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TABLE OF CONTENTS

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TABLE OF CONTENTS.............................................................................................................. 1

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CHAPTER 1. .............................................................................................................................. 3

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NATURE OF BUSINESS FINANCE ........................................................................................... 3

Objectives................................................................................................................................... 3

Financial goals of the firm........................................................................................................... 5

Non-financial goals ..................................................................................................................... 7

AGENCY THEORY. ................................................................................................................... 8

Types of Business Organizations ............................................................................................. 13

CHAPTER 2 ............................................................................................................................. 22

FINANCIAL STATEMENTS ANALYSIS.................................................................................... 22

Objectives................................................................................................................................. 22

Sources of Information.............................................................................................................. 24

Types of ratios.......................................................................................................................... 26

Financial forecasting................................................................................................................. 34

CHAPTER 3: ............................................................................................................................ 47

TIME VALUE OF MONEY. ....................................................................................................... 47

Objectives................................................................................................................................. 47

1.compounding......................................................................................................................... 48

2. Discounting........................................................................................................................ 57

CHAPTER 4 ............................................................................................................................ 68

COST OF CAPITAL.................................................................................................................. 68

Objectives................................................................................................................................. 68

Specific costs of capital ............................................................................................................ 69

CHAPTER 5: ............................................................................................................................ 84

CAPITAL BUDGETING DECISIONS ........................................................................................ 84

Objectives................................................................................................................................. 84

CAPITAL BUDGETING TECHNIQUES. ................................................................................... 92

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Non-discounted cash flow techniques....................................................................................... 93

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discounted cashflow techniques ............................................................................................... 98

CHAPTER 6 : ......................................................................................................................... 117

BASIC VALUATION MODELS................................................................................................ 117

Objectives............................................................................................................................... 117

Bond valuation........................................................................................................................ 119

preference shares valuation ................................................................................................... 127

valuation of ordinary shares.................................................................................................... 128

CHAPTER 7: ......................................................................................................................... 136

WORKING CAPITAL MANAGEMENT.................................................................................... 136

Content................................................................................................................................... 136

a .management of inventory ................................................................................................... 149

b. Management of cash ........................................................................................................ 155

c management of receivables ................................................................................................. 161

d. Management of current liablities ......................................................................................... 174

CHAPTER: 8 .......................................................................................................................... 184

SOURCES OF FUNDS........................................................................................................... 184

Objectives............................................................................................................................... 184

EQUITY FINANCE ................................................................................................................. 186

1) ordinary share capital ......................................................................................................... 186

2. Term loan ........................................................................................................................... 195

3. Preference shares (quasi-equity)........................................................................................ 198

4. Venture capital.................................................................................................................... 198

5.lease financing..................................................................................................................... 200

6.hire purchase....................................................................................................................... 204

Mortgages .............................................................................................................................. 208

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CHAPTER 9: ......................................................................................................................... 211

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DIVIDEND POLICY ................................................................................................................ 211

CHAPTER 10: ....................................................................................................................... 222

FINANCIAL MARKETS ......................................................................................................... 222

Financial markets

i. Primary and secondary market 223

capital market authority (cma)................................................................................................. 229

money market instruments ..................................................................................................... 233

special financial institutions. ................................................................................................... 238

other specialised financial institutions ..................................................................................... 240

ANSWERS TO REINFORCING QUESTIONS........................................................................ 244

GLOSSARY................................................................................. Error! Bookmark not defined.

TABLES ...................................................................................... Error! Bookmark not defined.

CHAPTER 1.

NATURE OF BUSINESS FINANCE

Objectives
At the end of this lecture students should be able to:

1. Define finance and discuss the scope and decision areas in financial management.
2. Discuss the goals of financial management.
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3. Explain the shareholder/management (agency) conflicts and possible solutions.

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4. Describe the types of Business Organizations
5. Describe Risk and required rate of return.
6. Describe investor’s risk profile.

Introduction
What is finance?
Finance is derived from the Latin word which implies to complete a contract. Hence we can define
finance as the application of and optimal utilization of scarce resources. The discipline of finance
applies economic principles and concepts in solving business problems.
Financial management: involves raising and allocating funds to the most productive end user so as to
achieve the objectives of a business or firm.
The following are the decision areas in finance:
Financing /Capital structure decision
The financial manager needs to understand the firms capital requirements whether short, medium or
long term. To this end he will ask himself this question “where will we get the financing to pay for
investments?”
The capital structure refers to the mix of long term debt, such as debentures, and equity such as
reserves and retained earnings. The financial manager aims at employing the source of funds that will
result in the lowest possible cost to the company.

/Capital budgeting decision

In capital budgeting the financial manager tries to identify investment opportunities that are worth
more (benefits) than they cost to acquire. The essence of capital budgeting is evaluation of
investments’ size, risk, and return the funds raised in the financing decision have to be allocated to a
viable investment.

Working capital management

The term Working capital refers to a firm’s current assets and current liabilities. The financial manager
has to ensure that the firm has adequate funds to continue with its operations and meet any day to
day obligations. Maintaining an optimal level is therefore important.
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Distribution decision
This involves the distribution of dividend which is payment of a share of the earnings of the company
to ordinary shareholders.
Further details of the above decisions will be discussed later in the text.

The goal of the firm from a financial management perspective could be broadly classified in two;
a. Financial goals.
b. Non-financial goals
Financial goals could be either profit maximization goal or wealth maximization.
Non-financial goals include survival, service provision, growth, or the welfare of employees.

Financial goals of the firm.

ÿ 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
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providing capital are risk averse. A good decision criterion must take into consideration such risk.

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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.
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.
ÿ 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
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maximizing the price of the company’s stock. The market price of a firms stocks represent the

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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
ÿ 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 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 ad 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.

ÿ Growth and expansion.

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This is a major objective for small companies which seek to expand operations so as to enjoy

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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.
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:
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.
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The remuneration scheme should be restructured in order to enhance the harmonization of the

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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 behavior 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.
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
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directors owe a duty of care to shareholders and as such can face legal liability for their acts of

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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.
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3. Default on interest payments to bondholders

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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
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.

3. Shareholders and the government

The shareholders operate in an environment using the license given by the government. The
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government expects the shareholders to conduct their business in a manner which is beneficial to the

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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.
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
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Shareholders and auditors

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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.

Types of Business Organizations

The three basic forms of business organizations are a proprietorship, a partnership and a corporation
(limited liability companies)

Sole Proprietorship

A proprietorship is an organization in which a single person owns the business, holds title to all the
assets and is personally responsible for all liabilities. The main virtue of a proprietorship is that it can
be easily established and is subject to minimum government regulation and supervision. The
proprietorship’s shortcomings include the owner’s unlimited liability for the all business debts, the
limitations in raising capital, and the difficulty in transferring ownership.

The proprietorship pays no separate income taxes. Rather the income or losses from the
proprietorship are included on the owner’s personal tax return.

Partnership
A partnership is similar to a proprietorship, except that it is owned by two or more persons. The profit
of the partnership is taxed on the individual partners after sharing.

A potential advantage of a partnership compared to a proprietorship is that a greater amount of

capital can be raised.
In a general partnership each partner is personally responsible for the obligations of the business. A
formal agreement (partnership deed) is necessary to set forth the privileges and duties of each
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partner, the distribution of profits, capital contributions, procedures for admitting new partners and

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modalities of reconstitutions of the partners in the event of death or withdrawal of a partner.

In a limited partnership, limited partners contribute capital and their liability is confined to that amount
of capital. There must be however, at least one general partner in the partnership who manages the
firm and his liability is unlimited.

Types of partners

1. General partners- they have an unlimited liability and take active participation the running of
the business.

2. Limited partners- they have a limited liability and do not take part in the management of the
partnerships.

3. Sleeping partners- they have no active role, but they contribute in the capital of the business
and will participate in the profits although at a lower proportion.

Joint stock company/ Corporation

Joint stock companies/Corporation A corporation is an “artificial entity” created by law. A corporation

is empowered to own assets, to incur liabilities, engage in certain specified activities, and to sue and
be sued. The principal features of this form of business organization are that the owner’s liability is
limited; there is ease of transfer of ownership through sale of shares; the corporation has unlimited
life apart from its owners and; the corporation has the ability to raise large amounts of capital.

A possible disadvantage is that corporation profits are subject to double taxation. A minor
disadvantage is the difficulties and expenses encountered in the formation. Corporation are owned by
shareholders whose ownership is evidenced by ordinary stocks shareholders expect earn a return by
receiving a dividend or gain decisions.

Corporations are formed under the provisions of the Companies Act (CAP486). A Board of Directors,
elected by the owners, has ultimate authority in guiding the corporate affairs and in making strategic
policy decisions. The directors appoint the executive officers (often referred to as management) of the
company, who run the company on a day-to-day basis and implement the policies established by the
directors. The chief executive officer (CEO) is responsible for managing day-to-day operations and
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carrying out the policies established by the board. The CEO is required to report periodically to the

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firm's directors.

The following are Strengths and weaknesses of the basic forms of business organizations
 Sole proprietorship Partnership Corporation

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1. Owner receives all profits 1. Can FINANCIAL MANAGEMENT
raise more capital 16 liability
1. Owners have limited

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(as well as losses) than a sole proprietorship which guarantees they cannot

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lose more than they invest.

