PREPARED BY
SHUKO MARY ZYAMBO
MSc Finance and Accounting
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Contents
Role and Purpose of Financial Management .................................................................................................. 4
The First Principles of Corporate Finance ................................................................................................... 4
The objectives in decision making .............................................................................................................. 4
The role of Financial Managers .................................................................................................................. 4
The Financial System ..................................................................................................................................... 5
The Role of The financial System ................................................................................................................ 5
The Five Components of the Financial System ............................................................................................ 6
Financial institutions .................................................................................................................................. 7
Financial instruments ................................................................................................................................. 7
Financial markets ....................................................................................................................................... 7
Financial ratio analysis ................................................................................................................................... 9
Liquidity or short term solvency ratios ....................................................................................................... 9
Activity ratios........................................................................................................................................... 10
Profitability ratios .................................................................................................................................... 10
Financial Leverage Ratios ......................................................................................................................... 11
Benefits and limitations of ratio analysis techniques ................................................................................ 11
Limitations of ratio analysis...................................................................................................................... 12
Forecasting and techniques of financial planning and control ................................................................. 13
Financial Control ...................................................................................................................................... 13
Working Capital Management ..................................................................................................................... 14
The elements of working capital .............................................................................................................. 14
Managing Liquidity .................................................................................................................................. 15
Overtrading ............................................................................................................................................. 16
Cash Management ................................................................................................................................... 16
Investment in short term funds ................................................................................................................ 17
Trade Receivable management ................................................................................................................ 17
Management of Trade Payables ............................................................................................................... 18
Inventory Management ........................................................................................................................... 19
Investment Appraisal Techniques ................................................................................................................ 20
Capital Budgeting ..................................................................................................................................... 20
The Time Value of Money ........................................................................................................................ 21
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Investment appraisal Methods ................................................................................................................. 24
Inflation in investment appraisal .............................................................................................................. 33
Risk and Uncertainty in investment appraisal ........................................................................................... 33
Sources of Finance ....................................................................................................................................... 35
Debt Financing ......................................................................................................................................... 38
Equity Finance ......................................................................................................................................... 38
The dividend policy .................................................................................................................................. 40
The weighted Average Cost of Capital WACC ............................................................................................... 41
Cost of Equity .......................................................................................................................................... 42
Capital asset pricing Model (CAMP) ......................................................................................................... 43
Cost of debt ............................................................................................................................................. 43
The Portfolio Theory ................................................................................................................................ 45
Capital structure ...................................................................................................................................... 46
Modigliani Miller Theory .......................................................................................................................... 46
Managing foreign Exchange Risk .................................................................................................................. 48
What is Foreign Exchange Risk? ............................................................................................................... 49
Managing Foreign Exchange Risk ............................................................................................................. 49
Business Valuation Methods ........................................................................................................................ 52
Asset-based valuation .............................................................................................................................. 53
Income based approach ........................................................................................................................... 54
Cash flow based Valuation Method .......................................................................................................... 56
Bibliography ................................................................................................................................................ 59
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Role and Purpose of Financial Management
Always select a financing mix that will reduce your cost of capital(Hurdle rate)
and corresponds to the assets that are being financed
If financial managers are unable to find investments that will beat the hurdle
rate ,the funds available should be given back to the shareholders in terms of
dividends
The objectives in decision making
The main priority that financial managers have when it comes to corporate
finance decision is to maximise the value of the firm.
The second most important decision is to maximise the shareholders wealth.
When markets are seen to be efficient when the stock is traded, the objective
is to maximise the stock prize.
All other objective just fall in place to help maximise the value of the firm
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Finally they have a role to the financial markets, the have to provide accurate
financial information in a timely manner.
The shareholders can have minimal control over the financial managers and
the financial managers can decide to put their own interest first.
The bondholders can also loose respect for an organisation if their own
interests ate not taken care of and may decide not to lend finances again.
If financial managers do not take care of all these aspects the organisation may
be in trouble. Financial managers can also provide inaccurate financial
information and delay delivering this information and this can cause investors
to be misled.
Other objectives
The other objectives that the organisation can choose to focus are
A firm can choose to increase the stock prize
To increase earnings and reduce costs
To increase sales and look for better marketing strategies
To maximise the market share and all these objectives are aligned to the main
objective which is maximizing firm value.
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Savings Mobilization: The financial system helps funds to move from those
that have excess funds (savers) such as the government, business firms, and
the public sector to those that are in need of the funds the borrowers. For
example the lenders (e.g. bond buyers) and the borrowers (e.g. bond issuers)
are connected in the financial markets
Investments: This is an important role in that it allows both entities and
individuals to invest in listed companies in financial market to help them get a
return on their excess funds
National Growth: The financial system helps funds to move from firm to firm
or industry to industry based on demand in that it helps the flow of these
funds from surplus entities to deficit entities
Entrepreneurship Growth: The financial system allows entrepreneurs to access
funds and invests in other projects
The Five Components of the Financial System
The financial system has five main components and these are
Money
Money can be defined as a mode of payment of goods and services
Therefore money theories look at the changes in money supply in accordance
to changes in the economic activities and price level of a country
Money and Recession
The periodic but irregular upwards and downwards movement of aggregate
output produced in the economy is referred to as the business cycle
Sustained (persistent) downwards movement in the business cycle are referred
to as recessions
Sustained (persistent) upward movement in the business cycle are referred to
as expansions
Money and Inflation
The aggregate price level is the average price of good and services in an
economy
Inflation refers to the continual rise in the price levels in an economy which will
in turn affect all economic players
There is a direct link between inflation and the growth of money in an
economy over long periods of time .A sharp increase in the inflation rate
usually has to do with a sharp rise in the growth of money supply
Countries that have high rates of inflation have rapidly growing money supplies
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Financial institutions
These allow funds to move from those that have excess funds with no productive use
for them to those with shortages of funds
Financial institutions also allow people to earn a decent return on their money
and high prevent risk by saving in an bank, financial companies and insurance
companies
Banks reduce the need to move around with money for example cheque, debit
cards and credit cards can be used to make large payments
Banks also reduce the inconvenience of spending time in queues by
innovations such as debit cards, deposit card taking ATM and services such as
mobile banking that allows customers to pay for bills and transfer money
without leaving the comfort of their homes.
