FINANCIAL MANAGEMENT

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TABLE OF CONTENTS

3.3. Learning Task: Financial Management................................................1

3.3.1. INTRODUCTION..............................................................................................................1
3.3.2. LEARNING OBJECTIVES.................................................................................................2
3.3.3. SECTIONS.......................................................................................................................2
3.3.3.1 Section I: An Overview of Financial Management.................................................2
3.3.3.2 Section II: Financial Analyses and Planning.........................................................7
3.3.3.3. Section III: The Time Value of Money.................................................................18
3.3.3.4. Section IV: Valuation of Asset and Cost of Capital.............................................25
3.3.3.5. Section V: Capital Budget...................................................................................35
3.3.3.6. Section VI: Capital structure...............................................................................43
3.3.3.7. Section VII: Value chain Finance........................................................................51
3.3.3.8. Section VIII: Women Empowerment and Finance...............................................60
3.3.3.9. Section IX: International Financial Management...............................................63
REFERENCE............................................................................................................................70
Appendixes...........................................................................................................................71

3.3. Learning Task: Financial Management

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Financial Management

3.3.1. Introduction
This learning task is designed so as to equip students with required knowledge and skill in
financial management . Accordingly, this learning task focuses on the acquisition of
financial resources and their effective utilization in running a business enterprise for
profit, with special emphasis on agribusiness organizations and possible contribution towards
effective value chain development. Topics include: Financial analysis and forecasting,
concept of asset evaluation, cost of capital, Investment decision making /capital budgeting,
capital structure decisions and time value of money, value chain financing, Women
empowerment and finance and international financial management.

3.3.2. Learning Objectives

The learning task is executed both in classroom and student self-study and case studies. Up on
completion of this learning task students will be able to:
 Apply basic principles and assumptions in financial management
 Understand the concept of financing decisions
 Describe and explain time value of money
 Make financial planning and forecast
 Understand the concept of asset evaluation and the cost of capital
 Make/ advise different investment decisions
 Understand how value chain finance will operate
 Illustrate women empowering and finance
 Understand international financial management

3.3.3. Sections

3.3.3.1 Section I: An Overview of Financial Management

Pre test
Dear student well come to the course financial management which is a corner stone for the
success and survival of every business!!!

Have you ever been heard the word financial management? Please take out a piece of paper
and write what you think about financial management before you read this section from your
previous knowledge. Then evaluate what you have written by reading this section -
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Meaning of Financial Management

Financial management is a combination of two discipline, management and finance. Let us
define each of them separately and then define the course financial management. Management
defined as the acts of getting people together to accomplish desired goals and objectives of
any business areas and organizational activities. Thus, management consists of the activities
of planning, organizing, staffing, leading, or directing, and controlling an organization (a

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Financial Management

group of one or more people or entities) or effort for the purpose of accomplishing a goal or
objectives using the available resources (these includes human
resources, financial resources, technological resources, and natural resources). On the other
hand, finance may be defined as the art and science of managing money.

Financial management is concerned with the creation, maintenance and maximization of

economic value or wealth through the application accounting theories and concepts in
management decision making. As a management process it is concerned on decision making
with an eye toward creating and maximizing wealth. The decisions involved are financial
decisions such as when to introduce a new product, when to invest in new assets, when to
replace existing assets, when to borrow from banks, when to issue stocks or bonds, when to
extend credit to a customer and how much cash to maintain. A successful study of financial
management requires the need for a conceptual framework or assumptions, contexts and
principles in which financial management theories can be developed. Therefore, we study
financial management under the assumptions of capital markets, in the context of corporate
form of business organizations and under the guidance of the basic principles that form the
financial management.

The major areas of finance are: (1) Financial services and (2) financial management
(managerial finance/ corporate finance. Financial service is concerned with design and
delivery of advice and financial products to individuals, businesses and governments within
the areas of banking and related institutions, personal financial planning, investments, real
estate, and insurance and so on. While, financial management is the management of capital
sources and their uses so as to attain the desired goal and objectives of the firm. It involves
sourcing of funds, making appropriate investments and promulgating the best mix of financial
resources in relation to the value of the firm.

Basic Assumptions
a) Existence of well-developed capital mark
Financial management is studied under the assumption that there is capital market and capital
exchange in the business environment concerned with free and competitive interaction and
reasonable costs and prices like any commodity market. This interaction in a well-developed
capital market exists between the corporation and financial markets in the following manner.
Initially, the corporation raises capital in the financial markets by selling securities –stocks
and bonds. Secondly, the corporation then invests this in return generating assets-new
projects. Thirdly, the cash flow from those assets is either reinvested in the corporation, given
back to the investors, paid to government in the form of taxes.

b) The Context of Corporate Form of Business Organizations

Financial management is studied in the context of a corporate form of business organization

and its decisions due to the following characteristics and advantages of a corporation.

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i. Basic characteristics
Separate legal existence, Limited liability, Ownership possession and transfer through stocks,
Separation of ownership from management, indefinite life time, Double taxation, the right to
issue shares.
ii. Advantages
 Ease of raising capital/ mobilization of huge amount of capital
 Existence of secondary capital markets /resale markets.
 A corporate entity is a self perpetuating entity
 Corporations have a better chance of growth due to their ability for easy raise of
capital.
Basic principles that form the basis for financial management
1. The risk –return trade-off
In financial decision making, we don’t take additional risk unless we expect to be
compensated with additional return that is, investors demand a high return for taking
additional risks. The risk– return relationship will be a key concept in the valuation of stocks
and bonds and proposal of new projects for acceptance.
2. The time value of money
A dollar received today is worth more than a dollar to be received in the future. The time
value of money is the opportunity cost of passing up the earning potential of a dollar today.
3. Cash –Not profits –is a king
In measuring wealth or value , we will consider cash flows, not accounting profits, because it
is the cash flows, not profits that are actually received by the firm, relevant for decision
making and can be reinvested .Accounting profits on the other hand, appear when they are
earned rather than when the money is actually in hand.
4. Incremental cash flows.
It is only what changes that count. In making business decisions in creating wealth, we only
consider incremental cash flow which is the difference between the cash flows if the decision
is made versus what they will be if the decision is not made/Relevant cash flow analysis/
5. The curse of competitive markets: why it is hard to find exceptionally profitable projects?
If an industry is generating large profits, new entrants usually attracted. The additional
competition and added capacity can result in profits being driven down to the required rate of
return, then some participants in the market drop out, reducing capacity and competition.
6. Efficient capital markets – capital markets are efficient and the prices are right. An
efficient capital market is a market in which the values of all assets and securities at any
instant in time fully reflect all available public information. Such markets characterized by the
existence of a large number of profits –driven individuals acting independently.
7. The Agency problem – Managers won’t work for owners unless it’s in their best interest.
It is the problem resulting from conflicts of interest between the managers (agents of the
stockholders) and the stockholders.
8. Taxes bias business decision- In incremental cash flow analysis, the cash flow to be
considered should be after- tax incremental cash flows to the firm as a whole.
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9. All risks are not equal – Some risks can be diversified away, and some cannot be.
Risk diversification is the process of reducing risk through increasing the alternatives of risk
full investment and other business decisions.
10. Ethical behavior is doing the right thing and ethical dilemmas are everywhere in the
business.
Key Activities of the Financial Manager
The primary activities of a financial manager are:
(1) Performing financial analysis and planning
(2) Making investment decision, and
(3) Making financial decisions.
Objectives of Financial Management
To make wise decisions a clear understanding of the objectives which are sought to be
achieved is necessary. The objective provides a framework for optimum financial decision-
making. The term objective is used in the sense of a goal or decision criterion for the four
decisions, investment decision, financial decision, dividend policy decision and asset
management decision, involved in financial management. The financial manager uses the
overall company’s goal of shareholders’ wealth maximization which is reflected through the
increased dividend per share, and the appreciations of the prices of shares in formulating the
financial policies and evaluating alternative course of actions. In order to do so, this overall
goal of wealth maximization needs to be related to take the following specific objectives of
financial management in account. These are:
 Aims at determining how large the business firm should be and how fast should it
grow?
 Aims at determining the best percentage composition of the firm’s assets (asset
portfolio decision of related to capital uses)
 Aims at determining the best percentage composition of the firm’s combined liabilities
and equity decisions related to capital sources.
Profit Maximizations as a Decision Criterion
Profit maximization is considered as the goal of financial management, in this approach,
actions that increase profits should be undertaken and actions that decrease profits are
avoided. Thus, the investment, financing and dividend decisions also be noted that the term
objective provides a normative framework decisions should be oriented to the maximization
of profit. Thus, in the entire decisions one test is used i.e. select asset, projects and decision
that are profitable and reject those which are not profitable. However, profit maximization
criterion is criticized on several grounds .Firstly; the reasons for the opposition that are based
on misapprehensions about the workability and fairness of the private enterprise itself.
Secondly, profit maximization suffers from the difficulty of applying this criterion in the
actual real world situations. We shall now discuss some of the limitations of profit
maximization objective of financial management. The profit maximization criterion is not
appropriate and suitable as an operational objective. It is unsuitable and inappropriate as an

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operational objective of investment, financing, and dividend decisions of a firm. It is vague

and ambiguous. It ignores important dimensions of financial analysis viz risk and time value
of money. An appropriate operational decision criterion for financial management should be
precise and exact, should be based on the bigger the better principle should consider both
quantities and quality dimensions of benefits and should consider time value of money.

Wealth Maximization as a Decision Criterion

Wealth maximization decision criterion is also known as value maximization or net present –
worth maximization is widely accepted as an appropriate operational decision criterion for
financial management decision. It removes the technical limitations of profit maximization
criterion and it pokes the three requirements of a suitable operational objective of financial
courses of action. These three features are exactness, quality of benefits, and the time value of
money.
Learning activity
Form groups with convenient members of students and discuss on the following points:
Nature of financial management, Role financial management, principle of financial
management, key activities of financial manager and objectives of financial management

Continuous assessment
Instructors giving this learning task are expected to give a continuous assessment and
feedback to students that include quizzes (at least in every section), presentation, assignment,
and participation in class. Note that, some of the continuous assessments may not be marked,
instead simply used to know the students level of understanding to give more help for the
learners.
Summary
This section provides a basic concept underlying financial management. Financial
management is concerned with acquiring, financing and managing assets to achieve a desired
goal. Finance is a very wide separate and distinct field of study. Financial management is an
area of study under finance, which deals about the financial problems of an individual firm.
The Finical management process involves Long-term investment decisions, Long-term
financing decisions, Asset management decision, and dividend decision. The financial
manager determines the appropriate risk-return trade off to maximize the value of the firm’s
stock. Financial managers are responsible for obtaining and using funds in a way that will
maximize the value of the firm. The primary goal of management in a publicly trade firm
should be to maximize profit and stockholders’ wealth which means maximizing the price of
the firm’s stock.
Practice Questions
1. Clearly explain the nature of financial management
2. What goal should always motivate the actions of a firm’s financial manager?
3. Discuss the objectives of financial management.

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4. Discuss the role of financial manager

5. Explain the importance of financial management
6. Explain the basic assumption of financial management
7. What is the difference between profit maximization and wealth maximization? Under
what conditions might profit maximization lead to wealth maximization?

3.3.3.2 Section II: Financial Analyses and Planning

Pre test
Dear student we have discussed all about financial management under section one. Indeed,
financial analysis and planning is a primary task of every manager in profit seeking business.
Hence, think with your friends and discus on meaning of financial analysis and planning why
financial statement analysis and planning customary needed in the firm and method of
analyzing financial statement?
…………………………………………………………………………………………………
……………………………………………………………………………………
Sources of Financial Information
The essence of managing risk is making good decisions. Proper and relevant decision making
depends on accurate information and proper analysis of them. Financial statements are
summaries of the operating, investment, and financing activities that provide information for
these decisions. But this information is not enough by themselves and need to be analyzed.
Financial analysis is a tool of financial management. It consists of the evaluation of the
financial condition and operating results of businesses and forecasting its future condition and
performance. Understanding the overall financial situation requires three key financial
statements: the balance sheet, the income statement and the cash flow statement.
o The Balance Sheet
The balance sheet is a financial statement that helps to communicate the financial position or
condition of a business. Completed balance sheet shows information such as the total value of
assets, debt and equity. As a result, this information can be analyzed to determine the
business' current ratio, its borrowing capacity and opportunities to attract equity capital.

o Income Statement
An income statement often provides a better measure of the operation's performance and
profitability. It shows the operating results of a firm, flows of revenue and expenses.
o Cash Flow Statement
Help to communicate the summary of cash receipt and payment for specific period of time.

Financial Analysis
Financial analysis is the assessment of firm's past, present, and anticipated future financial
condition. It is the base for intelligent decision making and starting point for planning the

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future courses of events for the firm. Its objectives are to determine the firm's financial strength
and to identify its weaknesses. The focus of financial analysis is on key figures in the financial
statements and the significant relationships that exist between them.
The Need for Financial Analysis
The following stakeholders are interested in financial statement analysis to make their
respective decision at right time;
-Investors - Lenders
-Management - Suppliers
-Employees - Government body
-Competitors
Methods of Financial Analysis
o Ratio Analysis
Is the most widely used financial statement analysis technique. A ratio is the mathematical
relationship between two quantities in the financial statement. It is essentially concerned with
the calculation of relationships, after proper identification and interpretation, used to provide
indicators of past performance in terms of critical success factors of a business. This
assistance in decision-making reduces reliance on guesswork and intuition, and establishes a
basis for sound judgment.
o Horizontal (Trend) Analysis
Horizontal Analysis expresses financial data from two or more accounting periods in terms of
a single designated base period; it compares data in each succeeding period with the amount
for the preceding period. For instance, compare current to past or future for the same
company.
o Vertical (Static) Analysis
In vertical analysis, all the data in a particular financial statement are presented as a
percentage of a single designated line item in that statement. For example, we might report
income statement items as percentage of net sales, balance sheet items as a percentage of total
assets; and items in the statement of cash flows as a fraction or percentage of the change in
cash.
Benchmarks for Evaluation
What is more important in ratio analysis is the thorough understanding and the interpretation
of the ratio values. To answers the questions as; it is too high or too low? Is good or bad? A
meaningful standard or basis for comparison is needed. We will calculate a number of ratios.
But what shall we do with them? How do you interpret them? How do you decide whether the
Company is healthy or risky? There are three approaches: Compare the ratios to the rule of
thumb, use Cross-sectional analysis or time series analysis.

o Rule of thumb
Comparing a company's ratios to the rule of thumb has the virtue of simplicity but has little to
recommend it conceptually. The appropriate value of ratios for a company depends too much

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on the analyst's perspectives and on the Company's specific circumstances for rules of thumb
to be very useful. The most positive thing to be said in their support is that, over the years,
Companies confirming to these rules of thumb tend to go bankrupt somewhat less frequently
than those that do not.
o Cross-Sectional Analysis
This involves the comparison of different firm's financial ratios at the same point in time. The
typical business is interested in how well it has performed in relation to its competitors. Often,
the firm's performance will be compared to that of the industry leader, and the firm may
uncover major operating deficiencies, if any, if changed, will increase efficiency. Another
popular type of comparison is to industry averages; the comparison of a particular ratio to the
standard is made to isolate any deviations from the norm. Too high or too low values reflect
symptoms of a problem. Comparing a Company's ratios to industry ratios provide a useful
feel for how the Company measures up to its Competitors. But, it is still true that company
specific differences can result in entirely justifiable deviations from industry norms. There is
also no guarantee that the industry as a whole knows what it is doing.
o Time-Series Analysis
This applied when a financial analyst evaluates performance of a firm over time. The firm's
present or recent ratios are compared with its own past ratios. Comparing of current to past
performance allows the firm to determine whether it is progressing as planned.
Types of Financial Ratios
There are five basic categories of financial ratios. Each represents important aspects of the
firm's financial conditions. The categories consist of; liquidity, activity, leverage, profitability
and market value ratios.

