CHAPTERONE

OVERVI
EW OFFI
NANCI
ALMANAGEMENT
1.
1.FI
NANCEASANAREAOFSTUDY
Whati sexactlymanageri
alfi
nanceorf i
nanceingeneral
? Whatar ethemaj or
responsi
bil
it
iesanddut i
esofmanager soff i
nance? Inordertoanswert hese
questi
ons,youneedt ounderstandtheareasthatf
inancecovers. Fi
nance,in
general
,consistsoft
hreeint
errel
atedar
eas:
1.Moneyandcapit
almarket
s,whi
chdealwi
thsecur
it
iesmar
ket
sand
f
inanci
ali
nst
it
uti
ons;
2.I
nvestments,which f ocus on the deci
sion of i
nvestor
s,both
i
ndivi
dual
sandinstit
utions,
astheychooseamongsecurit
iesfort
hei
r
i
nvestmentpor
tfol
ios;and
3.Financi
almanagement
,(or"businessfi
nance","
corpor
atef
inance"
,or
"manageri
alfi
nance"
),which involves t
he actualmanagementof
businessf
ir
ms
Thecareeropportuni
ti
eswi
thi
neachoft
heabovefi
eldsaremanyandvari
ed,
but
managersoff i
nancemusthaveknowledgeofal
lt hr
eeareasiftheyareto
per
for
mt hei
rjobswell
.
1.MoneyandCapi
tal
Mar
ket
s
Mostoft hef
inancepr
ofessi
onal
sgotoworkforfi
nanci
ali
nsti
tut
ions,i
ncl
uding
banks,insur
ance companies,i
nvest
ment compani
es,credi
ts and savings
associ
ati
ons.
♣ Foryoutosucceedi
ndoi ngsuchj obs, y
ouneedaknowl edgeofthefact
ors
thatcausei
nter
estratestor i
seandf al
l,theregul
ati
onst owhichfi
nanci
al
i
nstit
uti
onsaresubjected,andt hev ari
oust ypesoffinanciali
nst
ruments
suchasbonds,shar
es, mortgages,certi
ficat
esofdeposits,andsoon.
♣ You al so need a gener alknowledge of allaspects of busi
ness
admi ni
strat
ion,becauset hemanagementoff i
nanciali
nsti
tut
ionsi
nvol
ves
accounting,mar ket
ing,personnelmanagement,computersci
enceaswell
asfinancialmanagement .
♣ Anabi
l
ityt
ogetpeopl
etodot
hei
rjob(
i.
e.peopl
eski
l
ls)i
sver
ycr
it
ical
.
2.I
nvest
ment
s
Fi
nancegr
aduat
eswhogoi
ntoi
nvest
mentar
eas:
♣ Generall
yworkf orbr
oker
agehousesi
nthesal
esofsecur
it
iesoras
secur
ityanal
yst
s
♣ Other
swor kforbanksandi
nsur
ancecompani
esi
nthemanagementof
i
nvestmentport
fol
i
os,or
♣ The r
estwor kforfi
nanci
alconsul
ti
ng fi
rms,which adv
ise i
ndi
vi
dual
i
nvest
orsorpensi
onf
undsonhowt oi
nvestt
heirf
unds

1
♣ Thet
hreemaj
orf
unct
ionsi
nthei
nvest
mentar
eaar
e:
Sal
esofsecur
it
ies,
Anal
ysi
sofi
ndi
vi
dual
secur
it
ies,
and
Det
ermi
ningt
heopt
imal
mixofsecur
it
iesf
oragi
veni
nvest
or
3.Fi
nanci almanagement-Fi
nanci
almanagement i st he focus of thi
s
course.Fi
nanci
almanagementi simpor t
antinallt
ypesofbusi nesses,
i
ncludingbanks,andotherfi
nanci
alinsti
tut
ionsaswellasotherfor
m of
businesses.
(Seet
hechartdepi
ctedbelow)

2
 SCOPEOFFI
NANCI
ALMANAGEMENT

ANALYETHICALWAYOFVIEWI
NGTHE
FI
NANCIALPROBLEMSOFAFIRM

BALANCESHEET I
NCOMESTATEMENT
PERSPECTI VE PERSPECTIVE
"How Lar da
ge shoul n "
HowFastshoul
ditGr
ow?
"
Enter
pri
sebe?"

USESOF SOURCES TARGET CAPITAL

FUNDS OFFUNDS CAPITAL I
NTENSITY
"I
nwhat "
Whatshoul d STRUCTURE "Sal
esperinv
ested
f
orm bethe "Leverage, capi
tal,
Inv
estment
shoul
dit composition Retent
ionand tur
nover
"
holdits ofits Divi
dendpol i
cy"
Asset
s?" cl
aims?"

SUSTAI
NABLE
MI
XANDTYPE GROWTHRATE
OFASSETS DEBTAND "Salesgrowthrate
"
Current,Long- EQUITYUSAGE wit
houti ncr
easing
t
erm, Real,and "Lever
ageand l
ever ageori
ssuing
Fi
nancial" Equit
yfinanci
ng" newshares"

I
NVESTI
NG FINANCING DI
VIDEND
DECI
SION DECISI
ON DECI
SION

FUNCTI
ONSOFFI
NANCE(
Deci
sionAr
eas)(
Tobedeal
tint
hef
ir
stpar
toft se)
hecour

PLUS

MANAGEMENTOFFI
NANCI
ALRESOURCES(
Tobedeal
tint
hesecondpar
toft se)
hecour

Multi
-nat
ional Exchangerate(Cur
rency
Cash Recei
vabl
es I
nvent
ory Fi
nancial Val
uati
on),Deri
vat
ives,
Management Management Management Managementissues andRisks

EQUALS

FI
NANCI
ALMANAGEMENTASASPECI
ALI
SEDFI
ELDOFSTUDY

3
Financi
almanagementi s al
so i
mpor
tantin gover
nment
aloper
ati
ons,from
schoolstohospi
tal
s,fr
om zonaladmini
str
ati
velevel
stostat
eadmini
str
ativ
e
l
ev el
s,andev
enbeyondthat
.
Thetypeofjobsencounter
edi
nf i
nanci
almanagementr
angefrom deci
sions
regar
dingpl
antexpansiontochoosi
ngwhattypesofsecur
it
iestoissuet o
fi
nancetheexpansi
on.

4
 KEYACTI
VITI
ESOFTHEFI
NANCI
ALMANAGER

PERFORM BASI
CTASKS
MAKEDECI
SIONS

INVESTME
FIANANCI NT
FINANCI AL
AL DECISI
ONS FI
NANCING
ANALYSI S
PLANNI N "Transform
"
Short DECI
SIONS
G financial term and "
Capital
(FORCAS dataint o l
ong-term str
ucture
TING) usable i
nvestmen and
"Evaluat
e formt o ts Fi
nancing
productiv monitor poli
cy
e financial
capacit
y condi t
ion"
and
determin
e

"
Techni q "
Incr
ease "Capi
tal "
Financi
al
ues or budgeti
ng l
ev erage
(
Financia Decrease and andcr edi
t
l r
ati
os) capacity; measur e policy
and addit
ional mentof plus
I
nterpret f
undsor expected retention
ati
ons" reducti
on rateof /dividend
offunds" retur
n" policy

Measurem CostofCapital
entofRisk (requi
redrate
ofreturn)and
Valuati
on

5
 ♣ Fi
nanci
almanager
sal
sohav
ether
esponsi
bil
i
tyf
ordeci
ding:
Thecr
edi
tter
msunderwhi
chcust
omer
smaybuy
,
Howmuchi
nvent
oryt
hecompanyshoul
dcar
ry,
How muchcasht
okeeponhand,
Whet
hert
oacqui
reot
hercompany(
mer
geranal
ysi
s),
and
How muchofthefi
rm'
sear
ningst
oret
aini
nthebusi
nessv
ersus
pay
outasdi
vi
dends
Regardlessofwhichspeci
fi
careaoffi
nanceyouareemphasi
zingon,y
ouneed
knowledgeofallt
hethreear
eas(i
.e.moneyandcapi
talmar
ket
,inv
est
ments,
and
fi
nancialmanagement)
.
♣ Forexample,abankerlendi
ngtobusi
nessescannotdohisorherj ob
proper
lywi
thoutagoodunderst
andi
ngoffi
nanci
almanagement
,because
heorshemustbeabletojudgehowwel
lthebusi
nessesar
eoper
ati
ng.
♣ Inthesameway ,companyfi
nanci
almanagersneedtoknow whatt
hei
r
banker
sconsiderimpor
tantandhow inv
estor
sareli
kelytojudget
hei
r
companyper
formanceandthus,
deter
minethei
rst
ockpri
ces.
1.
2.THECENTRALROLEOFCAPI
TAL
Capi
tal
,asy ouallknow,isessent
ialf
ortheoper
ati
onofanyf i
rm.Fi
nancial
Management,i
nthisregar
d,maybedefi
nedint
ermsofther
elat
ionshi
pbetween
capi
tal
andthebusinessfi
rm.
♣ Abusinessfi
rm,
whet heri
tisanewlyestabl
i
shedoranexi
sti
ngone,must
obt
aincertai
namountofcapi t
alt
ofinanceit
sel
finor
dertoproduceand
sel
lgoodsandserv
icestoitscust
omers.
♣ Init
ialcapi
tal
/f
unds/ofthenewl
yfor
medf i
rm consist
soff undssecur
ed
from t heowner
soft hefi
rminthefor
m ofequi t
ycapitalandfrom t
he
creditorsi
nthefor
m ofbot
hshor
t-
ter
m andl
ong-termloans.
♣ Anexist
ingfi
rm mayf
inanceit
selfbyr
etai
ningpar
tofi
tsear
ningsi
n
addi
ti
ontothet
wosour
cesindi
cated.
♣ Thecapitaloft
hefir
m,whet heritisgenerat
edint
ernal
l
yfrom operati
ons
orprovi
dedbyowner sandcr editor
s,consti
tut
ethesourceoft hefir
m's
capi
talandhence,
recordedont heright
-handsi
deofthebalancesheetas
l
iabi
l
iti
esandowners'equit
y.
Theacquir
edcapit
alisusedt oempl oypersonnel
,toobtai
noffi
cesandot
her
manufact
uri
ngfaci
l
iti
es,i
nventori
es,andotherasset
s.Thecapitali
sal
soused
forpr
oduci
nggoodsandservicestomeetcustomers'demands.
♣ Theacquir
edassetsconst
it
utetheusesofthecapit
alofthef
ir
m andar
e
l
ist
edinthelef
t-
handsideofthebal
ancesheet(
i.
e.asset
s).
♣ Thebalancesheetoft
hef
ir
m,t
hus,
cont
ainsbot
htheusesandsour
cesof
thecapi
taloft
hefir
m.

6
 ♣ Thebal
ancesheetr
ecor
dst
hesev
aluesatt
hepar
ti
cul
arpoi
nti
nti
me.
♣ To compl
etethe bal
ance sheet,the f
ir
m recor
ds the r
esul
ts ofi
ts
oper
ati
onsdur
ingagiv
enperiod,suchasayeari
nit
sincomestat
ement.
♣ Theincomestatement,i
nt hi
sregar
d,l
ist
sthefir
msr evenuesgenerat
ed,
expensesi
ncurr
ed,andpr ofi
tear
nedoveraspanoft i
meandpr ovi
desa
measureoftheabi
li
tyofthefir
mt omanagei
tscapit
alsourcesanduses.
Thesetwof i
nancialst
atements,
(bal
ancesheetandincomesstatement),pict
ure
afir
m asanent i
tythatfi
nancesit
selfwi
thcapit
alfr
om vari
oussourcesandput s
thi
scapit
alint
ov ari
oususesinordertogener
atethedesi
redamountofrev enues
andprof
its.

1.
3.FI
NANCI
ALMANAGEMENTANDCAPI
TAL
1.
3.1.Capi
tal
:Sour
cesandUses
Capit
alsourcesandusesmustcar efull
ybemanagedifthef
irm needstobe
prof
it
ableforitsf inanci
ers. Financialmanagement
,inthi
sr egard,i
sthe
speci
ali
zedbusinessfunct
ionthatdealswi t
hthi
spr
obl
em.
♣ Ingeneral
,financi
almanagementcanbedefi
nedasthemanagementof
capi
talsourcesandusessoast oatt
aint
hedesi
redgoal
soft
hefi
rm(i.
e.
maximizati
onofsharehol
ders'
weal
th).
♣ Af i
rm'scapitalconsistsofi
temsofval
uethatareownedandusedand
i
temst hatareusedbutnotowned.Forexampl e,theoffi
cespacet hata
businessfir
m hasr entedfordoi
ngbusi
nessandthebankl oansthatthe
fi
rm hast akent of i
nanceitsoper
ati
onsareitemsofv al
uest hatthe
businessfir
m canusebutdoesnotown.Si mi
larl
y,i
nventor
iesandf i
xed
assetspurchasedbyt hefi
rm.
♣ Capi
talsourcesaret hoseitemsfound on t
her i
ght
-hand si
deofthe
bal
ancesheet(i
.e.
,theli
abi
l
iti
esandequi
tysect
ionasstat
edearl
ier
).
♣ Examplesoftheusesofcapi
taloft
hef
ir
m ar
erecei
vabl
es,i
nvent
ori
es,
andfi
xedassets.
1.
3.2.Fi
nanci
alManagement
:Basi
cFunct
ions
Asan ar ea ofstudy,f
inanci
almanagementi
sconcer
ned wi
tht
wo di
sti
nct
funct
ions.Theseare:
♣ Thef
inanci
ngf
unct
ion,
and
♣ Thei
nvest
ingf
unct
ion
Thef i
nancingfunct
iondescri
best hemanagementoft hesourcesofcapital
.The
i
nv est
ing funct
ion,on the otherhand,concent r
ates on t
he type,size,and
percentagecompositionofcapit
aluses.I tdealswit
hthequestion"howmuchof
the totalcapit
alpr ovi
ded by the financi
ng sources should be inv
ested i
n
receiv
ables,market
ablesecuri
ti
es, i
nventori
es,andfi
xedassets?"

7
 ♣ Thespecial
i
zedsetofmanagementduti
esandresponsi
bil
i
tiest
hatcent
er
aroundthefinanci
ngandi
nvest
ingfunct
ionsar
er ef
err
edt oasfi
nanci
al
management .
1.
3.3.Goal
oft
heFi
rm:
Prof
itv
s.Weal
thMaxi
mizat
ion
Oneaddit
ionalconceptcontainedi
nthedef i
nit
ionoffinanci
almanagementi
s
concer
nedwiththegoaldi
rectedbehav
iororgoralor
ient
ati
on.
♣ Thepr obl
emsandoppor tunit
iesthatfinanci
almanager sf
aceandthe
businessdeci
sionstheyarer equi
redto makeent i
rel
ydepend ont
he
purposesorgoalsoft
hei
rrespecti
veorganizat
ions.
♣ Pr
ofi
tseeki
ng or
gani
zations shoul
d actual
l
y behav
ein a way t
hey
maxi
mizet
heweal
thoftheirshar
ehol
ders.
I
tisv er
yimpor
tantf
oryouatthi
spointtodist
ingui
shbetween
weal
thmaximi
zati
onandpr
ofi
tmaxi
mizat
ionasgoalsofbusi
ness
f
ir
ms.
1.Pr
ofi
tMaxi
mizat
ion
Pr
ofi
t-
maxi
mi zat
ionisat r
adi
ti
onalmicr
oeconomicstheor
yofbusi
nessf
ir
m,
whi
chwashistor
ical
l
yconsi
der
edasthegoalofthefi
rm.
Profi
tmaximi
zat
ionst
ressesont
heef
fi
cientuseoff
inanci
al/
capi
tal
resour
cesoft
hefir
m.
Prof
itmaximizati
onasagoalofthebusi
nessf i
rmignor
es,however
,
manyoft her ealworldcompl
exi
ti
est
hatfinanci
almanagerstr
yt o
addr
essintheirdeci
sions.
Prof
it maxi
mizat
ion f
unct
ions l
argel
y as a theoret
ical goal
;
economi
stsuseittopr
ovehow fi
rmsbehav
erat
ional
lytoi ncr
ease
prof
it
.
When f
inance wasemerged asa separ
ate ar
ea ofst
udy
,ithas
r
etai
nedprofi
tmaxi
mizat
ion,
whichi
sthenewconcept.
Pr
ofi
tmaxi mi
zat
ionl
ooksatt
het
otalcompanypr
ofi
trat
hert
han
pr
ofi
tpershar
e.
Pr
ofitmaxi
mizat
iondoesnotspeakaboutt
hecompany'
sdi
vi
dendsas
ei
theraretur
ntosharehol
dersort heimpactofdi
vi
dendpol
icyon
st
ockpri
ces.
Inthemoreappl
ieddi
sci
pli
neoffi
nanci
almanagement,howev
er,f
ir
msmustdeal
everydaywi
thtwomajorf
actor
s:Theseareuncer
tai
ntyandti
ming.
A.Uncer
tai
ntyofRet
urns
Pr
ofi
tmaximizat
ionasthegoal
ofbusi
nessf
ir
msi
gnor
esuncer
tai
ntyandr
isksi
n
or
dertopr
esentthetheor
ymoreeasi
ly
.
Proj
ectsandinvest
mentalt
ernati
vesar
ecompar
edbyexami
ningt
hei
r
expect
edv al
uesorwei
ghtedav er
ageprof
it
s.

8
 Whetherornotoneprojecti
sri
ski
erthananot
herdoesn'
tentert
hese
cal
culat
ions;economists do di
scuss ri
sk,but tangent
ial
ly(or
i
maginativel
y).
Inreal
ity
,pr oj
ect
s dif
fera gr eatdealwi t
hr especttot he r
isk
char
acter
ist
ics,and di
sregar
ding these di
ff
erences can r
esul
ti n
i
ncorr
ectdecisi
ons.
Tobet terunderstandtheimpl i
cati
onofignor
edr isks,l
etusl ookattwomut uall
y
exclusi
v einvest
mental ter
natives(t
hati
s,onlyoneoft het wocanbeaccept ed).
Thef ir
stpr oj
ectinvolv
est heuseofexi st
ingplantt opr oduceplast
iccombs,a
productwi thanext remelyst abledemand. Thesecondpr ojectusesexisti
ng
planttopr oduceelectr
icv i
brati
ngcombs.Thel atterproductmaycat chonand
do wel l,buti tcould also fail
. The optimi
st ic,pessimisti
c,and expected
outcomesar egiv
enasf oll
ows:
Pr
ofi
tFi
gur
es
Pl
ast
icComb El
ect
ri
cComb
Opt
imi
sti
cout
come $10,
000 $20,
000
Expect
edout
come 10,
000 10,
000
Pessi
mist
icoutcome 10,
000 0
Therei snov ari
abi l
it
yassoci at edwi tht hepossi bleout comesofpr oduci ngand
sell
ingpl asticcombsbecausedemandf ort hi
spr oductisst able.I fthingsgo
well(optimi sti
c),poor l
y( pessimi stic),orasexpect ed,thepr ofitwil
lst il
lbet he
same,i .
e.Bi r
r10, 000.Wi tht hatoft heel ectri
ccombs,howev er,ther angeof
possiblepr ofi
tfiguresv ari
esf rom Bi rr20, 000,ifthingsgowel l(opti
mistic),toBir
r
10,000,ifthingsgoasexpect ed, ort ot hepr ofi
tfigureofzer o,ifthi
ngsgowr ong
(pessimistic).Her e,ifyoul ookatj ustt heexpect edprof i
tfi
gur eofBi r
r10, 000,i
t
i
st hesamef orbot hprojectsandy ouconcl udet hatbot hprojectsareequi v al
ent.
Theyar enot ,howev er. Ther eturns( profitfigures)associ atedwi thel ectri
c
combsi nv olveamuchgr eaterdegr eeofuncer t
aintyorrisk.
Thegoalofprof
itmaximizat
ion,however,
ignor
esuncert
aint
y(r
isk)and
consi
der
sthesepr oj
ectsequival
entinter
msofdesirabi
li
tyasitref
ers
onl
ytotheexpectedprof
itfi
guresfr
om theproj
ect
s.
B.Ti
mingofRet
urns
Anotherpr obl
em withprofi
tmaxi mizati
onast hegoalofbusi nessfir
mi st hatit
i
gnor est heti
mingoft hereturnsfrom project
s.Toi ll
ustr
ate,letusr eexami ne
ourpl asti
ccombv er
suselect r
iccombi nvestmentdecisi
ons.Thi st i
mel etus
i
gnor er i
skandsayt hateachoft heseprojectsisgoi
ngt oreturnapr ofitofBi r
r
10,000.assumet hatwhi l
etheel ectr
iccombcangoi ntoproductionaf terone
year,theplast
iccombcanbegi nproducti
oni mmediat
ely.Thet i
mingoft hepr ofi
t
fr
om t heseproj
ectsareasfollow:

9
 Pr
ofi
tFi
gur
es

Pl
ast
icComb El
ect
ri
cComb
Year1 $10,
000 $0
Year2 0 10,
000
Int hiscase,t het otalprofi
tf r
om eachpr ojecti sthesame,butt het i
mingof
earningt hepr ofit
sdi ff
ers. Aswewi llseel aterint hi
scourse,i
nt hechapter
deal i
ngwi ththeconceptof" Ti
meVal ueofMoney" ,moneyhasadef i
nit
etime
valueaspeopl ehav edefini
tepreferencef orcur r
entbenefit
soverfut
urebenefi
ts.
Thus,t hepl asti
ccombpr ojectisthebet t
eroft het wo.Assumet hattheBirr
10,000pr of
itf r
om Pl asti
ccombpr ojectdur ingy ear1isinvest
edi nasav i
ng
accountt hatear nsani nterestof5per centperannum.Thi smoneywoul dhav e
grownt obi rr10,500att heendoft hesecondy earasopposedt otheBirr10,
000
profitstober eportedbyt heelectr
iccombpr ojectatt heendofthesecondyear.
Si
ncei nvestmentopportuni
ti
esareavail
ableforthemoneyonhand,wear enot
i
ndiff
erentt othe timing of t
he returns (
profi
ts) f
rom t
hese invest
ment
opport
unities.Inotherwords,thereturnsobtai
nedcanber e-i
nvestedatthe
prev
ail
ingr ateofr
eturn.
Givenequival
entcashf l
owsfrom pr
ofi
ts,wewantt
hecashf
lowst
o
occursoonerrat
herthanlat
er.
Thef i
nanci
almanagermustalway sconsi
dert
hepossi
blet
imi
ngof
ret
urns(pr
ofi
ts)i
nfi
nanci
aldeci
sion-
maki
ng.
Theref
ore,the r
eal
-worl
dfact
orsofuncer
tai
ntyand ti
ming ofret
urnsfor
ce
fi
nanci
almanagerstolookbey
ondsi
mplepr
ofi
tmaximizat
ionasthegoaloft
he
busi
nessfir
m.
Theseli
mitati
onsofprofi
tmaximizat
ionasthegoalofbusinessf
ir
ms
l
eadust ot hemaximizat
ionofthemor erobustgoaloft
hebusiness
fi
rm,t
hatis,shar
ehol
ders'weal
th.
2.Weal
thMaxi
mizat
ion
Weal
thmaximizati
on,ontheot
herhand,i
samor ecomprehensi
vemodeldeal
ing
wi
ththegoalofthefir
m.Accordi
ngtothismodel
,iti
smadecl eart
hatt
hereare
t
woway si
nwhi chthewealt
hofshar
eholder
schanges.Theseare:
oughchangi
Thr ngdi
vi
dendpay
ment
s,and
ought
Thr hechangei
nthemar
ketpr
iceofcommonshar
es
Hence,t
hechangeinsharehol
der
s'weal
th,orchangei
nthev
alueofbusi
ness
f
ir
ms, maybecal
cul
atedasfoll
ows:
. Mu
i l
ti
plyt
hedi
vi
dendpershar
epai
ddur
ingt
heper
iodbyt
henumber
ofshar
esowned.
. Mu
i
i l
ti
plyt
hechangei
nshar
espr
icedur
ingt
heper
iodbyt
henumber
ofshar
esowned.

10
 i
i
i. Addt
hedi
vi
dendsandt
hechangei
nthemar
ketv
alueofshar
es,
computed i
n step 1 and 2 abov
e,to obt
aint
he change i
nthe
shar
eholder
s'weal
thduringt
heperi
od.
I
nor dertomaximi
zetheweal
thofshar
ehol
ders,abusi
nessfi
rm mustseekto
prov
idethelar
gesat
tai
nabl
ecombi
nati
onofdiv
idendspershar
eandstockpri
ce
appreci
ati
on.
Nevertheless,theproblem isthatwhil
eabusi nessf
irm mayhav esome
degreeoff reedom inset t
ingit
sdivi
dendpoli
cythati
sinaccordancewith
wealthmaxi mi zat
iongoal, i
tcannoti
nfl
uencethesharepri
ces,whichare
basical
ly set by t he inter
acti
on of buyers and seller
s i n the
securit
ies/stockmar kets.
Stockpr
icest
endt or ef
lecttheper
ceptionofthestockhol
der
sregarding
theabi
li
tyoft
hebusi nessfir
mt oearnprofi
tsandthedegreeofr
isksthat
thebusi
nessfi
rm assumesi nearni
ngitsprofi
t.
Theulti
materi
skt
hatthebusi
nessfi
rm usual
l
yfacesi
sthepr
obabi
l
ityt
hati
twi
l
l
fai
lorgobankr
upt
.Insuchanevent
,
The owner
s/shar
ehol
der
s oft he busi
ness f
ir
m woul
d see t
hei
r
i
nvest
mentbecomingwort
hless;
and
Thecredit
orswoul
dli
kel
yseet
hatatl
eastsomepor
ti
onoft
hei
rloans
gounpaid.
Theseeventshaveimpactsont hemar
ketpr
icesofshar
es,whi
ch,i
ntur
n,have
i
mpact sontheobject
ive/
goalofabusi
nessf
irm,t
hati
s,weal
thmaxi
mizat
ionof
sharehol
der
s.

1.
4.MAXI
MIZATI
ONOFSHAREHOLDER'
SWEALTH
Infor
mulati
ngthegoalofmaxi mizat
ionofsharehol
der
s'weal
th,wear
edoing
not
hingmor ethanmodify
ingthegoalofprofitmaximi
zati
ontodealwit
hthe
complexi
ti
esoftheoper
ati
ngenvir
onment.
We have chosen maxi mi
zat
ion of shar
eholder
s'wealth,t hat is,
maximi
zat
ionoft hetotalmarketval
ueoft heexist
ingshareholders'
commonstock,becausetheef
fectofal
lfi
nanci
aldeci
sionsisrefl
ected
thr
ought
heseprices.
Thesharehol
ders( ori
nvest
ors)reacttopoorinv
estmentordiv
idend
decisi
onsbycausingthetot
alval
ueoft hefi
rm'
sstocktofal
landthey
reactt
ogooddecisionsbypushi
ngt hepr
iceoft
hestockup.
Obvi
ously,
ther
earesomeseri
espract
icalprobl
emsi ndi
rectuseofthi
sgoaland
eval
uati
ngthereact
iont
ov ar
iousfi
nancialdeci
sionsbyexami ni
ngchangesin
thef
irm'
sstockval
ue.
I
nreal
i
ty,
dif
fer
entf
act
ors/
aspect
saf
fectst
ockpr
ices.
Toempl
oyweal
thmaxi
mizat
ionast
hegoalofy
ourbusi
nessf
ir
m,

11
 t
her
efor
e,youneednotconsi
dereverystockpr i
cechanget
obet
he
mar
keti
nter
pret
ati
onoft
heworthofyourdeci
sion.
Ot
herfact
orssuchaseconomi
cexpect
ati
ons,al
soaf
fectst
ockpr
ice
movements.
Appar
entl
y,whatyoudofocusonistheeff
ectthatyourdeci
sionshoul
dhav
eon
thest
ockpri
ceifever
ythi
ngelsewherehel
dconstant.
Themar ketpr
iceofthebusi
nessf
ir
m’sst
ockr
efl
ect
sthev
alueoft
he
fi
rm asseenbyitsowner
s.
Theweal t
hmaxi mizat
ionast hegoalofabusinessfi
rmtakesint
o
accountuncer
tai
ntyorrisk,
time,
andot
herf
act
orsthatar
eimport
antt
o
theownersofthefi
rm.
Thus,agai
n,theframeworkofmaximizati
onofshar
ehol
ders'weal
th
al
lowsforadecisionenvir
onmentt
hatincl
udest
hecomplexit
iesand
compli
cati
onsofthereal
wor l
d.
1.
5.THEAGENCYPROBLEM
Whil
ethegoalofthebusinessf
ir
misthemaximizati
onofsharehol
der
s'weal
th,
i
nreali
tyt
heagencypr
oblem mayint
erf
erewi
tht
hei mplement
ati
onofthi
sgoal
.
Theagencyproblem istheresul
tofaseparat
ionofthemanagement
andtheownershipofthefi
rm.Forexample,
al ar
gebusi
nessfi
rm may
runbyprofessi
onalmanager s,whoar
eagent sandhavelit
tl
eorno
ownershi
pposit
ion/st
akeinthefi
rm.
Becauseofthesepar
ati
onbet weenthedecisi
onmaker sandowner s,
managersmaymakedecisionsthatarenotinlinewit
hthegoalofthe
busi
nessfi
rm,ornotconsistentwit
ht heint
erestsofowner
s,thatis
outl
i
nedasmaximizat
ionofsharehol
ders'
wealth.
Prof
essionalmanager
s,bei
ngmer
eagentsofowners,mayattemptto
benefitt
hemselv
esinter
msofsal
aryandper
qui
sit
esattheexpenseof
sharehol
ders.
Theexactsi
gni
fi
canceoft
hispr
obl
em i
sdi
ff
icul
ttomeasur
e.
However
,whil
ei tmayinter
ferewiththei
mplement
ati
onofthegoalof
maxi
mizati
onofshareholders'weal
thinsomefi
rms,i
tdoesnotaff
ect
t
hegoal'
svali
dit
y,however.
Thecostsassoci at
edwitht
heagencypr
oblem ar
ealsodi
ffi
cultto
measure,butoccasi
onal
l
ywecanseetheef
fectoft
hispr
obl
em inthe
market
place.
♣ Forexample,i
fthe mar
ketfeelsthatthe managementofa
busi
nessf
ir
mi sdamagi
ngsharehol
ders'weal
th,wemi ghtseea
posi
ti
vereacti
on i
nthe st
ock pri
ce tot he remov
aloft hat
management.
1.
6.THEOBJECTI
VEOFFI
NANCI
ALMANAGEMENT

12
Thef inancialmanagerusest heoveral
lcompany 'sgoalofshar ehol
ders'wealth
maxi mizat i
on,whi chisrefl
ectedt
hrought heincreaseddi
videndpershar eand
theappr eci
ationsoft hepricesofshares,informulati
ngfinancialpol
iciesand
evaluati
ngal ternativ
ecoursesofoperat
ions.Inordertodoso, t
hisoverallgoalof
wealthmaxi mi zati
onneedst oberelatedtoand/ ortakethef oll
owingspeci f
ic
objectivesoff inanci
almanagementintoaccount:
1.Fi
nancialmanagementaimsatdet ermini
nghow l
arget
hebusi
ness
fi
rm shoul
dbeandhowf astshoul
di tgr
ow.
2.Fi
nanci
almanagementai ms atdetermi
ning t
he bestper
centage
composi
ti
onoft hef i
rm'sassets(assetpartof thedeci
sion,or
deci
si
onsrel
atedtocapit
aluses)
.
3.Financi
almanagementalsoai
msatdet
ermini
ngthebestper
centage
compositi
onoft hefi
rm'scombi
nedli
abi
li
ti
esandequitydeci
sions
relat
edtocapi
talsour
ces).
1.Det
ermi
ningt
heSi
zeandGr
owt
hRat
e
Thesi
zeoft
hebusi
nessf
ir
mismeasur
edbyt
hev
alueofi
tst
otal
asset
s.
♣ Ift
hebookvaluesar
eused,t
hesizeoft
hef
ir
misequalt
othet
otalasset
s
asindi
cat
edinthebal
ancesheet
.
♣ Whent hi
smet hodofsi
zedeterminati
onisused,thegrowthrateofthe
busi
nessfir
mi smeasuredbythey earl
yper
centagechangei nthebook
val
uesofallt
heitemsi
ntheassetssecti
onofthebalancesheet
.
As a studentoffinancialmanagement ,howev
er,you shoul
d be abl
et o
underst
andthatabusinessfir
mt hatislar
geandgrowi
ngfaster&lar
gerdoes
notnecessar
il
ypr
oduceincreasedearni
ngs.
2.Det
ermi
ningAsset
sComposi
ti
on(
Por
tfol
i
o)
Asindicat
edearl
ier
,assetsrepr
esenti
nvestment
sorusesofcapit
alt
hatt
he
busi
nessfir
m makesinseeki
ngtoearnarat
eofret
urnf
ori
tsowner
s.
♣ The mostcommon assetcat
egor
ies ar
e cash,i
nvent
ori
es,and f
ixed
asset
s.
♣ However
,financi
ali
nsti
tutions,suchasbanksandi nsur
ancecompani
es,
hav
e some whatdi fferentasset s cat
egori
es. They may l
istl
oans,
adv
ances,andnegoti
ablesecur i
ti
esasassets.
♣ Theper
cent
agecomposi
ti
onoftheasset
softhefi
rmiscomputedasr
ati
o
oft
hebookval
ueofeachassett
otot
albookv
aluesofal
lasset
s.
♣ Thechoiceoft
heper
cent
agecomposi
ti
onofasseti
temsaf
fect
sthel
evel
ofbusi
nessri
sk.
♣ Theassetstructur
edecisionrel
atetowhatpr oduct
sandser vi
cest he
busi
nessfi
rm shouldpr
oduce.Thef inancialmanagerisdirect
lyinvolv
ed
i
ndecisi
onsr el
atedtot
heasset sst
ructurethatmakest hebusinessf i
rm
moresuccessfuli
nawayi twil
lmaxi
mi zethewealthofsharehol
der s.

13
The weal
th maxi
mizi
ng asset
s st
ruct
ure can be descr
ibed i
n ei
theroft
he
fol
l
owingways:
. Th
i eassetst
ruct
uret
haty
iel
dst
hel
argespr
ofi
tforagi
venl
evelof
exposur
etobusi
nessr
isk,
or
. Th
i
i eassetst
ruct
uret
hatmi
nimi
zesexposur
etobusi
nessr
iskt
hati
s
neededt
ogener
atet
hedesi
redpr
ofi
t.
Inbot hoft hecases,thefi
nanci
almanagershoul
dr ecogni
zethattheasset
structur
eoft hebusi
nessfi
rmisthemaj
ordeter
minantoftheoveral
lri
sk-
ret
urn
profil
eofthef i
rm.
3.Det
ermi
ningt
heComposi
ti
onofLi
abi
l
iti
esandEqui
ty
Asitwasstat
edearl
ieri
nthi
schapt
er,l
i
abi
l
iti
esandequi
tyar
ethesour
cesof
capi
tal
ofbusi
nessf
ir
ms.
♣ They ar
ethe f
inanci
ng sources t
hatbusi
ness f
ir
ms use t
o make
i
nvest
menti
nvar
ioustypesofasset
s.
♣ Themostcommonf i
nanci
ngsour cesareaccount
sandnot espay
able;
accrualsforit
emssuchast axes,wages,andint
erest
s;loansanddebt
securit
iesofvar
iousmaturi
tydates;
andcommonst ocks,pr
eferr
edst
ocks,
andr et
ainedearni
ngs.
♣ Hereagain,banksandinsurancecompani
esmightsecur
efundsfr
om
l
iabi
li
tyaccountssuchast i
medeposit
s,demanddeposit
s,andsav
ing
deposi
ts.
♣ Asitwasdonef ortheper
centagecomposit
ionofasset
s,theli
abi
li
tyand
equit
ypercentagecomposit
ionsoft hebusinessfi
rm ismeasur ed by
div
idi
ngthebookv al
ueofeachliabi
l
ityorequit
yit
em byt hetot
albook
val
uesofalll
iabi
li
ti
esandequit
y.
♣ Themi xofli
abil
i
tiesandequi
tyoft
hebusi
nessi
swhati
sknownast
he
capi
talst
ruct
ure.
Whenthebusinessf i
rmfi
nancesitsi
nvestmentbyusi ngdebtcapital
,("l
everage"
bei
ng the j
argon used i
n Finance t
or efert hi
s),the busi
ness fir
m and i ts
shar
eholder
sf aceaddedr
isksalongwiththepossi bi
l
ityofaddedreturns.Thisis
duetot heeffectsoflever
age,whichi sr esult
ingfrom usi
ngdebtcapi talin
fi
nanci
nginvestments.
♣ Theaddedr
iski
sthepossi
bil
i
tyt
hatt
hef
ir
m mayf
acedi
ff
icul
tyt
orepay
i
tsdebt
sast
heymat
ur Thi
e.( sisr
efer
redt
oasanegat
ivel
ever
age)
♣ Theaddedr
etur
nscomef
rom t
heabi
l
ityoft
hef
ir
mtoear
nther
ateof
ret
urnhi
gherthantheinter
estpayment
sandrel
atedf i
nanci
ngcost
sof
usi
ngli
abi
li
ti
es.(Thi
sisr
eferr
edtoasaposi
ti
vel
everage)
♣ Theaddedret
urnsmaybepai dasdiv
idendsand/
orr
e-i
nvest
edi
nthefi
rm
togener
atemor eprofi
t. Thi
s,inef
fect
,wouldmaximi
zetheweal
thof
shar
ehol
dersofthebusi
nessfir
m.

14
St
ockpr i
ces,t
her
efor
e,reactt
ot hemanneroffi
nanci
ngofabusi
nessfi
rm as
wellastothesubsequentabi
li
tyorinabi
l
ityoft
hef i
rmtomanageit
scapital
st
ructur
e.
1.
7.EVOLUTI
ONOFTHEFI
NANCEFUNCTI
ON
Financef ort
hefir
sttimebecameasepar at
ear eaofstudyar
ound1900.Si
nce
then,thedutiesandr esponsi
bil
i
tiesofthefi
nancialmanager
shaveunder
gone
continuouschange,andexpectedtochangeinthefutur
easwell
.
Thet
womai
nreasonsf
ort
heongoi
ngchangei
nthef
unct
ionsoff
inancear
e:
. Th
i econt
inuousgr
owt
h and i
ncr
easi
ng di
ver
sit
yoft
henat
ionaland
i
nter
nat
ional
economy
,and
. Th
i
i et
imet
oti
medev
elopmentofnew anal
yti
calt
ool
sthathav
ebeen
adopt
edbyf
inanci
almanager
s
1.Fi
nanceBef
ore1930
Upt
o1900,
financewasconsi
der
edasapar
tofappl
i
edeconomi
cs.
♣ The1890sand1900swer
et heperi
odsofmaj
orcor
por
atemer
ger
sand
consol
i
dat
ionsi
ntheAmer
icaneconomy.
♣ Thesemerger
sandconsoli
dat
ionswer
egr
adual
l
ytr
ansmi
tt
edt
oot
her
economi
csall
overt
hewor
ld.
♣ Theseact
ivi
ti
esr
equi
redunpr
ecedent
edamountoff
inanci
ng.
♣ Themanagementoft hecapi
talstruct
ur eofcompaniesthathadbeen
for
medduet omergersandconsol i
dationsbecomeani mport
anttask.
Hence,f
inance was emerged as dist
inctfunct
ionalar
ea ofbusi
ness
management.
Themajortechnol
ogicali
nnovat
ionsofthe1920scr
eat
edent
ir
elynewi
ndust
ri
es
suchasradi
oandbr oadcast
ingstat
ions.
♣ Thesenewindustr
iespr
oducenotonl
ylar
gequant
it
iesofout
putbutal
so
ear
nedhighprof
itmargi
n.
♣ Fi
nancialmanagementwas f ound t
o be impor
tantin deal
ing wi
th
pr
oblemsr elat
edt opl
anni
ngandcontrol
l
ingtheli
qui
dit
yoft henewly
emergedindustr
iesoft
hatt
ime.
Thest ockmar ketcrash of1929 and t
hesubsequenteconomicdepr
ession
occurredi
nt heAmer i
caneconomyr esul
tedi
nthewor steconomi
ccondit
ions
thatoccur
redinthe20thcentur
y.
♣ Bankr
upt
cy,
reorgani
zat
ion,
andmer
esur
viv
albecomemaj
orpr
obl
emsf
or
manycor
porat
ions.
♣ The capi
talst
ructur
e,whi
ch was domi
nat
ed bydebt
,aggr
avat
ed t
he
sol
vencyandli
quidi
typr
obl
emsofcompani
es.
♣ Financi
almanagementisaddi
ti
onal
l
yresponsi
blef
ort
hepl
anni
ngoft
he
rehabil
i
tat
ionandsur
viv
aloft
hebusi
nessfi
rm.

15
 2.Fi
nanceSi
nce1950
Thesedays,
lar
genumberofpeopl
eisemploy
edandwor
ksi
nmanuf
act
uri
ngand
ser
vicei
ndustr
iest
hatdi
dn'
texi
stbef
ore.
♣ Muchofthi
srapi
deconomicgrowthoccur
redbecauseoft
hei
ncr
eased
r
ateoft
echnol
ogi
cal
advancement
.
♣ The computer
izat
ion pr
ocess i
n al
mostallofthese i
ndust
ri
es i
s an
exampleoftheextenttowhichoureconomyhasbecomedependenton
newtechnol
ogies.
♣ Asnewi ndust
ri
eshavearisenandasol derindust
ri
eshav esoughtwayst
o
adapt t
o t he rapi
dly changing technologi
es,finance has become
i
ncreasi
nglyanal
yti
calanddecisionori
ented.
♣ This ev
olut
ion ofthe fi
nance f unction has been i
nfl
uenced by t
he
devel
opmentofcomputerscience, operat
ionsresear
ch,
andisometri
csas
tool
sforfi
nanci
almanagementf unctions.
Tosummarize,theev
olut
ionoff
inancef
unct
ionscont
ainst
hef
oll
owi
ngt
hree
i
mport
antpoint
s:

1. Fi
nancei
srel
ati
vel
ynewasasepar
atebusi
nessmanagementf
unct
ion;
2. Fi
nanci
almanagement
,asi
tispr
esent
lypr
act
iced,
isdeci
sionor
ient
ed
and uses analyt
icaltools such as quanti
tat
ive and comput
eri
zed
techni
ques,economics,andmanagerialaccounti
ng;
3. The conti
nuing rapi
d pace of economi c development vi
rt
uall
y
guaranteesthatt
hef i
nancef
unct
ionwillnotonlycontinuetodevel
op
butalsohav etoacceler
atei
tspaceofdev elopmentt okeepupwith
thecompl exprobl
emsandoppor tuni
ti
est hatcorporatemangerare
faci
ng.

CHAPTERSUMMARY
Thi
sfir
stchapt
erhasprovi
dedyouani
ntroduct
iont
of i
nanceast
hear
eaofst
udy
andtomanageri
alf
inanceasanimpor
tantbusi
nessfunct
ion.
The chapteralso exami ned the goaloft he business f i
rm;the commonl y
acceptedgoalofpr of
itmaximizationi scontrast
edwi t
ht hemor ecompletegoal
oft hemaximizat
ionofshar eholders'weal t
h.Ast heweal thmaxi mizat
iongoal
dealswithuncert
aintyandt i
mei nar ealworldenvironment ,i
tisfoundtobet he
propergoaloft hef ir
m. I not herwor ds,shareholders'wealthmaxi mizat
ion
attemptstotakeintoaccountbot hriskandr etur
n,andi ssuper i
orinanumberof
i
mpor tantwaystothatofthetraditi
onal economicgoal ofprofi
tmaximizati
on.
Financefi
rstappearedasadi st
inctar
eaofst udyar
ound1900andi ni
ti
all
y
focused on capit
alstruct
ure composi
ti
on. Duri
ng t
he gr
eat depr
essi
on,

16
bankr upt
cy,and reorgani
zat
ion,f i
nance became an i mportantconsiderat
ion.
Since1950,f i
nancebecamedeci sionorientedwi threspectt obothassetand
capitalst
ruct
uremanagement , andbecamei ncreasinglyanalyt
icali
nnature.The
toolsoft hefinanci
almanagernow i ncl
udeaccount ing,economics,comput er
science,andquantit
ati
veanal
y sisofoperati
onsr esearch.

CHAPTERTWO
FI
NANCI
ALSTATEMENTANALYSI
S
2.
1.BASI
CFI
NANCI
ALSTATEMENTS
The dat a used in analy
zing financi
alstatements are contai
ned infi
nancial
statementssuchasi ncomest atement,bal
ancesheet,andst at
ementofretai
ned
earnings.I n expl
aining financialstatement anal
ysis,f i
nancialstat
ements
pertaini
ngt oAddisManuf actur
ingCompanyar eusedt hroughoutthi
schapter,
whichi sanidealcompanyconsi deredforani l
l
ustr
ati
vepur pose.
.
1.I
ncomeSt
atement
Asyou know from yourprevi
ouscourses,i
ncomest
atementmeasur
est
he
pr
ofi
tabi
l
ityofabusi
nessfi
rm overaper
iod.
♣ Thought heincomest at
ementsofmanymul ti
nat
ionalcompaniescov
era
European calendaryear,Addis Manuf
acturi
ng Companyhas adopt ed
fi
scaly eart hatcorr
esponds withthe Ethi
opi
an budgety earforan
accountingpurpose.
♣ TheEt hiopi
an budgetyearrunsf
rom Hamle1 t
o Sene30. Income
Stat
ementcanal sobepr epar
edonaquart
erl
ybasi
sandref
err
edt oas
i
nteri
mi ncomestatement.
Regardl
essofthest
art
ingandendi
ngdates,ort
hel
engt
hofthet
imecov er
ed,
theimport
antpoi
ntisthati
ncomestat
ementsummari
zest
heoperat
ionsofa

17
busi
nessf
ir
m ov
eragi
vent
imei
nter
val
.
♣ Asitcanbeseenf rom theincomestatementforAddisManuf act
uring
Company,thecompany'soperati
onsgenerat
edaf low ofrev
enues( net
sal
es)
,expenses,
andprofi
ts(
netincomes)duri
ngthetworeport
ingyears.

Addi
sManuf act
uri
ngCompany
Comparati
veIncomeStat
ement
Fort
heYearsEndedSene30,1992and1993
(Fi
gur
einthousandsofBi
rr
)

I
tems 1993 1992
NetSales Bi
rr120,
000 Bi
rr
110,000
Costofgoodssol d 90,
000
83,000
GrossPr of
it 30,
000
27,000
Operati
ngExpenses:
Sell
ingexpenses 5,
000
4,
800
Generalandadm exp 8,
000
7,
600
Depexpense 1,
100
800
LeasePay ments 1,
650
1,
600
Totaloperati
ngexp 15,
750

18
 14,
800
EBIT 14,
250
12,
200
I
nterestexpenses:
I
nterestonbanknot es 550
700
I
nterestonOt herdebt 3,
600
3,
960
Totali
nterestexpenses 4,
150 4,
660
Earni
ngsbef oretaxes 10,
100
7,
450
I
ncomet axes(34%) 3,
434 2,
564
NetIncome 6,
666 4,
976

2.Bal
anceSheet
A bal
ancesheetsummar i
zesthef
inanci
alposi
ti
onoft
hebusi
nessf
ir
m. I
t
usual
l
ycont
ainstwosect
ions:
(
1)Theasset(
i.
e.usesoff
unds)sect
ion,
and
(
2)Thel
i
abi
l
iti
esandshar
ehol
der
s'equi
ty(
i.
e.sour
cesoff
unds)sect
ion
The f
oll
owing i
st he comparat
ive bal
ance sheetforAddis Manufact
uri
ng
Company,ani
dealbusi
nessf
irm,onSene30,1992E.C.andSene30,1993E.C.

Addi
sManuf
act
uri
ngCompany
Compar
ati
veBal
anceSheet
Sene30,
1992and1993

I
tems 1993 1992
Cur
rentAsset
s:
Cash 2,
500 3,
000
Market
abl
esecur
it
ies 1,
000

19
 1,
300
Account sr ecei vable 16,000
12,
000
Inv ent or i
es 20,500
18,
700
Tot al curr entasset s 40,
000
35,
000
Fi
xedAsset s:
Landandbui l
dings 28,700
24,
200
Machi ner yandequi pment 31,600
29,
000
Tot al fi
xedasset s 60,300
53,
200
Lessaccumul ateddepr eciati
on 18,
300 17,200
Netf i
xedasset s 42, 000 36,000
Tot al asset s 82, 000 71,000
Li
abili
tiesandshar eholder s'equi t
y
Curr
entl i
abi li
ties
Account spay abl e 7,
200 6,000
Not espay abl e10%bank 5,500 7,000
Accr uedl i
abi l
iti
es 900 700
Cur rentpor t i
onofl ong- term debt 3, 000
3,
000
Ot hercur r
entl iabili
ties 1,
400 1,200
Tot al cur rentliabili
ti
es 18, 000 17,900
Long-terml iabi l
iti
es
Longt er m debt -12%mor t
gagebond 27,
000
30,
000
Tot al l
iabilities 45, 000 47,900
Sharehol der s' equi ty
Commonst ock, 5Bi r
rpar ,2,000
Shar esaut hor i
zed; 1,300shar es
out standi ngi n1993and1000
shar esout st andi ngin1992 6,500 5,000
Capi tal inexcessofpar 14,
000
5,350
Ret ainedear ni ngs 16,500 12,750
Tot al shar ehol ders'equit
y 37, 000 23,100
Tot al li
abi li
ti
es&SHE 82,000 71,000
As i
ndicated i
nthe abov
e comparati
ve bal
ance sheetprepar
ed forAddis
Manufacturi
ngCompany,tot
alasset
sequalt ot
alli
abil
it
iesandstockhol
der
s'
equi
ty.
♣ Thisstat
ementshowsthemi
xofl
i
abi
l
iti
esandequi
tyt
hati
susedt
o
fi
nancecompany
'sasset
s.

20
 ♣ Theassetsofthecompanyar
ethei
nvest
ment
sithadmadei
npr
ofi
t-
seeki
ngacti
vi
ti
es.
Curr
entasset
saremostliquidassetsoft
hecompany,whichcanbe
usedorconvert
edintocashwi thinaperiodofoneyearorless.
Hence,t
heBirrv
alueofcurrentasset
sister
medasagr ossworki
ng
capi
tal
ofthecompany.
Incontr
asttocur r
entasset
s,fi
xedasset
sdivi
sionconsist
soflong-
ter
mf i
nancialclai
msandi nvest
mentsinthephy si
calasset
ssuch
aspropert
ies,
plantsandequipment
.
♣ Thel
i
abi
li
tyandshar
eholders'equi
tysect
ionoft
hebal
ancesheetshows
howt
hecompanyisf
inanced.
♣ Liabi
li
tiesareval
uesofasset
sf i
nancedbyfundsfr
om credi
tor
s.Cur
rent
l
iabil
i
ties,asst
atedear
li
er,
aretobepaidbackinl
essthanoneyear
.
♣ Theamountoff undspr ov
idedbytheshareholder
s'di
rect
lyforAddis
Manuf act
uring company arerepr
esent
ed by the common stock and
addi
tionalcapit
ali nexcessofparport
ionsoft heshar
eholder
s'equit
y
sect
ionoft hebalancesheet
.
♣ Retai
nedearni
ngsarepartofshar
eholders'
equit
yobtai
nedasaresul
tof
theboardofdir
ect
orsdecisi
ontor et
ainporti
on,orent
ir
eamountofnet
profi
tsoft
hecompanyforrei
nvest
ment .
The account
ing pr
ocedur
es used t
o gener
atefi
nancialst
atements ar
e not
pri
maril
ydesi
gnedtoprovi
dedatai
nputsf
orfi
nanci
alst
atementsanal
ysi
s.
♣ As a consequence ofthi
s,the f
inanci
alst
atement
s maynotalways
prov
idetheinf
ormati
onthatthef
inanci
almanager
sneedforv
ari
oust
ypes
ofbusi
nessdecisi
ons.
♣ Forexample,t
heassetsareli
stedinthebalancesheetatt
hei
rhist
ori
cal
cost
st hatdonot,mostofthetime,ref
lectt
hecurrentmar
ketval
ues,or
ther
eplacementcost
softheseassets.
♣ Moreov
er,some di
ff
icult
ies can be expect
ed i
nint
erpr
eti
ng f
inanci
al
st
atementf
igur
esi
ndi
v i
duall
y.
♣ Fori
nst
ance,
ani
ncr
easei
nabal
anceofani
nvent
oryaccountcoul
dmean:
Theindi
vi
dualpurchasescostmorethateverduetoincr
easesin
pri
cesandthatt
hephy si
cal
inv
ent
oryl
evelshavenoti
ncr
eased,or
Thecompanyi
saccumul
ati
ngt
hati
thasbeenunabl
etosel
l
,or
The company i
s produci
ng,orpur chasi
ng i
nvent
ori
es i
nlar
ge
quanti
ti
esi
nanti
cipat
ionofincr
easesisthevol
umeofsalesint
he
fut
ure.
Thiscl
earl
yshowsthati
tisdi
ffi
cul
ttointer
prett
hebal
anceofagi
venaccount
separ
atel
yasitcoul
dmeandif
fer
entthi
ngs.

21
 3.St
atementoft
heRet
ainedEar
nings
Thestatementofret
ainedear
ningsl istshow muchofthenetprof
it/
incomeof
thecompanywaspaidoutasdi videndst otheshar
ehol
dersandhowmuchofi t
wasr et
ainedinthecompanyf orr einvest
mentsorfurt
herexpansi
onoft he
company .
♣ The statementofr etai
ned earnings normal
ly exhi
bit
s one i
mport
ant
rel
ati
onshipthatexi
stsbetweent heincomest at
ement( t
hatsummari
zes
theoperati
onofthecompanydur i
ngagi venti
meper i
od)andthebal
ance
sheet(t
hatsummar i
zesthefinancialposi
ti
onofthecompanyont hegi
ven
date)
.
♣ Theret
ainedearni
ngaccountintheshar
eholder
s'equi
tysect
ionofthe
bal
ancesheetofthecompanyist
heaccumulati
onofthenetpr
ofitoft
he
companythathasbeenr
etai
nedovert
heli
fet
imeofthecompany .
♣ Ever
yt heret
ainedear
ningsaccounti
sincr
easedbyanamountequalto
theexcessofnetprof
itoverdi
vi
denddecl
aredanddi
str
ibut
eddur
ingt
hat
year
.
♣ Hence,the ending balance ofthe retai
ned ear
nings accountt
hatis
computed i
nt he statementofr etained earni
ngs l
inks the i
ncome
stat
ementandthebal ancesheet.
♣ There ar
einf act,many otherway si
n whi
ch al
loft
hese f
inanci
al
st
atementsi
nteractwi
thoneanother
.
Thefol
lowingisthestat
ementofret
ainedear
ningsf
orAddi
sManuf
act
uri
ng
Company,anideal
company,
fort
hey
earendedSene30,
1993E.
C.

AddisManufacturi
ngCompany
Stat
ementofretainedearnings
FortheYearendedSene30, 1993E.C.
Retai
nedEarni
ngs,Hamle1, 1993 12,
750
Netincome 6,
666
Sub-
Total 19,
416
Less:Cashdiv
idends(
Commonst ock) 2,
916
16,
500
Ret
ainedEar
nings,
Sene30,
1993
Asy oucanseef rom thest atementofretai
nedear ningofAddi sManuf acturi
ng
Company ,theretai
nedear ningsaccounthasabal anceofBi rr12,750onHaml e1,
1993t hati
st heendingbal anceofSene30,1992car ri
edf orward.Thisbal ance
washshowni ntheshar eholders'
equi
tysecti
onoft hebal ancesheetpr eparedfor
Addismanuf acturi
ngcompanyonSene30,1992.I nthesameway ,theendi ng
balanceoft her etai
nedear ningsaccountshowni nt hest atementofr et
ained
earningforAddismanuf act
ur i
ngcompanyf orthey earendi ngonSene30,1993
(i
.e.16500Bi rr
)wasr epor t
edi nthesharehol
ders'equitysect ionofthebal ance

22
sheetf
ort
haty
ear
.

2.
2.RATI
OANALYSI
S
The firstst
ep in undert
aking f
inanci
alstatement
s analysi
si st
or ead and
understandt
hefinanci
alstatementandthei
raccompanyingnoteswi
thcare.Thi
s
i
sf oll
owedbyt hecomput ati
onofr at
ios(i.
e.undert
akingrati
oanal
ysis)and
i
nterpreti
ngwhattherati
osistomean.
♣ Theuseoff i
nancialrat
iosto anal
yzef i
nanci
alstat
ement si
snow a
common pr acti
ce to the ext
ent that even computer
ized f
inancial
stat
ementanalysisprogramspreparefinanci
alrat
iosaspar toft heir
overal
lanal
ysi
s.
♣ Bothlender
sandpot ent
iall
ender
susef i
nanci
alr
ati
ost
oev
aluat
eloan
appl
icat
ionsfr
om bor
rowingcompani
es.
♣ I
nvest
orsusefi
nanci
alr
ati
ostoassessthefutur
etal
eoft
hecompani
esi
n
whi
chtheyarecont
emplat
ingt
omakei nvest
ment.
♣ Manager
smakeuseoffinanci
alrati
osinordertojudgetheperf
ormance
ofthei
rcompani
es and to contr
olthe day-
to-day oper
ati
on ofthei
r
compani
es.
♣ Owner
smakeuseoffi
nanci
alrat
iost
oev
aluat
ewhet
hert
hei
rcompani
es
ar
emaximi
zi
ngthei
rweal
thornot
.
2.
2.1.Fi
nanci
alRat
ios:
Gener
al
Fi
nancialrat
ios can be desi
gned t
o measur
e al
mostany aspectoft
he
per
formanceofthecompany.
♣ Ingeneral
,fi
nanci
alanal
yst
suserat
iosasonet
ooli
nident
if
yingar
easof
str
engthsandweaknessesi
nthecompany.
♣ Fi
nanci
alratios,howev
er,t
end t
oident
if
ysy
mpt
oms r
athert
han t
he
pr
oblemsclassingsy
mptoms.
♣ Af i
nanci
alratiowhoseval
uei sjudged"
dif
ferent"orusual
lyhighorlow
mayhel pidentif
yasignif
icanteventbuti tdoesnotpr ovideenough
i
nformati
ont hathel
pstoidenti
fythereasonsf ortheoccurr
enceofthe
event
.
♣ Thefi
nanci
alrat
iosar
ejudgedhi
gh,l
ow,oraccept
abl
ewhent
heyar
e
compar
edwithst
andar
ds.
♣ St
andar
drat
ioscoul
dbe:
I
ndust
ry st
andar
ds:These ar
e st
andar
drat
ios comput
ed f
or

23
 companiesoperat
ingi
nthesamei ndust
ry.Forexampl
e,av
erage
rat
iost
andardscanbedev
elopedf
ortexti
l
eindust
ry.
Managementplans:Thesearefi
nanci
alr
ati
osar erati
osthatthe
managementofagi vecompanysetasgoal
s.Thesear eplansof
thecompanyandstandar
dsagai
nstwhi
chactualf
inanci
alr
ati
osare
compared.
Histor
icalstandards:Thesear efi
nanci
alratiosdevel
opedf r
om the
hist
oricalrecor ds ofthe companyov ersayt he last10 y ears.
Histor
icalstandar dsare,t
her efor
e,theav er
agef i
nancialrati
osfor
thecompanyf orthelast10y ears.Theseratioscanalsobeusedas
standardsagai nstwhichyoucompar ethecomput edr at
iostojudge
them ofhigh,loworaccept able.
2.
2.2.Ty
pesofFi
nanci
alRat
ios
Themostcommonf inanci
alr
ati
osusedf
orfinanci
alanaly
sisi udeLi
ncl quidi
ty,
Activ
ity(
AssetManagement)
,DebtManagement(Leverage)
,andPr of
it
abil
i
ty
rat
ios.
1.Li
qui
dit
yRat
ios
Liqui
dityr at
iosmeasuretheabil
ityofbusinessf i
r mtopayi tscur
rentl
i
abil
it
ies
andcur rentport
ionoflong-t
erm debtsast heymat ure.Liquidi
tyr
ati
osassume
thatcur rentassets ar
et he pri
ncipalsour ces ofcash formeet i
ng cur
rent
l
iabil
i
tiesandcur r
entport
ionofl ong-t
erml oans. Ther earet womostwidely
usedliquidit
yrat
ios.Thesearethecur r
entandqui ckoracidrati
os.
A.Cur
rentRat
io
Thecurr
entrat
ioi
scomput
edbydiv
idi
ngcur
rentassetsbycur
rentl
i
abi
l
iti
es.The
cur
rentrat
iosforAddi
sManufact
uri
ngCompanyf or1992and1993ar ethe
fol
l
owing:
Cur
rentRat
io =

Cur
rentRat
io(
for1992)=

Cur
rentRat
io(
for1993)=

Thelargert hecur r
entratio,t
hel essthediffi
cult
yt hecompanyf acesinpayi
ngits
obli
gationsatt herighttime.Inmanycases, lendersf requentlyrequi
rethecurr
ent
rati
ooft hebor rowingcompanyt or emainatorabov e2. 0timesasacondi ti
onfor
gradingorcont inui
ngt hecommer cialandindustri
al loans.
♣ Th i
sst andar dof2. 0t i
mesi sanar bi
tr
arilysel ectedf i
gureandmany
financi
alanal yst
sf eelthattheliqui
dit
yposi tionoft hecompanyshoul dbe
quest i
onedi ft
hecur rentrati
ooft hecompanyf all
sbel ow2.0times.
♣ Th i
si sbecause oft he factt hatallcur rentasset scannotbe easi l
y
conv er
tedbackt ocash
♣ I tisverydiffi
culttocollectaccountsreceivabl einfull
.

