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PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 1
CHAPTER ONE: THE FINANCIAL ENVIRONMENT

1.1 INTRODUCING FINANCIAL MANAGEMENT

“Finance is the management of money”, it is the management of money and investment or borrowed or
raised for the purchase of investment or the process of borrowing or raising of money for purchase of
investment or to provide money for a project. Finance is the heart-beat of all corporate bodies. Thus
management of finance has become relevant in modern business organisations. The financial effective
management rules the finance world today, as the survival instinct of corporate organisation continues
to be an important factor. Finance is a function in business (private/public) that acquires funds for the
organisation and manages those funds within the organisation. These activities include preparing of
budgets; doing cash flow analysis; and planning for the expenditure of funds assets (Nickel, et. al. 2005).

Fund, on the other hand, refers to a sum of money saved or made available for a particular purpose. It
could be called money or financial resources. Fund can take any of the following forms: Physical cash,
credit facilities that is trade credits, bank credits, etc, allowances or discounts received, differed expenses
such as differed taxes rents, rates, bills, etc., undistributed profits in the form of retained earnings,
reserves, depreciation provisions, etc. Ekechi (2003) defines fund as follows: “the funds, available to an
entity are the sum of the credit it can obtain, the long-term debt available, and the equity capital contributed by the
owners and left in the form of retained earnings. They flow into and out of a business as it changes its scale of
operations”. We have short term and long-term sources of funds. Short-term sources of funds are funds
needed for a short period of time. It must be raised within the shortest possible term in order to be
useful for a school or educational institution. If there is a delay in raising the fund, it would no longer be
beneficial to the educational administrator. Short-term sources of funds can be grouped into two,
namely, Internal and external sources. The internal sources are the ones available within the
organization. They include retained earnings, depreciation provisions, accounts payable, new equity
and proceeds from sales of assets. External sources of funds are those sources outside the school or
educational institution, which require contact with external bodies like the United Nations Children's
Fund (UNICEF), United Nations Educational Scientific and Cultural Organisation (NESCO), the World
Bank, exchange programmes embarked upon by various institutions.

Financial management simply refers to the management function which is concerned with the effective and
efficient sourcing and use of fund that is operated within a framework of clearly understood objectives and on the
basis of logical concept. It refers to that management activity that is concerned with decisions on how to
procure funds, of an organisation's financial resources, disburse and give account of funds provided for
the implementation of educational programmes. It can further be defined as the process of planning and
controlling of the financial resources of a firm. It includes the acquisition, allocation and management of firms’
financial resources. It has today been identified with the totality of how the firm raises finance, where the firm
sources funds, the cost of such funds, the alternative method(s) of utilising such funds and the final benefits
accruing from using such funds. To Pandey (2007), it is that managerial activity that is concerned with the
planning and controlling of the firm’s financial resources; whereas to Akinsulire (2014), it involves the use of
accounting knowledge, economic models, mathematical rules, systems analysis and behavioural science
for the specific purpose of assisting management in its functions of financial planning and control. The
CIMA Official Terminology defines financial management as the identification of possible strategies capable of
maximising an organisation’s net present value, the allocation of scarce resources among competing opportunities
and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. Van and
Wachowicz (2009) define financial management as being concerned with the acquisition, financing, and
management of assets based on a set goal.
Financial management and control is the bedrock of organisational management and its framework
should provide the principal source of reference for guiding managers and their financial advisers in the
efficient, effective and proper use of organisation’s resources. The scope of financial management, also
referred to as the specific areas of financial management include: (a) The procurement and raising of
funds; (b) The allocation o f financial resources to different educational institutions; (c) The effective
utilisation of funds; (d) Supervision of cash receipts and payments; and (e) Safeguarding of cash
balance.
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It is the strategic management responsibility or activity that is concerned with decisions on how to
procure funds, of an organisation's financial resources, disburse and give account of funds provided for
the implementation of organisational programmes. It covers those aspects of the overall strategic plan
of the business that concern the financial managers. The understanding of the financial management
provides the managers with the conceptual and analytical insights to make those decisions relating to
finance skilfully.

In essence, financial management is concerned with the planning and controlling of the firm’s financial
resources or assets. The management of finance would bring about control and coordination of the
funds to achieve viability of projects and programmes in the business sector.

1.2 THE ROLE OF FINANCIAL MANAGERS

To the financial manager, the cost and benefit of capital remain the most important factor, since the
primary objective of the firm is to maximise the shareholders’ wealth i.e. the present value of equity
holding. The shareholders’ wealth is affected by: 1. the volume or quantity of future cash flows; 2. the
timing of future cash flow; and 3. the risk attached to the future cash flow. Before the financial would
pursue this objective, he has to know how that wealth is determined by planning and producing
projected financial statements of the organisation; by budgeting, monitoring and controlling to ensure
available resources meet up with each plan in financial terms and fall within the total funds available;
monitoring and evaluating the activities of the organisation in line with set standards to ascertain
deviations or variances and call for appropriate corrective actions; working closely with the financial or
capital market operators to determine or watch the effect of their decisions on the share price; and
performance of functions within the legal, political and socio-economic structures. In other words, the
handle matters bordering around legal, political and socio-economic issues as they affect the
organisation’s cash flow, etc.

Thus, the financial manager must strike a balance between all these opposing negating goals to ensure
the sustainable survival of the firm. In solving the problem therefore:
1. The financial manager must ensure provision of adequate information of both the creditors and the
shareholders.
2. The shareholders can be appointed as directors so as to ensure active participation in the firm’s
activities.
3. The shareholders must have personal knowledge of who the financial managers are, and at the same
time financial managers must have adequate knowledge of who the shareholders are especially of their
varying interests.
4. The financial manager must strike a balance between organisational goals and the creditors’ interests
so as not to operate against the object clause of firm, otherwise its activities will be declared ultra-vires.
5. The financial manager must prevent utilisation of short term fund to finance long term project and
vice versa that may breach trust between the creditors and the firm.
1.3 THE FUNCTIONS OF FINANCE
These are those fundamental decisions about finance functions that have an horizon that is generally
greater than a year. These are mainly investment decisions, financing decisions and the dividend
decisions.
The major objective of management is to maximise the shareholders’ wealth. The shareholders’ wealth
is the present value of future cash flows or present value of future dividends payable to the
shareholders infinitely. The Shareholders wealth maximisation is gradually becoming the single and
narrow objective of firms pursued by financial managers making it the most fashionable objective of the
firm. This is being achieved through a combination of goals such as:
Increase in the market share of the firm
Increase in reported profits
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 Continuous survival of the business
Provision of valued services to customers
Ensuring public acceptability of the firm and its products/services coupled with both social
acceptability and legal acceptability.
The role of financial management embraces three major decision areas namely investment, financing
and asset management decisions.
However, functions of financial management can further include:
decisions Tax Management
Dividend decision
Liquidity (working capital) management
Risk Management Assets Management
1. Financial Decision: This is the effective management of the capital structure of the business. The
financial manager must ensure maximum mixture of debt and equity in financing the firm, so as to
ensure maximum returns to the shareholders. The maximum mix of finance of debt and equity must be
established to maximise the returns of shareholders.
2. Investment Decision: The financial manager should select the most profitable investment portfolio that
will reduce to the barest minimum the risk of the organisation not maximising stockholders’ wealth.
Since this is involved with capital expenditures, it may also be referred to as capital budgeting decision
and is involved with allocation of funds to long term assets or investments that will yield cash flows or
benefit in the future. It involves evaluating the prospective profitability of new investments and
measuring of a cut-off rate against which the prospective return of new investments could be compared.
Since future is full of uncertain and predictability is difficult, then investment proposal should be
evaluated in terms of both expected return and risk.
3. Dividend Decision: Dividend is the return on investment and payment by a firm to its providers of
equity finance or shareholders. It is a major aspect of financing decision. The financial manager must
select the best dividend policy per time, the timing dividend, the forms of dividend to be paid, the
methods of payment, the amount to be paid etc. The fund(s) to use is an important factor to be
considered by the financial Manager. As dividend can be paid either in cash (cash dividend), or by share
allocation (stock dividend), the amount to be retained by the firm for future finances must also be
considered; since retained earnings is the cheapest source of fund to the firm, and a bird in hand is
worth more than ten in the bush. Thus, cash dividend will mean more to some section/segment of
investors than the retained earnings which still remains an integral part of the shareholders wealth.
Thus, the financial manager must be able to draw the border line between amount to be declared as well
as retained for future use.
4. Acquisition Decision: The financial manager must be interested in the organisations internal and
external growth. The growth of corporate organisation can be varied, either by way of merger or
acquisition, by backward integration or forward integration etc.
5. Working Capital Management (Treasury Management): It is the totality of management of cash, debtor
prepayments, stocks creditors, short term loans accruals, etc. to ensure the profitability of the firm’s
operation. It is the management of current asset and liabilities of firm, which is fast becoming important
in the face of high cost of capital. In modern financial world, efficient management of the working
capital will ensure maximum utilisation of scarce financial resource and ipso facto maximisation of the
shareholder’s wealth. This may also be considered as liquidity management decision whereby the financial
manager develop sound techniques of managing current assets to ensure profitability-liquidity trade-
off. In other words, it is the financing decision that is directly concerned with the firm’s acquisition or
disposal of assets and commitment or recommitment of funds on a continuous basis to influence
production, marketing and other functions of the firm on operational basis.

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6. Financial Control and Reporting: Financial control and reporting is an important function of the
financial manager. He must be able to present a lucid yet concise financial report that provides
management with required information necessary to take financial decision.
7. Risk Management: This considers all uncertainties or unforeseen factors likely to affect the future of
the business
8. Tax Management
1.4 The Objectives of Business
Efficient financial management requires the existence of objectives or goals of the organisation as a
whole because the financial manager’s judgement as to the efficiency of a financial decision is based on
the light of some standard. Two well -known objectives of a business are financial objectives and non-
financial objectives.
1.4.1 Financial Objectives
The financial objectives pursued to attain by a business organisation may include;
a) Profit maximisation: As the firm produces maximum output for a given input or uses minimum input
for producing a given output, efficiency is enhanced, efficient allocation of resources under the
competitive market conditions brings about profit, which is considered the most appropriate
measure of a firm’s performance. The share or equity holders have ultimate control of the business
firm and take residual profits. Profit maximisation suffers some deficiencies as the primary objective
of the business since it is vague; ignores the timing of returns; ignores risk; fails to serve as an
operational criterion for maximising the owner’s economic welfare or operationally feasible measure
for ranking alternative causes of action in terms of their economic efficiency. That profit increases
when additional capital is introduced does not mean the shareholder’s equity earnings per share is
also rising. A company may earn short term profit (usually reported quarterly or bi-annually) at the
expense of long term profitability. Moreover, profit maximisation ignores risks, an inevitable fact of
business life, as business operates into the future.
b) Profitability maximisation: This objective is more preferred to profit maximisation as it takes into
account volume of investment that is has to earn the profit, that is, both the profit and assets used to
earn such profit. It measures accounting return on capital employed (ROCE), return on investment
(ROI), return on equity (ROE), Return on Asset (ROA), Earnings per share (EPS), yields on
investment such as dividend yield as a percentage of stock market value, etc. Some limitations
encountered in this objective include challenges to define profit in the light of accounting and
economics regarding capital and profit to be used, the uncertainty or risk that goes with the earning
is ignored, time value of money is ignored; and operationally feasible measure for ranking
opportunity cost (alternative course of action or the expected benefits derivable if the resources are not
committed to a proposed project) in terms of their economic efficiency is not provided.
c) Liquidity: An organisation is also concerned with the degree of liquidity of its assets to enable it pay
off its debts as and when due. The liquidity objective is short term pursued only in a period of
temporary economic meltdown, when ‘survival instinct’ is critical. While lack of liquidity in the
extreme can lead to firm’s insolvency as more assets become idle, and no profitability is enhanced,
but a proper trade-off must be achieved between profitability and liquidity, using sound techniques
of managing current assets so that funds are made available when needed, thereby impacting the
size, growth, profitability, risk and value of the firm. But shareholders do not likely desire to put
their funds in a company that lacks the required aggressiveness for long term profitability and
growth, hence the financial manager is expected to estimate the firms needs for current assets,
commit funds to acquire or dispose of assets on a continual basis in an efficient manner that would
influence production, marketing and other functions of the company/firm.
d) Long term stability/survival: In certain cases, the business would depend on its assets guaranteeing
substantial loans used to finance the business, maintaining status quo of its present size over a
relatively long time period with no intention for immediate expansion.

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e) Growth: A good objective of the business signifying growth in profits and assets, both short term and
long profitability are pursued to enhance financial stability. It is however deficient some way as
growth can be achieved by merely raising funds in the capital markets.
f) Wealth maximisation: This is the net present worth maximisation advocated to be an appropriate and
operationally feasible criterion to choose among financial objectives of a business. According to
Pandey (2007), the net present value or wealth can be defined more explicitly as:

NPV = W =

Where C1, C2, represent stream of cash flows (benefits) expected to occur of the course of action is
adopted; C0 is the cash outflow (cost) of that action and k is the appropriate discount rate
(opportunity cost of capital) to measure the quality of Cs; k reflects both timing and risks of benefits
and W is the net present value or wealth, which is the variance or difference between present value
of the stream of benefits and the initial cost.
i) Shareholders’ wealth maximisation seeks to maximise return to ordinary share/equity holders as
measured by the sum of dividends and capital appreciation. It also implies maximising the value of
the company or its share price, the result of a general consensus among market operators regarding
the value of the company and mirrors its expectations concerning the current and anticipated future
profits of the firm; reflecting time value of money to them and the risk or uncertainty attached to
those profits.
ii) Corporate wealth maximisation encompasses all interest groups including the shareholders,
lenders, employees, suppliers, customers, government and the community. The group interests are
treated at par as against maximising the shareholders’ interest alone and since the withdrawal of the
contribution or services of each group may lead to the closure of the company, each of them must
therefore be acknowledged and paid a minimum ‘return’. The intention is to maximise long-term
earnings and to retain sufficiency to increase the corporate wealth for the benefit of all stakeholders.
1.4.2 Non financial Objectives
These cover other objectives essential for this attainment or overall strategic objective of the company
other than maximising wealth of its shareholders or stakeholders. It covers market value, sales growth,
market development, technological objectives, organisation structure and socio-ethical objective.
It entails promotion of welfare of employees, management and society and quality service to customers,
etc and the firm must compromise financial objective to satisfy non-financial objectives.
1.4.3 Value for money (V4M) Objectives
The V4M objective is ancillary to realising both financial and non-financial objectives and replaces the
cost-effectiveness by bringing in element of quality in service. The components of the value for money
are 3Es (i.e. economy, efficiency and effectiveness).
a) Economy – conversion of primary input (cash) into usable secondary input (staff, consumable and
capital item).
b) Efficiency – conversion of usable resources into output for instance making the best use of
available resources
c) Effectiveness, ensuring judicious use of resources and ensuring that efficiently produced output
are directed to achieving the desired outcome.
Using V4M approach requires the proper specification of required outcome and putting in place
appropriate monitoring and control systems. However, the problem of measurement of outcomes
(measurement problem which limit monitoring) and problem of who is the assessor or evaluator of the
quality of outcome (normative problem) are two basic problems involved with the V4M approach.
1.5 Corporate Governance
Corporate governance is the system by which companies are directed and controlled. It is the system by
which companies are directed and managed in the best interest of the owners and investors, the general
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 6
mechanisms by which management are led to act in the best interest of the company owners
(Akinsulire, 2004). It is the process, structures and relationship through which the board of directors
oversees what the executives do to achieve the objective of the company (Dayton 1984). Governance,
according to Mueller (1981) is concerned with the intrinsic nature, purpose, integrity and identity of the
institution with the basic focus on the entity is relevance, continuity and fiduciary aspects – monitoring
and overseeing strategic direction, socio-economic and cultural context, externalities and constituencies
of the institution.
1.5.2 Focus of corporate governance
Corporate governance addresses such issues as board accountability, value and strategies, risk
management, performance monitoring and reporting, stakeholders’ interaction, accountability of
management in respect to accounting disclosures, controls, internal and external audit, financial
reporting and reporting standards; and committees of the board including Executive, Audit,
Remuneration, Nomination, Risk Management and Special Committees.
1.5.3 Essence of Good Governance
i. promotion of a culture in which directors give priority to ethical pursuit in the best interest of
shareholders
ii. allows for a review of audit regulation, corporate disclosure framework and shareholder
participation to improve transparency and accountability of company, compliance to statutory
regulations, best ethical practices, consumer protection and regulatory requirement, etc
iii. ensures that audit committee assists the Board of Directors to manage the accuracy and integrity of
financial statements of the establishment, ensuring compliance with set legal and regulatory
requirements, efficient performance of the company’s internal audit functions;
iv. ensures credibility of company and existence of managerial systems that promote creative and
progress entrepreneurship;
v. helps to maximise corporate value by enhancing transparency and efficiency for the future
vi. prevention of exploitation of investors by the managers
vii. prevention of theft and fraudulent practices through the mechanisms designed by the board and
management; and
viii. ensuring that providers of finance to the company (shareholders, investors, lenders) have their
rewards or return on their investment (e.g. dividends, interests, etc).
1.5.4 Principles of Corporate Governance
There is no single unique or best principle of good corporate governance to be adopted by all
organisations. However, a company may adopt, design and implement strategies in the light of
regulatory framework that will produce an efficient, qualitative and result-oriented outcome for
optimising corporate performance and accountability in the interest of all stakeholders – shareholders
and the broader economy. The basic principles of good corporate governance to be adopted include
laying solid foundation for management and oversight; structuring the board to add value; promoting
ethical and responsible decision-making; safeguarding the integrity of financial reporting; making
continuous, timely and balanced disclosure to Stock Exchange (capital market regulators); respecting the
shareholders’ rights; recognising and managing risks; encouraging enhanced performance evaluation;
remunerating fairly and responsibly; recognising legitimate interest of stakeholders; and adhering to the
prescribed code of ethics by Nigerian Corporate Governance Code of Conduct (2003) as published by
Stock Exchange Commission (SEC).
1.5.5 The Roles of Key Organs of the Company in corporate governance
From the design of the company’s framework, the respective roles and responsibilities between the
Board and management team members should be clarified to:
(i) ensure a balance of authority so that no single individual would have unlimited (excessive) power;
(ii) enable the Board to provide strategic guidance for the company (oversee corporate strategy,
performance objectives, review and rectify risk management, monitor tactical management
performance oversee capital expenditure and financial reporting); and
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 (iii) ensure control mechanisms and processes are instituted to maintain integrity of financial
statements, ensure compliance with prescribed laws, ethics, and standing rules; and cordial
relationship with customers, suppliers and stakeholders.
1. Decision - making functions of the Board
It holds comprehensive power over the corporate management and perform the following decision –
making roles:
(i) maps the business vision, set the business goals and strategies; and formulate policies
(ii) approve business plans and budgets
(iii) supervises management team and evaluate its performance
(iv) reviews and replaces management as appropriate and review their remuneration from time to time
(v) monitor major capital expenditure, corporate takeovers and effectiveness of governance practices
(vi) handles conflict resolution among interest groups at managerial and directorship/shareholders level
(vii) ensures integrity of accounting and financial reporting systems
(viii) oversees information disclosure process and risk management
(ix) supervises the compliance with statutory laws and professing ethics
2. Independent Directors Roles
It is expected that the Directors and Board perform their duties faithfully to manage and direct company
in the interest of all stake-holders. To assure this fact, each of the Directors must have independence or
opinion, and some of them must be independent, acting independently of management and free from
any business or other relationship that could materially interfere with or reasonably be perceived to
materially interfere with the exercise of his unfettered/unbiased judgement. As an independent
director, he need not have shareholding in the company but brings into use his expertise, experience
and integrity in the affairs of the business firm.
1.5.6 Structure of the Board
In structuring the corporation of the Board, there is need to separate the roles of the Chairman and CEO
or a presiding Director position be created to checkmate the excesses of the Chairman/CEO, where
there is no separation between the two offices. Directors should not be automatically reappointed.
Appointment should be rotational. Prior to election, details of directorship position, involving
significant time commitments, should be disclosed to the shareholders.
1.5.7 Ethical and Responsible decision Making
Companies should formulate code of ethics or conduct to guide the Directors, CEO and other key
executive members. This helps to promote good ethical and responsible decision making and enhance
maintenance of confidence in the company’s integrity. Code of conduct should address ethical issues,
establish compliance standards and procedures, avoid conflicts of interests, assure confidentiality, fair
dealing, provide mechanisms to report unethical behaviour and ensure that disciplinary measures are
put in place for any violations. To achieve better ethical and responsible decision making processes,
clarify standard of ethical behaviour required of each member at all levels of management, who may
materially influence the integrity, strategy and operation of the business and its financial performance.
Publish the company’s position concerning the issue of Board and employees trading in company
securities and associated product operating to limit the economic risks of those investments, provide
adequate information to the directors on products, customers’ viewpoints, market conditions and
critical strategic and organisational issues, well ahead of meetings. The directors should be empowered
to have access to such information and seek their information from those in the company and obtain
first-hand knowledge of the business.
1.6 Integrity and Financial Reporting
To ensure integrity of financial reporting that the company should put in place:
- a structure of review and authorisation procedure that would enhance truthful and factual
presentation of financial position of the business;

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 8
- a structure that ensures independence and competency the company’s external auditors and an
audits committee to review and consider the financial statements;
- to achieve the best practice of corporate governance;
- the company’s policies should require the CEO and Chief Finance Officer to state in writing to the
Board that the company’s financial reports present a true and fair view, in all materials respects and
in accordance with relevant accounting/reporting standards.
- Audit committee should be established to ascertain that mechanisms and processes monitoring
procedures are well established,
- According to S.359 (4) CAMA 2004 (as amended), the audit committee should compose of a
maximum of six members or equal number of independent directors and representative of
shareholders
- All members of audit committee should be literate in financial and business matters and have
understanding of the industry in which the company operates for proper discharge of duties;
- At least one member must be a recognised professional accountant with relevant educational and
professional accounting qualification.
- All members of the audit committee should be subjected to annual re-election.
1.6.1 Disclosure to Stock Exchange
It is obligatory for companies to disclose appropriate material/corporate information in a timely and
accurate manner to shareholders and other stakeholders to raise their confidence and give equal
opportunity that market participants, while preventing unfair practices using undisclosed information
companies should disclose all information both positive and negative which may be of material
influence in the stakeholder’s decision making through proper means except those determined or
classified by law to be confidential. Investors should be able to access it in a fair, timely and cost efficient
manner. It is also expected that a listed company without delay notify the regulatory information
department of the Stock Exchange of any major new development capable of facilitating substantial
charges in the prices of listed securities, the company’s financial position, the performance of its
business or the company’s expectation as to its performance so that an investor would not out-perform
the market, thereby resulting in inefficient capital market.
1.6.3 Protection of Shareholders’ Right
According to the law of contract, the rights of the shareholders should be protected and where there
exists infringement of the rights, shareholders should know appropriate means of redress. Company
should empower their shareholders through effective communication with them and giving them ready
access to balanced, precise and understandable information, free from ambiguity or technical jargons.
Proper notices of meetings should be given and strategies to promote efficient participation should be
designed. External auditor should be requested to attend Annual General Meeting (AGM) and make
himself available to answer questions regarding the conduct of the audit and the preparation and
content of the auditor’s report.
1.6.4 Risk Management
Company should design its system to identify, access, monitor, and manage risks and inform investors
of material changes in the risk profile. The basic consideration in the traditional risk management policy
should be the reduction of the variability of the firm’s future cash flows. Risk management system
designed should enhance the environment for identifying and capitalising on opportunities that would
create value. The best practice is achieved by establishing policies on risk oversight and the
management and chief executive officer (CEO) or chief finance officer (CFO) should write to the Board a
statement specifying that the company’s financial report present a true and fair view, and that the
organisation is being run on sound system of risk management, internal compliance system and control
in all material respects.
1.6.5 Performance Evaluation
So that good corporate governance is ensured, the performance of the Board, its Committees, individual
directors (executive and non-executive) and key executive members should be reviewed on regular
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 9
basis and the process for performance evaluation disclosed. In other words, the Directors and
management team should have access to continuing education to update and enhance their skill and
knowledge required to discharge their responsibilities effectively and efficiently. The management’s
activities should be evaluated under objective standards including business results, attainment of
business strategy, goals, etc. The evaluation results should be utilised as a basis for determining
management appointment and remuneration, etc.
1.6.6 Fair and Responsible Remuneration
Corporate governance guidelines of a company should contain remuneration policy and procedures
that maintain talented and motivated directors and employees to encourage enhanced performance of
the company. The policies should clearly show the relationship between performance and
remuneration and made known to the shareholders in a formal and transparent method. The board
should establish a remuneration committee, consisting mainly of independent directors with a formal
charter to review and recommend on executive remuneration and incentive policies, senior
management remuneration, company’s recruitment, retention and termination policies, etc. In
remunerating the management, the limit should be within the amount approved by the shareholders
and the company’s financial condition.
1.6.7 Stakeholders/Shareholders’ legitimate interest
A code of conduct is required to be established and disclosed to address issues such as fair trading, fair
dealing, conflict of interests, social responsibility to community and individuals, corporate
opportunities, compliance with law and encourage the reporting on any illegal or unethical behaviour,
as companies have a number of legal and other obligations to shareholders and all other stakeholders.
Corporate governance should be able to curb management and arbitrary decisions. The company
should start rethinking of the impact of director’s role to create a well governed organisation; and the
board must be proactive and effective in policy making process and ensure that the following corporate
governance reforms are instituted:
a) Board members must be expert, knowledgeable in complexities of the company and its industry;
finance; relevant laws and regulations to enhance effective participation in effective decision-
making;
b) Board meeting procedures should focus on debating new decisions, strategies and policies not just
on reviewing past performance; and also to participate in the long-range planning process right
from the onset (i.e. outset or inception);
c) Board committees such as Audit, Compensation/Remuneration and Nominations, etc should be
strengthened; and
d) There should be an annual event of formal and periodic evaluation of the CEOs and directors, a
process which should involve dialogue with the CEO about his strengths, weaknesses, objectives,
personal plans, and, of course, performance.
SUMMARY
Financial management is concerned with identifying possible strategies capable of maximising
organisation’s wealth, allocation of scarce resources among competing opportunities and implementing
and monitoring chosen strategy in order to achieve stated objectives. Core financial decision functions
are investment decisions, financing decisions and dividend decisions. Other functions of financial
management include tax management, liquidity or working capital management, risk management,
wealth maximisation, etc. The objectives of business may be grouped into financial, non-financial and
value for money objectives.
Corporate governance is concerned with the system of how company are directed and controlled in the
best interest of all stakeholders. After the viewing of the principles and essence of corporate
governance, it is imperative to deduce that corporate governance is a powerful force that enables the
organisation to build a virile business excellence and elevate board competence and guide teamwork to
release immense benefits to shareholders and all stakeholders.

