B.F. by S.K As at 5 May 2005

ii Acknowledgement
ACKNOWLEDGEMENT
We gratefully acknowledge permission to quote from the past examination papers of the
following bodies: Kenya Accountants and Secretaries National Eamination !oard
"KASNE!#$ C%artered &nstitute o' Management Accountants "C&MA#$ Association
o' C%artered Certi'ied Accountants "ACCA#(
We also wish to express our sincere gratitude and deep appreciation to Mr( Geo''rey
Ngene M!A) !(COM "*inance#) C+A "'inalist#) C*A "East A'rica#( He is a senior
lecturer at Strathmore University, School of ccountancy! He has generously given his
time and expertise and skilfully co"ordinated the detailed effort of reviewing this study
pack!
ST,AT-MO,E .N&/E,S&T0 1 ST.D0 +ACK
&nstruction 'or Student iii
&NST,.CT&ON *O, ST.DENTS
#his study guide is intended to assist distance"learning students in their independent studies! $n
addition, it is only for the personal use of the purchaser, see copyright clause! #he course has
been broken down into eight lessons each of which should be considered as approximately one
week of study for a full time student! Solve the reinforcement problems verifying your answer
with the suggested solution contained at the back of the distance learning pack! When the
lesson is completed, repeat the same procedure for each of the following lessons!
t the end of lessons %, &, ' and ( there is a comprehensive assignment that you should
complete and submit for marking to the distance learning administrator!
S.!M&SS&ON +,OCED.,E
)! fter you have completed a comprehensive assignment clearly identify each question
and number your pages!
%! $f you do not understand a portion of the course content or an assignment question
indicate this in your answer so that your marker can respond to your problem areas! *e
as specific as possible!
+! rrange the order of your pages by question number and fix them securely to the data
sheet provided! dequate postage must be affixed to the envelope!
&! While waiting for your assignment to be marked and returned to you, continue to work
through the next two lessons and the corresponding reinforcement problems and
comprehensive assignment!
,n the completion of the last comprehensive assignment a two"week period of revision should
be carried out of the whole course using the material in the revision section of the study pack!
t the completion of this period the final -ock .xamination paper should be completed under
examination conditions! #his should be sent to the distance"learning administrator to arrive in
/airobi at least five weeks before the date of your sitting the 0S/.* .xaminations! #his
paper will be marked and posted back to you within two weeks of receipt by the 1istance
2earning dministrator
!.S&NESS *&NANCE
i2
CONTENTS
ACKNOWLEDGEMENT((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((ii
&NST,.CT&ON *O, ST.DENTS((((((((((((((((((((((((((((((((((((((((((((((((((((((((((iii
CONTENTS((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((i2
!.S&NESS *&NANCE CO.,SE DES,&+T&ON(((((((((((((((((((((((((((((((((((((2
!.S&NESS *&NANCE &NDE3(((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((2i
LESSON ONE(((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((4
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57$#2 S#3U5#U3. /1 5,S# ,4 4U/1S!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!'9
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57$#2 $/:.S#-./# 1.5$S$,/S!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!;)
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1$:$1./1 7,2$5$.S /1 1.5$S$,/S!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!)%(
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LESSON TEN((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((499
3.:$S$,/ $1!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!);;
!usiness *inance Course Descri<tion 2
!.S&NESS *&NANCE CO.,SE DES,&+T&ON
*usiness 4inance is an introductory course in finance a pre"requisite for financial -anagement
of section six finance managers makes four crucial decisions of the firm
4inancing decision concened with the sources of funds, cost of capital, mix of various
capital components and evaluation of capital markets for long and short term financing
$nvestment in long"term investment decisions involving derivation of future cashflows
and appraising pro=ects and how securities of the firm may be valued
Working capital management which involves management of current assets to meet
short termliquidity needs of the firm
1ivisions of earnings between payment of dividends and retention for the purpose of
financing future pro=ects!
*usiness 4inance course explore these four main decisions under conditions of certainty this is
in addition to evaluating the performance of the firm using ratio analysis !*asic tools of finance
are also introduced at this level!
#he overall place of the course in 5!7! Syllabus is a bridge between accounting and 4inance
functions within the organi>ation before critical evaluation of finance under condition of
uncertainty in financial management!
$t also gives an overview of how various stakeholders of the firm have divergent ob=ectives
which impact on the goal of shareholders wealth maxmisation this is covered
Under agency theory!
!.S&NESS *&NANCE
2i !usiness *inance &nde
!.S&NESS *&NANCE &NDE3
2.SS,/ ): /ature of *usiness 4inance
3einforcing ?uestions
2.SS,/ %: Sources of 4unds
5omprehensive ssignment )
2.SS,/ +: -easuring *usiness 7erformance: 4inancial Statements nalysis
2.SS,/ &: 5apital Structure and 5ost of 4unds
5omprehensive ssignment %
2.SS,/ 9: 5apital $nvestment 1ecisions
2.SS,/ ': :aluation 5oncepts in 4inance
2.SS,/ <: 1ividend 7olicies and 1ecisions
5omprehensive ssignment +
2.SS,/ (: Working 5apital -anagement
2.SS,/ ;: -arket for 4unds
5omprehensive ssignment &
2.SS,/ )@: 3evision id: 0S/.* Syllabus! -odel answers to reinforcing questions!
Selected
past papers with model answers! Work through model answers ensuring they are
understood! ,n completion submit final assignment to the University!
*&NAL ASS&GNMENT
-ock .xamination 7aper
Lesson One 4
LESSON ONE
NAT.,E O* !.S&NESS *&NANCE
&NST,.CT&ONS
3ead 5hapter ) of 4inancial -anagement textbook by $!-! 7andey!
5omplete answers to rein'orcement questions at the end of the lesson!
5heck model answers given in lesson )@ of the study pack!
3einforcing 5omments
CONTENTS
3elationship between business finance and financial management!
Scope of 4inance functions!
6oalsA,b=ectives of the firm!
gency theory!
3isk"return #rade off!
#ypes of business organi>ation
!.S&NESS *&NANCE
5 Nature o' !usiness *inance
,ELAT&ONS-&+ !ETWEEN !.S&NESS *&NANCE AND *&NANC&AL
MANAGEMENT
DE*&N&T&ON=
*usiness finance is the process by which a financial managerAaccountant provides finance for
business use as and when it is needed! #his provision has to be undertaken on the basis of the
needs of a company! ,n the other hand, 4inancial -anagement is a branch of economies
concerned with the generation and allocation of scarce resources to the most efficient user
within the economy Bor the firmC! #he allocation of these resources is done through a market
pricing system! firm requires resources in form of funds raised from investors! #he funds
must be allocated within the organisation to pro=ects that will yield the highest return!
4( Needs Conse>uent on t%e O<erations o' a Com<any "!asic Needs#
#hese have to be financed in so far as they arise out of the companyDs operations e!g! salaries!
5( S%ortages o' Cas% !roug%t A?out !y .n'oreseea?le Circumstances E(G Non
+ayment !y De?tors
#hese needs have to be financed by short term finances e!g! overdrafts, but this may be
against financial prudence rather such needs should be financed by revolving finances in the
circular flow! However, the financial manager must manage his finances using such tools as:
5ash budget E statement of expected receipts and payments over a pro=ected period
of time E a forecast!
4unds flow statement E BctualC!
:ariance between actual funds flow with cash budget! #he variance must be managed to
keep the company liquid! ,n the other hand a financial manager has to meet the companyDs
strategicAlong term needs Blong term investmentC are useful to the company because:
)! $t influences the company si>e BassetsC
%! $t influences its growth Bplough backC
+! 4inances incidental needs!
&! $t influences the companyDs long"term survival E this is through continuous
investment!
#hese investments will call for long term financing in form of owners finance B,rdinary
Share 5apital and 3evenue reservesC! #his is a base on which other finances are raised! #he
company will also use external financing e!g! debts, loans, debentures, mortgages, lease
finance etc! #hese finances have to be used in acceptableAreasonable financial mix! #his
implies that the companyDs gearing level is kept low i!e! the relationship between owners and
creditors finance! #his should be below '<F otherwise the company may be forced into
receivership and subsequently liquidation! .ven then, when using creditors finances a
company must consider:
)! #hat cost of finance is less than the 3eturn which implies the rate should not be less
than the bank interest G inflation G risk!
Lesson One @
%! .conomic conditions prevailing E use debt under boom conditions!
+! 7resent gearing E if high this will lead to:
&! 2ow credit rating
9! 2owering of the companyDs share prices especially to less than 7ar value E this leads
to mass sale of shares E creditors rush to draw their finances and therefore
receivership!
'! 2ong term ventures have to call for independent feasibility studies before funds are
committed i!e!
<! ssessment of the return E at least should be greater than minimum return G risk G
inflation!
(! .conomic life E if uncertain, the return ought to be higher! Such life must allow the
company to pay off the loan!
#he financial manager must be guided by principles of financial prudence i!e!
)! He has to consult experts!
%! He has to involve investment committee
+! He has to ascertain whether everyone involved in the implementation of the venture
has not been left out either during the planning phase or implementation phase!
SCO+E O* *&NANCE *.NCT&ONS
#he functions of 4inancial -anager can broadly be divided into two: #he 3outine functions
and the
-anagerial 4unctions!
Managerial *inance *unctions
3equire skilful planning, control and execution of financial activities! #here are four
important managerial finance functions! #hese are:
a# &n2estment o' LongAterm assetAmi decisions
#hese decisions Balso referred to as capital budgeting decisionsC relates to the allocation of
funds among investment pro=ects! #hey refer to the firmDs decision to commit current funds
to the purchase of fixed assets in expectation of future cash inflows from these pro=ects!
$nvestment proposals are evaluated in terms of both risk and expected return!
$nvestment decisions also relates to recommitting funds when an old asset becomes less
productive! #his is referred to as replacement decision!
?# *inancing decisions
4inancing decision refers to the decision on the sources of funds to finance investment
pro=ects! #he finance manager must decide the proportion of equity and debt! #he mix of
debt and equity affects the firmDs cost of financing as well as the financial risk! #his will
further be discussed under the risk return trade"off!
c# Di2ision o' earnings decision
#he finance manager must decide whether the firm should distribute all profits to the
shareholders, retain them, or distribute a portion and retain a portion! #he earnings must also
!.S&NESS *&NANCE
be distributed to other providers of funds such as preference shareholder, and debt providers
of funds such as preference shareholders and debt providers! #he firmDs dividend policy may
influence the determination of the value of the firm and therefore the finance manager must
decide the optimum dividend E payout ratio so as to maximise the value of the firm!
d# Li>uidity decision
#he firmDs liquidity refers to its ability to meet its current obligations as and when they fall
due! $t can also be referred to as current assets management! $nvestment in current assets
affects the firmDs liquidity, profitability and risk! #he more current assets a firm has, the
more liquid it is! #his implies that the firm has a lower risk of becoming insolvent but since
current assets are non"earning assets the profitability of the firm will be low! #he converse
will hold true!
#he finance manager should develop sound techniques of managing current assets to ensure
that neither insufficient nor unnecessary funds are invested in current assets!
,outine 'unctions
4or the effective execution of the managerial finance functions, routine functions have to be
performed! #hese decisions concern procedures and systems and involve a lot of paper work
and time! $n most cases these decisions are delegated to =unior staff in the organi>ation!
Some of the important routine functions are:
aC Supervision of cash receipts and payments
bC Safeguarding of cash balance
cC 5ustody and safeguarding of important documents
dC 3ecord keeping and reporting
#he finance manager will be involved with the managerial functions while the routine
functions will be carried out by =unior staff in the firm! He must however, supervise the
activities of these =unior staff!
T-E O!BECT&/ESCGOALS O* A !.S&NESS
4! +ro'it maimiDation E #his is a traditional and a cardinal ob=ective of a business! #his is
so for the following reasons:
#o earn acceptable returns to its owners! (i.e. Must not be less than bank rates +
inflation + risk)
So as to survive Bthrough plough backsC
#o meet its day to day obligations!
5! To maimiDe t%e net wort% i!e! the difference between total assets and total liabilities!
#his is important because:
$t influences companyDs share prices!
$t facilitates growth Bplough backsC!
$t boosts the companyDs credit rating!
Lesson One 8
#his is what owners claim from the company!
@( To maimiDe wel'are o' em<loyees E Happy employees will contribute to the
profitability! #his includes:
3easonable salaries
#ransport facilities
-edical facilities for the employee and his family
3ecreation facilities Bsporting facilitiesC!
6( &nterests o' customers E the company has to provide quality goods at fair prices and have
honest dealings with customers!
8( Wel'are o' t%e society E the company has to maintain sound industrial relations with the
society:
void pollution
5ontribution to social causes e!g! Harambee contributions, building clinics etc!
7( *air dealing wit% su<<liers! company must:
-eet its obligations on time

void dishonor of obligations!
:( Duty to t%e go2ernment: company should:
7ay taxes promptly
6o by government plans
,perate within legal framework!
O/E,LA+S AND CON*L&CTS
,verlaps E when achieving ,/. -./S achieving the other
5onflicts E when achieving ,/. 5//,# allow the achievement of the other!
O2erla<s
/os! & H 9 E Some of the customers will be members of the Society!
/os! ) H % E $f a company is profitable it will in most cases increase its net worth!
/os! ) H ' E if a company maximises its profits, then it will be able to honour its
obligations
/os! % H 9 E /et worth H the society!
/os! + H 9 E .mployees may be the society!
/os! ) H 9 E 7rofits vs! Society
Con'licts
/os! ) H & E 7rofits vs! 5osts
!.S&NESS *&NANCE
/os! ) H + E 7rofits vs! 5osts
/os! ) H < E 7rofits vs! 5osts
/os! 9 H < E High taxes will reduce social benefits
/os! + H 9 E 5osts vs! ppropriated profits
/os! & H ' E *etter credit terms to customers will not enable the company to pay its
creditors
Lesson One :
T%e Main o?Eecti2es o' a ?usiness entity are e<lained in detail ?elow
ny business firm would have certain ob=ectives, which it aims at achieving! #he ma=or
goals of a firm are:
7rofit maximisation
ShareholdersD wealth maximisation
Social responsibility
*usiness .thics
a# +ro'it maimiDation
#raditionally, this was considered to be the ma=or goal of the firm! 7rofit maximi>ation
refers to achieving the highest possible profits during the year! #his could be achieved by
either increasing sales revenue or by reducing expenses! /ote that:
7rofit I 3evenue E .xpenses
#he sales revenue can be increased by either increasing the sales volume or the selling price!
$t should be noted however, that maximi>ing sales revenue may at the same time result to
increasing the firmDs expenses! #he pricing mechanism will however, help the firm to
determine which goods and services to provide so as to maximi>e profits of the firm!
#he profit maximi>ation goal has been critici>ed because of the following:
$t ignores time value of money
$t ignores risk and uncertainties
$t is vague
$t ignores other participants in the firm rather than shareholders
?# S%are%oldersF wealt% maimisation
ShareholdersD wealth maximisation refers to maximisation of the net present value of every
decision made in the firm! /et present value is equal to the difference between the present
value of benefits received from a decision and the present value of the cost of the decision!
B/ote this will be discussed further in 2esson %C!
financial action with a positive net present value will maximi>e the wealth of the
shareholders, while a decision with a negative net present value will reduce the wealth of the
shareholders! Under this goal, a firm will only take those decisions that result in a positive
net present value!
Shareholder wealth maximisation helps to solve the problems with profit maximisation! #his
is because, the goal:
5onsiders time value of money by discounting the expected future cash flows to the
present!
$t recogni>es risk by using a discount rate Bwhich is a measure of riskC to discount the
cash flows to the present!
c# Social res<onsi?ility
!.S&NESS *&NANCE
; Nature o' !usiness *inance
#he firm must decide whether to operate strictly in their shareholdersD best interests or be
responsible to their employers, their customers, and the community in which they operate!
#he firm may be involved in activities which do not directly benefit the shareholders, but
which will improve the business environment! #his has a long term advantage to the firm and
therefore in the long term the shareholders wealth may be maximi>ed!
d# !usiness Et%ics
3elated to the issue of social responsibility is the question of business ethics! .thics are
defined as the Jstandards of conduct or moral behaviourK! $t can be though of as the
companyDs attitude toward its stakeholders, that is, its employees, customers, suppliers,
community in general creditors, and shareholders! High standards of ethical behaviour
demand that a firm treat each o these
constituents in a fair and honest manner! firmDs commitment to business ethics can be
measured by the tendency of the firm and its employees to adhere to laws and regulations
relating to:
7roduct safety and quality
4air employment practices
4air marketing and selling practices
#he use of confidential information for personal gain
$llegal political involvement
*ribery or illegal payments to obtain business!
T-E AGENC0 T-EO,0 AND +,O!LEM
n agency relationship arises where one or more parties called the principal contractsAhires
another called an agent to perform on his behalf some services and then delegates decision
making authority to that hired party BgentC $n the field of finance shareholders are the
owners of the firm! However, they cannot manage the firm because:
#hey may be too many to run a single firm!
#hey may not have technical skills and expertise to run the firm
#hey are geographically dispersed and may not have time!
Shareholders therefore employ managers who will act on their behalf! #he managers are
therefore agents while shareholders are principal!
Shareholders contribute capital which is given to the directors which they utili>e and at the
end of each accounting year render an explanation at the annual general meeting of how the
financial resources were utili>ed! #his is called stewardship accounting!
$n the light of the above shareholders are the principal while the management are the
agents!
gency problem arises due to the divergence or divorce of interest between the
principal and the agent! #he conflict of interest between management and
shareholders is called agency problem in finance!
#here are various types of agency relationship in finance exemplified as follows:
)! Shareholders and -anagement
%! Shareholders and 5reditors
Lesson One 9
+! Shareholders and the 6overnment
&! Shareholders and uditors
9! Headquarter office and the *ranchAsubsidiary!
4( S%are%olders and Management
#here is near separation of ownership and management of the firm! ,wners employ
professionals BmanagersC who have technical skills! -anagers might take actions, which are
not in the best interest of shareholders! #his is usually so when managers are not owners of
the firm i!e! they donDt have any shareholding! #he actions of the managers will be in conflict
with the interest of the owners! #he actions of the managers are in conflict with the interest
of shareholders will be caused by:
i# &ncenti2e +ro?lem
-anagers may have fixed salary and they may have no incentive to work
hard and maximi>e shareholders wealth! #his is because irrespective of the
profits they make, their reward is fixed! #hey will therefore maximi>e
leisure and work less which is against the interest of the shareholders!
ii# Consum<tion o' G+er>uisitesH
7rerequisites refer to the high salaries and generous fringe benefits which the
directors might award themselves! #his will constitute directors
remuneration which will reduce the dividends paid to the ordinary
shareholders! #herefore the consumption of perquisites is against the interest
of shareholders since it reduces their wealth!
iii# Di''erent ,iskA<ro'ile
Shareholders will usually prefer high"risk"high return investments since they
are diversified i!e they have many investments and the collapse of one firm
may have insignificant effects on their overall wealth!
-anagers on the other hand, will prefer low risk"low return investment since
they have a personal fear of losing their =obs if the pro=ects collapse! BHuman
capital is not diversifiableC! #his difference in risk profile is a source of
conflict of interest since shareholders will forego some profits when low"
return pro=ects are undertaken!
i2# Di''erent E2aluation -oriDons
-anagers might undertake pro=ects which are profitable in short"run!
Shareholders on the other hand evaluate investments in long"run hori>on
which is consistent with the going concern aspect of the firm! #he conflict
will therefore occur where management pursue short"term profitability while
shareholders prefer long term profitability!
2# Management !uy Out "M!O#
#he board of directors may attempt to acquire the business of the principal!
#his is equivalent to the agent buying the firm which belongs to the
shareholders! #his is inconsistent with the agency relationship and contract
etween the shareholders and the managers!
!.S&NESS *&NANCE
4I Nature o' !usiness *inance
2i# +ursuing <ower and sel' esteem goals
#his is called Jempire buildingK to enlarge the firm through mergers and
acquisitions hence increase in the rewards of managers!
2ii# Creati2e Accounting
#his involves the use of accounting policies to report high profits e!g stock
valuation methods, depreciation methods recogni>ing profits immediately in
long term construction contracts etc!
Solutions to S%are%olders and Management Con'lict o' &nterest
5onflicts between shareholders and management may be resolved as follows:
4( +eggingCattac%ing managerial com<ensation to <er'ormance
#his will involve restructuring the remuneration scheme of the firm in order to enhance the
alignmentsAharmoni>ation of the interest of the shareholders with those of the management
e!g! managers may be given commissions, bonus etc! for superior performance of the firm!
5( T%reat o' 'iring
#his is where there is a possibility of firing the entire management team by the shareholders
due to poor performance! -anagement of companies have been fired by the shareholders
who have the right to hire and fire the top executive officers e!g the entire management team
of Unga 6roup, $*-, 6!-! have been fired by shareholders!
@( T%e T%reat o' -ostile Takeo2er
$f the shares of the firm are undervalued due to poor performance and mismanagement!
Shareholders can threatened to sell their shares to competitors! $n this case the management
team is fired and those who stay on can loose their control and influence in the new firm!
#his threat is adequate to give incentive to management to avoid conflict of interest!
6( Direct &nter2ention ?y t%e S%are%olders
Shareholders may intervene as follows:
$nsist on a more independent board of directors!
*y sponsoring a proposal to be voted at the 6-
-aking recommendations to the management on how the firm should be run!
8( Managers s%ould %a2e 2oluntary code o' <ractice) w%ic% would guide t%em in t%e
<er'ormance o' t%eir duties(
7( Eecuti2e S%are O<tions +lans
$n a share option scheme, selected employees can be given a number of share options, each of
which gives the holder the right after a certain date to subscribe for shares in the company at
a fixed price!
#he value of an option will increase if the company is successful and its share price goes up!
#he theory is that this will encourage managers to pursue high /7: strategies and
Lesson One 44
investments, since they as shareholders will benefit personally from the increase in the share
price that results from such investments!
However, although share option schemes can contribute to the achievement of goal
congruence, there are a number of reasons why the benefits may not be as great as might be
expected, as follows:
-anagers are protected from the downside risk that is faced by shareholders! $f the share
price falls, they do not have to take up the shares and will still receive their standard
remuneration, while shareholders will lose money!
-any other factors as well as the quality of the companyDs performance influence share price
movements! $f the market is rising strongly, managers will still benefit from share options,
even though the company may have been very successful! $f the share price falls, there is a
downward stock market ad=ustment and the managers will not be rewarded for their efforts in
the way that was planned!
#he scheme may encourage management to adopt Lcreative accountingD methods that will
distort the reported performance of the company in the service of the managersD own ends!
Note
#he choice of an appropriate remuneration policy by a company will depend, among other
things, on:
5ost: the extent to which the package provides value for money
-otivation: the extent to which the package motivates employees both to stay with
the company and to work to their full potential!
4iscal effects: government tax incentives may promote different types of pay! t
times of wage control and high taxation this can act as an incentive to make the
LperksD a more significant part of the package!
6oal congruence: the extent to which the package encourages employees to work in
such a way as to achieve the ob=ectives of the firm E perhaps to maximi>e rather than
to satisfy!
:( &ncurring Agency Costs
gency costs are incurred by the shareholders in order to monitor the activities of their agent!
#he agency costs are broadly classified into &!
aC T%e contracting cost( #hese are costs incurred in devising the contract between the
managers and shareholders!
#he contract is drawn to ensure management act in the best interest of shareholders and the
shareholders on the other hand undertake to compensate the management for their effort!
.xamples of the costs are:
/egotiation fees
#he legal costs of drawing the contracts fees!
#he costs of setting the performance standard,
bC Monitoring Costs #his is incurred to prevent undesirable managerial actions! #hey are
meant to ensure that both parties live to the spirit of agency contract! #hey ensure that
!.S&NESS *&NANCE
management utili>e the financial resources of the shareholders without undue transfer to
themselves!
.xamples are:
.xternal audit fees
2egal compliance expenses e!g! 7reparation of
4inancial statement according to international accounting standards,
company law, capital market authority requirement, stock exchange
regulations etc!
4inancial reporting and disclosure expenses
$nvestigation fees especially where the investigation is instituted by
the shareholders!
5ost of instituting a tight internal control system B$5SC!
cC O<<ortunity CostC,esidual Loss #his is the cost due to the failure of both parties to act
optimally e!g!
2ost opportunities due to inability to make fast decision due to tight internal
control system
4ailure to undertake high risk high return pro=ects by the manager leads to
lost profits when they undertake low risk, low return pro=ects!
dC ,estructuring Costs E e!g! new $!5!S!, business process reengineering etc!
5( S-A,E-OLDE,S AND C,ED&TO,SC?ondCde?enture %olders
*ondholders are providers or lenders of long term debt capital! #hey will usually give debt
capital to the firm on the strength of the following factors:
#he existing asset structure of the firm
#he expected asset structure of the firm
#he existing capital structure or gearing level of the firm
#he expected capital structure of gearing after borrowing the new
debt!
Note
$n raising capital, the borrowing firm will always issue the financial securities in form of
debentures, ordinary shares, preference shares, bond etc!
$n case of shareholders and bondholders the agent is the shareholder who should ensure
that the debt capital borrowed is effectively utili>ed without reduction in the wealth of the
bondholders! #he bondholders are the principal whose wealth is influenced by the value
of the bond and the number of bonds held!
Wealth of bondholders I -arket value of bonds x /o! of bonds Adebentures held!
n agency problem or conflict of interest between the bondholders BprincipalC and the
shareholders BagentsC will arise when shareholders take action which will reduce the
market value of the bond and by extension, the wealth of the bondholders! #hese actions
include:
Lesson One 4@
a# Dis<osal o' assets used as collateral 'or t%e de?t in t%is(
$n this case the bondholder is exposed to more risk because he may not recover the loan
extended in case of liquidation of the firm!
?# AssetsCin2estment su?stitution
$n this case, the shareholders and bond holders will agree on a specific low risk pro=ect!
However, this pro=ect may be substituted with a high risk pro=ect whose cash flows have high
standard deviation! #his exposes the bondholders because should the pro=ect collapse, they
may not recover all the amount of money advanced!
c# +ayment o' -ig% Di2idends
1ividends may be paid from current net profit and the existing retained earnings! 3etained
earnings are an internal source of finance! #he payment of high dividends will lead to low
level of capital and investment thus reduction in the market value of the shares and the bonds!
firm may also borrow debt capital to finance the payment of dividends from which no
returns are expected! #his will reduce the value of the firm and bond!
d# .nder in2estment
#his is where the firm fails to undertake a particular pro=ect or fails to invest moneyAcapital in
the entire pro=ect if there is expectation that most of the returns from the pro=ect will benefit
the bondholders! #his will lead to reduction in the value of the firm and subsequently the
value of the bonds!
e# !orrowing more de?t ca<ital
firm may borrow more debt using the same asset as a collateral for the new debt! #he
value of the old bond or debt will be reduced if the new debt takes a priority on the collateral
in case the firm is liquidated! #his exposes the first bondholdersAlenders to more risk!
Solutions to agency <ro?lem
#he bondholders might take the following actions to protect themselves from the actions of
the shareholders which might dilute the value of the bond! #hese actions include:
4( ,estricti2e !ondCDe?t Co2enant
$n this case the debenture holders will impose strict terms and conditions on the borrower!
#hese restrictions may involve:
aC /o disposal of assets without the permission of the lender!
bC /o payment of dividends from retained earnings
cC -aintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities!
dC 3estrictions on mergers and organisations
eC /o borrowing of additional debt, before the current debt is
fully servicedApaid!
fC #he bondholders may recommend the type of pro=ect to be
undertaken in relation to the riskness of the pro=ect!
!.S&NESS *&NANCE
5( Calla?ility +ro2isions
#hese provisions will provide that the borrower will have to pay the debt before the expiry of
the maturity period if there is breach of terms and conditions of the bond covenant!
@( Trans'er o' Asset
#he bondholder or lender may demand the transfer of asset to him on giving debt or
loan to the company! However the borrowing company will retain the possession of
the asset and the right of utili>ation!
,n completion of the repayment of the loan, the asset used as a collateral will be
transferred back to the borrower!
6( ,e<resentation
#he lender or bondholder may demand to have a representative in the board of directors of
the borrower who will oversee the utili>ation of the debt capital borrowed and safeguard the
interests of the lender or bondholder!
8( ,e'use to lend
$f the borrowing company has been involved in un"ethical practices associated with the debt
capital borrowed, the lender may withhold the debt capital hence the borrowing firm may not
meet its investments needs without adequate capital!
#he alternative to this is to charge high interest on the borrower as a deterrent mechanism!
7( Con2erti?ility= ,n breach of bond covenants, the lender may have the right to convert the
bonds into ordinary shares!
@( Agency ,elations%i< !etween S%are%olders And T%e Go2ernment
Shareholders and by extension, the company they own operate within the environment using
the charter or licence granted by the government! #he government will expect the company
and by extension its shareholders to operate the business in a manner which is beneficial to
the entire economy and the society!
#he go2ernment in this agency relationship is the <rinci<al while the com<any is the agent(
$t becomes an agent when it has to collect tax on behalf of the government especially
withholding tax and 78.!
#he company also carries on business on behalf of the government because the government
does not have adequate capital resources! $t provides a conducive investment environment
for the company and share in the profits of the company in form of taxes!
#he company and its shareholders as agents may take some actions that might pre=udice the
position or interest of the government as the principal! #hese actions include:
#ax evasion: #his involves the failure to give the accurate picture of the earnings or
profits of the firm to minimi>e tax liability!
$nvolvement in illegal business activities by the firm!
2ukewarm response to social responsibility calls by the government!
2ack of adequate interest in the safety of the employees and the products and services
of the company including lack of environmental awareness concerns by the firm!
Lesson One 48
voiding certain types and areas of investment coveted by the government!
Solutions to t%e agency <ro?lem
#he government can take the following actions to protect itself and its interests!
4( &ncur monitoring costs
.!g! the government incurs costs associated with:
Statutory audit
$nvestigations of companies under 5ompany ct
*ack duty investigation costs to recover tax evaded in the
past
:# refund audits
5( Lo??ying 'or directors%i< "re<resentation#
#he government can lobby for directorship in companies which are deemed to be of strategic
nature and importance to the entire economy or society e!g directorship in 0725, 0enya
irways, 05* etc!
@( O''ering in2estment incenti2es
#o encourage investment in given areas and locations, the government offers investment
incentives in form of capital allowances as laid down in the Second schedule of 5ap &<@!
6( Legislations
#he government has provided legal framework to govern the operations of the company and
provide protection to certain people in the society e!g! regulation associated with disclosure
of information, minimum wages and salaries, environment protection etc!
8( T%e go2ernment can incalculate t%e sense and s<irit o' social res<onsi?ility on t%e
acti2ities o' t%e 'irm) w%ic% will e2entually ?ene'it t%e 'irm in 'uture(
6( Agency ,elations%i< ?etween S%are%olders and Auditors
Shareholders appoint auditors as per the provisions of Section )9;B)C"B'C of the 5ompanies
ct! #he auditors are supposed to monitor the performance of the management on behalf of
the shareholders! #hey act as watchdogs to ensure that the financial statements prepared by
the management reflect the true and fair view of the financial performance and position of the
firm!
Since auditors act on behalf of shareholders they become agents while shareholders are the
principal! #he auditors may pre=udice the interest of the shareholders thus causing agency
problems in the following ways:
aC 5olluding with the management in performance of their duties whereby their
independence is compromised!
bC 1emanding a very high audit fee Bwhich reduces the profits of the firmC although
there is insignificant audit work due to the strong internal control system existing in
the firm!
!.S&NESS *&NANCE
cC $ssuing unqualified reports which might be misleading the shareholders and the
public and which may lead to investment losses if investors rely on such
misleading report to make investment and commercial decisions!
dC 4ailure to apply professional care and due diligence in performance of their audit
work!
Solutions to t%e con'lict
)! 4iring: #he auditors may be removed from office by the shareholders at the
6-!
%! 2egal action: Shareholders can institute legal proceedings against the auditors
who issue misleading reports leading to investment losses!
+! 1isciplinary ction E $570!
7rofessional bodies have disciplinary procedures and measures against their members
who are involved in un"ethical practices! Such disciplinary actions may involve:
Suspension of the auditor
Withdrawal of practicing certificate
4ines and penalties
3eprimand
&! Use of audit committees and audit reviews!
8( -EAD O**&CE AND S.!S&D&A,0C!,ANC-
-/5 has diverse operations set up in different geographical locations!
#he H? acts as the principal and the subsidiary as an agent thus creating an agency
relationship!
#he subsidiary management may pursue its own goals at the expense of overall corporate
goals! #his will lead to sub"optimisation and conflict of interest with the headquarter!
#his conflict can be resolved in the following ways:
aC 4requent transfer of managers
bC dopt global strategic planning to ensure commonality of vision
cC Having a voluntary code of ethical practices to guide the branch managers
n elaborate performance reporting system providing a %"way feedback mechanism!
7erformance contracts with managers with commensurate compensation package for the
same!
T-E ,&SKA,ET.,N T,ADEAO**
-ost financial decisions involve alternative courses of action! #he alternatives have different
returns and risk! 4or example, should we buy a replacement machine now or should we wait
until next year, should we set the debt"to"assets ratio at %@F, &@F or any other ratioM
#he higher the risk on any decision, the higher the required return to compensate for this risk!
#he relationship between 3eturn and 3isk can be expressed as follows:
3equired 3ate of 3eturn I 3isk"free rate G 3isk premium!
Lesson One 4:
3isk free rate is compensation for time and risk premium is compensation for risk of financial
actions! $t can be seen that the relationship is direct!
#he finance manager should avoid decisions with unnecessary risk! $n making financing
decisions for example, the finance manager must decide whether to finance with equity alone
or to use debt as well! #he expected return when debt is used is high since the cost of debt is
low! However, since payment of interest on debt is compulsory, the risk involved is high!
,n the other hand the cost of equity is high and therefore the return is low! #he risk is also
low since payment of ordinary dividend is not compulsory! #he firmDs liquidity decisions
will also affect the risk and the return of the firm!
T0+ES O* !.S&NESS O,GAN&SAT&ONS
)! Sole proprietorships
%! 7artnerships
+! Noint stock companies or 7ublicA7rivate limited companies!
SOLE +,O+,&ETO,S-&+
C%aracteristics
)! ccounts do not have to be audited
%! $t caters for personal attention of customers
+! 2imited to such finances as:
a! 7ersonal saving
b! 2oans from relatives H friends
c! Short"term loans from banks!
d! #rade credit from suppliers!
&! 2ess legal formalities to form!
9! Highly flexible Band adaptableC
'! Highly flexible decision"making process!
Ot%er Ad2antages
)! Sole trade usually skilled in the business Bgood for competitionC
%! 7rofits motivates owners
+! High supervision of employees
&! 2ow bureaucracy Bless time wastedC
Disad2antages
)! Short economic life therefore does not attract long"term finance, therefore, limited
expansion and growth!
%! Unlimited liability
+! Success depends on ability or =udgement of owner
Note
-ost sole traders do not employ professional advice which implies less growth and
stagnation!
2imited sources of finance!
2imited accounts knowledge!
!.S&NESS *&NANCE
4; Nature o' !usiness *inance
+A,TNE,S-&+S
De'initions
J#he relationship, which exists between persons carrying on a business in common with a
view of profit!K
4ormation of a partnership
)! ,rally
%! ctions of the person concerned
+! greement in writing!
&! *y a deed i!e! an agreement under seal!
Note
$n case the partners want to run their business under a name which does not disclose true
surname of all partners, such a firm must be registered under the registration of *usiness
/ames ct!
Ty<es o' +artners
)! 6eneral 7artners E Unlimited liability and active in participation in partnership
activities!
%! 2imited partners E 2imited liability and does not participate in the management of
partnerships!
+! Sleeping partners E has no active role, nevertheless, such a partner will have
contributed to the capital of the partnership business and will thus share in the profits
although at a lower proportion in most cases!
partnership deed constitutes a legal contract among the partners! #he articles of
partnerships must contain eleven clauses!
)! /ature of business!
%! 7rofit sharing ratio
+! 5apital contribution
&! 3ates of interest on both capital and drawings
9! #he provision for proper accounts and their audit!
'! 7owers of each partner!
<! 6rounds of dissolution!
(! 1etermination of 6oodwill
;! 1etermination of amount payable to outgoing partners!
)@! .xpulsion procedures!
))! #he arbitration clause!
BO&NT STOCK COM+AN&ES
$nitiators contribute to the capital base of such companies through the purchase of shares of
such companies! #hese companies are governed by the 5ompanies ct B5ap! &('C of );&(!
Such must be registered with the 3egistrar of 5ompanies after which it is issued with a
certificate of incorporation which indicates the *irth of the company!
Ad2antages
Lesson One 49
2imited liability!
7erpetual existence Bor going concernC which allows the company to make strategic
plans to raise finance in 5apital -arkets more easily!
#he company can own assets and incur liabilities on its own accord!
#itle to share is freely transferable which makes these shares more of an investment!
.xception E 7rivate limited companies whose transfer of shares needs the consent of
its members!
Shares may be used as securities!
2arge sources of finance!
Disad2antages
2oss of secrecy E poor competition
-any formalities in forming the company
Heavy initial capital outlay!
1ifficult to reconstruct the capital
*ureaucracies especially in decision making processes!
$nflexibility and thus low adaptability!
Note
#hey cannot participate in the activities outside the scope of their Job=ective clauseK!
1ifferences between a company and a partnership occur under the following factors:
6overnance
2egal view BentityC
#itle of shares BtransferabilityC
gency
2iability
6oing concern BdissolutionC
-embership number!
-OLD&NG COM+AN0
,ne which holds more than a half of the equity share capital of another company or is a
member andAor controls a big percentage of the *oard of 1irectors of one or more of other
companies which in this case are called subsidiaries for such a holding company!
holding company may be viewed as a Jfinancial institutionK in the sense that it uses
shareholders capital to acquire controlling interests in other companies by acquiring up to
9)F of the other companyDs shares or even more! $f such a holding company hold 9)F of
the shares of another
company, it means that it is the ma=ority shareholder and has substantial influence on the
operations of its subsidiary! $t will almost be like a sole owner of such a company by virtue
of such share holding!
+.!L&C L&M&TED COM+AN&ES
#hese are =oint stock companies which have sold shares to general public and thus have
attracted public money in form of share capital! Such companies are usually quoted on the
stock exchange! #hese companies usually raise large sums of money from the public and in
order to do so, such companies must:
!.S&NESS *&NANCE
5I Nature o' !usiness *inance
,btain permission from the capital market development authority also known as /ew
$ssue 5ommittee!
#he company in need of public money will have to obtain permission from the /S.
5ouncil before it can be allowed to have its shares Jdealt"inK!
#he law requires such a company to have a minimum of seven shareholders and there
is no upper limit!
+,&/ATE L&M&TED COM+AN&ES
#hese are /,# allowed to advertise their shares so as to attract public money and as such
they sell their shares privately Bknown as private placingC to interested members of the public!
#heir shares are not freely transferable as these are not quoted on the stock exchange and they
can only be transferred with the consent of the directors!
1ifferences between the two above lies on:
)! /umber of shares
%! #ransfer of shares
+! -ethods of raising funds from the public
&! /umber of directors
9! ?uotation
'! 6-Ds
<! 3etirement age of directors!
,E&N*O,C&NG J.EST&ONS
J.EST&ON ONE
,utline 4,U3 main ob=ectives, which conflict and at the same time overlap E explain these
overlap and conflicts!
J.EST&ON TWO
1iscuss the main problems sole tradersD encounter in a bid to raise finance on 0enyaDs
financial markets!
J.EST&ON T-,EE
Within a business finance context, discuss the problems that might exist in the relationships
Bsometimes referred to as agency relationshipsC between:
aC Shareholders and managers, and
bC Shareholders and creditors!
J.EST&ON *O.,
#wo neighboring countries have chosen to organi>e their electricity supply industries in
different ways! $n country , electricity supplies are provided by a nationalised industry! ,n
the other hand in country * electricity supplies are provided by a number of private sector
companies!
,e>uired
aC .xplain how the ob=ectives of the nationalised industry in country might
differ from those of the private sector companies in country *!
Lesson One 54
bC *riefly discuss whether investment planning and appraisal techniques are
likely to differ in he nationalised industry and private sector companies!
C%eck your answers wit% t%ose gi2en in Lesson 4I o' t%e Study +ack(
!.S&NESS *&NANCE
Lesson Two 55
LESSON TWO
SO.,CES O* *.NDS
&NST,.CT&ONS
3ead 5hapter %( and +) of 4inancial -anagement text book by $!-! 7andey!
CONTENTS
.quity capital
1ebt finance
*ills of exchange
2ease finance
,verdraft finance
7lastic money E 1ebenture finance
:enture capital
!.S&NESS *&NANCE
5@ Sources o' *unds
4( EJ.&T0 *&NANCE
4or small companies, this is personal savings Bcontribution of owners to the companyC! 4or
large companies equity finance is made of ordinary share capital and reservesO Bboth revenue
and capital reservesC! .quity finance is divided into the following classes:
aC Ordinary s%are ca<ital E this is raised from the public from the sale of ordinary
shares to the shareholders! #his finance is available to limited companies! $t is a
permanent finance as the ownerAshareholder cannot recall this money except under
liquidation! $t is thus a base on which other finances are raised!
,rdinary share capital carries a return that is variable Bordinary dividendsC! #hese
shares carry voting rights and can influence the companyDs decision making process
at the 6-!
#hese shares carry the highest risk in the company Bhigh securities E documentary claim toC
because of:
aC Uncertainty of return
bC 5annot ensure refund
cC Have residual claims E claim last on profits, claim last on assets!
However this investment grows through retention!
,ig%ts o' ordinary s%are%olders
)! 3ight to vote
a! elect *,1
b! SalesApurchase of assets
%! $nfluence decisions:
aC 3ight to residual assets claim
bC 3ight to amend companyDs by"laws
cC 3ight to appoint another auditor
dC 3ight to approve merger acquisition
eC 3ight to approve payment of dividends
,easons w%y ordinary s%are ca<ital is attracti2e des<ite ?eing risky
Shares are used as securities for loans Ba compromise of the market price of a shareC!
$ts value grows!
#hey are transferable at capital gain!
#hey influence the companyDs decisions!
5arry variable returns E is good under high profit
7erpetual investment E thus a perpetual return
Such shares are used as guarantees for credibility!
!.S&NESS *&NANCE
Lesson Two 56
Ad2antages o' using ordinary s%are ca<ital in 'inancing(
#hey facilitate pro=ects especially long"term pro=ects because they are permanent!!
$ts cost is not a legal obligation!
$t lowers gearing level E reduces chances of receivershipAliquidation!
Used with flexibility E without preconditions!
Such finances boost the companyDs credibility and credit rating!
,wners contribute valuable ideas to the companyDs operations Bduring 6- by
professionalsC!
?# ,ETA&NED EA,N&NGS
i# ,e2enue ,eser2es
#hese are undistributed earnings! Such reserves are retained for the following reasons:
#o make up for the fall in profits so as to sustain acceptable risks!
! #o sustain growth through plough backs! #hey are cheap source of
finance!
! #hey are used to boost the companyDs credit rating so they enable further finance to
be
obtained!
! $t lowers the companyDs gearing ratio E reduces chances of receivershipAliquidation!
ii# Ca<ital ,eser2es
)! $t is raised by selling shares at a premium! B#he difference between the market price
Bless floatation costsC and par value is credited to the capital reserveC!
%! #hrough revaluation of the companyDs assets! #his leads to a fictitious entry which is
of the nature of a capital reserve!
+! *y creation of a sinking fund!
c# +,E*E,ENCE S-A,E CA+&TAL "JuasiAE>uity#
$t is also called quasi"equity because it combines features of equity and those of debt! $t is
preference because it is preferred to ordinary share capital that is:
iC $t is paid dividends first E preferred to dividend
iiC $t is paid asset proceeds first E preferred to assets!
Unlike ordinary share capital, it has a fixed return! $t carries no voting rights! $t is an
unsecured finance and it increases the companyDs gearing ratio!
CLASS&*&CAT&ON
i# ,edeema?le Class
3edeemable preferential shares are bought back by issuing company after minimum
redemption period but before expiring of maximum redemption period after which they
become creditors! B5an sue the companyC!
ii# &rredeema?le +re'erence S%ares
58 Sources o' *unds
re perpetual preference shares as they will not be redeemed in the companyDs lifetime
unless it is under liquidation, Bit is permanentC!
Eam<le
5ompany P8Q 2imited has the following capital structure:
)@,@@@ Sh!)@ ordinary shares
)@,@@@ Sh!%@ preference shares
#otal share capital
Shs!
)@@,@@@
%@@,@@@
+@@,@@@
$f the companyDs assets proceeds were Sh!&@@,@@@ show how this would be shared under:
iC 7aripasu
iiC R
Share participation taking into account the par value!
Solution
iC$f the preference shareholders are participative:
sset proceeds
2ess preference claims
2ess ordinary shareholders claim
3esidue
#otal share capital I
Sh!
&@@,@@@
B%@@,@@@C
%@@,@@@
B)@@,@@@C
)@@,@@@
+@@,@@@
7articipative claim of ordinary shareholders is given by:
''< , '' @@@ , )@@
@@@ , +@@
@@@ , %@@
x
iiC Sharing under
%
)
ratio
sset proceeds
2ess preference claim
2ess ordinary share capital
7articipative claim
Shs!
&@@,@@@
B%@@,@@@C
%@@,@@@
B)@@,@@@C
)@@,@@@
7reference share capital claim I
+
)
%
)
@@@ , +@@
@@@ , %@@
x
!.S&NESS *&NANCE
Lesson Two 57
I
@@@ , )@@
+
)
x
I Shs!++,@@@
,rdinary share capital claim I
'
)
%
)
+
)
x
I
@@@ , )@@
'
)
x
I )',''<F
iii# NonA+artici<ati2e +re'erence S%ares
#hese do not claim any money over and above their par value, but are usually cumulative and
redeemable!
/# Cumulati2e +re'erence S%ares
#hese can claim arrears e!g! if a company sold )@F Shs!%@ preference shares and did not pay
dividends for the next two years, then in the third year shareholders will claim:
)@F x %@ x +yrs I Shs ' less withholding tax:
I Shs ' less 9F of Shs @!+@
I Shs 9!<@ net
2i# NonACumulati2e +re'erence S%ares
#hese cannot claim interest in arrears!
2ii# Con2erti?le
#hese can be converted into ordinary shares Bwhich is optionalC!
5onversion ratio I par value of ordinary shareApar value of preference shares e!g if par value
of ordinary shares is Sh!)@ and that of preference shares is Sh!%@, then conversion ratio I
%
)
%@
)@
i!e for every preference share you get % ordinary shares!
5onversion price par value of preference sharesAno! of ordinary shares to be acquired!
I
)@
%
%@
Shs
Eam<le
5ompany P8Q 2td has sold )@,@@@ ordinary shares of Shs!+@ Bpartly called upC plus %@,@@@
Shs!&9 preference shares, which are convertible! 5ompute the total number of ordinary
shares after conversion!
Solution
5onversion ratio I +@A&9 I %A+ for every % preference shares you get + ordinary shares!
5: Sources o' *unds
)
+
)
@@@ , %@
x I +@,@@@ ordinary shares!
5onversion price I +@ !
% A +
&9
Shs
#otal I &@,@@@ ordinary shares after conversion!
2iii# NonACon2erti?le +re'erence S%ares(
#hese cannot be converted into ordinary shares!
5( DE!T *&NANCE
1ebt finance is a fixed return finance as the cost BinterestC is fixed on the par value Bface
value of debtC! $t is ideal to use if thereDs a strong equity base! $t is raised from external
sources to qualifying companies and is available in limited quantities! $t is limited to:
iC :alue of security!
iiC 2iquidity situation in a given country! $t is ideal for companies where
gearing allows them to raise more debt and thus gearing level!
Classi'ication o' De?t *inance
Loan 'inance E this is a common type of debt and is available in different terms usually short
term! -edium term loans vary from % " 9 years! 2ong"term loans vary from ' years and
above
#he terms are relative and depend on the borrower! #his finance is used on the basis of
-atching approach i!e! matching the economic life of the pro=ect to the term of the loan! $t is
prudent to use short"term loans for short"term ventures i!e! if a venture is to last & years
generating returns, it is prudent to raise a loan of & years maturity period!
Conditions under W%ic% Loans Are &deal
aC When the companyDs gearing level is low Bthe level of outstanding loans is low!
bC #he companyDs future cash flows Binflows and their stabilityC must be assured! #he
company must be able to repay the principal and the interest!
cC .conomic conditions prevailing! #he company must have a long"term forecast of the
prevailing economic condition! *oom conditions are ideal for debt!
dC When the companyDs market share guarantees stable sales!
eC When the companyDs anticipated future expansion programs, =ustify such borrowing!
,e>uirements 'or ,aising Loan
aC History of the company and its subsidiaries!
bC /ames, ages, and qualifications of the companyDs directors!
cC #he names of ma=or shareholders E 9)F plus i!e! owner who must give consent!
dC /ature of the products and product lines!
eC 7ublicity of the product!
fC /ature of the loan E either secured, floating or unsecured!
!.S&NESS *&NANCE
Lesson Two 5;
gC 5ash flow forecast!
,easons W%y Commercial !anks +re'er To Lend S%ort Term Loans
aC 2ong"term forecasts are not only difficult but also vague as uncertainties tend to
=eopardise planning e!g! political and economic factors!
bC 5ommercial banks are limited by the 5entral *ank of 0enya in their long term
lending due to liquidity considerations!
cC Short"term loans are profitable! #his is because interest is high as in overdrafts!
dC 2ong term finance loses value with time due to inflation!
eC 5ost of finance E in the long term, the cost of finance may increase and yet they
cannot pass such a cost to borrowers since the interest rate is fixed!
fC 5ommercial banks do credit analysis that is limited to short term situations!
gC Usually security market favours short term loans because there are very few long
term securities and as such commercial banks prefer to lend short term due to
security problems!
Ad2antages o' .sing De?t *inance
$nterest on debt is a tax allowable expense and as such it is reduced by the tax
allowance!
Eam<le
$nterest I )@F tax rate I +@F
#he effective cost of debt BinterestC I $nterest rateB) E #C
I )@FB)"@!+@C
I <F
5onsider companies and *
5ompany *
Sh!D@@@D Sh!D@@@D
)@F debt ),@@@ "
.quity " ),@@@
),@@@ ),@@@
#he tax rate is +@F and earnings before interest and tax amount to 0sh!&@@,@@@! ll earnings
are paid out as dividends! 5ompute payable by each firm!
Com<any A !
Sh!D@@@D Sh!D@@@D
.*$# &@@ &@@
2ess interest )@F x ),@@@ B)@@C "
.*# +@@ &@@
2ess tax S +@F B;@C B)%@C
1ividends payable %)@ %(@
5ompany saves tax equal to Sh!+@,@@@B)%@,@@@ E ;@,@@@C since interest charges are tax
allowable and reduce taxable income!
59 Sources o' *unds
#he cost of debt is fixed regardless of profits made and as such under conditions of
high profits the cost of debt will be lower!
$t does not call for a lot of formalities to raise and as such its ideal for urgent ventures
$t is usually self"sustaining in that the asset acquired is used to pay for its cost i!e!
leaving the company with the value of the asset!
$n case of long"term debt, amount of loan declines with time and repayments reduce its
burden to the borrower!
1ebt finance does not influence the companyDs decision since lenders donDt participate
at the 6-!
Disad2antages
$t is a conditional finance i!e! it is not invested without the approval of lender!
1ebt finance, if used in excess may interrupt the companies decision making process
when gearing level is high, creditors will demand a say in the company i!e! and demand
representation in the *,1!
$t is dangerous to use in a recession as such a condition may force the company into
receivership through lack of funds to service the loan!
$t calls for securities which are highly negotiable or marketable thus limiting its
availability!
$t is only available for specific ventures and for a short term, which reduces its
investment in strategic ventures!
#he use of debt finance may lower the value of a share if used excessively! $t increases
financial risk and required rate of return by shareholders thus reduce the value of shares!
Di''erences ?etween De?t *inance and Ordinary S%are Ca<ital "E>uity *inance#
Ordinary s%are ca<ital De?t
aC
bC
cC
dC
eC
fC
gC
hC
iC
$t is a permanent finance
3eturn paid when available
1ividends are not tax allowable
Unsecured finance
5arry voting rights
3educes gearing ratio
/o legal obligation to pay
Has a residue claim
,wnersD money
aC
bC
cC
dC
eC
fC
gC
hC
iC
$t is refundable BredeemableC
$t is fixed return capital
$nterest on debt is a tax allowable expense
Secured finance
/o voting right
$ncreases gearing ratio
legal obligation to pay
5arries a superior claim
5reditors finance!
Similarities ?etween +re'erence and E>uity *inance
aC *oth may be permanent if preference share capital is irredeemable BconvertibleC!
bC *oth are naked or unsecured finances!
cC *oth are traded at the stock exchange
dC *oth are raised by public limited companies only
!.S&NESS *&NANCE
Lesson Two @I
eC *oth carry residue claims after debt!
fC *oth dividends are not a legal obligations for the company to pay!
@4 Sources o' *unds
Di''erences ?etween +re'erence and E>uity *inance
Ordinary s%are ca<ital +re'erence s%are ca<ital
aC
bC
cC
dC
eC
fC
Has a residue claim both on assets and
profit
5arries voting rights
3educes the gearing ratio
:ariable dividends hence grow over time
7ermanent finance
.asily transferable!
aC
bC
cC
dC
eC
fC
Has a superior claim
/o voting rights
$ncreases the gearing ratio
4ixed dividends hence no growth
Usually redeemable
/ot easily transferable
Similarities ?etween De?t and +re'erence S%are Ca<ital
aC *oth have fixed returns!
bC *oth will increase the companyDs gearing ratio!
cC *oth are usually redeemable!
dC *oth do not have voting rights!
eC *oth may force the company into receivership
fC *oth have superior claims over and above owners!
gC *oth are external finances!
hC #here is no growth with time!
Di''erences ?etween +re'erence S%are Ca<ital and De?t
DE!T +,E*E,ENCE S-A,E CA+&TAL
aC
bC
cC
dC
eC
$nterest is tax allowable
$nterest is a legal obligation
1ebt finance is always secured
1ebt finance is a pre"conditional
Has a superior claim
aC
b
C
cC
d
C
eC
1ividends are not tax allowable
1ividends are not a legal obligation
7reference is not secured finance
$s not conditional finance
Has a residue claim Bafter debtC
W%y &t May !e Di''icult *or Small Com<anies To ,aise De?t *inance &n Kenya "Say
Bua Kali Com<anies#
2ack of security
$gnorance of finances available
-ost of them are risky businesses as there are no feasibility studies done Bchances of
failure have been put to (@FC!
#heir si>e being small tends to make them U/0/,W/ i!e! they are not a significant
competitor to the big companies!
5ost of finance may be high E their market share may not allow them to secure debt!
Small loans are expensive to extend by bank i!e! administration costs are very high!
2ack of business principles that are sound and difficult in evaluating their
performance!
Solutions to t%e A?o2e +ro?lems
#here should be diversification of securities e!g! to accept guarantees!
.ducation of such businessmen on sound business principles!
!.S&NESS *&NANCE
Lesson Two @5
#he government should set up a special fund to assist the =ua kali businessmen!
.ncourage formation of co"operative societies!
#o request bankers to follow up the use of these loans!
@( !ills o' Ec%ange
*ills of .xchange are a source of finance in particular in the export trade! *ill of .xchange
is an unconditional order in writing addressed by one person to another requiring the person
to whom it is addressed to pay to him as his order a specific sum of money! #he commonest
types of bills of exchange used in financing are accommodation bills of exchange! 4or a bill
to be a legal documentO it must be
aC 1rawn by the drawer!
bC *ear a stamp duty
cC cceptable by the drawee
eC -ature in time!
$t is used to raise finance through:
iC 1iscounting it!
iiC /egotiating
iiiC 6iving it out as security!
Ad2antages o' .sing a !ill as a Source o' *inance
#hey are a faster means of raising finance Bif drawer is credibleC!
$s highly negotiableAliquid investment
1oes not require security
1oes not affect the gearing level of the company
$t is unconditional and can be invested flexibly
$t is useful as a source of finance to finance working capital
$t is used without diluting capital!
6 Lease *inance
2easing is a contract between one party called lessor Bowner of assetC and another called
lessee where the lessee is given the right to use the asset Bwithout legal ownershipC and
undertakes to pay the lessor periodic lease rental charges due to generation of economic
benefits from use of the assets! 2eases can be short term Boperating leasesC in which case the
lessor incurs the operating and maintenance costs of the assets or long term Bfinance leasesC
in which the lessee maintains and insure the assets!
2ease finance is ideal under the following conditions:
aC When the asset depreciates faster!
bC When the asset is sub=ect to obsolescence
cC When the available asset cannot meet the contemplated expansion program
dC When the assetDs cost is prohibiting
eC $f the asset is required seasonally
@@ Sources o' *unds
fC $f the asset can generate returns to pay off lease charges in the short run!
Ad2antage o' Leasing an Asset
$t does not tie up the companyDs funds in an asset!
#he arrangement may ensure lessor bears the maintenance costs reducing the
companies operating costs!
#he company has the option to purchase assets at the expiry of the lease period at
which time it will know the viability of the asset!
#he company BlesseeC will en=oy the lease charges as allowable expenses thus
reducing taxable income and tax liability!
2ease finance enables the lessee to use the asset to create financial surpluses which
may then be used to buy assets!
$t is usually a long"term arrangement which enables the company to plan returns
expected and operations which may be carried out!
Disad2antage o' Leasing an Asset
$t is a pre"conditional finance Bas on the use of assetC
$n the long term the lease charges may out"weigh the cost of buying own asset!
$t is available for a selected asset and this limits flexibility!
$t is useful for financing fixed assets and not working capital
2ease finance may not be renewed leading to loss of business!
2ease financing lowers the companyDs credit rating Bi!e! the asset in the balance
sheet is shown as leased assetC!
,easons W%y Lease *inance &s Not Well De2elo<ed &n Kenya
2ease charges are usually prohibitive i!e! the cost of finance is excessive!
$t may not be known to businessmen!
Uncertainty as to returns from such assets i!e! the returns from such assets leased may
not encourage the growth of lease finance!
#here is an imperfect market as a number of companies lease assets on basis of
credibility of the lessee!
2ack of flexibility i!e! a number of assets which are ideal for leasing are unavailable!
0enyaDs financial markets are underdeveloped and this has affected the development
of lease finance!
fter lease service is poor and this leads to loss of revenue!
8( O2erdra't *inance
#his finance is ideal to use as bridging finance in sense that it should be used to solve the
companyDs short term liquidity problems in particular those of financing working capital
Bw!c!C! $t is usually a secured finance unless otherwise mentioned! ,verdraft finance is an
!.S&NESS *&NANCE
Lesson Two @6
expensive source of finance and the over"reliance on it is a sign of financial imprudence as it
indicates the inability to plan or forecast financial needs!
Ad2antages o' O2erdra't *inance
$t is useful in financial crisis which an accountant cannot forecast due to abrupt fall in
profits thus liquidity problems!
$n some cases it may be secured on goodwill thus making it flexible finance!
$t does not entail preconditions and is therefore investible in high"risk situations
when the firm would not have finance in normal circumstances!
$t is raised faster and as usual is ideal to invest in urgent ventures e!g! documentary
investments e!g! treasury bonds, shares, treasury bills, housing bonds etc!
$f not used for a long period of time E it does not affect the companyDs gearing level
and therefore does not relate to companyDs liquidation or receivership!
2ess formalitiesAprocedures involved!
Disad2antages o' O2erdra't *inance
$t is expensive as the interest rates of overdrafts are much higher than bank rates!
#he use of this finance is an indication of poor financial management principle!
$t may be misused by management because it does not carry pre"conditions
*eing a short"term financial arrangement, it can be recalled at short notice leaving the
company in financial crisis!
7( +lastic Money "Credit Card *inance#
#his is finance of a kind whereby a company will make arrangements for the use of the
services of a credit card organisations Bthrough the purchase of credit cardsC in return for
prompt settlement of bills on the card and a commission payable on all credit transactions!
#his is used to finance goods and services of working capital in nature such as the payment of
fuel, spare"
parts, medical and other general provisions and it is rare for it to finance raw materials or
capital items!
,easons ?e%ind t%e *ast De2elo<ment o' T%is *inance "+lastic Money# &n Kenya
aC High incidences of fraud by dishonest employees has been responsible for
development of this finance as it minimises chances of this fraud because it
eliminates the use of hard cash in the execution of transactions!
bC 3isk associated with carrying of huge amounts of cash for purchases which cash is
open to theft and misuse has also been responsible for development of this finance!
cC 5redit cards have boosted the credibility of holder companies which enables them to
obtain trade credits under conditions which would have otherwise been difficult!
@8 Sources o' *unds
dC ,f late, 0enya has experienced emergence of elite, middle and high"income groupsD
in particular professionals who tend to use these cards as a symbol of status in
execution of day to day transactions!
eC #hese cards have been used by financial institutions and banks to boost their deposit
and attract long term clienteles e!g! 3oyal 5ard 4inance, Standard 5hartered!
fC number of companies and establishments have acquired such cards as a means of
settling their bills under certain times when their liquidity is low or when in financial
crisis!
Limitations o' Credit Cards as a Source o' *inance
iC #hese cards leads to overspending on the part of the holder and as such may
disorganise the organisationDs cash budget and cash planning!
iiC 2imited as to the activities they can finance as they are ideal for financing working
capital items and not fixed assets in which case they are not a profitable source of
finance!
iiiC #hey are expensive to obtain and maintain because of associated cost such as ledger
fees, registration, insurance, commission expenses, renewal fees etc!
ivC $t is a short"term source and is open only to a few establishments in which case a
company can obtain goods and services from those establishments that can accept
them!
vC .ntail a lot of formalities to obtain e!g! guarantees, presentation of bank statements
and even charging assets that are partially pledged to secure expenses that may be
incurred using these cards!
viC #hey may be misused by dishonest employees who may use them to defraud the
organisation off goods and services which may not benefit such organisations!
viiC 5redit card organisation may suspend the use of such cards without notice and this
will inconvenience the holder who may not meet hisAher ordinary needs obtained
through these cards!
:( De?enture *inance
form of long term debt raised after a company sells debenture certificates to the holder and
raises finance in return! #he term debenture has its origin from L1.*,.D which means L$
oweD and is thus a certificate or document that evidences debt of long term nature whereby
the person named therein will have given the issuing company the amount usually less than
the total par value of the debenture! #hese debentures usually mature between )@ to )9 years
but may be endorsed, negotiated, discounted or given as securities for loans in which case
they will have been liquidated before their maturity date! #he current interest rate is payable
twice a year and it is a legal obligation!
Classi'ication
i# Secured De?entures
#hese are those types of debentures which a company will secure usually in two ways,
secured with a fixed charge or with a floating charge!
!.S&NESS *&NANCE
Lesson Two @7
aC 4ixed 5harge E a debenture is secured with a fixed charge if it can claim on a specific
asset!
bC 4loating charge E if it can claim from any or all of the assets which have not been
pledged as securities for any other form of debt!
ii# Naked De?entures
#hese are not secured by any of the companyDs assets and as such they are general creditors!
iii# ,edeema?le De?entures
#hese are the type of debentures, which the company can buy back after the minimum
redemption period and before the maximum redemption period Busually )9 yearsC after which
holders can force the company to receivership to redeem their capital and interest
outstanding!
i2# &rredeema?le De?entures "<er<etuities#
#hese are never bought back in which case they form permanent source of finance for the
company! However, these are rare and are usually sold by companyDs with a history of stable
ordinary dividend record!
2# Classi'ication according to con2erti?ility
5onvertible debentures E 5an be converted into ordinary shares although they can also be
converted into preference shares!
5onversion price I par value of a debentureA/o! of shares to be received!
5onversion ratio I 7ar value of debenture
7ar value of ordinary shares
Eam<le
*5 5ompany 2td books:
)@!@@@, Sh!%@ ordinary share capital
)@,@@@, Shs!)@ (F preference share capital
9,@@@, Shs!)@@ )%F debentures
#he above debentures are due for conversion:
S%s(
%@@,@@@
)@@,@@@
9@@,@@@
,e>uired
iC 5ompute the conversion price
iiC 5ompute the conversion ratio
iiiC 5ompute new capital structure!
Solution
iC 5onversion price I par value of debentureA/o! of shares to be received!
/o! of shares to be received I )@@:%@ I 9:)
@: Sources o' *unds
#herefore I
%@
9
)@@
iiC 5onversion ratio I par value of debentureApar value of share I @ ! 9

