Construction financial management

Debre Birhan university
Institute of technology
Department of Construction Technology and
Management
Financial Management in Construction
By: Yibeltal Alamirew (MSc. PE)
0

CHAPTER 1: Introduction
An Overview of Financial Management
❑Capital Requirement of a Firm
❑Fields of Finance
❑Forms of business organization
❑Goals of Financial Management
❑Functions of Financial Management
❑Organization of Finance Functions
1

❑ FM is the planning for, acquiring and
Utilizing of funds in order to maximize the
efficiency and value of the firm.
❑ It involves
⚫Forecasting & Planning
⚫Major investment and financing decisions
⚫Coordination and Control
⚫Risk Management
What is Financial Management all about?
2

❑ No matter what the nature the proposed business is and
how it is organized, one has to address the following
questions.
➢ What capital investment should be made? That is what kind
of material and equipment should be purchased, or building
to be rented, etc.
➢ How and where the money to pay for the proposed capital
investment will be raised?
➢ How the day-to-day financial activities are handled like
collecting the receivables and paying the suppliers?
Cont’d
3

It has now broaden to deal with issues like:
➢ Which new proposals for employing capital should be accepted
by the firm?
➢ What steps can be taken to increase the value of the firm’s
common stock?
➢ How much working capital will be needed to support and
expand the company’s operation?
➢ Where should the firm go to raise the short and long-term
capital demand and how much will it cost?
➢ Should a firm declare a cash dividend on its common stock and
if so, how much a dividend should be declared?
Cont’d
4

Cont’d
❑ The term finance can be defined as the
management of the flows of money or its
equivalent through an organization, whether it is a
for or not-for profit firms, corporation or non-
corporate business, or government agency.
❑ Finance concerns itself with the actual flow of
money as well as any claims against money.
The flow of fund is a continuous process 5

Dividends
Outside Investment
Investment
Loan Payment Loan
Payment for
Material
Purchase
of Assets
Sale
of Assets
Payment
of Expenses
Collections
Net
Credit
Sales
Net
Cash
Sales
Stockholders’
(Equity)
Other Corporations,
Businesses and Agencies
Creditors
(Debt)
CASH
Raw
Materials
Fixed
Assets
Personal Expenses
Wages, Benefits
& Operating Exp.
Accounts
Receivables
Work in
Process
Product
Inventories
Labor
Expense
Sales
Expense
Depreciation
Cash Flow in a Firm
6

Cash flow of contractors towards project
participants
Contractor
Financial
Institutions
Sub
Contractor
Supplier’s
Credit
Head office
finance
(Own
reserve)
Project
owner -
Payments
Construction
Plant
Products
Sales
Equipment
and Form &
False Works
Rent

➢ Financial demand for Tendering
➢ Financial demand for Contracting
➢ Financial demand for Inputs (Resources)
➢ Financial demand for Supervision
➢ Financial demand for Payment Processing
Major financial demand required for Construction
works include:

❑ The project finance problem is to obtain funds to bridge the
time between making expenditures and obtaining revenues.
The Financing Problem
Sources of Finance to Contractors
❑ Internal
❖ Cash flow from operations
❖ Sale of assets
❑ External
❖ owners (equity)
❖ creditors (debt)

❑ Debt Security
➢ It arises when a firm borrows money from creditors.
The firm incurs liability to repay the amount of money
borrowed in some future maturity date
❑ Equity Securities
➢ It represents ownership claim in the firm. People who
purchase equity securities are entitled to rights and
conditions that are different from those of firm’s
creditors
Debt vs. Equity Financial Securities
10

Fields of
finance
Fund owned by Fund collected
through
Use of fund
Public Finance Federal, State and Local
Government
Revenue from
taxes and
levies, Loan ,
Grant etc
To accomplish Social and
Economic objectives.
Perform non-profit
oriented corporations.
Finance Securities Individuals, Institutional
investors
Purchase and sale
of stocks and
bonds.
Means of raising finance
for institutional
investors. Means of
achieving profit for
individuals.
International
Finance
Individuals, businesses
and governments
involved in
international
transactions
Through
International
transactions
Means of collecting
foreign currency.
Institutional
Finance
Banks, Insurance
companies, and
pension funds and
credit unions.
Individual savers Finance function of the
economy through
capital formation.
2. Fields of Finance

❑Sole proprietorship
❑Partnership
I. General Partnership
II. Limited Partnership
❑Corporation
I. Subsidiary
II. Affiliate
III. Division
❑Joint Venture
Alternative Forms of Business Organization
13

❑ Advantages:
➢ Ease of formation
➢ Subject to few regulations
➢ No corporate income taxes
❑ Disadvantages:
➢ Limited life
➢ Unlimited liability
➢ Difficult to raise capital
Sole Proprietorship
❑ A general partnership has roughly the same advantages
and disadvantages as a sole proprietorship.
14

❑ Advantages:
➢ Unlimited life
➢ Easy transfer of ownership
➢ Limited liability
➢ Ease of raising capital
❑ Disadvantages:
➢ Double taxation
➢ Cost of set-up and report filing
Double Taxation of Corporate Profits/Income
Assume Corporate and Individual Tax = 50%
Earnings Before Taxes $100 EBT
($50) Corporate Tax
Net Income After Tax $50 NIAT (Profits)
Assume 100% Div. Payout $50 Dividend income
($25) Personal Income
$25 After-tax Income
Corporation
15

❑ A joint venture is a partnership agreement in which two
or more individual- or group-run businesses join
together to carry out a single business project sharing
the initial investment & risks.
In the Ethiopian Code:
“A joint venture is an agreement between partners on terms
mutually agreed and is a subject to the general principles of
law relating to the partnerships.”
Joint Venture
16

❑Profit Maximization:
➢ It is vague
➢ It leaves consideration of timing and duration
undefined
➢ It overlooks future aspects
❑ Wealth Maximization:
➢ Avoid high level of risk
➢ Pay consistent dividend
➢ Seek growth in Sales
➢ Maintain market Price of Stocks
Goals of Financial Management
17

