Financial Management

(MAPM 722)

Chapter One
Overview of Financial
Management
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What is Finance?
• Finance
• Is the bottom line of every business activity
• is a prerequisite for obtaining physical resources, which
are needed to perform productive activities and
carrying business operations [such as sales, pay
compensations, reserve for contingencies and so on].
• is concerned with the process, institutions , markets,
and instruments involved in the transfer of money
between/among individuals, businesses, and
government.

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Defining Corporate/Business Finance
 Finance:
 Is the art and science of managing money
 Is the managerial activity that is concerned with the planning and
controlling of the firm’s financial affairs.
 Is the area of business management devoted to rational use of capital and
careful selection of sources of capital in order to achieve the desired goals
 Some important questions that are answered using finance:
 What long-term investments should the firm take on?

 Where will we get the long-term financing to pay for the

investment?
 How will we manage the everyday financial activities of the

firm?

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Relationship with other Disciplines
 The field of finance is closely relation to Economics and
Accounting.
 With Economics:
 Economics provides a structure of decision making in
such areas as risk analysis, pricing theory through DD
and SSS relationships, comparative return analysis, etc.
 Economics also provides the broader picture of the

economic environment in which companies must

continual make decisions.
 Further more, economic variables such as: GDP, FDI,
industrial production (output), disposable income, unemployment,
inflation, interest rates, taxes, etc. must be in the decision model of a
finance manager

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Relationship with other Disciplines
 With Accounting :
 Accounting is often said the language of finance

because it provides financial data through income

statements, balance sheets, and cash flow statements.
Finance managers must know how to interpret and use
these statements in allocating firm’s financial resources.

 Finance links economic theory with the numbers of

accounting. Hence, managers must know what it means
to assess the financial performance of the firm.

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Relationship…
 With Mathematics
 Modern approaches of the financial management applied
large number of mathematical and statistical tools and
techniques. They are also called as econometrics.
 Economic order quantity, discount factor, time value of
money, present value of money, cost of capital, capital
structure theories, dividend theories, ratio analysis and
working capital analysis are used as mathematical and
statistical tools and techniques in the field of financial
management.

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Relationship …
 With Production/Operations
 Profit of the concern depends upon the production
performance. Production performance needs finance,
because production department requires raw material,
machinery, wages, operating expenses etc. These
expenditures are decided and estimated by the financial
department and the finance manager allocates the
appropriate finance to production department.
 The financial manager must be aware of the operational
process and finance required for each process of
production activities.

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Relationship …
 With Marketing/Sales
 Produced goods are sold in the market with innovative
and modern approaches. For this, the marketing
department needs finance to meet their requirements.
 The financial manager or finance department is
responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial
management are interrelated and depends on each
other.

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Relationship …
 With HR
 Financial management is also related with human
resource department, which provides manpower to all
the functional areas of the management.
 Financial manager should carefully evaluate the
requirement of manpower to each department and
allocate the finance to the human resource department
as wages, salary, remuneration, commission, bonus,
pension and other monetary benefits to the human
resource department.
 Hence, financial management is directly related with
human resource management.

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Major Areas in the field of finance
 As the application of economic principles and
concepts to business decision making and problem
solving, finance consists of three categories:
 Financial management

 Investments

 Financial institutions

 Others:

 Personal finance
 Public finance

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Major Areas in the field of finance
 Financial management
 The area is concerned with financial decision making within a
business entity
 Include maintaining optimum cash balance, extending credit,
merger and acquisitions, raising of funds and the instruments to
be used for raising funds etc.
 Investments
 The area of finance focuses on the behavior of financial markets
and pricing of financial instruments
 Financial institutions
 This area deals with banks and other financial institutions that
specializes in bringing suppliers of funds together with the users
of funds.

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What is Financial Management?

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What is…
 Financial management can be seen as a subject, a
process, or a function.
 As a subject:
 It deals with decisions made by a business firm that

affects its finances.

 As a decision process:
 It is concerned with planning for raising, and utilizing

funds in a manner that achieves the goal of a firm.

 As a function
 It deals with the management of capital sources and

uses of a firm

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What is..
 Financial Management:
 Is the application of general management standards to the
financial resources of the firm
 Is broadly concerned with the acquisition and use of funds by a
business firm.
 The scope of financial management has grown in recent
years, but traditionally it is concerned with the following:
 How large should a firm be and how fast should it grow?
 What should be the composition of the firm’s assets?
 What should be the mix of the firm’s financing?
 How should the firm analyze, plan, and control its financial
affairs?

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Evolution of Financial Management
 FM emerged as a distinct field of study at the
turn of the 20th C.
 Its evolution may be divided into three broad
phases:
 Traditional,
 Transitional, and
 Modern

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Evolution…
 Traditional phase:
 Lasted for decades
 FM focused mainly on certain periodic events like
formation, issuance of capital, major expansion, merger,
reorganization, and liquidation in the life cycle of the firm.
 The approach was mainly descriptive and institutional.
The instruments of financing, the institutions and
procedures used in capital markets, and the legal aspects
of financial events formed the core of FM.
 The outsider’s point of view was dominant. FM was
viewed mainly from the point of view of the investment
bankers, lenders, and other outside interests

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Evolution…
 Traditional phase:
 Lasted for decades
 FM focused mainly on certain periodic events like
formation, issuance of capital, major expansion, merger,
reorganization, and liquidation in the life cycle of the firm.
 The approach was mainly descriptive and institutional.
The instruments of financing, the institutions and
procedures used in capital markets, and the legal aspects
of financial events formed the core of FM.
 The outsider’s point of view was dominant. FM was
viewed mainly from the point of view of the investment
bankers, lenders, and other outside interests

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Evolution…
 Transitional phase:
 Began around the early 1940s and continued through early
1950s
 During this phase greater emphasis was placed o the day
to day problems faced by financial managers in the areas
of fund analysis, planning, and control.
 The focus of FM was shifted to WCM

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Evolution…
 Modern phase:
 Began in the mid 1950s and has witnessed an accelerated
pace of development with the infusion of ideas from
economic theory and application of quantitative methods of
analysis
 The distinctive nature of this phase are:
 The central focus of FM is considered to be a rational matching of
funds raised to their uses [ to maximize wealth of owners]
 The approach of FM has become more analytical and quantitative
 Since the beginning of this phase significant development
have occurred in fields of capital budgeting, capital structure
theory, efficient market theory, option pricing theory, agency
theory, arbitrage pricing theory, valuation models, dividend
policy, WCM, financial modeling, and behavioral finance.

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Scope of Financial Management
 The Broad decisions areas or functions of
financial management are:
 Investment
 Financing
 Dividend
 Liquidity

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Scope of Financial Management
 Investment Decision/function:
 Also called Capital Budgeting decision which
involves the decision for allocation of capital or
commitment of funds to long-term assets like PPE
that would yield benefits for longer future
 Two important aspects of investment decisions
are:
 The evaluation of prospective profitability of new
investments and
 The measurement of a cut-off rate against that the
prospective return of new investments could be
compared

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Scope of Financial Management
 Financing Decision/function:
 Also called capital structure decision which
involves decisions on when, where, and how to
acquire funds to meet the firm’s investment
needs.
 The central issue is to determine the proportion of
equity and debt, i.e. mix of debt and equity
 Hence, what is important is to obtain best
financing mix.

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Scope of Financial Management
 Dividend Decision
 Is concerned about whether to decide to distribute
all the profits in the form of dividends or to distribute
a part of the profits and retain the balance.
 Finance managers should consider the investment
opportunities available to the firm, plans for
expansion and growth, etc.
 Liquidity
 Also called working capital management decision,
which refers to a firm’s short term assets, such as
its short-term liabilities.

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Function of Financial Manager
1a.Raising
2.Investments funds

Operations Financial Financial

1b.Obligations
(plant, Manager (stocks, debt Markets
equipment, securities) (investors)
3.Cash from
projects) operational
activities
4.Reinvesting 5.Dividends or
interest
payments

Finance function – managing the cash flow

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24
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Goals & Objectives of Financial Management
Mkt price of a firm’s stock represents
the value that mkt participants place
 Possible Goals on the company
 Maximizing shareholder’s wealth

Not Profit.
 Maximizing stock price in the mkt Even Not
EPS!!
 Objectives
 Maximizing economic welfare of shareholders or
owners welfare

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Why Not EPS?
 Not EPS as it
 Is based on accounting profits & affected by the
choice of accounting policies
 Doesn’t consider timing or expected return (risk
and return)
 Is subject to management’s manipulations

 While a company's EPS will often influence

the market price of its stock, the relationship
is rarely inverse.

