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Kwame Nkrumah University ofScience & Technology, Kumasi, GhanaKwame Nkrumah University ofScience & Technology, Kumasi, Ghana

ACF 261: BUSINESS FINANCE

Kwasi PokuAccounting and Finance

KNUST School of BusinessCollege of Humanities and Social Sciences

www.knust.edu.ghwww.knust.edu.gh

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Course outline:OVERVIEW OF BUSINESS FINANCE

key concepts in Business/Corporate

finance

financial management decisions

the objectives of a business

Corporate governance and the agency

problem


2. FINANCING A BUSINESS

- SOURCES OF EXTERNAL FINANCE

- SOURCES OF INTERNAL FINANCE

- SHORT TERM SOURCES OF FINANCE

– LONG TERM FINANCE FOR SMALL BUSINESSES


3.FINANCIAL PLANNING AND PROJECTEDFINANCIAL STATEMENTS- steps in developing plans- the role of projected financial statements- preparing projected financial statementsprojected financial statements and risk 4.FINANCIAL STATEMENT ANALYSIS ANDINTERPRETATION- financial ratios defined


- classification of FINANCIAL RATIOS

(Profitability, Efficiency, Liquidity, Gearing

and Investment)

- the need for comparison

- bases for Comparison

- key steps in financial ratio analysis

- limitations of ratio analysis


5. METHODS OF INVESTMENT APPRAISAL

- evidence on the employment of appraisal

techniques

- the appraisal methods

(the payback period, discounted payback,

accounting rate of return, Net Present Value (NPV)

, Internal Rate of Return (IRR),)


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6. MANAGEMENT OF WORKING CAPITAL

Major elements of current assets:

Management of stock

Management of debtors

Major elements of current liabilities

Management of cash: operating cash cycle

Management of trade creditors

Management of bank overdrafts


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7. INTRODUCTION TO CAPITAL STRUCTURE DECISIONSWhat the debate is about

The two schools of thought:- the traditionalists view the modernists view

8. INTRODUCTION TO DIVIDEND POLICYSchools of thought: - the traditionalists view- the modernists view


Recommended Reading 1. Atrill, P. (2003). Financial Management for Non-Specialists. 3rd edition. Pearson EducationLimited, Essex, U.K. 2. Arnold, G. (2008). Corporate FinancialManagement. 4th Edition. Financial Times/Prentice Hall/ Pearson Education. Essex, U.K. 3. Brealey, R.A, Myers S.C and Allen F. (2006).Corporate Finance. 8th Edition. McGraw Hill


4. Watson, D. and Head, A. (2010).Corporate Finance: principles and practice.5th Edition. Financial Times/ Prentice Hall/Pearson Education Limited. Essex, U.K.


Chapter one

Overview of Business Finance


Introduction

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Two key concepts in corporate finance thatare pivotal in helping managers to valuealternative choices are the relationship

between risk and return and the time value ofmoney .

Risk and return

Return refers to the financial rewards gained asa result of making an investment. The nature ofthe return depends on the form of theinvestment.


Risk refers to the possibility that the actualreturn may be different from the expectedreturn.

The actual return may be greater than the

expected return: this is usually a welcomeoccurrence. Time value of money

The time value of money is a key concept infinance and is relevant to both companies andinvestors.


In a wider context, it is relevant to anyoneexpecting to pay or receive money over a period oftime.

Simply stated, the time value of money refers to thefact that the value of money changes over time.

Imagine that your friend offers you either Ghc100today or Ghc100 in one year’s time. Faced with thischoice, you will (hopefully) prefer to take Ghc100. Thequestion to ask yourself is why do you prefer Ghc100today? There are three major factors at work here.


Illustration:

Imagine that your friend offers you eitherGhc100 today or Ghc100 in one year’s time.

Faced with this choice, you will (hopefully) preferto take Ghc100. why?

Time :

If you have the money now, you can spend it now.Alternatively, you can invest it so that in oneyear’s time you will have Ghc100 plus anyinvestment income you have earned.


Inflation:Ghc100 spent now will buy more goods and

services than Ghc100 spent in one year’s timebecause inflation undermines the purchasing powerof your money. Risk:

if you take Ghc100 now you definitely have themoney in your possession.

The alternative of the promise of Ghc100 in a year’stime carries the risk that the payment may be less thanGhc100 or may not be paid at all.


Starting a business

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Three questions to answer!What long term investments should you take on?That is what line of business should you beinvolved in and what sorts of buildings,machinery and equipment will you need?

Where will you get the long term financing to payfor your investment? Will you retain the profitwhich you make? Will you bring in other ownersor will you borrow the money?


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How will you manage your everyday financingactivities such as collecting from customers andpaying suppliers? (working capital management)

These are not the only questions by any means

but they are among the most important.

Business finance, broadly speaking is the studyof ways to answer these questions.


THE FINANCIAL MANAGER

A striking feature of large companies is that theowners (the shareholders) are usually notdirectly involved in making business decisions,particularly on a day to day basis.

Instead, the company employs managers torepresent the owner’s interest and makedecisions on their behalf.


KEY TASKS OF THE FINANCE FUNCTION•

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Financial planning - this involves developingfinancial projections and plans (such as cashflow statements and profit statements).Investment project appraisal - this involvesevaluating investment projects and assessingthe relative merits and risk of competingproposals.Financing decisions – this requires theidentification of financing requirements and theevaluation of possible sources of finance.


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Capital market operations - This involves anappreciation of how finance can be raisedthrough the markets, how securities are pricedand how the markets are likely to react toproposed investment and financing plan.

Financial control - this refers to the ways inwhich the plans are achieved. Once plans areimplemented it will be necessary for managersto ensure that things go according to plan.


FINANCIAL MANAGEMENT DECISIONS

Capital budgeting- it is a process of planning andmanaging a firm’s long-term investment. Itconcerns the first question of a firm’s long-terminvestments.

Capital structure- it refers to the specific mixture of

long term debt and equity the firm uses tofinance its operations. This involves ways inwhich the firm obtains and manages the longterm investments.


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Working capital management: the third questionconcerns working capital management. Thisrefers to a firm’s short term assets and its shortterm liabilities.

Some questions about WORKING CAPITAL that mustbe answered are: How much cash inventory should we keep on hand?Should we sell on credit ? If so what terms will weoffer and to whom will we extend them?How will we obtain any needed short term financing?Will we purchase on credit or will we borrow shortterm and pay cash?


THE OBJECTIVES OF A BUSINESS

The key idea underpinning modern financialmanagement is that, the primary objective of abusiness is shareholder wealth maximization,that is, to maximize the wealth of itsshareholders (owners).

In a market economy the shareholders willprovide funds to a business in the expectationthey will receive the maximum possible increasein wealth for the level of risk which must befaced.


When evaluating competing investmentopportunities, therefore the shareholders willweigh the returns from each investment againstthe potential risk involved.

The term Wealth in this context refers to themarket value of the ordinary shares. The market value of the shares will in turn reflectthe future returns the shareholder will receiveover time from the shares and the level of riskinvolved.


Some Possible Objectives•

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Achieving a target market shareQuite often the winning of a particular market shareis set as an objective because it acts as a proxy forother, more profound objectives, such as generatingthe maximum returns to shareholders.

Keeping employee agitation to a minimumHere, return to the organisation’s owners is kept to aminimum necessary level. All surplus resources aredirected to mollifying employees.


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SurvivalThere are circumstances where the overridingobjective becomes the survival of the firm. Severeeconomic or market shock may force managers tofocus purely on short-term issues to ensure thecontinuance of the business.

Creating an ever-expanding empireSome managers drive a firm forward, via organicgrowth or mergers, because of a desire to run anever-larger enterprise.


• Social ResponsibilityCompanies may be concerned with improvingworking conditions for employees, providing ahealthy product for consumers or avoiding anti-socialactions such as environmental pollution orundesirable promotional practices.


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Profit maximizationThis is much more acceptable objective, althoughnot everyone would agree that maximisation ofprofit should be the firm’s purpose.

Long-term shareholder wealth maximizationWhile many commentators concentrate on profitmaximisation, finance experts are aware of anumber of drawbacks of profit. The maximisation ofthe returns to shareholders in the long term isconsidered to be a superior goal.


WEALTH MAXIMISATION OR PROFIT MAXIMISATION

Wealth maximisation is not the only financialobjective which a business can pursue. Profitmaximization is often suggested as analternative for a business.

Profit maximisation is different from wealthmaximisation in a number of respects.


Measures of profit

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There are different measures of profit whichcould be maximised, including the following:Operating profit (i.e. net profit before interest andtax)Net profit before taxNet profit after taxNet profit available to ordinary shareholdersNet profit per ordinary share etc


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Differences in the choice of profit measure canlead to differences in decisions reachedconcerning a particular opportunity.

Profit maximisation is usually seen as a shortterm objective whereas wealth maximisation is along term objective. There can be conflict between long term andshort term performance. It will be quite possiblefor example to maximise short term profits atthe expense of long term profits.


Reducing operating expenses••••

Cutting research and development expenditureCutting staff training and developmentBringing cheaper quality material andCutting quality control mechanisms

These policies may all have a beneficial effect onshort term profits but may undermine the long termcompetitiveness and performance of a business.Whereas wealth maximisation takes risk intoaccount, profit maximisation does not


Fundamental Problems With ProfitMaximization

•The three (3) drawbacks are:

Quantitative difficultiesProfit maximization as a financial objective requiresthe definition and accurate measurement of profitand that all the factors contributing to it are knownand can be taken into account. It is very doubtful that this requirement can be meton a consistent basis.


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Timescale over which profit should bemaximised

The key question to ask here is ‘should profitbe maximised in the long term or in the shortterm?’

Given that profit considers one year at a time, thefocus is likely to be on short-term profit maximisationat the expense of long-term investment, putting thelong-term survival of the company into doubt.

No allowance for RiskIt would be inappropriate to concentrate our effortson maximising accounting profit when this objectivedoes not consider one of the key determinants of


How can Shareholder Wealth be Maximised?

i.

ii.

iii.

Three variables that directly affect shareholders’wealth:

The magnitude of cash flows accumulating to

the company

The timing of cash flows accumulating to the

company

The risk associated with the cash flows

accumulating to the company.


The major indicator of shareholder wealth is acompany’s ordinary share price, since this willreflect expectations about future dividendpayments as well as investor views about the long-term prospects of the company and its expectedcash flows.

The surrogate objective, therefore is to maximisethe current market price of the company’s ordinaryshares and hence to maximise the total marketvalue of the company.

Indicator of shareholder wealth;


SHWMShare price

Corporate netpresent value

(sum ofindividual

projects' NPVs)

NPV A

NPV B

NPV C

NPV D

NPV E

Fig. 1.1

The link between cash flows from projects andshareholder wealth


From Fig. 1.1,•

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Stage 1- accept projects with positive NPVs

Stage 2- given that NPV is additive, the NPV of thecompany as a whole should equal the sum of theNPV’s of the projects the company has undertaken.

Stage 3- the NPV of the company as a whole isaccurately reflected by the market value of thecompany through its share price.

Stage 4- shareholder wealth will be maximisedwhen the market capitalisation of the company ismaximised.


Good financial decisions that promoteshareholder wealth

i.

ii.

iii.

iv.

v.

Efficient Working Capital Management

Use appropriate Capital Structure to minimize

cost of capital

Use NPV for potential project assessment

Accept projects with positive NPVs.

Adopt appropriate Dividend Policy

Financial decisions risk assessment andprevention. E.g. Hedging interest and exchangerate risk


To maximise or to satisfy

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To begin with, this as an objective implies thatthe needs of the shareholders are paramount. The business can however be viewed as acoalition of various interest groups which allhave a stake in the business. The following groups may be seen asstakeholders:(Shareholders , Employees,Managers, Suppliers, Customers, The community)


If we accept this view of the business, theshareholders simply become one of a numberof the stakeholder groups whose needs haveto be satisfied.

It can be argued that, instead of seeking tomaximise the returns to shareholders, themanagers should try to provide eachstakeholder group with a satisfactory return.


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The term satisficing has been used to describethis particular business objective. Although thisobjective may sound appealing, there arepractical problems associated with its use.

Problems with satisficingIn a market economy there are strongcompetitive forces at work which ensures thatfailure to maximise shareholders wealth will notbe tolerated for long.


Apart from shareholders, there are otherstakeholders within a business. Satisfying theneeds of other stakeholder groups will often beconsistent with the need to maximiseshareholders wealth.

This kind of interdependence has led to theargument that the needs of other stakeholdergroups must be viewed as constraints withinwhich shareholders wealth should be maximised.


AGENCY THEORY; why does Agency exist?

Agency is the theoretical relationship that existsbetween the owner of a company and themanagers as agents they employ to run thecompany on their behalf.

The agency problem is said to occur whenmanagers make decisions that are not consistentwith the objective of the shareholder wealthmaximisation.


Contributing Factors to the Existence of theAgency Problem

i. Divergence of ownership and control. Shareholders (principal) appoint managers

(agent) to act on their behalf. ii. The goals of managers differ from those ofshareholders (principals) iii. Information Asymmetry exists between agentand principal


Possible Management Goals

a.

b.

c.

d.e.

Managers may follow their own welfare maximisinggoals;

Growth or maximising the size of the company

Increasing managerial power

Creating job security

Increasing managerial pay and rewardsPursuing their own social objectives or petprojects.


CORPORATE GOVERNANCE AND THE AGENCYPROBLEM

The issue of corporate governance hasgenerated much debate in recent years.

Corporate governance is used to describe theways in which businesses are directed andcontrolled.

The issue of corporate governance is importantbecause in businesses of any size, the owners (i.e. the shareholders) are usually divorced fromthe day-to-day control of the business.


Professional managers are employed by theshareholders to manage the business on theirbehalf. These managers may therefore be viewed asagents of the shareholders (who are principals). Given this agent - principal relationship , it mayseem safe to assume that managers will beguided by the requirements of the shareholderswhen making decisions.


In other words the wealth objective of theshareholders will become the manager’sobjectives.