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2.Low organizational costs 2. Borrowing power 2. Growth is not restricted by

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enhanced by more lack of funds. (can see shares)
owners
3. Not taxed separately: 3. More available 3. Ownership (shares) is readily
rather income included on brainpower and transferable
proprietor’s return. managerial skills
4. A high degree of 4. Not taxed separately. 4. Endless life of firm (does not
independence The partners are taxed depend on life of owners)
after receiving share of
profits
5. A degree of secrecy is 5. Can hire professional
achievable managers (separation of
ownership from control)
6. There is ease of 6. Can raise funds more easily
dissolution

Weaknesses
1. owner has unlimited 1.Owners have unlimited 1. Taxes generally higher due
liability – total wealth can be liability and may have to to double taxation- on
taken to satisfy debts cover the debts of other dividends and corporate profits
partners
2. Limited fund raising ability 2. Partnership is 2. More expensive to organize
tends to inhibit growth dissolved on the death or
withdrawal of a partner
3. proprietor must be a jack- 3. Difficult to liquidate or 3. Subject to greater regulation
of-all-trades transfer partnership
interest
4.Difficult to motivate 4. Lacks secrecy, because
employees’ career prospects stockholders must receive
financial report
5. Continuity dependent on
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RISK AND REQUIRED RATE OF RETURN

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Risk
The term risk is used interchangeably with the term uncertainty to refer to the variability of actual
returns from those expected from a given asset. It is the chance of an unexpected financial loss (or
gain). The greater the variability the higher risk.
Risk can be divided into financial risk and business risk.
Financial risk
This is the likelihood that the firm will be unable to meet its short term maturity obligations caused by
use of non owner supplied funds. Financial risk can be measured by use of liquidity ratio and
leverage ratios.
Business risk
This is the variability or volatility of future cash flows caused by uncertainty in factors affecting the
cashflows. Business risk can be measured by standard deviation. Business risk can be divided into;
Systematic and unsystematic risk.

Business risk =unsystematic risk + systematic risk

Risk

UNSYSTEMATIC RISK

SYSTEMATIC RISK

Number of assets.

Efficient portfolio

Unsystematic (Diversifiable) Risk

This is that part of total risk that can be diversified away by holding the investment in a suitably wide
portfolio. Research has shown that on average, most of the reduction benefits of diversification can
be gained by forming portfolios containing 15 -20 randomly selected securities. Diversifiable risk is
the portion of total risk that is associated with random (idiosyncratic causes which can be eliminated
through diversification. At the limit the market portfolio, comprising an appropriate portion of each
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asset in the market has no undiversifiable risk. The causes are firm-specific and include labour

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unrests, law suits, regulatory action, competition, loss of a key customer etc.

Non-diversifiable (Systematic) Risk

This is the risk inherent in the market as a whole and is attributable to market wide factors. This risk
component is not diversifiable and must thus be accepted by any investor who chooses to hold the
asset. Factors such as war, inflation, international incidents, government macroeconomic policies and
political events account for non-diversifiable risk.

Because any investor can costlesly create a portfolio of assets that will eliminate virtually all
diversifiable risk, the only risk relevant in determination of the prices and returns of an asset is its
non-diversifiable risk.

Capital Asset Pricing Model.

The CAPM links together non-diversifiable risk and the return for all assets. The model is concerned
with: (1) how systematic risk is measured , and (2) how systematic risk affects required returns and
share values. The CAPM theory includes the following propositions:

a. Investors require a return in excess of the risk-free rate to compensate them for systematic
risk.

b. Investors require no premium for unsystematic risk because it can be diversified away.

c. Because systematic risk varies between companies, investors will require a higher return from
investments where systematic risk is greater.

The Formula

The CAPM can be stated as follows.

R = R + b (R - R )
i f i m f

Where: R i
is the expected return from asset i.

R f
is the risk-free rate of return (return on the 91-day treasury bill
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R is the return from the market as a whole: The market portfolio will , by definition be

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m

fully diversified as it comprises all marketable assets.

b i
is the beta factor of asset i..

R -R m f
is the market premium

The Beta Coefficient and the Market Premium

The beta coefficient, b i

, measures the non-diversifiable risk. It is an index of the degree of volatility
of asset returns in terms of the volatility of the returns of the market portfolio (market’s risk) The beta
factor for the market portfolio is 1.0: the risk free asset will have a beta of 0. Assets that are riskier
than the market will have betas > 1.0 while those which are less risky will have betas less than 1.0.

Example

ABC Ltd. wishes to determine the required return on asset Z which has a beta of 1,5 > The risk-free
rate of return is found to be 7%; the return on the market portfolio is 11%. Find the required rate of
return on asset Z.

Using the CAPM formula,

R = R + b (R - R )
z f z m f

= 7% + 1.5(11% - 7%) =7% + 6% = 13%

The markets risk premium of 4% (11% - 7%), when adjusted for asset Z’s index of risk (beta) of 1.5
results in the asset’s risk premium of 6% (1.5 * 4%). That risk premium when added to 7% risk-free
rate, results in a 13% required rate.

Security Market Line (SML)

When the CAPM is depicted graphically it is called the security market line (SML). In the graph, risk,
as measured by beta, is plotted on the X-axis and the required return are shown on the Y-axis. The
risk-return trade-off is clearly shown by the SML
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Return

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The return on an asset is the total gain or loss experienced on an investment over a given period of
time. It is commonly measured as the change in value plus any cash distribution during the period,
expressed as a percentage of the beginning of the period investment value.
The following equation captures the essence of this value.
kt = (Ct + [Pt – Pt-1])/ Pt-1 (3.1)
Where kt = actual, expected, or required rate of return during period t
Pt = Price (value) of asset at time t
Pt-1 = Price value of asset at time t-1
Ct = Cash (flow) received from the asset investment in the time period t-1 to t.
t may be one day, 10 years or one year. When it is one year kt represents an annual rate of return.
The return could be positive or negative in the event of a loss.

Risk Profile.
The three basic risk preference behaviors among managers are – risk-aversion, risk-indifference and
risk-seeking.
Risk-indifference, is the attitude toward risk in which no change in return would be required for an
increment risk
Risk-aversion is the attitude toward risk in which an increased return would be required for an
increase in risk.
Risk seeking is the attitude toward risk in which a decreased return would be accepted for an
increase in risk.
Graphically illustrates the three risk preferences.
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Return

Risk averse

Risk indifference

Risk seeking

Risk

Most managers and investors are risk-averse; for an increase in risk they require an, increase in
returns. Consequently, managers and investors tend to be conservative rather than aggressive in
accepting risk. Accordingly, unless specified otherwise, a risk adverse financial behavior will be
assumed.

Reinforcing questions

1. (a) Define agency relationship from the context of a public limited company and briefly explain
how this arises. (6 marks)

(b) Highlight the various measures that would minimize agency problems between the owners and
the management.

2. In a company, an agency problem may exist between management and shareholders on one
hand and the debt holders (creditors and lenders) on the other because management and
shareholders, who own and control the company, have the incentive to enter into transactions that
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may transfer wealth from debt holders to shareholders. Hence the need for agreements by debt

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holders in lending contracts.

a) State and explain any four actions or transactions by management and shareholders that could
be harmful to the interests of debt holders (sources of conflict). (8 marks)

(b) Write short notes on any four restrictive covenants that debt holders may use to protect their
wealth from management and shareholder raids. (10 marks)

3. (a) Explain the term “agency costs” and give any three examples of such costs. (5 marks

4. (a) Identify and briefly explain the three main forms of agency relationship in a firm.

b) Although profit maximization has long been considered as the main goal of a firm,
shareholder wealth maximization is gaining acceptance amongst most companies as the key
goal of a firm.

Required:

(i) Distinguish between the goals of profit maximization and shareholder wealth
maximization. (4 marks)

(ii) Explain three limitations of the goal of profit maximization. (6 marks)

5. (a) Describe four non-financial objectives that a company might pursue that have the effect of
limiting the achievement of the financial objectives. (8 marks)

(b) List three advantages to the management of a company for knowing who their shareholders
are. (3 marks)

(c) State any 5 stakeholders of the firm and identify their financial objectives. (10 marks

CHAPTER 2
FINANCIAL STATEMENTS ANALYSIS

Objectives
At the end of this chapter you should be able to:
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1. Describe the meaning and relevance of financial analysis.

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2. Discuss the users of financial statements.
3. Describe sources of financial statements.
4. Describe in detail financial ratios.
5. Define financial forecasting.
6. Discuss the types of comparison used in financial statement analysis
7. Compute financial ratios and use them to evaluate financial strengths and weaknesses.
8. Discuss the limitations of financial statement analysis

Financial analysis is the process or critically examining in detail, accounting information given in
financial statements and reports. It is a process of evaluating relationship between component parts
of financial statements to obtain a better understanding of a firm’s performance. The measurement
and interpretation of business performance is done through the use of ratios. The financial statements
published by companies are too general to be used by the various of stakeholders and hence ratios
are used to highlight the different aspects of business operations.

A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A

ratio may be expressed as a percentage, as a fraction, or a stated comparison between two amounts.
The computation of a ratio does not add any information not already existing in the amount or
amounts under study. A useful ratio may be computed only when a significant relationship exists
between two amounts. A ratio of two unrelated amounts is meaningless. It should be re-emphasized
that a ratio by itself is useless, unless compared with the same ratio over a period of time and/or a
similar ratio for a different company and the industry. Ratios focus attention on relationships which
are significant but the full interpretation of a ratio usually requires, further investigation of the
underlying data. Thus ratios are an aid to analysis and interpretation and not a substitute for sound
thinking.

These ratios act as a guide for decision making of the various potential and actual users of the
financial information.
These users include:

1. Shareholders- they have invested in the firm and are the owners. Shareholders are interested
in the profitability and survival of the firm. They are typically concerned with the allocation of
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earnings for investment and the residual earnings which may be paid to them as dividends.

