LECTURE ONE

Introduction

Business finance or corporate finance simply means the management of the assets and

liability of the business. In a broad way, business finance according to Wikipedia (2020)

is defined as the area of finance dealing with the sources of funding and the capital

structure of corporations (business) and the actions that managers take to increase the

value of the firm to the shareholders, as well as tools and analysis used to allocate

financial resources. According to Saka (2020), business finance refers to the activities

involved in the mobilisation and utilization of funds or financial resources to achieve

overall objectives of a business firm or organisation.

Types of Business Objectives

Business objectives are the specific and measurable results organisations or companies

hope to maintain as their enterprises grow over time. For the purpose of this course, two

main categories of business objectives will be discussed. These are corporate objectives

and financial objectives.

Corporate Objectives means the outcomes and measurable goals set by a group of people

in common. Thus, corporate objectives are common to all organisations established for

profit making. These include Profit maximisation, wealth maximisation, solvency/

liquidity, survival, growth, social welfare, diversification, productivity, core values,

market leadership and among others.

Financial objectives on the other hand are peculiar to each firm and these include return

on investment, revenue growth, profit margin, financial sustainability, maximising firm’s

market value.

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The Role of Financial Manager

There are three principal roles of financial manager in an organisation and they are;

Investment decision

Financing decision

Dividend decision

Tools of Corporate Finance

Corporate finance involves financial and accounting decisions companies make on a day

to day basis. To help ease the burden of bookkeeping, budgeting and reporting, there are

a variety of corporate finance tools. Using these tools can help corporation control its

finances, which will lead to greater efficiencies. These include;

1. Present Value: This is one the most important tools used in business or corporate

finance. The rule of present value states that the value of any asset is the present value of

its cash flows at discount rate. Later in the course, we will learn how to calculate the

present value using those tools.

II. Financial Statement Analysis: The figures used in corporate finance are derived

from financial statement. This therefore means that it is necessary for students to

understand the financial ratios used by analysts.

III. Risk and Return: This is on the notion that investors and firms with higher risk

should be compensated with higher expected return. This then goes to explain how risk

should be measured and how high the return should be for a given level of risk.

IV. Option Pricing: Option is a type of contract between two persons where one person

grants the other person the right to buy or sell a specific asset at a specific price within a

specific time period. The value of option is closely related with the market value/ price of

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the security that underlines the option. In investment analysis, firms faced with option

pricing theory provide useful insights into the determinants of the values of these options.

In financing decisions, option pricing theory is useful in designing and valuing securities

with embedded options such as warrants, convertible securities and callable bonds.

Relevance of Business Finance to Organisation Growth

i. Providing various means of funding

ii. It helps investors to make reliable and useful financial and investment decisions

through the use of ratio analysis

iii. It helps to understand the role of cash flow and budgeting in business

management

iv. It helps to determine the performance and efficiency of a business

The roles of financial Manager

Financial manager performs three principal roles in the areas of certain financial decision

makings. These decisions are

1. Investment decisions 2. Financing decisions 3. Dividend decisions.

Investment Decisions

Investment Decision relates to the determination of total amount of assets to be held in

the firm, the composition of these assets and the business risk complexions of the firm as

perceived by its investors. It is the most important financial decision. Since funds involve

cost and are available in a limited quantity, its proper utilisation is very necessary to

achieve the goal of wealth maximisation.

The investment decisions can be classified under two broad groups:

(i) Long-term investment decision and

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(ii) Short-term investment decision.

The long-term investment decision is referred to as the capital budgeting and the short-

term investment decision as working capital management.

Capital budgeting is the process of making investment decisions in capital expenditure.

These are expenditures, the benefits of which are expected to be received over a long

period of time exceeding one year. The finance manager has to assess the profitability of

various projects before committing the funds

Financing Decision

Once the firm has taken the investment decision and committed itself to new investment,

it must decide the best means of financing these commitments. Since, firms regularly

make new investments; the needs for financing and financial decisions are ongoing.

Hence, a firm will be continuously planning for new financial needs. The financing

decision is not only concerned with how best to finance new assets, but also concerned

with the best overall mix of financing for the firm.

A finance manager has to select such sources of funds which will make optimum capital

structure. The important thing to be decided here is the proportion of various sources in

the overall capital mix of the firm. The debt-equity ratio should be fixed in such a way

that it helps in maximising the profitability of the concern.

Dividend Decision

The third major financial decision relates to the disbursement of profits back to investors

who supplied capital to the firm. The term dividend refers to that part of profits of a

company which is distributed by it among its shareholders. It is the reward of

shareholders for investments made by them in the share capital of the company. The

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dividend decision is concerned with the quantum of profits to be distributed among

shareholders. A decision has to be taken whether all the profits are to be distributed, to

retain all the profits in business or to keep a part of profits in the business and distribute

others among shareholders. The higher rate of dividend may raise the market price of

shares and thus, maximise the wealth of shareholders.

LECTURE NOTE 2

Forms of Business Organisation and Sources of Finance

Sole Proprietorship: Definition, Features, Merits and Demerits and Sources of Finance

Partnership: Definition, Features, Merits and Demerits and Sources of Finance

Limited Liability Companies: Definition, Types, Differences and Sources of Finance

based on Three Classifications, namely, Short-term, Medium-term and Long-term

Sole Proprietorship

Definition: this is a business organised, managed and controlled by one person. It is

otherwise known as one-man business.

Features

i. No legal requirement to set up

ii. No separation between ownership and management

iii. Controlled by one person, usually the owner

iv. Unlimited liability

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 v. No continuity; however, prior arrangement can pave way for continuity of

business

Merits and Demerits of Sole Proprietorship (assumed to be known)

Sources of Finance

i. Personal savings

ii. Trade Credit

iii. Loans from friends and relatives

iv. Loans and/or grants from government and charity organisations as the case in most

advanced countries

v. Loans from banks; however, this depends on the size of the business

vi. Overdraft from banks to those businesses with current account facilities

vii. Retained profit

viii. Sale of assets

ix. Angel financing - Angel Financing is a funding mechanism by which an investor

participates in the funding of a start-up firm, usually sole proprietorship, because he

believes in the business idea or who invented the business in exchange for equity

ownership.

