PRINCIPLES OF FINANCE

Whether the business concerns are big or small, they need finance to fulfill their business
activities. Finance may be defined as the art and science of managing money. According to
Oxford dictionary, the word finance connotes management of money‘. Webster‘s Ninth New
Collegiate Dictionary defines finance as the Science on study of the management of funds‘ and
the management of funds as the system that includes the circulation of money, the granting of
credit, the making of investments, and the provision of banking facilities. Therefore, Finance is
defined as the procurement of funds and their effective utilization in business concerns. The
concept of finance includes capital, funds, money, and amount. But each word is having unique
meaning. Studying and understanding the concept of finance become an important part of the
business concern.

SCOPE OF FINANCE

a. Financial Management (Corporate Finance)

Financial Management or corporate finance, deals with procurement of funds and their effective
utilization in the business entities. Financial management is the broadest of the three areas and is
important in all types of businesses including banks, financial institutions, industrial concerns,
and retail firms, governmental institutions such as schools, hospitals and even local
governmental departments. Corporate finance is concerned with budgeting, financial forecasting,
cash management, credit administration, and investment analysis and fund procurement of the
business concern. However, regardless of the area a finance specialist enters, he or she will need
a knowledge and understanding of all the three areas.

b. Investments

This area focuses on behaviour of financial markets and the pricing of securities. Finance
graduates who go into investment often work for a brokerage house either in sales or as security
analyst. Others work for banks, mutual funds, or insurance companies in management of their
portfolios; for financial consulting firms advising individual investors or pension funds on how
to invest their capital; for investment banks whose primary function is to help businesses raise
new capital; or as financial planners whose job is to help individuals develop long-term financial
goals and portfolios.

c. Financial Institutions

They deal with banks and other firms that specialize in bringing the suppliers of funds together
with the users of funds. One needs knowledge of valuation techniques, the factors that cause
interest rates to rise and fall, the regulations to which financial institutions are subject, and the
various types of financial instruments (mortgages, auto loans, fixed deposits, letters of credit
etc). General business administration knowledge of financial institutions is also important such
as marketing, accounting, computer systems and human resources management is also important.

FINANCE DECISIONS

The financial manager makes decisions relating to financial objectives. These decisions include
the following:

a. Investment Decision

Every business has to decide where to allocate scarce resources. Put more simply, every business
has to look at its available investment opportunities and decide whether to make the investment
or not. In making this decision, firms have to grapple with two basic issues.

a. The first is the rate of return that they need to make on an investment, given its risk, for it
to be a good investment.
b. The second is how to measure returns on investments, especially when the cash flows on
these investments are different from accounting earnings and vary over time.

b. Financing Decisions

This function is mainly concerned with determination of optimum capital structure of the
company keeping in mind cost, control and risk. Generally this is a Procurement of Funds
function since investments in assets must be financed somehow. Financial management is also
concerned with the management of short-term funds and with how funds can be raised over the
long term. There are two ways in which any business can raise financing. It can use the owner‘s
funds (equity) or it can borrow money (debt). Every business has to consider whether the mix of
debt and equity that it uses to fund investments is in fact the right one. The financing decision
examines whether the firm‘s existing mix of debt and equity is the right one.

Firms also have to pick from a variety of different financing choices – short term versus long
term debt, fixed rate versus floating rate debt- and determine what type of financing is best suited
for them. Owners‘equity is less risky source but it leads to dilution of ownership of current
shareholders but debt finance though cheap, exposes the company to risk of liquidation or
takeover in case it fails to pay interest on such loans.

c. Dividend Decisions

After firms make investments with their chosen financing mix, the investments generate cash
flows. When the cash flows come inform of profits, firms will have to make decisions on how
much of these profits will be invested back into the business and how much returned to the
owners of the business. In a publicly traded firm, cash flows can be returned either as dividends
or by buying back stock.
Johnson (2001) pointed out that strategic decisions involving dividend policy all have long term
economic implications to the value a company creates for its shareholders. When people buy
common stock (shares) they give up current consumption but expect to collect dividends and
eventually sell the stocks at a profit.

Therefore, return on common stock includes the cash dividend paid during the year together with
an appreciation in the market price or capital gain realized at the end of the year. Therefore,
shareholders of a business firm receive benefits in only two ways: appreciation of share prices
and dividends received otherwise, they would rather withdraw their capital and invest
somewhere else.

Johnson (2001) also argued that dividends provide a signal to the public equity market as to
management‘s expectations of the company‘s prospective cash flow generating ability hence
leads to appreciation of market share price. It can be seen that a good company would rather pay
all its earnings as dividends after all it will increase share price and shareholders wealth as well
as signal that the company has a bright future. However, this will be disastrous as part of the
profits should be retained and be invested back to ensure and assure shareholders of future
dividends. Therefore, the finance manager must strike a balance and decide the amount of
dividend to be paid

d. Risk Management Decisions

The generally argued that business entities faces risks in various forms and that the higher the
risk, the higher the return a business will receive. A finance manager is charged with the duty of
identifying the risk, measuring the risk using various techniques and methods of risk
measurement. A consultant or external experts may be used at this stage but the ultimate
responsibility still lies with the finance manager. Further, a choice of strategy of managing the
risk must be chosen e.g. transfer the risk to an insurance company, retain the risk or simply avoid
the risk.

FINANCIAL OBJECTIVES

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management

a. Shareholder wealth maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. Horne (2001) asserted that the objective of a
company must be to create value for its shareholders. Other writers such as Brigham et al (1994)
and Mauboussin (1998) added that the primary goal of a firm is stockholder wealth
maximization. The use of the objective of shareholder value maximization has been advocated as
an appropriate and operationally feasible goal since it provides an unambiguous measure of what
the firm should seek to maximize in making any decision. Shareholder wealth maximization is
also known as shareholder value maximization or net present worth maximization.

b. Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. However, Profit
maximization objective consists of certain drawback also:

i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.

ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.

iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may
be internal or external which will affect the overall operation of the business concern.

c. Non-Financial Objectives

A company may have important non-financial objectives, which will limit the achievement of
financial objectives. Examples of non-financial objectives are as follows.

i. The welfare of employees

A company might try to provide good wages and salaries, comfortable and safe working
conditions, good training and career development, and good pensions. If redundancies are
necessary, many companies will provide generous redundancy payments, or spend money trying
to find alternative employment for redundant staff. Effective achievement of this goal will imply
diversion of finances from investment opportunities to employee welfare hence forfeiting
shareholders ‘wealth creation.

ii. The welfare of management

Managers will often take decisions to improve their own circumstances, even though their
decisions will incur expenditure and so reduce profits. High salaries, company cars and other
perks are all examples of managers promoting their own interests. The dilemma is always the
answer to the question: who TRULY owns the company? Is it the Management or shareholders?

iii. The provision of a service

The major objectives of some companies will include fulfillment of a responsibility to provide a
service to the public.

iv. The fulfillment of responsibilities towards customers

Responsibilities towards customers include providing in good time a product or service of a

quality that customers expect, and dealing honestly and fairly with customers. Reliable and
quality supply arrangements, also after-sales service arrangements, are important.

v. The fulfillment of responsibilities towards suppliers

Responsibilities towards suppliers are expressed mainly in terms of trading relationships. A

company's size could give it considerable power as a buyer. The company should not use its
power unscrupulously. Suppliers might rely on getting prompt payment, in accordance with the
agreed terms of trade.

vi. The welfare of society as a whole

The management of some companies is aware of the role that their company has to play in
exercising corporate social responsibility. This includes compliance with applicable laws and
regulations but is wider than that. Companies may be aware of their responsibility to minimize
pollution and other harmful 'externalities' (such as excessive traffic) which their activities
generate. In delivering 'green' environmental policies, a company may improve its corporate
image as well as reducing harmful externality effects. Companies also may consider their
'positive' responsibilities, for example to make a contribution to the community by local
sponsorship. Other non-financial objectives are growth, diversification and leadership in research
and development. Non-financial objectives do not negate financial objectives, but they do
suggest that the simple theory of company finance, that the objective of a firm is to maximize the
wealth of ordinary shareholders, is too simplistic. Financial objectives may have to be
compromised in order to satisfy non-financial objectives

FUNCTIONS AND ROLES OF A FINANCE MANAGER

Financial management can be defined as the management of the finances of an organisation in

order to achieve the financial objectives of the organisation. The usual assumption in financial
management for the private sector is that the objective of the company is to maximize
shareholders' wealth.

Generally speaking, the functions of a finance manager are mainly two: Financial planning and
financial control functions. Under planning, the financial manager will need to plan to ensure
that enough funding is available (financing decisions) at the right time to meet the needs of the
organisation for short, medium and long-term capital.
a. In the short term, funds may be needed to pay for purchases of inventory, or to smooth out
changes in receivables, payables and cash: the financial manager is here ensuring that working
capital requirements are met. He will need to identify sources of such short term funds such as
overdrafts, short term loans, or from operating activities. This planning function may include
projection of the source, amount and timing of such funds and perhaps prepare a cash budget.

b. In the medium or long term, the organisation may have planned purchases of noncurrent assets
(formerly called Fixed Assets) such as plant and equipment, for which the financial manager
must ensure that funding, is available. In most cases funding of non-current assets is
distinguished from short-term funding and may include issue of loan term debt such as a
corporate bond, issue ordinary share capital or divesting a business unit to get finance (financing
decisions). Furthermore, a financial manager will decide the projects and non-current assets to
invest in (investment decisions), prioritize to know the timing and amount needed and also
analyse the risk inherent in such investments (risk management decisions).

The control function of the financial manager becomes relevant for funding which has been
raised. Are the various activities of the organisation meeting its objectives? Are assets being used
efficiently? To answer these questions, the financial manager may compare data on actual
performance with forecast performance. Forecast data will have been prepared in the light of past
performance (historical data) modified to reflect expected future changes. Future changes may
include the effects of economic development, for example an economic recovery leading to a
forecast upturn in revenues.

The two functions of planning and control are executed by finance manager by carrying out the
following roles among others:

a. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
non-current assets and forecast the amount needed to meet the working capital requirements in
future. This means that he/she must interact with people from other departments as they look
ahead and lay the plans that will shape the firm‘s future. This role is mostly achieved through
budgeting.

b. Financing Capital requirements

After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.
Nevertheless, for an on-going concern, growth in sales requires investments in plant, equipment
and inventory among other assets. Financial manager must help determine the optimal sales
growth, discount rate to be allowed, appraisal of suppliers and creditors, optimal credit period
necessary to attract customer, specific source of finance to be utilised.
c. Investment Decision

The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital. He
should be able to consider multiple investment opportunities, some mutually exclusive and
allocate available finances able to maximize owner‘s value. He/she must decide whether to lease
or buy, invest or divest with an aim of attaining higher than the desired rate of return or cost of
capital utilised.

d. Working Capital and Cash Management

Present day‘s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern. The finance manager have to ensure he avoid
overtrading and being over capitalised by choosing an appropriate approach between an
aggressive, moderate or conservative working capital approach

e. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization to be able to
participate in their budgeting processes, investment project appraisal and in managing other
activities that affects finances of the organisation such as sales and purchases.

f. Dealing with financial markets

Finance manager works as the link between money markets (banks and other short-term lenders)
and capital markets (stock and bond market) and the organisation. Each firm affects and is
affected by the general financial markets where funds are raised, firm‘s securities are traded and
where investors either make or lose money.

g. Risk Management

All businesses face risks, including natural disasters such as fires and floods, uncertainties in the
commodity and security markets, volatile interest rates, and fluctuating foreign exchange rates.
However, many of these risks can be reduced by purchasing insurance or by hedging in the
derivative markets. Finance manager is responsible for the firm‘s overall risk management
program, including identifying the risks that should be managed and then managing them in the
most efficient manner.
FINANCE AND RELATED DISCIPLINES

Finance is one of the important parts of overall management, which is directly related with
various functional departments like personnel, marketing and production. Finance covers wide
area with multidimensional approaches. The following are the important scope of finance.

i. Finance and Economics

Economic concepts like micro and macroeconomics are directly applied with the finance
approaches. Investment decisions, micro and macro environmental factors are closely associated
with the functions of financial manager. Finance also uses the economic equations like money
value discount factor, economic order quantity etc. Financial economics is one of the emerging
area, which provides immense opportunities to finance, and economical areas.

