Gaf 520

WELCOME TO
GAF 520
ADVANCED CORPORATE
FINANCE
BY SAKALA.E
OBJECTIVES
To provide an understanding of the financial investment process.
To provide an insight into the organization and operations of our financial markets.
To provide an understanding of how investment decisions are made.
To broaden the understanding of issues in corporate finance.
CONTENT
INTRODUCTION
Investment definition; relationship between risk and return; investment versus
speculation and gambling; types of investment – real investment, financial investment;
stages in the investment management process.
FINANCIAL MARKETS
Types of securities markets including money, capital, primary and secondary markets;
the over the counter market; the third and fourth markets; issuing and trading in
securities in the financial markets; principal players in the financial markets and their
role.
EFFICIENT MARKET HYPOTHESIS (EMH)
Meaning of efficiency; the efficient market hypothesis and forms of efficiency; tests and
results of efficient markets; efficiency of LuSE.
SECURITY ANALYSIS
Purpose of security analysis; Fundamental analysis; security market indicator series;
technical analysis; implications of EMH; analysis of fixed income securities.
PORTFOLIO THEORY
Measuring risk and return on individual assets and on portfolios;Markowitz
portfolio theory and formation; CAPM; introduction to arbitrage price theory;
portfolio theory versus efficient capital markets.
PORTFOLIO MANAGEMENT AND EVALUATION
Active versus passive management; strategic versus tactical asset allocation;
monitoring and revision of the portfolio; portfolio performance measures; stock
market price indices – types, calculation and interpretation.
CAPITAL STRUCTURE AND THE COST OF CAPITAL

Review of material covered in previous studies on financial leverage/gearing
and on the firm’s cost of capital; capital structure theories covering the
traditional theory and the M&M propositions; effect of gearing on equity betas;
criticisms of the M&M theory; choosing a capital structure.
CAPITAL INVESTMENT DECISION
Review of material covered in previous studies PBP, DPBP, NPV, IRR, ARR
and PI; capital rationing; capital budgeting issues under uncertainty;
investment decisions using CAPM; the lease or buy decision; bond
refunding as a capital budgeting decision.
DIVIDEND POLICY
Review of material covered in previous studies ; the M&M propositions and
the irrelevant hypothesis; the relevant and clientele hypotheses; expected
dividend as the basis for stock values; stock dividends and stock splits;
stock repurchases as an alternative to dividends.
VALUATION OF COMPANIES
Rationale; valuation methods – present value basis; share price basis; net
assets basis; capitalising earnings basis; P/E ratio; super profits and dual
capitalization methods; dividend yield basis; debt position of company to
be purchased.
WARRANTS AND CONVERTIBLES
Nature of warrants and convertibles; analysis of convertible securities;
decisions on the use of warrants and convertibles; reporting earnings if
warrants or convertibles are outstanding; other types of options.
Suggested Reading:
1) Financial Management: Text and Problems by M Y Khan & P K Jain,
Publisher: TMH, New Delhi.
2) Financial Management Theory & Practice by Prasanna Chandra,
Publisher: TMH, New Delhi.
3) Financial Management by I M Pandey, Publisher: Vikas Publishing
House, New Delhi.
4) Fundamentals of Financial Management by Van Horne, Publisher:
Prentice Hall of India.
5) Advanced Accounting by Gupta R.L. and Radha Swamy M.,
Publisher: Sultan Chand & Sons, New Delhi.
6) Financial Management by Kishore R., Publisher: Taxman’s Publishing
House, New Delhi
Finance is defined as the provision of money at the time when
it is required. Every enterprise,whether big, medium, small,
needs finance to carry on its operations and to achieve its
target. Infact, finance is so indispensable today that it is
rightly said to be the blood of an enterprise.Without adequate
finance, no enterprise can possibly accomplish its objectives.
Financial management refers to that part of the management

activity, which is concerned with the planning, & controlling of
firm’s financial resources. It deals with finding out various
sources for raising funds for the firm. It is practiced by many
corporate firms and can be called Corporation finance or
Business Finance
According to Guthmann and Dougall:
“Business finance can be broadly defined as the activity

concerned with the planning, raising controlling and
administrating the funds used in the business.”
According to Joseph & Massie:
Financial Management is the operational activity of
a business that is responsible for obtaining and effectively utili
zing the funds necessary for efficient operations
Financial management
Concerned
with
Financing decision Investment Decision Dividend Decision
Analysis
Risk and Return Relationship
To achieve the goal of
Profit Maximization Wealth Maximization

Functions of Financial Management
A financial manager has to concentrate on the following areas of the finance

function.
1.Estimating Financial Requirements:

The first task of the financial manager is to estimate short term and long-term
financial requirement of his business. For this purpose, he will prepare a financial
plan for the present as well as for the future. The amount required
for purchasing fixed assets as well as the needs of funds for working capital has to b
e ascertained. The estimation should be based on the sound financial principles so
that neither there are inadequate or excess funds with the concern. The inadequacy
will affect the working of the concern and excess funds may tempt a management to
indulge in extravagant spending
2.Deciding Capital Structure:
The capital structure refers to the kind and proportion of the
different securities for raising funds. After deciding about the
quantum of funds required it should be decided which type
of security should be raised. It may be wise to finance fixed
securities through long term debts. Long-term funds should
be employed to finance working capital also. Decision about
various sources of funds should be linked to cost of raising
funds. If cost of rising funds is high, then such sources may
not be useful. A decision about the kind of the securities to
be employed and the proportion in which these should be
used is an important decision which influences the short
term and the long term planning of the enterprise.
3.Selecting a Source of Finance:
After preparing a capital structure, an appropriate source of

finance is selected. Various sources from which finance may
be raised, includes share capital, debentures, financial
deposits etc. If finance is needed for short periods
then banks, public’s deposits, financial institutions may
be appropriate. If long-term finance is required the share
capital, debentures may be useful
4.Selecting a Pattern of Investment:
When fund have been procured then a decision about
investment pattern is to be taken. The selection of
investment pattern is related to the use of the funds. A
decision has to be taken as to which assets are to be
purchased? The fund will have to be spent first. Fixed asset
and the appropriate portion will be retained for the working
capital. The decision making techniques such as capital
Budgeting, opportunity cost analysis may be applied in
making decision about capital expenditures. While spending
in various assets, the principles of safety, profitability, and
liquidity should not be ignored
5.Proper Cash Management:
Cash management is an important task of financial manager. He has to
assess the various cash needs at different times and then make
arrangements for arranging cash. Cash may be required to make
payments to creditors, purchasing raw material, meet wage bills,
and meet day to day expenses. The sources of cash may be Cash sales,
Collection of debts, Short-term arrangement with the banks. The cash
management should be such that neither there is shortage of it and nor
it is idle. Any shortage of cash will damage the creditworthiness of the
enterprise. The idle cash with the business mean that it is not properly
used. Through Cash Flow Statement one is able to find out various
sources and applications of cash
6.Implementing Financial Controls:
An efficient system of financial management necessitates
the use of various control devices. Financial control device
generally used are;
a) Return Investment
b) Ratio analysis
c) Break even analysis.

d) Cost control.
e) Cost and internal audit
7.The use of various control techniques:
This will help the financial manager in evaluating the
performance in various Areas and take corrective measures
whenever needed.
8.Proper use of Surpluses:

The utilization of profits or surpluses are also an important
factor in financial management. A judicious use of surpluses is
essential for the expansion and diversification plans and also
protecting the interest of the shareholders. The ploughing
back of profit is the best policy of further financing. A balance
should be struck in using the funds for paying dividends and
retaining earnings for financing expansion plans.
Objectives of the Financial Management
The main objective of a business is to maximize the owner’s economic

welfare. Financial management provides a framework for selecting a
proper course of action and deciding a commercial strategy.The objectives
can be achieved by: (i) Profit maximization (ii) Wealth maximization
Profit Maximization:
Profit earning is the main aim of every economic activity. A business being
an economic institution must earn profit to cover its costs and provide
funds for growth.
No business can survives without earning profit. Profit is a measure of effi
ciency of a business enterprise. Profit also serves as a protection against
risks which cannot be ensured.
Arguments in favor of Profit Maximization
1.When profit earning is the aim of the business then the
profit maximization should be the obvious objective.
2.Profitability is the barometer for measuring the efficiency and
economic prosperity of a business enterprise, thus profit
maximization is justified on the ground of the rationality.
3.Profits are the main source of finance for the growth of the
business. So a business should aim at maximization of the
profits for enabling its growth and development.
4.Profitability is essential for fulfilling the social goals also. A
firm by pursuing the objectives of profits maximization also
maximizes the socio economic welfare.
5.A business may be able to survive under unfavorable
condition only if it had some past earnings to rely upon.
Arguments against of Profit Maximization
1.It is not precisely defined. It means different things for different people.
The term ‘Profit’ is vague and it cannot be precisely defined. It means
different things for different people. Should we mean (i) Short term profit or
long term profit? (ii) Total profit or earning pershare? (iii) Profit before tax
or after tax? (iv) Operating profit or profit available for the shareholders?
2.It ignores the time value of money and does not consider the magnitude
and the timing of earnings. It treats all the earnings as equal though they
occur in different time periods. It ignores the fact that the cash received
today is more important than the same amount of cash received after, say,
three years.
3.It does not take into consideration the risk of the prospective earning
stream.
Some projects are more risky than others. Two firms may have same expect
ed earnings per share, but if the earning stream in one is more risky the
market share of its share will be comparatively less.
4.The effect of the dividend policy on the market price of the shares is also
not considered in the objective of the profit maximization. In case,
earnings per share is the only objective then the enterprise may not think of
paying dividends at all because it retains profits in the business or investing
them in the market may satisfy this aim.
Wealth Maximization:
Financial theory asserts that the wealth maximization is the

single substitute for a stake holder’s utility. When the firm
maximizes the shareholder’s wealth, the individual stakeholders
can use this wealth to maximize his individual utility. It means
that by maximizing stakeholder’s wealth the firm is operating
consistently toward maximizing stakeholder’s utility. A stake
solder’s wealth in the firm is the product of the numbers of the
shares owned, multiplied with the current stock price per
share.
Stockholder’s current wealth in the firm = (No. Of
shares owned) * (Current stock price per share) Higher
the stock price per share, the greater will be the shareholder’s
wealth. Thus a firm should aim at maximizing its current stock
price, which helps in increasing the value of shares in the
market.
Maximum current
means Maximum stock means
Maximum Utility stock price per
holder’s wealth
share
Implication of the wealth maximization:

1.The Concept of wealth maximization is universally accepted, because it
takes care of interest of financial institution, owners, employees and society
at large.
2.Wealth maximization guides the management in framing the consistent
strong dividend policy to reach maximum returns to the equity holders.
3.Wealth maximization objective not only serves the interest of the
shareholder’s by increasing the value of their holdings but also ensures the
security to the lenders
Criticism of wealth maximization
1.It is a prescriptive idea. The objective is not descriptive of what the firm
actually does.
2.The objective of wealth maximization is not necessarily socially desirable.
3.There is some controversy as to whether the objective is to maximize the

stockholder’s wealth or the wealth of the firm, which includes other financial
claimholder’s such as debenture holders, preference shareholders.
4.The objective of wealth maximization may also face difficulties when

ownership and management are separated, as is the case in most of the
corporate form of organizations.When managers act as the agents of the real
owner, there is the possibility for a conflict of interest between shareholders
and the managerial interests.
What is advanced corporate finance?
Advanced Corporate Finance combines aspects of
corporate finance and value-based management. The
focus is on understanding the relationships between
investments and financing decisions on shareholder
value. Analysing these relationships is essential in
managing a firm for value.
Value-based management (VBM) is a mindset that views the
value of an organization as the ultimate measure of success.
Successful VBM depends on highly effective strategic planning,
supported by a performance management system that drives
the value mindset into the organization's overall culture.
The three elements of Value Based
Management:
 Creating Value. How the company can increase
or generate maximum future value.
 Managing for Value. Governance, change
management, organizational culture,
communication, leadership.
 Measuring Value. Value Based
Management is dependent on the corporate
purpose and the corporate values. The
corporate purpose can either be economic
(Shareholder Value) or can also aim at other
constituents directly (Stakeholder Value).
The main objective of VBM
Value-based management is focused on creating
future value, managing business assets and
human resources for value, aligning the interests
of stakeholders and measuring success through
company valuation.
AN OVERVIEW OF CORPORATE FINANCE AND FINANCIAL
MODELLING
• Investment decision
• Financing decision
• Dividend Decision
What is Financial
Management?
Concerns the acquisition,

financing, and management of
assets with some overall goal
in mind.
Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or
eliminated?
Financing Decisions
Determine how the assets (LHS of
balance sheet) will be financed (RHS of
balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?
Asset Management Decisions
• How do we manage existing assets efficiently?

• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset management.
What is the Goal of the Firm?
Maximization of Shareholder
Wealth!
Value creation occurs when we maximize the share
price for current shareholders.
PO = D(1+g) = D1/r-g
r-g
Shortcomings of Alternative
Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
• Could increase current profits while harming firm
(e.g., defer maintenance, issue common stock to
buy T-bills, etc.).
• Ignores changes in the risk level of the firm.
Shortcomings of Alternative
Perspectives
Earnings per Share Maximization
 Maximizing earnings after taxes divided by
shares outstanding.
Problems
• Does not specify timing or duration of expected
returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
Strengths of Shareholder Wealth
Maximization
• Takes account of: current and future profits and
EPS; the timing, duration, and risk of profits and
EPS; dividend policy; and all other relevant
factors.
• Thus, share price serves as a barometer for
business performance.
The Modern Corporation
Modern Corporation
Shareholders Management
There exists a SEPARATION between owners

and managers.
Role of Management
Management acts as an agent for

the owners (shareholders) of the
firm.
• An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.
Agency Theory
 Jensen and Meckling developed a

theory of the firm based on agency
theory.
• Agency Theory is a branch of economics
relating to the behavior of principals and
their agents.
Agency Theory
 Principals must provide incentives so

that management acts in the
principals’ best interests and then
monitor results.
• Incentives include, stock options, perquisites,
and bonuses.
Social Responsibility
• Wealth maximization does not preclude the

firm from being socially responsible.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
Corporate Governance
• Corporate governance: represents the system

by which corporations are managed and
controlled.
– Includes shareholders, board of directors,
and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
Board of Directors
• Typical responsibilities:
– Set company-wide policy;
– Advise the CEO and other senior executives;
– Hire, fire, and set the compensation of the CEO;
– Review and approve strategy, significant investments, and
acquisitions; and
– Oversee operating plans, capital budgets, and financial reports to
common shareholders.
• CEO/Chairman roles commonly same person in US, but
separate in Britain (US moving this direction).
Corporate finance typically covers such issues as capital structure, short-
term and long-term financing, project analysis, current asset management.
Capital structure addresses the question of what type of long-term financing
is the best for the company under current and forecasted market conditions;
project analysis is concerned with the determining whether a project should
be undertaken. Current assets and current liabilities management addresses
how to manage the day-by-day cash flows of the firm. Corporate finance is
also concerned with how to allocate the profit of the firm among shareholders
(through the dividend payments), the government (through tax payments)
and the firm itself (through retained earnings). But one of the most important
questions for the company is financing. Modern firms raise money by issuing
stocks and bonds. These securities are traded in the financial markets and
the investors have possibility to buy or to sell securities issued by the
companies. Thus, the investors and companies, searching for financing,
realize their interest in the same place – in financial markets
FINANCIAL MARKETS
CAPITAL MARKETS MONEY MARKET
PRIMARY SECONDARY PRIMARY SECONDARY

