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Introduction to Financial management
Key outlines
 Definition of finance
Defn of financial management.
Definition of financial manager.
The key finance functions or decisions or the scope.
Roles of the finance function.
The notary and routine roles of a financial manager.
Objectives of a firm.
The concept of Time value of Money.
• Definition of TVM.
• Reasons for TVM.
• Concept of Present Value(PV), Future Value(FV),
Annuities.
• Application of PVA i.e. loan amortization.
The concept of risk return relationship.
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(www. investorwords.com) defines finance as a branch
of economics concerned with resource allocation as well
as resource management, acquisition and investment. Simply,
finance deals with matters related to money and the markets
Finance for small business defined.
Is the managerial activity concerned with the raising and
allocation of the firms’ financial resources in order to attain
the firms’ objectives. (Julius k, 2003)
Financial manager is a person concerned with the raising
and allocation of the firms’ financial resources in order to
attain the firms’ objectives.
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Intro cont’es
ROLES OF FINANCIAL MANAGEMENT OR THE FINANCE
FUNCTION
Raising of funds
Allocation of funds/utilization.
Interlinking the finance function.
THE SCOPE OF FINANCIAL MANAGEMENT
From the above roles of financial management, the scope of financial
management spreads around 4 main decision areas i.e.
• Investment decision. Allocation of resources in long-term assets.
• Financing decision. Raising funds through debt or equity.
• Working capital or liquidity or short term decision. Resource
allocation in short term assets
• Dividends decision or Earnings Mgt. decision. Concerned with
distribution of profits or retention of profits for future cap. gain
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ROLES OF A FINANCIAL MANAGER
Notary roles of a financial manager
Raising funds
Efficient allocation of raised funds
Profit planning
Understanding capital markets
Routine roles of financial manager
Custody of reserves, insurance policy
Supervision of cash receipts and making payments and
Safeguarding of cash balances
Custody and safeguarding of securities, insurance policies
and other valuable papers
Record keeping and reporting
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THE OBJECTIVE OF A FIRM
1.Maximization of profits: This objective requires a firm to maximize its
revenue as it minimizes its costs.
This objective is generally criticized in financial management
because
 The definition of profit is vague
 Profit maximization ignores the concept of time value of money.
 The objective is in conflict with interests of other stakeholders
 Ignores risk
Justification of profit maximization
 Ensures economic survival of the firm’s target profit, then minimize
expenses and have enough funds to pay off its liabilities.
 It also maximizes the social economic welfare
 Firms aim at maximizing utility that can be measured in terms of
profit.
 Management forces allocate capital to those who can use it most
profitably.
 Shows efficiency 8/30/2022 Eva Mpaata
2. Wealth maximization – Wealth is the net cash flow expected from all
the assets in which resources of the firm have been invested;
n
Wealth max. = Σ Ai _ _ I0
i=1 (1 + K)
where;
Ai – cash flow invested in period i
K - discount rate/factor
I0 - initial cash flow
i - period over which a firm is expected to acquire resources and invest.
Importance
Takes into account risk
Considers TVM
Not in conflict with shareholders interest
Takes into account inflationary tendencies
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Other Objectives of the firm:
3. Maximization of market share.
4. Maximization of earnings per share
5. Maximization of employee welfare
6. Social responsibility.
7. Efficiency
8. Risk reduction (read on ur own)
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TIME VALUE OF MONEY
This is a concept that as a rational economic unit (individual
or firm) you prefer earlier cash flows to later cash flows (i.e.
prefer a sum of money today than later).
Reasons for time preference for money
Generally, the future is associated with risk and uncertainty
because of changes in the business environment.
Any rational consumer prefers current consumption to future
consumption.
The amount of money received earlier can be invested to
earn more return in the future. By waiting for later cash
flows, the investor foregoes this return.
Avoids inflationary tendencies.
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FUTURE VALUE
Is the value at some future time of a present amount of money evaluated
at a given interest rate. It expresses today’s cash flows into their worth in
future.
This refers to the value of the present cash flows on an investment when
compounded using an appropriate compound rate to reflect their future
values.
FV for a single sum of money
FVn = PVo(1 + i)n
FV based of frequency of compounding ie semi annual, biannual,
quarterly, monthly etc
FVnm - PVo (1 + i )nm
m
Fv of money based on continuous compounding
Fvcc = PV. ert
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PRESENT VALUE:
Present value refers to the value of future cash flows of an investment when discounted
using an appropriate discount rate to bring them back to their present worth.
PV for single sum of money
PV = FVn
(1 + i)n
PV based on frequency of compounding
PV = FV
(1+r/m)mn
PV of uneven cash flows
Present value of uneven cash flows.
PV = A1 + A2 + A3 + … An
(1+i)1 (1+i)2 (1+i)3 (1+i)n
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Future value of annuities.
An annuity refers to a uniform cash flow stream expected per year
for a specific number of years e.g. if 250 million shillings is
expected to be earned per year as interest on a bond. In this case,
the future value of annuity is given by;
FVA = A (1 + i)n – 1
I
Alternatively:
FVA = A x Future Value Interest Factor Annuity (FVIFA)
PVA = A 1-(1+r)^-n
r
Alternatively
PVA = A x Present Value Interest Factor Annuity (PVIFA)
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CONCEPT OF ANNUITY
Annuity is a uniform stream of cashlows expeted to be
received or paid annually for a given period of time
Types
Annuity due. Beginning of a given pd. Eg rent in
advance, prepayments, yaka etc
Deferred annuity. End of a given pd. Interest on loans,
electricity, water bills etc
Perpetual annuity. For ever eg. Consol bonds,
irredeemable debentures, pension
A
Thus; PV = i
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PRACTICAL APPLICATION OF PRESENT VALUE:
LOAN AMORTIZATION.
The present value concept has practical applications in
determining the payments required under an installment type of
loan.
Example: Suppose a firm borrows Shs.10m at 10% interest to
be repaid in the next 5 years. Equal installments are required
at the end of each year and these payments must be sufficient
to repay the principal sum together with the interest. Draw up
a loan amortization schedule to show how the loan would be
repaid.