Financial innovations simply refer both technological and service advances.
Technological advances help facilitate payments and access to information and
the emergence of recent financial instruments and services, new forms of
organisation and more developed and complete financial markets
Banks help in the study of money and the economy because they have been a
source of rapid financial innovations
Financial instruments
Financial instruments in financial markets refer to the commodities and
products that are traded in the financial markets. The other name for financial
instruments is securities
A security is a formal obligation that allows one party to receive payments or
share assets from the other for example loans, bonds and stocks.
For example a simple bank loan is also a financial instrument
Financial markets
Financial markets is a place that brings individuals, companies and
governments together to allow them to buy and to sell financial securities for
example bonds and stock and also trade in commodities such as Agricultural
goods and precious metals at a low transaction cost .
Markets such as bond markets and stock markets help to promote economic
efficiency by transferring financial resources from those who do not have
productive use of funds(savers ) to those who do(investors)
The stock Market
Stocks are a share of ownership on a firm’searnings or assets for those
individuals that have put in resources in the business.
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A stock increase wealth and therefore affects the willingness of people to
spend. The higher the stock market index due to higher share prices the more
likely people will spend because their returns will also be higher.
The changes in the stock will also affect the firm’s ability to raise funds. When
the stock prize is higher investors are willing as they know that they will have a
greater return on their investments
When the stock price decrease people are less likely to spend as they will not
make much wealth
The changes in stock price also affect a firm’s decision to sell stock to finance
investment spending. A recession causes the stock price to fall when ever
thing else held constant and therefore consumer spending also decreases.
The Bond markets and interest rates
A bond is a debt security that pays regular interest payments for period of time
and then the pays the principal of the debt at maturity of the debt
Bond markets are essential part of an economy as they are the markets that
determine interest rates.
Interest is the cost of borrowing money and is everything is held constant a
reduction in the interest rates will increase investments and consumption for
example spending on housing or holiday trips.
On the other hand a rise in interest rates can be considered good in that it
encourages savings because the return on investments will be higher but
discourages investors from taking up loans and as a result, consumption and
investments reduce
The Foreign Exchange Market
The foreign exchange market is where funds are converted from one currency
to another. The foreign exchange rate is the price of one currency in term of
the other
A strong currency reduces exports as the country’s goods will be more
expensive in another country and fewer foreigners will purchase good but a
strong currency will mean that our spending in another country will become
cheaper
A weak currency on the other hand increase exports but the countries pending
in other countries becomes more expensive
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The central bank
The central banks plays many important functions in regulating a country’s
financial institutions and markets .A central bank is a government body that
regulates one of the following
It regulates the financial institutions and controls the supply of money and in
an economy
The central bank is also in charge of government finances and it serves as the
bank commercial bank
When commercial banks are short of resources the central bank becomes its
lender and also the excess money that the commercial bank are deposited in
the central bank
The central bank is also in charge of the monetary policy. The monetary policy
is the management of the supply of money in an economy depending on the
economic activity of a country and the price levels.
Financial ratio analysis involves the methods and techniques that help organisations
to measure the health of the business. Information for financial ratio analysis is taken
from financial records that the business keeps that is; the income statements and the
balance sheet. Financial ratio analysis helps identify a company’s strong and weak
points. The main financial ratios are:
Liquidity or short term solvency ratios
These ratios measure the firm’s ability to meet its short term obligations in a timely
manner. The ratios used here are the current and quick ratio and they are calculated
as follows
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Activity ratios
Activity ratios simply measure how well or efficiently the firm is managing its assets
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Financial Leverage Ratios
Financial Leverage ratios show to what extent a firm uses external financing(Debt)
rather than internal financing(Shareholders Equity).It also measures the probability
of a firm to default on its debt contracts.
Market Price:The market price of a share is the price at which buyers and
sellers establish when the trade in shares. The market value of stock is the
market price multiplied by outstanding shares.
Price to earnings=Current market price/Earnings per Share of the latest year
Dividend Yield=Dividend per share/Market Price per Share
Market to book(M/B)=Market price per share/Book value per share
Dividend per Share=Dividend for the year/number of shares
Dividend Cover: Calculates the number of times the current dividend would be
paid out from available profits=Profits after tax/Dividend
Earnings per share: This is how much would be paid out per share if the
company decided to pay out all its profits as dividends=Profits after
tax/number of shares in issue
Benefits and limitations of ratio analysis techniques
The key to obtaining meaningful information from ratio analysis is comparison:
comparing ratios overtime within the same business to establish whether the
business is improving or declining, and comparing ratios between similar businesses
to see whether the company you are identifying is better or worse than the average
within its own business sector
A vital element in effective ratio analysis is understanding the need of the person for
whom the ratio is been undertaken
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Investors will be interested in the risk and return relating to their investment
,so will be concerned with dividends, market prices levels of debt versus equity
Suppliers and lenders are interested in receiving the payments due to them ,so
want to know how liquid the business is
Managers are interested in ratios that indicate how well the business is been
run and how well the business is doing in relation to competitors
Limitations of ratio analysis
Availability of comparable Information
Ideal levels vary industry by industry and even they are not definitive.
Companies may be able exist without any difficult with ratios that are rather
worse than the industry average
Need for careful interpretations
For example, if comparing two businesses liquidity ratios, one business may
have higher levels. This might appear to be good but further investigation
might reveal that higher ratios are as a result of higher inventory and
receivable levels which are a result of power working capital management by
the business with better ratios
Manipulation
Any ratio including profit may be distorted by choice of accounting policies.
