FINANCIAL
INSTITUTIONS AND FINANCIAL MANAGEMENT
Moses Olayinka
A
chapter in “READINGS IN CORPORATE FINANCE”
Published
by the Department of Accounting,
Faculty
of Management Sciences,
University
of Jos,
Jos-
Nigeria.
©2008
ISBN:
978-166-869-5
CHAPTER ELEVEN
FINANCIAL
INSTITUTIONS AND FINANCIAL MANAGEMENT
Moses Olayinka
Introduction
Managing Finance
in a company is not an easy task. If the cost of borrowing gets out of
proportion to the benefits of using borrowed funds, the firm stands the risk of
running at a loss. If on the other hand, the equity cost and requirement outweighs
borrowed funds then the unwanted condition of high capital cost exits. To
create a positive balance between equity capital and borrowed capital there is
the need to study the relationship between sources of funds, providers of such
funds and managers of the funds.
The assets of a
company can be financed either by increasing the owners’ claims or the
creditors’ claims (Pandey 2005:289). The owners’ claims usually increase
through the issue of shares or by retaining the earnings of the company; creditors’
claim increases simply by borrowing. The general ways of financing in a company
represents the financial structure of a firm and this is the central issue in
financial management.
Effective
Financial Management is especially important in today’s business environment.
In order to survive, an organization must be able to compete. In order to
compete, firms will need to have cash available for growth, advertising,
research and development of new products and ideas. In order to have cash
available, a company needs to build a strong and profitable capital structure,
through sound financial management. The activities of financial institutions
have a direct impact on the capital generation, application and overall profit
of an enterprise.
Financial Institutions
Financial
institutions are those organizations, or companies that are involved in
providing various types of financial services to their clients. These services
range from the collection of deposit to the provision of funds. In financial
economics, a financial institution
acts as an agent that provides pecuniary services to its clients or members.
These institutions provide intermediary services in the capital and money
markets. They are responsible for transferring funds from investors to companies
and entrepreneurs in need of funds. Their presence facilitates the flow of
funds in an economy.
Financial
institutions generally fall under financial regulations delineated by a government
or its agent. In Nigeria, The Banks and
other Financial Institutions Act (BOFIA) 1991, Laws of the Federation of Nigeria, provide the regulatory laws governing
the activities of financial institutions. Thus, it can be concluded that
a financial institution is that type of
institution, which performs the collection of funds from investors and surplus
owners to those in need of funds.
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In Nigeria, the
number of registered and functional financial institutions as at 2006,
according to the Central Bank of Nigeria, was 1467 in all. The list is made up
of:
24 Depository Money banks (commercial and Universal),
5 Discount Houses,
5 Development Finance Institutions,
610 Bureau dé Changé,
93 Primary Mortgage Institutions,
76 Finance Companies, and
654 Micro-Finance Institutions
Other financial
institutions operating in the country include Pension Fund Administrators (PFA)
and The Security and Exchange Commission (SEC)
Functions of financial institutions
Financial
institutions, which are immensely important to the smooth running of an
economy, have certain functions which accentuate their importance in the
society. These functions are best described by the role they play in the
economy.
A prominent
function of financial institutions is the transformation of assets, which are
acquired through markets, into a wider and more preferable form, which becomes
their liability– this function is performed mainly through financial
intermediation in money markets and security markets. Thus, the principal
function of financial institutions is to collect funds from investors and
savers and direct the funds to those in need of the funds.
Financial
institutions are also involved in exchanging of assets on behalf of their
customers and exchanging assets for their own personal account.
Furthermore,
these institutions create financial assets for their customers and sell those
assets to other market participants for a definite emolument.
They assist
their clients and investors to maximize profits by rendering investment advice
and managing their portfolios.
Financial
institutions also undertake a wide range of educational programmes to educate
investors on the fundamentals of investment and also regarding the valuation of
stock, bonds, assets, foreign exchanges, and commodities.
