CHAPTER ONE

Working Capital Management

Every business needs money, cash, to keep it operating. Money is the lifeblood of business it
meets day-to-day expenses and used to pay bills, as and when they become due. If key bills, such
as those for tax, bank repayments, rent and energy are left unpaid, the firm may be declared
bankrupt. Indeed, a lack of cash, rather than insufficient profit, is the main reason for
business failure.

Working capital

Working capital is the day-to-day finance available for running a business and is used to measure
a firm's ability to meet current obligations, such as the payment of wages, electricity and rent. A
high level of working capital indicates significant liquidity. It is also called net current assets or
net working capital.

Working capital is calculated by using the formula:

Current Assets are assets that are intended to be turned into cash within the present financial
year. Typically current assets comprise stock, debtors and cash.

 Stock is the least liquid of current assets. It comprises of stocks of raw materials
(components), semi-processed goods (work in progress) and finished goods. In some
countries stock is called inventory.
 Debtors are people or organisations that owe money to the business as the result of
buying goods or services on credit. It is an asset, because the firm should eventually
receive payment.
 Cash is the most liquid asset. It is held in the organisation or in the bank (cash-in-hand or
cash-at-the-bank). All other assets are measured against it to define liquidity.

Current Liabilities are anything owed by the organisation, which is likely to be paid within the
present financial year. Typically current liabilities comprise:

 an overdraft,
 creditors,
 dividends
 unpaid tax.

1
There is, in most businesses, a significant delay between paying out for the raw materials and
labour required to produce the goods or services and the receipt of cash from the sale of the
goods/services. This means that for most businesses their working capital (their net current
assets) needs to be very carefully managed.

The Importance of good working capital management

Management of working capital is an essential task of the finance manager. He has to ensure
that the amount of working capital available with his concern is neither too large nor too small
for its requirements.
A large amount of working capital would mean that the company has idle funds. Since funds
have a cost, the company has to pay huge amount as interest on such funds. If the firm has
inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital
may lead to a situation where the firm may not be able to meet its liabilities. Various studies
have shown that one reason for the poor performance of businesses has been the large amount of
funds locked up in working capital. This results in over-capitalization. Over-capitalization
implies that a company has too large funds for its requirements, resulting in a low rate of return
a situation which implies a less than optimal use of resources. A firm has, therefore, to be very
careful in estimating its working capital requirements. Maintaining an adequate working capital
is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure
the survival of the business in the long-term as well. When business makes investment decisions,
they must not only consider the financial outlay involved with acquiring the new machine or
the new building, etc., but must also take account of the additional current assets that are usually
required with any expansion of activity. For e.g.:

 Increased production leads to hold additional stocks of raw materials and work in progress.
 An increased sale usually means that the level of debtors will increase.
 A general increase in the firm’s scale of operations t ends to imply a need for greater
levels of working capital.

A question then arises what an optimum amount working capital is for a firm? We can say
that a firm should neither have too high an amount of working capital nor should the

2
same be too low. It is the job of the finance manager to estimate the requirements of
working capital carefully and determine the optimum level of investment in working capital

Optimum Working Capital

If a company’s current assets do not exceed its current liabilities, then it may run into trouble
with creditors that want their money quickly. Current ratio (current assets/current liabilities)
(along with acid test ratio to supplement it) has traditionally been considered the best indicator of
the working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing
firm implies that the firm has an optimum amount of working capital. This is supplemented by
Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1(one). Thus it is
considered that there is a comfortable liquidity position, if liquid current assets are equal to
current liabilities. Bankers, financial institutions, financial analysts, investors and other people
interested in financial statements have, for years, considered the current ratio at, ‘two’ and the
acid test ratio at, ‘one’ as indicators of a good working capital situation. As a thumb rule, this
may be quite adequate.

However, it should be remembered that optimum working capital can be determined only with
reference to the particular circumstances of a specific situation. Thus, in a company where the
inventories areeasily saleable and the sundry debtors are as good as liquid cash, the current ratio
may be lower than 2 and yet the firm may be sound.

In nutshell, a firm should have adequate working capital to run its business operations. Both
excessive as well as inadequate working capital positions are dangerous.

Estimating Working Capital Needs

Operating cycle is one of the most reliable methods of computation of working capital. However,
other methods like ratio of sales and ratio of fixed investment may also be used to determine
the working capital requirements. These methods are briefly explained as follows:

 Current assets holding period: To estimate working capital needs based on the average
holding period of current assets and relating them to costs based on the company’s
experience in the previous year. This method is essentially based on the Operating Cycle
Concept.

3
 Ratio of sales: To estimate working capital needs as a ratio of sales on the assumption that
current assets change with changes in sales.
 Ratio of fixed investments: To estimate working capital requirements as a percentage of
fixed investments

A number of factors will, however, be impacting the choice of method of estimating Working
Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and
variability in sales price would generally be considered. The production cycle and credit and
collection policies of the firm will have an impact on working capital requirements. Therefore,
they should be given due weightage in projecting working capital requirements.

WORKING CAPITAL MANAGEMENT

Working capital management refers to a company’s managerial accounting strategy designed to

monitor and utilize the two components of working capital, current assets and current liabilities,
to ensure the most financially efficient operation of the company.

Approaches of working capital management

The objective of working capital management is to maintain the optimum balance of each of the
working capital components. This includes making sure that funds are held as cash in bank
deposits for as long as and in the largest amounts possible, thereby maximizing the interest
earned. However, such cash may more appropriately be “invested” in other assets or in reducing
other liabilities.

Working capital management takes place on two levels:

 Ratio analysis can be used to monitor overall trends in working capital and to identify
areas requiring closer management.
 The individual components of working capital can be effectively managed by using
various techniques and strategies.

Financial Ratio Analysis

Financial ratio analysis is the process of calculating and comparing various ratios of amounts and
balances taken from the financial statements.

The main purposes of working capital ratios analysis are:

4
  To indicate working capital management performance; and
 To assist in identifying areas requiring closer management

Financial ratio analysis is valuable because it raises questions and indicates directions for more
detailed investigation.

The following ratios are of interest to those managing working capital

 Working capital ratio

 Debtors ratio
 Creditors ratio

Working Capital Ratio

Current Assets divided by Current Liabilities

The working capital ratio (or current ratio) attempts to measure the level of liquidity, that is, the
level of safety provided by the excess of current assets over current liabilities.

The “quick ratio” a derivative, excludes inventories from the current assets, considering only
those assets most swiftly realizable.

There is no particular benchmark value or range that can be recommended as suitable for all
companies. However, if a company tracks its own working capital ratio over a period of time,
the trends (i.e. the way in which the liquidity is changing) will become apparent.

Stock Turnover

Cost of sales divided by Average Stock level

This ratio applies only to finished goods. It indicates the speed with which inventory is sold or,
to look at it from the other angle, how long inventory items remain on the shelves. It can be used
for the inventory balance as a whole, for classes of inventory, or for individual inventory items.

In general, a higher turnover ratio indicates that a lower level of investment is required to serve
the company.

Debtor ratio (average collection period)

5
There is a close relationship between debtors and credit sales to third parties. If sales increase
debtors will increase, and conversely, if sales decrease debtors will decrease.

The best way to explain this relationship is to express it as the number of days that credit sales
are carried on the books.

Debtors x Days per period

Credit sales

Where trading terms are 30 days net cash, and customers buy from day-to-day during the 30 day
period and pay 30 days after a statement is rendered, a collection period of 45 days (the average
between 30 and 60 days) would be satisfactory.

If the average collection period extends beyond 60 days, debtors are holding cash that should
have flowed into the company. This means that the company is unable to satisfy pressing
liabilities or to invest that cash.

The debtor ratio does not solve the collection problem, but it acts as an indicator that an adverse
trend is developing. Remedial action can then be instituted.

Working capital operating cycle

Operating Cycle

The extent to which profits can be earned will naturally depend, among other things, upon the
magnitude of the sales. A successful sales programme is, in other words, necessary for earning
profits by any business enterprise. However, sales do not convert into cash instantly: there is
invariably a time-lag between the sale of goods and the receipt of cash. There is, therefore, a
need for working capital in the form of current assets to deal with the problem arising out of the
lack of immediate realisation of cash against goods sold. Therefore, sufficient working capital is
necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle.

Meaning of Operating Cycle

The simplest definition of the term operating cycle is, “The average time between purchasing or
acquiring inventory and receiving cash proceeds from its sale.”

The operating cycle can be said to be at the heart of the need for working capital. The continuing
flow from cash to suppliers, to inventory, to accounts receivable and back into cash is what is
6
called the operating cycle. In other words, the term cash cycle refers to the length of time
necessary to complete the following cycle of events:

1. Conversion of cash into inventory

2. Conversion of inventory into receivables

3. Conversion of receivables into cash.

Working Capital Cycle

The operating cycle consists of three phases.

Phase I

In phase I, cash gets converted into inventory. This includes purchase of raw materials,
conversion of raw materials into work-in-progress finished goods and finally the transfer of
goods to stock at the end of the manufacturing process. In the case of trading organizations, this
phase is shorter as there would be no manufacturing activity and cash is directly converted into
inventory. The phase is, of course, totally absent in the case of service organisations.

Phase II

In phase II of the cycle, the inventory is converted into receivables as credit sales are made to
customers. Firms which do not sell on credit obviously do not have phase II of the operating
cycle.

7
Phase III

The last phase, phase III, represents the stage when receivables are collected. This phase
completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables
and to cash again.

Operating cycle = Inventory conversion period + Receivables conversion period

The inventory conversion period is the length of time required to produce and sell the product. It
is defined as follows:

Inventory conversion period = average inventory

Cost of sales/365

Finally, the cash conversion cycle represents the net time interval between the collection of cash
receipts from product sales and the cash payments for the company’s various resource purchases.
It is calculated as follows:

Cash conversion cycle = Operating cycle – Payable deferral period

Cash Cycle

Cash conversion cycle expresses in days how long it takes a company to convert the materials it
purchases into cash. By checking how many days inventory it holds, how long it takes to collect
cash from customers and also considering how many days it can take to pay suppliers, it is
possible to get an idea of how comfortable a company’s cash flow position is.

Meaning of Cash Cycle

The cash cycle, also called the Cash Conversion Cycle (CCC), is a measure of the length of time
it takes to get from paying cash for stock to getting cash after selling it. It is equal to:

Stock days + Debtor days – Creditor days

In other terms it may also be said that the Cash Cycle (CC) is a metric that expresses the length
of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash
conversion cycle attempts to measure the amount of time each net input dollar is tied up in the
production and sales process before it is converted into cash through sales to customers. This

8
metric looks at the amount of time needed to sell inventory, the amount of time needed to collect
receivables and the length of time the company is afforded to pay its bills without incurring
penalties.

