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INTODUCTORY BUSINESS FINANCE

INTODUCTORY BUSINESS
FIANACE
FOR MBA, MPA AND ACCOUNTANCY STUDENTS

NONPUBLISHED TEXT

BY: Adeel Shahzad


MBA, ACMA (FINALIST)

INTRODUCTORY BUSINESS FINANCE BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)


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PREFACE
INTODUCTORY BUSINESS FINANCE

BUSINESS FIANACE is an essential part of the economic and non economic activities which leads to
decide the efficient procurement and utilization of finance with profitable manner. In the olden days the
subject Finance was a part of Economics with the traditional approaches. Now days it has been enlarged
with innovative and multi-dimensional functions in the field of business with the effect of
industrialization, BUSINESS FIANACE has become a vital part of the business concern and they are
concentrating more in the field of Financial Management. Financial Management also developed as
corporate finance, business finance, financial economics, financial mathematics and financial
engineering. Understanding the basic concept about the financial management becomes an essential
part for the students of economics, commerce and management.
This Study text provides detailed information about the finance and finance related area with simple
language and the concepts are explained with easy examples. This Study text is also prepared based on
the B.B.A., M.B.A, and M.P.A syllabus of various universities for the benefits of the students. This study
text takes references from different books as by Van Horne, Brigham, I.M Pandey, and C.Pramacivan.

AUTHOR

ADEEL SHAHZAD
MBA, ACMA

INTRODUCTORY BUSINESS FINANCE BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)


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CONTENTS
INTODUCTORY BUSINESS FINANCE

CHAPTER DESRCIPTION PAGE


INTRODUCTION TO BUSINESS FINANCE

1 Nature ,scope and functions of financial, Managements


Financial decisions areas 4-10

FINANCIAL MARKETS
2 Financial markets, Money markets, Capital markets ,Money market instruments
,Capital market instruments ,Primary and secondary Markets ,Institutional 11-15
framework

FINANCIAL STATEMENTS
3 ANALYSIS
Types of financial statements, Types of analysis , Common size analysis ,Trend
16-40

analysis , Comparative Statement Analysis ,Ratio Analysis


VALUATIONS
4 Concept of time value of Money ,Concept of present value and future value
Concept of Interest ,Concept of compounding ,Amortizing a loan, Valuation of bond ,
41-59

Valuation of Securities
CAPITAL BUDGETING
5 Overview , Scope , Process, Capital Budgeting Techniques, NPV,IRR,PI, payback
period
60-67

WORKING CAPITAL MANAGEMENT


6 Concepts, Components, Determinants, policies 68-71

DIVIDEND POLICY
7 Types of dividend, Determinants , Policy 72-73

CASH AND RECEIVABLE MANAGEMENT


8 Cash Management and Receivable Management 74-77

EARNING PER SHARE AND OPERATING LEVERAGE


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INTRODUCTION TO BUSNIESS FINANCE

CHAPTER 1

INTRODUCTION

Finance is called “The science of money”. Finance was a branch of Economics till 1890
. Economics is defined as study of the efficient use of scarce resources. The decisions
Made by business firm in production, marketing, finance and personnel matters form
The subject matters of economics.
Finance is the process of conversion of accumulated funds to productive use. It is so
Intermingled with other economic forces that there is difficulty in appreciating the
Role It plays.

DEFINITION OF BUSINESS FINANCE


According to the Wheeler, “Business finance is that business activity which concerns
with the acquisition and conversation of capital funds in meeting financial needs and
overall objectives of a business enterprise”.
According to the Guthumann and Dougall, “Business finance can broadly be defined
as the activity concerned with planning, raising, controlling, administering of the funds
used in the business”.
In the words of Parhter and Wert, “Business finance deals primarily with raising,
Administering and disbursing funds by privately owned business units operating in
non-financial fields of industry”.

BUSINESS FINANCE is that managerial activity which is concerned with the planning and controlling of the
firm’s financial resources. The funds raised from the capital market needs to be procured at minimum cost
and effectively utilized to maximize returns on investments. Business Finance is also called Financial
Management.

OBJECTIVE & SCOPE OF FINANCIAL MANAGEMENT


This Section includes:

1. Objective of Financial Management


2. Scope of Financial Management
3. Role of Financial Management
• Liquidity
• Profitability
• Management
4. Functions
• Investment Decisions
• Financing Decisions

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• Dividend Decisions

OBJECTIVE OF FINANCIAL MANAGEMENT:

Financial Management is “management of finance”. Managing of finance is nothing but


managing of money. Every activity of an organization is reflected in its financial statements.
Financial Management deals with activities which have financial implications. Objectives of
Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization

Wealth
Wealth

Profit

Objectives

Fig .1.1 Objectives of Financial Management

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is the traditional and
narrow approach, which aims at, maximizes the profit of the concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth
or the wealth of the persons those who are involved in the business concern.

TERM SHAREHOLDERS’ WEALTH: Shareholders’ wealth means market value of the share.

SCOPE OF FINANCIAL MANAGEMENT:


Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production.
Financial management covers wide area with multidimensional approaches. The following
are the important scope of financial management.
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc.

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area, which provides immense opportunities to finance, and economical areas.


Figure 1.2 Objectives of the Financial Management/Business Finance

ECONOMICS FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING

BUSINESS FINANCE

COST ACCOUNTING CORPORATE FINANCE HR ACCOUNTING

2. Financial Management and Accounting


Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But now a day’s financial management and accounting
discipline are separate and interrelated.
3. Financial Management or 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.
4. Financial Management and Production Management

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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5. Financial Management and Marketing

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.

6. Financial Management and Human Resource

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.

ROLE OF FINANCIAL MANAGEMENT:

The Role of Financial Management is basically classified into three Categories:

1. Liquidity
2. Profitability
3. Asset Management

1. Liquidity
Liquidity is ascertained on the basis of three important considerations:
a. Forecasting cash flows: matching the inflows against cash outflows;
b. Resources of fund: financial management will have to ascertain the sources
from which funds may be raised and the time when these funds are needed;
c. Managing the flow of internal funds: keeping its accounts, with a number of banks to ensure
a high degree of liquidity with minimum external borrowing.
2. Profitability
While ascertaining profitability, the following factors are taken into account:
a. Cost control: Expenditure in the different operational areas of an enterprise can be analyzed with the
help of an appropriate cost accounting system to enable the financial
manager to bring costs under control.
b. Pricing: Pricing is of great significance in the company’s marketing effort, image and
sales level. The formulation of pricing policies should lead to profitability, keeping, of
course, the image of the organization intact.
c. Forecasting Future Profits: Expected profits are determined and evaluated. Profit
Levels have to be forecast from time to time in order to strengthen the organization.
d. Measuring Cost of Capital: Each source of funds has a different cost of capital which
must be measured because cost of capital is linked with profitability of an enterprise.
3. Asset Management

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• The management of long-term funds, which is associated with plans for development
and expansion and which involves land, buildings, machinery, equipment, transport
facilities, research project, and so on;
• The management of short-term funds, which is associated with the overall cycle of
activities of an enterprise. These are the needs which may be described, as working
capital needs.

FUNCTIONS OF FINANCIAL MANAGEMENT:

The functions of financial management can be broadly classified into three major decisions, namely:

(a) Investment decisions,


(b) Financing decisions,
(c) Dividend decisions.
The functions of financial management are briefly discussed as under:

1. Investment Decision
The investment decision is concerned with the selection of assets in which funds will be
invested by a firm.
• The long term investment decision: The long term assets of a business firm include
fixed assets like machinery, plant, production facility etc. Long term assets will yield a
return over a period of time in future. The long term investment decision is known as
capital budgeting decision.
• The short term investment decision: short term assets (current assets).
Whereas short term assets are those assets which are easily convertible into cash within
. an accounting period i.e. a year. The financial manager is also responsible for the
. efficient management of current assets i.e. working capital management.

Capital Budgeting means the long-range planning of allocation of funds among the
various investment proposals.

2. Financing Decision The financing decision is concerned capital structure of a firm. The term capital
structure Refers to the proportion of debt capital and equity share capital.
3. Dividend Decision Dividend decisions are concerned with the distribution of profits of a firm to the
shareholders. How much of the profits should be paid as dividend? I.e. dividend pay-out ratio. The
decision will depend upon the preferences of the shareholder, investment opportunities available within
the firm and the opportunities for future expansion of the firm. The dividend pay out ratio is to be
determined in the light of the objectives of maximizing the market value of the share.

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Figure 1.3 FUNCTIONS FINANCIAL MANAGEMENT

1. INVESTMENT • Capital Budgeting


DECISIONS • Working Capital
Management

• Cost of Capital
2. FINANCING • Capital Structure
FINACIAL DECISIONS Decisions
MANAGEMENT • Leverages

3. DIVIDEND • Dividend Policy


DECISIONS • Retained - Earnings

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EXERCISE
1. What is finance? Define business finance?

2. Discuss the objectives of financial management?

3. Explain the scope of financial management?

6. Discuss the role of financial manager?

7. Explain the importance of financial management?

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FINANCIAL MARKETS
CHAPTER 2

This chapter includes:

• Concept of Financial Markets.


• Classification of Financial Markets.
• Private placement.
• Role of Financial Markets.

TERM FINANCIAL INSTRUMENTS: The shares, bonds, debentures and other claim papers are
the Financial Instruments or Financial Assets.
FINANCIAL MARKETS

Financial market is a place or a system where financial assets or instruments are


Created and Exchanged by market participants e.g. Karachi Stock Exchange (KSE).

TERM MARKET PARITICIPANTS:


• The peoples having surplus money or firms having surplus money.
• The firms in need of money.

Figure 2.1 TYPES OF FINANCIAL MARKETS

FINANCIAL MARKETS

CAPITAL MARKET MONEY MARKET

PRIMARY MARKET

SECONDARY MARKET

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CLASSIFICATION OF FINANCIAL MARKETS

Financial markets are classified into two main categories:


1. Capital Markets
2. Money Markets
1. CAPITAL MARKETS: The capital market is designed to finance the long-term investments. The
Transactions taking place in this market will be for periods over years e.g. Karachi Stock Exchange,
Lahore Stock Exchange, and Islamabad Stock Exchange.
TERM LONG-TERM INVSETMENTS: Long-term investment means providing funds or money for many years.

CAPITAL MARKET INSTRUMENTS:


The capital market generally consists of the following long term period i.e., more than one year
Period, financial instruments:
• Equity shares
• Preference shares
• bonds
1. EQUITY SHARES: The equity shareholders are the owners of the business, they purchase shares, the
money is used by the company to buy assets, and the assets are used to earn profits, which belong to
the ordinary share-holders.
FEATURES: Equity shareholders have following characteristics:
i) They are owner of the company.
ii) They have Voting rights in meeting of shareholders.
iii) They are entitled to Profit of the company after payment of dividend to preference
shareholders.

_______________________________________________Rs_______
Profit after tax xxx
Less: Dividend to Preference Shareholders xxx
Profit belonging to equity shareholders (Dividend) xxx
________________________________________________________
iv) The dividend on Equity shares is not fixed and may vary from year to year depending upon
the Amount of profits available. The rate of dividend is recommended by the Board of Directors
of the company and declared by shareholders in the Annual General Meeting.
2. PREFERENCE SHARES: Preference shares have following characteristics:
I. The share holders with preference shares are not entitled to vote in Annual General
Meet (AGM) or other meeting of the Shareholders regarding affairs of the company.
II. In case of Dividend they are entitled to the fixed amount of Dividend.
III. The Preference shares are hybrid security.
TERM HYBRID INSTRUMENT: The Hybrid means dual or Combination of two. Preference Shares are Hybrid because:
I. Like Equity shareholders the preference shareholders are entitled to dividend, it is
characteristics of Equity Shares.
II. Like Debt the preference shares are entitled to fixed rate, it is characteristics of debt.

3. BONDS: Bonds are long-term Financing debt instrument, which are issued with promise to pay fixed
amount of interest (Coupon) to the holders at regular periodic intervals.

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2. MONEY MARKETS: The money market as a wholesale debt market for highly-liquid, Short-term
instrument. Funds are available in this market for periods ranging from a single day up to a year. This
market is dominated mostly by government, banks and financial institutions.

TERM WHOLSALE DEBT MARKET: The place from where money cab be obtained for a short period at interest.
HIGH-LIQUID: means cash or easily convertible into cash.
MONEY MARKET INSTRUMENTS: The money market deals with the transactions of raising and supplying
money in a short period not exceeding one year through various instruments.

1. CALL MONEY MARKET: Call money refers to that transaction which is received or delivered
by the participants in the call money market and where the funds are returnable next day.
The call money transactions are also referred to as overnight funds.e.g banks, money
lenders.
2. NOTICE MONEYMARKET Notice money on the other hand is a transaction where the
participants will take time to receive or deliver for more than two days but generally for a
maximum of fourteen days. The rate at which the funds will be deployed or borrowed will
be determined on the basis of the market conditions at a given point of time. When the
market is highly liquid, the funds would be easily available.
3. Repurchase Agreements (Repos)
Repurchase agreements are simply called as ‘repos ‘arise when one party sells a security
(Shares or bond) to another party with an agreement to buy it back at a specified time and
price. Repos are active between the commercial banks. The period ranges between one
and 14 days.

EXAMPLE1: ABC Company needs Finance of Rs 20000 for a period of 10 days. It enter in Repo
arrangement with Muslim Commercial Bank .1000 Shares of the company are placed for Repo,
Current Market Price of share is Rs 20 with Terms to repurchase each Share at Rs 22.
Requirement: Determine Interest amount?
Sale Price (1000×20) 20000
Buy-Back Price (1000×22) 22000
Interest 2000

4. Treasury Bills.
Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is a promise by the Government to pay a stated sum after expiry of the
stated period from the date of issue (14/91/182/364 days i.e. less than one year).
They are issued at a discount to the face value, and on maturity the face value is paid to the
holder. The rate of discount and the corresponding issue price are determined at each
auction.
5. Commercial Paper
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper
the debt obligation is transformed into an instrument. CP is thus an unsecured promissory
note privately placed with investors at a discount rate to face value determined by market
forces.

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PRIMARY OR NEW ISSUE MARKET

The Capital Market is broadly classified as Primary market and Secondary Market.

• Primary market is the segment in which new issues are made.


• Secondary market is the segment in which outstanding/old securities are traded.

Methods of floating of new issues in primary market:


The various methods which are used in the floating of securities in the new issue market are:
• Public issues
• offer for sale
• Rights issues
Public issues
Under this method, the issuing company directly offers to the general public fixed number of
shares at a stated price through a document called prospectus. This is the most
common method followed by companies to raise capital through the issues of securities.
Public issue is classified into:
i) initial Public Offering
ii) Private Placement
i) Initial Public Offering (IPO)
When an existing listed company either makes a fresh issue of securities to the public or
makes an offer for sale of securities to the public for the first time.
ii) Private Placement
Under Private Placement shares are offered to Institutional Investors.
Offer for sale
The method of offer of sale constitute outright sale of securities through the intermediary of
issue houses or share brokers. In other words, the shares are not offered to the public directly.
This method consists of two stages:
I. The first stage is a direct sale by the issuing company to the issue house and
brokers at an agreed price.
II. In the second stage, the intermediaries (Broker or Issue House) resell the
above securities to the ultimate investors.
Rights Issue (RI)
When a listed company proposes to issue securities to its existing shareholders, whose names appear in
the register of members on record date, in the proportion to their existing holding through an offer
document, such issues are called ‘Rights Issue’.
INSTITUITONAL FRAMEWORK WITH REFERENCE OF PAKISTAN

The Pakistan’s financial sector has two broad segments .