%@
)@@
3eceive 9 ordinary shares for every ) debenture held!

iiiC /ew capital structure
/o! of new ordinary shares I 9@@@ x 9 I %9,@@@
Shs!
+9,@@@, Shs!%@ ordinary shares <@@,@@@
)@,@@@, Shs!)@, (F preference shares )@@,@@@
#otal capital (@@,@@@
2i# NonAcon2erti?le de?entures
#hese cannot be converted into ordinary preference shares and they are usually redeemable!
2ii# Su?Aordinate de?entures
Usually last for as long as )@ years and they are sold by financially strong companies! Such
are not secured and they rank among general creditors in claiming on assets during
liquidation! #his means that they are sub"ordinate to senior debt but superior to ordinary and
preference share capital!
,easons ?e%ind .n<o<ularity o' De?entures o' KenyaFs *inancial Market=
iC #heir par value is an extremely high value and as such they are unaffordable to
purchase by would be investors!
iiC #hey are in most cases secured debt and as such constrain the selling company in so
far as getting sufficient securities is difficult!
iiiC -ost of the would"be sellers have low credit worthiness which is difficult!
ivC 0enyaDs capital markets are not developed and as such there is no secondary
debenture market where they can be discounted or endorsed!
vC 1ebentures finance is not known among the general business community and as such
many would be sellers and buyers are ignorant of its existence!
viC *eing long term finance there are a few buyers who may be willing to stake their
savings for a long period of time!
viiC Such finance calls for a fixed return, which in the long rum will be eroded by
inflation!
;( /enture Ca<ital
:enture capital is a form of investment in new small risky enterprises required to get them
started by specialists called venture capitalists! :enture capitalists are therefore investment
specialists who raise pools of capital to fund new ventures which are likely to become public
corporations in return for an ownership interest! #hey buy part of the stock of the company at
a low price in anticipation that when the company goes public, they would sell the shares at a
higher price and therefore make a considerably high profit!
:enture capitalists also provide managerial skills to the firm! .xample of venture capitalists
are pension funds, wealthy individuals, insurance companies, cacia fund, 3ock fella, etc!
!.S&NESS *&NANCE
Lesson Two @;
Since the goal of venture capitalists is to make quick profits, they will invest only in firms
with a potential for rapid growth!
:enture capitalists, will only invest in a company if there is a reasonable chance that the
company will be successful! #heir publicity material states that successful investments have
three common characteristics!
aC #here is a good basic idea, a product or service which meets real customer needs!
bC #here is finance, in the right form to turn the idea into a solid business!
cC #here is the commitment and drive of an individual or group and the determination to
succeed!
Attri?utes o' 2enture ca<ital
iC .quity participation E :enture 5apital participate through direct purchase of shares
or fixed return securities Bdebentures and preference sharesC
iiC 2ong term investment E venture capital is an investment attitude that necessitates the
venture capitalists to wait for a long time B9 E )@ yearsC to make large profits Bcapital
gainsC!
iiiC 7articipation in -anagement E :enture capitalists give their -arketing, 7lanning and
-anagement Skills to the new firm! #his hands E on -anagement enable them
protect their investment!
,ole o' /enture Ca<ital in Economic De2elo<ment
#he types of venture that capitalists might invest will involve:
aC !usiness startAu<s E When a business has been set up by someone who has already
put time and money into getting it started, the group may be willing to provide
finance to enable it to get off the ground! With start"ups, venture capital often prefers
to be one of several financial institutions putting in venture capital!
bC !usiness de2elo<ment E #he group may be willing to provide development capital
for a company which wants to invest in new products or new markets or to make a
business acquisition, and so which so needs a ma=or capital in=ection!
cC Management ?uyout E management buyout is the purchase of all or parts of a
business from its owners by its managers!
dC Helping a company where one of its owners wants to realiDe all or <art o' %is
in2estment! #he venture capital may be prepared to buy some of the companyDs
equity!
*unding /enture Ca<ital
When a companyDs directors look for help from a venture capital institution, they must
recogni>e that:
aC #he institution will want an equity stake in the company!
bC $t will need convincing that the company can be successful Bmanagement buyouts of
companies which already have a record of successful trading have been increasingly
favored by venture capitalists in recent years!
cC $t may want to have a representative appointed to the companyDs board, to look after
its interests!
@9 Sources o' *unds
#he directors of the company then contract venture capital organi>ations, to try to find one or
more which would be willing to offer finance! venture capital organi>ation will only give
funds to a company that it believes can succeed!
,easons 'or Signi'icant Growt% in /enture Ca<ital in t%e De2elo<ed Countries
iC 7ublic attitude i!e a favourable attitude by the public at large towards
entrepreneurship, success as well as failure!
iiC 1ynamic financial system e!g efficient stock exchange and a competitive banking
system!
iiiC 6overnment support E e!g taxation system to encourage venture capital e!g tax
concessions and investment allowance taxes!
ivC .stablishment of venture capital institutions e!g investors in the industry!
vC 6rowth in the number of -anagement buyers B-*,C which have created a demand
for equity finance!
Constraints o' /enture Ca<ital in Kenya
)! 2ack of rich investors in 0enya, hence inadequate equity capital!
%! $nefficiencies of stock market E /S. is inefficient and investors cannot sell the
shares in future! 7rices do not reflect all the available information in the market!
+! $nfrastructural problems E this limits the growth rate of small firms which need raw
materials and unlimited access to the market factors of production!
&! 2ack of managerial skills on part of venture capitalists and owners of the firm!
9! /ature of small business in 0enya! #here are + categories!
a! 2arge -/5 E these are established firms and can raise funds easily!
b! sian owned small businesses E #hey are family owned hence do not require
interference of venture capitalists because they are not ready to share profits!
c! frican E owned business E need venture capital but have little potential for
growth!
'! 4ocus on low risk ventures e!g confining to low technology, low growth sectors with
minimum investment risks!
<! 5onservative approach by the venture capitalists!
(! 1elay in pro=ect evaluation e!g months or more hence entrepreneurs loose interest in
the pro=ect!
;! 2ack of government support and inefficient financial system!
Summary
$n sum, venture capital, by combining risk financing with management and marketing
assistance, could become an effective instrument in fostering developing countries! #he
experiences of developed countries and the detailed case study of venture capital however,
indicate that the following elements are needed for the success of venture capital in any
country!
!.S&NESS *&NANCE
Lesson Two 6I
broad"based Band less family basedC entrepreneurial traditional societies and
government encouragement for innovations, creativity and enterprise!
less regulated and controlled business and economic environment where attractive
customer opportunities exists or could be created from high"tech and quality products!
.xistence of disinvestments mechanisms, particularly over"the counter stock exchange
catering for the needs of venture capitalists!
4iscal incentives which render the equity investment more attractive and develops
Lequity cultD in investors!
more general, business and entrepreneurship oriented education system where
scientists and engineers have knowledge of accounting, finance and economics and
accountants understand engineering or physical sciences!
n effective management education and training programme for developing
professionally competent and committed venture capital managersO they should be
trained to evaluate and manage high technology, high risk ventures!
vigorous marketing thrust, promotional efforts and development strategy, employing
new concepts such as venture fair clubs, venture networks, business incubators etc! for
the growth of venture capital!
2inkage between universitiesAtechnology institutions, 3 H 1! ,rganisations, industry,
and financial institutions including venture capital firms!
.ncouragement and funding or 3 H 1 by private public sector companies and the
government for ensuring technological competitiveness!
Disad2antages o' /enture Ca<ital
1ilute ownership position of a firm
1ilute control of a firm

J.EST&ON ONE
aC What are the practical difficulties of a small scale enterprise wishing to obtain credit
to expand productionM B)@
marksC
bC 1istinguish between internal and external sources of finance for a limited liability
company! B)@
marksC
J.EST&ONTWO
aC Why do different sources of finance have different costsM B(
marksC
bC What are the advantages of having a farmersD bank compared with an ordinary
commercial bank in the provision of services to farmersM B)% marksC
J.EST&ON T-,EE
aC What is venture capitalM B&
marksC
64 Sources o' *unds
bC Why is the market for venture capital not yet well developed in 0enya or your
countryM
B)' marksC
J.EST&ON *O.,
aC 1istinguish between debt and equity capital! B)@ marksC
bC What are the advantages of leasing an asset compared to borrowing to buy an assetM
B)@ marksC
C-ECK 0O., ANSWE,S W&T- T-OSE G&/EN &N LESSON 4I O* T-E ST.D0
+ACK
!.S&NESS *&NANCE
Lesson Two 65
COM+,E-ENS&/E ASS&GNMENT 4
TO !E S.!M&TTED A*TE, LESSON 5
#o be carried out under .xamination condition and sent to the 1istance 2earning
dminstrator for marking by the University!
ANSWE, ALL J.EST&ONS( T&ME ALLOWED= T-,EE -O.,S
J.EST&ON ONE
aC Why does ordinary share capital have a high cost relative to debt capitalM B' marksC
bC $dentify the various methods of issuing new ordinary shares to shareholders!
B)9 marksC
J.EST&ON TWO
aC ,utline the functions of a financial manager in a contemporary corporate set"up!
B)% marksC
bC What are the weaknesses associated with profit maximisation goalM B(
marksC
J.EST&ON T-,EE
aC .xplain the types of agency costs that arise in agent"principal relationship that exist
between shareholders and managers! B)@ marksC
bC Why does 4inancial management in private Bcommercial firmsC differ from financial
management in governmentApublic sector! B)@ marksC
J.EST&ON*O.,
aC What are the disadvantages of Hire purchase as a source of financeM B'
marksC
bC ,utline the necessary conditions for success of venture capital financing in 0enya!
B)@ marksC
cC Why is operating lease called off"balance sheet financingM B&
marksC
6@ Sources o' *unds
J.EST&ON *&/E
#he 5huma /gumu 5ompany needs to finance a seasonal rise in inventories of Sh!&
million! #he funds are needed for six months! #he company is considering using the
following possibilities to finance the inventories:
iC warehouse loan from a finance company! #he terms are )( per cent annualised
with an (@F advance against the value of the inventory! #he warehousing costs are
Sh!+9@,@@@ for the six"month period! #he residual financing requirement which is
Sh!& million less the amount advanced will need to be financed by forgoing cash
discounts on its payables! Standard terms are %A)@ net +@O however the company
feels it can postpone payment until the fortieth day without adverse effect!
iiC floating lien arrangement from the supplier of the inventory at an effective interest
rate of %& per cent! #he supplier will advance the full value of the inventory!
iiiC bank loan from the companyDs bank for Sh!& million! #he bank can lend at the rate
of %%F! $n addition, a )@F compensating balance will be required which otherwise
would not be maintained by the company!
ivC .stablish a one year line of credit! #he commitment fees is 9F of the total
borrowings! #he interest rate is )<F p!a!
,e>uired
.xplain which is the cheapest option for the companyM "5I marks#
END O* COM+,E-ES&/E ASS&GNMENT 4
NOW SEND TO D&STANCE LEA,N&NG *O, MA,K&NG
!.S&NESS *&NANCE
Lesson T%ree 66
LESSON T-,EE
MEAS.,&NG !.S&NESS +E,*O,MANCE= *&NANC&AL
STATEMENTS ANAL0S&S
&NST,.CT&ONS
3ead 5hapter + of 4inancial -anagement textbook by $!- 7andey!
CONTENTS
1efinition and Users of 4inancial Statements
8ard Stick Used $n 3atio nalysis
5lassification 5omputation and interpretation of ratios
Uses Applications and limitation of ratios
4inancial forecasting
!.S&NESS *&NANCE
68 Measuring !usiness +er'ormance
De'inition
4inancial analysis is a process by which finance identifies the companyDs financial
performances by comparing the entities in the balance sheet and those in the profit and loss
account B7H2C! #his is so because balance sheet entities are usually responsible for those to
be found in the 7H2 i!e! assets shown in the balance sheet are responsible for sales, revenue
and expenses to be found in the 7H2! #his analysis is important to various parties with a
financial stake in the company! #hese include:
)! Shareholders E ctual owners are interested in the companyDs both short and long
term survival! 4or this reason they will use ratioDs such as:
aC 7rofitability ratios E which seek to establish viability!
bC 1ividend ratios E which seek to establish return to owners in form of
dividends! #he common ratios include earning yield B.A8C, 1ividend pay out
ratio B17,C, dividend yield, 7rice earning ratio, all of which will measure
return to owner!
%! 5reditors BtradeC E these are interested in the companyDs ability to meet their short"
term obligations as and when they fall due! 4or this reason they will use ratios such
as:
aC 2iquidity ratio E a qualitative measure of companyDs liquidity position
measured by acid test ratio!
bC 5urrent ratio E which is a measure of companyDs quantity of current assets
against current liabilities!
+! 2ong term lenders E #hese include finances through loans, mortgages and debenture
holders! #hese have both short and long term interest in the company and its ability
to pay not only interest on debt but also principal as and when it falls due! #hese
parties are interested in the following:
aC 2iquidity ratios E used to assess short"term liability to meet current
obligations!
bC 7rofitability ratios E used to ascertain whether the company can pay its
principal back!
cC 6earing ratio E used to gauge the companyDs risk in the investment!
dC $nvestment coverage ratio E shows the companyDs safety as regards the
payment of interest to the lenders of the debt!
&! 1irectors and management of company E #hey will therefore be interest in:
aC .fficiency of the company in generating profits!
bC #he companyDs viability from the investorDs point of view and the companyDs
ability to generate sufficient returns to investors!
cC 6earing ratio to gauge the safety and risk associated with the company!
!.S&NESS *&NANCE
Lesson T%ree 67
9! 7otential investors E these parties are interested in a company in total both on short
and long term basis in particular the companyDs ability to generate acceptable return
on their money!
#herefore, they will use:
aC 1ividend ratios
bC 3eturn ratios
cC 6earing ratios
'! 6overnment E #he 6overnment is interested mostly in utility companies Be!g! 0725,
07#5C and those that will provide public services E in this case the government will
be interested in their survival and thus ability to provide those services! $t may be
interested in taxation derived from these companies which is used for development!
6overnment may also be interested in employment level and as such it will use those
ratios that can enable it to achieve such ob=ectives of particular importance are:
aC 7rofitability ratios
bC 3eturn ratios
<! 5ompetitors E #hese are interested in the companyDs performance from the market
share point of view and will use the ratios that enable them to ascertain companyDs
competitive strength e!g! profitability ratios, sales and returns ratio etc!
(! 6eneral public E 5ustomers and potential customers E #hese are interested in the
ability of the company to provide good services both in the short and long run! #o
gauge the companyDs ability to provide goods and services on short and long term
basis! We have:
aC 3eturns ratio
bC Sales ratio
0A,D ST&CK .SED &N ,AT&O ANAL0S&S
4( +ast <er'ormance o' t%e com<any
#he companyDs past performance Bpast ratioC is used to measure or gauge the companyDs
performance and in particular the change in performance whether good BfavourableC, better,
same or even worse than the past! Such comparison is then used to interpret the companyDs
performance bearing in mind the factors that influenced the present and past performances!
5( A2erage industry ratios
#hese are useful as they indicate the average performance of various companies in a given
industry i!e! it gives the minimum performance of a number of companies in a given industry!
#hese ratios are useful in so far as to enable the analyst to make a reasonable comparison of
the companyDs performance vis"T"vis other companies in the same industry! However, for
this yardstick to be useful the term average should include those companies which are not
6: Measuring !usiness +er'ormance
extremely! $!e! very strong and very weak companies E which should be excluded to arrive at
industry average figures!
@( ,atio o' success'ul com<anies
Useful if the company can get figures of competitors who are leading in the market so as to
enable it to gauge its performance against better performance! However this information is
difficult to obtain and sometimes it calls for private investigators e!g! 7rivate .yes 2td!
6( ,atio o' ?udgeted <er'ormance
#hese are compared with actual performance ratios and investigations are made of any
unfavorable variance which should be explained!
Classi'ication o' ,atios
3atios are broadly classified into 9 categories:
)! 2iquidity ratios
%! #urnover ratios
+! 6earing ratios
&! 7rofitability ratios
9! 6rowth and valuation ratios
4( Li>uidity ,atios
lso called working capital ratios! #hey indicate ability of the firm to meet its short term
maturing financial obligationAcurrent liabilities as and when they fall due!
#he ratios are concerned with current assets and current liabilities! #hey include:
aC 5urrent ratio I 5urrent ssets
5urrent liabilities
#his ratio indicates the /o! of times the current liabilities can be paid from current assets
before this assets are exhausted!
#he most recommended ratio is %!@ i!e! the current asset must at least be twice as high as
current liabilities
bC ?uickAacid test ratios I 5urrent sset " Stock
5urrent liabilities
$s a more refined current ratio which exclude amount of stock of the firm! Stocks are
excluded for two basic reasons!
iC #hey are valued on historical cost basis
iiC #hey may not be converted into cash very quickly
#he ratio therefore indicates the ability of the firm to pay its current liabilities from the more
liquid assets of the firm!
!.S&NESS *&NANCE
Lesson T%ree 6;
cC 5ash ratio I 5ash in handAbank G short term marketable
securities
5urrent liabilities
#his is a refinement of the acid test ratio indicating the ability of the firm to meet its current
liabilities from its most liquid resources!
Short term marketable securities refers to short term investment of the firm which can be
converted into cash within a very short period e!g commercial paper and treasury bills!
dC /et working capital 3atio I /etworking 5apital x )@@
/et ssets
Where /et ssets or 5apital employed I #otal ssets E 5urrent liability
#his ratio indicates the proportions of total net assets which is liquid enough to meet the
current liabilities of the firm!
$t is expressed in F term!
5( Turno2er ,atiosCe''iciencyCasset management ratio
#urnover ratio indicate the efficiency with which the firm utilised the asset or resources at its
disposal to generate sales revenue or turnover!
#his ratio includes:
aC StockAinventory turnover I 5ost of Sales
verage stock
#he ratio indicate number of times the stock was turned into sales in a year i!e how many
times did the Lbuy"sellD process occur during the year! #he higher the stock turnover, the
better the firm and more likely the higher the sales!
bC Stock holding period I +'9 days
Stock turnover
I +'9 x verage stock i!e +'9
5ost of sales Stock turnover
#he ratio indicates number of days the stock was held in the warehouse before being sold!
#he higher the stock turnover, the lower the stock holding period and vice versa!
cC 1ebtorsAaccounts receiver turnover I nnual credit sales
verage debtor
#he ratio indicate the number of timesAfrequency with which credit customers or debtors were
turned into sale i!e the number of times they come to buy on credit per year after paying their
dues to the firm!
#he higher the debtors turnover the better the firm indicating that customers came to buy on
credit many times thus they paid within a short period!
dC 1ebtors collection period I +'9
1ebtors turnover
or +'9 x verage debtors
nnual credit sales
#his refers to credit period that was granted to the debtors on the period within which they
were supposed to pay their dues to the firm!
#he shorter the collection periodAcredit period the higher the debtors turnover and vice versa!
$f no opening debtors are given use the closing debtors to represent average debtors!
eC 5reditorsAaccounts payable turnover I nnual credit purchases
verage creditors
#he firm buy goods on credit from suppliers!
#he ratio indicate number of times p!a! the firm bought goods on credit after
paying the suppliers!
$f the creditors turnover is high, this indicates that the payment was made
within a short period of time!
fC 5reditors payment period I +'9
5reditors turnover
I +'9 x verage creditors
nnual credit purchases
#he ratio indicate the credit period granted by the suppliers i!e! the period
within which the firm should pay its liabilities to the suppliers!
#he shorter the period the higher the creditors turnover and vice"versa!
gC 4ixed asset turnover I nnual Sales
4ixed ssets
#his ratio indicate the efficiency with which, the fixed assets were utilised to
generate sales revenue e!g! a ratio of )!& means one shilling of fixed assets was
utilised to generate Sh!)!& of sales!
hC #otal asset turnover I nnual sales
#otal assets
#he ratio indicate amount of sales revenue generated from utilisation of one
shilling of total asset!
#he 5oncept of Working 5apitalA5ash ,perating 5ycle
!.S&NESS *&NANCE
Lesson T%ree 8I
Working capital cycle refers to period that elapses between the payment for raw materials
bought on credit Bcash outflowsC and the receipts of cash from finished goods sold on credit
Bcash inflowsC!
#he working capital cycle will involve the following:
aC 7urchase of raw materials on credit from suppliers
bC 7ayment of raw materials after the lapse of credit period
cC 5onversion of raw materials into finished goods
dC Sale of finished goods to creditors
eC 3eceipt of cash from debtors!
#his can be illustrated using a diagram as follows:
3aw material stock conversion period
5reditors 7ayment 7eriod 1ebtors 5ollection 7eriod
A ! C D
7urchase of 7ayment of 4inished goods 3eceipts of
3aw materials raw materials sold on credit cash goods
,n credit cash outflow sold on credit
5ash inflows
Working 5apital 5ycle
Working capital cycle I Stock conversion G debtors collection E 5reditors payment
4rom the diagram the working capital cycle of a period will be determined as follows:
Stock conversion period G 1ebtors collection period E 5reditors payment period
Note
lengthy working capital cycle is an indicator of poor management of stock and debtors
reflecting low turnover of stock and debtors and lengthy stockholding period and debtors
collection period!
#he working capital cycle can be reduced in any of the following ways:
)! /egotiate for a longer credit period with the suppliers
%! 3educe the stock conversion period or manufacturing period!
+! 3educe the debtors collection period by granting short crediting period! #his can be
achieved through offering discounts to customers to encourage them to pay earlier!
&! Holding fast moving goods to ensure high turnover!
9! #imely delivery of raw materials by suppliers especially if any delay in delivery will
lengthen the raw materials holding period!
+! 6earingA2everageA5apital Structure 3atio
#he ratio indicate the extent in which the firm has borrowed fixed charge capital
to finance the acquisition of the assets or resources of the firm!
#he two basic gearing ratios are:
aC 1ebtAequity ratio I 4ixed charge capital
.quity Bnet worthC
#his ratio indicate the amount of fixed charge capital in the capital structure of the firm for
every one shilling of owners capital or equity e!g a ratio of @!<( means for every Sh!) of
equity there is Sh!@!<( fixed charge capital!
bC 4ixed charge to total capital ratioI 4ixed charge capital x )@@
#otal capital employed
Where total capital employed I 4ixed charge capital G equity relative to total capital
employed by the firm e!g a ratio of @!+( means that, +(F of the capital employed is fixed
charge capital!
Ot%er le2erage or gearing ratios are
aC 1ebt ratio I #otal debts
#otal assets
Where total debt I fixed charge capital G liabilities!
#he ratio indicate the proportion of total assets that has been financed using long term and
current liabilities e!g a debt ratio of @!&9 mean &9F of total asset has been financed with debt
while the remaining 99F was financed with owners equityAcapital!
bC #imes interest earned ratio I ,perating profit Bearning before interest and tax
$nterest 5harges
#$.3 also called interest coverage ratio!
#his ratio indicate the number of times interest charges can be paid from operating profit!
#he higher the #$.3, the better the firm indicating that either the firm has high operating
profits or its interest charges are low!
$f #$.3 is high due to low interest charges, this indicates low level of gearingAdebt capital of
the firm!
&! 7rofitability 3atio
#his ratio indicate the performance of the firm in relation to its ability to derive returns or
profit from investment or from sale of goods i!e profit margin or sales!
!.S&NESS *&NANCE
Lesson T%ree 85
)! 7rofitability in relation to sales
#he ratio indicate the ability of the firm to control its cost of sales, operating and financing
expenses!
#hey include:
aC 6ross profit margin I 6ross profit x )@@
Sales
#he ratio indicate the ability of the firm to control cost of sales expenses e!g gross profit
margin of &@F means '@F of sales revenue was taken up by cost of sales while &@F was the
gross profit!
bC ,perating profit margin I ,perating profitA.arning before interest H tax
Sales
#he ratio indicates ability of the firm to control its operating expenses such as distribution
cost, salaries and wages, travelling, telephone and electricity charges etc! e!g a ratio of %@F
means:
iC (@F of sales relate to both operating and cost of sales expenses
iiC %@F of sales remained as operating margin profit
cC /et profit margin I /et profit x )@@ Bearning after taxC G interest
Sales
#his ratio indicates the ability of the firm to control financing expenses in particular interest
charges e!g! /et profit margin of )@F indicate that:
iC ;@F of sales were taken up by cost of sales, operating and financing expenses
iiC )@F remained as net profits!
%! 7rofitability in relation to investment
aC 3eturn on $nvestment B3,$C I /et profit x )@@
or return on total asset B3,#C #otal asset
#he ratio indicate the return on profit from investment of Sh!) in total assets e!g a ratio of
%@F means Sh!)@ of total asset generated Sh!% of net profit!
bC 3eturn on equity B3,.C I /et profit x )@@
or 3eturn on net worth B3,/WC equity
or 3eturn on shareholders equity B3,S.C
#he ratio indicate the return of profitability for every one shilling of equity capital
contributed by the shareholders e!g a ratio of %9F means one shilling of equity generates
Sh!@!%9 profit attributable to ordinary shareholders!
cC 3eturn on capital employed 3,5. I /et profit x )@@
or 3eturn on net asset B3,/C /et sset B5apital employedC
8@ Measuring !usiness +er'ormance
#his ratio indicate the returns of profitability for every one shilling of capital employed in the
firm!
9! #he 6rowth and :aluation 3atio
#his ratio indicates the growth potential of the firm in addition to determining the value of the
firm and investment made by various investors! #hey include the following:
aC .arnings per share .7S I .arnings to ,rdinary shareholders
/o! of ordinary shares
#his ratio indicate earnings power of the firm i!e how much earnings or profits are attributed
to every share held by an investor! #he higher the ratio the better the firm!
bC .arnings yield B.8C I .arnings per share x )@@
-arket price per share
#he market price per share B-7SC is the price at which new shares can be bought from
the stock market!
#hese ratios therefore indicate the returns or earnings for every one shilling invested in
the firm!
cC 1ividends per share B17SC I 1ividend paid
" #his indicates the cash dividend received for every share held by an investor! $f all
the earnings attributable to ordinary shareholders were paid out as dividend, then .7S I 17S!
dC 1ividend 8ield B18C I 1ividend per share x )@@
-arket price per share
,r 1ividend paid
-arket value of equity
Where market value of equity I /o! of shares x -7S
#his ratio indicates the cash dividend returns for every one shilling invested in the firm!
eC 7rice earnings B7A.C I -arket price per share B-7SC
3atio .arning per share
,3
I -arket value of equity
.arning to ,rd! Shareholders
7A. ratio is a reciprocal of earning yield B.8C! #he -7S is the price at which a new
share can be bought i!e investment per share! #he .7S is the annual incomeAearnings
from each share!
7. therefore indicate the payback period i!e number of years it will take to recover -7S
from the annual earnings per share of the firm!
fC 1ividend cover I .7S I .arning to ordinary shares
!.S&NESS *&NANCE
Lesson T%ree 86
17S 1ividend paid
#his indicate the number of times dividend can be paid from earnings to ordinary
shareholders! #he higher the 17S the lower the dividend cover and vice"versa e!g
consider the following two firms P and 8
P 8
.7S )%AI )%AI
17S +AI 9AI
1ividend cover )% I & )% I %!& times
+ 9
gC 1ividend pay out ratio I 17S x )@@ I 1ividend paid
.7S .arning to ordinary shareholder
#his is the reciprocal of dividend cover! $t indicates the proportion of earnings that was
paid out as dividend e!g a payout ratio of &@F means '@F of earnings were retained
while &@F was paid out as dividend, therefore retention ratio I ) E dividend payout ratio
hC *ook value per share I /etworth .quity
B*:7SC /o! of ordinary shares
#his is also called liquidity ratio which indicates the amount attributable to each share if
the firm was liquidated and all asset sold at their book value!
#he ratio is based on the residual amount which would remain after paying all liabilities
from the sales proceeds of the assets!
iC -arket to book value per share I -7S
*:7S
#his ratio indicates the amount of goodwill attached to the firm i!e the price in excess of
the sales value of the assets of the firm! $f the ratio is greater )B-*:7S U)C this indicate
a positive goodwill while if less than ) a Eve goodwill!
.sesCA<<lication o' ,atios
3atios are used in the following ways by managers in various firms!
)! .valuating the efficiency of assets utilisation to generate sales revenue i!e turnover
ratio!
%! .valuating the ability of the firm to meet its short term financial obligation as and
when they fall due Bliquidity ratiosC!
+! #o carry out industrial analysis i!e compare the firmDs performance with the average
industrial performance of the firm with that of individual competitors in the same
industry!
&! 4or cross sectional analysis i!e compare the performance of the firm with that of
individual competitors in the same industry!
9! 4or trendAtime series analysis i!e evaluate the performance of the firm over time!
'! #o establish the extent which the assets of the firm has been financed by fixed charge
capital i!e use of gearing ratio
<! #o predict the bankruptcy of the firm i!e use of selected ratios to determine the
overall ratio usually called Q"score! #he Q"score when compared with a pre"
determined acceptable a Q"score will indicate the probability of the bankruptcy of the
firm in future!
Limitations o' ,atios
3atios have the following weaknesses:
)! #hey ignore the si>e of the firm being compared e!g in cross"sectional analysis, the
firm being compared might be of different si>e, technology and product
diversification!
%! .ffect of inflation:
3atio ignores the effect of inflation in performance e!g increase in sales might be due
to increase in selling price caused by inflationary pressure in the economy!
+! 3atios ignore qualitative or non"quantifiable aspects of the firm e!g important assets
such as corporate image, efficient management team, customer loyalty, quality of
product, technological innovation etc are not captured in ratio analysis!
&! 3atios are computed only at one point in time i!e they are sub=ect to frequent changes
after computation e!g liquidity ratios will constantly change as the cash, debtors and
stock level changes!
9! -onopolistic firms
$t is difficult to carry out industrial and cross"sectional analysis for monopolistic
firms since they do not have competitors and they are the only firms in the whole
industry e!g #elkom"0enya, .ast frica *rewery etc!
'! Historical 1ata E 3atios are computed in historical information or financial statement
thus may be irrelevant in future decision"making of
<! 5omputation and interpretation
6enerally some ratios do not have an acceptable standard of computation! #his may
differ from one industry to another! .!g the return on investment may be computed
as:
3eturn on investment I .*$# or .#
#otal assets #otal assets
(! 1ifferent accounting policies E 1ifferent firms in the same industry use different
accounting policies e!g methods of depreciation and stock valuation! #his makes
comparison difficult!
*inancial *orecasting
4inancial forecasting refers to determination of financial requirements of the firm in advance!
#his requires financial planning using budgets!
#he financial planning and forecasting will also determined the activities the firm should
undertake in order to achieve its financial targets!
4inancial forecasting is important in the following ways:
)! 4acilitate financial planning i!e determination of cash surplus or deficit that are likely
to occur in future!
!.S&NESS *&NANCE
Lesson T%ree 87
%! 4acilitate control of expenditure! #his will minimise wastage of financial resources
in order to achieve financial targets!
+! $t avoids surprise to the managers e!g any cash deficit is known well in advance thus
the firm can plan for sources of short term funds such as bank drafts or short term
loans!
&! -otivation to the employees E 4inancial forecasting using budgets and targets will
enhance unity of purpose and ob=ectives among employees who are determined to
achieve the set target!
Met%odsCTec%ni>ues o' *inancial *orecasting
4( .se o' Cas% !udgets
cash budget is a financial statement indicating:
aC Sources of revenue and capital cash inflows
bC How the inflows are expended to meets revenue and capital expenditure of
the firm!
cC ny anticipated cash deficitAsurplus at any point during forecasting period!
5( ,egression Analysis
#his is a statistical method which involves identification of dependant and independent
variable to form a regression equation Vy I a G bxC on which forecasting will be based!
@( +ercentage o' Sales Met%od
#his method involves expressing various balance sheet items that are directly related to sales
as a percentage of sales! $t involves the following steps:
iC $dentify various balance sheet items that are directly with sales this items include:
aC /et fixed asset E $f the current production capacity of the firm is full an increase in
sales will require acquisition of new assets e!g! machinery to increase production!
bC 5urrent sset E n increase in sales due to increased production will lead to increase
in stock of raw materials, finished goods and work in progress! $ncreased credit sales
will increase debtors while more cash will be required to buy more raw materials in
cash!
cC 5urrent liabilities E $ncreased sales will lead to purchase of more raw materials
dC 3etained earnings E #his will increase with sales if and only if, the firm is operating
profitability and all net profits are not paid out as dividend!
Note
#he increase in sales does not require an increase in ordinary share capital, preference share
capital and debentures since long term capital is used to finance long term pro=ect!
iiC .xpress the various balance sheet items varying with sales as percentage of sales e!g!
assume for year %@@% stock and net fixed assets amount to Sh!)%- and )(-
respectively sales amount to Sh!&@-! #herefore stock as percentage of salesK
Stock I F +@ )@@
&@
)%
x
M
M
8: Measuring !usiness +er'ormance
4ixed asset I
F &9 )@@
&@
)(
x
M
M
iiiC 1etermine the increase in total asset as a result of increase in sales e!g suppose sales
increases from Sh!&@ - to Sh!'@ - during year %@@+! #he additional stock and net
fixed asset required would be determined as follows:
$ncrease in stock I F of sales x increase in sales
I +@F B'@ E &@C I Sh!'-
$ncrease in fixed asset I F of sales x increase in sales
I &9FB'@ E &@C I Sh!; -
ivC 1etermine the total increase in assets which will be financed by:
aC Spontaneous source of finance i!e increase in current liabilities
Where $ncrease I F of sales x increase in sales
bC 3etained earnings for the forecasting period
3etained earnings I /et profit E 1ividend paid
/et profit margin I /et profit
Sales
#herefore: /et profit I /et profit margin BFC x sales
Note
6enerally /et profit margin is called after tax return on sales!
,ut of the total assets that are required as a result of increase in sales, the financing will
come from the two sources identified! ny amount that cannot be met from the two
sources will be borrowed externally on short term basis which will be a current liability!
Assum<tions underlying K o' sales met%od
#he fundamental assumption underlying the use of F of sales method is that, there is no
inflation in the economy i!e the increase in sales is caused by increase in production and not
increase in selling price!
,ther assumptions include:
)! #he firm is operating at full or )@@F capacity! #herefore the increase in production
will require acquisition of new fixed assets!
%! #he firm will not issue new ordinary shares or debenture or preference shares thus
this capital will remain constant during the forecasting period!
+! #he relationship between balance sheet item and sales i!e balance sheet items as F of
sales will be maintained during forecasting period!
!.S&NESS *&NANCE
Lesson T%ree 8;
&! #he after tax, profit on sale or net profit margin will be achieved and shall remain
constant during the forecasting period!
&llustration
#he following is the balance sheet of P8Q 2td as at +)
st
1ecember %@@%:
/et fixed asset
5urrent assets
*inanced ?y=
,rdinary share capital
3etained earnings
)@F debentures
#rade creditors
ccrued expenses
Sh!D@@@D
+@@
)@@
&@@
)@@
<@
)9@
9@
+@
&@@
Additional &n'ormation
)! #he sales for year %@@% amounted to Sh!9@@,@@@! #he sales will increase by )9F
during year %@@+ and )@F during year %@@&!
%! #he after tax return on sales is )%F which shall be maintained in future!
+! #he companyDs dividend payout ratio is (@F! #his will be maintained during
forecasting period!
&! ny additional financing from external sources will be affected through the issue of
commercial paper by company!
,e>uired
aC 1etermine the amount of external finance for % years upto +)
st
1ecember %@@&!
bC 7repare a proforma balance as at +) 1ecember %@@&
Solution
$dentify various items in balance sheet directly with sales:
4ixed sset
5urrent sset
#rade creditors
ccrued expenses
/et fixed assets I +@@- x )@@ I '@F
9@@-
5urrent ssets I )@@- x )@@ I %@F
9@@-
#rade creditors I 9@ x )@@ I )@F
9@@
ccrued expenses I +@ x )@@ I 'F
9@@
cC 5ompute the increase in sales over the % years!
8ear %@@% sales I
M x 9<9
)@@
))9
9@@
8ear %@@+ sales I M x 9 ! '+%
)@@
))9
9<9
$ncrease in sales in %@@+"@+"%'I'+%!9 E 9@@ I )+%!9-
dC 5ompute the amount of external requirement of the firm over the % years of
forecasting period!
iC $ncrease in 4! ssets I F of sales x increase in sales
I '@F x )+%!9 I <;!9-
iiC $ncrease in 5! ssets I F of sales x increase in sales
I %@F of )+%!9 I %'!9-
#otal additional investmentAasset required )@'-
&nter<retation
4or the company to earn increase in sales of )+%!9- it will have to acquire additional assets
costing )@'-!
S%(FIIIF
dditional investmentAasset required )@',@@@
2ess: Spontaneous source of finance
$ncrease in creditors I F of sales x increase in sales
I )+%,9@@ x )@F B)+,%9@C
$ncrease in accrued expenses I F of sales x increase in sales
I )+%,9@@ x 'F B<,;9@C
2ess: 3etained earnings during % years of operation Binitial sourcesC
/et profit for %@@+ I /et profit margin x sales of %@@+
I )%F of 9<9,@@@ I ';,@@@
2ess: 1ividend payable (@F of ';,@@@ I 99,%@@ B)+,(@@C
/et profit for %@@& I /et profit margin x sales of %@@&
I )%F of '+%,9@@ I <9,;@@
2ess: dividend payable (@F of <9,;@@ I '@,<%@ B)9,)(@C
.xternal financial needs Bcommercial paperC 99,(%@
+ro'orma !alance S%eet
!.S&NESS *&NANCE
Lesson T%ree 7I
#his refers to the pro=ected balance sheet at the end of forecasting period! #he items in the
proforma balance which vary with sales would be determined in any of the following two
ways:
iC F of sales x sales at last year of forecasting B%@@&CO or
iiC *alance sheet item before forecasting plus increase in balance sheet item as a result
of increase in sales!
+ro'orma ?alance s%eet as at @4st Decem?er 5II6
/et fixed assets '@F x '+%!9 or +@@ G <;!9
5urrent ssets %@F x '+%!9 or )@@ G %'!9
,rdinary shares Bwill remain constantC
3etained earning <@ G )+!( G )9!)(
)@F debenture Bremain constantC
#rade creditor )@F x '+%!9 or 9@ G )+!%9
ccrued expenses 'F x '+%!9 or +@ G <!;9
.xternal borrowing E commercial
S%s(
+<;!9@
)%'!9@
9@'!@@
)@@!@@
;(!;(
)9@!@@
'+!%9
+<!;9
99!(%
9@'!@@
J.EST&ON ONE
n extract from the finance statements of 0enyango 4isheries 2td is shown below:
$ssued share capital:
)9@,@@@ ordinary shares of Sh!)@ each fully
paid
)@F loan stock );;;
Share premium
3evenue 3eserve
5apital employed
Shs!
),9@@,@@@
%,@@@,@@@
),9@@,@@@
<,@@@,@@@
)%,@@@,@@@
#he profits after +@F tax is Sh!'@@,@@@! However, interest charge has not been
deducted!
,rdinary dividend payout ratio is &@F!
#he current market value of ordinary shares Shs!+'
,e>uired
aC 3eturn on capital employed
bC .arnings per share
cC 7rice earnings ratio
dC *ook value per share
eC 6earing ratio
fC -arket to book value per share
J.EST&ON TWO
#he following financial statements relate to the *5 5ompany:
ssets S%s( Lia?ilities L Net wort% S%s(
5ash
1ebtors
Stock
#otal current assets
/et fixed assets
%(,9@
@
%<@,@@
@
'&;,9@
@
;&(,(@
@
%(9,<9
@
),%++,<9
@
#rade creditors
/otes payable B;FC
,ther current liabilities
2ong term debt B)@FC
/et worth
))',%9@
9&,@@@
)@@,9@@
+@@,@@@
''+,@@@
),%++,<9@
&ncome Statement 'or t%e year ended @4 Marc% 4998
Sales
Shs!
),;<%,9@@
!.S&NESS *&NANCE
Lesson T%ree 75
2ess cost of sales
6ross profit
Selling and administration expenses
.arning before interest and tax
$nterest expense
.stimated taxation B&@FC
.arnings after interest and tax
),+'(,@@@
'@&,9@@
&;(,<9@
)@9,<9@
+&,9@@
<),%9@
%(,9@@
&%,<9@
,e>uired
aC 5alculate:
iC $nventory turnover ratioO B+
marksC
iiC #imes interest earned ratioO B+ marksC
iiiC #otal assets turnoverO B+ marksC
ivC /et profit margin B+ marksC
B/ote: 3ound your ratios to one decimal placeC
bC #he *5 5ompany operates in an industry whose norms are as follows:
3atio $ndustry /orm
$nventory turnover '!% times
#imes interest earned ratio 9!+ times
#otal assets turnover %!% times
/et profit margin +F
,e>uired
5omment on the revelation made by the ratios you have computed in part BaC above when
compared with the industry average!
J.EST&ON T-,EE
#he following information has been extracted from the published accounts of 7esa
5orporation 2imited, a company quoted on the /airobi Stock .xchange!
Shs!
/et profit after tax and interest ;;@,@@@
2ess: dividends for the period <&@,@@@
#ransfer to reserves %9@,@@@
ccumulated reserves brought forward ()@,@@@
3eserves carried forward ),@'@,@@@
Share capital BSh!)@ par valueC Sh!(,@@@,@@@
-ar@%ket price per share now )%F
,e>uired
aC What is meant by a company quoted on the /airobi Stock .xchangeM
B' marksC
7@ Measuring !usiness +er'ormance
bC 5alculate for 7esa 5orposation 2imited the following ratios and indicate the
importance of each to -iss Hisa, a Shareholder:
iC .arnings per share! B& marksC
iiC 7rice earnings ratio B& marksC
iiiC 1ividend yield B& marksC
ivC 1ividend cover B& marksC
"Total= 55 marks#
J.EST&ON *O.,
#he executive director of 7esa 2td has circulated the following information as part of board
paper:
7esa 2td!
4inancial 7erformance for the year ended +) -arch:
4999 499;
iC
iiC
iii
C
ivC
3eturn on investment
6ross profit on sales
/umber of days credit given
dministrative cost of sales
)%F
%9F
+@ days
<F
)@F
%@F
&9 days
)@F
,e>uired
aC *rief report on each of the above & ratios indicating the reservation, if any,
you may have or =udging them as improvement in performance!
bC #a=iri 2td has sales of Sh!%@,@@@,@@@ in );;(! *eginning and closing stock
was Sh!(@@,@@@ and Sh!%,%@@,@@@ respectively! 6!7! margin is usually %9F
of sales!
,e>uired
iC Stock turnover ratio
iiC /umber of days stock held
iiiC *rief explanation on how the ratio computed in BiC above can be improved and
financial
5onsequences of such action!
C-ECK 0O., ANSWE,S W&T- T-OSE +/O/&DED &N LESSON 4I O*
T-E ST.D0 +ACK
!.S&NESS *&NANCE
Lesson T%ree 76
Lesson *our 78
LESSON *O.,
CA+&TAL ST,.CT.,E AND COST O* *.NDS
&NST,.CT&ONS
3ead 5hapter )+ of 4inancial -anagement text book by $!-! 7andey
CONTENTS
5ost of 5apital Structure 1ecisions
#erm Structure of interest rate
-odels of computing cost of capital
#he weighting verage cost of capital
-arginal cost of capital
!.S&NESS *&NANCE
77 Ca<ital Structure and Cost o'
*unds
CA+&TAL ST,.CT.,E
4actors #hat ffect 5apital Structure
)! vailability of securities E #his influences the companyDs use of debt finance which
means that if a company has sufficient securities, it can afford to use debt finance in
large capacities!
%! 5ost of finance Bboth implicit and explicitC E $f low, then a company can use more of
debt or equity finance!
+! 5ompany gearing level E if high, the company may not be able to use more debt or
equity finance because potential investors would not be willing to invest in such a
company!
&! Sales stability E $f a company has stable sales and thus profits, it can afford to use
various finances in particular debt in so far as it can service such finances!
9! 5ompetitiveness of the industry in which the company operates E $f the company
operates in a highly competitive industry, it may be risky to use high levels of debt
because chances of servicing this debt may be low and may lead a company into
receivership!
COST O* *&NANCE
De'inition
#his is the price the company pays to obtain and retail finance! #o obtain finance a company
will pay implicit costs which are commonly known as floatation costs! #hese include:
Underwriting commission, *rokerage costs, cost of printing a prospectus, 5ommission costs,
legal fees, audit costs, cost of printing share certificates, advertising costs etc! 4or debt there
are legal fees, valuation costs Bi!e! security, audit fees, *ankers commission etc!C such costs
are knocked off from:
iC #he market value of shares if these have only been sold at a price above par value!
iiC 4or debt finance E from the par value of debt!
$!e! if flotation costs are given per share then this will be knocked off or deducted from the
market price per share! $f they are given for the total finance paid they are deducted from the
total amount paid!