However in practice this does not always occur.The manager may be more concerned withpursuing their own interest such as increasingtheir pay and perks (e.g. expensive motor carsand so on) and improving their job security andstatus.As a result, a conflict may occur between theinterest of the shareholder and the interest of themanagers.


MANAGERS TO ACT IN SHAREHOLDERS’ INTEREST

i.

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Two types of actions are commonly employed inpractice: MonitoringThe shareholders may insist on monitoring closely

the actions of the managers and the way in which theresources of the business are used.

Use of independent audited financialstatements and additional reportingrequirements.

Shadowing of senior managers and the use ofexternal analysts.


ii. Incentive plansThe shareholders may introduce incentive plans for

the managers which link their remuneration to theshare performance of the business.

Common Incentives schemes;a. Performance-related Pay (PRP)- managerialremuneration can be linked to performanceindicators such as profit, earnings per share or returnon capital employed. b. Executive share option scheme- share optionsallow managers to buy a specified number of theircompany’s shares at a fixed price over a specifiedperiod.


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In this way, the interests of managers andshareholders will become more closely aligned.

PROBLEMS ASSOCIATED WITH THESE

ACTIONSThe first option is fine in theory, but in practice itis costly and difficult to implement.The second option is costly and can also bedifficult to implement. A common form ofincentives plan is to give managers shareoptions.


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One potential problem with this future form ofincentive is that it may encourage managers toundertake high risk projects.

Other tools;

Voting to remove directors

Selling off shares on the capital market


CORPORATE GOVERNANCE AND ECONOMICPERFORMANCE

If managers fail to take account of shareholdersobjective, it is clearly a problem for theshareholders. However, it may also be a problem for thesociety as a whole.


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To avoid these problems, most competitivemarket economies have a framework of rules tohelp monitor and control manager behaviour.These rules are usually based around threeguiding principles;DISCLOSURE- this lies at the heart of goodcorporate governance.

Adequate and timely information about corporateperformance enables investors to makeinformed buy-and-sell decisions and therebyhelps the market reflect the value of acorporation under present management.


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ACCOUNTABILITY- this involves defining theroles and duties of the directors and establishingan adequate monitoring process.

In the United Kingdom for example, company lawrequires that directors of businesses act in thebest interest of shareholders.

FAIRNESS- Managers should not be able tobenefit from access to inside information whichis not available to shareholders.


As a result, both the law and the stock exchangeplace restrictions on the ability of directors todeal in the shares of the business.

Other rules

The number of rules designed to safeguardshareholders has increased over the years. In1992, the Cadbury committee (so-named afterits chairman Sir Adrian Cadbury) produced acode of best practice on corporate governance.


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This code does not have the force of law, but thedirectors of companies whose shares are listedon the stock exchange are required to state intheir annual report the extent to which the codehas been implemented. The code covers such matters as the following:The responsibilities and the compositions of theboard of directors The role, appointment and independence non-executive directors


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The disclosure and determination of executivedirectors pay and the period of their servicecontracts.The responsibilities of various reporting andcontrol procedures within the business.

Following the Cadbury committee, the Greenburycommittee was set up to consider the issue ofdirectors pay in more detail.


In 1995, the committee also issued a code ofpractice which recommended, among other thingsthe setting up of the remuneration committee of

non-executives to consider executive directors’ payand greater disclosure of the way in which directorsare remunerated.

In 1998, the Hampel committee sought to ‘fine tune’the recommendations of the two earlier committeesand made various recommendations including theseparation of the roles of chairman and chiefexecutive, the use of directors contract of one yearor less and the training of directors in corporategovernance matters.


Turnbull Report (1999)

Higgs Report (2003)

Tyson Report

Smith Report

Combined Code (2000)


THE ROLE OF FINANCIAL MARKETS IN FINANCE

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Financial MarketsThese are systems or arrangements for bringingtogether those in need of funds and those withsurplus funds such that funds are passed on tothose in need from those who have surplus.

Suppliers of funds receive financial assets,financial securities, financial instruments, andfinancial vehicles in return.

Financial markets can be classified as eithermoney market or capital markets.


Money versus Capital Markets

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Money MarketsThese are markets for the trading of short-termdebt securities.

These short term debt securities are often calledmoney market instruments. E.g. banker’sacceptance

Capital Markets

These are markets for long-term debt and sharesor stock. The Ghana Stock Exchange (GSE) is anexample a capital market.


Primary versus Secondary Markets

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Primary marketsThese refers to the market for the original saleof securities by governments and corporations. In a primary market transaction, the corporationis the seller and raises money through thetransaction. In recent times many companies in Ghanaissued public shares for the first time in initialpublic offerings (e. g. GCB, GOIL and SIC).


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Corporations engage in two types of primarymarket transactions: public offering and privateplacement.

Public offering- as the name suggestsinvolves selling securities to the general public

Private placement- is a negotiated saleinvolving a specific buyer.


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Secondary marketsThese are where securities are bought and soldafter the original sale.

A secondary market transaction involves oneowner or creditor selling to another. It is therefore the secondary markets thatprovide the means for transferring ownership ofcorporate securities.

There are two kinds of secondary markets:auction markets and dealer markets.


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Dealer markets and long term debts arecalled over-the-counter (OTC) markets.

Today, like the money market, a significantfraction of the market for stocks and all of themarket for long term debt has no centrallocation; the many dealers are connectedelectronically. An auction market has a physical location(like Cedi House Accra for GSE, Bay Streetor Wall Street).


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In a dealer market, most buying andselling is done by the dealer. The primary purpose of an auction marketon the other hand, is to match those whowish to sell with those who wish to buy.


LISTING •

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Stocks that trade on organised stockexchange are said to be listed on thatexchange. Companies seek exchange listing in orderto enhance the liquidity of their shares,making them more attractive to investorsby facilitating raising equity.


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To be listed, firms must meet certainminimum criteria concerning for example,the number of shares and shareholdersand the market value. The criteria for listing differ for differentexchanges. The GSE has its own criteria to be metbefore companies can be allowed to getlisted.


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It also has continuing requirements thatlisted companies must meet in order toremain listed.

Some of the continuing requirementsborder on issues such as disclosure ofinformation and company relations withshareholders.


FINANCIAL INTERMEDIATION •

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The transfer of funds between suppliersand users of funds may be described asdirect or indirect. It is direct when the user of fundsinteracts directly with the supplier withoutthe involvement of a third party. At other times, a third party may beinvolved, playing the role of a facilitator.


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That is, making it possible, or more convenient forthe transfer of funds to take place betweensuppliers and users. This mode of transfer is referred to as indirect. Third parties that facilitate indirect transfers arereferred to as financial intermediaries, and theprocess is referred to as financial intermediation. For example, a bank which takes deposits from

suppliers of funds and makes loans to users offunds is acting as an intermediary .


FOREIGN EXCHANGE MARKET •

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The foreign exchange market is undoubtedly theworld’s largest financial market. It is the market where one country’s currency is

traded for another’s . Most of the trading takes place in a fewcurrencies: the US dollar ($), the Euro (€), Britishpound sterling (£), Japanese yen (¥) and SwissFranc (SF).


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The foreign exchange market is an over- the-counter market. There is no single location where traders gettogether. Instead, traders are located in majorcommercial and investment banks around theworld. They communicate using computer terminals,telephones and other telecommunicationdevices.


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One element in the communication network forforeign transactions is the Society for WorldwideInterbank Financial Telecommunications (SWIFT). It is a Belgian not for profit co-operative. A bank in Accra can send messages to a bank inLondon via SWIFT’s regional processing centres. The connections are through data transmissionlines.


Spot versus Forward rates•

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In practice, many exchange rates exist, not onlythe buy and sell rates between differentcurrencies, but also for the same currency overdifferent time horizons. Spot rate refers to the rate of exchange if buyingor selling the currency immediately. Forward rates allow the firing of buy and sellrates for settlement and delivery at a specificdate in the future.


• The different rates can be illustrated byconsidering the exchange rate between theSterling and Ghana cedi;

Sell rate Buy rate

GHs GHs

Spot rate 5.0124 5.1873

One-Month Forward rate 5.1250 5.1589

Three-Month Forward rate 5.2443 5.2887


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The higher of the two spots rates (5.1873) is thebuying rate (the number of GHs you would haveto give up to receive 1 pound),

whereas the lower spot rate (5.0124) is the sellrate (the number of GHs you will receive forgiving up 1 pound). The difference between the two spot rates is

called the spread . The rates below the spot rates are calledForward rates


Trends in Financial Markets andManagement

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Like all markets, financial markets areexperiencing rapid globalization. Financial engineering is the efforts of financialmanagers or investment dealers in designing newsecurities for financial processes. Successful financial engineering reduces andcontrols risks and minimises taxes.


End of chapter one


Chapter two

FINANCING A BUSINESS


Introduction

Under this topic, we examine the variousaspects of financing a business.

We begin by considering the main sources offinance available to a business and thefactors to be considered in choosing anappropriate source of finance.


SOURCES OF EXTERNAL FINANCE •

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External sources of finance require theagreement of someone beyond the directors andmanagers of the business. Thus, finance from an issue of new shares is anexternal source because it requires theagreement of potential shareholders.

Internal sources of finance, on the other hand, donot require agreement from other parties andarise from management decisions.


Thus retained profits are a source of internalfinance because the directors have the power toretain profits without the agreement ofshareholders.In practice, long and short term finance are nottightly defined but for the purposes of this lesson,long term finance will be defined as a source offinance that is due for repayment afterapproximately one year,whereas short-term finance will be defined as asource of finance that is repayable withinapproximately one year.


Fig.1 summarizes the main sources of external financeavailable for a business

OrdinarysharesPreference shares

Longterm

Loans /debentures

Leases

TOTALFINANCE

Bankoverdraft

Bills ofexchange

Shortterm

Debtcollecting

InvoiceDiscounting


ORDINARY SHARESOrdinary share capital forms the backbone of thefinancial structure of a business. It representsthe risk finance.

There is no fixed rate of dividend.

Ordinary shareholders receive a dividend only ifprofits available for distribution still remain afterother investors (preference shareholders andlenders) have received their returns in the formof dividend payouts or interest.


Because of the high risk associated with this form ofinvestment, ordinary shareholders will normallyrequire the business to provide a comparatively highrate of return.

Ordinary shareholders have a limited loss liability,which is based on the amount they have agreed toinvest in the business.

However, the potential returns from ordinary sharesare unlimited.


PREFERENCE SHARES

Preference shares offer investors a lower level ofrisk than ordinary shares.

Provided that there are sufficient profitsavailable, preference shares will normally begiven a fixed rate of dividend each year andpreference dividends will be paid.

Where a business is closed down , preferenceshareholders may be given priority over theclaims of ordinary shareholders.


Ordinary shareholders will exercise control overthe business : they are given voting rights, which

gives them the power to elect the directors andto remove them from office.

Preference shareholders are not usually givenvoting rights, although these may be grantedwhere the preference dividend is in arrears.


TYPES OF PREFERENCE SHARES

CUMMULATIVE preference shares:give investors the right to receive arrears ofdividends that have arisen as a result of there beinginsufficient profits in previous periods. The unpaid

amount will accumulate and will be paid whensufficient profits have been generated.

NON- CUMMULATIVE Preference shares:do not give investors this right. Thus, if a business isnot in a position to pay the preference dividend, duefor a particular period, the preference shareholderloses the right to receive the dividend.


PARTICIPATING PREFERENCE SHARES:give investors the right to a further share in profitafter they have been paid their fixed rate andordinary shareholders have been awarded adividend.

REDEEMABLE PREFERENCE SHARES:

allow the business to buy back the shares fromshareholders at some agreed future date.Redeemable preference shares are seen as alower risk investment than non-redeemableshares and so tend to carry a lower dividend.


LOAN CAPITAL

The major risk facing those who invest in loancapital is that the business will default oninterest payments and capital payments.

To protect themselves against this risk, lendersoften seek some form of security from thebusiness.

This may take the form of assets pledged eitherby a fixed charge on particular assets held by thebusiness, or a floating charge , which “hovers”over the whole of the business’s assets.


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A floating charge will cease to “hover” andbecome fixed on particular assets in the eventthe business defaults on it s obligations.

Assets to be pledged must have the followingcharacteristics;

They must be non perishable.

They must be capable of being sold easily.

They must be fairly high in value relative to their

size.


LOAN COVENANTS

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Lenders may further seek protection through the useof loan covenants. These are obligations or restrictions on the businessthat form part of the loan contract, such covenants

may impose:

The right of lenders to receive particular financialreports concerning the business.An obligation to insure the assets that are offered assecurity. A restriction on the disposal of certain assets held.


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A restriction on the right to issue further loancapital without prior permission of the existing

lenders.A restriction on the level of dividend payments orlevel of payment made to directors.Minimum acceptable levels of liquidity ormaximum acceptable levels of gearing.

Any breach of these restrictive covenants canhave serious consequences for the business.

The lender may demand immediate repaymentof the loan in the event of a material breach.


BONDS, LOANSTOCK AND DEBENTURES

This is simply a loan that is evidenced by a trustdeed. The debenture loan is frequently divided

into units (rather like share capital) and investorsare invited to purchase the number of units theyrequire.

The debenture loan may be redeemable orirredeemable. Debentures of public limitedcompanies are often traded on the stockexchange and their listed value will fluctuateaccording to the fortunes of the business,movements in interest rates and so on.


CONVERTIBLE LOANS AND DEBENTURES

A convertible loan or debenture gives an investorthe right to convert a loan into ordinary shares ata given future date and at a specified price.

The investor remains a lender to the businessand will receive interest on the amount of theloan until such time as the conversion takesplace.

The investor is not obliged to convert the loan ordebenture to ordinary shares.


This will only be done if the market price of theshares at the conversion date exceeds theagreed conversion price. Initially, the investment is in the form of a loanand regular interest payments will be made. Ifthe business is successful, the investor can thendecide to convert the investment into shares. The form of security is an example of a ‘financial

derivative ’.