For smaller companies ,working capital ratios may be distorted depending on
whether a big customer pays, or a large supplier is paid, before or after the
year end
Other information
Ratio analysis on its own is not sufficient for interpreting company accounts
,and there are other items of items that should be looked at
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Forecasting and techniques of financial planning and control
Financial planning
The projection of sales, income and assets based on alternative production and
marketing strategies as well as the determination of the resources needed to achieve
these projections
Financial Control
This is phase the in which financial plans are implemented. Controls deals with
feedback and adjustment processes required to ensure adherence to plans and
modifications of plans because of unseen circumstances
Importance of Financial planning and control
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Subtract the funds generated internally from the funds required to determine
external financial requirements
Step 3
Raising the additional funds needed
Dividend pay-out ratio changes –if reduced ,more retained earnings and
reduces the AFN
If profit margin changes-if income increased total and retained earnings
increase and reduce AFN
Plant capacity changes –less capacity used less need for AFN
Payment terms increased to 60days –account payables would double,
increasing liabilities and reduce AFN
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types of inventory like perishable goods as they would go bad before they are
sold and this can be a loss to a company
Trade receivables: allow a firm to have more clients and if a firm doesn’t offer
credit,customers may run away to those competitors that do, however good
trade receivable management is important to ensure that a firm does not run
out of cash which might force them to borrow at an additional cost.
Trade payables: Trade payables are a form of free financing to a firm and a firm
should take advantage of the trade limit given by suppliers but they should
ensure they pay their trade payables so as to keep a good reputation with
suppliers.
Managing Liquidity
Liquidity: This is the firm’s ability to meet its short term obligations using
resources that can easily be converted into cash.
Liquidity Management: Is the ability of a firm to generate cash when and
where it is needed.
Drags on Liquidity: Theses are factors that cause delays in the collection of
cash for example slow payments by customers and cash that is stuck up in
inventory.
Pulls on Liquidity: These are decisions that result in paying cash too quickly for
example settling trade receivables too early.
Sources of Liquidity: Cash, short term funds such as trade credits, short term
bank loans and bank overdrafts.
Operating and cash conversion cycle
This is the time it takes for a firm to buy inventory, manufacture the inventory and
sell the finished good and then collect the money from customers. It is calculated as
follows:
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Example
If a company’s has 73 inventory days, 73 receivable days and 57.3 payable days.
What are the operating cycles and the cash conversion cycles?
Operating cycles=73+73=146 days
Cash conversion =73+73-57=88.7 days
The length of a firms operating and cash conversion cycle will determine how
much liquidity a firm will need. The longer the cycles the greater the firms
need for liquidity.
Overtrading
Overtrading happens when the capital base of an organisation is too little to support
volumes of trade and it can be indicated by:
Disposal of assets
Mergers and Acquisitions
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Capital expenditure
Investment in short term funds
A firm must try as much as possible to invest its excess cash resources in short term
instruments but before doing this management must make sure that there is no risk
of losing funds.
The choice of these short term investments will greatly depend on:
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The factoring characteristics can vary and the initial payment may range
from 70% to 90% of the total trade receivables and the charge fee for this
exercise was at 1.5% but can be anything between 1% and 3%
Offering credit can reduce the cash resources available to the business, the
business might have to borrow to finance trade receivables. Factoring helps
solve this problem as it allows advance payment for the substantial part of
the trade receivables total. Those companies that decide to keep trade
receivables internally are at a comparative disadvantage when it comes to
cash resources and should therefore perm a balancing act with the other
elements of working capital to make sure that cash does not run out.They
should ensure they anticipate for any cash shortages and look for other
means of financing.
Loss of potential interest receivable.
Therefore the management of trade receivables has a lot to do with how well a
firm manages these risks associated with trade receivables.
The Credit control Function
The credits control function has a number of duties including
Making sure the run checks on customers with trade receivables
Reviewing customers details and updating them in case of changing
circumstances
The also set credit limits on customers
They review customer’s invoices and they chase up on those customers
invoices that are overdue.
They also advise management on the best possible ways to deal with trade
receivable
Management of Trade Payables
Trade payables are an important part of a business as they are regarded as a form of
freefinancing for the business
When a firm falls to pay its trade payables for a few day after the credit limit
offered, this is unlikely to bring any major problem but there are situations
where this financing mechanism can be abused and this can cause trade
suppliers to lose confidence in the business and also a firm may earn a bad
name.
Therefore a firm should be clear about its trade payables limits and know
whether its 30 or 60 days allowed ensuring they don’t delay payments
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In addition the firm may receive valuable discounts for early payment of trade
receivables and therefore a firm must measure the pros and cons of taking
credit compared to delaying paying.
Inventory Management
Inventory management is important in an organisation and the big challenge
that companies face is ensuring that they have optimal levels of inventory all
the time.
Managing levels of inventory is important as it helps a firm to meet its
customers’ demands quickly and without interruptions but again a firm has to
make sure it does not have too much excess inventory as this will bring about
additional holding costs
Holding costs
Holding cost are costs that are associated to keeping and storing inventory.
These include the warehouses and the insurance costs involved in securing this
inventory and the cost of the staff hired to move and monitor this inventory.
If inventory is ordered less frequently, the total costs incurred in ordering
processes in reduced too and vice versa
The Economic Order Theory
The economic order theory is a formula that helps firms to calculate the optimum
level of inventory and it is calculated as follows
√2 ∗ D ∗ O
=
H
Where Q=Economic order quantity
D=Demand for the inventory
O=Cost per order
H=Holding costs per unit
Example
If the demand for the period is 5000 units and the cost per order is 25 Kwacha and
the holding cost is 17 kwacha the economic order quantity is
√2 ∗ 5000 ∗ K25
=
17
Q=121 units
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So if the firm orders 121 units of inventory the holding cost will be minimised.
The Limitations of the Economic Order Quantity
The limitations include
Assuming that the holding costs are constant which is not usually the case
It also overlooks the changes or in demand and if the demand is seasonal the
application of this model may not provide sufficient frequent ordering to
guarantee an adequate an adequate level of stock during peak periods.
This method involves only manufacturing goods when there is an order for the
goods. This method aims at getting rid of holding costs completely; the target
is to keep inventory levels at zero.
