CHAPTER ONE

Financial Management: Overview

Finance is a distinct area of study that comprises facts, theories, concepts, principles,
techniques and practices related with raising and utilizing of funds (money) by
individuals, businesses, and governments.

Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore,
finance is also an area of study that deals with how, where, by whom, why, and through
what money is transferred among and between individuals, businesses, and governments.
Financial management is one major area of study under finance. It deals with decisions
made by a business firm that affect its finances. Financial management is sometimes
called corporate finance, business finance, and managerial finance. These terms are used
interchangeably in this material.

Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.

There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified
business function that deals with the management of capital sources and uses of a firm.
The primary function of accounting is to gather and present financial data. Finance, on
the other hand, is primarily concerned with financial planning, controlling and decision-
making. The financial manager evaluates the financial statements provided by the
accountant by applying additional data and then makes decisions accordingly.

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

economic value or wealth through the application of accounting theories and concepts in
management decision making. As a management process, it is a decision making with an
eye toward creating and maximizing wealth. The decisions involved are financial
decisions such as when to introduce a new product, when to invest on new assets, when
to replace existing assets, when to borrow from banks, when to issue stocks or bonds,
when to extend credit to a customer and how much cash to maintain. A successful study
of financial management requires the need for a conceptual framework.
A. Existence of well-developed capital markets
Financial management is studied under the assumption that there is capital
market and capital exchange in the business environment concerned with free and
competitive interaction and reasonable costs and prices like any commodity market .This
interaction in a well-developed capital market exists between the corporation and
financial markets in the following manner. Initially, the corporation raises capital in the
financial markets by selling securities –stocks and bonds .Secondly, the corporation then
invests this in return generating assets-new projects. Thirdly, the cash flow from those
assets is either reinvested in the corporation, given back to the investors, paid to
government in the form of taxes.

B. The context of corporate form of business organizations

Financial management is studied in the context of a corporate form of business
organization..
Basic characteristics
- Separate legal existence
- Limited liability
- Ownership possession and transfer through stocks.
- Separation of ownership from management
- Indefinite life time
- Double taxation
- Ability to issue shares.

C. Basic principles that form the basis for financial management

1. The risk –return trade-off

-In financial decision making, we don’t take additional risk unless we expect to
be compensated with additional return that is, investors demand a high return
for taking additional risks.
. –The risk– return relationship will be a key concept in the valuation of stocks and
bonds and proposal of new projects for acceptance.
2. The time value of money –A birr received today is worth more than a birr to be
received in the future .The time value of money is the opportunity cost of
passing up the earning potential of a dollar today.
3. Cash –Not profits –is a king
In measuring wealth or value , we will consider cash flows, not accounting
profits, because it is the cash flows, not profits that are actually received by the
firm, relevant for decision making and can be reinvested .Accounting profits on
the other hand, appear when they are earned rather than when the money is
actually in hand.
4. Incremental cash flows – It is only what changes that count. In making business
decisions in creating wealth ,we only consider incremental cash flow which is
the difference between the cash flows, if the decision is made versus what they
will be if the decision is not made/Relevant cash flow analysis/
5. The curse of competitive markets – why it is hard to find exceptionally profitable
projects? If an industry is generating large profits, new entrants usually are

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 attracted .The additional competition and added capacity can result in profits
being driven down to the required rate of return, then some participants in the
market drop out, reducing capacity and competition.
6. Efficient capital markets – capital markets are efficient and the prices are right. An
efficient capital market is a market in which the values of all assets and
securities at any instant in time fully reflect all available public information.
Such markets characterized by the existence of a large number of profits –
driven individuals acting independently.
7. The Agency problem – Managers won’t work for owners unless it’s in their best
interest. It is the problem resulting from conflicts of interest between the
managers (agents of the stockholders) and the stockholders.
8. Taxes bias business decision
In incremental cash flow analysis, the cash flow to be considered should be after- tax
incremental cash flows to the firm as a whole.

9. All risks are not equal – Some risks can be diversified away, and some cannot be.
Risk diversification is the process of reducing risk through increasing the
alternatives of risky investment and other business decisions.
10. Ethical behavior is doing the right thing and ethical dilemmas are everywhere in the
business.

Functions of Financial Management

This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.

In general, the functions of financial management include three major decisions a firm
must make. These are:
Investment decisions
Financing decisions
Dividend decisions

Investment Decisions

They deal with allocation of the firm’s scarce financial resources among competing uses.
These decisions are concerned with the management of assets by allocating and utilizing
funds within the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of
the firm’s finance to be invested in current and fixed assets.

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 ii) Determining the asset type: - determining which specific assets to maintain
within the categories of current and fixed assets.
iii) Managing the asset structure,
structure, i.e., maintaining the composition of current
and fixed assets and the type of specific assets under each category.

The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current
assets and short – term liabilities. The later, on the other hand, involves long – term
investment decisions like acquisition, modification, and replacement of fixed assets.

Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions
whether the firm should use equity or debt funds in order to finance its assets. They are
also concerned with determining the most appropriate composition of short – term and
long – term financing. In simple terms, the financing decisions deal with determining the
best financing mix or capital structure of the firm.

Dividend Decisions

The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should
be retained by the business for further expansion. There are trade offs on the dividend
policy of a firm. On the one hand, paying out more dividends will make the firm to be
perceived strong and healthy by investors ; on the other hand, it will affect the future
growth of the firm. So the dividend decision of a firm should be analyzed in relation to its
financing decisions.

Areas of Finance
What is exactly managerial finance or finance in general? What are the major
responsibilities and duties of managers of finance? In order to answer these questions,
you need to understand the areas that finance covers. Finance, in general, consists of
three interrelated areas: (1) Money and capital markets, which deal with securities
markets and financial institutions; (2) investments, which focus on the decision of

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investors, both individuals and institutions, as they choose among securities for their
investment portfolios; and (3) financial management or "business finance" which
involves the actual management of business firms. The career opportunities within each
field are many and varied, but managers of finance must have knowledge of all the three
areas if they are to perform their jobs well.

1) Money and Capital Markets: - Most of the finance professionals go to work for
financial institutions, including banks, insurance companies, investment companies,
credits and savings associations. For you to succeed in doing such jobs you need a
knowledge of the factors that cause interest rates to rise and fall, the regulations to which
financial institutions are subjected, and the various types of financial instruments such as
bonds, shares, mortgages, certificates of deposits and so on. You also need a general
knowledge of all aspects of business administration, because the management of financial
institutions involves accounting, marketing, personnel management, computer science as
well as financial management. An ability to get people to do their job (i.e. people skills)
is very critical.

2) Investments: - Finance graduates who go into investment areas generally work

for brokerage houses in the sales of securities or as security analysts. Others
work for banks and insurance companies in the management of investment
portfolios, or they work for financial consulting firms which advise individual
investors or pension funds on how to invest their funds. The three major
functions in the investment area are (1) sales of securities (2) the analysis of
individual securities, and (3) determining the optimal mix of securities for a given
investor.
Generally, the investment decision is concerned with managing the firm by allocating
and utilizing funds wisely with in the firm. It is determining the total birr amount

3) Financial management: - Financial management or managerial finance is the

focus of this material. In the entire body of this text, the discussions are specific
to financial management. It is the broadest area in finance and the one with
greatest number of job opportunities. Financial management is important in all
types of businesses, including banks, and other financial institutions as well as
other form of businesses. Financial management is also important in
governmental operations, from schools to hospitals and from zonal administrative
levels to states administrative levels and even beyond that.

The types of jobs encountered in financial management range from decisions

regarding plant expansion to choosing what types of securities to issue to finance the
expansion. Financial managers also have the responsibility for deciding the credit
terms under which customers may buy, how much inventory the company should
carry, how much cash to keep on hand whether to acquire other company (merger
analysis) and how much of the firms earnings to retain in the business versus payout
as dividends.

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Regardless of which specific area of finance you are emphasizing on, you need
knowledge of all the three areas (i.e. money and capital market, investments, and
financial management). For example, a banker lending to businesses cannot do the
job properly without a good understanding of financial management, because he or
she must be able to judge how well the businesses are operating. In the same way,
company's financial managers need to know what their bankers consider important
and how investors are likely to judge their company's performance and thus
determine their stock prices.

The Central Role of Capital and Goal of the Firm

Capital, as you know, is essential for the operation of any form of business and
financial management may be defined in terms of the relationship between capital and
the business firm. A business firm, whether it is a newly established or an existing
one, must obtain a certain amount of capital to finance itself in order to produce and
sell goods and services to its customers. Initial capital/funds of the newly formed
firm consist of funds secured from the owners of the firm in the form of equity capital
and from the creditors in the form of both short-term and long-term loans. An
existing firm may finance itself by retaining part of its earnings (plough- back of
profit or reinvestment) in addition to the two sources indicated. The capital of the
firm, whether it is generated internally from operations or provided by owners and
creditors, constitutes the sources of the firm’s capital and recorded on the right-hand
side of the balance sheet as liabilities and owners' equity.

The acquired capital is, thus used to employ personnel, to obtain offices and other
manufacturing facilities, inventories, and other assets. The capital is also used for
producing goods and services to meet customers' demands. The acquired assets
constitute the uses of the capital of the firm and are listed in the left-hand side of the
balance sheet (i.e assets). The balance sheet of the firm is thus contains both the uses
and sources of the capital of the firm. The balance sheet records these values at the
particular point in time. To complete the balance sheet, the firm records the results of
its operations during a given period of time, such as a year in its income statement.
The income statement, as you know, lists the firms revenues generated, expenses
incurred, and profit earned over a span of time and provides a measure of the ability
of the firm to manage its capital sources and uses. These two financial statements
(balance sheet and income statement) picture a firm as an entity that finances itself
with capital from various sources and puts this capital into various uses in order to
generate the desired amount of revenues and profits. Capital sources and uses must be
carefully managed if the firm needs to be profitable for its financiers. Financial
management is the specialized business function that deals with this problem.

In general, financial management can be defined as the management of capital

sources and uses so as to attain the desired goals of the firm (i.e maximization of
shareholders' wealth). A Firm’s capital consists of items of value that are owned and
used and items that are used but not owned. For example, the office space that a
business firm has rented for doing business and the bank loans that the firm has taken

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 to finance its operations are items of values that the business firm can use but doesn't
own. Capital sources are those items found on the right-hand side of the balance
sheet (i.e., the liabilities and equity section as indicated earlier.) Examples of the use
of the capital of the firm are receivables, inventories, and fixed assets.

The problems and opportunities that financial managers face and the business
decisions they are required to make entirely depend on the purposes or goals of their
organizations. Profit seeking organizations should actually behave in a way they
maximize the wealth of their shareholders. It is very important for you at this point to
distinguish between wealth maximization and profit maximization as goals of
business firms. There are two ways in which the wealth of shareholders changes.
These are: (1) Through changing dividend payments, and (2) through the change in
the market price of common shares. Hence, the change in shareholder’s wealth of
business firms may be calculated as follows:
1. Multiply the dividend per share paid during the period by the number of
shares owned.
2. Multiply the change in shares price during the period by the number of shares
owned.
3. Add the dividends and the change in the market value computed in steps 1 and
2 to obtain the change in the shareholder’s wealth during the period.

In order to maximize the wealth of shareholders, a business firm must seek to provide the
largest attainable combination of dividends per share and stock price appreciation. But
the problem is that while a business firm may have some degree of freedom in setting its
dividend policy that is in accordance with wealth maximization goal, it can not influence
the prices of shares, which are basically set by the interaction of buyers and sellers in the
securities/stocks markets. Stock prices tend to reflect the perception of the stockholders
on the ability of the business firm to earn profits and the degree of risks that the business
firm assumes in generating its profit. The ultimate risk that the business firm usually
faces is the probability that it will fail or go bankrupt. In such an event, the
owners/shareholders of the business firm would see their investment becoming worthless;
and the creditors would likely see that at least some portion of their loans go unpaid.
These events have impacts on the market prices of shares which in turn have impacts on
the objective of business firm that is wealth maximization of shareholders.

Profit-maximization, on the other hand, is a traditional micro economics theory of

business firms which was historically considered as the goal of the firm. Profit
maximization stresses on the efficient use of financial/capital resources of the firm.
Profit maximization as a goal of the business firm ignores however, many of the real
world complexities that financial managers try to address in their decisions. Profit
maximization largely functions as a theoretical goal in which economists use it to prove
how firms behave rationally to increase profit. When finance was emerged as a separate
area of study, it has retained profit maximization which is the new concept, profit
maximization looks at the total company profit rather than profit per share. Profit
maximization doesn't deal with the company's dividends as either a return to shareholders
or the impact of dividend policy on stock prices.

