ST.

PAULS UNIVERSITY
Private Bag 00217 Limuru Tel: 020-2020505/510, 0728-669000, 0736424440 Email: assistantregistrar@stpaulslimuru.ac.ke Website: http://www.stpauls-limuru.org

DEPARTMENT OF BUSINESS STUDIES BACHELOR OF BUSINESS & INFORMATION TECHNOLOGY COURSE CODE BFI 305: COURSE NAME: FINANCING SMALL BUSINESSES
DATE: 19TH AUGUST 2011 5.30 PM 8.30 PM TIME:

Instructions to Candidates:
1. Answer ANY FIVE questions. All questions carry equal

marks 2. Write your registration number on all sheets of the answer book used. 3. Use a new page for every question attempted and indicate the question number on the space provided on each page of the answer sheet. 4. Fasten together all loose answer sheets used.

5. Switch off all Mobile Phones and PDAs.

Financing small businesses

ANSWER ANY FIVE (5) QUESTIONS

{20 MARKS EACH}.

QUESTION 1 a. Describe how the nature of a firms affects its financing sources. (8marks) 1. Capital Structure Policy. As we have been discussing above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases. 2. Dividend Policy Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lowercost internally generated equity and newly issued equity is lowered. 3. Investment Policy It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change. Uncontrollable Factors Affecting the Cost of Capital These are the factors affecting cost of capital that the company has no control over: 1. Level of interest rates 2. Tax rates 1. Level of Interest Rates The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. 2. Tax Rates Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

b. Discuss the typical sources of financing used at the outset of a new business venture marks) Page 3 of 11

Financing small businesses

Internal sources The main internal sources of finance for a start-up are as follows: Personal sources These are the most important sources of finance for a start-up, and we deal with them in more detail in a later section. Share capital invested by the founder The founding entrepreneur (/s) may decide to invest in the share capital of a company, founded for the purpose of forming the start-up. This is a common method of financing a start-up. The founder provides all the share capital of the company, retaining 100% control over the business.

External sources Loan capital This can take several forms, but the most common are a bank loan or bank overdraft. A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and amount of repayments. The bank will usually require that the start-up provide some security for the loan, although this security normally comes in the form of personal guarantees provided by the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a bank overdraft. However, they dont provide much flexibility. A bank overdraft is a more short-term kind of finance which is also widely used by start-ups and small businesses. An overdraft is really a loan facility the bank lets the business owe it money when the bank balance goes below zero, in return for charging a high rate of interest. As a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed. Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time). Two further loan-related sources of finance are worth knowing about: Share capital outside investors For a start-up, the main source of outside (external) investor in the share capital of a company is friends and family of the entrepreneur. Opinions differ on whether friends and family should be encouraged to invest in a start-up company. They may be prepared to invest substantial amounts for a longer period of time; they may not want to get too involved in the day-to-day operation of the business. Both of these are positives for the entrepreneur. However, there are pitfalls. Almost inevitably, tensions develop with family and friends as fellow shareholders. Business angels are the other main kind of external investor in a start-up company. Business angels are professional investors who typically invest 10k - 750k. They prefer to invest in businesses with high growth prospects. Angels tend to have made their money by setting up and selling their own business in other words they have proven entrepreneurial expertise. In addition to their money, Angels often make their

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Financing small businesses own skills, experience and contacts available to the company. Getting the backing of an Angel can be a significant advantage to a start-up, although the entrepreneur needs to accept a loss of control over the business.

Savings and other nest-eggs An entrepreneur will often invest personal cash balances into a start-up. This is a cheap form of finance and it is readily ava decision to start a business is prompted by a change in the personal circumstances of the entrepreneur e.g. redundancy or a Investing personal savings maximises the control the entrepreneur keeps over the business. It is also a strong signal of comm outside investors or providers of finance. Re-mortgaging is the most popular way of raising loan-related capital for a start-up. The way this works is simple. The entr out a second or larger mortgage on a private property and then invests some or all of this money into the business. The use like this provides access to relatively low-cost finance, although the risk is that, if the business fails, then the property will b c. What is a financial intermediary (2 marks

Definition
Financial institution (such as a bank, credit union, finance company, insurance company, stock exchange, brokerage company) which acts as the 'middleman' between those who want to lend and those who want to borrow.

