CHAPTER ONE

1.0 INTRODUCTION TO FINANCIAL MANAGEMENT

Financial Management connotes responsibility for obtaining and effectively utilizing the funds
necessary for the efficient operation of an enterprise. The finance function also centers around
the management of funds, raising and using them effectively. It therefore covers all functions
concerned in attempting to ensure that financial resources are obtained and used in the most
effective way in order to secure required attainment of the organizational objectives.
Chartered Institute of Management Accountant (CIMA), defines financial management as ‘ the
identification of the possible strategies capable of maximizing an organization’s resources and its
allocation effectively among the competing opportunities, and the implementation and
monitoring of the chosen strategy for achieving the stipulated goals and objectives’.
Summarily, Financial management is about planning and controlling the financial affairs of an
organization, to ensure that the organization achieves its objectives (its financial and non-
financial objectives) in an efficient and effective manners.
Financial Management involves the use of accounting knowledge, economic models,
mathematical models and rules , systems analysis and behavioral science for the specific purpose
of assisting management in its functions of financial planning and control. It’s therefore deduced
on the following related subjects to be mentioned as follows;
(a) Financial Accounting;- The extracted balance sheet in a given organization could be
regarded as a statement of the results of financial management that is “ a healthy balance sheet
indicates a skillful financial management” or vice-versa.
(b) Management Accounting;- This gives the preferred techniques of information generation
such as costs and profitability of projects, the projection of cash flows, the effectiveness of
departure from previous established plans.
(c) Law;- This involves the enabling laws that govern almost every activities financial
managers does in an organization. For example, payment of dividends is subject to restriction of
law; also, raising of funds by means of share issue needs compliance with the company law.
(d) Economics;- This on the other hands help financial managers to have knowledge of what
is happening within and outside the business world.
(e) Behavioural Science;- It enables managers at all levels to clearly understand the different
behavior of followings; investors, creditors, employees, shareholders, competitors and so on.
1.1 OBJECTIVES OF FINANCIAL MANAGEMENT
A corporate objective is a purpose or aim that a company is trying to achieve. Although there are
differing views about what corporate objectives should be, it is generally accepted that the main
purpose of a company should be to provide benefits for its owners, the shareholders, in the form
of a financial return on their investment.
It could therefore be categorized under two major forms;
(a). The Financial or Primary Objectives
(b). Non-Financial or Secondary Objectives.

(a). The Financial Objectives or Primary Objectives

A financial/Primary objective can be expressed in a number of different ways, and there are
advantages and weaknesses or limitations with each. Three commonly-used financial objectives
are to maximize:
i. Shareholder wealth;
ii. Profitability; and
iii. Growth in earnings per share.

(i) Maximizing shareholder wealth

The overall objective of a company might be stated as maximizing the wealth of its owners, the

shareholders. Shareholder wealth is increased by dividend payments and a higher share price.

Corporate strategies are therefore desirable if they result in higher dividends, a higher share

price, or both.

Quantified targets can be established for some financial objectives, such as a target of increasing

profits by at least 10% per year for the next ten years. It could also be informs of maximizing the

net present value (NPV) of a course of action. The net present value of a course of action is the

different between the gross present value of the benefits of the action and the amount of

investment required to achieve those benefits.

A financial action which has a positive action resulting in negative NPV should be rejected

because if accepted it would cause diminution in existing wealth.

(ii). Maximizing Profitability

A company might express its main financial objectives in terms of profit maximization, and
targets can be set for profit growth over a strategic planning period. If the underlying objective is
to maximize shareholder wealth, targets should be set for growth in profits after tax because
these are the profits that are distributable to the company’s owners.
Traditionally, the business has been considered as an economic institution which has to develop
a common and unique measurement of efficiency through profit. It is therefore the rational to
assume profit maximization as a natural business objectives
Profit growth objectives have the advantage of simplicity. When a company states that its aim is
to increase profits by 20% per year for the next three years, the intention is quite clear and easily
understood – by managers, investors and others.

(iii). Growth in earnings per share.

The most common measure of profit per share is earnings per share or EPS. A financial objective
might be to increase the earnings per share each year and possibly to grow EPS by a target
amount each year for the next few years. If there is growth in EPS, there will be more profits to
pay out in dividends per share, or there will be more retained profits to reinvest with the intention
of increasing earnings per share in the future. Growth in EPS should therefore result in growth in
shareholder wealth over the long term. However, there are some problems with using EPS
growth as a financial objective. It might be possible to increase EPS through borrowing and debt
capital. If a company needs more capital to expand its operations, it can raise the money by
borrowing. Tax relief is available on the interest charges, and this reduces the effective cost of
borrowing. Shareholders benefit from any growth in profits after interest, allowing for tax relief
on the interest, and EPS increases.
However, higher financial gearing (the ratio of debt capital to total capital) can expose
shareholders to greater financial risk. As a consequence of higher gearing, the share price might
fall even when EPS increases.