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In the more applied discipline of financial management, however, firms must deal every
day with two major factors: These are uncertainty and timing of returns.

Wealth maximization means maximization of the value of a firm. Hence wealth

maximization is also called value maximization or net present value (NPV)
maximization.

To understand and appreciate the essence of wealth maximization, we need to consider

the various stakeholders in a given corporation. Stakeholders are all individuals or group
of individuals who have a direct or indirect interest in the firm. They include
stockholders, debtors, managers, employees, customers, governmental agencies and
others. But among these, managers should give priority to stockholders. In fact, the
overriding premise of financial management is that a firm should be managed to enhance
the well-being or wealth of its existing common stockholders. Stockholders’ wellbeing
depends on both current and expected dividend payments and market price of the firm’s
common stock.

Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in

financial management. There are several reasons why wealth maximization decision
criterion is superior to other criteria. First, it has an exact measurement unlike profit
maximization. It depends on cash flows (inflows and outflows). Second, wealth
maximization as a decision criterion consider the quality as well as the time pattern of
benefits. Third, it emphasizes on the long-term and sustainable maximization of a firm’s
common stock price in the financial market. Fourth, wealth maximization gives a
recognition to the interest of other stakeholders and to the societal welfare on the long-
term basis.

Technically, wealth maximization as a decision rule involves a comparison of value to

cost. Thus, an action that has a discounted value that exceeds its cost can be said to create
value and such action should be undertaken. Whereas an action with less discounted
value than cost reduces wealth and, therefore, should be rejected. The discounted value is
a value which takes risk and timing of benefits into account.

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Uncertainty of Returns:
Profit maximization as the goal of business firms ignores uncertainty and risks in order
to present the theory more easily. Projects and investment alternatives are compared by
examining their expected values or weighted average profits. Whether or not one project
is riskier than another doesn't enter these calculations; economists do discuss risk, but
tangentially. In reality projects differ a great deal with respect to the risk characteristics,
and disregarding this difference can result in incorrect decisions.

To better understand the implication of ignored risks, let us look at two mutually
exclusive investment alternatives (that is, only one of the two can be accepted). The first
project involves the use of existing plant to produce plastic combs, a product with an
extremely stable demand. The second project uses existing plant to produce electric
vibrating combs. The latter products may catch on and do well, but it could also fail.
The optimistic, pessimistic, and expected production outcomes are given as follows:

Profit figures
Plastic Comb Electric Com
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
Pessimistic Out come 10,000 0

There is no variability that is associated with the possible outcomes of producing and
selling plastic combs because demand for this product is stable. If things go well
(optimistic), poorly (pessimistic), or as expected, the profit will still be the same 10,000
Birr. With that of the electric combs however the range of possible profit figures varies
from 20,000 Birr if things go well (optimistic), to 10,000 Birr if things go as expected, or
to the profit figure of zero if things go wrong (pessimistic). Here, if you look at just the
expected profit figure of 10,000 Birr, it is the same for both projects and you conclude
that both projects are equivalent. They are not, however. The returns (profit figures)
associated with electric combs involve a much greater degree of uncertainty or risk.

The goal of profit maximization, however, ignores uncertainty (risk) and considers these
projects equivalent in terms of desirability as it refers only to the expected profit figures
from the projects.

Timing of Returns: Another problem with profit maximization as the goal of business
firm is that it ignores the timing of the returns from projects. To illustrate, let us
reexamine our plastic comb versus electric comb investment decisions. This time, let us
ignore risk and say that each of these projects is going to return a profit of 10,000 Birr
during the first year (year 1) but it is after one year before the electric comb can go into
production, while the plastic comb can begin production immediately. The timing of the
profit from these projects is as follow:

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 Profit figures
Plastic Comb Electric Comb
Year 1 $10,000 $0
Year 2 0 10,000

In this case the total profits from each project are the same, but the timing of earnings
from the investments differs. As we will see later on in the chapter of "the time value" of
money, money has a definite time value. Thus, the plastic comb project is the better of
the two. The 10,000 Birr profit from project during year 1 could be invested in the
saving account that earns an interest of 5 percent per annum. At the end of the second
year the money would have grown to 10,500 birr as opposed to the 10,000 Birr profits to
be reported at the end of the second year for the electric comb project. Since investment
opportunities are available for the money on hand, we are not indifferent to the timing of
the returns (profits) from these investment opportunities. Given equivalent cash flows
from profits, we want the cash flows to occur sooner rather than later. Therefore, the
financial manager must always consider the possible timing of returns (profits) in
financial decision making.

Therefore, the real-world factors of uncertainty and timing of returns force financial
managers to look beyond simple profit maximization as the goal of the business firm.
These limitations of profit maximization as the goal of business firms leads us to the
maximization of the more robust goal of the business firm, that is, maximization of
shareholders wealth.
In formulating the goal of maximization of shareholder's wealth, we are doing nothing
more than modifying the goal of profit maximization to deal with the complexities of the
operation environment. We have chosen maximization of shareholder's wealth that is
maximization of the total market value of the existing shareholders' common stock
because the effect of all financial decisions is reflected through these prices. The
shareholders react to poor investment or dividend decisions by causing the total value of
the firm's stock to fall and they react to good decisions by pushing the price of the stock
up. Obviously, there are some series practical problems in direct use of this goal and
evaluating the reaction to various financial decisions by examining changes in the firm's
stock value. Many things affect stock prices. To employ wealth maximization as the
goal of your business firm, you need not consider every stock price change to be the
market interpretation of the worth of you decision. Other factors such as economic
expectations, also affect stock price movements. What you do focus on is the effect that
your decision should have on the stock price if everything elsewhere held constant. The
market price of the business firm’s stock reflects the value of the firm as seen by its
owners. The wealth maximization as the goal of business firm takes into account
uncertainty or risk, time, and any other factors that are important to the owners of the
firm. Thus, again, the framework of maximization of shareholders' wealth allows for a
decisions environment that includes the complexities and complications of the real-world.

While the goal of the business firm will be maximization of shareholders' wealth, in
reality the agency problem may interfere with the implementation of this goal. The
agency problem is the result of a separation of the management and the ownership in

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firms. For example, a large business firm may be run by professional managers who
have little or no ownership position in the firm, owners being the shareholders. As the
result of this separation between the decision makers and owners, managers may make
decisions that are no in line with goal of business firm, or the interest of owners, that is
maximization of shareholders' wealth. Professional managers may attempt to benefit
themselves in terms of salary and promotions at the expense of shareholders. The exact
significance of this problem is difficult to measure. However, while it may interfere with
the implementation of the goal of maximization of shareholders' wealth, in some firms, it
does not affect the goal's validity. The costs associated with the agency problem are also
difficult to measure, but occasionally we can see the effect of this problem in the
marketplace. For example, if the market feels that the management of business firm in
damaging shareholders' wealth, we might see a positive reaction in the stock price to the
removal of that management.

The Objectives of Financial Management

The financial manager uses the overall company's goal of shareholders' wealth
maximization which is reflected through the increased dividend per share and the
appreciations of the prices of shares in formulating financial policies and evaluating
alternative course of operation. In order to do so, this overall goal of wealth
maximization needs to be related to take the following specific objectives of financial
management into account. These are:
1) Financial management aims at determining how large the business firm should
be and how fast should it grow.
2) Financial management aims at determining the best percentage composition of
the firm's assets (asset portfolio decision, or decisions related to capital uses).
3) Financial management also aims at determining the best percentage
composition of the firm's combined liabilities and equity decisions related to
capital sources).

1) Determining the Size and Growth Rate:

The size of the business firm is measured by the value of its total assets. If the book
values are used the size of the firm is equal to the total assets as indicated in the balance
sheet. When this method of size determination is used, the growth rate of the business
firm is measured by the yearly percentage change in the book values of all the items in
the assets section of the balance sheet.

As the student of financial management, you should be able to understand that business
firm that is large and growing fast and larger doesn't necessarily produce increasing
earnings.

2) Determining Assets Composition (Portfolio):

As indicated earlier, assets represent investments or uses of capital that the business firm
makes in seeking to earn a rate of return for its owners. The most common asset
categories are cash, inventories, and fixed assets. However, financial institutions, such as

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banks and insurance companies, have somewhat different asset categories. They may list
loans and advances and negotiable securities as assets. The percentage composition of
the assets of the firm is computed as ratio of the book value of each asset to total book
values of all assets. The choices of the percentage composition of assets item affect the
level of business risk. The asset structure decision relate to what products and services
the business firm should produce. The financial manager is directly involved in decisions
related to the assets structure that makes business firm more successful in a way it will
maximize the wealth of shareholders.
The wealth maximizing assets structure can be described in either of the following ways:
1) The asset structure that yields the largest profits for a given level of exposures
to business risk, or
2) The asset structure that minimizes exposure to business risk that is needed to
generate the desired profits.

In both of the cases (i.e. 1 and 2), the financial manager should recognize that the asset
structure of the business firm is the major determinant of the overall risk-return profile of
the firm.

3) Determining the Composition of Liabilities and Equity

As it was stated, liabilities and equity are the sources of capital of the business firms.
They are the financing sources that business firms use to make investment in various
types of assets. The most common financing sources are accounts and notes payable,
accruals for items such as taxes, wages, loans and debt securities of various maturity
dates, common stocks, preferred stocks and retained earnings. Here again, banks and
insurance companies might secure funds from liability accounts such as time deposits,
demand deposit, and saving deposits. As it was done for the percentage composition of
assets, the liability and equity percentage composition of the business firm is measured
by dividing the book value of each liability of equity item by the total book values of all
liabilities and equity. The mix of liabilities and equity of the business is what is known
as the capital structure.

When the business firm finances its investment by using debt capital, the business firm
and its shareholders face added risks along with the possibility of added returns. The
added risk is the possibility that the firm may face difficulty to repay its debts as they
mature. Stock prices react to the manner of financing of business firm, as well as, to the
subsequent ability or inability of the firm to manage its capital structure. The added
returns come from the ability of the firm to earn the rate of return higher than the interests
and related financing costs of using liabilities. The added returns may be paid as
dividends and/or reinvested in the firm to generate more profits. This in effect would
maximize the wealth of shareholders of the business firm.

The Evolution of the Finance Function

Finance becomes a separate area of study around 1900 for the first time. Since that time,
the duties and responsibilities of the financial managers have undergone continuous
change, and expected to change in the future as well. The two main reasons for the

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ongoing change in the functions of finance are (1) the continuous growth and increasing
diversity of the national and international economy, and (2) the time to time development
of new analytical tools that have been adopted by financial managers.

Finance Before 1930

Up to 1900, finance was considered as a part of applied economics. The 1890s and 1900s
were the periods of major corporate mergers and consolidations in the American
economy. These mergers and consolidations were gradually transmitted to other
economies all over the world. These activities required unprecedented amount of
financing. The management of the capital structure of companies that had been formed
as a result of mergers and consolidations become an important task, and finance was
emerged as distinct functional area of business management.

The major technological innovations of the 1920s created entirely new industries such as
radio and broadcasting stations. These new industries produce not only large quantities
of output but also earned high profit margin. Financial management was found to be
important in dealing with problems related to planning and controlling the liquidity of
the newly emerged industries of that time.

The stock market crash of 1929 and the subsequent economic depression occurred in the
American economy resulted in the worst economic conditions that occurred in the 20th
century. Bankruptcy, reorganization,, and mere survival become major problems for
many corporations. The capital structure which was dominated by debt aggravated the
solvency and liquidity problems of companies. Financial management is additionally
responsible for the planning of the rehabilitation and survival of the business firm.

Finance Since 1950

These cdays, a large number of people are employed and work in manufacturing and
service industries that didn't exist before. Much of this rapid economic growth occurred
because the increased rate of technological advancement. The computerization process in
almost all of these industries is an example of the extent to which our economy has
become dependent on new technologies. cAs new industries have arisen and as older
industries have sought ways to adapt to the rapidly changing technologies, finance has
become increasingly analytical and decision oriented. This evolution of the finance
function has been influenced by the development of computer science, operations
research and isometrics as tools for financial management functions.

To summarize, the evolution of finance functions contains the following three important
points:
1. Finance is relatively new as a separate business management function.
2. Financial management, as it is presently practiced, is decision oriented and
uses analytical tools such as quantitative and computerized techniques,
economics, and managerial accounting:
3. The continuing rapid pace of economic development virtually guarantees that

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 the finance function will not only continue to develop but also have to
accelerate its pace of development to keep up with the complex problems and
opportunities that corporate manger are facing.