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CHAPTER TWO: FINANCIAL MATHEMATICS

2.1 Present Value, Annuity and Perpetuity

Present Value – derived from Compound Interest (I=A-P where A = P(1 + r)n). Principal (P) is the initial
amount, rate (n$) is the rate of interest and future value (FV) is the compounded sum and time period
(n) is number of years.
Therefore FV = P(1+r)n ; P = F V
(1+r)n
i.e. P = F V1 + F V2 + F V3 ------ + F Vn or
(1+r)1 (1+r)2 (1+r)3 (1+r)n
P = A1 --------- + An where i = interest rate
(1+i)1 (1+i)n and t = no of years
P = t/(1+i)
t or in operational terms, the equation is written as
P = A1 x PVF1, i + A2 x PVF2, i + A3 x PVF3, i + …. +An x PVF n, i
(PVF = Present Value Factor i.e. 1/(1+i)n)
Annuity - Annuity is the fixed payment or receipt each year for a specified number of years. It is a given
sum of money payable or receivable periodically into the indefinite future or over a specified period of time.
Where FV is a constant stream of cash flow to be received over a period of time at a given rate of interest
the PV of all the cash flow can be derived as follows:
FV = 1 – 1/(1+r)n; the Annuity factor being 1 – 1/(1+r)n/r
Annuity may be annuity certain when it is payable for a fixed number of years independent of any
contingency such as death; it is contingent annuity if it depends on uncertain events e.g. death. Annuity
that will not begin until after a certain number of years is known as defined or reversion annuity while
annuity that occurs when payments are made at the end of the payment intervals is known as ordinary
annuity or annuity immediate. Where payments are made at the beginning of each period rather than at
the end it is annuity due. It is simple annuity when interest conversion period and the payment period
coincide while where the interest conversion period differs from the payment period, it is general
annuity.
Perpetuity – Where a constant stream of cash flows is to be received indefinitely or over a large number
of years, the PV of the constant sum (A) is equal to PV = A/r.
Net Present Value – The NPV technique recognises that Naira arising at different time period will not
command the same value. Therefore a higher value per N1 is given for year 1 cash flow than that of
year 2 while that of year 2 will also be higher than that of year 3 and so on at the same discount rate. If
the discount rate is not applied, that is, if the time value of money is not recognised, all transactions will
appear discounted. NPV represents an unrealised capital gain that becomes realised when the project is
undertaken. To aid an investor, independent project with positive NPV is accepted while that with a
negative NPV is rejected; and also, in mutually exclusive projects, the project with the highest positive
NPV is selected. NPV recognises time value of money, gives absolute measure of profitability that
reflects in the shareholder’s wealth at a glance; gives a clear accept or reject recommendation for
decision making and uses all the cash flows over a project’s lifespan. Every potential project has an
NPV.
2.1.2 Compounding Annuities, Perpetuities, Present and Future Values
Perpetuity is an annuity occurring indefinitely (Pandey, 2007). It is a constant cash flow that occurs at
periodic intervals to infinity. Perpetuities are not very common in financial decision-making. For
instance, the case of irredeemable preference shares (shares without a maturity), the company is expected
to pay preference dividend perpetually. By definition, in a perpetuity, time period, n, is so large
(mathematically n approaches infinity, ∞), that the expression, (1+i)n tends to become zero and the
formula for a perpetuity simply becomes:

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Note that care must be taken not to confuse the formula with the present value of a single payment e.g.
A payment of N50 at the end of one year has a present value of N50/(1+r); the perpetuity has a value of
N50/r, a quite different view. More so, the perpetuity formula shows the value of a regular stream of
payments starting from one period from the present.
Illustration 1: Abako is an investor, with expectation of a perpetual sum of N500annually from his
investment. What is the present value of his perpetuity if the interest rate is 10%?
Solution: P = 500/(10/100) = 500/0.1 (or 500 x 100/10) = N5000.
2.2 Present Value of an Uneven Cash Flow
Investments made by a firm do not frequently yield constant periodic cash flow, known as annuity. In
most cases, the firm may receive a stream of uneven cash flows; this is the PV factors for an annuity
cannot be used. In this case, the procedure is to calculate the PV of each cash flow and aggregate all the
PVs.
Illustration 2. Pandey has an opportunity of receiving $1000; $1500, $800, $1100 and $400 respectively at
the end of one through 5 years. Determine the PV of this stream of uneven cash flows, if the investor’s
required interest rate is 8%.
Solution: PV = (A/112)n = 1000/1.08 + 1500/(1.08)2 + 800/(1.08)3 + 1100/(1.08)4 + 400/(1.08)5
The complication of solving this equation can be resolved using the CVFA table or calculator and
multiplying them by the respective amount. PV = 1000 x PVF1.08 + 1500 xPVF2.08 + 800 xPVF3.08 + 1100
xPVF4.08 + 400 x PVF5.08
(Using CVFA Table - N/B formula = 1/(1+r)n e.g. 1/(1+0.08)2) 0.926 1 1000 $925.93

1000 X 0.926 + 1500 x 0.857 + 800 x 0.794 + 1100 x 0.735 + 400 x 0.681 0.857 2 1500 $1,286.01
0.794 3 800 $635.07
= 926.00 + 1285.50 + 635.20 + 808.50 + 272.40
0.735 4 1100 $808.53
= $3927.60
0.681 5 400 $272.23
Using Calculator $3,927.77
= + 1500 + 800 + 1100 x 400 $3,927.77
Ms-Excel 2007 Computation of PV
(1.08)3 (1.08)3 (1.08)4 (1.08)5 $3,927.77 is obtained by simply typing = NPV
(8%, C1:C5) but the column D is simple manual
925.93 + 1286.01 + 635.07 + 808.53 + 272.23 = 3927.77 calculation of present value of each cash flow

2.2 Present Value of an Annuity

An annuity is an asset that pays a fixed sum each year for a specified number of years, for instance, an
annuity is created once a shop-keeper leases a shop with a promise to make series of payments over an
agreed time period. An investor may be opportune to receive an annuity, a constant periodic amount
for a certain specified number of years. The present value of an annuity can be found out by calculating
the present value of the annual amount every year and will have to aggregate all the present values to
get the total present value of the annuity. For instance, an investor has an opportunity to receive an
annuity of N100 for four years, at the interest rate of 10% per year, the present value N100 received after
one year is, P = 100/(1.10) = N90.9, after two years, P = 100/(1.10)2 = N82.64, then, after three years, P =
100/(1.10)3 = N75.13 and after four years, P = 100/(1.10)4 = N68.30. Thus the total present value of an
annuity of N100 for four years would be N90.90 + N82.64 + N75.13 + N68.30 = N316.97.

If the N100 were to be received as a lump sum at the end of the fourth year, the present value would
only be N68.30.

The computation of the present value of annuity can be written operationally in the following general
form: P = A/(1+i) + A/(1+i)2 + .... .+A/(1+r)n where A = Amount (constant cash flow each year), 1 is
constant (100% value of A) and r = rate (%).

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A = [1/(1+i) + (1+i)2 + 1/(1+r)3 + ..... + 1/(1+i)n]; hence 8% is (100+8)% = (1.08)

A is a constant cash flow each year. The above equation can further be expressed as P =

Illustration IV
Uduak receives an annuity of N25000 for four years at an interest rate of 7%, what will be the present
value of the N25000 annuity?
Solution: PV = 25000/1.07 + 25000/(1.07)2 + 25000/(1.07)3 + 25000/(1.07)4
= N23364.48 + N21835.97 + N20407.45 + 19072.38 = N84,680.28
Using the equation formula: = N84,680.28
Do it yourself:
If Ponzi is to receive an annuity of N500 for 4 years at an interest of (a) 7% and (b) 10% respectively, what will be
the present value of N500 annuity?
(HINT P = 1693.60 and 1584.93)

2.3 Future Value of an Annuity Due

It is also possible to compute the compound value of annuity due. This can be done by re-investing the
Amount in the beginning of each year through the number of years which earns interest respectively
throughout the number of years. For instance, Ojo deposited N10 in a saving at the beginning of each
year for 4years to earn (a) 6% and (b) 7% interest, determine the compound values at the end of 4 years.

At 6%; F = 10 (1.06)4 + 10(1.06)3 + 10 (1.06)2 + 10 (1.06) = 12.62+11.91+11.24+10.60 = N46.37

At 7%; F = 10 (1.07)4 + 10(1.07)3 + 10(1.07)2 + 10(1.07) = 13.11 + 12.25 + 11.45 + 10.70 = N47.51

From the above, you can see that compound value of annuity due is more than an annuity because it
earns an extra interest for one year. If the compound value of annuity is multiplied by (1+i), the result is
the compound value of an annuity due. The formula for the compound value of an annuity due is:
Future value of an annuity due = FV of annuity due x (1 + i)  A x CVFA n, I x (1 + i)

Risk and Uncertainty Analysis

Risks exist as a result of the inability of the decision maker to make perfect forecast into the unknown.
There is no how a forecaster can forecast with perfection or certainty since the future events on which
they depend are uncertain. For investor, there is no risk in investment if he can forecast with certainty
the sequence of cash flow for it, but this is not always the case, as cash-flow cannot be forecast
accurately. Risk is associated with the variability of the future returns of a project and so the greater the
variability of the expected return the greater the risk (or the riskier the project). Risk can, however, be
measured more precisely using such common measures as standard deviation and coefficient of
variations.

2.4 The Probability Factor

Probability simply refers to measurement of the likelihood of occurrence of an event. If an event is

certain to occur, it is said to have a probability of one of occurring but if an event is certain not to occur,
we say that probability of its occurring is zero; hence probability of all events to occur lies between 0
and 1. A probability distribution may consist of a number of estimates. But in the simple form, it may
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 13
consist of only a few estimates. One best and most used form employs only the high, low and best
guess estimates.
Illustration V
The annual cash flow expected from a project together with the associated probabilities are as follows:
Assumption Cash flow (N) Probability
Best guess 4000 0.2
High guess 2400 0.6
Low guess 1600 0.2
The forecast considers the chance or probability of the annual cash flows being either N4000 (maximum)
or N1600 (minimum) at 20% each. There is a 60% probability that annual cash may be N2400.
Additional information provided by the forecaster is useful in the assessment of the impact of a variable
more clearly, which may assume different values on the profitability of an investment. This important is
how to obtain probability distribution.
Objective probability: The classical probability theory assumes that no statement whatsoever can be made
about the probability in a very long-run sense, given that the occurrence or non-occurrence of the event
can be repeatedly observed over a very large number of times under independent identical situations.
The classical concept of objective probability is of little use in analysing investment decisions between
these decisions are non-repetitive and hardly made under independent identical conditions over time.
Consequently, it has been opined by some people that it is not very useful to express the forecaster’s
estimates in terms of probability.
However, recently, probability has been seen from personalistic view, which holds that it makes a great
deal of sense to talk about the probability of a single event in that reference; for example the probability
of a rain tomorrow or of sales reaching a certain level next quarter, or that earning per share will exceed
N5. 50k next year or five years; hence, such probability assignments that reflect the state of belief of a
person rather the objective evidence of a large number of trials are called personal or subjective
probabilities.
Illustration VI

The following (A – E) are the five possible net cash flows of projects X and Y and their associated
probabilities. Both projects have a discount rate of 10%.

Project X Project Y
Cash flow (N) Probability Cash flow (N) Probability
A 90,000 0.10 245,000 0.10
B 100,000 0.20 200,000 0.15
C 150,000 0.40 158,000 0.50
D 140,000 0.20 120,000 0.15
E 155,000 0.10 75,000 0.10
Calculate the expected net present value for each project and indicate which project is preferable.

Solution of Expected value for Project X and Project Y

Possible Net cash Expected Net cash Expected
events flow (N) Prob. Value (N) flow (N) Prob. Value (N) NB
To calculate
A 90,000 0.1 9000 245,000 0.1 24500 10% simply
B 100,000 0.2 20000 200,000 0.15 30000 use your
calculator
C 150,000 0.4 60000 158,000 0.5 79000 and
D 140,000 0.2 28000 120,000 0.15 18000 compute as
follows:
E 155,000 0.1 15500 75,000 0.1 7500 1/1.1 = 0.909
ENCF N132500 N159000

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From the above table, Project Y has a higher expected net cash flow (N159, 000) than project X hence it
would be more preferred to Project X which has an expected net cash flow of N132,500 . Project Y will
also have a higher NPV when the expected net cash flows of the two projects are discounted at the same
rate. Since both projects have a discount rate of 10%, then let’s assume the initial cost for each project is
N50,000,00; the net present value for project X is (0.909 x N132,500 – N50000  N120442.5 - N50000
=N70442.5 ; while NPV for project Y = (0.909 x N159,000 – N50000  N144531 – N50,000 = N94531.

Illustration VII
Yusuf is presented with two proposals as follows: (a) a certain sum of N30000 or (b) a lottery ticket
which would give him a probability of 0.7 of winning N60000 and a probability of 0.3 of losing N10000.
Which one would you advise him to take?

Proposal a = N30,000
Proposal b = 0.7 x N60000 – 0.3 x N10000 = N42000 – N3000 = N39000.
Yusuf should accept the second proposal (proposal b) because it gives the highest return.

2.4.2 Expected Monetary Value or expected pay-off is a technique used to determine a net amount if
decisions are taken; that is to say that it is a technique that is used where there is uncertainty in terms of
loss or profit. Note that expected monetary value technique is adequate only in those cases where the
potential losses are not too great and the perspective profit range is narrow.

2.5 Decision Tree

This is the pictorial representation of the structure of the sequence of interrelated decisions and
Actions
B1
Outcomes
D2
B2
X1
A1 C1
X2
A1
D1 A2 C2
X3 W1

Y1
A2
W2 A1
Y2 C1 Cx1

D3
C2 A2
Cx2
Decision tree under uncertainty Decision tree under certainty

outcomes. A decision tree, also known as probability tree, is a diagrammatic representation of the
alternatives involved in a problem requiring sequential decisions so that all the possible
alternative/outcomes could be evaluated properly.

All the possible choices are shown on the tree as branches and all possible outcomes as subsidiary
branches. They invariably include probabilities and are evaluated using expected values, hence decision
trees show the decision points, the outcomes which are dependent upon probability and the outcome
values. By convention, decision points are represented by square nodes and outcomes or chance by
circles. In other words, there are two nodes – the decision node and the chance node.

Illustration VIII
Ibusa contemplates on whether to read her book or not. If she decides to read, she will toss a coin. She
will continue to read if she has a head from the coin, but discontinue if the tail. Draw the decision tree.

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In situations where decisions are sequential and depend on earlier decisions, decision tree provides a
convenient method of analysis. Applying a discounting to decision trees involves an extra stage in the
calculation. A present decision depends on future events and the alternative of a whole sequence of
decisions in future are affected by the present decision as well as future events, hence the consequence
of each decision is influenced by the outcome of a chance event. In constructing a decision tree, define
the investment proposal, identify decision alternative, draw a decision tree and analyse the resultant
data to select the best alternative; that is:
Step I: Represent decision points and outcomes on a decision tree
Step II: Calculate the PV at each point
Step III: Work back to decision points to evaluate the expected value of the decision alternatives at each
decision point.
Illustration
Barbie is an investor, who is considering project Y. She can invest either N0.5m or N1m in the project. If
she invests N0.5m, it has a 0.6 chance of receiving net cash flows of N220,000 per annum for the
following five years and 0.4 chance of receiving nothing. If she invests N1m, it has a 0.5 chance of
receiving N200,000 per annum for the following five years and also 0.5 chance of receiving N300,000 in
the first year, in which case she has a choice of investing a further N1m or not to invest at the end for the
first year.
If she invest a further N1m, her cash flows will be N600,000 p.a., and if she does not, her cash flows will
continue at N300,000 p.a. for years 2-5. Advise her on what decision to make assuming the cost of
capital is 10%.
Solution

NODE A NODE B
Yr CF DCF @ 10% PV Yr CF DCF @ 10% PV
0 (500,000) 1 (500,000) 0 (500,000) 1 (500,000)
1-5 220,000 3.7908 833,976 1-5 NIL 3.7908 NIL
N333,976 (N500000)

NODE C NODE D
Yr CF DCF @ 10% PV Yr CF DCF @ 10% PV
0 (1,000,000) 1 (1,000,000) 0 (1,000,000) 1 (1,000,000)
1-5 200,000 3.7908 758,160 1 (1,000,000) 0.9091 (909,100)
N241,840 1 300,000 0.9091 272,730
2-5 600,000 2.8817 1,729,020
(N92,650)

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 NODE E NODE F
Yr CF DCF @ 10% PV Combine A & B to make F
0 (1,000,000) 1 (1,000,000) A 333,976 x 0.6 200.386
1-5 300,000 3.7908 1,137,240 B (500,000) x 0.4 (200,000)
N137,240 N386

NODE G
Between D and E, apply the rule of the highest pay-off to make G
D = 92650
E = 137,240 Therefore, E qualified with N137,240

NODE H
Combine C and G to make H
C = (241,840) x 0.5 = (120,920)
G = 137,240 x 0.5 = 68620
(52300)

NODE G
Between F and H, apply the rule of the highest pay-off to make J
F = 386
H = (52,300) Therefore, F qualified with N386
Decision: The investor (Barbie) is advised to invest N500,000.00, a choice which produced a positive
NPV of N386.

Illustration
An electrical generating company is proposing two new alternative sources of power: Gas or hydro-
power. The engineer has estimated that hydro power plant has a probability of 0.75 to succeed with an
estimated net return of N10b while there is only 60% chance that gas plant will succeed with an
estimated net return of N15b. However, if any of the designs failed, the design could be modified or
abandoned. If the hydro power plant project is abandoned, the company will suffer a loss of N3b, and if
the gas plant is abandoned, the company will lose N7b. A modified hydro power plant project now has
30% chance of success with a return of N6b but will cost a loss of N7b if it still fails. A modified gas
plant project will have 80% chance to succeed at a net return of N10b while it will now attract a loss of
N7b if it failed again. You are required to produce an appropriate model for this project decision
making and evaluate the model for optional decision of this proposal.

Solution

(i)

(ii) Evaluation of alternative proposals

Hydro power plant
Expected return:
= 0.75 x N10b + 0.3 X N6b – (0.7 x N7b + 0.25 x N10b +N3b)
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 = (N7.5b + N1.8b) – (N4.9 + N6b + N7b)
= N9.3b- N10.4b
= N1.1b
Gas plant
= 0.6 x N15b + 0.8 x N10b – (0.2 x N7b + 0.4 x N15b + N7b)
= (N9b + N8b) – (N1.4b + N6b + N7b)
 N17b – N14.4 = N2.6b
Without abandonment = (0.6 x N15b + 0.8 x N10b) – (0.4 x N15b + 0.2 x N7b)
=N17b – N7.4
= N9.6
Therefore it is more profitable to go for the gas proposal

2.6 Simple and Compound Interest

An investor’s capital investment (initial capital outlay known as principal) may yield interest at a given
rate over a number of years without capitalisation of the interest. The interest on the principal at the
same rate over a number of years without consideration of recapitalisation of the interest is simple
interest. It is simply calculated as SI = P(r)t where P = principal, r = Rate% and t = time. The elementary
formula has always been (P x T x R/100).
However, where the interest is meant to be recapitalised, it is expected that the yield would not remain
the same over the number of years. For instance, if Okoro invests N1000 at a compound interest of 5%
for two years; at the end of year 1, the interest would be 1000 x 0.05 = 50; and so in Year II it is expected
the capital becomes N1050 and at the end of the year, the interest would be N52.25. Therefore, Okoro
would have a total interest of N52.50 + N50.00 = N102.25.
Illustration:
Benjamin is investing the sum of N50000 into a fixed deposit account, how much would he earn if at the
interest rate of 5% for three years, he is to earn (a) simple interest (b) compound interest.
(a) Simple Interest = 50000(0.5) x 3 = N7500
(b) Compound Interest = A – P where A = P(1 + r)n
A = amount at the end of the period; P = principal or initial capital; r = rate% and n = time
Therefore: 50000(1 + 0.05)3 = 50000(1.157625) = N57881.25
And so compound interest = N57881.25 – N50000 = N7881.25

Illustration
What compound rate would be required to produce N50000 after 5 years with an initial investment of
N40000?
Solution: FV = P(1+r)n
50000 = 40000(1+r)5
(1+r)5 = 50000/40000
= 5/ 4
5√(1+r) 5 = 5√5/4

(1+r) = 5√1.25
r = 5√1.25 – 1
r = 1.045639553 – 1
r = 0.0456
r = 0.05
r = 5% N/B: r = 4.56% or 5% to the nearest whole number.

2.7 Future Value

FV = P(1+r)n. This is calculated in the same manner as compound interest method.

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(1 + r)n is the future value factor; P = principal (initial capital or investment), r = rate %; n = time (years)
and FV = future value

Find the future value for N5000 for 3 years at 5% rate.

Solution: FV = 5000(1.05)3 = N5788.13

PV = FV(1/[1+r ]n) or FV(1+r)-n where (1/[1+r]n) is known as discount factor.

Illustration: Danazumi expects to receive N40000 at the end of 7 years and the opportunity cost of fund
is 6% annually, calculate the value of amount equated with the present.