• Organized segment
• Unorganized segment
I. The organized segment includes commercial banks, development financial institutions,
insurance companies and other non-banking financial institutions including mutual funds, unit
trusts, etc.
II. The unorganized sector of the Pakistan’s financial market consists mainly of Indigenous bankers,
Money lenders.

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EXERCISE
1. What is financial market?
2. Explain the money market instrument?

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FINACIAL STATEMENT ANALYSIS


CHAPTER 3

This Chapter includes:

• Concept of Financial Statements and it classification


• Types of Financial Analysis

CONCEPT OF FINANCIAL STATEMENT

“Financial statements provide a summary of the accounting of a business enterprise,


The balance-sheet reflecting the assets, liabilities and capital as on a certain data and
the income statement showing the results of operations during a certain period”

Financial Statements

Income Statement Balance Sheet

Statement of Cash flow Statement of Changes in Equity

Fig3.1 Financial Statements

Income Statement
Income statement is also called as profit and loss account, it determines the entire
Operational performance of the concern like total revenue generated and expenses
incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern.
Gross profit is determined by preparation of trading or manufacturing a/c and net profit
Is determined by preparation of profit and loss account.
Balance Sheet
Balance sheet reflects the financial position of the firm at the end of the financial year.
It helps to ascertain and understand the total assets, liabilities and capital of the firm.
One can understand the strength and weakness of the concern with the help of the
Balance Sheet.
Statement of Changes in Owner’s Equity
This statement provides information about the changes or position of owner’s equity
in the company.

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Statement of Cash Flow


It reflects the cash flows of the company during a financial year.

TERM FIANCIAL YEAR: Financial year means Accounting year which consists of 12 months.

FIANCIAL ANALYSIS AND ITS TYPES:

Analysis of financial statement for decision making by different users is called financial statement
analysis.

TYPES OF FIANCIAL ANALYSIS:

Types of Financial analysis

On the basis of On the basis of


material used Methods of Operations

External Internal Horizontal Vertical


Analysis Analysis Analysis Analysis

Fig 3.2 Types of Financial Statement Analysis

1. On Basis of Material Used: Based on the material used, financial statement analysis may be
classified into two major types such as External analysis and internal analysis.
A. External Analysis: The analysis by the outsiders (which are not part of management of the
firm) but have some stake in the company such as investors, creditors, government
organizations and other credit agencies, banks. External analysis mainly depends on the
published financial statement of the concern. This analysis provides only limited information
about the business concern.
B. Internal Analysis
This analysis is used to understand the operational performances of each and every department
and unit of the business concern. Internal analysis helps to take decisions regarding achieving
the goals of the business concern. Internal analysis is conducted by financial managers.
2. Based on Method of Operation Based on the methods of operation, financial statement analysis
may be classified into two major types such as horizontal analysis and vertical analysis.

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A. Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several years and based on that,
a firm may take decisions. Normally, the current year’s figures are compared with the base year (base
year is consider as 100) and how the financial information are changed from one year to another.
This analysis is also called as dynamic analysis.
B. Vertical Analysis
Under the vertical analysis, financial statements measure the quantities relationship of the various items
in the financial statement on a particular period. It is also called as static analysis, because, this analysis
helps to determine the relationship with various items appeared in the financial statement. For
example, a sale is assumed as 100 and other items are converted into sales figures.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

Techniques

Ratio Comparative Common size Trend


analysis Analysis Analysis Analysis

Fig 3.4 Techniques of Financial Statement Analysis

Trend Analysis
The financial statements may be analyzed by computing trends of series of information. It may be
upward or downward directions which involve the percentage relationship of each and every item of the
statement with the common value of 100%. Trend analysis helps to understand the trend relationship
with various items, which appear in the financial statements. These percentages may also be taken as
index number showing relative changes in the financial information resulting with the various period of
time. In this analysis, only major items are considered for calculating the trend percentage.

EXAMPLE 1 ____________________________________________________________________

Calculate Trend for the Following information of Unique Limited by taking 2001 as base:
Year Revenue(Rs) Expenses(Rs) Net income(Rs)
2001 40000 17000 23000
2002 45000 17300 27700
2003 53400 29000 24400
2004 49000 22000 27000
2005 52000 34000 18000
2006 78000 31000 47000
2007 70000 32000 38000

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SOL:
YEAR Revenue Expenses Net income
Amount Trend Amount Trend Amount Trend
Rs(000) percentage Rs(000) Percentage Rs(000) Percentage
2001 40 100% 17 100% 23 100%
2002 45 45/40 ×100= 17.3 17.3/17×100= 27.7 27.7/23×100=
112.5 % 101.76% 120.43%
2003 53.4 53.4/40 ×100= 29 29/17×100= 24.4 24.4/23×100=
133.5% 170.58% 106.00%
2004 49 49/40×100= 22 22/17×100= 27 27/23×100=
122.5% 129.41% 117.40%
2005 52 52/40×100= 34 34/17×100= 18 18/24×100=
130% 200% 78%
2006 78 78/40×100= 31 31/17×100= 47 47/23×100=
195% 182.35% 204.34%
2007 70 70/40×100= 32 32/17×100= 38 38/23×100=
175% 188.23% 165.22%

Interpretations: The sale of 2001 is taken as 100% and sales of 2002 are 112.5%, it means there is an
increase of 12.5 %( 112.5-100) from 2001 t0 2002 and so on.
Common Size Analysis
In Common size Analysis Reported figures are converted into percentage to some common base.
• In the Income Statement, the Sales are assumed to be 100 percent and all figures are expressed
as percentage of this total.
• In the balance sheet the total assets figures is assumed to be 100 and all figures are expressed
as a percentage of this total.
It is one of the simplest methods of financial statement analysis, which reflects the relationship of each
and every item with the base value of 100%.

EXAMPLE 2 ______________________________________________________________________

Give Common size Analysis for following Balance Sheets of Michigan Sate Company.
Particulars Year 2010 Year 2012
Fixed Assets
Investments 30000 35000
Advances 40000 40000
Fixed Assets 75000 75000
Other Assets 15000 15000

Total Fixed Assets 160,000 165,000


Current Assets
Cash 30000 35000
A/R 10000 40000

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Inventory 20000 35000


Total Current Assets 60000 110000
Total Assets 220,000 275,000
Shareholders’ Equity
Capital 80000 80000
Reserve and Surplus 5000 15000
Retained Earnings 15000 35000

Total Shareholders’ Equity 100,000 130,000


Current Liabilities
Trade Payables 10000 75000
Note Payables 60000 30000
Provision 50000 40000

Total Current Liabilities 120,000 145,000


Shareholders’ equity and 220000 275,000
Liabilities

Assume Total Assets as 100 %.


Sol:
Particulars Year Percentage Year 2012 Percentage
2010
Fixed Assets
Investments 30000 30/220×100=13.6% 35000 35/275×100=12.7%
Advances 40000 40/220×100=18.2% 40000 40/275×100=14.5%
Fixed Assets 75000 75/220×100=34% 75000 75/275×100=27.3%
Other Assets 15000 15/220×100=6.8% 15000 15/275×100=5.4%

Total fixed Assets 160,000 160/220×100=72.8% 165,000 165/275×100=60%


Current Assets
Cash 30000 30/220×100=13.6% 35000 35/275×100=12.7%
A/R 10000 10/220×100=4.5% 40000 40/275×100=14.5%
Inventory 20000 35000 35/275×100=12.7%
Total Current 60000 60/220×100=27.3% 110000 110/275×100=40%
Assets
Total Assets 220,000 220/220×100=100% 275,000 275/275×100=100%
Shareholders’
Equity
Capital 80000 80/220×100=36.4% 80000 80/275×100=29%
Reserve and 5000 50/220×100=22.7% 15000 15/275×100=5.4%
Surplus
Retained Earnings 15000 15/220×100=6.8% 35000 35/275×100=12.7%

Total Shareholders’ 100,000 100/220×100=45.4% 130,000 130/275×100=47.3%


Equity
Current Liabilities

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INTODUCTORY BUSINESS FINANCE

Trade Payables 10000 10/220×100=4.5% 75000 75/275×100=27.3%


Note Payables 60000 6/220×100=2.7% 30000 30/275×100=10.9%
Provision 50000 50/220×100=22.7% 40000 40/275×100=14.5%

Total Current 120,000 120/220×100=54.50% 145,000 145/275×100=52.7%


Liabilities
Shareholders’ 220000 220/220×100=100% 275,000 275/275×100=100%
equity and
Liabilities

(E) Concept implication: Apply yours Knowledge of Common size to following Income Statement:

ABC Company
Income Statement
For year ended 31 Dec 2001
___
Rs
Sales 790000
Cost of Goods Sold 49000
Gross Profit 300000
Selling, General, Administrative Expenses 100000
Profit before Interest and Tax 200000
Interest expense 25000
Profit before Tax 175000
Income Tax 16000
Profit after interest and Tax 159000

Assume Sales as 10%


Comparative Statement Analysis
Comparative statement analysis is an analysis of financial statement at different period of time. This
statement helps to understand the comparative financial position and operational performance at
different period of time.
Comparative financial statements again classified into two major parts:
• comparative balance sheet analysis
• Comparative profit and loss account analysis.

Comparative Balance Sheet Analysis

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INTODUCTORY BUSINESS FINANCE

Comparative balance sheet analysis concentrates only the balance sheet of the concern at different
period of time. Under this analysis the balance sheets are compared with previous year’s figures or one-
year balance sheet figures are compared with other years. This type of analysis helps to understand the
real financial position of the concern as well as how the assets, liabilities and capitals are placed during a
particular period.

EXAMPLE 3 ______________________________________________________________________

For Example 2, do Comparative Balance sheet analysis?


Sol:
Particulars Year 2010 Year 2012 Increased or decreased Increased or Decreased
/Rs /Percentage
Fixed Assets
Investments 30000 35000 +5000 5/30×100= + 16.6%
Advances 40000 40000 0 0
Fixed Assets 75000 75000 0 0
Other Assets 15000 15000 0 0

Total Fixed 160,000 165,000 +5000 5/160×100=+3.1%


Assets
Current Assets
Cash 30000 35000 +5000 5/30×100=+16.6%
A/R 10000 40000 +30000 30/10×100=+300%
Inventory 20000 35000 +15000 15/20×100=+75%
Total Current 60000 110000 +50000 50/60×100=+83.3%
Assets
Total Assets 220,000 275,000 +55000 55/220×100=+25%
Shareholders’
Equity
Capital 80000 80000 0 0
Reserve and 5000 15000 +10000 10/5×100=+200%
Surplus
Retained 15000 35000 +20000 20/35×100=+57.1%
Earnings

Total 100,000 130,000 +30000 30/100×100=+30%


Shareholders’
Equity
Current
Liabilities 10000 75000 +65000 65/10×100=+650%
Trade Payables 60000 30000 -30000 30/60×100=-50
Note Payables 50000 40000 -10000 10/50×100=-20
Provision

Total Current 120,000 145,000 +25000 25/120×100=+20.8%

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INTODUCTORY BUSINESS FINANCE

Liabilities
Shareholders’ 220000 275,000 +55000 55/220×100=25%
equity and
Liabilities

Comparative Profit and Loss Account Analysis


Another comparative financial statement analysis is comparative profit and loss account analysis. Under
this analysis, only profit and loss account is taken to compare with previous year’s figure or compare
within the statement. This analysis helps to understand the operational performance of the business
concern in a given period.
RATIO ANALYSIS
What is Ratio?
In mathematics ratio is defined as a medium of explaining the interrelation between two numbers or
variables. Ratio is computed by dividing one numeral by the other.
EXAMPLE: In a university there are total 2000 students, among which 1500 are male and 500 female.
Ratio would be expressed as 1500:500 0r 15:5 0r 3:1.
This implies that male students are three times in relation to the female.
Accounting Ratio: an accounting ratio basically shows relationship between two numbers or variables
from financial statement i.e. Income Statement, Balance sheet.
Classification of Ratio
● Liquidity Ratios
● Activity Ratios
● Financial leverage Ratios
● Profitability Ratios
● Coverage Ratio

Liquidity Ratio
It is also called as short-term ratio. This ratio helps to understand the liquidity in a business which is the
potential ability to meet current obligations.
Liquidity Ratio Classified:
• Current Ratio
• Quick Ratio or Asset test Ratio

Current Ratio: The Ratio between Current Assets and Current Liabilities Current/Liquid assets: The
is Known as Current Ratio. assets which are easily
converted into cash are called
Current Ratio
liquid assets e.g. Cash, Account
Receivable, Inventory,
Current ratio = Current Assets
Marketable securities.
Current liabilities
Current/Short-term liabilities:
Or
amounts payable within
= Cash +A/R+ Inventory+ Marketable Securities
coming one year e.g. Account
Account Payables +Notes payables
payables.

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INTODUCTORY BUSINESS FINANCE

QUICK RATIO OR ACID TEST RATIO:


Quick Assets: assets which are
Quick Ratio or Acid test Ratio easily converted into cash
without loosing their value
Quick ratio = Current Assets- Inventory called Quick Assets e.g. Cash,
Current liabilities Account Receivables,
Marketable Securities.
= Cash +A/R+ Marketable Securities Inventory is not Quick asset
Account Payables +Notes payables because when it is sold on
quick basis, it looses its value.

EXAMPLE 4 ________________________________________________________________________
_____
Assets Rs Liabilities Rs
Fixed Assets 60000 Equity 100,000
Current Assets
Inventory 40000 Long term liabilities 36000
Cash 60000 Short-term liabilities 24000

160000 160000
Compute Current Ratio and Quick Ratio?
SOL:
Current ratio = Current Assets
Current liabilities
= Cash +A/R+ Inventory+ Marketable Securities
Account Payables +Notes payables

=40000+60000/24000=4.17
»This ratio suggest that there are Rs 4.17 of Current Asset to Pay Rs 1 of short-term liabilities or Current
Assets are 4.17 times of current or short-term liabilities.
QUICK RATIO OR ACID TEST RATIO:
Quick ratio = Current Assets- Inventory
Current liabilities
= Cash +A/R+ Marketable Securities
Account Payables +Notes payables

= Cash +A/R+ Marketable Securities = 60000 =2.5


Account Payables +Notes payables 24000
»This ratio suggest that are there Rs 2.15 of Current Asset to Pay Rs 1 of short-term liabilities or Current
Assets are 2.15 times of current or short-term liabilities.