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2. lenders-lenders could be long-term or short-term lenders. They could be trade creditors, banks
or bondholders. They are interested in the liquidity of the firm which affects the perceived risk of
the firm.
3. Potential investors-an analysis of the firms profitability and risk would influence the decision on
whether to invest in a company’s stock or not they will make this decision by gauging the expected
return on their investment whether its in terms of a share price gain(capital gain) or dividends.
4. The government-the government is mostly interested in a company’s tax liability. In the case of
government owned corporations, it will be concerned in the survival and the continued ability of
the company to provide the services it’s charged with providing especially for public utilities.
5. The company’s management-they are interested in the efficiency of the company in generating
profits. The company’s general performance is often regarded as a reflection of the management’s
effectiveness. The gearing ratios, profitability, liquidity and investor ratios are important for
decision making.
6. Competitors-they use financial statements for comparison to see their competitive strength.
7. Consumers and potential consumers-they are interested in the company’s ability to continue
providing for them the goods or services they require.
Hence the financial statement analysis serves to aid the above groups of people in decision
making.

Sources of Information

The first procedure in financial statement analysis is to obtain useful information. The main sources of
financial information include, but are not limited to, the following;

Published reports
Quoted companies normally issue both interim and annual reports, which contain comparative
financial statements and notes thereto. Supplementary financial information and management
discussion as well as analysis of the comparative years' operations and prospects for the future will
also be available. These reports are normally made available to the public as well as the
shareholders of the company.

Registrar of Companies
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Public companies are required by law to file annual reports with the registrar of companies. These

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reports are available for perusal upon payment of a minimum fee.

Credit and Investment Advisory Agencies

Some firms specialize in compiling financial information for investors in annual supplements. Many
trade associations also collect and publish financial information for enterprises in various industries.
Major stock brokerage firms and investment advisory services compile financial information about
public enterprises and make it available to their customers. Some brokerage firms maintain a staff or
research analysis department that study business conditions, review published financial statements,
meet with chief executives of enterprises to obtain information on new products, industry trends,
negative changes and interpret the information for their clients.

Audit Reports

When an independent auditor performs an audit the audit report-is usually addressed to the
shareholders of the audited enterprise. The audit firms frequently also prepare a management report,
which deals with a wide variety of Issues encountered in the course of the audit Such a management
report is not a public document, however, it is a useful source of financial information.

Use of financial ratios

1. for evaluating the ability of the firm to meet its short term financial obligation as and when they
fall due
2. To interpret the performance of the firm over the period covered by the financial statements.
3. For comparison of the performance of the firm this can be done in the following ways
a) Cross sectional analysis-the performance of the firm in question is compared with that of
individual competitive firms in the same industry.
b) Trend/time series analysis-the firm’s performance is evaluated over time.
4. For predicting future performance of the firm.
5. To establish the efficiency of assets utilization to generate sales revenue
6. To establish the extent which the assets of the firm has been financed by fixed charge capital.

Limitations of financial ratios

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1. Ratios are computed at a specific point in time.

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2. Ratios ignore the effect of inflation in performance which is a vital part in the daily business
management
3. The comparison between firms is often done even for firms with differences in size and
technology
4. Ratio analysis engages the use of historical data contained in financial statements which may
be irrelevant in decision making.
5. The different accounting policies applied by firms in similar industries say in depreciation
calculation is a hindrance to comparison.

Types of ratios
Ratios are broadly classified into 5 categories

∑ Liquidity ratios
∑ Efficiency/turnover ratios
∑ Profitability ratios
∑ Gearing ratios
∑ Investor ratios

1. Liquidity ratios
Liquidity refers to an enterprise's ability to meet its short-term obligations as and when they fall
due. Liquidity ratios are used to assess the adequacy of a firm’s working capital. Shortfalls in
working capital may lead to inability to pay bills and disruptions in operations, which may be the
forerunner to bankruptcy. They are also known as working capital ratios. They are;

a) Current ratio = Current assets

Current liabilities

This ratio indicates the number of times the current liabilities can be paid from current assets
before these assets are exhausted. It is recommended that the ratio be at least 2.0 i.e. the current
assets must be at least twice as high as current liabilities.
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Example

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2004 2003

Sh.000 Sh.000

Current assets 26,400 15,600

Current liabilities (13,160) (6,400)

Net working capital 13,240 9,200.

Compute the Current liquidity ratio for the company. And analyze the
ratios.

Solution

In the year 2003 Sh.9.2 million of working capital is available to repay Sh.6.4 million of current
liabilities and in 2004 Sh.13.24 million is available of working capital to pay sh.l3.16 million of current
liabilities. This reflects a strong liquidity position in the years. This can be further explained using a
current liquidity ratio.

Current ratio = Current assets / Current liabilities

2004 2003

26400 /13,160 15600/6400

= 2: 1 = 2.4: 1

Observation
The enterprise appears to nave a strong liquidity position. There has been, however, a slight drop
from year 2003 to year 2004.

For every shilling that is owed in 2004, the firm has Sh.2 to pay the debt and for every shilling owed in
2003 , the firm has Sh.2.40 available to meet the liability. If the firm’s current ratio is divided into 1.0
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and the resulting value is subtracted from 1.0, the difference when multiplied by 100 represents the

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percent by which the firm’s current assets can shrink without making it impossible for the firm to cover
its current liabilities. A current ratio of 2 means that the firm can still cover its current liabilities even if
its current assets shrink by 50 percent ([1.0 – (1.0/2.0)]× 100).

b) Quick/acid test ratio = current assets- stock

Current liabilities
It is a more refined ratio than the current ratio in which the stocks are excluded as they may not be
easily converted to cash. the ratio indicates the firms ability to pay the current liabilities from the
more liquid assets of the firm.

c) Cash ratio = cash + short term marketable securities

Current liabilities
This is a refinement of the quick ratio indicating the ability of the firm to meet its current liabilities
from its most liquid resources. Short term marketable securities include commercial paper and
treasury bills and other short term investments.

2. Turnover ratios

They are also known as efficiency or activity ratios. They indicate the efficiency with which the firm
has utilized the assets or resources to generate sales revenue/turnover. Activity ratios can be
categorized into two groups: The first group measures the activity of the most important current
accounts, which include inventory, accounts receivable, and accounts payable1. The second group
measures the efficiency of utilization of total assets and fixed assets.

a) Stock/inventory turnover = cost of sales

Average stock
It indicates the number of times the stock was turned into sales in the year. The higher the ratio,
the better the firm and the higher the sales. A low stock turnover ratio indicates that the stock
levels are either very high or they are slow moving this leads to a reduction in the firms
profitability.
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Note: the average stock is the average of the opening and closing stock.

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b) Stock holding period = 360 Days x average stock
Cost of sales
Indicates the number of days the stock was held in the warehouse before being sold.

c) Debtors turnover = Annual credit sales

Average debtor
This ratio indicates the number of times debtors come to buy on credit after paying their dues to
the firm. If the rate is high the better the firm as it means they bought many times hence meaning
they paid within a shorter time. The average debtor is the average of the opening and closing
debtor balances. If no opening debtors are given use the closing debtors to represent average
debtors.

d) Debtors or average collection period = 360 Days

Debtor’s turnover
This refers to the credit period that was granted to the debtors on the period within which they
were to pay their dues to the firm.

e) Creditors/ accounts payable turnover = Annual credit purchases

Annual creditors
It indicates the number of times the firm bought goods on credit after paying its suppliers. if its
high then payment was made within a short period of time.

f) Creditors payment period = 360

Creditor’s turnover

= 360 x Average creditors

Annual credit purchases
This ratio indicates the credit period granted by suppliers.
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g) Total assets turnover = Annual sales
Total assets
This ratio indicates the amount of sales revenue generated from utilization of one shilling of total
assets.

3. Profitability ratios
Profitability ratios evaluate the firm’s earnings with respect to a given level of sales, a certain level
of assets, the owner’s investment, or share value. Evaluating the future profitability potential of the
firm is crucial since in the long run, the firm has to operate profitably in order to survive. The ratios
are of importance to long term creditors, shareholders, suppliers, employee’s and their
representative groups. All these parties are interested in the financial soundness of an enterprise.
The ratios commonly used to measure profitability include:

a) Gross profit margin = Gross profit x 100

Sales
It indicates the efficiency with which management produces each unit of a product i.e. by
controlling the cost of sales.

b) Net profit margin = Profit after tax x100

Sales
It indicates the ability of the firm to control financing expenses in particular interest expense

c) Operating profit margin = Operating profit/earning before interest and tax x 100
Sales
This ratio indicates the firm’s ability to control its operating expenses such as electricity, rent, rates
and other costs.

d) Return on investment/return on total assets = Net profit x 100

Total assets
This ratio indicates the return on profit from investment of one shilling in total assets
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e) Return on equity = net profit x 100

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Equity
This ratio indicates the return of profitability on one shilling of equity capital contributed by
shareholders.

f) Return on capital employed (ROCE) = net profit x 100

Net assets (capital employed)

4. Gearing/ leverage ratios

These ratios are used as a measure of the extent to which the company is financed by borrowed
and owners’ funds.
a) Debt to equity ratio = long term debt x 100
Common equity capital
Long term debt is sometimes referred to as fixed charge capital.

b) Debt to total capital ratio = long term debt x 100

Total capital

c) Debt ratio = Total debt(current plus long term liabilities)

Total assets

This ratio indicates the proportion of total assets that has been financed using long term and
current liabilities.

d) Times interest earned ratio = Profit before interest and tax

Interest charges
The interest coverage ratio shows the number of times that interest can be paid from the firm’s
earnings.

e) Equity ratio = capital employed

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Common equity capital

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5. Investor ratios
They are also known as market or valuation ratios. We will cover these types of ratios by giving an
illustration.

Marine centre ltd has the following data.