In addition to
all these functions some of the financial institutions also deal with various
economic activities associated with bonds, debentures, stocks, loans, risk
diversification, insurance, hedging, retirement planning, investment, portfolio
management, and many other types of related functions. With the help of their
functions, financial institutions transfer money or funds to various tiers of
economy and thus play a significant role in the domestic and the international
economic arena. In carrying out their business operations, financial
institutions use different types of economic models.
The Concept of Financial Management
Finance is one
of the most important aspects of business management. Without proper financial
planning a new enterprise is unlikely to be successful. Managing money (a
liquid asset) is essential to ensure a secure future, for an organization.
Equity financing mixed with the sale of bonds (or any other debt financing) is
called capital structure.
Jones (Jr.) and
Dudley (1978:15) in Okwoli and Kpelai (2006:1) define finance as:
“the issuance of, the
distribution of, and the purchase of liability and equity claims issued for the
purpose of generating
revenue-producing assets”.
Finance deals
with ways in which individuals, businesses, and organizations raise, allocate,
and use monetary resources over time, taking into account the risks entailed in
their projects. The term "finance" incorporates the following:
The study of money and other assets;
The management and control of
those assets;
Profiling and managing project
risks;
The science of managing money;
It follows
therefore, that the activity of finance is the application of a set of
accounting techniques that individuals and organizations (entities) use to
manage their money, particularly the differences between income and expenditure
and the risks of their investments. Finance is used by individuals (personal
finance), by governments (public finance), by businesses (corporate finance),
as well as by a wide variety of organizations including schools and non-profit
organizations. In general, the goals of each of the activities are achieved
through the use of appropriate financial instruments, with consideration to
financial institutional setting.
Financial Management – Delineated
Until about 1890
the study of financial management was treated as a branch of economics. Though
without much unique literature, its quantitative body of knowledge is drawn
from economic theories and applications. Financial management is of great
interest to managers, investors and academicians at large. To the practicing
manager, understanding finance is an inevitable requirement for success. Among
the most important reasons for this knowledge is the conceptual and analytical
edge it guarantees; if diligent application of its principles and practices are
employed.
Pandey (2006:3)
considers financial management as that managerial activity which is concerned
with the planning, and controlling of the firm’s financial resources.
In Okwoli and
Kpelai (2006:3), J. M. Scott defined financial management as “an analytical
process which involves an assessment of the future, determination of the
desired objectives in the context of the future, the development of alternative
courses of action to achieve such objectives, and the selection of a course or
courses from among these alternatives”
On the overall,
all capital employed in the running of the day-to-day business of a firm are
either those of the firm or sourced from outsiders. The core of financial
management revolves on the proper planning, organizing, controlling and
directing of funds, with due consideration to cost and profitability of the
enterprise.
Financial Functions
The basic
finance functions of any firm include;
- Investment decisions;
- Financing Decisions and
- Dividend decisions
Investment Decisions
The central
point of any managerial role is normally on the nature and type of investment
to commit the firm’s resources to. Two important aspects of investment decision
are;
i.
Evaluation of the profitability
of a new investment:
Investment
decision is capital in nature; therefore requires a thorough assessment of risk
involved in the investment due to uncertainty. Hence, profitability of new
projects should be determined in terms of both expected returns and risk
involved; and
ii.
Measurement of the cut-off rate:
The cut-off rate
of investment implies the required level of return for the investment; it is
the expected return or profit an investor desires for the investment. It is the
opportunity cost of capital on the investment.
Financing Decisions
Once a decision
to invest has been set, the next profound issue becomes that of determining the
source, time and how to acquire the funds required for the execution of the
investment plans. Practically, the deciding factors are what portion of owners
(equity) capital and debt (creditors) capital is needed to give a balanced mix.
The intricate task here is obtaining the best financial mix that is considered
the “optimum capital structure”.