SPECULATION
Together with the investment the term speculation is frequently used
Speculation can be described as investment too, but it is related with the
short-term investment horizons and usually involves purchasing the salable
securities with the hope that its price will increase rapidly, providing a quick
profit. Speculators try to buy low and to sell high, their primary concern is
with anticipating and profiting from market fluctuations. But as the
fluctuations in the financial markets are and become more and more
unpredictable speculations are treated as the investments of highest risk. In
contrast, an investment is based upon the analysis and its main goal is to
promise safety of principle sum invested and to earn the satisfactory return.
TYPES OF INVESTORS
There are two types of investors:
• individual investors;
• Institutional investors.
Individual investors are individuals who are investing on their own.
Sometimes individual investors are called retail investors. Institutional
investors are entities such as investment companies, commercial banks,
insurance companies, pension funds and other financial institutions. In
recent years the process of institutionalization of investors can be observed.
As the main reasons for this can be mentioned the fact, that institutional
investors can achieve economies of scale, demographic pressure on social
security, the changing role of banks.
Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or
eliminated?
A B
NPV 12000 10000
LIFE 7 YEARS 6 YEARS
INVESTING VERSUS FINANCING
The term ‘investing” could be associated with the different
activities, but the common target in these activities is to “employ”
the money (funds) during the time period seeking to enhance the
investor’s wealth. Funds to be invested come from assets already
owned, borrowed money and savings. By foregoing consumption
today and investing their savings, investors expect to enhance
their future consumption possibilities by increasing their wealth.
But it is useful to make a distinction between real and financial
investments. Real investments generally involve some kind of
tangible asset, such as land, machinery, factories, etc. Financial
investments involve contracts in paper or electronic form such as
stocks, bonds, etc. Following the objective as it presented in the
introduction this course deals only with the financial investments
because the key theoretical investment concepts and portfolio
theory are based on these investments and allow to analyze
investment process and investment management decision making
in the substantially broader context
Direct versus indirect investments
Investors can use direct or indirect type of investing. Direct
investing is realized using financial markets and indirect
investing involves financial intermediaries. The primary
difference between these two types of investing is that in
applying direct investing, investors buy and sell financial assets
and manage individual investment portfolio themselves.
Consequently, investing directly through financial markets
investors take all the risk and their successful investing
depends on their understanding of financial markets, its
fluctuations and on their abilities to analyze and to evaluate the
investments and to manage their investment portfolio.
Cash
Surplus units Deficit units
Deficit unit security
Cash Cash
Surplus units Financial
intermediary Deficit units
F.I security
Deficit unit security
Contrary, using indirect type of investing, investors are buying or
selling financial instruments of financial intermediaries (financial
institutions) which invest large pools of funds in the financial markets
and hold portfolios. Indirect investing relieves investors from making
decisions about their portfolio. As shareholders with the ownership
interest in the portfolios managed by financial institutions (investment
companies, pension funds, insurance companies, commercial banks)
the investors are entitled to their share of dividends, interest and
capital gains generated and pay their share of the institution’s
expenses and portfolio management fee. The risk for investor using
indirect investing is related more with the credibility of chosen
institution and the professionalism of portfolio managers. In general,
indirect investing is more related with the financial institutions which
are primarily in the business of investing in and managing a portfolio
of securities (various types of investment funds or investment
companies, private pension funds). By pooling the funds of thousands
of investors, those companies can offer them a variety of services, in
addition to diversification, including professional management of their
financial assets and liquidity.
The main types of financial investment vehicles are:
• Short term investment vehicles;
• Fixed-income securities;
• Common stock;
• Speculative investment vehicles;
• Other investment tools.
Short - term investment vehicles are all those which have a maturity of one
year or less. Short term investment vehicles often are defined as money-market
instruments, because they are traded in the money market which presents the
financial market for short term (up to one year of maturity) marketable
financial assets. The risk as well as the return on investments of short-term
investment vehicles usually is lower than for other types of investments. The
main short term investment vehicles are:
- Certificates of deposit;
- Treasury bills;
- Commercial paper;
- Bankers’ acceptances;
- Repurchase agreements
Certificate of deposit is debt instrument issued by bank that indicates a
specified sum of money has been deposited at the issuing depository
institution. Certificate of deposit bears a maturity date and specified
interest rate and can be issued in any denomination. Most certificates of
deposit cannot be traded and they incur penalties for early withdrawal.
For large money-market investors financial institutions allow their large-
denomination certificates of deposits to be traded as negotiable
certificates of deposits
Treasury bills (also called T-bills) are securities representing financial
obligations of the government. Treasury bills have maturities of less
than one year. They have the unique feature of being issued at a
discount from their nominal value and the difference between nominal
value and discount price is the only sum which is paid at the maturity
for these short term securities because the interest is not paid in cash,
only accrued. The other important feature of T-bills is that they are
treated as risk-free securities ignoring inflation and default of a
government, which was rare in developed countries, the T-bill will pay
the fixed stated yield with certainty.
Commercial paper is a name for short-term unsecured promissory
notes issued by corporation. Commercial paper is a means of short-
term borrowing by large corporations. Large, well-established
corporations have found that borrowing directly from investors
through commercial paper is cheaper than relying solely on bank
loans. Commercial paper is issued either directly from the firm to the
investor or through an intermediary. Commercial paper, like T-bills is
issued at a discount. The most common maturity range of commercial
paper is 30 to 60 days or less. Commercial paper is riskier than T-bills,
because there is a larger risk that a corporation will default. Also,
commercial paper is not easily bought and sold after it is issued,
because the issues are relatively small compared with T-bills and
hence their market is not liquid.
Banker‘s acceptances are the vehicles created to facilitate commercial trade
transactions. These vehicles are called bankers acceptances because a bank accepts
the responsibility to repay a loan to the holder of the vehicle in case the debtor fails to
perform. Banker‘s acceptances are short-term fixed-income securities that are created
by non-financial firm whose payment is guaranteed by a bank. This shortterm loan
contract typically has a higher interest rate than similar short –term securities to
compensate for the default risk. Since bankers’ acceptances are not standardized,
there is no active trading of these securities.
Repurchase agreement (often referred to as a repo) is the sale of security with
a commitment by the seller to buy the security back from the purchaser at a specified
price at a designated future date. Basically, a repo is a collectivized shortterm loan,
where collateral is a security. The collateral in a repo may be a Treasury security, other
money-market security. The difference between the purchase price and the sale price
is the interest cost of the loan, from which repo rate can be calculated. Because of
concern about default risk, the length of maturity of repo is usually very short. If the
agreement is for a loan of funds for one day, it is called overnight repo; if the term of
the agreement is for more than one day, it is called a term repo. A reverse repo is the
opposite of a repo. In this transaction a corporation buys the securities with an
agreement to sell them at a specified price and time. Using repos helps to increase the
liquidity in the money market.
Fixed-income securities are those which return is fixed, up to some
redemption date or indefinitely. The fixed amounts may be stated in
money terms or indexed to some measure of the price level. This type
of financial investments is presented by two different groups of
securities:
- Long-term debt securities
- Preferred stocks
Speculative investment vehicles could be defined as investments
with a high risk and high investment return. Using these investment
vehicles, speculators try to buy low and to sell high, their primary
concern is with anticipating and profiting from the expected market
fluctuations. The only gain from such investments is the positive
difference between selling and purchasing prices. Of course, using
shortterm investment strategies investors can use for speculations other
investment vehicles, such as common stock, but here we try to
accentuate the specific types of investments which are more risky than
other investment vehicles because of their nature related with more
uncertainty about the changes influencing the their price in the future.
Some types of Speculative investment vehicles include Options and
Futures
Other investment tools:
- Various types of investment funds;
- Investment life insurance;
- Pension funds;
- Hedge funds.
Investment companies/ investment funds. These receive money from investors
with the common objective of pooling the funds and then investing them in
securities according to a stated set of investment objectives. Two types of
funds:
• open-end funds (mutual funds) ,
• closed-end funds (trusts).
Open-end funds have no pre-determined amount of stocks outstanding and
they can buy back or issue new shares at any point. Price of the share is not
determined by demand, but by an estimate of the current market value of the
fund’s net assets per share (NAV) and a commission.
Closed-end funds are publicly traded investment companies that have issued a
specified number of shares and can only issue additional shares through a new
public issue. Pricing of closed-end funds is different from the pricing of open-
end funds: the market price can differ from the NAV.
Insurance Companies are in the business of assuming the risks of adverse events
(such as fires, accidents, etc.) in exchange for a flow of insurance premiums.
Insurance companies are investing the accumulated funds in securities (treasury
bonds, corporate stocks and bonds), real estate. Three types of Insurance Companies:
life insurance;
non-life insurance (also known as property-casualty insurance)
and reinsurance.
Pension Funds pool resources from those working with the aim of providing either a
lump pension payment on retirement or a stable periodic retirement payment. Pension
funds invest their funds in securities (treasury bonds, corporate stocks and bonds),
real estate.
Hedge funds are unregulated private investment partnerships, limited to institutions

and high-net-worth individuals, which seek to exploit various market opportunities and
thereby to earn larger returns than are ordinarily available. They require a substantial
initial investment from investors and usually have some restrictions on how quickly
investor can withdraw their funds. Hedge funds take concentrated speculative positions
and can be very risky. It could be noted that originally, the term “hedge” made some
sense when applied to these funds. They would by combining different types of
investments, including derivatives, try to hedge risk while seeking higher return.
1 Which of the following are financial intermediaries?
(1) Venture capital organization (2) Pension fund (3) Merchant bank
A 2 only B1 and 3 only C2 and 3 only D1, 2 and 3
2. Which of the following statements are correct?
(1) Capital market securities are assets for the seller but liabilities for the
buyer
(2) Financial markets can be classified into exchange and over-the-counter
markets
(3) A secondary market is where securities are bought and sold by investors
A 1 and 2 only B1 and 3 only C2 and 3 only D1, 2 and 3
(1) A certificate of deposit is an example of a money market instrument
(2) Money market deposits are short-term loans between organisations such
as banks
(3) Treasury bills are bought and sold on a discount basis
4. On a market value basis, GFV Co is financed 70% by equity and 30% by
debt. The company has an after-tax cost of debt of 6% and an equity beta of
1·2. The risk-free rate of return is 4% and the equity risk premium is 5%.
What is the after-tax weighted average cost of capital of GFV Co?
A 5·4% B7·2% C8·3% D8·8%
1 Which of the following are financial intermediaries?
(1) Venture capital organization (2) Pension fund (3) Merchant bank
A 2 only B1 and 3 only C2 and 3 only D1, 2 and 3
(1) Capital market securities are assets for the seller but liabilities for the buyer
(2) Financial markets can be classified into exchange and over-the-counter markets
(3) A secondary market is where securities are bought and sold by investors
(1) A certificate of deposit is an example of a money market instrument
(2) Money market deposits are short-term loans between organisations such as
banks
(3) Treasury bills are bought and sold on a discount basis
4. On a market value basis, GFV Co is financed 70% by equity and 30% by debt.
The company has an after-tax cost of debt of 6% and an equity beta of 1·2. The
risk-free rate of return is 4% and the equity risk premium is 5%.
A 5·4% B7·2% C8·3% D8·8%
INVESTMENT MANAGEMENT PROCESS
The Investment management process is the process

of managing money or funds. The investment
management process describes how an investor
should go about making decisions. Investment
management process have the following five stages:
1. Setting up of an investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Monitoring of the Investment Portfolio
5. Evaluation of portfolio performance
Setting of investment policy is the first and most important step in the
investment management process. An Investment policy includes setting up of
investment objectives. The investment policy should have the specific
objectives regarding the investment return requirement and risk tolerance of
the investor. For example, the investment policy may define that the target of
the investment average return should be 15 % and should avoid more than 10
% losses. Identifying investor’s tolerance for risk is the most important
objective, because it is obvious that every investor would like to earn the
highest return possible. But because there is a positive relationship between
risk and return, it is not appropriate for an investor to set his/ her investment
objectives as just “to make a lot of money”. Investment objectives should be
stated in terms of both risk and return. The investment policy should also state
other important constrains which could influence the investment management.
Constrains can include any liquidity needs for the investor, projected investment
horizon, as well as other unique needs and preferences of investor. The
investment horizon is the period of time for investments. Projected time horizon
may be short, long or even indefinite.
Analysis and evaluation of investment vehicles.
When the investment policy is set up, investor’s objectives defined and the
potential categories of financial assets for inclusion in the investment
portfolio identified, the available investment types can be analyzed. This
step involves examining several relevant types of investment vehicles and
the individual vehicles inside these groups. For example, if the common
stock was identified as investment vehicle relevant for investor, the analysis
will be concentrated to the common stock as an investment. The one
purpose of such analysis and evaluation is to identify those investment
vehicles that currently appear to be mispriced. There are many different
approaches how to make such analysis. Most frequently two forms of
analysis are used: technical analysis and fundamental analysis.
Technical analysis involves the analysis of market prices in an attempt to
predict future price movements for the particular financial asset traded on
the market. This analysis examines the trends of historical prices and is
based on the assumption that these trends or patterns repeat themselves in
the future.
Fundamental analysis in its simplest form is focused on the evaluation of
intrinsic value of the financial asset. This valuation is based on the
assumption that intrinsic value is the present value of future flows from
particular investment. By comparison of the intrinsic value and market value
of the financial assets those which are under priced or overpriced can be
identified. This step involves identifying those specific financial assets in
which to invest and determining the proportions of these financial assets in
the investment portfolio.
Po = D1/r-g , re= D1/Po +g,(Intrinsic Value) Market value Rr = Rf + b(Rm-
Rf)
Project Acceptance
and/or Rejection
Accept
X SML
EXPECTED RATE
X X
OF RETURN
X X O
X X
O O
O O Reject O
Rf O
SYSTEMATIC RISK (Beta)

Formation of diversified investment portfolio is the next step in
investment management process. Investment portfolio is the set of
investment vehicles, formed by the investor seeking to realize its’ defined
investment objectives. In the stage of portfolio formation the issues of
selectivity, timing and diversification need to be addressed by the investor.
Selectivity refers to micro forecasting and focuses on forecasting price
movements of individual assets.
Timing involves macro forecasting of price movements of particular type of
financial asset relative to fixed-income securities in general.
Diversification involves forming the investor’s portfolio for decreasing or
limiting risk of investment. 2 techniques of diversification:
• random diversification, when several available financial assets are put to
the portfolio at random;
• objective diversification when financial assets are selected to the portfolio
following investment objectives and using appropriate techniques for
analysis and evaluation of each financial asset
Monitoring of the Investment Portfolio
.
This step of the investment management process concerns the periodic
revision of the three previous stages. This is necessary, because over time
investor with long-term investment horizon may change his / her investment
objectives and this, in turn means that currently held investor’s portfolio may
no longer be optimal and even contradict with the new settled investment
objectives. Investor should form the new portfolio by selling some assets in his
portfolio and buying the others that are not currently held. It could be the
other reasons for revising a given portfolio: over time the prices of the assets
change, meaning that some assets that were attractive at one time may be no
longer be so. Thus investor should sell one asset and buy the other more
attractive in this time according to his/ her evaluation. The decisions to perform
changes in revising portfolio depend, upon other things, in the transaction
costs incurred in making these changes. For institutional investors portfolio
revision is continuing and very important part of their activity. But individual
investor managing portfolio must perform portfolio revision periodically as well.
Periodic reevaluation of the investment objectives and portfolios based on them
is necessary, because financial markets change, tax laws and security
regulations change, and other events alter stated investment goals.
Measurement and evaluation of portfolio performance.
This the last step in investment management process involves determining
periodically how the portfolio performed, in terms of not only the return
earned, but also the risk of the portfolio. For evaluation of portfolio
performance appropriate measures of return and risk and benchmarks are
needed. A benchmark is the performance of predetermined set of assets,
obtained for comparison purposes. The benchmark may be a popular index of
appropriate assets – stock index, bond index. The benchmarks are widely used
by institutional investors evaluating the performance of their portfolios. It is
important to point out that investment management process is continuing
process influenced by changes in investment environment and changes in
investor’s attitudes as well. Market globalization offers investors new
possibilities, but at the same time investment management become more and
more complicated with growing uncertainty
Financing Decisions
Determine how the assets (LHS of
balance sheet) will be financed (RHS of
balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?
CHOOSING THE FINANCING METHOD
The company has to establish whether it needs longer-term or shorter-term capital.
Raising more longer-term capital would require the issue of more share capital or more
loans
Factors in the choice of financing method
The main factors to consider in choosing a source of finance are as follows:
- The purpose of finance
- The amount of the finance: the cash budget can be used for this purpose
- Repayment of the finance
- The term of the finance this should be appropriate to the type of asset being
required
- The cost of finance – relative to other different forms of finance
- Security – provided for the loan should be adequate to the finance been sought
- Restrictive covenant
- Taxation – debt is tax deductible, whereas equity is not tax deductible, ie paid out of
post-tax profit
- Control of the business – by issuing new shares the control of the firms becomes
diluted
- The effect of gearing – this measures a business’s amount of debt relative to equity
Internally Generated Funds
These includes retained earnings and in addition, cash generated by the
business other than profit, example is the provision for depreciation, since in
actual fact, depreciation is a non-cash flow item, hence though such
provision for depreciation reduces the profit, it does not reduce the funds
available for investments. It is the one of the cheapest and most important
source of investment funds for many businesses and are usually the first
choice for managers
Reasons why managers prefer internally generated funds
- It has lower immediate cost than other borrowings (source of finance)
- There is limited need for authorisation by non-management stakeholders
- If such investment is profitable, it raises the earning per share and the
P/E ratio
- No dilution of control
- Does not bring with it third party scrutiny, unlike bank borrowing
- Gearing levels will not increase by the use of internally generated funds
Factors that may limit the use of internally generated funds:
- There may be insufficient internally generated funds by the organization
- The flow of funds may not match the timing of investment requirement
- Interest on debt attract corporation tax relief whereas dividends do not
- Although the immediate cash cost of new equity may be low and of
retained funds nil, the total cost of equity includes capital growth as well
as income (growth in the share price as well as dividends).
Kayambi Co is a five-year old private company specialising in the manufacture of a
range of health drinks, foods and supplements aimed at the fitness market. At
present, their biggest customers are health food shops and fitness centres. However,
now that their brand has become established, the wealthy owners, who also manage
the business, are convinced that sales could be increased dramatically through the
opening of an internet shop. They are currently considering how best to fund the
expansion of the business. Funds would be needed to set up the website, expand
manufacturing at the factory, and employ more staff to deal with administration,
dispatch and delivery of the web orders. It is estimated that $2 million would be
needed for the expansion. At present, the market value of the company’s equity is
$4 million and the company has loans of $0·5 million, repayable in six months’ time.
The company also has cash built up from retained earnings of $1·3 million.
Required:
(a) Outline THREE appropriate sources of medium/long-term finance that may be
available to Kayambi Co to finance its expansion. (Presume that government grants
and leasing are NOT appropriate.) (9 marks)
(b) Discuss FOUR factors that Kayambi Co should take into account when deciding
on the mix of debt and equity finance. (16 marks)
[Total25 marks]
QUESTION THREE
JOY Ltd is a small company situated in Mufulira.It has only six shareholders
who are all involved in the management of this company. The company would
want to develop a new product that could be sold to farmers which can be
used for cultivating. The company expects to make a profit of K2.6 million per
year over the initial four years of the projects life. However, the company do
not have the finances to start the project. The company would need about K3.2
million to kick start the project. The company would want to finance the project
by equity finance which it intends to get through financial markets. JOY ltd
would want to go public.
a) Explain to the owners what going public means, distinguishing between a
company being quoted and being listed on the stock exchange.(4 Marks)
b) Describe the seven phases involved in going public. (21
Marks)
[Total25 marks]
Asset Management Decisions
• How do we manage existing assets efficiently?

• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset management.
What is the Goal of the Firm?
Maximization of Shareholder
Wealth!
Value creation occurs when we maximize the share
price for current shareholders.
PO = D(1+g) = D1/r-g
r-g
EFFICIENT MARKETS HYPOTHESIS
(EMH)
The efficient markets hypothesis (EMH) suggests that profiting from predicting price
movements is very difficult and unlikely. The main engine behind price changes is the
arrival of new information. A market is said to be “efficient” if prices adjust quickly and,
on average, without bias, to new information. As a result, the current prices of
securities reflect all available information at any given point in time. Consequently,
there is no reason to believe that prices are too high or too low. Security prices adjust
before an investor has time to trade on and profit from a new a piece of information
The key reason for the existence of an efficient market is the intense competition
among investors to profit from any new information. The ability to identify over-and
under-priced stocks is very valuable (it would allow investors to buy some stocks for
less than their “true” value and sell others for more than they were worth).
The most crucial implication of the EMH can be put in the form of a slogan:
Trust market prices!
At any point in time, prices of securities in efficient markets reflect all known
information available to investors.
THREE VERSIONS OF THE EFFICIENT MARKETS HYPOTHESIS
The efficient markets hypothesis predicts that market prices should incorporate
all available information at any point in time. There are, however, different
kinds of information that influence security values. Consequently, financial
researchers distinguish among three versions of the Efficient Markets
Hypothesis, depending on what is meant by the term “all available information”.
WEAK FORM EFFICIENCY
The weak form of the efficienct markets hypothesis asserts that the current
price fully incorporates information contained in the past history of prices only
That is, nobody can detect mis-priced securities and “beat” the market by
analyzing past prices.
The weak form of the hypothesis got its name for a reason
–security prices are arguably the most public as well as the most easily
available pieces of information. Thus, one should not be able to profit from
using something that “everybody else knows”. On the other hand, many
financial analysts attempt to generate profits by studying exactly what this
hypothesis asserts is of no value
-past stock price series and trading volume data. This technique is called
technical analysis
SEMI-STRONG FORM EFFICIENCY
The semi-strong-form of market efficiency hypothesis suggests that the
current price fully incorporates all publicly available information. Public
information includes not only past prices,but also data reported in a company’s
financial statements (annual reports, income statements, filings for the
Security and Exchange Commission, etc.),
earnings and dividend announcements, announced merger plans, the financial
situation of company’s competitors, expectations regarding macroeconomic
factors (such as inflation, unemployment), etc. In fact, the public information
does not even have to be of a strictly financial nature. For example, for the
analysis of pharmaceutical companies, the relevant public information may
include the current (published) state of research in pain-relieving drugs.
The assertion behind semi-strong market efficiency is still that one should not
be able to profit using something that “everybody else knows” (the
information is public).
Nevertheless, this assumption is far stronger than that of weak-form efficiency.
STRONG FORM EFFICIENCY
The strong form of market efficiency hypothesis states that the current price
fully
incorporates all existing information, both public and private (sometimes
called inside information). The main difference between the semi -strong and
strong efficiency hypotheses is that in the latter case, nobody should be able
to systematically generate profits even if trading on information not publicly
known at the time. In other words, the strong form of EMH states that a
company’s management (insiders) are not be able to systematically gain
from inside information by buying company’s shares ten minutes after they
decided (but did not publicly announce) to pursue what they perceive to be
a very profitable acquisition. Similarly, the members of the company’s
research department are not able to profit from the information about the
new revolutionary discovery they completed half an hour ago. The rationale
for strong-form market efficiency is that the market anticipates, in an
unbiased manner, future developments.
Technical analysis involves the analysis of market prices in an attempt to
predict future price movements for the particular financial asset traded on
the market. This analysis examines the trends of historical prices and is
based on the assumption that these trends or patterns repeat themselves in
the future. Technical analysis is a means of examining and predicting price
movements in the financial markets, by using historical price charts and
market statistics. It is based on the idea that if a trader can identify
previous market patterns, they can form a fairly accurate prediction of
future price trajectories.
Fundamental analysis in its simplest form is focused on the evaluation of
intrinsic value of the financial asset. This valuation is based on the
assumption that intrinsic value is the present value of future flows from
particular investment. By comparison of the intrinsic value and market value
of the financial assets those which are under priced or overpriced can be
identified. This step involves identifying those specific financial assets in
which to invest and determining the proportions of these financial assets in
the investment portfolio.
Po = D1/r-g , re= D1/Po +g,(Intrinsic Value) Market value Rr = Rf + b(Rm-
Rf)
Capital structure
When it comes to business terms and conditions, the capital structure is one of
the basic foundations in this field. It is defined as the equilibrium between the
debt and a company’s equity. Without a stable structure, the business will
collapse.
Every business or company requires the investment or financial support for its
long-term operations. Understanding this financial aid and the procedure of step-
by-step investments in the industry is known as the capital structure. Calculating
the capital structure and preparing the plan depends upon the type of the
business. The evaluation of structure must be maintained in such a way so that
the ROI is always higher.
A company is funded with K16m of equity and K6m of debt. The
recent dividend growth rate at the company has been 6%. The
Asset beta is 1.2 and the debt beta is 0.25. The company faces a
tax rate of 30%. The risk free rate of interest is 4.6% and the
stock market return is 10.6%.
Find
a) cost of equity =13.9375%
b) cost of debt Kd = 6.1% Kd = 6.1%x0.7 = 4.27%
c) WACC=11.3%
Factors affecting the capital structure
Various factors might affect the evaluation of the structure; these factors are
categorised into two groups, internal factors and external factors.
Internal factors: The capital structure of a business or a startup depends
upon its size, theme, and nature. The firm’s age and the plan also play an
active role in determining the same. However, in official terms, the trading on
equity and the period or purpose of financing are significant factors affecting
any business’s capital structure.
External factors: The external factors consist of those policies and
documentation, that the owner cannot control. The external factors include
the taxation policy, economic fluctuation in the market, and the level of
competition. Several other factors include the nature of the investor, capital
markets condition, and the financial institutions’ policy. Based on the type of
business, the seasonal variation in the market also affects the capital
Importance of Capital structure
Calculating and managing a capital structure is required for growing a
business. Several salient features need to be considered while creating the
structure. Some of these are:
A capital structure must be designed in a way so that the value of the
company is higher than the cost of capital
The perfect evaluation assures the most economical and safe ratio between
different policies
Those structures are more preferred if they provide the minimum risk factor
An optimal capital structure must be straightforward and flexible according to
the market conditions
It must involve rules, terms, and conditions which are attractive and efficient
An optimal capital structure must correlate with all legal requirements to
prevent the hassle
Theories of capital structure 29/03/24
A business requires the most beneficial capital structure. So, many capital structure
theories are available to take as a reference; amongst them, we will discuss the four
most essential ones:
Net income theory:
This theory was postulated by David Durand, who put forward the idea of increasing the
proportion of debt in the overall capital structure. According to him, debt is a fund
source because it has a lower interest rate, eliminating the risk factor and playing a
significant role in deducting expenses for income tax. This theory is also called the
“Fixed ‘Ke’ theory.”
Net operating income theory:
Also known as the irrelevant theory, it was also postulated by David Durand. It depicts
that the company’s market value is not affected by changes in the capital structure. The
overall cost of equity can remain fixed no matter the proportion of debt.
Traditional theory:
The traditional theory was postulated by Ezra Solomon. The assumptions of this
approach are quite related to the net income theory. The main principle behind this
theory was to increase the proportion of debt to a certain limit in the capital structure.
Modigliani-Miller theory:
This theory came into existence by correlating the ideas of two co-members,
Franco Modigliani and Merton Miller. This theory had two further
assumptions.
Absence of Corporate taxes: According to Modigliani-Miller’s theory,
in the absence of the corporate tax, the value of the creditworthy firm
will be equal to that of the amount of equity compromised.
Presence of corporate taxes: In the case where taxes are applied,
the value of the creditworthy firm is equal to the value of the indebted
firm summed up with the product of the tax rate and the value of debt.
Conclusion
The capital structure of a company determines the best proportion of the
debt and equity of that company. Calculating and representing an optimal
capital structure with the minimum risk factor is mostly appreciated. Capital
structure is very much required for the successful running of a business and
to ensure profitable growth in the market. Without a proper capital structure,
a company might face several hurdles in the market. Henceforth, a proper
structure must be evaluated for which several theories are available to take a
reference.
Overall Cost of
Capital of the Firm
Cost of Capital is the required rate of

