Financial Management

FINANCIAL MANAGEMENT
PART 2
CPA SECTION 3
CCP SECTION 3
CS SECTION 3
STUDY TEXT
KASNEB JULY 2018 SYLLABUS
Revised on: January 2019

PAPER NO.8 FINANCIAL MANAGEMENT
GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will
enable him/her to apply financial management principles in practice.
8.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Analyse the sources of finance for an organisation and evaluate various financing
options
• Evaluate various investment decision scenarios available to an organisation
• Evaluate the performance of a firm using financial tools
• Make appropriate capital structure decisions for a firm
• Value financial assets and firms
• Make appropriate liquidity and dividend decisions for a firm
• Evaluate current developments in business financing strategies.
CONTENT
8.1 Overview of financial management

- Nature and scope of finance
- Finance functions
- Goals of a firm; financial and non-financial objectives, overlaps and conflicts among
the objectives
- Agency theory, stakeholder’s theory and corporate governance
- Measuring managerial performance, compensation and incentives
- Ethical issues in financial management
- Corporate social responsibility (CSR) and financial management
8.2 The financing decision

- Nature and objectives of the financing decision
- Factors to consider when making financing decisions
- Sources of finances for enterprises; internally generated funds and the externally
generated funds, long term sources, medium term and short term sources of finance
- Evaluation of financing options
- Methods of issuing ordinary shares - public issue, private placement, bonus issue,
employee stock option plans (ESOPS) and rights issues
8.3 Financial institutions and markets

- Nature and role of financial markets
- Classification of financial markets: primary and secondary securities market, money
and the capital markets, over-the counter and organised market, derivatives market,
mortgage market, forex market
- The security exchange listing and cross border listing
- Market efficiency - efficient market hypothesis
- Stock market indices
- The financial institutions and intermediaries: commercial banks, savings and loans
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associations and co-operative societies, foreign exchange bureaus, Unit trusts and
mutual funds, insurance companies and pension firms, insurance agencies and
brokerage firms, investment companies, investment banks and stock brokerage firms,
micro-finance institutions and small and medium enterprises (SMEs)
- The role of regulators in financial markets
- Central depository system and automated trading system
- Timing of investment at the securities exchange - Dow theory and Hatch system of
timing
8.4 Time-value of money

- Concept of time value of money
- Relevance of the concept of time value of money
- Time value of money versus time preference of money
- Compounding techniques
- Discounting techniques
8.5 Valuation models

- Concept of value; book value, going concern value, substitution value, replacement
value, conversion value, liquidation value, intrinsic value and market value
- Reasons for valuing financial assets/business
- Theories on valuation of financial assets; fundamental theory, technical theory,
random walk theory and the efficient market hypothesis
- Valuation of redeemable, irredeemable and convertible debentures and corporate
bonds
- Valuation of redeemable, Irredeemable and convertible preference shares
- Valuation of ordinary shares; net asset basis, price earnings ratio basis, capitalisation
of earnings basis, Gordon’s model, finite earnings growth model, Super-profit
model, Marakon model, Walter’s model, Discounted free cash flow, residual income
model
- Use of relative measures such as Economic Value added (EVA) and Market Value
Added (MVA)
- Valuation of unit trusts and mutual funds
- Valuation of private companies: income and market based approaches
8.6 Cost of capital

- Firms capital structure and factors influencing capital structure decisions
- Factors influencing firms cost of capital
- Relevance of cost of capital
- Component costs of capital
- The firm’s overall cost of capital
- Weighted average cost of capital (WACC)
- Weighted marginal cost of capital (WMCC)
- Introduction to break-points in weighted marginal cost of capital schedule
- Operating and financial leverage - degree of operating leverage and operating risk;
degree of financial leverage and financial risk
- Combined leverage - degree of combined leverage and total risk
8.7 Capital budgeting decisions

- The nature and importance of capital investment decisions
- Capital investment’s cash flows - initial cash outlay, terminal cash flows and annual
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net operating cash flows, incremental approach to cash flow estimation

- Capital investment appraisal techniques
- Non-discounted cash flow methods - payback period and accounting rate of return
- Discounted cash flow methods - net-present value, internal rate of return,
profitability index, discounted payback period and modified internal rate of return
(MIRR)
- Strengths and weaknesses of the investment appraisal techniques
- Expected relations among an investment’s NPV, company value and share price
- Capital rationing - evaluation of capital projects and determination of optimal capital
budget in situations of capital rationing for a single period rationing
- Capital investment options - timing option, strategic investment option, replacement
option and abandonment option
- Problems/difficulties encountered when making capital investment decisions in
reality
8.8 Financial analysis and forecasting

- Users of financial statements and their information needs
- Ratio analysis; nature of financial ratios, classification and calculation of financial
ratios and limitation of financial ratios
- Common size statements - Vertical and horizontal analysis
- Financial forecasting; cash budgeting and percentage of sales method of forecasting
8.9 Working capital management

- Introduction and concepts of working capital
- Working capital versus working capital management
- Factors influencing working capital requirements of a firm
- Importance and objectives of working capital management
- Working capital operating cycle; the importance and computation of the working
capital operating cycle
- Working capital financing policies aggressive, conservative and matching financing
policy
- Management of stock, cash, debtors and creditors
8.10 Dividend decision

- Forms of dividend
- How to pay dividends and when to pay dividends
- How much dividend to pay
- Firms dividend policy and factors influencing dividend decision
- Why pay dividends
- Dividend relevance theories; Bird in hand, Clientele effect, Information signaling
theory, Walter’s model, Tax differential theory, Modigliani and Miller dividend
irrelevance theory
8.11 Introduction to risk and return

- Risk-return trade off/relationship
- Distinction between risk free and risky assets
- Expected return of an asset
- Total risk of an asset
- Relative risk of an asset
- Expected return of a 2 asset-portfolio
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- The actual total risk of a 2-asset portfolio
8.12 Islamic finance
- Justification for Islamic Finance; history of Islamic finance; capitalism; halal; haram;
riba; gharar; usury
- Principles underlying Islamic finance: principle of not paying or charging interest,
principle of not investing in forbidden items such as alcohol, pork, gambling or
pornography; ethical investing; moral purchases
- The concept of interest (riba) and how returns are made by Islamic financial
securities
- Sources of finance in Islamic financing: muhabaha, sukuk, musharaka, mudaraba
- Types of Islamic financial products:- sharia-compliant products: Islamic investment
funds; takaful the Islamic version of insurance Islamic mortgage, murabahah,;
Leasing - ijara; safekeeping - Wadiah; sukuk - islamic bonds and securitisation;
sovereign - sukuk; Islamic investment funds; Joint venture - Musharaka, Islamic
banking, Islamic contracts, Islamic treasury products and hedging products, Islamic
equity funds; Islamic derivatives
- International standardisation/regulations of Islamic Finance: case for standardisation
using religious and prudential guidance, National regulators, Islamic Financial
Services Board
8.13 Emerging issues and trends
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CONTENT PAGE
Topic 1: Overview of financial management….....................................................................7

Topic 2: Financing decision.................................................................................................37
Topic 3: Financial institutions and markets…………………..............................................81
Topic 4: Time value of money............................................................................................127
Topic 5: Valuation models....................…..........................................................................141
Topic 6: Cost of capital …..................................................................................................155
Topic 7: Capital budgeting decision............................. …………………….……….…...187
Topic 8: Financial analysis and forecasting.......................................................................229
Topic 9: Working capital management...............................................................................262
Topic 10: Dividend decision ............................................................................…..............287
Topic 11: Introduction to risk and return.....................................................…...................302
Topic 12: Islamic finance....................................................................................................327
Topic 13: Emerging issues and trends
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TOPIC 1
OVERVIEW OF FINANCIAL MANAGEMENT
Introduction
Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
NATURE AND SCOPE OF FINANCE
1. Investment decisions includes investment in fixed assets (called as capital

budgeting). Investment in current assets is also a part of investment decisions called
as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control
of financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation

with regards to capital requirements of the company. This will depend upon expected
costs and profits and future programmes and policies of a concern. Estimations have
to be made in an adequate manner which increases earning capacity of enterprise.
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2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and
period of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.
FINANCE FUNCTIONS
The following explanation will help in understanding each finance function in detail
1. Investment Decision
One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting. It is important to
allocate capital in those long term assets so as to get maximum yield in future.
Following are the two aspects of investment decision
a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected
return. Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the
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expected return of the prospective investment. Therefore while considering

investment proposal it is important to take into consideration both expected return
and the risk involved.
Investment decision not only involves allocating capital to long term assets but also
involves decisions of using funds which are obtained by selling those assets which
become less profitable and less productive. It wise decisions to decompose
depreciated assets which are not adding value and utilize those funds in securing
other beneficial assets. An opportunity cost of capital needs to be calculating while
dissolving such assets. The correct cut off rate is calculated by using this opportunity
cost of the required rate of return (RRR)
2. Financial Decision
Financial decision is yet another important function which a financial manger must
perform. It is important to make wise decisions about when, where and how should a
business acquire funds. Funds can be acquired through many ways and channels.
Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix
of equity capital and debt is known as a firm’s capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes
this not only is a sign of growth for the firm but also maximizes shareholders wealth.
On the other hand the use of debt affects the risk and return of a shareholder. It is
more risky though it may increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders

return with minimum risk. In such a scenario the market value of the firm will
maximize and hence an optimum capital structure would be achieved. Other than
equity and debt there are several other tools which are used in deciding a firm capital
structure.
3. Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key
function a financial manger performs in case of profitability is to decide whether to
distribute all the profits to the shareholder or retain all the profits or distribute part of
the profits to the shareholder and retain the other half in the business.
It’s the financial manager’s responsibility to decide a optimum dividend policy

which maximizes the market value of the firm. Hence an optimum dividend payout
ratio is calculated. It is a common practice to pay regular dividends in case of
profitability Another way is to issue bonus shares to existing shareholders.
4. Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency.

Firm’s profitability, liquidity and risk all are associated with the investment in
current assets. In order to maintain a tradeoff between profitability and liquidity it is
important to invest sufficient funds in current assets. But since current assets do not
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earn anything for business therefore a proper calculation must be done before
investing in current assets.
Current assets should properly be valued and disposed of from time to time once
they become non profitable. Currents assets must be used in times of liquidity
problems and times of insolvency.
Role of finance manager
The functions of Financial Manager can broadly be divided into two: The Routine
functions and the Executive/Managerial Functions.
1. Executive functions of financial management, and

2. Routine functions of financial management.
3. Estimating cash flow,
4. Investment decisions,
5. Allocation of surplus,
6. Deciding additional finance,
7. Negotiating for additional finance and
8. Checking the financial performance.
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These executive functions of financial management (FM) are explained below.
1. Estimating capital requirements : The company must estimate its capital

requirements (needs) very carefully. This must be done at the promotion stage. The
company must estimate its fixed capital needs and working capital need. If not, the
company will become over over-capitalized or under-capitalized.
2. Determining capital structure : Capital structure is the ratio between owned capital
and borrowed capital. There must be a balance between owned capital and borrowed
capital. If the company has too much owned capital, then the shareholders will get ge
fewer dividends. Whereas, if the company has too much of borrowed capital, it has
to pay a lot of interest. It also has to repay the borrowed capital after some time. So
the finance managers must prepare a balanced capital structure.
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3. Estimating cash flow : Cash flow refers to the cash which comes in and the cash
which goes out of the business. The cash comes in mostly from sales. The cash goes
out for business expenses. So, the finance manager must estimate the future sales of
the business. This is called Sales forecasting. He also has to estimate the future
business expenses.
4. Investment Decisions : The business gets cash, mainly from sales. It also gets cash
from other sources. It gets long-term cash from equity shares, debentures, term loans
from financial institutions, etc. It gets short-term loans from banks, fixed deposits,
dealer deposits, etc. The finance manager must invest the cash properly. Long-term
cash must be used for purchasing fixed assets. Short-term cash must be used as a
working capital.
5. Allocation of surplus : Surplus means profits earned by the company. When the
company has a surplus, it has three options, viz.,
1. It can pay dividend to shareholders.
2. It can save the surplus. That is, it can have retained earnings.
3. It can give bonus to the employees.
6. Deciding additional finance : Sometimes, a company needs additional finance for
modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.
1. When the additional finance will be needed?
2. For how long will this finance be needed?
3. From which sources to collect this finance?
4. How to repay this finance?
Additional finance can be collected from shares, debentures, loans from financial
institutions, fixed deposits from public, etc
7. Negotiating for additional finance : The finance manager has to negotiate for
additional finance. That is, he has to speak to many bank managers. He has to
persuade and convince them to give loans to his company. There are two types of
loans, viz., short-term loans and long-term loans. It is easy to get short-term loans
from banks. However, it is very difficult to get long-term loans.
8. Checking the financial performance : The finance manager has to check the
financial performance of the company. This is a very important finance function. It
must be done regularly. This will improve the financial performance of the company.
Investors will invest their money in the company only if the financial performance is
good. The finance manager must compare the financial performance of the company
with the established standards. He must find ways for improving the financial
performance of the company.
The routine functions are also called as Incidental Functions.
Routine functions are clerical functions. They help to perform the Executive functions of
financial management.
The six routine functions of financial management are listed below.
1. Supervision of cash receipts and payments.

2. Safeguarding of cash balances.
3. Safeguarding of securities, insurance policies and other valuable papers.
4. Taking proper care of mechanical details of financing.
5. Record keeping and reporting.
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6. Credit Management.
The finance manager will be involved with the managerial functions while the routine
functions will be carried out by junior staff in the firm. He must however, supervise the
activities of these junior staff.
GOALS OF THE FIRM: FINANCIAL AND NON-FINANCIAL OBJECTIVES,

OVERLAPS AND CONFLICTS AMONG THE OBJECTIVES
FINANCIAL GOALS OF THE FIRM
 Profit-Maximization
Microeconomic theory of the firm is founded on profit maximization as the principal

decision criterion: markets managers of firms direct their efforts toward areas of attractive
profit potential using market prices as their signals. Choices and actions that increase the
firm’s profit are undertaken while those that decrease profits are avoided. To maximize
profits the firm must maximize output for a given set of scarce resources, or equivalently,
minimize the cost of producing a given output.
Applying Profit-Maximization Criterion in Financial Management
Financial management is concerned with the efficient use of one economic resource,
namely, capital funds. The goal of profit maximization in many cases serves as the basic
decision criterion for the financial manager but needs transformation before it can provide
the financial manger with an operationally useful guideline. As a benchmark to be aimed at
in practice, profit maximization has at least four shortcomings: it does not take account of
risk; it does not take account of time value of money; it is ambiguous and sometimes
arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable
events.
Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of
uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing
profits loses meaning as for it is no longer clear what is to be maximized. When faced with
uncertainty (risk), most investors providing capital are risk averse. A good decision
criterion must take into consideration such risk.
Timing Another major shortcoming of simple profit maximization criterion is that it does
not take into account of the fact that the timing of benefits expected from investments varies
widely. Simply aggregating the cash flows over time and picking the alternative with the
highest cash flows would be misleading because money has time value. This is the idea that
since money can be put to work to earn a return, cash flows in early years of a project’s life
are valued more highly than equivalent cash flows in later years. Therefore the profit
maximization criterion must be adjusted to account for timing of cash flows and the time
value of money.
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Subjectivity and ambiguity A third difficulty with profit maximization concerns the
subjectivity and ambiguity surrounding the measurement of the profit figure. The
accounting profit is a function of many, some subjective, choices of accounting standards
and methods with the result that profit figure produced from a given data base could vary
widely.
Qualitative information Finally many events relevant to the firms may not be captured by
the profit number. Such events include the death of a CEO, political development, and
dividend policy changes. The profit figure is simply not responsive to events that affect the
value of the investment in the firm. In contrast, the price of the firms share (which measures
wealth of the shareholders of the company) will adjust rapidly to incorporate the likely
impact of such events long before they are their effects are seen in profits.
 Value Maximization
Because of the reasons stated above, Value-maximization has replaced profit-

maximization as the operational goal of the firm. By measuring benefits in terms of cash
flows value maximization avoids much of the ambiguity of profits. By discounting cash
flows over time using the concepts of compound interest, Value maximization takes
account of both risk and the time value of money. By using the market price as a measure of
value the value maximization criterion ensures that (in an efficient market) its metric is all
encompassing of all relevant information qualitative and quantitative, micro and macro. Let
us note here that value maximization is with respect to the interests of the providers of
capital, who ultimately are the owners of the firm. – The maximization of owners’ wealth is
the principal goal to be aimed at by the financial manager.
In many cases the wealth of owners will be represented by the market value of the firm’s
shares - that is the reason why maximization of shareholders wealth has become
synonymous with maximizing the price of the company’s stock. The market price of a firms
stocks represent the judgment of all market participants as to the values of that firm - it
takes into account present and expected future profits, the timing, duration and risk of these
earnings, the dividend policy of the firm; and other factors that bear on the viability and
health of the firm. Management must focus on creating value for shareholders. This requires
Management to judge alternative investments, financing and assets management strategies
in terms of their effects on shareholders’ value (share prices).
NON-FINANCIAL GOALS
 Social Responsibility and Ethics
It has been argued that the unbridled pursuit of shareholders wealth maximization makes
companies unscrupulous, anti social, enhances wealth inequalities and harms the
environment. The proponents of this position argue that maximizing shareholders wealth
should not be pursued without regard to a firm’s corporate social responsibility. The
argument goes that the interest of stakeholders other than just shareholders should be taken
care of. The other stakeholders include creditors, employees, consumers, communities in
which the firm operates and others. The firm will protect the consumer; pay fair wages to
employees while maintaining safe working conditions, support education and be sensitive
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to the environment concerns such as clean air and water. A firm must also conduct itself
ethically (high moral standards) in its commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of
shareholders wealth maximization. So the question frequently posed is: is ethical behavior
and corporate social responsibility inconsistent with shareholder wealth maximization?
In the long run, the firm has no choice but to act in socially responsible ways. It is argued
that the corporation’s very survival depend on it being socially responsible. The
implementation of a pro-active ethics and corporate social responsibility (CSR) program is
believed to enhance corporate value. Such a program can reduce potential litigation costs,
maintain a positive corporate image, build shareholder confidence, and gain the loyalty,
commitment and respect of firm’s stakeholders. Such actions conserve firm’s cash flows
and reduce perceived risk, thus positively effecting firm share price. It becomes evident that
behavior that is ethical and socially responsible helps achieve firm’s goal of owner wealth
maximization.
 Growth and expansion
This is a major objective for small companies which seek to expand operations so as to
enjoy economies of scale.
Difficulty of Achieving Shareholders Wealth Maximization
Two difficulties complicate the achievement of the goal of shareholder wealth

maximization in modern corporations. These are caused by the agency relationships in a
firm and the requirements of corporate social responsibility (As discussed above).
AGENCY THEORY, STAKEHOLDER’S THEORY AND CORPORATE

GOVERNANCE
An agency relationship is created when one party (principal) appoints another party (agent)
to act on their (principals) behalf. The principal delegates decision making authority to the
agent. In a firm agency relationship exists between;
1. Shareholders and management

2. Shareholders and creditors
3. Shareholders and the government
4. Shareholders and auditors
Shareholders and management

The separation of ownership and control in most modern corporations’ causes a conflict of
interest between the personal interest of appointed managers (agent) and the interests of the
owners of the firms (principals).this conflict is known as the agency conflict.
The following are some decisions by managers which would result in a conflict with
shareholders:
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1. Managers may use corporate resources for personal use.

2. Managers may award themselves hefty pay rises
3. Managers may organize mergers which are intended for their benefit only and not for
the benefit of shareholders.
4. Managers may take holidays and spend huge sums of company money.
5. Managers may use confidential information for their benefit(insider trading)
Resolution of conflict
1. Performance based remuneration

This will involve remunerating managers for actions they take that maximize shareholders
wealth. The remuneration scheme should be restructured in order to enhance the
harmonization of the interest of shareholders with those of management. Managers could be
given bonuses, commissions for superior performance in certain periods.
2. Incurring agency costs

Agency costs refer to costs incurred by shareholders in trying to control management
behaviour and actions and therefore minimize agency conflicts.
These costs include:
a. Monitoring costs. They arise as a result of mechanisms put in place to ensure interests
of shareholders are met. They include cost of hiring external auditors, bonding
assurance which is insurance taken out where the firm is compensated if manager
commits an infringement, internal control system implementation.
b. Opportunity costs which are incurred either because of the benefit foregone from not
investing in a riskier but more profitable investment or in the due to the delay in
decision making as procedures have to be followed(hence, a timely decision will not
be made)
c. Restructuring costs are those costs incurred in changing or altering an organizations
structure so as to prevent undesirable management activities.
d. Board of directors- a properly constituted board plays the oversight role on
management for the shareholders.
3. Threat of corporate takeover

When management of a firm under performs this result in the shares of that firm being
undervalued there is the threat of a hostile takeover. This threat acts to force managers to
perform since should the firm be taken over they will be replaced.
4. Shareholders intervention
The shareholders as owners of the company have a right to vote. Hence, during the
company’s AGM the shareholders can unite to form a bloc that will vote as one for or
against decisions by managers that hurt the company. This voting power can be exercised
even when voting for directors. Shareholders could demand for an independent board of
directors.
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5. Legal protection
The companies act and bodies such as the capital markets authority have played their role
in ensuring trying to minimize the agency conflict. Under the companies act, management
and board of directors owe a duty of care to shareholders and as such can face legal liability
for their acts of omission or commission that are in conflict with shareholders interests. The
capital market authority also has corporate governance guidelines.
6. Use of corporate governance principles which specify the manner in which

organizations are controlled and managed. The duties and rights of all stakeholders are
outlined.
7. Stock option schemes for managers could be introduced. These entitle a manager to
purchase from the company a specified number of common shares at a price below market
price over duration. The incentive for managers to look at shareholders interests and not
their own is that, if they deliver and the company’s share price appreciates in the stock
market then they will make a profit from the sale.
8. Labour market actions such as hiring tried and tested professional managers and firing
poor performers could be used. The concept of 'head hunting' is fast catching on in Kenya
as a way of getting the best professional managers and executives in the market but at a fee
of course.
Shareholders vs. creditors
In this relationship the shareholders (agent) are expected to manage the credit funds
provided by the creditors (principal). The shareholders manage these funds through
management.
Debt providers/creditors are those who provide loan and credit facilities to the firm. They
do this after gauging the riskiness of the firm.
The following actions by shareholders through management could lead to a conflict
between them and creditors
1. Shareholders could invest in very risky projects-The management under the

directive of the shareholders may undertake highly risky investments than those
anticipated by the providers of long term debt finance. The creditors would not be
interested in highly risky projects because they stand to lose their funds when the
investments collapse. Even if the risky projects succeed they would not benefit
because they only get a fixed rate of return.
2. The dividend payments to shareholders could be very high-An increase in the
dividend rate in most cases is financed by a decrease in investments. This in turn
reduces the value of bonds. If the firm is liquidating and it pays a liquidating
dividend to its shareholders, the providers of capital could be left with worthless
claims.
3. Default on interest payments to bondholders
4. Shareholders could organize mergers which are not beneficial to creditors
5. Shareholders could acquire additional debt that increases the financial risk of the
firm
6. Manipulation of financial statements so as to mislead creditors
7. Shareholders could dispose of assets which are security for the credit given
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8. Under investments-The shareholders may invest in projects with a negative net

present value.
9. The shareholders may adopt an aggressive management of working capital. This may
bring conflicts in liquidity position of the firm and would not be in the interest of the
debt holders
Resolution of this conflict

1. Restrictive covenants- these are agreements entered into between the firm and the
creditors to protect the creditor’s interests.
These covenants may provide restrictions/control over:

i. Asset based covenants- These states that the minimum asset base to be
maintained by the firm.
ii. Liability based covenant- This limits the firm’s ability to incur more debt.
iii. Cashflow based covenant- States minimum working capital to be held by the
firm. This may restrict the amount of dividends to be paid in future.
iv. Control based covenant – Limits management ability to make various
decisions e.g. providers of debt fund may require to be represented in the
BOD meetings.
2. Creditors could also offer loans but at above normal interest rates so as to encourage
prompt payment
3. Having a callability clause to the effect that a loan could be re-called if the conflict
of interest is severe
4. Legal action could also be taken against a company
5. Incurring agency costs such as hiring external auditors
6. Use of corporate governance principles so as to minimize the conflict.
Shareholders and the government
The shareholders operate in an environment using the license given by the government. The
government expects the shareholders to conduct their business in a manner which is
beneficial to the government and the society at large.
The government in this agency relationship is the principal and the company is the agent.
The company has to collect and remit the taxes to the government. The government on the
other hand creates a conducive investment environment for the company and then shares in
the profits of the company in form of taxes. The shareholders may take some actions which
may conflict the interest of the government as the principal.
These may include;
(a) The company may involve itself in illegal business activities

(b) The shareholders may not create a clear picture of the earnings or the profits it
generates in order to minimize its tax liability.(tax evasion)
(c) The business may not response to social responsibility activities initiated by the
government
(d) The company fails to ensure the safety of its employees. It may also produce sub
standard products and services that may cause health concerns to their consumers.
(e) The shareholders may avoid certain types of investment that the government covets.
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Solutions to this agency problem
(i) The government may incur costs associated with statutory audit, it may also order
investigations under the company’s act, the government may also issue VAT refund
audits and back duty investigation costs to recover taxes evaded in the past.
(ii) The government may insure incentives in the form of capital allowances in some
given areas and locations.
(iii) Legislations: the government issues a regulatory framework that governs the
operations of the company and provides protection to employees and customers and
the society at large.ie laws regarding environmental protection, employee safety and
minimum wages and salaries for workers.
(iv) The government encourages the spirit of social responsibility on the activities of the
company.
(v) The government may also lobby for the directorship in the companies that it may
have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc
Shareholders and auditors

Auditors are appointed by shareholders to monitor the performance of management.
They are expected to give an opinion as to the true and fair view of the company’s financial
position as reflected in the financial statements that managers prepare. The agency conflict
arises if auditors collude with management to give an unqualified opinion (claim that the
financial statements show a true and fair view of the financial position of the firm) when in
fact they should have given a qualified opinion (that the financial statements do not show a
true and fair view). The resolution of this conflict could be through legal action, removal
from office, use of disciplinary actions provided for by regulatory bodies such as ICPAK.
STAKEHOLDERS THEORY
Stakeholder theory states that a company owes a responsibility to a wider group of

stakeholders, other than just shareholders. A stakeholder is defined as any person/group
which can affect/be affected by the actions of a business. It includes employees, customers,
suppliers, creditors and even the wider community and competitors.
Edward Freeman, the original proposer of the stakeholder theory, recognised it as an
important element of Corporate Social Responsibility (CSR), a concept which recognises
the responsibilities of corporations in the world today, whether they are economic, legal,
ethical or even philanthropic. Nowadays, some of the world’s largest corporations claim to
have CSR at the centre of their corporate strategy. Whilst there are many genuine cases of
companies with a “conscience”, many others exploit CSR as a good means of PR to
improve their image and reputation but ultimately fail to put their words into action.
Within an organisation there are a number of internal parties involved in corporate
governance. These parties can be referred to as internal stakeholders.
A useful definition of a stakeholder, for use at this point, is 'any person or group that can
affect or be affected by the policies or activities of an organization.
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The basis for stakeholder theory is that companies are so large and their impact on society
so pervasive that they should discharge accountability to many more sectors of society than
solely their shareholders demonstrated in the diagram below;
Stakeholder
er theory may be the necessary outcome of agency theory given that there is a
business case in considering the needs of stakeholders through improved customer
perception, employee motivation, supplier stability, shareholder conscience investment.
Each internal stakeholder has:
 An operational role within the company
 A role in the corporate governance of the company
 A number of interests in the company (referred to as the stakeholder 'claim').
'claim'
Operational role Corporate Main interests in the

governance role company
Responsible for the Control company in - pay
actions of the corporation. best interest of the - performance linked
stakeholders bonus
- share options
- status
- reputation
- power
Company Stakeholder Advise board on
secretary corporate governance - pay
matters
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Sub-board Directors -Identify and evaluate - Job stability

management risks faced by a - career progression
company. - status
-enforce controls. - working conditions
-monitor success. - performance linked
-reports concerns. bonus
Employees Carry out orders of - Comply with internal

management. controls
-Report breaches
Employee Protect employee interests Highlight and take - Power
representatives action against breaches
e.g trade in governance - Status
unions requirements e.g.
protection of whistle
blowers.
External corporate governance stakeholders

A company has many external stakeholders involved in corporate governance.
Each stakeholder has:
 a role to play in influencing the operation of the company
 its own interests and claims in the company.
External party Main role Interests and claims in company
Auditors Independent review of company’s - Fees

reported financial position. - Reputation
- Quality of relationship
- Compliance with audit
requirements
Regulators Implementing and monitoring - Compliance with regulations
regulations - Effectiveness of regulations.
Government Implementing and maintaining laws - Compliance with laws
with which all companies must comply - Payment of taxes
- Levels of employment
- Levels of imports/exports
Stock exchange Implementing and maintaining rules - Compliance with rules and
and rules and regulations for regulations
companies listed on the exchange - fees
Small investors Limited power with use of vote - Maximisation of shareholder value
Institutional Through considered use of their votes - Value of shares and dividend
investors can (and should) beneficially influence payments
corporate policy - Security of funds invested
- Timeless of information received
from company
- Shareholder rights are observed.
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CONFLICTING STAKEHOLDERS INTERESTS AND CORPORATE

GOVERNANCE
AGENCY THEORY
Agency theory is part of the bigger topic of corporate governance.
It involves the problem of directors controlling a company whilst shareholders own the
company. In the past, a problem was identified whereby the directors might not act in the
shareholders (or other stakeholders) best interests. Agency theory considers this problem
and what could be done to prevent it.
A number of key terms and concepts are essential to understanding agency theory.
 An agent is employed by a principal to carry out a task on their behalf.
 Agency refers to the relationship between a principal and their agent.
 Agency costs are incurred by principals in monitoring agency behaviour because of a
lack of trust in the good faith of agents.
 By accepting to undertake a task on their behalf, an agent becomes accountable to
the principal by whom they are employed. The agent is accountable to that principal.
In the field of finance shareholders are the owners of the firm. However, they cannot
manage the firm because:
 They may be too many to run a single firm.
 They may not have technical skills and expertise to run the firm
 They are geographically dispersed and may not have time.
Shareholders therefore employ managers who will act on their behalf. The managers are
therefore agents while shareholders are the principal.
Shareholders contribute capital which is given to the directors which they utilize and at the
end of each accounting year render an explanation at the annual general meeting of how the
financial resources were utilized. This is called stewardship accounting.
 In the light of the above shareholders are the principal while the management are the
agents.
 Agency problem arises due to the divergence or divorce of interest between the
principal and the agent. The conflict of interest between management and
shareholders is called agency problem in finance.
 There are various types of agency relationship in finance exemplified as follows:
1. Shareholders and Management
2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary
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Agency theory and corporate governance

Agency theory can help to explain the actions of the various interest groups in the corporate
governance debate.
Many companies are managed by directors who do not own the company. Many problems
have arisen due to the separation of ownership and control .e.g. directors having inadequate
skills to manage their area, or awarding themselves large bonuses whilst not meeting
targets. Due to the many problems which have arisen in the past, corporate governance has
been developed.
Governance could therefore be described as the system by which companies are directed
and controlled in the interests of shareholders and other stakeholders.
Companies are directed and controlled from inside and outside the company. Good
governance requires the following to be considered:
Direction from within:

 the nature and structure of those who set direction, the board of directors
 the need to monitor major forces through risk analysis
 the need to control operations: internal control.
Control from outside:

 The need to be knowledgeable about the regulatory framework that defines codes of
best practice, compliance and legal statute
 The wider view of corporate position in the world through social responsibility and
ethical decisions.
Providing a business case for governance is important in order to enlist management

support. Corporate governance is claimed to bring the following benefits:
 It is suggested that strengthening the control structure of a business increases
accountability of management and maximises sustainable wealth creation.
 Institutional investors believe that better financial performance is achieved through
better management, and better managers pay attention to governance, hence the
company is more attractive to such investors.
 The above points may cause the share price to rise - which can be referred to as the
"governance dividend" (i.e. the benefit that shareholders receive from good corporate
governance).
 Additionally, a socially responsible company may be more attractive to customers
and investors hence revenues and share price may rise (a "social responsibility
dividend").
Examples of principal-agent relationships

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A. Shareholders and Management

There is near separation of ownership and management of the firm. Owners employ
professionals (managers) who have technical skills. Managers might take actions, which
are not in the best interest of shareholders. This is usually so when managers are not
owners of the firm i.e. they don’t have any shareholding. The actions of the managers will
be in conflict with the interest of the owners. The actions of the managers are in conflict
with the interest of shareholders will be caused by:
i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and
maximize shareholders wealth. This is because irrespective of the profits they make,
their reward is fixed. They will therefore maximize leisure and work less which is
against the interest of the shareholders.
ii) Consumption of “Perquisites”
Perquisites refer to the high salaries and generous fringe benefits which the directors
might award themselves. This will constitute directors remuneration which will reduce
the dividends paid to the ordinary shareholders. Therefore the consumption is against
the interest of shareholders since it reduces their wealth.
iii) Different Risk-profile

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.
Managers on the other hand, will prefer low risk-low return investment since they have
a personal fear of losing their jobs if the projects collapse. (Human capital is not
diversifiable). This difference in risk profile is a source of conflict of interest since
shareholders will forego some profits when low-return projects are undertaken.
iv) Different Evaluation Horizons

Managers might undertake projects which are profitable in short-run. Shareholders on
the other hand evaluate investments in long-run horizon which is consistent with the
going concern aspect of the firm. The conflict will therefore occur where management
pursue short-term profitability while shareholders prefer long term profitability.
v) Management Buy Out (MBO)

The board of directors may attempt to acquire the business of the principal. This is
equivalent to the agent buying the firm which belongs to the shareholders. This is
inconsistent with the agency relationship and contract between the shareholders and the
managers.
vi) Pursuing power and self-esteem goals
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This is called “empire building” to enlarge the firm through mergers and acquisitions
hence increase in the rewards of managers.
vii) Creative Accounting

This involves the use of accounting policies to report high profits e.g. stock valuation
methods, depreciation methods recognizing profits immediately in long term
construction contracts etc.
Solutions to Shareholders and Management Conflict of Interest
Conflicts between shareholders and management may be resolved as follows:
1. Pegging/attaching managerial compensation to performance

This will involve restructuring the remuneration scheme of the firm in order to enhance the
alignments/harmonization 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.
2. Threat of firing
This is where there is a possibility of firing the entire management team by the shareholders
due to poor performance. Management 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 Group, IBM, G.M. have been fired by shareholders.
3. The Threat of Hostile Takeover

If the shares of the firm are undervalued due to poor performance and mismanagement.
Shareholders can threatened to sell their shares to competitors. In this case the management
team is fired and those who stay on can loose their control and influence in the new firm.
This threat is adequate to give incentive to management to avoid conflict of interest.
4. Direct Intervention by the Shareholders

Shareholders may intervene as follows:
 Insist on a more independent board of directors.
 By sponsoring a proposal to be voted at the AGM
 Making recommendations to the management on how the firm should be run.
5. Managers should have voluntary code of practice, which would guide them in the
performance of their duties.
6. Executive Share Options Plans

In 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.
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The value of an option will increase if the company is successful and its share price goes
up. The theory is that this will encourage managers to pursue high NPV strategies and
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:
Managers are protected from the downside risk that is faced by shareholders. If 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.
Many other factors as well as the quality of the company’s performance influence share
price movements. If the market is rising strongly, managers will still benefit from share
options, even though the company may have been very successful. If the share price falls,
there is a downward stock market adjustment and the managers will not be rewarded for
their efforts in the way that was planned.
The scheme may encourage management to adopt ‘creative accounting’ methods that will
distort the reported performance of the company in the service of the managers’ own ends.
Note
The choice of an appropriate remuneration policy by a company will depend, among other
things, on:
 Cost: the extent to which the package provides value for money
 Motivation: the extent to which the package motivates employees both to stay with
the company and to work to their full potential.
 Fiscal effects: government tax incentives may promote different types of pay. At
times of wage control and high taxation this can act as an incentive to make the
‘perks’ a more significant part of the package.
 Goal congruence: the extent to which the package encourages employees to work in
such a way as to achieve the objectives of the firm – perhaps to maximize rather than
to satisfy.
7. Incurring Agency Costs

Agency costs are incurred by the shareholders in order to monitor the activities of their
agent. The agency costs are broadly classified into 4.
a) The contracting cost. These are costs incurred in devising the contract between the
managers and shareholders.
The 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.
Examples of the costs are:
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 Negotiation fees
 The legal costs of drawing the contracts fees.
 The costs of setting the performance standard,
b) Monitoring Costs: This is incurred to prevent undesirable managerial actions. They are
meant to ensure that both parties live to the spirit of agency contract. They ensure that
management utilize the financial resources of the shareholders without undue transfer to
themselves.
Examples are:
 External audit fees
 Legal compliance expenses e.g. Preparation of financial statement according
to international accounting standards, company law, capital market authority
requirement, stock exchange regulations etc.
 Financial reporting and disclosure expenses
 Investigation fees especially where the investigation is instituted by the
shareholders.
 Cost of instituting a tight internal control system (ICS).
c) Opportunity Cost/Residual Loss: This is the cost due to the failure of both parties to
act optimally e.g.
 Lost opportunities due to inability to make fast decision due to tight internal
control system
 Failure to undertake high risk high return projects by the manager leads to lost
profits when they undertake low risk, low return projects.
d) Restructuring Costs – e.g. new I.C.S., business process reengineering etc.
B. SHAREHOLDERS AND CREDITORS/BOND/DEBENTURE HOLDERS
Bondholders are providers or lenders of long term debt capital. They will usually give debt
capital to the firm on the strength of the following factors:
 The existing asset structure of the firm
 The expected asset structure of the firm
 The existing capital structure or gearing level of the firm
 The expected capital structure of gearing after borrowing the new debt.
Note
 In raising capital, the borrowing firm will always issue the financial securities in form of
debentures, ordinary shares, preference shares, bond etc.
 In case of shareholders and bondholders the agent is the shareholder who should ensure
that the debt capital borrowed is effectively utilized without reduction in the wealth of
Page 26
the bondholders. The bondholders are the principal whose wealth is influenced by the
value of the bond and the number of bonds held.
 Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
 An agency problem or conflict of interest between the bondholders (principal) and the
shareholders (agents) will arise when shareholders take action which will reduce the
market value of the bond and by extension, the wealth of the bondholders. These
actions include:
a) Disposal of assets used as collateral for the debt in this.

In this case the bondholder is exposed to more risk because he may not recover the loan
extended in case of liquidation of the firm.
b) Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project.
However, this project may be substituted with a high risk project whose cash flows have
high standard deviation. This exposes the bondholders because should the project collapse,
they may not recover all the amount of money advanced.
c) Payment of High Dividends

Dividends may be paid from current net profit and the existing retained earnings. Retained
earnings are an internal source of finance. The payment of high dividends will lead to low
level of capital and investment thus a reduction in the market value of the shares and the
bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no
returns are expected. This will reduce the value of the firm and bond.
d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital
in the entire project if there is expectation that most of the returns from the project will
benefit the bondholders. This will lead to reduction in the value of the firm and
subsequently the value of the bonds.
e) Borrowing more debt capital

A firm may borrow more debt using the same asset as a collateral for the new debt. The
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. This exposes the first bondholders/lenders to more
risk.
Page 27
SOLUTIONS TO AGENCY PROBLEM
The bondholders might take the following actions to protect themselves from the actions of
the shareholders which might dilute the value of the bond. These actions include:
1. Restrictive Bond/Debt Covenant

In this case the debenture holders will impose strict terms and conditions on the borrower.
These restrictions may involve:
a) No disposal of assets without the permission of the lender.
b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the amount of current assets in
relation to current liabilities.
d) Restrictions on mergers and organisations
e) No borrowing of additional debt, before the current debt is fully serviced/paid.
f) The bondholders may recommend the type of project to be undertaken in relation to
the riskness of the project.
2. Callability Provisions
These 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.
3. Transfer of Asset
 The 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 utilization.
 On completion of the repayment of the loan, the asset used as a collateral will be
transferred back to the borrower.
4. Representation
The lender or bondholder may demand to have a representative in the board of directors of
the borrower who will oversee the utilization of the debt capital borrowed and safeguard the
interests of the lender or bondholder.
5. Refuse to lend
If 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.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.
6. Convertibility: On breach of bond covenants, the lender may have the right to convert
the bonds into ordinary shares.
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C. Agency Relationship between Shareholders and the government
Shareholders and by extension, the company they own operate within the environment
using the charter or licence granted by the government. The 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.
The government in this agency relationship is the principal while the company is the
agent. It becomes an agent when it has to collect tax on behalf of the government
especially withholding tax and PAYE.
The company also carries on business on behalf of the government because the government
does not have adequate capital resources. It provides a conducive investment environment
for the company and share in the profits of the company in form of taxes.
The company and its shareholders as agents may take some actions that might prejudice the
position or interest of the government as the principal. These actions include:
 Tax evasion: This involves the failure to give the accurate picture of the earnings or
profits of the firm to minimize tax liability.
 Involvement in illegal business activities by the firm.
 Lukewarm response to social responsibility calls by the government.
 Lack 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.
 Avoiding certain types and areas of investment coveted by the government.
Solutions to the agency problem

The government can take the following actions to protect itself and its interests.
1. Incur monitoring costs

E.g. the government incurs costs associated with:
 Statutory audit
 Investigations of companies under Company Act
 Back duty investigation costs to recover tax evaded in the past
 VAT refund audits
2. Lobbying for directorship (representation)

The 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 KPLC,
Kenya Airways, KCB etc.
Page 29
3. Offering investment incentives

To 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 Cap 470.
4. Legislations
The 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.
5. The government can in calculate the sense and spirit of social responsibility on the
activities of the firm, which will eventually benefit the firm in future.
D. Agency Relationship between Shareholders and Auditors

Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies
Act. The auditors are supposed to monitor the performance of the management on behalf of
the shareholders. They 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. The auditors may prejudice the interest of the shareholders thus causing agency
problems in the following ways:
a) Colluding with the management in performance of their duties whereby their

independence is compromised.
b) Demanding a very high audit fee (which reduces the profits of the firm) although there
is insignificant audit work due to the strong internal control system existing in the
firm.
c) Issuing 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.
d) Failure to apply professional care and due diligence in performance of their audit
work.
Solutions to the conflict
1. Firing: The auditors may be removed from office by the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors who
issue misleading reports leading to investment losses.
3. Disciplinary Action – ICPAK.
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Professional 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
 Fines and penalties
 Reprimand
4. Use of audit committees and audit reviews.
5. Headquarter office and branch /subsidiary.
The cost of agency relationships
Agency costs arise largely from principals monitoring activities of agents, and may be
viewed in monetary terms, resources consumed or time taken in monitoring. Costs are
borne by the principal, but may be indirectly incurred as the agent spends time and
resources on certain activities. Examples of costs include:
 incentive schemes and remuneration packages for directors
 costs of management providing annual report data such as committee activity and
risk management analysis, and cost of principal reviewing this data
 cost of meetings with financial analysts and principal shareholders
 the cost of accepting higher risks than shareholders would like in the way in which
the company operates
 Cost of monitoring behavior, such as by establishing management audit procedures.
MEASURING MANAGERIAL PERFORMANCE, COMPENSATION AND

INCENTIVES
MANAGERIAL INCENTIVES
Compensation, contracts particularly incentives and bonuses plans provide important
direction and motivation for top manager.
Executive incentive schemes should be competitive to attract and retain high quality
managers.
i) Communicate and reinforce key priorities in firms by linking bonuses to key
performance
measures.
ii) Encourage performance evaluation by rewarding good performance of managers.
Forms of bonuses
They vary from one organization to the other and payments can be made in:-
a) Cash /Shares of the company
b) Stock options
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c) Performance shares
d) Stock appreciation rights
Bonuses can also be made:-

i) Contingent to corporate result or divisional profits.
ii) Be based on annual performance or performance over a number of years.
A. CASH /SHARES
Company profit and individual performance forms the basis used to determine the
amounts of bonuses.
These are current bonuses paid in cash (monetary consideration or shares ie ownership
consideration). They reward executive on short term performance therefore there is a
risk of promoting a pre-occupation with short term results which will affect long term
interest.
Normally they are based on fixed percentages if corporate or divisional profits exceed a
certain amount e.g. a bonus of 5% if profits exceed Sh. 10 million etc.
Advantages
i. Bonus can be reduced or eliminated during periods of poor performance.
ii. Share compensation creates a good relationship between manager and shareholders.
iii. Good performance will be encouraged since rewards are related to performance.
Disadvantages
i. Bonuses will bring tax issues and therefore if given in shares, managers will have to
look for money to pay taxes
ii. Significant share ownership by managers may lead to risk averse behaviors.
B. STOCK OPTIONS
A stock option gives managers the right to purchase company shares at a future date and
at a price established when the option was granted. With stock options it will be assumed
that managers will attempt to influence long term performance rather than short term.
Managers will want share price to appreciate so that they make capital gains when they
exercise their option.
Advantages
i. Managers are encouraged to make long term decisions that will maximize value of
the
firm
ii. It encourages managers to reduce risks behaviour and undertake riskier projects with
higher payoffs.
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Disadvantages
i. Some events not directly under control of managers may affect share prices eg
political climate, competition etc.
ii. They have no apparent tax benefits to the company or managers.
C. PERFORMANCE SHARE
These are shares given by the company to managers/ employees if they attain a specific
level of performance. The main target is to attain a certain level of performance for a
number of years.
Executives receive rewards for maintaining a consistent performance or exceeding the
performance level. Performance shares are also referred to as executive share ownership
plans (ESOPS)
They have same advantages and disadvantages as stock options. However, they have an
additional problem of basing performance on profit measures which may promote creative
accounting or short term decisions which may not improve value of the firm.
D. STOCK APPRECIATION RIGHTS

These are deferred cash payments based on the increase in stock price from the time of their
award to the time of payment. Managers will be rewarded for appreciation in share price.
Therefore the value/ the amount of business will be a function of future share price.
Managers will be encouraged to make decisions that maximize share price and hence their
bonuses.
Executive compensation and agent relationship

Managers are agents of shareholders. The shareholders delegate decision making authority
to managers. Managers are hired by top management or directors to manage the firm or
divisions for decentralized units. In agency relationship there is an assumption that
managers look at financial compensation and wealth maximization as well as other items
that will come
with the job e.g. rewards. Managers will not prefer hard work and will therefore require
incentives to reduce agency conflicts. Incentive compensation is designed to harmonize
interest of owners and managers; however divergence of interest will always occur due to;
 risk attitude of managers;
 Existence of private information available to managers etc.
Owners need to monitor manager’s actions by incurring agency costs. Agency cost is the
sum
of the costs of incentive compensation i.e. cost of monitoring managers behavior etc.
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ETHICAL ISSUES IN FINANCIAL MANAGEMENT
Ethics are principles based on doing the right thing. They are the moral values by which an
individual or business operates. In theory, a business or individual can act ethically and still
attain ultimate success. A history of doing the right thing can be used as a selling point to
heighten a person's or organization's reputation in the community. Not only are ethics
morally valued, they are backed by legal repercussions for failure to act within certain
guidelines.
The ethics of a finance manager should be above approach. This includes more than just
acting in an honest, above-board manner. It means establishing boundaries that prevent
professional and personal interests from appearing to conflict with the interest of the
employer. A finance manager must provide competent, accurate and timely information that
fairly presents any potential disclosure issues, such as legal ramifications. The manager is
also ethically responsible for protecting the confidentiality of the employer and staying
within the boundaries of law.
Some laws are specifically designed to address unethical actions of finance managers. For
example, if a finance manager is aware of business activity that will affect a stock price and
uses that information to buy or sell stocks for financial again, he has broken a trust with his
employer. A finance manager who is aware that his company may be breaking the law may
be held legally responsible for a crime.
The dilemma faced by many finance managers comes in balancing the need to act ethically
while fulfilling the needs of the employer. The employer's ultimate goal is to maximize
earnings, and the drive to make money may cause an employee to act unethically. If a
manager believes his company may have crossed an ethical line, his first step should be to
take it up with his employer. If he feels the actions warrant legal intervention, he should do
so without fear of repercussion.
If a discussion with an employer does not resolve the ethical issues facing a finance
manager, he can report the activity to the appropriate government agency for investigation.
This is known as whistle blowing. Under laws, an employee has the right to report
suspicious activity without fearing for his job. While the activity may put a strain on his
working relationship, he is protected by law
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ISSUES FACED BY FINANCIAL MANAGERS
Financial managers prepare reports, oversee accounting functions, plan investment

strategies and direct cash management functions. They also are involved in branch
management functions at banks and other financial institutions. They are required to uphold
the highest ethical standards because internal and external stakeholders depend on
transparent, timely and complete financial documents to make decisions.
Accuracy
A company’s financial manager ensures that all financial publications accurately and fairly
reflect the financial condition of the company. Accounting errors and financial fraud, such
as what was seen in the cases of Enron and WorldCom, damage the interests of
shareholders, employees and affect confidence in the financial system. Some organizations
document ethics guidelines specifically for financial managers. For example, the ethics
code of the United States Postal Service requires senior financial managers to maintain
accurate records and books, maintain internal controls and prepare financial documents in
accordance with generally accepted accounting principles.
Transparency
Financial documents reflect a company's performance relative to its peers, and its internal
strengths and weaknesses. Regulatory agencies require publicly traded companies to submit
periodic financial statements and make full disclosures of material information. A change in
the senior executive ranks, buyout offers, loss or win of a major contract and new product
launches are examples of material information. Transparency also means explaining
financial information clearly, especially for those who aren't familiar with the company’s
operations. Financial managers should not hide, obscure or otherwise render relevant
financial information impossible for ordinary shareholders to understand.
Timeliness
Timely financial information is just as important as accurate and transparent information.
Management, investors and other stakeholders require timely information to make the right
decisions. Many cases exist of a publicly traded company's stock reacting sharply and
negatively to negative earnings surprises or unpleasant product-related news. For example,
a company should promptly disclose manufacturing problems that could temporarily affect
sales. Similarly, the company should not hold back news of a major contract loss in the
hope that it can replace the lost revenue with new contracts.
Integrity
Financial managers should strive for unimpeachable integrity. Customers, shareholders and
employees should be able to trust a financial manager's words. Managers should not allow
prejudice, bias and conflicts of interest to influence their actions. Managers should disclose
real or apparent conflicts of interest, such as an investment position in a stock or an
ownership interest in one of the bidding companies for a procurement contract. The
structure of certain stock-based incentive compensation schemes could also result in ethical
issues. For example, managers might be tempted to manipulate stock prices by selectively
disclosing or not disclosing relevant financial information.
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CORPORATE SOCIAL RESPONSIBILITY (CSR)
Corporate social responsibility (CSR) may be defined as “the commitment of business to

contribute to sustainable economic development, working with employees, their families,
the local community and society at large to improve their quality of life”
Corporations invest in CSR projects in an attempt to improve their reputation in society and
compete with global corporations. Companies boost about their CSR expenditure in their
annual reports to attract investors and satisfy various stakeholders like employees,
customers, suppliers, government, regulators, distributors etc. Companies use CSR as a
marketing tool and to establish good rapport with the public.
It is also used as a prevention strategy by the companies to protect them from corporate
scandals, unpredicted risks, possible ecological accidents, governmental rules and
regulations, protect noticeable profits, brand differentiation, and better relationship with
employees based on volunteerism terms.
Most corporations are much cognizant to publish their CSR activities on their websites,
sustainability reports and their advertising campaigns. CSR is also practiced because
customers as well as governments today are demanding more ethical behaviors from
organizations. In response, corporations are volunteering themselves to incorporate CSR as
part of their business policies, mission proclamation and values in multiple areas, respecting
labor and environmental laws, while taking care of the differing interest of various
stakeholders
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TOPIC 2
THE FINANCING DECISION
INTRODUCTION
The financing decisions are decisions regarding the methods that are used to raise
funds which would be used for making acquisitions. The financing decisions are decisions
concerning the liabilities and stockholders' equity side of the firm's balance sheet, such as a
decision to issue bonds.
The financing decisions involve various factors. They are determining the proper amount of
funds to employ in a firm, selecting projects and capital expenditure analysis, raising funds
on the most favorable terms possible and finally managing working capital such as
inventory and accounts receivable. The goals of corporate finance can be achieved only
when the corporate investment is financed appropriately. The financing mix will make an
impact the valuation.
The company should therefore identify an optimal mix of financing i.e. the one which
results in maximum value.
The sources of finance are usually comprised of a combination of debt and equity financing.
A project that is financed through debt results in a liability and obligation. When the
projects are financed through equity, it is less risky with respect to cash flow
commitments. The cost of equity is always higher than the cost of the debt. The equity
financing may result in an increased hurdle rate which will offset any reduction in the cash
flow risk. The management of the company must match the financing mix to the asset that
is being financed.
One of the theories as to how the firms make their financing decisions is the Pecking Order
Theory. Under this theory the firms should avoid external financing if they have an
availability of internal financing option. They also avoid equity financing if they have an
option of debt financing at lower interest rates. Another theory which helps firms in
financial decision is the Trade-off theory where firms are assumed to trade-off the tax
benefits of debt with the bankruptcy costs of debt when making their decisions.
NATURE FINANCING DECISION

The nature of financial decisions varies from one firm to the other. It may also be different
for the same firm over a period of time. The reason is that the nature of financial decisions
is influenced by the prevailing microeconomic and macroeconomic conditions. These
factors are explained below;-
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Microeconomic Factors
Microeconomic factors are related to the internal conditions of the firm. Important among
these conditions are:
1. Nature and size of the enterprise;
2. Level of risk and stability in earnings;
3. Liquidity position;
4. Asset structure and pattern of ownership;
5. Attitude of the management.
Nature and size of the enterprise;

If a firm is engaged in manufacturing operations or in the provision of public utility
services, its investment in fixed assets is large and hence the capital structure has a large
share of long-term capital. The share of long-term capital in the capital structure is also
large in firms producing capital goods. On the other hand, in trading concerns, a greater part
of the investment is found in current assets. With a greater ratio of current assets, the ratio
of current liabilities rises. Similarly, companies that is larger in size need a large capital.
Small firms may obtain their fixed assets on lease, but large firms would need to construct
their own building and assemble their own plant. Small firms have lower goodwill in the
capital market and so their financing decisions are different from that of large firms. It is
because of the lack of sufficient goodwill in the capital market that small firms are largely
dependent on internal finances and this is one of the reasons that their dividend decisions
are different from that of large firms.
Level of risk and stability in earnings;

Risk is another important factor influencing financial decisions. The greater the risk, the
higher the discount factor. Thus, risk influences the long-term investment decision or
capital budgeting decision. Again, if risk is higher or income is not stable, the finance
manager tries to impress on the shareholders for more retention of earnings rather than
adopting a liberal dividend policy. But with stable income or lower risk, the financial
decision will be just the reverse. In such cases, the fixed-cost capital, such as preference
shares and debentures, may be preferred and also the firm may adopt a liberal dividend
policy.
Liquidity position
The third factor influencing financial decisions is the liquidity position. Since dividend is
normally paid out of cash, firms with a sound liquidity position adopt a liberal dividend
policy. But if, in such cases, the working capital requirements are very large or the firm has
to meet significant past obligations, it will have to follow a conservative dividend policy.
Any tilt towards illiquidity will alter the nature of financing and dividend decisions.
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Asset structure and pattern of ownership

Again, in a closely-held company where the ownership lies in a few hands, the management
does not find it difficult to persuade the owners to accept a conservative dividend policy in
the interests of the firm. But in cases where there are many shareholders, their wishes
matter considerably.
Attitude of the management

Last but not least is the management’s attitude. A conservative finance manager will attach
greater importance to liquidity rather than to the profitability. On the other hand an
aggressive finance manager will stress on the latter, and financial decisions will be taken
accordingly. For example, a conservative finance manager attempts to tread a beaten path,
preferring to avoid fixed obligations for raising additional capital even if debt financing is
advantageous. The preference is to maintain a large volume of current assets. However, an
aggressive finance manager is ready to bear the risk involved in debt financing or that
involved in maintaining lower current assets. However, a prudent finance manager would
prefer a compromise between risk and return or between profitability and liquidity.
Macroeconomic Factors
Macroeconomic factors are the environmental factors that are beyond the control of the
firm’s management. They relate primarily to:
1. The state of the economy;
2. Governmental policy.
The state of the economy

The state of the economy changes from time to time and the financial decisions of a firm
conform to these changes. When the economy is growing or proceeding towards recovery,
the finance manager should be eager to avail investment opportunities. But when the
economy is facing a slump, the finance manager should proceed with care. For example, in
such a situation it would not be advisable to go for an expansion programme. Similarly,
when the economy is experiencing an uptrend, the finance manager can opt for trading on
equity as larger profits are assured. But in times of a downtrend, the stress should be on
internal financing. Again, during an uptrend, higher dividends can be declared, but during a
downtrend conservation of cash is necessary and therefore a strict dividend policy should be
followed.
The state of economy is also denoted by the structure of capital and money markets. If the
capital market is well developed having a multitude of financial institutions and
venturesome investors, the finance manager will find it easy to select the proportion-mix of
capital structure and, accordingly, financing decisions will be broader. He can manage with
a comparatively lower amount of cash as he can get funds whenever he desires. The
dividend policy too is broad in such cases as the shareholders are not necessarily interested
in regular and large dividends. But if the investors are not venturesome, they will wish for
large dividends and the finance manager will have to adopt a liberal dividend policy, and
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will not be able to opt for trading on equity to any great extent. Similarly, if the financial
institutions provide concessional assistance for priority projects, the investment decisions
will be influenced in favour of such projects. Moreover, if the financial institutions stress on
a particular debt-equity ratio, the financing decisions will be so influenced.
Governmental policy
Apart from the state of economy, governmental policy is no less significant in influencing
corporate financial decisions. State intervention or state regulation is found in almost all
countries. Thus corporate investment decisions are governed by the nature and extent of
state regulations.
SIGNIFICANCE OF THE FINANCING DECISION

There are two fundamental types of financial decisions that the finance team needs to make
in a business i.e investment and financing. The two decisions boil down to how to spend
money and how to borrow money. The overall goal of financial decisions is to maximize
shareholder value, so every decision must be put in that context.
Investment
An investment decision revolves around spending capital on assets that will yield the
highest return for the company over a desired time period. In other words, the decision is
about what to buy so that the company will gain the most value.
To do so, the company needs to find a balance between its short-term and long-term goals.
In the very short-term, a company needs money to pay its bills, but keeping all of its cash
means that it isn't investing in things that will help it grow in the future. On the other end of
the spectrum is a purely long-term view. A company that invests all of its money will
maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its
bills and will go out of business soon. Companies thus need to find the right mix between
long-term and short-term investment.
The investment decision also concerns what specific investments to make. Since there is no
guarantee of a return for most investments, the finance department must determine
an expected return. This return is not guaranteed, but is the average return on an
investment if it were to be made many times.
The investments must meet three main criteria:

1. It must maximize the value of the firm, after considering the amount of risk the
company is comfortable with (risk aversion).
2. It must be financed appropriately (we will talk more about this shortly).
3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to
shareholder in order to maximize shareholder value.
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Financing
All functions of a company need to be paid for one way or another. It is up to the finance
department to figure out how to pay for them through the process of financing.
There are two ways to finance an investment: using a company's own money or by raising
money from external funders. Each has its advantages and disadvantages.
There are two ways to raise money from external funders: by taking on debt or selling
equity. Taking on debt is the same as taking on a loan. The loan has to be paid back
with interest, which is the cost of borrowing. Selling equity is essentially selling part of
your company .When a company goes public, for example, they decide to sell their
company to the public instead of to private investors. Going public entails selling stocks
which represent owning a small part of the company. The company is selling itself to the
public in return for money.
Every investment can be financed through company money or from external funders. It is
the financing decision process that determines the optimal way to finance the investment.
Among different financial decisions, the one relating to investment in fixed assets or capital
budgeting is of special significance. While taking this decision financial manager has to
take special precautions.
These decisions are relatively more important because of the following reasons:
(1) Long-term Growth and Effect:

These decisions are concerned with long-term assets. These assets are helpful in production.
Profit is earned by selling the goods so produced. It can, therefore, be said the more correct
these decisions are, the greater will be the growth of business in the long run. In addition to
that, these affect future possibilities of the business.
(2) Large Amount of Funds Involved:

Decisions regarding fixed assets are included in the preview of capital budgeting. Large
amount of capital is invested in these assets. If these decisions turn out to be wrong, there
occurs heavy loss of capital which is a scarce resource.
(3) Risk Involved:

Capital budgeting decisions are full of risk. There are two reasons for it. First, these
decisions refer to a long period, and as such expected profits for several years are to be
anticipated. These estimates may turn out to be wrong. Second, because of heavy
investment involved, it is very difficult to change the decision once taken.
(4) Irreversible Decisions:

Nature of these decisions is such as cannot be changed so quickly. For instance, if soon
after setting up a cotton mill, it is thought of changing it, then the old machinery and other
fixed assets will have to be sold at throwaway price. In doing so, heavy loss will have to be
incurred. Changing of these decisions, therefore, is very difficult.
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FACTORS TO CONSIDER WHEN SELECTING SOURCE OF FUNDS
1. Cost: Every source of finance carries some cost with it, known as cost of capital.
While we talk about debt financing, other than lenders expectation, advantage of tax
deductibility indirectly lowers down the cost of debt. The interest rate or coupon rate
is the cost paid by the business for using the debt capital. When the costs of two
broad sources are compared, debt turns out to be a cheaper source of finance, since
the financial charges of debt is a tax deductable expense whereas dividend is not
For e.g. If the Interest paid for long term debt is 10% (D) and tax rate is 50%(t), the
effective cost for such debt to business is:
D (1-t) = 10(1-50%) = 5%
2. Risk: A business is exposed to various kinds of risks. These risks should be

considered while deciding on source of finance. For e.g. in case, a firm relies
majorly on debt financing, then they are said to be highly leveraged as it bears high
financial risk. That is, if debt repayments are not made on time this can lead to legal
action and hence there is a risk of bankruptcy. High financial leverage also effects
the earning per share. So, for deciding an optimal capital structure a company should
analyze the degree of leverage that it can tolerate.
3. Controlling: Controlling and management in the hands of the owner dilutes with
more and more equity introduced from outside in business. Promoters or owners who
do not want to lose the control of business and prefer to keep major decision making
in their hand, will consider equity financing only up to certain level.
4. Flexibility: It plays an important role in deciding the capital structure. A firm

functions in a dynamic business environment today. It should be able to respond to
sudden shocks to its cash flows stream. A highly leveraged firm may face shortage
of cash during adverse conditions, which may lead to sale of assets etc for generation
of cash. Also, in extreme cases, a firm may have to take a step of capital
restructuring or even liquidation on the worst side.
5. Floatation cost, which is high in case of equity.
6. Regulatory rules of various bodies also need to be adhered. In case of market listing
(IPO), rules framed by respective legal bodies of different countries have to comply
by.
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SOURCES OF FINANCE FOR ENTERPRISES

Sources of finance mean the ways for mobilizing various terms of finance to the industrial
concern. Sources of finance state that, how the companies are mobilizing finance for their
requirements. The companies belong to the existing or the new which need sum amount of
finance to meet the long-term and short-term requirements such as purchasing of fixed
assets, construction of office building, purchase of raw materials and day-to-day expenses.
Sources of finance may be classified under various categories according to the following
important heads:
EXTERNAL AND INTERNAL SOURCES OF FUNDS
Sources of Finance may be classified into various categories based on the period.
Internal sources
Internal sources of finance are those sources which are generated within the business .It
means the internal sources provide funds from the operations of the business, these consist
of: retained earnings, provisions e.g. provision for depreciation and provision for taxation,
sale and lease back
External sources
External sources of finance are those sources where finance is obtained from owners or
creditors. This consists of: Ordinary share capital, Preference share capital, debentures,
Trade credit, Hire purchase, loans from banks and other financial institutions.
LONG TERM, MEDIUM TERM AND SHORT TERM SOURCES OF FUNDS
LONG-TERM SOURCES OF FINANCE

Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets
like plant and machinery, land and building etc of a business are funded using long-term
sources of finance. Part of working capital which permanently stays with the business is
also financed with long-term sources of funds. Long-term financing sources can be in form
of any of them:
 Share Capital or Equity Shares
 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
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MEDIUM TERM SOURCES OF FINANCE

Medium term financing means financing for a period of 3 to 5 years and is used generally
for two reasons. One, when long-term capital is not available for the time being and second
when deferred revenue expenditures like advertisements are made which are to be written
off over a period of 3 to 5 years. Medium term financing sources can in the form of one of
them:
 Preference Capital or Preference Shares
 Debenture / Bonds
 Medium Term Loans from
o Financial Institutes
o Government, and
o Commercial Banks
 Lease Finance
 Hire Purchase Finance
SHORT TERM SOURCES OF FINANCE

Short term financing means financing for a period of less than 1 year. The need for short-
term finance arises to finance the current assets of a business like an inventory of raw
material and finished goods, debtors, minimum cash and bank balance etc. Short-term
financing is also named as working capital financing. Short term finances are available in
the form of:
 Trade Credit
 Short Term Loans like Working Capital Loans from Commercial Banks
 Fixed Deposits for a period of 1 year or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.
LONG-TERM SOURCES OF FINANCE
i) Equity/ordinary share capital

Equity Shares also known as ordinary shares, which means, other than preference shares.
Equity shareholders are the real owners of the company. They have a control over the
management of the company. Equity shareholders are eligible to get dividend if the
company earns profit. Equity share capital cannot be redeemed during the lifetime of the
company. The liability of the equity shareholders is the value of unpaid value of shares.
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Features of ordinary Shares
Ordinary shares consist of the following important features:
1. Maturity of the shares: ordinary shares have permanent nature of capital, which has
no maturity period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: ordinary shareholders have the right to get income left
after paying fixed rate of dividend to preference shareholder. The earnings or the
income available to the shareholders is equal to the profit after tax minus preference
dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity
shareholders have the right to get the claims on assets. These rights are only
available to the ordinary shareholders.
4. Right to control: ordinary shareholders are the real owners of the company. Hence,
they have power to control the management of the company and they have power to
take any decision regarding the business operation.
5. Voting rights: ordinary shareholders have voting rights in the meeting of the
company with the help of voting right power; they can change or remove any
decision of the business concern. Ordinary shareholders only have voting rights in
the company meeting and also they can nominate proxy to participate and vote in the
meeting instead of the shareholder.
6. Pre-emptive right: ordinary shareholder pre-emptive rights. The pre-emptive right
is the legal right of the existing shareholders. It is attested by the company in the
first opportunity to purchase additional equity shares in proportion to their current
holding capacity.
7. Limited liability: ordinary shareholders are having only limited liability to the value
of shares they have purchased. If the shareholders are having fully paid up shares,
they have no liability. For example: If the shareholder purchased 100 shares with the
face value of sh. 10 each. He paid only sh. 900. His liability is only sh. 100.
Total number of shares 100 Face

value of shares sh. 10
Total value of shares 100 × 10 = 1,000
Paid up value of shares 900
Unpaid value/liability 100
Liability of the shareholders is only unpaid value of the share (that is sh. 100).
Advantages of ordinary Shares
Ordinary shares are the most common and universally used shares to mobilize finance for
the company. It consists of the following advantages.
1. Permanent sources of finance: ordinary share capital is belonging to long-term
permanent nature of sources of finance; hence, it can be used for long-term or fixed
capital requirement of the business concern.
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2. Voting rights: ordinary shareholders are the real owners of the company who have
voting rights. This type of advantage is available only to the equity shareholders.
3. No fixed dividend: ordinary shares do not create any obligation to pay a fixed rate
of dividend. If the company earns profit, equity shareholders are eligible for profit,
they are eligible to get dividend otherwise, and they cannot claim any dividend from
the company.
4. Less cost of capital: Cost of capital is the major factor, which affects the value of
the company. If the company wants to increase the value of the company, they have
to use more share capital because, it consists of less cost of capital (Ke) while
compared to other sources of finance.
5. Retained earnings: When the company have more share capital, it will be suitable
for retained earnings which are the less cost sources of finance while compared to
other sources of finance.
Disadvantages of Ordinary Shares
1. Irredeemable: ordinary shares cannot be redeemed during the lifetime of the

business concern. It is the most dangerous thing of over capitalization.
2. Obstacles in management: ordinary shareholder can put obstacles in management
by manipulation and organizing themselves. Because, they have power to contrast
any decision which are against the wealth of the shareholders.
3. Leads to speculation: ordinary shares dealings in share market lead to secularism
during prosperous periods.
4. Limited income to investor: The Investors who desire to invest in safe securities
with a fixed income have no attraction for ordinary shares.
5. No trading on equity: When the company raises capital only with the help of
equity, the company cannot take the advantage of trading on equity.
PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is the shares, which have
preferential right to get dividend and get back the initial investment at the time of winding
up of the company. Preference shareholders are eligible to get fixed rate of dividend and
they do not have voting rights.
Preference shares may be classified into the following major types:
1. Cumulative preference shares: Cumulative preference shares have right to claim
dividends for those years which have no profits. If the company is unable to earn
profit in any one or more years, C.P. Shares are unable to get any dividend but they
have right to get the comparative dividend for the previous years if the company
earned profit.
2. Non-cumulative preference shares: Non-cumulative preference shares have no
right to enjoy the above benefits. They are eligible to get only dividend if the
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company earns profit during the years. Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When, the preference shares have a fixed maturity
period it becomes redeemable preference shares. It can be redeemable during the
lifetime of the company. The Company Act has provided certain restrictions on the
return of the redeemable preference shares.
Irredeemable Preference Shares
Irredeemable preference shares can be redeemed only when the company goes for
liquidator. There is no fixed maturity period for such kind of preference shares.
Participating Preference Shares
Participating preference shareholders’ have right to participate extra profits after
distributing the equity shareholders.
Non-Participating Preference Shares
Non-participating preference shareholders’ are not having any right to participate extra
profits after distributing to the equity shareholders. Fixed rate of dividend is payable to the
type of shareholders.
Convertible Preference Shares
Convertible preference shareholders’ have right to convert their holding into equity shares
after a specific period. The articles of association must authorize the right of conversion.
Non-convertible Preference Shares
There shares, cannot be converted into equity shares from preference shares.
Features of Preference Shares
The following are the important features of the preference shares:
1. Maturity period: Normally preference shares have no fixed maturity period except
in the case of redeemable preference shares. Preference shares can be redeemable
only at the time of the company liquidation.
2. Residual claims on income: Preferential shareholders have a residual claim on
income. Fixed rate of dividend is payable to the preference shareholders.
3. Residual claims on assets: The first preference is given to the preference
shareholders at the time of liquidation. If any extra Assets are available that should
be distributed to equity shareholder.
4. Control of Management: Preference shareholder does not have any voting rights.
Hence, they cannot have control over the management of the company.
Advantages of Preference Shares
Preference shares have the following important advantages.
1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is
called as fixed income security because it provides a constant rate of income to the
investors.
2. Cumulative dividends: Preference shares have another advantage which is called
cumulative dividends. If the company does not earn any profit in any previous years,
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it can be cumulative with future period dividend.