24
 ♣ Itisverydi ff
icultofsell
all t
heinventori
es.
♣ Short-t
er m prepay mentsar eunli
kelytobeconv ertedtocash.
♣ Ifthelessl i
quidasset sconst i
tutesignif
icantpor tionoft hetotalcur
rent
asset,y oumayneedcur rentrati
othatisev engr eaterthan2.0times.
Thecur rentratiosofAddi smanuf acturi
ngCompanyshowt hatthecompanyhas
Birr1.96i ncur rentasset sforeachBi r
rofcur r
entliabili
tiesduring1992andBi rr
2.22i ncur rentasset sforeachBi r
rofcur rentli
abili
tiesdur ing1993.I tisvery
diff
icultt osayt hisr ati
osar ehighorl owaswedon’ thav eindustr
ystandard,or
managementpl an,orhi stori
calst andard againstwecompar et hesecurrent
rati
os.
♣ Ho wev er,onecansayt hatAddi sCompanyi smor ecapabl ei
n1993t opay
i
t scurrentliabil
iti
esthani n1992.

B.Qui
ckRat
io
Qui
ckr at
ioissomet i
mescalled"aci
dtestrati
o".Itservesthesamegeneral
pur
poseast hatofthecurr
entrat
iobutmor estr
ingentasitexcl
udel
essl
iqui
d
cur
rentasset
sli
keinvent
oryfr
om curr
entasset
s.
♣ Itconsi
der
sonlyquickcur
rentasset
ssuchascash,
mar
ket
abl
esecur
it
ies,
andaccountr
eceiv
ables.
♣ Thisisdonebecauseinv
entori
es,pr
epai
dexpensesandsuppl
i
escannot
easi
lybeconv
ertedbacktocash.
♣ Thus,t
hequi ck(aci
dtest
)rat
iomeasur
estheabi
l
ityoft
hecompanyt
o
payitscur
rentl i
abi
li
ti
esbyconver
ti
ngitsmostli
qui
dasset
stocash,
whichi
seasier.
♣ Thequickr ati
oi scomputedbysubt
ract
ingi
nv ent
ori
es,pr
epai
dexpense,
andsuppliesf rom cur
rentasset
sanddi vi
dingther emai
nderbytotal
cur
rentl
iabili
ti
es.
ForAddi
sManuf
act
uri
ngCompany
,thequi
ckr
ati
osar
e:
Qui
ckRat
io=

Qui
ckRat
io(
for1992)=

Qui
ck Rat
io(
for1993)=

I
fthecompanywantst
opayt heent
ir
eamountofit
scurr
entl
iabi
li
ti
esbyusi
ng
i
ts qui
ckasset
s(i.
e.cur
rentasset
sminusthe sum ofinv
entori
es,pr
epai
d

25
expenses,andsuppl
i
es)
,it
squi
ckasset
sshoul
dbeequalt
oorgr
eat
ert
hani
ts
curr
entli
abil
it
ies.
♣ Thus,
theCompany
'squi
ckr
ati
oshoul
dbe1.
0ti
mesormor
ethant
hat
.
I
nt hecaseofAddisManufact
uri
ngCompany,thequi
ckasset
sof91cent
sar
e
avail
abl
etomeeteachBi
rrofcurr
entl
i
abi
l
iti
es.
♣ Thi
simpli
esthatt
hequi
ckasset
sar
enotenought
oset
tl
eal
lthecur
rent
obl
i
gati
ons.
♣ Unlesst hecompanyconv ert
sthenon-qui
ckcurr
entasset
stot heext
ent
theyprov i
decasht hatisenought
opayt her
emaini
ng9centsforeachBir
r
ofcur r
entliabil
it
ies,t
hecompanywi l
lfacedif
fi
cul
tyi
nmeet i
ngi t
sshort
-
term obli
gations.
Thequickrat
ioof1.08t i
mesf or1993,ontheot herhand,i
mpl i
esthatthe
companyhasBir
r1.08ofquickassetsf
oreachBir
rofcurrentl
iabi
l
iti
es.Again,
thecompanyi
singoodli
quidi
typosi
ti
ondur
ing1993compar edt
o1992.
2.Act
ivi
tyRat
ios(
AssetManagementRat
io)
Act
ivi
tyratiosmeasurethedegr
eeofef
fi
ciencywi
thwhi
cht
hecompanyut
il
izes
i
tsresources(asset
s).
♣ Ef
fi
ciencyi
sequat
edwi
thr
api
dresour
cet
urnov
ers.
♣ Someact i
vi
tyr
ati
osconcent
rat
eonindi
vi
dualasset
ssuchasinvent
ory,
or
accountsr
ecei
vabl
ewhil
eother
slookatt
heoveral
lcompanyper
formance,
oracti
vi
ty.
Thef
oll
owi
ngact
ivi
tyr
ati
osar
edi
scussedf
orAddi
sManuf
act
uri
ngCompany
:
A.I
nvent
oryTur
nov
erRat
io
Thisrati
oismeaningful
forcompaniesl
i
keAddi
sManufacturi
ngCompany
,whi
ch
holdinventor
ies ofdif
fer
entkinds.(i
tcoul
d be merchandi
se,r
aw mater
ial
,
processedgoods,andsoon).
♣ Thi
srat
iomeasur
est
henumberoft
imespery
eart
hatt
hecompanysel
l
s
i
tsi
nvent
ory
.
♣ I
tiscomputedbydiv
idi
ngtheBi
rramountofcost
sofgoodssoldbythe
Bi
rramountofi
nvent
oryatt
hecl
osingdat
eoftheaccount
ingper
iod.
ForAddi
sManuf
act
uri
ngCompany
,thei
nvent
oryt
urnov
err
ati
osar
e:
I
nvent
oryt
urnov
er=

I
nvent
oryt
urnov
er(
f0r1992)=

I
nvent
oryt
urnov
er(
for1993)=

26
I
ngeneral
,hi
ghinventoryturnov
ermaybet akenasasi gnofgoodi nv
entory
management
.Otherthingsbeingthesame,inventor
ytur
noverrat
ioscomput ed
f
orAddisManuf
actur
ingCompanyi ndi
catethatthecompanywasabl etosel
lits
i
nvent
ori
es4.
44timesand4. 39ti
meduring1992and1993E.C.respecti
vel
y.
♣ Theperf
ormance/
effi
ciencyoft
hecompanyi
nsel
l
ingi
tsi
nvent
ori
eswas
near
lyt
hesamedur i
ngt het
woyear
s.
♣ However
,youcannotsaytheinventoryturnoverrati
osforAddisCompany
showgoodorbadperformance,orhighef f
ici
encyorloweffi
ciencyasl
ong
asyoudonothavestandar
dinventoryturnoverrati
otocompar ewit
h.
I
nventor
yturnoverrat
io,asameasur
eofeff
ici
encyofbusi
nessact
ivi
ti
es,
suf
fer
s
f
rom bothconceptualandmeasur
ementpr
oblems.
♣ Forexample,hi
ghi
nvent
oryt
urnov
errat
iocoul
di ndi
cat
edthei
nadequacy
ofi
nventor
ytomeetcust
omerdemandswhichresult
sinl
ossofsal
es.
♣ Alow inventoryturnoverrati
o,ont heotherhand,canbecausedbyan
i
ncreasedlineofnew pr oductseachofwhi chrequi
resomemi nimum
i
nventorybalances,which,inturn,r
aisest hebal
anceofover
alli
nvent
ory
l
evelandlower stheinv
entoryturnov
err at
io.
♣ I
nbot
hoft hesecases,theinvent
oryt
urnov
err
ati
o,i
fiti
susedal
one,
may
l
eadt
oincorrectconcl
usions.
♣ Thi
sist
omeant
hathi
ghi
nvent
oryt
urnov
err
ati
omaynotal
way
sbegood.

A measur
ementprobl
em of i
nvent
orytur
nov
err
ati
o emanat
es f
rom t
he
denomi
nat
orusedi
ncal
cul
ati
ngt
herat
io.
♣ Sincethepurposeoft hisrat
ioi
stomeasuret
heinvent
oryt
urnoverrat
e,
thedenominatorshouldbeameasureoftheav
erageamountofinvent
ory
thatt
hecompanymai ntai
neddur
ingt
heyear
.
♣ However,i
nmostoft hecases,t
hefigur
eusedast hedenominat
oristhe
amountofinventoryonhandatt heendoft hereport
ingper
iodbecause
theav
erageinventor
ybalanceisnoteasi
lyobt
ainabl
e.
♣ Ifthe bal ance ofinv
entor
y atthe end oft he y eari
s nota good
representati
veoftheaver
ageyear
lyi
nventorybecauseofseasonaland/or
cycli
calpr oduct
ionandsell
ingpatt
erns,theusefulnessofthisrati
oi s
greatl
ylimited.
B.Tot
alAsset
sTur
nov
erRat
io
I
tmeasurestherel
ati
onshi
pbet
weenabi
rrofsal
esandabi
rrofasset
s,usual
l
y
onayear
lybasi
s.
♣ Afi
rm want
stogener
ateasmuchbir
raspossi
blei
nthef
orm ofsal
esper
abi
rrofani
nvest
mentitmadei
nassets.
♣ The assett
urnov
err
ati
ois a measur
e oft
he ov
eral
lact
ivi
tyoft
he
company.

27
 ♣ Iti
scomputedbydiv
idi
ngthetot
alnetsal
esofthecompanybyi
tst
otal
asset
sonthecl
osi
ngdateoft
heaccounti
ngper
iod.
ForAddi
sManuf
act
uri
ngco-
thet
otal
tur
nov
err
ati
osar
e:
Tot
alasset
stur
nov
er=

Tot
alasset
stur
nov
er(
for1992)=

Tot
alasset
stur
nov
er(
for1993)=

The t
otalassetstur noverrati
o of1. 55 timesdur ing 1992 i
mpliest hatthe
companywasabl et ogener at
eBi r
r1. 55f orasinglebirrithasinvestedinits
asset
sduri
ngt heyear.Dur i
ng1993, ont heotherhand,thecompanywasabl eto
makenetsalesofbirr1.46foreachbirrithasinvestedinthetot
alassets.
♣ Though t
het ot
alvol
umeofsal esisgreat
erdur i
ng 1993,theassets
tur
noverr
ati
osshowt hatthecompanywaseffi
cientingener
atinghi
gher
netsal
esperbir
rofi
nvestmenti
nasseti
n1992thani n1993.
♣ Thedecr
easeintheassett
urnoverrat
ioi
n1993mayindicateadecrease
i
ntheuti
l
izat
ionoft
heassetsforgener
ati
ngt
hedesi
redsalesrev
enue.
C.Av
erageCol
l
ect
ionPer
iod
Thi
srat
iotr
iestomeasuretheav
eragenumberofday
sitt
akest
hecompanyt
o
col
l
ecti
tsaccountr
ecei
vabl
es.
♣ The shor
tert
he av
erage col
l
ect
ion per
iod,t
he bet
tert
he company
's
act
ivi
ti
esar
e.
Asy
ouknow,
accountr
ecei
vabl
eisr
esul
tedf
rom cr
edi
tsal
es.
♣ Hence,t
hisr
ati
orel
atest
hedai
l
ycr
edi
tsal
est
oit
saccountr
ecei
vabl
e
bal
anceatt
heendoft
her
epor
ti
ngper
iod.
♣ Netsal
esmaybeusedi
ntheabsenceofcr
edi
tsal
es,t
houghi
treduces
thequal
it
yoft herati
oinmeasuri
ngt
henumberofday
sthatr
ecei
vabl
es
dotakebefor
et hei
rcol
lect
ion.
Theav
eragecol
l
ect
ionper
iodi
scomput
edi
nat
wo-
steppr
ocedur
e.
♣ Fi
rst
,youcomput
etheav
eragedai
l
ycr
edi
tsal
es(
int
heabsenceofcr
edi
t
salesyoucomputedtheaver
agedai
lysal
es)bydi
vi
dingt
he360day
sint
o
thetot
alcr
editsal
es,
ortot
alsal
es.
♣ Second,y
ou comput
ethe av
erage col
l
ect
ion per
iod by di
vi
ding t
he
accountrecei
vablebal
anceattheendoftheaccounti
ngperi
od(pref
erabl
y
theaverageaccountreceiv
ablei
favai
labl
e)bydailycredi
tsal
es,ordail
y
sal
esint heabsenceofthefor
mer.
Assumingthatal
lsal
esaremadeonaccountbyAddi
smanuf
act
uri
ngcompany
,
theav
eragecoll
ect
ionper
iodsar
e:

28
 St
ep1: Dai
l
yCr
edi
tSal
es=

Dai
l
yCr
edi
tSal
es(
for1992)=

Dai
l
yCr
edi
tSal
es(
for1992)=

When t
otalsales used i
nst
ead ofcredi
tsales i
nthe formula,the aver
age
col
l
ecti
on peri
od wi l
lface measur
ementproblem because the cash sal
es
i
ncl
udedinthetot
al sal
esdonothaveanyl
inkwit
haver
agecollecti
onperi
od.
Moreover,theuseoftheaccountrecei
vabl
ebalanceatt
heendofthemaynot
r
epresentthemont haverageofaccountsrecei
vabl
ewhenther
ear eseasonal
f
luct
uations.Inthi
scase,theaver
agecol l
ect
ionperi
odagai
nsuff
ersfr
om the
measurementproblem.

St
ep2:
Aver
ageCol
l
ect
ionPer
iod(
ACP)=

ACP(
for1992)=

ACP(
for1992)=

The av er
age col
l
ect
ion peri
od requi
res the anal
yst t
o prov
ide car
eful
i
nterpretati
onev
enwhenthesemeasurementprobl
emsareover
came,oratl
east
recognized.
♣ Ani ncrease,ordecr
easeinthev
aluesofav
eragecol
l
ect
ionper
iodshoul
d
notbeusedt oev al
uat
et heeff
ortthecompanyputsincol
lect
ingit
s
receivables.
Forexample,
theaver
agecoll
ect
ionperi
oddur
ingt
hey
ear1992i
snear
ly40day
s,
whichisshor
tert
hanthatoft
heyear1993.
♣ I
ft heshorterav er
agecoll
ect
ionperiodduri
ng1992wascausedbythe
ver
yt ightcr edi
tpoli
cyadoptedduringthatyear
,itmaynotbemor e
desir
ablethant heaveragecoll
ect
ionperi
odof48daysachi
eveddur
ing
1993under, sayali
beralcr
edi
tpoli
cy.
♣ Thisisbecausethecredi
tpol
i
ciest
hemsel
vescanbr
ingchangest
othe
averagecol
lect
ionper
iod.
♣ St
ri
ngentcr
edi
tpol
i
cydef
ini
tel
yreducest
heav
eragecol
l
ect
ionper
iod.
♣ I
fthesmallaver
agecoll
ect
ionperi
odofAddi
sManuf act
uri
ngCompany
dur
ing1992wascausedbyr
educedvol
umeofcredi
tsal
es,i
tmaynotbea

29
 goodi
ndi
cat
ionofgoodcr
edi
tcol
l
ect
ioncondi
ti
on.
Fur
ther
mor e,credi
tgr
ant
ing and t
he st
ruct
uri
ng ofcr
edi
tt er
ms ar
e major
competi
ti
vet ool
susedbythemar ket
ingmanagersrat
herthanthefi
nanci
al
managers.
♣ Manycompaniesar
efor
cedtosetcredi
tpoli
ciest
hatar
ecompar abl
ewi
th
t
hecredi
tpol
icyoft
hedominantcompanyinthesameindust
ry.
♣ Theav er
agecoll
ecti
onperi
od,i
nthi
sregar
d,hast
obei
nter
pret
edi
n
rel
ati
ontothecr
editt
ermspr
ovi
dedt
ocust
omers.
3.DebtManagementorLev
erageRat
ios
Theserat
iosmeasuretheext
entt
owhi
chacompanyf
inancesi
tsel
fwi
thdebtas
opposedtoequi
tyf
inanci
ng.
♣ Theser
ati
osar
eal edsol
socal
l vencyorcapi
talst
ruct
urer
ati
os.
♣ Theyar
eal
sot
ermedasf
inanci
all
ever
ager
ati
os.
Fi
nanci
alr
ati
ospr
ovi
det
hebasi
sforanswer
ingt
wobasi
cquest
ions:
. Ho
i whast
hecompanyf
inancei
tsasset
susi
ngdebt
s?
. Ca
i
i nt
hecompanyaf
for
dthel
eveloff
ixedchar
gesassoci
atedwi
th
theuseofnon-
owner
s-suppl
i
edf
undssuchasbondi
nter
est
sand
pri
nci
pal
payment
s?
Thef i
rstquest
ionisansweredusi ngbal
ancesheetl
ever
agerat
ios,whi
l
ethe
secondquesti
onisansweredthroughtheuseofi
ncomestat
ementbasedr
ati
os,
orsimplyt
hroughtheuseoflever
agerati
os.

A.Bal
anceSheetLev
erageRat
ios
These r
ati
os provi
de the basi
sf oranswer
ing t
he quest
ion "Where di
dt he
companyobtai
nf i
nanci
ngforitsi
nvest
ments?Thebalancesheetlev
eragerat
ios
i
nclude:
. De
i btRat
ioorDebt
-AssetRat
io
I
tmeasurestheextentt
owhi cht het
otalasset
soft hecompanyhavebeen
fi
nancedusi
ngborr
owedf unds.ForAddi
sManuf act
uri
ngCompany,t
herati
os
arecomput
edasfol
lows:
Debt
-AssetRat
io=

Debt
-AssetRat
io(
for1992)= =67.
46%

Debt
-AssetRat
io(
for1993)=

30
Attheendof1992,67. 46per centofthetotalasset sofAddi sManufacturi
ng
Companywer ef
inancedbyf undssecuredint hef or
m ofcur r
entandlong-ter
m
l
iabi
lit
ies.Theremai ning32. 54percentwasf inancedbyf undscontri
butedby
shareholder
sandr et
ai nedfrom t heprofi
tsear nedbyt hecompany .Similar
ly,
debtfinanci
ngconsti
tut esabout55per centoft hetotalassetsofthecompany
duri
ng1993.Thisleav es45per centofthetot
al assetstobef i
nancedwit
hequi t
y
sources.
♣ Thelevelofdebtf
inanci
nghasdecl
i
neddur
ing1993compar
edt
o1992
si
gnali
nggoodcondit
ion.
♣ Toomuchdebtf
inanci
ngi
sri
ski
ert
othecompany
.
♣ Addismanuf act
uri
ngcompanycanborrowmuchmor emoneydur
ing1993
thanitcoul
ddoi n1992becausetheassetst
ruct
ureoft
hecompanywas
moredebt -
dominatedi
n1992thanin1993.
♣ Hence,
lendersarewil
l
ingtogivel
oanstothecompanyduring1993,when
t
hedebt-assetr
ati
oisless,
thandur
ing1992,whendebt
-assetr
ati
oishigh.
You cannotsaymuch aboutt he capit
alstr
uct
ure ofAddi
s manufactur
ing
companyont hebasisofthedebt
-assetr
ati
oscomput
edaboveasyoudon'thave
anystandar
ddebt-assetr
ati
otobeusedasabenchmar k.
♣ I
ngeneral,cr
edi
tor
spr ef
erlow debt-
assetrat
ios,becauset
helowerthe
r
ati
os,becauset
hel owertherati
os,thelowerthechanceoflosi
ngthei
r
moneyuponmaturi
ty,orl
iqui
dati
on.
♣ Theowner s,ont
heotherhand,maywanthi
gherdebt(l
ever
age)r
ati
os
becausethecostofborr
owedmoneyi susual
l
ylessthanthecostof
owners'
funds.
Thedebt-assetr
ati
oscal
culat
edabov
eforAddismanufact
uri
ngcompanyshow
thatmoret hanhalfofthecompany
'sasset
swerefinancedwit
hfundsform
credi
tor
sdur i
ngthetwoy
ears.
♣ Asar esult
,t hecompanymayf i
ndi
tdi
ff
icul
tbor
row addi
ti
onalf
unds
wi
thoutfi
rstraisi
ngmor
eequi
ty.
♣ Other
wise,credit
ors woul
d be r
eluct
antt olend mor
e moneyt
othe
companywithitsdebt
-dominat
edcapit
alst
ruct
ure.
Thoughcredit
orsarewi
ll
ingtogiv
eloanstodebtdomi
natedbor
rowertheyare
wil
lathigheri
nter
estr
atethatcommensur
atewit
hthehighri
sktheyar
et aki
ng
aslender
s.
The debi t-asset r
ati
o of 67.46 percent for 1992 comput ed fro Addis
manuf acturingcompanycanalsobeinterpr
etedasonebi rrofi
nvestmenti
nthe
company 'sasset swasmadeupoft hecombi nationofabout67cent softhe
credi
tors'fundsandt heremai
ning33cent soft hesharehol
der
s'funds.Duri
ng
1993,abi rrofinvest
mentinthecompany '
sasset swasmadewi thabout55
centsofcr editor
s'f
undsandsharehol
derscontr
ibutedtheremai
ning45cents.

31
 .L
i
i ong-
Ter
m Debt
-Equi
tyRat
io
Thisr
ati
omeasurest heext
enttowhi
chcr edit
ors(
debt
-hol
der
s)pr
ovi
dedl
ong-
ter
mfinanci
ngr
elat
ivetoshar
ehol
der
s'f
inancing.
♣ Ther
ati
oiscomput
edbydi
vi
dingl
ong-
ter
m debt
sbyst
ockhol
der
s'equi
ty.
The l
ong-t
erm debtto equi
tyr
ati
os f
orAddi
s manuf
act
uri
ng companyar
e
computedasfol
l
ows:-
Long-
Ter
m Debt
-Equi
tyRat
io=

Long-
Ter
m Debt
-Equi
tyRat
io(
for1992)=

Long-
Ter
m Debt
-Equi
tyRat
io(
for1993)=

Thel
ong-
ter
m debt
-equit
yrat
iooft
hecompanydecreasedfr
om 130%i
n1992t
o
73%i
n1993.Thisdecreasemaybecausedbysev
eralf
actor
ssomeofwhi
char
e:
Somelong-
ter
m debtsmightbemat
uredandpai
dout
,whi
chr
educet
he
bal
anceofl
ong-t
erm debt
s,
Addi
s manufacturi
ng company might i
ncr
ease t
he lev
el of it
s
shar
ehol
der
s'equit
yeit
herbyi
ssui
ngaddi
ti
onal
shar
esatpr
emium,and
Someamountmightbeaddedtot
hecompany'sr
etai
nedear
ningsduet
o
ret
ent
ionoft
heport
ionoff
ull
amountofneti
ncome.
Yourinter
pret
ati
onfort helong-
term debt-
equi
tyrati
oof130per centachi
eved
duri
ng1992canbet hatforasingl
ebirrofsharehol
ders'equi
tyinthelong-
ter
m
fi
nancingther
eisbi
rr1.30oflong-t
erm debti
nthelong-t
ermf i
nanci
ng.
I
notherwor
ds,thel
ong-
ter
mf i
nanci
ngofbir
r2.30wasmadeinaway
t
hatbir
r1fr
om shar
ehol
ders'
equi
tyandbi
rr1.30fr
om l
ong-
ter
m debt
.
Inthesameway ,asinglebirri
nt helong-
ter
m equi
tyf
inanci
ngis
combinedwi
th73centsofl ong-
term debtf
inanci
ngt
oform atot
al
l
ong-t
ermfi
nanci
ngofbirr1.
73during1993.
I
not herwords,f
oreachbi
rrobtai
nedfr
om shar
eholders'equi
ty,t
he
l
ong-ter
m debthol
der
scont
ri
buted73centsi
nthelong-
termf i
nanci
ng
dur
ingtheyear.
Again,i
tisv er
ydiffi
cultto conclude t
hatthe l
ong-
ter
m debt-equityrati
os
computedf
orAddisManuf actur
ingCompanyshowgoodorbadcapi t
alstruct
ure
ofthecompanyaslongasy oudonothavestandar
dlong-
ter
m debt-equi
tyrati
o
tobeusedasapointofref
erence.

i
i
i. Debt
-Equi
tyRat
io
Thisrat
ioexpr
essesther
elat
ionshi
pbetweent
heamountoft het
otalasset
sof
thecompanyfi
nancedbycr
editor
s(debt
)andowner
s(equi
ty)
.

32
 Thus,thi
sr ati
o ref
lect
st he r el
ati
ve clai
ms of cr
edi
tor
s and
shar
ehol
dersagai
nstt
hetotalassetsofthecompany
.
Thedebt-
equi
tyrat
ioiscomput
edbydi
vi
dingt
het
otaldebt
sbyt
he
tot
alshar
ehol
der
s'equi
ty.
Thi
srati
oprov
idesanswertothequest
ion:Whatarethepr
opor
ti
onsofdebt
s
andequi
tyi
nfi
nanci
ngthetot
alasset
softhecompany
?
Thedebt
-t
o-equi
tyr
ati
osf
orAddi
smanuf
act
uri
ngcompanyar
ethef
oll
owi
ng:
Debt-Equi
tyRat
io=

Debt
-Equi
tyRat
io(
for1992)=

Debt
-Equi
tyRat
io(
for1993)=

The debt -
equityrati
o of2. 07 forAddi s manufacturi
ng company f or1992
i
ndicatest hatthecreditorsofthecompanyhav eprovidedaboutbi r
r2.07i n
fi
nancing theasset soft hecompanyf oreverysinglebi r
rcontr
ibuted f
rom
shareholders’equi
ty.Int hesamet oken,thedebt-equi
tyratioof1.
22f or1993
showst hatt hecredi
torshav epr
ovidedbi r
r1.22inf i
nancingtheassetsoft he
fi
rmf oreachbi r
rcontr
ibutedbyshareholder
s’equi
ty.
Whethert
hesetypesofcapi
talst
ructur
e(debtandequi
tymi x)ar
egood
orbaddependsonthest
andardsetfort
hedebt-
to-
equi
tyrat
io.
Unl
essyouaret
oldthi
sstandar
d,st
il
lyoucannotsayt
hedebtandequi
ty
mixofAddi
smanufact
uri
ngcompanyisgoodorbad.

B.Cov
erageRat
ios
Theser at
iosar
ethesecondcat
egor
y,i
.e.I
ncomeSt
atement
-Based,l
ever
age
rat
ios.
Theyar
eusedt omeasur ethecompany’
sabil
it
ytocov eritsfi
nanci
ng
cost
s(i
nter
estexpenses)associ
atedwi
tht
heuseofdebtf
inanci
ng.
Theserat
iospr
ovi
det hebasisforansweringthequest
ionofwhetherthe
companyhasusedtoomuchf inanci
all
everage.Thecover
agerat
ios,most
ofthet
imeformostcompanies,incl
udethefoll
owi
ng.
. Ti
i mesI
nter
estEar
nedRat
io(
Int
erestCov
erageRat
io)
Thi
srati
omeasurestheext
entt
owhichoperati
ngincomecandecl
i
nebef
oret
he
companyisunabl
etomeetit
sannual
int
erestcost
s.
♣ Fail
uretomeett hi
sobli
gat
ioncanbri
nglegalact
ionbyt
hecompany
’s
credi
tor
s,possi
blyr
esul
ti
ngi
nbankrupt
cy.
♣ Thisrat
ioisdeterminedbydivi
dingear
ningsbef
orei
nter
estandt
axes
(EBI
T)bythei
nterestchar
gesdur
ingthey
ear.

33
 ♣ Notet hatearni
ngs befor
ei nterestand t
axes (
EBIT),r
atherthan net
i
ncome,i susedasanumer atori nthef
ormulabecauseint
erestispaid
wit
ht hepr e-
taxincomeand t hecompany’sabil
it
yofpay ing i
nter
est
char
gesi snotaf
fectedbytaxes.
The t
imes int
erest ear
ned rati
os (i
nter
est cov
erage r
ati
os) f
or Addi
s
manuf
act
uri
ngcompanydur i
ng1992and1993are:
I
nter
estCov
erageRat
io=

I
nter
estCov
erageRat
io(
for1992)=

I
nter
estCov
erageRat
io(
for1993)=

The ti
mes int
erestearned (i
nterestcov er
age)ratios computed forAddi s
manufact
uri
ngcompanyr eveal
sthatthecompany ’
sear ni
ngsbef
orei nt
erestand
tax
esare2.62ti
mesand3. 43timeshigherthantherespecti
vei
nterestexpenses
ofthecompanyduri
ng1992and1993r espect
ivel
y.
♣ Asl ongasyoudonothavet
hei
ndust
ryav
erage,y
oucannotcat
egor
ize
theserat
iosashi
ghorasl
ow.
But
,gener
all
yspeaki
ng,
♣ Lowertimesint
erestearnedratiosuggestst hatcredi
torsareatr i
skin
recei
vi
ngtheint
erestpaymentsthatar edue;thecredit
orsmayt akelegal
acti
onthatmayresulti
nbankrupti
ngt hecompany ;andthecompanymay
facedif
fi
cul
tyinraisi
ngadditi
onalfinanci
ngt hroughdebtissuesast he
companyisunderri
skofpayinginter
estcharges.
♣ Al ar
gerint
erestcover
ager at
io,ontheotherhand,suggest sthatt he
companyhassuf f
ici
entmarginofsafet
yt ocoverit
si nt
erestexpenses;
andt heear
ningsbef
oreint
erestandtaxes(EBI
T)oft hecompanycoul d
decli
ne wit
houtjeopar
dizi
ng the company’
s abil
i
tyt o make i nt
erest
payments.
.F
i
i i
xedChar
geCov
erageRat
io
Thi
sr at
ioissimil
artot hatofthetimes-i
nter
est-
earnedrati
o,butitismore
i
nclusive as i
trecogni
zes otherfi
xed obl
igat
ions such as l
ease pay
ment
s,
pri
ncipalpayment
sofdebt s,
anddiv
idendpaymentsonpr ef
err
edstocks.
♣ Unli
keint
erestexpensesandleasepayment
s,thepri
nci
palpay
mentsof
debtsanddivi
dendpay ment
sonpr ef
err
edst
ocksarenott
axdeduct
ibl
es,
i
.e.t
heyarepaidfr
om aftert
axearni
ngs.
♣ Thus,
ataxadj
ust
mentshoul
dbemadef
ort
hesepay
ment
s.
Forexample,t
he company thatisr equir
ed to effectpri
ncipalpayment
s
amount
ingtobi
rr100from i
tsear
ningsaftertaxes(assumingat axrat
eof40
per
cent
)needsi
tsear
ningsbef
oretaxestobe( orbir
r166.67.

34
Thef i
xedchar gesobvi
ousl
yincl
udeint
erestexpenses,annuall
ong-
ter
mlease
obli
gations,pr
inci
palpayment
soflong-
term debts,anddivi
dendpayment
sfor
pref
erredstockhol
ders.
Thef
ormul
aforf
ixedchar
gecov
erager
ati
ois,
ther
efor
e,def
inedasf
oll
ows:

Fi
xedChar
geCov
erageRat
io=

Asy ou can observef r

om t heabov eequation,interestexpensesand l
ease
paymentsarenotadj ustedfortaxesbecauset heyarepaidfrom earni
ngbef
ore
tax,whil
epr i
ncipaland prefer
red divi
dend pay mentsar eadjusted f
ort
axes
becausetheyarepaidfrom t
heaf tert
axearni
ngs( netincome)
Consi
deri
ngthegivenincometaxr ateof34per
centandthepr i
ncipalpay
ments
of2500birrand3000bi r
rduri
ng1992and1993r espect
ivel
y,thefixedchar
ge
cover
agerati
osforAddisManufacturi
ngCompanycanbecomput edbyusingt
he
abovemathemati
calequati
onasf ol
lows:
Fi
xedChar
geCov
erageRat
io(
for1992)=

Fi
xedChar
geCov
erageRat
io(
for1993)=

Addi
smanuf actur
ingcompanyi sabletocoveri
tsfixedcharges,
(int
erest
s,lease
payments,andpri
ncipalpay
ment s)
,1.37ti
mesand1. 54ti
mesusingitsearnings
bef
oreinter
estandtaxesduring1992and1993r especti
vel
y.
♣ Inotherwords,t
heear
ningsbef
orei
nter
estandtaxesoft
hecompanyare
equalto1.37ti
mesthefi
xedchar
gesduri
ng1992and1.54ti
mesthef
ixed
chargesduri
ng1993.
4.Pr
ofi
tAbi
l
ityRat
ios
Pr
ofi
tabi
l
ityi
sthenetr
esul
tofanumberofpol
i
ciesanddeci
sions.

35
 ♣ Theprof
it
abi
li
tyrat
iospr
ovi
det
heov
eral
lev
aluat
ionofper
for
manceoft
he
companyandit
smanagement.
♣ Theserat
iosshowthecombinedef
fect
sofl
iqui
dit
y,act
ivi
ty,andl
ever
age
rat
iosontheoper
ati
ngresul
toft
hecompany
.
Thesever
alrat
iosf
all
i
ngundert
hiscat
egor
yar
edi
scussedi
nthef
oll
owi
ng
par
agr
aphs.
. Gr
i ossPr
ofi
tMar
gin
Thegr
osspr
ofi
tmar
ginr
ati
oiscal
cul
atedasf
oll
ows:

GrossProf
itMar
gin=Gr ossprofi
t
Netsales
Grossprof
itmar
ginofAddi sco.(
for1992)=27,000 =0.
2455,
or
24.55%
110,
000

Grosspr
ofi
tmar
ginofAddi
sco.(
for1993)=30,000 =0.
25,
or
25%
120,
000
Thus,Addi
smanufact
uri
ngcompany’
sgrosspr
ofi
tconsti
tutes24.
55%and25%
ofthecompany
’snetsal
esdur
ing1992and1993respect
ively
.
♣ Theserati
osrefl
ectt
hecompany’smar
k-upsoncost
sofgoodssol
das
wellastheabi
li
tyofthecompany’
smanagementtomini
mizet
hecost
sof
goodssoldinrel
ati
ontonetsal
es.
♣ Lar
gergr
ossmar
ginr
ati
oimpl
i
esl
owercost
sofgoodssol
drat
eandv
ice
ver
sa.
. Op
i
i er
ati
ngPr
ofi
tMar
gin
Movi
ngdowninthei
ncomestatement
s,thenextpr
ofi
tfi
gur
efol
l
owi
nggr
oss
pr
ofi
tist
heoper
ati
ngincome(orEBI
T).
♣ Thi
soperat
ingprof
itf
igur
eser
vesast
hebasi
sforcomput
ingt
he
oper
ati
ngprofi
tmargi
n.
♣ Theoperati
ngprofi
t,asyouknow,
ist
heexcessofgr
osspr
ofi
tov
ert
he
tot
aloperat
ingexpenses.
ForAddi
smanuf
act
uri
ngcompany
,theoper
ati
ngpr
ofi
tmar
ginsar
efoundas
fol
l
ows:

Oper
ati
ngpr
ofi
tmar
gin=Operati
ngIncome
Netsales
Oper
ati
ngpr
ofi
tmar
gin(
for1992)=12,200 =0. 1109,
or11.09%
110,000
Oper
ati
ngpr
ofi
tmar
gin(
for1993)=14, 250 =0.
1188,or11.
88%
120,
000

36
Theoperat
ingprof
itmarginsr
efl
ectthecompany’soperati
ngexpensesaswell
asit
scostsofgoodssold.Addismanuf act
uri
ngcompanyr emai
nedwith11.
09
per
centand11.88percentofi
tsnetsalesaft
ercoveri
ngitscostofgoodssol
d
andall
operati
ngexpensesduri
ng1992and1993r espect
ively
.

i.Ne
i
i tProfi
tMar gi
nRat i
o
Thenetprofitmarginonnetsalesmeasurestheprof
it
abi
li
tyoft
hecompanyona
perbi
rrbasisofnetsales.
♣ Th israti
oi s calcul
ated bydiv
idi
ng netincome bynetsal
e ofthe
companyf oragivenaccounti
ngperi
od.
Thenetprofi
tmar ginrat
iosforAddismanuf
actur
ingcompanyare:

Netprofitmar gin=Ear ningsaf tert axes

Netsal es
Netprofitmar gin(for1992)=4, 976 =0. 0452,or4. 52%
110, 000
Netprofitmar gin(for1993)=6. 666 =0. 0556
120,000
Thesenetpr ofi
tmar ginratioscanbei nterpretedi nsuchawayt hatAddis
manufacturi
ngcompanyhadear ned4. 52per cent ,ornearly5cent s,neti
ncome
perbi
rrofnetsal esitmadedur i
ng1992and5. 56per cent,ornear l
y6cents,per
bi
rrofsalesitmadedur i
ng1993.
♣ Th enetpr ofitmar ginoft hecompanyi si nfl
uencedbyt heamountof
i
nterestexpenses/ chargesandi ncomet axexpensesbecausenetpr of
it
i
sanear ni
ngaf t
eri nterestandt axes( EBI T).
i. Re
v turnonI nvestment( ROI)
I
tisalsoknownasr eturnonAsset s( ROA) .
♣ Th isratiomeasur est hecompany ’
spr of i
tabil
it
yperbi rrofi nvest
mentin
thetotalassets.
♣ Th eROI ,orROAi scal culatedbydi v
idingear ni
ngsaf tert axesbytotal
assets.
TheROIf orAddismanuf act ur
ingcompanyf ort het woy earsare:

Ret
urnonInvest
ment(ROI)=Ear
ningsAfterTaxes(
Net
I
ncome)
Totalasset
s
ROI(
for1992)=4,
976 =0.0701,or7.01%
71,
000
ROI(
for1993)=6,
666 =0.0813,or8.13%
82,
000
Thus,Addismanuf act
uri
ngcompanygenerated7.01per
cent
,orabout7cents,
in
theform ofnetincomeoutofeachbir
riti
nvestedini
tst
otal
assetsdur
ing1992,
and8.13per cent,
orabout8cent
s,inthef
orm ofneti
ncomeoutofeachbirrof
i
nv est
mentini t
stotal
assetsdur
ing1993.

37
 ♣ Whethert
heindicat
edretur
nsoninvest
mentsaregoodorbaddependson
t
heindust
rystandards,
orthemanagementplans.
♣ Whatyoucansayatt
hispoi
ntisthatt
hecompany
’sr
etur
noninvest
ment
hasshownsl
ighti
mprovementi
n1993comparedtot
hatof1992.
Youcanal
souseanat
ivef
ormul
atocomput
ether
etur
noni
nvest
ment
s(ROI
).
Thati
s:
Ret
urnoni
nvest
ment(
ROI
)=NetPr
ofi
tMar
ginxTot
alAsset
Tur
nov
er
=NetI
ncome x NetSal
es
NetSal
es TotalI
nvest
ment

TheROIf
orAddi
sManuf
act
uri
ngCompanydur
ing1993,
fori
nst
ance,
is:

ROIf
or1993=6,666 =0.
1802or18.
02%
37,000
Asitcanbededucedformt hecomputedROE,Addismanufact
uringcompany
hasgenerat
ed21.54percent,
orabout22cents,and18.
02percent,orabout18
cent
s,forever
ybi
rrofshareholder
s’equi
tydur
ing1992and1993r espect
ivel
y.
♣ Sinceearni
ngsaft
ertaxesarethenetearni
ngsaf
tercover
ingbothinter
est
chargesandtaxli
abi
l
iti
es,theyareavai
labl
eonl
yforthesharehol
dersof
theequit
ycapit
aloft
hef i
rm, orcompany.
5.Mar
ket
/BookRat
ios
Thesear
erat
iosr
ecent
lyi
ntr
oducedi
ntot
her
ati
oanal
ysi
s.
♣ Theyar
epr
imar
il
yusedf
ori
nvest
mentdeci
sionsandl
ong-
rangepl
anni
ng
I
ncl
udedi
ntheser
ati
osar
ethef
oll
owi
ng:
.E
i ar
ningPerShar
e(EPS)
Ear
ning pershare(EPS)expresses t
he pr
ofi
tear
ned percommon st
ock
out
standi
ngduri
ngtherepor
ti
ngperi
od.
♣ I
tprovi
desameasur eofover
allper
for
manceandisani
ndi
cat
oroft
he
possi
bleamountofdi
vi
dendsthatmaybeexpect
ed.
The ear
ning pershar
eforAddi
smanuf
act
uri
ng companyar
e comput
ed as
fol
l
ows:

Ear
ning pershare( EPS)= EAT ( netincome)– Pr ef
erred
di
vi
dend
Numberofcommonshar esoutst
anding
Or(EPS)=Earni
ngsav ai
labl
eforcommonst ockhol
ders
Numberofcommonshar esoutst
anding
EPS(for1992)=4,
976- 0 =4, 976 =4.98Birr
/shar
e
1000shares 1000shares

38
 EPS(
for1993)=6,
666-0 =6,666 =5.
13bi
rr
/shar
e
1,
300 1,
300
AddisManufact
uri
ngCompanyhasearnedBir
r4.98pershar
eduring1992and
Bir
r5.13persharedur
ing1993.Theearni
ngpersharehasshownanincrease
duri
ng1993,whi
chshowsimprovedper
for
manceofthecompanyduri
ngtheyear
.
♣ Thoughtheearni
ngspershar ewereBir
r4.
98andBi r
r5.13pershar
e
duri
ng1992and1993r especti
vel
y,t
heserat
iosdonott el
lyouhow
muchoftheseearningspersharearepai
dasdivi
dendandhowmuchis
ret
ainedi
nthebusiness.
♣ Moreover
,since you do not havet he indust
ry aver
age or the
managementplan,youcannotconcl
udethattheseearni
ngspershare
ar
eindi
cator
sofgoodorbadperformance.
. Pr
i
i ice-
to-
Ear
ningsRat
io(
P/E)
Thepr i
ce-ear
ningrat
ioexpressest
hemult
ipl
ethatthemarketpr
icesonthe
company ’
searningspershareandiscommonlyusedtoassesstheowner’
s
appr
aisalofshareval
ue.
♣ Thepri
ce-
to-
ear
ningsrat
ioiscomput
edbydividi
ngt
hemar
ketpr
iceofa
shar
ebytheear
ningpershar
ecomputedabov
e.
Assuming t
hecommonshar eofAddi
smanufactur
ing companyhasmar ket
pri
cesofBirr30andBir
r35attheendof1992and1993r espect
ivel
y,compute
theP/Erat
ioofthecompany
.

P/
Erat
io=Curr
entmar ketpr
icepershar
e
EPS
P/
Erat
io(
for1992)= 30 =6. 02ti
mes
4.98
P/
Erat
io(
for1992)= 35 =6. 82ti
mes
5.13
Youcani
nter
prett
heser
ati
osl
i
ket
his:
♣ Themar ketiswi
ll
ingtopayaboutbi
rr6in1992andaboutbir
r7i
n1993
foreverybi
rrint
hecompany’searni
ngs.Agai
n,t
heP/Erati
ohasshowna
sli
ghtimprovementduri
ng1993.
Sincet
heindustr
ystandar
dormanagementpl
ani
slacking,
iti
sv er
ydif
fi
cul
tfor
youtocat
egorizeAddismanuf
act
uri
ngcompanyashighlyv
aluedorlowval
ued
company.
♣ However,
youcansay,i
ngeneral
,thatahi
ghP/Erati
orefl
ect
sthe
market
’sper
cept
ionofthecompany ’
sgr
owthprospect
s.
♣ Thus,i
ftheinvest
orsi
nthestockmarketsbel
iev
ethatacompany’
sfutur
e
earni
ngspotenti
ali
sgood,t
heyarewill
ingtopayhi
gherpr
icesf
orthe
stockandfurt
herboastt
heP/Erat
io.
♣ Thepr
obl
em wi
thP/
Erat
ioi
sthatt
hemar
ketpr
icef
orashar
eofcommon

39
 st
ockmaynotbeav
ail
abl
ewhent
her
eisno’
stockmar
ket
.
i
i
i. BookVal
uePerShar
e
I
tist he val
ue ofeach shar
e ofcommon st
ock based on t
he company
’s
account
ingrecor
ds.
♣ I
tiscomputedbydi
vi
dingtheexcessoft
otalstockholders'equi
tyov
er
pr
efer
redst
ockt
othenumberofcommonsharesoutstanding.
The book val
ues pershar
er at
ios forAddis manufact
uring company ar
e
computedasfol
lows:
Bookval
uepershar
e=Tot al
stockhol
der
s'equi
ty–pr efer
redstock
Numberofcommonshar esoutstanding

Bookval
uepershare(f
or1992)=23, 100–0
1,000shar es
=23, 100 =23. 10
1000shar es
Bookval
uepershar
e(for1993)=37, 000–0
1,300shar es
= 37, 000 =28. 46
1,300shar es
Thebookv
alueofashar
eofcommonst ockofAddi
smanuf
act
uri
ngcompanyi
s
Bi
rr23.
10i
n1992andBirr28.
46dur
ing1993.
♣ Thisshowsthatt
hebookvalueofashar
eisl
essthanthemarketv
alueof
ashareduri
ngthetwoyear
s, assumi
ngt
hemarketpr
icesusedear
li
erin
theexampl
e.
♣ Hence,
theval
ueofashar
eint
hemar
ketdur
ingt
het
woy
ear
sisbet
ter
t
hanthebookval
ue.
Si
ncewedon’thavei
ndustr
yaverageormanagementgoal
,wecannotsayt
he
bookval
uespershar
erati
osareaboveorbel
owtheindust
ryav
erage,or
managementpl
an,however.
i
v. Di
vi
dendsPerShar
e(DPS)
I
tshows t he bi
rramountofdivi
dends pai
d on a shar
e ofcommon st
ock
out
standi
ngdur i
ngt
herepor
ti
ngper
iod.
♣ I
tisdet
ermi
nedbydi
vi
dingt
het
otalcashdi
vi
dendsoncommonshar
esby
t
henumberofcommonshar
esoutst
andi
ng.
Assumi ngAddi
smanufact
uringcompanydist
ri
but
edacashdivi
dendtocommon
shareholder
sofBir
r1,
900,000dur i
ng1992andBirr2,
600,
000duri
ng1993,t
he
div
idendpersharef
ort
hetwoy ear
sare:

Di
vi
dendpershar
e= Total
divi
dendsoncommonshare
Numberofcommonsharesout
standi
ng

40
 Di
vi
dendpershar
e(f
or1992)=1,900 = Bi
rr1.
9/shar
e
1000Shar
es

Di
vi
dendpershar
e(f
or1993)=2600 = Bi
rr2/shar
e
1,
300shar
es

Addi
smanufact
uri
ngcompanypai
dBir
r1.9divi
dendpercommonshar
edur
ing
1992andBi
rr2percommonsharedur
ing1993.
. Di
v vi
dendPay
outRat
io
I
tshowst
heper
cent
ageofear
ningspai
dtoshar
ehol
der
s.
♣ I
texpr
essest
hecashdi
vi
dendpai
dpershar
easaper
cent
ageofEPS.
♣ Div
idendpayoutr
ati
oiscomput
edbydi
vi
dingcashdi
vi
dendpershar
eby
earni
ngspershar
e.
Thedi
videndpay
outr
ati
osofAddi
smanuf
act
uri
ngcompanyar
ecomput
edas
fol
l
ows:

Di
vi
dendpay
outr
ati
o=Cashdi videndpershare ,or
Earningpershare
=Totaldi
videndtocommonst ock
Tot
alearningsavai
labl
eforcommonst
ock
hol
d

Di
vi
dendpay
outr
ati
o(f
or1992)=1.90 =38.
15%
4.
98

Di
videndpay
outr
ati
o(f
or1993)=2.0 =39%
5.13
Orelse
Di
videndpay
outr
ati
o(f
or1992)=1900 =38.18%
4,
976
Di
videndpay
outr
ati
o(f
or1993)=2,600 =39%
6,
666

Thedividendpayoutrat
iosindicat
et hatAddi
smanufacturi
ngcompanypai
d
about38per centofi
tsearningsintheform ofdi
vi
dendsforit
scommon
shareholder
sdur i
ng1992andpai d39per centofi
tsear
ningsint
hefor
m of
div
idendsdur i
ng1993.
v
i. Di
vi
dendYi
eld
I
tshowstherateear
nedbyshar
ehol
der
sfr
om di
vi
dendsr
elat
ivet
othecur
rent
marketpr
iceofshar
es.
♣ Di
vi
dendy iel
discomput
edbydi
vi
dingcashdi
vi
dendpershar
ebycur
rent
marketpr
icepershar
e.

41
Thedi
vi
dendy
iel
dsf
orAddi
smanuf
act
uri
ngcompanyf
or1992and1993ar
e:

Di
vi
dendy
iel
d=Cashdi
videndpershar
e
Mar
ketpri
cepershare

Di
vi
dendy
iel
d(f
or1992)=1.
9 =6.
33%
30
Di
vi
dendy
iel
d(f
or1993)= 2 =5.71%
35
Addismanufact
uri
ngcompanypaid6.33percentand5.
71per
centi
nt hef
orm of
div
idendst
ocommonshar ehol
dersperbir
rofthecurr
entmar
ketpr
icesofit
s
sharesdur
ing1992and1993respect
ivel
y.
♣ Unlesswedohav eindustr
yaverage,
iti
sdif
fi
cul
ttosaytheserat
ios
i
ndicategoodorbadsituati
on.However,
whatwecansay ,i
ngeneral
,i
s
thatthehi
gherdi
videndrate(y
iel
d)mayrefl
ectf
ewerinv
estment
opportuni
ti
esonthepartofAddismanufact
uri
ngcompany .
2.
3.APPROACHESTOUSI
NGRATIOSINTHEFI
NANCI
ALSTATEMENTS
ANALYSI
S
Thesearetwobasi
capproachesinanalyzi
ngasetoffinanci
alst
atement
susing
fi
nanci
alrati
os.Thesearethe crosssect i
onalanal
ysisand t
het i
meser i
es
anal
ysi
s. Thesetwoapproachescompl ementeachot herandbothshoul
dbe
usedaspartoft
heanaly
sisoffi
nancial
statements.
2.
3.1Cr
oss-
Sect
ional
Anal
ysi
s
Thisappr
oachenabl
esy
outoeval
uatecompany’
sfi
nanci
alcondi
ti
onsatagiv
en
pointi
ntimeandcomparecompany
’scurr
entperf
ormanceagai
nstthatoft
he
previ
ousyear
.
♣ Undercr
oss-
sect
ionalanal
ysi
s,youcompar
ether
ati
osofy
ourcompany
agai
nstt
hoseofi
tscompetit
ors.
♣ Thefir
stst
epincross-secti
onalanal
ysisofAddi
smanufact
uringcompany
i
st oeval
uatei
tsfinancialposi
ti
onatt heendof1993.Inordertodoso,
thecompany’
sfi
nancialstatementsareneeded.
♣ Thesecondstepistocomparet hecur
rentper
formanceoft hecompany
agai
nstthatoft he pr
evious y
earby compar i
ng the f
inanci
alrati
os
computedfor1992and1993,whichar
esummar i
zedinthefoll
owingt
able.

42
Summar
yofFi
nanci
alRat
iosofAddi
smanuf
act
uri
ngcompany
:

Ratio 1992 1993

Liquidity:
Cur rentratio- -
----
--
--
---
-----
--
---
--
---
--
--
--
--1.96 2.22
Qui ckr ati
o - --
----
--
--
---
-----
--
---
--
---
--
--
--
-0. 91 1.08
Act ivi
ty:
Invent orytur nov er - -
----
---
---
--
---
--
---
--
--
- 4. 44 4.39
Tot alasset st ur nover------
--
---
--
---
--
--
--
---
- 1. 55 1.46
Av eragecol lectionper iod- --
--
---
--
--
---
--
--
- 39day s 48
day s
Lev erage:
Tot aldebtt oasset s- ---
----
--
---
--
---
--
--
--
---67.46% 54.88%
Longt erm debtt oequi ty----
--
---
--
--
--
---
--
- 130% 73%
Tot aldebt -to-equi t
y- -
--
-----
---
--
---
--
--
--
---
- 2. 07 1.22
Timei nterestear ned- -
-----
--
---
--
---
--
--
--
---
-2. 62t imes 2.26
times
Fixedchar gescov erage- ---
--
---
--
---
--
--
--
--- 1.37t i
mes 1.54
times
Prof i
tabili
ty :
Gr osspr ofitmar gi
n- -
--
-----
---
--
---
--
--
--
---
-- 24. 55% 25%
Oper atingpr ofitmar gin- --
---
--
---
--
--
--
---
--
- 11. 09% 11.88%
Netpr ofi
tmar gin----
--
--
-----
---
--
---
--
--
---
-- 4. 52% 5.
56%
Ret urnoni nv estment( ROI )--
---
--
--
--
---
--
-- 7. 01% 8.13%
Ret urnonshar ehol ders’ equity(ROE)----
--21. 54% 18.02%
Compari
ngt hel
iqui
dit
yr at
iosof1992and1993ofAddi
smanufact
uri
ng
company,botht
hecurrentrat
ioandqui
ckrat
ioshowi
mprov
ementduri
ng
1993.
The act
ivi
tyr
ati
os ofAddi s manuf
act
uri
ng company i
mplythatthe
companywasl
esseffi
cienti
nuti
l
izi
ngi
tsasset
sin1993compar
edtowhat
i
thaddonedur
ing1993.
Theleverage(debtmanagement )r
ati
osofAddismanufact
uri
ngcompany
showt hatthecapi
talstr
uctur
ehasbeeni mprov
edduri
ng1993compared
tothatof1992,wherethecapit
alst
ruct
urehadbeenadebt-
dominat
edone.
Theprofi
tabi
li
tyr
ati
osalsosuggestthatt
hecompany’
sper
for
mancewas
moreprofi
tabl
eduri
ng1993thanithadbeeni
n1992.
Thefinalst
epi nthecr
oss-
secti
onalanal
ysi
siscompari
ngthefinancial
rat
ioscomputedforAddismanufactur
ingcompanyagai
nsttheaverage
fi
nancial
rat
ioscomput
edforal
lcompeti
ngcompaniesi
nthei
ndust
ry.
Theresul
toft hiscompar
isont el
l
sy outhepositi
onofAddismanuf
act
uri
ng
companyregar
dingit
sli
qui
dit
y,acti
vi
ty,
lev
erageandprof
it
abi
l
ity
.
Unf
ort
unat
ely
,wedonothav
eindust
ryav
eragesi
nourcount
ryt
ouse

43
 f
orcompar
isonpur
poses.

2.
3.2.Ti
meser
iesAnal
ysi
s
Thisapproachi
susedtoevaluat
etheper
for
manceoft
hecompanyov
ersev
eral
years.I
tlooksf
ort
hreefact
ors:
I
mpor
tantt
rendsi
nthedat
aoft
hecompany
Shi
ft
sint
rends,
and
Val
uest
hatdev
iat
esubst
ant
ial
l
yfor
mtheot
herdat
a
2.
4.ADVANTAGESANDLI
MITATI
ONSOFRATI
OANALYSI
S
2.
4.1.Adv
ant
agesofFi
nanci
alRat
ioAnal
ysi
s:
Thef
oll
owi
ngar
ethemaj
oradv
ant
agesoff
inanci
alr
ati
oanal
ysi
s:
1.Rat
iosar
eeasyt
ocomput
e
2.Rat
ios prov
ide st
andar
ds of compar
ison at a poi
nt i
nti
me and
compar
isonstobemadewit
hindust
ryav
erage,i
favai
l
abl
e.
3.Rati
oscanbeusedtoanal
yzecompany’
stimeseri
esinordertodiscov
er
tr
ends,
shi
ft
sintr
ends,
andvaluest
hatdevi
atef
orm ot
hersi
milarv
alues.
4.Rat
iosar
eusef
uli
nident
if
yingpr
obl
em ar
easofacompany
.
5.When combi ned with ot
her t
ool
s,fi
nanci
alrati
os anal
ysi
s makes
i
mportantcontri
but
ionstothet
askofev
aluat
ingt
hecompany’sfi
nanci
al
per
for
mance.

2.
4.2.Li
mit
ati
onsofRat
ioAnal
ysi
s
Thef
oll
owi
ngar
ethemaj
orl
i
mit
ati
onsoff
inanci
alr
ati
oanal
ysi
s:
1.Takenbyt
hemsel
ves,f
inanci
alr
ati
ospr
ovi
dei
nfor
mat
ionv
eryl
i
ttl
eini
ts
use.
2.Rati
osseldom provi
deanswerstoquest
ionstheyrai
sebecausegener
all
y
theydonotident
ifyt
hecausesfort
hedif
ficul
ti
esthatt
hecompanyfaced.
3.Rati
oscaneasi
lybemisi
nter
pret
edfori
nst
ance;adecr
easei
ntheval
ueof
agivenrat
iodoesnotnecessar
il
ymeanthatsomethi
ngundesi
rabl
ehas
happened.
4.Veryfewstandardsexi
stt
hatcanbeusedt
ojudget
headequacyofar
ati
o
orsetofr
atios.
5.Industr
y average cannot be reli
ed upon excl
usi
vel
yt o eval
uatea
company ’sperf
ormancebecausemostoft hecompaniesi
nani ndust
ry
mayper formfarbelowtheacceptablel
evelofper
for
mance,whi
chlowers
theindustr
yaverage.