Cash Conversion Cycle (CCC) is calculated as:

CCC = Stock days + Debtor days – Creditor days

Where:

Stock days represents days inventory outstanding

Debtors’ days represents days sales outstanding

Creditors’ days represents days payable outstanding

Let us understand each of these terms one by one.

Debtors’ days represents accounts receivable turnover in days and measures the average number
of days from the sale of goods to collection of resulting receivables. It is obtained by the
following formula:

(Accounts Receivable/Sales × 365)

Illustration 1

A manufacturer of widgets: “Hilal Widget Co.” has annual sales of `GH¢ 50,000,000 and with
accounts receivable outstanding of ` GH¢5,000,000 at the end of the year.

Required:
Calculate the Debtors’ days
Solution 1
Debtors’ days = (Accounts Receivable/Sales × 365)
= (GH¢5,000,000/GH¢50,000,000) × 365 = 36.5 days
Stock days represents inventory turnover and measures the length of time on average between
acquisition and sale of merchandise. For a manufacturer it covers the amount of time between
purchase of raw material and sale of the completed product. It is obtained by the following
formula:

(Inventory/COGS × 365)\

9
Illustration 2

Using the example of widget manufacturer “Hilal Widget Co.”, let’s suppose that the company
had a COGS of GH¢30,000,000 with inventory of GH¢4,110,000 at the end of the year.

Required:
Calculate the Stock days
Solution 2
Stock days = (Inventory/COGS × 365)\
= (GH¢4,110,000/GH¢30,000,000) × 365 = 50 days

Creditors’ days also represents payables turnover in days and measures the average length of
time between purchase of goods and payment for them. It is obtained by the following formula:

(Accounts Payable/COGS × 365)

Illustration 3

Continuing the same example, this time “Hilal Widgets Co.” has an accounts payable balance of
GH¢4,560,000 at the end of the year.

Required:
Calculate the Creditors’ days
Solution 3
Creditors’ days = (Accounts Payable/COGS × 365)
= (GH¢4,560,000/GH¢30,00,000 ) x 365 = 55.5 days
Illustration 4

Continuing the same example including illustration 1-3,

Calculate the:

1. Operating cycle
2. Cash conversion cycle

10
Solution 4

1. Operating cycle = Inventory conversion period + Receivables conversion period

=36.5 + 50 = 86.5 days
2. Cash conversion cycle (CCC) = Stock days + Debtor days – Creditor days
= (36.5 + 50 – 55.5) days
= 30 daays
Assignment

The following information was extracted from the trial balance (extract) of Amenumey ltd., a
private company.
GH¢
Sales 400,000
Purchases 220,000
Cost of Sales 300,000
Debtors 80,000
Creditors 36,000
Stocks:
Raw Materials 50,000
Work-in-progress 20,000
Finished Goods 40,000
Assume 365 calendar days.
Required

You have been tasked to construct the company’s cash operating cycle for a period of one year.

IMPORTANCE OF WORKING CAPITAL

Working capital is the life blood and nerve centre of a business. Just as circulation of blood is
essential in the human body for marinating life, working capital is very essential to maintain the
smooth running of a business. No business can run successfully without an adequate amount of
working capital. The main advantages of maintaining adequate amount of working capital are as
follows:

1. Solvency of the business: Adequate working capital helps in maintaining solvency of the
business by providing uninterrupted flow of production.

2. Goodwill: Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintaining goodwill.

11
3. Easy Loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and other on easy and favourable terms.

4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on
the purchases and hence it reduces costs.

5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw
materials and continuous production.

Regular payment of salaries, wages and other day-to-day commitments: A company which has
ample working capital can make regular payment of salaries, wages and other day-to-day
commitments which raises the morale of its employees, increases their efficiency, reduces
wastages and costs and enhances production and profits.

7. Exploitation of favourable market condition: Only concern with adequate working capital can
exploit favourable market conditions such as purchasing its requirements in bulk when the prices
are lower and by holding its inventories for higher prices.

8. Ability to face crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression because during such periods, generally, there is much pressure
on working capital.

9. Quick and regular return on investments: Every investor wants a quick and regular return on
his investments. Sufficiency of working capital enables a concern to pay quick and regular
dividends to its investors as there may not be much pressure to plough back profits. This gains
the confidence of its investors and creates a favourable market to raise additional funds ion the
future.

10. High morale: Adequacy of working capital creates an environment of security, confidence,
and high morale and creates overall efficiency in a business.

Management of working capital

Stock Management

12
Introduction

The level of stock held will depend upon a number of variables which will each have cost
implications. Management must make decisions about the control of stock levels with a view to
minimizing the cost to the business while achieving maximum efficiency in the availability of
materials to fulfil planned usage requirements.

Reasons for holding stock

Basically, firms hold stocks for the lowing reasons:

 To act as a buffer in times of unusually high demand

 To ensure continuity of production
 Avoid high costs of emergency orders
 To take advantage of quantity discounts by ordering more at a time
 To reduce ordering costs by ordering more items on fewer
 As part of the production process e.g. Maturing whisky or keeping oil in pipelines
 Seasonality of demand (e.g. Firework) or supplies
 Suppliers insist on minimum order quantities.

The following stock levels need to be considered:

1. Minimum Stock Level

This is the lowest level at which stock may not be allowed to fall. It is not prudent to allow stock
to fall below the minimum stock level.

Mathematically, the minimum stock level may be calculated as:

Minimum stock level = Re-order -(average consumption x average delivery period)

2. Maximum Stock Level

This is the largest possible quantity of stock that may be in store at any given time. It is not
prudent to maintain a quantity of stock above this level.

Mathematically, it is computed as÷

13
Maximum stock level =

Re-order level + Re-order quantity - [minimum usage x minimum lead time]

3. Re-Order Level of Stock

This is the level at which an order will be placed for additional supplies of material so that
delivery will be made before the business runs out of stock. The factors that influence there-
order stock level are:

Mathematically, it is computed as

Re-order stock level=Maximum consumption x Maximum delivery period.

a. rate of consumption
b. delivery period - reliability of supplier

4. Re-Order Quantity (Economic Order Quantity)

This is the optimum quantity that should be ordered each time an order is being placed. It is
often referred to as the economic order quantity. It is set in such a way as to optimize material
costs.

Economic Order Quantity (EOQ)

___________
= √ 2 DCo
Cc
Where: D = annual demand Co = Cost of order and Cc = Carrying cost per unit
5. Average Stock Level
This is the midway between the minimum stock level and the maximum stock level.

Mathematically, it is computed as:

Average stock level = minimum stock level + maximum stock level

Illustration 1

14
The following data relates to XYZ Ltd.

Minimum usage 250 per week

Maximum usage 750 per week

Re-order Quantity 30 units

Delivery period between 4 to 6 week

You are required to compute the following:

i) Re-order level
ii) Minimum stock level
iii) Maximum stock level
iv) The average stock level
SOLUTION 1

i) Re-order level = Max usage x Max Delivery period

= 750 x 6 week = 4500 units

ii) Minimum Stock level = Re-order stock – Average Stock x Average delivery period =
4500 – (500 x 5 weeks) = 2000 units

iii) Maximum stock level = Re-order level + Re-order Qty. – min. Usage x Min. delivery
period = 4500 + 30 – (250 x 4) = 3530 units
iv) Average stock level = ( min. Stock Level + ½ Re-order Qty
= 2000 + (30/2) = 2015 units

CASH BUDGET

Cash Planning is one aspect of cash management. The whole process of managing cash begins
with planning cash flows. A very good tool used in this direction is the cash budget.

Cash budget is a forecast of future sources and uses of cash.

Objectives of Cash Budget

15
 • To integrate and appraise the effect of functional/operating budget on the companies’
cash resources.

• To ensure that sufficient cash is available at all times to meet the level of operations that
are outlined in the various budgets.

• To anticipate cash shortages/surpluses and to allow time to plan how to deal with them.

• To provide a basis for comparison with actual and to identify unplanned occurrences.

Components of Cash Budget

The cash budget is composed of four major sections

• The receipt section

• The disbursement section

• The cash excess or deficiency section

• Financing section.
Cash available

This section includes all sources of cash that will be available to the organization. Sources of
cash include cash sales, payment by debtors, the sale of fixed assets, the issue of fresh shares or
loan stock, the receipt of interest and dividends from investments outside the business etc.

Factors that may have effect on cash from sales and cash collections of accounts
receivable/debtors include sales level, sales pattern, credit policy and collection experience.

Cash disbursement

This section describes expected payments during the budget period – payments for purchases of
raw materials, supplies and equipment, wages and salaries, operating expenses, interest expenses,
and taxes.

Financing

The difference between cash available and cash disbursement is the ending cash balance before
financing. A firm needs to determine the best avenues to invest excess cash if it expects to have
significant cash receipts over cash payments. The firm needs to weigh return, liquidity, and risk

16
in considering alternative investments. Both the additional funding and planned investments are
included in the financing section.

The steps in cash budgeting are as follows:

 Prepare or get the sales forecast for the period of the budget.

 Determine the cash receipts from these sales and when they will be received.

 Determine whether any asset sales are planned for the period and include cash to be
realized.

 Determine disbursements based on production plans, capital expenditure, dividend

payments, corporate taxes, etc.

 Compare receipts with disbursements for each period to determine whether there will be
a surplus or a deficit.

 If there will be a deficit, make arrangements to finance or adjust tactics in operation

and/or marketing.

Format of cash budget

Cash available January February March

Cash receipts from GH¢ GH¢ GH¢
Cash sales xxxx xxxx xxxx
Debtors xxxx xxxx xxxx
Proceeds: disposal xxxx xxxx xxxx
Proceeds: fresh issue xxxx xxxx xxxx
Total receipts xxxx xxxx xxxx
Cash disbursements
Cash to suppliers xxxx xxxx xxxx
Wages and salaries xxxx xxxx xxxx
Expenses xxxx xxxx xxxx
Dividends xxxx xxxx xxxx
Purchases of assets xxxx xxxx xxxx
Total payments xxxx xxxx xxxx

17
Net inflow (outflow) xxx xxx xxx
Balance b/f xxx xxx xxx
Balance c/f xxx xxx xxx

KK Ltd is an agro processing company situated in the SADA area. The company is preparing its
budget for the first three months of 2013 and has approached you for assistance. The following is
available:
(i) Information extracted from the Sales budget are as follows:
GHC
November 2012 160,000
December 2012 180,000
January 2013 150,000
February 2013 200,000
March 2013 200,000
(ii) Debtors settle according to the following pattern:-
70% within the month of sale
20% in the month following
10% in the second month after sales
(iii) Extracts from the Purchases budget were as follows:
GHC
December 2012 120,000
January 2013 100,000
February 2013 100,000
March 2013 120,000
All purchases are on credit. 90% are settled in the month following purchase and the balance
settled in the second month after purchase.
(iv) Wages are expected to be as follows:
GHC
January 2013 130,000
February 2013 155,000
March 2013 160,000
These are to be paid one month in arrears.
(v) Electricity of GHC2,000 per month is to be paid one month in advance.