 Liquidity Ratios
Liquidity refers to, the ability of a firm to meet its short-term financial obligations (current
liabilities) when and as they fall due. This ratio expresses the relationship between current
assets and current liability of the business concern during a particular Period. The following
are a major element of liquidity ratio.
Current Ratio
This measures a firm’s ability to satisfy or cover the claims of short term creditors by using
only current assets. That is, it measures a firm’s short-term solvency or liquidity. The current
ratio is calculated by dividing current assets to current liabilities. Therefore, the current ratio
for ABC Company, as indicated under annex section, is
For 2010 = 1,223,000 = 1.97
620,000
The unit of measurement is either birr or times. So, we could say that ABC Company has Birr
1.97 in current assets for every 1 birr in current liabilities, or, we could say that ABC
Company has its current liabilities covered 1.97 times over. An ideal current ratio is 2:1or
more. This is because even if the value of the firm's current assets is reduced by half, it can
still meet its obligations.

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o Quick (Acid-test) Ratio

This ratio measures the short term liquidity by removing the least liquid assets such as
inventories, prepaid expenses etc. Inventories are excluded because they are not easily and
readily convertible into cash and more over, losses are most likely to occur in the event of
selling inventories. Hence, to obtain a more refined liquidity measure, it is desirable to
remove them from the numerator of the current ratio. While prepaid expenses such as prepaid
rent, prepaid insurance, and prepaid advertising, pre paid supplies are excluded because they
are not available to pay off current debts. Acid-Test Ratio is computed as total current asset
minus the least liquid assets divided by total current liabilities;
For example: For 2010, Quick Ratio for ABC Company will be: 1,223,000- 289,000 = 1.51
620,000
The interpretation indicates that ABC Company has 1birr and 51 cents in quick assets for every
1 birr current liabilities. As a very high or very low acid test ratio is a sign of some problem, a
moderately high ratio is required by the firm.
Activity Ratios
These ratios are also known as assets management or turnover ratios. It measures the degree to
which assets are efficiently employed in the firm i.e. how well the firm manages its assets.
These ratios provide the basis for assessing how the firm is efficiently or intensively using its
assets to generate sales (profits). These ratios are called turnover ratios because they show the
speed with which assets are being converted into sales. Overall liquidity ratios generally do not
give an adequate picture of company’s real liquidity due to differences in the kinds of current
assets and liabilities the company holds. Thus, it is necessary to evaluate the activity ratio.
When you see the two companies (ABC and XYZ Company) their liquidity (current ratios) are
the same (2.5 times), but their composition is different, XYZ Company is more liquid than ABC
Company. Form this we understand that activity ratio is more important in showing a 'true"
liquidity position than current ratio. Although generalization can be misleading in ratio analysis,
generally, high turnover ratios usually associated with good assts management and lower
turnover ratios with poor assets management. Therefore the major activity ratios are the
following;
o Inventory Turnover Ratio
This ratio measures the effectiveness or efficiency with which a firm managing its investments
in inventories is reflected in the number of times that its inventories are turned over (replaced)
during the year. It is a rough measure of how many times per year the inventory level is
replaced or turned over. Inventory turnover ratio computed as cost of goods old divided by
average inventories of the company. For instance: Turnover ratio of ABC Company for the year
2010 will be; = 2,088,000/294,500
= 7.09 times
Therefore, ABC’s inventory is sold out or turned over 7.09 times per year. In general, a high
inventory turnover ratio is better than a low ratio. An inventory turnover significantly higher

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than the industry average indicates: Superior selling practice, improved profitability as less
money is tied-up in inventory.
o Average Age of Inventory
This indicates the number of days inventory is kept before it is sold to customers. It is
calculated by dividing the number of days in the year (360/ 365 days) to the inventory turnover.
Therefore, the Average Age of Inventory for ABC Company for the year 2010 is;
365 days = 51 days
7.09
This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it
is sold. Generally, the longer period indicates that, the company is keeping much inventory in
its custody and, the company is expected to reassess its marketing mechanisms that can boost its
sales because, the lengthening of the holding periods shows a greater risk of obsolescence and
high holding costs.
o Accounts Receivable Turnover Ratio
This ratio measures the liquidity of firm’s accounts receivables. That is, it indicates how many
times or how rapidly accounts receivable is converted into cash during a year. This ratio tells
how successful the firm is in its collection. If the company is having difficulty in collecting
its money, it has large receivable balance and low ratio. It is calculated by dividing the
amount of net sales to average amount of account receivable. Thus, the accounts receivable
turnover for ABC Company for the year 2010 is computed as;
Accounts receivable turnover ratio = 3,074,000 = 7.08
434,000*
Average Accounts Receivable is the accounts receivable of the year 2009 plus that of the year
2010 and dividing the result by two. So, 434 = 503,000 + 365,000/ 2 = 434,000*
From this ratio we understand that ABC Company collected its outstanding credit accounts
and re-loaned the money 7.08 times during the year. Generally, the account receivable
turnover ratio when substantially lower than the industry average may suggest that a
Company has more liberal credit policy (i.e. longer time credit period), poor credit selection,
and inadequate collection effort or policy, while a ratio substantially higher than the industry
average may suggest that a firm has more restrictive credit policy (i.e. short term credit
period), more liberal cash discount offers (i.e. larger discount and sale increase), more
restrictive credit selection.
o Average Collection Period
This shows how long it takes for account receivables to be cleared (collected). The average
collection period represents the number of days for which credit sales are locked in with
debtors (accounts receivables). The average collection period is calculated as dividing number
of days in a year (360 or 365 days) to receivable turnover ratio. Therefore, the average
Collection period for ABC Company for the year 2010 will be:
365 days/7.08 =51 days or
Or Average collection period = Average accounts receivables* 365 days/Sales

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434,000* 365 days/3,074,000* = 51 days

Thus, the higher average collection period is an indication of reluctant collection policy where
much of the firm’s cash is tied up in the form of accounts receivables, whereas, lower average
collection period than the standard designate aggressive collection policy that result reduction
of sales revenue.
o Average Payment Period
The average Payment Period (Average Age of accounts Payable) shows, the time it takes to
pay to its suppliers or creditors. It computed as dividing amount of account payable for the
period to average purchase amount per day. Purchase estimated as a given percentage of cost
of goods sold. Assume purchases were 70% of the cost of goods sold in 2010 for ABC
Company.
So, Average Payment Period = 382,000 = 95 days
2,088,000 x .70/365
This shows that, on average, the firm pays its suppliers in 95 days. The longer these days, the
more the credit financing the firm obtains from its suppliers.
o Fixed Asset Turnover ratio
This measures the efficiency with which the firm has been using its fixed assets to generate
revenue. It determined as dividing amount of net sales for the period to average fixed assets.
The Fixed Assets Turnover ratio for ABC Company for the year 2010 calculated as follows;
= 3,074,000 = 1.29
2,374,000*
This means that, ABC Company has generated birr 1.29 in net sales for every birr invested in
fixed assets. Other things being equal, a ratio substantially below the industry average shows;
underutilization of available fixed assets (i.e. presence of idle capacity) relative to the
industry, possibility to expand activity level without requiring additional capital investment,
over investment in fixed assets, low sales or both. This ratio generally helps the financial
manager to reject funds requested by production managers for new capital investments. Other
things being equal, a ratio higher than the industry average requires the firm to make
additional capital investment to operate a higher level of activity. It also shows firm's
efficiency in managing and utilizing fixed assets.
 Total Asset Turnover ratio
This ratio measures a firm’s efficiency in management its total assets to generate sales. It
computed as dividing total amount of net sales to amount of net total assets. For example; the
Total Assets Turnover for ABC Company for the year 2010 is;
3,074,000 = 0.85
3,597,000
This is to mean ABC Company generates birr 0.85 (85 cents) in net sales for every birr
invested in total assets. Generally, a high ratio suggests greater efficiency in using assets to
produce sales whereas; a low ratio suggests that the company is not generating a sufficient
volume of sales for the size of its investment in assets.
Leverage Ratios

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Leverage ratios are also called solvency ratio. Solvency is a firm’s ability to pay long term
debt as they come due. There are two types of debt measurement tools. These are:
Financial Leverage Ratio
These ratios examine balance sheet ratios and determine the extent to which borrowed funds
have been used to finance the firm. It is the relationship of borrowed funds and owner capital.
This includes;
Debt Ratio
Shows the percentage of assets financed through debt. It is calculated as dividing total liability
to total assets. Thus, the debt ratio for ABC Company for the year 2001 is as follows:
= 1,643 = 0.457 or 45.7 %
3,597
This indicates that the firm has financed 45.7 % of its assets with debt. Note that, higher ratio
shows more of a firm’s assets are provided by creditors relative to owners indicating that, the
firm may face some difficulty in raising additional debt as creditors may require a higher rate
of return (interest rate) for taking high-risk.
Debt - Equity Ratio
This shows the relationship between the amount of a firm’s total assets financed by creditors
(debt) and owners (equity). Thus, this ratio reflects the relative claims of creditors and
shareholders’ against the asset of the firm. It calculated as dividing total liabilities to total
owner’s equity or stockholder’s equity. The Debt- Equity Ratio for ABC Company for the
year 2010 can be;
= 1,643,000 = 0.84 or 84 %
1,954,000
Therefore, lenders’ contribution is 0.84 times of stock holders’ contributions from the total
assets of the company.
Coverage Ratio
These ratios measure the risk of debt and calculated by income statement ratios designed to
determine the number of times fixed charges are covered by operating profits. It measures the
relationship between what is normally available from operations of the firm’s and the claims
of outsiders. The claims include loan principal and interest, lease payment and preferred stock
dividends. These are the following;
Times Interest Earned Ratio
This ratio measures the ability of a firm to pay interest on a timely basis. And it calculated as
dividing earnings (net income) before interest and tax to total interest expense. For example,
the times interest earned ratio for ABC Company for the year 2010 is:

418,000 = 4.5 times

93,000
This ratio shows the fact that earnings of ABC Company can decline 4.5 times without
causing financial losses to the Company, and creating an inability to meet the interest cost.
Cash Coverage Ratio

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The problem with the times interest eared ratio is that, it is based on earnings before interest
and tax, which is not really a measure of cash available to pay interest. One major reason is
that, depreciation, a non cash expense has been deducted from earnings before Interest and
Tax (EBIT). Thus, one way of computing the cash coverage ratio can be dividing earnings
before interest and tax plus depreciation to interest expense. For ABC Company amount of
Depreciation is 223,000 for 2009 and 239,000 for 2010. So, Cash coverage ratio for the year
2001 is;
418,000 + 239,000 = 7.07 times
93, 000
This ratio indicates the extent to which earnings may fall without causing any problem to the
firm regarding the payment of the interest charges.
Profitability Ratios
Profitability is the ability of a business to earn profit over a period of time. Profitability ratios
are used to measure management effectiveness. Besides management of the company,
creditors and owners are also interested in the profitability of the company. Creditors want to
get interest and repayment of principal regularly. Owners want to get a required rate of return
on their investment. These ratios includes the following; Gross Profit Margin, Operating
Profit Margin, Net Profit Margin, Return on Investment, Return on Equity and Earning Per
Share
o Gross Profit Margin
This ratio computes the margin earned by the firm after incurring manufacturing or
purchasing costs. It indicates management effectiveness in pricing policy, generating sales
and controlling production costs. It is calculated as dividing gross profit to net sales. The
gross profit margin for ABC Company for the year 2010 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
This is to mean ABC Company profit is 32 cents for each birr of sales. A high gross profit
margin ratio is a sign of good management. Whereas, a low gross profit margin may reflect
higher CGS due to the firm’s inability to purchase raw materials at favorable terms, inefficient
utilization of plant and machinery, or over investment in plant and machinery, resulting higher
cost of production.
o Operating Profit Margin
This ratio is calculated by dividing the net operating profits by net sales. The net operating
profit is obtained by deducting depreciation from the gross operating profit. Example: The
operating profit margin of ABC Company for the year 2010 is:
418,000 = 13.60
3,074,000
When we interpreted this ratio ABC Company generates around 14 cents operating profit for
each of 1birr sales.
o Net Profit Margin

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Financial Management

This ratio measures the profitableness of sales. It is calculated by dividing the net profit to sales.
The net profit is obtained by subtracting operating expenses and income taxes from the gross
profit. Generally, non operating incomes and expenses are excluded for calculating this ratio.
This ratio measures the ability of the firm to turn each birr of sales in to net profit. A high net
profit margin is a welcome feature to a firm and it enables the firm to accelerate its profits at a
faster rate than a firm with a low profit margin. The net profit margin for ABC Company for the
year 2010 is:
230,750 = 7.5 %
3,074,000
This means that ABC Company has acquired 7.5 cents profit from each birr of sales.
o Return on Investment
The return on investment also referred to as Return on Assets. It measures the overall
effectiveness of management in generating profit with its available assets, i.e. how profitably
the firm has used its assets. The return on investment or assets is calculated as dividing net
income to total assets. The return on assets for ABC Company for the year 2010 is:
230,750 = 6.4 %
3,597,000
This is to mean ABC Company generates little more than 6 cents for every birr invested in
assets.
o Return on Equity ratio
The shareholders of a company may comprise common shareholders and preferred share
holders. When the company earns profit, it may distribute all or part of the profits as
dividends to the equity shareholders or retain them in the business itself. The Return on
Equity ratio is calculated as dividing net income to total stockholders’ equity.
The Return on equity of ABC Company for the year 2010 is;

230,750 = 11.8%
1,954,000
This is to mean ABC Company generates around12 cents for every birr in shareholders’ equity.
o Earnings per Share
This is another measure of profitability of a firm from the point of view of the ordinary
shareholders. It reveals the profit available to each ordinary shareholder. It is calculated by
dividing the profits available to ordinary shareholders (i.e. profit after tax minus preference
dividend) by the number of outstanding equity shares.
Therefore, the earning per share of ABC Company for the year 2010 is:
EPS = 220,750 = Birr 2.90 per share
76,262 shares
The interpretation of this indicates that ABC Company earns Birr 2.90 for each common share
outstanding.
Limitations of Ratio Analysis
While ratio analysis can provide useful information concerning a company’s operations and

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Financial Management

financial condition, it does have limitations that necessitate care and judgments such as;
o Inflation may have badly distorted firm’s balance sheets - recorded values are often
substantially different from “true” values. Further, because inflation affects both
depreciation charges and inventory costs, profits are also affected. Thus, a ratio analysis
for one firm over time, or a comparative analysis of firms of different ages, must be
interpreted with judgment.
o Due to fraud, financial statements are not always accurate; hence information based on
reported data can be misleading. Ratio analysis is useful, but analysts should be aware of
these problems and make adjustments as necessary.
o Firms can employ “window dressing” techniques to make their financial statements look
stronger.
Financial Planning
Forecasting in financial management is needed when the firm is ready to estimate its future
financial needs. Forecasting uses past data as a base and then planned and expected
circumstances are incorporated in order to estimate the future financial requirements.
o Steps involved in planning (predicting) Process of financial needs
1. Project the firm's sales revenues and expenses over the planning period.
2. Estimate the levels of investment in current and fixed assets that are necessary to support
the projected sales.
3. Determine the firm's financial needs throughout the planning period.
o Ingredients of Financial Planning
Assumptions
The financial plan should explicitly specify the environment in which the firm expects to
operate over the life of the plan.
o Sales Forecast
Almost all financial plans require a sales forecast. Most other values in the financial plan will
be calculated based on the sales forecast.
o Performance Statements
A financial plan will have a forecasted balance sheets, income statement, and statement of
cash flows. These are called pro forma statements.
o Assets Requirements
The financial plan should state the planned investments and the changes in the firm's assets.

o Financial Requirements
The plan should also describe the necessary financing arrangements needed to finance the
planned investments. Financing policy issues such as debt policy, debt-equity ratio, and
dividend should be discussed.
Techniques of Determining External Financial Requirements

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Financial Management

o Percent-of-Sales Method of Financial Forecasting

When constructing a financial forecast, the sales forecast is used traditionally to estimate
various expenses, assets, and liabilities. The most widely used method for making these
projections is the percent-of-sales method, in which the various expenses, assets, and
liabilities for a future period are estimated as a percentage of sales. These percentages,
together with the projected sales, are then used to construct pro forma (planned of projected)
balance sheets.
The calculations for a pro forma balance sheet are as follows:
1. Express balance sheet items that vary directly with sales. That means multiply those
balance sheet items that vary directly with sales by (1 + sales growth rate).
2. Multiply the income statement items by (1+ Sales Growth Rate). Thus, we are assuming
that each income statement item increases at the same rate as sales, which means that we
are assuming constant returns to scale.
3. Where no percentage applies (such as for long-term debt, common stock, and paid in
capital in excess of par), simply insert the figures from the present balance sheet.
4. Compute the projected retained earnings as present retained earnings plus projected net
income minus cash dividends paid.
5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected
liabilities and equity accounts to determine the total financing provided. Since liability
plus equity must balance the assets when totaled, any difference is a shortfall, which is the
amount of external financing needed.
o Formula Method of Financial forecast
A simple forecasting formula provides a short cut to projecting additional funds needed and can
be used to clarify the relationship between sales growth and financial requirements, as well as
the influence of other relevant variables on additional fund needed.
Additional Fund = [Required Increase] - [Spontaneous Increase] - [Increase in Retained]
`Needed in Assets in liabilities Earnings

Learning Activity
Instructor form students in group according to convenient members of students and make
student as they discuss on the following points: Nature and each of financial statement,
characteristics of financial analysis, various method of financial analysis, and financial
planning……………………. ………………………….........................…………………………
................................................................................................................................................