Chapter Summary

This first chapter has provided you an introduction to finance as the area of study and to
managerial finance as an important business function. The chapter also examined the goal
of the business firm, the commonly accepted goal of profit maximization as contrasted
with the more compete goal of the maximization of shareholders' wealth. This is because
of the fact that wealth maximization goal deals with uncertainty and time in a real world
environment. This goal is found to be the proper goal of the firm. In other words,
shareholders' wealth maximization attempts to take into account both risk and return and
is superior in a number of important ways to that of the traditional economic goal of
profit maximization.

Finance first appeared as a distinct area of study around 1900 and initially focused on
capital structure composition. During the great depression, bankruptcy and
reorganization, finance became an important consideration. Since 1950, finance became
an important consideration. Since 1950, finance became decision oriented with respect to
both asset and capital structure management and also became increasingly analytical in
nature. The tools of the financial manager now include accounting, economics, computer
science, and quantitative analysis of operations research.
Chapter - 2
Financial Analysis and Planning
Financial analysis is the process of selection, evaluation and interpretation of financial
data, along with other pertinent information, to assist investment and other financial
decisions. It is a diagnostic tool of analysis that can help management to identify the
strength and weakness of the firm so that corrective actions can be taken starting from
planning, and also to consider the strength of the company as a motive for
competitiveness and growth. Financial analysis and its application in business can be
viewed from different perspectives .From the investor’s view point financial analysis is a
tool for predicting the future performance of the firm on which the investment decision
related to this firm can be made. For the creditor financial analysis is used to show the
liquidity and solvency of the firm, so that dependable credit decisions or making loans in
such firms can be made. But the financial manager’s primary task is the acquisition and
use funds so as to maximize the value of the firm based on right decisions made, and
financial management information are useful to make such critical decisions .

Approaches to financial analysis

Based on the information required for financing and investing decisions, the approaches
of financial analysis include:
 Comparison of the performance of a firm with the performance of other firms in
the same industry

13
  Evaluation of the performance or position of a given firm overtime.
 Adjusting the financial statements of a firm to a common size financial statement

The data used in analyzing financial statements are contained in the financial statements
themselves such as income statement, balance sheet and statement of retained earnings.
In explaining financial statement analysis, financial statements pertaining to Addis
Manufacturing company are used throughout this chapter.

Income Statement
As you know from you previous courses, income statement measures the profitability of
business firm over a period of time. Though the income statements of many
multinational companies cover a European calendar year, Addis Manufacturing Company
has adopted fiscal year that corresponds with the Ethiopian budget year for an accounting
purpose. The Ethiopian budget year runs from Hamle 1 to Sene 30. Income Statement
can also be prepared on a quarterly basis and referred to as interim income statement.
Regardless of the starting and ending dates, or the length of the time covered, the
important point is that income statement summarize the operation of business firm over a
given time interval. As it can be seen from the income statements for Addis
Manufacturing Company, the company's operations generated a flow of revenues (net
sales), expenses, and profits (net incomes) during the two reporting years.

Addis Manufacturing Company

Income Statements
For the year ended Sene 30, 1992 and 1993
(in thousands of Birr)

1993 1992
Net Sales Birr 120,000 Birr 110,000
Cost of goods sold 90,000 83,000
Gross Profit 30,000 27,000
Operating Expenses:
1993 1992
Selling expenses 5,000 4,800
General and administrative expenses 8,000 7,600
Depreciation expense 1,100 800
Lease Payments 1,650 1,600

Total operating expenses 15,750 14,800

Earnings before interest and taxes 14,250 12,200
Interest expenses:
Interest on bank notes 550 700
Interest on Other debt 3,600 3,960
Total interest expenses 4,150 4,660
Earnings before taxes 10,100 7,450

14
 Income taxes (34%) 3,434 2,564

Net Income 6,666 4,976

Balance Sheet
A balance sheet basically summarizes the financial position of the business firm. It
usually contains two sections:
(1) The asset (i.e. uses of funds) section, and
(2) The liabilities and shareholders' equity (i.e. sources of funds) section.
The following is the comparative balance sheet for Addis Manufacturing Company, an
ideal business firm, on Sene 30, 1992 E.C. and Sene 30, 1993 E.C.

Addis Manufacturing Company

Comparative Balance Sheet
Sene 30, 1992 and 1993
1993 1992
Current Assets:
Cash 2,500 3,000
Marketable securities 1,000 1,300
Accounts receivable 16,000 12,000
Inventories 20,500 18,700
Total current assets 40,000 35,000
Fixed Assets:
Land and buildings 28,700 24,200
Machinery and equipment 31,600 29,000
Total fixed assets 60,300 53,200
Less accumulated depreciation 18,300 17,200
Net fixed assets 42,000 36,000
Total assets 82,000 71,000
Liabilities and shareholders' equity
Current liabilities
Accounts payable 7,200 6,000
Notes payable 10% bank 5,500 7,000
Accrued liabilities 900 700
Current portion of long-term debt 3,000 3,000
Other current liabilities 1,400 1,200
Total current liabilities 18,000 17,900
Long-term liabilities
Long term debt-12% mortgage bond 27,000 30,000
Total liabilities 45,000 47,900

Shareholders' equity
1 Common stock, 5Birr par, 2,000,000
Shares authorized; 1,300,000 shares
outstanding in 1993 and 1,000,000

15
 shares outstanding in 1992 6,500 5,000
2 Capital in excess of par 14,000 5,350
3 Retained earnings 16,500 12,750
Total shareholders' equity 37,000 23,100
Total liabilities & shareholder equity 82,000 71,000

As indicated in the above comparative balance sheet prepared for Addis Manufacturing
Company, total assets equal total liabilities and stockholders' equity. This statement
shows the mix of liabilities and equity that is used to finance company's assets. The
assets of the company are the investments it had made in profit-seeking activities.
Current assets are the most liquid assets of the company. There of one year, or less.
Hence, the Birr value of current assets is termed as a gross working capital of the
company.

As contrast to current assets, fixed asset division consists of long-term financial claims
and investments in the physical assets such as properties, plants and equipment. The
liability and shareholders' equity section of the balance sheet shows how the company is
financed. Liabilities are values of assets financed by funds from creditors. Current
liabilities, as stated earlier, are to be paid back in later years in the future. The amount of
funds provided by the shareholders directly for Addis Manufacturing company are
represented by the common stock and additional capital in excess of par portions of the
shareholders' equity section of the balance sheet. Retained earnings are part of
shareholders' equity obtained as a result of the board of director’s decision to retain
portion, or entire amount of net profits of the company for reinvestment.

The accounting procedures used to generate financial statements are not primarily
designed to provide data inputs for financial statements analysis. As a consequence of
this, the financial statements may not always provide the information that the financial
managers need for various types of business decisions. For example, the assets are listed
in the balance sheet at their historical costs that do not, most of the time, reflect the
current market values, or the replacement costs of these assets. Moreover, some
difficulties can be expected in interpreting financial statement figures individually. For
instance, an increase in a balance of an inventory account could mean:
1 The individual purchases cost more than ever due to increases in prices and that
the physical inventory levels have not increased, or
2 The company is accumulating that it has been unable to sell, or
3 The company is producing, or purchasing inventories in large quantities in
anticipation of increases in the volume of sales in the future.

These clearly show how it is difficult to interpret the balance of a given account
separately as it could mean different things.

Statement of the Retained Earnings:

The statement of retained earnings lists how much of the net profit/income of the
company was paid out as dividends to the shareholders and how much of it was retained
in the company for reinvestments or further expansion of the company. The statement of

16
retained earnings normally exhibits one important relationship that exists between the
income statement (that summarizes the operation of the company during a given time
period) and the balance sheet (that summarizes the financial position of the company on
the given date). The retained earning account in the shareholders' equity section of the
balance sheet of the company is the accumulation of the net profit of the company that
have been retained over the life time of the company. Every year, the retained earnings
account is increased by an amount equal to the excess of net profit over dividend declared
and distributed during that year. Hence, the ending balance of the retained earnings
account that is computed in the statement of retained earnings links the income statement
and the balance sheet. There are in fact, many other ways in which all of these financial
statements interact with one another.
The following is the statement of retained earnings for Addis Manufacturing Company,
an ideal company, for the year ended Sene 30, 1993 E.C.
Addis Manufacturing Company
Statement of retained earnings
For the year ended Sene 30, 1993 E.C.

Retained earnings, Hamle 1, 1992 12,750

Net income 6,666
Sub-Total 19,416
Less Cash dividends (common stock) 2,916
Retained earnings-Sene 30,1993 16,500

As you can see from the statement of retained earnings of Addis Manufacturing
Company, the retained earnings account has a balance of 12,750 Birr on Hamle 1,1992
which is the ending balance of sene 30, 1992 carried forward. This balance wash shown
in the shareholders' equity section of the balance sheet prepared for Addis manufacturing
company on sene 30, 1992. In the same way the ending balance of the retained earnings
account shown in the statement of retained earnings for Addis manufacturing company
for the year ending on Sene 30, 1993 (i.e. 16500 Birr) was reported in the shareholders'
equity section of the balance sheet for that year.

Ratio Analysis:
The first step in undertaking financial statements analysis is to read and understand the
financial statement and their accompanying notes with care. This is followed by the
computation of ratio and interpreting what the ratio is to mean (i.e. undertaking ratio
analysis). The use of financial ratios to analyze financial statements is now a common
practice to the extent that even computerized financial statement analysis programs
prepare financial ratios as part of their overall analysis. Both lenders and potential
lenders use financial ratios to evaluate loan applications from borrowing companies.
Investors use financial ratios to assess the future tale of the companies to make
investment with. Managers make use of financial ratios in order to judge the
performance of their companies and to control the day-to-day operation of their
companies. Owners make use of financial ratios to evaluate whether their companies are
maximizing their wealth or not.

17
The Basic Financial Ratios
Financial ratios can be designed to measure almost any aspect of the performance of the
company In general; financial analysts use ratios as one tool in identifying areas of
strengths and weaknesses in the company. Financial ratios, however, tend to identify
symptoms rather than the problems classing symptoms. A financial ratio whose value is
judged to be "different" or usually high or low may help identify a significant event but
doesn't provide enough information that helps to identify the reasons for the occurrence
of the event. The financial ratios are judged to be high, or low, or acceptable when they
are compared with standards. Standard ratios could be:
1 Industry standards, these are standard ratios computed for companies operating in
the same industry. For example, average ratio standards can be developed for
textile industry.
2 Management plans - these are financial ratios are ratios that the management of a
give company set as goals. These are plans of the company and standards against
which actual financial ratios are compared.
3 Historical standards - these are financial ratios developed from the historical
records of the company over say the last 10 years. Historical standards are,
therefore, the average financial ratios for the company for the last 10 years. These
ratios can also be used as standards against which you compare the computed
ratios to judge them of high, low or acceptable.

Types of Financial Ratios:

The most common financial ratios used for financial analysis include: liquidity, activity
(asset management), debt management (leverage), and profitability ratios.

1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its current liabilities and
current portion of long-term debts as they mature. Liquidity ratios assume that current
assets are the principal sources of cash for meeting current liabilities and current portion
of long-term loans. There are two most widely used liquidity ratios. These are the
current and quick or acid ratios.

Current Ratio:
The current ratio is computed by dividing current assets by current liabilities. The
current ratios for Addis Manufacturing Company for 1992 and 1993 are the following:

Current Ratio =

Current Ratio (for 1992) =

Current Ratio (for 1993) =

The larger the current ratio, the less would be the difficulty that the company face in
paying its obligations at the right time. In many cases lenders frequently require the
current ratio of the borrowing company to remain at or above 2.0 time as a condition for
grading or continuing the commercial and industrial loans. This standard of 2.0 times is

18
an arbitrarily selected figure and many financial analysts feel that the liquidity position of
the company should be questioned if the current ratio of the company falls below 2.0
times. This is because of the fact that all current assets cannot be easily converted back
to cash. It is very difficult to collect accounts receivable in full.

It is very difficult to sell all the inventories. Short-term prepayments are unlikely to be
converted to cash. If the less liquid assets constitute significant portion of the total
current asset, you may need current ratio that is even greater than 2.0 times. The current
ratios of Addis manufacturing Company show that the company has 1.96 Birr in current
assets for each Birr of current liabilities during 1992 and 2.22 Birr in current assets for
each birr of current liabilities during 1993. It is very difficult to say these ratios are high
or low as we don’t have industry standard, or management plan or historical standard
against we compare these current ratios. But one can say that Addis Company is more
capable in 1993 to pay its current liabilities than in 1992.