3. Redemption: Preference Shares can be redeemable after a specific period except in
the case of irredeemable preference shares. There is a fixed maturity period for
repayment of the initial investment.
4. Participation: Participative preference shareholders can participate in the surplus
profit after distribution to the equity shareholders.
5. Convertibility: Convertibility preference shares can be converted into equity shares
when the articles of association provide such conversion.
Disadvantages of Preference Shares

1. Expensive sources of finance: Preference shares have high expensive source of
finance while compared to equity shares.
2. No voting right: Generally preference shareholders do not have any voting rights.
Hence they cannot have the control over the management of the company.
3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They
may not enjoy more profits of the company.
4. Permanent burden: Cumulative preference shares become a permanent burden so
far as the payment of dividend is concerned. Because the company must pay the
dividend for the unprofitable periods also.
5. Taxation: In the taxation point of view, preference shares dividend is not a
deductible expense while calculating tax. But, interest is a deductible expense.
Hence, it has disadvantage on the tax deduction point of view.
DEFERRED SHARES
Deferred shares also called as founder shares because these shares were normally issued to
founders. The shareholders have a preferential right to get dividend before the preference
shares and equity shares. According to Companies Act 1956 no public limited company or
which is a subsidiary of a public company can issue deferred shares.
These shares were issued to the founder at small denomination to control over the
management by the virtue of their voting rights.
NO PAR SHARES
When the shares are having no face value, it is said to be no par shares. The company issues
this kind of shares which is divided into a number of specific shares without any specific
denomination. The value of shares can be measured by dividing the real net worth of the
company with the total number of shares.
The real net worth

Value of no. per share =
Total no. of shares
Debentures
A Debenture is a document issued by the company. It is a certificate issued by the company
under its seal acknowledging a debt.
According to the Companies Act 1956, “debenture includes debenture stock, bonds and
any other securities of a company whether constituting a charge of the assets of the
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company or not.”
Types of Debentures
Debentures may be divided into the following major types:
1. Unsecured debentures: Unsecured debentures are not given any security on assets
of the company. It is also called simple or naked debentures. These types of
debentures are treated as unsecured creditors at the time of winding up of the
company.
2. Secured debentures: Secured debentures are given security on assets of the
company. It is also called as mortgaged debentures because these debentures are
given against any mortgage of the assets of the company.
3. Redeemable debentures: These debentures are to be redeemed on the expiry of a
certain period. The interest is paid periodically and the initial investment is returned
after the fixed maturity period.
4. Irredeemable debentures: These kind of debentures cannot be redeemable during
the life time of the business concern.
5. Convertible debentures: Convertible debentures are the debentures whose holders
have the option to get them converted wholly or partly into shares. These debentures
are usually converted into equity shares. Conversion of the debentures may be:
Non-convertible debentures Fully
convertible debentures Partly
convertible debentures
6. Other types: Debentures can also be classified into the following types. Some of the
common types of the debentures are as follows:
1. Collateral Debenture
2. Guaranteed Debenture
3. First Debenture
4. Zero Coupon Bond
5. Zero Interest Bond/Debenture
Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period. Normally,
debentures consist of 10–20 years maturity period and are repayable with the
principle investment at the end of the maturity period.
2. Residual claims in income: Debenture holders are eligible to get fixed rate of
interest at every end of the accounting period. Debenture holders have priority of
claim in income of the company over equity and preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on Assets of
the company over equity and preference shareholders. The Debenture holders may
have either specific change on the Assets or floating change of the assets of the
company. Specific change of Debenture holders are treated as secured creditors and
floating change of Debenture holders are treated as unsecured creditors.
4. No voting rights: Debenture holders are considered as creditors of the company.

Hence they have no voting rights. Debenture holders cannot have the control over
the performance of the business concern.
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5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period.
Hence the business will not affect the yield of the debenture.
Advantages of Debenture
Debenture is one of the major parts of the long-term sources of finance which of consist the
following important advantages:
1. Long-term sources: Debenture is one of the long-term sources of finance to the
company. Normally the maturity period is longer than the other sources of finance.
2. Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it
is most suitable of the companies earn higher profit. Generally, the rate of interest is
lower than the other sources of long-term finance.
3. Trade on equity: A company can trade on equity by mixing debentures in its capital
structure and thereby increase its earnings per share. When the company applies the
trade on equity concept, cost of capital will reduce and value of the company will
increase.
4. Income tax deduction: Interest payable to debentures can be deducted from the total
profit of the company. So it helps to reduce the tax burden of the company.
5. Protection: Various provisions of the debenture trust deed and the guidelines issued
by the SEB1 protect the interest of debenture holders.
Disadvantages of Debenture
Debenture finance consists of the following major disadvantages:
1. Fixed rate of interest: Debenture consists of fixed rate of interest payable to
securities. Even though the company is unable to earn profit, they have to pay the
fixed rate of interest to debenture holders; hence, it is not suitable to those company
earnings which fluctuate considerably.
2. No voting rights: Debenture holders do not have any voting rights. Hence, they
cannot have the control over the management of the company.
3. Creditors of the company: Debenture holders are merely creditors and not the
owners of the company. They do not have any claim in the surplus profits of the
company.
4. High risk: Every additional issue of debentures becomes more risky and costly on
account of higher expectation of debenture holders. This enhanced financial risk
increases the cost of equity capital and the cost of raising finance through debentures
which is also high because of high stamp duty.
5. Restrictions of further issues: The company cannot raise further finance through
debentures as the debentures are under the part of security of the assets already
mortgaged to debenture holders.
DEBT FINANCE
Debt finance is a fixed return finance as the cost (interest) is fixed on the par value (face
value of debt). It is ideal to use if there’s a strong equity base. It is raised from external
sources to qualifying companies and is available in limited quantities.
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It is limited to:
i) Value of security.
ii) Liquidity situation in a given country. It is ideal for companies where gearing
allows them to raise more debt and thus gearing level.
Loan finance – this is a common type of debt and is available in different terms usually
short term. Medium term loans vary from 2 - 5 years. Long-term loans vary from 6 years
and above
The terms are relative and depend on the borrower. This finance is used on the basis of
Matching approach i.e. matching the economic life of the project to the term of the loan. It
is prudent to use short-term loans for short-term ventures i.e. if a venture is to last 4 years
generating returns, it is prudent to raise a loan of 4 years maturity period.
Conditions under Which Loans Are Ideal

a) When the company’s gearing level is low (the level of outstanding loans is low.
b) The company’s future cash flows (inflows and their stability) must be assured. The
company must be able to repay the principal and the interest.
c) Economic conditions prevailing. The company must have a long-term forecast of the
prevailing economic condition. Boom conditions are ideal for debt.
d) When the company’s market share guarantees stable sales.
e) When the company’s anticipated future expansion programs, justify such borrowing.
Requirements for Raising Loan
a) History of the company and its subsidiaries.

b) Names, ages, and qualifications of the company’s directors.
c) The names of major shareholders – 51% plus i.e. owner who must give consent.
d) Nature of the products and product lines.
e) Publicity of the product.
f) Nature of the loan – either secured, floating or unsecured.
g) Cash flow forecast.
Reasons Why Commercial Banks Prefer To Lend Short Term Loans
a) Long-term forecasts are not only difficult but also vague as uncertainties tend to
jeopardize planning e.g. political and economic factors.
b) Commercial banks are limited by the Central Bank of Kenya in their long term
lending due to liquidity considerations.
c) Short-term loans are profitable. This is because interest is high as in overdrafts.
d) Long term finance loses value with time due to inflation.
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e) Cost of finance – 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.
f) Commercial banks do credit analysis that is limited to short term situations.
g) 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.
Advantages of Using Debt Finance

 Interest on debt is a tax allowable expense and as such it is reduced by the tax
allowance.
Example
Interest = 10% tax rate = 30%
The effective cost of debt (interest) = Interest rate(1 – T)
= 10%(1-0.30)
= 7%
Consider companies A and B
Company A B
Sh.’000’ Sh.’000’
10% debt 1,000 -
Equity - 1,000
1,000 1,000
The tax rate is 30% and earnings before interest and tax amount to Ksh.400,000. All
earnings are paid out as dividends. Compute payable by each firm.
Company A B
Sh.’000’ Sh.’000’
EBIT 400 400
Less interest 10% x 1,000 (100) -
EBT 300 400
Less tax @ 30% (90) (120)
Dividends payable 210 280
Company A saves tax equal to Sh.30,000(120,000 – 90,000) since interest charges are tax
allowable and reduce taxable income.
 The cost of debt is fixed regardless of profits made and as such under conditions of
high profits the cost of debt will be lower.
 It does not call for a lot of formalities to raise and as such its ideal for urgent ventures
 It 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.
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 In case of long-term debt, amount of loan declines with time and repayments reduce its
burden to the borrower.
 Debt finance does not influence the company’s decision since lenders don’t participate
at the AGM.
Disadvantages
 It is a conditional finance i.e. it is not invested without the approval of lender.
 Debt 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 BOD.
 It is dangerous to use in a recession as such a condition may force the company into
receivership due to lack of funds to service the loan.
 It calls for securities which are highly negotiable or marketable thus limiting its
availability.
 It is only available for specific ventures and for a short term, which reduces its
investment in strategic ventures.
 The use of debt finance may lower the value of a share if used excessively. It increases
financial risk and required rate of return by shareholders thus reduce the value of shares.
Differences between Debt Finance and Ordinary Share Capital (Equity Finance)
Ordinary share capital Debt

a) It is a permanent finance a) It is refundable (redeemable)
b) Return paid when available b) It is fixed return capital
c) Dividends are not tax allowable c) Interest on debt is a tax allowable
d) Unsecured finance d) expense
e) Carry voting rights e) Secured finance
f) Reduces gearing ratio f) No voting right
g) No legal obligation to pay g) Increases gearing ratio
h) Has a residue claim h) A legal obligation to pay
i) Owners’ money i) Carries a superior claim
Creditors finance.
Similarities between Preference and Equity Finance

a) Both may be permanent if preference share capital is redeemable (convertible).
b) Both are naked or unsecured finances.
c) Both are traded at the stock exchange
d) Both are raised by public limited companies only
e) Both carry residue claims after debt.
f) Both dividends are not a legal obligations for the company to pay.
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Differences between Preference and Equity Finance
Ordinary share capital Preference share capital

a) Has a residue claim both on assets and profit a) Has a superior claim
b) Carries voting rights b) No voting rights
c) Reduces the gearing ratio c) Increases the gearing ratio
d) Variable dividends hence grow over time d) Fixed dividends hence no growth
e) Permanent finance e) Usually redeemable
f) Easily transferable. f) Not easily transferable
Similarities between Debt and Preference Share Capital

a) Both have fixed returns.
b) Both will increase the company’s gearing ratio.
c) Both are usually redeemable.
d) Both do not have voting rights.
e) Both may force the company into receivership
f) Both have superior claims over and above owners.
g) Both are external finances.
h) There is no growth with time.
Differences between Preference Share Capital and Debt
DEBT PREFERENCE SHARE CAPITAL

a) Interest is tax allowable a) Dividends are not tax allowable
b) Interest is a legal obligation b) Dividends are not a legal obligation
c) Debt finance is always secured c) Preference is not secured finance
d) Debt finance is a pre-conditional d) Is not conditional finance
e) Has a superior claim e) Has a residue claim (after debt)
Why it may be difficult for small companies to raise debt finance in Kenya (Say Jua
Kali Companies)
 Lack of security
 Ignorance of finances available
 Most of them are risky businesses as there are no feasibility studies done (chances of
failure have been put to 80%).
 Their size being small tends to make them UNKNOWN i.e. they are not a significant
competitor to the big companies.
 Cost of finance may be high – 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.
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 Lack of business principles that are sound and difficult in evaluating their
performance.
Solutions to the Above Problems

 There should be diversification of securities e.g. to accept guarantees.
 Education of such businessmen on sound business principles.
 The government should set up a special fund to assist the jua kali businessmen.
 Encourage formation of co-operative societies.
 To request bankers to follow up the use of these loans.
1. RETAINED EARNINGS
i) Revenue Reserves
These are undistributed earnings. Such reserves are retained for the following reasons:
 To make up for the fall in profits so as to sustain acceptable risks.
 To sustain growth through plough backs. They are cheap source of finance.
 They are used to boost the company’s credit rating so they enable further finance to
be obtained.
 It lowers the company’s gearing ratio – reduces chances of receivership/liquidation.
ii) Capital Reserves

 It is raised by selling shares at a premium. (The difference between the market price
(less floatation costs) and par value is credited to the capital reserve).
 Through revaluation of the company’s assets. This leads to a fictitious entry which
is of the nature of a capital reserve.
 By creation of a sinking fund.
Advantages of using retained earnings

a) The management of many companies believes that retained earnings are funds which do
not cost anything, although this is not true. However, it is true that the use of retained
earnings as a source of funds does not lead to a payment of cash.
b) The dividend policy of the company is in practice determined by the directors. From
their standpoint, retained earnings are an attractive source of finance because investment
projects can be undertaken without involving either the shareholders or any outsiders.
c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.
d) The use of retained earnings avoids the possibility of a change in control resulting from
an issue of new shares.
Another factor that may be of importance is the financial and taxation position of the
company's shareholders. If, for example, because of taxation considerations, they would
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rather make a capital profit (which will only be taxed when shares are sold) than receive
current income, then finance through retained earnings would be preferred to other
methods.
Disadvantages of using retentions

a) Shareholders may be sensitive to the loss of dividends that will result from retention for
re-investment, rather than paying dividends
b) Not so much a disadvantage as a misconception, that retained profits is cost-free method
of obtaining funds. There is an opportunity cost in that if dividends were paid, the cash
received could be invested by shareholders to earn a return.
A company must restrict its self-financing through retained profits because shareholders
should be paid a reasonable dividend, in line with realistic expectations, even if the
directors would rather keep the funds for re-investing. At the same time, a company that is
looking for extra funds will not be expected by investors (such as banks) to pay generous
dividends, nor over-generous salaries to owner-directors.
2. MORTGAGES
A mortgage is a loan specifically for the purchase of property. They are a specific type of
secured loan. Companies place the title deeds of freehold or long leasehold property as
security with an insurance company or mortgage broker and receive cash on loan, usually
repayable over a specified period. Most organizations owning property which is
unencumbered by any charge should be able to obtain a mortgage up to two thirds of the
value of the property.
Some businesses might buy property through a mortgage. In many cases, mortgages are
used as a security for a loan. This tends to occur with smaller businesses. The borrower can
use their own property as security for the loan - it is often called taking out a second
mortgage. If the business does not work out and the borrower could not pay the bank the
loan then the bank has the right to take the home of the borrower and sell it to recover their
money. Using a mortgage in this way is a very popular way of raising finance for small
businesses but as you can see carries with it a big risk.
The companies or partnerships can get loans for long periods by mortgaging their assets
with any mortgage brokers or any other financial institution. Freehold properties may be
used for this purpose. It is an important source of long-term capital for commercial
undertaking. Insurance companies, pension funds and finance companies are the main
mortgagees. The mortgagor agrees to deposit the title to the asset with the mortgagee. The
loans obtained by the mortgagor are to be repaid through installments over a specific period
of time.
3. SALE AND LEASE BACK

A company or partnership which own its own premises or fixed assets can obtain finance by
selling the property to an insurance company for immediate cash and renting it back.
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As firms grow they build up assets. These assets could be in the form of property,
machinery, equipment, other companies or even logos. In some cases it may be appropriate
for a business to sell off some of these assets to finance other projects.
A company should enter into a sale and lease back agreement if it cannot raise capital in
any other way. In this source of finance, a company can obtain full sales price and it can
also continue to use the fixed asset. But the firm now has to pay a hire charge regularly for
the period for which a lease agreement has been entered into.
4. DEBENTURE FINANCE
A form of long term debt raised after a company sells debenture certificates to the holder
and raises finance in return. The term debenture has its origin from ‘DEBOE’ which means
‘I owe’ 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. These debentures usually mature between 10
to 15 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. The current interest
rate is payable twice a year and it is a legal obligation.
CLASSIFICATION
i) Secured Debentures
These are those types of debentures which a company will secure usually in two ways,
secured with a fixed charge or with a floating charge.
a) Fixed Charge – a debenture is secured with a fixed charge if it can claim on a specific
asset.
b) Floating charge – 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 Debentures

These are not secured by any of the company’s assets and as such they are general creditors.
iii) Redeemable Debentures

These are the type of debentures, which the company can buy back after the minimum
redemption period and before the maximum redemption period (usually 15 years) after
which holders can force the company to receivership to redeem their capital and interest
outstanding.
iv) Irredeemable Debentures (perpetuities)

These 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 company’s with a history of
stable ordinary dividend record.
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v) Classification according to convertibility

Convertible debentures – Can be converted into ordinary shares although they can also be
converted into preference shares.
Conversion price = par value of a debenture/No. of shares to be received.
Conversion ratio = Par value of debenture
Par value of ordinary shares
Illustration
ABC Company Ltd books:
Sh.
10.000, Sh.20 ordinary share capital 200,000
10,000, Shs.10 8% preference share capital 100,000
5,000, Shs.100 12% debentures 500,000
The above debentures are due for conversion:
Required;-
i) Compute the conversion price
ii) Compute the conversion ratio
iii) Compute new capital structure.
Solution
i)Conversion price = par value of debenture/No. of shares to be received.
No. of shares to be received = 100:20 = 5:1

100
Therefore =  20
5
100
ii) Conversion ratio = par value of debenture/par value of share =  5.0
20
Receive 5 ordinary shares for every 1 debenture held.
iii) New capital structure

No. of new ordinary shares = 5000 x 5 = 25,000
Shs.
35,000, Shs.20 ordinary shares 700,000
10,000, Shs.10, 8% preference shares 100,000
Total capital 800,000
vi) Non-convertible debentures

These cannot be converted into ordinary preference shares and they are usually redeemable.
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vii) Sub-ordinate debentures

Usually last for as long as 10 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. This means that they are sub-ordinate to senior debt but superior to ordinary
and preference share capital.
Reasons behind Unpopularity of Debentures of Kenya’s Financial Market:

i. Their par value is an extremely high value and as such they are unaffordable to
purchase by would be investors.
ii. They are in most cases secured debt and as such constrain the selling company in so
far as getting sufficient securities is difficult.
iii. Most of the would-be sellers have low credit worthiness which is difficult.
iv. Kenya’s capital markets are not developed and as such there is no secondary
debenture market where they can be discounted or endorsed.
v. Debentures finance is not known among the general business community and as such
many would be sellers and buyers are ignorant of its existence.
vi. Being long term finance there are a few buyers who may be willing to stake their
savings for a long period of time.
vii. Such finance calls for a fixed return, which in the long run will be eroded by
inflation.
SHORT TERM SOURCES
Short term financial sources provide funds that may be used usually for less than three
years. Sometimes these funds are available only for period of less than one year. These
sources help for funding shortages in working capital. These sources should not be used to
finance long term investments. These are discussed below:
1. BILLS OF EXCHANGE
Bills of Exchange are a source of finance in particular in the export trade. A bill of
exchange 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. The
commonest types of bills of exchange used in financing are accommodation bills of
exchange. For a bill to be a legal document; it must be;-
a) Drawn by the drawer.
b) Bear a stamp duty
c) Acceptable by the drawee
e) Mature in time.
It is used to raise finance through:
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i) Discounting it.
ii) Negotiating
iii) Giving it out as security.
Advantages of Using a Bill as a Source of Finance
 They are a faster means of raising finance (if drawer is credible).
 Is highly negotiable/liquid investment
 Does not require security
 Does not affect the gearing level of the company
 It is unconditional and can be invested flexibly
 It is useful as a source of finance to finance working capital
 It is used without diluting capital.
2. OVERDRAFT FINANCE
This finance is ideal to use as bridging finance in sense that it should be used to solve the
company’s short term liquidity problems in particular those of financing working capital
(w.c.). It is usually a secured finance unless otherwise mentioned. Overdraft finance is an
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.
Advantages of Overdraft Finance

 It is useful in financial crisis which an accountant cannot forecast due to abrupt fall
in profits thus liquidity problems.
 In some cases it may be secured on goodwill thus making it flexible finance.
 It does not entail preconditions and is therefore investible in high-risk situations
when the firm does not have finance in normal circumstances.
 It 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.
 If not used for a long period of time – it does not affect the company’s gearing level
and therefore does not relate to company’s liquidation or receivership.
 Less formalities/procedures involved.
Disadvantages of Overdraft Finance

 It is expensive as the interest rates of overdrafts are much higher than bank rates.
 The use of this finance is an indication of poor financial management principle.
 It may be misused by management because it does not carry pre-conditions
 Being a short-term financial arrangement, it can be recalled at short notice leaving
the company in financial crisis.
3. TRADE CREDIT
The use of credit from suppliers is a major source of finance. It is particularly important to
small and fast growing firms. Trade credit is a cheap source of short term finance. It is also
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easy to obtain and it is a flexible source of financing. The only caution a company must
exercise over trade credit is to avoid a situation of over-trading.
Trade credit has double edged significance for a firm. It is a source of credit for financing
purchases and it is a use of funds to the extent that the firm finances credit sales to
customers. The trade credit is convenient and informal source of short-term finance. A firm
that does not qualify for credit from a financial institution may receive trade credit because
previous experience has familiarized the seller with the credit worthiness of his customer.
4. FACTORING
Factoring means selling debts for immediate cash to a factor who charges commission.
When the factor receives each batch of invoices from his client, he pays about 80% of its
value in cash immediately. Factoring can result in savings to management in the form of
savings in bad debt losses, salary costs, telephone, postage etc. This source of short term
finance is not yet very popular in Kenya. This method was adopted in U.K. first time in
1959.
Factoring is normally under-taken with recourse. The factor must bear the loss in the event
the person or firm which bought goods does not pay. The factoring firm will make an
appraisal of the credit worthiness of each customer of the seller and set a Limit for each of
these customers.
Aspects of factoring
The main aspects of factoring include the following.
a) Administration of the client’s invoicing , sales accounting and debt collection services
b) Credit protection for client’s debts, whereby the factor taKes over the risk of loss from
bad debts and so ‘insures’ the client against losses. This is known as a non-recourse
service. However, if the non-recourse service is provided the factor, not the firm, will
decide what action to take against non –players.
c) Making payments to the client advance of collecting debts. This is sometimes referred to
as ‘factor finance’ because the factor is providing cash to the client against outstanding
debts.
Advantages of factoring
The benefits of factoring for a business customer include the following.
a) The business can pay it suppliers promptly, and so be able to take advantage of any
early payment discounts that are available.
b) Optimum inventory levels can be maintained, because the business will have enough
cash to pay for the inventories it needs.
c) Growth can be financed through sales rather than by injecting fresh external capital
balance.
d) The business gets finance linked to its volume of sales. In contrast, overdraft limits
tend to be determined by historical balance sheets.
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e) The managers of business do not have to spend their time running its own sales
department, and can use the expertise of debtor management that the factor has.
Disadvantages of Factoring
a) The cost of factoring will reduce the profit margin of the company
b) It may reduce the scope of borrowing as book debts will not be available as security
c) It may damage the reputation of the company with its customers
d) Factors may want vet the customers hence influence the way the way the firm does its
business
5. PLASTIC MONEY (CREDIT CARD FINANCE)

This is finance of a kind whereby a company will make arrangements for the use of the
services of credit card organizations (through the purchase of credit cards) in return for
prompt settlement of bills on the card and a commission payable on all credit transactions.
This 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.
Reasons behind the Fast Development of This Finance (Plastic Money) In Kenya
a) High incidences of fraud by dishonest employees has been responsible for
development of this finance as it minimizes chances of this fraud because it eliminates
the use of hard cash in the execution of transactions.
b) Risk 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.
c) Credit cards have boosted the credibility of holder companies which enables them to
obtain trade credits under conditions which would have otherwise been difficult.
d) Of late, Kenya has experienced emergence of elite, middle and high-income groups’
in particular professionals who tend to use these cards as a symbol of status in
execution of day to day transactions.
e) These cards have been used by financial institutions and banks to boost their deposit
and attract long term clienteles e.g. Royal Card Finance, Standard Chartered.
f) A 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 of Credit Cards as a Source of Finance

i) These cards lead to overspending on the part of the holder and as such may
disorganise the organization’s cash budget and cash planning.
ii) Limited 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.
iii) They are expensive to obtain and maintain because of associated cost such as ledger
fees, registration, insurance, commission expenses, renewal fees etc.
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iv) It 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.
v) Entail 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.
vi) They may be misused by dishonest employees who may use them to defraud the
organization off goods and services which may not benefit such organizations.
vii) Credit card organization may suspend the use of such cards without notice and this
will inconvenience the holder who may not meet his/her ordinary needs obtained
through these cards.
6. INVOICE DISCOUNTING
Invoice discounting is the purchase (by the provider of discounting services) of trade
debts at a discount. Invoice discounting enables the company from which the debts are
purchased to raise working capital. Invoice discounting is almost similar to factoring. It
is the assignment of debts whereas the factoring is the selling of debts.
Invoice discounting is characterized by the fact that the lender not only has lien on the
debts but also has recourse to the borrower (seller) if the firm or person that bought the
goods does not pay. In this case, the loss is borne by the selling firm. Invoice discounting
firms act as the agents of the seller. A client should only want to have some invoices
discounted when he has temporary cash shortage, and so invoice discounting tends to
consist of one-off deals.
If a client needs to generate cash, he can approach a factor or invoice discounter, who
will offer to purchase selected invoices and advance up to 75% of their value. At the end
of each month, the factor will pay over the balance of the purchase price, less charges, on
the invoices that have settled in the month. Features of invoice discounting
 The firm collects the debts and does the credit control
 The customers do not usually know about invoice discounting
 The invoice discounter will check regularly to see that the company’s procedures are
effective
Confidential invoice discounting is an arrangement whereby a debt is confidentially

assigned to the factor, and the client’s customer will only become aware of the arrangement
if he does not pay his debt to the client.
7. HIRE PURCHASE
Hire purchase or installment credit is a method of paying for plant and machinery out of
income rather than capital. The use of the equipment is gained on payment of the first
installment. This source is relatively expensive but it leaves other sources of finance for
emergencies. Hire purchase is an increasingly important source of finance these days for
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the purchase of capital goods. In this method, the seller invoices the goods to the hire
purchase company which agrees with the customer to receive the total amount and hire
purchase interest in equal installments.
The hirer is required to pay these installments regularly. If he fails to pay these
installments then tl1e asset can be repossessed. In Kenya, if the hirer fails to pay any
installment before he clears two third of the total value of the asset then the hire
purchase finance company can repossess this asset. The hirer will not get good title to
the asset until he pays the final installment.
Hire purchase is a form of installment credit. Hire purchase is similar to leasing, with
the exception that ownership of the goods passes to the hire purchase customer on
payment of the final credit installment, whereas a lessee never becomes the owner of the
goods.
Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.
ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.
The finance house will always insist that the hirer should pay a deposit towards the
purchase price. The size of the deposit will depend on the finance company's policy and its
assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be
required to make any large initial payment.
An industrial or commercial business can use hire purchase as a source of finance. With
industrial hire purchase, a business customer obtains hire purchase finance from a finance
house in order to purchase the fixed asset. Goods bought by businesses on hire purchase
include company vehicles, plant and machinery, office equipment and farming machinery.
8. LEASE FINANCE
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns
a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of
the lease to the lessor, for a specified period of time.
Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery,
cars and commercial vehicles, but might also be computers and office equipment. There are
two basic forms of lease: "operating leases" and "finance leases".
Operating leases
Operating leases are rental agreements between the lessor and the lessee whereby:
i) The lessor supplies the equipment to the lessee
ii) The lessor is responsible for servicing and maintaining the leased equipment
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iii) The period of the lease is fairly short, less than the economic life of the asset, so that
at the end of the lease agreement, the lessor can either lease the equipment to
someone else, and obtain a good rent for it, or sell the equipment secondhand.
Finance leases
Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.
Suppose that a company decides to obtain a company car and finance the acquisition by
means of a finance lease. A car dealer will supply the car. A finance house will agree to act
as lessor in a finance leasing arrangement, and so will purchase the car from the dealer and
lease it to the company. The company will take possession of the car from the car dealer,
and make regular payments (monthly, quarterly, six monthly or annually) to the finance
house under the terms of the lease.
Other important characteristics of a finance lease:

i. The lessee is responsible for the upkeep, servicing and maintenance of the asset. The
lessor is not involved in this at all.
ii. The lease has a primary period, which covers all or most of the economic life of the
asset. At the end of the lease, the lessor would not be able to lease the asset to
someone else, as the asset would be worn out. The lessor must, therefore, ensure that
the lease payments during the primary period pay for the full cost of the asset as well
as providing the lessor with a suitable return on his investment.
iii. It is usual at the end of the primary lease period to allow the lessee to continue to lease
the asset for an indefinite secondary period, in return for a very low nominal rent.
Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since
the lessor is the owner) and to keep most of the sale proceeds, paying only a small
percentage (perhaps 10%) to the lessor.
Leases are popular because;-

i. The supplier of the equipment is paid in full at the beginning. The equipment is sold to
the lessor, and apart from obligations under guarantees or warranties, the supplier has
no further financial concern about the asset.
ii. The lessor invests finance by purchasing assets from suppliers and make a return out
of the lease payments from the lessee. Provided that a lessor can find lessees willing to
pay the amounts he wants to make his return, the lessor can make good profits. He
will also get capital allowances on his purchase of the equipment.
iii. Leasing might be attractive to the lessee if the lessee does not have enough cash to
pay for the asset, and would have difficulty obtaining a bank loan to buy it, and so has
to rent it in one way or another if he is to have the use of it at all; or if finance leasing
is cheaper than a bank loan. The cost of payments under a loan might exceed the cost
of a lease.
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Operating leases have following advantages:

i) The leased equipment does not need to be shown in the lessee's published balance
sheet, and so the lessee's balance sheet shows no increase in its gearing ratio.
ii) The equipment is leased for a shorter period than its expected useful life. In the case
of high-technology equipment, if the equipment becomes out-of-date before the end of
its expected life, the lessee does not have to keep on using it, and it is the lessor who
must bear the risk of having to sell obsolete equipment secondhand.
The lessee will be able to deduct the lease payments in computing his taxable profits.
Example
The primary period of the lease might be three years, with the agreement by the lessee to
make three annual payments of Ksh. 6,000 each. The lessee will be responsible for repairs
and servicing, road tax, insurance and garaging. At the end of the primary period of the
lease, the lessee may have the option either to continue leasing the car at a nominal rent
(perhaps Ksh. 250 a year) or sell the car and pay the lessor 10% of the proceeds.
Advantages of lease
i. In a lease arrangement the firm may avoid the cost of obsceneness if the lessor fails to
anticipate accurately the obsolesce of assets and sets the lease payment too low. This is
especially true with operating leases which is generally true for operating leases which
generally have short live.
ii. A lessee avoids many of the restrictive covenants that are normally included as part of
long loans
Disadvantages of lease
i. A lease does not have a stated interest cost. Thus in many leases the return to the
lessor is quit high; the firm might be better of borrowing to purchase the asset
ii. Under a lease, the lessee is generally prohibited from making improvements on the
lease property or asset without the approval of the lessor. If the property were owned
out rightly, this difficulty will not arise.
iii. Under a financial lease, if a lessee leases an asset that subsequently becomes obsolete
it still must make lease payments over the remaining term of the lease even if the asset
is an usable
EVALUATION OF FINANCIAL OPTIONS
When evaluating the financing options available for a company there are many factors that
need to be looked at, the following should be considered:-
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Financial performance and position
When considering the source of finance to be used by a company, the recent financial
performance, the current financial position and the expected future financial performance of
the company needs to be taken into account.
Whether you are evaluating recent or forecast financial performance, key areas to consider
include the growth in turnover, the growth in operating profit, the growth in profit after or
before tax and the movement in profit margins. Return on capital employed and return on
equity could be calculated. A key point for students to remember is that they only have
limited time and it is better to calculate a few key ratios and then move on and complete the
question than it is to calculate all possible ratios and fail to satisfy the requirement.
Evaluating the current financial position
The key consideration when evaluating the current financial position is to establish the
financial risk of the company. Hence, the key ratios to calculate are the financial gearing,
which shows the financial risk using data from the statement of financial position and
interest cover, which shows the financial risk using data from the income statement.
Equally, the split between short and long-term financing, and the reliance of the company
on overdraft finance, should also be considered.
When evaluating financial performance and financial position, due consideration should be
given to any comparative sector data provided. Indeed, if no such data is provided, I would
recommend that you state in your answer that you would want to consider such comparative
data. This is what you would do in real life and stating it shows that you are aware of this. If
the examiner has not provided such data, it is simply because he is constrained by the need
to examine many topics in just three hours.
Recommendation of a suitable financing method
When recommending a financing method, consideration should be given to a number of

factors. The factors include:
1. Cost – Debt finance is cheaper than equity finance and so if the company has the
capacity to take on more debt, it could have a cost advantage.
2. Cash flows – While debt finance is cheaper than equity finance, it places on the
company the obligation to pay out cash in the form of interest. Failure to pay this
interest can result in action being taken to wind up the company.
3. Hence, consideration should be given to the ability of the company to generate cash.
If the company is currently cash-generating, then it should be able to pay its interest
and debt finance could be a good choice. If the company is currently using cash
because it is investing heavily in research and development for example, then the
cash may not be available to service interest payments and the company would be
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better to use equity finance. The equity providers may be willing to accept little or no
cash return in the short term, but will instead hope to benefit from capital growth or
enhanced dividends once the investment currently taking place bears fruit. Also,
equity providers cannot take action to wind up a company if it fails to pay the
dividend expected.
4. Risk – The directors of the company must control the total risk of the company and
keep it at a level where the shareholders and other key stakeholders are content.
Total risk is made up of the financial risk and the business risk. Hence, if it is clear
that the business risk is going to rise – for example, because the company is
diversifying into riskier areas or because the operating gearing is increasing – then
the company may seek to reduce its financial risk. The reverse is also true – if
business risk is expected to fall, then the company may be happy to accept more
financial risk.
5. Security and covenants – If debt is to be raised, security may be required. From the
data given it should be possible to establish whether suitable security may be
available. Covenants, such as those that impose an obligation on the company to
maintain a certain liquidity level, may be required by debt providers and directors
must consider if they will be willing to live with such covenants prior to taking on
the debt.
6. Availability – The likely availability of finance must also be considered when

recommending a suitable finance source. For instance, a small or medium-sized
unlisted company will always find raising equity difficult and, if you consider that
the company requires more equity, you must be able to suggest potential sources,
such as venture capitalists or business angels, and be aware of the drawbacks of such
sources. Furthermore, if the recent or forecast financial performance is poor, all
providers are likely to be wary of investing.
7. Maturity – The basic rule is that the term of the finance should match the term of
the need (the matching principle). Hence, a short-term project should be financed
with short-term finance. However, this basic rule can be flexed. For instance, if the
project is short term – but other short-term opportunities are expected to arise in the
future – the use of longer term finance could be justified.
8. Control – If debt is raised then there will be no change in control. However, if

equity is raised control may change. Students should also recognise that a rights
issue will only cause a change in control if shareholders sell their rights to other
investors.
9. Costs and ease of issue – Debt finance is generally both cheaper and easier to raise
than equity and, hence, a company will often raise debt rather than equity. Raising
equity is often difficult, time-consuming and costly.
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10. The yield curve – Consideration should be given to the term structure of interest
rates. For instance, if the curve is becoming steeper this shows an expectation that
interest rates will rise in the future. In these circumstances, a company may become
more wary of borrowing additional debt or may prefer to raise fixed rate debt, or
may look to hedge the interest rate risk in some way.
Worked example
The following forecast financial position statement as at 31 May 2012 refers to Refgun Co,
a stock exchange-listed company, which is seeking to spend Sh. 90m in cash on a
permanent expansion of its existing trade.
Sh. m Sh. m
Assets
Non-current assets 130
Current assets 104
Total assets 234
Equity and liabilities
Share capital 60
Retained earnings 86
Total equity 146
Non-current liabilities
Long-term borrowings 70
Current liabilities
Trade payables 18
Total liabilities 88
Total equity and liabilities 234
The forecast results for Refgun Co, assuming the expansion occurs from 1 June 2012, are as
follows:
Year ending 31 May 2012 2013 2014 2015

Sh. m Sh. m Sh. m Sh. m
Revenue 71.7 79.2 91.3 98.6
Operating profit 24.4 28.5 33.7 37.1
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Notes:
1. The long-term borrowings are 8% bonds that were issued in 1996 with a 20-year
term
2. The current assets include Sh. 18m of cash, of which Sh. 15m is held on deposit
3. Refgun Co has consistently grown its profits and dividends in real terms
4. No new finance has been raised in recent years
5. The sector average financial gearing (debt/equity on a book value basis) is currently
85%
6. The sector average interest cover is currently 2.9 times
7. The company estimates that it could borrow at a pre-tax rate of 7.2% per year
8. The company pays tax on its pre-tax profits at a rate of 28%
Required:
Recommend a suitable method of raising the finance required by Refgun Co,

supporting your evaluation with both analysis and critical discussion.
Prior to reading the suggested solution students should carry out their own evaluation of
the forecast financial performance and the current and forecast financial position. A
consideration of the factors discussed earlier should lead students to a justified
recommendation.
Suggested solution
Refgun Co is seeking to spend Sh. 90m on a permanent expansion of its existing trade. It
should be noted that the company has significant retained earnings, Sh. 15m of which is
held in cash on deposit. This could presumably be used to help fund the expansion and, if
this is the case, the need for additional finance would be reduced to Sh. 75m. However, the
company may have a reason for holding cash – for example, to meet budgeted cash
payments in the near future.
Forecast financial performance
The forecast financial performance of Refgun Co will be a key consideration to potential

finance providers. Analysis of the forecast performance of Refgun Co gives the following
information:
Geometric average growth in turnover = (98.6/71.7)(1/3) – 1 = 11.2% Geometric average

growth in operating profit = (37.1/24.4)(1/3) – 1 = 15.0%
Year ending 31 May 2012 2013 2014 2015

Operating profit margin 34.0% 36.0% 36.9% 37.6%
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The forecast income statements for the years ending 31 May 2012 and 2015 are shown
below. Two income statements have been prepared for 2015, one assuming the expansion is
funded by debt and the other assuming the expansion is funded by equity:
Year ending 31 May 2012 2015 – debt 2015 – equity

Sh. m Sh. m Sh. m
Operating profit 24.4 37.1 37.1
Interest (5.6) (11.0) (5.6)
Profit before tax 18.8 26.1 31.5
Tax – 28% (5.3) (7.3) (8.8)
Profit after tax 13.5 18.8 22.7
The interest charge for 2012 is assumed to be (70 x 8%) = Sh. 5.6m
If debt finance is used the interest charge from 2013 onwards is assumed to be (70 x 8%) +
(75 x 7.2%) = Sh. 11.0m
Note: While it would be good to forecast the income statement for each year, time pressure
may mean this is not possible.
This analysis shows that the growth in revenue caused by the expansion is exceeded by the
growth in operating profit due to a steady rise in the operating margin of the company. This
may be a result of the company benefiting from economies of scale as a result of the
expansion. Whether debt finance or equity finance is used, both the returns to all investors
(operating profit) and the return to the equity investors (profit after tax) both show
considerable growth.
Current and forecast financial position
The gearing (D/E) is currently 70/146 = 47.9% on a book value basis. If debt finance is
raised this would rise to (70+75)/146 = 99.3%, while if equity finance was used it would
fall to 70/(146+75) = 31.7%. Even if debt finance was raised the gearing level would
rapidly fall again as the company makes and retains profits.
The interest cover is currently 24.4/5.6 = 4.4 times. If debt finance is used then this would
fall to 28.5/11.0 = 2.6 times in 2013. However, by 2015 it would have recovered to
37.1/11.0 = 3.4 times. If equity finance were to be used the interest cover would
consistently improve.
Refgun Co currently has less financial risk than the sector average and the financial risk
would decline even further if equity finance was used. If debt finance is used then the
financial risk would initially rise slightly above the sector average but would soon return to
the sector average level or below.
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Factors that Refgun Co should consider prior to choosing a financing method
 Cost and cash flows – Refgun Co would seem to have the capacity to raise more
debt as the non-current assets exceed the existing debt by Sh. 60m. Furthermore, the
company seems to be cash-generative in that it is currently holding Sh. 15m on
deposit, despite not having raised any finance for several years. Hence, the company
may be wise to take advantage of cheaper debt.
 Risk – As the company is expanding its existing trade there should be no material
change in business risk. If debt finance is chosen the directors should ensure that the
shareholders are happy with the extra financial risk. Given the analysis above, this
seems likely.
 Security and covenants – As long as the expansion involves investing in some non-
current assets there should be sufficient security available for potential lenders. The
company should check what potential covenants might be imposed and ensure that
they would be happy to live with them.
 Availability and maturity – Given the recent performance and the good forecasts,
the company is likely to have many finance sources available to it. Debt providers
should be willing to lend and shareholders would be likely to support a rights issue.
Equally, other investors may well wish to invest in the equity of the company. As the
finance is required to finance a permanent expansion of the company, long-term
finance should be raised. To the extent that the expansion requires investment in
additional working capital, some short-term finance could be raised. Consideration
should also be given to the fact that the existing bonds of the company are due to be
repaid in 2016. Subject to early redemption penalties, it may be worth looking into
refinancing this debt at the same time as raising the new debt especially as the cost of
new debt appears lower.
 Control – If debt is issued, no change would occur to control. A rights issue would
also have little impact on control while the issue of shares to new investors may
cause control issues.
 Costs and ease of issue – A debt issue is likely to be cheaper and easier than an
equity issue and, hence, may well be favoured by the directors.
 Yield curve – The directors of Refgun Co should consider the yield curve if it is
decided to raise debt.
Recommendation of a suitable financing method
From the analysis and discussion above, it would seem that Refgun Co should seek to
finance the expansion by raising long-term debt secured on the existing non-current assets
of the company and the new non-current assets acquired during the expansion. At the same
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time as raising the new debt, the refinancing of the existing debt should also be considered.
If shareholders and other key stakeholders are concerned about the financial risk exceeding
the industry average, then Refgun Co could raise some short-term debt with the aim of
repaying it as soon as more cash is earned. The impact on gearing could also be reduced by
acquiring some assets on operating leases, or by the sale and lease back of some existing
assets. The directors should take action to manage the interest rate risk that Refgun Co will
suffer.
METHODS OF ISSUING ORDINARY SHARES: PUBLIC ISSUE, PRIVATE

PLACEMENT, BONUS ISSUE, EMPLOYEE STOCK OPTION PLANS (ESOPS)
AND RIGHTS ISSUE
PUBLIC ISSUE
An initial public offering (IPO) or stock market launch is a type of public offering where
shares of stock in a company are sold to the general public, on securities exchange market,
for the first time. Through this process, a private company transforms into a public
company. Initial public offerings are used by companies to raise expansion capital, to
possibly monetize the investments of early private investors, and to become publicly traded
enterprises. A company selling shares is never required to repay the capital to its public
investors. After the IPO, when shares trade freely in the open market, money passes
between public investors.
Initial public offering (IPO) means issuing public equity, i.e. when a company is engaged
in offering of shares and is included in a listing on a stock exchange for the first time. It
allows the company to raise funds from the public.
If a company is already listed and issues additional shares, it is called seasoned equity
offering (SEO) or secondary public offering (SPO). When a firm issues equity at a stock
exchange, it may decide to change existing unquoted shares for quoted ones. In this case the
proceeds from sale of shares are received by initial investors. However, when a company
issues newly created shares, the raised funds are received by the company.
Process of going public: The issuing company has to develop a prospectus with detailed
information about the company operations, investments, financing, financial statements and
notes, discussion on the risks involved. This information is provided to potential investors
for making decision in buying large blocks of shares. The prospectus is registered within
and approved by the securities exchange commission. Afterwards the prospectus is sent to
institutional investors, meetings and road shows are organized in order to present the
company.
Share issues are often underwritten by banks. A bank, which is underwriting a share issue
agrees, for a fee, to buy any shares not acquired by investors. This guarantees that the
issuing company receives the funding that it expects. In the case of rights issues, firms
sometimes avoid paying a fee to underwriters by using the deep discount route. In a rights
issue, failure to sell the new shares would result from the share price (prior to the issue)
falling below the sale price of the new shares.
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The deep discount method prices the new shares at such a low level that the market price is
extremely unlikely to fall so far.
The share offer price is determined by the lead underwriter, which takes into account the
prevailing market and industry conditions. During the road show the lead underwriter is
engaged in book building, i.e. a process of collecting indications of demanded number of
shares by investors at various possible offer prices
An IPO accords several benefits to the previously private company:
 Enlarging and diversifying equity base

 Enabling cheaper access to capital
 Increasing exposure, prestige, and public image
 Attracting and retaining better management and employees through liquid equity
participation
 Facilitating acquisitions (potentially in return for shares of stock)
 Creating multiple financing opportunities: equity, convertible debt, cheaper bank
loans, etc.
There are several disadvantages to completing an initial public offering:
 Significant legal, accounting and marketing costs, many of which are ongoing
 Requirement to disclose financial and business information
 Meaningful time, effort and attention required of senior management
 Risk that required funding will not be raised
 Public dissemination of information which may be useful to competitors, suppliers
and customers.
 Loss of control and stronger agency problems due to new shareholders
IPO market has received negative publicity due to several problems:
Spinning: Spinning occurs, when investment bank allocates shares from an IPO to
corporate executives. Bankers’ expectations are to get future contracts from the same
company.
Laddering: When there is a substantial demand for an IPO, brokers encourages investors to
place the first day bids for the shares that are above the offer price. This helps to build the
price upwards. Some investors are willing to participate to ensure that the brokers will
reserve some shares of the next hot IPO for them.
Excessive commissions: These are charged by some brokers when the demand for an IPO
is high. Investors are willing to pay the commissions if they can recover the costs from the
return on the very first day, especially when the offer price of the share is set significantly
below the market value.
The literature contains strong evidence that IPOs on average perform poorly over a period
of a year or more. Thus from a long term perspective many IPOs are overpriced. Since
introduction of Sarbanes-Oxley Act in US, this aimed at improving company reporting
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PRIVATE PLACEMENTS
A private placement is the sale of a security to a small number of investors. Issuing entities
are interested in private placements because these transactions avoid the time-consuming
process of having securities registered for sale to the general public through the Securities
and Exchange Commission.
The type of investor that usually participates in a private placement is a wealthy individual
or a well-funded buy-side firm, such as a pension fund or hedge fund.
An investor may be offered an inducement to participate in a private placement. For

example, this could involve a price that is discounted from the market price, or perhaps the
addition of warrants to the securities.
A private placement differs from a public offering, where securities are offered for sale to
the general public via an underwriter. A public offering requires that a detailed prospectus
be issued, which is not the case for a private placement.
BONUS ISSUE
A bonus issue can be referred as a scrip issue/dividend re-investment issue/stock

dividend/scrip dividend. This method involves the issue of additional shares to existing
shareholders on a prorate basis. However, bonus issue does not bring additional capital to
the firm since it basically involves the capitalization of resources.
Whenever there is a bonus issue, investors may react differently because there are those
investors who would prefer cash dividends to stock dividends and vice versa. Similarly, a
bonus issue has a signal that may relay certain information to the investors.
Where markets are inefficient (no access to relevant information on share prices) investors
may be tempted to imagine that a company has liquidity problems. However, where
markets are efficient (access to relevant information on share prices) a bonus issue may
signal that the management of the company expects a bright future. This is because
A bonus issue may be interpreted to mean that the management expects the company to
generate greater profits in the future so as to be able to pay additional dividends.
Theoretically, a bonus issue is not expected to affect the shareholders wealth because the
results in increase in number of shares held and proportional decline in the price of a share.
Similarly a bonus issue is not expected to alter the capital structure of the company.
Benefits of a bonus issue
1. Tax benefit- cash dividends are taxed at the rate of 5% or 15% but stock dividends
are exempted from taxation
2. A bonus issue has a signal effect that it would relay some information to investors
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3. Stock dividends may lead to increase in future dividend to the investor especially if
the company follows a policy of paying a constant dividend per share each year.
4. May result in conservation of cash especially if the company is facing cash flow
problems.
5. A bonus issue is not expected to have an impact on capital structure therefore control
of owners would be maintained.
Definition of some terms
Stock split-refers to the splitting of existing shares into smaller share i.e. assume that a
share has a par value of sh. 50. This can be split into 2 shares of par value of sh. 25 each or
5 shares of par value of sh. 10 each using a split factor of 2 and 5 respectively.
This method is used to lower the market value of the firm’s shares by increasing the number
of shares to each shareholder. Quite often, the management of the firm believes that its
stock is over-valued and therefore lowering the market price will enhance trading activities
thereby enhancing the marketability of the shares.
The marketability of the shares would be advanced because the shares will be made
affordable e.g. National Media Group management contemplated splitting the par value of
their stock.
Stock splits are made prior to issuing additional shares to enhance stock marketability and
stimulate market activities. It is not unusual for a stock split to cause a slight increase in the
market value of the company’s share due to its information content (signal effect)
Reverse Stock split-it is the reverse of a stock split. In this case a number of outstanding
ordinary shares are exchanged for one new share for example 1 for 3 split means one new
share is exchanged for 3 old shares. Reverse splits are initiated to raise the market prices of
a firms stock if the management feels that the value of their stock is undervalued.
Stock repurchases-this involves repurchasing of outstanding common stock in the market

place. The practical motives of stock repurchase are:
i. To ensure that enough shares are available to implement the employees stock options
plans (ESOP).
ii. To facilitate acquisition where the management could want to exchange shares as
their consideration (share-for-share exchange)
iii. To discourage hostile takeovers because corporate raiders (predator) is less likely to
gain control of the firm if there are fewer publicly traded shares
iv. To enhance the shareholders value. This is possible because reducing the number of
shares outstanding may have the effect of increasing the EPS and hence increasing
market value.
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EMPLOYEE STOCK OPTIONS PLAN (ESOP)
These are special plans or schemes which allow employees of a company to purchase the
shares under special conditions.
There are two main schemes namely:
a) Executive share option plan

b) Lower level plan
Executive share option plan- these are incentive plans given to top management to
purchase given number of shares at a specified price and within a specified period of time.
The price at which the rights will be exercised is known as exercise price and period within
which rights are exercised is exercise period.
The main reason why these shares are given to top management is to minimize agency
conflict between management and shareholders.
Lower level plan-These are special schemes given to the non-executive employees. These
are plans for the lower level employees where the company sells shares to them at a lower
price (subsidized prices). At times the company may give them share free of charge. These
shares are usually managed by the employee’s pension schemes and restricted such that
they cannot sell the shares except at retirement where the shares will be sold to the
remaining employees.
RIGHTS ISSUE
A rights issue is an offer given to existing shareholders by the management of the company
to subscribe for additional shares at a discount i.e. shares are issued at a price set below the
prevailing market value of the shares. The price at which the shares are offered is known as
an offer price (subscription price).
Offer price is set below the prevailing market values of the company shares due to the
following reasons
i. To make the offer attractive to the existing shareholders so that they can take
advantage and acquire additional shares.
ii. To compensate existing shareholders for the additional risks they will be prepared to
bear buying shares in the same company rather than diversifying their investment to
reduce risk (portfolio building/portfolio construction)
iii. To ensure that between the announcement date and the issue date, the offer price
would still remain below the market price. However, if the market value falls below
offer price then the rights offer might not be successful because it would be cheaper
buying shares in the open market.
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iv. To create value on rights such that a shareholder who does not want to acquire
additional shares in the open market. The price at which of the right would be sold is
known as the value rights
Whenever there is rights issue, each outstanding share receive one right i.e. assume there is
a shareholder who owns 1000 shares
1 ℎ =1 ℎ
1000 1
1000 ℎ =
1
= 1000 ℎ
Whenever there is a rights issue the management will send an explanatory letter
(memorandum) to each of the existing shareholders providing the details of the issue. This
will be followed by a provisional allotment letter indicating the number of rights required to
acquire one new share and at what price e.g. 1 for 3 rights issue@sh.30, this can be
interpreted as follows:
That for every 3 rights an existing shareholder can acquire one additional share at sh.30
each. Assuming there is a shareholder in this company who owns 3000 shares and another
with 6000 shares. Determine the maximum number of additional shares each of these
shareholders will acquire and the sum payable?
a)
1 ℎ =1
ℎ
3000 1
3000 ℎ =
1
= 3000 ℎ
3 ℎ =1 ℎ
3000 1
3000 ℎ =
3
= 1000 ℎ @ ℎ. 30
ℎ ℎ = ℎ. 30,000
b)
1 ℎ =1 ℎ
6000 ℎ = 6000 ℎ
3 ℎ =1 ℎ
6000 1
6000 ℎ =
3
= 2000 ℎ
= 2000 ℎ @ ℎ. 30
ℎ ℎ = ℎ. 60,000
Rights issue are offered on a prorate basis i.e. in proportions to your current shareholding.
Implying the more outstanding shares you have the more rights you acquire and therefore
the more additional share you can acquire and vice versa.
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There are 4 important dates whenever there is a rights issue namely:
- Announcement date
- Register of members date
- Issue date
- Expiration date
Announcement date- the date when the management of the company will officially
announce to the existing shareholders of their intention of raising funds through issue of
rights issue
Register of members date- date up to which members appearing in the company register
are asked to subscribe for additional shares. Between announcement date and register of
members date the shares will be said to be selling cum rights i.e. with the rights. The price
with which the shares will be selling is known as cum right MPs i.e. the market price of a
share includes the value of a right.
Issue date-date at which the right certificate will be issued to members. After the register of
members date, shares begin to sell ex-right i.e. without the right at a price known as ex-right
market price per share. This is a price which excludes the value of a right.
Expiration date-the date after which a shareholder who will not have acquired additional
shares will be presumed to have ignored the rights issue.
There are three different options available to an existing shareholder upon receiving this
offer
1) To exercise all his rights- in this case an existing shareholder will acquire the
maximum number of additional shares he is entitled to.
2) To sell all his rights- in this case, an existing shareholder will not acquire additional
shares but will sell his rights in the open market at a price known as the Value of
rights
3) Ignore the rights issue- an existing shareholder will let the rights offer to lapse i.e.
will neither sell nor exercise his right.
4) Partly exercise his rights and sell the balance.
Factors which may affect the success of a rights issue
a) Offer price should be affordable. If the price is not affordable then the right would be
affected
b) The period within which to exercise the right should be reasonable. if exercise period
is not sufficient it will affect the rights issue.
c) If the market price fall below the offer price then the rights offer might not be
successful. This is because existing shareholders will find it cheaper to buy shares in
the open market.
d) The purpose for which the money would be raised for. Will the money be used to
finance expansion programs or to recognize (restructure) an organization whose
going concern is threatened.
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e) The return which shareholders will enjoy from other alternative investment. If the
other alternative investment can provide higher returns, then they may prefer the
alternative investment to a right issue.
Benefits of a rights issue to
a) The company
i. The company will raise funds which can be used to finance its expansion
programmes
ii. The firm will save on floatation costs because this method is cheaper compared to a
public issue method
b) The investors
i. The control of existing shareholders will be maintained i.e. theoretically a rights

issue is not expected to alter capital structure and therefore the control of owners will
be maintained
ii. The number of shares held increases therefore the owners return will be higher in
future if a company follows a policy of paying a constant dividend per share each
year.
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TOPIC 3
FINANCIAL INSTITUTIONS AND MARKETS
NATURE AND ROLE OF FINANCIAL MARKETS
Financial Market, in very crude terms, is a place where the savings from various sources
like households, government, firms and corporates are mobilized towards those who need it.
Alternatively put, financial market is an intermediary which directs funds from the savers
(lenders) to the borrowers.
In other words, financial market is the place where assets like equities, bonds, currencies,
derivatives and stocks are traded.
Some of the salient features of financial market are:
 Transparent pricing
 Basic regulations on trading
 Low transaction costs
 Market determined prices of traded securities
Roles of financial system
One of the important sustainability requisite for the accelerated development of an economy
is the existence of a dynamic financial market. A financial market helps the economy in the
following manner.
 Saving mobilization: Obtaining funds from the savers or surplus units such as
household individuals, business firms, public sector units, central government, state
governments etc. is an important role played by financial markets.
 Investment: Financial markets play a crucial role in arranging to invest funds thus
collected in those units which are in need of the same.
 National Growth: An important role played by financial market is that, they
contribute to a nation's growth by ensuring unfettered flow of surplus funds to deficit
units. Flow of funds for productive purposes is also made possible.
 Entrepreneurship growth: Financial market contribute to the development of the
entrepreneurial claw by making available the necessary financial resources.
 Industrial development: The different components of financial markets help an
accelerated growth of industrial and economic development of a country, thus
contributing to raising the standard of living and the society of well-being.
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The principle participants in the financial market are as follows:
Banks: largest provider of funds to business houses and corporates through accepting
deposits. Banks are the major participant in the financial market.
Insurance companies: issue contracts to individuals or firms with a promise to refund them
in future in case of any event and thereby invest these funds in debt, equities, properties,
etc.
Finance companies: engages in short to medium term financing for businesses by

collecting funds by issuing debentures and borrowing from general public.
Merchant banks: funded by short term borrowings; lend mainly to corporations for foreign
currency and commercial bills financing.
Companies: the surplus funds generated from business operations are majorly invested in
money market instruments, commercial bills and stocks of other companies.
Mutual funds: acquire funds mainly from the general public and invest them in money
market, commercial bills and shares. Mutual fund is also principle participant in financial
market.
Government: authorized dealers basically look after the demand-supply operations in

financial market. Also works to fill in the gap between the demand and supply of funds.
Characteristics of a good market

Financial markets have been found to be fairly good (perfect) in the advanced economies as
well as many number of emerging capital markets. The following are characteristics of a
good market
1. No entry barriers
Anyone can participate in the market therefore the suppliers/users of funds can enter the
market and deal with each other
2. Large no. of buyers and sellers

The market is ensured by the presence of large number of buyers and sellers of securities.
No single market participant should be large enough to influence the security prices.
3. Divisibility of financial asset

Financial assets are divisible and therefore affordable investments are made by all
participants.
4. Absence of transaction cost

Participants can buy and sell securities with care and without much cost.
5. No tax differences
Ideally there are no taxes; one set of investors should not be favored over others
6. Free trading-Anyone is free to trade in securities.
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FUNCTIONS OF FINANCIAL MARKETS
 Intermediary Functions: The intermediary functions of a financial markets include

the following:
o Transfer of Resources: Financial markets facilitate the transfer of real
economic resources from lenders to ultimate borrowers.
o Enhancing income: Financial markets allow lenders to earn interest or
dividend on their surplus invisible funds, thus contributing to the
enhancement of the individual and the national income.
o Productive usage: Financial markets allow for the productive use of the
funds borrowed. The enhancing the income and the gross national production.
o Capital Formation: Financial markets provide a channel through which new
savings flow to aid capital formation of a country.
o Price determination: Financial markets allow for the determination of price
of the traded financial assets through the interaction of buyers and sellers.
They provide a sign for the allocation of funds in the economy based on the
demand and to the supply through the mechanism called price discovery
process.
o Sale Mechanism: Financial markets provide a mechanism for selling of a
financial asset by an investor so as to offer the benefit of marketability and
liquidity of such assets.
o Information: The activities of the participants in the financial market result
in the generation and the consequent dissemination of information to the
various segments of the market. So as to reduce the cost of transaction of
financial assets.
 Financial Functions
o Providing the borrower with funds so as to enable them to carry out their
investment plans.
o Providing the lenders with earning assets so as to enable them to earn wealth
by deploying the assets in production debentures.
o Providing liquidity in the market so as to facilitate trading of funds.
o Providing liquidity to commercial bank
o Facilitating credit creation
o Promoting savings
o Promoting investment
o Facilitating balanced economic growth
o Improving trading floors
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CLASSIFICATION OF FINANCIAL MARKETS

Securities market can be divided into three categories: -
a) Capital and money markets.
b) Primary and secondary markets
PRIMARY AND SECONDARY MARKET

Primary financial markets are those markets where there is transfer of new financial
instruments. Financial instruments constitute assets, which are used in the financial
markets. They consists of cash, shares and debt capital both long term and short-term e.g.
commercial paper.
The primary financial markets trade is for securities which have not been issued e.g. if a
company wants to make an issue of ordinary share capital issue of commercial paper, issues
of preference shares, debentures etc, offers and purchase will be through the primary etc.
Secondary markets — the secondary financial markets are for already issued securities.
After a thorough issue of new securities in the primary market later trading of the securities
will take place in secondary market e.g. if a company is to make public issue of ordinary
share capital the issue will take place in primary market. If the initial purchasers wish to
dispose off the shares, trading will take place in the secondary market. The only distinction
between primary and secondary markets is the form of security being traded but there is no
physical separation of the markets.
CAPITAL AND MONEY MARKETS

This classification is based on the maturity of financial instruments. The capital market is a
financial market for long-term securities. The securities traded in these markets include
shares and bonds.
The money market is market for short-term securities. The securities traded in these
markets include promissory notes, commercial paper, treasury bills and certificates of
deposits while capital market is regulated by capital authority; the money market is
regulated by central banks.
ORGANIZED AND OVER- COUNTER MARKETS

An organized market is a market which is a specified place of security trading, defined
rules, regulations and procedures for security trading. Only listed securities trade in
organized market, where exchange is through licensed brokers who are members of
exchange
Conducted by accountants, auctioneers, estate agents and lawyers who were engaged in
other areas of specializations.
In 1951 an estate agent (Francis Drummond) established the first stock broking firm. He
then approached the finance minister of Kenya with an idea of setting up a stock exchange
in East Africa. in 1953 he too approached London Stock Exchange Officer and London
accepted to recognize the setting up of Nairobi Stock Exchange as an oversee stock
exchange. The major reorganization emerged in 1954 when stockbrokers emerged and
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registered the NSE as a voluntary association under society’s Act. It was registered as a
limited liability company.
Stock exchange terms
1. Broker
Is an agent who buys and sells securities in the Market on behalf of his client on a
commission basis. He also gives advice to his client and at times manages the portfolio for
his client. In connection with the new issue, a broker will advise on price to be charged, will
submit the necessary documents to the quotation department the stock exchange and the
capital market authority. He may be involved in arranging for funds or for the purchase of
shares and may underwrite the issue (assure the company that shares are sold if not broker
will buy them).
2. Jobber:
He is a dealer. He is not an agent but a principal who buys and sells securities in his own
name. His profit is referred to as Jobber’s turn. Since they are experts in the markets, they
are not allowed to deal with general public but only with brokers or other jobbers to avoid
exploitation of individual investors. A Jobber will quote two prices for a share.
The bid price-which is the price at which he is willing to buy securities
Offer price-price at which he is willing to sell the shares.
The difference between offer price and the bid price is called spread price = Ask price - Bid
price. A Jobber will take stocks in his books (also called along sale) when brokers have
predominantly selling orders, and will also sell short (Short sale) when brokers are engaged
in buying.
3. Bulls
Speculators in the market who believe that the main market movement is upwards and
therefore buy securities now hoping to sell them at a higher price in the future
4. Bears
These are speculators in the market who believe that the main market movement is
downwards therefore securities now hoping to buy them back later at a lower price.
5. Stags
These are speculators in the market who buy new shares because they believe that the price
Set by issuing company is usually lower than the theoretical value and that when shares are
later dealt with in the stock-exchange the share price will increase and they will be able to
sell them at profit.
Capital market instruments

This is a market for issuing long-term funds.
They include:
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i) Common share/ordinary share

ii) Preference share
iii) Debentures
iv) Treasury Municipal bonds
v) Warrants & Convertible
vi) Terms loans
vii) Mortgages
Services rendered by capital markets