return on the various types of financing.
The overall cost of capital is a weighted
average of the individual required rates
of return (costs).
Market Value of
Long-Term Financing
Type of Financing Mkt Val Weight
Long-Term Debt 6% K 35M 35%
Preferred Stock 9% K 15M 15%
Common Stock Equity 13% K 50M 50%
K 100M 100%
OR 35/100 X 6% + 15/100 X 9% + 50/100X13%
= 9.95%
WACC = MVdxKd(1-t) +MVPSXKps + Mve x Ke /MVd +
MV PS + MVE
Type of Financing Mkt Val RETURN
Long-Term Debt 6% K 35M K2.10M
Preferred Stock 9% K 15M K1.35M
Common Stock Equity 13% K 50M K6.50M
K 100M K9.95M
WACC = 9.95/100 X 100 = 9.95%
OR 35/100 X 6% + 15/100 X 9% + 50/100X13%
= 9.95%
WACC = MVdxKd(1-t) +MVPSXKps + Mve x Ke
MVd + MV PS + MVe
On a market value basis, GFV Co is financed 70% by equity and 30% by debt. The company
has an after-tax cost of debt of 6% and an equity beta of 1·2. The risk-free rate of return is
4% and the equity risk premium is 5%.
A 5·4% B7·2% C8·3% D8·8%
Cost of Debt
Cost of Debt is the required rate of return
on investment of the lenders of a company.
ki = kd ( 1 - T )
Determination of
the Cost of Debt
Assume that Basket Wonders (BW) has K1,000 par
value zero-coupon bonds outstanding. BW bonds
are currently trading at K385.54 with 10 years to
maturity. BW tax bracket is 40%.Find cost of debt
K0 + K1,000
K385.54 =
(1 + kd)10
Determination of
the Cost of Debt
(1 + kd)10 = K1,000 / K385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = .1 or 10%
ki = 10% ( 1 - .40 )
ki = 6%
Preferred Stock Valuation
Preferred Stock is a type of stock that
promises a (usually) fixed dividend, but
at the discretion of the board of
directors.
Preferred Stock has preference over
common stock in the payment of dividends
and claims on assets.
Preferred Stock Valuation
DivP DivP DivP

V=
(1 + kP)
+ (1 + k + ... +
P) (1 + kP)¥
1 2
¥ DivP
=S (1 + kP)t
or DivP (PVIFA k P, ¥)
t=1
This reduces to a perpetuity!

V = DivP / kP
Preferred Stock Example
Stock PS has an 8%, K100 par value issue
outstanding. The appropriate discount rate
is 10%. What is the value of the preferred
stock?
Po = D1/r-g = 8/0.1 = K80
DivP = K100 ( 8% ) = K8.00. kP =

10%. V = DivP / kP
= K8.00 / 10% = K80
Common Stock Valuation
Common stock represents a residual
ownership position in the corporation.
• Pro rata share of future earnings

after all other obligations of the
firm (if any remain).
• Dividends may be paid out of the pro
rata share of earnings.
Common Stock Valuation
What cash flows will a shareholder receive

when owning shares of common stock?
(1) Future dividends

(2) Future sale of the common
stock shares
Dividend Valuation Model
Basic dividend valuation model accounts for the PV

of all future dividends.
Div¥
Div1 Div2
V= (1 + ke)1 + (1 + ke)2 + ... + (1 + ke)¥
¥ Divt Divt: Cash Dividend
=S (1 + ke)t at time t
t=1
ke: Equity investor’s
required return
Adjusted Dividend Valuation
Model
The basic dividend valuation model adjusted for
the future stock sale.
Divn + Pricen
Div1 Div2
V= (1 + ke)1 + (1 + ke)2 + ... + (1 + ke)n
n: The year in which the firm’s
shares are expected to be sold.
Pricen: The expected share price in year n.
Dividend Growth Pattern
Assumptions
The dividend valuation model requires the forecast
of all future dividends. The following dividend
growth rate assumptions simplify the valuation
process.
Constant Growth
No Growth
Growth Phases
Constant Growth Model
The constant growth model assumes that

dividends will grow forever at the rate g.
D0(1+g) D0(1+g)2 D0(1+g)¥

V = (1 + k )1 + (1 + k )2 + ... + (1 + k ) ¥
e e e
D1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke: Investor’s required return.
Constant Growth Model
Example
Stock CG has an expected dividend growth rate
of 8%. Each share of stock just received an
annual K3.24 dividend. The appropriate
discount rate is 15%. What is the value of the
common stock?
Po= D1/r-g
G = 8%
R = 15%
D1 = K3.24 ( 1 + .08 ) = K3.50
VCG = D1 / ( ke - g ) = K3.50 / ( .15 - .08 ) = K50

Zero Growth Model
The zero growth model assumes that dividends will

grow forever at the rate g = 0.
D1 D2 D
VZG = + + ... +
¥
(1 + ke)1 (1 + ke)2 (1 + ke)¥
D1 D1: Dividend paid at time 1.

=
ke ke: Investor’s required return.
Zero Growth
Model Example
Stock ZG has an expected growth rate of 0%.
Each share of stock just received an annual
K3.24 dividend per share. The appropriate
discount rate is 15%. What is the value of the
common stock?
D1 = K3.24 ( 1 + 0 ) = K3.24
VZG = D1 / ( ke - 0 ) = K3.24 / ( .15 - 0 )

= K21.60
Growth Phases Model
The growth phases model assumes that

dividends for each share will grow at two or
more different growth rates.
n D0(1+g1) t ¥ Dn(1+g2)t
V =S + S (1 + ke)t
t=1 (1 + ke) t
t=n+1
Growth Phases Model
Note that the second phase of the growth phases

model assumes that dividends will grow at a
constant rate g2. We can rewrite the formula as:
n D0(1+g1)t 1 Dn+1
V =S +
(1 + ke)n (ke - g2)
t=1 (1 + ke)t
Growth Phases Model
Example
Stock GP has an expected growth rate of 16%
for the first 3 years and 8% thereafter. Each
share of stock just received an annual K3.24
dividend per share. The appropriate discount
rate is 15%. What is the value of the common
stock under this scenario?
Growth Phases Model
Example
0 1 2 3 4 5 6

D1 D2 D3 D4 D5 D6
Growth of 16% for 3 years Growth of 8% to infinity!
Stock GP has two phases of growth. The first, 16%, starts at time
t=0 for 3 years and is followed by 8% thereafter starting at time
t=3. We should view the time line as two separate time lines in
the valuation.
Growth Phases Model
Example
0 1 2 3 Growth Phase
#1 plus the infinitely
long Phase #2
D1 D2 D3
0 1 2 3 4 5 6

D4 D5 D6
Note that we can value Phase #2 using the Constant
Growth Model
Growth Phases Model
Example
V3 = D 4
We can use this model because
dividends grow at a constant 8%
k-g rate beginning at the end of Year 3.
0 1 2 3 4 5 6

D4 D5 D6
Note that we can now replace all dividends from year 4 to
infinity with the value at time t=3, V3! Simpler!!
Growth Phases Model
Example
0 1 2 3 New Time
Line
D1 D2 D3
0 1 2 3 D4
Where V3 =
V3 k-g
Now we only need to find the first four dividends to
calculate the necessary cash flows.
Growth Phases Model
Example
Determine the annual dividends.
D0 = K3.24 (this has been paid already)
D1 = D0(1+g1)1 = K3.24(1.16)1 =K3.76
D2 = D0(1+g1)2 = K3.24(1.16)2 =K4.36
D3 = D0(1+g1)3 = K3.24(1.16)3 =K5.06
D4 = D3(1+g2)1 = K5.06(1.08)1 =K5.46
D4 = 3.24(1.16)^3(1.08) = K5.46
Growth Phases Model
Example
0 1 2 3 Actual
Values
3.76 4.36 5.06
0 1 2 3 5.46
Where K78 =
.15-.08
78
Now we need to find the present value of the
cash flows.
Growth Phases Model
Example
We determine the PV of cash flows.
PV(D1) = D1(PVIF15%, 1) = K3.76 (.870) = K3.27
PV(D2) = D2(PVIF15%, 2) = K4.36 (.756) = K3.30
PV(D3) = D3(PVIF15%, 3) = K5.06 (.658) = K3.33
P3 = K5.46 / (.15 - .08) = K78 [CG Model]
PV(P3) = P3(PVIF15%, 3) = K78 (.658) = K51.32
Growth Phases
Model Example
Finally, we calculate the intrinsic value by summing
all of cash flow present values.
V = K3.27 + K3.30 + K3.33 + K51.32

V = K61.22
3 D (1+.16)t 1 D4
V=S
0
+
t=1 (1 + .15) t (1+.15)n (.15-.08)
Determination of the Cost
of Equity Capital
Assume that Basket Wonders (BW) has common
stock outstanding with a current market value of
K64.80 per share, current dividend of K3 per share,
and a dividend growth rate of 8% forever.
Find the cost of equity
ke = ( D 1 / P0 ) + g
ke = (K3(1.08) / K64.80) + .08
ke = .05 + .08 = .13 or 13%
A company has just paid an ordinary share dividend of 32·0 Ngwee and is expected
to pay a dividend of 33·6 Ngwee in one year’s time. The company has a cost of
equity of 13%.
What is the market price of the company’s shares to the nearest Ngwee on an ex
dividend basis? A K3·20 B K4·41 C K2·59 D K4·20
Mwewa Co has in issue 8 million shares with an ex dividend market value of K7·16 per share. A
dividend of 62 Ngwee per share for 2021 has just been proposed. The pattern of recent dividends
is as follows:
Year 2018 2019 2020 2021

Dividends per share (Ngwee) 55·1 57·9 59·1 62·0
Mwewa Co also has in issue 8·5% bonds with a total nominal value of K5 million. The market
value of each K100 bond is K103·42. Mwewa Co is planning to invest a significant amount of
money into an investment project in a new business area.
Mwewa Co has identified a proxy company with a similar business risk to the investment project.
The proxy company has an equity beta of 1·038 and is financed 75% by equity and 25% by debt,
on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Mwewa Co
has an equity beta of 1·6. Mwewa Co pays tax on profits at an annual rate of 30% per year.
REQUIRED
Calculate the cost of equity of Mwewa Co using the dividend growth model.
Calculate the cost of equity of Mwewa Co using the Capital Asset Pricing Model (CAPM)
On a market value basis, Kayambi Co is financed 70% by equity and 30%
by debt. The company has a cost of debt of 10% and an equity beta of 1·2.
The risk-free rate of return is 4% and the equity risk premium is 5%.The
corporation tax is 40%.
Calculate;
(a) After tax cost of debt
(b) Cost of equity
(c) What is the after-tax weighted average cost of capital of Kayambi Co?
(A)Stocks A and B have the following historical returns
Year Stock A’s returns Stock B’s returns
1 (18.00%) (14.50%)
2 33.00 21.80
3 15.00 30.50
4 (0.50) (7.60)
5 27.00 26.30
Required
Calculate the average rate of return for each stock (4 Marks)
Calculate the standard deviation of returns for each stock (10 Marks)
Calculate Coefficient of variation of stock A and stock B (4 Marks)
(B)What is the value to you today 14/11/22 of a 9% coupon bond with a par value
of K10,000 that was issued on 14/11/12 which matures on 14/11/30 if you want a
7% return? Use annual compounding. ( 4 Marks)
( C) Preferred stock of JOY Ltd has par value of K100, an annual dividend of K8, a
required rate of return 9% and a market price of K96. From this information would
you buy this stock?Explain with supporting calculations. (3 Marks)
CAPITAL BUDGETING
What is
Capital Budgeting?
The process of identifying, analyzing, and

selecting investment projects whose returns
(cash flows) are expected to extend beyond
one year.
The Capital Budgeting
Process
• Generate investment proposals consistent
with the firm’s strategic objectives.
• Estimate after-tax incremental operating
cash flows for the investment projects.
• Evaluate project incremental cash flows.
The Capital Budgeting
Process
• Select projects based on a value-maximizing

acceptance criterion.
• Reevaluate implemented investment projects
continually and perform post audits for
completed projects.
Classification of Investment
Project Proposals
1. New products or expansion of existing

products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
Screening Proposals
and Decision Making
1. Section Chiefs
2. Plant Managers Advancement
to the next
3. VP for Operations level depends
4. Capital Expenditures on cost
Committee and strategic
5. President importance.
6. Board of Directors
Estimating After-Tax
Incremental Cash Flows
Basic characteristics of relevant

project flows
 Cash (not accounting income) flows
 Operating (not financing) flows
 After-tax flows
 Incremental flows
Estimating After-Tax
Principles that must be adhered to in
the estimation
 Ignore sunk costs
 Include opportunity costs
 Include project-driven changes in working
capital net of spontaneous changes in
current liabilities
 Include effects of inflation
Tax Considerations and
Depreciation
 Depreciation represents the systematic
allocation of the cost of a capital asset
over a period of time for financial reporting
purposes, tax purposes, or both.
• The cash saving on tax-allowable

depreciation(or the cash payment for the
charge) is calculated by multiplying the
depreciation by the tax rate.
The cash saving on tax-allowable depreciation(or the cash payment for the charge) is
calculated by multiplying the depreciation by the tax rate.
A company bought an assets costing K80,000.It has a useful life of 4 years with zero
scrap value.The following cashflows are expected. Tax is paid at 30%.
Sales 200,000 120,000 130,000 100,000

Expenses 103,000 80,000 100,000 74,000
Profit 97,000 40,000 30,000 26,000
Tax without dep 29,100 12,000 9,000 7,800
Less depreciation 20,000 20,000 20,000 20,000
Profit with dep 77,000 20,000 10,000 6,000
Tax 23,100 6,000 3,000 1,800
Tax saving of Dep 6,000 6,000 6,000 6,000
Dep Tax saving = 30% x 20,000 = K6,000

Depreciation
• There are two possible assumptions about
when tax-allowable depreciation starts to be
claimed.
a. At the start of the project(at year 0)
b. In the first year.
EXAMPLE
A company is considering whether or not to purchase an item
of machinery costing K40,000 in 2024. it would have a life of
four years, after which it would be sold for K5,000. The
machinery would create annual cost savings of K14,000.The
machinery would attract tax allowable depreciation of 25% on
a reducing balance basis which would be claimed against
taxable income of the current year, which is soon to end. The
rate of tax is 30% which is payable one year in arrears. The
after-tax cost of capital is 8%.Should the machine be bought?
Year tax-allowable dep. Reducing balance
0 2024 (25% of cost)K10,000 30,000
1 2025 (25% of RB) 7,500 22,500
2 2026 5,625 16,875
3 2027 4,219 12,656
4 2028 3,164 9,492
Sale proceeds, end of year 4 5,000

Less reducing balance 9,492
Balancing allowance 4,492.
Year of claim dep. Tax saved year of tax payment
0 10,000 3,000 1
1 7,500 2,250 2
2 5,625 1,688 3
3 4,219 1,266 4
4 7,656 2,297 5
Year equip. Savings tax on savings tax saved on dep. Net disc rate pv
0 40,000 40,000 1.00 (40,000)
1 14,000 3,000 17,000 0.926 15,742
2 14,000 (4,200) 2,250 12,050 0.857 10,327
3 14,000 (4,200) 1,688 11,488 0.794 9,121
4 5,000 14,000 (4,200) 1,266 16,066 0.735 11,809
5 (4,200) 2,297 (1,903) 0.681 (1,296)
NPV 5,703.
INCORPORATING INFLATION.
• Real cash flows(i.e adjusted for inflation) should
be discounted at a real discount rate.
• Nominal cash flows should be discounted at a
nominal discount rate.
INFLATION
Fisher formula:
• (1 + i)= (1+ r)(1+h),
Where h=rate of inflation
r= real rate of interest
i= nominal rate of interest.
The nominal cost of capital is 10% and inflation rate
is 2%.Calculate the real rate of interest
(1 + i)= (1+ r)(1+h)
(1 + r) = (1+i)/(1+h)
1+ r = (1.1)/(1.02)
1+r = 1.078
r = 1.078 – 1
0.078
7.8%
CAPITAL INVESTMENT APPRAISAL
INTRODUCTION
Capital Budgeting involves the assessment of how much should be spent on assets or project
and which assets should be acquired.
Before deciding which project/assets to invest in, corporations must compare the benefits to be
derived from the acquisition/investment against the costs involved in the investment.
The investment will not purely depend upon financial aspects but to a large extent, the strategic
direction of the business. Remember the financial decisions fall within the long-term corporate
strategy formulation process.
Project appraisal is a generic term that refers to the process of assessing, in a structured way,
the case for proceeding with a project or proposal. It often involves comparing various options,
using economic appraisal or some other decision analysis techniques.
Methods of Ranking Investment Proposals