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YEAR Opening balance (O) Annual
Installment(A)
Interest
Payment (I)
Principal payment
P = (A-I)
Closing Balance
C = (O-P)
0
1
2
3
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The concept of Risk return relationship
Risk. Is any variability that may arise in return due to the decision taken to invest in a business
Return. is a benefit that may accrue just incase funds are committed in an asset or investment
The relationship is always positive implying that the higher the risk, the higher the returns and
vice versa.
Illustration
Expected return = Rfr+ B(Rm-Rr)
SML
Rfr
(risk)
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Topic two: The Finance Decision
Outline
• Definition of financing decision
• Theory of capital structure and the school
of thought
• Determining the Optimal Capital
Structure
• Source of short-term financing
• Long Term Sources of Funds
• Nature and importance of capital market
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Financing decision Is mix of debt or equity used in financing business
operations. Debt can be from short-term borrowing or long-term
borrowing.
The long-term borrowing plus equity make up the capital structure of the
firm i.e. capital structure is a sub-component of the financial structure of
the firm.
Definition of capital structure. This is the proportion of debt or equity
used to finance business operations.
Determinants of optimal capital structure
• The existing level of leverage
• Stability of sales
• Stage of growth
• The need for control of ownership
• Floatation and transaction costs
• Bankruptcy costs.
• Cost and availability of funds.
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THE CAPITAL STRUCTURE DEBATE:
There is a controversy in the financing field about the
relevance of the capital structure decision
THE TRADITIONAL/CLASSICAL SCHOOL OF
THOUGHT
• This school of thought advocates that the financing method
can influence the value of the firm through its impact on
the firm’s cost of capital
Ko = KdPd + KePe
• Cost of debt is generally lower than cost of equity because
of the tax shield advantage.
• Hence, the more debt, the less the cost of debt hence Ko
will fall.
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• However, as you use more of debt, it is possible that Ke will begin to
increase because shareholders will perceive more risk with increased
debt and may require a higher return on investment hence rise in Ke
which will in turn increase Ko.
• According to this school of thought at point A, the firm enjoys the
lowest cost of capital and optimal level of debt/equity. Therefore, as
a financial manager, you have to look for this level because it gives
the highest value to the firm.
Increase in the cost of equity due to perceived risk by the shareholders(Ke)
Overall cost of A C
Capital Reduction in cost of debt due to tax shield advantage (kd)
B
0
D/E Leverage level
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• AB this is a point where a firm enjoys
increasing wealth because overall cost of
capital is reducing due to the tax shield
advantage
• BC declining wealth because of the
overall cost of capital increases due to the
bankruptcy costs arising from the
percieved risk
• DE optimal level of capital structure.
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• ASSUPMTIONS OF TRADITION SCHOOL OF
THOUGHT
• The rate of interest on debt remains constant for a
certain period and thereafter with an increase in
leverage, it increases.
• The expected rate by equity shareholders remains
constant or increase gradually. After that, the equity
shareholders starts perceiving a financial risk and
then from the optimal point and the expected rate
increases speedily.
• As a result of the activity of rate of interest and
expected rate of return, the WACC first decreases
and then increases. The lowest point on the curve is
optimal capital structure.
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THE NEO-CLASSICAL SCHOOL OF THOUGHT (MM POSITION)
• Modigliani and Miller argued that the capital structure debate is a
mere detail. They argue that you cannot affect the value of the firm
simply by the way you finance its assets.
• They argue that value comes from assets that the firm has invested in
hence the asset mix, which is a function of the investment decision.
Once this decision (investment) is made, value will be generated
through cash flows which wealth is conserved and when created
cannot be altered by the financing decision
Assumptions of the Position:
• There are many buyers and sellers of securities such that no single
buyer or seller can single handedly affect their prices.
• Securities are completely divisible.
• There are no transaction costs.
• There are no taxes i.e. both personal and corporate taxes.
• Investors are rational i.e. base their decisions on risk and return.
• There are no bankruptcy costs.
• Individuals or investors borrow at risk free rate.
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• MM also recognize that when you use debt, you enjoy a tax
shield and that use of high debt increases the risk perceived
by shareholders due to increased debt obligations.
Ke increases as D/E increase
Overaall cost of
capital
Overall Ko remains constant
Kd falls
0 D/E Leverage
• The MM position emphasizes that the financial manager concentrates
on the investment decision (asset mix) instead of the financing
decision
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THE MIDDLE GROUND DEBATE
Both contributions above are extreme. The
middle frond debate reconciles the two
positions and it recognizes two
fundamental aspects of debt financing i.e;
• Debt financing has a tax shield advantage.
• Debt brings about some associated costs
with it i.e. agency costs and bankruptcy
cost.
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Financing decision cont’e
SOURCES OF FINANCING:
Short term sources of raising funds
a) Funds from Operations:
i. Retained earnings
• Spontaneous sources
ii. Trade credit
Advantages
• It has no explicit costs e.g. interest.
• It is flexible in that it grows with the growth in a firm’s sales and vice
versa.
• There are no complicated formalities in securing the credit since the
firms (buying and selling) do not sign any legal document.
• Trade credit is relatively easy to obtain especially to small firms.
Disadvantages
• Cash discounts foregone
• Firms buying on credit may be offered less favorable terms
• Stretching of the credit period by the buying firm may result into poor
credit rating
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iii. Accrued Expenses eg wages and salaries, taxes, interest and inefficiencies in the
billing by suppliers
Advantages
• That it has no explicit costs, is easy to obtain and, involves no formalities.
• Disadvantage
• That legal and practical aspects constrain the flexibility of a firm in lengthening the
payment interval
iv. Deferred Income
Advantages
• It is slightly cheap
• flexible e.g. rental income.
b. Bank Credit:
i. Overdraft facility
Advantages:
• It is flexible i.e. is dependent on banker/client relationship.
• There is no security (collateral) required.
• Available for longer periods – than for example accrued expenses.
Disadvantages:
• It is an expensive source of funds in that the borrower must pay interest.
• There is also payment of commitment fees.
• Transaction loans are obtained for a specific transaction while general-purpose loans
are obtained for general transactions.
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ii. Money – market based credit
iii. Factoring of debtors
iv. sources (miscellaneous) of short-term
v. Transaction loans and general purpose loans
Long term sources of raising funds
Ordinary Shares / Common Stock.
This is a permanent source of financing with no maturity date.
Ordinary shareholders are the legal owners of the business
• Have a residual claim on assets
• Have a residual claim on income
• As owners of the firm, they have voting rights.
