a whole—market risk.
❖ If we assume all shareholders’ hold diversified portfolios, the risk that is relevant in valuing
a particular investment is the market risk of that investment. The greater the market risk,
the greater the compensation— meaning a higher yield—for bearing this risk. And the
greater the yield, the lower the present value of the asset because expected future cash
flows are discounted at a higher rate that reflects the higher risk.

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❖ The cost of common stock is the sum of the investor’s compensation for the time value of
money and the investor’s compensation for the market risk of the stock:
Cost of common stock = Compensation for the time value of money +Compensation for market risk

❖ Let’s represent the compensation for the time value of money as the expected risk-free rate
of interest, rf. The risk-free rate of interest is the rate that is earned on an asset that has no
risk. If a particular common stock has market risk that is the same as the risk of the market
as a whole, then the compensation for that stock’s market risk is the marketrisk premium.
The market’s risk premium is the difference between the expected return on the market,
rm, and the expected risk-free rate, rf:
Market risk premium = rm– rf

❖ If the expected risk-free rate is 3% and the expected return on the market is 11%, the market
risk premium is 8%.
But if a particular common stock has market risk that is different from the risk of the market as a
whole, we need to adjust that stock’s market risk premium to reflect its different risk.
❖ Suppose the market risk premium is 8%. If a stock’s market risk is twice the whole market’s
risk, the stock’s premium for its market risk is 2 × 8%, or 16%. If a stock’s market risk is
half the risk of the market as a whole, the stock’s premium for market risk is 0.5 × 8%, or
4%. What we are doing here is fine tuning the compensation investors will need to accept
that stock’s market risk. We fine tune by starting with our benchmark of the risk of the
market as a whole and adjust it to reflect the market’s premium for the stock’s relative
market risk to come up with the stock’s premium.
❖ Let β represent the adjustment factor. Then the compensation for market risk is:
Compensation for market risk = B(rm– rf)

Because we know the compensation for the time value of money, rf, and now we know the
compensation for market risk, we see that the cost of common stock, re, is:
re = rf+ B(rm– rf)

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✓ The term (rm– rf) represents the risk premium required by investors for bearing the risk
of owning the market portfolio.
✓ The multiplier, β, fine tunes this market risk premium to compensate for the market
portfolio associated with the individual firm. β, commonly referred to as beta, is a measure
of the sensitivity of the returns on a particular security (or group of securities) to changes
in the returns on the market—a measure of market risk.
A common stock having a β greater than 1.0 has more risk than the average security in the market.
A common stock having a β less than 1.0 has less risk than the average security in the market.
➢ Suppose a firm’s stock has a β of 2.0. This means its market risk is twice the risk of the
average security in the market. If the expected riskfree rate of interest is 6% and the
expected return on the market is 10%, the cost of common stock, re, is: re= 0.06 + 2.0(0.10
– 0.06) = 0.14 or 14%
✓ In this example, the market risk premium is (10% – 6%) = 4%. A market risk premium of
4% means that if you own a portfolio with the same risk as the market as a whole (that is,
with a beta of 1.0), you would expect to receive a 10% return comprising: 6% to
compensate you for the price of time and 4% to compensate you for the price of market
risk.
✓ If you invest in a security with a β of 2.0, you would expect a return of 14% comprising:
6% to compensate you for the price of time and 2.0 times 4% = 8% to compensate you for
the price of that security’s particular risk.
The CAPM is based on two ideas that make sense: Investors are risk averse and they hold
diversified portfolios. But the CAPM is not without its drawbacks:
First, the estimates rely heavily on historical values returns on the stock and returns on the
market. These historical values may not be representative of the future, which is what we are
trying to gauge. Also, the sensitivity of a firm’s stock returns may change over time; for
example, when the firm changes its capital structure.
Second, if the firm’s stock is not publicly-traded, there are no data sources even for historical
values.