Therefore project appraisal and evaluation requires the following:
• Detailed statement giving the expected cash inflows and outflows
• assignment to the investment those relevant cash flows.
• Assessment of the impact of taxation
• Discount rate to account for the time value of money
• Add level rate to account for the risk associated with the investment that is the risk of use of
project cash flows.
INVESTMENT APPRAISAL METHODS
CASH BASED PROFIT BASED
ARR = Average profit

Initial investment cost
DOES NOT CONSIDER
CONSIDER TVM TVM
PAYBACKPERIOD
DPB
NPV
IRR
PI
You buy a bus costing K40,000 and expected useful life of 5
years after which it can be sold for K10,000.The bus is
expected to bring revenues of K100,000 each year.Other
operating costs are expected to be K80,000 per year.Suppliers
of capital require 10% return on their investment.If all
revenues and expenses are on cash basis,how much is
(a)Cash per each year
(b)Profit per year.
Year 0 1 2 3 4 5
Revenue K100,000 K100,000 K100,000 K100,000 K100,000
Other cash 10,000
Expenses 80,000 80,000 80,000 80,000 80,000
Purchase
of Assets 40,000
Net cash 20,000 20,000 20,000 20,000 30,000
Profit
Revenue K100,000 K100,000 K100,000 K100,000 K100,000
Expenses 80,000 80,000 80,000 80,000 80,000
Depreciation 6,000 6,000 6,000 6,000 6,000
Profit 14,000 14,000 14,000 14,000 14000
ARR = 14,000/40,000 X 100 =35%
A person was caught with a head of a human being with street value of K20 million and was
sentenced to 15 years in prison.
Risk takers
Risk neutral
Risk averse
Calculating the
• Initial cash outflow -- the initial net cash
investment.
• Interim incremental net cash flows -- those net
cash flows occurring after the initial cash
investment but not including the final period’s
cash flow.
• Terminal-year incremental net cash flows -- the
final period’s net cash flow.
Initial Cash Outflow
a) Cost of “new” assets
b) + Capitalized expenditures
c) + (-) Increased (decreased) NWC
d) - Net proceeds from sale of
“old” asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of “old” asset(s) if replacement
f) = Initial cash outflow
a) Net incr. (decr.) in operating revenue
less (plus) any net incr. (decr.) in
operating expenses, excluding depr.
b) - (+) Net incr. (decr.) in tax depreciation
c) = Net change in income before taxes
d) - (+) Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + (-) Net incr. (decr.) in tax depr. charges
g) = Incremental net cash flow for period
Terminal-Year Incremental
Cash Flows
a) Calculate the incremental net cash
flow for the terminal period
b) + (-) Salvage value (disposal/reclamation
costs) of any sold or disposed assets
c) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
d) + (-) Decreased (increased) level of “net”
working capital
e) = Terminal year incremental net cash flow
INITIAL INVESTMENT
Capital budgeting decisions involve careful estimation of the initial investment outlay and future
cash flows of a project. Correct estimation of these inputs helps in taking decisions that increase
shareholders wealth.
Initial investment is the amount required to start a business or a project. It is also called initial
investment outlay or simply initial outlay. It equals capital expenditures plus working capital
requirement plus after-tax proceeds from assets disposed off or available for use elsewhere.
Formula
Initial investment equals the amount needed for capital expenditures, such as machinery, tools,
shipment and installation, etc.; plus any increase in working capital, minus any after tax cash
flows from disposal of any old assets. Sunk costs are ignored because they are irrelevant.
Initial Investment = CapEx + ΔWC - D
Where,
CapEx is capital expenditure,
∆WC is the change in working capital and
D is the net cash flow from disposed asset.
Example
Konkola Copper Mine (KCM)started a copper and gold exploration and
extraction project in Chingola in 2015. In 2016-2017, it incurred
expenditure of K200 million on feasibility studies of the area and K500
million on equipment. In 2018, the company abandoned the project due
to disagreement with the government. Recently, a new business friendly
government is sworn in. KCM managing director believes the project
needs reconsideration. The company's financial analyst and chief
engineer estimate that K1,500 million worth of new equipment is
needed to restart the project. Shipment and installation expenditures
would amount to K200 million. Current assets must increase by K200
million and current liabilities by K90 million. The equipment purchased
in 2016-2017 is no longer useful and is to be disposed of for after tax
proceeds of K120 million. Find the initial investment outlay.
Solution
Initial investment
= equipment purchase price + shipment and installation +
increase in working capital − disposal inflows
= K1,500 million + K200 million + (K200 million − K90 million)
− K120 million
= K1,690 million.
KCM needs K1,690 million to restart the project. It needs to

estimate future cash flows from the project, and calculate net
present value and/or internal rate of return in order to decide
whether to go ahead with the restart or not.
K200 million expenditure on the feasibility studies is not part
of the initial investment because it is a sunk cost.
Jonken co is a private company based in Kitwe. The company is
considering investing into a project that will be producing belts to
be sold to the mining companies. The project will demand that
the company buys a special equipment that costs K800,000 from
South Africa to replace the old machine which have a book value
of K100,000. The old machine has one year of economic life with
expected scrap value of zero. The equipment have expected
useful life of 5 years with K120,000 scrap value. Jonken uses
straight line method of depreciation to depreciate its Non-Current
Assets and claims tax allowances at 25% per year reducing
balance. Installations costs of K100,000 will also be incurred
before the project starts but will be paid for next year when the
equipment starts operating.
At the beginning of the project, it is expected that there will be
K40 000 of inventory required. At the same time accounts
receivables will be K50 000 and accounts payable of K25 000. The
net working capital will be maintained at 3% of total sales
revenue per year until the end of the project.
OPERATING CASH FLOW
Operating cash flow (OCF) is a measure of the amount of cash
generated by a company's normal business operations. Operating
cash flow indicates whether a company can generate sufficient
positive cash flow to maintain and grow its operations, otherwise
it may require external financing for capital expansion.
TERMINAL CASHFLOW
Terminal cash flow is the net cash flow that occurs at the end of a
project and represents the after-tax proceeds from disposal of the
project assets and recoupment of working capital.
Terminal cash flow has two main components:
 Proceeds from disposal of project equipment, and
 cash flows associated with reversion of working capital to the
level that prevailed before the start of the project.
Terminal cash flow is an important input in the capital budgeting process. While
uniform periodic net cash flows are discounted using the present value of an annuity
formula, terminal cash flow is treated separately from other cash flows and discounted
using the present value of a of a single cash flow formula.
Formula
Terminal cash flow can be calculated using the following formula:
Terminal Cash Flow
= After-Tax Proceeds from Disposal ± Change in Working Capital
Terminal Cash Flow
= Pre-tax Sale Proceeds − Tax on Disposal ± Change in Working Capital
Terminal Cash Flow
= (S − BV) × (T) + WCN − WCO
Where,
S is the pre-tax sale proceeds,
BV is the book value of the disposed assets,
t is the tax rate on capital gains,
WCN is the new level of working capital and
WCO is the old level of working capital.
EXAMPLE
Safe Energy is appraising a new solar energy project. They expect the installed
equipment to have an economic life of 5 years after which it is to be replaced
by newer technology. The initial investment on the project amounts to K200
million, K20 million of which is on account of increased working capital. For tax
purposes, the equipment is to be depreciated on a straight line basis over 5
years with expected residual value of K20 million. The company's financial
analyst projects that the machinery can be disposed of for K40 million. Working
capital will revert back to its initial level at the end of 5 years. Applicable tax
rate on gain on disposal is 20%.
Required: Calculate the terminal cash flow.
Solution
Tax on Disposal
= (Proceeds − Book Value) × Tax Rate
= (K40 million − K20 million) × 20%
= K4 million
After Tax Proceeds from Disposal
= K40 million − K4 million
= K36 million
Terminal Cash Flow
= After-tax Proceeds from Disposal + Working Capital Recouped
= K36 million + K20 million
= K56 million
Non Discounted Cash Flow Methods
1. Payback method (or Payback Period)
The payback period is the number of years required to return the original investment from the net cash
flows (net operating income after taxes plus depreciation).This is a cash measure and as such it measures
the number of years taken to recoup the investment in cash terms.
Decision Rule
• If payback > acceptable time limit, reject project
• If payback < acceptable time limit, accept project
Advantages of PayBack method.
• It is very easy to calculate, but it can lead to wrong decision
• Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in
meeting other needs.
• Easy to apply (Simple to understand
Problems with the Payback Method
• Does not consider post-payback cash flows
• Does not consider time value of money
• Does not explicitly consider risk
• The "acceptable" time period is arbitrary
Assume the firm is considering two projects; project A and project B, each requires an investment of
K100 millions with nil value at end of project life. The cost of capital is 10%. Below is the summary of
expected net cash flows in millions.
YEAR CASHFLOW AMOUNT BALANCE OF INITIAL

REPAID INVESTMENT
0 (K100 m) NILL (k100m)
1 K50 m K50m (K50m)
2 K40 m K90m (10 m)
3 K30 m K100m NILL
Payback = Year before full recovery + Unrecovered cost at start of year

Cashflow during year
The payback from project A is
Project A: 2 and1/3 years: Using a table this could be shown as below
Pay Back Period = 2 years (K90m) + 10/30 years
= 2 1/3years = 2 years 4 months.
AVERAGE PROFIT = CASHFLOWS – DEPRECIATION = 132-100 = 32/6 =5.33
ARR = 5.33/100 = 5.33%

IT IS LESS THAN COST OF CAPITAL OF 10%.REJECT PROJECT.
Advantages of using ARR
• It is simple to calculate using accounting data
• Earning of each year is included in the calculating the
profitability of the project
Disadvantages of using ARR
• It is inconsistency with wealth maximization as the objective
of the firm
• Since it uses the accounting data it includes the amount of
accruals in calculating the earnings “net profit”.
• It is based on the familiar accrual accounting.
• It ignores the time value of money i.e. expected future
dollars are erroneously regarded as equal to present dollars.
1. Net Present Value Method (NPV)
It is the method of evaluating project that recognizes that the dollar received immediately is
preferable to a dollar received at some future date. It discounts the cash flow to take into the
account the time value of money.
This approach find the present value of expected net cash flows of an investment, discounted at
cost of capital and subtract from it the initial cash outlay of the project.
In case the present value is positive, the project will be accepted; if negative, it should be
rejected. If the projects under consideration are mutually exclusive the one with the highest net
present value should be chosen.
PROCEDURE
1.Find the present value of each cashflow, including both inflows and outflows (treating cash
outflows as negative cash flows) discounted at the project’s cost of capital.
2.Sum these discounted cashflows; this sum is defined as the project’s NPV.
3.If the NPV is positive, the project should be accepted, while if the NPV is negative, the
YEAR CASHFLOWS DISCOUNT DISCOUNTED
FACTOR (i/(1.i)^n CASHFLOW
0 (K100M) 1 [1/(1.1)^0] (100)
1 K50 m 0.9091 45.455
2 K40 m 0.8264 33.056
3 K30 m 0.7513 22.539
4 10 0.6830 6.83
5 1 0.621 0.621
6 1 0.564 0.564
NPV 9.066
IRR Decision Rules
Independent Projects: Accept project as long as the IRR > hurdle rate(required rate of return or cost of capital)
Mutually Exclusive Projects: Compute (IRR - hurdle rate) for each project, rank from highest to lowest and accept the
highest ranking project [assuming the computation (IRR - hurdle rate) > 0]
IRR--Advantages/Disadvantages
1) Advantages
• It Considers all cash flows
• It Considers time value of money
• It is Comparable with the hurdle rate
2) Disadvantages
• Does not show dollar improvement in value of firm if project is accepted
• IRR can be affected by the scale (size) of the project, i.e., Io
• Possible existence of multiple IRRs
Relationship Between IRR and the NPV Profile
1) When the IRR = the firm's hurdle rate, NPV = 0
2) When the IRR < the firm's hurdle rate, NPV < 0
3) When the IRR > the firm's hurdle rate, NPV > 0
NPV and IRR Methods: Possible Decision Conflicts
An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept"
Note: When projects are independent, no accept/reject conflict will arise
A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR.
Note: Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable
mutually exclusive projects
Ranking conflicts arise because of:
1) Timing differences in incremental cash flows
2) Magnitude differences in incremental cash flows
When a conflict arises among mutually exclusive projects, pick the one with the highest NPV
3. Profitability index
It is sometimes called Benefit Cost Ratio or present value index. It is calculated by taking the
present value of cash inflows divided by the present value of cash outflows. The decision criteria is
to accept project with a Profitability Index (PI) greater than one.
This ratio gives the return in the present terms per unit invested. Using this criterion, projects will
be ranked from the one with highest PI down to one with the lowest, and then project would be selected in the
order of ranking up to the point where the budget is exhausted.
This criterion is simple but suffers from two basic limitations.
It cannot be used to except in cases where there is only a single constraint. In case where the capital is rationed in more that
one period or where the capital is not the only constraint, the criteria will not provide the best solution.
It looks projects individually and does not take into account the overall portfolio where correlation of projects’ returns is
important.
PI = PRESENT VALUES/INITIAL (excluding initial investment cost)/ INVESTMENT COST

OR PI = 1 + NPV/INITIAL/ INVESTMENT COST
FROM OUR EXAMPLE
PI = 109.066/100 = 1.09066
OR PI = 1 + 9.066/100 = 1.09066
DECISION RULES
IF PI< 1,REJECT PROJECT

IF PI = 1,INDIFFERENT
IF PI> 1,ACCEPT PROJECT
SINCE FROM OUR EXAMPLE PI IS GREATER THAN 1,WE ACCEPT PROJECT

DISCOUNTED PAYBACK PERIOD.
This is the length of time required for an investment’s cashflows,discounted at the investment’s
cost of capital, to cover its cost.
Using our example,the discounted payback period for project A is
PAYBACK = 2 YEARS + 21.489/22.539 =2 YEARS 11MONTHS 13 DAYS.
YEAR CASHFLOWS DISCOUNT DISCOUNTED REAPID BALANCE OF

FACTOR CASHFLOW AMOUNT INITIAL
INVESTMENT
0 (K100M) 0 0 0 (K100m)
1 K50 m 0.9091 45.455 45.455 54.545
2 K40 m 0.8264 33.056 78.511 21.489
3 K30 m 0.7513 22.539 100 NIL
QUESTION
Bauze is a small manufacturing company that makes garden furniture. They are considering a
project where they will make special metal ornaments; this is considered to be in the normal area
of its business.
This will involve the company buying a new piece of equipment, the capital costs of which will be
K400 000; there will also be an extra K50 000 of installation costs which can be expensed straight
away. This piece of equipment will replace an old machine which has a book value of K50 000 and
one year to go before it will have been depreciated to zero. The new equipment will be depreciated
straight line to zero over five years with no salvage value at the end of its life. If the project is
undertaken, the old equipment will be sold for K90 000.
The ornaments will retail for K12 each and will cost a total of K8 each to get to the market. In the
final two years of the five-year project, it is expected that the costs will rise to K9 and K10,
respectively.
At the start of the project, it is expected that there will be K40 000 of stock required. At the same
time accounts receivables will be K50 000 and accounts payable of K25 000. These levels will be
maintained until the end of the project. The company expects to sell 80 000 units in the first
year,rising to 100 000 in year 2, and 120 000 in year 3, before falling back to 100 000 for each of
years 4 and 5.
The company expects to incur an extra K50 000 in marketing costs in the first year, followed by K40
000 a year thereafter. The project will also incur K40 000 of overhead costs from the parent
company.The survey cost of K30,000 will be paid in year 1 of the project.
Two managers from the parent company will come and work on the project; their current salaries
are K50 000 each and the parent company will have to hire two new managers to fill the vacated
positions. The company expects to start two new managers at a salary of K40 000 each.
The company is funded with K16m of equity and K6m of debt. The recent dividend growth rate at
the company has been 6%. The Asset beta is 1.2 and the debt beta is 0.25. The company faces a
tax rate of 30%. The risk free rate of interest is 4.6% and the stock market return is 10.6%.
Calculate
a) Pay back Period
b) Discounted Pay back Period
c) NPV
d) PI
e) IRR
f) ARR
WACC =Ke x E/E+D + Kd(1-t) x D/E+D
Ke = Rf + b(Rm-Rf)
4.6 + b(10.6 -4.6)
(A) ASSET BETA- (DEBT BETAXWEIGHT) = WEIGHTED EQUITY BETA

1.2-0.25X6/22 = 1.1318
Unweighted Equity beta = 1.1318x22/16 = 1.55625

Cost of equity = 4.6+ 1.55625x6 = 13.9375%
Cost of Debt = 4.6 + 0.25 x6 = 6.1%
WACC = 13.9375x16/22 + 6.1x0.7x6/22 = 11.3%

(B) Lay Out the Cash flows Year
0 1 2 3 4 5 Total
Investment -400,000
Setup -50,000
Sale of old equip 90,000
Account payable 25,000 -25,000
Account receivable -50,000 50,000
Inventory -40,000 40,000
Revenues 960,000 1,200,000 1,440,000 1,200,000 1,200,000
Costs -640,000 -800,000 -960,000 -900,000 -1,000,000
Salaries -80,000 -80,000 -80,000 -80,000 -80,000
Marketing -50,000 -40,000 -40,000 -40,000 -40,000
Tax 3,000 -48,000 -60,000 -84,000 -30,000 0
FCF -422,000 142,000 220,000 276,000 150,000 145,000
0.7252947
Discount Factor 1 0.89847 0.80725300 0 0.65165740 0.58549633 NPV
Discounted Cash Flow -422000 127582.74 177595.66 200181.34 97748.61 84896.97 266005.32
TAXATION CALCULATION Year
0 1 2 3 4 5
Profit on Sale of old Equip 40,000
-50,000
Setup Costs
960,000 1,200,000 1,200,000
Revenues 1,200,000 1,440,000
-640,000 -800,000 -960,000 -900,000 -1,000,000
Salaries -80,000 -80,000 -80,000 -80,000 -80,000

-50,000 -40,000 -40,000 -40,000 -40,000
Marketing
Depreciation of Old Machine 50,000
-80,000 -80,000 -80,000 -80,000 -80,000

Depreciation of new Machine
-10,000 160000 200000 280000 100000 0

Taxable Income
-3000 48000 60000 84000 30000 0

Tax @ 30%
Calculate
a) Pay back Period =2.22 years
b) Discounted Pay back Period =2.58 years
c) NPV =266005.32
d) PI = 1 + 266005.32/422000 = 1.63
e) IRR = 34.19%
f) ARR = 34.6% = 130,000/422,000 = 30.81%
IRR,GUESS 1,TRY 30%,NPV = 34.61

GUESS 2,TRY 32%,NPV =17.43
GUESS 3,TRY 35%,NPV =-6.43
IRR = 32% + 17.43 X (35%-32%)

NPV
(17.43- -6.43)
0 32% + 2.19%
r
34.19%
IRR
IMPACT OF TAXATION ON NPV
There are three important tax effects to consider