44
 6.I
nsomecases,t
heindust
ryaver
agerat
iosmaynotbeav ai
labl
eatall
,
whi
chi
sthepr
obl
em weencount
erint
hecaseofEt
hiopi
ani
ndustr
ies.
7.Manyl ar
gecompani esoper ateanumberofdi ffer
entindustr
iesandin
suchcases, i
tisdi
ffi
culttodev el
opameaningfulsetofrati
ostocompare
againstindustr
yav erage. Thi smakesrati
o analysi
smor eusefulf
or
smal l
erand nar r
owl yf ocused compani
es than forl ar
ge and multi
div
isionalones.
8.Inf
lat
ionsever
elydistort
sbalancesheetsofcompani es(recor
dedvalues
areusuall
ydif
ferentfrom ’
true’
,or‘market’value)
.Again,sinceinf
lat
ion
aff
ectsbothdepr eci
ati
onchar gesandi nventorycosts,profi
tsarealso
aff
ected.Rati
osdonotconsi derthesedistor
tionsunlessbalancesheet
andincomestatementf i
gur
esar eadj
ustedfortheeffectofinfl
ati
on.
9.Seasonalfl
uctuati
onscanalsodist
ortt
heanalysi
soffi
nanci
alst
atements
thr
ought heuseofr ati
os. Theseproblemscanbemi nimi
zedbyusi ng
monthly averages f
or inv
entori
es and recei
vabl
es when calcul
ati
ng
tur
noverrat
ios.
10.
Compani es can empl oy ‘window dr essing’t echni ques to make t he
fi
nancialstatement slookst ronger. Fori nstance,t hecompanymi ght
borrowonal ong- term basishugeamountofcasht owar dstheendoft he
accountingper iodf orf ew day sbutbackpai di nt hef ir
stweekoft he
subsequentaccount ingper iod. Thi sact iondi dimpr ovethecompany ’
s
currentandqui ckr at
iosandmadet hebal ancesheetoft hecompanylook
good.Howev er ,asy oucl earl
yunder stand,t hei mpr ov ementwasstri
ct l
y
duet ot he“wi ndow dr essing”t echniquet hecompanyhad empl oyed.
Undersuchsi tuation, i
tishighlylikelytomi sinterpretbot hthecurr
entand
quickratioast heysi gnalgoodl i
quidityposi tionoft hecompany ,whi
chi n
factisnot.
11.
Iti
sdi ff
iculttogener al
i
zewhet herapar ticul
arrati
oi s‘good’or‘bad’
.For
exampl e,ahi ghcurr
entratiomayi ndicateastrongliquidi
typosit
ion,which
isgood,ort heav ai
labi
li
tyofexcesscash,whi chi sobv i
ouslybadast he
excesscashi sanon- earni
ng( idle)asset. Simi
larly,ahighf i
xedasset
tur
nov errat i
omaydenot eei t
heracompanyt hatusesi t
sf i
xedasset s
eff
icientl
y,oronet hatisundercapi tali
zed and cannotaf fordt o buy
enough f ixed assetwhose v alue is used as a denomi natorwhen
calculat
ingt herat
ios.
CHAPTERSUMMARY
Anal
ysi
softhefi
nanci
aldat
acontai
nedinthecompany’
sincomestatement
sand
bal
ancesheet
sisaidedbytheuseofr at
iosanal
ysi
s.Rati
oanalysisi
susedto
obt
ainmeasur
esofcompany ’
sli
qui
dly
,act
ivi
ty,
debt
,andprofi
tabi
l
ity
.
The cross-sect
ionalapproach t
or at
io anal
ysi
s,suppl
emented withi ndustr
y
averages,canhelpinevaluati
ngt hefi
nancialposi
ti
onofacompanyatagi ven
pointint i
me. The t i
me ser i
esappr oach,toget
herwiththe preparati
on of
commonsi zeincomest atements,canhelpinshowingrecentf
inancialtrends,

45
shi
ft
sint
rends,
andv
aluest
hatdev
iat
efr
om ot
herdat
a.
The use off i
nancialrat
ios cannotdo adequat ej ob offi
nanci
alstatement
analy
sis. The use off inanci
alr ati
os al one willnotpr ovi
de a complete
understandi
ngofthecompany ’
sact i
vit
ies.Rat hertheuseoff i
nanci
alr
atioswil
l
rai
sequest i
onthat,whenpur sued,willprovidethei nfor
mati
onneededt oreach
aninformedjudgmentaboutt hefinancialcondit
ionoft hecompany.

46
 Chapter-3
Ti
mev
alueofMoney
Ti
mev
alueofMoney
:

Theconceptofi nteresti
soneoft hecor eideasi nfinanci
almanagement.
Indi
vi
dual s,aswel las,businessorganizat
ionsfrequentl
yencount
ersituat
ions
thati
nv olvecashreceiptsanddisbur
sement soverseveralperi
odofti
me.When
this happens, interest rates and inter
est pay ments become important
considerati
ons.

Businessor ganizat i
ondealswi t
hinterestrateswhenitmakesbot hf i
nanci
ngand
i
nv estmentdeci sions. Short-ter
m commer ci
aland industrialloans maybe
obtainedatr easonabl yloweri
nterestrateswhi l
elong-t
erminvest mentsinasset s
l
iker ealest
at e,machi neryandequipmentar eev al
uatedont hebasi softheprof i
t
thattheinvest or(company )expectsoutoft hem.Si nce,suchinv estmentrequire
thecommi tmentoff undsov ersev eralyeas,theexpectedpr ofi
tsneedt obe
measur edint ermsoft heratesofr eturnswhi chareequivalentt otheinterest
returnsthatcanber eceivedont heinvestedfunds.

Acompanycan, ther
efor
e,earnar at
eofr et
urnoni tsi
nv est
edf undsandar at eof
i
nterestonthefundsitl
enttobor r
ower s.Thekeyconceptt hatunderliesthisis
t
het imev al
ueofmoney :thatabi r
rtodayi swor t
hmor ethanabi rrrecei
v eda
yearfrom now.Thisisbecauseoft hef actthatthevalueofonebi r
rafteray ear
wil
lgrowt oonebir
randani nt
erestearnedoni tf
oritcanbei nvested,orgiv
enas
l
oansdur i
ngtheyear.

Inter esti st he pr i
ce pai df ort he use ofmoney ov er
ti
me. The r ate of
ret urn/inter estcanbest atedexpl i
citl
yasi tist hecasef orcommer ci
aland
mor tgage l oans pr ovided by t he commer ci
alBank ofEt hiopi
a( CBE)and
Const ruct i
on and Busi nessBank( CBB)r espectivel
y. Thei nter
estr atesar e
expl icitl
yexpr essed/statedf orbot hl oanst hought her at
esar esubj ectedt o
changesf rom t imet otimeast heCBEhasdonei stherecentpast.Somet imes,
thei nt erestr at eisimplicitl
yapplicable.Fori nstance,ift
hecommer cialBankof
Et hiopia( CBE)of fersfreechecki ngaccount st ocustomer swhoar ewi l
li
ngt o
keepami ni mum bal ance100Bi r
rint heiraccount ,t
hereisani mplicitint
erest
rat ef ort hechecki ngaccountopenedbyagi vencust omersincethe100Bi rris
tiedupasl ongast hechecki ngaccounti sact iv
e.

GeneralAssumptionsNeededi nComputi
ngInter
est
I
nor dertofocusoni nt
erestrateandtoavoi
dcompl i
cati
onsthatwoul
dtendto
hidetheessenti
alconcepts,t
hef ol
l
owi
ngt hr
eegeneralassumpti
onsar
eneeded
tobemade.Thesear e:

Cert
aint
y:-Iti
sthemostr
estr
ict
iveassumpti
on. Allcur
rentandfutur
edata
val
uesareassumedt
obeknownwithcert
aint
y,orasetoftechni
quesexi
stsf
or

47
esti
mat i
ngallunknownv ar
iabl
es.Cert
aint
yal
soappli
estotheaccur
acyoffut
ure
eventsandt heiroccurr
ences. Thisassumptionisusedforsimpli
cit
ysince
uncertai
ntyrequires t
he intr
oduct
ion oftechni
ques t
hatcannotbe easi l
y
understood.

Discret
eTimePer i
od:-Ti mei sdividedintoy earl
yi nter
val
s. Thet i
met hat
el
apsesbetweent helastdaysoftwoconsecut ivey earsisexpressedasoney ear.
Forexample,year3isthetimethatelapsesfrom t helastdayofy ear2andt ot he
l
astdayofy ear3.Thi sassumpt i
ondoesn' trequirecashf lowst ooccuront he
l
astdayofeachy ear.Whatisrequir
edi sthatcashf l
owshav et ooccuronlyat
pointsofti
met hatareseparatedbyoney eari nterval
s.Theassumpt ion,thus,
al
lowsust oabstractfr
om specif
iccalendardatesandt omeasur etimef r
om t he
pointatwhi
chapar ti
culari
nvestmentorfinancingpr ogram begins.

Yearl
yI nterestComput ations:-interestis comput ed once a yearand t he
comput ati
oni smadeatt heendoft hey ear
.Thi sassumpt i
oni st
hus,consist
ent
wit
ht hediscreteti
meper iodassumpt i
onmadeabov e.I
nreali
ty,manysit
uat i
ons
i
nvolvemont hl
y,dai
ly
,andev enconti
nuousi nt
erestcomput at
ionwherebymany
commer ci
albanksandsav ingsandcreditassociat
ionsofferdail
yorcontinuous
i
nterestcompoundi ngondeposi tor
s'money .

Compoundi
ngMethod
Therearet
woway sofdeposi
ti
ngpayments(money)i
ntoani
nter
estbear
ing
account
.Thesear
esi
ngl
epaymentandser
iesofpay
ments.

Future(compound)v al
ueofsinglepay ment
Abi r
ryoudeposi t
edi nani nt
erest-bear i
ngaccountt odaywor th'
syoumor ein
thefuturebecauset heaccountear nsyouani nterestonthemoneyy ouhav e
deposit
ed.Thepr ocessofgoingf rom today'
svalues,orpresentv al
ues(PV)to
fut
urev alues (
FV)i s call
ed compoundi ng. To i ll
ust
rat
et his,suppose you
deposit
ed100Bi rrattheCommer ci
alBankofEt hiopia(CBE)thatpays5percent
i
nteresteachy ea.Howmuchwoul dy ouhaveattheendofoney ear?Tobegin,i
t
i
sv erywi setodefinethefoll
owingter ms:

48
 PV = Presentv alue,orthe begi
nni
ng amount,iny our
account.Here
PV=100Bi rr.
i = i
nter
estratethatthebankpay
speryear
.Theint
erestear
ned
i
s
based on t hebal anceatt hebegi nning ofeach y earand i tis
assumedpai datt heendoft hey ear.Her e,i=5%, orexpr essedas
adeci mal , i=0. 05.
INT = Bi r
rofi nt eresty ouear ndur i
ngt hey ear,whi chisequal tothe
begi nni ngamountmul t
ipliedbyi .Her e,INT=100x0. 05=5Bi rrfor
thef irsty ear .
FVn = Fut urev alue,orendi ngamount ,iny ouraccountatt heendofn
y ears.Wher east hePVi st hev aluenowort hepr esentv alue, FVi s
thev alueoft hemoneyaf terny earsi nt
ot hef uture, aftertheear ned
interest shav ebeenaddedt ot heaccountbal anceev eryyear .
n = numberofper iodsi nv olvedi nt heanal y
sis, Heren=1.
Inourexampl eher e, wher en=1, thef ut ure( compound)v al
uecanbecal culated
asfoll
ows:
FV = FV1 =PV+I NT( interest )
=PV+PV( i)
=PV( 1+I )
0 5%=1 00(
1 1+0. 05 )=100(
2 1.05)=105B
3 4irr. 5
Thus,thefut urev alue( Fv )att heendofy earone,Fv 1,equal st hepr esentv alue
I
n
( i
t
Pvi
alde
)mulp
to
is
pli
it= -
edby1.1 00
0pl ustFv
hei
1=?nt er Fv
estr2=?
at e,soyFv3= ?
ouwi l F
lhavv =?
e105Bi
4 F
r v
raf
5=?
terone
I
n
yet
e
ar
rest
.E E
xa
t
er
nn
deid
ngouranal y5B
sis,ir
wrhatw 5.2
ou5B
l
dyirr
oue 5.5
n1Bpw
du irri t5.
hi 7
f9B
y i
oukr
rep 6
t.0
y8B
o i
urrr
100
FV
Bi(
re
rindo
nyf t
he year)
ourbankaccountf 1 05B
ourf irr1
ivey1 0B
earirr
s?Her 11 0
ei.25B
st ir
r1
het i 15
mel.7i6B
net i
rr12 7.
oshow t6 3he
B
air
runtatt
mo heendofeachy eardur ingt hef ivey ear sper i
od.

Not
ethef
oll
owi
ngpoi
nts

Not
ethef
oll
owi
ngPoi
nts

1)Youstartbydepositi
ng100Bi rrinthebankaccountwhichisshownasan
outf
lowof100Bi r
r(-
100)aty earzero( n=0)
2)Youear n(100)(0.
05)=5Bi r
rofi nterestduri
ngthef
ir
styearresul
ti
ngi n
105Birrattheendofy earone(n=1) .
3)Youstartthesecondy earwi
th105Bi r
r,andear
n5.25Bir
ront helarger

49
 balance,andt henendt hesecondy earwi th110. 25Bi rrwhichi s105Bi r
r
begi nningbal ancepl us5. 25Bi rri
nter estearneddur i
ngy eart wo( n=2) ,
5.25Bi rrishi ghert hant heinterestyouhadear neddur i
ngy earone( n=1)
becausey ouear ned( 5)( 0.05)=0. 25Bi rr,or25cent sinterestont he
i
nt erestear neddur i
ngt hef i
rstyear.
4)Thi spr ocesscont inues,andbecauset hebegi nningbal ancei shigherin
eachsucceedi ngy ear,theannuali nter estearnedi ncreasesaswemov e
fr
om y earone( n=1)t oy earfiv
e( n=5).
5)Thet otalinterestear nedov ert hefivey ears,27.63Bi rr
,isreflectedinthe
fi
nalbal anceaty earf i
ve( n=5),127. 63Bi rrasi ndicateont het i
mel i
ne
abov e.

Not
ethatthev
alueatt heendofy eart
wo( n=2)
,110.
25Bi
rr
,iscomput
edas
f
oll
ows:
FV2 =FV1(1+i
)
=PV (1+i)(1+i
),becauseFV1=PV1(1+i
)
2 2
=PV(1+i) =100( 1.
05) =110.
25Birr

Cont
inui
ngt
heanal
ysi
s,t
hebal anceattheendofyearthr
ee(
n=3)i
s:
FV3 =FV2( 1+i
)
=PV( )2(
1+i 1+i)
, becauseFV2=PV(1+i)2
3
=PV(1+i
)
3
=100(1+0.05)
=115.
76Birrand
FV5 =PV( )5
1+i
5 5
=100(1+0.05) =100( 1.
05)=127.
63Bi rr

I
ngeneral
,thef
utur
eval
ueofaninit
ialsum att
heendofny
ear
scanbef
oundby
appl
yi
ngthefol
lowi
nggener
alequat
ion.

n
Pv =PV(
1+i
)
Inter
estTabl e
n
Thef uturev alueinterestfactorf
oriandn( FV1Fi,)i
n, sdef i
nedas( 1+I),andthis
factorcanbef oundbyusi ngaregularcalculator.Interesttabl
eist hetablethat
i
sconst ructedbyusi ngt hefutur
ev alueinterestfactors.Itcontainsfuturevalue
i
nterestf actors( FV1Fi,)
n, val
uesfo rthew ider angeo f Iandnv al
u es.Si
ncet he
n
term( 1+i )isequalt ot heFV1Fi,
n,t
hef uturev al
ueequat i
onf orsinglepayment
canber e-writ
tenas:

FVn=PV(
FV1Fi,)
n,

Toill
ustrat
ehowt ousef ut
ureval
ueint
erestfact
ors(FV1F)incomputi
ngf uture
(compound)v al
ue ofanysi ngl
e payment,considerourfive-
year
,5 per cent
i
nterestrat
edepositof100Birri
ntheprevi
ousexampl e.Thefut
ureval
ueoft he
100Bi r
rattheendofy ear5canbedeterminedbylookingf
ortheFV1F5%,
5int he

50
i
nt er
esttable.Thisisdonebyl ooki
ngdownt hefi
rstcolumnt operi
od5,and
l
ookingacr ossthatrow tothe5per centcol
umn,wherewer eadtheval
ueof
1.2763whichcorrespondstoFV1F5%,
5.Thi
sval
ueis,
then,pluggedi
ntotheabov
e
equation.Thati
s:

FVs =PV (FV1F5%,

5)
FVs =100(1.
2763)
FVs =127.
63Bir
r.

Theref
ore,thef utur
ev alueattheendofy ear
s(n=5)computedbyusingthe
fut
urev al
ueinterestfactorfrom t
heint
erestt
abl
e,127.
63Birr,i
sexactl
ythe
sameast hef uturevaluewehav ef
oundbyusi ngthegeneralfut
ureval
ue
equati
onforsinglepayment .

Por
tionoffut
urev
aluetabl
eforsi
ngl
epay
ment( FV1F5%,
5)
Per
iod(n) 4% 5% 6%
1 1,
0400 1.0500 1.
0600
2 1.
0816 1.1025 1.
1236
3 1.
1249 1.1576 1.
1910
4 1.
1699 1.2155 1.
2625
5 1.
2167 1.2763* 1.
3382
6 1.
2653 1.3401 1.
4185

 Itisthefuturevalueinter
estf
actorthatcor
respondstofiveperi
ods
(n=5)andi nter
estr at
eof5per cent(i=5%) .Youcanr efertothe
completefuturevaluetabl
eofsingl
epay mentintheappendixt
ot hi
s
mat er
ial
.

Ot
herAppl
i
cat
ionoff
utur
eval
ueamountofsi
ngl
epay
ment
:

Thefutur
ev al
ueequati
onf orsi
nglepaymentstat
edinthi
smateri
alcanal
sobe
usedtofindint
erestr
ates,aswellas,membersofyear
sthatwil
lbeneededf
or
thecompoundedamountt oequalthedesi
redval
ue.

FindingtheI nter
estrat
e-Esti
matingtheinterestrateont
hedeposi tedmoneyis
ar ecurr
ingpr obl
em whenitisnotexplici
tl
ystated.Ausefulapproachistotr
eat
thei nt
erestrateasani mpl
ici
tint
erestrateandf oundbyusingtheinter
estt
able
(futurevaluetableofsi
ngl
epay ment).

Toi l
l
ustr
ate,assumet haty ouhaveinvest
ed15,000Bir
rtodayatabankwher eit
cangr owtothef utur
ev alueof17,000Birrwi
thint
hreeyearsfrom nowintothe
futur
e.Whati stheinterestrat
et hatthebankshouldpayf oryouraccountin
ordertoful
fi
llyourdesi
re?

Toanswerthi
squesti
on,tr
eatthe15,
000Bi
rraspresentv
aluewhi
chyouhave
deposi
tedi
ntoanaccountthatpay
sanunknowninter
estr
atebutgr
owstothe

51
compound(fut
ure)amountof17, 900Bi
rraft
erthr
eey ears.Subst
it
uti
ngt
hese
val
uesint
othefuturevalueofsi
ngl
epaymentequat
ion,
y ouget
:
3
FV3 =PV( 1+i)
3
17900=15,000( 1+i
)
3
(
1+i
) =FVI
Fi,
3=

Thef uturev alueinterestfactorint hei nterest(futurev al

ueofsinglepayment
table)correspondingt otheunknowni nter estrat
e( i)andaper i
odof3y ear
s9n=
3)is1. 193.Hence,l ookupt hethreey ear( n=3)r ow andr eadhori
zontal
l
yunt i
l
youf i
ndt het ablevalue(futurevaluei nterestfactor)t hati
sequalortheclosest
tothecomput edvalueof1. 193.Ther eisnot ablev aluethati
sexactl
yequalt o
1.193.Thet ablev al
ueof1. 191isfoundt obet hecl osestval
ueto1.193andi t
correspondst o6per cent
.Thus, t
hei nterestthatt hebankact ual
l
yhast opayt o
youraccounti ssl i
ghtlygreatert
han6per cent.

Fi
ndingthenumberofy ears:
-Thef ut
ure(compound)v alueofsinglepayment
equati
oncanbeusedt oesti
matet henumberofy earsthatarerequiredf ora
gi
venamountofmoneydeposi t
edataspeci fi
cinter
estr ateto produceor
desi
redcompoundamount .Assume, forexample,adepositof1000Birrismade
i
nani nter
estbeari
ngaccountthatpay s10per centcompoundedy earl
y.Your
goalasadeposi t
oristocoll
ect1,500Bi r
rafteranunknownnumberofy ears.
Howmanyy ear
sshouldyouwaitf
ort hedesir
edamountt ober eal
i
zed?

Bysubst
it
uti
ngt
hev
aluesi
ntot
hef
utur
eval
ueofsi
ngl
epay
mentequat
ion,y
ou
get
:

FVn=1000( 1+I)n
1,500=1000(1+0.
1)n=1000(1.
1)n
(1.1)n= 1500 =1.5,byusi
nglogar
it
hm
1000
n=l og1.
11.5=log1.
5= 0. 176 =4. 29y
ear
s
Log1.1 0. 041

Againitispossi bletol ookupt he10per centcol umni nt hefuturev al

uei nter
est
fact
ors( f
uturev alue)t abl
eandr eadv erti
cal l
yunt ilyouf indat ablev aluethatis
equalto1.5orcl osestt oit.Thecl osestt ablev aluei s1.611,whi chcor responds
tofiv
ey ears(n=5) .Thatmeansi fthe1000Bi rri
skepti nt heaccountt hatpays
10per centforf i
v ey ears;ther esul t
ingcompoundi ngamountwi l
lbe1, 611Birr.
Thisamountexceedst hedesi redamountof1, 500Bi rr.Ifthe1000Bi rriskeptin
theaccountonl yf orfoury ears, thet ablev aluei s1.464Bi r r
.Hence, the1000Bi r
r
hastobekepti nt heaccountf oraper i
odsl ightlygreatert han4y ears.
Present(Discount )value;
Supposet haty ouhav esomeext racash,y ouhav eachancet obuyal ow ri
sk
securi
tywhi chwi l
lpay127. 63Bi rrattheendof5y ears.Assumet hatAwash
Int
ernati
onalBank( AIB)iscur rent lyoffering5per cent,on5- yeartimedeposi t.
Howmuchshoul dy oudeposi tt odayi nt het imedeposi taccounti nor dert oget

52
t
hei
ndi
cat
edamountof127.
63Bi
rratt
heendofy
ear59n=5)
.

From thef utur

ev al
ueexampl epresent edinthepr evioussecti
on,wesawthatan
i
niti
alamountof100Bi rrinv
estedat5per centpery earwouldworth127.
63Bir
r
attheendofy ear5.Youar edefi
nitelyindi
fferenttot hechoi
cebetween100Bir
r
todayand127. 63Birrattheendoft hef i
vey ears,and100Bi rri
sdefi
nedasthe
presentv alue,orPVoft he127. 63Bi rrthati sduei n5y earsti
mewhent he
i
nterestrateoroppor tuni
tycostrateis5per cent.

I
ngeneral,t
hepr esentval
ueofacashf l
ow dueny ear
si ntothefutureisthe
amountwhich,i
fitwereonhandtoday,
willgr
owt oequalt
hef utur
ev al
ue.Since
100Bir
rtodaywouldgr owto127.
63Bir
rin5y earsat5percentint
erestrat
e,100
Bir
rist
hepresentvalueof127.
63Bir
rdue5y earsint
hefuture.

Fi
nding thepr esentv alueoft hef uturecashr ecei
pts,orpay mentiscalled
di
scount i
ng,andi tsimplythereverseoft hecompoundi ngprocess.Ifyouknow
pr
esentv alue,PV,youcompoundi ttofindt hefut
urevalue,FV.Inthesameway ,
i
fyouknow t hef uturevalue,Fv,youdi scountittofindthepr esentv
alue,PV.
Whendi scountingfuturevalue,
youf ol
l
owt hesesteps.
Ti
meLi ne.Showt hecashf l
owont hetimel ine

0 5% 1 2 3 4 5

Pv=?
Fv5=1 27.
63Birr
Equat
ion:
Todev el
opthediscounti
ngequation,webeginwi
ththecompoundi
ngequat
ion
usedi
nt heprev
ioussecti
on.
n
FVn=PV(1+I) =Pv(FV1Fi,
n)
andbysolvi
ngforPVi nsever
alequival
entf
orm,wear
riv
eat:

PV= subst
it
uti
ngPV1Fi,
nfor

t
het
erm ,
aregetPv=FVn(
PV1Fi,
n)

Hence,youcaninsertthefigur
esintothepresentval
ueequat
ioni
nor
dert
o
det
erminethepr
esentvalueof100Bir
rasindi
catedher
e:

PV=

Tabul
arSol
uti
on:
-
Thet
erm i
scal
l
edt
hepr
esentv
aluei
nter
estf
act
orf
oriandn(
PV1Fi,
).

Thepr
esentv
aluet
abl
ecanbedev
elopedf
rom t
hepr
esentv
aluei
nter
estf
act
ors

53
whi
char
ethev
aluesof f
ordi
ff
erentv
aluesf
oriand.Thepr
esentv
alue

i
nter estfactorfori
=5% andn=5i sf oundbylookingdownt hefir
stcol
umnt o
period5, andthenmov ingacrosstherowt o5%,wherethepresentval
uei
nterest
factorisr eadus0.7835,sot hepresentv al
ueofthe127.63Birrtobereceived
after5y earswhent herateofint
erestis5percenti
s100Bi r
r.ThatisPV=( FVs)
(PV1F5%,5)=( 127.
63)(0.7835)=100Bi rr.

APort
ionofpresentv
aluetableforsi
nglepayment
Peri
od(n) 4% 5% 6%
1
2
3
4
5 0.7835*
6
 0.7835isthepresentvalueint
erestf
actorcorrespondi
ngt
o5per
cent
,and
5peri
ods.

OtherAppl
i
cati
onofPresentVal
ueoft
heSingl
ePayment
Withthehelpofpresentval
ueequati
onandt abl
eyoucansol
vef
oranyone
vari
abl
eintheequat
ionwhentheot
herthr
eevar
iabl
esar
eknown:

Findingt heInt
erestRat e:Al t
hought het er
m ofcont r
actmaycl earl
ystat
et hatall
ther el
ev antcashflows,t hepr oblem ofdet ermini
ngt hei nterestrateorther ate
ofr eturnt othel ender ,ori nv estormayst il
lremainunsol ved. Whensi ngle
pay ment sareinvol
ved, theimpl i
edi nt er
estrateapproachusedf orcompoundi ng
problem canbeadopt edf orusei ndet erminingtheint erestr ateinthepresent
valuet able.Toill
ustratethis, supposet haty ouhavet akenal oanof1200Bi rrto
daywhi chistobepai daf tert hreey earstogetherwithi tsi nter
estbymaki nga
pay mentof1500Bi rr
.Whati st her ateofi nterestonthel oant hatyouhavet aken?

Toanswerthisquesti
on,f
irstofallyouneedtoidenti
fyvar
iabl
eswhichareknow.
I
nthi
sill
ustr
at i
on,t
hepresentv al
ue,PVisequalto1,200Birr
;thefut
urev
alue,FV
i
s1500Birr,theperi
odofthel oan,nisequalt
o3y ear
s.Theny ousubst
it
utethe
gi
venvar
iablesint
otheequat i
onandsol vef
orthetableval
ue:

Pv=

1200=

54
Lookingatt heyearthree(n=3)r
ow i
nthepresentval
uetabl
e;tryt
ol ocat
et he
presentvalueint
erestfact
or(t
abl
eval
ue)t
hatisequaltoorcl
osestt
o0. 80.The
result
ing table values are 0.
816 corr
esponding 7 percent and 0. 794
correspondingto8per cent
.Thus,t
heint
erestrat
eisbetween7per centand8
percent.

Findi
ngt heNumberofYear s:
- Thepresentv al
uetableandthepr esentv alue
equati
onf orsi
nglepay mentcanbeusedt odet er
minet henumberofy ears
requi
redf orthepresentvaluetoequalit
sf utureval
ueatagi venrateofy ear l
y
compoundi ng. Forinstance,how manyy earsdoy ouneedt owaitf ory our
depositof1000Bi rrtogrowt o1,200Bi
rrinasav ingaccountt
hatpay sinterest
compoundi ngyearl
yat6per cent?

Toanswert hi
squesti
on,letthe1000Bir
rbethepresentvalueoft
hefutur
ev al
ue
of1200Bi r
ratani nt
erestrateof6per centperyear.Bysubstit
uti
ngintothe
presentvalueequat
ionforsinglepaymentandsolv
ingforthedesi
redtabl
evalue,
youget.
PV=FVn( PV1Fi,
n)
1000 =1200( PV1F6%,
n)

PV1F6%,
nn=

Thenl ookatt he6per centcol umni nt hepr esentv aluetableofsi nglepay ment
andr eaddownt hepr esentv alueinterestfact orst i
llyouar r
iveatt hev al
uet hati s
equaloff al
lsbel ow t hecomput edt ablev al ue,0. 8333. Thet abl ev aluet hat
meet st hest at edr equi r
ementi s0. 792,andi tcor respondst o4y ear s,(n=4) .
Therefore,t he1000Bi r
rwi l
lhav etobekepti nt hesav i
ngaccountf or4y ears
(andcompoundedf ourt i
mes)bef oreitgrowst ot hedesi redv al
ueof1200Bi r
r.
Annui t
ies
Anannui tyisanequalamountofBi rrpay mentf orspeci fi
ednumberofy ear s.
Sinceannui t
iesoccurf r
equent lyinfinance,suchasbondi nterestpay ment s,y ou
havet obeabl et r
eatt hem accor dingly.al t
houghcompoundi nganddi scount ing
ofannui tiescanbedeal twi t
hf orsi nglepay ment ,thesepr ocessesar et i
me
consumi ng,speci allyf orl ongerannui t
ies.Theannui t
ypay ment scanoccurat
eit
hert hebegi nningort heendofper i
od. I ft hepay ment sar emadeatt he
beginningofeachper iod,t heannui t
yi sknownasannui tydue.I ft hepay ment s,
ont heot herhand,occuratt heendofeachper iod,ast heyt ypi call
ydo,t he
annuityiscal ledanor dinary ,
ordef err
edannui ty.
Sinceor dinaryannui t
iesar emor ecommoni nf inance,whent het erm annui tyi s
usedi nt hismat erialy oushoul dassumet hatt hepay ment soccuratt heendof
eachper iodunl essst at ed,otherwi se.

FutureVal
ueofanAnnui t
y
Anor di
nar
yordef erredannui t
yconsi
stsofaser i
esofequalpaymentmadeat
theendofeachper iod.I fyoudeposi
t100Birrattheendofeachyearfort
hree
yearsinasavingaccountt hatpay
s5percentperyear
,howmuchwi l
lyouhaveat
theendofy earthr
ee( n=3)?Toanswert hi
squesti
on,youmustfi
ndfuturev
alue

55
ofanannuit
y,FVAn. Eachpaymenthastobecompoundedoutt otheendof
per
iodn,and thesum oft
hecompoundedpayment
sgivesyouthefutur
eval
ue
ofanannui
ty,
FVAn.Thiscanbeshownbyusi
ngthef
oll
owingti
meline.

0 1 2 3
100Bi
rr 100Bi
rr 100Bi
rr
1
105.
00Bir
r=(
100)(
1.05)
2
110.
25Bir
r=(100)1.
05)
FVA3 =315.25Bir
r

The time line shows each cash fl

ow compoundi ng and t he sum oft he
compoundedcashf l
owswhichgivest hef ut
ureval
ueofanannui t
yatt heendof
yearthree(n3),FCA3of315.
25Birr
.Repr esent
ingthesinglepaymenti naser i
es
ofequalpay mentsofanannuitywithPMT( Payment )
,thef uturev alueofan
annuit
yatt heendofy eart
hree(n=3) ,FVA3 of315.25Bi rr
. Repr esentingthe
singl
epay menti naser
iesofequalpay mentsofanannui tywithPMT( payment),
thefuturevalueofanannuityforny earscanbedesi gnatedwi ththef ollowi
ng
equati
on:

0 1 2 n
FVAn=PMT( 1+i) +PMT( 1+i) +PMT( 1+i
) +-
--
-+PMT(1+i
)
0
Inthi
sequationthef i
rstter
m( i
.e.PMT( 1+i
) )i
sthecompoundedval
ueofthe
payment
attheendoflasty ear
,oryearnoft heannuit
ypayment
swhi l
ethel
astt
ermi
nthe
n-
1
equati
on(i.
e.PMT( 1+i) )ist hecompoundedamountoft hepay
mentmadeat
theendof
yearone(n=1).

Theabov
eequat
ioncanf
urt
herbesi
mpl
i
fiedt
o:
FVAn=(
PMT)( wher
ePMTi
sanannui
typay
mentdeposi
ted,

orr
eceiv
edatt
heendofeachy
ear
.
Theequat
ioncanber
e-wr
it
tenas:

FVAn=(
PMT) bysubst
it
uti
ng

f
or

Usingthisfutur
evalueofanannui
tyequati
on,thefut
urev
alueofthe100Bir
r
deposit
smadeatt heendofeachyearforthr
eey ear
satanint
erestr
ateof5
percentwouldbe:

FVA3=(
100) =(
100)(
3.1525)=315.
25Bi
rr

56
Tabul
arSol
uti
on:
Thefut
ureval
ueforanannui
tyi
sfor
medf
rom t
hef
utur
eval
uei
nter
estf
act
or

f
oranannui
ty(
FVI
FAi,
n),whi
char
ethev
aluesoft
het
erm i
nthe

abov ef uturev alueofannui tyequat ion. Thef uturev aluef oranannui tyt abl
e
cont ai
ns a setoff ut
urev alue interestf actorf oran annui t
yf orv ari
ous
combi nat ionofIandn.Tof i
ndananswert o3-y ears,100Bi rrannuit
ypr oblem by
usingf uturev alueof annui t
yt able,lookdown5per centcol umnt ot het hir
d
period;t hef utur evalueinterestf actorf orannui t
y( FVIFA5%,3)is3.1525.Thus,
thef uturev alueoft he100Bi rrannuityi s315. 25Bi rr.
FVAn = ( PMT)( FVIFAi,
n)
FVA3 =( 100)( FVIFA5%,3)=( 100)( 3.1525)=315. 25Bi r
r
Apor t
ionoft hef ut
urev al
ueofannui tyt abl
e
Per i
od( n) 4% 5% 6%
1
2
3
4 3.
1525*
5
6
* 3. 1525i st het ablev alue(t hef uturev alueannui tyinterestfactorf oran
annui t
y )cor respondi ng
to5per centand3per iod. Thecompl et ef uturev alueofannui tytableis
i
ncludedi nt heappendi x
tot hismat erial.

OtherApplicationsFut urevalueofAnnuit
y
Thef ut
urev alueofanannui t
yequati
onandtabl
ecanbeusedt osolv
eforthe
i
nterestratev ariable,aswel lasthenumberofpaymentv
ari
abl
e,inthemanner
thatisquitesi milartot hatusedhandingcompoundamount,si
nglepayment
problems.

Finding the I
nterestRat e: Some f inancialcont racts and cer taint ypes of
i
nv estmentsbybusi nessf i
rmscanbedescr i
bedasy iel
dingaf ut uresum i n
termsofaspeci f
icnumberofannui ty–pay mentr eceived.Thei nterestr ateisan
i
mpor t
antdeterminantinacceptingorrejecti
ngsuchoppor tuni
ties,buti tisrarel
y
statedexpli
cit
ly.Thei mpl i
edrat
ecan beobt ainai
nedbyt reat
ingt hef uturesum
ast hecompoundofannui t
ypaymentsandsol v
ingf ortheinter
estf utur evalueof
anannui t
ytable.
Toi ll
ustr
ateinterestratecomput at
ion,threeequalpay ment sof3, 000Bi rrare
offeredinr et
urnf or9, 800Birrtober eceiv
eduponmaki ngt hel astannui t
y
pay ment.Whati stheimpl i
edint
erestrate?

Toanswerthi
squesti
on,f
ir
sti
dent
if
ythevar
iabl
esinthecompoundi
ngannuit
y
equat
iont
hatareknownandplugt
heseknownv al
uesint
othisequat
ion.The

57
compoundamountofannui
ty,FVAintheil
lust
rationaboveis9,
800Bir
randt he
annui
typaymentmadeatt heand ofeach y ear,PMT is3000 Bir
r. The,
subst
it
uti
ngthesef
igur
esi
ntotheequat
ion,
andsol v
ingt
herequi
redt
ablev
alue.

FVAn =PMT

9,
800=3,
000

Asi
ndi
cat
edear
li
er, i
sthef
utur
eval
uei
nter
estf
act
orf
oranannui
ty,

FVIFAi,
nf oragiveni nterestrat
eIandagi vennumberofy ears,n.Todet er
mi ne
theinterestr at
e,lookupt hethreepay mentr ow (n=3)i
nt hetableforthet able
val
uest hatisequal ,orcl osestto3.266. Thet ableval
uecor respondingt o9
percentis3. 246,andt het abl
evaluecorrespondingt o9 percentis3.278.Si nce
thecomput edv alueof3. 266li
esbet weent heset wotablev al
ues,thei mplied
i
nterestr at
ei sgreaterthan8per centandlesst han9percent.

Findi
ngt heNumberofPay ment:
-I ftheinterestr
ate,thesizeofthedesir
ed
futur
ev al
ueofanannuit
y,and t
hesizeofeachannui typaymentaregi
ven,you
cancomput ethenumberofpay mentsrequiredtoattai
nthef ut
uresum ofan
annuit
ybyusingthef
utureval
ueofanannuityequati
onandt abl
e.

Forexample,howmanyannualdeposi tsof1000Bi rreachmustbemadei ntoan

accountthatpays6per centint
erestcompoundedy earlyi
nordertoaccumulat
e
5,500Birri
mmedi atel
yafterthelastdeposit? Here,the5,500Bir
risthefutur
e
valueofanannuity,and1000Bi r
ristheannualpay mentdeposit
edattheendof
everyyearfi
l
ltheterm ends.Ifyousubst i
tutethefuturesi
ntothefut
ureval
ueof
anannuityequat
ion, t
hedesir
edannuitytablevaluewillbe:

FVAn =PMT

5500=1000(
FVI
FAi,
n)because i
sequal
toFVI
FAi,n.

FVI
FA6%,n=
I
nor dert ocomputethenumberofannualdeposi t
stobemade,l ookatt he
6percentcol
umni nthefuturev
alueof anannui t
ytabl
eandreaddownunt ila
tabl
ev al
ueequals,orexceedsthecomput edval
ueof5.5.Thecomput ev alue
fal
lsbetween4.375and5.637whi chcorr
espondto4and5peri
odsrespecti
v ely
.
Thecor r
ectansweri
s5.637orfi
v eperi
ods(n=5)not4.
375whi
chcorrespondst o
thevalueofonly4paymentswhosef ut
ureval
uefal
lbehi
nd5,
500Bir
r.

58
APort
ionoft he\ FutureValueofanAnnui tyTabl
e
Per
iods( n) 6% 7% 8% 9% 10%
1 1.000 1.
000 1.
000 1.
000 1.000
2 2.060 2/070 2.
080 2.
090 2.100
3 3.184 3.
215 3.
246 3.
278 3.310
4 4.
375* 4.
440 4.
506 4.
573 4.641
5 637+
5. 5.
751 5.
866 5.
985 6.105
 4. 375ist hef uturevalueinter
estfact
orsforf
ourpay
mentsofanannui t
y
at6per centinterestrate.
+5. 637ist hefuturev al
uei nt
erestf
actoroffi
vepay
mentsofanannuityat6
percentinterestrate.

Present(Discount ed)valueofanAnnui ty:

Supposet haty ouareof fer
edt woalternati
ves:(1)at hree-annuit
ywi t
hpayment
of100Bi r
ratt heendofeachy earoverthecomi ngt hreeyears,or(2)a:ump-sum
paymentt oday .Youhav enoneedf orthemoneydur i
ngt henextthreeyears,so
i
fy ouacceptt heannui t
y ,youwouldsi mplydeposi tthepay ment si
nt hesaving
accountatDashenBankt hatpays5per centinterestratecompoundedy early
.
Similar
lytheLump- Sum pay mentwoul dbedeposi tedinthesameaccountasy ou
don'thaveot heropt i
on.Howl argeshouldtheLump- sum pay menttodayinorder
foritbeequi valenttotheannuity?
Toanswert hisquest i
on,letusstart
-upwi t
htheai doft hetimeline.

0 1 2 3
100 100 100

95.
24
90.
70
86.
38
PVS3=272.
32

Thepresentval
ueoftheser
iesofpay
mentsof100Bi
rrf
ort
hreey
ear
sannui
ty,
PVA3is272.32Bir
rasshownwitht
hehelpoft
heti
meli
ne.

Thesamepr oblem canbeexpressedbyusi

ngmat
hemati
calequati
on. The
generalmathemati
calequat
iont
hatcanbeusedt
ofi
ndthepresentv
alueofan
ordi
naryannuit
yisshownbelow:

PVAn=(
PMT)

Si
ncePMTi
scommonf
oral
lter
ms,
theabov
eequat
ioncanber
e-wr
it
tenas:

59
 PVAn =(
PMT)

Agai
ntheequat
ioncanber
ewr
it
tenas:

PVAn=(
PMT)

Thesummat
iont
ermi
nthi
sequat
ioni
scal
l
edt
hepr
esentv
aluei
nter
estf
act
or

f
oranannui
ty(
PVI
FA)andi
tequi
val
entt
o: or

Hence,
theabov
eequat
ioncanbest at
edas:
PVAn =(PMT)(
PVIFAi,
n),or

PVAn =(
PMT)

Byusingt hismathemati
calequati
on,thepresentvalueofanannui tyoft he
probl
em underconsider
ati
oncanbecomput edasf ol
lows. Youar egivenan
annui
typay ment
,PMTof100Bi r
r,i
nter
estr
ate,Iofpercentcompoundedy earl
y
andanannui t
yperi
od,nofthreeyear
s.Substit
uti
ngthesev aluesintot
heabov e
equati
on,yougetthepresentval
ueofanannui t
yof272. 32Bi rr
,whichwast he
sameast heamountcomput edbysummi ngtheindi
vi
dualdi scountedval
uedon
theti
me.

PVA3 =(
100)

=(100)(2.
7232)
=272.32Bir
r

Tabul
arSol
uti
on

Thet
erm= i
nthegener
alequat
ionofpr
esentv
alueof
anannuit
ywhi chisthepresentval
ueinter
estfactorforanannuity(PVIFA)is
usedtoconstr
uctthepresentval
ueofanannuitytabl
e.Thepr esentval
uet abl
e
ofanannuit
yisthetabul
ationoft
hepresentval
ueinter
estfactor
sforanannui t
y
ofdi
ff
erentcombinati
onsofIandnar r
angedIanor derbeginni
ngwi t
h-=1%and
n=1peri
od.Hence,t hepresentval
ueofanannuityequationasst at
edalready,

60
canber e-writ
teninawayi ti ssuitableforusingtablevalues.
PVAn=( PMT)( PVI FAi,n) wher ePV| I
FAi,
nist hepresentvalueinterestfactorforan
annuityf oragiv enint er estr ate( i
)andf oragi v
ennumberofy ears(n).
Tof i
ndananswert ot het hr ee-year,100Bi r
rannuityproblem underconsi derat
ion,
si
mpl yr efertoapr esentv alueofanannui tyt
able,whichispar tlyshownbel ow,
andlookt he5per centcol umndownt ot hethi
rdperiod.ThePVI FA5%,3is2.
7232,
yi
eldingt hepr esentv al ueof272. 32Bi rrforthet hreeannuitypay ment sof100
Bir
ratt heendofeachy ear .
PVA3 =( 100)( PVI FA5%, 3)=(100)( 2.
72.32)=272. 32Bi rr
Apor ti
onofpr esentv al ueofanAnnui t
yTabl e
Per i
od(n) 5% 6% 7% 8%
1 0.943 0.
935 0.
926
2 1.833 1.
808 1.
783
3 2.7232* 2.673 2.
624 2.
577
4 3.465 3.
387 3.
312
5 4.212 4.
100 3.
993
*Thepr esentv aluei nt
erestf actorforanannui tywheni nter
estr at
eis5
per centfort hree
Payment si s2. 7232.

OtherApplicationsofPr esentValueAnnuity
Asitwaspr esentedint hismat er
ialf
orfuturev alueofannui t
yandot herval
ues
(bot
hpr esentandf utur
e)ofsinglepay mentequat i
onsthepresentv al
ueannuit
y
canbeusedt osol veforanyoneofi tsfourv ariables (
i.
e.presentvalueofan
annuit
y,PVA;t hesi zeofanannui typaymentatt heendofeachper i
od,PMT;the
numberofy ears,orper i
odsf orwhicht heannui t
ywi l
llast
,n;andt heannual
i
nterest(di
scountr ate,I
)gi v
ent heval
uesf oranyt hreevari
abl
es.

FindingtheAnnual I
nterest(
Discount)Rate,i
I
fy ouar egi
venthenumberofannui t
ypay ments,
nt heamountofsi
nglepayment,
PMT, andequi
valentpresentval
ue,PVA, youcandeterminet
heint
erest(
discount
)
rate,Ithati
sappl i
cablewhilecompoundi ngthepresentval
ueofanannui t
y,PV,
orwhi ledi
scount
ingtheser i
esofannui t
ypayments, PMTS.

Consi derthef ol
lowingt hatclari
fiesthecomput ationofi nterest(discount)rate
pery ear,i
.
Assumet hatNI bInternati
onalBank( NIB)acceptedanappl icati
onf or200,
000
Bir
rcommer cialloanand pr oposest hef ol
lowing pay mentschedul efort he
borrower .Forequalannualpay ment sof63,100Birr,whatr ateofi nteresti
st he
commer cialloanappl i
canti swill
i
ngt opay ?
Thet hreev ariablesinthepr esentv al
ueofannuityequat iont hatareknowni nthis
exampl ear e:t hepresentv alueofannui tyof200,000Bi rr
,t hesizeofanannui t
y
paymentatt heendofeachy earof63, 100Bir r
,andt henumberofy ear
sf or
whicht heannui tylastsof4y ears.Theunknownv ar
iablei nt hi
sexampl eisan
annuali nt
er est(discountr ate,i
.I nsert
ingthefiguresf ort heknownv ari
abl
esi n

61
t
hepresentval
ueofannuit
yequat i
on,y
oucanobt
aint
heassoci
atedv
alueas
f
oll
ows:
PVAn =( PMT)( PVIFAi,
n)
PVA4 =( 63,
100)(PVIFAi,4)
200,
000=(63,
100)(PVIFAi,4)

(
PVI
FAi,
4)= 8.
169i
tisappr
oxi
mat
elyequal
to3.
170.

Thel ookatt hef ourpay ment s( n=4)col umni nt hepr esentv alueofannui tytable
andt rytol ocat et het abl ev aluet hati sequalorcl osestt o3. 170comput edabov e
forPVI FAi,4. T hisv aluei sex act lyequalt ot het ablev aluecor respondst o10
per cent . Ther efore,i ft hepr esentv alueof200, 000Bi r
ri spl acednow i nt he
sav ingaccountt hatpay s10per centr atecompoundedannual ly, i
twi l
lbeenough
tomakef ourequalpay ment sof63, 100t obemadeatt heendofeachy earf our
the comi ng f oury ear s. I n ot herwor ds,t he f our -
year s,63, 100 Bi rrannui ty
pay ment sar eequi v alentt ot hepr esentv alueof200, 000Bi r
rwhent heannual
i
nt erestr at epery eari s10per cent .
Findi ngt heNumberofPay ment s,n: -Whenf i
nanci alcont r
act ssuchasal owan
i
sar ranged,i ti ssomet imesconv eni entt oagr eeont hesi zeofequalpay ment s.
Onet hrat eofi nter esti sknown,t henumberofpay ment s,nr equi redtopayt he
l
oani nfullcanbeeasi l
ydet ermi nedwi t
ht hehel poft hepr esentv alueofannui ty
equat i
onandt abl e.Butt hisappr oachofdet er mi ningt henumberofpay ment s,n
hast opr obl ems.
1.I ft hef irstpay menti sl esst hant hei nterestpay mentont heent i
re
presentbal ance( loanamount ),thisf irstpay mentgoest othepay ment
ofonl yt hei nterestchar gewi t
houtay ingpar toft hepr incipal.
2.Somet imest hecomput edr equirednumberofpay ment smaybet ur
ned
outt obeani ntegerv alues.Asar esul t,mostl oansnegot iatedi nthis
mannerwi l
lhav eaf inalpay mentt hati sl argert hant heot herequal
pay ment s.
Toi l
lustrat ehow t odet ermi net her equi rednumberofanannui typay ment s,n
assumet hata50, 000Bi rrl oani st ober epai di ny earlyequali nstallment sof
14,000Bi rr.Thel oancar riesas6per centannuali nterest( discount )rate.How
manypay ment sar er equi redt of ul l
yr epayt hisl oan?
Ast hisf irstst em i nanswer ingt hisquest ion,y oumustmakesur et hatt he
i
nt erestchar geont hel oandur i
ngt hef irsty eari sl esst han14, 000Bi r
r,thef ir
st
annui t
ypay ment .Si nce6per centof50, 000Bi rrpr incipalamountoft hel oani s
only3000Bi rr,t he14, 000Bi rrpay mentatt heendoft hef irsty ear( n+1)wi l
l
prov idesomecashf ort hepar tlypay mentoft hepr i
ncipal amount .
Int hisexampl e,t hepr esentv alueofanannui t
y ,PVAi s50, 000Bi r r
,theannual
i
nt erest( di scount )r at ei s6per cent , andt hesi zeofannui typay ment satt heend
ofeach per iod ( y ear )i s 14, 000 Bi rr. The numberoft he r equired annui ty
pay ment si sunknown.Byi nser tingt hef igur esf ort he knownv ari
ablesi ntot he
presentv al ueofanannui t
yequat ion, y ougett hef ol l
owi ng:
PVAn =( PMT)( PVI FAi,n)
50,000 =( 14, 000)( PVI FA6%,n)

62
 PVI
FA6%,n = 3.
571

Thenl ookatt he6percentcol umni nthepresentv alueofanannui tytabl

e,and
readt hecolumndownunt ilyouar r
iveatat abl
ev al
uet hatisequal ,orexceedthe
comput edv alueof3.571. Thedesi r
edtablev al
uel iesbet ween3. 465which
corresponds t ofourpayment s( n=4)and 4. 212 whi ch corresponds tof i
ve
pay ments( n=5).Sot het ablev al
uet hatexceedst hecomput edv alueis4.212
andt henumberofpay ment sisgoi ngtobef ive.Howev er,si
ncet hecomput ed
valuei slesst hanthetablev alueof4. 212,thel oanpay mentschedul edoesn'
t
requirethef if
thpaymenttobeasl argeas14, 000Bi rr
,whi chwasi ndicat
edasa
secondpr oblem ofusingt hisappr oachofdet erminingt henumberofannui t
y
pay ments.Thepay mentschedul ef ortheloanpay mentwi thf i
vepay mentsis
shownbel ow.Pay mentsschedul eof50, 000Bi r
rloan,wi thfivepay mentsat6
percent(LoanAmor ti
zati
on).

Per
iod Unpaid Int
ereston Totalamount Year
ly I
nter
est Pri
nci
pal New
Pr
inci
pal Pri
ncipal unpai
d payment payment payment balance
1 50,
000 3,
000 53,
000 14,
000 3,
000 11,
000 39,000
2 39,
000 2,
340 41,
340 14,
000 2,
340 11,
660 27,3340
3 27,
340 1,
640 28,
980 14,
000 1,
640 12,
360 14,980
4 14,
980 899 15,
879 14,
000 899 13,
101 1,879
5 1,
879 113 1,
992 14,
000 113 1,
879 0

Asi tcanbeseenf rom t heabov epay mentschedul e(loanamor tizationt abl e),
eachl oanpay mentannui tyi sdi v
idedi ntopay mentofi nterestandpay mentof
principal.Si ncet hebal anceofpr i
nci palkeepsondecr easing, theint erestchar ge
i
sal sodecl i
ni ngy earaf tery earbecauset he6per centinterestr at
ei sappl iedon
andecr easi ngbal anceoft hepr incipaloft hel oan. Ont heot herhand,t he
amountofy ear lypay mentt hatgoesf orthepay mentoft hepr i
nci pal i
si ncreasi ng
from y eartoy ear.The14, 000Birrpay mentatt heendofy earone, fori nstance, i
s
usedf ir
stt opayt heint erestchar geoft hesamey ear,thati s3, 000Bi rr.Thi s
l
eav est her emai ning11, 000Bi rr(i
.e.14, 000Bi rr-3000Bi rr)whi chwi llbeusedt o
reducet heunpai dprincipalbal ancef r
om 50,000Bi r
rto39, 000Bi rr
.Att heendof
yeart wo, 6per centannuali nterestr ateisappl i
edont hebal anceoft hepr incipal
att hebegi nni ngoft hey earof39, 000Bi rrthati sunpai dandi tis2, 340Bi rras
i
ndi catedi nt heschedul e.Outoft he14, 000Bi rrpaymentatt heendofy eart wo,
2,340Bi rrisusedt opayt hei nterestchar geont heunpai dpr incipaldur ingt he
yearandt her emai ning11, 660Bi r
r( i.e.14,000Bi rr-2,
340Bi rr)i susedt of urther
reducet heunpai dpr i
ncipalf rom 39, 000Bi rratt hebegi nningofy eart wot oa
valueof27, 340Bi r
ratt heendoft hey ear.

Thepay mentprocessisrepeatedIthesamewayuntilyearfi
ve,attheendof
whichthebalanceoftheunpaidiszero.Ther
eisnoneedt opay14,000Birrat
theendofy earfi
veasthetotalunpai
damountofbot
ht hepri
nci
palandint
erest

63
chargeisonly1, 992Birr
.Hence,t hebor rowerneedst opayonl ythi
samountat
the endofy ears5.Hence,t hepay mentatt heendofy earfi
veisv er ysmal l
compar edwithpay mentsattheendoft hef i
rstfoury ears.Thissmal lpay ment
attheendofy earf i
vecanbeav oidedbymaki nglargerpay mentatt heendof
yearfour.Thati sbypay i
ngtheunpai dpr i
ncipalbalanceatt hebeginningoft he
yearplustheinterestchar
geont hebal ancedur ingthey ear.Theunpaidpr i
ncipal
balanceatthebegi nningofyearf ouris14, 980Bi r
randt heint
erestont hi
sis6
percentwhichcomest o899Birrandat otalof15,879Bi rrtobepaidatt heendof
yearfour.Thispr oducesalargerpay mentatt heendoft heyearcompar edwi t
h
otherannuit
ypay ment sdur
ingthef i
rstthreey ears(i
.e.14,000Bir
reachy ear).

Unev en, orUnequal Cashf lows:

Bydef initi
onanannui t
yi ncl udest hewor ds ' constantamount ',whi chi st o
under scor ethatanannui tyi nvolvespay ment s,orr eceiptsthatequali nev ery
period,oratt heendofev eryov er t hel i
feoft heannui ty. Althoughmany
fi
nanci aldeci sions do i nvol ve annui ti
es,some i mpor tantdeci sions involve
unequalornon- constantpay ment s,orr ecei pts,orcashf l
ows. Forexampl e,
commonst ockasy ouknow,payf luct
uat ingl evelofdi vi
dendsov erti
me,and
fi
xedasset sinv estment ssuchasmachi ner ydonotgener ateconst antcash
fl
owsov ert heirl i
vesast heydepr eciate. Asar esult,itisv erynecessar yt o
extendt het imev al
ueofmoneyanal ysistoi ncl udeunequal payment s,orreceipts,
orcashf lows.
Throughoutt hischapt er
,wehav eusedt het erm pay ment( PMT)f ortheannui ty
sit
uat i
on( i
.ewhent hecashf l
owsar eunif orm)andwehav etousecashf low( CF)
todonot eunequal ,ornon- const antcashf l
ows.
PresentVal ueofUnequal Cashf lows
Unequalcashf lowsar et hesameast hatoft hecombi nati
onofmanysi nglecash
fl
ows( pay ment s).Hence,t hepr esentv al ue,PVofunequalcashf lowsi sfound
ast hesum oft hepr esentv al ues, PV5oft hei ndi vi
dual payment s,orcashf lows.

Forexample,supposey ouar
er equi
redtofi
ndt hepresentv
alue,PV ofthe
fol
lowi
ngcashf l
ow st
ream,di
scountedat6percentasshownwiththehel
pof
theti
meli
ne.

0 6% 1 2 3 4 5 6
7
100 200 200 200 200 0
1000

How,thecanfindthepresentval
ue,PVofindi
vi
dualcashflowsbyusingt
he
pr
esentval
ueequationforsingl
epayment
,andsum t hesevaluestofi
ndt
he
pr
esentval
ueoftheent
ir
ecashf l
owstr
eam.Hereiswhatitl
ookslike:

64
0 6% 1 2 3 4 5 6
7
100 200 200 200 200 0
1000

PV1:94.34discounted
PV2:178.00 di scounted
PV3:167.92 discounted
PV4:158.42 di scounted
PV5:149.46 discount
ed
PV6:0 discount
ed
PV7:665.10 discounted
PV1 1,
413.34

Thei
ndi
vi
dual
presentv
alues,
aswel
las,
thepr
esentv
aluef
ort
heent
ir
ecash

f
lowst
ream canbecomput
edbyusi
ngt
hisgener
almat
hemat
ical
equat
ion:

PV= CF1(

Where:
CF1 = thecashf
low,orpayment,orrecei
ptattheendofyearorper i
od
one.
CF2 = thecashf
low,orpayment,orrecei
ptattheendofyear,orperi
od
two.
CFn =thecashfl
ow,orpayment,
orr ecei
ptatt
heendofyear,orperi
odn,
and.

CF1 t
hev
alueoft
hecashf
lowatt
heendofy
earoneconv
ert
edt
o

t
heequiv
alent
v
alueatt
heendofy
earzer
o(i
.
ePVofcashf
lowatt
heendofy
earone)
.

Each one oft he above pr

esentv al
ues was f ound bysui
ng the r
especti
ve
i
ndivi
dualpresentv al
ueequati
on.Fori nstance,thepr
esentv
alueofy earone'
s
cashflow wasf oundbythepr esentvalueequationofcashfl
ow attheendof

y
earone(
i.
e.CF1 Bi
rrandt
he

pr
esent v
alue,PV of t
he cash f
low at t
he end of y
ear t
wo i
s(CF2)

=(
200)(
00.
8900)=178Bi
rr
,andsoon.

65
Thepresentvaluesoft hecashflowst ream overthe7y earscanal way sbefound
byadding the presentv alues ofi ndivi
dualcash f lows as i ndicated above.
However,thepat t
ernoft hecashf l
ow wi t
hinthest ream mayal l
ow y out ouse
shor
t-
cutmet hod.Forexampl e,thecashf l
owsdur ingy eartwot hroughy earfi
ve
arei
nanannui tyform becauset hecashf l
owsdur ingt hesey earsar eunifor
m,
youcanuset hesef actandsolvet hesamepr oblem inasl ight
lydifferentmanner
butabitsi
mpl er.Thatis:

0 1 2 3 4 5 6
7
100 200 200 200 200 0
1000
94.
34
693.
00

658.
80
0.
00
665.
10
1413.
24

Thecashf lowsdur ingyeart wot hroughy earf i

ve,asitwasment i
oned, repr
esent
thepat ter
nofannui t
y.Thepr esentv alueofannui ty ,
PVAoft hecashf l
owsatt he
endofy earone( i.
e.oney earbef orethef irstannuitypaymentattheendofy ear
two)byusi ngt hemat hemat i
cequat ionf ort hepresentv al
ueofanannui t
ythat
wasal readydi scussed.Tor emi ndy ou,how t ofindthepresentvalueoft hese
cashf l
owsatt heendofy earone, i
tisshownbel ow:
PVAn =( PMT)( PVIFAi,n)
PVA4 =( 200)(PVI FA6%,4)
PVA4 = ( 200)( 3.465),her e3. 465i sthepr esentval
ueinterestfactor
correspondi ngt o6per centi nterestr ateandf ourpay ments orcashf l
ows.
Finali
zingtheabov ecomput at
ion, youar ri
veat :
PVA4 =( 200)( 3.465)=693. 00Birr

Aft
erdet
er mini
ngthepresentvalueofthefourannui
typayments,orcashflows
of200Birreachattheendofy earone,youhavetodetermi
nethepr esentval
ue
of693.
00Bi rratt
heendofy earzerobyusi ngthemathemati
calequat i
onfor
pr
esentvaluecomputat
ionforsingl
epayment,fut
ureval
ue.Thatis

PV = (
FV) .I
nthi
scase,t
hef
utur
eval
uei
sthe693.
00Bi
rr

whichist
hepresentval
ueofthefourannuit
ypay ment
sdur i
ngyeart
wothr
ough
yearfi
veattheendofyearone,t
heannuali nt
erest(
discount
)rat
eis6per
cent
,
andtheperi
odisonl
yoneyear(n=1)Ther ef
ore,

PV =(
693)

66
 = 653.
80Bi
rrasi
twasi
ndi
cat
edont
het
ime-
li
nebef
ore.

Futurev alueofunequal orunev encashf lowstream:

Thef utur ev alueofunequalcashf l
ows,orpay ment s,orr ecei
pts,somet imes
call
edt het ermi nalv alues)isf oundbycompoundi ngeachi ndivi
dualpay mentt o
theendoft hepay mentper iod,orendofcashf lowst r
eam.Thent hei ndividual
compoundedv alues( futurev alues)ar eadded, toobt ai nt heov erallcompounded
val
ueoft heent i
recashf l
owsi nt hest ream.Thef ollowi nggener alcompoundi ng
for
mul acanbeusedt odet erminebot ht heindividualcompoundedv aluesand
thecompounded, orfuturev al
ueoft heent ir
ecashf l
owst ream.
n-
i n-
2 n-n
FVn =CF1( 1+i) +CF2 ( 1+i ) +……+CFn( 1+i)
Wher e,
n-1
 CF1( 1+i ) isthef uturev alueoft hecashf lowatt heendoft hefirstyearat
theendoft henthy ear.
2
 CF2( 1+i ) isthecompoundamountoft hecashf lowatendoft hesecond
henthy n-
n
yearatt heendoft ear,anCFn( 1+i) ist hecompoundamountof
thecashf lowatt heendofnthy earattheendoft hesamey ear,whi chis
n-
n
thesame. CFn =CFn( 1+i)
0
= CFn ( 1+i) =CFn ( 1) =
CFn.
Toill
ust ratet hef uturev alueofunequalcashf lowst ream, considert hef ol
lowing
cashf l
owpat ternshownwi ththeai doft het i
me-line.