Partnership

This is defined as business that subsists between two or more people with the aim of

carrying business activities in order to make profits.

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Features

i. The number of membership is usually between two to twenty people or between 2

to 10 in case of professional partnership such as law, accounting, etc.

ii. Joint capital contribution

iii. Profits or losses are shared among the partners based on agreed ratios

iv. Registration of business is not compulsory or unnecessary

v. Mutual trust and confidence

vi. Unlimited liability

vii. Lack of continuity in case general partner dies

Types

General partnership: here, each partner represents the firm with equal right. All

partners can participate in management activities, decision making and have the right to

control the business.

Limited liability: the general partner has unlimited liability. Limited partners have

limited control over the business (limited to his investment) and are not associated with

everyday operations of the firm.

Merits and Demerits of Partnership (assumed to be known)

Sources of Finance

i. Joint capital

ii. Trade Credit

iii. Loans from financial institutions

iv. Loans or grants from government

v. Retained earnings

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 vi. Sale of assets

Classification of Sources of Funds for Corporate Organisations

There are three (3) categories of sources of funds available to limited liability companies.

They are short-term sources, medium-term sources and long-term sources.

Short-term sources of fund: These are funds that have duration or tenure of less than

one year before being due for repayment. They are meant primarily to cater for the

working capital need of an organisation. These include Bank Overdraft or Bank Credit,

Commercial Paper, Trade Credit, Bills Discounting, Debt Factoring, Invoice Discounting,

Bankers Acceptance or Acceptance Credit

Purpose of Short-term Finance

Short-term finance serves following purposes:

(1). It facilitates the smooth running of business operations by meeting day to day

financial requirements.

(2). With availability of short-term finance goods can be sold on credit. Credit sales are

for a certain period and collection of money from debtors takes time. During this time

gap, production continues and money will be needed to finance various operations of the

business.

(3). Short-term finance becomes more essential when it is necessary to increase the

volume of production at a short notice.

Types of Short-term Sources of Finance

Bank Overdraft: This is the facility given to current account holder customer of a bank

to withdraw above what he/she has in the account. Thus, only current account holder

enjoys bank overdraft. Historically, the first overdraft was set up in 1728 by Royal Bank

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of Scotland for merchant William Hog (Wikipedia, 2021). The facility attracts interest

charges as credit worthy customers are charged prime rate, a little above base rate, while

other categories of customers are charged premium rate that is above prime rate.

Commercial Paper: These are unsecured promissory notes for a specified amount

known as face value to be paid at a specified date which is issued by finance companies,

banks and corporations with excellent credit record. Ogunbi and Ogunseye (2011) put it

that is a money market security issued or sold by large corporations to meet short-term

debt obligations (like payroll) and is backed only by an issuing bank or corporation’s

promise to pay the face value amount on the maturity date specified on the note.

However, commercial papers can also be backed up by high quality collateral.

There are two types of Commercial Paper

Asset-backed Commercial Paper: This is commercial paper backed by high quality

collateral.

Credit-Supported Commercial paper: This is often guaranteed by an organisation with

excellent credit, such as a bank

Trade Credit: This is credit financing of raw materials or finished goods. This enables

an organisation to procure goods from suppliers on credit for re-selling and makes

payment in definite future time.

Bills Discounting: A bill is said to be discounted if immediate value can be obtained

over a bill, which matures in future from bank or discount house. Thus, the value

obtained now will be less than the face value of the bill.

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Debt Factoring: This is a financial transaction and a type of debtor finance in which a

business sells its account receivables (that is, invoices) to a third party called a factor at a

discount. The factor collects the amounts due on the receivables from debtors at maturity.

Invoice Discounting (Confidential Invoice Factoring/Discounting)

Under this method, debts are sold to factor that makes an immediate payment of an

agreed percentage of the face value of the debt sold. Only finance service with interest

charged and not sales accounting is supplied by the factor.

Customers’ Advances

Customers’ advance represents a part of the payment towards price on the product (s)

which will be delivered at a later date. Customers generally agree to make advances when

such goods are not easily available in the market or there is an urgent need of goods. A

firm can meet its short-term requirements with the help of customers’ advances.

Franchising

This is a method of expanding a business on less capital than otherwise needed. Under a

franchising arrangement, a franchisee pays a franchisor for the right to operate a local

business under the franchisor’s trade name.

Bankers Acceptance (Acceptance Credit): This is a bank guarantee to any bill of

exchange that it will undertake to liquidate the debt in the event of default at maturity.

The tenor is between 2 to 12 months

Accruals: These are interest free funds like tax deductions, delayed salaries payment,

union dues and other deductions which are yet to be remitted.

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Medium-term Sources of Funds

Medium Term finance are sources of finance available for the mid-term between 3-5

years typically used to finance an expansion of a business or to purchase large fixed

assets. It is usually the larger amounts of borrowing or the use of the funds that

differentiates medium sources of finance from short term, although a number of the short

term are available for the mid-term (UK Music, 2020).

Types of Medium-term Sources of Finance

Bank Term Loan: Loans for specific projects with duration between 2-5 years or 2-10

years to be secured with collateral security taking legal charge or equitable charge

Venture Capital: This represents funds invested usually in a new enterprise, that is,

monies which are invested in a commercial venture with highly uncertain chance of

success; hence, such monies are called risk capital and seed money. However, the product

or service to invest venture capital must be non-extent.

Stages involved in Venture Capital Funding

Provision of seed money: This is needed to develop a concept- product or service – and

a business plan.

Start-up or first-round financing: This is for furthering of research and development

and to formulate initial marketing and production plans.

Second-round financing: This is to get production and marketing efforts launched.

Third-round financing: Here, funds are used when a company is producing and selling

a product or service.