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Objective of FM
 Maximization of economic welfare of shareholders
(owners) is accepted as the financial objective of the firm
 Q: how?.
 There are two criteria for this:
 Profit maximization
 Wealth maximization
 Profit maximization (PM)
 According to this criteria, the financial decisions (I/F/D) of a firm
should be oriented to the maximization of profits (i.e. select those
assets, projects, and decisions which are profitable and reject
those which are not profitable).
 As a criteria, PM can be justified on the following grounds:

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Objective of FM
 As a criteria, PM can be justified on the following
grounds:
 Rational
 Test of business performance
 Main source of inspiration
 Basis of decision – making
 However, it has the following drawback also
 The term ‘profit’ is vague
 It ignores time value of money
 It ignores risk
 It ignores social responsibility

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Objective of FM
 Wealth maximization (WM)
 It is also know as, value maximization.
 According to this criteria, the financial decisions (I/F/D) of a firm
should be oriented to the maximization of profits (i.e. select those
assets, projects, and decisions which are profitable and reject those
which are not profitable).
 As a criteria, WM can be justified on the following grounds:
 It measures income in terms of cash flows, and avoids the ambiguity now
associated with accounting profits as, income from investments is
measured on the basis of cash flows rather than on accounting profits
 It recognizes time value of money by discounting the expected income of
different years at a certain discount rate (cost of capital)
 It analyses risk and uncertainty so that the best course of action can be
selected from different alternatives
 It is not in conflict with other motives like maximization of sales or market
value of shares. It helps rather in the achievement of all these other
objectives
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Agency Theory

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Agency Theory
 Agent:
 Refers individuals(s) authorized by another person, called the
principal, to act in the latter’s benefit.

 Agency theory:
 Describes the fundamental conflict between self-interested
managers and owners, when the former have the control of the firm
but the latter bear most of the wealth effects.

 Agency Problem:
 A potential conflict of interest between the agent (manager) and:
 The stockholders or

 The creditors (debt holders) or

 Customers

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Agency Relationship
 In financial management, the primary agency
relationships are between:
 (1) stockholders and managers and
 (2) stockholders and debt holders /Creditors/.

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Agency Conflict 1: Stockholders Vs Managers
 In most public corporations, agency conflicts are
important, because their managers generally own only a
small percentage of the stock.
 Studies indicate some managers try to maximize the size
of their firms. Why?
 Increase their job security
 Increase their personal power and status
 Since compensation is positively correlated with size that
justify a higher salary and bonus

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Agency Costs
 Managers can be encouraged to act in the stockholders’
best interests through a set of incentives, constraints,
and punishments.
 However, to reduce agency conflicts, stockholders must
incur agency costs, which include all costs borne by
shareholders to encourage managers to maximize the
firm’s long-term stock price rather than act in their own
self-interests.
 Because managers can manipulate the information that
is available in the market, it is critical that good incentive
compensation plans be based on stock prices over the
long term rather than the short term.

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Agency Costs
 Include:
 Direct
 Monitoring costs (the cost of reports and audits)
 Structural costs (by appointing outside investors in
the BoD)
 The opportunity cost of any contractual constraints
(limit the ability of managers to take timely actions).
 The cost of manager’s incentives and bonus fees
 Indirect
 The loss of wealth due to suboptimal behavior
by the agent

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Agency…
 Means of reducing agency conflict
 Attractive Incentives /Compensation Plans/
 Cash/Stock options
 Perquisites (bonus, better salary, promotion, etc)
 Proxy fight at Annual General Meeting (AGM)
 Voting to replace the existing management
 The threat of takeovers

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Agency Conflict 2: Stockholders Vs Creditors

 Creditors lend funds at rates that are based on the firm’s

perceived risk at the time the credit is extended, which in
turn is based on
 (1) the riskiness of the firm’s existing assets,
 (2) expectations concerning the riskiness of future asset
additions,
 (3) the existing capital structure, and
 (4) expectations concerning future capital structure
changes.

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Agency Conflict 2: Stockholders Vs Creditors
 Two of the most common types of conflicts that may arise
between stockholders and debt-holders.
 Investment in riskier assets
 Increasing leverage situations

1. Investment in riskier assets

Stockholders, acting through management, may decide to take on a large new

project that is far riskier than was anticipated by the creditors. This increased
risk will cause the required rate of return on the firm’s debt to increase, and that
will cause the value of the outstanding debt to fall. If the risky project is
successful, all the benefits go to the stockholders, because creditors’ returns
are fixed at the old, low-risk rate. However, if the project is unsuccessful, the
bondholders may have to share in the losses.

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Agency Conflict 2: Stockholders Vs Creditors
 Two of the most common types of conflicts that may arise
between stockholders and debt-holders.
2) Increasing leverage situation

Similarly, suppose its managers borrow additional funds and use the proceeds
to repurchase some of the firm’s outstanding stock in an effort to “leverage up”
stockholders’ return on equity. The value of the debt will probably decrease,
because more debt will have a claim against the firm’s cash flows and assets.

 In general, in both the riskier asset and the increased leverage situations,
stockholders tend to gain at the expense of creditors.

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Financial Management
(MAPM 722)

Chapter Two
Financial Analysis
and Planning

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What is Financial Analysis
 One of the most common challenges to project management is
the failure to correctly estimate expenses.
 In fact, a study conducted by Deloitte reports that 22% of
professionals consider budgeting issues to be a key barrier to
project implementation.
 These statistics indicate that the availability and sound
management of the business’s finances contributes significantly
to the success of the project.
What is Financial Analysis
 Financial analysis is a process of selecting, evaluating, and
interpreting financial data, along with other pertinent information, in
order to formulate an assessment of a company’s present and future
financial condition and performance.

 Financial analysis refers to an assessment of the viability, stability

and profitability of a business, sub- business or project.

 Financial analysis is also known as analysis and interpretation of

financial statements.

 Financial analysis is a method used to examine economic trends, set

financial policies, construct long-term business plans, and identify
ideal companies or projects for investment.
Need or Importance of for FA
 Financial statement analysis is used to identify the
trends and relationships between financial statement
items.
 Both internal management and external users (such as
analysts, creditors, and investors) of the financial
statements need to evaluate a company's profitability,
liquidity, and solvency.
 Nature of Analysis: The nature of the analysis depends
upon their [users] purpose or requirement. They [users]
make the necessary analysis and take the decision,
based on their assessment of the results obtained.
What is financial planning?

Financial Planning is an ongoing process to help

you make sensible decisions about money that
can help you achieve your goals in life
Financial Planning - Meaning

 Financial Planning is the process of estimating the capital

required and determining it’s competition.
 It is the process of framing financial policies in relation to
procurement, investment and administration of funds of an
enterprise.
 Financial Planning includes:
 Estimating the amount of capital to be raised
 Determining the form and proportionate amount of securities
 Formulating policies to manage the financial plan
Financial Planning - Importance
 Financial Planning is process of framing objectives, policies,
procedures, programs and budgets regarding the financial activities of
a concern. The importance include:
 To ensure adequate funds are available
 To ensure a reasonable balance between outflow and inflow
of funds so that stability is maintained
 To ensure suppliers of funds are easily investing in
companies which exercise financial planning.
Financial Planning – Importance (Cont’d)

 It helps in making growth and expansion programs which

helps in long-run survival of the company.
 It reduces uncertainties with regards to changing market
trends which can be faced easily through enough funds.
 It helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring
stability an d profitability in concern.
Steps in Financial Analysis
a) Identify exactly what the question is?
b) Establish the scope of the financial analysis
problem
c) Identify the schedule of events associated with
the project
d) Quantify and value events wherever possible.
e) Select an alternate rate of return and calculate the
project’s net present value.

