FM 2 Module Final

UNIT ONE
MANAGEMENT OF WORKING CAPITAL:

AN OVERVIEW
Contents
 Unit objectives
 Introduction
1.1. Net Working Capital Fundamentals
1.2. Net Working Capital Strategies
1.2.1. An Aggressive Financing Strategy
1.2.2. A Conservative Financing Strategy
1.2.3. Moderate Financing Strategy
 Model Examination Questions
 Answer to Model Examination Question
Unit Objectives
In this unit, the meaning and concepts of working capital will be discussed. Moreover,
alternative financing strategies will also be discussed. After studying this unit, you will
be able to:
 Understand the terminologies used in working capital management.
 Discuss the alternative current asset investment strategies and analyze their
impact on profitability and risk.
 Explain the trade-off between profitability and risk as it relates to changing
levels of current assets.
Introduction
The short–term financial management goals is to manage each of the firm’s current
assets (cash, marketable securities, accounts receivable, and inventory) and current
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liabilities (accounts payable, and accruals) to achieve a balance between profitability and
risk that contributes positively to the firm’s value.
 Dear students! In this unit you will have a discussion about the concepts of
working capital on top of that; alternative financing strategies will also be
discussed. The following are the three common alternative financing strategies:
 Aggressive financing strategy
 Conservative financing strategy
 Moderate financing strategy
1.1. Net Working Capital Fundamentals
 Dear students! Have you heard the term working capital before? If so, what do
you understand by the term working capital? Give your own answer in writing
before you go through the following discussions.
Working capital management involves the management and control of the gross
current assets as against the term net working capital. Net working capital is a related
concept which is denoted as current assets minus current liabilities. The broad categories
of working capital are current assets and current liabilities. Current assets comprise cash,
marketable securities, accounts receivable, prepayments, and inventory. Current
liabilities include accounts payable, bank loans, notes payable, and current debt (due in
one year time). When the current assets exceed the current liabilities, the firm has
positive net working capital. But, in a reverse position, the firm will have a negative
working capital position.
In general, the greater the margin by which a firm’s current assets cover its short–
term obligations (current liabilities), the better able it will be to pay its debt as they come
due.
The Tradeoff between Profitability and Risk

The firm’s need for financing is equal to the sum of its fixed and current assets. Current
assets can be divided into the following two groups:
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 Permanent Current Assets
 Fluctuating (Temporary) Current Assets
Permanent current assets are those which are held to meet the firm’s minimum
long–term needs (for instance, “Safety stocks” of cash and inventories). Fluctuating
current assets are those affected by the seasonal or cyclical nature of the firm’s sales.
In general speaking, the firm’s profitability and risk are affected by the ratio of
current assets to fixed assets. Profitability, in this context, is the relationship between
revenues and costs generated by using the firm’s assets – both current and fixed – in
productive activities. Risk, in this context is defined as the probability that a firm will be
unable to pay its bills as they come due.
 Dear Students! From the above discussion, it is assumed that the greater the
firm’s net working capital, the lower its risk. In other words, the more net
working capital, the more liquid the firm and the lower its risk of becoming
technically insolvent – when a firm cannot pay its bills as they come due.
 Check-Your Progress: Exercise- 1.1.
1. Define and describe the concept of the term net working capital.
__________________________________________________________________
__________________________________________________________________
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2. Discuss the tradeoff between the firm’s profitability and risk.
__________________________________________________________________
__________________________________________________________________
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1.2. Net Working Capital Strategies
One of the most important decisions to be made pertaining to current assets and
liabilities is how the current liabilities will be used to fiancé current assets. In doing this,
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there are three alternative strategies, namely, aggressive financing strategy, conservative
financing strategy, and moderate financing strategy.
Aggressive Financing Strategy

An aggressive financing strategy calls for the firm financing to meet at least its
seasonal requirements, and possibly some of its permanent requirements, with short–term
funds. The balance is financed with long – term funds. Under such restricted policy,
current assets are turned over more frequently and the holdings of cash, securities,
inventories, and receivables are minimized. This strategy can be illustrated graphically as
follows.
Figure 1– 1: Aggressive Financial Strategy
Total Assets
Birr
Fluctuating Current
Assets
Short-Term
Debt
Permanent Current
Assets
Long-Term Debt
Plus Equity Capital
Fixed Assets
Time
The firm that uses this financing strategy must refund debt more frequently and this
tend to increase the risk that it will be unable to obtain new financing as needed.
Moreover, the greater possible fluctuations in interest expenses associated with such
financing strategy also add to the firm risk. But, these risks may be compensated by the
higher expected after – tax earnings that can result from the lower cost of short–term
debt.
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Conservative Financing Strategy
Under conservative financing strategy relatively large amounts of cash, marketable
securities, and inventories are carried, and since sales are stimulated by liberal financing
policy to customers a corresponding high level of receivables are bound to occur. This
strategy can be illustrated graphically as follows.
Figure 1– 2: Conservative Financing Strategy Total Assets
Birr Short–Term Debt
Fluctuating
Current
Asset
Long-Term Debt
Permanent Current Assets Plus
Equity Capital
Fixed Assets
Time
In the above graph (Figure1–2) shows a conservative financing strategy which

uses a relatively high proportion of long–term debt. The relatively low proportion of
short–term debt reduces the risk that the firm will be unable to refund its debt, and it also
reduces the risk associated with interest rate fluctuations. Because of the cost of long–
term debt this strategy costs down the firm’s expected returns.
Moderate Financing Strategy
 Dear students! In our subsequent discussions we have seen two financing

strategies. Now we are going to have the discussion with the third type of
financing i.e. moderate financing strategy which falls in between the former
two extremes financing strategy.
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Under moderate financing strategy the maturity structure of the firm’s liabilities is
made to correspond exactly to the life of its assets. Under this approach fixed and
permanent current assets are financed with long – term debt and equity funds, whereas
fluctuating current assets are financed with short – term debt.
Under condition of certainty – when sales, costs, lead times, payment periods, and
so on, are known for sure – all firms would hold only minimal levels of current assets.
Any larger amounts would increase the need for external funding without a
corresponding increase in profits, while any smaller holdings would involve late
payments to suppliers a long with lost sales due to inventory shortages and an overly
restrictive credit policy. For graphical illustration, see Figure 1–3 below.
Figure 1–3: Moderate Financing Strategy
Birr Total Assets
Fluctuations Current Assets Short–Term Debt
Permanent Current Assets Long–Term Debt Plus

Equity Capital
Fixed Assets
Time
 Check-Your Progress: Exercise 1.2

1. Identify and explain three alternative working capital financing strategies.
__________________________________________________________________
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2. What are the reasons for not wanting to hold too little working capital? For not
wanting to hold too much?
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Illustrative Example
Alternative Working Capital Investment and Financing Strategies for RRC Company (In
Thousands Birr)
Aggressive Moderate Conservative
Current assets (C/A)…………………. 850 1,100 1,350
Fixed assets (F/A)…………………… 500 500 500
Total Asset………………………. 1,350 1,600 1,850
Current Liabilities (STD) (c/L)……... 700 600 500
(Interest rate, 12%)
Long – term liabilities (LTD)……….. 150 400 650
(Interest rate, 15%) 850 1,000 1,150
Equity……………………………….. 500 600 700
Total liabilities and equity…………. 1,350 1,600 1,850
Forecasted Sales ……………………. 2,000 2,000 2,000
Expected EBIT………………………. 300 300 300
Less Interest:
STD 12%........................ 84.00 72 60.00
LTD 15% ……………. 22.50 106.50 60 132 97.50 157.50
Taxable income ……………………… 193.50 168 142.50
Less Taxes (40%)……………………. 77.40 67.20 57.00
Net income after taxes……………. 116.10 100.80 85.50
Expected rate of return on equity (ROE)… 23.22% 16.80% 12.20%
Net working capital position
(C/A – C/L)…………………… 150 500 850
Current ratio (C/A  C/L) ……………. 1.21 1.83 2.70
EBIT: Earnings Before Interest and Taxes

The above table shows data for each financing strategy. The aggressive working
capital policy is expected to yield the highest return on Shareholders’ Equity, 23.22%
where as the conservative approach is expected to yield the lowest return 12.20%. The
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net working capital and current ratio are lowest under aggressive strategy and highest
under the conservative strategy, indicating that the aggressive strategy is the most risky.
The moderate financing policy yield an expected return and risk level somewhere
between the aggressive and the conservative policies.
Model Examination Questions
Part – I: Short Answer Questions

1. Differentiate the difference between fluctuating current assets and permanent
current assets.
2. Discuss, in brief, “the profitability versus risk tradeoffs” associated with
alternative levels of working capital investment.
3. Explain the financing strategy that emphasizes the financing of long term assets
with long – term debt.
4. What does it mean by the term net working capital?
Part – II: Work out Questions
1. Ogaden Gas has forecast tits total funds requirements for the coming year as shown in
the following table.
Month Amount Month Amount
January Br. 7,400,000 July Br. 5,800,000
February 5,500,000 August 5,400,000
March 5,000,000 September 5,000,000
April 5,300,000 October 5,300,000
May 6,200,000 November 6,000,000
June 6,000,000 December 6,800,000
Required:
Divide the firm’s monthly funds requirement into a permanent and seasonal component,
and find the monthly average for each of these components.
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2. Jiffar Business Group (JBG) is thinking about to determine the optimum level of
current assets for the coming year. Management expects sales to increase to
approximately Br. 40, 000,000. Fixed assets total Br. 25,000,000 and the firm wishes to
maintain 50% debt ratio. JBG’s interest cost is currently 8% on both short – term and
long – term debt. The firm expects to generate earnings before interest and taxes (EBIT)
at a rate of 12% on total sales. Three alternatives regarding the projected current asset
level are available to the firm: (1) Aggressive strategy requiring current assets of 45% of
projected sales, 92) moderate strategy requiring current assets of 50% projected sales and
93) conservative strategy requiring current assets of 60% of projected sales. Assume a
40% of income taxes.
Required: Determine the firms ROE under each financing strategy.
Answers to Model Examination Questions

Part – II: Workout Questions
1. i) Monthly average permanent current assets are Br. 5,000,000
ii) Monthly average seasonal funds are Br. 808,333
2. i) Aggressive, ROE = 8.6% Moderate, ROE = 9.0%
Conservative, ROE = 7.02
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UNIT TWO
CASH AND MARKETABLE SECURITIES MANAGEMENT
Contents
 Unit Objective
 Introduction
2.1 Motives for Holding Cash and Near Cash Balances
2.2 Estimating Cash Balances
2.3 Efficient Management of Cash
2.3.1 The Operating Cycle
2.3.2 The Cash Conversion Cycle
2.3.3 Managing the Cash Conversion cycle
2.4 Cash Management Techniques
2.4.1 Float
2.4.2 Speeding up Collections
2.4.3 Slowing Down Disbursements
2.5 Marketable Securities
 Answer to Model Examination Questions
Unit Objective
After studying this unit, you will be able to:
 Discuss the motives for holding cash.
 Explain float, including its three basic components.
 Understand the basic characteristics of marketable securities.
 Describe the two cash conversion models – Baumol model and Miller–Orr model.
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Introduction
Cash and marketable securities are the two most liquid assets of the firm. As far
as cash is concerned it is the ready currency to which all other liquid assets can be
reduced. Whereas marketable securities are short-term, interest–earning, money market
instruments that are used by the firm to obtain a return on temporarily idle funds. Both
cash and marketable are held by firms to reduce the risk of technical insolvency by
providing a pool of liquid resources. Appropriate balances can be determined by careful
consideration of the motives for holding them.
2.1 Motives for Holding Cash and Near-Cash Balances
 Dear students! Do you have any idea about the motives for holding cash and
near cash balances? If so, foreword your points in writing before you decide to
go through the following discussions.
As discussed earlier cash is the most liquid form of asset. As a ready currency, it is
made available either in the bank or with the business for its operations. There are three
motives for holding cash and near cash (marketable securities) balances. Each motive is
based on two underlying questions:
 What is the appropriate degree of liquidity to maintain? And
 What is the appropriate distribution of liquidity between cash and marketable
securities?
1. Transaction motive. Cash balances are necessary in business operations so as to
make planned payments, for items such as supplies and salaries. Whenever cash
inflows and cash outflows are closely matched, cash balances needed to meet the
transaction motive will be smaller. In line with achieving this motive, firms will
also achieve the following two motives.
2. Safety motive (precautionary motive). Firms need to hold some cash in reserve
for random, unforeseen fluctuations in inflows and outflows. The purpose is to
safeguard against uncertainties. Balances held to satisfy the safety motive are
invested in highly liquid marketable securities that can immediately transferred
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from securities to cash. Marketable securities keep the firm from being unable to
satisfy unexpected demand for cash.
3. Speculative motive. Some cash balances may be held to enable the firm to take
advantage of bargain purchases that might arise; these funds are called speculative
balances. Besides, these funds can be put to work so as to quickly take advantage
of unexpected opportunities that may arise. Speculative motive is the least
common of the three motives.
2.2 Estimating Cash Balances
Cash balances should be held at an optimal level so as to achieve the firm’s
ultimate objectives. Cash balance more than the optimal level will cost the firm’s
profitability, and to the other hand cash balance that is below the optimal level will result
in poor liquidity. Thus, management’s goal should be to maintain levels of cash balances
and marketable securities investments that contribute to improving the value of the firm.
To determine the appropriate transactional cash balances firms can use either subjective
approaches or quantitative models.
A. Subjective Approaches
Since this approach is subjective in nature it relies on the firm’s experience. If the
subjective approach to maintain cash balance is equal to 10 percent of the following
month’s sales and the forecast amount of sales for the following month is, for example,
birr 800,000, the firm would maintain a birr 80,000 (i.e. 0.10  800,000) transaction cash
balance.
B. Quantitative Models
There are two quantitative models that can be used to determine the appropriate
transactional cash balances are the Baumol Model and the Miller-Orr Model.
Baumol Model
The Baumol Model is a simple approach that provides for cost – efficient
transactional cash balances by determining the optimal cash conversion quantity. The
model treats cash as an inventory item whose future demand for settlement of
transactions can be forecasted with certainty. It is to mean that cash inflows and cash
outflows are assumed to be known with certainty. A portfolio of marketable securities
acts a reservoir for replenishing transactional cash balances and earning a return on
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excess transactional cash balances. The firm manages this cash inventory on the basis of
the cost of converting marketable securities in to cash and vice versa (the conversion
cost) and the cost of holding cash rather than marketable securities (opportunity cost).
The economic conversion quantity (ECQ), the cost- minimizing quantity in which to
convert marketable securities to cash or cash to marketable securities is:
2×conversioncos t×demand for cash
Conversion Cost
EOQ=
√ Opportunity cost (in decimal form )
Baumol stated that conversion cost may include the fixed cost of placing and
receiving an order so as to determine cash in the amount EOQ. On top of that, it also
includes the cost of communicating the necessity to transfer funds to or from the cash
account, associated clerical costs, brokerage fees, and any other costs incurred for
follow–up action.
Opportunity Cost
Opportunity cost is the rate of interest that can possibly be earned on marketable
securities. Alternatively, we can consider as the interest benefit or earnings per a given
currency (Birr) given up (sacrificed) during a specified time period as a result of holding
(tie up) funds in a non interest bearing cash account rather than having them invested in
interest-bearing marketable securities.
Total Cost
The total cost of cash is the sum of the total conversion and total opportunity
costs. Total conversion cost is determined as the cost per unit times the number of
conversions per period. In turn, the number of conversions per period can be found by
dividing the period’s cash demand by the economic conversion quantity (ECQ). The
total Birr opportunity cost equals the opportunity cost (in a decimal form) times the
average cash balance. The average cash balance is determined by dividing ECQ by 2.
Then, the total cost equation can be expressed as below:
Total Cost = (cost per conversion  number of conversions) + [opportunity cost (in a
decimal form)  average cash balance]
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Graphically, the Baumol Model portrayed as follows:
Figure 2-1: Baumol Model
Cash Balance (Br.)
ECQ
ECQ
2 Average Cash Balances
Time
Illustrative Exercise – 2.1

Suppose the management of Rainbow Inc. anticipates Br. 900,000 cash outlays
(demand) during the coming year. Recently, it is known that it costs Br. 25 to convert
marketable securities to cash and vice versa. Currently, marketable securities portfolio
earns a 9 percent annual rate of return.
Required: i) Determine ECQ, and
ii) Total cost
2×Br .25×br .900 ,000

Solutions: (i) ECQ = √ 0.09 = Br. 22,360
(ii) Total cost = (Br. 25  40) + (0.09  Br. 11, 180) = Br. 2,006.20
Since Br. 22,360 is received each time when the cash account is restored (replenished),
there will be 40 number of conversions during the year to replenish the account i.e. Br.
900,000  Br. 22,360 = 40, Thus, average cash balance is Br. 11, 180 (br. 22, 360  2).
The total cost of managing the cash is Br. 2,006.20.
Miller – Orr Model
In the event of uncertainty as to the prediction of future cash flows (inflows and
out flows of cash) Miller-Orr model is preferable. Even though this model is more
difficult to apply, it is generally considered more realistic and appropriate than Baumol
model.
The model provides for cost – efficient transactional cash balances by
determining an upper limit (i.e., maximum amount) and a return point for them. The
return point denotes the level at which the cash balance is set, either when cash is
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converted to marketable securities or vice versa. Cash balances are allowed to fluctuate
between the upper limit and a zero balance.
Return Point
The value for the return point is dependent on (1) conversion costs (2) the daily
opportunity cost of funds and (3) the variance of daily net cash flows. The variance is
estimated by using daily net cash flows (inflows minus outflows for the day). The
equation to determine the return point can be expressed as follows.
3×conversion cost×var ianceof daily cash flows

Return Point = √
3
4×daily opportunity cost(in decimal form )
Upper Limit
The upper limit for the cash balance is three times to the return point.
Cash Balance Reaches the Upper Limit
When the cash balance reaches the upper limit, an amount equal to the upper limit
minus the return point is converted to marketable securities:
Cash Converted to marketable Securities = Upper limit – return point
Figure 2.2: Miller–Orr Model
Upper
Limit
Transfer Cash to
Marketable Securities
Return
Point Transfer marketable
Securities to cash
Time
Cash Balance Falls to Zero
When the cash balance falls to zero, the amount converted from marketable
securities to cash is the amount represented by the return point:
Marketable Securities Converted to Cash = Return Point – Zero Balance
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Referring to the previous Exercise–2.1, it costs rainbow Inc. Br. 25 to convert
marketable securities to cash and vice versa; the firm’s marketable securities portfolio
earns a 9% annual return, which is 0.025 daily (9%  360). The variance of Rainbow
Inc.’s daily net cash flows is estimated to be Br. 30,000. The return point will be
determined as follows:
3×Br .25×Br .30 ,000

Return Point = √
3
4×0.00025
= Br. 1,310
The upper limit is 3  Br. 1,310 = 3,930
The firm’s cash balance will be allowed to vary between Br. 0 and Br. 3,930. When
the upper limit is reached, Br. 2,620 (Br. 3,930 – Br. 1,310) is converted from cash to
marketable securities that will yield interest. When the cash balance falls to zero, Br.
1310 (Br. 1,310 – Br. 0) is converted from marketable securities to cash.
 Check-Your Progress 2.1
1. What is the purpose of estimating cash balances?
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__________________________________________________________________
2. What purpose do the Baumol and Mill–Orr models serve? Briefly describe the
similarities and differences.
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2.3 Efficient Management of Cash
The firm’s production and sales techniques and its procedures for receipts and
payments are significantly influence cash balances and safety stocks. Through efficient
management of operating and cash conversion cycles the financial manager can maintain
a low level of cash investment and there by contribute toward maximization of the firm’s
value.
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 Dear students! What do you understand by the terms operating and cash
conversion cycle? What is their difference? Try to state these issues before you
go through the subsequent paragraphs.
2.3.1 The Operating Cycle
The operating cycle typically consists of three primary activities: Purchasing
resources, producing the product, and distributing (selling) the product. It is the amount
of time that elapses from the point when the inputs material and labor into the production
process (i.e., begins to build inventory) to the point when cash is collected from the sale
of the finished product that contains these production inputs. The cycle consists of two
components; the average age of inventory and the average collection period of sales. In
an equation it can be expressed as follows:
OC = AAI + ACP
Assume Royal Manufacturing Plant, sells all its product on credit basis. The
credit terms require customers to pay within 60 days of a sale. The firm’s computations
reveal that, on average, it takes 80 days to manufacture, and ultimately sell its product. In
other words, the firms Average Age of Inventory (AAI) is 80 days. Computation of the
Average Collection Period (ACP) indicates that it is taking the firm, on average, 60 days
to collect its accounts receivable. Thus, the firm’s operating cycle can be determined as
below:
AAI + ACP = OC
80 days + 60 days = 140 days
Graphically, it can be depicted as follows:
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Figure 2-3: The Operating Cycle
140days
(80 + 60)
Purchase Raw Sell Finished Collect

Materials on Good Account
Account Receivable
AAI ACP
(80 days) (60 days)
80 140
Average Payment
Period (APP)
(30 days)
Pay Account Payable
Cash Cash Conversion Cycle (CCC) 110 days Cash

Outflow (140 - 30) Inflow
2.3.2 The Cash Conversion Cycle

The cash conversion cycle represent the net time internal between the collection of
cash receipts from product sales and the cash payments for the company’s various
resource purchases. It is computed as follows:
Cash Conversion Cycle = Operating Cycle – Payable Deferral Period
Referring the previous Illustrative Exercise 2-3, the credit terms extended the firm
for raw material purchases currently require payment within 35 days of a purchase, and
employees are paid every 15 days. The firm’s calculated weighted average payment
period for raw materials and labor is 30 days, which represents the average payment
period (APP). The cash conversion cycle (CCC) of the firm is computed as follows:
CCC = OC – APP
= 140 – 30 = 110 days
Managing the Cash Conversion Cycle
In the normal course of business, the firm should employ certain strategies to
manage the cash conversion cycle. The basic strategies that should be employed are as
follows:
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i) Turnover inventory as quickly as possible, avoiding stock-outs
(depletions of stock) that might occur a loss of sales.
ii) Collect accounts receivable as quickly as possible without losing
future sales because of high – pressure collection techniques. To attract prompt
payment by customers, cash discounts may be allowed if it is economically
justifiable so as to attain this objective.
iii) Pay accounts payable as late as possible without damaging the firm’s
credit worthiness, but take advantage of any favorable cash discounts.
Efficient Inventory – Production Management
One of the strategies which is made available to the firm is to increase inventory
turnover. So as to achieve this, the firm can increase raw materials turnover shorten the
production cycle or increase finished goods turnover. Irrespective of which of these
approaches is used, the result will be a reduction in the amount of negotiated (non-
spontaneous) financing required i.e. the cash cycle will be shortened.
Illustrative Exercise -2.4

Referring to our previous illustrative Exercise -2.3, assume if Royal
Manufacturing Plant manages to increase inventory turnover by reducing the average age
of inventory from the current level of 80 days to 70 days, it will reduce its cash
conversion cycle by 10 days (80 days to 70 days) to 100 days (CCC= 110 days - 10
days). Suppose Royal currently spends Br. 8 million annually on operating cycle
investments. The daily expenditure is Br. 22,222 (i.e., Br. 8 million ÷ 360 days). Since
the cash cycle is reduced today 10 days, Br. 222,220 (i.e., Br. 22,222  10 days) of
financing can be repaid. If Royal pays 10% for its negotiated financing, the firm will
reduce financing costs and thereby increase profit by Br. 22,220 (0.10  Br. 220,000).
Accelerating the Collection of Accounts Receivable

Speeding up or accelerating, the collection of accounts receivable is another
means of reducing the cash cycle (and the negotiated financing need). Similarly, like
inventory, accounts receivable, tie up funds can be used to reduce financing or be
invested in earning assets. Let us consider the following illustrative exercise:
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Illustrative Exercise 2.5
Assume if Royal Manufacturing Plant, by changing its credit terms, is able to
reduce the average collection period from the current level of 60 days to 50 days, it will
reduce its cash cycle by 10 days (60 days – 50 days) to 100 days (CCC = 110 days – 10
days). Again, assume that Br. 8 million is spent annually – Br. 22,222 – to support the
operating cycle. Through improving the management of accounts receivable by 10 days,
the firm will require Br. 222,220 (i.e Br. 22,222  10) less in negotiated financing. With
an interest rate of 10 percent, the firm is able to reduce financing costs and thereby
increase profits by Br. 22,222 (0.10  Br. 222,220).
Stretching Accounts Payable

Stretch accounts payable i.e. a firm pays its bills as late as possible without
damaging its credit worthiness.

Based on the previous Illustrative Exercise -2.3, assume if Royal Manufacturing
Plant, can stretch the payment period from the current average of 30 days to an average
of 40 days, its cash cycle will be reduced to 105 days (80 days + 60 days – 35 days = 105
days). Moreover, operating cycle expenditures total Br. 8 million annually, stretching
accounts payable (i.e, spontaneous financing) 5 additional days will reduce the firm’s
negotiated financing need by Br. 111,110 [(Br. 8 million  360)  5 days]. When an
interest rate of 10 percent, the firm can reduce its financing costs and thereby increase
profits by br. 11,111 (0.10  Br. 111,110).