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Project financing: This is a method of financing a project in which the repayment of the

loan is tied to the streams of future cash inflows of the project itself. Thus, it is regarded

as self-liquidating facility.

Equipment Leasing: This is a contractual agreement between the lessor (owner of an

asset) and the lessee (user of the asset) for the use of the asset for a definite period of time

with consideration in form of rent to be paid by lessee.

There are two main types of Leasing

Operating Lease: This is rental agreement between a lessor and a lessee whereby the

lessor is responsible for the upkeep, maintenance, servicing and insurance of the leased

property or asset. Thus, all risks and rewards incident to ownership remain with the

lessor, which is, not transferred.

Characteristics of Operating Lease

i. The lessor is responsible for service, maintenance and insurance of the equipment

ii. The period of lease is less than the economic useful, working life of the leased

asset

iii. Payment of the initial lease will not cover the full cost of the asset (that is, capital

outlay)

iv. It can be cancelled by the lessee at short notice as the arrangement incorporate

cancellation clause

Finance Lease

In this rental arrangement, the lessee is responsible for the upkeep, maintenance,

servicing and insurance of the leased asset as the lessor is not involved at all.

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Note: Primary period means period of the lease, secondary period means after the

expiration of primary period. Peppercorn rent means rent for continue using or

alternatively sell the asset and remit 10% of the proceeds to lessor.

Advantages of Leasing

i. Tax advantages like capital allowance

ii. Access to up-to-date equipment

iii. Access to the use of asset by company during financial difficulty

iv. It can be used as hedge against inflation

v. Disadvantages of Leasing

vi. Dilution in control

vii. Payment of rentals whether profits are made or not

viii. If the rentals are fixed and the market interest rate falls, the lessee loses

Tracing problems associated with Leasing in Nigeria

Among the problems of leasing in the country are stated as follows;

i. Tax issues like recent introduction of auto-tariff policy by Federal Government of

Nigeria in 2014 which increases importation tariff by 35%

ii. The majority of commercial banks that do equipment leasing see leasing

companies as their main competitors and extend cheap credit to the leasing

companies to the impairment of the whole economy

iii. The non-availability of long-term low-cost borrowing has contributed to the

decline of equipment leasing in Nigeria

iv. Fraudulent practices by lessees are another unfavourable challenge to lease

development

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Sale and Leaseback: This is selling of an expensive but useful equipment and

repossession of same asset through a leasing contract which involves payment of periodic

rent. It is sometimes by private arrangement.

Hire Purchase (Vendor Credit): Hire purchase which is also known as vendor credit is

the acquisition of asset on credit and settlement is made through regular installmental

payments. The intention here, unless otherwise stated, is that hirer becomes the owner of

the asset immediately he effects payment of the last installment to the owner.

Mortgage: This is a loan arrangement on freehold and leasehold properties created

between the lender (mortgagee) and the borrower (mortgagor) with lender taking legal or

equitable charge.

LECTURE NOTE 3

Financial Market 1

Introduction and Definition

Types of Financial Market

Structure of Financial Market

Functions of Financial Market

Institutions in Money Market

Instruments of Money market

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Introduction and Definition of Financial Market

Oftentimes firms usually consider either starting new line of business or expanding the

existing enterprise. Thus, the need to source for funds to undertake such venture is

imperative. A Financial market is a platform where buyers and sellers are involved in sale

and purchase of financial products like shares, mutual funds, bonds and so on. Strictly in

finance, financial market is an avenue or medium though which funds are bought and

sold.

Types of Financial Market

Principally, there are two types of financial market namely Money Market and Capital

Market

Money market basically refers to a section of the financial market where financial

instruments with high liquidity and short-term maturities are traded. Capital market is a

market where financial instruments of long-term maturities are traded. Thus, a capital

market is a market where long-term funds are bought and sold.

Structure of Financial Market

There are two segments of both money market and capital market

Money market – Primary market and secondary market

Capital market – primary market and secondary market

Primary market – This is a market where new issues or fresh funds are raised. It allows

firms to raise funds to finance new venture.

Secondary market – this is a market where existing securities are traded on. This market

provides liquidity for existing securities.

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Functions of Financial Market

i. Price Determination: Demand and supply of an asset in a financial market help

to determine their price. Investors are the supplier of the funds, while the

industries are in need of the funds. Thus, the interaction between these two

participants and other market forces helps to determine the price.

ii. Mobilization of savings: For an economy to be successful it is crucial that the

money does not sit idle. Thus, a financial market helps in connecting those with

money with those who require money.

iii. Ensures liquidity: Assets that buyers and sellers trade in the financial market

have high liquidity. It means that investors can easily sell those assets and convert

them into cash whenever they want. Liquidity is an important reason for investors

to participate in trade.

iv. Saves time and money: Financial markets serve as a platform where buyers and

sellers can easily find each other without making too much efforts or wasting

time. Also, since these markets handle so many transactions it helps them to

achieve economies of scale. This results in lower transaction cost and fees for the

investors.

Other functions include:

i. Providing the borrower with funds so as to enable them to carry out their

investment plans.

ii. Providing the lenders with earning assets so as to enable them to earn wealth by

deploying the assets in production debentures.

iii. Facilitating credit creation

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 iv. Promoting investment

v. Facilitating balanced economic growth

vi. Improving trading floors

Institutions in Money Market

The institutions in money market include commercial banks (now Deposit Money

Banks), Central Bank, Non-banks financial institutions (Savings Bank), Discount House,

Acceptance House, Investment Houses, Insurance Companies, Mutual Funds

Instruments in Money Market

These instruments include Call Money\Call Deposits, Treasury Bills, Treasury

Certificate, Commercial Papers, Certificate of Deposits, Bankers Acceptances, Bank

Deposits, and others.