Cost o' ,etaining *inance
#his will include dividends for share capital and interest for debt finance Btax deductedC or
effective cost of debt! However, when computing the cost of finance apart from deducting
implicit costs, explicit costs are the most central elements of cost of finance!
&m<ortance o' Cost o' *inance
#he cost of capital is important because of its application in the following areas:
iC 2ong"term investment decisions E $n capital budgeting decisions, using /7: method,
the cost of capital is used to discount the cash flows! Under $33 method the cost of
capital is compared with $33 to determine whether to accept or re=ect a pro=ect!
7: Lesson *our
iiC 5apital structure decisions E #he compositionAmix of various components of capital
is determined by the cost of each capital component!
iiiC .valuation of performance of management E high cost of capital is an indicator of
high risk attached to the firm! #his is usually attributed to poor performance of the
firm!
ivC 1ividend policy and decisions E .!g if the cost of retained earnings is low compared
to the cost of new ordinary share capital, the firm will retain more and pay less
dividend! dditionally, the use of retained earnings as an internal source of finance
is preferred because:
$t does not involve any floatation costs
$t does not dilute ownership and control of the firm, since no new shares are
issued!
vC 2ease or buy decisions E firm may finance the acquisition of an asset through
leasing or borrowing long"term debt to buy an asset! $n lease or buy decisions, the
cost of debt Binterest rate on loan borrowedC is used as the discounting rate!
*actors T%at &n'luence t%e Cost o' *inance
)! #erms of reference E if short term, the cost is usually low and vice versa!
%! .conomic conditions prevailing E $f a company is operating under inflationary
conditions, such a company will pay high costs in so far as inflationary effect of
finance will be passed onto the company!
+! 3isk exposed to venture E if a company is operating under high risk conditions, such
a company will pay high costs to induce lenders to avail finance to it because the
element of risk will be added on the cost of finance which may compound it!
&! Si>e of the business E small company will find it difficult to raise finance and as
such will pay heavily in form of cost of finance to obtain debt from lenders!
9! vailability E 5ost of finance B5,4C prices will also be influenced by the forces of
demand and supply such that low demand and low supply will lead to high cost of
finance!
'! .ffects of taxation E 1ebt finance is cheaper by the amount equal to tax on interest
and this means that debt finance will entail a saving in cost of finance equivalent to
tax on interest!
<! /ature of security E $f security given depreciates fast, then this will compound
implicit costs Bcosts of maintaining that securityC!
(! 5ompanyDs growth stage E 8oung companies usually pay less dividends in which
case the cost of this finance will be relatively cheaper at the earlier stages of the
companyDs development!
Term Structure o' &nterest ,ates
#he term structure of interest rate describes the relationship between interest rates and the
term to maturity and the differences between short term and long term interest rates!
#he relationship between short and long interest rates is important to corporate managers
because:
!.S&NESS *&NANCE
7; Ca<ital Structure and Cost o'
*unds
)! #hey must decide whether to buy long term or short term bonds and whether to
borrow by issuing long"term or short"term bonds!
%! $t enables them to understand how long term and short term rates are related and what
causes the shift in their relative positions!
Several theories had been advanced to explain the nature of yield curve E #hese are:
)! 2iquidity preference theory
%! .xpectation theory
+! -arket segmentation theory
4( Li>uidity +re'erence T%eory
#his theory states that short term bonds are more favourable than long term bonds for
% reasons!
iC $nvestors generally prefer short term bonds to long"term securities because such
securities are more liquid in the sense that they can be converted to cash with little
danger of loss of principal! #herefore E investors will accept lower yields on short
term securities!
iiC t the same time borrowers react in exactly the opposite way!
6enerally borrowers prefer long term debt because short"term debt exposes them to
the risk of having to repay the debt under adverse! 5onditions, accordingly
borrowers are willing to pay higher rate other things held constant for long"term
process than short ones!
#aking together this two sets of preferences implies that under normal conditions, a positive
maturity risk premium exist which increases with maturity thus the yield curve should be
upward sloping! 2enders prefer liquidity Bshort term handsC while borrowers prefer long term
bonds and are willing to pay a JpremiumK for long term borrowing!
5( E<ectation T%eory
#his theory states that the yield curve depends on the expectation about future inflation rates!
$f inflation rate is expected to increase, then the rate on long"term bonds will exceed that of
short"term loan! #he expected future interest rates are equal to forward rates computed from
the expectations with regard to future interest rates are! ,ther factors which affect the
expectations with regard to future interest rates are:
7olitical stability
-onetary policy of the government
4iscal policy of the government Bgovernment expeditionC
,ther economic related factors including social factors!
#he following conditions are necessary for the expectation theory to hold!
iC 7erfect capital markets exists where there are many buyers and sellers of security
with non having a significant influence on the interest rates!
iiC $nvestors have homogeneous expectations about future interest rates and returns on
all investments!
iiiC $nvestors are rational wealth maximi>ers
79 Lesson *our
ivC *ankruptcy of firms due to use of borrowing is unlikely!
@( Market Segmentation T%eory
#his theory states that the ma=or investors Bborrowers and lendersC are confined to a particular
segment of the market and will not change even if the forecast of the likely future interest
rates changes!
#he lenders and borrower thus have a preferred maturity e!g a person borrowing to buy a
house or a company borrowing to build a power plant would want a long term loan! However
a retailer borrowing to build up stock in readiness for a peak reason would prefer a short term
loan! Similar differences exist among savers e!g a person saving to pay school fees for next
semester would want to lend on in the short"term market! person saving for retirement %@
years ahead would probably buy long"term security in 2!# market!
#he thrust of market segmentation theory is that the slope of yield curve depends on demand
and supply mechanism! n upward sloping curve would occur if there was a large supply of
funds relative to demand in the short term marketing but a relative shortage of funds in the
long"term market would produce an upward sloping curve!
Tests o' t%e @ t%eories
:arious test have been conducted mainly in US and they indicate that all the + theories have
some validity and thus the shape of the yield curve of any firm is affected by the following:
)! Supply and demand conditions in the short and long term market!
%! 2iquidity preferences of lenders and borrowers
+! .xpectation of future inflation! While any of the + factors may dominate the
market all the + effect the term structure of interest rate!
4actors influencing interest rates
#here are four most important factors that influence interest rates and the shape of yield
curve!
)! 5*0 E -onetary policy
%! #he level of government budget deficit
+! *alance of trade position
&! *usiness activity BcircleC in the economy
4( C!K M Monetary +olicy
#he money supply in the economy has a ma=or effect on both the level of economic activity
and the rate of inflation! #he level of money supply is controlled by the 5*0!
$f the 5*0 wants to stimulate the economy, it increases the money supply! #he initial effect
of such an action is to cause interest rates to decline but this may also lead to increase in
expected rate of inflation which in turn pushes the interest rates up in the long run! #he
reverse of this would happen if the 5*0 tightens the money supply in the economy!
Note
!.S&NESS *&NANCE
:I Ca<ital Structure and Cost o'
*unds
1uring periods when 5*0 is directly interfering with the market, the yield curve will be
distorted! S!# interests will be too high if the banks are tightening their credit and they could
be too low if the banks are easing the credit!
5( Go2ernment !udget De'icit
$f the 6overnment spends more than it takes in from tax revenue, it runs a budget deficit!
#his deficit must be covered or financed either by borrowing or printing more money! #he
0enya 6overnment has in the past used the two ways of financing its deficit in a balanced
manner! #he effect in interest rates is whether the deficit is financed through printing or
borrowing! #he
6overnment would borrow in the S!# market which increase the demand of available funds
for lending which subsequently pushes the interest rates up!
$f the 6overnment prints more money this will lead to inflation and the interest rate would
eventually rise! #herefore the larger the 6overnment deficit, the higher the level of interest
rates!
@( *oreign Trade !alance
$f the 6overnment buys BimportsC more than it sells BexportsC there will be a trade deficit
which will require financing! #he main source of financing could be debt! #his 6overnment
would once again go into the market and borrow and cause an upward pressure on funds
available for lending!
#his causes the interest rates to go up! $f there was a favourable balance of trade the
6overnment could not borrow and the interest rates could remain relatively stable!
6( !usiness acti2ity cycle
$nflation
*oom
3ecession
1epreciation
#he interest rates also depends on business cycles Bas aboveC! s the economy moves in the
four B&C business cycles, interest rates will shift as well e!g during economic recessions, short"
term interest rates experience sharp decline than 2!# interest rates! #his is because of the
following reasons:
#he 5*0 operates mainly in the S!# Sector BmarketC and its intervention has a ma=or effect
on S!# interest rates!
iiC 2!# interest rates generally reflect the average expected inflation rate over the next )@
E %@ years!
#hese expectations do not change generally because 2!# interest rates are fixed due to debt
covenants entered into during borrowing time!
Ot%er Determinants o' Market &nterest ,ates ",e>uired ,ate o' ,eturn#
*usiness cycle
:4 Lesson *our
9! 3isk free rate E #his is the interest rate that would exist on default free securities such
as #reasury bills and bonds!
3isk free rate is made up of two components:
3eal rate of return E interest rate if there was no inflation
$nflation premium
#herefore risk free rate B34C I 3eal rate of return G $nflation premium!
$f risk premium is added to risk free rate, required rate of return is derived! #herefore
required rate of return I real rate G inflation G premium G risk premium I 3isk free
rate G 3isk premium!
'! $nflation premium E $nvestors are compensated for reduction in purchasing power of
money! 4rom point B)C the higher the inflation premium, the higher the market
interest rate!
<! 1efault risk premium B137C
#his is the rate added to risk free rate for possibility of default in payment of loans!
Usually, its added if two securities have equal maturity and marketability!
(! 2iquidity premium E #his is premium added to equilibrium interest rate on a security
if that security cannot be converted to cash on short notice and close to the original
cost!
;! -aturity 3isk 7remium E a premium reflecting interest rate risk i!e risk of capital
losses which investors are exposed to because of hanging interest rate over time!
&NTE,EST ,ATE LE/ELS AND STOCK +,&CES
$nterest rates have two effects on corporate profits:
aC *ecause interest rate is a cost, the higher the rate of interest the lower the firmDs
profit other things held constant!
bC $nterest rates affect the level of economic activities which affect the level of
corporate profit!
$nterest rates obviously affect stock prices because of the effect on profit but even more
importantly they have an effect due to the competition in the market between shares and
bonds!
$f interest rates rise sharply, investors can get higher returns in the bond BmoneyC market
which induces them to sell shares BstocksC and transfer the funds from stock market to money
market B#reasury billsC!
Such transfers in response to increase in interest rates reduces demand for shares in the stock
exchange and this obviously depresses the share prices e!g in mid and late );;+ the 5*0
intervened in the short term market where it floated #reasury *ills whose interest rate was as
high as ((F well above the returns that can be expected from high yield stocks!
ccordingly, investors removed BmisdirectedC their money BfundsC from the stock market into
#reasury *ills! #he result was a stagnation of stock prices of quoted firms! ccordingly as
5*0 achieved its ob=ective of reducing the money supply in the economy the interest rates
!.S&NESS *&NANCE
:5 Ca<ital Structure and Cost o'
*unds
declined well below +@F and the immediate effect was a rebuild in demand for shares and
the share prices shot up instantaneously around 4ebruary );;&!
&m<ortance o' &nterest ,ates
#hese are of a particular relevance to a finance manager because:
iC #hey measure the cost of borrowing!
iiC $nterest rates in a country influence the foreign exchange rate of the countryDs
currency!
iiiC $nterest rates act as a guide to the sort of return that firmDs shareholders might want
hence changes in interest rates will affect rates for an approved creditworthy
borrower!
&nterest may ?e
aC *ase lending rates E *anks lend to individual and small firmDs at certain margins
above the base lending rates! $t is therefore the rates for an approved creditworthy
borrower!
bC $nter"*ank 2ending rates
4or large loans to big firms, banks will set interest rates at a margin below base rates
rather than above base lending rates!
T%e Treasury !ills ,ates M ,isk *ree
#he rates at much central bank sells treasury bills to the market!
#reasury bills are used to raise, short"term funds for the government! Securities issued
by the government to raise long term funds are called gilt"edged securities!
Why interest rates differ in different markets segments
$nterest rates may differ in different market and market segment because of:
iC Si>e of the loan: 1eposits above certain amounts into the bank might attract higher
interest rates than smaller deposits! 5onsequently, large borrowers would be charged
higher interest rates than small borrowers!
iiC 3isks: Higher risk borrowers must pay higher rates on their borrowing to compensate
lenders for greater risks involved!
iiiC #he need to make a profit in re"lending: e!g banks borrow for depositors and charge
higher interest Bprofit marginC when they lend to borrowers!
ivC 1uration of the lending
#he 2!#! loans will earn a higher rate of interest than shorter term loans due to the
maturity risk premium!
vC $nternational interest rates: #his vary from one country to another due to differing
rates of inflation and government policies on interest rates and foreign currency
exchange rates!
viC 1ifferent types of financial assets:
*uilding societies must offer higher yields to depositors to attract them using bonds
which have high rate of return!
:@ Lesson *our
MET-ODSCMODELS O* COM+.T&NG COST O* CA+&TAL
#he following models are used to establish the various costs of capital or required rate of
return by the investors:
3isk ad=usted discounting rate
-arket modelAinvestors expected yield
5apital asset pricing model B57-C
1ividend yieldA6ordonDs model!
iC ,isk adEusted discounting rate E #his technique is used to establish the discounting rate
to be used for a given pro=ect! #he cost of capital of the firm will be used as the
discounting rate for a given pro=ect if pro=ect risk is equal to business risk of the firm! $f
a pro=ect has a higher risk than the business risk of the firm, then a percentage risk
premium is added to the cost of capital to determine the discounting rate i!e! discounting
rate for a high risk pro=ect I cost of capital G percentage risk premium! #herefore a high
risk pro=ect will be evaluated at a higher discounting rate!
iiC Market Model E #his model is used to establish the percentage cost of ordinary share
capital cost of equity B0eC! $f an investor is holding ordinary shares, he can receive
returns in % forms:
1ividends
5apital gains
5apital gain is assumed to constitute the difference between the buying price of a share at the
beginning of the B7@C, the selling price of the same share at the end of the period B7)C!
#herefore total returns I 17S G 5apital gains I 17S G 7) E 7@!
#he amount invested to derive the returns is equal to the buying price at the beginning of the
period B7@C therefore percentage returnAyield I
#otal returns x )@@ I 17S G 7) E 7@ x )@@
$nvestment 7@
&llustration=
4or the past 9 years, the -7S and 17S for P8Q 2td were as follows:
);;(
Shs!
);;;
Shs!
%@@@
Shs!
%@@)
Shs!
%@@%
Shs!
-7S as at +)
st
1ec
17S for the year
&@
"
&9
+
9+
&
9@
+
9%
"
,e>uired
1etermine the estimated cost of equityAshareholders percentage yield for each of the years
involved!
Solution
!.S&NESS *&NANCE
*unds
8ear -7S 5apital gain 17S F 3eturn
);;( &@ " " "
);;; &9 9 +
F %@ )@@
&@
(
)@@
&@
+ 9

+
x x
%@@@ 9+ ( &
F %< )@@
&9
)%
&9
& (

+
x
%@@) 9@ "+ +
F @ )@@
9+
@
9+
+ +

+
x
%@@% 9% % "
F & )@@
9@
%
9@
@ %

+
x
iiiC Ca<ital asset <ricing model "CA+M# E 57- is a technique that is used to
establish the required rate of return of an investment given a particular level of risk!
ccording to 57-, the total business risk of the firm can be divided into %:
Systematic ,isk E #his is the risk that affects all the firms in the market! #his risk cannot be
eliminatedAdiversified! $t is thus called undiversifiable risk! Since it affects all the firms in
the market, the share price and profitability of the firms will be moving in the same direction
i!e! systematically! .xamples of systematic risk are political instability, inflation, power
crisis in the economy, power rationing, natural calamities E floods and earthquakes, increase
in corporate tax rates and personal tax rates, etc! Systematic risk is measured by a *eta
factor!
.nsystematic risk E #his risk affects only one firm in the market but not other firms! $t is
therefore unique to the firm thus unsystematic trend in profitability of the firm relative to the
profitability trend of other firms in the market! #he risk is caused by factors unique to the
firm such as:
2abour strikes by employees of the firmO
.xit of a prominent corporate personalityO
5ollapse of marketing and advertising programs of the firm on launching of a
new productO
4ailure to make a research and development breakthrough by the firm, etc
57- is only concerned with systematic risk! ccording to the model, the required rate of
return will be highly influenced by the *eta factor of each investment! #his is in addition to
the excess returns an investor derives by undertaking additional risk e!g cost of equity should
be equal to 3f G B3m E 3fC*.
5ost of debt I 3f G B3m E 3fC*d
Where: 3f I rate of returnAinterest rate on riskless investment e!g #! bills
3m I verage rate of return for the entire stock as shown by average
7ercentage return of the firms that constitute the stock index!
*e I *eta factor of investment in ordinary sharesAequity!
:8 Lesson *our
*d I *eta factor for investment in debenturesAlong term debt capital!
&llustration
00 2td is an all equity firm whose *eta factor is )!%, the interest rate on #! bills is currently
at (!9F and the market rate of return is )&!9F! 1etermine the cost of equity 0e, for the
company!
Solution
3f I (!9F 3m I )&!9F *eta of equity I )!%
0e I 3f G B3m E 3fC*.
I (!9F G B)&!9F " (!9FC )!%
I (!9F G B'FC)!%
I )9!<F
ivC Di2idend yieldCGordonFs Model E #his model is used to determine the cost of
various capital components in particular:
5ost of equity " 0e
5ost of preference share capital BperpetualC E 0p
5ost of perpetual debentures E 0d
aC 5ost of equity B0eCE #his can be determined with respect to:
Qero growth firm E 7@ I d@ #herefore I
@
@
P
d
3 I 0e
Where: d@ I 17S
3@ I 5urrent -7S
5onstant growth firm E 7@ I
( )
g K
g d
e
+ )
@
#herefore
( )
g
P
g d
K
e
+
+
@
@
)
!.S&NESS *&NANCE
*unds
bC 5ost of perpetual preference share capital B0pC
3ecall, value of a preference share B43SC I 5onstant 17S
0p
#herefore: dp I 7reference dividend per share
7p I -arket price of a preference share
cC 5ost of perpetual debenture B0dC E 1ebentures pay interest charges, which an
allowable expenses for tax purposes!
3ecall, :alue of a debenture B:dC I $nterest charges p!a! in W
5ost of debt 0d
#herefore 0d I
( ) T
V
Int
d
)
!
Where: 0d I F cost of debt
# I 5orporate tax rate
:d I -arket value of a debenture
Cost o' ,edeema?le De?entures and +re'erence S%ares
3edeemable fixed return securities have a definite maturity period! #he cost of such
securities is called yield to maturity B8#-C or redemption yield B38C! 4or a redeemable
debenture 0d Bcost of debtC I 8#- I 38, can be determined using approximation method as
follows:
( ) ( )
( )
%
)
)
)
A A
d
d
d
V M
n
V M T Int
RY VTM K
+
+
Where: $nt! I $nterest charges p!a!

# I 5orporate tax rate
- I 7ar or maturity value of a debenture
:d I 5urrent market value of a debenture
n I /umber of years to maturity
WE&G-TED A/E,AGE COST O* CA+&TAL "W(A(C(C(#
#his is also called the overall or composite cost of capital! Since various capital components
have different percentage cost, it is important to determine a single average cost of capital
attributable to various costs of capital! #his is determined on the basis of percentage cost of
each capital component!
:: Lesson *our
-arket value weight or proportion of each capital component!
W!!5!5 I
( )
,
_
+
,
_
+
,
_
V
D
T K
V
P
K
V
E
K
d p e
)
Where: 0e, 0p and 0d I 7ercentage cost of equity, preference share capital and debt capital
respectively
., 7 and 1 I -arket value of equity, preference share capital and debt capital
respectively!
/*: -arket value I -arket price of a security x /o! of securities!
: I #otal market value of the firm I . G 7 G 1!
&llustration
#he following is the capital structure of P8Q 2td as at +)A)%A%@@%!
,rdinary share capital Sh!)@ par value
3etained earnings
)@F preference share capital Sh!%@ par value
)%F debenture Sh!)@@ par value
Shs!-
&@@
%@@
)@@
%@@
;@@
Additional in'ormation
)! 5orporate tax rate is +@F
%! 7reference shares were issued )@ years ago and are still selling at par value -7S I
7ar value
+! #he debenture has a )@ year maturity period! $t is currently selling at Sh!;@ in the
market!
&! 5urrently the firm has been paying dividend per share of Sh!9! #he 17S is expected
to grow at 9F p!a! in future! #he current -7S is Sh!&@!
,e>uired
aC 1etermine the W55 of the firm!
bC .xplain why market values and not book values are used to determine the weights!
cC What are the weaknesses associated with W55 when used as the discounting rate,
in pro=ect appraisal!
a# i# Com<ute t%e cost o' eac% ca<ital com<onent
5ost of equity B0eC E Since the growth rate in dividends is given, use the constant
growth rate dividend model to determine the cost of equity!
d@ I Sh!9 7@ I Sh!&@ g I 9F
( ) ( )
F )+ ! )( )()%9 ! @ @9 ! @
&@
@9 ! @ ) 9 )
@
@
+
+
+
+
g
P
g d
K
e
!.S&NESS *&NANCE
:; Ca<ital Structure and Cost o'
*unds
5ost of perpetual preference share capital B0pC E preference shares are still selling at
par thus -7S I par value! $f this is the case, 0p I coupon rate I )@F!
-7S I 7ar value I Sh!%@
1p I )@F x Sh!%@ I Sh!%
F )@
%@ !
% !

Sh
Sh
P
d
MPS
DPS
K
p
p
p
5ost of debentures B0dC E the debenture has a )@ year maturity period! $t is thus a
redeemable fixed return security thus the cost of debt is equal to yield to maturity!
3edemption yield:
$nterest charges p!a! I )%F x Sh!)@@ par value
-aturity period BnC
-aturity value BmC
5urrent market value B:dC
5orporate tax rate B#C
I Sh!)%
I )@ years
I Sh!)@@
I Sh!;@
I +@F
( ) ( )
( )R
)
)
d
d
d
V M
n
V M T Int
RY YTM K
+
+

I
F )@ F ; ! ;
CR ;@ )@@ B
)@
)
C ;@ )@@ B C + ! @ ) B )% !

+
+ Sh
ii# Com<ute t%e market 2alue o' eac% ca<ital com<onent
-arket value of .quity B.C I -7S x /o! of ordinary shares
I
parvalue Sh
MDSC Sh
x Sh
)@ !
&@@ !
&@ !
I ),'@@
-arket value of preference share capital B7C
I 7ar value, since -7S I 7ar value per share I )@@
-arket value of debt B1C I :d x /o! of debentures
I
parvalue Sh
s Mdebenture Sh
x Sh
)@@ !
%@@ !
;@ !
I )(@
. G 7 G 1 I : I total -arket :alue I ),((@
iiiC 5ompute W!!5!5 using 0e I )(!)+F, 0p I )@F, 0dB)"#C I )@F
aC Using weighted average cost method,, W55 I
:9 Lesson *our
I
( )
,
_
+
,
_
+
,
_
V
D
T K
V
P
K
V
E
K
d p e
)
I

,
_
,
_
,
_
((@ , )
)(@
F )@
((@ , )
)@@
F )@
((@ , )
'@@ , )
F )+ ! )(
I )9!&+ G @!9+); G @!;9<&
I @!)';);+
X )'!;%F
bC *y using percentage method,
W55 I #otal monetary cost
#otal market value B:C
Where: -onetary cost I F cost x market value of capital
-onetary cost of . I )(!)+F x ),'@@ I %;@!@(
-onetary cost of 7 I )@F x )@@ I )@!@@
-onetary cost of 1 I )@F x )(@ I )(!@@
+)(!@(
#otal market value B:C ),((@
#herefore W55 I
)@@
((@ , )
@( ! +)(
x
I )'!;%F
bC $n computation of the weights or proportions of various capital components, the
following values may be used:
-arket values
*ook values
3eplacement values
$ntrinsic values
Market /alue E #his involves determining the weights or proportions using the current
market values of the various capital components! #he problems with the use of market values
are:
#he market value of each security keep on changing on daily basis thus market values can be
computed only at one point in time!
#he market value of each security may be incorrect due to cases of over or under valuation in
the market!
!ook 2alues E #his involves the use of the par value of capital as shown in the balance sheet!
#he main problem with book values is that they are historicalApast values indicating the value
of a security when it was originally sold in the market for the first time!
!.S&NESS *&NANCE
;I Ca<ital Structure and Cost o'
*unds
,e<lacement 2alues E #his involves determining the weights or proportions on the basis of
amount that can be paid to replace the existing assets! #he problem with replacement values
is that assets can never be replaced at ago and replacement values may not be ob=ectively
determined!
&ntrinsic 2alues E $n this case the weights are determine on the basis of the realAintrinsic
value of a given security! $ntrinsic values may not be accurate since they are computed using
historicalApast information and are usually estimates!
e# Weaknesses o' WACC as a discounting rate
W55A,verall cost of capital has the following problems as a discounting rate:
$t can only be used as a discounting rate assuming that the risk of the pro=ect is equal to
the business risk of the firm! $f the pro=ect has higher risk then a percentage premium
will be added to W55 to determine the appropriate discounting rate!
$t assumes that capital structure is optimal which is not achievable in real world!
$t is based on market values of capital which keep on changing thus W55 will change
over time but is assumed to remain constant throughout the economic life of the pro=ect!
$t is based on past information especially when determining the cost of each component
e!g in determining the cost of equity B0eC the past yearDs 17S is used while the growth
rate is estimated from the past stream of dividends!
Note
When using market values to determine the weightAproportion in W55, the cost of retained
earnings is left out since it is already included or reflected in the -7S and thus the market
value of equity! 3etained earnings are an internal source of finance thus, when they are high
there is low gearing, lower financial risk and thus highest -7S!
Marginal cost o' 'inance
#his is cost of new finances or additional cost a company has to pay to raise and use
additional finance
is given by:
#otal cost of marginal finance x )@@
5ost of finance B5,4C
5ost of finance may be computed using the following information:
iC -arginal cost of each capital component!
iiC #he weights based on the amount to raise from each source!
aC $nvestors usually compute their return basing their figures on market values or cost of
investment!
bC $nvestors purchase their investment at market value and as such, the cost of finance to
the company must be weighted against expectations based on the market conditions!
cC $nvestments appreciate in the stock market and as such the cost must be ad=usted to
reflect such a movement in the value of an investment!
;4 Lesson *our
)! -arginal cost of equity
-5. I
)@@
)
x
f P
D
o

Bfor >ero growth firmC
lso cost of equity
0e I
f P
D
o

)
Bfor normal growth firmC
Where: d) I expected 17S I d@B)GgC
7@ I current -7S
f I floation costs
g I growth rate in equity
%! 5ost of preference share capital:
0p I
)@@ x
f P
Dp
o

Where: 0p I 5ost of preference
1p I 1ividend per share
7o I -7S B-arket price per shareC
4 I 4lotation costs
+! 5ost of debenture
f V
T Int
K
d
d
C ) B
Where: 0d I 5ost of debt
$nt I interest
7o I -arket price for debenture Bat discountC
f I flotation costs
t I #ax rate
&! Nust like W55, weighted marginal cost of capital can be computed using:
iC Weighted average cost method
iiC 7ercentage method
Eam<le
P8Q 2td wants to raise new capital to finance a new pro=ect! #he firm will issue %@@,@@@
ordinary shares BSh!)@ par valueC at Sh!)' with Sh!) floatation costs per share, <9,@@@ )%F
preference shares BSh!%@ par valueC at Sh!)( with sh!)9@,@@@ total floatation costs, 9@,@@@
)(F debentures Bsh!)@@ parC at Sh!(@ and raised a Sh!9,@@@,@@@ )(F loan paying total
!.S&NESS *&NANCE
;5 Ca<ital Structure and Cost o'
*unds
floatation costs of Sh!%@@,@@@! ssume +@F corporate tax rate! #he company paid %(F
ordinary dividends which is expected to grow at &F p!a!
,e>uired
aC 1etermine the total capital to raise net of floatation costs
bC 5ompute the marginal cost of capital
Solution
aC Sh!D@@@D
,rdinary shares %@@,@@@ shares S Sh!)'
2ess floatation costs %@@,@@@ shares S
Sh!)
7reference shares <9,@@@ shares S Sh!)(
2ess floatation cost
1ebentures 9@,@@@ debentures S Sh!(@
4loatation costs
2oan
2ess floatation costs
#otal capital raised
+,%@@,@@@
%@@,@@@
),+9@,@@@
B)9@,@@@C
+,@@@,@@@
"YYYY
9,@@@,@@@
B%@@,@@@C
+,@@@
),%@@
+,@@@
&,(@@
)%,@@@
bC -arginal cost of equity 0e
g
f P
g d
K
e
+
+
@
@
C ) B
d@ I %(F x Sh!)@ par I Sh!%!(@
g I &F
f I Sh!)!@@
7@ I Sh!)'
#herefore marginal I @& ! @
) )'
C @& ! ) B (@ ! %
+
e
K I @!%+& I %+!&F
-arginal cost of preference share capital 0p
0p I dp
7@"f
dp I )%F x Sh!%@ par I Sh!%!&@
7@ I Sh!)(
f I 4loatation cost per shareI Sh!)9@,@@@ I Sh!%!@@
<9,@@@ shares
0p I %!&@ I @!)9 I )9F
)( E %
-arginal cost of debenture 0d:
0d I $nt B)"tC
:d"f
;@ Lesson *our
f I @
:d I Sh!(@
$nt I )(F x Sh!)@@ par I Sh!)(
# I +@F
0d I )(B)"@!+C I @!)9<9 I )9!<9F
(@
-arginal cost of loan 0d
0d I $nt B)"tC
:d"f
# I +@F
:d I Sh!9 million
f I Sh!@!% million
$nt I )(F x Sh!9- I Sh!@!;-
0d I @!; B)"@!+C I @!)+)%9I )+!)+F
9 E @!%
Source mount to
raise before f!
costs
Sh!D@@@D
F marginal
cost
-aturity cost
Sh!D@@@D
,rdinary shares
7reference shares
1ebenture
2oan
+,%@@
),+9@
+,@@@
9,@@@
)%,99@
%+!&F
)9!@F
)9!<9F
)+!)+F
<&(!(
%@+!9
&<%!9
'9'!9
%,@(@!+
Weighted marginal cost I %,@(@!+ x )@@ I )'!9(F
)%,99@
!.S&NESS *&NANCE
*unds
J.EST&ON ONE
#he following is the existing capital structure of 5ompany P8Q 2td!
,rdinary shares at Shs!)@ par
3etained
)%F preference shares Shs!)@ par
)'F loan Shs!)@@ par
#otal capital employed
Shs!
),@@@,@@@
(@@,@@@
&@@,@@@
+@@,@@@
%,9@@,@@@
#he companyDs ordinary shares have a dividend cover of + times and pays a dividend
of )@F on its ordinary share capital!
,rdinary shares sells at Shs!)(
7reference shares sell at Shs!)9
1ebentures are selling at par! #he tax rate is +@F
Com<ute
aC 6rowth in .quity! B)@ marksC
bC W!!5!5! B)@ marksC
J.EST&ON TWO
1istinguish between
5apital structure and financial structure!
1istinguish between *usiness risk and 4inancial risk!
What is the effect of introduction of debt capital on weighted average cost of
capital BW55C
1ifferentiate between marginal weighted cost of capital B-W55C and W55
J.EST&ON T-,EE
aC 1efine the term weighted average cost of capital! B+ marksC
bC What is meant by the marginal weighted average cost of capitalM B+ marksC
cC 5om"#ech 5ompany 2td! is in the #elecommunications $ndustry! #he companyDs
balance sheet as at +) -arch %@@@ is as below:
Lia?ility and Owners
E>uity S%(FIIIF
Assets
S%(FIIIF
5urrent liabilities
)(F debentures Bsh!),@@@ parC
)@F preference shares
,rdinary shares BSh!)@ parC
3etained earnings
)%,9@@
)',@@@
',%9@
)%,9@@
%(,)%9
<9,+<9
5urrent assets
/et fixed assets
+%,9@@
&%,(<9
YYYYY
<9,+<9
;8 Lesson *our
Additional in'ormation
#he debentures are now selling at Sh!;9@ in the market and will be redeemed )@ years from
now!
*y the end of last financial period, the company had declared and paid Sh!9!@@ as dividend
per share! #he dividends are expected to grow at an annual rate of )@F in the foreseeable
future! 5urrently, the companyDs shares are trading at Sh!+( per share at the local stock
exchange!
#he preference shares were floated in );;9 and their prices have remained constant!
-ost banks are lending money at an interest of %%F per annum!
#he 5orporation tax rate is &@F per annum!
,e>uired
iC 5alculate the market weighted cost of capital for this firm! B)%
marksC
iiC J#he book"value weights should be used discreetly when computing weighted cost of
capitalK! WhyK B% marksC
J.EST&ON *O.,
ssume that on +) 1ecember %@@) you are provided with the following capital structure of
Hatilcure 2td which is optimal!
Sh!D@@@D
2ong term debt B)'FC )+9,@@@
,rdinary share capital BSh!)@ parC ;@,@@@
3etained earnings <9,@@@
+@@,@@@
#he company has total assets amounting to sh!+'@ million but this figure is expected to rise to
Sh!9@@ million by he end of %@@%! 8ou are also informed that:
)! ny new equity shares sold will net ;@F after flotation costs!
%! 4or the year =ust ended the company paid Sh!+!@@ in dividends per share!
+! /ew )'F debt can be raised at par through the stock exchange!
&! #he past and expected earnings growth rate is )@F
9! #he current dividend yield is )%F
'! #he companyDs dividend payout ratio of 9@F shall be maintained in %@@%!
<! ssume marginal at rate of &@F
(! #he companyDs capital structure is optimal
,e>uired
aC 5ompanyDs net amount to the capital budget to be financial with equity if (9F of the
asset expansion is included in the %@@% capital budget! B+ marksC
bC How many shares must be sold to raise the required equity capitalM 3ound your
figure o the nearest thousand! B( marksC
cC What is the firmDs marginal cost of capitalM Show full workings! B)@ marksC
!.S&NESS *&NANCE
*unds
+ACK
;: Lesson *our
To !e Carried Out .nder Eamination Condition and Sent to Distance learning
Administrator 'or marking ?y t%e .ni2ersity
Answer All Juestions Time Allowed= T%ree -ours
J.EST&ON ONE
aC How can the action of shareholders reduce the value of the bond held by
debenture holdersM B)@ marksC
bC State and explain the mechanism of resolving the agency problem
between shareholders and debenture holders! B)@
marksC

J.EST&ON TWO
aC .xplain the term LgearingD in relation to the capital structure of a limited liability
company! B& marksC
bC yet 2td! and *ayet 2td! are two small si>e companies operating in -ombasa,
0enya! #he following information has been provided for the year ended +@ pril
);;(:
yet 2td!
Shs!
*ayet 2td!
Shs!
,rdinary share capital Sh!)@ par
)@F preference shares of Sh!)@ par
3etained profits
)9F 1ebentures
5apital employed
'@@,@@@
'@@,@@@
),%@@,@@@
(@@,@@@
%,@@@,@@@
%,@@@,@@@
&,@@@,@@@
),(@@,@@@
"
),(@@,@@@
),%@@,@@@
+,@@@,@@@
),@@@,@@@
&,@@@,@@@
,e>uired
5alculate the gearing ratio of each company and state in each case whether the gearing is
high or low! B5alculate to % decimal placesC! B'
marksC
5alculate the maximum percentage dividend on ordinary shares which each company could
declare, without utili>ing, or adding to, accumulated retained profits if profits for the year
ended +@ pril );;( was:
yet 2td!
Shs!
*ayet 2td!
Shs!
/et profit Bbefore $nterest and
taxC
B5orporation tax rate is &@FC
9@@,@@@ ),@@@,@@@
B' marksC
!.S&NESS *&NANCE
;; Ca<ital Structure and Cost o'
*unds
5omment on the results of bBiiC above! B% marksC
J.EST&ONT-,EE
#he following information is provided in respect to the affairs of 7ote 2imited which
prepares its account on the calendar year basis!
);;9
Shs!
);;&
Shs!
Sales
7urchases
5ost of goods sold
Stock at +) 1ecember
1ebtors at +) 1ecember
5reditors at +) 1ecember
#otal assets at +) 1ecember
'@@,@@@
&@@,@@@
+'@,@@@
)@@,@@@
;(,@@@
&@,@@@
+@@,@@@
9@@,@@@
+9@,@@@
++@,@@@
'@,@@@
)@%,@@@
%9,@@@
)(9,@@@
Stock and debtors at ) Nanuary );;& amounted to Sh!<@,@@@ and Sh!;(,@@@ respectively!
,e>uired
aC 5alculate the rate of stock turnover expressed:
iC s a ratioO B+ marksC
iiC $n days, for each of the years );;& and );;9! B+ marksC
bC 5alculate the rate of collection of debtors, in days, for each of the years );;&
and );;9! B+ marksC
cC 5alculate the rate of payment to creditors, in days, for each year );;& and
);;9!
B+ marksC
dC Show the cash operating cycle for each year! B' marksC
eC 5omment on the results! B' marksC
J.EST&ON *O.,
aC *riefly explain the meaning of a Jfloating rateK bond! B& marksC
bC 4rom the point of view of a companyDs financial manager, outline the merits
and demerits, to the company, of issuing floating rate debt as a means of
raising capital!
B)' marksC
;9 Lesson *our
J.EST&ON *&/E
#he ltman formula for prediction of bankruptcy is given as follows:
Q score I )!%P) G )!&P% G +!+P+ G )P& G @!'P9
Where: P) I Working capitalA#otal assets
P% I 3etained earningsA#otal assets
P+ I .arnings before interest and taxA#otal assets
P& I SalesA#otal assets
P9 I -arket value of .quityA2iabilities
$n this model, a Q"score of %!< or more indicates non"failure and a Q"score of )!( or
less indicates failure!
8ou are provided with the following information in respect of four listed companies!
Workin
g ca<ital
S%(FIIIF
,etaine
d
earnings
S%(FIIIF
Earning
s ?e'ore
interest
and ta
S%(FIIIF
Market
2alue
o'
e>uity
S%(FIII
F
Total
assets
S%(FIIIF
Lia?ilitie
s
S%(FIIIF
Sales
S%(FIIIF

2td
*
2td
5
2td
1
2td
!
&,@@@
%,@@@
',@@@
&@,@@@
'@,@@@
%@,@@@
%@,@@@
%@@,@@@
)@,@@@
@
"+@,@@@
+@,@@@

%@,@@@

9,@@@

&(,@@@
)@@,@@
@

%@@,@@@

)@@,@@@

(@@,@@@
),(@@,@@
@
)%@,@@@
(@,@@@
<&@,@@@
),@@@,@@@

%@@,@@@

)%@,@@@

;@@,@@@
%,@@@,@@
@
,e>uired
aC #he Q"Score for each of the companies! 5omment on the results obtained! B)@
marksC
bC $t has been suggested that other ratios ought to be incorporated into ltmanDs
bankruptcy prediction model! What is your opinion on thisM B9
marksC
cC 2ist the indicators of possible business failure! B9
marksC
!.S&NESS *&NANCE
9I Ca<ital Structure and Cost o'
*unds
END O* COM+,E-ENS&/E ASS&GNMENT NO(5
94 Ca<ital &n2estment Decisions
LESSON *&/E
CA+&TAL &N/ESTMENT DEC&S&ONS
&NST,.CT&ONS
3ead 5hapters <, )) and )% of 4inancial -anagement text book by $!-! 7andey
CONTENTS
$mportance of investment analysis
-ethods of analysing Aevaluating pro=ects
5omparisons of the -ethods
3eplacement of ssets
!.S&NESS *&NANCE
Lesson *i2e 95
&N/ESTMENT ANAL0S&S
ny company will invest finance for the sake of deriving a return which is useful for four main
reasons:
)! #o reward the shareholders or owners of the business for staking their money and by
foregoing their current purchasing power for the sake of current and future return!
%! #o reward creditors by paying them regular return in form of interest and repayment of
their principal as and when it falls due!
+! #o be able to retain part of their earnings for plough back purposes which facilitates not
only the companies growth present and the future but also has the implication of
increasing the si>e of the company in sales and in assets!
&! 4or the increase in share prices and thus the credibility of the company and its ability to
raise further finance!
Such a return is necessary to keep the companyDs operations moving smoothly and thus
allow the above ob=ective to be achieved!
financial manager with present investment policies will be concerned with how efficiently the
companyDs funds are invested because it is from such investment that the company will survive!
$nvestments are important because:
iC #hey influence companyDs si>e
iiC $nfluence growth
iiiC $nfluence companyDs risks
$n addition, this investment decision making process also known as capital budgeting, involves
the decision to invest the companyDs current funds in viable ventures whose returns will be
realised for long term periods in future! 5apital budgeting as financial planning is characterised
by the following:
)! 1ecisions of this nature are long term i!e! extending beyond one year in which case they
are also expected to generate returns of long term in nature!
%! $nvestment is usually heavy Bheavy capital in=ectionC and as such has to be properly
planned!
+! #hese decisions are irreversible and any mistake may cause the company heavy losses!
&m<ortance o' &n2estment Decisions
aC Such decisions are importance because they will influence the companyDs si>e Bfixed
assets, sales, and retained earningsC!
bC #hey increase the value of the companyDs shares and thus its credibility!
cC #he fact that they are irreversible means that they have to be made carefully to avoid
any mistake which can lead to the failure of such investment!
dC 1ue to heavy capital outlay, more attention is required to avoid loss of huge sums of
money which in the extreme may lead to the closure of such a company! However,
these decisions are influenced by:
i# +olitical 'actors E Under conditions of political uncertainty, such decisions cannot be
made as it will entail an element of risk of failure of such investment! #hus political
certainty has to be analysed before such decisions are made, such factors must be taken
into account such that the company forecasts the inflows and outflows within given
9@ Ca<ital &n2estment Decisions
limitations such as the degree of competition, performance of economy, changing tastes
etc! which influence ability to generate sufficient return from a venture which will pay
not only interest but principal on such funds invested!
ii# Tec%nological 'actors E #hese influence the returns of the company because such
technology will affect the companyDs ability to utilise its assets to the utmost ability in
particular if such assets become obsolete and cannot generate good returns or the output
of such machines may be low with time and may not meet planned expectations which
in most cases will have an impact on inflows from a venture!
Met%ods o' AnalyDing &n2estment
Ca<ital !udgeting Met%ods(
#here are two methods of analy>ing the viability of an investment:
a# Traditional met%ods
7ay back period method
ccounting rate of return method
?# Modern met%ods "Discounted cas% 'low tec%ni>ues#
/7: E /et present value method
$33 E $nternal rate of return method
7$ E 7rofitability index method
4or the above two Ba H bC methods to be used, they have to meet the following:
iC #hey should rank ventures available in the investment market according to their
viability i!e! they should identify which method is more viable than others!
iiC #hey should rank a venture first if the venture brings in return earlier and in large
lumpsums than if a venture brought in late and less inflows over the same period!
iiiC Should rank any other pro=ects as and when it is available in the investment market!
Such methods should take into account that all returns BinflowsC, must be cash returns as
it is necessary to be able to finance the cost of the venture!
T,AD&T&ONAL MET-ODS
+ay ?ack <eriod met%od
#his method gauges the viability of a venture by taking the inflows and outflows over time to
ascertain how soon a venture can payback and for this reason 7*7 Bor payout period or payoffC
is that period of time or duration it will take an investment venture to generate sufficient cash
inflows to payback the cost of such investment! #his is a popular approach among the traditional
financial managers because it helps them ascertain the time it will take to recoup in form of cash
from operations the original cost of the venture! #his method is usually an important
preliminary screening stage of the viability of the venture and it may yield clues to profitability
although in principle it will measure how fast a venture may payback rather than how much a
venture will generate in profits and yet the main ob=ectives of an investment is not to recoup the
original cost but also to earn a profit for the owners or investors!
!.S&NESS *&NANCE
Lesson *i2e 96
5omputation of payback period:
4( .nder uni'orm annual incremental cas% in'lows E if the venture or an asset generates
uniform cash inflows then the payback period B7*7C will be given by:
7*7 I $nitial cost of the venture
nnual incremental cost
e!g! $f a venture costs +<,;)@AI and promises returns of )@,@@@AI per annum indefinitely
then the 7*7 I
@@@ , )@
;)@ , +<
I +!<; years
#he shorter the 7*7 the more viable the investment and thus the better the choice of
such investments!
5( .nder nonAuni'orm cas% in'lows=
Under non"uniformity 7*7 computation will be in cumulative form and this means that
the net cash inflows are accumulated each year until initial investment is recovered!
Eam<le
ssume a pro=ect costs Sh!(@,@@@ and will generate the following cash inflows:
Cas% in'lows Accumulated in'lows
$nflows year ) I )@,@@@ )@,@@@
$nflows year % I +@,@@@ &@,@@@
$nflows year + I )9,@@@ 99,@@@
$nflows year & I %@,@@@ <9,@@@
$nflows year 9 I +@,@@@ )@9,@@@
#he Sh!(@,@@@ cost is recovered between year & and 9! 1uring year 9 Bafter year &C
Sh!9,@@@ is B(@,@@@ E <9,@@@C is required out the total year 9 cash flows of +@,@@@!
#herefore the 7*7 I
@@@ , +@
@@@ , 9
& + yrs
I &!)< years
Eam<le
5edes limited has the following details of two of the future production plans! ,nly one
of these machines will be purchased and the venture would be taken to be virtually
exclusive! #he Standard model costs Z9@,@@@ and the 1eluxe cost Z((,@@@ payable
immediately! *oth machines will require the input of the following:
iC $nstallation costs of Z%@,@@@ for Standard and Z&@,@@@ for the 1eluxe
iiC Z)@,@@@ working capital through their working lives!
*oth machines have no expected scrap value at end of their expected working lives of &
years for the Standard machine and six years for the 1eluxe! #he operating pre"tax net
cash flows associated with the two machines are:
8ear ) % + & 9 '
Standard
1eluxe
%(,9@@
+',@+@
%9,('@
+@,))@
%&,%)@
%(,+(@
%+,&)@
%9,;&@
"
+(,9@@
"
+9,)@@
#he deluxe machine has only been introduced in the market and has not been fully tested in the
operating conditions, because of the high risk involved the appropriate discount rate for the
deluxe machine is believed to be )&F per annum, %F higher than the rate of the standard
machine! #he company is proposing the purchase of either machine with a term loan at a fixed
rate of interest of ))F per annum, taxation at +@F is payable on operating cash"flows one year
in arrears and capital allowance are available at %9F per annum on a reducing balance basis!
,e>uired
4or both the Standard and the 1eluxe machines, calculate the payback period!
Solution
.stablish the cash flows as follows:
7re"tax inflows B.*1#C PP
2ess depreciation I capital allowance BPPC
.arnings before tax PP
2ess tax BPPC
.arnings after tax PP
dd back capital allowanceAdepreciation PP
,perating cash flows PP
Note
5apital allowanceAdepreciation is a non"cash item thus when deducted for tax purposes, it
should be added back to eliminate the non"cash flow effects!
5ash flows for standard machine:
8ear ) % + & 9
7retax inflow
2ess allowance BdepreciationC
#axable cash inflows
#ax S +@F ) yr in arrears
dd back capital allowance
,perating cash flows
dd working capital realised
#otal cash flows
%(,9@@
)<,9@@
)),@@@
"YYY
)),@@@
)<,9@@
%(,9@@
"
%(,9@@
%9,(9@
)+,)%9
)%,<+9
+!+@@
;,&+9
)+,)%9
%%,9'@
"
%%,9'@
%&,%)@
;,(&&
)&,+''
B+,(+)C
)@,9&9
;,(&&
%@,+(;
"
%@,+(;
%+,&)@
<,+(+
)',@%<
B&,+)@C
)),<)<
<,+(+
);,)@@
)@,@@@
%;,)@@
"
"
B&,(@(C
B&,(@(C
"
B&,(@(C
"
B&,(@(C
!.S&NESS *&NANCE
Lesson *i2e 97
5ash flows for 1eluxe machine
8ear ) % + & 9 ' <
7retax inflows
2ess
BdepreciationC
#ax S +@F in
arrears
$nflows after tax
dd back capital
llowance
dd back
wAcapital
#otal cash flows
+',@+
@
+%,@@
@
&,@+@
"
&,@+@
+%,@@
@
"
+',@+
@
+@,))@
%&,@@@
',))@
B),%@;C
&,;@)
%&,@@@
%(,;@)
"
%(,9;;
%(,+(@
)(,@@@
)@,+(@
B),(++C
(,9&<
)(,@@@
%',9&<
"
%',9&<
%9,;&@
)+,9@@
)%,&&@
B+,))&C
;,+%'
)+,9@@
%%,(%'
"
%%,(%'
+(,9'@
)@,)%9
%(,&+9
B+,<+%C
%&,<@+
)@,)%9
+&,(%(
"
+&,(%(
+9,)@@
<,9;&
%<,9@'
B(,9+)C
)(,;<9
<,9;&
%',9';
)@,@@@
+',9';
"
"
"
B(,%9%C
B(,%9%C
"
B(,%9%C
"
B(,%9%C
Standard 1eluxe
5ost 9@,@@@ G %@,@@@ <@,@@@ ((,@@@ G &@,@@@
)%(,@@@
8ear 5ash flows ccumulate
d
5ash
flows
ccumulated
)
%
+
&
9
'
<
%(,9@@
%%,9'@
%@,+(;
%;,)@@
B&,(@(C
"
"
%(,9@@
9),@'@
<),&&;
)@@,9&;
;9,<&)
"
"
+',@+@
%(,;@)
%',9&<
%%,(%'
+&,(%(
+',9';
B (,%9%C
+',@+@
'&,;+)
;),&<(
))&,+@&
)&;,)+%
)(9,<@)
)<;,&&;
V 7ay back period for standard: $nitial capital of Sh!<,@@@ is recovered during year +!
fter year %, we require <@,@@@ E ;,@'@ I )(,;&@ to recover initial capital out of year + cash
flows of Sh!%@,+(;!
V pplying the same concept for 1eluxe, payback period would be:
(%( , +&
+@& , ))& @@@ , )%(
&

+
I &!+; years
Accounting ,ate o' ,eturn Met%od "A,,#
#his method uses accounting profits from financial status to assess the viability of investment
proposal by diving the average income after tax by average investment! #he investment would
be equal to either the original investment plus the salvage value divided by two or the initial
investment divided by two or dividing the total of the investment book value after depreciating
9: Ca<ital &n2estment Decisions
by the life of the pro=ect! #his method is also known as financial statement method or book
value method! #he rate of return on asset method or ad=usted rate of return method is given by:
33 I verage income x )@@ or verage income E verage depreciation
verage investment $nitial investment
Unlike 7*7, this method will ascertain the profitability of an investment and it will give results
which are consistent with those given by return ratios e!g!
Shs!
7ro=ect P cost 9@@,@@@
Scrap value )@@,@@@
Stream of income before depreciation and taxes are as follows:
Shs!
8ear ) )@@,@@@
8ear % )%@,@@@
8ear + )&@,@@@
8ear & )'@,@@@
8ear 9 %@@,@@@
2et tax I 9@F and depreciation straight line! 5alculate the accounting rate of return!
Solution
1epreciation I 9@@,@@@ E )@@,@@@ I Shs!(@, @@@
9 years
8ear ) % + & 9
$ncome
2ess depreciation
.arnings before tax .*#
2ess tax S 9@F
.#
)@@,@@@
(@,@@@
%@,@@@
B)@,@@@C
)@,@@@
)%@,@@@
(@,@@@
&@,@@@
B%@,@@@C
%@,@@@
)&@,@@@
(@,@@@
9@,@@@
B+@,@@@C
+@,@@@
)'@,@@@
(@,@@@
(@,@@@
B&@,@@@C
&@,@@@
%@@,@@@
(@,@@@
)%@,@@@
B'@,@@@C
'@,@@@
verage income B.#C I +%,@@@
verage investment I B9@@,@@@ G )@@,@@@C R I +@@,@@@
,r 33 I verage income x )@@ I +%,@@@ x )@@ I )@!'<F
verage investment +@@,@@@
Note
#he best method of depreciation to use should be that which will produce larger depreciation
changes in the )
st
few years of the assets life and lesser changes in the later years because this
will produce a higher tax shield to the company with higher value of inflows! #hus reducing
balance is preferred as compared to sum of digits and straight line method!
!.S&NESS *&NANCE
Lesson *i2e 9;
T%e sal2age 2alue s%ould ?e treated as 'ollows=
$f the asset produces a salvage value at the end of the year, this will increase inflows for
payback period! #his value is only used to ascertain how much the company will reduce
original cost of investment to obtain average investment!
Acce<tance ,ule o' +ay?ack +eriod "+?<#
Using 7*7 method a company will accept all those ventures whose payback period is less than
that set by the management and will re=ect all those ventures whose 7*7 is more than that set by
the management! lternatively, 7*7 may be gauged against the term of the loan in which case
the 7*7 method will give a high ranking to all those ventures paying back before the term of the
loan and the highest ranking will be given to those pro=ects with shortest 7*7! However, in
assessing the viability of a venture it is also important to see which venture brings returns
earlier, other things being equal!
Ad2antages o' +ay?ack +eriod
)! Simple to use and understand and this has made it popular among executives especially
traditional financial managers in ascertaining the viability of a venture!
%! $deal under high"risk investments because it will identify which venture will payback
earlier thus minimising the risks with a venture!
+! dvantageous when choosing between mutually exclusive pro=ects because it will give
a clue as to which venture is viable if one considers the shortest 7*7 and the highest
inflow of a venture!
Disad2antages o' +ay?ack +eriod
)! 1oes not take into account time value of money and assumes that a shilling received in
the )
st
year and in the /th year have the same value so as to rank them together to
ascertain the 7*7 which is unrealistic given that a shilling now is valuable than a
shilling / years from now!
%! 7*7 method does not measure the profitability of a venture but rather measures the
period of time a venture takes to pay back the cost! #he method is outside looking
Blender oriented rather than owner orientedC!
+! 7*7 method ignores inflows after 7*7 and as such, it does not accommodate the
element of return to an investment!
&! #his method will not have any impact on the companyDs share prices because
profitability which is one of the most important factors in gauging the companyDs value
of shares is not a function of 7*7 and as such the method fall short of meeting the
criteria of investment appraisal!
Acce<tance ,ule o' Accounting ,ate o' ,eturn "Arr#
33 method will accept those pro=ects whose 33 is higher than that set by management or
bank rate and it will give highest ranking to ventures with highest 33 and vice versa!
Ad2antages
)! Simple to understand and use!
%! 3eadily computed from accounting data thus much easier to ascertain!
+! $t is consistent with profitability ob=ectives as it analyses the return from entire inflows
and as such it will give a clue or a hint to the profitability of venture!
Disad2antages
)! $t ignores time value of money!
%! $t does not consider how soon the investment should recover the cost Bit is owner
looking than creditor oriented approachC!
+! $t uses accounting profits instead of cash inflows some of which may not be realisable!
MODE,N MET-ODS O, DC* i(e( Discounted Cas% *low Tec%ni>ues
4( +resent /alue Conce<t
#his concept acknowledges the fact that a shilling losses value with time and as such if it is to
be compared with a shilling to be received in /th year then the two must be at the same values!
#his means that an investorDs analytical power is increased by hisAher ability to compare cash
inflows and outflows separated from each other by time! HeAshe should be able to work in the
reverse direction i!e! from future cash flows to their present values!
5( +resent /alue o' a Lum<sum
Usually an investor would wish to know how much heAshe would give up now to get a given
amount in year ), %, [ n! $n this situation he would have to decide at what rate of discount also
known as time preference rate, heAshe will use to discount the anticipated lumpsum using this
rate by applying the following formula:
( )
n
K
L
Pv
+
)
Where: 7v I 7resent value
2 I 2umpsum
0 I 5ost of finance or time preference rate
n I given year!
#his implies that if the time preference rate is )@F, the present value of )AI to e received at the
end of year ) is:
;@; ! @
) ! )
)
Pv
#he present value of inflows to be received in the %
nd
year to /th year, will be equal to:
( )
K
!
Pv
+
)
Where: I annual cash flows
/ I /umber of years
!.S&NESS *&NANCE
Lesson *i2e 4II
lso, the present value of a shilling to be received at a given point in time can in addition to
using the above formula, be found using the present value tables!
Suppose that an investor can expect to receive:
&@,@@@ at the end of year %
<@,@@@ at the end of year '
)@@,@@@ at the end of year (
5ompute his present BvalueC if his time preference is )%F!
( ) ( ) ( ) ( )
( ' %
)% ! )
@@@ , )@@
Y
)% ! )
@@@ , <@
)% ! )
@@@ , &@
)
+
+
K
L
Pv
I 0shs!)@<,<&@!%'
Using tables:
I &@,@@@B@!<;;%C G <@,@@@B@!9@''C G )@@,@@@B@!&@+;C
I )@<,(%@
@( +resent /alue o' an Annuity
n individual investor may not necessarily get a lumpsum after some years but rather get a
constant periodic amount i!e! an annuity for certain number of years! #he present value of an
annuity receivable where the investor time preference is )@F equal to:
( ) "
!
! Pv
+
)
C B
$ I time preference rate
.!g! 7v of )AI to be received after ) year if time preference rate is )@F!
I
;@; ! @
) ! @ )
)
+
fter % years it will be:
( ) ( )
(%'& ! @
) ! )
)
)
% %

+"
!
)
st
year " @!;@;@
%
nd
year " @!(%'&
+
rd
year " @!<9)+
&
th
year " @!'(+@
#otal " +!)';<
6( +resent /alue o' .ne2en +eriodic Sum
$n investment decisions it is very rare to get even periodic returns and in most cases a company
will generate a stream of uneven cash inflows from a venture and the present value of those
uneven periodic sums is equal to:
4I4 Ca<ital &n2estment Decisions
( ) ( ) ( ) ( )
K
!
K
!
K
!
K
!
Pv
+
+ +
+
+
+
+
+
)
!!!!!
) ) )
+
+
%
%
)
)
equation
( )
t
t
K
!
Pv
)
Where: t I Uneven cash inflows at time t
7v I 7resent value
0 I5ost of finance
company contemplates to receive Shs!:
%@,@@@ in year )
)(,@@@ in year %
%&,@@@ in year +
/il in year &
&@,@@@ in year 9
5ost of this finance is )%F
,e>uired
5ompute present value of that finance
Solution
( ) ( ) ( ) ( )
9 + % )
)% ! )
@@@ , &@
)% ! )
@@@ , %&
)% ! )
@@@ , )(
)% ! )
@@@ , +@
+ + + Pv
I (@,;)9!@@&
8( Net +resent /alue Met%od
#he method discounts inflows and outflows and ascertains the net present value by deducting
discounted outflows from discounted inflows to obtain net present cash inflows i!e the present
value method will involve selection of rate acceptable to the management or equal to the cost of
finance and this will be used to discount inflows and outflows and net present value will be
equal to the present value of inflow minus present value of outflow! $f net present value is
positive you invest, $f /7: is negative you do not invest!
7vBinflowC E 7vBoutflowsC I /7:
Note
$nitial outflow is at period >ero and their value is their actual present value! With this method,
an investor can ascertain the viability of an investment by discounting outflows! $n this case, a
venture will be viable if it has the lowest outflows!
!.S&NESS *&NANCE
Lesson *i2e 4I5
( ) ( ) ( ) ( )
C
K
!
K
!
K
!
K
!
PV

1
1
]
1
+
+ +
+
+
+
+
+
)
!!!!!
) ) )
+
+
%
%
)
)
Where: I annual inflow
0 I 5ost of finance
5 I 5ost of investment
/ I /umber of years
Eam<les
5ost of investment I )@@,@@@AI, interest rate I )@F, inflows year ) I (@,@@@AI year % I
9@,@@@AI
/7: I
( )
@@@ , )@@
) ! )
@@@ , 9@
) ! )
@@@ , (@
%
+
I )&,@&; positive hence invest!
Eam<le
Neremy limited wishes to expand its output by purchasing a new machine worth )<@,@@@ and
installation costs are estimated at &@,@@@AI! $n the &
th
year, this machine will call for an
overhaul to cost (@,@@@AI! $ts expected inflows are:
Shs!
8ear ) '@,@@@
8ear % <%,'9@
8ear + +9,<%@
8ear & &(,9)@
8ear 9 ;),'+@
8ear ' (+,<)9
#his company can raise finance to purchase machine at )%F interest rate!
5ompute /7: and advise management accordingly!
Solution
Shs!
5ost of machine at present value )<@,@@@
$nstallation cost &@,@@@
%)@,@@@
,verhaul cost in the &
th
year I (@,@@@
1iscounting factor I B)!)%C
&
#herefore present value I (@,@@@ I Shs!9@,(&)!&&'
B)!)%C
&
#otal present value of investment I %'@,(&)!&9
4I@ Ca<ital &n2estment Decisions
7: inflows I
( ) ( ) ( ) ( )
' 9 & + %
)% ! )
<)9 , (+
)% ! )
'+@ , ;)
C )% ! ) B
9)@ , &(
)% ! )
<%@ , +9
)% ! )
'9@ , <%
C )% ! ) B
@@@ , '@
+ + + + +
K
I %'%,)&<!%(
#herefore: /7: I %'%,)&<!%( E %'@,(&)!&9
/7: I ),+@9!(+
#he /7: is positive and $ would advise the management to invest!
Eam<le
3esilou limited intends to purchase a machine worth Shs!),9@@,@@@ which will have a residue
value Shs!%@@,@@@ after 9 years useful life! #he saving in cost resulting from the use of this
machine are:
Shs!
8ear ) (@@,@@@
8ear % +9@,@@@
8ear + "
8ear & '(@,@@@
8ear 9 <<9,@@@
Using /7: method, advise the company whether this machine should be purchased if the cut
off rate is )&F and acceptable saving in cost is )%F of the cost of the investment!
Solution
8ear ) % + & 9
Saving
Scrap value
#otal
amount
(@@,@@@
"
(@@,@@@
+9@,@@@
"
+9@,@@@
"
"
"
'(@,@@@
"
'(@,@@@
<<9,@@@
%@@,@@@
;<9,@@@
/7: I
( ) ( ) ( ) ( )
@@@ , 9@@ , )
)& ! )
@@@ , ;<9
)& ! )
@@@ , '(@
)& ! )
@@@ , +9@
)& ! )
@@@ , (@@
9 & % )
+ + +
I ),((@,@'<!) E ),9@@,@@@
I +(@,@'<!@<
3eturn I
)@@
@@@ , 9@@ , )
@ ! @'< , +(@
x
I %9!++<F U )%F hence invest!
N!= ssuming that the salvage will be realised!
Eam<le
section of a roadway pavement costs Z&@@ per year to maintain! What new expenditure of a
new pavement is =ustified if no maintenance will be required for the )
st
five years then Z)@@ for
the next )@ years and Z&@@ a year thereafterM ssume cost of finance to be 9F!
Solution
!.S&NESS *&NANCE
Lesson *i2e 4I6
#otal present value of maintenance costs under the re"surfacing scheme!
-aximum expenditure I
@@@ , ( Z
@9 ! @
&@@
7resent value of an nnuity for n years is given by the formula:

( )
1
1
1
1
]
1
K
K
A P
n
)
)
)
Whereby: 7: is 7resent value
is annuity
0 is cost of finance
n is number of year
7resent value of an annuity to perpetuity is given by the formula
7v I
K
A
Whereby: 7: is 7resent value
is annuity
0 is cost of finance
#herefore 7: maximum expenditure I @@@ , ( Z
@9 ! @
&@@
7: I -inimum expenditure I Z\&,&9+]

I Nustified expenditure I Z+,9&<
( ) ( )
( )
1
1
1
1
]
1
+
1
1
1
1
1
]
1
1
1
1
1
1
]
1
9 ! @
@9 ! )
)
&@@
9 ! @
&@@
9 ! @
@9 ! )
)
)
)@@
9 ! @
@9 ! )
)
)
)@@
)9
9 )9
PV
I Z&,&9+
N!: #he present value interest factors 7:$4 I
n
rC ) B
)
+
and present value
nnuity factors, 7:4 I
r
r
n
+ C ) B )
can be read from tables provided at the point of
interseption between the discounting rate and number of periods!
ACCE+T O, ,EBECT ,.LE O* N+/
Under this method, a company should accept an investment venture if /!7!:! is positive i!e! if
present value of cash outflows exceeds that of cash inflows or at least is equal to >ero! B/7:
^@C! #his will rank ventures giving the highest rank to that venture with highest /7: because
this will give the highest cash inflow or capital gain to the company!
Ad2antages o' N+/
$t recognises time value of money and such appreciates that a shilling now is more
valuable than a shilling tomorrow and the two can only be compared if they are at their
present value!
$t takes into account the entire inflows or returns and as such it is a realistic gauge of the
profitability of a venture!
$t is consistent with the value of a share in so far as a positive /7: will have the
implication of increasing the value of a share!
&! $t is consistent with the ob=ective of maximising the welfare of an owner because a
positive /7: will increase the net worth of owners!
Disad2antages o' N+/
!.S&NESS *&NANCE
Lesson *i2e 4I7
$t is difficult to use!
$ts calculation uses cost of finance which is a difficult concept because it considers both
implicit and explicit whereas /7: ignores implicit costs!
$t is ideal for assessing the viability of an investment under certainty because it ignores
the element of risk!
$t may not give good assessment of alternative pro=ects if the pro=ects are unequal lives,
returns or costs!
$t ignores the 7*7!
&rr "&nternal ,ate O' ,eturn#
#his method is a discounted cash flow technique which uses the principle of /7:! $t is defined
as the rate which equates the present value of cash outflows of an investment to the initial
capital!
$33 I 7v Bcash inflowsC I 7vBcash outflowsC or $33 is the cost of capital when /7: I @!
$t is also called internal rate of return because it depends wholly on the outlay of investment and
proceeds associated with the pro=ect and not a rate determined outside the venture!
( ) ( ) ( ) ( )
r
!
r
!
r
!
r
!
C IRR
+
+ +
+
+
+
+
+