1. List the key strategies with respect to inventory, accounts receivable, and
accounts payable for the firm that wants to manage its cash conversion cycle
efficiently?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
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2. What is the firm’s operating cycle? What is the cash conversion cycle? Compare
and contrast them. What is the firm’s objective with respective to each of them?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
3. If a firm reduces the average age of its inventory, what effect might this action
have on the cash conversion cycle? On the firm’s total sales? Is there a trade off
between average inventory and sales? Give reasons for your answers.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
2.4 Cash Management Techniques
 Dear students! In an earlier section we have been taught about efficient

management of cash through the discussion of certain key strategies. In this
section, we are going to discuss about a variety of cash management techniques
that can permit additional savings.
These techniques are aimed at minimizing the firm’s negotiated financing
requirements by taking advantage of certain imperfections in the collection and payment
systems. Certain techniques can further speed collections and slow disbursements.
These procedures take advantage of the “float’’ existing in the collection and payment
systems.
2.4.1 Float
 Dear students! Have you heard anything about float? What do you think about
it? Try to forward your own answer in writing.
Generally speaking, float refers to funds that have been dispatched by a payer but are
not yet in a form that can be spent by the payee. Float also exists when a payee has
received funds in a spendable form but these funds have not been withdrawn from the
account of the payee.
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Specifically, float means the difference between the bank balance (also called
available balance) and the book balance of an account holder.
Delays in the collection – payment system resulting from the transportation and
processing of checks are responsible for float. Since float is the result of imperfection in
the collection – payment system, with the help of electronic payment systems, foat will
virtually disappear. Until then, however, the financial manager must take advantage of
float.
Type of Float
In making financial transactions firms can experience both collection and
disbursement float.
Collection float results from the delay between the time when a payer or customer
deducts a payment from its checking account ledger and the time when the payee or
vendor actually receives these funds in a spendable form. Hence, collection float is
experienced by the payee and is a delay in the receipt of funds.
Disbursement float results from the lapse between the time when a firm deducts a
payment from its checking account ledger and the time when funds are actually
withdrawn from its account. Disbursement float is experienced by the payer and is a
delay in the actual withdrawal for funds.
Components of Float
Both collection float and disbursement float have the same three basic components:
A. Mail Float: the delay between the time when a payer places payment in the
mail and the time when it is received by the payee.
B. Processing float: the delay between the receipt of a check by the payee and
the deposit of it in the firm’s account.
C. Clearing Float: The delay between the deposit of a check by the payee and
the actual availability of the funds. This component of float is attributable to
the time required for a check to clear the banking system.
Graphical illustration of float resulting from a check issued and mailed by the
payer company to the payee company is depicted below.
22
Figure 2.4: Float
Check Issued and Check Received Book Keeping Entries
Mailed by the Payer by the Payee Company Made and Check Check Clears
Company Deposited
Mail Float Processing Clearing Float (4 Days)

(4 Days) Float (3 Days)
Time
0 4 7 11 (Days)
Total Float (11 Days)
2.4.2. Speeding Up Collections

The prime objective of a firm is not only to stimulate customers to pay their
accounts as promptly as possible but also to convert their payments into a spendable form
as quickly as possible. As a result, the collection float is minimized. To do so, a variety
of techniques can be used in speeding up collections.
Concentration Banking
When a firm has numerous sales outlets which are dispersed throughout the
country often establish offices as collection centers. Customers in these areas remit their
payments to these sales offices, which in turn deposit the receipts in local banks. At
certain times, funds can be transferred by wire from these regional banks to a
concentration or disbursing bank from which payments are made.
Concentration banking is used to reduce collection float by shortening the mail
and clearing float components. Since regionally disbursed collection centers bring the
collection point closer to the point from which the check is sent, mail float is reduced.
Clearing float should also be reduced, because the regional bank is likely to be in same
place or even it may be the same bank. For better understanding consider the following
illustration.
Assume Noble Distributor could consider concentration banking and reduce its
collection period by 4 days. If the firm normally carried Br. 4 million in receivables and
that level represented 40 days of sales, reducing 4 days from the collection process would
result in a Br. 400,000 decline in receivable [(4  40)  Br. 4,000,000)]. Given a 10
23
percent opportunity cost, the gross annual benefits (profits) would amount to Br. 40,000
(0.10  Br. 400,000). Assuming that costs related with concentration banking is less than
Br. 40,000 and no change in risk. Does Noble adopt the concentration banking system?
Yes, because incremental administrative costs and bank service fees and
opportunity cost of holding minimum bank balances are less than the expected annual
benefits of Br. 40,000.
Lockboxes. A lockbox plan is one of the oldest cash management techniques. In
lockbox system, the incoming checks sent to post office boxes rather than to the
corporate head quarters. Several times a day a local bank will collect the contents of the
lockbox and deposit the checks into the company’s local account, usually via an
electronic data transmission system in a format that permits on – line updating of the
firm’s accounts receivable records.
A lockbox system reduces the time required for a firm to receive incoming
checks, to deposit them, and to get them cleared through the banking system so the funds
are available for use.
The lockbox system is superior to concentration banking because it reduces
processing float as well as mail and clearing float. All receipts are immediately deposited
in the firm’s account by the bank so that processing occurs after funds are deposited in
the firm’s account. Thus, the system allows the firm to use the funds almost immediately
for disbursing payments. Besides additional reduction in mail float may also result,
because payments do not have to be delivered but are picked up by the bank at the post
office. For better understanding consider the following illustration.
Assume Equatorial Group, a manufacturer of cement, has annual credit sales of
br. 9 million, which are billed at a constant rate each day. It takes about 5 days to receive
customers’ payment at home office. It takes another day for the credit department to
process receipts and deposits them in the bank. Equatorial Group has got a chance for a
piece of advice by a cash management consultant that using a lockbox would reduce the
1
mail float from 5 days to 2 2 days and completely eliminate the processing float. The
lockbox system would cost the firm Br. 9,500 per year. The firm earns 12 percent on
24
investment of comparable risk. The lockbox system would release br. 87,500 of cash
1
[Br. 9 million  360 days)  (5 days mail float + 1 day processing float – 2 2 days
mail float ], that is currently tied up in mail and processing float. The gross annual
benefit would be Br. 10,500 (0.12  Br. 87,500). Since the Br. 10,500 annual benefit
exceeds the Br. 9,500 annual cost, Equatorial Group should adopt the lockbox system.
Direct Sends
A collection procedure in which the payee presents checks for payment directly to
the banks on which they are drawn, thus reducing clearing float.
Firms that have received a large number of checks drawn on banks in a given city
or large checks drawn on distant banks may arrange to present these checks directly for
payment to the bank on which they are drawn. The firm should assess whether the
decision to use direct send is favorable to it. If the benefits from the reduced clearing
time are greater than the cost, the checks should be sent directly for payment rather than
cleared through normal banking system.
Assume if a firm with on opportunity to earn 10 percent on its idle balances can,
through a direct send, make available Br. 3 million 3 days earlier than would otherwise
be the case, the benefit of this direct send would be Br. 2,500 [0.10  (3 days  360 days)
 Br. 3,000,000]. If the cost of achieving this 3 – day reduction in float is less than Br.
2,500, the direct send would be acceptable.
Other Techniques
 Preauthorized Check (PAC) – A check written by the payee against a
customer’s checking account for a previously agreed upon amount. Because of
prior legal authorization, the check does not require the customer’s signature.
 Depositor Transfer Check (DTC) - An unsigned check drawn on one
of the firm’s bank accounts and deposited into its account of a concentration or
major disbursement bank, there by speeding up the transfer of funds.
 Wire Transfers – Telegraphic communications that, via bookkeeping
entries, remove funds from the payer’s bank and deposit them into the payee’s
bank, thereby reducing collection float.
25
ACH (Automated Clearing House) Debits
Preauthorized electronic withdrawals from the payer’s account that are then
transferred to the payee’s account via settlement among banks by the automated clearing
house. They clear in 1 day, thereby reducing mail, processing, and clearing float.
2.4.3 Slowing Down Disbursements

The main objective of the firm in relation to accounts payable is not only to pay its
accounts as late as possible but also to slow down the availability of funds to suppliers
and employees once the payment has been dispatched. It means the whole effort is
maximization of disbursement float. Various techniques are made available to slow
down disbursements, and thereby increasing disbursement float.
 Controlled Disbursing
The strategic use of mailing points and bank accounts to lengthen mail float and
clearing float, respectively.
 Playing the Float

A method of consciously anticipating the resulting float, or delay, associated with
the payment process and using it to keep funds in an interest–earning form for as long as
possible.
 Staggered Funding
A way to play the float by depositing a certain proportion of a payroll or payment
into the firm’s checking account on several successive days following the actual issuance
of a group of checks.
 Payable–Through Draft
A draft drawn on the payer’s checking account, payable to a given payee but not
payable on demand; approval of the draft by the payer is received before the bank pays
the draft.
 Overdraft System
26
Automatic coverage by the bank of all checks presented against the firm’s account,
regardless of the account balance.
 Zero–Balance Account
A checking account in which a zero balance is maintained and the firm is required
to deposit funds to cover checks drawn on the account only as they are presented for
payment.
 ACH (Automated Clearing House) Credits
Deposits of payroll directly into the payees’ (employees’) accounts. Sacrifices
disbursement float but may generate good will for the employer.
1. Define float and describe its three basic components. Compare and contrast
collection and disbursement float, and state the financial manager’s goal with
respect to each of these types of float.
__________________________________________________________________
__________________________________________________________________
2. Briefly describe the key features of each of the following techniques for speeding
up collections: (i) concentration banking and (ii) lock boxes
2.5. Marketable Securities
 Dear students, what marketable securities are? Where do you classify them?
What are their major groupings? Attempt to answer these questions before you
proceed to the following discussions.
Marketable securities are known as short – term, interest – earning, money market
instruments that can easily be converted into cash. Marketable securities are classified as
part of the firm’s liquid assets. Most commonly the securities held as part of the firm’s
marketable securities portfolio are divided into two groups:
i) Government issues
ii) Nongovernment issues
27
1. List and describe the three motives for holding cash and near- cash (marketable
securities) balances. Which are the most common motives.
2. What is meant when we say money market instrument is highly liquid”?
3. Define collection float and identify the role of each type of float.
4. How does the lockbox system differ from concentration banking. What is the
overall objective of both these arrangements?
5. What purpose do the Baumol and Miller-Orr models serve? Briefly describe
their similarities and differences.
Part II: Work out Questions
1. Nile Products is concerned about managing cash efficiently. On the average,
inventories have an average age of 80 days, and accounts receivable are collected in 70
days. Accounts payable are paid approximately 30 days after they arise. The firm spends
Br. 30 million on operating cycle investments each year, at a constant rate. Assuming a
360 – day year:
Required: i) Calculate the Firm’s Operating Cycle.
ii) Calculate the Firm’s Cash Conversion Cycle.
iii) Calculate the amount of negotiated (non-spontaneous) financing required
so as to support the firm’s cash conversion cycle.
2. RRC Company has an inventory conversion period of 75days, a receivable collection
period of 45 days, and a payable deferral period of 30 days.
Required: i) What is the length of the firm’s cash conversion cycle?
ii) How many times per year does RRC company turnover its inventory?
iii) If RRc’s annual sales are Br. 3,375,000 and all sales are on credit, what is the
firm’s investment in accounts receivable?
3. A firm that has an annual opportunity cost of 9 percent is contemplating installation of
a lockbox system at annual cost of Br. 90,000. The system is expected to reduce mailing
28
1 1
time by 1 2 days, reducing processing time by 1 2 days, and reduce check clearing
time by 1 day. If the firm collects Br. 300,000 per day would you recommend the
system? Explain.
4. Global Cables currently has a centralized billing system. On an average 5 days
required for customer’s mailed payments to reach the central location. An additional 2
days are required for processing payments before a deposit can be made. The firm has a
daily average collection of Br. 800,000. The company has recently investigated the
possibility of initiating a lockbox system. Such a system would reduce the mailed
payments period from five to three days. Further, processing time would be reduced by
one day, because each lockbox bank would pick up mailed deposits twice a daily.
Required: a) Determine the reduction in cash balances that can be achieved through the
use of a lockbox system.
b) Determine the opportunity cost of the present system, assuming a 7.5% return on
short–term instruments.
c) If the annual cost of the lockbox system will be Br. 120,000, should such a system
be initiated?

1. i) Operating Cycle = 150 days
ii) Cash conversion cycle = 120 days
iii) Amount of cash required to finance CCC = Br. 10 million
2. i) Cash conversion cycle = 90 days
ii) Investment on accounts receivable = Br. 2,700,000
iii) Inventory turnover = 360/75 = 4.8 times
3. Yes, because the cost of the lockbox system Br. 90,000 is less than the
opportunity savings (Br. 108,000).
4. a) Reduction in cash balance = Br. 2,400,000
b) Opportunity cost = Br. 180,000
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c) The system should be initiated, because it costs lesser amount (Br.
180,000 > Br. 120,000)
30
UNIT THREE
ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT
Contents
 Unit Objective
 Introduction
3.1 Credit Selection
3.2 Changing Credit Standards and Terms
3.3 Collection Policy
3.4 Inventory Management
3.5 Techniques for Managing Inventory
3.5.1 The ABC System
3.5.2 The Basic Economic Order Quantity (EOQ) Model
3.5.3.2.1 The Reorder Point
3.5.3 Materials Requirement Planning (MRP) System
3.5.4 Just- In – Time (JIT) System
 Answers to Model Examination Questions
Unit Objective
This unit aims at discussing the efficient management of accounts receivable and
inventories. Particularly, there will be a discussion about credit standards, terms, and
collection policy. It will also discuss about the techniques of inventory management.
After studying this unit you will be able to:
 Discuss the key aspects of credit selection, including the five C’s of credit.
 Explain why a good inventory management essential to a firm’s success.
 Identify the two main categories of inventory costs.
 Explain the key features of collection policy, including aging accounts receivable,
the basic tradeoffs, and the popular collection techniques.
 Describe the common techniques for managing inventory, including the ABC
System, the basic economic order quantity (EOQ) model, the reorder point, the
materials requirement planning (MRP) system, and the jus t-in- time (JIT) system.
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Introduction
 Dear student! In this unit we are going to learn about effective and efficient
management pertaining to accounts receivable and inventories.
In relation to accounts receivable, issues about credit selection, credit standards and
terms will be discussed. Similarly, firms’ collection policies will also be discussed. On
the other hand, the unit will focus on the following popular techniques for managing
inventory:
 The ABC system
 The Basic Economic order Quantity (EOQ) model.
 The Reorder point
 The materials Requirement Planning System
 The Jus t-in- time (JIT) system
3.1. Credit Selection
 Dear student! In common sense, what types of criteria are you going to
set, if you were a supplier (seller) of a certain product on credit? How do
you reach a decision for extending the credit? Foreword your answer in
writing before you go to read the following sections.
Accounts receivable denotes the extension of credit by the firm to its customers. The
decision of extending credit to customers by most manufacturing firms resulting money
tied up in accounts receivable, and this in turn brought a loss of the time value of money.
On top of that, it runs the risk of nonpayment by its customers. In return for incurring
these costs, the firm can be competitive, attract and retain customers, and improve and
maintain sales and profits.
Generally, receivable management refers to the decisions a business makes regarding
its overall credit and collection policies and the evaluation of individual credit applicants.
A firm’s credit selection activity involves deciding whether to extend credit to a
customer and how much credit to extend. To do so, appropriate sources of credit
information and methods of credit analysis must be developed. At first it is advisable to
consider the five C’s of credit, which are the traditional focus of credit investigation.
32
The Five C’s of Credit
A firm’s analysis is focused on the key dimensions of an applicant’s creditworthiness.
Each of these five dimensions i.e. character, capacity, capital, collateral, and conditions is
briefly described as below:
a) Character: the applicant’s record of meeting past obligations i.e. financial,
contractual, and moral. Past payment history as well as any pending or resolved
legal judgments against the applicant would be used to evaluate its character.
b) Capacity: The applicant’s ability to repay the requested credit. Financial
statement analysis, with particular emphasis on liquidity and debt ratios, is
typically used to assess the applicant’s capacity.
c) Capital: The financial strength of the applicant as reflected by its ownership
position. Analysis of the applicant’s debt relative to equity and its profitability
ratios are frequently used to assess its capital.
d) Collateral: the amount of assets the applicant has available for use in securing
credit. The larger the amount of available assets, the greater the chance that a
firm will recover its funds if the applicant defaults. A review of the applicant’s
balance sheet, asset value appraisals and any legal claims field against the
applicant’s assets can be used to evaluate its collateral.
e) Conditions: The current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. Analysis of
general economic and business conditions, as well as special circumstances that
may affect the applicant or firm is performed to assess conditions.
Once the credit analyst has gathered information on these dimensions of the marginal
credit applicant and information on the profitability of the product to be purchased, the
traditional approach requires that all this information analyzed and synthesized. By this
process, the analyst is to make an informed judgment on the overall creditworthiness of
the applicant.
The firm’s accounts receivable can be directly controlled through involvement in the
establishment and management of (i) Credit Policy, which includes determining credit
selection, credit standards, and credit terms, and (ii) Collection Policy.
33
1. What does the credit selection activity include? Briefly list, define, and discuss
the role of the five C’s of credit in the process.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
2. What do the accounts receivable of a firm typically represent? What is meant by
a firm’s credit policy?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
3.2. Changing Credit Standards and Credit Terms
 Dear students! What do you understand whenever you come across the term
credit standards and credit terms? What major variables do you expect to be
involved in credit standards? Can you cite any credit terms you have been
known before? Please foreword your answers briefly in writing before you go
through the discussions below.
Credit Standards
The firm’s credit standards are the minimum requirements for extending credit to
a customer. Credit standards have a significant influence on sales as trade credit is one of
the many factors that influence the demand for a firm’s product. The relaxation of credit
terms involve certain costs and the enlarged administrative expense and increased
probability of bad debt and the cost of additional investment in receivables resulting from
increased sales and a slow average collection period.
An understanding of the key variables that must be considered when a firm is
contemplating relaxing or tightening its credit standards will give an idea of the kinds of
decisions involved.
Key Variables
The major variables that should be considered when evaluating proposed changes
in credit standards are (i) sales volume, (ii) the investment in accounts receivable, and
(iii) bad debt expenses. Let’s try to examine each in more detail.
34
Sales Volume
The volume of sales is expected to change due to credit standard changing. If
credit standards are relaxed, sales are expected to increase. If credit standards are
tightened, sales are expected to decrease. In return, increases in sales affect profits
positively, whereas decreases in sales affect profits negatively.
Investment in Accounts Receivable
Maintaining, or holding, accounts receivable involves a cost to the firm. This cost
is attributable to the forgone earnings opportunities resulting from the necessity to tie up
funds in accounts receivable. Thus, the higher the firm’s investment in accounts
receivable, the greater the carrying cost, and the lower the firm’s investment in accounts
receivable, the lower the carrying cost. Relaxation of credit standards will result in
increases in the volume of accounts receivable, and so does the firm’s carrying cost
(investment). The opposite occurs if credit standards are tightened. Consequently, a
relaxation of credit standards is expected to affect profits negatively because of large
amount carrying costs, whereas tightening credit standards would affect profits positively
as a result of lower carrying costs.
Bad Debt Expenses
Bad debt expense is one of the operating expenses of a firm. The probability or
risk of acquiring a bad debt increases as credit standards are relaxed. Relaxation of credit
standards increases bad debts expenses that affect profits negatively. The opposite effects
can be bad debts expenses and profits result from a tightening of credit standards.
Illustrative Exercise -3.2

To illustrate, assume a product sells for Br. 10 a unit of which Br. 7.00 represents
variable costs before taxes including administrative costs. Current annual sales are Br.
2,400,000 represented entirely by credit sales and the firm is considering a more liberal
extension of credit, which will result in a slowing in the average collection periods from
one to two months. However, existing customers are not expected to alter their payment
habits. The relaxation in credit side is expected to reproduce a 25% increase in sales to
Br. 3,000,000 annually. This Br. 600,000 increase represents 60,000 additional units.
35
Assume that the required rate of return on investment in receivable is 20% before taxes.
Is it advisable to relax the credit standards?
Solution:
Present Value of Receivables = Annual Sales /Receivable Turnover
= Br. 2,400,000/12 = Br. 200,000
New Level of Receivables = Br. 300,000 (Br. 500,000 – Br. 200,000)
Additional Investment in Receivables
Br. 300,000  0.7 = Br. 210,000
Required Return on Additional Investment
0.20  Br. 210,000 = Br. 42,000
Profitability on Additional Sales
Br. 3  60,000 units – Br. 180,000
Since the profitability on additional sales, (i.e. Br. 180,000) exceeds the required
rate on the additional investment (i.e. Br. 42,000) the firm will be advised to relax its
credit standards.
Changing Credit Terms

A firm’s credit terms specify the repayment terms required of all its credit
customers. A firm’s credit terms specify a credit period (s) and cash discount rate (s)
where a cash discount is offered. The credit period is the period elapsing between the
date when the purchasing company receives its statement of account and the date when
payment is due. The cash discount period is the period elapsing between the date when
the purchasing company receives its statement of account and the date when cash
discount is foregone. The cash discount rate expresses, in effect, the reduction in the
purchase price that the purchasing company will receive if it pays within the cash
discount period.
Typically, a type of short hand is used. For example, credit terms may stated as
2/10 net 30, which means that the purchaser receives a 2 percent cash discount if the bill
is paid within 10 days after the beginning of the credit period, if the customer does not
take cash discount, the full amount must be paid within 30 days after the beginning of the
credit period. The following illustration will facilitate the understanding of the concept.
36
Illustrative Exercise – 3.2.2
Assume a firm with annual credit sales of Br. 3,000,000 has an average collection
period of 2 months, and the sales terms are net 45 days with no discount given. The
annual turnover of receivables is 6 times, so that the average receivable balance is Br.
500,000 (3,000,000/6). If the terms are changed to 2/10 net 45, and 50% of the
customers take the advantage of cash discount and the average collection period is
reduced to one month, does the firm accept the change in credit terms assuming a 20%
rate of return?
Solution:
 If the terms are changed to 2/10, net 45, i.e a 2% discount is given.
 The average collection period reduced to one month and 50% of customers take
advantage of the 2% cash discount.
 The opportunity cost of the discount is 0.02  0.5  Br. 3,000,000 = Br. 30,000
 However, the turnover has improved to 12 times a year (360 days/30 days)
 The average receivable is reduced from Br. 500,000 to Br. 250,000 (3,000,000/12)
 As a result of the change, the firm is able to release Br. 250,000 from accelerated
collections.
 Opportunity saving of Br. 50,000 (Br. 250,000  0.20)
 Therefore, the firm should have to accept the change of credit terms because the
opportunity saving (Br. 50,000) is greater than the opportunity cost (Br. 30,000).

1. What key variables should be considered when evaluating possible changes in a
firm’s credit standards? What are the basic tradeoffs in a tightening of credit
standards?
__________________________________________________________________
__________________________________________________________________
2. Discuss what is meant by credit terms. What are the three components of credit
terms? How do credit terms affect the firm’s accounts receivable?
__________________________________________________________________
__________________________________________________________________
37
3. What are the expected effects of a decrease in the firm’s cash discount on sales
volume, investment in accounts receivable, bad debt expenses, and per unit profits,
respectively?
__________________________________________________________________
__________________________________________________________________
4. What are the expected effects of a decrease in the firm’s credit period? What is likely
to happen to sales volume, investment in accounts receivable, and bad debt expenses,
respectively?
__________________________________________________________________
__________________________________________________________________
3.3. Collection Policy
 Dear students, what does collection policy mean? What common factors need
to be considered to adopt a given collection policy? Give your own answer
before you decide to read the subsequent discussions.
The firm’s collection policy is the set of procedures for collecting accounts receivable
when they are due. Partially, the effectiveness of collection policy can be evaluated by
looking at the level of bad debt expenses. It is to be expected that the incidence of bad
debt losses and the average collection period will be reduced as the amount spent on
collection expenditure is increased. The relationship between the average collection
period and the level of collection expenditure is likely to be similar. The expected
relationship between bad debt losses and collection expenditure is shown graphically as
below.
38
Figure 3.1: Collection Policy Relationship
Collection expenditures and bad debt losses
Beyond ‘A’ dollar of collection expenditure the benefits from reduced bad debt losses will be less than the cost of the additional collectio
Bad debt Losses (Br.)
Bad debt attributable to credit policy

A
Collection expenditures (Br.)
The collection policy can be seen as a trade–off between collection costs,

and the resulting reduction in bad debt losses and shorter average collection period
which, in turn will result in a reduction in the firm’s investment in receivables. For better
understanding the effect collection policy on sales is illustrated as follows.

To illustrate, assuming the annual sales of a company to be of Br. 3,000,000 which are
not expected to change with change in the collection effort.
Programme Present Programme –A Programme -B
Annual collection expenditure Br. 116,000 Br. 148,000
Collection period 2 months 1 1 month
1 2 months
Percentage of Bad debt 5 3 1
The evaluation of collection programs exhibits that the opportunity saving

resulting from a speed up collection plus the reduction in bad debt losses exceeds the
additional collection expenditures in going from the present program to program –A, but
not from program A to program –B. The table below denotes the illustration.
39
Present Program A Program B
program
Annual Sales 3,000,000 3,000,000 3,000,000
Turnover of receivables 6 8 12
Average receivables 500,000 375,000 250,000
Reduction in receivable from present program 125,000
Reduction in receivable from program –A level 125,000
Return on Reduction in receivable (20%) 25,000 25,000
Bad debt (% of annual sales) 150,000 90,000 30,000
Reduction in bad debt losses from present losses to 60,000 60,000
A and from A to B
Opportunity saving on reduced receivables plus 85,000 85,000
reduction on bad debt losses
Additional collection expenditures from present 32,000
expenditure to program –A
Additional collection expenditures from program – 52,000
A expenditures to program B expenditure

What is meant by a firm’s collection policy?
________________________________________________________________________
________________________________________________________________________
3.4. Inventory Management
 Dear Students! What is inventory mean? And what are their types?
Inventory, or goods on hand, is a necessary current asset that allows the

production–sale process to operate with a minimum of disturbance. In general, inventory
management is concerned with keeping enough product on hand to avoid running out
while at the same time maintaining a small enough inventory balance to allow for
reasonable return on investment.
40
Investment Fundamentals
There are two aspects of inventory: (1) types of inventory and (2) differing viewpoints as
to the appropriate level of inventory.
Types of Inventory
There are three basic types of inventory i.e. raw materials, work in process, and finished
goods inventory. Let us discuss all these three items, one by one.
i) Raw Materials are those basic inputs which are used to manufacture the finished
products.
ii) Work–In–Process, however, is the intermediary stage that comes after the stage of
raw materials, but just before the stage of finished goods.
iii) The Finished Goods, in turn, comprise the end – products, that is, the goods at their
final stage of production, ready for sale in the market.
Different Viewpoints About Inventory Level
In a firm there are differing viewpoints pertaining to appropriate inventory levels
commonly exist among the fiancé, marketing, manufacturing, and purchasing managers
of a firm. Each department views inventory levels in light of its own objectives.
 Financial Manager’s overall position toward inventory levels is to keep them low.
Financial manager’s prime objective is to make sure that whether the firm’s money is
not being unwisely invested in excess resources.
 Marketing Manager, to the contrary, would like to have large inventories of each of
the firm’s finished goods so as to eliminate the need for backorders due to stock outs.
 Manufacturing Manager’s principal responsibility is to ensure whether the
production plan is correctly implemented and that it results in the desired amount of
finished goods of acceptable quality at a low cost. In meeting this objective, the
manufacturing manager would keep raw materials inventories high to avoid
production delays and would favor high finished goods inventories by making large
production-runs for the sake of lower unit production costs.
 Purchasing Manager is concerned solely with raw materials inventories. The
purchasing manager is responsible as to the provision of raw materials in the correct
quantities at the desired times and at favorable price. Without proper control, the
purchasing manger may tend to purchase grater quantities of resources that are
41
actually needed to get quantity discounts or in anticipation of rising prices or a
shortage of certain materials.
3.5. Techniques for Managing Inventory
 Dear students! List few inventory management techniques you are

familiar with before you go through the following discussions.
Generally, the common techniques which are used in inventory management are (a)
the ABC system, (2) the basic economic order quantity (EOQ) model, (3) the reorder
point, (4) the materials requirement planning (MRP) system, and (5) the just –in- time
(JIT) system.
3.5.1. The ABC System

A company using the ABC System divides its inventory in to three groups, A,B,
and C. A, B, and C system divides inventory into three categories of descending
importance based on the dollar investment in each. ‘A’ group (tegory) includes those
items that require the largest dollar investment. The ‘B’ group consists of the items
accounting for the next largest investment. The ‘C’ group typically consists of a large
number of items accounting for a relatively small dollar investment. Dividing its
inventory into A, B, and C items allows the firm to determine the level and types of
inventory control procedures needed. With regard to control of the ‘A’ times should be
most intensive because of the high dollar investment involved; the use of perpetual
inventory recording keeping that allows daily monitoring of these inventory levels is
appropriate. Regarding ‘B’ items, they are frequently controlled through periodic
checking possibly weekly-of their levels. On the other hand ‘C’ items could be
controlled by using unsophisticated procedures such as a red–line method, in which a
reorder is placed when enough inventory has been removed from a bin containing the
inventory item to expose a red line that has been drawn around the inside of the bin. In
monitoring A and B items the economic order quantity (EOQ) model is used.
42
3.5.2. The Basic Economic Order Quantity (EOQ) Model
Among one of the most commonly cited sophisticated tools for determining the
optimal order quantity for an item of inventory is the Economic Order Quantity (EOQ)
Model. It takes into account various operating and financial costs and determines the
order quantity that minimizes total inventory cost.
Regardless of the actual cost of merchandise, the total costs associated with
inventory can be divided into three broad categories: order cost, carrying costs, and total
cost.
Ordering Costs: Every time an order is placed for stock replenishment, certain costs are
involved. Ordering costs include the fixed clerical costs of placing and receiving an
order i.e. the cost of writing a purchase order, of processing the resulting paperwork, and
of receiving an order and checking it against the invoice. Generally, order costs are
normally stated as dollar per order.
Carrying Costs: Carrying costs constitute all the variable costs per unit of holding an
item in inventory for a specified time period. These costs are typically expressed as dollar
(Birr) per unit per period. Carrying costs include ware housing (storage) costs, insurance
costs, obsolescence and deterioration costs and most important, the opportunity or
financial, cost of tying up funds in inventory.
Total cost: The total cost of inventory is defined as the sum of the ordering and carrying
costs. Total cost is important in the EOQ model, because the model’s objective is to
determine the order quantity that minimizes it.
The stated objective of the EOQ model is to find the order quantity that
minimizes the firm’s total inventory cost. The economic order quantity can be depicted
graphically as below.
43
Figure 3.2: A graphical presentation of an EOQ
Cost (Birr)
Total Cost
Carrying Cost
200 --
100 --
Ordering Cost
0 100 200 300 400 EOQ (units)
As it is shown in the above graph the total cost line represents the sum of the
order costs and carrying costs for each order quantity. The minimum total cost occurs at
the point labeled EOQ, where the order cost line and the carrying cost line intersect.
EOQ for a given inventory item can be determined by developing a formula. By

letting
Where, S = usage in units per period
O = order cost per order
C = Carrying cost per unit per period
Q = Order quantity in units
To determine the total cost equation, the first step is to develop an expression for
the order cost function and the carrying cost function. The ordering cost can be
expressed as the product of the cost per order and the number of orders. Since the
number of orders equals the usage during the period divided by the order quantity (S/Q),
the order cost can be expressed as below:
Ordering Cost = O X S/Q
The carrying cost is defined as the cost of carrying a unit per period times the firm’s
average inventory. The average inventory is stated as the order quantity divided by 2
44
(Q/2), because inventory is assumed to be depleted at a constant rate. Thus, the carrying
cost can be expressed as follows:
Total Cost = ( O  S/Q) + ( C  Q/2)
To determine the optimal order quantity the firm can use the following formula:
2×5×0
EOQ=
√ C
Assume that Jiffar, Inc., a manufacturer of building materials, uses 2,000units of
an item annually. Its order cost is Br. 40 per order, and carrying cost is Br. 1 per unit per
year. Substituting S = 2,000 O = Br. 40, and C = Br. 1 Yields an EOQ of
400 units:
2×2000×Br . 40
EOQ=
√ Br .1
3.5.3. The Reorder Point
The reorder point is the economic order point that the inventory level signals the
time to reorder merchandise at the EOQ amount. A reorder point is required that
considers the lead-time needed to place and receive orders. Assuming a constant usage
rate for inventory, the reorder point can be determined by the following equation:
Reorder Point = Lead-time in Days  Daily Usage
To illustrate reorder point, for example, if a firm from experience knows that it
requires 10 days to place and receive an order, and if it uses six units of inventory daily,
the reorder point would be 60 units (10 days  6 units per day). Hence, the moment the
firm’s inventory level reaches 60 units, an order will be placed for an amount equal to the
economic order quantity. If the estimates of lead-time and daily usage are correct, the
order will be received exactly when the inventory level reaches zero. Since precise
forecasting of the estimates is difficult many firms typically maintain safety stocks.
3.5.4. Materials Requirement Planning (MRP) System