Thei ndivi
dualfuturev aluesar ecomput edbyusi ngt hemat hematicalequat
ion
forfutur
ev al
ueofsi nglepay ment .Forinstance,t
hef ut
urev alueforthecashfl
ow
duringyearonewascomput edusi ngit
swoncompoundi ngf ormula,
i.e:
n-1
FV1 =( CF1)(1+i)
7-1 6
FV1 =( 100)(1+0.06) =(100)(1.06) =( 100)( 1.
4185)
I
nt hesameway ,thef ut
ur ev alueofthecashf l
owoccur redatt heendofy eart
wo
i
s:
7-
2
FV2 =( 200)( 1+0.06)
5
=(200)( 1.06) =( 200)(1.
3382)=267. 64Bi rr
,andsoon.

Thefuturev aluesofthecashf l
ow stream overthesev enyearscanalway sbe
foundbyaddi ngthefutur
ev aluesofindivi
dualcashf l
owsasshownwi t
ht hehelp
oftheti
me- l
ine.Howev er,thecashflowpat ter
nwi thi
nthestream mayallowy ou
touseamet hodwhi chislesst i
meconsumi ngandsi mpler
.Thecashf lowsar e
i
nanannui tyamountof200Bi r
rever
yy earduringthesefouryear
s.Youcant ake
thi
sfactintoaccountandcomput ethef ut
urev al
uesoft hecashflowsov erthe
sevenyearsinasl i
ghtl
ydiffer
entmannerasf oll
ows.

67
0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000.
00=
FV7
0.
0 =
FV6
224.
72=
FV5
238.
20=
FV4

252.50=
FV3
267.65=
FV2
141.85 =
FV1
FVT =2,
124.
92

0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000 =FV7
0=FV6

874.
02
983.
06=FV2,3,
4,
5
141.
85=FV1
FVT=2,
124.
91Bi
rr

Asy oucanseef rom t heabovetimeline,thecashf l

owduringyear2,3,4,and5
areintheannuityf orm.Hence,t heirfuturevaluesatt heendofy ear5canbe
foundbyusingthemat hemati
calequat i
onf orfut
urev al
ueofanannui t
y.Inorder
tousethefuturev alueofanannui tyequation,youneedt oident
if
yt hevari
ables
thatar
eknown.I nt hi
scase,thecashf l
ow,orpay ment(PMT)is200Bi rratthe
endofeachy ear,theannualinteresti
s6per cent,andthenumbercashf lows,or
paymentsisfour(n=4) .
FVAn =( PMT)( FVI
FAi,
n)
FVA4 =(200)( 4.3746)=874. 92Birr

Thef ut
urevalueoft hefour200Bi r
rannui t
ycashf l
owsaty ear5is,theref
or e,
equalsto874. 92Birr
.Thi sfuturevaluehast obef ur
thercompoundedf ortwo
morey earsi
nor dertoobtainit
sf ut
urev al
ueatt heendofatt heendofy ear7by
usi
ngt hefuturevalueequati
onf orsi
ngl epayment( cashfl
ows).The874. 92Bi rr
i
st r
eatedast hepresentval
ue,PVatt hebegi nningofyear6,orattheendofy ear
5,anditistobecompoundedf ort woy ears(i
.e.year6andy ear7)whichimplies

68
theval
ueof2forn,andtheannualinter
est(di
scount
)rat
ewassai d6percent.
Ther
efore,
n
FV = ( PV)( 1+i
) -substi
tuti
ngthefigur
esfortheknownvar
iables,
youget:
2
FV =( 874.
92)(1+0.06)
2
=(874.
92)(1.06)
=(874.
92)(1.1236)
= 983.
06Birr

Thecomput
edfutur
eval
ueof983.
06Birri
sthefut
ureval
ueofthef
our200Bi
rr
cashf
lowsoccur
reddur
ingy
ear2t
hrough5,att
heendofyear7.

Semi -
annualandOt herCompoundi ngPer i
ods
Inalloftheil
lust
rati
veexampl esconsi der
edint hischapter,i
twasassumedt hat
i
nterestiscompounded once a y ear,orannual l
y. Thi s iscal l
ed annual
compoundi ng.Suppose, however,thatyouplaced100Bi rri
ntot
hebankaccount
thatpaysa6per centint
erestratebutt heinter
estr ateiscompoundedeachsi x
mont hs. Thiswhati scommonl yknownasSemi -annualcompounding. How
muchwoul dyouaccumul ateattheendoft hreey ears?

Whenev erpay mentsoccurmor efrequentlyt hanonceay ear,ori

fint erestis
statedtobecompoundedmor ethanonceay ear,thenyoumustconv ertthe
statedinterestrat
eperannum i nt
oa' per i
odicrat e'andthenumberofy ear sinto
t
'henumberofper i
ods'asfoll
ows.
Per i
odicrate =Statedr ate/Numberofpay mentperyear .
Numberofper iods=Numbery earsxcompoundi ngperi
odspery ear.
Inourexampl e,i
nhere, wher
ewemustf i
ndt hev alueof100Bi r
raft
erthreey ears
whent hest atedint
erestrateis6per centandcompoundedsemiannual ly(or
twiceay ear),youwoul dbegi
nbymaki ngthef ollowingconversi
on:
Per i
odicrate =6%/ 2 = 3%
Per i
ods =3x2 = 6

I
nthi
ssit
uati
on,t
heinvest
mentwil
learn3%ev
ery6mont hsf
or6per
iods.Ther
e
i
sasigni
fi
cantdi
ff
erencebet
weentheset
woprocedur
es.

Youshoul dmaket heabov econv er

sionbeforeyoust artsol
vingtheproblem,
becausecompoundi ngshoul dgeneral
lybedoneusingnumberofper iodsand
theperi
odicrat
e,notthenumberofy earsandnotthestatedannualint
erestrate.
Theperiodicr
ateandt henumberofper i
ods,
notyearl
yrateandnumberofy ear5,
shouldbeshownont hetime-l
i
neandusedi nthef uturevaluecomput ati
on
equati
onaswel l
.Her eistheti
me-li
ne.
0 1 2 3 4 5
6
-100
FV=?
Eachper i
odcoversvalueofsingl
epay mentequat
ion,t
hef utur
ev al
ueofthe100

69
Bi
rrplacedinthebankaccountwi l
lbe:
n
FVn =(PV)( 1+i), Her e,
i= 3% or0. 03;PV =100;andn=6
Ther
ef or
e,
6
FV6 =( 100)( 1.03)
=(100)( 1.1941)Bi
rr,
orthet
abul
arsoluti
oni
sFVn=(PV)(FVI
Fi,
n),
whereFVIFi,ni
sthefuturev al
ueofsingl
epaymenttabl
eval
uef
oragiveni
andn.

FV6 =(100)( FVIF3%,6)

Thetabl
ev al
uef orperi
od6underthe3%col
umnsi
s1.
1941.Subst
it
uti
ngt
his
val
ueint
otheequat i
on,youget :
FV6=( 100)(1.1941)=119.41Bi
rr

Perpetui
ti
es
A perpetuit
yi san annui tythatcont inuesf orev er;thatev er
yy earf r
om i t
s
establ
ishmentt hi
si nvestmentpayt he same bi rramount . The v erygood
exampl eofper petui
tyisapr eferredst ockt hatyieldsaconst antdi v
idendbi rr
divi
dendinfini
telyast helif
eoft hepr eferr
edst ocki sunli
mi ted.Det erminingthe
presentvalueofper petuityisdel i
ghtfull
ysi mpl eyoumer elyneedt odividethe
constantcashf low byt heprevai l
i
ngi nterest( di
scount)rat e.Forexampl e,t
he
presentvalueof100Bi rrperpetuitydiscount edbackt ot hepr esentt i
meat5
percentis100Bi r
r/0. 05=2000Bi rr. Thus,t hemat hemat icalequat ionto
comput ethepresentv alueofper petui
tyis:
PV =
Wher
e PV = t
hepresentval
ueofper pet
uity
pp = t
heconstantbi
rramountpr ovi
dedbyper
pet
uit
y
i = t
heannualint
erest(
discount)rat
e.

Fracti
onalTimePer i
ods:
Inalltheex ampl esusedsof arinthischapt er
,i twasassumedt hatpay ment
occursoncei nay earei theratthebegi nni
ngorendoft heyear,butnotatt he
samet i
mewi thinay ear.Howev er
,somet imesf racti
onalperi
odsar einvolved.
forexampl e, supposey ouhav edeposited100Bir rinthebankaccountt hatpay s
10per centint erest,compoundedannual l
y.Howmuchwoul dbeiny ouraccount
atthebankaf teramont hs,or75(9mont hsdividedby12mont hsi nthey ear)
percentoft hewayt hrought heyear.Youranswert ot hi
squesti
onmustbe100
Birr
;sinceint eresti scompoundedannual l
yandi nteresti
saddedonl yattheend
ofthey ear.Hence,t herei snointerestthatwoul dhav ebeenaddedaf t
eronl y
ninemont hs.Year sago, bef or
ecomput ermadedai l
ycompoundinganeasyt ask,
banksdi dcompoundi nterestonl
yannual l
y,buttodaymostft hem havest art
ed
compoundi ngi nterestsmont hl
yandev endaily
.

Nowl etthequest i
onbemodi fi
edli
kethi
s:Ifthebankaddsi nt
erestdai
lytoyour
accountdai l
y,thatis,usesdailycompoundingandi fthenomi nalrateis10
percentwitha360- dayy ear
,how muchwillbei nyouraccountafter9mont h?
Assumet hatallmont hsar ea 30-daymont hs. Theansweri s107.79 Bir
r
comput edasf ol
lows.

70
Fi
rst
,youhav
etoconver
ttheannual
int
erestr
atetothedai
l
yint
erestr
ateandt
he
numberofmonthsi
ntot
henumberofdays.
Dai
lyr
ate = = 0.
00027 =i
Numberofday s(peri
ods) = 9mont hsx30day s=270day s=
n
n
Futurevalueaft
er9mont hs,or270days= (PV)(1+i)
270
= (100)(1+0.
00027)
270
= (100)(1.
00027)
270
Byusi ngascientifi
ccalculatororacomputer,thet er
m( 1.00027) i
sequalt
o
1.0779.Therefore,
FV = (
100)( 1.0779) = 107.79Birr
Thisist omeant hatthe100Bi rrwi
llgr
ow to107. 79Birrafter9mont hsatan
annual i
nter
estrateof10per centcompoundeddai l
y.

Now,Supposet hatyouhavebor r
owed100Bi rrf
rom abankwhichchargesy ou
10 percentpery si
ear' mpl
ei nterest
'which meansannualratherthan dail
y
compounding,butyouhaveborrowedt hemoneyf oronl
y270day s.Howmuch
i
nterestwil
lyouhavetopayfortheuseofthemoneyf or270day
s?

Here,y
oual soneedtocalculat
ethedailyinterestrateasy oudidfortheprev
ious
example,andyoumul ti
plythedail
yinterestrateby270i nsteadofusing270as
anexponentbecausethedai l
yint
erestratei
sasi mpleint
er estr
ate.Ther
efore,
Theint
erestchargesduri
ng270day s = (100)(0.
00027)( 270
= 7.
50Bi rr

I
tmeans,y ouowethebankatot
alof107.
50Bir
r,ofwhich100Birrist
he
pri
nci
palyouhav
eborr
owedand7.
50Bir
risthei
nter
estaccr
uededdur
ingt
he
270days.

Final
l
y,considerasomewhatdiff
erentsi t
uat
ion.Supposethatyourcompanyhas
100customer sattheendof1993E.C., andyouhaveobser v
edthatthecust omer
baseofy ourcompanyhasbeenexpandi ngatther at
eof10per centpery ear
.
Assumingt hesamet rendofgrowt h,whati stheestimatedtotalcustomerof
yourcompanyatendoft henint
hmont hofthenewy ear,t
hatis,
1994E. C.?

This probl
em woul d be t
reated exactlyli
ke the bank accountwi t
h dail
y
compoundi ng.Ther ef
oret
het otalcust
omer sofy ourcompanyafter9monthis
thenewy earwoul dbe107.79.Si nce0.79customer sdoesn'
tmakesince,i
thas
tober oundedupt oonecustomerandt hetotalcustomerswouldbe108,which
means8mor ecustomersareexpectedt ocomenewl yduringthe9monthinthe
year1994.

BondValuati
on
Bondvaluat
ionrequir
esthecombinati
onofsev
eraldi
scount
ing,orpr
esentval
ue
computati
ontechniquesandprocedur
es,i
ndudingthatofsinglepaymentand

71
annui
tywithannuall
yorsemi
annual
l
ycompoundeddi
scountr
ates.Asy
ouwi l
l
see,thepresentvalueofagivenbondcanchangedramat
icall
yasi
nter
est
(di
scount
)ratechanges.

Whent hebondi spurchased, t

heholder(owner)ofthebondr ecei
vest wothi
ngs:
(1)inter
estpay ments,whi ch area ser i
esofequalpay ment susuallymade
semiannuall
y,and(2)repaymentoft heful
lpr
incipalati
tsmat uri
ty,r
egardl
essof
thepri
cethebondhol derpaidforthebond.
Forexampl e,considerthebondt hatpay45Bi rreverysix-mont hs,andcomes
dueint wentyyearstime;thati sattheendoft hetwentyy earsthebondholder
wil
lreceiv
e1000Bi rrwhichi susuallythepri
ncipalamountoft hebond,andwi l
l
ter
minate.Howmuchdoest hi
sbondwor t
h?

Gener al
lyspeaking,the bond wortht he presentv al
ue oft he cash f
lowsi t
provides.Thus, wheneverthemarketdiscountrate,orinter
estrat
echanges, the
valueoft hebondchanges. Letusnowexami net hevalueofthisbondassume
threecases: medium,l
owandhi ghmar ketint
erestratessay10percent,6percent
and14per centr
especti
vely
.

Case1:BondVal ueat10per
centMarketInt
er estRate:
Thebondv al
uei sthesum ofthepresentv alueofi nterestpaymentsandt he
presentv al
ueoft herepay
mentofbondpr i
ncipalatmat uri
tytothebondhol
der.
Thepr esentvaluesarecomputedbyusingthemar ketinterestr
ateof10percent
paidsemi annuall
yinthi
scase.

Bondvalueat Presentv
alueof Presentv
alueof
10%compounded =i
nter
estpayment t
her
epaymentof
Semiannual
ly annui
ty + bond'
spri
ncipal

Befor
eyouuset hepresentvalueofannui
tyandsinglepaymentequati
ons,you
needtoconv
erttheannualinterestr
atetothesemiannualr
ate,orper
iodi
crate
andthet
wentyyearbondlif
eintopaymentperi
odsasfoll
ows:

Semi
annual
int
erestr
ate = = 0.
05or5%
Pay
mentper
iods = 20y
ear
sx2per
iods = 40per
iods

Bondvalue(usingtabl
eval
ues)=( PMT)( PVIFAi,
n)+(FV)PVI Fi,
n)
where,
PMT = istheint
erestpay
mentatt heendofev er
y6months
PVIFAi,
n = thetablevaluefr
om t hepresentvalueofanannui
ty
tabl
eforaninterest
rate,
Iandnumberofpay ments,n.

72
 FV = t
her
epay
mentoft
hebond'
spr
inci
pal
att
heendoft
he
twent
yyear
s.
PV1Fi,
n = t
he t
abl
eval
ue f
rom t
he pr
esentv
alue ofsi
ngl
e
paymentt
ableforan
i
nter
estr
ate,
iandt
henumberofcompoundi
ngper
iod,
n.
Bondv alue(pr
esentval
ueofcashf
lows) =( 45) (PVIFA5%,40) + (
1000)
(PVI
F5%,40)
=(45)(17.
1591)+(1000)(0. 1420)
=772.16+142. 00
=914.16Bir
r

Hence,t
hev alueofthebondt hatpays45Bi r
rofinterestsemiannuall
ywhenthe
marketi
nterest(di
scount)ratei
s10per centperannum i s914.16Birr.Si
nce t
he
bondcarr
iesacouponr at
eof9per centperannum of4. 5percentpersixmonths,
i
twi l
lbesol datdi scountwhent hemar ketinterestrat
ei sgreaterthanthi
s
couponrate. (i
.e10per centmarketinterestrate,whichis5per centpersi
x
months)
.

Case2:Bondv alueat6per centMar ketInterestRat e:

Ift he mar ketr ate dropst o 6 percentpai d semi annual l
y ,t he procedur e of
comput ingt hebondv alueremainst hesame,andt heonl ychangei st heannual
i
nter estr ate,iwhi chi snow equalt o6per cent. Logi cal
lysi ncethev alueof
i
nter estr ate,iappearasadenomi natoroft hemat hemat icalequat ionsf or
presentv aluecomput ati
on,t hebond v al
ued shoul di ncreaseast hemar ket
i
nter estr ate, idrops.I not herwords, i
fthebondpay smor ei nter estr
at e(coupon
rate)t hant hemar ketinterestrate,i,thent hedemandf ort hebondi ncrease.
Thisi ncr easei nt hedemandf ort
hebondwi ll
r i
set hebond' sv alue.
Bondv al
ue( 6% annuali nterestr ate) = ( 45) ( PVI FA3%.40)+( 1000)
(PVI F3%,40)
compoundedsemi annual l
y
Bondv alue( 6%mar ketint
erestrate) = (45)( 23. 1148)+ ( 1000)
(0.3066)
= 1040.17+306. 60
= 1,
346. 77Bi rr
Orel se,y oucanuset hemat hemat i
calequat i
on,whi ch,infactl eadsy out ot he
samef inal result:
Bond v al ue ( 6% annual mar ket i nterest r at e) = (45)

=(
45) (
23.
11480 + (
1000)
[
0.3066]
=1040.
17+306.60
=1346.77Bi
rr
I
fthemarketi
nter
estrat
edropsfr
om 10per
centto6percent
,thev
alueoft
he
bondwi
l
lcli
mbfrom 914.
16Bir
rto1,
346.
77Bi
rr.

73
Case3:Bondv al ueatt heMar ketI nter
estRateof14per cent
Ifthemar ketdi scountr ateclimbsf rom 10per centt oper centcompounded
semi annuall
y ,the bond v al
ue wi l
ldr op,as t he f utur e cash f lows t ot he
bondhol dersarenowdi scountedbackt opresentatahi gherdi scountr ate.The
argumenther eist hatifthemar ketpay smor eint erestr atethanwhatt hebond
pays( thati
s9per centpery ear)
,thedemandf ort hebonddecl i
ne.I fthedemand
forthebonddecl ines,thevalueoft hebondwi l
lfal l
.Atamar keti
nt erestrat
eof
14pr esent,,iti
si ntui
ti
v el
ypossi blet oguesst hatt hev alueoft hebondi sless
thani t
spr i
ncipal amountev enbef orecomput i
ngi t.
Bondv al
ue( atannual marketinterestrateof14% = (45)( PVIFA7%,40)+
(1000)( PVIF7%,40)
= (45)( 13.3317)+( 1000)( 0.
0668)
= 599. 93+66. 80
= 666. 73Bi rr
orelse,y oucanuset hemar ketequat ionofpr esentv aluesoft hecashf l
ows
from thebond:

Bondv
alue = (
45)

= (45)(13.
3317)+ (
1000)(
0.0668)
= 599.93+66.80
= 666.73Bi
rr.

Ift
hemar ketint
erest(
discount
)ratecl
imbsf rom 10per centupt o14per cent,
the
val
ueoft hebondwi l
ldropf r
om 914. 16Bi
rrdownt o666. 73Bi r
r.Thi sclearl
y
showsthatthereisaninverserel
ati
onshipbetweent hemar ketinterest(di
scount)
rat
eandthev al
ueofthebond.Whent hemar keti
nterest(discount)rategoesup,
theval
ueoft hebondv al
uegoesdown, andvi
cev er
sa.
Summar y

Tomakedeci sions,fi
nanci
almanager smustcompar ethecost sandbenef it
sof
alt
ernativest hatdonotoccurdur i
ngthesamet i
meper iod.Whet hertomake
profit
abledeci sionsori nv
estment sort ot akeadv antageoff av
orableinterest
rates,fi
nanci aldeci si
onmaki ngr equi
resanunder standingoft hetimev alueof
money . Manager swhouset hetimev alueofmoneyi nalloft heirfi
nanci al
calculat
ions assur et hemselves ofmor el ogicaldeci sions. The t i
me v alue
processf irstmakesal lBi
rrvaluescompar able;sincemoneyhast i
mev alue,i t
mov esal lBir
rf lowseitherbackt othei
rvaluei nthef utureperiod.

Whendeal ingwi thsinglepaymentprobl

ems,thefourv ariablesinv
olvedare:(
1)
i
nitialpayment( PV);(2)theannualint
erestr
ate(i)(3)thenumberofy ear
s(n)
and( 4)thefuturevalue(FV)Givenanythreeoft
hesev ariables,wecansol vef
or
theunknownf ourt
hv ar
iabl
ebyusi nganappr opri
atemat hematicalequati
on
discussedinthechapt er.

Thecompoundamountofannui
typr
obl
emsuset
hef
oll
owi
ngv
ari
abl
es:(
1)t
he

74
numberofpay mentsint he annuit
y( n)
,( 2)the v al
ue/si
ze ofeach annui
ty
payment(PMT)( 3)theannualint
erest(di
scount)r at
e( i
)and(4)thecompound
amountofanannui t
y(FVA).I
fanyt hreeofthesev ari
abl
esaregiven,
thevalueof
thefourt
hv ar
iablecanbeobt ai
nedbyusi ngt hef ut
urev al
ueofanannui ty
equat
ion.

Thepresentv al
ueofannui typroblemsi nvolvesthefol
l
owingvari
abl
es.(1)The
annuali
nter
est(discount)rat
es( i)
;(2)presentval
ueofannuit
y(PVA),
(3)thesize
ofeachpay ment(PMT) ,and( 4)thenumberofpay ments(
n).Thepresentval
ue
foranannuityequationisusedt osolveforthev al
ueofanyonev ar
iabl
e,giv
en
val
uesfortheotherthreevariables.

Thet imev alueofmoneyt echniqueshav esev eral

appli
cati
ons,whi chinclude:91)
comput ationoft heimpl iedinterestrateint hesit
uati
onwher et her ateisnot
clearl
yst ated,(
2)loanr epay mentschedul e( l
oanamor ti
zati
on),(3)bondpr i
cing
(valuati
on)andsoon.Per petuit
iesareintroducedasspeci alform ofanannui ty
.
Perpetuiti
esdonotr equirepr esentvaluet ablesinordertoobt ai
nt heirpresent
valuesper petui
ti
eshav ev eryli
mi t
edapplicationsbythemselvesbutcanser veas
goodappr oximati
onstol ong-li
vedannui t
ies.

CHAPTER4
COSTOFCAPI
TAL
4.
1.THECONCEPTOFCOSTOFCAPI
TAL
4.
1.1.Pr
elude
Theconceptofcapi tali
sbasedont heassumptionthatthecoregoalofpr ofi
t-
Seeking business fi
rms ist o maxi
mize the weal
th ofshar eholders. This
assumpt i
onmakesi tpossi
bletofor
mulat
esev er
alequival
entdefini
tionsofcost
ofcapitalthatpinpointsomei mport
anti
mpl i
cati
onsint heconceptofcostof
capit
al.
Theconceptofcostofcapi t
alhasit
sr ootsint
heitemsont heright-
hand-si
deof
the balance sheet,which incl
udes v ar
ious t
ypes ofdebt,pr eferr
ed stock,
common st ock,and retai
ned ear
nings. These itemsar e call
ed the capi
tal
component s.Ani ncr
easei ntot
alassetmustbef inancedbyani ncreaseinone
ormor eofthesecapitalcomponents.
Capi
talis one ofthe necessar
ycomponents ofproducti
on/operat
ion ofa
busi
nessfi
rm,andli
keanyot herf
act
ori
thasacostofitsown.Thecostofeach
componentofcapi
tali
scall
edcomponent/
speci
fi
ccostthatpart
icul
arcapit
a.
Everyprofit
-making/seekingbusinessf irm hasitsownr isk-
returnchar acteri
sti
cs.
Eachgr oupofi nvest
orsi nthebusi nessf ir
m suchasbondhol ders,pr efer
red
stockholders,andcommonst ockholdersr equiresami nimum r ateofr eturnthat
commensur atewi t
hther isksthegr oupaccept sasar esultofi nvestingi nthe
fi
rm.Fr om t hestandpointofthef i
rm, thesegr oupsprov i
dethecapi tal( f
inancial
resources)neededt ofinancet hef i
rm’ sinvest ment
si ni t
st otalasset s. The

75
mini
mum rat
eofr et
urnthatt
hebusinessf
ir
m mustear
ninordert
osat i
sfythe
ov
erall
rat
eofret
urnrequi
redbyi
tsf
inancer
siscal
l
edthefi
rm’
scostofcapit
al.
4.
1.2.Def
ini
ti
onofcostofcapi
tal
andi
tsi
mpl
i
cat
ions
Themosti
mpor
tanti
mpl
i
cat
ionoft
hedef
ini
ti
onofcost
-of
-capi
talcanbest
ated
asfol
l
ows:
Ift
heact ualr
ateofreturnthatt
hebusi
nessf
ir
m earnsexceedsit
scost-of-
capit
al,
andi fthi
srateofreturnisearnedwit
houti
ncreasi
ngther i
skcharact
eri
sticsof
thefirm,thantheshar eholder
s’weal
thisi
ncreased,whichfur
therimpli
est he
achi
ev ementoft hebasi cgoalofthebusi
nessf i
rm( i
.e.themaximizati
onof
shareholder
s’wealt
h).
Ther easoningbehi ndthisi
mpl i
cationi
st hatwhenther at
eofret
urnoft hefi
rm
exceedsi tscostof -
capit
al,thebondholdersandpr eferr
edstockholderswi l
l
basicall
yr eceivethei
rf i
xedrateofr etur
n. Then,ther emaini
ngport
ionoft he
fi
rm’sr ateofr et
urnt hatisav ail
abl
et ocommonst ockhol
derswil
ldef i
nit
ely
exceedt heirrequi
redrateofreturn.Theexcessearnings, t
hen,
maybet reatedin
severalway sofwhi chsomear e:
 The businessfi
rm maydistr
ibutethese excessear
ningst
o common
st
ockholdersi
nthefor
m ofi
ncreaseddivi
dends,or
 Thebusinessfi
rm mayr etai
n and r
einv
esttheseexcessear
ningst
o
fur
theri
ncr
easei
tsubsequentrat
eofret
urn,or
 Thebusinessfirm maydividetheexcessear ningsbet
weent heincr
eased
di
videndsandr etai
nedear ni
ngs( i
.e.par
toft heexcessearningsmaybe
di
stri
butedtocommonst ockholdersinthefor m ofi
ncr
easeddi vi
dends,
andotherporti
onoft heearningsmayber et
ainedforf
urt
herexpansionof
fi
rm’soperat
ion.)
Astheconsequenceofthedeci
sionmadeinr elat
iontotheexcessearnings,t
he
common shar eswil
lbecomemor edemanded i nt hestockmar ketand the
i
ncreaseddemandforcommonshar eownershipwill
incr
easetheresalepri
cesof
commonshar es.Insuchaway ,sharehol
dersweal thwil
lbemaxi mized,thus,
meetingthebasi
cgoaloft
hebusinessfi
rm.
An alternati
ve defini
ti
on ofcost-
of-capi
talconsi ders cost-of-
capitalas t
he
mini
mum r ateofr etur
nthatthefir
m mustear noni tsinvestedcapi t
ali
fthe
marketv alueoft hef i
rmistoremai nunchanged.Thi sdef i
nit
ion,asy oucan
understand,assumescost -
of-
capit
alasa“ break-even”rate.Accor dingtothi
s
defi
niti
on,cost-of-
capit
ali
stheratethatmai ntainst hecurrentmar ketval
ueof
thefi
rm.I fthiscostofcapit
al(r
ateofr et
urn)isnotear ned,themar ketval
ueof
thefi
rm wi l
ldecli
ne.
Asecondi mpl icat
ionofcost-of
-capi
taldef i
nit
ionli
nkscost -
of-capit
alwi ththe
fi
rm’scapit
al-budgeti
ngprocess.Thecost -of-
capit
alistheratet hatservesasa
discountrt
e used i n eval
uati
ng in eval
uat i
ng capit
al-
budgeti
ng al ternat
ives.
Acceptingprojectalt
ernati
veswithrateofr eturnsthatthefirm. I nt hesame
taken,thefirm’smar ketv al
ueisdecr eased when t herateofr eturn on its

76
i
nvestmentproject
sf al
lsbel
ow it
scost–of–capi t
al. Hence,usi
ngcost-
of-
capi
tal(
discountrate)toeval
uatecapit
albudget
ingalt
ernati
vesisconsi
stent
wit
hthefir
m’sgoal ofshar
eholder
s’weal
thmaximi
zati
on.
4.
2.Measur
ingSpeci
fi
c(component
)Cost
-of
-capi
tal
Asitwasi ndicatedatt hebegi nning,thecapitalstructur
eofthebusinessfir
m
contai
nsdebts( bonds) ,
prefer
redst ocks,commonst ocks,andret
ainedear
nings
andhasi t
sownmi ni
mum r equi
r edrateofreturn,andconsequentl
yitsowncost-
of-
capit
al(theav eragecost-ofcapi t
al)
.Thecost -of
-capit
alhastobecomput ed
foreachcapitalsour ceandsecur i
tyissue.Thecost -of-
eachcapit
alsour
ceor
componenti scalledt hespecif
iccost -of
-capi
tal,orthecomponentcostoft hat
part
icul
artypeofcapi tal
.
Sincethemeasur ementofspeci fi
ccost-of
-capitalisadi f
fi
cultprocess,the
resul
ti
ngcost smustbel ookeduponasappr oximati
ons. Thediffi
cultyari
ses
primari
lybecauset hemar ketval
ueofthef i
rm changesconst ant
lyandagood
dealofthi
sf l
uctuati
oniscausedbyexternalfact
orssuchasi nfl
ati
on,overwhich
thef i
rm hasno cont rol
. Asar esul
t,somer elat
ivel
ysimpleappr oximat
ion
equati
onsareusedt odet
er mi
nethespecif
iccostofcapital
.
4.
2.1.Speci
fi
ccostofDebt
Sincemostl ong-
term debtsofthefi
rm arei
nthef or
m ofbonds,computationof
thecostofdebtcapi talisbasedonthechar
acter
isti
csofbondsandt heinter
est
chargest hebondsi mposeont hefi
rm. Esti
matingthi
sspecif
ic(component )
costofdebt s(bonds)r equi
rescomputi
ngtheeffecti
vecostofdebttothef ir
m
andst at
ingthiseff
ect i
vecostofdebttothefi
rm andstati
ngthi
sef f
ecti
v ecost
ofdebtasanannual compoundingrate.
Thecomputat
ionoft
hespeci
fi
c(component
)costofdebt
s(bonds)i
nvol
ves
thr
eest
eps:
Step1:Determinethenetpr oceedsperbondtothefir
mi ssuingt
heval
ueofthe
bond( usual
ly1000Bi rr
)af terthecostsofselli
ngt hebondt othefir
m are
deducted.Forinstance,thebondsi nthepar
ti
cularbondi ssuemayhave1000
Birrparval
ue.I ft
hebondsar esoldatparandtheissuingcompanypaysa20
Birrsel
li
ng(f
louti
ng)costsperbond,thenetpr
oceed.Perbondi s980Bi
rr.
Step 2:Det ermi ne t
he ef f
ective before-
tax cost-of-
debt( bond)use t he net
proceedf ormt hebondi ssueasat imezer ocashi nf
lows.Uset heannui tyof
i
nterestpay ment sand ther epaymentoft hebondspr i
ncipal(parv alue)at
mat ur
it
yast hecashoutflow.Theef f
ectiv
ebef or
e-taxcostofdebt( bond)isthe
rateatwhi chthesum oft hepr esentvaluesoft heinterestpay mentsannuityand
thepresentv al
uesoft hepr i
ncipal(parvalue)paymentatmat uri
tyi
sequalt othe
proceedsf ormt hebondissue.I ft
henetpr oceedisequalt ot heparv al
ue( f
ace
value)ofthebond,t heeff ecti
vebef ore-
taxcostofdebti sexact l
yequalst othe
i
nterestrateattachedtothebond( couponr ateofthebond) .
Step3:Sincetheinter
estpayment
sar ededucti
bleforincomet axpurpose,you
needtoconv er
tthecomputedbef
ore-
taxcostofcapital
intotheafter
-t
axcost-
of-
capit
al.Thisisdonebydeducti
ngthet ax-
savi
ngsratefrom thebefore-
taxcost

77
ofcapi
tal
.Ther
esul
ti
ngv
aluei
sthespeci
fi
ccost
-of
-capi
tal
.
Let
:
Kd=Ef
fect
ivebef
ore-
taxcostofdebt
T=Companyt
axr
ate,
then
Af
ter
-t
axcomponentcostofdebt=Kd(
1-T)

Toill
ust
rat
ethespecifi
ccostofcapitalofdebt(bond0,
assumethattheEthi
opian
Government(Nat
ionalBankofEthiopia)sel
lsbondissuesforBi
rr20mi l
li
onthat
i
st omaturei
n25y earsti
me.Eachbondi sexpectedtohaveaparv al
ueof1000
Bir
randcar r
iesacouponi nt
erestrat eof12per cent
. Theincomet axrat
ei s
assumedtobe40per cent
.Thegov ernment(NBE)net sforBi
rr985perbond.
Computethespecif
ic(component)costofdebt(bond)capit
alt
ot hegover
nment.
Thepr oceedsperbondt hatthegover
nment( NBE)col lect
sis985Bi rr.Si
ncet he
proceedf ormt hesaleoft hebondi slessthani t
sparv alue(facev al
ue),the
before-t
axcostofcapi t
alofdebtshouldbedi f
ferentf ormthecouponr at
eoft he
bond.Whenpr oceedsform salesoft
hebondl esst hanpar,iti
ssaidt obesol d
atadi scount.Hence,thegov er
nmentistopayt hecouponr ateplusthediscount
amount( whi
chi s15Bi r
rperbondi nthiscase).Thi simpli
esthattheef fect
ive
beforetaxcostofbondi sgr eatert
hanthecouponr ateof12per centbecauseof
theaddi t
ioncostpaidintheform ofdi
scountoni ssue.
Inthi
scasewehav et
ocomput ethediscounti
ngratethatwil
lequat
ethesum of
thepresentv aluesofinterestpaymentsannui t
yandt hepresentval
ueofthe
pri
nci
palr epaymentatmat uri
tyoft hebond. Thisr at
e,asi twasstat
ed,t
he
eff
ecti
vebef ore-t
axcostofcapitalofdebt(bond).Thisrat
eiscomputedbytr
ial
anderrorhint.Beginwit
ht hecouponr at
eandmov etothenexthi
gherr
ate.
Theannualint
erestpay mentequals1000x12% =120Bi r
rperbondperyear
.
Thus,t
he120Birrwillbepaidasanint
erestperbondforthecomi
ng25year
s.In
addi
ti
on,thepr
incipal(f
ace)valueofthebond( i
.e.1000Bi
rr
)wil
lbepai
datthe
endofthe25years9atmat uri
ty)
.
Netpr
esentval
ue=(Proceed fr
om sale ofbond)
.(Presentv
alue ofi
nter
est
pay
mentsannui
ty)-
(presentv
alueofpr
inci
pal
paymentatmatur
it
y)
NPV12%=985–[
120(
PVI
FA12%,
25)
]–1000(
PVl
F12%,
25)

=985–[
120(
7.8431)
]–1000(
0.0588)
=985–941.
17–58.
80=985–1000
=-
15
Sincethesum ofthepresentvaluesofcashout f l
owsi sgreaterthantheproceed
(cashinfl
ow),thenetpr
esentvaluei snegative15Bi r
r.Inotherwor ds,att
her at
e
of12per centthesum oft hepr esentv al
uesoft heinterestpay mentsand
princi
palpaymentisgreaterthant heamountofpr oceedatt hetimeofi ssue.
Hence, y
ouneedt otryt
henexthi gherdiscountrate,
thatis13per cent.

78
NPV13% =985–[
120(
Pvl
FA13%,
25)–1000(
PVl
F13%,
25)

=985–[
120(
7.330)
]–1000(
0.047)
=985–879.
60–47=985–927
=+58
Asy oumov ef r
om thediscountrateof12per centto13per centt henetpr esent
value(NPV)j umpsf orm negati
ve15Birrtoposi ti
ve58Birr.Thi sshowst hatthe
discountr atethatequal
izesthesum oft hepr esentval
ueofi nterestpay ments
annuityandt hepresentv al
ueoft heprinci
palpay mentandt hepr oceedform
bondi ssuel i
esbet ween12per centand13per cent
.I nor dert odet er
minet he
exactdi scountr at
e,thespecifi
ccostofcapi talofdebt ,t hatmakest henet
presentv alueofzer o,youaddt heabsol ut
ev al
uesoft henetpr esentvalues
correspondingt o12percentand13per cent:
1-
151+1+581=15+58=73
The1percentgapbet
ween12percentand13per
centcorr
espondstothe73Birr
di
ff
erencebetweent
henetpr
esentval
uescomput
edforthetwodiscountr
ates.
Hence,
thecostofdebtbef
ore-
tax=Kd=12%+15/
73%
=12%+0.
21%=12.
21%,
or
Kd=13%-
58/
73%
=13%-0.
79%=12.
21%
Af
ter
-t
axspeci
fi
ccostofcapi
tal
ofdebt
=Kd(
1-T)
=12.
21%(
1-0.
40)
=12.
21%(0.
60)
=7.
33%
Ther
efore,theEthi
opianGover
nmentisrequi
redt
opayanef fect
ivecost
-of
-
capi
talofdebtaf
ter
-t
axof7.
33percentont
hebondi
thasi
ssued.
Ont heotherhand, i
ftheEthiopianGov ernment(i
.e.NBE)sell
sthebondsatanet
proceedofBi rr1000perbond,whi chisequalt othepr i
nci
pal(parval
ue)ofthe
bond, t
hesum oft hepresentvaluesoft heseri
espay mentsandthepresentval
ue
oft hepri
ncipalpaymentatmat uri
tyoft hebondi sequaltotheproceedattime
zeroatt hediscounti
ngr atethatisequalt ot hebond’scouponr at
e,thati
s12
percent.Hence,t hespecifi
c( component )costofcapi t
alofdebt9bond)is12
percent.Atadi scountrateof12per cent,thenetpresentval
ueofcashi nf
lows
(proceeds)andt hecashoutf lows( i
nterestpaymentsandt herepaymentofthe
pri
ncipal0iszeroasshownbel ow:
Net
,pr
esentv
alue(
12%)=1000–[
120(
PVI
FA12%25)
]–1000(
PVI
F12%,
25)

=1000–[
120(
7.8431)
]–1000(
0.0588)
=1000–[
941.
17-
58.
80
=1000–1000=0

79
Sincethenetpresentv al
ueatadi scount(i
nter
est0r at
eof12per cent
,is0,the
specifi
ccostofcapit
alofdebt( bond)before-
tax(Kd)is12percent.Asagener al
rule,whentheproceedsf r
om thesal esofbondsar eequaltotheparvaluesof
thebonds,thespecif
iccost-of
-capitalofdebt
s( bonds)befor
e-t
axisequaltothe
couponr at
eatt
achedt othebonds.
Af
ter
-t
axspeci
fi
ccostofdebt(
bond)
ofcapi
tal
=Kd-Kdt
=12%-
(12%)
(0.
40)
=12%-
4.8%
=7.
2%
Therefor
e,t
heEt hiopianGovernment(NBE)isrequir
edtopayanef fect
ivecostof
capit
alofdebt( bond)after-
taxof7. 2percentifitsellsitsbondsf oranet
proceedof1000Bi r
rperbond.Ther easonforusi
ngafter-t
axcostofdebtcapital
ofdebti sasf ollows. Thev al
ueoff ir
m’scapitalstock,whichthef i
nancial
managerwant stomaxi mize,dependsont heaft
er-
taxcashf l
ows.Asintereston
debtsorbondsisat axdeducti
bleexpense,i
tproducestaxsav i
ngswhichreduce
thenetcostofdebt ,makingtheafter-
taxcostofdebtl essthanthebefore-t
ax
costofdebt.
4.
2.2.Thespeci
fi
ccostofpr
efer
redst
ock
Whenabusi nessf irm sel
l
spr ef err
edst ock,itexpect stopayfixeddi v
idendsto
i
nv est
ors( prefer r
edst ockhol ders)int her eturnf orthei
rmoneycapi tal
. The
divi
dendpay ment sar ebasical
lyt hecostoft hefirm pref
err
edst ock.Inorderto
expresst hesedi videndsasy earl
yr ated,thef ir
m usest henetpr oceedsi f
receiv
esaf terdeduct i
ngwhat ev ercostsincur r
edi nselli
ng9floating)theissue.
If,
forexampl et hef i
rm sel
lsthepr eferredstockf or40Bi r
rpershareandpay sa2
Birrsell
i
ng( fl
ot ati
oncost spershar e,t hef ir
m hast ouse38Bi r
r(40-2)net
proceedspershar ei ncomput ingthespeci f i
c( component)costofcapi t
alof
prefer
redst ock.
Thespecifi
ccostofcapitalofprefer
redstock,Kps,istheprefer
reddi
vi
dends,
Dps,di
videdbyt henetpr
oceedsfrom theissuanceofthesharePn,ort
hepri
ce
ofthesharethatthef
ir
m accept
safterdeducti
ngt hef
lot
ati
oncosts.

I
ngener
al,
speci
fi
ccostofPr
efer
redshar
e=Kps=

Forex ample,supposethatBontuShareCompanyhaspr ef
erredsockthatpaysa
10Bi r
rdi v
idendpershareandsell
sfor100Bi r
rpersharei
nt hemarket.I
fBont u
sharecompanyi ssuesnewsharesofprefer
redst
ock,itwi
l
lincuranunderwrit
ing
9orf l
otati
on)costof2.5percentofthesell
ingpri
ce,or2.
50Bi r
rpershare,soit
willnet9.50Bi r
rpershare.Therefore,t
hespecif
iccostofcapitalofpref
erred
stockf orBontuShareCompanywoul dbe:
Speci
fi
ccostofcapi
tal
ofpr
efer
redst
ock=Kps=Dps/
Pn=10/
97.
50=10.
26%
No taxadj
ustmentsaremadewhencal cul
ating t
hespeci
fi
ccostcapi talof
pr
eferr
edstock(Kps)becausepr
efer
reddiv
idendunli
keint
erestexpenseson

80
debt
,arenon-
taxdeductabl
e,hencet
herear
enott
axsav
ingassoci
atedwi
thuse
ofpr
eferr
edstockasasourceofcapi
tal
.
4.
2.3.Speci
fi
ccostofcommonst
ock
Thespeci fi
c(component)costofcapi talofcommonst ockistheminimum r
ate
ofretur
nt hatthebusi
nessfirm mostear nforit
scommonshar ehol
dersinor
der
to maintainthemar ketvalueoft hef ir
m’ sequit
y. Whent hefir
m sell
sits
commonst ockissueandnet sforPnBi rramountpershar e,i
tcansetthenet
proceedsequaltothestocks’int
rinsicvaluebecauseinvestorshavebeenwil
li
ng
toacquirethesecuri
tyatthepr i
cet hatnet sthefi
rm anamountofPnBi rr.The
i
ntri
nsicv al
ueofcommonst ocki sestimat ebyusinganequat i
on:
V=Do(
1+9) Wher
eDo=Cur
rentdi
vi
dendpershar
e
K-
9 g=Compounddi
vi
dendgr
owt
hrat
e
K = t
he rate of ret
urn requi
red by common
st
ockhol
ders(i
nvest
ors)
.
Thisequati
oni susedtocomput et hei ntr
insicvalueoftheshar eofcommon
stockthatreturnsan indefi
nit
e div i
dend st ream. In addit
ion,div
idendson
commonshar esar eassumedt ogr ow atagi vengrowthcompoundr at
eeach
year.Thebusinessfi
rmt hati
ssuet heshar eofcommonst ockcanestimatethe
specif
iccostofcapit
alofcommonst ockbyset ti
ngtheproceedsf or
m salesof
commonshar esequaltothefir
msi ntrinsicvalue(v)
Thenthemar keti
nter
est(
discount)r
ate(k)i
sameasur
eofspeci
fi
c(component
)
costofcapi
talofcommonst ockisgivenbythesy
mbolKe.
Todet
ermi
net
hev
alueofKe,
weequat
ePnandv
Pn=Do(
1+9) becauseV=Do(
1+9)
K-
9 K-
9
Subst
it
uti
ngKeKi
ntheabov
eequat
ion,
youget
;
Pn=Do(
1+9)
Ke-
9
Solv
ing f
orspeci
ficcostofcapi
talofcommon st
ock(
ke)f
rom t
he abov
e
equati
on,y
ouarr
iveat
:
Pn(
Ke–9)=Do(
1+9)
Ke–g=Do(
1+90
Pn

Ke=Do(
1+9) +9
Pn

81
Thisistheequati
onthatisusedmostf r
equentl
ytomeasur ethespecifi
ccostof
capit
alofcommon st ock. Howev er
,i tisbased on t heassumpt ion ofthe
divi
dendstream t
hatincreasesi
ndefi
nitel
yatagi v
encompoundr at
eof‘ 9’
.Thi s
compoundr ate,‘
9’
,isthecompoundr ateofgrowthofcommonst ockdi vi
dend
thatmightbedeterminedfrom t
herecordsinthepastrelatedtodivi
dendgr owth.
Therefor
e,theuseoft hisequati
onisl i
mitedtot hosebusi nessfir
mswhose
expectedfutur
edivi
dendst r
eam atl
eastapproxi
mat esthisassumption.
Forinst
ance,assumet hatNibinternat
ionalBank(N/B)sel
lsanissueofcommon
stocktopotentialinvestor
si nt hecountry.Thesel l
ingpri
cepert hecommon
shareofthebanki s20Bi rr
.Thebanki ncursasell
ing(fl
otat
ion)costof2.50Bir
r
pershare. Thecur r
entdividendoft hebank’ scommonshar eis2.00Br rper
share.Thecurrentdividendoft hebank’scommonshar ei
s2.00Birrperyearand
i
tisexpectedtogr owa5per centannualcompoundr ate.Comput ethespecifi
c
costofcapit
alofcommonst ockofNi bInter
nati
onalBank.
Thenetpr
oceedspershar
e=Pn=Sel
l
ingpr
ice–Fl
otat
ioncost
=20-2.
50
=Bi
rr17.
50pershar
e
Annual
div
idend=Do=2.
00Bi
rrpershar
e.
Di
vi
dendgr
owt
hrat
epery
ear=9=5%,
or0.
05
Ther
efor
e,
Ke=Do(
1+9) +9=(
2.00)
(1+0.
05) +0.
05
Pn 17.
50
=(
2.00)
(1.
05)+0.
05
17.
50
=2.
10 +0.
05
17.
50
=0.
12+0.
05=0.
17or17%
Therei
snoneedt omakeincometaxadj
ustmenttot hecomputedspeci
fi
ccost
ofcapi
talofcommonst ockof17per centbecausecommonst ockdiv
idends,
unl
ikei
nterestondebts(bonds)
,arenottaxdeductibl
e,hencether
eisnot ax-
savi
ngsassociat
edwit
htheuseofcommonst ockfinanci
ng.
4.
2.4.Speci
fi
cCostofRet
ainedEar
nings
Therear et wo dif
ficulti
eswi th comput i
ng thespeci fic( component)costof
capi
talofr etai
nedear nings.Bot hoft hesediff
iculti
esar isef r
om thenatureof
theret
ainedear ni
ngs.Ret ai
nedear ningsar eani nternal,asopposedt oexternal
sourceoff unds.Fi rst,ret
ainedear ningsar enotsecur it
ies,li
kethatofstocks
andbonds.Thus,t heydonothav emar ketval
ues/ pricest hatcanbeusedt o
computet heirspecifi
ccostofcapi tal.Second,si ncer etai
nedear ni
ngsdonot
repr
esentf undspr ovideddi r
ectl
ybycommonst ockhol ders( i
nvest
ors)
,there

82
maybeat
endencyt
oequat
ethespeci
fi
ccostofcapi
tal
ofr
etai
nedear
ningswi
th
zer
o.
Theappr oacht hatisusedt omeasur et hespeci f
iccostofcapi talofr etai
ned
earningsi stor eal i
zet hatr et ainedear ningsr epresentpr of i
tsear neddur ingthe
currenty earand av ailabl
et o common shar eholderst hatt he busi nessf i
rm
decides t or einv esti ni tsel fr athert han pay outas di v i
dends. Thus,t he
sharehol dersar emadet oreinv estpar toft heirear ningsi nthef i
rm.I nr eturn,t
he
sharehol dersexpectt hef i
rmt oear nar ateofr et
ur nont hisr etainedf undwhi ch
i
satl eastequalt ot her ateear nedont heout st andingcommonst ock.Once, t
he
businessf i
rm hasear nednetpr ofitaf t
ert ax,i ti sav ail
abl ef ort hecommon
sharehol dersi nt hef orm ofdi vidend.I fthenetpr of i
tafter-taxi sdeci dedt obe
rei
nv estedi nt hebusi nessi ti sequi valenttot heexi stingcommonst ockcapi t
al.
Botht heout standingcommonst ockandt her etainedear ningsbel ongt othe
commonst ockhol der s’equi tyandt heshar ehol dersexpectsi mi l
arr eturnson
bothcapi talsour ces.Ther ef ore, thespeci f
iccostofcapi talofr etainedear ni
ngs
i
sest imat edont hebasesont hespeci fi
ccostofcapi talofcommonst ock.
Howev er, si
ncenosel li
ng( float ing)cost sar ei ncur redi nrelationt ot her etenti
on
ofear nings, t
hecur rentmar ketpr i
ceofcommonst ock, i
nsteadofnetpr oceed, i
s
usedi nt hecomput ati
onofcostofcapi tal.
Theot herl ogicbehi ndat tachingt hespeci fi
ccostofcapi talofr etainedear ni
ngs
tot hatofcommonst ocki st hatt hemar ketpr iceofcommonst ocki st he
refl
ect i
onoft heper formanceoft hebusi nessf i
rm whi chi s,t
ot hesameext ent,
measur ed byt heamountofnetpr ofi
taf tertaxt hati sr et
ai ned f orfurther
expansi on.I fthetrendoft hebusi nessf ir
m showsacont inuousgr owt h,t
hef i
rm
woul d,inmostcases,r etainl argerpor ti
onofi t
sear ningsaf ter-taxandatt he
samet imet hemar ketpr iceoft hef irm’scommonshar eswi l
lei t
heri ncreaseor
bemai nt ainedatt hecur rentl evel.Thi sclearlyshowst heexi st enceofst r
ong
correlation bet ween r etained ear ningsand common st ock. Ther ef or
e,iti s
reasonabl etoest imat ethespeci fi
ccostofcapi talofretainedear ningsbasedon
themar ketv alueofcommonshar e( Po),currentdi v
idendpercommonshar e
(Do),andcompounddi videndgr owt hr at
epery ear(9)buti gnor ingt heselling
(fl
otation)cost ssincer etainedear ningsar enotmar ketabl
esecur i
t i
es.
Hence,
Speci
fi
ccostofcapi
tal
ofr
etai
nedear
nings=Kr=Do(
1+9) +9
Po
Wher
e,Do=Cur
rentdi
vi
dendpercommonshar
e
G=Compounddi
vi
dendgr
owt
hrat
e
Po=Cur
rentmar
ketpr
iceoft
hef
ir
m’scommonshar
e
Kr=Speci
fi
ccostofcapi
tal
ofr
etai
nedear
nings.
Theonlydif
fer
encebetweenthespecifi
ccostsofcapi
talequat
ionsofret
ained
ear
ningsandcommonst ockist hatthespecif
iccostofcapitalofret
ained
ear
ningsequat
ionusesthecur
rentmarketpr
iceofthef
ir
m’scommonst ockasa

83
denominator
,whi l
et hespecif
iccostofcapi t
alofcommonst ockequationuses
theproceedsf orm salesofcommonst ock( i.
e.thecurrentmar ketpriceof
commonshar el essanysel l
i
ng( f
loat
ing)costinvol
vedintheissui
ngpr ocessof
thecommonshar es. Referr
ingbackt ot heexampleont hespecifi
ccostof
capi
talofcommonst ockwascomput edtobe17per cent
.Thespeci f
iccostof
capi
talofret
ainedear ni
ngsforthesamedat asetis:
Kr =Do(
1+9) +9=2.
00(
1+0.
05) +0.
05
Po 20
=2.
00(
1.05) +0.
05 =2.
1+0.
05=0.
105+0.
05
20 20 =0.
11or11%
Therefor
e,thespecifi
ccostofcapi t
alofretai
nedear ni
ngsi sonl
yis11per cent.
Here,thespecif
iccostofcapitalofret
ainedearni
ng( 11percent
)islessthant he
specif
iccostofcapi t
alofcommonst ocks(17percent)becausecommonst ock
i
ssuance involves sel
li
ng (f
lotati
on)costwhi l
er etai
ning earni
ngs after-t
ax
doesn’ti
nvolv
eanycost s.
4.
3.Wei
ght
edAv
erageCost
-of
-Capi
tal
Once t he specifi
c 9componentcost s ofcapi talforeach f i
rm’sl ong term
fi
nancingsour cehasbeenmeasur ed,itispossibletomeasur ethefirm’sov er
all
cost-of-
capit
al.Ithasbeendef inedasar ateofreturnthatmustbeear nedbyt he
fi
rmi nor dertosat i
sfyt her equir
ement soft heindividualspeci
fi
c(component )
costsofcapi tal
.Theov er
allcostofcapi t
al(weightedav er
agecostofcapi t
al)
thatiscomput edf ormt hef i
rm’sexi stingcapi t
alst r
uctureall
owst hef ir
mt o
obtainameasur eofami nimum r ateofr et
urnthatmustbeear nedoni t
sentir
e
i
nv estments.Theov erallcostofcapi tal(weightedav eragecostofcapital
)ofthe
fi
rm canbeofhel pini dentif
yingt hedi scountratet obeusedi nev al
uat i
ngthe
capital
-budgeti
ngdeci sions.
Theov
eral
lcostofcapi
tal
(wei
ghtav
eragecostofcapi
tal
)isobt
ainedasf
oll
ows:
1.Mult
ipl
ythespecif
iccostofcapit
alofeachsour
cebyi
tsper
cent
age
composit
ioni
nthecapi
tal
str
uct
ureoft
hefi
rm
2.Addt
heproductsy
ouhavecomput
edunder(1)above.Ther
esul
ti
ngsum
i
scal
l
edthefir
m’swei
ght
edaver
agecostofcapi
tal
.
Thepercentagecompositi
ons(weight
s)thatisusedunder( 1)abovecanbe
basedeit
heront hebookv al
uesoft hesourcesofcapi t
alorontheirmar
ket
val
ues.Theuseofbothvaluestodeter
minethepercentagecomposi
ti
onofeach
capi
tal
sourceofthecapi
talst
ruct
urehasbothadvantagesanli
mit
ati
ons.
5.
3.1.BookVal
ueWei
ght
s
Thef i
rsapproacht omeasuringfirm’
swei ght edaver
agecostofcapit
alistouse
the balance sheetbook v alues oft he indivi
dualsour
ce oflong term and
permanentcapi t
al.Thesebookv al
uesr ef
lecttheamountofcapit
althefir
m has
rai
sedbysel l
ingsecur i
ti
esaswel last heamountofcapi talthathasbeen
generatedbyr einvest
ingear ni
ngst hatwer enotpai doutascommonst ock

84
div
idendsSinceeachsourceofcapi
talhasi
tsowncostofcapi
tal
,thefol
lowi
ng
thr
eestepsar eneededtocomputetheover
all
,wei
ght
edaver
age,costofcapi
tal
onthebasisofbookv al
ueweight
s:
1.Fi
nd the per
centage oflong-t
erm capit
alprov
ided byeach f
inancing
sour
ce.TheBi r
rv al
uesforeachcapi
talsour
cesaretakenf
rom t
hefirm’s
bal
ancesheet.
2.Mult
ipl
yeach capi
talper
cent
age byi
tsspeci
fi
c(component
)costof
capi
tal
.
3.Addt
hepr
oduct
syouhav
ecomput
edunderst
ep2.
To il
lustr
atetheuseofbookv al
uesofsour cesofcapi t
alast hebasi
sof
deter
mi ni
ng t
he over
allcostofcapit
al(weighted av
erage costofcapit
al)
,
assumeLeml em companywhosecapit
alstr
ucturecontai
nst hef
oll
owi
ngbook
val
uesandspecifi
ccostsofcapi
tal
ofi
tscapi
talsour
ces.
Leml
em Company
Bookv
aluesandspeci
fi
ccostofcapi
tal
foraGi
venCapi
tal
Str
uct
ure
Sour
ceofcapi
tal Bookvalue Speci
fi
ccostof
capi
tal
9%bonds,
1000Bi
rrpar 15,
000,
000Bi
rr 5.
4%,
or0.
054
50,
000Shar
es,
8Bi
rrpr
efer
red St
ocks 5,
000,
000Bi
rr 8.
0%,or
0.
080
Commonst
ock,
400,
000shar
es
Out
standi
ng 20,
000,
000Bi
rr 11.
0%,or
0.
110
Ret
ainedear
nings 10,
000,
000Bi
rr 10.
5%,
or0.
105

Thespeci fi
ccostsofcapi t
algivenf orLeml em Companyar eassumedt ohav e
beencomput edusingt heequationsf oreacht ypeofspeci fi
ccostsofcapi tal
i
ndicatedearli
er.Thebookv aluewei ghtsareobtainedbydividi
ngthebookv alue
ofeachf i
nanci
ngsour cebythet ot
albookv al
uesofal lfi
nancingsources( i
.e.
50,
000,000Bi rrinthecaseoft hisexampl e). Thebookv alueweightist hen
multipl
iedbyt hecor r
espondingspeci fi
ccostofcapi t
alt ogivethewei ghted
costs.Thesum oft heseweightedcost sequals8. 92percent.Thissum oft he
weightedcost softhecompanyi swhatwecal lthewei ghtedaveragecostof
capit
al( WACC).Thecomput ati
onoft heWACCont hebasisoft hebookv alue
weightsisshownbel ow.
Leml
em Company
Comput
ati
onofwei
ght
edAv
eragecostofcapi
tal

85
 Bookv
alue Speci
fi
ccost Wei
ght
ed
Sour
ceofcapi
tal Wei
ght
s ofcapi
tal cost
s
9%bond,
1000Bi
rrpar
…….0.
30……… 0.
054……………. 0.
0162
50,
000shar
es,
8Bi
rr
Pr
efer
redSt
ock-
--
--
--
--
--
--
- 0.
10-
--
--
--
- 0.
080-
--
--
--
--
--
--
--
- 0.
0080
CommonSt
ock,
400,
000
Out
standi
ngshar
es-
--
--
--
--
-0.
40-
--
--
--
- 0.
110-
--
--
--
--
--
--
--
- 0.
0440
Ret
ainedear
nings-
--
--
--
--
--0.
20-
--
--
--
- 0.
105-
--
--
--
--
--
--
--
- 0.
0210
Tot
al 0.
0892

Thet otal(
sum)ofwei ghtedcostsi
sequalto0.0892whichmeans8. 92per
cent.
Thisist omeant hatLeml em companyisrequir
edt oear
nami ni
mum of8.92
percentoni t
stotalfundsobt ai
nedfor
m alll
ong-t
erm sour
ces,i
fthecompanyis
tosat i
sfythemi nimum r equi
rement
sofi tsfi
nancers(suchasbondholders,
preferr
edstockholders,andcommonst ockhol
ders).
Theadvant
agesofusingbook-
val
ueweight
sincomput
ingacompany
’swei
ght
ed
aver
agecostofcapi
talar
easfoll
ows:
1.Theweight
edaver
agecostofcapi
tal(
WACC)computat
ioni
sassi
mpl
eas
bookv
aluesar
eavail
abl
einthebal
ancesheetoft
hecompany.
2.Thecomput edwei
ghtedaver
agecostofcapi
tal(WACC)usi
ngbookval
ue
weight
sisgeneral
lystabl
eovert
imebecausebookvaluewei
ght
sarenot
dependentonmarketval
uewhichishi
ghl
yvolat
il
e.
3.Whent hemar ketval
ues/
pricesoff
ir
m’ssecur
it
iesar
ebei
ngi
nfl
uencedby
ext
ernalfact
orslikei
nfl
ati
on,book.
Valueweightsmaypr ovi
det
heonl
yusabl
eest
imat
esoft
hef
ir
m’swei
ght
ed
averagecostofcapi
tal
.
Ther
earet wo pr
inci
palli
mitat
ionsinusing t
hebookval
uewei ght
sfort
he
comput
ati
onofweightedaver
agecostofcapi
tal(
WACC).
Thesear
e:
1.Bookvaluesprovideanhistor
ical(
basedonpastdat a)wei
ght
edaverage
costofcapi
talthatmaynoty iel
dacost-of
-capi
talv
aluethati
susef
ulfor
eval
uati
ngcurrentstr
ategi
es.
2.Theirusei snotconsistentwi t
ht heconceptcont ainedinthedef i
nit
ionof
theov erall
costofcapitalofthebusinessfir
m.Thatdef i
nit
ion, aswehav e
touchedupon,speaksofami nimum rateofr at eofr eturnneededt o
maint ai
nt he fir
m’s marketv al
ue,butt he bookv al
ue wei ghtsignore
mar ketv al
ues.Asar esult,thewei ght
edav eragecostofcapi talofthe
fi
rmt hati sdetermi
nedont hebasi sofbookv aluewei ghtscanbeused
onlytopr ovideaquickestimat eoftherateofreturnt hati
nv estorsrequi
re
form t heirf i
rm. Ot herwise,t he weighted av erage costofcapi tal

86
 calcul
atedbyusingbookv aluewei
ght
scan’
tref
lectwhati
sgoi
ngoni
n
themar ketatpr
esentaccur
atel
y.
5.
3.2.Mar
ketv
aluewei
ght
s
Asecondappr oachofmeasur i
ngweightedav eragecostofcapitalist ousethe
mar ketvaluesofthefir
m’ssecuri
ti
esaswei ghtsinthecomput ationalprocess.
Ther esul
tingcostofcapit
alf
rom t
hisprocessr efl
ectsther
ateofr eturncurr
ently
required byinvest
orsr at
herthan t
hehi stori
calr ateembodied i nt hefir
m’ s
balancesheet.
Thecomputati
onoft heweightedaver
agecostofcapit
alofafir
m usi
ngt
he
marketv
alueweight
srequi
resyoutogothr
oughthef
oll
owingf
ourst
eps:
1.Fi
ndthemarketval
ueofeachf
inanci
ngsour
ces,
usi
ngt
hecur
rentmar
ket
pr
icesoft
hesecuri
ti
es.
2.Divi
deeachoft
hemarketval
uesbythetot
almarketv
aluesofal
lcapi
tal
sourcesi
nor
dert
oobt
ainthemarketv
aluewei
ght
.
3.Multiplythe specifi
c costs ofcapit
al(al
ready det er
mined0 by thei
r
correspondi
ngmar ketvalueweights(f
orexampl e,thespecifi
ccostof
capitalofdebt
s( bonds)ismulti
pli
edbythemar ketvalueweightofdebts
(bond)).Ther esul
tingproduct
sarethewei
ghtedcosts.
4.Addthepr
oducts(weight
edcosts)youhavecomput edunderstep3above.
Thesum oftheproductsiswhatiscall
edthewei ghtedaveragecost
,of
capi
tal
(ov
erall
costsofcapit
al)(
basedonmar ketv
al ues)
.
Toi llust
rate,thecomput ati
onofwei ghtedav er
agecostofcapit
alofthef ir
m
usingt hemar ketval
uesofthefinanci
ngsources,assumethesameinformation
provided f orLemel em companywi t
hthenecessar ymarketval
uesf oreach
sour ceswhi char eobservedtobet hefoll
owing:Bondpri
cesare95per centof
theirparv alues,pr
eferr
edstocksare100Bi r
rpershare,
andcommonst ockssell
for75Bi rrpershar e.
Thef irsstepist odet er
minet hemar ketv aluef oreachf inancingsour ces.The
mar ketv al
uesf orbonds,pr efer redst ocks,andcommonst ocksar eav ail
ablei n
themar ketatanypoi ntintimesi ncet hesear esecur it
iesthatar eexchangedi n
thest ockex changemar kets. Buti ncount ries,l i
keour s,themar ketv aluef or
thesesecur iti
esar ehardlyav ailablebecauset hereisnoaf or mall
yor gani zed
stockexchangemar ketthatset spr i
cesf ort hesesecur i
ti
es.Ev enifthereexi sts
thest ockexchangemar ketf ort hesesecur ities, themar ketv al
uei snotav ai l
able
forretainedearningswhi char enotsecur itiesbutsour cesoff ir
m’ sfunds.Asy ou
rememberf rom ourpr evi
ousdi scussi ons, thespeci fi
ccostofcapi talofret ai
ned
earningswasest imatedont hebasi soft hespeci fi
ccostofcapi t
alofcommon
stock.I nthesameway ,
themar ketv alueofr etainedear ningsisder iv
edf rom t he
mar ketv al
ueofcommonst ock.TheMar ketv alueofcommonst ocki sdi vi
ded
betweencommonst ockandr et ainedear ni ngsi nthesamepr oporti
onoft heir
bookv al
ues.
Themar
ketv
aluesofeachf
inanci
ngsour
cesar
e:

87
 (
0.95)(
15,
000,
000) =14,
250,
000f
ort
hebonds
(
100)(
50,
000shar
es) =5,
000,
000f
ort
hepr
efer
redst
ock
(
75)(
400,
000shar
es) =30,
000,
000f
ort
hecommonst
ock
49,
250,
000f
ort
het
otal
capi
tal
str
uct
ure
Then,asstat
edabov e,t
hemar ketvalueofcommonst ockof30,000,000Bi r
ris
divi
dedbet
weencommonst ockandr etai
nedearni
ngsont hebasesoft heirbook
valuesi
nthebalancesheet.Theirbookv aluesare20,000,000Bi
rrforcommon
stockand10,
000,000Bir
rforr
etainedearningsand30,000,000int
otalforboth.

