CONTINUATION ………… AGEC 242 : AGRICULTURAL FINANCE

REQUIRED RATE OF RETURN

The time of preference for money is generally expressed by an interest rate.The rate will
be positive even in the absence of any risk. It may be called the risk-free rate, for
example, (100 today @5% will be 105 a year later) ,would Do you take 100 today or 105
in future. In reality investors will be exposed to some degree of risk. Hence he would
require a rate of return called risk premium which compensates them from both time
and risk. Hence the required rate of return will be calculated as :

required rate of return=risk free rate [time]+ risk premium[risk]

Required rate of return may also be called (opportunity cost of capital) . The interest
rate account for the term value of money irrespective of an individual preferences and
attitudes .

EXAMPLE (illustration)

Assume a firm with a required interest rate of 10%, if its offered kshs 115.5 one year
from now in exchange for kshs 100 which she would give up today, should they accept
it or not? YES , because its greater than,110 of 100 which she is required to sacrifice
today. Between what amount today and 115.5 kshs 1 year from now would our investor
be indifferent? What amount is equal to 115.5% at 110%,

if 110%=115.5

then it follows that . [115.5*100] /110=105 kshs

She would accept the offer.

Hence there are two common methods of adjusting cash flows for time value of money
[A] -Compounding- The
process of calculating future values [fv] of cash flows [b]-Discounting-
process of calculating present value[Pv] of cash flows

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FUTURE VALUE

Compound interest in the interest that is received on the original amount (principal ) as well as on any
interest earned but not withdrawn during earlier periods compounding in the process of funding the
future values of cash flows by applying the concept of compound interest .

FUTURE VALUE OF A
SINGLE CASH FLOW

Suppose your father gave you kshs 100 on your 10 th birthday. You deposited these in a bank at 10% rate
of interest for one year.

HOW much will you receive in one year?

10%*100=100+10=110
future
sum=Principal+Interest
=100+(0.1*100)=110

WHAT ABOUT TWO YEARS

f.s=[100+(0.1*100)+0.1(100+(0.1*100) =121
You can calculate any
future sum for any number of years .THEREFORE if i=Interest rate per
period
n=number of periods
f=future value

p=present value invested

Then F1=p+p*i=p(1+i)

At beginning of second year .F1=p(1+i)

Then F2=F1+F1i=F1(1+i)

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 HENCE F2=p(1+i)(1+i)=p(1+i)2
hence for (n) period it
will be Fn=p(1+i)n
The term (1+i)n is the
Compound Value Factor (CVF) of a lump kshs (1) and it always has a value greater than 1 for positive
interest rate (i) indicating that CVF increases as i and n increase.Therefore to compute the future value
of a lump sum amount, simply multiply its amount by CVF for (i) and n terms period that is F n=p*CVFn,i

EXAMPLE

If you deposited kshs 55,650 in a bank which was paying a 15% interest rate on a 10 years time deposit.
How much would the deposit grow at the end of ten years

FV=55650*4.046=225,159.90

Future value of annuity

Annuity - is a fixed
payment (receipts) each year for a specified number of years.eg if you rent a flat and promise to make
a series of payment over an agreed period you have created an annuity.

Computation of the compound value of an annuity

EXAMPLE

Suppose a constant sum of kshs 1 deposited in a saving account at the end of each year for four years at
6% interest .It implies that 1 shs deposited at end of first year will grow for 3 years ,1 st at end of 2nd year
for 2 years ;1 shs at end of 3rd year for I year and 1 at end of 4th year will not yield any interest
y1_3yrs-1*1.063=1.191
y2_2yrs_1*1.062=1.124

Y3_1_1*1.061=1.06
Y4-0_1*1.06 = 1

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 sum all
years=4.375
hence n periods
Fn=A{(1+i)n-1}/I this
represents the compound value factor for annuity(kshs1)

Sinking fund-This is a fund which is created out of a fixed payment each period to accumulate
to a future sum after a specified period

For example companies generally create sinking funds to retire bonds (debentures) on maturity. Factor
used to calculate the annuity for a given future sum is called the sinking funds factor ( SFF) and it ranges
from 0 to 1 . it equals to the reciprocal of the CVFA from the above example reciprocal of CVFA OF
4.3746 IS = 1 /4.3746 = 0.2286

Hence 21,875 8*0.2286 = 5000 kshs

So , A =Fn * 1/CFVA

A=Fn *SFFn,i

A=Fn[ i/(1+i)n -1]

Sinking fund factor is useful in determining the annual amount to be put in a fund to repay bonds at or
debentures at the end by a specific period.