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INTODUCTORY BUSINESS FINANCE

SIGNIFICANCE OF LIQUIDITY RATIO: Liquidity reveals ability of a firm to pay its short-term obligation, so for
short-term money lenders these are of great importance.

Activity Ratio
It is also called as turnover ratio. This ratio measures the efficiency of the current assets and liabilities in
the business concern during a particular period.
Activity Ratios classified
• Inventory turnover(ID)
• Inventory turnover in days(ITD)
• Receivable turnover(RT)
• Receivable turnover in days(RTD) or Average Collection Period
• Payable Turnover(PT)
• Payable turnover in days(PTD)
• Operating Cycle
• Cash Cycle
1. INVENTORY TURNOVER (IT): This ratio Suggest number of times finished goods turned into Sales.

Cost of goods sold


Inventory
2. INVENTORY TURNOVER IN DAYS (ITD): This ratio Suggest average number of Days the inventor
remained unsold.

=Days in a year /Inventory turnover (IT)

= ____Days in year___
Cost of goods sold
Inventory

=Days in a year ×inventory


Cost of Goods sold
3. RECEIVABLE TURNOVER (RT): This ratio tells Number of Times Account receivables turned into
Cash in a year. The higher the turnover, shorter the time period between credit sale and cash
collection is shorter.
Receivables Turnover= Annual Credit Sales/Receivables

4. RECEIVABLES TURNOVER IN DAYS (RTD) OR AVERAGE COLLECTION PERIOD: This ratio tells
average number of days for which Receivables were Outstanding before being collected.
= Days in a Year/Receivable turnover

= Days in a year____
Annual Credit Sales
Account Receivables
= Days in a year ×Account Receivables
Annual credit sales

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INTODUCTORY BUSINESS FINANCE

5. PAYABLES TURNOVER (PT): Payable turnover ratio suggests the number of times Account
payables turned into Cash in year .The higher the turnover, shorter the time period between
credit purchases and cash payments during a year.
Payables turnover=Annual Credit purchases/Account Payables

6. PAYABLES TURNOVER IN DAYS (PTD): This ratio suggests the average number of days for which
Account payables were outstanding before being paid.
= Days in a year
Payables Turnover
= days in a year
Annual Credit Purchases
Account payables
=days in a year ×Account payables
Annual credit purchases
7. OPERATING AND CASH CYCLE:
OPERATING CYCLE: The time interval from Credit purchases to cash collection for receivables, is called
TERM operating cycle.
CYCLE CASH: The time interval from cash payment for credit purchases to the cash collection for account
receivables is called cash cycle.

Raw Material Purchased on Payments for Account payables


credit.

Manufacturing process

Finished goods
Inventory
Turnover
Goods sold

Sold on Cash Sold on Credit

Creation of Account Receivables

Receivables Turnover
Receiving cash from Account Receivables

Figure 3.5 operating and cash cycle

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INTODUCTORY BUSINESS FINANCE

OPERATING CYCLE: Inventory Turnover in Days (INT) + Receivable Turnover in Days (RTD) = Operating
Cycle
CASH CYCLE: Operating Cycle - Payables turnover in days = Cash Cycle

EXAMPLE 5 ________________________________________________________________

Following are financial statements of ABC Company

ABC Company
Income Statement
For year ended 31 Dec 2008
___
Rs
Sales 790000
Cost of Goods Sold 490000
Gross Profit 300000
Selling, General, Administrative Expenses 100000
Profit before Interest and Tax 200000
Interest expense 25000
Profit before Tax 175000
Income Tax 16000
Profit after interest and Tax 159000

ABC Company
Balance Sheet
For year ended 31 Dec 2008
___
Rs
ASSETS
Fixed Assets:
Machinery 20000
Furniture 35000
Equipment 15000
Building 30000
Total Fixed Assets 100,000
Current assets:
Cash 20000
Account Receivables 20000
Inventory 30000
Marketable Securities 30000
Total Current Assets 100000
Total Assets 200000
Liabilities and Equity
Account Payables 30000
Long term liabilities 30000
Total liabilities 60000
Share capital 60000
Retained Earnings 80000
Shareholder’s equity 140000
Total liabilities and equity
INTRODUCTORY BUSINESS FINANCE 200000
BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)
27
INTODUCTORY BUSINESS FINANCE

• All sales are on Credit.


• There are 365 days in a year.
• Cost of goods sold is wholly made of purchases and all are on credit.
REQUIREMENTS: Compute following ratios:
(1)Inventory turnover (ID) (2) Inventory turnover in days (ITD) (3) Receivable turnover (RT)
(4) Receivable turnover in days(RTD) or Average Collection Period (5)Payable Turnover(PT)(6)Payable
turnover in days(PTD)(7)Operating Cycle(8)Cash Cycle
SOL:
(1) Inventory turnover= Cost of goods sold =49000/30000=1.63 times
Inventory
(2) Inventory Turnover in Days (ITD) = Days in a year ×inventory = 365×30000/49000=223 days
Cost of Goods sold
(3) Receivables Turnover= Annual Credit Sales/Receivables=790,000/20,000=39.5 times
(4) Receivables Turnover in days (RTD) OR Average collection period:
= Days in a year ×Account Receivables =365×20,000/790,000=9.24 days
Annual credit sales
(5)Payables Turnover: Annual Credit purchases/Account Payables =49000/30000=1.6 times
(6)Payables turnovers in days:
=days in a year ×Account payables = 365×30000/49000=223 days
Annual credit purchases
(7) OPERATING CYCLE: Inventory Turnover in Days (INT) + Receivable Turnover in Days (RTD)
=223 days + 9.24 days =232 days
(8) CASH CYCLE: Operating Cycle - Payables turnover in days = 232 days – 223days =9 days
Financial Leverage Ratio
TERM FINANCIAL LEVERAGE: An organization consisting of both Equity and Debt is called financial levered and
this state of organization is called Financial Leverage.
Financial Leverage Ratio Suggest an organization is made of how much debt and how much equity.
• Debt to Equity Ratio
• Debt to Total Asset Ratio
• Long-term debt to the Capitalization ratio
1. DEBT TO EQUITY RATIO: This ratio suggests the proportion of debt in the capital structure of a
firm. Higher the Ratio higher is the financial risk of default by the firm.
= ___ total Debt _____
Shareholder’s equity

= Current Liabilities+ Long-term liabilities


Shareholder’s equity
2. DEBT TO TOTAL ASSET RATIO: It shows the percentage of assets financed by the debt. Higher the
ratio, greater the financial risk and lower the ratio, lower is the financial risk.

TERM FINANCIAL RISK: The risk that firm will default with its creditors and shareholders is called financial
risk.
= ___ total Debt _____
Total assets

= Current Liabilities+ Long-term liabilities


Current Assets +Fixed Assets

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3. LONG-TERM DEBT TO TOTAL CAPITALIZATIO RATIO:


Long-term debt
Total capitalization
• Total Capitalization: Long-term debt + shareholders’ equity

EAMPLE 6 __________________________________________________________________

For Example 5, Compute Financial Leverage Ratios:

SOL:

1) Debt to Equity Ratio;


= ___ total Debt _____
Shareholder’s equity

= Current Liabilities+ Long-term liabilities =60000/140000=0.4285 OR 42.85%


Shareholder’s equity
»ABC company is made of 42.85% debt.
2) Debt to Total Asset Ratio:
= ___ total Debt _____
Total assets

Or = Current Liabilities+ Long-term liabilities =60000/200,000=0.30 0r 30%


Current Assets +Fixed Assets
»ABC Company’s 30% assets are financed by debt.
3) Long-term debt to total capitalization ratio:

Long-term debt =30000/30000+60000=0.33 0r 33%


Total capitalization
Total Capitalization: Long-term debt + shareholders’ equity
Profitability Ratio Net Sales* xxx
These ratios show the relationship of profit with sales and investment. Cost of Goods sold xxx
• Gross profit margin Gross profit xxx
• Net profit margin
• Total Asset (or Capital) Turnover *Net sales
• Return on Investment(ROI) Sales xxx
• Earning power Less: Sales Return xxx
• Return on Equity(ROE) Net sales xxx
1. GROSS PROFIT MARGIN :This ratio shows the relationship between gross profit
and sales. Higher the Gross Profit Margin, Higher is the Profitability of the Firm.
Gross Profit Margin Ratio= Gross Profit/net sales ×100
2. NET PROFIT MARGIN: This ratio shows the relationship between Net profit
and sales. Higher the Net Profit Margin, Higher is the Profitability of the Firm.
Net Profit Margin Ratio= Net Profit after taxes/net sales ×100 *Net sales
3. TOTAL ASSET(OR CAPITAL) TURNOVER: This ratio shows the relationship of Sales xxx
Net sales to Total Assets. Less: Sales Return xxx
Net sales Net sales xxx
Total assets

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INTODUCTORY BUSINESS FINANCE

TERM TOTAL ASSETS: Current assets plus fixed assets

4. RETURN ON INVESTMENT (ROI): Investment means total assets and return means Profit after
interest and tax. Thus
Net Profit after taxes
Total Asset
5. EARNING POWER :Earning power is the Return on investment(ROI) ratio but first introduced by
Du Pont Company and is equal to :
Earning power=net profit margin × Total Asset turnover
= net profit after taxes /sales × sales/Total Assets
=net profit after taxes /total assets
6. RETURN ON EQUITY (ROE): return means profit after taxes and preferred dividend
(Residual profit) and equity means Shareholders’ equity.

Net profit after taxes and preferred dividend Sales xxx


Shareholder’s equity Less: C.G. S xxx
This ratio indicates overall performance of the firm relevant to the Gross Profit xxx
Share holders. Less: expenses xxx
_________________________________________________ EBIT xxx
EAMPLE 7 Less: Interest xxx
EBT xxx
Less: Taxes xxx
For example 5, compute all profitability ratios and interpret them. Profit after tax xxx
Less: Preferred dividend xxx
SOL:
Residual profit xxx
1) Gross Profit Margin Ratio= Gross Profit/net sales ×100
=300000/790000×100=37.97%
»The gross profit is 37.97% of sales SHAREHOLDER’S EQUITY
2) Profit Margin Ratio= Net Profit after taxes/net sales ×100 Share Capital xxx
=159000/790000×100=20.13% Reserve (any) xxx
»The Net profit is 20.13% of sales. Retained Earnings xxx
3) total asset(or capital) turnover: Share holder’s equity xxx
Net sales = 790000/200,000=395%
Total assets
»The Net sales are 395% of total assets.
4) return on investment (ROI) :
Net Profit after taxes =159000/200000=79.5%
Total Asset
5) Earning power: net profit margin × Total Asset turnover = 20.13% × 395%=79.5%
6) Return on equity (ROE):

Net profit after taxes and preferred dividend = 159000/140000=113.57%


Shareholder’s equity

Coverage Ratio
Coverage ratio measures ability of a firm to pay its financial charges.
TERM FIANCIAL CHRAGES: Financial charges mean interest.

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INTODUCTORY BUSINESS FINANCE For banks two things are very
important:
i) Repayment of loan
• Interest coverage ratio
granted to
INTEREST COVERAGE RATIO: Profit before interest and taxes/interest expense organizations or
Higher the interest coverage ratio, higher is the chances of payment of interest ‘ individuals.
Charges. ii) Payment of interest.

EAMPLE 8 __________________________________________________________________________

Compute interest coverage ratio for example 5?


SOL:
Profit before interest and taxes/interest expense=200000/25000= 8 Times
SUMMARY OF RATIOS

Sr No Category Ratio Formula


Current Ratio Current Assets
Current liabilities
1 Liquidity
Quick Ratio Current Assets- Inventory
Ratios Current liabilities
Debt to Equity Ratio ___ total Debt _____
Shareholder’s equity
2
Debt to Total Asset ___ total Debt _____
Leverage Ratio Total assets

Ratios
Long-term debt to the Long-term debt
Capitalization Ratio Total capitalization
Inventory turnover Cost of goods sold
Inventory
Inventory Turnover in Days in a year ×inventory
Days (ITD) Cost of Goods sold

3 Receivables Turnover Annual Credit Sales/Receivables


(RT)
Receivables Turnover Days in a year ×Account Receivables
Activity Ratios in days (RTD) Annual credit sales

Payables Annual Credit purchases/Account Payables


Turnover(PT)
Payables turnovers in days in a year ×Account payables
days Annual credit purchases

operating cycle Inventory Turnover in Days (INT) +Receivable


Turnover in Days (RTD)
cash cycle Operating Cycle - Payables turnover in days
Profitability Gross Profit Margin Gross Profit/net sales ×100
4 Ratio
Ratios Net Profit Margin Net Profit after taxes/net sales ×100
Ratio

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INTODUCTORY BUSINESS FINANCE

Total Asset (or Net sales


Capital) Turnover Total assets

Return on Net Profit after taxes


investment (ROI) Total Asset

Earning power net profit margin × Total Asset turnover


Return on equity Net profit after taxes and preferred dividend
(ROE) Shareholder’s equity
5 Coverage Ratio Interest coverage Profit before interest and taxes/interest
Ratio expense

Case Study
FINANCIAL STATEMENT ANALYSIS

BACKGROUND OF THE ORGANIZATION:


The Muslim Commercial Bank Limited was incorporated on 9th July 1947 in Calcutta in Bengal. After
partition, the Registered Office of the bank was shifted to Dhaka where it commenced business from
August 1948. The Bank transferred its registered/Head office from Dhaka to Karachi in 1956.Muslim
Commercial Bank Limited was nationalized by the Government of Pakistan in January 1974 under the
Banks Nationalization Act, 1974. Subsequent to nationalization the operations of premium Bank Limited
were merged with the Muslim Commercial Bank Limited in June 1974.