18
(vi) Corporate tax GHC100,000 is expected to be paid in March 2013.
(vii) The company will receive settlement of an insurance claim of GHC5,000 in March 2013.
(viii) Overheads are expected to be GHC125,000 every month. (This includes depreciation of
GHC5,000).
(ix) The company has an overdraft facility with BBG Bank Ltd for the purpose of its day to day
operations up to GHC500,000.
Required:
(i) Prepare a monthly cash budget for the first quarter of 2013.
(ii) State briefly two (2) demerits of cash budget.
Solution

K. K. Ltd
Cash Budget for January, February & March
Jan Feb March

Receipts for sales 157,000 188,000 195,000

Insurance claim ______ ______ 5,000
Total Inflow 157,000 188,000 200,000
Payments
Purchases 108,000 102,000 100,000
Wages - 130,000 155,000
Electricity 2,000 2,000 2,000
Corporate Tax 100,000
Overheads 120,000 120,000 120,000
Total Outflow 230,000 354,000 477,000
Net Cash flow (73,000) (166,000) (277,000)
Opening cash balance - (73,000) (239,000)
Closing cash balance (73,000) (239,000) (516,000)

ii)
Demerits:
Subject of uncertainties
Based on estimates and assumptions which are not always realistic

Assignment
19
QUESTION
Albe Limited was incorporated some five years ago. The financial position as at 31st December,
2010 was as follows:
EQUITY AND LIABILITIES GHC GHC
Stated capital:
Ordinary share [40,000 at GHC12.50 each] 500,000
Preference shares [20,000 at GHC8.00 each] 160,000
660,000
Long term capital 140,000
800,000
NON-CURRENT ASSETS
Building and Land 400,000
Equipment 182,000
Motor Vehicles 48,000
630,000
CURRENT ASSETS
Inventory 40,000
Accounts Receivables 20,000
Cash at bank 124,000
184,000
CURRENT LIABILITIES
Accounts payable (14,000) 170,000
TOTAL ASSETS 800,000
The Company has produced the following estimates:
1) The accounts payable figure of GHC14,000 stated in the financial statement would be paid in
January, 2011.
The following credit purchases are settled a month after the month of purchase, after deducting
two percent (2%) discount.
GHC
January 28,000
February 42,000
March 36,000
April 45,000
May 41,000
June 37,000
2) Sales for January will be GHC51,300 and will increase at the rate of 20% per month until
March. In April, sales will rise to GHC80,000 and this will rise by10% per month thereafter.

20
Sales will be divided equally between cash and credit sales. Credit customers are expected to pay
two months after the sales.70% of sales will be generated by sales agents who will receive 10%
commission on sales.
The commission is payable one month after the sales.
3) The company intends to purchase further equipment in August for GHC45,000. However, a
deposit of 20% is supposed to be made in June.
4) Accounts receivable as at 31/12/2010 will be settled in January, 2011.
5) Other overheads will be GHC6,500 per month for the first three months and GHC8,400
thereafter. Wages and salaries will be GHC16,000 per month. Both types of expense will be
payable when incurred.
6) Depreciation is to be provided at the rate of 10% per annum on land and building and 20% per
annum on equipment (depreciation has not been included in the overheads mentioned above).
Required:
Prepare a monthly Cash Budget for Sedkan Ltd for January 2011 to June 2011.

Self-Assessment Questions -Multiple Choice Questions on Working Capital

1. Which of the following statements is true?

b. Cash is decreased when new debt is issued to purchase holiday merchandise.
a. Accepting the credit offered by a supplier is a source of cash.
c. Increasing the use of trade credit offered by a supplier is a use of cash.
d. Collecting an accounts receivable is a use of cash.

2. Which one of the following will increase the operating cycle?

e. increasing the inventory period
c. decreasing the cash cycle
b. decreasing the accounts payable period
a. increasing the accounts payable period
d. increasing the accounts receivable turnover rate

21
3. Which one of the following actions should a manager take if he or she wants to decrease the
operating cycle?
d. decrease the period of time for which credit is granted to customers
c. decrease the rate at which the average inventory is sold
a. delay payments to suppliers to decrease the cash cycle
b. increase the inventory level while maintaining constant sales
e. purchase all inventory with cash

4. All else equal, which one of the following will decrease the cash cycle?
c. increasing the operating cycle
e. decreasing the accounts receivable turnover rate
d. decreasing the accounts payable period
b. increasing the inventory turnover rate
a. increasing the credit period granted to a customer

5. Which one of the following statements is correct concerning the accounts payable period?
c. Managers generally prefer a shorter accounts payable period than a longer one.
a. The accounts payable period is equal to the cost of goods sold divided by the average accounts
payable.
d. Extending the accounts payable period effectively decreases the cash needs of a firm.
e. Increasing the accounts payable turnover rate increases the accounts payable period.
b. An increase in the accounts payable period will increase the operating cycle, all else equal.

6. Nelson's Mulch has the following current account values for the year.

Account Beginning Balance Ending Balance

Accounts receivable $1,300 $1,450
Inventory 2,100 1,900
Accounts payable 1,500 1,250
These accounts represent a net _____ of cash for the year.

e. use; $250.
a. source; $100.
b. source; $150.

22
d. use; $200.
c. use; $100.

7. The Winters Co. has annual sales of $918,700. Cost of goods sold is equal to 55 percent of
sales. The firm has an average accounts payable balance of $72,400. How many days on average
does it take The Winters Co. to pay its suppliers?
c. 38 days
d. 46 days
e. 52 days
b. 34 days
a. 29 days

8. The Sun Lee Co. has a receivables turnover rate of 11.5, a payables turnover rate of 9.8, and
an inventory turnover rate of 13.6. What is the length of the firm's operating cycle?
c. 37 days
a. 15 days
b. 22 days
d. 59 days
e. 67 days

9. Robert's International currently has an inventory turnover of 15, a receivables turnover of 18,
and a payables turnover of 10. How many days are in the cash cycle?
a. 8 days
c. 45 days
e. 81 days
b. 22 days
d. 74 days

10. Die Cast, Inc., has these projected sales estimates:

April May June July
Sales $1,200 $1,300 $1,700 $1,900

The company collects 15 percent of its sales in the month of sale, 70 percent in the following
month, and another 12 percent in the second month following the month of sale. Die Cast never
collects 3 percent of its sales. What is the amount of the June collections?

b. $1,406
c. $1,423
e. $1,631

23
d. $1,447
a. $1,309

11. The Thomas-Davis Co. has the following estimated sales:

Q1 Q2 Q3 Q4
Sales $3,800 $3,300 $2,800 $4,400

Purchases are equal to 67 percent of the following quarter's sales. The accounts receivable period
is 45 days and the accounts payable period is 60 days. Assume that there are 30 days in each
month. Thomas-Davis will purchase _____ of goods in quarter 3 and pay their suppliers _____
during quarter 3.

a. $1,876; $2,099
b. $1,876; $2,233
d. $2,948; $2099
c. $2,948; $1,876
e. $2,948; $2,233

12. There exists a close correlation between sales fluctuations and invested amounts
in .........................

13. A company’s operating cycle typically consists of three primary

activities: ...................... , ....................... and ....................

14. The ......................... shows the time interval over which additional no spontaneous sources of
working capital financing must be obtained to carry out the firm’s activities

State whether the following statements are true or false:

15. No business can run successfully without an adequate amount of working capital.

16. Working capital enables a concern to avail cash discounts on the purchases and hence it
reduces costs.

17. Working capital ensures regular supply of raw materials and continuous production.

24
 CHAPTER 2

Capital Budgeting

MEANING OF CAPITAL BUDGETING:

Capital budgeting is the process of making investment decisions in capital expenditures. A

capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over a period of time exceeding one year.

DEFINITIONS OF CAPITAL BUDGETING

1. According to Charles T. Horngreen, “Capital budgeting is long term planning for making and
financing proposed capital outlays.”

2. In the words of Lynch, “capital budgeting consists in planning development of available

capital for the purpose of maximising the long term profitability of the concern.”

SIGNIFICANCE OF CAPITAL BUDGETING

i. Capital budgeting makes a comparative study of the alternative projects so as to make the
best possible investment. For this purpose, the profitability of each project is estimated.
ii. Proper capital budgeting leads to proper timing of assets-acquisition and improvement in
quality of assets purchased
iii. It facilitates Cash Forecast: Capital investment requires substantial funds which can only
be arranged by making determined efforts to ensure their availability at the right time.
iv. It protects the interests of the shareholders and the enterprise because it avoids over-
investment and under-investment in fixed assets. By selecting the most profitable
projects, the management facilitates the wealth maximization of equity shareholders.

LIMITATIONS OF CAPITAL BUDGETING:

1. Uncertainty in future

The Capital budgeting proposals are infested with the uncertainty in future. All data used in the
evaluation of proposals is the estimates. The data is error-prone more with the human judgement,

25
bias or discretion in the identification of cash inflows and cash out flows. Even advanced capital
budgeting techniques such as sensitivity analysis cannot be useful if the data is erroneous.

2. Qualitative factors ignored

In capital budgeting, we consider only such factors which can be quantified in terms of money.
Factors such as improved morale of employees as a result of implementation of proposals are not
focused. The other factors in the business environment such as social, political and economic
conditions and so on, are not reflected here.

3. Volatile business conditions

The factors influencing investment decisions include technological advancement, government

policies, sales forecast, attitudes of management, estimated cash flows discount factor and rate of
return. Any change in one or more of these factors is going to affect the capital budgeting
decisions. .

4. Unrealistic Assumptions

There are certain unrealistic assumptions underlying capital budgeting process. They are:

i) There is no risk and uncertainty in the business environment. This is not correct. The future of
the business is full of uncertainty and we apply the management techniques to minimise the risk.
ii) The cash flows are received in lump sum at the end of the given period. iii) The key variables
such as sales revenue, costs, price or investments and so on are taken based on past data.
Particularly in times of raising prices, these seldom hold good for future. iv) The cost of capital
and discount rates are one and the same.

