KADUNA STATE UNIVERSITY

Faculty of Management Sciences

Department of Business Administration
Course
MBA 856: Managerial Finance
Course Facitator: Professor Yushau I. Ango (Dean Postgraduate School)
Course Learning Objectives: Finance has evolved to assume a very important position in
the decisional process of households, businesses, governments and other non-business
organisations. No financial decision can be efficiently and effectively implemented without
financial management. In view of the fact that most business decisions are measured in
financial terms, the financial manager plays a key role in the operation of the firm. People in
all areas of responsibility and departments/units – accounting, operations, marketing, human
resources management, etc. – need a basic understanding of the financial manager’s
functions.

Module 1
Unit 1: Introduction to Finance
Unit 2: Relationship between Finance and overall Operations of an Organization
Unit 3: Sources of Finance: Short-term sources
Unit 4: Sources of Finance: Long-term sources

Module 2
Unit 1: Working Capital Management
Unit 2: Determinants of Working Capital Needs
Unit 3: Cash Management and its Techniques
Unit 4: Credit Policy

Module 3
Unit 1: Theory of Capital Structure and Dividend Policy
Unit 2: Portfolio Theory and Liquidity

Module 4
Unit 1: Meaning and assumptions of cost of capital
Unit 2: Classification of cost of capital
Unit 3: Arguments for cost of capital

Unit 4: Computations of cost of capital

• Cost of equity
 • cost of debenture - redeemable ,irredeemable and convertible debentures
• cost of preferred stock
Unit 5: Measurement of overall cost of capital (WACC), application and interpretation.
Unit 6: Capital and Money Markets

Introduction
Managerial Finance is essentially a combination of economy and accounting. First, finance
managers utilized accounting information, cash flows, etc., for planning and distribution of
finance resources of the company. Secondly, managers use economic principles as a guide
for financial decision making that favor the interest of the organization. In other words,
finance constitutes an area applied in economics that is supported by accounting
information. Since finance reflexes what adds value to a company, finance managers
constitute important individuals for the majority of business.

Financial managers measure the development of the company, they determine the financial
consequences, the tendencies and recommend on how to use the assets of the organization
for the well being and survival of the business in the long run. At the same time financial
managers seek for the best external financial institutions and recommend the best
combination of financial resources for the shareholders of the company / organization.

In today´s world it is imperative to have the means and tools needed to be competitive; there
must be a vision that there are no borders in order to make a business successful and to
guarantee its survival in the long run. Decision making based on different scenarios must be
done in order to assure the right use of the assets on the company.

Managerial Finance

Managerial Finance is the science of managing financial resources in a firm so as to

maximize the value of the firm while on the other side managing the financial risks.
According to Gitman, Lawrence (2003), “Managerial finance is the branch of finance that
concerns itself with the managerial significance of finance techniques. It is focused on
assessment rather than technique”.
The difference between a managerial and a technical approach can be seen in the questions
one might ask of annual reports. One concerned with technique would be primarily
interested in measurement. They would ask: are moneys being assigned to the right
categories? Was generally accepted accounting practice GAAP followed? One concerned
with management though would want to know what the figures mean. They might compare
the returns to other businesses in their industry and ask: are we performing better or worse
than our peers? If so, what is the source of the problem? Do we have the same profit
margins? If not, why? Do we have the same expenses? Are we paying more for something
than our peers?

Managerial finance is an interdisciplinary approach that borrows from both managerial

accounting and corporate finance.

Functions of a Financial Manager

The financial manager assumes different names depending on the nature, size and
organisational structure of the business. In some organisations, he is known as
Finance Director or Director of Finance, in others, he is known as Finance
Controller or General Manager (Finance). In our discussion, it is assumed that the
financial manager refers to the person in charge of the finance department of an
organisation, whatever name he may be called. The financial manager is usually a
member of the Board of Directors and he normally enlightens the board on financial
implications of a firm’s decisions since most members of the Board are not usually
adequately versed in financial terms and practices.

The functions of a financial manager pervade all the departments of an organisation

in that he has to make key decisions affecting the operations of these departments as
far as finances are concerned. The ability of a financial manager to perform his
numerous functions depends on how he organises his department and his ability to
communicate with other departments. The organisation of finance department tends
to reflect the management style of the financial manager. Its management style is in
turn determined by his:

Level of confidence in his subordinates;

Value system; and

 Leadership tendency.

The value system of a manager refers to how he looks at the participation of other
people in the decision making process. His level of confidence in his subordinates
will determine whether he will delegate some of his functions to his subordinates
and trust them to exercise such functions effectively and efficiently. This in turn
influences the leadership tendency of the financial manager.
The functions of a financial manager have consistently broadened from his
traditional role which reflected the descriptive approach to the study of financial
management to a more dynamic approach. Such traditional functions included:

(i) providing means of payment for a firm’s bills;

(ii) management of a firm’s cash position to guarantee liquidity;

(iii) keeping accurate financial records;

(iv) preparation of financial reports or statements.

The modern functions of a financial manager have broadened to include analytical

aspects of an organisation’s finances. Thus, his functions include the following:

Anticipation of the Financial Needs of an Organisation

Anticipation of the financial needs of an organisation involves the determination of how

much the organisation would need within a certain period to run its activities. This in essence
is a forecasting activity. In other words, the financial manager has the responsibility of
deciding how much funds his organisation would need within the short- term, medium term
and long term periods. The short-term needs for funds are usually determined by considering
series of cash inflows and outflows. The financial manager can make a forecast of the firm’s
financial requirements for a period of one month, one year or many years ahead. Forecasts
are normally made in the form of budgets which consists of:

(1) cash budget which itself is based on series of other forecasts of movements in cash
related activities like: production, purchases, sales, salary and wages and capital
budgets;
(2) pro forma income statement which considers incomes, costs, taxes etc. before
arriving at the net income; and
(3) pro forma balance sheet which summaries the anticipated assets, liabilities and net
worth at the end of the period under forecast.

Acquisition of Financial Resources

Acquisition of financial resources is another important responsibility of the financial
manager. This is based on the nature of funds needed by the organisation. The financial
manager has to determine the time at which such funds could be acquired in order to make
them available to his organisation when it most needs them. Thus, timing of funds acquisition
is very important in financial management. Timing can equally help to reduce the cost of
borrowing if the financial manager knows when to raise such funds from the market. The
most important thing for the financial manager to do in terms of funds acquisition is to decide
on where he is going to acquire such funds. The nature and source of funds will determine the
cost of borrowing. Funds could be raised from a bank, a non-bank financial institution or
from the capital market. The ability of a financial manager to raise funds from any of the
sources would be determined by the size as well as the level of credit worthiness of the
business organisation. The financial manager has to make the basic decision of whether funds
should come from external or internal sources.

Allocation of Financial Resources

Allocation of financial resources is the third important responsibility of the financial

manager. Since the objectives of most businesses are profitability and liquidity, the financial
manager has to allocate funds to assets that would help in the achievement of these
objectives. The allocation of funds is normally done in a way that would minimise or
eliminate over investment in fixed assets, or stock piling of inventory. In allocation of funds,
the financial manager is normally conscious of maturity transformation in order to guarantee
the firm its needed liquidity level.

Funds Management

Funds management is highly related to allocation of funds. The financial manager can invest
temporary surplus funds in securities to earn interest income for the company. He should
know when to invest and when to divest. It is also the responsibility of the financial manager
to prepare periodic reports on the finances of the organisation for the information of
Management, Board of Directors, shareholders and the general public who may be interested
in the affairs of the organisation.

Financial Analysis and Interpretation

The financial manager can also undertake the analysis of the historical financial data of the
company in order to advise management on appropriate corporate and management strategies
to adopt. An appropriate interpretation of financial analysis can always afford him to do this.
By his close association with the financial markets, the financial manager is in a position to
determine the anticipated influence of fiscal and monetary policies on his company’s
operations. It is his responsibility to pass informed judgement to management in order to
 adopt appropriate management strategies which can minimise such effects on the company’s
operations.

Financial Planning and Control

The responsibility of the financial manager includes participation in product pricing. The
determination of unit cost of production is done by accounting method and is under the
control of the financial manager. Thus, pricing of products also attracts his attention since his
objective is to maximise the difference between revenues and costs. Long-range planning,
financial planning and control and budget preparation are very closely related.

FINANCE AND OVERALL OPERATIONS OF AN ORGANIZATION

Here, we shall explain how the financial function fits in or interacts with the other areas of
the firm. Note that the financial manager is typically responsible for:

 Managing cash and credit;

 Issuing and repurchasing securities such as stocks and bonds;
 Deciding how and when to spend capital for new and existing projects;
 Hedging (reducing the firm’s potential risk) against changes in foreign exchange
and interest rates;
 Purchasing of insurance;
 Oversees the accounting function.

Finance affects the firm in many ways and throughout all levels of a company’s
organizational chart. Finance permeates the entire business organization, providing guidance
for both strategic and day-to-day decisions of the firm and collecting information for control
and feedback about the firm’s financial decisions.

Operational managers use finance daily to determine how much overtime labour to use, or to
perform cost/benefit analysis when they consider new production lines or methods.

Marketing managers use finance to assess the cost effectiveness of doing follow-up
marketing surveys.