(a) Tax payments on operating profits
(b) Tax benefits from tax depreciation allowances
(c) Tax relief on interest payments on debt.
A company purchases a machine at a cost of K100,000.It has a life of four years and a scrap
value of K20,000 in year four.Tax depreciation allowance can be claimed on the machine on a
reducing balance basis at 25% per annum.The machine will generate the following annual net
income.
YEAR 1 2 3 4
Net income 30,000 40,000 50,000 40,000
The cost of capital is 12% net of corporation tax of 33% payable in arrears.
Should the machine be acquired or not.
SOLUTION
Assumptions
1.Asset is purchased on the first day of year 1
2.Tax is payable 1 year in arrears
1 2 3 4
WDV 100,000 75,000 56,250 42,187
Depreciation @ 25% 25,000 18,750 14,063
Proceeds (20,000)
Balancing Allowance 22,187
Tax Shield @ 33% 8,250 6,188 4,641 7,322
NET PRESENT VALUE
0 1 2 3 4 5
Cashflows (100,000) 30,000 40,000 50,000 40,000 -
Tax @ 33% (9,900) (13,200) (16,500) (13,200)
Tax Depreciation Allowance 8,250 6,188 4,641 7,322
Scrap 20,000
FCF (100,000) 30,000 38,350 42,988 48,141 (5878)
NPV @ 12% = K15,247
OR
0 1 2 3 4 5
CASH FLOWS (100,000) 30,000 40,000 50,000 40,000 -
DEP 25,000 18,750 14,063 22,187
PROFIT 5,000 21250 35937 17813
TAX (33%) 1,650 7,013 11,859 5878
FCF (100,000) 30,000 38350 42988 48141 (5878)

MUTUALLY EXCLUSIVE PROJECTS WITH UNEQUAL LIVES
LIFE NPV
PROJECT A 5 Years K10,000
PROJECT B 5 Years K12,000
LIFE NPV
PROJECT A 5 Years K10,000
PROJECT B 7 Years K12,000
It is possible for a firm to face a scenario where multiple capital projects show
a positive net present value, but only enough resources are available to fund
one of them. In this situation, the projects are considered to be mutually
exclusive.
Analyzing mutually exclusive projects can be complicated when the projects
have unequal lifetimes and simply choosing the project with the highest NPV
can lead to an incorrect decision.
There are two methods for choosing between mutually exclusive projects
with unequal lives: Equivalent Annual Annuity Approach
and Least Common Multiple of Lives Approach also called replacement chain
method
The replacement chain method is a capital budgeting decision
model that compares two or more mutually exclusive capital
proposals with unequal lives. The replacement chain method
involves repeating shorter projects multiple times until they reach
the lifetime of the longest project.
The replacement chain method is used in capital budgeting to rank mutually
exclusive projects with unequal life spans. As the first step, it is necessary to
determine the minimum common multiple life span for all projects under
consideration. As the second step, each of the projects should be repeated until
the minimum common multiple life span is reached. For example, if Project X has
a life span of 4 years and the life span of Project Z is 6 years, the shortest
common multiple life span is 12 years, which means that Project X should be
repeated 3 times and Project Z 2 times.
Assumptions
The replacement chain method is based on the following assumptions:
•any project can be repeated exactly at its replication date
•the cost of capital used as the discount rate remains constant
•all cash inflows and outflows remain the same at any iteration
NPV Rule
The net present value is used as a screening criterion when the replacement
chain method is applied, but the decision is based on the total NPV of all
iteration being performed. So the project with the highest total NPV should be
accepted.
Cost of capital is 15%
Year 0 1 2 3 4 5 6
Project L -K10,000 2,500 2750 3,000 3250 3750 3,500
Project S -K10,000 5,250 4,750 4,500
The life span of Project L is 6 years and 3 years for Project S, so the minimum
common multiple lifespan is 6 years, which means that Project S should be repeated
twice while Project L only once. To rank both projects, we need to use the NPV rule.
What is the NPV For each project?

Year 0 1 2 3 4 5 6
Project L -K10,000 2,500 2750 3,000 3250 3750 3,500
Project S -K10,000 5,250 4,750 4,500
Year 0 1 2 3 4 5 6
Project L -K10,000 2,500 2750 3,000 3250 3750 3,500
Project S -K10,000 5,250 4,750 -5,500 5,250 4,750 4,500
NPVL = 1,461.61
NPV S =1,849.33
Choose project S because it has a higher NPV
EAA = NPV/PVIFA = 1,461/1-1.15^-6/0.15 =386
1,115/1-1.15^-3/0.15 =488
K2,500 K2,750 K3,000 K3,250 K3,750 K3,500
NPVL = - =
+ + + + +
K10,000 + (1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 (1 + 0.15)5 (1 + 0.15)6 K1,461.61
The NPV of Project L is K1,461.61
The NPV of Project S is K1,115.72
The NPV for S is for 3 years.If the project is repeated that is for 6 years,what is
the NPV
The NPV for S is for 3 years.If the project is repeated that is for 6 years,which
project should be picked
NPVL = 1,461.61(1.15)^6 =K2575

1.15^6-1
NPVS = 1,115.72(1.15)^3 = K3261

1.15^3-1
We extend the lifespan for project S to 6 years
Year 0 1 2 3 4 5 6
Project L -K20,000 2,500 2750 3,000 3250 3750 3,500
Project S -K10,000 5,250 4,750 4,500
-10,000 5250 4750 4500
Project S -K10,000 5250 4,750 -5500 5250 4750 4500
K5,250 K4,750 K4,500
NPVS1 = -K10,000 + + + = K1,115.72
(1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3
-K10,000 K5,250 K4,750 K4,500

=
NPVS2 = + + +
(1 + 0.15) 3
(1 + 0.15)
4
(1 + 0.15)
5
(1 + 0.15)6 K733.61
The new NPV is K1,849.33
Thus, the total NPV of Project S is K1,849.33 and is greater than the K1,461.61 of Project L. So, if
the replacement chain method is applied, Company C should accept Project S.
Replicating projects in perpetuity
If the minimum common multiple life span is a great number, the replacement chain method
becomes cumbersome. For example, the projects with life spans of 7 and 9 years have a
minimum common multiple lifespan of 63 (7×9), which means that the 7-year project should be
repeated 9 times, and the 9-year project should be repeated 7 times.
This problem is solved by assuming that the projects are repeating in perpetuity. In such a
scenario, the formula to calculate the NPV of a project is as follows:
NPVP = NPV1 ((1 + r)N

(1 + r)N - 1
Here NPV1 is the net present value of a project at the initial replication, r is the cost of
capital, and N is the life span of the project in years.
For example, there are two mutually exclusive projects: Project S with an NPV of
K450,000 and a life span of 7 years and Project L with an NPV of K475,000 and a life
span of 9 years. They have a common cost of capital of 11%. If both of them are
replicated in perpetuity, which project should be chosen?

(1 + r)N - 1
(1 + 0.11)7
NPVS = K450,000 = K868,153
(1 + 0.11)7 - 1
(1 + 0.11)9
NPVL = K475,000 = K779,871
(1 + 0.11)9 - 1
In such a situation, Project S should be accepted.
Disadvantages
The key disadvantage of the replacement chain method is assuming that any project can be
repeated exactly. In fact, it is unlikely that the cost of capital and cash flows remain the same
at each replication.
Equivalent Annual Annuity (EAA) Approach
The EAA value represents the required size of an annual payment over an
asset’s life to make the present value of the project’s operating cash flows
equal to the net present value, when the cost of capital is applied as the
discount rate.
Year 0 1 2 3 4 5 6
Project L -K10,000 2,500 2750 3,000 3250 3750 3,500
Project S -K10,000 5,250 4,750 4,500
Using Equivalent Annual Annuity (EAA) method, which project would you pick.
Project L: 1,461.61 = A(1-(1.15)^-6

0.15
A = 1461.61
1-1.15^-6 EAA = NPV/PVIFA
0.15
AL= 386
AS =489
Choose project S because it has a higher annual cash inflow.

EQUIVALENT ANNUAL COST (EAC)
At some stage you have probably bought an asset such as a car, a washing machine or
a computer and you may have considered how long you should keep that asset prior to
replacing it. If the asset is kept for a longer period its initial cost, less any residual value,
is spread over more years which is likely to reduce your cost per year of ownership.
However, as the asset ages it is likely to require more and more maintenance and may
operate less effectively which will increase your costs per year. Determining the optimal
time to replace the asset (the optimal replacement cycle) is difficult.
Companies also face exactly the same asset replacement decisions. However as the
amounts involved can often be very significant, making decisions based on ‘gut feel’ is
not really accurate enough. The calculation of equivalent annual costs is a tool that can
be used to assist in this decision-making process.
The equivalent annual cost method involves the following steps:
•Step 1 – Calculate the net present value (NPV) of cost for each
potential replacement cycle.
•Step 2 – For each potential replacement cycle an equivalent annual
cost is calculated.
•The decision – The replacement cycle with the lowest equivalent
annual cost may then be chosen, although other factors may also
have to be considered.
EXAMPLE 1
A machine has a cost of K3,500. The annual maintenance costs of the
machine are forecast to be K900 in the first year, K1,000 in the second
year and K1,200 in the third year of ownership.
The residual value of the machine is expected to be K2,100 after two
years and K1,600 after three years.
The cost of capital of the company is 11% per year.
Calculate the optimal replacement cycle for the machine.
Year 0 1 2 3
Cashflows (K3,500) (900) (1,000) (1,200)
Residue value 2,100 1,600
Net cashflows (Y2)(K3,500) (900) 1,100
Net cashflows (Y3)(K3,500) (900) (1,000) 400
Cost of capital 11%

NPV Y2 (K3418.05)
NPV Y3 (K4829.93)
NPV Y2 (K3418.05) EAC = 3418.05 = (K1996)
PVIFA,2,11%
NPV Y3 (K4829.93) 4829.93 = (K1976)

PVIFA,3,11%
Step 1 – Calculate the NPV of cost for each potential replacement cycle.
As we have not been given the residual value after one year of ownership, we cannot
calculate an NPV of cost for a one-year replacement cycle. Hence, our decision here will be
between a two- or three-year replacement cycle.
NPV of cost – two-year replacement cycle:
Here we evaluate all the cash flows associated with buying and keeping the asset for two
years.
Time 0 1 2
Initial cost (3,500)
Maintenance (900) (1,000)
Residue 2,100
Net cash flows (3,500) (900) 1,100
11% Discount factors 1 0.901 0.812
Present values (3,500) (811) 893
Net present value (3,418)

NPV of cost – three-year replacement cycle:
We now evaluate all the cash flows associated with buying and keeping the asset for three years.
Year 0 1 2 3
Initial cost (3,500)
Maintenance (900) (1,000) (1,200)
Residue Value 1,600
Net Cashflow (3,500) (900) (1,000) 400
11% Discount factors 1 0.901 0.812 0.731
Present values (3,500) (811) (812) 292
NPV (4,831)
The two NPVs calculated should not be compared as quite
obviously buying and keeping an asset for a longer period is
likely to cost more than buying and keeping it for a shorter
period as there is less benefit to the owner. This has proved to
be the case here. In order to make a fair comparison we must
calculate the equivalent annual costs

Step 2 – For each potential replacement cycle an equivalent annual cost is calculated.
The costs calculated in Step 1 are spread over the period for which they will give benefit.
Hence, the NPV of cost for the two-year cycle is spread over two years and the NPV of cost for
the three-year cycle is spread over three years. This is done by using annuity factors to turn
each NPV of cost into an equivalent annual cost (EAC) at the end of each year of ownership.
Remember if you have equal annual cash flows for a number of years and want to calculate a
present value (PV) you must multiply the annual cash flow by an annuity factor: so to calculate
the equivalent annual cost or EAC from an NPV of cost we must divide by the relevant annuity
factor.
EAC – two-year cycle:
As the NPV of cost of K3,418 will give the benefit of ownership for two
years, we divide by the two-year annuity factor at the 11% cost of
capital to get the EAC.
EAC = K3,418/1.713 = K1,995 per year
This is the equivalent annual cost at time 1 and time 2 which equates to
an NPV of cost of K3,418
Two year annual factor = 1-r^-2/r
Two year Annuity factor at 11% = [1-(1.11)^-2]/0.11= 1.712523334

EAC – three-year cycle:
As the NPV of cost of K4,831 will give benefit for three years, we divide by the
three-year annuity factor at the 11% cost of capital to get the EAC.
EAC = K4,831/2.444 = K1,977 per year
This is the cost at time 1, time 2 and time 3 which equates to an NPV of cost of
K4,831.
The decision:
As the calculated equivalent annual costs are both annual costs,
they can be compared to come to a decision.
Hence, as an annual cost of K1,977 is less than an annual cost
of K1,995, the three-year replacement cycle is said to be the
optimal replacement cycle.
Weaknesses
Having worked through an example we should now consider the weaknesses of the approach we have used. These
include the following:
1.Our analysis has ignored the impact of taxation.
Both buying an asset and incurring a maintenance cost will cause tax cash flows. While these cash flows could be
included they would add to the complexity of the calculation. Past exam questions have specifically excluded the
impact of taxation on the cash flows.
2.Our analysis assumes that we can replace like with like.

Our analysis has assumed that the asset can be replaced by exactly the same asset in perpetuity. In reality, this will
not be possible as assets are constantly developing. Even if you replace your car with exactly the same model after a
number of years the new car will undoubtedly have improvements and other differences to the old one. In our
worked example above, if we were to imagine that the asset was a computer then although the calculated optimal
replacement cycle is three years, the difference in cost between the two- and three-year replacement cycles is
small. Hence, we might decide to use a two-year replacement cycle as we would then benefit from having a new,
more up-to-date computer with more functionality on a more regular basis
3.Our analysis assumes that we will want to replace like with like.
Additionally the analysis assumes we will want to replace the asset with the same asset in
perpetuity. In reality, business needs develop and when it becomes time to replace an asset a
company may want to acquire a different asset with different functionality. For instance, a
company may want an asset with greater capacity due to growth in their business.
4.Our analysis has ignored inflation.
Different cash flows may suffer from different specific inflation rates and as a result our analysis
may not be correct. For instance, the initial cost of assets often inflates quite slowly as
manufacturers find more efficient ways of production. However, maintenance costs often
inflate much more quickly as maintenance is often labour-intensive and labour costs often grow
quickly. This differential between the inflation rates of different cash flows means that an
alternative method, which you are not required to know, should be used. If all the cash flows
inflate at one rate then the EAC method can be used with real cash flows and a real cost of
capital.
Equivalent annual benefit
If a company is faced with mutually exclusive projects, where only one out of a number of
projects can be accepted, then the general rule is that the company should choose the project
that generates the highest NPV as this creates the biggest increase in shareholder wealth.
However, if the situation is such that it is anticipated that the same projects could be repeated
in perpetuity and the projects have different lives then the equivalent annual benefit
approach can be used. This is simply a further variation on the equivalent annual cost
approach and is demonstrated in the following example.
EXAMPLE 2
Two mutually exclusive projects are being considered:
•Project A has an NPV of K47m and is expected to last three years.
•Project B has an NPV of K58m and is expected to last four years.
It is anticipated that if either project is chosen it will be possible to repeat it for the
foreseeable future.
The cost of capital of the company is 13% per year.
Calculate which project the company should accept.

(1 + r)N - 1
Step 1 – Calculate the NPV for each potential project.
This would involve calculating the NPV of each project as normal. This is already done
for us to save time!
Project A – K47m
Project B – K58m
Step 2 – Calculate the equivalent annual benefit for each potential project.
This is calculated using annuity factors in exactly the same way as an EAC is calculated.
Hence, the NPV of Project A is divided by the 3-year annuity factor at the cost of capital
of 13% as the project life is three years. For Project B the 4-year annuity factor is used
to reflect the four-year life of the project.
Project A – equivalent annual benefit = K47m/2.361 = K19.9m per year
Project B – equivalent annual benefit = K58m/2.974 = K19.5m per year

The decision:
As Project A has the highest equivalent annual benefit it should be chosen instead of Project B,
which has the higher NPV, so long as the project can be repeated for the foreseeable future. This
result arises because although the shorter project produces the lower NPV that NPV will be
obtained more frequently than the NPV of the longer project.
The equivalent annual benefit technique suffers similar weaknesses to the EAC technique.
Example
Company C is considering two mutually exclusive projects with the same initial investment of
K20,000,000. The life span of Project L is 5 years, and the life span of Project S is 4 years. The
cost of capital is 12%.
Cash flows at
the end of
Initial Cost, CF0 relevant year,
CFt
0 1 2 3 4 5
Project L -K20,000,000 K5,000,000 K5,500,000 K7,500,000 K6,000,000 K5,500,000
Project S -K20,000,000 K6,250,000 K7,000,000 K7,500,000 K7,250,000
Which project would be chosen using

(a) EAA Method
(b)Replacement chain Method
As the first step, we need to calculate the NPV of both projects.
K5,000,000 K5,500,000 K7,500,000 K6,000,000 K5,500,000
NPV of
=
Project L = -
+ + + + K1,121,160.
K20,000,000
08
+ (1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5
K6,250,000 K7,000,000 K7,500,000 K7,250,000

NPV of Project S
= -K20,000,000 + + + = K988,111.64
+ (1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4
The second step involves calculating the equivalent annual annuity for both projects.
NPV × r
EAA =
1 - (1 + r)-N
Decision Rule
When several mutually exclusive projects with unequal life spans are compared, the
one with the highest EAA value should be accepted.
K1,121,160.08 × 0.12
EAA of Project L = = K311,020.72
1 - (1 + 0.12)-5
K988,111.64 × 0.12
EAA of Project S = = K325,320.38
1 - (1 + 0.12)-4
Project S has a higher EAA value than Project L, so Company C should accept it.
EAA
NPV of an Ordinary Perpetuity =
r
If both annuities are perpetuities, their present value will be as follows:
K311,020.72
NPVL = = K2,591,839.30
0.12
K325,320.38
NPVS = = K2,711,003.16
0.12
CAPITAL RATIONING
A restriction on an enity’s ability to invest capital funds, caused by
an internal budget ceiling being imposed on such expenditure by
the management (soft capital rationing) or by external limitations
being applied to the entity, as when additional borrowed funds
can not be obtained (hard capital rationing).
Capital rationing is a process that companies use to decide

which investment opportunities make the most sense for
them to pursue. The typical goal of capital rationing is to direct
a company's limited capital resources to the projects that are
likely to be the most profitable.
Types of Capital Rationing – Hard and Soft
Capital rationing is the strategy of picking up the most profitable
projects to invest the available funds. Hard capital rationing and
soft capital rationing are two different types of capital rationing
practices applied during capital restrictions a company faces in
its capital budgeting process. In efficient capital markets, a
company aims to maximize the shareholder’s wealth and its value
by investing in all profitable projects.
Soft rationing is when the firm itself limits the amount of capital
that is going to be used for investment decisions in a given time
period.
Hard capital rationing or “external” rationing occurs when the

company faces problems in raising funds in the external equity
markets. This can lead to a shortage of capital to finance the new
projects in the company.
Single-period capital rationing occurs when there is a
shortage of funds for one period only.
Multi-period capital rationing is where there will be a shortage of

funds in more than one period.
Single-period capital rationing.