WARRANTS

Holders of warrants have the right, but not theobligation, to acquire ordinary shares in abusiness at a given price and future date. In the case of both convertible loans and warrants,the price at which shares may be acquired isusually higher than the market price prevailing atthe time of issue. The warrant will usually state the number ofshares the holder may purchase and the time limitwithin which the option to buy shares can beexercised.


Warrants do not confer voting rights or entitle theholders to make any claims on the assets of thebusiness. They represent another form offinancial derivative.

Share warrants are often provided as a‘sweetner’ to accompany the issue of loancapital or debentures.


LEASING

When a business needs a particular asset (forexample, an item of plant), instead of buying it direct from a supplier, thebusiness may decide to arrange for anotherbusiness (typically a financial institution such as

a bank ) to buy it and then lease it to the business.

A finance lease, as such an arrangement isknown, is in essence a form of lending.


Although legal ownership remains with thefinancial institution, (the lessor), a finance leasearrangement transfers virtually all the rewardsand risks that are associated with the item beingleased to the business (the lessee).

A finance lease can be contrasted to anoperating lease where the rewards and risk ofownership stay with the owner and where thelease is short term in nature.


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An example of an operating lease is where abuilder hires earth moving equipment for a weekin order undertakes a particular job.

WHY BUSINESSES ADOPT FINANCE LEASE AGREEMENT.

Ease of borrowing – Leasing may be obtained moreeasily than other forms of long term finance.Lenders often require some form of security and aprofitable track record before making advances tothe business.

However, a lessor may be prepared to leaseassets to a new business without a track record

and to use the leased assets as security for theamounts owing .


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Cost – Leasing agreements may be offered atreasonable cost.

As the asset leased is used as security, standardlease arrangements can be applied and detailedcredit checking of Lessees may be unnecessary.This can reduce administrative costs for thelessor. Flexibility – Leasing can help provide flexibility

where there are rapid changes in technology.


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If an option to cancel can be incorporated intothe lease, the business may be able to exercisethis option and invest in new technology as itbecomes available. Cash flows – Leasing rather than purchasing anasset outright means that large cash outflowscan be avoided. The leasing option allows cash outflows to besmoothed out over the asset’s life.


SALE AND LEASEBACK ARRANGEMENT

A sale and leased back arrangement involves abusiness selling an asset to a financial institutionin order to raise finance.

However, the sale is accompanied by anagreement to lease the asset back to thebusiness to allow it to continue to use the asset.The payment under the lease arrangement is abusiness expense that is allowable againstprofits for taxation.


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Freehold property is often the asset that is thesubject of such an arrangement. When this is the case, there are usually rentreviews at regular intervals throughout the periodof the lease and the amount payable in futureyears may be difficult to predict. At the end of the lease agreement, the businessmust either try to renew the lease or findalternative premises.


SHORT TERM SOURCES OF FINANCE

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A short-term source of borrowing is one that isavailable for a short time period. Although there is no agreed definition of what ‘shortterm’ means, we shall define it as beingapproximately one year or less, The major sources of short-term borrowing are:Bank overdraftsBills of exchangeDebt factoringInvoice Discounting


Bank Overdrafts

Bank overdrafts represent a very flexible form ofborrowing. The size of an overdraft can (subject to

bank approval) be increased or decreased accordingto the financing requirement of the business. It is relatively inexpensive to arrange and interestrates are often very competitive

It is also fairly easy to arrange sometimes anoverdraft can be agreed by a telephone call to thebank.


Banks prefer to grant overdrafts that are self –liquidating: that is, the funds applied will result incash inflows that will extinguish the overdraftbalance.One potential drawback with this form of finance isthat it is repayable on demand. This may poseproblems for a business that is illiquid.

Bills of Exchange

It is a written agreement that is addressed by oneperson to another, requiring the person to whom it isaddressed to pay a particular amount of money atsome future date.


A bill of exchange is similar, in some respects, to anIOU.

The supplier who accepts the bill of exchange, mayeither keep the bill until the date the payment is due(this is usually between 60 and 180 days after the billis first drawn up) or may present it to a bank forpayment.

The advantage of using a bill of exchange is that itallows the buyer to delay payment for the goodspurchased but provides the supplier with anopportunity to receive immediate payment from abank if required.


Debt factoring

Debit factoring is a service offered by a financialinstitution (know as a factor). Many of the large

factors are subsidiaries of commercial banks. Debt factoring involves the factor taking over thedebt collection for a business.

The factor is usually prepared to make an advancedto the business up to 80 percent of approved tradecreditors.The balance of the debt, less any deductions for feesand interest, will be paid after an agreed period orwhen the debt is collected.


Types of factoring•

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Recourse Factoring – where the factor assumes noresponsibility for bad debts arising from credit sales.Non – Recourse factoring- where the factorassumes responsibility for bad debts up to anagreed amount.

Advantages:Factoring can result in savings in creditmanagement and can create more certain cashflows.It can also release the time of key personnel formore profitable ends. This may be extremelyimportant for smaller businesses that rely on thetalent and skills of few key individuals.


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In addition, the level of finance available will rise‘spontaneously’ with the level sales. The businesscan decide how much of the finance available isrequired and can use only that which it needs.

DisadvantagesThere is a possibility that some will see a factoringarrangement as an indication that the business isexperiencing financial difficulties. This may have an adverse effect on confidence inthe business.


Invoice Discounting

Invoice discounting involves a business approaching afactor or other financial institution.For a loan based on a proportion of the face value ofcredit sales outstanding if the institution agrees, the

amount advanced is usually 75-80 percent of the valueof the approved sales invoices outstanding

The business must agree to repay the advance withina relatively short period – perhaps 60 or 90 days.

The responsibility for collection of the trade debtsoutstanding remains with the business and repaymentof the advance is not dependent on the trade debtbeing collected,


•••••

Invoice discounting may be a one off arrangementwhereas debt factoring usually involves a longerterm arrangement between the client, and thefinancial institution.

The Factoring Process:Client Business sells goods on credit.Factor will invoice credit customer.Factor pays 80% to client immediately.Customer pays amount owing to factor.Factor pay 20% balance to client (less fees)when credit customer pays amount owing.


INTERNAL SOURCES OF FINANCE

In addition to external sources of finance, there arecertain internal sources of finance that a businessmay use to generate funds for particular activities.

The figure shows that the major long-term source ofinternal finance is the profits that are retained ratherthan distributed to shareholders.

These sources are represented below:


short-term

Reducedstock levels

DelayedPayment tocreditors

Tighter creditcontrol

TOTAL

INTERNAL

FINANCE

Retainedprofits

Long-term


Retained Profits

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Retained profits are a major source of finance(internal & external) for most businesses, Byretaining profits within the businessrather than distributing to shareholders in the formof dividends, the fund of the business are increased.

AdvantagesWhen issuing new shares, the issue costs may beSubstantial and there may be uncertainty over thesuccess of the issue.


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Retaining profits will have no effect over the controlof the business by existing shareholders. Howeverwhere new shares are issued to outside investors,there will be some dilution of control. Suffered byexisting shareholders.

DisadvantageA problem with the use of profits as a source offinance however, is that the timing and level ofprofits in the future cannot always be reliablydetermined.


Tighter Credit Control

If a business has a proportion of its assets in theform of debtors, there is an opportunity costbecause the funds are tied up and cannot be usedfor more profitable purposes.

By exerting tighter control over trade debtors, it maybe possible for a business to reduce the proportionof assets held in this form and to release funds forother purposes.To remain competitive , a business must takeaccount of the needs of its customers and the creditpolicies adopted by rival businesses within theindustry.


Reducing Stock Levels This is an internal source of finance that may proveattractive to a business. As with debtors, holding stocks imposes anopportunity cost on a business, however, a businessmust ensure that there are sufficient stocks availableto meet likely future sales demand. Failure to do so willresult in lost customer goodwill and lost sales.


Delayed Payment to creditors

By delaying payment to creditors, business fund areretained within the business for other purposes. Thismay be a cheap form of finance for a business. However, as we have seen under working capitalmanagement, there may be significant costsassociated with this form of financing.


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PROVIDING LONG TERM FINANCE FOR SMALLBUSINESSES

Although the stock exchange provides an importantsource of long-term finance for large businesses, it isnot really suitable for small businesses. Because of the aggregate market value of sharesthat are to be listed on the stock exchange, issuingcosts and other issues, small businesses must lookelsewhere for help in raising log term finance.


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However, various reports and studies over the past70 years have highlighted the problems that theyencounter in doing so.These problems, which can be a major obstacle togrowth, include:A lack of financial management skills (Leading todifficulties in developing credible business plans thatwill satisfy lenders).A lack of knowledge concerning the availability ofsources of long-term finance.Providing the levels of security required by somelenders.Meeting rigorous assessment (for e.g. a goodfinancial track record over five years).An excessively bureaucratic screening process forloan applications.


One consequence of these difficulties can beexcessive reliance on short-term sources of finance,such as bank overdrafts to fund the business. In addition to the problems identified , it is worthpointing out that the cost of finance for smallbusinesses is often higher than for large businessesbecause of the higher risks involved.


Other sources

Venture CapitalVenture Capital is long-term capital provided tosmall and medium sized businesses wishing to growbut which do not have ready access to stockmarkets. The supply of venture capital has increased rapidly inthe U.K over recent years since both governmentand corporate financiers have shown greatercommitment to entrepreneurial activity.


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In Ghana, venture capital is a new idea. In March2008, a new venture capital fund to help womenentrepreneurs was launched in Accra.

Types of Investment

Venture capitalists provide share capital and loanfinance for different types of business situations

including :START UP CAPITAL: This is available to businessesthat are still at the concept stage of developmentthrough to those businesses that are ready tocommence trading.GROWTH CAPITAL: This is aimed at providingadditional funding for young expanding businesses.


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BUY - OUT OR BUY - IN CAPITAL: This is used to fundthe acquisition of a business by the existingmanagement team or by a new management team. SHARE PURCHASE CAPITAL: This is used to fundthe purchase of shares in a business in order to buyout part of the ownership of an existing business.

RECOVERY CAPITAL: This is rescue finance which isused to turn around a business after a period of poorperformance.


THE VENTURE CAPITAL PROCESS

Step 1: Obtaining the FundsVenture capitalists obtain their funds from varioussources including large financial institutions (for e.g.Pension funds), wealthy individuals and directappeals to the public. Having obtained the funds there is often a two orthree year time lag between obtaining the requiredamount of funds and investing in appropriateinvestment opportunities.


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Step 2: Evaluating Investment opportunities andmaking a selectionOnce opportunities have been identified, thebusiness plans prepared by the management teamwill be reviewed and an assessment will be made ofthe investment potential of the business. The venture capitalist will usually be interested in the

following areas:The market for the product.The business process and the way in which they canbe managed efficiently.The quality of management.


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The opportunities for improving performance.The types of risks involved and the ways inwhich they can be managed.The track record and future prospects of thebusiness.

The financial attractiveness of the venture isoften assessed using the internal rate of return(IRS) method.


Step 3: Structuring the terms of the investmentWhen structuring the financing agreement,venture capitalists will try to ensure that theirown exposure to risk is properly managed. Some of the control mechanisms to protect theirinvestments include: receiving information onthe progress of the business at regular intervals;

manage the risk by sharing the financingrequirements of the business with other venturecapitalists.


STEP 4: Implementing the deal monitoring progress

Venture capitalists usually have a close workingrelationship with client businesses throughout theperiod of the investment. During the investment period, it is usual for theventure capitalist to offer expert advice on technicaland marketing matters. In this respect they provide a form of consultancyservice to their clients.


STEP 5: Achieving Returns and Exiting from theInvestment

A major part of the total returns from the investmentis usually achieved through the final sale of theinvestment. The particular method by which the realization of theinvestment is to be made is, therefore, of greatconcern to the venture capitalist.The most common form of trade sale (that is, wherethe investment is sold to another business).However, the floatation of the business on the stockexchange also provides an opportunity for theventure capitalist to realize the investment.


BUSINESS ANGELS

Business Angels are often wealthy individuals whohave been successful in business. They are usually willing to invest somewherebetween £10,000 and £100,000 in a short upbusiness or a business that is at an early stage ofdevelopment through a shareholding. In addition to providing finance, a business angel canusually offer a wealth of experience to buddingtycoons.


Business angel offer an informal source of sharefinance and it is not always easy for owners of smallbusiness to locate a suitable angel.

However, in the U.K, a number of business angelnetworks have now developed to help owners ofsmall businesses find their perfect partner.

The National Business Angels Network (NBAN) is anexample of such a network and is supported by anumber of financial institutions, and by the U.K.Department of trade and industry.


GOVERNMENT ASSISTANCE

Aryeetey et al (1994), Daniels and Ngwira (1992), theWorld Bank (1993) and a host of others haveconducted extensive research in to the role that SME’Splay as well as the problems they face. In Ghana, government through the ministry of tradeand Industry, NBSSI, etc are helping SME’S to achievetheir full potential. According to Daniels & Ngwira , SME’S employ about22% of the population in Developing Countries.This scheme aims to help small businesses that haveviable business plans but which lack the security toobtain a loan.


End of chapter two


Chapter three

FINANCIAL PLANNING AND PROJECTEDFINANCIAL STATEMENTS


Introduction.

It is vitally important that a business develops plansfor the future. Whatever a business is trying to achieve, it is unlikelyto be successful unless its managers have it clear intheir minds what the future direction of the businessis going to be. Finance lies at the very heart of the planning process.The financial resources of a business are limited andmust be applied in a way which enhancesshareholder wealth.


KEY STEPS IN DEVELOPING PLANS

1.

SETTING THE AIMS AND OBJECTIVES OF THEBUSINESS:

This is the starting point in the planning process.This will set out what the business is trying toachieve.The aims or goals of the business are often couchedin broad terms and may be set out in the form of amission statement.Objectives of a business are usually more specificthan its aims. They will set out more precisely whathas to be achieved


Objectives may include:

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to obtain a 20% return on assetsto work closely with customers in order toensure their requirements are metto grow in size so as to become one of the 100largest companies listed on the stock exchangeetc.