1. It offers long term finance which is necessary for acquisition of fixed assets of
companies and for development purpose generally.
2. Market provides permanent finance necessary for a strong financial base of going
concerns e.g. share capital, irredeemable preference shares, convertible debentures
and convertible preference shares.
3. The market provide services in the form of advice to investors as to which
investments are viable and can answer their investment needs e.g. advice given by
stock exchange brokers to their investing public
4. Enables companies and individuals to obtain long term finance which they can then
sale in the money market in form of short term loans therefore serving as a source of
livelihoods to such party
5. The market acts as a channel through which foreign investment find their way into
Kenya in form of foreigners buying shares in Kenya which they have to buy using
their currencies which brings in need foreign exchange.
6. The market is responsible for an orderly secondary market which facilitates the
liquidation of long term investments.
Reasons why capital markets are more developed in Kenya than money market
1. It’s easier to get access to capital market because in most cases the goodwill of the
borrower may not be necessary and at the same time such finance may not call for
security as the asset in question acts as its own security e.g. mortgage finance
2. There less risks of misuse of funds from this market because these are available in
form of fixed asset whose title remains with the lender, therefore less chances of
manipulation/misappropriation which is a characteristic of finance from money
market.
3. Long term finances available in this market are relatively cheaper because inflation
reduces the latter payments of interest and principle in real monetary funds
4. Long term investments using permanent long term finance are capable for paying for
themselves which may not entail further financial strain on the borrower therefore
making it attractive finance.
5. Kenya as a developing country requires long term investment for accumulation of
fixed asset and other long term resources all of which necessitates the development
of this capital market as a base for the development of the economy in general
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6. CBK has facilitated the development of this market by providing a conducive

atmosphere for setting up financial institutions which avail finance on long term
basis such as building societies, mortgage houses etc
7. Agriculture has and will remain the main stay of Kenyan market economy and this
has led to faster growth of agro-business industry which necessitates long term
investment, this creation of such institutions as agricultural on development of this
market by instructing such financial institutions as insurance companies to channel
all their savings into long term finances and also to avoid finance on long term basis
to industries and buildings constructions.
Differences between money and capital market
Capital market Money market

In this market goodwill is not important but Goodwill of the borrower qualifies him for
rather the ability to raise security is what this finance
matters
Finance is obtained in kind e.g. in form of Finance is obtained in cash
assets
Finance is usually cheaper due to the Finance is usually more expensive
effects of inflation on this money
The market acts as channel through which Usually the market does not deal in foreign
foreign exchange gets its way into the exchange for investment reasons
country
Finance is secured against a fixed asset Finance is usually unsecured
Finance usually takes long time to raise due Finance takes short time to raise
to lot of formalities
Finance calls for intermediaries in form of Finance does not call for intermediaries
brokers when raising
Funds are not highly negotiable Funds from this market are highly
negotiable
Central bank controls this market , this is The market is not influenced very much by
done through selective credit control and the central bank through credit squeeze and
credit squeeze selective credit control
Serves big companies more than small Open to all companies regardless of their
companies size
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SECURITIES EXCHANGE LISTING AND CROSS BORDER LISTING
History and organization of Nairobi securities exchange

In Kenya, dealing in shares and stocks started in the 1920's when the country was still a
British colony. However the market was not formal as there did not exist any rules and
regulations to govern stock broking activities. Trading took place on a ‘gentleman's
agreement.’ Standard commissions were charged with clients being obligated to honor their
contractual commitments of making good delivery, and settling relevant costs. At that time,
stock broking was a sideline business conducted by accountants, auctioneers, estate agents
and lawyers who met to exchange prices over a cup of coffee. Because these firms were
engaged in other areas of specialization, the need for association did not arise.
In 1951, an Estate Agent by the name of Francis Drummond established the first
professional stock broking firm. He also approached the then Finance Minister of Kenya,
Sir Ernest Vasey and impressed upon him the idea of setting up a stock exchange in East
Africa. The two approached London Stock Exchange officials in July of 1953 and the
London officials accepted to recognize the setting up of the Nairobi Stock Exchange as an
overseas stock exchange.
In 1954 the Nairobi Stock Exchange was then constituted as a voluntary association of
stockbrokers registered under the Societies Act. Since Africans and Asians were not
permitted to trade in securities, until after the attainment of independence in 1963, the
business of dealing in shares was confined to the resident European community. At the
dawn of independence, stock market activity slumped, due to uncertainty about the future of
independent Kenya.
1988 saw the first privatization through the NSE, of the successful sale of a 20%
government stake in Kenya Commercial Bank. The sale left the Government of Kenya and
affiliated institutions retaining 80% ownership of the bank.
Notably, on February 18, 1994 the NSE 20-Share Index recorded an all-record high of 5030
points. The NSE was rated by the International Finance Corporation (IFC) as the best
performing market in the world with a return of 179% in dollar terms. The NSE also moved
to more spacious premises at the Nation Centre in July 1994, setting up a computerized
delivery and settlement system (DASS). For the first time since the formation of the Nairobi
Stock Exchange, the number of stockbrokers increased with the licensing of 8 new brokers.
In 1996, the largest share issue in the history of NSE, the privatization of Kenya Airways,
came to the market. Having sold a 26% stake to KLM, the Government of Kenya proceeded
to offer 235,423,896 shares (51% of the fully paid and issued shares of Kshs.5.00 each) to
the public at Kshs.11.25 per share. More than 110,000 shareholders acquired a stake in the
airline and the Government of Kenya reduced its stake from 74% to 23%. The Kenya
Airways Privatization team was awarded the World Bank Award for Excellence for 1996
for being a model success story in the divestiture of state-owned enterprises.
On Monday 11 September 2006 live trading on the automated trading systems of the
Nairobi Stock Exchange was implemented.
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The East African Securities Exchanges Association came into being in 2004, following the
signing of a Memorandum of Understanding between the Dar-es-Salaam Stock Exchange,
the Uganda Securities Exchange and the Nairobi Stock Exchange.
In May 2006, NSE formed a demutualization committee to spearhead the process of
demutualization. A demutualization consultant (Ernst and Young) was appointed to advice
on the process.
In September 2006 live trading on the automated trading systems of the Nairobi Stock
Exchange was implemented. The ATS was sourced from Millennium Information
Technologies (MIT) of Colombo, Sri Lanka, who are also the suppliers of the Central
Depository System (CDS). MIT have also supplied similar solutions to the Colombo Stock
Exchange and the Stock Exchange of Mauritius. The NSE ATS solution was customized to
uphold the spirit of the Open Outcry Trading Rules in an automated environment.
In the same breadth, trading hours increased from two (10:00 am – 12:00 pm) to three hours
(10:00 am – 1:00 pm). Other innovations included the removal of the block trades board
and introduction of the functionality for the trading of rights in the same manner as equities.
Besides trading equities, the ATS is also fully capable of trading immobilized corporate
bonds and treasury bonds.
An MoU between the Nairobi Stock Exchange and Uganda Securities Exchange was
signed in November 2006 on mass cross listing. The MoU allowed listed companies in
both exchanges to dualist. This will facilitate growth and development of the regional
securities markets.
In February 2007 NSE upgraded its website to enhance easy and faster access of accurate,
factual and timely trading information. The upgraded website is used to boost data vending
business.
In July 2007 NSE reviewed the Index and announced the companies that would constitute
the NSE Share Index. The review of the NSE 20‐share index was aimed at ensuring it is a
true barometer of the market.
A Wide Area Network (WAN) platform was implemented in 2007 and this eradicated the
need for brokers to send their staff (dealers) to the trading floor to conduct business.
Trading is now mainly conducted from the brokers' offices through the WAN. However,
brokers under certain circumstances can still conduct trading from the floor of the NSE.
In 2008, the NSE All Share Index (NASI) was introduced as an alternative index. Its
measure is an overall indicator of market performance. The Index incorporates all the traded
shares of the day. Its attention is therefore on the overall market capitalization rather than
the price movements of select counters.
In April 2008, NSE launched the NSE Smart Youth Investment Challenge to promote stock
market investments among Kenyan Youths. The objective of the challenge is threefold:
 To occupy the minds of the youth positively and draw them away from the negative
energy created by the current political, economic and social situation in the country;
 Encourage the culture of thrift and saving funds amongst the university students;
 Encourage the youth to invest their savings in the capital markets.
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After the resignation of Mr. Chris Mwebesa, the NSE Board appointed Mr. Peter Mwangi
to be the New NSE Chief Executive in November 2008.
The Complaints Handling Unit (CHU) was launched in August 2009 to bridge the
confidence gap with NSE retail investors. CHU provides a hassle free and convenient way
to have any concerns processed and resolved. Investors, both local and in the Diaspora can
forward their issues via e‐mail, telephone, fax, or SMS and have the ability to track
progress on‐line.
The Nairobi Stock Exchange marked the first day of automated trading in government
bonds through the Automated Trading System (ATS) in November 2009. The automated
trading in government bonds marked a significant step in the efforts by the NSE and CBK
towards creating depth in the capital markets by providing the necessary liquidity.
In December 2009, NSE marked a milestone by uploading all government bonds on the
Automated trading System (ATS). Also in 2009, NSE launched the Complaints
Handling Unit (CHU) SMS System to make it easier for investors and the general public to
forward any queries or complaints to NSE
In July 2011, the Nairobi Stock Exchange Limited changed its name to the Nairobi
Securities Exchange Limited. The change of name reflected the strategic plan of the
Nairobi Securities Exchange to evolve into a full service securities exchange which
supports trading, clearing and settlement of equities, debt, derivatives and other associated
instruments. In the same year, the equity settlement cycle moved from the previous T+4
settlement cycles to the T+3 settlement cycle. This allowed investors who sell their shares,
to get their money three (3) days after the sale of their shares. The buyers of these shares
will have their CDS accounts credited with the shares, in the same time.
In September 2011 the Nairobi Securities Exchange converted from a company limited by
guarantee to a company limited by shares and adopted a new Memorandum and Articles of
Association reflecting the change.
In October 2011, the Broker Back Office commenced operations. The system has the
capability to facilitate internet trading which improved the integrity of the Exchange trading
systems and facilitates greater access to our securities market.
In November 2011 the FTSE NSE Kenya 15 and FTSE NSE Kenya 25 Indices were
launched. The launch of the indices was the result of an extensive market consultation
process with local asset owners and fund managers and reflects the growing interest in new
domestic investment and diversification opportunities in the East African region.
As of March 2012, the Nairobi Securities Exchange became a member of the Financial
Information Services Division (FISD) of the Software and Information Industry Association
(SIIA).
In March 2012 the delayed index values of the FTSE NSE Kenya 15 Index and the FTSE
NSE Kenya 25 Index were made available on the NSE website www.nse.co.ke. The new
initiative gives investors the opportunity to access current information and provides a
reliable indication of the Kenyan equity market’s performance during trading hours.
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Market segments and eligibility requirements for listing of securities at Nairobi

securities exchange
The Official list is categorized into three different market segments approved by the
Authority. The segments have different eligibility and disclosure requirements prescribed
by the Authority under The Capital Markets (Securities) (Public Offers, Listing and
Disclosures) Regulations, 2002 and provided under Part V as appendices to these rules.
These market segments are:
(i) Main Investment Market Segment (MIMS)
(ii) Alternative Investment Market Segment (AIMS)
(iii) Growth Enterprise Market Segment (GEMS)
(iv) Fixed Income Securities Market Segment (FISMS)
Reasons behind low quotation at Nairobi securities exchange

1. Most companies operating in Kenya are owned by families who value their control
and as such cannot go public as this will entail dilution of their control by the
incoming shareholders.
2. Quotation at NSE is supposed to be a means of raising finance from the public and
most of companies operating in Kenya have access to cheap finance and as such this
motive does not hold.
3. Going public does not entail a lot of formalities.
4. Going public also entails a loss of secrecy to the public because annual reports have
to be published. Such information is accessed by the competitors.
5. Some companies in Kenya are subsidiaries of multinational companies and are
already quoted at home and the original owners may not be willing to sell their
interest to the public.
6. Going public is expensive as a company is required to pay floatation fee among other
costs such as underwriting commission, brokerage fee, cost of printing prospectus,
advertising cost, legal fee, audit fee etc.
7. Some companies choose to remain private to avoid/evade corporate tax
8. Some companies that make high profits prefer investing those profits instead of
sharing them out, going public require profits to be given out to shareholders in form
of dividends.
Incentives that government has given companies to induce them to go public

1. it has offered tax holidays for companies going public in particular those investing in
specific areas e.g. agro-based company
2. has offered has offered preferential treatment to companies in allocation of foreign
exchange in importation of raw materials
3. Government is willing through quasi governmental body to participate in the equity of
such companies going public.
4. It has bank capital gain tax on sale of shares and tax on share transfer and its intended
to make shares attractive to investors
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5. Offered protection against importation of similar products to those currently

manufactured by Kenya quoted companies.
6. Embarked on promotional activities of product of these companies abroad in a bid to
secure them foreign market and this is done free of charge through trade fairs and
exhibitions in international market
7. Provided such facilities as good infrastructure and communication facilitates which
provide easy accessibility to sources of materials and markets to these companies’
goods has subsidized no. of products in a bid to make them affordable by majority of
consumers.
8. Has also given a tax deduction an concession to inputs of agro-based industries and
manufactured goods aimed at making them affordable to consumers
9. Given guarantees on repatriation of dividend and interest to non-resident investors in a
bid to attract their investment in Kenyan quoted companies.
Reasons why parastatals cannot be quoted

1. Most parastatals are not profit making organization and as such are supposed to
maximize society welfare in an objective cannot appeal to the public so as to buy share
e.g. national irrigation boards, K.T.D.A, K.P.C.U
2. Some parastatals give services which are crucial to the state and control to the public
interest which if they go public will prejudice such sensitive roles as this may not be
taken care of by profit oriented investors
3. Most of parastatals are government subsidies and also have access to foreign aid further
they can borrow from abroad using government guarantee and such no need for finance
from the public in form of share capital e.g. Kenya airways
4. Most parastatals has bad financial performance and for sometime been operating on
loses and as such this bad performance cannot make their shares attractive and also not
qualify for quotation e.g. Kenya railways, KMC, KCC, uplands
5. Some of the parastatals are so highly geared that no potentials investors can strive to
invest his money in such if they went public.
6. Some parastatals are geared towards achievements of short term objectives and as such
may not be willing to go public so as to be able to attract public investors e.g. Tana and
Athi river development authority.
Advantages of being quoted
1. A quoted company is able to raise finance in good terms because it will be able to
reduce its floatation cost its shares at a premium
2. It will be able to obtain underwriting facilitates because it can negotiate with strength
for good underwriter as its shares are likely to be sold out
3. Shareholders of a quoted company are open to a ready market from the stock exchange
through which they can sell their shares which allows them to gauge the worthiness of
their investment and which increases the goodwill to the company.
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4. Quoted company will be able to raise permanent finance by way of selling certain
security to the public as ordinary shares.
5. It will be to enjoy national and international prestige that boosts its goodwill.
6. The NSE will approve for quotation only these companies which in their opinion are
viable hence an assurance to potential shareholders that it is financial stable.
7. Quoted company is viewed as credit worthy from the creditors from the creditors point
of view
8. Quoted company is open to read up to date information which will come inform of
feedback regarding its share prices in the stock exchange
9. Quoted company will be able to get comparative figures from NSE
10. Being quoted will necessitate companies to operate within ethical guidelines and this
will prevent quoted companies from engaging in unethical activities and unfair
practices during the course of operations.
11. Quoted companies are allowed to enjoy privileges given by the government to induce
others to be quoted e.g. tax allowances and occasion of foreign exchange protection
from competitors etc
Limitations of being quoted
1. The company loses its secrets to competitors who may not have been quoted e.g.
publication of company’s accounts which threatens its survived
2. In case the company’s profit trend declines, such will be revealed to the public hence
lowering share prices of such company and its goodwill
3. Companies which profit records are not impressive maybe deregistered and dropped
out stock quotation which will be dangerous to such company as it will have lost its
secret to the public and may in the extreme lead such a company into receivership as
creditors will also lose confidence in it
4. Being quoted in the SE entails loss of control to incoming shareholders who acquire
votes in the company.
5. Quotation is expensive because the company will have to pay high floatation cost
such as underwriting commission
6. A company to be quoted is supposed to undergo tedious formalities such as getting
permission from the capital issue committee and S.E.C
7. In the short run the share prices of a quoted company may be low in the SE due to
oversupply of those shares in particular. If there has been a new issue and it will
lower share prices of the company and this in turn will lower its credibility from
creditors point of view.
8. Quoted company is committed to the payment of a permanent cost inform of
ordinary dividend which more over its not a tax allowable expense therefore
compounding the cost of the finance to the company
9. Quoted company will face problems of takeovers bids as a result of competitors who
may have had a chance to buy such shares in large blocks and this may dissolve the
company if they acquire a major shareholders.
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CROSS BORDER LISTING
Cross-listing is the listing of a company's common/ordinary shares on a different exchange

than its primary and original stock exchange. In order to be approved for cross-listing, the
company in question must meet the same requirements as any other listed member of the
exchange, such as basic requirements for the share count, accounting policies, filing
requirements for financial reports and company revenues.
Benefits that might accrue to a firm that undertakes cross boarder listing of its shares.
i. Increase in the trading volume of the company‘s securities since the securities are traded
in more than one stock exchange.
ii. Raised debt or equity capital i.e. the funds available in the domestic market may not be
sufficient for the investment needs of the company and hence cross border listing will
increases the borrowing capacity of the company
iii. Risk diversification i.e. a company that has cross border listed will have a well
diversified portfolio of shares thus spreading risks associated with the fluctuation of
share prices hence creating stability in the share price.
iv. Mobilization of saving across regions. That is border listing will ensures mobilization of
saving held by individuals and institutions in different capital markets
v. Acquisition of overseas investors and customers. Cross border listing boosts the
company‘s status in the global market and hence increases the market share of the
company and generates investments from foreign countries that are able to invest in the
local market
vi. Improves the goodwill of the company i.e. improved public image and brand awareness
as a result of cross border listing. This is because the company attracts media interest in
different countries therefore improving its corporate image and hence increasing its sales
volume.
Motivations for cross-listing
The academic literature has identified a number of different arguments to cross-list abroad
in addition to a listing on the domestic exchange. Roosenboom and Van Dijk (2009)[1]
distinguish between the following motivations:
 Market segmentation: The traditional argument for why firms seek a cross-listing is
that they expect to benefit from a lower cost of capital that arises because their
shares become more accessible to global investors whose access would otherwise be
restricted because of international investment barriers.
 Market liquidity: Cross-listings on deeper and more liquid equity markets could lead
to an increase in the liquidity of the stock and a decrease in the cost of capital.
 Information disclosure: Cross-listing on a foreign market can reduce the cost of
capital through an improvement of the firm’s information environment. Firms can
use a cross-listing on markets with stringent disclosure requirements to signal their
quality to outside investors and to provide improved information to potential
customers and suppliers. Also, cross-listings tend to be associated with increased
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media attention, greater analyst coverage, better analysts’ forecast accuracy, and
higher quality of accounting information.
 Investor protection ("bonding"): Recently, there is a growing academic literature
on the so-called "bonding" argument. According to this view, cross-listing in the
United States acts as a bonding mechanism used by firms that are incorporated in a
jurisdiction with poor investor protection and enforcement systems to commit
themselves voluntarily to higher standards of corporate governance. In this way,
firms attract investors who would otherwise be reluctant to invest.
 Other motivations: Cross-listing may also be driven by product and labor market
considerations (for example, to increase visibility with customers by broadening
product identification), to facilitate foreign acquisitions, and to improve labor
relations in foreign countries by introducing share and option plans for foreign
employees
Disadvantages of cross listing

1. Increased pressure on executives due to closer public scrutiny
2. Increased reporting and disclosure requirements
3. Additional scrutiny by analysts in advanced market economies
4. Additional listing fees
MARKETS EFFICIENCY: EFFICIENT MARKET HYPOTHESIS
The efficient markets hypothesis (EMH), popularly known as the Random Walk Theory, is
the proposition that current stock prices fully reflect available information about the value
of the firm, and there is no way to earn excess profits, (more than the market overall), by
using this information. It deals with one of the most fundamental and exciting issues in
finance – why prices change in security markets and how those changes take place.
Many investors try to identify securities that are undervalued, and are expected to increase
in value in the future, and particularly those that will increase more than others. Many
investors, including investment managers, believe that they can select securities that will
outperform the market. They use a variety of forecasting and valuation techniques to aid
them in their investment decisions. Obviously, any edge that an investor possesses can be
translated into substantial profits. If a manager of a mutual fund with $10 billion in assets
can increase the fund’s return, after transaction costs, by 1/10th of 1 percent, this would
result in a $10 million gain. The EMH asserts that none of these techniques are effective
(i.e., the advantage gained does not exceed the transaction and research costs incurred), and
therefore no one can predictably outperform the market.
Arguably, no other theory in economics or finance generates more passionate discussion

between its challengers and proponents. For example, noted Harvard financial economist
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Michael Jensen writes “there is no other proposition in economics which has more solid
empirical evidence supporting it than the Efficient Market Hypothesis,” while investment
maven Peter Lynch claims “Efficient markets? That’s a bunch of junk, crazy stuff”
The efficient markets hypothesis (EMH) suggests that profiting from predicting price
movements is very difficult and unlikely. The main engine behind price changes is the
arrival of new information. A market is said to be “efficient” if prices adjust quickly and, on
average, without bias, to new information. As a result, the current prices of securities reflect
all available information at any given point in time. Consequently, there is no reason to
believe that prices are too high or too low. Security prices adjust before an investor has time
to trade on and profit from a new a piece of information.
The key reason for the existence of an efficient market is the intense competition among
investors to profit from any new information. The ability to identify over- and underpriced
stocks is very valuable (it would allow investors to buy some stocks for less than their
“true” value and sell others for more than they were worth). Consequently, many people
spend a significant amount of time and resources in an effort to detect "mis-priced" stocks.
Naturally, as more and more analysts compete against each other in their effort to take
advantage of over- and under-valued securities, the likelihood of being able to find and
exploit such mis-priced securities becomes smaller and smaller. In equilibrium, only a
relatively small number of analysts will be able to profit from the detection of mis-priced
securities, mostly by chance. For the vast majority of investors, the information analysis
payoff would likely not outweigh the transaction costs.
The most crucial implication of the EMH can be put in the form of a slogan: Trust market
prices! At any point in time, prices of securities in efficient markets reflect all known
information available to investors. There is no room for fooling investors, and as a result,
all investments in efficient markets are fairly priced, i.e. on average investors get exactly
what they pay for. Fair pricing of all securities does not mean that they will all perform
similarly, or that even the likelihood of rising or falling in price is the same for all
securities. According to capital markets theory, the expected return from a security is
primarily a function of its risk. The price of the security reflects the present value of its
expected future cash flows, which incorporates many factors such as volatility, liquidity,
and risk of bankruptcy
However, while prices are rationally based, changes in prices are expected to be random
and unpredictable, because new information, by its very nature, is unpredictable.
Therefore stock prices are said to follow a random walk.
In summary an efficient capital market has the following characteristics:-

 Information whether good or bad is quickly reflected in security prices.
 Transaction costs e.g. commission paid to broker should be minimal so that they do
not discourage the buying and selling of securities
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 Investors should not obtain high returns for having received information earlier than
others hence all investors should receive information at the same time.
 There are no investors who will buy securities in large quantities with an aim of
influencing security price by causing an artificial shortage.
 No investor will make abnormal gains simply because they are experienced or
knowledgeable because the stock exchange rules will not allow this.
Need for market efficiency

An efficient market facilitates transactions therefore promoting liquidity and fair prices. All
deals are made known to all in the capital market therefore, a large number of buyers and
sellers interact in the capital market the demand and supply forces help in determining the
prices.
Since the information is publicly available and since no single investor is large enough to
influence the security prices, the capital market provide a measure of fair price of security.
A financial manager borrows and lends (invest) funds in the capital facilities the allocation
of funds between savers and borrowers. The allocation will be optimum if the capital
market has an efficient pricing mechanism.
Capital markets deals in securities and security prices has been observed to move randomly
and unpredictably. The randomness of the security price may be interpreted to mean that
investors in capital market take a quick cognizance to all information relating to security
prices and that security prices quickly adjust to such information therefore the efficiency of
security prices depends on the speed of price adjustment to any available information. The
more the speed of adjustment, the more the efficiency of the process will be.
The capital market efficiency may therefore be defined as the ability of securities to reflect
and incorporate all relevant information in their prices.
Assumptions made for efficient market hypothesis.

1. All Investors are rational.
2. Rational investors have adequate funds.
3. Information is instantly available to rational investors.
4. Rational investors do not believe that markets are semi-strong form efficient.
5. Transaction costs, market impacts effects and required compensation for risk are not
large enough to deter prices at prices close to fundamental value.
Types of market efficiency
a) Operational efficiency
- Transactional costs do not affect the prices but they can cause one transaction to be
more profitable than another
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- Transaction cost of two similar financial transactions may be different. Therefore

investors would prefer one transaction over another. Similarly, transactions costs of
how a person took a transaction may exhibit difficult gains. Therefore efficiency
may not be that perfect but to develop a framework for analyzing financial decision.
A good starting point is to assume that markets are perfect.
b) Information efficiency
- The degree of efficiency in the market depends on the level of disclosure and the
speed with which the information is processed by the market and incorporated in the
share prices.
- Most financial information is published and is publicly available but sometimes
certain persons may have superior information than others.
c) Allocation efficiency
- This is how fast and how evenly commodities are allocated to various players in the
market. This leads to appropriate investment in the market i.e. when forces of demand
and supply regulates the price and the information about changes is available then
allocation of transactions is appropriately done.
Three versions of the efficient markets hypothesis and how they are tested
The efficient markets hypothesis predicts that market prices should incorporate all available
information at any point in time. There are, however, different kinds of information that
influence security values. Consequently, financial researchers distinguish among three
versions/levels/degree of the Efficient Markets Hypothesis, depending on what is meant by
the term “all available information”.
Weak Form Efficiency
The weak form of the efficient markets hypothesis asserts that the current price fully
incorporates information contained in the past history of prices only. That is, nobody can
detect mis-priced securities and “beat” the market by analyzing past prices. The weak form
of the hypothesis got its name for a reason – security prices are arguably the most public as
well as the most easily available pieces of information. Therefore, one should not be able to
profit from using something that “everybody else knows”. On the other hand, many
financial analysts attempt to generate profits by studying exactly what this hypothesis
asserts is of no value - past stock price series and trading volume data. This technique is
called technical analysis
The empirical evidence for this forms of market efficiency, and therefore against the value
of technical analysis, is pretty strong and quite consistent. After taking into account
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transaction costs of analyzing and of trading securities it is very difficult to make money on
publicly available information such as the past sequence of stock prices.
How does one know the capital market is efficient in its weak form?
To answer this question no one can find out the correlation between the security price over
time.
 In an efficient capital market there should not exist a significant correlation between
the security prices over time.
 An alternative method of testing the weakly efficiency market hypothesis is to
formulate trading strategies using the security prices and compare their performance
with the stock market performance.
 The capital market will be inefficient if the investors trading strategy could beat the
market.
Weak form efficiency implies that excess returns can be carried by using investment
strategies based on historical share price. It also implies that technical analysis techniques
will be able to consistently produce excess returns though some form of fundamental
analysis may not sill provide excess returns.
Semi-strong Form Efficiency

The semi-strong-form of market efficiency hypothesis suggests that the current price fully
incorporates all publicly available information. Public information includes not only past
prices, but also data reported in a company’s financial statements (annual reports, income
statements, filings for the Security and Exchange Commission, etc.), earnings and dividend
announcements, announced merger plans, the financial situation of company’s competitors,
expectations regarding macroeconomic factors (such as inflation, unemployment), etc. In
fact, the public information does not even have to be of a strictly financial nature. For
example, for the analysis of pharmaceutical companies, the relevant public information may
include the current (published) state of research in pain-relieving drugs.
The assertion behind semi-strong market efficiency is still that one should not be able to
profit using something that “everybody else knows” (the information is public).
Nevertheless, this assumption is far stronger than that of weak-form efficiency. Semi strong
efficiency of markets requires the existence of market analysts who are not only financial
economists able to comprehend implications of vast financial information, but also
macroeconomists, experts adept at understanding processes in product and input markets.
Arguably, acquisition of such skills must take a lot of time and effort. In addition, the
“public” information may be relatively difficult to gather and costly to process. It may not
be sufficient to gain the information from, say, major newspapers and company-produced
publications. One may have to follow wire reports, professional publications and databases,
local papers, research journals etc. in order to gather all information necessary to effectively
analyze securities.
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How can we test that the capital market is semi strong?

-One can study the effect of securities such as earning dividends, bonuses issues, right
issues, changes in account policies, the speed with which the price of the share is adjusted
to this information.
-The semi-strong form market implies that the share price reflect an event or inform very
quickly and therefore it’s is not possible for an investor to beat the market using such
information.
Strong Form Efficiency

The strong form of market efficiency hypothesis states that the current price fully
incorporates all existing information, both public/published and private/unpublished
(sometimes called inside information). The main difference between the semi-strong and
strong efficiency hypotheses is that in the latter case, nobody should be able to
systematically generate profits even if trading on information not publicly known at the
time. In other words, the strong form of EMH states that a company’s management
(insiders) are not be able to systematically gain from inside information by buying
company’s shares ten minutes after they decided (but did not publicly announce) to pursue
what they perceive to be a very profitable acquisition. Similarly, the members of the
company’s research department are not able to profit from the information about the new
revolutionary discovery they completed half an hour ago. The rationale for strong-form
market efficiency is that the market anticipates, in an unbiased manner, future developments
and therefore the stock price may have incorporated the information and evaluated in a
much more objective and informative way than the insiders. Not surprisingly, though,
empirical research in finance has found evidence that is inconsistent with the strong form of
the EMH.
In conclusion we can say that strong form efficiency can be realized when the following
characteristics surface.
- Share prices reflect no information, public and private and everyone can earn returns.
- If there are legal buyers to private information becoming public as with insider trading
laws, strong form efficiency is possible except in the case where the laws are universally
agreed upon.
- To test for strong for efficiency a market needs not exist where investors can
consistently earn deficit returns over a short period of time.
- Even if some managers are not constantly observed to be beaten by the market, no
reputation even that of strong form efficiency. Some observers dispute that the notion
that market behaves consistently with the efficient market hypothesis especially in its
stronger forms. Some cannot believe that man made markets are strong form efficient
for reasons of insufficiency including slow diffusion of information , the greater power
of some market participants(financial institutions) and existence of apparently
sophisticated professional investors. Only a privileged few may have price knowledge of
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loss about to be enacted and this is why it’s difficult to test for strong form efficiency in
the capital market.
How the individual’s decision making process, given the receipt of information, is reflected
in the market prices of assets.
Naive hypothesis – asset prices are completely arbitrary and unrelated either to how much
they will pay out in the future or to the probabilities of various payouts.
Speculative equilibrium hypothesis – investor’s base their investment decisions entirely

on their anticipation of other individuals’ behavior with any necessary relation to the actual
payoffs that the assets are expected to provide.
Intrinsic value hypothesis – prices will be determined by each individual’s estimate of the
payoffs of an asset without consideration of its resale value to other individuals.
Rational expectation hypothesis – prices are formed on the basis of the expected future
payouts of the assets, including their resale value to their parties.
Question: if the efficient market hypothesis is valid, are investment analysis and active fund
managers worthwhile?
Answer: the efficient market hypothesis suggests that all relevant information is
quickly incorporated into security prices. This implies that there is no scope for making
profits from fore casting stock prices.
Investment analysis is concerned with stock selection and/or market timing. Stock selection
entails trying to ascertain mispriced investments with a view to buying underpriced
securities and selling overpriced securities.
Market timing attempts to forecast the points in time at which markets turns upward or
downwards. The EMH suggests that investment analysis is pointless on the ground that
available information is already reflected in assets prices and therefore cannot be used to
make forecasts of price changes.
Active fund management seeks to use the results of investment analysis to manage
portfolios outperform benchmarks, such as stock indices. If investment analysis is
ineffective, active fund management is pointless. Investors would do better to invest in
funds that aim to track stock indices and thereby avoid the expense of investment analysis
and active fund management.
However, there is a paradox for new information to become incorporated into security
prices, there may need to be buying or selling based on that information .investors who
undertake those trades could make profits. Those who are first to receive, or react to new
information will make profits. Investment analysis and active fund management on the part
of those who act quickest would be profitable. The absence of any profitable opportunities
would require all investor, both buyers and sellers, to instantly adjust their prices
expectation in the light of new information.
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Question: what is the relevance of the EMH to corporate financial managers?
Answer: The relevance of the EMH for financial management is that, if the
hypothesis holds true, the company’s real financial position will be reflected in the share
price. If the company makes a ‘good’ financial decision, this will be reflected in an increase
in the share price. Similarly, a ‘bad’ financial decision will cause the share price to fall. In
order to maximize shareholders wealth then the financial manager need only to concentrate
on maximizing the net present value of investment projects, and need give no consideration
to matters such as the way in which the future position of the company will be reflected in
the company’s financial statements. The financial managers may utilize rational decision
rules and have confidence that the market will rapidly cause the effects of those decisions to
be reflected in the company’s share prices.
Question: what are the implication of the EMH to an investor and to company and
managers?
Answer:
To an investor:-
 There is no need to pay for investment research.
 Studying published accounts and stock market tips will not generate abnormal
returns
 There are no bargains to be found on efficient stock exchanges
To company and managers:-
 Timing of new issues and rights issues is not important, since capital market
securities are never under priced.
 Altering the financial statements will not mislead the market.
 An efficient market correctly reflects the value of a company and expectations about
its future performance and returns. The financial manager should therefore focus on
making good financial decisions which increase shareholders wealth as they will be
correctly interpreted by the market and share price will adjust accordingly.
BEHAVIOURAL FINANCE
The efficient markets hypothesis (EMH) remains one of the cornerstones of modern finance
theory. It implies that, on average, assets trade at prices equal to their intrinsic values. As
we note in the text, the logic behind the EMH is straightforward. If a stock’s price is “too
low,” rational traders will quickly take advantage of this opportunity and will buy the stock.
Their actions will quickly push prices back to their equilibrium level. Likewise, if prices are
“too high,” rational traders will sell the stock, pushing the price down to its equilibrium
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level. Proponents of the EMH argue that prices cannot be systematically wrong unless you
believe that market participants are unable or unwilling to take advantage of profitable
trading opportunities.
While the logic behind the EMH is compelling, many events in the real world seem to be
inconsistent with the EMH. This has spurred a growing field that is called behavioral
finance theory. Rather than assuming that investors are rational, behavioral finance
theorists borrow insights from psychology to better understand how irrational behavior can
be sustained over time.
Pioneers in this field include psychologists Daniel Kahneman and Amos Tversky and
Richard Thaler, who is a professor of finance at the University of Chicago. Their work has
encouraged a growing number of scholars to work in this promising area of research.
Professor Thaler and his colleague, Nicholas Barberis, have summarized much of this
research in a recent article, which is cited below. They argue that behavioral finance
theory’s criticism of the EMH rests on two important building blocks. First, it is often
difficult or risky for traders to take advantage of mispriced assets. For example, even if you
know that a stock’s price is too low because investors have over reacted to recent bad news,
a trader with limited capital may be reluctant to buy the stock for fear that the same forces
that pushed the price down may work to keep it artificially low for a long period of time.
On the other side, during the recent stock market bubble, many traders who believed
(correctly!) that stock prices were too high lost a lot of money selling stocks in the early
stages of the bubble because stock prices went even higher before they eventually
collapsed.
While the first building block explains why mispricing may persist, the second tries to
understand how mispricing can occur in the first place. This component is where the
insights from psychology come into play. For example, Kahneman and Tversky suggested
that individuals view potential losses and potential gains very differently. If you ask an
average person whether he or she would rather have $500with certainty or flip a fair coin
and receive $1,000 if a head comes up and nothing if it comes out tails, most would prefer
the certain $500, which suggests an aversion to risk. However, if you ask the same person
whether he or she would rather pay $500 with certainty or flip a coin and pay $1,000 if it’s
heads and nothing if it’s tails, most indicate that they would prefer to flip the coin. Other
studies suggest that people’s willingness to take a gamble depends on recent performance.
Gamblers who are ahead tend to take on more risks, whereas those who are behind tend to
become more conservative.
These experiments suggest that investors and managers behave differently in down markets
than they do in up markets, which might explain why those who made money early in the
stock market bubble continued to keep investing in these stocks, even as their prices went
higher. Other evidence suggests that individuals tend to overestimate their true abilities. For
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example, a large majority (upward of 90 percent in some studies) of us believe that we have
above average driving ability or above-average ability to get along with others. Barberis
and Thaler point out that:
Overconfidence Bias
In business or trading, an overestimation of one's abilities and of the precision of one's

forecasts. Overconfident people set overly narrow confidence intervals in making
predictions. They tend to overweigh their own forecasts relative to those of others.
The self-serving attribution bias, under which individuals attribute past successes to their
own skills and past failures to bad luck, can lead to overconfidence.
In the context of financial markets, the confidence of a self-attributing investor increases

when public information is in line with his or her forecast, but it does not decrease as much
when public information contradicts his or her forecast. The investor therefore gains
excessive confidence over time, after receiving different confirming and disconfirming
public news.
Familiarity heuristic bias
In psychology, a heuristic is an easy-to- compute procedure or "rule of thumb" that people

use when forming beliefs, judgments or decisions. The familiarity heuristic was developed
based on the discovery of the availability heuristic by psychologists Amos
Tversky and Daniel Kahneman ; it happens when the familiar is favored over novel places,
people, things. The familiarity heuristic can be applied to various situations that individuals
experience in day to day life. When these situations appear similar to previous situations,
especially if the individuals are experiencing a high cognitive load, they may regress back
to the state of mind in which they have felt or behaved before. This heuristic is useful in
most situations and can be applied to many fields of knowledge; however, there are both
positives and negatives to this heuristic as well.
Hindsight bias
The hindsight bias is the inclination to see events that have already occurred as being more
predictable than they were before they took place. For example, after a situation occurs for
the first time, you begin to notice it when it reoccurs and therefore because you have now
experienced it, it's more readily available in your consciousness and you pull information
and predict aspects of the future because of this and think that you "knew it all
along.""Hindsight bias results from a biased reconstruction of the original memory trace,
using the outcome as a cue" Hindsight bias can alter memories and therefore future
predictions.
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Cognitive Dissonance
The unpleasant emotion that results from believing two contradictory things at the same
time. The study of cognitive dissonance is one of the most widely followed fields in social
psychology. Cognitive dissonance can lead to irrational decision making as a person tries to
reconcile his conflicting beliefs.
Let’s say an investor decides in advance that he is going to purchase shares of a firm when
the price drops to $78 a share. The price is currently at $80 a share. All of a sudden, the
company's stock price starts going up. The investor's belief that the stock would be a good
buy at $78 seems to be contradicted by the stock's current behavior. The investor decides to
buy at $85 instead of $78 to reconcile the cognitive dissonance he is experiencing. This
may not be as good of an investment decision, but the investor will rationalize himself into
thinking it is, mainly to get rid of his feeling of cognitive dissonance.
House Money Effect
The tendency for investors to take more and greater risks when investing with profits. The
house money effect gets its name from the casino phrase "playing with the house's money."
The house money effect was first described by Richard H. Thaler and Eric J. Johnson of the
Johnson Graduate School of Management of Cornell University.
The house money effect forecasts that investors are more prone to buy higher-risk stocks
after a profitable trade. Some believe that the house money effect is an example of mental
accounting, whereby capital is kept separate from recent profits, leading investors to view
said profits as disposable. As a result, they are more inclined to take greater risks with the
money.
Hindsight Bias
A psychological phenomenon in which past events seem to be more prominent than they
appeared while they were occurring.
Hindsight bias can lead an individual to believe that an event was more predictable than it
actually was, and can result in an oversimplification in cause and effect. It is studied in
behavioral economics.
Hindsight bias is a fairly common occurrence in investing, since the pressure to time the
purchase of securities in order to maximize return can often result in investors feeling regret
at not noticing trends earlier. For example, an investor may look at the sudden and
unforeseen death of an important CEO a something that should have been expected since
the CEO was likely to be under a lot of stress.
Financial bubbles are often the subjects of substantial hindsight bias. Following the Dot
Com bubble in the late 1990s and Great Recession of 2007, many pundits and analysts tried
to demonstrate how what seemed like trivial events at the time were actually harbingers of
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future financial trouble. If the financial bubble had been that obvious to the general
population, it would have been more likely to be avoided.
Investors should be careful when evaluating how past events affect the current market,
especially when considering their own ability to predict how current events will impact the
future performance of securities and the overall market. Believing that one is able to predict
future results can lead to overconfidence, and overconfidence can lead to choosing stocks
not for their financial performance but for personal reasons.
Disposition effect
The disposition effect is an anomaly discovered in behavioral finance. It relates to the

tendency of investors to sell shares whose price has increased, while keeping assets that
have dropped in value.
Investors are less willing to recognize losses (which they would be forced to do if they sold
assets which had fallen in value), but are more willing to recognize gains. This is irrational
behaviour, as the future performance of equity is unrelated to its purchase price. If anything,
investors should be more likely to sell “losers” in order to exploit tax reductions on capital
gains. In a study by Terrance Odean, this tax-motivated selling is only observed in
December, the final opportunity to claim tax cuts by unloading losing stocks; in other
months, the disposition effect is typically observed.
The disposition effect can be partially explained using loss aversion. More comprehensive
explanations also use other aspects of prospect theory, such as reflection effect, or involve
cognitive dissonance.
Behavioural finance is the study of the influence of psychology on the behavior of financial
practioners and subsequent effects on market. Behavioural finance is of interest because if it
helps explain why and how markets might be inefficient. Biasness give rise to excessive
trading and retention of losing position well after the evidence indicates that the basis for
original investment has changed. This shows that managers under-performs their
benchmarks and most investors are aware of the facts, although the urge to deny over
powers the rational conclusion.
Most of the standardized assumptions that underlie investment forecast and portfolio
management are wrong. They fail to take into account emotional and psychological bias of
those practicing the investment acts.
Fear, greed, risk seeking and evasion and peer pressures all play a role in the
underperformance of many investment managers relative to their objectives. Behavioural
finance with its roots in psychology of human decision making explains to us why most
investment managers are:-
1. More confident than they should be in their forecasting ability.
2. Do not process information efficiently.
3. Experience illusion of control
4. Do not act as if the choices they make come from a probability distribution.
5. Give undue credence to management and research.
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Question: which systematic biasness can occurs in financial markets?
Answer:-
 Tendency to give too much emphasis to the most recent information.
 Tendency to weight prospective losses about twice heavily as prospective profits.
Prospects theory suggests that they be weighted equally.
 Overconfidence: - tendency on the part of investors to regard success as arising from
their expertise while failures are due to bad luck or the action of others.
 Representativeness: - many investors extrapolate price movement. They believe if
prices have been rising in the past then they will continue to rise, and conversely with
falling prices.
 Conservatism: - investors are slow to change their views following the receipt of new
information.
 Narrow framing: - tendency of investor to focus too narrowly.
 Ambiguity aversion suggests investors prefer to invest in companies that they feel they
understand.
 Confirmation bias: - investors pay more attention to evidence that supports their
opinions than to evidence that contradicts them.
 Cognitive bias: - it’s the illusion of control
Efficient market and fundamental analysis
In finance the efficient markets hypothesis asserts that financial markets are informational
efficient or that prices on traded assets e.g. Stocks, bonds or properties already reflect all
known information and therefore are unbiased in the sense that they reflect collective belief
of all investors about future prospect.
Efficient market hypothesis states that it’s not possible to consistently outperform the
market by using any information that the market already knows except through luck.
Fundamental and technical Analysis
When day trading, a trader makes the decision about what to trade, when to trade, and how
to trade, using either fundamental or technical analysis. Both forms of analysis involve
looking at the available information and making a decision about the future price of the
market being traded, but the information that is used is completely different. Is it possible to
use both fundamental and technical analysis together, but it is more common for a trader to
choose one or the other.
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Fundamental Analysis
Fundamental traders use information about the global and national economies, and the
financial state of the companies involved, as well as non financial information such as
current political and weather information. Fundamental traders believe that the markets will
react to events in certain ways and that they can predict future market prices based on these
events. For example, if a company receives regulatory approval for a new product, a
fundamental trader might expect the company's stock price to rise. Conversely, if a
company has a financial scandal, a fundamental trader might expect its stock price to fall.
Fundamental traders need access to all of the available information as soon as it is
available, and are therefore often institutional traders with large support teams, rather than
individuals. Fundamental analysis has probably been in use since there were markets to
trade, and has traditionally been done manually, but as computing power increases it has
become possible for some fundamental information to be processed automatically.
Technical Analysis
Technical traders use trading information (such as previous prices and trading volume)
along with mathematical indicators to make their trading decisions. This information is
usually displayed on a graphical chart and is updated in real time throughout the trading
day. Technical traders believe that all of the information about a market is already included
in the price movement, so they do not need any other fundamental information (such as
earnings reports). There are many different types of charts and many different mathematical
indicators. Some indicators are better suited to short term trading, and others are better
suited for longer term trend following trading. Individual traders are usually technical
traders. Technical analysis appears to have been used at least 200 years ago in Japan.
Modern technical analysis is usually performed by the trader interpreting their charts, but
can just as easily be automated because it is mathematical. Some traders prefer automatic
analysis because it removes the emotional component from their trading, and allows them
to take trades based purely on the trading signals.
ANOMALIES IN EFFICIENCY MARKET
Efficiency in the market does not rule out price anomalies because as much as the
participants are aware of the information likelihood that through cartels they can manipulate
commodity i.e. securities and assets is likely.
Some can force a variety of pricing hence face pricing problems such as unnecessary
discounting and quoting prices below break-even point. The kinds of anomalies include:
1. Earnings Reports
It has been shown that an investor can profit from investing immediately when a company
reports because it takes time for the market to absorb the new information. This goes
against the EMH.
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2. January Anomaly
The January effect goes against the EMH. Essentially the January effect indicates that as a
result of tax-related moves, investors have been shown to profit by buying stocks in
December as they are being sold for losses and then selling them again in January.
3. Price-Earnings Ratio
Investing using the P/E ratio valuation metric has been an anomaly against the EMH. It has
been shown that investors can profit by investing in companies with a low P/E ratio.
4. Price-Earnings/Growth (PEG) Ratio

Investing using the PEG valuation metric has been anomaly against the EMH. It has been
shown similar to the P/E ratio that investors profit by investing in companies with low PEG
ratios.
5. Size Effect
Going against EMH, it has been shown that smaller companies, on a risk-adjusted basis,
have greater returns their larger peers.
6. Neglected Firms
Neglected firms are firms that Wall Street analysts deem too small to cover. As a result,
these firms tend to generate larger levels of return, negating the EMH.
Causes of market inefficiency or anomalies
1. Insider trading
This occurs when investors seek to obtain additional information from the relatives or
friends who could be working in the company in which they intend to purchase securities
from.
These investors end-up receiving information earlier than other investors in the market.
2. Taxation effect
In instances whereby some companies are required to pay taxes while others are not
required then those which pay taxes are likely to report lower profit when compared to
those which do not pay tax. Hence market investors will end up over-valuing security prices
of these companies which don’t pay taxes and under-valuing security prices of these
companies which pay taxes
3. Small business gap effect
Because of the sizes of the company the market may end up over-valuing or under-valuing
its security prices e.g. security prices of small companies may be under-valued and vice
versa
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STOCK MARKET INDICES
An index is a numerical figures which measures relative change in variables between two
periods. The index numbers are important because they show that the value of money,
securities, commodities is fluctuating i.e. appreciating or depreciating accordingly as the
index numbers of prices are rising/falling. A rise in the index numbers of prices will signify
deterioration in the value of money and vice versa.
Index number classification will depend on variables they are intended to measure. An
index is used to measure changes, which have occurred. Share indexes are used to measure
changes, which have occurred for shares in specific stock exchange e.g. stock indices
measures the changes of price or value changes where the value changes are brought about
by changes in the capitalization of the share in the exchange. NSE index is based on share
trading of 20 companies, which are considered very active. The 20 companies’ account
nearly 30% of NSE capitalization.
- A fall in NSE share index represents a fall in market price per share. Arise in NSE index
represent arise in the market price per share.
- An index may act as an indicator of activities in NSE the higher the demand of the share,
the higher is it market price and as a result the higher will be index.
Uses of index numbers
1. Price index numbers are used to measure changes in a particular group of prices and
help us in comparing the movement in prices of one commodity with another. They
are also designed to measure changes in purchasing power of money
2. Index numbers of industrial production provide a measure of change in the level of
industrial production in a country.
3. Quantity index numbers show the rise/fall in the volume of production exports and
imports
4. Import and export prices indices are used to measure changes in terms of trade of a
country by the terms of trade is meant ratio of import to export prices.
5. Index numbers are also used to forecast business condition of a country and to
discover seasonal fluctuations and business cycle.
6. Consumer price indices indicate the movement in retail prices of consumption goods
and services.
The stock exchange index indicates the level of investment in stock exchange securities as
compared to the base period.-this index is a measure of relative change from one point of
time to another. Stock indices are constructed to measure general price movement in listed
shares of a stock exchange. They are therefore important in measuring the market
sentiments.NSE e.g. has its base year as 1966 at 100. It was a portfolio based index of its
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shares recent changes has been done on computation methodology and computation of the
index. The stock index is a geometric mean of 20 companies at the close of business each
day.
Computation:
1. Closing share prices are multiplied in a similar manner
2. Previous day prices are multiplied in a similar manner
3. Divide the result in number 1 by the result in number2
4. Take 20th 100 of the above result in no.3multiply the result by previous day index,
this gives today’s index
i) Price weighted and value weighted indices
Price weighted index is a stock index in which each stock influence the index in proportion
to its price per share
- The value weighted index is generated by adding the prices of each of the stock in
the index and dividing them by the total number of stocks.
- Stocks with larger or higher price will be given more weight and therefore will have
a greater influence over the performance of the index e.g. assume that the index
contains only two stocks .one priced at sh.1 and the other priced at sh.10. The sh.10
shillings stock is weighted 9 times higher than the sh.1 stock. Overall this means that
the index is composed of 90% of Sh.10 stocks and 10% of Sh. 1 stock.
- A change in the value of Sh.1 stock will not affect the index value by a large amount
because it makes up only a small percentage of the index.
ii) Un weighted indices

It’s a simple arithmetic/geometric average used to calculate stock index. Equal weight is
invested in each share of the stocks in an index with equal shilling amounts invested in each
underlying stock; because the stocks are equally weighted on a stock’s performance, it will
not have a dramatic effect on the performance of the index of a whole.
This differs from weighted index where some stocks are given more weight than others,
usually based on their market capitalization.
iii) Global index

Global equity index covers securities in different countries and captures 98% of world’s
investable market capitalization. This covers every equity and sector relevant to
international investor needs.
iv) Style index
It’s a type of fundamentally weighted index that is designed to provide a benchmark for a
particular type of strategy. It provides a fair bench mark for activity managed funds that
follow a particular style i.e. it follows the performance ignoring cost.
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A bond market index

It’s a composite listing of bonds/fixed income instrument and a statistic relending
composite value of its components. It is used as a tool in a portfolio management process to
represent aggregate characteristics of underlying securities
When it comes to comparison of indices overtime this will enable investors to either
withhold money securities or commodities they have now or in case they speculate a fall in
value they might be willing to dispense with.
Market capitalization
This is market value of a company based on Number of shares issued of a company and
their market price at specified period of time. Market capitalization may also represent the
aggregate volume of transaction within NSE.
Market capitalization = No of shares traded X market price per share.
The higher the market capitalization the higher the activity of share trading, and vice versa
Benchmarking using indices
Most important type of bench marking from the point of view of investors is the
benchmarking of performance of funds and portfolio
Use of benchmarks is one reason why so many different indices exist.
Indices are not the best benchmark for performance measurements due to range available.
Drawbacks of stock indices

1. 20 company’s not true representation.
2. Thinness of the market — small changes in the above stocks tend to be considerably
magnified in the index
3. 1966 base year too far in the past.
4. Relatively small price changes-Some stock prices do not change for weeks.
5. Lack of clear portfolio selection criteria.
6. Use of arithmetic instead of preferred geometric mean in computing the index.
7. New companies have been quoted and others deregistered.
FINANCIAL INSTITUTIONS AND INTERMEDIARIES
Financial institutions serve as intermediaries by channeling the savings of individuals,

businesses, and governments into loans or investments. They are major players in the
financial marketplace. They often serve as the main source of funds for businesses and
individuals. Some financial institutions accept customers’ savings deposits and lend this
money to other customers or to firms. In fact, many firms rely heavily on loans from
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institutions for their financial support. Financial institutions are required by the government
to operate within established regulatory guidelines.
Key Customers of Financial Institutions

The key suppliers of funds to financial institutions and the key demanders of funds from
financial institutions are individuals, businesses, and governments.
The savings that individual consumers place in financial institutions provide these
institutions with a large portion of their funds. Individuals not only supply funds to financial
institutions but also demand funds from them in the form of loans. However, individuals as
a group are the net suppliers for financial institutions:
They save more money than they borrow.
Firms also deposit some of their funds in financial institutions, primarily in checking
accounts with various commercial banks. Like individuals, firms also borrow funds from
these institutions, but firms are net demanders of funds. They borrow more money than
they save.
Governments maintain deposits of temporarily idle funds, certain tax payments, and Social
Security payments in commercial banks. They do not borrow funds directly from financial
institutions, although by selling their debt securities to various institutions, governments
indirectly borrow from them. The government, like business firms, is typically a net
demander of funds. It typically borrows more than it saves.
The different types of financial institutions are described in Table 1. The most important
financial institutions that facilitate the flow of funds from investors to firms are commercial
banks, mutual funds, security firms, insurance companies, and pension funds. Each of these
financial institutions is discussed in more detail below
Commercial banks
Commercial banks accumulate deposits from savers and use the proceeds to provide credit
to firms, individuals, and government agencies. Therefore they serve investors who wish to
“invest” funds in the form of deposits. Commercial banks use the deposited funds to
provide commercial loans to firms and personal loans to individuals and to purchase debt
securities issued by firms or government agencies. They serve as a key source of credit to
support expansion by firms. Historically, commercial banks were the dominant direct lender
to firms. In recent years, however, other types of financial institutions have begun to
provide more loans to firms.
Like most other types of firms, commercial banks are created to generate earnings for their
owners. In general, commercial banks generate earnings by receiving a higher return on
their use of funds than the cost they incur from obtaining deposited funds. For example, a
bank may pay an average annual interest rate of 4 percent on the deposits it obtains and may
earn a return of 9 percent on the funds that it uses as loans or as investments in securities.
Such banks can charge a higher interest rate on riskier loans, but they are then more
exposed to the possibility that these loans will default.
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Although the traditional function of accepting deposits and using funds for loans or to
purchase debt securities is still important, banks now perform many other functions as well.
In particular, banks generate fees by providing services such as traveler’s checks, foreign
exchange, personal financial advising, insurance, and brokerage services. Therefore
commercial banks are able to offer customers “onestopshopping.”
Role of Commercial Banks as Financial Intermediaries

Commercial banks play several roles as financial intermediaries. First, they repackage the
deposits received from investors into loans that are provided to firms. In this way, small
deposits by individual investors can be consolidated and channeled in the form of large
loans to firms. Individual investors would have difficulty achieving this by themselves
because they do not have adequate information about the firms that need funds.
Second, commercial banks employ credit analysts who have the ability to assess the
creditworthiness of firms that wish to borrow funds. Investors who deposit funds in
commercial banks are not normally capable of performing this task and would prefer that
the bank play this role.
Third, commercial banks have so much money to lend that they can diversify loans across
several borrowers. In this way, the commercial banks increase their ability to absorb
individual defaulted loans by reducing the risk that a substantial portion of the loan
portfolio will default. As the lenders, they accept the risk of default. Many individual
investors would not be able to absorb the loss of their own deposited funds, so they prefer
to let the bank serve in this capacity. Even if a commercial bank were to close because of an
excessive amount of defaulted loans, the deposits of each investor are insured.
Therefore the commercial bank is a means by which funds can be channeled from small
investors to firms without the investors having to play the role of lender.
Fourth, some commercial banks have recently been authorized to serve as financial
intermediaries by placing the securities that are issued by firms. Such banks may facilitate
the flow of funds to firms by finding investors who are willing to purchase the debt
securities issued by the firms. Therefore they enable firms to obtain borrowed funds even
though they do not provide the funds themselves.
Other roles include: -
i. They provide a safe deposit for money and other valuables.

ii. They lend money to borrowers partly because they charge interest on the loans,
which is a source of income for them, and partly because they usually lend to
commercial enterprises and help in bringing about development.
iii. They provide safe and non-inflationary means for debt settlements through the
use of cheques, in that no cash is actually handled. This is particularly important
where large amounts of money are involved.
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iv. They act as agents of the central banks in dealings involving foreign exchange on
behalf of the central bank and issue travelers’ cheques on instructions from the
central bank.
v. They offer management advisory services especially to enterprises which borrow
from them to ensure that their loans are properly utilized.
Some commercial banks offer insurance services to their customers eg. The Standard Bank
(Kenya) which offers insurance services to those who hold savings accounts with it.
Some commercial banks issue local travelers’ cheques, e.g. the Barclays Bank (Kenya).
This is useful in that it guards against loss and theft for if the cheques are lost or stolen; the
lost or stolen numbers can be cancelled, which cannot easily be done with cash. This also
safe if large amount of money is involved.
Mutual Funds
A mutual fund is a professionally managed type of collective scheme that pools money
from many investors and invests it in stock and other securities. It is a collection of stocks
or bonds. This happens when a large number of people give their money to professionals, to
manage and invest, with the aim of achieving a return and in accordance with the objective
of the fund.
Mutual funds are managed under the company’s Act where investors invest in shares.
Some of mutual funds and unit trusts in Kenya are:-

 ICEA money market fund
 Commercial bank market
 Old mutual money market fund
 British America
 Stanbic money market fund
 Dyer and Blair equity
Unit trusts
A unit trust fund is an investment scheme that pools money together from many investors
who share the same financial objective to be managed by a group of professional managers
who invest the pooled money in a portfolio of securities such as shares, bonds and money
market instruments or other authorized securities to achieve the objectives of the fund. Unit
trust are managed under the unit trust Act where investors invest in unit trust.
To invest in a unit trust fund, investors buy units through the fund manager at the prevailing
selling price which is calculated daily. These units can be bought any time as long as the
fund has not reached its maximum approved size. Unit holders can also sell their units back
to the fund manager at the prevailing buying price.
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Employee share ownership plan (ESOP)
An ESOP is simply an option by the employees of a company to buy the shares of that
company at a price prescribed by the company. Normally, to make the ESOP attractive, the
option is lower than the market price. The company normally has the right to determine the
number of shares the employees gets which employees get them and the ownership is
actually transferred. It is normally given to high caliber employees as a way of motivating
them and retaining them in the company since they become shareholders.
Benefits of investing in collective investment schemes (mutual funds, unit trusts and
ESOP)
1. Diversification: investors in unit trusts can access a broader range of securities than
they could when investing on their own as individuals.
2. Liquidity: there is ease in selling and buying the units compared with investing
directly in shares of companies where prices and opportunities to transact depend on
the supply and demand at that time.
3. Continuous professional management: unit trusts are managed by a team of
experienced professionals who manage the fund in a structured manner as opposed to
the individual investor who may invest in a random fashion.
4. Access to a broader array of assets: unit trusts fund managers can trade in
investment products that are normally inaccessible to the individual investor, such as
government and corporate bonds, which may be restricted to institutional investors.
5. Convenient record keeping and administration: fund managers take care of
various types of schemes: CIS offer various types of schemes such as income plan,
growth plan, equity funds, debt funds, and balanced funds. An investor can therefore
select a plan according to his needs.
6. Scope for good return: fund managers invest in various industries and sectors;
therefore, the portfolio gets diversified, resulting in CIS generating equitable returns.
7. Tax benefits: the CIS income is tax exempt, and this can be extended to unit holders
in form of better returns.
Hedge Fund
A hedge fund is an alternative investment vehicle available only to sophisticated investors,
such as institutions and individuals with significant assets.
Like mutual funds, hedge funds are pools of underlying securities. Also like mutual funds,
they can invest in many types of securities—but there are a number of differences between
these two investment vehicles.
Hedge funds can invest in a wider range of securities than mutual funds can. While many
hedge funds invest in traditional securities, such as stocks, bonds, commodities and real
estate, they are best known for using more sophisticated (and risky) investments and
techniques.
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Hedge funds typically use long-short strategies, which invest in some balance of long
positions (which means buying stocks) and short positions (which means selling stocks with
borrowed money, then buying them back later when their price has, ideally, fallen).
Additionally, many hedge funds invest in “derivatives,” which are contracts to buy or sell
another security at a specified price. You may have heard of futures and options; these are
considered derivatives.
Many hedge funds also use an investment technique called leverage, which is essentially
investing with borrowed money—a strategy that could significantly increase return
potential, but also creates greater risk of loss. In fact, the name “hedge fund” is derived
from the fact that hedge funds often seek to increase gains, and offset losses, by hedging
their investments using a variety of sophisticated methods, including leverage.
Hedge funds are typically not as liquid as mutual funds, meaning it is more difficult to sell
your shares. Mutual funds have a per-share price (called a net asset value) that is calculated
each day, so you could sell your shares at any time. Most hedge funds, in contrast, seek to
generate returns over a specific period of time called a “lockup period,” during which
investors cannot sell their shares. (Private equity funds, which are similar to hedge funds,
are even more illiquid; they tend to invest in startup companies, so investors can be locked
in for years.)
Finally, hedge fund managers are typically compensated differently from mutual fund
managers. Mutual fund managers are paid fees regardless of their funds’ performance.
Hedge fund managers, in contrast, receive a percentage of the returns they earn for
investors, in addition to earning a “management fee”, typically in the range of 1% to 4% of
the net asset value of the fund. That is appealing to investors who are frustrated when they
have to pay fees to a poorly performing mutual fund manager. On the down side, this
compensation structure could lead hedge fund managers to invest aggressively to achieve
higher returns—increasing investor risk.
As a result of these factors, hedge funds are typically open only to a limited range of
investors. Specifically, U.S. laws require that hedge fund investors be “accredited,” which
means they must earn a minimum annual income, have a net worth of more than $1 million,
and possess significant investment knowledge.
Insurance brokerage Companies
Insurance companies provide various types of insurance for their customers, including life
insurance, property and liability insurance, and health insurance.
They periodically receive payments (premiums) from their policyholders, pool the
payments, and invest the proceeds until these funds are needed to pay off claims of
policyholders. They commonly use the funds to invest in debt securities issued by firms or
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by government agencies. They also invest heavily in stocks issued by firms. Therefore they
help finance corporate expansion.
Insurance companies employ portfolio managers who invest the funds that result from
pooling the premiums of their customers. An insurance company may have one or more
bond portfolio managers to determine which bonds to purchase, and one or more stock
portfolio managers to determine which stocks to purchase. The objective of the portfolio
managers is to earn a relatively high return on the portfolios for a given level of risk. In this
way, the return on the investments not only should cover future insurance payments to
policyholders but also should generate a sufficient profit, which provides a return to the
owners of insurance companies. The performance of insurance companies depends on the
performance of their bond and stock portfolios.
Like mutual funds, insurance companies tend to purchase securities in large blocks, and
they typically have a large stake in several firms. Therefore they closely monitor the
performance of these firms. They may attempt to influence the management of a firm to
improve the firm’s performance and therefore enhance the performance of the securities in
which they have invested.
Roles played by insurance companies in development of Kenya
i. Provide cover for business risks.

ii. Accumulate large sums of money from premium and this act as long term source of
finance both to policy holders and other parties such as company selling shares.
iii. An insurance firm is one that plays the middle men role between the policy holders
and insurance firms.
iv. Facilitates exchange of securities by linking policy holders to the insurance
company.
Investment companies
These are firms that don’t trade in goods and services but they invest on a speculative
motive in order to get profits they can invest in securities, mortgages, real estate’s etc.
Investment Banks and brokerage houses

These are institutions that buy new issue of securities for resale to other investors with a
view of making profit. This mostly takes place in the primary markets where they buy a lot
of floated securities i.e. shares, bonds, treasury bills and become sellers in the secondary
market which is the determinant of the two markets.
Brokerage houses are institutions that comprise investment banks which facilitate
investment process between these banks and the public. They don’t earn a profit/interest but
commission on the amount.
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Micro-finance institutions
This refers to the provision of financial services to low income clients, including consumer
and self employed. It also refers to movement that envisions a world in which as many poor
and nearly poor households as possible have permanent access to an appropriate range of
high quality financial services including not just credit but also savings insurance and fund
transfer.
A micro-finance institution is an organization that provides small loans. These transformed

into micro-financial institutions that have proved that the poor are bankable. Examples are
Kenya women, SMEP and Faulu Kenya.
Challenges to micro finance institutions

Traditionally banks have not provided funds to clients with little or no cash income. Poor
people fall below breakeven point i.e. banks lose money on providing loans or in any
transaction they make. Some of the clear challenges poor people do not have collateral and
they also default to re-pay the hence they are unreliable.
Importance of micro-finance
1. They provide financial services to self employed and low income earners
2. Major financier of small scale business
3. Provide their loans with an affordable rates
4. Supervise or inspect the business against which financial services is provided
therefore acting as an impetus to having more people in the economic venture into
business.
Syndication of commercial banks
It’s the process of a group of banks coming together to combine their financial resources to
create a large pool of loan to investors. The large pool of funds is more reliable and viable
in relation to increased demand of credit facilities to long term investors.
Syndicated loans are available to government/private investors where banks participating in

the syndicate combine funds to create loan for the borrowers. The default risk is therefore
spread among the banks within the syndicate.
Benefits that would accrue to the capital market in your country from syndication by
commercial banks
 Participating banks play useful roles by providing informative opinions and/or
additional expertise even after securities has been issued
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 Popular scheme for issuing securities to large and medium scale projects
 The ability of the customer to deal with single Bank/FI (“Lead Bank” and “Agent
Bank”)as a one-stop service point
 Syndication provides borrower/investor with a complete menu of available
securities
 The opportunity for the borrower to establish a track record with many banks from
just a single transaction
Diversification/sharing of risks, cost sharing and pooling of resources and reputation
Capital market regulation
The Kenyan capital market has attained a remarkable degree of growth are poised for
further leap forward in the current world. The process of modernization and
computerization has rendered the market not only abroad and liquid but also fair efficient.
All concerned with the market. The investors, the issuers, market players and more
importantly the regulators play a vital role. The stock exchange authority i.e. C.M.A, N.S.E
council, the Retirement Benefit Authority, Insurance Regulatory Authority and above all
the Kenyan government are the regulators of capital market.
ROLE OF REGULATORS IN FINANCIAL MARKETS
Role of capital market authority (CMA)
CMA was established in 1989 through the market authority Act Sec ii which includes the
principles and objectives of the authority.
The act provide for:
Development of all aspects of the capital Market and in particular it emphasizes on the
removal of impediments and creation of incentives for long-term investment productive
enterprises.
The creation, maintenance and regulation of the CMA through the implementation of
system in which the market participants are self regulatory and the creation of a market in
which securities can be issued and traded in an orderly, fair and efficient manner.
Protection of investor’s interests
Roles
1. The CMA has the responsibility of licensing and regulating stockbrokers, investment
advisers, security dealers and the authority depositories.
2. The capital market authority is involved in the process of listing of new companies.
Any company, intending to be quoted in the NSE must apply through
CMA.
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3. CMA is involved in the making of policies that would enhance the development of
the capital market e.g. policy regarding the buying and selling of securities, policies
on admission of individual and institutions to the capital market and generally
policies on the introduction of securities and their regulations
4. The CMA acts as a watchdog for shareholders of listed companies. This is through
regulating the operations of the listed company’s so as to protect investors against
penalty, insider trading or suspensions.
5. The authority assists in the development of new securities in the market. This is
through research and evaluations of various recommendations of stakeholders in the
NSE. It is the responsibility of the CMA to evaluate whether there is need of new
security and develop on appropriate policy
6. The CMA acts as a government advisor through the ministry of finance regarding
policies affecting the capital markets.
7. Removes bottlenecks and creates awareness for investment in long term securities.
8. Serves as efficient bridge between the public and private sector.
9. Creates an environment which will encourage local companies to go public..
10. Implements government’s programmes and policies with respect to capital market.
Roles to stock exchange in Kenya
1. Removes barriers on security transfer.