Solution: PV = FV(1/[1+r]n) OR PV = FV(1+r)-n

= 40000 (1/[1+0.06]7) = 40000(1+0.06)-7
= 40000(1/ 1.50363025899136) = 40000(0.66506)
= 40000(0.6650571136223363894552330809438) = N26602.28
= N 26602.28

2.8 Risk of Business

A number of techniques to handle risk are used by managers in practice, ranY7ging from the simple rule
of thumb to sophisticated statistical techniques. The most common and non-conventional techniques
include payback, risk-adjusted discount rate and certainty equivalent. They are simple, familiar and
partially defensible on theoretical grounds but are based on highly simplified and at times, unrealistic
assumptions, failing to take account of the whole range of the effect of risky factors on the investment
decision-making. Let us take few illustrations on handling risks of business.

Illustration

Microwaves Ltd deposits N20000 in a bank for a period of 10 years at the following rates:

Years 1 2 3 4 5
Rate% (a) 10 10 13 15 15
(b) 9 12 14 15 18
You are required to determine the balance in the account at the end of the period

Solution:

(a) FV = 20000 (1.1)2 (1.13)(1.15)2  20000(1.21)(1.13)(1.3225) 20000(1.80825425)

= N36165.09
(b) FV = 20000(1.09)(1.12)(1.14)(1.15)(1.18) 20000(1.888553184)
= N37771.06

2.9 Treating Amortisation, Annuity and Sinking Fund Problems

Zombie & Scooby-Do Ltd is to repay N250,000 loan with All-States Trust Bank over the next five years.
The loan which is at the interest rate of 20% p.a. shall be repaid in equal instalments. You are asked to
compute the amount of each instalment and show the loan amortisation schedule.

Solution:

DCF = 1 – (1+r)-n PV =
n

R = 0.2 (i.e. 20%) A = 250000 and n = 5years

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= Annual instalment = N83594.93 0r N83595 (to the nearest Naira)

Year Opening balance Interest Instalment Closing balance

1 250000 0.2 x 250000 50000 83,595 216405
2 216405 0.2 x 216405 43281 83,595 176091
3 176091 0.2 x 176091 35218 83,595 127714
4 127714 0.2 x 127714 25543 83,595 69662
5 69662 0.2 x 69662 13933 83,595 -
167975 417975
A total interest of N167975 is paid.
167975
250000 = 67.19%
The 67.19% represents the percentage of interest on N250000, which is more than half of the money.
Illustration
Assume Zombie needed N250000 to replace an asset in 5years time in order to generate the amount, the
company set aside an equal amount of its profit which will be invested at the rate of 20% p.a. Compute
the amount the company should set aside annually and show the sinking fund schedule.

Solution

FV Zombie Ltd Sinking Fund Schedule

(1+r)n – 1 Years Opening Interest Instalments Closing
r bal (a) (b) (c) balance
1 - - N33595 N33595
250,000 2 N33,595 6,719 N33595 73,909
(1 + 0.2)5 – 1 3 73,909 14,782 N33595 122,286
0.2 4 122,286 24,457 N33595 180,338
5 180,338 36,068 N33595 N 250,000
250,000
2.48832 -1
0.2
N/B: Interest = 0.2 x Opening balance
250,000 x 0.2 Closing balance = a + b + c
2.48832 -1 = N33595

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 20
CHAPTER THREE: INVESTMENT DECISION

3.1 Nature of Investment decision

The firm’s investment decisions involve capital expenditures. It deals with capital budgeting decisions of
how to allocate capital or commit funds to long term assets that would yield benefits (cash flows) in the
future. The important aspects of such decision involve evaluating the prospective profitability of new
investments and measuring a cut off rate against that the prospective return on new investments could
be compared. Future benefits of investments are difficult to measure and cannot be predicted with
certainty. The company therefore must think of the most efficient way of investing on long terms assets
in expectation of long term flow of benefits. There are risks in investment which arises because of the
uncertain returns. Investment proposals or investment evaluation decision should consider both
expected return and risk. Capital budgeting decisions may also involve replacement decisions, that is,
decision of re-committing funds when an asset becomes less productive or non-profit.
There are two groups of investment appraisal methods. The first group involves considering the time
value of money, while the second method does not give any cognisance to the time value of money.
The following facts could be established about capital expenditure, which are its characteristics:
a) The cash outlays are often large
b) The decision when taking is not easily reversible
c) The benefits are realized by the company over a long range of time
d) Calls for efficient and careful appraisal or alternative investment opportunities
e) Because of the long range cash flow benefits it is exposed to inflation.

3.1.1 Capital Budgeting or Capital Investment Decision

It is the commitment of financial resources of an organisation to capital budget with the expectation of
earning future benefits over a reasonable long period of time in the future. The capital budgeting
process involves the following steps:
 Identification of possible investment project
 Identification of alternative project
 Acquisition of relevant data on the various project
 Project appraisal based on data collected
 Selection of the best alternative or project option
 Project implementation
 Project monitoring and control
3.1.2 Procedures for investment decision
Capital investment planning and control may include identifying investment opportunity; developing
forecasts of benefits and costs; evaluating the net benefits; authorising the progressing and spending
capital expenditure and control the capital projects. In other words, the procedure involved in capital
budgeting include:
a) Possible investments are identified a new market or a new product
b) Identification of alternative projects like expansion, diversify etc.
c) Acquire relevant data on the various projects.
d) Select best alternative, the best alternative is the project that increases the net present value of the
firm. Implementation
e) Appraise/evaluate the projects based on data collected
f) Project monitoring and control to ensure forecast, and estimate in accordance to expectation

3.1.3 Types of Capital Investment Project

Capital investments should include all those expenditures which are expected to produce benefits to the
company over a long period of time, and encompass both tangible and intangible assets. It includes
expansion of existing business, expansion of new business and replacement and modernisation.
However:
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 21
 i. capital investment may be for maintenance of market position-advertisement of existing product
or market
ii. capital investment for safety and environmental consideration
iii. capital investment maybe for new product and diversification
iv. capital investment maybe for public consideration/consumption

HAND-ON INFORMATION: THE CENTRAL SECURITIES CLEARING SYSTEM

Central Securities Clearing System

The CSCS plc was incorporated on July 29, 1992 as a financial market infrastructure (FMI) for the Nigerian
capital market and commissioned in April 1997 (operationally on 14/04/1997). It was privatised as a public
limited company on 16/05/2012 by a special resolution. The SEC issued its licence as an agent for Central
depository, clearing and settlement of transactions in the capital market. It operates a computerised depository,
clearing, settlement and delivery system for the capital market securities transactions.

CSCS facilitates delivery – transfers of securities from seller to buyers and settlement (payment of bought
shares) of securities transactions on the approved Nigerian exchanges. It ensures securities are processed
electronically and at a substantially reduced period between commencement and end of a transaction.

No stock transactions can be completed without interfacing with the CSCS. The CSCS ensures speedy and
transparent conduct of share transactions on the NSE. For a shareholder an account with CSCS has become a
pre-requisite for share transfers, whether buying or selling shares.

Functions

i) Central depository for share certificates of companies quoted on the Nigerian Stock
Exchange (NSE)
ii) Serves as the sub-registry for all quoted securities (in conjunction with registrars of quoted
companies)
iii) Issuer of central securities identification numbers to shareholders
iv) Custodian (in conjunction with custodian member/members) for local and foreign
instruments
v) Enhances online links to key-parties, facilitates gradual migration to e-bonus and e-
dividend payments, and provides statements and transaction reports to stockholders who
want to track their account movements

By its depository function, the CSCS has created a central depository for the shares of the quoted
companies on the NSE, maintaining information/records of the shareholding certificates in the
depository

CSCS controls the clearing process of the shares transactions on the NSE. Information on daily
transactions is forwarded to the CSCS by the Stock Exchange enabling the CSCS to process them for
settlement, charging or giving the stockbrokers’ account for the shares though have bought or sold
respectively. This is done in collaboration with clearing banks appointed by the agency.

A stock broker is expected to have a settlement account with at least a clearing bank, which is to be
funded for any share purchase to be undertaken on a given day.

Through settlement procedures and rules, the CSCS ensures the smooth conduct of those transactions
and that parties meet their obligations, ensuring that shareholders receive their proceeds in good time.
The clearing and settlement process is designed to ensure that value is transferred within the
stipulated time-frame.

Part of the process is the delivery of stocks to a buyer. The CSCS as an integral part of the clearing and
settlement process ensures delivery of stocks to the party that bought as a result of availability of
shares which must be deposited in the depository prior to any transaction.

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3.1.4 Financing options for capital budget
A financial manager must find the most economical method of financing a capital project.

Common methods identified include:

a. borrow to buy
b. lease the machine by paying a lease rental
c. hire purchase
d. sales and lease back

Modern method of Computing NPV

The modern method computation of the NPV is as follows:

Step I – Identify the after tax cash flows associated with each alternative method of financing the project.

In the case of option to borrow and buy, the relevant cash flows are (i) initial outlay (ii) tax savings associated
with capital allowances claimed (iii) scrap value of the asset if any. Discount these cash flows using the company’s
after tax cost of borrowing.

For option to lease, the relevant cash flows are (i) lease payments (ii) tax savings associated with lease payments
(iii) tax savings associated with capital allowances. Discount these cash flows using the company’s after tax cost of
borrowing.

For Hire Purchase option, the relevant cash flows the relevant cash flows include (i) HP payments (ii) Tax
savings associated with capital allowances (iii) tax savings associated with HP interest and (iv) scrap value.
Discount these cash flows using the company’s after tax cost of borrowing.

Step II – Select the best financing method that is the alternative with the least PV of cost

Step III – Compute the NPV at this stage using the following relevant cash flows – (i) cash flows of the option
selected/finance method; after tax incremental benefits associated with the use of the assets and the after tax
incremental costs associated with the use of the asset. Discount these cash flows using the company’s after tax WACC

Illustration 1
A trader is to undertake a project worth N10m and having the following cash flow profile
Yr 1 CF (N)
1 5000000
2 6000000
3 8000000
Will be deemed to have made a profit of N9m. however, if the discount rate of 25% is applied in
order to account for the time value of money, the project will have a positive NPV of N1936000 as:
Solution
Yr CF (N) DF@0.25 PV (N)
0 1 (10,000,000)
1 5,000,000 .8000 4,000,000
2 6,000,000 .6400 3,840,000
3 8,000,000 .5120 4,096,000
1,936,000

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 23
 NPV represents an unrealised capital gain that becomes realised when the project is undertaken

3.2 Capital Investment Evaluation Techniques

There are two basic techniques of project appraisal – traditional or non-discounted method (ARR and ROCE) and
Payback Period.
Where average annual project = average annual profit after taxation and depreciation scrap
Decision criteria
If the computed ARR is greater than the organisation’s predetermined ARR, then the project should be selected,
otherwise, the project should be dropped. Where two mutually exclusive projects are involved, the one with
longer ARR is selected.
Discounted Cash Flow Techniques
The simplest of these include NPV and IRR.

3.2.1 Traditional Investment Appraisal Method

The traditional investment appraisal methods include
3.2.2 The Payback period method:
The principle behind the Pay back method has more regard for liquidity than profitability. It is a measure of
liquidity over cost (or initial outlay).
Advantages of Pay Back Period
1. It is easy to understand and estimate.
2. It is liquidity based; rather than profitability, thus seems more acceptable where liquidity stands as the main
factor to be considered.
3. It is less forecast biased sensitive, unlike other investment criterion used.
4. It is suitable for use in an unstable economic environment
Disadvantages of Pay Back Period
1. It disregards the time value of money.
2. It disregards all cash inflows which occur after the payback period.
3. It is not an objective criterion for decision-making
4. If it is not properly applied (Invoked). It may lead to wrong decision-making
5. It is highly subjective in nature.

Illustration II
Two projects A and B with the following relevant information
A outlay = N200,000
Inflows: Year 1 = N60,000; Year2 = N80,000; Year 3 = 80,000 Year 4 =100,000.
Project B: outlay = 200,000
Inflows Year 1 = N80,000; Year 2 = 80,000 Year 3 = 40,000 Year 4 = 60,000; Year 5 = N60,000
Compute the payback period.
Project ‘A’ Cash flow Cumulative
Y0 (200,000) (200,000)
Y1 60,000 140,000
Y2 80,000 60,000
Y3 80,000
Y4 100,000
Actual payback 2 years + 60,000
80,000 yrs  2yrs + 0.75 yrs = 2.75 years.

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Project B Cash flow Cumulative
Y0 (200,000) (200,000)
Y1 80,000 120,000
Y2 80,000 40,000
Y3 40,000
Y4 60,000
Y5 60,000
N.B Where there is equal annual cash inflow or where the stream of cash inflow is the same over the life
span of the project, then the pay back formula becomes
PB = I/Cn

I= Initial cash outlay

Annual cash inflow

In the above Fisher's interception model, Project A intercept pro at remaking project B more preferable.

N.B In the above illustration, the payback period of project A is cumbersome to ascertain from the
tabulated computation. This is largely due to the fact that the streams of cash inflows are the same over
period of the project's life. Thus, a formula will help to allay this uncertainty, in the case where the
streams of cash inflows are not the same over the life span of project.

Payback period = L + I - CFL

A (L+1)
Where L = the last complete year in which cumulative net cash are less than the initial investment
(outlay)
I = initial cash outlay (investment)
CFL = Cumulative cash inflow at period L
A (L+I) Actual cash inflows at the period immediately after period by applying the above formula, we
have to identity the last period with negative cumulative flows (i.e. - 60,000) for Yr2: -It is discovered
that at the end of this Yr2 (2nd year) N 140,000 out of the N200;000 has been realised. Meaning that the
remaining N60,000 difference has to be accounted for in the 3rd year say mid of the Yr3.

3.2.3 Average Return on Investment

It is otherwise known as the average accounting rate of return (ARR). It is used in measuring the rate of
return to investment. It uses accounting information as revealed by financial statements to measure the
profitability of an investment. It is the ratio of the average after tax profit divided by the average
investment. The average investment would be equal to half of the original investment if it were
depreciated constantly or by dividing the total of the investment’s book values after depreciation by the
life of the project. The accounting rate of return, thus, is an average rate and can be determined by the
equation or formula as follows:

ARR = Average profit (or Average income)

Average investment

Where:
Average profit (AP) = Total Profit Generated (after taxes without an adjustment for interest)
Number of years

Average investment = Initial cash outlay - S

2
Illustration III
Maryam Sani & Co. invested N2, 000,000 in a certain investment yielding the following capital inflow
after tax:
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 25
 Year 1 N100,000
Year 2 N200,000
Year 3 N50,000
Year 4 N40,000

Given that the life span of the investment is 4 years and having 10% interest rate per annum for the life
of the asset, you are required to compute the average Return on Investment (R.O.I)

Solution

Total profit: 100,000 + 200,000 + 50,000 + 40,000 = N390,000.00

Average Income = 390,000

4
= 97500
2000000/4 = 500000; 0.1 x 2,000,000 = 200,000; 500000 – 200000 = N300,000
Average investment = 300,000/2 = N150,000
R.O.I = 97500
150,000 = 0.65
R.O.I = 65%
Note: The payback period method and the average annual rate of return on investment (or Accounting
Rate of Return) method fall under the traditional method of investment appraisal because they do not
consider the time value of money.

3.3 Modern Investment Appraisal Method – Decision considering Time Value of Money
These are financing decisions methods that give cognisance to the time value of money. They are
equally called the scientific method of investment appraisal. They include
1. The net present value method.
2. The internal rate of return method.
3. Profitability index (Benefit-cost ratio) method
4. The net tern final value method.
3.3.1 Time Value of Money
The net present value and the Internal Rate of Return (IRR) incorporate time value of money. The time
value of money concept states that the value of N1 today will not be the same in a year's time, due to
depreciation in the real value of naira. In other words, what a naira can buy today in a year’s time an
amount above a naira would be required to purchase that same article. Thus a naira invested today
should yield an amount over and above the naira invested. Devaluation of money allows for this. Given
to this assertion, the lenders of money would also want to be compensated financially for parting with
present consumption. The amount they receive is known as interest. It should be noted that this interest
will be charged even if no inflation is anticipated and it is certain that the money will be received.

However in a relatively stable economy, the interest rate could be taking to account for devaluation in
naira. The interest rate per naira is the compensation for the loss of value by the naira amount. Hence
the interest rate is used for discounting.

3.3.2 Money and Real Interest Rate

The scientific method assumes therefore that the interest rate used is the real interest rate and not the
money interest rate. The real interest rate is the after tax interest rate while the money interest rate is the
before tax interest rate. The scientific method makes use of the real interest rate asking for granted that
inflation rate will be equal the tax rate. Since normally the value of good should only be inflated by the
tax paid thereon.
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For example the money interest rate is 20% and the tax rate is 30% the real interest rate will be (1-0.30)
(20%) = (0.70) (20%) = (0.7 x 0.2 = 0.14 (convert 0.14 to percentage = 14%).

3.4 Net Present Value Method

The net present value method is the total present value of a project which should be greater than the
initial capital outlay of the project before such project could be accepted. The decision rule is that:

Total present value > capital outlay: accept the project

Total present value < capital outlay: reject the project

Illustration IV

Akpaco Company wishes to invest N40, 000 in a project which has a 6 year life span. With Net cash
inflow as follows:

Year 1 100,000
Year 2 20,000
Year 3 50,000
Year 4 60,000
Year 5 100,000
Year 6 100,000
The interest rate of 10% is acceptable for the project acceptability should this project be accepted?

SOLUTION:

Time Cash Flow

DCF (10%) FV
Year 0 400,0001 (400,000)
Year 1 100,0000.909 90900
Year 2 200,0000.826 165200
Year 3 50,000 0.75 1 37550
Year 4 60,000 0.683 40980
Year 5 100,0000.621 62100
Year 6 100, 000
0.564 56400
NPV N53130
DECISION RULE: Since the present value, is more than the initial outlay the Company should accept
the project.

INTERNAL RATE RETURN (or cut-off/hurdle/target rate/marginal efficiency/breakeven cost of capital/DCF yield)

The internal rate of return is the interest rate or rate of return which produces a cumulative present value
that is equal to the initial outlay.

Step I – Find the positive NPV of the project at a given rate

Step II – Find the negative NPV of the project at a given rate

Step III – These Net present values and the associated interest
rates can now be used to secure the internal rate of return. It is
otherwise known as Linear Interpolation Method. Interpolate
using the formula:

IRR = L r + NPV/NPV+ NPV- x (H r – L r) OR:

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Where

RP =Interest rate of positive net present value

RH = Interest rate of negative net present value
VP = Positive Net present value
VN = Negative Net Present Value.
| | = Means absolute term, which is addition of both positive NPV and negative NPV.
LR = The rate that produce positive NPV
HR= The rate that produce negative NPV
NPVP = Positive NPV
NPVN = Negative NPV
This method appraises project by finding the IRR which is the rate of returns that gives a zero NPV on a
project, founded by interpolation as follows:
Where r = internal rate of return. The internal rate of return method helps to strike the point where the
present value of inflows equals the initial outlay. That is NPV = Cumulative present value - Initial
outlay = 0. IRR considers time value of money; has cash flow instead of profit; is a percentage (rate %)
and simple and easy to understand or interpret. It avoids disputes that characterise the choice of the
appropriate cost of capital to use when appraising projects. However, its demerits include: It is fairly
complex. Interpolation is on estimate, and can give rise to multiple IRR where there are irregular cash
flows. It is not a measure of absolute profitability.

ILLUSTRATION V

Spark Co Ltd is a manufacturing company wishing to invest a sum of N350,000 in a project with a view of the
following net cash inflows for 5 years:

Year 1 200,000

Year 2 100,000

Year 3 100,000

Year 4 40,000

Year 5 10,000

The acceptable interest rate is 10%. You are required to compute (1) The Net present value and; (2) Internal rate of
return for the project

SOLUTION
Time Cash Flow DCF (10%) PV DCF (16%) PV
Year 0 (350,000) 1 (350,000) 1 (350,000)
Year 1 200,000 0.909 181800 0.862 172400
Year 2 100,000 0.826 82600 0.743 74300
Year 3 100,000 0.751 75100 0.641 64100
Year 4 40,000 0.683 27320 0.552 22080
Year 5 10,000 0.620 6200 0.476 4760
23020 (12360)
2. To compute IRR of the Project
Rp + Vp (RN - Rp)
(Vp + VN)
10% + 23020 (16-10)
[23020 + 12360]
10% + 3.90 = 13.90
OR
16 - 12360 (16-10)
[23020 + 12360]
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16 - 12360 (16-10)
[35380]
16 – (0.34934 x 6)
16-2.096
=13.90
3.5 Capital Budgeting and Inflation
Inflation is the general increase in price of goods and services, persistently, over a given time period. It
affects cost of capital and the cash flow of the project under study.
3.5.1 Real and Money Cash Flows
Cash flow that is yet to be adjusted for inflation is real or current cash flow. Cash flow already adjusted
for inflation is known as money cash flow or nominal:- money cash flow = real cf (1 + information)
MCF = RCF (1 + 1) where 1 is the inflation rate
e.g. N10,000 (1 + 0.1) = N11,000 or MCFt = RCF (1 + i)t
Real and money COC
Cost of capital that has taken inflation into consideration is the money cost of capital. Cost of capital
without inflation consideration is real cost of capital.
1 + km = (1 + kr) (1 + 1)
Where km = money cost of capital
Kr = real cost of capital
1 = inflation rate
e.g. if FC = 10%, inflation = 5%
Mc = (1 + 0.1) (1 + 0.5) = 1.1 x 1.05 = 1.155
1.155 – 1
1.55%
3.5.2 Inflation and Investment Appraisal Assumption
i. Assumes that the CF and discounts rate given are in money terms except o otherwise
informal
ii. Where specific rate are given, adjust the relevant CF to bring to money terms
iii. Where specific and general inflation rate are given only specific should be used
vi. General inflation rate should only be used to adjust the COC where it is real or current
term.
3.5.3 Capital Budgeting and Taxation
Tax affects capital budgeting in the following ways:
a. The net cash profit from the project is subject to tax
b. The capital asset used attracts capital allowance (or written down allowance or tax allowance
which gets tax relief.
NOTE
i. Tax is payable one – year in arrears. This should be assumed except otherwise informed
ii. Capital allowance are claimed in the form of initial and balancing allowance
iii. Tax saving/relief on capital allowance are claimed one-year in arrears
iv. Investment in working capital does not attract tax relief.
3.5.4 Capital Budgeting and Rationing

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1. Definition - Capital rationing occurs when a firm is unable to accept all projects which are apparently
profitable because of limited amount of funds. It is a situation where there exists financial constraint,
whereby the finance available for new investment is limited to an amount that prevents the acceptance
of all projects with positive NPVs.
2. Types of rationing
a) External/hard/real rationing: The overall limitation placed on availability of fund in the economy as a whole
which may be due to government policy, imperfect capital market, banks, lending restructure, global policies,
etc.
b) Internal/soft/artificial capital rationing: which is a imposed limitation by management of a company, such as may
be determined by management that raising capital through stock market would be impossible due to
depressed level of share prices, or where management decides to maintain stable dividend payment rather
than ploughing back all the profits to finance expansion, or the firm sets for itself a cut-off rate not to borrow
above
c) Simple period capital rationing: where ration is limited to only one period, funds are freely available in next
period (or other times). The most appropriate tools to use is the discounted profitability index (DPI) or the
benefit cost ratio (BCR)
d) Multi period rationing: where limitation of capital extends over numbers of period. When capital is expected to
be in short supply for more than one year, the selection of an optimal investment programme cannot be made
by ranking projects according to DPI/BCR but the graphical approach (where there are two decision variables)
or simplex method (where there are more than two decision variables) of linear programming would have to
be used to derive a solution.
3. Project selection under capital rationing: these can be divided into two:
i. Where projects are divisible, the method of selection is by profitability index of each project
P1 = NPV – Evaluation of NPV per initial output
IO
ii. Where the project is not divisible, critical and error combination of different projects is done
with the combination with higher NPV in aggregate selected.
Illustration

Abuja Environmental Corporation working with a capital constraint of N7m is trying to decide which of
a variety of new location to install in-water works. The list of possible location is:
Location A B C D E
Investment (N’000) 1000 2400 3200 2200 1800
NPV (N’000) 600 1800 2000 3000 2000
What is the most optional way of spending the N7m assuming: (a) Projects are divisible and B and C are
mutually exclusive (b) Projects are not divisible?