Profit after tax Shs.30, 000,000
Total dividend for the year Shs.18, 000,000
Market price per share (MPS) shs.20
Number of ordinary shares 6,000,000

Using this data, determine the following investor ratios and explain their significance:

a) Earnings per share (EPS)

b) Dividend per share (DPS)
c) Price earnings ratio (P/E)
d) Dividend payout ratio
e) Retention ratio
f) Dividend yield
g) Earnings yield
h) Dividend covers
Solution
a) EPS = profit after interest, tax and preferred dividend
No. of ordinary shares issued

= 30,000,000 =shs 5
6,000,000
This ratio indicates the earnings power of the firm i.e. how much earnings or profits are attributed
to every share held by an investor. The higher the ratio, the better the firm.
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b) DPS = dividend paid

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No. of ordinary shares issued

= 18,000,000 =Shs. 3
6,000,000

It indicates the cash dividend received for every share held by an investor. if all earning
attributable to ordinary shareholders were paid out as dividends then, EPS=DPS

c) P/E ratio = MPS

EPS

= 20 =shs.4
5
The MPS is the price at which a new share can be bought. EPS is the annual income from each
share. Hence, P/E ratio indicates the number of years it will take to recover MPS from the annual
EPS of the firm. As will be observed in the earnings yield (EY) the price earnings ratio is a
reciprocal of EY.

d) Dividend payout ratio = DPS x 100

EPS

=3 x 100 = 0.6
5
It represents the proportion of earnings that was paid out as dividend.
e) Retention ratio =1- dividend payout ratio (DPR)

= 1-0.6
=0.4

f) Dividend yield = DPS x 100

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MPS

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= 3 x 100
20
=15%
g) Earnings yield = EPS x100
MPS

= 5 x 100
18
=27.8%
It shows the investors total return on his investment.
h) Dividend cover = EPS
DPS

= 5
3
= 1.67 times
It shows the number of times that the dividend can be paid from current year earnings.

Financial forecasting.
It involves determining the future financial requirements of the firm. This requires financial
planning using budgets.
Importance of financial forecasting.
∑ Facilitates financial planning i.e. determination of cash surplus or deficit that are likely to
occur in future.
∑ Facilitates control of expenditure so as to minimize wastage of financial resources.
∑ Forecasting using targets and budgets acts as a motivation to employees who aim at
achieving targets set
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Methods used in financial forecasting.

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1. Use of cash budgets
A cash budget is a financial statement indicating sources of revenue, the expected expenditure
and any anticipated cash deficit/ surplus.
2. Regression analysis
It is a statistical method which involves identification of dependent and independent variables to
form a regression equation y=a + bx on which forecasting is based.
3. Percentage of sales method
One of the items that have a great influence on forecasting is sales. Hence items in the balance
sheet which re related to sales are expressed as a percentage of sales. The following steps are
involved:

a) Identify balance sheet items that are directly related to sales

-net fixed assets-say acquisition of new machinery which increase production hence increase
sales.
-Current assets-an increase in sales due to increased in stock raw materials, work in progress
and finished goods. Increased credit sales will increase debtors while more cash will be required
to buy more raw materials in cash.
-current liabilities-increased sales will lead to purchase of more raw materials.
-Retained earnings-this will increase with sales if and only if, the firm is operating at a profit.
Long term capital items such as ordinary share capital, preference share capital and debentures
are not directly impacted by an increase in sales as they are used to finance long term projects.

b) Express the above identified items as a percentage of sales i.e determine the relationship
between the item and current sales.
c) Determine the increase in total assets as a result of increase in sales.

d) Determine total increase in spontaneous sources of finance (current liabilities) and increase in
retained earnings.
Retained earnings = net profit - dividend paid
Net profit margin = Net profit
Sales
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Therefore net profit = net profit margin x sales

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e) Get the external financing needed which is the difference between increase in users of funds(c)
and (d)

f) Prepare the proforma financial statements- these are projected statements at the end of the
forecasting period.
Note: information could be given which necessitates the determination of forecast sales, this will
be determined using the following formula:

Sn =So(1+ g)n
Where: Sn = sales n years from now
So=current sales
g=growth rate
n= forecasting period
Assumptions of percentage of sales method.
∑ The fundamental assumption is that there's no inflation in the economy .i.e. the increase in
sales is caused by an increase production and not increase in selling price.
∑ The firm is operating at full capacity. hence, the increase in production will require an
increase infixed assets
∑ The capital remains constant during the forecasting period i.e. no issue of ordinary or
preference shares and debentures
∑ That the relationship between the balance sheet items and sales remains the same during
the forecasting period.
∑ The net profit margin will be achieved and shall remain constant during the forecasting
period

Comparisons in Financial Analysis

The figures in the financial statements are rarely significant or important in themselves. It is their
relationships to other quantities, amounts and the direction of change from one point in time to
another point in time that is of importance. It is only through comparison of data that one can gain
insight and make intelligent judgments. Analysis thus involves establishing significant relationships
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that point to changes as well as trends. We thus can apply the ratios above in comparison of financial

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statements.

The two comparisons widely used for analytical purpose involve trend and cross-sectional analyses.

Trend Analysis
This is also known as time series analysis, horizontal analysis or temporally analysis. It involves the
comparison of the present performance with the result of previous periods for the same enterprise.
Trend analysis is therefore usually employed when financial data is available for three or more
periods. Developing trends can be seen by using multiyear comparisons and knowledge of these
trends can assist in controlling current operations and planning for the future. It can be carried out by
computing percentages for the element of the financial statement that is under observation. Trend
percentage analysis states several years' financial data in terms of a base year, which is set to be
equal to 100%.

In conducting trend analysis the following need to be taken into account:

(i) Accounting principles and policies employed in the preparation of financial

Statement must be followed consistently for the periods for which an analysis is

Being made to allow comparability.

(ii) The base year selected must be normal and a representative year.
(iii) Trend percentages should be calculated only for these items, which have logical
relationship.
(iv) Trend percentages should be carefully studied after considering the absolute
figures; otherwise they may lead to misleading conclusions.
(v) To make meaningful comparisons, trend percentage should be adjusted in light of
price changes to the base year.
Example

Assume that the following data is extracted from the books of ABC Ltd.
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2004 2003 2002 2001 2000
sh. 'M' sh. 'M' sh. 'M' sh. 'M' sh. 'M'
Sales 725 700 650 575 500
Net Income 99 97.5 93.75 86.25 75

From the above absolute figures, there appears to be a general increase in sales and income over
the years. When expressing the above date in terms of percentages with 2000 being the base year,
the following trend percentage is observed.

2004 2003 2002 2001 2000

Sales 145% 140% 130% 115% 100%
Net Income 132% 130% 125% 115% 100%
Net
income/Sales 13.70% 13.90% 14.40% 15% 15%

From the above table it can be observed that:

i) Sales and net income have grown over the years but at a 'increasing rate,
ii) Net income has not kept pace with growth in sates. When net income is expressed as a
percentage of rates,
iii) It is further observed that net income as a percentage of sates is decreasing over the
years and this needs to be investigated.

Financial statement analysis is not an end by itself; rather the analyses enable the right questions, for
which management has to look for answers.

Problems of Trend analysis

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1. To ensure comparability of figures, the results of each year will have to be adjusted using

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consistent accounting policies. The task of adjusting statements to bring them to a common
basis could be taunting.

2. Comparison becomes difficult when the unit of measurement changes in value due to general
inflation. Comparisons become quite difficult over time.

3. If the enterprise's environment changes over time with the result that performance
that was considered satisfactory in the past may no longer be considered so. More specific
measures rather than general trends may be preferred in such instances.

Cross Sectional Analysis

This involves the comparison of the financial performance of a company against other companies
within its industry or industry averages at the same point in time. It may simply involve
comparison of the present performance or a trend of the past performance. The idea under this
approach is to use bench-marking, whereby areas in which the company excels benchmark
companies are identified, and more importantly areas that need improvement highlighted. The
typical bench-marks used in cross-sectional analysis may be a comparable company, a leader in
the industry, an average firm or industry norms (averages).

Problems of Cross Sectional Analysis

1. It is difficult to find a comparable firm within the same industry. This is because firms may have
businesses which are diversified to a greater or lesser extent. Further, industry averages are
not particularly useful when analyzing firms with multi-product lines. The choice of the
appropriate benchmark industry for such firms is a difficult task.

2. Businesses operating in the same Industry may be substantially different in that, they may
manufacture tile same product but one may be using rented equipment while the uses its own
making comparison difficult.

3. Two firms may use accounting policies, which are quite different resulting in difference in
financial statements. It is usually very difficult for an external user to identify differences in
accounting policies yet one must bear them in mind when interpreting two sets of accounts.
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4. The analyst must recognize that ratios with large deviations from the norm are only the

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symptoms of a problem. Once the reason for the problem is known management must develop
prescriptive actions for eliminating it. The point to keep in mind is that ratio analysis merely
directs attention to potential areas of concern; it does not provide conclusive evidence as to
the existence of a problem.

Reinforcing questions

1. (a) Outline four limitations of the use of ratios as a basis of financial analysis.

(b) The following information represents the financial position and financial results of
AMETEX Limited for the year ended 31 December 2002.