Financial Market 2

Advantages and Disadvantages of Quotation

Securities and Exchange Commission

Central Securities Clearing System

Problems Associated with Nigerian Capital Market

Advantages of Quotation

To the existing shareholders

i. Immediate realisation of cash through sale of shares – ease of disposal for cash

realisation

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 ii. Marketability of shares – You can sell your shares easily and invest in another

company

iii. Ease of valuation for the purposes of Capital Gains Tax

iv. Collateral security

To the Company

i. Advantages to shareholders above will lead to a fall in the cost of capital thereby

increasing the market value of the company

ii. The company has easier access to more finance

iii. Ability to raise equity finance

iv. Marketability of shares will help enhance the possibility of using such shares for

settlement of mergers/acquisition prices

v. Risk perception of the company is low thereby attracting efficient management

talents etc.

vi. Increased publicity

Disadvantages of Quotation

i. It is expensive to the company

ii. Loss of control by existing shareholders

iii. Restriction in dividend policy since the share prices of the company will now be

more sensitive to changes in dividend

iv. Risk of take-over by other companies

v. Loss of privacy due to reporting and disclosure requirements

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Securities and Exchange Commission (Features and Functions)

The apex regulatory institution of the capital market

Established by Government

Registers listed securities

Registration of stock exchanges and dealing members

Sets the Rules and regulations and ensures compliance

Market surveillance to prevent insider abuse

Dispute resolution through SEC’s Administrative Proceedings Committee

The Central Securities Clearing System (CSCS)

Features

The Central Securities Clearing System Limited was incorporated on July 29, 1992 as

a subsidiary of The Nigerian stock Exchange.

• It operates a computerized clearing, settlement and delivery system for

transactions in shares listed on The Stock Exchange.

Functions:

• Central depository for share certificates of companies quoted on The Nigerian

Stock Exchange.

• Sub-registry for all quoted securities (in conjunction with registrars of

quoted companies)

• Issuer of central securities identification numbers to stockbrokers and investors

• Clearing and settlement of transactions

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• Safe Keeping/Custodian (in conjunction with custodian member(s) for local and

foreign instruments)

• The Central Securities Clearing System (CSCS) Ltd. was commissioned on April

8, 1997 and commenced operations on April 14, 1997

Concept of Underwriting

An underwriting contract is, therefore, a guarantee that in the event of under-

subscription, the underwriter will pay an agreed amount to the issuing company and

take possession of the un-subscribed shares (to be warehoused) for sale later on The

Floor of The Exchange.

Concept of Dematerialization

Dematerialization (“Demat” in short form) signifies conversion of a share certificate from

its physical form to electronic form for the same number of holding which is credited to

the investors account opened with a Stock broking firm/Depository Participant (DP) or in

custody of a Central Securities Depository.

Problems of Nigeria Capital Market

(i) Poor awareness of existence and functions of capital market by the public

(ii) Retention attitude of many investors

(iii) Poor general economic situations especially fall in oil price

(iv) Lack of timely and accurate information about listed companies on the floor

(v) Limited number of traded investment security instruments

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Financial Market (Stock Market)

Stock Market Participants and Roles

The Issuing House: This is usually the first party to be appointed to manage floatation of

securities on behalf of the Security Issuing Company.

The roles of Issuing House include:

i. They take a central role in putting together the prospectus for the issue

ii. They may also assist in the selection of the other parties.

iii. The issuing house is also responsible for registering the issue with, and

obtaining the approval of the SEC.

Registrar (Roles)

i. The registrar is responsible for tallying and analyzing the applications

ii. They execute the procedures decided upon for provisional allotment for

submission to the issuing house.

iii. Upon confirmation of the clearance of the allotment proposal by SEC, the

registrar sends out stock certificates to successful investors.

The Stockbroker

A Stockbroker is a licensed dealing member of an Exchange to deal in financial

instruments available in the Money & Capital Markets.

Roles:

i. He is to act as sponsor of the issue in his capacity as a dealing member of the

Exchange.

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 ii. The stockbroker will make the application for listing and handle relationships

with the executives of The Exchange responsible for scrutinizing applications.

iii. The stockbroker is expected to guide the directors of the company on

compliance with the listing requirements.

iv. Renders advisory and investment management services to clients

Methods of Accessing the Capital Market

Offer for Subscription: This is the direct sale of new securities (shares or debentures) to

the public before the shares are admitted by The Exchange for trading.

Features and Requirements:

i. Guidelines specified by SEC and The NSE are to be complied with before a

company can undertake a public offering of its shares.

ii. It involves the preparation of selling documents – referred to as prospectus and

abridged prospectus, underwriting agreement (optional), return sheet, printing of

share certificates etc.

iii. The approval of SEC is required on pricing, timing and amount to be offered

Listing by Introduction

This is applicable where a company seeking listing has met the minimum requirements

with regard to the spread and percentage of the issued shares held by the public.

Features and Requirements:

1. The process does not lead to raising of funds but allows the company participate

in the market through secondary market operations.

2. The full complement of parties to an issue is not required; hence, it is cost saving

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Rights Issue

Right issue is simply referred to as offer made to existing shareholders to acquire more

shares in the company usually at a concessionary price. The method is used when the

majority of the existing shareholders do not want a dilution of the shareholding structure

and they are willing to provide the additional capital required by the company.

Features and Requirements:

i. Rights are offered in proportion to existing shareholding may be in varying

proportions i.e. 2:1 read as 2 for 1 – i.e. For every one share being held, the

holder is entitled to purchase an additional two.

ii. Rights can also be offered as derivatives to new shareholders. – Rights Trading

commenced on The NSE on July 13, 1998.

iii. Investors not willing to take up their Rights can sell it on the floor at a price,

which may allow new shareholders to invest in the company and permit

existing shareholders to increase their holdings.

Bonus/Scrip Dividend

Bonus or Scrip dividend is also known as free issue. It is a method through which

companies increase their capitalization without selling additional shares. The effect is to

increase the paid up share capital.