The finished good are manufactured in exactly the quantities required and at
the exact time they are needed.
This method may mean good are delivered more frequently but in small
amounts and therefore the order cost tend to be higher where the holding
costs are reduced to a minimal.
Capital Budgeting
Capital budgeting is the decision making in corporate finance that has to do
with the methods and techniques used by firms to decide on long term
investments. Financial managers are often asked to make difficult decisions
involving large sums of money on capital expenditure. Capital expenditure
involves the acquisitions in other business or investments in non-current assets
and investment in financial instruments that will be held for a long time.
Capital expenditure decision has to do with carrying out investment appraisals
of future cash follows and profits.
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Capital expenditure decision has to do a lot with capital rationing which has to
do with how a firm spends its limited resources. Scarce finances in firm force
financial managers to decide on those investments that will yield the most
return in the future and are therefore making these evaluations to make sure
that no loss of funds is incurred.
The Time Value of Money
The time value of money lies on the fact that K1 today is not the same as K1 in 6
month time or in 5 years because of interest and inflation. The time value of money
tries to find the future value of money by compounding or finding the present value
of future values by discounting.
Compounding
Future Value=PV (1+R) ⁿ
PV is the future value
R is the interest rate
N is the time in consideration
(1+R)ⁿ is what is called the compounding factor
Example 1
At the end of year six, K1900 at an annual rate of 17% interest over six years will be?
FV=PV (1+R) ⁿ
FV=1900(1+0.17)⁶
FV=1900(2.565160) =K4, 873.8
Example 2
The compounding factor for an investment over 4 years at 3% per year is?
Compounding factor= (1+R)ⁿ
Compounding factor= (1+0.03)⁴=1.126
Discounting
Discounting is the reverse of compounding and simply helps us to find the present
value of money given some future values.
PV=FV *1/ (1+R) ⁿ OR
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PV=FV/ (1+R) ⁿ
1/(1+R) ⁿ is what is called the discounting factor
Example 1
Assuming a constant discount rate of 12%,the present value of K1300 trade
receivables at the end of 5 years is?
PV=FV/(1+R) ⁿ
PV=1300/ (1+0.12)⁵=737
Example 2
The discounting factor for an investment over 3 years at 10% in three decimal places
is?
Discount factor =1/ (1+R) ⁿ
DF=1/ (1+0.10) =0.751
Perpetuities
Perpetuities are the present value of money that has an infinite time. A perfect
example is that when you retire you are given monthly payments that have no future
ending and to find the present value we deal with perpetuities
Present value=Cash flows/interest
PV= C/R
For example 1
If a pensioner earns K500 yearly perpetuity at 6% interest what is the present value
PV=C/R
PV=500/0.06=K8, 333
Annuities
Annuities help us find the future values of money that is deposited regularly for a
period of time for example savings for retirement or an education policy for a child.it
is found using the formula below
FV= C (1+R)ⁿ-1 /R*(1+R)
FV=Future value
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C= Regular payments/Deposits amounts
N=number of payments
Example
If someone makes yearly deposits of 1000 Kwacha for 18 years at an interest of
5%.What is the future value of these deposits?
C=1000
R=5%=0.05
N=18 Years
FV=1000 (1+0.05)¹⁸-1 /0.05*(1+0.05)
FV=1000((2.40661923371-1)/0.05*1.05
FV=1000(1.40661923371)/0.05*1.05
FV=1000(28.132384673821(1.05)
FV=28,132.384673821(1.05)
FV=29,539 Kwacha
If the person just decided to save without investing, the amount saved will only be
1000*18 years=18,000 only but with interest earned 29,539 Kwacha
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Investment appraisal Methods
The payback period
The payback period is a simple investment appraisal technique that measures the
time it will take for an investment future cash flowto pay back the initial cost of the
investment
Example
The initial cost of two machines and their cash flows are as follows
Time Machine A Machine B
0 (450) (600)
1 160 246
2 160 196.8
3 160 172.2
4 100 102.5
5 100 102.5
5* 50 100
The payback period is found by looking at the accumulative cash flows and finding a
point in which these accumulative cash flows cover the initial cost or reaches the
point zero
Machine A
Time Cash flows Cumulative Cash flows
0 (450) (450)
1 160 (290)
2 160 (130)
3 160 30
4 100 130
5 100+50 280
The cumulative cash flows will reach point zero somewhere in year 3.We can
calculate the exact time in years and months as follows
Payback period=2 years + (130/160*12)
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Payback period=2years and 9 months
Machine B
Time Cash flows Cumulative Cash Flows
0 (600) (600)
1 246 (354)
2 196.8 (157.2)
3 172.2 15
4 102.5 117.5
5 102.5+100 320
The payback only considers cash flows within the payback period and ignores
all other cash flows and doesn’t consider the whole value of a project
Ignores the size and timing of cash flows
Ignores the time value of money in its calculations(Although discounted cash
flow can be used)
It does not really take into account risk
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The accounting rate of return
The accounting rate of return (ARR) method uses projections of accounting profits to
calculate the expected rate of return on capital employed into an asset or project .It
is calculated as follows:
Average expected return (Accounting profits)/Average capital employed *100
Steps in calculating the accounting rate of return
Example
If an investment cash outflow and cash inflows are as follows what the
accounting rate of return is if the residue value of the machinery is 25,000 and
if depreciation is calculated on a straight line basis
Step two is to calculate the depreciation per year for the machinery
Depreciation=initial value-residue value/time
Depreciation= (150000-25000)/3=41,667
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Step 5 Calculating the ARR
ARR=Average expected return (Accounting profits)/Average capital employed *100
ARR=75000/87500*100=0.8571=85.715%
Example 2
Calculate the accounting rate of return a K30000 residue value
Year 0 (240 000)
Year 1 100 000
Year 2 80 000
Year 3 50 000
Year 4 50 000
Year 5 50 000
Year 6 30 000
The problem with the ARR is that it treats all future cash flows in the same
weight; it does not consider the time value of money in its calculations
The method is calculated using accounting profits rather than cash flows and it
includes depreciation in its calculations, an accounting adjustment in which the
timing and nature is determined by management
Profit is not directly linked to primary financial objective of shareholder wealth
maximization
Relative measure and therefore ignores size of initial investment.