(b). Non-Financial or Secondary Objectives.

Another reasons for arguing that a company’s objective is not only to maximize the wealth of its
ordinary shareholders is that a company must have other important non-financial objectives
which acts as a limitation on its financial objectives. Therefore, the non-financial objectives to a
corporate organization shall include any of the followings;
i. To provide for the social and well- being of its employee’
ii. To cater for the welfare of management teams.
iii. To perform legally and ethically within the business environment.
iv. To contribute to the social and welfare of the society as a whole.
v To be socially responsible to the community and country at large.
vi. To provide goods and services at the highest quality to its customers.
vii. To make finance and career development a priority

1.2 SCOPES OF FINANCIAL MANAGEMENT DECISION

Generally, financial management’s scope covers four major decision areas which includes;
a. Investment decision
b. Financing decision
c. Dividend decision
d. Liquidity decision

INVESTMENT DECISION
This involves the identification of viable projects. i.e, it deals with the appraisal of projects using
various techniques to determine those that are viable. Choice of the most viable and profitable
projects involves picking the best and most profitable investment plan which one will invest in.
FINANCING DECISION
This involves the identification of those appropriate source(s) of finance that would be using to
finance the projects. Following factors are usually considered in financing decisions;
i. The cost associated with each source
ii. The characteristic of each source
iii. The risk level of the project to be considered
iv. The cash flow pattern for the project
v. The availability of each source of finance
vi. The effect of inflation and taxation on the cost acquired
vii. The real amount involved before the final selection is made.

DIVIDEND DECISION
The situation here warrants focusing attention on the compensation required by the providers of
funds. i.e, the determination of the appropriate amount to be paid as dividend and the profit that
would be ploughed back to finance expansion in the organization.

LIQUIDITY DECISION
Here, company must determine what provision of the fund ensuring to be kept in liquid form in
order to meet the day to day current obligations and current level of working capital it required.
Keeping basic fund in liquid leads to capital break down, it also leads to increase in operational
cost, and keeping little fund may lead to illiquidity,
Liquidity Ratio = Cost of Goods Sold
Average Stock

1.3 GOALS AND OBJECTIVES OF CORPORATE STRATEGY

Financial objectives, corporate objectives and corporate strategy
A corporate strategy is mainly concerned with the activities involving the decision made on
investment or business that an organization should pump its funds in, and setting targets for
achieving the overall company’s goals and objectives.
Corporate objective is a purpose or aim that a company is trying to achieve. Although there are
differing views about what corporate objectives should be, it is generally accepted that the main
purpose of a company should be to provide benefits for its owners, the shareholders, in the form
of a financial return on their investment.
The main corporate objective might therefore be expressed as a financial objective, such as
maximizing shareholder wealth or maximizing profits and maximizing growth in earning per
shares. Quantified targets can be established for some financial objectives, such as a target of
increasing profits by at least 10% per year for the next ten years.
Plans are formulated for the achievement of the corporate objective. In a large company, longer-
term plans are formulated as strategies, from which shorter- term plans are then prepared. Setting
the financial objective and financial targets for a company is therefore the initial stage in an
extensive process of strategy formulation and implementation. The process can be shown in a
simple diagram, as follows.

1.4 PRINCIPLES OF CORPORATE GOVERNANCE

The term Corporate governance has been defined in various ways; meaning “an internal system
encompassing the policies, and people, which serves the needs of shareholders and other
stakeholders, by directing and controlling management activities”, with good business savvy,
objectives and accountability.
In Nigeria, corporate governance regime is characterized by a combination of a statutory and
subsidiary legislation enacted by the relevant regulatory authorities.
The Organization for Economic Co-operation and Development, (OECD, 2004) identifies the
six main principles for corporate governance, thus as follows;

I. Ensuring the basis for an effective corporate governance framework

The corporate governance framework should promote transparent and efficient markets, be
consistent with the rule and clearly articulate the division of responsibilities among different
supervisory, regulatory and enforcement authorities.

II. The rights of shareholders and key ownership functions

The corporate governance framework should protect and facilitate the exercise of shareholder’s
rights. This principle is concerned with the basic rights of shareholders that should include the
right to transfer the ownership of their shares, the right to receive regular and relevant
information about the company.

III. The equitable treatment of shareholders

The corporate governance framework should ensure the equitable treatment of all shareholders,
including minority and foreign shareholders.

IV. The role of shareholders in corporate governance .

The corporate governance framework should recognize the rights of stakeholders that are
established by law, or through mutual agreements, which may include the employment rights and
agreement negotiated for employees with trade union representatives.

V. Disclosure and transparency

The corporate governance framework should ensure that timely and accurate disclosure is made
on all material matters regarding the company, including the financial situation, performance,
ownership and governance of the company.