)
!!!!!
) ) )
+
+
%
%
)
)
I inflow for each period
5 I 5ost of investment
#he value r can be found by:
iC #rial and error
iiC *y interpolation
iiiC *y extrapolation
i# Trial and error met%od
aC Select any rate of interest at random and use it to compute /7: of cash inflows!
bC $f rate chosen produces /7: lower than the cost, choose a lower rate!
cC $f the rate chosen in BaC above gives /7: greater than the cost, choose a higher
rate! 5ontinue the process until the /7: is equal to >ero and that will be the
$33!
Eam<le
pro=ect costs )',%@@AI and is expected to generate the following inflows:
Shs!
8ear ) (,@@@
8ear % <,@@@
8ear + ',@@@
5ompute the $33 of this venture!
Solution
4I: Ca<ital &n2estment Decisions
4
st
c%oice 4IK
( ) ( ) ( )
+ % )
) ! )
@@@ , '
) ! )
@@@ , <
) ! )
@@@ , (
+ +
I )<,9'9!<& U cost, choose a higher rate!
5
nd
c%oice 46K
( ) ( ) ( )
+ % )
)& ! )
@@@ , '
)& ! )
@@@ , <
)& ! )
@@@ , (
+ +
I )',&9+!'&'
@
rd
c%oice 48K
( ) ( ) ( )
+ % )
)9 ! )
@@@ , '
)9 ! )
@@@ , <
)9 ! )
@@@ , (
+ +
I )',);&!'%9
$33 lies between )&F and )9F!
ii# &nter<olation met%od
1ifference
7: at rate of )&F I )',&9+!'&'
%9+!'&'
7: required I )',%@@!@@@
"9!+<9
7: at rate of )9F I )',);&!'%9
#herefore, r denotes required rate of return
#herefore, r I )&F G B)9F " )&FC x
+<9 ! 9 '&' ! %9+
'&' ! %9+
+
I )&F G @!;(F
I )&!;(F
Acce<tance ,ule o' &,,
$33 will accept a venture if its $33 is higher than or equal to the minimum required rate of
return which is usually the cost of finance also known as the cut off rate or hurdle rate, and in
this case $33 will be the highest rate of interest a firm would be ready to pay to finance a
pro=ect using borrowed funds and without being financially worse off by paying back the loan
Bthe principal and accrued interestC out of the cash flows generated by that pro=ect! #hus, $33 is
the break"even rate of borrowing from commercial banks!
Ad2antages o' &,,
$t considers time value of money
$t considers cash flows over the entire life of the pro=ect!
$t is compatible with the maximisation of ownerDs wealth because, if it is higher than the
cost of finance, ownersD wealth will be maximised!
Unlike the /7: method, it does not use the cost of finance to discount inflows and for this
reason it will indicate a rate of return of interval to the pro=ect against which various
ventures can be assessed as to their viability!
!.S&NESS *&NANCE
Lesson *i2e 4I;
Disad2antages o' &,,
1ifficult to use!
.xpensive to use because it calls for trained manpower and may use computers
especially where inflows are of large magnitude and extending beyond the normal
limits!
$t may give multiple results some involving positive $33 in which case it may be
difficult to use in choosing which venture is more viable!
+,O*&TA!&L&T0 &NDE3 "+(&(#
7!$! Bbenefit"cost ratioC I 7resent value of inflows
7resent value of cash outlay
$f 7!$! is greater than )!@, invest! $f less than )!@, re=ect!
Eam<le
#he following information was from P8Q feasibility studies! $t has studied two ventures:
aC 5ost )@@,@@@AI and )'@,@@@AI at the beginning of the &
th
year and it will generate
inflows )"+
rd
year (@,@@@AI and from &"'
th
year 9@,@@@AI per annum!
bC $nitial cost %@@,@@@AI and (@,@@@AI at the beginning of the &
th
year and it will generate
the following inflows:
)
st
E %
nd
year "U Shs!)@@,@@@ per annum
+
rd
E '
th
year "U Shs!<@,@@@ per annum
Using the cost of finance of )%F compute the 7!$! of these two ventures, advise the
company accordingly!
Solution
aC ,utflows:
( )
+
)% ! )
@@@ , )'@
)
@@@ , )@@
+
I )@@,@@@ G ))+,((< I %)+,((9
$nflows:
( ) ( ) ( ) ( ) ( ) ( )
' 9 & + % )
)% ! )
@@@ , 9@
)% ! )
@@@ , 9@
)% ! )
@@@ , 9@
)% ! )
@@@ , (@
)% ! )
@@@ , (@
)% ! )
@@@ , (@
+ + + + +
I Shs!%<<,'%'
7!$! I
((9 , %)+
'%' , %<<
7!$! I )!%;(
bC ,utflows: I
( )
+
)% ! )
@@@ , (@
)
@@@ , %@@
+
I %9',;&&
$nflows I
( ) ( ) ( ) ( ) ( ) ( )
' 9 & + % )
)% ! )
@@@ , <@
)% ! )
@@@ , <@
)% ! )
@@@ , <@
)% ! )
@@@ , <@
)% ! )
@@@ , )@@
)% ! )
@@@ , )@@
+ + + + +
I
Shs!++(,9@)
7!$! I
;&& , %9'
9@) , ++(
I )!+%
Eam<le
company is faced with the following 9 investment opportunities:
5ost /7: 7!$ I #otal 7!vYYY
$nitial capital
7!$ 3anking
)!
%!
+!
&!
9!
9@@,@@@
)@@,@@@
&@@,@@@
%@@,@@@
)'@,@@@
)9@,@@@
&@,@@@
&@,@@@
)@@,@@@
;@,@@@
)!+
)!&
)!)
)!9
)!'
&
+
9
%
)
#his company has <9@,@@@AI available for investment pro=ects, + and & are mutually exclusive!
ll of the pro=ects are divisible! Which group should be selected in order to maximise the /7:!
$ndicate this /7: figure!
Solution
Using 7!$! to rank the pro=ects in order of preference 9, &, %, ), +!
$n order to maximise /7:, the following pro=ects combination should be selected:
Shs!
4unds available for investment <9@,@@@
5ost of pro=ect: 9 )'@,@@@
& %@@,@@@
% )@@,@@@
) %;@,@@@ B<9@,@@@C
/$2
/7: I ;@,@@@ G )@@,@@@ G &@,@@@ G
@@@ , )9@
@@@ , 9@@
@@@ , %;@
x
I +)<,@@@
Ad2antages o' <ro'ita?ility inde
aC Simple to use and understand!
bC #he element of /7: in the venture will indicate which venture is more powerful as the
most profitable venture will have the highest 7!$! as the difference or net 7!$! will
continue to the companyDs profitability!
cC $t acknowledges time value for money and at the same time the /7: of a venture at its
present value which is consistent with investment appraisal requirements!
Disad2antages o' <ro'ita?ility inde
aC $t may be useful under conditions of uncertain cost of finance used to discount inflows
and yet this cost is a complex item due to the implicit and explicit element!
!.S&NESS *&NANCE
Lesson *i2e 44I
bC $t may be difficult to ascertain if the economic life of a venture is long and it yields
large inflows because their discounting may call for use of computers that are
expensive!
COM+A,&SON O* MET-ODS
*oth traditional and modern methods will show or indicate strong weaknesses such that a
company cannot use either to select a viable venture and for this reason the selection of the
investment will depend on which method the company has identified it can meet its investment
needs! #he choice should not be limited to one method but at least % modern methods! $n all,
when ranking pro=ects, a conflict will rise between $33 and /7: especially under the following
conditions:
iC $f the lives of the pro=ects are different!
iiC Where the cash outlay is larger than the other!
iiiC When the cash flow pattern differs i!e the cash flows of one pro=ect may overtime
increase while those of the other decrease! $n this case /7: may give consistently
correct solution especially so because it does not yield multiple rates!
+!+ ,EC&+,OCAL
7*7 expresses the profitability of a pro=ect in terms of years! $t does not show any return as
measure of investment! #he 7*7 reciprocal has been utilised to rectify the situation, but it is
only of value where the pattern of cash flow is relatively consistent and where the life of the
asset is at least double the payback period of the asset! #he payback period is expressed as:
$nvestment
nnual cash flows
#his 7*7 reciprocal is often used as a guide to ascertain the discount factor in discounted cash
flow calculations i!e! to approximate $33!
7ayback period reciprocal I
)@@
)
x
P#P
,E+LACEMENT O* ASSETS
Eam<le
.state 1evelopers purchased a machine five years ago at a cost of Z<,9@@! #he machine had an
expected economic life of )9 years at the time of purchase and a >ero estimated salvage value at
the end of )9 years! $t is being depreciated on a straight line basis and currently has a book
value of Z9,@@@! #he 4inancial -anager has conducted a feasibility study aimed at acquiring a
new machine for Z)%,@@@ and is depreciated over its )@ years useful life! #he new machine will
expand sales from Z)@,@@@ to Z)),@@@ per annum and will reduce labour and materials usage
sufficiently to cut operating cost from Z<,@@@ to Z9,@@@! #he salvage value of the new machine
is Z%,@@@ at the end of useful life! #he current market value of the old machine is Z),@@@ and
tax is &@F! #he firms cost of capital is )@F! #he financial manager wishes to make a decision
on whether to replace the old machine with a new one and he seeks your held!
/!*! #he decision to replace takes into account the following:
aC .stimate the actual cash outlay attributable to the new machine
bC 1etermine the incremental cash flows!
cC 5ompute the /7: of incremental cash flows!
dC dd up the present value of the expected salvage value to the 7!:! of the incremental
cash flow!
!.S&NESS *&NANCE
Lesson *i2e 445
eC scertain whether the /7: Bnet present valueC is positive or whether the $33 Binternal
rate of returnC exceed the cost in which case invest if its positive!
Solution
aC $nitial capital for new machines Z
5ash price of new machine )%,@@@
2ess market value of old machine B),@@@C
2ess tax shield on sale of old machine:
-arket value ),@@@
2ess net book value 9,@@@
2oss on disposal &,@@@
#ax shield I &@F x &,@@@ B',@@@C
$ncreamental initial capital ;,&@@
bC 1epreciation of new machine I
yrs )@
@@@ , % @@@ , )%
I ),@@@
1epreciation of old machine I
yrs )@
@ @@@ , 9
I 9@@
$ncreamental depreciation 9@@
N!= #he /*: of old machine after 9 years is Z9,@@@! #his /*: will be depreciated over
the remaining )@ years!
Determine o<erating cas% 'lows=
$ncreamental sales I )),@@@ E )@,@@@ ),@@@
Savings in labour costs I 9,@@@ E <,@@@ %,@@@
$ncreamental .*1# +,@@@
2ess increamental depreciation Bnon"cash itemC B9@@C
$ncreamental .*# %,9@@
2ess tax S &@F ),@@@
$ncreamental .# ),9@@
dd back increamental depreciation 9@@
nnual cash flow %,@@@
#erminal cash flows at end of year )@ is equal to increamental salvage value!
/ew machine salvage value %,@@@
2ess old machine salvage value @
%,@@@
5ompute the /7: S)@F cost of capital:
7!: of cash flows I )&9 ! ' @@@ , % )@ , @@@ , %
)@ ! @
C ) ! ) B )
%@@@
F )@
)@
x xPV!$ x

)%,%;@
7!: of salvage value I
( )
+(' ! @ @@@ , % )@ , @@@ , %
) ! )
)
@@@ , %
F )@
)@
x xPVI$ x
<<%
)+,@'%
2ess increamental initial capital B;,&@@C
$ncreamental /!7!: +,''%
44@ Ca<ital &n2estment Decisions
3eplace the old machine
!.S&NESS *&NANCE
Lesson *i2e 446
J.EST&ON ONE
What are the advantages of discounted cash flows methodsM
J.EST&ONTWO
0iwanda 2imited is considering the purchase of a new machine! #wo alternative machines,
7esi #Q, and Upesi -,%, which will cost Sh!',@@@,@@@ and Sh!<,@@@,@@@ respectively are
available in the market! #he cash flow after taxation of each machine are as follows:
Cas% 'low
0ear +esi TNO
S%(
.<esi MO5
S%(
)
%
+
&
9
'@@,@@@
),(@@,@@@
%,@@@,@@@
+,@@@,@@@
%,&@@,@@@
),(@@,@@@
%,&@@,@@@
+,@@@,@@@
),(@@,@@@
),'@@,@@@
,e>uired
aC 5ompute the net present value of each machine! B( marksC
bC ssuming that each machine represents a pro=ect:
5ompute the return 0iwanda 2imited expects to earn from each of the two
pro=ects! B)@ marksC
5omment on the use of the results obtained in BaC and BbCBiC above in selecting
between the two pro=ects! B& marksC
"Total= 55 marks#
J.EST&ONT-,EE
#he Weka 5ompany 2td! has been considering the criteria that must be met before a capital
expenditure proposal can be included in the capital expenditure programme!
#he screening criteria established by management are as follows:
/o pro=ect should involve a net commitment of funds for more than four years!
ccepted proposals must offer a time ad=usted or discounted rate of return at least equal to the
estimated cost of capital! 7resent estimates are that cost of capital as )9 percent per annum after
tax!
ccepted proposals should average over the life time, an unad=usted rate of return on assets
employed Bcalculated in the conventional accounting method at least equal to the average rate of
return on total assets shown by the statutory financial statements included in the annual report of
the company!
proposal to purchase a new lathe machine is to be sub=ected to these initial screening
processes! #he machine will cost Sh!%,%@@,@@@ and has an estimated useful life of five years at
the end of which the disposal value will be >ero! Sales revenue to be generated by the new
machine is estimated as follows:
8ear 3evenue BSh!D@@@DC
),+%@
),&&@
),9'@
),'@@
),9@@
dditional operating costs are estimated to be Sh!<@@, @@@ per annum! #ax rates may be
assumed to be +9F payable in the year in which revenue is received! 4or taxation purpose the
machine is to be written off as a fixed annual rate of %@F on cost!
#he financial accounting statements issued by the company in recent years shows that profits
after tax have averaged )(F on total assets!
,e>uired
7resent a report which will indicate to management whether or not the proposal to purchase the
lathe machine meets each of the selection criteria! "Total= 49
marks#
J.EST&ON *O.,
aC What are the features of a sound appraisal techniqueM B' marksC
bC What practical problems are faced by finance managers in capital budgeting decisionsM
B' marksC
cC 1escribe the features of long term investment decisions! B( marksC
J.EST&ON*&/E
00 2td has six pro=ects available for investment as follows:
+roEect &nitial cost S%(FMF N+/ O 48K cost
o' ca<ital
)
%
+
&
9
'
'@
)9
%@
99
+@
&@
%)
;
;
)9
%@
"%
#he firm has Sh!)@@ - available for investment!
$dentify which pro=ects should be undertaken! Using 7!$ and /7: ranking, comment on
your answer!
!.S&NESS *&NANCE
Lesson *i2e 447
C-ECK 0O., ANSWE,S W&T- T-OSE +,O/&DED &N T-E LESSON 4I
44: Ca<ital &n2estment Decisions
LESSON S&3
/AL.AT&ON CONCE+TS &N *&NANCE
&NST,.CT&ONS
3ead 5hapter ( of 4inancial -anagement text book by $! - 7andey!
CONTENTS
*ases and importance of valuation
:aluation of ordinary shares
:aluation of bonds and 1ebentures
!.S&NESS *&NANCE
Lesson Si 44;
/AL.AT&ON O* !.S&NESS
business may be valued for different reasons such as for merger, takeover, acquisition, or
outright sale or liquidation! $n purchasing a business, a buyer will be interested in not only the
assets but also the future income this business is expected to generate!
!ASES O* /AL.AT&ON
)! T%eoretical 2alue E $n theory, if a purchaser buys a business, he is simply buying a
stream of future income flows and to arrive at the actual purchase price the buyer will:
aC 5onsider the estimated probable cash flows!
bC 1iscount cash flows to their present value!
cC dd together the separate amounts to give the present value of income stream!
Where future income flows are constant:
1
1
]
1
r
r
C PV
n
C ) B )
Where: 7: I 7resent value of income stream
c I $nflow per annum
r I 1iscounting rate
n I /umber of years the inflows will last
Eam<le
s a result of the purchase of an asset, the income stream will increase by Z),@@@ per annum for
%9 years! ssuming a discount rate of %@F, compute the maximum price to be paid for this
asset ignoring taxation!
Solution
-aximum price I 7resent value of all future cash inflows
-aximum price I Z)@,@@@ x 7:4%@F,%9
I Z)@,@@@ x
%@ ! @
C % ! ) B )
%9
I )@,@@@ x &!;&<'
I Z&;,&<'
$n practice the income streams are never uniform and have to be estimated from existing income
shown in the recent accounts!
%! Earning met%od E #he business is valued according to the total stream of income it is
expected to generate over its lifetime!
Determination o' maintaina?le earnings
aC #he first step in arriving at earning based valuation is to estimate the future
maintainable earnings and if the conditions in the future are expected to be similar to
those in the past, it is then prudent to face the forecast on the historical figures!
However, conditions do change and as such changes in cost and revenue! #herefore, a
449 /aluation Conce<ts in *inance
detailed examination of profits of the most recent profit and loss account will be
necessary to estimate the effects of the changes! While the information given will
depend upon the nature of the business the general principles to bear in mind must
include the trend of sales and gross profit!
bC nalysis of sales and gross profit percentage by:
iC 7roduct lines
iiC 1epartments
iiiC 6eographical areas
ivC 5ustomer type!
cC 5osts as a percentage of total sales!
dC Unusual fluctuations in the ratios!
eC /ecessity of expenditure in the business e!g! excessive remuneration on expenses
charged!
fC $nclusion of all costs!
gC .ffects of external conditions such as inflation or recession!
However, there are several ways of arriving at the value based on the earnings valuation!
iC .arnings yield valuation
iiC 7rice earnings ratio valuation
iiiC Super profits valuation
&# Earnings 0ield /aluation
.8 is given by the earnings made by the business expressed as a percentage of the market price
of the business i!e!
.8 I .arnings x )@@
-arket price of equity
.8 I .7S x )@@ I .arnings to Shareholders
-7S -arket value of equity
#herefore -arket :alue I .arning to shareholders
.arnings yield
Eam<le
.stimated maintainable earnings are Z%&@,@@@ per annum, rate of return required is %9F!
5ompute the value of the business!
:alue -:C I . x )@@
.8
I %&@,@@@ x )@@
@!%9
-!:! I Z;'@,@@@
#his method can be converted into the theoretical base, especially if the business is going
concern!
!.S&NESS *&NANCE
Lesson Si 45I
( ) 1
1
]
1
"
C
PV
%9 ! @ )
)
)
Note
s / approaches W
7v I 5
r
I %&@,@@@ I Z;'@,@@@
@!%9
ii# +rice Earning ,atio /aluation
7A. ratio is traditionally used for valuation of shares but it is an important ratio in the valuation
of business! #he 7A. ratio is the measure of how may years earning would LpurchaseD the
market value of the business and is given by:
7A. ratio I -:
.
-: I 7A. x .
/*: #he value of the business can be calculated by taking estimated earnings x 7A. ratio!
/AL.AT&ON O* SEC.,&T&ES=
#he previous methods were ideal for valuing the entire business but it is also necessary to
ascertain the value of part of a business namely shares, or securities or a block of shares in a
limited liability company! #he valuation of securities and shares in particular is necessary in the
following aspects:
iC #o facilitate take"over bids
iiC #o allow for mergers!
iiiC #o facilitate for company accounts disclosure
ivC 4or purposes of acquisitions or disposal of blocks of shares!
vC 4or purposes of computing capital gains tax Bnot applicable in 0enya at presentC
viC 4or tax payers executors in assessing the capital transfers processes
viiC 4or ascertaining stamp duty payable!
However, a number of parties are interested in the value of shares and securities and such will
include:
aC 5ompany shareholders, directors and vendors of the company!
bC #he existing and prospective shareholders!
cC *uyers of a company!
dC #ransferee and transferor parties, in particular from the point of view of income
tax!
eC $ncome tax department!
$n this valuation, it is necessary to look at a company form:
iC ?uoted company Bquoted sharesC
iiC Unquoted company Bunquoted sharesC
#he valuation of shares will also be influenced by ownership of the company! $f a company is
owned by ma=ority shareholders, its valuation will be different from if it was owned by minority
shareholders! $n addition, it is necessary to value shares because of:
aC $t is a requirement of the 5ompanyDs ct );&( in respect of quoted investments which
should state the investment book value, market value and stock exchange value where
this differs from market value! $n this case, the ct recognises the fact that the value of
shares may not always be reflected in the stock exchange price and for disclosure
purposes, it must be reflected!
iC $n respect of unquoted investments the company must state aggregate amount of the
book value and also state either the directors valuation which could be different from
investors own valuation! lso the company should give specifications of the earnings
and dividends attributed to these shares! #hese are necessary to enable interested
parties to make their own valuations!
iiC $n respect of both quoted and unquoted, shares the company should give details of the
shares so that they can assist in making a valuation of those shares =udged to be
significant for owning the company, namely, if individual investments exceed )@F of
the issued shares of a given class or where the book value of the investment exceeds
)@F of the companyDs assets!
bC 5apital transfer reasons i!e! the capital transfer requires a valuation of shares whether
from one person to another or even if they are transferred at the time of death!
:aluation date is important for valuation of companiesD properties!
#he main difficulties in valuation of shares are:
iC .xistence and method of valuation of goodwill!
iiC Succession of companyDs management
iiiC 6rowth in dividend
ivC 6rowth in equity!
!ASES O* S-A,E /AL.AT&ON
Share valuation can be done on the basis of income and asset values! However, on the basis of
income a share will be entitled to two forms of income! 4or this reason the bases of valuing
shares are:
iC .arnings method
iiC 1ividend method
iiiC ssets method
&# Earnings Met%od "Or Earning !asis /aluation#
Using the earning valuation method, a company will use its 7A. ratio to value its shares!
7A. I -:
.
!.S&NESS *&NANCE
Lesson Si 455
-: I . x 7A. "U value of ordinary share!
#he -: can be determined where the estimated earnings have been established by applying the
7A. ratio expected of this type of company!
Eam<le
5ompany P8Q is expected to generate post tax earnings of Sh!%@@,@@@ per annum and
companies in the same trade will generally have a 7A. ratio of eight B(C! ,n account of
company P8Q limited si>e, a ratio of six B'C is considered more appropriate! #he issued share
capital is ),@@@,@@@ordinary shares of Sh!9@ each!
,e>uired
:alue of shares I .7S x 7A.
I .arnings per share x 7A.
I %@@,@@@ x ' I Sh!)%!@@
),@@@,@@@
:alue of *usiness I .arnings x 7A. ratio
-: I . x 7A. I Sh!%@@,@@@ x ' I Sh!)!% million
ii# Di2idend !asis /aluation
,wnership of shares in entities E #he owner to receive a cash flow consisting of future
dividends and the value of a share should correspond to the present value of this future cash
flow! shareholder cannot expect cash flows in perpetuity as he will sell his shares at one time!
7o I 1o
0e
/ote: Where there is growth in equity, 7@ I
g K
g d
e

+ C ) B
@
Eam<le
5ompany P8Q pays a dividend of )@F on its Sh!'@ par value ordinary shares! #his company
uses a discount rate of )9F! ssuming no growth, compute the value of its ordinary share if
thereDs growth of 9F, what would be the value of this companyDs ordinary shares!
aC 7o I 1o 7o I ' I Sh!&@ Bno growthC
0e )9F
bC 7o I 'B)!@9C I Shs!'+ B9F growth rateC
@!)9"@!@9
iii# Asset !ased /aluation
45@ /aluation Conce<ts in *inance
#his method takes into account the entire business with reference to its assets and then divides
the resultant value by the number of shares in an issue to give the per share! #he principles are
the same as those in the valuation of businesses computed already! However, if a historical
dividend based on earning based valuation produces a figure which is less than the asset value
then there is a possibility that the buyer may be able to improve the management of the asset
being taken over! $n such a case, a buyer would be prepared to pay a price which though
excessive in terms of income might be =ustified by the underlying assets value!
Eam<le 4
$nformation extracted from the books of 0ent 2imited!
5urrent liabilities
*ank overdraft
Sh!
+@@,@@@
9@,@@@
+9@,@@@
2and
Stock in trade
Sh!
%9@,@@@
)@@,@@@
+9@,@@@
Stock has a realisable value of Sh!(@,@@@ and land Sh!+@@,@@@! #his company is assumed to be
have a share capital of %@,@@@ ordinary shares!
5ompute the value of its shares!
iC ssets method
ssets I 2 H * +@@,@@@
Stock (@,@@@
+(@,@@@
2iabilities \+9@,@@@]
+@,@@@
:alue of shares I +@,@@@ I Sh!)!9@
%@,@@@
Eam<le 5
0 H 0 5ompany 2imited is planning to absorb three other companies so as to realise its sales
records of Sh!9@@,@@@ per annum! $ts accountants have advised the company to maintain such a
si>e that it will enable its shares to sell at a minimum price of Sh!)'! #he companyDs last
published balance sheets indicate the following:
Sh!D@@@D
,rdinary shares of Sh!)@ each 9@,@@@
3eserves '9,@@@
5urrent liabilities &@,@@@
#otal )99,@@@
ssets: Sh!
4ixed assets (@,@@@
5urrent assets <9,@@@
#otal )99,@@@
!.S&NESS *&NANCE
Lesson Si 456
7rofits for the last 9 years were as follows:
Sh!D@@@D
)! ;,@@@
%! ',@@@
+! )@,@@@
&! (,@@@
9! )<,@@@
7A. ratio applicable is )%:)
5ompute the value of the business indicating the lowest offer price and the highest offer price
and the share value thereof whether it would be viable to take on the three companies if its to
maintain this share value!
+CE ,AT&O MET-OD
7A. I )%:) verage profits I )@,@@@,@@@
#herefore :alue of business I )@,@@@,@@@ x )% I Sh!)%@,@@@,@@@
:alue of shares I Sh!)%@ million I Sh!%&
9 million shares
ASSETS MET-OD
Sh!D@@@D
ssets )99,@@@
2ess: 5urrent liabilities \ &@,@@@]
))9,@@@
:alue of shares I Sh!))9- I Sh!%+
9- shares
Where: 7o I 7rice of ordinary shares
d I 1ividend at the end of year one
7) I 7rice of the share at the end of one year!
/AL.AT&ON O* !ONDS AND DE!ENT.,ES
#his will depend on expected cash flows consisting of annual interest plus the principal amount
to be received at maturity! #he appropriate rate of capitalisation or discount rate to be applied
will depend upon the riskiness of the bond e!g! government bonds are less risky and will
therefore call for lower discount rates than similar bonds issued by private companies which
will call for high rate of discount!
/aluation o' ?onds wit% maturity <eriod
When a bond or debenture has reached maturity, its value can be determined by considering
annual interest payments plus its terminal or maturity and this is done using the 7!:! concept to
discount the cash flows and the result will be compared to the market value of the bond to
ascertain whether it has overvalued or undervalued!
+
+
+
n
t
n t
%d
M
%d
Int
)
C ) B C ) B
Where: $nt I nnual interest
0d I 3equired rate of return
- I #erminalAmaturity value
n I /umber of years to maturity
Eam<le
0 is contemplating purchasing a + year bond worth &@,@@@AI carrying a nominal coupon rate of
interest of )@F! 0 required rate of return is 'F!
What should he be willing to pay now to purchase the bond if it matures at parM
Solution
$nt I )@F x &@,@@@ I &,@@@ p!a!
n I + yrs
0d I 'F
- I &@,@@@
:d I
+ + % )
C @' ! ) B
@@@ , &@
C @' ! ) B
@@@ , &
C @' ! ) B
@@@ , &
C @' ! ) B
@@@ , &
+ + +
I &,@@@ x 7:4'F,+ G &@,@@@ x 7:$4'F,+ I B&@,@@@ x %!'<+C G B&@,@@@ x @!(&@C I &&,%;%
!.S&NESS *&NANCE
Lesson Si 457
J.EST&ON ONE
aC P8Q 2td is expected to pay a 17S of Sh!' in one yearDs time! #he dividend payout
ratio is '@F and the 3eturn on .quity is )9F!
1etermine whether the share is overvalued if the -7S is Sh!&@! B' marksC
bC What is the significance of valuation securitiesM B9 marksC
cC *5 2td has issued a 9 year >ero coupon rate bond with maturity value of Sh!)@@,@@@!
#he bond is issued at a discount of +%F!
1etermine the rate of return of the bond! B9 marksC
dC What are the advantages of >ero coupon bondM B9 marksC
"Total= 49 marks#
J.EST&ON TWO
/yakua 2imited is contemplating acquiring U>a 2imited!
$ncremental cash flows arising from the acquisition are expected to be as follows:
A2erage o' years "in S%(FIIIF#
4A8 7A4I 44A
5ash flow after taxes
$nvestment required
/et cash flow
)@@
9@
9@
)9@
'@
;@
%@@
<@
)+@
U>a 2imited has an all equity capital structure! #he required rate of return of U>a
2imited is always 9 percent above the risk free rate! #he risk free rate is ; percent!
,e>uired
aC Using the information provided, compute the maximum price that /yakua 2imited
might pay for U>a 2imited! B)&
marksC
bC What other factors might influence the management of /yakua 2imited in their decision
to purchase U>a 2imitedM B'
marksC
"Total= 5I marks#
J.EST&ON T-,EE
aC ndreas 5ompany 2td! currently pays a dividend of Sh!% per share and this
dividend is expected to grow at an annual rate of )9F for the first + years then
at a rate of )@F for the next + years after which it is expected to grow at a rate
of 9F thereafter!
What value would you place on the stock if an )(F rate of return were
requiredM B<
marksC
45: /aluation Conce<ts in *inance
Would your valuation change if you expected to hold the stock for only +
yearsM .xplain! B9
marksC
bC #he stream of dividends of P8Q 2td for the past & years was as follows:
8ear );;; %@@@ %@@) %@@%
17S Sh! %!9@ %!'9 %!<' %!()
#he cost of equity is )&F! 1etermine the price of a share! B(
marksC
J.EST&ON *O.,
aC #he valuation of ordinary shares is more complicated than the valuation of bonds and
preference shares! .xplain the factors that complicate the valuation of ordinary
shares! B' marksC
#he most recent financial data for the 3are Watts disclose the following:
1ividend per share Sh!+!@@
.xpected annual dividend growth rate ' percent
5urrent required rate of return )9 percent
#he company is considering a variety of proposals in order to redirect the firmDs
activities! #he following four alternatives have been suggested:
)! 1o nothing in which case the key financial variables will remain unchanged!
%! $nvest in venture that will increase the dividend growth rate to <F and lower
the required rate of return to )&F!
+! .liminate an unprofitable product line! #he action will increase the dividend
growth rate to (F and raise the required rate of return to )<F!
&! cquire a subsidiary operation from another company! #his action will
increase the dividend growth rate to ;F and required rate of return to )(F!
,e>uired
4or each of the proposed actions, determine the resulting impact price and recommend the best
alternative!
"Total= 46
marks#
END O* COM+,E-ES&/E
C-ECK 0O., ANSWE,S W&T- T-OSE +,O/&DED &N LESSON 4I
!.S&NESS *&NANCE
45; Di2idend +olicies and Decisions
LESSON SE/EN
D&/&DEND +OL&C&ES AND DEC&S&ONS
&NST,.CT&ONS
3ead 5hapters %@ and %) of 4inancial -anagement text book by $! - 7andey!
CONTENTS
1ividend 7olicy and 1ecisions
lternative 1ividend 7olicies
1ividend #heories
-ode of paying 1ividends
4actors influencing dividend policies
1ividend ratios
Lesson Se2en 459
D&/&DEND +OL&C&ES AND DEC&S&ONS
1ividend policy determines the division of earnings between payment to stock holders ad re"
investment in the firm! $t therefore looks at the following aspects:
iC! How much to pay E this encompassed in the four ma=or alternative dividend policies!
5onstant mount ,f 1ividend 7er Share
5onstant 7ayout 3atio
4ixed 1ividend 7lus .xtra
3esidual 1ividend 7olicy
iiC When to pay E paying interim or final dividends
iiiC Why dividends are paid E this is explained by the various theories which has to
determine the relevance of dividend payment i!e!:
3esidual dividend theory
1ividend irrelevance theory B--C
Signalling theory
*ird in hand theory
5lientele theory
gency theory
ivC How to pay: cash or stock dividends!
&m<ortance o' Di2idend Decisions
1ividends decisions are integral part of a firmDs strategic 'inancing decision! $t is therefore a
plan of action adopted by management e!g payment of high dividends means less retained
earnings and the firm may have to go to the market to borrow for investment purposes! #his
will increase its gearing level!
Solution to t%e Di2idend +uDDle
firms dividend decision may have some relevance to the firmDs share value! #he managers
therefore requires to formulate an optimal dividend policy which will maximi>e the wealth of
the shareholders Bvalue of sharesC!
i# -OW M.C- TO +A0= ALTE,NAT&/E D&/&DENDS +OL&C&ES
a# Constant <ayout ratio
#his is where the firm will pay a fixed dividend rate e!g! &@F of earnings! #he 17S would
therefore fluctuate as the earnings per share changes!
1ividends are directly dependent on the firms earnings ability and if no profits are made no
dividend is paid!
#his policy creates uncertainty to ordinary shareholders especially who rely on dividend income
and they might demand a higher required rate of return!
!.S&NESS *&NANCE
4@I Di2idend +olicies and Decisions
?# Constant amount <er s%are "'ied D(+(S(#
#he 17S is fixed in amount irrespective of the earnings level! #his creates certainty and is
therefore preferred by shareholders who have a high reliance on dividend income!
$t protects the firm from periods of low earnings by fixing, 17S at a low level!
#his policy treats all shareholders like preferred shareholders by giving a fixed return! #he 17S
could be increased to a higher level if earnings appear relatively permanent and sustainable!
c# Constant D+S <lus EtraCSur<lus
Under this policy a constant 17S is paid every year! However extra dividends are paid in years
of supernormal earnings!
$t gives the firm flexibility to increase dividends when earnings are high and the shareholders
are given a chance to participate in super normal earnings
#he extra dividends is given in such a way that it is not perceived as a commitments by the firm
to continue the extra dividend in the future! $t is applied by the firms whose earnings are highly
volatile e!g agricultural sector!
d# ,esidual di2idend <olicy
Under this policy dividend is paid out of earnings left over after investment decisions have been
financed! 1ividend will only be paid if there are no profitable investment opportunities
available! #he policy is consistent with shareholders wealth maximi>ation!
ii# W-EN TO +A0
4irms pay interim or final dividends! $nterim dividends are paid at the middle of the year and
are paid in cash! 4inal dividends are paid at year end and can be in cash or bonus issue!
iii# D&/&DENDS T-EO,&ES "W-0 +A0 D&/&DENDS#
#he main theories are:
4( ,esidual di2idend t%eory
Under this theory, a firm will pay dividends from residual earnings i!e! earnings remaining after
all suitable pro=ects with positive /7: has been financed!
$t assumes that retained earnings is the best source of long term capital since it is readily
available and cheap! #his is because no floatation cash are involved in use of retained earnings
to finance new investments!
#herefore, the first claim on earnings after tax and preference dividends will be a reser2e for
financing investments!
1ividend policy is irrelevant and treated as passive variable! $t will not affect the value of the
firm! However, investment decisions will!
Lesson Se2en 4@4
Ad2antages o' ,esidual T%eory
4( Sa2ing on 'loatation costs
/o need to raise debt or equity capital since there is high retention of earnings which requires
no floatation costs!
5( A2oidance o' dilution o' owners%i<
/ew equity issue would dilute ownership and control! #his will be avoided if retention is high!
high retention policy may enable financing of firms with rapid and high rate of growth!
@( Ta <osition o' s%are%olders
High"income shareholders prefer low dividends to reduce their tax burden on dividends income!
#hey prefer high retention of earnings which are reinvested, increase share value and they can
gain capital gains which are not taxable in 0enya!
ii# MM Di2idend &rrele2ance T%eory
Was advanced by -odiglian and -iller in );')! #he theory asserts that a firmDs dividend
policy has no effect on its market value and cost of capital!
#hey argued that the firmDs value is primarily determined by:
bility to generate earnings from investments
2evel of business and financial risk
ccording to -- dividend policy is a passive residue determined by the firmDs need for
investment funds!
$t does not matter how the earnings are divided between dividend payment to shareholders and
retention! #herefore, optimal dividend policy does not exist! Since when investment decisions
of the firms are given, dividend decision is a mere detail without any effect on the value of the
firm!
#hey base on their arguments on the following assumptions:
)! /o corporate or personal kites
%! /o transaction cost associated with share floatation
+! firm has an investment policy which is independent of its dividend policy Ba fixed
investment policyC
&! .fficient market E all investors have same set of information regarding the future of the
firm
9! /o uncertainty E all investors make decisions using the same discounting rate at all time
i!e required rate of return BrC I cost of capital BkC!
iii# !irdAinA%and t%eory
dvanced by Nohn 2itner B);'%C and furthered by -yron 6ordon B);'+C!
!.S&NESS *&NANCE
4@5 Di2idend +olicies and Decisions
rgues that shareholders are risk a2erse and prefer certainty! 1ividends payments are more
certain than capital gains which rely on demand and supply forces to determine share prices!
#herefore, one bird in hand Bcertain dividendsC is better than two birds in the bush Buncertain
capital gainsC!
#herefore, a firm paying high dividends BcertainC will have %ig%er 2alue since shareholders will
require to use lower discounting rate!
-- argued against the above proposition! #hey argued that the required rate of return is
independent of dividend policy! #hey maintained that an investor can reali>e capital gains
generated by reinvestment of retained earning, if they sell shares!
$f this is possible, investors would be indifferent between cash dividends and capital gains!
i2# &n'ormation signaling e''ect t%eory
dvanced by Stephen 3oss in );<<! He argued that in an inefficient market, management can
use dividend policy to signal important information to t%e market w%ic% is only known to
t%em(
Eam<le E $f the management pays high dividends, it signals high expected profits in future to
maintain the high dividend level! #his would increase the share priceAvalue and vice versa!
-- attacked this position and suggested that the change in share price following the change in
dividend amount is due to in'ormational content o' di2idend <olicy rather than dividend
policy itself!#herefore, dividends are irrelevant if information can be given to the market to all
players!
1ividend decisions are relevant in an inefficient market and the higher the dividends, the higher
the value of the firm! #he theory is based on the following four assumptions:
)! #he sending of signals by the management should be cost effective!
%! #he signals should be correlated to observable events Bcommon trend in the marketC!
+! /o company can imitate its competitors in sending the signals!
&! #he managers can only send true signals even if they are bad signals! Sending untrue
signals is financially disastrous to the survival of the firm!
2# Ta di''erential t%eory
dvanced by 2it>enberger and 3amaswamy in );<;
#hey argued that tax rate on dividends is higher than tax rate on capital gains!#herefore, a firm
that pays high dividends have lower value since shareholders pay more tax on dividends!
1ividend decisions are relevant and the lower the dividend the higher the value of the firm and
vice versa!
Note
$n 0enya, dividends attract a withholding tax of 9F which is final and capital gains are tax
exempt!
2i# Clientele e''ect t%eory
dvance by 3ichardson 7etit in );<<
Lesson Se2en 4@@
$t stated that different groups of shareholders BclienteleC have different preferences for dividends
depending on their level of income from other sources!
2ow income earners prefer high dividends to meet their daily consumption while high income
earners prefer low dividends to avoid payment of more tax! #herefore, when a firm sets a
dividend policy, thereDll be shifting of investors into and out of the firm until an equilibrium is
achieved! 2ow, income shareholders will shift to firms paying high dividends and high income
shareholders to firms paying low dividends!
t equilibrium, dividend policy will be consistent with clientele of shareholders a firm has!
1ividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors!
2ii# Agency t%eory
#he agency problem between shareholders and managers can be resolved by paying high
dividends! $f retention is low, managers are required to raise additional equity capital to finance
investment!.ach fresh equity issue will expose the managers financing decision to providers of
capital e!g bankers, investors, suppliers etc!-anagers will thus engage in activities that are
consistent with maximi>ation of shareholders wealth by making full disclosure of their
activities!
#his is because they know the firm will be exposed to external parties through external
borrowing! 5onsequently, gency costs will be reduced since the firm becomes self"regulating!
1ividend policy will have a beneficial effect on the value of the firm! #his is because dividend
policy can be used to reduce agency problem by reducing agency costs!#he theory implies that
firms adopting high dividend payout ratio will have a higher due to reduced agency costs!
-ow to <ay di2idends "mode o' <aying di2idends#
)! 5ash and *onus issue
%! Stock split and reverse split
+! Stock repurchase
&! Stock rightsArights issue Bto discuss in classC
4( Cas% and ?onus issue
4or a firm to pay cash dividends, it should have adequate liquid funds!
However, under conditions of liquidity and financial constraints, a firm can pay stock dividend
B*ank issueC
*onus issue involves issue of additional shares for free Binstead of cashC to existing shareholders
in their shareholding proportion!
Stock dividendA*onus issue involves capitali>ation of retained earnings and does not increase
the wealth of shareholders! #his is because 3! .arnings is converted into shares!
Ad2antages o' !onus &ssue
a# Ta ad2antages
Shareholders can sell new shares, and generate cash in form of capital gains which is tax exempt
unlike cash dividends which attract 9F withholding tax which is final
?# &ndication o' %ig% <ro'its in 'uture=
!.S&NESS *&NANCE
*onus issue, in an inefficient market conveys important information about the future of the
company!
$t is declared when management expects increase in earning to offset additional outstanding
shares so that .!7!S is not diluted!
c# Conser2ation o' cas%
*onus issue conserves cash especially if the firm is in liquidity problems!
d# &ncrease in 'uture di2idends
$f a firm follows a fixedAconstant 1!7!S policy, then total future dividend would increase due to
increase in number of shares after bonus issue!
Nournal entry in case of bonus issue
1r! 3! .arnings Bpar valueC
5r! ,rdinary share capital Bpar valueC
N!: firm can also make a script issue where bonus shares are directly from capital reserve!
5( Stock S<lit and ,e2erse S<lit
#his is where a block of shares is broken down into smaller units BsharesC so that the number of
ordinary shares increases and their respective par value decreases at the stock split factor!
Stock split is meant to make the shares of a company more affordable by low income investors
and increase their liquidity in the market!
&llustration
*5 5ompany has )@@@ ordinary shares of Sh!%@ par value and a split of ):& i!e one stock is
split into &! #he par value is divided by &!
)@@@ stocks x & I &@@@ shares
par value I &@ I Sh!9
9
,rdinary share capital I &@@@ x 9 I Shs!%@,@@@
reverse split is the opposite of stock split and involves consolidation of shares into bigger
units thereby increasing the par value of the shares! $t is meant to attract high income clientele
shareholders! .!g incase of %@,@@@ shares S Shs!%@ par, they can be consolidated into )@,@@@
shares of Shs!&@ par! $!e! B%@,@@@ x RC I )@,@@@ and Sh!%@ I x % I &@AI
@( Stock ,e<urc%ase
#he company can also buy back some of its outstanding shares instead of paying cash
dividends! #his is known as stock re<urc%ase and shares repurchased, Bbought backC are called
treasury Stock! $f some outstanding shares are repurchased, fewer shares would remain
outstanding!
ssuming repurchase does not adversely affect firmDs earnings, .!7!S! of share would increase!
#his would result in an increase in -!7!S! so that capital gain is substituted for dividends!
Lesson Se2en 4@8
Ad2antages o' Stock ,e<urc%ase
4( $t may be seen as a true signal as repurchase may be motivated by management belief
that firmDs shares are undervalued! #his is true in inefficient markets!
5( .tiliDation o' idle 'unds
5ompanies, which have accumulated cash balances in excess of future investments, might find
share reinvestment scheme a fair method of returning cash to shareholders!
5ontinuing to carry excess cash may prompt management to invest unwisely as a means of
using excess cash!
Eam<le
firm may invest surplus cash in an expensive acquisition, transferring value to another group
of shareholders entirely! #here is a tendency for more mature firms to continue with investment
plan even when . B0C is lower than cost of capital!
@( En%anced di2idends and E(+(S(
4ollowing a stock repurchase, the number of shares issued would decrease and therefore in
normal circumstances both 1!7!S! and .!7!S! would increase in future! However, the increase in
.!7!S is a bookkeeping increase since total earnings remaining constant!
6( En%anced S%are +rice
5ompanies that undertake share repurchase, experience an increase in market price of the
shares! #his is partly explained by increase in total earnings having less andAor market signal
effect that shares are under value!
8( Ca<ital structure
companyDs managers may use a share buy back or requirements, as a means of correcting
what they perceive to be an unbalanced capital structure!
$f shares are repurchased from cash reserves, equity would be reduced and gearing increased
Bassuming debt exists in the capital structureC!
lternatively a company may raise debt to finance a repurchase! 3eplacing equity with debt can
reduce overall cost of capital due to tax advantage of debt!
7( Em<loyee incenti2e sc%emes
$nstead of cancelling all shares repurchase, a firm can retain some of the shares for employees
share option or profit sharing schemes!
:( ,educed take o2er t%reat
share repurchase reduced number of share in operation and also number of Lweak
shareholdersD i!e shareholders with no strong loyalty to company since repurchase would induce
them to sell!
#his helps to reduce threat of a hostile takeover as it makes it difficult for predator company to
gain control! B#his is referred as a poison pillC i!e! 5o!Ds value is reduced because of high
repurchase price, huge cash outflow or borrowing huge long term debt to increase gearing
!.S&NESS *&NANCE
Disad2antages o' stock re<urc%ase
4( -ig% <rice
company may find it difficult to repurchase shares at their current value and price paid may
be too high to the detriment of remaining shareholders!
5( Market Signaling
1espite directorDs effort at trying to convince markets otherwise, a share repurchase may be
interpreted as a signal suggesting that the company lacks suitable investment opportunities!
#his may be interpreted as a sign of management failure!
@( Loss o' in2estment income
#he interest that could have been earned from investment of surplus cash is lost!
*actors to consider in <aying di2idends "'actors in'luencing di2idend#
4( Legal rules
aC /et purchase rule
States that dividend may be paid from companyDs profit either past or present!
bC 5apital impairment rule: prohibits payment of dividends from capital i!e! from
sale of ssets! #his is liquidating the firm!
cC $nsolvency rule: prohibits payment of dividend when company is insolvent!
$nsolvent company is one where assets are less than liabilities! $nsolvent
company is one where assets are less than liabilities! $n such a case all earnings
and assets of company belong to debt holders and no dividends is paid!
5( +ro'ita?ility and li>uidity
companyDs capacity to pay dividend will be determined primarily by its ability to generate
adequate and stable profits and cash flow!
$f the company has liquidity problem, it may be unable to pay cash dividend and result to paying
stock dividend!
@( Taation <osition o' s%are%olders
1ividend payment is influenced by tax regime of a country e!g in 0enya cash dividend are
taxable at source, while capital are tax exempt(
#he effect of tax differential is to discourage shareholders from wanting high dividends! B#his
is explained by tax differential theoryC!
6( &n2estment o<<ortunity
2ack of appropriate investment opportunities i!e! those with positive returns B/!7!:!C, may
encourage a firm to increase its dividend distribution! $f a firm has many investment
opportunities, it will pay low dividends and have high retention!
8( Ca<ital Structure
Lesson Se2en 4@:
companyDs management may wish to achieve or restore an optimal capital structure i!e! if
they consider gearing to be too high, they may pay low dividends and allow reserves to
accumulate until a more optimalAappropriate capital structure is restoredAachieved!
7( &ndustrial +ractice
5ompanies will be resistant to deviation from accepted dividend or payment norms within the
industry!
:( Growt% Stage
1ividend policy is likely to be influenced by firmDs growth stage e!g a young rapidly growing
firm is likely to have high demand for development finance and therefore may pay low dividend
or a defer dividend payment until company reaches maturity! $t will retain high amount!
;( Owners%i< Structure
dividend policy may be driven by #ime ,wnership Structure e!g in small firms where owners
and managers are same, dividend payout are usually low!
However in a large quoted public company dividend payout are significant because the owners
are not the managers! However, the values and preferences of small group of owner managers
would exert more direct influence on dividend policy!
9( S%are%olders e<ectation
Shareholder clientele that have become accustomed to receiving stable and increasing div! Will
expect a similar pattern to continue in the future!
ny sudden reduction or reversal of such a policy is likely to dissatisfy the shareholders and
may result in a fail in share prices!
4I( Access to ca<ital markets
2arge, well established firms have access to capital markets hence can get funds easily
#hey pay high dividends thus, unlike small firms which pay low dividends Bhigh retentionC due
to limited borrowing capacity!
44( Contractual o?ligations on de?t co2enants
#hey limit the flexibility and amount of dividends to pay e!g! no payment of dividends from
retained earnings!
Di2idend ratios
)! 1ividend per shares B17SC I .arnings to ordinary shareholders
/umber of ordinary shares
$ndicate cash returns received fro every share holder!
%! 1ividend yield B18C I 17S
-7S
$ndicate dividend returns for every shilling invested in the firm!
!.S&NESS *&NANCE
4@; Di2idend +olicies and Decisions
+! 1ividend cover I 17S
17S
$ndicate the number of times dividends can be paid out of earnings of shareholders! #he higher
the 17S the lower the dividend cover!
&! 1ividend 7ayout 3atio I 17S
.7S
Shows the proportion of .arnings which was paid out as dividends and how much was retained!
J.EST&ON ONE
comparative study of the records of two oil companies, 2td and * 2td!, in terms of their
asset composition, capital structure and profitability shows that they have been very similar for
the past five years! #he only significant difference between the two firms is their dividend
policy! 2td! maintains a constant dividend per share while * 2td maintains a constant
dividend pay"out ratio! 3elevant data is as follows:
8ear .arnings
per share
Shs!
1ividend
per share
Shs!
7rice range
in stock
exchange
Shs!
.arnings
per share
Shs!
1ividend
per share
Shs!
7rice range
in stock
exchange
Shs!
);;'
);;<
);;(
);;;
%@@@
)!(;
)!9@
%!@@
%!'@
+!;@
@!&9
@!&9
@!&9
@!&9
@!&9
)' E )(
)% E )9
)& E %@
%) E %'
%' E &@
%!@9
)!&9
%!@<
%!99
&!@(
@!+9
@!%9
@!+'
@!&9
@!';
)) E )9
' " )&
< " )'
)9 E %+
%) E &&
,e>uired
aC 4or each company, determine the dividend pay"out ratio and the price earnings ratio
for each of the five years! B)%
marksC
bC * 2tdDs management is surprised that the shares of this company have not performed
as well as 2td!Ds in the stock exchange! What explanation would you offer for this
state of affairsM B&
marksC
5omment on the applicability of the Simple 7riceA.arnings B7A.C ratio to the typical
technology B$#C company with a high valuation and heavy losses!
B& marksC
J.EST&ON TWO
Lesson Se2en 4@9
aC $n relation to the financing of a firm, differentiate the following terms:
iC 4inancial structure from capital structure! B9
marksC
iiC *usiness risk from financial risk! B9
marksC
bC What is meant by gearing as used in the capital structure of 2imited 2iability 5ompanyM
B% marksC
#he following information is on a company in the power generation business:
)@F preference shares BSh!)@ parC
,rdinary share capital BSh!)@ parC
3etained profits
)9F debentures
S%s(
&@@,@@@
&@@,@@@
(@@,@@@
<@@,@@@
),9@@,@@@
),%@@,@@@
%,<@@,@@@
,e>uired
iC 5alculate the gearing ratio for the above company! B%
marksC
iiC $f the companyDs net profit Bbefore interest and taxC is Sh!%,@@@,@@@,@@@ and assuming a
dividend payout ratio of '@F of the earnings, compute the dividend per share B17SC!
B' marksC
iiiC $f the market price per share now is Sh!(@, compute the dividend yield!
B% marksC
"Total= 55 marks#
J.EST&ON T-,EE
.xplain the reasons why firms in the same industry with equal earnings and share capital would
pay different amount of dividendsM
C-ECK 0O., ANSWE,S W&T- T-OSE G&/EN &N LESSON 4IO* T-E ST.D0
+ACK
!.S&NESS *&NANCE
46I Di2idend +olicies and Decisions
COM+,E-ENS&/E ASS&GNMENT NO(@
TO !E S.!M&TTED A*TE, LESSON ;
J.EST&ON ONE
#he most recent balance sheet for Supremo 2td is presented here below:
Su<remo Ltd !alance S%eet M @I No2em?er 4998
Sh!
L@@@D
Sh!
L@@@D
5urrent ssets
4ixed ssets BnetC
(,(@@
)+,%@@
YYYY
%%,@@@
#rade creditors
ccrued expenses
5urrent liabilities
2ong"term debt
,rdinary shares
3etained earnings
%,%@@
%,%@@
&,&@@
(,(@@
%,%@@
','@@
%%,@@@
Lesson Se2en 464
#he company is about to embark on an advertising campaign which is expected to raise sales
from their present level of Sh!%<!9 million to Sh!+(!9 million by the end of next financial year!
#he firm is presently operating at full capacity and will have to increase its investment in both
current and fixed assets to support the pro=ected level of sales! $t is estimated that both
categories of assets will rise in direct proportion to the pro=ected increase in sales!
4or the year =ust ended, the firmDs net profits were 'F of the yearDs sales but are expected to rise
to <F of pro=ected sales! #o help support its anticipated growth in assets needs next year the
firm has suspended plans to pay cash dividends to its shareholders! $n years past, a dividend of
Sh!'!'@ per share has been paid annually!
SupremoDs trade creditors and accrued expenses are expected to vary directly with sales! $n
addition, notes payable will be used to supply the added funds to finance next years operations
that are not forthcoming from other sources!
,e>uired
aC iC .stimate the amount of additional funds to be raised through notes
payable! B&
marksC
iiC What one fundamental assumption have you made in making your estimateM
B% marksC
bC 7repare pro"forma balance sheet of Supremo 2td! on +@ /ovember );;'!
B)+ marksC
cC iC 5alculate and compare Supremo 2td!Ds current and debt ratios before and after
growth in sales! B& marksC
iiC What was the effect of the expanded sales on these two dimensions of
SupremoDs financial conditionM B%
marksC
"Total= 58 marks#
J.EST&ON TWO
P8Q 2td is intending to raise capital to finance a new pro=ect! #he current -!7!S is Sh!&+ cum"
div of year %@@) declared but not yet paid! 4or the past 9 years, the company has paid the
following stream of dividends!
8ear );;< );;( );;; %@@@ %@@)
1!7!S )!;@ %!%9 %!'@ %!'@ +!@@
#he existing capital structure of the firm is as follows:
Sh!-
,rdinary share capital Sh!)@ par &@
3etained earnings +9
)%F 1ebenture Sh!)@@ par %9
)@@
#he debentures are currently selling at Sh!;9 ex"interest! #he corporate tax rate is +@F!
,e>uired
aC 1istinguish between cum"div and ex"div -!7!S! B& marksC
bC 5ompute the ex"div -!7!S! B% marksC
!.S&NESS *&NANCE
465 Di2idend +olicies and Decisions
cC 5ompute the overall cost of capital! Use dividend growth model
to determine the cost of equity!
B; marksC
dC #he company wants to raise additional Sh!%@ million as follows:
9@F from retained earnings
+@F from issue of debentures at the current market value
%@F from issue of new ordinary shares with )@F floatation costs
iC 5ompute the number of ordinary shares to issue to raise the amount required!
B% marksC
iiC 5ompute the marginal cost of capital! B' marksC
!
J.EST&ON T-,EE
#he 0itale -ai>e -ills is contemplating the purchase of a new high"speed grinder to replace an
existing one! #he existing grinder was purchased two years ago at an installed cost of
Sh!+@@,@@@! #he grinder was estimated to have an economic life of 9 years but a critical
analysis of its performance now shows it is usable for the next five years with no resale value!
#he new grinder would cost Sh!9%9,@@@ and require Sh!%9,@@@ in installation costs! $t has a five
year usable life! #he existing grinder can currently be sold for Sh!+9@,@@@ without incurring
any removal costs! #o support the increased business resulting from purchase of the new
grinder, accounts receivable would increase by Sh!%@@,@@@, inventories by Sh!)9@,@@@ and trade
creditors by Sh!%;@,@@@! t the end of 9 years the new grinder would be sold to net Sh!)&9,@@@
after removal costs and before taxes! #he company provides for &@F taxes on ordinary income!
#he estimated profit before depreciation and taxes over the five years for both machines are
given as follows:
8ear .xisting grinder
S%s(
/ew grinder
S%(
)
%
+
&
9
)+@,@@@
)%@,@@@
))@,@@@
)@@,@@@
;@,@@@
%)9,@@@
%)9,@@@
%)9,@@@
%)9,@@@
%)9,@@@
#he company uses straight line method of depreciation for both machines!
,e>uired
aC 5alculate the initial investment associated with the replacement of the existing grinder
with the new one! Show your full workings! B'
marksC
bC 1etermine the incremental operating cash flows associated with the proposed grinder
replacement! B)& marksC
cC 5alculate the terminal cash flow expected from the proposed grinder replacement!
B% marksC
Lesson Se2en 46@
"Total= 55 marks#
J.EST&ON *O.,
1ereva and -akanga are considering purchasing the new +@ passenger Jwonder coachK to
engage in transport business! #hey have two alternatives of financing the purchase as shown
below:
*irst alternati2e
7urchase the vehicle whose current price is Sh!%,&@@,@@@ through a finance lease from
0enya -atatu 4inance 5ompany 2imited! #he terms of the lease will require four
equal payments per year for each of the three years! /o deposit is required!
Second alternati2e
,btain the vehicle through -wananchiDs *ank loan scheme being advertised in the papers!
1ereva and -akanga will be required to make a down payment of Sh!;@@,@@@ and then meet
four equal yearly payments of Sh!)9+,&+' each for the three years!
#he market rate of interest is currently )' per cent per annum!
1ereva and -akanga have been informed that as part of your social responsibility, you provide
free consultancy services to small scale businessmen!
,e>uired
aC #he finance lease payment to be made by 1ereva and -akanga if they opt for finances
from 0enya -atatu 4inance 5ompany 2imited! B& marksC
bC #he present value of the payment scheme of -wananchi *ank! B& marksC
cC #he interest expense charged by 0enya -atatu 4inance 5ompany 2imited on the third
instalment! B' marksC
6ive reasons why finance leases are referred to as Joff"balance sheetK finance!
B& marksC
eC iC Which of the two alternatives E 4inance 2ease or *ank 2oan scheme is
better in financial termsM B%
marksC
iiC 6ive one reason why the better alternative may not necessarily be
chosen by persons in 1ereva and -akangaDs circumstances! B%
marksC
"Total= 55 marks#
J.EST&ON *&/E
8ou are provided with the following information about -arco! 2td!
iC /umber of issued ordinary shares %9@,@@@
iiC -arket price per ordinary share Shs!+<!9@
iiiC #otal earnings for the year Sh!9,@@@,@@@ Bbefore taxC!
ivC 3ate of corporation tax +@F
!.S&NESS *&NANCE
466 Di2idend +olicies and Decisions
vC #he total ordinary dividend will be %9F of the earnings for the year after tax!
viC 7reference dividend will be Sh!+@@,@@@
4rom the above information, calculate:
iC .arnings per share
iiC 1ividend yield
iiiC .arnings yield
ivC 7rice earnings ratio B7A.C ratio
vC 1ividend cover!
END O* COM+,E-ENS&/E ASS&GNMENT @
Lesson Eig%t 468
LESSON E&G-T
WO,K&NG CA+&TAL MANAGEMENT
&NST,.CT&ONS
3ead 5hapters %%, %+, %& and %9 of 4inancial -anagement text book by $! - 7andey!
CONTENTS
$ntroduction
4inancing of Working 5apital A5urrent ssets
1eterminants of Working 5apital needs
$mportance of working capital management
-anagement of Short term investment
Working capital cycle
-anagement of cash , stock and ccounts 3eceivable
!.S&NESS *&NANCE
467 Working Ca<ital Management
WO,K&NG CA+&TAL
aC Working capital Balso called gross working capitalC refers to current assets!
bC /et working capital refers to current assets minus current liabilities!
cC Working capital management refers to the administration of current assets and current
liabilities!
#arget levels of each category of current assets
How current assets will be financed
dC 2iquidity management involves the planned acquisition and use of liquid resources over
time to meet cash obligations as they become due! #he firmDs liquidity is measured by
liquidity ratio such as current ratio, quick Bor acid testC ratio, cash ratio, etc!
*&NANC&NG C.,,ENT ASSETS
5urrent ssets require financing by use of either current funds or long term funds! #here are
three ma=or approaches to financing current assets! #hese are:
a# Matc%ing A<<roac%
#his approach is sometimes referred to as the hedging approach! Under this approach, the firm
adopts a financial plan which involves the matching of the expected life of assets with the
expected life of the source of funds raised to finance assets!
#he firm, therefore, uses long term funds to finance permanent assets and short"term funds to
finance temporary assets!
7ermanent assets refer to fixed assets and permanent current assets! #his approach can be shown
by the following diagram!
Lesson Eig%t 46:
?# Conser2ati2e A<<roac%
n exact matching of asset life with the life of the funds used to finance the asset may not be
possible! firm that follows the conservative approach depends more on long"term funds for
financing needs! #he firm, therefore, finances its permanent assets and a part of its temporary
assets with long"term funds! #his approach is illustrated by the following diagram!
3isk"3eturn trade"off of the three approaches:
$t should be noted that short"term funds are cheaper than long"term funds! BSome sources of
short"term funds such as accruals are cost"freeC! However, short"term funds must be repaid
within the year and therefore they are highly risky! With this in mind, we can consider the risk"
return trade off of the three approaches!
#he conservative approach is a low return"low risk approach! #his is because the approach uses
more of long"term funds which are now more expensive than short"term funds! #hese funds
however, are not to be repaid within the year and are therefore less risky!
#he aggressive approach on the other hand is a highly risky approach! However it is also a high
return approach the reason being that it relies more on short"term funds that are less costly but
riskier!
#he matching approach is in between because it matches the life of the asset and the life of the
funds financing the assets!
DETE,M&NANTS O* WO,K&NG CA+&TAL NEEDS
#here are several factors which determine the firmDs working capital needs! #hese factors are
comprehensively covered by #extbook of *usiness 4inance by -anasseh B7ages &@+ E &@'C!
#hey however include:
aC /ature and si>e of the business!
bC 4irmDs manufacturing cycle
cC *usiness fluctuations
dC 7roduction policy
eC 4irmDs credit policy
fC vailability of credit
gC 6rowth and expansion activities!
&M+O,TANCE O* WO,K&NG CA+&TAL MANAGEMENT
#he finance manager should understand the management of working capital because of the
following reasons:
a# Time de2oted to working ca<ital management
large portion of a financial managerDs time is devoted to the day to day operations of the firm
and therefore, so much time is spent on working capital decisions!
?# &n2estment in current assets
5urrent assets represent more than half of the total assets of many business firms! #hese
investments tend to be relatively volatile and can easily be misappropriated by the firmDs
employees! #he finance manager should therefore properly manage these assets!
!.S&NESS *&NANCE
46; Working Ca<ital Management
c# &m<ortance to small 'irms
small firm may minimise its investments in fixed assets by renting or leasing plant and
equipment, but there is no way it can avoid investment in current assets! small firm also has
relatively limited access to long term capital markets and therefore must rely heavily on short"
term funds!
d# ,elations%i< ?etween sales and current assets
#he relationship between sales volume and the various current asset items is direct and close!
5hanges in current assets directly affects the level of sales! #he finance management must
therefore keep watch on changes in working capital items!
CAS- AND MA,KETA!LE SEC.,&T&ES MANAGEMENT
#he management of cash and marketable securities is one of the key areas of working capital
management! Since cash and marketable securities are the firmDs most liquid assets, they provide
the firm with the ability to meet its maturing obligations!
5ash refers to cash in hand and cash on demand deposits Bor current accountsC! $t therefore
excludes cash in time deposits Bwhich is not immediately available to meet maturing obligationsC!
-arketable securities are short"term investments made by the firm to obtain a return on
temporary idle funds! #hus when a firm realises that it has accumulated more cash than needed,
it often puts the excess cash into an interest"earning instrument! #he firm can invest the excess
cash in any Bor a combinationC of the following marketable securities!
aC 6overnment treasury bills
bC gency securities such as local governments securities or parastatals securities
cC *ankerDs acceptances, which are securities, accepted by banks
dC 5ommercial paper Bunsecured promissory notesC
eC 3epurchase agreements
fC /egotiable certificates of deposits
gC .urocurrencies etc!
CAS- C0CLE AND CAS- T.,NO/E,S
Cas% Cycle refers to the amount of time that elapses from the point when the firm makes a cash
outlay to purchase raw materials to the point when cash is collected from the sale of finished
goods produced using those raw materials!
Cas% turno2er on the other hand refers to the frequency of a firmDs cash cycle during a year!
&llustration
P8Q 2td! currently purchases all its raw materials on credit and sells its merchandise on credit!
#he credit terms extended to the firm currently requires payment within thirty days of a purchase
while the firm currently requires its customers to pay within sixty days of a sale! However, the
firm on average takes +9 days to pay its accounts payable and the average collection period is <@
days! ,n average, (9 days elapse between the point a raw material is purchased and the point the
finished goods are sold!
Lesson Eig%t 469
,e>uired
1etermine the cash conversion cycle and the cash turnover!
Solution
#he following chart can help further understand the question:
$nventory 5onversion period B(9 daysC
3eceivable collection
7eriod B<@ daysC
#he cash conversion cycle is given by the following formula:
5ash conversion I $nventory conversion G 3eceivable collection E 7ayable deferral
5ycle period period period
4or our example:
5ash conversion cycle I (9 G <@ E +9 I )%@ days
5ash turnover I +'@
5ash conversion cycle
I
)%@
+'@
I + times
/ote also that cash conversion cycle can be given by the following formulae:
!.S&NESS *&NANCE
7ayable deferral
7eriod B+9 daysC
7urchase of
raw
7ayment for the
raw materials
Sale of
4inished goods
5ollection of
receivables
5ash conversion cycle I (9 G <@ " +9 I
48I Working Ca<ital Management
!ash conversion cycle "
1
]
1
+
+
s ingexpense Cashoperat
Accruals Payables
sales
s receivable
s costofsale
inventory
60 +
/*: $n this chapter we shall assume that a year has +'@ days!
SETT&NG T-E O+T&MAL CAS- !ALANCE
5ash is often called a non"earning asset because holding cash rather than a revenue"generating
asset involves a cost in form of foregone interest! #he firm should therefore hold the cash
balance that will enable it to meet its scheduled payments as they fall due and provide a margin
for safety! #here are several methods used to determine the optimal cash balance! #hese are:
a# T%e Cas% !udget
#he 5ash *udget shows the firmDs pro=ected cash inflows and outflows over some specified
period! #his method has already been discussed in other earlier courses! #he student should
however revise the cash budget!
?# !aumolFs Model
#he *aumolDs model is an application of the .,? inventory model to cash management! $ts
assumptions are:
)! #he firm uses cash at a steady predictable rate
%! #he cash outflows from operations also occurs at a steady rate
+! #he cash net outflows also occur at a steady rate!
Under these assumptions the following model can be stated:
"
bT
C
%
V