Dividend Decisions
For investing in
the company, owners (shareholders) deserve some reward. The function of
Financial Management is incomplete until providers of capital are fittingly
pleased. The decision to distribute all the profit, retain part or share a
portion of it is carried out at this level of decision point. A Dividend payout
ratio and retention ratio are called to play here. The former is the proportion
of profit distributed and the latter is the portion of profit kept for future
redistribution or investment.
The Cost of Capital
The cost of
capital is the rate of return that accrues to capital. It is the rate of return
which a firm must give to the suppliers of finance for using their money. The
cost of capital also implies the opportunity cost of capital for a project. The
Structure for the execution of a firm’s business usually consists of one or
more of the following capital components;
i.
Equity share capital;
ii.
Preferences share capital;
iii.
Retained earnings, and
iv.
Debts
The capital
structure of a company can be considered in terms of components (i.e. specific
cost of capital) or overall (i.e. average) cost of capital. The Specific or Component cost of capital is considered on the individual source of
the capital: These components are combined according to the weight of each
component to obtain the average cost.
The combined cost of all sources of capital is referred to as overall or average cost of capital; hence the overall cost is also called the Weighted Average Cost of Capital (WACC).
Determination of Capital Cost
The parts of
capital can be determined separately, using mathematical formulae. On a general
note the cost of capital is denoted as Ko. We can
consider the components’ cost implication using mathematical method to
determine such cost.
Cost of Equity Share Capital
The equity
capital of a company is defined as the issued ordinary shares of the company.
Equity has no explicit cost, as payment of dividends is not obligatory, though
this does not make it cost free as affirmed by some authors. It involves cost
of a foregone alternative. It confers the right of ownership to holders,
thereby reducing the risk attached to external borrowing, since it is a long
term capital with slim or no maturity date involved.
The opportunity
cost of equity is the rate of return required by shareholders on securities of
comparable risk. Thus, it is a price, which the company must pay to attract
capital from shareholders. In practice, shareholders expect to receive
dividends and capital gains. Therefore, the cost of equity can be thought to
include expected dividend yield and percentage capital gain. The
computation of the cost of equity capital is the direct function of dividend
payable on the equity capital and the market price per share, including the
issue cost. This capital cost is denoted as Ke and is measurable in
three ways depending on some variables available.
i.
Cost of Equity capital where
there is no cost of issue and Dividend per share remains constant, can be
calculated using the following formula:
Ke. = Div x 100%
P ….
(1)
Where; Ke = cost of equity capital
Div = Annual Dividend per share
P = Market Price Per share.
ii.
Cost of Equity capital where
there is cost of issue (i.e. the real life situation) is calculated using:
Ke. = Div
x 100%
P-C ….
(2)
Where; Ke = cost of equity capital
Div = Annual Dividend per share
P = Market Price Per share.
C = Issue Cost.
iii.
Cost of Equity capital where
issue cost exists but shares are issued at a discount; is calculated with the
formula:
Ke. = ___Div___
X 100%
P- (C + d) …. (3)
Where: Ke =
cost of equity capital
Div = Annual Dividend per share
P = Market Price Per share.
C = Issue Cost.
D = Discount on the share.
Illustration
1
Kensteve Nigeria
Plc. Has the following information:
Dividend per share 0. 11
Market price per share 2. 93
Issue costs Nil
Required:
calculate equity cost of capital.
Solution
Using formula
(1);
Ke. = Div
= 0.
11 x 100%
P 2.
93
= 3.75%
Illustration
2
Interfin
International has the following data;
Dividend per share 0. 11
Market price per share 2. 93
Issue costs 0. 05
Solution
Using formula
(2);
Ke. = Div
= 0.
11 x 100%
P-C
2. 93- 0.05
= 3.82%
Illustration
3
Using the
following financial information of Ifeoluwapo Nig. Plc., determine the cost of
equity;
Dividend per share 0. 11
Market price per share 2. 93
Issue costs 0. 05
Right Price share 2. 43
Solution
Using formula
(3);
Ke. = ___Div___ x 100%
P- (C + d)
= 0.11
x 100%
2. 93-(0.05+0.50*)
= 4.