2. Introduce wide range of instruments in the market.
3. Decentralizations of its operations.
4. Encourage development of institutional investors such as pension firms and
insurance firms.
5. Provide adequate information to players in the market. In order to prevent insider
trading.
6. License more bankers.
Role of capital market authority in determination of share prices

i) The CMA does not in any way influence share price of quoted security.
ii) The prices of such securities are determined by the demand and supply
mechanism.
iii) The CMA may: - Advice the company on the issue price of new securities.
- Alert investors if it feels that the issue price of certain securities is not in their interest.
- It guides against manipulation of share prices and insider trading.
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CENTRAL DEPOSITORY SYSTEM (CDS)
It acts as a means of representing ownership and movements of securities. CDA account

holders enjoy the convenience of obtaining electronic securities transfer and trade
settlement.
Who may open CDS account?
1. An individual who has reached the age of 18 years.

2. A corporation within the context of a company’s Act.
3. Any corporate body that is incorporated within Kenya.
4. A society under any written law relating to co-operative society.
5. Any society registered under societies Act
6. Statutory bodies incorporated under an act of parliament.
Need to open a CDS account.
It will facilitate buying and selling of shares and also to carry out other CDS transactions on
all equity and non-equity counters (bonds, warrants etc) which have been prescribed into
CDS.
How to open a CDS account
One can open a CDS account with any authorized depository agents. All stock broking
companies in Kenya are currently ATS. If you are an individual investor you may go to an
ADA of your choice. Procedure: -
a. Complete opening of your account form and two specimen signatures.

b. For Kenyans submit the documents together with two certified copies of your Kenya
national identity card as for foreigners you need to pay accounts opening fee and
submit two certified copies of your passport.
If you are a corporate investor:
a. Complete opening of accounts form and two specimen signature

b. Certificate of incorporation.
Your ADA will then open your CDS account and give you your CDS account number.
Objectives of applying Central Depository System
 Eliminate risks resulting from trading of material securities in the Capital Market.
i.e. damage or loss or forgery.
 Get hold of all material securities at the central level through gradual withdrawal of
securities traded in the markers and relieve issuers from printing securities
certificates in the other hand.
 Simplify the process of trading in stock exchange as a result of dealing on balances
and book entries instead of material securities.
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 Increase the securities turnover due to completion of ownership transfer within a

specified timeframe.
 Increase the market liquidity.
 Operating Settlement system according to Delivery Versus Payment (DVP) system.
 Relieve the issuers from cost, effort, time they take to print certificates for the
original capital or any amendment thereon and print one certificate with total issuing
value.
 Establish a database for all the securities issued and traded in the Egyptian Capital
Market.
 Establish a database for securities owners and their relevant data.
 Foster investor’s confidence through adhering to international standards.
AUTOMATED TRADING SYSTEM (ATS)/MECHANICAL TRADING SYSTEM
Automated system also refers to mechanical trading system. It’s a set of trading rules which
gives entry points and exit points automatically to investors. Automated trading
system/Auto trading and robo-trading form a strategy for trading as it allows the computer
to figure out what trade to make and actually execute the trade. It can trade a large array of
assets. This includes stocks, options etc.
ATS typically use artificial intelligence and develop their strategies through trial and error.
In theory the trial and error happens during development face. Computers are better at
trading than human being. The challenge is that successful ATS are few and far. ATS will
become a standard throughout the world in future since human beings simply do not make
good traders and most so called investors lose money.
In addition the current stock market downtown has left millions of stock and mutual fund
holders losing 50% of their portfolios with a little bit of luck, the trade will turn and
everybody in the world can benefit from ATS.
Advantages of computers over human beings
i. Computers have no emotions to cloud its judgment. 90% of traders and investors
lose money because of their emotions fear causes us to sell a stock and greed causes
us to buy into market. Most people have a strong desire to be right and this is their
ego getting the best of them.
ii. Computers have ability to process information faster and it can process all sorts of
data in contrast human beings can only take in a small amount of information at a
time.
iii. Computers have a large memory so that they can track many positions and pieces of
data simultaneously.
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iv. Computers are consistent and are totally immune to moods and therefore can
perform more consistently than human beings.
v. Computers do not embezzle. Scandals have made many people to question whether
they can trust financial managers/government to protect them.
When ATS becomes more popular people will consider it a viable alternative to traditional
way of investing. ATS will become more effective and successful human beings hence it
will become industry standard.
TIMING OF INVESTMENT A STOCK EXCHANGE
The ideal way of making profits at the stock exchange is to buy at the bottom of the market
(lowest M.P.S) and sell at the top of the market (highest M.P.S). The greatest problem
however is that no one can be sure when the market is at its bottom or at its top (prices are
lowest and highest).
Systems have been developed to indicate when shares should be purchased and when they
should be sold. These systems are Dow theory and Hatch system.
1. Dow Theory
This theory depends on profiting of secondary movement of prices of a chart. The principal
objective is to discover when there is a change in the primary movement.
This is determined by the behaviour of secondary movement but tertiary movements are
ignored. E.g. in a bull market, the rise of prices is greater than the fall of prices.
In a bear market the opposite is the case i.e. the fall is greater than the rise
In 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.
Basically, 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.
2. Hatch System
This is an automatic system based on the assumption that when investors sell at a certain %
age below the top of the market and buys at a certain percentage above the market bottom,
they are doing as well as can reasonably be expected. This system can be applied to an
index of a group of shares or shares of dividends companies e.g. Dow Jones and Nasdaq
index of America.
Rules for floatation of new shares on NSE

1. The company must have an issued share capital of at least Kshs.20 M.
2. The company must have made profits during the last 3 years.
3. At least 20% of issued capital (capital to be issued) should be offered to the public
4. The firm must issue a prospectus which will give more information to investors to
enable them to make informed judgement
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5. The market price of the companies share must be determined by the market forces of
demand and supply
6. The company should be registered under Cap. 486 with registrar of companies.
Note
 A prospectus is a legal document issued by a company wishing to raise funds from the
public through issue of shares or bonds.
 It is prepared by directors of the company and submitted to CMA and NSE for approval
 The CMA has issued rules relating to the design and contents of the prospectus, in
addition to those contained in the Companies Act.
It must provide details on

1. Number of shares to be issued
2. Offer/issue price per share
3. The dates during which the offer is valid or open
4. Financial statements of the firm showing EPS and DPS for the last 5 years
5. Action report etc.
6. Action may be taken against the directors if the prospectus is fraudulent.
The Advantages and Disadvantages of a Listing

Advantages
1. It facilitates the issue of securities to raise new finance, making a company less
dependent upon retained earnings and banks.
2. The wider share ownership which results will increase the likelihood of being able to
make rights issues.
3. The transfer of shares becomes easier. Less of a commitment is necessary on the part
of shareholders. For this reason the shares are likely to be perceived as a less risky
investment and hence will have a higher value.
4. The 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.
5. A market-determine price means that shareholders will know the value of their
investment at all times.
6. The 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 objectives measures are backward looking.
7. The shares of a quoted company can be used more readily as consideration in takeover
bids.
8. The company may increase its standing by being quoted and it may obtain greater
publicity.
9. Obtaining a quotation provides an entrepreneur with the opportunity to realize part of
his holding in a company.
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Disadvantages
1. The cost of obtaining a quotation is high, particularly when a new issue of shares is
made and the company is small. This is because substantial costs are fixed and hence
are relatively greater for small companies. Also, 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.
2. The increased disclosure requirements may be disliked by management.
3. The market-determined price and the greater accountability to shareholders that comes
with its concerning the company’s performance may not be liked by management.
4. Control of a particular group of shareholders may be diluted by allowing a proportion
of shares to be held by the public.
5. There will be a greater likelihood of being the subject of a takeover bid and it may be
difficult to defend it with wide share ownership.
6. Management conditions, management employees give themselves more salaries due to
prosperity obtained.
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TOPIC 4
TIME VALUE OF MONEY
CONCEPT OF TIME VALUE OF MONEY
Introduction
A shilling today is worth more than a shilling tomorrow. An individual would thus prefer to
receive money now rather than that same amount later. A shilling in ones possession today
is more valuable than a shilling to be received in future because, first, the shilling in hand
can be put to immediate productive use, and, secondly, a shilling in hand is free from the
uncertainties of future expectations (It is a sure shilling).
Financial values and decisions can be assessed by using either future value (FV) or present
value (PV) techniques. These techniques result in the same decisions, but adopt different
approaches to the decision.
Future value techniques
Measure cash flow at the some future point in time – typically at the end of a projects life.
The Future Value (FV), or terminal value, is the value at some time in future of a present
sum of money, or a series of payments or receipts. In other words the FV refers to the
amount of money an investment will grow to over some period of time at some given
interest rate. FV techniques use compounding to find the future value of each cash flow at
the given future date and the sums those values to find the value of cash flows.
Present value techniques
Measure each cash flows at the start of a projects life (time zero).The Present Value (PV)
is the current value of a future amount of money, or a series of future payments or receipts.
Present value is just like cash in hand today. PV techniques use discounting to find the PV
of each cash flow at time zero and then sum these values to find the total value of the cash
flows.
Although FV and PV techniques result in the same decisions, since financial managers
make decisions in the present, they tend to rely primarily on PV techniques.
COMPOUNDING TECHNIQUES
Two forms of treatment of interest are possible. In the case of Simple interest, interest is
paid (earned) only on the original amount (principal) borrowed. In the case of Compound
interest, interest is paid (earned) on any previous interest earned as well as on the principal
borrowed (lent). Compound interest is crucial to the understanding of the mathematics of
finance. In most situations involving the time value of money compounding of interest is
assumed. The future value of present amount is found by applying compound interest
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over a specified period of time
The Equation for finding future values of a single amount is derived as follows:
Let
FVn= future value at the end of period n
PV (Po) =Initial principal, or present value
k= annual rate of interest
n = number of periods the money is left on deposit.
The future value (FV), or compound value, of a present amount, Po, is found as follows.
At end of Year 1, FV1 =Po (1+k) = Po (1+k)1

= Po (
At end of Year 2, FV2=FV1 (1+k) = Po(1+k) (1+k) 1+k)2
At end of Year 3, FV3 = FV2 (1+k) = Po ( 1+k) ( 1+k) (1+k) = Po (1+k)3
A general equation for the future value at end of n periods can therefore be formulated as,
FVn = Po (1+k)n
Example:
Assume that you have just invested Ksh100, 000. The investment is expected to earn
interest at a rate of 20% compounded annually. Determine the future value of the
investment after 3 years.
Solution:
At end of Year 1,
FV1 =100,000 (1+0.2) =120,000
At end of Year 2,
FV2 =120,000 (1+0.2) OR { 100,000(1+0.2) (1+0.2)}=144,000
At end of Year 3, = 144,000(1+0.2) =100,000 ( 1+0.2) ( 1+0.2) (1+0.2) =
FV3 172,800
Alternatively,
FVn = Po ( 1+k)n
At the end of 3 years, FV3= 100,000 ( 1+0.2)3= Sh.172,800
Using Tables to Find Future Values
Unless you have financial calculator at hand, solving for future values using the above
equation can be quite time consuming because you will have to raise (1+k) to the nth
power.
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Thus we introduce tables giving values of (1+k)n for various values of k and n. Table A-3 at
the back of this book contains a set of these interest rate tables. Table A-3 Future Value of
$1 at the End of n Periods1 gives the future value interest factors. These factors are the
multipliers used to calculate at a specified interest rate the future values of a present amount
as of a given date. The future value interest factor for an initial investment of Sh.1
compounded at k percent for n periods is referred to as FVIFk n.
Future value interest factors = FVIFk n. = (1+k)n.
FVn = Po * FVIFk,n
A general equation for the future value at end of n periods using tables can therefore be
formulated as,
FVn = Po× FVIFk,n
The FVIF for an initial principal of Sh.1 compounded at k percent for n periods can be
found in Appendix Table A-3 by looking for the intersection of the nth row and the k %
column. A future value interest factor is the multiplier used to calculate at the specified rate
the future value of a present amount as of a given date.
From the example above, FV3 = 100,000 × FVIF20%,3 years
=100,000 × 1.7280
=sh.172, 800
Future value of an annuity
So far we have been looking at the future value of a simple, single amount which grows
over a given period at a given rate. We will now consider annuities.
An annuity is a series of payments or receipts of equal amounts (i.e. a pensioner receiving
Sh.100,000 per year for ten years after his retirement). The two basic types of annuities are
the ordinary annuity and the annuity due. Anordinary annuityis an annuity where the
cash flowoccurs at the end of each period. In an annuity due the cash flows occur at the
beginning of each period. This means that cash flows are sooner received with an annuity
due than for a similar ordinary annuity. Consequently, the future value of an annuity due is
higher than that of an ordinary annuity because the annuity due‟s cash flows earn interest
for one more year.
Example:
Determine the future value of a shs100, 000 investment made at the end of every year for 5
years assume the required rate of return is 12% compounded annually.
Solution.
The future value interest factor for an n-year, k%, ordinary annuity (FVIFA) can be found
by adding the sum of the first n-1 FVIFs to 1.000, as follows;
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End of year Amount Number of Future value interest factor Future value
deposited years (FVIF) from discount tables at end of year
Companied (12%)
1 100,000 4 1.5735 157350
2 100,000 3 1.4049 140490
3 100,000 2 1.2544 125440
4 100,000 1 1.12 112000
5 100,000 0 1 100000
FV after 5 years. 635280
The Time line and Table below shows the future value of a Sh.100,000 5-year
annuity
(ordinary annuity) compounded at 12%.
Timeline
The formula for the future value interest factor for an annuity when interest is compounded
annually at k percent for n periods (years) is
((1 + ) − 1)
, = (1 + ) =
Using Tables to Find Future Value of an Ordinary Annuity
Annuity calculations can be simplified by using an interest table. Table A-4 Future Value
of Annuity The value of an annuity is founding by multiplying the annuity with an
appropriate multiplier called the future value interest factor for an annuity (FVIFA)
which expresses the value at the end of a given number of periods of an annuity of Sh.1 per
period invested at a stated interest rate.
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The future value of an annuity (PMT) can be found by,
FVAn = PMT× (FVIFAk,n
Where FVAn is the future value of an n-period annuity, PMT is the periodic payment or
cash flow, and FVIFAk,n is the future value interest factor of an annuity. The value
FVIFAk,n can be accessed in appropriate annuity tables using k and n. The Table A-4 gives
the PVIFA for an ordinary annuity given the appropriate k percent and n-periods.
From the above example,
FVA5 =100,000×FVIFA12%, 5 years
=100,000×6.35280
=sh.635280
Finding Value of an Annuity Due
Assuming in the above example the investment is made at the beginning of the year
rather than at the end.
What is the value of Sh.100,000 investment annually at the beginning of each of the next 5
years at an interest of 12%.
Future value
Beginning of Amount Number of interest Future valueat
year deposit deposited Years factor (FVIF) from end of year
companie discount tables
d 12%
1 100,000 5 1.7623 176230

2 100,000 4 1.5735 157350
3 100,000 3 1.4049 140490
4 100,000 2 1.2544 125440
5 100,000 1 1.12 112000
FV after 5 711510
years.
The Time line and Table below shows the future value of a Sh.100, 000 5-year annuity
due compounded at 12%.
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Timeline
Using Tables to Find Future Value of an Annuity Due
A simple conversion can be applied to use the FVIFA (ordinary annuity)in Table A-4 with
annuities due. The Conversion is represented by Equation below.
FVIFk,n(annuity due) = FVIFk,n(ordinary annuity) x ( 1 +k)
From the above example,

FVIFA12%, 5yrs(annuity due) =FVIFA12%,5yrs(ordinary) x ( 1 + k)
=6.35280 x (1+.12)
=7.115136
Therefore future value of the annuity due = 100, 000 x 7.115136

=sh.711, 511.36
Compounding More Frequently.
Interest is often compounded more frequently than once a year. Financial institutions
compound interest semi-annually, quarterly, monthly, weekly, daily or even continuously.
Semi Annual Compounding
This involves the compounding of interest over two periods of six months each within a
year. Instead of stated interest rate being paid once a year one half of the stated interest is
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paid twice a year.
Example
Sharon decided to invest Sh.100,000 in savings account paying 8% interest compounded
semi annually. If she leaves the money in the account for 2 years how much will she have at
the end of the two years?
She will be paid 4% interest for each 6-months period. Thus her money will amount to.
FV4 = 100,000 ( 1+.08/2)2*2 =100,000(1+.04)4 =Sh.116,990

Or
Using tables = 100,000 x FVIF 4%,4periods =100,000 x 1.17 = Sh.117,000
Quarterly Compounding
This involves compounding of interest over four periods of three months each at one fourth
of stated annual interest rate.
Example
Suppose Jane found an institution that will pay her 8% interest compounded quarterly.
How much will she have in the account at the end of 2 years?
FV8 = 100,000(1+.08/4)4*2=100,000(1+.02)8 =100,000 x
1.1716 = 117,160
Or,
Using tables 100,000 x FVIF 2%, 8periods= 100,000*1.172 = 117,200
As shown by the calculations in the two preceding examples of semi-annual and quarterly
compounding, the more frequently interest is compounded, the greater the rate of growth of
an initial deposit. This holds for any interest rate and any period.
General Equation for compounding more frequently than annually

Let;
m = the number of times per year interest is

compounded n= number of years deposit is held.
k= annual interest rate.
m*n
 k
FV n ,k
 P 0 1  
 m
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Continuous Compounding
This involves compounding of interest an infinite number of times per year, at intervals of
microseconds - the smallest time period imaginable. In this case m approaches infinity and
through calculus the Future Value equation 2.1 would become,
FVn(continuous compounding) = Po x e k x n
Where there is the exponential function, which has a value of 2.7183. The FVIFk,n
(continuous compounding) is therefore ekn , which can be found on calculators.
Example
If Jane deposited her 100,000/= in an institution that pays 8% compounded continuously,
what would be the amount on the account after 2 years?
Amount = 100,000 x 2.718.08*2 = 100,000 x 2.7180.16 =100,000*1.1735 =117,350
DISCOUNTING TECHNIQUES
The process of finding present values is referred to as discounting. It is the inverse of

compounding and seeks to answer the question. “If I can earn k% on my money, what is the
most I will be willing to pay now for an opportunity to receive FV shillings n periods from
now?” The annual rate of return k% is referred to as the discount rate, required rate of
return, cost of capital, or opportunity cost.
The present value as the name suggests, is the value today of a given future amount.
Recall the basic compounding formula for a lump sum;
FVn = Po (1+k)1 Therefore making P the subject
Po = FVn
(1+k)n
FV 
n 1
PV k ,n
 FV
n n
 n
(1 k ) (1 k )
Example:
Assume you were to receive sh. 172,800 three years from now on an investment and the
required rate of return is 20 %. What amount would you receive today to be indifferent?
Solution.
Recall previous example on FV
PV20%,3yrs= 172,800/( 1 + 0.20)3 =172,800/1.728 = Sh.100,000
PV=Sh.100,000
FV5 = Sh.172800
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Using Present Value Interest Factor (PVIF) Tables
1 n
The factor denoted by n
, or (1 K ) as above is called the present value interest
(1 k )
factor (PVIF). The PVIF is the multiplier used to calculate at a specified discount rate the
present value of an amount to be received at a future date. The PVIFk,n is the present value
of one shilling discounted at k% for n-periods.
Therefore the present value (PV) of a future sum ( FVn ) can be found by
PV = FVn x (PVIFk, n).
In the preceding example the PV could be found by multiplying Sh. 172,800 by the
relevant PVIF. Table A - 1 Present Value of $1 Due at the End of n Periods gives a
factor of 0.5787for 20% and 3 years.
PV = 172800 x 0.5787 = Sh.99, 999.36
= sh. 100,000
Present Value of a Mixed Cashflows
We determine the PV of each future amount and then add together all the individual PVs
Example
The following is a mixed stream of cash flows occurring at the end of year
Year Cash flow
sh.000
1 400
2 800
3 500
4 400
5 300
If a firm has been offered the opportunity to receive the above amounts and if it‟s required
rate of return is 9% what is the most it should pay for this opportunities?
Solution
Year (n) Cash flow PVIF9%, n PV

1 400,000 0.917 366,800
2 800,000 0.842 673,600
3 500,000 0.775 386, 000
4 400,000 0.708 283,200
5 300,000 0.65 195,000
PV 1,904,600
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Present Value of an Annuity

The method for finding the PV of an annuity is similar for that of a mixed stream but can
be simplified using present value interest factor of an annuity (PVIFA) tables.
The present value interest factor of an annuity with end–of-year cash flows that are
discounted at k per cent for n period are
n
 
n
1 1  1  
PVIFAK,n=  = 1    

t 1 1 kn
k
  1k  
Table A - 2 Present Value of an Annuity provides the PVIFAk,n, which can be used in
calculating the present value of an annuity (PVA) as follows:
PVA = PMT × PVIFAk n
Example
Assume that a project will give you sh. 1000 at the end of each year for 4 years .What is
the maximum amount would you be willing to pay for that project if the required rate of
return is 10%.
Solution
The PVIFA at 10% for 4 years (PVIFA10%, 4yrs) from Table A-2 is 3.1699.
Therefore, PVA = 3.1699X 1000 = Sh.3, 169.9
(Confirm the answer with the above equation).
Present Value of an Annuity Due.
From the above example, assume that the project gives you sh. 1000 at the beginning of
each year for 4 years.
PVIFAk,n(annuity due) = PVIFk,n(ordinary annuity) x ( 1 +k)
= 3.1699 × (1+0.1)
=3.48689
Therefore future value of the annuity due = 1000 x 3.48689
=Sh.3, 486.89
Present Value of Perpetuity
Perpetuity is an annuity with an infinite life – never stops producing a cash flow at the end
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of each year forever.

The PVIF for a perpetuity discounted at the rate k is
PVIFAk, α = 1/k
Example
Wetika wishes to determine the PV of a Sh.1000 perpetuity discounted at 10%.
The present value of the perpetuity is 1000 x PVIFAk, α = 1000 x 1/0.1= Sh.10, 000.
This implies that the receipt of Sh.1,000 for an indefinite period is worth only Sh .10,000
today if Wetika can earn 10% on her investments (If she had Sh.10,000 and earned 10%
interest on it each year, she could withdraw Sh.1000 annually without touching the initial
Sh.10,000).
Deposits to Accumulate a Future Sum
It may be necessary to find out the periodic deposits that should lead to the built of a needed
sum of money in future.
We can use the expression below, which is a rewriting of FVn= Po × FVIFk,n.
PMT = FVAn/FVIFAk n
Where PMT is the periodic deposit, FVAn is the future sum to be accumulated, and FVIFAk
n is the future value interest factor of an n-year annuity discounted at k%.
Example
Ben needs to accumulate Sh. 5 million at the end of 5 years to purchase a company. He can
make deposits in an account that pays 10% interest compounded annually. How much
should he deposit in his account annually to accumulate this sum?
Solution
PMT = FVAn/FVIFAk n = 5,000,000/6.105= Sh.819,000
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Example
Suppose you want to buy a house in 5 years from now and estimate that the initial down
payment of Sh. 2 million will be required at that time. You wish to make equal annual end
of year deposits in an account paying annual interest of 6%. Determine the size of the
annual deposit.
FVAN = PMT X FVIFAK, N
PMT = FVAn/ FVIFAk n
PMT = 2,000,000/5.637= Sh.354,799
Finding unknown Interest Rate
A situation may arise in which we know the future value of a present sum as well as the
number of time periods involved but do not know the compound interest rate implicit in the
situation. The following example illustrates how the interest rate can be determined.
Example
Suppose you are offered an opportunity to invest Sh.100‟000 today with an assurance of
receiving exactly Sh.300,000 in eight years. The interest rate implicit in this question can be
found by rearranging FVn= Po × FVIFk,n as follows.
FV8 = P0 (FVIF k, 8 )
300,000 = 100,000 (FVIFKk,8)
FVIFk, 8 = 300,000 / 100,000 = 3.000
Reading across the 8-period row in the FVIFs table (Table A-3) we find the factor that
comes closest to our value of 3 is 3.059 and is found in the 15% column. Because 3.059 is
slightly larger than 3 we conclude that the implicit interest rate is slightly less than 15
percent.
To be more accurate, recognize that
FVIFk,8 = (1+k)8
(1+k)8 = 3
(1+k) = 31/8 = 30.125
1+k = 1.1472
k = 0.1472 = 14.72%
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LOAN AMORTIZING SCHEDULE
Amortizing Loan
An important application of discounting and compounding concepts is in determining the
payments required for an installment – type loan. The distinguishing features of this loan is
that it is repaid in equal periodic (monthly, quarterly, semiannually or annually) payments
that include both interest and principal. Such arrangements are prevalent in mortgage loans,
auto loans, consumer loans etc.
Amortization Schedule
An amortization schedule is a table showing the timing of payment of interest and

principal necessary to pay off a loan by maturity.
Example
Determine the equal end of the year payment necessary to amortize fully a Sh.600,000,
10% loan over 4 years. Assume payment is to be rendered (i) annually, (ii) semi-annually.
Solution
(i) Annual repayments
First compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.
Using tables we find the PVIFA10%,4yrs = 3.170, and we know that PVAn = Sh.600,000
PMT = 600,000/3.170 = Sh.189, 274 per year.
Loan Amortization schedule
Payments
End of year Loan Beg. Of Interest Principal End of
payment year year
principal principal.
[10%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 189,274 600,000 60,000 129,274 470,726
2 189,274 470726 47,073 142,201 328,525
3 189,274 328525 32,853 156,421 172,104
4 189,274 172104 17,210 172,064 -
(ii) Semi-annual repayments

For semi-annual repayments the number of periods, n, is 8 and the discount rate is 5%.
Let‟s compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.
Using tables we find the PVIFA5%,8periods =6.4632, and we know that PVAn = Sh.600,000
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PMT = 600,000/6.4632 = Sh.92,833 per year.
Loan Amortization schedule

Payments
End of period Loan Beginning of Interest Principal End of period
(6months) payment year principal principal.
[5%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 92833 600,000 30,000 62,833 537,167
2 92,833 537,167 26,858 65,975 471,192
3 92,833 471,192 23,559 69,274 401918
4 92,833 401, 918 20,096 72,737 329,181
5 92,833 329,181 16,459 76,374 252,807
6 92,833 252,807 12,481 80,192 172,615
7 92,833 172,615 8,631 84,202 88,413
8 92,833 88,413 4,421 88,412 -0-
Determining Interest or Growth Rate
It is often necessary to calculate the compound annual interest or growth rate implicit in a
series of cash flows. We can use either PVIFs or FVIFs tables. Let‟s proceed by way of the
following illustration.
Example
Roy wishes to find the rate of interest or growth rate of the following series of cash flows
Cash flow
Year (Sh.)
2004 1,520,000
2003 1,440,000
2002 1,370,000
2001 1,300,000
2000 1,250,000
Solution
Using 2000 as base year, and noting that interest has been earned for 4 years, we proceed as
follows:
Divide amounts received in the earliest year by amount received in the latest year.
1,250,000/1,520,000 = 0.822. This is the PVIFk,4yrs . We read across row for 4 years for
the interest rate corresponding to factor 0.822. In the row for 4 year in table of Table A-3 of
PVIFs, the factor for 5% is .823, almost equal to 0.822. Therefore interest or growth rate is
approximately 5%.
Note that the FVIFk,4yrs (1,520,000/1,250,000) is 1.216. . In the row for 4 year in table of
Table A-1 of FVIFs, the factor for 5% is 1.2155 almost equal to 1.216.We estimate the
growth rate to be 5% as before.
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TOPIC 5
VALUATION MODELS
Introduction
In finance, valuation is the process of estimating what something is worth. Valuation often
relies on fundamental analysis (of financial statements) of the project, business, or firm,
using tools such as discounted cash flow or net present value. As such, an accurate
valuation, especially of privately owned companies, largely depends on the reliability of the
firm's historic financial information. Items that are usually valued are a financial asset or
liability. Valuations can be done on assets (for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities (e.g., bonds issued by a company).
Valuation is used to determine the price financial market participants are willing to pay or
receive to buy or sell a business. In addition to estimating the selling price of a business, the
same valuation tools are often used by business appraisers to resolve disputes related to
estate and gift taxation, divorce litigation, allocate business purchase price among business
assets, establishing a formula for estimating the value of partners' ownership interest for
buy-sell agreements, and many other business and legal purposes. Therefore, not only do
managers want to keep reliable financial statements so that they can know the value of their
own businesses, but they also want to manage finances well to enhance the value of their
businesses to potential buyers, creditors, or investors.
CONCEPT OF VALUE
MARKET VALUE
Market value or OMV (Open Market Valuation) is the price at which an asset would trade
in a competitive auction setting. Market value is often used interchangeably with open
market value, fair value or fair market value, although these terms have distinct
definitions in different standards, and may differ in some circumstances.
International Valuation Standards defines market value as "the estimated amount for which
a property should exchange on the date of valuation between a willing buyer and a willing
seller in an arm’s-length transaction after proper marketing wherein the parties had each
acted knowledgeably, prudently, and without compulsion."
Market value is a concept distinct from market price, which is “the price at which one can
transact”, while market value is “the true underlying value” according to theoretical
standards. The concept is most commonly invoked in inefficient markets or disequilibrium
situations where prevailing market prices are not reflective of true underlying market value.
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For market price to equal market value, the market must be informationally efficient and
rational expectations must prevail.
BOOK VALUE
Book value may be defined as present or depreciated financial worth of the property. It is
determined by historical costs and the accounting estimate which is based on the criterion
of acquisition costs and the cost of production.
The value of major securities that are in the business’ accounting is estimated by the
number of securities and their nominal value adjusted for any premiums or discounts and
the amount of their depreciation. When talking about shares, it also includes the amount of
retained earnings and the amount of any backups.
Asset book value
The book value of an asset is the cost of an asset at the moment of buying. That value is
decreased over time because of depreciation, depletion and amortization. These processes
are diminishing the initial value of an asset and they are considered to be company’s costs.
Supplies and consumables are not assets, but rather expenses.
The main advantage
The main advantage of this concept is the value of the objectivity its foundation has. Due to
the inactivity and historical conservatism, it is not the most suitable for determining fair or
intrinsic value.
The difference between book value and market value
While book value represents pure, theoretical worth of a company according to its financial
reports, market value is determined by the stock market. Talking about the value of a
company usually means referring to its market value.
The relationship between these two values can be represented like this:
1. Book value is higher than market value – it means that the market doesn’t believe
that the company is worth the amount that is book value.
2. Book value is lower than market value – this case happens when the market sees the
potential in the company and it’s usually the case with constantly profitable
companies.
3. These two values are equal – the market doesn’t have motives to estimate higher or
lower price of the company than stated in the books.
Their relationship is important because they pretty much depend on each other. In fact,
there is a formula determining what is called the price-to-book ratio and it looks like this:
Price to book ratio = share price / (shareholders equity/number of shares outstanding)
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When book value and market value are equal, the result of the above equation is 1.
Anything less than 1 means that the book value is higher, and any result above 1 means that
the market value is higher.
REPLACEMENT VALUE
Replacement value is the cost to replace the assets of a company or a property of the same
or equal value. The replacement cost asset of a company could be a building, stocks,
accounts receivable or liens. This cost can change depending on changes in market value.
Also referred to as the price that will have to be paid to replace an existing asset with a
similar asset.
INTRINSIC VALUE
In finance, intrinsic value refers to the value of a company, stock, currency or product
determined through fundamental analysis without reference to its market value. It is also
frequently called fundamental value. It is ordinarily calculated by summing the discounted
future income generated by the asset to obtain the present value. It is worthy to note that
this term may have different meanings for different assets.
VALUATION OF FIXED INCOME SECURITIES
Fixed income analysis is the valuation of fixed income or debt securities, and the analysis
of their interest rate risk, credit risk, and likely price behavior in hedging portfolios. The
analyst might conclude to buy, sell, hold, hedge or stay out of the particular security.
Fixed income products are generally bonds issued by various government treasuries,
companies or international organizations. Bond holders are usually entitled to coupon
payments at periodic intervals until maturity. These coupon payments are generally fixed
amounts (quoted as percentage of the bond's face value) or the coupons could float in
relation to LIBOR or another reference rate.
The cash flow of a fixed income product generally consists of several coupon payments
over the period of the bond's life, and repayment of the principal at the time of maturity.
Since these cash flows occur at several times in the future, the "Time Value of Money"
approach is used to find the "Present Value" of each cash flow. The sum of all the present
values of the bonds cash inflows of the bond is its theoretical value.
Following are the typical questions an analyst finds answers for:
 Does the real interest rate built into the yield make sense?
 Is the real interest rate in line with the expected GDP growth rate (in case of treasury
bonds) or earnings growth rate (in case of corporate bonds)?
 What is the expectation of GDP growth ? Where do we stand in the economy cycle?
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 Where do we stand in the business cycle of the particular company, or economic

cycle of the particular country?
 Is there any change expected in the basic real interest rate in the near future?
 Do the prevailing monetary and economic conditions force any monetary easing or
tightening so that the base real rate will get changed?
 Is the inflation condition worsening or improving?
 Are the financial authorities in the country pro-acting or re-acting to the forces of
inflation and economic conditions?
 Is the risk premium built into the yield enough to compensate for the risks?
 What are the likely risks the market has currently priced into the premium and what
are the new or hidden risks the market has overlooked and to what extent?
 What is the nature and volume of demand for a particular bond?
The demand for fixed income products comes from banks, insurance companies, pension
fund companies, endowment organisations, External Government Treasuries, individual
investors like retirees and widows who need regular fixed cash in-flow.
The Fixed Income Analyst covers the term structure or yield curve analysis too. This is in
simple terms, analysing all bonds issued by the same entity for different maturities. Such
analysis enables one to understand the pricing differences between maturities comparable
inter-market bonds
The approaches for analysing fixed income products are broadly as follows: Fundamental
approach; Technical Approach; relative value Approach.
Valuation of bonds
This will depend on expected cash flows consisting of annual interest plus the principal
amount to be received at maturity. The appropriate rate of capitalization 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.
Valuation of bonds with maturity period

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 P.V. 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
Int M
 (1  kd)
t 1
t

(1  kd)n
Where: Int = Annual interest

Kd = Required rate of return
M = Terminal/maturity value
n = Number of years to maturity
Page 144
Example
K is contemplating purchasing a 3 year bond worth 40,000/= carrying a nominal coupon
rate of interest of 10%. K required rate of return is 6%.
What should he be willing to pay now to purchase the bond if it matures at par?
Solution
Int = 10% ×40,000 = 4,000 p.a.
n = 3 yrs
Kd = 6%
M = 40,000
4,000 4,000 4,000 40,000
Vd =   
1 2 3
(1.06) (1.06) (1.06) (1.06) 3
= 4,000 ×PVAF6%,3 + 40,000 × PVIF6%,3
= (40,000 × 2.673) + (40,000 × 0.840) = 44,292
CERTIFICATES OF DEPOSIT (CDS)
A certificate of deposit (CD) is a debt instrument sold by a bank to depositors. It pays

annual interest of a given amount and at maturity pays back the original purchase price.
The interest rate on a large CD is set by negotiation between the issuing institution and
its customer and it generally reflects the prevailing market conditions.
Example
A six month negotiable CD for Ksh. 100,000 with an interest rate of 7.5% would receive
back at the end of 180 days:
Ksh.100, 000 × (1 + ×0.075) = Ksh. 103,750
The yield on CDs is usually slightly above that of T-bills due to greater default risk, a
thinner resale market and the tax exemptions allowed on T-bill earnings.
CDS are an important source of money for commercial banks, from corporations, mutual
funds, charitable institutions, government agencies and the general public.
VALUATION OF SHARES
The valuation of securities and shares in particular is necessary in the following aspects:
i) To facilitate take-over bids
ii) To allow for mergers.
iii) To facilitate for company accounts disclosure
iv) For purposes of acquisitions or disposal of blocks of shares.
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v) For purposes of computing capital gains tax (not applicable in Kenya at present)
vi) For tax payer’s executors in assessing the capital transfers processes
vii) For ascertaining stamp duty payable.
However, a number of parties are interested in the value of shares and securities and such
will include:
a) Company shareholders, directors and vendors of the company.
b) The existing and prospective shareholders.
c) Buyers of a company.
d) Transferee and transferor parties, in particular from the point of view of income tax.
e) Income tax department.
In this valuation, it is necessary to look at a company form:

i) Quoted company (quoted shares)
ii) Unquoted company (unquoted shares)
The valuation of shares will also be influenced by ownership of the company. If a

company is owned by majority shareholders, its valuation will be different from if it was
owned by minority shareholders. In addition, it is necessary to value shares because of:
a) It is a requirement of the Company’s Act 1948 in respect of quoted investments which

should state the investment book value, market value and stock exchange value where
this differs from market value. In this case, the Act 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.
(i) In 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. Also the company should give specifications of the
earnings and dividends attributed to these shares. These are necessary to enable
interested parties to make their own valuations.
(ii) In 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 judged to be
significant for owning the company, namely, if individual investments exceed 10%
of the issued shares of a given class or where the book value of the investment
exceeds 10% of the company’s assets.
b) Capital 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. Valuation
date is important for valuation of companies’ properties.
The main difficulties in valuation of shares are:
i) Existence and method of valuation of goodwill.
ii) Succession of company’s management
iii) Growth in dividend
iv) Growth in equity.
Page 146
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. For this reason the bases
of valuing shares are:
i) Earnings method
ii) Dividend method
iii) Assets method
i) Earnings Method (Or Earning Basis Valuation)

Using the earning valuation method, a company will use its P/E ratio to value its shares.
P/E = MV
E
MV = E x P/E -> value of ordinary share.
The MV can be determined where the estimated earnings have been established by
applying the P/E ratio expected of this type of company.
Example
Company XYZ is expected to generate post tax earnings of Sh.200,000 per annum and
companies in the same trade will generally have a P/E ratio of eight (8). On account of
company XYZ limited size, a ratio of six (6) is considered more appropriate. The issued
share capital is 1,000,000ordinary shares of Sh.50 each.
Required;-
,
Value of shares = EPS × P/E = ×6 = sh.12
, ,
Value of Business = Earnings x P/E ratio

MV = E x P/E = Sh.200, 000× 6 = Sh.1.2 million
ii) Dividend Basis Valuation

Ownership of shares in entities – The 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. A shareholder cannot expect cash flows in perpetuity as he will sell his shares
at one time.
P o = Do
Ke
d0 (1  g)
Note: Where there is growth in equity, P0 = K  g
e
Example
Page 147
Company XYZ pays a dividend of 10% on its Sh.60 par value ordinary shares. This
company uses a discount rate of 15%. Assuming no growth, compute the value of its
ordinary share if there’s growth of 5%, what would be the value of this company’s
ordinary shares.
a) Po = Do Po = 6 = Sh.40 (no growth)

Ke 15%
b) Po = 6(1.05) = Shs.63 (5% growth rate)

0.15-0.05
iii) Asset Based Valuation

This 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. The
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. In such a case, a buyer would be
prepared to pay a price which though excessive in terms of income might be justified by
the underlying assets value.
Example
Information extracted from the books of Kent Limited.
Sh. Sh.
Current liabilities 300,000 Land 250,000
Bank overdraft 50,000 Stock in trade 100,000
350,000 350,000
Stock has a realisable value of Sh.80,000 and land Sh.300,000. This company is assumed
to have a share capital of 20,000 ordinary shares.
Compute the value of its shares.

Assets method
Assets = L & B 300,000
Stock 80,000
380,000
Liabilities [350,000]
30,000
Value of shares = 30,000= Sh.1.50

20,000
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Example
K & K Company Limited is planning to absorb three other companies so as to realise its
sales records of Sh.500,000 per annum. Its accountants have advised the company to
maintain such a size that it will enable its shares to sell at a minimum price of Sh.16. The
company’s last published balance sheets indicate the following:
Sh.‘000’
Ordinary shares of Sh.10 each 50,000
Reserves 65,000
Current liabilities 40,000
Total 155,000
Assets:
Fixed assets 80,000
Current assets 75,000
Total 155,000
Profits for the last 5 years were as follows:

Sh. ‘000’
1. 9,000
2. 6,000
3.10,000
4. 8,000
5.17,000
P/E ratio applicable is 12:1
Compute 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.
P/E RATIO METHOD
P/E = 12:1 Average profits = 10,000,000
Therefore Value of business = 10,000,000 ×12 = Sh.120,000,000
Value of shares = Sh.120 million = Sh.24

5 million shares
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ASSETS METHOD
Sh. ‘000’
Assets 155,000
Less: Current liabilities [ 40,000]
115,00
Value of shares =Sh.115M = Sh.23

5M shares
Where: Po = Price of ordinary shares

d = Dividend at the end of year one
P1 = Price of the share at the end of one year.
VALUATION OF COMPANIES
A business may be valued for different reasons such as for merger, takeover, acquisition, or
outright sale or liquidation. In purchasing a business, a buyer will be interested in not only
the assets but also the future income this business is expected to generate.
BASES OF VALUATION
1. Theoretical value – In 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:
a) Consider the estimated probable cash flows.
b) Discount cash flows to their present value.
c) Add together the separate amounts to give the present value of income stream.
Where future income flows are constant:
1  (1  r ) n 
PV  C 
 r 
Where: PV = Present value of income stream
c = Inflow per annum
r = Discounting rate
n = Number of years the inflows will last
Example
As a result of the purchase of an asset, the income stream will increase by £1,000 per
annum for 25 years. Assuming a discount rate of 20%, compute the maximum price to be
paid for this asset ignoring taxation.
Solution
Maximum price = Present value of all future cash inflows
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Maximum price = £10,000 × PVAF20%,25
25
= £10,000 × 1  (1.2) = 10,000 x 4.9476
0.20
= £49,476
In practice the income streams are never uniform and have to be estimated from existing
income shown in the recent accounts.
2. Earning method – The business is valued according to the total stream of income it
is expected to generate over its lifetime.
Determination of maintainable earnings

a) The 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. Therefore, a
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.
b) Analysis of sales and gross profit percentage by:
i) Product lines
ii) Departments
iii) Geographical areas
iv) Customer type.
c) Costs as a percentage of total sales.
d) Unusual fluctuations in the ratios.
e) Necessity of expenditure in the business e.g. excessive remuneration on expenses
charged.
f) Inclusion of all costs.
g) Effects of external conditions such as inflation or recession.
However, there are several ways of arriving at the value based on the earnings valuation.
i) Earnings yield valuation
ii) Price earnings ratio valuation
iii) Super profits valuation
i) Earnings Yield Valuation

EY is given by the earnings made by the business expressed as a percentage of the market
price of the business i.e.
EY = Earnings x 100
Market price of equity
EY = EPS x 100 = Earnings to Shareholders
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MPS Market value of equity
Therefore Market Value = Earning to shareholders

Earnings yield
Example
Estimated maintainable earnings are £240,000 per annum, rate of return required is 25%.
Compute the value of the business.
Value MV) = E x 100
EY
= 240,000 x 100
0.25
M.V. = £960,000
This method can be converted into the theoretical base, especially if the business is going
concern.
C 1 
PV  1  
i  1  0.25N 
Note
As N approaches ∞
Pv = C
r
= 240,000 = £960,000
0.25
ii) Price Earnings Ratio Valuation

P/E ratio is traditionally used for valuation of shares but it is an important ratio in the
valuation of business. The P/E ratio is the measure of how may years earning would
‘purchase’ the market value of the business and is given by:
P/E ratio = MV
E
MV = P/E x E
NB: The value of the business can be calculated by taking estimated earnings x P/E ratio.
Page 152
VALUATION OF UNIT TRUSTS
A unit trust (also known as a collective investment scheme) is a pool of money managed
collectively by a fund manager. Investment in a unit trust is by buying units in a trust.
Money pooled with that of other investors and invested in a portfolio of assets to achieve
the investment objective of the unit trust.
When a unit trust is first launched for sale, the price of each unit is usually fixed. If you
invest in an existing unit trust, the price of each unit will be based on the market value of
the underlying assets that the unit trust has invested in. The number of units received
depends on the amount of investment less the sales charge paid.
A unit trust calculates its NAV by adding up the current value of all the stocks, bonds, and
other securities (including cash) in its portfolio, subtracting out certain expenses of running
the fund (e.g. the manager's salary, custodial fees, and other operating expenses) and then
dividing that figure by the fund's total number of units. For example, a fund with 500,000
units that owns Ksh.9 million in stocks and Ksh.1 million in cash has an NAV of 20i.e (10
000 000/500 000 = 20)
VALUATION OF MUTUAL FUNDS
A mutual fund is an investment vehicle that is made up of a pool of funds collected from
many investors for the purpose of investing in securities such as stocks, bonds, money
market instruments and similar assets. Mutual funds are operated by money managers, who
invest the fund's capital and attempt to produce capital gains and income for the fund's
investors. A mutual fund's portfolio is structured and maintained to match the investment
objectives stated in its prospectus.
Net asset value (NAV) represents a fund's per share market value. This is the price at which
investors buy fund shares from a fund company and sell them to a fund company. It is
derived by dividing the total value of all the cash and securities in a fund's portfolio, less
any liabilities, by the number of shares outstanding. An NAV computation is undertaken
once at the end of each trading day based on the closing market prices of the portfolio's
securities.
For example, if a fund has assets of Sh.70 million and liabilities of Sh.30 million, it would
have a NAV of Sh.40 million.
This number is important to investors, because it is from NAV that the price per unit of a
fund is calculated. By dividing the NAV of a fund by the number of outstanding units, you
are left with the price per unit.
This pricing system for the trading of shares in a mutual fund differs significantly from that
of common stock issued by a company listed on a stock exchange. In this instance, a
company issues a finite number of shares through an initial public offering (IPO), and
possibly subsequent additional offerings, which then trade in the secondary market. In this
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market, stock prices are set by market forces of supply and demand. The pricing system for
stocks is based solely on market sentiment.
Because mutual funds distribute virtually all their income and realized capital gains to fund
shareholders, a mutual fund's NAV is relatively unimportant in gauging a fund's
performance, which is best judged by its total return.
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TOPIC 6
COST OF CAPITAL
Definition
This is the price the company pays to obtain and retain finance. To obtain finance a
company will pay implicit costs which are commonly known as floatation costs. These
include: Underwriting commission, Brokerage costs, cost of printing a prospectus,
Commission costs, legal fees, audit costs, cost of printing share certificates, advertising
costs etc. For debt there is legal fees, valuation costs (i.e. security, audit fees, Bankers
commission etc.) such costs are knocked off from:
i. The market value of shares if these has only been sold at a price above par value.
ii. For debt finance – from the par value of debt.
That is, if flotation costs are given per share then this will be knocked off or deducted from
the market price per share. If they are given for the total finance paid they are deducted
from the total amount paid.
FIRMS CAPITAL STRUCTURE AND FACTORS INFLUENCING CAPITAL

STRUCTURE DECISIONS
The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Debt comes in the form of bond issues or long-term notes
payable, while equity is classified as common stock, preferred stock or retained earnings.
Short-term debt such as working capital requirements is also considered to be part of the
capital structure.
The primary factors that influence a company's capital-structure decision are:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the
business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A utility
company generally has more stability in earnings. The company has les risk in its business
given its stable revenue stream. However, a retail apparel company has the potential for a
bit more variability in its earnings. Since the sales of a retail apparel company are driven
primarily by trends in the fashion industry, the business risk of a retail apparel company is
much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that
investors feel comfortable with the company's ability to meet its responsibilities with the
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capital structure in both good times and bad.
2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a
means of financing a project is attractive because the tax deductibility of the debt payments
protects some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no
surprise that companies typically have no problem raising capital when sales are growing
and earnings are strong. However, given a company's strong cash flow in the good times,
raising capital is not as hard. Companies should make an effort to be prudent when raising
capital in the good times, not stretching its capabilities too far. The lower a company's debt
level, the more financial flexibility a company has.
The airline industry is a good example. In good times, the industry generates significant
amounts of sales and thus cash flow. However, in bad times, that situation is reversed and
the industry is in a position where it needs to borrow funds. If an airline becomes too debt
ridden, it may have a decreased ability to raise debt capital during these bad times because
investors may doubt the airline's ability to service its existing debt when it has new debt
loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a
management's approach is, the less inclined it is to use debt to increase profits. An
aggressive management may try to grow the firm quickly, using significant amounts of debt
to ramp up the growth of the company's earnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt,
borrowing money to grow faster. The conflict that arises with this method is that the
revenues of growth firms are typically unstable and unproven. As such, a high debt load is
usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its revenues are
stable and proven. These firms also generate cash flow, which can be used to finance
projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition.
Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning
investors are limiting companies' access to capital because of market concerns, the interest
rate to borrow may be higher than a company would want to pay. In that situation, it may be
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prudent for a company to wait until market conditions return to a more normal state before
the company tries to access funds for the plant.
FACTORS INFLUENCING COST OF CAPITAL
1. Terms of reference – if short term, the cost is usually low and vice versa.
2. Economic conditions prevailing – If 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.
3. Risk exposed to venture – 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.
4. Size of the business – A 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.
5. Availability – Cost of finance (COF) 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.
6. Effects of taxation – Debt 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.
7. Nature of security – If security given depreciates fast, then this will compound
implicit costs (costs of maintaining that security).
8. Company’s growth stage – Young companies usually pay less dividends in which
case the cost of this finance will be relatively cheaper at the earlier stages of the
company’s development.
RELEVANCE OF COST OF CAPITAL
Cost of capital is considered as a standard of comparison for making different business

decisions. Such importance of cost of capital has been presented below.
1. Making Investment Decision

Cost of capital is used as discount factor in determining the net present value. Similarly, the
actual rate of return of a project is compared with the cost of capital of the firm. Thus, the
cost of capital has a significant role in making investment decisions.
2. Designing Capital structure

The proportion of debt and equity is called capital structure. The proportion which can
minimize the cost of capital and maximize the value of the firm is called optimal capital
structure. Cost of capital helps to design the capital structure considering the cost of each
sources of financing, investor's expectation, effect of tax and potentiality of growth.
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3. Evaluating the Performance

Cost of capital is the benchmark of evaluating the performance of different departments.
The department is considered the best which can provide the highest positive net present
value to the firm. The activities of different departments are expanded or dropped out on the
basis of their performance.
4. Formulating Dividend Policy

Out of the total profit of the firm, a certain portion is paid to shareholders as dividend.
However, the firm can retain all the profit in the business if it has the opportunity of
investing in such projects which can provide higher rate of return in comparison of cost of
capital. On the other hand, all the profit can be distributed as dividend if the firm has no
opportunity investing the profit. Therefore, cost of capital plays a key role formulating the
dividend policy.
COMPONENTS COSTS OF CAPITAL
The individual cost of each source of financing is called component of cost of capital. The
component of cost of capital is also known as the specific cost of capital which includes the
individual cost of debt, preference shares, ordinary shares and retained earning. Such
components of cost of capital have been presented below:
A. Cost of Debt
 Cost of perpetual or irredeemable debt
 Cost of non-perpetual or redeemable debt
 Cost of debt issued on redeemable condition
 Cost of callable debt
B. Cost of Preference Share
 Cost of perpetual preference Share

 Cost of redeemable preference Share
C. Cost of ordinary/equity shares or common stock
D. Cost of retained earning
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METHODS/MODELS OF COMPUTING COST OF CAPITAL
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
This 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. This is determined on the basis of
percentage cost of each capital component.
Market value weight or proportion of each capital component

E P D
K e    K p    K d 1  T  
W.A.C.C = V V V
Where:
Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital
respectively
E, P and D = Market value of equity, preference share capital and debt capital respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.
Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.
Sh. M
Ordinary share capital Sh.10 par value 400
10% preference share capital Sh.20 par 100
value 200
12% debenture Sh.100 par value 900
Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par
value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the
market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to
grow at 5% p.a. in future. The current MPS is Sh.40.
Required;-
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
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c) What are the weaknesses associated with WACC when used as the discounting rate,
in project appraisal.
a) i) Compute the cost of each capital component

Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth
rate dividend model to determine the cost of equity.
d0 = Sh.5 P0 = Sh.40 g = 5%
d0 1  g  51  0.05
Ke  g   0.05  0.18125  18.13%
P0 40
Cost of perpetual preference share capital (Kp) – preference shares are still selling at par
thus MPS = par value. If this is the case, Kp = coupon rate = 10%.
MPS = Par value = Sh.20
Dp = 10% × Sh.20 = Sh.2
DPS dp Sh.2
Kp     10%
MPS Pp Sh.20
Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a
redeemable fixed return security thus the cost of debt is equal to yield to maturity.
Redemption yield:
Interest charges p.a. = 12% x Sh.100 par = Sh.12
value = 10 years
Maturity period (n) = Sh.100
Maturity value (m) = Sh.90
Current market value (Vd) = 30%
Corporate tax rate (T)
1
Int1  T   M  Vd 
K d  YTM  RY  n
M  Vd ½
1
Sh.12(1  0.3)  (100  90)
10  9.9%  10%
= (100  90)½
ii) Compute the market value of each capital component

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Market value of Equity (E) = MPS x No. of ordinary shares

Sh.400 MDSC
= Sh.40 x = 1,600
Sh.10parvalue
Market value of preference share capital (P)

= Par value, since MPS = Par value per share = 100
Market value of debt (D) = Vd x No. of debentures
Sh.200 Mdebentures
=
Sh.90 x
Sh.100parvalue = 180
E + P + D = V = total Market Value = 1,880
iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%

a) Using weighted average cost method,, WACC =
E P D
= K e    K p    K d 1  T  
V V V
 1,600   100   180 

= 18.13%   10%   10% 
 1,880   1,880   1,880 
= 15.43 + 0.5319 + 0.9574

= 0.169193
≈ 16.92%
b) By using percentage method,

WACC = Total monetary cost
Total market value (V)
Where: Monetary cost = % cost x market value of capital

Monetary cost of E = 18.13% x 1,600 = 290.08
Monetary cost of P = 10% x 100 = 10.00
Monetary cost of D = 10% x 180 = 18.00
318.08
Total market value (V) 1,880
318.08
Therefore WACC = x100 = 16.92%
1,880
In computation of the weights or proportions of various capital components, the following
values may be used:
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 Market values
 Book values
 Replacement values
 Intrinsic values
Market Value – This involves determining the weights or proportions using the current
market values of the various capital components. The problems with the use of market
values are:
The market value of each security keep on changing on daily basis thus market values can
be computed only at one point in time.
The market value of each security may be incorrect due to cases of over or under valuation
in the market.
Book values – This involves the use of the par value of capital as shown in the balance
sheet. The main problem with book values is that they are historical/past values indicating
the value of a security when it was originally sold in the market for the first time.
Replacement values – This involves determining the weights or proportions on the basis
of amount that can be paid to replace the existing assets. The problem with replacement
values is that assets can never be replaced at ago and replacement values may not be
objectively determined.
Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic
value of a given security. Intrinsic values may not be accurate since they are computed
using historical/past information and are usually estimates.
e) Weaknesses of WACC as a discounting rate
WACC/Overall cost of capital has the following problems as a discounting rate:

 It can only be used as a discounting rate assuming that the risk of the project is equal to
the business risk of the firm. If the project has higher risk then a percentage premium
will be added to WACC to determine the appropriate discounting rate.
 It assumes that capital structure is optimal which is not achievable in real world.
 It is based on market values of capital which keep on changing thus WACC will change
over time but is assumed to remain constant throughout the economic life of the
project.
 It is based on past information especially when determining the cost of each component
e.g in determining the cost of equity (Ke) the past year’s DPS is used while the growth
rate is estimated from the past stream of dividends.
Note
When using market values to determine the weight/proportion in WACC, the cost of
retained earnings is left out since it is already included or reflected in the MPS and thus the
market value of equity. Retained earnings are an internal source of finance thus; when they
are high there is low gearing, lower financial risk and thus highest MPS.
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MARGINAL COST OF CAPITAL (MCC)
This is cost of new finances or additional cost a company has to pay to raise and use
additional finance is given by:
Total cost of marginal finance×100

Cost of finance (COF)
Cost of finance may be computed using the following information:

i) Marginal cost of each capital component.
ii) The weights based on the amount to raise from each source.
a) Investors usually compute their return basing their figures on market values or cost of
investment.
b) Investors 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.
c) Investments appreciate in the stock market and as such the cost must be adjusted to
reflect such a movement in the value of an investment.
1. Marginal cost of equity

D1
MCE = P  f x100 (for zero growth firm)
o
Also cost of equity

D1
Ke = P  f (for normal growth firm)
o
Where: d1 = expected DPS = d0(1+g)

P0 = current MPS
f = floation costs
g = growth rate in equity
2. Cost of preference share capital:

Dp
Kp = P  f x100
o
Where: Kp = Cost of preference
Dp = Dividend per share
Po = MPS (Market price per share)
F = Flotation costs
3. Cost of debenture
Int(1  T )
Kd 
Vd  f
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Where: Kd = Cost of debt

Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate
4. Just like WACC, weighted marginal cost of capital can be computed using:
i) Weighted average cost method
ii) Percentage method
Illustration
XYZ Ltd wants to raise new capital to finance a new project. The firm will issue 200,000
ordinary shares (Sh.10 par value) at Sh.16 with Sh.1 floatation costs per share, 75,000 12%
preference shares (Sh.20 par value) at Sh.18 with sh.150,000 total floatation costs, 50,000
18% debentures (sh.100 par) at Sh.80 and raised a Sh.5,000,000 18% loan paying total
floatation costs of Sh.200,000. Assume 30% corporate tax rate. The company paid 28%
ordinary dividends which is expected to grow at 4% p.a.
Required;-
a)Determine the total capital to raise net of floatation costs
b)Compute the marginal cost of capital
Solution
a)
Sh. ‘000’
Ordinary shares 200,000 shares @ Sh.16 3,200,000
Less floatation costs 200,000 shares @ Sh.1 (200,000) 3,000
Preference shares 75,000 shares @ Sh.18 1,350,000
Less floatation cost (150,000) 1,200
Debentures 50,000 debentures @ Sh.80 4,000,000
Floatation costs -____ 4,000
Loan 5,000,000
Less floatation costs (200,000) 4,800
Total capital raised 13,000
b) Marginal cost of equity Ke

d (1  g)
Ke 0 g
P0  f
d0 = 28% × Sh.10 par = Sh.2.80
g = 4%
f = Sh.1.00
P0 = Sh.16
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2.80(1.04)
Therefore marginal = Ke   0.04 = 0.234 = 23.4%
16  1
Marginal cost of preference share capital Kp
Kp = dp
P0-f
dp = 12%×Sh.20 par =Sh.2.40
P0 = Sh.18
f = Floatation cost per share = Sh.150,000 = Sh.2.00

75,000 shares
Kp = 2.40 = 0.15 = 15%
18 – 2
Marginal cost of debenture Kd:

Kd = Int (1-t)
Vd-f
f = 0
Vd = Sh.80
Int = 18% x Sh.100 par = Sh.18
T = 30%
Kd = 18(1-0.3) = 0.1575= 15.75%
80
Marginal cost of loan Kd
Kd = Int (1-t)
Vd-f
T = 30%
Vd = Sh.5 million
f = Sh.0.2 million
Int = 18% × Sh.5M = Sh.0.9M
Kd = 0.9 (1-0.3) = 0.13125 =13.13%

5 – 0.2
Source Amount to % Maturity cost
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raise before marginal Sh. ‘000’

fixed costs cost
Sh. ‘000’
Ordinary 3,200 23.4% 748.8
shares 1,350 15.0% 202.5
Preference 4,000 15.75% 630
shares 5,000 13.13% 656.5
Debenture 13,550 2237.8
Loan
Weighted marginal cost = 2,237.8×100 = 16.52%

13,550
BREAK POINT
Break point is the total amount of new investments that can be financed and the new capital
that can be raised before a jump in marginal cost of capital is expected. It is the point at
which the marginal cost of capital curve breaks out from its flat trend.
The break point can be worked out by dividing the retained earnings for the period by the
weight of the retained earnings in the target capital structure. The retained earnings in a
period equals the product of net income for the period and the retention rate (also called
plow-back rate), which equals 1 minus the dividend payout ratio.
The following equation can be used to calculate the break point:
(1 − )
=
Where NI is the net income for the period, DPR is the dividend payout ratio, i.e. the
dividends declared dividend by net income and We is the weight of retained earnings in the
target capital structure.
The break points are helpful in creating the marginal cost of capital curve, a graph that plots
capital raised on the X-axis and marginal weighted average cost of capital on the Y-axis.
Your company's marginal cost of capital was 10% at the start of 2017. Its net income for the
year was $30 million, 30% of which was paid out in dividends. Retained earnings form
45% of the target capital structure of the company.
The company's break point equals retained earnings for the period divided by proportion of
retained earnings in target capital structure.
Retained earnings for the period equals $21,000,000 (i.e. $30,000,000 × (1 – 30%)).
21,000,000
= = 46.67
0.45
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OPERATING AND FINANCIAL LEVERAGE - DEGREE OF OPERATING

LEVERAGE AND OPERATING RISK; DEGREE OF FINANCIAL LEVERAGE
AND FINANCIAL RISK
Leverage is that portion of the fixed costs which represents a risk to the firm.
Operating leverage, a measure of operating risk, refers to the fixed operating costs found in
the firm’s income statement.
Financial leverage, a measure of financial risk, refers to financing a portion of the firm’s
assets, bearing fixed financing charges in hopes of increasing the return to the common
stockholders. The higher the financial leverage, the higher the financial risk, and the higher
the cost of capital. Cost of capital rises because it costs more to raise funds for a risky
business.
Formula
The degree of financial leverage ratio is the percentage change in earnings per share (EPS) over the
percentage change in earnings before interest and taxes (EBIT).
% Change in EPS
DFL =
% Change in EBIT
The percentage change in EPS is the change in EPS (∆EPS) over EPS.
∆EPS
% Change in EPS =
EPS
In turn, the change in EPS can be calculated as follows:
(∆EBIT - ∆I) × (1 - T) ∆EBIT × (1 - T)

∆EPS = =
N N
Here ∆EBIT is a change in EBIT, ∆I is a change in the interest payment, and T is a tax rate.
Because the interest payment is fixed, change in the interest payment is equal to zero (∆I=0).
The EPS is calculated as follows:
(EBIT - I) × (1 - T)
EPS =
N
Here I represents the interest payment, and N is a number of preferred stocks outstanding.
Thus, the percentage change in EPS can be defined as follows:
∆EBIT × (1 - T)
% Change in EPS = = × =
N ∆EBIT × (1 - T) N ∆EBIT
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(EBIT - I) × (1 - T) N (EBIT - I) × (1 - T) EBIT - I

N
The percentage change in EBIT is the change in EBIT over the EBIT.
∆EBIT
% Change in EBIT =
EBIT
So, the degree of financial leverage can be calculated using the following formula.
∆EBIT
EBIT - I ∆EBIT EBIT EBIT
DFL = = × =
∆EBIT EBIT - I ∆EBIT EBIT - I
EBIT
Degree of financial leverage and preferred stock
If a company has preferred stocks outstanding, the formula above must be modified, taking into
account preferred dividends. In this case, earnings per share are found as follows:
(EBIT - I) × (1 - T) – D
EPS =
N
Here D is preferred dividends, and N is a number of preferred stocks outstanding. So the change in
earnings per share is
(∆EBIT - ∆I) × (1 - T) - ∆D ∆EBIT × (1 - T)

∆EPS = =
N N
where ∆D is the change in preferred dividends. As interest (I) and preferred dividends (D) are
constant, hence ∆I=0 and ∆D=0.
The percentage change in EPS can be determined as follows:
∆EBIT × (1 - T) ∆EBIT × (1 -
N T) N ∆EBIT × (1 - T)
% Change in
(EBIT - I) × (1 - = N × (EBIT - I) × (1 - = (EBIT - I) × (1 -
EPS =
T) – D T) - D T) - D
N
Thus, the degree of financial leverage ratio adjusted to preferred dividends is
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∆EBIT × (1 - T)
(EBIT - I) × (1 - T) - D ∆EBIT × (1 - T) EBIT EBIT × (1 - T)
DFL = = × =
∆EBIT (EBIT - I) × (1 - T) - D ∆EBIT (EBIT - I) × (1 - T) - D
EBIT
or
EBIT
DFL =
D
EBIT - I -
1-T
Example
Two companies have the same EBIT of $3,000,000 but different capital structure. Company Y is
mostly focused on equity financing using both common and preferred equity. Its preferred dividend
payment is $150,000, and the interest payment is $250,000. By contrast, Company Z tends to use
debt financing and has only common equity. Its interest payment is $1,250,000. The tax rate for
both companies is 30%.
The degree of financial leverage of Company Y is 1.18 and 1.71 for Company Z.
EBIT $3,000,000
DFL of Company Y = = = 1.18
D $150,000
EBIT - I - $3,000,000 - $250,000 -
1-T 1 - 0.30
EBIT $3,000,000
DFL of Company Z = = = 1.71
EBIT - I $3,000,000 - $1,250,000
Thus, Company Z is more sensitive to fluctuations in EBIT than Company Y. For example, if EBIT
of both companies rises by 5%, the EPS of Company Y will increase by 5.9% (5 × 1.18), and the
EPS of Company Z will increase by 8.55% (5 × 1.71). In contrast, the drop in EBIT by 10% will
lead to a decrease in the EPS of Company Y by 11.8% and by 17.1% for Company Z.
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COMBINED LEVERAGE
Combined leverage, as the name implies shows the total effect of the operating and
financial leverages. In other words, combined leverage shows the total risks associated with
the firm. It is the product of both the leverages.
Degree of Combined Leverage (DOL) = DOL * DFL
Degree of Combined Leverage, DCL
The degree of combined leverage (DCL) is a ratio that summarizes the effect of both operating and
financial leverage. This ratio shows the percentage change in earnings per share (EPS) caused by a
1% change in sales. The higher its value, the more vulnerable a company is for a decrease in sales.
Low vs. high combined leverage
The combined leverage summarizes the effect of fixed operating costs and fixed financial costs on
a company’s earnings per share (EPS). That ratio is a measure of the total risk of a business
because it includes both operating risk and financial risk.
A high value DCL ratio means that a large proportion of a company’s total costs are fixed, and
incremental sales will result in a higher incremental EPS. Other things being equal such companies
have to generate more sales to cover their total fixed costs.
A smaller proportion of fixed operating and financial costs will result in a lower value DCL ratio,
which means lower incremental EPS on incremental sales and lower sensitivity to the slippage in
sales.
Formulas and Calculation
In general terms, the degree of combined leverage can be calculated as the percentage change in
sales over the percentage change in EPS.
% Change in EPS
DCL =
% Change in Sales
It can be alternatively defined as the combined effect of degree of operating leverage (DOL) and
degree of financial leverage (DFL).
DCL = DOL × DFL
In terms of DOL and DFL formulas, the formula above can be modified in the following way:
Contribution Margin EBIT Contribution Margin S - TVC

DCL = × = =
EBIT EBIT - I EBIT - I S - TVC - FC - I
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Here EBIT represents earnings before interest and taxes, S is sales, TVC is total variable costs, FC
is fixed cost, and I represents the interest payment.
The formula above must be modified if there are preferred stocks outstanding.
S - TVC Contribution Margin

DCL = =
D D
S - TVC - FC - I - EBIT - I -
1-T 1-T
Here D is preferred dividends, and T is the tax rate.
Example
Let’s assume that two companies have the following financial results:
Company Y:
 Sales: $1,000,000
 Total variable operating costs: $400,000
 Fixed operating costs: $200,000
 Interest: $50,000
Company Z:
 Contribution margin: $400,000
 Earnings before interest and taxes: $300,000
 Interest: $75,000
 Preferred dividends: $35,000
 Tax rate is 30%.
The degree of combined leverage of Company Y is 1.71 and 2.29 for Company Z.
S - TVC $1,000,000 - $400,000