Inventory management system that uses EOQ concepts and a computer to
compare production needs to available inventory balances and determine when orders
should be placed for various items on a product’s bill of materials. The bill of materials
45
structure simply refers to every part or material that goes into making the finished
product. On the basis of the time it takes for a product that is in process to move through
the various production stages and the lead time required to get materials, the MRP system
determines when orders should be placed for the various items on the bill of materials.
3.5.5. Just–In–Time (JIT) System

Inventory management system that minimizes inventory investment by having
material inputs arrive at exactly the time they are needed for production. The JIT’s
objective is to minimize inventory investment, a JIT system uses no, or very little, safety
stock. Extensive coordination must exist between the firm, its suppliers, and shipping
companies to ensure that material inputs arrive on time. Failure of materials to arrive on
time results in a shutdown of the production line until the materials arrive. When JIT is
working properly, it forces process inefficiencies to surface and be resolved.
1. Briefly describe each of the following techniques for managing inventory; (a)
ABC system, (b) reorder point, (c) materials planning system, and (d) Just–In–
Time (JIT) system.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
2. What is the EOQ model? To which group of inventory items it is most
applicable? What does it consider? What financial cost is involved?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
1. Discuss the overall objective of receivable management, and compare and
contrast with cash management and inventory management.
2. What are the five traditional “C’s” the financial manager might consider in
evaluating the credit worthiness of a potential customer?
46
3. Compare and contrast credit standards and credit terms. How can credit standards
and credit terms affect the amount invested in receivables and the return on such
investments?
4. What is the purpose of holding inventory? Name several types of inventory and
describe their purpose.
5. How is the reorder point determined? What is the significance of the reorder
point to the financial manager?
6. Distinguish between inventory ordering costs and inventory carrying costs. What
is the significance of economic order quantity (EOQ) to the financial manager?
Part – II: Workout Questions
1. Zoble Department Store credit sales of Br. 1,880,000. Average collection period is of
two months. Average selling price per unit is Br. 10 and the average cost per unit is
Br. 8. The firm can reduce the average collection period by one month giving 2%
cash discount, as 50% of the customers will avail of this cash. The required return
for the firm is 20%. Should Zoble Department Store liberalize the credit policy?
Explain.
2. Jimma Repair Company is attempting to evaluate whether it should ease collection
efforts. The firm repairs 72,000 rugs per year at an average price of Br. 32 each.
Bad debt expenses are 1 percent of sales, and collection expenditures are Br. 60,000.
The average collection period is 40 days, and the variable cost per unit Br. 28. By
easing the collection efforts, the company expects to save Br. 40,000 per year in
collection expense. Bad debts will increase to 2 percent of sales, and the average
collection period will increase to 58 days. Sales will increase by 1,000 repairs per
year. If the firm has a required rate of return on equal – risk investments of 24
percent, what recommendation would you give the firm? Use your analysis to justify
your answer.
3. Tsedey Paint Company uses 60,000 gallons of pigment per year. The cost of
ordering pigment is Br. 200 per order, and the cost of carrying the pigment in
inventory is Br. 1 per gallon per year. The firm uses pigment at a constant rate every
day throughout the year.
a) Calculate the EOQ.
47
b) Calculate the total cost of the plan suggested by the EOQ.
c) Determine the total number of orders suggested by this plan.
d) Assuming that it takes 20 days to receive an order once it has been placed,
determine the reorder point in terms of gallons of pigment. (Assume the 360
– day year).
4. A firm expects sales of 40,000 units at a constant rate throughout the year that cost
Br. 5 per unit. It has a policy of 20 days as a safety stock level and has estimated that
carrying costs are 10 percent of inventory value. The firm’s order costs are Br. 16
and the lead – time for orders is 10 days. What is the reorder point for the firm, and
how many units should the firm order? Assume a year of 360 – day year.

Part – II: Work Out Questions
1. Yes, because the opportunity saving (Br. 24,000) is greater than the opportunity
cost (Br. 10,400).
2. The proposed plan should not be implemented, because a net loss of Br. 4,915 is
expected to result from easing collection efforts.
3. a) EOQ = 4,899 Gallons
b) Total cost = Br. 4,899.50
c) Number of orders = 12.25 orders
d) Reorder point = 3,333.4 Gallons
4. i) Reorder point = 3,333 units
ii) EOQ = 1,600 Units
48
UNIT FOUR
RISK, RETURN AND THE PORTFOLIO THEORY
Contents:
 Unit Objectives
 Introduction
4.1 Meaning of Return
4.2 Average Returns
4.3 Risk
4.3.1 Risk Preferences
4.3.2 Stand-Alone Risk
4.3.3 Probability Distributions
4.4 Expected Rate of Return
4.5 Risk Measurement
4.5.1 Measuring Risk: The Standard Deviation
4.5.2 Measuring Stand-Alone Risk: The Coefficient of Variation
4.6 The Portfolio Theory
4.6.1 Risk in a Portfolio Context
4.6.2 Portfolio Returns
4.6.3 Portfolio Risk
4.6.4 Diversifiable Risk versus Market Risk
4.6.5 The Concept of Beta
4.7 The Relationship Between Risk and Rates of Return
UNIT OBJECTIVES
After completing this unit, you will be able to:

 Define what risk and expected return mean in finance
 Understand the underlying concept of portfolio theory
 Understand and apply the concepts of risk and return in a portfolio context
49
Introduction
 Dear Learner! In this unit, we will start our discussion by defining precisely
what the terms return and risk mean as they relate to investments, we examine
procedures that investors and financial managers use to measure risk, and we
discuss the relationship between risk and return. Then, later on in the unit, we
extend these relationships to show how risk and return are used in the
development of the portfolio theory. Investors and financial managers must
understand these concepts and think about them as they plan the actions that
will shape their firms’ futures.
4.1 Meaning of Return
Return can be simply defined as the amount of money an investor gets back as a
reward for investing his/her money net of the original outlay. With most investments, an
individual or a firm spends money today with the expectation of earning even more
money in the future. The concept of return provides investors with a convenient way of
expressing the financial performance of an investment. To illustrate, suppose you buy 10
shares of a particular firm’s stock for Br. 1,000. The stock pays no dividends, but at the
end of one year, you sell the stock for Br. 1,100. What is the return on your Br. 1,000
investment?
One way of expressing an investment return is in monetary (Birr) terms. The birr
return is simply the total birr received from the investment less the amount invested:
Birr returns = Amount received - Amount invested
= Br. 1,100 - Br. 1,000
= Br. 100
If, at the end of the year, you had sold the stock for Br. 1,100, your birr return
would have been Br. 100. Although expressing returns in birr is easy, two problems
arise: (1) To make a meaningful judgment about the return, you need to know the scale
(size) of the investment; a Br. 100 return on a Br. 100 investment is a good return
(assuming the investment is held for one year), but a Br. 100 return on a Br. 10,000
investment would be a poor return. (2) You also need to know the timing of the return; a
Br. 100 return on a Br. 100 investment is a very good return if it occurs after one year,
but the same birr return after 20 years would not be very good. The solution to the scale
50
and timing problems is to express investment results as rates of return, or percentage
returns. Consider the rate of return on the 1-year stock investment, when Br. 1,100 is
received after one year, is 10%: The rate of return calculation “standardizes” the return
by considering the return per unit of investment. In this example, the return of 0.10, or 10
%, indicates that each birr invested will earn 0.10 (Br. 1.00) = Br. 0.10. If the rate of
return had been negative, this would indicate that the original investment was not even
recovered. For example, selling the stock for only Br. 900 results in a negative 10% rate
of return, this means that each birr invested lost 10 cents.
Note also that a Br. 100 return on a Br. 1,000 investment produces a 10% rate of
return, while a Br. 100 return on a Br. 10,000 investment results in a rate of return of only
1%. Thus, the percentage return takes account of the size of the investment. Expressing
rates of return on an annual basis, which is typically done in practice, solves the timing
problem. A Br. 100 return after one year on a Br. 1,000 investment results in a 10%
annual rate of return, while a Br. 100 return after five years yields only a 2% annual rate
of return.
In the previous one-year stock investment example, we assumed no dividends
payment. But, in practice, this may not be the case. Thus, we would consider now that
there is a Br. 1.5 per share dividends would be received during the year (i.e., Br. 1.5/share
X 10 shares = Br. 15).
The birr return is, then, calculated as:
Birr return = Amount Received - Amount Invested
=[(Amount Received from Sales)+( Amount Received from Dividends Payment)]–[Amount Invested]
= (Br. 1,100 + Br. 15) – Br. 1,000
= Br. 1,115 – Br. 1,000
= Br. 115
Now, at the end of the year, if you sold the stocks for Br. 1,100 and received
dividends of Br. 15 during the year, your birr return would have been Br. 115. As you
seen explicitly from the computation above, your return has the two components: one an
income component (i.e., Br. 15 dividends) and the other a capital gain component (i.e.,
Br. 100 because you sold the stock by Br. 100 more than you have bought). This
component of your return would have been a capital loss if you had been sold the stocks
51
with Br. 950 (i.e., a Br. 50 capital loss which is the difference between Br. 1,000 and Br.
950).
Coming back to the original illustration with dividends of Br. 15, your annual rate
of return would be 11.5% computed as follows:
Percentage Annual Returns = Dividends Received + Changes in Market
Values
Beginning Market Value
= Br. 15 + (Br. 1,100 – Br. 1,000) X 100%
Br. 1,000
= (Br. 115/ Br. 1,000) X 100%
= 11.5%
When we decompose the above formula into two, we can find easily the
percentage annual returns of the two components: the income and the capital gain (or
loss).
Dividends Yield = Dividends Received
= (Br. 15/ Br. 1,000) X 100%
= 1.5%
Capital Gain (or Loss) Yield = Changes in Market Values

= (Br. 100 / Br. 1,000) X 100%
= 10%
Adding the dividend and capital gain yields result in the total rate of return we
have found earlier (i.e., 11.5% = 10% + 1.5%).
4.2 Average Returns
 Dear Learner! Thus far, we devoted time on birr returns and percentage
returns once we have knowledge about a given investment’s financial performance.
However, in making investment decisions, we should have some information
concerning the future particularly the expected returns of an investment. For
dealing with such information, we would first summarize past (historical) returns
in a way that helps our discussions about the future. Summarizing historical
returns can be done in a variety of ways, but to make the discussion very simple,
let’s rely on average returns to be computed based on arithmetic means.
The arithmetic mean of returns is the average of the annual rate of returns that an
investment provided through a number of years. The more we take annual rates of returns
52
in the arithmetic mean return computation; the better would be the estimate of return that
an investor could have realized in a particular year over the past years. Arithmetic mean
of returns can be calculated simply by dividing the sum of annual rates of returns by the
number of years. To illustrate, suppose that the annual rate of returns for Leyikun Co’s
stock for the last 9 years were as follows:
Year Rate of Return (%) Year Rate of Return (%)

2001 7 2006 13
2002 6 2007 9
2003 8 2008 16
2004 12 2009 13
2005 11
The arithmetic mean of returns (AMR), then, would be:

AMR = (0.07 + 0.06 + 0.08 + 0.12 + 0.11 + 0.13 + 0.09 + 0.16 + 0.13) ÷ 9
= 0.95 ÷ 9 = 10.56%
Average returns can also be computed for a market in a similar way as we have
done for a single stock. In a different saying, returns of stocks that fairly represent the
market can be selected to compute average stock returns. If one is able to compute the
average return on the stock market, it would be sensible to compare this average with the
returns of other stocks.
Suppose that the average return on the stock market has been 12.5%. What we can
say about Leyikun Co’s stock performance is that it performs relatively lower than that of
the stock market performance being other factors not considered.
Dear Student! Once we are familiar with the basic concepts of return, we will
hold the detail discussions on returns to later parts of this unit. Now, let’s grasp some
points on risk.
 Check Your Progress: Exercise 4:1
1. Differentiate between birr return and rate of return.
__________________________________________________________________
__________________________________________________________________
53
2. Why is the rate of return superior to the birr return for the size of investment and the
timing of cash flows?
__________________________________________________________________
__________________________________________________________________
4.3 Risk
Risk can be defined literary as “a hazard; a peril; exposure to loss or injury.”
Risk, in the most basic sense, can also be defined as the chance of physical damage of
property, or a financial loss. Risk is said to be inherent when an event that harms has a
probability of occurrence. When the probability of the event’s occurrence is zero, you can
say there is no risk. In financial terms, we may define formally risk as the chance of
financial loss or the variability of returns associated with a given asset. Each financial
decision, then, presents certain risk and return characteristics, and all major financial
decisions must be viewed in terms of expected risk, expected return, and their combined
effects.
 Dear Learner! To make our discussion of risk understandable, it would be

better to bear in your mind the following five key points:
1. All financial assets are expected to produce cash flows, and the riskiness of an asset is
judged in terms of the riskiness of its cash flows.
2. The riskiness of an asset can be considered in two ways:
(a) On a standalone basis, where the asset’s cash flows are analyzed by
themselves, or
(b) In a portfolio context, where the cash flows from a number of assets are
combined, and then the consolidated cash flows are analyzed.
3. In a portfolio context, an asset’s risk can be divided into two components:
(a) Diversifiable risk, which can be diversified away and thus, is of little concern
to diversified investors, and
(b) Market (non-diversifiable) risk, which reflects the risk of a general security
market decline and which cannot be eliminated by diversification, hence does concern
investors. Only market risk is relevant—diversifiable risk is irrelevant to rational
investors because it can be eliminated.
54
4. An asset with a high degree of relevant (market) risk must provide a relatively high
expected rate of return to attract investors. Investors in general are averse to risk, so they
will not buy risky assets unless those assets have high expected returns.
5. In this unit, we focus on financial assets such as stocks and bonds, but the concepts
discussed here also apply to physical assets such as equipment and machines.
4.3.1 Risk Preferences
The perception and attitude of individuals towards risk are different. The three
basic risk preference behaviors are risk-averse, risk-indifferent (Neutral), and risk-seeking
(or risk-taking). The following figure depicted these behaviors.
Return
Risk-Averse
Averse
Indifferent Risk-Indifferent (Neutral)
Seeking
Risk-Seeking
Risk
0 X1 X2
Note that as risk goes from X1 to X2, for the risk-indifferent (neutral) individuals,
the required return does not change. In essence, no change in return would be required for
the increase in risk. In the case of the risk-averse individuals, the required return
increases as risk increases. Because they shy away from risk, these individuals require
higher returns to compensate them for taking greater risk. For the risk-seeking
individuals, the required return decreases for an increase in risk. Theoretically, because
they enjoy risk, these individuals are willing to give up some return to take more risk.
Most investors and financial managers are risk-averse, because for a given increase in
risk, they require an increase in return. In practice, the general tendency towards
accepting risk is conservative rather than aggressive. In this unit and the upcoming units,
we will assume this tendency that investors and financial managers are risk-averse.
4.3.2 Stand-Alone Risk
55
Stand-Alone Risk is the risk that an investor would face if he or she held only one
asset. Obviously, most assets are held in portfolios, but it is necessary to understand
stand-alone risk in order to understand risk in a portfolio context.
To illustrate the riskiness of financial assets, suppose an investor buys Br.
100,000 of short-term Government Treasury Bills (T-bills) with an expected return of
5%. In this case, the rate of return on the investment, 5%, can be estimated quite
precisely, and the investment is defined as being essentially risk-free. However, if the Br.
100,000 were invested in the stock of a company just being organized to prospect for oil
in the Gambela Regional State, then the investment’s return could not be estimated
precisely. One might analyze the situation and conclude that the expected rate of return,
in a statistical sense, is 20 %, but the investor should also recognize that the actual rate of
return could range from, say, + 1,000 % to - 100 %. Because there is a significant danger
of actually earning much less than the expected return, the stock would be relatively
risky.
No investment will be undertaken unless the expected rate of return is high
enough to compensate the investor for the perceived risk of the investment. In our
example, it is clear that if any investor would be willing to buy the oil company’s stock if
its expected return were the same as that of the T-bill. Risky assets rarely produce their
expected rates of return—generally, risky assets earn either more or less than was
originally expected. Indeed, if assets always produced their expected returns, they would
not be risky. Investment risk, then, is related to the probability of actually earning a low
or negative return— the greater the chance of a low or negative return, the riskier the
investment. However, risk can be defined more precisely, and we do so in the next
section.
4.3.3 Probability Distributions
An event’s probability is defined as the chance that the event will occur. For
example, a weather forecaster might state, “There is a 40% chance of rain today and a
60% chance that it will not rain.” If all possible events, or outcomes, are listed, and if a
probability is assigned to each event, the listing is called a probability distribution. For
our weather forecast, we could set up the following probability distribution:
OUTCOME PROBABILIT
56
(1) Y
(2)
Rain 0.4 = 40%
No Rain 0.6 = 60%
1.0 = 100%
Notice that the probabilities must sum to 1.0, or 100%. Probabilities can also be
assigned to the possible outcomes (or returns) from an investment. If you buy a bond, you
expect to receive interest on the bond plus a return of your original investment, and those
payments will provide you with a rate of return on your investment. The possible
outcomes from this investment are (1) that the issuer will make the required payments or
(2) that the issuer will default on the payments. The higher the probability of default, the
riskier the bond, and the higher the risk, the higher the required rate of return. If you
invest in a stock instead of buying a bond, you will again expect to earn a return on your
money. A stock’s return will come from dividends plus capital gains as we have seen
earlier. Again, the riskier the stock—which means the higher the probability that the firm
will fail to perform as you expected the higher the expected return must be to encourage
you to invest in the stock. With this in mind, consider the possible rates of return
(dividend yield plus capital gain or loss) that you might earn next year on a Br. 10,000
investment in the stock of either Marta Products Inc. or Yonas Company. Marta
Products manufactures and distributes computer equipment. Because it faces intense
competition, its new products may or may not be competitive in the marketplace, so its
future earnings cannot be predicted very well. Indeed, some new company could develop
better products and literally bankrupt Marta Products. Yonas Co., on the other hand,
supplies an essential service, and because it has city monopolies that protect it from
competition, its sales and profits are relatively stable and predictable. The rate-of-return
probability distributions for the two companies are shown in Table 4-1.
Table 4–1: Probability Distributions for Marta Products and Yonas Co.
Probability of Rate of Return on Stock if the Demand
Demand for the Demand Occurs
Products Occurrence Marta Yonas Co.
Products
Strong 0.3 100% 20%
Normal 0.4 15 15
Weak 0.3 (70) 10
1.0
57
There is a 30% chance of strong demand, in which case both companies will have
high earnings, pay high dividends, and enjoy capital gains. There is a 40% probability of
normal demand and moderate returns, and there is a 30% probability of weak demand,
which will mean low earnings and dividends as well as capital losses. Notice, however,
that Marta Products’ rate of return could vary far more widely than that of Yonas Co.
There is a fairly high probability that the value of Marta’s stock will drop substantially,
resulting in a 70% loss, while there is no chance of a loss for Yonas Co.
4.4 Expected Rate of Return

Expected Rate of Return is the rate of return expected to be realized from an
investment; the weighted average of the probability distribution of possible results. If we
multiply each possible outcome by its probability of occurrence and then sum these
products, as in Table 4-2, we have a weighted average of outcomes.
Table 4–2: Calculation of Expected Rates of Return: Payoff Matrix
Probability Marta Products Yonas Co.
Demand of Demand Rate of Return Product: Rate of Return on Product
for the Occurrence on Stock if the (2) x (3) Stock if the :
Products (2) Demand Occurs = (4) Demand Occurs (2) x (5)
(1) (3) (5) = (6)
Strong 0.3 100% 30% 20% 6%
Normal 0.4 15 6 15 6
Weak 0.3 (70) (21) 10 3
1.0 kˆ= kˆ=
15% 15%
The weights are the probabilities, and the weighted average is the expected rate
of return, kˆ , called “k-hat.”3 The expected rates of return for both Marta Products and
Yonas are shown in Table 4-2 to be 15%. This type of table is known as a payoff matrix.
The expected rate of return calculation can also be expressed as an equation that does the
same thing as the payoff matrix table.
Expected Rate of Return = kˆ = P1k1 + P2k2 + …. + Pnkn.
n
k ¿=∑ Pi k i
i=1
58
Where, ki = the ith possible outcome,
Pi = the probability of the ith outcome, and
n = is the number of possible outcomes.
Thus, kˆ is a weighted average of the possible outcomes (the ki values), with each
outcome’s weight being its probability of occurrence. Using the data for Marta Products,
we obtain its expected rate of return as follows:
kˆ = P1(k1) + P2(k2) + P3(k3)
= 0.3(100%) + 0.4(15%) + 0.3(-70%)
= 15%.
Yonas Co.’s expected rate of return is also 15 %:

kˆ = 0.3(20%) + 0.4(15%) + 0.3(10%)
= 15%.
4.5 Risk Measurement
4.5.1 Measuring Risk: The Standard Deviation
 Dear Student! A great deal of controversy has surrounded attempts to define

and measure risk. However, a common definition, and one that is satisfactory for
many purposes, is stated in terms of probability distributions such as those
presented in the figure below:
Probability Density
Yonas Co.
Marta Products
-70 0 15 100 Rate of Returns (%)
Expected Rate of Return

The tighter the probability distribution of expected future returns, the smaller the
risk of a given investment. According to this definition, Yonas Co. is less risky than
59
Marta Products because there is a smaller chance that its actual return will end up far
below its expected return.
To be most useful, any measure of risk should have a definite value—we need a
measure of the tightness of the probability distribution. One such measure is the
standard deviation, δ. The smaller the standard deviation, the tighter the probability
distribution, and, accordingly, the lower the riskiness of the stock.
Dear Learner! To calculate the standard deviation, you should follow the
following steps illustrated under Table 4-3 below:
1. Calculate the expected rate of return:
Expected Rate of Return = kˆ = P1k1 + P2k2 + …. + Pnkn.

Or using the formula
n
k ¿=∑ Pi k i
i=1
For Marta Products, we previously found kˆ = 15%.
2. Subtract the expected rate of return (kˆ ) from each possible outcome (k i) to obtain a
set of deviations about kˆ as shown in Column 1 of Table 4-3:
Deviationi = ki - kˆ
3. Square each deviation, then multiply the result by the probability of occurrence for
its related outcome, and then sum these products to obtain the variance of the
probability distribution as shown in Columns 2 and 3 of the table:
n
2
Variance=σ =∑ ¿¿ ¿
i=1
4. Finally, find the square root of the variance to obtain the standard deviation:
n
Standard Devaition=σ= √∑
i=1
(k i−k ¿ )2 Pi
Table 4-3: Computation of Marta Products’ Standard Deviation

Deviationi = ki - kˆ (ki - kˆ)2 (ki - kˆ)2pi
(1) (2) (3)
100 - 15 = 85 7,225 (7,225) = 2,167.5
(0.3)
15 - 15 = 0 0 (0)(0.4) = 0.0
-70 - 15 = -85 7,225 (7,225) = 2,167.5
(0.3)
Variance = 4,335.0
=δ
Standard Deviation = 65.84%
60
Thus, the standard deviation is essentially a weighted average of the deviations
from the expected value, and it provides an idea of how far above or below the expected
value the actual value is likely to be. Marta’s standard deviation is = 65.84%. Using the
same formula, we can find Yonas Co.’s standard deviation to be 3.87 %. Marta Products
has the larger standard deviation, which indicates a greater variation of returns and thus a
greater chance that the expected return will not be realized. Therefore, Marta Products is
a riskier investment than Yonas when held alone.
4.5.2 Measuring Stand-Alone Risk: The Coefficient of Variation
If a choice has to be made between two investments that have the same expected
returns but different standard deviations, most people would choose the one with the
lower standard deviation and, therefore, the lower risk. Similarly, given a choice between
two investments with the same risk (standard deviation) but different expected returns,
investors would generally prefer the investment with the higher expected return. To most
people, this is common sense—return is “good,” risk is “bad,” and, consequently,
investors want as much return and as little risk as possible. But how do we choose
between two investments if one has the higher expected return but the other the lower
standard deviation? To help answer this question, we use another measure of risk, the
coefficient of variation (CV), which is the standard deviation divided by the expected
return:
Coefficient of variation = CV = δ/k
The coefficient of variation shows the risk per unit of return, and it provides a
more meaningful basis for comparison when the expected returns on two alternatives are
not the same. Since Yonas Co. and Marta Products have the same expected return, the
coefficient of variation is not necessary in this case. The firm with the larger standard
deviation, Marta, must have the larger coefficient of variation when the means are equal.
In fact, the coefficient of variation for Marta is 65.84/15 = 4.39 and that for Yonas is
3.87/15 = 0.26. Thus, Marta is almost 17 times riskier than Yonas on the basis of this
criterion.
For a case where the coefficient of variation is necessary, consider Projects X and
Y. These projects have different expected rates of return and different standard
61
deviations. Project X has a 60% expected rate of return and a 15% standard deviation,
while Project Y has an 8% expected return but only a 3% standard deviation. Is Project X
riskier, on a relative basis, because it has the larger standard deviation? If we calculate
the coefficients of variation for these two projects, we find that Project X has a
coefficient of variation of 15/60 = 0.25, and Project Y has a coefficient of variation of 3/8
= 0.375. Thus, we see that Project Y actually has more risk per unit of return than Project
X, in spite of the fact that X’s standard deviation is larger. Therefore, even though Project
Y has the lower standard deviation, according to the coefficient of variation it is riskier
than Project X. Project Y has the smaller standard deviation, hence the more peaked
probability distribution, but it is clear that the chances of a really low return are higher for
Y than for X because X’s expected return is so high. Because the coefficient of variation
captures the effects of both risk and return, it is a better measure for evaluating risk in
situations where investments have substantially different expected returns.

1. What does “risk” mean?
_____________________________________________________________________
_____________________________________________________________________
2. What is a payoff matrix?

____________________________________________________________________
____________________________________________________________________
3. How does a standard deviation measures risk?

____________________________________________________________________
____________________________________________________________________
4. Which is a better measure of risk if assets have different expected returns: (a) the
standard deviation or (b) the coefficient of variation? Why?
____________________________________________________________________
____________________________________________________________________
5. Explain the following statement: “Most investors are risk averse.”