❑Liquidity functions
❖ Forecasting Cash flow
❖ Raising Funds
❖ Managing the flow internal funds
❑Profitability functions
❖ Cost Control
❖ Pricing
❖ Forecasting profits
❖ Profit-risk analysis
❑Managing assets
Functions of Financial Management
18

❑Most firms designate three major financial positions
▪ Chief Financial Officer (CFO)
▪ Treasurer
➢ Managing cash flows
➢ Forecasting financial need
➢ Relations with FI
▪ Controller
➢ Financial accounting, internal auditing, taxation,
payroll functions
Organization of Finance Function
19

CFO
Treasurer Controlle
r
Cash
Manager
Credit
Manager
Financial
Accounting
Manager
Management
Accounting
Manager
Capital
Budgeting
Manager
Fund Raising
Manager
Portfolio
Manager
Tax
Manager
Data
Processing
Manager
Internal
Auditor 20

❑ Short-term financing
❑ Medium-term financing
❑ Long-term financing
CHAPTER 2: Financing Decisions
Short, medium, and long term financing

❑ Short-term financing usually includes loans that mature within
a year or less.
❑ Short-term finance
➢Used to raise temporary funds to cover seasonal or cyclic
business peak or special funding needs involving a short
time frame.
➢Are self-liquidating.
❑ Goals of short-term financing:
➢ Finance inventories during a production/ construction
period. Short-term financing allows the firm to match its
funds against its needs over an annual, seasonal or other
cyclical period.
➢ To achieve low-cost financing. The interest-free sources
provide low-cost financing for the firm by reducing its
borrowing need from interest-bearing sources
1. Short Term Financing

Source of Short-term financing
I. Unsecured Interest-Free Sources
➢ Accounts Payable
➢ Accruals
➢ Advance Payments
➢ Advance for purchase of materials/ material on site
II. Unsecured Interest-bearing Sources
❑ Self-Liquidating Bank Loans
➢ Single payment note
➢ Unsecured overdraft facility/ Line of Credit
➢ Revolving credit agreement
❑ Non Bank Short-term sources
➢ Commercial Paper/ Bond (Treasury bond)
➢ Private Loans

Source of Short-term financing (cont’d)
III. Secured Short-term Sources
❑ A secured loan occurs when the borrower pledges a
specific asset, collateral, to back a loan.
❑ Collateral may be in the form of:
➢ Warehouse receipt loan
➢ Receivables
✓ Pledging of accounts receivable
✓ Factoring receivables

❑ Intermediate-term financing usually includes loans with
maturity greater than 1 year & less than 5 to 7 years.
❑ Intermediate-term finance categories
➢ Revolving Credit Agreement
➢ Term Loan
➢ Lease
❑ Intermediate-term financing institutions
➢ Commercial Bank Loans
➢ Insurance Companies
➢ Pension Funds
➢ Equipment Manufacturers
2. Intermediate-Term Financing

❑ Long-term financing usually refers to the borrowing of
money for a long period of time in order to invest in fixed
assets relatively permanent in nature with long life.
❑ The Two Common sources
I. Debt: Sources can be classified into two
➢ Term loans
➢ Bonds
II. Equity: Ownership money acquired through the sale of
common stocks, preferred stock and retained earnings.
3. Long-Term Financing

❑ Debt investors are entitled to a contractual set of cash
flows (interest and principal) whereas equity investors
have a claim of residual cash flows of the firm after it has
satisfied all other claims and liabilities
❑ Interest paid to debt investors represents a tax-deductible
expense whereas dividend paid to equity investors has to
come out of profit after tax.
❑ Debt has a fixed maturity whereas equity ordinarily has
infinite life.
❑ Equity investors enjoy the prerogative to control the
affairs of the firm whereas debt investors play a passive
role. However, they often impose certain restrictions on
the way the firm is run to protect their interests.
Equity vs. Debt

1. Common Stock
❑ Represents ownership capital as equity shareholders
collectively own the company.
➢ Bear risks of ownership
➢ Liable only to the amount of capital
❑ Rights and Position of Equity shareholders
➢ Right to income
➢ Right to control
➢ Pre-emptive right
➢ Right to Liquidation
Equity Capital

2. Preferred Stock
❑ Represents hybrid form of financing.
❑ Resembles Equity in the following ways
➢ Dividend is payable only out of distributable profits
➢ Preference dividend is not an obligatory payment
➢ Preference dividend is not a tax-deductible payment
➢ It is an expensive source of financing
❑ Resembles Debt in the following ways
➢ No right to vote
➢ Claims come before common stock
Equity Capital (Cont’d)

3. Retained Earnings
❑ Represents the only internal source of financing for
expansion and growth
❑ Advantages to the firm:
➢ Retained earnings are readily available: Low cost
➢ No dilution of control when the firm relies on retained
earnings
❑ Disadvantages to the firm:
➢ Limited
➢ High opportunity cost
Equity Capital (Cont’d)

1. Term Loans
❑ Represents a source of finance which is generally payable in 5
to 10 years.
❑ Used for acquisition of fixed assets and working capital margin
❑ Advantages:
➢ No dilution of control, debt owners do not interfere with the
firm
➢ Defaulting in case of decline goes to the debtors
➢ Issue costs of debt are significantly lower than those on equity
and preferred stock
Disadvantages:
• Debt financing entails fixed interest and principal
repayment obligation
Long-term Debt

2. Bonds
❑ Issue a bond with the promise of paying the investor
(Bond holding firm) a designated interest on his money at
certain scheduled intervals of time
❑ Term Bonds
❑ Serial Bonds
❑ Mortgage Bonds
❑ Debenture
❑ Callable bonds
Long-term Debt (Cont’d)

Collects and processes
financial information
Reports
information
to decision
makers
Managers
(internal)
Investors and
Creditors
(external)
Chapter 3
Firms Financial Operations
❑ The Accounting System

The Accounting System
Accounting System
Financial Accounting
System
Periodic financial
statements and related
disclosures
Managerial Accounting
System
Detailed plans and
continuous performance
reports
External Decision Makers
Investors, creditors,
suppliers, customers, etc.
Internal Decision Makers
Managers throughout the
organization

1. The Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Statement of Retained Earnings
❑ Financial statements summarize the financial activities of
the business.
❑ Financial statements paint a picture of the transactions that
flow through the business.