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4. The cost of Retained Earnings

As you know, dividends are paid out of a firm’s earnings. Their payment, madein cash to common
stockholders, reduces the firm’s retained earnings. Let’s say a firm needs common stock equity
financing of a certain amount; it has two choices relative to retained earnings:
➢ It can issue additional common stock in that amount and still pay dividends to stockholders
out of retained earnings. Or
➢ it can increase common stock equity by retaining the earnings (not paying the cash
dividends) in the needed amount. In a strict accounting sense, the retention of earnings
increases common stock equity in the same way that the sale of additional shares of
common stock does.
It is not necessary to adjust the cost of retained earnings for flotation costs, because by retaining
earnings, the firm “raises” equity capital without incurring these costs.
❖ Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends.
❖ Retained earnings are not securities like stocks and bonds and hence do not have market
price that can be used to compute costs of capital.
❖ The cost of retained earnings is the rate of return a corporation’s common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate earned
on the outstanding common stock. Therefore, the specific cost of capital of retained
earnings is equated with the specific cost of common stock. However, flotation costs are
not involved in the case of retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the following
formula:
Kr = D1 + g
Po
Where:
Kr = the cost of retained earnings D1 = the expected dividends payment at the end of
next year

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Po = the current market price of the firm’s common stock g = the expected annual
dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing Company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is involved
to sale a share of common stock.
Required: Compute the cost of retained earnings
Solution: Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula: Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
Class work: Zequala Textiles Share Company wishes to measure its cost of retained earnings.
The firm’s stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend at the
end of the year. The expected dividend growth rate is 8%. Required: Determine the cost of retained
earnings.
Weighted average cost of capital (wacc)

❖ The firm’s capital structure is composed of debt, preferred stock, common stock, and
retained earnings. Each capital source accounts to some portion of the total finance. But
the percentage contribution of one source is usually different from another. So we must
compute the weighted average cost of capital rather than the simple average.
❖ The weighted average cost of capital (WACC) is the weighted average of the individual
costs of debt, preferred stock and common equity (common stock and retained earnings).
It is also called the composite cost of capital.
❖ The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
❖ If the weights of the component capital sources are all given, the weighted average cost of
capital can be computed as:
WACC = WdKdt + WpsKps + WceKs

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Where:
WACC = the weighted average cost of capital Wps = the weight of preferred stock
Wd = The weight of debt Wce = the weight of common equity
Kdt = the after – tax cost of debt Kps = the cost of preferred stock
Ks = the cost of common equity
❖ The WACC is found by weighting the cost of each specific type of capital by its proportion
in the firm’s capital structure. Weights of the individual capital sources can be calculated
based on their book value or market value.
To illustrate the computation of the WACC, look at the following example.
Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax
costs are shown in the following table for each source of capital.
Source of capital Book value Market value Specific cost
Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preferred stock 84,000 125,000 12.0
Common equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000

Required: Calculate the firm’s weighted average cost of capital using:

1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2.65% + 0.48% + 7.36%
= 10.49%

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The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000
Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80%
= 11.52% If the market value weights are used, Muna should accept all projects with a
minimum rate of return of 11.52%

CHAPTER SIX
CAPITAL BUDGETING
Introduction
In the last chapter, we discussed the cost of capital. Now we turn to investment decisions involving
fixed assets, or capital budgeting. Here the term capital refers to long-term assets used in
production, while a budget is a plan that details projected inflows and outflows during some future
period. Thus, the capital budget is an outline of planned investments in fixed assets, and capital
budgeting is the whole process of analyzing projects and deciding which ones to include in the
capital budget. An investment proposal should be judged in relation to whether or not it provides
a return equal to, or greater than, that required by investors.
Capital budgeting: The process of identifying, analyzing, and selecting investment projects whose
returns (cash flows) are expected to extend beyond one year.
Need and Importance of Capital Budgeting
A number of factors combine to make capital budgeting perhaps the most important function
financial managers and their staffs must perform. First, since the results of capital budgeting
decisions continue for many years, the firm loses some of its flexibility. For example, the
purchase of an asset with an economic life of 10 years “locks in” the firm for a 10-year period.
Further, because asset expansion is based on expected future sales, a decision to buy an asset that
is expected to last 10 years requires a 10-year sales forecast. Finally, a firm’s capital budgeting

