Corporate Finance Study Guide 2015-2

Corporate Finance
MODULE 1
THE NATURE, SCOPE AND STRUCTURE OF CORPORATE

FINANCE
Discussion 1
1.0. INTRODUCTION TO THE STUDY OF CORPORATE FINANCE
1.1. Introduction
To understand issues of corporate finance we will start by examining the various

forms of organizations. We will also examine the general structure of
organizations. Our discussion will also critique the goals and controls of
organisations. The discussion will try to explain what corporate finance is, try to
relate corporate finance to other financial fields of study (financial management,
business finance etc.), explain the role(s) of the financial manager, discuss the
goal of corporate finance, and then analyse the financial management
environment.
1.2. Learning Outcomes
By end of this discussion, we should be able to:
a. Define Corporate Finance as a field of study.

b. Explain the goal, role and importance of corporate finance.
c. Demonstrate in-depth understanding of the scope and structure of
corporate finance.
d. Explain the common forms of business in Namibia.
e. Discuss the primary objective of for-profit organization.
f. Describe the finance manager’s business environment.
The International University of Management: SMBA 1

Corporate Finance
1.3. What is Corporate Finance?
 Corporate finance is the study of how organisations manage financial

resources of corporations. It is a branch of managerial finance. Managerial
finance is a study of that primarily focuses on how firms arrive at investment,
financing, working capital and dividend decisions.
 It is the area of finance dealing with the sources of funding and the capital
structure of corporations and the actions that managers take to increase the
value of the firm to the shareholders. It also includes the tools and analysis
used to allocate financial resources and used by financial managers to be
able to give financial advice.
 It is the study of how organisations’ financial resources may be efficiently and

effectively managed to maximise shareholders’ wealth.
 Corporate finance is primarily concerned with maximizing shareholder value

through long-term and short-term financial planning and the implementation of
various strategies.
 Everything from capital investment decisions, financing decisions, working

capital decisions, and dividend decisions to investment banking falls under
the domain of corporate finance.
1.4. Why is it important to study Corporate Finance?
 Because money is the ‘life-blood’ of every business i.e. the survival of every
business depends on availability of money since every activity of the business
needs money.

Corporate Finance
 Finance plays an important role in the health of the overall economy, which
impacts everyone, regardless of whether or not they have studied finance.
 Like companies, individuals are faced

with investment and financing decisions. Having a firm grasp of finance will
help individuals make those decisions.
 All businesses functions deal with finance because they need to be able to
make the financial argument for the funding of their projects and to manage
their budgets.
1.5. What is the role of Corporate Finance?
We need to be careful to draw a line between the role of the financial manager
and the role of corporate finance. The role of corporate finance refers to the part
played by corporate finance in the business in relation to the other functions in
the business. We look at a business as a whole made up of different functions
working coordinately toward common objectives. The organization has sales,
marketing, human resources, finance, operations etc. The activities in all these
functional units require money. Money in this context may be regarded as the
lifeblood of the organization. Since every functional unit above depends on
money, corporate finance’s role is to ensure the lifeblood of the organization is
properly managed. Proper management, in this case, means making the correct
financial decisions. The environment of corporate finance is all the activities that
are done to increase firm value. It involves the strategies and the techniques
available to finance managers which finance managers use to arrive at right
decisions.
1.6. The Concept of Organisation - What is an Organisation?

Corporate Finance
An organisation is a social unit of people that is structured and managed to meet

a need or to pursue collective goals. All organizations have a management
structure that determines relationships between the different activities and the
members, and subdivides and assigns roles, responsibilities, and authority to
carry out different tasks. Organizations are open systems--they affect and are
affected by their environment.
1.7. What is the Primary Objective of for-profit firms?
Organisations may be classified into two:
 Organisations that are in business for profit (for-profit organisations)

 Organisations that are in business not for profit (Not-for-profit
organisations)
In general, organisations have many objectives. The objectives range from
increasing market share, increasing sales, increasing productivity, and reducing
operation costs.
Both not-for-profit organisations and for-profit organisations have many

objectives. For-profit organisation, in addition to the many objectives, have one
primary objective which is; to maximise the wealth of shareholders. Maximisation
of shareholder wealth is same as maximising firm value.
1.8. What are the legal forms of businesses common to Namibia?
Organisations, like people, grow from infancy to adulthood. They may start as
sole proprietorships and grow into corporations through partnerships.
Sole proprietorships, partnerships and corporations each have their advantages

and disadvantages. The advantages and disadvantages range from life of
business, ability of the business to raise cash, and taxation. Noteworthy, as a
firm grows, the advantages of the corporate form may come to outweigh its
disadvantages.

Corporate Finance
1.8.1. Sole Proprietorship
A business runs by an individual. The owner is the business; the owner has all of
the profits and losses of the business. The owner also has all the control and all
the liability from the business operations. Business taxes are paid by the owner
through his or her personal income tax return.
Advantages:
 It is the simplest type of business to start.
 It is the least regulated form of organization (all you need is getting a

business license and opening your doors).
 The owner of a sole proprietorship keeps all the profits.
 Decisions are made quickly because there is no consultation.
Example: The many liquor outlets (shebeens) in Katutura, Windhoek.
Disadvantages:
 The owner has unlimited liability for business debts i.e. creditors can look
beyond business assets to the proprietor’s personal assets for payments.
 There is no distinction between personal and business income, so all

business income is taxed as personal income.
 The life of a sole proprietorship is limited to the owner’s lifespan. It can

collapse with the death of the owner.
 The amount of equity that can be raised is limited to the amount of the
proprietor’s personal wealth. This limitation often means that the- business
is unable to exploit new opportunities because of insufficient capital.

Corporate Finance
 Ownership of a sole proprietorship may be difficult to transfer because this

transfer requires the sale of the entire business to a new owner.
1.8.2. Partnership
A partnership is similar to a proprietorship, except that there are two or more

owners (partners). The partners share the profits/losses; have control and liability
for business operations. Partnership taxes are paid by the partners on their
personal tax returns, in proportion to their share of ownership.This form of
organization is common in real estate ventures. The advantages and
disadvantages of a partnership are basically the same as those of a
proprietorship.
Advantages:
 In a general partnership, all the partners share in gains or losses.
 In a limited partnership, liability for business debts is limited to the amount

that partner contributes to the partnership.
Disadvantages:
 All partners have unlimited liability for all partnership debts, not just some
particular share.
 A decision by one partner binds all partners.
 The partnership terminates when a general partner wishes to sell out or

dies.
 All income is taxed as personal income to the partners.
 The amount of equity that can be raised is limited to the partners’

combined wealth.

Corporate Finance
 Failure to spell out the rights and duties of the partners frequently leads to
misunderstandings later on
The disadvantages listed above add up to a single, central problem: the ability of
such businesses to grow can be seriously limited by an inability to raise cash for
investment.
1.8.3. Corporation
A corporation is a business which is set up as a separate legal entity (pseudo

persona) from its owners. The board of directors makes operational decisions.
Owners are protected (shielded) from liabilities of the corporation, and the
corporation pays corporate income taxes. The corporation is the most important
form (in terms of size) of business organization because of its unique
characteristics e.g. because it is a legal “person” separate and distinct from its
owners, and because it has many of the rights, duties, and privileges of an actual
person. Corporations can borrow money and own property, can sue and be sued,
and can enter into contracts.
The relative ease of transferring ownership, the limited liability for business
debts, and the unlimited life of the business are the reasons why the corporate
form is superior when it comes to raising cash. If a corporation needs new equity,
for example, it can sell new shares of stock and attract new investors.
Advantages:
Ownership (represented by shares of stock) can be readily transferred, and the

life of the corporation is therefore not limited.
 The corporation borrows money in its own name. As a result, the

stockholders in a corporation have limited liability for corporate debts.
The most they can lose is what they have invested.

Corporate Finance
Disadvantages:
 Because a corporation is a legal person, it must pay taxes.
 Moreover, money paid out to stockholders in the form of dividends is

taxed again as income to those stockholders. This is double taxation,
meaning that corporate profits are taxed twice i.e. at the corporate
level when they are earned and again at the personal level when they
are paid out.
1.8.4. Limited liability Company (LLC)
A business formed by members whose liability is limited to their investment. An

LLC is often used in place of partnerships to limit liability, while having the option
of being taxed through the personal tax returns of the members.
NB. Students are expected to be able to compare and contrast the above forms
of businesses and to know the advantages and disadvantages of each form of
business.
1.9. Why Does the Study of corporate Finance Focus on Corporations instead
of the other forms of Business?
Because corporation have unique characteristics that are essential to the study
of finance:
 Corporations are usually big and complex enough to give enough

challenges to the student of finance management. The size and complex
nature of corporation finances make it easier for one who has studied and
grasped management of corporation finances to handle/manage the
finances of the other smaller and less complex forms of business.

Corporate Finance
 Corporations (if listed on stock exchanges) may raise funds from members
of the general public. They can issue shares/stock.
 Corporations are ‘pseudo personas’ i.e. they can sue and can be sued in
courts of law.
1.10. The Scope and Structure of Corporate Finance-How does it compare with
other Finance Disciplines?
The study of corporate finance and managerial finance, business finance, and
financial management focuses on value creation. The focus is on what should be
done to increase the value of stock. An increase in the value of stock
automatically translates to increase in firm value or maximization of shareholder
wealth. At the centre of this increase in the value of stock is the financial
manager. Suffice to mention that the finance manager does not make the
decisions that increase firm value, rather, he/she recommends and or advises
the executive or top management on which right decisions to take in order to
maximize the value of stock.
Corporate finance explores in detail what is expected of a financial manager in

his/her advisory role. In short, the financial manager’s role revolves around the
following six areas of decision making, which areas make up the core structure of
the study of corporate finance:
1. Investment decisions (also known as capital budgeting or investment

appraisal). Capital budgeting or investment decisions are the financial
appraisal of projects. Under this area of study we seek to find out how
organisations (in particular financial managers) go about answering the
questions; what long-term investments should the business take? That is,
what lines of business should the firm be in and what sorts of buildings,
machinery, and equipment does the business need?

Corporate Finance
2. Financing decisions (also known as capital structure and capital mix

decisions). The questions to be asked and answered here are; where will
the firm get the long-term financing to pay for its investment? Will the firm
bring in other owners or will the firm borrow the money?
3. Working capital management decisions (also known as short-term

decisions). This is where the firm try to answer questions about how it will
manage its everyday financial activities such as collecting from customers
and paying suppliers.
4. Dividend decisions. Questions to be asked and answered are; What do we

do with profits made? Do we plow the profit back into the business or
distribute the profit to shareholders?
5. Integrated areas of financial management.
6. Financial analysis and planning.
The six highlighted above are not the only questions or areas studied in
corporate finance. They are, however, among the most important. Corporate
finance, broadly speaking, is the study of ways to answer the above questions.
Under each area of decisions, the finance managers have techniques, tools and
models (formulas) which they use to arrive at suitable courses of action, which
courses of action they advise management on.
Corporate finance is a specialized subset of managerial finance. Remember the

legal forms of business studied in business studies (sole proprietorship,
partnership and corporations). The corporation was highlighted as one of the
forms of business organizations, and the biggest of them all. Corporate finance
focuses on the management of financial resources in corporations. The rationale
of focus on the corporation for of business is that if we can understand the
management of finances in corporations (which are big and complex), there is

Corporate Finance
high likelihood that we will be able to manage the finances of the other smaller
forms of business (partnerships and sole proprietorships).
1.11. Why is it we focus on corporations in the study of Corporate Finance?
The corporation is the most important form (in terms of size) of business
organization. A corporation is a legal “person” separate and distinct from its
owners, and it has many of the rights, duties, and privileges of an actual person.
Corporations can borrow money and own property, can sue and be sued, and
can enter into contracts.
The relative ease of transferring ownership, the limited liability for business
debts, and the unlimited life of the business are the reasons why the corporate
form is superior when it comes to raising cash. If a corporation needs new equity,
for example, it can sell new shares of stock and attract new investors.
 Ownership (represented by shares of stock) can be readily transferred,

and the life of the corporation is therefore not limited.
 The corporation borrows money in its own name. As a result, the

stockholders in a corporation have limited liability for corporate debts.
The most they can lose is what they have invested.
 A corporation is a ‘legal person’, it owns assets, can sue and can be

sued in courts of law, and pay taxes.
 Moreover, money paid out to stockholders in the form of dividends is

taxed again as income to those stockholders. This is double taxation,
meaning that corporate profits are taxed twice i.e. at the corporate
level when they are earned and again at the personal level when they
are paid out.

Corporate Finance
1.12. The Goal of Financial Management
Assuming that we restrict ourselves to for-profit businesses, the goal of financial

management is to make money or add value for the owners. This goal is a little
vague, of course, so we examine some different ways of formulating it in order to
come up with a more precise definition. Such a definition is important because it
leads to an objective basis for making and evaluating financial decisions.
1.12.1 Possible Goals
If we were to consider possible financial goals, we might come up with some

ideas like; survive, avoid financial distress and bankruptcy, beat the competition,
maximize sales or market share, minimize costs, maximize profits, maintain
steady earnings growth, etc.
These are only a few of the goals we could list. Furthermore, each of these
possibilities presents problems as a goal for the financial manager.
For example, it is easy to increase market share or unit sales all we have to do is
lower our prices or relax our credit terms. Similarly, we can always cut costs
simply by doing away with things such as research and development. We can
avoid bankruptcy by never borrowing any money or never taking any risks, and
so on. It is not clear that any of these actions are in the stockholders’ best
interests. Profit maximization would probably be the most commonly cited goal,
but even this is not a very precise objective. Do we mean profits this year? If so,
then we should note that actions such as deferring maintenance, letting
inventories run down, and taking other short-run cost-cutting measures will tend
to increase profits now, but these activities are not necessarily desirable.

Corporate Finance
The goal of maximizing profits may refer to some sort of long-run or average
profits, but it is still unclear exactly what this means. First, do we mean
something like accounting net income or earnings per share? As we will see in
succeeding discussions, these accounting numbers may have little to do with
what is good or bad for the firm. Second, what do we mean by the long run?
More to the point, this goal does not tell us what the appropriate trade-off is
between current and future profits. The goals we have listed here are all different,
but they do tend to fall into two classes. The first of these relates to profitability.
The goals involving sales, market share, and cost control all relate, at least
potentially, to different ways of earning or increasing profit. The goals in the
second group, involving bankruptcy avoidance, stability, and safety, relate in
some way to controlling risk. Unfortunately, these two types of goals are
somewhat contradictory. The pursuit of profit normally involves some element of
risk, so it is not really possible to maximize both safety and profit. What we need,
therefore, is a goal that encompasses both factors.
1.12.2 The Goal of Financial Management (in detail)
The financial manager in a corporation makes decisions for the shareholder or

owners of the firm. Given this, instead of listing possible goals for the financial
manager, we really need to answer a more fundamental question: From the
shareholders’ point of view, what is a good financial management decision?
If we assume that shareholders buy stock or shares because they seek to gain
financially, then the answer is obvious: good decision increases the value of the
stock or share, and poor decisions decrease the value of the stock or share.
Given our observations, it follows that the financial manager acts in the
shareholders’ best interests by making decisions that increase the value of the
stock. The appropriate goal for the financial manager can thus be stated quite
easily;

Corporate Finance
The goal of maximizing the value of the stock avoids the problems associated
with the different goals we listed earlier. There is no ambiguity in the criterion,
and there is no short-run versus long-run issue. We explicitly mean that our goal
is to maximize the current stock value.
If this goal seems a little strong or one-dimensional to you, keep in mind that the
shareholders in a firm are residual owners. By this we mean that they are only
entitled to what is left after employees, suppliers, and creditors (and anyone else
with a legitimate claim) are paid their due. If any of these groups go unpaid, the
shareholders get nothing. So, if the shareholders are winning in the sense that
the leftover, residual, portion is growing, it must be true that everyone else is
winning also.
Because the goal of financial management is to maximize the value of the stock,
we need to learn how to identify those investments and financing arrangements
that favourably impact the value of the stock. This is precisely what we will be
studying in contemporary managerial finance. In fact, we could have defined
managerial finance as the study of the relationship between business decisions
and the value of the stock in the business.
The goal of financial management is to maximize the value of the firm. This
can be achieved by maximizing the current value of shares or stock
1.12.3. A More General Goal
Given our goal as stated in the preceding discussion an obvious question comes
up:
What is the appropriate goal when the firm has no trade stock?

Corporate Finance
From our earlier discussion on the forms of business common to Namibia, we

can safely say corporations are not the only type of business; and the stock in
many corporations rarely changes hands, so it is difficult to say what the value
per share is at any given time.
As long as we are dealing with for-profit businesses, only a slight modification is

needed. The total value of the stock in a corporation is simply equal to the value
of the owners’ equity. Therefore, a more general way of stating our goal is as
follows:
The goal of financial management, and also the goal of every for-profit
organization is to maximize the market value of the existing owners’ equity.
With this in mind, it does not matter whether the business is a proprietorship, a
partnership, or a corporation. For each of these, good financial decisions
increase the market value of the owners’ equity and poor financial decisions
decrease it.
As you may have seen by now, our goal does not imply that the financial
manager should fluke illegal or unethical actions in the hope of increasing the
value of the equity in the firm. What we mean is that the financial manager best
serves the owners of the business by identifying goods and services that add
value to the firm because they are desired and valued in the free marketplace.
1.12.4. The Primary Goal of the Firm and the Stakeholder Concept-Who to please?
Organisations do not exist or operate in a vacuum, but in an environment where

there are various publics. These various publics have a stake (stake means
interest) in the organization. The firm, thus, is like a goose laying the ‘golden
eggs’ for all the publics.