SIGNIFICANCE / IMPORTANCE OF COST OF CAPITAL IN CAPITAL BUDGETING

i. Cost of capital is used as discount factor in determining the net present value. ii. Similarly, the
actual rate of return of a project is compared with the cost of capital of the firm. iii. Thus the
cost of capital has a significant role in making investment decisions.

INVESTMENT DECISION PROCESS

1. Ascertainment of Project:

26
 Identifying the project for investment is the first step in capital budgeting. From various
projects, the project needs to be ascertained by department officer or head for analysis and the
suitable project is selected according to corporate strategies and submitted to the capital
expenditure planning committee for large organization or else to concerned head for long term
investment decisions.

2. Project Selection: Different projects are checked thoroughly by capital expenditure planning
committee and selection is based on the corporate strategy.

3. Project Analysis:

In this step, profitability of different projects is analyzed.

It may be classified into independent project, dependent project and mutually exclusive project.

The methods by which profitability of project can be ascertained are Pay-back period, Rate of
Return, Net Present Value, Internal Rate of Return etc.

4. Determining Priorities:

Giving priorities helps the firm or an individual to work smoothly.

By analyzing the project, one can know the profitability, urgency and risk involved and can
accordingly select the project.

Ranking different projects is required for the firm.

5. Project Approval:

After meeting all the requirements stated in the above step the project is approved and included
in capital expenditure budget.

Then the amount from which fixed assets are purchased in budget period is estimated.

6. Project Implementation:

Implementing the project is an important aspect for capital expenditure committee as they have
to consider the profitability of the project with time and cost limit.

27
7. Project Performance Review:

The final step is to check whether all the above steps are running smoothly or not and if any
problem occurred, it can be rectified with corrective actions.

The project expenditure needs to be compared with post completion expense of the investment
process, the actual return generating from investment, everything needs to be properly viewed.
Finally the performance can be known.

DEVELOPING CASH FLOW DATA FOR NEW PROJECTS

Cash flow is the amount obtained by subtraction of cash expenses from cash revenues. Usually
investment decisions have three types of cash flows. They are (i) Initial Investment (ii) Operating
cash flows (iii) Terminal cash flows

(i) Initial Investment:

The capital expenditure incurred in the beginning of the period, t= 0, to acquire asset is known
as initial investment.

It involves cost of new asset to acquire land, building, machinery etc., and also includes
expenses like insurance, freight, installation cost etc., net working capital and opportunity cost
which is incurred by the firm.

(ii) Operating Cash flows / New Annual Cash Flows:

Operating cash flows are the expected future benefits that are generated from investment in
capital assets.

These operating cash flows are evaluated on after-tax basis.

In order to find the net annual cash flows depreciation is added and tax is deducted.

Net Cash Inflows = Cash Revenues- cash Expenses-Tax

OR

Net Cash Inflow = Net Earnings after tax+ Depreciation.

28
(iii) Terminal Cash flows:

Terminal cash flows is the value of asset that is obtained by the firm in the last year of the asset
when it is sold as scrap.

When firm makes a replacement decision in which old asset is replaced for new asset, the
reduction in cost of new asset due to sale value of old asset is known as terminal flow of asset
replaced.

CAPITAL BUDGETING PROCESS

According to the definition of G.C. Philippatos, “capital budgeting is concerned with the
allocation of the firms source financial resources among the available opportunities. The
consideration of investment opportunities involves the comparison of the expected future streams
of earnings from a project with the immediate and subsequent streams of expenditure”. The
process of capital budgeting as follows:

1. Identification of various investments proposals:

The capital budgeting may have various investment proposals. The proposal for the investment
opportunities may be defined from the top management or may be even from the lower rank. The
heads of various departments analyse the various investment decisions, and will select proposals
submitted to the planning committee of competent authority.

2. Screening or matching the proposals:

The planning committee will analyse the various proposals and screenings. The selected
proposals are considered with the available resources of the concern. Here resources referred as
the financial part of the proposal. This reduces the gap between the resources and the investment
cost.

3. Evaluation:

After screening, the proposals are evaluated with the help of various methods, such as payback
period proposal, net discovered present value method, accounting rate of return and risk analysis.

29
Each method of evaluation used in detail in the later part of this chapter. The proposals are
evaluated by.

(a) Independent proposals

(b) Contingent of dependent proposals

(c) Partially exclusive proposals.

Independent proposals are not compared with other proposals and the same may be accepted or
rejected, whereas higher proposals acceptance depends upon the other one or more proposals.
For example, the expansion of plant machinery leads to constructing of new building, additional
manpower etc. Mutually exclusive projects are those which competed with other proposals and
to implement the proposals after considering the risk and return, market demand etc.

4. Fixing property:

After the evolution, the planning committee will predict which proposals will give more profit or
economic consideration. If the projects or proposals are not suitable for the concern’s financial
condition, the projects are rejected without considering other nature of the proposals.

5. Final approval:

The planning committee approves the final proposals, with the help of the following:

(a) Profitability

(b) Economic constituents

(c) Financial violability

(d) Market conditions.

The planning committee prepares the cost estimation and submits to the management.

6. Implementing:

The competent authority spends the money and implements the proposals. While implementing
the proposals, assign responsibilities to the proposals, assign responsibilities for completing it,

30
within the time allotted and reduce the cost for this purpose. The network techniques used such
as PERT and CPM. It helps the management for monitoring and containing the implementation
of the proposals.

7. Performance review of feedback:

The final stage of capital budgeting is actual results compared with the standard results. The
adverse or unfavourable results identified and removing the various difficulties of the project.
This is helpful for the future of the proposals.

METHODS OF CAPITAL BUDGETING OF EVALUATION

The methods of evaluations are classified as follows:

(A) Traditional methods (or Non-discount methods)

(i) Pay-back Period Methods

(ii) Post Pay-back Methods

(iii) Accounts Rate of Return

(B) Modern methods (or Discount methods)

(i) Net Present Value Method

(ii) Internal Rate of Return Method

(iii) Profitability Index Method

Pay-back Period

Pay-back period is the time required to recover the initial investment in a project.

Payback Period = Initial Investment/ Annual Cash Inflow

Merits of Pay-back method

31
The following are the important merits of the pay-back method:

1. It is easy to calculate and simple to understand.

2. Pay-back method provides further improvement over the accounting rate return.

3. Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits

1. It ignores the time value of money.

2. It ignores all cash inflows after the pay-back period. 3. It is one of the misleading evaluations
of capital budgeting.

Accept /Reject criteria

If the actual pay-back period (PBP) is less than the predetermined pay-back period, the project
would be accepted. If not, it would be rejected.

For example, if an investment of Gh¢ 10,000 in a machine is expected to produce annual cash
inflow of Gh¢2,500 for 6 years, then

¢ 10 ,000
PBP =
¢ 4 , 000
= 4 years

In the case of uneven cash inflows - When a project’s cash flows are not equal, but vary from
year to year, i.e., they are of non-conventional nature, the calculation of payback period takes a
cumulative form of annual cash inflows. In such a situation, payback period is calculated by the
process of cumulating cash inflows till the time when cumulative cash inflows become equal to
the original investment outlay.

Illustration 2

Certain projects require an initial cash outflow of GH¢ 25,000. The cash inflows for 6 years are
GH¢ 5,000, GH¢ 8,000, GH¢ 10,000, GH¢ 12,000, GH¢ 7,000 and GH¢ 3,000.

32
Solution 2

Year Cashflow GH¢ Cumulated Cashflow GH¢

0 25,000 (25,000)
1 5,000 (20,000)
2 8,000 (12,000)
3 10,000 (2,000)
4 12,000
5 7,000
6 3,000

The above calculation shows that in 3 years GH¢ 23,000 has been recovered GH¢ 2,000, is
balance out of cash outflow. In the 4th year the cash inflow is GH¢ 12,000. It means the pay-
back period is three to four years, calculated as follows Pay-back period = 3
years+2000/12000×12 months = 3 years 2 months.

Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for considering the project
evaluation.
Average Rate of Return = Average Profits (after taxes) x 100
Total Outlay of the Project

The average investments - Any of the following of the following formulae may be applied to
calculate average investment:

(a) Initial Investment/2

(b) Initial Investment + Scrap Value/2
Illustration 3

Sedkan Ltd is considering a project which requires an investment GH¢120,000 in machinery.

The machinery will last for four years after which it will have scrap value of GH¢20,000. The
expected annual profits before depreciation are:

Year GH¢
1 45,000

33
2 45,000
3 40,000
4 25,000
The company requires a minimum accounting rate of return of 15% from of this type. ARR is
measured as average annual profits as a percentage of the average investment.

Should the investment be undertaken?

Solution 3

Total profits before depreciation:

Year GH¢
1 45,000
2 45,000
3 40,000
4 25,000
Profit 155,000
Total depreciation = GH¢120,000-GH¢20,000) (100,000)
Total profit after depreciation 55,000
Length of project 4
Average annual accounting profit 13,750

Average investment (GH¢120,000+ GH¢20,000)/2 70,000

ARR = (GH¢13,750/GH¢70,000)*100% 19.64%

Merits

1. It is easy to calculate and simple to understand.

2. It is based on the accounting information rather than cash inflow.

3. It is not based on the time value of money.

4. It considers the total benefits associated with the project.

Demerits

1. It ignores the time value of money.

34
2. It is based on accounting profits, and not cash flow. However investments are about investing
cash to obtain returns. Investment decisions should therefore be based on cash flow, and not
accounting profits

3. Accounting profits are an unreliable measure. For example, the annual profit and annual
investment can both be changed simply by altering the rate of depreciation and the estimated
residual value. Different methods are also used for provision for depreciation.

Accept/Reject criteria

If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not it would be rejected.

Practice Question

A capital project would involve the purchase of an item of equipment costing GH¢240,000. The
equipment will have a useful life of 6 years and would generate cash flows of GH¢66,000 each
year for the first three years and GH¢42,000 each year for the final three years.

The scrap value of the equipment is expected to be GH¢24,000 after six years.

The Company currently achieves a return on capital employed, as a measure from the data in its
financial statement, of 10%.

Required:

b) Calculate the ARR of the project, using the initial cost of the equipment to calculate capital
employed
c) Calculate the ARR of the project, using the average cost of the equipment to calculate
capital employed

Net Present Value

Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and present value of cash
outflow. Net present value is the difference between the total present value of future cash inflows
and the total present value of future cash outflows.