Human resource managers use finance to evaluate the company’s cost for various employee
benefit packages.

Sources of Finance

Sources of funds available to financial managers can be divided into two broad areas: short-
term funds and long-term funds. Short-term funds are used to finance supplies, payrolls, and
are obtained for one year or less. Long-term funds are used to purchase buildings, land, long-
 lived machinery, and equipment. Good financial management requires that a funding source
be matched to the intended use of the funds. In this Unit, we shall concentrate on the short-
term sources.

SHORT-TERM SOURCES OF FINANCE

Short-term sources of funds represent current liabilities (funds owed). They

represent short-term obligations. Since they are supposed to be settled by cash, they
represent cash payments which must be settled as at when due. Examples of current
liabilities and their sources are explained as follows.
 Bank Overdraft
The source of overdraft is commercial banks, and they grant this to creditworthy
firms. Funds could be advanced to such firms within a period ranging between one
day and one year. These loans are supposed to be repaid on self-liquidating basis
(paying from proceeds which accrue from normal course of business operations).
 Account Payable
This can be referred to as trade credit. A firm can buy something on credit. Supplies
could be made on credit, and they give rise to trade credits. The repayment period
and terms of payment depend on the commercial and credit policies of the suppliers.

 Bill Finance

In simple terms, a bill is a promissory note. But there are different types of bills
and complexity exists in their meanings. In our case, a bill is a trade bill of
exchange which could be domestic or foreign. If a bill of exchange (inland) is
accepted from discounting operations, it could represent an important source of
fund.

 Deferred Tax Payment

Tax payment could be looked at from two perspectives:

1. Self imposed (a firm will not pay when it is supposed to pay and that
becomes a source);

2. Late assessment.
 Factoring

Debt could be factored. This is another source of short-term funds. Factoring

involves handing over of account receivable or any other debt to factors for
 collection with or without recourse.

 Hire Purchase Finance Arrangement

Firms that engage in selling on installment basis can make arrangement with hire
purchase firms to make credit facilities available to customers. Alternatively, a
firm may make hire purchase agreement with its customers. This may be known
as block discounting. Thirdly, a hire purchase firm can buy the product directly
from the manufacturer, and thereafter make direct arrangement with customers.

 Stock Finance

Stocks could be used to raise short-term funds in a number of ways. They could
be used as collaterals for secured loans from commercial or merchant banks. Raw
materials could be financed en route by means of trade bills and/or warehouse
receipt. This represents another type of secured loans on the value of stock of raw
materials. The bill could become negotiable if endorsed by a reputable commercial
house or bank, and could thereafter be sold outright or used as collateral for a
loan.

LONG-TERM SOURCES

Two major external sources of long-term funds are:

 Financial institutions (including lease finance companies), and

 Capital market.
Capital market is classified into:

 Organized;
 Unorganized.
The organized capital market will be our focus because it is the capital market that
will assess the performance of the firm.

Firms raise money from the capital market by:

 Issuing common stock (C/S);

 Issuing instruments of debt (long-term liabilities).
Note that a firm cannot issue debt instruments if it has no common stock.

Common Stock

Equity shares, common stock and ordinary shares, all mean the same thing, but a
stock is a group of shares, that is, a stock is made up of shares.
 Ordinary shares could be issued by firms which have been quoted on the stock
exchange. Ordinary shares constitute the equity base of a firm, and represent
ownership of the firm on pro-rata basis. This implies that an individual investment
is a small proportion of total investment.

Thus, each equity shareholder is entitled to a proportionate part of the firm’s

residual profit and asset. The capital contributed by the shareholders is, therefore,
known as risk capital. But they have some compensation like voting rights.

Preference Shares

The next class of shares which ranks above equity shares is the preference shares.
They are also known as preference stocks. Preference shares occupy an
intermediate position between common stock and debenture stocks.
Preference shareholders are entitled to fixed dividend payment as different from
equity shareholders which are entitled to variable dividend payments. They are
imperfect creditors because tax is paid before fixed dividend is paid to them; they
are not creditors and they are not the owners of the firm. They do not normally
have voting rights unless otherwise stipulated in the terms of the issue.

There are various types of preference shares:

(1) Cumulative preference shares

(2) Participating Non-Cumulative shares
(3) Participating Cumulative shares
(4) Redeemable and irredeemable Preference shares
(5) Convertible Preference shares

1. Cumulative Preference Shares

Preference shares could be cumulative or non-cumulative. Cumulative
preference shares allow for dividend payment to be deferred if a firm does
not make adequate profit to pay such dividend. Therefore, such firms are
normally required to pay such dividends in arrears before dividend could be
paid to common shareholders. Non-cumulative preference shares do not
allow for any form of deferment of dividend payment.

We can say that all preference shares are deemed to be cumulative unless
otherwise stated in the terms of the issue.

2. Participating Non-Cumulative Preference Shares

 This class of shareholders is entitled to a non-cumulative dividend at a fixed
rate but without a right to participate in the residual profit of a firm after the
equity shareholders have been paid.

3. Participating Cumulative Preference Shares

This class of shareholders is entitled to participate in the residual profit of a firm in

addition to the cumulative fixed dividend rate (i.e. they combine the features of
cumulative and participating).

4. Redeemable and Non-Redeemable/Irredeemable Preference Shares

Preference shares could be redeemable or irredeemable. Redeemable
preference shares are normally redeemed after a fixed period of time. We
can say that this class of preference shares has a definite maturity period
while irredeemable preference shares do not have definite maturity period
(but it could be sold at the security market – an artificial maturity period).

5. Convertible Preference Shares

Convertible preference shares convey upon the holders the right to convert
these shares into equity shares in accordance with the terms of issues. This
is an issue with speculative features. These shares are corporate fixed-
income securities that the investor can choose to turn into a certain number
of shares of the company’s ordinary shares after a predetermined time span
or on a specific date. The fixed income component offers a steady income
stream and some protection of the investors’ capital. However, the option to
convert these securities into stock gives the investor the opportunity to gain
from a rise in share price. It can be summarized that convertible preference
shares give the assurance of a fixed rate of return plus the opportunity for
capital appreciation.

Debenture Stocks
These are corporate bonds.

Two categories of debentures are:

  All banks debentures
This involves one to one relationship between a bank and a firm, and
lending is based on the assets.

 Debenture Stocks – Debenture stocks or corporate bonds are

normally issued under a firm’s seal. This represents the legal
evidence of a firm’s indebtedness. A debenture stock holder is a
creditor to the firm, therefore, he is entitled to a fixed interest
payment whether a firm makes profit or not. Debenture stock holders
do not have any voting right and their interest in the firm is limited to
the fixed interest payment no matter how successful the firm may be.

Lease Financing
This is an important source of long-term funds. It may be used as a source of
financing company expansion or for modernization of the productive apparatus of
the firm. Thus, through leasing, a company may make use of equipment without
actually owning it. The main objective of leasing is to put at the disposal of a firm a
plant or any fixed asset which serve the productive need of such a firm. The firm, in
making use of that equipment, is obliged to pay to the lessor adequate sum of money
which constitutes cost on the part of the firm.

Three units are involved in lease and they are as follows:

 A company which has the aim of expanding its productive capacity

and/or requires equipment for modernization;
 A supplier which specializes in manufacturing specialized
equipment;
 A company which is in a position of buying equipment from the
manufacturer or supplier and placing the equipment at the disposal of
other companies for productive use.

Three types of leases are:

 Operating lease;
 Financial lease;
 Sale and leaseback.

In the operating lease, we have the supplier/lessor and the lessee. The supplier is
also the manufacturer. Here, there is a leasing contract between the lessor and the
lessee which lasts for a short-term period. Operating lease has the following
characteristics:
(i) It lasts for a very short-term period.
(ii) Either the lessor/supplier or the lessee/firm can terminate the contract after a
month’s notice.
(iii) The supplier has the responsibility for every expenses relating to ownership
and operational expenses. He is also responsible for maintaining the
equipment.
(iv) The lessee normally pays to the lessor a fixed sum of money which can be
called a rent. This fixed sum of money takes into consideration depreciation,
maintenance expense and a profit margin. Thus, operating leasing can be called
‘maintenance leasing’ or ‘gross leasing’.

Financial lease is of a medium-term or long-term nature, and it is normally based

on a leasing contract which involves movable or immovable property. However, the
emphasis here is on movable property – equipment leasing. The main partners
involved are the producer, the lessor and the lessee, and there is no direct link
between the producer and the lessee. While the producer specializes in
manufacturing certain equipment, the lessor (in normal case) may be a financial
institution. The lessee, in most cases, is a small scale industry.

The lessor buys equipment from the producer and places it at the disposal of the
lessee. The responsibility of the lessor is to acquire the equipment while the lessee
makes periodic payment (rent) of a fixed sum, and the sum of these payments
normally exceeds the cost of the equipment.

The characteristics of financial lease include the following:

(i) Expenses for insurance contracts, installation expenses, maintenance expenses and
repairs are normally borne by the lessee. Such expenses are not normally
included or considered while calculating periodic payment. This makes this
type a ‘Net Leasing’.
(ii) The duration of the contract is normally based on the technical/economic life of
the equipment.
(iii) Only highly specialized equipment are normally involved in this type of
leasing contract.
(iv) The leasing contract, when finally entered, cannot easily be terminated either
by the lessor or the lessee. This can only happen by the lessee if and only if he
is able to pay in advance sum of the periodic payment remaining. In this case,
the average market rate of interest is applied to determine the remaining part of
the periodic payment.