Features and Requirements:

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 i. A company with accumulated capital reserves/share premium out of line with its

issued capital may decide to give additional shares to existing shareholders in

bonus.

ii. It may be offered as a substitute or complement to cash dividend.

iii. Scrip issues are offered in proportion to existing shareholding at no cost.

iv. With e-bonus, shareholders accounts in the depository are credited directly with

the bonus. The shareholders after receiving the notice can sell all or part of it on

the Trading Floor.

v. For a company to issue scrip, it requires the recommendation of the Board of

Directors to the shareholders at the AGM for approval.

Offer for Sale

Offer for sale occurs when there is need to replace the equity interest of existing

shareholders.

Features and Requirements:

i. The funds realized go to the shareholders whose shares are being offered for sale.

ii. Offer for sale has no influence on the balance sheet of the company. This is

because the process will not lead to a change in the issued shares of the

company.

Private Placement

Under private placement arrangement, securities of a company instead of being offered to

the general public or existing shareholders are sold to selected clients of the issuing

house/stockbrokers handling the issue

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Features and Requirements:

i. Private placement involves the invitation to selected high net worth individuals or

corporate organizations to invest in a company’s issue.

ii. Companies usually embark upon the process when the promoters do not want

complete dilution of control.

iii. As the securities are not yet listed on the stock exchange, promoters do not need

to meet the exchange requirement for public issue.

Lecture 3

Capital Formation

Introduction and Classification

Types: Circulating/Working Capital and Fixed Capital

Capital Adequacy: Meaning and Measurement

Factors determine Level of Capital Adequacy

Capital Formation: Meaning and Problems Associated with Capital Formation in Nigeria

Forms of Capital

Equity

Debt

Types of Capital

Circulating / Working Capital (WC = C. A – C. L)

Fixed Capital

Capital Adequacy

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This means having enough fund or resources to carry out the day to day activities of a

company or organisation or having enough funds to make a business remain stable. In

banks or other regulated financial institutions, capital adequacy otherwise known as

regulatory capital requirement is defined as statutory minimum capital reserve that a

financial institution or investment firm must have available. This is to protect the

depositors and the larger economy as failures of institutions such as banks can have

wider-scale repercussions.

Factors that determine level of Capital Adequacy

The nature and size of a firm like trading firm which requires more of working capital

than the fixed capital. Generally, more amount of working capital is required if the size of

business concern is large and the scale of operations is also high and vice versa.

Sometimes, small concerns need more working capital due to high overhead charges and

inefficient in use of available resources.

Production policy: if the production is carried out on the basis of order, less amount of

working capital is enough. Sometimes, the production is carried on in anticipation of

demand in future. If so, more amount of working capital is required. Some products have

seasonal demand. In this case, more amount of working capital is required.

Credit Policy of the Central Bank: If the Central Bank follows selective and restrictive

credit policies, a company will not be in a position to get credit facility from lenders such

as banks. In this case, such company requires more amount of working capital

Earning Capacity of the Company: Some companies have more earning capacity than

others due to better quality of the products, monopoly in market and the like. These

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companies are able to generate more cash inflows than other companies. Hence, these

companies require less amount of working capital

Sales Growth- Circulating capital increases as sales increase. The volume of sales and

the size of the working capital are directly related to each other. If the volume of sales

increases, the company requires more amount of working capital and vice versa.

Measurement of Capital Adequacy

i. Capital adequacy can be measured by performance of the following

ii. Working capital using current ratio with standard ratio of 2:1

iii. Fixed Asset performance- in terms of sales, efficiency and profitability

Reserves

CAPITAL FORMATION

Introduction

Economist defines capital as material wealth owned by an individual or business

enterprise. He also defines capital as a wealth available for or capable of use in the

production of further wealth. An accountant defines capital as the funds available to start

a business.

Capital formation is a concept used in macroeconomics, national accounts and financial

economics. In national accounting, capital formation equals net fixed capital investment,

plus the increase in the value of inventories held, plus (net) lending to foreign countries

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during an accounting period (a year or a quarter). Alternatively, the concept of gross

capital formation refers only to the accounting value of the additions of non-financial

produced assets to the capital stock less the disposals of these assets.

However, in financial economics, capital formation is referred to as any method for

increasing the amount of capital owned or under one’s control, or any method in utilising

or mobilising capital resources for investment purposes. Again, capital formation means

the expansion of capital goods in an economy, which leads to greater production of goods

and services.

Ogunbi and Ogunseye (2011) asserted that capital formation refers to all the produced

means of further production such as roads, railways, bridges, canals, dams, factories,

seeds, fertilisers, etc. It is the diversion of a part of society’s currently available resources

to the purpose of increasing the stock of capital goods (like plant and equipment,

transport facilities) or creation of semi finished goods so as to make possible an

expansion of consumable output in the future.

Capital Formation Process – 3 steps

Capital accumulation follows a process of three steps

First, growth in the volume of real savings

Second, savings mobilization through credit and financial institutions

Third, investment of savings

Hence, the formation of capital is not just a question of saving more, but also using those

savings to boost production

Problems Associated with Capital formation in Nigeria

i. Low level of savings due largely to non-cultivation of savings habit

28
 ii. Under banked nature of the Nigeria economy

iii. Ignorance like fear of safety of funds in banks due to illiteracy

iv. Diversion of loaned funds

v. Inflation effects on lenders or savers

Lecture Topic: Management of Financial Resources

Introduction: Financial resources refer to as all assets and liabilities available to

business organisations to run its day-to-day operation.

Hints on Prudent Management of Financial Resources

i. Surplus funds / cash must be well invested in other reputable firm’s securities

particularly risk-free ones

ii. All company’s assets must be well insured

iii. Fixed asset register must be well maintained and placed in the custody of a

responsible officer

iv. Diversification

v. Ensure that all securities held by company are well secured

vi. Assets usage must be well monitored

vii. Adequate planning and control of capital expenditure

Note: These above hints are not alternative approaches rather integrative approach.

The Concept of Lending

29
This is the oldest and most technical function of a bank / financial intermediary

Canons of Lending

This include

i. Character: through tracking credit record or status enquiry from other banks

Capability: special skills, experience and exposure in the prospective project.