ii. Finance and Accounting

Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the finance and accounting. In the olden periods, both
finance and accounting are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance manager to take
decisions. But nowadays finance and accounting discipline are separate and interrelated.

iii. Finance and Mathematics

Modern approaches of the finance applied large number of mathematical and statistical tools and
techniques. They are also called as econometrics. Economic order quantity, discount factor, time
value of money, present value of money, cost of capital, capital structure theories, dividend
theories, ratio analysis and working capital analysis are used as mathematical and statistical tools
and techniques in the field of finance.

iv. Finance and Production Management

Production management is the operational part of the business concern, which helps to multiply
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance
required for each process of production activities.

v. Finance and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The finance manager or finance
department is responsible to allocate the adequate finance to the marketing department. Hence,
marketing and finance are interrelated and depends on each other.

vi. Finance and Human Resource

Finance is also related with human resource department, which provides manpower to all the
functional areas of the management. Finance manager should carefully evaluate the requirement
of manpower to each department and allocate the finance to the human resource department as
wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the
human resource department. Hence, finance is directly related with human resource
management.

SOURCES OF BUSINESS FINANCE

Financial sources or funds available to a business organization could be classified into short-
term, medium term, and long-term, or into short-term and long-term. Sources of funds available
to business organizations could be classified into two main categories:

• Internal
• External

These categories have different types of sources, that is a firm can generate funds internally or
externally to finance its activities. External sources could also be short-term or long-term. This
unit will focus on how firms acquire funds in order to acquire assets.

Short-term sources

Short-term sources of funds represent current liabilities (funds owed). They represent short-term
obligations. Since they are supposed to be settled by cash, they represent cash payments which
must be settled as at when due. Examples of current liabilities and their sources are explained as
follows:

Bank Overdraft: The source of overdraft is banks, and they grant this to creditworthy firms.
Funds could be advanced to such firms within a period ranging between one day and one year.
These loans are supposed to be repaid on self-liquidating basis.

Account Payable: This is trade credit. A firm can buy something on credit. Supplies could be
made on credit, and they give rise to trade credits.

Bill Finance: This is bill is a promissory note. But there are different types of bills and
complexity exists in their meanings. In our case, a bill is a trade bill of exchange which could be
domestic or foreign. If a bill of exchange (inland) is accepted from discounting operations.

Deferred Tax Payment: Tax payment could be looked at from two perspectives: Self-imposed
(a firm will not pay when it is supposed to pay and that becomes a source) and Late assessment.
Factoring: Debt could be factored. This is another source of short-term funds. Factoring
involves handing over of account receivable or any other debt to factors for collection with or
without recourse.

Hire Purchase Finance Arrangement: Firms that engage in selling on installment basis can
make arrangement with hire purchase firms to make credit facilities available to customers.
Alternatively, a firm may make hire purchase agreement with its customers.

Stock Finance: Stocks could be used to raise short-term funds in a number of ways. They could
be used as collaterals for secured loans from commercial or merchant banks. Raw materials
could be financed en route by means of trade bills and/or warehouse receipt. This represents
another type of secured loans on the value of stock of raw materials. The bill could become
negotiable if endorsed by a reputable commercial house or bank, and could thereafter be sold
outright or used as collateral for a loan.

Long-Term Sources

Two major external sources of long-term funds are: Financial institutions (including lease
finance companies), and Capital market. Capital market is classified into: Organized and
Unorganized. The organized capital market will be our focus because it is the capital market that
will assess the performance of the firm. Firms raise money from the capital market by: Issuing
common stock (C/S); And Issuing instruments of debt (long-term liabilities). Note that a firm
cannot issue debt instruments if it has no common stock. Sources of long terms funds are:

Common Stock: Equity shares, common stock and ordinary shares, all mean the same thing, but
a stock is a group of shares, that is, a stock is made up of shares. Ordinary shares could be issued
by firms which have been quoted on the stock exchange. Ordinary shares constitute the equity
base of a firm, and represent ownership of the firm on pro-rata basis. This implies that an
individual investment is a small proportion of total investment. Each equity shareholder is
entitled to a proportionate part of the firm’s residual profit and asset. The capital contributed by
the shareholders is, therefore, known as risk capital. But they have some compensation like
voting rights.

Preference Shares: The next class of shares which ranks above equity shares are the preference
shares. They are also known as preference stocks. Preference shares occupy an intermediate
position between common stock and debenture stocks. Preference shareholders are entitled to
fixed dividend payment as different from equity shareholders which are entitled to variable
dividend payments. They are imperfect creditors because tax is paid before fixed dividend is paid
to them; they are not creditors and they are not the owners of the firm. They do not normally
have voting rights unless otherwise stipulated in the terms of the issue. There are various types of
preference shares:
Cumulative Preference Shares

Preference shares could be cumulative or non-cumulative. Cumulative preference shares allow

for dividend payment to be deferred if a firm does not make adequate profit to pay such
dividend. Therefore, such firms are normally required to pay such dividends in arrears before
dividend could be paid to common shareholders. Non-cumulative preference shares do not allow
for any form of deferment of dividend payment.

Participating Non-Cumulative Preference Shares

This class of shareholders is entitled to a non-cumulative dividend at a fixed rate but without a
right to participate in the residual profit of a firm after the equity shareholders has been paid.

Participating Cumulative Preference Shares

This class of shareholders is entitled to participate in the residual profit of a firm in addition to
the cumulative fixed dividend rate (i.e. they combine the features of cumulative and
participating).

Redeemable and Non-Redeemable/Irredeemable Preference

Preference shares could be redeemable or irredeemable. Redeemable preference shares are

normally redeemed after a fixed period of time. We can say that this class of preference shares
has a definite maturity period while irredeemable preference shares do not have definite maturity
period (but it could be sold at the security market – an artificial maturity period).

Convertible Preference Shares

Convertible preference shares convey upon the holders the right to convert these shares into
equity shares in accordance with the terms of issues. This is an issue with speculative features.
These shares are corporate fixed-income securities that the investor can choose to turn into a
certain number of shares of the company’s ordinary shares after a predetermined time span or on
a specific date. The fixed income component offers a steady income stream and some protection
of the investors’ capital. However, the option to convert these securities into stock gives the
investor the opportunity to gain from a rise in share price. It can be summarized that convertible
preference shares give the assurance of a fixed rate of return plus the opportunity for capital
appreciation.