The System
ASSETS
• Current
(Short-term)
• Fixed
(long-term)
• Other
LIABILITIES
• Current
• Long-term)
Shareholder’s
EQUITY
Debt
Stock
Sell Equity
Issue Debt
<Buy Assets>
<Buy Inventory>
Make Sales!
<Pay Costs>
<Pay Taxes>
Cash Flow
Balance Sheet Capital Supplied
3
4
Retain profits or
“repay” debt-holders
(with interest) and
stockholders (with
dividends)
Reta
in
Retu
rn
2 1
<Pay Interest>
<Pay Dividends>

❑ To inform the following parties of the financial
performance and position of the entity:
1)Management – for reviewing their performance during the
reporting period
2)Shareholders – for assessing the worth of their
investments and reviewing the effectiveness of the
Management
3)Investors – for judging the worth of the entity before
deciding to invest
4)Suppliers and Lenders – for judging the creditworthiness
of the entity before deciding to extend credit
5)Government – for calculating the amount of tax to be
collected
Purpose of Financial Statements

Let’s look at
Addis-Matador
CORP.’s
financial
statements.

Assets
❑ Current assets:
➢ Cash & securities
➢ Receivables
➢ Inventories
❑ Fixed assets:
➢ Tangible assets
➢ Intangible assets
Liabilities and Equity
❑ Current liabilities:
➢ Payables
➢ Short-term debt
❑ Long-term liabilities
❑ Shareholders' equity
1) Balance Sheet
Owns Owes

Addis-Matador CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
Liabilities
Accounts payable 7,156
$
Notes payable 9,000
Total liabilities 16,156
$
Stockholders' Equity
Contributed capital 2,000
$
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity 27,261
$
1. Name of entity
2. Title of statement
3. Specific date
4. Unit of measure
The
Balance
Sheet
reports the
financial
position of
an entity at
a particular
point in
time.

The Balance Sheet
Basic Accounting Equation
Assets = Liabilities + Stockholders’ Equity

Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$
Assets are
listed by their
ease of
conversion into
cash.
Cash
Amount of cash in the company’s bank
accounts.
Accounts
receivable
Amounts owed by customers from prior
sales.
Inventories
Parts and completed but unsold
products.
Plant and
equipment
Factories and production machinery.
Land Land on which factories are built.
Assets are
economic
resources
owned by the
business as a
result of past
transactions.

Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$
Liabilities are
debts or
obligations of
the business
that result from
past
transactions.
Accounts
payable
Amounts owed to suppliers for prior
purchases.
Notes
payable
Amounts owed on written debt
contracts.

Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$
Contributed
capital
Amounts invested in the business by
stockholders.
Retained
earnings
Past earnings not distributed to
stockholders.
Equity is the
amount of
financing
provided by
owners of the
business and
earnings.

Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$
Use $ on the
first item in a
group
and on the
group total.
Assets = Liabilities + Stockholders’ Equity

Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
1. Name of entity
3. Specific date (Unlike the balance sheet, this
statement covers a specified period of time.)
4. Unit of measure

Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$
The Income Statement reports the
revenues less expenses of the
accounting period.

Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$
Revenues are earnings from the sale of goods
or services to customers.
Revenue is recognized in the period in which
goods and services are sold, not necessarily
the period in which cash is received.

Revenues
June 2006
Cash from sale
collected on June 10th.
X
May 2006
$1,000 sale made
on May 25th.
X
When will the revenue from this transaction be recognized?
Earnings from the sale of goods or services.

Revenue
May 2006
$1,000 revenue
recognized in May
June 2006
When will the revenue from this transaction be recognized?
Earnings from the sale of goods or services.

Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$
Expenses are the dollar amount of resources used
up by the entity to earn revenues during a period.
An expense is recognized in the period in which
goods and services are used, not necessarily
the period in which cash is paid.

Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$
Cost of
goods sold
The cost to produce products sold this
period. Production costs: direct costs
Selling,
general and
administrative
Operating expenses not directly related
to production.
Research and
development
Expenses incurred to develop new
products.
Interest
expense
The cost of using borrowed funds.
Income tax
expense
Income taxes on current period’s pretax
income.

Expenses
May 2006 June 2006
May 11 paid $75 cash
for newspaper ad.
X
Ad appears
on June 8th.
X
The dollar amount of resources used up by the
entity to earn revenues during a period.
When will the expense for this
transaction be recognized?

Expenses
May 2006 June 2006
Advertising expense
recorded in June.
The dollar amount of resources used
up by the entity to earn revenues
during a period.
When will the expense for this
transaction be recognized?

Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$
If expenses exceed revenues,
we report net loss.

Addis-Matador CORP.
Retained earnings, January 1, 2006 6,805
$
Net income for 2003 3,300
Dividends for 2003 (1,000)
Retained earnings, December 31, 2006 9,105
$
1. Name of entity
3. Specific date (Like the income statement, this
4. Unit of measure

Addis-Matador CORP.
$
$
The Statement of Retained Earnings reports the way
that net income and the distribution of dividends affect
the financial position of the company during a period.

Because
revenues reported
do not always equal
cash collected. . .
. . . and expenses
reported do not
always equal
cash paid . . .
net income is
usually not equal
to the change
in cash for
the period.

Addis-Matador CORP.
Cash flows from operating activities:
Cash collected from customers 33,563
$
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities 1,069
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
1. Name of entity
3. Specific date (Like the income statement and
statement of retained earnings, this
4. Unit of measure

Addis-Matador CORP.
$
$
$
$
$
$
The Statement of Cash Flows reports the inflows
and outflows of cash during the period in the
categories of operating, investing, and financing.