VI. The responsibilities of the board

The corporate governance framework should ensure the strategic guidance of the company, the
effectiveness monitoring of management by the board and the board’s accountability to the
company and the shareholders.
 CHAPTER TWO
2.0 CAPITAL BUDGETING
Capital Budgeting can be described as the process of investment decision. It is explained as the
firm’s decision to invest its current funds most effectively in long term activities in anticipation
of an expected flow of future benefits over numbers of years.
It also involve making all investments in a long-term investment with the process of selecting
alternative long term investment opportunities by committing the company’s funds on a viable
and profitable projects.
The procedures involved in capital budgeting decision shall include the followings;
 Identification of possible projects or investment
 Evaluation of projects or investment
 Authorization of selected profitable projects
 Development of plans for selected projects
 Effective monitoring, control and supervision of projects
 Preparation of post audit for the projects.

CHARACTERISTICS OF CAPITAL BUDGETING

i. They relatively involve large amount of money/ huge funds
ii. The number of years involved is greater than one
iii. The benefits will accrue over a long period of time
iv. They involve irreversible decision
v. They are attract high risks

CONSIDERABLE FACTORS FOR CAPITAL BUDGETING

a. It involve the existence of huge expenditure.
b. It also involve the gestation period between the initial expenditure and returns.
c. The expectation of higher returns.
2.1 MATHEMATICS OF FINANCE
A Naira expected sometimes in the future is not equivalent to a Naira held today, simply because
of the time value of money. We can invest the Naira today to earn interest so that it will increase
in value to more than one Naira in the future.
Consequently, we would rather receive a Naira now than receive the same amount in the future,
even if we are certain of receiving it later. Therefore, the mathematical simplicity serves as
means of bringing out the relationship between certain basic things such as simple interest,
compound interest, annuity, sinking funds, amortization and calculations as such, their impact or
effect on Financial Management.

2.1.1 SIMPLE INTEREST CALCULATION

Simple interest;- When a person opens a savings account with a bank and deposits money into
that account the bank will pay the person money for saving with them. Similarly, if a person
borrows money from a bank the bank will expect that person to repay more than they borrowed.
Money is not free to borrow. When a person or entity borrows money the lender will charge
interest.
Therefore, Interest is the extra amount an investor receives after investing a certain sum, at a
certain rate for a certain time. Or Interest is the additional amount of money paid by the borrower
to the lender for the use of money loaned to him. The total interest associated with a loan is the
difference between the total repayments and the amount borrowed.
S.I = P x R x T Where;
S I is the interest amount
P is the principal sum
R is the rate of interest
T is the time period ( month/ year)
A question will specify whether interest is simple or compound. The two types of interest refer to
how interest is calculated (not how it is paid or received).
Example 1: A person borrows ₦10,000 at 10% with principal and interest to be repaid after 3
years.
The closing balance of ₦13,000 must be repaid to the lender at the end of the third year.
 Interest for year 1 (10%) 1,000
Interest for year 2 (10%) 1,000
Interest for year 3 (10%) 1,000
Total interest 3,000
Amount owed at the end of year 3 = 13,000
Or SI = 10,000 x 0.1 x 3 = 3,000
10,000 + 3,000 = 13,000
2.1.2 COMPOUND INTEREST CALCULATION
Compound Interest;- This is where the annual interest is based on the amount borrowed plus
interest accrued to date. The interest accrued to date increases the amount in the account and
interest is then charged on that new amount.
Compound interest is therefore, the periodic interest earned on the principal plus previous earned
interest and can be calculated as thus; C I = A – P
Where A = P (1+r)n
Example 2; What is the compound interest on N100 invested for 5 years at 5% interest rate, if it
is compounded per annum?
A = P (1+r)n
A = 100( 1+ 0.005)5
A = 100( 1.05))5
A = 127.63
C. I = 127.63 – 100
= 27.63

2.1.3 CALCULATION OF ANNUITY

Annuity is a series of equal payments or receipts over a given period of time, with compound
interest on the payments or receipts over a specific period. It can be divided into the
followings;
i. Ordinary Annuity
ii. Annuity Due
iii. Perpetual Annuity
iv. General Annuity
Annuity generally involved the future value and present value of a lump sum.
A future value is the amount of money or sum invested now which would be worthy at a future
date, and the future lump sum invested today can be computed as; FV = P (1+r)n
A present value of an investment can be described as the amount of money (lump sum)that one
would have to invest now for numbers of time/period earning interest at rate per period in order
to build up the value of an investment to the amount at the end of that time; PV = F x 1
(1+r)n

ORDINARY ANNUITY:- This is a series of equal payments or receipts that occur at the end
of each period involved or at the end of payments or receipts interval.
Formula; future value present value
FV = A[ (1+r)n -1] PV = A[ 1- (1+r)-n]
r r