Objectives should be SMART / quantifiable andshould be consistent which the aims of thebusiness.


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2. IDENTIFYING THE OPTIONS AVAILABLETo achieve the objectives of the business a numberof possible options (strategies) may be available tothe business.A creative search for the various strategies oroptions available should be undertaken by themanagers. The type of information collected should provide anexternal analysis of the competitive environmentrelevant to each option and may include such

matters as:market size and growth prospects


••••

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level of competition within the industrybargaining power of suppliers and customersthreat of substitute productsrelative power of trade unions, community interestgroups, etc. Information concerning the capabilities of thebusiness in each of the following areas may becollected.organization culturemarketing and distribution


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manufacturing and production optionsfinance and administration, etc.

3. EVALUATING THE OPTIONS AND MAKING ASELECTION

When deciding on the most appropriate option(s) tochoose, the managers must examine information inrelation to each option to see if that option fits…

…with the objectives which have been set and toassess whether or not it is feasible to provide theresources required.


In practice however, decision makers may not be asrational and capable as implied in the processdescribed above. Individuals may find it difficult tohandle a wealth of information relating to a wide rangeof options.

As a result, they may restrict their range of possibleoptions and /or discard some information in order toprevent themselves from being overloaded.

Also, information is often produced in summarizedform and that only a restricted range of options will beconsidered. Herbert Simon ( 1 9 5 2 ) referred to thisphenomenon as bounded rationality and so managersmust satisfice.


•••

THE ROLE OF PROJECTED FINANCIAL STATEMENTSProjected financial statements portray the predictedfinancial outcomes of pursuing a particular courseof action.By showing the financial implications of certaindecisions, managers should be able to allocateresources in a more efficient and effective manner.

COMPOSITION OF PROJECTED FINANCIALSTATEMENT a projected cash flow statementa projected profit and loss account anda projected balance sheet.


Where there are competing options, projectedstatements can be prepared for each of theoptions being considered. They will set out theexpected revenues and costs associated witheach option

When managers are developing a strategy forthe future, a planning horizon of three to five

years is typically employed and projectedfinancial statements for each year of theplanning period can be prepared for eachstrategic option being considered.


Projected financial statements are usually preparedfor internal purposes only. Managers are usually reluctant to share thisinformation with those outside the business. Managers usually feel that, the publication ofprojected information could damage thecompetitive position of the business.


Providing Projected Financial Information ToThose Outside the business

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Managers will often be prepared to provideprojected financial statements when trying toraise finance for the business. Prospectivelenders may require projected financialstatements before considering a loanapplication.Projected financial statements may also bepublished if the managers feel the business isunder threat. For example, a company which isthe subject of a takeover bid, to whichmanagers are opposed, may publish projectedfinancial statements in order to give itsshareholders, confidence in the future of thecompany.


PREPARING PROJECTED FINANCIAL STATEMENTS

To prepare projected financial statements,forecasts must be made of sales, costs and therequired investment in net assets over theplanning period.

FORECASTING SALES

For most business, the starting point for preparingprojected statements will be the forecast for sales. The ability to sell the goods or service producedwill normally be the key factor which decides theoverall level of activity for the business.


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Future sales could be influenced be the followingfactors.the degree of competitionplanned expenditure on advertisingquality of the product or servicegeneral state of the economychanges in consumer tastes

Some of these factors will be under the controlof the business, but others will not.


DEVELOPING THE SALES PROJECTIONS1.

They may be developed by simply aggregatingthe projections made by the sales force orregional sales managers.The use of market research techniques ispreferred especially during the launch of a newproduct or service.

2. Sales projections may also be based on

statistical techniques, or in the case of largebusinesses, economic models. These techniquesare usually complex and may incorporate anumber of variables and the relationshipsbetween these variables may be complex.


FORECASTING COSTS

As mentioned earlier, a reliable sales projection isessential, as many other items, including certaincosts, will be determined by the level of sales. However not all costs relating to a business will varywith the level of sales.

COSTS LIKELY TO VARY WITH LEVEL OF SALES (VARIABLE COSTS)1. Cost of sales2. Materials consumed3. Sales force commission


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COSTS LIKELY TO STAY CONSTANT (FIXED COSTS)Depreciationrentratesinsurancesalaries

These may stay fixed for a period.

SEMI-VARIABLE OR SEMI FIXED COSTSSome costs have both a variable and a fixedelement so may vary partially with sales output


They are referred to as semi-variable / semifixed costs. Such costs may be identified forinstance by examining past records of thebusiness. Heat and light cost may be anexample. A certain amount of heating and lighting will beincurred irrespective of the level of sales.However, if overtime is being worked due toincreased demand, this cost will increase.


FORECASTING BALANCE SHEET ITEMS

The level of activity will also have an effect oncertain items appearing in the balance sheet.

A number of items appearing on the balancesheet of a business are likely to increase‘spontaneously’ with an increase in the level ofsales.


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BALANCE SHEET ITEMS WHICH WILL INCREASE AS ARESULT OF AN INCREASE IN THE LEVEL OF SALES

An increase in the level of sales should lead toan increase in the level of current assets. A business is likely to need;more cash to meet increased cost incurredhigher levels of trade debtors as a result ofhigher saleshigher levels of stock to meet the increase indemand.


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AN INCREASE IN THE LEVEL OF SALES SHOULDALSO LEAD TO AN INCREASE IN THE LEVEL OFCURRENT LIABILITIES. A BUSINESS IS LIKELY TOINCUR:

more trade creditors as a result of increasedpurchasesmore accrued expenses as a result of increasedoverhead costsAn approach that can be used to forecast certainbalance sheet items is the per-cent of salesmethod. As the name suggests, this methodexpresses those elements that are connected tothe level of sales as a percentage of the sales forthe period.


To apply this method, managers must examinepast records to see which balance sheet items

vary in proportion to the level of sales.

However, other more sophisticated methodsinvolving statistical analysis can be employed ifthey are found to be more appropriate.


OTHER FORECASTING ISSUES

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When preparing forecasts, changes in governmentpolicy and changes in the economic environmentmust be carefully considered. In particular,estimates of the following must be made:the rate of corporation taxinterest rates for borrowingthe rate of inflation.

There is usually a great deal of publishedhistorical and forecast data to help in preparingsuch estimates.


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THE POLICIES AND EXISTING COMMITMENTS OFTHE BUSINESS MUST ALSO BE CONSIDEREDWHEN PREPARING THE PROJECTEDSTATEMENTS. THESE MAY RELATE TO SUCHMATTERS AS:capital expenditurefinancing methodsdepreciation methods and ratesdividend payments.Determining the rate of preference dividends isnot a problem as usually the rate is specified.For ordinary shares however, this rate is

determined by managers and also relies on levelof profits.


PROJECTED CASHFLOW STATEMENTThis is useful because it helps to identify

changes in the liquidity of a business over time. Cash has been described as the ‘life-blood’ of abusiness, it is vital for a business to havesufficient liquid resources to meet its maturingobligations. Failure to maintain an adequate level of liquiditycan have disastrous consequences for thebusiness.


How helpful!The projected cash flow statement helps toassess the impact of expected future events onthe cash balance.

Where there is a cash surplus , managers shouldconsider the profitable investment of the cash.Where there is a cash deficit, managers shouldconsider the ways in which this can be financed.The cash flow statement simply records thecash in flows and out flows of the business.


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The main sources of cash in flow are:cash sales , trade debtors, other income,loan capital issued, share capital issuedsale of fixed assets In practice, the main inflows will often be thecash from sales (cash sales and trade debtors)and financing (shares and loan capital issued). The main outflow will often be operating cost(purchases and overheads) and investment inasset.


There is no set format for the projected cashflow statement as it is normally used for internalpurposes only.

Management is free to decide on the form ofpresentation which best suits their needs.


Below is an outline cash flow statement (projected)for a six month period (January – June).

Jan Feb Mar Apr May Jun

Cash inflowIssue of shareCredit sales

……. ……. …… ……. ……. …….Cash out flowsCredit costsRent and ratesFittings ……. …… …… …… ……. ……..


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Net cash flowOpening balanceClosing balance………………………………………. You can see from this outline that:

each column represents a monthly periodat the top of each column, the cash in flow andout flows are set out and a monthly total forthese is also shown.

The difference between the monthly totals ofcash in flows and out flows is the net cash flowfor the month


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When preparing a cash flow statement, there aretwo questions we must ask concerning eachitem of information presented to us. The firstquestion is: Does the item of information concern a cash

transaction .(i.e. does it involve cash inflows or

outflows)? If the answer to this question is ‘no’then the information should be ignored for thepurposes of preparing this statement.

If the answer to the above question is ‘yes’ thena second question must be asked which is…


When did the cash transaction take place? It isimportant to identify the particular month inwhich the cash movement takes place.

Often, the movement will occur after the periodin which a particular transaction has been agreed,for example, where sales and purchases aremade on credit.

It is worth emphasizing that , the format usedabove is for internal reporting purposes only.


PROJECTED PROFIT AND LOSS ACCOUNT

A projected profit and loss account helps provide aninsight into the expected level of future profits.

When preparing the projected profit and lossaccount, it is important to include all revenues whichare realized (i.e. achieved) within the period.Normally, revenue is realized when the goods arepassed to, and accepted by a customer. Where salesare on credit, this will occur before the cash isactually received.

For this particular statement, the timing of the cashinflows from credit sales is not relevant.


PROJECTED BALANCE SHEETThe projected balance sheet reveals the end-of-period balances for assets, liabilities and capitaland should normally be the last of the threestatements to be prepared.

This is because, the previous statements preparedwill provide information to be used whenpreparing the projected balance sheet.The projected cash flow statement reveals theend-of-period cash balance for inclusion under‘current assets’ (or where there is a negativebalance, for inclusion under ‘creditors: amountsdue within one year).


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PROJECTED FINANCIAL STATEMENTS ANDDECISION MAKINGThe projected financial statements, once prepared,

should be critically examined by managers.There is a danger that the figures contained withinthe statements will be too readily accepted bythose without a financial background. Managers

must ask questions such as:How reliable are the projections which have beenmade?What underlying assumptions have been madeand are they valid?Have all relevant items been included?


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Managers must also find answers to a variety ofquestions including:Are the cash flows satisfactory? Can they beimproved by changing policies or plans (e.g.delaying capital expenditure decisions, requiringdebtors to pay more quickly etc)Is there a need for additional financing? Is itfeasible to obtain the amount required?Can any surplus funds be profitably reinvested?Are the sales and individual expense items at asatisfactory level?Is the level of borrowing acceptable?Is the financial position at the end of the periodacceptable?


PROJECTED FINANCIAL STATEMENTS AND RISK

When making estimates concerning the future, thereis always a chance that things will not turn out asexpected. The likelihood that what is estimated to occur willnot actually occur is referred to as risk.

In practice, there are various methods available tohelp managers deal with uncertainty concerning thefigures contained within the projected financialstatements.


SENSITIVITY ANALYSIS

This is a useful tool to employ when evaluatingthe contents of a projected financial statement. The technique involves taking a single variable(e.g. volume of sales) and examining the effectof changes in the chosen variable on the likelyperformance and position of the business.


By examining the shifts which occur, it is possibleto arrive at some assessment of how sensitive

changes are for the projected outcomes. Although only one variable is examined at a time,a number of variables, considered to be importantto the performance of a business may beexamined consecutively.

One form of sensitivity analysis is to pose seriesof ‘what if?’ Questions. If we take sales forexample we might ask the following ‘what if’?Questions.


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what if sales volume is 5 percent higher thanexpectedwhat if sales volume is 1 0 percent lower thanexpectedwhat if sales price is reduced by 1 5 percent?What if sales price could be increase by 2 0percent? In answering these questions, it is possible todevelop a better ‘feel’ for the effect offorecast inaccuracies on the final outcomes.


SCENARIO ANALYSIS

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Another approach to help managers gain a feelfor the effect of forecast inaccuracies is toprepare projected financial statementsaccording to different possible ‘states of theworld’.For example, managers may wish to examineprojected financial statements prepared on thefollowing basis.

an optimistic view of likely future eventsa pessimistic view of likely future eventsa ‘most likely’ view of future events.


This approach is known as scenarioanalysis and, unlike sensitivity analysis,it will involve changing a number of variablessimultaneously in order to portray a possible‘state of the world’.


END OF CHAPTER


Chapter fourFINANCIAL STATEMENT ANALYSIS AND

INTERPRETATION


Introduction

A wide range of individuals and organizationshave financial and other links with companies.

In our first lecture, we identified a number ofstakeholder groups such as employees,customers, suppliers and the community.

These stakeholder groups have their ownspecific interests which may sometimes conflict.


However, in one way or another, they are allconcerned with the performance of the company,its continuing existence, and its ability to providethem with a positive return in some form, mostusually cash. Ideally, each of these user groups would likeinformation about the past performance of theentity, about its current state of affairs and,perhaps most importantly, about its future – withall this information being directed to theirspecific concerns.


FINANCIAL RATIOS

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Financial ratios provide a quick and relativelysimple means of examining the financialcondition of a business.

A ratio simply expresses the relation of onefigure appearing in the financial statements tosome other figure appearing there (for example,net profit in relation to capital employed) orperhaps some resource of the business (forexample net profit per employee).


Ratios can be very helpful when comparing thefinancial health of different businesses. Differences may exist between businesses in the

scale of operations , and so a direct comparisonof say the profits generated by each businessmay be misleading. By expressing profit in relation to some othermeasure (for example sales), the problem of

scale is eliminated.


Example:

A business with a profit of, say, Ghc10,000 and asales turnover of Ghc100,000 can be comparedwith a much larger business with a profit of say,Ghc80,000 and a sales turnover of Ghc1,000,000by the use of a simple ratio. There is no generally accepted list of ratioswhich can be applied to company financialstatements, nor is there a standard method ofcalculating many ratios.


The ratios discussed in this section are thosethat many consider to be among the moreimportant for decision making purposes.


FINANCIAL RATIO CLASSIFICATION

Ratios can be grouped into certain categories,each of which reflect a particular aspect offinancial performance or position.