And legal capacity

ii. Capital: Borrower’s personal stake

iii. Cost: interest rate as it depends on the risk and terms of credit.

iv. Collateral: As an insurance against possible loss on loan, therefore, serving as

secondary source of repayment after primary cash flow.

Country for international lending

Connection is unacceptable as it negates the provision of BOFIA No. 25 of 1991 which

objects lending on filial or sentimental grounds as well as prudential guidelines (which

acts against clean lending)

However, further research adds the following to those above-mentioned factors condition,

purpose, amount, stability, and monitoring and repayment schedule.

Types of Bank Credit

i. Bank credit can take any of the following forms

ii. Overdraft

iii. Personal loan

iv. Bridging Loan: This is mostly found in property deals. This is obtaining loan on

property deal whose source of repayment has been identified as certain. It may be

30
 open or closed. Bridging loans are a short-term funding option, usually required to

‘bridge’ a gap between the purchases of one property and the sale of another.

v. Working capital finance

vi. Capital assets acquisition

vii. Farm Advance or Agricultural credit

viii. Probate advance

Financing local Purchase Order: financing of supply of goods or services by contractors

or merchants – a short term advance and self-liquidating facility. Because of the risk of

diversion of proceeds, financiers insist on confirmation of the orders in advance

Credits to Corporate Organisation; These have been discussed in lecture 2.

Topic: Cash Budgeting

Cash Budgeting: Introduction, Steps in Cash Management, Uses and Preparation

Introduction: A cash budget is a budget or plan of expected cash receipts and

disbursement during the period. A cash budget is an estimation of the cash inflows and

cash outflows for a business over a specific period of time. This budget is used to assess

whether the entity has sufficient cash to operate.

Basic steps of Cash Budgeting

i. Cash planning / cash budget

ii. Managing the cash book

iii. Determining the optimum cash balance

31
 iv. Investing the idle cash / surplus cash

v. Uses of Cash Budgeting

vi. It enables a company to plan expected inflows and outflows during a specified

period of time, usually a year

vii. It helps to identify short and long term cash needs of an organisation

viii. It determines future ability of the business to pay trade payables and other debts

early to take benefit of cash discount

ix. It helps a business to determine how much credit it can extend to its customers

before falling into liquidity problems

x. It ensures that sufficient cash is available when required to fulfil regular

operations

Topic: Illustration on Cash Budgeting

The following information reflects the financial transactions that occurred in Kahlill

Ventures. The opening cash balance as at 1 st January, 2020 was ₦100,000. The sales

budgets were as follows:

December 2019 ₦190,000

January 2020 ₦200,000

February 2020 ₦204,000

March 2020 ₦210,000

The past records show that the debtors settle according to the following pattern 60%

within the month of sales and 40% the month following. Information from the budget on

purchases was as follows:

December 2019 ₦140,000

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January 2020 ₦160,000

February 2020 ₦180,000

March 2020 ₦200,000

All purchases are on credit and creditors are settled 70% in the month of purchase and the

balance the following month. Wages attract ₦80,000 per month and overhead ₦60,000

per month. Tax of ₦40,000will be settled in January 2020 and the firm will receive

settlement of insurance claim of ₦70,000 in February 2020.

Required:

Prepare a Cash Budget for Kahlill Ventures for January and February 2020, showing the

details of your workings.

Kahill&Kahlill Ltd

Statement of Financial Position at 31 December, 2019

2018 2019

₦ ₦ ₦ ₦ ₦ ₦

Fixed assets at cost 12,000 13,200

Less: Depreciation 4,800 5,400

7,200 7,800

Current assets

Stock 1,400 1,300

Debtors 500 400

Cash 300 820

2,200 2,520

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Less: Current Liabilities

Creditors 600 620

Taxation 300 400

Proposed dividend 500 300

1,400 1320

800 1,200

8,000 9,000

Financed by:

Ordinary Share Capital 4,000 4,000

Profit and Loss Account 4,000 5,000

8,000 9,000

Statement of Profit or Loss for the year ended 31 December, 2019

Profit on ordinary activities before taxation (after charging depreciation ₦600) 1,700

Tax on profit on ordinary activities 400

1,300

Undistributed profits from last year 1,500

2,800

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Proposed dividend 300

Undistributed profits carried to next year 2,500

SOLUTION

Kahill&Kahlill Ltd

Cash Flow Statement for the year ended 31 December, 2019

₦ ₦

Net cash flow from operating activities

Net Profit before tax 1,700

Add: Depreciation 600

Decrease in stock 100

Decrease in Debtors 100

Increase in creditors 20

2,520

Net cash flow from investing activities

Payment to acquire fixed assets (1,200)

Net cash flow from financing activities

Dividends paid (500)

Taxation (300)

(800)

Increase in cash and cash equivalents 520

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 Lecture Topic: Financial Analysis Using Ratios

Introduction, Classifications of Ratios, Users of Financial Statement

Measurements

Usefulness of Financial Ratios and Limitations

Financial Analysis

Financial analysis is a process of analysing the financial statement of an organisation

such as corporations as contained in the published annual report. The analysis of

important data from financial statement informs the decision making process of interest

groups in a firm.

Classifications of Ratios

Ratio can be classified into two, namely;

Classification according to the source of data – balance sheet ratios, income statement

ratios; hybrid ratios – ratios derived from both the balance sheet and income statements

Classification according to the different economic aspects of operation – profitability

ratios; efficiency or activity ratios; financial solvency or stability ratios (leverage ratios);

liquidity ratios; investment ratios

36
Profitability ratios: these ratios measure the management overall effectiveness in

generating returns to a company. These involve

Gross Profit Margin or Operations Ratio: This ratio shows the relative efficiency of

the business after taking into consideration sales and cost of sales but before taking into

consideration operating expenses.