Example 3: Calculate the future value and present value of ordinary annuity of N6,000
deposited at the end of the year 1 to 3 at 16% compounded annually.
Solution;
(a) FV = A[ (1+r)n -1] (b) PV = A[ 1- (1+r)-n]
r r
= 6000[ (1+0.16)3 = 6000[1-(1+0.16)-3]
0.16 0.16
= 6000[ (1.16)3 = 6000[1-(1.16)-3]
0.16 0.16
= 6000[(1.5609)] = 6000[1-0.64]
0.16 0.16
= 6000 x 3.5056 = 6000x 0.36]
0.16
= N21,033.6 = 2156.05
0.16
= N13,475.34

ANNUITY DUE;- This is a series of payments or receipts that occur at the beginning of each
period involved rather than at the end.

Formula; future value present value

FV = A[ (1+r)n -1](1+r) PV = A[ 1- (1+r)-n] (1+r)
r r
Example 4: Calculate the future value and present value of an annuity due of N6,000 annual
deposited at the beginning of each year, compounded at 16% interest rate for 5years.
Solution;
(a) FV = A[ (1+r)n -1] (1+r) (b) PV = A[ 1- (1+r)-n](1+r)
 r r
= 6000[ (1.16)5-1](1.16) = 6000[1-(1.16)-5](1.16)
0.16 0.16
= 6000[ (2.4354-1.16) = 6000[0.52](1.16)
0.16 0.16
= 6000[1.2764] = 6000[]
0.16 0.16
= 6000 = 6000x3.77]
0.16
= N21,033.6 = 2156.05
PERPETUAL ANNUITY:- This is a series of equal periodic payments or receipts expected
indefinitely, and in this case, only the present value of a perpetual annuity is considered.

Formula; PV = A
r
Example 5: Charlse Olumo receives N6,000 perpetual annual payment at the rate of 16%, what
is the present value of the annuity.
Thus calculated as; PV = A
r
= 6000
0.16 = N37,500

GENERAL ANNUITY:- This is a situation whereby the interest conversion period differs from
the payment period and the differences determine the bases for computation.

2.1.4 SINKING FUNDS CALCULATION

This is a method of setting aside uniform amount of money at every period to accumulate to a
specific amount in the future. As each periodic amount is set aside, it will be immediately
invested. It can also be used in providing or replacement of fixed assets.
Example 6: Chief Igbayilola needs to provide N50,000 to replace his machine in 5 years time,
in order to provide this amount, he decided to set aside equal amount of annually out of his
salary. This amount is kept in his savings account that yield 20% interest per annum.
Kindly calculate (i) the sinking funds amount (ii) and prepare the sinking fund schedule.

SOLUTION:
(i) The sinking funds amount;- FV = A[ (1+r )n – 1]
r
50,000 = A[ (1.2)5 – 1]
0.2
 50,000 x 0.2 = A[1.4883]
10,000 x A[1.4883]
A = 10,000
1.4883
= N6,718.99
The amount set aside as sinking fund is N6,718.99

(ii) The sinking fund schedule.

a b c a+b+c
Year Balance b/f Interest @ 20% Sinking fund Balance c/d
1 - - 6,718.99 6,718.99
2 6,718.99 1,313.80 6,718.99 14,781.78
3 14, 781.78 2,957.36 6,718.99 24,457.13
4 24, 457.13 4,891.43 6,718.99 36,067.55
5 36,067.55 7,213.51 6,718.99 50,010.05

2.1.5 CALCULATION OF AMORTIZATION

This is a method of payment of loan or term debts, which include principal amount plus interest
spread over a period of time. Installment payment is prevalent in mortgage loans and certain type
of business loans. The main feature of any installment payment is that the borrower repays the
loan in equal period payment that embodies both interest and principal.
Example 7: Komolafe borrowed N50,000 to purchase a machine, he made arrangement to pay
over 5 years period with interest rate of 20% per annum on the unpaid balance. Calculate;
i. The amortization annual payment.
ii. Amortization schedule
Solution:
i. The amortization annual payment.
FV = A[1- (1+r )-n ]
r
50,000 = A[1- (1.2)-5]
0.2
50,000 x 0.2 = A[1-0.4019]
10,000 x A[0.5981]
A = 10,000
0.5981
= N16,718.99
 The annual payment is N16,718.99
ii. Amortization schedule.
a b c d=c-b a-d
Year Principal Interest @ 20% Annual installment Principal Balance c/f
Owing payment repayment
0 --- ------ ------ -------- 50,000
1 50,000 10,000 16,718.99 6,718.99 43,281.01
2 43,281.01 8,656.20 16,718.99 8,062,79 35,218.22
3 35,218.22 7,043.64 16,718.99 9,675.35 25,542.87
4 25,542.87 5,108,57 16,718.99 11,610.42 13,932.45
5 13,932.45 2,786.49 16,718.99 13,932.45 00.0

2.2 INVESTMENT APPRAISAL TECHNIQUES

Investment decision and appraisal involve the process of capital Budgeting. The term capital
refers to fixed assets and other financial resources used in production and other investment
activities while a budget is a plan of activities detailing all projected cash inflows and outflows
during the specified future period.
However, the investment decision could be inform of additions, dispositions, replacement and
modifications of activities or asset base that would ensure good returns on the effective
utilization of a firm’s financial resources, and which must be properly evaluated to justify the
organizational objectives.