Quick Ratio:
Quick ratio is sometimes called the acid test ratio. It serves the same general purpose as
that of the current ratio but more stringent as it exclude less liquid current assets like
inventory from current assets. It considers only quick current assets such as cash,
marketable securities, and account receivables. This is done because inventories, prepaid
expenses and supplies cannot easily be converted back to cash. Thus, the quick (acid-
test) ratio measures the ability of the company to pay its current liabilities by converting
its most liquid assets to cash which is easier.
The quick ratio is computed by subtracting inventories, prepaid expense and supplies
from current assets and dividing the remainder by total current liabilities. for Addis
Manufacturing Company the quick ratios are:
Quick Ratio =

Quick Ratio (for 1992) =

Quick Ratio (for 1993) =

If the company wants to pay the entire amount of its current liabilities by using its quick
assets (i.e current assets minus the sum of inventories, prepaid expenses and supplies), its
quick assets should be equal to or greater than its current liabilities. Thus the Company's
quick ratio should be 1.0 times or more than that. In the case of Addis Manufacturing
Company, the quick assets of 91 cents are available to meet each Birr or current
liabilities. This implies that the quick assets are not enough to settle all the current
obligations. Unless the company converts the non-quick current assets to the extent they
provide cash that is enough to pay the remaining 9 cents for each Birr of current
liabilities, the company will face difficulty in meeting its obligation. The current ratio of
1.08 times for 1993, on the other hand, implies that the company has 1.08 Birr of quick

19
assets for each Birr of current liabilities. Again, the company is in good liquidity position
during 1993 compared to 1992.

2. Activity Ratios:
Activity ratios measure the degree of efficiency with which the company utilizes its
resources. Efficiency is equated with rapid resource turnovers. Some activity ratios
concentrate on individual assets such as inventory, or accounts receivable while others
look at the overall company performance, or activity. The following activity ratios are
discussed for Addis Manufacturing Company, which is an ideal company considered for
an illustrative purpose.

Inventory turnover ratio: This ratio is meaningful for companies like Addis
Manufacturing Company which hold inventories of different kinds. (if could be
merchandise, raw material, processed goods and so on). These ratio measures the
number of times per year that the company sells its inventory. It is computed by dividing
the Birr amount of costs of goods sold by the Birr amount of inventory at the closing date
of the accounting period. For Addis Manufacturing Company, the inventory turnover
ratios are:

Inventory turnover =

Inventory turnover (f0r 1992) =

Inventory turnover (for 1993) =

In general, high inventory turnover may be taken as a sign of good inventory
management. Other things being the same, higher inventory turnover ratios
computed for Addis Manufacturing Company indicate that the company was able
to sell its inventories 4.44 times and 4.39 times during 1992 and 1993 E.c
respectively. The performance/efficiency of the company in selling its
inventories was nearly the same during the two years you cannot say the
inventory turnover ratios for Addis Company show good or bad performance, or
high efficiency or low efficiency as long as you don't have standard inventory
turnover ratio to compare with. Inventory turnover ratio, as a measure of
efficiency of business activities, suffers from both conceptual and measurement
problems. For example, high inventory turnover ratio could indicate the
inadequacy of inventory to meet customer demands which results in loss of sales.
A low inventory turnover ratio, on the other hand, can be caused by an increased
new product lines each of which requires some minimum inventory balances
which in turn raises the balance of overall inventory level and lowers the
inventory turnover ratio. In both of these cases, the inventory turnover ratio, if it
is used alone, may lead to incorrect conclusions. This is to mean that high
inventory turnover ratio may not always be good.

A measurement problem of inventory turnover ratio emanates from the

denominator used in calculating the ratio. Since the purpose of this ratio is to

20
 measure the inventory turnover rate, the denominator should be a measure of the
average amount of inventory that the company maintained during the year.
However, in most of the cases, the figure used as the denominator is the amount
of inventory on hand at the end of the reporting period because the average
inventory balance is not easily obtainable. If the balance of inventory at the end
of the year is not a good representative of the average yearly inventory as a result
of seasonal and/or cyclical production and selling patterns, the usefulness of this
ratio is greatly limited.

Total Assets Turnover Ratio:- It measures the relationship between a birr of sales and a
birr of assets, usually on the yearly basis. Basically the company wants to generate as
much birr as possible in the form of sales per a birr of an investment it made in assets.
The asset turnover ratio is a measure of the overall activity of the company. It is
computed by dividing the total net sales of the company by its total assets on the closing
date of the accounting period. For Addis Manufacturing co-the total turnover ratios are:

Total assets turnover =

Total assets turnover (for 1992) =

Total assets turnover (for 1993) =

The total assets turnover ratio of 1.55 times during 1992 implies that the company was
able to generate 1.55 Birr for a single birr it has invested in its assets during the year.
During 1993, on the other hand, the company was able to make a net sale of 1.46 birr for
each birr it has invested in the total assets. Though the total volume of sales is greater
during 1993, the assets turnover ratios show that the company was efficient in generating
higher net sales per birr of investment in asset in 1992 than in 1993. The decrease in the
asset turnover ratio in 1993 may indicate a decrease in the utilization of the assets for
generating the desired sales revenue.

Average Collection Period:- this ratio tries to measure the average number of days it
takes for the company to collect its accounts. The shorter the average collection period,
the better will be the company's activities. As you know, account receivable is resulted
from credit sales. Hence, this ratio relates the daily credit sales to its account receivable
balance at the end of the reporting period. Net sales may be used in the absence of credit
sales, though it reduces the quality of the ratio in measuring the number of days that
receivables do take before their collection. The average collection period is computed in
a two-step procedure. First, you compute the average daily credit sales (in the absence of
credit sales, you may take the average daily sales) by dividing the 360 days into the total
credit sales, or total sales. Second, you compute the average collection period by
dividing the account receivable balance at the end of the accounting period (preferably
the average account receivable if available) by daily credit sales, or daily sales in the
absence of the former. Assuming that all sales are made on account by Addis
manufacturing company, the average collection periods are:

Daily Credit Sales =

21
 Daily Credit Sales (for 1992) =

Daily Credit Sales (for 1992) =

When total sales are used instead of credit sales in the formula, the average collection
period will face the measurement problem because the cash sales included in the total
sales do not have any link with average collection period. Moreover, the use of the
account receivable balance at the end of the may not represent the month average of
accounts receivable when there are seasonal fluctuations. In this case, the average
collection period again suffers from the measurement problem. The average collection
period requires the analyst to provide careful interpretation even when these
measurement problems are overcome, are at least recognized. An increase, or decrease in
the values of average collection period should not be used to evaluate the effort the
company puts in collecting its receivables. If the shorter average collection period during
1992 was caused by the very tight credit policy adopted during that year, it may not be
more desirable than the average collection period of 48 days achieved during 1993 under,
say a liberal credit policy. This is because the credit policies themselves can bring
changes to the average collection period. Stringent credit policy definitely reduces the
average collection period. If the small average collection period of Addis Manufacturing
Company during 1992 was caused by reduced volume of credit sales, it may not be a
good indication of good credit collection condition.
Credit granting and the structuring of credit terms are major competitive tools used by the
marketing manager rather than the financial manager. Many companies are forced to set
credit policies which are comparable with the credit policy of the dominant company in
the same industry. The average collection period has to be interpreted in relation the
credit term provide to customers.

3. Debt Management or Leverage Ratios:

These ratios measure the extent to which a company finances itself with debt as opposed
to equity financing. These ratios are also called solvency or capital structure ratios. They
are also termed as financial leverage ratios. Financial ratios provide the basis for
answering two basic questions: How has the company finance its assets? And can the
company afford the level of fixed charges associated with the use of non-owners-supplied
funds such as bond interest and principal payments? The first question is answered
through the use of balance sheet leverage ratios, while the second question is answered
through the use of income statement based ratios, or simply through the use of leverage
ratios.

Financing ratios:- These ratios provide the basis for answering the question.
Where did the company obtain financing for its investments? The balance sheet
leverage ratios include:
1. Debt ratio or debt-asset ratio: it measures the extent to which the total assets of
the company have been financed using borrowed funds.
For Addis Manufacturing Company, the ratios are computed as follows:

Debt-asset ratio =

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 Debt-asset ratio (for 1992) =

Debt-asset ratio (for 1993) =

At the end of 1992, 67.46 percent of the total assets of Addis Manufacturing Company
were financed by funds secured in the form of current and long-term liabilities. The
remaining 32.54 percent was financed by funds contributed by shareholders and retained
from the profits earned by the company. Similarly, debt financing constitutes about 55
percent of the total assets of the company during 1993. This leaves 45 percent of the total
assets to be financing has declined during 1993 compared to 1992 signaling good
condition. Addis manufacturing company can borrow much more money during 1993
than it could do in 1992 because the asset structure of the company was more debt-
dominated in 1992 than in 1993. Hence, lenders are willing to give loans to the company
during 1993 when debt-asset ratio is less than during 1992 when debt-asset ratio is high.

You can't say much about the capital structure of Addis manufacturing company on the
basis of the debt-asset ratios computed above as you don't have any standard debt-asset
ratio to be used as a bench mark. In general, creditors prefer low debt-asset ratios,
because the lower the ratios, the lower the chance of losing their money upon maturity, or
liquidation. The owners, on the other hand, may want higher debt (leverage) ratios
because the cost of borrowed money is usually less than the cost of owners' funds. The
debt-asset ratios calculated above for Addis manufacturing company show that more than
half of the company's assets were financed with funds from creditors during the two
years. As a result, the company may find it difficult borrow additional funds without first
raising more equity otherwise, creditors would be reluctant to lend more money to the
company with its debt-dominated capital structure.

Though creditors are willing to give loans to debt dominated borrower at higher interest
rate that commensurate with the high risk they are taking as lenders. The debit-asset ratio
of 67.46 percent for 1992 computed for Addis manufacturing company can also be
interpreted as one birr of investment in the company's assets was made up of the
combination of about 67 cents of the creditors' funds and the remaining 33 cents of the
shareholders' funds. During 1993 a birr of investment in the company's assets was made
with about 55 cents of creditors' funds and the remaining 45 cents was contributed by
shareholders.
Long-Term Debt- Equity Ratio:- This ratio measures the extent to which long-term
financing sources are provided by creditors (debt-holders). The ratio is computed by
dividing long-term debts by stockholders' equity. The long-term debt to equity ratios for
Addis manufacturing company are computed as follows:-

Long-term debt - equity ratio =

Long-term debt-equity, ratio (for 1992) =

Long-term debt-equity, ratio (for 1993) =

23
The long-term debt-equity ratio of the company decreased from 130 percent in 1992 to 73
percent in 1993. This decrease may be caused by several factors some of which are:
Some long-term debts might be matured and paid out, which reduce the balance of long-
term debts, Addis manufacturing company might increase the level of its shareholders'
equity either by issuing additional shares at premium, and some amount might be added
to the company's retained earnings due to retention of the portion of full amount of net
income. Your interpretation for the long-term debt-equity ratio of 130 percent achieved
during 1992 can be for a single birr of share holders' equity in the long-term financing
there is 1.30 birr of long-term debt in the long-term financing. In other words the long-
term financing 2.30 birr was made 1 birr from share holders' equity and 1.30 birr from
long-term debt. In the same way, a single birr in the long-term equity financing is
combined with 73 cents of long-term debt financing to form a total long-term financing
of 1.73 birr during 1993. In other words, for each birr obtained from shareholders'
equity, the long-term debt holders contributed 73 cents in the long-term financing during
the year. Again, it is very difficult to conclude that the long term debt-equity ratios
computed for Addis Manufacturing Company show good or bad capital structure of the
company as long as you don't have standard long-term debt-equity ratio to be used as a
point of reference.

Debt-equity ratio: This ratio expresses the relationship between the amount of the total
assets of the company financed by creditors (debt) and owners (equity). Thus, this ratio
reflects the relative claims of creditors and shareholders against the total assets of the
company. This ratio provides answer to the question: What are the proportions of debts
and equity in financing in the total assets of the company?

The debt-equity ratio is computed by dividing the total debts by the total
shareholders'
equity. The debt-to-equity ratios for Addis manufacturing company are the
following:

Debt - equity ratio =

Debt-equity ratio (for 1992) =

Debt-equity ratio (for 1993) =

The debt-equity ratio of 2.07 for Addis manufacturing company for 1992 indicates that
the creditors of the company have provided about 2.07 birr in financing the assets of the
company for every single birr contributed from shareholders’ equity. In the same token,
the debt-equity ratio of 1.22 for 1993 shows that the creditors have provided 1.22 birr for
each birr assets financed by shareholders’ equity. Whether these types of capital
structure (debt and equity mix) are good or bad depends on the standard set for the debt-
to-equity ratio. Unless you are told this standard, you can’t say the debt and equity mix
of Addis manufacturing company is good or bad.