(i) If projects are mutually exclusive,pick the project with the
largest positive NPV
(ii)If projects are divisible,rank projects via the profitability index
(iii)If projects are indivisible,rank projects and combinations of
projects via total NPV.The optimal solution is found by using
trial and error
Joy Plc has K60,000 available to invest at time zero.Data is available about the
following four project
PROJECT
A B C D
Initial cost 30,000 20,000 40,000 10,000
Present value of subsequent
Cashflows 52,000 25,000 56,000 18,000
Assume that any surplus funds cannot be invested elsewhere

Determine the optimum investment plan for the company if:
(i)Projects are mutually exclusive (3Marks)
(ii)Projects are divisible (5 Marks)
(iii)Projects are not divisible (5 Marks)
PROJECT
A B C D
Initial cost 30,000 20,000 40,000 10,000
Present value of subsequent
Cashflows 52,000 25,000 56,000 18,000
NPV 22,000 5,000 16,000 8,000
(a) Pick Project A with the largest NPV

(b) PROJECT
A B C D
PV 52,000 25,000 56,000 18,000
Initial cost 30,000 20,000 40,000 10,000
PI 1.73 1.25 1.40 1.80
Rank 2 4 3 1
Undertake project D,A and half of C with NPV = 35

(C ) Projects not divisible
Trial and error
NPV
Project A+B+D 35
B+C 21
C+D 24
Choose A,B and D
P co has an asset which costs K20,000 and a useful life of 3 years.The company’s
cost of capital is 5%. Asset’s cash operating costs for each year and the resale
value at the end of each year are as below;
Year 1 Year 2 Year 3
K K K
Cash operating costs 9,000 10,500 11,900
End of year resale value 14,000 11,500 8,400
The asset should be replaced after ____________ Years
REAL OPTIONS
A real option gives a firm's management the right, but not the obligation to
undertake certain business opportunities or investments. Real option refer to
projects involving tangible assets versus financial instruments. Real options can include
the decision to expand, defer or wait, or abandon a project entirely.
In the context of investment decisions there are three options to be
considered
(a)Strategic Investment Options (Financial Call Option) also called follow-on
Options
(b)Timing Options (Financial Call Option) also called wait and see options
(c)The abandonment Option (Financial Put Option)
What is an option?
• From a dictionary:
• 1. “one thing which can be chosen from a set of
possibilities”
• 2. “the right to buy something in the future”
• They are traded both on exchanges and in the OTC

market.
Two types of options
• Call option: It gives to holder the right but not the
obligation to buy the underlying asset at a future date at a price
specified today.
• Put option: It gives to holder the right but not the
obligation to sell the underlying asset at a future date at a price
specified today.
• The predetermined price is called the exercise price and the date
at which the contract ceases to exist is called expiration date or
maturity.
• American options can be exercised at any time up to maturity
• European options can be exercised only at the expiration itself
• Note that the terms American and European do not refer to the
location of the option or the exchange
• Most of the options that are traded on exchanges are American
You agree to buy a vehicle from Ms Ngibo at K80,000.Find the value of
this call option if the market prices of the vehicle at the time you are to
get the vehicle is
A B C D
Market Price 65,000 70,000 80,000 90,000
Value of call option
You agree to sell a vehicle to Ms Ngibo at K80,000.Find the value of this

put option if the market prices of the vehicle at the time you are to sell
the vehicle is
A B C D
Market Price 65,000 70,000 80,000 90,000
Value of put option
Key terminology
• Strike or Exercise Price
– The price at which the underlying asset may be
bought/sold in an option contract (K, X)
• Exercise
– The ‘act’ of using the right given by the option
• Premium
– The price of an option. The holder pays it and the
writer receives it (c,C, p, P)
• Expiration date
– The date the option contract expires (T)
Key terminology cont’d
• Holder
– An investor who buys the option (takes a “long” position)
– Has to pay a certain amount of money – Premium – in order
to obtain the right to buy (call option) or sell (put option) the
underlying asset in the future
• Writer
– An investor who sells the option (takes a “short” position)
– Receives a certain amount of money – Premium – for selling
the right to buy (call) or sell (put) the underlying asset in the
future to the option’s holder
• Holders and Writers stand in opposite positions
Option positions
• An option contract has two sides
• One party buys the option (long position) and
the other sells the option (short position)
• The possible positions in options are
– Long position in a call option
– Short position in a call option
– Long position in a put option
– Short position in a put option
Pay offs – outcomes – Option classifications
• In the Money (ITM)

– Would lead to a cash inflow if exercised immediately
• At the Money (ATM)
– Would lead to no cash flow if exercised immediately
• Out of the Money (OTM)
– Would lead to a cash outflow if exercised immediately
• Real examples:
http://uk.finance.yahoo.com/q/op?s=AAPL
Hedging example- Answer
• The firm will choose not to exercise the
options and to buy the £1m directly in the
foreign exchange spot market (cash market) at
$1.2/£.
• The options contracts therefore expire
worthless.
• The firm can simply walk away from the
worthless option contracts.
OPTION VALUATION
Option pricing theory estimates a value of an options contract by assigning a price,
known as a premium, based on the calculated probability that the contract will finish in
the money (ITM) at expiration.
Some commonly used models to value options are

1.Black-Scholes
2.binomial option pricing
3.Monte-Carlo simulation
Option pricing theory uses 5 variables to theoretically value an option.
1) stock price
2)exercise price
3)Volatility
4) interest rate
5)time to expiration
The binomial option pricing model is an options valuation method
developed in 1979. The binomial option pricing model uses an
iterative procedure, allowing for the specification of nodes, or points
in time, during the time span between the valuation date and the
option's expiration date
The Black-Scholes model is another commonly used option pricing model. This model
was discovered in 1973 by the economists Fischer Black and Myron Scholes. Both
Black and Scholes received the Nobel Memorial Prize in economics for their
discovery.
The Black-Scholes model was developed mainly for pricing European options on
stocks. The model operates under certain assumptions regarding the distribution of
the stock price and the economic environment. The assumptions about the stock
price distribution include:
•Continuously compounded returns on the stock are normally distributed and
independent over time.
•The volatility of continuously compounded returns is known and constant.
•Future dividends are known (as a dollar amount or as a fixed dividend yield).
The assumptions about the economic environment are:
•The risk-free rate is known and constant.
•There are no transaction costs or taxes.
•It is possible to short-sell with no cost and to borrow at the risk-free rate.
Nevertheless, these assumptions can be relaxed and adjusted for special
circumstances if necessary. In addition, we could easily use this model to price
options on assets other than stocks (currencies, futures).
The main variables used in the Black-Scholes model include:
•Price of underlying asset (S) is a current market price of the asset
•Strike price (K) is a price at which an option can be exercised
•Volatility (σ) is a measure of how much the security prices will move
in the subsequent periods. Volatility is the trickiest input in the
option pricing model as the historical volatility is not the most
reliable input for this model
•Time until expiration (T) is the time between calculation and an
option’s exercise date
•Interest rate (r) is a risk-free interest rate
Dividend yield (δ) was not originally the main input into the model.
The original Black-Scholes model was developed for pricing options
on non-paying dividends stocks.
The Black-Scholes Formula
The Black-Scholes model is perhaps the best-known options pricing method. The
model's formula is derived by multiplying the stock price by the cumulative standard
normal probability distribution function. Thereafter, the net present value (NPV) of the
strike price multiplied by the cumulative standard normal distribution is subtracted from
the resulting value of the previous calculation.
In mathematical notation:
Value of a call option =[delta X share price] – [bank loan]

=[N(d1) x P ] – [N(d2) x PV(EX)]
Where N(d1) = Cumulative normal density function of (d1)
P = Stock Price
N(d2) = Cumulative normal density function of (d2)
PV(EX) = Present Value of Strike or Exercise Price = EXe^-rt
d1 = in[P/PV(EX) + δ√t
δ√t 2
d2 = d1-δ√t
The Black-Scholes
Find the value of a call option with the following features
1.Current stock price is K400
2.Exercise price is K400
3.Standard deviation on the stock is 32%
4.Time to maturity is 6 months
5.Interest rate per year is 4%
Step 1 Calculate the present value of the exercise price
400e^-0.04x0.5 = 392.08
Step 2: Calculate d1
d1 = In[400/392.08] + 0.32√0.5 =0.2015
0.32√0.5 2
Step 3: Calculate d2
d2 = 0.2015 - 0.32√0.5 = -0.025
Step 4: Find N(d1) and N(d2)
N(d1) =N(0.2015) = 0.5851
N(d2) = N(-0.025) = 0.4901
Step : Find the value of option
Option value = [0.5851 x 400] – [0.4901 x 392.08] =
K39.8
A company is considering a project. It has only 10%
debt in its capital structure, with a pre-tax cost of 8%. It
has a beta of 1.4; the risk free rate is 5%, and the
equity risk premium is 6.5%. The project would be 90%
equity funded. This would require an investment of K700
000 at the end of year 5 and this would produce a
stream of cash flows with a present value of K650 000 at
the end year 5. The volatility of the cash flows is
35%.The Company considers this project to be a real
option. Assume WACC is 13.25%. Find the value of this
real option. (25 Marks)
The Black Scholes option pricing model needs to be used here. It is contained in the formula sheet.
The present value of the year 5 cash flow needs to be obtained before calculating the option price.
We need to use the Black Scholes option pricing formula:
WACC = 13.25%
S0 348.9 650 is discounted by WACC, 5 years
X 700
T 5
rf 5%
vol 35%
d1 calc
ln(S0/X) = –0.69625
rf × T = 0.25 Top line = –0.44625
vol × (T0.5) = 0.782624 Bottom line = 0.783
divided = –0.5702
plus
0.5 × vol × √(T) = 0.3913 d1 = –0.1789
N(d1) = 0.42902
d2 calc
= d1 – vol × (T0.5) = d2 = –0.9615
N(d2) = 0.16815
Formula = S0 × N(d1) – Xe-rfT × N(d2)
S0 × N(d1) = 149.69
Xe-rfT = 545.16 this is the PV of the exercise price – discounted by 5 years:
Xe-rfT × N(d2) = 91.67 e = 2.71828
on calculator, press shift e, then 1 =. This gives 2.71828
Call price = 58.02 Take the 2.71828 to the power of (–0.05 × 5) = 0.7788
Multiply 700 by 0.7788 = 545.16
QUESTION
The Crammond Manufacturing Plc has a number of factories around the country and it
needs to upgrade the water purification systems in its factories.
The company is looking at two possible systems: the first, the Titan, will cost K120 000
per installation and will have an operating cost of K11 000 annually; the other system,
the Colossus, will cost K225 000 per installation and has an annual operating cost of
K6000 per installation. Both systems will be depreciated straight line to zero over their
working lives. The Titan will be replaced every 5 years and the Colossus will be replaced
every 8 years. The company faces a tax rate of 30%.This is a normal project for the
company, which has an asset beta of 0.9 and an equity beta of 1.0875. The company is
80% funded by equity and has just paid an annual dividend of 23.4Ngwee and its share
price is 260Ngwee. The risk free rate of interest is 4.35% and the stock market risk
premium is 5.5%. Ignore inflation.
Required:
a. Calculate the cost of capital that would be used to evaluate this investment decision.
(5 Marks)
b. Work out the equivalent annual cost for each machine and explain which system you
would choose. (15 Marks)
Monte-Carlo Simulation
Monte-Carlo simulation is another option pricing model.
The Monte-Carlo simulation is a more sophisticated
method to value options. In this method, the possible
future stock prices are simulated and then use them to find
the discounted expected option payoffs.
WORKING CAPITAL MANAGEMENT
Working capital is capital that is represented by the net current assets which is available for day-to-day
operating activities. It normally includes Inventories, trade receivables, cash and cash equivalents less
trade payables. Each of these components needs a control system but it is also essential to consider
working capital as a whole and how these components fit together.
Working capital management is concerned with the liquidity position of the company so the main aim is to
generate cash as quickly as possible.
Working capital management is crucial to the effective management of a business because

a) Current assets comprise over half the assets of some companies
b) A failure to control working capital, and their liquidity, is a major cause of business failure
When discussing working capital, two questions must be considered.
i. How much to invest in working capital

ii. How to finance it
Businesses must however avoid the extremes which are over trading on one hand and over-
capitalisation on the other.
 Overtrading is when a company has insufficient working capital base to support the level of
activity. Simply put, overtrading is trading without having enough capital. Overtrading can also
be described as under-capitalization. A company which is under-capitalized will try to do too
much with the limited amount of capital which it has. For example it may not maintain proper
stock of inventories. Also it may not extend much credit to customers and may insist only on
cash basis sales. It may also not pay the creditors on time. One can detect cases of overtrading
by computing the current ratio and the various turnover ratios. The current ratio is likely to be
very low and turn over ratios are likely to be very higher than normally in the industry
concerned.
 Over-capitalization is a situation where the company has too much working capital leading to
inefficiency. Simply put, over capitalization is having too much capital or not enough trade. It
means keeping funds idle and not using them properly. This is due to the under employment of
assets of the business, leading to the fall of sales and results in financial crises. This makes the
business unable to meet its commitments and ultimately leads to forced liquidation. The
symptoms in this case would be a very high current ratio and very low turnover ratio. Under-
trading is an aspect of over-capitalization and leads to low profit.
The components of working capital
Short-term, or current, assets and liabilities are collectively known as working capital. The table below
gives a breakdown of current assets and liabilities for Dynamic manufacturing Company.
Current Assets K’000 Current Liabilities K’000

Cash 114 Short-term loans 203
Marketable securities 89 Accounts payable 303
Accounts receivable 481 Accrued income taxes 46
Inventories 468 Current payments due on long-term debt 68
Other current assets 201 Other current liabilities 427
Total 1,352 Total 1,046
Total current assets are K1, 352 million and total current liabilities were K1, 046 million
Cash
Raw Materials
Receivables
Inventories
Finished
Goods
Inventories
If you prepare the firm’s balance sheet at the beginning of the process, you see cash (a current asset).
If you delay a little, you find the cash replaced first by inventories of raw materials and then by
inventories of finished goods (also current assets). When the goods are sold, the inventories give way
to accounts receivable (another current asset) and finally, when the customers pay their bills, the firm
takes out its profit and replenishes the cash balance.
A firm’s operating cycle (OC) is the time from the beginning of the production process to collection of
cash from the sale of the finished product. The operating cycle encompasses two major short-term
asset categories, inventory and accounts receivable. It is measured in elapsed time by summing the
average age of inventory (AAI) and the average collection period (ACP):
However, the process of producing and selling a product also includes the purchase of
production inputs (raw materials) on account, which results in accounts payable. Accounts
payable reduce the number of days a firm’s resources are tied up in the operating cycle. The
time it takes to pay the accounts payable, measured in days, is the average payment period
(APP). The operating cycle less the average payment period yields the cash conversion cycle. In
other words, first the raw materials must be purchased, processed, and sold, and then the bills
must be collected. However, the net time that the company is out of cash is reduced by the time
it takes to pay its own bills. As stated above the length of time between the firm’s payment for
its raw materials and the collection of payment from the customer is known as the firm’s cash
conversion cycle (CCC).
To calculate the operating and the cash cycle, we need to know how to find the values
of Average age of inventory (Inventory period), Average collections period (accounts
receivable period) and Average payment period (accounts payable period)
The following data has been extracted from Spinot Company
Income Statement Data Statement of Financial Position Data
Year Ending, End of First Quarter End of First Quarter
First Quarter 1999 1998 1999
K’ Billion K’ Billion K’ Billion
Sales 3,968 Inventory K 470 K468
Cost of goods sold 3,518 Accounts receivable 471 481
Accounts payable 304
303
We can use the data in the table above to answer four questions.
 How long on average does it take Spinot Company to produce and sell their product?
 How long does it take to collect bills?
 How long does it take to pay bills?
 And what is the cash conversion cycle?
The delays in collecting cash are given by the inventory and receivables period. The delay in paying bills is
given by the payables period. The net delay in collecting payments is the cash conversion cycle.
It is therefore taking this company an average of 2 months from the time they lay out money on inventories to
collect payment from their customers.
CASH MANAGEMENT
Cash is the lifeblood of economic activity. Without cash, business cannot
operate. Firms maintain cash balances for four primary purposes
1. Transactions needs
2. Precautionary purposes
3. Speculative purposes
4. Compensating balance purposes
Firms require cash balances to pay balances owed to suppliers, wages owed to employees, taxes
payable to governments, etc. Cash balances maintained to conduct such transactions reflect the
firm’s transactions demand for cash. This transactions demand for cash balances accounts for the
majority of balances maintained by most firms.
Some firms may maintain some cash balances for emergencies or simply to ensure that they
never run out. These precautionary balances or cash reserves usually account for a smaller
percentage of the total levels maintained by the firm.
In addition, many firms maintain speculative balances to enable themselves to quickly take
advantage of new investments, shifts in interest rates and fluctuations in exchange rates. For
example, when interest rates are low, firms maintain higher speculative cash balances; when
interest rates rise, firms commit their speculative balances to the higher yield securities.
Firms that maintain checking accounts with commercial banks are frequently required to
maintain minimum balances with their banks. These minimum balances, referred to as
compensating balances, are required to compensate commercial banks for the checking account
services they provide the firm or to avoid fees normally imposed for checking and other bank
services. Such compensating balances generally do not accrue interest or accrue interest at
OPTIMAL CASH BALANCES
After all this discussion, the question that should be in every student’s mind is “is there an
optimal cash balance that a firm should maintain”? Different companies in different industries
might prefer different optimal cash balances but there are some models that have been
developed to help calculate the optimal cash balance.
Perhaps, the more popular of the cash management models are based on the Baumol and
Miller-Orr models. As with all financial constructs, these cash management models require
several assumptions which are often not applicable in reality. In many cases, the fact that
certain assumptions may be violated in reality will barely affect the use or implications of
these models. However, if necessary, these models are simple and flexible enough to be easily
adapted to more realistic conditions. Equally important is that these models make it easy to
see how certain factors impact the firm’s optimal cash balances.
Both the Baumol and Miller-Orr models assume that the firm incurs an opportunity cost by
maintaining cash balances. That is, when the firm maintains a cash balance, it forgoes the
opportunity to invest money in interest or return-bearing assets. Thus, the firm's opportunity
cost is the foregone interest or returns on money it could have invested more profitably
elsewhere
Larger cash balances will imply larger foregone interest opportunity costs.
Secondly, these models assume that the firm incurs transactions costs when it
liquidates assets in order to obtain cash. (The Miller-Orr model assumes that
the firm also incurs transactions costs when it converts surplus cash to return-
bearing securities.) That is, when the firm sells assets (such as marketable
securities) to replenish its cash balances, it incurs a transactions cost (such as
a fixed brokerage fee). The more often the firm must transact to replenish its
cash balances, the higher will be its total transactions costs. Hence, these
models are structured to find the cash balance that minimizes the total costs
associated with maintaining and obtaining cash.
The Baumol Cash Management Model
This model applies the Economical Order Quantity (EOQ) model to cash. It assumes that
the cash requirements are funded by the sale of “parcels” of securities e.g. Treasury
bills. The model calculates the optimal size for the “parcel” of securities. This is known
as the economic transfer”. Under this model, the optimal cash order quantity is given by
following equation
Where
S= cash needs for the period
F= transaction costs (brokerage, commission etc) of selling a “parcel” of securities
H= opportunity cost of holding cash (interest forgone on securities)
Example
Bwalya plc requires K 6,000 per annum. Any cash raised will have an associated fixed
cost of K 300 and an interest rate of 15%. The interest rate on short-term securities is
10%.Advise Bwalya as to the level of finance it should raise at any one time.
Bwalya plc should raise this level of cash every 1.4 years
(8,485/6,000)
MILLER-ORR MODEL
This model sets out the upper and lower limits to the level of cash a firm should hold.
When these points are reached the firm either buys or sells short-term marketable
securities in order to reverse the trend of cash flows.
Steps involved in using the model are
i. Determine the lower level of cash the firm is happy to have. This is generally set at
a minimum safety, though in theory it could be zero
ii. Determine the variation in cash flows of the firm (perhaps over a 3 or 6 month
period)
iii.Calculate the spread of transactions, using the following formula.
iv.Calculate the upper limit=spread + lower limit