Corporate Finance
Shareholders
Government
Maximisation of
Taxes,
wealth or firm
Compliance
value
with laws
Financiers
Repayment of
Suppliers Firm loans given to
Payment for the firm
goods/services Goose laying
supplied to firm golden eggs
on credit
Customers
Good
Employees products &
Salaries & Community services
working Corporate
conditions Social
Responsibility
The finance managers are expected to play a balancing game i.e. not to ignore
the interests of shareholders. This raises two questions; if the various publics’
interests are to be observed, how can the firm maximize the wealth of the
shareholders? By admitting that the primary goal of for-profit firms is to maximize
the wealth of shareholders, are we not saying the finance managers should
concentrate on the interests of the shareholders only? The answer to the first
question is the firm can maximize the wealth of the shareholders and at the same
time observe the interest of the other publics. The answer to the second question
is, No! The finance managers should not concentrate on shareholders only. The
point to note here is although all the publics mentioned above are equal in
importance, some are more equal than others. The shareholders are more equal
than the other shareholders. He who pays the piper calls the tune. The
shareholders, by virtue of being the contributors of capital, call the shots. The

Corporate Finance
have the power to hire and fire the managers. As such the managers can ignore
them at their peril.
The long and short of it is that since shareholders control the firm then
shareholder wealth maximization is the relevant goal of the corporation.
However, this is not to say management will stop trying to advance its interest:
there will undoubtedly be times when management goals are pursued at the
expense of the shareholders, at least temporarily, since such management’s
days in office are always numbered.
1.13. Is the primary objective of wealth maximization the same as profit

maximization?
The underlying assumption of the theory of finance states that the primary
objective of the firm is the maximisation of shareholder wealth. Shareholder
wealth maximisation is achieved by maximising the value of the firm. Maximising
firm value translates to maximisation of shareholder wealth maximisation
because shareholders are the legal owners of the firm. By virtue of being owners
of the firm, all net profit belongs to them. Thus the greater the value of the firm
after liabilities, the greater the wealth of the shareholders. The value of the firm
and shareholder wealth are represented by the market price of the firm's shares,
which is the amount a shareholder could obtain for selling his part of the
business as a going concern.
Maximisation of business profits is often seen as the main objective. Does that
mean profit maximisation is the same as shareholder wealth maximisation? The
fact of the matter is although the profit objective is very important, it must not be
pursued blindly.
There are situations when we can increase profit while reducing firm value and
consequently reduce shareholder wealth. One scenario is when a firm raises

Corporate Finance
capital to undertake an investment with the aim of increasing profit, but such an
investment resulting in the fall of earnings per share. If raising capital increases
shareholders who participate in the sharing of the profits more than the
proportional increase in profit, the result will be increase in profit and fall in
earnings per share.
Example: A firm currently has 200,000 shares in issue and projected profits of
N$50,000, thus earnings per share (EPS) of 25 cents. If the firm issues a further
100,000 N$1 shares to invest in a project which will give a 10% return on
investment, then expected profits will increase by N$10,000. Note that there are
now 300,000 shares in issue, and the EPS has fallen to 20 cents (N$10,000 +
N$50,000/300,000 shares). The falling EPS causes the share price to drop, and
shareholder wealth is therefore also reduced.
1.14. The role and environment of Corporate Finance
We need to be careful to draw a line between the role of the financial manager
and the role of managerial finance. By role of managerial finance we refer to the
part played by managerial finance in the business in relation to the other
functions in the business. A business is a whole made up of different functions
working coordinately toward common objectives. The organization has sales,
marketing, human resources, finance, operations etc. The activities in all these
functional units require money. Money in this context may be regarded as the
lifeblood of the organization. Since every functional unit above depends on
money, managerial finance’s role is to ensure the lifeblood of the organization is
properly managed. Proper management, in this case, means making the correct
decisions. The environment of managerial finance is all the activities that are
done to increase firm value. It involves the strategies and the techniques used at
the disposal of the finance managers which are used to arrive at the right
decisions.
1.15. Conclusion

Corporate Finance
Managerial finance is the study of how financial resources may be efficiently and
effectively managed to increase the value of the firm. Unlike corporate finance
which focuses on corporations, managerial finance covers all the forms of
business organisations; sole proprietorship, partnership and the corporation. At
the centre of both managerial finance and corporate finance is creation of value,
which is achieved by taking decisions that increase the current market value of
the firm’s stock. Money is regarded the lifeblood of the firm. The finance manager
plays a very significant role in managerial finance as the chief advisor. There are
four critical areas of decision making which the finance manager has to contend
with, namely investment decisions also known as capital budgeting, financing
decisions also known as capital structure, dividend and working capital
management. We will carry on with our discussions in detail in the succeeding
sections of the Study Guide.
1.15. Review Questions
1. What do you understand by corporate finance?
2. Explain the goals of financial management.
3. What are the forms of business available in the current world scenario?
4. What are the four types of financial management decisions and what
questions are they designed to answer?
5. What does a financial manager do?
6. What is the difference between a financial manager and an accountant?
7. What are the three main decisions that a financial manager has to make?
8. Which side of the balance sheet is influenced by capital budgeting decisions?

Corporate Finance
9. Which side of the balance sheet is influenced by the capital structure decision?
10. What are the two ways in which investor or shareholder wealth can be
increased?
11. What is the main goal of financial management?
12. Which goal is short term and which is both short term and long term?
13. Explain the relationship of financial market and corporation.
14. What are agency problems and why do they exist within a corporation?
15. “Financial management and accounting are not different. Financial
management is a discipline of accounting that deals with investment and
financing decisions. This is why most treasurers are accountants”. Discuss.
16. “Profits and wealth maximization are the same since whether you use a
profit-based goal or a wealth based goal the final decisions are the
same”. Discuss.
17. In the USA, Europe and other developed economies there is now
apparently an abuse of profit-linked remuneration by Chief Executives who
become instant millionaires through these packages. The abuse has
reached high proportions such that some Chief Executives are ashamed
of the practice and are refusing the remunerations. Think of, or
research on what some of these practices might be and how the

Corporate Finance
shareholders can make sure that goal congruence is achieved.

Corporate Finance
Discussion 2
2.0. THE AGENCY-PRINCIPAL RELATIONSHIPS:- WHY ALWAYS FIGHT?
2.1. Introduction
In Discussion 2 we mentioned that organization, like people, grow from infancy to

adulthood. They grow in size from sole proprietorship to corporation through
partnership.
We described a sole proprietorship as a business managed an individual; the

owner. As the business grows it becomes difficult to be managed by one person.
Professionals are employed to help in managing the business. Sometimes the
owner(s) leave the entire management of the business in the hands of hired
managers. This arrangement creates an agent-principal relationship.
a. Explain the sources of conflict in agent-principal relationships.

b. Discuss strategies for reducing agent-principal conflict.
2.3. Goal Congruence –The need for common interests
There is need for financial managers to act in the best interests of the
shareholders. Financial managers are acting in the interest of shareholders if
they recommend decisions that increase the value of the stock. If decisions
recommended by finance managers increase firm value then there is goal
congruence since increasing firm value results in shareholder wealth
maximization.

Corporate Finance
We need to mention here that in large corporations ownership is usually spread

over many shareholders. In the introduction to this discussion we mentioned that
corporations are managed by hired professionals on behalf of the owners. This
dispersion of ownership arguably means that management effectively controls
the firm. This brings the questions; will management necessarily act in the best
interest of the shareholders? Is management not going to be tempted to pursue
its own goals at the expense of the shareholders’ wealth maximization goal?
2.4. Agency Relationships
In most medium-sized and large firms the owners of the firm are not the
managers. Professional managers are employed from outside the firm to manage
the firm. This brings about an agency-principal relationship between
shareholders and management. Agency come into being whenever someone
(the principal) hires another (the agent) to represent his/her interests. For
example, you might hire someone/an agent) to sell a car that you own while you
are away at school. Agency relationships give rise to the problem of monitoring to
make sure managerial actions maximize shareholder’s wealth. The need for
monitoring arises because managers do not always make decisions that are in
the interest of the owners. The objectives of managers (getting huge
remuneration, maximizing fringe benefits, keeping their jobs etc.). Sometimes
managers use short-terms horizons whereas the owners think long-term.
Managers usually have different attitude to risk than the owners. Agency-
principal relationships are, as a result, often marred by conflicts- conflict of
interest between the principal and the agent. Such a conflict is called an agency
problem.
Suppose that you hire someone to sell your car and that you agree to pay that
person a flat fee when he/she sells the car. The agent’s incentive in this case is
to make the sale, not necessarily to get you the best price. If you offer a

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commission of, say, 10% of the sales price instead of a flat fee, then this problem
might not exist. This example illustrates that the way in which an agent is
compensated is one factor that affects agency problems.
2.5. Management Goals
To see how management and shareholder interests might differ, imagine that the
firm is considering a new investment. The new investment is expected to
favourably impact the share value, but it is also a relatively risky venture. The
owners of the firm will wish to take the investment (because the stock value will
rise), but management may not because there is the possibility that things will
turn out badly and management jobs will be lost. If management does not take
the investment, then the stockholders may lose a valuable opportunity. This is
one example of an agency cost.
More generally, the term agency costs refers to the costs of the conflict of
interest between shareholders and management. These costs can be indirect or
direct. An indirect agency cost is a lost opportunity, such as the one we have just
described. Direct agency costs come in two forms. The first type is a corporate
expenditure that benefits management but costs the shareholders. Perhaps the
purchase of a luxurious and unneeded corporate jet would fall under this
heading. The second type of direct agency cost is an expense that arises from
the need to monitor, management actions. Paying outside auditors to assess the
accuracy of financial statement information could be one example.
It is sometimes argued that, left to themselves, managers would tend to

maximize the amount of resources over which they have control or, ‘more
generally, corporate power or wealth. This goal could lead to an overemphasis
on corporate size or growth. For example, cases in which management is
accused of overpaying to buy up another company just to increase the size of the

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business or to demonstrate corporate power are not uncommon. Obviously, if

overpayment does take place, such a purchase does not benefit the
shareholders of the purchasing company.
Our discussion indicates that management may tend to overemphasize

organizational survival to protect job security. Also, management may dislike
outside interference, so independence and corporate self-sufficiency may be
important goals.
2.6. What factors affect manager and shareholder goal congruence?
Whether managers will, in fact, act in the best interest of shareholders depends
on two factors. First, how closely are management goals aligned with
shareholder goals? This question relates to the way managers are compensated.
Second, can management be replaced if they do not pursue shareholder’s goal?
This issue relates to control of the firm. As we will discuss, there are a number of
reasons to think that, even in the largest firms, management has a significant
incentive to act in the interests of shareholders.
2.7. Managerial Compensation
Management will frequently have a significant economic incentive to increase

share value for two reasons:
1. Managerial compensation, particularly at the top, is usually tied to

financial performance. For example, managers are frequently given the
option to buy stock at a bargain price. The more the stocks is worth,
the more valuable is this option. In fact, options are increasingly being
used, to motivate employees of all types. Not just top management.
For example, in 2001, Intel announced that it was issuing new stock
option to 80,000 employees, thereby giving its workforce a significant

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stake in its stock price and better aligning employee and shareholder
interests. Many other corporations, large and small, have adopted
similar policies. Can you think of some firms that have done this in
Namibia?
2. Job prospects. The second incentive managers have relates to job

prospects: ‘Better performers within the firm will tend to get promoted.
More generally, those managers who are successful in pursuing
shareholder goals will be in greater demand in the labour market and
thus command higher salaries. In fact, managers who are successful in
pursuing shareholder goals can reap enormous rewards.
2.8. Review Questions
1. What is the agency problem?

2. What is an agency relationship?
3. Which are the two parties involved in the agency relationship?
4. What are agency problems and how do they come about?
5. Give two examples of direct agency costs.
6. What are the two forms of managerial compensation to control agency costs?
7. What incentives do managers in large corporations have to maximize share
value?

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Discussion 3
3.0. FINANCIAL MARKETS AND THE FINANCIAL SYSTEM
3.1. Introduction
The world is made up of systems. A system is a collection of people, institutions,

activities, processes and procedures working co-ordinately to achieve common goals. In
finance, we talk of the financial system which is the collection of people, institutions,
activities, processes and procedures that are involved in the transfer of money between
the savers (or surplus sectors of the economy) and borrowers (the deficit or financial
needy sectors of the economy).
The place and job of a financial manager is in the middle of the financial system. The
financial manager’s job involves dealing with a set of complex and closely
interconnected financial people, financial institutions, financial processes, financial
markets, financial instruments, services, practices, and transactions.
In this discussion we look at how the financial systems allocate financial resources in an
economy. We examine how financial resources are channelled from household savings
to the needy corporate sector for investment purposes.
3.2. Outcomes of Learning
1. By the end of this discussion we should be able to:

2. Define financial markets
3. Define the financial system.
4. Describe how financial markets and the financial system channel financial
resources.
5. Explain the role of financial markets and the financial system.
6. Identify the main players in financial markets and the financial system.
7. Discuss the types of financial markets
8. Classify financial markets.

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3.3. What is a Financial Market?
A market is a place, environment or medium where trade takes place.
A financial market is a place, environment or medium where financial goods (or

financial assets, financial securities) are traded. We can look at a financial
market as a mechanism that allows people to buy and sell financial securities
(such as stock and bonds) and items of value at low transaction costs.
NB. It is important to note that a market is not ALWAYS a physical place. It can
be a simple environment or medium in which trade (i.e. buying & selling) takes
place.
Markets work by putting buyers and sellers of financial securities in one ‘place’ or
‘environment’ thus making easier for them to find each other.
3.4. What is a Financial System?
A financial system can be defined at the global, regional or firm specific level:
Firm level: The set of implemented procedures that track the financial activities of
the company.
Regional level: The system that enables lenders and borrowers to exchange
funds.
Global level: A broader regional system that encompasses all financial

institutions, borrowers and lenders within the global economy.
In the study of finance, the financial system is the system that allows the transfer
of money between savers (and investors) and borrowers. Gurusamy, writing
in Financial Services and Systems has described it as comprising a set of
complex and closely interconnected financial institutions, markets, instruments,
services, practices, and transactions.
3.5. What is the role of financial markets and the financial system?

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Franklin Allen and Douglas Gale in Comparing Financial Systems: write;

"Financial systems are crucial to the allocation of resources in a modern
economy. They channel household savings to the corporate sector and allocate
investment funds among firms; they allow inter-temporal smoothing of
consumption by households and expenditures by firms; and they enable
households and firms to share risks. These functions are common to the financial
systems of most developed economies. Yet the form of these financial systems
varies widely.
We can summarise the role of financial markets as the mobilisation of funds from
the surplus sectors of the economy and channelling the funds to deficit sectors of
the economy. The role(s) of financial markets’ involve:
 The raising of capital

 Transferring risk
 International trade
3.5. How does the financial system function?
3.6.1. In what way does this role positively affect economies?

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By mobilising and re-channelling of funds (i.e. capital), financial markets and the
financial system are a driving force in economies since they are places or an
environment where the fuel of economies i.e. money, is made available to propel
the machine forward, i.e. to generate wealth and economic growth.
3.6.2. Where is money mobilised from and channelled to?
• Supply agents (i.e. mainly households and to a lesser extent, firms) have
"positive savings capacity", i.e. from savings (because they spend less
than they receive) and sales respectively. Although firms generally prefer
to reinvest profits or distribute dividends to shareholders, they often bank
the proceeds from their daily sales. Households are the only net supplier
of funds.
• Deficit Sectors. Users of funds. Households, corporations, and

governments can all be deficit units.The funds are channelled to this
needy side or demand side. Governments need cash to be able to provide
public goods (such as roads, dams, schools, hospitals etc.). Firms need
funds for start-up business ventures and for re-investment. Governments
and firms, thus, have "financing requirements".
3.7. What are the types of financial markets?
 Primary Markets – markets in which corporations raise funds through new

issues of securities, such as stocks and bonds. The term primary suggests
the financial instruments or assets are being traded for the first time. May
be first-time issues by firms initially going public, or may be the sale of
additional new shares of an already publicly traded firm, or first time debt
issuances.
 Secondary Markets – markets in which existing securities are traded.

The term secondary suggests the financial instruments or assets are
being traded for the second plus time i.e. they are second hand assets.

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 Money Markets – markets that trade debt instruments with short maturities
of up to one year. Examples are Treasury Bills (TBs), Commercial Paper
(CP), Negotiable Certificates of Deposits (CODs), Repurchase
Agreements, and Banker’s Acceptances (BAs).
 Capital Markets – markets that trade equity and debt instruments with
maturities of more than one year. These are markets where funds for
long-term investment purposes is raised or traded. Examples include
stocks, bonds, and mortgages.
 Organized Exchanges – physical meeting place and communication

facilities are provided for members to conduct their transactions.
 Over-the-Counter (OTC) markets – no central location. Financial claims

can be traded by phoning an OTC dealer or by using a computer system.
3.8. Who are the main players in financial markets?
a. Financial Institutions: These are institutions that serve as intermediaries

because markets are not perfect. Financial institutions may be divided broadly
into to two i.e. depository institutions and non-depository institutions:
Depository Institutions: These receive deposits and make loans. Examples are:
 Commercial Banks. The most dominant depository institution.
 Savings Institutions. These take in deposits and provide mortgage loans.
 Credit Unions. These take in deposits and provide retail loans.
Non-depository Financial Institutions: These are financial institutions that do not

accept deposits from consumers. They are generally called Finance Companies.
Examples are:
 Consumer finance companies
 Business finance companies
 Sales finance companies
 Mutual Funds – primary investment tool of many households.

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 Securities Firms – multiproduct firms that usually specialize in several

market related activities.
 Hedge Firms – sells shares to upscale investors and are allowed to invest
in risky assets. Largely unregulated.
 Insurance Companies – receive money from premiums and invest in

financial securities.
 Pension Funds – Governments and companies allow employees to invest

money in securities.
3.9. How are Financial Markets classified?
Classification of financial markets is not the same as types of financial markets.