Coverage Ratios:- The ratios are a second category of leverage, and they are used to
measure the company’s ability to cover its financing cost (interest expense) associated

24
with the use of debt financing. These ratios provide the basis for answering the question
of whether the company has used to much financial leverage. The coverage ratios, most
of the time for most companies, include the following.
Time interest earned ratio (Interest coverage ratio): This ratio measures the
extent to which operating income can decline before the company is unable to
meet its annual interest costs. Failure to meet this obligation can bring legal
action by the company’s creditors, possibly resulting in bankruptcy. This ratio is
determined by dividing earnings before interest and taxes (EBIT) by the interest
charges during the year. Note that earnings before interest and taxes (EBIT),
rather than net income, is used as a numerator in the formula because interest is
paid with the pre-tax income and company’s ability of paying interest charges is
not affected by taxes.

The time interest earned ratios (interest coverage ratios) for Addis manufacturing
company during 1992 and 1993 are:

Interest coverage ratio =

Interest coverage ratio for 1992) =

Interest coverage ratio (for 1993) =

The time interest earned (interest coverage) ratios computed for Addis manufacturing
company reveals that the company’s earnings before interest and taxes are 2.62 times and
3.43 times higher than the respective interest expenses of the company during 1992 and
1993 respectively. As long as you don’t have the industry average, you cannot categorize
these ratios as high or as low. But generally speaking, the lower time interest earned ratio
suggests that creditors are at risk in receiving the interest payments that are due; the
creditors may take legal action that may result in bankrupting the company; and the
company may face difficulty in raising additional financing through debt issues as the
company is under risk of paying interest charges. A larger interest coverage ratio, on the
other hand, suggests that the company has sufficient margin of safety to cover its interest
expenses; and the earnings before interest and taxes (EBIT) of the company could decline
without jeopardizing the company’s ability to make interest payments.

Fixed Charge Coverage ratio:- This ratio is similar to that of the time-interest-
earned ratio, but it is more inclusive as it recognize other fixed charges such as
lease payments, principal payments of debts, and preferred stock dividend
payments. Since principal payments of debts and preferred stock dividend
payments are not tax deductibles and paid from after tax earnings unlike interest
expenses, a tax adjustment should be made for these payments.
For example the company that is required to effect principal payments amounting
to 100 birr from its earnings after taxes (assuming a tax rate of 40 percent) needs
its earnings before taxes to be ( or 166.67 birr.
The fixed charges obviously include interest expenses, annual long-term lease
obligations, principal payments of long-term debts, and dividend payments for
preferred stockholders and the fixed charge coverage ratio is defined as:

25
 Fixed charge coverage ration =

As you can observe from the above equation, interest expenses and lease payments are not
adjusted for taxes because they are paid from earning before tax, while principal and
preferred dividend payments are adjusted for taxes because they are paid from the after tax
earnings (net income)
Considering the given income tax rate of 34 percent and the principal payments of 2500 birr
and 3000 birr during 1992 and 1993 respectively, the fixed charge coverage ratios for Addis
Manufacturing Company can be computed by using the above mathematical equation as
follows:

Fixed charge coverage ratio (for 1992) =

Fixed charge coverage ratio (for 1993) =

=
Addis manufacturing company is able to cover its fixed charges (interest, lease payments,
and principal payments) 1.37 times and 1.54 times using its earnings before interest and
taxes during 1992 and 1993 respectively. In other words, the earnings before interest and
taxes of the company are equal to 1.37 times the fixed charges during 1992 and 1.54 time
the fixed charges during 1993.
4. Profitability Ratios:

Profitability is the net result of a number of policies and decisions. The profitability
ratios provide the overall evaluation of performance of the company and its management.
These ratios show the combined effects of liquidity, activity and average ratios on the
operating result of the company. The several ratios falling under this category are
discussed in the following paragraphs.
Gross profit margin:- the gross profit margin ratio is calculated as follows:
Gross profit margin = Gross profit
Net sales
Gross profit margin of Addis co. (for 1992) = 27,000 = 0.2455, or
110,000 24.55%
Gross profit margin of Addis co. (for 1993) = 30,000 = 0.25, or
120,000 25%

26
Thus, Addis manufacturing company’s gross profit constitutes 24.55 percent and 25
percent of the company’s net sales during 1992 and 1993 respectively. These ratios
reflect the company’s mark ups on costs of goods sold as well as the ability of the
company’s management to minimize the costs of goods sold in relation to net sales.
Larger gross margin ratio implies lower costs of goods sold rate and vice versa.

Operating profit margin:- Moving down in the income statements, the next profit figure
following gross profit is the operating income (or EBIT). This operating profit figure
serves as the basis for computing the operating profit margin. The operating profit, as you
know, is the excess of gross profit over the total operating expenses.
Operating profit margin = Operating Income
Net sales
Operating profit margin (for 1992) = 12,200 = 0.1109, or 11.09%
110,000
Operating profit margin (for 1993) = 14,250 = 0.1188, or 11.88%
120,000
The operating profit margins reflect the company’s operating expenses as well as its costs
of goods sold. Addis manufacturing company remained with 11.09 percent and 11.88
percent of its net sales after covering its cost of goods sold and all operating expenses
during 1992 and 1993 respectively.

Net profit margin ratio:- the net profit margin on net sales measures the profitability of
the company on a per birr basis of net sales. This ratio is calculated by dividing net
income by net sale of the company for a given accounting period. The net profit margin
ratios for Addis manufacturing company are:
Net profit margin = Earnings after taxes
Net sales
Net profit margin (for 1992) = 4,976 = 0.0452, or 4.52%
110,000
Net profit margin (for 1993) = 6.666 = 0.0556
120,000
These net profit margin ratios can be interpreted in such a way that Addis manufacturing
company had earned 4.52 percent, or nearly 5 cents net income per birr of net sales it
made during 1992 and 5.56 percent or nearly 6 cents per birr of sales it made during
1993. Make sure also that the net profit margin of the company is influenced by the
amount of interest expenses/charges and income tax expense because net profit is an
earning after interest and taxes (EBIT).

Return on Investment (ROI) – It is also known as return on Assets (ROA). This ratio
measures the company’s profitability per birr of investment in the total assets. The
ROI, or ROA is calculated by dividing earnings after taxes by total assets. The ROIs
for Addis manufacturing company are:
Return on Investment (ROI) = earnings after taxes (net income )
Total assets
ROI (for 1992) = 4,976 = 0.0701, or 7.01%
71,000

27
 ROI (for 1993) = 6,666 = 0.0813, or 8.13%
82,000
Thus, Addis manufacturing company generated 7.01 percent, or about 7 cents in the form
of net income out of each birr it invested in its total assets during 1992, and 8.13 percent,
or about 8 cents in the form of net income out of each birr of investment in its total assets
during 1993. Whether the indicated returns on investments are good or bad depends on
the industry standards, or the management plans. But what you can say at this point is
that the company’s return on investment has shown slight improvement in 1993
compared to that of 1992.

5. MARKET/BOOK RATIOS:
These ratios are recently introduced into the ratio analysis. They are primarily used for
investment decisions and long-range planning and include:
Earnings per share (EPS): Expresses the profit outstanding during the reporting
period. It provides a measure of overall performance and is an indicator of the possible
amount of dividends that may be expected. The earning per share for Addis
manufacturing company is computed as follows:
Earnings per share (EPS) = Earnings after tax (net income) – Preferred dividend
Number of common shares out standing
Or (EPS) = Earnings available for common stock holders
Number of common shares outstanding
EPS (for 1992) = 4,976-0 = 4,976 = 4.98 Birr/share
1000 shares 1000 shares
EPS (for 1993) = 6,666 - 0 =6,666 = 5.13 birr/share
1,300 1,300
Addis manufacturing company has earned 4.98 Birr per share during 1992 and 5.13 Birr
per share during 1993. The earning per share has shown an increase during 1993 which
shows improved performance of the company during the year. Though, the earnings per
share were 4.98 Birr and 5.13 Birr per share during 1992 and 1993 respectively, these
ratios do not tell you how much of these earnings per share is paid as dividend and how
much is retained in the business. Moreover, since you don’t have the industry average or
the management plan you cannot conclude that these earnings per share are indicators of
good or bad performance.

Price-to-earnings ratio (P/E): expresses the multiple that the market prices on the
company’s earnings per share and is commonly used to assess the owner’s appraisal of
share value. The price-to-earnings ratio is computed by dividing the market price of a
share by the earning per share computed above. Assuming that at the end of 1992 and
1993 the common share of Addis manufacturing company has a market prices of 30 Birr
and 35 Birr respectively, compute the P/E ratio of the company.

P/E ratio = Current market price per share

EPS
P/E ratio (for 1992 ) = 30 = 6.02 times

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 4.98
P/E ratio (for 1992) = 35 = 6.82 times
5.13

You can interpret these ratios like this: the market is willing to pay about 6 birr in 1992
and about 7 birr in 1993 for every birr in the company’s earnings. Again the P/E ratio
has shown a slight improvement during 1993. Since the industry standard or
management plan is lacking, it is very difficult for you to categorize Addis manufacturing
company as highly valued or low valued company. But what you can say in general is
that a high P/E ratio reflects the market’s perception of the company’s growth prospects.
Thus, if the investors in the stock markets believe that a company’s future earnings
potential is good, they are willing to pay higher prices for the stock and further boast the
P/E ratio. The problem with P/E ratio is that the market price for a share of common
stock may not be available when there is no’ stock market.

Book value per share:- is the value of each share of common stock based on the
company’s accounting records. It is computed by dividing the number of common
shares outstanding into the excess of total stock holders equity over preferred stock.
The book value per share ratios for Addis manufacturing company is computed as
follows:

Book value per share = Total stock holder equity – preferred stock
Number of common shares outstanding

Book value per share (for 1992) = 23, 100 – 0 = 23,100 = 23.10
1,000 shares 1000 shares
Book value per share (for 1993) = 37,000 – 0 = 37,000 = 28.46
1,300 shares 1,300 shares
The book value of a share of common stock of Addis manufacturing company is 23 – 10
Birr in 1992 and 28.46 Birr during 1993. This shows that the book value of a share is
less than the market value of a share during the two years. Since we don’t have industry
average or management goal, we cannot say the book values per share ratios are above or
below the industry average, or management plan.

Dividends per share (DPS) : it shows the birr amount of dividends paid on a share of
common stock outstanding during the reporting period. It is determined by dividing the
total cash dividends on common shares by the number of common shares outstanding.
Assuming that Addis manufacturing company distributed a cash dividend to common
shareholders of 1,900,000 Birr during 1992 and 2,600,000 Birr during 1993, the dividend
per share for the two years are:

Dividend per share = Total dividends on common share

Number of common shares outstanding

Dividend per shae (for 1992) = 1,900 = 1.9 Birr

1000 Shares share

29
Dividend per share (for 1993) = 2600 = 2 Birr
1,300 shares share

Addis manufacturing company paid 1.9 Birr dividend per common share during 1992 and
2 Birr per common share during 1993.

Dividend payout ratio – It shows the percentage of earnings paid to shareholders. It

expresses the cash dividend paid per share as a percentage of EPS. Dividend payout ratio
is computed by dividing cash dividend per share by earnings per share. The dividend
payout ratios of Addis manufacturing company are computed as follows:

Dividend payout ratio = Cash dividend per share , or

Earnings per share
= Total dividend to common stock
Total earnings available for common stock hold

Dividend payout ratio (for 1992) = 1.90 = 38.15%

4.98

Dividend payout ratio (for 1993) = 2.0 = 39%

5.13

or else
Dividend payout ratio (for 1992) = 1900 = 38.18%
4,976
Dividend payout ratio (for 1993) = 2,600 = 39%
6,666

The dividend payout ratios indicate that Addis manufacturing company paid about 38
percent of its earnings in the form of dividends for its common shareholders during 1992
and 39 percent of its earnings was paid in the form of dividends during 1993.

Dividend yield: it shows the rate earned by shareholders from dividends relative to the
current market price of shares. Dividend yield is computed by dividing cash dividend per
share by current market price per share. The dividend yields for Addis manufacturing
company for 1992 and 1993 are:-

Dividend yield = Cash dividend per share

Market price per share

Dividend yield (for 1992) = 1.9 = 6.33 %

30
Dividend yield (for 1993) = 2 = 5.71%
35

30
Addis manufacturing company paid 6.33 percent and 5.71 percent of the current market
prices in the form of dividends to common shareholders during 1992 and 1993
respectively. Unless we do have industry average, it is difficult of say these ratios
indicate good or bad situation. But what we can say, in general, is that the higher
dividend rate (yield) may reflect fewer investment opportunities on the part of Addis
manufacturing company.

Approaches to use Financial Ratios

These are two basic approaches in analyzing a set of financial statements through the use
of financial ratios. These are the cross sectional analysis and the time series analysis.
These two approaches complement each other and both should be used as part of the
analysis of financial statements.