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decisions define its strategic direction, because moves into new products, services, or markets must
be preceded by capital expenditures.
An erroneous forecast of asset requirements can have serious consequences. If the firm invests too
much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it
does not invest enough, two problems may arise. First, its equipment and computer software may
not be sufficiently modern to enable it to produce competitively. Second, if it has inadequate
capacity, it may lose market share to rival firms, and regaining lost customers requires heavy
selling expenses, price reductions, or product improvements, all of which are costly. The
importance of capital budgeting can be summarized as follows.
1. Huge investments: Capital budgeting requires huge investments of funds, but the available funds
are limited, therefore the firm before investing projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore
financial risks involved in the investment decision are more. If higher risks are involved, it needs
careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the
decision is taken for purchasing a permanent asset, it is very difficult to dispose off those assets
without involving huge losses.
4. Complexity: Investment decisions are among the firm’s most difficult decisions. They
are an assessment of future events which are difficult to predict. It is reality a complex problem
to correctly estimate the future cash flow of an investment. The uncertainty in cash flow is
caused by economic, political, social and technological forces.
Classifying Investment Projects
1. Classification According to Their Economic Life
An investment generally provides benefits over a limited period of time, referred to as its economic
life. The economic life is an estimate of the length of time that the asset will provide benefits to
the firm. After its useful life, the revenues generated by the asset tend to decline rapidly and its
expenses tend to increase.
Typically, an investment requires an immediate expenditure and provides benefits in the form of
cash flows received in the future.

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➢ If benefits are received only within the current period within one year of making the
investment—we refer to the investment as a short-term investment.
➢ If these benefits are received beyond the current period, we refer to the investment as a long-
term investment and refer to the expenditure as a capital expenditure. An investment project
may comprise one or more capital expenditures. For example, a new product may require
investment in production equipment, a building, and transportation equipment.
Short-term investment decisions involve, primarily, investments in current assets: cash,
marketable securities, accounts receivable, and inventory. The objective of investing in short-term
assets is the same as long-term assets: maximizing owners’ wealth. Nevertheless, we consider
them separately for two practical reasons:
1. Decisions about long-term assets are based on projections of cash flows far into the future and
require us to consider the time value of money.
2. Long-term assets do not figure into the daily operating needs of the firm.
Classification According to Their Risk
Suppose you are faced with two investments, A and B, each promising a birr100 cash inflow ten
years from today. If A is riskier than B, what are they worth to you today? If you do not like risk,
you would consider A less valuable than B because the chance of getting the birr100 in ten years
is less for A than for B. Therefore, valuing a project requires considering the risk associated with
its future cash flows. The investment’s risk of return can be classified according to the nature of
the project represented by the investment:
✓ Replacement projects: investments in the replacement of existing equipment or facilities.
✓ Expansion projects: investments in projects that broaden existing product lines and existing
markets.
✓ New products and markets: projects that involve introducing a new product or entering into
a new market.
✓ Mandated projects: projects required by government laws or agency rules.
Analyzing capital expenditure proposals is not costless—benefits can be gained, but analysis does
have a cost. For certain types of projects, an extremely detailed analysis may be warranted, while
for other projects, simpler procedures are adequate. Accordingly, firms generally categorize
projects and then analyze them in each category somewhat differently:

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For a new product, the proposal usually originates in the marketing department. A proposal to
replace a piece of equipment with a more sophisticated model, however, usually arises from the
production area of the firm. In each case, efficient administrative procedures are needed for
channeling investment requests. All investment requests should be consistent with corporate
strategy to avoid needless analysis of projects incompatible with this strategy. In this regard
1. Replacement projects include the maintenance of existing assets to continue the current level of
operating activity. Projects that reduce costs, such as replacing old equipment or improving the
efficiency, are also considered replacement projects. To evaluate replacement projects we need to
compare the value of the firm with the replacement asset to the value of the firm without that same
replacement asset.
a) Replacement: maintenance of business. One category consists of expenditures to replace worn-
out or damaged equipment required in the production of profitable products. The only questions
here are should the operation be continued and if so, should the firm continue to use the same
production processes? If the answers are yes, the project will be approved without going through
an elaborate decision process.
B) Replacement: cost reduction. This category includes expenditures to replace serviceable but
obsolete equipment and thereby to lower costs. The purpose here is to lower the costs of labor,
materials, and other inputs such as electricity. These decisions are discretionary, and a fairly
detailed analysis is generally required.
3. Expansion of existing products or markets. These are expenditures to increase output of existing
products or to expand retail outlets or distribution facilities in markets now being served. Which
are intended to enlarge a firm’s established product or market Expansion decisions are more
complex because they require an explicit forecast of growth in demand, so a more detailed analysis
is required. The go/no-go decision is generally made at a higher level within the firm, also involve
little risk. However, investment projects that involve introducing new products or entering into
new markets are riskier because the firm has little or no management experience in the new product
or market.
4. Expansion into new products or markets. Diversification These investments relate to new
products or geographic areas, and they involve strategic decisions that could change the