QUESTION 3 a. Define business risks and explains its two dimensions. (5 the possibility of losses associated with the asstes and earnings potential of The risk that a company will not have adequate cash flow to meet its operating expenses. Also referred to as "systematic risk". Market risk is the uncertainity associated wth an investment decision. Pure risk wer only loss or no loss can occur-there is no potential gain. b. List and explain the basic types of pure risks Personal Risks:

(6m

The risks that directly affect an individual are known as personal risks. They involve the possibility of the co reduction of earned income, extra expense and the depletion of financial assets. Property Risks

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Financing small businesses All non living things owned by persons are property. Real state land and building, vehicles machines and equipments goods raw materials furniture etc are the common examples of property damaged or lost from numerous causes. Liability risks are another important type of pure risk that many people face. More than ever, we are living in a litigious society. One can be sued for any frivolous reason. One has to defend himself when sued, even when the suit is without merit. c. Discuss the common types of business insurance covers in Kenya. marks)

property insurance tolocation and its contents liability insures. workers compensation insurer policy. health insurance. life and disability. protect bz aganst death or disability of key employees product financial loss as a result of defect or body harmed professional liability protect bz against malpractice, errors n negligence in pr services to customers. Business interruption event of any disaster or continuity arrangement Commercial vehicle arrangement protects legal requirement of vehicle QUESTION 4 a. List the major functions of the Nairobi stock exchange (NSE) marks)

b. Discuss the role of savings and credit co-operative organizations (Saccos) in the development of small businesses in Kenya.

(15

QUESTION 5 a. List down the role of the Retirement Benefit Authority (RBA). marks) To regulate and supervise the establishment and management of retirement benefits schemes. To protect the interest of members and sponsors of retirement benefit schemes. To promote the development of the retirement benefits industry. Page 6 of 11

Financing small businesses

To advise the Minister for Finance on the national policy to be followed with regard to the retirement benefit To implement all government policies relating to it, i.e. the Retirement Benefits Authority. Ensure schemes come into compliance with the Act. Receiving and addressing members complaints with regard to their schemes or benefits. b. Distinguish between equity capital and debt capital. marks)

is capital raised from owners in the company. This is different from debt capital which is money raised by inc through the issuance of debentures and other types of bonds. Owners can choose to sell equity in the compan stock, to investors. This is usually done through a direct offering to the public or through an underwriter like bank. Equity capital is used to get companies off the ground is the capital that a business raises by taking out a loan. It is a loan made to a company that is normally repaid at some future date. Debt capital differs[1] from equity or share capital because subscribers to debt capital do not become part owners of the business, but are merely creditors, and the suppliers of debt capital usually receive a contractually fixed annual percentage return on their loan, and this is known as the coupon rate. Debt capital ranks higher than equity capital for the repayment of annual returns. This means that legally, the interest on debt capital must be repaid in full before any dividends are paid to any suppliers of equity.

c. Discuss the FIVE core functions of commercial banks. marks)

i) Primary functions, and ii) Secondary functions including agency functions.

i) Primary functions:
The primary functions of a commercial bank include: a) accepting deposits; and b) granting loans and advances; a) Accepting deposits The most important activity of a commercial bank is to mobilise deposits from the public. People who have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon the nature of deposits, funds deposited with bank also earn interest. b) Grant of loans and advances The second important function of a commercial bank is to grant loans and advances. Such loans and advances are given to
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Financing small businesses

members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the purpose, period and the mode of repayment. ii) Advances An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time. short-term financial assistance a) Cash Credit Cash credit is an arrangement whereby the bank allows the borrower to draw amounts upto a specified limit. The amount is credited to the account of the customer. The customer can withdraw this amount as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per agreed terms and conditions with the customers. b) Overdraft Overdraft is also a credit facility granted by bank. A customer who has a current account with the bank is allowed to withdraw more than the amount of credit balance in his account. It is a temporary arrangement. Overdraft facility with a specified limit is allowed either on the security of assets, or on personal security, or both.
24 :: Business Studies