Where: CP is the optimal amount of cash to be raised by selling marketable securities or by
borrowing!
? is the fixed cost of making a securities trade or of borrowing
T is the total annual cash requirements
i is the opportunity cost of holding cash Bequals the interest rate on marketable securities or the
cost of borrowingC
#he total cost of holding the cash balance is equal to holding or carrying cost plus transaction
costs and is given by the following formulae:
b
C
T
C" TC +
%
)
&llustration
*5 2td! makes cash payments of Shs!)@,@@@ per week! #he interest rate on marketable
securities is )%F and every time the company sells marketable securities, it incurs a cost of
Shs!%@!
Lesson Eig%t 484
,e>uired
aC 1etermine the optimal amount of marketable securities to be converted into cash every
time the company makes the transfer!
bC 1etermine the total number of transfers from marketable securities to cash per year!
cC 1etermine the total cost of maintaining the cash balance per year!
dC 1etermine the firmDs average cash balance!
Solution
aC
"
bT
C
%
V
Where: b I Shs!%@
# I 9% x %@,@@@ I Shs!9%@,@@@
i I )%F
)'' , )+ !
)% ! @
@@@ , 9%@ %@ %
V Sh
x x
C
#herefore the optimal amount of marketable securities to be converted to cash every time a sale is
made is Sh!)+,)''!
bC #otal no! of transfers I
V C
T
I
)'' , )+
@@@ , 9%@
I +;!9
X &@ times
cC b
C
T
C" TC +
%
)
I
)'' , )+
%@ @@@ , 9%@
%
)% ! @ )'' , )+ x x
+
I <;@ G <;@ I Shs!),9(@
!.S&NESS *&NANCE
#herefore the total cost of maintaining the above cash balance is Sh!),9(@!
dC #he firmDs average cash balance I R5
I
%
)'' , )+
I Shs!',9(+
Lesson Eig%t 48@
c# MillerAOrr Model
Unlike the *aumolDs -odel, -iller",rr -odel is a stochastic BprobabilisticC model which makes
the more realistic assumption of uncertainty in cash flows!
-erton -iller and 1aniel ,rr assumed that the distribution of daily net cash flows is
approximately normal! .ach day, the net cash flow could be the expected value of some higher
or lower value drawn from a normal distribution! #hus, the daily net cash follows a trendless
random walk!
4rom the graph below, the -iller",rr -odel sets higher and lower control units, H and 2
respectively, and a target cash balance, Q! When the cash balance reaches H Bsuch as point C
then H"Q shillings are transferred from cash to marketable securities! Similarly, when the cash
balance hits 2 Bat point *C then Q"2 shillings are transferred from marketable securities cash!
#he 2ower 2imit is usually set by management! #he target balance is given by the following
formula:
L
"
#
& +
1
1
1
]
1
+ A )
&
%
+
and the highest limit, H, is given by:
H I +Q " %2
#he average cash balance I
+
& L &
Where: Q I target cash balance
H I Upper 2imit
2 I 2ower 2imit
b I 4ixed transaction costs
i I ,pportunity cost on daily basis
_` I variance of net daily cash flows
!.S&NESS *&NANCE
&llustration
P8QDs management has set the minimum cash balance to be equal to Sh!)@,@@@! #he standard
deviation of daily cash flow is Sh!%,9@@ and the interest rate on marketable securities is ;F p!a!
#he transaction cost for each sale or purchase of securities is Sh!%@!
,e>uired
aC 5alculate the target cash balance
bC 5alculate the upper limit
cC 5alculate the average cash balance
dC 5alculate the spread
Solution
aC L
"
b
& +
1
1
]
1
+ A )
&
` +
I
@@@ , )@
+'@
F ;
&
C` 9@@ , % B %@ +
+
1
1
1
1
]
1
x
x x
I <,%)) G )@,@@@ I Sh!)<,%))
bC H I +Q E %2
I + x )<,%)) E %B)@,@@@C
I Shs!+),'++
Lesson Eig%t 488
cC verage cash balance I
+
& L &
I
+
@@@ , )@ %)) , )< & x
dC #he spread I H E 2
I +),'++ E )@,@@@
I Shs!%),'++
/ote: $f the cash balance rises to +),'++, the firm should invest Shs!)&,&%% B+),'++ E )<,%))C in
marketable securities and if the balance falls to Shs!)@,@@@, the firm should sell Shs!<,%))B)<,%))
E )@,@@@C of marketable securities!
Ot%er Met%ods
,ther methods used to set the target cash balance are #he Stone -odel and -onte 5arlo
simulation! However, these models are beyond the scope of this manual!
CAS- MANAGEMENT TEC-N&J.ES
#he basic strategies that should be employed by the business firm in managing its cash are:
iC #o pay account payables as late as possible without damaging the firmDs credit rating!
#he firm should however take advantage of any favourable cash discounts offered!
iiC #urnover inventory as quickly as possible, but avoid stockouts which might result in loss
of sales or shutting down the Lproduction lineD!
iiiC 5ollect accounts receivable as quickly as possible without losing future sales because of
high pressure collection techniques! #he firm may use cash discounts to accomplish this
ob=ective!
$n addition to the above strategies the firm should ensure that customer payments are converted
into spendable form as quickly as possible! #his may be done either through:
aC 5oncentration *anking
bC 2ock"box system!
aC 5oncentration *anking
4irms with regional sales outlets can designate certain of these as regional collection
centre! 5ustomers within these areas are required to remit their payments to these sales
offices, which deposit these receipts in local banks! 4unds in the local bank account in
excess of a specified limit are then transferred Bby wireC to the firms ma=or or
concentration bank!
5oncentration banking reduces the amount of time that elapses between the customerDs
mailing of a payment and the firmDs receipt of such payment!
bC 2ock"box system!
$n a lock"box system, the customer sends the payments to a post office box! #he post
office box is emptied by the firmDs bank at least once or twice each business day! #he
bank opens the payment envelope, deposits the cheques in the firmDs account and sends a
!.S&NESS *&NANCE
deposit slip indicating the payment received to the firm! #his system reduces the
customerDs mailing time and the time it takes to process the cheques received!
MANAGEMENT O* &N/ENTO,&ES
-anufacturing firms have three ma=or types of inventories:
)! 3aw materials
%! Work"in"progress
+! 4inished goods inventory
#he firm must determine the optimal level of inventory to be held so as to minimi>e the inventory
relevant cost!
!AS&C EOJ MODEL
#he basic inventory decision model is .conomic ,rder ?uantity B.,?C model! #his model is
given by the following equation:
n
o
C
DC
'
%
Where: ? is the economic order quantity

1 is the annual demand in units
5o is the cost of placing and receiving an order
5n is the cost of holding inventories per unit per order
#he total cost of operating the economic order quantity is given by total ordering cost plus total
holding costs!
#5 I R?5n G o
C
'
D
Where: #otal holding cost I R?5n
#otal ordering cost I o
C
'
D
#he holding costs include:
)! 5ost of tied up capital
%! Storage costs
+! $nsurance costs
&! ,bsolescence costs
#he ordering costs include:
)! 5ost of placing orders such as telephone and clerical costs
%! Shipping and handling costs
Lesson Eig%t 48:
Under this model, the firm is assumed to place an order of ? quantity and use this quantity until it
reaches the reorder level Bthe level at which an order should be placedC! #he reorder level is
given by the following formulae:
L
D
R
+'@
Where: 3 is the reorder level

1 is the annual demand
2 is the lead time in days
!.S&NESS *&NANCE
EOJ ASS.M+T&ONS
#he basic .,? model makes the following assumptions:
iC #he demand is known and constant over the year
iiC #he ordering cost is constant per order and certain
iiiC #he holding cost is constant per unit per year
ivC #he purchase cost is constant B#hus no quantity discountC
vC *ack orders are not allowed!
&llustration
*5 2td requires %,@@@ units of a component in its manufacturing process in the coming year
which costs Sh!9@ each! #he items are available locally and the leadtime in one week! .ach
order costs Sh!9@ to prepare and process while the holding cost is Shs!)9 per unit per year for
storage plus )@F opportunity cost of capital!
,e>uired
aC How many units should be ordered each time an order is placed to minimi>e inventory
costsM
bC What is the reorder levelM
cC How many orders will be placed per yearM
dC 1etermine the total relevant costs!
Suggested Solution=
aC
n
o
C
DC
'
%
Where: 1 I %,@@@ units

5o I Sh!9@
5n I Sh!)9 G )@F x 9@ I Sh!%@
2 I < days
un"ts
x x
' )@@
%@
9@ @@@ , % %

bC 3 I
+'@
DL
Lesson Eig%t 489
I
+'@
< @@@ , % x
I +; units
cC /o! of orders I
'
D
I
)@@
@@@ , %
I %@ orders
dC #5 I R?5n G o
C
'
D
I RB)@@CB%@C G
C 9@ B
)@@
@@@ , %
I ),@@@ G ),@@@
I Sh!%,@@@
Under the basic .,? -odel the inventory is allowed to fall to >ero =ust before another order is
received!
E3&STENCE O* J.ANT&T0 D&SCO.NTS
4requently, the firm is able to take advantage of quantity discounts! *ecause these discounts
affect the price per unit, they also influence the .conomic ,rder ?uantity!
$f discounts exists, then usually the minimum amount at which discount is given may be greater
than the .conomic ,rder ?uantity! $f the minimum discount quantity is ordered, then the total
holding cost will increase because the average inventory held increases while the total ordering
costs will decrease since the number of orders decrease! However, the total purchases cost will
decrease!
&llustration
5onsider illustration one and assume that a quantity discount of 9F is given if a minimum of %@@
units is ordered!
,e>uired
1etermine whether the discount should be taken and the quantity to be ordered!
Suggested Solution
We need to consider the saving in purchase costsO savings in ordering costs and increase in
holding costs!
Savings in purchase price:
!.S&NESS *&NANCE
47I Working Ca<ital Management
/ew purchase price I 9@ x ;9F I Sh!&<!9@ per unit
Savings in purchase price per unit I 9@ E &<!9@
I Sh!%!9@
#otal units per year I %,@@@
#otal savings I %,@@@ x %!9@ I Sh!9,@@@
Savings in ,rdering 5ost
ssuming an order quantity of %@@ units per order, the total ordering cost will be:
C 9@ B
)@@
@@@ , %
I Sh!9@@
,rdering cost if )@@ units is ordered
C )@@ B
)@@
@@@ , %
I Sh!),@@@
#herefore savings in ordering costs I ),@@@ E 9@@ I Sh!9@@
$ncrease in holding costs
Holding cost if %@@ units are ordered
RB%@@C);!<9 I Sh!),;<9
holding costs if )@@ units are ordered
RB)@@B%@C I Sh!),@@@
$ncrease in holding costs I ),;<9 E ),@@@ I Sh!;<9
#he /et .ffect therefore:
S%s(
Savings in purchases costs 9,@@@
Savings in ordering costs 9@@
#otal savings 9,9@@
2ess increase in holding costs ;<9
/et savings &,9%9
n
o
d
C
DC
'
%
<9 ! );
9@ @@@ , % % x x
'
d

5n I )9 G )@F x &!<9 I Shs!);!<9
Lesson Eig%t 474
#he discount should be taken because the net savings is positive! #o determine the number of
units to order we recomputed ? with discount ?d!
I )@@!' units
1ecision rule:
$f ?d a minimum discount quantity, then order the minimum discount quantity!
$f ?d a minimum discount quantity, then order ?d!
.NCE,TA&NT0 AND SA*ET0 STOCKS
Usually demand requirements may not be certain and therefore the firm holds safety stock to
safeguard stock out cases! #he existence of safety stock can be illustrated by 4igure 9!<!
#he safety stock guards against delays in receiving orders! However, carrying a safety stock has
costs Bit increases the average stockC!
&llustration
5onsider illustration one and assume that management desires to hold a minimum stock of )@
units Bthis stock is in hand at the beginning of the yearC!
,e>uired
aC 1etermine the re"order level
bC 1etermine the total relevant costs
Suggested solution
aC 3 I S
DL
+
+'@
Where: S is the safety stock
I
)@ <
+'@
@@@ , %
+ x
I &; units
bC #he average inventory I R? G S
#5 I BR? G SC5n G 1A?5o
I \RB)@@C G )@]%@ G C 9@ B
)@@
@@@ , %
I ),%@@ G ),@@@
I Shs!%,%@@
!.S&NESS *&NANCE
MANAGEMENT O* ACCO.NT ,ECE&/A!LE
$n order to keep current customers and attract new ones, most firms find it necessary to offer
credit! ccounts receivable represents the extension of credit on an open account by a firm to its
customers! ccounts receivable management begins with the decision on whether or not to grant
credit!
#he total amount of receivables outstanding at any given time is determined by:
aC #he volume of credit sales
bC #he average length of time between sales and collections!
ccounts receivables I 5redit sales per day x 2ength of collection period
#he average collection period depends on:
aC 5redit standards which is the maximum risk of acceptable credit accounts
bC 5redit period which is the length of time for which credit is granted
cC 1iscount given for early payments
dC #he firmDs collection policy!
a# C,ED&T STANDA,DS
firm may follow a lenient or a stringent credit policy! #he firm following a lenient credit
policy tends to sell on credit to customers on a very liberal terms and credit is granted for a longer
period!
firm following a stringent credit policy on the other hand, sell on credit on a highly selective
basis only to those customers who have proven credit worthiness and who are financially strong!
lenient credit policy will result in increased sales and therefore increased contribution margin!
However, these will also result in increased costs such as:
)! $ncreased bad debt losses
%! ,pportunity cost of tied up capital in receivables
+! $ncreased cost of carrying out credit analysis
&! $ncreased collection cost
9! $ncreased discount costs to encourage early payments
#he goal of the firmDs credit policy is to maximise the value of the firm! #o achieve this goal, the
evaluation of investment in receivables should involve the following steps:
)! .stimation of incremental operating profits from increased sales
%! .stimation of incremental investment in account receivable
+! .stimation of incremental costs
&! 5omparison of incremental profits with incremental costs
?# C,ED&T TE,MS
Lesson Eig%t 47@
5redit terms involve both the length of the credit period and the discount given! #he terms %A)@,
nA+@ means that a %F discount is given if the bill is paid before the tenth day after the date of
invoice otherwise the net amount should be paid by the +@
th
day!
$n considering the credit terms to offer the firm should look at the profitability caused by longer
credit and discount period or a higher rate of discount against increased cost!
c# D&SCO.NTS
:arying the discount involves an attempt to speed up the payment of receivables! $t can also
result in reduced bad debt losses!
d# COLLECT&ON +OL&C0
#he firmDs collection policy may also affect our analysis! #he higher the cost of collecting
account receivables the lower the bad debt losses! #he firm must therefore consider whether the
reduction in bad debt is more than the increase in collection costs!
s saturation point increased expenditure in collection efforts does not result in reduced bad debt
and therefore the firm should not spend more after reaching this point!
&llustration
3iffruff 2td is considering relaxing its credit standards! #he firms current credit terms is net +@
but the average debtors collection period is &9 days! 5urrent annual credit sales amounts to
Sh!',@@@,@@@! #he firm wants to extend credit period net '@! Sales are expected to increase by
%@F! *ad debts will increase from %F to %!9F of annual credit sales! 5redit analysis and debt
collection costs will increase by Sh!&,@@@ p!a! #he return on investment in debtors is )%F for
Sh!)@@ of sales, Sh!<9 is variable costs! ssume +'@ days p!a! Should the firm change the credit
policyM
Suggested Solution
5urrent sales I Sh!',@@@,@@@
/ew sales I Sh!',@@@,@@@ x )!%@ I Sh!<,%@@,@@@
5ontribution margin I Sh!)@@ E Sh!<9 I Sh!%9
#herefore contribution margin ratio I )@@
)@@ !
%9 !
x
Sh
Sh
I %9F
5ost benefit analysis
5ontribution -argin
/ew policy %9F x <,%@@,@@@ I ),(@@
5urrent policy %9F x ',@@@,@@@ I ),9@@ I +@@
5redit analysis and debt collection costs B(&C
*ad debts
/ew bad debts I %!9F x <,%@@,@@@ I )(@
5urrent bad debts I %F x ',@@@,@@@ I )%@ B'@C
!.S&NESS *&NANCE
1ebtors
/ew debtors I
days
per"od Cr
+'@
!
x cr! Sales p!a!
I
@@@ , %@@ , <
+'@
'@
x
I ),%@@
5urrent debtors I @@@ , @@@ , '
+'@
&9
x I <9@
$ncrease in debtors Btied up capitalC &9@
4orgone profits I )%F x &9@ B9&C
/et benefit BcostC )@%
#herefore, change the credit policy!
E/AL.AT&ON O* T-E C,ED&T A++L&CANT
fter establishing the terms of sale to be offered, the firm must evaluate individual applicants and
consider the possibilities of bad debt or slow payments! #his is referred to as credit analysis and
can be done by using information derived from:
aC #he applicantDs financial statement
bC 5redit ratings and reports from experts
cC *anks
dC ,ther firms
eC #he companyDs own experience
A++L&CAT&ON O* D&SC,&M&NANT ANAL0S&S TO T-E SELECT&ON O*
A++L&CANTS
1iscriminative analysis is a statistical model that can be used to accept or re=ect a prospective
credit customer! #he discriminant analysis is similar to regression analysis but it assumed that
the observations come from two different universal sets Bin credit analysis, the good and bad
customersC! #o illustrate let us assume that two factors are important in evaluating a credit
applicant the quick ratio and net worth to total assets ratio!
#he discriminant function will be of the form!
ft I a)BP)C G a%BP%C
Where: P) is quick ratio
P% is the network to total assets
a) and a% are parameters
#he parameters can be computed by the use of the following equations:
a) I S>> dx E Sx>d>
Sxx Sxx E Sx>`
a% I S>> dx E Sx>d>
S>> Sxx E Sx>`
Lesson Eig%t 478
Where: Sxx represents the variances of P)
S>> represents the variances of P%
Sx> is the covariance of variables of P) and P%
dx is the difference between the average of P)Ds bad accounts and P%Ds good accounts
d> represents the difference between the average of PDs bad accounts and PDs good
accounts!
#he next step is to determine the minimum cut"off value of the function below at which credit
will not be given! #his value is referred to as the discriminant value and is denoted by f#.
,nce the discriminant function has been developed it can then be used to analyse credit
applicants! #he important assumption here is that new credit applicants will have the same
characteristics as the ones used to develop the mode!
-ore than two variables can be used to determine the discriminant function! $n such a case the
discriminant function will be of the form!
ft I a)x) G a%x% G [ G anxn
!.S&NESS *&NANCE
J.EST&ON ONE
Wema 2td has estimated that the standard deviation of its daily net cash flows is Sh!%,9@@! #he
firm pays Sh!9@ in transaction costs to transfer funds into and out of this money market! #he rate
of interest in the money market is <!&'9F p!a! Wema uses the -iller",rr Model to set its target
cas% ?alances(
,e>uired
aC What is WemaDs target cash balanceM
bC What are the lower and upper cash limitM
cC What are the WemaDs decision rulesM
dC 1etermine WemaDs expected average cash balance!
J.EST&ON TWO
-ama Star .nterprises is a distributor or air filters to retail shops! $t buys its filters from several
manufacturers! 4ilters are ordered in lot si>es of )@@ and each order costs Sh!&@@ to place!
1emand from retail shops is %@@,@@@ filters per month and the carrying cost is Sh!)@ per filter per
month!
,e>uired
aC What is the optimal order quantity with respect to so many lot si>esK
bC $f a safety stock of %,@@@ filters is desired what is the total relevant costsM
cC certain manufacturer offers a discount of %F for purchases of 9@ lot si>es or more!
Should the discount be takenM Bssume that each filter costs Sh!)@@C!
Lesson Eig%t 47:
J.EST&ON T-,EE
Willie 1istributors 2td! uses discriminant analysis in customer classification! good customer is
defined as one who pays on or before the due date while a bad customer is one who does not meet
this standard!
#he finance director believes that the two most important ratios in discriminating between a good
and bad customer are the current ratio and the returns on investment Bi!e! .arnings *efore $nterest
and taxes divided by total assetsC, 8!
1ata relating to %@ accounts Bconsisting of )@ good and )@ badeC is shown below:
)!)
)!9
)!%
@!;
)!'
%!%
@!;
)!@
)!+
)!+
)+
)9
)9
%)
<
(
)'
)+
(
%
@!<
@!;
@!(
)!+
)!)
@!9
@!+
)!&
@!;
)!)
))
"&
'
%
'
(
(
'
+
)&
,e>uired
.stimate the discriminant function using the above data!
Use the discriminant function to find the Q score for each of the twenty accounts
1etermine a Q score that minimises the number of misclassifications!
"C+A <ilot <a<er#
J.EST&ON *O.,
aC .xplain why proper working capital management is important for the financial success of
a company!
bC t a recent seminar on J6ender .mpowerment in *usinessD the invited financial
consultant, -adame Hesabu dvised the participants that extending credit is one of the
comerstone of modern business! -adame *iashara, the managing director of *iashara
2imited took note of this important fact! fter the seminar, she authorised a review of
the credit system of her company! #he following facts are relevant!
B( marksC
aC nnual sales of the company are Sh!9,@@@,@@@
bC 5redit sales are %9 per cent of all sales
cC *ad debts average %F of all credit sales
dC verage collection period for debtor is &@ days
eC #he companyDs cost of capital is )& per cent per annum
fC /et profit on sales is )9 per cent!
!.S&NESS *&NANCE
Good accounts !ad accounts
*ased on these facts, she is recommending a thorough revamping of the credit policy of the
company! #he expected outcome of this action will be:
aC $ncrease in total sales by +@ per cent
bC 5redit sales will be &@ per cent of all sales
cC verage collection period will decrease to +9 days
dC *ad debts will increase to + per cent of credit sales
eC n additional part time credit control assistant will be hired for Sh!9@,@@@ per annum!
,e>uired
#he effectiveness or otherwise of the proposed revamping of credit policy! BShow all your
workingsC! B( marksC
Who should determine credit policyM B% marksC
"Total= 4; marks#
C%eck your answers wit% t%ose gi2en in Lesson 4I o' t%e Study +ack
Lesson Nine 479
LESSON N&NE
MA,KET *O, *.NDS
&NST,.CT&ONS
3ead the notes provided below!
#his chapter looks at the structure of financial markets in 0enya! #he money and securities markets
will be discussed!
CONTENTS
1efinitions
0enya 4inancial System
4inancial $ntermediaries
#he stock exchange Amarket
Stock market #erminologies
4actors influencing share prices
Stock -arket index
#iming of $nvestment at the stock exchange
dvatages and 1isadvatages of listing
3egulation of 5apital -arkets"#he 5apital market uthority
3ecent development E #he 5entral 1epository Systems B51SC
Speciali>ed and development financial $nstitutions
!.S&NESS *&NANCE
4:I Market 'or *unds
Market 'or *unds and *inancial &nstitutions in Kenya
4inancial markets refers to an elaborate system of the financial institution and intermediaries
and arrangement put in place and developed to facilitate the transfer of funds from surplus
economic units BsaversC to deficit economic units BinvestorsC!
Savers include individuals, small businesses, family units savings through institutions such as
S55,s, banks, insurance firms, pension schemes etc!
$nvestors include government, companies, family units etc!
Note
7hysical or commodity markets deal with real assets such as tea, coffee, wheat, automobile etc!
*unctions o' *inancial MarketsC&nstitutions in t%e Economy
)! 1istribution of financial resources to the most productive units! Savings are transferred
to economic units that have channels of alternative investments! B2ink between buyers
and sellersC!
%! llocation of savings to real investment!
+! chieving real output in the economy by mobili>ing capital for investment!
&! .nable companies to make short term and long term investments and increase liquidity of
shares!
9! 7rovision of investment advice to individuals through financial experts!
'! .nables companies to raise short term and long term capitalAfunds
<! -eans of pricing of securities e!g /!S!.! index shares indicate changes in share prices!
(! 7rovide investment opportunities! Savers can hold financial instrument for investment
made!
Kenya *inancial System
4inancial markets are broadly classified into %:
)! 5apital -arkets
%! -oney -arkets
e!g! commercial banks, S55,S, foreign exchange market, merchant banks etc!
5apital markets are sub"divided into %:
aC Security markets e!g stock exchange dealing with instruments such as shares, debentures
etc!
bC /on"securityAinstrument market e!g mortgage, capital leases, security market is sub"
divided into %!
7rimary market
Secondary market
CA+&TAL MA,KET
#hese are markets for long term funds with maturity period of more than one year! .!g of
4inancial instruments used here are debentures, terms, loans, bonds, warrants, preference shares,
ordinary shares etc!
Lesson Nine 4:4
#he capital market serves as a way of allocating the available capital to the most efficient users!
Ca<ital market 'inancial institution includes=
)! Stock exchange
%! 1evelopment bank
+! Hire purchase companies
&! *uilding societies
9! 2easing firms
*unctions o' Ca<ital Markets are=
aC 7roviding long term funds which are necessary for investment decisions!
bC 7rovide advice to investors as to which investments are viable!
cC 2ong term investments are made liquid, as the transfer between shareholders is
facilitated!
dC 4acilitates the international capital inflow!
eC 4acilitating the liquidation and marketing of a long term
fC cting as a channel through which foreign investments find their way into the market!
MoneyCdiscount markets
re discount and acceptance financial institutions
#his is a market for S!# funds maturing in one year! -oney market works through financial
institutions! $t facilitates transfer of capital between savers and users!
#he transfer can be direct Bfrom saver to investorC and indirectly through an intermediaryC!
4oreign exchange market is also part of money market!
#he money market or discount market is the market for short term loans!
*inancial &nstruments in Money market include=
)! 5ommercial paper
%! #reasury bills
+! *ills of exchange
&! 7romissory notes
9! *ank overdrafts
'! *ankers certificate of deposit
#hese instruments are sold by commercial banks, merchant banks, discounting houses,
acceptance houses, and government!
+rimary Markets
#hese are markets that deal with securities that have been issued for the first time! #he money
flows directly from transferor Bsaver of moneyC to transferee Binvesting personC! #hey facilitate
capital formation!
Economic Ad2antage o' +rimary Markets
)! 3aising capital for business!
%! -obilising savings
+! 6overnment can raise capital through sale of #reasury bonds
!.S&NESS *&NANCE
4:5 Market 'or *unds
&! ,pen market operation to effect monetary policy of the government i!e control of excess
liquidity in the economy
9! $t is a vehicle for direct foreign investment!
Economic Ad2antageC,ole o' Secondary Markets in t%e Economy
)! $t gives people a chance to buy shares hence distribution of wealth in economy!
%! .nable investors reali>e their investments through disposal of securities!
+! $ncreases diversification of investments
&! $mproves corporate governance through separation of ownership and management! #his
increases higher standards of accounting, resource management and transparency!
9! 7rivatisation of parastatals e!g! 0enya irways! #his gives individuals a chance for
ownership in large companies!
'! 7arameter for health economy and companies
<! 7rovides investment opportunities for companies and small investors!
#ypes of Stock -arkets
4( Organised Ec%ange and O2er t%e Counter "OTC# market
#his is where the buying and selling of securities is done by buyers and sellers are not
present but only the agents BbrokersC internet! #his system is called Jopen outcryK!
5( O2er t%e Counter Market "OTC#
7rovides an opportunity for unlistedAunquoted firms to sell their security
,tc is usually organi>ed by the dealers or stock brokers who buy securities themselves
and then sell them!
#hey maintain a reasonable balance between demand and supply and observe price
movements to determine profit margins on sale!
#rading may be done through telephones, computer networks, fax etc!
#he dealersAparticipants set the treading rules,#5 speciali>e in securities such as
corporate bonds, equity securities, #reasury bonds etc!
,#5 is underdeveloped in 0enya!
*eatures o' OTC Markets
)! 7rices are relatively low
%! Usually deal with new securities of firms
+! $s composed of small and closely held firms!
*&NANC&AL &NTE,MED&A,&ES
#hese are institutions which mediateAlink between the savers and investors:
Eam<les o' 'inancial intermediaries in Kenya(
4( Commercial !anks(
#hey act as intermediary between savers and users BinvestmentC of funds!
5( Sa2ings and Credit Associations
Lesson Nine 4:@
#hese are firms that take the funds of many savers and then give the money as a loan in form of
mortgage and to other types of borrowers! #hey provide credit analysis services!
@( Credit .nions
#hese are cooperative associations whose members have a common bond e!g employees of the
same company! #he savings of the member are loaned only to the members at a very low interest
rate e!g! S55,S charge p!m interest on outstanding balance of loan!
6( +ension *unds
#hese are retirement schemes or plans funded by firms or government agencies for their workers!
#hey are administered mainly by the trust department of commercial banks or life insurance
companies! .xamples of pension funds are /SS4, /H$4 and other registered pension funds of
individual firms!
8( Li'e &nsurance Com<anies
#hese are firms that take savings in form of annual <remium from individuals and them invest,
these funds in securities such as shares, bonds or in real assets! Savers will receive annuities in
future!
7( !rokers
#hese are people who facilitate the exchange of securities by linking the buyer and the seller!
#hey act on behalf of members of public who are buying and selling shares of quoted companies!
:( &n2estment !ankers
#hese are institutions that buy new issue of securities for resale to other investors!
#hey perform the following functions:
)! 6iving advice to the investors
%! 6iving advice to firms which wants to
+! :aluation of firms which need to merge
&! 6iving defensive tactics incase of forced takeover
9! Underwriting of securities!
T-E STOCK E3C-ANGE MA,KET
T%e &dea and De2elo<ment o' a Stock Ec%ange
Stock exchange Balso known as stock marketsC are special Jmarket placesK where already held
stocks and bonds are bought and sold! #hey are, in effect, a financial institution, which provides
the facilities and regulations needed to carry out such transactions quickly, conveniently and
lawfully!
!.S&NESS *&NANCE
Stock exchanges developed along with, and are an essential part of the free enterprises system!
B/o stock exchanges exist in the communist world outside Hong 0ong and -acao E which have
special status, and #aiwan which is also claimed by 5hinaC!
#he need for this kind of market came about as a result of two ma=or characteristics of =oint stock
company B7ublic 2imited 5ompanyC, shares!
)! 4irst of all, these shares are irredeemable, meaning that once it has sold them, the
company can never be compelled by the shareholder to take back its shares and give back
a cash refund, unless and until the company is winding up and liquidates!
%! #he second characteristic is that these shares are, however, very transferable and can be
bought and resold by other individuals and organi>ations, freely, the only requirement
being the filling and signing of a document known as a share transfer form by the
previous shareholder! #he document will then facilitate the updating of the issuing
companies shareholders register!
#hese two characteristics of =oint company shares brought about the necessity for an organi>ed
and centrali>ed place where organi>ations and private individuals with money to spare
BinvestorsC, and satisfy their individual needs! Stock exchanges were the result emerging to
provide a continuous auction market for securities, with the laws of supply and demand
determining the prices!
*unctions o' t%e Nairo?i Stock Ec%ange
#he basic function of a stock exchange is the raising of funds for investment in long"term assets!
While this basic function is extremely important and is the engine through which stock exchanges
are driven, there are also other quite important functions!
)! #he mobili>ation of savings for investment in productive enterprises as an alternative to
putting savings in bank deposits, purchase of real estate and outright consumption!
%! #he growth of related financial services sector e!g! insurance, pension and provident fund
schemes which nature the spirit of savings!
+! #he check against flight of capital which takes place because of local inflation and
currency depreciation!
&! .ncouragement of the divorcement of the owners of capital from the managers of capitalO
a very important process because owners of capital may not necessarily have the
expertise to manage capital investment efficiently!
9! .ncouragement of higher standards of accounting, resource management and public
disclosure which in turn affords greater efficiency in the process of capital growth!
'! 4acilitation of equity financing as opposed to debt financing! 1ebt financing has been
the undoing of many enterprises in both developed and developing countries especially in
recessionary periods!
<! $mprovement of access to finance for new and smaller companies! #his is futuristic in
most developing countries because venture capital is mostly unavailable, an unfortunate
situation!
(! .ncouragement of public floatation of private companies which in turn allows greater
growth and increase of the supply of assets available for long term investment!
#here are many other less general benefits which stock exchanges afford to! $ndividuals,
corporate organi>ations and even the government! #he government for example could raise long
Lesson Nine 4:8
term finance locally by issuing various types of bond through the stock exchange and thus be less
inclined to foreign borrowing!
Stock exchanges, especially in developing countries have not always played the full role in
economic development!
T-E ,OLE O* STOCK E3C-ANGE &N ECONOM&C DE/ELO+MENT
4( ,aising Ca<ital 'or !usinesses
#he Stock .xchange provides companies with the facility to raise capital for expansion through
selling shares to the investing public!
5( Mo?ilising Sa2ings 'or &n2estment
When people draw their savings and invest in shares, it leads to a more rational allocation of
resources because funds which could have been consumed, or kept in idle deposits with banks are
mobili>ed and redirected to promote commerce and industry!
@( ,edistri?ution o' Wealt%
*y giving a wide spectrum of people a chance to buy shares and therefore become part"owners of
profitable enterprises, the stock market helps to reduce large income inequalities because many
people get a chance to share in the profits of business that were set up by other people!
6( &m<ro2ing Cor<orate Go2ernance
*y having a wide and varied scope of owners, companies generally tend to improve on their
management standards and efficiency in order to satisfy the demands of these shareholder! $t is
evident that generally, public companies tend to have better management records than private
companies!
8( Creates &n2estment O<<ortunities 'or Small in2estors
s opposed to other business that require huge capital outlay, investing in shares is open to both
the large and small investors because a person buys the number of shares they can afford!
#herefore the Stock .xchange provides an extra source of income to small savers!
7( Go2ernment ,aises Ca<ital 'or De2elo<ment +roEects
#he 6overnment and even local authorities like municipalities may decide to borrow money in
order to finance huge infrastructural pro=ects such as sewerage and water treatment works or
housing estates by selling another category of shares known as *onds! #hese bonds can be raised
through the Stock .xchange whereby members of the public buy them! When the 6overnment or
-unicipal 5ouncil gets this alternative source of funds, it no longer has the need to overtax the
people in order to finance development!
:( !arameter o' t%e Economy
t the Stock .xchange, share prices rise and fall depending, largely, on market forces! Share
prices tend to rise or remain stable when companies and the economy in general show signs of
stability! #herefore their movement of share prices can be an indicator of the general trend in the
economy!
!.S&NESS *&NANCE
Ad2antages o' &n2esting &n S%ares
4( &ncome in 'orm o' di2idends
When you have shares of a company you become a part"owner of that company and therefore you
will be entitled to get a share of the profit of the company which come in form of dividends!
4urthermore, dividends attract a very low withholding tax of 9F only!
5( +ro'its 'rom Ca<ital A<<reciation
Shares prices change with time, and therefore when prices of given shares appreciate,
shareholders could take advantage of this increase and set their shares at a profit! 5apital gains
are not taxed in 0enya!
@( S%are Certi'icate can ?e used as a Collateral
Share certificate represents a certain amount of assets of the company in which a shareholder has
invested! #herefore this certificate is a valuable property which is acceptable to many banks and
financial institutions as security, or collateral against which an investor can get a loan!
Lesson Nine 4::
6( S%ares are easily trans'era?le
#he process of acquiring or selling shares is fairly simple, inexpensive and swift and therefore an
investor can liquidate shares at any moment to suit his convenience!
8( A2aila?ility o' &n2estment Ad2ice
lthough the stick market may appear complex and remote to many people! 7ositive advise and
guidance could be provided by the stockbrokers and other investment advisors! #herefore, an
investor can still benefit from trading in shares even though he may not be having the technical
expertise relevant to the stock market!
7( +artici<ating in Com<any Decisions
*y buying shares and therefore becoming a part"owner in an enterprise, a shareholder gets the
right to participate in making decisions about how the company is managed! Shareholders elect
the directors at the 5ompanyDs nnual!
6eneral meetings, whereby the voting power is determined by the number of shares an investor
holds since the general rules is that one share is equal to one vote!
STOCK MA,KET TE,M&NOLOG0
4( !,OKE,
dealer at the market who buys and sells securities on behalf of the public investors!
He is an agent of investors
He is the only authori>ed person to deal with the quoted securities! He is authori>ed by
5- and /S.
He obtains the suitable deal for his clientsAinvestors, gives financial advice and charges
commission for his services!
He doesnDt buy or sell shares in his own right hence he cannot be a market marker!
He must maintain standards set by the stock exchange!
5( BO!!E,SCS+EC.LATO,S
#his is a dealer who trades in securities in his own right as a principal!
He can set prices and activate the market through his own buying and selling hence he is
a market maker!
He engages in speculation and earns profit called NobbersD turn Bselling price E buying
priceC!
He does not deal with members of the public unlike brokers! However, brokers can buy
and sell shares through =obbers!
#here are + types of =obbers
a# !ulls
=obber buy shares when prices are low and hold them in anticipation that the price will
rise and sell them at gain!
When a market is dominated by bulls Bbuyers predominate sellersC, it is said to be bullish!
#he share prices are generally rising!
#herefore the market is characteri>ed by an upward trend in security prices!
$t signifies investors confidenceAoptimism in the future of economy!
!.S&NESS *&NANCE
4:; Market 'or *unds
?# !ears
speculatorA=obber who sells security on expectation of decline in prices in future!
#he intention is to buy same securities at lower prices in future thereby making a gain!
When market is dominated by bears Bsellers predominate buyersC it is said to be bearish!
$t is characteri>ed by general downward trend in share prices! $t signifies investors
pessimism about the future prospects of the economy!
c# Stags
#his is a =obber found in primary markets
He buys new securities offered to the public and believes that they are undervalued!
He believes the price will rise and sell them at a gain to the ultimate investors
Stags are vital because they ensure full subscription of the share issue!
@) .nderwriting
#his is the assumption of risk relating unsubscribed shares
When new shares are issued, they may be underwrittenAunsubscribed! merchant banker
agrees, under a commission to take up any shares not bought by the public!
#hey therefore ensure that all new issues are successful
Underwriters are very important in pry markets and play the following roles:
dvice firms on most suitable issue price