62%
Note: * is
obtained by subtracting 2.43 from 2.93 which represent the discount on the
issue.
THE GORDON’S THEORY
In all the three
situations above, the assumption is that the dividend per share is constant
from year to year. However, problems in computation may arise where dividend
rate is not constant. An easy way out is the application of M. J. Gordon’s
formula given as;
P-
Issue Cost …
(4)
Where; Div. 1 = dividend rate of
the first year
P = Market
Price per share
g = Annual growth rate.
Illustration
4
Let us apply
this formula using the following data extracted from the Egegwu Limited N
Market price per share 10:00
Issue costs per 2:00
Dividends per share: Year 1 1:00
Year
2 1.10
Year
3 1.21
Year
4 1.33
To calculate the
cost of equity capital (Ke.), we need to analyze the growth between
each two successive years as follows:
Year 2 dividend 1:10
Less Year 1 dividend 1:00
0.10
= 0.10 x 100
100
= 10%
Year 3 dividend 1: 21
Less Year 2 dividend 1:
10
0:
11
= 0. 11 x 100
1.
10
= 10%
Year 4 dividend 1: 33
Less Year 3 dividend 1:
21
0.
12
= 0. 12 x 100
1.
21
10%
It therefore
follows that the annual growth rate in dividend in the company is 10%.
Now we can
calculate:
Ke. = Div 1 + g%
P-
Issue Cost
= 1:00 x 100 + 10%
10:00-
2:00
= 12.5% + 10%
= 22.5%
Cost of Preference Share Capital
The cost of
preference shares is a direct function of the coupon rate and the cost of
issue. Although it is not legally binding upon firms to pay dividends on
preference share capital, it is generally paid when sufficient profit is made
by the firm or the terms of the issue confer both ordinary and preference
shares right to the preference shareholder. Preference share cost of capital
denoted as KP is calculated using the below formula:
KP = Div.
P-(C+d)
Where; KP = preference
share cost of capital
Div = Fixed
dividend payable
P = Market
Price per share
(C+d) = issue
cost + discount on share price.
Illustration
5
The following
situation exists for Nandel Company Limited
Price per shares 2:50
Issue costs 0.50
Discount 0.05
Dividend (fixed
coupon rate) 15%
Required;
Calculate the
cost of preference share capital
Solution
KP = Div.
= 0. 15 x 100%
P-(C+d) 2.50-(0.50+0.05)
= 7.7%
Capital Cost of Retained Earnings
Retained
earnings are the unappropriated profits of a company.
Illustration
6
The cost of
Moslag Automobile retained capital can be calculated given the following data;
Retained
earnings N1, 000
Withholding tax 100%
Cost of capital 10%
However, it is
worth noting here that in the absence of withholding tax, the cost of retained
earnings will be the same with the cost of equity. In this case the retained
earnings will be different:
Gross retained
earnings 1,000
Less withholding
tax (1000x10%) 100
900:00
Therefore, the
cost of equity portion of retained earnings is
10 x 900
100
= N90:00
Cost of retained
earnings
= 90 x 100%
1000
= 9%
Capital Cost of
Debts
A company may
raise debt in a number of ways. It may borrow from financial institutions as we
are considering in this case or from the public in the form of public deposits
or debentures (bonds) for a specific period at a fixed interest rate. Without
taking into consideration the effects of taxation, the cost of debt is simply
the stated interest rate on the instrument. In this case cost of debt denoted
as Kd. can be calculated as thus:
Kd. = Interest x 100
P-(C+d) …
(5)
Where; interest = fixed
interest rate on the instrument
P = Market
price of share
(C+d) = issue
cost + discount.
Note: this
formula is applicable only where corporation Tax is not taken into account.
When Corporation
Tax is taken into consideration the cost of debt will be calculated using the
formula below:
Kd. = Int.