DFL of Company Y = = = 1.71
S - TVC - FC - I $1,000,000 - $400,000 - $200,000 - $50,000
Contribution Margin $400,000

DFL of Company Z = = = 2.29
D $35,000
EBIT - I - $300,000 - $75,000 -
1-T 1 - 0.30
If both companies face a 5% decrease in sales, Company Y loses 8.55% (5 × 1.71) of EPS and
Company Z loses 11.45% (5 × 2.29).
Other Models used to establish cost of capital

The following models are used to establish the various costs of capital or required rate of
return by the investors:
 Risk adjusted discounting rate
 Market model/investors expected yield
 Capital asset pricing model (CAPM)
 Dividend yield/Gordon’s model.
i) Risk adjusted discounting rate – This technique is used to establish the discounting
rate to be used for a given project. The cost of capital of the firm will be used as the
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discounting rate for a given project if project risk is equal to business risk of the firm.
If a project 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 project = cost of capital + percentage risk premium.
Therefore a high risk project will be evaluated at a higher discounting rate.
ii) Market Model – This model is used to establish the percentage cost of ordinary share
capital cost of equity (Ke). If an investor is holding ordinary shares, he can receive
returns in 2 forms:
 Dividends
 Capital gains
Capital gain is assumed to constitute the difference between the buying price of a share at
the beginning of the (P0), the selling price of the same share at the end of the period (P1).
Therefore total returns = DPS + Capital gains = DPS + P1 – P0.
The amount invested to derive the returns is equal to the buying price at the beginning of
the period (P0) therefore percentage return/yield =
Total returns×100 = DPS + P1 – P0 x 100

Investment P0
Illustration
For the past 5 years, the MPS and DPS for XYZ Ltd were as follows:
1998 1999 2000 2001 2002

Shs. Shs. Shs. Shs. Shs.
MPS as at 31st Dec 40 45 53 50 52
DPS for the year - 3 4 3 -
Required
Determine the estimated cost of equity/shareholders percentage yield for each of the years
involved.
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Solution
Year MPS Capital DPS % Return

gain
1998 40 - - -
1999 45 5 3 53 8
x100  x100  20%
40 40
2000 53 8 4 84 12
 x 100  27 %
45 45
2001 50 -3 3 3  3 0
 x100  0 %
53 53
20 2
 x 100  4 %
2002 52 2 - 50 50
iii) Capital asset pricing model (CAPM) – CAPM is a technique that is used to establish
the required rate of return of an investment given a particular level of risk. According
to CAPM, the total business risk of the firm can be divided into 2:
Systematic Risk – This is the risk that affects all the firms in the market. This risk
cannot be market/eliminated/diversified. It 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. Examples of systematic risk are
political instability, inflation, power crisis in the economy, power rationing, natural
calamities – floods and earthquakes, increase in corporate tax rates and personal tax
rates, etc. Systematic risk is measured by a Beta factor.
Unsystematic risk – This risk affects only one firm in the market but not other firms.
It is therefore unique/ diversifiable to the firm thus unsystematic trend in profitability of
the firm relative to the profitability trend of other firms in the market. The risk is
caused by factors unique to the firm such as:
 Labour strikes by employees of the firm;
 Exit of a prominent corporate personality;
 Collapse of marketing and advertising programs of the firm on launching of a new
product;
 Failure to make a research and development breakthrough by the firm, etc
CAPM is only concerned with systematic risk. According to the model, the required
rate of return will be highly influenced by the Beta factor of each investment. This is
in addition to the excess returns an investor derives by undertaking additional risk e.g
cost of equity should be equal to Rf + (Rm – Rf)BE
Cost of debt = Rf + (Rm – Rf)Bd
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Where: Rf = rate of return/interest rate on riskless investment e.g T. bills

Rm = Average rate of return for the entire stock as shown by average
Percentage return of the firms that constitute the stock index.
Be = Beta factor of investment in ordinary shares/equity.
Bd = Beta factor for investment in debentures/long term debt capital.
Illustration
KK Ltd is an all equity firm whose Beta factor is 1.2, the interest rate on T. bills is
currently at 8.5% and the market rate of return is 14.5%. Determine the cost of
equity Ke, for the company.
Solution
Rf = 8.5% Rm = 14.5% Beta of equity = 1.2
Ke = Rf + (Rm – Rf)BE
= 8.5% + (14.5% - 8.5%) 1.2
= 8.5% + (6%)1.2
= 15.7%
iv) Dividend yield/Gordon’s Model – This model is used to determine the cost of
various capital components in particular:
a) Cost of equity - Ke
b) Cost of preference share capital (perpetual) – Kp
c) Cost of perpetual debentures – Kd
a) Cost of equity (Ke)– This can be determined with respect to:

d0
Zero growth firm – P0 = d0 Therefore = P
0
R = Ke
Where: d0 = DPS
R0 = Current MPS
d 0 1  g 
Constant growth firm – P0 = K g
e
d0 1  g 
Therefore K e  P0
g
b) Cost of perpetual preference share capital (Kp)

Recall, value of a preference share (FRS) = Constant DPS
Kp
Therefore: dp = Preference dividend per share
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Pp = Market price of a preference share
c) Cost of perpetual debenture (Kd) – Debentures pay interest charges, which

an allowable expenses for tax purposes.
Recall, Value of a debenture (Vd) = Interest charges p.a. in ∞

Cost of debt Kd
Int.
Therefore Kd = V 1  T 
d
Where: Kd = % cost of debt

T = Corporate tax rate
Vd = Market value of a debenture
Cost of Redeemable Debentures and Preference Shares

Redeemable fixed return securities have a definite maturity period. The cost of such
securities is called yield to maturity (YTM) or redemption yield (RY). For a redeemable
debenture Kd (cost of debt) = YTM = RY, can be determined using approximation method
as follows:
1
Int1  T   M  Vd 
K d / VTM / RY  n
1
M  Vd  2
Where: Int. = Interest charges p.a.
T = Corporate tax rate
M = Par or maturity value of a debenture
Vd = Current market value of a debenture
n = Number of years to maturity
CAPITAL STRUCTURE AND FINANCIAL RISK
A company's financial risk, takes into account a company's leverage. If a company has a
high amount of leverage, the financial risk to stockholders is high - meaning if a company
cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied
monetarily is high.
When a firm goes from solely equity financing to a mixture of debt and equity financing,
the firm's return on equity (ROE) becomes more volatile. Hence, a firm's financial risk
represents the impact of a firm's financing decision (or capital structure) on its ROE.
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Why does the usage of debt instruments make a firm riskier to common stockholders?
When a firm issues debt (i.e. financial leverage), it takes on additional responsibility of
financing the debt (i.e. paying interest payments on time). The inability of the firm to pay
the interest payments (or repay the principal) will result in a default that might lead to
bankruptcy. As the amount of debt used by the firm increases, the chances of it defaulting
will also go up (due to more constraints on its cash flows as a result of the interest
payments).
It is important to remember that the common stockholders have the last claim on the firm's
asset. As the amount of debt issued by the firm increases, more of the assets will be used to
pay off the debt holders before they are divided among the common stockholders. We know
that financial leverage increases the shareholders' expected returns, but it also increases the
volatility of those returns. Does the increase in the expected returns sufficiently compensate
the shareholders for the increase in risk? We need to turn to capital structure theory to help
shed some light on this question.
REVISION QUESTIONS
QUESTION 1
(a) Explain fully the effect of the use of debt capital on the weighted average cost of capital
of a company.
(b) Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to
finance a project in the following manner:
Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares
The present capital structure of the company is made up as follows:

1. 600,000 fully paid ordinary shares of Sh.10 each
2. Retained earnings of Sh.4 million
3. 200,000, 10% preference shares of Sh.20 each.
4. 40,000 6% long term debentures of Sh.150 each.
The current market value of the company’s ordinary shares is Sh.60 per share. The
expected ordinary share dividend in a year’s time is Sh.2.40 per share. The average
growth rate in both dividends and earnings has been 10% over the past ten years and this
growth rate is expected to be maintained in the foreseeable future.
The company’s long term debentures currently change hands for Sh.100 each. The
debentures will mature in 100 years. The preference shares were issued four years ago and
still change hands at face value.
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Required:
(i) Compute the component cost of:
- Ordinary share capital;
- Debt capital
- Preference share capital.
(ii) Compute the company’s current weighted average cost of capital.
(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10
million as envisaged. (Assume a tax rate of 30%).
Solution:
QUESTION 1
(a) At initial stages of debt capital the WACC will be declining upto a point where the
WACC will be minimal. This is because.
(i) Debt capital provides tax shield to the firm and after tax cost of debt is low.
(ii) The cost of debt is naturally low because it is contractually fixed and certain.
Beyond the optimal gearing level, WACC will start increasing as cost of debt
increases due to high financial risk.
(b) (i) Cost of equity
do(1  g)
Ke = +g
Po
do(1+g) = Sh2.40
Po = Sh60
g = 10%
2.40
Ke = + 0.10 = 0.14 = 14%
60
Cost of debt capital (Kd)
Since the debenture has 100years maturity period then Kd = yield to maturity
= redemption.
1
Int(1- T) (m - vd)
n
Kd = 1
(m  vd)
2
m = Maturity/per value = sh 150

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vd = market value = Sh. 100

n = number of years to maturity =100
Int = Interest = 6% × Sh. 150 = Sh.9 p.a
T = Tax rate = 30%
1
9(1 - 0.3)  (150 - 100)
Kd = 100  6.8 x 100 = 5.441%
(150  100) 1 125
2
Cost of preference share capital Kp
Kp = Coupon rate = 10% since MPS = par value
(ii) WACC or overall cost of capital Ko
M.V of equity = 600,000 shares x sh 60 MPS 36

M.V of debt = 40,000 debentures x Sh 100 4
4
M.V of preference shares = 200,000 shares x Sh 20
44
Ke = 14% Kd = 5.44% Kp = 10%
36 4 4
Ko = WACC = 14% + 5.44% +10% = 12.86%
44 44 44
The Sh 10M will be raised as follows:
Sh 6M from debt
Sh 4M from shares
Since there are no floatation costs involved then:
Marginal cost of debt = 5.4%

Marginal cost of ordinary share capital = 14%
4 6
Therefore marginal cost of capital = 14% ± 5.55% = 8.86%
10 10
QUESTION 2
On 1 November 2002, Malaba Limited was in the process of raising funds to undertake
four investment projects. These projects required a total of Sh.20 million.
Given below are details in respect of the projects:
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Project Required Initial Internal Rate of

Investment Return (IRR)
Shs. million
A 7 24%
B 6 16%
C 5 18%
D 2 20%
You are provided with the following additional information:

1. The company had Sh.5.4 million available from retained earnings as at 1 November
2002. Any extra equity finance will have to be sourced through an issue of new
ordinary shares.
2. The current market price per share on 1 November 2002 was Sh.22.40, ex-dividend
information on Earnings Per Share (EPS) and Dividends Per Share (DPS) over the
last 6 years is as follows:
Year ended 31 1997 1998 1999 2000 2001 2002
October
EPS (Sh.) 4.20 4.40 4.65 4.90 5.15 5.26
DPS (Sh.) 2.52 2.65 2.80 2.95 3.10 3.22
3. Issue of new ordinary share would attract floatation costs of Sh.3.60 per share.
4. 9% Irredeemable debentures (par value Sh.1,000) could be sold with net proceeds of
90% due to a discount on issue of 8% and floatation costs of Sh.20 per debenture.
The maximum amount available from the 9% debentures would be Sh.4 million after
which debt could be obtained at 13% interest with net proceeds of 91% of par value.
5. 12% preference shares can be issued at par value Sh.80.
6. The company’s capital structure as at 1 November 2002 which is considered optimum
is:
Ordinary share capital (equity) 45%

Preference share capital 30%
Debentures 25%
7. Tax rate applicable is 30%.

8. The company has to use internally generated funds before raising extra funds from
external sources.
Required:
(i) The levels of total new financing at which breaks occur in the Weighted Marginal
Cost of Capital (WMCC) curve.
(ii) The weighted marginal cost of capital for each of the 3 ranges of levels of total
financing as determined in (i) above.
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(iii) Advise Malaba Limited on the projects to undertake assuming that the projects are
not divisible.
Solution:
(i)
Levels determined by retained earnings available
5.4m = 12 million
0.45
Level determined by debt available
4m = 16million
0.25
(ii) Weighted marginal cost of capital for each of the ranges of financing:
From 0 Sh. 12 million
Cost of equity = 3.2215 -1 0.05 or 5%

2.52
Ke = Do (1.0g) + g (Retained earnings)

Po
= 3.22 (1.05) + 0.05
22.4
= 0.20 or 20%
Cost of preference shares
Kp 12 x 100%
80
15%
Cost of debt
Kd = I(1 –T) x 100%

Pd
= 90 × 0.7 × 100%
900
= 7%
WMCC = (0.45 × 20%) + 0.3(15%) + 0.25(7%)

For the range 12m 16m
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Only cost of equity changes since extended equity is to be raised.
Thus.
Ke = 3.22(1.05) + 0.05
22.4 – 3.6
=23%
Thus WMCC = (0.45 x 23%) + (0.3 x15%) + (0.25 x 7%)

= 16.6%
For the range 16m 20m

Cost of equity (Ke)
Cost of preference shares (Kp)
Cost of debt 430(0.7) x 100%
910
10%
Thus WMCC = (0.45 x 23%) + (0.3 x15%) + (0.25 x 10%)

= 17.35%
(iii) Graphical illustration of WMCC/investment projects’ IRR and level of

financing.
25
24
23
22 A
WMCC
D
21
C
20
19
2 4 6 8 10 12 14 16 18 20
QUESTION 3
(a) Explain why the weighted average cost of capital of a firm that uses relatively more
debt capital is generally lower than that of a firm that uses relatively less debt capital.
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(b) The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2003
was Sh.100,000,000. The company wishes to raise additional funds to finance a project
within the next one year in the following manner.
Sh.30, 000,000 from debt
Sh.20,000,000 from selling new ordinary shares.
The following items make up the equity of the company:

Sh.
3,000,000 fully paid up ordinary shares 30,000,000
Accumulated retained earnings 20,000,000
1,000,000 10% preference shares 20,000,000
200,000 6% long term debentures 30,000,000
The current market value of the company’s ordinary shares is Sh.30. The expected
dividend on ordinary shares by 30 April 2004 is forecast at Sh.1.20 per share. The average
growth rate in both earnings and dividends has been 10% over the last 10 years and this
growth rate is expected to be maintained in the foreseeable future.
The debentures of the company have a face value of Sh.150. However, they currently sell
for Sh.100. The debentures will mature in 100 years.
The preference shares were issued four years ago and still sell at their face value.
Assume a tax rate of 30%
Required:
(i) The expected rate of return on ordinary shares.
(ii) The effective cost to the company of:
 Debt capital
 Preference share capital
(iii) The company’s existing weighted average cost of capital.
(iv) The company’s marginal cost of capital if it raised the additional Sh.50,000,000 as
intended.
Solution:
(a) At initial stages of debt capital the WACC will be declining up to a point
where the WACC will be minimal. This is because.
(i) Debt capital provides tax shield to the firm and after tax cost of
debt is low.
(ii) The cost of debt is naturally low because it is contractually fixed
and certain.
Beyond the optimal gearing level, WACC will start increasing as cost
of debt increases due to high financial risk.
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(b) (i). Expected rate return on ordinary shares is equal to cost of equity,
ke
Ke – do(i +g) + g
Po
do(1+g) = Expected D.P.S = Sh.1.20

po = current M.P.S. = Sh 30
g = growth rate = 10%
ke - 1.20 + 0.10 – 0.14 = 14%

30
(ii). Effective of cost of
- Debt kd
- Debentures have a definite maturity period hence
Kd = Int (I – T) + (m – vd) 1/n
(m + vd)/2
= (6% x 150)( 1 – 0.3) + (150 – 100)1/100
(150 + 100) ½
= 6.3 +0.5 = 6.8 x 100 = 5.44%

125 125
vd = current make value and m = par/maturity value
- cost of preference share capital kp preference shares are selling at
par hence market price = par value and kp = coupon rate = 10%
(iii). M.V. of equity = Sh. 30 x 3m shares = 90 m

M.V of debt – Sh. 100 x 0.2m debentures = 20m
M.V. of preferred shares – par value = 20m
Total Market Value 130m
Wall = 14% (90/130) + 5.44% (20/130) + 10% (20/130) =

9.69+0.84+1.54
= 12.02%
(iv). No floatation costs one given hence marginal cost of debt and equities is
5.44% &14% respectively
- The amount to raise is 50m where 60% (30m/50m) will from debt
and 40% from issue of shares.
- Therefore WACC = (5.44% x 0.6) + (0.4 x 14%) = 8.864%
Page 183
QUESTION 4
(a) Explain the meaning of the term “cost of capital” and explain why a company should
calculate its cost of capital with care.
(b) Identify and briefly explain three conditions which have to be satisfied before the use
of the weighted average cost of capital (WACC) can be justified.
(c) Biashara Ltd. has the following capital structure:
Sh.’000’
Long-term debt 3,600
Ordinary share capital 6,500
Retained earnings 4,000
The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45 million.
He has proposed the following method of raising the funds:
 Utilise all the existing retained earnings
 Issue ordinary shares at the current market price.
 Issue 100,000 10% preference shares at the current market price of Sh.100 per
share which is the same as the par value.
 Issue 10% debentures at the current market price of Sh.1,000 per debenture.
Additional information;-
1. Currently, Biashara Ltd. pays a dividend of Sh.5 per share which is expected to grow at
the rate of 6% due to increased returns from the intended project. Biashara Ltd.’s
price/earnings (P/E) ratio and earnings per share (EPS) are 5 and Sh.8 respectively.
2. The ordinary shares would be issued at a floatation cost of 10% based in the market
price.
3. The debenture par value is Sh.1, 000 per debenture.
4. The corporate tax rate is 30%.
Required:
Biashara Ltd.’s weighted average cost of capital (WACC).
Solution:
(a) Cost of capital

 This is the rate used to discount the future cash flows of a business, to determine
the value of the firm. The cost of capital can be viewed as the minimum return
required by investors and should be used when evaluating investment proposals.
 In order to maximize the wealth of shareholders, the basic decision rule is that if
cash flows relating to an investment proposal are negative, the proposal should
be rejected. However, if the discounted cash flows are positive, the proposal
should be accepted. The discounting is carried out using the firm’s cost of
capital.
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Why cost capital should be calculated with care:

 Failure to calculate the cost of capital correctly can in incorrect investment
decisions being made.
 Where the cost of capital is understated, investment proposals which should be
rejected may be accepted.
 Similarly, where the cost of capital is overstated, investment proposals may be
rejected which should be accepted. In both cases, the shareholders would suffer a
loss.
Note There is an inverse relationship between N.P.V. and cost of capital. The higher
the cost of capital, the lower the N.P.V. and vice versa.
(b) Required conditions for using the WACC

 The WACC assumes the project is a marginal, scalar addition to the
company’s existing activities, with no overspill or synergistic impact likely to
disturb the current valuation relationships.
 It assumes that project financing involves no deviation from the current
capital structure (otherwise the MCC should be used.). The financing mix is
similar to existing capital structure.
 Using the WACC implies that any new project has the same systematic or
operating risk as the company’s existing operations. This is possibly a
reasonable assumptions for minor projects in existing areas and perhaps
replacements but hardly so for major new product developments.
(c) Current Capital Structure
Debt 3.6 25.5%

Equity 10.5 74.5%
14.1
Capital to be
raised
25.5
Debt /100 x 45 = 11.475
74.5
Equity /100 x 45 =
33.525
/45m
Ordinary share capital amount to be raised = 33.525 -4m =

29.525m
Number of ordinary shares = 29.525m Sh.40m = 738,125
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shares
Specific cost of retained earnings
EPS = 8 P/E = 5
Market price = 8 x 5 = 40
Ke = 5(1.06)1/40 + 0.06 = 19.25%
Preference shares
10
/100 x 100 = 10%
Debenture 10/100× 1000 =100
100
/1000 x 100 = 10%
effective cost = 10% (1 – 0.3) = 7%
Source Amoun Proportio Specific Weighted cost

t n cost
Retained earnings 4 8.9% 19.25% 1.7%
Ordinary share capital 29.525 65.6% 20.72% 13.6%
10% preference shares 10 22.2% 10% 2.22%
10% debentures 1.475 3.3% 6% 0.2%
45m 100 17.72%
WACC = 17.72%
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TOPIC 7
CAPITAL BUDGETING DECISION
Introduction
Capital budgeting decision is also known as the investment decision. The capital budgeting
process involves a firms decision to invest its funds in the most viable and beneficial
project. It is the process of evaluating and selecting long term investments consistent with
the firm’s goal of owner wealth maximization.
The firm expects to produce benefits to the firm over a long period of time and
encompasses tangible and intangible assets. For a manufacturing firm, capital investment
are mainly to acquire fixed assets-property, plant and equipment. Note that typically, we
separate the investment decision from the financing decision: first make the investment
decision then the finance manager chooses the best financing method.
These key motives for making capital expenditures are;
1. Expansion: The most common motive for capital expenditure is to expand the cause
of operations – usually through acquisition of fixed assets. Growing firms need to
acquire new fixed assets rapidly.
2. Replacements – As a firm’s growth slows down and it reaches maturity, most capital
expenditure will be made to replace obsolete or worn out assets. Outlays of repairing
an old machine should be compared with net benefit of replacement.
3. Renewal – An alternative to replacement may involve rebuilding, overhauling or
refitting an existing fixed asset.. A physical facility could be renewed by rewiring
and adding air conditioning.
4. Other purposes – Some expenditure may involve long-term commitments of funds
in expectations of future return i.e. advertising, R&D, management consulting and
development of view products. Other expenditures include installation of pollution
control and safety devises mandated by the government.
Features of investment decisions
1. The investment requires a high outlay of capital which must be planned.

2. Capital budgeting decisions have an influence on the rate and direction of the growth
of the organization unlike normal operation costs.
3. The investment has long-term implications. I.e. more than 1 year.
4. The decisions are irreversible. This implies that there might be no second hand market
for the assets since it’s usually tailor made for that particular firm.
5. The future expected cash flows from this project are uncertain thus these decisions
involve a high degree of risk.
Page 187
Steps in Capital Budgeting Process
The capital budgeting process consists of five distinct but interrelated steps. It begins with
proposal generation, followed by review and analysis, decision making, implementation and
follow-up. These six steps are briefly outlined below.
1. Proposal generation: Proposals for capital expenditure are made at all levels within
a business organization. Many items in the capital budget originate as proposals
from the plant and division management. Project recommendations may also come
from top management, especially if a corporate strategic move is involved (for
example, a major expansion or entry into a new market). A capital budgeting system
where proposals originate with top management is referred to a top-down system,
and one where proposals originate at the plant or division level is referred to as
bottom-up system. In practice many firms use a mixture of the two systems, though
in modern times has seen a shift to decentralization and a greater use of the bottoms-
up approach. Many firm offer cash rewards for proposal that are ultimately adopted.
2. Review and analysis: Capital expenditure proposals are formally reviewed for two
reasons. First, to assess their appropriateness in light of firm’s overall objectives,
strategies and plans and secondly, to evaluate their economic viability. Review of a
proposed project may involve lengthy discussions between senior management and
those members of staff at the division and plant level who will be involved in the
project if it is adopted. Benefits and costs are estimated and converted into a series
of cash flows and various capital budgeting techniques applied to assess economic
viability. The risks associated with the projects are also evaluated.
3. Decision making: Generally the board of directors reserves the right to make final
decisions on the capital expenditures requiring outlays beyond a certain amount.
Plant manager may be given the power to make decisions necessary to keep the
production line moving (when the firm is constrained with time it cannot wait for
decision of the board).
4. Implementation: Once approval has been received and funding availed
implementation commences. For minor outlays the expenditure is made and payment
is rendered: For major expenditures, payment may be phased, with each phase
requiring approval of senior company officer.
5. Follow-up: involves monitoring results during the operation phase of the asset.
Variances between actual performance and expectation are analyzed to help in future
investment decision. Information on the performance of the firm’s past investments
is helpful in several respects. It pinpoints sectors of the firm’s activities that may
warrant further financial commitment; or it may call for retreat if a particular project
becomes unprofitable. The outcome of an investment also reflects on the
performance of those members of the management involved with it. Finally, past
errors and successes provide clues on the strengths and weaknesses of the capital
budgeting process itself.
This topic will majorly discuss on the second step: Review and analysis.
Page 188
Basic terminologies in capital budgeting.
Independent Vs Mutually Exclusive Projects

Independent projects are those whose cash flows are unrelated or independent of one
another; the acceptance of one does not eliminate the others from further considerations (if
a firm has unlimited funds to invest, all independent project that meet it minimum
acceptance criteria will be implemented i.e. installing a new computer system, purchasing a
new computer system, and acquiring a new limousine for the CEO.
Mutually exclusive projects are projects that compete with one another, no that the
acceptance of one eliminates the acceptance of one eliminate the others from further
consideration. For example, a firm in need of increased production capacity could either, (1)
Expand it plant (2) Acquire another company, or (3) contract with another company for
production of required items.
Unlimited Funds Vs Capital Rationing

Unlimited funds- This is the financial situation in which a firm is able to accept all
independent projects that provide an acceptable return (Capital budgeting decisions are
simply a decision of whether or not the project clears the hurdle rate).
Capital rationing This is the financial situation in which the firm has only a fixed number of
shillings to allocate among competing capital expenditures. A further decision as to which
of the projects that meet the minimum requirements is to be invested in has to be taken.
Conventional Versus Non-Conventional Cash flows

Conventional cash flow pattern consists of an initial outflow followed by only a series of
inflows. ( For example a firm spends Sh.10 million and expects to receive equal annual cash
inflows of Sh.2 million in each year for the next 8 years) The cash inflows could be unequal
Non-conventional cash flows This is a cash flow pattern in which an initial outflow is not
followed only by a series of inflows, but with at least one cash outflow. For example the
purchase of a machine may require Sh.20 million and may generate cash flows of
Sh.5million for 4 years after which in the 5th year an overhaul costing Sh.8million may be
required. The machine would then generate Sh.5 million for the following 5 years.
Relevant Versus Incremental Cash flows
To evaluate capital expenditure alternatives, the firm must determine the relevant cash
flows which are the incremental after-tax initial cash flow and the resulting subsequent
inflows associated with a proposed capital expenditure. Incremental cash flows represent
the additional cash flows (inflowing and outflows) expected to result from a proposed
capital expenditure.
Sunk Costs Vs Opportunity Cost

Sunk costs are cash outlays that have already been made (past outlays) and therefore have
no effect on the cash flows relevant to a current decision. Therefore sunk costs should not
be included in a project’s incremented cash flows.
Opportunity costs are cash flows that could be realized from the best alternative use of an
owned asset. They represent cash flows that can therefore not be realized, by employing
that asset in the proposed project. Therefore, any opportunity cost should be included as a
cash outflow when determining a project’s incremental cash outflows.
Page 189
CAPITAL INVESTMENTS CASH FLOWS

Capital projects cash flows are classified into three categories, namely:
1. Total initial cost (IO)
2. Total terminal cash flow (TCn)
3. Annual Net Operating Cash flow (N.C.F)
TOTAL INITIAL COST (IO)
This is also known as the total initial cash outlay or the sum of the present of cash flow. The
total initial cost is determined by summing up the following.
i) The cost of the asset
ii) Other incidental costs relating to acquisition of the asset e.g. installation cost,
transportation and modification costs, payment of freight charges import duty,
additional investment in working capital etc.
Initial costs (IO)

Sh Sh.
Purchase cost xx
Add incidental costs (Note 1)
Installation cost xx
Transportation/freight xx
Import duty xx xx
xxx
Additional investment cost
Working capital (Note 2) xx
Total initial cost xxx
Incidental Costs – Note 1

These costs should be included in cost which is subjected to computation of annual
provision for depreciation of the asset. This means that the cost will be amortised on the
instalment basis over entire economic life of the asset. Therefore the cost will be recovered
through provision for depreciation.
Additional investment in working capital – Note 2

Undertaking a capital project can cause a change on working capital e.g. increase in stock
levels, increase in debtor’s balances, increase in creditor’s balances and the same things
apply to accrued and prepaid expenses. Where this is the case determine the net increase in
working capital and make the following two treatments.
i) At the beginning asset’s economic life, the net increase in working capital is treated
as an initial cost. If additional investment in working capital made in future, then
determine its present value.
Page 190
ii) At the end of asset’s economic life, it is assumed that additional investment in
working capital will be recovered, therefore treated as a terminal cash inflow.
TOTAL TERMINAL CASH FLOW (TCn)
Terminal cash flows are cash inflows which will be realised at the end of asset’s economic
life. This include;-
i) Salvage value of the asset
This is resale value of the asset at the end of its economic life which at times is known
as scrap value, disposal value and residue value.
ii) Working capital recovered
Total Terminal Cash flows (TCn)

Sh.
Salvage value xx
Working capital recovered xx
TCn xx
ANNUAL NET OPERATING CASH FLOWS (N.C.F)
This refers to annual cash flows which will be generated from the firm’s operations. An
accurate prediction of the net operating cash flow requires an accurate prediction of the
following:
i) Sale revenue or the total revenue per annum

i.e. TR = Unit Selling Price x Quantity Sold
TR = (P ×Q) = (PQ)
ii) An accurate computation of total variable cost i.e. costs which vary with output
e.g. direct material costs, direct labour costs, direct expenses, etc.
Total Variable Cost (TVC) = Cost Per Unit x Quantity Manufactured
iii) Annual Fixed Operating Cost
Page 191
The net operating cash flow per year is worked out as follows:
Annual Sales (PQ) xxx

Less: Annual variable costs xxx
Annual contribution xxx
Less: Annual fixed operating
Costs excluding depreciation xxx
Earnings before depreciation and tax (EBDT) xxx
Provision for depreciation (Note 3)
Less: Earnings before tax xxx
Corporation tax xxx
Less: Earnings after tax/Accounting profit xxx
Depreciation (provision) xxx
Add back: Net operating cash flow xxx
xxx
Provision for Depreciation (Note 3)

Provision for depreciation can be done using straight line basis or reducing balance bases.
(How to provide)
Provision for depreciation is a source of finance to a company in two ways;-
 To set aside fund which will be used in asset replacement upon exhausting their useful
life.
 Depreciation tax shield benefit i.e. D.T.S. benefit when making capital budgeting
decision, we make a fundamental assumption that provision for depreciation is
equivalent to wear and tear i.e. is a capital allowance and therefore will attract the tax
benefit (tax saving) known as depreciation tax shield benefit. D.T.S is therefore a
reduction in the tax liability (tax saving).
Therefore if provision for depreciation is not accounted for, tax liability will be greater
and the company may require a tax refund of the excess tax paid. This refund will be a
cash-in-flow.
Therefore Tax Shied (D.T.S) Benefit = Annual provision for depreciation x Tax rate
D.T.S. = D×T
From the above two cases it can be seen that there are two approaches that can be used to
compute annual Net Operating Cash flow of capital investment. These are:
Method 1
Net cash flows = (Earnings before depreciation and tax - depreciation) (1 –tax) +
depreciation
Page 192
N.C.F = [EBDT – D] [I – T] + D
Method 2
Net cash flows = Earnings before depreciation and tax (1 –tax) + depreciation tax shield
N.C.F = EBDT (1 – T) + D.T.S
Illustration
The management of a company is considering buying a machine at a cost of Sh. 2 million.
The machine is expected to have an economic life of 5 years at the end of which the salvage
value is estimated to be Sh. 500,000. It is estimated that the machine will produce the
following quantity at the end of each year for 5 years.
Year Quantity (Units)

1 10,000
2 15,000
3 18,000
4 20,000
5 15,000
Additional information;-
1. The unit selling price and unit variable costs are estimated at Sh. 50 and Sh. 15
respectively.
2. The annual fixed operating cost excluding depreciation are estimated at Sh. 100,000.
3. Investment in this asset is expected to cause increase in sale. To support this increase in
sale, the company will require additional working capital. Stock will increase by Sh.
100,000, debtors to reduce by Sh. 20,000 and creditors will increase by Sh. 30,000. The
increase in working capital will be required at the start of asset’s economic life.
4. Installation cost of the machine is estimated at Sh. 100,000. Freight charges and import
duty are estimated at Sh. 100,000 and Sh. 200,000 respectively.
5. The firm provides depreciation on straight line basis.
6. Cost of capital is 12%.
7. Coporation tax rate is 30%
Required
Determine the values of the relevant cashflows which are associated with the capital
project.
Deprecation = = = 380
D=
Page 193
Solution
i) The total initial cost

Sh. 000 Sh. 000
Cost of machine 2000
Add: Incidental costs
Installation costs 100
Freight charges 100
Import duty 200 400
2400
Investment in working capital
Increase in stock 100
Decrease in debtors (20)
Increase in creditors (30)
Increase in Net working capital 50
2450
ii) Total Terminal Cash flows (TCn)

Sh.000
Salvage value 500
Working capital recovered 50
TCn 550
iii) Annual Net Operating Cash Flow (N.C.F)
a) N.C.F = (EBDT – D) (1 – T) + D
Page 194
Net cash flows = (Earnings before depreciation and tax - depreciation) (1 –tax) +
depreciation
Year
1 2 3 4 5
Sh.000 Sh.000 Sh.000 Sh.000 Sh.000
Sales = P x Q 500 750 900 1000 750

Variable cost = C x Q (150) (225) (270) (300) (225)
Contribution 350 525 630 700 525
Less Fixed operating Cost (100) (100) (100) (100) (100)
excluding dep. ____ ____ ____ ____ ____
E.B.D.T 250 425 530 600 425
Less provision for Depreciation (380) (380) (380) (380) (380)
E.B.T (130) 45 150 220 45
Less tax (30 %) 39 (13.5) (45) (66) (13.5)
Earnings after tax (91) 31.5 105 154 31.5
Add back prov. For dep. 380 380 380 380 380
N.C. F 289 411.50 485 534 411.50
(b) N.C.F = EBDT (1 – T) + D.T.S
Net cash flows = Earnings before depreciation and tax (1 –tax) + depreciation tax shield
D.T.S = D×T
= 380,000 × = 114,000 Per annum for 5
years
Year Sh. Sh. ‘000’

‘000’
1 250 [1 – 30%] + 114 289
2 425 [0.7] + 114 411.5
3 530 [0.7] + 114 485
4 600 [0.] + 114 534
5 425 [0.7] + 114 411.5
Page 195
INCREMENTAL APPROACH FOR CASH FLOWS ESTIMATION
Incremental cash flow is the additional operating cash flow that an organization receives
from taking on a new project. A positive incremental cash flow means that the company's
cash flow will increase with the acceptance of the project.
There are several components that must be identified when looking at incremental cash
flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and
the scale and timing of the project. A positive incremental cash flow is a good indication
that an organization should spend some time and money investing in the project.
When determining incremental cash flows from a new project, several problems arise: sunk
costs, opportunity costs, externalities and cannibalization.
1. Sunk Costs;-these are the initial outlays required to analyze a project that cannot be
recovered even if a project is accepted. As such, these costs will not affect the future
cash flows of the project and should not be considered when making capital-
budgeting decisions.
2. Opportunity Cost;-This is the cost of not going forward with a project or the cash
outflows that will not be earned as a result of utilizing an asset for another
alternative.
3. Externality;-In the consideration of incremental cash flows of a new project, there
may be effects on the existing operations of the company to consider, known as
"externalities."
4. Cannibalization;-Cannibalization is the type of externality where the new project
takes sales away from the existing product.
CAPITAL BUDGETING TECHNIQUES.

There are different methods of analyzing the viability of an investment. The preferred
technique should consider time value procedures, risk and return considerations and
valuation concepts to select capital expenditures that are consistent with the firm’s goals of
maximizing owner’s wealth.
Capital budgeting techniques are grouped in two:
a) Non-discounted cash flow techniques (traditional methods)

i. Accounting rate of return method(ARR)
ii. Pay back period method(PBP)
b) Discounted cash flow techniques (modern methods)

i. Net present value method(NPV)
ii. Internal rate of return method(IRR)
iii. Profitability index method(PI)
Page 196
NON-DISCOUNTED CASH FLOW TECHNIQUES
PAY BACK PERIOD METHOD (PBP)
Payback period refers to the number of periods/ years that a project will take to recoup its
initial cash outlay.
This technique applies cash flows and not accounting profits.
Computation of payback period:
1. Under uniform annual incremental cash inflows – if the venture or an asset

generates uniform cash inflows then the payback period (PBP) will be given by:
Initial cost of the venture

PBP =
Annual incremental cost
E.g. If a venture costs 37,910/= and promises returns of 10,000/= per annum
indefinitely then the PBP =
37,910
10,000
= 3.79 years
The shorter the PBP the more viable the investment and thus the better the choice of
such investments
2. Under non-uniform cash inflows:

Under non-uniformity PBP computation will be in cumulative form and this means that
the net cash inflows are accumulated each year until initial investment is recovered.
Example
Assume a project costs Sh.80,000 and will generate the following cash inflows:
Cash inflows Accumulated inflows
Inflows year 1 = 10,000 10,000
Inflows year 2 = 30,000 40,000
Inflows year 3 = 15,000 55,000
Inflows year 4 = 20,000 75,000
Inflows year 5 = 30,000 105,000
The Sh.80,000 cost is recovered between year 4 and 5. During year 5 (after year 4)
Sh.5,000 is (80,000 – 75,000) is required out the total year 5 cash flows of 30,000.
5,000
Therefore the PBP = 4yrs  30,000 = 4.17 years
Illustration
Cedes limited has the following details of two of the future production plans. Only one of
these machines will be purchased and the venture would be taken to be virtually exclusive.
Page 197
The Standard model costs £50,000 and the Deluxe cost £88,000 payable immediately.
Both machines will require the input of the following:
i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe
ii) A £10,000 working capital through their working lives.
Both machines have no expected scrap value at end of their expected working lives of 4
years for the Standard machine and six years for the Deluxe. The operating pre-tax net
cash flows associated with the two machines are:
Year 1 2 3 4 5 6
Standard 28,500 25,860 24,210 23,410 - -
Deluxe 36,030 30,110 28,380 25,940 38,500 35,100
The 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 14% per annum, 2% higher than the rate of the
standard machine. The company is proposing the purchase of either machine with a term
loan at a fixed rate of interest of 11% per annum, taxation at 30% is payable on operating
cash-flows one year in arrears and capital allowance are available at 25% per annum on a
reducing balance basis.
Required;-
For both the Standard and the Deluxe machines, calculate the payback period.
Solution
Establish the cash flows as follows:
Pre-tax inflows (EBDT) XX

Less depreciation = capital allowance (XX)
Earnings before tax XX
Less tax (XX)
Earnings after tax XX
Add back capital allowance/depreciation XX
Operating cash flows XX
Note
Capital allowance/depreciation is a non-cash item thus when deducted for tax purposes, it
should be added back to eliminate the non-cash flow effects.
Page 198
Cash flows for standard machine:

Year 1 2 3 4 5
Pretax inflow 28,500 25,850 24,210 23,410 -

Less allowance (depreciation) 17,500 13,125 9,844 7,383 -
Taxable cash inflows 11,000 12,735 14,366 16,027
Tax @ 30% 1yr in arrears -___ 3.300 (3,831) (4,310) (4,808)
11,000 9,435 10,545 11,717 (4,808)
Add back capital allowance 17,500 13,125 9,844 7,383 -

Operating cash flows 28,500 22,560 20,389 19,100 (4,808)
Add working capital realised - - - 10,000 -
Total cash flows 28,500 22,560 20,389 29,100 (4,808)
Cash flows for Deluxe machine
Year 1 2 3 4 5 6 7
Pretax inflows 36,030 30,110 28,380 25,940 38,560 35,100 -
Less (depre) 32,000 24,000 18,000 13,500 10,125 7,594 -
4,030 6,110 10,380 12,440 28,435 27,506 -
Tax@ 30% in
arrears - (1,209) (1,833) (3,114) (3,732) (8,531) (8,252)
Inflows after tax 4,030 4,901 8,547 9,326 24,703 18,975 (8,252)
Add back capital
Allowance 32,000 24,000 18,000 13,500 10,125 7,594 -
28,901 26,547 22,826 34,828 26,569 (8,252)
Add back
w/capital
- - - - - 10,000 -
Total cash flows 36,030 28,599 26,547 22,826 34,828 36,569 (8,252)
Standard Deluxe
Cost 50,000 + 20,000 70,000 88,000 + 40,000 128,000
Page 199
Cash Accumulated Cash Accumulated

Year flows flows
1 28,500 28,500 36,030 36,030
2 22,560 51,060 28,901 64,931
3 20,389 71,449 26,547 91,478
4 29,100 100,549 22,826 114,304
5 (4,808) 95,741 34,828 149,132
6 - - 36,569 185,701
7 - - ( 8,252) 179,449
* Pay back period for standard: Initial capital of Sh.7,000 is recovered during year 3. After
year 2, we require 70,000 – 51,060 = 18,940 to recover initial capital out of year 3 cash
flows of Sh.20,389
2+ = 2.92 years
* Applying the same concept for Deluxe, payback period would be:
128,000  114,304
4 = 4.39 years
34,828
Illustration 2:
AQMW systems, a medium sized software engineering company that is currently

contemplating two projects: project A requires an initial investment of Sh.42million and
project B requires an initial investment of Sh.45million. The projected relevant cash flows
for the two projects are shown below.
PROJECT A PROJECT B
Initial Investment (yr 0) Sh.42 million Sh.45 million
Operating cash flows
Year 1 Sh.14 million Sh.28 million
Year3 Sh.14 million Sh.10 million
Average Sh.14 million Sh.14 million
For project A, (Annuity cashflows)
Payback period = = 3.0 years
Page 200
For project B (a mixed cashflows), the initial investment of Sh.45million will be recovered
between the 2nd and 3rd year-ends.
Year Cash flow (Sh) Cumulative cash flow (Sh.)

1 28million 28million
5
2  2.5years
Pay back period = 10
Only 50% of year 3 cash inflows of Sh.10million are needed to complete the payback
period of the initial investment ofSh.45million. Therefore payback period of project B is 2.5
years.
Decision Criteria
If AQMW systems maximum acceptable Payback period was 2.75 years, Project A would
be rejected and project B would be accepted. If projects were being ranked, Project B
would be preferred.
Where the projects are independent the project with the lowest PBP should rank as the first
as the initial outlay is recouped within a shorter time period.
For mutually exclusive projects the project with the lowest PBP should be accepted.
Advantages of PBP
1. It’s simple to understand and use.

2. It’s ideal under high risk investment as it identifies which project will payback as
soon as possible
3. PBP is cost effective as it does not require use of computers and a lot of analysis
4. PBP emphasizes on liquidity hence funds which are released as early as possible can
be reinvested elsewhere
Weaknesses of PBP
1. It does not consider all the cashflows in the entire life of the project.
2. It does not measure the profitability of a project but rather the time it will take to
payback the initial outlay
3. PBP does not take into account the time value of money
4. It does not have clear decision criteria as a firm may face difficulty in determining
the minimum acceptable payback period
5. It is inconsistent with the shareholders wealth maximization objective. Share values
do not depend on the payback period but on the total cashflows.
Page 201
ACCOUNTING RATE OF RETURN METHOD (ARR)
This is the only method that does not use cashflows but instead uses accounting profits as
shown in the financial statements of a company. It is also known as return on investment
(ROI).
The ARR is given by:
Average annual pro it after tax

= 100
Average investment
Illustration:
Aqua ltd has a proposal for a project whose cost is Sh.50million and has an economic useful
life of 5 years. It has a nil residual value. The earnings before depreciation and tax expected
from the project are as follows:
Year Earnings before depreciation and tax

Sh.’000’
1 12000
2 15000
3 18000
4 20000
5 22000
The corporate tax rate is 30% and depreciation is on straight line basis.
Solution:
50M − 0
Depreciation = = 10M
5
Calculation of the average income,
Year
1 2 3 4 5
Earnings before
dep. 12000 15000 18000 20000 22000
Less depreciation 10000 10000 10000 10000 10000
Earnings after dep 2000 5000 8000 10000 12000
Tax @ 30% -600 -1500 -2400 -3000 -3600
Profit after tax 1400 3500 5600 7000 8400
1400 + 3500 + 5600 + 7000 + 8400

Average Income =
5
= ℎ. 5,180,000
Initial investment + salvage value

Average investment =
2
50 000 000 + 0
Average investment =
2
Page 202
= 2500000
Average income
ARR = x 100
Average investmen
5 180 000
ARR = x 100
25 000 000
= 20.72%
Decision criteria:
If the projects are mutually exclusive the project with the highest ARR is accepted. If
projects are independent, they should be ranked from the one with the highest ARR which
should come first to the one with the lowest as the last.
If the firm has a minimum acceptable ARR, then the decision will be based on the project
with a higher ARR as per their preferred rate.
Advantages of ARR
1. Simple to understand and use.
2. The accounting information used is readily available from the financial statements.
3. All the returns in the entire life of the project are used in determining the project’s
profitability.
Weaknesses of ARR
1. Ignores time value of money.

2. Uses accounting profits instead of cashflows which could have been arbitrarily
determined.
3. Growth companies earning very high rates of return on the existing assets may reject
profitable projects as they have set a higher minimum acceptable ARR, the less
profitable companies may set a very low acceptable ARR and may end up accepting
bad projects.
4. Does not allow for the fact that profits can be reinvested.
DISCOUNTED CASHFLOW TECHNIQUES
1. Present Value Concept

This concept acknowledges the fact that a shilling loses value with time and as such if it is
to be compared with a shilling to be received in Nth year then the two must be at the same
values. This means that an investor’s analytical power is increased by his/her ability to
compare cash inflows and outflows separated from each other by time. He/she should be
able to work in the reverse direction i.e. from future cash flows to their present values.
Page 203
2. Present Value of a Lumpsum

Usually an investor would wish to know how much he/she would give up now to get a
given amount in year 1, 2, … n. In this situation he would have to decide at what rate of
discount also known as time preference rate, he/she will use to discount the anticipated
lumpsum using this rate by applying the following formula:
L
Pv 
1  K n
Where: Pv = Present value

L = Lumpsum
K = Cost of finance or time preference rate
n = given year.
This implies that if the time preference rate is 10%, the present value of 1/= to e received at
the end of year 1 is:
1
Pv   0.909
1.1
The present value of inflows to be received in the 2nd year to Nth year, will be equal to:
A
Pv 
1  K N
Where: A = annual cash flows

N = Number of years
Also, 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:

40,000 at the end of year 2
Compute his present (value) if his time preference is 12%.

L 40,000 70,000 100,000
Pv    _
1KN 1.12 1.12 1.128
2 6
= Kshs.107,740.26
Using tables:
= 40,000(0.7992) + 70,000(0.5066) + 100,000(0.4039)
= 107,820
Page 204
3. Present Value of an Annuity

An 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. The present value of
an annuity receivable where the investor time preference is 10% equal to:
A
Pv ( A )  I = time preference rate
1  i
E.g. Pv of 1/= to be received after 1 year if time preference rate is 10%.
1
=  0.909
1  0.1
A 1
After 2 years it will be:
  0.8264
2
1  i 1.12
1st year - 0.9090
2nd year - 0.8264
3rd year - 0.7513
4th year - 0.6830
Total - 3.1697
4. Present Value of Uneven Periodic Sum

In 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:
A1 A2 A3 AN
Pv     ..... 
1  K 1 1  K 2 1  K 3 1  K N
Equation
At
Pv   1  K  t
Where: At = Uneven cash inflows at time t

Pv = Present value
K =Cost of finance
Illustration
A company contemplates to receive Shs.:
20,000 in year 1
18,000 in year 2
24,000 in year 3
Nil in year 4
40,000 in year 5
Page 205
Cost of this finance is 12%
Required;-
Compute present value of that finance
Solution
30,000 18,000 24,000 40,000
Pv    
1.121 1.122 1.123 1.125
= 80,915.004
5. Net Present Value Method

The 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.
If net present value is positive you invest, If NPV is negative you do not invest.
Pv(inflow) – Pv(outflows) = NPV
Note
Initial outflow is at period zero and their value is their actual present value. With this
method, an investor can ascertain the viability of an investment by discounting outflows.
In this case, a venture will be viable if it has the lowest outflows.
 A1 A2 A3 AN 
NPV      .....   C
 1  K 1 1  K 2 1  K 3 1  K N 
Where: A = annual inflow

K = Cost of finance
C = Cost of investment
N = Number of years
Examples
Cost of investment = 100,000/=, interest rate = 10%, inflows year 1 = 80,000/= year 2 =
50,000/=
80 ,000 50 , 000
NPV =   100 ,000 = 14,049 positive hence invest.
1 .1 1 . 12
Illustration
Jeremy limited wishes to expand its output by purchasing a new machine worth 170,000
and installation costs are estimated at 40,000/=. In the 4th year, this machine will call for
an overhaul to cost 80,000/=. Its expected inflows are:
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Sh
Year 1 60,000
Year 2 72,650
Year 3 35,720
Year 4 48,510
Year 5 91,630
Year 6 83,715
This company can raise finance to purchase machine at 12% interest rate.
Compute NPV and advise management accordingly.
Solution
Sh.
Cost of machine at present value 170,000
Installation cost 40,000
210,000
Overhaul cost in the 4th year = 80,000

Discounting factor = (1.12)4
Therefore present value = 80,000 = Shs.50,841.446
(1.12)4
Total present value of investment = 260,841.45
60,000 72,650 35,720 48,510 91,630 83,715

PV inflows =     
(1.12) 1.122 1.12K 3 (1.12) 4 1.125 1.126
= 262,147.28
Therefore: NPV = 262,147.28 – 260,841.45

NPV = 1,305.83
The NPV is positive and I would advise the management to invest.
Illustration
Resilou limited intends to purchase a machine worth Shs.1,500,000 which will have a
residue value Shs.200,000 after 5 years useful life. The saving in cost resulting from the
use of this machine are:
Shs.
Year 1 800,000
Year 2 350,000
Year 3 -
Year 4 680,000
Year 5 775,000
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Using NPV method, advise the company whether this machine should be purchased if the
cut off rate is 14% and acceptable saving in cost is 12% of the cost of the investment.
Solution
Year 1 2 3 4 5
Saving 800,000 350,000 - 680,000 775,000
Scrap value - - - - 200,000
Total amount 800,000 350,000 - 680,000 975,000
800,000 350,000 680,000 975,000

NPV =     1,500,000
1.141 1.142 1.144 1.145
= 1,880,067.1 – 1,500,000
= 380,067.07
380,067.0
Return = x100 = 25.337% > 12% hence invest.
1,500,000
NB: Assuming that the salvage will be realised.
Illustration
A section of a roadway pavement costs £400 per year to maintain. What new expenditure
of a new pavement is justified if no maintenance will be required for the 1st five years then
£100 for the next 10 years and £400 a year thereafter? Assume cost of finance to be 5%.
Solution
Total present value of maintenance costs under the re-surfacing scheme.
400
Maximum expenditure =  £8,000
0.05
Present value of an Annuity for n years is given by the formula:

 1 
1  n 
PV  A  1 K  
 K 
 
 
Whereby: PV is Present value
A is annuity
K is cost of finance
n is number of year
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Present value of an annuity to perpetuity is given by the formula

A
Pv =
K
Whereby: PV is Present value

A is annuity
K is cost of finance
400
Therefore PV maximum expenditure =  £8,000
0.05
PV = Minimum expenditure = £[4,453]
= Justified expenditure = £3,547
 1   1   
 1  1 .05 15   1  1 .05 5  400  1 
PV  100    100    400  
 1 .05 
15
 0 .5   0 .5  0 .5 
     0 .5 
= £4,453
1
NB: The present value interest factors PVIF = and present value
(1  r)n
1  (1  r ) n
Annuity factors, PVAF = can be read from tables provided at the point of
r
intersection between the discounting rate and number of periods.
Accept or reject rule of NPV
Under this method, a company should accept an investment venture if N.P.V. is positive
i.e. if present value of cash outflows exceeds that of cash inflows or at least is equal to
zero. (NPV ≥0). This will rank ventures giving the highest rank to that venture with
highest NPV because this will give the highest cash inflow or capital gain to the company.
Advantages of NPV
 It 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.
 It takes into account the entire inflows or returns and as such it is a realistic gauge of
the profitability of a venture.
 It is consistent with the value of a share in so far as a positive NPV will have the
implication of increasing the value of a share.
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It is consistent with the objective of maximising the welfare of an owner because a positive
NPV will increase the net worth of owners.
Disadvantages of NPV
 It is difficult to use.
 Its calculation uses cost of finance which is a difficult concept because it considers
both implicit and explicit whereas NPV ignores implicit costs.
 It is ideal for assessing the viability of an investment under certainty because it
ignores the element of risk.
 It may not give good assessment of alternative projects if the projects are unequal
lives, returns or costs.
 It ignores the PBP.
INTERNAL RATE OF RETURN (IRR)

This method is a discounted cash flow technique which uses the principle of NPV. It is
defined as the rate which equates the present value of cash outflows of an investment to the
initial capital.
IRR = Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0.
It is also called internal rate of return because it depends wholly on the outlay of
investment and proceeds associated with the project and not a rate determined outside the
venture.
A1 A2 A3 AN
IRR  C     ..... 
1
1  r  2
1  r  3
1  r  1  r N
A = inflow for each period

C = Cost of investment
The value r can be found by:

i. Trial and error
ii. By interpolation
iii. By extrapolation
i) Trial and error method

a) Select any rate of interest at random and use it to compute NPV of cash inflows.
b) If rate chosen produces NPV lower than the cost, choose a lower rate.
c) If the rate chosen in (a) above gives NPV greater than the cost, choose a higher rate.
Continue the process until the NPV is equal to zero and that will be the IRR.
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Example
A project costs 16,200/= and is expected to generate the following inflows:
Sh.
Year 1 8,000
Year 2 7,000
Year 3 6,000
Compute the IRR of this venture.
Solution
1st choice 10%
8,000 7,000 6,000

  = 17,565.74 > cost, choose a higher rate.
1.11 1.12 1.13
2nd choice 14%
8,000 7,000 6,000

  = 16,453.646
1.141 1.142 1.143
3rd choice 15%
8,000 7,000 6,000

  = 16,194.625
1.151 1.152 1.153
IRR lies between 14% and 15%.
ii) Interpolation method

Difference
PV at rate of 14% = 16,453.646
253.646
PV required = 16,200.000
-5.375
PV at rate of 15% = 16,194.625
Therefore, r denotes required rate of return

253.646
Therefore, r = 14% + (15% - 14%) x
253.646  5.375
= 14% + 0.98%
= 14.98%
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Acceptance Rule of IRR

IRR will accept a venture if its IRR 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 IRR will be the highest rate of interest a firm would be ready to pay to finance
a project using borrowed funds and without being financially worse off by paying back the
loan (the principal and accrued interest) out of the cash flows generated by that project.
Thus, IRR is the break-even rate of borrowing from commercial banks.
Advantages of IRR
 It considers time value of money
 It considers cash flows over the entire life of the project.
 It is compatible with the maximisation of owner’s wealth because, if it is higher than
the cost of finance, owners’ wealth will be maximised.
 Unlike the NPV 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 project against which
various ventures can be assessed as to their viability.
Disadvantages of IRR
 Difficult to use.
 Expensive 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.
 It may give multiple results some involving positive IRR in which case it may be
difficult to use in choosing which venture is more viable.
DISCOUNTED PAYBACK PERIOD
One of the major disadvantages of simple payback period is that it ignores the time value of
money. To counter this limitation, an alternative procedure called discounted payback
period may be followed, which accounts for time value of money by discounting the cash
inflows of the project.
In discounted payback period we have to calculate the present value of each cash inflow
taking the start of the first period as zero point. For this purpose the management has to set
a suitable discount rate. The discounted cash inflow for each period is to be calculated using
the formula:
Actual Cash Inflow

Discounted Cash Inflow =
(1 + i)n
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Where;-
i - is the discount rate;
n - is the period to which the cash inflow relates.
The above formula is split into two components which are actual cash inflow and present
value factor (i.e. ). Thus discounted cash flow is the product of actual cash flow and
( )
present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that
we have to use the discounted cash flows as calculated above instead of actual cash flows.
The cumulative cash flow will be replaced by cumulative discounted cash flow.
B
Discounted Payback Period = A +
C
Where;
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.
Decision Rule
If the discounted payback period is less that the target period, accept the project. Otherwise
reject.
Illustration
An initial investment of Sh.2, 324,000 is expected to generate Sh.600, 000 per year for 6
years. Calculate the discounted payback period of the investment if the discount rate is
11%.
Solution
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the
actual cash flows by present value factor. Create a cumulative discounted cash flow
column.
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Present Value Discounted Cumulative

Year Cash Flow
Factor Cash Flow Discounted
n CF PV=1/(1+i)n CF×PV Cash Flow
Sh. Sh. Sh.
0 (2,324,000) 1 (2,324,000) (2,324,000)
1 600,000 0.9009 540,541 (1,783,459)
2 600,000 0.8116 486,973 (1,296,486)
3 600,000 0.7312 438,715 (857,771)
4 600,000 0.6587 395,239 (462,533)
5 600,000 0.5935 356,071 (106,462)
6 600,000 0.5346 320,785 214,323
Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years
Advantages and Disadvantages
Advantage
Discounted payback period is more reliable than simple payback period since it accounts
for time value of money. It is interesting to note that if a project has negative net present
value it won't pay back the initial investment.
Disadvantage
It ignores the cash inflows from project after the payback period.
PROFITABILITY INDEX (PI)
Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for
ranking projects because it allows you to quantify the amount of value created per unit of
investment.
P.I. (benefit-cost ratio) = Present value of inflows

Present value of cash outlay
If P.I. is greater than 1.0, invest. If less than 1.0, reject.
Illustration
The following information was from XYZ feasibility studies. It has studied two ventures:
a) Cost 100,000/= and 160,000/= at the beginning of the 4th year and it will generate
inflows 1-3rd year 80,000/= and from 4-6th year 50,000/= per annum.
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b) Initial cost 200,000/= and 80,000/= at the beginning of the 4th year and it will
generate the following inflows:
1st – 2nd year -> Shs.100,000 per annum

3rd – 6th year -> Shs.70,000 per annum
Using the cost of finance of 12% compute the P.I. of these two ventures, advise the
company accordingly.
Solution
100,000 160,000
a) Outflows: 
1 1.123 = 100,000 + 113,887 = 213,885
80,000 80,000 80,000 50,000 50,000 50,000

Inflows:      = Shs.277,626
1.121 1.122 1.123 1.124 1.125 1.126
277,626
P.I. = 213,885
P.I. = 1.298
200,000 80,000
b) Outflows: = 
1 1.123 = 256,944
100,000 100,000 70,000 70,000 70,000 70,000

Inflows =     
1.121 1.122 1.123 1.124 1.125 1.126 = Shs.338,501
338,501
P.I. = 256,944
= 1.32
Example
A company is faced with the following 5 investment opportunities:
Cost NPV P.I = Total PV P.I Ranking

Initial capital
1. 500,000 150,000 1.3 4
2. 100,000 40,000 1.4 3
3. 400,000 40,000 1.1 5
4. 200,000 100,000 1.5 2
5. 160,000 90,000 1.6 1
This company has ksh.750, 000available for investment projects, 3 and 4 are mutually
exclusive. All of the projects are divisible. Which group should be selected in order to
maximize the NPV. Indicate this NPV figure.
Solution
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Using P.I. to rank the projects in order of preference 5, 4, 2, 1, 3

In order to maximize NPV, the following projects combination should be selected:
Sh.
Funds available for investment 750,000
Cost of project: 5 160,000
4 200,000
2 100,000
1 290,000 (750,000-460,000) (750,000)
NIL
290,000
NPV = 90,000 + 100,000 + 40,000 + x150,000 = 317,000
500,000
Advantages of profitability index

a) Simple to use and understand.
b) The element of NPV in the venture will indicate which venture is more powerful as the
most profitable venture will have the highest P.I. as the difference or net P.I. will
continue to the company’s profitability.
c) It acknowledges time value for money and at the same time the NPV of a venture at its
present value which is consistent with investment appraisal requirements.
Disadvantages of profitability index

a) It 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.
b) It 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.
NPV PROFILE
The NPV profile is a graph that illustrates a project's NPV against various discount rates,
with the NPV on the y-axis and the cost of capital on the x-axis. To begin, simply calculate
a project's NPV using different cost-of-capital assumptions. Once these are calculated, plot
the values on the graph.
Example of an NPV profile
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This comparison allows decision-makers to determine the profitability of a project or

initiative in different potential financing scenarios, enabling more effective cost-benefit
planning.
COMPARISON OF THE NPV AND IRR METHODS WHEN EVALUATING

INDEPENDENT AND MUTUALLY EXCLUSIVE PROJECTS
Net present value is an absolute measure i.e. it represents the amount of value added or lost
by undertaking a project. IRR on the other hand is a relative measure i.e. it is the rate of
return a project offers over its lifespan.
NPV and IRR are two of the most widely used investment analysis and capital budgeting
decision tools. Both are discounting models i.e. they take into account the time value of
money phenomena. However, each method has its strengths and weaknesses and there are
situations in which they do not agree on the ranking of acceptability of projects. For
example, there might be a situation in which project X has higher NPV but lower IRR than
project Y. This NPV and IRR conflict depends on whether the projects are independent or
mutually exclusive.
Independent projects
Independent projects are projects in which decision regarding acceptance of one project
does not affect decision regarding others.
Since all independent projects can all be accepted if they add value, NPV and IRR conflict
doesn’t arise. The company can accept all projects with positive NPV.
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Mutually exclusive projects

Mutually exclusive projects are projects in which acceptance of one project excludes the
others from consideration. In such a scenario the best project is accepted. NPV and IRR
conflict, which can sometimes arise in case of mutually exclusive projects, becomes critical.
The conflict either arises due to the relative size of the project or due to the different cash
flow distribution of the projects.
Since NPV is an absolute measure, it will rank a project adding more value regardless of the
original investment required. IRR is a relative measure, and it will rank projects offering
best investment return higher regardless of the total value added.
Why the NPV and IRR Sometimes select different Projects

When comparing two projects, the use of the NPV and the IRR methods may give different
results. A project selected according to the NPV may be rejected if the IRR method is used.
Suppose there are two alternative projects, X and Y. The initial investment in each project
is Ksh. 2,500. Project X will provide annual cash flows of Ksh500 for the next 10 years.
Project Y has annual cash flows of Ksh100, Ksh200, Ksh300, Ksh400, Ksh500, Ksh600,
Ksh700, Ksh800, Ksh900, and Ksh1, 000 in the same period.
Using the trial and error method explained before, you find that the IRR of Project X is
17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be
preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your
decision if the NPV method is used? The answer is that the decision will change depending
on the discount rate you use. For instance, at a 5% discount rate, Project Y has a higher
NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher
NPV.
The purpose of this numerical example is to illustrate an important distinction: The use of
the IRR always leads to the selection of the same project, whereas project selection using
the NPV method depends on the discount rate chosen.
Project size and life

There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of
the project being studied are the most common ones. A 10-year project with an initial
investment of Ksh100,000 can hardly be compared with a small 3-year project costing
Ksh10,000. Actually, the large project could be thought of as ten small projects. So if you
insist on using the IRR and the NPV methods to compare a big, long-term project with a
small, short-term project, don’t be surprised if you get different selection results.
Different cash flows

Furthermore, even two projects of the same length may have different patterns of cash flow.
The cash flow of one project may continuously increase over time, while the cash flows of
the other project may increase, decrease, stop, or become negative. These two projects have
completely different forms of cash flow, and if the discount rate is changed when using the
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NPV approach, the result will probably be different orders of ranking. For example, at 10%
the NPV of Project A may be higher than that of Project B. As soon as you change the
discount rate to 15%, Project B may be more attractive.
When are the NPV and IRR Reliable?