AMETEX Limited
Trading, profit and loss account for the year ended 31 December 2002

Sh.”000” Sh.”000”
Sales – Cash 300,000

- Credit 600,000

900,000

Less: cost of sales

Opening stock 210,000

Purchases 660,000

870,000

Less: closing stock (150,000) 720,000

Gross profit 180,000

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Less expenses:

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Depreciation 13,100

Directors’ emoluments 15,000

General expenses 20,900

Interest on loan 4,000

(53,000)
127,000
Net profit before tax
(38,100)
Corporation tax at 30%
88,900
Net profit after tax

Preference dividend 4,800

14,800
Ordinary dividend 10,000
74,100
Retained profit for the year

AMETEX Limited

Balance Sheet as at 31 December 2002

Sh.”000” Sh.”000” Sh.”000”

Fixed Assets 213,900

Current Assets:

Stocks 150,000

Debtors 35,900

Cash 20,000 205,900

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Current Liabilities:

Trade creditors 60,000

Corporation tax payable 63,500

Proposed dividend 14,800 138,300 67,600

281,500

Financed by:

Ordinary share capital (Sh.10 par 100,000

value)
60,000
8% preference share capital
81,500
Revenue reserves
40,000 ______
10% bank loan
281,500

Additional information:

1. The company’s ordinary shares are selling at Sh.20 in the stock market.

2. The company has a constant dividend pay out of 10%.

Required:
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Determine the following financial ratios:

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(i) Acid test ratio. ( 2 marks)
(ii) Operating ratio ( 2 marks)
(iii) Return on total capital employed ( 2 marks)
(iv) Price earnings ratio. ( 2 marks)
(v) Interest coverage ratio ( 2 marks)
(vi) Total assets turnover ( 2 marks)

(c) Determine the working capital cycle for the company. (4 marks)

(Total: 20 marks)

2. (b) Rafiki Hardware Tools Company Limited sells plumbing fixtures on terms of 2/10 net 30. Its
financial statements for the last three years are as follows:

1998 1999 2000

Sh.’000’ Sh.’000’ Sh.’000’

Cash 30,000 20,000 5,000

Accounts receivable 200,000 260,000 290,000

Inventory 400,000 480,000 600,000

Net fixed assets 800,000 800,000 800,000

1,430,000 1,560,000 1,695,000

Accounts payable 230,000 300,000 380,000

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Accruals 200,000 210,000 225,000

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Bank loan, short term 100,000 100,000 140,000

Long term debt 300,000 300,000 300,000

Common stock 100,000 100,000 100,000

Retained earnings 500,000 550,000 550,000

1,430,000 1,560,000 1,695,000

Additional information:

Sales 4,000,000 4,300,000 3,800,000

Cost of goods sold 3,200,000 3,600,000 3,300,000

Net profit 300,000 200,000 100,000

Required:

(a) For each of the three years, calculate the following ratios:

Acid test ratio, Average collection period, inventory turnover, total debt/equity, Net profit margin
and return on assets.

(b) From the ratios calculated above, comment on the liquidity, profitability and gearing positions
of the company.

3. The following financial statements relate to the ABC Company:

Shs. Liabilities & Net worth Shs.

Assets
Cash 28,500 Trade creditors 116,250
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Debtors 270,000 Notes payable (9%) 54,000

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Stock 649,500 Other current liabilities 100,500

Total current assets 948,800 Long term debt (10%) 300,000

Net fixed assets 285,750 Net worth 663,000

1,233,750 1,233,750

Income Statement for the year ended 31 March 1995

Shs.

Sales 1,972,500

Less cost of sales 1,368,000

Gross profit 604,500

Selling and administration 498,750

expenses
105,750
Earning before interest and tax
34,500
Interest expense
71,250

28,500
Estimated taxation (40%)
42,750
Earnings after interest and tax

Required:

a) Calculate:

i) Inventory turnover ratio; (3 marks)

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ii) Times interest earned ratio; (3 marks)

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iii) Total assets turnover; (3 marks)

iv) Net profit margin (3 marks)

(Note: Round your ratios to one decimal place)

b) The ABC Company operates in an industry whose norms are as follows:

Ratio Industry Norm

Inventory turnover 6.2 times

Times interest earned ratio 5.3 times

Total assets turnover 2.2 times

Net profit margin 3%

Required:

Comment on the revelation made by the ratios you have computed in part (a) above when
compared with the industry average.

Discussion questions.

1. Explain what is meant by capital gearing. What are the advantages and disadvantages of a highly
geared company to: - (i) its shareholders

(ii) Its debenture holders

2. Write explanatory notes on the following;- (i) price earnings ratio

(ii) The importance of dividend cover

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CHAPTER 3:
TIME VALUE OF MONEY.

Objectives
At the end of this chapter you should be able to:

1. Explain meaning of time value of money and its role in finance.

2. Explain the concept of future value and perform compounding calculations.
3. Explain the concept of present value and perform discounting calculations.
4. Apply the mathematics of finance to accumulate a future sum, preparing loan amortization
schedules, and determining interest or growth rates.
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Introduction .

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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 sums 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
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).
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Compound interest is crucial to the understanding of the mathematics of finance. In most situations

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involving the time value of money compounding of interest is assumed. The future value of present
amount is found by applying compound interest 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

At end of Year 2, FV2 =FV1 (1+k) = Po(1+k) (1+k) = Po ( 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, FV3 = 144,000(1+0.2) =100,000 ( 1+0.2) ( 1+0.2) (1+0.2) = 172,800

Alternatively,
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At the end of 3 years, FV3 = 100,000 ( 1+0.2)3 = Sh.172,800

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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.

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 an 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
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So far we have been looking at the future value of a simple, single amount which grows over a given

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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. An ordinary annuity is an annuity where the cash flow occurs 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;

End of year Amount Number of Future Future

deposited years value value at
companied interest end of year
factor
(FVIF) from
discount
tables(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 635280
years.
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The Time line and Table below shows the future value of a Sh.100,000 5-year annuity (ordinary

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annuity) compounded at 12%.

Timeline

157350

140490

125440

125440

100000

635280

0 1 2 3 4 5

100,000 100,000 100,000 100,000 100,000

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The formula for the future value interest factor for an annuity when interest is compounded annually

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at k percent for n periods (years) is;

[(1+ k ) - 1]
n
n
= Â (1+ k )
t -1
FVIFA k ,n
t =1
=
k

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.

The future value of an annuity (PMT) can be found by,

FVAn = PMT x (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%.
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Beginning of Amount Number of Future Future

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year deposit deposited years value value at
companied interest end of year
factor
(FVIF) from
discount
tables 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%.

Timeline

176230

157350

140490

125440

112000

711510

0 1 2 3 4

100,000 100,000 100,000 100,000 100,000

Using Tables to Find Future Value of an Annuity Due

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A simple conversion can be applied to use the FVIFA (ordinary annuity)in Table A-4 with annuities

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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 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
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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
Ê kˆ
FV n,k
= P0 Á1 + ˜
Ë m¯
(2.4)

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 (2.5)
Where e 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?
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Amount = 100,000 x 2.718.08*2 = 100,000 x 2.7180.16 =100,000*1.1735 =117,350

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2. DISCOUNTING
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 = 1
PV = FV C
n

(1+ k ) (1+ k )
k ,n n n n

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

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1
, or (1+ K )
-n
The factor denoted by as above is called the present value interest factor
(1+ k )
n

(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
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If a firm has been offered the opportunity to receive the above amounts and if it’s required rate of

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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

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

È
ˆ ˘˙
n
n
1 1Í Ê 1
PVIFAK,n = Â = Í1 - Á ˜˙
t =1
(1+ k ) n
k
ÍÎ Ë 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
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Assume that a project will give you sh. 1000 at the end of each year for 4 years .What is the

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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 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%.
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The present value of the perpetuity is 1000 x PVIFAk, α = 1000 x 1/0.1= Sh.10, 000.

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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

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

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A situation may arise in which we know the future value of a present sum as well as the number of

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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%
Amortizing a 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
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(i) Annual repayments

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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 year

payment 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%.

Lets 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
PMT = 600,000/6.4632 = Sh.92,833 per year.
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Loan Amortization schedule

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Payments

End of Loan Beg. Of Interest Principal End of

period payment year period
(6months) 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

Year Cash flow (Sh.)

2004 1,520,000
2003 1,440,000
2002 1,370,000
2001 1,300,000
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2000 1,250,000

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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 PVIF k , 4 yrs . 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 FVIF k , 4 yrs

(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.

Discussion Questions

1. Why does money have time value?

2. What is a deferred annuity (annuity due)?
3. List five different applications of time value of money.
4. If, as an investor, you had a choice of daily, monthly, or quarterly compounding, which
would you choose? Why?
5. Describe the procedure used to amortize a loan into a series of equal annual payments.
What is a loan amortization schedule?
6. What is perpetuity?

Problems

2-1. If you invest Sh.12,000 today, how much will you have :

i. In 6 years at 7%.

ii. In 15 years at 12 %.

iii. In 25 years at 10 %.

iv. In 25 years at 10 % compounded semi-annually.

2-2. How much would you have to invest today to get:

v. Sh.12, 000 in 6 years at 12%.
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vi. Sh.8,000 in 5 years at 20%

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vii. Sh.15, 000 in 15 years at 8%.

viii. Sh.30, 000 each year for 20 years at 6%.

ix. Sh.40, 000 each year for 40 years at 5%.

2-3. William Kimilu borrows Sh.7, 000,000 at 12% interest rate toward the purchase of a new
house. His mortgage is for 30 years.
a. How much will his annual payments be?
b. How much interest will he pay over the life of the loan?
c. How much should he be willing to pay to get out of a 12% mortgage and into a 10%
mortgage with 30 years remaining on the mortgage?

2-4. Your younger sister, Agnes will start college in one year’s time. The college fees will amount to
Sh.80, 000 per year for four years payable at the beginning of each year. Anticipating Agnes’s
ambition, your parents started investing Sh.10, 000 per year five years ago and will continue to
do so for five more years. How much more will your parents have to invest for the next five
years to have the necessary funds for Agnes’s education? Use 10% as the appropriate interest
rate throughout the question.