Debenture Stocks: These are corporate bonds. Two categories of debentures are:

All banks debentures

This involves one to one relationship between a bank and a firm, and lending is based on the
assets.
Debenture Stocks – Debenture stocks or corporate bonds are normally issued under a firm’s
seal. This represents the legal evidence of a firm’s indebtedness. A debenture stock holder is a
creditor to the firm, therefore, he is entitled to a fixed interest payment whether a firm makes
profit or not. Debenture stock holders do not have any voting right and their interest in the firm is
limited to the fixed interest payment no matter how successful the firm may be.

Lease Financing: This is an important source of long-term funds. It may be used as a source of
financing company expansion or for modernization of the productive apparatus of the firm. Thus,
through leasing, a company may make use of equipment without actually owning it. The main
objective of leasing is to put at the disposal of a firm a plant or any fixed asset which serve the
productive need of such a firm. The firm, in making use of that equipment, is obliged to pay to
the lessor adequate sum of money which constitutes cost on the part of the firm. Three types of
leases are:

Operating leases
This is a lease agreement between a lessor and a lessee whereby the lessor is responsible for the
upkeep, maintenance, servicing and insurance of the leased asset. All risk and reward incidental
to the ownership remain with the lessor. This type of lease agreement does not cover the useful,
economic, working life of the leased asset. Consequently, at the end of the agreement, the lessor
can lease the same asset to someone else (or to the same lessee) and obtain rental for it. The lease
can sometimes be cancelled at a short notice.

Capital/financial leases
These are lease agreement between the user of the leased asset (i.e, the lessee) and a provider of
financial (that is the lessor). The lessee is responsible for the upkeep, maintenance, servicing and
insurance of the leased asset. Consequently, all risk and rewards incidental to ownership are
substantially transferred to the lessee. Title may or may not eventually be transferred at the end
of the lease agreement. The lease has a primary period, which converts the expected useful,
economic working life of the asset. At the end of the primary period, the lessor would not be able
to take possession of the asset and lease it for a good rental to someone else because the asset
would have aged or become obsolete.

After the primary period, the lessee has the option to continue to lease the asset for an indefinite
secondary period, in return for a very low nominal rent. Sometimes called a “peppercorn rent”
Alternatively, the lessee mighty be allows to buy the asset or sell it on behalf of the lessor.
Finance is usually non-cancellable

Sale and Leaseback

This is a situation where an asset previously owned by a company is disclosed off and
immediately repossessed through a leasing contract.

WORKING CAPITAL MANAGEMENT

In business, when sales arise not in cash, the immediate outlet is receivables – accounts
receivables or trade debtors and current asset cash and receivables (debtors) which assist in the
operations of a business enterprise. The management of these receivables is very vital to the
business as a going concern. Organisations usually have claims to future inflows of cash. These
claims are known as accounts receivables and note receivables expressed in financial statements.

Inventories are the balance of goods on hand (part of current assets). In a producing enterprise,
they comprise raw materials, work-in-progress and finished products. These inventories need to
be managed properly to avoid unnecessary cost. Management of inventory will be explained as
part of working capital management.

Working capital management refers to the management of current or short-term assets and short-
term liabilities. Components of short-term assets include inventories, loans and advances,
debtors, investments, and cash and bank balances. Short-term liabilities include creditors, trade
advances, borrowings and provisions. The major emphasis is, however, on short-term assets,
since short-term liabilities arise in the context of short-term assets.

Working capital management is, therefore, concerned with the ways and means of making
working capital adequate to meet the firm’s short-term obligations. The effective working capital
management involves the adoption of appropriate management policy. The main components of
Working capital management are:

Cash management focuses on managing cash flows in and out of an enterprise i.e. cash flows
within and cash balances held by an enterprise at a given point in time which is utilised either by
financing the deficit gap or investing surplus cash. Note: Sales generate cash disbursed. Surplus
cash is invested while deficit is borrowed to makeup. Cash management attempts to control cash
cycle at a minimum cost and tries to achieve liquidity. Cash management places cash as the most
significant and at the same time the least productive asset at the disposed of an enterprise. It is a
means of settling indebtedness of the enterprise.

It is not easy to predict cash flows accurately, that means, it takes time and dexterity to achieve
its ideal position. That means the aim of cash management is to maintain adequate control over
cash position to be able to keep the enterprise sufficiently liquid and to use excess cash in some
profitable way. Cash management is concerned with the managing of:

a. Cash flows into and out of the enterprise

b. Cash flows within the enterprise
c. Cash balances held by the enterprise at a point of time by financing deficit or investing
surplus cash.

Steps to Cash Management

This involves two paths of action –

a. having the right amount on hand to pay your bills

b. using any excess of that amount wisely.
 We will now consider an approach for a reliable cash management which involves four steps:
a. Keeping adequate records on cash book control
b. Identifying the cash flow pattern
c. Estimating future cash balances and
d. Utilizing excess cash to generate income.
Cash comes from:
i. Daily cash sales
ii. Payments made by customers to their accounts
iii. Loans acquired for short-term needs
iv. Additional capital borrowed on long term basis.

Motives for holding cash

Business need to hold cash to achieve the following three motives: Transactions, Precautionary
and Speculative

Transaction Motive

This requires an enterprise to hold cash to perform it ordinary business activities. This cash is to
pay for purchase, wages and salaries, other operational expenses, tax dividends etc. With
effective management of cash receipts and cash payment will make the holding of cash not
necessary as there will be enough cash when payment is to be made.

Precautionary Motive

This is for the enterprise to meet up contingencies as they arise in the future. Cash at this stage is
used to provide a cushion or buffer to withstand some unexpected emergency. The precautionary
amount of cash will depend upon the predictable nature of the cash flow of the business.

Speculative Motive

This is holding cash for investing in profit-making opportunities as and when the need arises.
The opportunity to make profit by an enterprise may arise when the security prices change. This
is an opportunity to hold cash and expect a rise in interest rates and security prices will fall.