The following broad categories provide a usefulbasis for explaining the nature of the financialratios to be dealt with.


(a) Profitability ratio: - Business come into being with the primarypurpose of creating wealth for the owners. Profitability ratios provide an insight into thedegree of success of the owners in achieving thispurpose. They express the profits made in relation to otherkey figures in the financial statements or to somebusiness resource.


(b)

(c)

Efficiency/Activity:Ratios may be used to measure the efficiencywith which certain resources have been utilizedwithin the business.These ratios are also referred to as activityratios. Liquidity:

This is very vital to the survival of a business in thesense that there has to be sufficient liquidresources to meet maturing obligations.


Certain ratios may be calculated which examine therelationship between liquid resources held andcreditors due for payment in the near future.

(d) Gearing:

Gearing is an important issue which managers mustconsider when making financial decisions.

The relationship between the amount financed by theowners of the business and the amount contributedby outsiders has an important effect on the degreeof risk associated with a business.


(e) Investment: -Certain ratios are concerned with assessing thereturns and performance of shares held in aparticular business.

THE NEED FOR COMPARISON/BENCHMARKS

Calculating a ratio will not by itself tell you verymuch about the position or performance of abusiness.It is only when you compare this ratio with somebench mark that the information can beinterpreted and evaluated.


BASES FOR COMPARISON(1) Past Periods/Trend Analysis – By comparing the

ratio you have calculated with the ratio of aprevious period, it is possible to detect whetherthere has been an improvement or deterioration inperformance.

(2) Planned Performance/Setting Financial Targets

– Ratios may be compared with the targets whichmanagement developed before thecommencement of the period under review.The comparison of planned performance withactual performance may therefore be a useful wayof revealing the level of achievement attained.


(3) Similar Businesses – In a competitive environment,a business must consider its performance in relationto those of other businesses operating in the sameindustry. Survival may depend on the ability to achievecomparable levels of performance. This is a useful basis for comparing a particular ratioachieved by similar businesses during the sameperiod.


KEY STEPS IN FINANCIAL RATIO ANALYSIS (1)

(2)

(3)

The first step involves identifying the key indicatorsand relationships which require examination. Inorder to carry out this step, the analyst must be clearwho the target users are and why they need theinformation. The next step is to calculate the appropriate ratiosfor the particular users and the purpose for whichthey require the information. The final step is the interpretation and evaluation ofthe ratios. Interpretation involves examining theratios with an appropriate basis for comparison andother information which may be relevant.


THE RATIOS CALCULATED

PROFITABILITYThe following ratios may be used to evaluate theprofitability of the businesses.

(a) RETURN ON ORDINARY SHAREHOLDERS FUNDS

The ROSF compares the amount of profit for theperiod available to the ordinary shareholders, withthe ordinary shareholders stake in the business.


The ratio which is normally expressed inpercentage terms is as follows:

ROSF = Net profit after tax & pref. dividend (if any) x 100

Ordinary share capital plus reserves

The net profit after taxation and after anypreference dividend is used in calculating theratio as this residual figure represents theamount of profit available to ordinaryshareholders.


In the case of Alexis Plc, the ROSF ratio for the yearended 31 M arch 19 x 2 is:

R O SF = £15 9 . 2 x 100

£4 9 8.3 = 31.9 %

For the year ended, 31st M arch 19x3 R O SF = £1 6 4 . 2 X 100

£ 6 3 6 . 6 = 2 5 .8 %


RETURN ON CAPITAL EMPLOYED ( ROCE)The R O CE is a fundamental measure of businessperformance. This ratio expresses the relationship between thenet profit generated by the business and the longterm capital invested in the business. The R O CE is expressed in percentage terms asfollows:


ROCE = Net Profit before Interest and Taxation Share capital + Reserves + Long term loans

N et profit before interest and taxation is usedbecause the ratio attempts to measure thereturns to all suppliers of long term financebefore …

… any deduction for interest payable to lendersor payments of dividends to share holders aremade.


For the year ending 31 M arch 1 9 x 2, the R O CE forAlexis Plc is:

R O CE = £ 2 4 3. 4 x 100

£ 6 9 8.3= 34.9 0 %

For 31 M arch 1 9 x3,R O CE = £ 246.4 x 100

£ 696.6 = 3 5 . 4 %


•

•

ROCE is considered by many to be a primarymeasure of profitability. It compares inputs(capital invested) with outputs (profit). This comparison is of vital importance inassessing the effectiveness with which fundshave been deployed.


Although ROSF and ROCE measure returns oncapital invested, ROSF is concerned withmeasuring the returns achieved by ordinaryshareholders, … .... whereas ROCE is concerned with measuringreturns achieved from all the long term capitalinvested.


Net Profit marginThe net profit margin relates the net profit for theperiod to the sales during that period. The ratio isexpressed as:

Net Profit = Net Profit before Interest

and Taxation x 100 Sales

The net profit before interest and taxation is used inthis ratio as it represents the profits from tradingoperations before any costs of servicing long termfinance are taken into account. This is often regardedas the most appropriate measure of operationalperformance …..


… . for comparison purposes as differences arisingfrom the way in which a particular business isfinanced will not influence this measure.

In practice the net profit after taxation is alsoused, on occasions, as the numerator. The purpose for which the ratio is required willdetermine which form of calculation isappropriate.The ratio compares one output of the business(profit) with another output (sales).


The net Profit margin of Alexis Plc (based on the netprofit before interest and taxation) for the year ended 31March 19x2 is:

Net Profit Margin = £243.4 x 100

£2,240.8= 10.9%

For the year ended 31 March 19x3

Net Profit Margin = £246.4 x 100

£2,681.2 = 9.2%


GROSS PROFIT MARGINThe gross profit relates the gross profit of thebusiness to the sales generated for the same period.Gross profit represents the difference between salesand cost of sales. The ratio is therefore a measure of profitability inbuying (or producing) and selling goods before anyother expenses are taken into account. As cost of sales represents a major expense for retailingand manufacturing businesses, a change in this ratio canhave a significant effect on the ‘bottom line’ (that is thenet profit for the year).


Gross Profit Margin = Gross Profit x 100 Sales

For the year to 31 March 19x2, the ratio for Alexis Plc is:Gross Profit Margin = £495.4 x 100

£2,240.8= 22.1%

Gross Profit Margin for the year to 31 March 19x3is:

Gross Profit Margin = £609.2 x 100£2,681.2

= 22.7%


The profitability ratios for Alexis Plc can be set out asfollows:

19x2 19x3ROSF 31.9% 25.8%ROCE 34.9% 35.3%Net Profit Margin 10.9% 9.2. %Gross Profit margin 22.1% 22.7% COMPARISON OF THE RATIOS OF ALEXIS Plc

The gross profit margin shows a slight increase in 19x3over the previous year. This may be for a number ofreasons such as an increase in selling prices and adecrease in the cost of sales.


However, the net profit margin has shown a slightdecline over the period.This means that operating expenses (wages, rate,insurance and so on) are absorbing a greaterproportion of sales income in 19x3 than in the previousyear.

EFFICIENCY RATIOS

Efficiency ratios examine the ways in which variousresources of the business are managed. The following ratios consider some of the importantaspects of resource management.


Average Stock Turnover PeriodStocks represent a significant investment for abusiness. For some types of businesses forexample manufacturers), stocks may account for asubstantial proportion of the total assets held. The average stock turnover period measures theaverage number of days for which stocks are beingheld. The average stock for the period can be calculatedas a simple average of the opening and closingstock levels for the year.


However, in the case of a highly seasonal businesswhere stock levels may vary considerably over the year,a monthly average may be more appropriate.

In the case of Alexis Plc, the stock turnover period forthe year ended 31 March 19x2 is:

Stock Turnover Period

= Average Stock Held x 365 days. Cost of sales

= £ (241 + 300)/2 x 365 days £1745.4

= 57 days (to nearest day),


This means that, on average the stock held is being‘turned over’ every 57 days. A business will normally prefer a low stock turnoverperiod to a high period as funds tied up in stocks cannotbe used for other profitable purposes.

The average stock turnover period for Alexis Plc for theyear to 31 March 19x3 is:

Stock Turnover Period = £ (300 + 370.8)/2 x 360

£2,072= 59 days


Average Settlement Period for Debtors(Debtor Days)

A business will usually be concerned with how long ittakes for customers to pay the amounts owing. The

speed of payment can have a significant effect onthe cash flows for the business. The average settlement period for debtorscalculates how long, on average, credit customerstake to pay the amounts which they owe to thebusiness.


A business will normally prefer a shorter averagesettlement period than a longer one as, once againfunds are being tied up which may be used for moreprofitable purposes.

The ratio is as follows: Debtor Days = Trade Debtors x 365 days

Credit sales

We are told that all sales made by Alexis Plc are oncredit and so the average settlement period fordebtors for the year ended 31 March 19x2 is:


Debtor Days = £240.8 x 365£2240.8

= 39 Days

Average settlement period for debtors for the year to19x3 is

Average settlement = £210.2 x 365

£2681.2 =29 Days


AVERAGE SETTLEMENT PERIOD FOR CREDITORS(CREDITOR DAYS)

The average settlement Period for creditors tells ushow long, on average the business takes to pay itstrade creditors. As trade creditors provide a free source of financefor the business, it is perhaps not surprising thatsome businesses attempt to increase their averagesettlement period for trade creditors. However such a policy can be taken too far and canresult in a loss of goodwill by suppliers.


The ratio is calculated as follows: Creditor Days = Trade Creditors x 365 days

Credit Purchases

Trade Creditors for the year ended 31 March 19x2 is asfollows:

Creditor Days = £221.5 x 365 Days

£1804.4= 45Days


For the year ended 31 March 19x3:

Creditor Days = £228.8x 365 Days£2142.8

= 39 Days SALES TO CAPITAL EMPLOYED RATIO

The sales to capital employed Ratio examines howeffective the long – term capital employed of thebusiness has been, in generating sales revenue. The long term capital employed here is shareholdersfunds plus long term loans.


Generally speaking, a higher sales to capital employedratio is preferred to a lower one. A higher ratio will normally suggest that the capital (asrepresented by total assets less current liabilities) isbeing used more productively in the generation ofrevenue.

However a very high ratio may suggest that thebusiness is undercapitalized, that is, it has insufficientlong term capital to support the level of sales achieved.

The ratio is calculated as follows:


Sales to capital = salesEmployed ratio long term capital employed

(that is, shareholders’ funds + long term loans) The ratio for Alexis Plc in 19x2 is: Sales to capital employed

= £2,240.8 = 3.2 times£ (498.3+200.0)

For 19x3, the ratio is: Sales to capital = £2,681.2 = 3.8 timesEmployed £ (636.6+60.0)


SALES PER EMPLOYEEThe sales per employee ratio relate sales generated to aparticular business resource. It provides a measure ofthe productivity of the workforce.The ratio is calculated as follows:

Sales Per employee = Sales

Number of employees The ratio for Alexis Plc in 19x2 is: Sales Per Employee = 2,240,800

14= £160057


For the year ended 31 March 19x3 , the ratiois:

Sales Per Employee = £2,681,200

18= £148,956

The efficiency ratios for Alexis Plcmay be SUMMARIZED AS FOLLOWS:


••

•

••

19x2 19x3Stock turnover Period 57 days 59 daysAverage settlement 39 days 29 days

for DebtorsAverage settlement 45 days 39 days

Period for CreditorsSales to capital employed 3.2 times 3.8 timesSales Per employee £160 057 140,956

COMPARISON OF EFFICIENCY RATIOS FOR ALEXIS Plc

A comparison of the efficiency ratios between yearsprovide a mixed picture. The average settlement periodbetween debtors and creditors has reduced.


The reduction may have been the result of deliberatepolicy decisions, for example tighter credit control fordebtors, paying creditors promptly in order to maintaingood will or to take advantage of discounts.

The stock turnover period has shown a slight decreaseover the period but this may not be significant.

Overall , there has been an increase in the sales tocapital employed ratio which means that the sales haveincreased by a greater proportion than the capitalemployed of the business. Sales per employee, however, has declined and thereasons for this should be investigated.


LIQUIDITY RATIOS:CURRENT RATIO

The current ratio compares the liquid assets (cash andthose assets held which will soon be turned into cash) ofthe business with current liabilities (creditors due withinone year).The ratio is calculated as follows:

Current ratio = Current AssetsCurrent Liabilities

For the year ended 31 March 19x3 the ratio is:

Current ratio = £574.3 = 1.8 times£321.8


For 19x3 the ratio is:Current ratio = £622.0

£364.8= 1.7 times

The ratio reveals that the current assets cover thecurrent liabilities by 1.8 times. In some texts, the notion of an ideal current ratio(usually 2 times) is suggested for businesses. However this fails to take into account the fact thatdifferent types of businesses require differentcurrent ratios.


The higher the ratio, the more liquid the business isconsidered to be. As liquidity is vital to the survival ofthe business, a higher current ratio is normally preferredto a lower one.

ACID TEST RATIOThe acid test ratio represents a more stringent test ofliquidity. It can be argued that, for many businesses, thestock in hand cannot be converted to cash quickly.

Note that in the case of Alexis Plc, the stock turnover periodwas more than 50 days in both years. As a result, it may bebetter to exclude this particular asset from any measure ofliquidity.The acid test ratio is based on this idea and is calculated asfollows:


Acid test ratio = Current Assets (excluding stock)Current liabilities

The Acid test ratio for Alexis Plc for the year ended19x2 is as follows:Acid test ratio = £(574.3-300)

£321.8 = 0.9 times

For 19x3, the Acid test ratio is; Acid test ratio = £(622.0-370.8)

£364.8 = 0.7 times


We can see that the ‘liquid’ current assets do not quitecover the current liabilities and so the business may beexperiencing some liquidity problems.

In some types of businesses, however, where a patternof strong positive cash flow exists, it is not unusual forthe acid test ratio to be below 1.0 without causingliquidity problems.