The business volume of the bank can be analyzed by the following table:-

Rupee in million

Description 2007 2008 2009 2010 2011

Deposits 292,098 330,182 367,605 431,372 491,189

Advances 218,961 262,135 253,249 254,552 225,801

Investments 113,089 96,632 167,134 213,061 316,652

Total Equity 55,120 58,436 69,740 79,204 88,802

Profit After Taxation 15,266 15,375 15,495 16,873 19,425

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INTODUCTORY BUSINESS FINANCE

The Balance sheet of the MCB for the five years shown:-

Years 2007 2008 2009 2010 2011

Cash and balances with Treasury Banks 39,684 39,631 38,775 45,407 53,123

Balance with other banks 3,808 4,043 6,010 1,479 2,281

Lending to financial institutions 1,051 4,100 3,000 4,402 955

Investments 113,089 96,632 167,134 213,061 316,652

Advances 218,961 262,135 253,249 254,552 225,801

Operating fixed assets 16,024 17,264 18,015 20,948 22,008

Other assets 17,869 19,810 23,040 27,706 32,413

Total assets 410,486 443,616 509,224 567,553 653,233

10,479 10,551 8,201 10,266 9,467

Bill payable

Borrowing 39,407 22,664 44,662 25,685 39,100

Deposits 292,098 330,182 367,605 431,372 491,189

Sub-ordinate loans 479 - - - -

Other liabilities 11,722 21,346 15,819 16,092 18,380

Share capital 6,283 6,283 6,911 7,602 8,362

Reserves 34,001 36,769 38,386 40,163 42,186

Inappropriate profit 5,131 9,193 15,779 21,416 28,366

Surplus 9,706 6,191 8,664 10,024 9,887

Total liabilities 355,366 385,180 439,484 488,349 564,431

Share holder’s Equity 55,120 58,436 69,740 79,204 88,802

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INTODUCTORY BUSINESS FINANCE

INCOME STATEMENT FOR LATEST FIVE YEARS


Year 2007 2008 2009 2010 2011

Mark-up / Return / Interest Earned 31,787 40,044 51,616 54,821 68,147

Mark-up / Return / Interest Expensed 7,866 11,561 15,837 17,988 23,620

Net Mark-up / Interest Income 23,921 28,483 35,779 36,834 44,526

Provision & write off 3,061 4,042 7,465 3,685 4,168

Net Mark-up / Interest Income after provisions 20,860 24,441 28,314 33,149 40,358

Fee, commission and brokerage income 2,635 2,953 3,332 4,130 4,921

Dividend income 632 618 460 544 1,003

Income from dealing in foreign currencies 693 728 341 632 921

Gain on sale of investment-net 1,488 637 774 412 736

Other income 563 856 736 548 531

Total Non-Mark-up / Interest Income 6,448 5,791 5,643 6,265 8,112

NON MARK-UP / INTEREST EXPENSE 6,000 8,365 10,801 13,160 16,987

PROFIT BEFORE TAXATION 21,308 21,868 23,155 26,254 31,483

Taxation Current year 6,042 6,493 7,660 9,380 12,058

PROFIT AFTER TAXATION 15,266 15,375 15,495 16,873 19,425

REQUIRED: Give complete financial picture of MCB by fragmenting in:


I) Trend analysis (Simple index Analysis)
II) Common size Analysis (Both income statement and balance sheet)
III) Comparative Statement Analysis (Both income statement and balance sheet)
IV) Ratio Analysis (all ratio whichever is possible if not possible then state reason why)

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QUESTIONS AND SOLUTIONS BANK
INTODUCTORY BUSINESS FINANCE

TH
SELECTED QUSTIONS FROM FUNDAMENTALS OF FINANCIAL MANAGEMENT 11 EDITION BY VAN C HORNE

P1: The data for various companies in the same industry are as follows:
_____________________________________________COMAPNY__________________Rs (Million) ____
A B C D E F
SALES 10 20 8 5 12 17
TOTAL ASSETS 8 10 6 2.5 4 8
NET INCOME 7 2 8 5 1.5 1

Determine the total assets turnover, net profit margin and earning power for each?

SOL: C Total Assets Turnover=net sales/total assets×100


Net profit margin=net profit/sales ×100
Earning Power = Net profit margin × total assets turnover

A B C D E F

Total asset turnover 10/8 20/10 8/6 5/2.5 12/4 17/8

125% 200% 133.33% 200% 300% 212.5%

Net Profit Margin 7/10 2/20 8/8 5/5 1.5/12 1/17

70% 10% 100% 100% 12.5% 5.88%

Earning power 125%×70% 200%×10% 133.33%×100% 200%×100% 300%×100% 212.5%×5.88%

87.5% 20% 133.335 200% 300% 12.50%

P2: Cordiera Carson Company has following balance sheet and income statement for 20X2(in
thousands):
BALANCE SHEET INCOME STATEMENT___________
Cash 400 Net Sales (all credit) 12680
Accounts Receivables 1300 cost of goods sold 8930
Inventories 2100 Gross profit 3750
Current Assets 3800 selling, general and administrative 2230
Net Fixed Assets 3320 Interest expense 460
Total Assets 7120 Profit before tax 1060
Account payables 320 Taxes 390
Accruals 200 Profit after taxes 670
Short-tem loans 1100
Current liabilities 1680
Long-term debt 2000
Net worth 3440
Total liabilities and
Worth 7120

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INTODUCTORY BUSINESS FINANCE

On basis of this information, compute (a) Current ratio,(b)Acid test ratio,(c)Average collection
period,(d)inventory turnover ratio,(e)The debt to net worth ratio,(f)long-term debt to total capitalization
ratio,(g)gross profit margin,(h)net profit margin and (i) return on equity?
SOL: ((a) Current Ratio= Current Assets = 3800/1680=2.26
Current liabilities
(b) Quick Ratio or Acid Test Ratio= Current Assets- Inventory = 3800-2100/1680=1.011
Current liabilities
(c) Receivables Turnover in days (RTD) or Average collection period=
Days in a year ×Account Receivables = 365×1300/12680=37.42 days
Annual credit sales
(d) Inventory turnover= Cost of goods sold =8930/2100=4.25
Inventory
(e) Debt to Equity Ratio or debt to net worth ratio=___ total Debt _____ =Total debt/net worth
Shareholder’s equity
1680+2000/3440=1.07
(f) Long term debt to total capitalization ratio= Long-term debt =2000/2000+3440=0.37
Total capitalization
(g) Gross Profit Margin Ratio= Gross Profit/net sales ×100=3750/12680 ×100=29.57%
(h) Net Profit Margin Ratio= Net Profit after taxes/net sales ×100=670/12680 ×100 =5.28%
(i) Return on equity (ROE) = Net profit after taxes and preferred dividend =670/3440=.1948
Shareholder’s equity
P3: The Following information is available on the vainer Corporation:
BALANCE SHEET AS OF DECEMBER 31,20X06 (IN THOUSANDS)
_________________________________

Cash and Marketable Securities 500 Account Payables 400


Account Receivables ? Bank loan ?
Inventories ? Accruals 200
Current Assets ? Current liabilities ?
Long-term debt 2650
Net fixed Assets ? Common Stock and retained earnings 3750
Total Assets ? Total liabilities and equity ?
_____________________________________________________________________________________________
_____________________________________________________________________
INCOME STATEMENT FOR 20X06(IN THOUSANDS)
Credit sales 8000
Cost of Goods sold ?
Gross Profit ?
Selling and administrative expenses ?
Interest expense 400
Profit before taxes ?
________________________________________
OTHER INFORMATION____________________________
Current ratio 3 to 1
Depreciation Rs 500
Net profit margin 7%
Total liabilities/shareholder’s equity 1 to 1
Average collection period 45 days
Inventory turnover ratio 3 to 1
__________________________________________________

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INTODUCTORY BUSINESS FINANCE

Assuming that Sales and production are steady throughout a 360-day year, complete the balance
sheet and income statement?

SOL:

Current Ratio=Current Assets/Current liabilities=3/1

Net profit margin=Net Profit after taxes/Net sales=7%

Total liabilities/shareholders’ equity = 1 to 1

Average Collection period=days in year × Account receivables/credit sales

Inventory turnover ratio =C.G.S/inventory

Average Collection period=days in year × Account receivables/credit sales

45 DAYS=360×A.R/8000

A.R=45×8000/360=Rs 1000

Net profit margin=Net Profit after taxes/Net sales

7%=Net profit after taxes/8000

NET PRFOIT AFTER TAXES =7% × 8000=Rs 560

PROFIT BEFROE TAXES=560/56 ×100 =Rs 1000

TAX=1000×44/100=Rs 440

Total liabilities/shareholders’ equity

Total liabilities/3750=1/1

TOTAL LAIBILTIES=1/1×3750=Rs 3750

TOTAL LAIBILTIES=CURRENT LAIBILITIES + LING-TERM DEBT

3750= CURRENT LAIBILITIES + 2650

CURRENT LAIBILTIES =3750-2650=1100

Current Ratio=Current Assets/Current liabilities

3/1=Current Assets/1100

CURRENT ASSETS=1100×3/1=3300

CURRENT ASSETS=Marketable securities + Account Receivable + Inventories

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INTODUCTORY BUSINESS FINANCE

3300=500+1000+inventories

Inventories +1500=3300

Inventories = 3300 – 1500 =Rs 1800

Inventory turnover ratio =C.G.S/inventory

3/1=C.G.S/1800

C.G.S=3/1 × 1800 =Rs 5400

Credit sales – C.G.S=GROSS PRFOIT

8000 – 5400 =2600

Gross Profit – Selling and administrative expense – interest expense=PROFIT BEFROE TAX

2600 - Selling and administrative expense – 400 =1000

- Selling and Administrative expenses=1000+400-2600=-1200


Selling and Administrative expenses=1200

Complete balance sheet and income statement

BALANCE SHEET AS OF DECEMBER 31,20X06 (IN THOUSANDS)


_________________________________

Cash and Marketable Securities 500 Account Payables 400


Account Receivables 1000 Bank loan 500
Inventories 1800 Accruals 200
Current Assets 3300 Current liabilities 1100
Long-term debt 2650
Net fixed Assets 4200 Common Stock and retained earnings 3750
Total Assets 7500 Total liabilities and equity 7500
_____________________________________________________________________________________________
_____________________________________________________________________
INCOME STATEMENT FOR 20X06(IN THOUSANDS)
Credit sales 8000
Cost of Goods sold 5400
Gross Profit 2600
Selling and administrative expenses 1200
Interest expense 400
Profit before taxes 1000
Taxes(44%) 440
Profit after tax 560

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INTODUCTORY BUSINESS FINANCE

P4: A Company has Total annual Sales (all credit) of Rs 400,000 and a gross profit margin of 20 percent.
Its Current assets are Rs 80, 000, current liabilities Rs 6000, inventories Rs 30000 and Cash Rs 10000.
a. How much average inventory should be carried if management wants the inventory turnover to
be 4?
b. How rapidly (In how many days) must account receivable be collected if management wants to
have an average of Rs 50,000 invested in receivables (assume a 360-day year)?
SOL: to determine inventory level we needs inventory turnover ratio:

a. Inventory turnover= C.G.S/Inventory =

Sales 100% Inventory Turnover = C.G.S/Inventory

Less C.G.S 80% 4 = 320000/inventory

Gross profit Margin 20% inventory =320000/4=Rs 80000

Thus C.G.S =400,000 ×80%=Rs 320000

b. Receivables Turnover in days (RTD) = Days in a year ×Account Receivables


Annual credit sales

= 360 × 50000/400000= 45 days

P5: Stoney Mason, Inc has sales of Rs 6 million, o total asset turnover ratio of 6 for the year and net
profits of Rs 120000.

a. What is Company’s return on assets or earning power?


b. The company is considering the installation of new point-of-sales cash registers throughout its
stores. This equipment is expected to increase efficiency inventory control, reduce clerical
errors, and improve record keeping throughout the system. The new equipment will increase
the investment in assets by 20% and is expected to increase the net profit margin from 2 to 3
percent. No change in sales is expected. What is effect of new equipment on return on assets
ratio or earning power?

SOL: a. Earning Power =net profit margin × Asset turnover ratio

Earning Power =net profit after tax/net sales × Net sales/Total assets

Earning Power=120000/6000000 × 6

= 2 × 6 =12/100 =0.12

b. Earning Power =net profit after tax/net sales × Net sales/Total assets

Net sale/Total assets =6000000/1000000=Rs 1

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=0.03 × (6/1×120%)

=0.03 ×7.2=21.6%

P5: The long-term debt section of balance sheet of Queen Anne’s Lace Corporation appears as follows:

__________________________________________________________
9 ¼ % mortgage bonds Rs 2500,000
12 3/8 % Second mortgage bonds 1500,000
10 ¼ % Debentures 1000,000
14 1/2 % Subordinate debentures 1000,000
Rs 6000,000
______________________________________________________________
If the average earnings before interest and taxes of company are Rs 1.5 million and all debt is long term,
what is the overall interest coverage?

SOL: The total interest expense is:

On 9 ¼ % mortgage bonds = 2500,000 × 9.25/100 =231,250

On 12 3/8 % Second mortgage bonds = 1500000 × 12.375/100=185,625

On 10 ¼ % Debentures =1000, 000 × 10.25/100=102,500


On 14 1/2 % Subordinate debentures =1000, 000 × 14.50/100=145000
Total interest 664375

INTEREST COVERAGE= EBIT/INTEREST=1500000/664375=2.25

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VALUATION CONCEPTS
INTODUCTORY BUSINESS FINANCE

CHAPTER 4

This Chapter includes:

• Concept of time value of Money


• Concept of present value and future value
• Concept of Interest
• Concept of compounding
• Amortizing a loan

CONCEPT OF TIME VALUE OF MONEY:

The Phrase “time value of money” consists of three words:

TIME: Time means the time period.


VALUE: Value is the ‘worth’ of a thing. It can also be defined as ‘a bundle of
Benefits’ expected from it. It can be tangible or intangible.
MONEY: Money means the cash or currency etc.
This phrase implies that with passage of time the value of money changes either
Increases or decreases.
Illustration: Suppose two persons:
Mr. A who has Rs 500 and he has save these Rs 500 in locker at his home.
Mr.B Who has Rs 500 and he has deposited this Rs 500 into Bank at Interest
10%.
After one year Mr. A will have Rs 500 because he has saved money in his locker
for one year.
Mr.B will has after one year:
Rs
Interest (500×10/100) 50
Original Amount 500
550
Ω So after one year Purchasing power of money declines because the thing that
we can purchase today at Rs 500, after one year it would be purchased at Rs
550.
CONTRIBUTORY FACTORS:
The Factors that cause value of money to fall or rise are:
i)INFLATION: The Inflation cause value of money to fall
The deflation cause value of money to rise
ii)INTEREST RATE: The fluctuation in interest also influence value of money.

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INTODUCTORY BUSINESS FINANCE

CONCEPT OF FUTURE VALUE AND PRESENT VALUE:

Future value: The value of a cash flow in the future is Future value .sometime also called terminal value,
future means the next second, next minute, next hour, next days etc.
Present value: The value of a cash flow in present time is called present value.

t=0 t=1 t=2 t=3 t=4

Present Future Value


Value

Fig 4.1 Distinction between present value and future value.

CONCPT OF COMPUND INTEREST: Compound interest means interest earned on interest.

Suppose you have deposited Rs 5000 in a Bank at 8 % Compounded annually for four years. The simple
computations are under:

Year Present value/Principle Interest future value

1 5000 400 5400

2 5400 432 5832

3 5832 466 6298

4 6298 504 6802

FORMULA: n
FV=PV (1+i) or FV= PV (PVIF)
4
FV= 5000(1+0.08) =6802
FUTURE VALUE FORMULA:

n
FV=PV (1+i) or FV= PV (FVIF)
i,n

PRESENT VALUE FORMULA:

-n
PV=FV (1+i) or PV= FV (PVIF)
i,n

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INTODUCTORY BUSINESS FINANCE

INTEREST RATE COMPOUNDING: The interest may be compounded annually, semiannually, quarterly,
monthly, weekly, daily ,Hourly,Contineously.