At the maturity of the contract, the lessee can decide to take any of the following
actions:
 (i) He might renew the contract but with lower periodic payment because of
reduction in cost of the equipment.
(ii) He can return the scrap.
He can pay the residual value of the asset in order to take over the ownership of the
asset.

MEANING OF WORKING CAPITAL MANAGEMENT

CONCEPT WORKING CAPITAL

Working capital refers to all short-term or current assets used in the course of a firm’s
daily operations. We can view working capital from two perspectives:

(1) Gross working capital (total current assets) and net working capital (current assets
minus current liabilities);

(2) Circulating capital (cash is the most important component of working capital).
Net working capital represents a more appropriate assessment of the firm’s liquidity
position. It measures the level of liquidity which could be used to meet the liquidity
requirements of the firm.

Working capital management refers to the management of current or short-term assets

and short-term liabilities. Components of short-term assets include inventories, loans and
advances, debtors, investments, and cash and bank balances. Short-term liabilities
include creditors, trade advances, borrowings and provisions. The major emphasis is,
however, on short-term assets, since short-term liabilities arise in the context of short-
term assets.

Working capital management is, therefore, concerned with the ways and means of
making working capital adequate to meet the firm’s short-term obligations. The effective
working capital management involves the adoption of appropriate management policy.

The accounts of working capital items are always volatile in nature because the change
in the account is with respect to a change in the firm’s level of operations.
Working capital accounts are current assets and current liabilities. Cash is used in
making various payments. Cash could mean either the legal currency or cheques.
Cash management starts at a point when a customer pays either in cash or by
cheques and ends when a firm actually collects the cash or cheque.
Account receivable management, on the other hand, involves the process of
managing account receivable until a customer is able to pay his bill. Therefore, there
is a line of distinction between cash and account receivable (debtors).

DETERMINANTS OF WORKING CAPITAL NEEDS

There are several factors which determine the firm’s working capital needs. These
factors are comprehensively covered by A Textbook of Business Finance by
Manasseh (Pages 403 – 406). They however include:
• Nature and size of the business.
• Firm’s manufacturing cycle
• Business fluctuations
• Production policy
• Firm’s credit policy
• Availability of credit
• Growth and expansion activities.
Working Capital Cycle
Often referred to as the “Operating Cycle” or the “Cash Cycle” this indicates the total
length of time between investing cash in raw materials and its recovery at the end of the
cycle when it i s collected from debtors. This can be shown diagrammatically:
It is difficult to determine the optimum cycle. Attention will probably be focused
more on individual components than on the total length of the cycle. Comparison with
previous periods or other organisations in the same industry may reveal areas for
improvement.

The factors determining the level of investment in current assets will vary from
company to company but will, generally, include:
• Working Capital Cycle – companies with longer working capital cycles will
require higher levels of investment in current assets.
• Terms of Trade – period of credit offered; whether discounts permitted.
• Credit Policy – company‟s attitude to risk (“conservative” v “aggressive”).
• Industry – some industries have long operating cycles (e.g. engineering), whereas
 others have short cycles (supermarket chain)
CASH MANAGEMENT
Cash is an idle asset and the company should try to hold the minimum sufficient for its
needs.
Three motives are suggested for holding liquid funds (cash, bank deposits, short-
term investments):

• Transaction Motive - to meet payments in the ordinary course of business –

pay employees, suppliers etc. Depends upon the type of business, seasonality of
trade etc.
• Precautionary Motive - to provide for unforeseen events e.g. fire at premises.
• Depends upon management‟s attitude to risk and availability of credit at short
notice.
• Speculative Motive - to keep funds available to take advantage of any unexpected
• “bargain” purchases which may arise - e.g. acquisitions, bulk-buying etc.

CASH MANAGEMENT
Cash is an idle asset and the company should try to hold the minimum sufficient for its
needs.
Three motives are suggested for holding liquid funds (cash, bank deposits, short-
term investments):

• Transaction Motive - to meet payments in the ordinary course of business –

pay employees, suppliers etc. Depends upon the type of business, seasonality of
trade etc.
• Precautionary Motive - to provide for unforeseen events e.g. fire at premises.
• Depends upon management‟s attitude to risk and availability of credit at short
notice.
• Speculative Motive - to keep funds available to take advantage of any unexpected
“bargain” purchases which may arise - e.g. acquisitions, bulk-buying etc.

CASH MANAGEMENT TECHNIQUES

(1) Speed up the collection of account receivable, that is, collect account receivable as
soon as possible. This intensifies funds inflows.

(2) Pay account payable as late as possible without causing credibility problem
between you and your supplier.
What is important to the firm is to have cash at its disposal. Cash is the focus of the firm.

MANAGEMENT OF ACCOUNT RECEIVABLE

Goods could be produced or purchased by a firm on credit. The same firm can also sell a
part on credit and that gives rise to account receivable. Therefore, credit sales constitute
account receivable. Account receivables are assets owed to the firm by various
categories of customers. Trade debts are extended to customers in order to achieve the
following objectives:

 to attain an optimum sales volume;

 to generate more profits or to expand market share and contain the activities
of competitors.
As a note of warning, credit sales should be done cautiously because of the costs
involved.

DIFFERENT TYPES OF COSTS AND HOW TO MINIMIZE THEM

It is important to consider the following cost effective measures:

(1) The cost of financing account receivable should be minimized. This is because
account receivable ties up a firm’s cash and in times of cash/ liquidity problems,
such account must be used to finance operations.
Administrative expenses involved should be controlled. A firm needs to employ
staff to keep record of credit sales and expenses. It also spends on the purchase
of materials for record keeping. Thus, the larger the account receivable, the
larger the expenses could be.
(2) Losses from bad and doubtful debts should be minimized. Bad debts give rise to
losses. A generous credit policy could result in an increase in bad and doubtful
debts. Adequate measures should, therefore, be evolved in order to control the
possible negative effects on the liquidity of a firm.

(3) Collection cost should be minimized. A generous credit policy can increase the
risk of collecting or effecting payment of account receivable because it can attract
high bad risk customers. Thus, customers should be selected based on the
yardstick established by the firm.

THE CREDIT POLICY

Credit policy can be classified into two extreme categories:
(1) Liberal or generous credit policy (LCP);
(2) Stringent credit policy (SCP).
LCP accommodates all categories of customers and various forms of payment
arrangements that can attract customers.

The SCP is adopted to maximize cash sales. Thus, only highly creditworthy customers,
who may have temporary liquidity problems, may be considered for credit sales.

While LCP results in high volumes of bad debts, and by implication, create liquidity
problems, the SCP minimizes these problems. It is, therefore, advisable that any credit
policy should consider the following:
(1) credit terms
(2) credit standard
(3) collection procedures
Credit terms (terms of credit) refer to the determination of the collection period and
measures which could be used to induce early payment, e.g. discount.
In the case of credit standard, it should stipulate variables which could be used in
analyzing applicants for credit sales. The variables are:
(i) character
(ii) capacity
(iii) condition
(iv) capital

Thirdly, the collection procedures should indicate the standard ways of collecting
account receivable, for example, the use of various means of communication, and
communication is important to remind the debtors when they are expected to pay.
Collection procedures, therefore, involve the following:
(i) Sourcing of credit information on the prospective customers – based on the past
experiences (books of accounts), credit agencies/bureau, banks.
(ii)Credit analysis – which should be based on the following:
 Types of customers
 Nature of business
 Business background
 Nature of product
 Size of the credit sales
 Payment records
 Debt and credit policy of the firm
Using all this information will help to determine the strengths and weaknesses of the
firm.

(iii) The prompt collection procedure.

WAYS TO COLLECT ACCOUNT RECEIVABLE AS SOON AS POSSIBLE

(1) Reduce the mailing time of payment.
(2) Reduce the timeframe between payments and actual use of funds.
(3) Increase the movement of funds to disbursement banks. How?
(i) Concentration banking. This is important in the case of very big companies
including multinational companies. This involves the establishment of
multiple collection centres at strategic locations. This is done to shorten the
timeframe between mailing and collection.

Lock Box System. Here a company can rent Post Office Boxes at strategic locations and
advice customers to make payments at the nearest Post Office Box. A bank in the same
locality will thereafter be authorized to pick up remittances from each box and the bank
can do this (collection from the box) several times in a day.

SIMPLE METHOD OF MANAGING ACCOUNT RECEIVABLE

There should be a link between account receivable and account payable. Note that
account receivable depends on the credit policy of the firm; sales depend on production.
The establishment of the links/cycles will facilitate the ability of the firm to meet the
demands of its short-term creditors (i.e. to pay account payable).
 How do we establish the link?
The link can be established by determining the average age of account payable (trade
credit) and account receivable.