• Limited liability to the amount of share investment in the
firm.
• Re-emptive rights i.e. have priority to buy newly issued
shares.
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Advantages OS to the firm:
• Dividend is not a fixed financial charge as compared to long-term debt. It is
therefore not mandatory.
• It is a permanent source of capital i.e has no maturity
• By issuing its common stock, a firm increases its financial base and future borrowing
capacity.
disad
• Floatation implies costs.
• Issuance of new common stock may result into dilution of ownership
• Dividends are not tax deductible.
• Because ordinary shareholders perceive a high risk because of their nature (residual
claims)
Preferred Stock:
These are hybrid securities in that they have features of both bonds and common stock.
Like bonds, the charges (dividends) of preference stockholders are fixed.
Their major features include;
• Convertibility feature
• Cumulative feature
• Claim on assets and income
• Participating feature
• Adjustable rate feature
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Advantages to the firm:
• Dividends are mandatory but non-payment may not lead to liquidation like bonds.
• Do not participate in extra dividends in good years.
• Have no voting rights.
• Inclusion of call options and sinking fund (funds set aside for calling back shares)
allow firms with the ability to replace the issue if interest rate declines.
Disadvantages:
• Cost is higher than that of bonds since they are more risky and dividends are not tax
deductible.
• Although omitted, their cumulative nature makes their payment mandatory.
• Usually preference shares are redeemable, making them a less permanent source of
funds.
Bonds: ie debentures, mortgage bonds, income, convertible and zero coupon bond.
Advantages to the firm:
• Bondholders have no voting rights.
• Bondholders do not participate in extra profits of the firm.
• Since bondholders perceive less risk, they attach a lower RRR.
• Less expensive than any other source because interest is a tax-deductible expense
and in addition, bonds do not have floatation costs.
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Disadvantages:
• Bond obligations are usually paid irrespective of whether profits are made or not
(apart from income bonds) and if they are not made, bondholders can call for
bankruptcy charges.
• Bondholders can institute restrictive covenants e.g. restrict further borrowing,
determine use of assets, determine when to pay or not to pay dividends, etc.
Leasing Financing
• . It involves a contractual relationship between the lessor and lessee (user).
Advantages:
• Can be a great advantage where initial outlays are high hence reduces outflow of
cash.
• The risk of obsolescence usually lies with the lessor Maintenance and service is
usually the responsibility of the lessor.
Disadvantages:
• The firm foregoes investment allowances hence does not enjoy an element of tax
incentives.
• When assets revert to the lessor, it may cause a standstill in operations and cash
flows.
Business angels
Hire purchase
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Personal finance.
Over view
Understanding the importance of having a
personal budget
Categories of income and expenses and how to
manage them
Personal savings(savings account, fixe deposit
accounts etc.)
Personal investments( real estate, shares,
bonds, notes, treasury bills)
Factors considered while investing
Aspects of money.
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Personal finance refers to how individuals
manage their day to day finances or money and
plan for the future.
The main objective of personal finance is to
achieve financial independence.
Individuals do not need to live on paycheck to
paycheck basis and set their own objectives or
goals.
Therefore individuals need to develop a
spending plan or a budget to achieve this
objective
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Budget. This is a forecasted statement of individuals
expenses and the incomes you expect to receive over
a given period of time.
Why prepare a personal budget
Helps to plan for expenses or manage them
Save for the future
Helps spend wisely
plan for emergencies
To live within ones means
Helps to reduce family arguments about money
Make your dream come true
Achieve ur financial goal
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INCOME.
This is the money received or a portion of earnings received from
committing your efforts into production
(business dictionary.com) defines income as the flow of cash or cash-
equivalents received from work (wage or salary), capital (interest or
profit), or land (rent).
Categories of income
 Bonuses, child support, salaries, social security, tips, wages, interests
or dividends, rents or royalties, retirement income and disability
benefits
How to manage income
 Avoid leakages
 Broaden ur earnings base
 Spend on priorities
 Be creative or innovative
 Get it for free
 Choose the best saving plan
 Have a good attitude
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Personal expense.
These are the outgoings or spending's for individual purposes
of family related spending.
Categories of expenses
Debt payments i.e. loan, student loan and credit card
Education, tuition, day care, books and supplies
Entertainment and recreation i.e. sports, hobbies, concerts
Food i.e. grocery, dinning out KFC
Rent i.e. housing, mortgage
Insurance
Persona i.e. clothing, hair care, gym dressing
Gifts i.e. birth days
Savings i.e. retirement, education, emergency fund
Transportation
Utilities i.e. phone charges, water electricity
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How to manage expenses
Do the math
Live within ur means
Stick to ur budget
Get it for free
Spend on priorities
Reduce on gifts
Keep watch of phantom money
Have spending goals
Share it
Find the best buy
Bargain where necessary
“Too many people spend money they earned to buy things they
don't want to impress people that they don't like”. --Will
Rogers
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Savings.
A portion of income not spent on consumption ( income kept
aside to cater for future needs)
How to manage savings
Use a quarter rule
Manage your expenses well
Plan for the income well
Keep watch of phantom money
Make sure it is impossible to access ATM machines
Set you goals
Set up an envelope system
Choose something to save for
Watch your saving grow
“It's not how much money you make, but how much money
you keep, how hard it works for you, and how many
generations you keep it for.” --Robert Kiyosaki
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Debt management
These are borrowings an individual has either from an
individual or from a financial institution. It is mostly
called a loan.
How debt is managed
Budget
Negotiate
Prioritize payments
Consolidate your obligations
Use a credit counselor
Use it for the purpose
Do not let your expenses surpuse ur income
Spend within your means
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Creating wealth or investment management
Any activity done to generate capital gains
Investment avenues/ avenues of investment
 Financial securities i.e.. Bonds, shares, T.Bs, certificate of deposit
 Non financial securities
 Pension funds or mutual funds
 Real assets i.e. real estate, diamond, gold, art and ornaments
 Agriculture i.e. farming, piggery etc.