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Steps in Financial Analysis
a) Identify exactly what the question is.
 This step is often called “framing the question.”
 It may seem like a trivial step; however, it is perhaps the most
important. Usually, a financial analysis is done to provide input into
some decision-making process.
 Here are some questions that should be asked:
 ! What is the decision that needs to be made? Was there a
problem which precipitated the need for a decision? What
issues need to be addressed by the decision?
 ! Who will be affected by the decision? Have all potential
stakeholders been considered?
 ! How will the results of the financial analysis be used in
making the decision? Have all of the possible alternatives
been considered?

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Steps in Financial Analysis
b) Establish the scope of the financial analysis problem.
 It is generally not necessary, or even desirable, to consider everything
that might affect a project.
 Part of the analysis should involve identifying the key aspects of the
project.
 The following are some basic questions that should be considered
before initiating any financial analysis problem.
 ! Which impacts will be included in the analysis? Will the analysis
consider only impacts that affect the owner of the project owner,
or should the analysis also account for impacts on neighboring
lands? What about the general public?
 ! When does the project end? Does it have an end? How far out

should you go in considering impacts? What is the time horizon

of the analysis?

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Steps in Financial Analysis
c) Identify the schedule of events associated with the
project.
 ! When are activities expected to happen? When do benefits occur?
When are
 goods produced? When are services provided? When do costs occur?
 ! Are there any other significant events that should be considered?
d) Quantify and value events wherever possible.
 For each good, service, cost or benefit that occurs, three pieces of
information are needed:
 1) the quantity,
 2) the value (generally, this would be the quantity times its price),
and
 3) the timing of the good, service, cost or benefit (this was
determined in step 3).

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Steps in Financial Analysis
e) Select an alternate rate of return and calculate the
project’s net present value.
 A key consideration when selecting a discount rate is the financial
position of the person or company for whom the analysis is being
done.
 If the person (or company) is going to borrow money to carry out
the project, then the rate of interest on the loan is usually the best
discount rate.
 If the person (or company) is going to invest their own money in

the project, then the ideal discount rate would be the rate of
return on the investment that the money would be used for if the
project was not pursued.

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Criteria for Project Evaluation
 The primary purpose of doing a financial analysis of a project
is to evaluate the project’s profitability or cost-
effectiveness relative to some alternative project or
investment.
 Frequently, the results of the financial analysis are used to
compare alternative projects to select which ones should be
implemented.
 Sometimes projects are mutually exclusive, such as alternate
prescriptions for a stand. In this case, only one project will be
selected and the task is solely to determine which of the
choices is best.

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Types and Sources of Financing
 There are two main types of financing: debt and equity
 Equity financing refers to the money subscribed by investors
and shareholders, whose returns on investment are in the form
of dividends and capital growth equivalent to the value of their
equity in the project organization.
 However, the project organization can make dividend
disbursements only after the interest and scheduled loan
repayment obligations have been met.
 If the project is successful, the returns on investment for equity
holders can be substantial; if it fails, equity providers may receive
no returns.
Types and Sources of Financing
 Debt financing refers to money borrowed from a
number of sources, including banks.
 This debt involves periodic repayments of the debt and
interest, based on agreed-upon schedules.
 The money borrowed through this type of financing
arrangement has to be repaid first, before the
repayment of other types of finances.
 This type of debt is also sometimes known as senior
debt.
Investment appraisal methods

 Accounting rate of return (ARR)

 Good measure of profitability
 Does not take into consideration the TVM Concept
NDCFM
 Payback period (PP)
 Measures liquidity not profitability
 Does not take into consideration the TVM Concept

 Net present value (NPV) DCFM

 Internal rate of return (IRR)

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Discounted Cash Flow
Methods
Net Present Value /NPV/
 The net present value (NPV) of an investment proposal is defined as
the sum of the present values of the cash flows minus the sum of the
present values of the net investments.
NPV= the sum of the PV of NCF – initial investment

Decision Rule
• Accept the project if NPV is positive

• Reject the project if NPV is negative

NPV
 Example 1:
 Assume that the project requires initial investment of $ 215,500. Annual net
cash flows are expected to be $ 70,000 for 5 years. If the required rate of
return is 10%, what is NPV?
 Solution

Year Cash Flow (in Discount Factor Present

Birr) (10%) Value (in Birr)

1 70,000 0.909 63,630

2 70,000 0.826 57,820
3 70,000 0.751 52,570 NPV= $ 265,300 – 215,500
NPV= $ 49,800
4 70,000 0.683 47,810
5 70,000 0.621 43,470
Total 265,300
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Financial Management
(MAPM 722)
Chapter Three

The Time Value of

Money and the
Concept of Interest

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The Concept of
Time Value of Money /TVM/

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TVM
 In the case of longer-term projects (investments), the
time at which profits start accruing can have a bearing
on the worth of future earnings because of the TVM.

 TVM is an important financial concept that states

 Money loses its value over time which makes it more desirable to
have it now rather than later

 In other words, it means, money earned now is worth

more than money earned at some time in the future,
 Reasons!
 Additional return could have been obtained if the money had
been invested in the intervening period:
 Purchasing power is reduced, due to Inflation
TVM
 Furthermore, profits made much later in the future are
more vulnerable to changes in circumstances than near-
term earnings; for this reason, less value should be
attached to them.

 In the case of long-term investments (projects), it has

become normal practice to consider the TVM by applying
a discount rate to future cash flows.

 The discount rate used is based on the required or

desired rate of return, and may also include the expected
rate of inflation over the life of the project.
Future Value Vs Present Value
 Financial values and decisions can be assessed by
using either future value or present value techniques.
Although these techniques will result in the same
decisions, they view the decision differently.
 Future value techniques typically measure cash flows at
the end of a project’s life.
 Present value techniques measure cash flows at the
start of a project’s life (time zero).
 Future value is cash you will receive at a given future
date, and present value is just like cash in hand today.

7/3/2023 Compiled By Habtamu B. (PhD) 70

Compounding and discounting
 The future value technique uses compounding to find the future
value of each cash flow at the end of the investment’s life and
then sums these values to find the investment’s future value.
 Alternatively, the present value technique uses discounting to
find the present value of each cash flow at time zero and then
sums these values to find the investment’s value today

7/3/2023 Compiled By Habtamu B. (PhD) 71

Future Value of a Single Amount
FV1 = PV(1 + i)
and
FV2 = FV1(1 + i)

 Substituting PV(1 + i) in the first equation for FV1

in the second equation:
FV2 = PV(1 + i)(1 + i) = PV(1 + i)2

 For (n) Periods:

FVn = PV(1 + i)n

7/3/2023 Compiled By Habtamu B. (PhD) 72

Future Value of a Single Amount
 Example:
 Suppose you invest $100 at 5% interest, compounded
annually.
 What is the value at the end of year 1
 What is the value at the end of year 2
 At the end of one year, your investment would be worth:
$100 + .05($100) = $105
or
$100 (1 + .05) = $105
 During the second year, you would earn interest on $105.
At the end of two years, your investment would be worth:
$105 (1 + .05) = $110.25
Future Value of a Single Amount


7/3/2023 Compiled By Habtamu B. (PhD) 74

Future Value of a Single Amount


7/3/2023 Compiled By Habtamu B. (PhD) 75

Interest Rates, Time, and Future Value

Future Value of $100

2500
16%
2000
0%
1500
6%
10% 1000
16% 10%
500 6%
0%
0
0 4 8 12 16 20
Number of Periods
Nonannual Periods
mn
 i
FVn  PV 1  
 m
1
PV  FVn mn
 i 
1 
m 
m = number of times compounding occurs per year
i = annual stated rate of interest

 Example: Suppose you invest $1000 at an annual

rate of 8% with interest compounded a) annually, b)
semi-annually, c) quarterly, and d) daily. How much
would you have at the end of 4 years?
Nonannual Periods

 Annually
 FV4 = $1000(1 + .08/1)(1)(4) = $1000(1.08)4 = $1360

 Semi-Annually
 FV4 = $1000(1 + .08/2)(2)(4) = $1000(1.04)8 = $1369

 Quarterly
 FV4 = $1000(1 + .08/4)(4)(4) = $1000(1.02)16 = $1373

 Daily
 FV4 = $1000(1 + .08/365)(365)(4)

= $1000(1.000219)1460 = $1377
Present Value of a Single Amount
 Calculating present value (discounting) is simply the
inverse of calculating future value (compounding):

FVn  PV (1  i ) n Compoundin g
FVn  1 
PV   FVn  n
Discountin g
(1  i ) n
 (1  i ) 
 1 
where :  n
is the PV of $1 interest factor
 (1  i ) 
Present Value of a Single Amount
 Example:
 How much would you be willing to pay today for the right
to receive $10,000 five years from now, given you wish
to earn 6% on your investment:

 1 
PV  $10,000  5
 (1.06) 
= $10,000(.7 47)
= $7,470
Interest Rates, Time, and Present Value
(PV of $100 to be received in 16 years)

Present Value of $100

120

100
0%
80 0%
6%
60
6% 10%
40 16%
10
20 %
16%
0
0 4 8 12 16
End of Time Period
ANNUITY

7/3/2023 Compiled By Habtamu B. (PhD) 82

Annuities
 An annuity is a stream of equal periodic cash flows,
over a specified time period. These cash flows are
usually annual but can occur at other intervals, such as
quarterly or monthly.
 The cash flows in an annuity can be inflows or outflows
 Types of Annuities
 There are two basic types of annuities. For an ordinary
annuity, the cash flow occurs at the end of each period.
For an annuity due, the cash flow occurs at the
beginning of each period.