Sell Equity
Issue Debt
<Buy Assets>
<Buy Inventory>
Make Sales!
<Pay Costs>
<Pay Taxes>
“Natural”
Cash Flows
<Pay Interest>
<Pay Dividends>
Sell Equity
Issue Debt
<Pay Dividends>
<Buy Assets>
Make Sales!
<Buy Inventory>
<Pay Costs>
<Pay Taxes>
<Pay Interest>
Cash flow statement
Classifications
Financing
Investing
Operating
=NET CASH FLOW

Addis-Matador CORP.
$
$
$
$
$
Cash flows directly related to
earning income are shown in the
operating section.

Addis-Matador CORP.
$
$
$
$
$
$
Cash flows related to the
acquisition or sale of productive
assets are shown in the
investing section.

Addis-Matador CORP.
$
$
$
$
$
$
Cash flows from or to investors
or creditors are shown in the
financing section.

Addis-Matador CORP.
$
$
$
$
$
$
The statement ends with a
reconciliation of Cash.

Relationship Among the Financial Statements
Addis-Matador CORP.
Income Statement
Revenues
$
Expenses
$
Pretax income 4,400
$
Net income 3,300
$ Addis-Matador CORP.
$
$
Net income from the
income statement
increases ending
retained earnings on the
statement of retained
earnings.

Relationship Among the Financial Statements
Addis-Matador CORP.
$
$
Ending retained earnings
from the statement of
retained earnings is one
of the components of
stockholders’ equity on
the balance sheet.
Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$

Relationship among the Financial Statements
The change in cash on the statement of cash flows added to the
beginning of the year balance in cash equals the ending balance in
cash on the balance sheet.
Addis-Matador CORP.
Balance Sheet
Assets
Cash 4,895
$
Inventories 8,517
Land 981
Total assets 27,261
$
Liabilities
$
Notes payable 9,000
$
$
$
Addis-Matador CORP.
$
$
$
$
$
$

2. Financial Analysis
❑ Assessment of the firm’s past, present and future financial
conditions
❑ Done to find firm’s financial strengths and weaknesses
❑ Primary Tools:
➢ Financial Statements
➢ Comparison of financial ratios to past, industry, sector
and all firms.
1. Common Size Financial Statements
❑ Each component of the statement is represented in terms
of percentages.
➢ Income statement: Each item is calculated as a percent
of net sales
➢ Balance sheet: Each item is calculated as a percent of
assets or total liabilities and stockholder’s equity.

Financial Analysis (Cont’d)
2. Comparative (Common-Base year) Financial Statements
➢ Financial information reported side by side in vertical columns
to see relationship and trends between years.
➢ Trend Analysis
➢ Horizontal analysis shows birr and percent changes from year
to year.
3. All Financial Statement ratios should be compared to:
❑ Should analyze ratios based upon standards of comparison
such as
I. Industry ratios and standards
II. Similar businesses in the same industry (competition)
III. Past performance ratios.
IV. Prior years operating results

Ratio Analysis
❑ Liquidity: Can we make required payments?
❑ Debt management: Right mix of debt and equity?
❑ Asset management: Right amount of assets vs. sales?
❑ Profitability: Do sales prices exceed unit costs, and are
sales high enough as reflected in PM, ROE, and ROA?

a) Liquidity Ratios
❑ An asset that can be converted to cash quickly without
having to reduce asset’s price very much.
❑ Current Ratio:
s
liabilitie
Current
assets
Current
ratio
Current =
❑ Quick or Acid Test Ratio: Is calculated by deducting
inventory from current assets as a proportion of current
liabilities
s
liabilitie
Current
s
Inventorie
-
assets
Current
ratio
Quick =

b) Leverage Ratios
❑ Debt Ratio
The ratio of total debts to total assets: measures the
percentage of funds provided by creditors
Assets
Total
Debt
Total
Ratio
Debt =
❑ Times-Interest-Earned (TIE) Ratio
The ratio of earnings before interest and taxes (EBIT) to
interest charges; a measure of the firm’s ability to meet its
annual interest payments.
charges
Interest
EBIT
ratio
coverage
Interest =

c) Profitability Ratios
❑ A group of ratios that show the combined effects of
liquidity, asset management, and debt on operating results.
❑ Gross profit margin
This ratio shows the margin left after meeting production
costs. It measures the efficiency of production and pricing.
Income
profit
Gross
margin
profit
Gross =
❑ Return on Capital Employed
A measure of how efficiently the capital is employed. A key indicator of
profitability of a firm. Firms that are efficiently using their assets have a
relatively high return. Less efficient firms have a lower return.
Assets
Current
profit
Net
employed
capital
on
Return =

Profitability Ratios (cont’d)
❑ Return on Equity
Profit indicator to shareholders. The ratio indicates the degree to
which the firm is able to convert equity to generate net profit
that eventually can be claimed by shareholders
equity
Total
profit
Net
equity
on
Return =
d) Asset Management Ratios (Turnover)
❑ The asset management ratios measures how effectively the
firm is managing its assets
❑ Inventory turnover ratio
This ratio is calculated by dividing sales by inventories
s
Inventorie
Sales
ratio
turnover
Inventory =

Asset Management Ratios (Cont’d)
Assets
Total
Sales
ratio
over
Asset turn
Total =
❑ Total Asset turnover ratio
Measures how efficiently assets are employed
❑ Fixed Asset turnover ratio
Measures how efficiently fixed assets are employed
assets
fixed
Net
Sales
ratio
over
Asset turn
Fixe =

Investment Decisions
Chapter 4
Chapter Summary
1. Discuss the time value of money and standard
calculations showing the relationship b/n PV and FV.
2. Discuss different methodologies of economic analysis for
investment appraisal.
3. Discuss how to budget capital on contract investment and
how to establish ROCE and Mark-up in corporate budget
planning.
4. Identify the different systems of control levels to monitor
capital allocated for investment.

Introduction
❑ Investment is decision making process by which firms
evaluate the purchase of fixed assets
❑ Investment policy is the firm’s formal planning process
❑ Significance of investment:
➢ substantial expenditure
➢ long time period
➢ sales forecasts
➢ investment appraisal
➢ planning horizon

❑ Investor prefer to receive payment of a fixed amount of
money today, rather than an equal amount in the future.
Why?
➢ People prefer current consumption to future
➢ To account for opportunity cost (to the least the interest
payment)
4.1. The time value of money
CF0 CF1 CF3
CF2
0 1 2 3
I%
❖ Show the timing of cash flows.
❖ Tick marks occur at the end of periods, so Time 0 is today;
Time 1 is the end of the first period (year, month, etc.) or
the beginning of the second period.