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The Net Present Value
The Net Present value method of investment appraisal uses the discounting
technique to express the estimated future cash follows in the same term
The Net Present Value (NPV)=-Initial cost of investment+ discounted cash flows.
Example: Machine A
The initial expenditure of an investment in machine A is K450000 and the cost for
machine B is K600000 and the discount factor is 10%.What is the NPV if we the
estimated cash flows are as follows and which machine should this company invest
in?
Time Cash Flows Discount Factor Discounted Cash
flows
0 (450 000) 1 (450 000)
1 160 000 0.909 145 440
2 160000 0.826 132 160
3 160000 0.751 120 160
4 100 000 0.683 68 300
5 150 000 0.621 93 150
109 210
Machine B
The decision criteria for the NPV are that if NPV is greater than zero we should accept
that project and if it’s less than zero we reject the project. Where there is more than
one alternative go for the project that has a higher NPV.
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In the case of the two machines we see that machine B would be the best choice
because it has a higher NPV of K111 253compared to the NPV machine A which is
K109 210
Strengths of NPV
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Time Cash Flows
0 (680 000)
1 180 000
2 200 000
3 240 000
4 350 000
In this case we know that IRR must be between 12% and 16%
When we calculate NPV with 12% the result is 33,620
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When we calculate NPV with 16% the result is (29 200)
We the have to find the total distance between the two NPV figures which is 33
620+29 200=62 820
Then Find the distance between 12% and 16% which is equal to 4%
The IRR is calculated as follows
33620/62820*4%=2.14
Note: IRR is 12%+2.14=14.14%
Alternatively we can use the negative NPV in this case IRR is calculated as
29 200/62820*4%=1.859
Note: IRR is 16%-1.859=14.14
The decision criterion is that when IRR is greater than the cost of capital we accept
the project and if IRR is less than the cost of capital then we reject the project.
If a choice has to be made between two possible project pick the project with a
higher IRR
Example 2
Let us say that the NPV are as follows using different discount factors
Interest rate Net Present Value
10% 111 253
12% 79 142
14% 49 093
16% 21625
18% (4 083)
20% (27 989)
We can tell that the IRR is between 16% and 18% where there is a positive and
negative NPV
The total distance between for the two NPVS IS 21625+4083=25 708
The distance between 16% and 18% is 2%
Using the positive NPV,IRR is calculated as follows:
21625/25708*2%=1.68%
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IRR 16%+1.68%=17.68%
Alternatively using the negative NPV,IRR is calculated as follows:
4083/25708*2%=0.325
IRR is 18%-0.32%=17.68%
Strengths of IRR
The IRR takes into account the time value of money when making calculation
Weaknesses
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Capital Tax benefits 28%
Allowances tax
Year 1 200000*0.25 K50 000 14 000
Year 2 150000*0.25 K37 500 10 500
Year 3 112 5000*0.25 K28 125 7875
Year 4 84 375*0.25 K21 094
Balancing K43 281 12 119
allowance
*(84375-21094- 44 494
20000)
Example: If investors are looking for a return of 5% and the inflation rate is at
1.6%.What is the nominal return:
1+ (1.05) (1.016) =0.0668
Inflated return is 6.68%
We can use either a nominal or a real term approach to investment appraisal
Nominal cash flows are discounted with a nominal cost of capital
Real cash flows are discounted with a real cost of capital
Cash flows inflated with specific or general inflation are nominal cash flows
Nominal cash flows deflated by a general rate of inflation are real cash flows
The NPV found by discounting real cash flows with real cost of capital is same
as NPV found by discounting nominal cash flows with nominal cost of capital
Risk and Uncertainty in investment appraisal
Risk refers to a set of unique circumstances that can be assigned probability
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Uncertainty implies probabilities that cannot be assigned to different set of
circumstances
In practice risk and uncertainty are often used interchangeably
Risk increases with variability of returns
Uncertainty increases with project life
Sensitivity Analysis
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Problems with Sensitivity Analysis
Sources of Finance
The availability of finance is often dependent upon the type and the size of the
business. Start-up and small companies do not have access to the amount and type
of finance that well established businesses have.
Therefore, we are going to look at the sources of finance for organisation through
different business stages.
Sources of Finance for new start-up businesses
The need for finance start up business is far different from those of established ones.
Small businesses may need money for one of the following.
Already available cash resources-This is what the owner of the business already
has. These can come from saving, from part time work done or by a
redundancy payoff of the owner
Family and friends-These can provide valuable financial support to the business
through injection of equipment or through injection of cash resources. The
only challenge with this type of financing is that when a business fails,
relationships may suffer.
Grant Finance-This is another type of funding available to small businesses.
These can be a very good source of funds as a grant doesn’t normally need to
be prepaid. The only realproblem is that these funds are available only for
specific purposes like in the employment of individual in highly unemployed
areas and the grant authority may need to keep a close eye on how the
business is doing.
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Commercial Borrowing
Commercial borrowing may not be the most ideal type of financing for a start-up
business due to one of the following
The charges or interest paid on loans can be stress to a start- up business and
can make a difference between success and failure if not properly assessed.
Banks also need a track record of successful trading for them to give out a loan
which the new start-up businesses do not possess.
To offer a commercial loan the bank needs security so that if the business fails
to pay they can sell the security such as an asset and to recover their funds.
This can be a great challenge for start-up businesses .A loan that is secured is
less risky from the bankers’ point of view. The nature and the value of the
security is directly linked to the interest rate charged. The higher the risk the
greater the interest rate charged and vice versa
When requesting for financing the new business usually needs to provide a
detailed business plan which has all the details of the business including
products, market analysis, sales and profit forecast and the investments
required to mention just a few.
Sources of finance for a growing company
As mentioned earlier the needs of start-up business is different from that of a
growing business. The main need for financing for a growing business is to expand
the range of the products or services offered or moving into new markets.