.nsure shares are fully subscribed by taking up all unsubscribed shares
dvice the firms on where to source funds to finance floatation costs!
6( !lue C%i<s
re first class securities of firms which have sound share capital and are internationally
reputable!
#hey have very good dividend record and are highly demanded in the markets!
$ndividuals holding such securities are reluctant to sell them because of their high value!
8( Going s%ort or long on a s%are
#his is the process of selling Bgoing shortC or buying Bgoing longC on a share that one
does not haveAown
#he aim is to make gain from assumed change in the market value of shares
#his practice is not allowed in 0enya
$t is aided by brokers in countries where it is practiced
$nvestors going short or long are required to pay a premium called margin on the
transaction!
T,AD&NG MEC-AN&SM AT NSE
Lesson Nine 4:9
)! n investor approaches a broker who takes his bidAoffer to the trading floor!
%! t the trading floor, the buying and selling brokers meet and seal the deal!
+! #he investor is informed of what happenedAtranspired at the trading floor through a
contract note! #he note is sent to buying and selling investors!
#he note contains details such as:
/umber of shares bought or sold
*uyingAselling price
5hargesAcommission payable etc!
&! Settlement is made through the brokers!
9! ,ld share certificate is cancelled Bfor selling investorC and a new one is issued in the
name of buying investor!
*actors to Consider w%en !uying S%ares o' a Com<any
)! .conomic conditions of the country and other non"economic factors e!g! unfavourable
climatic conditions and diseases which may lead to low productivity and poor earnings!
%! State of management of the company e!g are the *!,!1! and key management personnel
of reputeM #hey should be trusted and run the company honestly and successfully!
+! /ature of the product dealt in and its market share e!g is the product vulnerable to
weather conditionsM $s it sub=ect to restrictionsM
&! -arketability of the shares E how fast or slowly can the shares of the firm be soldM
9! 1iversification i!e does the company have a variety of operations e!g multi"products so
that if one line of business declines, the other increases and the overall position is
profitable!
'! 5ompanyDs trading partners Blocal and abroadC and its competitors!
<! 7rospects of growth of the firm due to expected growth in demand of products of the
firm!
Note
Stock broker can give all the above advice when buying shares!
*actors A''ectingC&n'luencing S%are +rices
ll sorts of influences affect share prices! #hese influences include:
)! #he recent profit record of the company especially the recent dividend paid to
shareholders and the prospects of their growth and stability!
%! #he growth prospects of the industry in which the company operates!
+! #he publication of a companyDs financial results i!e! *alance Sheet and profit and loss
statement!
&! #he general economic conditions situations e!g boom and recession e!g during boom,
firms would have high profits hence rise in prices!
9! 5hange in companyDs management e!g entry and exit of prominent corporate
personalities!
'! 5hange on 6overnment economic policy e!g spending, taxes, monetary policy etc! #hese
changes influence investorsD expectations!
<! 3umour and announcements of impending political changes eg! 6eneral elections and
new president will cause anxiety and uncertainty and adversely affect share prices!
!.S&NESS *&NANCE
4;I Market 'or *unds
(! 3umours and announcement of mergers and take"over bids! $f the shareholders are
offered generous termsAprices in a take"over, share prices could rise!
;! $ndustrial relations eg strikes and policies of other firms!
)@! 4oreign political developments where the economy heavily depends on world trade!
))! 5hanges in the rate of interest on 6overnment securities such as #reasury *ills may make
investors switch to them! .xchange rates will also encourage or discourage foreign
investment in shares!
)%! nnouncement of good news eg that a ma=or oil field has been struck or a ma=or new
investment has been undertaken! #he /7: of such investment would be reflected in
share prices!
)+! #he views of experts e!g articles by well"known financial writers can persuade people to
buy shares hence pushing the prices up!
)&! $nstitutional buyers such as insurance companies can influence share prices by their
actions!
)9! #he value of assets and the earnings from utili>ation of such assets will also influence
share prices!
STOCK MA,KET &NDE3
De'inition
n index is a numerical figure which measures relative change in variables between two periods!
Eam<les
$f sales in year %@@@ are equal to 0shs!%9 - and for year %@@) Shs!+@ -, the sales index would
be as follows:
Sales index I year %@@) sales I Shs!+@ - x )@@ I )%@
8ear %@@@ sales Shs!%9 -
8ear %@@) sales are )%@F of year %@@@ sales, year %@@@ is called !ase year(
stock index therefore measures relative changes in prices or values of shares! #he /S. has its
base year as );''! %@ companies constitute the index!
#he stock index is computed using 6eometric mean B6!-C as follows:
#odays stock index I B#odayDs share price 6!-C
%
x )@@
8esterdayDs share price 6!-!
Where 6!- I
n
n
xP x xP xP xP P !!!!!!!!
& + % )
Where 6!-! 7) x 7% x 7+ x 7& """"""" 7n I share price of companies that constitute stock index!
/ I number of companies
When stock prices are rising, stock market index will rise and vice versa!
Stock market index therefore is an indicator of investors confidence in the economy!
&llustration
Lesson Nine 4;4
#he following ' companies constitute the index of democratic republic of 0usadikika!
5ompany * 5 1 . 4
#odayDs share price %@ 9% (+ )% <( )@@
8esterdayDs share price %9 9+ (+ )@ <9 ;'
5ompute the stock market index for today!
$n constructionAcomputation of stock index the following should be considered:
)! 5hoice of base year on which to base the price changes
%! #he selection of representative securitiesAfirms
+! 5ombining the securitiesAfirms to construct the index eg use of geometric mean
&! Use of suitable weight to be attached to the securities depending on their relative importance!
9! #he weightsAnumber of firms in a sector is kept constant over a reasonably long period!
LE/EL O* T,AD&NG ACT&/&T&ES &N T-E NA&,O!& STOCK E3C-ANGE
#he activities in /S. are normally low due to:
)! 4ew 2isted companies
%! .conomy is made up of small firms which are family owned or sole proprietorship!
+! 2evel of awareness among the population is low
&! 4ew instruments traded
9! 2ow dividend payout to those already holding shares!
STOCK E3C-ANGE &NDE3 "SE&#
Stock .xchange $ndex is a measure of relative changes in prices of stocks from one period to
another indices!
/airobi Stock .xchange %@ " share $ndex B%@ companiesC B1aily basisC Stanchart $ndex " 4rom %9
most active companies in a given period Bweekly basisC 5omputation of price index!
.ses o' Stock Ec%ange &nde
)! #o gauge price Bwealth movement in the stock market
%! #o assess overall returns in the market portfolio
+! #o assess performance of specific portfolio using S.$ as a benchmark!
&! -ay be used to predict future stock prices
9! ssist in examining and identifying the factors that underlie the price movements!
LimitationsCDraw?ack o' NSE inde
)! #he %@ companies sample whose share prices are used to compute the index are not true
representatives!
%! #he base year of );;' is too far in the past
+! /ew companies are not included in the index yet other firms have been
suspendedAderegistered e!g! #H, 04* etc!
&! 1ormant firms E Some of the %@ firms used are dormant or have very small price
changes!
!.S&NESS *&NANCE
4;5 Market 'or *unds
9! #hinness of the market E small changes in the active shares tend to be significantly
magnified in the index
'! #he weights used and the method of computation of index may not give a truly
representative index!
W%en is a s%are <rice said to ?e un'airQ
Where the price is not determined by demand and supply forces!
$f the price is not consistent with the activities of the firm e!g a decline in share price of a
firm with very good growth prospects!
7rice is not compatible with the price of other similar shares of firms in the same industry
$f there is insider trading:
#his situation arises where individuals within the firm in privileged positions e!g top
management and director take advantage of the information available to them which has
not been released to the public!
#hey may use such information to dispose off share to make capital gains or avoid capital
loss
Eam<le E where individuals BinsidersC are aware that a firm has made a loss in a year
and such information, if released to the public, would cause a crash on share price, the
information may be leaked to certain people who could sell the shares in advance!
T&M&NG O* &N/ESTMENT A STOCK E3C-ANGE
#he ideal way of making profits at the stock exchange is to buy at the bottom of the market
Blowest -!7!SC and sell at the top of the market Bhighest -!7!SC! #he greatest problem however
is that no one can be sure when the market is at its bottom or at its top Bprices are lowest and
highestC!
Systems have been developed to indicate when shares should be purchased and when they should
be sold! #hese systems are Dow t%eory and -atc% system(
4( Dow T%eory
#his theory depends on profiting of secondary movement of prices of a chart! #he principal
ob=ective is to discover when there is a change in the primary movement!
#his is determined by the behaviour of secondary movement but tertiary movements are ignored!
.g in a bull market, the rise of prices is greater than the fall of prices!
$n a bear market the opposite is the case ie the fall is greater than the rise
$n a bear market, the volume of the business being done at a certain stage can also be used to
interpret the state of the market!
*asically, it is maintained that if the volume increases along with rising prices, the signs are
bullish and if the volume increases with falling prices, they are bearish!
5( -atc% System
#his is an automatic system based on the assumption that when investors sell at a certain F age
below the top of the market and buys at a certain percent above the market bottom, they are doing
as well as can reasonably be expected! #his system can be applied to an index of a group of
shares or shares of dividends companies eg 1ow Nones and /asdaq index of merica!
Lesson Nine 4;@
&llustration 4
n investor uses the hatch system to determine when to buy and sell his shares! He sells the
shares when prices are )9F less of the top price and buy the shares when prices are )9F less of
the top price and buy the shares when prices are )9F more of the bottom price! t the beginning
of Nanuary, the share price was %@@AI! t the end of the year the share price was Shs!+%@!
iC 1etermine the buying and selling price of the shareholders
iiC $f the shareholder had )@,@@@ shares, determine the amount of capital gain on these
shares!
iiiC #he investor had 1!7!S of +!@@ at the end of the year! 5ompute his shilling return in F!
,ules 'or 'loatation o' new s%ares on NSE
)! #he company must have an issued share capital of at least 0shs!%@ -!
%! #he company must have made profits during the last + years!
+! t least %@F of issued capital Bcapital to be issuedC should be offered to the public
&! #he firm must issue a prospectus which will give more information to investors to enable
them to make informed =udgement
9! #he market price of the companies share must be determined by the market forces of
demand and supply
'! #he company should be registered under 5ap! &(' with registrar of companies!
Note
prospectus is a legal document issued by a company wishing to raise funds from the
public through issue of shares or bonds!
$t is prepared by directors of the company and submitted to 5- and /S. for approval
#he 5- has issued rules relating to the design and contents of the prospectus, in
addition to those contained in the 5ompanies ct!
&t must <ro2ide details on
)! /umber of shares to be issued
%! ,fferAissue price per share
+! #he dates during which the other is valid or open
&! 4inancial statements of the firm showing .7S and 17S for the last 9 years
9! ction report etc!
'! ction may be taken against the directors if the prospectus is fraudulent!
#he dvantages and 1isadvantages of a 2isting
Ad2antages
)! $t facilitates the issue of securities to raise new finance, making a company less
dependent upon retained earnings and banks!
%! #he wider share ownership which results will increase the likelihood of being able to
make rights issues!
+! #he transfer of shares becomes easier! 2ess of a commitment is necessary on the part of
shareholders! 4or this reason the shares are likely to be perceived as a less risky
investment and hence will have a higher value!
!.S&NESS *&NANCE
&! #he greater marketability and hence lower risk attached to a market listing will lead to a
lower cost of equity and also to a weighted average cost of capital!
9! market"determine price means that shareholders will know the value of their
investment at all times!
'! #he share price can be used by management as an indicator of performance, particularly
since the share price is forward looking, being based upon expectations, whilst other
ob=ectives measures are backward looking!
<! #he shares of a quoted company can be used more readily as consideration in takeover
bids!
(! #he company may increase its standing by being quoted and it may obtain greater
publicity!
;! ,btaining a quotation provides an entrepreneur with the opportunity to reali>e part of his
holding in a company!
Disad2antages
)! #he cost of obtaining a quotation is high, particularly when a new issue of shares is made
and the company is small! #his is because substantial costs are fixed and hence are
relatively greater for small companies! lso, the annual cost of maintaining the quotation
may be high due to such things as increased disclosure, maintaining a larger share
register, printing more annual reports, etc!
%! #he increased disclosure requirements may be disliked by management!
+! #he market"determined price and the greater accountability to shareholders that comes
with its concerning the companyDs performance may not be liked by management!
&! 5ontrol of a particular group of shareholders may be diluted by allowing a proportion of
shares to be held by the public!
9! #here will be a greater likelihood of being the sub=ect of a takeover bid and it may be
difficult to defend it with wide share ownership!
'! -anagement conditions, management employees give themselves more salaries due to
prosperity obtained!
CA+&TAL MA,KET A.T-O,&T0 "CMA#
Was established in );;@ by an ct of 7arliament ot assist in creation of a conducive environment
for growth and development of capital markets in 0enya!
,OLE O* CMA
)! #o remove bottlenecks and create awareness for investment in long term securities
%! #o serve as efficient bridge between the public and private sectors
+! 5reate an environment which will encourage local companies to go public
&! #o grant approvals and licences to brokers
9! #o operate a compensation fund to protect investors from financial losses should licenced
brokers fail to meet their contractual obligation
'! ct as a watchdog for the entire capital market system
<! #o establish operational rules and regulations on placement of securities
(! #o implement government programs and policies with respect to the capital markets!
Note
part from the above roles, 5- can undertake the following steps to encourage development of
stock exchanges in 0enya or other countries!
Lesson Nine 4;8
)! 3emoval of *arriers on security transfers
%! $ntroduce wider range of instruments in the market
+! 1ecentrali>ation of its operations
&! .ncourage development of institutional investors such as pension funds, insurance firms
etc!
9! 7rovide adequate information to players in the market in order to prevent insider trading
'! 2icence more brokers!
,ole o' CMA in determination o' s%are <rices
)! #he 5- does not in any way influence share price of quoted companies!
%! #he prices of such securities is determined by the demand and supply mechanism
+! However, 5- may:
&! dvice the company on the issue price of new securities
9! lert the investors if it feels that the issue price of certain securities is not in their interest
'! $t guards against manipulation of share prices and insider trading!
Ot%er Terminologies
)! 55,U/#S )& day periods into which the stock exchange
trading calendar is di2ided!
%! 55,U/#S 18 Sixth or seventh day following the expiry of an
accounts period on which settlement on all period deals must ?e com<leted(
+! *50W31#$,/ Where stock cannot be delivered on settlement
date although it has been paid for, a third party is found who owns and will lend similar
stock! s a security measure, this stock is paid for in full! When the original stock that
could not be delivered on time is finally available, the lender will be given back his stock
and will refund monies paid to him less backwardation which is a commission for the
loan!
&! *,/US SH3.S dditional shares issued to shareholders at no
additional cost to themselves as a form of extra dividend! lso known as scrip issue!
9! 522",:.3 *argaining and closing deals in a stock
exchange without a formal floor and position dealings, where the secretary reads, calls
out each security to be dealt, one at a time!
'! 5338",:.3When a deal has been arranged but, for some
valid reason, either the buyer cannot pay on time, or the Nobber may not be able to deliver
stock on time! $n this case, a third party can be introduced to solve the problem!
<! 5,/#/6, $s interest charged a client by his broker to
cover the costs of borrowing money from a third party so as to pay for stock bought on
his behalf! #his happens when a client has commissioned his broker to purchase
securities but for some reason, cannot pay on time!
(! 5U-! /1 .P! hese prefixes are written in front of other
words such as capital, rights and dividends to qualify them! J5umK is short for
cumulative, which means Jinclusive ofK! J.xK on the other hand is short for excluding,
which is the opposite of including!
!.S&NESS *&NANCE
$n commerce these terms refer to rights of buyers and sellers of securities when these are
sold before a dividend has been effected but after it has been declared! #hese terms are
necessitated
by the fact that shares are bought and sold throughout the year, but companies only
declare dividends after the end of their financial year when profits can be determined, and
moreover, payment of dividends may take place long after they have been declared!
#hus J.x 5apitalK infers that the seller of shares has sold them ecluding their right to
receive a ?onus s%are issue which has been declared at the time of sale! J5um 5apitalK
then means he sells them inclusive of this right!
.x 3ights 5um 3ights: #he #erm J3ightsK refers to the decision by the directors to raise
new share capital at current market rates but to give a prior option to existing
shareholders to purchase a fixed number of shares at preferential rates below market
values! .x and 5um proceeding it refers to the sale of shares decision, but before the
dividend!
5um 1ividend: #hese terms simply mean that the seller of shares retain his right to
receiving the dividend on the shares he sells although the title to the shares has passed to
the buyer reserve:
7!S! J5umK anything shares give the buyer above par value because his purchase comes
inclusive of the rights to collect on prior earnings! #hey are therefore sold at higher
prices than J.xK shares!
;! 42,,3 2oose term referring to the trading area of a
stock exchange! #his encompasses all the position dealings or JmarketsK of the
exchange!
)@! 6$2#".16.1 S.5U3$#$.S #hese are loan securities that are issued by 6overnments
and because they are backed by the 6overnments JcontinuityK, they are considered
perfectly safe, giving regular periodic interest payments, a fixed rate of interest, and
guaranteed capital redemption at the expiry of the loan term eg #reasury bonds!
+(S(
Similar securities issued by public corporations are called bonds, if they are issued by
public companies they are called debentures!
CENT,AL DE+OS&TO,0 S0STEM "C(D(S#
$tDs a computeri>ed ledger system that enable the holding or transfer of securities without the
need for physical movement! #he ownership of security or shares is through a book entry instead
of physical exchange 51S is for security what a bank is for cash transfer between banks! .g
and * are % shareholders of P8Q 2td! P8Q 2td! does not need to deliver the share certificate to
or * but a ledger account for both shareholders would be maintained at the 51S! #heir
accounts will be credited with the number of shares! $f want to sell shares to * the 51S will
debit Ds account and credit *Ds account!
Ad2antages o' CDS
)! $t shortens the registration process in the stock exchange i!e! high speed of registering
shareholders!
%! $t improves the liquidity of stock exchange than increase the turnover of the equity shares
in the market!
Lesson Nine 4;:
+! $t will lower the clearing and settlement cost eg no need to prepare share certificates and
seal them Bputting a sealC!
&! $ts faster and less risky settlement of securities which make the market more attractive for
investors e!g instances of fraud will be reduced since there is no physical share certificate
which may be forged!
9! #here will be improved and timely communication between company and the investors
hence reduced delay in receiving dividends and right issues and improve information
dissemination concerning a company!
'! $t will lead to an efficient and transparent securities market to adhere to $nternational
Standards for the benefit of all stakeholders!
*unctions o' CDS
)! $mmobilisation of securities ie elimination of physical movement of securities!
%! 1ematerialisation i!e elimination of physical certificates or documents showing
entitlement to a security so that ownership exists only as computer records!
+! .ffective 1elivery :s! payment B1:7C ie simultaneous delivery and payment between
the % parties exchanging or transferring securities! #his can be done without delay if
51S is linked to the central payment clearing system e!g 5*0!
&! 7rovision of detailed listings of investors according to the type of securities they hold e!g
ordinary shares, preference shares!
9! .ffective 1istribution of 1ividends, interests, rights issues and bonus issues!
'! 7rovision of book entry account ie electronic exchange of ownership of securities and
payment of cash!
+arties &n2ol2ed &n CDS
4( Go2ernment
4or the purpose of attracting foreign investors and supporting the infrastructure of capital
markets!
5( Ca<ital Market Aut%ority
#o improve the transparency of market and reduce instances of fraud!
@(Nairo?i Stock Ec%ange
*ear transactions costs and improve liquidity of the market investors!
6( &n2estors
$nstitutions, private investors and market professionals! 4or faster settlements and ownership
transfer and reduced cost of transfer through reduced paper work and labour intensive activities!
8( !rokers
3educes paper work, forgery and improved efficiency
7( !anks
.ase of clearing and settling of payments!
De2elo<ment !anks And S<ecialised *inancial &nstitutions
!.S&NESS *&NANCE
4;; Market 'or *unds
#here are some sectors in the economy that may not secure adequate funds from commercial
banks for various reasons!
aC -ay take a long time to reali>e returns
bC High risk associated with such sectors
cC unattractiveAlow return
dC Uncertainty or highly volatile returns
eC 3equire heavy investment in infrastructure
#hese sectors include:
#ourism
3ural housing
griculture
3ural enterprise
Small commercial businesses e!g Nua 0ali etc!
Such sector e!g agriculture and tourism are essential for a balanced economic growth and
development!
#he government has thus established financial institutions to cater specifically for these otherwise
unattractive but essential sector! #hey include:
)! $ndustrial development bank B$1*C E give loans for industrial development in 0enya!
%! 1evelopment 4inance 5ompany of 0enya B1450C E #o finance various pro=ect will spur
economic development and create employment!
+! c0enya $ndustrial .state B0$.C E this is a branch of $ndustrial and 5ommercial
development cooperation B$515C dealing with industrial development!
&! griculture 4inance 5o"operation B45C
9! 7ost *ank E #o mobili>e rural savings
'! /ational Housing 5ooperation E for development of houses to ensure shelter for
everyone!
<! 0enya #ourism 1evelopment 5ooperation B0#15C for promotion of #ourism in 0enya!
Ad2antagesC*unctionsCCase 'or De2elo<ment *inancial &nstitutions
)! #hey provide venture capital
%! #hey provide facilities for large lending
+! #hey provide technical expertise and support emerging pro=ects transferable from other
sectors of development economies!
&! #hey are risk capital providers in areas which are not attractive to commercial banks and
other ma=or lenders due to risk involved!
9! #hey carry out feasibility study to evaluate viability of pro=ects!
Case against S<ecialiDed &nstitutions and De2elo<ment !anks
)! #hey are being phased out by 6lobalisation and liberali>ation where needy sectors can
easily get expertise from outside!
%! 5ommercial banks have now matured up to provide capital for all sectors!
+! #hey were only useful during periods of foreign exchange restriction
&! #hey are risk capital providers in areas which are not attractive to commercial banks and
other ma=or lenders due to risk involved!
9! #hey increase government spending!
Lesson Nine 4;9
!ANK&NG &NST&T.T&ONS
T%e Central !ank
#his is a bank which is entrusted with the responsibility of maintaining
economic stability and financial soundness of a country! $t is therefore
entrusted with two ob=ectives:
)! 3esponsibility of maintaining financial soundness of the economy! #he
%! bank has therefore to identify gaps in financial markets and to seek
+! solutions to these gaps!
&! #o act as a commercial bank! $t therefore has to operate profitability
9! when offering services to difference parties!
Esta?lis%ment o' Central !ank o' Kenya
.stablished by 5entral *anking ct, );'', and the *anking ct );'(!
Management o' t%e !ank
-anagement and policy entrusted to a *oard of 1irectors, comprising of seven
members including the 6overnor, 1eputy 6overnor, and 7s to treasury! #he
6overnor of the 5entral *ank is the executive head of the bank! #he 6overnor
in charge today is -ichael 5heserem!
!.S&NESS *&NANCE
49I Market 'or *unds
Statutory &n'ormation and Accounts
#he bank is required to publish a return of its assets and liabilities every
month! copy of the return to be submitted to 4inance -inister! #he bank has
also to prepare and publish an annual report within + months of the end of
fiscal year! 4iscal year ends +@th Nune!
Central !anks
*unctions o' Central !ank
)! *anker to the government
%! 2ender to the government
+! .nsure .conomic stability
&! 7rinting of currency notes
9! 2ender of last resort
Tools .sed To Control T%e Le2el O' Money &n Circulation
)! -onetary policies e!g #reasury bills, #reasury bonds, 3eserve ratio etc
%! 4iscal policies e!g taxation
Commercial !anks
#hese are financial institutions that accept deposits of money
from the general public, safeguard the deposits and make them available to
their owners when need arises!
Esta?lis%ment
.stablished under the *anking ct );'(!
*unctions o' Commercial !anks
)! ccepting deposits
%! 5ollecting money on behalf of customers and credit this money in
customers accounts
+! #ransferring of money from individual accounts to another persons
accounts through credit transfer!
&! Supply currency " foreign currency obtainable at commercial bank!
9! 2ending money, the banks lend loans to customers from which they earn
interest!
'! 4acilitate $nternational #rade " issue letters of credit and undertake foreign exchange
transactions on behalf of their customers!
<! ct as trustees and executives of wills if one wants to make a will
heAshe writes one and appoints a commercial bank as the trustee and executor of the bill!
(! 7rovision of safer keeping of valuables like title deeds, gold, certificates!
;! -aking decision affecting development! *efore advancing loan to a prospective customer,
commercial banks are very careful and strict so as to give loans to invest in viable sector of
the economy!
)@! 7rovision of saves for keeping money and other valuables over night!
Lesson Nine 494
Ot%er *inancial &nstitutions
4( Mortgages
n arrangement where the property being purchased provides the security for funding!
,ther assets may be used as security for funding of another asset!
*eatures
)! -ortgagor and mortgagee agree on a long term financing arrangement
%! 4inancing relates to acquisition of specific asset
+! -ortgagor provides a contribution which is paid up"front!
&! 3epayment is over a specified long term period!
9! $nterest rate is stated with provision for variations of the determination of the finance!
Di''iculties in mortgage arrangements
)! $nitial contribution is not affordable by ma=ority of the population e!g! /yayo Highrise
%! .state!
+! 7otential participants avoid getting tied up in long term loans
&! .xperiences with mortgage arrangements have been discouraging!
9! $nterest rate fluctuations make planning uncertain
5( -ousing *inance Com<any o' Kenya
#his is the largest mortgage company in 0enya! $t implements the governmentDs policy
of stimulating house ownership! $t is registered under the *uilding Society ct but
operates as a finance company under the *anking ct!
@( Kenya &ndustrial Estate
#his is a body established by the government for the purpose of promoting industrial
development!
a# En%ancement o' ac>uisition o' skills necessary 'or industrial de2elo<ment
#echnological innovations! #he body is concerned with the provision of a base that will
be considered necessary for technology development e!g! through research!
$t provides capital necessary for industrial development
$t provides guarantees for loans to be used for industrial development especially for small
scale industries!
6( &ndustrial and Commercial De2elo<ment Coo<eration "&CDC#
#his was incorporated in );9& by the 0enya 6overnment
#he main ob=ective is to facilitate industrial development! $t concentrates on pro=ects
requiring financial participation and active extension of services
4unds provided are from the 6overnment and commercial banks!
8( Kenya Tourist De2elo<ment Cor<oration
#his was established by the 6overnment specifically to promote tourism! #he main
ob=ectives of 0#15 are:
)! #o provide assistance for establishment of tourism pro=ects
!.S&NESS *&NANCE
495 Market 'or *unds
%! #o provide financial assistance for the establishment of hotels and tourism lodgings
+! #o provide equity finance on =oint venture basis in international hotel organi>ations!
7( Merc%ant !anks
-erchant *anks begun life as merchants and begun to operate in financial firms, within
the );
th
5entury!
#he merchant banks act as a principal when they buy share from the company before the
issue is made! -erchant banks accept bills of exchange which deal in the leasing of
industrial equipment!
J.EST&ON ONE
#he following information is reported in a daily newspaper with respect to shares traded on the
/airobi Stock .xchange:
2ast
)%
months
H
Shs!
2
Shs!
Security 8esterday
Shs!
7revious
1eal
Shs!
Shares
traded
)
%
+
&
9
%@@!@@
;@!9@
&@!@@
+'%!@@
)&@!@@
<9!@@
&+!9@
&!@@
)@%!@@
;@!@@
0aku>i 2imited ,rd! Sh!9
.xpress 0enya 2td! ,rd! Sh!9
#H 2td! ,rd! Sh!)@
Unga 2td! ,rd! Sh!9
*arclays *ank 2td! ,rd!
Sh!)@
)%@!@@
Suspende
d
+)<!@@5*
;@!@@
)+@!@@5
1
&+!9@
+)(!@@
;@!@@
)@,@@@
,e>uired
aC Why does the price of a share changeM B' marksC
bC iC What does the 51 against 0aku>iDs share price meanM B% marksC
iiC Under the yesterdayDs column for .xpress 0enya 2td!, there is a dash B"C!
.xplain! B%
marksC
iiiC #H is indicated as suspended! .xplain why a company may be
suspended from the stock exchange! B' marksC
ivC .xplain the 5* against the Unga share price! B% marksC
vC What is the meaning of the ,rd! Sh!)@ indicated against the *arclays
*ankM
% marksC
"Total= 5I marks#
J.EST&ON TWO
Lesson Nine 49@
aC $n relation to capital markets, differentiate between the terms stock markets and financial
markets! B&
marksC
bC #he /airobi Stock .xchange is set to undergo ma=or changes in terms of services
when the 5entral 1epository System B51SC is put in place after the 7arliament
passes the *ill on the issue!
iC What is the 5entral 1epository System B51SCM B& marksC
iiC How will it benefit the parties to be affected by itM B&
marksC
cC #he shares of /dege irways 5ompany 2td! have been trading at Sh!(!@@ per share for the
last several months! #he existing shareholders argue that such shares are undervalued!
#hey say that, the shares should normally be trading at around Sh!)9 per share!
iC When would a share price said to be unfairM B& marksC
iiC $f the price earnings ratio for /ege irways 5ompany 2td! ordinary shares is %!9
imes while the price earnings ratio of the shares of 7iki 7iki 5ompany 2td! is )@
times, which share is more attractive to a potential investorM 6ive reasons!
B& marksC
+! aC With reference to capital market, define the following terms:
iC 5ontango operation B% marksC
iiC *ackwardation B% marksC
iiiC Stags B% marksC
ivC 3ole of investment banker B& marksC
bC -r! 5astro uses a %@F hatch system of timing when to invest in a stock market!
$n a given year, the top of a given share was Sh!)9@ and its bottom was Sh!;@!
1uring the year, the company paid an interim 17S of Sh!)!9@ and a final 17S of
Sh!&!9@!
1etermine the F return on investment! B& marksC
&! aC .xplain how the savings and credit co"operative societies mobilise savings and
aid investments! B< marksC
bC How do the /on"6overnmental organisations B/6,DsC that extend credit to
informal businesses and small traders ensure that the level of credit default is
lowM B' marksC
cC Would you consider it prudent to convert savings and credit co"operative
societies and the institutions which are used by /on"6overnmental ,rganisations
in BbC above into banksM B9 marksC
"Total= 4; marks#
!.S&NESS *&NANCE
+ACK
J.EST&ON ONE
Safaricom /1 Shelter frique are examples of companies that have in the recent past issued
floating rate bonds!
,e>uire
aC *riefly explain the meaning of a Jfloating rateK bond! B& marksC
bC 4rom the point of view of companyDs financial manager, outline the merits and demerits,
to the company, of issuing floating rate debt as a means of raising capital!
B)'
marksC
"Total= 5I marks#
J.EST&ONTWO
Swale 2td! wants to raise Sh!)9,@@@,@@@ in additional funds through a rights offering! #he
following statements were prepared =ust before the planned rights offerings:
!alance S%eet as at @4 Marc% 4996
Sh!D@@@D Sh!D@@@D
5urrent assets
4ixed assets
&9,@@@
+@,@@@
YYYYY
<9,@@@
5urrent liabilities
2ong"term debt B%9FC
,rdinary shares Bsh!)@ parC
3etained .arnings
)<,@@@
)(,@@@
)9,@@@
%9,@@@
<9,@@@
$ncome Statement for the year ended +) -arch );;&
Sh!D@@@D
.arnings before interest and taxes )+,9@@
$nterest &,9@@
Lesson Nine 498
.arnings before tax ;,@@@
#axation B&@FC +,'@@
/et $ncome 9,&@@
dditional information:
)! #he company had a price"earnings ratio of <!9 at the time of the rights offering! $ts
dividend payout ratio is &@F!
%! #he proposed rights offering subscription price per share is Sh!)9!
+! /o change is expected in the return on total assets or dividend payout ratio after the
rights offering!
,e>uired
aC How many rights are required to buy one new shareM B+ marksC
bC 5alculate the return on total assets! B% marksC
5alculate the following immediately before the rights issue:
" 1ividend per shareO B% marksC
" -arket price per share! B% marksC
dC 5alculate the dividend per share and market price per share one year after the rights of
offering and state whether you would recommend the rights offering! B6ive reasonsC
B(
marksC
eC 7repare the companyDs balance sheet immediately after the rights offering under BcC
above! B<
marksC
J.EST&ON T-,EE
aC firm may adopt a conservative policy or an aggressive policy in financing its
working capital needs!
5learly distinguish between:
conservative policy and B+ marksC
n aggressive policy! B+ marksC
bC #he following information relates to the current trading operations of -a=i -a>uri
.nterprises B--.C 2td:
" 2evel of annual sales Buniform per monthC " Sh!'@@ million
" 5ontribution to sales ratio " )9F
" 1ebtors recovery period:
7ercentage verage collection
of debtors period BdaysC
%9 +%
'@ 9@
)9 (@
" 5redit sales as a percentage of total sales " '@F
" 3equired return on investments " )9F
" 2evel of bad debts B%F of credit salesC " Sh!<,%@@,@@@
!.S&NESS *&NANCE
#he management of the company is in the process of reviewing the companyDs credit
management system with the ob=ectives of reducing the operating cycle and improving the firmDs
liquidity! #wo alternative strategies, now being considered by management are detailed as
follows:
Alternati2e A= c%ange o' credit terms
#he proposal requires the introduction of a %F cash discount which is expected to have the
following effects:
)! 9@ per cent of the credit customers Band all cash customersC will take advantage of the %
per cent cash discount!
%! #here will be no change in the level of annual sales, the percentage of credit sales and the
contribution of sales ratio!
+! #here will be savings in collection expenses of Sh!%,<9@,@@@ per month!
&! *ad debts will remain at % per cent of total credit sales!
9! #he average collection period will be reduced to +% days!
Alternati2e != contracting t%e ser2ices o' a 'actor
#he factor would charge a fee of %F of total credit sales and advance --. 2td! ;@F of total
credit sales invoiced by the end of each month at an interest rate of )!9F per month!
#he effects of this alternative are expected to be as follows:
/o change is expected in the level of annual sales, proportion of credit sales and
contributions margin ratio!
Savings on debt administration expenses of Sh!),&@@,@@@ per month will result
ll bad debt losses will be eliminated
#he average collection period will drop to %@ days!
,e>uired
iC .valuate the annual financial benefits and costs of each alternative Bssume +'@Mday
yearC B(
marksC
iiC dvise --. 2td! management on the alternative to implement B%
marksC
iiiC .xplain briefly other factors that should be considered in reaching the decision in BiiC!
above B& marksC
"Total= 5I marks#
J.EST&ON *O.,
2ove 2td is considering acquiring *eautiful 2td! 4or the past six years, the profits of *eautiful
2td! has been as follows:
8ear );;' );;< );;( );;; %@@@ %@@)
7rofits
Sh!D-D
(9 ;+ )@< ))+ ))+ ));
Lesson Nine 49:
2ove 2td expects to pay a 17S of Sh!+!%@! #he current -7S is Sh!&@! #he growth in
dividends will be matched with the growth in earnings of *eautiful 2td! once acquired!
#he future expected profits p!a! Bequal to the average of past profitsC will also grow a rate
equal to past profits growth rate! 2ove 2td is an all equity firm! *eautiful 2td has 9@
million ordinary shares!
,e>uired
aC 5ompute the cost of equity of 2ove 2td! B'
marksC
bC Using the cost of equity computed in BaC above, determine the maximum
price with 2ove 2td should pay for each share of *eautiful 2td to acquire it!
B)@ marksC
cC What is the significance of valuation of securities!
B& marksC
9! 7rime Shoes 2td! manufactures various types of shoes! #he company is now considering
its working capital policy for );;&! 4ixed assets are pro=ected at Sh!+@ million and
current liabilities at Sh!%< million! Sales and .arnings before interest and taxes B.*$#C
are partially a function of the companyDs investment in working capital particularly its
investment in stocks and debtors! 7rime Shoe 2td! is considering the following three
different working capital investment policies:
ggressive policy " small investment in current assets
5onservative policy " large investment in current assets
-oderate policy " moderate investment in current assets!
#he following information relates to three policies:
Aggressi2e Moderate Conser2ati2e
Sh!D@@@D Sh!D@@@D Sh!D@@@D
$nvestment in
5urrent ssets &%,@@@ &9,@@@ &(,@@@
7ro=ected Sales ((,9@@ ;@,@@@ ;),9@@
.*$# (,9@@ ;,@@@ ;,)9@
,e>uired
aC 1etermine the working capital investment policies for each of the following:
iC 3ate of return on total assets! B+ marksC
iiC /et working capital B+ marksC
iiiC 5urrent ratio B+ marksC
ivC ,perating margin B+ marksC
vC 5urrent assets turnover B+ marksC
bC 1escribe the profitability E risk trade offs of these three policies!
!.S&NESS *&NANCE
49; Market 'or *unds
B' marksC
END O* COM,E-ENS&/E ASS&GNMENT No( 6
NOW SEND TO D&STANCE LEA,N&NG *O, MA,K&NG(
Lesson Ten 499
LESSON TEN
,E/&S&ON A&D
CONTENTS
KASNE! S0LLA!.S
MODEL ANSWE,S TO ,E&N*O,C&NG J.EST&ONS
2esson ,ne
2esson #wo
2esson #hree
2esson 4our
2esson 4ive
2esson Six
2esson Seven
2esson .ight
2esson /ine
2esson #en
+AST C+A E3AM&NAT&ON +A+E,S
Nune %@@)
1ecember %@@)
-ay %@@%
ANSWE,S TO +AST C+A E3AM&NAT&ON +A+E,S
Nune %@@)
1ecember %@@)
-ay %@@%
MOCK E3AM&NAT&ON
!.S&NESS *&NANCE
5II ,e2ision Aid
KASNE! S0LLA!.S
S+EC&*&C O!BECT&/ES
candidate who passes this sub=ect should be able to:
Understand the concept of business finance
nalyse the sources of funds for business
.valuate various investment decision scenarios for an organisation
ppraise the performance of a business using financial tools
Understand the current developments in business financing strategies!
CONTENT
Nature o' !usiness *inance
3elationship between business finance and financial management
6oals of the firm
gency theory
#ools of business finance: #ime value of moneyO interest rates, cash flows, risk and return
Bexcluding portfolio managementC
Sources of funds for Small *usiness .nterprises BS*.sC
5ost of funds
7reparation of financing proposals
*ond markets
5ommercial papers!
Ca<ital &n2estment Decisions
/ature of capital investment decisions
5apital budgeting techniques under certaintyO the traditional and discounted cash flow
methodsO /et 7resent :alue B/7:C and $nternal 3ate of 3eturn B$33CO comparison of these
method!
*inancial Markets
/ature and role of financial markets
5apital -arketsO the stock exchangeO terminologies, practices and functions including
quotations, dealings, parties and documents used, market efficiency, computation and
interpretation of the stock indexO commercial banks and non"banking financial institutions!
#he role of 5apital -arkets uthority and 5entral *anks and 5entral *ank of 0enya!
-oney -arketsO merchant banksO hire purchase and lease hire companiesO Housing finance
companiesO insurance companiesO building societiesO 7ension and provident fundsO special
financing institutions: $ndustrial and 5ommercial 1evelopment 5orporation B$515C,
Lesson Ten 5I4
$ndustrial 1evelopment *ank B$1*C, 5ommonwealth 1evelopment 5orporation B515C
B#heir functions and operationsC!
3aising of funds by 6overnment: $nternal and .xternal 1ebt
5entral 1epository System!
/aluation Conce<ts in *inance
$ntroduction to valuation concepts: market value, book value, replacement value, intrinsic
value!
*asic valuation of financial assets
Measuring !usiness +er'ormance
3atio analysis as it affects and relates to business evaluation including ratios that measure
profitability or earning performance
3atios that measure solvency and liquidity
5overage ratios
4inancial stability ratios
8ield ratiosO dividend per share, earnings per share, price earnings ratio
Use of financial ratios by interested parties: management, creditors, investors, employees!
Working Ca<ital Management
Working capital policies: long"term and short"term investment mix!
5ash, inventory, debtors and creditors management
Emerging Trends in !usiness *inance
!.S&NESS *&NANCE
5I5 ,e2ision Aid
MODEL ANSWE,S TO ,E&N*O,CEMENT J.EST&ONS
LESSON 4
J.EST&ON ONE
iC 7rofit maximisation
iiC -aximisation of the welfare of the employees
iiiC $nterest of customers
ivC Welfare of the society
O/E,LA+
iC $f a company maximises profits, it will also be able to meet the needs of the employees in
terms of provision of good benefits in addition to good salaries!
iiC #here may be some overlap if a business gives better facilities and contributes to social
causes to benefit the society! 7art of which may be made up of employees who will
benefit twice by way of their employees and then by way of social benefits!
iiiC 7art of the employees may also be customers and as such in a bid to satisfy employees
who are also customers, a company will have met the heads of one party twice which will
be an overlap in ob=ectives!
ivC $f a company maximises profits it will also be able to meet the needs of the society as it
can contribute to the society by donations from excess profit!
CON*L&CTS
iC However, profit maximisation may conflict with the interest of customers as by
maximising profits, a company is bound to charge a higher price!
iiC $n a bid to maximise the welfare of employees by way of high salaries and other
benefits, the company will compromise the welfare of the society such as
contribution to social causes as most of its profits will have been taken up by
high salaries and benefits!
iiiC $f the company meets the customers needs it will not be able to meet the needs of
the society! .!g! charging low prices will lead to low profits and thus low
contribution to social causes!
Lesson Ten 5I@
J.EST&ON TWO
aC *eing small businesses, sole traders are viewed as risky enterprises and this lowers their
credibility in financial markets and their ability to raise finance!
bC Small businesses in 0enya do not have sufficient collateral securities to cover their loans and
as such may not qualify for loans especially long term loans due to lack of securities!
cC *eing small, these businesses may not be known to lenders and thus cannot raise such
finances as overdraft finance!
dC #heir si>e does not allow them to sell shares on the 0enyan stock exchange!
eC number of small companies in 0enya are family owned and thus excessive use of share
capital or even debts finance means loss of their control which they cannot allow!
fC number of small business in 0enya do not keep proper books of accounts and such
cannot raise debt finance as lenders will insist on obtaining audited accounts and or
forecasts
which these sole traders do not keep!
gC #hey also lack sound business management principles in the absence of which a business
cannot survive in the long run and this limits financiers ability to fund such business!
J.EST&ON T-,EE
gency relationship exists when one or more persons Bthe principalC hire another person Bthe
agentC to perform some tasks on his or their behalf! #he principal will delegate some decision"
making authority to the agent! #he problems of agency relationships occur when there is a
conflict of interest Bor lack of goal congruenceC between the principal and the agent! #he
relationship can be explained as follows:
aC S%are%olders and Managers
#he relationship between shareholder and manager may clearly be described as one of
agency! #his is so because shareholders appoint managers to run the company on their
behalf!
Unless managers are themselves ma=or shareholders, their interests may not coincide with
those of the firmDs owners! .xamples of possible conflicts include:
iC -anagers might not work industriously to maximise shareholders wealth
if they feel that they will not fairly share in the benefits of their labour!
iiC #here might be little incentive for managers to undertake significant
creative activities including looking for profitable new pro=ects
BventuresC or developing new technology!
iiiC -anagers might pursue pro=ects which they find personally satisfying at
the expense of other pro=ects offering a better return to the company!
!.S&NESS *&NANCE
5I6 ,e2ision Aid
ivC -anagers might award themselves high salaries Bor executive packagesC
than what the shareholders would consider to be =ustified!
$n order to try to ensure that managers act in the best interests of shareholders,
the shareholders incur agency costs such as:
aC 5ost of monitoring management activities Be!g! audit feeC
bC 5ost of structuring corporate organisation to minimise undesirable
management actions Be!g! internal controlsC!
cC 7egging managers remuneration to the success of the firm! Such
remuneration schemes might include:
7rofit based salaries and bonuses
Share option schemes
7erformance shares
dC $n addition, the threat of firing can also be seen as an incentive for
efficient management as is the possibility of =ob loss if a companyDs
share price through management action is low and a take"over occurs!
J.EST&ON *O.,
aC #he ob=ectives of the nationalised electricity supply industry are likely to be strongly
influenced by the government and may not be primarily financial! State owned enterprises
exist to provide a service and to ensure that social needs are satisfied: they are not usually
profit maximising! #he prime ob=ective of a nationalised electricity supply industry might
be to promote the development of an efficient, co"ordinated and economic system of
electricity supply with subsidiary ob=ectives concerned with earning an acceptable return on
capital employed Bacceptable being defined by the governmentC and achieving efficiency
through cost control! Service considerations might mean the provision of electricity
facilities to remote areas at far less than the cost price! $n order to provide reasonably
priced electricity for all people, a government might be prepared to subsidi>e the
nationalised industry and set a negative target return on capital! lternatively the target
return might be set such that the industry is a substantial contributor to government
finances!
#he ob=ectives of a private sector electrical supply company will mainly be determined by
the senior management of the company! #he prime ob=ective of a company is mainly the
maximisation of shareholders wealth! $n practice, they might be content to achieve a
Jsatisfying level of shareholders wealthK and also be concerned with a number of non"
financial ob=ectives! Such ob=ectives include market share, growth, environmental factors,
good working conditions and to facilitate employee and corporate survival! Some of these
non"financial ob=ectives will strongly affect the financial success of the company and
shareholders wealth! vital industry like provision of electricity, even if privately owned,
might still be sub=ect to strong government influence and constraints especially in provision
of services and pricing!
Lesson Ten 5I8
bC Strategic planning in a nationalised industry is sub=ect to government approval! Small"
scale investments will be planned and approved by the management of the nationalised
industry! However, the amount of investment undertaken is likely to be influenced by the
government and the use of external sources from the capital market will usually be limited
by the government!
Strategic investment planning in the private sector is strongly influenced by
market forces with managers considering the possible effects of investments on
share prices and shareholderDs wealth! 7rivate sector investment appraisal
techniques usually assume that the company is seeking to maximise shareholders
wealth in an efficient market! s there are no share prices in a nationalised
industry and investor wealth maximisation is not the assumed ob=ective, some
private sector investment appraisal techniques will not be appropriate! However,
this does not mean that all private sector techniques cannot be used in the public
sector! 1iscounted cash flow for example is often used in a nationalised
industry!
!.S&NESS *&NANCE
5I7 ,e2ision Aid
LESSON 5
J.EST&ON ONE
aC 7ractical difficulties faced by small scale enterprises in obtaining credit:
" 2ack of collateralAsecurity for new creditAloan facilities
" 3estrictive terms and conditions including formalities involved for instance,
in obtaining loan facilities!
" .xistence of financial system which cater for large borrowers only! Such
financial systems e!g! banks view small businesses as risky!
" High cost of borrowing i!e interest rate which is usually prohibitive because
of high perceived risk of small enterprises!
" 7oor managerial skills such that no financial records are maintained and it is
difficult to assess cash flows of such enterprises!
" Underdeveloped capital markets which caters for large firms! -ay be the
formation of alternative investment market segments B$-SC at the /S. is
an attempt to accommodate small firms!
bC $nternal sources of finance:
" #his refers to sources of finance which arise from internal operations of
the firm! .xamples of internal sources of finance are:
1epreciation which yield tax shield and is a provisionAtransfer to a
sinking fund for future asset replacement!
3etained earnings E profits not paid out as dividends but retained to
financial future investment needs!
1eferred tax is a liability to the government which is a source of
financial before its paid up by the firms!
" Usually, the cost of depreciation and deferred tax are not computed!
#hey are usually cost"free sources of finance! #he cost of retained
earnings is the foregone benefitsAdividends by ordinary shareholders!
" .xternal sources of finance is the capital Beither long or short termC
borrowed from sources external to the firm! #he cost of such capital may
be high thus may restrict the firm to use internal sources of financing
only in particular retained earnings! .xamples of external sources of
financing are:
short term loans
bank overdraft
debt capital using debentures or corporate bonds
preference shares capital
issue of new ordinary shares!
Lesson Ten 5I:
J.EST&ON TWO
aC Why different sources of capital have different costs!
1ifferent sources have different costs because of:
" 1uration of lending e!g! long term loans will earn a higher interest rate than
short term loans due to the maturity risk premium!
" Si>e of loan E usually, large borrowers will be charged higher interest rates
than their small borrowers!
" Uncertainty of returns e!g interest charges are fixed hence lower cost of debt
compared to dividends which are uncertain thus higher cost of equity!
" 1ifferent types of financial assets some borrowers e!g building societies will
offer higher yields to depositors to attract them! #heir bonds have high
interest rate!
" 7erceived risk by lenders:
" *orrowers who are perceived by different market segments to be high
risk will have to incur higher cost of capital!
" /eed to make profit margin:
" 1epending on the source of funds for lending, different sources of capital
will add a F profit margin thus different cost of capital!
bC dvantages of having a farmerDs bank:
" /o need for a collateral in securing a loan to! ,nly a guarantor may be
required!
" 2ess formalities in borrowing of loans!
" -inimum deposits will be low according to the savings ability of farmers!
" ,ther standing charges such as ledger fees withdrawal and deposit fees etc
will be eliminated!
" $t would meet the unique finance needs of the farmers including giving
advise on how to invest the money borrowed!
" 2ower cost of borrowing compared to the punitive interest rate charged by
banks!
!.S&NESS *&NANCE
5I; ,e2ision Aid
J.EST&ON T-,EE
aC :enture 5apital
" 4orm of financing given to new, small risky business by specialised
organisations called venture capitalists!
" :enture capitalists e!g! 3ockfeller and cacia fund provide long term
debt or equity capital in return for ownership interest in the firms! #hey
also provide managerial skills for the business!
" Usually, financing is at the early stage of business development when
risk of business failure is high!
bC 3easons why venture capital market is not developed in 0enya:
" $gnorance E -a=ority of small scale business owners are not aware of
existence of venture capital hence underdevelopment of this market in
0enya!
" 4irms may prefer other forms of financing for fear of being dominated by
financiers in profit sharing and decision making!
" lmost all small firms are not quoted on stock exchange and their
activities are not known by venture capitalists!
" 2ack of adequate competent managers to evaluate small businesses
which may be viable for venture capital financing!
" #here are very few venture capitalists in 0enya! #hey also have
conservative financing approach hence not many people would approach
them for financing!
" 2ack o institutional framework and government support to develop
venture capital market in 0enya!
" $nefficient financial system and stock market which is not well
developed to support venture capital development in 0enya!
" :enture capitalists may not have adequate capital and managerial skills
to undertake venture capital financing!
Lesson Ten 5I9
J.EST&ON*O.,
aC 1istinguish between debt and equity!
De?t E>uity
" 5arries a fixed rate of return!
" $nterest is tax allowable
" 1ebenture holdersAlenders are creditors
of the firm
" /o residual claim on the income of the
firm
" /o right to vote or attend 6-
" 1ebenture holders provide long term
debt capital
" Have a variable rate of return
" 1ividends are not tax allowable
" ,rdinary shareholders are owners
of
the firms
" Shareholders have residual claim
on
the profits and assets of the firm
" Shareholders have voting right and
attend 6- to vote on important
management issues!
" Shareholders provide permanent
capital
bC dvantages of leasing:
" 2ease charges are tax allowable hence a tax shieldAsaving for the firms
" /o risk of obsolescence E the firm can revoke the lease e!g in case of
operating leasing thus it avoids risk of ownership
" $ncreased flexibility E Short termAoperating leases are cancellable hence
convenient when the asset is needed temporary!
" voidance of investment initial outlay E #he firm is able to secure full
use of the asset without immediate heavy initial capital investment!
" ,ff"balance sheet financing E $n case of operating lease, lease
obligations are not shown in the balance sheet! #hey do not affect the
gearing of the firm! #he firmDs borrowing position is thus not affected!
,perating leases is thus called off"balance sheet financing!
" 2easing does not require a collateral E $t is also less expensive compared
to a bank loan! $n long term BfinanceC leases, the lessor is given a chance
to buy the asset!
!.S&NESS *&NANCE
54I ,e2ision Aid
LESSON @
J.EST&ON ONE
aC 3eturn on capital employed: 3!,!5!.
Since interest is tax allowable, it yield tax shield Binterest x tax rateC profits after
interest and tax I '@@,@@@ E interest G tax shied
I '@@,@@@ E B)@F x %-C G B)@F x %- x +@FC
I '@@,@@@ E %@@,@@@ G '@,@@@
I Sh!&'@,@@@
3,5. I
)@@
@@@ , @@@ , )%
@@@ , &'@
x
I +!(+F
bC .arnings per share I
@@@ , )9@
@@@ , &'@
I Sh!+!@<
cC 7rice earnings ratio I
@< ! +
+'
I ))!<+ years
dC *ook value per share I .quity Bnet worthC
/umber of shares
.quity I ),9@@,@@@ G ),9@@,@@@ G <,@@@,@@@ I )@,@@@,@@@
*U7S I Sh!)@,@@@,@@@ I Sh!''!<@
)9@,@@@
eC .arningI 4ixed charge capital I Sh!%,@@@,@@@ x )@@ I )'!<F
#otal capital Sh!)%,@@@,@@@
,r I 4ixed charge capital I Sh!%,@@@,@@@ I @!%@
.quity Sh!)@,@@@,@@@
#his indicates low gearing!
fC -arket to book value per share B-*:7SC ratio!
-*:7S I -7S
*:7S
I +' I @!9&
''!<@
Lesson Ten 544
J.EST&ON TWO
aC iC $nventory turnover ratio I 5ost of sales
verage stock Bclosing stockC
I ),+'(,@@@ I %!) times
'&;,9@@
iiC #imes interest earned ratio I ,perating profit .*$#C
$nterest charges
I )@9,<9@ I +!) times
+&,9@@
iiiC #otal assets turnover I Sales
#otal ssets
I ),;<%,9@@ I )!' times
),%++,<9@
ivC /et profit margin I /et profit Bprofit after taxC x )@@
Sales
I &%,<9@ x )@@ I %!%F
),;<%,9@@
i!e %!%F is the net profit margin
;<!(F is the cost of sales!
bC $ndustrial analysis
" $ndustrial analysis involve comparison of firm performance with the industrial
average performance or norms!
" #his analysis can only be carried out for a given year! $!e
#imes seriesAtrend analysis
" #his involve analysis of the performance of a given firm over time i!e ratio of
different year of a given 5o! are compared in order to establish whether the
performance is improving or declining and in case a weakness is detected e!g
decline in liquidity ratio, this will force the management to take a corrective
action!
" When commenting on industrial and trend analysis the following & critical points
should be highlighted:
aC $n case of individual ratio classify them in their immediate category e!g
when commenting on #$.3 indicate this in a gearing ratio!
!.S&NESS *&NANCE
545 ,e2ision Aid
When commenting on a given category of ratio identify the ratios in that
category e!g if required to comment on liquidity position identify the
liquidity ratio from the ratios computed!
bC State the observation made e!g total asset turnover is declining or increasing over time Bin
case of trend analysisC or the ratio is lower or higher than the industrial norms Bin case of
industrial analysisC!
cC State the reason for observation i!e! explain why the ratio is declining or
increasing!
dC State the implication for observation e!g decline in liquidity ratio means that the ability of
the firm to meet in short term financial obligation is declining over time!
,atio A!C Ltd( &ndustrial Norm
$nventory #urnover
#imes interest earned ratio
#otal sset turnover
/et profit margin
%!)
+!)
)!'
%!%F
'!%
9!+
%!%
+F
iC $nventory turnover
" #his is a turnover or efficiency ratio
" #he rate is lower than industrial norm
" low stock turnover could be attributed to:
iC 5harging higher price than competition
iiC -aintenance of slow movingAobsolete goods
iiiC Where the firm is selling strictly on cash while
competitors are selling on credit!
" #he firm is not efficiently utilising its inventory to generate sales
revenue!
iiC #imes interest earned ratio B#$.3C
" #his is a gearing ratio
" $t is lower than industrial average or norm
" #his could be due to low operating profit due to high
operating expenses or high interest charges due to high level of
gearingAdebt capital!
" #his implies that the firm is using a relatively high level of fixed charge
capital to finance the acquisition of assets!
iiiC #otal asset turnover
" #his is efficiency ratioAactivity
" 2ower than industrial average
" #his could be due to holding large non"operational or fully
depreciated asset which are not utilised by the firms!
Lesson Ten 54@
" #his implies inefficiency in utilisation of total assets to generate sales
revenue!
ivC /et profit margin
" $s a profitability ratio
" 2ower than industrial norm
" #his could be due to low level of net profit of the firm
relative to sales revenue!
" #his implies that the firm has a low ability to control its
cost
of sales, operating H financing expenses e!g in case of
*5 2td selling H admin expenses are equal to (%!9F
of gross profit
&;(,<9@ x )@@
'@&,9@@
" lso the cost of sales expense is ';!&F of sales i!e
),+'(,@@@ x )@@
),;<%,@@@
J.EST&ON T-,EE
aC iC .arning per share
.7S I .arning to ,rdinary Shareholders
I ;;@,@@@ I ;;@,@@@ I Sh!)!%&
(,@@@,@@@ b )@ (@@,@@@
" #he ratio indicates earnings attributable to each ordinary share held by
shareholders!
" Shows earning power of the firm!
iiC 7rice earning ratio
7. I -7S I )% I ;!< timesAyears
.7S )!%&
" #he 7. indicate that -iss Hisa will take ;!< years Bpayback periodC to
recover her investment in form of buying price per share i!e the firm!
iiiC 1ividend yield
18 I 17S I @!;%9 x )@@ I <!<F
-7S
" #he ratio indicate F dividend return for every shilling invested in the
firm!
!.S&NESS *&NANCE
546 ,e2ision Aid
ivC 1ividend cover
15 I .7S I )!%& I )!+& times
17S p!;%9
" #he ratio indicate number of times dividend can be paid from earnings
attributable to ordinary shareholders! #he higher the 17S to lower the
15 and vice"versa!
vC *ook value per share B*:7SC
*:7S I /etworth B.quityC
/umber of ordinary shares
.quity I 3etained earnings G ordinary share capital
I ),@'@,@@@ G (,@@@,@@@ I ;,@'@,@@@
*:7S I
@@@ , (@@
@@@ , @'@ , ;
I Sh!))!+%9
J.EST&ON *O.,
iC 3eturn on $nvestment I /et profit
#otal asset
" #his ratio can increase due to increase in net profit or decrease in total asset!
" #he increase may not be due to improvement in performance if it is caused by:
aC disposal of asset
bC increase in net profit due to reduction in tax rate
cC $ncrease in net profit due to gain associated with disposal of assets or
reduction in interest charges resulting from repayment of loans!
iiC 6ross profit on sales I 67 -argin I 6ross profit x )@@
Sales
" #his ratio can improve due to increase in gross profit and due to reduction in cost
of sales or increase in sales!
" $t may not be =udged as improvement if the increase is caused by:
aC increase in sales as a result of increase in selling price!
bC increase in 67 caused by reduction in cost of raw materials
cC Where cost of sales decrease due to the use of low quality materials
production!
iiiC /umber of credit given
1ebtors collection period
Lesson Ten 548
I +'9 or +'9 x verage BclosingC debtors
1ebtors #urnover nnual credit sales
" 3eduction in debtors collection period is improvement but it is not a better
performance over the years if the reduction:
aC Was achieved through offering discount to customers which is a cost of
credit policy!
bC $f it resulted in decline in credit sales of the firm whereby customers who
could not pay within &9 days switch their business to competitors!
ivC dministration cost of sales
dministrative cost of sales 3atio I dministrative cost x )@@
Sales
" #his ratio can improve BreductionC in ratio over the years in case administration
cost reduces or sales increase! reduction in this ratio is not an improvement in
performance if it is caused by:
aC $ncrease in sales as a result of increase in selling price!
bC 1ecrease in administrative expenses resulting from hiring less qualified
personnel who might compromise the quality of product or service!
bC iC Stock #urnover 3atio I 5ost of Sales
verage Stock
I verage stock I (@@,@@@ G %,%@@,@@@
%
I ),9@@,@@@
5ost of sales I <9F of %@,@@@,@@@
I )9,@@@,@@@
Stock turnover I )9,@@@,@@@ I )@ times
),9@@,@@@
iiC /umber of days stock held I +'9
Stock turnover
I
days 9 ! +'
)@
+'9
or I +'9 x verage stock

5ost of sales
I
days
x
9 ! +'
@@@ , @@@ , )9
@@@ , 9@@ , ) +'9
!.S&NESS *&NANCE
547 ,e2ision Aid
iiiC #he stock turnover ratio can be improved as follows:
aC Selling on credit to customers who should pay within a short credit
period! #his can be achieved through offering of discount!
bC -aintenance of fast moving goods
cC .nsure timely delivery of goods by supplies especially if a delay in
delivery would lead to decline in turnover!
dC doption of =ust"in"time BN$#C of managing stock instead of the
.conomic",rder"?uantity B.,?C!
#he financial consequences of a high stock turnover are:
aC 3eduction in stock holdingAcarrying cost
bC $ncrease in stock ordering cost since stock is ordered frequently to meet
the
frequent customer demand!
Lesson Ten 54:
LESSON 6
J.EST&ON ONE
aC 6rowth rate in equity!
#his can be determined using retention ratio method!
6rowth I 3,. x 3etention ratio
17S I )@F x par value I )@F x Sh!)@ I )!@@
1ividend cover I .7S I + times
17S
#herefore: .7S I +
Sh!)!@@
.7S I Sh!)!@@ x + I Sh!+!@@
3etention ratio I 3etained amount
.arnings to shareholders
3eturn on equity B3,.C I .arning to Shareholders
.quity
.arnings to ordinary shareholders I
.quity I Sh!),@@@,@@@ G (@@,@@@ I ),(@@,@@@
3,. I +@@,@@@ x )@@I )'!<F
)(,@@@,@@@
g I ''!<F x )'!<F I ))F
bC W!!5!5
5ost of equity
d@ I Sh!)!@@
g I ))F
7@ I -7S I Sh!)(!@@
!.S&NESS *&NANCE
''!<F @!''<
Sh!+
) +
.7S
17S .7S

x+@@,@@@
Sh!)@par
@@ Sh!),@@@,@
Sh!+!@@x
g +
+
@
7
gC B)
@
d
0e
54; ,e2ision Aid
5ost of preference share capital 07 I
07 I dp
7@
dp I preference 17S I )%F x Sh!)@ I Sh!)!%@
7@ I -7S I Sh!)9
5ost of debt 0d
$nt! I $nterest I )'F x )@@ I Sh!)'
:d I :alue of debenture I Sh!)@@ I 7ar value
# I +@F
,r since par value I :d, then coupon rate I 0d
0dB)"#C I )'B)"@!+C I ))!%F
-!:alue of equity
. I Sh!),@@@,@@@ x )( I ),(@@,@@@
Sh!)@ par
-kt! :alue of preference share capital
7 I &@@,@@@ x 9 I '@@,@@@
Sh!)@ par
-!: of debenture I par value I +@@,@@@
#otal market value %,<@@,@@@
-arket :alue F 5ost -onetary cost
F % ! )< )<% ! @ )) ! @
)(
C )) ! ) B )
+ Ke
(F x)@@
)9
)!%@
p
0
( ) # )
d
:
$nt!
d
0
))!%F @!))% @!+C B)
)@@
)'
d
0
Lesson Ten 549
.quity
7!S! 5apital
1ebt
),(@@,@@@
'@@,@@@
+@@,@@@
%,<@@,@@@
)<!%F
(!@F
))!%F
+@;,'@@
&(,@@@
++,'@@
+;),%@@
W55 I +;),%@@ x )@@ I )&!&;FI )&!9F
%,<@@,@@@
J.EST&ON TWO
aC 1istinguish between capital structure and financial structure!
" 5apital structure is the mix or composition of long term and permanent
capital of the firm e!g! the mix of equity preference share capital an
debentures!
" 4inancial structure is the entire liabilities side of the balance sheet i!e
capital structure and current liabilities!
*alance Sheet
5urrent
liabilities
#rade creditors
ccruals
*ank overdraft
PP
PP
PP
33
,rdinary share
capital
3eserves
7ref! Share
capital
1ebentures
PP
PP
PP
PP
PP
bC *usiness risk and financial risk
" *usiness risk is the uncertainty inherent in the operations of the firms! $t
is the uncertainty in operating profits occasioned by the use of high level
of fixed operating expenses Coperating leverageC such as salaries, rent,
insurance, depreciation etc!
" 4inancial risk is the additional risk borne by ordinary shareholders when
the firm has to use additional debt capital to finance its assets! $t is thus
caused by high gearing i!e use of fixed charge capital such as debt and
preference share capital!
!.S&NESS *&NANCE
F 9 ! )&
<@@ , %
+@@
% ! ))
<@@ , %
'@@
F (
<@@ , %
(@@ , )
F % ! )<
,
_
+
,
_
+
,
_
$A!!
5
a
p
i
t
a
l

S
t
r
u
c
t
u
r
e
4
i
n
a
n
c
i
a
l

S
t
r
u
c
t
u
r
e
55I ,e2ision Aid
" 4inancial risk leads to high fixed financing expenses Binterest charges
and preference dividendsC thus fluctuations in .7S of the firm and
eventually liquidity problems!
Lesson Ten 554
cC .ffects of debt capital on W55
" t initial stages of introduction of debt capital, W55 will decline since
the tax shield associated with interest charges is higher than the
bankruptcy costs! #he value of the firm is maximi>ed at a point where
W55 is lowest!
" dditionally, debt capital have lower cost due to certainty of interest
income and the tax shield i!e! 0dB)"#C!
" However, as more debt is introduced, financial risk increase and
debenture holders and shareholders will demand high return leading to
increase in W55!
dC -W55 and W55
" W55 is the market value weighted cost of capital! $t is based on:
V market value of each capital component
V F cost of each capital component!
" Using market values, the cost of retained earnings B0rC is left out since it
is reflected in market value of equity!
" /o floatation costs are incorporated in W55
Where: 0e, 0d, 0p I F cost of equity, debt and preference share
capital!
., 1, 7 I -arket value of equity, debt and preference
share capital!
: I #otal market value I . G 1 G 7
" -W55
" #his is the overallAcomposite cost of additional or marginal
capital
" 4loatation costs are incorporated in each F cost of capital apart
from cost of retained earnings!
" #he amount to raise from each source is usually based on book
value capital structure which is considered to be optimal! #he
weights are based on the amount of capital raised from each
source!
!.S&NESS *&NANCE
( )

,
_
,
_
,
_
+ +
:
7
p
0
:
1
# )
d
0
:
.
e
0 W55
555 ,e2ision Aid
" 0em, 0rm, 0dm, 07m I -arginal cost of equity, retained earnings,
debt
and preference share capital
" .m, 3m, 1m, 7m I mount of additionalAmarginal capital to raise
from ordinary shares, retained earnings, debt
and preference shares!
" # I #otal amount to raise I .m, 3m, 1m, 7m
J.EST&ON T-,EE
BaC and BbC E 3efer to ?%BdC above!
cC 5ompute the F cost of each capital component!
5ost of debentures 0d
" Since debentures are redeemable in )@ years time, the cost is called yield
to maturity B8#-C or redemption yield B38C!
" $f debentures are not redeemable BperpetualB 0d is called running or flat
yield!
" Using approximation method for yet 8#-,
$nt I $nterest charges I )(F x ),@@@ I Sh!)(@
# I #ax rate I &@F
- I -aturity or par value I sh!),@@@
:d I 5urrent market value I Sh!;9@
n I /umber of years I )@ years
5ost of equity
( )

,
_
,
_
,
_
,
_
+ + +
#
m
7
pm
0
#
m
1
# )
dm
0
#
m
3
r
0
#
m
.
em
0 -W55
( ) ( )
( )
%
)
A ) )
d
d
d
M
n M % &nt
K '( (%M
+
+

( ) ( )
( )
%
)
;9@ ),@@@
)@
)
;9@ ),@@@ @!& ) )(@
d
0
+
+
))!'F x)@@
;<9
))+

( )
g +
+
@
7
g )
@
d
e
0
Lesson Ten 55@
d@ I Sh!9!@@
7@ I -7S I Sh!+(
g I growth rate I )@F
5ost of preference share capital 0p
Since -7S I 7ar value, then 07 I 5oupon rate I )@F
/*: #he prices of preference shares have not changes since floatation
hence -7S I par value
5apital -arket :alue F 5ost -onetary
5ost
.quity %&!9 )),'+<!9
1ebt ))!'& ),<'+!%
7reference
share capital
I 7ar value ',%9@ )@

'%9!@
#otal '(,;9@ )&,@%9!<
cC iiC *ook value weights should be used discretely since they are historical!
#hey
relate o the past when the capital was initially raised!
!.S&NESS *&NANCE
( )
%&!9F @!%&9 Y@!)@
+(
@!)@ ) 9
e
0
+
&<,9@@
Sh!)@
Sh!)%,9@@
Sh!+(x
)9,%@@
Sh!),@@@
Sh!)',@@@
Sh!;9@x
%@!+F
'(,;9@
)&,@%9!<
W55
%@!+F @!%@+
'(,;9@
',%9@
)@
'(,;9@
)9,%@@
))!'
'(,;9@
'&<,9@@
%&!9 W55 + +
,
_
,
_
,
_
556 ,e2ision Aid

J.EST&ON *O.,
aC mount of capital to raise I 9@@- E +'@- I )&@-
mount to raise in );;' I (9F x )&@- I ));-
Since the existing capital structure is optimal, the Sh!));- would be raised as
follows:
2og term debt
3etained .arnings
mount to raise for equity I +9!<@- G %;!<9- I '9!&9-
bC 1etermine the market price per share
1ividend yield I )%F I @!)%
17S I Sh!+!@@
18 I 17S
-7S
-7S I 17S I +!@@ I Sh!%9
18 @!)%
-7S net of floatation cost I Sh!%9 x ;@F I %%!9@
mount to raise from issue of ordinary shares I Sh!+9,<@@,@@@
$ssue price per share I Sh!%%!9@
/umber of shares to issue
I ),9(',''<
I ),9(<,@@@ shares
9+!99- x));-
+@@-
)+9-

+9!<@- x));-
+@@-
;@-

%;!<9- x));-
+@@-
<9-

9@ ! %% !
@@@ , <@@ , +9 !
)h
)h
Lesson Ten 558
cC 5ompute the marginal cost of each source of finance
-arginal cost of equity
5ost of retained earnings 0r Bno floatation costsC
5ost of retained debt 0d
Since new debentures can be sold at par, then:
0d I coupon rate I )'F
0dB)"#C I )'FB)"@!&C I ;!'F
9+!99- from debentures
mount to raiseI
));-
+9!<@- from ordinary shares
%;!<9- from retained
earnings
-arginal weighted cost of capital B-W55C
I &!+% G <!&) G 9!(@ I )<!9+F
!.S&NESS *&NANCE
( )
( )
%&!<F @!%&< @!)@
%%!9@
)!)@ +
g
c
f
@
7
g )
@
d
r
0 + +
( )
( )
%+!%F @!%+% @!)@
%9
)!)@ +
g
@
7
g )
@
d
r
0 + +
+
,
_
,
_
,
_
+ +
));
%;!<9
%+!%
));
+9!<
%&!<F
));
9+!99
;!'F -W55
557 ,e2ision Aid
LESSON 8
J.EST&ON ONE
3efer to the Study 7ack for advantages of /7:, $33 and 7!$ methods of pro=ect appraisal!
J.EST&ON TWO
aC 5omputation of /7:
#he discounting factor Bpresent value interest factor 7:$4C can be computed
using the formulae
( )
( )
n
n
r
r