2-5. You are the chairperson of the investment retirement fund for Actors Fund. You are asked to
set up a fund of semi-annual payments to be compounded semi-annually to accumulate a sum
of Sh.5, 000,000 after 10 years at 8% annual rate (20 payments). The first payment into the
fund is to take place 6 months from now, and the last payment is to take place at the end of the
tenth year.
a. Determine how much the semi-annual payment should be.
On the day after the sixth payment is made ( the beginning of the fourth year), the interest rate
goes up to 10% annual rate, and you can earn 10% on the funds that have accumulated as
well as on all future payments into the fund. Interest is to be compounded semi-annually on all
funds.

b. Determine how much the revised semi-annual payments should be after this rate
change (there are 14 semi-annual payments remaining). The next payment will be in the
middle of the fourth year.

2-6. You can deposit Sh. 100,000 into an account paying 9% annual interest either today or exactly
10 years from today. How much better off would you be at the end of 40 years if you decide to
make the initial deposit today rather than 10 years from today?
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2-7. Lumumba needs to have Sh.1, 500,000 at the end of 5 years in order to fulfill his goal of

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purchasing a sports car. He is willing to invest the amount as a lump sum today but wonders
what type of investment return he will need to earn. Figure out the annual compound rate of
return needed in each of the following cases.
a. Lumumba can invest Sh.1
b. , 020,000 today.
c. Lumumba can invest Sh.815,000 today
d. Lumumba can invest Sh.715,000 today

2.8 Lucas wishes to determine the future value at the end of two years 0f a Sh.150, 000 deposit
made today into an account paying a nominal interest rate of 12%.

a. Find the future value of Lucas’ deposit assuming that interest rate is compounded:

1) Annually

2) Quarterly

3) Monthly

b. Using your findings in a demonstrate the relationship between compounding frequency

and future value

c. What is the maximum future value obtainable give the Sh.150,000 deposit, 2-year time
period, and 12% nominal rate? Using your findings in a to explain.

2-9 Rita Wanda wishes to select the better of two ten-year annuities.

Annuity X is an ordinary annuity of Sh.250, 000 per for 10 years.

Annuity Y is an annuity due of Sh.220, 000 per for ten years.

a. Find the future value of both annuities assuming that Rita can earn (1) 10% annual
interest, (2) 20% annual interest.
b. Briefly explain the differences between the values

2-10. You plan to retire in exactly 20 years. Your goal is to create a fund that will allow you to draw
Sh.200, 000 per for 30 years between retirement and probable death. You will be able to earn
11% during the retirement period.
a. How large a fund will you need when you retire in 20 years to provide the 30-year
Sh.200, 000 annuities.
b. How much would you need today as a lump sum to provide the amount calculated in a)
above if you earn only 9% during the 20 years preceding retirement?
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2-11. While vacationing in Lamu Island Chris Musundi saw the vacation home of his dreams. It was

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listed with a sale price of Sh.20, 000,000. The only catch is that Chris is 40 and plans to
continue working till he is 65. Chris expects property values to increase at the general rate of
inflation. Chris can earn a return of 9% annually on his funds and is willing to invest a fixed
amount for the 25 years to fund the cash purchase of such a house when he retires.
a. If inflation is expected to average 5% for the next 25 years what will Chris dream house
cost when he retires?
b. How much must Chris invest at the end of each of the 25 years in order to have the
cash purchase price of the house when he retires?
c. If Chris invests at the beginning instead of at the end of teach of the 25 years, how
much must he invest each year?

2-12 Rodgers Masengo just closed a Sh.2, 000,000 business loan that is to be repaid in 3 equal
end-of year repayments. The interest rate on the loan is 13%.
Prepare an amortization schedule for the loan.

CHAPTER 4

COST OF CAPITAL

Objectives
At the end of the chapter you should be conversant with:

1. Meaning and application of cost of capital.

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2. Computation of specific cost of capital.

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3. Weighted average cost of capital (WACC) and weighted marginal cost of capital (WMCC)

4. Term structure of interest rates.

Introduction.
The cost of capital of a project is the minimum required rate of return expected on funds committed to
the project. It is the required rate of return by the providers of funds.
Significance of cost of capital
a) It is useful in long term investment decisions so as to determine which project should be
undertaken. The techniques used to make this decision include net present value and IRR.
b) It is also used in capital structure decisions to determine the mix of various components in the
capital structure. The cost of capital of each component is determined.
c) Used for performance appraisal. A high cost of capital is an indicator of high risk attached to the
firm usually attributed to the performance of the management of a firm
d) In making lease or buy decisions. In lease or buy decisions the cost of debt is used as the
discounting rate.

SPECIFIC COSTS OF CAPITAL

Specific costs of capital are the costs of capital of each source of capital such as debt, preference
shares and equity.
a) Cost of debt (kd)
The cost of debt for a perpetual debenture will be;
Kd = I
Pb
I is the annual interest
Pb is the current market value of a debenture

If the debenture is redeemable after a certain period of time/it has a maturity period the following
formula will be applied to get the cost of debt or yield to maturity;
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kd = I + M -Pb
n
M + Pb
2
I is the annual interest
M is the par value of the debenture
Pb is the current market value of the debenture
n is the period to maturity
The above formula gives the pre-tax cost of debt the after tax cost of debt for which interest paid on
debentures is an allowable expense for tax purposes will therefore be;
Kd (1-T) T being the tax rate.

b) Cost of preference shares (kp)

The required return to the preference shareholders with perpetual preference share capital will be;
Kp = d p
Pp
dp is the preference dividend per share
Pp is the market price per preference share
Where the company incurred floatation cost the kp = dp
Pp-Fc
Fc is the floatation cost

c) Cost of ordinary shares/equity (ke)

Equity can be either internally generated (from retained earnings) or externally generated (the
common share capital).
The cost of retained earnings (kr). Retained earnings are an internal financing received without
incurring floatation costs. It can be calculated as follows;

kr = d 1 + g
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Po

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The cost of external equity (ks) can be calculated as follows;

ks = d 1 + g
P0 -Fc
Where Fc is the floatation cost which may be given as the percentage of the price or in shilling value.

Weighted average cost of capital (WACC)

This is the overall/composite cost of capital that a firm is currently using. It is calculated by
determining the weighted average cost of each source of capital in the firm’s capital structure.

WACC(ko) = kd( D ) + kp ( P ) + kr ( R ) + ks ( S )
V V V V

Where;
kd, kp, kr, ks =percentage cost of debt, preference share capital, retained earnings and external
equity respectively
D, P, R, S =total debt, preference, retained and ordinary share capital respectively
V= total value/capital of the firm
Hence, D, P, R, S are the proportions or weights of debt, preference capital, retained
V V V V earnings and external equity in the capital structure respectively
Example.
Bahati Company has the following capital structure.

Source amount
Debentures 8,000,000
Preference capital 2,000,000
Retained earnings 4,000,000
Ordinary share capital 6,000,000
20,000,000
The component costs of capital are; kd is 6%, kp is10.5%, kr is 14%,ks is 17.2%
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Compute the WACC.

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Ko = wdkd+ wpkp + wrkr + wsks

The wd,wp,wr,ws are the weights of the specific sources of capital whose sum is 1.
ko = 6 ( 8m) + 10.5( 2m ) +14( 4m) +17.2 ( 6m)
20m 20m 20m 20m

Ko = 11.41%
The weighted average cost of capital can be used to evaluate the performance of management.
Since it is a historic cost it is not useful in investment decisions as it is irrelevant. In making decisions
the future costs are considered and hence the need for the marginal cost of capital (MCC).
Marginal cost of capital (MCC)
This is the cost of raising an additional shilling. It considers the cost of raising additional or future
financing. An increase in the level of financing increases the cost of various types of finances. As
retained earnings are exhausted there may be a need to issue new ordinary shares which comes with
high floatation costs hence a higher marginal cost of capital.

Example.
Mina ltd has 300,000 of retained earnings available. The kr is 13%. If the company exhausts the
retained earnings it can issue equity whose cost is 14%. The firm expects that it can borrow up to
400,000 at 5.6%, beyond that additional debt will have an after tax cost of 8.4%
Unlimited amounts of funds can be raised by issuing preference stock at a current cost of 10.6%.Mina
Ltds capital structure is 40% debt, 50% equity,10% preference.
Calculate the marginal cost of capital of the various ranges of total financing.
The Break point reflects the level of total new financing at which the cost of one of the financing
components rises.
BPj = AF
Wj
Where; AF is the amount of funds available from source j at a given cost before braking point.
Wj is the capital structure weight of source j
BP of equity = 300,000 = 600,000
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0.5

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BP of debt = 400,000 = 1,000,000
0.4
Breaking point MCC
0- 600,000 0.4(5.6)+ 0.1(10.6) +0.5(13) = 9.8%
600,001- 1,000,000 0.4(5.6) + 0.1(10.6) + 0.5(14)=10.8%
Over 1m 0.4(8.4) +0.1(10.6) + 0.5(14)=11.5%
Preference share capital cost does not change with the breaking points as we are told we can raise
unlimited funds at the same cost. The retained earnings are exhausted at the 600,001 shilling so the
cost increases as new equity is issued at 14%.
The marginal cost of capital schedule shows the relationship between the MCC and the amount of
funds raised by the company.
Weaknesses of WACC as a discounting rate.
∑ It is an historical cost and therefore would not be appropriate t use in investments decision as
only future cash flows should be used. When calculating cost of equity the dividend is used
and so is the growth rate which is gotten from past stream of dividends.
∑ It assumes that the capital structure is optimal which is not achievable in the real world.
∑ It can only be use das 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.

WEIGHTED MARGINAL COST OF CAPITAL (WMCC) SCHEDULE.

This is a schedule that shows the relationship between the marginal cost of capital; and the amount of
funds raise d by a company. The marginal cost of capital can either be constant or have breaks or
breaking points.

cost Cost
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Kd KpKr and Ks are constant.
Amount

Constant Breaking points.