____________________________________________________________________
____________________________________________________________________
6. How does risk aversion affect rates of return?
62
____________________________________________________________________
____________________________________________________________________
4.6 The Portfolio Theory

4.6.1 Risk in a Portfolio Context
In the preceding discussions, we considered the riskiness of assets held in
isolation. Now we analyze the riskiness of assets held in portfolios. As we shall see, an
asset held as part of a portfolio is less risky than the same asset held in isolation.
Accordingly, most financial assets are held as parts of portfolios. This being the case,
from an investor’s standpoint the fact that a particular stock goes up or down is not very
important; what is important is the return on his or her portfolio, and the portfolio’s risk.
Logically, then, the risk and return of an individual security should be analyzed in terms
of how that security affects the risk and return of the portfolio in which it is held.
To illustrate, Lakew Inc. is a merchandising company that operates nationwide
through a number of offices. The company is not well known, its stock is not very liquid,
its earnings have fluctuated quite a bit in the past, and it doesn’t pay a dividend. All this
suggests that Lakew is risky and that its required rate of return, k, should be relatively
high. However, Lakew’s required rate of return in 2001, and all other years, was quite
low in comparison to those of most other companies. This indicates that investors regard
Lakew as being a low-risk company in spite of its uncertain profits. The reason for this
counter-intuitive fact has to do with diversification and its effect on risk. Lakew’s
earnings rise during recessions, whereas most other companies’ earnings tend to decline
when the economy slumps. It’s like fire insurance—it pays off when other things go bad.
Therefore, adding Lakew to a portfolio of “normal” stocks tends to stabilize returns on
the entire portfolio, thus making the portfolio less risky.
4.6.2 Portfolio Returns
The expected return on a portfolio, kˆp, is simply the weighted average of the
expected returns on the individual assets in the portfolio, with the weights being the
fraction of the total portfolio invested in each asset:
kˆp = w1k^1 + w2k^2 + …. + wnk^n.
n
k ¿p=∑ w i k ¿i
i=1
63
Here the kî’s are the expected returns on the individual stocks, the w i’s are the
weights, and there are n stocks in the portfolio. Note (1) that w i is the fraction of the
portfolio’s birr value invested in Stock i (that is, the value of the investment in Stock i
divided by the total value of the portfolio) and (2) that the wi’s must sum to 1.0.
4.6.3 Portfolio Risk
As we just saw, the expected return on a portfolio is simply the weighted average
of the expected returns on the individual assets in the portfolio. However, unlike returns,
the riskiness of a portfolio, δp, is generally not the weighted average of the standard
deviations of the individual assets in the portfolio; the portfolio’s risk will be smaller than
the weighted average of the assets. In fact, it is theoretically possible to combine stocks
that are individually quite risky as measured by their standard deviations and to form a
portfolio that is completely riskless, with δp=0.
The tendency of two variables to move together is called correlation, and the
correlation coefficient, r, measures this tendency. In statistical terms, the returns on, say
Stocks W and M, are perfectly negatively correlated, if r = -1.0. The opposite of perfect
negative correlation, with r = -1.0, is perfect positive correlation, with r = +1.0. Returns
on two perfectly positively correlated stocks (M and M’) would move up and down
together, and a portfolio consisting of two such stocks would be exactly as risky as the
individual stocks. Thus, diversification does nothing to reduce risk if the portfolio
consists of perfectly positively correlated stocks.
When stocks are perfectly negatively correlated (r = -1.0), all risk can be
diversified away, but when stocks are perfectly positively correlated (r = +1.0),
diversification does no good whatsoever. In reality, most stocks are positively correlated,
but not perfectly so. On average, the correlation coefficient for the returns on two
randomly selected stocks would be about +0.6, and for most pairs of stocks, r would lie
in the range of +0.5 to +0.7. Under such conditions, combining stocks into portfolios
reduces risk but does not eliminate it completely. As a rule, the riskiness of a portfolio
will decline as the number of stocks in the portfolio increases. If we added enough
partially correlated stocks, could we completely eliminate risk? In general, the answer is
no, but the extent to which adding stocks to a portfolio reduces its risk depends on the
degree of correlation among the stocks: The smaller the positive correlation coefficients,
64
the lower the risk in a large portfolio. If we could find a set of stocks whose correlations
were zero or negative, all risk could be eliminated. In the real world, where the
correlations among the individual stocks are generally positive but less than +1.0, some,
but not all, risk can be eliminated.
4.6.4 Diversifiable Risk versus Market Risk
As noted above, it is difficult if not impossible to find stocks whose expected
returns are negatively correlated—most stocks tend to do well when the national
economy is strong and badly when it is weak. Thus, even very large portfolios end up
with a substantial amount of risk, but not as much risk as if all the money were invested
in only one stock. Some risk always remains, however, so it is virtually impossible to
diversify away the effects of broad stock market movements that affect almost all stocks.
To see more precisely how portfolio size affects portfolio risk, consider the figure
below, which shows how portfolio risk is affected by forming larger and larger portfolios
of randomly selected stocks from the market. Standard deviations are plotted for an
average one-stock portfolio, a two-stock portfolio, and so on.
The graph illustrates that, in general, the riskiness of a portfolio consisting of
large company stocks tends to decline and to approach some limit as the size of the
portfolio increases. According to data accumulated in recent years, the standard
deviation, δ1, of a one-stock portfolio (or an average stock), is approximately 35%.
Effects of Portfolio Size on Portfolio Risk for Average Stocks
Portfolio Risk, δp (%)
35 -
30 -
Diversifiable Risk
25 -
Minimum
Attainable Risk
δp=20.4 in a
Portfolio of Average
Stock
15 - Portfolio’s
Stand-alone Portfolio’s Market
10 – Risk: Declines Risk: Remains
65
as Stocks are Constant
5- Added
0 10 20 30 40 2,000+
Number of Stocks in the Portfolio
A portfolio consisting of all stocks, which is called the market portfolio, would
have a standard deviation, δM, of about 20.4%, which is shown as the horizontal dashed
line in the figure above. Thus, almost half of the riskiness inbuilt in an average individual
stock can be eliminated if the stock is held in a reasonably well-diversified portfolio.
Some risk always remains, however, so it is virtually impossible to diversify away the
effects of broad stock market movements that affect almost all stocks.
The part of a stock’s risk that can be eliminated is called diversifiable risk, while
the part that cannot be eliminated is called market risk. The fact that a large part of the
riskiness of any individual stock can be eliminated is vitally important, because rational
investors will eliminate it and thus render it irrelevant.
Diversifiable risk is caused by such random events as lawsuits, strikes,
successful and unsuccessful marketing programs, winning or losing a major contract, and
other events that are unique to a particular firm. Since these events are random, their
effects on a portfolio can be eliminated by diversification—bad events in one firm will be
offset by good events in another. Market risk, on the other hand, stems from factors that
systematically affect most firms: war, inflation, recessions, and high interest rates. Since
most stocks are negatively affected by these factors, market risk cannot be eliminated by
diversification. We know that investors demand a premium for bearing risk; that is, the
higher the riskiness of a security, the higher its expected return must be to induce
investors to buy (or to hold) it. However, if investors are primarily concerned with the
riskiness of their portfolios rather than the riskiness of the individual securities in the
portfolio, how should the riskiness of an individual stock be measured? One answer is
provided by the Capital Asset Pricing Model (CAPM): A model based on the
proposition that any stock’s required rate of return is equal to the risk-free rate of return
plus a risk premium that reflects only the risk remaining after diversification. The CAPM
is an important tool used to analyze the relationship between risk and rates of return. The
primary conclusion of the CAPM is this: The relevant riskiness of an individual stock is
66
its contribution to the riskiness of a well-diversified portfolio. The basic concepts of the
CAPM were developed specifically for common stocks, and, therefore, the theory is
examined first in this context. However, it has become common practice to extend
CAPM concepts to capital budgeting and to speak of firms having “portfolios of tangible
assets and projects.”
 Dear Learner! Up to this point, you may noticed how a stock might be quite
risky if held by itself, but if half of its risk can be eliminated by diversification, then
its relevant risk, which is its contribution to the portfolio’s risk, is much smaller
than its stand-alone risk.
A simple example will help make this point more clear. Suppose you are offered
the chance to flip a coin once. If a head comes up, you win Br. 20,000, but if a tail comes
up, you lose Br. 16,000. This is a good bet—the expected return is 0.5(Br. 20,000) +
0.5(Br. 16,000) = Br. 2,000. However, it is a highly risky proposition, because you have a
50 % chance of losing Br. 16,000. Thus, you might well refuse to make the bet.
Alternatively, suppose you were offered the chance to flip a coin 100 times and you
would win Br. 200 for each head but lose Br. 160 for each tail. It is possible that you
would flip all heads and win Br. 20,000, and it is also possible that you would flip all tails
and lose Br. 16,000, but the chances are very high that you would actually flip about 50
heads and about 50 tails, winning a net of about Br. 2,000. Although each individual flip
is a risky bet, collectively you have a low-risk proposition because most of the risk has
been diversified away. This is the idea behind holding portfolios of stocks rather than just
one stock, except that with stocks all of the risk cannot be eliminated by diversification—
those risks related to broad, systematic changes in the stock market will remain.
Are all stocks equally risky in the sense that adding them to a well-diversified
portfolio would have the same effect on the portfolio’s riskiness? The answer is no.
Different stocks will affect the portfolio differently, so different securities have different
degrees of relevant risk. How can the relevant risk of an individual stock be measured?
As we have seen, all risk except that related to broad market movements can, and
presumably will, be diversified away. After all, why accept risk that can be easily
eliminated? The risk that remains after diversifying is market risk, or the risk that is
inherent in the market, and it can be measured by the degree to which a given stock tends
67
to move up or down with the market. In the next section, we develop a measure of a
stock’s market risk, and then, in a later section, we introduce an equation for determining
the required rate of return on a stock, given its market risk.
4.6.5 The Concept of Beta
The tendency of a stock to move up and down with the market is reflected in its
beta coefficient, b. Beta is a key element of the CAPM. An average-risk stock is defined
as one that tends to move up and down in step with the general market as measured by
some stock indices such as the Dow Jones Industrials, the S&P 500, or the New York
Stock Exchange Index (Note: Dear Learner! These indices are well known in the
developed nations that are assumed to indicate performance of a given economy. You
may have noticed them from various media news releases.) Such a stock will, by
definition, be assigned a beta, b, of 1.0, which indicates that, in general, if the market
moves up by 10%, the stock will also move up by 10%, while if the market falls by 10%,
the stock will likewise fall by 10%. A portfolio of such b = 1.0 stocks will move up and
down with the broad market averages, and it will be just as risky as the averages. If b =
0.5, the stock is only half as volatile as the market—it will rise and fall only half as much
—and a portfolio of such stocks will be half as risky as a portfolio of b = 1.0 stocks. On
the other hand, if b = 2.0, the stock is twice as volatile as an average stock, so a portfolio
of such stocks will be twice as risky as an average portfolio. The value of such a portfolio
could double—or halve—in a short time, and if you held such a portfolio, you could
quickly go from millionaire to pauper.
1. Explain the following statement: “An asset held as part of a portfolio is generally
less risky than the same asset held in isolation.”
____________________________________________________________________
____________________________________________________________________
2. What is meant by perfect positive correlation, perfect negative correlation, and zero
correlation?
____________________________________________________________________
____________________________________________________________________
3. In general, can the riskiness of a portfolio be reduced to zero by increasing the
number of stocks in the portfolio? Explain.
____________________________________________________________________
____________________________________________________________________
68
4. Why is beta the theoretically correct measure of a stock’s riskiness?
____________________________________________________________________
____________________________________________________________________
5. Explain what it meant by the Capital Asset Pricing Model (CAPM).
____________________________________________________________________
____________________________________________________________________
4.7 The Relationship between Risk and Rates of Return
 Dear Learner! In the preceding section, we saw that under the CAPM theory,
beta is the appropriate measure of a stock’s relevant risk. Now we must specify the
relationship between risk and return: For a given level of risk as measured by beta,
what rate of return will investors require to compensate them for bearing that risk?
To begin, let us define the following terms:

 kî = expected rate of return on the ith stock.
 ki = required rate of return on the ith stock. Note that if kî is less than ki,
you would not purchase this stock, or you would sell it if you owned it. If kˆ i were
greater than ki, you would want to buy the stock, because it looks like a bargain.
You would be indifferent if kî = ki.
 k = realized, after-the-fact return. One obviously does not know k at the
time he or she is considering the purchase of a stock.
 kRF = risk-free rate of return. In this context, k RF is generally measured by
the return on a government Treasury bonds.
 bi = beta coefficient of the ith stock. The beta of an average stock is bA =
1.0.
 kM = required rate of return on a portfolio consisting of all stocks, which is
called the market portfolio. kM is also the required rate of return on an average (bA
= 1.0) stock.
 RPM = (kM - kRF) = risk premium on “the market,” and also on an average
(b = 1.0) stock. This is the additional return over the risk-free rate required to
compensate an average investor for assuming an average amount of risk. Average
risk means a stock whose bi = bA = 1.0.
69
 RPi = (kM - kRF)bi = (RPM)bi = risk premium on the ith stock. The stock’s
risk premium will be less than, equal to, or greater than the premium on an
average stock, RPM, depending on whether its beta is less than, equal to, or greater
than 1.0. If bi = bA = 1.0, then RPi = RPM.
Market Risk Premium, RPM is the additional return over the risk-free rate
needed to compensate investors for assuming an average amount of risk. The market
risk premium, RPM, shows the premium investors require for bearing the risk of an
average stock. The size of this premium depends on the perceived risk of the stock
market and investors’ degree of risk aversion. Let us assume that at the current time
Treasury bonds yield kRF = 6% and an average share of stock has a required rate of return
of kM = 11%. Therefore, the market risk premium is 5 % calculated as:
RPM = kM - kRF = 11% - 6% = 5%.
While the market risk premium represents the risk premium for the entire stock
market, the risk premium on individual stocks will vary. For example, if one stock were
twice as risky as another, its risk premium would be twice as high, while if its risk were
only half as much, its risk premium would be half as large. Further, we can measure a
stock’s relative riskiness by its beta coefficient. If we know the market risk premium,
RPM, and the stock’s risk as measured by its beta coefficient, b i, we can find the stock’s
risk premium as the product (RPM) bi. For example, if bi = 0.5 and RPM = 5%, then RPi is
2.5%: Risk premium for Stock i = RPi = (RPM) bi = (5%)(0.5) = 2.5%.
The required return for any investment can be expressed in general terms as:
Required return = Risk-free return - Premium for risk.
Here the risk-free return includes a premium for expected inflation, and we
assume that the assets under consideration have similar maturities and liquidity. Under
these conditions, the required return for Stock i can be written as follows:
Required return Risk- Market risk Stock i's

SML Equation: on Stock i = free rate + premium beta
70
ki = kRF + (kM - kRF) bi
= kRF + (RPM) bi
= 6% + (11% - 6%) (0.5)
= 6% + 5% (0.5)
= 8.5%.
The above equation is called the Security Market Line (SML). It is the line on a
graph that shows the relationship between risk as measured by beta and the required rate
of return for individual securities. If some other Stock j were riskier than Stock i and had
bj = 2.0, then its required rate of return would be 16 %: kj = 6% + (5%)2.0 = 16%.
An average stock, with b = 1.0, would have a required return of 11 %, the same as the
market return: kA = 6% + (5%)1.0 = 11% = kM.
The Security Market Line (SML) is often expressed in graphical form as follows:
Required Rate of Return (%) SML: ki = kRF +(kM
- kRF)bi
=
6% + (11% - 6%)bi
=
6% + (5%)bi
kHigh=16
Market Risk
kM=kA=11 Premium: 5%.Applies
Relatively Risky
also to an Average Stock,
Stock’s Risk
& is the Slope Coefficient
Premium: 10%
kLow= 8.5 Safe Stock’s in the SML Equation
Risk Premium:2.5%
kRF = 6
Risk-Free
Rate, kRF
71
0 0.5 1.0 1.5 2.0 Risk, bi
 Dear Learner! Note the following points referring the graph depicting SML:
1. Required rates of return are shown on the vertical axis, while risk as measured
by beta is shown on the horizontal axis. This graph is quite different from the one shown
in prior to it.
2. Riskless securities have bi = 0; therefore, kRF appears as the vertical axis
intercept in the graph. If we could construct a portfolio that had a beta of zero, it would
have an expected return equal to the risk-free rate.
3. The slope of the SML (5% in this figure) reflects the degree of risk aversion in
the economy—the greater the average investor’s aversion to risk, then (a) the steeper the
slope of the line, (b) the greater the risk premium for all stocks, and (c) the higher the
required rate of return on all stocks.
4. The values we worked out for stocks with bi = 0.5, bi = 1.0, and bi = 2.0 agree
with the values shown on the graph for kLow, kA, and kHigh, respectively. Both the Security
Market Line and a company’s position on it change over time due to changes in interest
rates, investors’ aversion to risk, and individual companies’ betas.
 Check Your Progress: Exercise 4-4
1. Differentiate among the expected rate of return (kˆ), the required rate of return (ki),
and the realized, after-the-fact return (k) on a stock i. Which would have to be larger
to get you to buy the stock, kˆ or ki? Would kˆ, ki, and k typically be the same or
different? Explain.
____________________________________________________________________
____________________________________________________________________
2. What is the SML graph? Why do we construct it?
____________________________________________________________________
____________________________________________________________________
GURE6-12
72

1. If investors’ aversion to risk increased, would the risk premium on a high-beta stock
increase more or less than that on a low-beta stock? Explain.
2. If a company’s beta were to double, would its expected return double?
3. Is it possible to construct a portfolio of stocks that has an expected return equal to the
risk-free rate?
4. A stock had a 12% return last year, a year in which the overall stock market declined in
value. Does this mean that the stock has a negative beta?
Part-II: Work Out Questions
1. You bought 400 shares of Meta Abo Brewery S. Co, at Br. 30 per share. Over the year,
you received Br. 0.75 per share in dividends. If the stock sold for Br. 33 at the end of
the year, what was your Birr return? Your percentage return?
2. Using the following returns, calculate the average returns, the variances, and the
standard deviations for the following stocks:
Year Melaku, Inc. Jaleta Co.
1 12% 5%
2 -4 -15
3 0 10
4 20 38
5 2 17
3. Suppose you bought 200 shares of stock at an initial price of Br. 42 per share. The
stock paid a dividend of Br. 2.40 per share during the following year, and the share price
at the end of the year was Br. 31. Compute your total Birr return on this investment. Does
your answer change if you keep the stock instead of selling it? Why or why not?
73
4. In the previous problem, what is the capital gains yield? What is the dividend yield?
What is the total rate of return on the investment?
5. Rework Questions 3and 4 assuming that you buy 750 shares of the stock and the
ending share price is Br. 60.

Part-II: Work Out Questions
1. Your Birr return is just your gain or loss in Birr. Here, we receive Br. 0.75 in dividends
on each of our 400 shares, for a total of Br. 300. In addition, each share rose from Br. 30
to Br. 33, so we make Br. 3 × 400 shares = Br. 1,200 there. Our total Birr return is thus
Br. 300 + 1,200 = Br. 1,500. Our percentage return (or just “return” for short) is equal to
the Br. 1,500 we made divided by our initial outlay of Br. 30 × 400 shares = Br. 12,000;
so Br. 1,500/12,000 = 0.125 = 12.5%. Equivalently, we could have just noted that each
share paid a Br. 0.75 dividend and each share gained Br. 3, so the total Birr gain per share
was Br. 3.75. As a percentage of the cost of one share (Br. 30), we get Br. 3.75/30 = .125
=12.5%.
2. First, calculate return averages as follows:
Melaku, Inc. Jaleta Co.
12% 5%
-4 -15
0 10
20 38
2 17
30% 55%
Average Returns 30/5=6% 55/5=11%

Using the averages above, calculate the squared deviations from the average returns and
sum the squared deviations as follows:
(12 - 6)2 = 36 (5 - 11)2 = 36
(-4 - 6)2 = 100 (-15 - 11)2 = 676
(0 - 6)2 = 36 (10 - 11)2 = 1
(20 - 6)2 = 196 (38 - 11)2 = 729
(2 - 6)2 = 16 (17 - 11)2 = 36
384 1,478
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Calculate return variances by dividing the sums of squared deviations by four, which is
the number of returns less one.
384 1,478
384 / 4 = 96 1,478 / 4 = 369.5
Standard deviations are then calculated as the square root of the variance.

384 / 4 = 96 1,478 / 4 = 369.5
σ =√ 96 = 9.8% σ =√ 369.5 = 19.22%
3. Birr return = 200(Br. 31 – Br. 42) + 200(Br. 2.40) = –Br. 1,720. No, whether you
choose to sell the stock or not does not affect the gain or loss for the year; your stock is
worth what it would bring if you sold it. Whether you choose to do so or not is irrelevant
(ignoring taxes).
4. Capital gains yield = (Br. 31 – Br. 42)/Br. 42 = –26.19%

Dividend yield = Br. 2.40/Br. 42 = +5.71%
Total rate of return = –26.19% + 5.71% = –20.48%
5. Birr return = 750(Br. 60 – Br. 42) + 750(Br. 2.40) = Br. 15,300

Capital gains yield = (Br. 60 – Br. 42)/Br. 42 = 42.86%
Dividend yield = Br. 2.40/Br. 42 = 5.71%
Total rate of return = 42.86% + 5.71% = 48.6%
UNIT FIVE
LEVERAGE, CAPITAL STRUCTURE, AND
DIVIDEND POLICY
Contents:
 Unit Objectives
 Introduction
5.1 The Target Capital Structure
5.2 Business and Financial Risks
5.2.1 Business Risk
5.2.2 Operating Leverage
5.2.3 Financial Risk and Financial Leverage
5.3 Determining the Optimal Capital Structure
5.3.1 WACC and Capital Structure Changes
5.3.2 The Hamada Equation
5.3.3 The Optimal Capital Structure
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5.4 Modern Capital Structure Theory
5.4.1 The Effect of Taxes
5.4.2 The Effect of Bankruptcy Costs
5.4.3 Trade-Off Theory
5.5 Dividends and Dividend Policy
5.5.1 Dividends
5.5.2 Dividend Policy

Unit Objectives
After completing this unit, you will be able to:

 Define what operating leverage and financial leverage mean
 Understand and explain the underlying concepts of capital structure decisions
 Describe what dividends are and their importance
 Explain different types of dividend policies
Introduction
 Dear Learner! In the first part of financial management course, when we

calculated the weighted average cost of capital for use in capital budgeting, we
assumed that the firm had a specific target capital structure. However, the optimal
capital structure may change over time, changes in capital structure affect the
riskiness and cost of each type of capital, and all this can change the weighted
average cost of capital. Moreover, a change in the cost of capital can affect capital
budgeting decisions and, ultimately, the firm’s stock price.
Many factors influence the capital structure decision, and, as you will see,
determining the optimal capital structure is not an exact science. Therefore, even firms in
the same industry often have dramatically different capital structures. In this unit, we first
consider the effect of capital structure on risk, and then we use these insights to help
76
answer the question of how firms should determine the mix of debt and equity used to
finance their operations. Finally, we will have a discussion on dividends and dividend
policy.
5.1 The Target Capital Structure

Target Capital Structure is the mix of debt, preferred stock, and common equity
with which a firm plans to raise capital. Firms should, first, analyze a number of factors,
and then establish a target capital structure. This target may change over time as
conditions change, but at any given moment, management should have a specific capital
structure in mind. If the actual debt ratio is below the target level, expansion capital
should generally be raised by issuing debt, whereas if the debt ratio is above the target,
equity should generally be issued.
Capital structure policy involves a trade-off between risk and return: Using more
debt raises the risk borne by stockholders. However, using more debt generally leads to a
higher expected rate of return on equity.
Higher risk tends to lower a stock’s price, but a higher expected rate of return
raises it. Therefore, the optimal capital structure must strike a balance between risk and
return so as to maximize the firm’s stock price.
Four primary factors influence capital structure decisions.
1. Business risk, or the riskiness inherent in the firm’s operations if it used no
debt. The greater the firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is
deductible, which lowers the effective cost of debt.
3. Financial flexibility, or the ability to raise capital on reasonable terms under
adverse conditions. Financial managers know that a steady supply of capital is necessary
for stable operations, which is vital for long-run success. They also know that when
money is tight in the economy, or when a firm is experiencing operating difficulties,
suppliers of capital prefer to provide funds to companies with strong balance sheets.
Therefore, both the potential future need for funds and the consequences of a funds
shortage influence the target capital structure—the greater the probable future need for
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capital, and the worse the consequences of a capital shortage, the stronger the balance
sheet should be.
4. Managerial conservatism or aggressiveness. Some managers are more
aggressive than others; hence some firms are more inclined to use debt in an effort to
boost profits. This factor does not affect the true optimal, or value-maximizing, capital
structure, but it does influence the manager determined target capital structure.
These four points largely determine the target capital structure, but operating
conditions can cause the actual capital structure to vary from the target.
 Check-Your Progress: Exercise 5-1

1. What four factors affect the target capital structure?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
2. In what sense does capital structure policy involve a trade-off between risk and
return?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
5.2 Business and Financial Risks
 Dear Learner! In the previous unit, when we examined risk from the viewpoint
of a stock investor, we distinguished between market risk, which is measured by the
firm’s beta coefficient, and stand-alone risk, which includes both market risk and
an element of risk that can be eliminated by diversification.
Now we introduce two new dimensions of risk: (1) business risk, or the riskiness of
the firm’s stock if it uses no debt, and (2) financial risk, which is the additional risk
placed on the common stockholders as a result of the firm’s decision to use debt.
Conceptually, the firm has a certain amount of risk inherent in its operations: this
is its business risk. If it uses debt, then, in effect, it partitions its investors into two groups
and concentrates most of its business risk on one class of investors—the common
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stockholders. However, the common stockholders will demand compensation for
assuming more risk and thus require a higher rate of return. In this section, we examine
business and financial risk within a stand-alone risk framework, which ignores the
benefits of stockholder diversification.
5.2.1 Business Risk
Business risk in a stand-alone sense is a function of the uncertainty inherent in
projections of a firm’s return on invested capital (ROIC), defined as follows:
ROIC=
NOPAT
=
( Net Income
¿
¿ Common Stockholders ¿ )+( After Tax Interst Payments)
Capital Capital
, here NOPAT is net operating profit after taxes
and capital is the sum of the firm’s debt and common equity. (We ignore preferred stock
in this section.) If a firm uses no debt, then its interest payments will be zero, its capital
will be all equity, and its ROIC will equal its return on equity, ROE:
Net Income ¿ Common Stockholders ¿
ROIC ( Zero Debt )=ROE=
( ¿ )
Capital Equity
Therefore, the business risk of a leverage-free firm can be measured by the
standard deviation of its ROE, δROE.
To illustrate, consider Belay Electronics Company, a debt-free (unlevered) firm.
Figure 5-1 gives some clues about the company’s business risk. The top graph shows the
trend in ROE from 1991 through 2001; this graph gives both security analysts and
Belay’s management an idea of the degree to which ROE has varied in the past and might
vary in the future. The lower graph shows the beginning-of-year subjectively estimated
probability distribution of Belay’s ROE for 2001, based on the trend line in the top
section of Figure 5-1. As both graphs indicate, Belay’s actual ROE in 2001 was only 8%,
well below the expected value of 12%—2001 was a bad year.
FIGURE 5 – 1 Belay Electronics: Trend in ROE and Subjective Probability Distribution of ROE, 2001
(a) Trend in Return on Equity (ROE)

ROE (%)
2001 ROE as Projected at Beginning of Year = 12%
20 --
10 --
79
Actual 2001 ROE
0 | 1993 | 1995 | 1997 | 1999 | 2001 |
-10 --
(b) Subjective Probability Distribution of ROE for 2001

Probability Density
0 8 12 ROE (%)
Actual ROE Expected ROE
Belay’s past fluctuations in ROE were caused by many factors—booms and

recessions in the national economy, successful new products introduced both by Belay
and by its competitors, labor strikes, a fire in Belay’s main plant, and so on. Similar
events will doubtless occur in the future, and when they do, the realized ROE will be
higher or lower than the projected level. Further, there is always the possibility that a
long-term disaster will strike, permanently depressing the company’s earning power; for
example, a competitor might introduce a new product that would permanently lower
Belay’s earnings. This uncertainty regarding Belay’s future ROE, assuming the firm uses
no debt financing, is defined as the company’s business risk. Because Belay uses no debt,
stockholders bear all of the company’s business risk. Business risk varies not only from
industry to industry but also among firms in a given industry. Further, business risk can
change over time.
 Dear Learner! Note here that (1) any action that increases business risk in the
stand-alone risk sense will generally also increase a firm’s beta coefficient and (2)
a part of business risk as we define it will generally be company-specific, hence
subject to elimination by diversification by the firm’s stockholders.
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Business risk depends on a number of factors, the more important of which are listed
below:
 Demand variability. The more stable the demand for a firm’s products, other things
held constant, the lower its business risk.
 Sales price variability. Firms whose products are sold in highly volatile markets are
exposed to more business risk than similar firms whose output prices are more
stable.
 Input cost variability. Firms whose input costs are highly uncertain are exposed to a
high degree of business risk.
 Ability to adjust output prices for changes in input costs. Some firms are better able
than others to raise their own output prices when input costs rise. The greater the
ability to adjust output prices to reflect cost conditions, the lower the degree of
business risk.
 Ability to develop new products in a timely, cost-effective manner. Firms in such
high-tech industries as drugs and computers depend on a constant stream of new
products. The faster its products become obsolete, the greater a firm’s business risks.
 Foreign risk exposure. Firms that generate a high percentage of their earnings
overseas are subject to earnings declines due to exchange rate fluctuations. Also, if a
firm operates in a politically unstable area, it may be subject to political risks.
 The extent to which costs are fixed: operating leverage. If a high percentage of costs
are fixed, hence do not decline when demand falls, then the firm is exposed to a
relatively high degree of business risk. This factor is called operating leverage, and
it is discussed at length in the next section.
Each of these factors is determined partly by the firm’s industry characteristics,
but each of them is also controllable to some extent by management. For example, most
firms can, through their marketing policies, take actions to stabilize both unit sales and
sales prices. However, this stabilization may require spending a great deal on advertising
and/or price concessions to get commitments from customers to purchase fixed quantities
at fixed prices in the future.
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Similarly, firms such as Belay Electronics can reduce the volatility of future input
costs by negotiating long-term labor and materials supply contracts, but they may have to
pay prices above the current spot price to obtain these contracts.
5.2.2 Operating Leverage
As noted above, business risk depends in part on the extent to which a firm builds
fixed costs into its operations—if fixed costs are high, even a small decline in sales can
lead to a large decline in ROE. So, other things held constant, the higher a firm’s fixed
costs, the greater its business risk. Higher fixed costs are generally associated with more
highly automated, capital intensive firms and industries. However, businesses that
employ highly skilled workers who must be retained and paid even during recessions also
have relatively high fixed costs.
If a high percentage of total costs are fixed, then the firm is said to have a high
degree of operating leverage. In physics, leverage implies the use of a lever to raise a
heavy object with a small force. In politics, if people have leverage, their smallest word
or action can accomplish a lot. In business terminology, a high degree of operating
leverage, other factors held constant, implies that a relatively small change in sales
results in a large change in ROE.
Figure 5-2 illustrates the concept of operating leverage by comparing the results
that Belay Electronics could expect if it used different degrees of operating leverage. Plan
A calls for a relatively small amount of fixed costs, Br. 20,000. Here the firm would not
have much automated equipment, so its depreciation, maintenance, property taxes, and so
on would be low. However, the total operating costs line has a relatively steep slope,
indicating that variable costs per unit are higher than they would be if the firm used more
operating leverage. Plan B calls for a higher level of fixed costs, Br. 60,000. Here the
firm uses automated equipment (with which one operator can turn out a few or many
units at the same labor cost) to a much larger extent. The breakeven point is higher under
Plan B—breakeven occurs at 60,000 units under Plan B versus only 40,000 units under
Plan A.
PLAN A PLAN B
Price Br. 2.00 Br. 2.00
82
Variable costs Br. 1.50 Br. 1.00
Fixed costs Br. 20,000 Br. 60,000
Assets Br. 200,000 Br. 200,000
Tax rate 40% 40%
We can calculate the breakeven quantity by recognizing that operating

breakeven occurs when ROE = 0, hence when earnings before interest and taxes (EBIT)
= 0: (This definition of breakeven does not include any fixed financial costs because
Belay is an unlevered firm. If there were fixed financial costs, the firm would suffer an
accounting loss at the operating breakeven point. We will introduce financial costs
shortly.)
EBIT = PQ - VQ - F = 0.
Here P is average sales price per unit of output, Q is units of output, V is variable
cost per unit, and F is fixed operating costs. If we solve for the breakeven quantity, Q BE,
we get this expression:
QBE = F ÷ (P –V)
Thus for Plan A, QBE = Br. 20,000 = 40,000 units.