1. Cross-Sectional analysis:

This approach enables you to evaluate company’s financial conditions at a given point in
time and compare company’s current performance against that of the previous year.
Under cross-sectional analysis, you compare the ratios of your company against those of
its competitors. The first step in cross-sectional analysis of Addis manufacturing
company is to evaluate its financial position at the end of 1993.
In order to do so, the company’s financial statements are needed. The second step is to
compare the current performance of the company against that of the previous year by
comparing the financial ratios computed for 1992 and 1993 which are summarized in the
following table.

Summary of the Financial Ratios of Addis manufacturing company.

Ratio 1992 1993

Liquidity:
Current ratio ------------------------------------ 1.96 2.22
Quick ratio ------------------------------------ 0.91 1.08

Activity:
Inventory turnover --------------------------- 4.44 4.39
Total assets turnover -------------------------- 1.55 1.46
Average collection period -------------------- 39 days 48 days

Leverage:
Total debt to assets --------------------------- 67.46% 54.88%
Long term debt to equity --------------------- 130% 73%
Total debt-to-equity --------------------------- 2.07 1.22
Time interest earned --------------------------- 2.62 times 2.26 times
Fixed charges coverage ----------------------- 1.37 times 1.54 times

Profitability: Gross profit margin ---------------------------- 24.55% 25%

31
 Operating profit margin ----------------------- 11.09% 11.88%
Net profit margin ------------------------------ 4.52 % 5.56%
Return on investment (ROI) ------------------ 7.01 % 8.13%

Comparing the liquidity ratios of 1992 and 1993 of Addis manufacturing company, both
the current ratio and quick ratio show improvement during 1993. The activity ratios of
Addis manufacturing company imply that the company was less efficient in utilizing its
assets in 1993 compared to what it had done during 1993. The leverage (debt
management) ratios of Addis manufacturing company show that the capital structure has
been improved during 1993 compared to that of 1992 where the capital structure had
been a debt-dominated one. The profitability ratios also suggest that the company’s
performance was more profitable during 1993 than it had been in 1992. The final step in
the cross-sectional analysis is comparing the financial ratios computed for Addis
manufacturing company against the average financial ratios computed for all competing
companies in the industry. The result of this comparison tells you the position of Addis
manufacturing company regarding its liquidity, activity, leverage and profitability.
Unfortunately we don’t have industry averages in our country to use for comparison
purposes.

2. Time series Analysis: - It is the approach that is used to evaluate the performance of
the company over several years. This approach looks for three factors: (1) important
trends in the data of the company. (2) Shifts in trends, and (3) values that deviate
substantially form the other data.

The following are the major advantages financial ratio analysis:

1. Ratios are easy to compute

2. Ratios provide standards of comparison at a point in time and comparisons to be
made with industry average, if available.
3. Ratios can be used to analyze company’s time series in order to discover trends,
shifts in trends, and values that deviate from other similar values.
4. Ratios are useful in identifying problem areas of a company.
5. When combined with other tools, financial ratios analysis makes an important
contribution to the task of evaluating the company’s financial performance.

The following are the major limitations of financial ratio analysis:

1.Taken by themselves, financial ratios provide very little information that is useful.
2. Ratios seldom provide answers to questions they raise because generally they do
not identify the causes for the difficulties that the company faced.
3. Ratios can easily be misinterpreted for instance; a decrease in the value of a given

32
 ratio doesn’t necessarily mean that something undesirable has happened.
4. Very few standards exist that can be used to judge the adequacy of a ratio or a set
of ratios. Industry average cannot be relied upon exclusively to evaluate a
company’s performance because most of the companies in an industry may
perform far below the acceptable level of performance which lowers the industry
average. In some cases, the industry average ratios may not be available at all
that is the problem we encounter in the case of Ethiopian industries.
5. Many large companies operate a number of different industries and in such cases
it is difficult to develop a meaningful set of ratios to compare against industry
average. This makes ratio analysis more useful for smaller and narrowly focused
companies than for large and multi divisional ones.
6. Inflation has severely distorted balance sheets of companies (recorded values are
usually different from ’true’, or ‘market’ value.) Again since inflation affects
both depreciation charges and inventory costs, profits are also affected. But
ratios do not take these distortions into account unless balance sheet and
income statement figures are adjusted for the effect of inflation.
7. Seasonal fluctuations can also distort the analysis of financial statements through
the use of ratios. These problems can be minimized by using monthly
averages for inventories and receivables when calculating turnover ratios.
8. Companies can employ ‘window dressing’ techniques to make the financial
statements look stronger. For instance, the company might borrow on a long-
term basis huge amount of cash towards the end of the accounting period for
few days but back paid in the first week of the subsequent accounting period.
This action did improve the company’s current and quick ratios and made the
balance sheet of the company look good. However, as you clearly understand,
the improvement was strictly due to the “window dressing” technique the
company had employed. Under such situation, it is highly likely to
misinterpret both the current and quick ratio as they signal good liquidity
position of the company which in fact is not.
9. It is difficult to generalize whether a particular ratio is ‘good’ or ‘bad’. For
example, a high current ratio may indicate a strong liquidity position which is
good, or the availability of excess cash which is obviously bad as the excess cash
is a non-earning (idle) asset. Similarly, a high fixed asset turnover ratio may
denote either a company that uses its fixed assets efficiently, or one that is
undercapitalized and can’t afford to buy enough fixed asset whose value is used
as a denominator when calculating the ratios.

FINANCIAL FORECASTING
Financial forecasting is one of the four major jobs of a firm’s financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making
financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process
which involves:

33
 - evaluation of a firm’s need for increased or reduced productive capacity and
- evaluation of the firm’s need for additional finance

Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects:

- It helps a firm to predict appropriate demand for its products.

- It helps a firm to project its sales and accordingly to predict its assets properly.
- It contributes significantly to the firm’s profitability.
- It plays a crucial role in the value maximization goal of a firm.

Financial forecasts are also ways for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast will be analyzed. Finally, the firm’s management will
have an opportunity to make some decisions beforehand.

So, all in all, financial forecasting is a requirement for the investment, financing, as well
as dividend policy decisions of a firm.
The financial forecasting process generally involves the following procedures:
i) Forecasting of sales for the future period
ii) Determining the assets required to meet the sales targets, and
iii) Deciding on how to finance the required assets.

The above three procedures are very important in projecting the financial statements and
key financial ratios. However, among the three procedures, the first one, i.e, sales
forecast is the most crucial.

Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by reviewing the
sales of the recent pasts. The whole crucial points of a financial forecasting process lies in
an accurate forecast of sales. If this procedure is off, the firm’s profitably as well as its

34
value will be negatively affected. So in forecasting sales, several factors should be
considered:

1. the historical sales growth pattern of the firm at both divisional and corporate levels,
2. the level of economic activity in each of the firm’s marketing areas,
3. the firm’s probable market share,
4. the effect of inflation on the firm’s future pricing of products,
5. the effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
6. individual products’ sales forecasts at each divisional level.

Forecast of sales is a base for forecasting of the firm’s income statement which in turn
helps to project retained earnings. In forecasting the income statement assumptions about
the costs, tax rates, interest charges and dividends are required.

Sales forecasts are also grounds for determination of the firm’s assets requirement.
If sales are to increase, then assets must also grow. The amount each asset account must
increase depends whether the firm was operating at full capacity or not. If higher sales are
projected, more cash will be needed for transactions, higher sales will create higher
receivables. Similarly, higher sales require higher inventory and higher plant and
equipment.

Finally, the firm will face the question of financing its required assets. Some of the
required finance can be covered by the increased retained earnings. The retained earnings
increment will result from increased sales and profit. Still some other portion of the
finance can be covered by some liabilities which will grow by the same proportion with
that of sales. The remaining finance must be obtained from available external sources.

The third procedure of the financial forecasting process, i.e. forecast of financial
requirements involves again three sub procedures. These are:

1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast.

35
2. Determing how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be
generated under normal operations. The first is portion of the net income retained in
the firm (retained earnings). The second one is the increase in the firm’s liabilities as
a direct and automatic result of its decision to increase sales. This finance is called
spontaneous finance. For example, if sales are to increase, inventory must increase.
The increase in inventory requires more purchases which in turn causes the accounts
payable to be increased. The accounts payable will increase spontaneously with the
increase in sales. Other examples include accruals like salaries and wages payable
and income tax payable.
3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from
external sources. This finance is called the additional funds needed (AFN).
Required increase Required increase in
AFN = in assets __ normally generated funds.

Additional funds needed (AFN) are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock.

36
 Chapter - 3
Time value of Money
Time value of Money:

The concept of interest is one of the core ideas in financial management. Individuals, as
well as, business organizations frequently encounter situations that involve cash receipts
and disbursements over several period of time. When this happens, interest rates and
interest payments become important considerations. Business organization deals with
interest rates when it makes both financing and investment decisions. Short-term
commercial and industrial loans may be obtained at reasonably lower interest rates while
long-term investments in assets like real estate, machinery and equipment are evaluated
on the basis of the profit that the investor (company) expects out of them. Since, such
investment require the commitment of funds over several year, the expected profits need
to be measured in terms of the rates of returns which are equivalent to the interest returns
that can be received on the invested funds.

A company can, therefore, earn a rate of return on its invested funds and a rate of interest
on the funds it lent to borrowers. The key concept that under lies this is the time value of
money: that a birr today is worth more than a birr received a year from now. This is
because of the fact that the value of one birr after a year will grow to one birr and an
interest earned on it for it can be invested, or given as loans during the year. Interest is the
price paid for the use of money overtime. The rate of return/interest can be stated
explicitly as it is the case for commercial and mortgage loans provided by the commercial
Bank of Ethiopia (CBE) and Construction and Business Bank (CBB) respectively. The
interest rates are explicitly expressed/stated for both loans though the rates are subjected
to changes from time to time as the CBE has done is the recent past. Sometimes, the
interest rate is implicitly applicable. For instance, if the commercial Bank of Ethiopia
(CBE) offers free checking accounts to customers who are willing to keep a minimum
balance 100 Birr in their account, there is an implicit interest rate for the checking
account opened by a given customer since the 100 Birr is tied up as long as the checking
account is active.

General Assumptions Needed in Computing Interest

In order to focus on interest rate and to avoid complications that would tend to hide the
essential concepts, the following three general assumptions are needed to be made.
These are:

Certainty: - It is the most restrictive assumption. All current and future data values are
assumed to be known with certainty, or a set of techniques exists for estimating all
unknown variables. Certainty also applies to the accuracy of future events and their
occurrences. This assumption is used for simplicity since uncertainty requires the
introduction of techniques that cannot be easily understood.

Discrete Time Period: - Time is divided into yearly intervals. The time that elapses
between the last days of two consecutive years is expressed as one year. For example,
year 3 is the time that elapses from the last day of year 2 and to the last day of year 3.

37
This assumption doesn't require cash flows to occur on the last day of each year. What is
required is that cash flows have to occur only at points of time that are separated by one
year intervals. The assumption, thus, allows us to abstract from specific calendar dates
and to measure time from the point at which a particular investment or financing program
begins.

Yearly Interest Computations: - interest is computed once a year and the computation
is made at the end of the year. This assumption is thus, consistent with the discrete time
period assumption made above. In reality, many situations involve monthly, daily, and
even continuous interest computation where by many commercial banks and savings and
credit associations offer daily, or continuous interest compounding on depositors' money.

Compounding Method
There are two ways of depositing payments (money) into an interest bearing account.
These are single payment and series of payments.

Future (compound) value of single payment

A birr you deposited in an interest - bearing account today worth's you more in the future
because the account earns you an interest on the money you have deposited. The process
of going from today's values, or present values (PV) to future values (FV) is called
compounding. To illustrate this, suppose you deposited 100 Birr at the Commercial Bank
of Ethiopia (CBE) that pays 5 percent interest each yea. How much would you have at
the end of one year? To begin, it is very wise to define the following terms:

PV = Present value, or the beginning amount, in your account. Here

PV = 100 Birr.
i = interest rate that the bank pays per year. The interest earned is
baded on the balance at the beginning of each year and it is assumed paid
at the end of the year. Here, i = 5%, or expressed as a decimal, i = 0.05.
INT = Birrs of interest you earn during the year, which is equal to the
beginning amount multiplied by i. Here, INT = 100 x 0.05 = 5 Birr for the
first year.
FVn = Future value, or ending amount, in your account at the end of n
years. Whereas the PV is the value now, or the present value, FV n is the
value of the money after n years into the future, after the earned interests
have been added to the account balance every year.
n = number of periods involved in the analysis, Here n = 1.