7/3/2023 Compiled By Habtamu B. (PhD) 83

Future Value of an Annuity
 Ordinary Annuity:
 Example:
 Suppose you invest $100 at the end of each
year for the next 3 years and earn 8% per year
on your investments. How much would you be
worth at the end of the 3rd year?
T1 T2 T3
$100 $100 $100

Compounds for 0 years:

$100(1.08)0 = $100.00

Compounds for 1 year:

$100(1.08)1 = $108.00

Compounds for 2 years:

$100(1.08)2 = $116.64
______

Future Value of the Annuity $324.64

FV3 = $100(1.08)2 + $100(1.08)1 +$100(1.08)0
= $100[(1.08)2 + (1.08)1 + (1.08)0]
= $100[Future value of an annuity of $1
factor for i = 8% and n = 3.]
(See table)
= $100(3.246)
= $324.60

FV of an annuity of $1 factor in general terms:

(1  i) n  1
(useful when using a non - financial calculator )
i
Future Value of an Annuity
 Example
 If you invest $1,000 at the end of each year for the next
12 years and earn 14% per year, how much would you
have at the end of 12 years?
 Use the formula:
(1  i) n  1
FV  Periodic PYT * [ ]
i

FV 1 2 = $1000(27.2 71) given i  14% and n  12

= $27,271
Present Value of an Annuity
 Example 2
 Suppose you can invest in a project that will
return $100 at the end of each year for the next
3 years. How much should you be willing to
invest today, given you wish to earn an 8%
annual rate of return on your investment?
T0 T1 T2 T3
$100 $100 $100

Discounted back 1 year:

$100[1/(1.08)1] = $92.59
Discounted back 2 years:
$100[1/(1.08)2] = $85.73
Discounted back 3 years:
$100[1/(1.08)3] = $79.38
PV of the Annuity = $257.70
PV  $100[1 /(1.08)1 ]  $100[1 /(1.08) 2 ]  $100[1 /(1.08)3 ]
= $100[1 /(1.08)1  1 /(1.08) 2  1 /(1.08)3 ]
= $100[Prese nt value of an annuity of $1 factor for i  8% and n  3]
(See Table)
 $100(2.577 )
 $257.70

PV of an annuity of $1 factor in general terms :

1
1
(1  i ) n
(useful with non - financial calculator s)
i
Present Value of an Ordinary Annuity
 Example:
 Suppose you won a national lottery in the amount of
$10,000,000 to be paid in 20 equal annual payments
commencing at the end of next year. What is the present
value (ignoring taxes) of this annuity if the discount rate
is 9%?
1
 Formula: 1
(1  i )
n
PV  Periodic PYT * [ ]
i

P V = $500,000(9 .129) given i  9 % and n  2 0

= $4,564,500
Annuity Due
 A series of consecutive payments or receipts of equal
amount at the beginning of each period for a specified
number of periods.
 To analyze an annuity due using the tabular approach,
simply multiply the outcome for an ordinary annuity for the
same number of periods by (1 + i).
 Note: Throughout the course, assume cash flows occur at
the end of each period, unless explicitly stated otherwise.
 FV and PV of an Annuity Due:
F V n  F V o f an o rd inary annuity (1  i)
P V  P V o f an o rd inary annuity (1  i)
Annuity Due


7/3/2023 Compiled By Habtamu B. (PhD) 93

Exercise
 BACK Co plans to deposit $ 500 at the end of each of the next four years in a bank
account that pays 12% interest compounded annually. How much will be the
balance of the account at the end of year-4? What will be the balance at the end of
year-4 if the deposit is made at the beginning of each year?

 Answer:
 If deposit is made at the end of each year for four years, the future value is $ 2,389.66

 If deposit is made at the beginning of each year for four years, the future value is $ 2,676.42

7/3/2023 Compiled By Habtamu B. (PhD) 94

Exercises
1. BACK Co plans to deposit $ 500 at the end of each of the next four years in a bank
account that pays 12% interest compounded annually. How much will be the
balance of the account at the end of year-4? What will be the balance at the end of
year-4 if the deposit is made at the beginning of each year?

 Answer:
 If deposit is made at the end of each year for four years, the future value is $ 2,389.66

 If deposit is made at the beginning of each year for four years, the future value is $ 2,676.42
 On January 1, 2014 BACK Co purchased equipment by signing a note promising to
pay $ 80,000 at the end of each of the next five years starting 2014. What is the cost
of the equipment today if the market interest rate is 10% compounded annually?
What is the cost of the equipment today if payment is to be made at the beginning
of each year?
 Answer:
 If deposit is made at the end of each year for five years, the future value is $ 488,408

 If deposit is made at the beginning of each year for five years, the future value is $ 537,248.80

7/3/2023 Compiled By Habtamu B. (PhD) 95

Special Case Annuities
 Perpetuities
 An ordinary annuity whose payments or receipts continue forever.
An ordinary annuity whose payments or receipts continue forever.
 Thus the present value of a perpetuity is simply the periodic receipt
(payment) divided by the interest rate (discount rate) per period
PP
PV 
i
 If PP is growing at a constant rate g rather than being constant, then,
PV = PP1/(r-g)
Where: g = growth rate

 Exercise
Exercise
 An investment offers a perpetual cash flow of $ 500 every year. The return
you require on such an investment is 8%. What is the value of this
investment if interest is compounded:
 a) annually?
 b) quarterly?
 c) What if the yearly cash flow grows at 3% annually?
 Answer:
 A) Annually = $ 500/0.08 = $ 6250
 B) Quarterly = Br 500/(0.08/4) = $ 25,000
 C) Annually with a growth rate = $ 500/(8% - 5%) = $ 10,000

7/3/2023 Compiled By Habtamu B. (PhD) 97

Financial Management
(MAPM 722)

Chapter Four
Bond and Stocks Valuation and Cost of Capital
7/3/2023 Compiled By Habtamu B. (PhD) 98
What is valuation concepts
 In general the value of an asset is the price that is a
willing and able buyer pays to a willing and able seller.