Br. 2.00 - Br. 1.50
And for Plan B,

QBE = Br. 60,000 = 60,000 units.
Br. 2.00 - Br. 1.00
Figure 5-2: Illustration of Operating Leverage
Plan A Plan B
Revenues & Costs Revenues & Costs
(Thousands of Birr) (Thousands of Birr)
Sales Revenues Sales Revenues
240 --- Operating Profit 240 --- Operating Profit
(EBIT) (EBIT)
200 --- 200 ---
160 --- Operating 160 --- Operating

Loss Total Operating Loss Total Operating
120 --- Costs 120 --- Costs
Breakeven Point (EBIT=0)
80 --- Breakeven Point (EBIT=0) 80 --- Fixed Costs
40 --- Fixed Costs 40 ---

0 | | | | | | 0 | | | | | |
20 40 60 80 100 120
20 40 60 80 100 120
Sales (Thousands of Units) Sales (Thousands of Units)
83
PLAN A PLAN B
Operating Operating
Units Birr Operating Profits Net Operating Profits
Demand Probability Sold Sales Costs (EBIT) Income ROE Costs (EBIT) Net Income ROE
Br. Br. (Br. (Br.12,000 -6 . Br. (Br.
Terrible 0.05 0 0 20,000 20,000) ) 0% 60,000 60,000) (Br.36,000) -18%
Poor 0.20 40,000 80,000 80,000 0 0 0.0 100,000 (20,000) (12,000) -6
Normal 0.50 100,000 200,000 170,000 30,000 18,000 9.0 160,000 40,000 24,000 12
Good 0.20 160,000 320,000 260,000 60,000 36,000 18.0 220,000 100,000 60,000 30
Wonderful 0.05 200,000 400,000 320,000 80,000 48,000 24.0 260,000 140,000 84,000 42
Expected Value 100,000 200,000 170,000 30,000 18,000 9.0% 160,000 40,000 24,000 12%
7.41 14.82
Standard Deviation 24,698 % 49,396 %
Coefficient of Variance 0.82 0.82 1.23 1.23
NOTE: The income tax rate is 40 %, so NI = EBIT(1 - Tax rate) = EBIT(0.6).
How does operating leverage affect business risk? Other things held constant, the
higher a firm’s operating leverage, the higher its business risk. This point is
demonstrated in Figure 5-3, where we develop probability distributions for ROE under
Plans A and B.
The top section of Figure 5-3 graphs the probability distribution of sales that was
presented in tabular form in Figure 5-2. The sales probability distribution depends on
how demand for the product varies, not on whether the product is manufactured by Plan
A or by Plan B. Therefore, the same sales probability distribution applies to both
production plans; this distribution has expected sales of Br. 200,000, and it ranges from
zero to about Br. 400,000, with a standard deviation of δSales = Br. 98,793.
We use the sales probability distribution, together with the operating costs at each
sales level, to develop graphs of the ROE probability distributions under Plans A and B.
These are shown in the bottom section of Figure 5-3. Plan B has a higher expected ROE,
but this plan also entails a much higher probability of losses. Clearly, Plan B, the one
with more fixed costs and a higher degree of operating leverage, is riskier. In general,
holding other factors constant, the higher the degree of operating leverage, the greater
the firm’s business risk. In the discussion that follows, we assume that Belay Electronics
has decided to go ahead with Plan B because it believes that the higher expected return is
sufficient to compensate for the higher risk.
Figure 5-3: Analysis of Business Risk
(a) Sales Probability Distribution Under Either Plan A or B
84
Probability Density
0 Br. 200,000 Sales (in Birr)

(Expected Sales)
(b) ROE Probability Distribution
Probability Density
Plan A
Plan B
0 9 12 ROE (%)
(Expected (Expected
ROEA) ROEB)
To what extent can firms control their operating leverage? To a large extent, operating
leverage is determined by technology. Thus, by its capital budgeting decisions, a
company can influence its operating leverage, hence its business risk. Once a firm’s
operating leverage has been established, this factor exerts a major influence on its capital
structure decision.
5.2.3 Financial Risk and Financial Leverage

Financial risk is the additional risk placed on the common stockholders as a
result of the decision to finance with debt. Conceptually, stockholders face a certain
amount of risk that is inherent in a firm’s operations—this is its business risk, which is
defined as the uncertainty inherent in projections of future operating income. If a firm
uses debt (financial leverage), this concentrates the business risk on common
85
stockholders. To illustrate, suppose 10 people decide to form a share company to
manufacture computer components. There is a certain amount of business risk in the
operation. If the firm is capitalized only with common equity, and if each person buys
10% of the stock, then each investor shares equally in the business risk. However,
suppose the firm is capitalized with 50% debt and 50% equity, with five of the investors
putting up their capital as debt and the other five putting up their money as equity. In this
case, the five investors who put up the equity will have to bear all of the business risk, so
the common stock will be twice as risky as it would have been had the firm been financed
only with equity. Thus, the use of debt, or financial leverage, concentrates the firm’s
business risk on its stockholders. This concentration of business risk occurs because debt
holders, who receive fixed interest payments, bear none of the business risk.
To illustrate the concentration of business risk, we can extend the Belay
Electronics example. To date, the company has never used debt, but the financial
manager is now considering a possible change in the capital structure. Changes in the use
of debt will cause changes in earnings per share (EPS) as well as changes in risk— both
of which will affect the company’s stock price. To understand the relationship between
financial leverage and EPS, first consider Table 5-1, which shows how Belay’s cost of
debt, would vary if it used different percentages of debt. The higher the percentage of
debt, the riskier the debt, hence the higher the interest rate lenders will charge.
Table 5-1: Interest Rates for Belay with Different Debt/Assets Ratios
_______________________________________________________________________
___
INTEREST RATE, kd,
AMOUNT BORROWEDa DEBT/ASSETS RATIO ON ALL
DEBT
Br. 20,000 10% 8.0%
40,000 20 8.3
60,000 30 9.0
80,000 40 10.0
100,000 50 12.0
120,000 60 15.0
____________________________________________________________________________________________________________________
a
We assume that the firm must borrow in increments of Br. 20,000. We also assume that
Belay is unable to borrow more than Br. 120,000, which is 60 % of its Br. 200,000 of
assets, because of restrictions in its corporate charter.
86
For now, assume that only two financing choices are being considered—
remaining at 100% equity, or shifting to 50% debt and 50% equity. We also assume that
with no debt Belay has 10,000 shares of common stock outstanding and, if it changes its
capital structure, common stock can be repurchased at the Br. 20 current stock price.
Now consider Table 5-2, which shows how the financing choice will affect Belay’s
profitability and risk.
First focus on Section I of Table 5-2, which assumes that Belay uses no debt.
Since debt is zero, interest is also zero, hence pre-tax income is equal to EBIT. Taxes at
40% are deducted to obtain net income, which is then divided by the Br. 200,000 of
equity to calculate ROE. Note that Belay receives a tax credit if the demand is either
terrible or poor (which are the two scenarios where net income is negative). Here we
assume that Belay’s losses can be carried back to offset income earned in the prior year.
The ROE at each sales level is then multiplied by the probability of that sales level to
calculate the 12% expected ROE. Note that this 12% is the same as we found in Figure 5-
2 for Plan B.
Section I of Table 5-2 also calculates Belay’s earnings per share (EPS) for each
scenario under the assumption that the company continues to use no debt. Net income is
divided by the 10,000 common shares outstanding to obtain EPS. If the demand is
terrible, the EPS will be —Br. 3.60, but if demand is wonderful, the EPS will rise to Br.
8.40. The EPS at each sales level is then multiplied by the probability of that sales level
to calculate the expected EPS, which is Br. 2.40 if Belay uses no debt. We also calculate
the standard deviation of EPS and the coefficient of variation as indicators of the firm’s
risk at a zero debt ratio: δEPS = Br. 2.96, and CVEPS = 1.23.
Table 5- 2: Effects of Financial Leverage: Financed with No Debt or with 50% Debt
SECTION I. ZERO DEBT
Debt ratio 0%
Assets Br. 200,000
Debt 0
Equity Br. 200,000
Share Outstanding 10,000
Demand for Pre-tax Taxes

Product Probability EBIT Interest Income (40%) Net Income ROE EPS*
(1) (2) (3) (4) (5) (6) (7) (8) (9)
87
Terrible 0.05 (Br. 60,000) Br. 0 (Br. 60,000) (Br. 24,000) (Br. 36,000) -18 % (Br. 3.60)
Poor 0.20 (20,000) 0 (20,000) (8,000) (12,000) -6.0 (1.20)
Normal 0.50 40,000 0 40,000 16,000 24,000 12.0 2.40
Good 0.20 100,000 0 100,000 40,000 60,000 30.0 6.00
Wonderful 0.05 140,000 0 140,000 56,,000 84,000 42.0 8.40
Expected Value 40,000 0 40,000 16,000 24,000 12.0% 2.40
Standard Deviation 14.82% 2.96
Coefficient of Variance 1.23 1.23
* The EPS figures can also be obtained using the following formula, in which the numerator amounts to an income
statement at a given sales level laid out horizontally:
EPS = (Sales - Fixed costs - Variable costs - Interest)(1 - Tax rate) = (EBIT - I)(1 -
T)
Shares outstanding Shares outstanding
SECTION II. 50% DEBT

Debt ratio 0. 5
Assets Br. 200,000
Debt Br. 100,000
Interest rate 12.00%
Equity Br. 200,000
Share outstanding 5,000
Demand for Pre-tax

Product Probability EBIT Interest Income Taxes (40%) Net Income ROE EPS
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Terrible 0.05 (Br. 60,000) Br. 12,000 (Br. 72,000) (Br. 28,800) (Br. 43,200) -43 .2% (Br. 8.64)
Poor 0.20 (20,000) 12,000 (32,000) (12,800) (19,200) -19.20 (3.84)
Normal 0.50 40,000 12,000 28,800 11,200 16,800 16.8 3.36
Good 0.20 100,000 12,000 88,000 35,200 52,800 52.8 10.56
Wonderful 0.05 140,000 12,000 128,000 51,200 76,800 76.8 15.36
Expected Value 40,000 12,000 28,000 11,200 16,800 16.8 3.36
Standard Deviation 29.64 5.93
Coefficient of Variance 1.76 1.76
Now let’s look at the situation if Belay Electronics decides to use 50% debt
financing, shown in Section II of Table 5-2, with the debt costing 12%. Demand will not
be affected, nor will operating costs, hence the EBIT columns are the same for the zero
debt and 50% debt cases. However, the company will now have Br. 100,000 of debt with
a cost of 12%, hence its interest expense will be Br. 12,000. This interest must be paid
regardless of the state of the economy—if it is not paid, the company will be forced into
bankruptcy, and stockholders will probably be wiped out. Therefore, we show a Br.
12,000 cost in Column 4 as a fixed number for all demand conditions. Column 5 shows
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pre-tax income, Column 6 the applicable taxes, and Column 7 the resulting net income.
When the net income figures are divided by the equity investment— which will now be
only Br. 100,000 because Br. 100,000 of the Br. 200,000 total requirement was obtained
as debt—we find the ROEs under each demand state. If demand is terrible and sales are
zero, then a very large loss will be incurred, and the ROE will be —43.2%. However, if
demand is wonderful, then ROE will be 76.8%. The probability-weighted average is the
expected ROE, which is 16.8% if the company uses 50% debt.
Typically, financing with debt increases the expected rate of return for an
investment, but debt also increases the riskiness of the investment to the owners of the
firm, its common stockholders. This situation holds with our example—financial leverage
raises the expected ROE from 12% to 16.8%, but it also increases the riskiness of the
investment as measured by the coefficient of variation from 1.23 to 1.76.
Figure 5-4 graphs the data in Table 5-2. It shows in another way that using
financial leverage increases the expected ROE, but that leverage also flattens out the
probability distribution and increases the probability of a large loss, thus increasing the
risk borne by stockholders.
We can also calculate Belay’s EPS if it is financed with 50% debt. Recall that
EPS is calculated as net income divided by shares outstanding. With debt = 0, there
would be 10,000 shares outstanding. However, if half of the equity were replaced by debt
(debt = Br. 100,000), there would be only 5,000 shares outstanding, and we must use this
fact to determine the EPS figures that would result at each of the possible demand levels.
With a debt/assets ratio of 50%, the EPS figure would be -Br. 8.64 if sales were terrible;
it would rise to Br. 3.36 if sales were normal; and it would soar to Br. 15.36 if sales were
wonderful.
Figure 5-4: ROE Probability Distributions: With and Without Leverage
ProbabilityDensity
0% Debt
89
50% Debt
0 12 16.8
ROE (%)
The EPS distributions under the two financial structures are graphed in Figure 5-5,
where we use continuous distributions rather than the discrete distributions contained in
Table 5-2. Although expected EPS would be much higher if financial leverage were
employed, the graph makes it clear that the risk of low, or even negative, EPS would also
be higher if debt were used.
Figure 5-5: Probability Distributions of EPS with Different Amounts of Financial
Leverage
Probability
Density
Zero Debt Financing
50% Debt Financing
0 Br. 2.40 Br. 3.36 EPS (Birr)

Another view of the relationships among expected EPS, risk, and financial
leverage is presented in Figure 5-6. The tabular data in the lower section were calculated
in the manner set forth in Table 5-2, and the graphs plot these data. Here we see that
expected EPS rises until the firm is financed with 50% debt. Interest charges rise, but this
effect is more than offset by the declining number of shares outstanding as debt is
substituted for equity. However, EPS peaks at a debt ratio of 50%, beyond which interest
rates rise so rapidly that EPS falls in spite of the falling number of shares outstanding.
Figure 5-6: Relationship among Expected EPS, Risk, and Financial Leverage
90
Expected Risk(CVEPS)
EPS(Br.)
Peak EPS=Br. 3.36
Additional Risk to
3.50 Shareholders from Use of
3.00
Financial Leverage:
2.50 2.00
Financial Risk
2.00
1.23
=
Basic
0 10 20 30 40 50 60
Business Risk
Debt/Assets (%)
0 10 20 30 40 50 60
Debt/Assets (%)
The right panel of Figure 5-6 shows that risk, as measured by the coefficient of
variation of EPS, raises continuously, and at an increasing rate, as debt is substituted for
equity.
We see, then, that using leverage has both good and bad effects: higher leverage
increases expected earnings per share (in this example, until the D/A ratio equals 50 %),
but it also increases risk. Clearly, Belay’s debt ratio should not exceed 50 %, but where,
in the range of 0 to 50%, should it be set?
1. What is business risk, and how can it be measured?
__________________________________________________________________
__________________________________________________________________
2. What are some determinants of business risk?
__________________________________________________________________
__________________________________________________________________
3. Why does business risk vary from industry to industry?
__________________________________________________________________
__________________________________________________________________
4. What is operating leverage?
__________________________________________________________________
__________________________________________________________________
5. How does operating leverage affect business risk?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
91
6. What is financial risk, and how does it arise?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
7. Explain this statement: “Using leverage has both good and bad effects.”
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
5.3 Determining the Optimal Capital Structure

As we saw in Figure 5-6, Belay’s expected EPS is maximized at a debt/assets
ratio of 50%. Does that mean that Belay’s optimal capital structure calls for 50% debt?
The answer is a deep no—the optimal capital structure is the one that maximizes the
price of the firm’s stock, and this generally calls for a debt ratio that is lower than the
one that maximizes expected EPS.
5.3.1 WACC and Capital Structure Changes
The capital structure that maximizes the stock price is also the one that minimizes
the WACC. Because it is usually easier to predict how a capital structure change will
affect the WACC than the stock price, many managers use the predicted changes in the
WACC to guide their capital structure decisions.
Recall from your Financial Management I course that when there is no preferred
stock in a firm’s capital structure, the WACC is defined as follows:
WACC = wd (kd) (1 - T) + wc (ks)
= (D/A) (kd) (1 - T) + (E/A) (ks).
In this expression, D/A and E/A represent the debt and equity ratios, and they sum to 1.0.
Note that in Table 5-3 an increase in the debt/assets ratio raises the costs of both
debt and equity. [The cost of debt, kd, is taken from Table 5-1, but multiplied by (1 - T) to
put it on an after-tax basis.] Bondholders recognize that if a firm has a higher debt ratio,
this increases the risk of financial distress, and more risk leads to higher interest rates.
Table 5-3: Belay’s Stock Price and Cost of Capital Estimates with Different
Debt/Assets Ratios
A–T Expected Estimated Estimated Resulting
D/A D/E kd EPS Beta ks=[kRF + (km - kRF)b] Price P/E Ratio WACC
(1) (2) (3) (4) (5) (6) (7) (8) (9)
0% 0.00% 4.8% Br. 2.40 1.50 12.0% Br. 20.00 8.33X 12.00%
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10 11.11 4.8 2.56 1.60 12.4 20.65 8.06 11.64
20 25.00 5.0 2.75 1.73 12.9 21.33 7.75 11.32
30 42.86 5.4 2.97 1.89 13.5 21.90 7.38 11.10
40 66.67 6.0 3.20 2.10 14.4 22.22 6.94 11.04
50 100.00 7.2 3.36 2.40 15.6 21.54 6.41 11.40
60 150.00 9.0 3.30 2.85 17.4 18.97 5.75 12.36
5.3.2 The Hamada Equation

An increase in the debt ratio also increases the risk faced by shareholders, and this
has an effect on the cost of equity, ks. This relationship is harder to quantify, but it can be
done. To begin, recall that a stock’s beta is the relevant measure of risk for diversified
investors. Moreover, it has been demonstrated, both theoretically and empirically, that
beta increases with financial leverage. Robert Hamada developed the following equation
to specify the effect of financial leverage on beta:
b = bU [1 + (1 - T) (D/E)]
The Hamada equation shows how increases in the debt/equity ratio increase beta.
Here bU is the firm’s unlevered beta coefficient, that is, the beta it would have if it has no
debt. In that case, beta would depend entirely upon business risk and thus be a measure of
the firm’s “basic business risk.” D/E is the measure of financial leverage used in the
Hamada equation.
Note that beta is the only variable under management’s control in the cost of
equity equation, ks = kRF + (kM - kRF) bi. Both kRF and kM are determined by market forces
that are beyond the firm’s control. However, b i is determined (1) by the firm’s operating
decisions as discussed earlier in the unit, which affects bU, and (2) by its capital structure
decisions as reflected in its D/A (or D/E) ratio.
As a starting point, a firm can take its current beta, tax rate, and debt/equity ratio
and calculate its unlevered beta, bU, by simply transforming the previous equation as
follows:
bU = b/[1 - (1 - T)(D/E)]
Then, once bU is determined, the Hamada equation can be used to estimate how
changes in the debt/equity ratio would affect the leveraged beta, b i, and thus the cost of
equity, ks.
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We can illustrate the procedure with Belay Electronics. First, we assume that the
risk-free rate of return, kRF, is 6%, and that the required return on an average stock, k M, is
10%. Next, we need the unlevered beta, b U. Because Belay has no debt, its D/E = 0.
Therefore, its current beta of 1.5 is also its unlevered beta; hence b U = 1.5. Now, with bU,
kRF, and kM specified, we can use the CAPM to estimate how much Belay’s market beta
would rise if it began to use financial leverage, hence what its cost of equity would be at
different capital structures. These beta estimates are shown in Column 5 of Table 5-3.
Currently, based on Plan B and no debt, Belay has a beta of b = 1.5. Further, the
risk-free rate is kRF = 6% and the market risk premium is kM - kRF = 10% - 6% = 4%.
Therefore, Belay’s current cost of equity is 12% as shown in Column 6:
ks = kRF + Risk premium
= 6% + (4%)(1.5)
= 6% + 6%
= 12%.
The first 6% is the risk-free rate; the second is the risk premium. Because Belay
currently uses no debt, it has no financial risk. Therefore, the 6% risk premium reflects
only its business risk.
If Belay changes its capital structure by adding debt, this would increase the risk
stockholders bear. That, in turn, would result in an additional risk premium.
Conceptually, this situation would exist:
ks = kRF + Premium for business risk + Premium for financial risk.
Figure 5-7 (using data calculated in Column 6 of Table 5-3) graphs Belay’s
required return on equity at different debt ratios. As the figure shows, k s consists of the
6% risk-free rate, a constant 6% premium for business risk, and a premium for financial
risk that starts at zero but rises at an increasing rate as the debt ratio increases.
Figure 5-7: Belay’s Required Rate of Return on Equity at Different Debt Levels
Required Rate on Equity
(%)
ks
Premium for
Financial Risk
12
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Premium for
Business Risk
kRF = 6 kRF
Risk-Free Rate:
Time Value Plus
Expected Inflation
0 10 20 30 40 50 60
Debt/Equity (%)
5.3.3 The Optimal Capital Structure

Column 9 of Table 5-3 shows Belay’s weighted average cost of capital, WACC,
at different capital structures. Currently, it has no debt, so its capital structure is 100%
equity, and at this point WACC = k s = 12%. As Belay begins to use lower-cost debt, the
WACC declines. However, as the debt ratio increases, the costs of both debt and equity
rise, at first slowly but then at a faster and faster rate. Eventually, the increasing costs of
the two components offset the fact that more low-cost debt is being used. At 40% debt,
the WACC hits a minimum of 11.04%, and after that it rises with further increases in the
debt ratio.
Dear Student! Note too that even though the component cost of equity is generally
higher than that of debt, using only lower-cost debt would not maximize value because of
the feedback effects of debt on the costs of debt and equity. If Belay Electronics were to
issue more than 40% debt, it would then be relying more on the cheaper source of capital,
but this lower cost would be more than offset by the fact that using more debt would raise
the costs of both debt and equity.
On a market-value basis, our debt-to-capital ratio was 47%. By employing this
capital structure, we believe that our weighted average cost of capital is nearly optimized
—at approximately 10%. Although reducing debt significantly would somewhat reduce
the marginal cost of debt, significant debt reduction would likely increase our weighted
average cost of capital by raising the proportion of higher-cost equity.
Finally, recall that the capital structure that minimizes the WACC is also the
capital structure that maximizes the firm’s stock price. In principle, we could use the
stock valuation techniques described in Financial Management I to predict how changes
in capital structure would affect the stock price. This exercise is difficult, especially for
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firms that do not pay a dividend or whose cash flows are not constant over time.
However, Belay Electronics pays out all of its earnings as dividends, so it reinvests none
of its earnings back into the business and its growth in earnings and dividends per share
are zero. Thus, in Belay’s case we can use the zero growth stock price model developed
in Financial Management I to estimate the stock price at each different capital structure.
These estimates are shown in Column 7 of Table 5-3. Here we see that the expected stock
price first rises with financial leverage, hits a peak of Br. 22.22 at a debt ratio of 40%,
and then begins to decline. Thus, Belay’s optimal capital structure occurs at a debt ratio
of 40%, and that debt ratio both maximizes its stock price and minimizes its WACC.
The EPS, cost of capital, and stock price data shown in Table 5-3 are plotted in
Figure 5-8. As the graph shows, the debt/assets ratio that maximizes Belay’s expected
EPS is 50%. However, the expected stock price is maximized, and the cost of capital is
minimized, at a 40% debt ratio. Thus, Belay’s optimal capital structure calls for 40%
debt and 60% equity. Management should set its target capital structure at these ratios,
and if the existing ratios are off target, it should move toward the target when new
security offerings are made.
Figure 5–8: Effects of Capital Structure on EPS, Cost of Capital, and Stock Price
Expected EPS
(Br.)
Maximum EPS = Br. 3.36
3.50
3.00
2.50
=
0 10 20 30 40 50 60 Debt/Assets (%)
Cost Capital
(%)
20 Cost of Equity ,ks
15
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WACC
10
Min. = 11.04% After-Tax Cost of Debt, kd ( 1- T )
5
0 10 20 30 40 50 60 Debt/Assets (%)
Stock Price
(Br.)
Maximum = Br. 22.22
23
22
21
20
19
=
0 10 20 30 40 50 60 Debt/Assets (%)

1. What happens to the costs of debt and equity when the debt/assets ratio increases?
Explain.
__________________________________________________________________
__________________________________________________________________
2. Using the Hamada equation, show the effect of financial leverage on beta.
__________________________________________________________________
__________________________________________________________________
3. Give the equation for calculating a firm’s unlevered beta.

__________________________________________________________________
4. Using a graph and illustrative data, identify the premiums for financial risk and
business risk at different debt levels. Do these premiums vary depending on the
debt level? Explain.
__________________________________________________________________
__________________________________________________________________
5. Is expected EPS maximized at the optimal capital structure?