_
EAMPLE 1
____________________________________________________________________

(Paper: introductory Business Finance, Q.NO:1, summer 2009, Sarhad University)

The cash flow of Rs 250000 is compounded annually, semiannually, quarterly, monthly, weekly, daily,
Hourly, And Continuously at interest of 10 % for 5 years. Calculate Future value of cash flow?

SOL:

COMPUNDED ANNUALLY = when compounded annually, the i=10% and n=5

FV= PV (FVIF)
i,n
FV=250000(PVIF) (i=10% and n=5)
FV=250000(1.6105) =Rs 402625
COMPUNDED semiannually =When compounded semiannually, then i=10/2=5% n=5×2=10 years

FV=250000(PVIF) (i=5% and n=10)


FV=250000(1.629) =Rs 407250
COMPUNDED quarterly = when compounded quarterly, then i=10/4=2.5% n=5 × 4 =20

20
FV=250000(1+0.025) =250000(1.638) =Rs 409500
COMPUNDED monthly =when compounded monthly, then i=10%/12=0.834% n=5×12=60

60
FV=250000(1+0.0.00834) =250000(1.645) =Rs 411250

COMPUNDED weekly =when compounded monthly, then i=10%/52=0.1923% n=5× 52=260

60
FV=250000(1+0.001923) =250000(1.648) =Rs 412000 1 year= 52 weeks

COMPUNDED daily =when compounded daily, then i=10%/365=.0274% n=5×365=1825

1825 1 year= 365 days


FV=250000(1+0.000274) =250000(1.649) =Rs 412250

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INTODUCTORY BUSINESS FINANCE

COMPUNDED hourly =When Compounded hourly, then i=10%/8760=.00115% n=5×8760=43800

43800
1 year= 365 days×24 hours=8760 hours
FV=250000(1+0.0000115) =250000(1.655) =Rs413750

COMPUNDED continuously =when compounded continuously, then following formula is used.

FUTURE VALUE FORMULA


i×n
FV=PV (e)
e=natural log of 1 and e=2.71828
PRESENT VALUE FORMULA
i×n
PV=FV/(e)

I×n 0.10×5 0.5


FV=PV (e) =250000(2.71828) =250000(2.71828) =250000(1.649) =Rs 412250
DETERMINING INTEREST RATE AND TIME PERIOD

EAMPLE 2 Interest Rate


____________________________________________________________________

Michilan Chemical Processing Industries Need Rs 500,000 for 5 years, the Royal Bank agree to made this
payment to Michilan if Michilan agrees to repay Rs 750,000 after 5 Years. What would be the implicit
rate of interest?
SOL: For determine implicit interest rate of compound interest we use Future value formula (Usually).
n
FV=PV (1+i) or PV (FVIF)
i,n

FV=PV(FVIF) 750,000=500,000(PVIF i=? n=5 years)


(PVIF i=? n=5 years)=750,000/500,000
=1.5 Factor
Seeking in FVIF table, in row of 5 years and finding the factor 1.5 and the column of 1.5 factors is
interest rate. The factor 1.469 comes under interest rate 8 % and 1.539 under 9%, the actual rate is
between 8% and 9 % which can be fined by interpolation but we assume it is 9%.

EAMPLE 3 Time Period


___________________________________________________________

Michilan Chemical Processing Industries Need Rs 1000,000, the Royal Bank agree to made this payment
to Michilan if Michilan agrees to repay Rs 1400,000. The implicit rate of interest IS 11%, in how much
the amount should be returned?

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INTODUCTORY BUSINESS FINANCE

SOL: FV=PV (FVIF) 1400, 000=100,000(FVIF i=11% n=? )


i,n (FVIF i=11% n=? )=1400, 000/1000, 000

=1.4 FACTOR
The factor 1.4 comes column 11 % and in row of 4 years. Thus time period is 4 years.

(E) Concept implication: Apply yours Knowledge of Compounding to following question:

The cash flow of Rs 10,000 is compounded annually, semiannually, quarterly, monthly, weekly, daily,
Hourly, And Continuously at interest of 10 % for 5 years. Calculate Present value of cash flow?

CONCEPT OF ANNUITY

Annuity: The series of equal payments made at equal intervals is called annuity. e.g. You have taken a
loan form a bank payable in installment is a simple example of annuity, suppose you have taken Rs
500,000 payable in installments of Rs 50000 each year for 12 years. Rs 50000(equal amount) shall be
payable by you after each year (equal interval).

Series OF Payments

Annuity Uneven Cash Flow

Ordinary Annuity Annuity Due

Fig 4.2 Classification of series of payments

ORDINARY ANNUITY: if the each payment of the series is made at the end of each period, the annuity is
said to be ordinary annuity.

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INTODUCTORY BUSINESS FINANCE

FORMULA:
Future value formula

FV=R [1i -1)] n

[1i -1]] = future value interest factor annuity (FVIFA)


n

i
FV=R (FVIFA)

Present value formula

PV=R [1  1i ] -n

[1  1i ]=present value interest factor annuity (PVIFA)


-n

i=interest rate
n=period
R=payments
PV=Present value
FV=future value

EAMPLE 4
_____________________________________________________________________

You need to have Rs 80,000 at end of 10 years to meet education expenses of yours son. To accumulate
this sum, you have decided to save a certain amount at end of each the next 10 years and deposit in the
bank. The bank pays 8 percent compounded annually for long-term deposits. How much will you have to
save each year?

SOL: you need Rs 80,000 after ten years; it means it is future value (FV). You accumulate at end of each
year, it means it is annuity and at end of each of next 10 years, it means it is ordinary annuity.

FORMULA:

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INTODUCTORY BUSINESS FINANCE

FV=R [1i -1)] 0r FV=R (FVIFA)


n

[
80,000=R 10.0810 -1) ] 0R 80,000=R (FVIFA i=8% n=10)
0.08
80,000=R (14.487)

R=80,000/14.487=Rs 5522

(E) Concept implication: Apply yours Knowledge of Annuity to following question:

Mr. Muneeb is recently retired from Government Service and he has received a sum of Rs 100,000 in
respect of Pension, he is willing to deposit this amount in an insurance company to purchase an annuity
which gives constant fixed payments for remaining of his life at end of each year and his expected
remaining life is 10 years, the interest rate is 9 % compounded annually. Required: Determine he will
receive what amount for remaining of his life. (Hints: Presently he has Received Rs 100,000, so it is
present value)?

ANNUITY DUE: If each payment of series is made at begin of each period, the Annuity is said be Annuity
due.
FORMULA:
Future value formula

FV=R [1i -1)] × (1+i)


n

[1i -1]] = future value interest factor annuity (FVIFA)


n

i
FV=R (FVIFA)

Present value formula

PV=R [1  1i ] × (1+i)


-n

[1  1i ]=present value interest factor annuity (PVIFA)


-n

i
i=interest rate
n=period
R=payments
PV=Present value
FV=future value
INTRODUCTORY BUSINESS FINANCE BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)
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INTODUCTORY BUSINESS FINANCE

EAMPLE 5 ______________________________________________________________________

Mr. Muneeb is recently retired from Government Service and he has received a sum of Rs 100,000 in
respect of Pension, he is willing to deposit this amount in an insurance company to purchase an annuity
which gives constant fixed payments for remaining of his life at begin of each year and his expected
remaining life is 10 years, the interest rate is 12% compounded annually. Determine he will receive
what amount for remaining of his life?

SOL

PV=R [1  1i ] × (1+i)


-n or PV=R (PVIFA) × (1+i)
i
100,000=R (PVIFA i=12 % n=10 years) × (1+0.12)
100,000=R (6.353) × (1.12)
100,000=R (7.115)
R=100,000/7.115=Rs 14055
Concept implication: Apply yours Knowledge of Annuity due to following question:
(E)
You need to have Rs 80,000 at end of 10 years to meet education expenses of yours son. To accumulate
this sum, you have decided to save a certain amount at begin of each the next 10 years and deposit in
the bank. The bank pays 8 percent compounded annually for long-term deposits. How much will you
have to save each year?

UNEVEN CASH FLOW The series of payments which fulfill following two conditions is said to be annuity:
i) Series includes equal payments
ii) Payables at equal intervals etc each year
If condition (i) is not satisfied means series includes unequal payments, the series is said to be uneven
cash flow.
EAMPLE 6 _____________________________________________________________________

(Paper: introductory Business Finance, Q.NO:4, summer 2009, Sarhad University)


The H & L Bark Company is considering the purchase of a debarking machine that is expected to provide
cash flow as follows:
________________END OF YEAR_ (Rs) ___________________________________
______________________1 2 3 4 5 6 7 8 9_
Cash flow 1400 1800 1500 1700 1400 1800 2100 2200 1600
If the appropriate annual discount rate is 4 percent, what is present value of this cash flow stream?

SOL
____________________________________________________________________________________
YEAR CASH FLOWS(Rs) PVIF @ 14% PRESENT VALUE______
1 1400 .877 1228

2 1800 .769 1384

3 1500 .675 1012

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INTODUCTORY BUSINESS FINANCE

4 1700 .592 1007

5 1400 .520 728

6 1800 .456 821

7 2100 .399 838

8 2200 .350 770

9 1600 .307 491


Total Present value of cash flow stream 8279

AMORTIZING A LOAN
The loan we take from banks for different purposes my be amortized and each installments is
determined by use of present value formula of annuity.

If installment is payable at begin of period:

PV=R [1  1i ] × (1+i)


-n

i
If installment is payable at end of period:

PV=R [1  1i ] -n

i
_______________________________________________________________________
EAMPLE 7

Mutual Trust Enterprises needs Rs 250,000 to expand its business, thus sanctioned a loan of Rs 250,000
from MB bank with following terms:

• Loan shall be payable in five years i.e. five installments.


• The installment shall be made at end of each year.
• Bank will charge implicit interest rate at 9%.

Requirement: Give Amortization schedule?

SOL

PV=R [1  1i ] -n OR PV=R (PVIFA)


i
250,000=R (PVIFA i=9% n=5)
250,000=R (3.890)
R=250000/3.890=Rs 64267

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_____________________________________________________________________________________
_______________________AMORTIZATION SCHEDULE________________________________________
YEAR PAYMENT(R) INTEREST@9% PRINCIPAL LIABILITIY_______

0 --- ---- ---- 250,000

1 64267 250,000×9%=22500 64267-22500=41767 250,000-41767=208233

2 64267 208233×9%=18741 64267-18741=45523 208233-45523=162710

3 64267 162710×9%=14644 64267-14644=49623 162710-49623=113087

4 64267 113087×9%=10178 64267-10178=54089 113087-54089=58998

5 64267 58998×9%=5310 64267-5310=58957 58998-58957=0

Concept implication: Apply yours Knowledge of Loan Amortization to following question:


(E) Mr. Y need Rs 100,000 to build his home, so he got loan from House building finance Corporation
(HBFC) with following terms:

i. Loan shall be payable in 12 equal monthly installments, each payable at end of the
month
ii. The bank charges interest at 12 % compounded annually.

Requirement: Amortize the loan?

LONG-TERM FINANCE

LONG-TERM FINANCE

EQUITY FINANCE DEBT FINANCE

Common share or Common Stock Bonds

Preference share or Preference Stock Debentures

Bank loan

Fig 4.3 Types of long-term corporate Finance

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INTODUCTORY BUSINESS FINANCE

Long-term Financial Requirements or Fixed Capital Requirement


Long-term financial requirement means the finance needed to acquire land and building for business
concern, purchase of plant and machinery and other fixed expenditure. Long-term financial requirement
is also called as fixed capital requirements. Fixed capital is the capital, which is used to purchase the
fixed assets of the firms such as land and building, furniture and fittings, plant and machinery, etc.
Hence, it is also called a capital expenditure.
DEBT FINANCE: Debt finance means taking DEBT from peoples, banks or financial institutions to meet
long-term expenditures of purchasing plant machinery etc. Debt finance may be raised in any of
following ways.
i. Bonds
ii. Debentures
iii. Bank loan
Bond: It is a certificate issued by the company under its seal acknowledging a debt.
Features of Bond
1. Face value/par value/Maturity value: The value/amount which is paid to the bond holder on
maturity of bond is said to be Face value, par value, or Maturity value.
1. Maturity period: Bond consists of long-term fixed maturity period. Normally, Bond consists of 10–20
years maturity period and is repayable with the principle investment at the end of the maturity period.
2. No voting rights: Debenture holders are considered as creditors of the company. Hence they have no
voting rights. Bond holders cannot have the control over the performance of the business concern.

BONDS
General
Public Company

MONEY

Fig 4.4 Movements of bonds and Money

VALUATION OF BOND:
Value means Price of Bond and Valuation is the Process of determine price of bond is called Valuation.
The valuation of bond depends on type of bond.
• COUPON BOND
• ZERO COUPON BOND
• PERPETUAL BOND
VALAUTION OF COUPON BOND: Coupon bond is has following characteristic:
i. It has face value which is paid on maturity; generally the face value is Rs 1000.
ii. It pays Interest (Coupon) on face value at interest rate determined by the corporate directors.

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Illustrative: ABC Company issued 5-year bonds having a face value of Rs 1000 and pays
coupon at rate of 9%.The cash flow Stream will be appear as follow:

0 1 2 3 4 5

0 90 90 90 90 90
Present 1000
Value/Price
?

Thus, Value/Price of Bond will be:

Value/Price of bond= Present value of Annuity + Present value of Compound Payment

P or V= R [1  1i ] + FV 1i
-n -n

i
Where p/v is price of bond
R is the Payments of Coupon/interest
FV is the Face value of bond
i is the investor’s required rate of return/Discount rate
n is the time period of bond

[ ]
As 1  1i-n = PVIFA and 1i-n =PVIF
i

P or V=R (PVIFA) +FV (PVIF)

BBBBBBBBBBBBBBBB___________________________________________________________________
EAMPLE 8

(Paper: introductory Business Finance, Q.NO:5, Spring2008, 2007, 2006, Sarhad University)
The Mecentile‘inc’ issued 9% Coupon bond of face value Rs 1000 for 10 years. The Investors’ discount
rate is 12%.determine value of bond.
SOL: R=1000×9/100=Rs90 i=12% 0r 12/100=0.12 n=10 FV=1000

P or V= R [1  1i ] + FV 1i
-n -n

[ ]
v=90 1  1.12  + 1000 1.12 
0.12

Or
V=90(PVIFA i=12% n=10) + 1000 (PVIF i=12% n=10)

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V=90(5.650) + 1000(0.322) =599 + 322=Rs 921

EAMPLE 9
_____________________________________________________________________
(Paper: introductory Business Finance, Q.NO:4, Spring 2009 Sarhad University)
The Radish‘inc’ issued bond of face value Rs 1000 for 10 years. The Company pays Rs 80 Coupon and The
Investors’ discount rate is 9%.determine Price of bond?
SOL:
P or V=R (PVIFA) +FV (PVIF)
=80(PVIFA i=9% n=10) + 1000 (PVIF i=9% n=10)
=80 (6.418) + 1000 (0.422)
= 514 + 422= Rs 936
_____________________________________________________________________________________

Concept implication: Apply yours Knowledge of Bond valuation to following question:


(E) (Paper: introductory Business Finance, Q.NO:4, Spring 2007 Sarhad University)
The Carpet Company issued bond of face value Rs 1000 for 5 years. The Company pays Rs 75 Coupon
and The Investors’ discount rate is 9%.
i. Determine Price of bond?
ii. If Bond is issued for 8 years, then what is price of bond?
iii. If Investors’ discount rate is 12%, then what is price of bond?