Constant cost of capital schedule occurs if it is possible to raise a limited amount of funds from each
of the sources at the same cost. A breaking point MCC occurs if additional funds from any of the
sources can only be raised at a higher cost. The most common MCC schedule is one with a break
when retained earnings are exhausted.

Breaking Point = Total cheaper funds from a given source

Proportion of that source in the capital structure.
Example
Makueni 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.
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The current market value of the company’s ordinary shares is Sh.60 per share. The expected
ordinary share dividends 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.

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
(b) (i) Cost of equity

do(1 + g)
Ke = +g
Po

do(1+g) = Sh2.40

Po = Sh60
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g = 10%

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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)
Kd = n
(m + vd) 1
2

m = Maturity/per value = sh 150

vd = market value = Sh. 100

n = number of years to maturity =100

Int = Interest = 6% x 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

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(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
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Term structure of interest rates.
The term structure of interest rates describes the relationship between interest rates and the term to
maturity and the differences between the short term and long term interest rates.
Theories which have been advanced to explain the nature if he yield curve –which is a graph of the
term structure of interest rates depicting the relationship between yield to maturity of a security-on the
y-axis and the time to maturity-on the x-axis.

Theories of term structure.

1. Liquidity preference theory.
This theory states that short term bonds are more favourable than long term bonds because;
Investors perceive less risk in short term securities because they are more liquid. Hence they can
accept lower yields to avoid the risk.
Borrowers on the other hand, will prefer longer tem bonds so as to delay repayment of the debt. They
are thus willing too pay a higher rate for longer term bonds.
These preferences result in a premium being paid which increases as the time to maturity increases.
Hence this explains an upward sloping yield curve.
2. Expectations hypothesis
This theory states that the yield curve depends on the expectations about the future inflation rate. If
the inflation rate is expected to rise, then the rate on long term bonds will exceed that of short term
loan. In this case the yield curve would be upward sloping, the reverse is true. The expected future
interest rates are equal to forward rates computed from the expectations with regard to the future
interest rates.
The following conditions are necessary for the expectations hypothesis to hold;
∑ There’s a perfect capital market with many buyers and sellers.
∑ Investors are assumed to be rational. Are wealth maximizers
∑ Investors have homogeneous expectations about future interest rates and return on
investment.
∑ The bankruptcy of firms due to the use of borrowing is unlikely.
3. Market segmentation theory
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It state that the market for loans is segmented on the basis of maturity and are confined to a segment

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of the market and will not change even if the forecast of the likely future interest changes.
The supply and demand for loans in each segment will determine the prevailing rates in that segment.
Take an example of someone borrowing to build a house they would most likely prefer a long term
loan. The lower rates say in the short term segment and high rates in the long term segment would
result in an upward sloping curve.

Reinforcing questions

1. (a) Explain the meaning of the term “cost of capital” and explain why a company should calculate
its cost of capital with care. (4 marks)

(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. (6 marks

2. Vitabu Ltd. is a merchandising firm. The following information relates to the capital structure of the
company:

1. The current capital structure of the company which is considered optimal, comprises:

Ordinary share capital – 50%, preference share capital – 10% and debt – 40%.

2. The firm can raise an unlimited amount of debt by selling Sh.1,000 par value, 10 year 10%
debentures on which annual interest payments will be made. To sell the issue it will have to
grant an average discount of 3% on the par value and meet flotation costs of Sh.20 per
debenture.

3. The firm can sell 11% preference shares at the par value of Sh.100. However,, the issue and
selling costs are expected to amount to Sh.4 per share. An unlimited amount of preference
share capital can be raised under these terms.

4. The firm’s ordinary shares are currently selling at Sh.80 per share. The company expects to
pay an ordinary dividend of Sh.6 per share in the coming year. Ordinary dividends have been
growing at an annual rate of 6% and this growth rate is expected to be maintained into the
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foreseeable future. The firm can sell unlimited amounts of new ordinary shares but this will

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require an under pricing of Sh.4 per share in addition to flotation costs of Sh.3 per share.

5. The firm expects to have Sh.225,000 of retained earnings available in the coming year. If the
retained earnings are exhausted, new ordinary shares will have to be issued as the form of
equity financing.

The company is in the 30% corporation tax bracket.

Required:

(a) The cost of each component of financing. (12 marks)

(b) The level of total financing at which a break in the marginal cost of capital (M.C.C) curve
occurs. (2 marks)

(c) The weighted average cost of capital (W.A.C.C):

(i) Before exhausting retained earnings. (3 marks)

(ii) After exhausting retained earnings. (3 marks)

(d) Explain fully the effect of the use of debt capital on the weighted average cost of capital of a
company. (6 marks)

3 .The Salima company is in the fast foods industry. The following is the company’s balance sheet
for the year ended 31 March 1995:

Assets Sh.’000’ Liabilities and owners equity Sh.’000’

Current Assets 65,000 Current liabilities 25,000

85,000 16% Debentures (Sh.1,000 31,250

par)
Net fixed assets 12,500
15% Preference shares
25,000
Ordinary shares (Sh.10 par)
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______ Retained profits 56,250

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150,000 150,000

Additional information:

1. The debenture issue was floated 10 years ago and will be due in the year 2005. A similar
debenture issue would today be floated at Sh.950 net.

2. Last December the company declared an interim dividend of Sh.2.50 and has now declared a
final dividend of Sh.3.00 per share. The company has a policy of 10% dividend growth rate
which it hopes to maintain into the foreseeable future. Currently the company’s shares are
trading at Sh.75 per share in the local stock exchange.

3. A recent study of similar companies in the fast foods industry disclose their average beta as
1.1.

4. There has not been any significant change in the price of preference shares since they were
floated in mid 1990.

5. Treasury Bills are currently paying 12% interest per annum and the company is in the 40%
marginal tax rate.

6. The inflation rate for the current year has been estimated to average 8%.

Required:

(a) Determine the real rate of return. (2 marks)

(b) What is the minimum rate of return investors in the fast foods industry may expect to earn on
their investment? Show your workings. (7 marks)

(c) Calculate Salina’s overall cost of capital. (6 marks)

(d) Discuss the limitations of using a firm’s overall cost of capital as an investment discount rate.
(6 marks)

Discussion questions

1. (b) The total of the net working capital and fixed assets of Kandara 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.
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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. (2 marks)

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(ii) The effective cost to the company of:

ß Debt capital ( 2 marks)

ß Preference share capital ( 2 marks)

(iii) The company’s existing weighted average cost of capital. (4 marks)

(iv) The company’s marginal cost of capital if it raised the additional Sh.50,000,000 as
intended. (4 marks)
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CHAPTER 5:

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CAPITAL BUDGETING DECISIONS

Objectives
At the end of this chapter, you should be able to:

1. Define capital budgeting.

2. Describe and compute Cash flow components.
3. Critically evaluate the capital budgeting techniques.
4. Evaluate projects and rank them based on the budgeting techniques. Already learned.
4. Discuss the potential difficulties and conflicts in using alternative discounted capital
methods.

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.
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3. Renewal – An alternative to replacement may involve rebuilding, overhauling or refitting an

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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.

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
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two systems, though in modern times has seen a shift to decentralization and a greater use of

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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.

Estimation of cash flows is one of the most important and challenging step because decisions
made depend on cashflows projected for each proposal. Cashflows must be relevant and
therefore need to have the following criteria,
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ÿ They must be future cashflows because cashflows already received or paid are sunk costs

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hence irrelevant in decision making.
ÿ Cashflows must be incremental. This enables the firm to analyze cashflows of the firm with or
without the project.
ÿ Cashflows must involve an actual inflow or outflow of cash. Thus expenses which do not
involve a movement of cash e.g. Depreciation are not cashflows.
Cash flow components

The cash flows of any project can include three basic components:

(1) An initial investment

(2) Operating cash flows

(3) Terminal cash flows.

All projects will have the first two; some however, lack the final components.

Initial Investment
The initial investment is the relevant cash outflow for a proposed project at time zero. It is found by
subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero.
Atypical format used to determine initial cash flow is shown below.

Cost on new asset xx

Installation cost xx

Installed cost of new asset xx

Proceeds from sale of old assets xx

+ Tax on sale of old assets xx

After-tax proceeds from sale of old

asset xx
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+ Change in Net working
capital xx

Initial Investment xx

The installed cost of new asset = cost of new asset (acquisition cost) + installation cost (additional
cost necessary to put asset into operation) +After-tax proceeds from sale of old asset

Change in networking capital (NWC) Net working capital is the difference between current assets
(CA) and current liabilities (CL) i.e. NWC = CA –CL. Changes in NWC often accompany capital
expenditure decisions. If a company acquires a new machinery to expand its levels of operation,
levels of cash, accounts receivables, inventories, accounts payable, accruals will increase. Increases
in current assets are uses of cash while increases in current liabilities are sources of cash. As long as
the expanded operations continue, the increased investment in current assets (cash, accounts
receivables and inventory) and increased current liabilities (accounts payables and accruals) would
be expected to continue.

Generally, current assets increase by more than the increase in current liabilities, resulting in an
increase in NWC which would be treated as an initial outflow (This is an internal build up of accounts
with no tax implications, and a tax adjustment is therefore unnecessary).

Operating Cash Flows

These are incremental after tax cash during its lifetime. Three points should be noted:-

- Benefits should be measured on after tax basis because the firm will not have the use of any
benefits until it has satisfied the government’s tax claims.
- All benefits must be measured on a cash flow basis by adding back any non-cash charges
(depreciation)
- Concern is only with the incremental (relevant) cash flows. Focus should be only on the
change in operating cash flows as a result of proposed project. The following income
statement format is useful in the determination of the operating cash flows.
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General format for estimating operating cash flows:

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1. Sh.