 Average age of the account payable ----

TCB x ND = AATC

ETC

where:

TCB = Trade credit balance at the beginning of the accounting

 period
ETC = Expected trade credit for the accounting period
ND = Number of days in the accounting period
AATC = Average age of trade credit

TCB and ETC depend on the production capacity, sales and the trade credit policy of the
firm.
For example:

If TCB = N10,00

ETC = N15,00
ND = 90 days

AATC= 10,000 x 90 days = 60 days

15,000
AATC (60 days) represents the number of days on the average trade credit will remain
unpaid.

The ability of the firm to pay depends on production and sales cycles. Thus, the period
should have an appropriate link with production and sales cycles in order to balance the
flow of cash between payment and receipts. If the AATC is less than the production and
sales cycles, it implies early payment. Thus, cash outflows may tend to exceed cash
inflows. When the AATC is more than the production and sales cycles, it implies
inability or unwillingness to settle debt. This means that trade credit will accumulate at
an increasing amount. It could pose two major problems – credibility and solvency. The
reason is either that there is a liberal credit policy or an extended period. If, on the other
hand, the increasing amount of trade credit is a result of a firm’s unwillingness to pay, it
may lead to excess cash which, if not properly applied, may lead to a loss in earnings
potential.

 How do we determine the age of Trade debt?

It is important to time the payment of trade debts (account receivable).
TDB x ND = AATC
 ECS

where:

TDB = Total debt balance at the beginning of the accounting

period
ECS = Expected credit sales in the accounting period
ND = Number of days in the accounting period
AATD = Average age of trade debts

Example:

If TDB = N10,000

ECS = N30,000
ND = 90 days

AATD = 10,000 x 90
days

30,000

= 30 days
Cash Management Models

A number of cash management models have been developed to determine the optimum
amount of cash that a company should hold.One approach is to use the Economic Order
Quantity (EOQ) Model, which is used in stock management (see Stock Management section
later). Another (and more sophisticated) approach is the Miller-Orr Model. This determines a
lower limit, an upper limit and a normal level on cash balances. If cash reaches the lower
limit the firm sells securities to bring the balance back to the normal level. On the other
hand, if the cash balance reaches the upper limit the firm should buy sufficient securities to
return to the normal level. The various limits are set by reference to the variance of cash flows,
transaction costs and interest rates.

Economic Order Quantity (EOQ)

Total stock-holding costs could be broadly classified as “Holding” costs and “Ordering”
costs. The EOQ model attempts to minimise total costs by balancing between holding and
ordering costs. If large batches are ordered this will result in high holding costs and low
ordering costs. Conversely, if small batches are ordered this will result in low holding costs and
high ordering costs.

2 cd h
EOQ =

where: c = cost per order

d = annual demand for item of stock
h = annual cost of holding a unit in stock

The EOQ Model makes a number of assumptions:

• Order cost is constant regardless of the size of the order.

• Use of the item of stock is constant.
• No stock-outs occur.
• Purchase price is constant.
Example:
A company has annual demand for 2,000 units. Each unit can be purchased for
RWF20. The cost of placing each order is RWF20 and the annual cost of holding an
item in stock is RWF2. Calculate the Economic Order Quantity.
 2 cd 2 x 20 x 2,000
EOQ = 2 =200 units

Cost of Funds
Introduction

It is important that a company is aware of its cost of capital. In certain cases it is not
initially apparent what this cost is (e.g. new share issue, retained earnings etc.) and a
number of models have been developed to assist in calculating the cost of individual
sources of finance. In fact, it is not possible to make an informed financial decision
without considering the cost of capital for the company. A company’s cost of capital
is the rate of return that must be earned in order to satisfy the combined required
rates of return of the company’s investors. As such the cost of capital is the
minimum acceptable rate of return for capital investments. Having calculated the
cost of each individual source of finance it is then important to calculate an overall
cost for the company, based on the mix of funds which it chooses to use.
This is the price the company pays to obtain and retain finance. To obtain finance a
company will pay implicit costs which are commonly known as floatation costs.
These include: Underwriting commission, Brokerage costs, cost of printing a
prospectus, Commission costs, legal fees, audit costs, cost of printing share
certificates, advertising costs etc. For debt there is legal fees, valuation costs (i.e.
security, audit fees, Bankers commission etc.) such costs are knocked off from:
• The market value of shares if these has only been sold at a price above par value.
• For debt finance – from the par value of debt.
I.e. if flotation costs are given per share then this will be knocked off or deducted
from the market price per share. If they are given for the total finance paid they are
deducted from the total amount paid.

Cost of Retaining Finance

This will include dividends for share capital and interest for debt finance (tax
deducted) or effective cost of debt. However, when computing the cost of finance
apart from deducting implicit costs, explicit costs are the most central elements of
cost of finance.
Importance of Cost of Finance
The cost of capital is important because of its application in the following areas:

• Long-term investment decisions – In capital budgeting decisions, using NPV

method, the cost of capital is used to discount the cash flows. Under IRR method
the cost of capital is compared with IRR to determine whether to accept or reject
a project.
• Capital structure decisions – The composition/mix of various components of
capital is determined
by the cost of each capital component.
• Evaluation of performance of management – A high cost of capital is an indicator
of high risk attached to the firm. This is usually attributed to poor performance of
the firm.
• Dividend policy and decisions – E.g if the cost of retained earnings is low
compared to the cost of new ordinary share capital, the firm will retain more and
pay less dividend. Additionally, the use of retained earnings as an internal source
of finance is preferred because:

• It does not involve any floatation costs

• It does not dilute ownership and control of the firm, since no new shares
are issued.

• Lease or buy decisions – A firm may finance the acquisition of an asset through
leasing or borrowing long-term debt to buy an asset. In lease or buy decisions, the
cost of debt (interest rate on loan borrowed) is used as the discounting rate.
Factors That Influence the Cost of Finance
• Terms of reference – if short term, the cost is usually low and vice versa.
• Economic conditions prevailing – If a company is operating under inflationary
conditions, such a company will pay high costs in so far as inflationary effect of
finance will be passed onto the company.
• Risk exposed to venture – if a company is operating under high risk conditions,
such a company will pay high costs to induce lenders to avail finance to it
because the element of risk will be added on the cost of finance which may
compound it.
• Size of the business – A small company will find it difficult to raise finance and
as such will pay heavily in form of cost of finance to obtain debt from lenders.
• Availability – Cost of finance (COF) prices will also be influenced by the forces
of demand and supply such that low demand and low supply will lead to high
 cost of finance.
• Effects of taxation – Debt finance is cheaper by the amount equal to tax on
interest and this means that debt finance will entail a saving in cost of finance
equivalent to tax on interest.
• Nature of security – If security given depreciates fast, then this will compound
implicit costs
(costs of maintaining that security).
• Company’s growth stage – Young companies usually pay less dividends in
which case the cost of this finance will be relatively cheaper at the earlier
stages of the company’s development.

CALCULATION OF COST OF CAPITAL

1. Equity

• Constant Dividends

d
r=
M
v

Where: r = cost of capital

d = annual dividend
MV = market value (ex. div)
r = 150
800
 = 18.75%

• Growth in Dividends

r= Do (1+g) +g
MV

Where: r = cost of capital

Do = most recent

dividend MV = market

value (ex. div)

g = annual rate of growth in dividends
Example:
Dividend of RWF20 per share about to be paid. Dividends expected to
grow by 10% per annum in the future. Current market value of share is
RWF160.

2. Preference Shares
d
r=
M
V

Where: r = cost of capital d = annual

dividend MV= market value (ex. div)

Example:
7% Preference Shares RWF1000; Current market value 700 ex. Div
Irredeemable Debentures

r= K
(l – t) MV
Where: r = cost of capital

k = coupon rate
t = rate of corporation
 tax MV = market value (ex.

interest)

Weighted Average Cost of Capital

Weighted Average Cost of Capital this is a composite of the individual costs of financing,
weighted by the percentage of financing provided by each source. In other word Weighted
Average Cost of Capital is a function of the individual costs of capital and the percentage of
capital provided by debt, preference share and common stock, i. e., the mark up of the capital
structure. The weighted average cost of capital is very crucial in project appraisal because it
ensures that the only those investments that provide higher returns than the cost of capital are
acceptable. As such Weighted Average Cost of Capital is the rate that is applied in
discounting cash flows for investment appraisal.

Example

Tanburawa Incorporated capital Structure is given as follows:

Source of Finance Amount After tax cost

£000 %
Debt 3,600 12
Preference Shares 5,400 15
Equity Capital 21,000 21

Required: Weighted Average Cost of Capital of Tanburawa Corporation and comment on the
result.

CAPITAL STRUCTURE
Factors That Affect Capital Structure
• Availability of securities – This influences the company’s use of debt finance
which means that if a company has sufficient securities, it can afford to use debt
finance in large capacities.
• Cost of finance (both implicit and explicit) – If low, then a company can use
more of debt or equity finance.
• Company gearing level – if high, the company may not be able to use more
debt or equity
finance because potential investors would not be willing to invest in such a
 company.
• Sales stability – If a company has stable sales and thus profits, it can afford to use
various finances in particular debt in so far as it can service such finances.
• Competitiveness of the industry in which the company operates – If the company
operates in a highly competitive industry, it may be risky to use high levels of
debt because chances of servicing this debt may be low and may lead a company
into receivership.