Financial markets are classified according to:
 Asset Duration. This is classification according to the length of asset life.

In this class we have the money market and the capital market;
-Short-term (maturity < 1 year) Money Market
-Long-term (maturity > 1 year) Capital Market
 Nature of claim. This is classification according whether the asset is debt

or equity. In this class we have debt markets and equity markets.
 Newness of issue. This is classification on the basis of whether the

financial asset is being traded for the first time or second plus time. In this
class we have the Primary Market in which new security issues are sold to
buyers for the first times, and we also have Secondary Market in which
securities previously issued are bought and sold for the second plus time.
 Nature of market. This is classification according to how trading is

conducted in the market. In this class we have Exchange Market where

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the trade is conducted in central locations (e.g., Namibia Stock Exchange,

New York Stock Exchange, Chicago Commodity etc.), and we also have
the Over-the-Counter Market in which dealers at different locations buy
and sell.
 Geographical coverage. This is classification in terms of the size of

market. In this class we find world market, national markets, regional
markets, and local markets
 Time of discharge. This is classification in terms of immediateness of

discharge i.e. whether transactions are finalized promptly or at some
future date. In this class we find spot market and the futures markets
3.10. What are the examples of financial products?
In this study guide the terms financial assets, financial instruments, financial
tools, financial commodities and financial goods and financial commodities will be
used interchangeably. In later discussions we shall explain how they differ from
financial claims and financial securities. Examples of financial assets or
securities include; bonds, stock, treasury bills, commercial paper, deposits,
certificate of deposits, futures, swaps, forwards, options etc.
3.11. How may financial instruments be classified?
Financial instruments can be categorized by form depending on whether they

are cash instruments or derivative instruments:
 Cash instruments are financial instruments whose value is determined

directly by the markets. They can be divided into securities, which are
readily transferable, and other cash instruments such as
loans and deposits, where both borrower and lender have to agree on a
transfer.

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 Derivative instruments. These are financial instruments which derive their

value from the value and characteristics of one or more underlying entities
such as an asset, index, or interest rate. They can be divided
into exchange-traded derivatives and over-the-counter derivatives.
Alternatively, financial instruments can be categorized by asset class depending

on whether they are equity based (reflecting ownership of the issuing entity)
or debt based (reflecting a loan the investor has made to the issuing entity). If it is
debt, it can be further categorised into short term (less than one year) or long
term.
Foreign Exchange instruments and transactions are neither debt nor equity
based and belong in their own category.
Combining the above methods for categorization, the main instruments can be
organized into a table as follows:
Instrument Type
Asset Class Securitie Exchange –traded
Other cash OTC derivatives
s derivatives
Interest rate swaps,
Bond futures Interest rate caps and
Debt (long term)
Bonds Loans Options on floors, Interest rate
> 1 year
bond futures options, Exotic
derivatives
Bills,
Deposits,
Debt (short term) e.g. TBs, Short-term interest Forward rate
Certificate of
≤ 1 year Commerci rate futures agreements
deposits
al paper
Stock options, Stock options, Exotic
Equity Stock N/A
Equity futures derivatives
Foreign exchange
options, Outright
Foreign Spot foreign
N/A Currency futures forwards, foreign
exchange exchange
exchange swaps,
currency swaps

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3.12. Progress Review Questions
1. Financial markets have the basic function of:
a. Getting people with funds to lend together with people who want to borrow
funds.
b. Assuring that the swings in the business cycle are less pronounced.
c. Assuring that governments need never resort to printing money.
2. Which of the following can be described as involving direct finance?
a. A corporation takes out a loan from a bank.

b. People buy shares in a mutual fund.
c. A corporation buys commercial paper issued by another corporation.
d. An insurance company buys shares of common stock in the over-the-
counter markets.
3. Which of the following are short-term financial instruments?
a. A negotiable certificate of deposit.

b. A banker’s acceptance.
c. A six-month loan.
d. A Bank of Namibia Treasury bill.
e. All of the above.
3. An important financial institution that assists in the initial sale of securities in
the primary market is the;
a. investment bank.
b. commercial bank.
c. stock exchange.
d. brokerage house.
5. The assets of commercial banks include;

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a. mortgages.
b. consumer and business loans.
c. Namibia government securities.
d. all of the left or above.
6. The problem created by asymmetric information before the transaction occurs

is called …………………, while the problem created after the transaction
occurs is called…………………...
a. adverse selection; moral hazard

b. moral hazard; adverse selection
c. costly state verification; free-riding
d. free-riding; costly state verification
8. What are financial markets?
9. What is a money market?
10. What is the difference between primary and secondary markets?
11. What is the role of the financial institutions in the business environment?
12. How are financial markets and financial intermediaries related in the flow of funds?

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Discussion 4
4.0. TIME VALUE OF MONEY
4.1. Introduction
In this discussion we discuss the proverbial adage “a bird in hand is better than
two in the bush’. We discuss the investors’ preference for money.
By the end of this discussion we should be able to:
1. Explain factors underlying investors’ preference for money.

2. Calculate future values of money using simple interest and compound
interest.
3. Calculate present values of money.
4. Apply the Time Value of Money concept into real life situations.
4.3. Time Value of Money
Investors have time preference for money. Having preference means that
investors would rather have money today than receiving the same amount of
money in the future. Money can be invested to earn interest. If you are offered
the choice between N$10,000 now and N$10,000 at the end of three years, you
naturally take the money now to get three years’ interest. Financial managers

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make the same point when they say that money in hand today has a time value
or when they quote perhaps the most basic financial principle:
A dollar today is worth more than a dollar tomorrow
Suppose you have won a cash prize of N$10,000 and you have two
options to receive the N$10,000 now (option A) or to receive the N$10,000
at the end of three years (option B). Which option would you choose?
4.4. What Is Time Value?
From our N$10,000 cash prize above, most people would choose to
receive the N$10,000 now. This is because three years is a long time to
wait and a lot of things may happen between now and the end of three
years. Why would any rational person defer payment into the future when
he or she could have the same amount of money now? For most of us,
taking the money in the present is just plain instinctive. So at the most
basic level, the concept of time value of money demonstrates that, all
things being equal, it is better to have money now rather than later.
Think of reasons why most people would want to receive the N$10,000 now
instead of after three years.
We may want to find answers to the following questions; does N$10,000

received now have the same value as a N$10,000 received one year from
now or three years from now? Actually, although the N$10,000 is the
same, we can buy much more with the N$10,000 received now than we
can buy with the N$100 received after one year or after three years. This is
because with passage of time prices of goods and service have a
tendency of increasing thereby eroding the purchasing power of our
money. On the other hand, one who receives the N$10,000 now may

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deposit it in a fixed deposit account where it will earn some interest unlike
the one who will receive it after one year or after three years.
From our discussion, it is evident the N$10,000 received now is not having
same value as N$10,000 received next year or after three years. This is
because if we receive the N$10,000 today, we can increase the
N$10,000’s future value by investing it and gaining interest over a period of
time. In case of the second option (i.e. receiving the N$10,000 after three
years), we do not have time on our side, and the payment received in three
years would be our future value because we are receiving it in the future.
We can be revisit our example of Option A and Option B and illustrate the
concept of time value of money with a timeline:
If we choose Option A, our future value will be N$10,000 plus any interest
acquired over the three years. The future value for Option B, on the other
hand, would only be N$10,000 and there will be no interest on it because it
was not invested.
In practice, financial managers have ways of calculating exactly how

much more Option A is worth, compared to Option B.
4.5. Future Value Concept
Time value of money is important because most finance decisions that are made
in managerial finance have cash flows that occur in the future. To incorporate
time value of money future values and present values must be calculated. The
compound and discount rate used should reflect the real interest rate, inflation

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rate and the default and liquidity risk. Rate used is therefore a function of real
rate, inflation premium, default premium, and liquidity premium.
4.5.1. Future Values
The future value is the terminal value of an amount that is invested either as a
lump sum or periodically for a specified period, at a specified interest rate.
4.5.1 Future Value of a Lump sum investment
If a lump sum is invested for one year the future value will be:
Future Value = Principal + (Principal x Interest Rate)

= Pₒ + Pₒi
= Pₒ (1+ i)
Where:
Pₒ is the principal or amount invested.
i is an annual interest rate.
Example: Suppose we have N$100 invested in a bank account currently paying

an interest rate of 6% per year on deposits. After a year, your account will earn
interest of N$6;
Got by N$100 x 0.06 = N$6
You start the year with N$100 and you earn interest of N$6, so the value of your
investment will grow to N$106 by the end of the year:
Value of investment after 1 year = N$100 + N$6
= N$106

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Notice that the N$100 invested grows by the factor (1 + .06) = 1.06. In general,
for any interest rate i, the value of the investment at the end of 1 year is (1 + i)
times the initial investment:
Value after 1 year = initial investment × (1 + i)

= N$100 × (1.06)
= N$106
What if you leave this money in the bank for a second year? Your balance, now
N$106, will continue to earn interest of 6%. So;
Interest in Year 2 = N$106 x 0.06
= N$6.36
You start the second year with N$106 on which you earn interest of N$6.36. So
by the end of the year the value of your account will grow to N$106 + N$6.36 =
N$112.36.
In the first year your investment of N$100 increases by a factor of 1.06 to N$106;
in the second year the N$106 again increases by a factor of 1.06 to N$112.36.
Thus the initial N$100 investment grows twice by a factor 1.06:
Value of account after 2 years = N$100 × 1.06 × 1.06
= N$100 × (1.06)2
= N$112.36
If you keep your money invested for a third year, your investment multiplies by
1.06 each year for 3 years. By the end of the third year it will total N$100 ×
(1.06)3 = N$119.10, scarcely enough to put you in the millionaire class, but even
millionaires have to start somewhere.

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Clearly for an investment horizon of t years, the original N$100 investment will
grow to N$100 × (1.06)t. For an interest rate of r and a horizon of t years, the
future value of your investment or your formula cab be generalized for any period
t to be:
Future Value of N$100 = N$100 (1 + i)t
Notice in our example that your interest income in the first year is N$6 (6% of
N$100), and in the second year it is N$6.36 (6% of N$106). Your income in the
second year is higher because you now earn interest on both the original N$100
investment and the N$6 of interest earned in the previous year. Earning interest
on interest is called compounding or compound interest. In contrast, if the bank
calculated the interest only on your original investment, you would be paid simple
interest.
Example: Suppose you need N$3,000 next year to buy a new computer. The
interest rate is 8% per year. How much money should you set aside now in order
to pay for the purchase? All we need to do is to calculate the present value at an
8% interest rate of a N$3,000 payment at the end of one year. This value is:
Present Value = N$3,000

1.08
= N$2,778
Notice that N$2,778 invested for 1 year at 8% will prove just enough to buy your
computer:
Future value = N$2,778 × 1.08
= N$3,000

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The longer the time before you must make a payment, the less you need to
invest today. For example, suppose that you can postpone buying that computer
until the end of 2 years. In this case we calculate the present value of the future
payment by dividing $3,000 by (1.08)2:
N$3,000
Present Value = (1.08)2
= N$2,572
Thus you need to invest N$2,778 today to provide N$3,000 in 1 year but only
N$2,572 to provide the same N$3,000 in 2 years.
Future Value = N$2,778 x 1.08
= N$3,000
If we choose Option A and invest the total amount at a simple annual rate
of 7%, the future value of our investment at the end of the first year is
N$10,700. We get the N$10,700 by multiplying the principal amount (i.e.
the N$10,000) by the interest rate (i.e. the 7%) and then adding the
interest gained to the principal amount:
Future Value of N$10,000 at end of year 1 = (N$10,000 x 0.07) + N$10,000
= N$10,700
We can also calculate the total amount of a one-year investment with a

simple manipulation of the above equation:
 Original equation: (N$10,000 x 0.07) + N$10,000 = $10,700

 Manipulation: N$10,000 x [(1 x 0.07) + 1] = N$10,700
 Final equation: N$10,000 x (0.07 + 1) = N$10,700
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The manipulated equation above is simply a removal of the like-variable

N$10,000 (the principal amount) by dividing the entire original equation by
N$10,000.
Suppose the N$10,700 left in our investment account at the end of the first
year is left untouched and we invested it at 7% for another year, how much
would we have? To calculate this, we would take the N$10,700 and
multiply it again by 1.07 (0.07 +1). At the end of two years, we would have
N$11,449:
Future Value of N$10,000 at end of year 2 = N$10,700 x (1 + 0.07)
= N$11,449
The above calculation, then, is equivalent to the following equation:
Future Value = N$10,000 x (1+0.07) x (1+0.07)
= N$11,449
Think back to math class and the rule of exponents, which states that the
multiplication of like terms is equivalent to adding their exponents. In the
above equation, the two like terms are (1+0.07), and the exponent on each
is equal to 1. Therefore, the equation can be represented as follows:
Future Value = N$10,000 x

= N$10,000 x
= N$11,449
We can see that the exponent is equal to the number of years for which
the money is earning interest in an investment. So, the equation for
calculating the three-year future value of the investment would look like
this:
Future Value = N$10,000 x

= N$10,000 x
= N$12,250
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This calculation shows us that we do not need to calculate the future value
after the first year, then the second year, then the third year, and so on. If
you know how many years you would like to hold a present amount of
money in an investment, the future value of that amount is calculated by
the following equation:
4.6. Present Value Concept
Money can be invested to earn interest. If you are offered the choice between
N$100,000 now and N$100,000 at the end of the year, you naturally take the
money now to get a year’s interest. Financial managers make the same point
when they say that money in hand today has a time value or when they quote
perhaps the most basic financial principle:
A dollar today is worth more than a dollar tomorrow.
We have seen that N$100 invested for 1 year at 6 percent will grow to a future
value of 100 × 1.06 = N$106. Let’s turn this around: How much do we need to
invest now in order to produce N$106 at the end of the year? Financial managers
refer to this as the present value (PV) of the N$106 payoff.
Future value is calculated by multiplying the present investment by 1 plus the

interest rate, .06, or 1.06. To calculate present value, we simply reverse the
process and divide the future value by 1.06:
Present value = N$106

(1.06)
The International University= of Management: SMBA
$100 45
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After 2 years, if we do not know or forgot the answer, we just divide future value
by (1.06)2:
Present Value = N$112.36

(1.06)2:
In general, for a future value or payment t periods away, present value is:
= N$100
Present Value = Future value after t periods
(1 + i)ᵗ
In this context the interest rate i is known as the discount rate and the present
value is often called the discounted value of the future payment. To calculate
present value, we discounted the future value at the interest i.
The longer the time before you must make a payment, the less you need to
invest today. For example, suppose that you can postpone buying that computer
until the end of 2 years. In this case we calculate the present value of the future
payment by dividing N$3,000 by (1.08)2:
N$3,000
PV = (1.08)2 = N$2,572
Thus you need to invest N$2,778 today to provide N$3,000 in 1 year but only
N$2,572 to provide the same N$3,000 in 2 years.
If we receive N$10,000 today, the present value of the N$10,000 remains

unchanged i.e. N$10,000 because present value is what your investment
gives you now if you were to spend it today. If the N$10,000 were to be
received after a year, the present value of the amount would not be
N$10,000 because we do not have it in our hand now, in the present. To
find the present value of the N$10,000 received in the future, we need to

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pretend that the N$10,000 is the total future value of an amount that we
invested today. In other words, to find the present value of the future
N$10,000, we need to find out how much we would have to invest today in
order to receive that N$10,000 in the future.
To calculate present value, or the amount that we would have to invest

today, we must subtract the (hypothetical) accumulated interest from the
N$10,000. To achieve this, we can discount the future payment amount
(N$10,000) by the interest rate for the period. In essence, all we are doing
is rearranging the future value equation discussed above so that we may
solve for P. The above future value equation can be rewritten by replacing
the P variable with present value (PV) and manipulated as follows:
Let us walk backwards from the N$10,000 offered in Option B. We should

remember, the N$10,000 to be received in three years is really the same
as the future value of an investment. If today we were at the two-year
mark, we would discount the payment back one year. At the two-year
mark, the present value of the N$10,000 to be received in one year is:
Present Value of N$10,000 at end of year 2 = N$10,000 x

= N$9,346
Note that if today we were at the one-year mark, the above N$9,346 would
be considered the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive
the payment of N$10,000 in two years. At an interest rate of 7%, the
calculation for the present value of N$10,000 payment expected in two
years would be:

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Present Value of N$10,000 at end of year 1 = N$10,000 x
= N$8,734
Of course, because of the rule of exponents, we do not have to calculate

the future value of the investment every year counting back from the
N$10,000 investment at the third year. We could put the equation more
concisely and use the N$10,000 as FV. So, here is how we can calculate
today's present value of the N$10,000 expected from a three-year
investment earning 7%:
PV of N$10,000 received at end of year 3 = N$10,000 x
= N$8,163
So the present value of a future payment of N$10,000 is worth N$8,163

today if interest rates are 7% per year. In other words, choosing Option B
is like taking $8,163 now and then investing it for three years. The
equations above illustrate that Option A is better not only because it offers
you money right now but because it offers you N$1,837 (N$10,000 -
$8,163) more in cash. Furthermore, if you invest the N$10,000 that you
receive from Option A, your choice gives you a future value that is N$2,250
($12,250 - $10,000) greater than the future value of Option B.
4.7.1. Present Value of a Future Payment
Let us add a little spice to our investment knowledge. What if the payment
in three years is more than the amount we would receive today? Say we
could receive either N$13,000 today or N$18,000 in four years. Which
would we choose? The decision is now more difficult. If we choose to
receive N $13,000 today and invest the entire amount, we may actually
end up with an amount of cash in four years that is less than N$18,000.