4.1. The time value of money (cont.…)
General Assumption:
❑ Cash Flows (CFs) occur at the END of the period, unless
stated otherwise.
❑ Payments (PMTs) occur at the END of the period (ordinary
annuity), unless stated otherwise.
CFs can either be:
I. Lump Sum (Birr1000 to be received in 1 year or 5 years,
or Birr1000 invested today), or
II. Recurring CFs (non-constant CFs), e.g. B100 in YR1,
B200 in YR 2, B300 in YR3) or
III. PMTs (constant CFs, e.g. B100 per year for 3 years).

❑ Financial investments involve cash flows occurring at
different points in the time series.
❑ Cash flows have to be brought to the same point
1. Present and future value of a single amount
A. Simple interest: no interest is earned on the interest.
❑ Interest is accounted only for the principal
FVn= PV (1+nr)
Where,
PV= is the value at time=0
FV= is the value at time=n
r=is the rate at which the amount will be compounded
each period
n= is the number of periods

B. Compound interest: interest payment is reinvested.
FV = PV (1+r)n
Where,
PV= is the value at time=0
FV= is the value at time=n
r=is the rate at which the amount will be compounded each
period
n= is the number of periods

Relationship b/n PV and FV
PV
Simple Interest
Comp. Interest
Period
FV

2. Present Value of uneven series
• Present value of uneven cash flow stream
r = discount rate
CF0 A1 A3
A2
0 1 2 3
I%
(1+r)1
An
PVn = A1
+
(1+r)1
A2
+
(1+r)2
….+
(1+r)n

3. Present Value of Annuity
❑ Constant cash flow at regular interval of time.
CF0 A A
A
0 1 2 3
I%
1
r
(1 - )
PVn = A( )
1
(1+r)n
4. Future Value of Annuity
FVn = A( )
(1+r)n - 1
r

4.2 Investment Appraisal
❑Investment proposals are evaluated from different
dimensions:
➢ Economic evaluation
➢ Social benefit
➢ Environmental impact
➢ Consistent with local and nation development plan
➢ Others….
❑Topic focus: Economic evaluation for investment
appraisal

❑ Important investment evaluation methods:
1. payback period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Cost-Benefit Analysis
5. Cost-effective Analysis
6. Multi-criteria Analysis
7. Liner programming
8. Dynamic Programming
4.2 Investment Appraisal (cont…)

❑ Payback period is the expected number of years required
to recover the original investment.
❑ It measures risk, not return.
❑ The shorter the payback period, the more desirable will be
the project
❑ First the maximum acceptable payback period (nmax) is
specified against which the calculated payback period (n)
is compared.

❑ Standard method for the financial appraisal of long-term
projects
❑ Used for capital budgeting, and widely throughout
economics, it measures the excess or shortfall of cash
flows, in present value (PV) terms, once financing charges
are met.
❑ Indicator of how much value an investment or project
adds to the value of the firm.
4.2.2 The Net Present Value (NPV)

• NPV is calculated as:
4.2.2 NPV (cont…)
NPV = Σ Bt (1 + r)-t - Σ Ct (1 + r)-t
Where, Bt = Benefit or return at the end of year t
Ct = Cost outlay or investment at the end of year t
r = required return (discount rate)
t = time of the cash outlay
n = total time of the project
t=1
n
t=1
n

•In financial theory, if there is a choice between two mutually
exclusive alternatives, the one yielding the higher NPV should be
selected
•The rate used to discount future cash flows to their present
values is a key variable of this process
•Most firms have a well defined policy regarding their capital
structure, so the weighted average cost of capital (after tax) is
used as the discount rate
•Another method is to use a variable discount rate with higher
rates applied to cash flows occurring further along the time span,
(reflecting the yield curve premium for long-term debt).
4.2.2 NPV (cont…)

•It is appropriate to use higher discount rates to
adjust for risk for riskier projects
•If a project offers a high risk, the reqiured return
on the project will also be high.
4.2.2 NPV (cont…)
Degree of Risk
Expected
Return

• Procedure for analysis using NPV
1. Find the present value of each cash flow, including
both inflows and outflows, discounted at the
projects cost of capital
2. Sum this discounted cash flows: NPV
3. Evaluate based on the value of 2 above
4.2.2 NPV (cont…)
0 1 2 3
−100.00 10 60 80
9.09
49.59
60.11
NPV = 18.79

If… It means... Then...
NPV > 0
the investment
would add value
to the firm
The project may be accepted
NPV < 0
the investment
would subtract
value from the
firm
The project should be rejected
NPV = 0
the investment
would neither
gain nor lose
value for the
firm
We should be indifferent in the
decision whether to accept or reject
the project. This project adds no
monetary value. Decision should be
based on other criteria, e.g. strategic
positioning or other factors not
explicitly included in the calculation.
4.2.2 NPV (cont…)

•Is the discount rate that equates the present value
of the project’s expected cash inflow’s to the
present value of the project’s costs.
PVinfows = PVinvestment costs
IRR is a rate that brings NPV=0
4.2.3 Internal Rate of Return (IRR)
0 1 2 3
−100.00 10 60 80
100.00
NPV = 0

•The use of the IRR always leads to the selection of the same project,
•project selection using the NPV method depends on the discount
rate chosen,
•NPV and IRR could result in different selections
Comparing NPV and IRR

•It is similar to NPV in the way one compares the value added.
•Compares the value added per the cost incurred and used to
evaluate projects of different sizes.
4.2.4 The Cost Benefit Ratio (CBR)


=
−
=
−
+
+
= n
t
t
n
t
t
r
C
r
B
CBR
1
1
1
1
)
1
(
)
1
(

Cash Flow Forecasting
• The most important, but also the most difficult,
step in capital budgeting is estimating projects’
cash flows
• The investment outlays and the annual net cash
inflows after a project goes into operations
• Relevant Cash flows
The specific cash flows that should be considered in a capital
budgeting decisions. Rules:
1. Capital budgeting decisions must be based on cash
flows, not accounting income.
2. Only incremental cash flows are relevant. Costs that
occur iff we accept the project.