 Borrow or lend
 Notes
Considerations for an investment
 Return
 Risk
 Marketability
 Convenience
 Tax shield i.e. initial, continuous and terminal
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What an individual needs to impress when
you need to keep a proper personal finances
Identify your goals
Budget
Conduct a financial review
Debt management
Building wealth
“You can only become truly accomplished at something you love. Don’t
make money your goal. Instead, pursue the things you love doing, and
then do them so well that people can’t take their eyes off you”. --Maya
Angelou
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CAPITAL BUDGETING DECISION/
INVESTMENT DECISION
Capital budgeting refers to the decision to invest in
long-term assets. The assets are expected to be used
over a long period of time
• Examples/ categories of capital budgeting decisions
include acquisition of a new plant and equipment,
replacement, expansion of the existing investment
e.g expansion of the firm’s production capacity,
research and dev’t, regulatory or environmental
Investments can also be classified as;
• Mutually exclusive investments
• Independent investments
• Contingent investments;
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Importance of Capital Budgeting Decision:
The capital budgeting decision is a central decision to
any business because;
• It determines the asset mix and hence shapes the
business risk hence the growth of a firm.
• It is expensive and therefore involves heavy initial
outlays of the business resources.
• Benefits accrue in future which future is associated
with risk and uncertainty.
• Investment decisions are difficult to reverse and in
the event that they are reversed, the decision can be
very costly.
• They influence the firm’s growth in the long run.
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Procedures/Steps of Capital Budgeting:
• Review of company policy
• Identifying possible investment opportunities/ ideas.
• Screening to reduce the number of alternatives to the
most feasible alternatives.
• Estimate cash flows for the feasible alternative and
acquiring relevant information.
• Appraisal/evaluation of cash flows using the
techniques of investment appraisal i.e. NPV, IRR, PI
etc.
• Select and implement the most feasible alternative
based on the project with the highest NPV, IRR, PI
etc.
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TYPES OF CASHFLOWS
Initial outlay
Intermediate cash flows
Terminal cash flows
Components of initial outlay/Cash Outflows:
• Cost of the asset/invoice value of the asset/book
value.
• Capitalized expenditure/incidental
• Opportunity cost.
• Investment allowances (tax holidays) which reduce
on initial outlay.
• Changes in working capital.
• Sunk costs.
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Format for initial outlay:
Invoice value xxx
Add: Capitalized expenditures/incidental cost.
Clearing xx
Transportation xx
Installation, xx
Warehousing xx XX
Cost of the asset XXXX
Add: Increase in working capital. xx
Opportunity Cost xx
Less: Decrease in working capital. xx
Investment incentives / allowances xx xx
Net Cash outflow/ initial outlay. xxx
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Intermediate Cash flows: format
Period 1 2 3 4
Revenue xxx xxx xxx xxx
Add: cost savings xxx xxx xxx xxx
Projected earnings xxx xxx xxx xxx
Less Operating costs (xx) (xx) (xx) (xx)
EBDIT xxx xxx xxx xxx
Less Depreciation (xx) (xx) (xx) (xx)
EBIT xx xx xxx xx
Interest (xx) (xx) (xx) (xx)
EBT xx xx xx xx
Tax (xx) (xx) (xx) (xx)
Earnings after tax xxx xxx xxx xxx
Add back depreciation xx xx xx xx
Operating cash flows xxx xxx xxx xxx
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Terminal Cash flows:
These occur at the end of the investment life and
they include;
The Scrap/Salvage value SVt = SV0 (1-t)
Where: SVt = Salvage value after tax
SV0 = Salvage value before tax
t = Tax rate
Working capital released/recovered.
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Techniques that ignore time value of money.
i) Payback Period Technique:
 Payback period for even cashflows
Payback period = Initial Outlay
Annual cash inflow.
 Payback period for uneven cash flows
Payback period = Year 5 + Amount of outlay yet to be recovered X
12months
Cash inflow in the next yr.
Merits of the Technique:
 It is a simple technique use and understand.
 It uses cash flow information, which is the relevant information in the
objective of the firm.
Demerits of the Technique:
 It ignores time value of money. Cash inflows are simply added
together as if the investor is indifferent to the timing of the cash
inflows.
 It ignores cash flows after the payback period.
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The accounting rate of return / average rate of return
The ARR is the ratio of average annual profits after taxes to average investment.
ARR = Average Annual profits after taxes * 100%
Average investment on the project
Average Annual profits = A1 + A2+ A3+ … + An
n
Average investment = sum of book values
n
Merits of the Technique:
 It is simple to use and understand
 It uses profit information and therefore there is no need to make adjustments in
financial statements.
 It takes into account all the profits of the project life.
Demerits:
 It ignores time value of money by simply adding together all expected profits
without discounting them to their present worth.
 It uses accounting profits which are vague and inconsistent with the basic objective
of maximizing wealth.
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Net Present Value (NPV)
n
NPV =  Ai - Io
i=1 (1+K)i
Merits of NPV Technique:
NPV takes into account time value of money by discounting the cash
flows to their present worth.
It uses cash flow information which is relevant to the objective of
wealth maximization.
It is superior to all other techniques of capital budgeting because an
investment cannot have more than one value of NPV.
It shows the absolute contribution of an investment to the wealth of the
firm
Demerits of NPV:
Difficulty in estimating cash flows and then computing it especially
when long periods are involved for example 100 years
Determining the discount rate is complex
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Internal Rate Of Return
n
IRR =  Ai - Io = 0
i=1 (1+K)i
Interpolation method
IRR = Lower rate + Difference between PV of
inflows at lower rate & IRR__ X Diff. between the 2
rates
Difference between PV inflows
at lower rate and higher rate
Advantages/Merits of IRR:
Recognizes time value of money
Uses cash flows which are consistent with objective of firm
Demerits:
You may fail to get a rate that equates the present value of
benefits to that of outlays.
Calculation of IRR is complicated.
There is a problem of multiple internal rates of return.
8/30/2022 Eva Mpaata
Profitability Index (PI):
Profitability index is the ratio of present value of cash inflows
to present value of initial outlay.
PI = Present Value of Cash inflows
Present Value of Initial Outlay.
Merits:
Recognizes time value of money.
Easy to compute and use.
Uses cash flows which are consistent to the objective of
wealth maximization.
Demerits:
Need to adjust financial statement figures to determine cash
flows which is time consuming.