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We could find the future value of N$13,000, but since we are always living
in the present, let us find the present value of N$18,000 if interest rates are
currently 7%. We must remember that the equation for present value is:
In the equation above, all we are doing is discounting the future value of an
investment. Using the numbers above, the present value of an N$18,000
payment in four years would be calculated as follows:
PV of N$18,000 received at end of year 4 = N$18,000 x
= N$13,732
From the above calculation we now know our choice is between receiving
N$13,000 or N$13,732 today. Of course we should choose to postpone
payment for four years!
4.7.2. Time is Money
The above calculations demonstrate that time literally is money - the value
of the money you have now is not the same as it will be in the future and
vice versa. So, it is important to know how to calculate the time value of
money so that you can distinguish between the worth of investments that
offer you returns at different times.
The time preference for money is caused by the following factors:
 Money received today can be invested to earn more money through

receipt of interest. This interest is at a real rate of interest. Delaying receipt
of money represents an opportunity cost that must be taken into account
in financial decision-making.

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 Inflation reduces the purchasing power of money. If money can purchase

more goods or services today than in the future there will be preference to
have the money today unless the money is received in the future is more
than what is received today.
 There is risk that money to be received may not be received. This is

default risk and must be taken into account when an investor makes a
decision to invest and receive a return in the future.
 If the investment is in a security, which is a financial asset, there is the risk

that the investor might not be able to liquidate the investment into cash at
a fair market price. This is called liquidity risk. This risk must be taken into
account in finance decisions.

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Discussion 5
5.0. FINANCIAL STATEMENTS, TAXES, AND CASH FLOW
5.1. Introduction
In this discussion we focus on financial statements, taxes, and cash flow. Our
objective is not to prepare financial statements, but to recognize that financial
statements are important in making financial decisions. We will briefly examine
financial statements with a view to pointing out some of their more relevant
features. Particular attention will be given to the two important differences:
a. Between accounting value and market value, and
b. Between accounting income and cash flow.

By the end of this discussion we should be able to:
1. Appreciate the importance of financial statements.
2. Explain the difference between market value and book value.
3. Explain the difference between accounting income and cash flow.

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4. Explain the difference between average and marginal tax rates.
5. Determine a firm’s cash flow from its financial statements.
5.3. The Balance Sheet
The balance sheet is summary of what the organisation owns (its net assets),
what the organisation owes (its liabilities), and the difference between the two
(the firm’s equity). The balance sheet is stated at a given date. It is therefore a
snapshot! A critical examination of the balance sheet will show that a balance
sheet is the accounting equation arranged differently. Note! The accounting
equation is; Assets = Capital + Liabilities. We will try to fit the accounting
equation into a simple balance sheet by a few illustrations.
Illustration 1: Suppose we start a business and deposit an initial capital of N$250

000 in the business’ Bank Windhoek cheque account. The transaction result in
the following accounting equation and or balance sheet:
Assets = Liabilities + Owner's Equity

+N$250 000 = N$0 + +N$250 000
Cash at bank
The asset “Cash” is increased by N$250 000 and the Owner’s Equity is also
increased by N$250 000. The business owes the owners N$250 000.
Illustration 2: The business purchases machinery on credit, for N$125 000. The
transaction will affect the accounting equation and hence the balance sheet as
follows.
Assets = Liabilities + Owner's Equity

Bank +N$ 250 000
Machine N$ 125 000 = N$125 000 + +N$250 000
Total N$ 375 000 Creditors

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The asset “Machinery” is increased by N$125 000 and the liability is also
increased by N$125 000.
As shown in the illustrations above, the right-hand side of the equation or

balance sheet lists the liabilities and equity.
Next we need to have a clear understanding of the terms used in our accounting
equation or balance sheet i.e. assets, capital and liabilities:
5.3.1 Assets: Assets are classified as either current or fixed. Some prefer the terms
current and non-current, respectively. A fixed asset or non-current asset is one
that has a relatively long life. Fixed assets can be either tangible (i.e. you can see
and touch them) i.e. plant and machinery, vehicles or a computer, or intangible
(i.e. you cannot see it or touch it) e.g. goodwill, trademark or patent. A current
asset has a life of less than one year. This means that the asset will convert to
cash within 12 months. For example, inventory would normally be purchased and
sold within a year and is thus classified as a current asset. Obviously, cash itself
is a current asset. Accounts receivable (money owed to the firm by its customers)
is also a current asset.
5.3.2. Liabilities and Owners’ Equity: The Right-Hand Side: The firm’s liabilities are
the first thing listed on the right-hand side of the balance sheet. These are
classified as either current or long-term. Current liabilities, like current assets,
have a life of less than one year (meaning they must be paid within the year) and
are listed before long-term liabilities. Accounts payable (money the firm owes to
its suppliers) is one example of a current liability.
A debt that is not due in the coming year is classified as a long-term liability. A
loan that the firm will payoff in five years is one such long-term debt. Firms
borrow in the long term from a variety of sources. We will tend to use the terms

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bond and bondholders generically to refer to long-term debt and long-term

creditors, respectively.
Finally, by definition, the difference between the total value of the assets (current
and fixed) and the total value of the liabilities (current and long-term) is the
shareholders’ equity, also called common equity or owners’ equity i.e. Capital =
Assets – Liabilities. This feature of the balance sheet is intended to reflect the
fact that, if the firm were to sell all of its assets and use the money to payoff its
debts, then whatever residual value remained would belong to the shareholders.
So, the balance sheet “balances” because the value of the left-hand side always
equals the value of the right-hand side. That is, the value of the firm’s assets is
equal to the sum of its liabilities and shareholders’ equity i.e.
Assets = Liabilities + Shareholders’ equity
This is the balance sheet identity, or equation, and it always holds because
shareholders’ equity is defined as the difference between assets and liabilities.
5.3.3. Net Working Capital. The difference between a firm’s current assets and its
current liabilities is called net working capital. Net working capital is positive when
current assets exceed current liabilities. Based on the definitions of current
assets and current liabilities, this means that the cash that will become available
over the next 12 months exceeds the cash that must be paid over that same
period. For this reason, net working capital is usually positive in a healthy firm.
The assets on the balance sheet are listed in order of the length of time it takes
for them to convert to cash in the normal course of business. Similarly, the
liabilities are listed in the order in which they would normally be paid, e.g.:
Fixed Assets Long-term Liabilities

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Plant & machinery Bonds

Furniture & fittings Long-term loan
Motor vehicles
Current Assets Short-term liabilities

Stock Trade creditors
Debtors
Bank
The structure of the assets for a particular firm reflects the line of business that
the firm is in and also managerial decisions about how much cash and inventory
to have and about credit policy, fixed asset acquisition, and so on.
The liabilities side of the balance sheet primarily reflects managerial decisions
about capital structure and the use of short-term debt.
There are three particularly important things to keep in mind when examining a
balance sheet: liquidity, debt versus equity, and market value versus book value.
5.4 Liquidity
Liquidity refers to the speed and ease with which an asset can be converted to
cash. Diamond and gold are relatively liquid assets; a plant and machinery are
not. Liquidity actually has two dimensions: ease of conversion versus loss of
value. Any asset can be converted to cash quickly if we cut the price enough. A
highly liquid asset is therefore one that can be quickly sold without significant
loss of value. An illiquid asset is one that cannot be quickly converted to cash
without a substantial price reduction. Assets are normally listed on the balance
sheet in order of decreasing liquidity, meaning that the most liquid assets are
listed first. Current assets are relatively liquid, and include cash and those assets
that we expect to convert to cash over the next 12 months. Accounts receivable,
for example, represents amounts not yet collected from customers on sales
already made. Naturally, we hope these will convert to cash in the near future.

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Inventory is probably the least liquid of the current assets, at least for many
businesses.
Fixed assets are, for the most part, relatively illiquid. These consist of tangible
things such as buildings and equipment that don’t convert to cash at all in normal
business; activity (they are, of course, used in the business to, generate cash).
Intangible assets, such as a trademark, have ‘no physical existence but can be
very valuable. Like tangible fixed assets, they won’t ordinarily convert to cash
and are generally considered illiquid. Liquidity is valuable. The more liquid a
business is, the less likely it is to experience financial distress (that is, difficulty in
paying debts or buying needed assets). Unfortunately, liquid assets are generally
less profitable to hold, For example, cash holdings are the most liquid of all
investments, but they sometimes earn no return at all if they just sit there. There
is therefore a trade-off between” the advantages of liquidity and forgone potential
profits.
5.5 Debt versus Equity
To the extent that a firm borrows money, it usually gives first claim to the firm’s
cash flow to creditors. Equity holders are only entitled to the residual value, the
portion left after creditors are paid. The value of this residual portion is the
shareholders’ equity in the firm, which is just the value of the firm’s assets less
the value of the firm’s liabilities:
Shareholders’ equity = Assets – Liabilities
This is true in an accounting sense because shareholders’ equity is defined as

this residual portion: More important, it is true in an economic sense: If the firm
sells its assets and pays its debts, whatever cash is left belongs to the
shareholders.
The use of debt in a firm’s capital structure is called financial leverage. The more
debt a firm has (as a percentage of assets), the greater is its degree of financial

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leverage. As we discuss in later chapters, debt acts like a lever in the sense that
using it can greatly magnify-both gains and losses. So, financial leverage
increases the potential reward to shareholders, but it also increases the potential
for financial distress and business failure.
5.6 Market Values and Book Values of Assets
5.6.1 Market Value versus Book Value
The values shown on the balance sheet for the firm’s assets are book values and
generally are not what the assets are actually worth. Under Generally Accepted
Accounting Principles (GAAP), audited financial statements in most countries

generally show assets at historical cost. In other words, assets are “carried on
the books” at what the firm paid for them, no matter how long ago they were
purchased or how much they are worth today.
For current assets, market value and book value might be somewhat similar
because current assets are bought and converted into cash over a relatively,
short span of time. In other circumstances, the two values might differ quite a bit.
Moreover, for fixed assets, it would be purely a coincidence if the actual market
value of an asset (what the asset could be sold for) were equal to its book value.
For example, a railroad might own enormous tracts of land purchased a century
or more ago. What the railroad paid for that land could be hundreds or thousands
of times less than what the land is worth today. The balance sheet would
nonetheless show the historical cost. The difference between market value and
book value is important for understanding the impact of reported gains and
losses.
We may need to note that changes in accounting rules may lead to reductions in
the book value of certain types of financial assets. However, a change in
accounting rules all by itself has no effect on what the assets in question are

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really worth. Instead, the market value of a financial asset depends on things like
its riskiness and cash flows, neither” of which have anything to do with
accounting.
The balance sheet is potentially useful to many different parties. A supplier might
look at the size of accounts payable to see how promptly the firm pays its bills. A
potential creditor would examine the liquidity and degree of financial leverage.
Managers within the firm can track things like the amount of cash and the amount
of inventory that the firm keeps on hand. Managers and investors will frequently
be interested in knowing the value of the firm. This information is not on the
balance sheet. The fact that balance sheet assets are listed at cost means that
there is no necessary connection between the total assets shown and the value
of the firm. Indeed, many of the most valuable assets that a firm might have-good
management, a good reputation, and talented employees-don’t appear on the
balance sheet at all.
Similarly, the shareholders’ equity figure on the balance sheet and the true value
of the stock need not be related. For financial managers, then, the accounting
value of the stock is not an especially important concern; it is the market value
that matters. Henceforth, whenever we speak of the value of an asset or the
value of the firm, we normally mean its market value. So, for example, when we
say the goal of the financial manager is to increase the value of the stock, we
mean the market value of the stock.
5.7. The Income Statement
The income statement measures performance over some period of time, usually
a quarter or a year. The income statement equation is:
Revenues - Expenses = Income

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If we think of the balance sheet as a snapshot, then you can think of the income
statement as a video recording covering the period between a before and an
after picture. The first thing reported on an income statement would usually be
revenue and expenses from the firm’s principal operations. Subsequent parts
include, among other things, financing expenses such as interest paid. Taxes
paid are reported separately. The last item is net income (the so-called bottom
line). Net income is often expressed on a per-share basis and called earnings per
share (EPS). The difference between net income and cash dividends is the
addition to retained earnings for the year. This amount is added to the cumulative
retained earnings account on the balance sheet.
5.7.1 Calculating Earnings and Dividends per Share
Suppose that CellOne Pty Ltd income statement showed net earnings amounting
to N$510 million and the company has 300 million shares outstanding at the end
of 2008. Question may be asked; what was CellOne’s EPS? What were
dividends per share? If total dividends were N$250 million and knowing that 300
million shares were outstanding, we can calculate earnings per share, or EPS,
and dividends per share as follows:
Earnings per share = Net income/Total shares outstanding
= N$510/300 = N$1.70 per share
Dividends per share = Total dividends/Total shares outstanding
= N$250/300 = N$0.83 per share
5.7.2 GAAP and the Income Statement
An income statement prepared using GAAP will show revenue when it accrues.
This is not necessarily when the cash comes in. The general rule (the realization
principle) is to recognize revenue when the earnings process is virtually complete

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and the value of an exchange of goods or services is known or can be reliably

determined. In practice, this principle usually means that revenue is recognized
at the time of sale, which need not be the same as the time of collection.
Expenses shown on the income statement are based on the matching principle.
The basic idea here is to first determine revenues as described previously and
then match those revenues with the costs associated with producing them. So, if
we manufacture a product and then sell it on credit, the revenue is realized at the
time of sale. The production and other costs associated with the sale of that
product will likewise be recognized at that time. Once again, the actual cash
outflows may have occurred at some very different time. As a result of the way
revenues and expenses are realized, the figures shown on the income statement
may not be at all representative of the actual cash inflows and outflows that
occurred during a particular period.
5.7.3 Non-Cash Items
A primary reason that accounting income differs from cash flow is that an income
statement contains non-cash items. The most important of these is depreciation.
Suppose a firm purchases an asset for N$50,000 and pays in cash. Obviously,
the firm has a N$50,000 cash outflow at the time of purchase. However, instead
of deducting the N$50,000 as an expense, an accountant might depreciate the
asset over a five-year period.
If the depreciation is straight-line and the asset is written down to zero over that
period, then N$50,000/5 = N$10,000 will be deducted each year as an expense.
The important thing to recognize is that this N$10,000 deduction is not cash but
just an accounting number. The actual cash outflow occurred when the asset
was purchased.

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The depreciation deduction is simply another application of the matching

principle in accounting. The revenues associated with an asset would generally
occur over some length of time. So, the accountant seeks to match the expense
of purchasing the asset with the benefits produced from owning it.
As we will see, for the financial manager, the actual timing of cash inflows and
outflows is critical in coming up with a reasonable estimate of market value, so
we need to learn how to separate the cash flows from the non-cash accounting
entries. In reality, the difference between cash flow and accounting income can
be very huge. For example, CellOne may report a net loss of even N$500 million
and also report a positive cash flow of N$400 million! The reason such a huge
difference may arise is that CellOne may be having big non-cash deductions
related to, among other things, the acquisition of signal equipment.
5.7.4 Time and Costs
It is often useful to think of the future as having, two distinct parts: the short run
and the long run. These are not precise time periods. The distinction has to do
with whether costs are fixed or variable. In the long run, all business costs are
variable. Given sufficient time, assets can be sold, debts can be paid, and’ so on.
If our time horizon is relatively short, however, some costs are effectively fixed
they must be paid no’ matter what (property taxes, for example). Other costs
such as wages to labourers and payments to suppliers are still variable. As a
result, even in the short run, the firm can vary its output level by varying
expenditures in these areas.
The distinction between fixed and variable costs is important, at times, to the
financial manager, but the way costs are reported on the income statement is not
a good guide as to which costs are which. The reason is that, in practice,

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accountants tend to classify costs as either product costs or period costs.

Product costs include such things as raw materials, direct labour expense, and
manufacturing overhead. These are reported on the income statement as costs
of goods sold, but they include both fixed and variable costs. Similarly, period
costs are incurred during a particular time period and might be reported as
selling, general, and administrative expenses. Once again, some of these period
costs may be fixed and others may be variable. The company president’s salary,
for example, is a period cost and is probably fixed, at least in the short run.
5.8 Cash Flow
By cash flow, we simply mean the difference between the number of dollars that
came in and the number that went out.
There is no standard financial statement that presents this information in the way
that we wish. However, there is a standard financial accounting statement called
the statement of cash flows, but it is concerned with a somewhat different issue
that should not be confused with what is discussed in this section. From the
balance sheet identity, we know that:
Assets = Liabilities + Equity
Similarly, the cash flow from the firm’s assets must equal the sum of the cash
flow to creditors and the cash flow to stock holders (or owners). The following
formulas summarise everything:
 Cash Flow From Assets (CFFA) = Cash Flow to Creditors (CFC) + Cash
Flow to Stockholders (CFS).