Continuous Assessment
Instructor giving this learning task is expected to give a continuous assessment and feedback
to students that include quizzes (at least in every section), assignment, and participation in
class. Note that some of the continuous assessments may not be marked, instead simply used
to know how much the students understand what they learned.

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Financial Management

Summary
The Primary purpose of this section is to discuss the techniques used by the stockholders
when they analyze the basic financial statement. Financial statement analysis is the
assessment and interpretation of the basic financial statement (income statement, balance
sheet and statement of cash flow) items to show the financial condition and results of
operation of a firm. The financial statement analysis generally begins with calculations of
different ratios such as liquidity, assets management, debt management, profitability and
market value ratios. In addition to calculating these ratios, trend analysis is used as it reveals
whether the firm's financial position is improving or deteriorating over time. Regardless of
showing the financial condition and operation ratios have some limitations and therefore, it is
advisable to take these limitations while using ratio for evaluating financial performance.
Firms project their financial statements and determine their capital requirements. A firm can
determine the additional fund needed by estimating the amount of new assets to support the
forecasted level of sales and then subtracting from that amount both the spontaneous funds
that will be generated from operations and the additions to retained earnings.

Concepts and critical thinking questions

1. Describe types of financial statement and illustrate its function?
2. Clearly explain the nature of financial statement analysis?
3. What are the uses for financial statement analysis?
4. State why financial statement analysis is needed?
4. Explain various methods of financial statement analysis.
5. What are some problems that can come up with financial statement analysis?

3.3.3.3. Section III: The Time Value of Money

Pre test
Dear learner! Have you ever heard the word time value of money? Having the concept of time
value money is quit important in the world of business and for every person. Hence, discuses
in peer on the time value of money, peculiarly, discus on future and present value of money
before proceeding to the section.
………………………………………………………………………………………………
………………………………………………………………………………………………

Overview of Time Value of Money

The time value of money is the opportunity cost of passing up the earning potential of a birr
today. The first basic point in the concept of the time value of money is to understand the
meaning of interest. Interest is the cost of using money (capital) over a specified time period.
There are two basic types of interest: simple interest and compound. Simple interest can be

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Financial Management

understood in two different ways. One is that simple interest is an interest computed for just a
period. If interest is computed for one period only, the interest is always simple interest.
Compound interest, on the other hand, is an interest computed for a minimum of two periods
whereby the previous interests produce another interest for subsequent or next periods. Here
both the principal and previous interests bring additional interest.
1. Future Value
To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final period.
The cash flow(s) could be a single cash flow, an annuity or uneven cash flows.
A. Future Value of a Single Amount
This is the amount to which a specified single cash flow will grow over a given period of time
when compounded at a given interest rate. The formula for computing future value of a single
cash flow is given accordingly:
FVn = PV (1 + i)n Where:FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or FVn = PV (FVIFi,n)
Where: (FVIFi, n) = The future value interest factor for i and n
The future value interest factor for i and n is defined as (1 + i) n and it is the future value of
Br.1 for n periods at a rate of i percent per period.
Example: Marta deposited Br. 1,800 in her savings account in Meskerem 1990. Her account
earns 6 percent compounded annually. How much will she have in Meskerem 1997?
FVn = PV (1 + i)n = Br. 1,800 (1.06)7
= Br. 2,706.53
B. Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits) made
at fixed intervals for a specified number of periods. For a series of cash flows to be an annuity
four conditions should be fulfilled. First, the cash flows must be equal. Second, the interval
between any two cash flows must be fixed. Third, the interest rate applied for each period
must be constant. Last but not least, interest should be compounded during each period. If any
one of these conditions is missing, the cash flows cannot be an annuity.
Broadly annuities are classified into three types: i) ordinary annuity, ii) annuity due, and iii)
deferred annuity
i) Future value of an Ordinary Annuity – An ordinary annuity is an annuity for which the
cash flows occur at the end of each period. Therefore, the future value of an ordinary
annuity is the amount computed at the period when exactly the final (n th) cash flow is made.
Graphically, future value of an ordinary annuity can be represented as follows:

0 1 2 ------------------ n

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Financial Management

PMT1 PMT2 ---------------PMTn

The future value is computed at point n where PMTn is made.

FVAn = PMT Where: FVAn = Future value of an ordinary annuity PMT

= Periodic payments
i = Interest rate per period
n = Number of periods
Or FVAn = PMT (FVIFAi,n)
Where: (FVIFAi, n) = the future value interest factor for an annuity

Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to make
equal monthly deposits for 5 years. The first payment is made a month from today, in a bank
account which pays 12 percent interest, compounded monthly. How much should you deposit
every month to reach your goal?
Given: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?
FVAn = PMT (FVIFAi, n)
 Br. 25,000 = PMT (FVIFA, %, 60)
 Br. 25,000 = PMT (81.670)
 PMT = Br. 25,000/81.670
 PMT = Br. 306.11
ii) Future value of an Annuity Due. An annuity due is an annuity for which the payments
occur at the beginning of each period. Therefore, the future value of an annuity due is
computed exactly one period after the final payment is made. Graphically, this can be
depicted as:
0 1 2 --------------------- n
PMT1 PMT2 PMT3 ----------------------- PMTn + 1
The future value of an annuity due is computed at point n where PMTn + 1 is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or

= PMT ( 1 + i)

Example: Assume that pervious example except that the first payment is made today instead
of a month from today. How much should your monthly deposit be to accumulate Br. 25,000
after 60 months?
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
 Br. 25,000 = PMT (FVIFAi, n) (1 + i)
 Br. 25,000 = PMT (81.670) (1.01)
 PMT = Br. 25,000/82.487

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Financial Management

 PMT = Br. 303.08

iii) Future value of Deferred Annuity is an annuity for which the amount is computed two or
more period after the final payment is made.
0 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

The future value of a deferred annuity is computed at point n + x
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x

= PMT (1 + i)x
Where x = the number of periods after the final payment; and X  2.
Example: Henock has a savings account, which he had been depositing Br. 3,000 every year
on January 1, starting in 1990. His account earns 10% interest compounded annually. The last
deposit Hencok made was on January 1, 1999. How much money will he have on December
31, 2003? (No deposits are made after 1999 January).
Jan.
1990 1991 1992 93 94 95 96 97 98 99 2000 2001 02 03 2004
3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
The future value is computed on December 31, 2003 (or January 1, 2004).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62
C. Future Value of Uneven Cash Flows
Uneven cash flow stream is a series of cash flows in which the amount varies from one period
to another. The future value of an uneven cash flow stream is computed by summing up the
future value of each payment.
Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest rate
is 8% compounded annually. Assume the future value is computed at the end of year 5.

0 1 2 3 4 5
1,000 3,000 4,000 1,200 900
FVIF8%, 4 Br. 1,000 (1.3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%, 2 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00
FV = Br. 12,001.20

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Financial Management

2.Present Value
Present value is the exact reversal of future value. A present value is the amount of money
that should be invested today at a given interest rate over a specified period. The process of
computing the present value is called discounting.
A. Present Value of a Single Amount
It is the amount that should be invested now at a given interest rate in order to equal the future
value of a single amount.

PV = Where: PV = Present Value

FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Or PV = FVn (PVIFi, n)
Where: (PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n
Example: Sunrise Plc owes Br. 50,000 to Olyad Co. at the end of 5 years. Olyad Co. could
earn 12% on its money. How much should Olyad Co. accept from Sunrise Plc as of today?
Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV =?
PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370
B. Present Value of an Annuity
i) Present value of an Ordinary Annuity is a single amount of money that should be invested
now at a given interest rate in order to provide for an annuity for a certain number of future
periods.

PVAn = PMT = PMT (PVIFAi, n)

Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity
=
Example: Ato Andualem retired as general manager of 3Z Foods Complex. But he is
currently involved in a consulting contract for Br. 35,000 per year for the next 10 years. What
is the present value of Andualem’s consulting contract if his opportunity cost is 10%?
Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?
PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = Br. 215,061.
This means if the required rate of return is 10%, receiving Br. 35,000 per year for the next 10
years is equal to receiving Br. 215,061 today.

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Financial Management

ii) Present value of an Annuity Due – is the present value computed where exactly the first
payment is to be made, graphically, this is shown below:

0 1 2 3 ---------------- n
PMT1 PMT2 PMTn
The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0.

PVAn = (Annuity due) = PMT (1 + i) = PMT (PVIFAi, n) (1 + i)

Example: Addis Corporation bought a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase, and
the prevailing interest rate that applies for the transaction is 8%. Compute the purchase price
of the machinery.
Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) =?
PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54.
So, the cost of the machinery for Addis is Br. 36,234.54. We have identified the case as an
annuity due rather than ordinary annuity because the first payment is made today, not after
one period.
C. Present Value of Uneven Cash Flows
The present value of an uneven cash flow stream is found by summing the present values of
individual cash flows of the stream.
Example: Suppose you are given the following cash flow stream where the appropriate
interest rate is 12% compounded annually. What is the present value of the cash flows?
Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300
Br. 400 (0.8929) PVIF12%, 1
= Br. 357.16
Br. 100 (0.7972) PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42
D. Present Value of a Perpetuity
Perpetuity is an annuity with an indefinite cash flow. In perpetuity payments are made
continuously forever. The present value of perpetuity is found by using the following formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example: What is the present value of perpetuity of Br. 7,000 per year if the appropriate
discount rate is 7%?
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?

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Financial Management

PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.

i 7%
This means that receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.

Learning Activity
Instructor form students in group according to convenient members of students and make
student as they discuss on: time value of money, future vs present value and type of annuity.
Instructor, please give practical question to equip the student all about time value of money.
Facilitate students well, by providing demonstrative material and evidence from relevant
books, financial institutions and other that enable students to gate insight knowledge.

………………………….........................…………………………………………………………
....................................................................................................................................
Continuous Assessment
Instructors giving these learning tasks are expected to give a continuous assessment and
feedback to students. So that, pleas assess students either in the form of quizzes, assignment,
class presentation and discussion.

Summary
 Most financial decisions involve situations in which someone pays money at one point
in time and receives money at some later time. Dollars paid or received at two
different points in time are different, and this difference is recognized and accounted
for by time value of money (TVM) analysis.
 Compounding is the process of determining the future value (FV) of a cash flow or a
series of cash flows. The compounded amount, or future value, is equal to the
beginning amount plus the interest earned.
 Discounting is the process of finding the present value (PV) of a future cash flow or a
series of cash flows; discounting is the reciprocal, or reverse, of compounding.
 An annuity is defined as a series of equal periodic payments (PMT) for a specified
number of periods.
Future value of an annuity:
Present value of an annuity:
 An annuity whose payments occur at the end of each period is called an ordinary
annuity.
 Perpetuity is an annuity with an infinite number of payments.
 The longer the time period and the higher the interest rate, the larger the future value.
But the opposite is true for present values.
 The concepts and techniques of the time value of money have many applications in
financial management.
Practical and critical question

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Financial Management

1. How much must you deposit now on January 1, 1999 to have a balance of Br. 10,000 on
December 31, 2003? Interest is compounded at an 8% annual rate.
2. Upper Awash Agro industry plans to accumulate Br. 500,000 to retire its long-term debt on
December 31, 2010. To achieve the plan, the company has just deposited Br. 100,000
today January 1, 2003. But, the company knows that this deposit alone would not enable
to achieve the target and wants to make equal annual deposits starting January 1, 2005
until January 1, 2010. Assuming the appropriate interest rate is 6% compounded annually,
how much should Upper Awash Agro industry deposit every January so as to achieve its
plan?
3. On January 1, 1998, JAKRAND integrated Agro Industry Corporation sold a bundle of
fruits to fruit Juice Sunrise Company. Sunrise signed a Br. 200,000 non-interest bearing
promissory note due on January 1, 2001. The prevailing interest rate for a similar note on
January 1, 1998, was 9%. How much is the selling price of the JAKRAND integrated Agro
Industry Corporation?
4. How large must each annual payment be for a Br. 100,000 loan to be repaid in equal
installments at the end of each of the next 5 years? The interest rate is 10%, compounded
annually.
5. Assume the above example except that the first payment is to be made after 1 year from the
date of purchase. How much would be the cost of the machinery now for Addis Corporation?

3.3.3.4. Section IV: Valuation of Asset and Cost of Capital

Pre test
Dear student have you ever heard valuation of bond and stock. As well as, cost of capital.
Think to the term and write your idea on a piece of paper before proceeding to this section.
Explain how to determine the value of bond, stock and cost of capital on the space provided
bellow.……..…………………………………………………………………………………
……………………………………………………………………………………………
Valuation: An Overview
There are different values for a particular asset. These include the following; the value of all
assets as shown on the firm’s balance sheet, book value; the value that could be realized if an
asset were sold individually at the time of termination, liquidation value; the observed value
for the asset in the market place, market value; and present value of the assets expected future
cash flows, intrinsic value (fair value). If the intrinsic value is greater than the market value,
the security is undervalued in the eyes of the investor. If the market value exceeds the
investors intrinsic value the security is overvalued. For our purposes the value of an asset is its
intrinsic value, which is the present value of its expected future cash flows, where these cash
flows are discounted back to the present value using the investor’s required rate of return.
Thus, intrinsic value is a function of three elements.
1. The amount and timing of the assets expected cash flows.
2. The riskiness of these cash flows.

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Financial Management

3. The investor’s required rate of return for undertaking the investment.

Valuation: The Basic Process
The valuation process can be described as assigning value to an asset (bond, preferred stock,
and common stock) by calculating the present value of its expected future cash flows.
Therefore, the value of the assets (V) is computed as follows;

V = CF1 + CF2 + CF3 + CF + ………+ CFn or V= CFt

(1+k) 1 (1+k) 2 (1+k) 3 (1+K) 4 (1+k) n t=1 (1+K)t

Where:
V = the intrinsic value of an asset producing expected future cash flows, CFt, in years
1 through n.
CFt = Cash flows to be received in year t.
K = the investor’s required rate of return.
Bond Valuation
The term bond is defined as a long term promissory note that promises to pay the bond holder
a predetermined, fixed amount of interest each year until its maturity. At maturity, the
principal will be paid to the bond holder. The process of valuing a bond requires first that we
understand the terminologies and institutional characteristics of a bond.
 Par Value: The par value is the stated face value of the bond at the end of the life of the
bond; it is usually set at $ 1000. Face value cannot be altered after the bond has been
issued and different from intrinsic value of the bond.
 Coupon Interest Rate: The rate which is fixed and expressed as a percentage of bonds
face value to determines the periodic coupon or interest payments.
 Coupon Payments: The coupon payments represent the periodic interest payments from
the bond issuer to the bond holder.
 Maturity Date: The maturity date represents the date on which the bond matures, i.e. the
date on which the face value is repaid.
 Call Date: The date in which callable bond redeemed by the issuer prior to maturity, the
earliest date at which the bond can be called.
 Call Price: The amount of price the issuer has to pay to call a callable bond (there is a
premium for calling the bond early).
 Required Return: The rate of return that investors currently require on a bond
 Yield-to-Maturity: The rate of return that an investor could earn if he/she bought the
bond at its current market price and held it until maturity.
The valuation process for a bond requires knowledge of three essential elements.
1. The amount of the cash flows to be received by the investor
2. The maturity date of the loan
3. The investors required rate of return.