Generally speaking, you can use and rely on both the NPV and the IRR if two conditions
are met. First, if projects are compared using the NPV, a discount rate that fairly reflects
the risk of each project should be chosen. There is no problem if two projects are
discounted at two different rates because one project is riskier than the other. Remember
that the result of the NPV is as reliable as the discount rate that is chosen. If the discount
rate is unrealistic, the decision to accept or reject the project is baseless and unreliable.
Second, if the IRR method is used, the project must not be accepted only because its IRR is
very high. Management must ask whether such an impressive IRR is possible to maintain.
In other words, management should look into past records, and existing and future business,
to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If the
firm is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the
project must be reevaluated by the NPV method, using a more realistic discount rate.
NB;-The internal rate of return (IRR) is a popular method in capital budgeting. The IRR is
a discount rate that makes the present value of estimated cash flows equal to the initial
investment. However, when using the IRR, you should make sure that the calculated IRR is
not very different from a realistic reinvestment rate.
EXPECTED RELATIONS AMONG AN INVESTMENT'S NPV, COMPANY

VALUEAND SHARE PRICE
The net present value calculator (NPV calculator) is a tool that can assist in estimating the
intrinsic value of a company (its true worth) when considering whether to purchase its
stock.
The calculation is based on forecast earnings for a number of years in the future. The
investor can then compare the calculated intrinsic value to the current stock price to
determine its value as an investment.
More generally, a net present value enables an investor to determine the difference between
the present value (PV) of the future cash flows from an investment and the amount to be
initially invested.
This present value of the expected cash flows is computed by discounting the expected cash
flows at the individual investor's required rate of return (also referred to as the discount
rate).
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There are a number of ways to calculate a stock's value, but one of the most elegant and
relatively simple ways continues to be via the dividend discount model (DDM) individual
investors can estimate the price they should be willing to pay for a stock or determine
whether a given stock is undervalued or overvalued.
The dividend discount model starts with the premise that that a stock's price should be equal
to the sum of its current and future cash flows, after taking the "time value of money" into
account.
Under this approach there are three ways of determining whether a given stock is
undervalued or overvalued.
Example
For example, an investment of Sh.2, 000 today at 10 per cent will yield Sh.2, 200 at the end
of the year. So the present value of Sh.2, 200 at the required rate of return (10 per cent) is
Sh.2, 000.
The initial investment (Sh.2,000 in this example) is deducted from this figure to arrive at
NPV which here is zero (Sh.2,000- Sh.2,000).
A zero NPV means the initial investment is repaid plus the required rate of return. A
positive NPV means a better return than a zero NPV. A negative NPV means a worse return
than the return from a zero NPV.
Illustration
An investor expects to invest in a company and to get shs.150 as dividends from a share
next year and hopes to sell off the share at sh.30 after holding it for 1 year. The required
rate of return.
Required;-
What is the present value of the share?
How much should he be willing to buy a share of the company?
SOLUTION
Value of a share = +
( ) ( )
.
= + = sh.26.25
( . ) ( . )
The value he should be willing to pay for the share should besh.26.25 or less. Sh. 26.25 is
the intrinsic value of the share. The investor would buy this share only if the current market
price is lower than or equal to the value.
Illustration
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An investor intends to invest in XYZ Company and expects to get sh. 3.5, 4, 4.5 as
dividends from a share during the next 3 years and hopes to sale it off at sh.75 at the end of
the third year. The required rate of return is 25%.
Required;-
What’s the present value of the share of XYZ Company?
Value of the share = + + +

( ) ( ) ( ) ( )
. .
+ + + = sh.46.06
( . ) ( . ) ( . ) ( . )
Net Present Value Analysis

A positive result from the subtraction above would indicate a better return on the
investment than the required return. This is what is meant by a margin of safety. This would
suggest that the stock is undervalued at the current share price
A zero result from the subtraction carried out above would indicate a return on investment
equal to the required return set by the investor. This would suggest that the stock represents
fair value at the current share price.
A negative result would indicate a poorer return than that set be the investor. This would
then suggest that the stock is overvalued at the current share price.
The return required by the investor has an important influence on the determination of
calculated fair value. The greater the return required by the investor, the lower the current
share price needs to be to achieve a positive result from the subtraction carried out above.
CAPITAL RATIONING
In a situation where the firm has unlimited funds, capital budgeting becomes a simple
process in that all independent investment proposals yielding return greater than some
predetermined levels are accepted. However this is not the situation prevailing in most
business firms in real world. They have a fixed capital budget. The firm must, therefore,
ration them.
Thus, capital rationing refers to a situation in which a firm has more acceptance investment,
requiring a greater amount of finance than what is available within the firm. A system of
ranking of investment project is used in capital rationing. Project can be ranked on the basis
of some predetermined criterion such as the rate of return. The project with the highest
return is ranked first and the project with the lowest acceptable return last. Any investment
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to be undertaken will need to be assessed as regards its viability using an acceptable

appraisal approach.
Soft capital rationing

It is caused by internally generated factors of the company. It is a self-imposed capital
rationing by the management of the company. Management may put a maximum budget
limit to be spent within a specific period.
Examples/causes of soft capital rationing

1) A self-imposed budgetary limit where the management puts a ceiling on the maximum
amount to be spent on investments.
2) Management may decide against issuing more equity finance in order to maintain
control over the company’s affairs by existing shareholders.
3) Management may opt not to raise more equity so as to avoid dilution in the Earning
per share.
4) Management may decide against raising additional debt due to the following reasons:
a) To avoid increase in interest payment commitment
b) To control the gearing or operating leverage so as to maximize the financial risk.
5) If a company is small or family owned, its managers may limit the investment funds
available to maintain constant growth through retained earnings as opposed to rapid
expansion.
Hard capital rationing

It is externally imposed by the market and is caused by the factors beyond the control of the
company. It occurs where the company has exhausted all its borrowing limits and is unable
to raise funds externally.
Causes of hard capital rationing
1) Economic factors e.g. high interest rates and high inflation
2) Perception by investors that the company is risky. Where the company is deemed
risky e.g. in an infant industry or operating in a very competitive market, the
investors will not provide funds to that company.
3) High competition for funds by different companies resulting into an increase in the
costs of borrowing.
4) Depressed stock exchange. The company’s share market price is very low and so
may find it hard to raise funds from the stock market.
Divisible projects
These are projects that can be undertaken in parts or in proportions depending on the capital
available for investment. In capital rationing situations, where funds available are not
enough to the entire project, the remaining funds can be partly invested in the next viable
projects.
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Illustration
ABC Ltd. is considering investing in the following independent projects
Project PV of cash Initial cost NPV PI

flow
1 230,000 200,000 30,000 1.15
2 141,250 125,000 16,250 1.13
3 194,250 175,000 19,250 1.11
4 162,000 150,000 12,000 1.08
The company has set a capital limit of Sh.300000.
Required:
Advice the management on the projects to undertake
Solution
If there was no capital rationing then all the 4 projects would be accepted coz they have
positive NPV. However with capital rationing, the projects have to be compared using PI
index. With sh.300, 000, we could have invested in three options. Invest in project 1; invest
in projects 2 and 3; invest in projects 2 and 4. We will select the option that gives us the
highest weighted average profitability index.
A major assumption made in analysis is that the PI index of all projects is excess of one and
the unused funds PI is equal to one.
Weighted average PI:

For option 1: 1.15(200/300) + 1.0(100/300) = 1.1
For option 2: 1.13(125/300) + 1.11(175/300) = 1.118
For option 3: 1.13(125/300) + 1.08(150/300) + 1(25/300) = 1.094
Decision: Invest in project 2 and 3 since this result in the highest weighted average PI.
Illustration
Uchumi Bakery is experiencing capital rationing in year zero when only Ksh 60,000 is
available. No capital rationing is expected in the future period. But, none of the three
projects under consideration can be postponed.
The firm’s cost of capital is 10% and the expected cash flows are as follows;-
Project Year 0 Year 1 Year 2 Year 3 Year 4
A (30,000) 20,000 20,000 40,000 40,000
B (28,000) (50,000) 40,000 40,000 20,000
C (30,000) (30,000) 40,000 40,000 10,000
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Required:
Determine which projects should be undertaken in year zero in view of the considered
capital rationing given that projects are divisible.
Solution
Project Year 0 Year 1 Year 2 Year 3 Year 4 NPV
PVIF, 10% 1.000 0.909 0.826 0.751 0.683
A (30,000) (18,180) 16,520 30,040 27,320 5,700
B (28,000) (45,450) 33,040 30,040 13,660 3,290
C (30,000) (27,270) 24,780 30,040 6,830 4,380
NB: based on NPV, the three projects are acceptable for investment in the following order,
A, C and B.
Efficiency analysis of the proceeds with which the invested capital generates wealth is as
follows;
Project NPV Initial Cost PI
(IC)
A 5,700 (30,000) 0.114
B 3,290 (28,000) 0.118
C 4,380 (30,000) 0.146
Decision;-
Based on the above analysis, investment should be done in the following order, C, B, and
A. since the available capital is Ksh. 60,000, the first two projects will be undertaken
wholly while the last project will be undertaken partially as the projects are divisible.
REVISION QUESTIONS
QUESTION 1
(a) In making investment decisions, cashflows are considered to be more important than
accounting profits. Briefly explain why this is the case.
(b) Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each
of these projects requires Sh.400,000,000 in initial cash outlay. The details of the two
projects are as follows:
Project A
This project is made up of two sub-projects. The first sub-project will require an initial
outlay of Sh.100,000,000 and will generate Sh.25,600,000 per annum in perpetuity. The
second sub-project will require an initial outlay of Sh.300,000,000 and will generate
Sh.85,200,000 per annum for the 8 years of its useful life. This sub-project does not have a
residual value at the end of the 8 years. Both sub-projects are to commence immediately.
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Project B
This project will generate Sh.87,000,000 per annum in perpetuity.
The company has a cost of capital of 16%.
Required:
i) Determine the net present value (NPV) of each project.
ii) Compute the internal rate of return (IRR) for each project.
iii) Advise Magma Ltd. on which project to invest in, and justify your choice.
QUESTION 2
(a) In the context of capital budgeting, explain the difference between “hard rationing” and
“soft rationing”.
(b) finance manager of Bidii Industries Ltd., which manufactures edible oils, has identified
the following three projects for potential investment:
Project I
The project will require an initial investment ofSh.18 million and a further investment of
Sh.25 million at the end of two years. Cash profits from the project will be as follows:
Sh.
End of year 2 15,000,000
3 12,000,000
4 8,000,000
5 8,000,000
6 8,000,000
7 8,000,000
8 8,000,000
Project II
This project will involve an initial investment of Sh.50 million on equipment and Sh.18
million on working capital. The investment on working capital would be increased toSh.20
million at the end of the second year. Annual cash profit will be Sh.20 million for five
years at the end of which the investment in working capital will be recovered.
Project III
The project will require an initial investment on capital equipment of Sh.84 million and
Sh.24 million on working capital. The profits from the project will be as follows:
Contribution Fixed costs

Sh. Sh.
End of year 1 35 million 8 million
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Fixed costs include an annual depreciation charge ofSh.3 million. At the end of year 3, the
working capital investment will be recovered and the capital equipment will be sold for
Sh.8 million.
Bidii Industries Ltd.’s cost of capital is 12%. Ignore taxation.
Required:
(i) Evaluate each project using the net present value (NPV) method.
(ii) Which of the three projects should Bidii Industries Ltd. accept?
QUESTION 3
(a) Describe in brief the greatest difficulties faced in capital budgeting in the real world
(b) Mumias Milling Company purchased a grinder 3 years ago at a cost of Sh.3.5 million.
The grinder had a life of 8 years at the time of purchase. It is being depreciated at 15%
per year on a declining balance. The company is considering replacing it with a new
grinder costing Sh.7 million with an expected useful life of 5 years.
Due to increased efficiency, the profit before depreciation is expected to increase by

Sh.400,000 a year. The old and new grinders will now be depreciated at 25% per year on a
declining balance for tax purposes.
The salvage value of the new grinder is estimated at Sh.210,000. The market value of the
old grinder, today, is Sh.4 million. It is estimated to have a zero salvage value after 5 years.
The company’s tax is 30% and the after tax cost of capital is 12%.
Required
Should the new grinder be bought? Explain.
QUESTION 4
Magharibi Cane Millers Ltd. is a company engaged in the pressing and processing of sugar
cane juice into refined sugar. For some time, the company has been considering the
replacement of its three existing machines.
The production manager has learnt from a professional newsletter on sugar of the
availability of a new and larger machine whose capacity is such that it can produce the same
level of output per annum currently produced by the three machines. Furthermore, the new
machine would cut down on the wastage of juice during processing. If the old machines are
not replaced, an extraordinary overhaul would be immediately necessary in order to
maintain them in operational condition. This overhaul would at present cost Sh.5,000,000
in total.
The following additional information is available:
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1. The old machines were purchased 5 years ago and are being depreciated over 15 years
on a straight line basis, with an estimated final scrap value of Sh.600,000 each. The
current second hand market value of each of the machines is Sh.1,000,000.
2. The annual operating costs for each of the existing machines are:
Sh. Sh.
Raw sugar cane 60,000,000
Labour (one operator) 1,350,000
Variable expense 925,000
Maintenance (excluding overhaul expenditure) 2,000,000
Fixed expenses:
Depreciation 75,000 -
Fixed factory overhead absorbed 2,700,000 2,775,000
3. The new machine has an estimated life of ten years and its initial cost will comprise:
Sh.
Purchase price (scrap value in 10 years Sh.4,500,000) 87,000,000
Freight and installation 13,000,000
100,000,000
4. The estimated annual operating costs, if all the current output is processed on the
new machine are:
Sh. Sh.
Raw sugar cane 162,000,000
Labour (one operator) 3,900,000
Variable expense 2,275,000
Maintenance (excluding overhaul expenditure)
Fixed expenses:
Depreciation 9,550,000
Fixed factory overhead absorbed 7,800,000 17,350,000
Maintenance 4,500,000
5. The company’s cost of capital is 10%.
6. For a project 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.
Required:
(a) (i) Net present values of the proposed replacement decision using discount rates of
10% and 20%.
(ii)The estimated internal rate of return (IRR) of the replacement decision using the
values determined in (i) above.
(iii)Advice management on the proposal based on your answer in (ii) above.
(b) Decision as to whether the project meets the financial viability test.
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(c) Comment on any other qualitative considerations that could influence this decision.
Note: Ignore taxation
QUESTION 5
P. Muli was recently appointed to the post of investment manager of Masada Ltd. a quoted
company. The company has raised Sh.8,000,000 through a rights issue.
P. Muli has the task of evaluating two mutually exclusive projects with unequal economic
lives. Project X has 7 years and Project Y has 4 years of economic life. Both projects are
expected to have zero salvage value. Their expected cash flows are as follows:
Project X Y
Year Cash flows (Sh.) Cash flows (Sh.)
1 2,000,000 4,000,000
2 2,200,000 3,000,000
3 2,080,000 4,800,000
4 2,240,000 800,000
5 2,760,000 -
6 3,200,000 -
7 3,600,000 -
The amount raised would be used to finance either of the projects. The company expects
to pay a dividend per share of Sh.6.50 in one year’s time. The current market price per
share is Sh.50. Masada Ltd. expects the future earnings to grow by 7% per annum due to
the undertaking of either of the projects. Masada Ltd. has no debt capital in its capital
structure.
Required:
a) The cost of equity of the firm.
b) The net present value of each project.
c) The Internal Rate of return (IRR) of the projects. (Rediscount cash flows at 24%
d) for project X and 25% for Project Y).
e) Briefly comment on your results in (b) and (c) above.
f) Identify and explain the circumstances under which the Net Present Value (NPV) and
the Internal Rate of Return (IRR) methods could rank mutually exclusive projects in a
conflicting way.
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TOPIC 8
FINANCIAL ANALYSIS AND FORECASTING
USERS OF FINANCIAL STATEMENTS AND THEIR INFORMATIONAL NEEDS
The following are the different users of accounting information and their specific
information needs.
1. Managers require Financial Statements to manage the affairs of the company by

assessing its financial performance and position and taking important business
decisions.
2. Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their analysis.
3. Prospective Investors need Financial Statements to assess the viability of investing
in a company. Investors may predict future dividends based on the profits disclosed
in the Financial Statements. Furthermore, risks associated with the investment may
be gauged from the Financial Statements. For instance, fluctuating profits indicate
higher risk. Therefore, Financial Statements provide a basis for the investment
decisions of potential investors.
4. Financial Institutions (e.g. banks) use Financial Statements to decide whether to
grant a loan or credit to a business. Financial institutions assess the financial health
of a business to determine the probability of a bad loan. Any decision to lend must
be supported by a sufficient asset base and liquidity.
5. Suppliers need Financial Statements to assess the credit worthiness of a business
and ascertain whether to supply goods on credit. Suppliers need to know if they will
be repaid. Terms of credit are set according to the assessment of their customers'
financial health.
6. Customers use Financial Statements to assess whether a supplier has the resources
to ensure the steady supply of goods in the future. This is especially vital where a
customer is dependant on a supplier for a specialized component.
7. Employees use Financial Statements for assessing the company's profitability and its
consequence on their future remuneration and job security.
8. Competitors compare their performance with rival companies to learn and develop
strategies to improve their competitiveness.
9. General Public may be interested in the effects of a company on the economy,
environment and the local community.
10. Governments require Financial Statements to determine the correctness of tax
declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of the
economy.
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Internal and External Users
The users may be classified into internal and external users.
Internal users refer to managers who use accounting information in making decisions
related to the company's operations.
External users, on the other hand, are not involved in the operations of the company but
hold some financial interest. The external users may be classified further into users with
direct financial interest – owners, investors, creditors; and users with indirect financial
interest – government, employees, customers and the others.
RATIO ANALYSIS
NATURE OF FINANCIAL RATIO ANALYSIS
In financial analysis, ratio is used as an index of yardstick for evaluating the financial
position and performance of the firm. It is a technique of analysis and interpretation of
financial statements. Ratio analysis helps in making decisions as it helps establishing
relationship between various ratios and interpret thereon. Ratio analysis helps analysts to
make quantitative judgement about the financial position and performance of the firm.
Ratio analysis involves following steps:
1. Relevant data selection from the financial statements related to the objectives of the
analysis.
2. Calculation of required ratios from the data and presenting them either in pure ratio
form or in percentage.
3. Comparison of derived different ratios with:
 The ratio of the same concern over a period of years to know upward or
downward trend or static position to help in estimating the future, or
 The ratios of another firm in same line, or
 The ratios of projected financial statements, or
 The ratios of industry average, or
 The predetermined standards, or
 The ratios between the departments of the same concern assessing either the
financial position or the profitability or both.
4. Interpretation of the ratio
Ratio analysis uses financial report and data and summarizes the key relationship in
order to appraise financial performance. The effectiveness will be greatly improved
when trends are identified, comparative ratios are available and inter-related ratios
are prepared.
Users of ratios
There are a vast number of parties interested in analyzing financial statements including
shareholders, lenders, customers, employees, government, and competitors. In many
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occasions, they will be interested in different things therefore there is no any definite, all-
encompassing list of points for analysis that would be useful to all these stakeholders.
However, it is possible to construct a series of ratios that together will provide all of them
with something that they find relevant and from which they can investigate further if
necessary.
Ratio category Examples of interested parties

Profitability Shareholders, management, employees, creditors, potential investors
Liquidity Shareholders, suppliers, creditors, competitors
Efficiency Shareholders, potential purchasers, competitors
Shareholder Shareholders, potential investors
Capital structure Shareholders, lenders, creditors, potential investors
TYPES OF FINANCIAL RATIOS
Ratios can be classified into:
a) Liquidity ratios.
b) Leverage or gearing ratios.
c) Activity ratios.
d) Profitability ratios.
1. Liquidity ratios
These measure firm’s ability to meet its short-term maturing obligations as and when they
fall due. The lower the ratio, the higher the liquidity risk and vice versa. Failure to meet
short term liabilities due to lack of liquidity may lead to poor credit worthiness, litigation by
creditors and insolvency.
2. Leverage or gearing ratios
These measure extent to which a company uses its assets which have been financed by non
owner supplied funds. They measure financial risk of the company. The higher the ratio, the
higher the financial risk. Gearing refers to the amount of debt finance a company uses
relative to its equity finance.
3. Activity ratios
These measure the efficiency with which a firm uses its assets to generate sales. They are
also called turnover ratios as they indicate the rate at which assets are converted into sales.
4. Profitability ratios
They measure the management’s effectiveness as shown by returns generated on sales and
investment. They indicate how successful management has been in generating profits of the
company.
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5. Investment or equity ratios

These are used to evaluate the overall performance of a company. E.g. in determining
company’s dividend policy, determining theoretical value of company’s securities and
predicting effects of rights issue.
1. LIQUIDITY RATIOS
Current ratio
This is computed by dividing total current assets by total current liabilities:
Current ratio of more than one means that a company has more current assets than current
liabilities.
Acid test or quick ratio
This is calculated by dividing total current liabilities excluding stock by current liabilities.
A firm with a satisfactory current ratio may actually be in a poor liquidity position when
inventories form most of the total current assets.
−
=
STUDYTEXT
2. GEARING OR LEVERAGE RATIOS
3.
Debt ratio or capital gearing ratio
This measures the proportion of debt finance to capital employed by a company. A
company is highly geared if the ratio is greater than 50%.
= 100
Debt equity ratio
This measures the proportion of non owner supplied funds to owner’s contribution to the
company. A company is highly geared if the debt equity ratio is greater than 100%.
=
ℎ
Times interest cover
This shows number of times earnings by a company cover its current payments. The higher
the ratio, the lower the gearing position and thus the lower the financial risk.
Earnings before interest and tax + Depreciation

Times interest cover =
ℎ
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3. PROFITABILITY RATIOS
Return on capital employed (ROCE)

This measures the efficiency with which a company uses long term funds or permanent
assets to generate returns to shareholders.
Pro it before interest and tax or operating pro it

ROCE =
Capital employed consists of shareholders funds (ordinary share capital, preference share
capital, share premium and retained earnings) and long term debts. Capital employed can
also be calculated as fixed assets plus net working capital.
221S T U D Y T E X T
Gross profit margin
This ratio shows how well cost of production has been controlled in relation to distribution
and administration costs.
= 100
Net profit margin

This measures firm’s ability to control its production, operating and financing costs
= 100
Net assets turnover
This gives a guide to productive efficiency i.e. how well assets have been used in
generating sales.
=
Operating profit/margin ratio
This indicates efficiency with which costs have been controlled in generating profit from
sales.
= 100
Operating expenses ratio

This indicates a firm’s ability to control production and operating costs to generate a given
level of sales.
= 100
Return on investment
These measures the efficiency with which a company uses its total funds in capital
employed to generate returns to owner’s funds.
Net pro it after tax
Return on investment = 100
Capital employed
Return on equity. (ROE)
This measures the efficiency with which a company other supplier’s funds to generate
returns to shareholders.
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Earnings attributable to equity shareholders

Return on equity = 100
Equity
Equity comprises of ordinary share capital, share premium and reserves.

STUDYTEXT
4. ACTIVITY RATIOS
Fast forward - These measure the efficiency with which a firm uses its assets to generate
Debtor’s turnover
This shows the number of times debtors pay within the year. It indicates how efficient the
firm is in management of credit. The higher the ratio, the more efficient management is in
managing its credit policy.
’ =
Debtor’s days or ratio

This is also called the average collection period. It shows the average period of credit
taken by customers who buy on credit. It is compared the company’s allowed credit period
by suppliers to give an indication of credit administration efficiency.
’ =
=
’
Creditor’s turnover
This indicates the number of times creditors are paid by a company during a year.
ℎ
’ =
Creditor’s days or ratio

This is also called the average deferral period. It indicates the average time that suppliers
allow a company to settle its dues.
’ =
ℎ
=
’
Stock or inventory turnover

This indicates the efficiency of a firm in selling its products so as to generate sales. It shows
the times stock is turned over or converted into sales within a year. It shows how rapidly
stock is being turned into cash through sales.
Cost of sales
Stock or inventory turnover =
STUDYTEXT
Stock days/inventory conversion period
This indicates the number of days it takes to convert inventory into sales. The fewer the
number of days, the more efficient a company is in converting stock into sales.
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S
= .
Cash working cycle/Working capital cycle/Operating cycle

This is the period for which working capital financing is needed. The higher the working
capital cycle, the higher the investment in working capital. It is the period of time that
elapses between the point at which cash is spent on production or purchase of raw
materials/stock to time stock is converted into cash or cash is collected from a customer.
Average collection period xxx

Add inventory conversion period xxx
Less average deferral period (xxx)
Working capital cycle xxx
Calculation of Operating Cycle

The length of the operating cycle of a manufacturing firm is the sum of:
i) Inventory conversion period
ii) Receivables/debtors’ conversion period
The inventory conversion period is the total time needed to produce and sell the product. It
includes:
1. Raw material conversion period.
2. Work-in-Process conversion period.
3. Finished goods conversion period.
The debtors’ conversion period is the time required to collect the outstanding amount from
customers.
A firm may acquire resources on credit and defer payments. Payables may thus arise. The
payables deferral period is the length of time the firm is able to defer payments on purchase
of resources. The difference between the payables deferral period and the sum of the
inventory conversion period and receivable conversion period is referred to as the
operating/cash conversion cycle.
1. Inventory conversion period.
It is the sum of raw material conversion period, working in progress conversion period and
finished goods conversion period.
Raw material conversion period. - It is the average time period taken to convert raw
material into work in Process.
Raw material conversion period = Raw material inventory / (Raw material

consumption/ 360)
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Working in process conversion period. - It is the average time taken to complete the
semi-finished or work in process.
= /( /360)
Finished goods conversion period.- It is the time taken to sale the finished goods .
Finished goods conversion period = Finished goods inventory/ (cost of sales/ 360)
Debtors conversion period.
It is the time taken to convert the debtors to cash. It represents the average collection
period.
= /( /360)
Payables deferral period.
It is the average time taken by the firm to pay its suppliers / creditors.
= /( ℎ / 360)
Summary
Inventory conversion period + Debtors conversion period – Creditors deferral period

=Net operating cycle
Example
The following information relates to Mutongoi Limited.
Sh.000
Purchase of raw material 6,700
Usage of raw material 6,500
Sale of finished goods (all on credit) 25,000
Cost of sales(Finished goods) 18,000
Average creditors 1,400
Average raw materials stock 1,200
Average work in progress 1,000
Average finished goods stock 2,100
Average debtors 4,700
Assume a 365 days year.
Required:
The length of the operating cash cycle.
Solution.
Raw material conversion period = Raw material inventory / (Raw material consumption/
360)
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= (1,200/6,500) × 365
= 67days
Work in process conversion period = Working process inventory / (Cost of production /360)
= (1000/18000) × 365
=20 days
ℎ
= ℎ /( / 360)
= (2100/18000) × 365
=43 days
= /( /360)
= (4700/25000) × 365
=69 days
= /( ℎ / 360)
= (1400/6700) × 365
= 76 days
Length of operating cycle.
Inventory conversion period.
Raw material conversion period 67
Work in process conversion period 20
Finished goods conversion period 43 130
Debtors conversion period 69
Gross working capital cycle 199
Less: Creditor deferral period (76)
Net Cash Operating cycle 123
Cash turnover/Operating turnover

This shows number of times a company needs to replenish its working capital in a year.
Number of days in a year
ℎ =
Fixed assets turnover

This indicates level of sales generated by fixed asset base of a company. It shows the
efficiency with which a company utilizes its assets to generate sales.
Sales
Fixed assets turnover =
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4 FINANCIACCD Y T E X T
5. INVESTMENT OR EQUITY RATIOS
Fast forward - These are used to evaluate the overall performance of a company
Earnings Per Share (EPS)
This indicates the amount shareholders expect to generate in form of earnings for every
share invested. It shows profitability of a company on a per share basis.
Earnings attributable to equity shareholders

=
ℎ
Dividend per Share (DPS)

This represents the amount of cash dividend that shareholders expect to receive for every
share invested in the company.
Total ordinary dividends
Dividend Per Share =
ℎ
Dividend pay out ratio

This indicates proportion of earnings attributable to equity shareholders that are paid out to
common shareholders as dividends. It is used in analysis of dividend policy of the firm.
Total common dividends

= 100
ℎ ℎ
Dividend per share

= 100
ℎ
Dividend retention ratio
= 100
ℎ ℎ
Dividend cover
Earnings per share (EPS)
=
ℎ ( )
Earnings yield
This measures the potential return that shareholders expect to earn for every share invested
in a company. It evaluates the shareholders returns in relation to the market value of a share.
Earnings per share (EPS)

= 100
ℎ ( )
DYTEXT
Dividend yield
This ratio measures how much an investor expects to receive from cash dividends for every
share purchased or invested in a company.
Dividend per share (DPS)
= 100
ℎ ( )
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Price earnings ratio

This indicates how much an investor is prepared to pay for a company’s share given its
current earnings per share. The higher the price earnings ratio, the more confident investors
are that the company will perform well in future.
ℎ ( )
=
ℎ ( )
1. Short term solvency or liquidity measure

Here the primary concern is the firm’s ability to pay its bills over the short term without
undue stress. Consequently this ratios focus on current assets and liabilities.
Illustration for business performance analysis
The following two financial statements will be used in calculation of ration to determine
business performance. The figures are in millions.
BRIDGEVIEW COMPANY LTD

STATEMENT OF FINANCIAL POSITION AS AT 31st DECEMBER
2010 2011
Non-current Assets
Net plan and equipment 2731 2880
Current assets
Cash 84 98
Accounts receivables 165 188
Inventory 393 422
Total 642 708
Total assets 3373 3588
Liabilities and owners equity
Current liabilities
Accounts payable 312 344
Notes payable 231 196
Total 543 540
Long term debt 531 457
Owners equity
Common stock and paid-in surplus 500 550
Retained earnings 1799 2041
Total 2299 2591
Total liabilities and equity 3373 3588
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Income statement for 2011
Sales 2311
Cost of goods sold 1344
Depreciation 276
Earnings before interest and Tax 691
Interest paid 141
Taxable income 550
Taxes (34%) 187
Net income 363
Dividends 121
Assume also that 33 million shares were outstanding at the end of 2010 and 2011. Market
price per share is ksh 88.
Required: calculate the key ratios the financial statements above and state the importance
of the ratios calculated.
Solution:
a) Current ratio.
=
708
= 1.31
540
The higher the current ratio, the better the company is in covering current liabilities. But at
the same time it may mean an inefficient use of assets such as having excess inventory.
b) Quick (acid test ratio)
Base inventory is the least record of current assets, the acid test ratio doesn’t take
consideration of inventory and therefore this ratio is written as
−
708 − 422
= 0.53
540
In this case the company has fewer current assets covering current liabilities.
c) Cash ratio
A very short term creditor may be interested in the cash inventory.
ℎ
98
= 0.18
540
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d) Net working capital to total assets
708 − 540
× 100 = 4.7%
3588
Since net working capital is frequently viewed as a ratio of short term liquidity of a firm, it
is measured relative to total assets. A relatively low value may indicate relatively low
liquidity levels.
e) Interval measure
This assumes operations were disrupted but the company is still compelled to pay some
short-term obligations. It tries to find out how much will current assets cover daily
operating costs.
=
Average daily operating cost from our illustration assumed to be
1344
= = 3.68
365 365
Therefore IM
708
= = 192
3.68
2. Long term solvency measures

This group of ratios is intended to measure the firm’s long run ability to meet its obligations
or more generally it’s financial. These are sometimes called financial leverage ratios or
leverage ratios.
i. Total debt ratio

It takes into account all debts of all maturities to all creditors.
−
=
3588 − 2591
= 0.28
3588
ii. Debt-equity ratio
=
540 + 457
= 0.38
2591
iii. Equity multiplier
=
3588
= = 1.38
2591
iv. Long term debt ratio
This ratio takes into account only long term debt and not short term obligation. The formula
is
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=
+
457
= = 0.15
457 + 2591
The long term debt + equity is sometimes called firms capitalization.

v. Times interest earned
This ratio measures how well a company has its interest obligation covered.
=
691
= = 4.9
141
vi. Cash coverage

The difference between cash coverage and times interest earned is that depreciation not
being an item involving movement of cash is added back to EBIT.
+
ℎ =
691 + 276
= = 6.9
141
3. Asset management/turnover ratio

Sometimes called asset neutralization ratios, the ratios in this category are intended to
describe how efficiently or intensely a firm uses its assets to generate sales.
a) Inventory turnover and Day sales in inventory
=
1344
= = 3.2
422
Inventory was turned 3.2 times. It may also be imperative to use average inventory figures
if they are available.
b) Day sales inventory
365
=
365
= = 114
32
It tells that on average inventory sits in store for 114 days before it is sold.
c) Receivables turn over
This measures how fast receivables are collected.
2311
= 12.3
188
This means that outstanding credit were collected and reloaded 12.3 times during the years.
d) Day sales and receivables/ average collection period
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365
=
365
= = 29.67
12.3
On average credit sales were collected in 30 days.
e) Networking capital ratio or sales

Ratios measures how much would we get out of our working capital.
2311
= 13.8
(708 − 540)
f) Fixed asset turnover
2311
= 0.80
2880
g) Total asset turnover
2311
= 0.64
3588
For every shilling invested in assets we generate sh.0.64 sales
4. Profitability measures
These measures are intended to measure how efficiently the firm uses its assets and how
efficiently the firm manages its operations. The focus in the group is on the bottom line i.e.
income
a. Profit margin
363
= 15.7%
2311
b. Return on assets
363
= 10.12%
3588
c. Return on equity
363
= 14%
2591
5. Market value measures

These ratios are crucial when comparing the earning power of an organization and its
distribution (of dividend) policy with other organizations.
i. Price Earnings ratio
⁄ =
Page 243
363
= = = 11
ℎ 33
88
⁄ =
11
=8
We can interprete this to mean that Bridgeview’s shares sell for 8 times to earning.
ii. Market-Book ratio
=
88
= = 1.2
2591
33
Book value in this case is total equity, not just common stock divided by no. of shares
outstanding. The better if the ratio is more than one meaning share is doing well in the
market.
iii. Dividend payout ratio
This measures amount of cash paid out to shareholders
ℎ
=
121
= = 0.33
363
iv.
Retention/plough back ratio
=1−
Because everything paid is retained.
v. Capital intensity ratio
=
It’s the reciprocal of assets turnover ratio .
Du-Pont identity
This was developed by du-Pont Company of USA. Du-Pont identity asserts that R.O.E is
affected by 3 things
- Operating efficiency (as measured by profit margin)
- Assets use efficiency (as measured by total assets turn over)
- Financial leverage (as measured by equity multiplier)
= × × =
Decomposing Du-Point multiplier further (5way Du-Point multiplier)

The 5 way Du-Point decomposition is the one found in financial data bases such as
Bloomberg. According to this formula
= × × × × =
a.
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=
It measures how much of a company’s pre-tax profit it gets to keep.
b.
=
It captures the effects of interest on ROE
c.
=
Measures effect of operating profitability on ROE
d.
=
Indication of overall efficiency of the company
e.
=
It’s the total amount of a company’s assets relative to its equity capital.
Simply put the decomposition of Du-Point identity into 5 components expresses a
company’s ROE as a function of its tax rate, interest burden, operating profitability
efficiency, efficiency and leverage. An analyst uses this framework to determine what
factors are driving the companies ROE.
LIMITATIONS OF RATIOS ANALYSIS
1. Subjectivity
Ratios are subjective to accounting information that depends on the accounting
policies adopted by a particular organization hence making it impossible for cross
sectional analysis if a company uses different accounting policies. It is difficult to
categorize firms due to diversifications i.e. some companies have more than one line
of business and thus will fall into several industries thus difficult in ratio comparison.
2. Irrelevance
Ratios are historical figures which may irrelevant in making future decisions.
3. Qualitative aspects are ignored

Qualitative aspects such competent management, experience and motivation of
employees are not captured in computation of ratios.
4. Ambiguity
Different people will use different stances to describe financial information e.g.
including preference share capital in equity or return on capital being referred to as
gross capital employed.
5. Usefulness
Ratios are computed at a specific point in time. By the time they are analyzed for
decision making, circumstances may have changed thus ratios are only useful in the
short term
Page 245
6. Monopoly
For a company without competitor, it may not be .possible to analyze its
performance with other companies in the same industry.
COMMON SIZE STATEMENTS
Common size financial statement analysis is analyzing the balance sheet and income
statement using percentages. All income statement line items are stated as a percentage of
sales. All balance sheet line items are stated as a percentage of total assets. For example, on
the income statement, every line item is divided by sales and on the statement of financial
position every line item is divided by total assets.
This type of analysis enables the financial manager to view the income statement and
balance sheet in a percentage format which is easy to interpret.
As with financial ratio analysis, you can compare the common size income statement from
one year to other years of data to see how your firm is doing. It is generally easier to make
that comparison using percentages rather than absolute numbers.
Common size ratios offer simple comparisons. We have common size ratios for both the
balance sheet (where you compare total assets) and the income statement (where you
compare total sales):
 To get a common size ratio from a balance sheet, the total assets figure is assigned the
percentage of 100 percent. Every other item on the balance sheet is represented as a
percentage of total assets. For example, if SAM has total assets of shs.10, 000 and debt
of shs.3, 000, then debt equals 30 percent (debt divided by total assets, or shs.3, 000 ÷
shs.10, 000, which equals 30 percent).
 To get a common size ratio from an income statement (or profit and loss statement),
you compare total sales. For example, if SAM has shs.50,000 in total sales and a net
profit of shs.8,000, then you know that the profit equals 16 percent of total sales.
Common Size Statements

In order to avoid the limitations of Comparative Statement, this type of analysis is designed.
Under this method, financial statements are analyzed to measure the relationship of various
figures with some common base. Accordingly, while preparing the Common Size Profit and
Loss Account, total sales are taken as common base and other items are expressed as a
percentage of sales. Like this, in order to prepare the Common Size Balance Sheet, the total
assets or total liabilities are taken as common base and all other items are expressed as a
percentage of total assets and liabilities.
Here is an example of a common size analysis of an income statement and balance sheet
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Illustration
From the following particulars of AVS Ltd., for the year 2002 and 2003, you are required to
prepare a common size Income Statement:
Statement of Profit and Loss Account
Particulars 2002 2003

Sh. Sh.
Net Sales 4,000 5,000
Less : Cost of Goods Sold 3,750 3,750
Gross Profit 1,000 1,250
Less : Operating Expenses :
Office & Administrative Expenses 200 250
Selling & Distribution Expenses 225 300
Total Operating Expenses 425 550
Net Profit 575 700
Solution
Common Size Income Statement

Particulars 2002 Percentage 2003 Percentage
Sh. (% ) Sh. ( %)
Net sales 4,000 100 5,000 100
Less : Cost of Goods Sold 3,000 75 3,750 75
Gross Profit 1,000 25 1,250 25
Less: Operating Expenses:
Office and Administrative 100 2.5 100 2
Expenses
Selling and Distribution 150 3.75 200 4
Expenses
Total Operating Expenses 250 6.25 300 6
Net Profit 750 18.75 950 19
Illustration
From the following statement of financial position, prepare a Common Size statement of
financial position:
Statement of Financial Position

Page 247
Liabilities 2002 2003 Assets 2002 2003

Share Capital 2,64,000 2,80,000 Cash in Hand 10,000 10,750
Current Liabilities 65,000 70,000 Cash at Bank 3,500 5,000
Long-term Debt 1,00,000 87,500 Bills Receivable 22,500 22,750
Bills Payable 12,500 - Sundry Debtors 90,000 85,000
Sundry Creditors 10,000 16,000 Inventories 70,000 83,000
Bank Overdraft 50,000 71,500 Fixed Assets 300,000 307,500
Prepaid Expenses 5,500 10,500 - -
501,500 525,000 501,500 525,000
Solution
Common statement of financial position.
Particulars 2002 Percentage 2003 Percentage
(% ) (% )
Assets :
Current Assets :
Cash in Hand 10,000 1.99 10,750 2.05
Cash at Bank 3,500 0.69 5,000 0.95
Sundry Debtors 90,000 17.95 85,000 16.29
Inventories 70,000 13.96 83,000 15.81
Bills Receivable 22,500 4.48 22,750 4.3
Prepaid Expenses 5,500 1.09 10,500 2.00
Total Current Assets 201,500 40.18 17,500 41.43
Fixed Assets 300,000 59.82 307,500 58.57
Total Assets 501,500 100 % 525,000 100%
Liabilities & Capital :

Current Liabilities 65,000 12.96 70,000 13.33
Bills Payable 12,500 2.50 - -
Sundry Creditors 10,000 1.99 16,000 3.05
Bank Overdraft 50,000 9.97 71,500 13.62
Total Current Liabilities 137,500 27.42 157,500 30
Long. Term Liabilities
Long-Term Debts 100,000 19.94 87,500 16.66
Capital and Reserve :Share
Capital 264,000 52.64 280,000 53.34
Total Liabilities 501,500 100 % 525,000 100%
FINANCIAL PLANNING AND FORECASTING
Dimensions of financial planning
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1. Planning horizon-it is the long range time period financial planning process.
Focuses on usually the next 2-5 years.
2. Aggregation- it is the process by which smaller investment proposals of the firms
operational units are added up and treated as one major project.
Benefits of planning
1. Interactions - The financial plan makes explicit linkages between investment

proposals for the different operating activities of the firm and the financing sources
available to the firm.
2. Options - The financial plan provides the opportunity for the firm to develop,
analyze and compare many different scenarios and does viability of options.
3. Avoiding surprises – Financial plan identifies what may happen to the firm if
different events take place, financial plan does employ anticipatory approach as a
tool for risk management.
4. Feasibility and consistency- To generate a coherent plan, goals and objectives will
have to be modified and priorities will have to be established.
Financial Forecasting
Financial forecasting refers to determination of financial requirements of the firm in
advance. This requires financial planning using budgets.
The financial planning and forecasting will also determined the activities the firm should
undertake in order to achieve its financial targets.
Financial forecasting is important in the following ways:

1. Facilitate financial planning i.e. determination of cash surplus or deficit that are likely
to occur in future.
2. Facilitate control of expenditure. This will minimize wastage of financial resources in
order to achieve financial targets.
3. It avoids surprise to the manager’s 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.
4. Motivation to the employees – Financial forecasting using budgets and targets will
enhance unity of purpose and objectives among employees who are determined to
achieve the set target.
Methods/Techniques of Financial Forecasting
1. Use of Cash Budgets

A cash budget is a financial statement indicating:
Page 249
a) Sources of revenue and capital cash inflows

b) How the inflows are expended to meets revenue and capital expenditure of the firm.
c) Any anticipated cash deficit/surplus at any point during forecasting period.
2. Regression Analysis
This is a statistical method which involves identification of dependant and independent
variable to form a regression equation *y = a + bx) on which forecasting will be based.
3. Percentage of Sales Method

This method involves expressing various balance sheet items that are directly related to
sales as a percentage of sales. It involves the following steps:
i) Identify various balance sheet items that are directly with sales this items include:
a) Net fixed asset – If 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.
b) Current Asset – An increase in sales due to increased production will lead to
increase in stock of raw materials, finished goods and work in progress. Increased
credit sales will increase debtors while more cash will be required to buy more raw
materials in cash.
c) Current liabilities – Increased sales will lead to purchase of more raw materials
d) Retained earnings – This will increase with sales if and only if, the firm is operating
profitability and all net profits are not paid out as dividend.
Note
The 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 project.
ii) Express the various balance sheet items varying with sales as percentage of sales
e.g. assume for year 2002 stock and net fixed assets amount to Sh.12M and 18M
respectively sales amount to Sh.40M. Therefore stock as percentage of sales”
12 M
Stock = x100  30%
40 M
18M
Fixed asset = x100  45%
40 M
iii) Determine the increase in total asset as a result of increase in sales e.g suppose sales
increases from Sh.40 M to Sh.60 M during year 2003. The additional stock and net
fixed asset required would be determined as follows:
Increase in stock = % of sales x increase in sales
= 30% (60 – 40) = Sh.6M

Increase in fixed asset = % of sales x increase in sales
= 45%(60 – 40) = Sh.9 M
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iv) Determine the total increase in assets which will be financed by:
a) Spontaneous source of finance i.e increase in current liabilities

Where Increase = % of sales x increase in sales
b) Retained earnings for the forecasting period

Retained earnings = Net profit – Dividend paid
Net profit margin = Net profit

Sales
Therefore: Net profit = Net profit margin (%) x sales
Note
Generally Net profit margin is called after tax return on sales.
 Out of the total assets that are required as a result of increase in sales, the financing will
come from the two sources identified. Any amount that cannot be met from the two
sources will be borrowed externally on short term basis which will be a current
liability.
Assumptions underlying % of sales method

The fundamental assumption underlying the use of % 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.
Other assumptions include:

1. The firm is operating at full or 100% capacity. Therefore the increase in production
will require acquisition of new fixed assets.
2. The firm will not issue new ordinary shares or debenture or preference shares thus this
capital will remain constant during the forecasting period.
3. The relationship between balance sheet item and sales i.e balance sheet items as % of
sales will be maintained during forecasting period.
4. The after tax, profit on sale or net profit margin will be achieved and shall remain
constant during the forecasting period.
Page 251
Illustration
The following is the balance sheet of XYZ Ltd as at 31st December 2002:
Sh.’000’
Net fixed asset 300
Current assets 100
400
Financed by: 100

Ordinary share capital 70
10% debentures 50
Trade creditors 30
Accrued expenses 400
Additional Information
1. The sales for year 2002 amounted to Sh.500,000. The sales will increase by 15%
during year 2003 and 10% during year 2004.
2. The after tax return on sales is 12% which shall be maintained in future.
3. The company’s dividend payout ratio is 80%. This will be maintained during
forecasting period.
4. Any additional financing from external sources will be affected through the issue of
commercial paper by company.
Required
a) Determine the amount of external finance for 2 years upto 31st December 2004.
b) Prepare a proforma balance as at 31 December 2004
Solution
Identify various items in balance sheet directly with sales:
 Fixed Asset
 Current Asset
 Trade creditors
 Accrued expenses
Net fixed assets = 300M x 100 = 60%

500M
Current Assets = 100M x 100 = 20%

500M
Trade creditors = 50 x 100 = 10%

500
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Accrued expenses = 30 x 100 = 6%

500
c) Compute the increase in sales over the 2 years.
115
Year 2003 sales = 500x  575M
100
115
Year 2004 sales = 575x  632.5M
100
Increase in sales in 2003-2004 = 632.5 – 500 = 132.5M
d) Compute the amount of external requirement of the firm over the 2 years of
forecasting period.
i) Increase in F. Assets= % of sales x increase in sales

= 60% × 132.5 = 79.5M
ii) Increase in C. Assets = % of sales × increase in sales
= 20% of 132.5 = 26.5M
Total additional investment/asset required 106M
Interpretation
For the company to earn increase in sales of 132.5M it will have to acquire additional
assets costing 106M.
Sh.’000’
Additional investment/asset required 106,000
Less: Spontaneous source of finance
Increase in creditors = % of sales x increase in sales
= 132,500 x 10% (13,250)
Increase in accrued expenses = % of sales x increase in sales
= 132,500 x 6% (7,950)
Less: Retained earnings during 2 years of operation (initial sources)
Net profit for 2003 = Net profit margin x sales of 2003
= 12% of 575,000 = 69,000
Less: Dividend payable 80% of 69,000 = 55,200 (13,800)
Net profit for 2004 = Net profit margin x sales of 2004
= 12% of 632,500 = 75,900
Less: dividend payable 80% of 75,900 = 60,720 (15,180)
External financial needs (commercial paper) 55,820
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Proforma Balance Sheet

This refers to the projected balance sheet at the end of forecasting period. The items in the
proforma balance which vary with sales would be determined in any of the following two
ways:
i) % of sales x sales at last year of forecasting (2004); or
ii) Balance sheet item before forecasting plus increase in balance sheet item as a result
of increase in sales.
Proforma balance sheet as at 31st December 2004

Sh.
Net fixed assets 60% x 632.5 or 300 + 79.5 379.50
Current Assets 20% x 632.5 or 100 + 26.5 126.50
506.00
Ordinary shares (will remain constant) 100.00
Retained earnings 70 + 13.8 + 15.18 98.98
10% debenture (remain constant) 150.00
Trade creditor 10% x 632.5 or 50 + 13.25 63.25
Accrued expenses 6% x 632.5 or 30 + 7.95 37.95
External borrowing – commercial 55.82
506.00
EXTERNAL FINANCING AND GROWTH
External financing needs and growth are obviously related. All other things are the same.
The higher the growth rate in sales/assets, the greater will be the need for external
financing.
Financial policy and growth

 Internal growth rate
This is the maximum growth rate that can be achieved with no extra financing of any kind.
×
ℎ =
1− ×
Where, ROA=return on assets and

b= retention ratio.
Example:
Assume net income is sh.66M. Total assets are 500M and of the 66M, 44M was retained.
Calculate internal growth rate or the maximum growth rate that can be attained with no
external financing?
Page 254
66
= = 0.132
500
44
= = 0.69
66
0.132 × 0.67
ℎ = = 0.0097
1 − 0.132 × 0.67
= 9.7%
Therefore the company can expand at a maximum rate of 9.7% per year without external
financing
.
 Sustainable growth rate
In the previous example, if the company wishes to grow more rapidly than 9.7%, the
external finance must be arranged. The sustainable growth rate is the maximum growth rate
a firm can achieve without external equity financing while maintaining constant debt:
equity ratio.
It is the maximum rate of growth a firm can attain without increasing its financial leverage.
No issue of equity.
×
=
1− ×
Example:
If net income is 66M and total equity is 250M and the plough back ratio is 0.67.
66
= = 0.264
250
0.264 × 0.67
=
1 − 0.264 × 0.67
= 21.36%
The company can expand at a maximum rate of 21.36% per year without external equity
financing. The company wills most likely increase its equity through retained earnings.
However, if the company doesn’t have sufficient R/E it will have to borrow to finance
growth but still not use external equity. In the above example ROE, plough back ratio i.e.
0.67 is the same as in the earlier illustration.
Determinants of growth
1. Profit margin
-An increase in profit margin will increase the firm’s ability
2. Dividend policy
-A decrease in the percentage of net income paid out as a dividend will increase the
retention ratio. This increases the internally generated equity and therefore increases
sustainability.
3. Financial policy
-An increase in D: E ratio increases the firm’s financial leverage. Since this makes
additional debt financing available, it increases the sustainable growth rate.
4. Total asset turnover
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-An increase in the firms total asset turnover increases the sales generated for each
dollar in asset. This increases the firms need for new assets as sales growth and thereby
increases SGR
Financial distress
Financial distress indicates a condition when promises to creditors of a company are broken
or honored with difficulty. Sometimes it leads to bankruptcy.
Cost of financial distress

 Bankruptcy cost
Includes audit fees, legal fees and management fees
 Reduction in management efficiency
Financial distress in companies leads to problems that can reduce efficiency of
management. This is due to the shift of focus from long term to short term gains among
managers, principally due to diminished commitment. Also good staff leaves the firm for
better opportunities.
 Conflict of interest between shareholders and creditors
As the firms liquidation values slips below its debt, its shareholders interest that the
company invests in risky projects which increases the probability of the firm’s value to go
below debt. Risky project are not in the interest of creditors, since they increase the
probability of the firms value to decrease further, leaving them with even less. Since these
projects do not necessarily have a positive NPV, costs may rise from lost profits.
Management may also choose to distribute to save money from the creditors.
 High cost of capital
With financial distress of a company short term loans from creditors and banks will be
given to the firm at higher interest rates because of poor credit standing.
Options for relieving financial distress

- Debt restructuring
This is a process that allows a public company or sovereign entity facing cash flow
problems and financial distress to reduce and negotiate its deluges in order to improve or
restore liquidity rehabilitate so that it can continue its operation.
- Bankruptcy
If promises to creditors cannot be kept,, bankruptcy becomes an option for both companies
and individuals
Predicting business failure
Business failure can be predicted using linear discriminant model. Linear discriminant
models divide firms into high or low bankruptcy classes based on their financial
characteristics. The widely used model is the Altman’s Z-score.
Altman’s Z-score
It is a quantitative method of determining a company’s financial health and likehood of
bankruptcy.
The Z-score model is the 1960’s brain child of professor Edward Altman of NYU. It uses 8
variables that are EBIT, total assets, and net sales, market value of equity, total liabilities,
current assets, current liabilities and retained earnings.
The formula for the Z-score:
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− = 1.2 + 1.4 + 3.3 + 0.6 + 1.0
ℎ , =
Interpretation of Altman’s Z-score

Z-score above 3 means a company is considered safe based on financial figures only.
Z-score between 2.7 and 2.99 means this is the zone where one should exercise caution. It
could mean the performance of the company is at risk.
Z-score between 1.8 and 2.7 means there is a good chance of a company going bankruptcy
within 2 years of operations from the date of financial statement/figures.
Z-score below 1.8 means the probability of financial embarrassment is very high and
chances of the firm surviving are minimal.
Question:
Using the financial statement of 2011 of Bridgeview Company, Calculate the Z-score for
the company and interprete the results.
Solution
− = 1.2 + 1.4 + 3.3 + 0.6 + 1.0
−
= =
708 − 540
= = 0.047
3588
2041
= = 0.569
3588
Page 257
691
= = 0.193
3588
= +
= 457 + 540 = 997
= 33 × 88 = 2904
2904
= = 2.91
997
=
2311
= = 0.64
3588
− = 1.2 + 1.4 + 3.3 + 0.6 + 1.0

− = 1.2(0.047) + 1.4(0.569) + 3.3(0.193) + 0.6 + 1.0(0.64)
= 3.5799
QUESTION
(a) Outline two types of information which could be obtained from the following sources:
i. Proxy statement (2 marks)
ii. Corporate press release (2 marks)
iii. Annual reports to regulators (2 marks)
(c) The top management of Zedrock Limited has provided you with the following
financial statements relating to its two divisions, alpha and beta, for the year
ended 30 June 2012
Page 258
Income statement for the year ended 30 June 2012

Alpha Division Beta Division
Sh.”millions” Sh.”millions”
Revenue 4,000 6,000
Cost of sales (3,000) (4,800)
Gross profit 1,000 1,200
Expenses:
Distribution costs 200 150
Administrative expenses 290 250
Interest paid 10 400
(500) (800)
Profit before tax 500 400
Income tax expense (120) (90)
Profit after tax 380 310
Dividend paid (150) (100)
Retained profit for the year 230 210
Retained profit brought forward 220 2,480
Retained profit carried forward 450 2,6900
Statement of financial position as at 30 June 2012:

Sh.”millions” Sh.”millions”
Non-current assets at cost:
Land and buildings 1,200 5,000
Furniture and motor vehicles 600 1,000
1,800 6,000
Current assets:
Inventory 400 800
Trade receivables 850 750
Financial assets 100 230
Cash at bank - 100
1,350 1,880
Total assets 3,150 7,880
Equity and liabilities:

Ordinary share capital(sh.1 par value) 1,000 1,600
Retained profits
450 2,690
1,450 4,290
Non-current liabilities:
Bank loan 500 3,000
Current liabilities:
Accounts payable 1,080 590
Bank overdraft 120 -
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1,200 590
3,150 7,880
Additional information:
1. The two divisions sell goods on both cash and credit terms. On average, the credit sales
account for 80% of the total sales while purchases account for 90%
2. The cash flow from operating activities for the two divisions are sh.750 millions and
sh.800 million respectively.
3. The division deal with electronic goods.
Required:
(i) Common size income statement for the year ended 30th June 2012 (6 marks)
(ii) Common size statement of financial position as at 30th June 2012 (6 marks)
(iii)Comment on the performance of the two divisions and state which division and state is better
(2 marks)
(Total: 20 marks)
Suggested solution:
a) Proxy statements
A proxy is a means whereby a shareholder authorizes another person to act for him or her at
a meeting of shareholders. A proxy statement contains information necessary for
shareholders in voting on matters for which the proxy is solicited.
Proxy statements contain pertinent information regarding a company including:-
i. The identity of shareholders owning 5% or more of the outstanding shares.
ii. Biography information on the BOD
iii. compensation arrangement with officers and directors
iv. Employees benefit plans and certain transactions with officers and directors related
parties.
v. Voting procedures and information
vi. Background information about the company’s nominated directors
vii. Executive compensation
Corporate press release

These are news that follows within the publishing requirements of a company. They
includes:-
i. Recent financial statements released and key performances
ii. Any new important information like change of management, new products or
strategies
Annual report to Regulators

These should include:-
i. Mergers, consolidation, acquisition and similar matters
ii. Financial statements
iii. Audited accounts and reports
 Based on the income statement, Alpha division appears to be better than Beta
division in terms of gross profit, net profit margin and profits retained.
Page 260
 Based on the statement of financial position, Beta division seems to be better

because it has more capital than alpha and its non-current asset base is better.
b)
Zedrock Limited
Common size Income statement for the year ended 30 June 2112

% % % %
sales 100 100
Cost of sales (75) (80)
Gross profit 25 20
Expenses:
Distribution costs 5 2.5
Administrative expenses 7.25 4.16
Finance cost 0.25 6.67
(12.5) (13.33)
Gross Profit 12.5 6.67
Income tax expense (3) (1.50)
Profit after tax 9.5 5.17
Dividend paid
(3.75) (1.67)
Retained profit for the year 5.75 3.50
Zedrock Limited
Statement of financial position as at 30 June 2012:
% % %
%
Non-current assets at cost:
Land and buildings 38 63.5
Furniture and motor vehicles 19 12.6
57 76.1
Current assets:
Inventory 12.8 10.2
Trade receivables 27.0 9.5
Financial assets 3.2 2.9
Cash at bank - 43 1.3 23.9
Total assets 100 100
Equity and liabilities:

Ordinary share capital(sh.1 par value) 31.7 20.3
Retained profits 14.3 34.1
46 54.4
Non-current liabilities:
Bank loan 15.9 38.1
Current liabilities:
Accounts payable 34.3 7.5
Bank overdraft 3.8 38.1 - 7.5
100 100
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TOPIC 9
WORKING CAPITAL MANAGEMENT
INTRODUCTION AND CONCEPTS OF CAPITAL MANAGEMENT

Management of Working Capital is also an important part of financial manager. The main
objective of the Working Capital Management is managing the Current Asset and Current
Liabilities effectively and maintaining adequate amount of both Current Asset and Current
Liabilities. Simply it is called Administration of Current Asset and Current Liabilities of the
business concern.
Management of key components of working capital like cash, inventories and receivables
assumes paramount importance due to the fact the major portion of working capital gets
blocked in these assets.
Meaning
Working capital management is an act of planning, organizing and controlling the

components of working capital like cash, bank balance inventory, receivables, payables,
overdraft and short-term loans.
Definition
According to Smith K.V, “Working capital management is concerned with the problems
that arise in attempting to manage the current asset, current liabilities and the inter-
relationship that exist between them”.
According to Weston and Brigham, “Working capital generally stands for excess of
current assets over current liabilities. Working capital management therefore refers to all
aspects of the administration of both current assets and current liabilities”.
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FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS OF A FIRM
Requirements Of working capital depend upon various factors such as nature of business,
size of business, the flow of business activities. However, small organization relatively
needs lesser working capital than the big business organization. Following are the factors
which affect the working capital of a firm:
1. Size of Business
Working capital requirement of a firm is directly influenced by the size of its business
operation. Big business organizations require more working capital than the small business
organization. Therefore, the size of organization is one of the major determinants of
working capital.
2. Nature of Business
Working capital requirement depends upon the nature of business carried by the firm.
Normally, manufacturing industries and trading organizations need more working capital
than in the service business organizations. A service sector does not require any amount of
stock of goods. In service enterprises, there are less credit transactions. But in the
manufacturing or trading firm, credit sales and advance related transactions are in large
amount. So, they need more working capital.
3. Storage Time or Processing Period

Time needed for keeping the stock in store is called storage period. The amount of working
capital is influenced by the storage period. If storage period is high, a firm should keep
more quantity of goods in store and hence requires more working capital. Similarly, if the
processing time is more, then more stock of goods must be held in store as work-in-
progress.
4. Credit Period
Credit period allowed to customers is also one of the major factors which influence the
requirement of working capital. Longer credit period requires more investment in debtors
and hence more working capital is needed. But, the firm which allows less credit period to
customers’ needs less working capital.
5. Seasonal Requirement
In certain business, raw material is not available throughout the year. Such business
organizations have to buy raw material in bulk during the season to ensure an uninterrupted
flow and process them during the entire year. Thus, a huge amount is blocked in the form of
raw material inventories which gives rise to more working capital requirements.
6. Potential Growth or Expansion Of Business

If the business is to be extended in future, more working capital is required. More amount
of working capital is required to meet the expansion need of business.
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 Classifications
 Small business loan
 Small Business
 Small business owner
7. Changes in Price Level

Change in price level also affects the working capital requirements. Generally, the rise in
price will require the firm to maintain large amount of working capital as more funds will
be required to maintain the sale level of current assets.
8. Dividend Policy
The dividend policy of the firm is an important determinant of working capital. The need
for working capital can be met with the retained earning. If a firm retains more profit and
distributes lower amount of dividend, it needs less working capital.
9. Access to Money Market

If a firm has good access to capital market, it can raise loan from bank and financial
institutions. It results in minimization of need of working capital.
10. Working Capital Cycle

when the working capital cycle of a firm is long, it will require larger amount of working
capital. But, if working capital cycle is short, it will need less working capital.
11. Operating Efficiency

The operating efficiency of a firm also affects the firm's need of working capital. The
operating efficiency of the firm results in optimum utilization of assets. The optimum
utilization of assets in turn results in more fund release for working capital.
IMPORTANCE OF WORKING CAPITAL MANAGEMENT
Working capital is the life blood and nerve center of business. Working capital is very
essential to maintain smooth running of a business. No business can run successfully
without an adequate amount of working capital. The main advantages or importance of
working capital are as follows:
1. Strengthen The Solvency

Working capital helps to operate the business smoothly without any financial
problem for making the payment of short-term liabilities. Purchase of raw materials
and payment of salary, wages and overhead can be made without any delay.
Adequate working capital helps in maintaining solvency of the business by providing
uninterrupted flow of production.
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2. Enhance Goodwill
Sufficient working capital enables a business concern to make prompt payments and
hence helps in creating and maintaining goodwill. Goodwill is enhanced because all
current liabilities and operating expenses are paid on time.
 Financial Forecast
 Financial Forecasting
 Advantages of solar panels
 Bond
3. Easy Obtaining Loan

A firm having adequate working capital, high solvency and good credit rating can
arrange loans from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material

Quick payment of credit purchase of raw materials ensures the regular supply of raw
materials from suppliers. Suppliers are satisfied by the payment on time. It ensures
regular supply of raw materials and continuous production.
5. Smooth Business Operation

Working capital is really a life blood of any business organization which maintains
the firm in well condition. Any day to day financial requirement can be met without
any shortage of fund. All expenses and current liabilities are paid on time.
6. Ability to Face Crisis

Adequate working capital enables a firm to face business crisis in emergencies such
as depression.
THE WORKING CAPITAL CYCLE
The volume of working capital depends on the amount blocked in current assets. These
amounts are released over a time period and gradually changes shape from one item to
another. This changing process rotates in a cyclical order.
The length of the cycle or the time taken to rotate the cycle once is known as the working
capital cycle or the operating cycle.
The operating cycle of a company can be said to cover distinct stages, each stage requiring
a level of supporting investment. The time gap between the firm’s paying cash for
materials, entering into work in process, making finished goods, selling finished goods to
the debtors and the inflow of cash from debtors is known as working capital or operating
cycle. According to the nature of business the duration of working capital cycle varies. It is
the responsibility of the finance manager to shorten the length of working capital cycle.
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For a manufacturing firm, the cycle starts with the investment made in raw materials and
other components. The inventories can be bought on trade credit as a result creditors will
increase. Further goods are manufactured that are sold on credit as a result debtors will
increase. Finally debtors pay in the form of cash or cheque and consequently creditors are
paid out. How cash makes its journey through different stages has been depicted in Figure
7.3.
Reasons for a Longer Operating Cycle:
Working capital requirements depend on the operating cycle. It starts with payment for
acquisition of raw materials and ends with the collection of receivables from debtors. The
duration of the working capital cycle varies according to the nature of business.
The reasons for longer operating cycle are given below:
1. Firstly the working capital cycle may be longer if the availability of raw materials is
not easy. As a result the organization will have to hold large amount of raw materials
in stores.
2. Secondly the processing period may be longer. The nature of the product is such that
the product passes through various departments to get finished.
3. Thirdly the product may be slow moving. In that case the time taken to deplete the
finished goods stock will be longer.
4. Finally the credit policy and the inefficiency of the organization in debt collection
also increase the length of operating cycle.
Measuring the Operating Cycle:
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Formula
Operating Cycle = Days' Sales of Inventory + Days Sales Outstanding
Days sales of inventory equals the average number of days in which a company sells its
inventory. Days sales outstanding on the other hand, is the period in which receivables are
realized in cash.
An alternate expanded formula for operating income is as follows:
365 365
Operating Cycle = × Average Inventories + × Average Accounts Receivable
Purchases Credit Sales
Example
Walmart Stores Inc. (NYSE: WMT) is all about inventories. Find its operating cycle
assuming all sales are (a) cash sales and (b) credit sales. You can use cost of revenue as
approximate figure for purchases (i.e. no need to adjust it for changes in inventories).
USD in million
Revenue 469,162
Cost of revenue 352,488
Inventories as at 31 January 2013 43,803
Inventories as at 31 January 2012 40,714
Average inventories 42,259
Accounts receivable as at 31 January 2013 6,768
Accounts receivable as at 31 January 2012 5,937
Average accounts receivable 6,353
Solution
Part (a)
Days taken in converting inventories to accounts receivable = 365/352,488*42,259 = 43.75
Since there are no credit sales, time taken in recovering cash from accounts receivable is
zero. Customers pay cash right away.
Operating cycle is 43.75 days and this represents the time taken in selling inventories.
Part (a)
There is no change in days taken in converting inventories to accounts receivable.
Days taken in converting receivables to cash = 365/469,162*6,353 = 4.92
Operating cycle = days taken in selling + days taken in recovering cash = 43.75 + 4.92 =
48.68
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It should be compared with operating cycle of Walmart Competitors, like Amazon, Costco,
Target.
WORKING CAPITAL POLICIES
Based on the attitude of the finance manager towards risk, profitability and liquidity,
the working capital policies can be divided into following three types.
(i) Matching Approach

This approach is also known as the moderate or hedging approach. This policy aims to
balance the risk and return involved in holding too much or too little working capital. Under
this approach, the firm adopts a financial plan which involves the matching of the expected
cash inflows (sources of funds) with the expected cash outflows the (uses of funds raised).
The firm therefore moderately balances its inventories of raw materials (work-in-progress
and finished goods) to ensure that there are no down times, customer demand is adequately
met and costs of holding such inventories are limited. Also, the firm holds just sufficient
cash and cash equivalents sufficient to meet obligations as they fall due and be able to take
advantage of investment opportunities to earn interest income from otherwise idle cash.
This way, the firm is able to keep its financing costs at moderate levels. However, it should
be noted that it is quite difficult to predict the working capital requirements of a firm with a
lot of certainty.
(ii) Conservative Approach

An exact matching of assets life with the life of the funds may not be possible. In this
approach a firm aims to reduce risks by holding high levels of working capital. To achieve
this, customers are allowed generous credit terms in order to stimulate demand and finished
goods inventories are kept high to ensure availability to customers. Also, raw materials and
work in progress are high to avoid stock outs and downtime in manufacturing. To ensure
that suppliers’ goodwill is assured and hence regular supplies, the firm pays them promptly.
The firm may store excess liquidity by investing in marketable securities to minimize
shortages of cash.
This approach is good in that a business is assured of its working capital requirements.
However, the firm holds a lot of unproductive assets such as excess inventories leading to
obsolescence hence the cost of financing is very high. By holding cash and near cash
equivalents, a firm will also be forgoing a lot of worthwhile investment opportunities by.
The firm stands to lose since return on working capital is low.
(iii) Aggressive Approach

A firm using the aggressive policy aims to reduce the cost of financing. To achieve this, it
reduces the level of inventories, speeds up collection from customers and delays payments
Page 268
to suppliers. This policy is enhanced by applying techniques such as just-in-time and

economic order quantity. Such a policy has the disadvantage of increased chances of down
time due to stock outs and loss of goodwill due to delayed payments to suppliers.
Risk-Return trade-off of the three approaches:

It should be noted that short-term funds are cheaper than long-term funds. (Some sources
of short-term funds such as accruals are cost-free). 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.
The conservative approach is a low return-low risk approach. This is because the approach
uses more of long-term funds which are now more expensive than short-term funds. These
funds however, are not to be repaid within the year and are therefore less risky.
The 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.
The matching approach is in between because it matches the life of the asset and the life of
the funds financing the assets.
MANAGEMENT OF STOCK, CASH, DEBTORS AND CREDITORS
The management of cash and marketable securities is one of the key areas of working
capital management. Since cash and marketable securities are the firm’s most liquid assets,
they provide the firm with the ability to meet its maturing obligations.
Cash refers to cash in hand and cash on demand deposits (or current accounts). It therefore
excludes cash in time deposits (which is not immediately available to meet maturing
obligations).
Marketable securities are short-term investments made by the firm to obtain a return on
temporary idle funds. Thus when a firm realizes that it has accumulated more cash than
needed, it often puts the excess cash into an interest-earning instrument. The firm can
invest the excess cash in any (or a combination) of the following marketable securities.
a) Government treasury bills
b) Agency securities such as local government’s securities or parastatals securities
c) Banker’s acceptances, which are securities, accepted by banks
d) Commercial paper (unsecured promissory notes)
e) Repurchase agreements
f) Negotiable certificates of deposits
g) Eurocurrencies etc.
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MANAGEMENT OF INVENTORIES/STOCK
Manufacturing firms have three major types of inventories:

1. Raw materials
2. Work-in-progress
3. Finished goods inventory
The firm must determine the optimal level of inventory to be held so as to minimize the
inventory relevant cost.
BASIC EOQ MODEL

The basic inventory decision model is Economic Order Quantity (EOQ) model. This
model is given by the following equation:
2DC o
Q 
Cn
Where: Q is the economic order quantity

D is the annual demand in units
Co is the cost of placing and receiving an order
Cn is the cost of holding inventories per unit per order
The total cost of operating the economic order quantity is given by total ordering cost plus
total holding costs.
D
TC = ½QCn + Co
Q
Where: Total holding cost = ½QCn

D
Total ordering cost = Co
Q
The holding costs include:

1. Cost of tied up capital
2. Storage costs
3. Insurance costs
4. Obsolescence costs
The ordering costs include:
1. Cost of placing orders such as telephone and clerical costs
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2. Shipping and handling costs
Under this model, the firm is assumed to place an order of Q quantity and use this quantity
until it reaches the reorder level (the level at which an order should be placed). The
reorder level is given by the following formulae:
D
R L
360
Where: R is the reorder level

D is the annual demand
L is the lead time in days
EOQ Assumptions
The basic EOQ model makes the following assumptions:
i) The demand is known and constant over the year
ii) The ordering cost is constant per order and certain
iii) The holding cost is constant per unit per year
iv) The purchase cost is constant (Thus no quantity discount)
v) Back orders are not allowed.
Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming
year which costs Sh.50 each. The items are available locally and the leadtime in one week.
Each order costs Sh.50 to prepare and process while the holding cost is Shs.15 per unit per
year for storage plus 10% opportunity cost of capital.
Required
a) How many units should be ordered each time an order is placed to minimize inventory
costs?
b) What is the reorder level?
c) How many orders will be placed per year?
d) Determine the total relevant costs.
Suggested Solution:
2DC o
a) Q 
Cn
Where: D = 2,000 units

Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days
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2 x 2,000 x 50
Q  100units
20
DL
b) R = 360
2,000 x 7
=
360
= 39 units
D
c) No. of orders =
Q
2,000
=
100
= 20 orders
D
d) TC = ½QCn + Co
Q
2,000
= ½(100)(20) + (50)
100
= 1,000 + 1,000
= Sh.2,000
Under the basic EOQ Model the inventory is allowed to fall to zero just before another
order is received.
EXISTENCE OF QUANTITY DISCOUNTS
Frequently, the firm is able to take advantage of quantity discounts. Because these
discounts affect the price per unit, they also influence the Economic Order Quantity.
If discounts exists, then usually the minimum amount at which discount is given may be
greater than the Economic Order Quantity. If 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.
Illustration
Consider illustration one and assume that a quantity discount of 5% is given if a minimum
of 200 units is ordered.
Required;
Determine whether the discount should be taken and the quantity to be ordered.
Page 272
Solution
We need to consider the saving in purchase costs; savings in ordering costs and increase in
holding costs.
Savings in purchase price:
New purchase price = 50 x 95% = Sh.47.50 per unit

Savings in purchase price per unit = 50 – 47.50
= Sh.2.50
Total units per year = 2,000
Total savings = 2,000 x 2.50 = Sh.5,000
Savings in Ordering Cost
Assuming an order quantity of 200 units per order, the total ordering cost will be:
2,000
(50) = Sh.500
100
Ordering cost if 100 units is ordered
2,000
(100) = Sh.1,000
100
Therefore savings in ordering costs = 1,000 – 500 = Sh.500
Increase in holding costs
Holding cost if 200 units are ordered
½(200)19.75 = Sh.1,975
Holding costs if 100 units are ordered
½(100(20) = Sh.1,000
Increase in holding costs = 1,975 – 1,000 = Sh.975
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The Net Effect therefore:

Shs.
Savings in purchases costs 5,000
Savings in ordering costs 500
Total savings 5,500
Less increase in holding costs 975
Net savings 4,525
2DC o
Qd 
Cn
2 x 2,000 x 50
Qd 
19.75
Cn = 15 + 10% x 4.75 = Shs.19.75
The discount should be taken because the net savings is positive. To determine the number
of units to order we recomputed Q with discount Qd.
= 100.6 units
Decision rule:
If Qd< minimum discount quantity, then order the minimum discount quantity.
If Qd< minimum discount quantity, then order Qd.
UNCERTAINTY AND SAFETY STOCKS

Usually demand requirements may not be certain and therefore the firm holds safety stock
to safeguard stock out cases. The existence of safety stock can be illustrated by Figure 5.7.
The safety stock guards against delays in receiving orders. However, carrying a safety
stock has costs (it increases the average stock).
Illustration
Consider illustration one and assume that management desires to hold a minimum stock of
10 units (this stock is in hand at the beginning of the year).
Required
a) Determine the re-order level
b) Determine the total relevant costs
Suggested solution
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DL
a) R = S
360
Where: S is the safety stock
2,000
= x 7  10
360
= 49 units
b) The average inventory = ½Q + S
TC = (½Q + S)Cn + D/QCo
2,000
= [½(100) + 10]20 + (50)
100
= 1,200 + 1,000
= Shs.2,200
CASH CYCLE AND CASH TURNOVERS
Cash 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.
Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a
year.
Illustration
XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on
credit. The 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 35 days to pay its accounts payable and the
average collection period is 70 days. On average, 85 days elapse between the point a raw
material is purchased and the point the finished goods are sold.
Required
Determine the cash conversion cycle and the cash turnover.
Solution
The following chart can help further understand the question:
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Inventory Conversion period (85 days)
Receivable collection
Payable deferral Period (70 days)
Period (35 days)
Purchase of Payment for the Sale of Finished Collection of

raw materials raw materials goods receivables
Cash conversion cycle = 85 + 70 - 35

= 120
The cash conversion cycle is given by the following formula:
Cash conversion = Inventory conversion + Receivable collection – Payable deferral

Cycle period period period
For our example:

Cash conversion cycle = 85 + 70 – 35 = 120 days
Cash turnover = 360

Cash conversion cycle
360
= 120
= 3 times
Note also that cash conversion cycle can be given by the following formulae:
 inventory receivables Payables Accruals 

Cash conversion cycle = 360    
 costofsale s sales Cashoperatingexpenses 
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SETTING THE OPTIMAL CASH BALANCE
Cash is often called a non-earning asset because holding cash rather than a revenue-
generating asset involves a cost in form of foregone interest. The 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. There are several methods used to determine the optimal cash
balance. These are:
a) The Cash Budget

The Cash Budget shows the firm’s projected cash inflows and outflows over some
specified period. This method has already been discussed in other earlier courses. The
student should however revise the cash budget.
b) Baumol’s Model
The Baumol’s model is an application of the EOQ inventory model to cash management.
Its assumptions are:
1. The firm uses cash at a steady predictable rate

2. The cash outflows from operations also occurs at a steady rate
3. The cash net outflows also occur at a steady rate.
Under these assumptions the following model can be stated:
C*  2bT
i
Where: C* is the optimal amount of cash to be raised by selling marketable securities

or by borrowing.
b 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 (equals the interest rate on marketable securities or
the cost of borrowing)
The total cost of holding the cash balance is equal to holding or carrying cost plus
transaction costs and is given by the following formulae:
TC  1 Ci  T b
2 C
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Illustration
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable
securities is 12% and every time the company sells marketable securities, it incurs a cost of
Shs.20.
Required
a) Determine the optimal amount of marketable securities to be converted into cash
every time the company makes the transfer.
b) Determine the total number of transfers from marketable securities to cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.
Solution
2bT
C*
a) i
Where: b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%
2 x 20 x 520 ,000
C*   Sh.13,166
0.12
Therefore the optimal amount of marketable securities to be converted to cash every time a
sale is made is Sh.13, 166.
T
b) Total no. of transfers = C*
520,000
= 13,166
= 39.5
≈ 40 times
1 T
c) TC  Ci  b
2 C
13,166 x 0.12 520 ,000 x 20

= 
2 13,166
= 790 + 790 = Shs.1,580
Therefore the total cost of maintaining the above cash balance is Sh.1,580.
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d) The firm’s average cash balance = ½C
13,166
= 2
= Shs.6,583
c) Miller-Orr Model
Unlike the Baumol’s Model, Miller-Orr Model is a stochastic (probabilistic) model which
makes the more realistic assumption of uncertainty in cash flows.
Merton Miller and Daniel Orr assumed that the distribution of daily net cash flows is
approximately normal. Each day, the net cash flow could be the expected value of some
higher or lower value drawn from a normal distribution. Thus, the daily net cash follows a
trendless random walk.
From the graph below, the Miller-Orr Model sets higher and lower control units, H and L
respectively, and a target cash balance, Z. When the cash balance reaches H (such as point
A) then H-Z shillings are transferred from cash to marketable securities. Similarly, when
the cash balance hits L (at point B) then Z-L shillings are transferred from marketable
securities cash.
The Lower Limit is usually set by management. The target balance is given by the
following formula:
1/ 3
 2
Z   3B  L
4i 
 
and the highest limit, H, is given by:

H = 3Z - 2L
4Z  L
The average cash balance =
3
Where: Z = target cash balance
H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
δ² = variance of net daily cash flows
Page 279
Illustration
XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The
standard deviation of daily cash flow is Sh.2,500 and the interest rate on marketable
securities is 9% p.a. The transaction cost for each sale or purchase of securities is Sh.20.
Required;-
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread
Solution
1/ 3
 3b² 
a) Z   L
 4i 
 
 3x 20x (2,500)² 
   10,000
=  9% 
4x
 360 
= 7,211 + 10,000 = Sh.17,211
b) H = 3Z – 2L
= 3 x 17,211 – 2(10,000)
= Shs.31,633
4Z  L
c) Average cash balance =
3
4x17,211  10,000
=
3
Page 280
d) The spread = H–L

= 31,633 – 10,000
= Shs.21,633
Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 (31,633 –
17,211) in marketable securities and if the balance falls to Shs.10,000, the firm should sell
Shs.7,211(17,211 – 10,000) of marketable securities.
Other Methods
Other methods used to set the target cash balance are The Stone Model and Monte Carlo
simulation. However, these models are beyond the scope of this book.
CASH MANAGEMENT TECHNIQUES
The basic strategies that should be employed by the business firm in managing its cash are:
i) To pay account payables as late as possible without damaging the firm’s credit rating.
The firm should however take advantage of any favourable cash discounts offered.
ii) Turnover inventory as quickly as possible, but avoid stock outs which might result in
loss of sales or shutting down the ‘production line’.
iii) Collect accounts receivable as quickly as possible without losing future sales because
of high pressure collection techniques. The firm may use cash discounts to
accomplish this objective.
In addition to the above strategies the firm should ensure that customer payments are
converted into spendable form as quickly as possible. This may be done either through:
a) Concentration Banking
b) Lock-box system.
a) Concentration Banking
Firms with regional sales outlets can designate certain of these as regional collection
centre. Customers within these areas are required to remit their payments to these sales
offices, which deposit these receipts in local banks. Funds in the local bank account in
excess of a specified limit are then transferred (by wire) to the firms major or concentration
bank.
Concentration banking reduces the amount of time that elapses between the customer’s
mailing of a payment and the firm’s receipt of such payment.
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b) Lock-box system.
In a lock-box system, the customer sends the payments to a post office box. The post
office box is emptied by the firm’s bank at least once or twice each business day. The
bank opens the payment envelope, deposits the cheques in the firm’s account and sends a
deposit slip indicating the payment received to the firm. This system reduces the
customer’s mailing time and the time it takes to process the cheques received.
MANAGEMENT OF ACCOUNT RECEIVABLE/DEBTORS

In order to keep current customers and attract new ones, most firms find it necessary to
offer credit. Accounts receivable represents the extension of credit on an open account by
a firm to its customers. Accounts receivable management begins with the decision on
whether or not to grant credit.
The total amount of receivables outstanding at any given time is determined by:
a) The volume of credit sales

b) The average length of time between sales and collections.
Accounts receivables = Credit sales per day × Length of collection period
The average collection period depends on:

a) Credit standards which is the maximum risk of acceptable credit accounts
b) Credit period which is the length of time for which credit is granted
c) Discount given for early payments
d) The firm’s collection policy.
a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The 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.
A 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.
A lenient credit policy will result in increased sales and therefore increased contribution
margin. However, these will also result in increased costs such as:
1. Increased bad debt losses
2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments
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The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this
goal, the evaluation of investment in receivables should involve the following steps:
1. Estimation of incremental operating profits from increased sales

2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs
b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount given. The terms
2/10, n/30 means that a 2% 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 30th day.
In 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) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of receivables. It can
also result in reduced bad debt losses.
d) COLLECTION POLICY
The firm’s collection policy may also affect our analysis. The higher the cost of collecting
account receivables the lower the bad debt losses. The firm must therefore consider
whether the reduction in bad debt is more than the increase in collection costs.
As saturation point increases expenditure in collection efforts does not result in reduced
bad debt and therefore the firm should not spend more after reaching this point.
Illustration
Riffruff Ltd is considering relaxing its credit standards. The firms current credit terms is
net 30 but the average debtors collection period is 45 days. Current annual credit sales
amounts to Sh.6,000,000. The firm wants to extend credit period net 60. Sales are
expected to increase by 20%. Bad debts will increase from 2% to 2.5% of annual credit
sales. Credit analysis and debt collection costs will increase by Sh.4,000 p.a. The return
on investment in debtors is 12% for Sh.100 of sales, Sh.75 is variable costs. Assume 360
days p.a. Should the firm change the credit policy?
Solution
Current sales = Sh.6,000,000
New sales = Sh.6,000,000 x 1.20 = Sh.7,200,000
Contribution margin = Sh.100 – Sh.75 = Sh.25
Sh.25
Therefore contribution margin ratio = x100 = 25%
Sh.100
Cost benefit analysis
Contribution Margin
New policy 25% x 7,200,000 = 1,800
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Current policy 25% x 6,000,000 = 1,500 = 300

Credit analysis and debt collection costs (84)
Bad debts
New bad debts = 2.5% x 7,200,000 = 180
Current bad debts = 2% x 6,000,000 = 120 (60)
Debtors
Cr.period
New debtors = x cr. Sales p.a.
360days
60
= x 7,200,000 = 1,200
360
45
Current debtors = x 6,000,000 = 750
360
Increase in debtors (tied up capital) 450
Forgone profits = 12% x 450 (54)
Net benefit (cost) 102
Therefore, change the credit policy.
EVALUATION OF THE CREDIT APPLICANT

After establishing the terms of sale to be offered, the firm must evaluate individual
applicants and consider the possibilities of bad debt or slow payments. This is referred to
as credit analysis and can be done by using information derived from:
a) The applicant’s financial statement
b) Credit ratings and reports from experts
c) Banks
d) Other firms
e) The company’s own experience
Application of Discriminant Analysis to the Selection of Applicants

Discriminative analysis is a statistical model that can be used to accept or reject a
prospective credit customer. The discriminant analysis is similar to regression analysis but
it assumed that the observations come from two different universal sets (in credit analysis,
the good and bad customers). To illustrate let us assume that two factors are important in
evaluating a credit applicant the quick ratio and net worth to total assets ratio.
The discriminant function will be of the form.
ft = a1(X1) + a2(X2)
Where: X1 is quick ratio

X2 is the network to total assets
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a1 and a2 are parameters
The parameters can be computed by the use of the following equations:

a1 = Szz dx – Sxzdz
SxxSxx – Sxz²
a2 = Szz dx – Sxzdz
SzzSxx – Sxz²
Where: Sxx represents the variances of X1

Szz represents the variances of X2
Sxz is the covariance of variables of X1 and X2
dx is the difference between the average of X1’s bad accounts and X2’s goodaccounts
dz represents the difference between the average of X’s bad accounts and X’s good
accounts.
The next step is to determine the minimum cut-off value of the function below at which
credit will not be given. This value is referred to as the discriminant value and is denoted
by f*.
Once the discriminant function has been developed it can then be used to analyse credit
applicants. The important assumption here is that new credit applicants will have the same
characteristics as the ones used to develop the mode.
More than two variables can be used to determine the discriminant function. In such a case
the discriminant function will be of the form.
ft = a1x1 + a2x2 + … + anxn
CREDITORS MANAGEMENT
Managing creditors / payables is a key part of working capital management.
Trade credit is the simplest and most important source of short-term finance for many
companies. The objectives of payables management are to ascertain the optimum level of
trade credit to accept from suppliers.
Deciding on the level of credit to accept is a balancing act between liquidity and
profitability.
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By delaying payment to suppliers companies face possible problems:

 supplier may refuse to supply in future
 supplier may only supply on a cash basis
 there may be loss of reputation
 supplier may increase price in future.
Early settlement discounts

A proportion of the firm's suppliers will normally offer early settlement discounts which
should be taken up where possible by ensuring prompt payment within the specified terms
where settlement discount is allowed. However, if the firm is short of funds, it might wish
to make maximum use of the credit period allowed by suppliers regardless of the settlement
discounts offered.
Annual cost of a discount

The calculation of the annual cost of a discount can be expressed as a formula:
Notice that the annual cost calculation is always based on the amount left to pay, i.e. the
amount net of discount.
If the annual cost of the discount exceeds the rate of overdraft interest then the discount
should not be accepted
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TOPIC 10
DIVIDEND DECISION
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It
may also be termed as the part of the profit of a business concern, which is distributed
among its shareholders.
FORMS OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Hen
Dividends are classified into:
a) Cash dividend
b) Stock dividend
c) Bond dividend
d) Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is
paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash
dividends are common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance.
Under this type, cash is retained by the business concern. Stock dividend may be bonus
issue. This issue is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient
sufficie
funds to pay cash dividend, the company promises to pay the shareholder at a future
specific date with the help of issue of bond or notes.
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Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed
under the exceptional circumstance.
.
DIVIDEND POLICY
Dividend policy determines the division of earnings between payment to shareholders and
reinvestment in the firm. It therefore involves the following four aspects:
1. HOW MUCH TO PAY
It encompasses the 4 major alternative dividend policies.
a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings.
Dividends will therefore fluctuate as the earnings change. Dividends are therefore
directly dependant on the firms earning ability. If no profits are made, no
dividends are paid. The policy creates uncertainty in ordinary shareholders
especially those who depend on dividend income thus they may demand a higher
required rate of return.
b) Constant amount per share/fixed dividend per share
The dividend per share is fixed in amount irrespective of the earnings level. This
creates uncertainty and is thus preferred by shareholders who have a reliance on
dividend income. It protects the firm from periods of low earnings by fixing
dividends per share at a low level. Thus policy treats all shareholders like
preference shareholders by giving a fixed return. Dividend per share could be
increased to a higher level if earnings appear relatively permanent and sustainable.
c) Constant amount plus extra
Here, a constant dividend per share is paid every year. However, extra dividends
are paid in years of supernormal earnings. This policy gives firms the flexibility
to increase dividends when earnings are high and shareholders are given a chance
to participate in the supernormal profits of the firm. The extra dividends are given
in such a way that it is not seen as a commitment to continue the extra in the
future. It is applied by firms whose earnings are highly volatile e.g. the
agricultural sector.
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d) Residual amount
Under this policy, dividend is paid out of earnings left over after investment
decisions have been financed. Dividends will therefore only be paid if there are no
profitable investment opportunities available. This policy is consistent with
shareholders wealth maximization.
2. WHEN TO PAY
Dividends can either be interim or final.
Interim dividends are paid in the middle of the financial year and are paid in cash.
Final dividends are paid at the year end and can be and can be in cash and stock form
(bonus issue).
3. WHY PAY
a) Residue dividend theory
Under this theory, a firm will pay dividends from residue earnings ie. Earnings
remaining after all suitable projects with a positive NPV have been financed. It
assumes that retained earnings are the best source of long term capital since it is
readily available and cheap. This is because no floatation costs are involved in the
use of retained earnings to finance new investments therefore the first claim on
profit after tax and preference dividend. There will be a reserve for financing
investments. Dividend policy is therefore irrelevant and treated as a passive
variable. It will hence not affect the value of the firm. However the investment
decision will.
Advantages of residual theory
1. Savings on floatation costs

2. There is no need to raise debt or equity capital since there is a high retention of
earnings which require no floatation costs.
3. Avoidance of dilution of ownership. A new equity issue will dilute ownership and
control. This will be avoided if retention is high.
4. Tax position of shareholders. High income shareholders prefer low dividends to
reduce their tax burden from dividend income. They prefer high retention of
earnings which are reinvested. This increase the share value and they make capital
gains which are not taxable.
b) MM dividends irrelevance theory.
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This was proposed by Modigliani and Muller .This theory asserts that a firms divided
policy has no effect on its market value and cost of capital .They argued that the firm
value is primarily determined by .
(i) Ability to generate earnings from investments .
(ii) Level of business and financial risk .
According to MM dividend policy is a passive residue determined by the firms needs for
investment funds. It does not matter how earnings are divided between divided and
retention therefore divided policy does not exist . When investment decisions are made
dividend decision is a mere detail without any effect on the value opf the firm
C) The main dividend theories are:
i. Residual dividend theory

ii. MM dividend irrelevance theory
iii. Bird in hand theory
iv. Information signaling effect theory
v. Tax differential theory
vi. Clientele effect theory
vii. Agency theory
4. HOW TO PAY DIVIDENDS/ MODE OF PAYING DIVIDENDS
a) Cash or Bonus issue
Ideally, a firm should pay cash dividends, for such a company it must ensure that it
that it has enough liquid funds to make payment. Under conditions of liquidity and
financial constraints, a firm can pay stock dividends (bonus issue ) Bonus issue
involves an issue of additional shares in addition to or instead of cash to the existing
shareholders prorate to their share holding in the company. A stock dividend / bonus
issue involves capitalization of retained earnings therefore does not increase the wealth
of the shareholders. This is because retained earnings are converted into share capital.
Advantages of a bonus issue
i. To indicates that the form plans to retain a portion of earnings permanently in

the business.
ii. To continue dividend distribution s without disbursing cash needed for
operation.
iii. T o increase the trading of shares in the market.
iv. Tax advantage. Shareholders can sale the new shares to generate cash in the
form of capital gains which are tax exempt unlike cash dividends which attract a
5% withholding tax which is final.
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v. Indication of higher profits in the future of the company. A bonus issue is

inefficient market survey is important information that the firm expects high
profits in future to offset additional outstanding share so that the earnings per
share is not diluted.
b) Stock Splits and reverse split.

A stock split is a change in the number of shares outstanding accompanied by an
offsetting change in the par or stated value per share.
The primary purpose of a stock split is to increase the market activity of the stock.
Example
A company has 1000 ordinary shares of sh.20 each and a share split has been
announced of 1:4. The effect on ordinary share capital is a s follows;
New par value = 20/4
=sh.5
Ordinary shares outstanding = 1000×4
=4000
The ordinary share capital remains the same (4000×5=sh. 20,000)
A reverse split is the opposite of a stock split as it involves consolidation of shares

into bigger units thereby increasing the par value of the shares .It is meant to attract
high income clientele.
Example
In the case of 20,000 shares at sh.20 par value, they can be considered into 10,000
shares at par value of sh.40 par value.
Example
Company Z has the following capital structure,
sh.000
Ordinary shares (Sh.20 par) 8000
Share premium 3600
14000
The company shares have been selling in the market for sh.60. The management has
declared a share split of 4 share for every one share held. Assume that the shares are
expected to sell at sh17 after the stock split.
Required,
i. Prepare the capital structure of the company after the company’s stock split.
ii. Compute the capital gain for a shareholder who held 40,000 shares before the split.
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Solution
i)
shares
Number of shares before split sh.8000,000÷20 400,000
Number of shares after split 400,000×4 1,600,000
New par value 20/4 sh.5
Capital structure sh.000

Ordinary shares (Sh.5 par) 8,000
Share premium 3,600
Retained earnings 2,400
14,000
ii)
sh.000
Shares before split 40,000×60 2400
Share after split 40,000×4×17 2750
Capital gain 2750 -2400 320
c) Stocks repurchase.
The company can also buy back some of its outstanding shares instead of paying cash
dividends. This is known as a stocks repurchase and the share bought back are known
as treasury stock. If some outstanding shares are repurchased, fewer share s would
remain outstanding .Assuming a repurchase does not adversely affect the firm’s
earnings , EPS would increase .This would result in an increase in the market price per
share so that a capital gain is substituted for dividends.
Advantages of stock repurchase.
1. Utilization of idle funds.
Companies which have accumulated cash balances in excess of future investments

might find a share re-investment scheme a fair method of returning cash to
shareholders .Continuing to carry excess cash may prompt management to invest
unwisely as a means of using excess cash e.g. a firm may invest in a tendency for
more mature firms to continue in investment plans even when the expected return is
lower than the cost of capital.
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2. Enhanced dividends and EPS.
Following a stock repurchase, the number of shares issued would decrease therefore
in normal circumstances , both DPS and EPS would increase in future . However the
increase in EPS is a book-keeping increase since total earnings remain constant.
3. Enhanced share price.
Companies that undertake a stock repurchase experience an increase in the market

price of the share.
4. Capital structure.
A company’s managers may use a share buy-back or repurchase as a means of

correcting what they perceive to be an unbalanced capital structure .If shares are
repurchased from cash reserves, equity would be reduced and gearing increased ,
assuming debt exists in the capital structural term natively , a company may raise
debt to finance a repurchase . Replacing equity with debt can reduce the overall cost
of capital.
5. Reducing takeover threat.
A share repurchase reduces the number of shares in operation and also the number of
weak shareholders i.e. shareholders with no strong loyalty to the company since a
repurchase would induce them to sell .This helps to reduce the threat of as hostile
takeover as it makes it difficult for a predator company to gain control .This is also
referred to as a poison pill i.e. a company’s value is reduced because of huge cash
outflow or borrowing huge long-term debt to increase gearing.
Disadvantages of a stock repurchase.
1. High price.
A company may find it difficult to repurchase\se at their current value or the price
paid maybe too high to the detriment of the remaining shareholders.
2. Market signaling.
Despite directors efforts at trying to convince markets otherwise, a share repurchase

may be taken as a signal that the company lacks suitable investment opportunities
.This may be interpreted as a sign of management failure.
3. Loss of investment income.
The interest that could have been earned from investment of excess cash is lost.
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FIRMS DIVIDEND POLICY AND FACTORS INFLUENCING DIVIDEND

POLICIES
The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy

In this type of dividend policy the investors get dividend at usual rate. Here the
investors are generally retired persons or weaker section of the society who want to
get regular income. This type of dividend payment can be maintained only if the
company has regular earning.
Payment of dividend at the usual rate is termed as regular dividend.
Advantages of regular dividend policy:
i) It establishes a profitable record of the company.

ii) It creates confidence amongst the shareholders.
iii)It aids in long-term financing and renders financing easier.
iv) It stabilizes the market value of shares.
v) The ordinary shareholders view dividends as a source of funds to meet their day-to-
day living expenses.
vi) If profits are not-distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distributed. However,
it must be remembered that regular dividends can be maintained only by companies of
long standing and stable earnings.
2. Stable Dividend Policy

The term 'stability of dividends' means consistency in the stream of dividend payments. In
more precise terms, it means payment of certain minimum amount of dividend regularly. A
stable dividend policy may be established in any of the following three forms:
a) Constant payout ratio

This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would
therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firm’s earnings ability and if no profits are made no
dividend are paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend
income and they might demand a higher required rate of return.
b) Constant amount per share (fixed D.P.S.)

The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is
therefore preferred by shareholders who have a high reliance on dividend income.
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It protects the firm from periods of low earnings by fixing DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a fixed return. The
DPS could be increased to a higher level if earnings appear relatively permanent and
sustainable.
c) Constant DPS plus Extra/Surplus

Under this policy a constant DPS is paid every year. However extra dividends are paid in
years of supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and the
shareholders are given a chance to participate in super normal earnings
The extra dividend is given in such a way that it is not perceived as a commitment by the
firm to continue the extra dividend in the future. It is applied by the firms whose earnings
are highly volatile e.g agricultural sector.
d) Residual dividend policy

Under this policy dividend is paid out of earnings left over after investment decisions have
been financed. Dividend will only be paid if there are no profitable investment
opportunities available. The policy is consistent with shareholders wealth maximization.
Advantages of Stable Dividend Policy

(i) It is sign of continued normal operations of the company.
(ii) It stabilizes the market value of shares
(iii) It creates confidence among the investors, improves credit standing and makes
financing easier.
(iv) It provides a source of livelihood to those investors who view dividends as a source of
fund to meet day-to-day expenses.
(v) It meets the requirements of institutional investors who prefer companies with stable
divide.
3. Irregular Dividend Policy

In this policy the firm doesn’t pay fixed dividend regularly and it changes from year to year
according to changes in earnings level. This is followed by the companies which have
unstable earning
Some companies follow irregular dividend payments on account of the following:
(i) Uncertainty of earnings
(ii) Unsuccessful business operations
(iii) Lack of liquid resources
4. No Dividend Policy
A company can follow a policy of paying no dividends presently because of its unfavorable
working capital position or on account of requirements of funds for future expansion and
growth.
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FACTORS INFLUENCING DIVIDEND POLICIES
1. Legal rules:
a) Net profit rule- This states that the dividends may be paid from company profits,
either past or present.
b) Capital impairment rule- This prohibits payment of dividends from capital i.e.
from the sale of assets. This would be liquidating the firm.
c) Insolvency rule- This prohibits payment of dividends when a company is
insolvent .An insolvent company is one where assets are less than liabilities .In
such a case all earnings and assets belong to debt holders and no dividends are
paid.
2. Profitability and liquidity.

A company’s capacity to pay dividends will be determined primarily by its ability to
generate adequate and stable profits and cashflows. If the company has liquidity
problems, it may be unable to pay cash dividends and resort to paying stock dividends.
3. Investment opportunity.
Lack of appropriate investment opportunities i.e. those with positive returns may
encourage a firm to increase its dividend distribution. If a firm has many investments
opportunities it will pay low dividends and have high retention.
4. Tax position of share holder

Dividend payment is influenced by the tax regime of a country e.g. in Kenya cash
dividends are taxed at source, while capital gains are tax exempt. The effect of tax
differential is to discourage shareholders from wanting high dividends.
5. Capital structure.
A company’s management may wish to achieve or restore an optimal capital structure.
E.g. If they consider gearing to be too high they may pay low dividends and allow
reserves to accumulate until a more optimal capital structure is achieved or restored.
6. Industrial practice
Companies will be resistant to deviate from accepted dividend or payment norms in the
industry.
7. Growth stage.
Dividend policy is likely to be influenced by the firms growth stage, e.g. a young
rapidly growing firm is likely to have high demand for developing funds therefore may
pay low dividends or differ dividend payment till the company reaches maturity. It will
therefore retain high amounts.
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8. Owners hip structure.

A dividend policy may be driven by the ownership structure in affirm e.g. in small firms
where the owners and managers are the same, dividend payout is usually low. However, in
large quoted public companies, dividends are significant since the owners are not the
managers. The value and preferences of a small group of owner managers would exert more
direct influence on the dividend policy.
9. Access to capital markets.

Large well established firms have access to capital markets hence can get funds easily.
They therefore pay high dividends unlike small firms which pay low dividends due to the
limited borrowing capacity.
10. Shareholders expectation.

Shareholder s that have become accustomed to receiving stable and increasing dividends
will expect a similar pattern to continue in to the future .Any sudden reduction or reversal
of such a policy is likely to dissatisfy shareholders and the results in falling share prices.
11. Contractual obligations on debt covenants.

This limits the flexibility and amount of dividends to pay e.g. the cashflow based covenants.
Important ratios on dividends
Dividend pay-out ratio
This ratio reflects a company's dividend policy. It indicates the proportion of

earnings per share paid out to ordinary shareholders as divided. It is computed
as follows:
ℎ
=
ℎ
ℎ ℎ =
Dividend Yield Ratio
This shows the dividend return being provided by the share. It is given by
ℎ
=
ℎ
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DIVIDEND RELEVANCE THEORIES
The main dividends theories are:
1. Residual dividend theory

Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining
after all suitable projects with positive NPV has been financed.
It assumes that retained earnings are the best source of long term capital since it is readily
available and cheap. This is because no floatation cash are involved in use of retained
earnings to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve
for financing investments.
Dividend policy is irrelevant and treated as passive variable. It will not affect the value of
the firm. However, investment decisions will.
Advantages of Residual Theory
1. Saving on floatation costs

No need to raise debt or equity capital since there is high retention of earnings which
requires no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if
retention is high.
A high retention policy may enable financing of firms with rapid and high rate of
growth.
3. Tax position of shareholders
High-income shareholders prefer low dividends to reduce their tax burden on
dividends income.
They prefer high retention of earnings which are reinvested, increase share value and
they can gain capital gains which are not taxable in Kenya.
2. MM Dividend Irrelevance Theory
This is the theory that a firm’s dividend policy has no effect in either its value or its cost of
capital. MM argued that a firm’s value is determined only its basic earning power and its
business risk. They argued that the value of the firm depends only on the income produced
by its assets, not on how this income is split between dividends and retained earnings.
MM noted that any shareholder can in theory construct his/her own dividend policy e.g. if
a firm does not pay dividends, shareholder who wants a 5% dividend can “create” it by
selling 5% of his/her stock. Conversely, if a company pays a higher dividend than an
investor desires, the investor can use the unwanted dividends to buy additional shares of the
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company’s stock. If investors could buy and sell shares and thus create their own dividend
policy without incurring cost, then the firm’s dividend policy would truly be irrelevant.
However, it should be noted that investors who want additional dividends must incur
brokerage costs to sell shares and investors who do not want dividends must first pay taxes
on the unwanted dividends and then incur brokerage costs to purchase shares with the after-
tax dividends. Since taxes and brokerage costs to purchase shares with the after-tax
dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be
relevant.
Was advanced by Modigliani and Miller in 1961. The theory asserts that a firm’s dividend
policy has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by:
 Ability to generate earnings from investments
 Level of business and financial risk
According to MM dividend policy is a passive residue determined by the firm’s need for
investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders
and retention. Therefore, 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.
They base on their arguments on the following assumptions:

1. No corporate or personal kites
2. No transaction cost associated with share floatation
3. A firm has an investment policy which is independent of its dividend policy (a fixed
investment policy)
4. Efficient market – all investors have same set of information regarding the future of
the firm
5. No uncertainty – all investors make decisions using the same discounting rate at all
time i.e required rate of return (r) = cost of capital (k).
3. Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are
more certain than capital gains which rely on demand and supply forces to determine share
prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush
(uncertain capital gains).
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Therefore, a firm paying high dividends (certain) will have higher value since shareholders
will require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is
independent of dividend policy. They maintained that an investor can realize capital gains
generated by reinvestment of retained earnings, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and capital gains.
Gordon & Lintner argued that K decreases as the dividend pay-out is increased because
investors are less certain of receiving the capital gains that are supposed to result from
retaining earnings than they are of receiving dividend payments.
Gordon & Linter argued in effect that investors value a dollar or shilling of expected
dividend more highly than a dollar / shilling of expected capital gains.
Ks = D1 + g
Po
The bird-in-hand theory is based on the logic that what is available at present is preferable
to what may be available in the future. Basing their model on this argument, Gordon and
Lintner argued that the future is uncertain and the more distant the future is, the more
uncertain it is likely to be. Therefore, investors would be inclined to pay a higher price for
shares on which current dividends are paid.
4. Information signaling effect theory

Advanced by Stephen Ross in 1977, he argued that in an inefficient market, management
can use dividend policy to signal important information to the market which is only
known to them.
Example – If the management pays high dividends, it signals high expected profits in
future to maintain the high dividend level. This would increase the share price/value and
vice versa.
MM attacked this position and suggested that the change in share price following the
change in dividend amount is due to informational content of dividend policy rather than
dividend policy itself. Therefore, dividends are irrelevant if information can be given to the
market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the
higher the value of the firm. The theory is based on the following four assumptions:
1. The sending of signals by the management should be cost effective.
2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
4. The managers can only send true signals even if they are bad signals. Sending untrue
signals is financially disastrous to the survival of the firm.
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5. Tax differential theory

Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital gains. Therefore, a
firm that pays high dividends have lower value since shareholders pay more tax on
dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm
and vice versa.
Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital gains are tax
exempt.
6. Clientele effect theory

Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different preferences for
dividends depending on their level of income from other sources.
Low income earners prefer high dividends to meet their daily consumption while high
income earners prefer low dividends to avoid payment of more tax. Therefore, when a firm
sets a dividend policy, there’ll be shifting of investors into and out of the firm until an
equilibrium is achieved. Low, income shareholders will shift to firms paying high
dividends and high income shareholders to firms paying low dividends.
At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has.
Dividend decision at equilibrium is irrelevant since they cannot cause any shifting of
investors.
7. Agency theory
The agency problem between shareholders and managers can be resolved by paying high
dividends. If retention is low, managers are required to raise additional equity capital to
finance investment. Each fresh equity issue will expose the managers financing decision to
providers of capital e.g bankers, investors, suppliers etc. Managers will thus engage in
activities that are consistent with maximization of shareholders wealth by making full
disclosure of their activities.
This is because they know the firm will be exposed to external parties through external
borrowing. Consequently, Agency costs will be reduced since the firm becomes self-
regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because
dividend policy can be used to reduce agency problem by reducing agency costs. The
theory implies that firms adopting high dividend payout ratio will have a higher value due
to reduced agency costs.
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TOPIC 11
INTRODUCTION TO RISK AND RETURN
RISK AND RETURN
When considering a prospective investment the financial manager, or any rational investor,
will be concerned not only with the volume and timing of its expected future cash flows but
also with their riskiness, by which in finance we mean their tendency to vary from some
expected or mean value. The greater the range or spread of possible returns from an
investment, the greater its risk. Thus both the return and the risk dimension of investment
decisions must be evaluated.
Risk and return are intimately related and we shall spend some time exploring this funda-
mental relationship (or in technical terms the correlation), between risk and return. We will
see how the notion of return cannot be considered in isolation from risk - the two variables
are inseparable. We will also examine risk and return in the context of modern portfolio
theory and see how risk can be reduced by diversification.
For the financial manager the goal of investment decisions is to maximise shareholder
wealth, and making sound investment decisions that enhance shareholder wealth lies at the
very heart of the financial manager's job. Wealth-enhancing investment decisions (corporate
or personal) cannot be made without an understanding of the interplay between investment
returns and investment risk. The risk-return relationship is central to investment decision
making, whether evaluating a single investment or choosing between alternative
investments
Potential investors, for example, will assess the risk-return relationship or trade-off in
deciding whether to invest in company securities such as shares or bonds. Investors will
evaluate whether, in their view, the securities provide a return commensurate with their
level of risk.
THE RISK – RETURN TRADE OFF/ RELATIONSHIP
Every financial decision contains an element of risk and an element of return. The
relationship between risk and return exists in the form of a risk-return trade-off, by which
we mean that it is only possible to earn higher returns by accepting higher risk. If an
investor wishes to earn higher returns then the investor must appreciate that this will only
be achieved by accepting a commensurate increase in risk. Risk and return arc positively
correlated, an increase in one is accompanied by an increase in the other.
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The implication for the financial manager in evaluating a prospective investment project is
that an- effective decision about the: project's value to the firm cannot be made simply by
focusing on its expected level of returns: the project's expected feral of risk must also be
simultaneously considered. This risk-return trade-off is central to investment decision-
making.
Risk diversification
It is unlikely that the financial manager or corporate treasurer will be involved with
investing the entire firm's capital resources in only a single project or asset, this would be
very risky. As the old adage goes, all the firm's eggs would be in one basket. More probable
resources will be invested in a collection or portfolio of investment projects as totals will be
reduced through diversification.
This means risk will be spread and therefore not all the firm's investment eggs will be in the
one basket. From the shareholder's perspective, the firm itself can be viewed as a portfolio
of assets or investment projects managed by a professional team - the firms managers.
Holding a group of diversified assets (that is, assets that do not move in the same direction
at the same time) in a portfolio reduces overall risk and risk reduction through
diversification is a key aspect of the corporate treasury risk management role.
Thus the financial manager's concern is not just with the relative timing of investment
returns but also with their relative risks, (that is, the potential variability of their future
returns) and how together these will impact on the firm's market value and shareholder
wealth.
Shareholder wealth maximisation means maximising the value of the share price while risk
and return are two key determinants of share price. We will begin our study of risk and
return by first considering return; it is the easier of the two to understand.
EXPECTED RETURN OF AN ASSET
An investment's return can be actual or expected and is measured in terms of cash-flows,

positive or negative. Measuring actual return is usually a retrospective and comparatively
easier exercise than measuring expected return. In calculating actual return the relevant data
is historic and is known with certainty: determining expected return is altogether a more
problematic exercise as we are dealing with the future and the future is uncertain.
An investment's expected return - usually denoted E(r) or f (referred to as 'r bar')-is the
Investment's most likely return and is measured in terms of the future cash flows, positive
and negative, it is expected to generate. It represents the investor's best estimate of the
investment's future returns.
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As a general rule the rate of return (actual or expected) on any investment over a defined
period of time can be calculated simply as:
×100 = %
A refinement to the above would be to allow for changes in the value of the investment over
the period, such as the capital gain on a share.
( − )+
For example, if you bought a security such as a share for shs.10.00 which one year later was
valued at shs.11.00 and it paid you a shs.0.50 dividend during the year, your return would
be:
( . . . . ) . . . .
×100 = %= ×100 = 15%
. . . .
If you invested in a security such as a bond, the income is the cash you receive in the form
of interest plus any principal repayments and/or changes in the market price of the bond.
The above is an example of actual or realized returns where the relevant variables (cash
income, beginning value and ending value) are known. They are calculated after the event,
are thus sometimes referred to as ex post returns.
In contrast, when faced with making an investment decision the relevant variables are not
known with certainty, and consequently they have to be estimated. In making investment
decisions for the firm, the financial manager will need to make estimates of the returns
(cash flows) expected from an investment.
The expected return is determined ex ante, (before the event) that is before the investment is
made, and is calculated by the same method as before only this time expected values are
substituted in the formula for the actual values.
( − )+
For example, you know that your share is currently valued at shs.11.00. If you expect its
most likely value to be shs.12.00 one year from now and expect it to pay you a dividend of
shs.0.75 during the year, your expected return E(r) would be:
( . . . . ) . .
E(r) = × 100 = %
. .
. .
= × 100 = 15.9%
. .
Clearly, in one year's time the actual return from this investment may be very different )in
the expected return. However, at the present point in time, the expected return is our best
guess of the share’s future return.
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The determination of return, actual or expected, in general can be expressed mathematically

as:
r1 =
Where;
rt = actual or expected rate of return during period t

vt = value of asset at time tn
Vt -1 = value of asset at time t-1
CF = cash flow from investment over the period t-1 to t
Frequently in finance we will be measuring returns over the period of a year, so rt often
represent the annual rate of return. Where an investment is held for a period greater or less
than a year it is best to convert the return to an annual return, as this makes reviewing and
comparing investment performance easier.
For example, if you bought a share six months ago for shs.100 and sold it today for shs 106,
and in the meantime received a dividend of shs.3 your- return over the six- month holding
period (known as the holding period return)would be calculated as:
Holding period return = (shs.106 – shs.100 + shs.3)/shs.100 = 9%
To convert this to an annual rate of return we can divide the six-month holding period
return by 0.5, thus the annualized return is: 9/0.5 = 18%. For any investment we convert its
holding period return to an annual return by dividing the holding period by the number of
holding periods, expressed in terms of years, thus:
Annual return - holding period return/number of holding periods (in years)
18% = 9%/0.5
We have previously defined expected return as the most likely future return. When
considering a potential investment an investor is likely to determine a range of possible
future returns for the investment before deciding on the most likely return.
Returning to our previous share example, if you wish to estimate the share's future return,
you may intuitively consider a number of possible future values.
For example assume there is a 25 per cent share of the future return remaining at 15 per
cent, a 50 percent chance of it increasing to 16 per cent and a 25 percent chance that it
might be 17 percent. You could then compile a probability distribution of future returns as
follows:
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Probability (p) Return (r) (p) × (r)

0.25 15% 3.75
0.50 16% 8.00
0.25 17% 4.25
E(r) = 16.00%
The expected return E(r) is therefore defined as: a weighted average of possible returns
where the weightings are the respective probabilities of each possible return occurring. All
the relative weightings will add up to 1.0.
The expected return E(r) is derived mathematically as:1
E(r) = r1P(r1) + r2P(r2) + ... + rnP(rn)
Where,
r1 = rate of return for the identified ith outcome J
P(r1) = probability of earning return i for the identified outcome/
n = number of possible outcomes
Illustration – Expected return, E(r)
The financial manager of Manifested Technologies wishes to determine the expected rate of
return from a proposed investment projects. The expected returns from the project are
related to future performance of the economy over the period as follows:
Economic scenario Probability of Rate of return (r)

occurrence (p)
Strong growth 0.25 15%
Moderate growth 0.50 12%
Low growth 0.25 8%
The expected return E(r) is calculated as:
E(r) = 0.25(15%) + 0.50(12%) + 0.25(8%)
= 11.75%
The expected return E(r) is the weighted average of the range of possible returns where the
weightings are the respective probabilities of each return in the range being realized. In this
case the probability weightings will have been determined subjectively by the firm’s
management.
Required rate of return

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The required rate of return is the minimum rate of return an investor requires an investment
to earn, given its risk characteristics, for the investment to be considered worthwhile. The
required rate of return is equal to the rate of return given by a risk free or safe, investment-
such as a government treasury bill-plus a risk premium. The risk premium is necessary to
compensate the investor for undertaking a risky investment.
Required rate of return, R(r) = risk-free return + risk premium.
Once determined, the required return can then be used as a benchmark against which an
investment's expected return can be compared.
An investment's expected return may or may not be the same as the investor's required
return. If the return which an investment is expected to yield is greater than the return the
investor requires then the investment will be considered worthwhile. Should the expected
return be less than the required return, then the investor will not consider the investment to
be beneficial.
For instance, if in the Illustration above the financial manager of Manifested Technologies
normally required a return of 15 per cent from investments of similar risk, then investment
project would be rejected as its expected return of 11.75 per cent significantly less than its
required return of 15 per cent.
We can now turn to the other member of the inseparable duo - risk.
Risk
Generally speaking, risk can be defined as: the chance that the actual outcome will differ
from the expected outcome or in our current context the chance that the actual return will
differ from the expected return. Clearly there is a chance that the actual return will be
greater than, equal to, or less than the expected return. In finance it is this potential
variability of returns that we call risk.
Attitudes to risk
Investment decisions will be influenced by the investor's risk propensity or the investor's
attitude to risk. Investors who have a low risk propensity, in other words they have
preference for less risk are said to be risk-averse.
Investors who have a high risk propensity or a positive desire for risk arc referred to as risk-
takers or risk-seeking. Other individuals may be risk-indifferent or risk-neutral, that is for
an increase in risk, and they do not necessarily require an increase in return.
It should be noted that risk aversion is a preference for less risk, it does not imply complete
risk avoidance; it is simply a reference for less risk rather than more risk. Different
investors will also differ in their degrees of risk aversion. Individuals and corporations are
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risk-averse in the sense that they are willing to reduce their risk burden" by paying others to
assume some of their risks.
For example, they will pay premiums to insurance companies to accept their everyday
personal and business risks. Of course insurance underwriters will only assume the risk for
a price. This is another way of saying that investors must be paid or compensated for
assuming more risk.
Shareholders and managers are generally considered to be risk-averse, that is, for an
increase in risk they require a commensurate increase in return. It is common practice in
finance to assume that all investors are risk-averse and that is similarly our assumption
throughout this text.
Measuring risk
Before making an investment decision we would certainly wish to have some indication of
the level of risk associated with our investment, so how can we measure or quantify risk?
Standard deviation
The standard deviation, , is a statistical measure of the dispersion or deviation of possible

outcomes around an expected or mean value; we use it to measure an asset's or investment's
total risk. As we shall see, total risk consists of two elements, diversifiable i and non-
diversifiable risk, but more of this later.
The standard deviation is defined as the square root of the variance. The variance is defined
as the weighted average of the squared deviations of possible outcomes from the expected
value or mean. The variance and standard deviation are expressed mathematically as
follows:
Variance, Var (r) = ∑ ( − ̅ ) × P( )
And
Standard deviation = ∑ ( − ̅ ) × P( )
Where,
Var (r) = the variance of returns

= the standard deviation of returns
̅ = the expected or mean value of a return
ri = return of the ith outcome
P(r1) = probability of occurrence of the ith outcome
n = number of outcomes considered
The higher the variance and consequently the standard deviation, the greater is the degree of
dispersion and therefore the higher is the asset's or investment's total risk. In cases where all
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the outcomes, r1 are knows and their respective probability occurrence, P(ri), are all the
same, the expected return, ̅ , is calculated as the simple-value of all the outcomes, thus:
∑
r=
Given the same conditions (all the outcomes, ri are known and their respective probabilities
of occurrence, P (ri), are all equal), the standard deviation of returns, is given by:
∑ ( ̅)
=
Illustration– Standard deviation as a measure of asset3 risk
Having determined the expected rate of return on a proposed investment the financial
manager of
Future Spec Technologies now wishes to calculate the standard deviation as an indicator of
the investment's total risk. The expected returns from the project arc related to the future,
performance of the economy over the period as follows:
Economic scenario Probability of occurrence Rate of return (r)

(p)
Strong growth 0.25 15%
Moderate growth 0.50 12%
Low growth 0.25 8%
The expected return E(r) was calculated as:
E(r) = 0.25(15%) + 0.50 (12%) 0.25(8%)
= 11.75%
To find the standard deviation of returns, , we first have to determine the variance. The
Variance is found by: (1) subtracting each individual return from rise-mean return (column
4 in the-table below); (2) squaring each difference to remove any negative values, (column.
5 ); and (3) multiplying each squared deviation by its respective probability
Weighting (column7)
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The variance is the sum of the squared deviations times their respective probabilities. The
standard deviation is then the square root of the variance.
Thus the standard deviation of return, , is the derived as follows.
(2) – (3) (4) × (4) (5) ×(6)

(1) (2) (3) (4) (5) (6) (7)
I ̅ ̅ − ̅ ( ̅ − ̅) P( ) ( ̅ − ̅) x P( )
1 15% 11.75% 3.25% 10.56% 0.25 2.64
2 12 11.75 0.25 0.06 0.50 0.03
3 8 11.75 -3.75 14.06 0.25 3.53
Variance = ∑ ( − ̅ ) x P( )= 6.19%
= ∑ ( − ̅ ) x P( ) = √6.19 = 2.49%
Thus the standard deviation for this proposed investment is 2.49%
Comparing alternative investments
In choosing between two alternative investments which have the same expected returns but
different standard deviations, a rational, risk-averse investor would select the investment
with the lower standard deviation (total risk). Conversely, in choosing between two
investments which have identical risk but different expected returns, the investment with
the higher return would usually be selected.
For example consider the following choice between two alternative investment
opportunities, Asset C and Asset D:
Asset C Asset D
Expected return, (E) r 10% 12%
Standard deviation, 5% 5%
Which investment would you choose?
Both investments have the same degree of risk, but Asset D promises a higher return than
Asset
C. Given this information, rational, risk-averse investors would choose Asset D. In the
language of financial management Asset D is said to dominate because all rational investors
would select Asset D in preference to Asset C, if this was their only choice.
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Asset pricing
This illustrates an important feature of the way asset pricing, or valuing, works in financial
markets. If two such investment opportunities were to exist simultaneous: a competitive
market, all rational investors would invest their funds in Asset D in preference to Asset C.
If, for Illustration, we assume that both assets are company shares trading in the stock
market, the competitive activity between profit-seeking investors would increase the
demand for Asset D, which would in turn bid up its price in market.
An increase in an investment's market price will result in a reduction in its return. For
example, if the price of Asset D in the market was currently £10.00 and it is expected to pay
a dividend of sh. 1.20, the expected return would be: (sh. 1.20/ sh. l0.00) x 100 = 12 %.
Should the competitive demand for Asset D bid its price up to sh. 12.00 the expected return
would then be reduced to: (sh. 1.20/ sh.12.00) × 100 = 10 per cent.
Moreover, investors who owned Asset C would try to sell and invest their cash in Asset D,
thus bidding down the price of Asset C and conversely increasing its return expected return
from Asset C will continue to increase, while that of Asset D will continue to decrease until
eventually competition will force the market for the shares into equilibrium.
At this point both investments will then yield the same expected returns for the same level
of risk.
In a competitive financial market there cannot exist simultaneously two investment

opportunities which have equal risk but offer different returns, or alternatively offer equal
returns but have different risks - the continual competitive activity of profit-seeking
investors will prevent it.
The key point is that in a competitive market rational investors competing with each other
for profits will ensure that similar risk investments offer similar returns.
Also in an efficient market expected return will equal required return, for the very same,
competitive reasons. In an efficient market if an investment's expected return is greater;
than its required return investors will seek to buy it. This will push its price up and its
expected return down, until expected return and required return are in equilibrium.
Conversely should an asset's expected return be less than its required return, then investors
will seek to sell forcing the price down and expected return up, until the two are again
equal. Notice to the nature of the relationship between price and return, there is an inverse,
relationship between an investment's return and its price in the market. When price
increases, return will fall and vice versa.
So how can we choose between two alternative investments each of which has different
risk/return characteristics? Is there any way of making a rational comparison between two
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investments. We can draw on another statistical measure which is useful in such a case, the
coefficient of variation.
Coefficient of variation (CV)
Consider the following investment choice.
Asset X Asset Y
Expected return 10% 20%
Standard deviation 5% 8%
Both assets have different expected rates of return and different standard deviations. Asset
Y with the higher expected return also has the higher level of risk. This is what risk-averse
investors would expect in a competitive market, the higher risk investment carries-a higher
risk premium, in the form of a higher rate of return.
The risk premium is the amount by which the return from a risky investment exceeds that of
a risk-free investment. A risk premium is necessary to entice risk-averse investors to invest.
In the above example is Asset Y therefore the more risky investment?
Expected return and standard deviation are absolute measures, to make a valid comparison
between two such investments we need a relative measure of risk and return. This is where
the coefficient of variation (CV) is helpful. The coefficient of variation is a relative
measure, or ratio, of dispersion and is particularly useful in comparing assets that have
different risk-return characteristics.
Basically the higher the CV, the higher the risk. The coefficient of variation is measured as
the ratio of the standard deviation to the expected return:
= ̅
For Assets X and Y the coefficient of variation is calculated as
Asset X Asset Y
Expected return, r 10% 20%
Standard deviation, 5% 8%
Coefficient of variation (CV) = 5 ÷10 8 ÷20
= 0.50 0.40
We can see that although Asset Y has the higher absolute risk measure, , it has the lower
coefficient of variation, which means that it actually has lower risk per unit of return. The
returns from Asset X are relatively more volatile (risky) compared to those from Asset. For
a rational, risk-averse investor the preferred choice in this case' would be Asset Y. Although
as always, the final decision rests with the investor and depends on investor's risk
propensity or attitude to risk.
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Risk and time
Risk is often viewed as an increasing function of time the further into the future project, the
greater the potential variability of returns. In developing a financial model of an
investment's future cash flow returns, the more distant the cash flows are projects into the
future, the more risky they become.
We will now move on to explore what happens to risk and return when we wish to combine
assets or investments together into a portfolio.
PORTFOLIO THEORY
So far we have explored the risk-return relationship in the context of a single asset. Now we
are going to explore the effect on risk and return when an investor is managing a portfolio
of assets, rather than just a single asset. A portfolio is simply a collection for a group of
assets, and, as we shall see later, preferably a diverse group of assets.
Portfolios can consist of, at one extreme, just a few investments held by individuals or, at
the extreme, of hundreds or even thousands of investments managed by the giant1
investment management funds. Now suppose, 'just for an instant', that you had a Shs.l
million windfall on the lottery what would you do with the money?
Probably you would invest some of your new found wealth. Invest it in what kind of assets?
Perhaps a proportion would go into a bank or building society deposit account(s). You may
decide to invest" in a new house, you may also decide to invest a proportion in a range of
shares on the stock market. Another proportion you may decide to invest in a long-term
savings scheme, purchase a work of art, and so forth.
This diverse group of investments would be your asset or investment portfolio. It is unlikely
that you would invest all your money in a single asset, as this would be the high risk
strategy.
Rather, your objective should be to create an efficient portfolio, which is one which will
maximize your return for a certain level of risk, or alternatively minimize your risk for a
required level of return.
You would also be concerned with how future changes to your portfolio through; disposals
and/or acquisitions of individual assets would affect the overall level of risk and return on
your portfolio.
Thus the risk of any single prospective asset or investment should not be viewed in
isolation; it should be viewed in the context of its impact on the risk and return of the
existing portfolio of assets.
The same investment principles apply for financial managers of commercial firms, as they
essentially managing a portfolio of assets in die form of investment projects, financial
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managers will also be concerned with achieving an efficient investment portfolio their firms
and with assessing how changes in a firm's portfolio will impact on its levels of risk and
return, and ultimately on its share price in the financial markets. But before discovering
how changes to a portfolio will affect its risk and return we must first be able calculate the
risk and return of a portfolio. We will deal with portfolio return first.
Portfolio return
To find the expected return of a portfolio E(rp), or ̅ p, we can apply what we have learned
previously about the expected return being a weighted average of possible outcomes.
However, when dealing with a portfolio of assets the expected return is calculated as the
weighted average of the expected returns of all the individual assets making up the portfolio
and this applies in all cases to portfolios of all sizes, not just two-asset portfolios.
The individual asset weightings are simply the respective proportion of the portfolio
invested in each asset and, as with our previous probability weightings, all the proportionate
weightings will sum to 1.0 (or 100 per cent). The, expected return on a portfolio is
represented mathematically as follows:
E(rp) = w1r1 + w2r2 + ….. + wnrn

Where
E(rp) = the expected return of the portfolio

w1 = weights of the individual assets (where i=1,2…..n)
r1 = expected return of the individual assets (where i = 1,2,..n)
n = number of assets in the portfolio
For example, if you decided to invest Shs.10,000 of your lottery winnings in a two-asset
portfolio in the following proportions:
Security 1 Security 2
Expected return on security, E(r) 20% 16%
Amount invested Shs.6,000 Shs.4,000
Proportion invested 0.6 0.4
The expected return on this portfolio would be:
E(rp) = 0.6 (20%) + 0.4 (15%)
= 12% + 6%
= 18%
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Portfolio risk
As we are about to learn, calculating portfolio risk is a more complex task than calculating
portfolio return, so do not be discouraged if some of the concepts at first seem difficult
grasp, with a little practice they will soon become familiar.
Based on our knowledge of portfolio return it would seem logical to measure the risk of our
two security portfolio in a similar manner, by simply calculating a weighted average of the
respective standard deviations of the two securities, where the weightings are against the
portfolio proportions.
For example, assuming the standard deviations of the two securities 1 and 2 above to be 9%
and 7%, respectively, the standard deviation of the portfolio, p, would calculated as:
Amount invested Shs.6,000 Shs.4,000
Standard deviation of security, 9% 7%
Standard deviation of the portfolio, = w1 1+w2 2
= 0.6(9%) + 0.4(7%)
= 5.4% + 2.8%
= 8.2%
A word of warning, however, calculating the portfolio's risk by simply taking a weighted
average of the two standard deviations assumes a very special condition: namely that the
two assets are perfectly positively correlated.
Unfortunately, except for this very special case of perfect positive correlation, portfolio risk
is a measured by simply calculating a weighted average of the standard deviations of all the
individual assets in the portfolio, some more work is required.
To hold a portfolio of only two assets, both of which are perfectly positively correlated is
not a good investment strategy, for reasons we are shortly to explain. It is a much bet
strategy to diversity and invests in two assets which are not perfectly positively correlated.
Can you think why? Consider this for a moment before proceeding.
To appreciate why it is better to diversify, that is invest in assets which are less than
perfectly positively correlated, it is necessary first to understand the statistical concepts
correlation and covariance and how they relate to portfolio diversification. Students who are
familiar with these concepts can proceed to the 'Asset Correlation' section without loss of
continuity.
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CORRELATION, COVARIANCE AND PORTFOLIO DIVERSIFICATION
CORRELATION
Correlation is a statistical technique which is used to measure the relationship between data
variables or data series management correlation is used to measure the direction of the
relationship between two assets or investments. Correlation measures both the degree and
direction of the relationship. Broadly speaking there are three categories or states of
correlation as follows:
i. Positive correlation. This is the state which exists when two variables move in the
same direction at the same direction e.g. sales and profits. Under normal business
conditions one would expect sales and profits to be positively correlated. An increase
in sales would normally be expected to produce an increase in profits, and a fall in
sales: reduction in profits.
ii. Negative correlation. This state occurs when two variables move in the opposite
direction at the same time that is they are inversely related. Assuming normal;
business conditions, one would expect the price and demand for a company's
products be negatively correlated. An increase in price is likely to produce a decrease
in demand and vice versa.
iii. Zero correlation. This applies when there is no relationship between variables, a
change in one variable is independent of a change in the other.
The correlation coefficient
The degree to which two variables, or the returns from two assets, are correlated is
measured by correlation coefficient, p (Greek letter 'rho') which ranges from +1.0 for
perfect positive correlation to -1.0 for perfect correlation. A correlation coefficient of 0
suggests no relationship between variables.
Perfect positive correlation (P = +1.0) exists where two variables move together in exactly
the same direction at the same rime and by the same relative degree of magnitude.
For example, if we have two perfectly correlated variables A and B and variable A
increases by 10 per cent, then β will also increase by a constant amount or proportion of this
10 per cent. The increase for B could be less than, equal to, or greater than 10 per cent.
The key point is that the relative change between the variables remains constant over time.
In the case of perfect negative correlation (p = -1.0), this occurs when two variables move
in exactly opposite direction at the same time and by the same relative degree of magnitude.
Again the proportionate relationship between the variables must remain constant over time.
A correlation coefficient lying between 0 and +1.0 suggests that there is a generally
positive, but not necessarily a precise predictable, relationship between variables and the
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closer p is to 0, the weaker tine positive relationship. Similarly a correlation coefficient

lying between 0 and -1.0 suggests a generally negative, but not necessarily a precise
predictable, relationship between variables, and similarly the closer p is to 0, the weaker the
negative relationship.
It is important to appreciate that the correlation coefficient is an expression of an average

relationship. There can be temporary or short-term deviations in the relationship, but
correlation is concerned with the average nature of the relationship over the longer term.
Asset correlation
Figure below illustrates three broad types of possible correlation states between of two
assets in a portfolio and indicates .their respective correlation coefficient. Correlation was
perfectly positive in diagram (a), or perfectly negative in all the points would lie in a
straight line; the line would slope upwards to and downwards to the right in (b).
Types of correlation: two-asset portfolios.
Asset C, rate of return


Asset A, rate of return

 

 
 

Asset D, rate of return
Asset B, rate of return (b) Negative correlation
(a) Positive correlation P < 0.0
P > 0.0
Asset Y, rate of return
 

 
 
 

  
Asset X, rate of return

(c) Zero correlation
P = 0.0
The returns on most securities in the stock market arc positively correlated, but not
perfectly positively correlated. This is because the returns on most assets tend to follow the
movements in the general economy. If the financial markets anticipate a good economic
outlook then expected share returns tend to go up, and conversely if the markets take a very
gloomy view of future economic conditions then expected returns tend to go down.
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RISK OF A 2 ASSET PORTFOLIO
We can now return to quantifying the risk of a two-asset portfolio-by using the statistical
measures of variance and standard deviation. We will look first at the variance of return for
a two-asset portfolio which is given by the following formula:
Varp = (w1)2 ( 1)2 + (w2)2( 2)

2
+ 2(w1wℓ , 1 2)
Varp = the variation of returns for a two-asset portfolio.
Wi = weights or proportions of the individual portfolio assets (i = 1, 2)
= standard deviations of the individual portfolio assets (i = 1, 2)
P12 = correlation coefficient of returns between assets 1 and 2
To find the standard deviation for a two-assets portfolio we simply take the square root of
the variance as follows:
1 = ( ) ( ) + ( ) ( ) + 2( )
If you are new to the do not be deterred by these complex-looking formulae: they are notas
formidable as they look.
If you will note that calculating both the variance and standard deviations of a portfolio for
more complex than simply calculating a weighted average of the variances or standard
deviations of the two separate assets. Although both formulae include the weighted average
of the variances of the two separate assets they also incorporate a third term,
2( ), which represents a weighted measure of the covariance of the asset
returns.
COVARIANCE
The variance of a portfolio is described as: the weighted sum of the individual asset
variances plus twice their covariance (COV) and the standard deviation of a portfolio is
defined as the square root of the weighted sum of the individual asset variances plus twice
their covariance (COV).
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The covariance term in the above equations is represented by (p12)( 1, 2) and notice that,
as for the standard deviations of the respective assets, it is weighted by the product of the
respective proportions of each asset (w1w2) in the portfolio.
Covariance (COV) is a measure of how two assets move together in terms of the degree and
magnitude of the movement. Remember correlation measures degree and direction s of
movement.
The covariance of two securities', Security 1 and Security 2, denoted COV12, is simply the
product of the standard deviations of the two securities 1, 2 multiplied by their correlation
coefficient (pl2), that is, (p12)( 1, 2). The correlation coefficient of the two securities (p12)
is equal to the covariance of the two securities, COV12, divided by the product of their
standard deviations ( 1, 2).
The relationship between covariance and correlation can be seen more clearly from the
following:
Covariance, COV12, = (p12)( 1, 2)
Therefore
Correlation coefficient (p2) =

( , )
You will note that covariance includes correlation. Covariance is an absolute measure of
how two variables move together and depends on the units in which the variables are
measured - this is one of its difficulties.
For example, if the two variables were (a) the height, and (b) the weight of people the value
of covariance would depend on whether the variables were measured imperially (i.e in feet
and stones, or even inches and pounds), or metrically (i.e. in metres and kilograms, or
simply centimetres and grams).
Correlation, on the other hand, is an improved covariability concept; it is a relative measure

of covariability and is completely independent of the units of measurement either variable.
Whereas covariance can assume any value however, large or correlation can only assume
values ranging between -1.0 and +1.0 and this makes more convenient measure to work
with; consequently, covariance is converted into a correlation coefficient.
CALCULATING THE RISK OF A 2 ASSET PORTFOLIO
If we now return to the two-asset portfolio consisting of Security 1 and Security 2, and this
time determine the portfolio risk (variability of returns) p, by applying the previous
equation and assuming perfect negative correlation between asset returns.
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Amount invested £6,000 £4,000
Standard deviation of returns 9% 7%
= w1 1+w2 2
= 0.6(9%) + 0.4(7%)
= 5.4% + 2.8%
= 8.2%
1 = ( ) ( ) + ( ) ( ) + 2( )
= (0.6) (9%) + (0.4) (7%) + 2[(0.6)(0.4)(−1.0)(9%)(7%)]
= 29.16 + 7.84 + 2(−15.12)
= √37.0 − 30.24
= √6.76
= 2.6%
You will notice that the risk of the two-asset portfolio has reduced significantly with perfect
negative correlation (pl2 = -1.0) compared with our previous calculation of 8.2 per cent,
when we assumed that the two assets were perfectly positively correlated (p!2 -+1.0). For
practice you may wish to verify the original calculation of p = 8.2 per cent by applying the
above equation and substituting p12 = +1.0.
It is important to remember that portfolio variances and standard deviations are now just
simple weighted averages of the individual asset variances and standard deviations. When
correlation is less than perfectly positive, the risk of the portfolio will be less than a
weighted average of the risks of the individual assets.
Portfolios consisting of more than two assets
When more than two assets are included in a portfolio the expected return is always, a
weighted average of the expected returns of all the individual assets, no matter how many
assets comprise the portfolio.
Unfortunately the process of computing variance and standard deviations for more than two
asset portfolios is not so simple, it becomes an increasingly complex task as more assets are
added to the portfolio. The covariance of each additional asset with each existing asset in
the portfolio must be computed and the number of covariance terms actually increases
exponentially.
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For example, if we were to add a third security, Security 3 to our two security portfolio
above we now need to calculate three pairs of covariance (COV12,.COV13 and COV23)
rather than just one, COVl2, as before. If a fourth security is added you get six covariance
combinations and so on.
Fortunately, as we are about to explain, once a portfolio reaches 20 to 30 assets randomly

selected, the scope for increasing risk reduction by including additional assets diminishes
dramatically.
Portfolio diversification
We have just seen that if we combine negatively correlated assets the overall variability (i.e.
risk) of portfolio returns can be substantially reduced. This is the principle of
diversification, which is, reducing risk by holding a portfolio of diverse assets. In other
words not holding all your investment eggs in one basket. Although, as we shall discover
later, total risk can be significantly reduced by diversifying asset holdings in a portfolio, it
cannot be completely eliminated.
We can examine the effects on the risk of our two-asset portfolio if the correlation between
the two securities is zero:
1 = (0.6) (9%) + (0.4) (7%) + 2[(0.6)(0.4)(0)(9%)(7%)]
= √29.16 + 7.84 + 0
= 6.1%
This time portfolio risk has been reduced below the weighted average of the two individual
securities when they were perfectly correlated, but you will notice that the reduction in risk
is not as substantial as with perfect negative correlation.
The effects of portfolio weightings
What do you think would happen to the risk of the portfolio if you decided to change the
weightings of your investment in each security? Observe the effect of changing the
portfolio weightings to a 50/50 split, still assuming perfect negative correlation:
1 = (0.5) (9%) + (0.5) (7%) + 2[(0.5)(0.5)(−1.0)(9%)(7%)]
= 1.0%
The risk of the portfolio has reduced as there is now a lesser proportion invested in the more
risky asset, Security 1.
To summarise our correlation findings so far see table below:
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Portfolio risk for various two-asset combinations and correlations