CAPITAL STRUCTURE THEORIES

THE NET INCOME APPROACH (NI)
The essence of the NI approach is that the firm can increase its value or lower the
overall cost of capital by increasing the proportion of debt in the capital
structure. The crucial assumptions of this approach are:

• The use of debt does not change the risk perception of the investor. Thus Kd and
Ke remain constant with changes in leverage.
• The debt capitalization rate is less than equity capitalization rate (i.e. Kd < Ke).
The implications of these assumptions are that with constant K d and Ke,
increased use of debt, by magnifying the shareholders earnings will result in a
higher value of the firm via higher value of equity. The overall cost of capital will
therefore decrease. If we consider the equation for the overall cost of capital,

Ko = K e D
-( K
-Kd)
e V
Ko decreases as D/V increases because Ke and Kd are constant as per our
assumptions and Kd is less than Ke. This also implies that Ko will be equal to Ke if
the firm does not employ any debt (i.e. when D/V = 0) and that K o will approach Kd
as D/V approaches 1.

NET OPERATING INCOME (NOI) APPROACH

The critical assumptions of this approach are:
• The market capitalizes the value of the firm as a whole.
• Ko depends on the business risk. If the business risk is assumed to remain
constant, then Ko will also remain constant.
• The use of less costly debt increases the risk of the shareholders. This causes Ke to
increase
and thus offset the advantage of cheaper debt.
• Kd is assumed to be constant.
• Corporate income taxes are ignored.
The implications of the above assumptions are that the market value of the firm depends
on the business risk of the firm and is independent of the financial mix.

TRADITIONAL APPROACH TO CAPITAL STRUCTURE

The traditional approach to the valuation and leverage assumes that there is an
optimal capital structure and that the firm can increase total value through the
judicious use of leverage. It is a compromise between the net income approach and
the net operating income approach. It implies that the cost of capital declines with
increase in leverage (because debt capital is cheaper) within a reasonable or
acceptable limit of debts and then increases with increase in leverage. The optimal
capital structure is the point at which K o bottoms out. Therefore this approach
implies that the cost of capital is not independent of the capital structure of the firm
and that there is an optimal capital structure. The traditional approach has been
criticized as follows:

• The market value of the firm depends on the net operating income and the risk
attached to it, but not how it is distributed;
• The approach implies that totality of risk incurred by all security holders of a
firm can be altered by changing the way this totality or risk is distributed
among the various classes of securities. In a perfect market this argument is
not true.
The traditional approach however has been supported due to tax deductibility of interest
charges and market imperfections.
 THE MODIGLIANI-MILLER (MM) HYPOTHESIS
The MM, in their first paper (in 1958) advocated that the relationship between
leverage and the cost of capital is explained by the net operating income approach.
They argued that in the absence of taxes, a firm’s market value and the cost of
capital remains invariant to the capital structure changes. The arguments are based
on the following assumptions:
• Capital markets are perfect and thus there are no transaction costs.
• The average expected future operating earnings of a firm are represented by
subjective random variables.
• Firms can be categorized into “equivalent return” classes and that all firms within
a class have
the same degree of business risk.
• They also assumed that debt, both firms and individual’s is riskless.
• Corporate taxes are ignored.
Proposition I
The value of any firm is established by capitalizing its expected net operating income
(If Tax = 0)
VL = EBIT
VU = EBIT
WACC K
=
 O

• The value of a firm is independent of its leverage.

• The weighted cost of capital to any firm, levered or not is

• Completely independent of its capital structure and

• Equal to the cost of equity to an unlevered firm in the same risk class.

Proposition II
The cost of equity to a levered firm is equal to
• The cost of equity to an unlevered firm in the same risk class plus
• A risk premium whose size depends on both the differential between the cost
of equity and debt to an unlevered firm and the amount of leverage used.

Ke D
= + Risk premium +(
l
K = K eu K eu - K d ) E
eu
As a firm’s use of debt increases, its cost of equity also rises. The MM showed that a
firm’s value is determined by its real assets, not the individual securities and thus
capital structure decisions are irrelevant as long as the firm’s investment decisions are
taken as given. This proposition allows for complete separation of the investment and
financial decisions. It implies that any firm could use the capital budgeting
procedures without worrying where the money for capital expenditure comes from.
The proposition is based on the fact that, if we have two streams of cash, A and B,
then the present value of A +B is equal to the present value of A plus the present
value of B. This is the principle of value additivity. The value of an asset is therefore
preserved regardless of the nature of the claim against it. The value of the firm
therefore is determined by the assets of the firm and not the proportion of debt and
equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to
substitute personal for corporate leverage, thereby replicating any capital structure the
firm might undertake. They used the arbitrage process to show that two firms alike in
every respect except for capital structure must have the same total value. If they don’t,
arbitrage process will drive the total value of the two firms together.
llustration
Assume that two firms the levered firm (L) and the unlevered firm (U) are identical in
all important respects except financial structure.
Firm L has frw 4 million of 7.5% debt, while Firm U uses only equity. Both firms have
EBIT of frw 900,000 and the firms are in the same business risk class.
Initially assume that both firms have the same equity capitalization rate K e(u) =
Ke(L) = 10%. Under these conditions the following situation will exist.

Firm U
 Value of Firm U’s Equity= EBIT - KD
Ke

= frw 9,000,000

Total market value = Du + Eu

= 0 + 9,000,000

= frw 9,000,000
Firm L

Value of Firm L’s Equity = EBIT - KD = 900,000- 0.075(4,000,000)

Ke 0.10

= frw 6m

Total market value = DL + EL

= 4m + 6m

= frw 10,000,000

CPA EXAMINATION I1.1 MANAGERIAL FINANCE 45

Thus the value of levered firm exceeds that of unlevered firm. The
arbitrage process occurs as shareholders of the levered firm sell their
shares so as to invest in the unlevered firm.
Assume an investor owns 10% of L’s stock. The market value of this
investment is frw 600,000. The investor could sell this investment for frw
600,000, borrow an amount equal to 10% of L’s debt (frw 400,000) and
buy 10% of U’s shares for frw 900,000. The investor would remain with
frw 100,000 which he can invest in 7.5% debt. His income position
would be:

Frw frw
Old income 10% of L’s frw 600,000 equity 60,000
income
New income 10% of U’s income 90,000
Less 7.5% interest on 400,000 (30,000) 60,000
Plus 7.5% interest on extra frw 100,000 7,500
Total new investment income 67,500

The investor has therefore increased his income without increasing risk.
As investors sell L’s shares, their prices would decrease while the purchaser
of U will push its prices upward until an equilibrium position is established.

Conclusion:
Taken together, the two MM propositions imply that the inclusion of more
debt in the capital structure will not increase the value of the firm, because
the benefits of cheaper debt will be exactly offset by an increase in the
riskiness, and hence the cost of equity.
MM theory states that in a world without taxes, both the value of a firm
and its overall cost of capital are unaffected by its capital structure.
Portfolio Theory
Introduction

A portfolio is a collection of different investments which

comprise investor‟s total investments. For example, a property
investor’s portfolio may consist of many investment properties in
different locations and which are used for varied purposes. Other
examples of a portfolio are an investor’s holding of shares, or a company’s
investment in many different capital projects. Portfolio Theory is
concerned with setting guidelines for selecting suitable shares,
investments, projects etc. for a portfolio.

PORTFOLIO RISK AND RETURN

By investing all of one‟s funds in a single venture the whole
investment may be lost if the venture fails. However, by spreading the
investment over a number of ventures the risk of losing everything will be
reduced. If one of the ventures fails only a proportion of the
investment will be lost and hopefully, the remainder will provide a
satisfactory return.
Risk
Investment risk refers to the likelihood that:

• The investment will suffer a reduction in capital value

• That the returns expected from the investment will not
materialize/will be lower than expected
Example
An investor has RWF100, 000 to invest. He is considering two
companies A and B but is unsure as to which company to select. He
expects that either company will produce a return of 12%, which is
acceptable. As he is a little worried about the risk of the investments he
eventually decides to invest RWF50, 000 in each company.
What actually transpires is that company A produces a return of 22%
but company B produces a disappointing return of only 2%. By
diversifying – i.e. by holding shares in both companies - the investor
achieves an overall return of 12% (1/2 x 22% + 1/2 x 2%). If he had
invested all of the RWF100,000 in company B a return of only 2%
would have been achieved. Thus, the risk of achieving a less than
satisfactory return has been reduced by investing in both companies. The
exceptional return of company A has offset the poor return of company B.
Investors are generally risk-averse and will seek to minimise risk where
possible. The objectives of portfolio diversification are to achieve a
satisfactory rate of return at minimum risk for that return.

A portfolio is preferable to holding individual securities because it

reduces risk whilst still offering
a satisfactory rate of return – i.e. It avoids the dangers of “putting
all your eggs in one basket”

When investments are combined, the levels of risk of the

individual investments are not important. It is the risk of the
portfolio which should considered by the investor. This requires
some measure of joint risk and one such measure is the coefficient
of correlation. The relationship between investments can be
classified as one of three main types:
• Positive Correlation – when there is positive correlation
between investments if one performs well (or badly) it is likely
that the other will perform similarly. For example, if you buy
shares in one company making souvenirs and another which
owns tourist hotels you would expect poor tourist numbers to
mean that both companies suffer. Likewise, good tourist
numbers should bring additional sales for both companies.
• Negative Correlation – if one investment performs well, the
other will do badly and vice versa. Thus, if you hold shares in
one company growing coffee and another which makes soft
 drinks such as lemonade, the change in fashion for a type of
drink will affect the companies differently.
• No Correlation – the performance of one investment will be
independent of how another performs. If you hold shares in a
mining company and a leisure company it is likely that there
would be no obvious relationship between the profits and
returns from each.
The Coefficient of Correlation can only take values between –1
and +1. A figure close to +1 indicates high positive correlation and
a figure close to –1 indicates high negative correlation. A figure of
0 indicates no correlation.