Thus,20,
000,
000 x30,
000,
000=20,000,
000Bir
r(t
hemarketv
alueofcommon
30,
000,
000 stockall
ocat
edtocommonstock,and

10,
000,
000 x30,
000,
000 = 10,
000,
000Bi
rr(
themar
ketv
alueof
30,
000,
000 commonst
ockal
l
ocat
edt
oret
ained
ear
nings.
Theresult
ingmarketval
uesandthemarketv
alueweight
scomput
edf
rom t
he
marketval
uesthemsel
vesarei
ndi
cat
edbelowfort
hecompany.
Leml
em Company
Mar
ketv
aluesandt
hei
rwei
ght
sfort
hecompany
’scapi
tal
str
uct
ure
Sour
ceofcapi
tal Mar
ketv
alue Mar
ketv
aluewei
ght
9%bond,
1000Bi
rrpar-
--
--
--
--
- 14,
250,
000-
--
--
--
--
--
--
--
- 0.
289
50,
000shar
es,
8Bi
rrpr
efer
red
St
ock-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-- 5,
000,
000-
--
--
--
--
--
--
--
-- 0.
102
Commonst
ock,
400,
000shar
es
Out
standi
ng-
--
--
--
--
--
--
--
--
--
- 20,
000,
000-
--
--
--
--
--
--
--
- 0.
406
Ret
ainedear
nings-
--
--
--
--
--
- 10,
000,
000-
--
--
--
--
--
--
--
- 0,
203
Tot
al 49,
250,
000 1,
000
Themarketvalueweightforbondsof0. 289i sdeterminedbydet er
minedby
di
vi
dingthemarketval
ueofbonds(i
.e.14,
250,000)bythet ot
almarketval
ues(
i.
e.
49,
250,
000).Theothermarketv
alueweightsaredeter
mi nedinthesamemanner.
Nextt othedet er
minati
onofmar ketv
alueweights,t
hesewei ght
saremul t
ipl
i
ed
byt hecor r
espondingspecif
iccostofcapit
aloft hefi
nancingsourcesandthe
result
ing products ar
e added. The sum of0. 0898 or8. 98 percentwhich
representsthecompany ’
swei ght
edaveragecostofcapit
al,computedbyusing
mar ketval
uewei ghtsasshownbelow.
Leml
em Company

88
 Wei
ght
edAv
eragecostofcapi
tal
usi
ngmar
ketv
aluewei
ght
s
Sourceofcapi
tal Mar
ketv
aluewei
ghtx speci
fi
ccost=
weighted
Cost

9%bonds,
1000Bi
rrpar 0.
289 0.
054 0.
0156
50,
000shar
es,
8Bi
rrPr
efer
redst
ock 0.
102 0.
080 0.
0082
CommonSt
ock,
400,
000
Shar
esout
standi
ng 0.
406 0.
110 0.
0447
Ret
ainedear
nings 0.
203 0.
105 0.
0213
Tot
al 0.
0898
Ther
efor
e,theaver
agecostofcapi
tal
thatr
efl
ect
sthecur
rentcondi
ti
onsi
nthemar
ket
i
s8.98percentf
orLemlem Company.
The adv
ant
ages ofusing the marketv
alue wei
ght
sin comput
ing a company
’s
wei
ghtedav
eragecostofcapit
alar
e:
1.The use ofmarketvalue wei
ghtsis consist
entwiththe conceptof
maint
aini
ngmarketval
uesinthecost
-of
-capi
taldef
ini
ti
on.
2.Theyprovi
decurrentest
imatesoff inancer
s( invest
ors)requi
redrat
eof
ret
urn,whi
char emor erelevantthanhi st
oricalbookv alueweight
sin
eval
uati
ngcur
rentcapi
talbudgeti
ngalternat
ives.
3.To t
heext entthatbusinessf i
rm hasattai
neditstargetedordesired
capi
talstructur
e,marketvalueweight
swil
ly i
eldgoodesti
mat eofcostof
capi
talthatwouldbeincurredincasethef
ir
m needsadditi
onalfi
nanci
ng.
Thel
i
mit
ati
onsofusi
ngmar
ketv
aluewei
ght
sincomput
ingcost
-of
-capi
tal
are:
1.Marketvaluewei ghtsar emor edi ff
icul
ttousei ncomput ingt heov eral
l
costofcapitalofthef irmt hant hebookv alueweightswhi char er eadi l
y
avail
abl
e.Itisdiffi
cultnotonl ytoobt ainthemar ketvalueoft hefinanci ng
sourcesbutal so to allocat et hemar ketv alueoft hecommon st ock
betweencommonst ockandr et
ainedear ni
ngswhent hespeci ficcostof
capit
alofr etai
nedear ningsi si fthesel l
i
ngcost s(flot
ationcost s)of
commonshar esareinsi gnificantandt obei gnor
ed,thespeci fi
ccost s-of
-
capit
alofcommonst ockandr etainedearningsarethesameandt her eis
noneedtoal l
ocatethemar ketv aluesofcommonst ockbet weent het wo.
2.Sincethemar ketvalues/pri
cesofthef i
rm’ssecuri
ti
eschangedai l
y,the
mar ketvalueof t hef i
rm anditscorr
espondi
ngcostdaily,themar ket
valueofv alueweightsalsochangedai l
yofcapi t
alusi
ngmar ketvalue
weightsalsochangedai l
yandhighl
yinst
abletomakeuseoft hem.
3.Marketval
ueweightcanser
iousl
ydist
orttheoveral
lcostofcapit
alofthe
busi
nessfi
rm whenthepri
cesofitssecur
iti
esaresigni
fi
cantl
yinfl
uenced

89
 byexternalfact
ors/f
or cessuchasi nfl
ati
on.Infl
ati
oncandepr essbond
pri
cessev er
elyforaper iodoft i
me.Thi shasanef f
ectofincreasi
ngt he
speci
fi
ccostofcapi talbondsbey ondwhati twouldhav ebeen.I fmarket
val
uewei ghtsaretor eli
edupont hecomput edweightedaveragecostof
capi
talmayhav etobeadj ustedsubj ect
ivel
yforwhathavebeent hought
tobedistort
ionsbyext ernalforces.
4.
4.Mar
ginal
CostofCapi
tal
(MCC)
I
nt hepr evioussection,itwast ri
edt oanal yzecost-of-
capitalwhent hef irm’s
total f
inancingremainedconst ant.Inr eali
ty,t
hedesi r
eofthef ir
mt of i
nancenew
i
nv estmentpr oposal
susi nginternaland/ orexternalf
undsr equiresthatt hef ir
m
hast oincreaseitstotalcapitalbase.Whent hishappenst hecostofcapi talof
theaddi t
ionalf i
nancingi scalledMar gi
nalCostofCapi tal( MCC). Thus,t he
mar ginalcostofcapi t
al ,
MCC, isdefinedast hecostoft helastBi r
rofnewcapi tal
thef ir
mr aises,andthi scost(i.
eMCC)r i
sesasmor eandmo9r ecapitalisr aised
duringagi venper i
od.I ftheaddi t
ionalf i
nancingusesmor ethanonet y
peof
funds,suchasacombi nati
onofr etainedear ningsanddebt s,thewei ght ed
aver agecostofcapi talofthenewf i
nanci ngiscal l
edthewei ghtedmar ginalcost
ofcapi tal
.
4.
4.1.Cal
cul
ati
ngt
heMar
ginal
CostofCapi
tal
Thef i
rm’smar gi
nalcostofcapi
tal(
MCC)i saf unct
ionofseveralvar
iables.
Becauseoft hi
s,cal
culati
ngthemarginalcostofcapital
isoftenadiff
icultt
ask
thatyi
eldsonlyapproximati
onsoftr
uei soft
enadi f
ficul
ttaskthatyi
eldsonly
approximati
onsoft r
uev al
ues.Thefourvariabl
esthatimpactonMCCdosoby
i
nfluencingthespecif
iccostofcapi
talofthenewf i
nancingsources.These
vari
ablesare:
1.I
nvest
orsmayper
cei
vethatthefir
m’ sbusi
nessriskwil
lincreaseasar
esul
t
ofnewinv
est
mentdeci
sionsthatrequi
readdit
ionalf
inancing.
2.Ifnewfinanci
ngchangesthepercentagecomposit
ionoft hef
inanci
ng
sources(compositi
onofcapit
alst
ructure)
,it
sfi
nancialr
iskmayincrease.
Incr
easesinfinanci
alandbusi
nessriskswill
beref
lectedinhi
gherMCC.
3.Theinvest
mental ter
nat
ivesthatareavail
abl
eanddesi rabletothefi
rm may
requi
realargeamountoff i
nancingrel
ativet
oitsexist
ingt ot
alcapit
al.In
thi
scase,thesizeofthedesiredfi
nancingmayincreaset hefi
rm’sMCCand
thusmayr educetheimportanceofsomeoft heinvestmental t
ernat
ives.
4.Externalfor
cessuchasinfl
ati
onmayi ncr
easet hefi
rm’sMCCt othepoint
wherei tdel
aysrai
singl
ong-t
erm ext
ernalcapit
alandforcingthefi
rmt o
fi
nancei tsnewinv
estmentproposal
swi t
hf undsfr
om retainedearni
ngs
source.
TheMarginalCostofCapi
tal
( MCC)calcul
ati
onprocedur
esf
oll
owedi
nthi
s
mater
ial
ar ebasedonthefol
lowingassumptions.
1. Thenewf i
nanci
ngdeci
sionhasaminimum i
mpactontheexi
sti
ngcapi
tal
deci
sionhasamini
mum i mpactont
heexi
sti
ngcapi
tal
struct
ureoft
he

90
 f
irm.Thisassumpti
oni
mpliesthattheper
cent
agecomposi
ti
onofnew
f
inanci
ngisspeci
fi
edbythefi
nancialmanager
soft
hefi
rms.
2. Thesecondassumpt ionist hatt
hefi
rm canr easonablyforecastthe
specif
iccostsofcapi
taloft henewfinanci
ngwhi char ewitherthesameas
thespecif
iccostofcapitaloftheexi
stingcapitalst
ructur
eort otaldi
ff
erent
.
Thisimpli
estheneedf orsomeabi l
it
yt oesti
mat etheimpactofsome
addedbusinessri
skandt heexter
nalvari
ablesont hespecificcostof
capit
al.
3. Mar ketv al
ueweightsar
eused.Thechoi ceofweight
sisbasedont he
realizat
ionsthatnewcapit
ali
sobtainedbypay i
ngthecost-
of–capit
al
whi chisagoodest i
mateofthecurrentmarketpri
ceofcapit
althatmarket
valuewei ghtsbasedMCCi smorerelevantt
hantheMCCt hatiscomput ed
ont hebasisofbookv al
uesoftheexisti
ngcapit
alstr
uctur
e.
4.
4.2.Fi
nanci
ngNewI
nvest
mentPr
oposal
Wit
hRet
ainedEar
nings
Whent hebusi
nessfi
rmisabletof
inanceitsnewinvestmental
ter
nat
ive
completel
ywit
hretai
nedearni
ngsthemar gi
nalcostofcapi
tal(
MCC)equal
sthe
speci
fi
ccostofcapit
alofr
etai
nedearning.
Toil
lust
rat
e,supposethattheexi
sti
ngcapi
talstr
uctur
ecomposi
ti
onandspeci
fi
c
cost
sofcapitalofeachfi
nanci
ngsourceofSelam Shar
eCompanyar
easfoll
ows:
Sour
ceofCapi
tal Per
cent
ageComposi
ti
on Speci
fi
c-cost
-of
-Capi
tal
Bonds…………………….
.0.
30………………………… 0.
06
CommonEqui
ty(
Common
St
ock&r
etai
nedear
ning)
..0.
70………………….
.…… 0.
13
Asitwasdiscussedearl
i
er,theweight
edav
eragecostofcapi
tal
(WACC)f
ort
his
capi
tal
str
uctureofSelam ShareCompanyi
s:
(
0.3) (
0.06)+(
0.70) (
0.13) = 0.
018+0.
091 =0.
109,
or10.
90%.
Assumeal sot hatSel
am Shar eCompanyhasdeci dedtofinancethenew
i
nv estmentpr oposalthatrequiresastart-
upcostof2.
5mi ll
ionBir
renti
rel
ywith
fundsr etai
nedear ni
ngssour ce.Thequest ionher
e,i
s,“Whatisthecostof
capitaltofinancenewi nvestmentpr oposal(MCC)byret
aini
ngformt heearni
ngs
ofthecompanydur i
ngt hecurrentyear?”
Assumeal sot hatt hegi v
enspeci fi
ccostofcapi t
alar econstant,themar ginal
costofcapi tal(MCC)ofaddi t
ionalfi
nancingis13per centwhichist hespeci fi
c
costofcapi t
al ofretainedearnings.Thought hewei ghtedaveragecostofcapi tal
(WACC)oft heexi sti
ngcapi t
alstruct
ureofSel am ShareCompanyi s10. 9percent
themar ginalcostofcapi taloftheadditionalcapitali
s13per centbecauset he
fi
nancingofnewi nv est
mentpr oposalwasnotmadei nthesamepat ternoft he
exi
stingcapi talstructure(i.
e30per centbonds,and70per centcommonequi ty
i
ncludingbot hcommonst ockandr et
ainedear nings). Rathert headdi t
ional
capit
alr equirementt of i
nancet henew i nvestmentpr oposalwasr ai
sed100
percentf r
om r etainedear ni
ngs.Hence,t hemar ginalcostofcapi tal(MCC)of

91
addit
ionalf
inanci
ngof2.5mill
ionBir
risequalt
othespeci
fi
ccostofcapi
tal
ret
ainedear
ningsthati
s13per
cent.
4.
4.3.Fi
nanci
ngNewI
nvestPr
oposal
wit
hConst
antCostofCapi
tal
Ift
hespecifi
ccostsofcapit
alinthenewf i
nancingequalt hespeci
fi
ccostsofthe
exi
stingcapit
alstr
uctur
eofthefirm,andifthenewf i
nancingdoesn'
tchangethe
exi
stingcapit
alstr
uctur
eproport
ion,thenthemar ginalcostofcapi
talequal
sthe
weightedaveragecostoft
heexisti
ngcapit
al st
ructureofthefi
rm.
Toill
ustr
atethi
scase,assumetheexi
sti
ngcapit
alst
ruct
urecomposi
ti
onandthe
specif
iccostofcapi
talofeachfi
nanci
ngsourcesofTureShareCompanyi
sas
fol
lows:
Per
cent
age Speci
fi
cCost
Capi
tal
Sour
ce Composi
ti
on of
Capi
tal
Bonds……………………………….
.0.
10……………………………….
. 0.
05
CommonSt
ocks…………………… 0.
50………………………………. 0.
10
Ret
ainedear
nings…………………. 0.
40……………………………… 0.
09
Thewei
ghtedav
eragecostofcapit
al(
WACC)oft
heexist
ingcapi
talst
ruct
ureof
Tur
eShareCompanyis9.
1percentcomput
edasf
oll
ows:
WACC= (
0.10)(
0.05)+(
0.5)(
0.10)+ (
0.4)(
0.09)
= 0.
005+0.
05+0.
036
= 0.
091or9.
1%
TureShareCompanypr oposest of i
nancea4mi l
li
onBi r
rcapi talproj
ectbyusing
ret
ainedearni
ngsof1. 6mi ll
i
onBi rrgenerat
eddur i
ngt hecur r
entthecur r
ent
accounti
ngperiod,byraising400,000Bi r
rthroughbondsi ssues,and2mi ll
ion
Bir
rthroughcommonshar eissues.Thecompanyest i
mat est hespecif
iccostof
capi
talofthenewsour ceoff undsandf oundt hattheyareequalt othespecifi
c
costsoftheexi
stingcapitalstr
uctureforeachcapitalsour ces.Oft hetot
alnew
fi
nancingeachsourceprov i
desthefoll
owing:
Ret
ainedear
nings:16mi
l
li
onBi
rr/4mi
l
li
onBi
rr=0.
40,
or40%
Bonds :400,
000Bi
rr
/4mi
l
li
onBi
rr =0.
10,
or10%
CommonSt
ock : 2mi
l
li
onBi
rr
/4mi
l
li
onBi
rr =0.
50,
or50%
Theper centagecomposit
ionoft henew f i
nancingist hesameast hatoft he
percentagecompositi
onoftheexist i
ngcapit
alstructur
e( i
.e.bot hoft hecapital
str
uctures,new andexist
ing,aref ormedf r
om 10per centbonds,50per cent
commonst ock,and40percentret
ainedearnings.)Therefore,themar gi
nalcost
ofcapital(MCC)undersuchcondi ti
ons(i
.e.whent henew f inancingdecision
doesn'tentail
sanychangeint hecomposi t
ionoft heexistingcapi talstr
ucture,
andwhent hespeci
fi
ccostofcapitalofthenewf inanci
ngsour cesar ethesame
asthatofthespecifi
ccost
sofcapi tali
ntheexisti
ngcapi t
alstructure)isequalto

92
thewei
ghtaveragecostofcapi
taloft
heexi
sti
ngcapi
talst
ruct
ure(
WACC)
,ori
t
canbecomputedas:
Thewei
ght
edMCC =(
0.40)(
0.09)+(
0.10)(
.0.
05)+(
0.50)(
0.10)
=0.
036+0.
005+0.
05=0.
091,
or9.
10%
Thus,t
heweightedmar gi
nalcostofraisi
ngtheaddi
ti
onal4milli
onBir
rfi
nanci
ng
i
sequaltothewei ght
edav eragecostoftheexi
sti
ngcapit
al(i
.e.bef
orethenew
fi
nanci
ng)whichis9.1percent.Here,
youcanmakeagener al
conclusi
onthat:
 Whenthespecif
iccost sofcapi
talofeachsour
ceinthenewfi
nanci
ngare
equal
tothei
rcorrespondingspeci
fi
ccostsofcapi
tal
intheexi
sti
ngcapi
tal
str
uct
ureofthefi
rm, and
 Whent henewfi
nancingdeci
sion(addit
ionalf
undraisi
ngdeci
sion)doesn'
t
changethecomposi t
ionoft
heexi sti
ngcapitalst
ruct
ureofthef i
rm,you
can concl
ude thatthe wei
ghted costofcapi t
alofadditional(new)
fi
nanci
ngMCC,i sequaltothewei ghtedaveragecostofcapitalofthe
exi
sti
ngcapit
alstruct
ure(
WACC) .
4.
4.4Fi
nanci
ngNewI
nvest
mentPr
oposal
wit
hConst
antSpeci
fi
cCostofCapi
tal
Thesear esituat i
onswher ethespeci f
iccostofcapi t
alwillnotbeaf fect
edbyt he
amountoff unds raised as we assumed t he preceding exampl es. I ft he
per centagecomposi tionofnew f i
nancingr emai nconstant,andt hent hef ir
m' s
wei ghted costofcapi talremai ns constant . When on t he ot herhand,t he
wei ghtedmar ginalcostofcapi talexceedst hewei ghtedav eragecostofcapi tal
oft heexistingcapi talexceedst hewei ghted av eragecostofcapi t
aloft he
exist i
ngcapi talst r
ucture,rai
singaddi t
ionalf undswi l
li ncreaset hewei ght ed
aver agecostoft henewcapi t
alst r
ucture(i.
e.thecapitalstruct ureoftheexi sting
plusnew f inanci ng).Toi ll
ustratet heimpactofanew f inanci ngwi t
hdi fferent
wei ghtedmar ginalcostofcapital( MCC)ont heweightedav eragecostofcapi tal
(WACC)oft heexi sti
ngcapitalstructure,considerthecurrentcapi t
alstructureof
Mi srakShar eCompanyt hatcont ainsat otalof50mi l
li
onBi r
randt hef ol
l
owi ng
component s.
Sour
ceofCapi
tal Per
cent
ageComposi
ti
on Speci
fi
ccostofCapi
tal
Bonds 0.
25 0.
055
CommonSt
ock 0.
50 0.
110
Ret
ainedear
nings 0.
25 0.
105

Thewei
ght
edav
eragecostofcapi
tal
fort
hiscapi
tal
str
uct
urei
s:
WACC= (
0.25)(
0.055)+(
0.50)(
0.110)+(
0.25)(
0.105)
= 0.
01375+0.
055 +0.
02625
= 0.
095,
or9.
5%
Thecompanyexpect
stogener
ate2mi
l
li
onBi
rri
nret
ainedear
ningsf
rom cur
rent

93
operat
ions. Totalexpendi
tures f
orthe proposed capit
ali
nvestmentoft he
companyr angefr
om 5mi l
li
ont o10mil
li
on.Inordertokeepitscapi
talst
ructure
compositi
onconstant,r
eali
zingthat2mi l
l
ionBi r
rwillbeprovi
dedbyr etained
earni
ngs,thecompanywouldhav etor
aiseexactl
y8mi ll
i
onBirri
nnewcapi talas
fol
lows:
Bonds : 2mi
l
li
onBi
rrwhi
chconst
it
ute25per
cent
CommonSt
ock : 4mi
l
li
onBi
rrwhi
chconst
it
ute50per
cent
Ret
ainedear
nings : 2mi
l
li
onwhi
chconst
it
ute25per
cent
Thespeci
fi
ccostofcapi
tal
ofr
aisi
ngt
he8mi
l
li
onBi
rri
sest
imat
edasf
oll
ows:
Sour
ceofcapi
tal Speci
fi
ccostofcapi
tal
Bonds 0.
06
CommonSt
ock 0.
12
Ret
ainedear
nings 0.
105
Asy oucanobser v ethespeci fi
ccostsofcapi t
alofbondsandcommonst ocks
i
ssuesf or thenew f i
nanci ngareslightl
ydiff
erentfrom t hespecifi
ccost sof
capit
alofbondsandcommonst ockissuesintheexisti
ngcapi talstr
uct ure(i
.e.
beforethe new f inancing). Though t he new financi
ng doesn' tchange t he
company '
s exi
sting capi talstr
ucture compositi
on,t he diff
erences thatexist
betweent hespeci fi
ccost sofcapi talofbondsand commonst ockf orthe
exi
stingandnewcapi taloft hecompanyr esul
tsinthewei ghtedmar gi
nalcostof
capit
al(MCC)t hati sdifferentfr
om thewei ght
edav eragecostofcapi t alofthe
exi
stingcapi
talstructure( WACC).
Thewei
ghtedmarginalcostofcapi
tal(MCC)ofrai
singtheaddit
ionalf
undsof8
mil
li
onBi
rrtof
inancethenewlyproposedinv
est
mental t
ernat
ivei
s:
Wei
ght
edMCC =(
0.25)(
0.06)+ (
0.50)(
0.12)+(
0.25)(
0.105)
=0.
015+0.
06+0.
02625
=0.
1013or10.
13%
Theref
ore,Mi
srakShareCompanyhast opayanav eragecostof10.13percent
,
orabout10centsoneachBi r
r,ontheaddit
ional8mi ll
ionBi
rrit
sneedstoriseto
fi
nancethenewcapitali
nvestmentproposal,whichisgreat
erthantheweighted
aver
agecostofcapi
taloftheexist
ingcapi
talstr
ucture,9.
5percent
.
IfMi srakshar ecompanyr ai
sestheadditi
onal8mi ll
i
onBi r
rfundsaspert he
i
ndi cated composi t
ion (
i.
e.25 percentfrom sell
ing bonds,50 per centf r
om
i
ssui ngcommonshar esandt heremaini
ng25per centf r
om ret
ainingearnings)
,
thewei ghtedaveragecostofcapi t
alofthenew 58mi l
li
onBir
r( i.
e.50mi l
l
ion
existingcapi t
alplus8mi l
li
onBirrfr
om additi
onalfinanci
ng)capitalstr
uctureis
9.59per centascomputedbelow.
SourceofCapit
al Bi
rrAmount Per
cent
ageComposi
ti
onxSpeci
fi
cCost=
WeightedCost

94
Bonds(
exi
sti
ng)……12,
500,
000 0.
2155 0.
055
0.0119
Bonds(
new)
………. 2,000,
000 0.
0345 0.
060
0.
0021
CommonSt
ock
(
exi
sti
ng)
……….
. 25,
000,
000 0.
4310 0.
110
0.
0474
CommonSt
ock(
new) 4,000,
000 0.
0690 0.
120
0.
0083
Ret
ainedear
nings
(
exi
sti
ng) 12,
500,
000 0.
2155 0.
105
0.
0226
Rel
i
nedear
nings(new)2,
000,
000 0.
0345 0.
105
0.
0036
Total 58,
000,
000 1,
0000 WACC
0.0959

Theref or
e,thenew f inancing of8 mi l
lion Bir
rwi t
hi tsassociat ed wei ghted
mar ginalcostofcapitalof10. 13percenthasi ncreasedt heweight edav erage
costofcapi t
al(WACC)f rom 9.5percentt o9.56per cent.Assumef ur thert
hatt he
researchconductedbyMi srakShar eCompanyi ndicatest hatt
headdi t
ional2
milli
onBi rrneedt ofinancet heent i
re10mi ll
i
onBi r
roft heproposedcapi tal
i
nv estmentcoul d be r ai
sed by i ssuing addi ti
onalcommon st ock wi thout
changi ngitsspecif
iccostf rom 12per cent
. Thewei ghtedmar ginalcostof
capital(MCC)ofr aisi
ngt he10mi ll
ioni sdifferentfrom theweight edmar ginal
costofcapi t
alofrai
sing8mi l
lionBi
rrinthenewf i
nancing,anditwoul dbe:
Sour
ceofCapi
tal Bi
rrAmount Per
cent
ageComposi
ti
on
Bonds 2,
000,
000 0.
20
CommonSt
ock 6,
000,
000 0.
60
Ret
ainedear
nings 2,
000,
000 0.
20
Tot
al 10,
000,
000 1.
00
Hence,t
her=weight
edmar
ginalcost(
MCC)ofr
aisi
ngt
he10mi
l
li
onBi
rri
nthe
newfi
nanci
ngis:
= (
0.2)(
0.026)+(
0.6)(
0.12)(
0.2)(
0.105)
= 0.
012+0.
072+0.
021
= 0.
105,
or10.
5%
Againt
hemar gi
nal
costofcapi
tal
isdif
fer
entfr
om theweight
edaveragecostof
theexi
sti
ngcapi
talst
ruct
ure(
50mi l
l
ionBi
rrexi
sti
ngcapi
talst
ruct
ure)whichi
s

95
onl
y9.
5per
cent
ages.
I
fMisr
akShareCompanyr ai
sest heent
ir
e10mill
i
onBirrasindicatedabove,
the
wei
ght
edaveragecostofcapitaloft
henew60mi l
li
onBirrcapit
alstr
uctur
e(i.
e.
50mil
l
ionBi
rrexi
sti
ngcapitalplus10mill
i
onBi
rrnewfinancing)thenbecomes:
Per
cent
age Speci
fi
ccost Wei
ght
ed
Sour
ceofCapi
tal Bi
rrAmount Composi
ti
on ofcapi
tal cost
Bonds(
exi
sti
ng)
…. 12,
500,
000 0.
2083 0.
055 0.
0115
Bonds(
new)……. 2,
000,
000 0.
0333 0.
060 0.
0020
CommonSt
ock
(
exi
sti
ng)
……… 25,
000,
000 0.
4167 0.
110 0.
0458
CommonSt
ock(
new)
. 6,
000,
000 0.
1000 0.
120 0.
0120
Ret
ainedear
nings
(
exi
sti
ng)
……….
. 12,
5000,
000 0.
2083 0.
105 0.
0219
Ret
ainedear
nings(
new)2,
000,
000 0.
0333 0.
105 0.
0035
Tot
al…………. 60,
000,
000 1.
0000 WACC 0.
0967
Theweightedaver
agecostofcapit
al(WACC)oft hecompanyi ncr
easesfrom 9.
5
per
centto9.67percentasaresul
tofit
s10mi ll
i
onBirraddit
ionalf
inanci
ng.The
per
centagecompositi
onofit
scapital
struct
urealsochangesandisnow:
Sour
ceofCapi
tal Bi
rrAmount Per
cent
ageComposi
ti
on
Bonds…………………….14,
500,
000 0.
24
CommonSt
ock…………… 31,
000,
000 0.
52
Ret
ainedear
nings………… 14,
500,
000 0.
24
Tot
al………………….
.60,
000,
000 1.
00
I
nt hi
si l
l
ust r
ativeexampl e,t
hecompany ’sweightedmar ginal costofcapitali
s
10.13per centfor8mi ll
ionBirrfi
nancingand10. 5per centfor10mi l
li
onBi rr
fi
nancingev et houghthespeci fi
ccostsofcapi t
al r
emai nconst antforboth
amount sofaddi ti
onal f
inancingdecisions.Thisincreaseint hewei ght
edMCC
occursbecauset hepercentagecomposi ti
onofeachf i
nancingpackagei s
dif
ferent.Hence, inevaluati
ngt hecapitali
nvestmentpr oposal of8mi ll
ionBirr,
thefi
nanci alanalysthast ouseadi scountrate(MCC)of10. 13per cent.Similar
ly,
thediscountr ateforevaluati
ngt he10mi ll
ionBirrcapit
alinvestmentpr oposal i
s
the10.5per cent,whichisagai nthecor r
espondingMCC.

96
 Chapt
er5
Capi
tal
Budget
ingPr
ojectEv
aluat
ionTechni
ques:

6.
1.I
NTRODUCTI
ON
Long-term i nv
estment sar eal so cal led capit
albudget ing. Thet erm capital
accordingt oWest onandBr i
gham,1985,r ef
erst ot hef ixedasset susedi n
production,whileabudgeti sadet ailedplanofpr ojectedcashf l
owsdur ingsome
futur
e per iod. Thus,t he capi t
albudgetoft he f irm out l
ines the planned
expendituresoft hef i
xedasset s,andcapi t
albudget i
ngi sthewhol eprocessof
analyzi
ngpr oj
ectswhoser eturnsar eexpect edtoext endbey ondt heper iodof
oney earanddeci dingwhi chpr ojectshoul dbei ncludedi nt hecapi t
alpr oj
ect.
Capitalbudget i
ngexpendi t
uresi ncludeexpendi turesforl and, buil
ding,equipment,
andf orpermanentaddi t
ionstowor kingcapitalassoci atedwi thplantexpansi on,
foradv erti
singandpr omot i
oncampai gns,andf orr esear chanddev elopment
programs.
Theopt i
mum capi t
albudgeti ssimultaneouslydeter
mi nedbyt hei nt
eractionof
suppl yanddemandf or
cesundercondi t
ionsofuncertaint
y.Thef orcesofsuppl y
ref
ert othesupplyofcapi taltot hefir
m,ori tscostofcapi talschedule.The
for
cesofdemand on t heot herhand,r ef
ertot hei nvestmentoppor tuniti
es
availableforthef
ir
m, asmeasur edbyt hest r
eam ofrevenuest hatwi ll
resultfr
om
ani nvestmentdecisi
on.Uncer t
aintyofconditi
onsent ersthedeci sionsbecause
i
ti si mpossibletoknow exact l
yei t
hert hecostofcapi talort hest r
eam of
revenuest hatwil
lbederivedfrom aproject.
6.
1.1.I
mpor
tanceofCapi
tal
Budget
ing
Thef
oll
owi
ngar
esomeoft
hei
mpor
tanceofcapi
tal
budget
ing:
1.Ithasalong-t
erm ef
fects. Ther esul
tofcapit
albudgeti
ngdeci
sions
conti
nues overan extended peri
od. This enabl
es t
he fi
rm t
o be
competit
ivei
nthemarketbykeepingitsexi
sti
ngcust
omers.
2.Effective capit
albudget i
ng willimpr ove botht he ti
mi ng ofasset s
acquisitionsandt hequalityoftheacqui redassets.Capitalasset smust
ber eadyatt het i
met heyareneeded.I fthefirmf or
ecast sit
sdemand
proper l
yandpl ansi tsrequiredcapaci tyincreases,itwi l
lbeabl et o
mai ntainitsmar ket,
(eventoobt ai
nal argershareoft hemar ket).Afi
rm,
whi chf orecast
si t
scapitalassetsrequirementsinadv ance,willhavethe
oppor tunitytopurchaseandi nstal
ltheassetbef oreit
ssalesexceedsi ts
capaci ty.
3.Capitalbudget
ingenablest hefi
rmt oraisefundsearlybeforethesales
approacht hemaximum capaci t
ylevel
s.Bef orethefi
r m spendsalarge
amountofmoney ,itmustt akethepr operplans. Largeamount sof
fundsar enotav ai
labl
eov ernight. Afirmt hatcontemplatesamaj or
capit
alexpenditureprogr
am mayneedt oarrangeitsf i
nancingseveral

97
 y
ear
sinadv
ancet
obesur
eofhav
ingt
hef
undsr
equi
redf
ort
hepr
ogr
am.
6.
1.2.Appr
oachest
oCapi
tal
Budget
ing
Asyst
emat
icappr
oacht
ocapi
talbudget
ingr
equi
rest
hef
oll
owi
ngpr
ocedur
est
o
f
oll
ow:
1.Thef
ormul
ati
onofl
ong-
ter
m st
rat
egyandgoal
s
2.The creat
ive sear
ch and i
dent
if
icat
ion of new i
nvest
ment
oppor
tuni
ti
es
3.Theest
imat
ionandf
orecast
ingofcur
rentandf
utur
ecash-
fl
ows
4.A setofdecisi
on rul
es thatcan di
ff
erent
iat
e accept
abl
efr
om
unaccept
abl
ealt
ernat
ives.
5.Thebuil
dingofsui
tabl
eadmini
str
ati
vefr
ameworkthatiscapabl
eof
tr
ansf
erri
ngtherequi
redi
nfor
mationtot
hedeci
sionlev
el.
6.The cont
rol
li
ng ofexpendi
tur
es and t
he car
efulmoni
tor
ing of
proj
ecti
mplementat
ion.
I
ff i
nanci
almanagersunder
takeallt
he6- st
epsundert hecapi t
albudget
ing
appr
oach,theyar
eabl
etomakeeff
ecti
vecapit
albudget
ingdeci
sions.
1.For
mul
ati
onofLong-
ter
m Goal
s
Long-t
erm goal
sserveast hegui
def ormanager i
aldecisi
ons. A syst
emati
c
approachtocapit
albudget
ingdeci
sions,thus,requirest
heformulati
onofaset
oflong-t
erm goal
s. Managementwi llbeconcer nedwithbotht heexpect
ed
ret
urnsandtheri
sksassumedoni t
scapitalinv
estment .
2.Gener
ati
ngI
nvest
mentPr
oposal
s(I
deas)
Agoodi nvestmentproposali snotj ustborn;someonehast osuggesti t.In
additi
on,someonewi thint
hef i
rm mustbewi ll
ingtolistent osuchpr oposals.In
theabsenceofcr eati
vesear chf ornewi nvestmentoppor tuni
ti
es,event hemost
sophisti
cated eval
uati
on techni ques maybe wor t
hl ess.I naf irm wi t
h well
equippedr esear
chanddev elopmentdi v
isi
on,sophi sti
cat ednew pr oducts,or
processesar ecr
eatedbyt hedi vi
sion.I nasmal lf
irm, thesear chforinvest
ment
possibi
li
tiesmaybe l essst ructured. Itof t
en takest he form ofempl oyee
suggestionbox,ori
nformal discussionsdur i
ngacof feebr eak.
Thesearchforopportuni
ti
esshoul
dincludetheacquisi
ti
onofexi st
ingproducti
on
andmar ket
ingfaci
li
ti
esbymeansofamer gerwi
thanot hercompany ,aswellas,
theexpansi
onoft hecompany '
sownf acil
i
tiesorthecreationofanent i
rel
ynew
div
isi
on.Thel ong-
ter
mi nvest
mentproposalsmaybecl assifi
edasf ol
l
ows:
a) Replacement(
Maint
enanceofBusiness)
:Thi
sr ef
erstotheexpendi
tur
es
necessarytor
epl
acewor noutordamagedfixedasset
soft hebusi
ness
fi
rm.
b) Replacement(CostReducti
on):Itr
eferstoexpendit
uresthataremadeto
repl
aceserviceabl
ebutobsolete(outdat
ed)equipmentsinordert
olower
thecostoflabor,mat
eri
als,
orotherit
emssuchasel ectr
ici
ty.

98
 c) Expansion ofExi
sti
ng Pr
oducts orMarket
s:These ar
e expendi
tur
es
necessaryt
oproducenewproductort
oex
pandint
oageographi
careanot
curr
entl
ybeingser
ved.
d) Safet
yand/orEnvi
ronmentalProj
ects:Thesear eexpendit
uresnecessar
y
forcomplyi
ngwithgovernmentorders,laboragreements,andinsur
ance
poli
cyter
ms.Theseexpenditur
esareof t
encall
edmandat oryinv
estments,
non-r
evenuepr
oducingi
nvestment.
I
ngener
al,
capi
tal
budget
ingpr
oject
scanbecl
assi
fi
edi
ntot
hreecat
egor
ies:
A.CostReduct
ionPr
oject
s:
Theseproj
ectsareintendedtoreducethefi
rm'
soperati
ngcost
ssuchascostof
l
abor,materi
alselect
rici
tyandsoon. Costr educti
onisachi
evedthr
ought he
repl
acementofplantsorf i
xedassets.Thebenefi
tfr
om costr
educt
ionpr
ojects
i
scostsavings.
B.Rev
enueExpansi
onPr
oject
s:
Themai npurposeoft heseprojectsistoi ncr
easethev olumeofsal es(r
evenue)
throught heincr
easedl evelofoutputoft heexisti
ngpr oduct,expandi
ngproduct
distri
buti
on outlet
st he mar ket
s cur r
entser ved,int r
oducing new products
(productdevelopment ,expanding(searching)themar ketintonew geographi
cal
areas( marketdevelopment )
,and/ori nt
roducingnew pr oductsfornew markets
(diversi
fi
cati
on). Thebenef it
sar er eal
izedint heform ofi ncr
easednetcash
i
nf l
ows.
C.Non-
Rev
enuePr
oduci
ng(
Mandat
ory
)Inv
est
ment
s:
Theseproject
sar esafetyand/ orenvir
onment alpr
otecti
onproj
ect
saresaf
ety
and/orenvi
ronmentalprotecti
onprojectsthatarenecessaryf
orcompl
yi
ngwith
governmentorder
s,l
aboragr eements,orinsur
ancepolicyt
erms.
3.For
ecast
ingCashFl
ows
Oncet heinvestmentpr oposalsar eidentif
ied,t henextst epi stof or
ecastt he
cashflows( f
orr evenueexpansi onorcostsav i
ngpr oj
ects).Thisisaccompl i
shed
bydeter mi
ningexpect edrevenuesandcost sf oreachpr oject.Ev enthought he
ti
mingandsi zeoff uturecashf lowsusual l
yr emainuncer t
aint hr
oughoutt he
budgeting process,t hepr operest i
mat i
on oft hecash f lowsi sv it
al.Int he
anal
ysisofcapi talbudget ingdecisi
ons,annualcashf l
owsar eusedi nsteadof
theaccount i
ngpr ofit
s.Cashf l
owsandaccount ingprofi
tscanbev erydiff
erent
becauseaccount i
ngpr ofi
tsincl
udenon- cashr evenuesandnon- cashexpenses.
Infact,account i
ngprofit
sareimpor t
ant ,
butcashflowsareoftenmor eimportant
forthepur poseofset t
ingav alueofaf ir
m. I ntheentir
ecapi t
albudget ing
procedures, probabl
ynot hi
ngisofgr eateri
mportancethanar el
iabl
eestimateof
thecostsav ingsofrevenueincreaset hatwil
lbeachievedfrom theprospective
outl
ay sofcapi t
alfunds. Allthesubsequentanal ysi
s'swewi lldi
scussint his
chapterar ebasedont hecashf l
owf iguresnottheaccounti
ngpr of
itfi
gures.All
thecapi t
albudget i
nganal y
sesareassuccessf ulasthedatainputyouar eusing.
Capitalbudget i
ngproceduresareper f
ormedbyt hegr oupofexper tssuchas

99
engi
neer
s,account
ants,economi
sts,costanal
yst
s,andotherqual
if
iedper
sons.
Themethodofdeter
mi ni
ngthecashflowsoftheproj
ectwi
llbedi
scussedi
nthis
chapt
erl
ater
.
4.Ranki
ngI
nvest
mentPr
oposal
s
Thisact i
vit
yinvol
vest hesett
ingofdecisi
onr ule(
s)t hathelpust odif
fer
enti
ate
proj
ectst hatar
eaccept abl
eandunaccept able.Then,wechooseand/ ormake
decisi
ont oacceptthepr oj
ectalt
ernat
ivethatisr ankedf i
rstasitwil
lmaximize
the value ofthe fir
m. The mai n objecti
ve oft he financi
almanagerwhi l
e
undertaki
ngcapi t
albudgeti
ngistoanswerthef oll
owingquest i
ons:
1.Whi
chofthesever
almutuall
yexcl
usi
vei
nvest
mental
ter
nat
iveshav
e
t
obechosenfori
mplementati
on?and
2.How manyindependentpr
oject
s,i
.e.pr
oject
sthatar
enotmut
ual
l
y
excl
usi
ve,
havetobeaccepted?
Diff
erentt echniques are used tor ank and choose among many pr oj
ect
alt
ernati
ves.Someoft hesetechni
quesar ethepaybackper i
od,theaccount
ing
rateofreturn,thenetpr esentval
uemet hod,theint
ernalr
ateofr et
urn,andthe
profi
tabi
li
tyindex.Eachoneoft hesetechniqueswillbediscussedindetai
lin
Chapter15oft histextbook.
5.TheAdmi
nist
rat
iveFr
amewor
k
Capit
albudgetingi
samul t
i-
dimensi
onalact
ivi
tyt
hatdemandsahi ghdegr
eeof
cooperat
ionamongv ari
ousdepartment
s. Thefinalappr
ovalofmajorcapi
tal
expendit
ures,howev
er ,r
estsontheshoulder
soft heboardofdir
ector
softhe
company .
6.ThePost
-Compl
eti
onAudi
t(Moni
tor
ing)
Thisst epper tainst oimpl ement edpr ojectal t
ernati
ve(
s) .Thepost -
compl et
ion
auditinvolvescar efulmoni t
oringofpr ojectimpl ement
at i
onandi sanecessar y
manager ialtool. Acar efulanal ysisofdev iati
onsofact ualperfor
mancef r
om
plannedl evelsenabl est ot akef eedbackandmaypr ev entpoorperformance
histor
yf r
om r epeatingitselfinf utur
epr ojects.Thepost -complet
ionauditcanbe
abet terandr ewar di
ngexper i
encef ordeci sionmaker s. Thepost -
compl et
ion
audithas t wo pr incipalobj ect i
ves. These ar et oimpr ovethe accuracyof
forecastsandt oimpr ovethef i
rm’ soper ati
ons.
6.
1.3.Assumpt
ionst
hatunder
li
eCapi
tal
Budget
ing
Anumberofassumpt ionsmustbei nt
roducedinor dertoconcentrat
eont he
manager ialaspectofcapi talbudget ing.Theef fectoft heseassumpt i
onsist o
excl
udenon- fi
nancialconsi derationsandt oremov esomecompl i
cati
onst hat
obscuret he major poi nts under capi t
albudget ing. These assumpt ions
consti
tuteagener alsetofcondi t
ionswi t
hinwhichthef i
nanci
alaspectsoflong-
ter
m al ternati
ves can be ev aluated. You can use anyone oft he capital
budgeting/cashf l
ow ev aluati
on/cr i
teri
aandt echniquespr esent
edi nthenext
chapteronl ywhenthefol l
owi ngassumpt i
onsaref ul
fi
lled:

100
 Shareholder
s'Weal t
h Maxi mizati
on ist he Basi c Motive ofCapital
BudgetingDeci
sion.Allcapit
albudgeti
ngalternat
ivesconsider
edherear e
acceptedorrej
ectedont hebasisoft hei
reffectonshar ehol
ders'weal
th.
Noot hercompany'sgoalsinfl
uencetheinvestmentselecti
ondecisi
ons.
 Cost sandRev enuesar eknownWi thCer tai
nty.Thecostsandr evenues
associat edwitheachi nvest mentalternativeareknownwi t
hcer t
aint
y,or
thereexi stsaf orecastingt echniquet hatcangeneratethev al
ueswi t
ha
verysmal ler
ror.I tmaybev er
ydi f
fi
culttoest i
materevenuesandcost s
mor et hant woort hreey earsintot hef utur
e. However,ifapr oposed
i
nv estmenthasat eny eareconomi cl i
fe,accurat
eforecastsmustbe
avail
abl eforalltenyear s.
 Inf
lowsandOut fl
owsofCashOccuronceaYear .Thi sassumpt ionis
i
mpor t
anti
nordertocomput ethepresentandfutur
ev aluesofcashf lows,
becausecapit
albudget i
ngcr i
ter
iausedi scounti
ngt echniques. Cash
i
nflowsoroutf
lowsar eassumedt ooccuronlyonceay ear(i
.e.ei
therat
the end ofa gi ven yearoratdi scretey ear
lyi nterv
als. Hence,
compoundingand/ordiscount
ingoccuronlyonceay ear.
 Infl
owsandOut f
lowsar ebasedonCash.Thedat arequi
redforev
aluat
ing
i
nv est
mentpr oposals mustbe st ated i
n cash as opposed tot he
accounti
ngincome.Thi sisbecauseofthefactthatthecompanyuses
cashtopayitsbill
sandt opaycashdi vi
dendsoncommonandpr efer
red
stock. I
fthebusi nessf i
rm doesnotgener atecashr et
urnsfr
om its
i
nv est
ments,i
twillsoonerorl
aterbecomeinsolv
ent.
 CashFl owsExhi bitaConv enti
onalPat ter
n.Thef undt hatisr equir
edt o
under t
akeani nvestmentr epresentsi nfl
owst ot hecompany ,andt he
ret
urnsf r
om thei nvest mentr epr esentsout flowsf rom thecompany .If
wer epr esentthecashout fl
owswi t
ht hemi nus" -
"signandt hecash
i
nflowswi ththepl us" +"si gn,t hent heconv enti
onalcashf lowsunder
capitalbudgeti
ngi sdef inedast het i
meser iesofcashf l
owst hatcontains
onlyonechangei nsi gn.Forexampl e,ifani nvestmental ternati
vehas
onecashout fl
owf oll
owedbyt hr eecashi nflowscanber epresentedas:-,
+,+,+. Thi sisconsi deredt ohav eaconv ent i
onalcashf low patter
n.
Inv
est mental t
ernativesar eassumedt oexhi bitconv enti
onalcashf lows.
Evaluati
ngani nvestmental t
ernat i
vet hatv iolatest hi
sassumpt ioncan
becomev erydif
ficult
.
 TheRequi r
edRateofRet urnisknownandconst ant.Ther equi
redrateof
ret
urni sgeneral
lylookedatast heminimum r ateofr etur
nt hatthe
companymustear ni fsharehol
ders'weal
thisnott odecrease.Her e,t
he
minimum requi
redrateofreturnoninvest
mentalternat
ivesisassumedt o
beknownandconst antov ertheli
feoftheproposedinvestment.Ar ri
vi
ng
attherequir
edrat
eofr etur
ni si
mpor t
antfort
wor easons:
1.I
ftherateistoohigh,t
hecompanywi
l
lendupi
nrej
ect
ing
qui
tepr
ofi
tabl
eproj
ects,
and

101
 2.Ifther atei
st oosmallorl
ow,thecompanywil
lendupi n
accepti
ng pr oj
ect
st hatar
e notprof
it
abl
e and decr
ease
shareholder
swealth.
 Capit
alRat i
oningdoesn'texist.Whenev eracompanyi snotabl etofinance
i
tsentir
ecapi talbudgeti
ng( i
nvestment),capi
talrat
ioni
ngi ssaidtoexist.I n
suchasi tuati
on,somei nvestmentswi l
lhavet ogivenup.Thecashf low
eval
uati
onand accept /rej
ectdeci si
onst o bemadei nt henextchapt er
consi
derst hatt hereisno anycapi talproblem orl i
mitati
on. Howev er,
capi
talrati
oningorcapi t
alshortagedoescont ainimportantimplicat
ionsf or
fi
nanci
almanager s.Chapter15al sodiscussescapi t
albudgetingdeci si
ons
whenrationingexists.
6.
2.Par
tsofI
nvest
mentandCashFl
owConcept
Investmenthasbeendef inedasal ong-
term commi tmentofeconomi cresour
ces
madewi tht heobjecti
veofpr oducingandobt aini
ngnetgai nsi nthef utur
e.The
conv enti
onalmet hodsofi nv est
mentappr ai
salbasi cal
lyevaluatet heexpected
netpr ofit(salesincomel esscost sand i ncomest axes)agai nstt hecapital
i
nv ested.Fort hepurposeofi nvestmentappr aisal
,itisnecessar ytoassessand
evaluateov eracertainperi
od, al
linputsrequir
edandal lout
put sproducedbyt he
project.Thatiswhyt heconceptofcashf l
owsi sdev eloped.
I
nt hisr egard,thecash-fl
ow concepti sneededf orplanningoft hef l
ow of
fi
nancialmeans,i n otherwor ds,t
hesour cesand appl i
cation off unds.The
appraisaloflongterminvestmentsismadei ntermsofcashf lowsthatoccurat
di
fferentstagesint hecapi
talbudgetingprocess.Liter
all
y,ther ear
et hreepar
ts
ofcashf lowsinlong-t
erminvestments.Thesear e:
1.Theinit
iali
nvest
ment.Thei
nit
iali
nvest
mentisanoutl
ayofcasht
hat
takespl
aceatthebegi
nni
ngofthel
ifeofthepr
oject
.
2.Theoperat
ingcashfl
ows.Theoperat
ingcashinf
lowsfrom r
evenue
sour
cesandthecashout
fl
owsf
ordif
fer
entexpendi
tur
es.
3.Theter
minalcashfl
ows.Thesear
ethecashi
nfl
owsandout
fl
owst
hat
takepl
aceattheendoft
heproj
ectl
if
e.
In addit
ion,t
he discounted cash-f
low concepthas become t he gener
all
y
acceptedmethodforinvest
mentappr ai
sal
.Thebasi
cassumpt ionunderl
yi
ngthe
discount
edcash-f
lowconceptisthatmoneyhasat i
mevalue,insofarasagiven
sum ofmoneyav ail
ablenow iswor t
hmor ethananequalsum av ai
labl
einthe
futur
e.OneBi r
rtodayi smorev al
uabl
et hanoneBir
ray earhence. Thisis
because:
 Indi
vi
dual
s, i
n gener
al, pr
efer cur
rent consumpt
ion t
o f
utur
e
consumpt
ion.
 Capitalcanbeemployedproducti
velytogener
ateposi
ti
veret
urns.An
i
nv estmentofoneBir
rtodaywoul dgr ow t
o(1+r)ay ear
;where(ri
s
therateofret
urnear
nedont heinvestment)
.
 I
n an i
nfl
ati
onar
yper
iod,one Bi
rrt
odayr
epr
esent
s a gr
eat
err
eal

102
 pur
chasi
ngpowert
hanoneBi
rray
earaf
ter
.
Manyf i
nancialprobl
emsi nvol
vecashf l
owsoccur ri
ngatdi ffer
entpoi nt
softime.
Forev al
uatingsuchcashf l
owsanexpl ici
tconsiderat
ionoft imev al
ueofmoney
i
sr equired.Thisdiff
erencecanbeexpr essedasaper centagerateindicat
ingthe
rel
ativ
echar geforagi venperiod,whichi susuall
yay ear
.Consideringapr oj
ect
mayobt ainacer tai
namountoff unds“ F”,i
fthissum i srepaidafteroney ear
i
ncludinganagr eedinterest“I
”,t
het ot
alsum t obepai dafteroney earwouldbe
(F+I )
,wher e:
F+I=F(
1+r
)
Andrisdefi
nedastheint
erestr
ate(
in%pery
ear
)di
vi
dedby100.I
fthei
nter
est
rat
eis,
forexampl
e,12%,t
henrequal
s0.
12.
Supposethat“
CFn”isthenomi nalvalueofafutur
ecashfl
owint heyear“n”,
and
“CFpv”i
sthevalueatthepresentt i
me( pr
esentval
ue)oft
hisexpect
edi nf
lowor
outf
low,t
hen(assumingrisconst ant):
CFpv=CFn/(1+r )n or
–n
CFpv=CFn(
1+r)
Thegener
alf
ormul
afort
hef
utur
eval
ueofasi
ngl
eamounti
s:
1+k)n
FV=PV(
Wher
e:FV=Fut
urev
alueaf
ter“
n”y
ear
s
PV=Amountt
oday(
presentv
alue)
K=I
nter
estr
atepery
ear
n=Numberofy
ear
sforwhi
chcompoundi
ngi
sdone.
6.
3.Fundament
alsofCashFl
owPr
oject
ion
6.
3.1.Gener
al
 Esti
mati
ngcashflows:Esti
matingpr
ojectcashflows,i
.e.i
nvest
ment
outl
aysandsubsequentcashinfl
owsaftertheproj
ecti
scommi ssioned,
is
themostimport
antbutalsothemostdiffi
cultst
epincapit
albudgeti
ng.
 Forecasti
ngproj
ectcashf l
owsinvolv
esnumer ousv
ari
abl
esanddi
ff
erent
professi
onal
smaypar ti
cipatei
nthisexer
cise.
 Capit
alout
lay
sareest
imatedbyengi
neer
ingandpr
oduct
devel
opmentdepar
tment
s.
 Rev
enuepr
oject
ionsar
epr
ovi
dedbyt
hemar
ket
inggr
oup.
 Operati
ngcostsareest
imat
edbyproduct
ionpeople,cost
accountant
s,pur
chasemanager
s,per
sonnelexecuti
ves,t
axexper
ts,
andothers.
 Ther
oleoft
hef
inancemanageri
sto:
 Coor
dinatet
heef
fort
sofv
ari
ousdepar
tment
sandobt
ain
i
nfor
mat i
onfr
om t
hem,

103
  Ensuret
hatthefor
ecast
sar
ebasedonagr
eatdeal
ofconsi
stent
economicassumpti
ons,
 Keept
heexer
cisef
ocusedonr
elev
antv
ari
abl
es,
and
 Mi
nimi
zet
hebi
asesi
nher
enti
ncashf
lowf
orecast
ing.
6.
3.2.El
ement
soft
heCashFl
owSt
ream
Toeval
uat
eapr oj
ect,y
oumustdetermi
nether
elevantcashflows,
whi
char
ethe
i
ncr
ementalaf
tertaxcashf
lowsassoci
atedwi
ththeproject
.
A.CashFl
owSt
ream
i
.Ini
ti
ali
nvest
mentcashf
lows:
Incl
udestheaft
ert
axcashoutl
aysoncapi
tal
expendi
tur
esandnetwor
king
capit
alwhenthepr
ojecti
ssetup.
 Leasi
ngofl
and
 Machi
ner
y,equi
pment
,tool
s,et
c
 I
nst
all
ati
on,
test
ing,
andst
art
-upcost
s
 Addi
ti
onal
inv
est
menti
nNWC.
[
NB.Oftengovernmentuni
tsencourageinvestor
sbypr ovidi
ngvar
ious
i
nvest
mentincenti
ves.Oneoftheseincent
ivesistheinvestmentt
axcredi
tthati
s
net
tedagai
nsttheini
ti
ali
nvest
mentout lay
,sinceiti
sani nfl
owtothefi
rm.]
i
i
.Oper
ati
ngCashFl
ows:
 Theaftert
axcashinfl
owsresul
ti
ngf r
om t
heoperationsoftheprojectduri
ng
i
tseconomicli
fearecall
edoper
atingCashFlows.Thenetoperatingcash
fl
owscouldbepositi
veornegat
ive.I
fweassumeconv ent
ional
cashf low
patt
ern,t
henetoperat
ingcashf
lowwi l
lbeposit
ive.
i
i
i.Ter
minal
CashFl
ows:
Theaft
ertaxcashfl
owsr
esul
ti
ngfr
om theter
minati
onoft
hepr
ojectandt
he
di
sposalofi
tsasset
satt
heendofi
tseconomicli
fe.
 Sal
vagepr
oceedsf
rom di
sposal
ofasset
snetoft
ax(
inf
low)
 Recov
eryofnetwor
kingcapi
tal
(inf
low)
 Li
qui
dat
ionanddi
sposal
cost
s(out
fl
ow)
 Taxpai
dongai
nondi
sposal
ofol
dasset
s(out
fl
ow)
 Taxsavi
ng/taxshi
eldduetol
ossondi
sposal
ofol
dasset
s
(benef
it
/tr
eatedasaninfl
ow)
B.Ti
meHor
izonf
orAnal
ysi
s
Thet
imehor
izonf
orcashf
lowanal
ysi
sisgener
all
ythemi
nimum oft
hef
oll
owi
ng:
i
. Physi
cal
li
feoft
hemachi
ner
iesandequi
pment
s/Techni
cal
li
feofpl
ant
Asset

104
  Per
ioddur
ingwhi
cht
hepl
antr
emai
nsi
naphy
sical
l
yusabl
econdi
ti
on
 Thenumberofyear
sthemachiner
ies&equi
pmentsi
nthepl
antwoul
d
per
for
mthefuncti
onsforwhi
chtheyhadbeenacqui
red
 I
tdependsont
hewearandt
earwhi
cht
hepl
anti
ssubj
ectt
o
 Suppli
ersofthepl
ant’
smachiner
iesandequi
pment
smaypr ovi
de
i
nformationonthephysi
cal
li
feundernor
maloper
ati
ngcondit
ions
 Whil
etheconceptofphysi
cal
li
femaybeusef
ulfordeter
mini
ngt he
depr
eciat
ioncharge,
iti
snotv
eryusef
ulf
ori
nvestmentdeci
sion
makingpurposes
i
i
. Technol
ogi
cal
li
feoft
hemachi
ner
iesandequi
pment
sint
hepl
ant
 Newtechnol
ogi
caldevel
opment
stendtorenderexi
sti
ng
machi
neri
esandequipment
sinthepl
antobsolet
e.
 Thet
echnol
ogi
call
if
eofaplantr
efer
stotheper
iodofti
meover
whi
chthepr
esentpl
antwoul
dnotberender
edobsolet
ebyanew
pl
ant
.
 I
tisv erydi
ffi
cultt
oesti
matebecauset
hepaceofnew
developmentsisnotgover
nedbyanylaw.Yet
,anest
imat
eoft
he
technologi
calli
fehast
obemade.
i
i
i.Pr
oductMar
ketl
i
feoft
hepl
ant(
ProductLi
feCy
cle)
:
 Aplantmaybephy sical
lyusable,
itstechnol
ogymaynotbeobsolete,
but
themarketfori
tsproductsmaydi sappearorshr
inkandhence,
its
cont
inuancemaynotbej ust
if
ied.
 Theproductmar
ketl
ifeofaplantr
efer
stotheperi
odoverwhi
cht
he
productoft
hepl
antenjoy
sreasonabl
ysat
isfact
orymar
ket
i
v.I
nvest
mentPl
anni
ngHor
izonoft
hef
ir
m:
I
trefer
stothetimeperiodforwhichafi
rm wishestolookaheadforpur
poseof
i
nvestmentanalysi
s.I
tnatural
l
ytendstovarywiththecomplexi
tyandsi
zeofthe
i
nvestment.ForExample,t
hefoll
owingroughesti
mat ecanbeused:
 Smal
li
nvest
ment
,(Repl
acementdeci
sions)
,maybe5y
ear
s
 Medi
um si
zei
nvest
ment
s,(
Expansi
onofpl
antcapaci
ty)
,maybe10y
ear
s
 Lar
gesi
zei
nvest
ment
,(Set
ti
ngupanewdi
vi
sion)
,maybe15y
ear
s
6.
3.3.Basi
cPr
inci
plesofCashFl
owEst
imat
ion
1.Pr
inci
pleofCashFl
ow
Pr
ojecteval
uat
ionshoul
dbebasedoni
tscashf
lowsi
nst
eadofaccr
ual
income
measurementconcept
.
Rat
ional
e:
 I
tiscasht
hatcanber
einv
est
edi
not
herpr
oject
s.