PRESENT VALUE
Present value of a future cash flow (inflow or outflow) is the amount of current cash that
is of equivalent value to the decision maker. Discounting in the process of determining present value of
a series of future cash flows.

Present Value of a Single Cash Flow

(Illustration)

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How much would an investor give up now to get an amount of kshs 1at the end of one year.Assuming a
10% interest rate, we know that an amount sacrified in the beginning of the year will grow to 110
percent .

Therefore the amount to be sacrificed today would be 1/1.10 which is kshs 0.909
EXAMPLE: At 10% rate
kshs to be received after one year is 110% of 0.909 sacrificed now..If after 2 years then it will be
1/(1.102)=0.826
HENCE

IF i=interest rate

n=time period

,f=future value of cash flows

So the present value(P) will be

P=f1/(1+i)1
The general
formula of present value of a lump sum to be received after some future periods is :

P=Fn/(1+i)n=Fn{(1+i)-n}
p=Fn{1/(1+i)n} discounted factor or present value factor and it less than one
for positive I indicating
that a factor amount has a smaller present value so the
pv=Fn*pvfni
EXAMPLE
What is the present
Value of kshs 50000 to be received after 15 years at 9% interest rate.

Pv =50,000*Pvf 15, 0.09 =50,000 * 0.275 =13,750

NB; The present Value decline for a given interest rate as time period increases.

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PRESENT VALUE OF ANNUITY
illustration
The
total present value of an annuity of 1kshs for four years is kshs 3.169 as follows p=1/(1.10) +
1/(1.10)2+ 1/(1.1)3 + 1/(1.1)3=3.169

= 0.909 + 0.826 + 0.751 + 0.683 = 3.169

Hence the computation of present value of annuity can be written in the following general form.

P= A/ (1+i) + A/ (1+i)2 + A /(1+i)3……………..A/(1+i)n

= A [ 1/(1+i) + A/ (1+i)2 + 1/ (1+i)3 …………….,1/(1+i)n

P= A [ 1/i - 1/ i(1+i)n] …….present value factor of an annuity of 1ksh (PVFA0 and it is the sum of single
payment present value factor.

Example : Suppose that a person receives an annuity of kshs 5000 for 4 years . if the rate of interest is
10%

Then Pv = 5000 [ 1/0.10 – 1/0.10 ( 1.10)4 ]

=5000 *(10-6.830) = 5000 83.170 = 15,850

Pv =annuity * PVFAn,i

Pv =5000 *PVFA 4,0.10 =5000* 3.170

CAPITAL RECOVERY AND LOAN AMORTIZATION

Assume you made an
investment today for a given period of time at a specified rate of interest (what will be the annual
income)
capital recovery in the annuity of an investment made today for a specified period of
time at a given rate of interest
The reciprocal of the
present value annuity factor is called capital recovery factor (CRF) If P=A*PVFAn,i

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Then A=P[1/PVFAn,i]…….. this is the capital recovery factor (CRF)

EXAMPLE:

Suppose you want to invest 10,000 today for a period of four years .if your interest rate is 10%.How
much income per year should you receive to recover your investment if
A=P{1/[(1/i)-1/(i(1+in)} =[A =1000[1/1/0.1-1/0.1(1.1)4]

=10,000[1/3.170] =10,000*0.3155 = 3,155KSH

NB: Capital recovery factor leaps in the preparation of a loan repayment schedule.

PRESENT VALUE OF PERPETUITY

Perpetuity _ This is annuity that occurs indefinitely. Example: A case of inredeemable preference case
ie : preference shares without a maturity. In this case time period is n and n is infinity.

Hence present value of perpetuity =perpetuity / interest rate

P=A/i

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Example suppose an investor expect Ksh 500 annually from his investment. What in the present value of
his perpetuity if interest rate is 10%

P=A/i

P=500/0.10= 5,000

PRESENT VALUE OF AN UNEVEN CASHFLOW

Illustration :

consider that an investor has an opportunity of receiving ksh 1000 , 1500,800, 1100 and 400
respectively at the end of year 1 to year 5. If the interest is 8% what in the present value.