METHODS/TECHNIQUES OF APPRAISAL
In investment appraisal, the financial managers need to examine the different methods of
selecting investments in long-term assets and chose the appropriate one to suit the selected
projects having considered other necessary economical factors.
Such techniques can be categorized into two viz;
(i) The traditional / non-discounted techniques
(ii) The modern / discounted cash flow techniques
THE TRADITIONAL / NON-DISCOUNTED TECHNIQUES
There are two techniques under this method;
1. The Accounting Rate of Returns (ARR)
2. The Payback Period (PBP)
THE MODERN / DISCOUNTED CASH FLOW TECHNIQUES
The four (4) techniques under this method are;
1. The Discounted Payback Period (DPBP)
2. The Net Present Value (NPV)
3. The Internal Rate of Return (IRR)
4. The Profitability Index (P I)

The Accounting Rate of Returns (ARR):- is entirely an accounting based technique of

investment appraisal because it makes use of the accounting concepts and assessed by
calculating the return on investment (ROI) or return on capital employed (ROCE). It measures
the ratio of accounting profits to the accounting investment and evaluates project based on these
ratios or returns.
It can thus be calculated as;
ARR = Average annual accounting profits after depreciation and interest but before taxation x 100
Average capital invested

Example 1: Arsenal Plc, is to undertake a project requiring an investment of N100,000 on

necessary machine. The project is to last for 5 years at the end of which the machine will have
net book value of N20,000. The profits before depreciation are ;
Years Profits (N)
1 40,000
2 44,000
3 48,000
4 52,000
5 58,000
You are required calculate the ARR of the project.

Solution
i. Calculation of depreciation N
Cost of investment = 100,000
Net Book Value = (20,000)
Accum. Depr. 80,000

Average depr/year = N80,000

5 = N16,000

ii. Calculation of Average Investment N

 Initial Investment = 100,000
Net Book Value = 20,000
120,000

Average investment = N120,000

2
= N60,000

iii. Calculation of Annual Profit

Year Profit Dep. Net Profit
1 40,000 16,000 24,000
2 44,000 16,000 28,000
3 48,000 16,000 32,000
4 52,000 16,000 36,000
5 58,000 16,000 42,000
Total Annual Profit 162,000

Therefore, the average annual profit is N162,000

5 = N32,400
ARR = Average annual accounting profits after depreciation and interest but before taxation x 100
Average capital invested
= N32,400 x 100
N60,000 = 54%

DECISION RULES
i. Accept the project with highest ARR
ii. Ensure that the selected project has an ARR that is equal to or greater than
management rate set.
iii. Reject if the project ARR is lesser than that set by the management.

ADVANTAGES OF ARR
a) It is simple to calculate and easy to understand
b) It considers the profits over the entire project’s life, unlike the Payback period
c) It uses readily available accounting data (annual profit)
d) It can be easily interpreted and understood by all the users of data
e) It could be used in comparing performance for many companies

DISADVANTAGES OF ARR
a) It takes no account of the time value of money
b) It ignores the risks and management attitudes towards any associated risks
c) It uses accounting profit rather than cash flow as basic measure for benefits.
 d) There are no clear definition in accounting of profit and capital employed
e) It can be calculated in several ways.

The Payback Period (PBP):- This technique measures the project on the basis of the period
within which the investment pays back itself or the period of recovery of initial investment.
According CIMA, its defined as “the period, usually expressed in years, which it takes the cash
inflows from a capital investment project to equal the cash outflows”. The payback period
technique is used to determine how quickly a project repays its outlay.

Example 2: Arikzon Plc, runs a manufacturing business. The project involves an immediately
cash outlay of N200,000 and estimates that the net cash inflows from the project will be as
follows;
Years Profits (N)
1 20,000
2 40,000
3 220,000
4 80,000
Calculate the Arikzon PBP for the project.

Solution
Years Cashflows Cumm. Cashflow Balance
0 (200,000) 0 (200,000)
1 20,000 20,000 (180,000)
2 40,000 60,000 (140,000)
3 220,000 280,000 80,000
4 80,000 360,000 160,000

PBP = 2years + 140,000 x 12

220,000
= 2yrs + 7.636 i.e, payback period is 2years, 7 months, 6 weeks and 4 days.