VAUATION OF ZERO COUPON BOND: Zero Coupon bond has following characteristic:
i. It has face value which is paid on maturity; generally the face value is Rs 1000.
ii. It pays no Interest (Coupon).

Illustrative: ABC Company issued 5-year Zero Coupon bond having a face value of Rs 1000
.The cash flow Stream will be appear as follow:

0 1 2 3 4 5

0
Present 1000
Value/Price
?

Formula for Coupon bond:

P or V=R (PVIFA) +FV (PVIF)

Zero Coupon bond pays no interest thus R=0, so

P or V=0 (PVIFA) +FV (PVIF)

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INTODUCTORY BUSINESS FINANCE

P 0r V = 0 + FV (PVIF)

P 0r V = FV (PVIF)

EAMPLE 10
_____________________________________________________________________
(Paper: introductory Business Finance, Q.NO:3, Winter 2005 Sarhad University)
Rybies Company issued 8-year Zero Coupon bond having a face value of Rs 1000; the investor’s required
rate of return is 11%.Determine Price of bond?
SOL: P 0r V = FV (PVIF)
=1000(PVIF i=11% n=8)
=1000(5.146) =Rs 514.6
_____________________________________________________________________________________

VALUATION OF PERPETUAL BOND: Perpetual bond has following characteristic:


i. It has face value but it never mature means never face value is paid to bondholder and bond
never is it returned.
ii. It pays Interest (Coupon) on face value at interest rate determined by the corporate directors.

Formula for Coupon bond:

P or V= R [1  1i ] + FV 1i
-n -n

i
Never matures thus n=0 and FV=0

P or V= R [1  1i ] + 0 1i
 

= R (1-0) + 0 =R/i
i
P or V = R/i

EAMPLE 11
______________________________________________________________________

MACNAZI COMPANY issued 1000 face value bond which pays interest at 9% and bond will never mature.
The investor’s required rate of return is 15 %. Compute Price of bond?
SOL: R=1000 ×9/100= Rs 90
P or V = R/i=90/0.15=Rs 600
_____________________________________________________________________________________

“The Present value of what is given to the bondholder is the Value or Price of bond”

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EQUITY FINANCE: Equity finance means finance that involves ownership is called Equity finance. The
sources of equity finance are:
i. Equity share or Common Stock
ii. Preferred share or Preferred Stock
1. EQUITY SHARES/COMMON STOCK: The equity shareholders are the owners of the business, they
purchase shares, the money is used by the company to buy assets, and the assets are used to earn
profits, which belong to the ordinary share-holders.
FEATURES: Equity shareholders have following characteristics:
iv) They are owner of the company.
v) They have Voting rights in meeting of shareholders.
vi) They are entitled to Profit of the company after payment of dividend to preference
shareholders.

_______________________________________________Rs_______
Profit after tax xxx
Less: Dividend to Preference Shareholders xxx
Profit belonging to equity shareholders (Dividend) xxx
________________________________________________________
iv) The dividend on Equity shares is not fixed and may vary from year to year depending upon
the Amount of profits available. The rate of dividend is recommended by the Board of Directors
of the company and declared by shareholders in the Annual General Meeting.
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity
period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed
rate of dividend to preference shareholder.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the
right to get the claims on assets. These rights are only available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to
control the management of the company and they have power to take any decision regarding the
business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of
voting right power; they can change or remove any decision of the business concern. Equity
shareholders only have voting rights in the company meeting.
6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of
the existing shareholders. It is attested by the company in the first opportunity to purchase additional
equity shares in proportion to their current holding capacity.
7. Limited liability: Equity shareholders are having only limited liability to the value of shares they have
purchased. If the shareholders are having fully paid up shares, they have no liability.
2. PREFERENCE SHARES/PREFRED STOCK: Preference shares have following characteristics:
I. The share holders with preference shares are not entitled to vote in Annual General Meet
(AGM) or other meeting of the Shareholders regarding affairs of the company.
II. In case of Dividend they are entitled to the fixed amount of Dividend IN THE YEAR OF
PROFIT.
CHRARCTERISTICS OF PREFERRED STOCK:
The Preferred Stock has no stated maturity date, thus it is also perpetual in nature.

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VALUATION OF PREFRRED STOCK:


Formula for perpetual bond;
P or V = R/i
Where R= interest or coupon payments but on preferred stock Dividend is paid instead of interest thus
R=D (D=Dividends)
So P or V = D/i

EAMPLE 12
______________________________________________________________________

(Paper: introductory Business Finance, Q.NO:3, Winter 2010 Sarhad University)


Margana Cipher Corporation Rs 200-par value Preferred was issued and company paid dividend of Rs
9.40/share and investors’ required return is 14 %.
i. What is value of preferred Stock?
ii. If Value of preferred stock is 85 and investor’s required return is 14% then what is dividend per
share?
iii. If dividend per share is Rs 15 and Value of preferred stock is Rs 115, then what is investor’s
required return?
SOL: P or V = D/i
P OR V= VALUE OF PREFERRED STOCK
D=Dividend
i=Investor’s required return
i)Value of Preferred Stock?
D=9.40 and i=14%
P or V = 9.40/0.14=Rs 67
ii) Value of dividend?
P or V=Rs 85 and i=14% D=?
P or V = D/I
85=D/0.14
D=85×0.14=Rs 11.9
iii) Investor’s required return Rate?
P or V=115 and D=15 i=?
P or V = D/I
115=15/i
I=15/115 × 100=13.04%
_____________________________________________________________________________________

Concept implication: Apply yours Knowledge of Preferred Stock valuation to following question:
(E) Omara Corporation issued 9% preferred Stock of face value/par value Rs 250.The investors’
required rate of return is 15%.What is Value of Preferred Stock?

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VALAUTION OF COMMON STOCK/EQUITY STOCK:


The Price or value of Common Stock is determined with help of Gordon Dividend Valuation Model.
GORDON DIVIDEND VALAUTION MODEL: The Price or value of equity is determined by Following
Procedure:

STEPT 1
All Cash disbursements (Dividend) to the shareholder’s are discounted at investor’s required
Rate of return (Ke) to their Present values (PV).
STEP 2
Sum up all Present values computed in step1, the Summation is Price of Common Stock.

YEAR DIVIDEND PV
1 D1 D1 1ke  or __D1__
1ke

2 D2 D2 1ke 0r __D2__
1ke
3 D3 D31ke  or __D2__
1ke
;
;
;
;

;
n Dn Dn 1ke  or __Dn__
1ke

Value= D1/1ke + D2/1ke + D3/ 1ke + ----------------------- Dn/1ke

GROWTH PATTERNS: Dividend of the Company with the passage of time Grow, The Growth comes in
following patterns:
• Constant Growth
• Zero Growth
• Two Phase Growth
CONSTANT GROWTH: If the Dividend of the company is expected to grow at a constant rate Forever, This
pattern is called Constant Growth.

Illustrative: wytech Company currently paid Dividend of Rs 21 and assume that Dividend will grow at 9%
forever. So
Current dividend = D0=Rs 21
1
Dividend after one year=D1=21×9/100=1.89+21=Rs 22.89 or = D0 (1+g) =21(1+.09) =Rs 22.89
2 2
Dividend after Two year= D2=22.89×9/100=2.0601+22.89=24.9501 or = D0 (1+g) = 21(1+0.09) =24.9501
3 3
Dividend after Three year = D3 = 24.9501 ×9/100=2.25+24.9501=27.200 or D0 (1+g) =21(1+0.09) =27.200

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FORMULA:
P or V = D1/Ke-g
Where D1 is the dividend in first year and D1=D0 (1+g)
P or V = Value or Price of Common Stock
Ke= Inventor’s required rate of return
g= Growth rate of dividend

EAMPLE 13 ______________________________________________________________________

KLC is public company and currently paid Rs 15.50 dividend per share, which is expected to grow at rate
of 12% forever. Investor’s required rate of return is 15%.Determine Value of Common Stock?

SOL: Company has Constant Growth, Thus formula for Constant Growth is

P or V = D1/Ke-g

D0=15.50 D1=15.50(1+0.12) = Rs 17.36 g=12%=0.12


Ke=15%=0.15 and V=?
P or V=17.36/0.15-0.12=Rs 578
______________________________________________________________________________

EAMPLE 14
_______________________________________________________________________

WYLEN CO has common stock of Rs 40000 and the dividend expected to be Rs12 the next year, which is
expected to grow at 8% forever. Investor’s required rate of return is 12%.Determine Price of Common
Stock?
SOL: Company has Constant Growth, Thus formula for Constant Growth is
P or V = D1/Ke-g
D1=12 g=8%=0.08 Ke=12%=0.08 and V=?
P or V =12/0.12-0.08=Rs 300

_____________________________________________________________________________________

ZERO GROWTH: Under a Zero growth Dividend Policy, company pays fixed dividend through the entire
life of a company and there is no growth in the dividend, thus also called NO Growth Policy.

Formula for Constant Growth


P or V = D1/Ke-g
As no growth thus g=0, so
P or V = D1/Ke-0=D1/Ke

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EAMPLE 15 ______________________________________________________________________

Hitech Communication Company is a Zero growth company and has paid a dividend of Rs 22.50/share.
Investor’s required rate of return is 10%.Determine value of common stock?
SOL: Company has Zero Growth, Thus formula for Zero Growth is

P or V = D1/Ke
P or V=22.50/0.10=Rs 225
_____________________________________________________________________________________
TWO PHASE GROWTH: The dividend of a Company may grow in two phases:
• PHASE1: initially Dividend of the company grows at a higher rate for first few years.
• PHASE2: After few years, growth rate come down to normal level and this growth remains
constant forever or perpetually.
_______________________________________________________________________
EAMPLE 16

Michilan Company has paid Dividend of Rs 5, which is expected to grow at 10 % for first four years and
thereafter at 7% forever. Investor’s required rate of return is 12%.Determine value of Common Stock?
SOL: Dividend has two phases of Growth:
Phase 1: Dividend grows at 10% for first four years.
Phase 2: After First four years, Dividend Grows at 7% forever.
PHASE 1:
YEAR DIVIDEND PVIF@12% PV
1 1
1 5(1+0.010) =5(1.10) =5.50 0.893 4.91
2
2 5(1.10) =6.05 0.797 4.82
3
3 5(1.10) = 6.655 0.712 4.74
4
4 5 (1.10) =7.3205 0.636 4.65
19.12
PHASE 2:
Value of Stock = P or V = P or V = D1/Ke-g here we need D5 Instead of D1, thus

Dividend at end of five year =D5=D4 (1.07) =7.3205(1.07) =7.84

Value of Stock at end of four year= P or V = D5/Ke-g=7.84/0.12-0.07=156.8


Present value of Stock=156.8(PVIF i=12% n=4) =156.8(0.636) =99.72

PRESENT VALUE OF STOCK=19.12+99.72= Rs 118.84

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CAPITAL BUDGETING
INTODUCTORY BUSINESS FINANCE

CHAPTER 5
This Chapter Includes:
• Introduction
• Scope and Process
• Estimation of relevant cash flow
• Capital Budgeting Techniques
INTRODUCTION: Capital Budgeting is combination of Two words:
Capital: The word Capital refers to be the total investment of a company in tangible
and intangible assets. Some time also called Capital expenditure.e.g.
1. Purchase of fixed assets such as land and building, plant and machinery,
good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration
To the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
Budgeting: Budget is Future Estimate of Cost and process of making Budget is called
budgeting.
CAPITAL BUDGETING: Capital Budgeting is a process which suggests an organization
To Invest in or not in capital assets.
CAPITAL BUDGETING PROCESS:

Identification of Various Investments

Screening or Matching the Available Resources


S
T
E Evaluation of Proposals
P
S

Fixing Property

Final Approval

Implementation

Fig 5.1 Capital Budgeting process

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1. Identification of various investments proposals: The Company may have various investment
proposals. The proposal for the investment opportunities may be defined from the top management or
may be even from the lower rank. The heads of various departments analyze the various investment
decisions, and will select proposals submitted to the planning committee of competent authority.
2. Screening or matching the proposals: The planning committee will analyze the various proposals and
screenings. The selected proposals are considered with the available resources of the concern. Here
resources referred as the financial part of the proposal. This reduces the gap between the resources and
the investment cost.
3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as
pay back period, IRR, accounting rate of return, Net present value (NPV) And Profitability Index. Each
method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
Independent proposals are not compared with other proposals and the same may be accepted or
rejected. Whereas higher proposals acceptance depends upon the other one or more proposals. For
example, the expansion of plant machinery leads to constructing of new building, additional manpower
etc.
Mutually exclusive projects are those which competed with other proposals and to implement the
proposals after considering the risk and return, market demand etc.
4. Fixing property: After the evolution, the planning committee will predict which proposals will give
more profit or economic consideration. If the projects or proposals are not suitable for the concern’s
financial condition, the projects are rejected without considering other nature of the proposals.
5. Final approval: The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions
The planning committee prepares the cost estimation and submits to the management.
6. Implementing: The competent authority spends the money and implements the proposals. While
implementing the proposals, assign responsibilities to the proposals, assign responsibilities for
completing it, within the time allotted and reduce the cost for this purpose. The network techniques
used such as PERT and CPM. It helps the management for monitoring and containing the
implementation of the proposals.
7. Performance review of feedback: The final stage of capital budgeting is actual results compared with
the standard results. The adverse or unfavorable results identified and removing the various difficulties
of the project. This is helpful for the future of the proposals.

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METHODS OF CAPITAL BUDGETING

Methods of Capital Budgeting

Non-Discount Methods Discount Methods

Payback Period Method Net Present Value Method

Accounting rate of Return Profitability Index Method

Internal Rate of Return (IRR)

Fig 5.2 Capital Budgeting Techniques

Illustrative: Suppose you have opened a College for Providing Commerce Education, you have
totally invested Rs 500,000 and it is expected that the cash flow from project will be as under:
Year 1 2 3 4 5 6 7

Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000

POINTS

1. You have opened a commerce college; it is Project in Simple sense.


2. You have invested Rs 500,000, the money move out of your Pocket or Out of your
business, thus Cash out Flow or Initial Investment or Cash Outlay.
3. You will receive Rs 50,000 after 1 year, Rs 65000 after two years and so on. These are
cash inflows or cash inlays because money comes in your pocket or in your business.