Cash Flow Forecasting
• Annuity
• Constant stream of payments
• Lease, rent, etc
• Random
• Construction business for contractors is expected to
be increasing
• Individual contract amount takes the form of the S-
curve
The Cash flows typically include the following items:
1. Initial investment outlay
2. Operating cash flows over the project’s life
3. Terminal year cash flows

Cash flows of a construction company occur as a result
of the contractual and credit arrangements existing on
a series of contracts within any trading period.
Sources of finance on contracts:
 Internal Source
- generated from the companies operation
- most of they are locked up b/c:
→ Stage payment
→ Disagreement
 External Sources
- from lenders based on interest
4.3 Capital Budgeting on Contract investment

The two parameters that affect a construction company’s profitability:
1. The company's ROCE
2. The mark-up on contract costs to achieve the desired ROCE
To determine firm’s mark-up target, it is required establish:
i) Return on Capital Employed (ROCE)
Represents return anticipated by the company in relation with the total
capital employed.
• Successful measurement of profitability
• Starting parameter for budgeting and performance measurement
• Determined at the head office level
• Collected from cash flow of individual contract through inclusion of
Mark-up
4.3.1 Establishing ROCE and Mark up in Corporate Budget
Planning

ROCE is made to account for the following costs:
•The average weighted cost of capital (interest of capital
employed)
•Profit margin (dividends, capital reserves...)
•Corporate obligations such as taxations and deprecation
costs.
•Contingencies to cover uncertainties (Risks)
ii) Annual Turnover on contracts.
•This can be obtained from the firm’s short-term plan
committed or planned for execution in the current year.

• One of the items in the Mark-up
• Costs entitled in administrating the company and providing off-site services
• The amount of GOC for individual project is decided by management as
part of their policy.
• Vary with individual firms, but broadly includes (within a company’s
accounts )
- rent on office and yard
- fees, salaries and wages for directors and office staff
- office equipment, stationary, telephones, cars
- office heating and lighting
- insurance on office and staff
• Estimated as the percentage of expected turnover
iii) General overhead costs (off-site
administration):

Steps to reach at company’s Mark- up
Step 1. Estimate total capital to be employed for the
fiscal year (TCE)
- estimated from the Balance Sheet of the
Company
Assets Liabilities
Current Assets
Cash…………….
Marketable securities ….
Account Receivables…….
Inventories…………..
Other current assets….
Fixed assets
Buildings…….
Machineries……
Equipments…..
Land……………..
Current Liabilities
Short term loans………
Account payable……….
Accrued income taxes…….
Current payments due on
Long-term dept…..
Other current liabilities….

Step 2. Determine ROCE as the percentage of the TCE.
- Average weighted cost of capital (interest of capital employed)……***% TCE
- Profit Margin (dividends and reserves)……………………………………….***% TCE
- Corporate obligations (tax, deprecation)…………………………………….***% TCE
- Contingencies to cover uncertainties (risk) ………………………………..***% TCE
ROCE…………………………………….Σ***% TCE
Step 3. Estimate expected turnover for the fiscal year
۰ This can be obtained
- from the firm’s short-term plan committed, or
- planned for execution in the current year.
Steps to reach at company’s Mark-Up (cont…)

Step 4. Determine the General Overhead Cost (GOC)
- Estimated as the percentage of the annual turnover
- based on the previous year’s turnover
GOC…………………***% Turnover
Step 5. Determine the Mark-up
Mark-up (Head Office) = GOC + ROCE
Step 6. Determine the Total Production Cost (TPC)
Σ Production Cost = Turnover – Mark-up
Step 7. Determine Mark-up individual Project
Steps to reach at company’s Mark-Up (cont…)
TPC
mark-up
mark-up at individual project = *100%

Example
The following is the balance sheet of a G5 contractor.
Additional information are also outlined following this.
Assets Liabilities
Current Assets
550,000
Fixed assets
230,000
.
Total Assets: 780,000
Current Liabilities
450,000
Loans 153,234
Preference shares 11,766
Share Capital 32,080
Retained Earnings 132,920
Total L and E 780,000

Example (cont’d)
1. Total Capital Employed (TCE from the BS)
2. The following shows return on the capital employed:
i. Average weighed cost of capital…………….6.5%
ii. Profit margin: ………………………………….....6%
iii. Corporate obligations……………………………4.5%
iv. Contingences to cover uncertainties ……..3%
3. Planned total turnover
The company is planning for a total turnover of
Birr2,500,000 in the fiscal year
4. Administrative Expense
The previous year’s overhead cost was Birr150,000
while its total turnover was Birr2,000,000.

1. Estimate the total mark-up of the company at the head
office and the mark-up on individual contracts.
2. The company is invited to tender for a construction of a
school building with a direct cost of Birr2,000,000 and
estimated site overhead of 6%. What will be the minimum
amount of the contract price that will be offered by the
procurement committee?