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Financial Management

The value of the bond (VB) is the present value of both interest to be received and the par or
maturity value of the bond. This may be expressed as:

VB = + or VB = (It x Pv 1FA k b,n ) + (Mx PVl Fkb,n)

Where:
It = the dollar interest to be received in each payment
M= the par value of the bond
Kb = the required rate of return for the bond holder
N = the number of periods to maturity
Illustration
Consider that AB dairy farming, on Jan1, 2010 issued a 10% coupon interest rate, 10 year
bond with Br 1000 par value that pays interest annually. If the investor requires a 10% rate of
return on this bond. What is the value of the bond to investor?
Solution: I (interest) = M x Kc = Br 1000* 10% = Br 100

Vb = + or I (PVIFA

) + M (PVIF kb,n)
kb,n

= + = (Br 100 * 6.1446) + (Br 1000

X0.38 55)
= Br 1000.
Semi-Annual Interest Payments
For bonds that pay interest semi annually, we need to adjust the size of interest payments as
the coupon interest amount is to be paid in two semiannual installments rather than a onetime
annual payment at the time of valuation of such bonds. Then, the valuation equation becomes;

VB = +

or
VB= ( +

Illustration
Suppose a bond has $ 1000 face value, a 10 percent coupon (paid semiannually), five years
remaining to maturity, and is priced to yield 8 percent. What is its value?
Solution; I = MC = $1000 x 10% = 100

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Financial Management

VB = + or VB =

= $ 405 .54 + $ 675. 60 = $1,081.14

Bond holders Expected Rate of Return (Yield to Maturity, YTM)

The bond holder’s expected rate of return is the rate the investor will earn if the bond is held
to maturity, provided of course, that the company issuing the bond does not default on the
payments.
o Computation of Yield –to- Maturity all the Bond (YTM)
YTM is the bonds annual average rate of return to the investor if
1. The bond is held to maturity and
2. The dollar coupon interest payments are reinvested at the rate kd (reinvestment
assumption). YTM can be computed as follows;

YTM =

Where:
I= Periodic dollar coupon
payments (Kc X M)
M= the dollar principal payment at maturity (Fv)
Vb= the value (present value) of bond
n= the number of periods until maturity of the bond
Kc= the fixed coupon interest rate on the bond
Illustration
Suppose a zero – coupon with five years remaining to maturity and a face value of $ 1,000 has
a price of $ 800. What is the yield to maturity on this bond?

Solution: YTM = YTM = = = 4.4.%

Required Returns and Bond Values

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Financial Management

Whenever the required return of bond differs from the bonds coupon interest rate, the bond’s
value will differ from its par value or face value. Accordingly, there are three important
relationships;
1. A decrease in interest rates (required rates of return) will cause the bond to increase
value. The change in value caused by changing interstates rate is called interest rate risk.
2. If the bond holders required rate of return (current interest rate) equals the coupon
interest rate, the bond will be sold at par, or maturity value, if the current interest rate
exceeds the bond’s coupon rate; the bond will be sold below par value or at a discount
and if the current interest rate is less than the bond’s coupon rate, the bond will be sold
above par value or at a “premium”.
3. A bond holder owning a long-term bond is exposed to greater interest rate – risk than
when owning short – term bonds.
Yield –to- Maturity and bond value
Since the bonds coupon rate (kc) is fixed for the life of the bond, the following (YTM) bond
price relationship is expected.
1. If YTM > Kc the bond sells at discount below par value
2. If YTM < kc the bond sells at premium above par value
3. If YTM = kc the bound sells at par value.
Preferred Stock Valuation
Preferred stock is defined as equity with priority over common stock with respect to the
payment of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid
security which shares features with both common stock and debt.
Preferred Dividend/Preferred Dividend Rate
The preferred dividend rate is expressed as a percentage of the par value of the preferred
stock. Since the preferred dividends are generally fixed, preferred stock can be valued as a
constant growth stock with a dividend growth rate equal to zero. Thus, the price of a share of
preferred stock can be determined using the following equation.
Vp = Where: Vp = the preferred stock price,
Dp = the preferred dividend and
Kp = the required return on the stock
Illustration
Find the price of a share of preferred stock given that the par value is $100 per share, the
preferred dividend rate is 8% and the required return is 10%.
Solution: Vp = but Dp = Mx Dr = 100x0.8=$8, Vp = = $80

Common Stock Valuation

Like bonds and preferred stocks, a common stock’s value is equal to the present value of all
future cash flows expected to be received by the stock holder. However, in contrast to bonds,

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Financial Management

common stock does not promise its owners interest income or a maturity payment. Nor does
common stock entitle the holder to a predetermined constant dividend as preferred stock does.
For common stock, the dividend is based on the profitability of the firm and on managements’
decision to pay dividends or to retain the profits for reinvestment purposes. Thus, the growth
of future dividends is a prime distinguishing feature of common stock.
Let’s develop common stock valuation process by steps starting with a one – period horizon
and progressing to a multiple period horizon.
One Period Valuation Model
For an investor holding a common stock for only one year, the value of the stock would be the
present value of both the expected cash dividend to be received in one year (D1) and the
expected market price per share of the stock at year end (P1) .If ks represents an investors
required rate of return, the value of common stock (po) would be:
Po = +

Illustration
Assume kuku Company is considering the purchase of stock at the beginning of the year. The
divided at year end is expected to be Br 3 and the market price by the end of the year is
expected to be Br 80. If the investor’s required rate of return is 15 percent. What would be
the value of the stock?
Solution: Po= + = +
= Br 3 (0.870) + Br 80 (0.870)
= Br2. 61 + Br 69.6
= Br 72.21
This is to mean, the implication of Br 72.21 is that if the investor buys this stock for Br 72.21
today, receives a Br 3 dividend, and sells the stock for Br 80 one year from now, the investor
will earn the 15% rate of return that was required to invest.
Two Period Valuation Models
Now, suppose the investor plans to hold a stock for two years before selling. How is the value
of the stock determined when the investment horizon changes? The answer is to incorporate
the additional years information be.
Po = + +

Illustration
Assume the expected dividend for ABC Company in the second year be Br 4, the expected
price at the end of the second year be Br100, and the required rate of return remains 15%.
Find the value of the common stock.
Solution: Po = + +

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= +

= Br 79.38
Multiple Period Valuation Model
Since common stock has no maturity date and is held for many years, a more general, multi
period model is needed. The general formula for common stock valuation model is defined as
follows:

Po = +

Po = + + D3 + …………. + +

Illustration
Assume that an investor expects Br 3 dividend for each of 10 years and a selling price of Br
50 at the end of 10 years. What would be the value of the common stock today?

Solution: Po = + = 3 (6.15) + Br 50 (0.38)

= Br 37.75

Cost of Capital: An Overview

Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When
the firms are using different sources of finance, the finance manager must take careful
decision with regard to the cost of capital; because it is closely associated with the value of
the firm and the earning capacity of the firm.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating
and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the help of the following equation.
K = rj + b + f. Where, K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.

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What Impacts the Cost of Capital?

1. Riskiness of earnings
2. The debt to equity mix of the firm
3. Financial soundness of the firm
4. Interest rate levels in US/ global market place
Significance of Cost of Capital
Cost of capital is useful as a standard for evaluating investment decisions, designing a firm’s
debt policy, and appraising the financial performance of top management.
o Major Types of Cost of Capital (Sources of Capital)
The following are some of the major type of cost of capital;
Specific cost of capital, Cost of Debt (Kd),
Cost of Preferred Stock (Kp) Cost of Common Stock (Ks)
The Specific Cost of Capital
A firm’s capital is supplied by its creditors and owners. Firms raise capital by borrowing it
(issuing bonds to investors or promissory notes to banks) or by issuing preferred or common
stock. The overall cost of a firms capital depends on the return demanded by each of these
suppliers is called the specific cost of capital.
Cost Debt (kd)
When a firm borrows money at a stated rate of interest, determining the cost of debt, kd, is
relatively straight forward. Cost of debt is the after tax cost of long-term funds through
borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual
or redeemable.
Thus, the after tax cost of debt, kd, is computed as follows:

Where:
T = Corporate tax rate
F = Flotation cost as a percentage of value of debt
Ki = investor required rate of return before tax
If there is no flotation costs, the Kd can be computed using the formula

Illustration
Assume that XYZ company is to issue long term notes, investors will pay Br, 1000 per note
when they are issued if the annual interest payment by the firm is Br 100.The firm’s tax rates
is 45%, and flotation costs are 2%.calculate the cost of this debt.

Solution: kd= = 4.4%

Cost of Preferred Stock (kp)

The cost of preferred stock (kp) is the rate of return investors require on a company’s new
preferred stock plus the cost of issuing the stock. Therefore, cost of preferred stock is
calculated as follow.
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Or If flotation cost exists

Where:
Kp = The cost of the preferred stock issue; the expected return
Dp = The amount of the expected preferred stock dividend
Pp = the current price of the preferred stock
F = the flotation costs per share
Illustration
Suppose that Midrock Company has preferred stock that pays Br 13 dividend per share and
sells for Br 100 per share in the market. Compute the cost of preferred stock.
Solution: Kp = = = 13%
The Cost of Common Stock (ks) (Cost of Internal Equity)
The cost of common stock equity, ks is the rate at which investors discount the expected
dividends of the firm to determine its share value. Two techniques for measuring the cost of
common stock equity capital are available. One uses the constant growth valuation model
(Gordon growth model); the other uses the capital asset pricing (CAPM). Using the Constant
Growth Valuation Model (the Gordon Growth Model), the cost of common stock, Ks is
computed as follows;

Where: Po= Value of common stock

D1 = Dividend to be received in 1 year
Ks = Investors required rate of return
g = rate of growth
Solving the model for ks results in the formula for the cost of common stock
+ g or
Illustration
Suppose that IBM industries common stock is selling for $ 40 a share. A next year's common
stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of 5% per
year indefinitely. Compute the expected rate of return on IBM’s common stock.
Solution: +g=
= 0.105 + 0.5 = 0.155 or 15.5%
A firm may pay dividends that grow at changing rate; it may pay dividends that grow at
changing rate; it may pay no dividends at all for the managers of the firm may believe that
market risk is the relevant risk. In such cases, the firm may chose to use the capital asset
pricing model (CAPM) to calculate the rate of return that investors require for holding

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company’s common stock according to the degree of non diversifiable risk present in the
stock.
The CAPM formula for the cost of common stock is;

Ks = rf = b (rm - rf )

Where:-
Ks = the required rate of return from the company’s common stock equity
B = Beta coefficient which is an index of systematic risk
rf = Risk free rate
rm = Return on the market portfolio
Illustration
Suppose AB industries has a beta of 1.39, the risk free rate as measured by the rate on short
term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market is
12%. Given those market conditions find the required rate of return for BATU’S common
Stock.
Ks = rf + b (rm-rf)
= 3% + 1.39 (12%-3%)
= 3% + 1.39 (9%)
0.1551 or 15.5%
Learning Activity
Dear instructor form student in group and facilitate students as they discus on cost of capital
and types of securities mostly used by business enterprise in Ethiopia.
Continuous Assessment
Instructors giving these learning tasks are expected to give a continuous assessment and
feedback to students that include quizzes, assignment, and participation in class.
Summary
This section presented a series of intrinsic value models that can be used to measure the
desirability of financial assets as investment alternatives. Important value concepts together
with their valuation models were identified, intrinsic value was chosen because of its ability to
incorporate cash flows, the time value of money, and investor’s required rate of return
separate intrinsic value models were constructed for valuing bonds, preferred stock, and
common stock.
Concepts and practical question
1. Define cost of capital.
2. Discuss Cost of capital computation based on certain assumptions.
3. Explain the classification of cost.
4. Mention the importance of cost of capital.
5. Explain the computation of specific sources of cost of capital.
6. How overall cost of capital is calculated?
7. Explain various approaches for calculation of cost of equity.

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3.3.3.5. Section V: Capital Budget

Pre Test
Dear student critically think and tray to answer these questions before proceeding to this
section.
1. What is capital budgeting? Explain its needs and importance.
2. What are the stages of capital budgeting process?
3. Explain the various methods of capital budgeting techniques.
....................................................................................................................................................
.........................................................................
Definition of Capital Budgeting

Capital budgeting refers to the process of evaluating and selecting long-term investments that
are consistent with the firm’s goal of maximizing owner wealth. One of the key
responsibilities of the managers is to review and analyze proposed investment decisions in
order to make sure that only those that contribute positively to the value of the firm are
undertaken.

Indeed, capital budget concerned to all whole process of analyzing projects whose returns are
expected to extend beyond the period of one year and deciding which project should be
included in the capital project. It includes expenditures for land, building, equipment, and for
permanent additions to working capital associated with plant expansion, for advertising and
promotion campaigns, and for research and development programs.

Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds, but the available
funds are limited, therefore the firm before investing projects, plan control its capital
expenditure.
2. Long-term: Capital expenditure is long-term in nature. Therefore financial risks involved in
the investment decision are more. If higher risks are involved, it needs careful planning of
capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once
the decision is taken for purchasing a permanent asset, it is very difficult to dispose of those
assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment
Approaches/ Steps to Capital Budgeting
A systematic approach to capital budgeting requires the following procedures to follow:
1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities.
3. The estimation and forecasting of current and future cash-flows.

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Financial Management

4. A set of decision rules that can differentiate acceptable from unacceptable alternatives.
5. The building of suitable administrative framework that is capable of transferring the
required information to the decision level.
6. The controlling of expenditures and the careful monitoring of project implementation.
If the financial managers under take all the 6-step under the capital budgeting approach, they
are able to make effective capital budgeting decisions.
Capital Budgeting Project Evaluation Techniques
Capital budget evaluation techniques are classified as:
I. Traditional methods (or Non-discount methods)
II. Modern methods (or Discount methods)
I. The Traditional Technique
They are called the traditional techniques because they do not consider the time value of
money concepts in ranking investment proposals. Two methods are included under the
traditional technique, namely the payback period and the accounting rate of return.
a) The payback period
Pay-back period is the time required to recover the initial investment in a project. If the cash
flows from the project are in an annuity form, the payback period can easily be determined by
dividing the initial investment by the annual cash flow in the annuity. That is,
Payback period (in years) = Initial investment
Annual Cash flows
When the cash flows from the project are not in an annuity, the payback period is computed
as follows:
Payback period = year before full recovery + UN recovered cost

Annual flow during the next year

Illustration
Suppose the project costs Br.24, 000 and annual cash inflow is Br.6,000 for five years.
Calculate the payback period?
Pay back period = 24,000/6000 = 4 years
The figure implies the initial investment amount of this particular project will be recovered
with in the first four years of the project life (i.e. 6,000 for each four years is 24,000).
Illustration
The computation of the payback period when the cash flows from the project are not in an
annuity form assumes the project requires an initial investment of 60,000 Birr. The after-tax
cash flows from the project are Br.8,000 during year 1, Br.15,000 during year 2, Br.22,000
during year 3, Br.20,000 during year 4, and year 5 each. Here, the cash flows are not uniform.
In this case, we first need to compute the cumulative cash flows of the project.
Year Annual Cash flow Cumulative cash flow
1 8,000 8,000
2 15,000 23,000
3 22,000 45,000

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4 20,000 65,000*
5 20,000 85,000
Looking at the cumulative cash flows, the cumulative cash flows at the end of year 3, which is
45,000, is less than the initial investment where as the cumulative cash flows at the end of
year 4 65,000 is slightly greater than the initial investment. This implies that the payback
period for this project is greater than 3 years but less than 4 years. The exact payback period
can be computed as follows:
Payback period = 3 years + (15,000/20,000) years
= 3 years + 0.75 years = 3.75 years, or
= 3 years +(0.75) (12 months) = 3years & 9months.
Advantages of Payback Period:
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence
Disadvantage of Payback Period
The disadvantages of the payback period are:
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
b) The Accounting Rate of Return (ARR)
The accounting rate of return (ARR) is the rate of return that calculated by dividing the
projects expected annually net profit by the average investment outlays. It is symbolized
as follow:
ARR =
Average cost of Investment = Original costs + salvage value
2
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.
Illustration
The accounting rate of return consider the project that has the original investment Br.70,000,
and the salvage value of Br.6,000 at the end of year 4. The straight line method of
depreciation is used. Income before depreciation and taxes Br.40,000 for year 1, Br.42,000
for year 2, Br.36,000 for year 3, and Br.50,000 for year 4. Determine the accounting rate of
return if income tax rate on the project is 4 percent. To compute the accounting rate of return
(ARR) for this project, first we should have to determine the average investment and the
annual depreciation amount.
Average investment = initial investment +salvage value
2
= (70,000 + 6000)/2 = Br.38, 000
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Financial Management