35
NPV = Total Present value of Future Cash inflows - Initial Investment.

Merits

1. It recognizes the time value of money.

2. It considers the total benefits arising out of the proposal.

3. It is the best method for the selection of mutually exclusive projects.

4. It helps to achieve the maximization of shareholders’ wealth.

Demerits

1. It is difficult to understand and calculate.

2. It needs the discount factors for calculation of present values.

3. It is not suitable for the projects having different effective lives.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected.

Illustration 3

Suppose a project costs GH¢ 5,000. Its estimated economic life is 2 years. The firm’s cost of
capital is estimated to be 10%. The estimated cash inflows from the project are GH¢ 2,800 p.a.

Calculate its NPV.

Solution 3

As the firm’s cash inflows are of conventional pattern (i.e. even amount), the compound value
factor can be used for calculating their NPV
GH¢
Total Present Value = GH¢ 2,800 x 1.813 = 5,272
Less Cost of the Project 5,000

36
Net Present Value 272

Illustration 4
From the following information, calculate the net present value of the two projects and suggest
which of the two projects should be accepted.
Project X Project Y
Initial Investment GH¢ 20,000 GH¢ 30,000
Estimated Life 5 years 5 years
Scrap Value GH¢ 1,000 GH¢ 2,000
The profits before depreciation and after taxation (cash flows) are as follows
Year 1 Year 2 Year 3 Year 4 Year 5
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000
Discount rate is 10%

Solution 4
Year Cash flow Cash flow Discount Present value Present value
X (GH¢) Y (GH¢) Factor 10% X (GH¢) Y (GH¢)
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242
scrap 1,000 2,000 0.621 621 1,242
TPV 24,227 34,728
Initia invstmt 20,000 30,000
NPV 4,227 4,728

Project Y should be selected as net present value of project Y is higher.

37
Internal Rate of Return
Internal rate of return is time adjusted technique and covers the disadvantages of the traditional
techniques. In other words it is a rate at which discount cash flows to zero.
The internal rate of return is the discount rate that makes the NPV of an investment zero. That is
to say that when we evaluate a project with the NPV tool and we have a zero NPV, then the
discount rate that was used in the evaluation is the NPV.

Merits
1. It considers the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate of return.

Accept/ Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than the
present value of the outflows, the proposed project is accepted. If not it would be rejected.

A company can purchase a machine at the price of £2200. The machine has a productive life of
three years and the net additions to cash inflows at the end of each of the three years are £770,
£968 and £1331. The company can buy the machine without having to borrow and the best
alternative is investment elsewhere at an interest rate of 10%.

Evaluate the project using the internal rate of return

Solution 8 IRR Try 15%

Year Cash flow Discount Factor (15%) PV

0 (2200) 1.000 (2200)

38
1 770 0.8696 669.59
2 968 0.7561 731.90
3 1331 0.6575 875.13
NPV 76.62
IRR Try 16%
Year Cash flow DC (16%) PV
0 (2200) 1.000 (2200)
1 770 0.8621 663.83
2 968 0.7432 719.42
3 1331 0.6407 852.77
NPV 36.01
NPV is still positive. Keep on trying till we obtained negative NPV.

Try 17%

Year Cash flow DCF (17%) PV

0 (2200) 1.000 (2200)

1 770 0.8475 652.58

2 968 0.7305 711.48

3 1331 0.6244 831.08

NPV (4.86)

NL
IRR=L+ ×( H− L)
N L−N H

Where:

L = Lower rate of interest

H = Higher rate of interest

NL = NPV at lower rate of interest

NH = NPV at higher rate of interest

By Interpolation

39
IRR = 16 + 36.01 / 40.87 = 16.88%

Profitability Index Method

This method is also known as Benefit-Cost Ratio. One major demerit of NPV method is that it
cannot be applied to compare those mutually exclusive projects which differ in costs
substantially. To compare and evaluate such projects, the profitability index should be
calculated. The profitability index is the relationship that exists between the present values of net
cash inflows and cost outlays of the projects. It can be calculated as follows:
Gross BCR = Total Present Values of Cash Inflows
Initial Investment

Questions
Question 1

Hukportie Ltd is a manufacturer of product “Okwada” which is sold for GH¢5 per
unit. Variable costs of production are currently GH¢3 per unit, and fixed costs
excluding depreciation is GH¢350,000. The current machine which was purchased for
GH¢120,000 has a written down value of GH¢20,000 and a resale value of GH
¢12,000. This can however be used for the next four years.
A new machine is available which would cost GH¢90,000. This could be used to make
product “Okwada” for a variable cost of only GH¢2.50 per unit. Fixed costs, however,
would increase by GH¢7,500 per annum as a direct consequence of purchasing the
machine. The machine would have an expected life of 4 years and a resale value after
that time of GH¢8,000. Sales of product Okwada are estimated to be 75,000 units per
annum. Hukportie limited expects to earn at least 12% per annum from its investments.
Taxation and depreciation should be ignored.

Required:
Advise whether Hukportie Ltd should purchase the new machine.

40
Solution 1
QUESTION ONE Determination of cost savings: GH¢

Existing variable cost per unit 3.00

Less new variable cost per unit 2.50

Savings in variable cost 0.50

Total savings in variable cost (GH¢75,000 x GH¢ 0.5) 37,500.00

Less additional cost per annum 7,500.00

Net cash savings in cost 30,000.00

The net investment should be 78,000. This is because the receipt on disposal of old
asset should be deducted from the cost of the new machine.
The resale value of the machine is GH¢ 8,000.
Candidates can use annuity due formula to determine the NPV

Using Annuity Due, NPV is obtained as:

= - Co + C x AF + C/ (1+ r) 𝑛

= - 78,000 .00 + 30,000.00 x 3.038 + 8,000.00 / (1.12) 4

= - 78,000.00 + 91,140.00 + 5,084.14

= 18,224.14

Alternatively, NPV can be calculated as:

Year Cash flows DF (12%) PVs
0 (78,000.00) 1.000 (78,000.00)
1 30,000.00 0.893 26,790.00
2 30,000.00 0.797 23,910.00
3 30,000.00 0.712 21,360.00
4 8,000.00 + 30,000.00 0.636 24,168
NPV 18,224

41
 Alternatively
PV of Operating Cost.
- Old Machine : VC = 3 x 75,000 225,000
Add FC 350,000
575,000 @ 3.038 = 1,746,850

- New Machine : VC 2.5 x 75,000 187,500

Add FC 357,500
545,000 @ 3.038 = 1,655,710
Net Investment (90,000 – 12,000) @ 1 78,000
Resale Value 8000 @ 0.636 (5,088)
1,728,622

QUESTION 2

AUTOMATED SEMI-AUTOMATED
GH¢ GH¢
Original purchase price 2,000,000 1,000,000
Installation cost 500,000 200,000
Yearly Sales revenue 2,000,000 2,000,000
Yearly material and labour cost 900,000 1,400,000
Yearly variable overhead 600,000 300,000
Yearly apportioned fixed overhead 200,000 100,000

Estimated useful life 15 years 14 years

Method of depreciation Straight line Straight line
Cost of Capital 10% 10%

Required:
i) Select the appropriate plant on the basis of
 Payback Period
 Net Present Value

ii) Explain TWO (2) advantages of discounted cashflow method of investment appraisal.

Pay Back Period is defined as the period, usually expressed in years, which it takes
the cash flows from a capital investment project to equal the cash flows generated.
Semi-Automated Plant Automated
Plant GH¢000 GH¢000
Yearly sales Revenue 2,000 2,000

42
 Less Variable cost:
Material and Labour cost 1,400 900
Variable overhead 300 600
Contribution of cash flow 300 500

Payback period = Investment cost = 1,200 2,500

Yearly cash flow 300 500
4 years 5 years
Decision:

Semi-automated plant is considered more suitable because of PBP of 4 years as against 5

years for an automated plant.
Using Discounted Cash Flow, the NPV of the Plants
Automated
Year Cash Flow DCF @ 10% Present
Value
GH¢ GH¢

0 (2,500,000) 1.000 (2,500,000)

1-15 500,000 7.606 3,803,000
NPV 1,303

Semi-Automated
Year Cash Flow DCF @ 10%
Present Value
GH¢ GH¢
0 (1,200,000) 1.000 (1,200,000)
1-14 300,000 7.367 2,210,100
NPV 1,010,100

Decision
It is advisable to select automated plant that gives a higher NPV though the capital
requirement of the plants differs.
i) Advantages of Discounted Cash Flow
 It uses the time value of money.
 It uses the cost of capital.
 Uses cash flow instead of accounting profit.
 Considers the entire life of the project.

43
QUESTION 3
DDB limited has decided to set up a factory to process groundnuts into oil. The feasibility
studies cost them GH¢35,000. The consultants have advised that the initial outlay will be GH
¢250,000, however, they were unable to estimate the cash inflow due to the uncertain economic
environment.
Required:
Using NPV as an appraisal technique you are required to calculate;
i) The constant cash inflow needed to break even if the cost of capital is 15% and the project is to
last for 10 years.
ii) By how much should the cash inflow increase to break even if cost of capital is increased to
20%.
ii) If the cash inflow is GH¢45,000, for how long should the project run to break even if the
cost of capital is 15%.

QUESTION 4

The Maintenance Manager of Prudence Ltd insists that management should maintain an
old equipment that had been used for 5 years and is fully depreciated rather than buy a
new one. The old equipment has a current operating cost of GH¢53,000.00 per annum.
The operating cost of the equipment is expected to increase at 5% every year over the
next four years, with a sale value of GH¢6,500.00 in the fifth year.

The Maintenance Manager has proposed, that a new system with enhanced technology
to reduce operating cost to GH¢32,000.00 for the next three years and GH¢33,600.00
for the fourth and fifth years be introduced. The new equipment will cost GH
¢60,000.00 and when introduced, a redundancy cost of GH¢25,000.00 will be paid,
with the old equipment sold for GH¢12,000.00. The sale value of the new equipment
will be GH¢10,200.00 after its five years’ useful life.

Required: Using Net Present Value (NPV) method of capital appraisal with 20% cost of
capital, advice management on which option Prudence Ltd should go for.