__________________________________________________________________
__________________________________________________________________
5.4 Modern Capital Structure Theory
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 Dear Learner! In the previous section, we showed how a firm might estimate its
optimal capital structure. For a number of reasons, we would expect capital
structures to vary considerably across industries. Moreover, capital structures vary
among firms within a given industry. What factors can explain these differences?
In an attempt to answer this question, academics and practitioners developed a

number of theories, and the theories have been subjected to criticism. Modern capital
structure theory began in 1958, when Professors Franco Modigliani and Merton Miller
(hereafter MM) published what has been called the most influential finance article ever
written. MM proved, under a very restrictive set of assumptions, that a firm’s value is
unaffected by its capital structure. Put another way, MM’s results suggest that it does not
matter how a firm finances its operations, hence capital structure is irrelevant. However,
MM’s study was based on some unrealistic assumptions, including the following:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.
Despite the fact that some of these assumptions are obviously unrealistic, MM’s
irrelevance result is extremely important. By indicating the conditions under which
capital structure is irrelevant, MM also provided us with clues about what is required for
capital structure to be relevant and hence to affect a firm’s value. MM’s work marked the
beginning of modern capital structure research, and subsequent research has focused on
relaxing the MM assumptions in order to develop a more realistic theory of capital
structure.
5.4.1 The Effect of Taxes
MM published a follow-up paper in 1963 in which they relaxed the assumption
that there are no corporate taxes. Tax Laws allow separate-legal entities to deduct interest
payments as an expense, but dividend payments to stockholders are not deductible. This
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differential treatment encourages these entities to use debt in their capital structures.
Indeed, MM demonstrated that if all their other assumptions hold, this differential
treatment leads to a situation that calls for 100% debt financing.
However, this conclusion was modified several years later by Merton Miller. He
noted that all of the income from bonds is generally interest, which is taxed as personal
income at higher tax rates, while income from stocks generally comes partly from
dividends and partly from capital gains. Further, dividends and capital gains combined
are taxed at a lower rate, and even tax on capital gains is deferred until the stock is sold
and the gain is realized. So, on balance, returns on common stocks are taxed at lower
effective rates than returns on debt.
Because of the tax situation, Miller argued that investors are willing to accept
relatively low before-tax returns on stock relative to the before-tax returns on bonds. For
example, an investor might require a return of 10% on Belay Electronics’ bonds, and if
stock income were taxed at the same rate as bond income, the required rate of return on
Belay’s stock might be 16% because of the stock’s greater risk. However, in view of the
favorable treatment of income on the stock, investors might be willing to accept a before-
tax return of only 14% on the stock.
Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt
financing, but (2) the more favorable tax treatment of income from stocks lowers the
required rate of return on stock and thus favors the use of equity financing.
5.4.2 The Effect of Bankruptcy Costs
MM’s irrelevance results also depend on the assumption that there are no
bankruptcy costs. However, in practice bankruptcy can be quite costly. Firms in
bankruptcy have very high legal and accounting expenses, and they also have a hard time
retaining customers, suppliers, and employees. Moreover, bankruptcy often forces a firm
to liquidate or sell assets for less than they would be worth if the firm were to continue
operating.
Note, too, that the threat of bankruptcy, not just bankruptcy as such, brings about
these problems. Key employees jump ship, suppliers refuse to grant credit, customers
seek more stable suppliers, and lenders demand higher interest rates and impose more
restrictive loan agreements if potential bankruptcy becomes visible.
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Bankruptcy-related problems are more likely to arise when a firm includes more
debt in its capital structure. Therefore, bankruptcy costs discourage firms from pushing
their use of debt to excessive levels.
Bankruptcy-related costs have two components: (1) the probability of their
occurrence and (2) the costs they would produce given that financial distress has arisen
(Dear Learner! See on the next unit on financial distress and bankruptcy). Firms whose
earnings are more volatile face a greater chance of bankruptcy and, therefore, should use
less debt than more stable firms. This is consistent with our earlier point that firms with
high operating leverage, and thus greater business risk, should limit their use of financial
leverage. Likewise, firms that would face high costs in the event of financial distress
should rely less heavily on debt. For example, firms whose assets are illiquid and thus
would have to be sold at “fire sale” prices should limit their use of debt financing.
5.4.3 Trade-Off Theory

The preceding arguments led to the development of what is called “the tradeoff
theory of leverage,” in which firms tradeoff the benefits of debt financing (favorable
corporate tax treatment) against the higher interest rates and bankruptcy costs. A
summary of the trade-off theory is expressed graphically in Figure 5-9.
Figure 5-9 Effect of Leverage on the Value of Belay’s Stock

Value of Belay’s Stock MM Result
Incorporating the
Effects of Corporate
Value Added by Taxation:
Debt Tax Shelter Price of the Stock if
Benefits There
Were No Bankruptcy-
Value of the Related
Stock with No Costs
Debt = Br. 20
Value Reduced by
Bankruptcy-Related
Costs
100
Actual Price of Stock
0 D1 D2
Value of Stock if the
Firm Used No Financial
Leverage
Leverage, D/A
Threshold Debt Optimal Capital Structure:
Level Marginal Tax Shelter Benefits
Where Bankruptcy =
Costs Become Marginal Bankruptcy-Related
Material Costs
Here are some observations about the figure:

1. The fact that interest is a deductible expense makes debt less expensive than
common or preferred stock. In effect, the government pays part of the cost of debt capital,
or, to put it another way, debt provides tax shelter benefits. As a result, using debt causes
more of the firm’s operating income (EBIT) to flow through to investors. Therefore, the
more debt a company uses, the higher its value and stock price. Under the assumptions of
the Modigliani-Miller with-taxes, a firm’s stock price will be maximized if it uses
virtually 100% debt, and the line labeled “MM Result Incorporating the Effects of
Corporate Taxation” in Figure 5-9 expresses the relationship between stock prices and
debt under their assumptions.
2. In the real world, firms rarely use 100% debt. The primary reason is that firms
limit their use of debt to hold down bankruptcy-related costs.
3. There is some threshold level of debt, labeled D1 in the figure, below which the
probability of bankruptcy is so low as to be immaterial. Beyond D 1, however,
bankruptcy-related costs become increasingly important, and they reduce the tax benefits
of debt at an increasing rate. In the range from D 1 to D2, bankruptcy-related costs reduce
but do not completely offset the tax benefits of debt, so the firm’s stock price rises (but at
a decreasing rate) as its debt ratio increases. However, beyond D 2, bankruptcy related
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costs exceed the tax benefits, so from this point on increasing the debt ratio lowers the
value of the stock. Therefore, D2 is the optimal capital structure. Of course, D 1 and D2
vary from firm to firm, depending on their business risk and bankruptcy costs.
4. While theoretical and empirical work supports the general shape of the curves
in Figures 5-8 and 5-9, these graphs must be taken as approximations, not as precisely
defined functions. The numbers in Figure 5-8 are shown out to two decimal places, but
that is merely for illustrative purposes—the numbers are not nearly that accurate in view
of the fact that the data on which the graph is based are judgmental estimates.
5. Another disturbing aspect of capital structure theory as expressed in Figure 5-9
is the fact that many large, successful firms, use far less debt than the theory suggests.
In addition to the types of analysis discussed above, firms generally consider the
following factors when making capital structure decisions:
A. Sales stability. A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales.
B. Asset structure. Firms whose assets are suitable as security for loans tend to use debt
rather heavily. General-purpose assets that can be used by many businesses make
good collateral, whereas special-purpose assets do not. Thus, real estate companies
are usually highly leveraged, whereas companies involved in technological research
are not.
C. Operating leverage. Other things the same, a firm with less operating leverage is
better able to employ financial leverage because it will have less business risk.
D. Growth rate. Other things the same, faster-growing firms must rely more heavily on
external capital. Further, the flotation costs involved in selling common stock exceed
those incurred when selling debt, which encourages rapidly growing firms to rely
more heavily on debt. At the same time, however, these firms often face greater
uncertainty, which tends to reduce their willingness to use debt.
E. Profitability. One often observes that firms with very high rates of return on
investment use relatively little debt.
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F. Taxes. Interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Therefore, the higher a firm’s tax rate, the greater the advantage
of debt.
G. Control. The effect of debt versus stock on a management’s control position can
influence capital structure. If management currently has voting control (over 50% of
the stock) but is not in a position to buy any more stock, it may choose debt for new
financings. On the other hand, management may decide to use equity if the firm’s
financial situation is so weak that the use of debt might subject it to serious risk of
default, because if the firm goes into default, the managers will almost surely lose
their jobs. However, if too little debt is used, management runs the risk of a
takeover. Thus, control considerations could lead to the use of either debt or equity,
because the type of capital that best protects management will vary from situation to
situation. In any event, if management is at all insecure, it will consider the control
situation.
H. Management attitudes. Since no one can prove that one capital structure will lead to
higher stock prices than another, management can exercise its own judgment about
the proper capital structure. Some managers tend to be more conservative than
others, and thus use less debt than the average firm in their industry, whereas
aggressive managements use more debt in the pursuit for higher profits.
I. Lender attitudes. Regardless of managers’ own analyses of the proper leverage
factors for their firms, lenders’ attitudes frequently influence financial structure
decisions.
J. Market conditions. Conditions in the stock and bond markets undergo both long- and
short-run changes that can have an important bearing on a firm’s optimal capital
structure.
K. The firm’s internal condition. A firm’s own internal condition can also have a
bearing on its target capital structure. For example, suppose a firm has just
successfully completed an R&D program, and it forecasts higher earnings in the
immediate future. However, the new earnings are not yet anticipated by investors,
hence are not reflected in the stock price. This company would not want to issue
stock— it would prefer to finance with debt until the higher earnings materialize and
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are reflected in the stock price. Then it could sell an issue of common stock, retire
the debt, and return to its target capital structure.
1. Why does M&M’s theory with taxes lead to 100 % debt?
__________________________________________________________________
__________________________________________________________________
2. How would an increase in corporate taxes affect firms’ capital structure
decisions? What about personal taxes? How does sales stability affect the target
capital structure?
__________________________________________________________________
__________________________________________________________________
3. How do the types of assets used affect a firm’s capital structure?

_________________________________________________________________
_________________________________________________________________
__
4. How do taxes affect the target capital structure?
_________________________________________________________________
_________________________________________________________________
__
5. How do lender and rating agency attitudes affect capital structure?
_________________________________________________________________
_________________________________________________________________
__
6. How does the firm’s internal condition affect its actual capital structure?
__________________________________________________________________
__________________________________________________________________
5.5 Dividends and Dividend Policy

5.5.1 Dividends
 Dear Students! In the last section of this unit, our focus will be on distributions
to shareholders.
Corporate earnings distributed to stockholders are called dividends. Dividends are
paid in either cash or stock and are typically issued quarterly. They may be paid only out
of retained earnings and not from invested capital such as capital stock or the excess
received over stock par value. In general, the more stable a company’s earnings, the more
regular its issue of dividends.
A company’s dividend policy is important for the following reasons:
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1. It bears upon investor attitudes. For example, stockholders look unfavorably
upon the corporation when dividends are cut, since they associate the cutback
with corporate financial problems. Further, in setting a dividend policy,
management must ascertain and fulfill the objectives of its owners. Otherwise,
the stockholders may sell their shares, which in turn may bring down the market
price of the stock. Stockholder dissatisfaction raises the possibility that control of
the company may be seized by an outside group.
2. It impacts the financing program and capital budget of the firm.
3. It affects the firm’s cash flow position. A company with a poor liquidity
position may be forced to restrict its dividend payments.
4. It lowers stockholders’ equity, since dividends are paid from retained earnings,
and so results in a higher debt-to-equity ratio.
If a company’s cash flows and investment requirements are volatile, the company
should not establish a high regular dividend. It would be better to establish a low regular
dividend that can be met even in years of poor earnings.
Relevant dates associated with dividends are as follows:
1, Declaration date. This is the date on which the board of directors declares the
dividend. On this date, the payment of the dividend becomes a legal liability of the firm.
2. Date of record. This is the date upon which the stockholder is entitled to receive the
dividend.
3. Ex-dividend date. The ex-dividend date is the date when the right to the dividend
leaves the shares. The right to a dividend stays with the stock until 4 days before the date
of record. That is, on the fourth day prior to the record date, the right to the dividend is no
longer with the shares, and the seller, not the buyer of that stock, is the one who will
receive the dividend. The market price of the stock reflects the fact that it has gone ex-
dividend and will decrease by approximately the amount of the dividend. To illustrate,
consider that the date of record for the dividend declared by the Acheme Company is
October 20. Hailu sells Jemal his 100 shares of Acheme Company on October 18. Hailu,
not Jemal, will receive the dividend on the shares.
105
4. Date of payment. This is the date when the company distributes its dividend checks to
its stockholders.
Dividends are usually paid in cash. A cash dividend is typically expressed in birr
per share. However, the dividend on preferred stock is sometimes expressed as a
percentage of par value, consider the following two examples to understand better.
 Example: On November 15, 2009, a cash dividend of Br. 1.50 per share was
declared on 10,000 shares of Br. 10 par value common stock. The amount of
the dividend to be paid on the date of payment by the company is Br. 15,000
(10,000 X Br. 1.50).
 Example: Markos Corporation has 20,000 shares of Br. 10 par value, 12%
preferred stock outstanding. On October 15, 2009, a cash dividend was
declared to holders of record as of December 15, 2009. The amount of
dividend to be paid by Markos Corporation is equal to: 20,000 shares X Br. 10
par value = Br. 200,000 X 12% = Br. 24,000
Some companies allow stockholders to automatically reinvest their dividend in

corporate shares instead of receiving cash. The advantage to the stockholder is that he or
she avoids the brokerage fees associated with buying new shares. However, there is no
tax advantage since the stockholder must still pay ordinary income taxes on the dividend
received.
5.5.2 DIVIDEND POLICY

A finance manager’s objective for the company’s dividend policy is to maximize
owner wealth while providing adequate financing for the company. When a company’s
earnings increase, management does not automatically raise the dividend. Generally,
there is a time lag between increased earnings and the payment of a higher dividend.
Only when management is confident that the increased earnings would be sustained will
they increase the dividend. Once dividends are increased, they should continue to pay at
the higher rate.
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 Dear Learner! The various types of dividend policies are briefly explained here:
1. Stable dividend-per-share policy. Many companies use a stable dividend-per-share

policy since it is looked upon favorably by investors. Dividend stability implies a low-
risk company. Even in a year that the company shows a loss rather than profit the
dividend should be maintained to avoid negative connotations to current and prospective
investors. By continuing to pay the dividend, the shareholders are more pertinent to view
the loss as temporary. Some stockholders rely on the receipt of stable dividends for
income. A stable dividend policy is also necessary for a company to be placed on a list of
securities in which financial institutions (pension funds, insurance companies) invest.
Being on such a list provides greater marketability for corporate shares.
2. Constant dividend-payout-ratio (dividend per share/earnings per share) policy. With
this policy a constant percentage of earnings is paid out in dividends. Because net income
varies, dividends paid will also vary using this approach. The problem this policy causes
is that if a company’s earnings drop drastically or there is a loss, the dividends paid will
be sharply reduced or nonexistent. This policy will not maximize market price per share
since most stockholders do not want variability in their dividend receipts.
3. A compromise policy. A compromise between the policies of a stable birr amount and
a percentage amount of dividends is for a company to pay a low birr amount per share
plus a percentage increment in good years. While this policy affords flexibility, it also
creates uncertainty in the minds of investors as to the amount of dividends they are likely
to receive.
Stockholders generally do not like such uncertainty. However, the policy may be
appropriate when earnings vary considerably over the years. The percentage, or extra,
portion of the dividend should not be paid regularly; otherwise it becomes meaningless.
4. Residual-dividend policy. When a company’s investment opportunities are not stable,
management may want to consider a fluctuating dividend policy. With this kind of policy
the amount of earnings retained depends upon the availability of investment opportunities
in a particular year. Dividends paid represent the residual amount from earnings after the
company’s investment needs are fulfilled.
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Theoretical Position
Theoretically, a company should retain earnings rather than distribute them when
the corporate return exceeds the return investors can obtain on their money elsewhere.
Further, if the company obtains a return on its profits that exceeds the cost of capital, the
market price of its stock will be maximized.
Capital gains arising from the appreciation of the market price of stock have a tax
advantage over dividends. On the other hand, a company should not, theoretically, keep
funds for investment if it earns less of a return than what the investors can earn
elsewhere. If the owners have better investment opportunities outside the firm, the
company should pay a high dividend.
Although theoretical considerations from a financial point of view should be
considered when setting dividend policy, the practicality of the situation is that investors
expect to be paid dividends. Psychological factors come into play which may adversely
affect the market price of the stock of a company that does not pay dividends.
5.5.2.1 Factors That Influence Dividend Policy
 Dear Student! A firm’s dividend policy is a function of many factors, some of

which have been described above. Other factors that influence dividend policy are
as follows:
1. Company growth rate. A company that is rapidly growing, even if profitable, may
have to restrict its dividend payments in order to keep needed funds within the
company for growth opportunities.
2. Restrictive covenants. Sometimes there is a restriction in a credit agreement that
will limit the amount of cash dividends that may be paid.
3. Profitability. Dividend distribution is keyed to the profitability of the company.
4. Earnings stability. A company with stable earnings is more likely to distribute a
higher percentage of its earnings than one with unstable earnings.
5. Maintenance of control. Management that is reluctant to issue additional common
stock because it does not wish to weaken its control of the firm will retain a greater
percentage of its earnings. Internal financing enables control to be kept within.
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6. Degree of financial leverage. A company with a high debt-to-equity ratio is more
likely to retain earnings so that it will have the needed funds to meet interest
payments and debts at maturity.
7. Ability to finance externally. A company that is capable of entering the capital
markets easily can afford to have a higher dividend payout ratio. When there is a
limitation to external sources of funds, more earnings will be retained for planned
financial needs.
8. Uncertainty. Payment of dividends reduces the chance of uncertainty in
stockholders’ minds about the company’s financial health.
9. Age and size. The age and size of the company bear upon its ease of access to
capital markets.
10. Tax penalties. Possible tax penalties for excess accumulation of retained earnings
may result in high dividend payouts.
Controversy
The dividend policy controversy can best be described by presenting the
approaches put forth by various authors:
1. Gordon et al. believe that cash flows of a company having a low dividend payout will
be capitalized at a higher rate because investors will perceive capital gains resulting from
earnings retention to be more risky than dividends.
2. Miller and Modigliani argue that a change in dividends impacts the price of the stock
since investors will perceive such a change as being a statement about expected future
earnings. They believe that investors are generally indifferent to a choice between
dividends or capital gains.
3. Weston and Brigham et al. believe that the best dividend policy varies with the
particular characteristics of the firm and its owners, depending on such factors as the tax
bracket and income needs of stockholders, and corporate investment opportunities.
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5.5.2.2 Stock Dividends and Stock Split
5.5.2.2.1 Stock Dividends
A stock dividend is the issuance of additional shares of stock to stockholders. A

stock dividend may be declared when the cash position of the firm is inadequate and/or
when the firm wishes to prompt more trading of its stock by reducing its market price.
With a stock dividend, retained earnings decrease but common stock and paid-in capital
on common stock increase by the same total amount. A stock dividend, therefore,
provides no change in stockholders' wealth. Stock dividends increase the shares held, but
the proportion of the company each stockholder owns remains the same. In other words,
if a stockholder has a 2% interest in the company before a stock dividend, he or she will
continue to have a 2% interest after the stock dividend. For example assume Ato Jote
owns 200 shares of Newland Corporation. There are 10,000 shares outstanding; therefore,
Ato Jote holds a 2% interest in the company. The company issues a stock dividend of
10%. Ato Jote will then have 220 shares out of 11,000 shares issued. His proportionate
interest remains at 2% (220/11,000).
5.5.2.2.2 Stock Split
A stock split involves issuing a substantial amount of additional shares and

reducing the par value of the stock on a proportional basis. A stock split is often
prompted by a desire to reduce the market price per share, which will make it easier for
small investors to purchase shares. To illustrate, consider the example of Smart
Corporation. It has 1,000 shares of Br. 20 par value common stock outstanding. The total
par value is Br. 20,000. A 4-for-1 stock split is issued. After the split 4,000 shares at Br. 5
par value will be outstanding. The total par value thus remains at Br. 20,000.
Theoretically, the market price per share of the stock should also drop to one-fourth of
what it was before the split.
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 The differences between a stock dividend and a stock split are as follows:
1) With a stock dividend, retained earnings are reduced and there is a pro rata
distribution of shares to stockholders. A stock split increases the shares outstanding
but does not lower retained earnings.
2) The par value of stock remains the same with a stock dividend but is proportionally
reduced in a stock split.
 The similarities between a stock dividend and a stock split are:
1) Cash is not paid.
2) Shares outstanding increase.
3) Stockholders’ equity remains the same.
5.5.2.3 Stock Repurchases
Treasury stock is the term given to previously issued stock that has been
purchased by the firm itself. Buying treasury stock is an alternative to paying dividends.
Since outstanding shares will be fewer after stock has been repurchased, earnings per
share will rise (assuming net income is held constant). The increase in earnings per share
may result in a higher market price per share.
To illustrate, assume Tariku Company’s example. Tariku Co. earned Br. 2.5
million in 2008. Of this amount, it decided that 20percent would be used to purchase
treasury stock. At present there are 400,000 shares outstanding. Market price per share is
Br. 18. The company can use Br. 500,000 (20% X Br. 2.5 million) to buy back 25,000
shares through a tender offer of Br. 20 per share.
Current earnings per share is:
Net Income Br .2,500,000
EPS= = =Br .6 .25
Outstanding Shares 400,000
The current P/E multiple is:

Market Price per Share Br .18
= =2.88×¿
EPS Br .6 .25
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Earnings per share after treasury stock is acquired becomes:
Br .2,500,000
=Br .6 .67
375,000
The expected market price, assuming the P/E ratio remains the same, is:
P/E multiple X new earnings per share = expected market price
2.88 X Br. 6.67 = Br. 19.21
To stockholders, the advantages arising from a stock repurchase include the following:
a. If market price per share goes up as a result of the repurchase, stockholders can
take advantage of the capital gain deduction. This assumes the stock is held more
than one year and is sold at a gain.
b. Stockholders have the option of selling or not selling the stock, while if a dividend
is paid, stockholders must accept it and pay tax.
To the company, the advantages from a stock repurchase include the following:
a. If there is excess cash flow that is deemed temporary, management may prefer to
repurchase stock than to pay a higher dividend that they feel cannot be
maintained.
b. Treasury stock can be used for future acquisitions or used as a basis for stock
options.
c. If management is holding stock, they would favor a stock repurchase rather than
a dividend because of the favorable tax treatment.
d. Treasury stock can be resold in the market if additional funds are needed.
To stockholders, the disadvantages of treasury stock acquisitions include the following:
a. The market price of stock may benefit more from a dividend than a stock
repurchase.
b. Treasury stock may be bought at an excessively high price to the detriment of the
remaining stockholders. A higher price may occur when share activity is limited
or when a significant amount of shares are reacquired.
To management, the disadvantages of treasury stock acquisition include the following:
a. If investors feel that the company is engaging in a repurchase plan because its
management does not have alternative good investment opportunities, a drop in
the market price of stock may ensue.
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b. If the reacquisition of stock makes it appear that the company is manipulating the
price of its stock on the market, the company will have problems with the
government regulatory bodies. Further, if Tax Authorities conclude that the
repurchase is designed to avoid the payment of tax on dividends, tax penalties
may be imposed because of the improper accumulation of earnings as specified in
the tax laws.
 Check-Your Progress: Exercise 5-5

1. What is meant by dividends?
__________________________________________________________________
__________________________________________________________________
2. List and explain the relevant dates associated with dividends.
__________________________________________________________________
__________________________________________________________________
3. Explain the various types of dividend policies.
__________________________________________________________________
__________________________________________________________________
4. What are the factors affecting the dividend policy of a firm?
__________________________________________________________________
__________________________________________________________________
5. Contrast the controversy between Gordon and Miller and Modigliani on dividend
policy.
__________________________________________________________________
__________________________________________________________________

1. Guta Motors, a producer of generators, is in this condition: EBIT = Br. 4 million; tax
rate = T = 35%; debt outstanding = D = Br. 2 million; k d = 10%; ks = 15%; shares of
stock outstanding = N0 = 600,000; and book value per share = Br. 10. Since Guta’s
product market is stable and the company expects no growth, all earnings are paid out as
dividends. The debt consists of perpetual bonds.
Required:
a. What are Guta’s earnings per share (EPS) and its price per share (P0)?
b. What is Guta’s weighted average cost of capital (WACC)?
c. Guta Motors can increase its debt by Br. 8 million, to a total of Br. 10 million, using
the new debt to buy back and retire some of its shares at the current price. Its interest
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rate on debt will be 12% (it will have to call and refund the old debt), and its cost of
equity will rise from 15% to 17%. EBIT will remain constant. Should Guta Motors
change its capital structure?
d. If Guta Motors did not have to refund the Br. 2 million of old debt, how would this
affect things? Assume that the new and the still outstanding debt are equally risky,
with kd = 12%, but that the coupon rate on the old debt is 10%.
2. ABC Electronics produces tape recorder components that sell for P = Br. 100. ABC
Electronics’ fixed costs are Br. 200,000; 5,000 components are produced and sold each
year; EBIT is currently Br. 50,000; and ABC Electronics’ assets (all equity financed) are
Br. 500,000. ABC estimates that it can change its production process, adding Br. 400,000
to investment and Br. 50,000 to fixed operating costs. This change will (1) reduce
variable costs per unit by Br. 10 and (2) increase output by 2,000 units, but (3) the sales
price on all units will have to be lowered to Br. 95 to permit sales of the additional
output. ABC has tax loss carry-forwards that cause its tax rate to be zero. ABC uses no
debt, and its average cost of capital is 10%.
Required:
a. Should ABC make the change?
b. Would ABC’s breakeven point increase or decrease if it made the change?
3. The balance sheet of the Delta Corporation shows a capital structure as follows:
Current liabilities Br. 0
Bonds (6% interest) 100,000
Common stock 900,000
Total claims Br. 1,000,000
Its rate of return before interest and taxes on its assets of Br. 1million is 20%. The value
of each share (whether market or book value) is Br. 30. The firm is in the 50 percent tax
bracket.
Required: Calculate its earnings per share.
4. Lakew Corporation's net income for 2007 was Br. 300,000. It retained 40 percent. The
outstanding shares are 100,000. Determine the dividends per share.
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5. Shola Corporation has 10,000 shares of common stock outstanding. On March 5, the
company declared a cash dividend of Br. 5 per share payable to stockholders of record on
April 5. What is the amount of the dividend?
6. Black Company’s capital structure on December 30, 19x1, was:
Common stock (Br. 1 par, 100,000 shares) Br. 100,000
Paid-in capital on common stock 20,000
Retained earnings 680.000
Total stockholders’ equity Br. 800,000
The company’s net income for 19x1 was Br. 150,000. It paid out 40 percent of earnings
in dividends. The stock was selling at Br. 6 per share on December 30.
Assuming the company declared a 5% stock dividend on December 31, what would be
the reformulated capital structure on December 31?
1. a. EBIT Br. 4,000,000

Interest (Br. 2,000,000 X 0.10) 200,000
Earnings before taxes (EBT) Br. 3,800,000

Taxes (35%) 1,330,000
Net income Br. 2,470,000
EPS = Br. 2,470,000/600,000 = Br. 4.12.
P0 = Br. 4.12/0.15 = Br. 27.47.
b. Equity = 600,000 = Br. 10 = Br. 6,000,000.

Debt = Br. 2,000,000.
Total capital = Br. 8,000,000.
WACC = wdkd(1 - T) + wcks
= (2/8)(10%)(1 - 0.35) + (6/8)(15%)
= 1.63% + 11.25%
= 12.88%.
c. EBIT Br. 4,000,000

Interest (Br. 10,000,000 X 0.12) 1,200,000
Earnings before taxes (EBT) Br. 2,800,000
Taxes (35%) 980,000
Net income Br. 1,820,000
Shares bought and retired:
ΔN = Δ Debt/P0 = Br. 8,000,000/ Br. 27.47 = 291,227.
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New outstanding shares:
N1 = N0 - ΔN = 600,000 - 291,227 = 308,773.
New EPS:
EPS = Br. 1,820,000/308,773 = Br. 5.89.
New price per share:
P0 = Br. 5.89/0.17 = Br. 34.65 versus Br. 27.47.
Therefore, Guta Motors should change its capital structure.
d. In this case, the company’s net income would be higher by (0.12 - 0.10) (Br.
2,000,000) (1 - 0.35) = Br. 26,000 because its interest charges would be lower. The new
price would be:
( Br .1,820,000+ Br .26,000)/308,773
P 0= =Br .35 .18
0.17
In the first case, in which debt had to be refunded, the bondholders were compensated for
the increased risk of the higher debt position. In the second case, the old bondholders
were not compensated; their 10 percent coupon perpetual bonds would now be worth
Br. 100/0.12 = Br. 833.33,
or Br. 1,666,667 in total, down from the old Br. 2 million, or a loss of Br. 333,333. The
stockholders would have a gain of
(Br. 35.18 – Br. 34.65)(308,773) = Br. 163,650.
This gain would, of course, be at the expense of the old bondholders. (There is no reason
to think that bondholders’ losses would exactly offset stockholders’ gains.)
2. a. (1) Determine the variable cost per unit at present, using the following definitions
and equations:
Q = units of output (sales) = 5,000.