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 Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net
Capital Spending (NCS) – Changes in Net Working Capital (NWC)
 OCF (I/S) = EBIT + Depreciation – Taxes
 NCS (B/S & I/S) = ending net fixed assets – beginning fixed assets +
depreciation.
 Changes in NWC (B/S) = ending NWC –beginning NWC.
 CFC (B/S & I/S) = interest paid – net new borrowing.
 CFS (B/S & I/S) = dividends paid – net new equity raised.
This is the cash flow identity. It says that the cash flow from the firm’s assets is
equal to the cash flow paid to suppliers of capital to the firm. What it reflects is
the fact that a firm generates cash through its various activities, and that cash is
either used to pay creditors or paid out to the owners of the firm. We discuss the
various things that make up these cash flows next.
5.8.1. Cash Flow from Assets
Cash flow from assets involves three components: operating cash flow, capital
spending, and change in net working capital. Operating cash flow refers to the
cash flow that results from the firm’s day-to-day” activities of producing and
selling. Expenses associated with the firm’s financing of its assets are not
included because they are not operating expenses.
Capital spending refers to the net spending on fixed assets (purchases of fixed
assets less sales of fixed assets): Finally, change in net working capital is
measured as the net change in current assets relative to current liabilities for the
period being examined and represents the amount spent on net working capital.
The three components of cash flow are examined in more detail next.
5.8.2 Operating Cash Flow

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To calculate operating cash flow (OCF), we want to calculate revenues minus

costs, but we do not want to include depreciation because it is not a cash
outflow, and we do not want to include interest because it is a financing expense.
We do want to include taxes, because taxes are, unfortunately, paid in cash.
Given earnings before interest and taxes (EBIT) (i.e. earnings that do not include
interest paid, we will need to make two adjustments: first, we must recall that
depreciation is a non-cash expense. To get cash flow, we first add back the
depreciation because it was not a cash deduction. The other adjustment is to
subtract the taxes amounts because these were paid in cash. The result is
operating cash flow:
Operating cash flow is an important number because it tells us, on a very basic
level, whether or not a firm’s cash inflows from its business operations are
sufficient to cover its everyday cash outflows. For this reason, a negative
operating cash flow is often a sign of trouble.
There is an unpleasant possibility of confusion when we speak of operating cash

flow. In accounting practice, operating cash flow is often defined as net income
plus depreciation. The accounting definition of operating cash flow differs from
ours in one important way: interest is deducted when net income is computed.
This definition of cash flow thus considers interest paid to be an operating
expense. Our definition treats it properly as a financing expense. If there were no
interest expense, the two definitions would be the same.
To finish our calculation of cash flow from assets, we need to consider how much
of the operating cash flow was reinvested in the firm. We consider spending on
fixed assets first.
5.9. Capital Spending
Net capital spending is just money spent on fixed assets less money received
from the sale of fixed assets. Suppose at the end of 2008, net fixed assets for

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CellOne were N$1.644m. During 2009, CellOne wrote off (depreciated) N$65m
worth of fixed assets on the income statement. So, if CellOne did not purchase
any new fixed assets, net fixed assets at the end of 2009 would have been
N$1.644m – N$65m = N$1.579m i.e. at end of 2009. Suppose, instead the 2009
balance sheet shows N$1.709m in net fixed assets, this would mean CellOne
must have spent a total of N$1.709m – N$1.579m = N$130m on fixed assets
during the year. We could get the same using the following formula:
Net Capital Spending = Ending net fixed assets - Beginning net fixed assets+ Depreciation
Ending net fixed assets N$1.709

- Beginning net fixed assets N$1.644
+ Depreciation N$ 65
Net Capital Spending N$ 130
This would happen if the firm sold off more assets than it purchased. The net
here refers to purchases of fixed assets net of any sales of fixed assets.
5.10 Change in Net Working Capital
In addition to investing in fixed assets, firms also invest in current assets. For
example, suppose at the end of 2009, CellOne had current assets amounting to
N$1.403m and we are told at the end of 2008, current assets were N$1,112. This
would mean that during the year 2009, CellOne invested N$1.403m – N$1.112m
= N$291m in current assets.
As a firm changes its investment in current assets, its current liabilities will
usually change as well. To determine the change in net working capital, the
easiest approach is just to take the difference between the beginning and ending
net working capital (NWC) figures. Suppose CellOne’s net working capital at the
end of 2009 was N$1.403m – N$389m = N$1.014m. If at the end of 2008, net

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working capital was N$1.112m – N$428m = N$684m, then from these figures, we
can calculate change in net working capital as follows:
Ending NWC N$ 1.014m

- Beginning NWC N$ 684m
Change in NWC N$ 330m
Net working capital thus increased by N$330m. Put another way, CellOne had a
net investment of N$330m in NWC in 2009. This change in NWC is often referred
to as the “addition to” NWC.
Given the figures we have come up with, we are ready to calculate cash flow
from assets. The total cash flow from assets is given by operating cash flow less
the amounts invested in fixed assets and net working capital.
5.11. A Note on “Free” Cash Flow
Cash flow from assets sometimes goes by a different name, free cash flow. Of
course, there is no such thing as “free” cash (we wish!). Instead, the name refers
to cash that the firm is free to distribute to creditors and stockholders because it
is not needed for working capital or fixed asset investments. We will stick with
“cash flow from assets” as our label for this important concept because, in
practice, there is some variation in exactly how free cash flow is computed;
different users calculate it in different ways. Nonetheless, whenever we hear the
phrase “free cash flow,” we should understand that what is being discussed is
cash flow from assets or something quite similar.
5.11.1 Cash Flow to Creditors and Stockholders
The cash flows to creditors and stockholders represent the net payments to
creditors and owners during the year. Their calculation is similar to that of cash
flow from assets. Cash flow to creditors is interest paid less net new borrowing;
cash flow to stockholders is dividends paid less net new equity raised.

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Table
I. The cash flow identity
Cash flow from assets = Cash flow to creditors (bondholders)+ Cash flow to
stockholders (owners)
II. Cash flow from Assets

Cash flow from assets = Operating cash flow - Net capital spending - Change in
net working capital (NWC)
where:
a. Operating cash flow = Earnings before interest and taxes (EBIT) +
Depreciation – Taxes;
b. Net capital spending = Ending net fixed assets - Beginning net fixed
assets + Depreciation
c. Change in NWC = Ending NWC - Beginning NWC
III. Cash Flow to Creditors (Bondholders)

Cash flow to creditors = Interest paid - Net new borrowing
IV. Cash Flow to Stockholders (Owners)

Cash flow to stockholders = Dividends paid - Net new equity raised
Cash flow to creditors is sometimes called cash flow to bondholders; we will use
these terms interchangeably.
5.11.2 Cash Flow to Stockholders

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To get net new equity raised, we need to look at the common stock and paid-in
surplus account. This account tells us how much stock the company has sold. It
is essential that a firm keep an eye on its cash flow.
5.12. Conclusion
In this discussion we highlighted that the balance sheet is a snapshot of the

firm’s assets and liabilities at a given time. On the balance sheet, assets are
listed in the order of liquidity i.e easy of conversion to cash without significant
loss of value. Te balance sheet represents the accounting equation i.e. Assets =
Capital + Liabilities. The balance sheet provides the book value of assets,
liabilities and equity. Market value is the price at which the assets, equity and
liabilities can actually be bought if they were to be sold. Market values represent
a more real realistic picture and therefore are more important to decision makers.
5.13. Revision Exercise
1. Explain Financial Statements
2. Differentiate between financial Value and Book Value
3. What is Income Statement?
4. Explain Tax System in corporate finance
5. Explain Cash Flow

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Discussion 6
6.0. FINANCIAL RATIOS
6.1. Introduction
One of the objectives of financial strategists is to assess the financial

performance of the firm and to take necessary corrective action. One way of
determining the performance of a business is by using ratios.
6.2. Outcomes of Learning
By the end of the discussion you should be able to:
1. Demonstrate an in-depth understanding of financial ratios.

2. Use financial ratios to assess the performance of a company.
3. Identify and implement ideal courses of action based on financial ratios.

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6.3. What are Financial Ratios?
In our previous studies of accounting and finance we saw how the Balance Sheet
or Statement of Financial Position of a business reports the company's position
at a point in time, how the Income Statement reports a company's operations
over a period of time, and how the Cash Flow Statement reports a company's
sources and uses of funds over that period. This is called financial statement
analysis. The real value of financial statement analysis is to use these
statements to forecast a firm's future earnings, or put differently, the forecast the
firm’s future performance.
From an investor's point of view, forecasting the future is very important. From a
manager's viewpoint, financial statement analysis is useful as a way to anticipate
future conditions and, most important, as a starting point for developing
strategies that influence a company's future course of business.
An important step toward achieving these goals is to analyse the firm's financial
ratios. Ratios are designed to highlight relationships between the financial
statement accounts. These relationships begin to reveal how well a company is
doing in its primary goal of creating value for its shareholders.
The ratios, alone, usually give the analyst very little information. There are two
ratio analysis techniques that provide additional insight into a company. The first
technique is to compare the ratios of one company with other similar companies
within the same industry. The second technique is to observe trends of the ratios
over a period of time.
These trends give clues about a company's performance.
The most common financial ratios can be grouped into five broad categories:
 Liquidity Ratios
 Asset Management Ratios

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 Debt Management Ratios

 Profitability Ratios
 Market Value Ratios
We will discuss each of these groups of ratios and the formulas used to calculate
them. Refer to Shilongo Corporation's Balance Sheet and Income Statement as
we calculate each ratio.
Shilongo Corporation
December 31, 2012 (In Millions N$)
ASSETS LIABILITIES AND EQUITY

Cash 5.7 Accounts Payable 22.7
Marketable Securities 6.3 Notes Payable 31.5
Accounts Receivable 50.9 Accrued Wages and Taxes 2.3
Inventories 88.7 Other Current Liabilities 4.9
Prepaid Expenses 1.1 Total Current Liabilities 61.4
Other Current Assets 0.3
Total Current Assets 153.0 Long-term Debt 107.4
Preferred Stock 12.3
Gross Fixed Assets 158.8 Total Long-term 181.1
Liabilities
Less Depreciation 24.9
Net Fixed Assets 133.9 Common Stock (8 Mil. 10.4
Outst.)
Retained Earnings 95.4
Total Common Equity 105.8
Total Assets 286.9 Total Liabilities and Equity 286.9

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Recall that current asset accounts include cash, marketable securities,

inventories, and prepaid expenses. The current liabilities include accounts
payable, notes payable, and accrued wages and taxes.
The Current Ratio means that, if necessary, the company could use its current
assets to pay off its current liabilities 2.49 times. If a company is experiencing
financial difficulty, it may begin to pay its bills more slowly. This causes an
increase in bank loans and similar activities. If current liabilities are rising more
quickly than current assets, the Current Ratio will fall. This could indicate trouble
in the company.
This ratio means little as a single value. However, when it is compared to similar
companies in the industry or used in a trend analysis, the ratio becomes much
more meaningful. For example, if the industry average Current Ratio is 1.82
times, the analyst may conclude that Shilongo Corporation's policies are effective
in assuring that it will be able to satisfy its current liabilities. If Shilongo's Current
Ratio is 2.67 times and, in the prior year, was 2.94 times, an analyst may begin to
investigate reasons why the company has been less effective this year compared
to the previous year.
6.3.1 Quick (Acid-Test) Ratio
The Quick (Acid-Test) Ratio is computed by subtracting inventories from

current assets, then dividing the remainder by current liabilities. Shilongo
Corporation's Quick Ratio can be calculated as follows:
Quick Ratio = (Current Assets - Inventories) / (Current Liabilities)

= (N$153.0 - N$88.7) / (N$61.4)
= 1.05 times
Inventories usually are the least liquid of the current assets. They are the

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most difficult to convert to cash and most likely to incur losses in the course
of a liquidation. The Quick Ratio gives an indication of the firm's ability to
meet short-term obligations without relying on the sale of inventories.
Shilongo Corporation can use its most liquid current assets to pay off the
current liabilities 1.05 times.
6.3.2. Asset Management Ratios
These ratios attempt to measure how effectively the company is managing its
assets. They are designed to tell the analyst if the amounts of each type of
asset reported on the Balance Sheet are reasonable, given current and
anticipated operating levels of the firm.
Asset Management Ratios include:
 Inventory Turnover Ratio
 Average Collection Period
 Fixed Assets Turnover Ratio
 Total Assets Turnover Ratio
6.3.3. Inventory Turnover Ratio
The Inventory Turnover (Inventory Utilization) Ratio is calculated by dividing

the Net sales of the firm by its inventories.
Inventory Turnover = (Net Sales) / (Inventories)

= (N$287.6) / (N$88.7)
= 3.24 times
This means that the firm's inventory is roughly sold out and restocked, or
turned over, a little more than three times per year. Obsolete, unnecessary, or
excess products held in inventories cause the Asset Turnover Ratio to fall,

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which may indicate a need for management action.
The analyst should consider two weaknesses of the Inventory Turnover Ratio.
The first concern is that sales are stated at market prices, whereas inventories
are usually carried at cost. In an environment with rapidly changing prices, the
ratio would overstate the inventory turnover rate. When market prices are
volatile, a more accurate calculation may be made using Cost of Goods Sold in
the numerator.
The other weakness is that sales occur over the entire year, whereas the
inventory is valued at a point of time. A business with highly seasonal trends
may calculate the ratio using an average inventory figure.
6.3.4. Average Collection Period
The Average Collection Period (ACP) is often used to appraise:
Accounts receivable. It is computed by dividing average daily sales by the

ACP = (Accounts Receivable) / (Average Daily Sales)
Accounts Receivable. Average daily sales are found by dividing the total
= (N$50.9) / (N$287.6/360 days)
year's sales
= by 63.7
360 (the
daysnumber of days in the year). For Shilongo
Corporation, the calculation is:
The Average Collection Period represents the number of days the company
must wait after a sale is made before receiving cash. If Shilongo Corporation
gives its customers credit terms of 30 days, this ratio indicates that the
company is inefficient in collecting its receivables.
6.3.5 Fixed Assets Turnover Ratio
To measure the utilization of the firm's plant and equipment, the Fixed Assets
Turnover (Fixed Asset Utilization) Ratio can be used. It is the firm's sales
divided by its fixed assets.
Fixed Assets Turnover = (Sales) / (Net Fixed Assets)

= (N$287.6) / (N$133.9)
The International University= of Management:
2.15 times SMBA 74
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This gives the analyst an idea of how well the fixed assets are being utilized.
Shilongo Corporation's fixed assets are generating slightly more than two
times their value in sales for the company. Unnecessary or underutilized fixed
assets that do not increase sales cause this ratio to become lower. Once
again, consider that in a period of rapidly changing prices, the value of fixed
assets on the Balance Sheet may be seriously understated. This causes a
firm with older equipment to report a higher turnover than a firm with more
recently purchased plants and equipment.
If the industry average for Fixed Assets Turnover is 2.98 times, a manager of
Shilongo Corporation may begin to investigate how other companies in the
industry are able to generate more sales from their fixed assets.
6.3.6. Total Assets Turnover Ratio
The Total Assets Turnover Ratio measures the utilization of the company's
assets. To compute the Total Assets Turnover Ratio, divide sales by total
assets. For Shilongo Corporation, it is:
Total Assets Turnover = (Sales) / (Total Assets)

= (N$287.6) / (N$286.9)
= 1.00 times
Like the Fixed Assets Turnover Ratio, this ratio gives the analyst an indication
of how well a company is utilizing its assets. The Total
Assets Turnover Ratio indicates how many times the value of all assets is
being generated in sales. The same concerns about understated assets also
are applicable to the Total Assets Turnover Ratio.
6.3.7. Debt Management Ratios
As discussed earlier, a company can choose to raise part of its capital in the
form of equity (money from investors in the company) or in the form of debt

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(money borrowed from creditors). Debt is generally less expensive than

equity, especially when tax issues are relevant (interest payments often are
tax-deductible, but dividends usually are not). A company's capital structure
refers to the mix of debt and equity that is used to finance assets. Most
companies seek an ideal capital structure, one that maximizes the total value
of the company.
Financial leverage is the use of debt financing to raise capital for operations
and growth. The concept of financial leverage can be explained with a short
example.
Consider a company wishing to grow and expand its operations. The

company believes that, with an additional N$10 million in capital, it can
generate N$40 million in net income in the coming year. The company can
find investors to invest N$10 million in the company. However, at the end of
the year, the new investors will be entitled to a share of the income, thus
diluting the return to the original shareholders.
If the company borrows the N$10 million, the company will simply pay the
interest on the loan (and the principal if the loan is due). The entire net
income, less the interest payment, will be available for the original
shareholders.
This use of debt as a source of capital has three important implications:
1. By using debt, control of the firm is achieved with limited equity

investment.
2. If only a small percentage of the total funds are invested by

equity holders, then creditors bear the risks of the company. For
this reason, creditors often require a certain percentage of
equity invested funds as a margin of safety.