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fundamental nature of the business. Invariably, a detailed analysis is required, and the final
decision is generally made at the top level of management.
5. Safety and/or environmental projects. Expenditures necessary to comply with government
orders, labor agreements, or insurance policy terms fall into this category. These expenditures are
called mandatory investments, and they often involve nonrevenue-producing projects
In general, relatively simple calculations, and only a few supporting documents, are required for
replacement decisions, especially maintenance investments in profitable plants. More detailed
analyses are required for cost-reduction projects, for expansion of existing product lines, and
especially for investments in new products or areas. Also, within each category, projects are
grouped by their dollar costs: Larger investments require increasingly detailed analysis and
approval at higher levels. Thus, a plant manager might be authorized to approve maintenance
expenditures up to $10,000 using a relatively unsophisticated analysis, but the full board of
directors might have to approve decisions that involve amounts greater than $1 million or
expansions into new products or markets.
3. Classification According to Their Dependence on Other Projects
Projects can be classified as follows according to the degree of dependence with other projects:
❖ independent projects,
❖ mutually exclusive projects,
❖ contingent projects, and
Mutually exclusive investments: Mutually exclusive investments serve the same purpose and
compete with each other. If one investment is undertaken, others will have to be excluded. A
company may, for example, either use a more labor-intensive, semi-automatic machine, or employ
a more capital-intensive, highly automatic machine for production. Choosing the semi-automatic
machine precludes the acceptance of the highly automatic machine.
Independent investments: Independent investments serve different purposes and do not
compete with each other. For example, a heavy engineering company may be considering
expansion of its plant capacity to manufacture additional excavators and addition of new
production facilities to manufacture a new product – light commercial vehicles. Depending on the
profitability and availability of funds, the company can undertake bother investments.

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Contingent investments: Contingent investments are dependent projects: the choice of one
investment necessitates under taking one or more other investments. For example, if a company
decides to build a factory in a remote, back ward area, it may have to invest in houses, roads,
hospitals, schools etc., for employees to attract the work force. Thus, building of factory also
requires investment in facilities for employees. The total expenditure will be treated as one single
investment.
Capital-Budgeting Evaluation Techniques/ Project Appraisal methods
It is also known as capital budgeting decision rule or criteria.
Capital budgeting evaluation techniques are classified into two categories
1) Non-discounted cash flow/traditional methods
I) Payback period/PBP/
II) Accounting (Average) rate of Return
2) Discounted cash flow / DCF/ methods
I. Discounted Payback period/PBP/
II. Net Present value method/NPV?
III. Profitability Index/PI/
IV. Internal rate of return
In order to determine whether a given project is acceptable or not, discounted as well as non-
discounted cash flow methods could be used. Discounted methods take time value of money and
the required rate of return in to account where as the non-discounted methods do not take the time
value of money and the required rate of return into account.
1) Non-discounted Methods
I. Payback Period
The payback period, defined as the expected number of years required to recover the original
investment, was the first formal method used to evaluate capital budgeting projects. It tells us the
number of years required to recover our initial cash investment based on the project’s expected
cash flows.
Accept /Reject criteria: If the actual pay-back period is less than the predetermined pay-back
period, the project would be accepted. If not, it would be rejected.

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When cash flow of an investment is in annuity form, payback period is computed by
dividing the net investment by the annuity.

Example 1: An investment has a net investment of 12,000 and annual cash flows of 4,000 for five
years.
Payback period = 12,000/ 4,000 = 3 years
When an investment’s cash flows are not in annuity form, the cumulative cash flows are used in
computing payback period.

Example 2: Compute the payback period for the following cash flows, assuming a net
investment of 100,000.