P = average sales price per unit of output = Br. 100.
F = fixed operating costs = Br. 200,000.
V = variable costs per unit.
EBIT = P(Q) - F - V(Q)
Br. 50,000 = Br. 100(5,000) - Br. 200,000 – V (5,000)
5,000V = Br. 250,000
V = Br. 50.
(2) Determine the new EBIT level if the change is made:
New EBIT = P2 (Q2) - F2 - V2 (Q2)
= Br. 95(7,000) - Br. 250,000 - Br. 40(7,000)
= Br. 135,000.
(3) Determine the incremental EBIT:
Δ EBIT = Br. 135,000 - Br. 50,000 = Br. 85,000.
(4) Estimate the approximate rate of return on the new investment:
∆ EBIT Br .85,000
∆ ROE= = =21.25 %
Investment Br . 400,000
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Since the ROA exceeds ABC’s average cost of capital, this analysis suggests
that ABC should go ahead and make the investment.
b. The change would increase the breakeven point. Still, with a lower sales price, it
might be easier to achieve the higher new breakeven volume.
F Br .200,000
Old :Q BE= = =4,000 units
P−V Br .100−Br .50
F Br .250,000
New :Q BE= = =4,545 units
P2−V 2 Br .95−Br .45
3. EBIT (20% X Br. 1,000,000) Br. 200,000

Less: Interest (6% X Br. 100,000) 6,000
Earnings before tax (EBIT) Br. 194,000

Less: Income tax (50%) 97,000
Earnings after tax (EAT) Br. 97,000
Number of common shares outstanding is:

Br. 900,000 = 30,000 shares
Br. 30
EPS = Br. 97,000 = Br. 3.23
30,000 shares
4. Dividends = Br. 300,000 X 60% = Br. 180,000 = Br. 1.80/share

Shares 100,000 shares 100,000 shares
5. Dividends Payment = Outstanding Shares X Dividends per Share declared

10,000 X Br. 5 = Br. 50,000
6. The stock dividend is 5,000 shares (5% X 100,000 shares). Retained earnings is
reduced by the fair market value of the stock dividend of Br. 30,000 (Br. 6 X 5,000
shares), paid-in capital on common stock is increased by Br. 25,000 (Br. 5 X 5,000
shares), and common stock is increased at the par value of the shares issued of Br.
5,000 (Br. 1X 5,000 shares).
The reformulated capital structure on December 31 is:

Common stock (Br. l00, 000 + Br. 5,000) Br. 105,000
Paid-in capital on common stock (Br. 20,000 + Br. 25,000) 45,000
Retained earnings (Br. 680,000 - Br. 30,000) 650,000
Br. 800,000
Dear Learner! Notice that after the stock dividend, total stockholders’ equity remains the
same.
117
UNIT SIX
LEASE AND LEASE FINANCING
Contents
 Unit Objectives
6.1 Lease
6.1.1 The Lease Contract
6.1.2 Basic Types of Leases
6.1.3 Advantages and Disadvantages of Leasing
6.2 Lease Financing
6.2.1 Leasing as a Form of Debt
6.2.2 The Lease-Vs-Purchase Decision
6.2.3 Effects of Lease on Future Financing
Unit Objectives
Upon completion of this unit, you are required to be able to:
 Define the concept of leasing
 Describe how leasing be beneficial to a business firm
 Differentiate among the various types lease agreements
 Define and explain leasing as one form of debt
 Use various method of lease financing
6.1 Lease
Lease can be defined as a right to use property (usually equipment or capital
goods) on payment of periodical amount. This may broadly be equated to an installment
credit being extended to the person using the asset by the owner of capital goods with
small variation.
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6.1.1 The Lease Contract
There are two principal parties to any lease transaction as under:
Lessor is the actual owner of the property being leased permitting use to the other
party on payments of periodical amount.
Lessee is the party that acquires the right to use the property on payment of
periodical amount.
6.1.2 Basic Types of Leases
A lease transaction has many variants relating to the type and nature of leased
asset, amortization period, residual value of equipment, period of leasing, option for
termination of lease, etc. Various types of leasing transactions are, therefore, conducted
in the market on the basis of these variants. The different leasing options may however,
be grouped in two broad categories as:
(a) Operating Lease: In this type of lease transaction, the primary lease period is
short and the lessor would not be able to realize the full cost of the equipment and other
incidental charges thereon during the initial lease period. Besides the cost of machinery,
the lessor also bears insurance, maintenance and repair costs. The lessee acquires the
right to use the asset for a short duration. Agreements of operating lease generally
provide for an option to the lessee/lessor to terminate the lease after due notice. These
agreements may generally be preferred by the lessee in the following circumstances:
 When the long-term suitability of the asset is uncertain.
 When the asset is subject to rapid obsolescence.
 When the asset is required for immediate use to tide over a temporary
problem.
Computers and other office equipments are the very common assets which form
subject matter of many operating lease agreements.
(b) Financial Lease: As against the temporary nature of an operating lease
agreement, financial lease agreement is a long-term arrangement, which is irrevocable
during the primary lease period which is generally the full economic life of the leased
asset. Under this arrangement lessor is assured to realize the cost of purchasing the leased
asset, cost of financing it and other administrative expenses as well as its profit by way of
lease rent during the initial (primary) period of leasing itself. Financial lease involves
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transferring almost all the risks incidental to ownership and benefits arising thereof
except the legal title to the lessee against its irrevocable undertaking to make
unconditional payments to the lessor as per agreed schedule. This is a closed end
arrangement with no option to lessee to terminate the lease agreement subsequently. In
such lease, the lessee has to bear insurance, maintenance and other related costs. The
choice of asset and its supplier is generally left to the lessee in such transactions. The
variants under financial lease are as under:
 Lease with purchase option-where the lessee has the right to purchase
the leased assets after the expiry of initial lease period at an agreed price.
 Lease with lessee having residual benefits-where the lessee has the right
to share the sale proceeds of the asset after expiry of initial lease period and/or to renew
the lease agreement at a lower rental.
In a few cases of financial lease, the lessor may not be a single individual but a
group of equity participants, and the group borrows a large amount from financial
institutions to purchase the leased asset. Such transaction is called ‘Leveraged lease’.
 Check Your Progress 6-1
1. Define the concept of leasing?
________________________________________________________________________
________________________________________________________________________
2. How leasing is beneficial to Business organizations?
________________________________________________________________________
________________________________________________________________________
3. Differentiate between operating lease and financial lease.
________________________________________________________________________
________________________________________________________________________
6.1.3 Advantages and Disadvantages of Leasing

6.1.3.1 Advantages
 The first and foremost advantage of a lease agreement is its flexibility. The
leasing company in most of the cases would be prepared to modify the
arrangement to suit the specific requirements of the lessee. The ownership of the
leased property gives them added confidence to enable them to be more
accommodative than the banks and other financial institutions.
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 The leasing company may finance 100% cost of the property without insisting for
any initial disbursement by the lessee, whereas 100% finance is generally never
allowed by banks/financial institutions.
 Banks/financial institutions may involve lengthy appraisal and impose stringent
terms and conditions to the sanctioned loan. The process is time consuming. In
contrast leasing companies may arrange for immediate purchase of equipment on
mutually agreeable terms.
 Lengthy and time consuming documentation procedure is involved for term loans
by banks/financial institutions while lease agreement is very simple with this
regard.
 In short-term lease (operating lease) the lessee is safeguarded against the risk of
obsolescence. It is also an ideal method to acquire use of an asset required for a
temporary period.
 The use of leased assets does not affect the borrowing capacity of the lessee as
lease payment may not require normal lines of credit and are payable from
income during the operating period. This neither affects the debt equity ratio or
the current ratio of the lessee.
 Leased equipment is an ‘off the balance sheet’ asset being economically used by
the lessee and does not affect the debt position of lessee.
 By employing ‘sale and lease back’ arrangement, the lessee may overcome a
financial crisis by immediately arranging cash resources for some emergent
application or for working capital.
 Piecemeal financing of small equipments is conveniently possible through lease
arrangement only as debt financing for such items is impracticable.
 Tax benefits may also sometimes accrue to the lessee depending upon his tax
status.
6.1.3.2 Disadvantages
 The lease rentals become payable soon after the acquisition of assets and no
moratorium (suspension) period is permissible as in case of term loans from
financial institutions. The lease arrangement may, therefore, not be suitable for
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setting up of new projects as it would entail cash outflows even before the project
comes into operation.
 The leased assets are purchased by the lessor who is the owner of equipment. The
seller’s warranties for satisfactory operation of the leased assets may sometimes
not be available to lessee.
 Lessor generally obtain credit facilities from banks etc. to purchase the leased
equipment which are subject to hypothecation charge in favour of the bank.
Default in payment by the lessor may sometimes result in seizure of assets by
banks causing loss to the lessee.
 Lease financing has a very high cost of interest as compared to interest charged
on term loans by financial institutions.
What are the advantages and disadvantage of lease financing?
___________________________________________________________________________
___________________________________________________________________________
6.2 Lease Financing

6.2.1 Leasing As a Form of Debt
Lease financing is a substitute for debt. This is because a company must make its
lease payments to continue use the leased asset. Otherwise, the lessor can reclaim the
asset (which it legally owns) and sue the lessee for the missed payment.
The consequences of failing to make a lease payment are the same as the
consequences of failing to pay interest or repay principal on the outstanding debt. The
lessor becomes a creditor who can force the lessee into bankruptcy. Consequently, for
purposes of financial analysis, a company’s lease payment obligations belong in the same
risk as the company’s interest and principal repayment obligations.
6.2.2 The Lease-Versus-Purchase Decision
The lease-versus-purchase (or lease-versus-buy) decision is one that commonly
confronts firms that are contemplating the acquisition of new fixed assets. The
alternatives available are (1) lease the assets, (2) borrow funds to purchase the assets, or
(3) purchase the assets using available liquid resources. Alternatives 2 and 3, although
122
they differ, are analyzed in similar fashion. Even if the firm has the liquid resources with
which to purchase the assets, the use of these funds is viewed as equivalent to borrowing.
Therefore, here we need to compute only the leasing and purchasing alternatives.
The lease-versus-purchase decision involves application of the capital budgeting
methods discussed in the first part of financial management. First, we determine the
relevant cash flows and then apply present value techniques. Although for clarity, the
approach demonstrated here analyzes and compares the present values of the cash flows
for the lease and the purchase, a more direct approach would calculate the net present
value (NPV) of the incremental cash flows. The following steps are involved in the
analysis:
Step 1 Find the after-tax cash outflows for each year under the lease alternative. This
step generally involves a fairly simple tax adjustment of the annual lease payments. In
addition, the cost of exercising a purchase option in the final year of the lease term must
frequently be included.
Step 2 Find the after-tax cash outflows for each year under the purchase alternative. This
step involves adjusting the sum of the scheduled loan payment and maintenance cost
outlay for the tax shields resulting from the tax deductions attributable to maintenance,
depreciation, and interest.
Step 3 Calculate the present value of the cash outflows associated with the lease (from
step 1) and purchase (from step 2) alternatives using the after-tax cost of debt as the
discount rate. Although some controversy surrounds the appropriate discount rate, the
after-tax cost of debt is used to evaluate the lease-versus-purchase decision because the
decision itself involves the choice between two financing alternatives having very low
risk. If we were evaluating whether a given machine should be acquired, the appropriate
risk-adjusted rate or cost of capital would be used, but in this type of analysis, we are
attempting only to determine the better financing technique-leasing or borrowing.
Step 4 Choose the alternative with the lower present value of cash outflows from step 3.
This will be the least-cost financing alternative.
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 Dear Learner! The application of each of these steps is demonstrated in the
following example.
Yamrot Company, a small machine shop, is contemplating acquiring a new

machine tool costing Br. 24,000. Arrangements can be made to lease or purchase the
machine. The firm is in the 40% tax bracket. Lease: The firm would obtain a five-year
lease requiring annual end-of-year lease payments of Br 6,000. All maintenance costs
would be paid by the lessor, and insurance and other costs would be borne by the lessee.
The lessee would exercise its option to purchase the machine for Br. 4,000 at termination
of the lease. Purchase: The firm would finance the purchase of the machine with a 9%,
5-year loan requiring end-of-year installment payments of Br. 6,170. The machine would
be depreciated under Modified Accelerated Cost Recovery System (MACRS) using a 5-
year recovery period. The firm would pay Br. 1,500 per year for a service contract that
covers all maintenance costs; insurance and other costs would be borne by the firm. The
firm plans to keep the machine and use it beyond its 5-year recovery period.
Using these data, we can apply the steps presented above earlier.
Step 1 The after-tax cash outflow from the lease payments can be found by multiplying
the before-tax payment of Br. 6,000 by 1 minus the tax rate, T, of 40%.
After-tax cash outflow from lease = Br. 6,000 × (1 - T) = Br. 6,000 × (1 – 0.4)= Br. 3,600
Therefore, the least alternative results in annual cash outflow over the 5-year lease of Br.
4,000 cost of the purchase option would be added to the Br. 3,600 lease outflow to get a
total cash outflow in year 5 of Br. 7,600 ( Br. 3,600 + Br. 4,000).
Step 2 The after-tax cash outflow from the purchase alternative is a bit more difficult to
find. First, the interest component of each annual loan payment must be determined,
because tax authorities allow the deduction of interest only-not principal-from income for
tax purposes. Table 6-1 presents the calculations required to split the loan payments into
their interest and principal components. Column 3 and 4 show the annual interest and
principal paid in each of the 5 years.
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Table 6-1: Determining the Interest and Principal Components of Yamrot Company
Loan Payments
Payments
Loan Beg-of-Year Interest Principal End-of-Year Principal
Payments Principal [0.09 × (2)] [(1) – (3)] [(2) - (4)]
End of Year (1) (2) (3) (4) (5)
1 Br. 6,170 Br. 24,000 Br. 2,160 Br. 4,010 Br. 19,990
2 6,170 19,990 1,799 4,371 15,619
3 6,170 15,619 1,406 4,764 10,855
4 6,170 10,855 977 5,193 5,662
5 6,170 5,662 510 5,660 -
The annual loan payment is shown in column 1, and the annual maintenance cost,
which is tax-deductible expense, is shown in column 2 of the Table 6-2. Next, we find the
annual depreciation write-off resulting from the Br. 24,000 machine. Using the applicable
MACRS 5-year recovery period depreciation percentage-20% in year 1, 32% in year 2,
19% in year 3, and 12% in year 4 and 5-given under column 3 of Table 6-2.
Table 6-2: After-Tax Cash Outflows Associated with Purchasing for Yamrot Company
End Loan Maintenance Depreciation Interest Total Tax Shields After-tax

of Payments Costs Deductions [(0.4)X(5)] Cash
Year (1) (2) (3) (4) [(2)+(3)+(4)] Outflows
(5) [(1)+(2)-(6)]
(6) (7)
1 Br. 6,170 Br. 1,500 Br. 4,800 Br. 2,160 Br. 8,460 Br. 3384 Br. 4,286
2 6,170 1,500 7,680 1,799 10,979 4392 3,278
3 6,170 1,500 4,560 1,406 7,466 2986 4,684
4 6,170 1,500 2,880 977 5,357 2143 5,527
5 6,170 1,500 2,880 510 4,890 1956 5,714
Table 6-2 presents the calculations required to determine the cash outflows
associated with borrowing to purchase the new machine. Column 7 of the table presents
the after-tax cash outflow associated with the purchase alternative.
Step 3 the present values of the cash outflows associated with the lease (from step 1) and
purchase (from step 2) alternatives are calculated in Table 6-3 using the firm’s 6% after-
tax cost of debt.
Table 6-3: A Comparison of the Cash Outflows Associated with Leasing Vs. Purchasing for Yamrot
Company
Leasing Purchasing
After-tax Present Present Value of After-tax Present Value Present Value of
Cash Value Outflows Cash Factors Outflows
Outflows Factors [(1) × (2)] Outflows [(4) × (5)]
End of Year (1) (2) (3) (4) (5) (6)
1 Br. 3,600 0.943 Br. 3,395 Br. 4,286 0.943 Br. 4,042
2 3,600 0.890 3,204 3,278 0.890 2,917
3 3,600 0.840 3,024 4,684 0.840 3,935
4 3,600 0.792 2,851 5,527 0.792 4,377
5 7,600 0.747 5,677 5,714 0.747 4,268
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 Dear Student! Applying the appropriate present value interest factors given in
columns 2 and 5 to the after-tax cash outflows in column 1 and 4 results in the
present values of lease and purchase cash outflows given in column 3 and 6,
respectively. The sum of the present values of the cash outflows for the leasing
alternative is given in column 3 of Table 6-3, and the sum for the purchasing
alternative is given in column 6 of the table.
Step 4 Because the present value of cash outflows for leasing (Br. 18,151) is lower than
that for purchasing (Br. 19,539), the leasing alternative is preferred. Leasing results in an
incremental savings of Br. 1,388 (Br. 19,539 – Br. 18,151 ) and is therefore the less
costly alternative.
6.2.3 Effects of Lease on Future Financing
Because leasing is considered a type of financing, it affects the firm’s future

financing. Lease payments are shown as a tax-deductible expense on the firm’s income
statement. Anyone analyzing the firm’s income statement would probably recognize that
an asset is being leased, although the actual details of the amount and term of the lease
would be unclear. The following discussion attempts to show the effects of lease
financing on the financial ratios of the firm.
A financial analyst must view lease as a long-term financial commitment of the
lessee because the consequences of missing a financial lease payment are the same as
those of missing an interest or principal payment on debt. With the inclusion of each
financial (capital) lease as an asset and corresponding liability (i.e., long-term debt)
provides for a balance sheet that more accurately reflects the firm’s financial status. It
thereby permits various types of financial ratio analyses to be performed directly on the
statement by any interested party.
Illustrative Example:
In order to better understand the effects of lease financing on the balance sheet
and the financial ratios then computed, let’s consider the case of Belay AB PLC. The
company has reported the following balance sheet:
126
Current Br. Current Liabilities Br. 50,000,000
Assets 50,000,000
Fixed Assets 150,000,000 Long-term Liabilities 50,000,000
Total Liabilities 100,000,000
Stockholders’ Equity 100,000,000
Total Assets Br. Total Liabilities & Br.
200,000,000 Stockholders’ Equity 200,000,000
The company’s treasurer has, then, computed the debt-to-equity ratio as:
Total Debt Br . 100,000,000

Debt-to-Assets Ratio = Total Assets = Br.200 ,000,000 =
50%
However, Belay AB PLC has a capital lease obligation of Br. 12 million a year
for the next 15 years, which is reported off the balance sheet in the footnote to the
financial statements. The lease obligation has a Br 100 million present value. Based on
our discussion above, this lease obligation should be treated as a debt and must be
included in the balance sheet. Thus, the new balance sheet looks like:
Current Assets Br. 50,000,000 Current Liabilities Br.
50,000,000
Fixed Assets 150,000,000 Long-term Liabilities 50,000,000
Leased Property under 100,000,000 Obligations under Capital 100,000,000
Capital Lease* Lease*
Total Liabilities 200,000,000
Stockholders’ Equity 100,000,000
Total Assets Br. Total Liabilities & Br.
300,000,000 Stockholders’ Equity 300,000,000
We see that both a new asset and a new liability have been created, as indicated
by the asterisks. The essence of this treatment is that a long-term, non-cancelable lease is
tantamount to purchasing the asset with borrowed funds, and this should be reflected on
the balance sheet. Note that between the original balance sheet and the revised one, the
debt-to-equity assets ratio has gone from 50% to 66.7%, as computed below.
Total Debt Br . 200,000,000

Debt-to-Assets Ratio = Total Assets = Br . 300 , 000 , 000 =
66.7%
127
What does it mean by leveraged leasing?
__________________________________________________________________
__________________________________________________________________

1. Bard Corporation leases a Br. 75,000 machine. It is required to make 15 equal annual
payments at year-end. The interest rate on the lease is 16 percent. What is the periodic
payment?
2. Assume the same information as in the previous question, except that now the annual
payments are to be made at the beginning of the year. What is the periodic payment?
3. Tint Corporation leased Br. 150,000 of equipment and is to make equal year-end
annual payments of Br. 22,000 for 15 years. What is the interest rate on the lease?
4. Property is to be leased for 15years at an annual rental payment of Br. 40,000 payable
at the beginning of each year. The capitalization rate is 10 percent. What is the
capitalized value of the lease?

1. Periodic Payment = Br. 75,000 ÷ 5.575 = Br. 13,452.91
2. Periodic Payment = Br. 75,000 ÷ (1 + 5.468) = Br. 75,000 ÷ 6.468 = Br. 11,595.55
3. Interest Rate on Lease

Br. 150,000 = 6.818
Br. 22,000
Going to the present value of annuity table in Appendix and looking across 15
years to a factor closest to 6.818, we find 6.811 at a 12 percent interest rate.
4.
Capitalized Value of Lease= Annual lease payment = Br. 40,000 = Br. 4,780.86
Present value factor 1+ 7.3667
128
UNIT SEVEN
BUSINESS FAILURE AND BANKRUPTCY
Contents
 Objectives
 Introduction
7.1. Business Failure Fundamentals
7.1.1. Types of Business Failure
7.1.2. Major Causes of Business Failure
7.1.3. Voluntary Settlements
7.2. Bankruptcy
7.2.1. Bankruptcy Legislation
7.2.2. Reorganization in Bankruptcy
7.2.3. Liquidation in Bankruptcy
Unit Objective
This unit aims at discussing about meaning, types and major causes of business
failure. It also discusses about reorganization and liquidation in bankruptcy. After
studying this unit, you will be able to:
 Understand the types and major causes of business failure and the use of
voluntary settlements to sustain or liquidate the failed firm.
 Explain the bankruptcy legislation and the procedures involved in reorganizing or
liquidating a bankrupt firm.
Introduction
It is a common phenomenon in a business world to be encountered with business
failure and bankruptcy. In this unit, the various types of business failure will be
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discussed, just like technical insolvency and liquidity crisis. On top of that, the unit will
hold a discussion about major causes of business failure like mismanagement, poor
financial action, economic downturns, etc. On the other hand, in this unit, major issues
related to bankruptcy will be discussed i.e. reorganization and liquidation in bankruptcy.
7.1. Business Failure Fundamentals
 Dear Student! Do you know the reasons why businesses fail? What do you
expect about the major causes to their failure? What is going to be the final
resolutions for their failure?
A business failure is an unfortunate circumstance. Usually business firms grow,

mature, and fail, but we do not know when they fail (after first year or two of life). The
business failure can be viewed in many ways and can result from one or more causes.
7.1.1. Types of Business Failure
In a normal course of business, a firm may fail because its returns are negative or
low. A firm that steadily reports operating losses is very likely experience a decline in
market value. If the firm is unable to earn a return that exceeds its cost of capital, it can
be considered as it is failed. Eventually, negative or low returns unless timely remedied,
are likely to result in among one of the following more serious types of failure.
Technical Insolvency: Which is a second type of failure occurs when a firm is unable to
pay its liabilities as they come due. A firm can be technically insolvent even if its total
assets exceed total liabilities because of liquidity crisis. If some of its assets can be
converted into cash within a reasonable period, the company may be able to escape
complete failure. Otherwise, the repercussion is the third and most serious type of failure
i.e., bankruptcy. Bankruptcy occurs when a firm’s liabilities are greater than the fair
market value of its assets. A bankrupt firm has a negative stockholders’ equity. This
means that the claims of creditors cannot be satisfied unless the firm’s assets can be
liquidated for more than their book value.
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7.1.2. Major Causes of Business Failure
Primarily, the cause of business failure is mismanagement, commonly which
accounts of more than half of all cases. Numerous specific managerial faults can cause
the firm to fail.
Nonetheless, thousands of small business ventures do fail every year in America.
“companies stumble for many reasons,” observed Clayton Christensen in across the
board, “among them bureaucracy, arrogance, tired executive bloods, poor planning, short
– term investment horizons, inadequate skills and resources, and just plain bad luck.”
These factors – as well as myriad others – can have a debilitating impact on an operation,
as many small business surveys will attest. Among chief reasons for business failure
include poor planning, poorly conceived expansion, cash flow difficulties, inability to
rein in flawed business strategies, deterioration in customer base, inattention to warning
signs, economic downturns, ineffective sales force and high production costs.
Poor Planning: Ultimately, many business fail because of fundamental shortcomings in

their business planning. Planning begins with finding the right business and is integral to
every aspect of business operations, including selecting site, deciding on financing,
anticipating work force needs, budgeting, and managing company growth. Planning that
is ground in realistic expectations and accurate, current information is an invaluable asset.
Conversely, planning that is based on hopes and hearsay can cripple or destroy ever a
good business idea in fairly short order.
Poorly Conceived Expansion: “Every business owner wants to grow his or her
business, but expanding with no infrastructure in place makes a business ripe for failure,”
wrote Tonia Shakespeare in Black Enterprise. “You can incur tremendous losses when
you expand outside your core market. Not only is the physical aspect of expansion costly
but there are different buying habits in different geographical locations. If your venture
in to an area outside your home, you had better prepare by doing a lot of research.”
Cash Flow Difficulties: Poor cash flow kills thousands of small businesses every year.
“Most business owners don’t realize how much money it takes to run a business,” wrote
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Tania Shakespeare. “Understand what it takes to get a revolving line of credit before you
start your business. It’s always easier to get money when you don’t need it, so don’t wait
until you are desperate. Develop your business plan using conservative projections and
don’t be overly optimistic.” Shakespeare warned that profitable, fast – growing
businesses can also run into cash crunches that can ultimately lead to bankruptcy. “That
is why or going cash – flow analysis – tracking the money coming in and going out of the
business – is a must.”
Inability to Rein in Flawed Business Strategies: Some business owners simply refuse to
admit when they are wrong. Many small businesses can recover from ill – conceived
business initiatives if they are recognized and halted before too much damage is done.
But all too often, business owners and managers stubbornly sick with strategies that are
doomed to failure, rationalizing that the initiative will begin paying off next month or
next quarter. And before they know it their business is gone, dragged down by poor
planning and inordinate pride. Writing in Management Today, Robert Heller
characterized this tendency thrusly: “Top management sets its sights on some grand but
imperfectly conceived objective, launches an incompetent plan of action, pours in cash
rather than control when the action misfires, and ignores all the adverse evidence until the
disaster strikes.”
Deterioration in Customer Base: This can happened for any number of reasons,
including poor service, high prices, and new competitors. Making, improvements in
products, services offered, marketing inventory, customer service, and work force
personnel can all do a great deal to halt deterioration in customer a relations.
Inattention to Warning Signs: Most small business failures do not come out of the blue.
Certainly, business failures that result from catastrophic natural disasters or the sudden
death of a key business member cannot be anticipated, but most businesses expire as a
result of more mundane (ordinary) factors. New customer complaints and surges in
returns are often early warning signs of operational problems. Basic financial tools in
helping business owners diagnose what is aliling their company.
132
The numbers contained in these documents often provide ample warning of poor cash –
flow management, inventory problems, excessive debt, undercapitalization, or
untrustworthy customers, but the business owner has to take the time to look or the
warning signs may so unheeded until it is too late.
Economic activity – especially economic downturns can contribute to the failure of a

firm. If the economy goes into recession, sales may decrease abruptly, leaving the firm
with fixed costs and insufficient revenues to cover them.
A final cause of business failure is corporate maturity. Firms, like individuals, do

not have infinite lives. Like a product, a firm goes through the stages of birth, growth,
maturity, and eventual decline. The firm’s management should attempt to prolong the
growth stage through research the development of new products, and mergers.
7.1.3. Voluntary Settlements

When a firm becomes technically insolvent or bankrupt, a voluntary Settlement
may be arranged with its creditors which enable it to bypass many of the costs involved
in legal bankruptcy proceedings. Voluntary settlement with the creditors permits the
company to save many of the costs that would be present in bankruptcy. Such a
settlement is done out of court.
The settlement is normally initiated by the debtor firm, because such an
arrangement may enable it to continue to exist or to be liquidated in a manner that gives
the owners greater chance of covering part of their investment. With the aid of key
creditor, the debtor arranges a meeting between itself and all its creditors. During the
meeting session a committee of creditors is selected to investigate and analyze the
debtor’s condition and recommend a plan of action.
The committee may decide to the entire firm to continue to operate if it is
anticipated that the firm will recover. Creditors may also continue to do business with
the firm. In sustaining the company’s existence there may be an extension, a
composition, creditor control or integration of the above.
133
Voluntary Settlement to Sustain the Firm
In normal circumstance, the rational for sustaining a firm is that it is reasonable to
believe that the firm’s recovery is feasible. By sustaining the firm, the creditor can
continue to receive business from it. To accomplish this, a firm may use a number of
strategies. An extension is an assignment in which creditors receive payment in full even
though not immediately. Current purchases are made with cash until all past debts have
been paid. The second arrangement, called composition, is a voluntary reduction of the
amount the debtor owes the creditor. The creditors obtain from the debtor a stated
percentage of the obligation in full settlement of the debt regardless of how low the
percent is. The agreement is designed to allow the debtor to continue to operate. A third
arrangement is creditor control. In this case, a committee of creditors may decide to take
control of the business if they are not happy with current management. They will operate
the business in order to satisfy their claims. Once paid, the creditors may recommend
that new management replace the old before further credit is given. Sometimes, a plan
involving some combination of extension, composition, and credit control will result.
Voluntary Settlement Resulting in Liquidation