In our example here, where n = 1, the future (compound) value can be calculated as
follows:
FVn = FV1 = PV + INT (interest)
= PV + PV (i)
= PV (1 + I)
= 100 (1+0.05) = 100 (1.05) = 105 Birr.

38
Thus, the future value (Fv) at the end of year one, Fv 1, equals the present value (Pv)
multiplied by 1.0 plus the interest rate, so you will have 105 Birr after one year.
Extending our analysis, what would you end up with if you kept your 100 Birr in your
bank account four five years? Here is the time line to show the amount at the end of each
year during the five years period.

Note the following Points

1) You start by depositing 100 Birr in the bank account which is shown as an out
flow of 100 Birr (-100) at year zero (n = 0)
2) You earn (100) (0.05) = 5 Birr of interest during the first year resulting in 105
Birr at the end of year one (n = 1).
3) You start the second year with 105 Birr, and earn 5.25 Birr on the larger balance,
and then end the second year with 110.25 Birr which is 105 Birr beginning
balance plus 5.25 Birr interest earned during year two (n = 2), 5.25 Birr is
higher than the interest you had earned during year one (n = 1) because you
earned (5) (0.05) = 0.25 Birr, or 25 cents interest on the interest earned during
the first year.
4) This process continues, and because the beginning balance is higher in each
succeeding year, the annual interest earned increases as we move from year one
(n=1) to year five (n=5).
5) The total interest earned over the five years, 27.63 Birr, is reflected in the final
balance at year five (n=5), 127.63 Birr as indicate on the time line above.

Note that the value at the end of year two (n=2), 110.25 Birr, is computed as follows:
FV2 = FV1 (1+i)
= PV (1+i) (1+i), because FV1 = PV1 (1+i)
= PV (1+i)2 = 100 (1.05)2 = 110.25 Birr

Continuing the analysis, the balance at the end of year three (n = 3) is:
FV3 = FV2 (1+i)
= PV (1+i)2 (1+i), because FV2 = PV (1+i)2
= PV (1+i)3
= 100 (1 + 0.05)3
= 115.76 Birr and
FV5 = PV (1+i)5
= 100 (1 + 0.05)5 = 100 ( 1.05)5 = 127.63 Birr
In general, the future value of an initial sum at the end of n years can be found by
applying the following general equation.
Interest Table
The future value interest factor for i and n (FV1F i,n,) is defined as (1+I)n, and this factor
can be found by using a regular calculator. Interest table is the table that is constructed
by using the future value interest factors. It contains future value interest factors
(FV1Fi,n,) values for the wide range of I and n values. Since the term (1+i) n is equal to the
FV1Fi,n, the future value equation for single payment can be re-written as:

39
 FVn = PV (FV1Fi,n,)
To illustrate how to use future value interest factors (FV1F) in computing future
(compound) value of any single payment, consider our five-year, 5 percent interest rate
deposit of 100 Birr in the previous example. The future value of the 100 Birr at the end
of year 5 can be determined by looking for the FV1F5%,5 in the interest table. This is done
by looking down the first column to period 5, and looking across that row to the 5 percent
column, where we read the value of 1.2763 which corresponds to FV1F 5%,5. This value is,
then, plugged into the above equation. That is:

FVs = PV (FV1F5%,5)
FVs = 100 (1.2763)
FVs = 127.63 Birr.

Therefore, the future value at the end of years ( n=5) computed by using the future value
interest factor from the interest table, 127.63 Birr, is exactly the same as the future value
we have found by using the general future value equation for single payment.

Portion of future value table for single payment (FV1F5%,5)

Period (n) 4% 5% 6%
1 1,0400 1.0500 1.0600
2 1.0816 1.1025 1.1236
3 1.1249 1.1576 1.1910
4 1.1699 1.2155 1.2625
5 1.2167 1.2763* 1.3382
6 1.2653 1.3401 1.4185

1 It is the future value interest factor that corresponds to five periods (n=5) and
interest rate of 5 percent (i = 5%).
Other Application of future value amount of single payment:

The future value equation for single payment stated in this material can also be used to
find interest rates, as well as, members of years that will be needed for the compounded
amount to equal the desired value. Estimating the interest rate on the deposited money is
a recurring problem, when it is not explicitly stated. A useful approach is to treat the
interest rate as an implicit interest rate and found by using the interest table (future value
table of single payment).

To illustrate, assume that you have invested 15,000 Birr today at a bank where it can
grow to the future value of 17,000 Birr within three years from now into the future. What
is the interest rate that the bank should pay for your account in order to fulfill your
desire? To answer this question, treat the 15,000 Birr as present value which you have
deposited into an account that pays an unknown interest rate but grows to the compound
(future) amount of 17,900 Birr after three years. Substituting these values into the future
value of single payment equation, you get:
FV3 = PV (1+i)3
17900 = 15,000 (1+i)3

40
 (1+i)3 = FVIFi,3 =
The future value interest factor in the interest (future value of single payment table)
corresponding to the unknown interest rate (i) and a period of 3 years 9n = 3) is 1.193.
Hence, look up the three year (n=3) row and read horizontally until you find the table
value (future value interest factor) that is equal or the closest to the computed value of
1.193. There is no table value that is exactly equal to 1.193. The table value of 1.191 is
found to be the closest value to 1.193 and it corresponds to 6 percent. Thus, the interest
that the bank actually has to pay to your account is slightly greater than 6 percent.

Finding the number of years:- The future (compound) value of single payment
equation can be used to estimate the number of years that are required for a given amount
of money deposited at a specific interest rate to produce or desired compound amount.
Assume, for example, a deposit of 1000 Birr is made in an interest bearing account that
pays 10 percent compounded yearly. Your goal as a depositor is to collect 1,500 Birr
after an unknown number of years. How many years should you wait for the desired
amount to be realized?

By substituting the values into the future value of single payment equation, you get:

FVn = 1000 (1+I)n

1,500 =1000 (1+0.1)n =1000 (1.1)n
(1.1)n = 1500 = 1.5, by using logarithm
1000
n = log1.1 1.5 = log 1.5 = 0.176 = 4.29 years
log 1.1 0.041

Again it is possible to look up the 10 percent column in the future value interest factors
(future value) table and read vertically until you find a table value that is equal to 1.5 or
closest to it. The closest table value is 1.611, which corresponds to five years (n =5).
That means if the 1000 Birr is kept in the account that pays 10 percent for five years, the
resulting compounding amount will be 1,611 Birr. This amount exceeds the desired
amount of 1,500 Birr. If the 1000 Birr is kept in the account only for four years, the table
value is 1.464 Birr. Hence, the 1000 Birr has to be kept in the account for a period
slightly greater than 4 years.

Present (Discount) value;

Suppose that you have some extra cash, you have a chance to buy a low risk security
which will pay 127.63 Birr at the end of 5 years. Assume that Awash International Bank
(AIB) is currently offering 5 percent, on 5-year time deposit. How much should you
deposit today in the time deposit account in order to get the indicated amount of 127.63
Birr at the end of year 5 9n=5).

We saw that an initial amount of 100 Birr invested at 5 percent per year would worth
127.63 Birr at the end of year 5. You are definitely indifferent to the choice between 100
Birr today and 127.63 Birr at the end of the five years, and 100 Birr is defined as the

41
present value, or PV of the 127.63 Birr that is due in 5 years of time when the interest
rate or opportunity cost rate is 5 percent. In general, the present value of a cash flow due
n years into the future is the amount which, if it were on hand today, will grow to equal
the future value. Since 100 Birr today would grow to 127.63 Birr in 5 years at 5 percent
interest rate, 100 Birr is the present value of 127.63 Birr due 5 years in the future.

Finding the present value of the future cash receipts, or payment is called discounting,
and it simply the reverse of the compounding process. If you know present value, PV,
you compound it to find the future value, FV. In the same way, if you know the future
value, Fv, you discount it to find the present value, PV. When discounting future value,
you follow these steps.
Time Line. Show the cash flow on the time line

0 5% 1 2 3 4 5
Pv =? Fv5 = 127.63 Birr.

Equation:
To develop the discounting equation, we begin with the compounding equation used in
the previous section.
FVn= PV(1+I)n = Pv (FV1Fi,n)
and by solving for PV in several equivalent form, we arrive at:

PV = substituting PV1Fi,n for

the term , are get Pv = FVn (PV1 Fi,n)

Hence, you can insert the figures into the present value equation inorder to determine the
present value of 100 Birr as indicated here:

PV =
Tabular Solution:-

The term is called the present value interest factor for i and n (PV1F i,). The
present value table can be developed from the present value interest factors which are the

values of for different values for i and. The present value interest factor for i=
5% and n=5 is found by looking down the first column to period 5, and then moving
across the row to 5%, where the present value interest factor is read us 0.7835, so the
present value of the 127.63 Birr to be received after 5 years when the rate of interest is 5
percent is 100 Birr. That is PV = (FVs) (PV1F5%, 5) = (127.63) (0.7835) = 100 Birr.

A Portion of present value table for single payment

42
 Period (n) 4% 5% 6%
1
2
3
4
5 0.7835*
6
4 0.7835 is the present value interest factor corresponding to 5 percent, and 5 period.

Other Application of Present Value of the Single Payment

With the help of present value equation and table you can solve for any one variable in
the equation when the other three variables are known:

Finding the Interest Rate: Although the term of contract may clearly state that all the
relevant cash flows, the problem of determining the interest rate, or the rate of return to
the lender, or investor may still remain unsolved. When single payments are involved,
the implied interest rate approach used for compounding problem can be adopted for use
in determining the interest rate in the present value table. To illustrate this, suppose that
you have taken a loan of 1200 Birr to day which is to be paid after three years together
with its interest by making a payment of 1500 Birr. What is the rate of interest on the
loan that you have taken?

To answer this question, first of all you need to identify variables which are known. In
this illustration, the present value, PV is equal to 1,200 Birr; the future value, FV is 1500
Birr, the period of the loan, n is equal to 3 years. Then you substitute the given variables
into the equation and solve for the table value:

Pv =

1200 =

Looking at the year three (n=3) row in the present value table, try to locate the present
value interest factor (table value) that is equal to or closest to 0.80. The resulting table
values are 0.816 corresponding 7 percent and 0.794 corresponding to 8 percent. Thus,
the interest rate is between 7 percent and 8 percent.

Finding the Number of Years:- The present value table and the present value equation
for single payment can be used to determine the number of years required for the present
value to equal its future value at a given rate of yearly compounding. For instance, how
many years do you need to wait for your deposit of 1000 Birr to grow to 1,200 Birr in a
saving account that pays interest compounding yearly at 6 percent?

43
To answer this question, let the 1000Birr be the present value of the future value of 1200
Birr at an interest rate of 6 percent per year. By substituting into the present value
equation for single payment and solving for the desired table value, you get.
PV = FVn (PV1Fi,n)
1000 = 1200 (PV1F6%,n)
PV1F6%,nn =
Then look at the 6 percent column in the present value table of single payment and read
down the present value interest factors till you arrive at the value that is equal of falls
below the computed table value. The table value that meets the stated requirement is
0.84, and it corresponds to 4 years, (n=4). Therefore, the 1000 Birr will have to be kept
in the saving account for 4 years (and compounded four times) before it grows to the
desired value of 1200 Birr.

Annuities
An annuity is an equal amount of Birr payment for specified number of years. Since
annuities occur frequently in finance, such as bond interest payments, you have to be able
treat them accordingly. Although compounding and discounting of annuities can be dealt
with for single payment, these processes are time consuming, especially for longer
annuities. The annuity payments can occur at either the beginning or the end of period.
If the payments are made at the beginning of each period, the annuity is known as annuity
due. If the payments, on the other hand, occur at the end of each period, as they typically
do, the annuity is called an ordinary or deferred annuity. Since ordinary annuities are
more common in finance, when the term annuity is used in this material you should
assume that the payments occur at the end of each period unless stated, otherwise.

Future Value of an Annuity

An ordinary or deferred annuity consists of a series of equal payment made at the end of
each period. If you deposit 100 Birr at the end of each year for three years in a saving
account that pays 5 percent per year, how much will you have at the end of year three
(n=3)? To answer this question, you must find future value of an annuity, FVA n. Each
payment has to be compounded out to the end of period n, and the sum of the
compounded payments gives you the future value of an annuity, FVA n. This can be
shown by using the following time line.