If the payback period is not an integer, it is usually rounded up to the next integer, since cash flows
occur at the end of each year. Accordingly the payback period of the above example can be taken
as 4years.
Advantages of the payback period
✓ Easy to calculate and understand
✓ Adjusts for uncertainty of late cash flows
✓ Biased towards liquidity
Disadvantages
✓ ignore the time value of money
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✓ requires an arbitrary/subjective cutoff date
✓ ignores cash flows beyond the payback date
✓ Biased against long term projects such as research and development, and new projects
Problems.
A major shortcoming of the payback method is that it fails to consider cash flows occurring after
the expiration of the payback period; consequently, it cannot be regarded as a measure of
profitability. Two proposals costing $10,000 each would have the same payback period if they
both had annual net cash inflows of $5,000 in the first two years. But one project might be expected
to provide no cash flows after two years, whereas the other might be expected to provide cash
flows of $5,000 in each of the next three years.
In addition to this shortcoming, the method ignores the time value of money. It simply adds cash
flows without regard to the timing of these flows. Finally, the maximum acceptable payback
period, which serves as the cutoff standard, is a purely subjective choice. Although a poor gauge
of profitability, the payback period does give a rough indication of the liquidity of a project.
II. Accounting (Average) rate of Return
The accounting rate of return compares the average after-tax profits with the average size of
investment. It is computed by dividing a project's expected average net income by the average
investment.

Decision Rule: A project is acceptable if it its average accounting return exceeds a target average
accounting return.
Example 1: Consider an investment in new machinery that requires an initial outlay of 20,000 and
has an expected salvage value of zero after five years. Assuming that, this machine, if acquired,
will result in an increase in after tax profits of 800 each year for five years. Compute ARR.

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To examine the limitation of this method, consider the following three proposals, each with an
expected life of five years. Assume the initial investment associated with each project is 10,000
and will have an expected salvage value of zero in five years. The minimum acceptable ARR for
this firm is 8%, and the annual accounting profits are given below. Determine their ARR.

The ARR is 10% for each project, which indicates that ARR method doesn’t consider the timing
of cash flows. A casual examination leads us to the conclusion that project B is the best as it yields
its returns earlier than project A or C.
Advantages of ARR
✓ Easy to calculate and understand
✓ Needed information will usually be available
Disadvantages
✓ not a true rate of return; time value of money is ignored
✓ uses an arbitrary bench mark /cut off rate
✓ Based on accounting ( book) value, not cash flows and market value

2) Discounted cash flow criteria

I. The discounted payback
We saw that one of the shortcomings of the payback period rule was that it ignored time value.
There is a variation of the payback period, the discounted payback period that fixes this particular
problem. The discounted payback period is the length of time until the sum of the discounted cash
flows is equal to the initial investment. The discounted payback rule would be:

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To see how we might calculate the discounted payback period, suppose that we require a 12.5
percent return on new investments. We have an investment that costs $300 and has cash flows of
$100 per year for five years. To get the discounted payback, we have to discount each cash flow
at 12.5 percent and then start adding them. In Table 9.3, we have both the discounted and the
undiscounted cash flows.
Looking at the accumulated cash flows, we see that the regular payback is exactly three years (look
for the highlighted figure in Year 3). The discounted cash flows total $300 only after four years,
however, so the discounted payback is four years, as shown.
How do we interpret the discounted payback? Recall that the ordinary payback is the time it takes
to break even in an accounting sense. Because it includes the time value of money, the discounted
payback is the time it takes to break even in an economic or financial sense. Loosely speaking, in
our example, we get our money back, along with the interest we could have earned elsewhere, in
four years

Based on our example, the discounted payback would seem to have much to recommend it. You
may be surprised to find out that it is rarely used in practice. Why? Probably because it really
isn’t any simpler to use than NPV. To calculate a discounted payback, you have to discount
cash flows, add them up, and compare them to the cost, just as you do with NPV. So, unlike an
ordinary payback, the discounted payback is not especially simple to calculate.
A discounted payback period rule has a couple of other significant drawbacks. The biggest one is
that the cutoff still has to be arbitrarily set and cash flows beyond that point are ignored. Also, just
because one project has a shorter discounted payback than another does not mean it has a larger
NPV.
All things considered, the discounted payback is a compromise between a regular payback and
NPV that lacks the simplicity of the first and the conceptual rigor of the second. Nonetheless, if

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we need to assess the time it will take to recover the investment required by a project, then the
discounted payback is better than the ordinary payback because it considers time value. In other
words, the discounted payback recognizes that we could have invested the money elsewhere and
earned a return on it. The ordinary payback does not take this into account. The advantages and
disadvantages of the discounted payback rule are summarized in the following table.