+
+
)
)
)
.+ES& TNO
8ear 5ash flow
L@@@D
7:$4)%F,n 7!: 7:$4)<F,n 7!:
)
%
+
&
9
'@@
),(@@
%,@@@
+,@@@
%,&@@
@!(;+
@!<;<
@!<)%
@!'+'
@!9'<
9+(!9
),&+&!'
),&%&!@
),;@(!@
),+'@!(
@!(99
@!<+)
@!'%&
@!9+&
@!&9'
9)+!@
),+)9!(
),%&(!@
),'@%!@
),@;&!&
#otal present value
2ess initial capital
/et present value
',''+!%
',@@@!@
''+!%
9,<<+!%
',@@@!@
B%%'!(C
.+ES& MO5
8ear 5ash flow
L@@@D
7:$4)%F,n 7!: 7:$4)<F,n 7!:
)
%
+
&
9
),(@@
%,&@@
+,@@@
),(@@
),'@@
@!(;+
@!<;<
@!<)%
@!'+'
@!9'<
),'@<!&
),;)%!(
%,)+'!@
),)&&!(
;@<!%
@!(99
@!<+)
@!'%&
@!9+&
@!&9'
),9+;!@
),<9&!&
),(<%!@
;')!%
<%;!'
#otal present value
/et present value
<,<@(!%
<,@@@!@
<@(!%
',(9'!%
<,@@@!@
B)&+!(C
Lesson Ten 55:
bC #he rate of return for each pro=ect is the internal rate of return B#ime E ad=usted
rate of return of a pro=ectC!
Since both pro=ects are yielding a positive /7: at )%F discounting, rediscount
the cash flows again at a higher trial discounting to get a negative or >ero /7:!
#ry )<F \done in part BaC]!
+esi TNO .<esi MO5
/7: S )%F ''+!% <@(!%
/7: S $!3!3! @ @
/7: S )<F "%%'!( ")&+!(
$!3!3! for 7esi #Q, I
( ) )% )<
( ! %%' % ! ''+
@ % ! ''+
F )%
I
FC 9 B
(;@
% ! ''+
F )% +
I )9!<+F
$!3!3! for Upesi -,% I
( ) F )% F )<
( ! )&+ % ! <@(
@ % ! <@(
F )%
I
FC 9 B
(9%
% ! <@(
F )% +
I )'!)'F
bBiiC " *oth pro=ects have a positive /7: S )%F cost of capital! However
pro=ect
Upesi -,% has higher /7:!
" *oth pro=ects produce $!3!3! greater than cost of capital! However,
pro=ect Upesi -,% has higher $!3!3!
" #herefore, accept pro=ect Upesi -,%!
J.EST&ON T-,EE
1epreciation p!a! I %@F x %,%@@,@@@ I &&@,@@@
7repare a cash flow schedule:
8ear
)
Sh!D@@@D
%
Sh!D@@@D
+
Sh!D@@@D
&
Sh!D@@@D
9
Sh!D@@@D
Sales
2ess operating costs
.*,#
2ess depreciation
.*#
2ess tax S +9F
.# I accounting profits
dd back depreciation
),+%@
<@@
'%@
&&@
)(@
'+
))<
&&@
),&&@
<@@
<&@
&&@
+@@
)@9
);9
&&@
),9'@
<@@
('@
&&@
&%@
)&<
%<+
&&@
),'@@
<@@
;@@
&&@
&'@
)')
%;;
&&@
),9@@
<@@
(@@
&&@
+'@
)%'
%+&
&&@
!.S&NESS *&NANCE
55; ,e2ision Aid
5ash flows 99< '+9 <)+ <+; '<&
Screening Criteria
)! #he net commitment of funds should not exceed & years i!e the payback period
should at least be & years! #herefore, compute the payback period!
8ear 5ash flows ccumulated 5ash flows
)
%
+
&
9
99<
'+9
<)+
<+;
'<&
99<
),);%
),;@9
%,'&&
+,+)(
#he initial capital of Sh!%,%@@,@@@ is recovered after year +! fter year + Bduring
year &C a total of Sh!%;9,@@@ B%,%@@ E ),;@9C is required out of the total year &
cash flows of Sh!<+;,@@@! #herefore payback period I yrs yrs & ! +
<+;
%;9
+ +
%! #he time ad=usted or discounted rate of return is the $!3!3 of the pro=ect!
1iscount the cash flows at )9F cost of capital given:
3ecall discounting factor B7:$4C I
( )
n
n
r
r
+
+

)
)
C ) B
8ear 5ash
flows
L@@@D
7:$4)9F 7!: 7:$4)&F,n 7!:!
)
%
+
&
9
99<
'+9
<)+
<+;
'<&
@!(<@
@!<9'
@!'9(
@!9<%
@!&;<
&(&!9;
&(@!@'
&';!)9
&%%!<)
++&!;(
@!(<<
@!<<@
@!'<9
@!9;%
@!9);
&((!&;
&((!;9
&()!%(
&+<!&;
+&;!()
#otal 7!:!
/!7!:!
%,);)!&;
%,%@@!@@
B(!9)C
%,%&'!+@
%,%@@!@@
&'!+@
Since the /7: is negative at )9F cost of capital rediscount the cash flows again
at a lower rate, say )&F, to get a positive /7:!
/7: S )&F I &'!+
/7: S $!3!3! I @
/7: S )9F I "(!9)
$!3!3! I
( ) F )& F )9
9) ! ( + ! &'
@ + ! &'
F )&
I
FC ) B
() ! 9&
+ ! &'
F )& +
I )&!(9F
Lesson Ten 559
+! #he unad=usted rate of return on assets employed is the accounting rate of return!
33 I verage accounting profits B.#C x )@@
verage investment
verage accounting profits I
yrs 9
%+& %;; %<+ );9 ))< + + + +
I %%+!' p!a!
verage investment I B$nitial capital G Salvage valueCR
I B%,%@@ G @CR
I ),)@@
!3!3 I
)@@
)@@ , )
' ! %%+
x
I %@!+F
J.EST&ON *O.,
aC #he features of a sound pro=ect appraisal technique are:
$t should consider the time value of money by discounting the cash flows!
$t should give a direct decision criteria on when to accept or re=ect a pro=ect!
$t should rank independent pro=ects in order of their economic viability
$t should distinguish between acceptance and unacceptable pro=ects which
are mutually exclusive!
$t should generally be applicable to any conceivable pro=ect available!
bC 7ractical problems faced by finance managers in capital budgeting:
2ack of information on viable investment opportunities!
2ack of adequate capital to undertake all viable independent pro=ects!
Uncertainty of future cash flows or benefits including methods of assessing
risk of a pro=ect!
#he appropriate pro=ect appraisal technique to use
.ffects of inflation, changes in cost of capital and their qualitative
information!
cC #he features of long term investment decisions are:
#hey involve significant amount of initial capital!
#hey are usually irreversible since reversing such decisions leads to loss
since some specialised assets already acquired may not have second hand
market!
!.S&NESS *&NANCE
5@I ,e2ision Aid
#hey involve risk and uncertainty with reference to economic life, cash
flows, cost of capital, inflation rate, political and technological changes etc!
#he benefits are received over a series of years!
#here is significant time lag between the time capital is committed and the
time benefitsAcash flows are received!
#hey require prioritisation of scarce financial resources hence the need to
evaluate independent pro=ects!
Lesson Ten 5@4
J.EST&ON *&/E
7!$ I #otal 7resent :alue
$nitial 5apital
*ut /7: I 7!: E $nitial cost
#herefore total 7!: I /7: G initial cost
Since pro=ect ' has a negative /7:, it should outrightly be re=ected! .valuate 9 pro=ects
remaining!
7ro=ect $nitial
5apital
/7: #otal 7: 7$ 3anking
) '@ %) () () I )!+9
'@
&
% )9 ; %& %9 I )!'@
)9
%
+ %@ ; %; %; I )!&9
%@
+
& 99 )9 <@ <@ I )!%<
99
9
9 +@ %@ 9@ 9@ I )!'<
+@
)
llocate the Sh!)@@- according to 7$ ranking!
7ro=ect 3ank $nitial capital /7:
9
%
+
)
)
%
+
& *alance
+@
)9
%@
+9 +9 x %)
)@@ )@@
%@
;
;
)%!%9
9@!%9
Using /7: 3anking
7ro=ect $nitial capital /7: 3anking
) '@ %) %
% )9 ; &
+ %@ ; 9
& 99 )9 +
9 +@ %@ )
!.S&NESS *&NANCE
5@5 ,e2ision Aid
llocation on basis of /7: ranking
7ro=ect 3ank $nitial capital /7:
9 ) +@ %@
) % '@ %)
9A99 of & + *alance 9 9A99 x )9 @!(%
#otal /7: &)!(%
Using 7!$ ranking, /7: is higher since the 7!$ ignores the si>e of the pro=ect and rank
pro=ects in relative terms i!e according to 7!: profitability for every shilling of initial
capital!
Lesson Ten 5@@
LESSON 7
J.EST&ON ONE
aC .xpected 17S d@B)GgC I Sh!'!@@
5ost of equity 0e I )9F
? I 3etention ratio x cost of equity B3U.C
I B)"@!'C x @!)9 I @!@' I 'F
7@ I
@' ! @ )9 ! @
' C ) B
@
+
g K
g d
e
I Sh!''!<@
-7S I Sh!&@
#he share is undervalued!
bC Significance of valuation of securities:
" #o determine the price of a security incase of mergers and acquisitions
" Where a firm is floating shares for the first time
" Where a firm wants to sell its subsidiary to a third party
" When the firm is sold to a management buyout team as a going concern!
cC Qero coupon bond does not pay periodic interest charges!
7ar value I Sh!)@@,@@@ I lumpsum at end of year 9
$ssue price B7:C I )@@,@@@B)"@!+%C I '(,@@@
/umber of years I 9years
3ecall future value I 7: x B) G rC
n
)@@,@@@ I '(,@@@B) G rC
9
B)GrC
9
I
@@@ , '(
@@@ , )@@
I )!&<@'
) G r I
9
&<@' ! ) I )!@(
r I )!@( E ) I @!@( (F
dC dvantages of >ero coupon rate
#he firm is able to raise debt capital without fixed commitment to pay
fixed periodic interest charges
$t creates certainty on the amount of debt payable in future at maturity
#he borrower does not have to worry about changes in market interest rate!
!.S&NESS *&NANCE
5@6 ,e2ision Aid
J.EST&ON TWO
aC #he maximum price to pay is equal to the present value of all the expected future
net cash flows!
1iscounting rate I ;F G 9F I )&F
7: of year ) E 9 net cash flows p!a! Sh!D@@@D
9@ x 7:4)&F,9 I 9@ x +!&++ )<)!'9
7: of year ' E )@ net cash flows p!a!
I ;@B7:4)&F,)@ " 7:4)&F,9C
I ;@B9!%)' E +!&++C )'@!&<
7: of year )) " W net cash flows p!a!
I )+@B7:4)&F,W " 7:4)&F,)@C
I )+@B

,
_
%)' ! 9 )&+ ! <

)& ! @
)
%9@!9)
-aximum price to pay 9(%!'+
/otes: 7:4 I 7resent value annuity factor
I
( )
v
r
n
+ ) )
I 7:4 in perpetuity I )Ar
bC ,ther factors to consider:
" #he firm which the consideration would take e!g pay cash or share for
share exchange!
" $ncreased borrowing power of /yakua 2td!
" 1ilution in future .7S and ownership in /yakua 2td!
" 1oes acquisition of U>a increases the market share of /yakua especially
if U>a 2td was a competitor!
" How dows the risk of /yakua 2td! change with acquisition of U>a 2td!
" What is the growth potential of U>a 2td!M
J.EST&ON T-,EE
aC 17S I Sh!%!@@
5ost of equity 0e I )(F
0ear E<ected D+S +/&*4;K)n +/
)
% )9F
+
&
9 )@F
'
< " Wc9F
%B)!)9C
)
I %!+@
%B)!)9C
%
I %!'9
%B)!)9C
+
I +!@&
+!@&B)!)@C
)
I +!+9
+!@&B)!)C
%
I +!'(
+!@&B)!)C
+
I &!@9
d@B)GgC
I <) ! +%
@9 ! @ )( ! @
C @9 ! ) B @9 ! &
@!(&(
@!<)(
@!'@;
@!9)'
@!&+<
@!+<@
@!+<@
)!;9
)!;@
)!(9
)!<+
)!')
)!9@
)%!)@
YYYY
#otal 7: I 7rice of a share %%!'&
Lesson Ten 5@8
!.S&NESS *&NANCE
5@7 ,e2ision Aid
7:$4 I
( )
n
r + )
)
aBiiC I bBiiC
#he value of a share will change if held for only + years since intrinsic value
shall be based on + year expected 17S only!
bC 5ompute the growth
d@B)GgC
n
I dn
Where: d@ I %!9@
n I number of years of growth I + years
dn I %!()
#herefore: %!9@B)GgC
+
I %!()
B)GgC
+
I
9@ ! %
() ! %
I )!)%&
) G g I
+
)%& ! ) I )!@&
g I @!@& X &F
7@ I
( )
g K
g d
e

+ )
@
I
( )
)@ ! @
;%% ! %
@& ! @ )& ! @
@& ! ) () ! %
I Sh!%;!%%
J.EST&ON *O.,
aC :aluation of ordinary shares is more complicated than valuation of bonds and
preference shares because of:
" Uncertainty of dividend unlike interest charges and preference dividends
which are certain
" #he data for valuation of ordinary shares is historical which may not reflect
future expectations!
" constant stream of dividends per share is assume
" #he growth rate is assumed constant and is computed from past dividends!
" #he cost of equityArequired rate of return on equity is assumed to be constant
though it changes over time!
Lesson Ten 5@:
bC iC $f they do nothing:
d@ I Shs!+!@@
g I 'F
0e I )9F
7@ I
@' ! @ )9 ! @
C @' ! ) B + C ) B
@
+
g K
g d
e
I
Sh!+9!++
iiC $nvest in a venture
d@ I Shs!+!@@
g I <F
0e I )&F
7@ I
@< ! @ )& ! @
C @< ! ) B + C ) B
@
+
g K
g d
e
I
Sh!&9!('
iiiC .liminate unprofitable product line
d@ I Shs!+!@@
g I (F
0e I )<F
7@ I
@( ! @ )< ! @
C @( ! ) B + C ) B
@
+
g K
g d
e
I
Sh!+'!@@
ivC cquire a subsidiary
d@ I Shs!+!@@
g I ;F
0e I )(F
7@ I
@; ! @ )( ! @
C @; ! ) B + C ) B
@
+
g K
g d
e
I
Sh!+'!++
#he best alternative is to invest in a venture since this option has the highest
impact price of Sh!&9!('!
!.S&NESS *&NANCE
5@; ,e2ision Aid
LESSON :
J.EST&ON ONE
aC 1ividend payout ratio I )@@ x
EPS
DPS
8ear 2td!
* 2td
);;'
);;<
);;(
);;;
%@@@
F ( ! %+ )@@
(; ! )
&9 ! @
x
F @ ! +@ )@@
9@ ! )
&9 ! @
x
F 9 ! %% )@@
@@ ! %
&9 ! @
x
F +@ ! )< )@@
'@ ! %
&9 ! @
x
F 9 ! )) )@@
;@ ! +
&9 ! @
x
F ) ! )< )@@
@9 ! %
+9 ! @
x
F % ! )< )@@
&9 ! )
+9 ! @
x
F & ! )< )@@
@( ! %
+9 ! @
x
F < ! )< )@@
99 ! %
+9 ! @
x
F ; ! )' )@@
@( ! &
+9 ! @
x
7rice E earning ratio I
EPS
MPS
8ear 2td! * 2td
);;'
);;<
);;(
);;;
( )
t"(es yrs A @ ! ;
(; ! )
R )( )'
+
( )
yrs @ ! ;
9@ ! )
R )9 )%
+
( )
yrs 9 ! (
@@ ! %
R %@ )&
+
( )
yrs @ ! ;
'@ ! %
R %' %)
+
( )
t"(es yrs A +& ! '
@9 ! %
R )9 ))
+
( )
yrs ; ! '
&9 ! )
R )& '
+
( )
yrs 9' ! 9
@( ! %
R )' <
+
( )
yrs &9 ! <
99 ! %
R %+ )9
+
Lesson Ten 5@9
%@@@ ( )
yrs &' ! (
;@ ! +
R &@ %'
+ ( )
yrs ;< ! <
@( ! &
R && %)
+
bC #he shares of * 2td! are not performing well because of uncertainty of 17S compared to
certainty of 17S for 2td! #his uncertainty leads to higher required rate of return by ordinary
shareholders thus lower market value of a share!
cC $f a firm is making heavy losses, the .7S would be negative! With a positive 7A. ratio
the -7S would be negative i!e!
-7S I ".7S x 7A. ratio
negative -7S cannot be interpreted hence the 7A. ratio model collapses!
J.EST&ON TWO
aC 3efer to 2esson < on factors influencing dividend policies!
bC iC firm with a large proportion of high income individuals will pay low or
no dividends! Such shareholders prefer high capital to reduce their tax burden since capital gains
in 0enya are tax exempt!
iiC growth company with abundance of good investment opportunities!
Such a firm would pay low and retain more profits to finance its good investment opportunities!
iiiC company with ordinary growth and high liquidity!
Such a firm could pay high dividends and retain less! With high liquidity and much unused debt
capacity, the firm can easily borrow debt capital to achieve optimal debt capital! $t has access to
capital markets!
ivC dividend paying company that experiences an unexpected drop in earnings from trend!
Such a firm would pay medium dividends but if the drop in earnings persist in future it should
adopt payment of low dividends!
vC company with volatile earnings and high business risk!
#his firm should pay low dividends and retain more profits to finance its investments! With high
business risk, the firm does not have access to capital markets and it is difficult to raise secure
debt capital which would nevertheless increase the financial risk of the firm!
J.EST&ON T-,EE
Solution: 3efer to 2esson < for discussion of factors influencing dividend policy!
!.S&NESS *&NANCE
56I ,e2ision Aid
LESSON ;
J.EST&ON ONE
aC #arget cash balance,
L
"
b
& +
1
1
]
1
+
)
%
&
+
Where: b I 9@
2 I )@,@@@
_ I %,9@@
i I
+'@
@<&'9 ! @
( )
@@@ , )@
+'@
@<&'9 ! @
&
` 9@@ , % 9@ +
+
)
+
1
1
1
1
]
1
x
x
&
I \)!)+%@<&' x )@
)%
]
)A+
I )@&)'!'&( G )@,@@@
I Sh!%@&)'!'&(
X Sh!!%@&)<
bC 2ower 2imit is given and is equal to Sh!)@,@@@
Upper 2imit H I +Q E %2
H I +B%@,&)<C E %B)@,@@@C
I Sh!!&),%9)
Lesson Ten 564
cC 1ecision 3ule:
Wema should hold a cash balance of between Sh!)@,@@@ and Sh!&),%9)! ny time the balance
reaches Sh!&),%9), then marketable securities should be bought amounting to Sh!%@,(+& B&),%9)
E %@,&)<C to return the balance to the target! When the cash balance reaches Sh!)@,@@@, then
marketable securities Bor borrowingsC should be sold worth Sh!)@,&)< to bring the balance to the
target level!
dC .xpected average cash balance I
+
& L &
I
( )
+
@@@ , )@ &)< , %@ &
I Sh!!%+,((;
J.EST&ON TWO
aC .,? I optimal amount to order I
n
C
DC
@
%
Where: 1 I annual demand I %@,@@@ filters x )% I %&@,@@@
5@ I Sh!&@@
5n I Sh!)@
f"lters
x x
E)' ' < ! +() , &
)@
&@@ @@@ , %&@ %

/o! of lot si>es I ()< ! &+
)@@
< ! +() , &
&& lot si>es
bC Without safety stock:
'
DC
'C TC
n
@
R +
( ) &@@
< ! +() , &
@@@ , %&@
)@ < ! +() , & R x x x +
%),;@; G %),;@; I Sh!&+,()(
$n presence of %@@@ filters per annual of safety stock then:
@
C RB C
'
D
C S ' TC
n
+ +
!.S&NESS *&NANCE
565 ,e2ision Aid
&@@
< ! +() , &
@@@ , %&@
)@ ! C @@@ , % < ! +() , & RB x Sh + +
+),;@; G %),;@; I 9+,()(
cC .ffects of the discount
$f the firm is to order 9@ lots, then filters I 9@ lots x )@@ filters per lot I 9,@@@
filters!
#hat is new .,? I ? I 9,@@@ filters
/ew buying price I ;(F x )@@ I Sh!;(
nalysis of savings
/et Savings
5urrent buying costs I %&@,@@@ filters x )@@ I %&,@@@,@@@
/ew buying costs I %&@,@@@ filters x ;( I %+,9%@,@@@ &(@,@@@
Ordering costs
5urrent I
&@@
< ! +() , &
@@@ , %&@
@
x C
'
D
I %),;@;
/ew I
&@@
@@@ , 9
@@@ , %&@
x
I );,%@@
%,<@;
-olding cost
5urrent R?5n I R x &,+()!< x )@ I %),;@;
/ew I R x 9,@@@ x )@ I %9,@@@ B+,@;)C
$ncreamental cost &<;,')(
,verall net benefits
#ake the discount since it yields positive overall net benefits!
J.EST&ON T-,EE
aC #he discriminant function of the form Q I ;)P) G ;%P%
Where a) I S>>dx E Sx>d>
S>>Sxx E BSx>C`
nd a% I Sxxd> E Sx>dx
S>>Sxx E BSx>C`
Lesson Ten 56@
/ote: the terms have been defined in the text!
We need to first compute dx and d>!
Good Accounts !ad Accounts
P
)!)
)!9
)!%
@!;
)!'
%!%
@!;
)!@
)!+
)!+
)!+
8
)+
)9
)<
%)
<
(
)'
)+
(
%
)%
P
@!<
@!;
@!(
)!+
)!)
@!9
@!+
)!&
@!;
)!)
@!;
8
))
"&
'
%
'
(
(
'
+
)&
'
dx I )!+ E @!; I @!&
d> I )% E ' I @!'
#he next step is to determine Sxx, S>> and Sx>
Use the scientific calculator to determine the variance of the PDsBSxxC and the variance of 8Ds
BS>>C!
We also use the following formula to determine Sx> Bth covariance between P and 8C
P
)!)
)!9
)!%
@!;
)!'
%!%
@!;
)!@
)!+
)!+
@!<
@!;
@!(
)!+
)!)
@!9
@!+
8
)+
)9
)<
%)
<
(
)'
)+
(
%
))
"&
'
%
'
(
(
P8
)&!+
%%!9
%@!&
)(!;
))!%
)<!'
)&!&
)+
)@!&
%!'
<!<
"+!'
&!(
%!'
'!'
&
%!&
Q
9!)&
'!9%
'!)%
'!@<
9!+&
<!@9
9!)<
&!(;
&!<9
+!'<
+!<'
)!9<
+!)%
+!'<
&!%&
%!<)
%!%@
!.S&NESS *&NANCE
( )( ) [ ] ( ) ( ) ( * + * ( ( + + * !
+( o

566 ,e2ision Aid
)!& ' (!& &!'9
@!; + %!< %!(+
-ean )!) )& )9!& 9!+%
)!) ; ;!()9
` @!)'+ +&!'
5o:xy I ;!()9 E B)!)CB;C I "@!@(9
#herefore: dx I @!&
d> I @!'
Sxx I @!)'+
S>> I +&!'
Sxy I "@!@(9
a
)
I +&!'B@!&C " C"@!@(9CB'C
+&!'B@!)'+C E B"@!@(9C`
a
%
I @!)'+B'C E B"@!@(9CB@!&C
9!'+%
I )!@)% I @!)(@
9!'+%
#herefore the function will be given by:
Q I %!9&(B)!)C G @!)(B)+C
I 9!)&
#he Q scores are indicated in the above table!
#he Q score that minimi>es misclassification form can be easily identified from the Q score
computed above! 4rom these scores a Q score of &!<@ will have only % accounts being
misclassified!
J.EST&ON *O.,
aC 3efer to lesson ( in the study manual
bC iC nalysis
Since net profit margin is given, analyse the net benefits on the basis of
net profits
Current <olicy New <olicy
Sales
5redit sales
*ad debts
5redit period
/7 -argin
9,@@@,@@@
I %9Fx9@@@,@@@ I
),%9@,@@@
I %F of credit sales
I &@ days
9- x )!+@ I ',9@@,@@@
&@Fx',9@@,@@@I%,'@@,@
@@
+F of credit sales
+9 days
Lesson Ten 568
)9F )9F
nalysis
/et profits
/ew policy I )9F x %,'@@,@@@ I +;@,@@@
,ld policy I )9F x ),%9@,@@@ I )(<,9@@
/et benefit %@%,9@@
*ad debts
/ew policy I +F x %,'@@,@@@ I <(,@@@
,ld policy I %F x ),%9@,@@@ I %9,@@@
/et benefit BcostC
B9+,@@@C
1ebtors
/ew policy I
@@@ , '@@ , %
+'@
+9
x
I %9%,<<(
,ld policy I @@@ , %9@ , )
+'@
&@
x I )+(,((@
$ncrease in debtors I ))+,((;
!.S&NESS *&NANCE
567 ,e2ision Aid
4orgone benefits on tied up capital I )&F x ))+,((; I
B)9,;&9C
5redit controller salary
/ew policy 9@,@@@
,ld policy @
B9@,@@@C
/et benefits (+,999
bC iiC #he credit policy should be determined by the *oard of directors of the
firm with advise from finance manager and credit controller!
Lesson Ten 56:
LESSON 9
J.EST&ON ONE
aC #he price of a share would change due to demand and supply forces in the stock
exchange which may be triggered by factors such as:
nnouncement of dividends
7ublication of financial statements showing profitability of the firm
nnouncement of mergers and acquisitions
7olitical stability in the country e!g! general elections
.conomic performance and policies such as fiscal and monetary policies
6rowth and investment opportunities of the firm
#he change in management team of the firm
5hanges in interest rates in the economy which will affect the cost of
capital and value of the firm!
bC iC 51 means 5um"dividends i!e! the firm has declared dividends and the
shareholders registered is not yet closed! 1uring this period shares are
selling cum"div!
iiC dash B"C means no shares were traded Bno shares were either bought or
soldC
iiiC company may be suspended from the stock exchange if:
$ts share price falls below the par value
#he firm Be!g a bankC is put under statutory management by 5*0
When the firm is insolvent i!e! total liabilities are greater than total
assets!
When its capital falls below the required capital base
When the firm fails to hold an 6- and publish its audited financial
statements
When a firm violates rules and regulations of 5apital -arket
uthority e!g failure to seek permission from 5- to make rights
issue!
ivC 5* means 5um"bonus or script issue or capitali>ation issue! #he firm
has declared a bonus issue which has not been given to shareholders!
vC ,rd! Sh!)@ indicates the parAnominal value of a share as indicated in the
capital clause of the firm! $t is the price at which shares were sold when
the firm was getting quoted on the stock exchange!
!.S&NESS *&NANCE
56; ,e2ision Aid
J.EST&ON TWO
aC 4inancial markets E #here are markets which facilitate transfer of funds from
surplus economic units BlendersC to deficit economic units BborrowersC!
" $n these markets, financial assets and liabilities are created where
financial assets are held by lenders and liabilities are incurred by
borrowers!
" 4inancial markets consist of capital and money markets i!e! markets for
long term and short term instruments respectively!
Stock market is a form of capital market where long term securities such
as shares and debentures are traded through demand and supply forces
which determine security prices!
" #he buying and selling of securities is usually through a stock broker!
Stock market is a portion of financial markets!
bC iC 5entral 1epository System B51SC
#his is an automatedAelectronic or computeri>ed system of trading of
shares where a shareholder shall have a share account in the 51S which will
act as the prime facie evidence of shares ownership! #he share
certificate is thus not required since all share records are electronically
held!
#he share account is debited on purchase of shares and credited on sale
of shares!
iiC #he advantages of 51S are:
$t will facilitate fast trading of shares
#he transfer of shares between investors could take only + days
3educed transaction costs e!g! no need for stamp duty since share
certificates are not required!
$t will improve the liquidity of the stock exchange due to increased
share turnover
$t will lead to more efficient effective and transparent securities
market to achieve international standards!
$t leads to dematerialisation since no physical share certificate is
required! #he account at 51S is adequate evidence of share
ownership!
cC iC share price would be said to be unfair if:
$t is not determined by demand and supply forces
$f the price is not consistent with the activities of the firm e!g a firm
with high profits and good growth potential experiencing decline in
share price!
#he price is not compatible with the price of other similar shares of
firms in the same industry!
Lesson Ten 569
$n case of insider trading!
iiC 7A. ratio indicates the payback period of an investment! #he shares of
/dege 2imited are preferable since payback is only %!9 years compared
to )@ years for 7iki 7iki 2td!
J.EST&ON T-,EE
aC iC 5ontango E interest paid by the investor for money borrowed by a stock
market to buy shares for the investor!
iiC *ackwardation E 5ommission paid to the lender of shares where a dealer
JborrowedK shares which he had to deliver immediately!
iiiC Stages:
" Speculatory who buy new securities believing they are
undervalued!
" #hey sell them when price rises to make a gain!
ivC 3ole of investment bankers
" dvising on issue price of new shares
" Underwriting
" 4inancing decisions of the firm
" 7ortfolio management
" 1efensive mechanism in case of acquisition
" :aluation of securities
bC Selling price
I Sh!)9@ x B)"@!%C I Sh!)%@ i!e %@F below the
highest price
*uying price
I Sh!;@ x B) G @!%C I Sh!)@( i!e %@F above the
highest price
5apital gains I Sh!)% per share
$nterim and final 17S I )!9@ G &!9@ I Sh! '
#otal returns from the share Sh!)(
$nvestment I *!7 I Sh!)@(
F return on investment I F < ! )' )@@
)@(
)(
x
J.EST&ON *O.,
aC Savings and 5redit 5o"operative Societies mobili>e savings and assist in investment
as follows:
" $ndividuals with surplus funds make voluntary savings with Saccos!
Saccos are thus vehicles of savings in the economy!
!.S&NESS *&NANCE
58I ,e2ision Aid
" $ndividuals who need to make investments borrow from Saccos without
the need for collateral!
" #he interest rate charged on borrowers Bwho are also saversC is below the
market interest rate!
" #he borrowing is based on the savers savings! #he repayment terms are
very attractive! 3epayments are guaranteed by fellow Sacco members!
" SaccosD thus provide means of savings and sources of borrowing for
investment!
bC #he credit default for /6, that extend credit to informal businesses and small
traders is kept low in various ways such as:
" mount advanced is based on the borrowers ability to pay!
" Use of friendsAother traders as guarantors of the borrower
" 2ender has to do research and acquire knowledge on the conditions
surrounding the borrower!
" 2enders usually have follow"up mechanism to ensure effective use of
amount borrowed and provide support on effective use of debt!
" 7ressure is exerted by fellow borrowersAguarantors on the defaulting
borrower to pay!
cC /o! #his is because:
SaccoDs are not profit making firms and are strictly for serving members
interest!
$f they are converted into banks, the lending mechanism is formali>ed
which could frustrate the efforts of the Saccos and members!
Lesson Ten 584
+AST C+A E3AM&NAT&ON +A+E,S
KEN0A ACCO.NTANTS AND SEC,ETA,&ES NAT&ONAL E3AM&NAT&ONS !OA,D
C+A +A,T && and C+A +A,T &&&
Bune 5II4 Time= @ -ours
nswer 22 questions in S.5#$,/ $ and ,/. question in S.5#$,/ $$! -arks allocated to
each question are shown at the end of the question! Show all your workings!
SECT&ON &
J.EST&ON ONE
aC State the circumstances under which it would be advantageous to lenders and to
borrowers from the issue of:
iC 1ebentures with a floating rate of interest! B& marksC
iiC Qero"coupon bonds! B& marksC
B$gnore taxationC
bC iC *riefly discuss the disadvantages of the constant growth dividend model as a
valuation model! B&
marksC
iiC #he dividend per share of -ava>i 2imited as at +) 1ecember %@@@ was Sh!%!9@!
#he companyDs financial analyst has predicted that dividends would grow at %@F
for five years after which growth would fall to a constant rate of <F! #he analyst
has also pro=ected a required rate of return of return of )@F for the equity market!
-ava>iDs shares have a similar risk to the typical equity market!
,e>uired
#he intrinsic value of shares of -ava>i 2td as at +) 1ecember %@@@! B( marksC
"Total= 5I marks#
J.EST&ON TWO
aC #he management of 4uraha 7ackers 2td! $s planning to carry out two activities at the
same time to:
iC determine the best credit policy for its customers
iiC find out the optimal level of ordering orange =uice from its suppliers
#he following data have been collected to assist in making the decisions:
)! nnual requirements of orange =uice are %,)@@,@@@ litres!
%! #he carrying cost of the =uice is Sh!( per litre per year!
+! #he cost of placing an order is She!( per litre per year!
!.S&NESS *&NANCE
585 ,e2ision Aid
&! #he required rate of return for this type of investment is )(F after tax!
9! 1ebtors currently are running at Sh!'@ million and have an average collection
period of &@ days!
'! Sales are expected to increase by %@F if the credit terms are relaxed and to result
in an average collection period of '@ days!
<! '@F of sales are on credit!
(! the gross margin on sales is +@F and is to be maintained in future!
,e>uired
iC Use the inventory B*aumolC model to determine the economic order quantity and the
ordering and holding costs at these levels per annum! B( marksC
iiC 1etermine if the company should switch to the new credit policy! B& marksC
bC #he ppolo 5ollection 5ompany 2td! .mploys agents who collect hire purchase
instalments and other outstanding amounts on a door to door basis from -onday to
4riday! #he agents bank their collections at the close of business everyday from -onday
to #hursday! t the close of business on 4riday the weekDs bankings are withdrawn and,
together with 4ridayDs collections, are remitted to the head office! #he takings are evenly
spread daily and weekly! #he budget for the next year shows that total collections will
amount to Sh!%' million! #he bankings are used to reduce an overdraft whose interest
rate is );F!
#he collection manager has suggested that instead of banking collections, they be
remitted daily to the head office by the collectors!
,e>uired
1etermine the increase in annual interest if the collection managerDs suggestion was adopted!
B( marksC
"Total= 5I marks#
Lesson Ten 58@
J.EST&ON T-,EE
3afiki Hardware #ools 5ompany 2imited sells plumbing fixtures on terms of %A)@ net +@! $ts
financial statements for the last three years are as follows:
499;
S%FIIIF
4999
S%FIIIF
5III
S%FIIIF
5ash
ccounts receivable
$nventory
/et fixed assets
ccounts payable
ccruals
*ank loan, short term
2ong term debt
5ommon stock
3etained earnings
dditional information:
Sales
5ost of goods sold
/et profit
+@,@@@
%@@,@@@
&@@,@@@
(@@,@@@
),&+@,@@@
%+@,@@@
%@@,@@@
)@@,@@@
+@@,@@@
)@@,@@@
9@@,@@@
),&+@,@@@
&,@@@,@@@
+,%@@,@@@
+@@,@@@
%@,@@@
%'@,@@@
&(@,@@@
(@@,@@@
),9'@,@@@
+@@,@@@
%)@,@@@
)@@,@@@
+@@,@@@
)@@,@@@
99@,@@@
),9'@,@@@
&,+@@,@@@
+,'@@,@@@
%@@,@@@
9,@@@
%;@,@@@
'@@,@@@
(@@,@@@
),';9,@@@
+(@,@@@
%%9,@@@
)&@,@@@
+@@,@@@
)@@,@@@
99@,@@@
),';9,@@@
+,(@@,@@@
+,+@@,@@@
)@@,@@@
,e>uired
aC 4or each of the three years, calculate the following ratios:
cid test ratio, verage collection period, $nventory turnover, #otal debtAequity, /et
profit margin and 3eturn on assets! B)%
marksC
bC 4rom the ratios calculated above, comment on the liquidity, profitability and gearing
positions of the company! B( marksC
"Total= 5I marks#
J.EST&ON *O.,
aC .xplain fully the effect of the use of debt capital on the weighted average cost of capital
of a company! B' marksC
bC -illennium $nvestments 2td! wishes to raise funds amounting to Sh!)@ million to fiancd a
pro=ect in the following manner:
Sh!' million from debtO and
Sh!& million from floating new ordinary shares!
#he present capital structure of the company is made up as follows:
)! '@@,@@@ fully paid ordinary shares of Sh!)@ each!
%! 3etained earnings of Sh!& million!
!.S&NESS *&NANCE
586 ,e2ision Aid
+! %@@,@@@, )@F preference shares of Sh!%@ each!
&! &@,@@@ 'F long term debentures of Sh!)9@ each!
#he current market value of the companyDs ordinary shares is Sh!'@ per share! #he expected
ordinary share dividends in a yearDs time is Sh!%!&@ per share! #he average growth rate in both
dividends and earnings has been )@F over the past ten years and this growth rate is expected to
be maintained in the foreseeable future!
#he companyDs long term debentures currently change hands for Sh!)@@ each! #he debentures
will mature in )@@ years! #he preference shares were issued four years ago and still change
hands at face value!
,e>uired
iC 5ompute the component cost of:
" ,rdinary share capitalO B% marksC
" 1ebt capitalO B% marksC
" 7reference share capital B% marksC
iiC 5ompute the companyDs current weighted average cost of capital! B9 marksC
iiiC 5ompute the companyDs marginal cost of capital if it raised the additional Sh!)@ million
as envisaged! B9 marksC
Bssume a tax rate of +@FC! "Total= 5I marks#
SECT&ON &&
J.EST&ON *&/E
aC #he 5- B5apital -arket uthorityC has put in place several tax incentives to encourage
investments in capital markets!
Highlight some of the tax incentives by the 5apital -arkets uthority! B& marksC
bC .xplain the benefits that are en=oyed by investors because of the existence of organi>ed
security exchanges! B( marksC
cC *riefly describe the benefits of the 5entral 1epository System B51SC to the following
stakeholders:
iC 6overnmentO B% marksC
iiC 5apital -arkets uthority and /airobi Stock .xchange! B% marksC
iiiC $nvestors! B% marksC
"Total= 4; marks#
J.EST&ON S&3
aC What are financial intermediaries and what role do they play in the economyM B; marksC
bC 4oreign 1irect $nvestment B41$C plays a crucial role in revamping less developed
economies,
,e>uired
Write brief notes on the obstacles to the flow of 41$ into the 0enyan economy! B; marksC
Lesson Ten 588
"Total= 4; marks#
C+A +A,T && and C+A +A,T &&&
Decem?er 5II4
each question are shown at the end of the question! Show all your workings!
SECT&ON &
J.EST&ON ONE
aC Highlight four advantages and disadvantages to a company of being listed on a stock
exchange! B( marksC
bC $n relation to the stock exchange:
iC .xplain the role of the following members:
floor brokers B% marksC
market makers B% marksC
underwriters B% marksC
iiC .xplain the meaning of the following terms:
bull and bear markets B% marksC
bid"ask spread B% marksC
short selling B% marksC
"Total= 5I marks#
J.EST&ON TWO
-ulti"2ink, a trading company, currently has negligible cash holdings but expects to make a
series of cash payments totaling Sh!)9@ million over the forthcoming year! #hese payments will
become due at a steady rate! #wo alternative ways have been suggested of meeting these
obligations!
Alternati2e &
#he company can make periodic sales from existing holdings of short"term securities! #he
average percentage rate of return on these securities is )% over the forthcoming year! Whenever
-ulti"2ink 2td sells the securities! $t will incur a transaction fee of Sh!)9,@@@! #he proceeds
from the sale of the securities are placed on short"term deposit at <F per annum interest until
needed!
Alternati2e &&
#he company can arrange for a secured loan amounting to Sh!)9@ million for one year at an
interest rate of )(F per annum based on the initial balance of the loan! #he lender also imposes a
!.S&NESS *&NANCE
587 ,e2ision Aid
flat arrangement fee of Sh!9@,@@@ which would be met out of existing balances! #he sum
borrowed could be placed in a notice deposit at ;F per annum and drawn down at no cost as and
when required! -ulti"2ink 2td!Ds treasurer believes that cash balances will be run down at an
even rate throughout the year!
,e>uired
aC iC .xplain the weaknesses of the *aumol model in the management of cash!
B+ marksC
iiC dvise -ulti"2ink 2td! as to the better alternative for managing its cash!
B< marksC
bC 2ynx Services 2td!, a debt collection agency, has estimated that the standard deviation of
its daily net cash flow is Sh!%%,<9@! #he company pays Sh!)%@ in transaction cost every
time it transfers funds into and out of the money market! #he rate of interest in the
money market is ;!&'F! #he company uses the -iller",rr -odel to set its target cash
balance! #he minimum cash balance has been set at Sh!(<,9@@!
,e>uired
iC #he companyDs target cash balance! B+ marksC
iiC #he lower and upper cash limit! B% marksC
iiiC 2ynx Services 2td!Ds decision rules! B9 marksC
J.ST&ON T-,EE
-agharibi 5ane -illers 2td! is a company engaged in the pressing and processing of sugar can
=uice into refined sugar! 4or some time, the company has been considering the replacement of its
three existing machines!
#he production manager has learnt from a professional newsletter on sugar of the availability of a
news and larger machine whose capacity is such that it can produce the same level of output per
annum currently produced by the three machines! 4urthermore, the new machine would cut down
on he wastage of =uice during processing! $f the old machines are not replaced, an extraordinary
overhaul would be immediately necessary in order to maintain them in operational condition!
#his overhaul would at present cost Sh!9,@@@,@@@ in total!
#he following additional information is available:
)! #he old machines were purchased 9 years ago and are being depreciated over )9 years on
a straight line basis, with an estimated final scrap value of Sh!'@@,@@@ each! #he current
second hand market value of each of the machines is Sh!),@@@,@@@!
%! #he annual operating costs for each of the existing machines areO
3aw sugar cane
2abour Bone operatorC
:ariable expense
-aintenance Bexcluding overhaul
expenditureC
4ixed expenses
1epreciation
Shs!
<9,@@@
%,<@@,@@@
Shs!
'@,@@@,@@
@
),+9@,@@@
;%9,@@@
%,@@@,@@@
"
Lesson Ten 58:
4ixed factory overhead absorbed %,<<9,@@@
+! #he new machine has an estimated life of ten years and its initial cost will comprise:
Shs!
7urchase price Bscrap value in )@ years, Sh!&,9@@,@@@C (<,@@@,@@@
4reight and installation )+,@@@,@@@
)@@,@@@,@@@
&! #he estimated annual operating costs, if all the current output is processed on the new
machine are:
3aw sugar cane
2abour
:ariable expense
4ixed expenses:
1epreciation
4ixed factory overhead absorbed
-aintenance
Shs!
;,99@,@@@
<,(@@,@@@
Shs!
)'%,@@@,@@
@
+,;@@,@@@
%,%<9,@@@
)<,+9@,@@@
&,9@@,@@@
9! #he companyDs cost of capital is )@F!
'! 4or a pro=ect to be implemented, it must pass both the profitability test, as indicated by its
internal rate of return and also satisfy a financial viability test, in that it must pay back for
itself within a maximum period of five years!
,e>uired
aC iC /et present values of the proposed replacement decision using discount rates of
)@F and %@F! B( marksC
iiC #he estimated internal rate of return B$33C of the replacement decision using the
values determined in BiC above! B& marksC
iiiC dvise management on the proposal based on your answer in BiC above!
B% marksC
bC 1ecision as to whether the pro=ect meets the financial viability test! B&
marksC
cC 5omment on any other qualitative considerations that could influence this decision!
/*: $gnore taxation! B% marksC
"Total= 5I marks#
J.EST&ON *O.,
#hree years ago, -rs 3ehema Wa>iri was retrenched from the 5ivil Service! She invested
substantially all her terminal benefits in the shares of *5 2td! a company quoted on the stock
exchange! #he dividend payments from this investment makes up a significant portion of -rs!
Wa>iriDs income! She was alarmed when *5 2td, dropped its year %@@) dividend to Sh!)!%9
per share from Sh!)!<9 per share which it had paid in the previous two years!
!.S&NESS *&NANCE
58; ,e2ision Aid
Lesson Ten 589
-rs Wa>iri has approached you for advice and you have gathered the information given below
regarding the financial condition of *5 2td! and the finance sector as a whole!
4999
S%FIIIF
5III
S%FIIIF
5II4
S%FIIIF
5ash
ccounts receivable
$nventory
#otal current assets
2and and buildings
-achinery
,ther fixed assets
#otal assets
ccounts and notes payable
ccruals
#otal current liabilities
2ong term debt
3etained earnings!
)9,%9@
(@,+%@
;(,'@@
);&,)<@
%9,%+@
++,(@@
)&,;%@
%'(,)%@
+&,%%@
)9,<@@
&;,;%@
'@,(9@
))9,@@@
&%,+9@
%'(,)%@
)&,&@@
(<,(@@
)9(,(@@
%'),@@@
%<,'@@
+',&@@
)(,%@@
+&+,%@@
<+,<'@
+&,@@@
)@<,<'@
'@,(9(
))9,@@@
9;,9(%
+&+,%@@
(,@@@
)+&,&@@
%9&,@@@
+;',&@@
%9,@@@
+@,'@@
)',&@@
&'(,&@@
)+9,(&(
'<,@@@
%@%,(&(
(),<%@
))9,@@@
'(,(+%
&'(,&@@
A!C Ltd( &ncome Statement 'or t%e year ending
@4 Octo?er
4999
S%FIIIF
5III
S%FIIIF
5II4
S%FIIIF
Sales Ball on creditC
5ost of sales
6ross profit
6eneral administrative and selling
expenses
,ther operating expenses
.arnings before interest and tax B.*$#C
$nterest expense
/et income before taxes
#axes
/et income
/umber of shares issued
7er share data:
.arnings per share B.7SC
1ividend per share
-arket price BaverageC
(%<,@@@
B''),'@@C
)'9,&@@
B'+,'@@C
B%9,&@@C
<',&@@
B)%,(@@C
'+,'@@
B%9,&@@C
+(,%@@
&,'@@,@@@
Sh!(!+@
Sh!)!<9
Sh!&(!;@
(9(,@@@
B<)@,@@@C
)&(,@@@
B&<,%'&C
B+),(@@C
'(,;+'
B%',(@@C
&%,)+'
B)',(9&C
%9,%(%
&,'@@,@@@
Sh!9!9@
Sh!)!<9
Sh!%9!9@
(;@,@@@
B<)%,@@@C
)<(,@@@
B9),%@@C
B+(,%@@C
((,'@@
B'+,'@@C
%9,@@@
B)@,@@@C
)9,@@;
&,'@@,@@@
Sh!+!%'
Sh!)!%9
Sh!)+!%9
!.S&NESS *&NANCE
57I ,e2ision Aid
$ndustry 4inancial ratios
"5II4#
?uick ratio
5urrent ratio
$nventory turnover
verage collection period
4ixed asset turnover
#otal assets turnover
/et income to net worth
/et profit margin on sales
7rice".arnings B7A.C ratio
1ebtA.quity ratio
)!@
%!<
< times
+% days
)+!@ times
%!' times
)(F
+!9F
' times
9@F
Notes
)! $ndustry ratios have been roughly constant for the past four years!
%! $nventory turnover, total assets turnover and fixed assets turnover are based on the year"
end balance sheet figures!
,e>uired
aC #he financial ratios for *5 2td! for the past three years corresponding to industry ratios
given above! B)@ marksC
bC rrange the ratios calculated in BaC above in columnar form and summarise the strengths
and weaknesses revealed by these ratios based on:
iC #rends in the firmDs ratios! B' marksC
iiC 5omparison with industry averages! B' marksC
B#he summary should focus on the liquidity, profitability and turnover ratiosC!
"Total= 5I marks#
SECT&ON &&
J.EST&ON *&/E
aC 2ist and explain five factors that should be taken into account by a businessman in
making the choice between financing by short"term and long"term sources!
B)@ marksC
bC .numerate four advantages of convertible bonds from the point of view of the borrower!
B( marksC
"Total=4; marks#
Lesson Ten 574
J.EST&ON S&3
$n a company, an agency problem may exist between management and shareholders on one hand
and the debt holders Bcreditors and lendersC on the other because management and shareholders,
who own and control the company have the incentive to enter into transactions that may transfer
wealth from debt holders to shareholders! Hence the need for agreements by debt holders is
lending contracts!
,e>uired
aC State and explain any four actions or transactions by management and shareholders that
could be harmful to the interests of debt holders Bsources of conflictC!
B( marksC
bC Write short notes on any four restrictive covenants that debt holders may use to protect
their wealth from management and shareholder raids! B)@ marksC
"Total= 4; marks#
!.S&NESS *&NANCE
575 ,e2ision Aid
C+A +A,T && and C+A +A,T &&&
May 5II5
each question are shown at the end of the question! Show 22 your workings!
SECT&ON &
J.EST&ON ONE
aC 1iscuss the drawbacks of using the following approaches in estimating a securityDs value!
iC *ook valueO B+ marksC
iiC 3eplacement valueO B+ marksC
iiiC Substitution valueO B+ marksC
ivC $ntrinsic value! B+ marksC
bC /gomongo Holdings 2imited has investment interests in three companies! 0irinyaga
:ideo 2imited B0:2C! 0ilgoris Hauliers 2imited B0H2C and #urkana 4isheries 2imited
B#42C! #he following financial data relate to these companies:
)! s at +) 1ecember %@@), the financial statements of two of the companies
revealed the following information:
5ompany 7rice of share
S%(
Earnings <er s%are
S%(
Di2idend <er
s%are
S%(
0irinyaga :ideo
2td B0:2C
0ilgoris Hauliers
2td! B0H2C
)'@
%<@
(
)(
(
;
%! .arnings and dividend information for #urkana 4isheries 2td! B#42C for the past
five years is given below:
0ear ended @4
Decem?er
499:
S%(
499;
S%(
4999
S%(
5III
S%(
5II4
S%(
.arnings per share
1ividend per share
9!@
+!@
'!@
+!@
<!@
+!9
)@!@
9!@
)%!@
9!9
#he estimated return on equity before tax required by investors in #urkana
4isheries 2td!Ds shares is %@F!
Lesson Ten 57@
,e>uired
iC 4or 0irinyaga :ideo 2td! B0:2C and 0ilgoris Hauliers 2td! B0H2C, determine and
compare:
1ividend yields B% marksC
7riceA.arnings ratios B% marksC
1ividend covers B%
marksC
iiC Using the dividends growth model, determine the market value of ),@@@ shares held in
#urkana 4isheries 2td! B#42C as at +) 1ecember %@@)!
B& marksC
"Total= 55 marks#
J.EST&ON TWO
5lean Wash 2td! manufactures and markets automatic washing machines! mong the many
hundreds of components which it purchases each year from external suppliers for assembling into
the finished articles are drive belts, of which it uses &@@,@@@ units per annum! $t is considering
converting its purchasing delivery and stock control of this item to a Nust"$n"#ime BN$#C system!
#his will raise the number of orders placed but lower the administrative and other costs of placing
and receiving orders! $f successful, this will provide the model for switching most of its inwards
supplies into this system!
1etails of current and proposed ordering and carrying costs are given below:
,rdering cost per order
7urchase cost per item
$nventory holding cost Bas a percentage of the purchase costC
Current
S%(4I)III
S%(58
5IK
+ro<osed
S%(5)8II
S%(58
5IK
#o implement new arrangements will require a Lone"offD reorgani>ation costs estimated at
Sh!)&@,@@@ which will be treated as a revenue item for tax purposes! #he rate of corporation tax
is +%!9F and 5lean Wash 2td! can obtain finance at an effective cost of )(F! #he life span of the
new system is ( years!
,e>uired
aC iC #he economic order quantity with current and proposed arrangements!
B9 marksC
iiC /et 7resent :alue B/7:C of the new arrangement! $s the new arrangement
worthwhileM B)@ marksC
bC *riefly explain the nature and ob=ectives of N$# purchasing agreements concluded
between components users and suppliers!
B9 marksC
!.S&NESS *&NANCE
576 ,e2ision Aid
"Total= 5I marks#
Lesson Ten 578
J.EST&ON T-,EE
#he management of fro ?uatro 2td! want to establish the amount of external financial needs for
the next two years! #he balance sheet of the firm as at +) 1ecember %@@) is as follows:
/et fixed assets
Stock
1ebtors
5ash
#otal assets
4inanced by:
3etained earnings
)%F long term debt
#rade creditors
ccrued expenses
S%(FIIIF
)%&,(@@
+&,&@@
%(,(@@
<,%@@
);;,%@@
(&,@@@
+9,%@@
%@,@@@
+',@@@
%&,@@@
);;,%@@
4or the year ended +) 1ecember %@@), sales amounted to Sh!%&@,@@@,@@@! #he firm pro=ects that
the sales will increase by )9F in year %@@% and %@F in year %@@+!
#he after tax profit on sales has been ))F but the management is pessimistic about future
operating costs and intends to use an after"tax profit on sales rate of (F per annum!
#he firm intends to maintain its dividend pay out ratio of (@F! ssets are expected to vary
directly with sales while trade creditors and accrued expenses from the spontaneous sources of
financing! ny external financing will be effected through the use of commercial paper!
,e>uired
aC 1etermine the amount of external financial requirements for the next two years! B<
marksC
bC iC proforma balance sheet as at +) 1ecember %@@+! B)@ marksC
iiC State the fundamental assumption made in your computations in BaC and b BiC
above!
B) markC
"Total= 4; marks#
!.S&NESS *&NANCE
577 ,e2ision Aid
J.EST&ON *O.,
7! -uli was recently appointed to the post of investment manager of -asada 2td! a quoted
company! #he company has raised Sh!(,@@@,@@@ through a rights issue!
7! -uli has the task of evaluating two mutually exclusive pro=ects with unequal economic lives!
7ro=ect P has < years and 7ro=ect 8 has & years of economic life! *oth pro=ects are expected to
hav >ero salvage value! #heir expected cash flows are as follows:
+roEect
0ear
3
Cas% 'lows "S%(#
0
Cas% 'lows "S%(#
)
%
+
&
9
'
<
%,@@@,@@@
%,%@@,@@@
%,@(@,@@@
%,%&@,@@@
%,<'@,@@@
+,%@@,@@@
+,'@@,@@@
&,@@@,@@@
+,@@@,@@@
&,(@@,@@@
(@@,@@@
"
"
"
#he amount raised would be used to finance either of the pro=ects! #he company expects to pay a
dividend per share of Sh!'!9@ in one yearDs time! #he current market price per share is Sh!9@!
-asada 2td! expects the future earnings to grow by <F per annum due to the undertaking of
either of the pro=ects! -asada 2td! has no debt capital in its capital structure!
,e>uired
aC #he cost of equity of the firm! B+ marksC
bC #he net present value of each pro=ect! B' marksC
cC #he $nternal 3ate of 3eturn B$33C of the pro=ects! B3ediscount cash flows at %&F for
7ro=ect P and %9F for 7ro=ect 8C! B' marksC
dC *riefly comment on your results in BbC and BcC above! B% marksC
eC $dentify and explain the circumstances under which the /et 7resent :alue B/7:C and the
$nternal 3ate of 3eturn B$33C methods could rank mutually exclusive pro=ects in a
conflicting way! B9 marksC
"Total= 55 marks#
Lesson Ten 57:
SECT&ON &&
J.EST&ON *&/E
aC What is meant by the term Jcapital flightKM B9 marksC
bC Why have frican economies been characteri>ed by much capital flight in the pastM
B( marksC
cC What is the impact of massive capital flight on the value of the domestic currencyM
B9 marksC
"Total= 4; marks#
J.EST&ON S&3
aC 1iscuss the main factors which a company should consider when determining the
appropriate mix of long"term and short"term debt in its capital structure! B' marksC
bC -alingi 2eisure $ndustries is already highly geared by industry standards, but wishes to
raise external capital to finance the development of a new beach resort!
,utline the arguments for and against a rights issue by -alindi 2eisure $ndustries!
B' marksC
cC .xamine the relative merits of leasing versus hire purchase as a means of acquiring
capital assets! B'
marksC
"Total= 5I marks#
!.S&NESS *&NANCE
57; ,e2ision Aid
,E/&S&ON J.EST&ONS
J.EST&ON ONE
#he following are the financial statements of 3ichardo 2td! for the year ended +) -arch );;9:
!alance S%eet as at @4 Marc% 4998
5ash
1ebtors
Stock
/et equipment
Shs!
&(@,@@@
'&@,@@@
%,@(@,@@@
),'@@,@@@
&,(@@,@@@
#rade creditors
/otes 7ayable ;BFC
2ong term debt B)@FC
Shareholders .quity
Shs!
('@,@@@
(&@,@@@
),'@@,@@@
),9@@,@@@
&,(@@,@@@
Sales
2ess: 5ost of sales
6ross profit
1educt: Selling expenses
dministrative and general
expenses
$nterest charges
7rofit before taxation
#axation
/et profit
Shs!
'@@,@@@
),)%@,@@@
%+9,'@@
Shs!
',@@@,@@@
+,'@@,@@@
%,&@@,@@@
),;99,'@@
&&&,&@@
)<<,<'@
%'','&@
ll sales are net and on credit!
#he following industry ratios are also provided to you!
$ndustry verages
5urrent ratio
cid test ratio
Stock turnover ratio
#otal assets turnover ratio
#imes interest earned ratio
/et profit margin
3eturn on investment
#otal assets to shareholders equity
3eturn on shareholders equity
%!9 times
)!) times
%!& times
)!& times
+!9 times
&!@ percent
9!' percent
+!@ times
)'!( percent
,e>uired
aC 5alculate the ratios shown above for 3ichardo 2td! and present them in columnar
form along the industry averages! B)&
marksC
bC 5omment upon the following about 3ichardo 2td! in relation to the industry
averages:
iC 2iquidity position! B+ marksC
Lesson Ten 579
iiC 4inancial risk B+ marksC
iiiC ,verall performance B+ marksC
"Total= 5@ marks#
J.EST&ON TWO
aC 1eni 2imited wishes to raise funds for expansion using corporate bonds!
iC What is a corporate bondM B% marksC
iiC State and explain two advantages in the use of corporate bonds! B%
marksC
iiiC What costs are associated with the issue of corporate bondsM B&
marksC
bC 1eni 2imited has issued Sh!)@,@@@, )'F bonds redeemable at par on ) Nune %@@;! #he
bonds are dated ) -ay );;;! #he bonds may however be redeemed at par on ) Nune
%@@)! Upon issue the bonds will be traded on the Stock .xchange! #he market rate of
interest on ) -ay was )&F!
,e>uired
iC #he issue price of the bond! B& marksC
iiC #he expected market price of the bond as at ) Nune %@@)! #he market rate
of interest is expected to be )@F! B&
marksC
iiiC Should 1eni 2imited redeem the bond on ) Nune %@@)M WhyM
B& marksC
"Total= 5I marks#
J.EST&ON T-,EE
3$#. 2td! maintains an average monthly balance of Sh!+%@,@@@ in accounts receivable
throughout the year! #he company is in need of additional working capital and is considering two
alternative methods of raising it!
-.#H,1 ) 4actoring accounts receivable
-.#H,1 % commercial bank loan secured by accounts receivable!
#he companyDs bankers have agreed to lend the firm (@F of its average accounts receivable at an
interest of +@F per annum! #he amount will be made available in a series of +@ day advances!
#he advances would be discounted and a 'F compensating balance will be required!
#he factor is willing to establish a factoring arrangement on a continuing basis! $t charges %F for
servicing the accounts and )9F per annum on any advances taken! *oth charges are made on
discount basis! $n addition, the factor requires a 9F reserve to cover returned items! 3$#. 2td!
sells its merchandise on terms of net +@!
,e>uired
aC 5alculate the amount of advances 3$#. 2td! can expect to have under each
alternative! B)& marksC
bC 5alculate the effective rate of interest for each financing alternative! B& marksC
!.S&NESS *&NANCE
5:I ,e2ision Aid
cC Which alternative would you recommend and whyM B% marksC
"Total= 5I marks#
Lesson Ten 5:4
J.EST&ON *O.,
5apital markets in 0enya have expanded over the last few years! #his expansion is due to:
iC #he initiatives of 5apital -arkets uthority
iiC #he introduction of new financial instruments
iiiC #he appreciation of the role and functions of the capital markets by 0enyans!
,e>uired
aC What are the roles of 5apital -arkets uthorityM B' marksC
bC .xplain the meaning of the term J4inancial $nstrumentK B& marksC
cC 1escribe the following investments which are available in the 0enyan -arket today:
iC #reasury *illO B& marksC
iiC 5ommercial 7aper B& marksC
"Total= 4; marks#
J.EST&ON *&/E
-r! Hesabu 0a>i is considering giving up his paid employment and going into business on his
own account! He is considering buying a quarry pit with a JlifeK of about +9 years! #o purchase
this business, he would have to pay Z%,+<9,@@@ now! -r! 0a>i wishes to retire in %@ yearsD time!
He predicts that the net cash operating receipts from this business will be Z'%9,@@@ per annum for
the first )9 years and Z9@@,@@@ per annum for the last 9 years! He thinks that the business could
be sold at the end of the %@ year period for Z<9@,@@@! dditionally, he estimates that certain
capital replacements and improvements would be necessary and this should amount to Z9@,@@@
per annum for the first 9 yearsO Z<9,@@@ per annum for the next 9 years, Z)@@,@@@ per annum for
the next < years and nothing for the last three years! #his expenditure would be incurred at the
start!
-r! 0a>i has excluded any compensation to himself from the above data! $f he should purchase
the business, however, he would have to leave his present =ob in which he earns Z%9@,@@@ a year!
#o finance the purchase of this business, he would have to reali>e his present savings which are
invested to yield a return of )@ per cent before tax, and have a comparable risk factor!
,e>uired
aC dvise -r! 0a>i as to whether or not it is advisable to purchase the business in the light of
the information given!
$gnore $ncome #ax! B)' marksC
bC $s there any additional information which you would have liked to have available to you
before giving advise to -r! 0a>iM B&
marksC
"Total= 5I Marks#
!.S&NESS *&NANCE
5:5 ,e2ision Aid
S.GGESTED SOL.T&ONS M DECEM!E, 5II4
J.EST&ON ONE
a# De?enture wit% 'loating interest rate=
" debenture whose interest rate is variable and pegged to charges in interest rate
on #reasury bills e!g a debentureAbond may have a +F premium above interest
rate on #reasury bill such that:
$f interest rate on treasury bill is <F, interest rate on the bond is <F G
+F I )@F!
$f interest rate on #reasury bill rises to (!9F, the interest rate on the bond
rises to (!9F G +F I ))!9F!
" Such a bond is advantageous when market interest rates are volatile!
" $f market interest rate falls, the borrower pays lower interest charges and when it
rises, the lender receives more interest income!
" Since the coupon rate is matched to market interest rate, the intrinsic value of the
bond is usually stable and easy to determine!
bC Qero coupon bonds
" #he bonds do not pay periodic interest charges hence the words >ero coupon
bond! #hey are issued at a discount and mature at par!
" #herefore, interest is accumulated and accounted for in the redemption value of
the bond!
" #he lender is not locked into low fixed interest rate while the borrower does not
have fixed financial obligations of paying fixed interest charges!
" #he liquidity of the borrower is not affected until the redemption date!
Draw?acks o' di2idend growt% model
" $t is only applicable if the cost of equity, 0e is greater than growth rate, in
dividends i!e!
7@ I d@B)GgC
0e E g
$f gUke, then the model would collapse!
Lesson Ten 5:@
" $t is based on historical information where d@ is the past dividend per share, and
LgD is based on historical stream of dividends which may not represent the future!
" $t assume a constant stream of dividends in future, growth rate and cost of equity
all of which are not achievable in real world!
iiC 5ompute the expected 17S at end of each period and discount at )@F rate
.xpected 17S I d@B)GgC
n
End o' year E<ected D+S +/&*4IK)n 7!:
)
%
+
&
9
'"W
%!9@B)!%C
)
I +!@@
%!9@B)!%C
%
I +!'@
%!9@B)!%C
+
I &!+%
%!9@B)!%C
&
I 9!)(
%!9@B)!%C
9
I '!%%
d@B)GgC
0e " g
@!;@;
@!(%'
@!<9)
@!'(+
@!'%)
%!<+
%!;<
+!%&
+!9&
+!('
I
@< ! @ )@ ! @
C @< ! ) B %% ! '
I %%)!(9 @!'%) )+<!<<