(1-T) x 100
P-(C+d)
Where; Int. = fixed interest rate on the instrument
1 = A whole
number
T = corporation
Tax
P = Market
price of share
(C+d) = issue
cost + discount on issue
Illustration
7
Tine Plc. has
the following data:
12% debentures N1, 000, 000 of N1:00 each
Corporation tax 30%
Discount 2%
Issue cost N0.02k
Solution
Calculating the
cost of debt will prove thus:
Kd. = 0.12
(1- 0.30) x 100%
1:00-
(0.02+0.02)
= 8.75%
The Overall or Weighted Average Cost of Capital (WACC)
In all the
specific or component computations above, the cost of the firm’s capital
remained on an individual level. The overall cost of capital denoted as Ko
is the weighted mean of the costs of all the parts of a company’s capital
structure.
Illustration
8
Determine the
overall cost of capital for Johnson Company, given the following details:
Structure Amount
Cost
Ordinary shares 2, 000 15
Retained earnings 500 15
12% Preference shares 1000 13
10% debentures 500 9
Solution:
Class Amount Proportion Cost Weighted
Ordinary shares 2000 0.500 0.15 0.075 00
Retained
Earnings 500 0.125 0.15 0.01875
12% Pref. shares 1000 0.250 0.13 0.03250
10% debentures 500 0.125 0.09 0.01125
4000 1.000 0.13750
The
determination of the proportion of each component of the capital structure out
of the total capital is obtained as:
Ordinary shares 2, 000
4,
000 = 0.500
Retained earnings 500
4,
000 = 0.125
12% Preference
shares 1,000
4,
000 = 0.250
10% debentures 500
4,
000 = 0.125
The cost of
capital of the company is (0.1375 x 100%), which is 13.75%. The implication of this is that any business
venture the company will engage in must yield a return of 13.75% and above to
be profitable to the firm.
The Incremental Cost of Capital
The incremental
cost of capital also called the marginal cost of capital refers to the
additional cost of capital resulting from financing additional investment or
capital project. The source of this capital as we have stated earlier on can be
equity (i.e. owners’) capital or Debt (i.e. borrowed fund). The essence of this
is to calculate the effect of funds sourced at specific rates from within or
outside the firm.
Illustration
9
The existing
capital structure of Shatong Limited is given below;
Structure Market Value Cost
Equity 12,
000, 0000 15
Debts 2,
000, 0000 10
A new project of N 4, 000, 000 has been identified for the
company. The project could be financed by issue of new ordinary shares or 10%
of Debt. If financed by equity the shareholders will demand an additional 5%
rise in their investment.
Solution:
To determine
which mix should be the best, we need to analyze all scenarios.
First
consideration is the capital structure and the cost of capital:
Type Amount Proportion Cost
Weighted Average
Equity 12,
000 0.857 0.15 0.1286
Debts 2,
000 0.143 0.10 0.0143
14, 000 1.000 0.1429
Ko = 0.1429
x 100%
= 14.29%
Now let us
consider the situation when equity capital is used to finance the new project.
Financing By
Equity:
Type Amount Proportion Cost
Weighted Average
Equity 16,
000 0.889 0.15 0.1334
Debts 2,
000
0.111 0.10 0.0111
18, 000
1.000 0.1445
Ko
= 0.1445 x 100%
= 14.45%
Additional
Cost
Capital Amount Cost
Cost
New 18, 000 14.45 18,
000 x 0.1445 = 2, 601
Original (14, 000) 14.29 14,
000 x 0.1429 = (2, 000.6)
4, 000 600.40
Therefore
Additional cost rate = 600.40 x 100%
4,
000
= 15%
When financed by
Debt at the 10%, the following is the result;
Type Amount Proportion Cost Weighted Average
Equity 12,
000 0.667 0.20 0.1334
Debts 6,
000 0.333 0.10 0.0333
18, 000 1.000 0.1667
Ko = 0.1667
x 100%
= 16.67%
Additional
Cost
Capital Amount Cost
Cost
New 18, 000 16.67 18,
000 x 0.1667 = 3, 000.6
Original (14, 000) 14.29 14,
000 x 0.1429 = (2, 000.6)
4, 000 1,
000
Therefore
Additional cost rate = 1, 000 x 100%
4,
000
= 25%
Decision
From this
hypothetical illustration, it is clear that the cost of borrowing is obviously
higher than equity financing by 10%. In this case the best option for the firm
is to finance the new project using equity at the rate of 10%.