ABUJA ENVIRONMENTAL CORPORATION

Evaluation of optima way of spending the limited find of 7m

Project NPV I.O Profitability Index Ranking

A 600 1000 600 .6 5th

1000
B 1800 2400 1800 .75 3rd
2400
C 2000 3200 2000 .625 4th
3200
D 3000 2200 3000 1.36 1st
2200
E 2000 1800 2000 1.11 2nd
1800

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Project selection Assume It is Divisible

Option 1 Return Option 2 Return

Project I.O
D 2200 3000 D 2200 3000
E 1800 2000 E 1800 2000
B 2400 1800 C 3000 1875
A 600
7000 7160 7000 6875

= N360 C= 3000 x 2000 = N1875

600 x 600
A= 3200
1000

Combining projects A,B,D, and E would produce a return of N7160 while D, E, C would only produce
N6875; hence the Corporation should embark on Option I and not Option II.

Project Not Divisible

Project Combination Total Total NPV

investment
A, B, C (1000 + 2400 + 3200) 6600 4400
C, D (3200 + 2200) 5400 5000
D, E, B (2200 + 1800 + 2400) 6400 6800
A , C, D, (1000 + 3200 + 2200) 6400 6000
A, B, D (1000 + 2400 + 2200) 5600 5400
A, D, E (1000 + 2200 + 1800) 5000 5600
 Your combination should not exceed N7m.

The best combination is DEB with a total NPV of N6800.

CHAPTER FOUR: PORTFOLIO THEORY AND CORPORATE RESTRUCTURING

4.1 Defining Portfolio and Portfolio Theory
When considering investment appraisal, the traditional approach is to estimate the standard deviation.
Standard deviation is the variability of the return of the project and since standard deviation measures
risk, it could be deducted that it is suitable for risk analysis. This method is only suitable when
considering one project only. A rational investor would not like to commit all his resources into one
project, asset or security but to minimise risk and maximise return, he will therefore prefer the project
having the higher return at the same level of risk with another and where two securities have the same
return he will select the one with the lower risk.
A theory is the systematic or scientific presentation of facts, a cohesive set of hypothetical, conceptual and
pragmatic principles forming a general frame of reference for a field of study; a set of interrelated constructs
(concepts), definitions and propositions that present a systematic view of phenomena by specifying relations
among variables, with the purpose of explaining and predicting the phenomena. Or, we can also define a theory
as a set of interrelated concepts at a fairly high level of generality.
A portfolio is a collection of several securities or a bundle of individual assets or securities on behalf of
an investor. A portfolio is a collection of various investments that make up an investor’s total
investment. It is a combination of two or more assets (securities) ordinary share. Portfolio must consist
of at least two different investments or securities.
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Therefore, we can define a portfolio theory as the way and manner in which a portfolio is selected with
the aim of reducing, eliminating or decreasing the risk in the given portfolio. Portfolio theory, also
known as Co-variance approach, (mean and variance or standard deviations) helps to select the
combination of securities portfolio which gives the highest returns for minimum risk involved. It
provides a normative approach to investors to make decisions to invest their wealth in assets or
securities under risk. The theory seeks to maintain returns on investments while reducing the risks
involved. The business world is based on uncertainty, a rational investor, is risk-averse or vulnerable to
negative shocks if he/she relies on a single source of income, it stands to reason and less risky to have
diverse sources of income or to put it another way, to hold a portfolio of asset or investment. The theory
therefore encourages investor to hold well diversified portfolios instead of investing his resources into
just one or few assets. It brings out the sense in an adage which says you should not put your whole eggs in
one basket.
The theory therefore brings out the 3 Rs to look for an investment analysis: (a) Returns; (b) Risks; and
(c) Relationship between the components of the portfolio
There must be more than one investment before it could be addressed a portfolio. The theory examines
these 3Rs in the context of investment or securities (shares in companies) or projects. It is a scientific
explanation of the relationship between risk, return and correlation in the combination of two or more
individual assets for the purpose of evaluation of the portfolio.
4.2 Justification for Portfolio Theory
The theory was developed by Harry Markowitz in 1952. The thinking behind the explanation given by
the theory of reducing effect of spreading investment risk over a range asset is that in a portfolio
unexpected project failure will be compensated for, to some extern by the unexpected good news in
another investment or project.
In the theory, Harry Markowitz has instrument to measure or identify investment portfolio which gives
the highest return for a particular level return. The return earned on a share which is referred to as the
holding period returns for one year is:
R = Dividends Received + (share price at the end of period – purchase price)
Purchase Price
R = D1 + P1 - Po
P1
4. 3 Assumptions of Portfolio Theory
1. That all investors are rational and risk-averse. This assumption that investor do not like risk is one of
the foundations of portfolio theory, without these the issue of diversification becomes less important
2. That investors hold well diversified portfolio instead of investing their entrepreneurial wealth in a
single or few assets
3. Investors seek to maximise utility which is a function of risk and expected return. If a rational
investor holds a well-diversified portfolio of assets, then their concern should be the expected rate of
return and risk of the portfolio rather than individual assets and the contribution of individual asset
to the portfolio risk.
4. That portfolio with the highest expected return and lower risk would be preferred to the one with
the lower expected return.
5. If two securities or investment have the same risk but different expected returns, the one with higher
expected return will be selected.
6. If two securities or investment have the same expected risk the one with lower expected risk will be
selected
7. Risk is measured by the standard deviation of returns
8. It is assumed that there is no transaction cost.
9. The market for share is perfect.
10. There is no taxation
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 32
11. That returns of assets are normally distributed
12. For a given risk level, investors prefer higher return than lower return.
4.4 Portfolio Return (or Expected Rate of Return on a Portfolio)
According to Pandey (2007), “portfolio Return equals to the weighted average of the returns of individual asset
(securities) in the portfolio, with weights being equal to the proportion of investment value in each asset”.
The Portfolio Return of a given portfolio can be expressed using the formula:
E (Rx) = (R1 x P1) + (R2 x P2) + (R3 x P3) +…. + (Rn x Pn)
E (Rx) = Or

Where ‘Wt’ is the weighted/proportion of total funds invested in security, t

‘n’ = number of security in the portfolio
For a portfolio that consists of two securities, x and y the expected return of the portfolio can be
expressed as:
WX + WY = 1
E(RP) = WX∑(RT)+ WY∑(RY)
Where E(RP) = expected return of a portfolio
WX = weighted or proportion of total funds invested in security x
WY = weighted or proportion of total funds invested in security y.
Or, E(RP) = w x E(RX) + (1 – w) x E(RY) [N/B: w is the proportion of investment in asset X and (1-w) is the remaining
investment in asset Y]
That is, Expected Return on portfolio = (weight of security X) x (expected return on security X) + (weight of security Y) x
(expected return on security Y).

In summary:
1. Where the assets are 2: E(RPxy) = wxE(Rx) + (1 – w)∑(Ry)
2. When the assets are more than two: E(RPx,y,z) = wxE(Rx) + wy(Ry) + (1 – wxwy)E(Rz)

Illustration I
Assume you have an opportunity to invest your resources either in project X or project Y; the possible
outcomes of two assets in different states of economy are given in the table below:
State of Probability Return (%)
Economy X Y
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20

The expected rate of return of X is the sum of the product and outcomes and their respective probability
as follows:
E (Rx) = (-8 x 0.1) + (10 x 0.2) + (8 X 0.4) + (5 x 0.2) + (-4 x 0.1) = 5%
Similarly, the expected rate of return of Y is:
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 33
E (RY) = (14 x 0.1) + (-4 x 0.2) + (6 x 0.4) + (15 x 0.2) + (20 x 0.1) = 8%
Expected portfolio return E(RP) = (0.5 x 5) + (0.5 x 8) = 6.5%
Given the expected returns of individual assets, the portfolio returns depends on the weights
(investment proportion) of assets. It may be possible to change the expected rate of return on the
portfolio by changing the proportionate investment in each asset. If (a) 20% or (b) 35% of the investor’s
wealth is invested in wealth X and the remaining in wealth Y, then the rate of portfolio return under this
change mix of wealth in X and Y will be:
(a) E (RP) = (5 x 0.2) + (1- 0.2) x 8
 1 + 6.4 = 7.4%
(b) E (RP) = (5 x 0.35) + (1- 0.3.5) x 8
 1.75 + 5.20 = 6.95%
Illustration II
Dr BONGO has the opportunity of investing 30% of his wealth in Project Bomb and the remaining in
Project Bang. Calculate the portfolio return if the returns of the two assets in different states of the
economy are:
State of Probability Return (%)
Economy Bomb Bang
A 0.15 5 -3
B 0.25 3 4
C 0.20 2 3
D 0.15 -2 1
E 0.25 1 -2
Solution
E (RP) Bomb = 0.15(5) + 0.25(3) + 0.20(2) + 0.15(-2) + 0.25(1)
= 0.75 + 0.75 + 0.40 + (-0.30) + 0.25
= 1.49%
E (RP) Bang = 0.15(-3) + 0.25(4) + 0.2(3) + 0.15(1) + 0.25(-2)
= (-0.45) + 1.0 + 0.60 + 0.15 + (-0.50)
= 0.80
Expected portfolio return:
Since WBOMB = 30%; 0.30
Then, WBANG = (100% - 30% = 70%); 1 – 0.30 = 0.70
Hence, E(RP) = 1.49(0.30) + 0.8(0.70) = 1.01%
Alternatively,
E (RP) = [0.15(5) + 0.25(3) + 0.20(2) + 0.15(-2) + 0.25(1)] – [0.15(-3) + 0.25(4) + 0.2(3) + 0.15(1) + 0.25(-2)]
=[0.75 + 0.75 + 0.40 + (-0.30) + 0.25] – [0.15(-3) + 0.25(4) + 0.2(3) + 0.15(1) + 0.25(-2)]

= 1.49 – 0.80 = 0.69 ≃0.7

E (RP) = (1.49 x 0.3) + (0.7 x 0.8)  0.45 + 0.56 = 1.01%

Illustration III
Mikel Jacquesen has interest in investing in Projects A,B,C in the portfolio of N2,000,000 having
N400,000; N1,000,000 and N600,000 respectively. Using the following table in respect of the state of
economy, probability and returns:

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 34
 State of Probability Return (%)
Economy A B C
V 0.10 4 3 -3
W 0.20 5 2 4
X 0.30 7 5 -2
Y 0.15 8 0 1
Z 0.25 -2 -1 0

You are required to calculate the (i) expected return on each of the projects and (b) expected return on the
portfolio.
Solution
Total Portfolio = N2000000
Proportion of return on investment: A = 400000 =0.2 B = 1000000 =0.5; C = 600000 = 0.3
2,000,000 2,000,000 2,000,000
(a) Expected return on each of the projects:
A B C
0.1(4)+0.2(5)+0.3(7)+0.15(8)+0.25(-2) 0.1(3)+0.2(2)+0.3(5)+0.15(0)+0.25(-1) 0.1(-3)+0.2(4)+0.3(-2)+0.15(1)+0.25(0)
0.4+1+2.1+1.2-0.5 = 4.2% 0.3+0.4+1.5+0-0.25 = 1.95% -0.3+0.8-0.6+0.15+0 = 0.05%

(b) Expected return on the portfolio:

E(Rp) = 0.2(4.2) + 0.5(1.95) + 0.3(0.05)
= 0.84 + 0.975 + 0.015
= 1.83%
4.5 Portfolio Risk
This refers to the risk that is associated with two or more securities or assets combined together. It could
be seen as the relationship between the securities that make up a portfolio. Furthermore, it is the risk
associated with portfolio. Risks do not only depend on the relationship among the securities. It is the
variability of portfolio return due to changes in the return of individual asset and other market factors
that determine the returns. Securities included in a portfolio are associated with each other and
therefore the portfolio risk also accounts for the covariance between the returns of securities. The
magnitude of the portfolio risk is dependent upon the correlation between the securities. Portfolio risk
will be equal to the weighted risk of individual securities if the correlation coefficient is +1.0 but for
correlation efficient less than 1, the portfolio risk will be less than the weighted average risk.
Portfolio risk is measured by determining by its variance or the standard deviation as:

n n
∑ ∑ W1Wj ij
t=1 j=1

Where:

Wi = weight or proportion of total fund invested in Security i

Wj = weight or proportion of total fund invested in Security j
= covariance between possible returns from securities j and i.
The variance of a two-asset portfolio is not the weighted average of the variances of assets since they Co-
vary as well. The variance of two-security portfolio is given by the following equat x2wx2
y wy +2wxwyCovarxy = x wx y wy +2wxwy x yCovxy
2 2 2 2 2 2

The variance of a portfolio includes the proportionate variances of the individual securities and the co-
variance of the securities. The co-variance depends on the correlation between the securities in the
portfolio. The risk of the portfolio would be less than the weighted average risk of the securities for low
or negative correlation. Applying the equation the variance of portfolio of X and Y will be as follows:

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 35
 p = x
2w 2
x y wy
2 2
xy

2w 2
y wy
2 2
p = x x

xy
Where W x2 = weight or proportion of total fund invested in security x squared
Wy2 = weight or proportion of total funds invested in security y squared
= variance of return on security x
= variance of return on security y
= standard deviation of return on security x
= standard deviation of return on security y
Corxy = correlation coefficient between possible returns for security A and B and its value lies
between -1 and +1
Optimal portfolio will occur at a given point where the return on a portfolio is a maximum and the risk
is minimum.
4.6 Covariance of Portfolio
Covariance of a portfolio refers to the relationship between securities in the portfolio which can be either
positive or negative or zero relationship. It is the product of the standard deviations of individual
securities times their correlation coefficient. The covariance of returns on two assets measures their co-
movement. The covariance measures the degree to which the returns on two securities or investments
cover or co-move. If the returns tend to go up together, and go down together then the covariance will
be a positive number. If however, the return on one investment moves up in the opposite direction to
the return of the other, when a particular event occurs, then there would be a negative covariance of the
securities. If then there is no movement at all, that shows the returns are independent of each other, the
covariance would be zero. Portfolio risk or standard deviation depends on the degree of covariance of
the return of securities in the portfolio. This can be calculated as follows:
i. Determine the expected returns on assets/securities individually
ii. Determine the deviation of possible returns from the expected return from each
asset/security (Rx – E(Rx)(Ry – E(Ry)*(Rz-E(Rz))
iii. Determine the sum of the product of each deviation of returns of two assets and respective
probability

 Positive covariance – X’s and Y’s returns could be above their average returns at the same time.
Alternatively, X’s and Y’s returns could be below their average returns at the same time. In either
situation, this implies positive relation between two returns; and the co-variance would be positive.
 Negative Covariance – X’s returns could be above its average returns while Y’s return could be
below its average returns and vice versa. This denotes a negative relationship between the returns
of X and Y; and the covariance is negative.
 Zero covariance – Returns on X and Y could show no pattern; that is, there is no relationship. In this
situation, covariance would be zero. In reality, covariance may be non-zero due to randomness and
negative and positive terms may not cancel out each other.

In the above diagram, Ry represents return in Asset (Y) and Rx = return in Asset (X).
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 36
4.6.1 CORRELATION: This is a measure of the linear relationship between two variables or returns of
securities X and Y. It is the measure of measure of both variability of returns of securities and their
association. The measure is the correlation while the value of correlation is the correlation coefficient
Thus the formula for covariance of returns on X and Y can also be expressed as follows:
Co-Var XY = (standard deviation X) x (Standard deviation Y) x (Correlation XY)
Covxy x yCorxy

N/B: are standard deviations of returns for securities X and Y and CorXY is the correlation between
returns of X and Y. From the above equation , it is easy to determine the correlation by dividing
covariance by the standard deviations of returns on securities X and Y.
Correlation X, Y = Covariance X, Y÷ Standard deviation (X)x Standard deviation (Y)
CorXY = CovXY x y

Where covariance
Or
Cor x, y = x y (Cov x,Y)
A correlation coefficient of +1.0 implies a perfectly positive correlation (movement in the same
direction), while a correlation coefficient of -1.0 implies a perfectly negative correlation (movement in
opposite direction). When the correlation between two variables is zero (or not different from zero)
it means they are not related to each other. In some other cases, the returns of any two securities
may be weakly correlated, either negatively or positively.
The importance of covariance and correlation coefficient include:
- It measures statistically the degree to which two securities return move together. If two
securities having the same probability perform well or badly together, their returns are said to be
in the same direction; they would have a positive covariance. If on the other hand, their returns
move in opposite direction their covariance would be negative and if their movement is
independent of each other’s return, then the signs will cancel out and covariance would be zero.
- Correlation coefficient is the covariance of X and Y divided by the product of the standard
deviation of the two securities, an alternate way of quantifying the covariance between returns
on securities X and Y. It takes the value between -1 and +1. If correlation is +1, it means the
returns on two securities are perfectly positively correlated and if it is -1, it means they are
perfectly negatively correlated, and if zero, then they are absolutely uncorrelated.

Try Out QUESTION

T-Co is a rational investor. The following table relates to its investment in the two-asset portfolio
and the returns thereof. Calculate expected return on each security and the standard deviation and
correlation between the two securities.
State of Economy Probability Returns
X Y
A 0.15 5 -3
B 0.25 3 4
C 0.20 0 2
D 0.15 -2 1
E 0.25 1 -1
Given that: E(Rx) = 1.45 and E (Ry) = 0.85
Solution
Portfolio risk =
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 37
4.7 Corporate restructuring includes mergers and acquisitions, amalgamations, takeovers,
leveraged buyouts, buy-back of shares, capital re-organisation and sales of business units, etc. Most
popular means of corporate restructuring is mergers and acquisitions which are intended to limit
competition, utilise under-utilised market power/resources, displace existing management, overcome
the problem of slow growth and profitability in ones own industry, gain economies of scale, increase
income with proportionately less investment, establish a transnational bridgehead without excessive
start-up costs to gain access to a foreign market, circumvent govt regulation, reap speculative gains and
create an image of aggressiveness and strategic opportunism. The basic forms of acquisition are
horizontal merger, vertical merger and conglomerate merger.
Following the extremely complex problems inherent in mergers such as tax, legal and accounting issues
to be dealt with, the mechanics and tactics of a merger are employed: friendly bid and hostile bid.
Instruments of friendly bid include sweetheart deal, bear hug offer, and god-father offer. Instruments of
hostile bid by predator company include proxy fight, proxy battle, tender offer, Saturday night special,
corporate raid, dawn raid and Lady Macbeth strategy. Actions by target firms to prevent hostile bids
are asset revaluation, seek management takeover or buyout, seek government injunction (restriction
under anti-monopoly or anti-trust law), embark on serious public promotion, appeal to shareholders not
to sell their shares and attack the intention of the predator company. Other special actions include
publicity campaign, white knight, white squire, white squire defence, lock up defence, shark repellent,
greenmail, white mail, macaroni defence, Pac-man defence, poison pill, poison nut, suicide pill, golden
parachutes, people pill, sandbag, lobster trap and hubris hypothesis.
Types of restructuring include: business restructuring (reorganisation of business units/divisions,
including diversification into new businesses, outsourcing, etc); asset restructuring (acquiring or sale of
assets e.g. lease back of assets, securitisation of debt, etc); and corporate restructuring basically to
enhance shareholder value. A company can enhance value by capital restructuring designing
innovative securities that help reduce cost of capital. Leveraged buyouts (LBOs or asset bases or private
going) differ from ordinary acquisition as a large fraction of the purchase is debt financed (which may
be funk or below investment grade) and may go private and its shares no longer traded on the open
market. LBOs targets include high growth, high market share companies, high profit potential
companies, high liquidity and high debt capacity companies, low operating risk companies.
Factors to be considered in M & A are: consideration of valuation, form of consideration, attitude of
target company’s shareholders, accounting treatment, new dividend policy after merger, taxation
implication, location, goodwill, age of assets, predict lines capital, patent right, contract employment of
key management staff, attitude of predator company’s shareholders and company culture.
Factors influencing the likelihood of successful acquisition include ownership (shareholders and capital
structure), management (efficiency and capability, value of management team in capital market),
finance (purchase consideration, increased profitability after acquisition and mode of effecting purchase
consideration cash, shares or loan stock); rival bidder (existence and strength), competition (nature of
market and major competitors) and taxation.
M & A would fail as a result of excessive premium, faulty evaluation, absence of research, and failure to
manage post-merger integration.
Financial benefits of M & A include growth opportunity, enhanced investment opportunities, borrowing
power, cost effectiveness and diversification of risk.
M & A may be financed by cash offer, and share exchange. The choice of the means of financing is
influenced by impact on the acquiring company’s capital structure, financial condition, liquidity
position of acquiring company, capital market conditions and availability of long term debt.
Government regulate M & A through SEC, NSE, FIRS, Federal Ministry of Finance, Federal High Court,
and Companies and Allied Matters Act (CAMA) 1990 LFN 2004 (as amended).
Those involved in M & A include financial advisers, reporting accountants, solicitors to the companies,
registrars, tax consultants, stockbrokers and solicitors to the scheme.

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 38
CHAPTER FIVE: SOURCES OF FINANCE
5.1 SOURCES OF FINANCE
One of the most crucial decisions in any business is the financing decision, which involves identifying
the sources available for funds to be raised, the understanding of the characteristics of each source, the
identifying of costs associated with each source and the availability of funds from such source. The
assets of any business must be financed somehow and when a business is growing, the additional assets
must be financed by additional capital. An entity may finance its capital by combining long term capital
(equity or shares – ordinary and preference shares, reserves, loan capital like debentures, bank loans and
mortgages, etc) with some short term credits such as bank overdraft, trade credit from suppliers, etc.
Firms have different opportunities and sources from where to raise its capital funds to run its business.
The sources of finance can therefore be conveniently classified into three groups:
- These are finance sources up to one year.
- These are finance sources between 1 to 5 years duration.
- These are finance sources from 5 years and above.
5.1.1 Short Term Sources
These are financing sources up to one-year duration (i.e. they are repayable within one year). It is
suitable for funding shortages in working capital. They should not, if it can be avoided, be used to
finance a long-term investment. A company that funds long term project with short term funds may be
forced to renegotiate a long-term loan under unfavourable condition or to sell the asset, which is needed
for the continuation of the business. In addition, where short term sources are recalled by the holders, a
company might find itself in a position of technical or legal bankruptcy. The main methods of obtaining
short-term funds are:
1. Borrowing from friends and relations
2. Borrowing from co-operatives
3. Trade credits (i.e. Suppliers) - The use of credit from suppliers is a major source of finance. It is a
facility granted to a company by a supplier since the system allows the company to pay at a later date.
The cost of cash discount is depicted as follows:
Cost of Cash Discount (i.e. Implied cost) = % Discount X 365
100% - %Discount CN - CD
Where:
CN = Maximum payment period
CD = Maximum discount period

4. Accruals - These are deferred payment on items like salaries and wages, rent, tax. Accruals are
amount owing on services rendered to firms for which payments have not been made. The amount
owed is a source of finance. E.g. wages, tax payable etc.

5. Bank borrowing -This usually takes two forms namely: Bank overdraft (E.g. Drawings Against
unclear Effect Facility) and Bank loan facility. Bank rate is negotiable with Central Bank of Nigeria
requirements and the cost to the company is calculated as follows:

Cost of the overdraft = Interest payment X 365.

Total sum utilised Period of Loans

Factors to Consider Before Granting Bank Borrowing:

- The purpose for which the advance is required

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 39
- The Amount of the advance

- The Repayment term of the advance

- The Term of payment (i.e. how could the advance be paid?)

- The Collateral security of the advance

- Does the Character or record of the customer justify the advance?

- What is the Capital structure of the borrowing company?

- How Credible/Credit-worthy are the owners of the business?