It is argued that if investments show high negative correlation then

by combining them in a portfolio overall risk would be reduced.
Risk will also be reduced by combining in a portfolio
securities which have no significant correlation at all. If perfect
negative correlation occurs portfolio risk can be completely
eliminated but this is unlikely in practice.

Usually returns on securities are positively correlated, but not

necessarily perfectly positively correlated. In this case investors
can reduce portfolio risk by diversification.

You may be asked to calculate the expected return of individual

investments and also their risk (Standard Deviation). You may also
be expected to calculate an expected return if the individual
investments are then combined in a portfolio.

EFFICIENT PORTFOLIO AND THE EFFICIENT FRONTIER

Efficient portfolios can be defined as those portfolios which
provide the highest expected return for any degree of risk, or
the lowest degree of risk for any expected return.

The investor should ensure that he holds those assets which will
minimise his risk. He should therefore diversify his risk.
The risk can be divided into two:

• The diversifiable (unsystematic) risk;

• The non-diversifiable (systematic) risk.
The diversifiable risk is that risk which the investor can be able to
eliminate if he held an efficient
portfolio.
The non-diversifiable risk on the other hand is those risks that still
exist in all well diversified efficient
portfolios.
The investor therefore seeks to eliminate the diversifiable risk This
can be shown below:

Figure 7.1 Diversification of Risk

From the graph shown above as the number of assets increases, the
portfolio risk reduces up to point M. At this point the lowest risk has
been achieved and adding more assets to the portfolio will not reduce
the portfolio risk.
 An efficient portfolio therefore is well diversified portfolio.
Note: The non-diversifiable risk can also be referred to as the market
risk.

EFFICIENT SET OF INVESTMENT

If consider many assets, the feasible set of investment will be given
by the following graph

Figure 7.2

The shaded area is the attainable set of investment. However, investors

will invest in a portfolio with the highest return at a given risk or the
lowest risk at a given return. The efficient set of investment, therefore,
will be given by the frontier B C D E. This frontier is referred to as the
Efficient Frontier.
Any point on the efficient frontier dominates all the other points on the
feasible set.
Investment risk can be systematic: the risk of the market as a whole and/or
unsystematic i.e. risk specific to a specific investment/industry.

Unsystematic risk can be reduced through portfolio diversification whilst

systematic risk must be accepted by the investor.

SYSTEMATIC AND UNSYSTEMATIC RISK

When securities are combined in a portfolio part of each security’s
total risk (its standard deviation) is eliminated. This is the basis of
diversification. That part of an individual security’s total risk which can
be eliminated by combining that security with an efficient portfolio is
called unsystematic (or specific) risk. The balance of an individual
security’s total risk (that part which cannot be eliminated by
diversification) is called systematic (or market) risk.
Unsystematic Risk – Risk which can be eliminated by diversification. It is the
variation in a company’s returns due to specific factors affecting that
company and not the market as a whole, e.g. strikes, the breakdown of
machinery, changes in fashion for that company’s products etc. This specific
risk is a random fluctuation uncorrelated with the returns on the market
portfolio (the market as a whole). Therefore, when a large number of shares are
held these random fluctuations tend to cancel out – i.e. there is risk reduction.
Systematic Risk – Risk which cannot be eliminated by diversification. This is
the fluctuation in returns due to general factors in the market affecting all
companies e.g. inflation, government policy, economic conditions etc. It is that
part of the fluctuations in returns which is correlated with those of the market
portfolio.
When a capital asset (S) is combined with no other assets, the risk of the
portfolio is simply the standard deviation of (S). When further assets
are added, however, the contribution of (S) to the portfolio risk is quickly
reduced – diversification is eliminating the unsystematic risk. It takes a
surprisingly low number of shares in a portfolio to eliminate the majority
of unsystematic risk (twenty shares in a portfolio will eliminate
approximately 94% of unsystematic risk). All unsystematic risk could
only be eliminated when the market portfolio is held.

Only systematic risk is relevant in calculating the required return on

capital assets. This is because, on the assumption that investors hold
efficient portfolios, unsystematic risk is automatically eliminated when
another asset is incorporated within that portfolio. The only effect an asset
has on portfolio risk is through its systematic risk.

Example:
Your client is planning to invest in a portfolio of investments. Details
are as follows:

Investment 1

Investment of RWF300,000 in Cape Verde property. Expected annual

returns are as follows:
Annual Investment Return Probability of Occurrence
-20% 0.5
40% 0.5

Investment 2

Investment of RWF700,000 in a London Alternative Investment

Market (AIM) equity index fund for a minimum five year period.
The fund provides a guarantee against capital erosion, and its
expected annual returns are as follows:
Annual Investment Return

Probability of Occurrence 8%

0.9
12% 0.1

The co-efficient of correlation between the two investments is

calculated at - 0.2.
Kigali AIM investment
Has a minimum investment period of 5 years. Thus is not liquid
as the investment is ʻtied-inʼ for five years. This should be
considered carefully prior to making that proposed investment.

Musanze Property
On the face of it the property could be sold and liquidated at
short notice. However, you should look carefully at whether or
not in reality such property can be sold quickly without the need
to reduce prices drastically.

AIM investment
The risk is lower than the Musanze investment as the return expected
is 8.4% with an
associated risk of 1.2% calculated as follows:

Investment in AIM Fund

Deviation S Deviation =
% Return Probability Expectation Deviation Squared Square Root
X P x*p x – EV (x-EV)2 P((x-EV)Sq)
8 0.9 7.2 -0.4 0.16 0.144
12 0.1 1.2 3.6 12.96 1.296
Expected Value (EV) 8.4 1.44 1.2

The fund is less risky as it presents no probability of capital erosion.

Musanze Property
Whilst the potential return of 40% looks attractive there is also the
risk of investment losses of 20%. The annual return expected from
your investment in Musanze property is 10% and the risk attaching
thereto measured by standard deviation is 30%. They are
calculated as follows:

Investment in Musanze Property

Deviation
 % Return Probabilit Expectation Deviation Squared
y S Deviation
x P x*p x – EV (x-EV)2 P((x- =
EV)Sq) Squar
e
Root
-20 0.5 -10 -30 900 450
40 0.5 20 30 900 450
Expected Value 10 900
(EV)
30
This investment is significantly riskier than the AIM fund.

Overall Portfolio Return

The overall expected return from your proposed portfolio is
8.88%. This is a weighted average of the expected return of both
investments in the proposed portfolio, using the proportion of
each investment as the respective weights. It is calculated as
follows:

Expected Portfolio Return

Investment Expected Weighted Expected

Portfolio
Share % Return Investment Return
Musanze 10 30% 3%
AIM Fund 8.4 70% 5.88%
Expected Return 8.88%
(EV)

Capital Pricing Model

Some investments may be regarded as risk-free – such as investment in
government bonds. . Investors in risky investments should expect to earn
a higher return than investors in risk-free investments, to compensate for
the risks they are taking. Thus, if investors in Bonds can obtain a
return of, say, 6%, an investor in a risky asset should expect a yield in
excess of 6%. The Capital Asset Pricing Model uses this approach of
rewarding investors in risky assets with a premium on top of the yield on
risk-free assets. The CAPM is:

Rs = Rf + ß (Rm - Rf )

Where:
Rs = The expected return on a capital asset(s)
Rf = The risk-free rate of return
ß = A measure of the systematic risk of the capital asset (the
Beta factor)
Rm = The expected return from the market as a whole
This is a very important formula. Note that the expected return (Rs) is equal
to the risk-free rate of return (Rf) plus an excess return or premium (Rm -
Rf ) multiplied by the asset‟s Beta factor.