105
  Theaccount
ingdata(i
.e.i
ncome)i
sdi
ff
icul
ttounder
standbecausei
tisf
ull
oft
echni
calj
argons.
 Dif
fer
entaccount
ingappr
oaches&treat
ment swouldr
esultindi
ffer
entnet
i
ncomefigur
esevenintheabsenceofdi
ffer
encesinoper
ations.
2.Fi
nanci
alCostExcl
usi
onpr
inci
ple
Ther
earetwosi
desofapr oject
:theinvest
ment(orasset
)si
deandt hef
inanci
ng
si
de.Thecashf
lowsassociatedwiththesesi
desshouldbesepar
ated.
Pr
oject
s

I
nvestmentsi
de Fi
nanci
ngSide
I
nv s
esti
de
me ntout
fl
ows Fi
nanci
nginf
lows(
Funds)
Retur
noninv
estment Fi
nanci
ngcost
s&
expenses(
out
flows)
[I
tisani
nfl
ow] [
Incl
udedi
nthecostof
capi
tal
]
Notethatthecashf lowsont hei nvestmentsideoft hepr oj
ectshoul dexclude
fi
nancingcostsandexpenses( i
.e.interests&divi
dends).
Thef inancingcostsare
i
ncludedint hecashf lowsont hef inancingsideandr eflectedint hecostof
capit
al.I
nthisregar
d, t
hecostofcapi t
alisthehurdl
er at
ewi thwhi chtherateof
ret
urnont hei nv
estmentsi dewi llbej udgedorev aluat
ed.Si ncet hefi
nancing
costsareincludedint hecostofcapi t
al,anyincl
usionoft hesecost sint he
i
nvestmentcashf l
owswi ll
resultindoubl ecounti
ngofcost s.
Therefore,whi
ledefiningthecashflowsont heinvestmentsi de,fi
nancingcosts
shouldnotbeconsi deredbecausetheyarealreadyrefl
ectedinthecostofcapi tal
fi
gureagai nstwhicht herat
eofr etur
nf i
gurewi l
lbeev aluated.Ifinter
estis
deducted inthepr ocessofar r
ivi
ng atprofitaftertax,anamountequalt o
“I
nterestX( 1-
Taxr ate)”shoul
dbeaddedt ot he“profi
taftertax”.Below isthe
adj
ust menttobemadeont heaft
ertaxoperati
ngprofit
:
EBI
T(1–T)=Oper
ati
ngPr
ofi
tAf
terTax(
OPAT)
(
EBT+I
nter
est
)x(
1–T)= Adj
ust
edOper
ati
ngPr
ofi
tAf
terTax/
PAT
(
EBT)
(1-
T)+I
nter
est(
1-T)=PAT; [
Not
ethatEBTx(
1-T)=EAT]
EAT+I
nter
est(
1-T)=Adj
ust
edOper
ati
ngPr
ofi
tAf
terTax(
orOper
ati
ngEar
ningAf
terTax)
[Notethatt
heaftertaxbalanceofint
erestisaddedbackaspertheadj
ustment
becausethetaxadvantagefrom payi
nginterest
,i.
e.t
hetaxshiel
d,i
sal
ready
consi
deredinthecomput ati
onofthenetcostofdebtcapit
al.
]
3.I
ncr
ement
alpr
inci
ple
Thecashf
lowofapr
ojectmustbemeasur
edi
nincr
ement
alt
erms.Lookatwhat

106
happenst
othecashf
lowsoft
hef
ir
m wi
thandwi
thoutt
hepr
oject
:
Pr
ojectcashFl
ows =CashFl
owsf
ort
hef
ir
m – CashFl
owsf
or
t
he
f
ory
ear(
t) wi
tht
hepr
ojectf
or f
ir
m wi
thoutt
he
[
Incr
emental
cashflows] Year(
t)
proj
ectf
oryear(
t)
Gui
del
i
nes:
A.Consi
deral
lInci
dent
alef
fect
s
Inaddi t
iontot hedirectcashflowsoft heproject
,al
lit
sincidentalef
fectsont he
restoft hefir
m mustbeconsi dered.Theprojectmayenhancet hepr
ofitabi
l
ityof
someoft heexi st
ingact i
vit
iesoft hef i
rm becausei thasacompl ement ary
rel
ati
onshi pwi ththem ori tmaydet r
actfrom theprofit
abil
it
yofsomeoft he
exist
ingact i
vit
iesoft hefi
rm becauseithasacompet it
iverel
ationshi
pwi ththem.
Suchi ncident
al ef
fectsshouldbet akenint
oaccount.

B.I
gnor
esunkcost
s
A sunkcosti sanout l
ayalreadyincurredinthepastoral r
eadycommi t
ted
i
rrev
ocably.Sunkcostscannotber ecoveredandhence,arenotrelevant.So,i
tis
notaff
ectedbytheaccept anceorreject
ionofthepr
ojectordonoti nfluencethe
proj
ectrelat
eddecisions.Sunkcost sarenotdiff
erenti
al,i
.e.theydonotv ary
amongal t
ernat
ives.
C.I
ncl
udeOppor
tuni
tycost
s
I
fapr oj
ectusesresourcesalr
eadyav ai
lablewiththefirm,thereisapotentialf
or
anopportuni
tycost.I
tisacostcreatedf ortherestofthefirm asaconsequence
ofundertaki
ngthepr oject
.Theoppor t
unitycostofar esour ceisthebenef i
t
for
gonethatwouldhav ebeender i
vedf r
om i tbyputti
ngitt oitsbestal
ternati
ve
use.Thatis,theresourcemi ghthav ebeenr ent
edout ,sold,orrequir
edel se
whereinthefi
rm
D.Est
imat
ewor
kingcapi
tal
proper
ly
Apartfrom f
ixedcosts,
aprojectr
equi
reswor ki
ngcapit
alinvestment.Outlay
son
workingcapit
alhavetobeproperl
yconsideredwhil
eforecasti
ngtheprojectcash
fl
ows.Wor ki
ngcapital(
ormorepreci
sely
, networki
ngcapital
)isdef
inedas:
[
Cur
rentasset
s]-[
Cur
rentl
i
abi
l
iti
es]
Ther
equi
rementofwor
kingcapi
tal
isl
i
kel
ytochangeov
ert
ime.
 Whil
ef i
xedassetinvest
mentsaremadedur i
ngt heearl
yyear
soft he
proj
ectanddepreci
ateover
ti
me,workingcapi
tali
srenewedperi
odi
call
y
andhence,
isnotsubj
ecttodepr
eci
ati
on
 Thus,t
heworkingcapi
talattheendoft
hepr
ojectli
fei
sassumedtohave
asalv
age(orrecover
y)valueequalt
oit
sbookv al
ue.Somet
imes,t
henet

107
 wor
kingcapi
tal
maynotbef
ull
yrecov
eredduet
ouncol
l
ect
ibl
ebal
ances.
E.Post–TaxPr
inci
ple
Cashf l
owsshouldbemeasur edonanaf ter
-t
axbasis.Somef i
rmsmayi gnore
taxpaymentsandtryt
ocompensat ethi
smi st
akebydiscount
ingthepr
e-taxcash
fl
owsatar at
ehigherthanthecostofcapi taloft
hef i
rm.Sincethereisno
rel
iabl
ewayofadj ust
ingthediscountrate,youshouldalwaysuseafter–t ax
cashflowsal
ongwithaft
ertaxdiscountr
ate.
F.Tr
eat
mentofl
osses
Becausethefi
rm aswellasthepr
ojectcani
ncurlosses,l
etusl
ookatv
ari
ous
possi
blecombi
nationsandt
hewaystodealwi
ththem:
Scenar
io Pr
oject Fi
rm Act
ion
1 Losses Losses Def
ert
axsav
ings
2 Losses Pr
ofi
t Taket
axsav
ingsi
nthey
earofl
oss
3 Pr
ofi
ts Losses Def
ert
axesunt
ilt
hef
ir
m makespr
ofi
t
4 Pr
ofi
ts Pr
ofi
t Consi
dert
axesi
nthey
earofpr
ofi
t
St
andAlone Losses _ Def
ert
axessav
ingsunt
ilt
hepr
ojectmakes
pr
ofi
ts
G.Ef
fectofNon-
CashChar
ges
Noncashchar gescanhav ei
mpactsoncashflowsi
ftheyaf
fectt
axl
iabi
l
ity
,for
example,depr
eciat
ions.Taxbenef
itofdepr
eci
ati
oni
scomputedas:[
Amountof
Depreci
ati
onxTaxr ate]
H.Consi
stencyPr
inci
ple
Cash fl
ows and t
he di
scountrat
es appl
ied t
ot hese cash f
lows mustbe
consi
stentwi
thr
espectt
otheinv
est
orgroup&choicesforval
uat
ion.
i
) I
nvest
orgr
oup:
Case1:Thecashfl
ow avail
abl
etoal
linvest
orsaft
erpayi
ngtaxesandmeeti
ng
i
nvest
mentneedsoftheproj
ect
.Cashfl
owt oal
linv
est
orsiscomputedas:

= EBI
T(1–T)
+Depr
eci
ati
on/
othernon-
cashchar
ges
-Capi
tal
expendi
tur
es
-Changesi
nnetwor
kingcapi
tal

Case2:Thecashflowofapr ojectfr
om thepointofvi
ewequi
tyshar
eholder
sis
thecashflow av
ailabl
et o equit
yshar eholder
saf t
erpayi
ng t
axes,meeti
ng
i
nvest
mentneeds,andfulf
il
li
ngdebtr el
atedcommi t
ments.

108
Cashf
lowt
oequi
tyshar
ehol
der
s=Pr
ofi
tAf
terTax(
PAT)
+Depr
eci
ati
on&ot
hernoncashchar
ges
-Pr
efer
encedi
vi
dend
-Capi
tal
expendi
tur
es
-Changesi
nnetwor
kingcapi
tal
-Repay
mentofdebt
s
+Pr
oceedsf
rom debti
ssues
-Redempt
ionofpr
efer
encecapi
tal
/st
ocks
+Pr
oceedsf
rom newpr
efer
encei
ssues

Thedi
scountr
atemustbeconsi
stentwi
tht
hedef
ini
ti
onoft
hecashf
low.
CashFl
ow Di
scountRat
e
Cashf
lowt
oal
li
nvest
ors Wei
ght
edav
eragecostofcapi
tal
(WACC)
Cashf
lowt
oequi
tyhol
der
s Costofequi
tycapi
tal
i
i
.Choi
ces:
I
ncorporat
eexpect
edi nf
lat
ionintheesti
matesoffut
urecashfl
owsandappl
ya
nominaldi
scountr
atetothesame. Orel
se,est
imat
ethefutur
ecashf
lowsi
nreal
ter
msandappl yareal
discountrat
etothesame.
Rel
ati
onshi
pbet
weennomi
nal
andr
eal
val
ues:
Nomi
nal
CashFl
ow(
t)=Real
cashf
low(
t)x(
1+Expect
edi
nfl
ati
onr
ate)t
Nominaldi
scountr
ate=(
1+Realdi
scountr
ate)x(
1+Expect
edI
nfl
ati
on
r
ate)–1
Ther
efore,amatchshoul
dal
soexi
stbet
weent
het
ypeoft
hecashf
lowandt
he
di
scountrat
eused.

CashFl
ow Di
scountRat
e
Nomi
nal
cashf
low Nomi
nal
discountr
ate
Real
cashf
low Real
discountr
ate
General
l
y ,incapit
albudgeti
nganal
ysi
s,nomi
nalcashf
lowsar
eest
imat
edand
nominaldiscountr
atesareused.
6.
4.Det
ermi
ningPr
ojectCashFl
ows
6.
4.1.ComponentCashFl
owDet
ermi
nat
ion
1.NetI
nit
ial
Inv
est
ment(
NINV)
:
Theneti
nit
iali
nvestment
,(NI
NV,
)inaproj
ectisdef
inesastheproj
ect’
sini
ti
alnet
cashout
lays,t
hatis,t
heoutl
aysatti
meperiodzero/now.Iti
scalcul
atedusing

109
t
hef
oll
owi
ngst
eps:
Step1:Thenew pr ojectcostplusanyi nst
all
ati
onandshippi
ngcosts,
i
mpor tt
ari
ff
s,andot hercosts associ
atedwithacqui
ri
ngtheassetand
putt
ingi
tintoser
vice,
[
Theassetcostplusi
nst
all
ati
onandshi
ppi
ngcost
sfr
om t
hebasi
supon
whi
chdepreci
ati
oniscomputed]
Pl
us
Step2:Anyincr
easeinNetwor
kingcapi
tali
nit
ial
l
yrequi
redasar
esul
tof
thenewinv
estment,
Mi
nus
Step3:Grossproceedsfr
om t
hesal
eofexi
sti
ngassets,i.
e.sel
l
ingpr
ice
ofoldasset
s,whentheinv
est
menti
sarepl
acementdeci
sion,
[
Thi
snormal
lyi
scomputedastheact
ualsalv
ageval
ueoftheassetbei
ng
r
epl
acedl
essanycost
sassoci
atedwi
thphysi
cal
l
yremovi
ngorsell
ingit
].
Pl
usormi
nus
St
ep4:
Taxesassoci
atedwi
tht
hesal
eoft
heexi
sti
ngasset
s,
[
Taxesassoci at
edwi t
hgainondi sposaloftheol
dassetort axsavi
ngs
duetol ossondi sposal
.Thetotaltaxef f
ectmaybeei t
herpositi
veor
negati
ve,thatiswhyi tisei
theraddedt oorsubtract
edf r
om thenew
proj
ectcost]
.
2.Net(
Oper
ati
ng)CashFl
ows(
NOCFs)
Thepr ocessofest i
matingincrement
alcashf lowsassociatedwit
haspeci f
ic
proj
ectisanimpor t
antpartofthecapi
talbudgeti
ngprocess.Capi
talbudget
ingis
concernedprimari
lywiththeaftert
ax( net
)operati
ngcashf l
ows,(NOCFs),ofa
part
icularpr
oject
,orchangeincashinf
lowsmi nuschangeincashout f
lows.
Foranyy eardur
ingtheli
feofapr oj
ect
,theNOCFmaybedef inedasthechange
i
noper ati
ngearningsaft
ertaxes,(∆OEAT),pl
usthechangeindepreci
ati
on,(∆
Depreci
ation)
,minusthechangei nthenetworki
ngcapit
alinvest
mentrequi
red
bythefir
mt osupporttheproj
ect,(∆NWC).
NOCF=∆OEAT+∆Depr
eci
ati
on-∆NWC
Operati
ng earni
ngs aftertax,(OEAT),di
fferfrom earnings aftertax,(EAT) ,
becauseOEAT doesnotconsi deri
nter
estexpensesi ni tscalculati
ons.Net
Operati
ngCashFl ows,NOCFs,asusedf orcapit
albudgeti
ngpur poses,normal l
y
donotconsi derfinancingchar
ges,suchasi nterest
,becauset hesef i
nancing
chargeswil
lber eflect
edinthecostofcapi t
althatisusedt odiscountproject
cashflows.
I
ny ear
swhenaf i
rm musti ncr
easeitsinvest
menti nnetworkingcapit
al(NWC)
associ
atedwithaparti
cularproject
,thi
si ncr
easedinvestmentinNWCr educes
NOCF.Nor mall
y,howev er,att he end oft he l
i
fe oft he proj
ect
,t he NWC
i
nvestmentaccumulat
edov erthelif
eoft heproj
ectisrecover
ed( f
orexample,as

110
i
nventori
esaresoldandaccountsrecei
vablearecollected).Thus,∆ NWC i
s
negati
ve(areducti
on)attheoperat
ingstage.Ifadecl i
nei nthenetworki
ng
capi
tali
sexpect
edov ert
heli
feoft
heproj
ect,theef
fectwoul dbetoincr
easet
he
NOCFoft hepr
oject
,however
.
Thus,
theNOCFofapr
ojecti
scomput
edasf
oll
ows:
Changei
nRev
enue-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
- ∆R
Less:
Changei
noper
ati
ngcost
s--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-- –∆OC
Changei
ndepr
eci
ati
on-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
- – ∆Depr
eci
ati
on
Equal
s:Changei
nOper
ati
ngear
ningsbef
oret
ax-
--
--
--
--
--
--
--
--
-- ∆OEBT
Less:
Taxes-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
- –T(
∆OEBT)
Equal
s:Changei
noper
ati
ngear
ningsaf
tert
ax -
--
--
--
--
--
--
--
--
--
- ∆OEAT
Pl
us:
changei
ndepr
eci
ati
on-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--+∆Depr
eci
ati
on
Less:
Changei
nNetwor
kingcapi
tal
(Incr
ease)-
--
--
--
--
--
--
--
--
--
--
--
-– ∆NWC
Equal
s:Netoper
ati
ngcashf
low(
Annual
)-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-- NOCF
[NB.∆NWCcanoccuraspar tofthenetinv
estmentatti
mezer o(0)oratany
ti
medur i
ngthelif
eoftheproj
ect.Furt
hermor
e,theNOCFoft hefi
nalyearofthe
proj
ectischar
acteri
zedbycashflowsassoci
atedwit
hdisposalofoldasset
sof
theproj
ectandrecover
yoft
hecumul ati
veNWC].
I
nthi
sregard,t
hedi
sposal
priceoftheol
dasset
sandt heassoci
atedgai
norl
oss
woul
daffectt
heamountoftheaft
ertaxcashpr
oceedsobtai
ned.
Cases
 Oldassetsaresoldformor ethanthei
rori
ginalcost.Theamounti n
excessoftheori
ginalcostistr
eat
edascapitalgainandhence,taxed
atcapit
algai
ntaxrate.Theamountinbetweenoriginalcostandbook
val
ueistaxedator
dinarytaxrat
e.
 Salvagepr oceeds(sel
li
ngprice)oft heoldassetsisl esst hanthe
currentbookv al
ue.Thelossi
ncurredwouldreducet
het axableincome
and br i
ngs a tax savi
ng,which is an i
mplici
tcash inflow to be
recognized.TheNOCFshoul di ncl
udethesalvageproceedspl usthe
taxsav i
ngarise.
 Sal
vagepr oceeds(sell
ing pri
ce)oftheold asset
sisequaltothe
cur
rentbookv al
ue.Therewillbenogai
nornolossandhence,
onl
ythe
sal
vageproceedswillbeincl
udedasaninf
lowofcash.
6.
4.2.Summar
yofPr
ojectCashFl
owDet
ermi
nat
ion
1.I
nvest
mentPhase:Det
ermi
nat
ionofneti
nit
ial
inv
est
ment(
NINV)
:
A.Newpr
ojectcase:
NI
NV=Costofpr
oject+I
nvest
menti
nNWC

111
 -I
nvest
mentt
axcr
edi
t
B.Repl
acement(
CostReduct
ion)pr
oject
s:
NINV=Costofr
epl
acementasset
s-Netdi
sposal
proceedsofol
d
asset
s
Where:Netdi
sposal
proceeds=Sel
l
ingpr
iceofOA–Taxesongai
non
di
sposal
Or Sel
l
ingpr
iceofOA+Taxsav
ings(
shi
eld)onl
osson
di
sposal
[I
ngeneral
,replacementpr
oject
sdonotr
equi
readdi
ti
onal
inv
est
menti
nnet
worki
ngcapi
t al
].
C.Expansi
onpr
oject
s:
NI
NV=CostofNewAsset
s+I
ncr
easei
nNWC
-Netdi
sposal
proceedsonOA
2.Oper
ati
ngPhase:
Det
ermi
nat
ionofnetoper
ati
ngcashf
lows(
NOCFs)
:
Newpr
oject Repl
acementorExpansi
on
Case1 Case2 Case1 Case2
Rev
enue Rev
enue ∆Rev
enue ∆Rev
enue
-Oper
ati
ngcost
s -Oper
ati
ngcost
s - ∆Oper
ati
ng - ∆Oper
ati
ng
cost
s cost
s
-Depr
eci
ati
on -Depr
eci
ati
on
- ∆Depr
eci
ati
on - ∆Depr
eci
ati
on
EBI
T EBI
T ∆EBI
T ∆EBI
T
-I
nter
est - -I
nter
est -
EBT OEBT ∆ EBT ∆OEBT
-Tax -Tax -∆Tax -∆Tax
=EAT =OEAT = ∆EAT = ∆OEAT
Adj
ust
ment
s: Adj
ust
ment
s: Adj
ust
ment
s: Adj
ust
ment
s:
+Depr
eci
ati
on +Depr
eci
ati
on + + ∆Depr
eci
ati
on
∆Depr
eci
ati
on
+I
nter
est(
1-T) _
_ -
+I
nter
est(
1-T)
-∆NWC -∆NWC -
(
Expansi
on) -∆NWC ∆NWC(
Expansi
on)
∆NOCF ∆NOCF ∆NOCF ∆NOCF

[Note:
Case1hereshowst heprocessofadjustmentneededinthe
det
erminat
ionofpr
ojectcashf
lowsi fi
nter
estisini
ti
all
ydeduct
edasanexpense;

112
andCase2showstheadj
ustmenti
fint
erestchar
geswerenotdeduct
ed.Tisthe
taxrat
eandt
heaft
ertaxbal
anceofi
nteresti
sobtai
nedbymulti
ply
ingitby(
1–
T)]
.
3.Ter
minat
ionSt
age:
Ter
minal
CashFl
ows=NOCFoft
hef
inal
year
Add: +Recov
eryofNWC
Netdi
sposal +Sel
l
ingpr
iceofol
dasset
s
pr
oceedsfrom
+Taxsav
ingsonl
ossondi
sposal
,or
ol
dassets
-Addi
ti
onal
taxesongai
nondi
sposal
+Taxsav
ingsonbaddebtl
osses/
uncol
l
ect
ibl
eaccount
s/,
i
fany

Thist opicisconcer nedwi tht her anki ngofpr oject sf ort hedeci sionofwhet heror
nott heyshoul dbeaccept edf ori ncl usioni nt hecapi talbudget .I tisassumed
thatpr ojectst obecov eredi nt hist opicar eequal l
yr isky . Al lcashf lowsar e
assumedt ooccuratt heendoft hedesi gnat edy ear . Gener all
y ,thepr oj
ect
evaluationt echni quesar ecl assi fiedi nt otwocat egor ies.Thesear e:
1. TheTr adi ti
onal Cr it
er ia( techni que)
Theyar ecal ledt het radi tionalt echni quesbecauset heydonotconsi der
thet i
mev alueofmoneyconcept si nr anki ngi nvest mentpr oposal s.Two
met hodsar ei ncludedundert het raditi
onalt echni que, namel yt hepay back
periodandt heaccount ingr ateofr eturn.
a)Thepay backper i
od:-Thepay backper iodi st henumberofy ear sthat
isr equi red f ort he busi nessf ir
m t or ecov erf rom t he pr oj ectt he
amountoft hei nitiali nv est menti nt ot al.I ft hecashf l
owsf rom t he
proj ectar ei n an annui tyf orm,t he pay backper i
od can easi lybe
det ermi nedbydi v idingt hei ni
ti
ali nvest mentbyt heannualcashf l
owi n
theannui ty.Thati s,
Pay backper i
od( iny ear s) = Initial i
nv est ment
Annual Cashf l
ows
Whent hecashf l
owsf rom t hepr ojectar enoti nanannui ty,thepay backper iodis
comput edasf oll
ows:
Pay backper i
od = y earbef oref ullrecov ery+Unr ecov eredcost
Annual flowdur i
ngt henexty ear
Toi ll
ust r
atet hecomput ationoft hepay backper i
odwhent hecashf lowsf r
om
thepr ojectisanannui tyf or m,supposet hepr ojectr equi resani ni
tialinv est ment
of24, 000Bi r
randt heannualaf ter-taxcashf lowsof6, 000Bi r
rforf i
v ey ear s.The
paybackper iodi s, ther ef ore,
Paybackper iod = 24, 000/ 6000 = 4y ears
Thisist omeant hatt hei nitial i
nv est mentamountoft hispar ti
cularpr oj
ectwi l
lbe
recov eredwi thi nt hef i
rstf oury ear soft hepr ojectl i
fe( i.
e.6, 000f orf oury earsis
24,000) .

113
Toi ll
ust ratet hecomput at i
onoft hepay backper iodwhent hecashf lowsf rom
thepr oj ectar enoti nanannui tyf orm,assumet hepr ojectr equi r
esani ni t
ial
i
nv estmentof60, 000Bi rr.Theaf ter-taxcashf lowsf rom t hepr ojectar e8, 000Bi rr
duringy ear1, 15,000Bi rrdur ingy ear222, 000Bi rrdur ingy ear3, 20,000Bi rrdur i
ng
year4,andy ear5each.Her e,t hecashf lowsar enotuni f
or m.I nt hiscase,we
fi
rstneedt ocomput ethecumul at ive.
Year Annual Cashf low Cumul ati
v ecashf low
1 8,000 8,000
2 15,000 23, 000
3 22,000 45, 000
4 20,000 65, 000*
5 20,000 85, 000
Lookingatt hecumul ativecashf lows,t hecumul ativ ecashf lowsatt heendof
year3, whi chi s45, 000i sl esst hant hei nitiali nv estmentwher east hecumul at i
ve
cashf lowsatt heendofy ear4t hati s65, 000i ssl ightlygr eat ert hant hei ni t
ial
i
nv estment .Thi si mpl i
est hatt hepay backper iodf ort hispr ojecti sgr eat ert han3
yearsbutl esst han4y ear s. t heexactpay backper iodcanbecomput edas
foll
ows:
Pay backper iod = 3y ears + (15,000/ 20,000)y ear s
= 3y ears + 0.75y ear s =3. 75y ear s,
or
= 3y ears + (0.75) ( 12 mont hs) =
3yearsand
9mont hs.
Thisi st rue i fthe cash f l
owsof20, 000Bi rrdur ing y earf ourar e uni for ml y
distri
but edov ertheent irey ear.Ot herwise, thepay backper i
odi sdi ff
er entf rom 3
yearsand9mont hs.Fori nstance,i fthecashf low of20, 000Bi rrisexpectt o
occuronl yonceatt heendofy ear4, thepay backper iodwi l
lbe4y ear s.
Asagener alrule, theshor terthepay backper iod, thebet tert hepr ojecti s.Thus,
thepr ojecti saccept edifitspay backper iodi sl essorequal tot heper iodr equi red
byt hemanagementoft hebusi nessf i
rm.I ft wopr oj ectsar emut uallyexcl usi ve
(i
.e.ift heaccept anceofonepr oj ectpr ecl udest heaccept anceoft heot her ),a
projectwi t
ht heshor terpay backper i
odi ssel ect edev enifbot hoft hem f ulfillthe
accept ancecr i
teria.Ont heot herhand,i ft wopr oj ectar eindependent( i.e.t he
cashf l
owsofoneoft hepr ojectdonoti nf luencet hecashf lowsoft heot her),
botht hepr ojectscanbeaccept edasl ongast heirpaybackper i
odsar el esst han
theplannedpaybackper iod.

AdvantagesofPaybackPer
iod:
Thepay backperi
odisaneasyandani
nexpensi
vemet
hodt
oev
aluat
eandr
ank
proj
ectalter
nat
ives

Disadvant
ageofPaybackPeri
od
Thedisadvant
agesofthepaybackperi
odare:
1. Itignor
esthecashf l
owsbey ondthecomputedpaybackper
iodt
hough
theyareimpor
tantf
oracceptanceorrej
ect
iondeci
sions.

114
 2. Iti gnoresthet imev al ueofmoneywhi chisani mportantvari
ablethat
demandsconsi der
ationi nevaluati
ngt hedesirabil
it
yofagi venproj
ect.
b) TheAccount i
ngRat eofRet urn(ARR)
Theaccount i
ngrateofr et urn(ARR)i sther ateofr et
urnthatiscalculat
edby
div
idingt heproj
ect ’
sexpect edannuallynetpr ofitbyt heaverageinvestment
outl
ay s.Theav erageinv estmentout lay,ont heot herhand,iscomput edby
div
idingthesum ofor i
ginalcostoft heprojectandt hesalvagev al
ueofr et
urn
(ARR)canbeexpr essedwi t hanalgebraicequat i
onasf oll
ows.

ARR =

Av
eragecostofI
nvest
ment = Or iginal cost s+sal v agev alue
2
Toi l
lustratet heaccount ingr ateofr etur nconsi dert hepr ojectt hathast he
origi
nalinv estmentof70, 000Birr
,thel i
feof4y ears,andt hesal vagev al
ueof
6,000Birratt heendofy ear4.Thest raightl inemet hodofdepr eciati
oni sused.
Incomebef oredepr eciationandt axesar e40, 000Bi rrfory ear1,42, 000Birrfor
year2,36, 000 Birrf ory ear3,and 50, 000 Bi r
rf ory ear4. Det ermine the
accountingr ateofr eturni fincomet axr ateont hepr ojecti s40per cent
. To
comput et heaccount i
ngr ateofr eturn( ARR)f ort hispr oject ,fi
rstwehav et o
determinet heav er
agei nv estmentandt heannual depr eciati
onamount .
Av erageinvestment = (70, 000+6000) /2 = 38,000Bir
r
Annual depr
eciation = (70, 000-6, 000)/ 4 = 16,000Bir
r
Thencomput ethenewpr of i
tforeachy eardur ingt hef oury ear s.
Year1 Year2 Year3 Year4
Incomebef oredepr.&t axes 40,000 42,000 36, 000 50,000
Less:Annual depreciati
on 16,000 16,000 16, 000 16,000
Incomebef oretaxes 24,000 26,000 20, 000 34,000
Less:Incomet axes(40%) 9,600 10,400 8,000 13,600

Thenwecomput etheav er ageNetPr ofitduri

ngt hef oury ears.
Thatis:
Av eragenetprof it = (14,400+15, 600+12, 000+20, 400)/
4
= 15,600Bi rr
Hence, ARR = Av erageAnnual netprofit = 15,
600 =
0.41or41%.
Av eragecostofi nv estment 38,
000
Thisist omeant hatf oranav erageof1Bi r
rinv estedint hi
spr oject
,ther
eisan
averager eturnof41cent sint heform ofnetpr of i
tpery earov ertheenti
ref our
yearsoft helifeofthepr oject.
Theaccount ingr at
eofr eturnmet hodofpr ojectev aluati
on,likethepay back
peri
odmet hod,ignorest het i
mingofcashf l
owsort het imev alueofmoney .
Moreov er,theaccount ingr ateofreturni gnor
est hef luct
uat i
onsoft hecashflows
overthel if
eoft heproj ectasi tassumesanav eragecashf l
owsev er
yduringt he
proj
ect'
sl if
e.

115
2.TheDi scount edCashf low( DCF)Cr iteria(Techni ques) :
Thedi scount ed cash f low t echni quesar eot hermet hodsofev aluating and
rankingi nv est mentpr ojectpr oposal s.Theset echniquesempl oyt het i
mev alue
ofmoneyconcept ,unl i
ket het radit i
onalmet hods. FourDCFt echni quesar e
discussedi nt hesect i
ont hatf oll
ows.
a)Thedi scount edPay backper iod
Thedi scount edpay backper i
odi sdef inedast henumberofy ear sthati sr equired
tor ecov ert heamountofmoneyi nv est edi napr ojectatt hebegi nningaf ter
discount ingt hef ut urecashf lowst ot heirpr esentv alues.Di scount edpay back
periodi scomput edi nt hesamemannerast hatoft her egularpay backper i
od
exceptt hedi scount edcashf lowsar eusedi nt hecaseoft hef ormeron.The
expectedf ut urecashf lowsar edi scount edbyt hepr ojectscostofcapi t
al.
Toi ll
ustr atet hecomput ationoft hedi scount edpay backper iod,supposet hata
givencapi talbudget i
ngal ternativei sexpect edt ohav eani ni t
ialinv estmentof
30,000Bi rrandt hel ifeof5y ears. Theaf t
er -taxcashf l
owsf rom t hepr oject
duringy ear s1, 2,3,4and5ar e15, 000Bi rr,18,000Bi r
r,12, 000Bi r
r,20, 000Bi r
r,and
22,000Bi rrr espect ively.Thecostofcapi tal( ther equi redrat eofr eturn)is10
percent .Whati st hedi scount edpay backper i
odf ort hispr oj
ect ? Toanswerhi s
quest i
on, f
irstwehav et ocomput et hedi scount edcashf lowsandt hecumul ative
cashf lowsf oreachy earwhi chhel pbuy st ol ocatet hedi scount edpay back
periodoft hispr oject . Hence,t hedi scount edcashf lowsandt hecumul ative
cashf l
owsy earbyy earar eshowasf ollows.
Year Cashf lows DiscountFact or PresentVal ue
Cumul at iveCF
1 15, 000 0.909 13,635
13,635
2 18, 000 0.826 14,868
28,503
3 12, 000 0.751 9,012

4 20,
000 0.
683 13,
660
5 22,
000 0.
621 13,
662

Asy oucanseef rom t hecumul ati

vedi scountedcashf lowst hedi scounted
pay backper iodf orpr ojectisbet ween2and3y ears. Thi sisbecauset he
cumul ativedi scount edcashf low att heendofy ear2i sl esst hant heinit
ial
i
nv estmentof30, 000Bi rrandthecumul ateddi scountedcashf lowsatt heendof
year3i sgr eaterthanthesamei ni
tialneti nvestment .Theexactpay backper i
od
(di
scount ed)canbecomput edas:
Discount edPaybackper iod = 2years+( 1,497/ 9,
0120)y ears
= 2years+0. 17y ear
s=2. 17years
= or2y ears+( 0.17)( 12mont hs)
= 2yearsand2mont hs.
Itrequirest hepr ojectaper iodof2y ear sand2mont hst or ecoverit
si ni
ti
alnet
i
nv estmentt akingt hetimev alueofmoneyi ntoaccount .Thi sistrueonlyifthe
cashf lowsassumedt ooccuruni f
ormlyt hr oughoutt hey ear.Butt hecashf lows

116
aredi scount edbackt ot hei rpr esentcashequi val ent sbyconsi der ingt hatt he
cashf lowsar eoccur ringatt heendofev eryy ear .Hence,t hepr ojectneedst o
waitf oronemor ey ear saf tery ear2i nor dert or ecov ert her emai ningpr esent
valueequi v alentamountof1, 497Bi rratt heend ofy ear2. Ther ef or e,t he
discount edpaybackper iodoft hi spr ojecti s3y ear si nst ead.
b)TheNetPr esentVal ue( NPV)Met hod
The netpr esentv alue ( NPV)met hod i s an i nv est mentpr oj ectpr oposal s
evaluat ing and r anki ng met hod usi ng t he netpr esentv al
ue,whi ch i st he
diff
er encebet weent hepr esentv aluesoff ut ur ecashi nflowsandt hepr esent
valueofcashout flows,di scount edatt hegi vencostofcapi tal,oroppor tuni t
y
costofcapi tal.
Inor dert ouset hismet hodpr oper ly,t hef ol l
owi ngpr ocedur esar ef ollowed.
1. Fi ndt hepr esentv alueofeachcashf low,i ncl udingbot hi nf l
owsand
outf lowsusi ngt hecostofcapi tal oft hepr oj ectf ordi scount ing.
2. Sum t hedi scount edcashout flowsandt hedi scount edcashout fl
ows
separ at ely .
3. Obt aint hedi fferencebet weent hesum oft hecashi nf lowsandt he
sum oft hecashf lows.
Ifallt hecashout flowsf ort hepr oj ectoccuratt i
mezer o,i.e.att hebegi nni ngof
year1,t hepr esentv alueoft hecashourf lowsi st hesameast ot henet
i
nv est mentamount .
Deci sionRul ef ort heNetPr esentVal ue( NPV)Met hod:
Ifthepr oject sar ei ndependent ,t hepr oject swi thposi ti
v enetpr esentv aluesar e
theoneswhosei mpl ement at ionmaxi mi zest heweal thofshar ehol der s.Hence,
suchpr oject sshoul dbeaccept edf ori mpl ement at i
on. I ft hepr oject s,ont he
otherhand,ar emut ual lyexcl usi ve,t heonewi tht hehi gherposi t
iv eNPVshoul d
beaccept edl eadi ngt ot her eject ionoft hepr oject swi thl owerposi tiveNPV.
Project swi thnegat i
v eNPVshoul dnotbeconsi der edf oraccept ancei nt hef i
rst
place.
Ther ational ef ort heNPVmet hodi st hatanNPVofzer osi gnifi
est hatt hecash
fl
owsoft hepr ojectar ej ustsuf fici entt or epayt hei nvest edcapi tal andt opr ovi
de
ther equi redr ateofr etur n, nomor enol ess.I ft hepr ojecthasaposi t
iv eNPV, itis
gener at i
ngmor ecasht hanneededt oser vi
cei tsdebt sandt opr ov idet her equi re
rateofr etur nt ot heshar ehol der s,andt hisexcesscashaccr uessol elyt ot he
fi
rm' sshar ehol der s.Ther efor e, ift hef irmt akesonapr ojectwi thaposi ti
v eNPV,
theweal thoft heshar ehol der swi l
l bei mpr ovedasi ndi cat edabov e.
Toi llustrat et heNPVasamet hodofpr ojectpr oposal sr ankingassumet hata
givenpr ojecti sexpectt ohav eani nitialinv est mentandpr ojectl i
feof40, 000Bi r
r
and 5 y ear sr espect ivel y. The annualaf ter-tax cash f low i s est imat ed at
12,000Bi rrforeachoneoft hef i
v ey ear s.Usi ngt her equi redr ateofr et urnof10
percent ,whati st henetpr esentv alue( NPV)oft hepr oject ?Howdoy ouj udget he
accept abilit
yoft hispr oj ect ?
Inor deranswert hesequest ion,i ti swi set oi dent ifyt hecashi nf lowsand
outflows.I nt hecaseoft hispr oject ,t her ear eannui t
ycashi nf l
owsof12, 000
everyy earf orf ivey ear sandsi ngl ecashoutf l
owof40, 000att i
mezer o.
Thepr esentv alueoft heannui tycashout flowsi s:

117
 Presentv alueofannui ty =( 12,000)Annui tyf actor)
Theannui tyfact orgiv ent heperiodof5y ear
sanddi scountrat
eof10per centis
3.791subst i
tutingt hef actorItheequat ionabov e
PVA = (
12, 000)(3.791) = 45,492Bi r
r
PresentVal ueofCashoutf lows = 40,000Bi r
r
Hence,
TheNetPr esentv alue(NPV) = Present Val ue of inflows l ess
presentv alueo ofoutf lows
= 45,492-40, 000 =
5,
492Bi r
r
Sincet hepr ojectmakest henetpr esentv alue( NPV)ofposi tive5, 492Birr,i
t
should be accept ed. Consequent l
y,t he weal th oft he shareholders woul d
i
ncr easeby5, 492Bi rrint otalast heresul tofaccept i
ngandr unningthispr oject
.
Thus, thepr ojectcanbej udgedasanaccept ableone.
Tof urtheri l
lustratet heNPVmet hod,consi dert hef oll
owingmut uallyexclusive
projectalternatives, t
oget herwitht hei
rcashf l
ows.

Al
ter
nat
ive Year0 Year1 Year2 Year3 Year4 Year5

A (
80,
000) 20,
00 25,
000 25,
000 30,
000 20,
000
0
B (
100,
000) 25,
00 20,
000 30,
000 35,
000 40,
000
0

Ther equi r
edr ateofr etur
nonbot hpr ojectsis12per cent
.Then,ev al
uat ethese
projectsusi ngthenetpr esentv al
uemet hod.
Theev al
uat ionoft heset wopr ojectsr equir
est hecomput ati
onoft henetpr eset
valuesf orbot hpr ojects.Asy oucanseet hecashf l
owsf r
om bot hprojectsare
noti nannui tyforms.Thecashf l
owsar eirr
egul arforbot hprojects.Hence,we
need t o discounteach oft he cash f l
ows i ndivi
dual l
y. Then t he indivi
dual
discount edcashf l
owsar eadded. Thecashoutf lowsatt i
mezer owi llbe
deduct edf rom thesum oft hedi scount edcashi nflowsi nor dertogett henet
presentv alueoft hepr oj
ect.Thenetpr esentv alue( NPV)f orprojectAis:
Year Cashf l
ows Di scountFact or(12%) Pr esentValues
1 20,
000 0.893 17,860
2 25,
000 0.797 19,925
3 25,
000 0.712 17,800
4 30,
000 0.636 19,080
5 20,
000 0.567 11,340
Presentvaluesofcashi nfl
ows( sum) 86,005
Presentv aluesofcashout fl
ows 80,000
NetPr esentVal ue( NPV) 6,
005Bi rr

Thenetpr
esentv
alue(
NPV)f
orpr
ojectBi
s:

Year Cashf
lows Di
scountFact
or(
12%) Pr
esentVal
ues

118
 1 25,000 0.
893 22,
325
2 20,000 0.
797 15,
940
3 30,000 0.
712 21,
360
4 35,000 0.
636 22,
260
5 40,000 0.
567 22,
680
Presentval
uesofcashinfl
ows(
sum) 104,
565
Presentval
uesofcashoutfl
ows 100,
000
NetPresentVal
ue( NPV) 4,
565Bir
r

Sincet het wopr ojectsar emut uallyexcl usi

v e,theonewi tht hehi gherNPVhast o
beaccept ed.Thus, projectAi ssel ectedasi tsNPVi shighert hant hatofproject
B.Hadt het wopr ojectbeeni ndependentofoneanot her,bothoft hem wouldbe
accept edbecausebot hpr ojectshav eposi t
ivenetpr esentv alues( NPVs)
TheNPVPr ofil
e
Asi ndicat edabov e,thenetpr esentv alueoft heprojectdependssol el
yont he
sizeandt imingoft hecashf lows, thei nvestmentoutl ays, andt hedi scountrat e.
Asi mpl egr aphicdev i
cet hatv isualizest hi
sdependencei scal ledt heNPVpr of i
le.
Toi l
lustratet heNPVpr ofilessupposet hatapr ojectisexpect edt ohav eaninitial
i
nv estmentof200Bi rrandt hef ir
sty earcashf l
ow of230Bi rr.Thenetpr esent
valueoft hissimpl i
fi
edpr ojectusi ngf oural ternativ
edi scountr atesof0,10, ,15,
and20per centsisshownasf ol l
ows.
Presentv alue NetPr esent
Discount Di
scountFact or of230Bi r
r LessnetI nv estment Value
Rate
0 1.000 230. 00 200 30.00
10% 0.909 209. 07 200 9.
07
15% 0.870 200. 01 200 0.
00
20% 0.833 191. 59 200 -8.
41

TheNPVpr ofil
ecaneshownwi t
hthehel
poftheX-
ycoordi
natepl
anewheret he
Y-axi
sist
or epresentt
heNPVsandtheX-
axi
sistor
epr
esentthedi
scountr
ates.

30*
20
10 *
*
-
10 10 15 20 25
*

Thedi
scountfact
oris1whenthediscountr
atei
szer
o.Thisr
efl
ectst
hefactthat
0Bir
rrecei
vedtomorrowisequalt
oabi rrr
ecei
vedt
odayinaworldwherethere
i
snoot herprofi
tabl
ealt
ernat
iveofusingmoney. Att
hediscountrat
eof15

119
percentt heNPVi szer o,whi chmeanst hatt hi
spr ojecti sear ningexactly15
percentr et urns.
Theabov egr aphi ndicatest hatt heNPVoft hepr ojectunderconsi der
ati
onis
positi
v ewhent hedi scountr atesar el essthan15per cent ,
andnegat i
vewhenthe
discountr atesar egr eatert han15per cent. Ther efor e,thi
spr ojectshouldbe
accept edi fandonl yiftheoppor tunitycostofi sbelow15per cent.
C)TheI nternal RateofRet urn(IRR)
Thei nter nalr at
eofr eturni sthedi scountr atewhi chequat est hepr esentval
ue
theexpect edcashf l
owswi ththei niti
al i
nvestmentout lays.Inot herwor ds,I
RRis
amet hodofr ankingi nvestmentpr ojectpr oposalsusi ngt her ateofr etur
nonan
asset( inv estment ).AtI RR,t hesum oft hepr esentv aluesofal lcashi nfl
owsis
equal tot hesum oft hepr esentv aluesofal lcashout fl
ows.Thati s:
Pv( cashi nflows)=PV( cashout f
lows).Hence,t henetpr esentval
ueof
anypr ojectatadi scountr atethati sequal toot heIRRi szero.
Comput ingt heI nternalRat eofRet ur n
1.Uni form CashI nf
lowsov ert heLi f
eoft hePr oject:

Int hiscase, t
hepr esentv aluet abl eofanannui tycanbeusedt ocal cul
at ethe
IRRsi ncet hecashi nflowsar ei nannui tyf or m.Thef ol
lowingst epscanbe
followedt ocalcul ateI RRf orconst antcashi nflows.
Step1: Fi ndt hecr iti
cal valueofdi scountf act or
Discountf actor =Initi
al invest ment
Annual Cashi nf low
Step2: Fi ndt heI RR byl ooki ngal ongt heappr opr i
atel i
ne( year)oft he
presentv alueof
annui tyt ableunt ilt hecol umnwhi chcont ainst hecr it
icaldiscount
fact or( i
.e.
thedi scountf actorcomput edunderst ep1)i slocat ed.
Toi ll
ust r
at et hecal culationofI RRwhent hecashf l
owsar ei nanannui t
yf orm,
assumet hatapr ojecthasaneti nvest mentof26, 030Bi rrandannualnetcash
i
nflowsof5000Bi rrf orsev eny ear s.Whati st heI RRoft hispr oject?I nor derto
answert hisquest ion, weneedt of oll
owt het wost epsdi scussedabov e.
Step1 Comput ethecr i
tical discountf act or.Thati s
Discountf actor = 26,030=5. 206
5,000
Step2Af terdet ermi ningt hecr it
icaldi scountf actor ,wel ookf ort hev aluet hatis
equal
tothisf actori nt he pr esentv al ueofannui tytableacr osst heline
cor respondi ng
to7y ear s(i.en=7) .Thedi scountf act orof5. 206appear sint he8
per cent
columnont hel i
ne/ rowof7y ear s.Ther efore, t
heI RRi s8per cent.
2.Fl uct uat i
ngCashI nfl
owov ert heLi feoft hePr oject
Whent hecashi nf lowsf rom t hepr ojectar enoti nanannui tyf orm,I RR is
calculatedt hroughani terativepr ocessort hrough" t
rialander ror".I tmaybe
dif
ficulttoi dent i
fyf rom whi chdi scountr atet ost art.Agoodf i
rstguesscanbe

120
madebyest imat ingt hedi scountf act or.
I
ngener al,t
hef ollowingpr ocedur esar eusedt ocal cul atetheI RRoft henon-
uniform netcashf lows.
Step1: Findt heest imat eddi scountf act or.I nfact, i
fthef l
uctuati
onsIthe
cashi nflowsi sv er ylarge,t heest imat eddi scountf actordoesn’ thel pyoumuchi n
locatingt heI RRi nthepr esentv alueofannui t
ytable.
Estimat eddi scountf actor=Neti nvest ment
Av eragecashi nfl
ows
Step2: Lookatt hepr esentv alueofannui tyt ablet oobt ai nthenear est
discountr atef ort heest imat eddi scountf act ordet erminedi nst ep1.
Step3: Calcul atetheNPVusi ngt hedi scountr atei dentif
iedi nstep2.
Step4: Ifther esultingNPVi sposi tiv
e, chooset hehi gherdi scountrateand
repeatt hepr ocedur e.Chooset hel owerdi scountr ateift heNPVi snegativ
e,and
repeatt hesamepr ocedur eunt i
lyouf i
ndt hedi scountr at ethatequat estheNPV
tozer o.
Toi l
lustratetheI RRcomput ationunderf l
uct uatingcashi nflowsf rom theproject
assumeapr ojectt hathasani ni
tialinv estmentof40, 000Bi r
randt hefoll
owi ng
netcashi nfl
ows:
Year1, 15,000Bi rr;
year2, 10, 000Bi r
r;
Year3, 10,000Bi r
r;
y ear4, 15,000Bi rr
; and
y ear5, 15,000Bi rr.

121
 Whati st heI RRoft hispr oject ?
Inor dert oest imat et hedi scountf actor ,y ouneedt ogi vewei ghtt othecashf l
owsov erthe
l
ifeoft hepr oject .Lar gerwei ght sshoul dbegi vent ot hecashf lowst owar dst hebegi nni ngof
thelifeoft hepr ojectt hant ot hecashf lowst hatoccurt owar dst heendoft hepr ojectl ife.
Hence,
Year Wei ght Cashf lowxwei ght
1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
190, 000
Av eragenetcashf low = 190, 000= 12, 667
15
Est imat eddi scountf act or = 40, 000 = 3. 158
12, 667
Byl ooki ngupi nt hepr esentv aluet abl ef orannui ty,theappr oxi mat et hedi scountf actorof
3.158onl ine5( n=5)i s18per cent .Thus,t hest arti
ngpoi ntoft hei ter ativepr ocessi s18
percent .TheNPVoft hepr ojectusi ngt hedi scountr ateof18per centi s:
NPV =( 15, 000)( 0.847)+( 10, 000)( 0. 718)+( 10, 000)( 0. 609)+( 15, 000)( 0.516)+
(15, 000)( 0. 437)-40, 000=40, 270-40, 000=270
Sincet heNPVcomput edusi ngadi scountr ateof18per centi sposi ti
ve, ar ehav et ot akea
discountr atehi ghert han18per centi nsear chf ort heNPVofzer o.Sot hesecondguesscan
be19per cent .TheNPVoft hepr oj ectusi ngt hedi scountr ateof19per centi s:
NPV =( 15,000)( 0.840)+( 10,000)( 0.706)+( 10, 000)( 0.593)+( 15, 000)( 0.499)+
(15, 000)( 0. 419)-40, 000=39, 260-40, 000=- 640
Aspert heabov ecal cul ations, NPVi snegat ivewhent hedi scountr ateof19per centi sused
andposi ti
v ewhent hedi scountr at eof18per centi sused.Thus, theI RRf ort hi sprojectf al
ls
between18per centand19per cent .I ft heexactI RRi sneeded, thei nter pol ationmet hodi s
canbeused.Thati s:
Step1: Obt aint heNPVoft hesmal lerr atebyt heabsol utesum andaddt her esulti
ng
quot ientt othesmal lerr ate, ordi videt heNPVoft hel ar gerr atebyt heabsol utesum
andsubt ractt her esul t
ingquot ientf rom t hel argerr at e.
Step2: Di videt heNPVoft hesmal l
err atebyt heabsol ut esum andaddt her esul t
ing
quot ientt ot hesmal l
err at e,ordi v i
det heNPVoft hel argerr at ebyt heabsol ute
sum andsubt r
actt her esul ti
ngquot ientf r
om t hel ar gerr ate.
Byf ollowi ngt heabov et wost eps, theexactI RRf orthi sproj ecti st hus:
Theabsol utesum oft heNPVs=| 270| +| -
640| =270+640=910
Then, dividingt heNPVoft hesmal l
err at ebyt heabsol utesum, youget270/ 910=0. 30t ot he
near estt wodi gitsaf tert hedeci mal poi nt,andaddt hisf i
gur et ot hesmal lerr ate
IRR =18%+0. 30% =18. 30%
ory oucandi videt heNPVoft hel ar gerr at ebyt heabsol utesum, andy ouget :
-640/ 910-0. 70t ot henear estt wodi gi tsaf terthedeci mal poi nt, andsubt r
actt hi s
fi
gur ef rom t hel ar gerr atet oobt aint heexactI RR.
IRR =19%-0. 70% =18. 3%
Inbot hcases, youar riv eatt hesameI RRv al ueof18. 3per cent .
Ther ationalf ort heI RRmet hodi st hatt heI RRonapr ojecti si t
sexpect edr ateofr eturn.I f
theI RRofagi v eni nv est mentpr ojectexceedst hecostoft hef undsusedf orf i
nanci ngt he
project( costofcapi t
al ),ther ei st her emai ningsur plusaf terpay i
ngf ort hecapi tal,andt his

122
surplusaddsupont heweal thoft heshar ehol der soft hef ir
m. Ther ef ore,sel ect i
ngt he
projectwhoseI RRexceedsi tscostofcapi talincr easet heshar ehol der s'weal th.Ont he
otherhand,t hepr ojectwi tht heI RRl esst hant hecostofcapi talimposesanunnecessar y
costoncur rentshar ehol der s. Ther eturnf rom t hepr ojectwi l
lt ocov erev ent hecostof
capital .
Decisi onRul ef orI RR
Apr oj ectwhoseI RRi sgr eatert hani tscostofcapi tal,orRequi redRat eofRet urn( RRR)i s
accept edandwhoseI RRi slesst hant heRRRoft hepr ojectisr ejected.
d.Pr of i
tabi li
tyIndex( PI ):
Profitabi lit
yindexi st her at i
ooft hepr esentv alueoft heexpect ednetcashf lowoft hepr oject
andi tsi nitialinvest mentout lay .
PI= PV/ IO
wher e
PV= Pr esentv alueofexpect ednetf l
ows
I
O= Initial invest mentout l
ay
PI= Pr of itabili
tyI ndex
Profitabi lit
yindexpr ov idesormeasur eofpr ofitabil
ityinamor er eadil
yunder standabl eter
ms.
Itsi
mpl yconv ertst heNPVcr iterioni ntoar elativemeasur e.
NPVVSPr ofitabilit
yI ndex
TheNPVandt hepr ofitabi li
tyi ndexcr i
teriar eacht hesameaccept ance- reject i
ondeci si
ons
forindependentpr oject s.Thepr ofitabilityindexi sgr eatert han1i fthenetpr esentv al
ueof
thepr oj ecti sposi t
iv e. Howev er,i nt hecaseofmut uall
yexcl usivepr oj
ect s,NPV and
profitabi li
tyi ndexwi llr esul tindi fferentaccept ance- rejecti
ondeci sion. Oneadv antageof
NPVi nt hiscasei st hati tr eflectst heabsol utesi zeofal ternat i
vei nv est mentpr oposals
profitabi li
tyindexdoesnotr ef l
ectdi fferencei ni nvest mentsi ze.Ther ef or e,theNPVi smor e
appr opr iatef ormut ual lyexcl usiv epr oject sthanpr of i
tabili
tyindex.
Consi dert hef ollowi ngt womut uallyexcl usi vepr ojects.
PresentVal ue I
nitial Profitabi li
ty
ofcashFl ow I
nv est ment NPV Index
ProjectA 200 100 100 2.0
ProjectB 3000 2000 1000 1. 50
From t heabov eexampl epr ojectAi saccept edusi ngpr ofitabi li
tyindexbecausei tsPIi s
great ert hant hatofpr oj ectB.Howev er,NPVofpr oj
ectBi sgr eaterthant hatoft heNPVof
projectA.Thus, ev ent hought hepr of i
tabili
tyi ndexofapr oj
ecti sav eryusef ultool ,i
tshoul d
notbeusedasadeci sionr ulewhenmut uallyexcl usivepr oject sofdi f
f erentsi zear ebei ng
consi der ed.