Management of Receivables

Trade credit make way for trade debtors otherwise known as account receivable which a business
(an enterprise) expects to receive in form of cash in the near future (usually which a short period
within the financial period e.g. a week, fortnight, month, quarter, half a year, a year). The
customers benefiting from this gesture are known as trade debtors or generally listed as debtors
(to be claimed as asset of the organisation. Receivables are risk elements, meaning that
management must identify some elementary facts (characteristics).
i. It involves the analysis of the implication of value of credit sales. Cash sales are riskless.
Credit sales need to be carefully analysed as cash payment will be in future. The integrity of the
beneficiary of the sales must not be in doubt judging by the track record of the trade business.

ii. Based on economic value, the purchaser benefits at the time sales immediately while the
owner of the sales expects an equivalent of the trade value in future time.

iii. It connotes that the buyer will provide the cash payment for the good/services received in
a future period.

The time lag is the risk which is borne by the seller. He need be sufficient and surplus in its cash
holding, control and management to stay afloat till that aspect of account is received as a whole.
Any hiccup in repayment by the customer (beneficiary) will negative affect the cash flow level at
the expected time. You should note that debtors form a reasonable part of current assets of many
enterprise especially where the customer need this service to enhance their being in business as a
going concern.

Inventory management: Inventory management is a tool to avoid excessive and inadequate

levels of inventories and maintain sufficient inventory for the smooth operations of the enterprise
in terms of production and sales output. The management should provide the enterprise with an
order at the right time with the right source to acquire the right quantity at the right price and
quality. An effective inventory management ensures

i. A continuous supply of raw materials to facilitate functional production and distribution.

ii. The maintenance of sufficient stocks of raw materials in short supply period and
anticipate changes in price level
iii. Sufficient finished goods inventory for smooth sales distribution in order to sustain
efficient customer service.
iv. Minimum carrying cost and time and
v. Investment control in inventories and optimum level of operation. Managing current
assets generally require a great attention and inventory is inclusive.
vi. Inventory is constantly being in use. Raw materials and work-in progress inventories are
used in production. Finished goods are sold, spare parts replace worn-out parts. The rate
of usage, depend on the type of inventory.
vii. Managing the level of inventory can be compared with maintaining the level of water in a
bath tub with an open drain.

The water flows out continuously. If it flows too slowly, the tub is soon empty. If it is let too fast,
the tub overflows. Like the water tub the particular inventory items is dynamic, while the level
may stay the same.

The fundamental financial decision problems are:

 a. to determine the proper level of investment in inventory and
b. to decide how much inventory to be acquired at each period to maintain the required
level.
c. Maintaining inventories means:
d. Tying up the enterprise’s funds and
e. Incurrence of storage and
f. Handling of costs

CAPITAL INVESTMENT DECISION

Capital investment decision may be defined as the firm’s decision to invest its current financial
resources efficiently in a long term project in the anticipation of an expected flow of benefits
over a period of time. It is an integral part of the corporate plan of an organization since the
decision will determine the value of the firm, influence its growth, profitability and risk. The
survival of a firm depends largely on its ability to increase the wealth of the owners; necessitate
an effective and efficient allocation of available financial resources among the various available
growth opportunities.

A capital investment decision involves a critical appraisal before being embarked upon, because
it involves the commitment of a huge amount of financial resources, which are usually
irreversible. Therefore, every capital investment decision needs to be evaluated for its
profitability, by comparing the investment of current financial resources with the expected
stream of future benefit.

However, while some projects’ future benefit are quantifiable which allows appropriate
techniques to be employed to determine their economic worth, others such as welfare projects,
educational projects, and public projects need not be so justified.

Capital investment decision and other related financial conclusions usually involve more than
one year period, thereby, affecting the cash flow of more than a year. These results in differences
in the timing and risk involved. Comparing the cash flow of different years becomes difficult.
The recognition of the time value of money and risk is vital in financial decision as they affect
the objective of maximizing the shareholders’ wealth.

In order to compare the cash flow, there should be appropriate adjustment for the differences in
timing and risk involves through discounting cash flow approach. Discounting is the process of
determining the present value of a future payment (or receipt) or a series of future payment (or
receipt)

Types of Capital Budgeting/ Investment Decision

Capital budgeting decisions may be classified as follows:

a. Replacement of fixed assets because of expiration in it economic life span in order to
improve operating efficiency and to reduce cost.
b. Expansion due to successful operations, which generate growth in sales of product or
delivery of service. The reason for decision is avoid shortage or delay in delivery of goods and
services in order to meet growth in demand and to increase revenue.
c. Diversification to reduce risk or failure by operating in several markets and line of
business rather than in single market or one line of business. It allows the firm to protect itself
against collapse of sales in a single product or single market
d. Research and development particularly for firms in industries where technology rapidly
change which will demand expending huge sums of money for researching and developing new
products. If large sums of money are needed for equipment such proposals will normally be
included in the capital budget.
e. Miscellaneous proposals such as safety-related or pollution-control devices do not
directly help achieve profit oriented goals.
Process of Capital Budgeting.

This involves the following steps:

i. Project planning- identification of potential investment opportunities after carrying out

strength, weaknesses, opportunity and treat (SWOT)
ii. Evaluate the project by
Determining the projects’ cash inflows and cash outflows
Select a capital budgeting technique to be used in the evaluation
Appraisal of the projects using the selected technique
iii. Selecting the project that will maximize shareholders wealth among the available
investment.
iv. Raise the funds, purchase the assets and deploy the assets to carryout the project. This is
known project implementation.
v. Project control through monitoring the project with the help of feedback report such as
performance reports and capital expenditure progress reports.
vi. Reviewing the entire project so as to explain its failure or success. This may have
implication for planning and evaluation.

Factors of Capital Budgeting.

When preparing capital budget, the following factors should be carefully considered:
(i) Economic Change: As such it is always important to try and foresee future economic
developments. One development that must quickly be detected is the emergence of new
competitors and new market.
(ii) Technology Change: Nowadays change in the technological field is very rapid. Faster
communication, increasing automation, new forms of materials and the endless products of more
and more research and development makes it essential that any plan spanning the years predicts
the broad development in technology.
(iii) Socio-political Change: The societal values, norms and orientations do change even
though not as rapid as the economic and technological changes in the societal norms and values
would greatly influence consumers preferences and taste, which will affect future demands of
goods and services of the firm. Therefore, management should anticipate such changes and
incorporate them. In the long-term plan (i.e. the capital budgeting).
(iv) Future Prospect: The current decision on capital budget should be taken with
provision for future growth or expansion in terms of future additional equipment that will be
needed to meet the future demand, reacting to new challenges and opportunities etc.
(v) Financing: In all capital budgeting decisions one ultimately arrives at the question of
how will needs (i.e. projects) be financed? This demands very much on the financing policy of
the enterprise, either by using equity or debt capital or a combination of both.