PAYBACK METHOD: This Method tells in what period the amount invested in a project will be returned.
Payback Period Method When Cash inflow from Project is Even:
Pay-back period = Initial investment
Annual cash inflows
_____________________________________________________________________
EAMPLE 1

A project requires initial cash outlay of Rs 100000 and will provide cash inflows as under:

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Year 1 2 3 4 5 6 7

Cash inflow (Rs) 20000 20000 20000 20000 20000 20000 20000
Required: Compute Payback Period?
SOL: Pay-back period = Initial investment = 100,000/20,000=5 years
Annual cash inflows

Payback Period Method When Cash inflow from Project is Uneven:

Pay-back period = a+ (b-c)/d


Where a= Year in which Accumulative cash inflow is less or equal to Initial Investment
b= Initial investment
c= Accumulative cash inflow which is equal or less than investment
d=Cash inflow of next year

EAMPLE 2
________________________________________________________________________

PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7

Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute Payback period?

SOL:

_____________________________________________________________________________________
YEAR CASH OUTFLOW CASH INFLOW ACCUMULATIVE CASH INFLOW
0 450,000 ------------ ---------------------------
1 50,000 50,000
2 65000 115000
3 67000 182000
4 110,000 292000
5 140,000 432000 C
6 130,000 562000
7 120,000 682000

a
d
b

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Payback period= a+ (b-c)/d=5 + 450000-432000/130000=5 +0.14=5.14 years.

Accept /Reject criteria: If the actual pay-back period is less than the predetermined pay-back period,
the project would be accepted. If not, it would be rejected.

ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF RETURN


Average rate of return means the average rate of return or profit taken for considering the project
evaluation. This method is one of the traditional methods for evaluating the project proposals:
Accounting Rate of return=Average profit × 100
Original investment
_____________________________________________________________________
EAMPLE 3

MARINE CO is considering purchasing equipment for fabrication of Microprocessors. For equipment


following proposals have been received.

Proposal I Proposal II
ANALOG EQUIPMENT DIGITAL EQUIPMENT
Cost of the machine Rs. 2,20,000 Rs. 160,000
Estimated life 5½ years 10 years
Estimated sales p.a. Rs. 200,000 Rs. 200,000
COSTS
Material 50,000 50,000
15000 75000
Labour
Variable overheads 24000 20000

Required: Calculate Accounting Rate of return for each proposal and on its basis determine which is
better?

SOL: Marine Company


Profitability Statement
Proposal I Proposal II
Sales 200,000 200,000
Less: C.G.S
Material 50000 50000
Labour 15000 75000
Variable overheads 24000 20000
Depreciation:
(220,000/5.5) 40000 ------
(160000/10) ------- 16000

_____ ______
129000 161000
Profit 71000 39000

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Average Rate of Return = Average profit × 100


Original investment
= 71000/220000 × 100=32% 39000/160000× 100=24%

The Analog Equipment has ARR 32 % which is greater than ARR of Digital Equipment that is 24%.so
Proposal I should be pursue.

_____________________________________________________________________________________

Accept/Reject criteria If the actual accounting rate of return is more than the predetermined required
rate of return, the project would be accepted. If not it would be rejected.
NET PRESENT VALUE: Net present value is the difference between the total present value of future
Cash inflows and the total present value of future cash outflows .

EAMPLE 4 _____________________________________________________________________
__________
PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7

Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute NPV if investor’s required rate of return is 10%?

SOL:

YEAR CASH FLOWS PVIF@10% PV


0 (450,000) 1 (450,000)
1 50000 0.909 45450
2 65000 0.826 53690
3 67000 0.751 50317
4 110000 0.683 75130 +
5 140000 0.621 86940
6 130000 0.564 73320
7 120000 0.513 61560
Present value of cash inflows 446407
Net Present Value -3593
_____________________________________________________________________________________
Accept/Reject criteria If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.
PROFITABILITY INDEX: The Ratio of present value of cash inflows from project and cash outlay or cash
outflows is called Profitability index.
Profitability index = PV of cash inflows/cash outflows
Accept/Reject Criteria: if Profitability index of a project is greater than one, than it should be accepted,
otherwise rejected.

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EAMPLE 5 _______________________________________________________________________
__________

For example 4, compute Profitability index?


SOL:

Profitability Index = PV of cash inflows /cash outflow=446407/450,000=0.99


Profitability index is less than 1, so project should not be accepted.
_____________________________________________________________________________________

INTERNAL RATE OF RETURN METHOD: The Discount rate which equates the Present value of the future
net cash flows with Cash outlay is called internal rate of return.

Discount Rate =Internal rate of return


Present value of Cash inflows from the project = xxx
Cash out flows = xxx
000

EAMPLE 6 ____
__________ ____________________________________________________________________

PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7

Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute IRR if investor’s required rate of return is 10%?

SOL:

STEP 1 Calculate Appropriate IRR by:


• Adding all cash inflows
50000+65000+67000+110000+140000+130000+120000=Rs 682000
• Divide all Sum of cash inflows calculated as above by number of years
682000/7= Rs 97428 per year
Divide investment by cash flow per year, the result is discount factor
STEP 2
Discount factor = 450,000/97428=4.619

STEP 3 Looking factor calculated by step 2 in PVIFA table and choosing most appropriate rate, it
is IRR. The Close rate is 11% where factor is 4.712.Thus IRR is 11% .

This IRR is appropriate IRR but not Accurate IRR, For Accurate IRR; we have to follow further three
steps:

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STEP 4 The NPV is calculated at Rate determined by Step 3:

YEAR CASH FLOW PVIF @11% PV


0 (450,000) 1 (450,000)
1 50,000 0.901 45050
2 65000 0.812 52780
3 67000 0.713 47771
4 110000 0.659 72490
5 140000 0.593 83020
6 130000 0.535 69550
7 120000 0.482 57840
434501
Net Present value -15499

STEP 5 Now apply another lower or upper rate.

Let suppose 9%

YEAR CASH FLOW PVIF @9% PV


0 (450,000) 1 (450,000)
1 50,000 0.917 45850
2 65000 0.842 54730
3 67000 0.772 51724
4 110000 0.708 77880
5 140000 0.650 91000
6 130000 0.596 77480
7 120000 0.547 65640
464304
Net Present value +14304

STEP 6
The actual IRR lies between rates determined under step 4 and 5.o interpolate between
these rates.

IRR=lower rate + Positive net present value × DP


Difference in positive and Negative net present value

Where DP is Difference between lower and higher discount rates


Lower rate=9% Positive net present value =+14304 Negative net present value=-15499
DP=11%-9%=2%
= 9% + 14304/14304-(-15499) × 2%
=9% +14304/29803 × 2=
=9%+0.96=9.96%

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RELAVENT CASHFLOWS

CAPITAL BUDGETING ALWAYS CONSIDER CASH FLOWS RATHER THAN PROFITS


Dividends are mostly paid in the form of cash , so the shareholders are more concerned about cash
flows of the company and less about the profits of the company, thus shareholders wealth is the cash
received in form of dividend, this is the reason the capital budgeting consider cash flows rather than
profits. So we have to compute the cash flows from profits. Cash flows are computed from Profits as
under:

Take Profit after Tax and made following computations

PROFIT AFTER TAX XXX


ADD: DEPRECIATION XXX
LESS: CAPITAL EXPENDITURE (XXX)
LESS: Increase in Working Capital (XXX)
ADD: Decrease in Working Capital XXX
Net cash flow XXX

Note: Details of Cash flow is covered in Business Finance Decisions


Decisions.
ions.

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INTODUCTORY BUSINESS FINANCE
WORKING CAPITAL MANGEMENT
CHAPTER 6

MEANING OF WORKING CAPITAL


Capital of the concern may be divided into two major headings.

CAPITAL

FIXED CAPITAL WORKING CAPITAL

FIXED CAPITAL: Fixed capital means that capital, which is used for long-term
Investment of the business concern. For example, purchase of permanent assets.
Normally it consists of non-recurring in nature.
WORKING CAPITAL: Working Capital is another part of the capital which is needed for meeting day to
day requirement of the business concern. For example, payment to creditors, salary
paid to workers, purchase of raw materials etc.
GROSS WORKING CAPITAL: The gross working capital is the capital invested in total
current assets of the business concern.

Gross working Capital = Cash + Account Receivables + Inventory


NET WORKING CAPITAL: Net Working Capital is the specific concept, which considers
both current assets and current liability of the concern.
“Net Working Capital is the excess of current assets over the current liability of the
Firm during a particular period”

Net working Capital = Current Assets – Current liabilities

TYPES OF WORKING CAPITAL

PERMANENT WORKING CAPITAL: It is the capital; the business concern must maintain
Certain amount of capital at minimum level at all times. The level of Permanent
Capital depends upon the nature of the business. By working capital means the cash,
Inventory etc.
TEMPORARY WORKING CAPITAL It is also known as variable working capital.
It is the amount of capital which is required to meet the Seasonal demands and
Some special purposes. It can be further classified into Seasonal Working Capital and
Special Working Capital.
The capital required to meet the seasonal needs of the business concern is called as
Seasonal Working Capital. The capital required to meet the special exigencies such
As launching of extensive marketing campaigns for conducting research, etc is the
Special working Capital.

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NEEDS OF WORKING CAPITAL

Working Capital is needed for the following purposes.


1. Purchase of raw materials and spares: The basic part of manufacturing process is raw materials. It
should purchase frequently according to the needs of the business concern. Hence, every business
concern maintains certain amount as Working Capital to purchase raw materials, components, spares,
etc.
2. Payment of wages and salary: The next part of Working Capital is payment of
wages and salaries to labor and employees. Periodical payment facilities make employees perfect in
their work. So a business concern maintains adequate the amount of working capital(Cash) to make the
payment of wages and salaries.
3. Day-to-day expenses: A business concern has to meet various expenditures regarding the operations
at daily basis like fuel, power, office expenses, etc.
BALANCED WORKING CAPITAL POSITION.
Excessive and inadequate Working Capital leads to some problems in the business concern.
A. Causes and effects of excessive working capital.
(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and
spares.
(ii) It creates bad debts, reduces collection periods, etc.
(iii) It leads to reduce the profits.
B. Causes and effects of inadequate working capital
(i) Inadequate working capital cannot buy its requirements in bulk order.
(ii) It becomes difficult to implement operating plans and activate the firm’s profit target.
(iii) It becomes impossible to utilize efficiently the fixed assets.
(iv) The rate of return on investments also falls with the shortage of Working Capital.
(v) It reduces the overall operation of the business.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS
The following are the major factors which are determining the Working Capital requirements.
1. Nature of business: Working Capital of the business concerns largely depend upon the nature of the
business. If the business concerns follow rigid credit policy and sell goods only for cash, they can
maintain lesser amount of Working Capital. A transport company maintains lesser amount of Working
Capital while a construction company maintains larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the length of the production cycle. If the
production cycle length is small, they need to maintain lesser amount of Working Capital. If it is not,
they have to maintain large amount of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business condition
and it will affect the requirements of the Working Capital. In the booming conditions, the Working
Capital requirement is larger and in the depression condition, requirement of Working Capital will
reduce. Better business results lead to increase the Working Capital requirements.
4. Production policy: It is also one of the factors which affect the Working Capital requirement of the
business concern. If the company maintains the continues production policy, there is a need of regular
Working Capital. If the production policy of the company depends upon the situation or conditions,
Working Capital requirement will depend upon the conditions laid down by the company.
5. Credit policy: Credit policy of sales and purchase also affect the Working Capital requirements of the
business concern. If the company maintains liberal credit policy to collect the payments from its
customers, they have to maintain more Working Capital. If the company pays the dues on the last date it
will create the cash maintenance in hand and bank.

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6. Growth and expansion: During the growth and expansion of the business concern, Working Capital
requirements are higher, because it needs some additional Working Capital and incurs some extra
expenses at the initial stages.
7. Availability of raw materials: Major part of the Working Capital requirements are largely depend on
the availability of raw materials. Raw materials are the basic Components of the production process. If
the raw material is not readily available, it leads to production stoppage. So, the concern must maintain
adequate raw material; for that purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning capacity, they can generate
more Working Capital, with the help of cash from operation. Earning capacity is also one of the factors
which determine the Working Capital requirements of the business concern.
WORKING CAPITAL MANAGEMENT POLICY

1. Conservative Working Capital Policy.


2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.
1. Conservative working capital policy: Conservative Working Capital Policy refers to minimize risk by
maintaining a higher level of Working Capital. This type of Working Capital Policy is suitable to meet the
seasonal fluctuation of the manufacturing operation.
2. Moderate working capital policy: Moderate Working Capital Policy refers to the moderate level of
Working Capital maintenance according to moderate level of sales. It means one percent of change in
Working Capital that is Working Capital is equal to sales.
3. Aggressive working capital policy: Aggressive Working Capital Policy is one of the high risky and
profitability policies which maintain low level of Aggressive Working Capital against the high level of
sales, in the business concern during a particular period.

Conservative policy
Current Assets
Moderate policy

Aggressive Policy

Sales

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EXERCISE
1. What is working capital? Define it.
2. Discuss the concept of working capital?
3. What are the types of working capital?
4. Explain the needs of working capital?
5. Critically explain the factors affecting the requirement of working capital?
6. Explain the working capital management policy?

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DIVIDEND POLICY
CHAPTER 7

Meaning of Dividend
Dividend refers to the Company’s net profits distributed among the shareholders. It
May also be termed as the part of the profit of a Company, which is distributed
Among its shareholders.
TYPES OF DIVIDEND/ FORM OF DIVIDEND
Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

TYPES OF DIVIDEND

CASH DIVIDEND

STOCK DIVIDEND

BOND DIVIDEND

PROPERTY DIVIDEND

Fig 7.1 types of dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend.
Cash dividends are common and popular types followed by majority of the Corporations.
Stock Dividend
Stock dividend is paid in the form of the company’s stock due to less availability of cash
And Company is not available to pay cash dividend.
Bond Dividend
The payment of dividend in form of company’s bond due to less availability of cash
And Company is not available to pay cash dividend.
Property Dividend
Property dividends are paid in the form of some assets other than cash due to less
Availability of cash And Company is not available to pay cash dividend.

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DETERMINANTS OF DIVIDEND
Profitable Position of the Firm: Dividend decision depends on the profitable position of the business
concern. When the firm earns more profit, they can distribute more dividends to the shareholders.
Uncertainty of Future Income: Future income is a very important factor, which affects the dividend
policy. When the shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains: The Companies ORDINANCE 1984 AND INCOME TAX ORDINANCE 2001 has put several
restrictions regarding payments and declaration of dividends.
Liquidity Position: Liquidity means availability of cash. Liquidity position of the firms leads to easy
payments of dividend. If the firms have high liquidity (More cash), the firms can provide cash dividend
otherwise, they have to pay stock dividend.
Growth Rate of the Firm: High growth rate implies that the firm can distribute more dividends to its
shareholders.
Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the
Government gives tax incentives, the company pays more dividends.
TYPES OF DIVIDEND POLICY
• Regular dividend policy
• Stable dividend policy
• Irregular dividend policy
• No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is called as regular dividend policy. This type of policy is
suitable to the small investors, retired persons and others.
Stable Dividend Policy
Stable dividend policy means payment of certain minimum amount of dividend regularly.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful business operation, they may
follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems.
These types are having adequate profit. For others no dividend is distributed.
No Dividend Policy
Sometimes the company may follow no dividend policy because of its unfavorable working
Capital position of the amount required for future growth of the concerns.