4.3.2 The Corporate Budget
• is the starting point for setting up a monitoring and reporting
system
• reference point against which the measurement of financial
performance and the achievement of planned objectives are
made
Corporate Budget (Cash Outlay)
= Administrative Cost + ∑ Capital Required by
Individual Contracts
This has to be balanced with:
Capital Budget (Cash Inflow)
= Net Working Capital + Finance Sources (Debt,
Sales of stocks, Sales of Fixed Assets)

4.4 A System of control levels
• There are different control levels in a construction company:
1. Managing Director Level
2. Contracts Management level
3. Site management level

Control Responsibility Components
•Managing Director Level
➢ Major Contracts production Costs
➢ Administrative Expenses
➢ Return on Capital Employed
•Contract Management Level
➢ Production Costs of Different Contracts
•Site Management Level
➢ Direct Cost of projects:
Labor Cost
Material Cost
Plant Cost

Responsibility
level
Responsibilities Statement used
General
Management
Turnover Control
Overhead control
Account
Management
Corporate
budget
(master Budget)
Contracts
Management
Contract Cost
Management
Contract Budget
Statement
Operational
Budget Statement
Control Statement
Site
Management
Activity Cost
Control
Activity Cost
Statement
Operational
statement

Monitoring and Control at Contract
Management Level
• At this level comparison between the estimated
and actual cash flow takes place
• Contract Managers produce three basic control
statements at Contract Management Level with the
help of quantity surveyors.
1. Contract Budget Statement
2. Operational Budget Statement
3. Control Statement

1. Contract Budget Statement
Operations
Labor
cost
Material
cost Equip.
Cost
Sub-
Cont.
Total
Cost
(BCWS)
Value Margin
Site
Overhead
Earth Work
Concrete Work
Exterior Works
Roofing
TOTAL * ** ***
* Production Costs
** Tender Sum
*** Contract Markup by the corporate

2. Operational Budget Statement
• After the contract budget is prepared,
operational budget is produced on monthly basis
using the contract work Program
• Has two primary functions:
1. Provide managers with cost data on
monthly basis
2. Enable managers at each level to take decisions or
implement corrective actions when necessary

Operational Budget Statement/sample
Operations
Total
Budget
Cost
Sep., 2007 Oct., 2007
Cost
(BCWP)
Value Margin
Cost
(BCWP)
Value Margin
Site Overhead
Earth Work
Concrete
Work
Exterior
Works
Roofing
BCWS
Monthly
Total
Cum. Total

3. Control Statements
It is of vital importance that the value of the work
carried out is accurately monitored and adequately
recorded and presented for agreement and
subsequent payment by the client

Performance Measurement & Evaluation
C
O
S
T
TIME
Current Situation Planned Completion
Planned
Budget
ACWP
BCWP
BCWS
EAC
ETC
CV
SV
Forecast Time Overrun
Forecast Cost Overrun

Performance Measurement & Evaluation

CHAPTER 5
Working Capital Management
❑ Working Capital: all the short term assets used in daily
operations.
❑ Differ from capital budgeting;
➢ Timing : short term
➢ Swift transformation into other asset

Definitions
❑ Gross Working Capital (WC): Total current assets used in
operations.
❑ Net Working Capital: Current assets – Current liabilities.
❑ Working Capital Policy: basic policy decisions as to:
1. the level of each type of current asset, and
2. how current assets will be financed.
❑ Working Capital Management: Controlling cash,
inventories, and A/R, plus Short-Term liability
management.
❑ Setting the WC policy and carrying out the policy in day-
to-day operations

ABC appears to have large amounts of working capital
given its level of sales.
Selected Ratios--ABC plc.
ABC Industry
Current 1.75x 2.25x
Quick 0.83x 1.20x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 45.00 32.00
Inv. turnover 4.82x 7.00x
F. A. turnover 11.35x 12.00x
T. A. turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
ROE 10.45% 21.00%
5.1 Working Capital Policy

How does ABC’s working capital policy compare
with the industry?
❑ Working capital policy is reflected in current ratio, quick
ratio, turnover of cash and securities, inventory turnover,
and DSO.
❑ These ratios indicate ABC has large amounts of working
capital relative to its level of sales. ABC is either very
conservative or inefficient.
Is ABC inefficient or just conservative?
❑ A conservative (relaxed) policy may be appropriate if it
leads to greater profitability.
❑ However, ABC is not as profitable as the average firm in
the industry. This suggests the company has excessive
working capital.

5.1.1 Characteristics of Current Assets
Finished Goods
Accounts Receivable
Work in Progress
Wages, Salaries, Overheads
Raw Materials
Suppliers
Cash

5.1.2 Operating Cycle and Cash Cycle
❑ Investments in working capital are influenced by four
key events in the production and sales cycle of the firm:
➢ Purchase of raw materials,
➢ Payment for raw materials,
➢ Sale of finished goods
➢ Collection of cash sales

Operating Cycle and Cash Cycle
Order
Stock
arrives
Credit
Invoice
Cash paid for
Materials
Cash
Received
Accounts Receivable
Inventory Period
Accounts
Payable
Operating Cycle
Cash Cycle

5.1.3 Factors affecting WC Requirements
1. Sales Volume: some level of WC is required to support
steady sales.
2. Nature of business: length of operating cycle
3. Market condition: Competition can guide WC policy
(credit sales, stock levels)
4. Conditions of Supply: prompt and adequate supply lowers
level of inventory and lead time (JIT).

5.1.4 Cash Requirement for WC
❑ As a finance manager, one will be interested in figuring out
how much cash to arrange to meet the working capital need
of the firm.
Step 1. Estimation of the cash cost of various current assets
required by the firm
Step 2. Deduct the current liabilities from the cash cost of
current assets

5.2 Cash and Liquid Management
❑ All money items and sources that are immediately
available to help pay a firm’s bills
❑ Treasury bills: unconditional promise by the government’s
treasury agent
❑ Commercial Paper: short-term unsecured promissory notes
issued by firms
❑ Certificate of Deposit: represents a negotiable receipt of
funds deposited in a bank for a fixed period

5.2.1 How large a cash balance is needed?
1. Transaction needs: A firm needs cash to carry out the day-
to-day functions of the business.
2. Contingency needs: For unexpected occurrences or
emergencies that require cash.
3. Opportunity needs: The chance to profit from having cash
available.
5.2.2 Forecasting Cash Flow
❑ Determining the amounts and timing of future inflows and
outlays of cash.
Failure of forecast casts risks as:
1. Default: unable to pay interest or principal on borrowings
2. Overdue bills: failure to pay short term obligations (A/P)
3. Lost savings on purchases: loss of discounts on cash
purchases

5.3 Credit Management
Why Credit?
1. Competition: causes firms to sell on credit to attract
customers
2. Facilitates Sales: as it augments customers resources
Finished
Goods
On
Credit
Accounts
Receivables
Accounts
Payable
Debtors
Creditors

5.3 Credit Management (cont’d)
Accounts Receivable makes a major component of a firms
working Capital Needs, Investment in A/R depends on:
1. How much the firm sales on credit, and
2. How long it takes to collect the receivables:
5.3.1 Terms of Payment
Order Delivery
Converted to
cash
Sale
Cash in
Advance
Cash on
Delivery
Cash Terms Credit Terms
Terms of payment vary widely in practice.