The liquidity ratios for Alexis Plc over the two yearperiod may be summarized as follows:

19x2 19x3Current ratio 1.8 1.7Acid text ratio 0.9 0.7


COMPARISON OF LIQUIDITY RATIOSA comparison of the two years reveals a decrease inboth the current ratio and acid test ratio. Thesechanges suggest a worsening liquidity position forthe business.

The business must monitor its liquidity carefully andbe alert to any further deterioration in these ratios.

GEARING

Gearing occurs when a business is financed, at leastin part, by contributions from outside parties.


The level of gearing (that is the extent to which abusiness is financed by outside the parties)associated with a business is often an importantfactor in assessing risk. Where a business borrows heavily, it takes on acommitment to pay interest charges and makecapital repayments.

This can be a real financial burden and can increasethe risk of a business becoming insolvent.Nevertheless, it is the case that most businesses aregeared to a greater or lesser extent.


GEARING RATIOThe gearing ratio, measures the contribution of long-termlenders to the long term capital structure of a business. It iscalculated as follows:

Gearing = Long term liabilities share

capital + reserves + Long term liabilities

The gearing ratio for Alexis Plc for the year ended 31 March19x2 is;

Gearing ratio = £200 x 100

£ (498.3+200) = 28.6%


o

o

Gearing Ratio for 19x3:

= £60 x 100= 8.6%£(636.6+60)

This ratio reveals a substantive fall in the level ofgearing over the year. The gearing ratio for 19x2 revealsa level of gearing which would not normally beconsidered to be very high. However, in deciding on what an acceptable level ofgearing might be, we should consider the likely futurepattern and growth of profit and cash flows.


INTEREST COVER RATIO

The interest cover ratio measures the amount of profitavailable to cover interest payable.The ratio may be calculated ass follows;

Interest Cover ratio = Profit before interest & taxation

Interest Payable

The ratio for Alexis Plc for the year ended 31 March 19x2 is: Interest Cover ratio = £(219.0+24)

£24 = 10.1 times


The ratio shows that the level of profit is considerablyhigher than the level of interest payable. Thus, a significant fall in profits could occur before profitlevels failed to cover interest payable.

The Interest cover ratio for 19x3 is;Interest Cover ratio

= £(240.2+6.2) £6.2

= 39.7 times


COMPARISON OF GEARING RATIOS

19x2 19x3Gearing Ratio 28.6% 8.6%Interest Cover Ratio 10.1 times 39.7 times

Both the gearing ratio and interest cover ratio havechanged significantly in 19x3 . This is owing mainlyto the fact that a substantial part of the long – termloan was repaid during 19x3.This repayment had the effect of reducing the relativecontribution of long-term lenders to the financing of thebusiness and reducing the amount of interest payable.


INVESTMENT RATIOSThere are a number of ratios which are designed to helpinvestors who hold shares in a company to assess thereturns on their investment.

DIVIDEND PER SHARE

The dividend per share ratio relates the dividendannounced during a period to the number of shares inissue during that period. The ratio is calculated asfollows:

Dividend = Dividends announced duringPer share the Period

No. of shares in Issue


In essence, the ratio provides an indication of cashreturn which an investor receives from holding shares ina company.Although it is a useful measure, it must always beremembered that the dividends received will usually onlyrepresent a partial measure of return to investors.

The ploughed back profits also belong to theshareholders and should, in principle, increase the valueof the shares held.

The ratio can be calculated for each class of shareissued by a company. Alexis Plc has only ordinaryshares in issue and therefore only one dividend pershare ratio can be calculated.


Dividend per share for Alexis Plc for the year-ended 19x2 is: Dividend Per share = £40.2

£600(i.e. £0.50 shares and £300 share capital)

= 0.067 = 6.7p

The dividend per share for 19x3 is; Dividend per share = £60.0

668.20.089 = 9.0p


Comparing dividend per share between companies is notalways useful as there may be differences between thenominal value of shares issued. However, it is often useful to monitor the trend ofdividends per share for a particular company over aperiod of time.

DIVIDEND PAYOUT RATIO

The dividend payout ratio measures the proportion ofearnings which a company pays out to share holders inthe form of dividends.

The ratio is calculated as follows;


Dividend = Dividends Announced for the year x 100Payout Ratio Earnings for the year available for Dividends

In the case of ordinary (equity) shares, the earningsavailable for dividend will normally be the net profit aftertaxation and after any preference dividends announcedduring the period.The ratio is normally expressed as a percentage.

The dividend payout ratio for Alexis Plc in 19x2 is; Dividend Payout ratio = £40.2 x 100

£159.2 = 25.3%


The ratio for 19x3 is;

Dividend Payout ratio = £60 x 100£164.2

= 36.5% EARNINGS PER SHARE

The earnings per share of a company, relates theearnings generated by the company during a period andavailable to shareholders to the number of shares inissue.


For ordinary shareholders, the amount available will berepresented by net profit after tax (less any preferencedividend where applicable).The ratio for ordinary shareholders is calculated asfollows:

Earnings Per = Earnings Available to OrdinaryShare Shareholders

No. of ordinary shares in issueThe EPS for Alexis P/c in 19x2 is: EPS = £159.2 600

= 26.5P


The EPS for Alexis P/c in 19x3 is:EPS = £164.2

668.2= 24.6P

The ratio is regarded by many investment analysts as afundamental measure of share performance. The trend

in earnings per share overtime is used to help assessthe investment potential of a company’s shares.

It is not usually very helpful to compare the earnings pershare of one company with another.


Difference in capital structures can render any suchcomparison measure meaningless.

However, like dividend per share, it can be veryuseful to monitor the changes which occur in thisratio for a particular company over time.

OPERATING CASH FLOW PER SHARE

It cans be argued that, in the short run at least,operating cash flow per share provides a betterguide to the ability of a company to pay dividendsand to undertake planned expenditures than theearnings per share figure.


o The operating cash flow (OCF) per ordinary share iscalculated as follows:

OCF per ordinary = Operating Cash flows – Preference dividends (if any)

No. of ordinary shares in Issue

The OCF for Alexis Plc in 19x2 is: OCF per share = £231.0

600.0= 38.5p


OCF per share in 19x3 is;

OCF per share = £251.4 668.2 = 37.6p

There has been a slight decline in the ratio over the two-year period. Note that , for both years, the operating cashflow per share for Alexis Plc is higher than the earningsper share. This is not unusual.

The effect of adding back depreciation in order to deriveoperating cash flows will often ensure a higher figure isderived.


PRICE/EARNINGS RATIOThe price/earnings ratio relates the market value of ashare to the earnings per share. This ratio can be

calculated as follows:

P/E ratio = Market Value per Share Earnings per share

The Ratio = £ 2.50 = 9.4 times 26.5p

The P/E ratio for Alexis Plc in 19x3 is P/E ratio = £3.50 24.6 = 14.2 times


o

o

The ratio reveals that the capital value of the share in19x2 is 9.4 times higher than its current level of earnings.The ratio is in essence, a measure of market confidenceconcerning the future of a company. The higher the P/E ratio, the greater the confidence inthe future earning power of the company and,consequently, the more investors are prepared to pay inrelation to the earnings stream of the company.


THE INVESTMENT RATIOS FOR ALEXIS Plc19x2 19x3

Dividend Per share 6.7p 9.0pDividend Payout ratio 25.3% 36.5%Earnings Per share 26.5p 24.6pOCF per share 38.5p 37.6pPrice/Earnings ratio 9.4 times 14.2 times COMPARISON OF INVESTMENT RATIOS

There has been a significant increase in the dividend per share in19x3 when compared to the previous year.

The dividend payout ratio reveals that this can be attributedat least in part to, an increase in the proportion of earningsdistributed to ordinary shareholders.


Earnings per share show a slight fall in 19x3 whencompared with the previous year. A slight fall alsooccurs in the operating cash flows per share.

However, the price/earnings ratio shows a significantimprovement. The market is clearly much moreconfident about the future prospects of the business atthe end of the year to 31 March 19x3 .


(1)

LIMITATIONS OF RATIO ANALYSIS

Although ratios offer a quick and useful method ofanalyzing the position and performance of a businessthey are not without their limitations.

Quality of Financial statements: - It must always beremembered that ratios are based on financialstatements….

…. and the results of ratio analysis are dependent on thequality of these underlying statements.

Ratios will inherit the limitations of the financial

statements on which they are based.


In recent years, for example, conventional accounts havebeen distorted as a result of changing price levels.

Traditional accounting assumes unfortunately, that, themonetary unit will remain stable over time even thoughthere have been high levels of inflation during the pastfew decades.One effect of inflation is that values of assets held forany length of time, may bear little relation to currentvalues.

Generally speaking , the value of assets held will beunderstated in current terms during a period of inflationas they are recorded at their original costs (less anamount written off for depreciation).


(2) The basis for comparison:-

When comparing businesses, it is important to note thatno two businesses will be identical and the greater thedifferences between businesses being compared, thegreater the limitations of ratio analysis.

(3) Balance Sheet ratios-

Because the balance sheet is only a ‘snapshot’ of thebusiness at a particular moment in time, any ratiosbased on balance sheet figures, such as the liquidityratios calculated, may not be representative of thefinancial position of the business for the year as whole.


END OF CHAPTER


Chapter six

MANAGEMENT OF WORKING CAPITAL


•••

••

Introduction:Working capital is usually defined as: ‘Current assets lessCurrent liabilities (that is, creditors due within one year)’.The major elements of current assets are;

StocksTrade DebtorsCash (in hand and at bank)

The major elements of current liabilities are:

Trade Creditors andBank Overdrafts


OBJECTIVES OF WORKINGCAPITAL MANAGEMENT

To be effective, working capital managementrequires a clear specification of the objectivesto be achieved. The two main objectives ofworking capital management are to increasethe profitability of a company and to ensurethat it has sufficient liquidity to meet short-termobligations as they fall due and so continue inbusiness (Pass and Pike 1984). Profitability isrelated to the goal of shareholder wealthmaximization, so investment in current assetsshould be made only if an acceptable return isobtained.


While liquidity is needed for a company tocontinue in business, a company may choose tohold more cash than is needed for operational ortransaction needs, for example for precautionaryor speculative reasons.WORKING CAPITAL POLICIESBecause working capital management is soimportant, a company will need to formulateclear policies concerning the variouscomponents of working capital. Key policy areasrelate to the level of investment in working capitalfor a given level of operations and the extent towhich working capital is financed from short-term funds such as a bank overdraft.


A company should have working capitalpolicies on the management of inventory,trade receivables, cash and short-terminvestments in order to minimise thepossibility of managers making decisionswhich are not in the best interest of thecompany. Examples of such suboptimaldecisions are giving credit to customerswho are unlikely to pat and orderingunnecessary inventories of raw materials.


TYPES OF WORKING CAPITAL POLICIESAGGRESSIVE POLICYAn aggressive policy with regard to the levelof investment in working capital means that acompany chooses to operate with lowerlevels of inventory, trade receivables and cashfor a given level of activity or sales. Anaggressive policy will increase profitabilitysince less cash will be tied up in currentassets, but it will also increase risk since thepossibility of cash shortages or running outof inventory is increased.


CONSERVATIVE POLICYA conservative and more flexible workingcapital policy for a given level of turnoverwould be associated with maintaining alarger cash balance, perhaps even investingin short0term securities, offering moregenerous credit terms to customers andholding higher levels of inventory. Such apolicy will give rise to a lower risk financialproblems or inventory problems, but at theexpense of reducing profitability.


MODERATE POLICYA moderate policy would tread a middle pathbetween the aggressive and conservativeapproaches.It should be noted that the working capitalpolicies of a company can be characterised asaggressive, moderate or conservative only bycomparing them with the working capitalpolicies of similar companies. There are noabsolute benchmarks of what may be regardedas aggressive or otherwise, but thesecharacterisations are useful for analysing theways in which individual companies approachthe operational problem of working capitalmanagement.


•

•

The size and composition of working capital can varybetween industries.

For some types of business, the investment in workingcapital can be substantial, for example , amanufacturing company will invest heavily in rawmaterials, work – in – progress and finished goods andwill often sell goods on credit thereby incurring tradedebtors.

A retailer, on the other hand, will hold only one form ofstock (finished goods), and will usually sell goods forcash.


Working capital represents a net investment inshort-term assets. These assets are continuallyflowing into and out of the business and areessential for day to day operations.

The various elements of working capital areinterrelated and can be seen as part of a short-term cycle. The management of working capital isan essential part of the short term planningprocess.

It is necessary for management to decide howmuch of each element should be held.


–

••••

Managers must try to identify changes occurring so as toensure the level of investment in working capital isappropriate.

What kind of changes in the business environmentmight lead to a decision to change the level ofinvestment in working capital? Try and identify fourpossible changes

In answering this activity, you may have thought of thefollowing;Changes in interest ratesChanges in market demandChanges in seasonsChanges in the state of the economy


In the sections, which follow, we will consider eachelement of working capital separately, examining thefactors, which must be considered to ensure their propermanagement.

MANAGEMENT OF STOCKA business may hold stocks for various reasons. Themost common reason is, of course, to meet theimmediate day – to -day requirements of customers andproduction.However, a business may hold more than is necessary for thispurpose, if it is believed that future supplies may be interruptedor scarce.Similarly, if the business believes that cost of stocks will risein the future, it may decide to stockpile.


Where a business holds stock simply to meet the day-to-day requirements of its customers and production, it willnormally seek to minimize the amount of stock held.

This is because, there are significant costs associatedwith holding stocks.

These include storage and handling costs, financingcosts, the risk of pilferage and obsolescence, and theopportunities foregone in tying up funds in this form ofasset.


•

•

•

•••

Loss of sales, from being unable to provide the goodsrequired immediately.Loss of goodwill from customers, through inability tosatisfy customer demandHigh transportation cost incurred to ensure stocks arereplenished quickly.Lost production owing to shortage of raw materialsInefficient production scheduling due to shortages.Purchasing stocks at a higher price than may otherwisehave been necessary in order to replenish stock quickly.

COSTS ASSOCIATED WITH TOO LOW STOCK


(a) FORECASTS OF FUTURE DEMAND;In order for there to be stock available to meet futuresales, a business must produce appropriate forecasts.The forecast should deal with each product line.