44
Assignment

Jedkan Ltd is contemplating three available investment opportunities, the cash flow of which is
given below:
Initial Year 1 Year 2 Year 3 Year 4 Year 5
investment GH¢ GH¢ GH¢ GH¢ GH¢
Project A (100) 40 40 40 40
Project B (120) 10 10 10 10 200
Project C (150) 100 80

In each case the initial investment represents the purchase of plant and machinery, whose
realisable value will be 10% of initial cost, receivable in addition to the above flow at the end of
the life of the project

Required:

Advise the company on which it should prefer, taking as your investment criterion the following
alternative measures.
i) Payback period
ii) Accounting rate of return (based on average investment)
iii) Net present at discount rate of 15%
iv) Internal rate of return

Multi-Choice Questions

1. The span of time within which the investment made for the project will be recovered by
the net returns of the project is known as

(A) Period of return

(B) Payback period

(C) Span of return

(D) None of the above

45
2-Projects with __________ are preferred

(A) Lower payback period

(B) Normal payback period

(C) Higher payback period

(D) Any of the above

3-___________ on capital is called ‘Cost of capital’.

(A) Lower expected return

(B) Normally expected return

(C) Higher expected return

(D) None of the above

4-The values of the future net incomes discounted by the cost of capital are called

(A) Average capital cost

(B) Discounted capital cost

(C) Net capital cost

(D) Net present values

5-Under Net present value criterion, a project is approved if

(A) Its net present value is positive

(B) The funds are unlimited

(C) Both (A) and (B)

(D) None of the above

6-The internal Rate of Return (IRR) criterion for project acceptance, under theoretically
infinite funds is: accept all projects which have

(A) IRR equal to the cost of capital

(B) IRR greater than the cost of capital

46
(C) IRR less than the cost of capital

(D) None of the above

7-Which of the following criterion is often preferred

(A) Net present value

(B) Profitability index

(C) Internal Rate of Return

(D) All of the above

8-The project is accepted of

(A) if the profitability index is equal to one

(B) The funds are unlimited

(C) If the profitability index is greater than one

(D) Both (B) and (C)

9-Where capital availability is unlimited and the projects are not mutually exclusive, for
the same cost of capital, following criterion is used

(A) Net present value

(B) Internal Rate of Return

(C) Profitability Index

(D) Any of the above

10-A project is accepted when

(A) Net present value is greater than zero

(B) Internal Rate of Return will be greater than cost of capital

(C) Profitability index will be greater than unity

(D) Any of the above

47
11-With limited finance and a number of project proposals at hand, select that package of
projects which has

(A) The maximum net present value

(B) Internal rate of return is greater than cost of capital

(C) Profitability index is greater than unity

(D) Any of the above

ABC Company is considering two investments both of which cost $10,000. The cash flows are
as follows:

Year Project A Project B

1 GH¢6,000 GH¢5,000
2 4,000 3,000
3 3,000 8,000

12. Based on the payback method, which of the two projects should be chosen?
a. Project A which has a payback period of 2.0 years.
b. Project A which has a payback period of 2.25 years.
c. Project B which has a payback period of 2.0 years.
d. Project B which has a payback period of 2.25 years.

12. Based on the net present value method, assuming a cost of capital of 10%, which of the
two projects should be chosen?
a. Project A which has a net present value of GH¢11,011.
b. Project A which has a net present value of GH¢1,011.
c. Project B which has a net present value of GH¢13,031
d. Project B which has a net present value of GH¢3,031.

13. Which method provides more confidence, the payback method or the net present value
method?
a. Payback because it provides a good timetable.
b. Payback because it tells you when you break even.

48
c. Net present value because it considers all inflows and outflows and the time value of money.
d. Net present value because it does not need to use cost of capital.

The Pan American Bottling Co. is considering the purchase of a new machine that would
increase the speed of bottling and save money. The net cost of this machine is GH¢45,000.
The annual cash flows have the following projections.

Year Cash Flow

1 GH¢15,000
2 GH¢20,000
3 GH¢25,000
4 GH¢10,000
5 GH¢5,000

14. What is the net present value of selecting the new machine, assuming cost of capital of
10%?
a. GH¢11,883
b. GH¢13,883
c. GH¢15,883
d. GH¢17,883

15. What is the internal rate of return?

a. About 7%
b. About 10%
c. About 23%
d. About 27%

16. Should Pan American buy the machine?

a. Yes. NPV is positive and IRR exceeds cost of capital.
b. Yes. NPV is positive and IRR is less than cost of capital.
c. No. NPV does not provide enough information.
d. No. IRR is higher than the cost of capital.

49
Big Sky Construction Company is considering two new investments. Project E calls for the
purchase of earth-moving equipment. Project H represents the investment in a hydraulic
lift. Big Sky wishes to use a new present value profile in comparing the projects. The
investment and cash flow patterns are as follows:

Year Project E (GH¢) Project H (GH¢)

0 (20,000) (20,000)
1 5,000 16,000
2 6,000 5,000
3 7,000 4,000
4 10,000

17. What is the NPV of both projects using zero discount rate?
a. $8,000 for project E and $5,000 for project H
b. $8,000 for project H and $5,000 for project E
c. $28,000 for project E and $25,000 for project H
d. $20,000 for both projects.

18. What is the NPV of both projects using 9% discount rate?

a. $22,121 for project E and $21,970 for project H
b. $20,000 for both projects.
c. $2,121 for project E and $1,970 for project H
d. $8,000 for project E and $5,000 for project H

19. The IRR of project E is _______

a. About 9%
b. About 13%
c. About 16%
d. About 20%

20. If the two projects are mutually exclusive, which project would you accept using NPV,
assuming cost of capital of 18%.
a. Project E
b. Project H

50
c. Both
d. Neither

51
 Chapter 3
Dividend Policy
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.

According to the Institute of Chartered Accountant of India, dividend is defined as “a

distribution to shareholders out of profits or reserves available for this purpose”.

TYPES OF DIVIDEND/ FORM OF DIVIDEND

Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.

Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under
this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue
is given only to the existing shareholders of the business concern.

Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.

52
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will be distributed
under the exceptional circumstance.

Dividend Decision
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management.

Dividend decision consists of two important concepts which are based on the relationship
between dividend decision and value of the firm

Much of the interest surrounding dividend policy has been concerned with the relationship
between dividend policy and shareholder wealth

The key question to be answered is can the pattern of dividends adopted by a business influence
shareholder wealth?”

Various dividend valuation models suggest that dividends are important in determining share
price

One such model, you may recall, is the dividend growth model which is as follows:
Po = D1
Ko-g
Where
D1 = expected dividend for next year
g = a constant rate of growth
Ko = the expected return on the share

53
 The Two (2) Schools of Thought
1. The traditional view of dividend policy
2. The modernist (m&m) view on dividend policy
The Traditional View Of Dividend Policy
The early finance literature accepted the view that dividend policy was important to shareholders

It was argued that a shareholder would prefer to receive GHc1 today rather than to have GHc1
reinvested in the business, even though, this might yield future dividends

The reason for this was that future dividends (or capital gains) are less certain and so will be
valued less highly

The saying ‘a bird in the hand is worth two in the bush’ is often used to describe this argument

Referring back to the dividend growth model, the traditional view suggests that Po will rise if
there is an increase in D1, as dividends received later will not be valued so highly.

If this line of reasoning is correct, the effect of applying a higher discount rate of future
dividends will mean that the share of businesses that adopt a high retention policy will be
adversely affected.

THE IMPLICATION FOR CORPORATE MANAGERS

 That, corporate managers should adopt as generous a dividend distribution policy as

possible, given the investment and financing policies of the business, as this will
represent the optimal dividend policy for the business
 In view of the fact that the level of payout will affect shareholder wealth, the dividend
payment decision will be an important policy decision for managers.

THE MODERNIST (M&M) VIEW ON DIVIDEND POLICY

Modigliani and Miller (M&M) have challenged this view of dividend policy.

They argue that, given perfect and efficient markets, the pattern of dividend payments adopted
by a business will have no effect on the shareholder wealth

54
  Where such markets exist, the wealth of shareholders will be affected solely by the
investment projects that the business undertakes.

 To maximize shareholders wealth, therefore, the business should take on all investment
projects that have a positive NPV

 The way in which the returns from these investment projects are divided between
dividends and retention is unimportant.

 Thus, a decision to pay a lower dividend will simply be compensated for by an increase
in share price

 If a business does not pay a dividend, the shareholder can create a ‘homemade’ dividends
by selling a portion of the shares held.

 If, on the other hand, a business provides a dividend that the shareholder does not wish to
receive, the amount can be reinvested in additional shares in the business.

 In view of this fact, there is no reason for an investor to value the shares of one business
more highly than another simply because it adopts a particular dividend policy

IMPLICATIONS FOR CORPORATE MANAGERS

 The M&M view suggest that there is no such thing as an optimal dividend policy, and
that one policy is as good as another

 That is, the dividend decision is irrelevant to shareholder wealth

 Thus, managers should not spend time considering the most appropriate policy to adopt,
but should, instead, devote their energies to finding and managing profitable investment
opportunities

 M&M believe that dividends simply represent a movement of funds from inside the
business to outside the business

 The change in the location of funds should not have any effect on shareholder wealth

55
  The problem with the traditional argument is that it is based on a misconception of the
nature of risk

 The risks borne by a shareholder will be determined by the level of business borrowing
and the nature of the business operations

 These risks do not necessarily increase over time and are not affected by the dividend
policy of the business

 Dividends will only reduce risks if the amount received by the shareholder is then placed
in a less risky form of investment (with a lower level of return)

 The logic of the M&M arguments has proven to be unassailable and it is now widely
accepted that, in the world of perfect and efficient capital markets;

Dividend policy should have no effect on shareholder wealth

 The burning issue, however, is whether or not the MM analysis can be applied to the real
world of imperfect markets

 The assumptions are, in essence, that we live in a ‘frictionless’ world where there are:

1. No share issue costs

2. No share transaction costs

3. No taxation

 The first assumption means that money paid out in dividends can be replaced by the
business through a new share issue without incurring additional costs

 The second assumption means that investors can make homemade dividends or reinvest
in the business at no extra costs (or no barriers for investors to pursue their own dividend
and investment strategies)

 The third assumption concerning taxation is unrealistic and, in practice, tax may be an
important issue for investors.

56
  The three assumptions discussed undoubtedly weaken the M&M analysis when applied
to the real world

 However, this does not necessarily mean that their analysis is destroyed.

 One direct way to assess the validity of M&M’s arguments, in the real world, is to see
whether there is a positive relationship between the dividends paid by businesses and
their share price

The Importance of Dividends

 Whether to accept the M&M analysis, there is little doubt that, in practice, the pattern of
dividends is seen by investors and corporate managers as being important.