5.3.1 Terms of Payment (Cont’d)
Credit Terms can be:
i. Open Account: time available between the shipment and
invoice
ii. Bill of Exchange: a more secure arrangement that represents
an unconditional order by the seller asking the buyer to pay
on demand or at certain future date, the amount specified on
it
iii.Consignment: agent relationship between the seller and the
buyer
iv.Letter of Credit: issued by a bank on behalf of its customer
to the seller.
◼ Lower Credit risk & uncertainty, safety to the buyer

5.3.2 Costs of Maintaining Receivables
As with all assets and operations, the willingness to allow
credit sales involve certain costs :
i. Financing the Receivables
ii. Administrative and collection expenses
iii. Bad Debt loss

5.3.3 Policies for Managing Receivables
The firm should establish its receivable policies after carefully
considering both the benefits and costs of different policies.
I. Profit: Costs (tied up, collection, bad debt, discounts) should be
compared with additional sales as a consequence of a proposed
policy. Degree of relaxing a policy as determined by residual
income:
II. Growth in Sales: growth is so important aside from profits, it
should be viewed as a separate factor in determining receivable
policies. ( ) ( ) ( )
k
I
r
S
p
S
R 
−

−

=


5.3.4 Credit Policy Variables
The credit policies have a bearing on the level of sales, bad debt loss, discounts
taken by customers, and collection expenses. The important dimensions are:
i. Credit Standards: What standard should be applied in accepting or
rejecting an account for credit granting? Can range from Liberal to stiff
credit policy …
ii. Credit Period: Has a direct proportionality with sales
iii. Cash Discount: Firms generally offer cash discounts to induce customers
to make prompt payments.
iv. Collection Effort: aimed at timely collection of the R & consists of:
• Monitoring the state of receivables,
• Dispatch of letters to customers whose due date is approaching,
• Electronic and telephonic advice to customers around the due date,
• Threat of legal action to overdue accounts,
• Legal action against overdue accounts.

5.4 Inventory Management
Defn: Goods held for eventual resale by the firm.
Three types of inventories:
i. Raw Materials
ii. Goods in Process: materials committed to the
production process but have not been completed
iii. Finished Goods: ready for sale. Final output of
the production process. “Merchandise inventory”

5.4.1 Benefits of holding inventory
Inventories are used to provide cushions so that the purchasing, production,
and sales functions can proceed at their own optimum paces.
i. Avoiding Losses of Sales: Ability of a firm to give quick service and to
provide prompt delivery is closely tied to the proper management of
inventory
ii. Gaining Quantity Discounts: to make bulk purchases of goods at large
discounts.
iii. Reducing Order Costs: Forms must be typed, checked, approved and
mailed; when goods arrive, they must be accepted, inspected and
counted.
iv. Achieving Efficient Production Runs: If the firm has to change setups
frequently, it would experience high unit costs of production.

5.4.1 Benefits of holding inventory (Cont’d)
Firms
Hold
Inventories
To
Purchasing
Producing
Selling
Avoid Losses
of Sales
Gain Quantity
Discounts
Reduce Order
Costs
Achieve
Efficient
Production
Separate Which
Helps

5.4.2 Costs of holding inventory
The effective management of inventory involves a tradeoff between having
too little and also too much inventory.
Inventory costs:
i. Ordering Costs: requisitioning, preparation of purchase order,
expediting, transport and receiving and placing in storage, set-up
costs
ii. Carrying Costs: interest on capital locked up in inventory, storage
and handling costs, insurance, depreciation, and property taxes.
iii. Shortage Costs: arise when inventories are short of requirement for
meeting the needs of production or the demand of customers.
◼ Loss of sales, loss of customer goodwill, disruption of production
schedules.

5.4.3 Inventory Management – Minimizing Costs
• The goal of effective inventory management is to minimize the total
costs that are associated with ordering and holding inventories.
• Choose the level of inventory with the lowest total cost after estimating
the different expenses with varying inventory levels.

5.4.3 Inventory Management – Minimizing Costs
(Cont’d)
The two basic questions relating to inventory mgt
◼ Size of the Order: Q optimal
◼ The Level to Order: Q level
10
10 20 30 40 50 60 Units
0
Costs
Total Cost
Carrying Cost
Ordering Cost
Optimum
Level

i) Order Quantity
Economic Order Quantity (EOQ)
◼ The Economic Order Quantity refers to the order
size that will result in the lowest total of order and
carrying costs for an item of inventory.
◼ Order costs increase as number of orders increase
◼ Carrying costs increase as large stocks are kept
Variables in the EOQ model:
U: The forecast usage/demand for goods or raw materials
for a year is known,
Q: Quantity Ordered,
F: Cost per Order,
C: Percent Carrying Cost
P: Price per Unit,
TC: Total Costs of ordering and carrying

i) Order Quantity
The total cost of ordering and carrying is minimized
when the derivative of the above equation is equated
to zero:
( ) ( )( )
C
P
Q
F
Q
U
TC
2
+
=
0
2
2
=
+
−
=
PC
Q
UF
dQ
dTC
PC
UF
Q
2
2
=
PC
FU
Q
2
=

i) Order Quantity
Example: Given the following for a company:
U= Annual sale= 20,000 Units
F= fixed cost per order = Birr 2,000
P= Purchase price per unit= Birr 12
C= Carrying cost = 25% of inventory value
PC
FU
Q
2
=
units
x
x
x
Q 164
,
5
25
.
0
12
000
,
20
000
,
2
2
=
=

ii) Order Level
◼If the usage rate of materials and lead
time for procurement are known with
certainty then;
The ordering level = Lead time in
days for procurement X Average daily
usage

Construction financial management

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