DECISION RULES
i. Accept project with the least PBP
ii. Ensure that the selected project has a PBP that is equal to or less than that set by the
management.
iii. Reject any project that has greater PBP.

ADVANTAGES OF PBP
 a) It is simple to calculate and understand.
b) It is the least affected by uncertainties.
c) It uses cash profit instead of accounting profit , unlike the ARR
d) It can be easily used in risk analysis,
e) It is a fast screening techniques

DISADVANTAGES OF ARR
a.) It ignores the time value of money
b.) There are no rules for setting the maximum acceptable PBP by the management.
c.) It ignores the cash flows after the PBP
d.) It doesn’t define the problems of what is the outlay and where the pay back is.
e.) It ignores the risks and management attitudes towards any associated risks

THE MODERN / DISCOUNTED CASH FLOW TECHNIQUES

Discounted cash flow is a technique for evaluating proposed investments, to decide whether they
are financially worthwhile. The methods here are more superior to those of non-discounted ones
because they take cognizance of time value of money and appropriate cost of capital is involved.
The four (4) methods under this technique are;
1. The Discounted Payback Period (DPBP)
2. The Net Present Value (NPV)
3. The Internal Rate of Return (IRR)
4. The Profitability Index (P I)

The Discounted Payback Period (DPBP);- When assessing an investment decision using the
NPV method, it is sometimes useful to calculate the discounted payback period. This is the
length of time it will take before the positive returns from the investment, measured as
discounted values, pay back the amount invested.
Discounted payback may be relevant to investment decisions when a company has a policy of
not investing unless the discounted payback period is less than, say 4 years.
Example 3; If a project initial cost is N100,000 and successfully operated for good 5 years with
the cost of capital of 10% per annum. Calculate the discounted payback period if the project
annual returns are; N30,000, N30,000, N40,000, N30,000, N20,000 respectively.
Solution:
Years Cash flows DCF@10% PV Cumm. DCF Balance
0 (100,000) 1.0000 (100,000) ------ --------
 1 30,000 0.9091 27,273 27, 273 (72,727)
2 30,000 0.8264 24,792 52,065 (47,935)
3 40,000 0.7513 30,052 82,117 (17,883)
4 30,000 0.6830 20,490 102,607 2,607
5 20,000 0.6209 12,418 115,025 15,025
DPBP = 3 years + 17883 x 12
20,490
= 3 years + 10.473
The DPBP is therefore = 3 years, 10 month and 5 weeks.
Note;- The principles and decision rules here are the same as in the normal payback period
method, the only difference is that the cash flows to be used are discounted at the appropriate
cost of capital provided.
Therefore, this version of payback technique will not suffer from the disadvantages of
discountenance of time value concerned.

The Net Present Value (NPV):- The net present value can be described as the summation of all
discounted cash flows (PV) that are associated with each project. It is the benefit that accrues to
an organization for adopting an investment in a project.
A positive NPV indicates that the project yields capital at a rate of return exceeding the cost of
capital and such project should be accepted.
Example 4; If a project initial cost is N100,000 and successfully operated for good 5 years with
the cost of capital of 10% per annum. Calculate the NET PRESENT VALUE of the project, if it’s
annual returns are; N30,000, N30,000, N40,000, N30,000, N20,000 respectively.
Solution;
Years Cash flows DCF@ 10% PV
0 (100,000) 1.0000 (100,000)
1 30,000 0.9091 27,273
2 30,000 0.8264 24,792
3 40,000 0.7513 30,052
4 30,000 0.6830 20,490
5 20,000 0.6209 12,418
+NPV = 15,025
DECISION RULES
i. Accept projects with positive NPV (in case we have more than one project)
ii. Accept projects with highest positive NPV (in case of mutually exclusive projects)
iii. Reject any project that has a negative NPV.

ADVANTAGES OF NPV
a) It is simple to calculate and understand.
b) It recognizes the time value of money
c) It absolutely measure a profitability that reflects/ increase shareholders’ wealth
d) It utilizes all cash flow over the projects’ life span
e) It uses cash profits instead of accounting profit
f.) It clearly indicate the basis of accepting or rejecting a project.
DISADVANTAGES OF NPV
a.) It’s calculate require patience and technicality.
b.) It relies heavily on the correct estimate of cost of capital
c.) It’s interpretation may be difficult for non-accounting managers for decision
making.
d.) It ignores the risks associated with the project
e.) It doesn’t incorporate management’s attitude towards firm’s risks.