 There are two basic approaches to valuation:

 Discounted cash flow valuation and
 Relative valuation
 Discounted cash flow valuation:
 The value of any asset is estimated by computing the present
value of the expected cash flow on it.
 The actual process of estimation generally requires the following
inputs:
 Discount rate
 Expected cash flow
 The time period

7/3/2023 Compiled By Habtamu B. (PhD) 99

What is valuation concepts
 Relative Valuation
 Has an objective of valuing an asset based on ‘how similar
assets are currently priced in the market’
 The key steps I this approach are:
 Defining “comparable” firms or assets and
 Choosing a standardized measure of value (usually value as a
multiple of earning, cash flows , or book value) to compare the
firms
 For our discussion, we will use the discounted cash flow
valuation approach

7/3/2023 Compiled By Habtamu B. (PhD) 100

Common Stock
Valuation

Habtamu B. (PhD)
Common Stock Valuation
 Basic concepts in CS valuation:
 Market price – the price at which a stock sells in the
market
 Growth rate (g) – the expected rate of growth in
dividend per share
 Required Rate of Return (Ks) – the minimum rate
of return that a stockholder considers acceptable.
 Required Rate of Return has five components:
 the real risk-free interest rate,
 inflation premium,
 liquidity premium,
 default risk premium, and
 maturity premium
Habtamu B. (PhD)
Types of CS Valuation Models
 Divided Discount Model [DDM]
 Free Cash Flow Model [FCFM]

 The Dividend Discount Model

 Assumptions of the model
 Dividends are paid annually
 The first dividend is received one year after the stock
is bought

Habtamu B. (PhD)
Dividend Discount Model
1. Single Period Valuation Model
 Assumption: the investor will hold the share only for one year and
then sale it.
 Formula:
D1 P1 Where:
P0   D1 = dividend per share after one year
(1  ks)1 (1  ks)1
P1 = Price of a share expected after one year
 Or P0 = Current price of the share
D1  P1
P0 
(1  ks)1

2. Multi-period Valuation Model

- Is a more realistic and complex model
- Formula:
D1 D2 D  Dt
P0    ...   
(1  ks)1 (1  ks) 2 (1  ks)  t 1 (1  ks)t

7/3/2023 Compiled By Habtamu B. (PhD) 106

CS Valuation Models
 Realistic Assumption to simplify the multi-period valuation
model based on the dividend per share (DPS) growth trend

DPS remains constant forever, implying that growth rate is

nil (the zero growth model)

DPS grows at a constant rate per year forever

(the constant growth model)

DPS grows at a constant rate for a finite period, followed

by a constant normal rate of growth forever thereafter.
(the two-stage model or variable )

Habtamu B. (PhD)
CS Valuation Models
 Zero Growth Model
 Formula: D
P0 
ks
 Constant Growth Model
 Assumes DPS grows at a constant rate (g).
 Formula: D1 D1 (1  g ) D1 (1  g ) n
P0    ... 
(1  ks)1
(1  ks) 2
(1  ks) n

 Or Simply; P0 
D1
Where,
ks  g D1 = Expected dividend per share for
year 1
ks = Required Rate of Return
g = Dividend growth rate

7/3/2023 Compiled By Habtamu B. (PhD) 108

Exercises
 Exercise I
 The most recent common stock dividend of SH Manufacturing
S. Co. was $ 60 per share. The dividends are expected to
remain at the current level for the foreseeable future.
Determine the value of the stock if the required rate of return
is 12%.
 Ans. $ 500
 Exercise II
 ZG Motor Corporation’s common stock currently pays an
annual dividend of $ 75 per share. The dividends are
expected to grow at a constant annual rate of 3% to infinity.
Estimate the value of ZG’s common stock if the required
return is 11%.
 Ans. $ 965.63
7/3/2023 Compiled By Habtamu B. (PhD) 109
What if Dividends not Paid?

In this case we use the

Residual Income Model

Habtamu B. (PhD)
CS Valuation Models

EPS0 (1  g)  B0  ks
P0  B0 
ks  g

Earnings per share at time 0, EPS0

Book value per share at time 0, B0
Earnings growth rate, g
Discount rate, ks

Habtamu B. (PhD)
Residual Income Model
 E.g.
 The book value of a share which has a current earnings
of $ 12 is $ 60. If the earnings per share growth rate is
10%,
a) What is the price of the share at a required rate of
return of 13%?
b) Determine the growth rate if the market price is $ 110
and the required rate of return is 13%

Answer:
a. $ 240
b. g= 3.7%

7/3/2023 Compiled By Habtamu B. (PhD) 112

Preferred Stock
Valuation

Habtamu B. (PhD)
Preferred Stock Valuation


Where,
Vp = Value of PS
Dp = Preferred dividend
Kp = Required rate of return on PS

Habtamu B. (PhD)
Preferred Stock Valuation
 An investor wishes to estimate the value of its
outstanding preferred stock. The preferred issue has a $
1000 par value and pays an annual dividend of $ 60 per
share. Similar-risk preferred stocks are currently earning
a 7.5% annual rate of return. What is the value of the
outstanding preferred stock?
 Answer = $800
 A preferred stock pays an annual dividend of $ 90 and
the current market price is $ 720. Compute the required
rate of return for the preferred stock.

 Answer = 12.5%

7/3/2023 Compiled By Habtamu B. (PhD) 115

Bond Valuation

Habtamu B. (PhD)
Bond Valuation
 A bond is a long-term contract under which a
borrower agrees to make payments of
interest and principal on specific dates to the
holders of the bond.
 Bonds are issued for long-term debt capital
by corporations and government agencies

Habtamu B. (PhD)
Types and Issuers of Bonds

Treasury Bonds- are also called government bonds

Foreign Bonds- issued by foreign govt or foreign corp.

Municipality Bonds - issued by state & local

governments

Corporate Bonds - are issued by business firms

Habtamu B. (PhD)
Types of Corporate Bonds
Zero-Coupon bonds – issued at a discount and don’t have
stated interest rate

Floating Rate Bonds – whose interest rate fluctuates

with shifts in general level of interest

Callable Bonds – can be redeemed by the issuer

prior to maturity

Convertible Bonds – are exchangeable for common

stock at the option of the holder.

Term Bonds: are bonds that pays periodic interest and

principal at maturity

Habtamu B. (PhD)
Features of Bonds
 Par Value: is stated face value of a bond
 Coupon Interest Rate: Stated annual interest rate on a
bond
 Due Date: is a specific date on which the par value of a
bond must be paid
 Call Provision: gives the issuer the right to call the
bonds for redemption. This provision generally states
that the issuer must pay the bondholders call premium
(equals one year’s interest amount) in addition to the FV.
 Required Rate of Return: is the rate of return currently
an investor require on a bond.

Habtamu B. (PhD)
Features…
 Yield to Maturity: is the rate of return an investor would
earn if s/he bought the bond at its current market price
and held it until maturity. It equates the discounted value
of a bond’s future cash flows to its current market price.
 Yield to Call: is the rate of return an investor would earn
if s/he bought a callable bond at its current market price
and held it until the call date given that the bond was
called on the call date.
 Premium on bonds: when Market Price > Face Value
 Discount on bonds: when Market Price < Face Value

Habtamu B. (PhD)
Valuation of Term Bonds

Habtamu B. (PhD)
Determining Value of A Term Bond


Where,
VB = the value of a bond
INT = Periodic interest payment
M = Principal repayment at due
date
kd = Required rate of return on
Semi-annual: bonds
INT/2 n = Number of periods to maturity
n*2
Kd/2

Habtamu B. (PhD)
Bond Valuation
 E.g.
 A Corporation issued a new series of bonds on January
1, 2015. The bonds were sold at their par of $ 1,000,
have 12% coupon, and mature in 10 years. Coupon
payments are made quarterly. What was the price of the
bond on the date of issuance if the required rate of
interest was 8%?
 Answer = $1272.90

7/3/2023 Compiled By Habtamu B. (PhD) 124

Coupon Rate (CR), Required Rate of Return
(Yield), Price (VB) - Relationship
 When :
 Yield < CR Price (VB) > Par (Premium Bond)
 Yield = CR Price (VB) = Par
 Yield > CR Price (VB) < Par (Discount Bond)

Premium
Par
Discount

10% 14% 18% Yield

Habtamu B. (PhD)
Cost of Capital

7/3/2023 Compiled By Habtamu B. (PhD) 126

Cost of Capital /Financing/
 The cost associated with borrowing money depends on the
particular form of capital borrowed.
 These can be:
 Cost of Debt

 Cost of Equity

 Cost of Debt: is the cost of debt financing, or the interest paid

on the money borrowed.
 Cost of Equity: is the dividends paid to shareholders plus any
estimate of the equity’s capital growth.
 Equity could include:
 Preferred shares
 Common shares
 Retained earnings
Cost of Capital
 Cost of capital: is defined as the rate of return that is necessary
to maintain the market value of the firm (or price of the firm’s
stock).
 The cost of capital is computed for individual financial assets or
as a weighted average of the various capital components, such
as debt, preferred stock, common stock, and retained earnings.
 Managers must know the cost of capital, often called the
minimum required rate of return in:
 making capital budgeting decisions;

 helping to establish the optimal capital structure; and

 making decisions such as leasing, bond refunding, and

working capital management.
Individual (specific) Cost of Capital

7/3/2023 Compiled By Habtamu B. (PhD) 129

Computing individual /specific/cost of capital
 COST OF DEBT
 Is the minimum rate of return required by suppliers of debt.
 Generally, it is the cheapest source of finance.
 Debt source may take several forms (such as bonds, promissory
notes, bank loans, etc)
 Steps to calculate the cost of new bond issue:
 Determine net proceeds from the sale of each bond (V)
 V= market price of the bond (Mp)– floatation costs (f)
 Compute the before tax cost of bond using the following formula:
 M V 
 Ki= I  
 n  Where: Ki = Before tax cost debt
 M V  I= annual interest payment

 2 
 M = Par value of the bond
V = Net proceeds from sale of
 Compute the after tax cost of bond using the bond
 K K (1 – tax rate)
d= i
N=time to maturity in years

7/3/2023 Compiled By Habtamu B. (PhD) 130

Cost of Debt
 Example:
 ABC Industrial Group [our case company here after] is
planning to sell 15-year, $ 1,000 par-value bonds that
carry a 12% annual coupon interest rate. As a result of
lower current interest rates, ABC bonds can be sold for $
1,010 each. If flotation costs of 3.0% of the par value per
bond will be incurred in the process of issuing the bonds,
compute the after tax cost of the bond at 40% tax rate.