P=1000/(1.08)+ 1500/(1.08)2 +800/(1.08)3 +1100/(1.08)4 +400/(1.08)5

Pv= 1000PvF1.08 + 150PvF2.008 + etc

Hence the general formular is:

P= ∑nt=1 At/(1+i)t

NET PRESENT VALUE (NPV)

Wealth is define as net present value. Net present value of a financial decision is the difference between
the present value of cash inflows and the present value of cash outflows.

Example: suppose you have 200,000 ksh you want to invest the money in land which can fetch 245,000
after 1 year. When you sell it. You should undertake this investment. If the present value of expected

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ksh 245000 after a year is greater than the investment outlay of ksh 200,000 today. If the opportunity
cost (interest rate is 15%) what is the present value of 245000.

Pv =245000*(PvFI,0.15)

=245000*0.870=213,150

NPV= 213150-200000= 13,150

General formular =NPV =[c1/(1+k) +c2/(1+k)2]-C

NPV =∑nt=1ct/(1+k)t-c

PRESENT VALUE AND RATE OF RETURN

A bond that pays some specified amount in future ( without periodic interest ) in exchange for the
current price today is called a zero interest bond. You may be interested to know what rate of interest is
being offered. Hence you can use the concept of present value to find out the rate of return or yield of
these offers. Eg: a bond offers you to deposit ksh 100 and promise to pay 112 ksh after one year. What
rate of interest would you earn?

100*(1+i)=112

100= 112/(1+i)

(1+i) =112/100

i =112/100 -1=0.12 or 12%

 Example 2:what about 1000 today for 1762 for now

1000=1762/(1+i)5=1762(pvf5i)

pvf5i=1000/1762=0.576=12%
The rate of return of an
investment is called internal rate of return or yield since it depends exclusively on the cash flows
of investment.
VALUATION OF BONDS

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 AND SHARES
FEATURES OF A BOND

 a bond is long term debt instrument or security

 bonds is issued by the government don’t have any risk
 A bond with maturity is payable after specified period

MAIN FEATURES OF A BOND OR DEBERTIRES ARE

A>face value-per value
issued at a per value
B<interest value-its fixed
and unknown
C>Maturity-its issued for a specified period of time
D>Redemption value-its
in the value that a bondholds will get on maturity E>market
value-may be traded in the stock exchange.Its the price at which it is currently sold and bought
BONDS
VALUES AND YIELDS
the expected cashflows
consist of annual interest payments plus repayment of principal.The discounted rate would depend the
risk of the bond.
BONDS CATEGORY

1.Bonds with maturity

2.perpertual bonds

3.pure discounts bond

BONDS WITH MATURITY

The present value of a bond (debenture) is the discount value of its cash flows. Its
annual interest payments plus bonds terminal.
By company its present

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value of a bond with its current market value it can be determined whether the bond is overvalued or
undervalued.

EXAMPLE
suppose Mutwiri want to purchase a 5 year bond kshs 1000 per value bearing a normal
rate of interest of 7% per annum.The investors required rate of return is 8%.what should he be willing to
pay now to purchase the bond if it matures at per?
Bond value=present
value of interest+present value maturity

YIELD TO MATURITY
suppose the market price
of a bond in kshs 883.4(face value kshs 1000).The bond will pay interest at 6% per annum for
5years ,after which it will be redeemed at.what bonds rate of return .

The (YTM) is the measure of a bonds rate of return that considers by the interest income and any
capital gain or loss.YTM is the IRR.

883.4=60/(1+YTM)+60/(1+YTM)2+60/(1+YTM)3+60/(1+YTM)4+60+1000/(1+YTM)5

Obtain by trial and error

Perpertuals bonds yield to maturity

=interest income/Bonds price

EG.Kshs 1000 per value perpertual bond is 8% and its price is 800 it YTM

=interest/bond=80/800=0.10% or 10

READ ABOUT CURRENT YIELD

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RISK AND RETURN

Return on a single asset

ILLUSTRATION 1) Suppose you bought 100 shares of a company at the beginning of a year at a market
price of kshs 225.The per value of each share is kshs 10 ,then the total investment is 225*100=22500
kshs .Suppose further that the company paid dividend at 25%,as the dividend rate applies to the par
value of a share your dividend per share would be kshs 25/100*10=2.5kshs per share.

DIVIDEND=Dividends per share *No of shares

=2.50*100=kshs 250

Further suppose that the price of the share at the end of the year turns out to be kshs 267.50.Then since
the ending share price increased you have made a capital gain:

Hence capital gain or loss=(SELLING PRICE-BUYING PRICE)*number of shares

=(267.50-225)*100=4250

Therefore the total returns is

Total return=Dividend+capital gain

TR=250+4250=4500

If you sold your shares at the end of the year your cash flows would be the dividends income plus the
proceeds from the sale of the shares.