Annual depreciation using straight line method is computed as follow:

= Initial cost – salvage value
Estimated life of project
= (70,000 - 6,000)/4 = Br.16, 000
Then compute the new profit for each year during the four years.
Year 1 Year 2 Year 3 Year 4
Income before depr. & taxes 40,000 42,000 36,000 50,000
Less: Annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Income taxes (40%) 9,600 10,400 8,000 13,600
Then we compute the average Net Profit during the four years as follow:
Average net profit= (14,400 + 15,600 + 12,000 + 20,400)/4
= Br.15, 600
Hence, ARR = Average Annual net profit = 15,600 = 0.41 or 41%
Average cost of investment 38,000
The obtained figure implies that, for an average Br.1 invested in this project, there is an
average return 41 cents in the form of net profit per year over the entire four years life of the
project

Advantage ARR
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Disadvantage ARR
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project
3. it ignores the fluctuations of the cash flows over the life of the project
II. The Discounted Cash flow (DCF) Criteria (Techniques)
The discounted cash flow techniques are other methods of evaluating and ranking investment
project proposals. These techniques employ the time value of money concept, unlike the
traditional methods. Four DCF techniques are discussed in the sections that follow.
a) The discounted Payback period
Discounted payback period is computed in the same manner as that of the regular payback
period except the discounted cash flows are used in the case of the former on. The expected
future cash flows are discounted by the project’s cost of capital.
b) The Net Present Value (NPV) Method
The NPV method is an investment project proposals evaluating and ranking method using the
NPV, which is the difference between the present values of future cash inflows and the
present value of cash outflows, discounted at the given cost of capital, or opportunity cost of
capital. In order to use this method properly, the following procedures are followed.
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1. Find the present value of each cash flow, including both inflows and out flows
using the cost of capital of the project for discounting.
2. Sum the discounted cash outflows and the discounted cash outflows separately.
3. Obtain the difference between the sum of the cash inflows and the sum of the cash
flows.
If all the cash outflows for the project occur at time zero, i.e. at the beginning of year 1, the
present value of the cash out flows is the same as to the net investment amount.
Decision Rule for the Net Present Value
If the projects are independent, the projects with positive net present values are the ones
whose implementation maximizes the wealth of shareholders. Hence, such projects should be
accepted for implementation. If the projects, on the other hand, are mutually exclusive, the
one with the higher positive NPV should be accepted leading to the rejection of the projects
with lower positive NPV. Projects with negative NPV should not be considered for
acceptance in the first place. Therefore, if the firm takes on a project with a positive NPV, the
wealth of the shareholders will be improved as indicated above.
Illustration
The NPV as a method of project proposals ranking assume that a given project is expect to
have an initial investment and project life of 40,000Birr and 5 years respectively. The annual
after-tax cash flow is estimated at 12,000Birr for each one of the five years. Using the
required rate of return of 10 percent, what is the net present value (NPV) of the project? How
do you judge the acceptability of this project?
Present value of annuity = (12,000) (Annuity factor)
The annuity factor given the period of 5 years and discount rate of 10 percent is 3.791
substituting the factor I the equation above
PVA= (12,000) (3.791) = 45,492Birr
Present Value of Cash out flows = 40,000Birr
Hence,
The Net Present value (NPV) = Present Value of inflows - present value of outflows
=45,492 - 40,000=5,492Birr
Since the project makes the net present value (NPV) of positive 5,492Birr, it should be
accepted. Consequently, the wealth of the shareholders would increase by 5,492Birr in total
as the result of accepting and running this project. Thus, the project can be judged as an
acceptable one.
C) The Internal Rate of Return (IRR)
The internal rate of return is the discount rate which equates the present value the expected
cash flows with the initial investment outlays. In other words, IRR is a method of ranking
investment project proposals using the rate of return on an asset (investment). At IRR, the
sum of the present values of all cash inflows is equal to the sum of the present values of all
cash outflows. That is: PV of cash inflows = PV (cash outflows). Hence, the net present
value of any project at a discount rate that is equal to the IRR is zero.
Computing the Internal Rate of Return
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Financial Management

1. Uniform Cash Inflows over the Life of the Project:

In this case, the present value table of an annuity can be used to calculate the IRR since the
cash inflows are in annuity form. The following steps can be followed to calculate IRR for
constant cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow
Step 2: Find the IRR by looking along the appropriate line (year) of the present value
of annuity table until the column which contains the critical discount factor (i.e. the
discount factor computed under step 1) is located.
Illustration: Assume that a project has a net investment of birr 26,030 and annual net cash
inflows of birr 5000 for seven years. What is the IRR of this project? In order to answer this
question, we need to follow the two steps discussed above.
Step 1 Compute the critical discount factor.
Discount factor = 26,030 = 5.206
5,000

Step 2 After determining the critical discount factor, we look for the value that is equal to this
factor in the present value of annuity table across the line corresponding to 7 years (i.e. n=).
The discount factor of 5.206 appears in the 8 percent column on the line/row of 7 years.
Therefore, the IRR is 8 percent.
2. Fluctuating Cash Inflow over the Life of the Project
When the cash inflows from the project are not in an annuity form, IRR is calculated through
an iterative process or through "trial and error". It may be difficult to identify from which
discount rate to start. A good first guess can be made by estimating the discount factor. In
general, the following procedures are used to calculate the IRR of the non-uniform net cash
flows.
Step 1:Find the estimated discount factor.
Estimated discount factor = Net investment
Average cash inflows

Step 2:Look at the present value of annuity table to obtain the nearest discount rate for the
estimated discount factor determined in step 1.
Step 3:Calculate the NPV using the discount rate identified in step 2.
Step 4:If the resulting NPV is positive, choose the higher discount rate and repeat the
procedure. Choose the lower discount rate if the NPV is negative, and repeat the same
procedure until you find the discount rate that equates the NPV to zero.
Illustration
Assume a project that has an initial investment of 40,000 Birr and the following net cash
inflows: Year 1, 15000Birr; year 2, 10000Birr; Year 3, 10000 Birr; year 3, 15000 Birr; and
year 5, 15000Birr. What is the IRR of this project?

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Year Weight Cash flow x weight

1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
190,000
Average net cash flow= 190,000 = 12,667
15
Estimated discount factor = 40,000 = 3.158
12,667
By looking up in the present value table for annuity, the approximate the discount factor of
3.158 on line 5 (n=5) is 18 percent. Thus, the starting point of the iterative process is 18
percent. The NPV of the project using the discount rate of 18 percent is:
NPV = (15,000) (0.847) + (10,000) (0.718) + (10,000) (0.609) + (15,000) (0.516) +
(15,000) (0.437) - 40,000 = 40,270 - 40,000 = 270

Since the NPV computed using a discount rate of 18 percent is positive, are have to take a
discount rate higher than 18 percent in search for the NPV of zero. So the second guess can
be 19 percent. The NPV of the project using the discount rate of 19 percent is:
NPV = (15,000) (0.840) + (10,000) (0.706) + (10,000) (0.593) + (15,000) (0.499) +
(15,000) (0.419) - 40,000 = 39,260 - 40,000 = -640
As per the above calculations, NPV is negative when the discount rate of 19 percent is used
and positive when the discount rate of 18 percent is used. Thus, the IRR for this project falls
between 18 percent and 19 percent. If the exact IRR is needed, the interpolation method is
can be used. That is:
Step 1: Obtain the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum and
subtract the resulting quotient from the larger rate.
Step 2: Divide the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum and
subtract the resulting quotient from the larger rate. By following the above two steps, the
exact IRR for this project is thus:
The absolute sum of the NPVs = |270| + |-640| = 270 + 640 = 910
Then, dividing the NPV of the smaller rate by the absolute sum, you get 270/910 = 0.30 to
the nearest two digits after the decimal point, and add this figure to the smaller rate (IRR =
18% + 0.30% = 18.30%) or you can divide the NPV of the larger rate by the absolute sum,
and you get -0.70 ( -640/910 = - 0.70) to the nearest two digits after the decimal point, and
subtract this figure from the larger rate to obtain the exact IRR. IRR = 19% - 0.70% =
18.3%. In both cases, you arrive at the same IRR value of 18.3 percent.
Decision Rules for IRR

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A project whose IRR is greater than its cost of capital, or Required Rate of Return (RRR) is
accepted and whose IRR is less than the RRR of the project is rejected.
d. Profitability Index (PI)
Profitability index is the ratio of the present value of the expected net cash flow of the project
and its initial investment outlay.
PI = PV/IO where =
PV = Present value of expected net flows
IO = Initial investment outlay
PI = Profitability Index
Projects with Unequal Lives
Earlier in this section, we assumed that mutually exclusive projects have equal lives. But
there are many situations in which alternative investments have unequal lives. The most
common example of such situation is unequal replacement decision. Since it is not
appropriate to compare projects of unequal lives, adjustment must be made. Even though
there are different methods (approaches) of dealing with mutually exclusive alternatives with
different lives, three of them are introduced in this chapter.
Learning Activity
Dear instructor form students in Group and make as student discus on capital budget. Please
give capital budget of Agribusiness enterprise in Ethiopia for each group and facilitate as
students carefully evaluate long term investment of a given organization.
…………………………………………………………………………………………………
…………………………………………………………………………………………
Continuous assessment
Assessment method employed includes: Quiz, Test, Group Discussion and presentation.
Summary
Capital budget is a set of investment alternatives the returns of which occur over a period of
two or more years. The three most widely used capital budgeting criteria are (1) the payback
period, (2) The net present value, and (3) the internal rate of return. Each of these criteria has
its advantages and disadvantages. Even though NPV is the most conceptually difficult of the
three criteria, it is the preferred on because it takes into account the time value of money and
it is measured in birr amount unlike the payback period which is measured in years and the
IRR which is measured in terms of rate.

3.3.3.6. Section VI: Capital structure

Pre–Test
Dear student have you heard the term capital structure. Pleas think to the term carefully and
explain nature and theory of capital structure there by all about optimum capital structure,
Discuss the various factors affecting the capital structure. State your idea in line to the
environment and how should a firm go about choosing its debt– equity ratio?

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Financial Management

…………………………………………………………………………………………………
………………………………………………..
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make up

capitalization. Hence, Capital structure is defined as the process of mix of long-term debt and
equity maintained by the firm. Deciding the suitable capital structure is the important decision
of the financial management because it is closely related to the value of the firm.
Optimum capital structure
Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum. Optimum capital structure
may be defined as the capital structure or combination of debt and equity that leads to the
maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity shares, preference shares and bond.
Factors determining capital structure
The following factors are considered while deciding the capital structure of the firm.
Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost
financing such as debt, equity and preference share capital. It is closely related to the overall
cost of capital.
Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
long- term finance such as equity and debt consist of fixed cost while mobilization.
When the cost of capital increases, value of the firm will also decrease. Hence the firm must
take careful steps to reduce the cost of capital.
Nature of the business: Use of fixed interest/dividend bearing finance depends upon the
nature of the business. If the business consists of long period of operation, it will apply for
equity than debt, and it will reduce the cost of capital.
Size of the company: It also affects the capital structure of a firm. If the firm belongs to
large scale, it can manage the financial requirements with the help of internal sources. But if it
is small size, they will go for external finance. It consist high cost of capital.

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Financial Management

Legal requirements: Legal requirements are also one of the considerations while dividing
the capital structure of a firm. For example, banking companies are restricted to raise funds
from some sources.
Requirement of investors: In order to collect funds from different type of investors, it will
be appropriate for the companies to issue different sources of securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long term
funds from external sources. Hence the company must consider government policy regarding
the capital structure.
Theories of capital structure
Capital structure is the major part of the firm’s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relationship
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
There are four major theories explaining the relationship between capital structure, cost of
capital and value of the firm.
1. Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain level
of debt.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
Illustration
Awash Agro industry PLc. needs Br. 3,000,000 for the installation of a new factory. The new
factory expects to yield annual earnings before interest and tax (EBIT) of Br.500, 000. In
choosing a financial plan, Awash Agro PLC., has an objective of maximizing earnings per
share (EPS). The company proposes to issuing ordinary shares and raising debit of Br.
300,000 and Br.1, 000,000 of Br. 1,500,000. The current market price per share is Br. 250 and
is expected to decrees to Br. 200 if the funds are borrowed in excess of Br. 1,200,000. Funds
can be raised at the following rates.
–up to Br. 300,000 at 8%
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Financial Management

–over Br. 300,000 to Br. 1, 500, 000 at 10%

–over Br. 1,500,000 at 15%
Assuming a tax rate of 50% advice the company.
Solution
Earnings before Interest and Tax (BIT) less Interest Earnings before Tax
less: Tax@50%.
Alternatives

I II III
)Br. 300,000 debt( . Br. 1,000,000 debt( )Br. 1,500,000 debt(
500,000 500,000 500,000
24,000 100,000 225,000
476,000 400,000 275,000
238,000 200,000 137,500

238,000 200,000 137,500

2,700,000 2000,000 1,500,000
250 250 200
10800 8,000 7,500
238,000 200,000 137,500
No. of shares 10,800 8,000 7,500
Earnings per share 22.03 25 18.33

The security alternative which gives the highest earnings per share is the best. Therefore, the
company is advised to revise Br. 1,000,000 through debt amount and Br. 2,000,000 through
ordinary shares.
2. Net Income (NI) Approach
Net income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as the
total value of the firm. According to this approach, use more debt finance to reduce the
overall cost of capital and increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
Market value of the equity can be ascertained by the following formula:
S = NI
Kc
Where
S = Market value of equity
NI = Earnings available to equity shareholder
KC= Cost of equity/equity capitalization rate
Format for calculating value of the firm on the basis of NI approach.
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Financial Management

Particulars Amount

Net operating income (EBIT) xxx

Less: interest on bond xxx
Earnings available to equity holder (NI) xxx
Equity capitalization rate (Ke) xxx
Market value of equity (S) xxx
Market value of debt (B) xxx
Total value of the firm (S+B) xxx
)%( Overall cost of capital = Ko = EBIT/V xxx%
Illustration
(a) A Company expects a net income of Br. 100,000. It has Br. 250,000, 8% bond. The
equality capitalization rate of the company is 10%. Calculate the value of the firm and overall
capitalization rate according to the net income approach (ignoring income tax).
(b) If the bond debts are increased to Br. 400,000. What shall be the value of the firm and the
overall capitalization rate?
Solution
(a) Capitalization of the value of the firm

Br.
Net income 100,000
Less: Interest on 8% bond of Br. 250,000 20,000
Earnings available to equality shareholders 80,000
Equity capitalization rate 10%

80,000 x 100
10
Market value of equity = 800,000
Market value of bond = 250,000
Value of the firm(S+B) = 1,050,000
Calculation of overall capitalization rate

Overall cost of capital (Kc) = Earnings = EBIT

Value of the firm V
= 100,000 x 100
1,050,000
= 9.52%
(b) Calculation of value of the firm if bond debt is raised to Br. 300,000.
Birr.
Net income 100,000
Less: Interest on 8% bond of Br. 400,000 32,000
68,000
Equity Capitalization rate 10%

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Financial Management

Market value of equity = 68,000 x 100 = 680,000

10
Market value of bond = 400,000
Value of firm = 1,080,000
Overall cost of capital = 100,000 x 10
1,080,000 = 9.26%
Thus, it is evident that with the increase in debt financing, the value of the firm has increased
and the overall cost of capital has increased.
3. Net Operating Income (NOI) Approach
Is another modern theory of capital structure, suggested by Durand. This is just the opposite
of the Net Income approach. According to this approach, Capital Structure decision is
irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the
capital structure changes. Hence, the change in capital structure will not lead to any change in
the total value of the firm and market price of shares as well as the overall cost of capital. NI
approach is based on the following important assumptions;
 The overall cost of capital remains constant;
 There are no corporate taxes;
 The market capitalizes the value of the firm as a whole
Value of the firm (V) can be calculated with the help of the following formula:
V = EBIT
Kc
Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Kc = Overall cost of capital
Illustration
XYZ expects a net operating income of Br. 200,000. It has 800,000, 6% bond. The overall
capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate
(Cost of Equity) according to the net operating income approach. If the bond debt increased to
Br.1,000,000. What will be the effect on volume of the firm and the equity capitalization rate?
Solution
Net operating income = Br. 200,000
Overall cost of capital = 10%
Market value of the firm (V) = EBIT
Kc
= 200,000×100 = Br. 2,000,000
10
Market value of the firm =Br. 2,000,000
Less: market value of bond = Br. 800,000
1,200,000
= EBIT-I

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Financial Management

V-D
Where:
V= Value of the firm
D= Value of debt of capital
200,000 – 48,000 x 100
2,000,000 - 800,000
=12.67%
If the debentures bond debt is increased to Br. 1,000,000, the value of the firm shall remain
changed to Br. 2,000,000. The equity capitalization rate will increase as follows:
= EBIT- I
V-D
= 200,000 – 60,000
2,000,000- 1,000,000 ×100
= 140,000
1,000,000 ×100
= 14%.
4. Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
 There is a perfect capital market.
 There are no retained earnings.
 There are no corporate taxes.
 The investors act rationally.
 The dividend payout ratio is 100%.
 The business consists of the same level of business risk
EBIT (1-t)
Kc Where
EBIT = Earnings before interest and tax
Kc = Overall cost of capital
t= Tax rate
Rate of return

Ke

Kc

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Financial Management

D/E
Risk Bearing Debt
Risk Due Debt
Illustration
There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any
debt in its financing, while B has Br. 250,000 , 6% bond in its financing. Both the firms have
earnings before interest and tax of Br. 75,000 and the equity capitalization rate is 10%.
Assuming the corporation tax is 50%. calculate the value of the firm.
Solution
The market value of firm A which does not use any debt.
Vu= EBIT= 75,000 =75,000×100/10
Ko 10/100 = Rs. 750,000
The market value of firm B which uses debt financing of Br. 250,000
Vt= Vu + t Vu = 750,000 = t = 50% of Br. 250,000
= 750,000 + 125,000
= Br. 875,000

Learning Activity

Students are expected to discuss in group about the various issues concerning nature capital
structure, optimum capital structure and theory of capital structure.