 7.35%

7/3/2023 Compiled By Habtamu B. (PhD) 131

Cost of Preferred stock
 Formula: Where:
Kp = cost of preferred stock
dp dp = annual preferred stock dividend per share
 Kp = Pn= the net proceeds that could be obtained from a
Pn sale of a new preferred share

 E.g. ABC Industrial group has just issued preferred stock which pays
a quarterly dividends of $ 26 per share at a flotation cost of 6% of
the par value. If the preferred stock sells at 95% of its par where the
par value is $ 1000, compute the cost of preferred stock.

 Answer: 11.69%

7/3/2023 Compiled By Habtamu B. (PhD) 132

Cost of common stock
 Is the minimum rate of return that a firm must earn for its
common stockholders in order to maintain the value of
the firm.
 The firm doesn’t make explicit commitment to pay
dividends to common stock but the investors expect
dividends, hence, such stocks carry cost.
 If bond holders and preferred stockholders exist, the
common stockholders will assume the maximum risk in
corporate investments.
 The cost of common stock can be computed using:
 The Constant Growth Valuation Model (CGVM)
 The Capital Asset Pricing Model (CAPM)

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Cost of Common Stock
 The Constant Growth Valuation Model (CGVM)
 Formula:
D1
 Ks = P  g
n

where : D1  exp ected dividend per share next year

Pn  Net proceeds from sale of common stock
 E.g. g  exp ected annual dividendsgrowth rate
 ABC Industrial Group has issued common stock to investors at
selling price of $ 1500 per share where the par value was $
100. Where selling expense was 5% of the par value per share.
The current dividend is $ 150 per share and it is expected to
grow at 4% annual rate. What is the cost of issuing this
common stock?
 Answer = 14.43
7/3/2023 Compiled By Habtamu B. (PhD) 134
Cost of Common stock
 Capital Asset Pricing Model (CAPM)
 Formula:
R f  ( K m  R f ) i
 Ks = where : R f  the risk free rate of return
K m  the market rate of return on common stock
i  rate of return on the firm' s common stock relativeto the market return
 E.g.
 Assume an electronic company uses CAPM to estimate
its cost of common equity. The current interest yield on
TB is 9.2% and the market rate of return is 14%. If beta
is 1.3, compute the cost of common stock.
 Answer = 15.44%

7/3/2023 Compiled By Habtamu B. (PhD) 135

Cost of Retained Earnings [REs]
 REs are not securities like stocks and bonds and hence do
not have market price that can be used to compute costs of
capital.
 The cost of REs is the rate of return a corporation’s common
stockholders expect the corporation to earn on their
reinvested earnings, at least equal to the rate earned on the
outstanding common stock.
 Therefore, the specific cost of capital of REs is equated with
the specific cost of common stock. However, flotation costs
are not involved in the case of REs.
 E.g. Compute the cost of retained earnings to ABC industrial
group.
 Answer= 14.44%

7/3/2023 Compiled By Habtamu B. (PhD) 136

Weighted Average Cost of Capital

7/3/2023 Compiled By Habtamu B. (PhD) 137

Weighted Average Cost of Capital (WACC)
 The specific cost of capital is used in evaluating an
investment proposal to be financed by a particular capital
source.
 Practically, however, investment are financed by two or more
sources of capital. In such a situation, we cannot make use
of the individual cost of capital. Rather we should use the
average cost of capital employed by the firm.
 The firm’s capital structure is composed of debt, preferred
stock, common stock, and retained earnings. Each capital
source accounts to some portion of the total finance. But the
percentage contribution of one source is usually different
from another. So we must compute the weighted average
cost of capital rather than the simple average.

7/3/2023 Compiled By Habtamu B. (PhD) 138

WACC
 Formula:

 WACC = Wd * Kd  WPs * K p  Ws * Ks  WRE * K RE

Where:
Wd = the weight of debt
Wps= weight of Preferred stock
Ws = weight of common stock
WRE= weight of Retained earnings

 Weights of the individual source of finance can be

computed based on Book value and market value.

7/3/2023 Compiled By Habtamu B. (PhD) 139

WACC
 Assume the following data for ABC Industrial Group. As per the
current balance sheet of the firm, the book values of the
sources of financing is given below.
 Bond (20 bonds) $ 20,000
 Preferred Stock (5 shares @ $ 1000) 5,000
 Common Stock (600 shares @ $ 100 Par) 60,000
 Retained Earnings 90,000
 From our previous examples, it is to be recalled that the specific
costs of capital of ABC Industrial group were computed as
follows:
 Cost of Bond 7.35%
 Cost of Preferred Stock 11.69%
 Cost of Common Stock 14.43%
 Cost of Retained Earnings 14.44%
 Compute the WACC
7/3/2023 Compiled By Habtamu B. (PhD) 140
Solution – Based on book value
Item Book Weight (based Cost of WACC
Value on BV) Capital

Bond 20,000 0.1143 7.35% 0.8401%

Preferred Stock 5,000 0.0286 11.69% 0.3343%

Common 60,000 0.3428 14.43% 4.9466%

RE 90,000 0.5143 14.44% 7.4265%
Total 175,000 1.000 13.5475%

WACC

7/3/2023 Compiled By Habtamu B. (PhD) 141

WACC
 If the market values of the sources of financing is given below.
 Bond $ 20,200
 Preferred Stock 4,750
 Common Stock
900,000*
 Retained Earnings

 Compute WACC based on market value

7/3/2023 Compiled By Habtamu B. (PhD) 142

Solution – Based on market value
Item Book Comparable Weight Cost of WACC
Value market value (based on Capital
(MV) MV)

Bond 20,000 20,200 0.022 7.35% 0.1617%

Preferred 5,000 4,750 0.005 11.69% 0.0585%
Stock

Common 60,000 360,000 0.389 14.43% 5.6133%

RE 90,000 540,000 0.584 14.44% 8.4329%
Total 924,950 1.000 14.2664%

WACC

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7/3/2023 Compiled By Habtamu B. (PhD) 144
Financial Management
(MAPM 722)

Chapter Five
Investment Decision Making/Capital
Budgeting
7/3/2023 Compiled By Habtamu B. (PhD) 145
Capital Budgeting
 Capital budgeting is the process that companies use for
decision making on capital projects—those projects with a
life of a year or more.

 It is the process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are
expected to extend beyond one year.