Cash flow at the end of the year

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=Dividends+value of the sold shares

=250+(267.50*100)=27000

This amount equals to the initial investments of kshs 22500 plus the total return of kshs 4500

=22500+4500=27000

Percentage returns:It is more common and convenient to express returns in percentage terms.

From the example above a total of return of kshs 4500on an investment of kshs 22500 was
earned.Hence it can be expressed as follows

Return in percentage=kshs 4500/22500=0.2 or 20%

The rate of return or a share consists of the dividend yield and the capital gain yield.Hence the rate of
return of a share held for one year is as follows

>Rate of return=Dividend yield+capital gain yield

R1=D1V1/p0+P1-P0/P0=D1V1+(P1-P0)/PO

Where R1 IS RATE OF RETURN IN YEAR 1

D1V1 IS dividend per share in year 1

P0 is the price of share in the beginning of the year

P1 in the price of the shares at end of the year

AVEREGE RATE OF RETURN

Given the yearly(annual ) returns,one can calculate average or mean return.The average rate of return
in the sum of the various one period rates of return divided by the number of periods

IE R=1/n(R1+R2+…..Rn)=1/n∑nt=1Rt

Where R is the average rate of return,Rt the observed or realized rates of return in periods 1,2……t and
in the number of periods.

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RISKS OF RATES OF RETURN

Variance and standard deviation

Risk of returns are viewed as the variability in rates of return.The variabilityof rates of return may be
defined as the extent of the deviation of individual rates of return from the average rate of return.There
are two measures of dispersion (i)VARIANCE and (ii) standard deviation

The following steps are involved in calculating variance and standard deviation of rate of return of assets
using historical returns

(i)calculate the average rate of return

ꜙR=1/n∑nRt

(ii)calculate the deviation of individual rates of return from the average rate of return from the average
rate of return and square it ie (R-ꜙR)2

(iii)calculate the sum of the squares of the deviations as determined in the preceeding step (ii)and divide
it by the number of periods less one to obtain variance

Ie=Ờ2=1/n-1∑nt=1(Rt-ꜙR)2

NB)In the case of sample of observation we divide the sum of squares of the deviations by n-1 to
account for the degree of freedom.If you were using using population data then the divider will be n

(iv)calculate the square root of the variance to determine the standard deviation ie

Standard deviation=√(variance)

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 Year Rate of return
1992 149.7
1993 70.54
1994 16.52
1995 22.71
1996 49.52
1997 92.33
1998 36.13
1999 52.64
2000 7.29
2001 12.95
Average rate of return 51.03 add the rates of return divide by the total years

Variance=1/10-1{(149.7-51.03)2+(49.52-51.03)2+(92.33-51.03)2+all the other years

=1/9(1740.18)=1933.8

Standard deviation =√1933.8=43.97%

This means that the annual rates of return of the shares show a high degree of variability the deviateon
average by about 44% from the average rate of return of 51.03%

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EXPECTED RATE OF RETURN

The expected rate of return [E(R)] in the sum of the product of each outcome (return) and its
associated probability.

ie Expected rate of return =rate of return under scenario 1 * probability scenario 1 + rate of return
under scenario 2 * probability if scenario 2 + rate of return under scenario n * probability scenario n ie
ER = R1 * P1 + R2 *P2 + R…….+ Rn *Pn = E(R) = ∑nt=1Ripi

ECONOMIC CONDITION RATE OF RETURN PROBABILITY EXPECTED RATE OF

RETURN
GROWTH 18.5 0.25 4.63
EXPANSION 10.5 0.25 2.62
STAGNATION 1.0 0.25 0.25
DECLINE -0.6 0.25 -1.5
So E(R)=(18.5*0.25)+(10.5*0.25)+(1.0*0.25)+(-6.0*0.25)=0.06 or 6%

NB>The expected rate of return in the average return.