I $ntrinsic value I #otal present value I )9&!))
J.EST&ON TWO
aC iC .conomic order quantity B.,?C I
Ch
DC
@
%
Where: 1 I annual demand in units I %,)@@,@@@ litres
5@ I order cost per order I Sh!),&@@
5h I holding cost per unit p!a! I Sh!(
? I .,? I
(
&@@ , ) @@@ , )@@ , % % x x
I %,<)@!(( litres
,rdering costs I @
C
'
D
I
&@@ , )
(( ! ))@ , %<
@@@ , )@@ , %
x
I
Sh!)@(,&&+!9
Holding costs I R?5h I R x %<,))@!(( x ( I Sh!)@(,&&+!9
iiC .valuation of credit policy:
" 5urrent debtors I '@-
" 5urrent credit period I &@ days
!.S&NESS *&NANCE
5:6 ,e2ision Aid
" #herefore current credit sales p!a! I
M x
days
days
'@
&@
+'@
I
9&@-
" /ew credit sales p!a! I
F )@@
F )%@
9&@Mx I '&(-
" /ew debtors I M x'&(
+'@
'@
I )@(-
5ost benefit analysis:
/ew gross profits I +@F x '&(- I );&!&
5urrent 6ross profits I +@F x 9&@- I )'%!@ +%!&-
/ew debtors )@(-
5urrent debtors '@-
$ncreaseAtied up capital &(-
4orgone profits I 3,$ x tied up capital I )(F x &(- B(!'&C
/et benefit %+!<'
Switch to the new credit policy!
bC .xpected collection p!a! I Sh!%',@@@,@@@
.xpected collection per week I Sh!%',@@@,@@@ I 9@@,@@@
9% wks
5ollection per day I
days 9
@@@ , 9@@
I )@@,@@@
$nterest rate per day I
+'9
F );
I @!@9%F per day
#he current policy is to collect cash and deposit it on daily basis! #he new policy is to
collect cash, remit to headquarter on 4riday! $f money is not deposited on -onday,
interest will be foregone for & days! $f money is not deposited on Wednesday, interest is
forgone for % days!
Day Amount not
?anked
Num?er o'
days delayed
&nterest c%arges
-onday
#uesday
Wednesday
#hursday
)@@,@@@
)@@,@@@
)@@,@@@
)@@,@@@
&
+
%
)
)@@,@@@ x @!@9%F x & I
)@@,@@@ x @!@9%F x + I
)@@,@@@ x @!@9%F x % I
)@@,@@@ x @!@9%F x ) I
%@(
)9'
)@&
9%
#otal interest per week 9%@
nnual cost I 9%@ x 9% I %<,@&@
Lesson Ten 5:8
J.EST&ON T-,EE
,atio *ormulae 499; 4999 5III
cid test
ratio I
5urrent assets E stock
5urrent liabilities
+@ G %@@ I @!&+
%+@ G %@@ G )@@
&' ! @
)@@ %)@ +@@
%'@ %@
+ +
+
&@ ! @
)&@ %%9 +(@
%;@ 9
+ +
+
verage
debtors
collection
period
1ebtors x +'@
5redit sales p!a!
%@@ x +'@ I )( days
&,@@@
%'@ x +'@ I %)!(
days
&,+@@
%;@ x %<!9 days
+,(@@
$nventory
#urnover
5ost of sales
verage stock
+,%@@ I ( times
&@@
+,'@@ I <!9@ times
&(@
+,+@@ I 9!9 times
'@@
#otal
debtAequity
#otal debt
.quity
(+@ I )!+( times
)@@ G 9@@
;)@ I )!&@ times
)@@ G 99@
)@&9 I )!') times
)@@ G 99@
/et profit
margin
/et profits x )@@
#otal ssets
+@@ x )@@ I <!9F
&@@@
%@@ x )@@ I &!'F
&+@@
)@@ x )@@ I %!'F
+(@@
3,# /et 7rofits x )@@
#otal assets
+@@ x )@@ I %)F
)&+@
%@@ x )@@ I )+F
)9'@
)@@ x )@@ I 9!;F
),';9
/*: #otal debt I 5urrent liabilities G long term debt!
bC 2iquidity 7osition
" #his is shown by acid test ratio
" #he ratio has fluctuated over the years between @!&@ and @!&'
" #his could be due to high level of inventories and increasing debtors
" #he firmDs ability to meet short term financial obligations is declining over time!
7rofitability position
" #his is shown by net profit margin and 3,# ratios
" *oth ratios are declining over time
" #his is particularly due to high operating and cost of sales expenses which are
increasing over time leading to low net profits! dditional sales of the firm are
declining!
" #he firm needs to control its costs of sales and operating expenses!
6earing position
" #his is shown by total debtAequity ratio
" #his ratio is increasing over time due to increasing accounts payable and accruals
while equity remains fairly constant!
" #he firm is thus relying more on short term financing Baggressive financing
approachC increasing financial risk and possibility of bankruptcy!
!.S&NESS *&NANCE
5:7 ,e2ision Aid
J.EST&ON *O.,
aC t initial stages of debt capital the W55 will be declining upto a point where the
W55 will be minimal! #his is because!
iC debt capital provides tax shield to the firm and after tax cost of debt is low!
iiC #he cost of debt is naturally low because it is contractually fixed and certain!
*eyond the optimal gearing level, W55 will start increasing as cost of debt increases
due to high financial risk!
bC iC 5ost of equity
0e I
g
P
g d
+
+
@
@
C ) B
d@B)GgC I Sh!%!&@
7@ I Sh!'@
g I )@F
0e I F )& )& ! @ )@ ! @
'@
&@ ! %
+
5ost of debt capital B0dC
Since the debenture has )@@ years maturity period then 0d I yield to maturity I
redemption!
0d I
CR B
)
C B C ) B
vd (
n
vd ( T Int
+
+
m I -aturityApar value I Sh!)9@
vd I market value I Sh!)@@
n I number of years to maturity I )@@
$nt I $nterest I 'F x Sh!)9@ I Sh!; p!a!
# I #ax rate I +@F
0d I
)@@
)%9
( ! '
CR )@@ )9@ B
)@@
)
C )@@ )9@ B C + ! @ ) B ;
x
+
+
I 9!&&)F
5ost of preference share capital 0p
0p I 5oupon rate I )@F since -7S I par value
Lesson Ten 5::
iiC W55 or overall cost of capital 0o
Sh!D-D
-!: of equity I '@@,@@@ shares x Sh!'@ -7S +'
-!: of debt I &@,@@@ debentures x Sh!)@@ &
-!: of preference shares I %@@,@@@ shares x Sh!%@ &
&&
0e I )&F 0d I 9!&&F 0p I )@F
0o I W55 I

,
_
+
,
_
+
,
_
&&
&
F )@
&&
&
F && ! 9
&&
+'
F )&
I )%!('F
#he Sh!)@- will be raised as follows:
Sh!' - from debt
Sh!& - from shares!
Since there are no floatation costs involved then:
-arginal cost of debt I 9!&&F
-arginal cost of ordinary share capital I )&F
#herefore marginal cost of capital I
,
_
+
,
_
)@
'
F 99 ! 9
)@
&
F )&
I (!('F
J.EST&ON *&/E
aC #he tax incentives to encourage investments in capital markets are:
" 5apital gains are tax exempt
" /ew quoted firm with effect from )
st
Nanuary %@@+ will have a lower corporate
tax rate of %9F p!a! for the first 9 years of quotation!
" :enture capital firms en=oy a ten year tax holiday
" #he withholding tax on dividends is only 9F which is final tax
" 4loatation costs of newly quoted firms and tax allowable expenses
" #he transfer of securities is exempted from stamp duty and :#
" $ncome of collective investment scheme is tax free!
bC #he benefits that en=oyed by investors due to existence of organi>ed security exchanges
e!g /airobi Stock -arket are:
" #he firms are able to issue new shares and raise capital easily!
" #he exchange is a vehicle of mobili>ing savings in the economy!
" Since investors can buy new shares, this enable them to diversify their
investments and reduce risk
!.S&NESS *&NANCE
5:; ,e2ision Aid
" $t is a means through which foreign direct investment B4,$C can flow into the
economy!
" $nvestors are able to know the price of their securities as determined by demand
and supply forces in the stock exchange!
" Since investors cannot buy or sell shares themselves, they interact with
stockbrokers and get investment advice!
cC #he benefits of central depository system B51SC to the:
iC 6overnment:
" #here will be greater mobili>ation of savings in the economy
" $t is a convenient way for 4,$
" $t reduces the cost of capital since transaction costs are significantly
reduced!
iiC 5apital -arket uthority and /S.
" $ncreased share turnover
" $ncreased stock market liquidity
" $mproved transparency of stock market
" *etter service delivery
iiiC $nvestors
" 3educed share transfer costs
" 4aster and more efficient settlement of deals
" $nvestments become more liquid
" 3educed share certificate is required BdematerialisationC
Lesson Ten 5:9
J.EST&ON S&3
aC 4inancial $ntermediaries
" #hese are financial institutions which linkAintermediate between the surplus
economic units BsaversC and deficit economic units BborrowersC
" #hey can be either money market intermediaries e!g! commercial banks or capital
markets intermediaries e!g stock market
" #hey play the following roles:
#hey link the lenders and borrowers
#hey collect savings themselves and channel them to viable investments
#hey create liquidity of securities
#hey parcel up small savings from small scale savers and lend in form of bid
loans!
bC #he obstacles to 41$ are:
" 2ack of adequate legal framework and legislations
" $nadequate human resource capital
" 7olitical instability and general insecurity
" 5orruption and cases of bad governance!
" $nadequate tax and economic incentives
" Underdeveloped capital markets and financial system!
" High cost of capital due to relatively high interest rates and inflation rates!
" Unstable exchange rates which increases the cost of managing foreign exchange
risk!
DECEM!E, 5II4
J.EST&ON ONE
aC company is said to be quoted when its shares are traded on an organi>ed stock
exchange! #he advantages of being quoted are:
" $t is easier to obtain additional capital by issuing new shares!
" #he price of a share can be easily determined through demand and supply forces!
" #he ownership of the firm is spread among many shareholders creating stability
of
share prices!
" $t becomes very easy to transfer ownership from shares! #his is because no
authority is required from the firmDs shareholders!
" #he buying and selling activities creates liquidity and marketability of the share!
" #he acquisition of other firm or mergers with other firms becomes easy
especially
when there is a share for share exchange!
" 6reater prominent status and better credit standing is given to quoted firms thus
creating goodwill for the firm!
#he disadvantages of being quoted are:
!.S&NESS *&NANCE
5;I ,e2ision Aid
" $t involves high floatation costs
" #he firm has to adhere to stringent stock exchange rules and regulations
" Stringent disclosure requirement thus public scrutiny and lack of privacy
" .xtra administrative burdens on the management due to the need to comply with
so
many regulatory authorities!
" #here is dilution in ownership and control from wide holding of shares!
bC iC 4loor brokers
" #hese are agents of investors who buy and sell securities on behalf of the
investors!
" #hey earn a commission for services rendered to the client!
" #hey deal with market makers who usually have the shares which stock
brokers want to buy for client!
iiC -arket makers
" Stock market dealers holding securities of selected firms! #hey thus
Jmake
a marketK for the firmDs shares!
" #hey are members of the stock market and will usually announce the
shares
they have and the price at which they are willing to sell them!
" #hey buy shares of new firms and sell them to stockbrokers thus making
profits which is the difference between buying price and selling price!
iiiC Underwriter
" #his is a financial intermediary Busually an investment bankerC who
performs the following functions!
*uying the shares not subscribed for by the public thus performs an
insurance function to ensure that the firm is able to raise targeted profits
from issue of all the shares!
-ight help in pricing of new security issues!
cC iC *ear and *ull market
" *ull market is a stock market characteri>ed by increase in share prices
whereby marginal increase in share prices is higher than marginal
declines in share prices!
" *ear market is characteri>ed by general decline in share prices! #he
marginal share price declines are higher than marginal share price
increases!
iiC *id E as spread
#his is the difference between the offer and the buying price of a share!
iiiC Short selling
Lesson Ten 5;4
" #his is selling a share when prices are high believing that they will
decline Bbear marketC thus be bought again at a lower price!
" #he seller usually JborrowK such a share, deliver it to the client and on
purchase of the share at a lower price, it is returned to the JlenderK
!.S&NESS *&NANCE
5;5 ,e2ision Aid
J.EST&ON TWO
aC iC Weaknesses of *aumol -odel
#he weaknesses of the *aumol B.,?C model are inherent in its assumptions which
are:
" #he annual cash requirement is known and constant
" #ransactionA#ransfer or conversion costs are known ad fixed!
" #he firm has a steady cash inflow and outflow!
" #he interest rate on short term marketable securities remain constant over cash planning
period!
*aumol model is a deterministic model which assumes certainty of parameters of the models!
ii# Alternati2e 4
1etermine the total cost of holding cash under this alternative!
V 2ost interest income I )%F x )9@m x R I ;,@@@,@@@
V ,ptimal cash balance,
"
TC
C
%
# I )9@m
5 I Sh!)9,@@@
i I )%F I @!)%
)% ! @
@@@ , )9 @@@ , @@ , )9@ % x x
C I ',)%+,<%&
V /umbers of conversion p!a! I
<%& , )%+ , '
@@@ , @@@ , )9@
C
T
I %&!9 I %9
V #otal conversion cost I b
C
T
I %9 x )9,@@@ I +<9,@@@
V $nterest income on short term deposit
I R5id
I R x ',)%+,<%& x <F I %)&,++@
Where id I interest rate on short term deposits!
Summary
2ost income ;,@@@,@@@
5onversion cost +<9,@@@
2ess interest income B%)&,++@C
/et cost ;,)'@,'<@
Lesson Ten 5;@
Alternati2e &&
$nterest paid )9@m x )(F %<,@@@,@@@
2ess interest received I )9@m x ;F B)+,9@@,@@@C
dd arrangement fees 9@,@@@
#otal cost )+,99@,@@@
3ecommendation: #he policy of selling short term securities results in lower cost thus preferable!
bC 2ynx Services
iC #he firm should use the -iller",rr model which is a stochastic model!
,ptimal cash balance, Q I L
"
b
+
+
%
&
+
b I 5onversion costs I Sh!)%@
e` I 1aily variance of cash flows I BSh!%%,<9@C`
2 I 2ower cash balance I Sh!(<,9@@
i I 1aily interest rate on short term marketable
securities I
days +'@
@;)'9 ! @
I @!@@@%9&'
Q I 9@@ , (<
@@@%9&' ! @ &
C` <9@ , %% B )%@ +
+
+
x
x x
I 9',<<@ G (<,9@@ I Sh!)&&,%<@
iiC Upper 2imit H I +Q E %2
I B+ x )&&,%<@C E B% x (<,9@@C I %9<,()@
iiiC 2ower limit: #his is given in the question as Sh!(<,9@@
iiiC 1ecision rate:
V $f the cash balance increases from optional balance Q to upper limit H, buy short term
marketable securities worth H E Q i!e %9<,()@ E )&&,%<@ I ))+,9&@! #he returns to balance Q!
V $f the cash balance declines to lower limit 2, sell short term marketable securities equal to
Q E 2 i!e! Sh!)&&,%<@ E (<,9@@ I 9',<<@!
V #he firm should hold a cash balance with a spread between H and 2 BH E 2C i!e! %9<,()@
E (<,9@@ I )<@,+)@!
!.S&NESS *&NANCE
5;6 ,e2ision Aid
J.EST&ON T-,EE
aC iC " 1etermine the increamental initial capital at year @
ShD@@@D
7urchase cost E new machine )@@,@@@
2ess proceeds from sale of + machines i!e!
Sh!),@@@,@@@ x + machines B+,@@@C
2ess savings in overhaul cost Bin p!vC B9,@@@C
$ncreamental initial capital ;%,@@@
" $ncreamental salvage value at end of year )@
sale of new machine! &,9@@
2ess sale of + machines S Sh!'@@,@@@ E foregone B),(@@C
%,<@@
" 1erivation of annual cash flows!
#he cash flows are equal to annual savings in operating costs! Since tax is ignored, increamental
depreciation Bnon"cash itemsC is irrelevant since there is no tax shield! #he annual cash savings
are as follows:
/ew
machine
+ existing machines /et
savings
3aw sugar cane
2abour
:ariable expenses
-aintenance
4ixed factory
overheads
)'%,@@@
+,;@@
%,%<9
&,9@@
'@,@@@ x + I )(@,@@@
),+9; x + I &,@9@
;%9 x + I %,<<9
%,@@@ x + I ',@@@
))%,<@@ x + I
(,)@@
)(,@@@
)9@
9@@
),9@@
+@@
.*# I .# 5ash flows p!a!
/7: analysis S)@F and %@F
%@,&9@
8ear 5! 4lows 7:S)@F,n 7!: 7:4S%@F,n 7!:
@
) E )@ p!a
)@
/7:
B;%,@@@C
%@,&9@
%,<@@
)!@@@
'!)&9
@!+('
BGveC
B;%,@@@C
)%9,''9!%9
),@&%!&9
+&,<@<!&9
)!@@@
&!);%
@!)'%
B"veC
B;%,@@@C
(9,<%'!&
&+<!&
B 9,(+'!%C
iiC $!3!3
/!7!: S )@F I +&,<@<!&9
/!7!: S %@F I "9,(+'!%
Lesson Ten 5;8
$!3!3! I
I
iiiC #he firm should replace the existing + machines with a new one since the /7: is positive
and $33 U )@F cost of capital!
bC 4inancial viability test
#his means that the payback should not exceed 9 years in case of annuities,
payback period I $nitial capital
nnual cA4lows
I ;%,@@@
%@,&9@
I &!9 years
#he pro=ect thus meets financial viability test
cC ,ther qualitative factors
#he need for training of staff to use the new machine
7ossibility of breackdown of the single machine which would halt the operations with + existing
machines, if one breaks down, production would still continue with the other two!
#echnological changes affecting the new machine
.ffects on staff morale due to laying off of some employees!
vailability of spare parts for the new machine
3iskness of the replacement decisions!
!.S&NESS *&NANCE
( ) )@F %@F
9,(+'!%
+&,<@<!&9
+&,<@<!&9
)@F
+
( ) )(!9'F )@F
&@,9&+!'9
+&,<@<!&9
)@F +
,
_
5;7 ,e2ision Aid

J.EST&ON *O.,
3atio 4ormula );;; %@@@ %@@) $ndustrial
norms
L C
Sto*% ! C
!
!
L C
! C
!
!
5ost of Sales
v! Stock Bclosing
stockC
+'9 x closing
debtors
5redit sales
SalesYYY
4ixed ssets
SalesYYY
#otal ssets
/et income x )@@
.quity
/et income x )@@
Sales
-7S
.7S
4ixed 5harge
5apital
.quity
);&,)<@"
;('@@
&;;%@
I ),;)&
);&,)<@
&;,;%@
I +,(;@
''),'@@
;(,'@@
I '!<)@ times
+'9 x (@+%@
(%<,@@@
I +9!&9
I +9 days
(%<,@@@
<+,;9@
I ))!)(+ times
(%<,@@@
%'(,)%@
I +!@( times
+(,%@@x)@@

))9,@@@G&%+9
@
I %&!+F
+(,%@@x)@@
(%<@@@
I &!'F
&(!;@
(!+@
I 9!(;
I 9!; times
'@,(9(
x)@@
))9@@@G&%+9
@
I+(!'<F
%')@@@E
)9((@@
)@<!<'@
I @!;&(
%'),@@@
)@<,<'@
I %!&%%
<)@,@@@
)9(,(@@
I &!&<)times
+'9 x (<,(@@
(9(,@@@
I +<!+9
I +< days
(9(,@@@
(%,%@@
I )@!&+(
times
(9(,@@@
+&+!%
I %!9 times
%9,%(%x)@@

))9@@@G9;9(
%
I )&!9F
%9,%(%x)@@
(9(@@@
I %!;9F
%9!9@
9!9@
I &!' times
'@,(9(
x)@@
))9@@@G9;9(
%
I+&!('F
+;'&@@"
%9&@@@
%@(,(&(
I @!'(%
+;',&@@
%@(,(&(
I )!(;( I %
<)%,@@@
%9&,@@@
I %!(@+ times
+'9 x )+&,&@@
(;@,@@@
I +<!+9
I 99 days
(;@,@@@
<%
I )%!+' times
(;@,@@@
&'(!&
I )!;@ times
)9,@@@x)@@

))9@@@G'((+
%
I (!%F
)9,@@@x)@@
(;@,@@@
I )!';F
)+!%9
+!%'
I &!@' times
(),<%@
x)@@
))9@@@G'((%
@
I&&!&9F
I )!@
I %!<
I <!@ times
I +% days
I )+!@ times
I %!' times
I )(F
I +!9F
I ' times
I 9@F
Lesson Ten 5;:
bC iC #rend in the firm rates analysis
" #his will indicate the performance of the firm over time i!e years );;;, %@@@
H %@@)! #his will be summarised as follows:
Li>uidation +osition
" #his is shown by quick and current ratio
" #he ratios are declining over time
" #his is due to poor working capital management policy as shown by
high increase in current liability of the years!
" #he firmDs ability to meet its short term financial obligation is
declining over time
+ro'ita?ility <osition
" #his is shown by return on equity and net profit margin
" *oth ratios are declining over time
" #his could be attributed in decline in net income due to persistent
increase in operating expenses but in particular the interest expenses!
" #he firmDs ability to control financing expenses is declining over time!
#his is shown by high interest charges caused by high gearing especially
in year %@@)!
Turno2er ,atio +osition
" #his is shown by inventory turnover, fixed assets, and total assets,
turnover plus average collection period!
" part from fixed assets turnover which slightly increased in year %@@)
all the others are declining over time!
" #his is due to low turnover of stock as shown by increase in industry and
the general increase in total assets!
" #his implies that, the firm is not efficient utilising the assets to
generate sales revenue e!g increase in average collection period reduces
inventory turnover thus insignificant increase in sales! dditional, the
firm may be having idle assets which may be fully depreciated or may be
it is not operating at full capacity!
iiC 5omparison with industry average:
" #his will involve industrial analysis which is carried out only at one point in time!
#herefore the performance of *5 2td! is compared with industrial norms on average for
year %@@) only!
Li>uidity <osition
" Shown by quick and current ratios
" 4or year %@@) both ratios are lower than industrial norms
!.S&NESS *&NANCE
5;; ,e2ision Aid
" #his is due to poor policy of capital management
" #he firmDs ability to meet its short term financial obligation is on
average lower than that of other firms in the marketAindustry!
+ro'ita?ility <osition
" Shown by 3!,!. and net profit margin ratio
" 4or year %@@), both ratios are lower than industrial norms
" #his is due to low net income specifically due to high interest
charges in year %@@)!
" #he firm to control its gearing level and financingAinterest
expenses is lower than that of other firms in industry!
Turno2er ratio <osition
" #his is shown by inventory, fixed assets and total assets turnover ratio plus average
debtors collection period!
" 4or year %@@) all the ratios are worse than industrial norms!
" #his could be due to high level of total assets or where the assets are under"utilised!
" ,n average, the efficiency with which the firm utilised its assets to
generate sales revenue for year %@@) was for much lower than industrial norms!
J.EST&ON *&/E
aC $n deciding whether to go for short"term or long term finance, the following factors
should be considered:
5ost of finance e!g a decline in interest rates are expected to decline, use short term funding now
and replace it with long term funds in future!
vailability of securityAcollateral e!g it is easier to raise short term funds where no collateral may
be requested by the lender!
-atching e!g! a )@ year asset would be fixed with a )@ year loan while a six month cash shortfall
would be financed with six month bank overdraft!
vailability of capital E e!g lenders may be willing to lend long term depending on their
expectations on inflation rate!
2iquidity of the firm e!g if the liquidity ratio is low, it may not be possible to obtain further
finance without causing concern to creditors!
4lexibility E short term loans are more flexible because the firm can react to changes in interest
rate unlike long term loans where the firm is locked in long term fixed interest payment
commitments!
3estrictive terms are conditions e!g long term loans may have restrictive covenants making them
less attracting!
Lesson Ten 5;9
J.EST&ON S&3
aC #he actions by management and shareholders which could be harmful to the bondholders
Bsources of conflictC are:
1isposal of assets used as a collateralAsecurity for the loan term bondholders!
sset substitution i!e! substitution agreed low risk pro=ect with a high risk pro=ect which sub=ect
the bondholders to more risk!
*orrowing additional debt capital E such debt may take a priority charge on asset on liquidation
of the firm!
7ayment of high dividends thus all pro=ects with positive /7: would not be taken and value of
the firm is not maximi>ed!
Under investment E a borrowing firm may have the incentive to re=ect pro=ects with a positive
/7: if the benefit from accepting the pro=ect will substantially accrue to bondholders!
bC #he restrictive bond covenants includes:
3estriction on investment E the bondholders direct the type of pro=ect to be undertaken to avoid
cases of asset substitution!
3estriction on disposal of assets unless with explicit permission from lenders!
3estrictions on mergers and acquisitions which may affect the value of bonds!
5ovenants restricting issue of new debentures to raise additional debt!
3estrictions specifying the liquidity level working capital to be maintained!
3estrictions on the payment of dividends
*ond requirements e!g purchase of insurance by managers and specification of accounting
technique used by the borrower!
5ovenants to modify pattern of pay off to bondholder e!g sinking funds creation, convert the
bondsAdebentures into ordinary shares, retireAcall the bond before maturity date etc!
MA0 5II5
J.EST&ON ONE
!.S&NESS *&NANCE
59I ,e2ision Aid
aC iC #he book value of a security is the shilling amount recorded on the firmDs
balance
sheet! #he book value is a poor indication of the value of a stock for at least three reasons:"
$t is historical in nature rather than future orientated
5omparability of reported book values between companies is a significant problem
*ook values reflect solely the original shilling amount investment made by a security holder!
iiC 3eplacement value represents a securityDs claim to the current reproduction value of the
firmDs assets 3eplacement :alue has two ma=or drawbacks!
3eplacement value is difficult to determine
stock bears an economic value to the extent that future cash flows are expected! #hese cash
flows might be totally unrelated to the assetDs replacement value!
iiiC Substitution value reflects the value of a security when compared with that of substitute
securities! #here are % problems with using substitution value!
$t neglects any economiesAdiseconomies of scale that might arise when products and * are
produced together as opposed to separately
7ractical problem of identifying comparable firms!
ivC $ntrinsic value relates value to future payouts from the securityO the price is determined
by the estimated payoffs rather than resale value!
bC iC 1ividend 8ield:
#his provides a method of comparison between the performance of dividend companies!
0irinyaga :ideo 2imited ( I 9F
)'@
0ilgoris Hauliers 2imited ; I +!++F
%<@
lthough 0H2 pays a higher dividend than 0:2 the later is preferred since the dividend yield is
higher!
7riceA.arnings ratio:
#his measures the absolute level of earnings to the market price of shares!
0irinyaga :ideo 2imited
(
)'@
I %@ yrsAtimes
0ilgoris Hauliers 2imited ErrorR Not a 2alid em?edded o?Eect( I )9 yrsAtimes
0:2 is more attractive than 0H2!
Di2idend Co2er
7rovides an indication of the probable ability of the company to sustain the current level of
dividend payments! very low level of dividend cover suggests that dividends may be more
Lesson Ten 594
volatile! $n general the higher the retentions the more likely there is to be a good level of capital
appreciation!
0irinyaga :ideo 2imited
(
(
I ) time
0ilgoris Hauliers 2imited
;
)(
I % times
0H2 has more potential for capital growth than 0:2 since the later pays almost all its earnings
in the form of dividends and retains little for investment in income generating pro=ects!
1ividend in );;< x B) G gC
&
I 1ividend in %@@)
B) G gC
&
I 9!9A+
( )
&
(+ ! ) ) + g
g I )'!+'F
-: I
,
_
+
)'+' ! @ % ! @
)'+' ! @ )
9 ! 9
-: I )<9!()('9
-arket value of )@@@ shares is Sh!)<9,();!
J.EST&ON TWO
aC iC .,? I
ost ha txun"tpur* Carry"ng
t der"ng xde(andxor
sec cos
cos %
*efore re"organisation I
%9 % ! @
@@@ , )@ @@@ , &@@ %
x
x x
.,? I &@,@@@ units
fter re"organisation I
%9 % ! @
9@@ , % @@@ , &@@ %
x
x x
.,? I %@,@@@ units
iiC $mplementation of the new system will affect both total ordering costs per annum and
stockholding cost under the existing system these costs are as follows:
@@@ , &@
@@@ , &@@
I )@
Ordering cost I /umber of orders per year
5ost per order I Sh!)@,@@@ per order
!.S&NESS *&NANCE
595 ,e2ision Aid
5osts per annum I )@,@@@ x )@ I )@@,@@@
Carrying cost I verage stock is %@,@@@
5ost is %@,@@@ x %9 x %@F I )@@,@@@
#otal costs I )@@,@@@ G )@@,@@@ I %@@,@@@
Under the proposed scheme the costs would become:"
,rdering costs: /umber of orders I
@@@ , %@
@@@ , &@@
I %@
5ost per order is Sh!%,9@@
#herefore total ordering cost I %@ x %,9@@ I Sh!9@,@@@
Carrying costs " verage stock is )@,@@@ units! #hus total carrying cost is:
" )@,@@@ x %9 x %@F I Sh!9@,@@@
#otal costs I Sh!)@@,@@@
#he annual tax saving is therefore B%@@,@@@ E )@@,@@@C I )@@,@@@
#his will give rise to an after tax cash flow of \)@@,@@@ x B)"@!+%9C] I Sh!'<,9@@
1iscounting the cash flows at )(F
8ear @\)&@,@@@ x B) E @!+%9C] x )!@ I ;&,9@@
8ear ) E ( B'<,9@@ x &!@<(C I %<9,%'9
/7: or re"organisation I )(@,<'9

bC N$# represents a complete management philosophy and is more than =ust a collection of
techniques! $t aims to manufacture to order for each customer and to eliminate idle resources in
all areas of the company! $t is a technique which enables management to order and buy what it
requires at that particular point in time!
$n terms of purchasing, a N$# system aims to ensure that components are delivered =ust
immediately prior to the need to use then in the production process! $t therefore requires a close
relationship to be built up between customer and supplier, the later being required to deliver
quality assured components to match production schedules! Suppliers in turn should benefit it
from fair long"term sales as the purchaser reduces its number of sources! #his should allow the
supplier to achieve scale economies and improved production planning! #he customer should
achieve a reduction in ordering costs and in stock levels and associated carrying costs!
J.EST&ON T-,EE
aC $tem directly varying with sales I F of %@@) sales
/et fixed assets I
)@@
@@@ , %&@
(@@ , )%&
x
I 9%F
Stock I
)@@
@@@ , %&@
&@@ , +(
x
I )'F
Lesson Ten 59@
1ebtors I
)@@
@@@ , %&@
%((@@
x
I )%F
5ash I
)@@
@@@ , %&@
%@@ , <
x
I +F
(+F
#rade 5reditor I
)@@
@@@ , %&
@@@ , +'
x
I )9F
ccrued expenses I
)@@
@@@ , %&@
@@@ , %&
x
I )@F
%9F
8ear %@@% sales I %&@,@@@,@@@ x )!)9 I %<',@@@,@@@
8ear %@@+ sales I %<,'@@,@@@ x )!%@ I ++)!%@@!@@@
#otal increase in sales I ++),%@@,@@@ E %&@,@@@,@@@ I B%%,(@@,@@@C
$ncrease in total assets I (+F x ;),%@@,@@@ I <9,';',@@@
2ess: increase in current liabilities I %9F x ;),%@@,@@@ I B%%,(@@,@@@C
2ess: retained earnings:
8ear %@@% /et 7rofit I (F x %<',@@@,@@@ I %%,@(@,@@@
2ess: (@F dividends I B)<,''&,@@@C B &,&)',@@@C
3etained earnings:
8ear %@@+ /et 7rofit I (F x ++),%@@,@@@ I %',&;',@@@
2ess: (@F dividends I B%),);',(@@C
3etained earnings B 9,%;;,%@@C
.xternal financial needs Bcommercial paperC &+,)(@,@@@
bC iC +roA'orma !alance S%eet as at @4 Decem?er 5II@
/et fixed assets
Stock
1ebtors
5ash
9%F x ++),%@@,@@@
)'F x ++),%@@,@@@
)%F x ++),%@@,@@@
+F x ++),%@@,@@@
)<%,%%&,@@@
9%,;;%,@@@
+;,<&&,@@@
;,;+',@@@
%<&,(;',@@@
*inanced ?y=
3etained earnings +9,%@@,@@@ G &,&)',@@@ G
9,%;;,%@@
)%F long term debt
#rade 5reditors )9F x ++),%@@,@@@
ccrued expenses )@F x ++),%@@,@@@
5ommercial paper
(&,@@@,@@@
&&,;)9,%@@
%@,@@@,@@@
&;,'(@,@@@
++,)%@,@@@
&+,)(@,(@@
%<&,(;',@@@
iiC /o change in value of money BinflationC during the forecasting period!
!.S&NESS *&NANCE
596 ,e2ision Aid
Lesson Ten 598
J.EST&ON *O.,
aC 5ost of equity BkeC I
( )
g
P
g d
+
+
@
@
)
I @< ! @
9@
9@ ! '
+
I %@F
bC +roEect 3
8ear 5ash flows +/&*5IK)n 7!:
)
%
+
&
9
'
<
%,@@@,@@@
%,%@@,@@@
%,@(@,@@@
%,%&@,@@@
%,<'@,@@@
+,%@@,@@@
+,'@@,@@@
#otal 7!:
/!7!:! BGveC
@!(++
@!';&
@!9<;
@!&(%
@!&@%
@!++9
@!%<;
),''',@@@
),9%',(@@
),%@&,+%@
),@<;,'(@
),)@;,9%@
),@<%,@@@
),@@&,&@@
(,''%,<%@
B(,@@@,@@@C
''%,<%@
+roEect 0
8ear 5ash flows +/&*5IK)n 7!:
)
%
+
&
&,@@@,@@@
+,%@@,@@@
&,(@@,@@@
(@@,@@@
@!(++
@!';&
@!9<;
@!&(%
+,++%,@@@
%,@(%,@@@
%,<<;,%@@
+(9,'@@
(,9<(,(@@
B(,@@@,@@@C
9<(,@@@
cC +roEect 3
/!7!: S %&F I "+@@,%<'
/!7!: S %@F I ''%,<%@
$!3!3! I %@F G
FC %@ F %& B
)%@ , %;' <%@ , ''%
<%@ , ''%
+
I %@F G %!( I %%!(F
+roEect 0
/!7!: S %9F I ";&,&@@
/!7!: S %@F I 9<(,@@@
!.S&NESS *&NANCE
597 ,e2ision Aid
$!3!3 I %@F G
( ) F %@ F %9
&@@ , ;& @@@ , 9<(
@@@ , 9<(
,
_
+
%@G &!+ I %&!+F
dC " /!7!: method ranks pro=ect P as number one
" $!3!3 method ranks pro=ect 8 as number one
" #here is conflict in ranking of mutually exclusive pro=ects!
eC 5onflict between /!7!: and $!3!3
" $n case of difference in economic lives of pro=ects
" $n case of difference in si>e of the pro=ects
" $n case of difference in timing of cash flow
" $n case of non"conventional cash flows!
J.EST&ON *&/E
aC J5apital flightK is the smuggling of funds from a country through usually unofficial
channels overseas! $t is commonly found in economies that have foreign exchange
control laws BregulationsC where investments move from home country seeking higher
returns in other countries!
bC " 7olitical instability E -any members of the ruling elite unsure about their fate
should their regimes be overthrown E thus transfer wealth to more stable
countries!
" 2ower rate of return in home country
" Higher taxation of companies and individuals
" rtificially high local currency value encourages capital flight as those involved
reali>e much higher values of hard currencies on exchange!
" 7oor infrastructure
" 1ue to high levels of corruption among the ruling elite E they want to keep their
wealth out of reach of their local fellow citi>ens who would raise questions on
how wealth was created!
" High inflation rate
" 2egal framework e!g fiscal policies!
cC -assive capital flight forces a country to devalue local currency as they often have to run
to the multilateral finance institutions like World *ank and $-4 for salvation of the very
constantly worsening *alance of 7ayment problem!
J.EST&ON S&3
aC iC Matc%ing
#he traditional view is that fixed assets should be financed by long term sources of
finance and current assets by a mixture of long"term and short term sources!
iiC Cost E #he company may find it easier to raise short"term finance with low security than
long"term finance!
Lesson Ten 59:
iiiC Security E #he company may find it easier to raise short"term finance with low security
than long"term finance!
,isk E $n opting for short"term debt, the company faces the risk that it may not be able to
renegotiate the loan on such good terms! 2ong"term loans are thus less risky!
*lei?ility E Short"term debt is more flexible since it allows the firm to react to interest rate
charges and avoid being locked into an expensive long"term fixed rule commitment when rates
are falling!
bC !ene'its o' a rig%ts issue to Malindi Leisure &ndustries=
#he company is highly geared as rights issue would reduce the level of gearing and reduce in the
level of financial risk!!
$f the issue is successful it will not significantly change the voting structure!
$f underwriters are raised then the amount of finance that will be raised in known and guaranteed!
$f the market is high, -alindi 2eisure $ndustries should be able to achieve a rights issue at a
relatively low cost since less shares will be issued! B2ower floatation costsC
2ess administrative procedures e!g no need for prospectus!
Draw?acks o' rig%ts issue
#he issue will need to be priced at a discount to the current share price in order to make it
attractive to investors! #hus will result in a diluter in earnings and a fall in share price!
$f the issue is not successful, a significant number of shares may be taken by underwriters thus
changing the voting structure!
dministration and underwriting costs are high!
Shareholders may be unable or unwilling to increase their investment in -alindi 2eisure
$ndustries!
cC Ad2antages o' leasing
/o risk of obsolescence in the lessee
2easing does not require a down payment to be made at the start of the contract unlike hire
purchase! B/o heavy initial capital outlay requiredC!
2ease finance can be arranged relatively, cheaply, quickly and easily!
2easing premiums are allowable against tax
,perating leases are off"balance sheet financing
Ad2antages o' %ire <urc%ase
Unlike leasing, hire purchase allows the user of the asset to obtain ownership at the end of the
agreement period!
#he interest element of the payments is allowable against tax!
#ax shield on depreciation of asset
5ash inflows on salvage value at the end of economic life of asset!
!.S&NESS *&NANCE
59; ,e2ision Aid
,E/&S&ON ANSWE,S
J.EST&ON ONE
aC 3atios
5urrent ratio I 5urrent ssets t"(es (( ! )
('@ (&@
@(@ , % '&@ &(@
+
+ +
%!9
times
5urrent liability
cid test ratio I 5urrent ssets E stock
t"(es '' ! @
('@ (&@
'&@ &(@
+
+
)!)
times
5urrent 2iabilities
Stock turnover ratio I 5ost of sales
t"(es <+ ! )
@@@ , @(@ , %
@@@ , '@@ , +
%!&
times
verage stock
#otal assets turnover I Sales
t"(es %9 ! )
@@@ , (@@ , &
@@@ , @@@ , '
)!&
times
#otal assets
#imes interest earned ratio:
I ,perating profit B.*$#C
t"(es (; ! %
'@@ , %+9
'@@ , %+9 &@@ , &&&
+
+!9
times
$nterest expenses
/et profit margin I /et profit B.#C
F && ! &
@@@ , @@@ , '
'&@ , %''
&F
Sales
Lesson Ten 599
3eturn on investment I .#
F 9' ! 9
@@@ , (@@ , &
'&@ , %''
9!'F
#otal investment
#otal assets to shareholders equity:
I #otal assets
t"(es % ! +
@@@ , 9@@ , )
@@@ , (@@ , &
+!@
times
SAH equity
3eturn on shareholders equity:
3,S.A3eturn networth
I .# and preference div!
F <9 ! )<
@@@ , 9@@ , )
'&@ , %''
)'!(F
.quity
bC 5omment on:
iC Li>uidity
" #his is shown by current and acid test ratios
" *oth ratios are lower than the industrial average
" #his could be attributed to poor working capital management policy,
defective credit policy and increase in current liabilities
" #he firmDs ability to meet its short term maturing financial obligations is
lower than the industrial average
iiC *inancial risks
" #his is shown by the gearing ratios
" 4or 3ichardo 2imited #$.3 B#imes interest earned ratioC is the indicator
of financial risk
" #he ratio is lower than the industrial average
" #his is due to high interest charges due to use of fixed charged capital
Eam<le= #he total capital of the firm consists of long term debt and equity
both totalling to +!)-!
6earing ratio I 4ixed 5harge capital
#otal capital
I
)@@
@@@ , )@@ , +
@@@ , '@@ , )
x
I 9)!'F
#he firm is highly gearing hence the high financial risk and high interest charges!
!.S&NESS *&NANCE
@II ,e2ision Aid
iiiC O2erall <er'ormance
" #his is indicated by profitability ratios
" $n case of 3ichardo 2td! this is shown by net profit margin, 3,$ and
return on equity ratios
" #he ratios are higher than the industrial average except return on
investment which is equal to industrial average
" #he firm is generating adequate returns from its investments more than
other firms in the market!
Note
#he firm has lower liquidity ratio hence high liquidity risks! #he firm is highly
geared hence high financial risks! #he firm is therefore using borrowed capital in
order to gear up or increase its profitability or returns which are higher than the
industrial average! $t is therefore a high risk, high return firm!
Lesson Ten @I4
J.EST&ON TWO
aC iC Cor<orate ?ond
long term debt instrument issued by a company to raise long term
capital! $t pays period interest charges and promises the payment of
principal at maturity!
iiC Ad2antages o' cor<orate ?ond
aC $nterest charges are tax deductible and hence provide interest tax
shield benefit!
bC $t enables a firm to raise long term capital without the lenders
gaining ownership of the firm!
cC #he lenders do not share in extra profits once they have a fixed
rate of return!
iiiC 5osts associated with issue of corporate bonds! #hese are called
floatation costs and are incurred in floatation of any new securities!
" 5ommissionAfee paid to underwriters e!g merchant banks or
investment bankers!
" 5osts of preparing bond certificate and prospectus
" 7rofessional fee paid to financial advisors, lawyers, auditors and
accountants
" 5ommission paid to sponsoring stock brokers
" 5ost of registering the bond with 5-
" dvertising and other floatation costs!
bC iC $ssue price I 7!: of expected interest income G 7!: of redemption value
3edemption value )@,@@@ payable only at end of )@
th
year
5oupon rate )'F
$nterest p!a! I
)@@
)'
@@@ , )@ x I ),'@@AI p!a! for )@ years
1iscounting rate I market rate of time of issue I )&F
7 : of period interest B),'@@ x 7!:!!4)&F,)@C
),'@@ x 9,%)' (,+&9!'
7!: of redemption value )@,@@@ x 7!:!!4)&F,)@
)@,@@@ x @!%<@ %,<@@!@
-arket value of a bond )),@&9!'
iiC :alue of the bond will be based on the remaining maturity period!
/umber of years elapsed I % years
/umber of years remaining B)@"%C I ( years
!.S&NESS *&NANCE
@I5 ,e2ision Aid
1iscounting rate I market rate E )
st
Nune %@@) I )@F
7eriodic interest income I ),'@@ p!a! for ( years
3edemption value I )@,@@@
7: of period interest I ),'@@ x 7!:!!4)&F,(
I ),'@@ x 9!++9 (,9+'
7: of redemption value I )@,@@@ x 7!:!!4)&F,(
I )@,@@@ x @!&'< &,'<@
-arket value of a bond )+,%@'
iiiC 8.Sf #his is because the firm can borrow new debt capital at a lower
interest rate! $f the market interest rate is lower than the coupon rate, the
firm can always redeem the debt capital after carrying out a bond
refunding decision analysis i!e repay the current debt capital with high
interest capital and borrow a new debt capital at a lower interest rate!
J.EST&ON T-,EE
aC MET-OD 4= *actoring
mount of debtors I Shs!+%@,@@@
5redit period I monthly I +@ days
Step ): 5ompute amount of service fee
Service fee I xdebtors
)@@
%
I @@@ , +%@
)@@
%
x I Sh!',&@@ within credit
period
Service fee with credit period I Sh!',&@@
Service fee within one year I
,
_
&@@ , '
'@
+'@
x
I Sh!<',(@@
Step %: 5ompute amount of reserves
I
@@@ , +%@
)@@
9
x
I )',@@@
Step +: 5ompute annual interest charges
$nterest charges p!a! I $!3 B1ebtors E 3eserveC
( ) @@@ , )' @@@ , +%@
)@@
)9
x
I Shs!&9,'@@
$nterest charges p!a! I &9,'@@
Lesson Ten @I@
$nterest charges within a period I
'@@ , &9
+'@
+@
x
I Shs!+,(@@
mount to advance I 1ebtors E 3eserves E Service fee E $nterest charges
within a period within a period
MET-OD 5= +ledging
A line o' credits
bank may enter into a formal understanding or arrangement with the borrower to the effect that
the borrower will not take the lumpsum of loan!
" #he bank will create a loan account for the borrower where the amount
of loan required will be deposited!
" #his arrangement is called a line of credit!
#he borrower will be withdrawing the amount of cash heAshe requires
from the loan account as long as he does not exceed the amount agreed
with the bank and deposited with the loan account!
.very time the borrower withdraws a certain amount from the loan
account, he is said to be taking down a certain amount of money on the
line of credit! .!g! if the loan account has Sh!),@@@,@@@ and the borrower
withdraws Shs!)@@,@@@ he shall have taken down Shs!)@@,@@@ on the line
of credit!
,ften times the borrower may be required to maintain a minimum
balance in the loan account over and above what was borrowed!
#his amount should not be withdrawn but the bank will charge interest
on it! #his minimum balance is called compensating balance!
mount of loan to advance I (@F of debtors I @@@ , +%@
)@@
(@
x I
%9',@@@
2ess 'F compensating balance I
,
_
@@@ , %9'
)@@
'
x
I
B)9,+'@C
2ess interest charges p!a!
,
_
)@@
+@
@@@ , %9' x
I <',(@@
$nterest charges within +@ days I
(@@ , <'
+'@
+@
x
I
B ',&@@C
mount to advance %+&,%&@
!.S&NESS *&NANCE
@I6 ,e2ision Aid
/ote: $nterest charges will be based on total amount including
compensating balance i!e! Shs!%9',@@@!
bC 4actoring I .ffective annual interest rate
I nnual interest charges G nnual service fees x )@@F
mount advanced
I
F )@@
(@@ , %;+
(@@ , <' '@@ , &9
x
,
_
+
I &)!<F
7ledging I .ffective annual interest rate I nnual interest charges x )@@F
mount dvanced
I
F )@@
%@@ , %+&
(@@ , <'
x
,
_
I +%!(F
cC 7ledging because it is cheaper!
J.EST&ON *O.,
,ole o' Ca<ital Market Aut%ority
iC $ssue rules, regulations and procedures of trading in capital markets!
iiC 2icensing of brokers and requiring them to have a minimum base capital for
operations!
iiiC 4air trading in stock exchange to prevent cases of insider trading and ensure
prices are determined by demand and supply mechanism on information supplied
in the market!
ivC $t operates compensation fund to indemnify an investor incase a broker fails to
fulfill his contractual financial obligations!
vC $mplementing government policies to ensure development of capital market
infrastructure in 0enya!
viC 5redit awareness for investment in long term securities!
*inancial &nstrument
4inancial instruments are financial securities held by investors BlendersC in form of
financial assets! #hey indicate the amount which is owed to the lender by the borrower!
#hey can be long term and short term financial securities!
Short term securities include: 5ommercial paper, #reasury bills, /otes payable,
promissory notes, bills of exchange etc!
Lesson Ten @I8
2ong term financial instruments will include debentures, mortgages, ordinary shares,
preference shares etc!
i# Treasury ?ill
" $t is a short term financial instrument used by the 6overnment to raise
money from the market!
" $t is issued at a discount and matures at par value!
" $t has a fixed interest rate during its maturity period
" $t is a riskless investment and its interest rate is called risk free rate!
" $ts maturity period can be ;) days or )(% days!
ii# Commercial <a<er
" short term financial instrument used by financially strong and sound
firms in the market!
" Used to raise short term capital
" #hey are unsecured Bthey =ust require a guarantorC
" #hey are issued at a discount and mature at par value
" #heir maturity period varies from +@, '@, ;@, )%@, )9@, %<@ days etc!
" #hey are cheaper source of short term finance compared to bank
overdrafts and short term bank loans!
J.EST&ON *&/E
aC 6o into business
$nitial capital B%,+<9,@@@C
7!: of year ) E )9 5ash flow
I '%9,@@@ x 7:4)@F,)9
I '%9,@@@ x <!'@' I &,<9+,<9@
7: of year )' E %@ cash flow
I 9@@,@@@B7:4)@F,%@ " 7:4)@F,)9C
I 9@@,@@@B(!9)& E <!'@'C I &9&,@@@
7: of salvage value
I <9@,@@@ x 7:4)@F,%@
I <9@,@@@ x @!)&; I ))),<9@
7: of costs Bannuity dueC
8ears ) E 9 I 9@,@@@ x 7:4)@F,9BlGrC
I 9@,@@@ x +!<;< x )!) B%@(,9@9C
8ear ' E )@ I <9,@@@B7:4)@F,)@ " 7:4)@F,9CB) G rC
I <9,@@@B'!)&9 E +!<;)C)!) B);&,%@9C
8ear )) E )< I )@@,@@@B7:4)@F,)< " 7:4)@F,)@CB)GrC
I )@@,@@@B(!@%% E '!)&9C)!) B%@',&<@C
#,#2 7: %,++9,+%@
3emain in =ob!
7 : I %9@,@@@ x 7:4)@F,%@ I %9@,@@@ x (!9)& I %,)%(,9@@
!.S&NESS *&NANCE
@I7 ,e2ision Aid
1ecision: 6o into business cost of higher 7: of %@',(%@
bC ,ther factors:
" 7ossibility of salary increament
" #ax effects
" $nclusion of salary to self in the analysis
" ccuracy of cash flow estimates
" ttitude to risk
" 5ost of capital E will it be constant for %@ years
" Salvage value E how accurate is it!
MOCK E3AM&NAT&ON
To ?e carried under eamination condition and sent to t%e Distance
Learning Administrator 'or making ?y t%e .ni2ersity(
Time Allowed= @ -ours Attem<t All Juestions
J.EST&ON ONE
aC 1escribe the characteristics of long term capital investment decisions! B&
marksC
bC *5* company is a manufacturer of bricks and concrete blocks! #he company is
considering replacing part of the current manual labour force by purchasing a small
tractor with a forklift for use in loading bricks and concrete blocks! #he purchase price
would be Sh!9<@,@@@! #he tractor will have an economic life of 9 years but would
require a Sh!%@,@@@ overhaul at the end of + years! fter 9 years the tractor could be sold
for Sh!))@,@@@!
#he company estimates it will cost Sh!%9@,@@@ per year to operate the tractor! $t will,
however, save Sh!)+@,@@@ annually on labour cost! *ecause of increase in handling
efficiency, losses caused by breakages will be cut by Sh!%%@,@@@ per year! Sales will also
go up by Sh!&9@,@@@! #he new sales level is expected to be maintained throughout the
tractorDs life! ssume the companyDs gross margin ratio is &@F, corporate tax rate +@F,
and cost of capital )'F! lso assume straight"line method of depreciation!
,e>uired
1etermine the /7: of the pro=ect and state whether the tractor should be purchased! B)+
marksC
cC $dentify + circumstances under which /7: and $33 will give conflicting results for
mutually exclusive pro=ects! B+ marksC
J.EST&ON TWO
United Steel has =ust been reorgani>ed to produce industrial machinery! #he company is in the
process of establishing a financial policy and the following two alternative plans have been
suggested!
7lan P: %,@@@,@@@ ordinary shares of Sh!)@ each!
Lesson Ten @I:
Sh! )%,@@@,@@@ long term loan at )(F per annum!
7lan 8: %,9@@,@@@ ordinary shares at Sh!)@ each
Sh!<,@@@,@@@ long term loan at )(F per annum!
#he founders of United Steel have pro=ected the following .arnings *efore $nterest and
#axes B.*$#C!
Economic +%ase +ro?a?ility E!&T
Sh!D@@@D
@!% )',@@@
* @!' %(,@@@
5 @!% &@,@@@
#he companyDs marginal tax rate is &@F!
,e>uired
aC iC 5alculate the expected .arnings 7er Share B.7SC for each financial plan! B)@
marksC
iiC Which financial plan should be acceptedM WhyM B% marksC
bC 5alculate the level of .*$# where the .7S are equal for the two plans! B(
marksC
J.EST&ON T-,EE
aC What economic advantages are created by the existence of:
iC 7rimary markets B+
marksC
iiC Secondary markets B+ marksC
iiiC 7ortfolio management firms! B& marksC
bC .xplain how the 5apital -arkets uthority can ensure:
iC 4aster growth and development of the /airobi Stock .xchange or Stock
.xchange in your country! B' marksC
iiC 1evelopment of other stock exchanges in 0enya or in your country!
B& marksC
"Total= 5I marks#
J.EST&ON *O.,
aC What is meant by:
iC 5ost of equity capitalM B% marksC
iiC 5ost of preferred sharesM B% marksC
bC 7esa 2imited wishes to take advantage of the new commercial paper market now popular
in 0enya! $t wishes to issue two debenture papers! *oth bear coupons of )& percent, and
the effective yield required on each is %@ percent! 7aper has a maturity of )@ years and
!.S&NESS *&NANCE
@I; ,e2ision Aid
paper * a maturity of %@ years! *oth will be paying interest annually and Shs!)@@,@@@ at
maturity!
,e>uired
iC What is the price of each paperM B' marksC
iiC $f the effective yield on each paper rises to %& percent, what is the price of each paperM
B&
marksC
iiiC .xplain why the price of one paper falls more than the price of the other when the
effective yield rises! B%
marksC
cC .xplain the concept of weighted average cost of capital! B& marksC
"Total= 5I marks#
J.EST&ON *&/E
aC Write explanatory notes on:
iC 4lat yield and redemption yieldO B& marksC
iiC 7rice earnings rationO B% marksC
iiiC Significance of dividend cover! B+ marksC
bC #he nominal value of a companyDs share is Sh!&9 and the dividend for the year is )@F on
nominal value of the share! #he current market price of the share is Sh!;@! #he shareDs
earnings yield is )9F!
,e>uired
computation of:
iC 1ividend coverO B+ marksC
iiC .arningsO and B& marksC
iiiC 7riceA.arnings ratio B& marksC
"Total= 5I marks#
END O* MOCK E3AM&NAT&ON
NOW SEND 0O., ANSWE,S TO T-E D&STANCE
LEA,N&NG CENT,E *O, MA,K&NG
Lesson Ten @I9
!.S&NESS *&NANCE
@4I ,e2ision Aid

B.F. by S.K As at 5 May 2005

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ii Acknowledgement

-eet its obligations on time

iiC 5onversion ratio I par value of debentureApar value of share I @ ! 9

3eceive 9 ordinary shares for every ) debenture held!

Where: $nt! I $nterest charges p!a!

7resent value of an nnuity for n years is given by the formula:

7: I -inimum expenditure I Z\&,&9+]

Where: ? is the economic order quantity

Where: 3 is the reorder level

Where: 1 I %,@@@ units

dvice firms on most suitable issue price

or I +'9 x verage stock

556 ,e2ision Aid

%)' ! 9 )&+ ! <

I %%)!(9 @!'%) )+<!<<

5;7 ,e2ision Aid

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