NPVVsI RR
TheNPV andt heI RR pr ojectrankingt echni quesl eadt ot hesameaccept ance- r
ejection
decisi
onsf orindependentpr oj
ects.Howev er, t
hesemet hodsmayl eadt odifferentdeci sions
wheni ti simpossi bl
et ounder takeal linv est mentoppor tunit
ies. Inot herwor ds,when
i
nv est
mentoppor tuni
t i
esar emut uall
yexcl usiv e,NPVandI RRmayr esul
tincont r
adict i
ng
decisi
ons. Ift hisi st hecase,whi choneof t hetwomet hods shoul dbeusedt osel ect
between/amongt hemut uallyexclusivepr oject s? Whatar et her easonsf ort hedi ff
er ence
betweent het womet hods? Letusf ir
stdi scusst her easonsf ort hedif f
er ence. These
reasonscanbecl assifiedint otwo.Thesear e:
1.Di f
fer
encei nt heSi zeofi nvest
ment
Allinvestment sdonotusual l
yrequi r
et hesameamountofi ni
tialout l
ay.Onei nvestment
mayhav elargeri niti
alinv estmentt hani t
sal ternat
ives.I nt hi
scase,NPVl eadst obet t
er

123
i
nv est mentdeci sion because i tensur es t hatt he f irm wi llr each t he opt imalscal e of
i
nv est ment .NPVaut omat i
cal lyexami nesandcompar est hei ncr ement alcashf lowsagai nst
thecostofcapi tal.TheI RRcr i
terioni gnor est hi simpor tantaspectofani nvestmentdeci sion
becauset her et urni sexpr essedi naper cent age.
Toi l
lust rat e, thedi ffer encebet weent heNPVandI RRaspr oj ectr anki ngt echniquesconsi der
thef ollowi ngmut ual l
yexcl usi vepr oject s, pr oj ectAandpr oj ectB.
0 1 2 3 4 5
ProjectA (
50, 000) 17, 000 17, 000 17, 000 17, 000 17, 000
ProjectB (32, 000) 12, 000 12, 000 12, 000 12, 000 12, 000
Ther equi redr ateofr etur nf ort hi spr ojecti sBper cent .Whi choneoft heset wopr oject s
shoul dbesel ect ed? Fr om t heabov ei l
lust rativ eexampl e,wecanseet hatt hel i
vesofbot h
project sar et hesame.Howev er,t hei ni tiali nv estmentofpr oj ectAi slargert hant hatof
projectB.Thus, onecanl ear nt hatt her ei sadi fferencei nt hesi zeorscal eofi nv estment .I n
ordert oi dent ifyt hepr oj ectt obesel ect ed,t heNPVandI RRf orbot hpr ojectshav et obe
calculat ed.Si ncet hecashf l
owsf orbot hpr ojectsar ei nanannui tyf orm,t heI RRcanbe
easilydet er mi nedf rom t hepr esentv al uet abl eofannui tyaf terdet erminingt hedi scount
factor s.Ther ef ore, thedi scountf act orf orpr oj ectA= 50, 000=2. 941
17,000
Looki ngi nt hepr esentv al uet abl eofannui tyi nt her aw of5y ear s,t hedi scountf actorof
2.941cor respondst o20. 8per cent .
Thedi scountf act orf orpr oj ectB=32, 000=2. 667
12,000
Looki ngi nt hepr esentv alueofannui tyt abl eacr osst he5y ear( n=5)r ow, t
hedi scountf actor
of2. 667cor respondst o25. 5per centand
TheNPVofpr ojectA = ( 17,000)( thedi scountf act or sofannui tyatt her equired
rat eof8per cent )-50, 000.
= ( 17, 000)( 3. 993)-50, 000
= 17, 881Bi rr.
TheNPVofpr ojectB=( 12, 000)( thedi scountf actorofannui tyatt her equi r
edr ateofr eturn
of8per cent )-32, 000
=( 12, 000)( 3.993)-32, 000 = 15, 916
Theabov ecal culat i
onsi ndi cat et hatbot hpr oj ect sar eaccept abl ei ft heyar eindependent
project s.Howev er, thosepr oject sar emut ual lyexcl usi ve.Asar esul t,IRRr ankspr ojectB
fi
rst,butNPVr ankspr ojectAf i
rst .Thus, ther ei sapar adoxbet weent het womet hods.
Inor dert ocl ar i
fysuchpar adoxi calr esul t ,iti sadv isabl einv ol ved.Thent hei nternalr at eof
return( cr oss ov err ate)i s det er mi ned on t he i ncr ement alcash f l
ows and addi ti
onal
i
nv est ment .Addi tionali nv est menti st hedi ff erencebet weent hei nv est mentout l
ay soft he
twopr oject s. Cr ossov err at ei st hedi scountr ateatwhi cht heNPVpr ofil
esoft het wo
project scr oss,andt hus,atwhi cht hepr oj ect s'NPVsar eequal . Thus,t hei nternalr at eof
returnoni ncr ement alcashf lowsi st hesameast hecr ossov err at e.Thecr ossov errat ef or
thei ll
ust rat ionunderconsi der ationi scal cul at edi nt hesame,pr ocedur esasI RRf ort he
project ,i.
e.
Discountf act or= 18, 000=3. 600
5,000
From t hepr esentv al ueofanannui tyt abl e,t hedi scountf act orof3. 600cor r
espondst ot he
12per centcol umn. Thus,t hecr ossov err at ei s12per cent .Thecr ossov errat eindi cates
thatt heNPVgi vespr iorit
yt opr ojectAatdi scountr at esbel owcr ossov errateof12per cent,
butIRRsuppor tspr oj ectBf oradi scountr at eabov et hecr ossov err at e.
Sincet hecostofcapi tali s8per cent ,t hei ncr ement alcashf low r epr esentsapr of i
tabl e

124
oppor tunity. Ther efore,t hel ar gerpr ojectwhi chi ncor por atest heseaddi ti
onalcashf lows
shoul dbeaccept ed.
Ift hecr ossov err atei sl esst hant hecostofcapi tal( RRR) ,thepr oj ectwi tht hesmal l
er
i
nv est mentshoul dbesel ect edbecauset headdi tionalcommi tmentofr esour ceswi llnotbe
compensat ed.
Ther efore,byexami ningandcompar i
ngt hei ncr ement alcashf lowsagai nstt hecostof
capi tal,theNPV met hodensur est hatt hef i
rm wi llr eacht heopt i
malscal eorsi zeof
i
nv est ment .
2.Di f
ferencei nTi mi ngofCashf lows:
TheNPV andt heI RR canst i
llgi vecont radictor yr anki ngsev enwheni nitiali nv est ment
out laysar et hesamebecauseoft hedi ff
erencei nt het i
mi ngoft hecashf lows.Mostoft he
cashf lowsf rom onepr ojectmayoccuri nt heear lyy ear sandmostoft hecashf lowsf rom
theot herpr ojectmayoccurdur ingt hel at ery ears.Thecr it
ical i
ssuei st hat" howusef ul i
st he
proj ectifitgener atescashf l
owssoonert hanl ater ?"So, whi chmet hodshoul dbesued?
Basi cal l
y,thecashf lowst hatoccursoonerar ebet tert hant hecashf lowst hatoccurl ater
becauseear lycashf lowscanber einvest ed.I nf act ,wecannotuset hescal eofi nv est ment
proj ectar gumentdi scussedear l
iert oj ust i
fyt hepr efer enceofNPVt oI RR.Howev er, wecan
stil
luset hesamei ncrement alcashf lowt echni que.So,howcanwej ustif
yt heuseofNPV
asapr ojectr anki ngandev al uat i
ngmet hodwhendi ffer encesi nt hescal eofi nv est mentdo
notexi st?
Inor dert oj ustifyt hesuper ior i
tyofNPVr uleov ert hatoft heI RR,weneedt oconsi dert he
reinv estmentr ateassumpt ionofear l
ycashf lows. Accor dingt ot her ei nv estmentr ate
assumpt ion,NPVmet hodi mpl i
citlyassumest hatt hecostofcapi tal( RRR)i st her ateof
whi chcashf lowscanber einv est ed,wher east heI RRmet hodassumest hatt hebusi ness
fir
m hast heoppor tunityt or einv estatt heI RR.Whi chassumpt i
ondoy out hinki sbet ter?
Thebestassumpt ioni st heonet hatconsi der sther ei nvest mentofcashf l
owsatt hecostof
capi tal,i.
,e.NPVmet hod,TheI RRmet hodi ncor rect l
ypenal i
zest her ecei ptsofmor edi stant
year sbyusi nghi ghdi scountr ate( IRR)becauseI RRi sgr eatert hanr equi redr at eofr eturn
(RRR) .Thus, thebestr einvest mentr ateassumpt i
oni st hecostofcapi talwhi chi sconsi stent
withNPVmet hod.
Toi ll
ust r
ate,l etusassumet hatpr ojectAandpr ojectBhav et hesamei nitiali nv est ment s,
10,000bi rr.TheRRRi sf ort hef i
rm 10per cent .
Year Pr ojectA Proj ectB
0 (10, 000) (10, 000)
1 - 6,000
2 13, 924 7,200
IRR 18% 20%
NPV 1501 1401
Whi chpr ojectshoul dbesel ect ed?
IRRsi nglest hatpr oj
ectBi sbet tert hanpr oj ectA,wher easNPVsi gnal st hatpr ojectAi s
bet tert hanpr ojectB.Si nceNPVmet hodi sthesuper iort opt heI RRmet hodi nsel ecting
bet weent womut ual l
yexcl usi vepr oject s,pr ojectAi ssel ected.Pr ojectAwi llpr ov i
det he
mostweal tht otheshar ehol der s.Topr ov et hesoundnessoft hisdeci sion, wecancal culate
thet erminal valueofeachpr oj ectusi ngf utur eval uet echni que.Thus, termi nal valueof :
ProjectA = 13, 924Bi rr
ProjectB = 7, 200Bi r
r+( 6000)( 1.1)Bi rr=13, 800Bi r
r

Sincethetermi
nalval
ueofpr
ojectA i
sgr
eatert
hantheterminalval
ueofpr
ojectB,t
he
formerpr
ojecti
ssel
ect
edwhi
chisinl
i
newit
htheNPVdeci
sionrules.

125
 Project
swi t
hUnequal Lives
Earli
eri nt hischapt er,weassumedt hatmut uallyexcl usiv
epr ojectshav eequall ives.But
therear emanysi t
uationsi nwhi chal t
ernat
ivei nvestment shav eunequall i
ves.Themost
common exampl e ofsuch si tuat i
on isunequalr epl acementdeci sion. Si nce i
ti snot
appr opriatet ocompar epr oj
ectsofunequall i
v es,adjustmentmustbemade.Ev ent hough
therear edi fferentmet hods(appr oaches)ofdeal ingwi thmut uall
yexcl usivealter
nativeswith
diff
er entlives, t
hreeoft hem areintroducedint hischapt er.
1.TheRepl acementChai nApproach:
Replacementchai n,whi chiscall
edcommonl ifeappr oach, i
sthemet hodofcompar i
ng
projectsofunequal l
iveswhi chassumest hateachpr ojectcanber epeatedasmanyt i
mesas
necessar ytor eachacommonl if
espan.Then, theNPVort heothermet hodi susedt o
evaluat ethepr oj
ect.
Toi ll
ust r
atet hecompar i
sonofpr oj
ectswi t
hunequall i
vesconsi dert womut uall
yexcl usi
ve
projectswhosecashf lowsar esummar i
zedbel ow.Thedi scountr ateforbot hpr oj
ectsi s10
percent .
0 1 2¬¬ 3 4 5 6
Pr
ojectA (
40,000) 10,000 12, 000 15, 000 11, 000 9,000 11,000
Pr
ojectB (
30,000) 12,000 14, 000 13, 000 - - -

Thet wopr oj ect sar eincompar abl e.Thus, accor dingt or eplacementchai nappr oach, pr oject
Bwi llber epeat edi nt hreey ears.Assumi ngt hatannualcashf l
owandt hedi scountr ateswi l
l
notchange.Thus, ifprojectBi sr epeated, i
tsy ear4, y
ear s,andy ear6cashf lowsar e12, 000
bir
r ,14000bi r r,and13, 000bi r
rr espect i
vely.I nthi sway ,thet wopr oject
shav et hesamel i
f e.
Ifpr ojectBi sr epeat ed, i
tscashf lowswi llbe:
0 1 2 3 4 5 6
(30,000) 12, 000 14,000 13,000 12, 000 14,000 13, 000
Thepr esentv aluecomput ationoft her epeat edpr oj ectBr equiresat wo-st eppr ocess.These
are:
Step1: y oucomput et hepr esentv aluesatt =of orpr oj
ectBandatt =3f ort her epeat ed
projectB.
Pr esentv alueatt imezer o( t
=o)=( 12, 000)( 0.909)+( 14,000)( 0.826)+( 13,000)
(0.751)=
32, 235bi rrpr esentv alueatt ime3( t=3)=( 12,000)( 0.909)+( 14,000)( 0.826)+
(13,000)
(0.751)=32, 235bi rr
Step2: Di scountt hepr esentv alueoft her epeat edpr ojectBatt i
me3( t=3)t othepr esent
valueat
t
imezer o(t=o).Thati s,pr esentv alueofr epeat edpr ojectBatt i
mezer o= ( 32,235)
(
0. 751) = 24, 208bi rr.
Then,addt hepr esentv alueoft hef ir
stt hreey ear scashf lowst ot hepr esentv alueoft he
repeat edpr oj ectaf terthreey ears.Thati s:
Tot alpr esentv alue=32, 235+24, 208=56, 443bi rr. Hence, t
heNPVoft her epeat edpr oject
B=56, 443–30, 000–26, 443bi rr.
TheNPVofpr ojectAi scal culatedasf ollows.
Year Discountf act or Cashf low presentv alue
1 0.909 10,000 9,090
2 0.826 12,
000 9,912
3 0.751 15,
000 11,265
4 0.683 11,
000 7,513

126
 5 0. 621 9,000 5,589
6 0. 564 11,000 10,204
Presentv al ueofcashf lows 49,573
Less: Presentv alueofi nit
ial inv est ment 40,000
NPVofpr ojectA 9,573
Ther efor e,usi ngt heNPV met hodf orpr oj ectcompar isonoft het wopr ojects,pr ojectB
shoul dbesel ect ed.
Undert her epl acementchai nappr oachofcompar ingpr oject swi thunequall iv
es,t hel east
commonf act oroft hepr oject sl ivesi susedt of indt hecommonusef ullife.Fori nst ance,i f
thel i
feofpr ojectAi s5y earsandt hatofpr ojectBi s3y ear s,projectAi sr epeat ed3t i
mes
andpr oj ectBi sr epeat ed5t imesbecauset hel eastcommonf actorfort het wopr ojectl i
ves
(i.
e.3and5)i s15y ear s.
1. Equi val entAnnual Annui ty( EAA)Met hod:
Thismet hodenabl esust ocal cul at etheannualpay ment sapr ojectwoul dpr ovidei fitwer e
anannui ty .Whencompar ingpr oject sofunequall ives,theonewi t
hhi gherequi valentannual
annui tyshoul dbechosen.Thr eest epsar ef lowedundert hismet hod.
Step1: Fi ndeachpr oject ’
sNPVov eritsini t
ial lif
e.TheNPVf ortheabov epr oj
ect sar eas
follows:
Pr ojectA=9573bi rr( ascomput edbef ore)
Pr ojectB=( 12, 000)( 0.909)+( 14, 000)( 0.826)+( 13,000)( 0.751)–30, 000
=32, 235–30, 000=2, 235bi r
r
Step2: Fi ndt heequi v alentannualannui tyt hathast hesamepr esentv alueast hepr ojects’
NPV.
Equi valentannual annui t
ycanbecal cul atedasf oll
ows.
Forpr ojectA:
NPV=pvofcashf lows–pvofi nitial outlay s.
9573=pvofcashf l
ows–40, 000
9, 573+40, 000=PVofcashf lows
PVofcashf lows=49, 573.Byl ooki ngupi nt hepr esentv alueofannui tyt ableatn=6and
I=10%,t hedi scountf act ori s4, 355.Asy ouknowpvofcashf l
ows=cashf lowsx Di scount
factor .49, 573=( 4. 355)( x)wher exi stheequi v alentannual annui t
y.
X=49, 573/ 4.355=11, 383bi rr
Forpr ojectB:
NPV=pvofcashf lows–pvofi ni
tialoutl ay s
2, 235=pvofcashf l
ows–30, 000
pvofcashf lows=2, 235+30, 000=32, 235
Byl ooki ngupi nt hepr esentv al ueofannui tyt abl ef orthedi scountf actort hatcor respondst o
n=6andI =10%i s2. 487.Hence
(y
)=32, 235wher eyr epr esent st heequi valentannualannui tyamountf ort hepr oject.
Solv i
ngf oryweget .
Y=32, 235/ 2.487=12, 961bi rr
Step3: Thepr ojectwi tht hehi gherequi valentannualannui tywi l
lalway shav et hehi gher
NPV
whenext endedoutt oanycommonl ife.Ther efor e,projectB’ Sequi valentannual
annui ty
(EAA)i sl ar gert hanpr ojectA’ S,pr ojectBwoul dechosen.
2. AbandonmentVal ueAppr oach.
This appr oach pr esumes t hat t he l arger -
liv ed i nvest ment al t
ernat i
vei s pr emat urel
y
termi nat edatt heendoft hel ifeoft heshor terpr ojectal ternat iv
e.Thi spr esumpt ionr equires

127
ust oest imat eanabandonmentv aluef orl ong- l
iv edi nv est mentatt heendoft hel if
eoft he
shor terpr ojectal t
er nat ive. Assumet heabov eexampl eandt heest imat edabandonment
valueof5, 000bi rrf orpr ojectAatt heendofy ear3, whi chi st heendoft hel ifeofpr ojectB.
Then, comput et heNPVf orbot hpr oject satt her equi redr ateofr etur nof10per cent .Hence,
TheNPVf orpr ojectAi fitabandonedatt heendofy ear3i s:
NPV=( 10, 000)( 0.909)+( 12,000)( 0.826)+( 30,000)( 0.751) -
(40, 000) .Her et hecahsf lowof30, 000bi rrconsi der edf ory ear3i st hesum oft hecash
fl
owdur ingt hey earf rom pr ojectA( i.e25, 000)andt heabandonmentv alueoft hepr oj ectof
5000bi rr.
TheNPVf orpr ojectA=41, 532–40, 000=1, 532bi rr.
TheNPVf orpr ojectB=( 12, 000)( 0.909)+914, 000)( 0.826)+( 13, 000)
(
0. 751)–30, 000=32, 235–30, 000
=2, 235bi rr
Accor dingt ot heabov eanal ysis, t
her ef ore,pr ojectBi sbet t
ert hanpr ojectA.
Capi t
al Rat ioning
Capi talr at i
onali sasi tuat i
oni nwhi chaconst rainti spl acedont het otalsi zeoft hef i
rm’s
capi talbudget . Capi talr ati
oni ssai dt o exi stwhenwehav epr ofitable( posi tiv
eNPV)
i
nv est ment sav ai l
abl ebutwecan’ tgett heneededf indt oundert akeal loft hem.Twomai n
reasonscanbement ioned.Onei swhati scal l
edsof tr ationingwhi chi st hesi tuationt hat
occur swhenuni tsar eal locat edacer t
ainamountoff inanci ngf orcapi talbudget i
ng.Such
allocat ioni spr imar il
yameansofcont rolli
ngandkeepi ngt r
ackofov er al
lspendi ng.Sof t
rationi ngdoesn’ tmeant hatt hebusi nessf irm asawhol ei snotshor tofcapi tal.Theot her
reasoni shar dr ationi ng.Har dr ati
oni ngi st hesi tuat iont hatoccur swhenabusi nesscannot
raisingf inanceorf undsf orapr ojectunderanyci rcumst ances.Abusi nessf i
rm wi thasound
fi
nanci al statusdoesnotf acehar dr at i
oni ng.
Consi dert hef ollowi ngassumpt i
ons:
1.Thet imi ngandmagni t
udeoft hecashf lowsofal l pr ojects( all projectal t
er nat i
v es)are
known.
2.Thecostofcapi tal isknown
3.Al lproject sar est r i
ct l
yi ndependent
4.Thet otali nv est mentout layofal lthosepr oject st hathav eaposi t
iv eNPVexceedst he
firm’sbudgetconst raints.
Taki ngt heseassumpt ionsi ntoaccount ,thepr obl em undercapi talr at i
oni ngi sast ohowt o
chooseasubsetofdesi rablepr oj ect sinsuchawayt hatt otali nvest mentdoesnotexceed
thebudget ..Inor dert osol vet hispr oblem, thesoundpr ocedur esar easf oll
ows:
1.Rankal lpr oject swi thposi ti
v eNPVsi naccor dancewi tht heirpr of i
tabi l
ityi ndeed.
2.Sel ectpr oject sf rom t het opoft hel ist( wi tht hehi ghestpr ofitabi l
it
yi ndex)unt i
lthe
fixedbudgetar eexhaust ed.
Toi l
lust ratehow t osel ectpr ojectal ternat i
v eswhent hecompanyhasal imi tedcapi tal
amount( i.
e.whent her ei scapi t
alr ationing)supposet hataf i
rm hasaf ixedcapi talbudgetof
600, 000bi rrandhast hef ol l
owi ngi nv estmental ter nat ives.
Pr oject Initial I
nv est ment NPV Prof i
tabi li
tyI ndex
A 150, 000 40, 000 1.50
B 190, 000 40, 000 1.40
C 120, 000 70, 000 1.80
D 180, 000 50, 000 1.30
E 330, 000 60, 000 2.00
Thequest ioni st hatwhi choft hesepr ojectsshoul dt hef i
rm sel ectandi mpl ementgi vethe
fi
xedamountofcapi tal budgeti ndi cat edabov e?

128
Toanswert hi squest ion,f irstwehav et or ankt hesepr ojectbasedont hev alueoft hei r
profitabi l
ityi ndex.Hence, thei rar rangementaccor di ngt ot hei rpr of i
t abili
t yi ndexi sF- C- A- B-D.
Thisi st omeant hatpr ojectFi swi t ht hehi ghestpr of it
abi li
t yi ndexandpr oj ectDi swi tht he
l
owestpr ofitabi li
tyi ndex. Ther ef ore,gi vent hecapi t
albudgeconst raintof600, 000bi rr,
project sF, CandAar esel ect ed.Thei niti
alcapi talr equi rement sf ort hesepr oject sar et he
sum oft hei nitiali nv est mentcost soft hesepr oject sF, CandAar esel ect ed. Thei nitial
capitalr equi rementf ort hesepr oject si s600, 000.( i
.e.330, 000+ 120, 000+ 150, 000=
600,000) .Sot het otal initialinv est mentcostoft het hreepr oj ect si sexact lyequal tot het ot al
capitalbudgetoft hef ir
m.Thi si mpl iest hatt her estoft hepr oj ectal ter nat ivescannotbe
i
mpl ement edbecauseoft hel ackofcapi talt hought heyar eal laccept abl eones.Thet ot al
netpr esentv alue( NPV)oft hepr oj ect st hatwer esel ect edi s60, 000bi rr+70, 000bi rr+
40,000bi rr=170, 000bi rr.
Capi tal Budget i
ngUnderRi sk
Upt ot hispoi nt ,wehav ei gnor edr i
ski ncapi talbudget ing;t hati swehav edi scount ed
expect edcashf l
owsbackt ot hei rpr esentv aluesandi gnor edanyuncer taint yt hatmi ght
surroundt heexpect edcashf l
ows. I nr eal i
ty ,thef uturecashf lowsassoci at edwi tht he
i
nt r
oduct i
onofanew sal esout l
etoranew pr oductar eest imat esofwhati sexpect edt o
happeni nt hef ut ure,notnecessar ilywhatwi llhappeni nt hef ut ure.But ,t hesecashf lows
discount edt ot hei rpr esentv alueshav eonl ybeenourbestest i
mat eoft heexpect edcash
fl
ows.
Inthissect ion, wewi llassumet hatundercondi ti
onsofr i
skwedon’ tknowbef orehandwhat
cashf lowswi llact ual l
yr esul tf rom t henew pr oj ect . Howev er ,wedohav eexpect ations
concer ningt heoutcomesandar eabl etoassi gnpr obabi li
t i
est ot heseout comes.St aledi n
anot herway ,al thoughwedonotknowt heexactcashf lowsr esul tingf rom t heaccept anceof
anew pr oject ,wecanf ormul atet hepr obabi li
tydi stribut i
onsf rom whi cht hef lowswi llbe
drawn.Ri sk, her e, isdef inedast hepot ent i
al variabi l
ityi nthef utur ecashf lows.
Rel ev antRi sksi nCapi tal Budget ing
Incapi talbudget ing,apr oject ’sr iskcanbel ookedati nt hr eel ev els.Fi r st,t her ei sat ot al
projectr i
sk, whi chi sapr oject ’sr iski gnor ingt hef actt hatmuchoft hisr iskwi l
lbedi v er sified
awayast hepr ojecti scombi nedwi t
ht hef irm’ sot herpr oject sandr isks.Second,wehav e
the pr oj ect ’
s cont r
ibut i
on t of irm’ sr i
sk,whi ch i st he amountofr i
sk t hatt he pr oj ect
contr i
but est ot hef i
rm asawhol e; thismeasur econsi derst hef actt hatsomeoft hepr oj ect ’
s
ri
skswi llbedi v ersifiedawayast hepr ojecti scombi nedwi tht hef ir
m’ sot herpr oject sand
asset s,buti gnor est heef fect sofdi ver si
f i
cat ionoft hef irm’ sshar ehol der s.Fi nal l
y,t her ei s
whati sknownasasy stemat icr isk, whi cht her i
skoft hepr oj ectf rom t hev i
ewpoi ntofawel l
diversifiedshar ehol der ;thismeasur econsi der st hef actt hatsomeoft hepr oject ’
sr iskwi l
l be
diversifiedawayast hepr ojecti scombi nedwi t
ht hef ir
m’ sot herpr oj ect s,andi naddi tion
someoft her emai ningr i
skwi llbedi versifiedawaybyshar ehol der sast heycombi net his
stockwi thot herst ocksi nt hepor tfolio.
Ri sk, Ret urnandNetPr esentVal ue
When a f inanci almangeri s consi dering a setofr isky al ter nat i
v es,one i mpor tant
consi der at i
oni nv olvest hechoi ceoft her equi redr ateofr et ur n. Gi vent her iskav ersi on
natur eofmanger s,t her equi r edr ateofr etur nofeachpr ojecti st hef unct i
onofi tsr isk.The
ri
skiert hepr oject , thehi ghert her equi redr at eofr etur ni s.
Select i
ngt heappr opr iater equi redr at eofr etur ni nv olvessubj ect ivej udgment s.Gi v ent he
gener alpat ternsofmanager ialr i
skav ersion,whi chshowst hedi rectr elat i
onshi pbet ween
ri
skandr etur n, thef ollowi nggui del inescanbeest abl i
shed.
1.Thecoef f i
cientofv ariat i
oncanbeusedast hemeasur eofr iskperbi rrofr et ur n.As
such, itcanbeusedt or ankt her i
skynessofpr obabi lit
ydi st ribut i
onsofcashv al ues.

129
 2.Ther equi redr at eofr et urncanbesett ot hesum oft her isk-freer atepl ussome
additional retur nt ocompensat ef orr i
sk.
TheRi skAdj ust edNetPr esentVal ue( RANPV) :
Ther iskadj ust ednetpr esentv alue( RANPV)ser viceasacapi talbudget i
ngdeci sioncr i
teri
on
undercondi tionsofr i
skandi sdef i
nedast hesum oft hepr esentv aluesoft heexpect edcash
valuesdi scount edatt her equi r
edr at eofr et urn.
TheRANPVcoef ficientt hati sposi tiveorzer oi ndicatest hatt hepr oj ectear nsatl eastt he
ri
skadj ust edr equi redr ateofr et urnandt hatadopt i
ngsuchapr ojectcani ncreaset hev alue
ofthef irm andt hust heshar ehol der s’ weal th.
Whenar i
skyi nv est menti st obeev aluatedonanacceptorr ejectbasi s, theRANPVcr i
teri
on
providest hef oll
owi ngdeci sionr ule:Acceptt her i
skypr ojecti fitsRANPVi sposi ti
veorzer o;
rej
ecti tifthepr oject ’sRANPVi snegat ive.
Toi l
lustratehowt oev aluat eapr ojectunderacondi t
ionofr isk( i.e.whent hecashf lowsar e
notcer tainlyknowr athergi venpr obabi lit
ydi stribut i
onsunderdi f
f erentst ateoft heeconomy )
supposear iskypr oj ectt hathasal ifeoff oury ear s.
Theest i
mat edr iskadj ust edr ateofr eturni s10per cent.Thei nitialinv est mentoft hepr oject
i
s29, 000bi rr
Year St ateofEconomy Cashf low Pr obabi li
ty
1 Boom 12,000 0.20
Av erage 10,000 0.50
Recessi on 7,000 0.30
2 Boom 18,000 0.10
Av erage 15,000 0.50
Recessi on 13,000 0.40
3 Boom 15,000 0.30
Av erage 14,000 0.40
Recessi on 12,000 0.30
4 Boom 19,000 0.30
Av erage 16,000 0.50
Recessi on 14,000 0.20
Comput et hepay backper iodf ort hisr i
skypr oj ect. Whati st heRANPV oft hepr oject ?
Comput et heI RRoft hepr oject .Cal culatet hepr of i
tabili
tyi ndexoft hepr oj
ect.Bef orewe
answereachoneoft hequest ions, letuscomput edt heexpect edcashf l
owsf oreachy earof
thepr ojectlifeasf ollows:
Year1: (12,000)( 0.20)+( 10, 000)( 0.50)+( 7,000)( 0.30)=9, 500bi rr
Year2: (18,000)( 0.10)+( 15, 000)( 0.50)+( 13,000)( 0.
40)=14, 500bi rr
Year3: (15,000)( 0.30)+( 14, 000)( 0.40)+( 12,000)( 0.
30)=13, 700bi rr
Year4: (19,000)( 0.30)+( 16, 000)( 0.50)+( 14,000)( 0.
20)=16, 500bi rr
Usingt heseexpect edcashf lowsf ort hepr oject ,thepay backper i
odcanbecomput edas
fol
lows:
Year Expect edCashf l
ow Cumul ativecashf lows
1 9,500 9,
500
2 14, 500 24,000
3 13, 700 37,700
4 16, 500 54,200
Thepay backper iodf ort hispr oj ecti sl ongert han2y earsandshor tert han3y earsbecause
theinitialinv estmentof29, 000bi rrisgr eat ert hant hecumul ativ ecashf lowsatt heendof
year2of24, 000bi r randl esst hant hecumul at i
v ecashf lowsatt heendofy ear3.Ift hecash
fl
owsar eex pect edt ooccuronl yatt heendofy ear s,thepay backper iodoft hepr oj
ectwi l
lbe

130
3y ear s.Thi sbecauset heamountoft hei nitiali nv est mentnotpai dbackatt heendofy ear2
(i
.e.29, 000bi rrless24, 000bi rrwhi chi s5, 000bi r
r)wi llnotpai dbackt i
l
ltheendofy ear3.On
theot herhand,i ft heexpect edcashf l
owsoccuruni f
or ml yt hroughoutt hey ear ,thepay back
per i
odwi llbebet ween2y earand3y ear s.Theexactpay backper i
odiscomput edasf ollows.
Pay backper iod=2y ear s+Amountofi ni ti
al inv est mentnotpai dback
Expect edcashf lowdur ingy ear3
=2y ear s+5, 000 y ear s
13, 700
=2y ear s+0. 36y ear s=2. 36y ear s, or
2y ear s+( 0. 36)( 12mont hs)=2y ear sand4mont hs
TheRi skadj ust edNetpr esentv alue( RANPV)oft hepr oj ectcanbecomput edbyusi ngt he
expect edcashf lowsdet er mi nedabov e.Theseexpect edcashf lowsar edi scount edatt he
ri
skadj ust eddi scount ingr at eof10per cent .Thei niti
ali nv estmentamounti ssubt ract ed
from t hesum oft hedi scount edexpect edcashf lowsanddi fferenceiswhati sknowast he
ri
skadj ustednetpr esentv alue( RANPV) .
RANPV=( 9500)( 0. 909)+( 14, 500)( 0.826)+( 13,700)( 0.751)+
(16, 500)( 0.683)–29, 000=8, 635. 50+11, 977+10, 288.70
+11, 269. 50–29, 000=42, 170. 70–29, 000=13, 170. 70
TheI RRoft hispr ojecti sdet er mi nedt hr oughani terat i
vepr ocessbecauset heexpectcash
fl
owsar enoti nanannui tyf or m. Toi dent ifyt hest artingpoi nt,weassi gnawei ght,t he
highestwei ghtt ot hecashf lowsoft hef irsty earandt hel owestwei ghttot hecashf lowsof
thel asty eari nt hepr oj ectl ife.
Year Expect edcashf l
owsWei ght Expect edcashf l
owXwei ght
1 9, 500 4 38, 000
2 14, 500 3 43, 500
3 13, 700 2 27, 400
4 16, 500 1 16, 500
10 125, 000
Thewei ght edav er agecashf lows=125, 400/ 10=12, 540
Theest imat eddi scountact or =29, 000
12, 540
Theest imat eddi scountf act orof2. 313i sneart ot hepr esentv alueofannui tytablev alueof
2.320whi chi sf oundi nt he26per centcol umni ny ear4r ow.Hence,t hef irstguessi s26
per cent .
TheRANPVusi ng26per centast her i
skadj ust eddi scount ingf actor:
(9,500)( 0.794)+( 14,500)( 0.630)+( 13, 700)( 0. 500)+( 16, 500)( 0.397)
–29, 000=7, 543+9, 135+6, 850+6, 550. 50–29, 000
=30, 078. 50–29, 000=1, 078. 50bi r r
.
Sincet heRANPVusi ngadi scountr at eof29per centi sal ar geposi ti
ve,wehav etot ryl arger
discountr at es.Secondguess:Letust ry2per centbecauset heNPVcor respondi ngt o26
per centi sf arf rom zer o.Hence,i tseemsr easonabl et oconsi der29per centt han27or28
per cent .
RANPV( 29%)=( 9,500)( 0.775)+( 14, 500)( 0.601)+( 13700)( 0.446)
+( 16, 500)( 0361)–29, 000=7, 362. 50+8, 714. 50
+( 6384. 20+5956. 50–29, 000=28, 417. 70–29, 000
=- 582. 30bi rr
Sincet heNetpr esentv al ueatadi scountr at eof29per centi snegat ive,t heI RRf ort his
proj ectmustbel esst han29per centandgr eat ert han26per cent .Therefore, theint eractive
processcont inues.Thet hi r
dguesscanbeei ther27per centor28per centlett het hirdguess

131
be28per cent .
RANPV( 28%)=( 9500)( 0. 781)+( 14,500)( 0.610)+( 13, 700)( 0. 477)
+( 16, 500)( 0.373)–29, 000=7, 419. 50+8845+6534. 90+6, 154. 50–29, 000=
28, 953. 90–29, 000=- 46. 10bi rr
StilltheNPVoft hepr ojecti snegat i
veatt hedi scountr ateof28per cent ,whi chi mpl i
est hat
theI RRi sbet ween28per centand26per cent .Ther ei sadi fferenceof2per centbet ween
theset woper cent ages.Hence, theI RRoft hispr ojectcanbecomput edasf ollows.
Thesum oft heabsol utesum oft heRANPVof
thet wor at esi s=/ 1078. 50/+/ -46. 20/=1, 124. 60
IRR=26%+2( 1078. 50)%=26%+2( 0.959)%
1,124. 60 =26%+1. 92%
=27. 92%
or,wecanmaket hef our thguess,t hati s27% andcomput eRANPV usi ng27% ast he
discountr at e.Thati s:
RANPV ( 27%)=( 9, 500)( 0.787)+( 14500)( 0.620)+( 13, 700)( 0. 488)+( 16500)( 0.
384)–
29,000=7, 476. 50+8990+6685. 60+6336–29, 000=29, 488. 10–29, 000=488. 10bi rr
Ther efore, IRRoft hispr ojecti sbet ween27per cent sand28per centbecausewhenwemov e
from 27per cent st o28per cent ,theNPVmov esf rom posi tive488. 10t onegat ive46. 10.Thi s
i
mpl iest hatatsomepoi ntbet ween27per centand28per cent ,t heNPVt ouchedupont he
valueofzer ot hati st heI RRoft hepr oj ect.I nor dert odet er mi net heexactI RR,wemayuse
thef oll
owi ngst eps.
Step1: obt aint heabsol utesum oft henetpr esentv alues.
Theabsol utesum =/ -46. 10/+/ 488. 10/=534. 20
Step2:Di videt heRANPVoft hesmal lerr atebyt heabsol ut esum andaddt hequot i
enttot he
smal l
err ateordi videdt heRANPV oft hel ar gerr at ebyt heabsol utesum and
subt ractt hequot ientf rom t hel argerr ate.
IRR=27%+488. 10% or28%-46. 1%
534. 20 534. 20
=27%+0. 91%or28%-0. 09%=27. 91%
Chapt ersummar y
Capi talbudgeti sasetofi nv est mental ternat ivest her etur nsofwhi choccurov eraper iodof
twoormor ey ear s.Capi talbudget ingi st hepr ocessofgener at ingcapi talbudget ,andt his
processconsi stsofsev er aldi fferentt ypesofpr ocedur es. Thet hr eemostwi del
yused
capi talbudget ingcr iteriaar e1)t hepay backper iod,2)t henetpr esentv al ue,and3)t he
i
nt ernalr ateofr etur n.Eachoft hesecr i
ter i
ahasi tsadv ant agesanddi sadv ant ages.Ev en
thoughNPVi st hemostconcept ual lydi fficultoft het hr eecr iteria,i ti st hepr eferr
edon
becausei tt akesi ntoaccountt het imev alueofmoneyandi ti smeasur edi nbirramount
unliket hepay backper i
odwhi chi smeasur edi ny ear sandt heI RRwhi chi smeasur edi n
termsofr ate.
The pay back per iod,NPV,and I RR capi talbudget ing cr iteria can be used i n maki ng
accept /reject ,r epl acement ,mut uallyexcl usi ve,andcapi talr at ioni ngi nvest mentdeci sions.
Eachoneoft hisi nv est mentdeci sionshasi tsowndeci sionr ul es.
Thepay backcr i
ter i
oni sincl udedamongdeci si onr ulesbecausei tcont i
nuest obeusedi n
i
nv est mentdeci sions.Howev er ,sincepay backdoesnotmeasur epr of itsort het imev alueof
moneyi tcannotber eli
edupont opr oducecapi talbudget st hatmaxi mi zet hef i
nanci al
wel fareoft heowner sofabusi nessf irm.
NPV and I RR deci sion r ules pr oduces i dent icaland cor rect r esul t
s when maki ng
accept /rejectandr epl acementdeci sions.Butwheni nv est mental ter nativesar eev al
uat ed
wi t
hi n a mut uallyexcl usi vef ramewor kt he NPV and I RR deci sion r ules can pr oduce

132
conf l
ict i
ng r ankings. Whenconf l
ict
ing r anki ngsdo occur ,deci si onshoul d bemadei n
accor dancewi t
ht her esul toft heNPVcr iterion.
Thepr esenceofacapi talconst raintshi ftst heemphasi sf r
om al ternat iveswi t hinagi ven
projectt ot hecont r
ibut ionofshar eholder sweal thmadebyt heent i
recapi talbudget .The
decisi onr uleusedf orcapi tal-r
at i
oningsi tuationssel ectsthef easi blesetofi nvestment
alt
er nat ivesthatpr omi sest hel argesttot al NPVsubj ectt othecapi t
al const raint.
Capi talbudget ing undercondi tion ofr isk is concer ned wi tht he ev aluat i
on ofcapi tal
budget ingal ter
nat i
veswhent heneti nv estment soft hepr oj
ect sandt hesubsequentcash
fl
owsf rom t hesepr oj ect sar eknownonl ytot heext entoft heirpr obabi l
itydi stribut i
on.The
probabi li
tydistri
but i
onshowst heexpect edcashf lowsandi ni
tial i
nv estment sunderdi fferent
statesoft heeconomy .Ri skypr oject
sshoul dbeev al
uat edbyt akingt hei rr isksandr eturns
i
nt oaccount .I npr i
nci ple,t hepr ojectt hatexposest hebusi nessf irmt ohi gherr iskshoul d
gener at ehi gherr eturnsi nor dert obeaccept able. Inor dert odev elopcapi talbudget ing
cri
ter i
af orriskypr oj
ect s, fi
nanci almanager sar eassumedt ober i
skav erts.Thi si st omean
thatf inanci almanager sdonotwantt ot akeanyr i
skswi thpr ojects.I ft heyar et ot aker i
sk,
thepr oject sshoul dbet heki ndsofpr oject st hatarecapabl eofgener atinghi gherr eturns,
whichi smor ethanof fset tingt her i
skstobeassumed.

CHAPTER–6
Longt
ermfi
nanci
ng

LEVERAGE,
OPERATI
NG,FI
NANCIALANDCOMBI
NED
THECONCEPTOFLEVERAGE:

Thel ev erageconcepti sv erygener al.I tisnotl i

mi tedt of i
nance,orbusi ness,ingener al
.I t
canbeusedt oanal y zedi f f
er entt ypesofpr oblems.Fori nst ance,ot herdi sci
pli
nes,suchas
economi csandengi neer inguset hesameconcepti nt reat ing/anal yzingpr oblemsr elatedto
theirspeci ficar eas. I neconomi cs,l everagei sr ef erredt oasel ast i
city. Whenusedi n
fi
nanci alset ting, l
ev er agemeasur est hebehav i
orofi nterrelat edv ar i
abl es, suchasuni tssold,
salesr evenue, ear ningsbef or einterestandt axes(EBI T),andear ningspershar e(EPS) .
Themat eri
ali nt hischapt erwi llbeeasi l
yunder stoodi fy oukeept wopoi ntsiny ourmi nd.
Thesear e:
1.Lev erage measur es t he r elationship bet ween t wo v ar i
abl es,as opposed t o
measur i
ngv ar iablesi ndependent l
y.Thev alueofonev ariablemustdependont he
valueoft hesecondv ariable.
2.I nor derf ort hel ev er agecoef f
icientstohav eusef ulappl i
cat i
ony ouhav etobeabl e
toident i
fywhi chv ariablei st hedependv ariabl eandwhi chi sindependent .I nother
wor ds,t hecause- ef fectr elationshipbet weent hev ari
abl esmustbeknown.When
twov ariabl ear erel atedoneascauseandt heot herasef fectt hedegr eeofl everage
descr ibes t he r esponsi veness oft he dependentv ar iablet o changes i nt he
i
ndependentv ari
abl e.
LeverageDef ined:
Consi dert hatY and X r epresentt wo v ari
ables.When t he v alues t aken by Y ar e
determi ned/ inf l
uencedbyt hev aluest akenbyX,t heny oucansayt hatYdependsonX.
Accor dingly,Yi st hedependentv ar i
abl eandXi st hei ndependentv ariable.Theal gebr ai
c
statementoft hedependenceofYonXi s.Wr it
tenas:

133
 Y = F(
X),andreadas" y "i
st hefunct
ionof"x".
Supposethaty ouknowthei ni
tialvaluesofXandY.Thei ndependentv ari
ableXnowt akes
onanew v alue.Theny oucomput et hechangei nt hevalueXandi tsper centagechange.
Basedont his,youcanalsodet erminet heresult
ingchangeandt hepercentagechangei nthe
dependentv ari
able,Y.Leveragei sthendef inedasthepercentagechangei nt hedependent
vari
abl
e( i
.e.Y)di vi
dedbytheper centagechangei ntheindependentvariabl
e, X.Inalgebrai
c
ter
ms, t
hedef i
nit
ionofl
everagei sdev elopedasf oll
ows.
Suppose:

Toi ll
ustrate,thesal
esofHadaasTr adingdepend,amongother,thingsonthesizeoft he
company '
sbudgetallott
edf oradvert
isement.Supposet hecompanyspends10, 000Bir
ron
adverti
sing( t
heindependentv ar
iabl
eandsel l
s400uni t
sofoutput(thedependentvari
able)
.
Duringthenextt i
me,thebudgetal l
ottedtoadverti
sementwil
lincreaset o100,
000Bir
rand
thecompanyexpect sthev olumeofsal esof500uni t
s.Whati sthel ev
erageofsaleswith
respecttothebudgetf oradverti
sement .

Toanswert hequesti
on,youuset heabov el ever
ageequat ion.Thechangeintheadverti
sing
budgetis1000Birr(i
.e. =11,000-10,000),andt heper cent
agechangeofadv erti
sing
budget(i
.e.% )is1000/ 10,
000/ whihi s10per cent.Thechangei nuni
t ssol
di s100
uni
ts(i.
e. =500-400),andtheper centagechangei nunitssol
d(i
.e.% )is100/400,
which i
s25 per cent
. Bysubst i
tuti
ng t heseper centagesofchangesi ntot helever
age
equati
on,yougetthecoeffi
cientofleverageof2.5.Thati s:

Thel
ever
agecoef
fici
entof2.
5meansthatt
heresul
ti
ngper
centageinnumberofuni
tssol
dis
2.
5ti
mesgreat
erthantheper
cent
agechangei
ntheadver
ti
singbudget.

Lever
ageinFinancial Sett
ing
Incomest atementandbalancesheetpr ov
idet hev ariabl
esandt hefuncti
onalrelat
ionships
amongt hesevari
ables. Thesev ari
abl
esandr elationshipsar emor eexpl ai
nedbyusi ng
l
ev er
ageasat ooloff i
nancialanal
ysi
s.Thef unctionalrelat
ionshipsaremadeexpl ici
tby
expressi
ngt heincomest atementinalgebrai
ct erms. Youcanusesy mbol storepresent
i
ncome st atementitems/accounts,and wr i
tet he relati
onships among t he accountsi n
symbolicform.

134
The al gebr aicequi v
al entofan i ncome st atementcan be qui te compl icated when t he
companymar ketssev eralproduct s.Forpur poseofsi mplicity,
thef ol l
owingassumpt ionsar e
madeconcer ni
ngt heout put ,pr oduct i
oncost s,f inancingcost sandf ederalincomet axes
paid.
1.Thecompanypr oducesonl yonepr oductandsel lsitf oraconst antpr i
ce. ( Al
l
out putissold, soout putequal ssales) .
2.Pr oducti
onandoper ationcost sconsi stofav ariablecostperuni tofout putanda
fixedcosti ncur r
edov ert heaccount ingper iod.
3.Thecompanypay st heamountofi nter estr equiredonanyoutsandi ngdebt .
4.Thecompanypay sdi videndonpr eferredst ockoutst andi ng.
5.Company 'si ncomet axr ateisassumed40per centoft axablei ncome,unl ess
st at
edt obedi f
ferent .
Ofal lexpensesr eportedi nt hei ncomest atement ,someoft hem suchasr ents,util
it
ies,and
somesal ar yandmai ntenanceexpenses,ar eessent i
allyfixedov ert heaccount i
ngper iod.
Othercost s,suchascost sofpur chasesandwages,t endt ov arywi ththel evelofout put.
Somecost s,cal l
edsemiv ar iablecost s hav ebot h f i
xedandv ar i
ablecomponent s. For
exampl e,ov ert
imepay rollexpensesandaddi tionalr epairandmai ntenancecost smaybe
i
ncur redwhent helevelofpr oduct i
onappr oachespl antcapaci ty
.t hemostcommonwayof
reportingsemiv ari
ablecost si nt hei ncomest atementi stsepar at ethe fixedandv ar
iable
component sandaddedt ot hef ixedandv ariabl eexpenseaccount s.Interestexpenseand
preferredst ockdi vi
dendsar econsi deredtobef ixedf inancingcost sreport
edi ntheincome
statement . Al thoughi nterestmustbepai dwhendue,t hepay mentofpr eferr
edst ock
divi
dendsi snotal egal r
equirement .
Operat
ingLev erage:

Operatingl
everagemeasur esther el
ati
onshipbet weenout putandear ningsbeforei nt
erest
andt axes(EBIT). Morespeci fically
,operati
ngl ev eragemeasur estheef f
ectofchangi ng
l
evelsofout putonEBI T. Hence,ahi ghdegr eeofoper atingl everage,otherthingshel d
constant,meanst hatar elat
ivelysmal lchangei nsal eswi llr esulti
nal argechangei n
operati
ngincome( EBIT).Thef unct i
onalrel
ati
onshi pbet weent heset wov ari
ablesis:
Y =F( T),whichmeansear ni
ngsbeforeint erestandt axes( EBI
T)dependsupont he
numberofuni tsproducedandsol d.Whent helev elofout putchangef rom itsinit
ialval
ue,
theinit
ialval
ueofEBI Talsochanges. Thus,oper atinglever ageisdef i
nedasar esult
ing
percentagechangei nEBI T dividendbyt heper cent agechangei nout put. Sy mboli
cally
,
operati
nglever
agei sexpressedas:

Toill
ust r
ate,assumet hatthepr i
ceperuni tofout put(P)is10Bi rr
,thev ar
iablecostperunit
ofoutput( V)is4Bi rr
,thefixedcost( F)is30,000Bi rr,
andt helevelofoutput(T)is8000nits.
Now assume f urthert hatt he l
ev elofout puti ncreasest o 10,000 units. Whati sthe
coeff
icientofoperat i
ngleveragef orthiscase?
Befor
ecomput i
ngt hecoef fi
cientofoper ati
ngl everage,youhav et ocomput eEBITat8000
uni
tsand10, 000unitslevelofout put.Ingeneral,
EBIT =sal es-v ari
ablecost-Fi xedcosts
EBIT =( T)( P)-(T)(V)-F.Ther ef
ore,
EBITat8000uni tsoutputlevel = (8000)(10)-(8000)( 4)-30,
000
= 80,000-32,000-30, 000

135
 = 80,000-62,000
= 18,000Birr
,and
EBI
Tat10, 000uni
tsoutputl
evel= (10,000)(10)-(
10,000)(4)-30,000
= 100,000-40,000-30,000
= 30,000Birr
Usi
ng theabov ealgebr
aicequati
onf oroper
ating lev
erage,thecoef f
ici
entofoper
ati
ng
l
ever
ageiscomput edasfol
lows:
Percent
agechangeinoutput = % =25%

Per
cent
agechangei
nEBI
T= % = 66.
7%

Then = 2.
67

Thecoef fi
cientofoperat
ingleverageof2.67isinterpret
edasf ol
lows: A 1per cent
age
changeinout putfr
om anini
ti
alvalueof8,
000uni
tsproducesa2. 67percentchangeinEBIT.
Sinceoutputincreasedby25per centf
rom i
tsi
nit
ialvalueof8000units,EBITincr
easesby
(0.25)(
2.67)equalto66.
7percent.

Theaboveequati
oni sthedefini
ti
onalequati
onf oroperati
ngleverage.Youneedt ousea
measurementequati
ont hati
sequival
enttot hedefini
ti
onalequati
onf ortheexpl
anat
ionof
thepr
opert
iesofoperat
inglev
erage.Wesai dthat,EBIT=Y=( T)(P)-(T)(V)-F
=T(P-V)-F
Hence,t
hemeasurementequat i
onforoperat
ingleverageis:

Theleft-
handsideofthi
sequati
onisreadas:oper
ati
ngl ever
agegi ventheval
ueofoutput
.
Bytakingthedataoftheprevi
ousexampleandputti
ngt hem intotheabovemeasurement
equat
ion,yougetthesamecoeff
ici
entofoper
ati
ngl
everageof2. 67.Thatis:

Ournextdi scussionsont heoper ati

ngl ever agecent eraroundt hi
smeasur ementequat ionof
theoper at i
ngl ever age.Thi smeasur ementequat ionf oroper at
ingleveragei scor rectonly
whenear ningsbef oreint erestandt axes( Y)i sequalt osalesrevenue, (
T)( P)mi nust hesum
variablecost s,( T)(V)andf ixedcost( F). Di f
ferentmeasur ementequat ionf oroper ati
ng
l
ev erageshoul dbeusedwhencompany '
scost sar enon-li
nearand/ orwhent hecompany
usesmul t i
plepr oductl ine.
Proper ti
esofOper at i
ngLev er age:
Thepr oper ti
esofoper atingl everagedet ermi neitsuseasat ooloffi
nanci alanal ysis.These
propertiesar ebestexpl ainedbyusi ngoper at i
ngbr eakev enandEBI T.Oper at i
ngbr eakevenis
definedast hel evelofout putt hatmakest hev alueofEBI Tequalt ozer o.Att hislevelof
outputt ot alsal esr evenue, (
T)( P)isjustsuf fici
entt opayoper ati
ngv ari
able( T)( V)andf i
xed
(F)cost s,andnoear ningsar eav ai
labl et ocov erf inanci
alcost s(i.
e.int erestexpenses) .
Whent hel evelofout putexceedsoper atingbr eakev en,thecompanygener at estot alrevenue
thatpr ovidest heposi t
ivel evelofEBI T.Ont heot herhand,t helevelofout putthati sbel ow
thebr eakev enl evel,companyi ncur
sanoper at
ingloss.I nanequat ionfor m,t heoper ati
ng

136
br
eakev
enisexpr
essedas:
(T)(P)=( T)(V)+F
(T)(
P)-(T)(V)-F=0
T(P-V)-F=0
T(P-V)=F,andsol
vi
ngf
orTy i
elds
T= F
(
P-V) whereT=levelofoutput
P=t
heselli
ngpriceperuni
tofoutput
V=t
hev ar
iabl
ecostperunitofoutput

Inordertoill
ustr
atetheoperati
ngbreakeven,assumethatShewaTr adingsell
si t
sproduct
for25Bir
r.Thev ari
ablecostperuni
tofoutputis10Bir
r.Thetotalf
ixedoper at
ingexpenses
duri
ngagi venreporti
ngperi
odequal60,000Bir
r.Atwhatlevelofout put(
inunits)doesthe
companyr eachesit
soperati
ngbreakev
en?
Theoperatingbreakeveniscal
culat
edbyusi ngtheaboveequati
onf oroperati
ngbreakeven
computati
on.Thati s
T =

T = = 4,
000uni
ts

Therefor
e,ShawaTr adingreportsearningsbeforeinter
estandtaxes(EBI
T)ofzer
oi fit
producesand sell
s4, 000 uni
tsofi tspr oduct
s. Ifoperat
ing l
ever
ageiscal
cul
ated at
operati
ngbreakev
en,thecoeffi
cientofoperati
nglev
eragewil
lbe:
(
OL/
T=4000) =

=undef
ined

Notethatthecoef
fi
cientofoperat
inglev
erageatthepoi
ntofoperat
ingl
everageisundef
ined,
notzero.
Usi
ngt hesamedat agivenforShawaTr adi
ng,t
hecoeffi
cientofoper
ati
ngl ev
erageatthe
fol
l
owingdi f
fer
entl
evelofoutputare:

137
Plot
ti
ngthesecoeffici
entsofoper
ati
ngl
ever
ageontheX-YplanewhereY-axi
srepr
esent
s
thecoef
fi
cientofoperat
ingl
ever
ageandX-
axi
srepr
esent
sthel
evelofout
put
s.
Y
3.0

2.
0

1.
67

1.0
0 X
-0.33% 2000 4000 6000 8000 10000
-1.0

-
2.0

-
3.0

Thegr aphf ort hecoef fi

cient sofoper atingl ever agef ort hel evelsofout putl esst hatt he
operati
ngbr eakev enof4000uni tsliesbel owt heX- axi
sbecauset hecoef ficientsofoper ating
l
everagear enegat i
v e.Thegr aphf ort hecoef f
icientsofoper at i
ngl ev eragef ort hel evelsof
outputgreat ert hant heoper at ingbr eakev en4000uni tsont heot herhand,l i
esabov et hex-
axi
sbecauseal l thecoef fi
cient sofoper atingl ever agear eposi ti
ve.
Thev ert
icalbr okenl ineispl ot tedatoper atingbr eakevenof4000uni tsandi tindi catest hat
operati
ngl ev eragei sundef inedatt hel evelofout put. Thehor izont albr okenl i
nedr awn
thr
ought hev alueof1. 0fory -axi si ndicatest hel imit
ingv alueofoper ati
ngl ev erage. f or
val
uesofout putgr eat erthanoper atingbr eakev enof4, 000uni ts,thecoef f
icientofoper ating
l
everagei sgr eat ert han1. 0, decr easingwi thincr easingleesofout putandappr oaches1. 0as
alimitbutnev ert ouch. t hisbecauset owhat ev eramountt hel ev elofout puti ncreases
beyondt heoper at i
ngbr eakev en,t hecoef fi
cientofoper ati
ngexpensecannotbeexact l
y
equalto1.0.
Whent hel ev elofout putisbel ow t heoper at i
ngbr eakev enof4000uni t
s,t hecoef fi
cientof
operati
ngl ever agehasanegat i
v ev alueandappr oacheszer oasout putgoest ozer o.Thus,
thecoefficientofoper ati
ngl ev eragecancl earlyi ndi
cat eswher et hev alueofout puti si n
rel
ati
ont heoper at ingbr eakev en.I ft hecoef fi
cientofoper ati
ngl everagei sasmal lnegat i
v e,

138
thelevelofout puti sv erysmal landfullf orbel inedt heoper atingbr eakeven. I fthe
coeffi
cientofoper ati
ngl ev erageisundefined, thelevelofout putcorrespondst ot hepoi ntof
operati
ngbr eakev en.Ifont heot herhand,t hecoef fici
entofoper atingleveragei sasmal l
posit
iveneart o1.0, t
hel evel ofoutputisverylar geandf arbey ondtheoper ati
ngbr eakev en.
Thev alueoft hecoef fi
cientofoper ati
nglev erageatv ari
ousl evel
sofout putdependont he
rel
ati
vemi xoff i
xedandv ariabl
ecost s.Theabov egr aphwasdr awnf orthecoef f
icientsof
operati
ng leveragecomput ed undert heassumpt i
on t hatt hesell
ing pr i
ceperuni t,the
vari
ablecostperuni t
,andt hef i
xedcostdur ingagi v
enper i
odar econstant.I fanyoneoral l
ofthev aluesoft hesev ari
abl eschange,oper ati
ngbr eakevenaswel last hecoef ficientsof
operati
ngl everagedochangeandanew setofoper ati
ngl ever
agesoccurov erdi ffer
ent
l
evelsofout put .Fort hespeci alcasesheerf i
xedcost sf orthecompanyequalz ero,the
coeffi
cientofoper ati
ngl ever ageequals1.0f oral ll
evelofout put.Thispr opertyofoper ati
ng
l
everagei sdemonst r
atedbyset tingF=0int hemeasur ementequat i
onf oroper at
ingl everage
i
ndicatedearlier.
(

Buti tisnotr eali

st i
ct ot hinkofbusi nessf i
rm wi t
houtf i
xedoper atingcost s.Thati swhyt he
coef fi
cientofoper ati
ngl ev eragecannotbe1. 0f oranyl evelofout put. Asl ongast he
companyi ncur ssomeamountoff i
xedoper atingcost s, thecoef fi
cientofoper atingl everage
cannotbe1. 0.
InterpretationofOper atingLev erage:
Ther ear ef undament alandr elatedi nterpretat i
onsf oroper ati
ngl everage. Al thought he
i
nter pretati
onoft hecoef ficient sofoper atingl everagei sast raightf orwar dandsi mpl et ask,
ther ear esi tuationswher et hei ral gebr aicsi gnsand/ orv al
uesofout putwi t
hr espectt o
oper ati
ngbr eakev enr equi readdedwhi leinterpr eti
ngt hem.
Fundament al Int
erpr etation:
Forgener alpur pose,y ou can i nt erpretany coef ficientofoper ating leverage as t he
per centagechangei nEBI Tt hatr esul tsfrom a1per centchangei nt hel evelofout put.
Toi l
lustratet hi
swayofi nterpr etation,assumet hatgener alMer chandi seSt oresel lsi t
s
productatasel li
ngpr iceperuni tof40Bi rrandt hev ar i
ablecostofsel li
ngthepr oductper
uniti s25Bi rr.Thef i
xedoper atingexpenseoft hedepar t
mentamount sto105, 000Bi rrper
mont h(ther eportingper iod) .Whati st heEBI Tandt hecoef ficientofoper at
ingl everageat
theout putl ev elof8000uni ts?
EBI T= Y = Tot al rev enue-v ariableoper ati
ngcost s-Fi xedoper atingcost s.
= ( T)( P)-( T)( V)-F
= ( 8000)( 40)-( 8000)( 25)-105, 000or
= 8000( 40- 25)-105, 000
= 8000( 15)-105, 000
= 120, 000-105, 000=15, 000Bi r
r
(OL/ T=8000) = T( P-V) = 8,000( 40-25)__ _
__
T( P-V)=F 9,000( 40-25)-105, 000

= 8,000(15)______ = 120, 000__

_ _
= 120,000
8,
000( 15)-105,000 120,000-
105,
000 15,000
=8.0
Ifthelevelofoutputincreasesby1per cent( f
rom8000uni t
st o8,080unit
s)inthenext
accounti
ngperi
od, whathappenstoEBI T?
Thef undament
aldef i
nit
ionofoper atingleverageascomput edhere,say
st hatEBI
Twi l
l
i
ncreaseby8per centwhent helev
elofout putincreasesby1percent
.I nor
dertoprov
ethat

139
thepercent ageincr
easesIEBI Tis8percentwhent hel evelofoutputi
ncreaseby1per cent,
comput et heamountofEBI Twhent helev elofout putis8,080units(aftera1per cent
i
ncreases).
EBIT = Y = (T)(
P)-(T)( V)-F
= 8080(40-25)-105, 000
= 8080(15)-105, 000 =121, 200-105,000=16, 200Bir
r
EBIT ( attheinit
ial
level
ofoutputof8000uni ts)=15,000Birr
.
Theper centageinEBI Tcausedbythe1percenti ncreasesint hel
evelofoutput,
theref
ore,is:

Thist he same per cent age change obt ained by usi ng t he measur ementequat i
on for
operat i
ngl ever age( coef ficientofoper atingl everage) . Thef undament alint
erpretati
onof
operat i
ngl everagecanbef ur t
hergener alizedasf oll
ows:
"Theper cent agechangei nEBI Tt hatr esultsfrom agi v enper centagechangeinout put
i
s
equalt ot hev al
ueofoper at i
nglever ageatt hei nit
ialvalueofout putmulti
pli
edbyt he
Percent agechangei nout put .
"
To i l
l
ust ratet his gener alf undament ali nterpretati
on usi ng t he same dat af orGener al
Mer chandi se,supposet hatt hei niti
alout putof8000uni tsdecreasesby12per cent(i.e.f
rom
8000uni tsto7, 040uni ts) .Whati stheper centagechange( decreases)i nEBITresult
ingfrom
thi
sdecr easei nt helevel ofout put .
The r esulting per centage change i n EBI T can easi l
y be comput ed by mul t
ipl
ying the
coefficientofoper ati
ngl ev erageatt hei nit
iallevelofout putbyt hepercentagechange
(decrease)i nthel evelofout put .Thati s:Theper centagechangei nEBI T=(8)(-0.
12)=- 0.96
or-96per cent.Theper cent agedecr easecanbev erif
iedbycomput ingbot hthevalueofEBI T
whent hel evelofout put( T)i s7, 040( whichi s12per centbel owt hei ni
ti
alamountof8, 000
unit
s)andt heresul t
ingper cent agechangei nEBIT.
EBIT = Y = (T)(P)-( T)( X)-F
= (7,
040)( 45)-7,040x25)-105, 000
= 600Bi rr
EBIT( whent helev el ofout putis8000uni ts)=15, 000bi rr
Theper centagechangei nEBI T, therefore, i
s
%

Ther
ef or
e,thedecreasetheoutputlev
elby12per cent,or960uni
tscauses96percent
,or
14,
400BirrdecreaseinEBI
T.
Rel
atedInterpr
etati
onsofOper
atingLever
age:
Thef oll
owing aresomeoft her elat
ed i
nter
pret
ationsthatarebased on pr
opert
iesof
oper
atinglever
age:
1.A posi
ti
ve coeff
ici
entofoper
ati
ng l
ever
age i
ndicat
es thatlev
erage i
s bei
ng
comput
edatal evel
ofout
putgr
eat
ert
hanoperat
ingbreakeven.
2.A negati
vecoeff
ici
entofoperat
ing beverageindi
catest
hatl
ever
agei
sbei
ng
computedatalev
elofout
putbel
owoper ati
ngbreakev
en.
3.Alargeabsoluteval
ueofoperati
ngleverage(thecoeff
ici
entofoperat
ingl
everage
wit
houtalgebraicsi
gn)indi
catesthatoutputisclosetotheoperati
ngbreakeven
andthatt
heabsol ut
esizeofEBITiscl
oset ozero,
orrel
ati
velysmall
.