Documents to be Requested before Granting Bank Borrowing

a. Application requesting for the loans.

b. Memorandum of Association
c. Articles of Association
d. Names, Address & Particulars of the Directors
e. List of directors' shareholding.
f. Boards Resolution
g. Certificate of Incorporation

h. Collateral Security including personal guarantee of the Managing Director.

i. Audited Account of the company.

j. Management Accounts & Reports of the company.

k. Cash flow projection of the company.

l. Acceptance of the offer letter (by affixing company seal & two directors or a director &
secretary must sign on behalf of the company).

6. Speeding up payment from Trade debtors (Customers) - This depends on the availability of sound
credit control and reminder system.

7. Debt Factoring - A factor is an agent that manages trade debts. Factoring involves turning over the
responsibility for collecting a firm's debt to specialist institution. A factor agent usually offers three main
services namely:

- Taking over the management of clients sales ledgers.

- Insuring their clients against the risk of bad debts.

- Providing finance by means of advances against the security of trade debtors.

8. Bill of Exchange - This is a form of short term finance used in trade financing. A bill of exchange is one
method of settlement in a trade between a seller and a buyer. A bill of exchange takes two forms:

- These are bills of exchange in which the buyer acknowledges it by writing accepted
across it and signing it.

- These are bills or exchange drawn on a bank, which will accept them. This is known as
acceptance credit.

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 40
9. Invoice Discounting - This is similar to factoring except that only the financing service is used meaning
that the copies of company's invoices sent to customers are discounted with a financial institution and
the trading company still collects the debt as agents for the financial institution and remits the cash on
receipt to the account open for that purpose.

10. Commercial paper - This is a short term and an unsecured money market instrument used to invest
company's surplus. Large companies with good credit rating can raise short-term funds by issuing
commercial notes, which arc then purchased by investors in the money market. The financial institution
does not guarantee the notes but assists in finding investors to buy them. The investors effectively lend
directly to the company issuing the notes. The financial institution charges commission for the service.

5.1.2 Medium Term Sources

These are financing sources between one to five years duration.

1. Medium Term loans: These are usually issued for a definite period when compared with overdraft. This
is a negotiated loan between a financial institution and a company between 1-5 years, usually at a fixed
rate of interest. Medium Term Loans in form of bank lending can be secured or unsecured. Unsecured
lending is not common and is only available to credit worthy companies. Secured lending requires
heavy collateral securities and proper evaluation of credit worthiness of all customers are also
considered.

2. Hire purchase agreement: This is in form of a credit sales agreement by which the owner of the assets or
supplier grant the purchaser the right to take possession of the assets but ownership will not pass until
all the hire purchase payment has been paid. The purchaser will pay the hire purchase payment over an
agreed period. No form of collateral is required. It is normally reflected in the balance sheet of the
borrower. It reduces the gearing ratio and increases ability to raise further finance. It also attracts capital
allowance.

3. Lease: A lease is a contractual agreement between the owner of an asset (lessor) and the user of the
asset (lessee) granting the user or lessee the exclusive right to use the asset for an agreed period in
return for the payment of rent. The main advantage of lending to a lessee is the use of an asset without
having to buy. This conserves an organization's funds.

There are two major types of lease:

lease is non-cancellable. The lessee

is responsible for the upkeep, insurance and maintenance of the leased asset. Finance lease is an
example of off-balance sheet financing. It is off balance sheet because sources of financing fixed asset are
not shown as liabilities on the balance sheet.

lessor) is responsible for the upkeep, insurance,

servicing and maintenance of the leased asset

4. Sales and leaseback: This is an arrangement by which a firm sells its assets to a financial institution for
cash and the financial institution immediately leases it back to the firm.

5. Venture capital: This is a major source of capital for SMEs and collapsed businesses. The provider of
finance might decide to participate in the company instead of allowing the client to run the business
himself. The participation might be in the form of equity or debenture stock. Small companies normally
require this type of finance because of their inadequate collateral securities and poor management skills
and talents. It is otherwise known as business angel.

6. Project finance: This requires evaluation of the company and its project. The project itself serves as a
collateral security for the fund. It is a risky source of finance if the project fails. However, the financial
institution should request for additional collateral security.

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 41
5.1.3 Long Term Sources

These are financing sources of 5 years and more duration.

1. Loan Stock/Debentures: This is long-term debt finance raised by a company for which interest is paid
usually at a fixed rate. The company must pay the interest whether it makes profit or not. Loan stock
also has a nominal value of ₦100. Debentures are a form of loan stock that is legally defined as the
written acknowledgement of a debt incurred by a company usually given under company seal and
containing provisions as to the payment of interest and eventual repayment of principal.

Loan stock and debentures are often secured. The security can take the form of fixed charge (usually on
a specific asset/ property). Floating charges (charge on certain asset of the company e.g.
stock/property). Floating charges can crystallize to a specific security if the company defaults in
meeting its obligations under the terms of loan/debenture. Loan stock/debentures also are unsecured.
However only high creditworthy companies can issue unsecured loan stock. The interest on unsecured
loan stock is usually higher than that of a secured loan stock.

Loan stock and debentures are usually redeemable, irredeemable and convertible. The interest
payments on loan stock/ debentures are allowable for corporation tax. The higher the loan
stock/debentures in a company's capital structure, the higher the gearing or leverage. Gearing or
leverage increases financial risk of a company since interest must be paid irrespective of profitability.

2. Preference Shares: The holders of preference shares are entitled to a fixed percentage dividend before
ordinary shareholders can be paid any dividend. Preference shares are a form of hybrid security
between ordinary shares and debentures. These are often issued as an alternative to debt when the
company pays no tax. Preference shares can be redeemable or irredeemable.

3. Ordinary Shares: Ordinary shareholders are the owners of the firm. They exercise control over the firm
through their voting rights. A firm contemplating on raising funds through ordinary shares will incur
floatation cost/issue cost.

Ways of Raising Ordinary Shares

invitation to the public at large so as to

invite them to subscribe for share in the company. The public issue must comply with CAMA 1990.
This is also known as Initial Public Offering (IPO).

Techniques of Conversion

that can be converted into one

ordinary share. It represents the effective price of ordinary shares paid for on conversion. CP can be
derived as follows:
Conversion Price = Market Value/Nominal value of Convertible security
Number of ordinary shares issued on conversion
It is the number of convertible security that could be exchanged for new
ordinary shares or security. It is expressed as follows:
Conversion Rate = Number of ordinary shares issued on conversion
Market value/nominal value of converted security
n Value (CV): It is the market value of ordinary shares into which unit of stock or
convertible security will be converted. This is expressed as follows:
Conversion Value = Conversion Rate X Market Value per share

of conversion, the holder of such security has two options i.e. to

convert and not to convert. The cost of option is derived as follows:

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 42
 Cost of option = Actual price of convertible security - Conversion price
Conversion Rate
t: This is the difference between the conversion price and market price.

NOTE:

i) Where conversion price is greater than (>) market price of share, it is

equal to discount.

ii) Conversion premium/discount could be presented in form of yield i.e.

Conversion Yield is known as: Premium/Discount X 100
Conversion Price 1
sation issue: This is issued to existing shareholders by whom further shares are
credited as fully paid-up out of the company’s reserves in proportion to existing holdings. This is
known as capitalisation of reserves.

subscription through an issuing

house in which the sales proceeds go to the existing shareholders not the company. Simply put, offer for
sale is the sale of existing shares by existing shareholders but not a fresh issue of shares. This method
was used by Daar Communication Plc and all the proceeds were paid directly into Daar Holding Plc for the
existing shareholders of the company.

Offer for Sale by Tender: This is when a company’s share is being issued out by a company to the
public asking the price that all intending shareholders can subscribe. This is referred to as striking price
and the stock exchange will ensure that all shares are taken up at the striking price.

4. Retained Earnings: This is a part of a company’s profit not paid out as ordinary dividend. It is also a
source of financing. It is a cheap source of raising finance as compared to share issue because no issue
cost is involved. Raising funds through retained earnings avoid dilution of control since there is no
share issue to outsiders. Retained earnings are an important source of financing for companies that do
not have access to the capital markets.

5.2 RIGHTS ISSUE

5. 3.1: The meaning of right issue

A right issue is an issue of new shares to existing shareholders in proportion to the number of shares
already held by each shareholder. This enables existing shareholders to subscribe cash for shares in
proportion to their existing holdings. The price at which the new shares are issued by the company is
always below the current market price of the shares so as to encourage the existing shareholders to take
up the issue. Options open to shareholders when a right issue is made (i.e. Pre-emptive rights of
existing shareholders)

1. Subscribe for the new shares: If the shareholders have sufficient cash resources to buy the new shares
and they feel that the company will use the money so raised to finance a profitable investment
opportunity, then they should take up all the rights. The new shares are acquired without the need to
pay stamp duty or brokerage commission provided it is the original shareholder that takes up the rights.

2. Sell part and buy part: If the shareholders feel the new shares are worth having but they lack the cash
to pay for them, they can sell sufficient part of the rights to enable them to take up the balance.

3. Sell the rights: If the shareholders are not happy about the rights issue they should sell the rights.
Usually, the rights are sold via a broker who will charge brokerage commission.

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4. Do nothing at all: If the amount payable for the new shares has not been received by a stipulated
deadline, the company will sell the new shares in the market. The shareholders will receive the sales
proceeds of the new shares less the rights price and any expenses.

5. 3.2 Factors to be considered when setting the Price of a Right Issue

a) The existing/current share price

b) Current price of comparable stocks

c) The reasons for the issue

d) The size of the issue and ability of the shareholders to subscribe

e) Any current government controls

5.3.3 Definition of Rights issue terms

Theoretical Ex-right price/value: This is the new market price that arises as a result of an adjustment to
allow for rebate price of the new shares. This can be calculated as:

Theoretical Ex-right price/value = Total Investment in all new shares ÷ Total number of shares after the rights
OR
(Market Value of old shares Theoretical value or the new shares) ÷ Total number of shares after the rights
OR
(Number of shares in issue X market price)+(Number of rights shares X price of right shares) ÷ Total number of shares in issue after the rights

Theoretical Nil price or The value of the rights: When the right issues are made usually at a rebate price,
automatically again will occur to shareholders. This gain is called Nil Price and is calculated as follows:

Theoretical Nil price/value = (Theoretical Ex-right price/value minus Right issue price)

not offered to the general

public but is placed to a number of institutions such as Pension fund, Insurance Company etc.

nto ordinary shares.

Theoretical Right issue

Illustration

Vagabond & Folly Plc has 80million ordinary share of N4.00 each and has recently decided to raise
further capital through a 1 for 4 right issue just before the issues was announced the market price of the
ordinary share was N5.00 and the right was put at N4.80. You are required to (a) Compute the
theoretical ex-rights value of the and the theoretical nil paid value of the right; and (b) advice an existing
shareholder of 5000 ordinary share of the possible course of action available to him in respect of his
entitlement

Solution

(i) 4 existing shares at N5 N20

1 right issue at N4.8 N4.80
N24.80
Theoretical ex- right value = N24.80 ÷ 5 = N4.96

Theoretical Nil-paid value

= Theoretical ex- right value – Right price

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 44
 N4.96 – N4.8 = N0.16

(ii) The course of actions available to the holder of 5000 shares is either a) Sell all the right or (b) a
mixture of sell and buy (take the right)

In the option of selling all the right, the following computations are necessary:

Proceed of sales (5000/4) 1250 x 0.16 = 200

Value of the original investment 5000 x 4.96 = 24800
N25000
Subscribe fully:

Value of investment 6250 X 4.96 N31000

Less: Cost of investment 1250 x 4.80 N6000
N25000
b) A mixture of sell and buy (take the right)

Let us assume that the shareholder sold units of the shares

Cash received will be N0.16x

Total number of shares remaining will be 1250 – X

Cost of the remain share = (1250 - X) 4.80

Total value of the right 0.16X

Therefore 0.16X = 4.80(1250 – X)

4.96X = N6000

X = 6000 ÷ 4.96 = 1210

The right to be taken by the shareholder does not want a change in the cash position is 1250 – 1210 = 40
Therefore he should sell 1210 shares and subscribe for 40 shares

CHAPTER SIX: THE NIGERIAN FINANCIAL MARKETS AND INSTITUTIONS

6.1 INTRODUCING FINANCIAL MARKETS AND INSTITUTIONS

The Nigerian Financial Markets and Institutions are key players in the provision of financial assets and
liabilities to enhance effective business and industrial operations. The Financial System consists of
financial intermediaries, financial markets, financial instruments, rules, conventions and norms that
facilitate and regulate the flow of funds through the macro economy. The financial system is controlled
by the government through the agency of the Central Bank, which supervises the activities of financial
intermediaries and monitors adherence to the government’s monetary and fiscal policies. It is a set of
rules, regulations and the aggregation of financial arrangements, institutions, agents, etc that interact
with each other and the rest of the world to foster economic growth and development of the nation
(CBN). The major types of financial intermediaries are Commercial Bank, Merchant Banks,
development Banks, finance Institutions, Insurance Companies, credit and savings institutions,
Investment Trust and Mortgage Institutions.

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Financial Markets, on the other hand, are simply the various facilities provided by the financial system
for the creation, custodianship and distribution of financial assets and liabilities. The market has two
major segments, the money market and the capital market.

The financial system ensures efficient transfer of savings from those who generate them to those who
ultimately use them for investment or consumption. It also provides avenue for organising and
managing payments system; mechanisms for the collection and transfer of savings by banks and other
depository institutions; arrangements covering the abilities of capital markets with the respect to the
issue and trading of long-term securities; arrangements covering the working of the money market in
respect of short-term financial instruments; and arrangements covering the activities of financial
markets complementary to the money and capital market for example the foreign exchange markets, the
arrangements for risk insurance; the future markets etc.

Some of the major problems with Nigerian capital market include infrastructure inadequacies; paucity
of security; buy and hold attitudes of the Nigerian investors and low level of education especially in
security and industrial education.

6.1.1 MONEY MARKET

This is the market, which creates opportunities for raising/investing short-term funds. By short-term
capital, we mean capital is lent or borrowed for a period, which might range from as short as overnight
up to about one year, and sometimes longer. Various financial instruments are exchanged in the money
market, including Treasury Bills, Treasury certificates, Bill of Exchanges, Commercial papers, certificates
of Deposits, Bankers’ Acceptances etc. Commercial Banks are the major participants in this market.
Other participants include, Merchant Banks, Central Bank of Nigeria, Insurance Companies, National
Provident Fund, Mortgage Banks, Finance Houses etc.

 Treasury bills – are short term risk-free and safest liquid securities issued by the CBN on the behalf of
Federal Government usually issued in denominations of N1000 and are sold on auction basis with a
maturity span of 91 days, 182 days, and 365 days sold at a discount on their face or par value.
 CBN Certificates – are medium term liquid securities to bridge the gap between treasury bills and
long term FG bonds with maturity of 180 and 364 days
 Commercial papers – are short term negotiable unsecured promissory notes with higher rates than
those on banker’s acceptances sold by big and reputable companies mostly finance houses to raise
funds in the money market, and traded on discount basis.
 Banker’s acceptances – negotiable time draft belonging to a class of instrument known as bill of
exchange. A bill is usually drawn on a bank (drawee) and properly signed by the drawer, made
payable to the drawer himself or his order (named third party). Once a drawee (a person/bank upon
whom the bill is drawn) has accepted the bill by endorsing “ACCEPTED” on it, it becomes a banker’s
acceptance and can maturity between 30 days and 180 days. There is a considerable safety and
liquidity than commercial papers but not as high as those of treasury bills. Although banker
acceptances attract higher rates than treasury bills, they are sold on a discount basis too, and may be
used as bank guarantee for domestic or international trade financing.
 Certificate of deposit – Fixed deposits, a certificate of deposit is a deposit receipt issued to a depositor
by the bank, as acknowledgement of the deposit of an agreed sum of money for a fixed time period
ranging from 30days to any period agreed with the bank. Fixed deposits attract higher rates of
interest than regular savings and that increases with the time period of deposit.

The merits of money market instruments include:

 The instruments can be discounted on the secondary market or at the discount window of the CBN
while restrictions are placed on withdrawals, this discount flexibility increases liquidity;
 There is minimum risk and safety of income and capital as issuers of securities are government,
banks and reputable large-scale organisation;

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 46
 There is a well-structured organisational arrangement in terms of the market and the participating
institutions.

The demerits on the other hand include:

 As a result of low level of business risk, the Return on investment is usually low;
 There is fixity of income and capital is only repaid at the end of the instrument tenure hence the
values of both income and capital can be eroded by inflationary pressures;
 There is zero growth for both the capital and income streams over the investment period.

6.1.2 CAPITAL MARKETS

This is the market for raising/investing intermediate and long-term funds. Financial instruments traded
on this market, e.g. Equities and loan stocks, have maturity periods of 3 years or longer. Hence most
financial activities that are necessary in the investment process are consummated in this market.
Principal participants in this market include Nigerian Stock Exchange, Security and Exchange,
Commission, stock broking firms, Issuing Houses, (Banking and Investment Companies), Government
and quoted companies. We have both bonds market and shares (or stocks) markets. The bonds market
performs exchange of cash and securities (lending and borrowing) while shares market undertakes the
buying and selling of shares or stocks. Capital market may be primary market for new issues and
security market for trading existing securities. The backbone of the secondary market is the stock
exchange. Each market in the capital market has its own distinct and unique characteristics and not a
unifying interest rate, hence they are called “capital markets”.

The functions of the capital market include providing financial interface and intermediate between
surplus units and deficit units; offering new and wider opportunities for financing new enterprises;
acting as a means of exchanging securities at mutually beneficial terms thereby liquidity through the
pricing mechanism or as a means of ascertaining security prices. They act as an easy accessible means of
efficiently trading in securities and allocating and rationing funds among competing demands and uses.

The roles of capital market in economic development process include enhancing business expansion and
modernisation through financing options/opportunities for businesses; provide means of allocating the
nation’s real and financial resources between various industries and companies; providing liquidity for
investment funds and serving as a measure of confidence in the economy.

They provide opportunities for government to finance economic development-oriented projects;

provide needed seed money for venture capital development; create avenue for government to privatise
its erstwhile state-owned companies and provide industrial management with some idea of the current
cost of capital through its pricing mechanisms. Provide avenue for marketing securities for fresh
expansion, act as a reliable medium for broadening business ownership-base and provide facilities for
foreign businesses to offer their shares to Nigerian investors. The capital market encourages
transparency, good accounting system and management practices through disclosure requirements for
relevant and adequate qualitative information for investors to make well-informed decisions.

6.1.3 FINANCIAL INTERMEDIATION

Financial intermediation is the process by which financial intermediaries provide a linkage between
surplus units and deficit units in the economy. Surplus units are firm/individuals who have excess
funds above their immediate needs while those who need this fund for immediate investment
programmes are referred to as deficit units. It is the financial intermediaries that develop the facilities
and instruments, which make this lending and borrowing possible. In Nigeria, Financial intermediaries
include Commercial, Merchant and Development Banks, Mortgage banks, finance houses, insurance
companies, Pension funds administrators, etc.
There are four aspects of the intermediation functions: Maturity intermediation, Liquidity
intermediation, Size/Denomination intermediation and risk intermediation. These four aspects also
explain why financial intermediation exists.
PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 47
1. MATURITY INTERMEDIATION
Most of the deposits mobilised by banks have short-term maturities since most customers withdraw
their deposit on demand, whereas the banks will lend this money for a longer period to borrower. The
satisfaction of these two contradictory objectives (that of depositors and borrowers) is what is referred to
as maturity transformation. A great deal of
Expertise is required here on the part of the bank to avoid mismatch.
Note that is these long-term loans that really make any economy to be viable since they are the ones
needed for economic development.
2. LIQUIDITY INTERMEDIATION
Despite the short duration of the deposits they mobilise and the longevity of the loans the give, banks
still need to ensure the liquidity of the economy i.e. they have no excuse for not meeting the demand of
their customers when they come to withdraw their money. Note that what actually makes the banking
system to function is the confidence which depositors have in the system.
3. SIZE/DEMONINATION INTERMEDIATION
Banks accept both small and large deposits from diverse customers and make these available as loans.
Without financial intermediaries, one could imagine how difficult it would be for a deficit unit to move
from one small surplus unit to another in search of investment funds.
4. RISK INTERMEDIATION
Banks even – out deposit risk by accepting deposits from heterogeneous depositors (individuals,
companies in various industries etc) of various sizes. Again, they minimise or average out lending risks
by making loans available to diverse borrowers of various sizes.

6.1.4 FINANCIAL DISINTERMEDIATION

Financial disintermediation is a process whereby either:
(a) Ultimate borrowers and lenders by-pass the normal methods of financial mediation (such as
depositing money with and borrowing money from banks) and find other ways of lending or
borrowing funds, or

(b) Lending and borrow directly with each other, avoiding financial intermediation altogether.
For example, if the government squeezes bank lending and company liquidity is high, then
companies are likely to lend directly to each other in the inter-corporate money market
usually by means of commercial papers. This is particularly so in the case of one subsidiary
in a group of companies lending to another.
6.2 CAPITAL MARKETS INSTRUMENTS
Capital markets trade on several instruments including those by government and others by quoted
companies. The markets through the second-tier security market promote small and medium sized
industries; promote bond markets and the funding of the activities of listed companies through initial
public offers. The various instruments of the capital markets can be discussed as follows:
6.2.1 Government Securities – The characteristics of government securities include:
Issuing prices – they are usually in par value units of N1000 and at so much per cent
Interest – each security usually has a rate of interest attached to it at the time of issuance at the nominal
or coupon rate, which may be fixed or variable
Yield – the market rate of interest and driving force for the market price or real value of all quoted fixed
interest government securities, the higher the yield the lower the value of the quoted fixed interest bond
and vice versa
Redemption or repayment – the specified future date or future time period within which the nominal
amount borrowed would be repaid.
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The government quoted securities have the following merits:
Capital is usually secured as it is backed by the federal or state government as the case may be. Also as
a bond approaches its repayment date, the market value will not fluctuate so much from its par value;
income is also secured as default in paying interest is not expected from government. Being a quoted
security, there is a market where disposal can take place if there is need for cash.
On the other hand, the government-quoted security is very risky as price fluctuation would cause
fluctuation in interest rate too. Also, both income streams and capital values may be eroded by inflation
risk.
6.2.2 Quoted companies Securities – Long term finance (including medium term) is financing that is
made available for more than one year. The main sources of medium/long term finance are loan
capital, preference share and ordinary (equity) share capital.
a) Loan (debt) capital is fixed interest, secured loan stocks or debentures issued by companies. Loan
stocks are said to be secured by a fixed charge on the company’s specific identifiable property and a
floating charge on all the assets of the company both movable and immovable. A floating simply refers
to company’s ability to continue to deal with the assets charged, use them as collateral for further loans
until it does something which makes the charge to crystallise, an event at which the company can no
longer deal with the assets. Debenture holders can sell as many assets as they require to redeem their
loan-capital. A trust deed is usually prepared to protect the interest of debenture holders to define the
rights of the holders in case of default, etc. Factors to consider when raising finance through issue of
loan stocks include the issuing or floatation costs, the servicing costs, the interest payment, capital
repayment obligatory terms, tax deductibility, and control of affairs by restriction covenants.
b) Preference Share Capital is a form of share capital whose holders are part-owners of the company and
are entitled to a fixed rate of income (dividend), receiving such dividends before the equity
shareholders. Unlike interest payment, holders need not be paid in case of loss except where the shares
are expressed as cumulative, then the previously unpaid dividends would be paid before the ordinary
shareholders. On liquidation, the preference shareholders subject to the provisions of the Articles are
entitled to a return of capital before the ordinary or equity shareholders. On raising finance through
preference shares, the following factors must be put into account: Control or voting rights of preference
shareholders (preference shareholders may only have rights to vote when their dividends are in arrears
otherwise, they cannot vote); tax deductibility (dividends are not tax deductive), repayment of capital
(in the case of redeemable, it must be repaid on maturity otherwise the shareholders share same fate as
equity shareholders when capital is irredeemable), dividend payment (returns not obligatory or
dividends are not paid except declared by directors); servicing costs and issue or floatation cost. Both
servicing and floatation costs of preference shares are more and they are more risky than those of
lenders but less than those of equity shareholders.
c) Equity or Ordinary Share capital is raised through the issue of ordinary shares. Shareholders are the
owners of the firm, bearing the greatest risk, may or may not receive dividends, and their capital may
partially or totally lost. They gain much when company is successful as they take residual income, they
have voting rights used to exercise control. The floatation costs of equity shares usually fluctuate
according to issuing method used and amount raised and usually very high; servicing costs and returns
of equity shares are very high in terms of dividends and capital growth due to presumably greater risk
bearing; and pricing of issue is a critical factor when raising new capital from the general public as it
determines how the public are attracted and also how sufficient funds are raised to execute the firm’s
programmes. Moreover, success of issue via general public, control of the firm and voting rights of
shareholders, dividend payment commitment and obligation for repayment of capital except in
liquidation are factors that are considered when choosing to raise finance through equity shares.
6.3 REGULATORY INSTITUTIONS WITHIN THE FINANCIAL SYSTEM
There are a number of participants in the Nigerian capital markets. Some of these include:
(1) Central Bank of Nigeria (CBN)
(2) Securities and Exchange Commission (SEC)
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 (3) Nigerian Insurance Commission (NAICOM)
(4) Nigerian Pension Commission (PENCOM)
NOTE: With the establishment of NDIC, banks are required to take insurance on the deposits of their
customers. The objective is to ensure the safety of depositors’ money in case of bank failure.