The sources of finance mentioned earlier can also be appropriate for this stage too,
although some may be more appropriate than others for example commercial
borrowing may now be appropriate for this stage as a growing company may have
some records of successful trading. The other sources of finance available at this
stage are:
Venture Capital
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The management role of the venture capitalist comes in very handy to the
growing business as they bring in experience and contacts into the new
business that would otherwise be difficult to get.
After their term into the business as finished, the venture capitalist withdraws
out of the business by selling their equity stalk back to the original owners of
the business or by realizing their investments when the successful business is
floated on the stock exchange
Individuals
Rich Individual investors can provide financing into a growing business directly or
through an intermediary such a venture capital. These called business angels.
Another common term is the DRAGON; this refers to the owners of a growing
company pitching their business ideas to owners of well established companies and if
these big companies like their business ideas then the growing company are
rewarded with a financial input in exchange for equity stake in the business plus their
direct management input into the business.
Leasing
The acquisition of non –current assets may require significant cash outflow. One way
to acquire big fixed assets is to lease them. There are two types of leasing
Operating lease-are for relatively short periods of times and are regular rental
payments for the use of the asset and these types of leases are for assets such
as photocopiers and vehicles
Finance lease-These cover most or all of the life of an asset and are a way of
purchasing an asset in instalments. The business that leases the asset pays the
provider of the lease regular amounts of cash agreed in advance. The regular
payments include an element both of capital payments in respect of the asset
acquisition and interest payments which is the cost related to the lease.
Sources of Finance for large businesses
Sources of Finance for a large business include
Commercial borrowing
Leasing
Issue of new shares
Flotation on the stock exchange
And investment by the venture capitalist
Debt
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Debt Financing
The Choice between debt and equity
Advantages of debt
Debt is a cheaper form of finance than shares, as debt interest is tax deductible
in most tax regimes
Debt should be more attractive to investors because it will be secured against
the assets of the company
Debt holders rank above shareholders in the event of liquidation
Issue costs are normally lower for debt than for shares
There is no immediate change in the existing structure of control, although this
may change overtime if the bonds are convertible to shares
There is no immediate dilution in earnings and dividend per share
Lenders do not participate in high profits compared to shares
Disadvantages of debt
Interest has to be paid to no matter what the company’s profits in a year are.
In particular the company may find itself locked into long term debt at
unfavourable rates of interest .The company is not legally obliged to pay
dividends
Money has to be made available for redemption or repayment. However
redemption will fall in real terms during times of inflation
Heavy borrowing increases the financial risk for ordinary shareholders. A
company must be able to pay interest charges and repay the debt from its cash
resources and at the same time maintain a healthy balance sheet which
doesn’t deter would be lenders
Shareholders may demand a higher return because an increased interest
burden increases the risk that dividends will not be paid
There might be restrictions on a company’s power to borrow. The company’s
constitution may limit borrowing .The borrowings limits can’t be except with
approval of the shareholders at general meetings of the company
Equity Finance
Issue of new shares (Equity Finance)
Upon the initial formation of a company, ordinary share capital is issued to the
first shareholders and the number of shareholders is low usually one or two. As
the business grows more shares are issued to other people
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Private companies are not permitted to offer shares to the general public or
have their shares quoted on the stock exchange
Public limited companies are allowed to issue new share
Rights of shareholders
Ordinary (Equity) share capital entitles its owners the shareholders to vote
which they can exercise at the general meetings
The other right of shareholders is to receive dividends
The company directors decide upon the level of dividends to be paid out
Shareholders can vote on appointments, remuneration and removal of
directors
Vote on important issues such as allowing repurchase of shares ,using shares in
a takeover bids or change in authorised share capital
Receive share of the company’s assets after the company has been liquidated
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The purpose of a takeover is to allow better quality management to take on
control of operations of the target company which should lead to improved
efficiency and better return for shareholders of a company which is taking over
the other. Mergers and acquisitions do not always produce the desired effects
The dividend policy
The dividend policy is closely linked to the financing decision of a company
The dividend decision must take into account the views and expectations of
shareholders
Retained earnings are preferred as a source of investments
Dividend payments reduce the earnings available for investments ,increasing
the need for external funds to meet investments plans
Operating Issues
40
Where dividends are cut to provide funds for investments depends on
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If the company had also issued K3 million in preferred stock at a cost of 9%, the Wacc
can be calculated as follows
Company total financial requirement=10+3+5=18
Data
Wd=5/18=0.28 Rd=0.12 T=0.3 We=10/18=0.56 Re=0.15
Wp=3/18=0.16 Rp=0.09
Wacc= WACC= Wd *Rd (1-T) + Wp*Rp+ Wp*Rp
Wacc=0.28*0.12(1-0.3) +0.56*0.15+0.16*0.09=0.1219
Wacc =12.19%
Cost of Equity
The cost of equity is the return that investors are looking for on their investment and
thus because a company has to pay them a return, it is a cost to the business
The cost of equity can be calculated using
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Example
Extremity prices shares at K40 per share and it paid a dividend 0f K3 last year and it
expects its dividend to grow at 7% each year. Calculate the cost of equity
Re= Do*(1+g)/Po +g
Re=3(1+0.07)/40+7%=0.15025
Re=15.03%
Capital asset pricing Model (CAMP)
The cost of equity can also be calculated using the CAPM
Rj= Rf +Bj (Rm –Rf)
Where
Rm is return of the market
Rf risk free rate
(Rm-Rf) equity risk premium
Bj is the beta value of ordinary share
Example
The industry beta for a construction company in the UK is 1.3 and the UK market risk
free interest rate and market return are estimated to be at 5% and 9% per year.
Calculate the cost of equity.
Ke=5%+1.3*(9%-5%)=10.2%
Cost of debt
The cost of debt is the interest that a company pay pays on its borrowing. For an item
to be classified as debt it has to meet these three criteria
It has to give rise to the contractual commitments that has to be meet in good
and bad times
The commitment is usually tax deductible
Failure to make the commitment can cost the company control over the
business
The after tax effect of debt
Cost of debt=Rd (1-t)
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A company has a pre-tax cost of debt at 7.13% if the tax rate is at 40%.What is the
effective cost of debt?