140
 4.Aposit
ivecoef
fi
cientofoper
ati
ngl ev
eraget
o1.0indi
cat
est
hatout
puti
srel
ati
vel
y
f
oraboveoperati
ngl ev
eragebreakevenandthatt
heamountofEBITi
srel
ati
vel
y
l
arge.
Thei mpl icat ionoft hehi gherdegr eeofoper at i
ngl ev eragei st hatt hesmal lerchangei nt he
l
ev elofout put( unitssol d)wi llbringhi gherchangeofpr of i
tbef or ei nt erestandt axes( EBI T).
Thus,oper at ing l ev erage i s def initel yan at t
r i
but e oft he busi ness r isk t hatconf ront s
businessf irms. Busi nessr iski sdef i
nedast her elativedi sper si onorv ar i
abili
tyi nt he
company '
sexpect edear ni ngsbef orei nt er estandt axes( EBIT) .Aswehav eseenwi tht he
i
llustr
ativ eexampl es, thedegr eeofoper at ingl ev er agef allsast hel ev elofout put( sal es)past
thecompany '
sbr eakev enpoi nt.
Applicationofoper atingl ev erage:
Theappl icat ionofoper atingl everagear et heext ensi onofi tspr oper tiesandi nt erpret ations.
Thebasi cappl icationsdi scussedbel ow.
1.ItExpl ai nst heMagni fi
cat i
onofPer cent ageChangesi nEBI T:
Thef undament alappl icationofoper atingl ev er agel i
esi nexpl aini ngwhychangesIt he
lev elof out put ( sal es) can pr oduce di spr opor ti
onat e changes i n EBI T. The
measur ementequat ionofoper at ingl ev er agei ndi cat est hatasl ongasf i
xedcost sar e
gr eat ert han zer o,a 1 per centchange i n out put( sal es)can pr oduce a di fferent
per cent agechangei nEBI T.I npar ticul ar,f orv aluesofout put ,( sal es) ,gr eatt hant he
br eakev enquant ityt heper cent agechangei nEBI T,whi chr esul tf rom a1per cent
changei nout put( sal es)i sal way sgr eat ert han1per cent .
2.Itexpl ainsEr rorsi nEBI T For ecast :
- Theot heri mpor t antappl i
cat ionofoper ating
lev eragedeal swi tht hatexpl anat i
onofer ror si nEBI Tf or ecast s. Thought her ear e
manycausesofsucher rors,t hemagni fi
cat ionofper cent agechangei nEBI Tpr ov ides
oner easonwhyact ual candev iat esi gni fi
cant l
yf rom i tsf or ecastv alue.
Whent hecompanyi sf orecast ingi tsexpect edl evelofout put( sal es)ort hecomi ng
account ingper iod, itmustf i
rstdet er mi net hesel l
ingpr i
ce( p), var iablecostperuni t( V),
andf ixedcost s( F) .Thecompanyt henf or ecast si t
sexpect edEBI Tandcomput est he
coef ficientofoper at i
ngl ev erageatt hef or ecastv alueofout put( sal es) .Foreach1
per centt hatact ualout put( sal es)dev iat es f rom f orecast ed out put( sal es) ,t he
per cent agedev iat i
onofact ualf r
om f orecast edEBI Ti sequalt ot hecoef ficientof
oper at i
ng l ev er agemul ti
plied byt heper cent age er rori nf orecast ed out put( sales
vol ume)
3.Itmeasur esbusi nessr isk:Busi nessr i
ski st hemeasur eofpr obabi li
tyorl i
kelihoodt hat
thecompanywi l
lgooutofbusi nessbecausei tisunabl et ol ear naposi t
ivel ev elof
EBI T.Ther ear emanyappr oachesofmeasur i
ngbusi nessr isk.Theuseofoper ating
lev eragepr ov ideonesuchmeasur ebycombi ni ngt hef ir
stt woappl icat i
onspr esent ed
abov eas1and2.Wheny ouf or ecastout put( sal es)andEBI Tf oragi v enaccount ing
per iod,t hef or ecast sar esai dt obemadeundercondi ti
onsofbusi nessr iskwhenev er
theact uall ev el sofout put( sal es)andEBI T.Thel argert hedev iation,t her iski ert he
situat ioni s.Thecoef fici
entofoper at ingl ev eragecanbeusedt omeasur ebusi ness
risksi ncei ti ndicat edt heext entt owhi chf or ecast i
nger r
orwi l
lpr oducemagni fi
ed
per cent ageer rori nEBI T.Thel ar gert hecoef fi
ci entofoper atingl ev er age,t hegr eat er
ther isksi ncei tindi cat est heext entt owhi chf or ecast i
nger rorwi l
lpr oducemagni fi
ed
per cent ageer rori nEBI T.Thel ar gert hecoef fi
ci entofoper atingl ev er age,t hegr eat er
ther isksur roundi ngt hef orecastv al ueofEBI Tandast heconsequencet hegr eat ert he
riskt hatt heact ual EBI Twi llturnoutt obenegat ive.
Thedegr eeofbusi nessr iskal sochangeswhent hef irm makesassetcomposi t
ion
deci si onst hatal tert hef ixedandv ariabl ecost soft hecompany .I fchangi ngt he

141
 company '
spr oduct i
oncost saltersitsoper atingbr eakev enpoint,itresul t
si nanewset
ofoper atingl everagecoef f
ici
ent sandt hecompany '
sbusi nessr i
skchanges.I ngener al
,
i
ncr easing t he company 's breakev en i ncreases i ts degr ee ofbusi ness risk;and
decr easingbr eakev enreducest hedegr eeofbusi nessr i
sk.
Toi ll
ustratet heef fectoft hechangei nt hecomposi ti
onoft heasset soft hecompany
ont hebr eakev enquant i
ties,oper ati
ngl ev eragecoef f
icientsandbusi nessr isk,assume
Alem Manuf acturingcompanywhosemanuf acturi
ngcost si ncludef i
xedpor t
ionof
4,800,000Bi rrandv ari
ablepor tof26Bi rrperuni t.Thesel l
ingpr i
cei s51bi rrperunitof
thecompany .Thecompanyi sconsi der i
ngt oaut omat eapor ti
onof i t
spr oduction
process. Becauseoft heaut omat i
onpr ocess,t hef ixedmanuf act uringcost soft he
company i ncrease t o 5, 400,000Bi rr
,but v ar
iable manuf acturing cost s per unit
decr easest o25Bi rrcomput et hebr eakev enquant i
tiesbef oreaut omat i
onandaf t
er
automat i
on.Cal culatetheoper atinglev eragecoef fi
cientsgivent hel ev elsofout put(T)
of225, 000 uni ts,250, 000 uni ts,and 275, 000 uni t
s. Commenton t hedegr eeof
businessr i
sk.Theoper atingbr eakevenquant it
ybef oreaut omat ioni scomput edby
usingcostdat ebef oretheaut omat i
ondeci sion:Hence;
T(
bef
oreaut
omat
ion)=

T(
bef
oreaut
omat
ion)=
Theoper
ati
ngbr
eakev
enquant
it
yaf
teraut
omat
ioni
scomput
edbyusi
ngcostdat
aaf
ter
t
heaut
omat
iondeci
sion.Hence,T(
aft
eraut
omat
ion)=

=
Thecoeffi
cientsofoperat
inglever
agef orthegi
venval
uesofout
put(T)arecontai
nedin
thef
oll
owingt abl
e.Allt
hecoef f
ici
ent
sar ecomputedbyusi
ngt
hegeneralequat
ionf
orthe
coef
fi
cientoroperat
ingl
everage.Thatis,

Out putquant i
ty (OL/T)bef or e (
OL/T)after
(T) Aut omat i
on automat ion
225, 000 6.82 13.00
250, 000 4.
31 5.
91
275, 000 3.
31 4.09
Asy oucanseef rom t hist able,thecoef f
icientsofoper ati
ngleverageaf t
erautomationar e
greatert hant hecoef fici
ent sofoper at
ingl ever agebef oreaut omat i
on. Mor eov er
,t he
breakeven quant i
ty af teraut omat i
on is gr eat ert han the breakev en quantit
y bef ore
automat ion. Si ncet heoper ati
ngbr eakev enquant ityandt hecoef fi
cientsofoper ating
l
ev er
agehav ei ncr easedasar esultofaut omat ion,t hecompany '
soper ati
ngr i
sk,asi tis
measur edusi ngt heoper ati
ngl ev eragecoef fi
cient s,hasal soincr eased.Thisi l
lustr
ative
exampl e, t
her ef or e,rev ealst hatthef i
nancialmanagerofagi vencompanycanchanget he
operati
ngr isk( eitheri ncreaseordecr ease)byal teringt hecomposi ti
onofcomposi ti
onof
company '
sasset s.
Financi
al Lev er age:
Operati
ngl ev erageandf i
nanci alleveragear eappl icationofthesameconcept .Asar esult
,
the definiti
on and pr oper ti
esoff i
nanciall ever age ar e paral
lelt ot hose ofoper ating
l
ev er
age.Fi nanci allev eragecanbedef inedast hepr act
iceoff inancingapor ti
onoft he

142
 company
'sassetswit
hsecur
it
iesbeari
ngafixedrat
eofreturninhopeofi
ncr
easi
ngt
he
ul
ti
materet
urntothecommonsharehol
der
s,Earni
ngPerShare(EPS)
.

Financiallever
agemeasur estherel
ati
onshi
pbetweenEBI
TandEPS.Mor especif
ical
ly,i
t
reflectstheeffectofchangi
nglevelsofEBITonEPS(ear
ningpershar
e).Thef uncti
onal
relati
onshipbetweenthetwov ar
iabl
esis:
EPS = F(EBIT)
Ther el
ati
onshipcanbemor especif
icasfol
l
ows:
EPS = wher
e,
Y = EBI T
I = interestcostsofthecompany
t = incomet axr at
e
E = preferredstockdividend
N = Numberofcommonshar es
Whent hel evelofEBITchangesf rom itsini
ti
alval
ue,t
hei ni
ti
alval
ueofEPSal sochanges.
Financi
alleveragecanal sobedef inedast heresul
ti
ngpercentagechangeinEPSdivi
dedby
thepercentagechangei nEBI T.Algebraical
ly
,fi
nanci
all
everageisexpressedas:

Not ethatEBITi st heindependentv ari

ablewhenmeasur i
ngfi
nanci all
everage,butitthe
dependentv ariablewhenmeasur i
ngoper atingleverage. Asar esult,EBI
Ti ssomet imes
calledtheli
nkingv ar
iabl
ewi threspecttoleverageapplicati
onsi
nfinance.
Letusassumet hatEdigetEnt er
priseisashar ecompanywi tht heout st
andingcommon
shar esof60,000.Theent er
priseincursinterestexpensesamount ingto100,000Birr
.The
fixedprefer
redst ockdividendamount sto80, 000Bir
r.Theenterprise'
sEBITi s500,000Bi
rr
.
Income t axrat eis 40percent.Whati st he EPS att hi
slev
elofEBI T using the gi
ven
i
nf ormati
on?

Assumet
hatEBI
Toftheenter
pri
seincreasesf
rom 500,
000Bi
rrt
o600,000Bir
r.Thisi
ncrease
i
nEBITaf
fect
stheEPSoftheenter
prises.Usi
ngtheEBITof600,000Birr
,theresul
ti
ngEPS
i
s:

143
Usi
ngt
heequat
ioni
ndi
cat
edf
orf
inanci
all
ever
ageabov
e,t
hecoef
fi
cientoff
inanci
all
ever
age
i
scomput
edas:
Per
cent
agechangei
nEBI
T=

Per
cent
ageChangei
nEPS=

Thecoef fi
cientoffi
nanci all
ever
ageof1. 87isi
nterpr
etedasf ol
lows:
A 1per centchange( increaseordecr ease)i
nEBI Tf rom t heinit
ialvalueof500,000Bir
r
producesa1. 87percentchange( i
ncreaseordecrease)i nEPS.Si nceEBI Thasincr
easedby
20per centfrom 500,000Birrto600,000,EPShast oi
ncr easeby1. 87(0.20)= 0.374,or37.
4
percentfrom 2.67birrto3.67Birr.
MeasurementofFinanci
alLev erage:
Themeasur ementequat ionusedtocal cul
atet
hecoefficientoffinanci
allever
ageis:

Sy
mbol
i
cal
l
y

Thelef
t-
handsideoft
heabov
eequat
ion(
i.
eFL/
Y)i
sreadas:f
inanci
all
ever
age,gi
vent
he
val
ueofEBIT.

144
BypluggingthedataforEdgetEnt
erpr
isebefor
etheincr
easei
nEBI T.t
hecoeff
icientof
fi
nanciall
ever
agecanbecomputedbyusingtheabov
emeasurementequat
ionf
orfinanci
al
l
everage.Thatis:

Thecoef f
icientoffi
nanci
all
ever
ageof1.87comput edbyusi
ngthemeasur
ementequati
on
forfi
nanciallever
ageisexact
lyt
hesameast hecoeff
ici
enty
ouhavecomputedbydi
vidi
ng
thepercentagechangeinEPSbytheper
centagechangeinEBI
Tearl
i
er.

Thesef i
nanciallever
ageequat i
onsar eappr opri
ateinsi t
uati
onswher ecompany'
sEBI T
i
nvolvesmul t
ipleproductli
nesand/ornonlinearproducti
onandoper at
ioncost
s.thet er
m
fi
nanciall
everageisusedbecausethistypeofleveragefocusesontheEPSimpactsr
esulti
ng
fr
om thef i
nancingdecisi
onsofacompany .Financiall
everagei
ssomet i
mescall
edbalance
sheetlev
erageorcapi t
alstr
uct
urelever
age.

Inordert oseet heapplicabi

li
tyoffi
nanci
allever
ageequati
onsinthesi t
uati
onwher eEBITi
s
obtainedf rom thepr oducti
onandsel lofmul t
ipl
eproductsandnon- li
eroperationcosts,
assumeOdaaShar eCompanywhi chproducesandsel l
ssev er
aldi f
fer
entpr oducts. I
n
fi
nanci ngthisactivi
ti
es,thecompanyhasf l
oatedtwoissueseachoft hefol
lowingbondsan
deferredstock,andhas1mi ll
ionsharesofcommonst ockoutst
anding.considertheincome
taxrateof40per cent.

BondissueA= 10,
000,
000bi
rrat8%inter estrate
BondissueB= 20,
000,
000bi
rrat10%int erestrate
Pref
erredst
ockser
iesA =200,000shares,4.50Birrdivi
dendpershar
e
Pref
erredSt
ockSer
ieB =300,000shares,7.00Bi rrdiv
idendpershar
e.

Comput
etheEPSandt
hev
alueoff
inanci
all
ever
ageatt
heEBI
Tlev
elof10,
000,
000Bi
rr
.

Fi
rsty
ouhav
etocomput
ethet
otali
nter
estchangesonbondsandt
het
otalpr
efer
red
st
ock
di
vi
dendon, al
lpr
efer
redshar
es.
I(int
erestchar
ge)=( 0.
08)(10,
000,
000)+(
0.10)(
20,000,000)
=800,000+2,000,
000+2,800,
000Birr

E(
Pref
err
edst
ockdi
vi
dend)=(
4.5)(200,000)+(7)(300,
000)
= 900,000 +2,100,
00=

145
Aft
ersetti
ngthefi
xedi
nter
estcost
sonbondsandt hef
ixeddi
vi
dendpaymentst
oprefer
red
sharehol
ders,
ther
emai
nderoftheear
ningst
othecommonsharehol
der
sisequal
to1.32Bir
r
pershare.

Then,
y oucancomput
ethev
alueoft
hef
inanci
all
ever
agebyusi
ngt
hegener
almeasur
ement
equat
ion.Thati
s:

Againy ourint
erpret
ati
onfort hefinanci
allever
ageof4.55ist hata1per centchange
(i
ncreaseordecrease)i
ntheEBIToft hecompanycausesachange(incr
easeordecrease)i
n
theEPSoft hecompanyifotherthi
ngsremainthesame.

Pr
oper
ti
esofFi
nanci
alLev
erage

Thepr opert
iesoff i
nanciallever agecanbewel lexplainedbyusi ngt heconceptoff i
nanci al
breakevenamountofEBI T.Fi nanci albreakevenamountofEBI Ti sdef inedast hev alueof
EBITt hatmakesEPSequalt ozer o.Att hepointoff i
nancialbr eakev en,thecompany '
sEBI T
i
sj ustsuf f
icientto coveri tsf i
xed f i
nancing costs( bond i nterestand pr eferr
ed st ock
divi
dends)onabef or
e-t
axbasi s,leavingnoear ningf orcommonshar eholders.Abov et hi
s
breakevenamountofEBI T,thecompanypr oducesaposi t i
velev elofear ni
ngsav ailableto
commonshar ehol
dersandaposi ti
v eEPS.Bel ow thisbr eakevenpoi nt,profitavail
abl eto
commonshar ehol
dersandEPSar ebot hnegative.I tist huspossi blef orthecompanyt o
reportposi
ti
v elevelofEBITev ent houghi t
sEPSi snegat i
ve.Thi swi l
lhappenwhent heEBI T
ofthecompanyi slessisposi t
ivebutl essthantheEBI Tt hatleadst of i
nanci albreakev en.In

146
otherwords,EPSisnegat
ivewhenthepositi
veEBITisnotsuff
ici
entt
ocov
ert
hef
ixed
fi
nanci
alcosts(
cost
sofbondsanddi
videndsonpr
efer
redst
ock)
.

Basedont hedefini
ti
ongiv
enforfi
nancialbr
eakev
en,wecanexpr
essl
ever
ageEPSi
sequal
tozero.Hence,
(Y-
I)(I
-t
)-
E =0
N
Solv
ingforY,orEBIT,i
nthi
sequat
ion,y
ouget :
Y=I+

Theval
ueofY,
orEBITthaty
ougetbyusingthi
sequat
ionwi
l
lresul
tint
heEPSofzer
owhi
ch
i
sref
err
edtoasthepoi
ntoffi
nanci
albr
eakev
en.

Toil
lustr
atethepointoffi
nancialbreakevenassumethatt
hetotali
nter
estcost
s( I
)andtotal
fi
xeddi v
idendsonpr efer
redst ock( E)forBirrasharecompanyar e2,
000,
000bi rrand
1,
300,000respect
ivel
y.Then,thefinancialbr
eakevenamountofY,orEBITi
scalcul
atedas:

Y = I+ i
nser
ti
ngt
hev
aluesi
ntot
heequat
ionandusi
ngt
hei
ncome
t
ax
r
ate of40per
cent,
youget
:

Y = 2,
000,
000 2,
000,
000+2,
166,
667=4,
166,
667Bi
rr

Ifthecompany '
sEBITisexactl
y4,166,667Birr,i
tcanjustcoverit
sf i
xedfi
nanci
ngcost
s
(i
ntereston bonds and di
vi
dends on pr
eferred st
ock)
. Not hi
ng remai
ns forcommon
sharehol
der
sasearnings.TheEPsi
szeroasi ndicat
edasfol
lows.

Sincezerodivi
dedbyanynumberi szero,t
heEPSiszer
oforanynumberofoutst
anding
commonshar es.sincetheEPsatt
helev
elofEBI
Tof4,
166,
667Bi
rri
szer
o,t
hisl
evelofEBIT
i
st hef
inanci
albreakev
enamount.

I
ffinanci
all
ever
ageiscalculatedatfi
nanci
albr
eakev
en,t
her
esul
ti
ngcoef
fi
cientoff
inanci
al
l
everagehasundef
inedvalue,.comput
edas:

147
 = Undef
ined

Usi
ngthesamedat aforBir
rashar
ecompany ,t
hemeasurementequat
ionforfi
nanci
al
l
ever
agecanbeusedtocomputet
hecoef
fi
cient
soffi
nanci
all
ever
agef
ordi
ffer
entv
aluesof
EBI
T.

Thesecoeff
ici
ent
soft hefi
nanciall
ever
agecanbepl
ott
edintheX-YplanewheretheY-
axi
s
repr
esent
sthecoeff
ici
entsoffinanci
all
ever
ageandt
hea-axi
srepr
esentsthev
aluesofEBI
T
ofthecompanyasfoll
ows.

y-
axi
s
5.
0
age

4.
0
ev
l er

3.
0
al

4,
166,
667bi
rr
nanci

2.
0
i
entoff

1.
0

0 1 2 3 4 5 6 7 8 9 10 11 x-
axi
s
f
Coefci
i

-
1.0

148
 EBI
T(i
nmi
l
li
onsofbi
rr
)
-
2.0

-
3.0

Thesmoot hcurvesIt heabovegr aphindicat

et hatt her eareauni quevalueoff i
nancial
l
ev er
agef oreach amountofEBI T. Thev ert
icalbr oken likeisdr awn att hef i
nancial
breakevenamountofEBI Tof4,166,667Birrandi ndicat esthatthecoef fi
cientoff i
nancial
l
ev er
agei sundefinedatt hi
spoint. Thehor i
zont albr okenl i
net hatpassest hr
ought he
coeffi
cientoff
inanciallever
ageof1. 0thatisforthev aluesofEBI Tgr eaterthanf i
nancial
breakeven,t
hecoef f
ici
entsoffi
nanciall
ever
ageisgr eatert han1.0,butneverbeequal to1.
0.

WhenEBITofthecompanyfall
sbelowthef
inanci
albr
eakev
en,t
hecoef
fi
cient
soff
inanci
al
l
ever
agealnegat
iveandappr
oacheszer
oasEBITgoestozer
o.

Theabov egraphr evealst her elati

onshipbet weenEBI T andt hecoef fi
cientoff inanci
al
l
everagewhenbondi nterestr ates,pref er
redst ockdivi
dend'sandi ncomet axratear ehel
d
constant.Ifanyopenoral loft hesev ari
ableschange,italter
st hecoef fici
entsoff inanci
al
l
everagef ordi
fferentlevelofEBI Tsi ncei talsochangest hef i
nancialbr eakeven.I nav ery
specialcasewher ethesum ofi nterestsonbondsanddi vi
dendsonpr eferredstockequal st
o
zero,thecoeff
icientoffinanciall everageequal s1.0f oral
lv al
uesofEBI Tgr eaterthanzero.
Thiswi l
lhappenwhenbot hi nterestonbonds( I
)anddi vi
dendsonpr eferr
edst ock( E)are
zero.Whent hisisthecase, theequat ionforf i
nancial
leveragewillber educedt o:

Butsuchasit
uati
on,wherebothint
erestonbondsanddi vi
dendsonpref
err
edstockar
ezer
o
i
sv er
yrar
e.Hence,i
tisunl
ikel
ythatt
hecoeffi
cientoff
inanci
allev
eragei
sequal
to1-0.

I
nterpr
etati
onofFinanciall
everage:
Aswi t
hoper ati
ngleverage,therearef undamentalandr el
atedinterpret
ati
onsoffi
nanci
al
l
everage.Thesi zeofthecoeffici
entoff i
nanci
all
ev erageandt hevalueofEBI Twi
thr
espect
tofi
nancialbr
eakevenpointhelpinter
pretthecoef
ficientinspecif
icsituati
ons.

Fundament
alInt
erpr
etat
ion:
-Thefundament
ali
nter
pret
ati
onofthecoef
fi
cientoffi
nanci
al
l
everagei
sthatiti
sthepercent
agechangei
nEPSthatresul
tsf
rom a1percentchangei
n
EBIT.

Toi l
lust
ratethefundamentalinterpr
etati
onofthecoeffi
cientoff i
nanci
allev er
age,assume
thatAgaShar ecompany '
sint
er estonbondsanddiv i
dendsonpr eferr
edstockar e1,000,000
Birrand500,000Bir
rrespect
ively.Thei ncomet
axr at
eis40per cent.Whent helevelofEBIT
equals4,000,
000Birr
,theval
ueofEPSandcoef f
ici
entoffinanci
allever
agear e:

149
 =

Thecomput edcoef f
ici
entoff
inanci
alleverageof1.85indicat
est
hatthedecr
easeIEBITby1
percent(f
rom 4,000,000Bi
rrto3,960,
000Bi r
r)wil
lresultinthefal
lofby1.85percent.To
provet he corr
ectness ofthisinter
pretati
ons solvef orEPS when EBIT decr
eases t
o
3,
960,000Birr
.

Hence,
theper
cent
agechangei
nEPS(
i.
e.% EPS)i
scomput
edas:

Thepercentagechange(
decr
ease)i
nEPScomputedher
eisthesameast ot
hepercentage
change(decrease)i
nEPSwehadcomputedear
li
erbyusingthemeasur
ementequati
onof
fi
nanci
allev
erage.

Thef
undament
ali
nter
pret
ati
on off
inanci
all
ever
agecan bef
urt
hergener
ali
zed ast
he

150
percentagechangeinEPSt heirr
esult
sf r
om agivenper centagechangei nEBITmul t
ipl
i
edby
thepercentagechangei nEBIT.Therefor
e,youcandet erminetheper centagechangeinEPS
giv
en t he percent
age change in EBIT and t
he coef f
ici
entoff inancialav er
age. The
percentage change in EPS isthe productoft he percentage change i n EBI
T and t
he
coeffi
cientoffi
nancial
lever
age.

Forexample,assumet hesamedat aforAgaShar eCompanyandt heincreaseItheini

tial
val
ueofEBI T by10per cent(from 4,000,000Bi r
rto 4,
400,000Bi r
r). Wehav ealready
computedthecoef fi
cientoff i
nanci
all ev
er agegiventheini
tiall
evelofEBI Ttobe1. 85
per
cent.Hence,t hepercentagechangei nEPSshar ecanbecomput edbymul t
ipl
yi
ngt he
per
centagechangeinEBI Tbythecoeffi
cientoffinanci
all
ever
age.

=(
0.100)(
1.85)=0.
185,
or18.
5%

Thiscomput
edper cent
agechangei
nEPS( % EPS)of18.
5canbev er
if
iedbycalcul
ati
ngt he
val
uesofEPSbot hatthelev
elsof EBITof4,000,
000Bi
rrand4,
400,
000Bir
r(i
.e.10percent
abovethei
nit
ial
valueofEBITof4,
000,
000Bi
rr
).

TheEPSwhent
helev
elofEBITis4,
000,
000Bi
rri
s13Bi
i
r,and
whenEBI
Tamount
sto4,
400,000Bi
rrt
heEPSis:

Then,
theper
cent
agechangei
nEPS
(

Rel
atedI
nter
pret
ati
ons:

Thefol
lowingr elatedi nter
pret ationsar ebasedont hepr oper tiesoffinanciall
everage:
1.Aposi ti
vecoef fi
cientoff i
nanci alleveragemeanst hatl ev er
agei sbeingcomput edf ora
valueofEBI Tt hatisgr eatert hanf i
nanci albreakev enamount .
2.Anegat ivecoef fi
cientoff inanci alleverage,ont heot herhand, indicat
esthatleverageis
beingcomput edf orav alueofEBI Tbelowf i
nanci al br eakevenamount .
3.Al ar
geabsol ut ev al
ueoff inancialleveragei ndicat est hatleverageisbeingcomput ed
forthev alueofEBI Tthati scl oset ot hebr eakevenandt hattheabsol utevalueofEPSi s
rel
ativel
ysmal l
.
4.Aposi ti
vecoef fici
entoff i
nanci alleveraget hatiscl oset o1.0i ndi
catesthatleverageis
beingcomput edf ort hev alueofEBI Tt hatisrel ativ elyforabov ef i
nancialbreakeven
amountandt hatt hecor respondi ngv al
ueofEPSi sr elativel
ylarge.

Appl
i
cat
ionsofFi
nanci
alLev
erage:

151
Theappl i
cations,orusesoff inanci
allev
er agear ebasedoni tspr opertiesandont he
fundamentali nter
pret
ationoff inanci
alleverage. Theseappl icationsoccurr epeat
edlyi n
manager i
alfi
nance.Thef ol
lowingaresomeofappl i
cationsoffinancialleverage.
1.ItMagni fi
estheper centagechangeEPS: - Thef undament alappl i
cationoff i
nanci al
l
everagei stoexplainwhychangesi nEBI Tcanproducemagni fi
edper centagechanges
i
nEPS. Themeasur ementequat i
onf orfinanci
all ev
eragei ndicatest hataslongas
f
ixedfinancingcost s(i
nterest
sonbondsanddi videndsonpr eferr
edst ock)aregreater
t
hanzer o,a1per centinEBI Tproducest hepercentagechangei nEPSt hatisdi
fferent
f
rom 1.0.

2.Itexpl
ainserrorsinEPSf orecasts:-asecondappl icati
onoff i
nanci
all
everageoccursin
explai
ninger r
orsi nforecastingEPS. I tiscommont hatcompaniesf orecasttheir
expectedEBI TandEPSf orapar ti
cul
araccount ingper i
od. Theyalsocomput ethe
coeffi
cient
soff inanci
all
everageatt heforecast edl ev
elsofEBIT.Foreachper centt
hat
theact ualvaluesofEBI Tdev iatefr
om thef orecastv alues,t
hepercentagedev i
ati
ons
ofactualv al
uesofEPSf rom t hef or
ecastv aluesar ecomput edbymul t
ipl
yingthe
coeffi
cient
soft hecompany '
s' fi
nanci
alleveragebyt hepercentageer
rorsIforecasti
ng
EBIT.

Forinst
ance,
XYZcor porationf orecastsitsEBITf ort
hecomi ngaccounti
ngperiodtobe
30,000,
000Bi
rr
.Ther el
ev antv aluesoft hecor porat
ion'sincomest at
ementitemsar e:
i
nterest
sonbonds( I
)is4, 000,000Bi r
r;divi
dendsonpr ef
erredstock(E)is1,
500,000and
thenumberofcommonshar esout standingis2,000,000;andt hei
ncomet axrateis40
percent
.TheEPSandt hecoef f i
cientoffinanci
al l
everagef ort
heforecast
edamountof
EBITare:
EPS = ( 30,000,
000- 4,000,000)(1-0.4)-1,500,000
2,000,000

= (
26,
000,
000)0.6)-
1,500,
000
2,000,
000

= 15,
600,
000-
1,500,
000 = 14,
100,
000 = 7.
05Bi
rr
,and
2,
000,
0000 2,
000,
000

I
ftheactualEBITisturnedt
obe10per centabovetheforecast
edEBI T,val
ue,act
ual
EPSwillbe(1.28)(0.
10) = 0.128or12.8percentabovetheforecastedEPSv al
ue.
Hence,t
heactualEBITof33,000,
000bi
rrwil
lyiel
danEPSv al
ueof(7.05Birr
)(1.
28)=
9.
02Bir
r.

Thi
sappl
icat
ionoffi
nanci
all
ever
agesuggest
sthati
tmaybepossi
blet
oant i
cipate
EPSfor
ecast
ingerr
orsbecauseonecomponentingener
ati
ngt
heseerror
si st he

152
 coeff
ici
entoff
inanciall
ever
ageatforecast
edl
evel
ofEBI
T.Thelar
gert
hev
alueofthe
coeff
ici
entoffinanciall
everage,t
hel ar
gert
herangeofpossi
bleEPSf
orecast
ing
err
ors.

3.ItMeasur eFinanci alRisk:Fi nanci alr iski sadi r

ectr esultoft hecompany '
sf i
nanci ng
deci sion. I nt hecont extofsel ect i
ngpr operf inanci ngmi x,thisappl iest o( 1)t he
addi tionalv ariabi l
itytot hecompany '
scommonshar eholder sand( 2)theaddi ti
onal
chanceofsol vencybor nebyt hecommonshar ehol dercausedbyt heuseoff i
nanci al
l
ev er age. I not herwor ds,f i
nanci alr iski st hepr obabi lityorl ikeli
hood ofser ious
fl
uct uat ionsinEPSbecauseofcompany '
schoi ceofapar ti
cularcapi talst r
uctur e.
Financi all everage i s one oft he sev eralappr oaches t o measur i
ng financi alr isk.
For ecast edv aluesofEBI TandEPSar esai dt ober i
skywhenev ert heact ualEBI Tand
EPSv aluedev iatef rom t hei restimat edv alues.Thel ar gert hedev i
ations,ther i
skiert he
situat i
ons. Fi nanci all ev erage can be used t o measur ef i
nanci alr i
skbecause i t
i
ndi cat est hesi zeofEPSf or ecast ing er rort hata1per centEBI Tf orecastinger rorcan
produce. t hel ar gerthecoef fi
cientoff inanci all ever age,t hegr eat erthedegr eeof
fi
nanci alrisk.Thi sisbecausel argev aluesoff inanci all ev
er ager equi r
erel ati
velysmal l
EBI Tf orecastinger rorsi nor dert opr oducenegat iv eEPS v alues. Thecompany 's
degr eeoff i
nanci al ri
skchangeswhenev ert hecompanyal ter sitsfixedf i
nanci ngcost s.
Shi ft
si nf i
nanci alr i
skal sooccurwhent hef i
rm subst i
tutesonet ypeoff inancingf or
anot heri fnew v aluesf orIand/ orEemer ge.Thechangei ncommonshar edoesn' t
altert hedegr eeoff i
nanci alriskasmeasur edbyf i
nancel everagebecausecommon
stockdi v i
dendsar enotcont ainedi nt hemeasur ementequat i
onf orf i
nanci alleverage.
Changei nt hei ncomet axr atecanal soaf fectthecompany '
sf i
nanci all
ev erageasi ti s
oneoft hei nput st othef inanci al lever ageequat ion.

Thechangeinthevaluesofthefixedf i
nanci
ngcost sproducesanew f inanci
albr
eakeven
amountofEBIT,andanew setoff i
nanciall
everagecoeffi
cient
s.I ncr
easingthefi
nancial
breakev
enamountincreasesacompany 'sdegreeoff i
nancialri
sk;decr
easingthefi
nancial
breakev
endecr
easesthedegreeoffinanci
alri
sk.

Forexample.Ay atHouseConstr
uctionCompanyhasa4mil
l
ionBir
rEBIT,1.
2mill
ioni
n
i
nter
estpaymentondebt ,a40percentt
axrat
e,andnoot
herfi
xedfi
nanci
ngcost
s.The
company'
sfinancial
breakev
eni
s:

Y =I+ E =1.
2mi
l
li
on+ 0¬¬¬¬_
_ = 1.
2mi
l
li
on+0 = 1.
2mi
l
li
on
1-t

Supposet hatt
hecompanyhasdecidedt
oexpandandwi
llfi
nancetheexpansionbysel
l
ing
addit
ionalsharesofcommonst ockorbyf
loat
ingani
nit
ialissueofpref
erredstockt
hat
requi
res600,00Bir
rdi
videndpay
ment.

Ifcommonstocki
ssuancei schosenasthef i
nanci
ngalternati
ve;fi
nanci
albreakevenamount
andthedegr
eeoff i
nancialri
skarenotaffect
ed.Financiall
everagecoeffi
cientsforselect
ed
EBITval
uesarecomput edinthefol
lowi
ngt able.Al
lthecoef fi
cientoff
inanciall
everageare
computedbyappl
yi
ngt hegeneralmeasurementequation;i.
e.

153
 EBIT CommonSt ocki
ssued Pref
err
edst ockissued
4.
0mil
li
onBir
r* 1.
43* 2.22**
4.
5mil
li
onBir
r 1.
36 1.96
5.
0mil
li
onBir
r 1.
32 1.79
*(
FL/
Y=4mi ll
ion)= 4,000,
000 = 4000,
000 = 1. 43
4000,
000-
1,200,
000 2,800,000

*
*(FL/
Y=4mi
l
li
on)= 4000,
000 = 4,
000,
000 =2. 22
4000,
000-
1200,
000-
600,
000 1,
800,
000
1-04

I
fthecompanydeci
dest ofi
nancet
henew expansi
onwi
thpr
efer
redst
ock,t
hef
inanci
al
br
eakev
enamounti
ncreasest
o:

Y = 1,
200,
000 + 600,
000 = 1200,
000+1000,
000 =2,
200,
000Bi
rr
1-0.
4

I
ft hecompany ,ont heot herhand,deci
dest ofinancetheexpansionwi thcommonst ock
i
ssuance,thefinancialbreakevenamountdoesnotchangeasi ndicatedearl
i
er.Hence,the
decisi
on doesn'thav eanyi mpacton thef i
nancialri
sk. Thei ncreaseinthef i
nancial
breakevenamountr esulti
ngf rom t
heini
tiali
ssuanceofprefer
redst ockincr
easethefir
ms
fi
nancialr
iskasfinancial
r i
skismeasuredbythecoef f
ici
ent
soffinanciall
ever
age.

Combi nedleverage
Combi nedleveragei snotadi sti
ncttypeofl everage. Iti sthecombi nationofbot ht he
operati
ngandf inancialleverages.Combi nedleveragemeasur est herelati
onshi pbet ween
outputs(unit
ssol d)andEPS.Thef uncti
onalr
elati
onshipbet weent hesetwov ar i
ablesis:
EPS =f (T)
Ther el
ati
onshipcanbemademor especifi
cas:
EPS = [ T( P-V)-F-I](1-t)-E
N
Whent helevelofout put(sales),Tchangesf r
om i t
siniti
alv al
ue,theini
ti
alv alueofEPSal so
changes.Combi nedl everagei snot hi
ngbuttheper centagechangei nEPSdi videdbyt he
percentagechangei noutput( sales),
T.Thedef ini
ti
onal equationofcombi nedl everageis:

Toil
lustr
atethecomputati
onofthecombi
nedl
ever
age,assumethatShal
aShar
eCompany
.
Sel
l
si tsproductat50Bir
rperunit
.Theunitv
ari
ablecostofsal
esis30bir
randt
hefi
xed

154
operati
ng expensesequal150, 000 Birrf
ortheaccounti
ng per
iod. Thefixed costsof
fi
nancingincludethefi
xedinterestcostonbondsof50,
000Birrandthefi
xeddivi
dendson
prefer
redstockof20, 000Birr. Whatisthecompany'
sEPSoft hecompany,ifi
tl ev
elof
outputorsalesis15,
000units?

EPS=[
T(P-
V)-F-I
)(1-
t)-E Subst
it
uti
ngv
aluef
orknow
N

Var
iabl
es,
youget:EPS = [
15,
000(
50-
30)-150,
000-40,
000](
1.0.
4)-20.
000
10,
000

=[
(15,
000)(
20)-190,000](0.
6)-20,
000
10,000

=(
3,00,
000-
190,
000)(0.
6)-20,
000
10,
000

= 66,
000-20,
000 = 46,
000 = 4.
60Bi
rr
10,000 10,
000

I
fthev
olumeofout
putorsal
esi
ncreasesto16,
500unit
s,EPSincr
easest
o:
EPS = [ [
16,
000(50-30)-150,
000-40,
000](1.0.
4)-20.000
10,
000

= (
330,
,
000-
190,
000)(0.
6)-20,
000= 84,
000-
20,000=64,
000
10,
000 10,
000 10,
000

= 6.
40Bi
rr

Byusi
ngthegeneralalgebr
aicequati
onfort
hecombi
nedl
ever
agei
ndi
cat
ed,
thecoef
fi
cient
s
oft
hecombinedleverageiscomputedas:

Per
cent
agechangei
nout
put = 16,500-
15,
000 = 1,
500 = 0.
10,
or10%
15,000 15,
000

Per
cent
agechangei
nEPS = 6.
40-4.
60 = 1.
80 =0.
391or39.
1%
4.
60

(
CL/
T) = L(
EPS) =

Thi
scomput edcoef
fici
entofcoeffici
entofcombinedlever
ageof3. 91percenti
si nt
erpr
eted
i
nsuchawayt hat1percentchangeinout putorvol
umeoft hesalesfrom alevelof15,000
uni
tspr oducesa3. 91percentchangei nEPS. Si nceoutput(Salesvolume)isassumed
i
ncreasedby10per cent,t
heresul
tingpercentagechange(i
ncreases)i
nEPSi s(0.1)(3.
91)or
39.
1per cent.

155
MeasurementofcombinedLever
age
Thefollowing t
wo measur
ementequat
ionscanbeused t
o comput
ethecoef
fi
cientof
combinedlever
age:Thesear
e:
(
CL/
T)=

(
CL/
T)=(
OL/
T)(
FL/
Y)

Thelef
t-
handsidesoftheseequat
ions(
i.
e.CL/
T)ar
ereadascombi
nedl
ever
age,gi
vent
he
val
ueofoutputorsal
es.

The fir
stmeasurementequat i
on ofcombi ned leverage can be used t
o computethe
coef
fici
entofcombinedl
everagedirect
lyf r
om asetofdat a.Thesecondequat i
onisused
whent heseparat
ecoeffi
cient
sofoper ati
ngandf i
nanci
all ever
agearecomputed. The
coef
fici
entofcombinedl
everageisthepr oductoft hecoeffi
cientoffi
nanci
alandoper
ati
ng
l
everagesasindi
cat
edbysecondequat i
onabov e.

Theequi
val
enceofthedef
ini
ti
onalandmeasurementequati
onsf
orthecombi
nedl
ever
aged
canbedemonst
rat
edbyusingtheprev
iousdat
agivenforShol
aShar
eCompany.

Atthelev
elofoutput(sal
esvol
ume)of15,000 uni
ts,
thev
aluesofEBI
T,oper
ati
ngLev
erage
(OL/T)
,andfi
nancial
lever
age(FL/
Y)equal
.

EBI
T = Y T(P-
V)-F
= 15,
000(50-
30)-150,
000 = 150,
000Bi
rr

(
OL/
T)= T(P-V)
T(P-V)-
F

(
OL/
T=15,
000)= 15,
000(
50-
30) = (
15,
000)(
20) = 2.
0

15,
000(
50-
30)-150,
000 (
15,
000)
(20)-150,
000

(
FL/
Y)=

(
FL/
Y =150,
000)=

= 150,
000 =1.
957
76,
667

Now,you can use t

he second ofequati
on oft
he combi
ned l
ever
age t
o comput
ethe
coef
fi
cientoft
hecombinedlever
age.Thatis:
(LC/T=( OL/
T)( FL/
Y)=( 2.0)(
1.957)-3.
914 or3.
91.

156
Thefi
rstequat
ioncanal
sobeusedasanal
ter
nat
iveofcomput
ingcoef
fi
cientofcombi
ned
l
ever
age.Thatis:
(
CL/
T) =

Val
uesf
ort
hev
ari
abl
es,
youget
:

= 300,000 = 3.
91
76,667

Notethebotht hemeasurementequat
ionsproducethesamecoef f
ici
entofcombi
ned
l
ever
age that was obtai
ned f
rom the prev
ious def
ini
ti
onalequat
ion (
i.
e.CL/T =
.
Pr
operti
esofCombinedLever
age

Thepr opert
iesofcombi nedofcombi nedl ever
agearesimilartothoseofoper at
ingand
fi
nanciall
everagesbecausecombinedlev er
ageisacombinati
onoft hetwodist
incttypesof
l
everage.Thesepr oper
tiescanbeexplainedbyusingtheconceptofoveral
lbr
eakeven.The
overal
lbreakevenisdef
inedasthelev
el ofoutput(v
olumeofsales)thatmakesEPSequal to
zero.From theincomest at
ementofacompany :

EPS = [
T-P-
V)-F-
I](
1-t
)-E, byequat
ingEPStozer
oandsol
vi
ngf
orout
put
N (
volumeofsal
es)T,y
ouget
:

O= [
T(P-
V)-F-
I)(
1-t
)-E
N

[T(
P-V)-F-
I](
1-t
)-E=0

T(
P-V)-F-
I=E ;T(
P-v
)= E+F+I
1-
t 1-
t
T=I+F+E/(1-
t)
(P-
V)

Usi
ngthedat
asetofSholaShar eCompanyconsi
der
edi nprev
iousexamples,t
heov
eral
l
br
eakev
enamountofout
putis:
T = 30,
000+150, 000+20,000/(
1-0.
4) =30,000+150,
000+33, 333
50-30 20

= 223,333= 11,
167uni
ts
20

157
You can use t
he f
irstmeasurementequati
on forcombi
ned lev
erage t
o comput
et he
coef
fi
cient
sofcombinedl
everageatdi
ff
erentl
evel
sofout
put(v
olumeofsales)asf
oll
ows:

Aswehav edonef oroper

ati
ngandfi
nanciall
everagecoeff
ici
ents,t
hecoeff
ici
entsofthe
combi nedlever
agecomputedabovecanbepl ottedontheX- Y pl
anewheret heY-
axis
represent
st hecoef
fi
ci
entofthecombinedlev
er ageandX-axi
sr epr
esent
sthev ol
umeof
output(sal
es).

5.
0-
4.
0-
3.
0-
2.
0-
1.
0---
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--

-
1.0- *
5 10 15 20 25
-
2.0- out
put(v
olumeofsales)i
nthousandsofuni
ts
-
3.0-
-
4.0-
-
5.0-
-
6.0-
*

Thev erti
calbrokenl i
nedr awnt hrough11, 167units( t
heov eral
lbreakev en)indicat
esthatt he
combi nedl ever
age( CL/ T)is undef i
nedatt hisl evelofout put(v olumeofsal es). The
horizont albrokenlinedr ownt hrought hecoef fi
cientofcombi nedl ev erageof1. 0indicates
thatf ort heout putlevelsgr eaterthant heov erallbreakeven,thecoef fi
cientofcombi ned
l
ev eragei salway sgreaterthan1. 0,butdecreaseswi t
hincreasi
ngl evelsofout put(vol
umeof
sales)andappr oaches1. 0,andnev erbe1. 0.

Whent helevelofoutput(vol
umeofsal es)isbelowt
heov er
allbr
eakeven,thecoef
fici
entof
combinedleverageisnegativeandapproacheszeroasoutputlev
el()sal
esv ol
ume)goest o
zero.Inthespecialcasewher efi
xedoper ati
ngcost
sandf i
xedfinanci
ngcost sar
eallzero
(F=I=E=0) ,thecoeffi
cientofcomb9iendl ever
ageisequalto1. 0foralllev
elsofoutput
(sal
esvolumegr eat
erthanzero.

158
I
nter
pret
ati
onofCombi
nedLev
erage:

Int
erpret
ingt
hecoeff
ici
entof combinedlev
erager
estsont heproper
tiesthatweej
ust
explai
ned.Thef
undamentali
nter
pret
ati
onoft
hecoef
fi
cientofcombi
nedlever
ageis:

Thecoeff
ici
entofcombi nedlev
erageisthepercentagechangei nEPSt hatresul
ts
f
rom a1
per
centchangeinoutput
.I ti
sal
sopossibletogeneral
izet
hisint
erpr
etat
ioninsucha
waythatr
esult
sfrom agi
v enper
centagechangeinoutput(
salesvol
ume)

Tof urt
herexpl aint hisfundament alinter
pretati
onoft hecoef fi
cientofcombi nedl ev
erage,
assume,t hesamedat asetf orShol aShar ecompanyusedi npr evi
ousexampl es.Att he
i
nitiallevelofout put( salesv olume)of15, 000uni t
s,wehav ecomput edEPSof4. 60bi r
rand
thecoef fi
cientofcombi nedl everage( CL)of3. 91f orthecompany . Thef undament al
i
nt erpret
ationst atest hatifout putincr
easesby15per cent,forexampl e( from 15,000uni t
st o
17,250uni ts),theper centagechangei nEPSwi llbe( 3.91)(0.15)or0. 587or58. 7percent .
Thus,EPSwi l
lincr easeby( 4.60)(0.587)or2.70bi r
r.Ther esult
ingv alueofEPSi s4.60Bi rr
plus2. 70bi rr whi chequal s7. 30bi rr
.Inthesameway ,ifoutputl ev el( v
olumeofsal es)
decr easesby5per cent( fr
om 15, 000uni t
st o14,250uni ts).EPSwoul dalsof allby(3.91)
(0.05),or0.196, or19. 6per cent .ThebirrdecreaseinEPSwoul dbe( 4.60)( 0.196)or0.90bi rr
or90cent sandt her esul
tingv alueofEPSwoul dbe( 4.
60bi rr–0. 90birr)3. 70birr
.

Thefol
l
owingar
ether
elat
edi
nter
pret
ati
onst
hatar
ebasedont
hepr
oper
ti
esofcombi
ned
l
ever
age:

1.Aposi
ti
vecoef
fi
cientofcombi
nedl
ever
agei
ndicatest
hatl
ever
ageisbei
ngcomput
ed
f
oralevelofoutputgreat
ert
hantheover
allbreakevenquant
it
yofoutput(
sal
es
vol
ume).
2.Anegat
ivecoef
fici
entofcombi
nedl
everagei
ndi
catesthatl
ever
ageisbei
ngcomput
ed
atal
evelofout
putbelowtheov
eral
lbr
eakevenquant
it
yofoutput(
salesv
olume.
)
3.A l
argeabsol utev al
ueoft hecoeffici
entofcombi nedleverageindi
cat
est hatthe
cor
respondingout putl
evel(
salesvolume)isclosetotheoveral
lbr
eakevenquanti
tyof
out
put(sales)
, andtheabsolut
ev al
ueofEPSi smi ni
mal
4.Apositi
vecoef fi
cientofcombinedleveraget hatiscl oseto1. 0indicatest
hatoutput
l
evel(sal
esv olume)i srel
ati
vel
yfargr eaterthant heov er
allbreakevenquantit
yand
t
hatthev al
ueofEPSi ssizabl
e.Thereforea1per centincreaseinout putl
evel(
sales
v
olume)wi l
lincreaseEPSbyr el
ati
vel
ysmal l
per centage.

Appl
i
cat
ionsofcombi
nedLev
erage:

Thecombi
nedl
ever
agecanbeappl
i
edorusedt
o:

i
) Expl
ainwhychangesint
helevelofout
putproducemagni
fi
edper
cent
agechanges
i
nEPS,
i
i
) Expl
ainEPSfor
ecast
inger
rors,
and
i
i
i) Prov
ideameasureofanoveral
lcompanyri
sk.

159
 i
) Combi ned lev erage explains whychanges i n out putl ev elpr oduce magni fi
ed
percentagechangei nEPS. Asal readyi ndicat ed,combi ned l ev eraget ri
est o
explainwhya1per centchangei nout putproducesadi spr oportionat eper centage
changei nEPSasl ongasf ixedf i
nanci ngcost sar egr eatert hanzer o.I ncreasesin
thef i
xedf i
nanci ngcostcomponent susedt omeasur eoper ati
ngl everageand/ or
fi
nancialleveragecanpr oducegr eat l
yi ncreasedcoef fi
cientofcombi nedl everage
becausecombi nedl ever
agei st hepr oductoft hecoef ficientsofoper ati
ngand
fi
nancial l
everage.
i
i
) Combi nedl everagecanbeusedt oexpl ainer rorsi nEPSf orecast s.Acompany
usuallyf orecast s its expect ed l ev el of out put (sal es v ol ume) and t he
correspondingEPSandcomput est hecoef fi
ci entofcombi nedl everageatt he
for
ecast edl evelofout put( sal
esv olume) .Ot hert hi
ngskeptconst ant,foreach
percentageofdev iati
oninact uall evelofout put( salesv olume)f ormi tsforecasted
l
evel,thisper centagedev iati
onofact ualEPSf rom i tsfor ecastedEPSi sequalt o
the coef f
ici
entofcombi ned l ev erage mul tiplied by t he per cent age er rorin
for
ecast edout putlevel.

i
i
i) Combi nedl everagecanbeusedt oprovideameasur eofov erallcompanyr i
sk.
Theov eral
l companyr i
skthatthecompanyassumesi sthepossi bi
li
tythatitwill
go
outofbusi nessandt hati
tsshar eholders’i
nvestmentwi l
lbecomewor t
hless.I n
suchanev ent,thepr i
ceoft heshar eoft hecompanywi llgodown( i.
e.theweal th
ofshar eholders’wi llbemi nimized) .Sincecombi nedlever agei sthepr oductof
operati
ngl everage( whichmeasur esoper at
ingrisk)andf inancialleverage( which
measur esf i
nanci alrisk),i
tmeasur estheov eral
l(combi ned)r i
sk.I ngener al,the
l
argert hecoef ficientofcombi nedl ever
agef oraf or
ecast edl evelofout put,the
greatertheov erallri
sk.Thatt hecompanyandi tsshareholder sencount er.

Anyi nvestment -fi

nancingdeci siont hatr esult
si nanal teredcompany ’
sov erallbreakev en
quantit
yofout putwi l
lchanget hedegr eeofov erallri
sknessofi nv estingi nt hatpar t
icular
company . A decr easei nuni tsellingpr i
ce,ori ncreasesi nfi
xedpr oduct ioncost s,uni t
vari
ableproduct ioncost s,orfi
xedf inancingcost si ncreaset heover
al lbr eakev enquant i
tyof
output(salesv olume)andt hecoef ficientofcombi nedl everage.Thi sf urtheri ndi
catest hat
theincreaseint heov eral
lriskofi nv esti
ngi nthecompany .Ani ncr easei nt heuni tsel l
ing
pri
ce,ordecr easesi npr oducti
onorf inancingcost s,ont heotherhand,decr easet heov eral
l
breakevenquant it
yofout putandt hecoef fi
cientofcombi nedlever age. Thi swillfurther
decreasetheov eral
lcompanyr isk.

Chapt
erSummar
y

Thechapterhasdi scussed l
ever
age(oper
ati
ng,fi
nanci
aland combi
ned)asa t oolfor
fi
nanci
alanal y
sis. The chapt erhas t
ri
ed t
o explai
ny ou t
he def
init
ions,pr
oper
ti
es,
i
nterpr
etat
ions,andappli
cati
onsofoper
ati
ngfi
nanci
al,
andcombinedl
everage.

Operat
inglever
ageist her esponsi venessofthecompany ’
sEVITtochangesi nt hequantit
y
ofoutputorsales.Itarisesf rom t hecompany ’
suseoff i
xedoperati
ngcosts.Whenf ixed
oper
atingcostsarepresent edint hecompany ’
scostst
ructure,
changesinthel
ev elofoutput,
orsalesar emagnified int o even greaterchangesin EBIT. Thecompany ’
sdegr eeof
oper
atinglev
eragefrom thei niti
allevelofoutput(
sal
esvolume)isthepercentagechangei n

160
EBITdivi
dedbythepercent
agechangei
nthel
evelofout
put
/sal
es. Oper
ati
ngl
ever
age
prov
idesameasureofoper
ati
ngr
isk.

Acompanyempl oysfinanci
all
everagewheni tfinancesapot i
onofitsasset
swi t
hsecur
it
ies
beari
ngaf i
x edrateofr et
urn(bondsandpr eferredstock)
.Thepr esenceofbondsand/or
pref
erredst ockinthecompany ’scapitalst
ructuremeanst hatitisusingfi
nanci
all
ever
age.
Whenf inanciall
everageisused,changesinEBITl eadint
olargerchangesinEPS.

Theconceptoff inanci
all
everagedwel l
sont hesensi t
ivi
tyofEPStochangesinEBIT.The
degreeoff i
nanciallev
erageisdef i
nedast heper centagechangeinEPSdi v
idedbyt he
percent
agechangei nEBIT.Allotherthingsequal,t
hemor ebondsandpr
efer
redsharesthe
companyempl oy
si nitsfi
nancialst
ruct ur
e,thelargeristhedegreeoffi
nanciall
ever
age.
Fi
nanciall
everageprovi
desameasur ef orfi
nancialr
iskofinvest
ingi
nfi
xedrat
esecuri
ti
es.

Compani esuseoper ati

ngandf i
nanci
allev
eragesinv ar
iousdegr
ees. Thejointuseof
oper
at i
ngandf inanci
allev
eragecanbemeasur edbycomputingthecombinedl ev
erage
coef
fici
ent,def
inedast hepercent
agechangeinEPSdiv
idedbythepercent
agechangeinthe
l
evelofoutput( sales)
.

Combi
nedlever
ageexpl ainshowoper at
ingandfinanciall
everageinter
acttomakechanges
i
nthel
evelofoutput(sales)pr oducemagnif
iedchangesi nthelevelofEPS.Mathemat
ical
ly
,
combi
nedlever
agei sthepr oductofoperat
ingandf inanci
alleverageatanygivenl
evelof
out
put
/sal
es.Combi nedl everagehelpstomeasuretheov eral
lcompanyr i
sk.

161