Continuous assessment
The continuous assessment for this section has to be designed so as to test how much
students’ understanding various issues of capital structure and capital structure theory. The
Methodology includes quiz, group/individual, assignments, real data analysis, class works.
Summary

Dear student, with confidence, you have already acquired knowledge about capital structure
concepts and its effects on the earnings per share, and the cost of capital. In this unit, we have
considered various issues of capital structure. Capital structure is the major part of the firm’s
financial decision which affects the value of the firm and it leads to change EBIT and market
value of the shares. There is a relationship among the capital structure, cost of capital and
value of the firm. The aim of effective capital structure is to maximize the value of the firm
and to reduce the cost of capital.
Capital structure is defined as the process of mix of long-term debt and equity maintained by
the firm. Firm should use their resource particularly their equity and debt at optimum level
unless; a business exposed for great bankruptcy that in turn the business to risk. Thus,

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Financial Management

optimal capital structure is refers that mix of debt and equity that leads to the maximum value
of the firm. At any point in time, management has a specific target capital structure in mind,
presumably the optimal one, although this target may change over time.
The following factors are considered while deciding the capital structure of the firm.
Leverage, cost of capital, nature of the business, size of the company, legal requirements,
requirement of investors and government policy.
There are four major theories that help to explain the relationship between capital structure,
cost of capital and value of the firm. Those are, traditional Approach, net Income (NI)
approach, net operating income (NOI) approach and Modigliani and Miller approach.
In spite of the fact that, each firm has a theoretically optimal capital structure, as a practical
matter we cannot estimate it with precision. Accordingly, financial executives generally treat
the optimal capital structure as a range for example, 40% to 50% debt rather than as a precise
point, such as 45%. The concepts discussed in this chapter help managers understand the
factors they should consider when they set the target capital structure ranges for their firms.
Concept and practical question
1. 1. Define capital structure.
2. What is optimum capital structure?
3. Discuss the various factors affecting the capital structure.
4. Explain the capital structure theories and suggest your idea.
5. Which types of capital structure theory is more relevant acceptable by business. Illustrate
critically and clearly by using a model example.

3.3.3.7. Section VII: Value chain Finance

Pre-Test
What is Value chain? , What comes to your mind when you hear the term finance and value
chain finance? Student thinks critically to the question inline to other related disciple and
writes your opinion on a piece of paper before proceeding to this section on the space
provided for you here.
.
…………………………………………………………………………………………………
…………………………………………………………………………………………………

Meaning and Definition of Value Chain Financing

A value chain consists of a series of activities that add value to a final product, beginning with
the production, continuing with the processing or elaborating of the final product, and ending
with the marketing and sale to the consumer or end user. The inter-dependent linkages of the
chain and the security of a market-driven demand for the final product can provide suppliers,
producers, processors and marketing companies with more secure access to procurement and
sale of products. This reduces costs and risks of doing business and improves access to
finance as well as other services needed by those within the value chain.

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Financial Management

Value chain finance is defined as the flows of funds to and among the various links within a
value chain. Stated another way, it is any or all of the financial services, products and support
services flowing to or through a value chain to address the needs and constraints of those
involved in that chain, be it a need for finance, a need to secure sales, procure products,
reduce risk and/or improve efficiency within the chain. Value chain finance is a
comprehensive approach which looks not only at the direct borrower but rather analyzes the
value chain and those within it, and their linkages in order to best structure financing
according to those needs The linkages also allow financing to flow up and down the chain.
For example, inputs can be provided to farmers and repaid directly from the sale of the
product without having to go through a traditional loans process.
Value chain finance aims to address perceived constraints and risks by providing innovative
ways of delivering financial services to rural producers and agribusinesses. It means that the
product flow in the value chain is used as a carrier to provide financial services. This way of
financing can spread risk among the financial institutions and chain actors and provides
alternatives to traditional collateral requirements. Value chain development is a growing
approach worldwide to increase incomes of small producers and the economically active poor.
Access to adequate and timely financial services for all actors in the chain has proven a key
element for success. This implies that not only large producers and traders but also small
producers need access to appropriate financial services to make optimal use of value addition
and income generation. Such finance is, however, not always available, and chain actors
working in agricultural and rural value chains frequently complain about a lack of access to
financial services.

Traditionally, most regular banks and microfinance institutions have avoided rural finance
since this is perceived as risky and costly, with cash flow requirements that are irregular and
difficult to manage. Banks shy away from the high transaction costs and risks related to
agriculture such as crop failure, diseases and market fluctuations. Also the lack of physical
collateral is a restriction, and the risk of political interference that can damage the repayment
behavior of the rural clientele is high. Most microfinance institutions opt for high-density
urban or peri-urban areas where they serve their clients in standardized – often group- based –
systems, usually unfit for the needs of small farmers. In answer to this gap in finance, there
has been a tendency for companies worldwide to patronize a certain chain as a whole and
directly finance producers or traders. While this may be a good short-term solution to a
burning problem, one may also question whether this will provide enough perspective for
sustainability and scaling up of chain interventions needed to reach out to many millions of
small rural producers and processors worldwide. It provides tremendous potential for
unleashing capital, scaling up and sustaining chain prospects, but it needs to be managed and
organized well.

Value chain finance as defined above needs to build on trust and strong relationships between

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Financial Management

chain actors and financial service providers. Parties need to know and understand each other,
and this often requires a change of mindset, particularly with the banks but also with the
microfinance institutions, producers and companies. Innovative financial products and
services are needed such as insurance, over-drafts, factoring and leasing models, as well as
investment loans, guarantees and venture capital. Such a variety of sizes and types of financial
products can be offered only through a combination of financial service providers. This
requires building vertical linkages in the financial sector. For example, microfinance
institutions can link with producer organizations to provide small input loans to producers,
while banks simultaneously provide an investment loan to a processing company in the chain.
The microfinance institutions and banks need to link up to align their services in this chain for
potential overdraft facilities to small traders.
Rural Financing through Microfinance
Agriculture is the backbone of the economy in developing countries. Millions of micro-
entrepreneurs farmers, processors, traders, transporters, input suppliers – run their businesses
in difficult circumstances. Roads are potholed, distances are long, market prices are often
unknown, inputs may not be available, electricity is unreliable – these entrepreneurs need to
deal with many challenges on a daily basis. All this points to enormous entrepreneurial
potential, but most of these entrepreneurs are asset-poor and their management is informal, so
financial institutions are reluctant to finance them. Without finance, farmers may not be able
to buy good seeds, hire workers, or invest in equipment. For traders, a lack of finance may
mean that they cannot pay cash when they take delivery of the crops – so the farmers may sell
their crops elsewhere. For small-scale processors, a lack of finance may mean they cannot
expand their operations. Private financial institutions have tended to regard such micro-
entrepreneurs as un-bankable. Banks did not think they were creditworthy. Micro
entrepreneurs have no credit histories or collateral to offer; many are illiterate, so cannot fill
in the necessary paperwork. For bankers it is easier and more lucrative to provide a handful of
large loans to well-established businesses, rather than lots of small loans to such micro-
entrepreneurs (Yunus 2007: 47–8). With commercial banks reluctant to lend to the rural poor,
and public agricultural development banks closed because of bad performance, it took
microfinance institutions to prove that the asset-poor are bankable. With the use of new
lending techniques, the microfinance industry showed that lending to micro-entrepreneurs is
not only feasible, but can even be an attractive market opportunity.

In the 1970s and 1980s, microfinance institutions began providing small loans to poor people.
Muhammad Yunus, winner of the Nobel Peace Prize in 2006, pioneered microcredit. He set
up a project testing the idea of lending small amounts of money to the poor. The project
showed that the poor are very well able to pay back their loans. So in 1983, Yunus created a
special bank for this purpose in Bangladesh, called Grameen Bank (which means “village
bank”). The microfinance industry offers different types of financial products (International
Year of Microcredit 2005; De Klerk 2008):

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Financial Management

• Microcredit means making small loans to low-income entrepreneurs so they can develop
small businesses. Microcredit has helped large numbers of poor people to overcome problems
due to irregular and undependable income, and to smooth their cash flows.
• Micro-savings are deposit services that allow people to save small amounts of money for
future use, often without minimum balance requirements.
• Micro-insurance includes life insurance for entrepreneurs and their employees and, on a
smaller scale, crop insurance. It is a system by which people and businesses make payments
to share risks.
Microfinance has been truly revolutionary in proving that the poor are bankable, and also in
allowing poor people to signal their creditworthiness. But microfinance is not a panacea. Here
are some of its limitations:
 High costs - High interest rates
 Small amounts only -Short-term loans
 Little flexibility in loan conditions - Importance of savings underestimated
 Limited reserve of funds, etc.
Value Chain and Value Chain Actors
Unpredictable weather, dodgy infrastructure, volatile prices, low status, and little support:
despite all these problems, millions of farmers, traders, service providers and other micro-
entrepreneurs still manage to deliver fresh food every day to urban consumers, export produce
to distant markets, and stay in business. That reflects their resilience, creativity and huge
entrepreneurial potential. That potential becomes fully clear if we look at the value chains that
link farm production to rural trading and other sectors of the economy. These chains show
that farmers do not operate in isolation, but are part of a wider system. The small scale
businesses of asset-poor farmers at the beginning of the chain are intimately connected with
larger businesses of traders, food processors and supermarket chains at the end. A value chain
refers to the entire system of production, processing and marketing of a particular product,
from inception to the finished product. A value chain consists of a series of chain actors,
linked together by flows of products, finance, information and services. The chain actors are
the individuals or organizations that produce the product, or buy and sell it. Flows of finance,
information and services are not limited to the actors within a chain. Often other individuals
and institutions are involved, surrounding the chain actors. We call these “chain supporters”.
Chain supporters may provide various financial services to the chain actors. These supporters
include moneylenders, savings and credit groups, microfinance institutions, banks, equity
funds, and so on. The financial services they provide include loans, pre-financing,
shareholdings, factoring, leasing arrangements, and so on. It is not just financial institutions
that provide financial services; for example, an input supplier may give a farmer a loan in the
form of fertilizer, in return for repayment plus interest after harvest. Chain supporters may
also provide a wide array of non-financial services: input supplies, farm labor, transport,
grading, processing, storage, packaging, advertising, research, training, advice, organization,
and so on. These services may be vital for the chain actors to produce the product, turn it into

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Financial Management

something that someone else wants to buy, and deliver it to the consumers.
Financing Value Chain

For the value chain to work well, all the chain actors need access to finance. But their needs
for finance differ. A value chain perspective allows us to analyze the needs for finance for
different actors in the chain, and see opportunities to fill these needs. In general, different
chain actors have the following needs:
 Input suppliers: These provide farmers with seeds, chemicals, fertilizer and equipment,
plus perhaps training or in-kind credit (such as a loan of fertilizer).
 Farmers, their families and hired workers manage the crops or animals, and are involved
in post-harvesting practices and marketing. Most farmers have too little money. During
the production season, they often lack working capital to buy seeds and other inputs, or to
hire workers to plough the land, sow, irrigate, weed and harvest the crop and to care for
the animals.
 Farmer organizations Cooperatives and farmers’ associations have been one way of
delivering credit to farmers, with loans often tied to farm inputs and machinery. However,
like other semi-formal institutions, co-ops suffer from flawed administrative controls,
lack of independent decision-making, inflexibility and high administrative costs
(UNCTAD 2004). Apart from such loans, co-ops face various other financial needs. They
need to cover their administrative costs.
 Traders: The traders buy produce from the farmers or co-ops and bulk it before selling it
on. Their business depends crucially on making their working capital flow as quickly as
possible in buying and re-selling produce.
 Processors: Small-scale processors may also lack the working capital they need to buy
bulked products from a farmer group or trader.
 Wholesalers and exporters: These sell the processed product to local and global
retailers, supermarkets and corner shops, who in turn sell to consumers.
In general, there are three types of finance for the actors in the value chain:
 Chain liquidity - Short-term loans from suppliers or buyers within the value Chain
 Agricultural finance - Financial services from commercial banks, microfinance
institutions and other financial institutions
 Value chain finance - Financial services that are based on cooperation in the value
chain.
In value chain finance, a financial institution engages with the actors in the chain. This creates
a triangle of cooperation. The triangle is between the seller, the buyer, and the financial
institution. Together they make an agreement which covers four essential aspects:
• The product that is produced and sold
• The finance needed to produce and deliver the product
• The way the parties communicate and exchange information
• The way risks are managed.
Value Chain Finance Framework

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Financial Management

Value chain finance thus combines two worlds – the world of value chain actors with the
world of specialized financial service providers. The first is a world of soil management,
crops, irrigation, harvesting, transport, trading, consumer marketing, etc. The latter is a world
of balance sheets, risk management, credit rating, guarantees, collateral, and so on. The more
these two worlds are connected, the more they benefit from each other:
 Smallholder farmers, traders, processors and other chain actors can improve their
access to financial services. Previously they might be excluded from bank loans due to
a lack of collateral, a perception of high risk, or other barriers. But now they can
obtain external finance based on the fact that they have a small but viable business that
forms part of a wider and more stable system of value creation which implies value
chain.
 Financial institutions can develop whole new markets for their services. Smallholder
farmers, traders, processors and agribusinesses become bankable clients. In many
developing countries, agriculture is the backbone of the economy. Therefore, the
ability to serve this sector greatly increases the scope of action for financial
institutions.
In this section, we take a closer look at how value chain finance works. We will present a
framework to understand and analyze value chain finance.

The Triangle of value chain finance

In value chain finance, a financial institution engages with the actors in the chain. This creates
a triangle of cooperation (Figure 3.1). The triangle is between the seller, the buyer, and the
financial institution.
Together they make an agreement which covers four essential aspects:
 The product that is produced and sold
 The finance needed to produce and deliver the product
 The way the parties communicate and exchange information
 The way risks are managed.
Below we explain the four aspects in more detail, using another example of a farmer selling
coffee to a processor. Keep in mind that the buyer and seller could also be other chain actors,
like traders, wholesalers or retailers.