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By leveraging the owners' (equity investors') capital, return on investment is

increased if the firm earns more on the use of the borrowed funds than it pays
in interest
Analysts have developed ratios to determine the extent of the use of

borrowed funds to finance assets and to determine how many times the
income generated by those assets can be used to make interest payments.
These ratios include:
 Total Debt to Total Assets Ratio
 Times Interest Earned (TIE) Ratio
 Fixed Charge Coverage Ratio
Total Debt to Total Assets Ratio (Debt Ratio)
The Total Debt to Total Assets Ratio measures the percentage of total funds
provided by the use of debt. It is calculated by dividing total debt (liabilities)
by total assets.
Debt Ratio = (Total Debt) / (Total Assets)

= (N$61.4 + N$107.4) / (N$286.9)
= 58.8%
Notice that total debt includes current liabilities and long-term debt. This Debt
Ratio is used by creditors to help decide if they will loan money to the
company.
6.3.8. Times Interest Earned (TIE) Ratio
The Times Interest Earned Ratio gives the analyst an idea of how far
operating income can decline before the company is unable to meet its
interest payments on currently held debt. The TIE Ratio for Shilongo
Corporation is computed by dividing earnings before interest and taxes
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(EBIT) by the interest charges.
Times Interest Earned = (EBIT) / (Interest Charges)

= (N$22.5) / (N$6.0)
= 3.8 times
The calculation uses earnings before interest and taxes in the numerator
because interest payments are tax deductible in many countries, and the
ability to pay current interest is not affected by taxes. The TIE Ratio indicates
to the analyst how many times the company can make interest payments with
the earnings generated by the firm.
6.3.9. Fixed Charge Coverage Ratio
The Fixed Charge Coverage Ratio has one important difference from the TIE
Ratio. Many companies enter long-term lease agreements for assets. This
ratio recognizes those leases as obligations and includes the lease payments
as fixed charges along with interest payments on loans. The Fixed Charge
Coverage Ratio is computed by dividing EBIT plus lease payments by
interest charges plus lease payments.
Fixed Charge = (EBIT + Leases) / (Interest Charges + Leases)

= (N$22.5 + N$2.1) / (N$6.0 + N$2.1)
= 3.0 times
This ratio is used more often than the TIE ratio, especially in industries where
leasing of assets is common. It tells how many times all fixed payments
incurred by the company can be made by using all the earnings of the firm.
6.3.10. Profitability Ratios
All policies and decisions made by a company are driven by the company's
profitability goal. The previous ratios were designed to provide information
about the operations of a company. Another group of ratios, Profitability

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Ratios, highlight the combined effects of liquidity, asset management, and

debt management. These ratios include:
 Profit Margin Ratio
 Basic Earnings Power Ratio
 Return on Total Assets Ratio
 Return on Common Equity Ratio
6.3.11 Profit Margin Ratio
The Profit Margin Ratio shows the percentage of sales that is left for
distribution to the common shareholders. The calculation is net income
available to common shareholders divided by sales for the period. For our
Shilongo Corporation example, the calculation is:
Profit Margin = (Net Income to Common) / (Sales)

= (N$6.2) / (N$287.6)
= 2.16%
The Profit Margin Ratio reveals to the analyst how much profit is being
generated by the company for each dollar of sales.
6.3.12. Basic Earnings Power Ratio

The Basic Earnings Power Ratio is used to help compare firms with different
degrees of financial leverage and in different tax situations. It provides the
analyst with an idea of how effectively the assets are used to generate
earnings. The computation is earnings before interest and taxes (EBIT)
divided by total assets.
Basic Earnings Power = (EBIT) / (Total Assets) = (N$22.5) / (N$286.9)

= 7.84% of Total Assets

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EBIT is used in the Basic Earnings Power Ratio to eliminate any interest
payments or tax considerations of the firm. The Basic Earnings Power Ratio
indicates the percentage of total assets generated as earnings.
6.3.13. Return on Total Assets Ratio
By taking net income available to common shareholders and dividing it by

the value of all the assets, the analyst calculates the return on those assets.
The Return on Total Assets (ROA) Ratio is used to determine the return
generated by the company on its assets. For Shilongo Corporation, the
calculation is:
Return on Total Assets = (Net Income to Common) / (Total Assets)
= (N$6.2) / (N$286.9)
= 2.16% of Total Assets
By taking net income available to common shareholders and dividing it by the

value of all the assets, the analyst calculates the return on those assets. The
Return on Total Assets (ROA) Ratio is used to determine the return
generated by the company on its assets.
6.3.14. Return on Common Equity Ratio
The Return on Common Equity (ROE) Ratio is a measure of the rate of return
on stockholders' investments. It is calculated by dividing
Net income available to common shareholders by the total common equity

capital in the firm.
Return on Common Equity = (Net Income to Common) /(Common Equity)

= (N$6.2) / (N$105.8)
= 5.86% of Common Equity
The ROE Ratio tells the analyst the return that common shareholders had on
their investments.
6.3.15. Market Value Ratios

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Market Value Ratios relate the company's stock price data with the earnings and
capital structure of the company. This information gives the analyst an idea of the
view investors have of the company's past performance and also their view of the
firm's future prospects. These ratios include:
 Price / Earnings Ratio

 Market / Book Ratio Price / Earnings Ratio
Price / Earnings (P/E) Ratio shows how much investors are willing to pay for
every dollar of the company's reported profits. It is calculated by dividing the
market price per share of Common Stock by Earnings per Share (EPS). The
earnings per share calculation is net income.
Available to common divided by the Number of Shares Outstanding. The
Number of Shares can be found next to the common equity figure on the Balance
Sheet. Be sure to check the units on the Number of Shares; they may not always
be the same as the other figures on the Balance Sheet. On Shilongo
Corporation's Balance Sheet, all figures are in millions.
Earnings per share = (Net Income to Common) / (Number of shares)

= (N$6.2) / (8.0 shares)
= N$0.775 per share
For our Shilongo Corporation example, if the price of Shilongo stock is N$12.70
per share, the P/E Ratio is
Price / Earnings = (Market price per share) / (Earnings per share)

= (N$12.70) / (N$0.775)
= 16.4 times
The P/E Ratio indicates that the common shares are selling for 16.4 times the
earnings of Shilongo Corporation.

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Amount investors will pay relative to value on books
6.3.16. Market / Book Ratio

The Market / Book Ratio shows how much investors are willing to pay relative to
the value of the company as shown on its books. The total market value of a
company is the value that investors in the stock market (where the shares are
being traded) think the company is worth. This value is derived from the stock
price at which the shares are trading. For example, the market value for Shilongo
Corporation is N$101.6 million (8 million shares times N$12.70 per share).
To calculate the Market / Book Ratio, the analyst must first compute the book
value per share. This computation is the value of common equity divided by
the Number of Shares.
Book value per share =(Common Equity) / (Number of shares)

=(N$105.8) / (8.0 shares)
=N$13.225
The Market / Book Ratio per share
is calculated by dividing the market price per share by
the book value per share.
Market / Book = (Market price per share) / (Book value per share)
= (N$12.70) / (N$13.225)
The Market / Book Ratio indicates how many times above (or below) the book
= 0.96 times
value of the company investors are paying for an equity position. In our Shilongo
Corporation example, investors are not quite willing to pay the book value for the
equity of the company. (1.00 times means that the market price and the book
price are the same.)
6.3.17. Using Ratios
The ratios we have just studied provide the analyst with information about a
company's liquidity, asset management, debt management, and profitability.
They also indicate how market investors value the company's efforts. These
ratios also provide additional insights when compared to the ratios of other
companies and when trends are mapped over a period of time.

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An astute analyst will first calculate a company's ratios and then make
comparisons with other similar companies in that industry or with the industry as
a whole. Any significant discrepancies will signal the analyst that closer
inspection may be needed.
For example, if most of the industries competing with Shilongo Corporation have
Profit Margin Ratios of over 4% and Shilongo has a Profit Margin Ratio of 2.16%,
the analyst will begin to look for reasons why Shilongo is performing so poorly. It
is important to compare companies within the same industry to gain useful
observations. An automobile manufacturer will have a much different structure
than a consulting company.
Trend analysis can also provide insights into the conditions of a company. By
calculating ratios over a period of several years, an analyst can uncover potential
problems within the firm.
For example, if Shilongo Corporation has an Inventory Turnover Ratio of 3.24

times in 1993, 3.86 times in 1992, and 4.56 times in 1991, an analyst will begin to
look for reasons why it is taking longer for Shilongo Corporation to sell its
products. These trends give clues as to whether the financial condition is
improving or deteriorating. By using industry comparisons and trend analysis, the
analyst can focus the investigation on areas of a company that may need
attention.
6.4 Revisions Exercise

1. What are financial ratios?
2. How do finance managers use financial rations?
3. Identify and explain the broad categories into which financial ratios may be
classified.

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4. Use the following Balance Sheet and Income Statement to answer the
questions about financial ratios.
For each question, decide which ratio is appropriate and use it to calculate the
answer. Mark the correct answer and indicate which ratio you used.
Shakukutanai Pty Ltd – Balance Sheet
ASSETS LIABILITIES AND EQUITY

Cash 7.4 Accounts Payable - Fruit 10.2
Marketable Securities 0.6 Accounts Payable - Material 9.6
Accounts Receivable 23.7 Notes Payable 23.0
Raw Goods Inventory 19.5 Accrued Wages and Taxes 1.7
Finished Goods Inventory 22.4 Other Current Liabilities 0.6
Prepaid Expenses 1.5 Total Current Liabilities 45.1
Other Current Assets 0.8
Total Current Assets 75.9 Long-term Debt 45.1
Preferred Stock 7.8
Gross Fixed Assets 101.2 Total Long-term Liabilities 98.0

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Less Depreciation 19.9

Net Fixed Assets 81.3 Common Stock (6.5 Mil. 15.1
Outst.)
Retained Earnings 44.1
Total Common Equity 59.2
Total Assets 157.2 Total Liabilities and Equity 157.2
Shakukutanai Pty Ltd – Income

Statement
December 31, 1993 (In Millions $)

Net Sales 150.6
Operating Expenses 101.2 Depreciation
3.1
EBIT 46.3
Interest Expense 11.5
Earnings Before Taxes 34.8
Taxes (@ 40%) 13.9
Net Income to Shareholders 20.9
Preferred Dividends 6.3
Net Income to Common 14.6
Common Dividends 12.0 Earnings Retained

2.6
Shakukutanai Pty Ltd
Statement of Consolidated Income
Net Sales 150.6
Operating Expenses
4.1 How many times can Shakukutanai pay off current liabilities without relying on
inventories?
____ a) 0.75 times
____ b) 1.19 times
____ c) 1.25 times

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____ d) 1.68 times
____ e) 1.80 times
Ratio:______________________________________________
4.2 How many times did Shakukutanai sell out and restock its merchandise?
____ a) 2.00 times
____ b) 2.29 times
____ c) 3.59 times
____ d) 6.72 times
____ e) 7.72 times
Ratio:______________________________________________
Possible Solution
4.1. How many times can Fruit Packing, Inc. pay off current liabilities without relying on
inventories?
a) 0.75 times
Quick Ratio= (Current Assets - Inventories) / (Current Liabilities)

= (N$75.9 - N$19.5 - N$22.4) / (N$45.1)
= 0.75 times
Subtract both Raw and Finished Goods Inventory
4.2. How many times did Fruit Packing, Inc. sell out and restock its merchandise?
c) 3.59 times
Inventory Turnover = (Sales) / (Inventories)

= (N$150.6) / (N$19.5 + N$22.4)
= 3.59 times

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Discussion 5
5.0 Financial Markets and the Financial System
5.1 Introduction
In this discussion we look at the environment in which finance managers operate.
Specifically we examine what goes on in the financial environment; the players, the
goods involved, the tools at the finance managers’ disposal.
We have seen that the primary advantages of the corporate form of organization are
that ownership can be transferred more quickly and easily than with other forms and
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that money can be raised more readily. Both of these advantages are significantly
enhanced by the existence of financial markets, and financial markets play an extremely
important role in managerial finance.
5.2 Learning Outcomes
a. Define markets.
b. Identify and describe the players/participants in financial markets.
c. Explain the role and functions of financial markets.
d. Explain the types of financial markets/classification of financial markets.
5.3 What is a Financial Market?
A market is a place or medium where trade takes place. It is a place or medium of

commercial or competitive activity where exchange of goods or services takes place. It
is important to emphasise that a market is not always a physical place. We buy cars and
goods from other countries on the internet and they get delivered to us without us being
to any physical market. Looked at this way, a market may be viewed as a medium, not
as a place.
Having discussed a market in general, may now define a financial market is a place or
medium where financial goods are traded. This definition requires that we know the type
of goods that are traded in financial markets and who the players in the financial
markets are.
5.3.1 Players in the Financial Markets

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The following institutions and people are found in financial markets and make up the
financial system:
a. Financial institutions
i. Banks: Commercial banks, merchant banks, building societies, post office
savings bank
ii. Pension houses.
iii. Stock exchanges.
b. Government
c. Business (companies).
d. Individuals (depositors, stock brokers, stock dealers etc.)
5.3.2 The Role and Functions of Financial Markets
The role of financial markets is to facilitate the mobilization of excess funds from sectors
of the economy with excess cash and the channeling of such funds to deficit sectors of
the economy.
5.3.3 Cash Flows to and from the Firm
The interplay between the corporation and the financial markets is illustrated in Figure
1.3. The arrows in Figure 1.3 trace the passage of cash from the financial markets to
the firm and from the firm back to the financial markets.

Corporate Finance
Figure 5.1
Suppose we start with the firms selling shares of stock and borrowing money to raise
cash. Cash flows to the firm from the financial markets. The firm invests the cash in
current and fixed assets. These assets generate some cash, some of which goes to pay
corporate taxes. After taxes are paid, some of this cash flow is reinvested in the firm.
The rest goes back to the financial markets as cash paid to creditors and shareholders.
A financial market, like any market, is just a way of bringing buyers and sellers together.
In financial markets, it is debt and equity securities that are bought and sold. Financial

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markets differ in detail, however. The most important differences concern the types of
securities that are traded, how trading is conducted and who the buyers and sellers are.
Some of these differences are discussed next.
5.3.4 Primary versus Secondary Markets
Financial markets function as both primary and secondary markets for debt and equity
securities. The term primary market refers to the original sale of securities by
governments and corporations. The secondary markets are those in which these
securities are bought and sold after, the original sale. Solely corporations of course,
issue equities. Both governments and corporations issue debt securities. In the
discussion that follows, we focus on corporate securities only.
5.3.5 Primary Markets
In a primary market transaction, the corporation is the seller, and the transaction raises
money for the corporation. Corporations engage in two types of primary market
transactions: public offerings and private placements. A public offering, as the name
suggests, involves selling securities to the general public, whereas a private placement
is a negotiated sale involving a specific buyer.
By law, Public offering of debt and must be registered within the Securities and
Exchange Commission (SEC). Registration requires the firm to disclose a great deal of
information before selling any securities. The accounting, legal, and selling costs of
public offerings can be considerable. Partly to avoid the various regulatory requirements
and the expense of public offerings, debt and equity are often sold privately to large
financial institutions such as life insurance companies or mutual funds. Such private
placements do not have to be registered with the SEC and do not require the
involvement-.of underwriters (investment banks that specialize in selling securities to
the public).

Corporate Finance
5.3.6 Secondary Markets
A secondary market transaction involves one owner or creditor selling to another. it is

therefore the secondary markets that provide the means for transferring ownership of
corporate securities, Although a corporation is’ only directly involved, in a primary
market transaction (when it sells securities to raise cash), the secondary markets are
still critical to large corporations. The reason is that investors are much more willing to
purchase securities in a primary market transaction when they know that those
securities can later be resold if desired.
5.3.7 Dealer versus Auction Markets
There are two kinds of secondary markets; auction markets and dealer markets.
Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer,
for example, buys and sells automobiles. In contrast, brokers and agents match buyers
and sellers, but they do not actually own the commodity that is bought or sold. “A real
estate agent, for example, does not normally buy and sell houses. Dealer markets in
stocks and long-term debt are called over-the counter (OTC) markets. Most trading in
debt securities takes place over the counter. The expression over the counter refers to
days of old when securities were literally bought and sold at counters in offices around
the country. Today, a significant fraction of the market for stocks and almost all of the
market for long-term debt has no central location; the many dealers are connected
electronically.
Auction markets differ from dealer markets in two ways. First, an auction market or
exchange has a physical location (like the Namibia Stock Exchange). Second, in a
dealer market, the dealer does most of the buying and selling. The primary purpose of
an auction market, on the other hand, is to match those who wish to sell with those who
wish to buy. Dealers play a limited role.

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Trading in corporate securities or equity shares of most large firms in most countries
often takes place in organized auction markets. The largest such market is the New
York Stock Exchange (NYSE), which accounts for more than 85 percent of all the
shares traded in auction markets. Other auction exchanges include the American Stock
Exchange (AMEX) and regional exchanges such as the Pacific Stock Exchange. In
addition to the stock exchanges, there is a large Over-The-Counter (OTC) market for
stocks. In 1971, the National Association of Securities Dealers (NASD) made available
to dealers and brokers an electronic quotation system called NASDAQ (NASD
Automated Quotation system, pronounced “naz-dak” and now spelled “Nasdaq”). There
are roughly two times as many companies on Nasdaq as there are on NYSE, but they
tend to be much smaller in size and trade less actively. There are exceptions, of course.
Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of Nasdaq
stocks is much less than the total value of NYSE stocks. There are many large and
important financial markets outside the United States, of course, and U.S. corporations
are increasingly looking to these markets to raise cash. The Tokyo Stock Exchange and
the London Stock Exchange (TSE and LSE, respectively) are two well-known examples.
The fact that OTC markets have no physical location means that national borders do not
present a great barrier, and there is now a huge international OTC debt market.
Because of globalization, financial markets have reached the point where trading in
many investments never stops…it just travels around the world. Listing Stocks that
trade on a waived exchange are said to be listed on that exchange. In order to be listed
firms must meet certain minimum criteria concerning, for example, asset size and
number of shareholders. These criteria differ from one exchange to another.
NYSE has the most stringent requirements of all exchanges in the United States. For
example, to be listed on NYSE, a company is expected to have a market value for its
publicly held shares of at least USD100 million and a total of at least 2,000 shareholders
with at least 100 shares each. There are additional minimums on earnings, assets, and
number of shares outstanding.

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Discussion 6

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6.0 CAPITAL BUDGETING
6.1 Introduction
One of the objectives of financial strategists is to determine which projects to invest in.
Capital budgeting is the analysis of capital projects. A project is an investment made by
a firm in the hope of a future return. The purpose of such investment is to maximise the
wealth of shareholders. In our maiden discussion we stated that the role of the financial
manager is to advise top management on four critical areas of decision-making. One of
the areas we identified is capital budgeting. We also pointed out that the finance
manager uses a number of tools to be able to give good advice to top management.
6.2 Outcomes of Learning
1. Demonstrate an in-depth understanding of what capital budgeting is about.