 To evaluate capital budgeting processes, their consistency

with the goal of shareholder wealth maximization is of
utmost importance.
The Concept of Capital Budgeting
 capital budgeting – long-term for capital expenditures i.e.,
investment in productive assets (tangible and intangible long-
term assets)
 huge investments – large amount of money involved
 long-term commitment (permanent in nature) with long-term
effects
 irreversible – decision difficult or impossible to reverse
 uncertainty – surrounding outcomes
 Affect the risk structure of the firm
 Influence the growth and prospect of the firm in the long run
Capital budgeting decision process: Steps
 Steps
 identifying investment opportunities/options – search for
alternatives
 evaluating investment opportunities/options – use of different
evaluation criteria
 selection and approval
 Make the accept/reject decision.
 Independent projects: Accept/reject decision for a project is not
affected by the accept/reject decisions of other projects.
 Mutually exclusive projects: Selection of one alternative
precludes another alternative.
 investment/implementation
 performance review (monitoring and evaluation)
Categories of Capital Budgeting: Types
 The following decisions would qualify as projects:
a. Major strategic decisions to enter new areas of business or
new markets
b. Decisions on new ventures within existing businesses or
markets,
c. Acquisitions of other firms
d. Decisions that may change the way existing ventures and
projects are run [policy changes]
e. Decisions on how best to deliver a service that is necessary
for the business to run smoothly.
The Position of Capital Budgeting
The Position of Capital Budgeting

Financial Goal of the Firm:

Wealth Maximisation

Investment Decison Financing Decision Dividend Decision

Long Term Assets Short Term Assets Debt/Equity Mix Dividend Payout Ratio

Capital Budgeting
The Concept of Cash Flows
 From a project organization’s point of view, effective cash
flow management can mean the difference between project
success and failure.
 Because: the amount of cash inflow and outflow, and the
timing of these flows during the course of a project, can have
a significant influence on project costs and schedule.
 Hence, simply defined, cash flow is:
 the movement of funds in and out of a project, while
 Cash flow management focuses on:
 the timing of moving funds.
The Concept..
 This is often a matter of great importance to project
managers, because even if a project is making good
technical progress and is on schedule, it will be
considered a financial failure if it runs out of money.
 Projects that suffer from poor cash flow ultimately
incur additional costs and, possibly, significant delays
as well.
 Sometimes, however, even borrowing additional
money or stopping work until funds are received
may not be viable options.
Cash Flow Patterns
 Cash flow patterns associated with capital investment projects can
be classified as: conventional or nonconventional.
 A conventional cash flow pattern consists of an initial outflow
followed only by a series of inflows.

 A nonconventional cash flow pattern is one in which an initial

outflow is followed by a series of inflows and outflows.
Conventional

Non-conventional
Capital Budgeting: Processes
 Search for investment opportunities. This process will
obviously vary among firms and industries.
 Estimate all cash flows for each project.
 Evaluate the cash flows. a) Payback period. b) Net Present
Value. c) Internal Rate of Return. d) Modified Internal rate of
Return.
 Make the accept/reject decision.
 Independent projects: Accept/reject decision for a project
is not affected by the accept/reject decisions of other
projects.
 Mutually exclusive projects: Selection of one alternative
precludes another alternative.
 Periodically reevaluate past investment decisions.
Capital budgeting techniques
 capital budgeting techniques – methods for
evaluating investment options
 classified into tradition and modern ones
 traditional/non-discounted methods
 do not consider time value of money and timing difference in
cash flows
 include payback period and accounting rate of return
 modern/discounted methods
 consider time value of money
 include Discounted PBP, NPV, IRR, profitability-index (benefit-
cost ratio) and discounted payback period
Non- Discounted Cash flow Methods
(Traditional Approaches)

7/3/2023 Compiled By Habtamu B. (PhD) 158

Capital budgeting techniques …
a)payback period
 number years needed for a project to recover its costs
 selection criterion – select a project with a payback
period
 less than a cutoff or

 shorter than that of an alternative project

 strength – simple to apply, biased towards liquidity, adjusts for

uncertainty of later cash flows, and considers cash flows instead of
income and expenses
Capital budgeting techniques …

Payback Period …
 Limitations:
 Ignores risk
 Ignores TVM and timing difference of cashflows
 Ignores cash flows beyond the payback period
 Doesn’t give a precise acceptance rule and based on
arbitrary cut-off point
 Biased against long-term projects
Capital budgeting techniques …
Example 1
ABC Co is considering to purchase a new machine for
$360,000. The life of the machine is 10 years. The machine will
reduce annual costs by $50,000.
Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the
maximum desired payback period of the management is 8
years?
c) Would the company purchase the new machine if the useful
life of the machine is 5 years instead of 10 years? Why?
d) Answer: Answers: a) 7 years, 2 months & 12 days, b) yes!, c) no!, the machine ends
without recovering its cost
Capital budgeting techniques …
Example 2
ABC Co is considering to purchase a
new machine having a life of 6 years.
The investment and expected cash
inflows related to the machine are
given below.

Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the maximum desired
payback period of the management is 4 years?
c) Answer: a) 4 years & 8 months b) No!
Capital budgeting techniques …
Example 2
ABC Co is considering to purchase a
new machine having a life of 6 years.
The investment and expected cash
inflows related to the machine are
given below.

Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the maximum desired
payback period of the management is 4 years?
c) Answer: a) 4 years & 8 months b) No!
Capital budgeting techniques …

Capital budgeting techniques …
 strength
 easily understandable
 simple to compute
 recognizes profitability factor
 uses usually available information (Why? It uses data from financial
accounting reports)

 limitations
 uses accounting data /book values instead of cash flows/market
values
 ignores time value of money, thus, it is not a true rate of return
 uses an arbitrary benchmark/cutoff rate
ARR= Average annual net income
Average investment or average book value

Example
Consider a company that is evaluating whether to buy a
new store in a new mall. The purchase price is $500,000.
We will assume that the store has an estimated life of 5
years. We assume that the store will worth nothing at the
end of the lifetime. Use straight line depreciation.

Annual revenue for the five years is: $ 460,000, $

450,000, $ 270,000, $ 165,000 and $ 250,000 and
operating expenses are 35% of the annual revenue.
Assume further that the firm is 25% income tax bracket.
Compute the ARR and indicate your decision assuming
further that the target ARR is 30%:
167
Description Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
Revenue (in $) 460,000 450,000 270,000 165,000 250,000
-Expenses (35%) 161,000 1575,500 94,500 57,750 87,500
Income before D & T 299,000 292,500 175,500 107,250 162,500
- Depr. 100,000 100,000 100,000 100,000 100,000
Income Before T 199,000 192,500 75,500 7,250 62,500

- Tax (25%) 49,750 48,125 18,875 1,812.50 15,625

NI after Tax 149,250 144,375 56,625 5,437.50 46,875

Br.149250 144375 56625 5437.5  46875 Br.402562.50

Average NI = $ 80,512.50   Br.80,512.50
5

Initial Investment  SV $500000 0

Average Investment (BV) =   $250,000
2 2

7/3/2023 ARR Compiled By Habtamu B. (PhD)

= $ 80512.50/$ 250000 = 32.21% 168
Discounted Cash Flow Methods
(Modern Approaches)
a. Discounted PBP

 Example
Take the information given below and compute the discounted
PBP if the required rate of return is 10%. Should the project be
accepted?
Year Annual CF Discount factor Present Cumulative
(10%) value Present CF

1 30,000
2 35,000
3 40,000
4 50,000
5 65,000
b. PBP
Year Annual CF Discount factor Present Cumulative
(10%) value Present CF

1 30,000 0.909 27,270 27,270

2 35,000 0.826 28,910 56,180
3 40,000 0.751 30,040 86,220
4 50,000 0.683 34,150 120,370
5 65,000 0.621 40,365 160,735


Advantages and Disadvantages of Discounted Payback Period

Advantages
1. Considers the time value of money.
2. Considers the project’s cash flows’ risk through the
cost of capital.
Disadvantages
1. No concrete decision criteria that indicate whether
the investment increases the company’s value.
2. Requires an estimate of the cost of capital in order
to calculate the payback.
3. Ignores cash flows beyond the discounted payback
period
b. Net Present Value /NPV/
 The net present value (NPV) of an investment proposal is
defined as the sum of the present values of the cash
flows minus the sum of the present values of the net
investments.