It is important that every attempt is made to ensure theaccuracy of these forecasts, as they will determinefuture ordering and production levels.

These forecasts may be derived in various ways. Theymay be developed using statistical techniques, or theymay be based on the judgment of the sales andmarketing staff.

PROCEDURES AND TECHNIQUES FOR MANAGING STOCKS


(b) FINANCIAL RATIOS:A financial ratio, which can be used to help monitorstock levels, is the average stock turnover period whichwe have already examined. The ratio, as you may recall,is calculated as follows:

Average stock = Average Stock held x 365 days

Turnover period cost of sales

The ratio will provide a picture of the average period forwhich stocks are held and can be useful as a basis forcomparison.


(c) RECORDING AND REORDERING SYSTEMS:The management of stocks in a business of any sizerequires a sound system of recording stock movements.There must be proper procedures for recording stockpurchases and sales.

Periodic stock checks will usually be required to ensurethat the amount of physical stocks held is consistentwith the stock records.

To determine the point at which stock should be ordered,information concerning the lead time (the time betweenthe placing of an order and the receipt of the goods) andthe likely level of demand will be required.


In most businesses, there will be some uncertaintysurrounding the above factors, and so a buffer or safetystock level may be maintained in case problems occur.

The effect of holding safety stock will be to raise thereorder point for goods.

(d) LEVELS OF CONTROL

Management must make a commitment to themanagement of stocks. However, the cost of controllingstocks must be weighed against the potential benefits.

It may be possible to have different levels of control.


o

o

o

A business may find that it is possible to divide its stockinto three broad categories: A, B and C. Each categorywill be based on the value of stock held. Category Astocks will represent the high – value items.

For example, 10 per cent of the physical stocks held mayaccount for 65 per cent of total value.

For these stocks , management may decide toimplement sophisticated recording procedures, exerttight control over stock movements and have a highlevel of security at the stock location.


Category B stocks will represent less valuable items held,perhaps 30 percent of the total volume of stocks mayaccount for 25 percent of the total value of stocks held.

Categorizing stock in this way can help ensure thatmanagement’s effort is directed to the most importantareas and that the cost of controlling stocks arecommensurate with their value.

(e) STOCK MANAGEMENT MODELSIt is possible to use decision models to help managestocks, the economic order quantity (EOQ) Model isconcerned with the question: how much stock shouldbe ordered?


In its simplest form, the EOQ model assumes thatdemand is constant, so that stocks will bedepleted evenly ever time and that stocks will bereplenished just at the point the stock runs out.

EOQ also assumes that the key costs associatedwith stocks are the cost of holding them andordering them.


•

It also assumes that companies do not require anysafety stock and that stock can be purchased in singleunits that correspond exactly to the EOQ, for example,

158 units and not in multiples of 50 or 100 units .

Finally the EOQ assumes that no discounts are availablefor bulk purchases. The above assumptions do notmean we should dismiss the model as being of littlevalue.

The model can be refined to accommodate theproblems of uncertainty and uneven demand as hasbeen done by many businesses.


MATERIALS REQUIREMENTS PLANNING (MRP)A material requirement planning (MRP) system takes asits starting point forecasts of sales demand. It then uses computer technology to help schedule thetiming of deliveries of bought in parts and materials tocoincide with production requirements to meet thedemand.

MRP is a coordinated approach, which links material andparts deliveries to their scheduled input to theproduction process.


o

o

o

JUST – IN – TIME (JIT) STOCK MANAGEMENTSome manufacturing businesses have tried to eliminatethe need to hold stocks by adopting a just – in – time(JIT) stock management.

This method was first used in the US defence industryduring World War II but in more recent times has beenwidely used by Japanese businesses.

The essence of this approach is, as thename suggests, to have supplies delivered to a businessjust in time for them to be used in the productionprocess.


By adopting this approach the stock holding problemrests with the suppliers rather than the business. A

close relationship between the business and itssuppliers is required to make the approach effective.

In JIT, as the suppliers will be required to hold stocks forthe business, they may try to recoup this additional costthrough increased prices. Finally the close relationship necessary between thebusiness and its suppliers may prevent the businessfrom taking advantage of cheaper sources of supplywhen they become available.


••••••

MANAGEMENT OF DEBTORSSelling goods on credit is very widespread and appearsto be the norm outside the retail trade. When a business offers to sell its goods or services oncredit, it must have clears policies concerning :Which Customers should receive credit(five Cs of credit )How much credit should be offeredWhat length of credit it is prepared to offerWhether discounts will be offered for prompt paymentWhat collection policies should be adoptedHow the risk of nonpayment can be reduced.


MANAGEMENT OF CASHWhy Hold Cash?

According to economic theory, there are 3 motivesfor holding cash. They are:

(1) Transaction motive: In order to meet day-to-daycommitments such as payment of wages, overheadsand goods purchased to be paid at due dates.

(2) Precautionary motive – if future cash flows areuncertain for any reason, it would be prudent to hold abalance of cash.

(3) Speculative motive – A business may decide to holdcash in order to be in a position to exploit profitableopportunities as and when they arise.


1.

2.

3.

HOW MUCH CASH SHOULD BE HELD?The decision as to how much cash a particular businessshould hold is a difficult one. This decision is usuallyinfluenced by the following factors:

The nature of the business- some businesses such asutilities (water & electricity) may have predictable cashflows and so can hold lower cash balances.The opportunity cost of holding cash- where there areprofitable opportunities, it may be wiser to invest in thoseopportunities than to hold a large cash balance.The availability of near liquid assets- if a business hasmarketable securities or stocks which may easily beliquidated, then the amount of cash held may be reduced.


4. Availability of borrowing- if a business can borrow easily,(and quickly); there is less need to hold cash.

5. Interest rates/cost of borrowing: When interest rates

are high, the option of borrowing becomes lessattractive.


As discussed above companies have severalreasons for holding funds in liquid or near-liquidform. Cash which is surplus to immediate needsshould earn a return by being invested on a short-term basis.There must be no risk of capital loss, since thesefunds are required to support a company’scontinuing working capital needs. To the risk ofloss, it is important for large companies to setlimits on the amount they deposit with individualbanks as banks can, and do, fail.

INVESTING SURPLUS CASH


The factors which should be considered whenchoosing an appropriate investment methodfor short-term cash surplus are:

The size of the surplus, as some investmentmethods have minimum amountsThe ease with which an investment can berealisedWhen the investment is expected to matureThe risk and yield of the investmentAny penalties which may be incurred for earlyliquidation.


Short-term methods that can be useful inmanaging corporate liquidity include moneymarket deposits, certificates of deposit,treasury bill, commercial paper and gilt-edgesgovernment securities.TERM DEPOSITSCash can be put on deposit with a bank toearn interest, with the interest rate dependingon the size of the deposit, its maturity and thenotice required for withdrawals. To maximisereturn, companies should obtain quotationsfrom several banks before making a depositsince interest rates vary between banks asthey compete for funds.


Money market deposits are useful wherecash flow needs are predictable with a highdegree of certainty.In the UK, large companies can lend directlyto banks on the interbank market at ratesclose to the London Interbank Offered Rate(LIBOR). Smaller companies lend indirectlyonto the market through term deposits withtheir banks.


TREASURY BILLTreasury bills of two-, three- and six-monthmaturities are issued on a discounted basisby the Ghana government. They are boughtand sold on the discount market (part of themoney market). The yield on treasury bills islower than on other money marketinstruments because of the lower defaultrisk associated with government borrowing.In fact , the treasury bill yield is often usedan approximation of risk-free rate of return.


GILT-EDGED GOVERNMENT SECURITIESGilt-edged government securities (gilts) arethe long-term equivalent of treasury bills, withmaturities usually grater than five years.Short-term cash surpluses should not beinvested in newly issued gilts since their longmaturities make their market prices sensitiveto interest rate changes and the risk of capitalloss in the short term could be high. Giltsclose to maturity can be bought as short-terminvestment, however, and may be regarded asliquid assets similar to treasury bills.


OPERATING CASH CYCLE

When managing cash, it is important to be aware of theoperating cash cycle of the business.

This may be defined as the time period between theoutlay of cash necessary for purchase of stocks and theultimate receipt of cash from sale of the goods.


The operating cash cycle is important because it has asignificant influence on the financing requirements of thebusiness.The longer the cash cycle, the greater the financingrequirements of the business and the greater thefinancial risks.

For a business, which buys and sells on credit, theoperating cash cycle can be calculated from thefinancial statements by the use of certain ratios, as

follows;Average stock turnover period + (plus) Averagesettlement period for debtors – (minus) Averagepayment period for creditors = (equals) Operating cashcycle.


HOW A COMPANY CAN REDUCE THE CASH CYCLEIf a company has a long stock holding period, it canreduce the level of stock held.

Imposing tighter credit control, offering discounts orcharging interest on overdue accounts can reduceaverage settlement period for debtors.

However any policy decisions concerning stocks anddebtors must take account of current trading conditions.

The cycle could also be reduced by extending the periodof credit taken to pay suppliers. However, this optionmust be giving careful consideration.


MANAGEMENT OF TRADE CREDITORS

To monitor the level of trade credit taken, managementcan calculate the average settlement period forcreditors; as we have already seen, it is calculated as

follows: Trade creditors * 365 days Credit purchases

However, this provides an average figure, which can bedistorted. A more informative approach would be to produce anageing schedule for creditors.


MANAGEMENT OF BANK OVERDRAFTS Bank overdrafts are flexible form of borrowing and arecheap, relative to other sources of finance. For thisreason, the majority of UK companies employ bankoverdraft to finance their business. Although in theory, bank overdrafts are short-termsource of finance, in practice they can extend over along period of time as many businesses continuallyrenew the overdraft facility with the bank.


The decision concerning whether or not to have a bankoverdraft should first consider the purpose of borrowing. Overdrafts are most suitable for overcoming short-termfunding problems (for example, increases instockholding requirements owing to seasonalfluctuations) and should be self liquidating. For longer term funding problems or borrowings, whichare not self-liquidating, other sources of finance may bemore suitable.


END OF CHAPTER


Chapter five

METHODS OF INVESTMENT APPRAISAL


The process of allocating or budgeting capital is usuallymore involved than just deciding on whether or not tobuy a particular asset.

Management of a company will frequently face broaderissues like whether or not they should launch a newproduct or enter a new market.

Decisions such as these will determine the nature of afirm’s operations for years to come primarily becausenon-current asset investments are generally long-livedand not easily reversed once they are made.

Introduction


Bravery, information, knowledge and a sense ofproportion are essential ingredients when undertakingthe onerous task of investing other people’s money, ….. but there is another element which is also of crucialimportance, that is, the employment of an investmentappraisal technique which leads to the “correct” decision;a technique which takes into account the fundamentalconsiderations.In April 2003 , Toyota South Africa announced that it is to investR1.7 billion in a new export programme to supply vehicles toEurope, the rest of Africa as well as the Caribbean, as the nextstage of an expanding multi-billion rand roll-out of exports.Toyota’s announcement offers an example of a capitalbudgeting decision.


A number of surveys enquiring into the appraisalmethods used in practice have been conducted overthe past 25 years.

The results from surveys conducted by Pike and alsoby Glen Arnold and Panos Hatzopoulos aredisplayed in Table 2.1 and 2.2.

Payback remains in wide use, despite the increasingapplication of discounted cash flow techniques;internal rate of return is at least as popular as netpresent value.

EVIDENCE ON THE EMPLOYMENT OF APPRAISALTECHNIQUES


•

However, NPV is gaining rapid acceptance. Accountingrate of return continues to be the laggard, but is stillused in over 50 percent of large firms. One observation that is emphasized in many studies isthe tendency for decision markers to use more than onemethod.

In the 1997 study, 67 percent of firms used three or fourof these techniques, these methods are regarded asbeing complementary rather than competitors.


Table 2.1.Proportion of Companies Using TechniquePike Surveys

1975(%) 1980(%) 1986(%) 1992(%)Pay back 73 81 92 94ARR 51 49 56 50IRR 44 57 75 81NPV 32 39 68 74 Pikes Studies focused on 100 large UK firms.


Table 2.2.Arnold and Hatzopoulos Surveys (1997)

Small(%) Medium(%) Large(%) Total(%)Payback 71 75 66 70ARR 62 50 55 56IRR 76 83 84 81NPV 62 79 97 80

Capital budget (per year) for companies in Arnold andHatzopoulos study approx.Small: £1-50m. Medium: £1-100m. Large: £100m+


The payback period for a capital Investment is the lengthof time before the accumulated stream of forecastedcash flows equals the initial investment. It is the length of time it takes for an investment to berepaid out of the net cash inflows from a project. Thedecision rule is that if a project’s payback periodis less than or equal to a predetermined threshold figure;it is acceptable We can illustrate how to calculate a payback with theexample below.

THE PAYBACK PERIOD


Fig. 1 Net Project Cash flows

0 1 2 3 4Year

-£50,000 £30,000 £20,000 £10,000 £5,000

Figure 1 shows the cash flows from a proposed investment project. The question to be asked here is, how many years do we haveto wait until the accumulated cash flows from this investment equalor exceed the cost of investment?


As figure 1 indicates the initial investment is £50,000. After thefirst year, the firm recovered £30,000, leaving £20,000.

The cash flow in the second year is exactly £20,000, so thisinvestment pays for itself in exactly two years. Put another way,the payback period is two years.

If we require a payback period of say, 3 years or less, then thisinvestment is acceptable.Now that we know how to calculate the payback period onan investment, using the payback period rule for makingdecisions is straight forward.A particular cut-off time is selected say, two years, and allinvestment projects that have payback periods of two years orless are accepted and all of those that pay off in more thantwo years are rejected.


Consider the example in the tablebelow:

Year Net Cash flows Cumulative Cash flows

Net £000 £000 £0000 (100) (100)1 20 (80) (20-100)2 40 (40) (40-80)3 60 20 (60-20)4 60 80 (60+20)5 20 100 (20+80)6 20 120 (20+100)

The payback period for this investment is nearly threeyears, that is, it will be nearly three years before the £100,000 outlay is covered by the inflow.