The participants are the various institutions that actively involved in the purchase and sale of stocks and
shares and those institutions that are involved as regulatory authorities. They include in the main
individuals and companies, banks and non-bank financial institutions, issuing houses, acceptance
houses and stockbrokers.

6.2. CENTRAL BANK OF NIGERIA

Historically, prior to the establishment of Central Bank of Nigeria by the CBN Act of 1958, there existed
a body known as the West African Currency Board (WACB). This Board, which was established by the
then British Colonial Government, was intended to serve as a Central Bank for the Anglophone West
African countries. Thus, the board was charged with the primary responsibility of issuing the West
African Pound, which served as the legal tender currency in Ghana, Nigeria, Sierra-Leone and Gambia.

Another function performed by WAEC was the management of the reserves held in trust for these
colonies. Such reserves were invested by the board on behalf of the West African countries as
instruments in the London Money Market. The weaknesses of the board for which it was criticised are
as follows:
- It carried on commercial banking activities alongside other commercial banks;
- The board lacked the basic apparatus to control the supply of money;
- The board got involved in physical distribution of currency from one point to another;
- Its activities were considered discriminatory against indigenous West African Industrialist;
- It was not on the development of the colonies and most of its activities were based on commerce and
trade

These factors led to the widespread agitation for indigenous Central Banks in the area.
The Central Bank of Nigeria (CBN) is the apex regulatory authority of the financial system in the
country. It was established by the CBN Act 1958 and commenced operations on July 1st, 1959. The
promulgation of the CBN decree 24 and Banks and other financial institutions (BOFI) Decree 25, both in
1991 gave the bank more flexibility in regulation and supervision of the banking sector and licensing
finance companies which hitherto operated outside any regulatory frame work.

The principal objectives of the bank as stipulated in the CBN Act of 1958 are as follow:
 The issuance of legal tender currency in Nigeria;
 To maintain the external reserve and value of the legal tender in order to safeguard the
international value of the currency;
 To promote monetary stability and a sound financial system;
 They serve as the banker and financial adviser to the Federal Government;
 Bankers to other banks within Nigeria and abroad.

To achieve the above objectives, CBN undertakes the following functions as stated in the Act. The basic
functions performed by CBN can be broadly categorized into three:
a) Traditional functions
b) Regulatory functions and
c) Developmental functions.
TRADITIONAL FUNCTIONS
1. It issues the legal tender (currencies) – Naira and Kobo
2. It acts as the Banker and financial adviser to the federal government
- CBN acts as the banker to other banks and finance institutions: This includes performing the
function of cheque Clearing and lender of last resort

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 50
 3. It manages the accounts and debt of the country
4. CBN acts in banking supervision and examination

REGULATORY FUNCTIONS
The regulatory functions of the CBN are mainly directed at the objective of promoting maintaining the
monetary and price stability in the economy. To perform this regulatory function CBN formulates
policies to control the amount of money in circulation, control other banks and major players in the
financial market, control rates of banks credits and therefore the supply of money in the economy. The
instruments used by CBN to achieve these functions are:
a) Open Market Operation (OMO)
b) Bank Rate
c) Rediscount Rate
d) Direct Control of Banks’ Liquidity
e) Direct Control of Bank Credit
f) Special Deposits
g) Moral Persuasion
h) Minimum Cash Ratio

DEVELOPMENTAL FUNCTIONS
The establishment of CBN in 1959 was premised on the need to promote and accelerate the much
needed economic growth and development in Nigeria, which would invariably promote the growth of
the financial market. This financial market comprises the Money and Capital market, assistance to
development banks and institutions and the formulation and execution of government economic
policies.
The Money Market is the market for mobilising short-term funds with instruments such as Treasury
Bills, Treasury Certificates, Commercial Papers, Certificate of Deposit (CDs), Eligible Development
stocks (EDS) and Bankers’ Acceptances.
The CBN plays a major role in the Capital Market, which deals with long-term funds by fostering its
growth through the annual subvention granted to them.
The CBN also helps to promote and assist the development banks and institutions. These include the
Bank of Industry (BOI), the Nigerian Agricultural Insurance Company (NAIC), the Federal Mortgage
Bank of Nigeria (FMBN), the Nigerian Deposit Insurance Corporation (NDIC), the Nigerian Export-
Import Bank (NEXIM) and the Securities and Exchange Commission (SEC).
In addition, the CBN is involved in the formulation and execution of viable economic policies and
measures for the government. Also since 1970, the bank has been instrumental in the promotion of
wholly owned by Nigerian enterprises.
In summary, the CENTRAL OF NIGERIA (CBN) functions include:
- Apex bank that regulates the financial system.
- Banker to all banks and Government.
- Regulates the economy through its Monetary Policy Guidelines (MPG).
- Lender of last resort.
- Liaise on behalf of Federal Government of Nigeria, with the monetary authorities of other
countries.
- Exchange rate management.
- Public debt management.
- Management of Balance of Payments and Reserves.
KEY HIGHLIGHTS OF MONETARY POLICY GUIDELINES (MPG)
- Credit ceiling
- Sectorial allocation of credits.
- Cash reserve requirements.

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 - Liquidity ratio.
- Interest rate policy.
GENERAL OBJECTIVES OF MONETARY POLICY GUIDELINES (MPG) AND FGN BUDGETS
 To reduce excess liquidity in the financial economy
 To moderate the high rate of inflation
 To reduce the pressure on the balance of payment
 To build up external reserves and stabilise the exchange rate of the Nigeria naira
 To ensure efficient and judicious allocation of scarce resources to the productive sectors of the
economy
 To encourage direct local production
 To generate employment opportunities
THE NIGERIA DEPOSIT INSURANCE CORPORATION (NDIC)
The Nigeria Deposit Insurance Corporation is a corporation established to complement the regulatory
and supervisory role of the CBN in the money market. It is however autonomous of the CBN and
reports directly to the Federal Ministry of Finance. NDIC effectively took off in 1989 and was set up to
provide deposit insurance and related services for banks in order to promote confidence in the banking
industry.
The composition of the Corporation include
 Representative of the CBN
 A representative of the Federal Ministry of Finance
 The managing director of the NDIC
 Two executive directors of NDIC
 Six nominees of the President of the Federal Republic of Nigeria, which one of them would function
as the Chairman.
The functions of the Corporation include:
 It is empowered to examine the books and affairs of insured banks and other deposit taking financial
institutions.
 To insure the deposit liabilities of all licensed banks in Nigeria so as to engender confidence in the
banking system. It collects a deposit of 15/16 of 1% of the total deposit liabilities of all licensed
banks as insurance premium;
 To give assistance in the interest of depositors to such banks in case of imminent or actual financial
difficulties so as to avoid damage to public confidence in the system
 To guarantee payments of a maximum of N50000 (although plans is still on the pipeline to hike
insured deposits to N200000) to the depositors in case of bank failure
 To assist the monetary authorities to formulate and implement banking policy in order to enhance
banking practice and fair competition.
So far, the major achievement of NDIC has been the provision of accommodation facility to the tune of
N2.3b to 10 banks which enabled them to regularise their overdrawn account positions at the CBN
immediately after the 1989 liquidity crisis.
DEBT MANAGEMENT OFFICE (DMO): This office is an office in the Presidency. The federal
government of Nigeria took a very bold step to address the debts problems of the nation by establishing
an autonomous DMO in the year 2000. The creation of the DMO consolidates debt management
functions in the single agency, thereby ensuring proper coordination. The DMO centralises and
coordinates the country’s debt recording and management activities, including debt service forecasts,
debt service payments, and professional advice on debt negotiations as well as new borrowings.
THE SECURITIES AND EXCHANGE COMMISSION (SEC): The SEC is the apex regulatory organ of
the Nigerian capital market and was formerly known as Capital Issues Committee (thereafter a
Commission), established by the SEC Act 71 of 1979 (re-enacted in 1988 as Decree No 29 of 1988. The

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Commission basic objectives include protection of investors and capital market development towards
enhanced socio-economic growth and development. The commission approves and regulates mergers
and acquisitions and authorises the establishment of unit trusts (a method of investment whereby money
subscribed by several people is pooled in a single fund for the investment in securities on behalf of the unit holders,
and management of which is embodied in the legal provision of a Trust Deed). In the course of deregulation of
the capital market, the function of price determination has been transferred to the issuing houses. The
SEC performs the regulatory function of protecting investing public from deceit and unscrupulous
practices in the sale of securities; registration of applicants to assess their fitness and worthiness of
instrument for offer; registering all new securities to be offered for sale or for subscription; maintaining
surveillance over dealings in securities; approving the timing and prices of new issues; ensuring
efficiency of the capital market and monitoring the performance of various enterprises, reviewing of
accounts; making rules and creating and reviewing procedures as demanded by occasions; enforcing
and ensuring compliance to securities law by various participants in the system; protecting the securities
market against any manipulations including insider trading and registering all stock exchanges
including their branches and capital market operations.
THE NIGERIAN STOCK EXCHANGE: This is the primary market in which companies and other
institutions can raise funds by issuing shares or loan stocks. It is an organised secondary market for
trading existing stocks and shares. The instruments listed on the Nigerian Stock Exchange (NSE) are
Federal Government Development loan stocks; industrial loan stock/debentures and equity stocks. The
functions of the NSE include providing the platforms for buying and selling existing securities;
providing liquidity for investors; regulating the activities of stock brokers; provision of opportunity for
continuous assessment of the value of listed securities and the worth of their issues; quotation on the
stock exchange helps to increase the stature of the security; encourages transactions in the new issue
market; help to spread the promoter’s risks and help to make available volume of corporate information
to the public by demanding quoted firms to submit their detailed and periodic information.
NATIONAL INSURANCE COMMISSION (NAICOM): The NAICOM established in 1997 by
NAICOM Act No 1 of 1997 to replace the Nigerian Insurance Supervisory Board (NISB) is aimed at
enhancing the effective administration, supervision, regulation and control of insurance business in
Nigeria. Its specific functions include the establishment of standards for the conduct of insurance
business, protection of insurance policy holders and establishment of a bureau to which complaints may
be submitted against insurance companies and their intermediaries by members of the public. NAICOM
ensures adequate capitalisation and reserve, good management, high technical expertise and judicious
fund placement in the insurance industry. Approves rate of insurance premiums and the rate of
commission to be paid in respect of all classes of insurance business, ensure adequate protection of
strategic government assets and other properties; act as adviser to the Federal Government on all
insurance related matters; approve standards, conditions and warranties applicable to all classes of
insurance business; regulate transactions between insurers and re-insurers in Nigerian and those
abroad; protect insurance policy-holders and beneficiaries and third parties to insurance contracts;
publish for sale and distribution to the public annual reports and statistics on the insurance industry.
PENSION FUND ADMINISTRATOR: PENFUND is an entity licensed by the National Pension
Commission and charged with the responsibility of managing and investing the pension funds. Each
employee is free to choose a PENFUND Administrator (PFA). The Act provides that the National
Pension Commission (PENCOM) will regulate the PFAs and outline PFAs functions as follows:
- Opening retirement savings account for all employees with a Personal Identity Number (PIN)
attached;
- Investment and management of pension funds and assets;
- Maintenance of books of account on all transactions relating to pension funds managed by the PFAs;
- Provision of regular information on investment strategy, market returns and other performance
indicators to the Commission;
- Provision of customers service support to employees, including access to employees account
balances and statements on demands
- Causing retirement benefits to be paid to the employees; and
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- Taking responsibility for all retirement calculations and carrying out all other functions directed by
the Commission.
ISSUING HOUSES: The issuing houses undertake the following:
- The pricing of new securities along with the issuing company;
- Underwriting of securities
- Bringing new securities issues to the market
- Determining the timing of new issues as approved by the SEC
- Performing specialist activities; and
- Provision of professional financial advisory services.
STOCKBROKERS: Stockbroker is a firm or an individual who acts as agent, buys and sells securities
on behalf of investors in the stock market for a commission called brokerage. Investors can only buy
and/or sell through stockbrokers who are licensed to represent them and trade on the Stock Exchange.
Stockbrokers also provide professional advice on the selection and management of investments and
assist project sponsors to raise money on the capital market. They help in executing purchases and sales
orders on behalf of clients, provide liquidity for securities, pricing of securities in the secondary market
and contributing to the development of the capital market by exercising high degree of discipline,
conduct and professionalism and by enlightenment services to the clients.
THE FEDERAL MORTGAGE BANK OF NIGERIA (FMBN): The FMBN took over the assets and
liabilities of the Nigerian Building Society. The FMBN provides banking and advisory services, and
undertakes research activities pertaining to housing. Building societies are reluctant to lend to
companies but following the adoption of the National Housing Policy in 1990, the FMBN has been
empowered to licence and regulate primary mortgage institutions in Nigeria and act as the apex
regulatory body for the Mortgage Finance Industry. The financing function of the Federal Mortgage
Bank of Nigeria was carved out and transferred to the Federal Mortgage Finance, while the FMBN
retains its regulatory role. The FMBN is under the control of the CBN.
FINANCIAL SERVICES COORDINATING COMMITTEE (FSCC)
This committee is charged with the primary responsibility of promoting safe, sound and efficient
financial sector in the country. Its membership is drawn from the key regulatory and supervisory
institutions including the CBN, NAICOM, Corporate Affairs Commission, Federal Ministry of Finance,
SEC and the CBN chairs and coordinates the activities of the Committee and all regulatory institutions
in the Nigerian financial system.
Financial Managers and the Markets: In carrying out his functions of allocation, and sourcing for
funds, the financial manager is a net user of capital resources. He enters the money market to invest
surplus funds on temporary basis to the company’s requirements and raise funds through the capital
markets. He designs strategies for choosing the best and cheapest sources of funds and considers the
rate of return he pays when making choice and accepting company’s projects.
The Efficient Market Hypothesis: Capital markets are said to be efficient when prices of securities in
the markets fully reflect all information about the company, industry to which it belongs and the
economy as a whole. This means that any new information about a company coming into the market is
instantaneously reflected in the price of the company’s share such that no investor would make an
above average return on an investment, as the price of a security is supposedly bound to fluctuate
randomly around its true or intrinsic value. Efficient market does not mean ‘perfect’ market but a
market where security is price efficient; right and represents the best estimate of the security’s true value
based on the available information.
According to Harry Markowitz, market efficiency may be weak form whereby the information on past
movements of share price is already reflected on the current price and so future price cannot be forecast
based on the use of past information; semi-strong form, whereby current price reflects fully and
immediately all publicly available information while excluding insiders’ information; and the strong
form whereby all information both insider and external information is fully and immediately reflected
in the current security market price.
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Assertions relating to capital market efficiency are not directly testable. How can tests be carried out on
whether all available information is fully reflected in prices of securities and what amount of
information is available to the researcher? Having some information available to the researcher, the
only test that could possibly be carried out are whether or not prices of securities behave in a way that
appears consistent with Efficiency. Such tests which have been carried out in matured capital markets
have attempted to do this. The implication of market efficiency includes the following: -
 To the investors, market efficiency implies that investors should not waste their time looking for a
security that would provide returns in excess if the normal or expected returns simply by analysing past
information on the direction of share price or by analysing new economic information about the security
of the company or the company itself. An above average return can only be made when the investor has
access to information that has not come to the knowledge of the investing public at large.
 To the financial managers, the necessary implications border around the following:
- Rational investors can astutely interpret the activities of an enterprise’s management and cannot
be deceived by mere window dressing that has the effect of unnecessarily increasing share price
- Financial managers should be prepared to release relevant information about their activities to
the investing public/market to be instantaneously incorporated into the share price, which
resultantly bring about increase in share price.
- Negative information not made available due to its adverse effect may be leaked out to the
market by investors who happen to know that the managers do suppress negative information
- Financial managers will be wasting their time for a recovery of the price of the security in the
depressed market before they come out with new issues
- Investors in the stock market are very rational when they put values on risky financial assets
- Financial managers are directly linked with investors through prices of securities and the prices
do respond speedily and rationally to new information.
Application of Market Efficiency to the Nigerian Stock Market
It would be observed from the above discussion that market inefficiency would imply that investors can
make above average returns by exploiting the market with such inefficiency. If this is the yardstick for
measuring the efficiency or otherwise of a stock market, it could be said that Nigerian capital markets
exemplify a semi-strong form of market efficiency as sometimes, relevant insiders’ information would
be suppressed from the public domain. Some empirical events appear to support this view. One
singular important observed event was the way prices on the Nigerian Stock Market astronomically rose
from early 2008 only to go down to their present low prices. It was evident that the sharp increases in
prices were not supported by any fundamentals of the country’s quoted companies. They were only
driven by uneconomic events.
Cost of Capital
This can be defined as the minimum rate of return on the investment project that keeps the present
wealth of shareholders constant or unchanged. It is the minimum rate of return on an investment that
must be earned in order to satisfy shareholders and other providers of the capital of the firm. It can be
perceived as the interest or dividend payable and can also include expenses incurred in the process of
raising capital such as legal and publicity costs. Cost of capital therefore represents the financial
standard for allocating the firm’s funds supplied by shareholders and creditors to the various
investment projects in the most efficient manner. The cost of capital is usually computed to seek a
means of maximising the value of the firm and to determine the minimum required rate of return to use
as a cut-off point in making investment decision.
The capital structure of a typical enterprise will include equity or ordinary share capital, preference
share capital and debentures.
Cost of equity capital – the minimum rate of return that must be earned on equity to keep the value of
existing equity constant. The shareholder’s required rate of return which equates the PV of the expected
dividends with the market value of the share. It reflects the return shareholders would be obtained if
cash flows were paid out as dividends. It is calculated as:

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Ke = D1/P0 + g = dividend in Yr 1/Market price of stock + annual growth rate of dividend
The model of dividend valuation = D0 + d1/(1+kc)1 + d2/(1+kc)2....dn/(1+kc)n
Where d = the constant dividend per share; Ke = cost of equity capital; and n = year/time period
Assume JOGODO has a dividend growth rate of 9%, market price of stock of N750 and a floating cost of
7% of share price and a dividend per share of N130 was recently received. Determine its cost of equity.
Ke = d1/P0 + g
D1 = d0(1+g)  130(1+0.09)
= 130(1.09)
= = N141.70
Ke = 141.70/(750 – (0.07 x 750)) + 0.09  (141.70/750 – 52.5) + 0.09
= 141.7/697.50 + 0.09
= 0.203154 + 0.09 = 0.2932
= 29.32%
Cost of Preference Share Capital – the estimation of fixed interest or dividend capital is much easier
than the estimation of the cost of ordinary capital as the interest received by the holder of the security is
fixed by contract and will not fluctuate in amount. This can be computed as:

Supposed Danatata Ltd issues an 18% N500perpetual preference share at a current market of N675,
what is the cost of the preference shares?
Kp = Div/P0 = 90/675
= 0.1333
= 13.33%
Cost of Debt – the rate that must be received from investment to satisfy the minimum required rate of
return for the creditors. It is the minimum rate of return required by creditors (such as debenture
holders) in order to maintain their existing market value. It is calculated as:
Kd = F(1-t)/mvd X 100; where kd = cost of debt capital; F = latest market value of interest paid or
payable; mvd = market value of debt ex-interest; and t = corporation tax rate; OR
Kd = i/p0 where Kd = before tax cost of debt; i = coupon rate of interest and p0 = issue price
P0 =

Kd = i/P0 (1 – T)
Assume GWAGWALADAWA Ventures Ltd incorporates 7% of N500000 perpetual debenture that are
currently selling at =N=570000. If the corporate tax rate is 17.5%, determine the after tax cost of debt.
Solution: kd = i/p0(1 - T)
= i = 7% of N500000 = N35000
P0 = N570000
T = 18.5%
Kd = 35000/570000 X (1 – 0.185)
35/570 x 0.815
= 0.0614 + 0.815
=0.8764
= 87.64%
WEIGHTED AVERAGE COST OF CAPITAL (WACC): This is also known as the composite cost of
capital, which is the rate at which a company is expected to pay on average to all its securities holders to
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finance its assets. It is the aggregate of costs of the various sources of finance in use by an enterprise, a
minimum return that an organisation must have on an existing asset base to satisfy its various suppliers
of finance or capital i.e. creditors, shareholders and other providers of capital otherwise they will invest
elsewhere. In calculating WACC, the company must first of all estimate the cost of each type of capital
used, the proportion of the total capital coming from each source then weights the costs, which are
added to give the overall cost of capital. WACC is used as a discount rate of appraising new investment
The use of WACC is based on the assumptions that: (a) the existing gearing ratio remains unchanged or
constant (b) the project under consideration is a marginal addition to overall projects of the company;
(c) the project is of the same average risk with that of the company; (d) perfect market condition exists.