II. Net present value(NPV)

The net present value (NPV) of an investment proposal is defined as the sum of present values of
the cash flows minus the sum of present values of the net investment

NPV is the difference between an investment’s market value and its cost. In other words, NPV is
a measure of how much is created or added by undertaking an investment.

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Advantages
✓ Considers all expected future cash flows,
✓ The time value of money is taken in to account, and
✓ Considers the risk of the future cash flows.
Limitations
NPV calculations result in a dollar amount, which is the incremental value to owners' wealth.
However, investors and managers tend to think in terms of percentage returns.
To calculate NPV we need a cost of capital. This is not so easy. The concept behind the cost of
capital is simple: It is compensation to the suppliers of capital for (a) the time value of money and
(b) the risk they accept that the cash flows they expect to receive may not materialize as promised.
Getting an estimate of how much compensation is needed is not so simple. That's because to
estimate a cost of capital we have to make a judgment on the risk of a project and how much return
is needed to compensate for that risk.

Exercise 6
From the following information, calculate the net present value of the two project and suggest
which of the two projects should be accepted a discount rate of the two.
Project X Project Y
Initial Investment birr 20,000 30,000
Estimated Life 5 years 5 years

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Scrap Value 1,000 2,000

The profits before depreciation and after taxation (cash flows) are as follows:
Birr Year 1 Year 2 Year 3 Year 4 Year 5
Project x 5,000 10,000 10,000 3,000 2,000
Project y 20,000 10,000 5,000 3,000 2,000

Solution
Cash Inflows Present PV of Net Cash
Value @10% Inflow
Year Project X Project Y 1 Pro X Pro Y
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242
Scrap Value 1,000 2,000 0.621 621 1,245
Total present value Initial 24,227 34,728
Investments 20,000 30,000
Net present value 4,227 4,728

Project Y should be selected as net present value of project Y is higher.

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III. Profitability Index (PI)
Profitability index (PI), sometimes called benefit-cost ratio, is defined as the quotient of the PV of
future cash flows to the initial investment.

The decision rule is:

The profitability index tells us how much value we get for each dollar invested. If the PI is greater
than one, we get more than $1 for each $1 invested -- if the PI is less than one, we get
less than $1 for each $1 invested. Therefore, a project that increases owners' wealth has a PI
greater than one. Therefore,

As long as we don't have to choose among projects, so that we can take on all profitable projects,
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using PI produces the same decision as NPV. This technique is very closely related to the
NPV technique and will always give the some accept-reject decision as the NPV analysis.
NPV versus PI
Because NPV and PI are so closely related, for most mutually exclusive choice problems, NPV
and PI will select the same best alternative. However, in some situations it is possible to get a
conflict of rankings. Consider the following two mutually exclusive investments.

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Assignment and Work sheet for financial management I
1. Suppose initial cash outflow of $100,000, the Faversham Fish Farm expected to generate net
cash flows of $34,432, $39,530, $39,359, and $32,219 over the next 4 years. Assume the cost
f capital is 12 %. calculate the paypack period, internal rate of return and net present value
YEAR CASH FLOWS
0
1. 34,432 2. 39,530
3. 39,359 4. 32,219
2. Suppose we are asked to decide whether or not a new consumer product should be launched.
Based on projected sales and costs, we expect that the cash flows over the fiveyear life of the
project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year.
It will cost about $10,000 to begin production. We use a 10 percent discount rate to evaluate
new products. What should we do here? Given the cash flows and discount rate, calculate the
total value of the product by discounting the cash flows ?
3. What is the payback period for this investment? If The initial cost is $500. After the first two
years, the cash flows total $300( 100@1, 200@2). After the third year, the total cash flow is
$800?
4. Present value of cash out flows $ 180, 000, Present value of cash inflows $ 221, 513 determine
PI?
5. A project has a total up-front cost of $435.44. The cash flows are $100 in the first year,
$200 in the second year, and $300 in the third year. What’s the IRR? If we require an 18
percent return, should we take this investment?
6. Assume that in today’s market, rRF ! 5.6%, the market risk premium is RPM !
5.0%, and Allied’s beta is 1.48. Using the CAPM approach, Allied’s cost of equity
is estimated to be ______? 13
7. Allied’s stock sells for $23.06, its next expected dividend is $1.25, and analysts expect its
growth rate to be 8.3%, find the required rate of return? 13.7. Assuming that Allied has a
"flotation cost of 10%, its cost of new common equity, re,is ______?. Allied raises fund consist
of 45 cents of debt with an after-tax cost of 6%, 2 cents of preferred stock with a cost of 10.3%,