2. Appreciate the goal of every financial manager.
3. Identify and explain the tools at the disposal of finance managers when
appraising projects for possible investment.
4. Use the various appraisal techniques to identify which projects to invest in.
6.3 The Goal of Every Finance Manager
The goal of a good finance manager should be to invest in all projects that add VALUE,
and avoid those that would subtract value. Oshili, this sounds easy, does it not? If it only
were so. Valuation is often very difficult.
It is not the formulas that are difficult. As you will find out, even in the so called most
complex formulas in managerial finance, the math is not hard. It is just a few symbols,
and the overwhelming majority of finance formulas only use the four major operations
(addition, subtraction, multiplication, and division). Admittedly, even if the formulas are

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not sophisticated, there are a lot of them, and they have an intuitive economic meaning
that requires experience to grasp; which is not a trivial task. But if you managed to pass
high- school mathematics and managed to pass you bachelor degree, if you are
motivated, and if you keep an open mind, you positively will be able to handle the math.
It is not the math that is the real difficulty in valuation.
Instead, the difficulty is the real world! It is deciding how you should judge the future;
whether Namibia will receive enough rain next season, whether the economy will enter
a recession or not, where you can find alternative markets, and how interest rates or the
stock market will move. In our class discussions we will see how we can forecast in the
best way, but it will mostly remain up to you to make smart forecasts. Noted, unless we
are magicians or sangomas, forecasting remains a difficult and often idiosyncratic task.
But there is also a ray of light here: If valuation were easy, a computer could do your job
of being a manager. This will never happen. Valuation will always remain a matter of
both art and science that requires judgment and common sense. The formulas and
finance that we shall discuss are only the necessary toolbox to convert your estimates
of the future into what you need today to make good decisions.
6.4 The Law of One Price
Most of our discussions in managerial finance are based in some form or another on the
law of one price i.e. two identical items at the same venue should sell for the same
price. Otherwise, why would anyone buy the more expensive one? This law of one price
is the logic upon which almost all of valuation is based. If you can find other projects
that are identical - at least along all dimensions that matter- to the project that you are
considering, then your project should be worth the same and sell for the same price. If
you put too low a value on your project, you might pass up on a project that is worth
more than your best alternative uses of money. If you put too high a value on your
project, you might take a project that you could buy cheaper elsewhere.
Note how value is defined in relative terms. This is because it is easier to determine
whether your project is better, worse, or similar to its best alternatives than it is to put an

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absolute value on your project. The closer the alternatives, the easier it is to put a value
on your project. It is easier to compare and therefore value a new Toyota Camry-
because you have good alternatives such as Honda Accords and one-year used Toyota
Camry-than it is to compare the Camry against a Plasma TV, a vacation, or pencils. It is
against the best and closest alternatives that you want to estimate your own project’s
value. These alternatives create an “opportunity cost” that you suffer if you take your
project instead of the alternatives.
Many corporate projects in the real world have close comparables that make such
relative valuation feasible, e.g. say you want to put a value on a six bedroom house in
Olympia, Windhoek. You have many alternatives: you could determine the value of a
similar six bedroom house in Academia, Windhoek; or you could determine the value of
a similar house in Klein Windhoek; or you could determine how much it would cost you
to just buy a similar house in the mentioned suburbs; or you could determine how much
money you could earn if you invest your money instead into the stock market or deposit
it into a savings account. If you understand how to estimate your house’s value relative
to your other opportunities, you then know whether you should build it or not. But not all
projects are easy to value in relative terms. For example, how would the City of
Windhoek determine the value of controlling waste and refuse dumping? There are no
easy alternative projects to compare these to, so any valuation would inevitably be
haphazard.
6.5 How do Finance Officers do it?
In this segment of our discussion we look at some of the tools at the disposal of finance
managers which help the value projects; Valuation Techniques. We will need to rank
them according to how they are commonly used in business. The question is how do we
rank them and how do we know which of them are commonly used, assuming the most
used are the most reliable.
Fortunately, we have a good idea of which of them are commonly used. In a survey in
2001, Graham and Harvey (from Duke University) surveyed 392 managers, asking them

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what techniques they use when deciding on projects or acquisition. The results are
listed below and will consume most of the discussion forming these notes in subsequent
discussions. These techniques according frequency of usage are.
1. Internal Rate of Return (IRR) (26%). 19%

2. Net Present Value (NPV) (26%). 19%
3. Payback Period (14%). 15%
4. Earning Multiples (P/E Ratios) (13%).10%
5. Discounted Payback (10%). 8%
6. Accounting Rate of Return (7%). 5%
7. Profitability Index (4%). 3%
The percentages against each tool shows frequency of usage in industry and
commerce. The net present value tool is the most used. This is because use of the net
present value rule as a criterion for accepting or rejecting investment projects will
maximize the value of the firm’s shares. Remember the objective of for-profit firms is to
maximize the value of the firm’s shares. However, the other criteria are sometimes also
considered by firms when evaluating investment opportunities as the percentages of
frequency of usage above shows. The less usage of some of these tools is because
some of them are liable to give wrong answers; others simply need to be used with
care. In this discussion we introduce all these alternative investment appraisal tools. It is
up to finance managers to pick which of them to use.
6.6 Net Present Value

The most used and probably the most important investment appraisal technique is the
net present value (NPV). The NPV is the present value of all of an investment’s
projected cash flows. The future cash flows are adjusted for time value of money i.e. the
effect of inflation and risk associated with receiving money in the future instead of today.
In discussion 2, we learned how to discount future cash flows to find their present value.
We now apply these ideas to evaluate a simple investment proposal.

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Example 1: Suppose that you are in the real estate business and that you are
considering construction of an office block. The land would cost N$50,000 and
construction would cost a further N$300,000. You foresee a shortage of office space
and predict that a year from now you will be able to sell the building for N$400,000.
Thus you would be investing N$350,000 now in the expectation of realising N$400,000
at the end of the year. You should go ahead if the present value of the N$400,000
payoff is greater than the investment of N$350,000.
Assume for the moment that the N$400,000 payoff is a sure thing. The office building is
not the only way to obtain N$400,000 a year from now. You could invest in a 1-year
Bank of Namibia treasury bill (TB). Suppose the TB offers interest of 7%. How much
would you have to invest in it in order to receive N$400,000 at the end of the year? That
is easy: you would have to invest N$373,832.
The N$373,832 present value is the only price that satisfies both buyer and seller.
In general, the present value is the only feasible price, and the present value of
the property is also its market price or market value.
To calculate present value, we discounted the expected future payoff by the rate of
return offered by comparable investment alternatives. The discount rate, 7% in our
example, is often known as the opportunity cost of capital. It is called the opportunity
cost because it is the return that is being given up by investing in the project.
The building is worth N$373,832, but this does not mean that you are N$373,832 better
off. You committed N$350,000, and therefore your net present value (NPV) is
N$23,832. Net present value is found by subtracting the required initial investment from
the present value of the project cash flows:
NPV = PV – required investment

= N$373,832 – N$350,000
In other =
words,N$23,832
your office development is worth more than it costs—it makes a net
contribution to value.

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The net present value rule states that managers increase shareholders’ wealth by
accepting all projects that are worth more than they cost. Therefore, they should
accept all projects with a positive net present value.
Example 2: The net present value rule works for projects of any length. For example,
suppose that you have identified a possible tenant who would be prepared to rent your
one bedroom flat in Katutura for 3 years at a fixed annual rent of N$16,000. You
forecast that after you have collected the third year’s rent the house could be sold for
N$450,000. Thus the cash flow in the first year is C1 = N$16,000, in the second year it is
C2 = N$16,000, and in the third year it is C3 = N$466,000. For simplicity, we will again
assume that these cash flows are certain and that the opportunity cost of capital is r =
7%.
To find the present values, we discount the future cash flows at the 7% opportunity cost
of capital:
PV = (1 + C1r)1 + (1 + C2r)2 + (1 + C3r)3

N$16,000 N$16,000 N$466,000
= 1.07 + (1.07)2 + (1.07)3
= N$409,323
The net present value of the revised project is NPV = N$409,323 – N$350,000 =
N$59,323. Constructing the office block and renting it for 3 years makes a greater
addition to your wealth than selling the office block at the end of the first year.
Of course, rather than subtracting the initial investment from the project’s present value,
you could calculate NPV directly, as in the following equation, where C0 denotes the
initial cash outflow required to build the office block. (Notice that C0 is negative,
reflecting the fact that it is a cash outflow).

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Example 3: Ongwediva Technologies is considering the purchase of a new computer

system to help handle its warehouse inventories. The system costs N$50,000, is
expected to last 4 years, and should reduce the cost of managing inventories by
N$22,000 a year. The opportunity cost of capital is 10 percent. Should Ongwediva
Technologies go ahead?
Do not be put off by the fact that the computer system does not generate any sales. If
the expected cost savings are realized, the company’s cash flows will be N$22,000 a
year higher as a result of buying the computer. Thus we can say that the computer
increases cash flows by N$22,000 a year for each of 4 years. To calculate present
value, you can discount each of these cash flows by 10 percent. However, it is smarter
to recognize that the cash flows are level and therefore you can use the annuity formula
to calculate the present value:
PV = cash flow × annuity factor = N$22,000

×
[ ]
(1 + 0.10)
= N$22,000 × 3.170 = N$69,740

The net present value is
NPV = (N$50,000) + $69,740 = $19,740
The project has a positive NPV of N$19,740. Undertaking it would increase the value of
the firm by that amount.
6.6.1 A Comment on Risk and Present Value
In our discussion of the office development we assumed we knew the value of the
completed project. Of course, you will never be certain about the future values of office
buildings. The N$400,000 represents the best forecast, but it is not a sure thing.
Therefore, our initial conclusion about how much investors would pay for the building is
wrong. Since they could achieve N$400,000 risklessly by investing in N$373,832 worth

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of U.S. Treasury bills, they would not buy your building for that amount. You would have
to cut your asking price to attract investors’ interest.
Here we can invoke a basic financial principle:
A risky dollar is worth less than a safe one
Most investors avoid risk when they can do so without sacrificing return. However, the
concepts of present value and the opportunity cost of capital still apply to risky
investments. It is still proper to discount the payoff by the rate of return offered by a
comparable investment. But we have to think of expected payoffs and the expected
rates of return on other investments.
Not all investments are equally risky. The office development is riskier than a TB, but is
probably less risky than investing in a start-up biotech company. Suppose you believe
the office development is as risky as an investment in the stock market and that you
forecast a 12% rate of return for stock market investments. Then 12% would be the
appropriate opportunity cost of capital. That is what you are giving up by not investing in
comparable securities. You can now recompute NPV:
PV = N$400,000 × 1
1.12
= N$400,000 × .893
= N$357,143
NPV = PV – $350,000
= N$7,143
If other investors agree with your forecast of a N$400,000 payoff and with your
assessment of a 12% opportunity cost of capital, then the property ought to be worth
N$357,143 once construction is under way. If you tried to sell for more than that, there
would be no takers, because the property would then offer a lower expected rate of

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return than the 12% available in the stock market. The office building still makes a net
contribution to value, but it is much smaller than our earlier calculations indicated.
6.7. Mutually Exclusive Projects

Mutually exclusive projects are two or more projects that cannot be pursued
simultaneously. Most of the projects we have considered so far involve take-it-or-leave-
it decisions. But almost all real-world decisions about capital expenditures involve
either–or choices.
Illustration. You could build an apartment block on that vacant site rather than build an
office block. You could build a 5-story office block or a 50-story one. You could heat it
with oil or with natural gas. You could build it today, or wait a year to start construction.
Such choices are said to be mutually exclusive.
6.7.1. Choosing between Two Projects
It has been several years since Ongwediva Technologies last upgraded its office
networking software. Two competing systems have been proposed. Both have an
expected useful life of 3 years, at which point it will be time for another upgrade. One
proposal is for an expensive cutting-edge system, which will cost N$800,000 and
increase firm cash flows by N$350,000 a year through increased productivity. The other
proposal is for a cheaper, somewhat slower system. This system would cost only
N$700,000 but would increase cash flows by only N$300,000 a year. If the cost of
capital is 7%, which is the better option?
The following table summarizes the cash flows and the NPVs of the two proposals:
Cash Flows, Thousands of Dollars
System C0 C1 C2 C3 NPV at 7%
Faster –800 +350 +350 +350 +118.5
Slower –700 +300 +300 +300 + 87.3

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In both cases, the software systems are worth more than they cost, but the faster
system would make the greater contribution to value and therefore should be your
preferred choice.
Mutually exclusive projects, such as our two proposals to update the networking
system, involve a project interaction, since taking one project forecloses the other.
Unfortunately, not every project interaction is so simple to evaluate as the choice
between the two networking projects, but we will explain how to tackle three important
decisions:
 The investment timing decision. Should you buy a computer now or wait and
think again next year? (Here today’s investment is competing with possible future
investments.)
 The choice between long- and short-lived equipment. Should the company save
money today by installing cheaper machinery that will not last as long? (Here
today’s decision would accelerate a later investment in machine replacement.)
 The replacement decision. When existing machinery should be replaced? (Using

it another year could delay investment in machine replacement.)
6.7.2. Investment Timing
Let us return to the example of Ongwediva Technologies where the company was
contemplating the purchase of a new computer system. The proposed investment has a
net present value of almost N$20,000, so it appears that the cost savings would easily
justify the expense of the system. However, the financial manager is not persuaded.
She reasons that the price of computers is continually falling and therefore proposes
postponing the purchase, arguing that the NPV of the system will be even higher if the
firm waits until the following year. Unfortunately, she has been making the same
argument for 10 years and the company is steadily losing business to competitors with
more efficient systems. Is there a flaw in her reasoning?

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This is a problem in investment timing. When is it best to commit to a positive-NPV

investment? Investment timing problems all involve choices among mutually exclusive
NPV at Year
Year of Cost of PV of Purchase NPV
Purchase Computer Savings (r = 10%) Today
0 N$50 N$70 N$20 N$20.0

1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 25.5 ← optimal
4 33 70 37 25.3 purchase
5 31 70 39 24.2 date
Ongwediva Technologies: the gain from purchase of a computer is rising, but the NPV
today is highest if the computer is purchased in Year 3 (figures in thousands of dollars).
6.8 Internal Rate of Return (IRR)

The other most used tool in capital budgeting is the Internal Rate of Return (IRR), also
known as the Hidden Rate of Return. In this part of our capital budgeting discussion we
examine the IRR.
6.8.1 IRR Explained
IRR is one of the evaluation or investment appraisal methods. It is sometimes called the
‘hidden rate’ because we do not know the rate and our task is to determine this rate. It is
also sometimes referred to as the economic rate of return (ERR). By definition, IRR is
the discount rate often used in capital budgeting that makes the net present value of all
cash flows from a particular project equal to zero. Further elaborated, IRR is that rate
which when used to discount a project’s cash flows will result in a NPV = 0.
In general, the higher a project's internal rate of return, the more desirable it is to
undertake the project. As such, IRR can be used to rank several prospective projects a

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firm is considering. Assuming all other factors are equal among the various projects, the
project with the highest IRR would probably be considered the best and is undertaken
first.
You can think of IRR as the rate of growth a project is expected to generate. While the
actual rate of return that a given project ends up generating will often differ from its
estimated IRR rate, a project with a substantially higher IRR value than other available
options would still provide a much better chance of strong growth.
IRRs can also be compared against prevailing rates of return in the securities market. If
a firm cannot find any projects with IRRs greater than the returns that can be generated
in the financial markets, it may simply choose to invest its retained earnings into the
market.
The IRR is frequently used by corporations to compare and decide between capital
projects, but it can also help you evaluate certain financial events in your own life, like
lotteries and investments.
The IRR is the interest rate (also known as the discount rate) that will bring a series of
cash flows (positive and negative) to a NPV of zero (or to the current value of cash
invested). Using IRR to obtain net present value is known as the discounted cash flow
method of financial analysis.
6.8.2 Where do we use IRR?
IRR is by corporations that wish to compare capital projects. For example, a corporation
will evaluate an investment in a new plant versus an extension of an existing plant
based on the IRR of each project. In such a case, each new capital project must
produce an IRR that is higher than the company's cost of capital. Once this hurdle is
surpassed, the project with the highest IRR would be the wiser investment, all other
things being equal (including risk).

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IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a
company allocates a substantial amount to a stock buyback, the analysis must show
that the company's own stock is a better investment (has a higher IRR) than any other
use of the funds for other capital projects, or than any acquisition candidate at current
market prices.
6.8.3 Calculation Complexities
The IRR formula can be very complex depending on the timing and variances in cash
flow amounts. Without a computer or financial calculator, IRR can only be computed by
trial and error. One of the disadvantages of using IRR is that all cash flows are assumed
to be reinvested at the same discount rate, although in the real world these rates will
fluctuate, particularly with longer term projects. IRR can be useful, however, when
comparing projects of equal risk, rather than as a fixed return projection.
6.8.4 Calculating IRR
You will remember we calculated IRR using a trial and error method. We used the
following formula:
The other way of computing IRR is by using the example of a mortgage with even
payments. Try to follow this example; I hope it will help you in your calculations.

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Assume an initial mortgage amount of N$200,000 and monthly payments of N$1,050 for
30 years. The IRR (or implied interest rate) on this loan annually is 4.8%.
Because the a stream of payments is equal and spaced at even intervals, an alternative
approach is to discount these payments at a 4.8% interest rate, which will produce a net
present value of N$200,000. Alternatively, if the payments are raised to, say N$1,100,
the IRR of that loan will rise to 5.2%.
The formula for IRR, using this example, is as follows:
 Where the initial payment (CF1) is N$200,000 (a positive inflow)
 Subsequent cash flows (CF 2, CF 3, CF N) are negative N$1050 (negative

because it is being paid out)
 Number of payments (N) is 30 years times 12 = 360 monthly payments
 Initial Investment is $200,000
 IRR is 4.8% divided by 12 (to equate to monthly payments) = 0.400%
6.9 Pay Back Period
These days almost all large companies use discounted cash flow in some form, but
sometimes they use it in combination with other theoretically inappropriate measures of
performance. We next examine two of these measures, the payback period and the
book rate of return.
A project’s payback period is the length of time an investment takes to recover the
project’s initial investment. Suppose a washing machine costs about N$400. But we are
currently spending N$3 a week, or around N$150 a year, on laundry. So the washing
machine should pay for itself in less than 3 years. You have just encountered the
payback rule.