Investment Decision Evaluation Techniques

Once the necessary financial information has been collected, the figures will be subjected to
various evaluation techniques to assess the economic worth or profitability of the proposals.
Several evaluation techniques have been developed for assessing the economic worth of projects.
They are:
(a) Non- discounted cash flow methods
 Payback period
 Accounting Rate of Resulting (ARR)
(b) Discounted cash flow methods
 Internal Rate of Return (IRR)
 Net Present Value (IRR)
 Profitability index (PI).

Payback period

The payback period approach is one of the most used traditional methods of evaluating a project.
It is simply the length of time that it takes to recover the entire initial capital outlay invested in a
project. In evaluating a project using payback period method, the net cash flows from the project
are used for the evaluation. Where there is constant or uniform annual net cash flow from the
project, the formula for calculating the payback period, is:

Payback period= Initial Investment capital outlay

Annual net cash flow

Acceptance rule: For accepting a project using the payback period criterion, the project must be
within the maximum period set by the management prior to the evaluation of the project.
However, if the payback period calculated is more than the maximum acceptance period, the
project will be rejected.

The major drawback of payback period method is that it fails to consider the cash flows that
occur after the payback period. Consequently it cannot be regarded as a tool for measuring
profitability. For instance, two projects costing ₦10,000,000 each would have the same payback
period if they both had a sum of ₦10,000,000 cash flow for the first two years; but where one of
the projects is expected to earn ₦4,000,000 in year 3 and the other provides on each flow the
acceptance criterion maybe misleading.
In addition to this short coming, the method does not take account of the maximum rate of return
required by investors (that is the cost of capital) and the magnitude or timing of cash flow during
the payback period.

Accounting Rate of Return (ARR)

The accounting rate of return uses accounting information provided by the financial statement, to
determine the economic worth of an investment. It is calculated as the average project’s earning
after tax and depreciation, divided by the average book value of the investment during its life.

ARR = Average Net Income x 100%

Average Investment

The net income for any year is the net cash flow minus depreciation and tax. The average
investment would be equal to half of the original investment. Accounting rate of investment is
also known as return on investment.

In arriving at a decision, this method accepts all projects that have ARR higher than the
maximum target set by the management and reject those which are lower. For mutually exclusive
projects, this method project accepts ARR, provided that it is higher than the maximum set
target.

The major shortcoming of the accounting rate of return is that it uses accounting profit rather
than cash flow in appraising projects. In addition to this, the ARR method ignores the time value
of money and offers no guidance on what the right-targeted rate of return should be

The Discounted Cash Flow Methods

Net Present Value (NPV)

NPV is one of the DCF techniques that recognize the time value of money. It is the net
contribution of a project to its owner’s wealth, that is, the present value of the future cash flow
minus the present value of initial capital investment. It takes into consideration the income that
investment will generate over a time period minus the cost of the investment. With the presenting
value method, all cash flows are discounted to their present values, using the required rate of
return.

A variation of NPV is the net terminal value (NTV) sometimes called net future value. It is the
sum of money that the investor will have at the end of the project in excess of the amount that
would have been obtained had the project not been undertaken. This method usually gives the
same accept or reject decision for a project as NPV, if the same required rate of returned is used,
in relation to an individual investment opportunity, the NPV decision rule is to invest in the
project if the NPV is positive and not to invest if the NPV is negative.

The positive NPV will result only if the project generates cash inflows at a rate higher than the
opportunity cost of capital. Where the NPV is equal to zero, this implies that the project generate
cash flows at a rate just equal to the opportunity cost of capital and may be acceptable or
rejected. In selecting between mutually exclusive projects, the one with the highest positive NPV
should be selected

Internal Rate of Return (IRR)

The internal rate of return is also known as the yield of a project, it is defined as the cost of
capital for which the NPV of a project would be zero, it is that rate of return, which if applied,
would cause the investor to be indifferent between investing in a project and not doing so.

It can be deduced from the formula above that is the same as that for calculating NPV. The only
different is that, in NPV method the required rate of return is assumed to be known, while in IRR
method the required rate of return has to be determine.

If this approach is adopted, the internal rate of return calculated is compared with the company’s
cost of capital, if the yield of the project (that is IRR), exceeds the cost of capital the investment
is undertaken. If the yield is less than the cost of capital the investment is rejected.

There is also the trial by error method, known as interpolation method where the discount factor
is played with. The discounting factor yielding a positive NPV is improved to move towards
negative and a mid-way is discovered to arrive to zero.

As the calculated IRR (A-B) exceeds the 5% cost of capital of the company, project A should be
chosen

Profitability Index

This method of project evaluation is also known as benefit-cost ratio. It implies the ratio of the
present value of cash inflow at the required rate of return, to the initial cash outflow of the
investment. The index is a measure of a project’s profitability as the criterion produces by unit
return of the capital invested.

Capital Rationing

Capital rationing when there are insufficient funds to execute all viable and profitable project.
The inadequacy of resources to finance project could arise from budget ceiling placed by the
management or the inability to raise funds by a firm. This constraint may relate to the
consumption of any scarce resource required by all or some of the projects. For instance, capital
in one or more periods. Under capital rationing situation, the objective is to select the
combination of investment proposals that provide the highest net present value, subject to the
constraint for the period.

Single Period Constraint Problem

In a single period capital constraint problem, the goal is to get the project that provides the
highest net present value per unit of the capital invested. This ratio is known as profitable index.
All this projects need to be ranked by their size of profitability index and then worked down the
list until the available funds are exhausted.

However, project under a capital rationing situation might involve mutually exclusive, or
mutually dependent or indivisible projects. Care must be taken to treat each case thoroughly.