8/30/2022 Eva Mpaata
8/30/2022 Eva Mpaata

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fm intro and financing capital budeting.pptx

  • 1. Introduction to Financial management Key outlines  Definition of finance Defn of financial management. Definition of financial manager. The key finance functions or decisions or the scope. Roles of the finance function. The notary and routine roles of a financial manager. Objectives of a firm. The concept of Time value of Money. • Definition of TVM. • Reasons for TVM. • Concept of Present Value(PV), Future Value(FV), Annuities. • Application of PVA i.e. loan amortization. The concept of risk return relationship. 8/30/2022 Eva Mpaata
  • 2. (www. investorwords.com) defines finance as a branch of economics concerned with resource allocation as well as resource management, acquisition and investment. Simply, finance deals with matters related to money and the markets Finance for small business defined. Is the managerial activity concerned with the raising and allocation of the firms’ financial resources in order to attain the firms’ objectives. (Julius k, 2003) Financial manager is a person concerned with the raising and allocation of the firms’ financial resources in order to attain the firms’ objectives. 8/30/2022 Eva Mpaata
  • 3. Intro cont’es ROLES OF FINANCIAL MANAGEMENT OR THE FINANCE FUNCTION Raising of funds Allocation of funds/utilization. Interlinking the finance function. THE SCOPE OF FINANCIAL MANAGEMENT From the above roles of financial management, the scope of financial management spreads around 4 main decision areas i.e. • Investment decision. Allocation of resources in long-term assets. • Financing decision. Raising funds through debt or equity. • Working capital or liquidity or short term decision. Resource allocation in short term assets • Dividends decision or Earnings Mgt. decision. Concerned with distribution of profits or retention of profits for future cap. gain 8/30/2022 Eva Mpaata
  • 4. ROLES OF A FINANCIAL MANAGER Notary roles of a financial manager Raising funds Efficient allocation of raised funds Profit planning Understanding capital markets Routine roles of financial manager Custody of reserves, insurance policy Supervision of cash receipts and making payments and Safeguarding of cash balances Custody and safeguarding of securities, insurance policies and other valuable papers Record keeping and reporting 8/30/2022 Eva Mpaata
  • 5. THE OBJECTIVE OF A FIRM 1.Maximization of profits: This objective requires a firm to maximize its revenue as it minimizes its costs. This objective is generally criticized in financial management because  The definition of profit is vague  Profit maximization ignores the concept of time value of money.  The objective is in conflict with interests of other stakeholders  Ignores risk Justification of profit maximization  Ensures economic survival of the firm’s target profit, then minimize expenses and have enough funds to pay off its liabilities.  It also maximizes the social economic welfare  Firms aim at maximizing utility that can be measured in terms of profit.  Management forces allocate capital to those who can use it most profitably.  Shows efficiency 8/30/2022 Eva Mpaata
  • 6. 2. Wealth maximization – Wealth is the net cash flow expected from all the assets in which resources of the firm have been invested; n Wealth max. = Σ Ai _ _ I0 i=1 (1 + K) where; Ai – cash flow invested in period i K - discount rate/factor I0 - initial cash flow i - period over which a firm is expected to acquire resources and invest. Importance Takes into account risk Considers TVM Not in conflict with shareholders interest Takes into account inflationary tendencies 8/30/2022 Eva Mpaata
  • 7. Other Objectives of the firm: 3. Maximization of market share. 4. Maximization of earnings per share 5. Maximization of employee welfare 6. Social responsibility. 7. Efficiency 8. Risk reduction (read on ur own) 8/30/2022 Eva Mpaata
  • 8. TIME VALUE OF MONEY This is a concept that as a rational economic unit (individual or firm) you prefer earlier cash flows to later cash flows (i.e. prefer a sum of money today than later). Reasons for time preference for money Generally, the future is associated with risk and uncertainty because of changes in the business environment. Any rational consumer prefers current consumption to future consumption. The amount of money received earlier can be invested to earn more return in the future. By waiting for later cash flows, the investor foregoes this return. Avoids inflationary tendencies. 8/30/2022 Eva Mpaata
  • 9. FUTURE VALUE Is the value at some future time of a present amount of money evaluated at a given interest rate. It expresses today’s cash flows into their worth in future. This refers to the value of the present cash flows on an investment when compounded using an appropriate compound rate to reflect their future values. FV for a single sum of money FVn = PVo(1 + i)n FV based of frequency of compounding ie semi annual, biannual, quarterly, monthly etc FVnm - PVo (1 + i )nm m Fv of money based on continuous compounding Fvcc = PV. ert 8/30/2022 Eva Mpaata
  • 10. PRESENT VALUE: Present value refers to the value of future cash flows of an investment when discounted using an appropriate discount rate to bring them back to their present worth. PV for single sum of money PV = FVn (1 + i)n PV based on frequency of compounding PV = FV (1+r/m)mn PV of uneven cash flows Present value of uneven cash flows. PV = A1 + A2 + A3 + … An (1+i)1 (1+i)2 (1+i)3 (1+i)n 8/30/2022 Eva Mpaata
  • 11. Future value of annuities. An annuity refers to a uniform cash flow stream expected per year for a specific number of years e.g. if 250 million shillings is expected to be earned per year as interest on a bond. In this case, the future value of annuity is given by; FVA = A (1 + i)n – 1 I Alternatively: FVA = A x Future Value Interest Factor Annuity (FVIFA) PVA = A 1-(1+r)^-n r Alternatively PVA = A x Present Value Interest Factor Annuity (PVIFA) 8/30/2022 Eva Mpaata
  • 12. CONCEPT OF ANNUITY Annuity is a uniform stream of cashlows expeted to be received or paid annually for a given period of time Types Annuity due. Beginning of a given pd. Eg rent in advance, prepayments, yaka etc Deferred annuity. End of a given pd. Interest on loans, electricity, water bills etc Perpetual annuity. For ever eg. Consol bonds, irredeemable debentures, pension A Thus; PV = i 8/30/2022 Eva Mpaata
  • 13. PRACTICAL APPLICATION OF PRESENT VALUE: LOAN AMORTIZATION. The present value concept has practical applications in determining the payments required under an installment type of loan. Example: Suppose a firm borrows Shs.10m at 10% interest to be repaid in the next 5 years. Equal installments are required at the end of each year and these payments must be sufficient to repay the principal sum together with the interest. Draw up a loan amortization schedule to show how the loan would be repaid. 8/30/2022 Eva Mpaata
  • 14. YEAR Opening balance (O) Annual Installment(A) Interest Payment (I) Principal payment P = (A-I) Closing Balance C = (O-P) 0 1 2 3 8/30/2022 Eva Mpaata
  • 15. The concept of Risk return relationship Risk. Is any variability that may arise in return due to the decision taken to invest in a business Return. is a benefit that may accrue just incase funds are committed in an asset or investment The relationship is always positive implying that the higher the risk, the higher the returns and vice versa. Illustration Expected return = Rfr+ B(Rm-Rr) SML Rfr (risk) 8/30/2022 Eva Mpaata
  • 16. 8/30/2022 Eva Mpaata Topic two: The Finance Decision Outline • Definition of financing decision • Theory of capital structure and the school of thought • Determining the Optimal Capital Structure • Source of short-term financing • Long Term Sources of Funds • Nature and importance of capital market
  • 17. 8/30/2022 Eva Mpaata Financing decision Is mix of debt or equity used in financing business operations. Debt can be from short-term borrowing or long-term borrowing. The long-term borrowing plus equity make up the capital structure of the firm i.e. capital structure is a sub-component of the financial structure of the firm. Definition of capital structure. This is the proportion of debt or equity used to finance business operations. Determinants of optimal capital structure • The existing level of leverage • Stability of sales • Stage of growth • The need for control of ownership • Floatation and transaction costs • Bankruptcy costs. • Cost and availability of funds.