The variance and standard deviation

=∑ni=1{Rn-E(R)}2Pn

CONCLUSION:In these case the returns are expected to fluactuate widely.The expected rate of return
low 6% and the std in high.investors would like to search for an investment with higher expected return
and lower std

EXERCISE:

The shares of hypothetical company limited has the following anticipated returns with associated
probabilities

RETURNS% PROBABILITIES

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 -20 0.05
-10 0.10
10 0.20
15 0.25
20 0.25
25 0.15
Calculate the expected returns ,variance and standard deviation.(8mks)

VALUATION OF SHARES

A company may issue two types of shares

1.Ordinary shares

2.Preference shares>may be issued with or without a maturity period .Redeemable preference shares
and shares with maturity (irredeemable) without dividends are fixed (cumulative or non cumulative
preference shares)

Cumulative preference shares unpaid dividends accumulate and are payable in future

FEATURES OF PREFERENCE AND ORDINARY SHARES

1.claims>preference shares holders have a claim on assets and incomes prior to ordinary
shareholders.Equity (ordinary)shareholders have a residual claim on a companys incomes and assets.

2.Dividend>preferences>fixed rate……Ordinary>rate in not known

3.Redemption>redeemable preference shares have a maturity date

4.conversion>convertible preference shares (after a certain date can be converted to ordinary shares

Value of preference share

EXAMPLE:suppose an investor is considering the purchase of a 12 year 10% kshs 100 par value
preference share.The redemption value of the preference share on maturity is kshs 120.The investor
required rate of return is 10.5%.What should you be willing to pay for the shares now?

Hence the investor would expect kshs 10 as preference dividend each year for 12 years and 110 on
maturity (ie end of 12 years)

Po=10{1/0.105-1/0.05*(1.05)2}+120/(1.105)2=101.30

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Hence value of preference share =pv of dividends+pv of maturity value

Po=∑nt=1PD1V1/(1+KP)t+Pn/(1+KP)t

Po=PD1V{1/kp-1/KP(1+KP)n}+Pn/(1+Kp)n

Valuation of irredeemable preference shares

Consider a company which issued kshs 100 irredeemable preference share on which it pays a dividend
kshs 9 supposing it currently yielding a dividend of 11%.what is the value of the preference shares

HENCE p0=PD1V/KP=9/0.11=81.82

VALUATION OF ORDINARY SHARES

Its more difficult than valuation of preference shares because,rate of dividends is not known

Earnings and dividends are expected to grow

Dividend capitalization>The value of a share today depends on cash inflows expected by investors and
the risk associated with those of cash inflows.Cash inflows expected from an equity share consists of
dividends that the owner expects to receive while holding the share and the price ,which he expected to
obtain when the share is sold.

NB/price will include the original investment plus a capital gain

Generally the expected cash inflows consists of only of future dividends and therefore the value of an
ordinary share in determined by capitalization the future dividend stream at the opportunity cost of
capital.

Hence the value of a share ib the present value of its future stream of dividends

SINGLE PERIOD VALUATION

Suppose an investor want to buy a shares and will hold it for 1 year.He expects it to pay a dividend of
kshs 2next year and will sell the share at an expected price of kshs 21 at the end of the year and the rate
of return Ke is 15%.how much would he pay for the share today.

P0=D1V1+P1/1+KE

=2+21/1.15=20

NB>An under valued share has a market price less than the shares present value

An over valued share has a market price higher than the shares present value

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After an year it has a growth of

G=(p1+po)/p0=21-20/20=0.05 or 5%

Hence of share price is expected to grow at g% then P1=P0(1+g)

P0=D1V1+P0(1+g)/1+Ke

P0(1+Ke))=D1V1+P+0(1+g)

P0+P0Ke=D1V1+PO+POg

Final deriviation=D1V1/(KE-g)

For example above them if expected growth is 5%

P0=D1V/(Ke-g)=2/(0.15-0.05)=20

MULTIPLE PERIOD VALUATION

Suppose D1v2=2.10kshs p2=22.05

Then p1=2.10+22.05/1.15=21

P0=2/1.15+2.1+22.05/(1.15)2=20

Hence P1=D1V2+p2/(1+Ke)

P0=1/(1+Ke)*(D1V1+P1)

THEN P0=1/Ke{D1V1+D1V2+P2/(1+KE)}

Generally>>>>P0=∑nt=1D1V1/(1+Ke)t+Pn/(1+Ke)n

NB>in principle the time horizon could be very large infact it can be assumed to approach infinity if the
time horizon approached to infinity then the present value of the future price will approach zero.

Thus the share price of a share today is the present value of an infinite stream of dividends

P=∑nt=1D1Vt/(1+ke)t

READ ABOUT (GROWTH IN DIVIDENDS)

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 CAPITAL BUDGETING DECISIONS
INTRODUCTION>>>An efficient allocation of capital in the most important finance function in the
modern times.It involves decision to commit the firms fund to long term assit.