Rd=7.13%
Tc=40%
Cost of debt=0.017(1-0.40) =0.0428
Effective cost of debt is 4.28%
The higher the tax rate the higher the tax savings for the company paying interest
Example 2
Suppose a company with 35% income tax issues a bond with 5% stated rate ,the after
tax cost of the bond would be calculated as follows
Cost of debt=Rd (1-t)
0.05(1-0.35) =3.25%
To calculate the annual cost of debt, multiply the after tax interest rate of the debt by
the principle amount of the debt
For example, suppose the principle value of a loan is K100 000 and the adjusted after
tax interest rate is 3% the annual cost of debt will be?
0.03*100 000=3000
Calculating the average cost of debt
If a company had total debt of 100 000.This was divided into 25 000 loan and 75 000
worth of bonds with 3% and 6% after tax cost of debt respectively
Your average cost of debt would be calculated by multiplying cost of debt for the
loan by the share
Average cost of debt =0.25*3%+0.75*6%=5.25%
After tax adjusted interest rate and the company interest rate
If a company does not disclose the pre-tax interest rate of the loan, but you
need the information, you can still calculate pre-tax cost of debt .For example
suppose a company with 40% tax rate issued a k100 000 bond with an after-tax
cost of debt of K3000
Express the tax rate as a decimal using the equation 40/100=0.40 and then
subtract the tax rate from 1 (1-0.40) =0.60
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Calculate the pre-tax cost of debt by the result. Use the equation
3000/0.6=5000
Valuing Fixed interest bonds
Redeemable bonds have several interest payments plus repayment of interest and
are calculated as follows
Po=I/ (1+Kd)¹+I/ (1+Kd) ²+…I+RV/ (1+Kd) ⁿ
I-Interest payment
RV-Redemption value of the principal
Kd=Cost of debt capital
The Portfolio Theory
In 1952 Harry Markowitz presented a paper on modern portfolio theory. His findings
greatly changed the asset management theory.
There are two main concepts in modern portfolio which are
Any investors goal is to maximise return for any level of risk
Risk can be reduced by creating a diversified portfolio of unrelated assets
Maximise Return-Minimise Risk
Return is considered to be the appreciation of any asset in stock price and also any
capital inflows such as dividends. Standard deviation is a fair measure of risk as
investors look wants a steady increase on their investments than big swings which
might possibly end up as losses.
Risk is evaluated as the range by which an assets price will on average vary known as
standard deviation.
If an asset has 10% deviation from the mean and an average expected return of 8%
you may observe returns of between -2% and 18%.
In a practical application of Markowitz Portfolio Theory let’s assume there are two
portfolios of assets both with an average return of 10%
Portfolio A has a risk of 8% and portfolio B has a risk of 12%.Both portfolios have the
same return, any investor will choose to invest in portfolio A as it has the same
expected return as B but with a lower risk.
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It is important to understand risk as there would be no expected rewards without it.
Investors are compensated for risk and in theory the higher the risk the higher the
return.
As portfolio B has a higher risk, it may obtain a return of 22%, but it can also
experience a return of -2%.
All things being equal it is still preferable to hold the portfolio that has an expected
range of returns of 2% and 18%, as this is most likely to help you reach your financial
goal.
Diversified Portfolio
Risk as seen above is a welcome factor when investing as it allows us to rip rewards
for taking up possibility of diverse outcomes.
Modern portfolio theory however states that a mixture of diverse assets will
significantly reduce the overall risk of a portfolio.
Assets that are unrelated will also have unrelated risk. This concept is defined as
correlation. If two assets are very similar, then their prices will move in a very similar
pattern. Two assets from the same industry are likely to be affected by the same
macroeconomic factors
This lack of correlation is what helps a diversified portfolio of assets have a lower
risk,measured by standard deviation than the simple sum of the risk of each asset.
Capital structure
Capital structure refers to the way in which an organisation is financed, by a
combination of long term capital (shares, loans convertible loans) and short term
liabilities such as bank overdrafts
Both propositions are looked at from two points of view capital structure with taxes
and with no taxes
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Both of the proposition use extremely restrictive assumptions
These notions are held in perfect markets
No taxes
No transaction cost
No financial distress
Many buyers and sellers
Free entry and exit
Proposition 1: (No taxes) the value of a firm
Capital structure Irrelevance
The value of the firm is unaffected by its capital structure
Leveraged firm and unlevered firm have the same value
Notation: VL=VU
Proposition 2: (No taxes) Wacc unaffected by leverage
Cost of equity increases linearly as a company increases its proportion of debt
financing
Wacc affected by capital structure
Both propositions 1 and 2 show that in a world with no taxes the value of a firm for a
levered firm is the same as that of unlevered firm
In addition the Wacc is unaffected by leverage
Next to consider: With taxes and the impact of taxes
MM Proposition 1 with taxes
These are costs incurred when a company has trouble paying fixed cost
(interest)
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These can be direct cost associated with bankruptcy expenses and indirect cost
for example loss of customer trust.
Managers try to maintain certain debt rating in order to minimise the cost of
capital
An increase in debt rating will lower cost of debt and cost of capital
Factors to consider when evaluating capital structure
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What is Foreign Exchange Risk?