  • 18. 8/30/2022 Eva Mpaata THE CAPITAL STRUCTURE DEBATE: There is a controversy in the financing field about the relevance of the capital structure decision THE TRADITIONAL/CLASSICAL SCHOOL OF THOUGHT • This school of thought advocates that the financing method can influence the value of the firm through its impact on the firm’s cost of capital Ko = KdPd + KePe • Cost of debt is generally lower than cost of equity because of the tax shield advantage. • Hence, the more debt, the less the cost of debt hence Ko will fall.
  • 19. 8/30/2022 Eva Mpaata • However, as you use more of debt, it is possible that Ke will begin to increase because shareholders will perceive more risk with increased debt and may require a higher return on investment hence rise in Ke which will in turn increase Ko. • According to this school of thought at point A, the firm enjoys the lowest cost of capital and optimal level of debt/equity. Therefore, as a financial manager, you have to look for this level because it gives the highest value to the firm. Increase in the cost of equity due to perceived risk by the shareholders(Ke) Overall cost of A C Capital Reduction in cost of debt due to tax shield advantage (kd) B 0 D/E Leverage level
  • 20. 8/30/2022 Eva Mpaata • AB this is a point where a firm enjoys increasing wealth because overall cost of capital is reducing due to the tax shield advantage • BC declining wealth because of the overall cost of capital increases due to the bankruptcy costs arising from the percieved risk • DE optimal level of capital structure.
  • 21. 8/30/2022 Eva Mpaata • ASSUPMTIONS OF TRADITION SCHOOL OF THOUGHT • The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases. • The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily. • As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.
  • 22. 8/30/2022 Eva Mpaata THE NEO-CLASSICAL SCHOOL OF THOUGHT (MM POSITION) • Modigliani and Miller argued that the capital structure debate is a mere detail. They argue that you cannot affect the value of the firm simply by the way you finance its assets. • They argue that value comes from assets that the firm has invested in hence the asset mix, which is a function of the investment decision. Once this decision (investment) is made, value will be generated through cash flows which wealth is conserved and when created cannot be altered by the financing decision Assumptions of the Position: • There are many buyers and sellers of securities such that no single buyer or seller can single handedly affect their prices. • Securities are completely divisible. • There are no transaction costs. • There are no taxes i.e. both personal and corporate taxes. • Investors are rational i.e. base their decisions on risk and return. • There are no bankruptcy costs. • Individuals or investors borrow at risk free rate.
  • 23. 8/30/2022 Eva Mpaata • MM also recognize that when you use debt, you enjoy a tax shield and that use of high debt increases the risk perceived by shareholders due to increased debt obligations. Ke increases as D/E increase Overaall cost of capital Overall Ko remains constant Kd falls 0 D/E Leverage • The MM position emphasizes that the financial manager concentrates on the investment decision (asset mix) instead of the financing decision
  • 24. 8/30/2022 Eva Mpaata THE MIDDLE GROUND DEBATE Both contributions above are extreme. The middle frond debate reconciles the two positions and it recognizes two fundamental aspects of debt financing i.e; • Debt financing has a tax shield advantage. • Debt brings about some associated costs with it i.e. agency costs and bankruptcy cost.
  • 25. 8/30/2022 Eva Mpaata Financing decision cont’e SOURCES OF FINANCING: Short term sources of raising funds a) Funds from Operations: i. Retained earnings • Spontaneous sources ii. Trade credit Advantages • It has no explicit costs e.g. interest. • It is flexible in that it grows with the growth in a firm’s sales and vice versa. • There are no complicated formalities in securing the credit since the firms (buying and selling) do not sign any legal document. • Trade credit is relatively easy to obtain especially to small firms. Disadvantages • Cash discounts foregone • Firms buying on credit may be offered less favorable terms • Stretching of the credit period by the buying firm may result into poor credit rating
  • 26. 8/30/2022 Eva Mpaata iii. Accrued Expenses eg wages and salaries, taxes, interest and inefficiencies in the billing by suppliers Advantages • That it has no explicit costs, is easy to obtain and, involves no formalities. • Disadvantage • That legal and practical aspects constrain the flexibility of a firm in lengthening the payment interval iv. Deferred Income Advantages • It is slightly cheap • flexible e.g. rental income. b. Bank Credit: i. Overdraft facility Advantages: • It is flexible i.e. is dependent on banker/client relationship. • There is no security (collateral) required. • Available for longer periods – than for example accrued expenses. Disadvantages: • It is an expensive source of funds in that the borrower must pay interest. • There is also payment of commitment fees. • Transaction loans are obtained for a specific transaction while general-purpose loans are obtained for general transactions.
  • 27. 8/30/2022 Eva Mpaata ii. Money – market based credit iii. Factoring of debtors iv. sources (miscellaneous) of short-term v. Transaction loans and general purpose loans Long term sources of raising funds Ordinary Shares / Common Stock. This is a permanent source of financing with no maturity date. Ordinary shareholders are the legal owners of the business • Have a residual claim on assets • Have a residual claim on income • As owners of the firm, they have voting rights. • Limited liability to the amount of share investment in the firm. • Re-emptive rights i.e. have priority to buy newly issued shares.