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Financial Management

Product flow Before the season starts, the farmer agrees to produce and deliver coffee to the
processor. Preferably this is recorded in a contract. The batch of coffee the farmer will deliver
at the end of the season is specified as precisely as possible to determine its market value.
Also, the parties estimate the costs needed to produce, harvest and deliver the coffee. In this
way, the parties calculate both the loan size that the farmer needs for working capital, as well
as the collateral value of the coffee. Normally a loan would not be more than 70% of the
market value of the product, in order to prevent repayment problems in case the harvest is
disappointing.
Financial flow After the purpose and the size of the loan are determined, the parties agree on
other important aspects of the financial product. These include:
 The interest rate of the loan.
 The timing and form of disbursement The loan may be given at once upfront, or in
small parts during the season when the farmer needs the money.
It may be paid directly to the farmer by the financial institution, or through the processor. It
may be paid in cash, or in kind, or in some combination of the two.
The timing and form of repayment The repayment can be done by the processor by
deducting the loan from the value of the coffee the farmer delivers. Or the money may be
repaid directly by the farmer;
• The liability for the loan The farmer may be solely responsible for repaying the loan, or it
may be a shared responsibility between the farmer and the processor.
Information flow The farmer and the processor also agree on the information that they will
share with the financial institution to guarantee the loan is managed well. There are two
important periods of information sharing:
• Before the loan is approved Before the financial institution can release the funds, it needs a
good insight into the operations of the farmer and his or her business relation with the
processor. This is called due diligence. Usually the financial agency will ask for information
like:
 A signed contract between the farmer and the processor
 Information on previous years’ production
 A detailed plan on how the loan will be used
 A membership statement of a cooperative or other types of farmer groups
 The farmer’s identity document
 Report of a technical audit of the farm.
 During the loan period After the loan is released, the financial institution will
appreciate frequent information about how the business is going. This is called
monitoring. Usually the financial institution will require a monthly report about the
status of the crop, the expenditure so far, and the outlook for the rest of the season.
Preferably the report is based on technical visits from the processor’s field staff.
 Risk management Finally, the parties agree on how the risks of the loan are being
managed. This is called securitization of the loan. In traditional finance, the bank
usually requires hard collateral in the form of fixed assets (such as land and
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machinery) for a total value of up to two times the size of the loan. The purpose of
value chain finance is to reduce hard collateral requirements so that farmers and other
chain actors can more easily access financial services. Usually in value chain finance
we see the following forms of collateral:
 The contract between buyer and seller As mentioned earlier, normally a loan
would not exceed 70% of the value of the contract.
 The product itself The financial institution may put a claim on the product while it
is being stored or shipped.
 Solidarity guarantees and peer pressure The financial institution may require that
peers, neighbors or family of the farmer become co-guarantors for the loan. Hence,
the triangle of value chain finance is an elaborate agreement between the buyer, the
seller and the financial institution. Their agreement covers the product, the financial
service, the sharing of information, and the management of risks. Each case study will
closely examine how these details are arranged in the particular finance deal at stake.
Situations of Value Chain Finance
Value chain finance is not always needed. A value chain may work well without any
intervention from a financial agent. If value chain finance is not tailored to the capacities and
needs of the businesses in the chain, it may even disrupt the value chain, creating bubbles,
debts and dependencies. Hence it is important to ask in which situations value chain finance is
relevant. In this section, we have identified three situations where value chain finance has
been used:
 Crafting new chains - Financial services are introduced as part of an integral approach to
building a new value chain with smallholder producers. The total intervention package
includes organizing farmers, technical assistance, building management capacity,
technological upgrading, securing a market outlet, and financing investments or business
operations. Sometimes a market opportunity exists, but no value chain to supply the
products that consumers demand. Or the other way around: sometimes producers have the
potential to deliver good products, but there is no value chain to link them to the market.
In these situations, it is necessary to build the value chain. Finance is then obviously one
of the aspects that need to be arranged.
 Expanding chain liquidity - Financial agents link up with an existing value chain to
finance the product flow in the chain, so that the businesses involved can grow and scale
up their operations. The main service here is the provision of working capital for the
production and trading of the farm product. Many value chains work reasonably well, but
they cannot realize their full potential due to a lack of working capital. For many traders,
farmers and small-scale processors, working capital is the main limiting factor for further
business growth. They have no collateral and therefore no access to bank loans.
 Unleashing investments in the chain - Financial agents’ link with an existing chain to
provide financial services that enable chain actors to upgrade their businesses through
middle-term investments (2–6 years). Besides the lack of working capital, another key

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reason value chains may not realize their full potential is the lack of investment capital.
Entrepreneurs need investment capital to upgrade their technologies, introduce new
products, develop new markets, etc.
The Chain of Value Chain Finance
Value chain finance is all about collaboration. There is collaboration between the financial
agent and the chain actors and service providers (the triangle). But often there is also
collaboration between various financial agents working together to serve the value chain:
local banks, international banks, microfinance institutions, development finance
organizations, insurance companies, and credit and saving associations. This is what we call
the chain of value chain finance. The chain of value chain finance further reduces the risks
and transaction costs of financing the value chain. We have seen three specific purposes of
cooperation among financial agents: covering all needs in the value chain, sharing the risks,
and reaching out to producers.
Opportunities and Limitations of Value Chain Finance
Value chain finance is an empowerment tool for the poor, but at the same time a profitable
market opportunity for the finance industry. Here we summarize some of the main
opportunities and limitations of value chain finance.
 Including the poor
For many poor people living in rural areas, accessing finance is difficult. A value chain
finance triangle is necessary to provide them with the funds they need. Nevertheless, for the
poorest access to value chain finance will remain difficult as they are often not structurally
involved in a supply chain. For value chains to include the poor, initiatives should also ensure
that they are empowered by building their capacity and involving them in decision-making.
Value chain finance should favor the poor, counter balancing the monopoly power of strong
chain actors.
 The added value of value chain finance
Upgrading in a value chain does not happen automatically. Bottlenecks often occur, especially
for small-scale suppliers. Value chain finance can help to overcome some of these bottlenecks
and smoothen or upscale a chain, so increasing the chain’s competitiveness. But its power
remains limited if it is not accompanied with market links, business skills, information flows,
the right policy framework, enforcement mechanisms, and so on. Value chain finance is not
the ultimate solution for a problem in a chain and it does not replace existing financial
services. It makes new sources and finance available for rural entrepreneurs and through this
contributes to the empowerment of the poor.
Value chain finance benefits processors and other buyers to secure a supply of better-
quality raw materials. hence, Value chain finance enables the processor to invest in its
suppliers and to gain their loyalty. Providing financial services directly to the processor
enables it to invest in processing equipment. This in turn, Consumers benefit by gaining
access to higher-quality products, a more regular supply and a greater choice of products.
.

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Value chain finance has immense contribution for the financial institution. Namely, increase
in the number of clients and the size of a loan portfolio, a gain in the trustworthiness of
clients, and improvements in the quality of financial services the institution can offer. Value
chain finance also, mitigates risks for financial institutions and reduces their transaction costs.
For example, the costs of credit screening, monitoring and enforcement are lower because the
chain actors do much of this work themselves. That cuts the financial institution’s costs and
lets it provide loans at lower interest rates.
The product flow in the value chain is used as a carrier to provide financial services. Market
risks (the risk that no buyer will be found) are almost absent, because the buyer is involved in
the deal. Default risks (the risk that farmers do not pay back the loan) are lower, because
repayment is done right at delivery of the farm products. Production risks (the risk that the
farmer fails to produce the product) remain, but may be lower because the buyer may give
technical assistance to the farmer.

Value Chain Finance and Microfinance

Value chain finance both complements and goes beyond microfinance. An important
difference is that value chain finance is tied to actors, transactions and relations in a value
chain. Therefore it can reach other actors than microfinance, and at the same time it leaves out
actors that (fortunately) microfinance institutions can reach. Micro-finance can be part of
value chain finance, but needs to be complemented with other types of financial services that
can address varied needs in the chain.
Learning Activity
Dear instructor form a students in group and facilitate as student discus in value chain, value
chain finance and it role as well as, on the ‘the role of Ethiopia Commodity Exchange (ECX)
and Commercial Banks in Ethiopia in value chain financing
…………………………………………………………………………………………………..
…………………………………………………………………….
Continuous assessment
 Case Study, visiting, report writing and presentation.
Summary
Agriculture is the backbone of the economy in developing countries. Millions of micro-
entrepreneurs farmers, processors, traders, transporters, input suppliers – run their businesses
in difficult circumstances. Without finance, farmers may not be able to buy good seeds, hire
workers, or invest in equipment. Private financial institutions have tended to regard such
micro-entrepreneurs as un-bankable. Banks did not think they were credit worthy. Micro
entrepreneurs have no credit histories or collateral to offer; many are illiterate, so cannot fill
in the necessary paperwork. Value chain finance is a process of linking financial institutions
to the value chain actors, offering financial services to support the product flow, and building
on the established relationships in the chain. Value chain finance aims to address perceived
constraints and risks by providing innovative ways of delivering financial services to rural
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producers and agribusinesses.

Concept and Practical question
1. What is value chain and value chain finance
2. Describe value chain actors
3. illustrate the economic benefit of value chain finance in Ethiopia by using examples
4. What are the opportunities and challenges of value chain finance in Ethiopia

3.3.3.8. Section VIII: Women Empowerment and Finance

Pre-test
Dear student do you have knowledge about women empowerment and financing of women to
empower in the economy? Do you believe as there is strong relationship between women
empowerment and finance? Have you think enough before the role of finance in empowering
women? Think critically and try to answer these question and write on piece of paper in
different angle before reading this section. ………………………………………………..
……………………………………………………………………………………

"Empowerment" has been used to represent a wide range of concepts and to describe a
proliferation of outcomes. The term has been used more often to advocate for certain types of
policies and intervention strategies than to analyze them, as demonstrated by a number of
documents from the United Nations (UNDAW 2001; UNICEF 1999), the Association for
Women in Development (Everett 1991), Feminist activist writings often promote
empowerment of individuals and organizations of women (Sen and Grown 1987; Jahan 1995;
Kumar 1993) but vary in the extent to which they conceptualize or discuss how to identify it.

Women's empowerment needs to occur along the following dimensions: economic, socio-
cultural, familial/interpersonal, legal, political, and psychological. However, these dimensions
are very broad in scope, and within each dimension, there is a range of sub-domains within
which women may be empowered. Women’s empowerment can be achieved through different
approaches which includes empowering women in the context of appropriate national policy
and regulatory frameworks; investments in basic social and economic infrastructure that is
gender-sensitive; microfinance, particularly for women; capacity building that includes
gender budget policies; business frameworks that are sensitive to the gender implications of
their undertakings; and calls for governments to “Mainstream the gender perspective into
development policies at all levels and in all sectors”.
o Types of Empowerment
Economic empowerment: women's access to savings and credit gives them a greater
economic role in decision-making through their decision about savings and credit. When
women control decisions regarding credit and savings, they will optimize their own and the
household's welfare. The investment in women's economic activities will improve
employment opportunities for women and thus have a 'trickle down and out' effect. The
financial sustainability and feminist empowerment paradigms emphasize women's own

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income-generating activities. In the poverty alleviation paradigm, the emphasis is more on

increasing incomes at the household level and the use of loans for consumption. In the
feminist empowerment paradigm, individual economic empowerment is seen as dependent on
social and political empowerment.
Increased well-being: access to savings and credit facilities and women's decision about what
is being done with savings and credit strengthens women's say in economic decisions of the
household. This enables women to increase expenditure on the well-being of themselves and
their children. This is the main concern in the poverty alleviation paradigm. Women's control
over decision-making is also seen as benefiting men through preventing leakage of household
income to unproductive and harmful. Other welfare interventions are advocated in addition to
micro-finance, typically nutrition, health and literacy campaigns to further decrease
vulnerability and improve women's skills. In the financial self-sustainability and feminist
empowerment paradigms, improved well-being is an assumed outcome from increasing
women's economic activities and incomes.
Social and political empowerment: a combination of women's increased economic activity
and control over income resulting from access to micro-finance with improved women's
skills, mobility, access to knowledge and support networks (Figure 6). Status within the
community is also enhanced. These changes are reinforced by group formation, leading to
wider movements for social and political change. The financial self-sustainability paradigm
and the poverty alleviation paradigm assume that social and political empowerment will occur
without specific interventions to change gender relations at the household, community or
macro-levels. By contrast, the feminist empowerment paradigm advocates explicit strategies
for supporting women's ability to protect their individual and collective gender interests at the
household, community and macro-levels.
Economic empowerment is the capacity of women and men to participate in, contribute to and
benefit from growth processes in ways which recognize the value of their contributions,
respect their dignity and make it possible to negotiate a fairer distribution of the benefits of
growth. Economic empowerment increases women’s access to economic resources and
opportunities including jobs, financial services, property and other productive assets, skills
development and market information. Women’s economic participation and empowerment are
fundamental to strengthening women’s rights and enabling women to have control over their
lives and exert influence in society.2 It is about creating just and equitable societies. Women
often face discrimination and persistent gender inequalities, with some women experiencing
multiple discrimination and exclusion because of factors such as ethnicity or caste. Women
perform 66% of the world’s work, and produce 50% of the food, yet earn only 10% of the
income and own 1% of the property. Whether the issue is improving education in the
developing world, or fighting global climate change, or addressing nearly any other challenge
we face, empowering women is a critical part of the equation (Former President Bill Clinton
addressing the annual meeting of the Clinton Global Initiative (September 2009) ).

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The economic empowerment of women is a prerequisite for sustainable development, pro-poor

growth and the achievement of all the Millennium Development Goals (MDGs). Gender
equality and empowered women are catalysts for multiplying development efforts. Investments
in gender equality yield the highest returns of all development investments.3 Women usually
invest a higher proportion of their earnings in their families and communities than men. A
study in Brazil showed that the likelihood of a child’s survival increased by 20% when the
mother controlled household income. Increasing the role of women in the economy is part of
the solution to the financial and economic crises and critical for economic resilience and
growth. However, at the same time, we need to be mindful that women are in some contexts
bearing the costs of recovering from the crisis, with the loss of jobs, poor working conditions
and increasing precariousness.
Microfinance programs have significant potential for contributing to women's economic,
social and political empowerment. Access to savings and credit can initiate or strengthen a
series of interlinked and mutually reinforcing 'virtuous spirals' of empowerment.
Microfinance development has emerged as major strategy to combat the twin issues of
poverty and unemployment that continue to pose a major threat to the polity and economy of
both the developed and developing countries. In recent years, governmental and
nongovernmental organizations in many low income countries have introduced credit
programs targeted to the poor. Many of these programs specifically target women, based on
the view that they are more likely than men to be credit constrained, have restricted access to
the wage labor market, and have an inequitable share of power in household decision making.
The Grameen Bank of Bangladesh is perhaps the best-known example of these small-scale
production credit programs for the poor, and over 90% of its clients are women. Earlier work
(Pitt and Khandker 1998; Pitt et al. 1999; Pitt 2000; Pitt et al. 2003) has found that the effects
of program participation differ importantly by the gender of program participant. For
example, Pitt and Khandker (1998) find that the flow of consumption expenditure increases
18 taka for every 100 taka borrowed by women, but only 11 taka for every 100 taka borrowed
by men. Pitt et al. (2003), using a totally different approach to parameter identification, find
that credit provided women importantly improves measures of health and nutrition for both
boys and girls, while credit provided men has no significant effect.

Learning Activity
Students should visit financial institutions, especially micro-finances and discuss its impact on
women……………………………………………………………………
Continuous assessment
o Case Study, Field Visit, Group Discussions, Presentation.