For companies that sell their goods and services internationally and get paid in
foreign currency, foreign exchange risk is the likely hood that a change in exchange
rates will result into a company receiving a lower amount of cash flows for its
international operations than originally anticipated. For local Zambian companies
that import and pay their foreign suppliers in foreign currency, it is the likely hood
that a change in exchange rates will mean that the company has to pay more than
planned
This form of foreign exchange exposure, which impacts the cash flow of a company,
is what is referred to as transaction exposure
Managing foreign exchange risk successfully can bring about a lot of benefits
including:
Future contracts
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Futures are exchange traded contracts to buy and sell a standard quantity of
financial instruments or foreign currency at an agreed price on an agreed date
Company taking out futures contracts places initial margins with clearing house
Contracts are marked to market so variation margins may be needed to meet
losses
Hedging exchange rate risk using US futures
UK exporters hedge against rising exchange rates by buying currency futures to
guarantee delivery of foreign currency
UK importers hedge against falling exchange rates by selling currency futures
to guarantee sale of foreign currency
Future positions closed out by opposite trade
Example of hedging using currency futures
Company A hedges $300 000 receipt due in 3 months by buying US currency
Futures
Sterling future prices:$1.535
Translate exposure at future price:
$ 300000/1.535=195 440 pounds
Number of contracts =195 440 pounds/62 500 =3.13 so buy 3 currency futures
(under hedge)
Initial margin :62 500 *1.535*0.03=$2878
Assume that exchange rate moves to $1.555
Gain =200 ticks*6.25=$1250
Company A margin account gains $1250,while counterparty has call for
variation margin for same amount
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Gives the holder the right but not the obligation to borrow or lend at a given
rate, or to buy and sell foreign currency at a given rate
Option premium is paid when the option is bought
Over the counter options are sold by banks and are tailored to customers’
needs
Traded options are bought and sold in financial markets
Example of hedging using options
A company expects the exchange rate to rise so buys sterling US call options to
hedge receipt 0f $1m due in 3 months
Spot:$1.65 option strike price is $1.65
Cost of option is 7 cents per pound of contract
Contract size is 62 500 pounds
Translate exposure at option strike price:$1000 000/1.65=606 061 pounds
Number of contract size 606061/62500==9.7 so buy 10 call option\
Company has over hedged
Premium :10*62500*0.07=$43 750
Worst outcome is to exchange dollars at a rate of 1.65+0.07=$1.72/pound
giving 581 395 pounds
If spot rate on expiry is less than $1.65/pound the company will use spot and
let option elapse
Factors affecting traded option prices
Strike price: Higher strike price for put will reduce their cost
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An exchange of one stream of future cash flows for another stream of future
cash flows with different characteristics
Swaps are used extensively by banks and companies for hedging interest rate
risk and foreign exchange risk over long time periods
Banks intermediate by warehousing swaps until counterparty is found
Disadvantages of swaps
53
000 000 000 000
Non-Current 1000 +700-200 1500
Assets
Current Assets
Inventory 500 -100 400
Receivables 300 -50 250
Cash 400 1200 400 1050
2200 2550
Share capital 400 400
Reserves 900 1150
1300 1550
400 400
500 +100 600
2200 2550
Additional information
In the balance sheet non-current assets contain land and building valued at K700 000
above their book value. Plant and machinery would sell for K200 000 less their book
value. Inventory would sell for K400 000 and only K250 000 would be realised from
account receivables and closure cost would add up to a K100 000.
The minimum amount that the shareholders should accept is K1550 000 the amount
of the shareholders equity plus reserves after revaluation (or alternatively K2500
000-400 000-600 000)
This method relies on finding listed companies in similar businesses to the company
being valued (the target company) and looking at the relationship they show
between the share price and the earnings and using that relationship as a model, the
share price of the target company can be estimated.
The price earnings ratio (P/E)
The price earnings ratio is the price per share divided by the earnings per share and
shows how many years’ worth of earnings are paid for in the share price.
54
Let’s say that the market price of a small chain of Zambian based grocery shop has to
be estimated. The company has just enjoyed post tax earnings of K200 000 out of
which it paid K50 000 of dividends
The first task is to identify three Zambian companies in the grocery business then
look at their published characteristics
Here all the P/E are similar, sometimes they are not even in the same sector
because one or more been distorted, for example a company’s market price might
be usually high because of bid speculations or its earnings might be low because of
onetime restructuring cost in the latest year financial statements.
It is also important to look closely at listed companies range of activities as often
large companies have an element of diversification for example Pick and Pay is
regarded as a Zambian supermarket chain, but approximately one third of its revenue
are earned overseas and the importance to the company for selling clothes, electrical
good and financial services is growing rapidly.
The average P/E for selected companies is calculated and in this case its 10.2 and this
represents the relationship that quoted companies are showing between their
earnings per share and their price per share.
Remember 10.2 means that anyone who buys a share is buying it 10.2 times its
published earnings.
55
Assuming that we are happy with a P/E of 10.2 and the earnings of K200 000.Then
the calculated market value is K2 040 000 is the starting point for negotiations.
This method involves finding the present value of free cash flows for the target firm
and then adding the present value of the terminal value.
A firm’s free cash flow is the actual amount of cash that a company has left from its
operations that would be used to pursue opportunities that enhance shareholders
value.
The free cash flow is derived from the operations of a company after subtracting
working capital, investments and taxes. Free cash flow is measured as follows
Earnings before interest and tax (EBIT)
Less tax on EBIT
Plus non-cash charges (e.g. depreciation)
Less capital expenditure
Less working capital increases
Plus working capital decreases
Plus salvage value received
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Solution
K
Earnings before interest and tax(EBIT) 90 000
Less taxes 36 000
Operating income after tax 54 000
Plus depreciation(Non cash item) 6 000
Less capital expenditure 9 000
Less changes to working capital 1 000
Free cash flow 50 000
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Find the present value of the terminal value
Terminal value₀=39,159/1.095⁵=24 875
Next add the discounted free flows and the present value of the terminal value
4148+24 875=29023
The target value of this company is K29023 million and is the starting point for
negotiations
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Bibliography
ACCA P4 Study Kit. (2016-2017).
Atrill P. (2008). Financial Management for Decision Makers,5th Edition,FT Prentice Hal.
Lehand, H. (1994). Corporate Debt Value,Bond Convenants,and Optimal Capital StructureJournal of Finance.
McLaney E.J. (2009). Business Theory and Practice,8th Edition.FT Prentice Hall.
Myers, S. (1984). Corporate Financing and Investment Decisions When Firms have Information That Investors
Do not Have,Journal of Financial Economics ,5.
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