Illustration
Suppose a company is faced with the problem of investing N100, 000,000 in three projects
which are all attractive and profitable at 10% opportunity cost of capital. Which of the projects
should be undertaken by calculating the profitability index given the following evaluation
results?
Project Outlay NPV @ 10%
1 N100, 000,000 N21, 000,000
2 N50, 000,000 N16, 000,000
3 N50, 000,000 N12, 000,000

Solution:

Profitability index= Presented cash inflow (NPV)

Initial Outlay

Project 1 = N21, 000,000 = 0.21

N100, 000,000

Project 2 = N16, 000,000 = 0.32

N50, 000,000

Project 3 = N12, 000,000 = 0.24

N50, 000,000

Choice Profitability Required Cumulative Capital Ranking of Projects

Index Capital Outlay
N N
2 0.32 50,000,000 50,000,000 1st
3 0.24 50,000,000 100,000,000 2nd
1 0.21 100,000,000 200,000,000 3rd

The projects are ranked in the order ‘2’, ‘3’ and ‘1’. Project ‘2’ is best. It requires capital outlay
of ₦50,000. Project ‘3’ is the next best, but since it also ₦50,000 to execute and only ₦50,000 is
available, the investment has to be expected. As a general, the use of profitable index is possible
where there is only one constraint. Where there are two or more constraints, the use of
profitability index is not feasible

Multi-Period Constraint Problem

Capital investment decision under multi-constraint situation have the objective of choosing a
combination of project which gives the firm the maximum total net present value, subject to the
company’s resource availability. To achieve this, it is necessary to maximize the net present
value (NPV) of the project, using the techniques of linear programming or integer programming,
where it is not possible to undertake the project in parts.

Capital Investment under Inflation

Inflation is an important factor of economic and must be considered in capital budgeting. Since
the cash flow of an investment project may occur over a long period of time, the impact of
inflation should be correctly included for the investment analysis to be free of bias. The impact
of inflation in capital budgeting could be adjusted for either in the cash flow or discounting rate.
The discount rate is usually determined and is therefore, stated nominal terms.

However, where either cash flow or discount rate are expressed in real terms, they can be
reverted to their normal value through the following formula

Nominal Rate = (1+ Real Rate) (1+ inflation Rate) -1

To convert real cash flow to nominal cash flows, the formula is:
Real cash flow (1+ inflation Rate)

If the discount rate is stated in nominal term, then consistency requires that cash flows be
estimated in nominal terms, thus taking account of inflation rate of prices.

Costs are usually sensitive to inflation; some cost increase at a faster rate than others. Certain
items are not affected by inflation, for instance the tax shield on depreciation (depreciation is not
allowed on the book value of asset for tax purposed). In evaluating the economic worth of a
project, the real cash flows could be discounted at a real discount rate, although not commonly
done, or discounting nominal cash flows at the nominal rate. Both methods will usually give the
same answer, subject to approximation error.

Leasing

A lease is an agreement between two parties, the lessor and the lessee. It is a contract of bailing
with the lessee rarely becoming the owner of practice. A lessor is someone who owns a capital
asset, but grants the lessee use of it. A lessee is someone who does not own the asset but uses it,
and in return makes payment under the lease to the lessor, for a specified period of time
instalmentally, subject to the agreement between the parties.

Types of Leases
There are two basic type of leases:
a. Operating leases
b. Capital/ financial leases
Operating leases
This is a lease agreement between a lessor and a lessee whereby the lessor is responsible for the
upkeep, maintenance, servicing and insurance of the leased asset. All risk and reward incidental
to the ownership remain with the lessor.

This type of lease agreement does not cover the useful, economic, working life of the leased
asset. Consequently, at the end of the agreement, the lessor can lease the same asset to someone
else (or to the same lessee) and obtain rental for it. The lease can sometimes be cancelled at a
short notice.

Capital/financial leases
These are lease agreement between the user of the leased asset (i.e, the lessee) and a provider of
financial (that is the lessor). The lessee is responsible for the upkeep, maintenance, servicing and
insurance of the leased asset. Consequently, all risk and rewards incidental to ownership are
substantially transferred to the lessee. Title may or may not eventually be transferred at the end
of the lease agreement

The lease has a primary period, which converts the expected useful, economic working life of the
asset. At the end of the primary period, the lessor would not be able to take possession of the
asset and lease it for a good rental to someone else because the asset would have aged or become
obsolete.

After the primary period, the lessee has the option to continue to lease the asset for an indefinite
secondary period, in return for a very low nominal rent. Sometimes called a “peppercorn rent”

Alternatively, the lessee mighty be allows to buy the asset or sell it on behalf of the lessor.
Finance are usually non-cancellable

Sale and Leaseback

This is a situation where an asset previously owned by a company is disclosed off and
immediately repossessed through a leasing contract.

Advantage of leasing
a. It is an alternative source of making use of an asset for which a company is unable raise
funds to purchase and yet acquires it for immediate use.
b. When a company requires credit facility to purchase an asset, the leading institution
might not be willing to give out the entire cost of the asset; thus, they often provide part
thereof. However, with leasing, the finance for the asset is total (i.e. 100%) as the
property is preserved intact and in the form of lessee wants.
c. Financial institution usually insert restrictive covenants on companies when loan are
given out, such as non-payment of dividend till the debt is liquidated.
d. An operating lease provides an ‘off the balance sheet’ source of finance, thus, giving
cosmetic, fictitious finance ratios (that is hidden gearing). It eliminate high gearing effect
on companies which are normally associated with loans.
 e. The risk of obsolescence is effectively removed from the lessee in an operating lease
arrangement.

Disadvantages of Leasing
i. The rentals are payable whether profit are made or not. Default in payment may lead to
repossession and disrupt the company’s production.
ii. There is an inherent dilution in control just as any other debt financing, in that the rental
payment effected would have reduced the level of distributable profits.
iii. In a finance lease, the risk of ownership is effectively that of the lessee. Should the asset
become obsolete because the high technological changes, the lessee bear any
consequential loss.
iv. If interest rate falls and lease rentals are fixed, the lessee loses
v. If interest rate rises and lease rentals are fixed, the lessor loses

Hire Purchase

Hire purchase is the acquisition of assets on credit and settlement is made through regular
installment payments. It is provision of finance for assets which is repaid by installment over a
period of time in accordance with the contractual agreement entered into from the outset. The
intention is that the hirer becomes the owner of the asset immediately he effects payment of the
last installment and the purchase option

Advantage of Hire Purchase

a. Asset which cannot be acquired outright may be obtained on hire purchase and payment
made for them over a period of time. This avoids a strain on the cash resources of the
hirer.
b. There is repossession of the asset by the owner if the hirer defaults in repayment
c. The hirer is afforded the opportunity of receiving credit from the owner in a form of
installmental payment over an agreed period of time
d. It enables the hirer to obtain the benefit of the capital allowance unlike leasing where the
capital allowance are given to the hirer except for finance leases (in Nigeria).