PBIT
Gross Profit Margin or Operations Ratio =
Sales

PAIT
Net Profit Margin =
Sales

PAT
Return on Investment =
Total Assets

PBIT
Return on Capital Employed =
Capital Employed

Capital employed = total assets – current liabilities

Capital Employed turnover: This shows the efficiency of utilisation of capital employed

Sales
in generating sales. Formula =
capital Employed

Expense to Sales Ratio: this ratio like a gross profit margin shows where the

improvement or deterioration in a net profit margin has occurred.

Individua l Expense
Formula = ×100
Sales

Total Assets turnover: This ratio shows efficiency of utilisation of total assets in

generating sales

Sales
Formula (times) =
Total Assets

37
Liquidity Ratios: These are ratios used to judge the ability of a firm to meet its short-

term maturing obligations. The ratios under this category include:

Current Assets
Current ratio =
Current Liabilities

Current Assets – Closing Stock

Acid-test or Quick ratio =
Current L iabilities

Cash
Absolutely Liquidity Ratio =
Current Liabilities

Efficiency Ratios – hybrid ratios – these ratios measure how fully the management is

utilising the resources at its disposal. These include:

Average Collection Period (ACP): this shows the average length of time (measured in

days or months or year) in which debts remain uncollected.

Debtors
ACP = ×365 days
Annual Credit Sales

Creditors’ Payment Period (CPP): This ratio shows the average length of time

(measured in days or months or weeks) in which creditors remain unpaid.

Creditors
CPP = ×365 days
Purchases

When information on purchases is not given or available, cost of goods sold can be used

as the denominator

38
Stock Turnover: this ratio is the number of times that inventory is used during a

measurement period (usually a year).

Cost of Goods Sold

Stock Turnover =
Average Stock

Long term Solvency and Stability Ratios

These are ratios concerned with the ability of a company to meet its long term

obligations. Thus, they show the degree of safety of a business from failure in the long

term. These include;

Gearing or Financial Leverage Ratio: this is the relationship between fixed interest capital

(interest bearing long term loans plus fixed dividend bearing shares) and ordinary

shareholders’ fund.

¿ Interst Loans+ Preference Share Capital

Gearing = '
Ordinary Sahreholder s Funds

Ordinary shareholders’ fund (Net Assets Employed) = total assets – CL – TL or

Ordinary shareholders’ fund = ord. Share capital + premium account + reserves +

retained earnings.

A high gearing ratio shows high financial risk.

PBIT
Fixed Interest Cover: Formula =
¿ Interest

Long term debt

Long term debt to Owners Equity =
Owners Equity ¿ ¿

Current Liabilties
Current debt to Equity =
Stockholders Equity

Total Liabilties
Total debt to Equity =
Owners Equity

39
 Debt (Long term debts)
Debt to Capitalisation ratio =
Debt + Equity

Investors’ or Stock Market Ratios

These are ratios used by investors in the Stock Exchange to enable them compare

alternative investments. These include

EPS: This is profit attributable to each equity share, based on the profit for the period

after tax and after deducting minority interests (if it is a consolidated account) and

preference dividends.

PAIT −Preference Dividend

EPS =
Issued Ordinary Shares∈ranking for dividend

Price-Earnings (P/E) Ratio: this is the most important yardstick for assessing the

relative worth of a share. The P/E ratio is a measure of the price paid for a share relative

to the annual net profit earned by the firm per share.

MPS
P/E Ratio =
EPS

Dividend per Share: this ratio shows the dividend and retention policy of the company.

Total Ordinary Dividend

DPS =
Issued Ordinary Shares

Earning Yield: this shows potential return on investment. It is the reciprocal of P/E ratio.

EPS
Earning Yield = × 100
MPS

Dividend Cover: this is the number of times we could pay actual dividends out of

current profits available for distribution.

40
 EPS
Dividend cover =
DPS

Market Capitalisation Value = Market price per share × no. of ord. Shares

Usefulness of Financial Ratios

i. They are useful in identifying problem areas

ii. It create room for comparison of firms at a particular period of time

iii. It allows comparison of company with that of industry

iv. They are used for performance evaluation

v. They allow investors the opportunity of making alternative investment

Limitations of Financial Ratios

i. Differences in accounting method adopted by various organisations

ii. Ratios are based on historical data which may be unsuitable for present situations

iii. Ratios do not show changes in numerator and denominator

iv. If the source of data is faulty, the ratio analysis will be a wasteful exercise.

Topic: Capital Budgeting

Definition

Capital budgeting is the process by which an organisation evaluates and selects long-term

investment projects with the expectation of realising future benefits over a reasonable

long period of time. Capital budgeting process involves:

Project identification

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Project evaluation – based on cost-benefit and comparison with management set

standard

Project selection – particularly where there are generally mutually exclusive projects

begging for allocation of available scarce resources

Project execution That is, the implementation stage

Project monitoring – the goal is to ensure that implementation is on course (not off

track), cost saving and quality driven

Post audit

Characteristics of Capital Budgeting

i. They involve large outlay

ii. The benefits will accrue over a long period of time, usually well over one year and

often much longer, so that the benefits cannot all be set against costs in the current

year’s P&L account

iii. They are risky

iv. They involve irreversible decision

Methods of Appraisal

There are two methods of appraisal

The traditional / conventional method

The modern / discounted cash flow method

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The Traditional / Conventional Method

There are two techniques under this method

The Accounting Rate of Return – ARR

The Payback Period – PBP

The Modern / Discounted Cash flow Method

The two techniques under this method are:

The Net Present Value – NPV

The Internal Rate of Return – IRR

Payback Period

This involves the determination or estimation of years it will take to recover the original

cost of the projects through the earnings of the project. The approach is widely used by

small businesses and rarely in large corporations. Here, the management set a

predetermined standard against which the calculated PBP will be compared.

Decision rule: Accept a project if the calculated PBP is less than or at worst equal to

management’s target or standard PBP. For mutually exclusive projects, accept project

with shorter PBP provided the calculated PBP is less than an organisation’s target PBP.