v. In order to minimise the costs of holding cash, securities should be sold when a
pre-calculated level is reached. This level is the sum of the lower limit and 1/3 of
the spread.
Maximum level
Minimum
Example
Pat ltd faces an interest rate of 0.5% per day and its brokers charge K 75
for each transaction in short-term securities. Their managing director has
stated that the minimum cash balance that is acceptable is K 2,000, and
that the variance of cash flows on a daily basis is K 16,000. What is the
maximum level of cash the firm should hold and at what point should it
start to purchase or sell securities?
In answering this question, let’s go through the steps that we discussed above
i. Determine the lower level of cash the firm is happy to have. The minimum cash
balance that has been stated by their managing director is K 2,000
ii. Determine the variation in cash flows of the firm (perhaps over a 3 or 6 month period).
This is also given as K 16,000
iii. Calculate the spread of transactions, using the following formula.
iv. Calculate the upper limit=spread + lower limit= 1,694 + 2,000= K 3,694
v. In order to minimise the costs of holding cash, securities should be sold when a pre-
calculated level is reached. This level is the sum of the lower limit and 1/3 of the
spread. = K 2,000 + (1/3 x K 1,694)= K 2,565
Thus the firm is aiming for a cash holding of K 2,565 meaning that if the balance of cash
reaches K 3,694 the firm should buy K 3,964 – K 2,565= K 1,129 of marketable
securities, and if it falls to K 2,000 then K 565 of securities should be sold.
MANAGEMENT OF INVENTORIES
The first component of the cash conversion cycle is the average age of inventory. The objective
for managing inventory, as noted earlier, is to turn over inventory as quickly as possible without
losing sales from stock-outs.
Reasons for holding Inventory include
i. To meet demand by acting as a buffer in times of unusually high consumption ( to reduce
stock outs)
ii. To ensure continuous production.
iii. To take advantage of quantity discounts at the point of purchase
iv. To buy in ahead of a shortage or ahead of a price rise
v. For technical reasons (e.g. Maturing whisky in casks or keeping oil in pipelines)
vi. To reduce ordering costs
Costs associated with inventory
Inventory does come with cost and the following are the main costs associates with
inventory
• Purchase price- This comprises the purchase price plus an unrecoverable tariffs and
taxes incurred in the procurement of inventory.
• Holding costs- This includes cost of capital tied up in the inventory, Insurance costs,
deterioration, obsolescence and theft, warehousing and stores administration
• Re-order costs- This includes transport costs and clerical and administration
expenses;
• Shortage costs- This encompasses production stoppages caused by lack of raw
materials, stock-out costs for finished goods (anything from a delayed sale to a lost
customer) and emergency re-order costs
• Systems costs- people and computers
Common techniques for managing inventory
Numerous techniques are available for effectively managing the firm’s inventory.
Here we briefly consider four commonly used techniques.
ABC System
The aim of the ABC system is to reduce the work involved in inventory control in a
business which may have several thousand types of inventory items.
A firm using the ABC inventory system divides its inventory into three groups: A, B,
and C. The A group includes those items with the largest monetary investment.
Typically, this group consists of 20 percent of the firm’s inventory items but 80percent of
its investment in inventory in terms. The B group consists of items that account for the
next largest investment in inventory. The C group consists of a large number of items
that require a relatively small investment. The inventory group of each item determines
the item’s level of monitoring.
Economic Order Quantity (EOQ) Model
The optimal order size for inventory items is the economic order quantity (EOQ)
model. The EOQ model considers various costs of inventory and then determines what
order size minimizes total inventory cost.
EOQ assumes that the relevant costs of inventory can be divided into order costs and
carrying costs. (The model excludes the actual cost of the inventory item.)
Graphically, the EOQ is depicted as follows
Example
Annual demand for material is 300 units, the ordering cost K2 per
order, the units cost K 20 each and it is estimated that the
carrying costs will be 15% per annum. Determine the EOQ and
the numbers of orders to be placed per year.
𝐸𝑂𝑄=
√
2𝑥2 𝑥300
3
=20𝑢𝑛𝑖𝑡𝑠
MANAGEMENT OF ACCOUNTS RECEIVABLES
The second component of the cash conversion cycle is the average collection period.
This period is the average length of time from a sale on credit until the payment
becomes usable funds for the firm. The average collection period has two parts. The
first part is the time from the sale until the customer mails the payment. The second
part is the time from when the payment is mailed until the firm has the collected funds
in its bank account. The first part of the average collection period involves managing
the credit available to the firm’s customers, and the second part involves collecting and
processing payments.
Credit selection and standards
Credit selection involves application of techniques for determining which customers should
receive credit. This process involves evaluating the customer’s creditworthiness and comparing it
to the firm’s credit standards, its minimum requirements for extending credit to a customer.
Five C’s of Credit
One popular credit selection technique is the five C’s of credit, which provides a framework for
in-depth credit analysis. Because of the time and expense involved, this credit selection method
is used for large-dollar credit requests. The five C’s are
1. Character: The applicant’s record of meeting past obligations.
2. Capacity: The applicant’s ability to repay the requested credit, as judged in terms of financial
statement analysis focused on cash flows available to repay debt obligations.
3. Capital: The applicant’s debt relative to equity.
4. Collateral: The amount of assets the applicant has available for use in securing the credit. The
larger the amount of available assets, the greater the chance that a firm will recover funds if
the applicant defaults.
5. Conditions: Current general and industry-specific economic conditions, and any unique
ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are the major source of unsecured short-term financing for
business firms. They result from transactions in which merchandise is purchased but no
formal note is signed to show the purchaser’s liability to the seller. The purchaser in
effect agrees to pay the supplier the amount required in accordance with
credit terms normally stated on the supplier’s invoice. The discussion of accounts
payable here is presented from the viewpoint of the purchaser.
Role in the Cash Conversion Cycle
The average payment period is the final component of the cash conversion cycle.The
average payment period has two parts: (1) the time from the purchase of raw materials
until the firm mails the payment and (2) payment float time (the time it takes after the
firm mails its payment until the supplier has withdrawn spendable funds from the firm’s
account).
The firm’s management of the time that elapses between its purchase of raw
materials and its mailing payment to the supplier is termed as accounts
payable management.
When the seller of goods charges no interest and offers no discount
to the buyer for early payment, the buyer’s goal is to pay as slowly as
possible without damaging its credit rating. This means that accounts
should be paid on the last day possible, given the supplier’s stated credit terms.
For example, if the terms are net 30, then the account should be paid 30 days
from the beginning of the credit period, which is typically either the date of
invoice or the end of the month (EOM) in which the purchase was made. This
allows for the maximum use of an interest-free loan from the supplier
and will not damage the firm’s credit rating (because the account is paid
within the stated credit terms). In addition, some firms offer an explicit or
implicit “grace period” that extends a few days beyond the stated payment
date; if taking advantage of that grace period does no harm to the buyer’s
relationship with the seller, the buyer will typically take advantage of the grace
period.
DIVIDEND POLICIES AND THEORIES
26/04/24
A company has 120,000 ordinary shares in issue. It is expected that total profit after
tax next year will be K600,000.The current company policy is zero dividends. Some
directors have complained that this zero dividend policy will affect the current share
price of K50.The company has proposed to give 75% of its retained earnings next year
as dividends. The company has accounting rate of return of 10%.
REQUIRED;
(a)With supporting calculations, explain the effect that the proposal will have on the
share price.
(5 Marks)
(b)Describe the dividend theory that your calculations in (a) above supports and
describe alternative theories related to dividends. (15 Marks)
Tailoka is a large company with gearing debt to equity ratio by market values of
1:2.The company’s profit after tax in the most recent year were K2,700,000 of which
K1,070,000 was distributed as ordinary dividends. The Company has 5 million issued
ordinary shares which are currently trading on the LUSE at K3.21.Corporate tax rate is
35% and corporate debt is risk free.Tailoka would want to undertake a new capital
project. The project is a major diversification into a new industry. You have been tasked
to provide estimates of the discount rate to be used in evaluating this new investment.
You have been given the following information showing estimates for the next five
years.
Growth rate of own company earnings 12%

Average Equity Beta coefficient 1.5
Average industry gearing (debt to equity) ratio 1:3 by market value
Average payout ratio 55%
Stock market total return on equity 16%
Growth rate of own company dividends 11%
Growth rate of own company sales 13%
Treasury bills 12%
Own company dividend yield 7%
Own company geared equity beta 1.4
Own company share price rise 14%
a) Calculate the company’s weighted Average Cost of Capital (WACC) using
the Capital Asset Pricing Model (CAPM). (5 Marks)
b) Calculate the company’s weighted Average Cost of Capital (WACC) using
the dividend valuation model (5
Marks)
c) Describe the situations under which the above two models will produce
same values for WACC (3 Marks)
d) Discuss any five (5) practical problems of using CAPM in investment
appraisal. (5 Marks)
e) Prepare a brief report recommending which discount rate you should use
for this investment.Information from parts (a),(b) and (c ) above may be
useful. (12 Marks)
[Total:30 Marks]
What is “distribution policy”?
• The distribution policy defines:

– The level of cash distributions to shareholders
– The form of the distribution (dividend vs. stock
repurchase)
– The stability of the distribution
Dilemma
• Should the firm use retained earnings for:
– Financing profitable capital investments?
– Paying dividends to shareholders?
• Dividend policy addresses this dilemma

• Comprised :
– Dividend payout ratio: the amount of dividends relative to net
income or EPS
– Dividend stability
Trade-off
• Dividend policies involve trade-offs:

Share return
P1 – P0 + D1
Return =
P0
P1 – P0 D1
= +
P0 P0
Capital Dividend
= gain + yield
Dilemma
Should the firm use retained earnings for:
• Financing profitable capital investments?

– Negligible external financing
• Paying dividends to shareholders?

Trade-off
P1 – P0 D1
Return = +
P0 P0
Capital Dividend
gain yield
If the firm pays dividends, shareholders receive an

immediate cash return, but the capital gains will
decrease, as this cash is not invested in the firm
Dividend policy
• How much of the firm’s earnings should

be distributed to shareholders as
dividends?
• How much should be retained for

capital investment?
The answer to one question largely
determines the answer to the other!
Dividend Yields for Selected Industries
Industry Div. Yield %
Airline 0.2
Software & Programming 0.3
Biotechnology & Drugs 0.3
Restaurants 1.0
Chemical Manufacturing 2.2
Paper & Paper Products 2.7
Electric Utilities 4.4
Tobacco 5.6
Source: Yahoo Industry Data
Do investors prefer high or low payouts?
There are three theories:
• Dividends are irrelevant: Investors don’t

care about payout.
• Bird-in-the-hand: Investors prefer a high
payout.
• Tax preference: Investors prefer a low
payout, hence growth.
Dividend Irrelevance Theory
• Investors are indifferent between dividends
and retention-generated capital gains. If they
want cash, they can sell stock. If they don’t
want cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic assumptions (no
taxes or brokerage costs), hence may not be
true. Need empirical test.
Bird-in-the-Hand Theory
• Investors think dividends are less risky

than potential future capital gains, hence
they like dividends.
• If so, investors would value high payout
firms more highly, i.e., a high payout
would result in a high P0.
Tax Preference Theory
• Low payouts mean higher capital gains.

Capital gains taxes are deferred.
• This could cause investors to prefer firms
with low payouts, i.e., a high payout
results in a low P0.
Implications of 3 Theories for Managers
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout
Which theory is most correct?
• Empirical testing has not been able to

determine which theory, if any, is correct.
• Thus, managers use judgment when
setting policy.
• Analysis is used, but it must be applied
with judgment.
What’s the “clientele effect”?
• Different groups of investors, or clienteles,

prefer different dividend policies.
• Firm’s past dividend policy determines its
current clientele of investors.
• Clientele effects impede changing
dividend policy. Taxes & brokerage costs
hurt investors who have to switch
companies due to a change in payout
policy.
What’s the “information content,” or
“signaling,” hypothesis?
• Investors view dividend changes as signals

of management’s view of the future.
Managers hate to cut dividends, so won’t
raise dividends unless they think raise is
sustainable.
• Therefore, a stock price increase at time of
a dividend increase could reflect higher
expectations for future EPS, not a desire for
dividends.
What’s the “residual distribution model”?
• Find the reinvested earnings needed for
the capital budget.
• Pay out any leftover earnings (the
residual) as either dividends or stock
repurchases.
• This policy minimizes flotation and equity
signaling costs, hence minimizes the
WACC.
325
Using the Residual Model to
Calculate Distributions Paid
Net Target Total

Distr. = income – equity capital
ratio budget
Distr. = Net – Required equity

income
326
Application of the Residual Distribution Approach: Data for SSC
• Capital budget: K112.5 million.

• Target capital structure: 20% debt, 80%
equity. Want to maintain.
• Forecasted net income: K140 million.K90
million,K160 million
• Number of shares: 100 million.
327
Application of the Residual Distribution
Approach
Number of shares 100 100 100

Equity ratio (ws) 80% 80% 80%
Capital budget K112.5 K112. K112.5
5
Net income K140.0 K90.0 K160.0
Req. equ.: (ws X Cap. Bgt.) K90.0 K90.0 K90.0
Dist. paid: (NI – Req. equity) K50.0 K0.0 K70.0
Payout ratio (Dividend/NI) 35.7% 0.0% 43.8%
Dividend per share K0.50 K0.00 K0.70
328
How would a change in investment
opportunities affect dividend under the
residual policy?
• Fewer good investments would lead to

smaller capital budget, hence to a higher
dividend payout.
• More good investments would lead to a
lower dividend payout.
Advantages and Disadvantages of the
Residual Dividend Policy
• Advantages: Minimizes new stock issues and

flotation costs.
• Disadvantages: Results in variable dividends,
sends conflicting signals, increases risk, and
doesn’t appeal to any specific clientele.
• Conclusion: Consider residual policy when
setting target payout, but don’t follow it rigidly.
Kasaka is listed company on Lusaka Stock Exchange operating
as a restaurant. The company has 120,000 ordinary shares in
issue. Due to mismanagement, the company experienced
losses for three years. As a result, the management introduced
zero dividend policy. The shareholders ushered in new
management and the company performance has improved.
Last year the company made a profit after tax of K350,000. It
is expected that total profit after tax next year will be
K600,000. Some directors have complained that this zero
dividend policy will affect the current share price of K50.The
company has proposed to give 75% of its retained earnings
next year as dividends. The company has accounting rate of
return of 10%.
The board of directors had the following views about dividends
 Some board members felt that the dividends were not necessary to
shareholders.
 Some board members felt that the company should introduce a stable
dividend policy
 Still other board members felt that dividends should only be given to
shareholders when the company has no new investments.
REQUIRED;
(a)Explain the effect that the three proposals could have on the share price
and state three advantages and three disadvantages of each proposal.
(13 Marks)
(b)Explain any three factors that directors of any company should consider
when developing a dividend policy for a company. (12
Marks)
[Total 25 Marks]
Stock Repurchases
• Repurchases: Buying own stock back from stockholders.
• Reasons for repurchases:
– As an alternative to distributing cash as dividends.
– To dispose of one-time cash from an asset sale.
– To make a large capital structure change.
– To use when employees exercise stock options.
333
The Procedures of a Repurchase
• Firm announces intent to repurchase stock.
• Three ways to purchase:
– Have broker/trustee purchase on open market
over period of time.
– Make a tender offer to shareholders.
– Make a block (targeted) repurchase.
• Firm doesn’t have to complete its announced intent
to repurchase.
334
Capital Budgeting Decision-making under Certainty:
A condition of certainty exists when the decision-maker knows with reasonable
certainty
1.what the alternatives are,
2.what conditions are associated with each alternative,
3. the outcome of each alternative.
Under conditions of certainty, accurate, measurable, and reliable information on

which to base decisions is available.
The cause and effect relationships are known and the future is highly predictable
under conditions of certainty.
Such conditions exist in case of routine and repetitive decisions concerning the
day-to-day operations of the business.
Decision-making under Risk:
When a manager lacks perfect information or whenever an information

asymmetry exists, risk arises.
Under a state of risk, the decision maker has incomplete information about
available alternatives but has a good idea of the probability of outcomes for each
alternative.
While making decisions under a state of risk, managers must determine the
probability associated with each alternative on the basis of the available
information and his experience.
NATURE OF RISK
It would be rare for the outcome of a business decision to be known with certainty in advance. A
measure of risk or uncertainty is present in almost all circumstances in business.
Decision theory attempts to distinguish the two concepts i.e. the concept of risk and the concept
of uncertainty.
Risks exist where several alternative outcomes are possible, but previous experiences enables the
decision maker to give (assign) a probability to the likely outcome of each alternative.
Uncertainty on the other hand refers to a situation where a decision maker has no previous
experience and therefore no statistical evidence on which to base his predictions.
Decision makers themselves may have differing attitudes to risk. They may be risk neutral, risk-
seekers or risk averse.
The difference between these three types is a function of attitude towards variability of returns
around an expected value (EV). A risk neutral decision maker ignores variability and is
concerned only with the expected values of outcomes.
Decision Trees
The decision tree is one way or method of analyzing risk and uncertainty. The
decision tree model is only as good as the information it contains. The main difficult
is of course, as always, accurately providing the probabilities that determine the
uncertainties involved in the investments.
The decision tree is a pictorial representation of the probabilistic information to
manage and aid decision making. The technique is usually used to evaluate
alternative investment plans.
The illustration below gives a simple example to illustrate a diagrammatic
representation of the decision tree.
Illustration;
Return in Investment C Probabilities Investment D Probabilities
Yr 1 40, 000 0.5 (20, 000) 0.3
Yr 2 120, 000 0.5 180, 000 0.7
Expected 80, 000 120, 000 net profits
When the expected profit is calculated, it appears that plan D would be the best
option. But the plan has a 0.3 chance of a loss K 20,000,000 whereas plan C will
always generate a profit.
Notation of A Tree Diagram
The tree diagram has squares and circles as symbols that take on extraordinary
meaning;
The square represents a point at which a decision is made; in this case there is only one
decision to be made – the choice between plan C and D at the onset. The circle
represents a point at which a chance event takes place. The lines, the branches of the
tree represent the logical sequence between possible outcomes. The values under the
profit heading in the diagram below represent the possible outcomes. The “payoff”
figures are then calculated by multiplying the possible outcomes by their probabilities of
taking place.
Fly Co is considering undertaking a new project. Market research has shown that a
good project can increase profit by 30%, an average one by 20% and a poor one by
10%. Experience has shown that the company has invested in a good project 35% of
the time, an average one 45% of the time and a poor one 20% of the time. The
company's normal profits are K180,000 per annum and cost of the new project would
be K40,000.
Should the company invest in this project?

ul 0.3
K18,900
essf
Succ
Not Successful 0.7
35
0. 0 .2
d
ful K16,200
oo
s
es
G
Average 0. c
180,000 45 Suc
No
tS
ucc
Po
ess
or
ful
0.
0.8
2
l 0 . 1 K3,600
Successfu
Not S
Total = K38,700
ucc
Less investment K40,000

essfu
Decrease in profit K 1,300

l 0.9
Decision-making under Uncertainty:
Conditions of uncertainty exist when the future environment is
unpredictable and everything is in a state of flux. The decision-maker is not
aware of all available alternatives, the risks associated with each, and the
consequences of each alternative or their probabilities.
The manager does not possess complete information about the alternatives
and whatever information is available, may not be completely reliable. In
the face of such uncertainty, managers need to make certain assumptions
about the situation in order to provide a reasonable framework for decision-
making. They have to depend upon their judgment and experience for
making decisions.
Most significant decisions made in today’s complex environment are
formulated under a state of uncertainty.
Risk is objective but uncertainty is subjective; risk can be measured or
quantified but uncertainty cannot be.
The decision making under risk process is as follows:
a. Use the information you have to assign your beliefs (called subjective probabilities) regarding
each state of the nature, p(s),
b. Each action has a payoff associated with each of the states of nature X(a,s),
c. We compute the expected payoff, also called the return (R), for each action
d. We accept the principle that we should minimize (or maximize) the expected payoff,
e. Execute the action which minimizes (or maximize)
The payoffs (in Kwacha) of three Projects A1, A2 and A3 and the possible states of economy S1, S2 and S3 are
given below :
The probabilities of the states of nature are 0.3, 0.4 and 0.3 respectively.
Determine which project to undertake using the expected value and
expected Opportunity Loss methods.
Expected Monetary Value
State of economy Probability Projects
A1 A2 A3
S1 0.3 -20 -50 200
S2 0.4 200 -100 -50
S3 0.3 400 600 300
EMV A1: 0.3X-20 + 0.4X 200 + 0.3 X 400 = 194