Disadvantage of Hire Purchase

a. The disadvantage of hiree purchase to the hiree is that the cost of the finance, that is,
interest rate, is likely to be higher than other forms of finance.
b. Unlike the situation of leasing, the hire must make an initial deposit out of capital, which
may be very limited.

Evaluating lease, ‘Borrow & Buy’ and Hire Purchase Problems - Computation of NPV –
Where there are Association Benefit arising from The Asset’s usage

STEP 1: The associated relevant cash flow are:

(i) Initial outlay, that is, capital cost of the asset.
(ii) After-tax incremental benefits associated with the use of the asset
(iii) After-tax incremental costs associated with the use of the asset
(iv) Tax saving associated with capital allowance claimed
 (v) Scrap value of the asset, if any.
*Discount these cash flow using the company’s after-tax Weighted Average Cost of Capital

STEP 2: identify the after-tax cash flow associated with each alternative method of financing the
project.

(a) ‘Borrow and Buy’

In the case of the option to borrow and buy, the relevant cash flow are:
(i) Initial outlay, that is capital cost of the asset
(ii) Tax saving associated with the capital-allowances claimed
(iii) Scrap value of the asset, if any

*Discount these cash flow, using the company’s after-tax cost of borrowing.

(b) Leasing
The relevant cash flows in the case of the option to lease are:
(i) Lease payments.
(ii) Tax saving associated with lease payment
(iii) Tax saving associated with capital allowances
-Finance lease only;

*Discount these cash flows, using the company’s after-tax cost of borrowing

(c) Hire Purchase

In the case of the hire purchase option, the relevant cash flows are:
(i) Hire purchase (HP) payment
(ii) Tax saving associated with capital allowances.
(iii) Tax saving associated with hire purchase interest.
(iv) Scrap value

*Discount thise cash flows, using the company’s after tax cost of borrowing

STEP 3: Selecting the best financing method, that is the alternative, with the least PV of cost

Identification of Discount Rates

a. If the company is in a taxable status, use the post or after tax cost of capital, it does
matter if the company is making losses, as this will only means the carry forward of tax
liability.
b. If the company is not in a taxable position, apply the pre-tax cost of capital

Capital Budgeting under Risk and Uncertainty

Uncertainty and risk analysis in capital investment decisions plays a vital role because the real
economic worth of a project cannot be properly determined if they are not considered. Risk is a
situation in which various outcomes to a decision are possible and the probabilities to those
alternative outcomes are known. Uncertainty, on the other hand, describes a situation where there
is no such knowledge of probabilities about the outcomes. Risk and uncertainty in investment
decision arises because of the inability of the financial manager to forecast the possible future
event of the project with certainty. In resolving the issues of risk and uncertainty, various
techniques are applied to analyze their effect on capital investment decision. Some of the
techniques are:

(a) Payback-period
(b) Finite Horizon
(c) Certainty Equivalent
(d) Risk Adjustment Discount Rate
(e) Sensitivity Analysis and simulation
(f) Expected NPV
(g) Standard Deviation and variance
(h) Co-efficient of variation
(i) Decision Tree

Payback Period

In the payback period method, the shorter the time required to return the project initial outlay, the
better. In the simplest form, the payback method completely ignore the after payback returns, the
distribution of returns within the payback period, and discount rate. The payback period method
is based on the rationalization of “the sooner, the surer” and focuses attention on the nearer
future, thereby emphasizing the liquidity of the firm through the early recovery of the capital.

Finite Horizon

In the finite horizon method, returns beyond a particular date are ignored, while the returns
within a certain period are subjected to analysis. The longer the horizon the less this will matter
and the nearer, the method becomes a straight forward discounting cash flow method.

Certain Equivalent

Under the certain equivalent method, a risk adjusted factor known as certain equivalent co-
efficient is used to adjust the risk effect in the project cash flow. Multiplying a period’s cash flow
with the co-efficient produces the certainty equivalent cash flow which is a discounted to
appraise the project.

Risk Adjusted Discount Rate

Unlike the certainty equivalent method where adjustment for the riskiness of a project is done on
the cash flow, in the risk adjusted discount rate method, the project risk effect is adjusted for the
discounting rate. For the riskiness of a project, a risk premium is determined and added to the
risk-free discount rate. If for instance, a firm evaluate its risk-free project at 10% and defines
extra 5% for risk premium, risky project will be evaluated at 15%.
Risk-Adjusted Discount Rate = Risk Free Rate + Risk Premium
Sensitivity Analysis and Simulation

This method is valuable, practical and is widely used. Sensitivity analysis is a particular kind of
simulation in which limiting and crucial values of a project’s parameters are ascertained. The
parameters will usually be the values which will render NPV to zero

Sensitivity analysis is a measured of the impact of a change in the value of one of the project’s
variable such as discount rate, lifespan, sale volume, sale price and annual fixed cost. The more
the changes that occurs in the NPV, the more crucial the parameters of sensitive analysis to the
firm.

Expected NPV
This is based on the principle of expected value. Once probabilities are assigned to future
outcomes of net cash flow of a period, the expected value would be calculated and discounted.
The expected NPV arithmetically takes discount of the expected variability of two or more
possible outcome by averaging possible outcome weighted by their respective probabilities.

Standard Deviation and Variance

Standard deviation is an absolute measure of risk. It measures the dispersion of cash flow or the
spread about the mean value. The standard deviation of NPV

Standard deviation is a proxy measure of total risk for the investment and takes no account of
possible offsetting variation in other projects that may be undertaken by the investors
Variance is the square of standard deviation. It is the average squared departure of NPV from it
mean value

Co-efficient of Variation
Co-efficient of variation is a relative measure of risk. It is simply the ratio of standard deviation
of possible outcome divided by its expected value, depicted by the following formula:

Co-efficient of variation = standard deviation

Expected value

Decision Tree
This is a method of representing alternative sequential decision and the possible outcomes from
the former, in a graphical form. Since present investment decision may have implication for the
future and the outcome of those chance events are not known, then a probability distribution can
be assigned. Decision tree shows the relationship on a future event and their consequences.