The Internal Rate of Return (IRR);- This is the rate that equates the present value of all cash
inflows with the present value of all cash outflows , it is the cost of capital (% rate) that will
produce zero NPV if applied to a project, i. e, the cut off rate or hurdle rate.
In order to generate the cost of capital that will produce exactly zero NPV, and for easy IRR
calculation, the following procedures must be followed;
i. There should be two (2) different discount rates, (the provided and the suggested
ones)
ii. There must be two (2) opposite values of NPV, (positive and negative)
iii. The interpolated formulae should be applied in order to generate IRR, especially
where the two NPVs are similar, (+ve and +ve , –ve and –ve and /or –ve and +ve).
Though, the most common and expected NPVs are; +ve and –ve.
iv. Increase or decrease (almost double at times) the rate provided rate in order to arrive
at the positive or negative NPV needed.
Example 5; If a project initial cost is N100,000 and successfully operated for good 5 years with
the cost of capital of 10% per annum. Calculate the Internal Rate of Return of the project, if it’s
annual returns are; N30,000, N30,000, N40,000, N30,000, N20,000 respectively.
Solution;
Years Cash flows DCF@ 10% PV DCF@ 20% PV
0 (100,000) 1.0000 (100,000) 1.0000 (100,000)
1 30,000 0.9091 27,273 0.8333 24,999
2 30,000 0.8264 24,792 0.6944 20.832
3 40,000 0.7513 30,052 0.5787 23,148
4 30,000 0.6830 20,490 0.4822 14,466
5 20,000 0.6209 12,418 0.4109 8,038
+NPV = 15,025 -NPV = (8,518)

IRR =LR + +NPV x (HR – LR)

+NPV – ( -NPV)
= 10% + 15,025 x (20% - 10%)
15,025 – (-8,518) x 10%
= 10% + 15,025 x 10%
23,543
= 10% + 0.63828 x 0.1
= 10% + 6.3828
= 16.38%
NOTE: Where otherwise upturned, i.e, (+ve and +ve , –ve and –ve and /or –ve and +ve). The
interpolated formulae should be applied in order to generate IRR, as follows;
(a) IRR = LR + +NPV x HR - LR
+_ NPV
(b) IRR = HR - - NPV x LR - HR
+_ NPV

DECISION RULES
i. Accept all projects whose IRR are equal to or greater than the company’s cost of capital.
ii. Accept projects that produces highest IRR in case of mutually exclusive projects
iii. Reject any project that has lowest IRR or below the management’s target.

ADVANTAGES OF IRR
a) It recognizes the time value of money.
 b) The rates are presented in form that can be easily interpreted and understood.
c) It is more useful to divisional managers in large organization.
d) It provides us the margin of safety when calculating firm’s cost of capital
e) It sometimes avoids disputes that characterize the choice of selecting cost of
capital in use.

DISADVANTAGES OF IRR
(a) It is technical and somehow difficult in use than other methods
(b) It normally produces more than one IRR for a project
(c) It may result into sub-optimal decision in most situation
(d) It decisions may bring conflicts when mutually exclusive project are considered.
(e) It doesn’t incorporate management’s attitude towards firm’s risks.

The Profitability Index (P I):- This is another time adjusted method used in measuring the
present value of returns on investment. It is described as the ratio which is obtained by dividing
the PV of the future cash inflows by the PV of cash outflows. Profitability Index is also known
as Benefit- Cost Analysis or the excess of present value index.
However, it can be calculated as thus;
i. PI = NPV of a project
Outlay required during the restricted year.

ii. PI = GPV of a project

Outlay required during the restricted year.

Example 6; Assuming that HOLLY GABRIEL ENTERPRISES, is planning to invest in five (5)
different projects (A- E) and has borrowed sum of N1,000,000 to execute the viable ones. Thus
presented below;

Projects Initial Outlays NPV

A 500,000 800,000
B 100,000 150,000
C 200,000 100,000
D 150,000 60,000
E 20,000 8,000
Calculate the Profitability Index for the projects.
Solution;
 Projects Initial Outlays NPV PI
A 500,000 800,000 1.6
B 100,000 150,000 1.5
C 200,000 100,000 0.5
D 150,000 60,000 0.4
E 20,000 8,000 0.4
N:B; PI = Net Present Value
Initial Outlay
For project A;- P I = 800,000
500,000 = 1.6
B;- P.I = 150,000
100,000 = 1.5
C;- P.I = 100,000
200,000 = 0.5
D;- P.I = 60,000
150,000 = 0.4
E;- P.I = 8,000
20,000 = 0.4

IMPORTANCE OF PROFITABILTY INDEX IN PROJECTS EVALUATION

(a.) It recognizes the time value of money
(b) It uses both cash inflows and outflows throughout the projects years
(c) It considers the cash flows rather than accounting profits as benefit
(d) It is capable of handling any discount rate to determine the present value of cash
flows.
(e) It is the most suitable method for capital rationing.