REASONS FOR THE IMPORTANCE OF DIVIDENDS…

1. The clientele effect
2. The information signaling
3. The need to reduce agency costs

57
 Chapter Four
Right Shares Issue

Rights issue is variously referred to as privileged subscription or pre-emptive rights. This is an

offer to existing shareholders to subscribe for more shares in proportion to their existing
holdings, usually at a lower price than its current market price.
When new shares are offered to the general public, the proportionate ownership of existing
shareholders is likely to be reduced. However if a pre-emptive right is contained in the firm’s
article of incorporation, the firm must first offer any new issue of shares to existing shareholders.
A pre-emptive rights is a right of existing shareholders to be given the opportunity to buy any
new shares been issued first before selling to the public. An issue of common stock to existing
shareholders is called a rights offering or issue. Here each shareholder is issued an option to buy
a specified number of new shares from the firm at a specified price within a specified time, after
which the rights expire. For example, a company which share is trading at GH¢10 may let
current shareholders buy a fixed number of shares at GH¢8 per share within two months. The
terms of the option are evidenced by certificates known as share warrants or rights. Such rights
are often traded on securities exchange or over the counter. The critical purpose of issue rights
below the trading price is to attract the existing shareholders to participate. For example a
company inviting the existing shareholders to subscribe for 1 new share for every 5 shares held
means that existing shareholder will get 1 new share for every 5 old shares held. Usually the
price at which the new shares are issued by way of rights issue is less than the prevailing market
price of the stock, i.e. the shares are offered at a discount.

Right Share Issue Defined

A rights offering (rights issue) is a group of rights offered to existing shareholders to purchase
additional stock shares, known as subscription warrants, in proportion to their existing
holdings. ... Rights are often transferable, allowing the holder to sell them in the open market.

58
Immediate effect of making a right share issue

A rights issue is one way for a cash-strapped company to raise capital often to pay down debt.
Shareholders can buy new shares at a discount for a certain period. With a rights issue, because
more shares are issued to the market, the stock price is diluted and will likely go down

Objective of rights issue

The objective of rights issue is to raise extra capital for the company. Since the cost of raising
capital by issuing shares is cheaper than by issuing debt, many companies adopt this route of
issuing additional shares to its existing shareholders.
Some of the most important advantages of rights issues of a company are as follows:

1. Control in the hands of existing shareholders: ...

2. No dilution in the value of existing shares: ...
3. Expenses Saved: ...
4. Better Image: ...
5. More Certainty of getting shares: ...
6. No Misuse by directors:

THEORETICAL EX-RIGHTS PRICE

The theoretical ex-right price is the price of the share after the rights issue. This price is a little
below the market price of the shares before the rights issue. The ex-rights price equal a weighted
average of the price of the rights and the pre-issue price

The formula for finding the theoretical ex-rights price given below:

Shares value (price x number of shares) before the rights issued+ Share values at the right issue)
Total number of the shares holdings (share holding before rights issue + rights shares)

59
VALUE OF THE RIGHTS

It is the theoretical gain received by shareholders after exercising their rights.

The value of rights is defined as the Old price of the shares before the rights issue less the
theoretical ex-right price. In order to find the value of each rights divide the value of the rights
with the number of old shares required for a new share.

SHAREHOLDER’S GAIN OR LOSS

There is the need to establish whether a shareholder makes a loss or a gain when there is a rights
issue. The shareholders have the following options opened to them when there is a rights offer:

Take up all the rights

Sell all the rights

Take some of the rights and sell the remaining rights

Do nothing

Illustration 1

Illustration 1
Jedkan Ltd has issued share capital of 600,000 shares with a nominal value of ¢50 each with
current market price of ¢70. The company is offering a rights issue of 2 share for every 5 shares
originally held at ¢60.

(i) Compute the theoretical or ex-rights price of the share

(ii) Calculate the value of the rights

(iii) Determine the Nil paid prices

(iv) Calculate the number of rights the company can offer

Solution 1

(i ) Theoretical ex-rights price

Value of existing shares 600,000 @ ¢70 420,000,000

60
Value of new shares 240,000 @ ¢60 144,000,000
840,000 564,000,000

Theoretical ex-rights price 564,000,000/840,000,

= ¢67.14

(ii). Value of the rights = price before the rights issue- Ex-right price

= ¢70-¢67.14=¢2.86

(iii). Nil paid price is defined as Ex-rights price less Cost of issue

= ¢67.14-¢60= ¢7.14

(iv). Number of rights the company can offer is 600,000/5 = 240,000 shares

Illustration 2

Ayala Kanin Ltd has 75,000 Ordinary Shares, which currently has a market price of GH¢24. The
Company’s Board of Directors wishes to make rights issue of one (1) new share for four (4) old
shares at GH¢16 in order to raise money for expansion.

You are required to:

i) Calculate the number of rights the company can offer

ii) Calculate the ex-right price
iii) Calculate the nil paid price
iv) Calculate the value of a right

Solution 2
(i ) Number of rights the company can offer is 75,000/4 = 18,750 shares
ii) Theoretical ex-rights price

Value of existing shares 75,000 @ ¢24 ¢1,800,000.00

Value of new shares 18,750 @ ¢16 ¢300,000.00

93,750 2,100,000.00

Theoretical ex-rights price 2,100,000/93,750 ¢22.40

(iii). Nil paid price is defined as Ex-rights price less right price = ¢22.40- ¢16=¢6.40

61
(iv). Value of the rights = Price before the rights issue- Ex-right price=¢24- ¢22.40=¢1.60

Illustration 3
XYZ Ltd made net profit after tax of GH¢2 million and has 1 million shares outstanding.
Earnings per share is GH¢2 and the share sells at 10 times earnings (that is its price earnings
ratio is 10). The market price of each share is therefore GH¢20. The company plans to raise GH
¢5million of new equity funds by a rights offering. The subscription price is GH¢10 and assume
ABU has 2 shares before the right issue

Required

a). State three (3) options open to shareholders of XYZ Ltd.

b). Determine the number of new shares to be issued by the company.

c). How many rights will be required to purchase one share of stock?

d). What is the value of rights?

e). What is the ex-rights price?

Solution 3

a). The three main options open to the shareholders are:

i Subscribe for the full number of entitled shares

ii. Order all the rights to be sold

iii. Do nothing and let the rights expire

b). Number of new shares to be issued = Funds to be raised

Subscription price
5,000,000 = 500,000shares
10
c). Number of rights needed to buy a share of the stock

Old shares= 1,000,000 = 2 rights

=New shares 500,000
d). Value of the right = Old price-New price - Theoretical ex-rights price

62
 Ex-rights price

Number Price Value

Existing 2 20 40
New 1 10 10
3 50
Ex-rights price = 50/3 = GH¢16.67

Therefore Value of a right = Old price-New price -theoretical ex-rights price

= GH¢20-GH¢16.67=GH¢3.33

e. Ex-rights price = GH¢16.67

Assignment 1
ABC Ltd has 10,000 Ordinary Shares, which currently has market price of GH¢20. The
Company’s Board of Directors wishes to make rights issue of two new shares for five (5) old
shares at GH¢13.00 in order to raise money for expansion. Required:

i) Calculate the ex-right price

ii) Calculate the nil paid price
iii) Calculate the value of a right
iv) Kofi holds 4,000 shares, but has no money to subscribe for the new shares, advice
him on the number of shares to sell in order to finance his rights.

Shareholder’s Gain or Loss

There is the need to establish whether a shareholder makes a loss or a gain when there is a right
issue. Shareholders have the following options opened to them when there is a right offer:

i).Take up all the rights

ii). Sell all the rights
iii). Take some of the rights and sell the remaining rights
iv). Take no action

63
Illustration 4
A Ghanaian Company has issued a capital of 5,000shares, having a current market value of
10.00each. The company wishes to make a rights issue of one new share every five (5) shares
held at GH4.

Mr. Stone hold 100 shares before the right issue indicate the effect on the value of holding if he:

(i) Take up all the rights

(ii) Sells all the rights
(iii) Take up 60% and sells 40%
(iv) Take no action

Solution 4: Theoretical ex-rights price using the unit approach

Value of existing shares 5 @ ¢10 ¢50.00

Value of new shares 1 @ ¢4 ¢4.00

6shares ¢54.00

Theoretical ex-rights price 54.00/6shares ¢9.00

Total Approach - Theoretical ex-rights price

Value of existing shares 5,000 @ ¢10 ¢50,000.00

Value of new shares 1,000 @ ¢4 ¢4,000.00

6,000 shares ¢54,000.00

Theoretical ex-rights price ¢54,000.00/6,000 shares ¢9.00

Evaluation of Options
i) Take up all your rights

Existing no .of shares 100

Rights issue 100/5 20

Total number of shares 120

Ex- right s price 9.00

64
 Value of holdings 1,080.00

Less cost of taking rights (20 shares *¢4) 80.00

Value after rights issue GHؑ¢1,000.00

Value before rights issue (100 *GH¢10) GHؑ¢1,000.00

Effect Nil

ii) Sell all your rights

Proceeds from sale of shares 20x¢9) 180.00

Cost of rights 20x ¢4 80.00

Profits from sale 100.00

Value of existing holdings100x ¢9 900.00

Value after rights issue GH¢1,000

Value before rights issue GHؑ¢1,000

Effect Nil

iii) Take up 60% and sell 40%

Existing no .of shares 100

60% of rights offer: 60%x20 12

Total number of shares 112

Ex- right s price 9.00

Gross Value of holdings 1,008.00

Proceeds from 40%( 40%x20) x¢9 72.00

1,080.00

Less cost of taking rights (20 shares *¢4) 80.00

Value after rights issue GHؑ¢1,000.00

65
 Value before rights issue GHؑ¢1,000.00

Effect Nil

iv) Takes no action

Value of existing 100x¢9 900.00

Value before 100x10 1,000.00

Effect – Loss (100.00)

Comments
From the above, rights issue does not affect the value of shareholders provided they do not fold
their arms and take no action.
If you take all your rights, your value is maintained and your control is also maintained.
If you sell all your rights, you maintained your value, but you lose some control.
If you sell and take part, you maintained your value but lose some control.
If you do nothing, you will lose both your value and control.

Assignment
XYZ Limited, a small pharmaceutical company, have issued share capital of 2,000,000 with a
nominal value of GH¢1 each. The present market value of the share is GH¢15 each. The
company has decided to acquire a new plant and it is to raise additional funds through rights
issue to finance the plant. The rights issue stipulate that each shareholder is entitled to 1 new
share for every 5 shares at GH¢¢12. Mr. Shakur owns 5,000 shares. You are required to show
the effects on Mr. Shakur when he:

(i) Sells all the rights

(ii) Take up 70% and sells 30%
(iii)Take no action
(iv)Take up all the rights

66
Multiple Choice Questions

1. A payment made out of a firm's earnings to its owners in the form of either cash or stock is
called a: a. dividend.

b. distribution.