EMV A2: 0.3 X -50 + 0.4 X -100 + 0.3 X 600 =125
EMV A3: 0.3 X 200 + 0.4 X -50 + 0.3 X 300 = 130
Choose project with highest EMV which is project A1
.
Expected Opportunity Loss (EOL)
State of economy Probability Projects
A1 A2 A3
S1 0.3 220 250 0
S2 0.4 0 300 250
S3 0.3 200 0 300
EOL A1: 0.3X 220 + 0.4X 0 + 0.3 X 200 = 126

EOL A2: 0.3 X 250 + 0.4 X 300 + 0.3 X 0 =195
EOL A3: 0.3 X 0 + 0.4 X 250 + 0.3 X 300 = 190
Choose project with Lowest EOL which is project A1
.
This indicates that the optimal act is again A1.
Decision making under Uncertainty
There are a variety of criteria that have been proposed for

the selection of an optimal course of action under the
environment of uncertainty. Each of these criteria make an
assumption about the attitude of the decision-maker.
Maximin Criterion:
This criterion, also known as the criterion of pessimism, is used

when the decision-maker is pessimistic about future. Maximin
implies the maximisation of minimum payoff.
The pessimistic decision-maker locates the minimum payoff for

each possible course of action. The maximum of these
minimum payoffs is identified and the corresponding course of
action is selected.
Maximax Criterion:
This criterion, also known as the criterion of optimism, is
used when the decision-maker is optimistic about future.
Maximax implies the maximisation of maximum payoff.
The optimistic decision-maker locates the maximum payoff

for each possible course of action.
The maximum of these payoffs is identified and the

corresponding course of action is selected.
From the example given above,which project will the

company undertake
Regret Criterion:
This criterion focuses upon the regret that the decision-
maker might have from selecting a particular course of
action. Regret is defined as the difference between the
best payoff we could have realised, had we known which
state of nature was going to occur and the realised payoff.
This difference, which measures the magnitude of the loss

incurred by not selecting the best alternative, is also
known as opportunity loss or the opportunity cost.
The regret criterion is based upon the minimax principle,

i.e., the decision-maker tries to minimise the maximum
regret. Thus, the decision-maker selects the maximum
regret for each of the actions and out of these the action
which corresponds to the minimum regret is regarded as
optimal.
Example : A Company has three potential projects A1, A2 and A3, where the rate of
return of each of them can be affected by the occurrence of any one of the four
possible events S1, S2, S3 and S4. The monetary payoffs of each combination of Ai
and Sj are given in the following table:
Events S1 S2 S3 S4
Actions
A1 27 12 14 26
A2 45 17 35 20
A3 52 36 29 15
Which project should the company take using

a. Maximin Criterion
b. Maxmax
c. Regret Criterion:
Solution: Since 17 is maximum out of the minimum payoffs, the optimal project is A 2.
For Maxmax we choose project A3
From the maximum regret column, we find that the regret corresponding
to the course of action is A3 is minimum. Hence, A3 is optimal.
Musa Co is a manufacturer of baby equipment and is planning to launch a revolutionary new
style of sporty chair. The company has commissioned market research to establish possible
demand for the chair and the following information has been obtained. If the price is set at
K425, demand is expected to be 1,000 chairs, at K500 it will be 730 chairs and at K600 it will be
420 chairs. Variable costs are estimated at either K170, K210 or K260.
A decision needs to be made on what price to charge.
The following contribution table has been produced showing the possible outcomes.
Price
K425 K500 K600
Variable cost K170 255,000 240,900 180,600
K210 215,000 211,700 163,800
K260 165,000 175,200 142,800
(a) What price would be set if Musa were to use a maximax decision criterion?
(b) What price would be set if Musa were to use a maximin decision criterion?
(c ) What price would be set if Musa were to use a minimax regret decision criterion?
Draw up an opportunity loss table. (10 Marks)
(d)If the probabilities of the variable costs are K170: 0.4, K210: 0.25 and K260: 0.35, which price
would the risk-neutral decision maker choose? (9 Marks)
What price would be set if Musa were to use a maximax decision criterion?
K425
What price would be set if Musa were to use a maximin decision criterion?
K500
What price would be set if Musa were to use a minimax regret decision criterion?
We can draw up an opportunity loss table.
Variable cost Price
K425 K500 K600
K170 – K14,100 K74,400 (W1)
K210 – K3,300 K51,200 (W2)
K260 K10,200 – K32,400 (W3)
Minimax regret K10,200 K14,100 K74,400
Minimax regret strategy (price of K425) is that which minimises the maximum regret (K10,200).
If the probabilities of the variable costs are K170: 0.4, K210: 0.25 and K260: 0.35, which price
would the risk-neutral decision maker choose?
Expected values calculations:
K425: (255,000 × 0.4) + (215,000 × 0.25) + (165,000 × 0.35) = K213,500
K500: (240,900 × 0.4) + (211,700 × 0.25) + (175,200 × 0.35) = K210,605
K600: (180,600 × 0.4) + (163,800 × 0.25) + (142,800 × 0.35) = K163,170
K425
Sensitivity Analysis
Sensitivity analyses can be used in any situation so long as the relationship
between the key variables can be established. Typically this involves changing
the value of a variable and seeing how the results are affected.
Definition
Sensitivity analysis is a term used to describe any technique whereby decision

options are tested for their vulnerability to changes in any ‘variable’ such as
expected sales volume, sales price per unit, material costs or labour costs
The main common approaches to sensitivity analysis are as follows:
a) To estimate by how much costs and revenues would need to differ from their
estimated values before the decision would change.
b) To estimate whether a decision would change if estimated costs were X%

higher than estimated, or estimated revenues Y% lower than estimated.
c) To estimate by how much costs and or revenues would need to differ from
their estimated values before the decision maker would be indifferent
between two options.
Sensitivity analyses include.
i. What if analysis under information systems using spreadsheets.

ii. Linear programming.
iii. Flexible budgeting can also be a form of sensitivity analysis
Sensitivity analysis is one method of analyzing the risk surrounding a capital

expenditure project and enables an assessment to be made of how
responsive the project’s NPV (net present value) is to changes in the
variables that are used to calculate the net present values (NPV).
Z Ltd has estimated the following sales and profits for a new product which it may launch on to
the market.
K’000 K’000
Sales (2,000 units) 8,000
Variable Costs:
material 4,000
labour 2,000
(6,000)
Contribution 2,000
Less: incremental fixed (1,600)

Profit 400
Required:
Analyse the sensitivity of the project.

• Material cost
• Labour
• Fixed costs
• Sales
• Variable costs
Bauze is evaluating two investment projects, as follows.
Project 1
This is an investment in new machinery to produce a recently-developed product. The
cost of the machinery, which is payable immediately, is K1·5 million, and the scrap value
of the machinery at the end of four years is expected to be K100,000. Capital
allowances (tax-allowable depreciation) can be claimed on this investment on a 25%
reducing balance basis. Information on future returns from the investment has been
forecast to be as follows:
Year 1 2 3 4
Sales volume (units/year) 50,000 95,000 140,000 75,000
Selling price (K/unit) 25·00 24·00 23·00 23·00
Variable cost (K/unit) 10·00 11·00 12·00 12·50
Fixed costs (K/year) 105,000 115,000 125,000 125,000
This information must be adjusted to allow for selling price inflation of 4% per year and
variable cost inflation of 2·5% per year. Fixed costs, which are wholly attributable to the
project, have already been adjusted for inflation. Bauze pays profit tax of 30% per year
one year in arrears.
Required:
(a) Calculate the net present value of Project 1 and comment on whether this project is
financially acceptable to Bauze. (12 marks)
Project 2
Bauze plans to replace an existing machine and must choose between two machines.
Machine 1 has an initial cost of K200,000 and will have a scrap value of K25,000 after
four years. Machine 2 has an initial cost of K225,000 and will have a scrap value of
K50,000 after three years. Annual maintenance costs of the two machines are as
follows:
Year 1 2 3 4
Machine 1 (K/year) 25,000 29,000 32,000 35,000
Machine 2 (K/year) 15,000 20,000 25,000
Where relevant, all information relating to Project 2 has already been adjusted to
include expected future inflation. Taxation and capital allowances must be ignored in
relation to Machine 1 and Machine 2.
Other information
Bauze has a nominal before-tax weighted average cost of capital of 12% and a nominal
after-tax weighted average cost of capital of 7%.
Required:
(b) Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss
which machine should be purchased. (6 marks)
(c) Critically discuss the use of sensitivity analysis and probability analysis as ways of
including risk in the investment appraisal process, referring in your answer to the
relative effectiveness of each method. (7 marks)
Solution:
a) If incremental fixed costs are more than 25% above estimate, the
project would make a loss.
b) If unit costs of materials are more than 10% above estimate the
project would make a loss.
c) Similarly, the project would be sensitive to an increase in unit labour
cost of more than 20% above estimate.
Management would then be able to judge more clearly whether the

project is likely to be profitable. The items to which profitability is most
sensitive to in this example are the selling price and material costs.
Problems with sensitivity analysis
(a)The method requires that changes in each key variable are isolated but
management is more interested in the combination of the effects of
changes in two (2) or more key variables.
Looking at factors in isolation is unrealistic since they are often
interdependent.
(b)Sensitivity analysis does not examine the probability that any particular
variation in costs or revenues might occur
Koko Plc is a manufacturing company. The company is considering launching a
product. The following estimates have been made:
Year Profit estimate Probability

K’000
1 43,200 0.50
2 8,000 0.30
3 32,000 0.20
In addition the company has estimated an amount of K14,400,000 as the investment
needed. There is a 60% chance that the project will succeed. Should the project be
undertaken? Advise with supporting calculations (10 Marks)
A project has an NPV of K1 Million.The Present value of material costs which are included in the
NPV calculation are K5 Million.What is the sensitivity of the project to material cost
BUSINESS VALUATION
BUSINESS VALUATION
METHODS
NET ASSET DISCOUNTED CASH

EARNINGS METHODS
METHOD FLOW
BOOK REPLAC NRV P/E

VALUES EMENT DIVIDEND
FUTURE RATIO
COST VALUATION
CASHFLOWS
MODEL
DISCOUNTED
AT WACC
The summarized Statement of Financial Position of Linda at 1 December 2023 is as
follows
ASSETS
K’000
Non Current Assets 23,600
Current Assets 8,400
Total Assets 32,000
EQUITY AND LIABILITIES

Capital and Reserves
K1 ordinary Shares 8,000
Retained Earnings 11,200
Total 19,200
Non Current Liabilities

6% Loan 8,000
Current Liabilities 4,800
Total Equity and Liabilities 32,000
(a)Calculate the value of one ordinary Share in Linda,using a net asset based
valuation method.
(b) If the estimated replacement cost of non current assets is K40,000,00 Calculate
the value of one ordinary Share in Linda
K’000
Non Current Assets 23,600
Current Assets 8,400
Less 6% loan (8,000)
Less Current Liabilities (4,800)
Net Asset Value 19,200
Value per Share K19,200,000/8,000,000 = K2.40
(b) Value per Share = (K19,200,000 + K40,000,000 – 23,600,000)/8,000,000

K4.45
DISCOUNTED CASH FLOW
This approach uses the Dividend Valuation Model Theory. The theory states that the
value of the company Or share is the present value of the expected future dividends,
discounted at the shareholders' required Rate of return.
Example
A company has just paid a dividend of K250,000.It has 2 million shares in issue.The
current return to share holders in the same industry is 12% although it is expected
that an additional risk premium of 2% will be applicable to the Company being a
smaller and unlisted company.
Required
Calculate the expected valuation of the company if
(a) Dividends are expected to be constant
(b) Dividends are expected to grow at 4% per annum
(c) Dividends are expected to stay constant for three years and then grow at 4% per
annum thereafter.
(a) Dividends are expected to be constant
Po = 250,000/0.14 = K1.786 million or K1.786 million / 2 million shares = 0.893 per
share
(b) Dividends are expected to grow at 4% per annum

Po = K250,000 x 1.04/0.14-0.04 = K2.6 million or K2.6 million/2 million shares = K1.3
per share
(c ) Dividends are expected to stay constant for three years and then grow at 4% per
annum thereafter.
First 3 years
Present value of expected dividends = K250,000 AF 1-3 (14%) = K0.580
Perpetuity from year 4
[(250,000x1.04)/0.14-0.04]Xdf3(14%) =K1.755 million
Total value = 0.580 + 1.755 = K2.335 or K2.335 million /2million shares = K1.17 per
share
P/E Valuation Method
This method values a business by applying a suitable P/E ratio to the business’s
earnings (profit after tax).
For unlisted company which have no market driven P/E ratio,industry average or one
for a similar company will be used as a proxy.
Value of company = Total post-tax earnings x P/E ratio

Value per share = EPS X P/E ratio.
Price Earnings ratio (P/E ratio) = Share price/Earnings per share.
If there is no P/E ratio,Earnings yield which is the reciprocal of P/E ratio can be used.
Value of a company = Total earnings/Earnings yield
Value per share = EPS/Earnings Yield
EXAMPLE.
Mumba is an unquoted entity with a recently reported after ax earnings of
K3,840,000.It has issued 1 million ordinary shares. A similar listed entity has a P/E
ratio of 9.
Required
Calculate the value of one share in Mumba using the P/E basis of valuation.
P/E basis of valuation
Value of the company

K3,840,000 x 9 = K35,600,000
Value per share

EPS = K3,840,000 / 1,000,000 =K3.84
Value per share = K3.84 x 9 = K3.56
The expected after cash flows of an all equity financed company with 2
million shares in issue will be as follows:
Year K
1 120,000
2. 100,000
3. 140,000
4. 50,0000
5 onwards 130,000
A suitable cost of capital for evaluating the company is 12%
Calculate the value of the company’s equity using the DCF Basis of valuation
Year K
1 120,000
2. 100,000
3. 140,000
4. 50,0000
5 onwards 130,000
Discounting the cash flows at 12% result into present value of K392,050
This ignores cash flows after 5 .Assuming the year 5 cash flow continues to
infinity,this has a present value of:
130,000/0.12 = K1,083,333
This has a present value today of
K1,083,333 x o.567 = K614,250
This gives a total present value of equity of K614,250 + K392,050 = K1,006,300
With 2 million shares,K1,006,300/2,000,000 =K0.5 per share.
Eat Co is forecast to generate a constant stream of post tax cash flows (after interest
charges) of K10 m per year.The company is not listed and no cost of capital has been
calculated.However,a similar listed entity Food co which operates in the same business
sector has a cost of equity of 10%.
Food co is all equity financed where as Eat co has 20% debt and 80% equity by market
values.The tax rate is 30% and the yield on Eat’s debt is 4%.
Calculate the value of Eat co using the discounted cash flow method.
Ke = Keu + (Keu-Kd)(1-t)(Vd/Ve
= 10% +(10%-4%)(1-0.3)20/80
= 11.05%
The value of Eat co’s equity is K10/0.1105 = K90.5m
The following information is available for MCK co.
Statement of Profit or Loss for the most recent accounting period
K’Million
Revenue 285.1
Cost of sales (120.9)
Gross Profit 164.2
Operating expenses (including depreciation of K12.3 Million) (66.9)
Profit from operations 97.3
Finance costs (10.0)
Profit before Tax 87.3
Taxation (21.6)
Profit after tax 65.7
Other information
1.Selling prices are expected to rise by 3% pa for the next 3 years and then stay constant there
after.
2. Sales volume are expected to rise by 5% pa for the next 3 years and then stay constant there
after.
3.Assume that cost of sales is a completely variable cost,and that other operating expenses
including depreciation are expected to stay constant.
4.MCK co invested K15 million in non current assets and K2 million in working capital last
year.These annual amounts are expected to stay constant in future
5.MCK co’s financing costs are expected to stay constant each year in the future.
6.The marginal rate of tax is 28,payable in the year in which the liability arises.
7.Assume that book depreciation equals tax depreciation.
8.MCK co has 500 millino shares in issue.
9.The WACC of MCK co is 9% and its cost of equity is 12%
Calculate the value of the equity in MCK in total and per share.
Year 1 Year 2 Year 3 etc
K’m K’m K’m
Sales (x1.03x1.05) 308.3 333.5 360.6
Cost of Sales (x1.05) (126.9) (133.3) (140.0)
Gross Profit 181.4 200.2 220.6
Operating expenses ( 66.9) (66.9) (66.9)
Financing costs (10.0) (10.0) (10.0)
Forecast profit before tax 104.5 123.3 143.7
Less Taxation(28%) (29.3) (34.5) (40.2)
Add back depreciation 12.3 12.3 12.3
Less Capital expenditure (15.0) (15.0) (15.0)
Less working capital investment (2.0) (2.0) (2.0)
Forecast free cash flows 70.5 84.1 98.8
DF 12% 0.893 0.797 0.797/0.12
Present value 63.0 67.0 656.2
NPV = K786.2 MILLION.
This is the total value of the equity in MCK Co.
Value per share is K786.2 m/500 m= K1.57

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WELCOME TO

CAPITAL STRUCTURE AND THE COST OF CAPITAL

Financial management refers to that part of the management

“Business finance can be broadly defined as the activity

Risk and Return Relationship

To achieve the goal of

Profit Maximization Wealth Maximization

A financial manager has to concentrate on the following areas of the finance

1.Estimating Financial Requirements:

After preparing a capital structure, an appropriate source of

c) Break even analysis.

8.Proper use of Surpluses:

The main objective of a business is to maximize the owner’s economic

Financial theory asserts that the wealth maximization is the

Implication of the wealth maximization:

2.The objective of wealth maximization is not necessarily socially desirable.

3.There is some controversy as to whether the objective is to maximize the

4.The objective of wealth maximization may also face difficulties when

Concerns the acquisition,

• How do we manage existing assets efficiently?

There exists a SEPARATION between owners

Management acts as an agent for

 Jensen and Meckling developed a

 Principals must provide incentives so

• Wealth maximization does not preclude the

• Corporate governance: represents the system

CAPITAL MARKETS MONEY MARKET

PRIMARY SECONDARY PRIMARY SECONDARY

Deficit unit security

Hedge funds are unregulated private investment partnerships, limited to institutions

The Investment management process is the process

SYSTEMATIC RISK (Beta)

• How do we manage existing assets efficiently?

b) cost of debt Kd = 6.1% Kd = 6.1%x0.7 = 4.27%

Cost of Capital is the required rate of

DivP DivP DivP

This reduces to a perpetuity!

DivP = K100 ( 8% ) = K8.00. kP =

• Pro rata share of future earnings

What cash flows will a shareholder receive

(1) Future dividends

Basic dividend valuation model accounts for the PV

The constant growth model assumes that

D0(1+g) D0(1+g)2 D0(1+g)¥

D1: Dividend paid at time 1.

VCG = D1 / ( ke - g ) = K3.50 / ( .15 - .08 ) = K50

The zero growth model assumes that dividends will

(1 + ke)1 (1 + ke)2 (1 + ke)¥

D1 D1: Dividend paid at time 1.

VZG = D1 / ( ke - 0 ) = K3.24 / ( .15 - 0 )

The growth phases model assumes that

Note that the second phase of the growth phases

Growth of 16% for 3 years Growth of 8% to infinity!

V = K3.27 + K3.30 + K3.33 + K51.32

Year 2018 2019 2020 2021

The process of identifying, analyzing, and

• Select projects based on a value-maximizing

1. New products or expansion of existing

Basic characteristics of relevant