Asset combination Correlation coefficient of Portfolio risk,
W1 W2 returns 1 1
0.8 0.4 + 1.0 8.2%
0.6 0.4 0.0 6.1%
0.6 0.4 -1.0 2.6%
0.5 0.5 -1.0 1.0%
0.4 0.6 -1.0 0.6%
We can now summarise some of the key points about the effect of correlation portfolio
risk.
1. If there is perfect positive correlation of returns between two assets, portfolio equal to
the weighted average of the standard deviations (individual risks) of assets. No
reduction in risk is achieved.
2. If there is perfect negative correlation of returns between two assets, portfolio may be
virtually eliminated when the optimum combination of assets is achieved.
3. If the correlation of returns between two assets is less than 1.0, portfolio risk can
reduced by diversification. The less the degree of positive correlation, the greater will be
the risk reduction effects. However, combining assets which are negative will reduce
risk further.
Remember that the investor or financial manager's goal is to achieve an efficient portfolio,
that is one which yields the highest expected return for a given level of risk (standard
deviation), or minimises risk (standard deviation) for a given level of return.
Diversified firms
A common practical application of diversification is for corporate firms to engage in

countercyclical operations, or businesses. The objective is to counteract cyclic economic,
seasonal and market conditions, by investing in a portfolio of businesses which respond
differently to the same, economic or seasonal circumstances e.g. economic recession or
economic boom.
For example, diversification in its most simple form would be a retailing company
smoothing out seasonal fluctuations in sales and earnings by selling different product lines
at different times of the year e.g. in swim suits and sweaters in winter.
A retailing company could take diversification a stage further and develop activities in other
business areas such as the hotel and leisure industry or property development, international
diversifications may be considered, particularly investing in foreign markets which have
economic cycles negatively correlated to the firm's domestic cycle.
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Illustration
Return.
Calculate the rate of return earned (realized) on each of the following investments over the
past year.
Investment Opening value Closing value Cash flow

(shs) (shs) (shs.)
1 10,000 11,000 500
2 20,000 19,000 500
3 3,500 3,800 -100
4 123,000 131,000 9,000
5 65,000 63,000 1,100
Solution
The rate of return, rt, earned on an investment is given by:
Investment
1 [(11,000 – 10,000) + 500]/10,000 15.0%

2 [(19,000 – 20,000) + 500]/20,000 -2.5%
3 [(3,800 – 3,500) - 100]/3,500 5.7%
4 [(131,000 – 123,000) + 900]/123,000 13.8%
5 [(63,000 – 65,000) + 1,100]/55,000 -1.4%
Illustration
Risk and return.
Calculate the expected return and risk (standard deviation) of the following investment. If
the return on a risk-free investment (e.g. a Treasury bill) is currently 7 per cent should the
following investment be undertaken?
Return Probability
5% 0.10
6% 0.20
7% 0.40
8% 0.30
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Solution
a) Expected return, E(r)
Return, r1 Probability, P(r1) r1 x P (r1)
5% 0.10 0.5
6% 0.20 1.2
7% 0.40 2.8
8% 0.30 2.4
E(r) = 6.9%
b) Standard deviation of return,
(2) – (3) (4) × (4) (5) ×(6)

(1) (2) (3) (4) (5) (6) (7)
I ̅ ̅ ̅ − ̅ ( ̅ − ̅) P( ) ( ̅ − ̅ ) x P( )
1 5% 6.9% 1.9% 3.61% 0.10 0.36

2 6 6.9 0.9 0.81 0.20 0.16
3 7 6.9 -0.1 0.01 0.40 0.00
4 8 6.9 -1.1 1.21 0.30 0.36
Varr = ∑ ( ̅ − ̅ ) × P( ) = 0.68%
r = ∑ ( ̅ − ̅ ) × P( ) = √0.88% = 0.94%
The proposed investment has an expected return of 6.9 per cent and a standard deviation
0.94 per cent. Compared with the return on the risk-free investment of 7 per cent, this
investment would not be worthwhile. The expected return is marginally lower at 6.9 per
cent and it is a risky investment.
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REVISION QUESTIONS
QUESTION 1
An investor has an investment fund of Sh. as 1,000,000.he intends to apportion this fund
into two securities. A and B. as follows; sh. 200,000 insecurity A and sh.800, 000 insecurity
B
The return on each security is dependent on the state of the economy as how below:
State of economy Probability Return on security A Return on security B
Boom 0.4 18% 24%

Average 0.5 14% 22%
Recession 0.1 12% 21%
Required:
(i) Expected returns on the portfolio

(ii) Standard deviation of each security
(iii) Correlation coefficient between security A and security B
(iv) Assess the extent of risk diversification by the investor through the portfolio
holdings
Solution:
i) WA = 200,000 = 0.2 WB = 800,000 = 0.8

1m 1m
ERp = Weighted Average = WA ERA + WB ERB

ERA = 18 ×0.4 + 14 × 0.5 + 12×0.1 = 15.4
ERB = 24 ×0.4 + 22 x 0.5 + 21×0.1 = 22.7
ERp = 0.2× 15.4 + 0.8 × 22.7 = 21.24%
(ii)
n
2
i   CR  ER )
i 1
i 1 P1
A B
(18 - 15.4)2 0.4 = 2.704 (24 - 22.7)2 0.4 = 0.676
(14-15.4)2 0.5 = 0.98 (22-22.7)2 0.4 = 0.245
(12-15.4)2 0.1 = 1.156 (21-22.7)2 0.4 = 0.289
Variance 4.84 Variance 1.21
  4.84  2.2   1.21  1.1
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iii) Correlation Co-efficient between discounting A&B
CovAB
VAB 
AB
n
COAB = 
i 1
=( RA  ER A )( RB  ERB ) Pi
= (18 - 15.4)(24 - 22.7)0.4 = 1.352

= (14 - 15.4)(22 - 22.7)0.5 = 0.49
= (12 - 15.4)(24 - 22.7)0.1 = 0.578
Cov AB = 2.42= 1
COAB
VAB =  2.42
AB
2.2 ×1.1
=1
weighted p  weighted p
Percentage Risk diversification =  100
weighted p
Weighted p = WA  A + WB  B= 0.2×2.2 + 0.8× 1.1 = 1.32
Actual p = w2 AA2  w2 BB 2  2 wAACOAB
= 0.2 2  2.2 2  0.82  1.12  2  0.8  2.5  1.32
% Risk diversification > 1.32  1.32 100%  0%

1.32
Thus there will be no risk minimization because the securities are perfectly positively co-
related.
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TOPIC 12
ISLAMIC FINANCE
Introduction
Islamic finance, despite its name, is not a religious product. It is however a growing series
of financial products developed to meet the requirements of a specific group of people.
Conventional finance includes elements (interest and risk) which are prohibited under
Shari’ah law. Developments in Islamic finance have arisen to allow Muslims to invest
savings and raise finance in a way which does not compromise their religious or ethical
beliefs.
It is estimated that between 1.5 and 1.8 billion people (one quarter of the world’s
population) are Muslim. Geographically, most Muslims live in Asia (over 60%) or the
Middle East and North Africa (about 20%). Despite these figures, Islamic finance is still
very much a niche market, with the vast majority of Muslims, who have access to finance,
using conventional financial products. The following map shows the geographical spread of
the Muslim population throughout the world as a percentage of each country’s population,
with the highest concentrations in the darkest shades of purple.
The meaning of Islamic finance
Islamic finance is a term that reflects financial business that is not contradictory to the
principles of Shari’ah. Conventional finance, particularly conventional banking business,
relies on taking deposits from, and providing loans to, the public. Therefore, the banker-
customer relationship is always a debtor‑creditor relationship. A key aspect of conventional
banking is the giving or receiving of interest, which is specifically prohibited by Shari’ah.
For example a conventional bank’s fixed deposit product is based on a promise by the
borrower that is the bank to repay the loan plus fixed interest to the lender that is the
depositor. Essentially, money deposited will result in more money which is the basic
structure of an interest.
In other non‑banking businesses, conventional products and services, such as insurance and
capital markets could be based on elements that are not approved by Shari’ah principles
such as uncertainty (Gharar) in insurance and interest in conventional bonds or securities. In
the case of insurance, the protection provided by the insurer in exchange for a premium is
always uncertain as to its amount as well as its actual time of happening. A conventional
bond normally pays the holder of the bond the principal and interest.
Conventional practices could also involve selling or buying goods and services that are not
lawful from a Shari’ah perspective. These might be non‑halal foods such as pork,
non‑slaughtered animals or animals not slaughtered according to Islamic principles, alcohol
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or services related to gambling, pornography and entertainment. In short, conventional

business practices could be non‑compliant from a contractual structure perspective (if they
are based on interest and uncertainty) and / or from a transactional perspective when they
are involved in producing, selling or distributing goods and services that are not lawful
according to Shari’ah.
JUSTIFICATION FOR ISLAMIC FINANCE
HISTORY OF ISLAMIC FINANCE

The financial industry has historically played an important role in the economy of every
society. Banks mobilize funds from investors and apply them to investments in trade and
business. The history of banking is long and varied, with the financial system as we know it
today directly descending from Florentine bankers of the 14th – 17th century. However,
even before the invention of money, people used to deposit valuables such as grain, cattle
and agricultural implements and, at a later stage, precious metals such as gold for
safekeeping with religious temples.
Around the 5th century BC, the ancient Greeks started to include investments in their
banking operations. Temples still offered safe-keeping, but other entities started to offer
financial transactions including loans, deposits, exchange of currency and validation of
coins. Financial services were typically offered against the payment of a flat fee or, for
investments, against a share of the profit.
The views of philosophers and theologians on interest have always ranged from an absolute
prohibition to the prohibition of usurious or excess interest only, with a bias towards the
absolute prohibition of any form of interest. The first foreign exchange contract in 1156 AD
was not just executed to facilitate the exchange of one currency for another ata forward
date, but also because profits from time differences in a foreign exchange contract were not
covered by canon laws against usury.
In a time when financial contracts were largely governed by Christian beliefs prohibiting
interest on the basis that it would be a sin to pay back more or less than what was lent, this
was a major advantage.
Islamic banking is banking or banking activity that is consistent with the principles of
sharia (Islamic law) and its practical application through the development of Islamic
economics. As such, a more correct term for Islamic banking is sharia compliant finance.
Sharia prohibits acceptance of specific interest or fees for loans of money (known as riba,
or usury), whether the payment is fixed or floating. Investment in businesses that provide
goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also
haraam("sinful and prohibited"). Although these prohibitions have been applied historically
in varying degrees in Muslim countries/communities to prevent unIslamic practices, only in
the late 20th century were a number of Islamic banks formed to apply these principles to
private or semi-private commercial institutions within the Muslim community.
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As of 2014, sharia compliant financial institutions represented approximately 1% of total

world assets By 2009, there were over 300 banks and 250 mutual funds around the world
complying with Islamic principles and as of 2014 total assets of around $2 trillion were
sharia-compliant. According to Ernst & Young, although Islamic Banking still makes up
only a fraction of the banking assets of Muslims, it has been growing faster than banking
assets as a whole, growing at an annual rate of 17.6% between 2009 and 2013, and will
grow by an average of 19.7% a year to 2018
CAPITALISM
Islamic Finance and banking is as old as the religion itself with its principles primarily
derived from the Quran. An early market economy and an early form of mercantilism,
sometimes called Islamic capitalism, was developed between the eighth and twelfth
centuries. The monetary economy of the period was based on the widely circulated currency
the gold dinar, and it tied together regions that were previously economically independent.
A number of economic concepts and techniques were applied in early Islamic banking,
including bills of exchange, partnership (mufawada, including limited partnerships, or
mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal), cheques,
promissory notes, (Muslim traders are known to have used the cheque or ṣakk system since
the time of Harun al-Rashid (9th century) of the Abbasid Caliphate., trusts, transactional
accounts, loaning, ledgers and assignments. Organizational enterprises independent from
the state also existed in the medieval Islamic world, while the agency institution was also
introduced during that time. Many of these early capitalist concepts were adopted and
further advanced in medieval Europe from the 13th century onwards.
HALAL
In Islam, Halal is an Arabic term meaning “lawful or permissible” and not only
encompasses food and drink, but all matters of daily life.
Industry sectors that generally don’t manufacture or market forbidden products are
considered halal, and are acceptable for Muslim investors. Some classic examples of
suitable industries are:
 Chemical manufacture
 Computers and computer software
 Energy
 Telecommunications
 Textiles
 Transportation
When considering a halal investment, you need to look deeply into a company’s business to
discover its core source of revenue, or how it actually makes its money. Its industry sector,
or part of the economy to which it belongs, may not always tell the clear operations or
dealings of a business firm.
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HARAM
Islamic law identifies business activities as haram when they generate profits in
unacceptable ways. Haram business activities include the manufacture or marketing of any
of these products:
 Alcohol
 Gambling or gaming activities
 Conventional financial services
 Pork and pork products
 Pornography
In addition, most Shariah scholars advise against investing in tobacco companies or those
involved in weapons and other defense-industry products. And many classify the
entertainment industry in general as haram.
RIBA
The literal translation of the Arabic word riba is increase, addition or growth, though it is
usually translated as 'usury'. While English speakers usually understand usury as the
charging of an exploitative interest rate, the word 'riba' in Arabic applies to a wider range of
commercial practices.
In Islamic finance, riba is commonly translated as interest rate excess. The prohibition of
riba is the cornerstone of Islamic finance.
Riba symbolizes both the earning of money via a predetermined rate on a loan and social
justice.
Although making profit is allowed in Islam, earning money on money is not, because there
is no productive and/or trade activity creating additional wealth.
Riba creates social injustice because lenders requiring interest on loans tend to profit from
the weak position of borrowers. Thus, because social justice and fairness in business are the
most important parts of economic transactions, riba is prohibited by Shariah, or Islamic law.
GHARAR(Or Uncertainty)
It is defined as to knowingly expose oneself or one’s property to jeopardy, or the sale of a
probable item whose existence or characteristics are not certain. An example in the context
of Islamic finance is advising a customer to buy shares in a company that is the subject of a
takeover bid, on the grounds that the share price is likely to increase. Gharar does not apply
to business risks such as investing in a company.
Gharar can appear in a number of forms. For example, to sell a non-fungible asset (such as
a horse) that one does not own (to "sell short") is widely prohibited on the grounds of
gharar since only the owner of the horse has the right to sell it. In the event that the seller
cannot acquire the horse before it becomes deliverable to the buyer, harm of some kind may
befall the buyer. Neither can one sell an item of uncertain quality, an unborn calf for
example, since the buyer and the seller do not know the precise quality of the thing that
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they are trading. A third example of gharar can be seen where a contract document is not
drawn up in clear terms. For example if a contract of sale states in one place that the price
of the object of sale is Sh.100 and in another place Sh.200, then there is uncertainty as to
the price at which the parties have agreed to trade.
PRINCIPLES UNDERLYING ISLAMIC FINANCE

There are a number of key principles and prohibitions relevant to finance and commercial
transactions which distinguish Islamic finance from the conventional forms.
The key Shari’ah principles which underpin Islamic finance, and have led to the creation of
a separate finance industry, are as follows:
a) Prohibition on usury and interest (riba)
Prohibition of riba, a term literally meaning “an excess” and interpreted as “any
unjustifiable increase of capital whether in loans or sales” is the central tenet of the system.
More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount
of principal (i.e., guaranteed regardless of the performance of the investment) is considered
riba and is prohibited. The general consensus among Islamic scholars is that riba covers not
only Usury but also the charging of “interest” as widely practiced.
This prohibition is based on arguments of social justice, equality, and property rights. Islam
encourages the earning of profits but forbids the charging of interest because profits,
determined ex post, symbolize successful entrepreneurship and creation of additional
wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the
outcome of business operations and may not create wealth if there are business losses.
Social justice demands that borrowers and lenders share rewards as well as losses in an
equitable fashion and that the process of wealth accumulation and distribution in the
economy be fair and representative of true productivity.
Under the Shari’ah, it is not permissible to charge, pay or receive interest. The Shari’ah
does not recognize the time value of money and it is therefore not permissible to make
money by lending it. Money must be used to create real economic value and it is only
permissible to earn a return from investing money in permissible commercial activities
which involve the financier or investor taking some commercial risk. This prohibition is the
main driving force behind the development of the modern Islamic finance industry. Riba
can take one of two forms: riba al-naseeyah and riba al-fadl.
1. Riba al-naseeyah is the amount of excess received by a lender in addition to the

capital amount lent. This type of riba is comparable to the traditional concept of
interest in conventional lending activities.
2. The second type, riba al-fadl, is excess compensation without any form of
consideration in return.
In modern finance, riba al-fadl could be applicable to several exchange of commodities
contracts.
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The idea is that when compensation is paid, it should be justified or be set against a specific
activity and the return should also be associated with a specific risk. Therefore when parties
exchange commodities of similar value and one party pays excessive compensation to the
other party, this is considered riba.
b) Prohibition on realizing a gain from speculation (mayseer)

It is not permissible to earn a profit from speculation. Gambling is therefore not permitted
under Shari’ah. Any contracts or arrangements which involve speculation are also not
permitted. That said, it is accepted under the Shari’ah that there is an element of speculation
in most commercial arrangements and, unlike the absolute prohibition of interest, it is a
question of the degree of speculation involved and whether the intention behind the
transaction is to realise a gain from some productive effort or purely speculation.
The distinction between prohibited speculation and legitimate commercial speculation is

not always clear in practice and there are examples where it can be difficult to distinguish
between the two. For example, it is generally accepted that it is permissible to make an
equity investment in a company engaging in a business activity that is permissible under the
Shari’ah with a view to realizing future dividends and capital gains on the investment.
There is of course a degree of commercial speculation involved about the future prospects
of the company when an investor makes an equity investment, but whether such speculation
is permissible or not would depend on the intention of the investor, i.e. was the intention to
make a quick profit by speculating in the likely movement of the share price over a very
short period of time (as is arguably the case with day trading), or was the decision made on
the basis of careful evaluation of the company's past results and future prospects?
At the other end of the spectrum, equity derivatives such as index-linked derivatives are
generally viewed as unacceptable under Shari’ah because they involve speculation on the
movement of an equity index.
c) No uncertainty (gharar) in commercial transactions

Certainty of terms in any transaction is a key requirement under the Shari’ah. Again, as
with speculation, a degree of commercial uncertainty is acceptable but there must not be
any uncertainty about the key terms of the transaction. For example, in a transaction for the
sale of assets, the sale contract should set out a clear description of the assets being sold, the
sale price and the time for delivering the assets to the purchaser. Similarly, a leasing
contract needs to set out clearly the assets which are being leased, the duration of the lease
and the rent payable under the lease. One of the reasons that conventional insurance
contracts are not considered permissible under the Shari’ah is that there is no certainty as to
when a claim will be paid, given that there is no way of knowing if and when the insured
event will occur.
In the context of modern day Islamic finance, key examples of Gharar are:
(a) Advising a customer to buy shares of a particular company that is the subject of a
takeover bid, on the grounds that its share price can be expected to rise;
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(b) Buying a house, the price of which is to be specified in the future;

(c) When the subject matter or specifications to a contract are unknown; and
(d) Deferred payment under a contract where the deferment is for an unknown period.
d) All activity must be for permitted purposes (halal)

Muslims must not engage in (or derive any benefit from) activities which are prohibited
under the Shari’ah. It is therefore not permissible for Muslims to invest in businesses which
engage in prohibited activities such as casinos, breweries or factories making pork products.
It is also not permissible for Islamic banks to provide any financing to such businesses.
However, a very strict interpretation of these rules would mean that Muslims would only be
able to invest in a very limited number of businesses internationally.
For example, it would not be permissible for Muslims to invest in a hotel that serve alcohol,
a food company which also manufactures pork products as part of its product range or any
business that lends or borrows money at interest.
In light of the practical considerations of international commerce and in order to enable

Muslim investors to participate in it, a number of prominent Shari’ah scholars have
advanced the view that it is permissible for Muslims to invest in businesses or companies
which are not entirely Shari’ah compliant so long as certain conditions are met. These
conditions include (among other things):
(a) The principal business activity must be permissible under Shari’ah;
(b) Any income derived from prohibited activities should only form a small percentage
of the overall income of the company or business.
(c) The aggregate amount of interest-bearing debt incurred by a company or business
must not exceed a certain percentage of its assets or market capitalization.
(d) The accounts receivable of the company on the business must not exceed a certain
percentage of its assets or market capitalization.
e) Making Money from Money is not Permissible

One of the wrong presumptions on which all theories of interest are based is that money is a
commodity. It is, therefore, argued that just as a merchant can sell his commodity for a
higher price than his cost, he can also sell his money for a higher price than its face value,
or just as he can lease his property and can charge a rent against it, he can also lend his
money and can claim interest thereupon. Islamic principles, however, do not subscribe to
this presumption.
Money and commodity have different characteristics and, therefore, they are treated
differently.
Islamic instruments are clearly distinguishable from the interest-based financing on

the following grounds.
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1. Islamic finance operates differently from conventional financing where the financier
gives money to his clients as an interest-bearing loan, after which he has no concern as
to how the money is used by the client. In the case of Murabahah attitude, on the
contrary, no money is advanced by the financier that he wishes to purchase a
commodity, therefore, Murabahah is not possible at all unless the financier creates
inventory. In this manner, financing is always backed by assets.
2. In the conventional financing system, loans may be advanced for unethical purposes. A
gambling casino can borrow money from a bank to develop its gambling business. A
pornographic magazine or a company making nude films is as good customers of a
conventional bank as a house-builder. Thus, conventional financing is not bound by any
divine or religious restrictions. But the Islamic banks and financial institutions cannot
remain indifferent about the nature of the activity for which the facility is required. They
cannot effect Murabahah financing system for any purpose which is either prohibited in
Shariàh or is harmful to the moral health or the society;
3. It is one of the basic requirements for the validity of Murabahah that the commodity is
purchased by the commodity before selling it to the customer. The profit claimed by the
financier is the reward of the risk he assumes. No such risk is assumed in an interest-
based loan.
4. In an interest bearing loan, the amount to be repaid by the borrower keeps on increasing
with the passage of time. In Murabahah, on the other hand, a selling price once agreed
becomes and remains fixed. As a result, even if the purchaser (client of the Bank) does
not pay on time, the seller (Bank) cannot ask for a higher price, due to delay in
settlement of dues. This is because in Shariàh attitude there is no concept of time due of
money.
5. Leasing is ethical too because the financing is offered through providing an asset having
usufruct. The risk of the leased property is assumed by the lessor / financier throughout
the lease period in the sense that if the leased asset is totally destroyed without any
misuse or negligence on the part of the lessee, it is the financier / lessor who will suffer
the loss.
SOURCES OF FINANCE IN ISLAMIC FINANCING
Islamic banks cannot charge interest on lending, therefore, they have to find other ways of
financing entrepreneurs who are not ‘borrowers’ as the case with traditional banks but
basically stand as partners to the bank. Hence Islamic banks use the term ‘investments’ to
denote their ‘borrowing’ activities. These are done in basically Islamic investment
instruments which fall in two groups:
a) Sharing money with the investor (participating financing and thereby sharing in the
profits or losses). This includes the contracts of Musharaka and Murabaha.
b) Acting as intermediaries through a variety of sales and rental contracts. Islamic banks
acquire or ‘own’ the goods they acquire on behalf of would-be partners before re-
selling them or renting (at a higher margin).
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MURABAHA
Means trade with mark-up or cost-plus sale. It is one of the most widely used instruments
for short-term financing is based on the traditional notion of purchase finance. The investor
undertakes to supply specific goods or commodities, incorporating a mutually agreed
contract for resale to the client and a mutually negotiated margin.
Murabaha was originally an exchange transaction in which a trader purchases items
required by an end user. The trader then sells those items to the end-user at a price that is
calculated using an agreed profit margin over the costs incurred by the trader.
Features of Murabahah Financing

1. Murabahah is not a loan given on interest. It is the sale of a commodity for a deferred
price which includes an agreed profit added to the cost.
2. Being a sale, and not a loan, the murabahah should fulfill all the conditions necessary
for a valid sale.
3. Murabahah cannot be used as a mode of financing except where the client needs funds
to actually purchase some commodities. For example, if he wants funds to purchase
cotton as a raw material for his ginning factory, the Bank can sell him the cotton on the
basis of murabahah. But where the funds are required for some other purposes, like
paying the price of commodities already purchased by him, or the bills of electricity or
other utilities or for paying the salaries of his staff, murabahah cannot be effected,
because murabahah requires a real sale of some commodities, and not merely advancing
a loan.
4. The financier must have owned the commodity before he sells it to his client.
5. The commodity must come into the possession of the financier, whether physical or
constructive, in the sense that the commodity must be in his risk, though for a short
period.
6. The best way for murabahah, according to Shariah, is that the financier himself
purchases the commodity and keeps it in his own possession, or purchases the
commodity through a third person appointed by him as agent, before he sells it to the
customer. However, in exceptional cases, where direct purchase from the supplier is not
practicable for some reason, it is also allowed that he makes the customer himself his
agent to buy the commodity on his behalf. In this case the client first purchases the
commodity on behalf of his financier and takes its possession as such. Thereafter, he
purchases the commodity from the financier for a deferred price.
His possession over the commodity in the first instance is in the capacity of an agent of
his financier. In this capacity he is only a trustee, while the ownership vests in the
financier and the risk of the commodity is also borne by him as a logical consequence
of the ownership. But when the client purchases the commodity from his financier, the
ownership, as well as the risk, is transferred to the client.
7. As mentioned earlier, the sale cannot take place unless the commodity comes into the
possession of the seller, but the seller can promise to sell even when the commodity is
not in his possession. The same rule is applicable to murabahah.
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8. In the light of the aforementioned principles, a financial institution can use the
murabahah as a mode of finance by adopting the following procedure:
Firstly: The client and the institution sign an over-all agreement whereby the institution
promises to sell and the client promises to buy the commodities from time to time on an
agreed ratio of profit added to the cost. This agreement may specify the limit upto
which the facility may be availed.
Secondly: When a specific commodity is required by the customer, the institution
appoints the client as his agent for purchasing the commodity on its behalf, and an
agreement of agency is signed by both the parties.
Thirdly: The client purchases the commodity on behalf of the institution and takes its
possession as an agent of the institution.
Fourthly: The client informs the institution that he has purchased the commodity on his
behalf, and at the same time, makes an offer to purchase it from the institution.
Fifthly: The institution accepts the offer and the sale is concluded whereby the
ownership as well as the risk of the commodity is transferred to the client.
All these five stages are necessary to effect a valid murabahah. If the institution
purchases the commodity directly from the supplier (which is preferable) it does not
need any agency agreement. In this case, the second phase will be dropped and at the
third stage the institution itself will purchase the commodity from the supplier, and the
fourth phase will be restricted to making an offer by the client.
The most essential element of the transaction is that the commodity must remain in the
risk of the institution during the period between the third and the fifth stage. This is the
only feature of murabahah which can distinguish it from an interest-based transaction.
Therefore, it must be observed with due diligence at all costs, otherwise the murabahah
transaction becomes invalid according to Shariah.
9. It is also a necessary condition for the validity of murabahah that the commodity is
purchased from a third party. The purchase of the commodity from the client himself on
‘buy back’ agreement is not allowed in Shariah. Thus murabahah based on ‘buy back’
agreement is nothing more than an interest based transaction.
10. The above mentioned procedure of the murabahah financing is a complex transaction
where the parties involved have different capacities at different stages.
(a) At the first stage, the institution and the client promise to sell and purchase a
commodity in future. This is not an actual sale. It is just a promise to effect a sale in
future on murabahah basis. Thus at this stage the relation between the institution and
the client is that of a promisor and a promise.
(b) At the second stage, the relation between the parties is that of a principal and an
agent.
(c) At the third stage, the relation between the institution and the supplier is that of a
buyer and seller.
(d) At the fourth and fifth stage, the relation of buyer and seller comes into operation
between the institution and the client, and since the sale is effected on deferred
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payment basis, the relation of a debtor and creditor also emerges between them
simultaneously.
All these capacities must be kept in mind and must come into operation with all their
consequential effects, each at its relevant stage, and these different capacities should
never be mixed up or confused with each other.
11. The institution may ask the client to furnish a security to its satisfaction for the
prompt payment of the deferred price. He may also ask him to sign a promissory note
or a bill of exchange, but it must be after the actual sale takes place, i.e. at the fifth stage
mentioned above. The reason is that the promissory note is signed by a debtor in favour
of his creditor, but the relation of debtor and creditor between the institution and the
client begins only at the fifth stage, whereupon the actual sale takes place between
them.
12. In the case of default by the buyer in the payment of price at the due date, the price
cannot be increased. However, if he has undertaken, in the agreement to pay an amount
for a charitable purpose, he shall be liable to pay the amount undertaken by him. But
the amount so recovered from the buyer shall not form part of the income of the seller /
the financier. He is bound to spend it for a charitable purpose on behalf of the buyer, as
will be explained later in detail.
SUKUK
Similar characteristics to that of a conventional bond with the difference being that they are
asset backed, a sukuk represents proportionate beneficial ownership in the underlying asset.
The asset will be leased to the client to yield the return on the sukuk.
Since fixed-income, interest-bearing bonds are not permissible in Islam, Sukuk securities
are structured to comply with the Islamic law and its investment principles, which prohibit
the charging of and/or paying interest. This is generally done by involving a tangible
asset in the investment. For example, giving partial ownership of a property built by the
investment company to the bond owner accomplishes this purpose, since the bond owner is
then able to collect his profit as a rent, which is allowed under Islamic law.
Muslim jurists subject the buying and selling of debt obligations to certain conditions in
order to comply with the prohibition of riba (interest), gharar (uncertainty), and maysir
(gambling). In summary, the debt must be a genuine one i.e., it must not be a subterfuge to
borrow money such as an asset-linked buy-back arrangement. The debtor must
acknowledge the trade and creditors must be known, accessible, and sound.
Trading must be on a spot basis and not against debt. Importantly, the price cannot be other
than the face value. In line with these principles, early doctrine on interest-free finance
disallowed corporate or government bonds and the discounting of bills. Pressures for
innovation have resulted in finding a way out of these limitations, admitting ‘financial
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engineering’. In particular, leasing based bonds (sukuk al-ijara) have been developed.
Although other sukuk have been issued, e.g sukuk al-mudaraba, sukuk al-musharaka, sukuk
al-murabaha, the ijara sukuk remains the most popular.
Sukuk al-Ijara
The most commonly used sukuk structure is sukuk al-ijara. The popularity of this structure
can be attributed to a number of different factors; some commentators have described it as
the classical sukuk structure from which all other sukuk structures have developed, whilst
others highlight its simplicity and its favour with Shari’a scholars as the key contributing
factors. In the Islamic finance industry, the term “ijara” is broadly understood to mean the
‘transfer of the usufruct of an asset to another person in exchange for a rent claimed from
him’ or, more literally, a “lease”.
In order to generate returns for investors, all sukuk structures rely upon either the
performance of an underlying asset or a contractual arrangement with respect to that asset.
The ijara is particularly useful in this respect as it can be used in a manner that provides for
regular payments throughout the life of a financing arrangement, together with the
flexibility to tailor the payment profile - and method of calculation - in order to generate a
profit. In addition, the use of a purchase undertaking is widely accepted in the context of
sukuk al-ijara without Shari’a objections. These characteristics make ijara relatively
straightforward to adapt for use in the underlying structure for a sukuk issuance.
MUSHARAKA
It is a partnership where profits are shared as per an agreed ratio whereas the losses are
shared in proportion to the capital/investment of each partner. In a Musharaka, all partners
to a business undertaking contribute funds and have the right, but not the obligation, to
exercise executive powers in that project, which is similar to a conventional partnership
structure and the holding of voting stock in a limited company. This equity financing
arrangement is widely regarded as the purest form of Islamic financing.
Musharaka is a partnership, normally of limited duration, formed to carry out a specific

project.
It is, therefore, similar to a Western-style joint venture, and is also regarded by some as the
purest form of Islamic financial instrument, since it conforms to the underlying partnership
principles of sharing in, and benefiting from, risk.
Participation in a musharaka can either be in a new project, or by providing additional funds
for an existing one. Profits are divided on a pre-determined basis, and any losses shared in
proportion to the capital contribution. In this case, the bank enters into a partnership with a
client in which both share the equity capital- and maybe even the management -of a project
or deal, and both share in the profits or losses according to their equity shareholding. There
are two basic types of musharaka:
i) Sharikah al milk: partnership based on joint ownership. This may be voluntary e.g. in
the purchase of a ship, or involuntary e.g. as a result of inheritance.
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ii) Sharikah al uqud: partnership based on a contractual relationship.
There are five subdivisions:

1. Sharikat al Mufawadah(full authority and obligation): a limited partnership with equal
capital contributions, responsibility, full authority on behalf of others, and responsibility
for liabilities, incurred through the normal course of business.
2. Sharikat al Inan(restricted authority and obligation): a limited partnership with unequal
capital contributions. They do not share equal responsibility, and this reflects their share
of the profits.
3. Sharikat al Wujuh(goodwill /credit worthiness): companies based on the reputation of
one or both parties, typically small scale business.
4. Sharikat al Abdan(labour, skill and management): a company based on the contribution
of human efforts, no capital contributions, again, typically small scale business.
5. Sharikat al Mudaraba: a mudaraba
Basic Shariah rules concerning Musharakah

1. Musharaka contract must be built on the condition that capital investment is specific,
existent and immediately available. A contract is void if it is built on non-existent funds
or debt.
2. The partners in Musharaka contract are not necessary to have equal shares participation
in capital funds.
3. The participation capital must be in form of money and tangible assets.
4. It is permissible for one partner to singly handle and control Musharaka project with the
mandate of the other partners, but it is not permit to imposing any conditions that
prevents one or more of the partners from work. Because, Musharaka contract
empowers all partners within contract to dispose of and work with the capital.
5. It is not permissible to take security for profit return on capital but it is permissible that
to take a guarantee against negligent or misbehave of working partners.
6. To valid Musharaka contract, the profit share must be determined in pro rata ratio for
all partners, in order to avoid uncertainty. The profit share cannot be determined in
lump sum because this contravenes the requirement of Shariah law toward partnership
contract.
7. Profit share ratio of each partner must be based on the proportion of their shares in
capital. However, some of the jurists permit variation in profit shares whereupon it is
determined by mutual agreement
8. In case of losses, each partner bears losses according to its proportion of ratio of capital
investment.
9. Since partnership principle is permissible contract, not a binding contract, thus it is
permissible for any partner to leave the contract whenever he/she wishes. However, the
event must occur with the knowledge of the other partners because it may prejudices
his/her interest.
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MUDARABA
This is identical to an investment fund in which managers handle a pool of funds. The
agent-manager has relatively limited liability while having sufficient incentives to perform.
The capital is invested in broadly defined activities, and the terms of profit and risk sharing
are customized for each investment. The maturity structure ranges from short to medium
term and is more suitable for trade activities.
Mudaraba implies a contract between two parties whereby one party, the rabbal-mal
(beneficial owner or the sleeping partner), entrusts money to the other party called the
mudarib (managing trustee or the labour partner). The mudarib is to utilize it in an agreed
manner and then returns to the rabb al-mal the principal and the pre-agreed share of the
profit. He keeps for himself what remains of such profits.
The following rules must govern all Mudaraba transactions:

 The division of profits between the two parties must necessarily be on a proportional
basis and cannot be a lump sum or guaranteed return.
 The investor is not liable for losses beyond the capital he has contributed. The mudarib
does not share in the losses except for the loss of his time and efforts.
 Briefly, an Islamic bank lends money to a client to finance a factory, for example, in
return for which the bank will get a specified percentage of the factory's net profits
every year for a designated period. This share of the profits provides for repayment of
the principal and a profit for the bank to pass on to its depositors. Should the factory
lose money, the bank, its depositors and the borrower all jointly absorb the losses,
thereby putting into practice the pivotal Islamic principle that the providers and users of
capital should share risks and rewards.
Islamic banks use this instrument to finance those seeking investments to run their own
enterprises or professional units, whether they be physicians or engineers or traders or
craftsmen.
The bank provides the adequate finance as a capital owner in exchange of a share in the
profit to be agreed upon.
It is worth noting that this mode is a high risk for the bank because the bank delivers capital
to the mudarib who undertakes the work and management and the mudarib shall only be a
guarantor in case of negligence and trespass. Islamic banks usually take the necessary
precautions to decrease the risk and to guarantee a better execution for the mudaraba and
pursue this objective with seriousness.
However, it may be noted that, under mudarabah, the liability of the financier is limited to
the extent of his contribution to the capital, and no more.
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DIFFERENCE BETWEEN MUSHARAKAH AND MUDARABAH
The difference between musharakah and mudarabah can be summarized in the following
points:
1. The investment in musharakah comes from all the partners, while in mudarabah;
investment is the sole responsibility of rabb al-mal (beneficial owner or the sleeping
partner)
2. In musharakah, all the partners can participate in the management of the business and
can work for it, while in mudarabah, the rabb al-mal(beneficial owner or the sleeping
partner) has no right to participate in the management which is carried out by the
mudarib (managing trustee or the labour partner) only.
3. In musharakah all the partners share the loss to the extent of the ratio of their investment
while in mudarabah the loss, if any, is suffered by the rabbal-mal only, because the
mudarib does not invest anything. His loss is restricted to the fact that his labor has gone
in vain and his work has not brought any fruit to him. However, this principle is subject
to a condition that the mudarib has worked with due diligence which is normally
required for the business of that type. If he has worked with negligence or has
committed dishonesty, he shall be liable for the loss caused by his negligence or
misconduct.
4. The liability of the partners in musharakah is normally unlimited. Therefore, if the
liabilities of the business exceed its assets and the business goes in liquidation, all the
exceeding liabilities shall be borne pro rata by all the partners. However, if all the
partners have agreed that no partner shall incur any debt during the course of business,
then the exceeding liabilities shall be borne by that partner alone who has incurred a
debt on the business in violation of the aforesaid condition. Contrary to this is the case
of mudarabah. Here the liability of rabb al-mal is limited to his investment, unless he
has permitted the mudarib to incur debts on his behalf.
5. In musharakah, as soon as the partners mix up their capital in a joint pool, all the assets
of the musharakah become jointly owned by all of them according to the proportion of
their respective investment. Therefore, each one of them can benefit from the
appreciation in the value of the assets, even if profit has not accrued through sales.
TYPES OF ISLAMIC FINANCIAL PRODUCTS
Islamic financial companies have developed many different products to meet customer
needs and provide sharia-compliant alternatives to widely available conventional options. In
this article, you discover some common categories of Islamic financial products.
In practice, a product can be developed to serve many purposes — not only to satisfy social
justice demands. However, no matter the motivation for creating a product (such as to meet
market demand), every Islamic financial product must exist under the framework of sharia
law.
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SHARIA-COMPLIANT PRODUCTS
A Shariah compliant fund is an investment vehicle fund structured in accordance to Shariah
rules. Shariah funds can be managed as mutual funds, exchange trade funds or hedge funds.
They are in essence common funds with an extra layer of Islamic rules integrated in the
investment policies of the fund. While the funds are required to be fully compliant with
Shariah rule, the companies structuring, managing and promoting the funds do not have to
be necessarily Shariah compliant.
ISLAMIC INVESTMENT FUNDS

The term "Islamic Investment Fund" means a joint pool wherein the investors contribute
their surplus money for the purpose of its investment to earn halal profits in strict
conformity with the precepts of Islamic Shariah. The subscribers of the Fund may receive a
document certifying their subscription and entitling them to the pro-rated profits actually
accrued to the Fund. These documents may be called "certificates" "units" "shares" or may
be given any other name, but their validity in terms of Shariah, will always be subject to
two basic conditions:
First, instead of a fixed return tied up with their face value, they must carry a pro-rated
profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied
up with the principal) can be guaranteed. The subscribers must enter into the fund with a
clear understanding that the return on their subscription is tied up with the actual profit
earned or loss suffered by the Fund. If the Fund earns huge profits, the return in their
subscription will increase to that proportion; however, in case the Fund suffers loss, they
will have to share it also, unless the loss is caused by the negligence or mismanagement, in
which case the management, and not the Fund, will be liable to compensate it.
Second, the amounts so pooled together must be invested in a business acceptable to
Shariah. It means that not only the channels of investment, but also the terms agreed with
them must conform to the Islamic principles.
Keeping these basic requisites in view, the Islamic Investment Funds may accommodate a
variety of modes of investment which are discussed below;-
Equity Fund
In an equity fund the amounts are invested in the shares of joint stock companies. The
profits are mainly achieved through the capital gains by purchasing the shares and selling
them when their prices are increased. Profits are also achieved by the dividends distributed
by the relevant companies.
It is obvious that if the main business of a company is not lawful in terms of Shariah, it is
not allowed for an Islamic Fund to purchase, hold or sell its shares, because it will entail the
direct involvement of the shareholder in that prohibited business.
Similarly the contemporary Shariah experts are almost unanimous on the point that if all the
transactions of a company are not in full conformity with Shariah, which includes that the
company borrows money on interest nor keeps its surplus in an interest bearing account, its
shares can be purchased, held and sold without any hindrance from the Shariah side. But
evidently, such companies are very rare in the contemporary stock markets. Almost all the
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companies quoted in the present stock market or in some way involved in an activity which
violates the injunctions of Shariah.
Conditions for Investment in Shares

The dealing in equity shares can be acceptable in Shariah subject to the following
conditions:
1. The main business of the company is not in violation of Shariah. Therefore, it is not
permissible to acquire the shares of the companies providing financial services on
interest, like conventional banks, insurance companies, or the companies involved in
some other business not approved by the Shariah, such as the company’s
manufacturing, selling or offering liquors, pork, haram meat, or involved in gambling,
night club activities, pornography etc.
2. If the main business of the companies is halal, like automobiles, textile, etc. but they
deposit there surplus amounts in a interest-bearing account or borrow money on
interest, the shareholder must express his disapproval against such dealings, preferably
by raising his voice against such activities in the annual general meeting of the
company.
3. If some income from interest-bearing accounts is included in the income of the
company, the proportion of such income in the dividend paid to the share-holder must
be given charity, and must not be retained by him. For example, if 5% of the whole
income of a company has come out of interest-bearing deposits, 5% of the dividend
must be given in charity.
4. The shares of a company are negotiable only if the company owns some non-liquid
assets. If all the assets of a company are in liquid form, i.e. in the form of money that
cannot be purchased or sold, except on par value, because in this case the share
represents money only and the money cannot be traded in except at par.
Commodity Fund
Another possible type of Islamic Funds may be a commodity fund. In the fund of this type
the subscription amounts are used in purchasing different commodities for the purpose of
the resale. The profits generated by the sale are the income of the fund which is distributed
pro-rated among the subscribers. In order to make this fund acceptable to Shariah, it is
necessary that all the rules governing the transactions and fully complied with. For
example:
1. The commodity must be owned by the seller at the time of sale, therefore, short sales
where a person sells a commodity before he owns it are not allowed in Shariah.
2. Forward sales are not allowed except in the case of salam and istisna' (For their full
details my book "Islamic Finance" may be consulted).
3. The commodities must be halal; therefore, it is not allowed to deal in wines, pork, or
other prohibited materials.
4. The seller must have physical or constructive possession or the commodity he wants to
sell. (Constructive possession includes any act by which the risk of the commodity is
passed on to the purchaser).
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5. The price of the commodity must be fixed and known to the parties. Any price which is
uncertain or is tied up with an uncertain event renders the sale invalid.
Mixed Fund
Another type of Islamic Fund maybe of a nature where the subscription amounts are
employed in different types of investments, like equities, leasing, commodities, etc. This
may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more
than 51% while the liquidity and debts are less than 50% the units of the fund may be
negotiable. However, if the proportion of liquidity and debts exceeds 50%, its units cannot
be traded in according to the majority of the contemporary scholars. In this case the Fund
must be a closed-end Fund.
OTHER FORMS OF FUNDS

Ijarah Fund
Ijarah means leasing. In this fund the subscription amounts are used to purchase assets like
real estate, motor vehicles, or other equipment for the purpose of leasing them out to their
ultimate users
Murabahah Fund
Murabahah is a specific kind of sale where the commodities are sold on a cost-plus basis.
This kind of sale has been adopted by the contemporary Islamic banks and financial
institutions as a mode of financing. They purchase the commodity for the benefit of their
clients, then sell it to them on the basis of deferred payment at an agreed margin of profit
added to the cost. If a fund is created to undertake this kind of sale, it should be a closed-
end fund and its units cannot be negotiable in a secondary market.
TAKAFUL- THE ISLAMIC VERSION OF INSURANCE

The word takaful is derived from the Arabic verb kafala which simply means to take care of
one’s need. In other words “A” for example, guarantees to take over the liability of “B” in
the event of a calamity afflicted upon the latter. Under this simple illustration it is only a
one-sided relationship in the sense that only “A” would be the party that assumes the
responsibility. However, following the above example, if “B” were at the same time would
reciprocate to take care of the needs of “A” then a kind of joint guarantee between them is
established. Therefore the pact between at least two parties agreeing to jointly guarantee
one another in the event of a loss, as a consequent of being afflicted by a calamity defines
the term Takaful.
LEASING- IJARA
Ijara is an exchange transaction in which a known benefit arising from a specified asset is
made available in return for a payment, but where ownership of the asset itself is not
transferred. The ijara contract is essentially of the same design as an installment leasing
agreement. Where fixed assets are the subject of the lease, such can return to the lessor at
the end of the lease period, in which case the lease takes on the features of an operating
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lease and thus only a part amortization of the leased asset's value results. In an alternative
approach, the lessee can agree at the outset to buy the asset at the end of the lease period in
which case the lease takes on the nature of a hire purchase known as ijara wa
iqtina (literally, lease and ownership). Some jurists do not permit this latter arrangement on
the basis that it represents more or less a guaranteed financial return at the outset to the
lessor, in much the same way as a modern interest-based finance lease. The terms of ijara
are flexible enough to be applied to the hiring of an employee by an employer in return for
a rent that is actually a fixed wage.
Some generally agreed conditions for ijara are as follows:

a) The leased item should be transferred to the lessee on completion of the lease agreement
and should be of a condition that is fit for performance of the required tasks. The lessor
should transfer the leased items to the lessee in their completed form.
b) The usufruct of the leased item should have value.
c) The amount and timing of the lease payments should be agreed in advance, though the
agreed schedule and amount of those payments need not be uniform.
d) The lease payment schedule becomes active upon complete acquisition of the usufruct
of the leased goods, whether such usufruct is in fact enjoyed by the lessor or not.
e) The period of the lease must be specified.
f) The conditions of usage of the leased items must be stated.
g) The lessor must have full possession and legal ownership of the asset prior to leasing it.
h) The leased asset must continue to exist throughout the term of the lease. Items which are
consumed in the process of usage, ammunition for instance, cannot be leased.
i) In contrast with most conventional finance leases, the responsibility for maintenance and
insurance of the leased item under ijara remains that of the lessor throughout.
j) A price cannot be pre-determined for the sale of the asset at the expiry of the lease.
However, lessor and lessee may agree the continuation of the lease or the sale of the
leased asset to the lessee under a new agreement at the end of the initial lease period.
k) In the event of late payment of rental, the ijara may be terminated immediately.
l) The lessor may claim compensation for any damage caused to the leased assets as a
result of negligence on the part of the lessee.
Three types of ijara arrangements can exist according to sharia principles:

 Lease-ending ownership/lease with ownership (ijara wa iqtina/ ijara muntahia
bitamleek);- In this ijara contract, the lessee owns the leased asset at the end of the lease
period. This lease contract doesn’t contain any promise to buy or sell the assets, but the
bank may offer a (verbal) unilateral promise of transfer of ownership or offer a
purchase schedule for the asset.
 The lessee also is allowed to make a (verbal) unilateral promise to purchase the asset.
The purchase price is ultimately decided by the market value of the asset or a negotiated
price.
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 Operating lease (operating ijara); - This type of ijara contract doesn’t include the
promise to purchase the asset at the end of the contract. Basically, this setup is a hire
arrangement with the lessor.
 Forward lease (ijara mawsoofa bil thimma);- This contract is a combination of
construction finance (istisna) and a redeemable leasing agreement. Because this lease is
executed for a future date, its called forward leasing. The forward leasing contract buys
out the project (generally a construction project) as a whole at its completion or
intranches (portions) of the project.
SAFEKEEPING-WADIAH
Wadiah is safekeeping of a deposit. Such a deposit is hold in trust (Amanah). If the the
depositor pays for this favour, the depositary needs to replace it in case of lost. The usage of
the deposit is subject to permission of the depositor.
In practical terms the bank client accepts the usage of the deposit by the bank but is not
entitled to participate in the profits or losses. The deposit is guaranteed.
Deposit in Arabic is called wadiah. The term wadiah is derived from the verb wada’a,
which means to leave, lodge or deposit.
Basic rules and conditions of Wadiah (deposit)

1. Contracting parties: the depositor and the custodian must be person of sound mind.
2. The depositor is able to the take the property whenever he wants.
3. Offer (ijab) and acceptance (qabul): the majority of jurists are the view there is must be
a valid offer and acceptance made in wadiah contract
4. Deposited property: it must be owned and deliverable. The item must be also form of
property that can be physically possessed.
Types of Wadiah (Deposit)
Wadiah can be classified into two types:
1. Safe custody based on trust (Wadiah yad Amanah)

Originally term of deposit is amanah (trust) where it is charitable and divinely rewarded. It
is basically a trust to keep. So, the custodian shall keep the deposit as his keeping and
taking care of his own property. He is not responsible for any damages except due his
negligence. He does not gain any profit from the contract. The permission will be required
of the utility of the property. Lastly is that he is must return the property at any time upon
demand of the owner.
2. Guaranteed Safe Custody (Wadiah yad Damanah)

This is the combination between safe-keeping (al wadiah) and guarantee (daman). This type
deposit facilitates wider application in the Islamic banks system, particularly where the
deposits are the sources of funds for banks. Some of the features are the custodian is
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entitled to use the deposit property for trading or any other purposes. So, has right to gain
some profit derived from the utilisation of the property and the sometime he is fully
responsible for the damage.
APPLICATION OF WADIAH IN ISLAMIC BANK

Saving deposit
All Islamic bank operate savings deposit account, however, the operation of these accounts
vary at different banks. Generally, a saving deposit permits costumer to deposit and
withdraw their money at any time and does not require a minimum balance in deposit
account. It does not have maturity date; therefore the cash can be withdrawn at any time
based on the costumer’s demand
Current deposit
Current deposit account is a form of demand deposit that offers users safe keeping of their
cash deposit, and the choice to be paid in full upon demand. Current account deposit
facilities are usually offered the either individuals or companies. It also shares similar
features with saving deposit as it permits for the cash to be withdrawn at any time. The
main point of departure between current deposit and s saving deposit is the presence of
cheque book and multi-functional card used in the former. If the account holders were to
withdraw more than what is sufficient in their balance, there will also be no charges
incurred.
Term deposit
A term deposit is a type of arrangement where the customer’s deposits are held at a bank for
fixed terms. There deposits will be then deposited to a number of investment pools where it
will be invested in business activities which are accordance to the sharia. The money
deposited in a term deposit can only be withdrawn at the end of the terms as stated in the
contract or by giving a predetermined number of days as notice. Usually, term deposits are
short-term deposits where the maturities are within a period of one month to a few years.
Islamic term deposit are commonly structured based on the commodity murabahah,
wakalah unrestricted investment and mudarabah general investment
Investment deposit
The investment deposit is usually known as profit and loss sharing (PLS) account or simply,
the investment account. The ratio of profit distribution between the bank and depositor shall
be agreed at time of accounting opening subject to the sharia that a partner may agree on
ration of profit and losses have to be shared strictly in the ratio of capital .The main point of
departure between the investment deposit and both saving and current deposit is the former
is normally structured based on either the mudarabah and wakalah bi istismar principle
which do not entail a guarantee of either principal or the return of profit. Nevertheless, the
investment account holders have an opportunity to earn more attractive returns although
there is also likely hood having to bear the risk of capital losses.
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ISLAMIC BANKING
The most important services offered by Islamic banks:
 Current Accounts Performed in the normal banking traditions; the only difference is that
Islamic banks obtain the explicit consent of the depositors to use their funds in its other
investment oriented activities. These accounts are guaranteed by the Bank.
 Saving Accounts This banking service is offered free of charge. No interest or profit is
paid, but in return, some banks may give special privileges which may be given to
depositors e.g. financing of small projects and sale of consumer durables or productive
goods by instalment and gifts etc. This is regarded as incentive to regular savers to
encourage deposits.
 Investment deposits This type of account is peculiar to Islamic banks. It is the
counterpart of fixed or term deposits in traditional banking. However, there are some
basic differences:
1. Theoretically it is not a ‘deposit’ but money advanced or offered by the ‘depositor’
for the bank to invest on his behalf — on the basis of Mudaraba — the depositor
being the financier (Rabul Mai) and the bank in this case being the manager
(Mudarib) — or agent.
2. It is given with the explicit approval of the depositor that it will be subject to profit
and loss. (Risk-sharing being the basic characteristic of Islamic financing).
3. The investment account holder is entitled — in the case of profit — to all the profit
actually realised by the investment account (minus the banks percentage share of the
profit in consideration for its managerial effort). Therefore, Islamic banks cannot
determine in advance what level of return it may give to investment account holders
(depositors).
Correspondent banking services Islamic banks also offer their services in the sphere of
international trade finance through correspondent banking.
To do this, they establish correspondent relationship with banks to facilitate services to be
done on their behalf. In case of direct money transfers, no special relationship is needed
beyond availing the correspondent bank with ready balances in the current account to meet
such obligations. The correspondent bank can legitimately claim its commission on these
services. There is no Sharia prohibition against this.
Islamic banks, however, may ask a correspondent bank to add their confirmation to letters
of credit opened on behalf of foreign suppliers to importers. (Suppliers ask for this as an
added security for their payments). Either Islamic banks keep huge surpluses in their
account with the correspondent bank to cover its obligations to the third party; (i.e. the
suppliers), while it seeks to replenish its account with the correspondent bank. This in fact
would be ‘lending’ by the correspondent bank for which Islamic banks would not accept to
pay any interest. How then did Islamic banks solve this problem?
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Foreign banks accepted dealing with Islamic banks on the basis of mutual agreements
advised and accepted by simple exchange of letters to avail Islamic banks with confirmation
facilities up to an agreed ceiling without charging interest should the accounts go red. In
consideration, Islamic banks undertake to abide by the following:-
 To keep a reasonable amount of cash in their current account with the confirming
banks.
 Endeavour to cover any debit as soon as possible. (It is part of the understanding that
the Islamic bank does not ask for any reward on any balance due to it, should the
other bank utilize these funds profitably. Therefore, there is no condition set by the
other party if the Islamic bank account goes in the red for some time.)
As partial security, the correspondent bank would, on adding his confirmation, debit the
Islamic banks with a certain ‘cash margin’ which it will transfer immediately to its own
account. (They are authorized to do this automatically). Thus Islamic banks need in fact,
only to keep sufficient balances in their correspondent banks account to cover the cash
margins of the letters of credit and not the whole value of these letters.
a. All types of money transfers Domestic as well as international bank transfers are
offered.
b. Collection of bills (but not their discounting).
c. Letters of credit and guarantees; - all forms of letters of credit and letters of
guarantee. Islamic banks charge fees for these services. This is permissible in Islam.
d. Safes Safe custody services are also available in some Islamic banks.
ISLAMIC CONTRACTS
Despite the various differences of interpretation that exist, three categories of Islamic
contract of relevance to commercial and financial activity are widely recognized in both
contemporary and classical literature.
They are:
a) Contracts of exchange;
b) Contracts of charity; and
c) Contracts of investment partnership.
Other forms of contract, contracts of guarantee for example, are not dealt with in the
following outline.
It is generally agreed that commercial transactions should be concluded:
a) At a price that is agreed mutually and not under duress;
b) Between parties that are sane, and that are old enough to understand the implications of
their actions (in other words who are mumayiz);
c) Without uncertainty or deception (gharar) with regard, for example, to the quality of
the goods or the seller's ability to deliver them. (Hence, short selling is widely and there
is a general requirement that at the time of contracting the goods transacted should be in
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existence, under the ownership of the seller and in the seller's physical or constructive
possession);
d) The contract should not be based upon a counter value that is itself prohibited under
Islamic law (alcohol for consumption) for example.
INTERNATIONAL STANDARDISATION/REGULATIONS OF ISLAMIC

FINANCE
The financial crisis revealed underlying weakness in the current global financial
architecture. International financial regulation seeks to promote stability by preventing
systemic failure, but the crisis has severely damaged the credibility of the status quo,
leading to calls by many to correct its apparent failures before new ones arise. Upon this
background, a variety of alternatives are being proposed and seriously considered by those
who feel wronged by the current architecture.
Islamic finance is one of these alternatives. At the 2009 World Islamic Economic Forum,
“Muslim presidents, prime ministers and princes called on the world to adopt Islamic
financial practices to overcome the global crisis and urged Islamic banks to undertake
‘missionary work’ in the west to promote sharia banking.”
Proponents view Islamic finance as inherently more stable than conventional finance,
bolstered by the fact that Islamic institutions appear to have largely avoided the fallout of
the crisis due to lack of exposure to the subprime mortgage market and the absence of
complex structured products.
The need for change is undeniable, but whether Islamic finance should replace the current
system is dubious. What is relevant to policymakers in the current crisis is the experience of
Islamic financial regulation in comparison to conventional regulation.
The success of any global movement requires the establishment of a universal framework to
regulate and stabilize activities —in the case of Islamic finance, the establishment of an
Islamic financial architecture. This paper will briefly explain Islamic finance, and then
consider the framework for conventional banks, highlighting the requirements of the Basel
II agreement and the proposed changes under the Basel III amendments. It will consider the
Islamic Financial Services Board (IFSB), the current Islamic regulatory body, compared to
the Basel II agreement, and examine the need for certain countries, specifically Bahrain, to
adopt both regulatory systems. It will conclude by considering the ramifications for the
future of international financial regulation
Unique Characteristics of the Regulation of Islamic Finance Institutions

- Regulation of IFIs necessitates recognition of their unique characteristics and
requirements:
 Shari’ah compliance risk, investment equity risk, displaced commercial risk
 Need to address gaps in Basel Standards with respect to the treatment of capital.
- Need to set prudent capital adequacy requirements reflecting inherent IF risks.
Page 350
 Equity-like IF investment transactions cannot be regulated as debt-creditor

conventional relationships.
 IAHs should more appropriately be aligned somehow with shareholders.
 This should be reflected in the risk weights assigned to individual asset components
of IFIs.
 IFIs have to allocate more resources to support the identification, assessment and
management of risks
CASE FOR STANDARDISATION USING RELIGIOUS AND PRUDENTIAL

GUIDANCE
Standardization means establishing universal Shari’ah standards possibly through a flexible
“codification” of the Shariàh principles and precepts, which would eliminate the need for
individual decisions by Shari’ah scholars, thus reducing the problems of the shortage of
Shari’ah scholars and the divergence of Shari’ah interpretation.
The Islamic finance industry is not currently codified and individual transactions need
approval by Shari’ah scholars. This means that a globally recognized Islamic manuscriptis
needed to help consolidate interpretations of Islamic law in order to speed up product
development and reduce the risk of noncompliance with Shari’ah.
The absence of standardization has resulted in un-unified Islamic governance models,
consequently ‘demonstrating compliance with Shari’ah can be difficult as different
institutions have different governance models by which they set, measure, and monitor their
compliance.
Three organizations have been spearheading the effort to set standards followed by Islamic
financial institutions (IFI’s), namely the Islamic Financial Services Board (IFSB) and the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), as well
as the International Islamic Financial Market (IIFM).
Benefits of standardization
Most observers of the Islamic finance industry agree that the standardization of both
regulation and Shari’ah interpretation would facilitate the industry’s growth.
The benefits of standardizing Shari’ah interpretation include time and cost savings,
financial stability, greater transparency and consistency in financial reporting, as well as
improved public confidence.
Most importantly, standardization would take the compliance burden off of product
developers’ shoulders. Another benefit is increasing cross-border marketability; currently a
product that is considered to be compliant in Malaysia, which is reputed to be rather liberal,
may be rejected by GCC scholars and/or customers.
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Greater harmonization of practices among Islamic financial institutions would help the
consolidation and further expansion of the industry.
Standardization could eventually eliminate the need for a Shari’ah board at every single
Islamic financial institution
The lack of standardization has been forcing Islamic banks to enter into derivatives
transactions with international financial institutions in order to avoid the complexities of
dealing with two Shari’ah boards if they were to deal with another Islamic bank.
Challenges that face standardization

Challenges that face standardization include different interpretations of Shari’ah, diverse
stages of maturity of Islamic financial markets; country-specific laws and regulatory
practices, and the absence of consensus among scholars.
Concerns have also been voiced that standardization of the product development process
could reduce returns, thus rendering the industry less attractive to new entrants, which
would hinder innovation and competition.
ISLAMIC FINANCIAL SERVICES BOARD

The Islamic Financial Services Board is an international body based in Kuala Lumpur,
Malaysia, and it began its operations in March 2003. The institution is working as
international standard setting body of regulatory and supervisory agencies that have their
main interest in ensuring the effective performance and stability of the Islamic financial
services industry covering the area of banking, capital market, and insurance. The members
of IFSB include regulatory and Supervisory authorities in addition to Islamic Development
Bank, Asian Development Bank, Islamic Corporation for the Development of Private
Sectors, the International Monetary Fund, World Bank, and Bank for International
Settlements, and several market players and professional firms operating in different
countries across the world. The primary target of IFSB is to develop uniform regulatory and
transparency standards to address characteristics specific to Islamic financial institutions,
keeping in mind the national financial environment, international standards, core principles,
and good practices. The IFSB has also been enhancing awareness of issues that are
pertinent to or have an impact on the regulation and supervision of the Islamic financial
services industry. In short, the performance of IFSB is divided into three main areas:
1) Regulatory perspective: It has taken an effort to promote the development of a

prudent and transparent Islamic financial services industry through introducing new,
or adapting existing, international standards consistent with Islamic principles. It also
provides guidance on the effective supervision and regulation of institutions offering
Islamic financial products; by developing Islamic criteria for identifying, measuring,
managing, and disclosing risks, taking into account international standards for
valuation, income, and expense calculation and disclosure.
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2) Coordination and harmonization perspective: To harmonize Islamic financial

service industry, IFSB cooperates with other relevant agencies, those who are working
to setup standards for stability and the soundness of the international monetary and
financial systems such as Islamic Development Bank, Asian Development Bank,
Islamic Corporation for the Development of Private Sectors, the International
Monetary Fund, World Bank, and Bank for International Settlements. It also gives
initiative support to enhance cooperation among member countries relevant to Islamic
financial instrument development, better operation and risk management efficiency.
3) Training and research perspective: In order to support further development of
Islamic financial service industry, the IFSB also provides training programme and
facilitates personal development in areas that relevant to better effective regulation of
Islamic financial service industry and related markets. It is also undertaking research
and surveys on the industry and creating a database of Islamic bank, financial
institutions and industry experts.
The IFSB has issued standards and guiding principles to regulate the Islamic financial
services industry. These standards cover the areas of risk management, capital adequacy,
corporate governance, the supervisory review process, market discipline and transparency,
governance for the Islamic collective investment scheme, the Shariah governance system,
the development of the Islamic capital market, and the conduction of business. In addition,
several standards of Islamic Takaful regulations were issued.
INTERNATIONAL ISLAMIC FINANCIAL MARKET

IIFM is the International Islamic Financial Services Industry’s standard setting organization
focused on the Islamic Capital & Money Market (ICMM) segment of the industry. Its
primary focus lies in the standardization of Islamic financial products, documentation and
related processes at the global level.
IIFM was founded with the collective efforts of the Central Bank of Bahrain, Islamic
Development Bank, Bank Indonesia, Central Bank of Sudan and the Bank Negara Malaysia
(delegated to Labuan Financial Services Authority) as a neutral and non-profit organization.
Besides the founding members, IIFM is supported by other jurisdictional members such as
State Bank of Pakistan, Dubai International Financial Centre, Indonesian Financial Services
Authority as well as a number of regional and international financial institutions and other
market participants.
Page 353
ACCOUNTING AND AUDITING ORGANIZATION FOR ISLAMIC FINANCIAL

INSTITUTIONS (AAOIFI)
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is
an Islamic international autonomous non-for-profit corporate body that prepares
accounting, auditing, governance, ethics and Shari'a standards for Islamic financial
institutions and the industry. Professional qualification programs (notably CIPA, the Shari’a
Adviser and Auditor and the corporate compliance program) are presented now by AAOIFI
in its efforts to enhance the industry’s human resources base and governance structures.
Objectives of AAOIFI
The objectives of AAOIFI are:
1. To develop accounting and auditing thoughts relevant to Islamic financial institutions;
2. To disseminate accounting and auditing thoughts relevant to Islamic financial
institutions and its applications through training, seminars, publication of periodical
newsletters, carrying out and commissioning of research and other means;
3. To prepare, promulgate and interpret accounting and auditing standards for Islamic
financial institutions; and
4. To review and amend accounting and auditing standards for Islamic financial
institutions.
AAOIFI carries out these objectives in accordance with the precepts of Islamic Shari’a
which represents a comprehensive system for all aspects of life, in conformity with the
environment in which Islamic financial institutions have developed. This activity is
intended both to enhance the confidence of users of the financial statements of Islamic
financial institutions in the information that is produced about these institutions, and to
encourage these users to invest or deposit their funds in Islamic financial institutions and to
use their services
Page 354

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FINANCIAL MANAGEMENT

KASNEB JULY 2018 SYLLABUS

Revised on: January 2019

PAPER NO.8 FINANCIAL MANAGEMENT

8.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:

8.1 Overview of financial management

8.2 The financing decision

8.3 Financial institutions and markets

8.4 Time-value of money

8.5 Valuation models

8.6 Cost of capital

8.7 Capital budgeting decisions

net operating cash flows, incremental approach to cash flow estimation

8.8 Financial analysis and forecasting

8.9 Working capital management

8.10 Dividend decision

8.11 Introduction to risk and return

- The actual total risk of a 2-asset portfolio

8.12 Islamic finance

8.13 Emerging issues and trends

Topic 1: Overview of financial management….....................................................................7

OVERVIEW OF FINANCIAL MANAGEMENT

NATURE AND SCOPE OF FINANCE

1. Investment decisions includes investment in fixed assets (called as capital

Objectives of Financial Management

1. To ensure regular and adequate supply of funds to the concern.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation

a. Evaluation of new investment in terms of profitability

expected return of the prospective investment. Therefore while considering

A sound financial structure is said to be one which aims at maximizing shareholders

It’s the financial manager’s responsibility to decide a optimum dividend policy

It is very important to maintain a liquidity position of a firm to avoid insolvency.

Role of finance manager

1. Executive functions of financial management, and

These executive functions of financial management (FM) are explained below.

1. Estimating capital requirements : The company must estimate its capital

The routine functions are also called as Incidental Functions.

The six routine functions of financial management are listed below.

1. Supervision of cash receipts and payments.

GOALS OF THE FIRM: FINANCIAL AND NON-FINANCIAL OBJECTIVES,

FINANCIAL GOALS OF THE FIRM

Microeconomic theory of the firm is founded on profit maximization as the principal

Applying Profit-Maximization Criterion in Financial Management

Because of the reasons stated above, Value-maximization has replaced profit-

 Social Responsibility and Ethics

 Growth and expansion

Difficulty of Achieving Shareholders Wealth Maximization

Two difficulties complicate the achievement of the goal of shareholder wealth

AGENCY THEORY, STAKEHOLDER’S THEORY AND CORPORATE

1. Shareholders and management

Shareholders and management

1. Managers may use corporate resources for personal use.

1. Performance based remuneration

2. Incurring agency costs

3. Threat of corporate takeover

6. Use of corporate governance principles which specify the manner in which

Shareholders vs. creditors