0c. repurchase.

d. payment-in-kind.

e. stock split.

2. The ability of shareholders to undo a firm's dividend policy and create an alternative dividend
policy by reinvesting dividends or selling shares of stock is called (a):

a. perfect foresight model.

b. personalization.

c. capital structure irrelevancy.

d. homemade leverage.

e. homemade dividend policy.

3. The market's reaction to a change in a firm's dividend payout is referred to as the:

a. information content effect.

b. clientele effect.

c. efficient markets hypothesis.

d. distribution effect.

e. dividend fallout.

67
 CHAPTER 5

VALUATION OF BUSINESS AND SHARES

Valuation is an assessment of the worth of an enterprise which is subject to a merger or takeover

so that the value of the enterprise can be determined. Such valuation helps in determining the
value of shares of the acquired and acquiring company to safeguard the interest of the
shareholders of both companies. A share represents a bundle of rights like right to elect
directors, to vote on resolutions of the company, share in the surplus, if any, on liquidation etc.
valuation of shares in a merger or takeover is made on a consideration of a number of relevant
factors, such as stock exchange prices of the shares of the two companies, the dividends paid on
the shares, relevant growth prospects of the companies values of the net assets and even factors
which are not evident from the face of the balance sheet like quality and integrity of
management, present and prospective competition, yield on comparable securities, market
sentiments etc. valuation has to be carried out by the exercise of judicious discretion and
judgment as it is very crucial and complicated issue.

Purpose of valuation

The following situations may require a valuation to be carried out.

(i) Purchase of a ‘block of share’s which may or may not give the holder a controlling
interest in the company
(ii) Formulation of schemes of mergers
(iii) Acquisition of interest of dissenting shareholders under a scheme of reconstruction
(iv) Conversion of shares
(v) Granting of a loan on the security of shares
(vi) Employees Stock Ownership plan (ESOP)

For transactions involving a relatively small number of shares, which are quoted on the stock
exchange, normally the price prevailing on the stock exchange is accepted. However, valuation
by experts is called for the when the parties involved in the transaction/deal/scheme, etc. fail to
arrive at a mutually acceptable value or the agreements or Articles of Association provide for
valuation by experts. Valuation by an expert may be necessary when:

(i) Shares are unquated;

(ii) Shares relate to private limited companies;
(iii) Courts direct;
(iv) Articles of Association so provide;
(v) Relevant agreements so provide;
(vi) Statute requirement

68
Factors influencing valuation of shares and businesses

(1) The stock exchange price of the shares of the two companies before the commencement
of negotiations or the announcement of the bid.
(2) Dividends paid on the shares.
(3) Relative growth prospects of the two companies.
(4) In case of equity shares, the relative gearing of the shares of the two companies.
(‘gearing’ means ratio of the amount of Issued preference share capital and debenture
stock to the amount of issued ordinary share capital.)
(5) Net assets of the two companies.
(6) Voting strength in the merged (amalgamated) enterprise of the shareholders of the two
companies.
(7) Past history of the prices of shares of the two companies.

VALUATION OF COMPANIES

Valuation of private companies

While the principles of valuation of private companies are the same as for public companies, an
important difference is that for private company targets we do not have the benchmark valuation
provided by the stock market. Also a public company is often widely researched by investment
analysts. Information about a private company may be sparse. Forecasting the future cash flows
is thus a more difficult exercise. Offsetting this disadvantage is the fact that private company
bids are almost always friendly, with easier access to the target’s management information.

Valuation of listed companies

Shares of listed companies, which are traded, are quoted on the stock exchange and are freely
available. These shares can be sold or bought at the stock exchanges. The market price of the
shares reflects their value. However, there cannot be complete reliance on the market value of
shares because of two short comings. Firstly, at times, correct information about a company is
not available to the investors, and, secondly, due to insider trading, there are distortions, which
are reflected in the market price of shares.

Valuation of unlisted companies

The P/E ratio cannot be calculated in the case of unlisted companies, as the market price of the
shares is not available. Hence, a representative P/E ratio of a group of comparable quoted
companies can be taken after suitable adjustments. Generally, for private limited companies or
small companies, which are not quoted and are closely held, a discount is applied for valuation to
the prevalent P/E ratio of comparable listed company.

69
Valuation based on assets

Book value

The tangible book value of a company is obtained from the balance sheet by taking the adjusted
historical cost of the company’s assets and subtracting the liabilities; intangible assets (like
goodwill) are excluded in the calculation. Book value of assets does help the valuer in
determining the useful employment of such assets and their state of efficiency. In all cases of
valuation on assets basis, except book value basis, it is important to arrive at current replacement
and realization value. It is more so in case of assets like patents, trademarks, know-how, etc.
which may posses value, substantially more or less than those shown in the books. Using book
value does not provide a true indication of a company’s value, nor does it take into account the
cash flow that can be generated by the company’s assets.

Replacement cost

Replacement cost reflects the expenditures required to replicate the operations of the company.
Estimating replacement cost is essentially a make or buy decision.

Appraised value

The difference between the appraised value of assets and the appraised value of liabilities is the
net appraised value of the firm. This approach is most commonly used in a liquidation analysis
because it reflects the divestiture of the underlying assets rather than the ongoing operations of
the firm.

Excess earnings

In order to obtain a value of the business using the excess earnings method, a premium is added
to the appraised value of net assets. This premium is calculated by comparing the earnings of a
business before a sale and the earnings after the sale, with the difference referred to as excess
earnings. In this approach, it is assumed that the business is run more efficiently after a sale.
The total amount of excess earnings is capitalized (e.g, the difference in earnings is divided by
some expected rate of return) and this result is then added to the appraised value of net assets to
derive the value of the business.

Open market valuation

Open market value refers to the price of the assets of the company which could be fetched or
realized by negotiating sale provided there is a willing seller. Each asset of the company is
normally valued on the basis of liquidation as resale item rather than on a going-concern basis.
The assets of the company, which are not subject to regular sale, could be assessed on
depreciated or replacement cost. Besides, intangible assets like goodwill are also assessed as per
normal practices and recognized conventions.

70
Valuation based on earnings

Valuation based on earnings using the rate of return on capital employed is a common in use.
From the last earnings declared by a company, items such as tax, preference dividend, if any, are
deducted and net earnings are taken. An alternate to this method is the use of the price-earning
(P/E) ratio instead of the rate of return. The P/E ratio of a listed company can be calculated by
dividing the current price of the share by earning per share (EPS). Therefore, the reciprocal of
P/E ratio is called earnings – price ratio or earning yield.

Thus P/E = EPS where p is the current price of the shares. The share price can thus be
determined as p = EPS x P/E ratio.

SIGNIFICANCE OF P/E RATIO AND EPS

In practice, investors attach a lot of importance to the earnings per share (EPS) and the price-
earnings (P/E) ratio. The product of EPS and P/E ratio is the market price per share.

Exchange Ratio

The current market values of the acquiring and the acquired firms may be taken as the basis for
exchange of shares. The share exchange ratio (SER) is given as follows:

Share price / EPS /Net asset of the acquired firm

Share Exchange Ratio = Share Pr ice/ EPS/ Net asset of the acquiring firm

Example 1

Company A wishes to take over Company T by issuing its shares to shareholders of Company T.
Financial details of the two companies are as follows:

Company A Company T
¢ ¢
Equity shares 100,000,000 50,000,000
Income Surplus 38,000,000 6,000,000
Preference share 20,000,000 -
10% debentures 15,000,000 5,000,000
173,000,000 61,000,000
Fixed assets 122,000,000 35,000,000
Net current assets 51,000,000 26,000,000
173,000,000 61,000,000
Maintainable annual ¢24,000,000 ¢15,000,000
Profit (after tax) for
equity shareholders
Number of shares 10,000,000 5,000,000
Market price per equity share ¢ 24 ¢27
Price earning ratio 10 9

71
Required:

What offer do you think Company A could make to Company T in terms of exchange ratio,
based on net assets, earnings per share and market price per share

Solution
(a) Net assets
Company A Company T
Fixed Assets 122,000,000.00 35,000,000.00
Net current assets 51,000,000.00 26,000,000.00
Total assets 173,000,000.00 61,000,000.00
Less preference shares 20,000,000.00 -
Less 10% Debentures 15,000,000.00 5,000,000.00
Net assets 138,000,000.00 56,000,000.00

Divided by number of shares 10,000,000.00 5,000,000.00

Net asset per share 13.80 11.20
11. 20
= 0. 81
Exchange ratio = 13 . 80

(b) Exchange rario based on earnings per share

Company A Company T
Earnings after tax for equity holders 24000000.00 15000000.00
Divided by number of shares 1000000.00 5000000.00
EPS 2.4 3
3
= 1 .25
Exchange ratio = 2. 4
The shareholders of Company T should get 1.25 shares of company A for every share held by
them.

(ic) Exchange ratio based on market price per share

72
 27
= 1 .125
24

The shareholders of company T should get 1.125 shares of company A for every share held by
them

1. The exchange ratio based on the net asset value is the best from company A’s point of
view as this basis will require it to issue the minimum number of shares.

Try question

Kwabla Ltd. plans to acquire Kwabena Ltd. on a share exchange basis. You have been presented
with the following data:
Kwabena Ltd. Kwabena Ltd.
Profit after tax GH¢75,000 GH¢55,000
Earnings per share 7.5 5.5
Price earnings ratio 2 1
Number of shares 10,000 5,500
You are required to:

(i) Calculate the market price of each company before the acquisition
(ii) Calculate the exchange ratio Kwabla Ltd. should offer so as not to dilute its EPS
(iii) Calculate the exchange ratio Kwabla Ltd. should offer without diluting its market
value per share

Practice questions

1. What is valuation of a company?

2. Identify five (5) reasons why a company may be valued

3. Briefly explain six (6) factors that may influence a company’s valuation

4. Establish the relationship between earnings per share and price earnings ratio

5. KKK Ltd. plans to acquire JJJ on a share exchange basis. You have been presented with
the following data:
KKK Ltd. JJJ Ltd.
Profit after tax GH¢705,000 GH¢650,000
Earnings per share 7.05 6.84
Price Earnings ratio 4 2
Number of shares 100,000 95,000
You are required to:
(i) Calculate the market price of each company before the acquisition
(ii) Calculate the exchange ratio KKK Ltd. should offer so as not to dilute its EPS
Calculate the exchange ratio KKK Ltd. should offer without diluting its market value per share

73