3.3.3.9. Section IX: International Financial Management

Pre test

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What is international financial management? In a global economy how international

agreements affect international financial decisions and examine the reasons why firms expand
operations beyond their domestic borders and the issues related to taxes with foreign
currencies exchange before proceeding to this section.
-----------------------------------------------------------------------------------------------------------------
-------------------------------------
Over Views of International Financial Management

Financial management decisions of most firms are not confined to domestic borders. Many
financing and investment decisions involve economies and firms outside a firm’s own
domestic borders either directly, through international transactions, or indirectly, through the
effects of international issues on the domestic economy. International financial management
is the management of a firm’s assets and liabilities considering the global economy in which
the firm operates. Many U.S. firms derive a large part of their income from international
operations. For example, Dow Chemical, International Business Machines, Coca-Cola, U.S.
Corporation, derives most of their sales from outside the United States.
The global economy
Many countries export a substantial portion of the goods and services they produce. Indeed,
that the role of exports and imports in the economy is ever increasing. Countries will produce
and export goods and services for which they have a comparative or competitive advantage
and countries will import goods and services for which other countries have a comparative or
competitive advantage. A comparative or competitive advantage may originate from a
country’s natural resources (such as petroleum), its human resources (such as education), its
capital investment (which may or may not be aided by the government), or its laws or
regulations that may promote certain activities.
For example, the chief exports of the United States are machinery, transportation equipment
(e.g., trucks and aircraft), chemicals, and grain products, which relate to the vast capital
investment in the heavy industries (e.g., steel production) and acreage devoted to farm
products. The chief import of the United States is petroleum because of the diminished U.S.
oil reserves combined with the strong demand for fuel and petroleum-based products (e.g.,
plastics). Many advocate free trade, which is trading among countries without barriers such as
export or import quotas and tariffs (taxes on imported goods).
Multinational Firms
A multinational company is a firm that does business in two or more countries. Most large
U.S. corporations are multinational firms, deriving a large part of their income from
operations beyond the U.S. borders.
Companies expand beyond their domestic borders for many reasons:
To gain access to new markets. Growth in the domestic market may slow, but there may be
opportunities to grow in other countries..

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To achieve production efficiency. By shifting operations to other, lower-cost nations, a

company can reduce its operating costs.
To gain access to resources. Companies that rely on natural resources, such as oil
companies, establish access to these resources by establishing subsidiaries in other countries.
This assures these companies of their basic materials to maintain uninterrupted operations.
■ To reduce political and regulatory hurdles. Shifting operations to other countries may be
necessary to overcome the many hurdles established by nations to protect their domestic
businesses. For example, in the 1970s Japanese auto firms established manufacturing and
assembly plants in the United States to avoid import quotas imposed by the United States.
■ To diversify. Over any given period of time, the level of business activity may be different
in different countries. This results in opportunities to reduce the overall fluctuations in a
firm’s business revenues and/or costs by doing business abroad.
■ To gain access to technology. As technology is developed in other countries, a firm may
expand operations in other countries, say, through joint ventures, to assure access to patents
and other developments that ensure its competitiveness both domestically and internationally.
Foreign Currency
Doing business outside of one’s own country requires dealing with the currencies of other
countries. Financial managers must be aware of the issues relating to dealing with multiple
currencies. In particular, the financial manager must be aware of exchange rate and the related
currency risk.
Exchange Rates
The exchange rate is the number of units of a given currency that can be purchased for one
unit of another country’s currency; the exchange rate tells us about the relative value of any
two currencies. The exchange rate can be quoted in terms of the number of units of the
domestic currency relative to a unit of the foreign currency (referred to as a direct quotation),
or in terms of the number of units of the foreign currency relative to a unit of the domestic
currency (referred to as an indirect quotation).
Consider the exchange rate of U.S. dollars and Swiss francs. From the perspective of the U.S.
firm, the exchange rate would be the number of U.S. dollars needed to buy a Swiss franc. If
the rate is 0.70, this means that it takes $0.70 to buy one Swiss franc, 1CHF. From the
perspective of the Swiss firm, the rate is US$0.70/1CHF = 1.4286; that is, it takes 1.4286
Swiss francs to buy one U.S. dollar.
Countries have different policies concerning their currency exchange rate. In the floating
exchange rate system, the currency’s foreign exchange rate is allowed to fluctuate freely by
supply and demand for the currency.
Another type of policy is the fixed exchange rate system, where the government intervenes to
offset changes in exchange rates caused by changes in the currency’s supply and demand. The
third type of policy is a managed floating exchange rate system, which falls somewhere
between the fixed and floating systems. In the managed floating rate system, the currency’
exchange rates are allowed to fluctuate in response to changes in supply and demand, but the

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government may intervene to stabilize the exchange rate in the short-run, avoiding short-term
fluctuations in the exchange rate.
Currency Risk
Currency risk, also called exchange-rate risk, is the risk that the relative values of the
domestic and foreign currencies will adversely change in the future, changing the value of the
future cash flows. Financial managers must consider currency risk in investment decisions
that involve other currencies and make sure that the returns on these investments are sufficient
compensation for the risk of changing values of currencies. The uncertainty of exchange rates
affects a financial manager’s decisions.
Consider a U.S. firm making an investment that produces cash flows in British pounds, £.
Suppose you invest £10,000 today and expect to get £12,000 one year from today. Further
suppose that £1 = $1.48 today, so you are investing $1.48 times 10,000 = $14,800. If the
British pound does not change in value relative to the U.S. dollar, you would have a return of
20%:
Return = £12,000 - £10,000 = 20%
£10,000
But what if one year from now £1 = $1.30 instead? Your return would be less than 20%
because the value of the pound has dropped in relation to the U.S. dollar. You are making an
investment of £10,000, or $14,800, and getting not $17,760, but rather $1.30 times £12,000 =
$15,600 in one year. If the pound loses value from $1.48 to $1.30, your return on your
investment is:
Return = $15,600 – $14,800 = $800 = 5.41%
$14,800 $14,800
The buying and selling of foreign currency takes place in the foreign exchange market, which
is an over-the-counter market consisting of banks and brokers in major world financial
centers. Trading in foreign currencies may be done in the spot market, which is the buying,
and selling of currencies for immediate delivery, or in the forward market, which is the
buying and selling of contracts for future delivery of currencies. If a U.S. firm needs euros in
90 days, it can buy today a contact for delivery of euros in 90 days. Forward contracts can be
used to reduce uncertainty regarding foreign exchange rates. By buying a contract for euros
for 90 days from now, the firm is locking in the exchange rate of U.S. dollars for euros. This
use of forward contracts in this manner is referred to as hedging. By hedging, the financial
manager can reduce a firm’s exposure to currency risk.
Purchasing Power Parity
If there are no barriers or costs to trade across borders (including costs to move the good or
service), the price of a given product will be the same regardless of where it is sold. This is
referred to as the law of one price. Applied to a situation in which there are different
currencies on either side of the borders, this means that after adjusting for the difference in
currencies, the price of a good or service is the same across borders. In the case of different
currencies, the law of one price is known as purchasing power parity (PPP). If purchasing

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power parity holds, we can evaluate the exchange rate of two currencies by looking at the
price of a good or service in the two different countries.
Tax Considerations
Taxes paid by corporate entities can be classified into two types: income taxes and indirect
taxes. The former includes taxes paid to the central government based on corporate income
and possibly any local income taxes. Indirect taxes include real estate value-added and sales
taxes, as well as miscellaneous taxes on business transactions. Corporate income tax affects
investing and financing decisions in foreign countries.
Intercompany Transactions and Transfer Prices
As just explained, to minimize taxes in foreign countries with high tax rates, a firm may use
excessive debt in controlled entities. To further reduce taxes, the interest rate on the “loan”
may be above market rates.
An excessive interest rate charged to subsidiaries in high tax countries is but one expense that
a company with foreign operations can consider reducing worldwide taxes. It is common for a
company’s subsidiaries in different countries to buy and sell goods from each other. The price
for the goods in such intercompany transactions is called a transfer price. Establishing
transfer prices to promote goal congruence within a multinational company is a complicated
topic. In practice, goal congruence seems to be of secondary importance to the minimization
of worldwide taxes manly income taxes and import duty taxes in the establishment of transfer
prices.
Financing Outside Domestic Market
Because of the globalization of capital markets throughout the world, a corporation is not
limited to raising funds in the capital market where it is domiciled. Globalization means the
integration of capital markets throughout the world into a global capital market. Indeed,
financial management is quit important in a global economy.
From the perspective of a given country, capital markets can be classified into two markets:
an internal market and an external market. The internal market is also called the national
market. It can be decomposed into two parts: the domestic market and the foreign market.
The domestic market is where issuers domiciled in the country issue securities and where
those securities are subsequently traded.
The foreign market of a country is where issuers not domiciled in the country issue securities
and where the securities are then traded. The rules governing the issuance of foreign securities
are those imposed by regulatory authorities where the security is issued. For example,
securities issued by non-U.S. corporations in the United States must comply with the
regulations set forth in U.S. securities law and other requirements imposed by the Securities
and Exchange Commission.
Hedging Currency Risk
Given the existence of currency risk, the natural question is how a firm can hedge this risk.
There are four derivative instruments that firms can use to protect against adverse foreign

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exchange rate movements: (1) currency forward contracts, (2) currency futures contracts, (3)
currency swaps, and (4) currency options. We discuss each below.
Currency Forward Contracts
forward contract is one in which one party agrees to buy the underlying asset, and another
party agrees to sell that same underlying asset at a designated price and date in the future.
Forward contracts in which the underlying asset is foreign exchange is called a currency
forward contract.
Most currency forward contracts have a maturity of less than two years. For longer-dated
forward contracts, the bid-ask spread for a forward contract increases; that is, the size of the
spread for a given currency increases with the maturity. Consequently, forward contracts
become less attractive for hedging long-dated foreign currency exposure.
Forward contracts, as well as futures contracts, can be used to lock in a foreign exchange rate.
In exchange for locking in a rate, the hedger forgoes the opportunity to benefit from any
advantageous foreign exchange rate movement. Futures contracts that are creations of an
exchange have certain advantages over forward contracts for types of underlying assets.
For foreign exchange, however, the forward market is the market of choice rather than futures
contracts, which we describe next.
Currency Futures Contracts
There are U.S.-traded currency futures contracts for the major currencies traded on the
International Monetary Market (IMM), a division of the Chicago Mercantile Exchange, as
well as other exchanges. The maturity cycle for currency futures is March, June, September,
and December. The longest maturity is one year. Consequently, as in the case of a currency
forward contract, currency futures are limited with respect to hedging long-dated foreign-
exchange risk exposure.
Currency Swaps
When issuing bonds in another country where the bonds are not denominated in the base
currency, the issuer is exposed to currency risk. One way to hedge this risk is to use currency
futures contracts or currency forward contracts. While these derivative instruments allow an
issuer to lock in an exchange rate, they are difficult to use in protecting against the currency
risk faced when issuing a bond or when facing other long term liabilities..
Learning Activity
Students are expected to discuss on the issues of international financial management, effect of
international agreement on international financial decision, the task of financial manager of
multinational company and currency exchange.
Continuous assessment
The continuous assessment for this section has to be designed so as to test students’
understanding of international financial management issues, effect of international agreement
on international financial decision and currency exchange on multinational financial decision
in global economy. The assessment should be in the form of quiz, group/individual
assignments, real data analysis, class works and presentation.

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Summary
International financial management is the management of a firm’s assets and liabilities in the
global economy. Issues such as foreign currency exchange, taxes, and unique risks, such as
political and currency risk, make the financial management of a firm more challenging.
Countries trade with each other, exporting goods and services for which they have a
comparative advantage and importing goods and services for which they do not have a
comparative advantage.
Companies do business outside of their own country’s borders to gain access to new markets,
to enhance production efficiency, to gain access to resources, to reduce hurdles to expand in
other nations, to diversify, and to gain access to certain technology. Financial managers of
companies doing business abroad must be aware of foreign currency exchange and its
associated risk. Changes in foreign currency exchange rates can affect a company’s
profitability. Currency forward contracts, currency futures contracts, currency swaps, and
currency options are four derivative instruments that firms and investors can use to protect
against adverse foreign exchange rate movements and financial manager must have
awareness.
Concept and basic question
1. List reasons why firms may want to do business outside of their own country’s borders.
2. How does a fixed-rate exchange rate system differ from a floating- rate exchange system?
3. Suppose that the exchange rate for one U.S. dollar for another currency, say the euro yen
(EY), is $1 US = 2EY. And suppose that if the exchange rate remains the same, you will get a
20% return on your investment in the EY’s currency over a one-year period.
4. If the exchange rate were to change such that $1 = 3 EY, what return do you expect on your
investment?
5. If the exchange rate were to change such that $1 = 1.5 EY, what

Proof of ability

At the end of this learning task the student will be evaluated through summative exam,
attachment, simulation (50 or 40%). It incorporates all the sections in the learning task.
Methods of
Product: The student has Criteria assessment
able:
Structured and fully explained content of
To Compute different the statements, demonstrated correct Written exam,
financial ratios, value computations on the statement and case study, group
securities and determined analyze the data. assignment
time value of money.
Identified policies, activities or
To Analyze financial procedures, steps followed in evaluation, Written exam,
statements of business use of relevant data, real case analyzed group work,

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Financial Management

(Ethiopian &International context),

enterprises and evaluate Logicality/validity of the argument, supervision,
long term investment. correctness and precision presentation.

To make planning and Steps followed, data gathered, data Written exam,
decision on investment. analyzed, employed logical/scientific Case study,
argumentation/forecast presentation.
Identified policies, activities or
To Report different procedures, steps followed in evaluation, Written exam,
financial management use of relevant data, real case analyzed presentation
actions like time value of (Ethiopian &International context),
money, cost of capital, Logicality/validity of the argument,
value of bonds and stocks, correctness and precision
capital budget, and capital
structure.

Identified policies, activities or

To analyses value chain procedures, steps followed in evaluation, Written exam,
finance among value chain use of relevant data, real case analyzed Case study,
actor, illustrate the outcome (Ethiopian &International context), presentation
of value chain finance. Logicality/validity of the argument,
Solve the challenges of correctness and precision
value chain finance.

Identified policies, activities or

To examine the currency procedures, steps followed in evaluation, Written exam,
exchange and currency use of relevant data, real case analyzed Case study,
exchange contract and its (Ethiopian &International context), presentation
risk Logicality/validity of the argument,
correctness and precision

Reference
1. Anthony G. Puxty, J. Colin, Richard M.S. Wilson; Financial Management: Method and
meaning.
2. Block & Hurt, 1989.Foundation of Financial Management. 5th ed.
3. Bodil Dickerson, 1998. Introduction to Financial Management. 4th ed. USA: McGraw hill
Co.

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4. Dayananda, Ridard Irons, steve Harrison, John Herb Ohan, and Patrick Rowland, Capital
Budgeting.
5. Eugene F. Brigham, Louis C.Gapenski, 1993. Intermediate Financial Management. 4th
Edition. Dryden press.
6. Frank J. Fabozzi and Pamela: financial Management and Analysis 2nd edition.
7. Gallagher H. and Andrew M., Fincial Management; Principles and Practice; 4th edition.
8. Harold K. and Gary E., Understand Financial Management: a practical guide.
9. Jae K., Joel G. Shaum’s outline Series; theory and problems, second edition.
10. James C.Van horne, 1998.Financial Management and Policy. 11th ed. Stanford University.
11. Keown & Martin, 1995. Basic Financial Management. 6th ed. University of Phoenix.
12. Scott smart, William L. Megginson, Introduction to Corporate Finance, 7th edition.
13. Yaregal Abegaz, 2007, Fundamentals of Financial Management. 1st ed. Addis Ababa:
Accounting Society of Ethiopia Press.
14. Lucian Peppelenbos, 2010 KIT and IIRR, “Value Chain Finance”, ISBN: 978-94-6022-
055-5. www.kitpublishers.nl
15. Anteneh Gorfu and Kenenisa Lemi, 2011, Financial management I, distance and
continuing educational study material, Jimma University, Ethiopia.
16. Brigham and Houston, Fundamentals of financial management, ninth edition

Appendixes
1. Financial statements (income statements and balance sheets) of ABC Company for two
consecutive accounting periods
ABC Company, Income Statements
Variables 2010 2009
Sales 3,074,000 2,567,000
Less Cost of Goods Sold 2,088,000 1,711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General and Adm. Expenses 468,000 445,000
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000
Less Interest Expenses 93,000 91,000
Net Profit Before Tax 325,000 212,000
EPS 2.90 1.81

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Net Income After Tax 230,750 150,520

Less Preferred Stock Dividends 10,000 10,000
Earnings Available to Common 220,750 140,520
Shareholders

2. The composition of current assets for ABC and XYZ company in terms of Birr
ABC and XYZ Balance Sheet Statement
ABC Company XYZ Company
Cash 0 7,000
Marketable Security 0 17,000
Account recivable 0 5,000
Inventories 35,000 6,000
Total Current Asset 35,000 35,000
Current Liabilities 0 6,000
Account payable 14,000 2,000
Notes payable 0 4,000
Accrued expense 0 2,000
Total current liability 14,000 14,000

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