EXERCISE
1. What is dividend? Explain the types of dividend.
2. Explain the factors affecting the dividend policy.
3. Discuss the various types of dividend policy.

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CASH AND RECEIVAVBLE MANAGEMENT


CHAPTER 8

CASH MANAGEMENT
The term cash includes coins, currency, cheques held by the business concern
And balance in its bank accounts
Business concern needs cash to make payments for acquisition of resources and services
for the normal conduct of business. Cash is one of the important and key parts of the
current assets.
Motives for Holding Cash
1. Transaction motive
It is a motive for holding cash or near cash to meet routine cash requirements to finance
transaction in the normal course of business. Cash is needed to make purchases of raw-
materials, pay expenses, taxes, dividends etc.
2. Precautionary motive
It is the motive for holding cash or near cash as a cushion to meet unexpected
contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc.
3. Speculative motive
It is the motive for holding cash to quickly take advantage of opportunities typically outside
the normal course of business. Certain amount of cash is needed to meet an opportunity
to purchase raw materials at a reduced price or make purchase at favorable prices.
4. Compensating motive
It is a motive for holding cash to compensate banks for providing certain services
or loans. Banks provide variety of services to the business concern, such as clearance of
cheque, transfer of funds etc.
Cash Management Techniques
A. Speedy Cash Collections.
B. Slowing Disbursements.
Speedy Cash Collections
Business concern must concentrate in the field of Speedy Cash Collections from customers.
For that, the concern prepares systematic plan and refined techniques. These techniques
aim at, the customer who should be encouraged to pay as quickly as possible and the
payment from customer without delay. Speedy Cash Collection business concern applies
some of the important techniques as follows:
Prompt Payment by Customers:
Business concern should encourage the customer to pay promptly with the help of
offering discounts, special offer etc. It helps to reduce the delaying payment of customers
and the firm can avoid delays from the customers. The firms may use some of the
techniques for prompt payments like billing devices, self address cover with stamp etc.
Early Conversion of Payments into Cash:
Business concern should take careful action regarding the quick conversion of the
payment into cash. For this purpose, the firms may use some of the techniques like postal
float, processing float, bank float and deposit float.

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Concentration Banking
It is a collection procedure in which payments are made to regionally dispersed collection centers, and
deposited in local banks for quick clearing. It is a system of decentralized billing and multiple collection
points.
Lock Box System
It is a collection procedure in which payers send their payment or cheques to a nearby Post box that is
cleared by the firm’s bank. Several times that the bank deposits the cheque in the firms account. Under
the lock box system, business concerns hire a post office lock box at important collection centers where
the customers remit payments. The local banks are authorized to open the box and pick up the
remittances received from the customers. As a result, there is some extra savings in mailing time
compared to concentration bank.
Slowing Disbursement
Slowing disbursement of cash is possible with the help of the following methods:
1. Avoiding the early payment of cash
The firm should pay its payable only on the last day of the payment. If the firm avoids early payment of
cash, the firm can retain the cash with it and that can be used for other purpose.
2. Centralized disbursement system
Decentralized collection system will provide the speedy cash collections. Hence centralized
disbursement of cash system takes time for collection from our accounts as well as we can pay on the
date.
RECEIVABLE MANAGEMENT
The term Receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business.

Receivables are also one of the major parts of the current assets of the business concerns. It arises only
due to credit sales to customers, hence, it is also known as Account Receivables or Bills Receivables.

Receivable Management is defined as the process of making decision resulting to the


investment of funds in these assets which will result in maximizing the overall return on the
investment of the firm.

The objective of receivable management is to promote sales and profit until that point is reached
where the return on investment in further funding receivables is less than the cost of funds raised to
finance that additional credit.
The costs associated with the extension of credit and accounts receivables are identified as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.
Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales have been
made.
Capital Cost
This is the cost on the use of additional capital to support credit sales which alternatively could have
been employed elsewhere.

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Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of salaries to the
staff kept for maintaining accounting records relating to customers, cost of investigation etc.
Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be able to recover
the over dues because of the inability of the customers.
Factors Considering the Receivable Size
Receivables size of the business concern depends upon various factors. Some of the important
factors are as follows:
1. Sales Level
Sales level is one of the important factors which determine the size of receivable of the firm. If the firm
wants to increase the sales level, they have to liberalize their credit policy and terms and conditions.
When the firms maintain more sales, there will be a possibility of large size of receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from firm to firm or even
some times product to product in the same industry. Liberal credit policy leads to increase the sales
volume and also increases the size of receivable. Stringent credit policy reduces the size of the
receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon the credit terms,
size of the receivables may increase or decrease. Hence, credit term is one of the factors which affects
the size of receivable.
4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales. Normally it is
expressed in terms of ‘Net days’.
5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date. A special
discount will be provided to the customer for his payment before the due date.
6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the management
involves systematic approaches to the receivable, the firm can reduce the size of receivable.

EXERCISE
1. Explain the motives of holding cash?
2. Discuss the cash management techniques?
3. What is receivable management? Explain it?

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INTODUCTORY BUSINESS FINANCE
COST OF CAPITAL
Z CHAPTER 9

Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.

Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of overall wealth of the
Shareholders.

MEASUREMENT OF COST OF CAPITAL


It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings

LONGTERM-FINANCE

DEBT PREFERENCE CAPITAL EQUITY

BANK-LOAN PREFERENCE EQUITY/COMMON


SHARES SHRES
BONDS

DEBENTURE Similar Techniques for solving

TFC

Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the
equity financed portion of an investment project in order to leave unchanged the market price of
the shares”

Dividend approach
i)When company pays dividend with constant growth in dividend:

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The following formula is used to compute cost of equity:

Ke =D0 (1+g) + g 0R D1 + g
P0 P0

Where D0 =Dividend per share in the current year


g=Dividend growth rate
P0=Current market price of the share
Ke=Cost of equity
D1=Dividend in the next year i.e. D1 = D0 (1+g)

EXAMPLE 1 _____________________________________________________________

Marizon Company plans to issue 30000 new shares of Rs. 100 each market price.
The company pays a dividend of Rs. 12 per share initially and growth in dividends is
expected to be 5%.
Compute the cost of equity?

Ke =D0 (1+g) + g
P0

D0 =Rs 12, g=5%=0.05, P0=100


Ke =D0 (1+g) + g = 12(1+0.05) + 0.05 =0.176×100=17.6%
P0 100
_____________________________________________________________________________________

ii) When Company pays dividend with no growth i.e. Zero growth g=0

Ke =D0 (1+0) + 0 0R D1 + 0
P0 P0

Ke= D0
P0

EXAMPLE 2 _________________________________________________________________________

Marizon Company plans to issue 30000 new shares of Rs. 100 each market price.
The company pays a dividend of Rs. 12 per share initially and growth in dividends is Zero.
Requirement: Calculate cost of equity?

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SOL:
Ke= D0 = 12/100 =0.12 × 100 =12%
P0
_____________________________________________________________________________________

Capital Asset Pricing Method (CAPM):

Formula Ke=RF + (Rm-RF) β

Where Ke= Cost of Equity


RF= Risk free rate (The rate of return of Treasury bonds and bills issued by the State Bank or
federal Government is consider as Risk Free rate)
Rm = the Return of the whole stock market is called Market rate of return.
β =beta= the change in the rate of return of company in respect to change in the market rate of
return.

EXAMPLE 3 _______________________________________________________________________

Brilliant Corporation needs financial advice on ascertaining Cost of equity. The Risk free rate is 6% and
market rate of return is 14%, while Company’s beta is 1.20.Caculate cost of equity?
SOL:
Ke=RF + (Rm-RF) β = 6% + (14% - 6%) 1.20
= 6% + (8%) 1.20
= 6% + 9.6%=15.6%

_____________________________________________________________________________________

COST OF DEBT

DEBT

BANK-LOAN BONDS DEBENTURE TFC

SIMILAR TECHNIQUES

Cost of debt is the after tax cost of long-term funds through borrowing (bank-loan, bonds,
debenture and Term finance certificates (TFC)).Simply the rate of interest demanded by
the lenders of long-term funds.

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BANK-LOAN:
The Rate of interest charge by the bank on long term loan is the cost of debt.
BONDS, DEBENTURES AND TERM FINANCE CERTIFICATES (TFC)
The Bonds, debentures and term-finance certificates are mostly similar and collectively called debt.
The cost of debt is determined in following situations.
• Debt is redeemable:
1. When debt is issued at par value.
2. When debt is issued at premium or discount
• Debt is irredeemable:
DEBT IS REDEEMABLE: When debt (bonds, debentures or TFC) is redeem (call up back), such debt is
called redeemable debt. Cost of debt for redeemable debt is determined in following two situations:
1. DEBT IS ISSUED AT PAR OR FACE VALUE: When debt is issued at par value, the following formula
is used for computing cost of debt.

FORMULA KD=R/ VD

Where KD=Cost of debt


R=interest or Coupon payment
VD=Value of Debt/face value/par value of debt

EXAMPLE 4 _________________________________________________________________________

Millac Corporation issued 10%bonds at a price of Rs 1000 and the face value of the bond is Rs 1000.The
bonds will be redeem after 10 years. Compute cost of debt?
SOL:
KD=R/ VD
R=1000 × 10/100=100
VD=1000 KD=R/ VD =100/1000 × 100=10%
_____________________________________________________________________________________
2. DEBT ISSUED AT DISCOUNT OR PREMIUM: When debt is issued at discount or premium from the
face value, then YTM of bond or debenture or TFC is computed, which is the cost of debt.
COMPUTING YTM
STEP 1
Using the following formula compute Reference rate, this may or may not be the YTM.

Reference Rate= R+1/n (FV-Po)


1/2(FV+Po)
Where R=interest or Coupon payment
FV=Face Value
Po=Price of bond, debenture OR TFC at which bond is issued
n=Number of years for which bond, debenture or TFC is issued

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STEP 2

Use reference rate to Compute NPV for the debt, if NPV is zero, then it is the YTM of debt; if not then
follow the step 3.
STEP 3

If NPV computed at reference rate is positive, then choose a rate which generate Negative NPV and vise
versa.

STEP4

Apply following formula:

IRR= Lower rate + Positive NPV_____________ ×DP


Positive NPV – Negative NPV

EXAMPLE 5 ______________________________________________________________________
Arabian Co , issued debenture at Rs 970 ,while par value of debenture is Rs 1000.Company pays 9%
interest on debenture ,the debenture will be redeem after 5 years.
Requirement: Compute Cost of Debt?
SOL:
Step1: Reference Rate= R+1/n (FV-Po)
1/2(FV+Po)

R=1000×9%=90
n=5
FV=1000 = 90+1/5(1000-970) = 90+6 =96_ ×100=9.75%
Po=970 1/2(1000+970) 985 985

Step2:
First take 9% for computing NPV, which is close to Reference rate.
NPV @ 9%

Page Turnover

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YEAR CASHFLOW PVIF@9% PV


0 (970) 1 (970)
1 90 0.917 82.53
2 90 0.842 75.78
3 90 0.772 69.48
4 90 0.708 63.72
5 90 0.650 58.50
5 1000 0.650 650__
1000_
NPV +30__
9% rate generates +30 NPV, so now a higher rate will produce negative NPV. Try Let 11%.

YEAR CASHFLOW PVIF@11% PV


0 (970) 1 (970)
1 90 0.901 81.09
2 90 0.812 73.08
3 90 0.731 65.79
4 90 0.659 59.31
5 90 0.593 53.37
5 1000 0.593 593__
926__
NPV -44__
Step3:
IRR= Lower rate + Positive NPV_____________ × DP
Positive NPV – Negative NPV

IRR= 9% + 30_____ × (11%-9%)


30-(-44)
= 9%+30/74 × 2%
=9%+0.80%=9.80%

_____________________________________________________________________________________

IRREDEEMABLE DEBT: When debt (bonds, debenture or TFC) is irredeemable (will never call up back or
will never mature), the debt is said to be irredeemable debt. To determine cost of debt for
irredeemable debt, the following formula is used.

KD=R/Po

Where KD=cost of debt


R=coupon or interest
Po= price of bond

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EXAMPLE
________________________________________________________________________________
6

Abami Co Issued irredeemable bonds of par value Rs 1000 at a price of Rs 970 and company will pay an
interest of 8% on bonds. You are Chief Financial Officer (CFO) AND computing cost of debt is one of your
preliminary duties, you are required to perform your duty?
SOL:

R=1000×8%=80
Po=970 KD=R/Po =80/970 ×100=8.25%
_____________________________________________________________________________________
Cost of Preference Capital (KP)
In case of preference share dividend are payable at a fixed rate. However, the dividends are
not allowed to be deducted for computation of tax. So no adjustment for tax is required. Just
Like debentures, preference share may be perpetual or redeemable.
WIGHTED AVERAGE COST OF CAPITAL (WACC):
Weighted average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firms capital structure.

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EARNING PER SHARE AND BUSINESS
INTODUCTORY OPERATING
FINANCE

LEVARAGE
CHAPTE 10
EARNING PER SHARE (EPS)
Earning per share means the profit that belongs to equity shareholders (common stock).
EPS is computed as follow:

EPS = Profit after tax – preference dividend


Outstanding number of share*

Outstanding number of share: The share issued to the public.


Preference dividend: The dividend given to preference shareholders.

EXAMPLE 1
____________________________________________________________________

ABC Company has 50000 numbers of shares outstanding and it has profit after tax of
Rs 600000 .The dividend given to preference shareholders is Rs 100000.
Required: Compute Earning per Share?
SOL:

EPS = Profit after tax – preference dividend = 600,000 -100,000/50,000=Rs 10


Outstanding number of share

____________________________________________________________________________

DEGREE OF OPERATING LEVERAGE


The degree of operating leverage may be defined as percentage change in the profits
resulting from a percentage change in the sales.

DOL = Percentage change in profits =Δ Profits/original Profit


Percentage change in sales Δ Sales/Original Sales

EXAMPLE 2 ____________________________________________________________________

MyTech Company is going want to compute Degree of operating leverage and need yours
Help (Being a Financial Analyst) .The records are as under:
• SALES Rs 30000 on Jan 1 2011
• Expected a sales of Rs 45000 next month
• Profit Rs 12000 on Jan 1 2011
• Expected a profit of Rs 19500 next month
SOL:

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DOL = Percentage change in profits =Δ Profits/original Profit


Percentage change in sales Δ Sales/Original Sales

Change in Profit =Δ Profits=19500-12000=7500


0riginal Profit=12000
Change in sales= Δ Sales=45000-30000=15000
Original Sales=30000

=7500/12000 = 0.625 =1.25


15000/30000 0.50
IMPLICATIONS: This simply implies that a change of 1% in Sales will Cause a change of 1.25% in Profit.

THE END

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