2.3 EVALUATION OF CAPITAL PROJECTS

Management needs to develop a methodological objective so as to find alternative to capital
projects on a reasonable basis. Considering both quantitative and qualitative issues involved in
using the whole organizational resource to invest in any or many capital projects. Project
evaluation involve a systematic and objective assessment of an intended project or investment to
the completed level with the aim of determining its relevance and progress level and for the
purpose of achieving projects objectives, efficiency and effectiveness as well as proper
evaluation.
Critical part of this process involve both calculating the appropriate discount rate and also
calculating the conservative cash flows. An independent accounting firm can best look at project
or investment issues impartially, and bias estimation can be dangerous. They need to evaluate or
predict how well each capital asset alternative will do and also to determine in the net benefits to
the firm are consistent with the required capital allocation, given the scarcity of resources most
priority.
The financial expert in every organization must perform the following tasks in taking their
capital decisions;
i) Identifying the targeted cost of capital.
ii) Articulate the evaluation of start up costs.
iii) The calculation of cash flows for those projects chosen for the evaluation purposes.
iv) Involving the heavy funds.
v) Long term implication of funds invested.
vi) Most difficult or irreversible decisions to make.

CLASIFICATION OF CAPITAL PROJECTS

1. REPLACEMENT OF ASSETS:- The capital expenditures such as fixed assets,
damaged and warn-out or out dated equipment become necessary to replace on the
account of new technology. This is importance in order to reduce the maintenance costs,
minimizing labour and material costs and other variable costs e.g electricity bills.
2. EXPANSION OF EXISTING PRODUCT OR MARKET:- An organisation needs to
increase its existing production capacity to meet up with higher and regular demands,
also to expand its outlets or distributional facilities to the new market needed to be served
and these thereby require additional capital investment.
3. DIVERSIFICATION OF INVESTMENT:- Many organizations may want to reduce
their risks by operating in various and different markets instead of operating on a single
market, this therefore involves capital investment by purchasing new machinery and
facilities to handle and properly taking care of the new investment and its products.
4. ENVIRONMENTAL SAFETY REGULATIONS:- These involve spending necessary
and required huge amount of money to be reliably complied with the government
regulations, labour union policies, legal and insurance required policies as well as
performing corporate social responsibilities.
 5. RESEARCH AND DEVELOPMENT:-These are highly required in case of industries/
organizations where technology is rapidly changing with high competitive rate, and large
sums of money must be spent on research and development purpose.
6. MISCELLANEOUS:- Organizations are necessarily unavoidably spend money on
projects that are not directly involving profit oriented but add great values to the business.
Examples are; office building total parking, installation of pollution control equipment,
legal fees and similar cash outlays.

Summarily, capital project evaluation is basically on these decision/factors;

i. Capital Budgeting Decision
(a) Mathematics of Finance (simple & compound interest, loan and amortization,
annuities, etc)
(b) Discounted and Non-discounted techniques (PBP, ARR, DPBP, NPV, IRR etc)
ii. Capital Rationing Decision
(a) Profitability Index (P I)
(b) Cost Benefit Ration (CBR)
iii. Accept/Reject Decision.
(a) Independent Project
(b) Dependent Project
iv. Mutually Exclusive Project Decision.

2.4 INVESTMENT DECISION UNDER TAXATION, INFLATION, RISK &

UNCERTAINTY
INVESTMENT DECISION UNDER TAXATION
Tax has been described as a compulsory levy or fee imposed by the constituted authority of a
particular territory on individual, corporate bodies, basically on income and consumption, that
could raise within a the stipulated territory as a means of generating revenue towards financing
government expenditures. Taxation been the process and techniques of assessing and collecting
of tax(es) through the relevant constituted authorities.
Taxation has so far been ignored in all the investment appraisal techniques considered. However,
a company will have a potential liability to pay tax on all profits, whereas, tax is the cash
payment and its effects are relevant to an investment decision using the DCF criterion.
In practice, tax is calculated on the adjusted profit and if information is given in the question as
to the expected profit, the tax payable must be calculated as accurate as possible.
Cash inflow gives rise to cash outflow by way of tax at the company’s tax rate in the same way
that additional receipts will give rise to tax payment as additional cost will give way to tax
saving.
Also,
AREAS WHERE TAXATION AFFECTS INVESTMENT DECISION
Taxation will affects the investment decision (Capital Budgeting) through its project cash
inflows and outflows in form of qualifying capital expenditure or recurrent expenditure and in
the following areas;
1. Capital Budget – This is the effect on the cash flow and on the profitability of and
investment
2. Cost of Capital – Its calculation here will make loan to be cheap as interest payable on loan
is the tax deductable.
3. Short term cash budget- Here, payment of tax on profit and on other incomes like PAYE
will affect cash flow in short in a short term.
4. The implication of tax on other essential items will need to be appreciated and can be
analyzed as follows; No. Items Tax Effect
1. Revenue Tax payment
2. Cost Tax savings
3. Capital Allowance Tax savings
4. Balancing Allowance Tax savings
5. Balance Charge Tax payment
6. Working Capital No effect