DIVIDEND POLICY
At the end of each financial year, the company management would prepare the financial statements, get
the statements audited and from this statement prepared, it would be established if profits are made or
not. When profits are realised, the board of directors would determine the level of the profit that would
be paid as dividend to the equity holders and the form the dividend is to take, recommendation usually
made during the company’s A.G.M. Dividend is the amount of a firm’s profits paid to the proprietors of
the firm i.e. shareholders of a company.
Dividend policy is the set of guidelines of a company uses to decide how much of its earning will be
paid out to shareholders. Dividend policy is extremely important as its announcement has effect on
share values. A stable dividend policy would lead to higher price of the company’s share prices because
of the greater confidence of investors about the future prospects of the company. The ratio of ordinary
share dividends to retained earnings is known as dividend payout ratio. While some theories suggest that
there is a relationship between dividend policy and the value of a business in terms of the price per
share, other theories are of the view that there is no such relationship.
Dividend policy is affected by such factors as legal provisions and government regulations including
statutory requirements like reserves; contractual constraints; share valuation; liquidity constraints;
internal re-investment opportunities; company growth prospects; capital market considerations; tax
considerations/taxation; level of inflation; owner’s consideration (shareholders’ wealth maximization
consideration); control; risk factors; loan redemption; schools of thoughts on dividend policy; dividend
policy in other similar companies; and liquidity preference of the dominant shareholders.
THEORIES OR SCHOOL OF THOUGHTS OF DIVIDEND POLICY
There are two main schools of thought in relation to dividend policy. These are the Relevancy school
and the Irrelevancy school of thought.
The Dividend Supremacy or Relevancy School of Thought considers dividend decision as a relevant and
major factor influencing the business organisation’s value or share price. This theory has been proposed
by such proponents as James E Walter (Prof.) and Myron J. Gordon (1959). The basic assumption of this
school is that the market value of a company’s share depends on the size of dividends paid and the
growth rate in dividends and the shareholders’ required rate of return; the growth rate in dividends
depends on how money is capitalised and reinvested in the company and so on the rate of earnings
retention and the shareholders will want their firm to pursue a retention policy that maximises the value
of their shares.
Walter believes that dividend payouts are relevant and have a bearing on the share prices of the firm
and that the investment policies of a firm cannot be separated from its dividend policy as both are
interwoven. The choice of an appropriate dividend policy affects the value of the firm and so his
dividend model establishes a relationship between the firm’s rate of return (r), its costs of capital (k), to
give a dividend policy that maximises the shareholder’s wealth. Walter’s arguments were based on the
following assumptions:
 That the firm finances all investments through retained earnings
 The firm maintains constant IRR and WACC
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  The firm has a very long or infinite lifespan
 The corporate tax does not exist
 All earnings are either distributed as dividends or re-capitalised internally immediately.
The following are some of the critiques or limitations against the Walter’s Model
 Walter has assumed that investments are exclusively financed by retained earnings and no
external financing is used, hence it is applicable only to all-equity firms. Without external
financing such as debts or debentures, there is no possibility of an optimum dividend or
investment policy;
 IRR (r) is assumed to be constant which against is not realistic. In practice, r decreases as more
investments are undertaken because more profitable investments are given prior attention before
the profitable ones, in that order
 Constant opportunity cost of capital (k) is also untenable as cost of capital varies directly with
the firm’s risk. By assuming constant opportunity cost of capital (k or Ke), the model ignores the
effect of business risk on the value of business, on which it has direct impact.
Myron Gordon provided in his article Dividends, Earnings and Stock Prices some empirical data to
support the dividend supremacy or relevancy hypothesis and the effect of dividend payout ratios on the
price earnings ratios. According to him, this was conclusive evidence that equity stock value is derived
from dividends. From the supremacy model, an investor who plans to hold his shares in perpetuity as
most investors do expects nothing other than dividends and such an investor would be naive to ignore
payout possibilities in his assessment.
Just as Walter, Gordon contends that dividends are supreme and relevant and that dividend policy
affects the value of the firm. His opinion was based on the assumptions that (a) the firm is all-equity
financed without debt; (b) there is no external financing but only retained earnings re-investments; (c)
constant return or internal rate of return (IRR) and weighted average cost of capital (WACC); (d) the
cost of capital is assumed to remain constant in spite of the risk (constant cost of capital – k) but greater
than the growth rate; (e) perpetual earning (f) corporate tax does not exist; and (g) constant return from
the retention ratio (ƃ) is assumed to be constant once decided upon and by implication, the growth rate
(g = br) will remain constant for an infinite time also.
Walter’s model formula: MV = D/Ke + [e(E-D)/Ke]/Ke same as D + [r(E-D)/Ke]/Ke
Where MV = market value per share; D = dividend per share; Ke = cost of capital; g = growth rate of
earnings; E = Earnings per share and r = IRR
Myron Gordon’s model formula is: MV = E(1 – b)/(Ke – br)
Where MV = market value per share; E = earnings per share; b = retention ratio; Ke = cost of capital (i.e.
capitalisation rate); r = rate of return on investment and br = g = growth rate in r.
Dividend Relevancy or Supremacy theory has the following supportive arguments:
i. Information value argument that dividend policy has image-making potentials;
ii. Certainty argument, that cash dividends reduce uncertainty of capital gains and so, many
shareholders would prefer firms that pay cash dividends regularly;
iii. Clientele argument; dividend policy would attract identifiable class of investors to it;
iv. Taxation argument; the rate disparity on tax system has impact on investors’ preference for either
cash dividends or retained earnings as more would like retained earnings to cash dividends if the
marginal rate of tax on personal income is higher than the rate of capital gain tax;
v. Capital rationing argument; that when a company is faced with capital rationing problem,
because of insufficient funds to undertake all the available viable capital expenditure projects, then
the payment of dividends by reducing the retained earnings will inevitably deplete the funds
available. Therefore, Casberg in his “Analysis for Investment Decision” puts it that dividend should be
reduced in order, at least, to maximise the supply of capital.
vi. Asymmetric information, applies to the fact that shareholders and managers have incomplete and
different information and so each of them would not precisely state the reaction of the other
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vii. Signalling properties of dividends, with asymmetric information which affects information
contents of dividends, dividends can be represented as signals from the managers of the enterprise
to the shareholders and financial markets, by encoding and decoding relevant information.
viii. Dividend Uncertainty/Bird in the Hand Argument: This argument was first put forward by
Krishman when he buttressed:
“of two stocks with identical earnings record, and prospects but the one paying a larger dividend
than the other, the former will undoubtedly command a higher price merely because stockholders
prefer present to future values. Myopic vision plays a part in the price-making process.
Stockholders often act upon principle that a bird in the hand is worth two in the bush and for this
reason are willing to pay a premium for the stock with the higher dividend rate, just as they
discount the one with the lower rate”.
The fact of the argument is that the investors are rational or risk averse and would prefer immediate
dividend to future dividend (capital gains), hence a birth in hand worth more than two in the bush.
This argument arises from the existence of uncertainty in the capital market economy. If there is
certainty and there are no transaction costs, dividend can be capitalised into the share price of the
company, but with uncertainty, a series of other issues arise. The required rate of return, cost of
capital rises as dividend payout is reduced. Risk-averse investors are indifferent to the division of
earnings into dividends and capital gains in the share prices. Therefore, according to Gordon (1959),
to offset a 1% reduction in dividends requires more than 1% increase. With the volatile capital
market nature in Nigeria, the maintenance of the increase in share prices is not guaranteed.
Shareholders may prefer to have the cash and invest it or spend it. In present economy, it is
practically a general belief that dividends are relevant and each company must develop a dividend
policy that fulfils the goals of its owners and maximises the shareholders’ wealth in the long run.
IRRELEVANCY SCHOOL OF THOUGHT: This school of thought has among its various proponents,
prominently, Franco Modigliani and Merton Miller (1961) hence it is popularly known as M & M model
of dividend policy. According to Miller and Modigliani, under a perfect market condition, the dividend
policy of the enterprise is irrelevant as it has no effect on the market value of the firm; but the company
value depends on the company’s earnings that result from its investment policy; thus given an
investment decision of a firm, dividend decision has no relationship with determining the firm’s value.
The MM Irrelevancy theory is anchored on the following assumptions:
- Perfect capital markets, where investors are ration and that have perfect and costless information
- No floatation and transaction costs on securities
- No taxes and if it does exist, the same rate of tax is applicable to capital gain and dividend income
- Risks of uncertainty do not exist, investors can easily compute future prices and dividends
- Company will maintain a fixed investment policy
- Perfect certainty by every investor as to future investments and profits of the firm
This theory is further strengthened by the following arguments:
- If the entire company’s profits are distributed as dividends, each existing shareholder would gain
but would suffer a proportionate loss in the form of reduction in relative share of the company; as
no retained earnings will lead to issue of new shares or loan while earnings retention will lead to
appreciation in the value of existing shares as no new issues would be required for new investment
- Stockholders’ consumption preference need not be jeopardised by dividend policy, as investors
may willingly re-invest surplus cash paid on dividends by buying more new shares
- Dividend is not critical factor in determining share values as whether the firm’s projects are
financed by retained earnings or new external equity, the impact on shareholders remain the same
- If the firm with investment opportunities decides to pay a dividend so that retained earnings are
insufficient to finance all its investments, earning additional funds from outside sources would
make up the shortfall in funds. The consequent loss of value of existing shares as a result of
obtaining outside finance instead of using retained earnings is exactly equal to amount of the
dividend paid. A company should therefore be indifferent between paying a dividend and
obtaining new outside funds and retaining earnings. Furthermore, the model argues that if a

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 company raises new funds not in the form of shares but as an issue of loan stock the irrelevance of
dividend policy remains the same (unaffected).

CHAPTER SEVEN: FINANCIAL MANAGEMENT FOR SPECIFIC BUSINESS ENTITIES

7.1 Issues Relevant to the Financing or Small & Medium Scale Enterprises
The definition and classification of SMEs differ from one country to another. To our own context SMEs
refer to any organisation or firms that are likely to be unquoted, ownership of the business is
restricted to a few individuals, typically, a family group a and is not a micro-business that is
normally regarded as those very small business that act as a medium for self-employment of the
owners. In fact, SMEs differ from one country to the other and from other organisations in terms of
capital outlay, number of employees, sales turnover, fixed capital investments, available plant and
machinery, market share and the level of development.
7.1.2 Problem/Obstacle of Small Scale Industries Financing
Small Scale Industries face some problems such as; Management problem, Financing, Production
of non-standardised products, Location problem-usually in urban centres, little access to new
technologies, problem of marketing opportunity/skills, etc.
These obstacles include
1 Informational asymmetries: Entrepreneurs do not normally make information about their business
available to lender/investor for assessment and lenders would like to adopt precautionary measures
to reduce moral hazard problems or simply use credit rationing to turn down request for financing
as a result of insufficient funds.
2 Risk profile: These is higher risk associated with small scale activities due to more uncertain
competitive environment, more variable rate of return, higher rates of failure and comparatively less
equipped state in terms of both human and capital resources to withstand economic adversities.
Besides, there is poor accounting system which undermines the accessibility and reliability of
information concerning profitability and repayment capacity.
3 Transaction costs: Irrespective of risk profile consideration, handlings SMEs financing is an
experience business and is usually more difficult to recoup the costs. These problems may also be
made severe due to lack of management information systems in financial institutions, undeveloped
state of the economic information industry and the poor state certain public services such as
registration of property titles and collaterals.
4 Lack of collaterals to mitigate the risks associated with ‘moral hazard’.
5 Institutional and legal factor: As a result of highly concentrated and uncompetitive nature of
banking sectors due to restrictive government regulations a very conservative lending policies or
high interest rates may be adopted, or insufficient developed legal system effectively prevent the
development of certain financing instruments including the pledging of owned assets as collaterals
or use of collaterals as a risk mitigating element. Company laws offer security interests to aid in
determining the efficacy of collaterals; may offer only limited protection to minority shareholders,
which affects the development of venture capital and angel financing. Third, even when adequate
legislation is available, problems of enforcement do exist. More so the ‘information infrastructure’
such as credit bureau and other mechanisms for collecting and exchanging information on payment
performance is not yet developed.
7.1.3 Nature of a firm and its financing sources
According to Moore, et.al (2008), there are four basic factors to determine how a firm is financed. These
include:

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  Economic potential of the firm: Firm that provide rates or return that exceed the investor’s
required rate or return create value for the investor. A firm with high growth a large profits
potential would be exposed to several sources of financing.
 Size & Maturity of the firm: Older larger firms would have access to bank credit than the
younger & smaller ones.
 Nature or type of firm’s assets: Banks specifically consider tangible and non-tangible assets
when evaluating loan requests
 Owner’s preference for debt/equity: the ultimate choice of the proprietor or promoter between
debt and equity financing involves certain trade-offs with regard to potential profitability,
financial risk and voting control.
7.1.4 Sources of Business Finance for SMEs in Nigeria
Sources of finance for SMEs include Owner financing, Overdraft financing, Bank loans, Equity
financing, Trade credit, Business angel financing, Leaning, Factoring and Venture capital, etc.
- Business Angel – wealthy men/informal groups investing or interested in assisting new business
that will enhances the immediate community.
- Venture capital – the provision of investment finance in form of equity or quasi-equity instrument
not listed in the stock exchange. It is a long-term investment that offers the investors gain rather
than dividends, and the fund providers are also involved in contributing their expertise to the
management.
- Export finance – this is used in international trade to ensure prompt and full payments on exports.
- Debt finance provided by banks in the form of lines of credits, term loans and mortgages
- Leasing and hire purchase or asset financing
- Trade credit from suppliers of goods
- Large corporation funding and financing.

LESSON EIGHT: FINANCIAL RATIOS

Accountants do not only present the financial statements at the end of the financial year. They
may also help the users of the financial information to analyse and interpret the accounting
statements to their understanding and use in decision making. One of the basic tools used by
accountants to undertake such analytical work is the ratio.

Ratio can be used to uncover conditions and trends difficult to detect by inspecting individual
component that make up the ratio. Ratio helps in evaluating trading performance of a firm in
order to measure the quality of management, appraise and monitor constituents of capital
structure and costs associated with them. Ratios are particularly vital in understanding
financial statement as they permit comparison of information from one financial statement to
another.

Financial statements are prepared with the aim of satisfying various demands of accounting
information users. A ratio is the relationship that one number bears to another number. It can
be defined as a tool of financial analysis that expresses statistical relationships between figures,
which are aimed at highlighting statements and significant features.

Ratio analysis is a technique used to establish and present a link or relationship between one bit
of financial information and another to show the trends inherent in financial statements. It is a
means through which aggregate financial data presented in the financial statements are
reduced to meaningful ratios or index for measurement, comparison and evaluation. A ratio
simply means a mathematical expression of the relationship of an item to another expressed as
a per cent, rate, or portion.

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Uses of Financial Ratio Analysis

a) Provision of a good basis for assessment and evaluation of managerial performance and
efficiency;
b) It aids in adding meaning to financial statements, by reducing bald figures in the
financial statement into meaningful ratio and so makes it easy to focus attention to
salient figures or points in the financial statements;
c) Revelation of company’s financial performances
d) Provision of basis for comment on organisation’s financial capabilities
e) Helps in the establishment of changes and trends inherent in financial statements and
identification of underlying causes behind apparent changes and trends in company’s
performance
f) Establishment of basis of comparison between the past, present and future performance
of an enterprise.

Features or aspects that may be necessary for analysis include:

a) Solvency
b) Profitability of an enterprise
c) Borrowing ability of the firm
d) Ownership and control
e) Financial strengths and weaknesses
f) Scope of improvement
g) Gearing
h) Interest cover
i) Dividend cover

It has been established earlier that the Categories of Accounting ratios are

a) Profitability ratios
b) Liquidity ratios
c) Stability or gearing ratios
d) Investment ratios
e) Activities ratios

The financial statements can be interpreted by using individual items contained in the financial
statement and by using ratios to compute and analysis the financial statement.

The approaches of interpreting financial accounts or ratio analyses.

These include:

(a) Trend/Time Series Analysis: This involves computing ratios and comparing them with
previous years ratios of the same company to assess the performance of the company;
(b) Cross-section analysis: This approach entails computing ratios of a company and
comparing them with the average of the industry in which the company operates to
assess the performance of the company.

Based on these two approaches, the reference point to which ratios of the company may be
compared include previous year’s ratios, average of the industry and inter-company
analysis.

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Two ratios are widely used to assess gearing and these are: (a) gearing ratios and (b) interest cover ratio.

(a) Gearing Ratio: - This is a ratio that is used to measure the contribution of long-term lenders to the
long term capital structure of a business organisation. Gearing ratio can be calculated in many
ways depending on the need of the users. It could be computed in the following ways:
ix. Gearing ratio = Long term (non-current) liabilities X 100
Share capital + Reserves + Long term liability
(ii) Gearing Ratio = Equity Capital /Total capital X 100

(iii) Gearing ratio = Fixed Interest capital/total capital X 100

OR Debenture + Preference shares x 100
Shareholders’ Equity

Gearing Capital for Duomo Plc:

Gearing ratio (2006): (200 x 100)/ (563 + 200) = 26.2%

Gearing ratio (2007): (300 x 100)/(534 + 300) = 36.0%

Comment: This ratio has revealed a significant increase in the level of gearing within the two years.

(b) Interest Cover Ratio: This is the ratio that measures what is available out of operating profit to
cover interest payable to lenders. It indicates the number of times a company affords to pay
interest out of available current earnings before tax. It is computed as follows:
Interest cover ratio: Operating Profit/Interest Payable

i.e. profit before interest and tax (times)/interest expenses

For Duomo Plc:

Interest Cover Ratio (2006) = 243/18 = 13.5 times

Interest Cover Ratio (2007) = 47/32 = 1.5 times

Comment: The computed interest cover ratio for 2006 showed that the level of operating profit is
considerably higher than the level of interest payable. The implication of this is that operating profit
will have to fall significantly before the operating profit level will fail to cover interest payable. The
lower the level of operating coverage, the greater the risk to lenders that interest payments will not be,
and the greater the risk to shareholders that the lenders will take action against the business
organisation to recover the interest due.

Summary of gearing ratios are as follows: 2006 2007

GEARING RATIO 26.2% 36.0%

INTEREST COVER RATIO 13.5 times 1.5 times

D) INVESTMENT RATIOS: These are ratios used by investors to assess their returns or returns on
their investments. They widely used ratios are:

 Dividend pay-out ratio

 Dividend yield ratio
 Earnings per share ratio
 Operating cash flow per share ratio
 Price-earnings ratio
a) Dividend payout ratio: This is the ratio that measures the proportion of earnings that an enterprise
pays out to shareholders in the form of dividends. It is easily computed as:
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 Dividend announced for the year x 100
Earnings for the year available for dividends

With respect to equity shareholders, the earnings available for dividend which is usually profit for
the year, that is profit after taxation less any preference dividends relating to the year
For Duomo Plc, dividend payout ratio (2006) = 40m/165m x 100 = 24.2%
Dividend payout ratio (2007) = 40m/11m x 100 = 363.6%
Comment: This is an alarming increase in the ratio over two years; hence, paying a dividend of
N40m in 2007 will probably be very imprudent or non-conservative because what is available to
equity shareholders is far less than the announced dividend.
b) Dividend cover ratio: This is computed as earning s for the year available for dividend all over the
dividend announced for the year. That is, earnings for the year available for dividend divided by
dividend announced for the year. In respect of Duomo Plc, it is 165m/40m = 4.1 times. Note that
earnings available for dividend can cover the actual dividend by over four times
c) Dividend yield ratio: This is the ratio that helps investors to measure the cash return on their
investment in a business organisation. It relates the cash return on a share to its current market
value. It is computed as (Dividend per share/(1-t) x 100)/market value per share; where t is the
dividend tax credit (rate of income tax).
Explanation: In some countries, like USA and UK, investors who receive dividends on their
investments also receive a tax credit. This tax credit can be offset against any other tax liability
arising from dividends received. The dividends are issued at net of income tax at the dividend tax
credit rate.
Some investors may want to compare the returns earned on equity shares with the returns accruing
from other investment. These other investments are normally quoted on a gross up (i.e. pre-tax
basis). As a result, it becomes imperative to gross up the dividend to make comparison more
meaningful and easier. This can only be achieved by dividing the dividend per share by 1-t (where
t is the dividend tax credit rate of income tax). In the case of Duomo Plc assuming a dividend tax
credit of 10%, what is the dividend yield rate for the tax years?
Dividend yield rate (2006) = [0.067 (1-0.1) x 100]/2.5 = 3.0%
Note: Proposed dividend/number of shares = 40m/300 x 2 = 0.067 per share (300 is multiplied by 2
because the shares were quoted at N0.50 each)
Dividend yield rate (2007) = [0.067 (1-0.1) x 100]/1.5 = 4.9%
d) Earnings per share: This assesses earnings earned per share by relating the earnings generated by the
enterprise that is available to shareholders during a given period to the number of equity share-
holders on issue. The profit available to equity shareholders during a given year is the profit from
operation after tax and after any preference dividend where applicable. It is computed as:
Earnings per share = earnings available to ordinary shareholders (equity owners)/no of shares on issue
For Duomo Plc: Earnings per share (2006) = 165m/600m = 27.54
Earnings per share (2007) = 11m/600m = 1.8k
Note: some analysts as one of the fundamental statistics or measures of share equity performance
e) Cash generated from operations per share: Cash generated from operations (CGO), as obtained from
cash-flow statement, provides a better guide to the ability of an organisation to pay dividends and
to undertake planned expenditures than the earnings per share figure. It is computed as:
Cash generated from operations/ No of ordinary shares issued
For Duomo Plc: CGO per share (2006) = 251m/600m = 41.80k
CGO per share (2007) = 34m/600m = 5.70k
Comment: Note that for both years, the CGO per share for the company is higher than the earnings
per share. This is not a novel issue because it is caused by the adding back of depreciation charged
to obtain the CGO.
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f) Price/Earning (P/E) Ratio: This ratio provides a useful guide to market confidence regarding the
future of the company as it relates the market value of a share to the earnings per share. This can be
computed as:

P/E Ratio = Market value of each share/earnings per share

For Duomo Plc:
P/E ratio (2006) = 2.50/27.5 = 9.1 times
P/E ratio (2007) = 1.50/1.8 = 83.3 times
Summary of Investment ratios for Duomo Plc 2006 2007
Dividend payout ratio 24.2% 363.6%
Dividend yield ratio 3.0% 4.9%
Earnings per share 27.5k 1.8k
Cash generated from operations per share 41.8k 5.7k
P/E ratio 9.1 times 83.3 times
Illustrative Question
Jazzy Plc has owners’ equity of N100000. The following ratios have been computed for the company.
Current debt to total debt 0.40
Total debt to owners’ equity 0.60
Fixed asset to owners’ equity 0.60
Total asset turnover 2 times
Inventory turnover 8 times
You are required to use the above information to complete the following Balance Sheet of Jazzy Plc as at
31 December, 2012.
Equity and Liabilities N
Current debt
Long term debt
Total debt
Owners’ equity
Total Capital

Assets N
Cash
Stock/Inventory
Total current assets
Fixed assets
Total assets
Solution:
Total equity = N100000

(a) Then fixed assets = 0.60 x 100,000 = N60,000

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 (b) Since total debt to owners’ equity (total debt) = 0.60; then 0.60 of 100,000 = 0.60x100,000 = N60000
(c) Total capital employed = Total debt + Equity capital = N60,000 + N100,000 = N160,000
(d) Total assets = Fixed assets + Current assets. Since fixed assets = N60,000 then Current assets =
Capital employed (total assets) – fixed assets = N160,000 – N60,000 = N100,000
(e) Current debt to total debt = 0.4; then total debt by current debt = 0.4 x 60000 = N24000
Long term debt = N60000 – N24000 = N36000 (OR 0.6 x 60000 = N36000)
(f) Inventory turnover = 8 times and assets turnover = 2 times
2/8 x 160000 = 40,000 (inventory)
Cash = N100,000 – N40000 = N60,000

Note: with all the above information, the full Balance Sheet can be prepared below:

JAZZY PLC

BALANCE SHEET AS AT 31ST DECEMBER, 2012

Assets
Cash 60,000
Inventory 40,000
Total current assets N100,000
Fixed Assets 60,000
Total Assets N160,000
Financed by:
Equity/Liabilities
Current Debts 24,000
Long-term debts 36,000
Total debt/borrowed capital 60,000
Owners’ Equities 100,000
Total equity N160,000

Advantages/Merits of Ratios

 To determine profitability of businesses

 To measure the solvency/liquidity of the enterprise
 For analysis of financial statements to determine its status and ability to pay interest and
dividend, etc
 For easy comparative analysis of companies’ performances
 To simplify complicated accounting information for quick/rational decision making
 To determine the short term financial position
 For forecasting or estimating future of the business
 To assess or measure the operating efficiency of the company.