NATURE OF INVESTMENT DECISIONS

The investment decision of a firm are generally known the capital budgeting or capital expenditure
decisions.

A capital budgeting decision may be defined as the firms decisions to invest its current funds most
effectively in the long term assets in anticipation of an expected flow of benefits over a series of
years .The long term assets are those that affects the firms operations beyond the one year period.

The firms investment decisions would generally include expansion,acquisition,modernization and

replacement of the long term assets sale of a division or business also an investment decision sales
distribution and development programme have a long term implications for the firm expenditures and
benefit and therefore hence should be evaluated as investment decisions

The following are features of investment decisions

>The exchange of current funds for future benefits

>The funds are invested in long term assets

>The future benefits will occur to the firm over a series of years

NB.It is the cash flow which is important not the accounting profit

.Investment decisions affect the firms value

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.An investment will add to the shareholders wealth if it yields benefit in excess of the minimum benefits
as per the opportunity cost of capital

IMPORTANCE OF INVESTMENT DECISIONS

They influence the firms growth in the long run

They affect the risk of the firm

They involve commitment of large amount of funds

They are irreversible

They are among the most difficult decision to make

TYPES OF INVESTMENT DECISIONS

(i)Expansion and diversification>A company may add capacity to its existing product lines to expand
operations

(i)Replacement and modernization>The main objective of modernization and replacement is to improve

operatimg efficiency and reduce cost .cost saving will reflect in the increased profit but the firms
revenue may remain unchanged .Assets become outdated and absolute with technological changes
hence need to be replaced.Replacement decisions help to introduce more for efficient and economical
assets and therefore are called cost-reduction investments.

Another useful way to classify investment is as follows

>mutually exclusive investments

>independent investment

>contigent investment

Mutually exclusive investments serve the same purpose and compete with each other.If one is taken the
other have to be excluded

Independent investment…..They serve different purposes and do not compete with each other

Contigent investment……They are dependent projects the choice of one investment necessitates
undertaking one or more other investments

INVESTMENT EVALUATION CRITERIA

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Three steps are involved

>Estimation of cash flows

>Estimation of the required rate of return

>Application of a decision rule for making the choice

INVESTMENT DECISION RULE

It may be reffered to as capital budgeting techinique.Asound appraisal technique should be used to

measure the economic worth of an investment project.The following other characteristics should also be
possessed by sound investment evaluation criterion

>should consider all cash flows to determine the true profitability of the project

>should provide for an objective way of separating good projects from bad projects

>should help ranking of projects according to their true profitability

>should help to choose among mutually exclusive projects that project which maximizes the
shareholders wealth

>it should be criterion which is applicable to any conveivable investments project independent of
others.

EVALUATION CRETIRIA

Capital budgeting techniques may be grouped into

1.Discounted cash flows

>net present value

>internal rate of return

>profitability index

2.Non discounted cash flows criteria

>pay back period

>discounted payback

>accounting rate of return

NPV:ILLUSTRATION

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Assume that project x costs kshs 2500 now and in expected to generate year cash flows of kshs
900,800,700,600 and 500 in years 1 through 5.ASSUME a cost of capital of 10%

Then the NPV

NPV={900/1.1+800/(1.1)2+700/(1.1)3+600/(1.1)4+500/(1.1)5}-2500

NPV=225kshs

Project x adds wealth of owners

Hence its accepted

General formula

NPV=∑nt=1ct/(1+k)t-cf

ACCEPTANCE RULE

If the NPV is positive

Reject NPV if negative

NPV IF ZERO maybe accepted means that the project generates cash flows at a rate just equal to the
opportunity cost of capital

In mutually exclusive project the one with the higher NPV should be selected

Projects should be ranked in order of NPV

Read about why NPV IN TRUE MEASURE OF AN INVESTMENT PROFITABILITY AND ALSO THE
LIMITATIONS OF NPV

EXERCISE;suppose you have 2 projects A and B noth costing 50 kshs .Project A return kshs 100 after one
year and kshs 25 after two years . on the other hand project B returns kshs 30 after one year and kshs
100 after year 2.calculate the NPV AND RANK THE PROJECTS at discount rate of 50% and 10%

INTERNAL RATE OF RETURN

Also known as yield on an investment marginal efficiency of capital rate of return over cost ,time
adjusted rate ofinternal return.