  • 28. 8/30/2022 Eva Mpaata Advantages OS to the firm: • Dividend is not a fixed financial charge as compared to long-term debt. It is therefore not mandatory. • It is a permanent source of capital i.e has no maturity • By issuing its common stock, a firm increases its financial base and future borrowing capacity. disad • Floatation implies costs. • Issuance of new common stock may result into dilution of ownership • Dividends are not tax deductible. • Because ordinary shareholders perceive a high risk because of their nature (residual claims) Preferred Stock: These are hybrid securities in that they have features of both bonds and common stock. Like bonds, the charges (dividends) of preference stockholders are fixed. Their major features include; • Convertibility feature • Cumulative feature • Claim on assets and income • Participating feature • Adjustable rate feature
  • 29. 8/30/2022 Eva Mpaata Advantages to the firm: • Dividends are mandatory but non-payment may not lead to liquidation like bonds. • Do not participate in extra dividends in good years. • Have no voting rights. • Inclusion of call options and sinking fund (funds set aside for calling back shares) allow firms with the ability to replace the issue if interest rate declines. Disadvantages: • Cost is higher than that of bonds since they are more risky and dividends are not tax deductible. • Although omitted, their cumulative nature makes their payment mandatory. • Usually preference shares are redeemable, making them a less permanent source of funds. Bonds: ie debentures, mortgage bonds, income, convertible and zero coupon bond. Advantages to the firm: • Bondholders have no voting rights. • Bondholders do not participate in extra profits of the firm. • Since bondholders perceive less risk, they attach a lower RRR. • Less expensive than any other source because interest is a tax-deductible expense and in addition, bonds do not have floatation costs.
  • 30. 8/30/2022 Eva Mpaata Disadvantages: • Bond obligations are usually paid irrespective of whether profits are made or not (apart from income bonds) and if they are not made, bondholders can call for bankruptcy charges. • Bondholders can institute restrictive covenants e.g. restrict further borrowing, determine use of assets, determine when to pay or not to pay dividends, etc. Leasing Financing • . It involves a contractual relationship between the lessor and lessee (user). Advantages: • Can be a great advantage where initial outlays are high hence reduces outflow of cash. • The risk of obsolescence usually lies with the lessor Maintenance and service is usually the responsibility of the lessor. Disadvantages: • The firm foregoes investment allowances hence does not enjoy an element of tax incentives. • When assets revert to the lessor, it may cause a standstill in operations and cash flows. Business angels Hire purchase
  • 31. 8/30/2022 Eva Mpaata Personal finance. Over view Understanding the importance of having a personal budget Categories of income and expenses and how to manage them Personal savings(savings account, fixe deposit accounts etc.) Personal investments( real estate, shares, bonds, notes, treasury bills) Factors considered while investing Aspects of money.
  • 32. 8/30/2022 Eva Mpaata Personal finance refers to how individuals manage their day to day finances or money and plan for the future. The main objective of personal finance is to achieve financial independence. Individuals do not need to live on paycheck to paycheck basis and set their own objectives or goals. Therefore individuals need to develop a spending plan or a budget to achieve this objective
  • 33. 8/30/2022 Eva Mpaata Budget. This is a forecasted statement of individuals expenses and the incomes you expect to receive over a given period of time. Why prepare a personal budget Helps to plan for expenses or manage them Save for the future Helps spend wisely plan for emergencies To live within ones means Helps to reduce family arguments about money Make your dream come true Achieve ur financial goal
  • 34. 8/30/2022 Eva Mpaata INCOME. This is the money received or a portion of earnings received from committing your efforts into production (business dictionary.com) defines income as the flow of cash or cash- equivalents received from work (wage or salary), capital (interest or profit), or land (rent). Categories of income  Bonuses, child support, salaries, social security, tips, wages, interests or dividends, rents or royalties, retirement income and disability benefits How to manage income  Avoid leakages  Broaden ur earnings base  Spend on priorities  Be creative or innovative  Get it for free  Choose the best saving plan  Have a good attitude
  • 35. 8/30/2022 Eva Mpaata Personal expense. These are the outgoings or spending's for individual purposes of family related spending. Categories of expenses Debt payments i.e. loan, student loan and credit card Education, tuition, day care, books and supplies Entertainment and recreation i.e. sports, hobbies, concerts Food i.e. grocery, dinning out KFC Rent i.e. housing, mortgage Insurance Persona i.e. clothing, hair care, gym dressing Gifts i.e. birth days Savings i.e. retirement, education, emergency fund Transportation Utilities i.e. phone charges, water electricity
  • 36. 8/30/2022 Eva Mpaata How to manage expenses Do the math Live within ur means Stick to ur budget Get it for free Spend on priorities Reduce on gifts Keep watch of phantom money Have spending goals Share it Find the best buy Bargain where necessary “Too many people spend money they earned to buy things they don't want to impress people that they don't like”. --Will Rogers
  • 37. 8/30/2022 Eva Mpaata Savings. A portion of income not spent on consumption ( income kept aside to cater for future needs) How to manage savings Use a quarter rule Manage your expenses well Plan for the income well Keep watch of phantom money Make sure it is impossible to access ATM machines Set you goals Set up an envelope system Choose something to save for Watch your saving grow “It's not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” --Robert Kiyosaki
  • 38. 8/30/2022 Eva Mpaata Debt management These are borrowings an individual has either from an individual or from a financial institution. It is mostly called a loan. How debt is managed Budget Negotiate Prioritize payments Consolidate your obligations Use a credit counselor Use it for the purpose Do not let your expenses surpuse ur income Spend within your means
  • 39. 8/30/2022 Eva Mpaata Creating wealth or investment management Any activity done to generate capital gains Investment avenues/ avenues of investment  Financial securities i.e.. Bonds, shares, T.Bs, certificate of deposit  Non financial securities  Pension funds or mutual funds  Real assets i.e. real estate, diamond, gold, art and ornaments  Agriculture i.e. farming, piggery etc.  Borrow or lend  Notes Considerations for an investment  Return  Risk  Marketability  Convenience  Tax shield i.e. initial, continuous and terminal
  • 40. 8/30/2022 Eva Mpaata What an individual needs to impress when you need to keep a proper personal finances Identify your goals Budget Conduct a financial review Debt management Building wealth “You can only become truly accomplished at something you love. Don’t make money your goal. Instead, pursue the things you love doing, and then do them so well that people can’t take their eyes off you”. --Maya Angelou
  • 41. 8/30/2022 Eva Mpaata CAPITAL BUDGETING DECISION/ INVESTMENT DECISION Capital budgeting refers to the decision to invest in long-term assets. The assets are expected to be used over a long period of time • Examples/ categories of capital budgeting decisions include acquisition of a new plant and equipment, replacement, expansion of the existing investment e.g expansion of the firm’s production capacity, research and dev’t, regulatory or environmental Investments can also be classified as; • Mutually exclusive investments • Independent investments • Contingent investments;
  • 42. 8/30/2022 Eva Mpaata Importance of Capital Budgeting Decision: The capital budgeting decision is a central decision to any business because; • It determines the asset mix and hence shapes the business risk hence the growth of a firm. • It is expensive and therefore involves heavy initial outlays of the business resources. • Benefits accrue in future which future is associated with risk and uncertainty. • Investment decisions are difficult to reverse and in the event that they are reversed, the decision can be very costly. • They influence the firm’s growth in the long run.