After a thorough investigation by the creditor committee, recommendations have
been made, and talks among the creditors and the debtor have been made, the only
possible acceptable course of actions, may be liquidation of the firm.
Liquidation can be carried out into two ways – Privately or through the legal
procedures provided by bankruptcy law. If the debtor firm is willing to accept
liquidation, legal procedures may not be required. In general, the avoidance of litigation
enables the creditors to obtain quicker and higher settlements. However, all the creditors
must agree to a private liquidation for it to be feasible.
The objective of the voluntary liquidation procedure is to recover as much per
dollar (Birr) owed as possible. In a voluntary liquidation, common stockholders, who are
the firm’s true owners, cannot receive any funds until the claims of all other parties have
been satisfied. A common procedure is to have a meeting of the creditors at which they
make an assignment by passing the power to liquidate the firm’s assets to an adjustment
bureau, a trade association, or a third party, which is designated the assignee. The
134
assignee is sometimes referred to as the trustee, because it is entrusted with the title to the
company’s assets and the responsibility to liquidate them efficiently. After liquidation of
the firm’s assets trustee distributes the recovered funds to the creditors and owners (if any
funds are left for the owners).
 Check your Progress 7.1
1. What are the three types of business failure? What is the difference between
technical insolvency and bankruptcy? What are the major causes of business
failure?
__________________________________________________________________
__________________________________________________________________
7.2. Bankruptcy
 Dear student! What is bankruptcy mean? What are the chapters included in a
bankruptcy legislation? What are the similarities and differences between
reorganization and liquidation in bankruptcy? Discuss briefly.
Bankruptcy is a legal proceeding, guided by federal law, designed to address

situations wherein a debtor – either an individual or a business – has accumulated debts
so great that the individual or business is unable to pay them off or when liabilities
exceed the fair market value of assets. In either of these situations a firm may be
declared legally bankrupt. However, creditors generally attempt to avoid forcing a firm
into bankruptcy if it appears to have opportunities for future success. If is designed to
distribute those assets held by the debtor as equitable as possible among creditors.
Bankruptcy proceedings may be initiated either by the debtor – a voluntary process – or
by creditors – an involuntary process.
When a business becomes insolvent, it does not have enough cash to meet its
interest and principal payments. A decision must then be made whether to dissolve the
firm through liquidation or to permit it to reorganize and thus stay alive. These issues
are addressed in the Ethiopian Commercial Code of 1960.
135
7.2.2. Reorganization in Bankruptcy
If no voluntary settlement is agreed upon, the company may be put into
bankruptcy by its creditors. The bankruptcy proceeding may either reorganize or
liquidate the firm. There are two basic types of reorganization petitions – voluntary and
involuntary. Any firm that is not a municipal or financial institution can file a petition for
voluntary reorganization on its own behalf. Involuntary reorganization is initiated by an
outside party, usually a creditor.
An involuntary petition against a firm can be filed if one of the three conditions is met:
1) The firm has pas t- due debts of $5,000 or more.
2) Three or more creditors can prove that they have aggregate unpaid claims
of 5,000 against the firm. If the firm has fewer than 12 creditors, any
creditor that is owed more than $5,000 can file the petition.
3) The firm is insolvent, which means (a) that is not paying its debts as they
come due, (b) that within the immediately preceding 120 days a custodian
(a third party) was appointed or took possession of the debtor’s property,
or 9c) that the fair market value of the firm’s assets is less than the stated
value of its liabilities.
Procedures
The procedures for initiation and execution of corporate reorganization entail separate
five parts: filing, appointment, development and approval of a reorganization plan,
acceptance of the plan, and payment of expenses.
Filing: A reorganization petition under chapter 11 must be filed in a federal bankruptcy

court. In the case of an inventory petition, if it is challenged by the debtor, a hearing
must be held to determine whether the firm is insolvent. If it is, the court enters an
‘Order of Relief” that formally initiates the process.
Appointment: Upon the filing of a reorganization petition, the filing firm becomes the
debtor in possession (DIP) of the assets. If creditors object to the filing firm being the
debtor in possession, they can ask the judge to appoint trustee.
136
Reorganization Plan: after review its situation, a debtor in possession submits a plan of
reorganization to the court. The plan and a disclosure statement summarizing the plan
are filed. A hearing is held to determine whether the plan is fair, equitable, and feasible
and whether the disclosure statement contains adequate information. The court’s
approval or disapproval is based on its evaluation of the plan in light of these standards.
A plan is considered fair and equitable if it maintains the priorities of the contractual
claims of the creditors, preferred stockholders, and common stockholders. The court
must also find the reorganization plan feasible, meaning that is must be workable. The
reorganized corporation must have sufficient working capital; sufficient funds to cover
fixed charges, sufficient credit prospects, and sufficient ability to retire or refund debts as
proposed by the plan.
Acceptance of the Reorganization Plan: Once approved, the plan along with the
disclosure statement is given to the firm’s creditors and shareholders for their acceptance.
Under the bankruptcy reform act, creditors and owners are separated into groups with
similar types of claims. As far as the case of creditors groups is concerned approval by
holders of at least two – thirds of the dollar amount of claims as well as a numerical
majority of creditors groups is concerned approval by holders of at least two – thirds of
the dollar amount of claims as well as numerical majority of creditors in the group is
required. In the case of ownership groups (preferred and common stockholders), two –
thirds of the shares in each group must approve the reorganization plan for it to be
accepted. Once, if it is found to be accepted and confirmed by the court, the plan is put
into effect as soon as possible.
Payment of Expenses. After the reorganization plan has been approved or disappr9ved,
all parties to the proceedings whose services were beneficial or contributed to the
approval or disapproval of the plan file a statement of expenses. When the courts find
these claims acceptable, the debtor must pay these expenses within a reasonable period of
time.
137
Assume a petition for reorganization of Blue Nile Company was filed under chapter 11.
The trustee determined that the company’s liquidation value after subtracting expenses
was Br. 2.5 million. The trustee estimates that the recognized business will generate Br.
360,000 in annual earnings. The cost of capital rate is 12 percent. Assuming the
earnings would continue indefinitely, the value of Blue Nile Company as a going concern
is:
1
Br. 360,000  0.12 = Br. 3,000,000
Since the company’s value as a going concern (Br. 3.0 million) exceeds the value in
liquidation (Br. 2.5 million), reorganization is called for.
7.2.3. Liquidation in Bankruptcy

Liquidation occurs if the courts have determined that reorganization is not
feasible. Normally, a petition for reorganization must be filed by the managers or
creditors of the bankrupt firm. If no petition is filed, if a petition is field and denied, or if
the reorganization plan is denied, the firm must be liquidated. There are three important
aspects of liquidation in bankruptcy i.e. Procedures, the Priority of Claims, and the final
accounting.
Procedures: When a firm adjudged bankrupt, the judge may appoint a trustee to perform
the many routine duties required in administrating the bankruptcy. The trustee takes
charge of the property of the bankrupt firm and protects the interest of its creditors. Once
the firm has been adjourned bankrupt, a meeting of creditors must be held between 20
and 40 days thereafter.
At the meeting, the creditors are made known about the prospects for the
liquidation. The meeting is presided over by the bankruptcy court clerk. In the event of
liquidation, the trustee is given the responsibility to liquidate the firm, keep records,
examine creditors’ claims, distribute the money, provide information as required, and
produce final reports on the liquidation.
138
Priority of Claims: Liquidation of all the firm’s assets and distribution of the proceeds
to the holders of provable claims are the responsibilities of the trustee. To determine the
provability of claims, the courts have established certain procedures.
The priority of claims, which is specified in chapter 7 of the Bankruptcy Reform
Act, must be maintained by the trustee when distributing the funds from liquidation. It is
quite important that to recognize any secured creditors have specific assets pledged as
collateral and, in liquidation, receive proceeds from the sale of those assets. When the
proceeds from the sale of assets are not sufficient to meet their claim, the secured
creditors become unsecured, or general, creditors for the uncovered amount, because
specific collateral no more exists. Consequently, these and all other unsecured creditors
will divide up, on a pro rata basis, any funds remaining after all prior claims have been
satisfied.
Order of Priority of claims in liquidation of a failed firm
1. Secured creditors are entitling to the proceeds of the sale of the specific property
that was used to support their loans.
2. The trustee’s costs of administering and operating the bankrupt firm are next in
line.
3. Expenses incurred after bankruptcy was filed come next.
4. Wages due workers, up to a limit of Br. 2,000 per worker, follow.
5. Claims for unpaid contributions to employees benefit plans are next. This amount,
together with wages, cannot exceed Br. 2,000 per worker.
6. Unsecured claims for customer for deposits up to & 900 per customer are sixth in
line.
7. Federal, state, and local taxes due come next.
8. Unfunded pension plan liabilities are next.
9. General unsecured creditors are month on the list.
10. Preferred stockholders come next, up to the par value of their stock.
11. Common stockholders are finally paid, if anything is left, which is rare.
Final Accounting: After Completion of liquidating the bankrupt firm’s assets and
distribution of the proceeds accordingly makes a final accounting to bankruptcy court and
creditors. Once the court approves the final accounting, the liquidation is complete.
139
The balance sheet of sunrise corporation is shown below.
Assets
Current Assets:
Cash ……………………………… Br. 9,000
Marketable Securities ……………. 7,000
Receivables ………………………. 1,200,000
Inventory …………………………. 3,000,000
Prepaid expenses …………………. 5,500
Total Current Assets ……… Br. 4,221,500
Non curent assets
Land ……………………………….. 1,900,000
Fixed assets ……………………….. 2,400,000
Total non current assets …….. 4,300,000
Total assets …………………………………. Br. 8,521,500
LIABILITIES AND STOCK HOLDERS’ EQUITY
Current Liabilities
Accountings Payable ………………….. Br. 300,000
Bank loan payable …………………….. 1,000,000
Accrued Salaries ……………………… 350,000
Employee benefits payable …………… 85,000
Customer claims – unsecured ………….. 70,000
Taxes Payable …………………………. Br.400,000
Total Current liabilities …………. Br. 2,205,000
Noncurrent liabilities
First – mortgage payable ………………… Br. 1,500,000
Second – mortgage payable ……………… 1,100,000
Subordinated debentures …………………. 800,000
Total noncurrent liabilities ………. 3,400,000
Total liabilities …………………………………… Br. 5,605,000
Stockholders’ equity
140
Preferred stock …………………………………. 600,000
Common stock …………………………………. 690,000
Paid – in capital ……………………………….. 1,550,000
Retained earnings ……………………………… 76,500
Total stock holders’ equity …………….. Br. 2,916,500
Total liabilities and stockholders’ equity ……….. Br. 8,521,500
Additional Data are as Follows:

1. The mortgages relate to the firm’s total noncurrent assets.
2. The subordinated debentures are subordinated to the bank loan payable
3. The trustee has sold the current assets for Br. 2.2 million and the noncurrent assets
for Br. 2 million.
4. The administration expense related to bankruptcy proceeding was Br. 900,000.
Required: Determine the distribution of the proceeds.
Solutions:
Proceeds ………………………………………………………. Br. 4,200,000
First – mortgage – payable from
Br. 2,000,000 proceeds of non current
Assets ………………………………………………Br. 1,500,000
Second – mortgage – payable from
Br. 2,000,000 proceeds of non current
Assets …………………………………………….. 500,000 2,000,000
Balance after secured creditors
Next priority
Administration expenses ………………….Br. 900,000
Accrued salaries ………………………… 350,000
Employee benefits payable ……………… 85,000
Customer claims – unsecured …………… 70,000
Taxes Payable …………………………… 400,000 Br. 1,805,000
Proceeds available to general creditors Br. 195,000
The distribution of the Br. 195,000 creditors follows:
141
Pro Rata
Allocation for
General creditor Amount balance to be paid
Second – mortgage balance
(Br.1,100,000 – Br.500,000) Br. 600,000 Br. 43,333.33
Accounts payable……………… 300,000 21,666.66
Bank loan payable ……………. 1,000,000 130,000.00
Subordinated debentures………. 800,000 0
Total Br. 2,700,000 Br. 195,000.00
N.B: since the debentures are subordinated, the bank loan payable must be met in full
before any amount can go to the subordinated debentures. Thus, subordinated debenture
holders receive nothing.
The holders of preferred and common stock receive nothing, since the unsecured
creditors themselves have not been fully paid.
 Check your Progress – 7.2

1. Identify the two basic types of reorganization petitions. Explain their differences.
__________________________________________________________________
__________________________________________________________________
2. Under what condition liquidation of a bankrupt firm occurs?
__________________________________________________________________
__________________________________________________________________
3. What are the concerns of chapter 7 and 11 of the bankruptcy reform act of 1978?
Discuss briefly.
__________________________________________________________________
__________________________________________________________________
142
Part I: Short Answer Questions
1. Explain bankruptcy legislation and the procedures involved in reorganizing or
liquidating a bankrupt firm
2. What is voluntary settlement? What the strategies are involved in the settlement.
3. Identify the three aspect of liquidation in bankruptcy. Give brief explanation.
4. Describe the procedures involved in liquidating the bankrupt firm.

1. Assume that petition for reorganization of Zoma Corporation filed under chapter
11. It was determined by the trustee that the firm’s liquidation value, after
considering expenses, was Br. 6.3 Million. The trustee predicts that the
reorganized business will desire Br. 600,000 in annual profit. The cost of capital
rate is 10 percent. Assuming also profits will continue indefinitely. Is
reorganization or liquidation recommended?
2. Plant and equipment with a book value of Br 3.2 million was sold for Br. 3
million. The mortgage bonds on the plant and equipment are Br. 2.5 million.
How will the mortgage bondholders be treated in liquidation?
3. Plant and equipment having a book value of Br. 980,000 was sold for Br.
750,000. Mortgage bonds on the plant and equipment are Br. 700,000. How will
the mortgage bondholders be treated in liquidation?

Part – II: Work Out Questions
1. Since the value of the company as a going concern (Br. 6,000,000) is less than its
value in liquidation (Br. 6.3 million), the business should be liquidated.
2. The proceeds from the collateral sale are not enough to meet the secured claim. The
unsatisfied portion of Br. 500,000 of the claim becomes a general creditor claim.
3. The mortgage bondholders will be fully satisfied in liquidation. The surplus of Br.
50,000 will be returned to the trustee to pay other creditors.
143
UNIT EIGHT
MULTINATIONAL FINANCE
Contents
 Unit Objectives
 Introduction
8.1 Features and Types of Multinational Companies
8.2 The Foreign Exchange Market
8.2.1 Stop and Forward Foreign Exchange Rate
8.2.2 Currency Risk Management
8.2.3 Forecasting Exchange Rates
8.5 International Sources of Financing
Unit Objectives
After studying this unit, you will be able to:
 Understand the features and types of multinational companies.
 Describe the foreign exchange market.
 Understand and explain the nature of sport and forward exchange rates.
 Describe how currency risk can be managed.
 Clarify how exchange rates are forecasted.
 Identify the sources of fiancé for multinational firms.
Introduction
Dear students, so far we have been taught about the concepts and issues involving in
financial management assuming that the corporate setting is operation in its home
country. However these days, such assumption is getting little support as many firms are
expanding beyond boards due to the dynamics in the global business activities. Hence,
our discussion focuses on the unique features and types of multinational companies,
foreign exchange market, foreign exchange rate, international sources of financing, etc.
144
Financial managers of multinational companies are encountered with a wide range of
issues that are not existing when a company operates in a home country. Besides, in this
unit, we also discuss the key point of departure between multinational and domestic
companies operations.
8.1. Features and types of Multinational Companies
 Dear student! What does a multinational company mean? What are the major
differences between multinational companies and domestic companies?
Explain briefly. Give your answers in writing before you go through the
following discussions.
Features of Multinational Companies (MNC)

Multinational companies have got certain typical features that can differentiate
them from domestic companies. These are multiple – currency problem, various legal,
institutional, and economic constraints.
Multiple – Currency Problem: Sales revenues may be collected in one currency, assets
denominated in another, and profits measured in a third.
Variations pertaining to tax laws, labor practices, balance – of – payment polices,
and government controls with regard to the types and sizes of investments, types and
amount of capital raised, and repatriation of profits.
International control problem: When the parent office of an MNc and its affiliates are
widely located, internal organization difficulties arise.
Types of Multinational Companies

In general, companies involved in multinational business may tend organize their
activities in the following forms: Wholly owned subsidiaries: a company which is large
and well –established with much international experience may eventually have wholly
owned subsidiaries.
145
Import /export activities: A small company having limited foreign experience
operating in “risky areas” may be restricted to export and import activity. Sufficient
amount exists, the company may establish a foreign branch when sales office. As the
company’s production matures, the production facilities may be located in the foreign
market. To do so, some foreign countries require licensing. In this case, a foreign
licensee sells and produces the product. The difficulty with this is that confidential
information and expertise are easily transferred to the licensees and who eventually
become a competitor in the event of the expiration of the agreement.
Joint Ventures: Another way to proceed globally is a joint venture with a foreign
company and share the risk. As strategy, some foreign governments require this to be the
way to follow to operate in the countries. The disadvantage is less control over activities
and a conflict of interest.
 Check Your Progress – 8.1
1. What is Multinational Corporation?
__________________________________________________________________
__________________________________________________________________
2. Identify the features and types of multinational companies.
__________________________________________________________________
__________________________________________________________________
8.2. The Foreign Exchange Market
 Dear students! What do you understand by foreign exchange market? What is

exchange rate? Explain very briefly in writing before you go to read the following
paragraphs.
The foreign exchange market is undoubtedly the world’s largest financial market.
It is the market where country’s currency is traded for another’s.
146
With the exception of a few European centers, there is no central marketplace for
the foreign exchange market. Instead, business is carried over telephone or telex.
Typically, banks are major dealers.
8.2.1. Spot and Forward Foreign Exchange Rate

An exchange rate is simply the price of one country’s currency expressed in
another country’s currency. Practically, almost all trading of currencies worldwide takes
place in terms of the U.S. dollar.
Exchange rates may be in terms of dollars per foreign currency unit (called a
direct quote) or units of foreign currency per dollar (called an indirect quote).
Therefore, an indirect quote is the reciprocal of a direct quote and vice versa.
An indirect quote – 1/direct quote
f/$ = 1($/)
The exchange rates are known as spot rates, which means the rate paid for
delivery of the currency “on the spot”, or in reality, no more than two days after the day
of the trade. In a common practice, it is also possible to buy (sell) currencies for delivery
at some agreed – upon future date, usually 30, 90 or 180 days from the day the
transaction is negotiated. This rate is known as the forward exchange rate.
If one can obtain more of the foreign currency for a dollar in the forward than in
the spot market, the forward currency is less valuable than the spot currency, and the
forward currency is said to be selling at a discount. Conversely, if one can obtain less of
the foreign currency for a dollar in the forward than in the spot market, the forward
currency is more valuable than the spot currency, and the forward currency is said to be
selling at a premium.
Cross Rates: A cross rate is the indirect calculation of the exchange rate of one currency
from the exchange rates of two other currencies.
147
Table 8.1. Foreign Exchange Rates (June 5, 2009)
Country Contract Us Dollar Currency per
Equivalent U.S. $
Britain spot 1.6170 0.6184
(pound) 30 – day future 1.6153 0.6191
90 – day future 1.6130 0.6200
180 – day future 1.6089 0.6215
Germany Spot 0.7282 1.3733
(mark) 30 – day future 0.7290 1.3716
90 – day future 0.7311 1.3677
180 – day future 0.7342 1.3620
Japan spot 0.011955 83.65
(yen) 30 – day future 0.012003 83.31
90 – day future 0.012100 82.64
180 – day future 0.012247 81.65

Based on the information given in Table 8.1. Above, you could determine the yen per
pound (or pound per yen) exchange rates. For example:
($/pround)  (yen/$) = (yen/)
 83.65 = 135.26 yen/f
 83.65 = 135.26 yen/f
Hence, the pound per yen exchange rate will be:
1/135.26 = 0.00739 pound per yen

Assume that on January 1, Addis, inc. received an order from a Japanese customer for
3,500,000 yen to be paid upon receipt of the goods, scheduled for April 1. The rates for $
1 U.S are given below:
148
Exchange Rates for $ 1 for year
Spot rate, January 1……………………….. 83
Forward rate, April 1……………………… 82
Spot rate march 1………………………….. 81
Required: i) Calculate what Addis would receive from Japanese customer in U.S. dollars
using the spot rate ate the time of the order.
ii) Calculate what Addis would receive from Japanese customer in U.S dollars using the
spot rate at the time of payment.
Solution
i) $42,168.67 ($3,500 yen /83 yen per $)
ii) $ 43,209.88 ($ 3,500,000 yen /81)
8.2.2. Currency Risk Management
It is likely that a change in is some exchange rate will benefit some subsidiaries
and hurt others. The net effect on the overall firm depends on its net exposure. The
MNCs financial management is concerned with the dilemma of three different types of
foreign exchange risk they are:
Translation exposure, often called accounting exposure, measures the impact of
exchange rate changes on the firm’s financial statement. An example would be the
impact of French franc devaluation on the U.S $ firm’s reported income statement and
balance sheet.
Translation exposure measures potential gains or loss on the future settlement of

outstanding obligations that are denominated in foreign currency. An example would be
US Dollar loss often the French devalues, on payments received for an expert invoiced in
French before that devaluation.
Operating exposure often called economic exposure; it is the potential for the
change in the present value of future cash flows due to an unexpected change in the
exchange rate.
149
Illustrative Example – 8.3
Buyer king trading company imports French cheeses for distribution in the US on June 1,
the company purchase costing 200,000 francs. Payment is due in francs on August 1.
The spot rate on June 1 was $ 0.20 per franc, and on august 1, it was $ 0.25 per franc.
The exchange loss will be:
Liability in dollars, August 1…………….. Br.40,000(200,000  $0.20)
Pay in Dollars, August 1…………………. 50,000(200,000  $0.25)
Exchange loss……………………. Br. 5,000
8.2.3. Forecasting Foreign Exchange Rates
Whenever a firm is involved in an international market forecasting foreign exchange rate
is formable task. Most MNCs rely primarily on bank and bank services for assistance
and information in preparing exchange rate projections. Following are economic
indicators that need to be considered the most important for the forecasting process:
 Recent rate movements
 Relative inflation rates
 Balance of payments and trade
 Money supply growth
 Interest rate differentials
Interest rates
Interest rates have an important influence on exchange rates. In fact, there is an
important economic relationship is known as the interest rate parity theorem (IRPT). The
IRPT states that the ratio of the forward and spot rates is directly related to two interest
rates specifically, the premium or discount should be:
rf −r d
P(or D) = 1+r f
Where rf and rd = foreign and domestic interest rates (where interest rates are relatively
low, this equation can be approximated by: P (or D) = - (r f = rd).The IRPT implies that the
P9or D) calculated by the equation should be the same as the p(or D) calculated by the
equation should be the same as the P9or D) calculated by:
F−S 12 months
× ×100
P (or D) = S n
150
Example: On April 3, 1995, a 30 – day forward contract in Japanese yen was selling at a
4.82 percent premium.
0. 012003−0 .011955 12 months
× ×100=4 . 82%
0 . 011955 1month
The 30 – day 0.5 T – bill rate is 8% annualized. What is the 30 – day Japanese rate?
r f −r d
Using the equation: P (or D) = 1+r f
0. 08−r f
0.0482 = 1+r f
- 0.0318 = -1.0482 rf
rf = 0.0303 = 3.03%
The 30 – day Japanese rate should be 3.03%
 Check your progress – 8.2
1. Are change rates changes necessarily good or bad for a particular company?
__________________________________________________________________
__________________________________________________________________
2. Define spot and forward rates.
__________________________________________________________________
__________________________________________________________________
8.3. International Sources of Financing

A global company may fiancé its activities abroad, especially in countries in
which it is operating. A company which is successful in domestic markets in more likely
to be able to attract financing for international expansion.
The most important international sources of funds are the Eurocurrency market
and the Eurobond market. Also, MNCs often have access to national capital markets in
which their subsidiaries are located.
Euromarkets offers non domestic financing opportunities for both the short – term
(Eurocurrency) and the long – term (Eurobonds). Eurobond is an international bond that
is sold primarily in countries other than the country of the currency in which the issue is
denominated. In the case of short- term financing, the forces of supply and demand are
among the main factors determining exchange rates in Eurocurrency markets.
151
The Eurocurrency market is largely short – term (usually less than 1 year of
maturity) market of bank deposits and loans denominated in any currency except the
currency of the country where the market is located. For example, in London, the
Eurocurrency market is a market for bank deposits and loans denominated in dollars,
yens, francs, marks, and any other currency except British pounds.
The Eurobond market is a long – term market for bonds denominated in any
currency except the currency of the country where the market is located. Eurobonds may
be of different types such as straight convertible, and with wants.
Generally, the Euromarkets offer borrowers and investors in one country the
opportunity to deal with borrowers and investors from many other countries, buying and
selling bank deposits, bonds, and loans denominated in many currencies.

1. What is an exchange rate?
2. Explain the difference between direct and indirect quotations.
3. What is a cross rate
4. Differentiate been spot and forward exchange rates.
5. Briefly explain interest rate parity, illustrating with as example.
1. Suppose the spot exchange rate for the Canadian dollar is can $1.32 and the six –
month forward rate is can $ 1.34.
Required:
a) Which is worth more, a U.S. dollar or a Canadian dollar?
b) Assuming absolute PPP holds, what is the cost in the omitted states of a product if the
price in Canada is can $ 2.19?
c) Is the U.S. dollar selling at a premium or a discount relative to the Canadian dollar?
d) Which currency is expected to appreciate in value?
2. Assume on December 1, BM Trading received an order from a British customer for
$2,000,000 to be paid on receipt of the goods, scheduled for March 1. The rates for $
1U.s. are as follows:
152
Exchange Rates for $ 1 for British f
Spot rate, December 1 1.617
Forward rate, March 1 1.615
Spot rate, August 1.616
Required: i) how much does BM expect to receive from British customer in dollars using
the spot rate at the time of the order?
ii) How much does BM expect to receive from the British customer in dollars using the
spot rate at the time of payment?
3. Paris, inc. imports French cheeses for distribution in the U.S. On April 1, the
company purchased cheese costing 300,000 Frances. Payment is due in francs on the
spot rate on April was $0.20 per franc, and on July 1, it was July 1. $ 0.25 per franc.
Required:
a) How much would Paris have to pay in dollars for the purchase if it paid on
April 1?
b) How much would Paris have to pay in dollars for the purchase if it paid on July 1?
c) If Paris paid for the purchase using the July 1 spot rate, what would be the exchange
gain or loss?
1. a) The U.S. dollar, since (can $1) / ( can $ 1.32/$1) = $0.7576
b) The U.S. dollar is selling at a premium, because it is more expensive in
the forward market than in the spot market (can $ 1.34 versus can $ 1.32).
c) The Canadian dollar is expected to depreciate in value relative to the
dollar, because it takes more Canadian dollars to buy one U.S. dollar in
the future than it does today.
2. i) $ 1,236,658.30 ($2,000,000/1.617).
ii) $ 1,237,623.70 ($2,000,000/1.616).
3. a) 300,000 francs  $ 0.20 per frame = $60,000
b) 300,000 frames  $0.25 per frame = $ 75,000
c) Liability in dollars, April 1 $ 60,000
Paid in dollars, July 1 ………………… 75,000
Exchange loss ………………… $ 15,000
153

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What are the three common alternative financing strategies discussed?

What are the three common alternative financing strategies discussed?

What are the broad categories of working capital?

What are the broad categories of working capital?

UNIT ONE

MANAGEMENT OF WORKING CAPITAL:

The Tradeoff between Profitability and Risk

 Check-Your Progress: Exercise- 1.1.

Aggressive Financing Strategy

In the above graph (Figure1–2) shows a conservative financing strategy which

 Dear students! In our subsequent discussions we have seen two financing

Permanent Current Assets Long–Term Debt Plus

 Check-Your Progress: Exercise 1.2

EBIT: Earnings Before Interest and Taxes

Model Examination Questions

Part – I: Short Answer Questions

Required: Determine the firms ROE under each financing strategy.

Answers to Model Examination Questions

2.1 Motives for Holding Cash and Near-Cash Balances

2×conversioncos t×demand for cash

Illustrative Exercise – 2.1

2×Br .25×br .900 ,000

3×conversion cost×var ianceof daily cash flows

Marketable Securities Converted to Cash = Return Point – Zero Balance

3×Br .25×Br .30 ,000

Graphically, it can be depicted as follows:

Purchase Raw Sell Finished Collect

Pay Account Payable

Cash Cash Conversion Cycle (CCC) 110 days Cash

2.3.2 The Cash Conversion Cycle

Illustrative Exercise -2.4

Accelerating the Collection of Accounts Receivable

Stretching Accounts Payable

Illustrative Exercise 2.6

 Check-Your Progress: Exercise 2.2

 Dear students! In an earlier section we have been taught about efficient

Mail Float Processing Clearing Float (4 Days)

Total Float (11 Days)

2.4.2. Speeding Up Collections

2.4.3 Slowing Down Disbursements

 Playing the Float

2.5. Marketable Securities

Answers to Model Examination Questions

Illustrative Exercise -3.2

Changing Credit Terms

 Check-Your Progress: Exercise 3.2

3.3. Collection Policy

Bad debt attributable to credit policy

The collection policy can be seen as a trade–off between collection costs,

Illustrative Exercise – 3.3

The evaluation of collection programs exhibits that the opportunity saving

 Check-Your Progress: Exercise 3.3

3.4. Inventory Management

Inventory, or goods on hand, is a necessary current asset that allows the

3.5. Techniques for Managing Inventory

 Dear students! List few inventory management techniques you are

3.5.1. The ABC System

0 100 200 300 400 EOQ (units)

EOQ for a given inventory item can be determined by developing a formula. By