A sample case(A one period project)

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Illustration:Assume that you have deposited kshs 10000 with a bank and you would get back 10800 after
one year

The rate of return would be

RR=(10800-10000)/10000=0.08 or 8%

If 10000(1.08)=10800

Then r=(c1-c0)/c0

And r=(c1/c0)-1

C1/C0=1+V

So C0=C1/(1+V)

Hence the rate of return depends on the projects cash flows rather than any outside factor.Therefore its
refered to as internal rate of return in the rate that equals the investment outlay with the present value
of cash flow received after one period.

Hence it the discounted rate which makes NPV=0

So if C0=∑nt=1ct/(1+r)t

In IRR the rate is not known.Hence you need to find the rate at which NPV=0

CALCULATING IRR BY TRIAL AND ERROR

1. select any discount rate to compute the PV of cash inflows

2.If the calculated PV of inflows is lower than the PV of cash outflows a lower rate should be tried

A higher value should be tried if the pv of inflows is higher than the present value of outflows

EXAMPLE

A project costs kshs 16000 and in expected to generate cash inflows of kshs 8000,7000 and 6000 at the
end of each years for 3 years.calculate the IRR.

Take 20% as your discounted rate.

NPV=-16000+8000(0.833)+7000(0.743)+6000(0.6410)=-1004

Select a lower rate (refer back)

Npv=-16000+8000(0.862)+7000(0.743)+6000(0.641)=-57

Still the rate is lower

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Say 15%which gives its NPV as 200

This indicates that the IRR should be between 15% to 16%

The IRR rate of return can hence be approximated by the method of linear interpolation as follows

DIFFERENCE
Pv required 16000 0
Pv at lower rate 15% 16200 200
Pv at higher rate 16% 15943 257

r=15%+(16%-15%)200/257=15.8%

IRR for an annuity is given by

PVFA=CO/A

NB/NPV declines as the discount rate increases and for discount rates higher than the projects IRR the
NPV will be negative.

ACCEPTANCE RULE

Accept the project if its IRR is higher than the opportunity cost of capital(r≥k)

NB/k is also known as the required rate of return

Reject if (r≥k)

Read importance of IRR and its limitations.

PROFITABILITY INDEX

It in the ratio of the present value of each cash inflows at the required rate of return to the initial cash
outflows of the investment.

PI=pv of cash inflows/initial cash outlay=PVC1/C0

=∑nt=1ct/(1+k)t-C0

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ACCEPTANCE RULE

The following are the PI acceptance rule

1.Accept the project when PI is greater than 1

2.Reject the project when PI is less than 1

3.May accept the project when PI is equal to one

PAYBACK

It in one of the most popular and widely recognized traditional methods of evaluating investment
proposals

It in the number of years required to recover the original cash outlay invested in a project

Payback=initial investment/annual cash inflow=c0/c

Illustration

Assume that a project require an outlay of kshs 50000 and yields annual cash of 12500 for 7 years.The
payback period for the project in

Pb=50000/12500=4 yrs

Unequal cash flows >In the case the unequal cash inflows the payback period can be found out by
adding up the cash flows unril the total is equal to the initial cash outlay.

ACCEPTANCE RULE

Investors compare the projects payback with predetermined standard payback.The project would be
accepted if its paybackperiod is less than the maximum payback period set by management .Ranking
done as followed highest ranking to the project with the shortest payback period

EVALUATION OF PAYBACK PERIOD

Payback in a popular investment creates in practice.It is considered to have certain virtuals

1 . simplicity>it is simple to understand and easy to calculate.This is evident from their heavy reliance on
it for appraising investment proposals

2.cost effective>it costs less than most of the sophisticated techniques that require a lot of the analysts
time

3.short term effects >A company can have more favourable run effects on earnings per share by setting
up a shorter standard payback period.However it may not be a wise longterm policy as the company
may have to sacrifice its future growth for correct earnings

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4.Risk shield>The risk of the project can be tackled by having a shorter standard payback period as it
may ensure guarantee against loss

5.Liquidity.The emphasis in payback is on the early recovery of the investment .Thus it gives an insight
into the liquidity of the project.the funds so released can be put to other uses.