0 1 2 3
100 Birr 100 Birr 100 Birr
105.00 Birr = (100) (1.05)1

110.25 Birr = (100) 1.05)2

FVA3 = 315.25 Birr

The time line shows each cash flow compounding and the sum of the compounded cash
flows which gives the future value of an annuity at the end of year three (n3), FCA 3 of
315.25 Birr. Representing the single payment in a series of equal payments of an annuity
with PMT (Payment), the future value of an annuity at the end of year three (n=3), FVA 3

44
of 315.25 Birr. Representing the single payment in a series of equal payments of an
annuity with PMT (payment), the future value of an annuity for n years can be designated
with the following equation:
FVAn = PMT(1+i)0 + PMT(1+i)1 + PMT(1+i)2+----+ PMT (1+i)n
In this equation the first term (i.e. PMT (1+i)0) is the compounded value of the payment
at the end of last year, or year n of the annuity payments while the last term in the
equation (i.e. PMT (1+i)n-1) is the compounded amount of the payment made at the end of
year one (n=1). The above equation can further be simplified to:

FVAn= (PMT) ( where PMT is an annuity payment deposited, or

received at the end of each year.
The equation can be re-written as:

By substituting for
Using this future value of an annuity equation, the future value of the 100 Birr deposits
made at the end of each year for three years at an interest rate of 5 percent would be:

FVA3= (100) =(100) (3.1525) = 315.25Birr

Tabular Solution:
The future value for an annuity is formed from the future value interest factor for an

annuity (FVIFAi,n), which are the values of the term in the above future
value of annuity equation. The future value for an annuity table contains a set of future
value interest factor for an annuity for various combination of I and n. To find an answer
to 3-years, 100 Birr annuity problem by using future value of annuity table, look down 5
percent column to the third period; the future value interest factor for annuity
(FVIFA5%,3) is 3.1525. Thus, the future value of the 100 Birr annuity is 315.25 Birr.
FVAn = (PMT) (FVIFAi,n)
FVA3 = (100) (FVIFA5%, 3) = (100) (3.1525) = 315.25 Birr
A portion of the future value of annuity table
Period (n) 4% 5% 6%
1
2
3
4 3.1525*
5
6
* 3.1525 is the table value ( the future value annuity interest factor for an annuity)
corresponding
to 5 percent and 3 period. The complete future value of annuity table is included in
the appendix
to this material.

45
Other Applications Future value of Annuity
The future value of an annuity equation and table can be used to solve for the interest
rate variable, as well as the number of payment variable, in the manner that is quite
similar to that used handing compound amount, single payment problems.

Finding the Interest Rate:

Some financial contracts and certain types of investments by business firms can be
described as yielding a future sum in return for making a specific number of an annuity -
payments. The interest rate is an important determinant in accepting or rejecting such
opportunities, but it is rarely stated explicitly. The implied rate can obtained by treating
the future sum as the compound of annuity payments and solving for the interest future
value of an annuity table.
To illustrate interest rate computation, three equal payments of 3,000 Birr are offered in
return for 9,800 Birr to be received upon making the last annuity payment. What is the
implied interest rate? To answer this question, first identify the variables in the
compounding annuity equation that are known and plug these known values in to this
equation. The compound amount of annuity, FVA in the illustration above is 9,800 Birr
and the annuity payment made at the and of each year, PMT is 3000 Birr.

FVAn = PMT

9,800 = 3,000

As indicated earlier, is the future

value interest factor for an annuity, FVIFAi,n for a given interest rate I and a given
number of years, n. To determine the interest rate, look up the three payment row (n=3)
in the table for the table values that is equal, or closest to 3.266. The table value
corresponding to 9 percent is 3.246, and the table value corresponding to 9 percent is
3.278. Since the computed value of 3.266 lies between these two table values, the
implied interest rate is greater than 8 percent and less than 9 percent.

Finding the Number of Payment:- If the interest rate, the size of the desired future
value of an annuity, and the size of each annuity payment are given, you can compute
the number of payments required to attain the future sum of an annuity by using the
future value of an annuity equation and table. For example, how many annual deposits of
1000 Birr each must be made into an account that pays 6 percent interest compounded
yearly in order to accumulate 5,500 Birr immediately after the last deposit? Here, the
5,500 Birr is the future value of an annuity, and 1000 Birr is the annual payment
deposited at the end of every year fill the term ends. If you substitute the futures into the
future value of an annuity equation, the desired annuity table value will be:

FVAn = PMT

46
 5500 = 1000 (FVIFAi,n) because is equal to FVIFAi, n.

FVIFA6%, n =
In order to compute the number of annual deposits to be made, look at the 6percent
column in the future value of an annuity table and read down until a table value equals,
or exceeds the computed value of 5.5. The compute value falls between 4.375 and 5.637
which correspond to 4 and 5 periods respectively. The correct answer is 5.637 or five
periods (n=5) not 4.375 which corresponds to the value of only 4 payments whose future
value fall behind 5,500 Birr.

A Portion of the \Future Value of an Annuity Table

Periods (n) 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000
2 2.060 2/070 2.080 2.090 2.100
3 3.184 3.215 3.246 3.278 3.310
4 4.375* 4.440 4.506 4.573 4.641
5 5.637 +
5.751 5.866 5.985 6.105
5 4.375 is the future value interest factors for four payments of an annuity at 6
percent interest rate.
+ 5.637 is the future value interest factor of five payments of an annuity at 6 percent
interest rate.

Present (Discounted) value of an Annuity:

Suppose that you are offered two alternatives: (1) a three-annuity with payment of 100
Birr at the end of each year over the coming three years, or (2) a :ump-sum payment
today. You have no need for the money during the next three years, so if you accept the
annuity, you would simply deposit the payments in the saving account at Dashen Bank
that pays 5 percent interest rate compounded yearly. Similarly the Lump-Sum payment
would be deposited in the same account as you don't have other option. How large
should the Lump-sum payment today in order for it be equivalent to the annuity?
To answer this question, let us start-up with the aid of the time line.
0 1 2 3
100 100 100

95.24
90.70
86.38
PVS3=272.32

The present value of the series of payments of 100 Birr for three years annuity, PVA 3 is
272.32 Birr as shown with the help of the time line.

The same problem can be expressed by using mathematical equation. The general
mathematical equation that can be used to find the present value of an ordinary annuity is
shown below:

47
 PVAn = (PMT)
Since PMT is common for all terms, the above equation can be re-written as:

PVAn = (PMT)
Again the equation can be rewritten as:

PVAn = (PMT)
The summation term in this equation is called the present value interest factor for an

annuity (PVIFA) and it equivalent to: or

Hence, the above equation can be stated as:

PVAn = (PMT) (PVIFAi,n) , or
By using this mathematical equation, the present value of an annuity of the problem
under consideration can be computed as follows. You are given an annuity payment,
PMT of 100 Birr, interest rate, I of percent compounded yearly and an annuity period, n
of three years. Substituting these values into the above equation, you get the present
value of an annuity of 272.32 Birr, which was the same as the amount computed by
summing the individual discounted valued on the time.

PVA3 = (100)
= (100) (2.7232)
= 272.32 Birr

Tabular Solution

The term = in the general equation of present value of an

annuity which is the present value interest factor for an annuity (PVIFA) is used to
construct the present value of an annuity table. The present value table of an annuity is
the tabulation of the present value interest factors for an annuity of different
combinations of I and n arranged I an order beginning with -=1% and n=1 period.
Hence, the present value of an annuity equation as stated already, can be re-written in a
way it is suitable for using table values.

PVAn = (PMT) (PVIFAi,n) where PV|IFAi,n is the present value interest factor for an
annuity for a given interest rate (i) and for a given number of years (n). To find an answer
to the three-year, 100 Birr annuity problem under condiseration, simply refer to a present
value of an annuity table, which is partly shown below, and look the 5 percent column

48
down to the third period. The PVIFA5%,3 is 2.7232, yielding the present value of 272.32
Birr for the three annuity payments of 100 Birr at the end of each year.
PVA3 = (100) (PVIFA5%,3) = (100) (2.72.32) = 272.32 Birr

A portion of present value of an Annuity Table

Period (n) 5% 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.7232* 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
* The present value interest factor for an annuity when interest rate is 5 percent
for three payments is 2.7232.

Uneven, or Un equal Cash flows:

By definition an annuity includes the words 'constant amount' , which is to underscore
that an annuity involves payments, or receipts that equal in every period, or at the end of
every over the life of the annuity. Although many financial decisions do involve
annuities, some important decisions involve unequal or non-constant payments, or
receipts, or cash flows. For example, common stock as you know, pay fluctuating level
of dividends overtime, and fixed assets investments such as machinery do not generate
constant cash flows over their lives as they depreciate. As a result, it is very necessary to
extend the time value of money analysis to include unequal payments, or receipts, or cash
flows. Throughout this chapter, we have used the term payment (PMT) for the annuity
situation (i.e when the cash flows are uniform) and we have to use cash flow (CF) to do
note unequal, or non-constant cash flows.

Present Value of Unequal Cash flows

Unequal cash flows are the same as that of the combination of many single cash flows
(payments). Hence, the present value, PV of unequal cash flows is found as the sum of
the present values, PV5 of the individual payments, or cash flows. For example, suppose
you are required to find the present value, PV of the following cash flow stream,
discounted at 6 percent as shown with the help of the time line.
0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000

How, the can find the present value, PV of individual cash flows by using the present
value equation for single payment, and sum these values to find the present value of the
entire cash flow stream. Here is what it looks like:

0 6% 1 2 3 4 5 7
100 200 200 200 200 0 1000

PV1 : 94.34 discounted

PV2 : 178.00 discounted

49
PV3: 167.92 discounted
PV4:158.42 discounted
PV5: 149.46 discounted
PV6: 0 discounted
PV7: 665.10 discounted
PV1 1,413.34
The individual present values, as well as, the present value for the entire cash flow stream
can be computed by using this general mathematical equation:

PV = CF1 (
Where:
CF1 = the cash flow, or payment, or receipt at the end of year or period one.
CF2 = the cash flow, or payment, or receipt at the end of year, or period two.
CFn = the cash flow, or payment, or receipt at the end of year, or period n, and.

CF1 the value of the cash flow at the end of year one converted to the
equivalent
value at the end of year zero (i.e PV of cash flow at the end of year one).

Each one of the above present values was found by suing the respective individual
present value equation. For instance, the present value of year one's cash flow was found
by the present value equation of cash flow at the end of year one (i.e. CF 1

Birr and the present value, PV

of the cash flow at the end of year two is (CF 2) = (200)

(00.8900) = 178 Birr, and so on.

The present values of the cash flow stream over the 7 years can always be found by
adding the present values of individual cash flows as indicated above. However, the
pattern of the cash flow within the stream may allow you to use short-cut method. For
example, the cash flows during year two through year five are in an annuity form because
the cash flows during these years are uniform, you can use these fact and solve the same
problem in a slightly different manner but a bit simpler. That is:

0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000
94.34

50
c693.00

658.80
0.00
665.10
1413.24

The cash flows during year two through year five, as it was mentioned, represent the
pattern of annuity. The present value of annuity, PVA of the cash flows at the end of
year one (i.e. one year before the first annuity payment at the end of year two) by using
the mathematic equation for the present value of an annuity that was already discussed.
To remind you, how to find the present value of these cash flows at the end of year one, it
is shown below:
PVAn = (PMT) (PVIFAi,n)
PVA4 = (200) (PVIFA6%,4)
PVA4 = (200) (3.465), here 3.465 is the present value interest factor
corresponding to 6 percent interest rate and four payments or cash flows. Finalizing the
above computation, you arrive at:
PVA4 = (200) (3.465) = 693.00 Birr

After determining the present value of the four annuity payments, or cash flows of 200
Birr each at the end of year one, you have to determine the present value of 693.00 Birr at
the end of year zero by using the mathematical equation for present value computation
for single payment, future value. That is

PV = (FV) . In this case, the future value is the 693.00 Birr which is
the present value of the four annuity payments during year two through year five at the
end of year one, the annual interest (discount) rate is 6 percent, and the period is only one
year (n = 1) Therefore,

PV = (693)
= 653.80 Birr as it was indicated on the time-line before.

Future value of unequal, or Uneven cash flow stream:

The future value of unequal cash flows, or payments, or receipts, sometimes called the
terminal values) is found by compounding each individual payment to the end of the
payment period, or end of cash flow stream. Then the individual compounded values
(future values) are added, to obtain the overall compounded value of the entire cash flows
in the stream. The following general compounding formula can be used to determine
both the individual compounded values and the compounded or future value of the entire
cash flow stream.

51
 FVn = CF1 (1+i)n-i + CF2 (1+i)n-2 +……+ CFn (1+i)n-n
Where,
1 CF1 (1+i)n-1is the future value of the cash flow at the end of the first year at the end of
the nth year.
2CF2 (1+i)2 is the compound amount of the cash flow at end of the second year at the
end of the nth year, an CFn (1+i)n-n is the compound amount of the cash flow at the
end of nth year at the end of the same year, which is the same. CFn = CFn (1+i)n-n

52