Limitations of Ratios

i. Based on financial statements which is historical in nature

ii. It is only based on quantifiable data without reflecting the effect of non-quantifiable or qualitative
factors
iii. Financial data which are static in nature preclude the material effect of changes in business
environment

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 iv. Different accounting policies of organisation may affect accuracy and comparability of ratio results
between two companies with different accounting policies. In other words differences in
accounting policies of different companies will distort comparison of ratio results between the
different companies
v. Inflationary measures can distort the information provided by ratios
vi. Parameters and variables for computing some ratios are not uniform, that is, there are no uniform
or universal standard of computing ratios
vii. Ratios may produce misleading results in the absence of absolute data; mostly as a result of the
snapshot nature of balance sheet upon which they are based and so may not represent the
financial position of the business as a whole
viii. Ratio analysis is usually a costly technique and may not be affordable by small businesses
Summary
Ratio analysis is a proportion or fraction expressing the relationship between one financial item and
another in the same financial statement. Ratios compare two related figures from the same set of
financial statements and aid understanding of what the financial statements portray. Past analysis is an
inexact science and so results must be interpreted with caution. Performances of similar businesses and
planned performances are often applied to provide benchmark ratios.
Categories of ratios are:
 Liquidity (or Solvency) ratios, concerned with ability to meet short term obligations including
current ratio, acid test or quick ratio, net working capital ratio, cash ratio and interval measure.
 Efficiency ratios, which are concerned with efficiency of using assets or resources such as average
stock (or inventory) turnover period, average settlement period for debtors (receivables), average
settlement period for creditors (payables), sales revenue to capital employed and sales revenue per
employee
 Investment ratios, which are concerned with returns to shareholders, include dividend payout ratio,
dividend yield ratio, earnings per share, and price-earnings ratio.
 Operating or Activity or Turnover ratio, which are employed to evaluate efficiency with which the
firm manages and utilises its assets and indicates the speed with which assets are being turned
over or converted into sales e.g. percentage changes in sales; inventory (stock) turnover; gross
profit percent; debtors’ turnover, assets turnover, repairs and maintenance as a percentage of net
fixed assets, bad debts as a percentage of sales, operating expenses as a percentage of sales,
working capital turnover
 Leverage Ratios, which are concerned with determining the firm’s current debt paying ability or
financial strength to meet long term obligations. They are also capital structure or financial
leverage ratios such as debt ratio, time interest earned, debt service coverage, debt equity ratio.
 Profitability ratios, such ratios are concerned with effectiveness at generating profit or computed to
measure the operating efficiency of the company, e.g. gross profit margin; net profit margin;
contribution ratio; operating expenses ratio, return on investment (ROI), returns on equity (ROE),
return on capital employed (ROCE) and return on ordinary shareholders’ funds (ROSF).

LESSON NINE: BUSINESS VALUATION

A business valuation exercise could be carried out in the following circumstances:

1) Take-over bid
2) Unquoted companies going public
3) A scheme of merger
4) Sale of shares
5) Shares being pledged as collateral for a loan be unquoted companies, etc.

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Business valuations do not only require the mastering of one or two accounting techniques, but also an
in-depth appreciation of many commercial and financial matters because unlike other difficult
accounting problems there are no precise or correct answers.
METHODS OF VALUATION
1. Net asset basis method
- Statement of financial position (Balance sheet)/Historical variant
- Realisable value variant
- Replacement value variant
2. Earnings basis method
- ARR approach
- P/E ratio approach
3. Dividend yield basis method
4. CAPM method
5. Share prices
6. Berliner method
7. Super profit method
8. Dual-capitalisation of profit method
9. Discounted future profit method
Each method will give a different business valuation. It is most unlikely, that each method would be
used in isolation, and several valuations may be made, each using a different technique or different
assumptions. The valuations may then be compared and a final price may be reached as a compromise
between the different values.
NET ASSETS BASIS – BALANCE SHEET VARIANT: This method involves the use of the total value
of the tangible assets attributable to the company. Intangible assets (i.e. fictitious assets) are to be
excluded from the calculation. The total of all the liabilities are then deducted from the total of the
tangible assets to produce the net tangible assets which is the basis of valuation.
The net assets basis of valuation should be used:
i. When the company is on the verge of liquidation
ii. When unquoted shares are offered as collateral for a loan
iii. As a measure of comparison in a scheme of merger
iv. As a measure of the security in a share value
The difficulty in an asset valuation method is not in the arithmetic involved, but in the process of
establishing the asset value to use. The values appearing in the Balance sheet provided are net book
values which are derived from accounting concept.
NET ASSETS BASIS – REALISABLE VALUES VARIANT: A more realistic set of figures should be
used instead of the net book values, and these are the market worth i.e. realizable values, which are the
values realizable should the assets be sold. In an examination situation, in the absence of the realizable
value of any particular asset, the book value should be used.
NET ASSETS BASIS – REPLACEMENT VALUES VARIANT: This method involves the use of the
prices of new assets hence it is appropriate for use when a similar new company is being set-up. In an
examination situation, in the absence of the replacement value of any particular asset, the book value
should be used.
EARNINGS BASIS METHOD: An earning basis valuation is the most popularly used method of
estimating share prices when a substantial shareholding is involved. This would occur for example,
when an investor is trying to buy a large shareholding or when two companies are planning a merger.
A company may be valued on an earning basis using either:
 An accounting rate of return (ARR) or

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  A price earnings ratio (P/E ratio)
These two approaches are basically the same since the P/E ratio is the reciprocal of the earnings yield
which is itself a measure of the return on capital employed
ARR APPROACH: The ARR method of assessing the value of a company is to use some predetermined
notion of the rate of return an investor would expect on a particular type of investment and then having
decided on the earnings of the company, to calculate capital sum that would result in such a rate of
return
Formula for
Valuation = Estimated future profits
Return on Capital Employed
Illustration 9 -1
Baba Jakunle Limited is considering acquiring Olukunle Limited. At present Olukule Ltd. is earning on
average N480,000 after tax. The directors of Baba Jakunle Ltd. feel that after reorganisation, this figure
could be increased to N600,000. All the companies in the Baba Jakunle group are expected to yield a
post-tax return of 15% on capital employed. What is the highest sum that Baba Jakunle Ltd. should pay
for the acquisition of Olukunle Ltd.
Solution 9 -1
Valuation = N600,000
0.15 = N4,000,000
PRICE-EARNING (P/E) RATIO APPROACH: The price-earnings multiples (or ratios) have become
the most favoured tool for share valuations. The P/E ratio is the ratio of a share price to the earnings per
share (based on the company’s most recent published results)
P/E ratio = MVS/EPS
P/E ratio = TOTAL MARKET VALUE/TOTAL EARNINGS
TOTAL MV = P/E ratio X TOTAL EARNINGS
NOTE
a. A high P/E ratio indicates that investors have a high regard for the company’s prospects and the
quality of its earnings
b. A low P/E ratio indicates that investors regard the company’s earning as risky and of low
quality, that dividend cover is too high
Investors do not use a P/E ratio to value a quoted company’s shares; rather the P/E ratio is a measure of
the relationship between the investors valuation of a share and its earnings. The P/E ratio is a means of
comparison but is has no inherent significance of its own right. It would therefore be unusual to try to
value a quoted company’s shares with a P/E ratio, because the market value will already have been
established by market transactions of buying and selling.
The P/E ratio method of valuation is suitable for estimating the value of unquoted company shares
CONCLUSION ON EARNINGS BASIS
i. An ARR is likely to be used in a takeover when the acquiring company is trying to assess the
maximum amount it is willing to pay. This is because it is a measure of management efficiency and
the rate used can be selected to reflect the return which the acquiring company thinks should be
obtainable after any post-acquisition re-organisation has been completed.
ii. An ARR method is more appropriate in valuing a controlling interest in a very small company that
cannot realistically be compared with any quoted ones.
iii. P/E ratio method of valuation is suitable for estimating a value of unquoted company’s shares
iv. The use of an average P/E ratio (published and Interim accounts) for each sector in which a
company operates will automatically take account of the average growth expected for that sector. A

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 valuation based on a simple ARR will not take account of growth although it is possible to make
suitable adjustments. Hence analysts will often use prospective P/E ratio.
DIVIDEND YIELD BASIS: This method is suitable for the valuation of small shareholdings in
unquoted companies. It is based on the principle that the value of a share is the present value of all
future dividend payments, discounted at a suitable (marginal) rate of shareholdings time preference.
There are two approaches under this technique using net and gross dividends:
1. Dividend without growth
2. Dividend with growth
Dividend without Growth
Remember Ke = d / mv
MV = d/Ke (r)
Net dividend = Dividend (net)/Required rate of return
Gross dividend = Dividend (gross)/Required rate of return
Dividend with Growth
Growth Model MV = do (1 + g)
r - g
SHARE PRICES: These are the prices quoted on the stock exchange. Users are to use the quoted prices
to multiply the number of shares under consideration.
BERLINER METHOD: This is a technique for valuing a company which takes into account both the
earnings and the assets of the company to be purchased.
Valuation = Value of net tangible assets + Maintainable Profits
(on going concern basis) Required rate of return
2
This approach clearly attempts to combine both bases of valuation, not surprisingly, all the difficulties
that apply to the two methods separately apply in conjunction here. The averaging of the two methods
is not inspired by any particular theory, it is simply a compromise which may provide a practical
solution if the bargaining parties cannot agree on the basis of valuation
SUPPER-PROFITS METHOD: This method which is out of fashion starts by applying a “fair return”
to the net tangible assets and comparing the result with the expected profits. Any excess of profits (the
supper profits) is regarded as providing the foundation for a calculation of good will. The good will is
normally taken as a fixed number of year’s super profit. This is where the method differs from the
normal earnings basis, as the latter assumes that the expected level of earnings will continue
indefinitely.
Illustration 9– 2
SmithKlime Limited has net tangible assets of N300,000 and present earnings of N50,000. Dr. Oludele
who considers that a “fair return” for this type of industry is 12% has asked you to value SmithKlime
Ltd. taking goodwill at three years super profits.
Solution -2
N
Present/Expected earnings 50,000
Fair return on net tangible assets (12% x N300,000) (36,000)
Super Profits 14,000

Goodwill: 3 x N14,000 = N42,000

Value of SmithKlime Ltd N300,000 + N42,000 = N342,000

The supper-profits method is therefore a combination of:
i. Net assets basis valuation and
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 ii. A type of earnings – based valuation for good-will
The principal drawbacks to the method are that:
a. The normal rate of return required is a subjective valuation
b. The number of years’ purchase of super-profits is arbitrary.
DUAL CAPITALIZATION OF PROFIT: This technique, which is related to the super profit method,
relies on the following formula:
Total valuation =
Value of net Tangible assets + expected Profits – (Return required on net tangible assets x value of net tangible
assets)
Return required on intangible assets
Illustration 9 – 3
The estimate of maintainable profits for Quick Success Limited is N275,000 per year. The expected yield
on tangible assets is 10% and on intangible assets 15%. The value of tangible assets is N2,000,000.
Required: What is the value of Quick Success Ltd. under the dual capitalization profits?
Solution 9–3
Value of net Tangible assets + Expected Profit – (Return required on net tangible assets x value of net tangible
assets
Return required on intangible assets
= Value of tangible assets +Expected Profits – (MR R R x Value of tangibles)
Required rate of return on Intangibles
= N2,000,000 + N275,000 – (10% x N2,000,00)
15% = N2,500,000
The valuation given by this technique is neither better nor worse than that produced by other
techniques, despite its apparent sophistication. It is easy to distinguish between tangible and intangible
assets but not to identify the rates of return that would be required on the two separate types.
DISCOUNTED FUTURE PROFITS METHOD: Theoretically the valuation procedure is straight
forward. The purchasing company is buying a stream of future returns. The purchaser is buying the
difference between its own cash flow before the acquisition, and the combined companies’ cash flow
after the acquisition. The difference needs to be estimated, discounted and summed to give its present
value. This is the present value of the receipts from the purchase.
Illustration 9– 4
Oldbreed Plc wishes to make a bid for the entire company Newbreed Limited. Newbreed Ltd. makes
after tax profits of N40,000 per annum. Oldbreed Plc believes that by spending further money on
additional investments, the after tax cash flows would be:-
Year Cash flow (net of tax)
0 (100,000)
1 ( 80,000
2 60,000
3 100,000
4 150,000
5 150,000
The after-tax cost of capital of Oldbreed Plc is 15% and the company expects all its investments to pay
back in discounted value terms, within 5 years.
What is the maximum price that the company should be willing to pay for the shares of Newbreed Ltd?
Solution 9 -4
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 YR CFS DCF@15% PV
0 (100,000) 1 (100,000)
1 (80,000) .8696 ( 69,568)
2 60,000 .7561 45,366
3 100,000 .6575 65,750
4 150,000 .5718 85,770
5 150,000 .4972 74,580
Maximum purchase price

ILLUSTRATION 9-5
The directors of Niger Plc, a large conglomerate, are considering the acquisition of the entire share
capital of Minna Limited, a private Ltd company which manufactures a range of engineering machinery.
Neither company has any long-term debt capital. The directors of Niger Plc believe that if Minna Ltd. is
taken over, the business risk of Niger Plc will not be affected.

The accounting reference date of Minna Ltd. is 31 July. Its balance sheet as on 31 July 20 x 4 is expected
to be as follows: - N N
Fixed assets (net of depreciation) 651,600
Current asset – Stocks and work in progress 515,900
Debtors 745,000
Bank balance 158,100 1,419,000
2,070,600
Current Liabilities – Creditors 753,600
Bank overdraft 862,900 (1,616,500)
454,100
Representing:
Capital and reserves – Issued ordinary shares of N1 each 50,000
Distributable reserves 404,100
454,100
Minna Limited’s summarised financial record for the five years to 31 July 20 x 4 is as follows: -
Year ended 31 July 20 x 0 20 x 1 20 x 2 20 x 3 20 x 4 (estimated)
N N N N N
Profit before extra 30,400 69,000 49,400 48,200 53,200
Ordinary items
Extra ordinary items 2,900 (2,200) (6,100) (9,800) (1,000)
Profit after extra 33,300 66,800 43,300 38,400 52,200
Ordinary items
Dividends (20,500) (22,600) (25,000) (25,000) (25,000)
12,800 44,200 18,300 13,400 27,200
The following additional information is available
a. There have been no changes in the issued share capital of Minna Limited during the past five
years
The estimated values of Minna Limited’s fixed assets and stocks and word in progress as on 31
July 20 x 4 are:
Replacement cost Realisable value
N N
Fixed assets 725,000 450,000
Stock and work in progress 550,000 570,000
b. It is expected that 2% of Minna Limited’s debtors at 31 July 20 x 4 will be uncollectable.

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 c. The cost of capital of Niger Plc is 9%. The directors of Minna Limited estimate that the
shareholders of Minna require a minimum return of 12% per annum from their investment in the
company.
d. The current P/E ratio of Niger Plc is 12. Quoted companies with business activities and
profitability similar to those of Minna have P/E ratios of approximately 10, although these
companies tend to be larger than Minna.
Requirements:
1. Estimate the value of the total equity of Minna Limited as on 31 July 20 x 4 using each of the
following bases:
i. Balance sheet value (net assets basis method)
ii. Replacement cost
iii. Realizable value
iv. The Gordon dividend growth model
v. The P/E ratio model
2. Explain the role and limitations of each of the above five valuation bases in the process by which
a price might be agreed for the purchase by Niger plc of the total equity capital of Minna Limited
3. State and justify briefly the approximate range within which the purchase price is likely to be
agreed.
Note: Ignore taxation.
Solution 9–5
(a) i. balance sheet value (net assets basis method) = N454,100

ii. replacement cost value

N454,100 + (N725,000 – 651,600) + (N550,000 – 515,900) = N561,600

iii. realisable value

N454,100+(N450,000-651,600) + (N570,000-515,900) – N14,900*
= N291,700

Note: N14,900 = 2% x N745,000 (bad debts). Bad debts are assumed not to be of relevance to
balance sheet and replacement cost values.

iv. Using the /rb/ model

average proportion of earnings retained

b = 12,800 + 44,200 + 18,300 + 13,400 + 27,200 = 0.495 (say 0.5 i.e. 50%)
33,300 + 66,800 + 43,300 + 38,400 + 52,200
Return on investment this year = 53,200
Average investment

= 53,200
(454,100 – 27,200/2)

= 0.1208 (i.e., r = 12%)

Then g = rb
g = 0.5 x 12% i.e. 6%

so MV cum div = N25,000(1.06) +N25,000 i.e. N466,667

v. P/E ratio model

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 Comparable quoted companies to Minna Ltd. have P/E ratio of 10. Minna Ltd. is much smaller
and being unquoted (too small for USM quote) its P/E ratio would be less than 10, but how much
less?
If we take a P/E of 5: MV=N53,200 x 5 ie N266,000
If we take a P/E of 10x2/3: MV=N53,200x10x2/3 ie N354,667
If we take a P/E of 10(max. possible): MV=N53,200x10 ie N532,000

(b) (i) Balance sheet value: Unless both parties are financially naïve, the balance sheet value will not
play a part in the negotiation process. Historical costs are not relevant to a decision on the future
value of the company.
(ii) Replacement costs: This gives the cost of setting up a similar business. Since this gives a higher
figure than any other valuation in this case, it shows the maximum price for Niger Ltd to offer.
There is clearly no goodwill to value.
(iii) Realisable value: This shows the cash which the shareholders in Minna Ltd could get
by liquidating the business. It is therefore the minimum price which they would accept.
All the methods (i) to (iii) suffer from limitation that they do not look at the going concern
value of the business as a whole. Methods (iv) and (v) do consider this value. However, the
realisable value is of use in assessing the risk attached to the business as going concern, as it
gives the base value if things go wrong and the business has been abandoned.
(iv) Dividend model: The figures have been calculated using Minna’s K(12%). If(2)or(3) were
followed, the value would be the minimum that Minna’s shareholders would accept(realised
value in(iii). the relevance of a dividend valuation to Niger will depend on whether the current
retention and reinvestment policies would be continued certainly the value to Niger should be
based on 9% rather than12% (both companies are ungeared and in the same risk the class so the
different required returns must be due to the relative sales and the fact that Niger’s shares are
more marketable).
(v) P/E ratio model: The P/E ratio model is an attempt to get at the figure which the market
would put on a company like Minna. It does provide an external yardstick, but is a very crude
measure. As already stated, the P\E ratio which applies to large quoted companies must be
lowered to allow for the size of Minna and the non-marketability of its shares. Another limitation
of P/E ratio is very dependent on the expected future growth of the firm. It is therefore not easy
to find a P/E ratio of a ‘similar firm’. However, in the practice the P/E model may well feature in
the negotiations over price simply because it is an easy to understand yardstick.
(c) The range within which the purchase price is likely to be agreed will be the minimum price
which the shareholders of Minna will accept and the maximum price which the directors of
Niger will pay.
Examining the figures in part (a), the range is N291,700 (realisable value) to N561,600
(replacement cost).
The main problem with this method of valuation is that a company is not worth the value of its
assets. Rather, it is worth the value of the income and profits that its assets can generate. A
break-up valuation has meaning if the company will be broken up and its assets sold off, but a
going concern valuation is only really of interest when the buyer of a company wishes to acquire
assets of substance for the purchase prices.
(d) The terms that might be offered to the shareholders of a ‘victim’ company are as follows:
(i) Price: - The price would have to be sufficiently attractive to persuade a majority of the
shareholders to sell.
(ii) Purchase consideration: - The purchase consideration might be cash, shares, loan stock
and a combination of any of these.

1. Cash has the advantage of allowing the shareholders to realise their investment. The
disadvantage is that they will have no equity interest in the enlarged company.

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 97
 2. Loan stock would only be attractive if the rate of interest on the stock is competitive
and if the stock is marketable, or if the stock is convertible into equity at some date in
the future, on terms that are attractive to the shareholders.
3. A share-for-share exchange has the advantage that shareholders in the ‘victim’
company will become shareholders in the enlarged company after the take-over. The
enlarged company in this case will also be a public company, whose shares are
readily marketable.
The main disadvantages are that: -
(a) The purchase price of the ‘victim’ company’s shares will depend on the value of the buying
company’s shares. If these shares fall in values after the take-over, the value of the purchase
price would also fall.
(b) If the ‘victim’ company is bought on a lower P/E ratio than the buying company’s P/E ratio,
their comparable EPS after the take-over will be less.

LESSON TEN: INTERNATIONAL FINANCE

No country can stand on its own and produce all it needs, hence in our daily life we find ourselves in
constant contact with goods produced outside the country. These internationally traded goods such as
cars, TV, computers, etc may be competing in the same local markets. Any organisation that engages in
exporting or importing activities or receives or makes payments in foreign currency exposes itself to the
possibility of fluctuations in exchange rates, which may be positive (increasing i.e. gain) or negative
(decreasing i.e. loss). Due to the risk involved in exchange, it can be said that foreign exchange
management imposes an extra burden on a company’s finance manager, which are reflected on balance
of trade, balance of payment on current account and invisible balance.

International Financial Market is where financial wealth is traded between individuals or governments
of different countries. It can be seen as a wide set of rules and institutions where assets or resources and
services are traded between agents in surplus and agents in deficit and where institutions lay down the
rules. These financial markets include the stock market, bond market, currency market, derivative
markets, commodity market and money market; all collectively called the market; the institutions that
work in them with differing aims and functions as well as direct and indirect policies orientated to make
the market the place (not necessarily physical and ruled but regulated) where exchange can take place
between surplus and deficit units as efficiently as possible.

Governance in the financial market can be defined as the set of rules in interconnecting the agents
operating within the market and the institutions. These rules define the market and can be defined at
both a microeconomic and macroeconomic levels.

Microeconomic rules deal not only with individuals but also with the market itself and its micro-
structure. Macroeconomic rules deal with the market as a whole but they are also strictly connected
with policies regulating the market. At this level, governance is important for the financial market in
order to define every single rule of the trading process but at the microeconomic level the steps to trade
assets on the financial market are listing, trading and post-trading. Another class of microeconomic
governance rules are those which state for instance who can operate in the market and how.

How to finance overseas investment: These can be by borrowing from the Nigerian financial market;
borrowing in a country of operation; borrowing from a third-country; combination of such strategies;

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 98
retention from holding company or subsidiaries; fronting loans; raising equity from the Nigerian
financial market; raising equity from the foreign market and raising equity from international market.

The factors influencing the form of finance include matching of risk, remittance from overseas, taxation,
grants and subsidiaries; and cost of borrowing.

Types of international markets include international debt markets (where funds or debt capital can be
raised through fixed interest bonds – third countries sovereign bonds or large company corporate
bond); international loans and deposit markets operated by banks for lending and borrowing; foreign
exchange (forex) market for trading of currencies (euro, dollar, pound, etc), international trade where
goods and services are traded (vehicle currency); and reserves and anchors.

Fundamental factors driving an exchange rate include interest rates; economic growth, inflationary
trends, balance of payments, market speculators (special factors like political events, commodity prices),
and globalisation and security markets.

Globalisation and financial markets: Global markets are markets in which the law of one price applies,
in the sense that it would be possible to buy or sell products for the same price irrespective of
geographical location and local circumstances. When products are sold or bought outside national
boundaries, price differentials may remain as long as there are costs specifically associated with cross-
border exchange as opposed to exchange within national boundaries. Hence the process of
internationalisation of financial markets is only a step towards global financial markets. This distinction
between globalisation and internationalisation seems to apply to financial markets as well as to markets
for goods and non-financial services. Although financial markets in recent years have gained clear
cross-border orientation, it can still be argued that they are still not truly global market.

Benefits of globalisation include – enhances opportunity to smooth consumption and savings to most
productive investment opportunities; more rapid spreading of technological advances, financial
innovations, enhanced financial performance, advancement in payment, settlement and trading systems
and financial information systems.

Financial intermediation – financial intermediary include banks, building societies, insurance company
and investment banks or pension funds, etc. It offers a service to help an individual/firm to save or
borrow money. They provide such roles as pooling the resources of small savers, providing
safekeeping, accounting and payment mechanisms for resources, providing liquidity, diversifying risks,
collecting and processing information, screening, monitoring, creating long term customer relationship,
collateral, credit rationing and disclosure. Most of these have been earlier discussed.

REFERENCES
ANAN Study Pack (PEA II): Finance and Financial Management, 2014
Eddie McLaney & Peters Atrills (2008): Accounting – An Introduction (4th Ed) Edinburg Gate, England; Pearson
Educational
NOUN Study Packs: Public Financial Management, Budgeting and Financial Management & Education Finance
(2008, 2010, & 2012)
Akinsulire, O (2014): Financial Management (8th Ed.) Lagos; El-Toda Ventures
Pandey, I.M. (2007): Financial Management (9th Ed) New Delhi, India; Vikas Publishing House
Udomette, B.S.E. (in press): Contemporary Framework and Practice in Government Accounting and Public
Finance Management; Abuja – Sigma & Starlife Concepts

PEA II: Finance and Financial Management - Professional Study Kit (c) Udomette B.S.E. 99