Example
The returns from the market as a whole have been 15% for some
time, which compares with
a risk-free rate of return of 7%. Alpha Ltd‟s shares have a Beta
factor of 1.25. What would be the expected returns for Alpha‟s
shares if:
• Market returns increased to 16%
• Market returns slumped to 9%

1. Rs = Rf + ß (Rm -
= Rf ) 7% +
1.25(16% - 7%)
= 7% + 11.25%
= 18.25%

2. Rs = Rf + ß (Rm - Rf )
= 7% + 1.25(9% - 7%)
= 7% + 2.5%
= 9.5%
The Financial Market
The financial market is a setting in which there is an exchange by people of
commodities, financial securities and other valuable items at transaction costs
that reflect demand and supply conditions. Some of these securities are bonds,
stocks and commodities as well as agricultural products and precious metals.
Within the financial sector, the term financial market is often used to refer just
to the markets that are used to raise finance which may be long term such as
capital market or short term such as money market. The term can also be used
generally for all markets in the financial sector such as capital market made up
of stock and bond markets, commodity market, money market, derivatives
market, futures market, foreign exchange markets and spot market, interbank
market.
It is also possible to further divide the capital market into primary and
secondary markets. New securities are sold in the primary market such as initial
public offerings while investors buy and sell securities in the secondary market

CAPITAL MARKET
Capital markets refer to financial markets that facilitate the buying and selling
of long- term debt and equity-backed securities. The capital market facilitates
the transfer of the wealth of savers to those who need funds for the purpose of
long-term productive use, such as companies or governments regarding long-
term investments. It is also a financial market whereby equity-backed securities
and long-term debt are traded. It is a market where funds are made available for
more than one year for investment. The wealth of savers in the capital markets
is channelled to those who are ready to put them into long term productive
investments. These investors can be government agencies or private companies.
In order to protect investors against fraud and other sharp the practices, the
Securities and Exchange Commission (SEC) oversees the activities of the
capital market in Nigeria. The Securities and Exchange Commission regulates
the operations of the capital markets, in their respective jurisdictions around the
world, to protect investors against fraud, among other duties. The capital market
is concerned with long term finance. In another perspective, capital market
consists of a series of channels through which some savings of the economy are
made available for industrial and commercial enterprises and public authorities.
The capital markets are used for the raising of long term finance, such as the
purchase of shares, or for loans that are not expected to be fully paid back for at
least a year. Whenever a firm borrows from the primary capital markets, often
the purpose is to invest in additional physical capital goods, which will be used
to enhance generation of its income. It can take many months or years before
the investment generates sufficient return to pay back its cost, and hence the
finance is long term. The loans in form of debt instruments like bonds from the
capital markets are securitized, that is, they take the form of resalable securities
that can be traded on the markets. Lending from the capital markets is not
regulated unlike lending from banks and similar institutions. A third difference
is that bank depositors and shareholders Capital market investors do not tend to
be risk averse. Nevertheless, capital markets are not accessible to small and
medium enterprises compared to banks.

Participants/Operators of the Capital Markets

Participants in the capital market consist mainly of the firms and individuals
who have surplus funds and those who have a deficit of funds to undertake
economic activities. It is thus a market for investors and those who seek to
finance their deficit positions. The participants in the capital market can be
categorized into four, namely: Providers of Funds - this includes individual and
institutional investors, unit trust, Nigeria Social Insurance Trust Funds (NSITF),
insurance companies and other corporate bodies; Users of funds - this includes
government and companies/corporations for their long-term investment;
intermediaries - This includes stock brokering firms, issuing houses and
registrars; and the Nigerian Stock Exchange (NSE) - The NSE provides the
platform, information and the rules and regulations needed to ensure orderly and
smooth operations of the exchange.

Instruments Traded in the Capital Market

Capital market instruments are typically corporate securities that may be either
debt, equity or derivative securities used to raise money for long-term purposes
as opposed to money market instruments which are traded short-term debt
instruments. The instruments/products traded in the capital market have wider
fluctuations than money market instruments and are considered to be relatively
risky investments.
The major instruments used to raise funds in the Nigeria capital market include:
Equities (ordinary and preference share); Government bonds (federal, states,
and local government); and Industrial loans stocks (debenture, preference share
and corporate bonds). Others include Unsecured zero coupons, mortgage loans,
Unit trust scheme, Unquoted or unlisted securities. The instruments traded in
the capital market depend mainly on the debt and level of development of the
stock exchange.

Segments of Capital Market

Capital market operates in two segments such as the primary and secondary
markets. Therefore, the two divisions within the capital market are the primary
and secondary markets.

Primary Markets

In primary markets, new stock or bond issues are sold to investors, often
through an underwriting mechanism. The primary market is an aspect of capital
market that involves issuing of new securities by corporate organizations or
governments in order to raise funds. In this market, interested members of the
public acquire these securities without intermediaries from issuers, which could
be corporate organization, in case of initial public offer/private placement, or
from the central government for treasury bills and bondsThe main entities
seeking to raise long-term funds on the primary capital markets are
governments (which may be state, municipal, local or national) and business
entities such as companies. Governments tend to issue only bonds and
development loan stocks, whereas companies often issue either equity and debt
instruments such as corporate bonds. The main entities purchasing the bonds or
stock include pension funds, hedge funds, sovereign wealth funds, and less
commonly wealthy individuals and investment banks trading on their own
behalf. When a firm decides to raise money for long term investment, one of its
first steps is to consider whether to issue bonds or shares. The process is more
likely to involve face-to- face meetings than other capital market transactions
and companies will have to enlist the services of an investment bank to mediate
between themselves and the market. On the primary market, each security can
be sold only once, and the process to create batches of new shares or bonds is
often lengthy due to regulatory requirements. The investment bank then acts as
an underwriter, and will arrange for a network of brokers to sell the bonds or
shares to investors. This second stage is usually done mostly through
computerized systems, and more often than not, brokers will contact their
favoured clients to advise them of the opportunity. Firms raising the funds from
the capital market can avoid paying fees to investment banks by using a direct
public offering, even though it involves incurring other legal costs and can take
up considerable management time.

Secondary Markets

These are the markets for old securities. Therefore, in the secondary markets,
existing securities are sold and bought among investors or traders over the
counter, usually on an exchange or the stock exchange, which serves as the
nerve centre for the market operations. Such transactions in existing securities
can also be traded with means of electronic arrangements. The existence of
secondary markets enhances the willingness of investors to deal in the primary
markets, as they know they are likely to be able to swiftly cash out their
investments whenever the need arises.

Trading on the secondary markets involve the use of an electronic trading

platform. Most transactions in capital market are executed electronically.
Nevertheless, sometimes a human operator is involved, and sometimes
unattended computer systems execute the transactions such as the algorithmic
trading. Most transactions in capital market take place on the secondary market.

On the secondary markets, there is no limit on the number of times a security

can be traded, and the process is usually very swift, and with the rise of
strategies such as high- frequency trading, a single security could in theory be
traded thousands of times around the world within a single hour. The
transactions on the secondary market don't directly help raise funds, but they do
boost the chances for firms and governments to raise funds on the primary
market, since prospective investors have assurance that if they want to get their
money back, they will easily be able to re-sell their securities.

Money Market
The money market exists to provide funds for short term use of corporate
entities and the government. It has developed over time because there are
parties that had surplus funds to part with while there are others who needed
such funds for operational use. The money market consists of financial
institutions and dealers in money or credit who wish to either borrow or lend.
Participants borrow and lend for short periods of time, typically up to thirteen
months. Money market trades in short-term financial instruments commonly
called "paper."

Participants of Money Market

The core of the money market consists of the following financial

institutions and corporate entities as well as government authorities.

1. Commercial banks

They engage in inter-bank borrowing and lending to each other using

commercial paper, repurchase agreements, and similar instruments.
These instruments are often benchmarked or priced by reference
established rates, e.g., London Interbank Offered Rate (LIBOR) and
Nigerian Interbank Offered Rate (NIBOR) for the appropriate term
and currency.

2. Finance companies

Basically, they usually fund themselves by issuing large amounts of

asset-based commercial paper which is secured by the pledge of
eligible assets into a conduit. Examples of eligible assets include
 auto loans, credit card receivables, residential mortgage loans,
commercial mortgage loans, mortgage-backed securities and similar
financial assets.

3. Large corporations

These companies are known for strong credit ratings issue

commercial papers on their own credit. Some other large
corporations arrange for banks to issue commercial paper on their
behalf by using commercial paper lines.

4. Government authorities
Federal, State and local governments issue paper to meet
development funding needs. States and local governments issue
municipal papers, while the federal government issues Treasury bills
and Treasury certificates and other public debt instruments.

5. Trading companies

These companies often purchase bankers’ acceptances to be tendered

for payment to overseas suppliers.

6. Central banks

The apex banks of all countries do participate in the money markets

to issue at one time and purchase at some other time, government
papers on behalf of the government, and by extension to regulate
demand for money and amount of money in circulation.

7. Merchant banks

Merchant banks also engage in transactions in money market by participating in

money market operations as well as issuing handling bills of exchange and
promissory notes for large corporations.

Functions of the money market

The money market performs certain functions which are identified as follows:

i) The market helps to transfer large sums of money from savers to

users for project undertakings;

ii) It aids to transfer from parties with surplus funds, which will have
remained idle, to parties with a deficit;

iii) It facilitates the opportunity for governments to raise funds for

developmental purpose;

iv) The market facilitates the implementation of the monetary policy in the
economy;
v) It influences the determination of short-term interest rates in
various economies around the world.

Common money market instruments

There are peculiar financial instruments that are being offered

for transactions in the money market. These instruments are
identified and explained below.

1. Certificate of deposit – this refers to time deposit, which is

commonly offered to consumers by banks, thrift institutions, and
credit unions.

2. Repurchase agreements – these are short-term loans that are

normally for less than two weeks and frequently for one day as
arranged by selling securities to an investor with an agreement to
repurchase them at a fixed price on a fixed date.

3. Commercial paper – this is a short term usually promissory notes

issued by company at discount to face value and redeemed at face
value.
4. Eurodollar deposits – these are deposits made in U.S. dollars at a
bank or bank branch located outside the United States.