NPV= the sum of the PV of NCF – initial investment

Decision Rule
• Accept the project if NPV is positive

• Reject the project if NPV is negative

c. NPV
 Example 1:
 Assume that the project requires initial investment of $
215,500. Annual net cash flows are expected to be $ 70,000
for 5 years. If the required rate of return is 10%, what is NPV?
 Solution
Year Cash Discount Present
Flow (in Factor (10%) Value (in
Birr) Birr) NPV= $ 265,300 – 215,500
1 70,000 0.909 63,630 NPV= $ 49,800
2 70,000 0.826 57,820
3 70,000 0.751 52,570
4 70,000 0.683 47,810
5 70,000 0.621 43,470
Total 265,300
 Exercise 1:
 Assume a $ 50,000 investment and the following cash
flows for two alternatives. Assuming the cost of capital
or required rate of return is 7%, which alternative would
you select under:
a)Discounted Payback Period method
b)NPV method
c)Based on your answer in ‘a’ and ‘b’ above, which project
should be accepted
Year Investment A Investment B
1 $ 10,000 $ 20,000
2 11,000 25,000
3 13,000 10,000
4 16,000 5,000
5 30,000 0
Internal Rate of Return

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IRR
 The internal rate of return (IRR) is a metric used in
financial analysis to estimate the profitability of
potential investments.
 IRR is a discount rate that makes the net present
value (NPV) of all cash flows equal to zero in a
discounted cash flow analysis.
 Keep in mind that IRR is not the actual money
(birr) value of the project.
 Generally speaking, the higher an IRR, the more
desirable an investment is to undertake.

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Advantage and Disadvantages
 IRR measures the  IRR may have multiple
quality or efficiency of an solutions:
investment, but not the
 Up to as many
magnitude.
solutions as there
 Has intuitive appeal,
extremely widely used in are sign changes in
practice. the cash flow.
 Does not require a  IRR may also have
discount rate. zero solutions:
 Many downsides – can  E.g., Zero sign
be extremely misleading. changes.
Highly non-robust.
 Common example:
 Shunned by textbooks
and academics. Project never
Prevailing wisdom: Use reaches profitability.
NPV, avoid IRR!
IRR

1. Determining IRR when Net Cash flows are annuity

Example 1: Assume that the project requires initial

investment of $ 375,560. Annual net cash flows are
expected to be $ 72,000 for 10 years. If the required
rate of return is 10%, what is IRR?

Solution:

PBP =

PBP = $ 375,560/$ 72,000

PBP= 5.2161
1. Determining IRR when Net Cash flows are
annuity

 The leading discount factor is found under i =

14%. Thus, the IRR of the project is 14%.
 Decision:
 Accept the project as its IRR (14%) exceeds
the required rate of return (10%).

 What if the leading discount factor is not

exactly found the present value of an annuity
table? The following example illustrates this
case?
IRR
Example 2: Assume that the project requires initial
investment of $ 380,000. Annual net cash flows
are expected to be $ 70,000 for 10 years. If the
required rate of return is 10%, what is IRR?

Solution:
Step 1: Compute the leading discount factor or Payback period

Initial Investment
PBP =
Annual NCF
380,000
=  5.429
70,000
IRR
Step 2: Locate the IRR by looking along the appropriate period (n) in the present value of
an annuity table until the column which includes the leading discount factor is
reached. The discount rate of this column is the IRR for the project. In this
example, the leading discount factor is not found in the table.
Step 3
 In the year row (n=10) of the present value of an annuity table, take
two discount factors closest to the leading discount factor but one
bigger and the other smaller than it.
Rate Discount factor
12% 5.6502
13% 5.4262
 This implies that the exact internal rate of return is found between
12% and 13%.
IRR
Step 4 Determine the exact IRR using the following formula:

IRR = r – [ x 1%]

Where,
r = the taken discount rate (either 12% or 13%)
PBP = Payback period or leading discount factor
DFr = Discount factor of r
DFrL = Discount factor of the lower rate (i.e. 12%)
DFrH = Discount factor of the higher rate (i.e. 13%)
IRR


IRR
 If r = 13%
2. Determining IRR when Net Cash Flows are not Annuity
Example: Assume that the project requires initial investment
of $ 350,000. Annual net cash flows are expected to be as
follows:
Year Cash Flow
1 60,000
2 70,000
3 90,000
4 80,000
5 100,000
6 120,000

If the required rate of return is 10%, what is IRR?

IRR
 Use discount factors at 11% and 12%.
Year NCF Discount factor at Present Value
(2) 11% (3) (4) = (2) X (3)
1 60,000 0.901 54,060
2 70,000 0.812 56,840
3 90,000 0.731 65,790
4 80,000 0.659 52,720
5 100,000 0.593 59,300
6 120,000 0.535 64,200
Total Present Value of NCF 352,910
Deduct: Initial Investment 350,000
NPV 2910
IRR
 Using 11% and 12% (cont’d)
Year NCF Discount factor at Present Value
(2) 12% (3) (4) = (2) X (3)
1 60,000 0.893 53,580
2 70,000 0.797 55,790
3 90,000 0.712 64,080
4 80,000 0.636 50,880
5 100,000 0.567 56,700
6 120,000 0.507 60,840
Total Present Value of NCF 341,870
Deduct: Initial Investment 350,000
NPV (8130)
IRR
At 11%, NPV is Positive while at 12%, NPV is negative.
Hence, it indicates that IRR lies between 11% and 12%.
To determine the exact IRR, interpolation method can be
used:
 Obtain the absolute sum of NPVs of the two rates

= /2910/ + /-8130/
= 11,040
 Divide NPV of the smaller rate by the absolute sum,
multiply the quotient by 1% and add the result to the
smaller rate. Or
 Divide NPV of the bigger rate by the absolute sum,
multiply the quotient by 1% and subtract the result from
the bigger rate.
IRR – using the smaller rate


Check for the bigger rate!

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Profitability Index
It is the ratio of the present value of cash inflows at the
required rate of return, to the initial cash out flows of the
investment.
n
Ci
 PI = 
i 1 (1  i ) n = PV of Cash inflows/ PV of Cash outflows
C0

 Where: PI = Profitability Index

Ci = Periodic cash inflow
C0 = Cash outflows or Initial cash outlays or investments
i = Required rate of return
n = Number of periods
PI
 Decision Rule
 Accept the project when profitability index is grater than one;
PI>1
 Reject the project when profitability index is less than one;
PI<1
 May accept/reject the project when profitability index is one;
PI=1
Choosing between two different projects?
→ Higher PI is best choice

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Example:
 Assume that a machine will cost $ 100,000 and will
provide annual net cash inflows for the coming six years
are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

50,000 40,000 30,000 20,000 20, 000 20,000

 The cost of capital is 15%.

 Calculate the machine PI. Should the machine be
purchased?

7/3/2023 195
Solutions
Year Cash Discount factor of 15% Discounted cash inflow
1 50,000 0.8696 43,480
2 40,000 0.7561 30,244
3 30,000 0.6575 19,725
4 20,000 0.5718 11,436
5 20,000 0.4972 9,944
6 20,000 0.4323 8,646
PV of cash inflows = 123,475
$123,475
PI = $100,000 = 1.235

Decision:

Since, the projects PI is greater than one (i.e. 1.235), the machine
should be purchased.
Advantages and Disadvantages of
Profitability Index
 Advantages  Disadvantages
 Closely related to NPV,  May lead to incorrect decisions in
generally leading to comparisons of mutually exclusive
identical decisions investments (can conflict with NPV)
 Considers all CFs
 Considers TVM
 Scale is not revealed ( 10/5 = 1000/500,
Would you rather make 100% or 50% on
 Easy to understand
your investments? What if the 100% return
and communicate
is on a $1 investment, while the 50% return
 Useful in capital is on a $1,000 investment?)
rationing
In summary

Pa yba ck Accounting Ne t pre se nt Inte rna l ra te

pe riod ra te of re turn va lue of re turn
Ba sis of Ca sh Accrua l Ca sh flow s Ca sh flow s
me a sure me nt flow s income Profita bility Profita bility
Me a sure Numbe r Pe rce nt Dolla r Pe rce nt
e x pre sse d a s of ye a rs Amount
Ea sy to Ea sy to Conside rs time Conside rs time
Unde rsta nd Unde rsta nd va lue of mone y va lue of mone y
Stre ngths Allow s Allow s Accommoda te s Allow s
compa rison compa rison diffe re nt risk compa risons
a cross proje cts a cross proje cts le ve ls ove r of dissimila r
a proje ct's life proje cts
Doe sn't Doe sn't Difficult to Doe sn't re fle ct
conside r time conside r time compa re va rying risk
va lue of mone y va lue of mone y dissimila r le ve ls ove r the
Limita tions proje cts proje ct's life
Doe sn't Doe sn't give
conside r ca sh a nnua l ra te s
flow s a fte r ove r the life
pa yba ck pe riod of a proje ct 198
End

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