Limitation

1.cashflow after payback

2.cash flows ignored

3.cash flow patterns

4.Administrative difficulties

5.Inconsistent with shareholders value

Read about the following

Accounting rate of return

FINANCIAL STATEMENT ANALYSIS

Financial analysis is the processof identifying the financial strengths and weakness of the firm by
perperty establishing relationship between the items of the balance sheet and the profit and loss
account

NATURE OF RATIO ANALYSIS

Rate analysis is a powerful tool of financial analysis

The ratio analysis involves comparision for a useful interpretation of the financial statements. The
standars of comparision may consist of

>past ratios

>competitors rates

>industry ratios

>projected ratios

TYPES OF RATES

>liquidity rates

>leverage ratios

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>Activity ratios

>profitability ratios

NB/leverage ratios show the proportions of debt and equity in financing the forms assets

NB/average inventory=opening stock +closing balance/2

MEASURESOF FINANCIAL LEVERAGE

The most commonly used measures of financial leverage are (ie)debt ratio-ratio of debt to total capital

1:D/(D+E)

=D/C

D in debt

E in equity(shareholders)

C in total capital(D+E)

E book of value

2.DEBT-Equity ratio =D/E

3.Interest coverage>The ratio of net operating income to interest charges ie EBIT/Interest

Read more on these

The 1st 2(debt tatio and debt equity ratio)are also measures of capital gearing.they are static in nature as
they show the borrowing position of the company at a point of time.

The coverage ratio indicates the capacity of the company to meet fixed financial charges.The reciprocal
of interest charge

NB/GEARING RATIO

It compares some form of owners equity to borrowed funds.Gearing is a measure of financial leverage
demonstrating the degree to which a firms activities are funded by owners funds versus creditors funds

Gearing%=long term liabialition/capital employed*100

NB /liabilities include loans more than one year.

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DEBT RATIO

Several debt ratios may be used to analyse the long term solvency of a form.The firm may be interested
in knowing the proportion of the interest bearing debt.hence the firm may compute debt ratio by
dividing TOTAL DEBT by capital employed or net assets.Total debt will include short and long term
borrowings from financial institution bond deffered payments arrangement gor buying capital
equipments bank borrowing public deposits and any other interest bearing loan

Capital employed will include total debt and net worth(NW)

DEBT RATIO=Total debt(total debt)/Total debt +net worth

=TOTAL DEBT/CAPITAL EMPLOYED

Note that capital employed (CE)equals net worth (NA)that consists of net fixed assets (NFA) and net
current assets

Net current assets are current assets minus current liabilities excluding interest bearing short term debt
for working capital.

NFA+CA=NW+TD+CL

NFA+CA-CL=NW+TD

NFA+NCA=NW+TD

NA=CE

Hence debt ratio=TOTAL DEBT/NET ASSETS

DEBT EQUITY RATIO

The relationship describing the lenders contribution for each shilling of the owners contribution in called
debt-equity ratio

Calculated as

Debt-equity rate=TOTAL DEBT/NET WORTH

COVERAGE RATIOS

Debt ratios described above are static in nature and fail to indicate the firms to meet interest
obligations.The interest coverage ratio or the times interest earned in used to the firms debt sewiang
capacity

It is calculated as follows

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Interestcoverage=EBIT/Interest

The interest coverage ratio shows the number of firms the interest charges are coved by funds that are
ordinary available for their payment.since taxes are computed after interest ,interest coverage is
calculated in relation to before tax earnings .funds equal to depreciation are also available to pay
interest changes.these are calculate the interest average ratio as earnings before interest taxes
depreciation and amortization(EBITDA)divided by interest.

Interest coverage=EBITDA/Interest

NB/A higher ratio is desirable but to high a ratio indicates that the firm is very conservative in using debt
and that it is not using credit to the best advantage of shareholders.

ACTIVITY RATIOS

These ratios are employed to evacute the efficiency with which the firm manages and utilizes its assets
these ratios are also called turnover ratios because they indicate the speed mlt which assets are being
converted or turned over intersales.hence activity ratios involve a relationship between sales and assets

They include

Inventory turn over>It indicates the efficiency of the firm in producing and selling its products calculated
as flows

Inventory turn over=cost of goods sold/Average inventory

Average inventory in the average of opening and closing balancesof inventory

DEBTORS (ACCOUNTS RECURABLE)TURNOVER

Financial analysts apply three ratios to judge the quality of liquidity of debtors

a)debtors turn over

b)collection period

c)aging schedule of debtors

debtors turnover=credit sales/Average debtors

it indicates the the number times debtors turn over.The higher the value of debtors turnover the more
efficient in the management of credit

it may also be calculated as

debtors turnover=sales/debtors

when information about credit sale and opening and closing.

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THE END

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