Conclusion and Recommendations
As providers of
capital aid the activities of businesses, the financial manager must be able to
determine the cost at which borrowed funds can be paid and profit made by the
firm. The optimum capital structure is a balance that good financial managers
can achieve, using all the available data.
Financial Institutions as we have seen
provide funds to bridge the gap between the deficit investment plans of
firms and for using such funds from the surplus sector, the firm is required to
pay in most cases high interest rates. It then follows that the value at which
a firm can borrow must be below the overall cost of capital or Weighted Average
Cost of Capital of the firm. However, where additional finance is required in
the form of Incremental capital to execute a new project or complete an
on-going project, a more analytical decision requirement should be employed.
As we look at
the beneficial roles of Financial Institutions in financing the projects of
firms, we must keep in mind also the profitability threats of the debt
financing with particular emphasis on Nigeria where lending rate from
institutional firms are slightly on the high side, particularly when juxtaposed
with those of other western or developed economies. In the last 10 years,
lending rate has been in the double digits, fluctuating amid 16.5% to 21.5%
depending on the financial institution. It is most favourable however, to raise
funds from specialized institutions in the relevant industry; this offers a
cheaper cost of capital when compared with the general lending rates.
In all we must
admit that the role of financial institution in the area of fund provision to
firms has been of great positive impact to the entire economy at large.
TUTORIAL QUESTIONS
1. E. Jimson
Limited is an automobile servicing company; it desires to achieve an overall
capital cost of 15% or less, based on the prevailing trends in the automobile
industry. In broad terms the average company in the industry is 42% financed by
debt and 58% equity financed, the following information is available from the
company to aid the decision for optimum capital structure of the firm.
The various
sources of fund considered for the financing of the company are:
Equity (ordinary
Shares):
1, 600, 0000
ordinary shares of N1:00 each. The dividend expected from the investment in the
share in one year’s time is N 1:30,
based on an annual growth rate of 2% per annum and a market price of N 10:00
Preference
Shares:
5% 5,000,000
Preference Shares of N 1:00 and market
price of N0. 625
Debts;
8% corporate
debts with a nominal value of N 4, 500,
000 and a market value of N 4,000,000.
Bank overdraft
of N 680, 000
Trade and other
short term creditors N 2, 150, 0000
Required:
Calculate
weighted Average cost of capital of the company.
What will be the
additional cost of capital rate, if a new project costing N 2, 000, 000 is financed through
debenture of 10%?
2. Financial
Institutions aid the smooth flow of funds within an economy. Using a recent
record of lending rate, explain how firms have benefited from the provisions of
these institutions.
3. Describe the
concept of “Optimum Capital Structure”
References
Ajemba J. F.
(2006): Mixed Reactions Trail CBN’s New Rate Policy.
The Nigerian
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Financial Institution Act (1991): Laws of the
Federation of Nigeria. Retrieved 3rd of March 2008, from http://www.nigerialaw.org/ConstitutionOfTheFederalRepublicOfNigeria.htm
Brealey and
Myers (1996): Principles of Corporate Finance. McGraw-
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Jones J. and
Dudley E. S. (1978): Basic Managerial Finance, Halt
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America.
Kannan R.
(2008): Financial Services and Financial Management-
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Faculty of Social Sciences, University of Jos, Jos Nigeria.
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(2005); Financial Management, Ninth edition, Vikas
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India
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