  • 43. 8/30/2022 Eva Mpaata Procedures/Steps of Capital Budgeting: • Review of company policy • Identifying possible investment opportunities/ ideas. • Screening to reduce the number of alternatives to the most feasible alternatives. • Estimate cash flows for the feasible alternative and acquiring relevant information. • Appraisal/evaluation of cash flows using the techniques of investment appraisal i.e. NPV, IRR, PI etc. • Select and implement the most feasible alternative based on the project with the highest NPV, IRR, PI etc.
  • 44. 8/30/2022 Eva Mpaata TYPES OF CASHFLOWS Initial outlay Intermediate cash flows Terminal cash flows Components of initial outlay/Cash Outflows: • Cost of the asset/invoice value of the asset/book value. • Capitalized expenditure/incidental • Opportunity cost. • Investment allowances (tax holidays) which reduce on initial outlay. • Changes in working capital. • Sunk costs.
  • 45. 8/30/2022 Eva Mpaata Format for initial outlay: Invoice value xxx Add: Capitalized expenditures/incidental cost. Clearing xx Transportation xx Installation, xx Warehousing xx XX Cost of the asset XXXX Add: Increase in working capital. xx Opportunity Cost xx Less: Decrease in working capital. xx Investment incentives / allowances xx xx Net Cash outflow/ initial outlay. xxx
  • 46. 8/30/2022 Eva Mpaata Intermediate Cash flows: format Period 1 2 3 4 Revenue xxx xxx xxx xxx Add: cost savings xxx xxx xxx xxx Projected earnings xxx xxx xxx xxx Less Operating costs (xx) (xx) (xx) (xx) EBDIT xxx xxx xxx xxx Less Depreciation (xx) (xx) (xx) (xx) EBIT xx xx xxx xx Interest (xx) (xx) (xx) (xx) EBT xx xx xx xx Tax (xx) (xx) (xx) (xx) Earnings after tax xxx xxx xxx xxx Add back depreciation xx xx xx xx Operating cash flows xxx xxx xxx xxx
  • 47. 8/30/2022 Eva Mpaata Terminal Cash flows: These occur at the end of the investment life and they include; The Scrap/Salvage value SVt = SV0 (1-t) Where: SVt = Salvage value after tax SV0 = Salvage value before tax t = Tax rate Working capital released/recovered.
  • 48. 8/30/2022 Eva Mpaata Techniques that ignore time value of money. i) Payback Period Technique:  Payback period for even cashflows Payback period = Initial Outlay Annual cash inflow.  Payback period for uneven cash flows Payback period = Year 5 + Amount of outlay yet to be recovered X 12months Cash inflow in the next yr. Merits of the Technique:  It is a simple technique use and understand.  It uses cash flow information, which is the relevant information in the objective of the firm. Demerits of the Technique:  It ignores time value of money. Cash inflows are simply added together as if the investor is indifferent to the timing of the cash inflows.  It ignores cash flows after the payback period.
  • 49. 8/30/2022 Eva Mpaata The accounting rate of return / average rate of return The ARR is the ratio of average annual profits after taxes to average investment. ARR = Average Annual profits after taxes * 100% Average investment on the project Average Annual profits = A1 + A2+ A3+ … + An n Average investment = sum of book values n Merits of the Technique:  It is simple to use and understand  It uses profit information and therefore there is no need to make adjustments in financial statements.  It takes into account all the profits of the project life. Demerits:  It ignores time value of money by simply adding together all expected profits without discounting them to their present worth.  It uses accounting profits which are vague and inconsistent with the basic objective of maximizing wealth.
  • 50. 8/30/2022 Eva Mpaata Net Present Value (NPV) n NPV =  Ai - Io i=1 (1+K)i Merits of NPV Technique: NPV takes into account time value of money by discounting the cash flows to their present worth. It uses cash flow information which is relevant to the objective of wealth maximization. It is superior to all other techniques of capital budgeting because an investment cannot have more than one value of NPV. It shows the absolute contribution of an investment to the wealth of the firm Demerits of NPV: Difficulty in estimating cash flows and then computing it especially when long periods are involved for example 100 years Determining the discount rate is complex
  • 51. 8/30/2022 Eva Mpaata Internal Rate Of Return n IRR =  Ai - Io = 0 i=1 (1+K)i Interpolation method IRR = Lower rate + Difference between PV of inflows at lower rate & IRR__ X Diff. between the 2 rates Difference between PV inflows at lower rate and higher rate Advantages/Merits of IRR: Recognizes time value of money Uses cash flows which are consistent with objective of firm Demerits: You may fail to get a rate that equates the present value of benefits to that of outlays. Calculation of IRR is complicated. There is a problem of multiple internal rates of return.
  • 52. 8/30/2022 Eva Mpaata Profitability Index (PI): Profitability index is the ratio of present value of cash inflows to present value of initial outlay. PI = Present Value of Cash inflows Present Value of Initial Outlay. Merits: Recognizes time value of money. Easy to compute and use. Uses cash flows which are consistent to the objective of wealth maximization. Demerits: Need to adjust financial statement figures to determine cash flows which is time consuming.