Example

Question 1 - If a photocopier project costs ₦34,000 and generates ₦15,000; ₦13,000;

₦10,000 and ₦8,000 as cash flows in its four years of operation, what is its PBP?

Question 2 – Chelsea Ltd is considering the following project;

Capital cost of equipment ₦240,000

43
Estimated Life 4 years

Residual Value Nil

Estimated Profits before depreciation:

Year 1 ₦60,000

Year 2 ₦80,000

Year 3 ₦105,000

Year 4 ₦75,000

If the company’s target rate of return is 20%, should the project be accepted? Assuming

the company uses a straight line depreciation method.

Merits of PBP

i. It is simple to use and understand

ii. It is based on cash flows not subjective accounting profits

iii. It is sensitive to scarcity of capital

iv. It provides a clear indication of the time required to convert a risky investment

into a safe one.

Demerits of PBP

i. It ignores time value of money

ii. It does not consider the total profits of a project. In fact, payback period does not

consider the situation after the PBP.

iii. It does not consider the return on capital investment

iv. It is subjective in determining the company’s target PBP.

Accounting Rate of Return (ARR)

44
ARR shows relative profitability of investment in individual projects. This technique is

assessed by calculating the return on investment (ROI) i.e. it is based on Return on

Capital Employed (ROCE).

ARR is entirely an accounting based technique of investment appraisal. It makes use of

accounting concepts of accounting profits and ‘capital employed’ hence it uses

accounting profit instead of economic profit

It can be calculated as follows:

ARR = Estimated total profits/estimated initial investment times 100

ARR = Estimated total profits / estimated average investment times 100

ARR = Estimated average profits / estimated average investment times 100 (this is the

most popular and acceptable formula where the examiner is silent)

ARR = Estimated average profits / estimated initial investment times 100

Average Annual Profit

The most widely used definition of ARR = ×100
Average Investment

Decision Rule

The project will be undertaken if the calculated accounting rate of return is higher than

the target accounting rate of return otherwise it will be rejected.

Merits of ARR

i. It is simple to use

ii. It takes into account total profits throughout the project life span

Demerits of ARR

i. It ignores the time value of money

ii. It ignores the earnings life of the project

iii. Company’s ARR target is subjectively determined

45
Example

Consider D. Drogba Ltd with the following data

Capital investment 400,000

Depreciation 20% p.a

Profit (before depreciation)

Year 1 160,000

Year 2 160,000

Year 3 120,000

Year 4 120,000

Year 5 80,000

Determine the ARR based on (i) Original investment (ii) Average Investment

Topic: Risk and Portfolio Management

Risk is the possibility that the actual return from holding a security will deviate from the

expected return. That is, if the actual return of a security deviates from expectations there

is a risk associated with the return of that security.

Return means gain from holding a security. It is determined as amount received at the end

of the period minus initial amounts invested.

Types of Risk

There are two types of risks in investment analysis, namely;

Systematic risk

Unsystematic risk

46
Systematic risk – this type of risk affects all securities and consequently cannot be

diversified away by any investor. Systematic risk is due to overall market risk such as

changes in the economy, tax reform, exchange rate fluctuations, interest rate fluctuations,

stock market crash, earthquakes, changes in the world energy situation, global deadly

virus (e.g. covid-19).

Unsystematic risk – this type of risk do not affect all securities, by diversification, we

can reduce and even eliminate them with efficient diversification. This risk is normally

caused by internal factors such as bad management, local strike and loss of market. The

type of unsystematic risk includes business risk, financial risk and management risk.

Measurement of Risk

If it is possible to find out the probability of occurrence of possible returns of a security,

then, assessing the risk of the security is possible. The probability distribution in the

assessment of risk can be summarised in terms of two parameters: the expected value and

the variance or standard deviation.

The expected value of returns is given by:

n
E ( Ri ) =∑ Ri P i
i=1

Where E ( Ri ) is the expected value of returns on security i

Ri is the return associated with an event i (or a possibility)

Pi is the probability associated with event i

47
n is the total number of events

The variance of return is given by:

n
σ 2i =∑ {Ri −E ¿ ¿
i=1

The standard deviation is the square root of the variance and is given by:

√∑
n
σ i= {Ri−E ¿¿ ¿
i=1

Illustration

The return on Security P held by Kahlill for a one-year holding period is not certain.

However, the probability of possible returns of security P is given as follows:

Event i Possible Return (%) probability of event

1 20 0.3

2 22 0.6

3 26 0.1

Calculate the expected value and standard deviation of the return of security P.

Investment Portfolio

Portfolio means the collection of various investments that make up an investor’s total

investment. These investments can be in form of holding securities (financial assets),

48
physical assets (e.g. buildings and properties) or capital projects or any combination

thereof.

Modern Portfolio Theory

Modern Portfolio theory was espoused by an American economist named Harry

Markowitz in 1952. The originator proposed the theory as a means to create and construct

a portfolio of assets to maximize returns within a given level of risk, or to devise a

portfolio with a desired, specified and expected level of return with the least amount of

risk. The idea is to eliminate idiosyncratic risk or the inherent with the least amount of

risk.

Expected Return of a Portfolio

The expected return of a portfolio is simply the weighted average of the expected returns

of the constituent securities. The expected return of the portfolio is given by:
n
E ( R p ) =∑ w j E(R) j
i=1

Where E ( R p ) = expected return on Portfolio P

w j = proportion of portfolio funds invested in security j

E(R) j = expected return on security j

n = number of events; i = individual event

Illustration on Portfolio Theory

Mr. Kahlill, a son of Finance Lecturer and an investor in The Nigeria Stock Exchange

was advised by his father not to put all his money on one investment. As a result, Mr.

49
Kahlill combines a portfolio which consists of 60% in Shell BP shares and 40% in GSK

PLX shares. The random returns of the two securities are given as follows:

Event Probability Return on Shell Shares Return on GSK Shares

1 0.3 25% 16%

2 0.5 20% 17%

3 0.2 17% 18%

You are required to calculate expected return on Mr. Kahlill’s Portfolio

50