c) Discounting of Bills Banks provide short-term finance by discounting bills, that is, making payment of the amount before the due date of the bills after deducting a certain rate of discount. The party gets the funds without waiting for the date of maturity of the bills. In case any bill is dishonoured on the due date, the bank can recover the amount from the customer.
QUESTION 6 a. Describe the working-capital cycle of a small business.

(10

Working capital is the money needed to fund the normal, day to day operations of your working capital is needed by the business to:

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Financing small businesses

Pay suppliers and other creditors Pay employees Pay for stocks Allow for customers who are allowed to buy now, but pay later (so-called trade debtors)

The operating cycle (working capital cycle) consists of the following event which continues throughout the life of business. Conversion of cash into raw-materials; Conversion of raw-materials into work-in-progress; Conversion of work-in-progress into finished stock; Conversion of finished stock into accounts receivables through sales; and Conversion of account receivables into cash.

The duration of the operating cycle for the purpose of estimating working capital is equal to the sum of the durations of each of the above said events, less the credit period allowed by the suppliers. In the form of an equation, the operating cycle process can be expressed as follows : Operating Cycle = R + W + F + D C R = Raw material storage period W = Work-in-progress holding period F = Finished goods storage period D = Debtors collection period C = Credit period availed.

b. Discuss the role of microfinance in development of rural areas in Kenya. marks) efficient provision of savings credit n insurance facilities enable pple 2 smoothen their consumption and enhance income earning capacity. Contribute 2 improvement of resource allocation n ultimately economic growth. Improves country infrastructure Promote tradeEmployment Women empowerment

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Financing small businesses Education

QUESTION 7 a. What is a mortgage? List TWO mortgage houses in Kenya. Marks)

A mortgage is a loan to purchase a property. A mortgage loan uses the property as collateral to guarantee rep loan. The borrower gives the lender a lien against the property, and the lender can foreclose on the property i does not repay the loan per the agreed terms. Housing finance Standard chartered bank kenya ltd b. Discuss the techniques commonly used in making capital budgeting decisions. marks) Valuation of Investment _ Many methods used in investment appraisal but, in general, these methods may be categorized into 2 areas: _ Non-discounted cash flow methods (NCF) _Payback _Average return on book value (not to be covered) _ Discounted cash flow methods (DCF) _NPV _IRR DCF methods properly focus on opportunity cost of money for firm! Concentrate on cash flows rather than on accounting profits PROJECT CASH FLOWS Goal is to Identify & Value Cash Flows Once we have the cash flows we can value the project or company! c. Relevant Cash Flows: WHAT ARE THESE? _ Relevant cash flows are those that come into or out of being because a project is undertaken, thus we are interested in incremental cash flows. _ Incremental cash flows Any and all changes in the firms future cash flows that are a direct consequence of taking the project. B. The Stand-Alone Principle Viewing projects as mini-firms with _ their own assets, Page 10 of 11

Financing small businesses _ revenues and _ costs Allows us to evaluate the investments separate from the other activities of the firm. PRO FORMA FINANCIAL STATEMENTS AND PROJECT CASH FLOWS Getting Started: Pro Forma Financial Statements Treat the project as a mini-firm: (This section initially ASSUMES that you know you have a good project/ business!) d. PROFORMAS: Start with pro forma (forecasted) income statement and balance sheet (dont include interest for valuation, include to estimate funds needed). _ The proforma income statement forecasts sales, costs and thus profit for the life of the project. c. Describe the role of financial intermediaries in poverty reduction in the 21st century. marks) loans employment development of private sectors encourage gvnments donours n instituitions 2 b more accountable 2 d poor infrastructure technology food security gender equality access to education n communication programs fair distribution of income End of Exam

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