5. Federal agency short-term securities – these are peculiarly

available in the U.S. They are short-term securities issued by
government sponsored enterprises such as the Farm Credit System,
the Federal Home Loan Banks and the Federal National Mortgage
Association.

6. Federal funds – also peculiar to the U.S., they are interest-bearing

deposits held by banks and other depository institutions at the
Federal Reserve, which are immediately available funds that
institutions borrow or lend, usually on an overnight basis. They are
lent for the federal funds rate.

7. Municipal notes - also peculiar to the U.S., they are short-term

notes issued by municipalities in anticipation of tax receipts or other
revenues.

8. Treasury bills and Treasury certificates – these are short-term

debt obligations of a national government that are issued to mature in
three to twelve months.
9. Money funds – these are pooled short maturity, high quality
investments which buy money market securities on behalf of retail or
institutional investors.

10. Foreign Exchange Swaps – this involves exchanging a set of

currencies in spot date and the reversal of the exchange of currencies
at a predetermined time in the future.

11. Short-lived mortgage and asset-backed securities – these are

short-term securities that are usually issued by mortgage institutions
for mortgage development in the economy.

12. Discount and accrual instruments – there are two types of

 instruments in the fixed income market that pay the interest at
maturity, instead of paying it as coupons. Discount instruments, like
repurchase agreements, are issued at a discount of the face value, and
their maturity value is the face value. Accrual instruments are issued
at the face value and mature at the face value plus interest.

Present
Value Table
-n
Presen
t value
of 1
i.e. (1
+ r)
Where r = discount rate
n = number of periods until payment
Periods

Discount rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·98 0·961 0·943 0·925 0·90 0·890 0·87 0·85 0·842 0·826 2
0 7 3 7
3 0·97 0·942 0·915 0·889 0·86 0·840 0·81 0·79 0·772 0·751 3
1 4 6 4
4 0·96 0·924 0·888 0·855 0·82 0·792 0·76 0·73 0·708 0·683 4
1 3 3 5
5 0·95 0·906 0·863 0·822 0·78 0·747 0·71 0·68 0·650 0·621 5
1 4 3 1
6 0·94 0·888 0·837 0·790 0·74 0·705 0·66 0·63 0·596 0·564 6
2 6 6 0
7 0·93 0·871 0·813 0·760 0·71 0·665 0·62 0·58 0·547 0·513 7
 3 1 3 3
8 0·92 0·853 0·789 0·731 0·67 0·627 0·58 0·54 0·502 0·467 8
3 7 2 0
9 0·91 0·837 0·766 0·703 0·64 0·592 0·54 0·50 0·460 0·424 9
4 5 4 0
10 0·90 0·820 0·744 0·676 0·61 0·558 0·50 0·46 0·422 0·386 10
5 4 8 3
110·89 0·804 0·722 0·650 0·58 0·527 0·47 0·42 0·388 0·350 11
6 5 5 9
12 0·88 0·788 0·701 0·625 0·55 0·497 0·44 0·39 0·356 0·319 12
7 7 4 7
13 0·87 0·773 0·681 0·601 0·53 0·469 0·41 0·36 0·326 0·290 13
9 0 5 8
14 0·87 0·758 0·661 0·577 0·50 0·442 0·38 0·34 0·299 0·263 14
0 5 8 0
15 0·86 0·743 0·642 0·555 0·48 0·417 0·36 0·31 0·275 0·239 15
1 1 2 5
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·88 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
5

2 0·812 0·797 0·78 0·769 0·75 0·74 0·731 0·71 0·706 0·69 2
3 6 3 8 4
3 0·731 0·712 0·69 0·675 0·65 0·64 0·624 0·60 0·593 0·57 3
3 8 1 9 9
4 0·659 0·636 0·61 0·592 0·57 0·55 0·534 0·51 0·499 0·48 4
3 2 2 6 2
5 0·593 0·567 0·54 0·519 0·49 0·47 0·456 0·43 0·419 0·40 5
3 7 6 7 2
6 0·535 0·507 0·48 0·456 0·43 0·41 0·390 0·37 0·352 0·33 6
0 2 0 0 5
7 0·482 0·452 0·425 0·400 0·37 0·35 0·333 0·31 0·296 0·27 7
6 4 4 9
8 0·434 0·404 0·376 0·351 0·32 0·30 0·285 0·26 0·249 0·23 8
7 5 6 3
9 0·391 0·361 0·333 0·308 0·28 0·26 0·243 0·22 0·209 0·19 9
4 3 5 4
10 0·352 0·322 0·295 0·270 0·24 0·22 0·208 0·19 0·176 0·16 10
7 7 1 2

11 0·317 0·287 0·261 0·237 0·21 0·19 0·178 0·16 0·148 0·13 11
5 5 2 5
12 0·286 0·257 0·231 0·208 0·18 0·16 0·152 0·13 0·124 0·11 12
7 8 7 2
13 0·258 0·229 0·204 0·182 0·16 0·14 0·130 0·11 0·104 0·09 13
3 5 6 3
14 0·232 0·205 0·181 0·160 0·14 0·12 0·111 0·09 0·088 0·07 14
1 5 9 8
15 0·209 0·183 0·160 0·140 0·12 0·10 0·095 0·08 0·074 0·06 15
3 8 4 5

Annuity Table

Present value of an annuity of 1 i.e. 1 –(1 + r)–n

r
Where r = discount rate
n = number of periods until payment
Periods

Discount rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·94 1·91 1·886 1·85 1·833 1·80 1·783 1·75 1·73 2
2 3 9 8 9 6
3 2·941 2·88 2·82 2·775 2·72 2·673 2·62 2·577 2·53 2·48 3
4 9 3 4 1 7
4 3·902 3·80 3·71 3·630 3·54 3·465 3·38 3·312 3·24 3·17 4
8 7 6 7 0 0
5 4·853 4·71 4·58 4·452 4·32 4·212 4·10 3·993 3·89 3·79 5
3 0 9 0 0 1
6 5·795 5·60 5·41 5·242 5·07 4·917 4·76 4·623 4·48 4·35 6
 1 7 6 7 6 5
7 6·728 6·47 6·23 6·002 5·78 5·582 5·38 5·206 5·03 4·86 7
2 0 6 9 3 8
8 7·652 7·32 7·02 6·733 6·46 6·210 5·97 5·747 5·53 5·33 8
5 0 3 1 5 5
9 8·566 8·16 7·78 7·435 7·10 6·802 6·51 6·247 5·99 5·75 9
2 6 8 5 5 9
10 9·471 8·98 8·53 8·111 7·72 7·360 7·02 6·710 6·41 6·14 10
3 0 2 4 8 5
11 10·37 9·78 9·25 8·760 8·30 7·887 7·49 7·139 6·80 6·49 11
7 3 6 9 5 5
12 11·26 10·5 9·95 9·385 8·86 8·384 7·94 7·536 7·16 6·81 12
8 4 3 3 1 4
13 12·13 11·3 10·6 9·986 9·39 8·853 8·35 7·904 7·48 7·10 13
5 3 4 8 7 3
14 13·00 12·1 11·3 10·56 9·89 9·295 8·74 8·244 7·78 7·36 14
1 0 9 5 6 7
15 13·87 12·8 11·9 11·12 10·3 9·712 9·10 8·559 8·06 7·60 15
5 4 8 8 1 6
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·69 1·66 1·647 1·626 1·60 1·58 1·566 1·54 1·52 2
0 8 5 5 7 8
3 2·444 2·40 2·36 2·322 2·283 2·24 2·21 2·174 2·14 2·10 3
2 1 6 0 0 6
4 3·102 3·03 2·97 2·914 2·855 2·79 2·74 2·690 2·63 2·58 4
7 4 8 3 9 9
5 3·696 3·60 3·51 3·433 3·352 3·27 3·19 3·127 3·05 2·99 5
5 7 4 9 8 1
6 4·231 4·11 3·99 3·889 3·784 3·68 3·58 3·498 3·41 3·32 6
1 8 5 9 0 6
7 4·712 4·56 4·42 4·288 4·160 4·03 3·92 3·812 3·70 3·60 7
4 3 9 2 6 5
8 5·146 4·96 4·79 4·639 4·487 4·34 4·20 4·078 3·95 3·83 8
8 9 4 7 4 7
9 5·537 5·32 5·13 4·946 4·772 4·60 4·45 4·303 4·16 4·03 9
 8 2 7 1 3 1
1 5·889 5·65 5·42 5·216 5·019 4·83 4·65 4·494 4·33 4·19 1
0 0 6 3 9 9 2
1 6·207 5·93 5·68 5·453 5·234 5·02 4·83 4·656 4·48 4·32 1
1 8 7 9 6 6 7
1 6·492 6·19 5·91 5·660 5·421 5·19 4·98 4·793 4·61 4·43 1
2 4 8 7 8 1 9
1 6·750 6·42 6·12 5·842 5·583 5·34 5·11 4·910 4·71 4·53 1
3 4 2 2 8 5 3
1 6·982 6·62 6·30 6·002 5·724 5·46 5·22 5·008 4·80 4·61 1
4 8 2 8 9 2 1
1 7·191 6·81 6·46 6·142 5·847 5·57 5·32 5·092 4·87 4·67 1
5 1 2 5 4 6 5