Example 3 – Mutually Exclusive Projects Project 1 Project 2 Project 3

Year £000 £000 £000 0 (200) (200) (200)

1 40 10 802 80 20 1003 80 170 204 60 20 2005 40 10 5006 40 10 20 The payback period for each project is three years andso the payback period approach would regard theprojects as being equally acceptable.


It is quick and easy to calculate and can be easilyunderstood by managers.

Projects which can recoup their cost quickly arereviewed as more attractive than those with longerpayback periods. Research undertaken by Glen Arnold suggests thatPayback is rarely used as a primary investmenttechnique, but rather as a secondary method whichsupplements the more sophisticated methods.

ADVANTAGES OF PAYBACK PERIOD


1.DISADVANTAGES

The first drawback of the Payback Period rule is that itmakes no allowance for the time value of money.

It ignores the need to compare future cash flows with theinitial investment after they have been discounted totheir present values.

2. In example three, the payback for each of the project is

three years and so the payback approach would regardthe projects as being equally acceptable .

The payback method cannot distinguish between

those projects which pay back a significant amount at anearly stage and those which do not.


In example three, project three repays £180,000 in year 2while projects one and two pay £120,000 and £30,000respectively.

3.Another drawback of the payback rule is that it ignoresreceipts or cash flows beyond the payback period. Thismay lead to rejection of long term profitable projects.More generally, using a payback period rule will tend tobe bias towards shorter term investments.

4. Another short coming is the arbitrary selection of

the cut-off point. There is no theoretical basis for settingthe appropriate time period and so guesswork, whim andmanipulation take over.


DISCOUNTED PAYBACKAware of the pitfalls of payback, some decision makersuse a variant called the discounted payback method.

With discounted payback the future cash flows arediscounted prior to calculating the payback period. Thisis an improvement on the simple payback method, inthat; it takes into account t the time value of money. The discounted payback period is the length of time untilthe sum of the discounted cash flows is equal to theinitial investment. The discounted payback rule would be: ‘…Based on the discounted Payback rule , an investmentis acceptable if its discounted payback is less than somespecified number of years,


• The process of discounting relies on a variant of thecompounding formula;

F= P (1+r) n where;F= future valueP= present Valuer= interest raten= number of years over which compounding takes

place. E.g. If a saver deposited £100 in a bank account paying

interest at 8% per annum , after three years , theaccount will contain £125.97. The figure was arrivedat using the above formula as follows:


F= P (1+r) n = 100(1+0.08)3 = £125.97

The formula can be changed so that we can answerthe following questions: How much must I deposit inthe bank now to receive £125.97 in three years at anannual interest rate of 8%.

P= F/ (1+r) n or F* 1/ (1+r) n

P= 125.97/ (1+0.08)3= 100


If we consider the case of Example 4, we candiscount the net cash flows of projects A, B and Cusing a discount rate of 10 percent as follows. To get the discounted payback, we have to discounteach cash low at 10 percent and then add them upand then subtract the initial investment capital fromit. The discounted payback method is therefore basedthe NPV rule that projects with a positive NPV areselected. The NPV formula is as follows;NPV= FO+F1/ (1+r)

n where;


where; FO = cash flow at time zero and

F1= cash flow at time one (t1)

r= rate of interest andn= number of years. To calculate the discounted payback for projects A, B, and

C IN EXAMPLE 4, the NPV formula becomes.


NPV= FO+F1/ (1+r) 1 + F2/ (1+r) 2+ F3/ (1+r) 3…………+ F6/ (1+r) 6

t=n t=nNPV = ∑ FO+Fn/ (1+r)

n or NPV = ∑ Fn/ (1+r) n- FO

t=1 t=1

WhereFn= the net cash flow at the end of year nF0= the initial investment outlay at t= 0

r =the discount rate based on the opportunity cost ofcapital

n = the projects expected life cycle.


For example 4 , the discounted Payback is asfollows:

Project A-10+6/1.1+2/ (1.1)2+1/ (1.1)3+1/ (1.1)4+2/ (1.1)5+2/ (1.1)6=

£0.913m

Project B-10+1/1.1+1/ (1.1)2+2/ (1.1)3+6/ (1.1)4+2/ (1.1)5+2/ (1.1)6= -

£0.293m

Project C-10+3/1.1+2/ (1.1)2+2/ (1.1)3+2/ (1.1)4+15/ (1.1)5+10/ (1.1)6=

£12.208m


Project A has a positive NPV and is thereforeshareholder wealth enhancing.

Project B, has negative NPV; the firm would be better

served by investing the £ 10m in the alternative thatoffers a 10 percent return .

Project C had the largest positive NPV and is therefore

the one that creates most shareholder wealth. Example 5-class work (refer to the handout )


Another attractive, but fatally flawed, approach tofinancial decision making is the accounting rate of return.In spite of its flaws, the accounting rate of return methodis worth examining because it is used frequently in thereal world.The accounting rate of return (ARR) is also commonlyreferred to as the Return on Investment (ROI) or theReturn on Capital Employed (ROCE).

There are many ways in which this measure can bederived, its base form being the ratio of some measureof accounting profit to a corresponding measure ofcapital outlay.

ACCOUNTING RATE OF RETURN


•••

One of the more common ways of derivingthis ratio for decision making is to calculate aproject’s average profit after depreciation butbefore any allowance for taxation and dividedthis by the average capital employed duringthe life of the project.

Let us consider a simple example:Example 6A project requires an initial capital outlay of$500,000 and has a life of 5 years, at theend of which it can be sold as scrap for $50,000.


Let us consider a simple example:Example 6

A project requires an initial capital outlay of $500,000 andhas a life of 5 years, at the end of which it can be sold asscrap for $50,000. The expected annual profits over thisperiod for the project are:

Year $1 40,0002 100,0003 160,0004 120,0005 30,000ARR= Average Annual Profit/Average Capital Employed * 100


Average Annual Profit ;(40,000+100,000+160,000+120000+30,000)/5= $90,000 Average Capital Employed:$500,000+$50,000/2=$275,000

ARR= 90,000/275,000*100=32.73%. Note that the denominators for the first two stages of thiscalculation were 5 and 2 respectively .In (a) 5 was used togive the average annual profit , while in (b) 2 was used togive the simple average of capital deployed throughout theentire five year life of the project.


•

•

•

Once the ARR has been determined , a simpleaccept / reject decision is then made on the basis ofthe percentage return achieved. Providing the ARR , which in this case was 40%,exceeds some predetermined ‘target’ rate of return,the project is accepted , otherwise , it is rejected. In the case of competing projects, the decision ruleis to accept the one with the higher ARR providedthat it is larger than the target rate.


Example 7Consider the following Projects .They both have afive year life and require an initial investment of £200,000 with anticipated scrap value of £0.

Year Project A Project B Project C Project D

1 £10,000 £50,000 £5,000 £13,0002 £20,000 £40,000 £18,000 £37,0003 £30,000 £30,000 £88,000 £10,0004 £40,000 £20,000 £6,000 £15,0005 £50,000 £10,000 £2,000 £20,000

ARR= Average Annual Profit /AverageCapital employed


A(i) 150,000/5=30,000 B(i) 150,000/5=30,000A (ii) 20,000-0/2=100,000 B(ii) 20,000-0/2=100,000Project A: ARR Project B: ARR=30,000/100,000*100 =30,000/100,000*100 ARR=30% ARR=30%

ADVANTAGES OF ARR

One of the advantages are its ease of calculation , the factthat it considers the accounting profit flows throughout….

….the life of a project and that it produces a percentage rate of

return which is a ratio commonly used by market analystand others when measuring the profitability of a company.


DISADVANTAGES OF ARRSince this is an accounting ratio, non-cash itemssuch as depreciation are included. The production of a ratio in percentage terms fails toreflect the absolute size of investment and, althoughthe whole life of individual projects are considered,this method fails to distinguish between the differinglives of mutually exclusive projects. Finally and most fundamentally, the ARR methodignores the timing of the earnings stream of projects.


An illustration of this is provided by example 7 whichcompares two projects each having a five year life andrequiring an initial investment of £200,000 with ananticipated scrap value of £0.


••

•

The time value of moneyOne of the incentives to save is the possibility of gaininga higher level of future consumption by sacrificing somepresent consumption. It is therefore apparent that compensation is required toinduce people to make a consumption sacrifice.Compensation will be required for at least three things.

DISCOUNTED CASH FLOW TECHNIQUES


Time:That is individuals generally prefer to have £ 1.00 todaythan £ 1.00 in five years time. That is, the utility of £1.00now is greater than £1.00 received in five years fromhence. The rate of exchange between certain futureconsumption is the pure rate of interest .This occurseven in a world of no inflation and no risk .

If you live in such a world you might be willing tosacrifice £100 of consumption now if you werecompensated with £104 to be received in one year .Thiswould mean that your pure rate of interest is 4%.


o

o

Inflation:The price of time (or the interest rate needed to compensatefor time preference) exists even when there is no inflationsimply because people generally prefer consumption now toconsumption later. If there is inflation, then the providers of finance will have to becompensated for that loss in purchasing power as well as fortime.

Risk:The promise of a receipt of a sum of money some years hencegenerally carries with it an element of risk; the payout may nottake place or the amount may be less than expected.Risk simply means that the future return has a variety ofpossible values.


Thus the issuer of a security, whether it be a share, abond or a bank account must be prepared tocompensate the investor for time, inflation and riskinvolved, otherwise no one will be willing to buy thesecurity.Different investment a categories, carry differentdegrees of uncertainty about the outcome of theinvestment.For instance, an investment on the Russian stock market,with its high volatility is regarded more risky than buyingshares I B.P. with its steady growth prospects. Investorsrequire different risk premiums o top of the RFR toreflect the perceived level of extra risk. Thus:Required Return= RFR+ Risk Premium(Time Value of money)


DISCOUNTED CASH FLOWThe Net Present Value and Internal Rate of Return

techniques, both being discounted cash flow methodstake into account the time value of money.

t=n t=n NPV = ∑ FO+Fn/ (1+r) n or NPV = ∑ Fn/ (1+r) n- FO t=1 t=1


Example 1Project Alpha, simple cash flow

Year cash flows0-Now -20001 (1year from now) +6002 +6003 +6004 +600

NPV calculation for Project Alpha, assuming that thetime value of money is 19%

-2000+600/ (1+0.19) +600/ (1+0.19)2+600/ (1+0.19)3+600/(1+0.19)4

-2000+504.20+423.70+356.05+299.20=-416.85


•••

The NPV rule is as follows;NPV>0 AcceptNPV<0 Reject


Example 2.Let us consider projects C and D assuming the opportunitycost of capital is 10%

Project C Project DYear cash flows PV Year cash flows PV 0 -20,000 -20,000 0 -20,000 -20,000 1 +12,000 +10,908 1 +8,000 +7,272 2 +8,000 +6,608 2 +8,000 +6,608 3 +8,640 +6,489 3 +4,000 +3,004 4 4 +8,000 +5,464

5 +6,000 +3,726 NPV =+ 4,005 NPV= +6,074


•

Both projects have positive NPV’s , but if they weremutually exclusive projects D would be preferred . This is the reverse situation to the advice that wouldhave been given by the payback period method . The difference between payback period and NPV isthat the latter takes into account those cash flowsarising after the payback cut off period and alsoconsiders the time value of money. Example 3- class work- REFER TO HANDOUT


Example 3- class workKSB Plc is examining two projects A and B. The cash flows

are as follows; A BYear £ £0 -240,000 -240,0001 200,000 20,0002 100,000 120,0003 20,000 220,000

Using discount rates of 8% and 16%, calculate the NPV’sand state which project is superior.

NPV = NPV= FO+F1/ (1+r) 1 + F2/ (1+r)

2+ F3/ (1+r) 3


Project A @ 8% OR 0.08 -2400+200,000/ (1+0.08) +100,000/ (1+0.08)2+20,0000/ (1+0.08)3

-240,000+185,185+85,734+15,877= £46,796 Project B @ 8% OR 0.08-2400+20,000/ (1+0.08) +120,000/ (1+0.08)2+220,0000/ (1+0.08)3

-240,000+18,519+102,881+174,643= £56,043

Using 8% discount rate both projects produce positiveNPV’s and therefore would enhance shareholder wealth.However project B is superior.


Using 16% as the discount rateProject A @ 16% or 0.16-2400+200,000/ (1+0.16) +100,000/ (1+0.16)2+20,0000/ (1+0.16)3

-240,000+172,414+74,316+12,813= £19,7543 Project B @ 16% or 0.16-2400+20,000/ (1+0.16) +120,000/ (1+0.16)2+220,0000/ (1+0.16)3

-240,000+17,241+89,180+140,945= £7,366.

Using 16% discount rate , project A generated moreshareholder value so would be preferred to project B.This is despite the fact that project B in pureundiscounted cash flow terms produces an additional£40,000.


The internal rate of return (IRR) is the discount ratewhich when applied to the future cash flows will makethem equal to the initial outlay.

In essence , it represents the yield from an initialinvestment opportunity . The IRR takes into account the time value of money .Itis the discount rate which will produce a zero NPV.

The rule for internal rate of return decision is:

If k is greater than r= rejectIf k is less than or equal to r, accept

INTERNAL RATE OF RETURN


If the opportunity cost of capital(k) is greater than the internal rate of return (r) on

a project then it must be rejected.


o

o

MERITS OF NPVThe timing of cash flow – By discounting the variouscash flows associated with each project accordingto when they are expected to arise, the NPV takesinto account the time value o f money.

The discount factor is based on the opportunity costof capital.

The whole of the relevant cash flows-NPV includesall of the relevant cash flows irrespective of whenthey are expected to occur.

It treats them differently according to their dates ofoccurrence but they are all taken into account.


o The objective of the business- the output of theNPV analysis has a direct bearing on the wealthof the shareholders of a business (positiveNPV’s enhance wealth, negative ones reduce it).


END OF CHAPTER


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