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and 53 cents of common equity from additions to retained earnings with a cost of 13.5%. find
WACC?
8. On May 30, 2008, Alabama Power Co. had two issues of ordinary preferred stock with a
$25 par value that traded on the NYSE. One issue paid $1.30 annually per share and sold
for $21.05 per share. The other paid $1.46 per share annually and sold for $24.35 per
share. What is Alabama Power’s cost of preferred stock? Using the first issue, calculate that
the cost of preferred stock?
9. Abay bond has a 10 percent coupon rate and a $1,000 face value. Interest is paid semiannually,
and the bond has 20 years to maturity. If investors require a 12 percent yield, what is the bond’s
value?
10. The next dividend for the TORPA will be $4 per share. Investors require
a 16 percent return on companies such as Gordon. Gordon’s dividend increases by 6 percent
every year. Based on the dividend growth model, what is the value of Gordon’s stock today?
What is the value in four years?
11. Bangada co. has just paid a cash dividend of $2 per share. Investors require a 16 percent return
from investments such as this. If the dividend is expected to grow at a steady 8 percent per
year, what is the current value of the stock? What will the stock be worth in five years?
12. The Timberlake Co. just paid a dividend of $1.95 per share on its stock. The dividends are
expected to grow at a constant rate of 6 percent per year indefinitely. If investors require an 11
percent return, what is the current price? What will the price be in three years? In 15 years?
13. The next dividend payment by Hot Wings, Inc., will be $2.10 per share. The dividends are
anticipated to maintain a 5 percent growth rate forever. If the stock currently sells for $48 per
share, what is the required return? For the company in the previous problem, what is the
dividend yield? What is the expected capital gains yield?
14. An investment project has annual cash inflows of $4,200, $5,300, $6,100, and $7,400, and a
discount rate of 14 percent. What is the discounted payback period for these cash flows if the
initial cost is $7,000? What if the initial cost is $10,000? What if it is $13,000?
15. An investment has an installed cost of $684,680. The cash flows over the four-year life of the
investment are projected to be $263,279, $294,060, $227,604, and $174,356. If the discount

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rate is zero, what is the NPV? If the discount rate is infinite, what is the NPV? At what discount
rate is the NPV just equal to zero?
16. Suppose we observe the following dividend for some company from 2005-09 is $1.10, 1.20,
1.35, 1.4, 1.55 then find the dividend growth rate?
17. A company’s 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 30
years sells at a price of $515.16. The company’s federal-plus-state tax rate is 40%. What is the
firm’s component cost of debt for purposes of calculating the WACC?
18. Shi Importers’ balance sheet shows $300 million in debt, $50 million in preferred stock, and
$250 million in total common equity. Shi faces a 40% tax rate and the following data: rd 6%,
rps 5.8%, and rs 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and
65% common stock, what is Shi’s WACC?
19. Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon rate
of 9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the issue proceeds,
what is the after-tax cost of debt?
20. You are a financial analyst for the Hittle Company. The director of capital budgeting has asked
you to analyze two proposed capital investments, Projects A and B. Each project has a cost of
$10,000, and the cost of capital for each project is 12%. The projects’ expected net cash flows
are as follows:
Project A Project B
0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR),
and modified internal rate of return (MIRR). b. Which project or projects should be accepted if
they are independent? c. Which project should be accepted if they are mutually exclusive?

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