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For the washing machine the payback period was just under 3 years. The payback rule
states that a project should be accepted if its payback period is less than a specified
cut-off period. For example, if the cut-off period is 4 years, the washing machine makes
the grade; if the cut-off is 2 years, it does not.
As a rough rule of thumb the payback rule may be adequate, but it is easy to see that it
can lead to nonsensical decisions. For example, compare projects A and B. Project A
has a 2-year payback and a large positive NPV. Project B also has a 2-year payback
but a negative NPV. Project A is clearly superior, but the payback rule ranks both
equally. This is because payback does not consider any cash flows that arrive after the
payback period. A firm that uses the payback criterion with a cut-off of two or more
years would accept both A and B despite the fact that only A would increase
shareholder wealth.
Cash Flows, Dollars Payback
Period, NPV
Project C0 C1 C2 C3 Years at 10%
A –2,000 +1,000 +1,000 +10,000 2 N$7,249

B –2,000 +1,000 +1,000 0 2 –264
C –2,000 0 +2,000 0 2 –347
A second problem with payback is that it gives equal weight to all cash flows arriving
before the cut-off period, despite the fact that the more distant flows are less valuable.
For example, look at project C. It also has a payback period of 2 years but it has an
even lower NPV than project B. Why? Because its cash flows arrive later within the
payback period.
To use the payback rule a firm has to decide on an appropriate cut-off period. If it uses
the same cut-off regardless of project life, it will tend to accept too many short-lived
projects and reject too many long-lived ones. The payback rule will bias the firm against
accepting long-term projects because cash flows that arrive after the payback period
are ignored.

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Large construction projects usually have long payback periods. However, most firms
that employ the payback rule use shorter cut-off periods. If they used the payback rule
mechanically, long-lived projects would not have a chance.
The primary attraction of the payback criterion is its simplicity. But remember that the
hard part of project evaluation is forecasting the cash flows, not doing the arithmetic.
Today’s spreadsheets make discounting a trivial exercise. Therefore, the payback rule
saves you only the easy part of the analysis.
We have had little good to say about payback. So why do many large companies
continue to use it? Senior managers don’t truly believe that all cash flows after the
payback period are irrelevant. It seems more likely (and more charitable to those
managers) that payback survives because the deficiencies are relatively unimportant or
because there are some offsetting benefits. Thus managers may point out that payback
is the simplest way to communicate an idea of project desirability. Investment decisions
require discussion and negotiation between people from all parts of the firm and it is
important to have a measure that everyone can understand. Perhaps also managers
favour quick payback projects even when they have lower NPVs, because they believe
that quicker profits mean quicker promotion. That takes us back where we discussed
the need to align the objectives of managers with those of the shareholders.
In practice payback is most commonly used when the capital investment is small or
when the merits of the project are so obvious that more formal analysis is unnecessary.
For example, if a project is expected to produce constant cash flows for 10 years and
the payback period is only 2 years, the project in all likelihood has a positive NPV.
We pointed out that net present value and internal rate of return are both discounted
cash-flow measures. In other words, each measure depends only on the project’s cash
flows and the opportunity cost of capital. But when companies report to shareholders on
their performance, they do not show simply the cash flows. Instead they report the firm’s
book income and book assets.

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6.10 Book Rate of Return
Book rate of return is accounting income divided by book value. In our earlier
discussions we pointed out that net present value and internal rate of return are both
discounted cash-flow measures. In other words, each measure depends only on the
project’s cash flows and the opportunity cost of capital. But when companies report to
shareholders on their performance, they do not show simply the cash flows. Instead
they report the firm’s book income and book assets.
Shareholders and financial managers sometimes use these accounting numbers to

calculate a book rate of return (also called the accounting rate of return). In other
words, they look at the company’s book income (i.e., accounting profits) as a proportion
of the book value of the assets:
Book Rate of Return = Book Income

Book Assets
Illustration: Mr Shivolo invests N$90,000 in brick moulding equipment. The equipment

will increase cash flows by N$50,000 a year for 3 years, when it will need to be
replaced. The contribution to accounting profits equals this cash flow less an allowance
for depreciation of N$30,000 a year. (We ignore taxes to keep things simple.) The book
return on this project in each year can be calculated as follows:
Book Value Net Income Book Value,

Start of Year during Year
We have already seen that cash End of Year Book
flows and Rate of Returnincome may be
accounting very different.
(N$ thousands) (N$ thousands) (N$ thousands) = Income/Book Value at Start of Year
90 50 – 30 = 20 60 20/90 = .222 = 22.2%
60 50 – 30 = 20 30 20/60 = .333 = 33.3%
30 50 – 30 = 20 0 20/30 = .667 = 66.7%
For example, the accountant labels some cash outflows as capital investments and
others as operating expenses. The operating expenses are deducted immediately from
each year’s income, while the capital investment is depreciated over a number of years.

Corporate Finance
Thus the book rate of return depends on which items the accountant chooses to treat as
capital investments and how rapidly they are depreciated. Book rate of return is not
generally the same as the internal rate of return. The difference between the two can
be considerable. Book rate of return therefore can easily give a misleading impression
of the attractiveness of a project.
Managers seldom make investment decisions nowadays on the basis of accounting

numbers. But they know that the company’s shareholders pay considerable attention to
book measures of profitability and naturally, therefore, they look at how major projects
would affect the company’s book rate of return
6.11 Investment Criteria When Projects Interact
Let us pause for a moment to review. We have seen that the NPV rule is the most
reliable criterion for project evaluation. NPV is reliable because it measures the
difference between the cost of a project and the value of the project. That difference—
the net present value—is the amount by which the project would increase the value of
the firm. Other rules such as payback period or book return may be viewed at best as
rough proxies for the attractiveness of a proposed project; because they are not based
on value, they can easily lead to incorrect investment decisions. Of the alternatives to
the NPV rule, IRR is clearly the best choice in that it usually results in the same
accept-or-reject decision as the NPV rule, but like the alternatives, it does not quantify
the contribution to firm value. We will see shortly this can cause problems when
managers have to choose among competing projects.
We are now ready to extend our discussion of investment criteria to encompass some
of the issues encountered when managers must choose among projects that
interact— that is, when acceptance of one project affects another one. The NPV rule
can be adapted to these new problems with only a bit of extra effort. But unless you
are careful, the IRR rule may lead you astray.

Corporate Finance
Which method should be used?
We have looked at the different methods of investment appraisal. The question now is
which of these methods should be used. For us to answer this question, we need to
come up with parameters that we can use to determine the best tool to use. A good
investment appraisal tool must have the following characteristics:
1. Uses cash flows instead of profits.
2. Takes into account time value of money.
3. Measures profitability of the investment.
4. Uses all of the project’s cash flows.
5. Must be reliable i.e. gives same results when used by different project
appraisers.
6. Takes into account the firm’s cost of capital.
7. Must be applicable to technically challenging situations such as conventional

cash flows.
Net Present Value. The NPV method meets all the conditions stated above.
Internal Rate of Return. The IRR meets most of the conditions above. The problem
arises with condition 7, where the project has no conventional cash flows. Projects with
non-conventional cash flows are those that have a negative cash flow after project
implementation. Such projects can result in the IRR having either no return or multiple
returns.

Corporate Finance
Revision Exercise
1. Namdeb invests N$60,000 in a project. The project generates a cash inflow of

N$30,000 a year for each of 3 years and nothing thereafter. Book income in each year
is equal to this cash flow less an allowance for depreciation of N$20,000 a year. For
simplicity, we assume there are no taxes.
a. Calculate the project’s internal rate of return. (If you do not have a financial
calculator or spreadsheet program, this will require a little trial and error.)
b. Now calculate the book rate of return in each year by dividing the book income
for that year by the book value of the assets at the start of the year.

Corporate Finance
Discussion 7
7.0 WORKING CAPITAL MANAGEMENT
7.1 Introduction
Management of working capital is one of the most important issues in the management
of organizations today. Many financial executives are trying to identify the basic
determinants of working capital and the optimal level of working capital (Lamberson
1995). It is true that companies can minimize risk and improve the overall performance
by understanding the role and determinants of working capital.
7.2 Outcomes of Learning
1. Demonstrate an in-depth understanding of what working capital is, its

importance, and how effective management of working capital can improve the
performance the organisations.
2. Identify and explain the main components of working capital.
3. Use the various working capital management ratios to determine the most ideal
levels of working capital for given organisations.
7.3 Working Capital Management in the Past and the Present
Traditionally, researchers in managerial finance focused on long-term financial

decisions making, particularly capital structure, dividends, investments, and company
valuation decisions. However, short-term assets and liabilities are important
components of total assets and needs to be carefully analysed. In the USA, a study was

Corporate Finance
conducted to investigate the relationship among the aggressive and conservative

working capital policies and profitability, as well as risk of firms for 208 public limited
companies listed at KSE for the period of 1998-2005. The empirical results found that
there is a negative relationship between working capital policies and profitability i.e.
there is no significant relationship between the level of current assets and liabilities, and
risk of the firms.
In general, from the viewpoint of Chief Financial Officer (CFO), management of working
capital is simple and a simple concept of ensuring the ability of the organization to
finance the difference between the current assets and current liabilities (Harris 2005).
Today, management of working capital is one of the most important issues in the
organizations where many financial executives are trying to identify the basic
determinants of working capital and the optimal level of working capital (Lamberson
1995). Consequently, companies can minimize risk and improve the overall
performance by understanding the role and determinants of working capital.
7.4 What is Working Capital?
Working capital is the difference between current assets and current liabilities. Usually
current assets exceed current liabilities—that is, firms have positive net working capital.
To see why firms need net working capital, imagine a small company, that makes small
novelty items for sale at gift shops. It buys raw materials such as leather, beads, and
rhinestones for cash, processes them into finished goods like wallets or costume
jewellery, and then sells these goods on credit.
If you prepare the firm’s balance sheet at the beginning of the process, you see cash (a
current asset). If you delay a little, you find the cash replaced first by inventories of raw
materials and then by inventories of finished goods (also current assets). When the
goods are sold, the inventories give way to accounts receivable (another current asset)
and finally, when the customers pay their bills, the firm takes out its profit and
replenishes the cash balance.

Corporate Finance
7.5 Working Capital Policies
The impact of working capital policies on profitability is highly important, however, a little
empirical research has been carried out to examine this relationship. This discussion
touches on the potential relationship of aggressive and conservative policies with the
accounting and market measures of profitability.
7.6 The Objective of Working Capital Management
The main objective of working capital management is to maintain an optimal balance

between each of the working capital components. Business success heavily depends
on the ability of financial executives to effectively manage receivables, inventory, and
payables (Filbeck and Krueger 2005).
7.7 Aggressive Working Capital Management Policy
This is a policy where the firm maintains a low level of current assets as percentage of
total assets. The policy may also be used for the financing decisions of the firm in the
form of high level of current liabilities as percentage of total liabilities.
Excessive levels of current assets may have a negative effect on the firm’s profitability
whereas a low level of current assets may lead to lower level of liquidity and stockouts
resulting in difficulties in maintaining smooth operations (Van Horne and Wachowicz,
2004).
7.8 Conservative Working Capital Management Policy
This is a policy where the firm maintains a high level of current assets as percentage of
total assets. Firms can reduce their financing costs and increase the amount of funds
available for development projects by reducing the amount of investment tied up in short
term assets. The high level of current assets may reduce the risk of liquidity, risk of
stockouts etc. buts is associated with the opportunity cost of funds that may have been
invested in long-term assets.

Corporate Finance
7.9 Optimal Level of Working Capital
An optimal level of working capital would be the one in which a balance is achieved
between risk and efficiency. Most of the financial managers’ time and effort are
allocated in optimizing the levels of current assets and liabilities back toward optimal
levels (Lamberson,1995). Optimal working capital management requires continuous
monitoring to maintain proper level in various components of working capital i.e. cash
receivables, inventory and payables etc. In general, current assets are considered as
one of the important component of total assets of a firm. A firm may be able to reduce
the investment in fixed assets by renting or leasing plant and machinery, whereas, the
same policy cannot be followed for the components of working capital.
7.10 Components of Working Capital
The main components of working capital are current assets and current liabilities. It is
these two that are collectively known as working capital.
Current Assets.
Examples are:
Accounts receivable. Accounts receivable arise because companies do not usually

expect customers to pay for their purchases immediately. These unpaid bills are a
valuable asset that companies expect to be able to turn into cash in the near future. The
bulk of accounts receivable consists of unpaid bills from sales to other companies and
are known as trade credit. The remainder arises from the sale of goods to the final
consumer. These are known as consumer credit.
Inventory. May consist of raw materials, work in process, or finished goods awaiting
sale and shipment.
Cash and marketable securities. The cash consists partly of dollar bills, but most of the
cash is in the form of bank deposits. These may be demand deposits (money in

Corporate Finance
checking accounts that the firm can pay out immediately) and time deposits (money in
savings accounts that can be paid out only with a delay). The principal marketable
security is commercial paper (short-term unsecured debt sold by other firms). Other
securities include Treasury bills, which are short-term debts sold by the central bank
e.g. Bank of Namibia.
In managing their cash companies face much the same problem you do. There are
always advantages to holding large amounts of ready cash—they reduce the risk of
running out of cash and having to borrow more on short notice. On the other hand, there
is a cost to holding idle cash balances rather than putting the money to work earning
interest. In later we will tell you how the financial manager collects and pays out cash
and decides on an optimal cash balance.
Current Liabilities
Examples:
Accounts payable— A company’s principal current asset consists of unpaid bills. One
firm’s credit must be another’s debit. Accounts payable are outstanding payments due
to other companies.
Short-term borrowing: The other major current liability consists of short-term borrowing.
This includes bank overdraft and notes payable.
Working Capital and Cash Conversion Cycle
The components of working capital constantly change with the cycle of operations, but
the amount of working capital is fixed. This is one reason why net working capital is a
useful summary measure of current assets or liabilities.

Corporate Finance
Cash
Raw materials
Receivables
inventory
Finished goods
inventory
The diagram above depicts four key dates in the production cycle that influence the
firm’s investment in working capital. The firm starts the cycle by purchasing raw
materials, but it does not pay for them immediately. This delay is the accounts payable
period. The firm processes the raw material and then sells the finished goods. The
delay between the initial investment in inventories and the sale date is the inventory
period. Sometime after the firm has sold the goods its customers pay their bills. The
delay between the date of sale and the date at which the firm is paid is the accounts
receivable period.
The top part of the diagram shows that the total delay between initial purchase of raw
materials and ultimate payments from customers is the sum of the inventory and
accounts receivable periods: first the raw materials must be purchased, processed, and
sold, and then the bills must be collected. However, the net time that the company is out
of cash is reduced by the time it takes to pay its own bills. The length of time between
the firm’s payment for its raw materials and the collection of payment from the customer
is known as the firm’s cash conversion cycle. To summarize,
Cash conversion cycle = (inventory period + receivables period) – accounts payable

period
The longer the production process, the more cash the firm must keep tied up in
inventories. Similarly, the longer it takes customers to pay their bills, the higher the
value of accounts receivable. On the other hand, if a firm can delay paying for its own

Corporate Finance
materials, it may reduce the amount of cash it needs. In other words, accounts payable
reduce net working capital.
The firm’s financial statements can be used to estimate the inventory period, also called
days’ sales in inventory:
average accounts receivable

Accounts receivable period =
annual sales/365 average
accounts payable
Accounts payable period =
annual cost of goods sold/365

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Corporate Finance

THE NATURE, SCOPE AND STRUCTURE OF CORPORATE

1.0. INTRODUCTION TO THE STUDY OF CORPORATE FINANCE

To understand issues of corporate finance we will start by examining the various

1.2. Learning Outcomes

By end of this discussion, we should be able to:

a. Define Corporate Finance as a field of study.

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1.3. What is Corporate Finance?

 Corporate finance is the study of how organisations manage financial

 It is the study of how organisations’ financial resources may be efficiently and

 Corporate finance is primarily concerned with maximizing shareholder value

 Everything from capital investment decisions, financing decisions, working

1.4. Why is it important to study Corporate Finance?

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 Like companies, individuals are faced

1.5. What is the role of Corporate Finance?

1.6. The Concept of Organisation - What is an Organisation?

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An organisation is a social unit of people that is structured and managed to meet

1.7. What is the Primary Objective of for-profit firms?

Organisations may be classified into two:

 Organisations that are in business for profit (for-profit organisations)

Both not-for-profit organisations and for-profit organisations have many

1.8. What are the legal forms of businesses common to Namibia?

Sole proprietorships, partnerships and corporations each have their advantages

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1.8.1. Sole Proprietorship

 It is the simplest type of business to start.

 It is the least regulated form of organization (all you need is getting a

 The owner of a sole proprietorship keeps all the profits.

 Decisions are made quickly because there is no consultation.

Example: The many liquor outlets (shebeens) in Katutura, Windhoek.

 There is no distinction between personal and business income, so all

 The life of a sole proprietorship is limited to the owner’s lifespan. It can

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 Ownership of a sole proprietorship may be difficult to transfer because this

A partnership is similar to a proprietorship, except that there are two or more

 In a general partnership, all the partners share in gains or losses.

 In a limited partnership, liability for business debts is limited to the amount

 A decision by one partner binds all partners.

 The partnership terminates when a general partner wishes to sell out or

 All income is taxed as personal income to the partners.

 The amount of equity that can be raised is limited to the partners’

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A corporation is a business which is set up as a separate legal entity (pseudo

Ownership (represented by shares of stock) can be readily transferred, and the

 The corporation borrows money in its own name. As a result, the

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 Because a corporation is a legal person, it must pay taxes.

 Moreover, money paid out to stockholders in the form of dividends is

1.8.4. Limited liability Company (LLC)

A business formed by members whose liability is limited to their investment. An

 Corporations are usually big and complex enough to give enough

The International University of Management: SMBA 8

Corporate finance explores in detail what is expected of a financial manager in

1. Investment decisions (also known as capital budgeting or investment

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2. Financing decisions (also known as capital structure and capital mix

3. Working capital management decisions (also known as short-term