Incremental sales over the life of the project xx

Less cost of sales (xx)

Savings before depreciation and tax xx

Less depreciation (xx)

Savings before tax xx

Less Tax(Savings before tax × Tax rate) (xx)

Savings after tax xx

Add back depreciation (xx)

Net incremental cash flows xx

2. OR

(As above)

Savings before depreciation and tax xx

Less tax(Savings before tax & dep. × Tax rate) (xx)

Savings after tax xx

Add depreciation tax shield(Depreciation ×Tax rate) xx

Net incremental cash flows (xx)

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Terminal Cash Flows

The cash flows resulting from the termination and liquidation of a project at end of its economic life
are its terminal cash flow. Terminal cash flow is determined as incremental after tax proceeds from
sale or termination of a new asset or project. The format below can be used to determine terminal
cash flows.

Proceeds from sale of new assets Project xx

+ Tax on sale of new asset xx

xx

Proceeds from sale of old asset xx

+ Tax on sale of old asset xx xx

+ Change in NWC xx

Terminal Cash Flow xx

Note that for a replacement decision both the sale proceeds of the old asset and the new asset are
considered. In the case of other decision (other than replacement), the proceeds of an old asset
would be zero. Note also that with the termination of the project the need for the increased working
capital is assumed to end. This will be shown as a cash inflow due to the release of the working
capital to be used business needs. The amount recovered at termination will be equal to the amount
shown in the calculation of the initial investment.

Basic terminologies in capital budgeting.

Independent Vs Mutually Exclusive Projects

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Independent projects are those whose cash flows are unrelated or independent of one another; the

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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
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year an overhaul costing Sh.8million may be required. The machine would then generate Sh.5 million

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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.

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. Pay back period method(PBP)

ii. Accounting rate of return method(ARR)
b) Discounted cash flow techniques (modern methods)

iii. Net present value method(NPV)

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iv. Internal rate of return method(IRR)

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v. Profitability index method(PI)

NON-DISCOUNTED CASH FLOW TECHNIQUES

PAY BACK PERIOD METHOD (PBP)

Pay back 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.

I f the project generates constant annual cash inflows, the Pay back period will be given by,

PBP=Initial Investment

Annual cash flow

Illustration:

Example
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

Year 2 Sh.14 million Sh.12 million

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Year3 Sh.14 million Sh.10 million

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Year 4 Sh.14 million Sh.10 million

Year 5 Sh.14 million Sh.10 million

Average Sh.14 million Sh.14 million

For project A, (Annuity cashflows)

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Pay back period = 14 = 3.0 years

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

2 12million 40million

3 10million 50million

4 10million 60million

5 10million 70million

5
2+ = 2.5 years
Pay back period = 10

Only 50% of year 3 cash inflows of Sh.10million are needed to complete the pay back period of the
initial investment ofSh.45million. Therefore pay back period of project B is 2.5 years.

Decision Criteria
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If AQMW systems maximum acceptable Pay back period was 2.75 years, Project A would be rejected

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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 pay back period but on the total cashflows.

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:

ARR= Average annual profit after tax ×100

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Average investment

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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:

Depreciation = 50 m - 0 = 10m

Calculation of the average income,

Year

1 2 3 4 5
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Earnings before dep. 12000 15000 18000 20000 22000

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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

Average Income =1400+3500+5600+7000+8400

=Ksh. 5,180,000

Average investment=Initial investment + salvage value

Average investment=50000000 + 0

=2500000

ARR= Average income x100

Average investment

ARR = 5,180,000 × 100

25,000,000

=20.72%
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Decision criteria:

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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

NET PRESENT VALUE (NPV)

This is the difference between the present value of cash inflows and the present value of cash
outflows of a project. To get the present values a discount rate is used which is the rate of return or
the opportunity cost of capital. The opportunity cost of capital is the expected rate of return that an
investor could earn if the money would have been invested in financial assets of equivalent risk.
Hence it’s the return that an investor would expect to earn.
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When calculating the NPV the cashflows are used and this implies that any non-cash item such as

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depreciation if included in the cashflows should be adjusted for. In computing NPV the following steps
should be followed:

Cashflows of the investment should be forecasted based on realistic assumptions. If sufficient

information is given one should make the appropriate adjustments for non-cash items

Identify the appropriate discount rate. (It is usually provided)

Compute the present value of cashflows identified in step 1 using the discount rate in step2

The NPV is found by subtracting the present value of cash out flows from present value of cash
inflows.

È C C2 C3 Cn ˘
NPV = Í 1 + + + L + n˙
- C0
Î (1 + k ) (1 + k ) (1 + k ) (1 + k ) ˚
2 3

n
Ct
NPV = Â - C0
t =1 (1 + k ) t

CO Initial investment.

NPV= PV (inflows) –PV (outflows)

Decision Criteria
When NPV is used to make accept – reject decisions, the decision criteria are as follows:

∑ If the NPV is greater than 0, accept the project

∑ If the NPV is less than 0, reject the project.
If NPV > 0, the firm will earn a return greater than its cost of capital, thereby enhancing the market
value of the firm and shareholders wealth.
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Recall the previous illustration (AQMW systems)

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Additional information; the firms required rate of return is 30%.

Compute the NPV of AQMW systems and advise the management of the company

Project A

Annual Cash inflow (annuity) 14million

PVIFA 10%, 5 years (tables) 3.791

PV of cashflows. 53.074million

Less initial Investment 42.million

Net Present Value 11.074million

Project B

Year Cash Inflows PVIF PV

1 28million 0.909 25.452m

2 12m 0.826 9.912m

3 10m 0.751 7.510m

4 10m 0.683 6.830m

5 10m 0.621 6.210m

Present Value 55.914m

Less initial investment(CO) (45.000m)

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NPV 10.912m

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Decision criteria,

Both projects are acceptable as the NPV is positive.

Project A is preferable to project B as it has a higher NPV of 11million comparing to B of 10.9million.

PROFITABILITY INDEX.

It is defined as the ratio of the present value of the cashflows at the required rate of return to the initial
cashout flow on the investment.

PI= Present value of cash inflow

Initial cash outflow.

It is also called the benefit –cost ratio because it shows the present value of benefits per shilling of t
he cost. It is therefore a relative means of measuring a project’s return. It thus can be used to
compare projects of different sizes.

Decision criteria:

If PI > 1 Accept project.

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PI < 1 Reject project.

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PI = 0 Indifferent.

For example from previous example,

PI= 18,368.98

15,000

= 1.22

Profitability Index is +1.22 >1

Thus the project is viable as PI IS More than 1.

For example if you have two mutually exclusive independent projects with the following NPV and PI

Project NPV PI

A 6000 1.44

B 5000 1.22

Decision: Using PI, both projects are acceptable as their PI is greater than 1.

Since the projects are mutually exclusive, select Project A as it has a higher than that of B.

Advantages of PI.
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1. It considers time value of money.

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2. It considers all cash flows yielded by the project.
3. It ranks projects in order of the economic desirer ability.
4. It gives a unique decision criterion.
5. It is a relative measure of profitability and therefore can be used to compare projects of
different sizes.

Weaknesses of PI.

1. It is not consistent with maximizing shareholders wealth.

2. It assumes the discount rate is known and consistency which might not be the case.

INTERNAL RATE OF RETURN.(IRR)

This is the discounting rate that equates present value of expected future cashflows to the cost of the
investment .It is therefore the discounting rate that equates NPV to zero.

C1 C2 3
C0 2 3 n

n
Ct
C0 = Â
t =1 (1 + r )t
n
Ct
Â
t =1 (1 + r ) t
- C0 = 0
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Where: Co=initial investment

C1/C2/C3/Cn=cashflow in year1, 2, 3… up to year n

L =cash flows from period 3 to year n

r = is the rate that equates the initial investment to the present value of cash
inflows over the life of the project.(IRR)

The IRR can be found by using the following methods:

i) trial and error

ii) interpolation

i) Trial and error

Decision criteria:

Accept the project when r > k.

Reject the project when r < k.

The investor is indifferent when r = k.

In case of independent projects, IRR and NPV rules will give the same results if the firm has no
shortage of funds.

POTENTIAL DIFFICULTIES IN USING DISCOUNTED CASH FLOW METHODS

1. For a single conventional, independent projects, the IRR, NPV and PI methods lead us to make
similar accept/reject decision. Various types of circumstances and projects differences can cause
ranking difficulties.Two situations that could cause inconsistencies arise when (1) When funds are
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limited necessitating capital rationing and, (2) when ranking two or more project proposals are

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mutually exclusive.

Capital Rationing
Occurs any time there is a budget constraint or ceiling on the amount of money that can be invested
during a specific period of time (For example, the company has to depend on internally-generated
funds because of borrowing difficulties, or a division can make capital expenditures only up to a
certain ceiling).

With capital rationing, the firm attempts to select the combination of investments that will provide the
greatest increase in the firm of the value subject to the constraining limit.

Example

Assume your firm faces the following investment opportunities:

Project Initial Cash Flows IRR NPV PI

Shs.000 Sh.000

A 50,000 15% 12,000 1.24

B 35,000 19 15,000 1.43

C 30,000 28 42,000 2.40

D 25,000 26 1,000 1.04

E 15,000 20 10,000 1.67

F 10,000 37 11,000 2.10

G 10,000 25 13,000 2.30

H 1,000 18 100 1.10

If the budget ceiling for initial cash flows during the present period is Shs.65,000,000 and the
proposals are independent of each other, your aim should be to select the combination projects that
provide the highest in firm value the Shs.65 m can deliver.
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Selecting projects in descending order of profitability according to various discounted cash flows

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methods, which exhausts Sh.65 million reveals the following:

Using the IRR Using the NPV

Project IRR NPV Initial outlay Project NPV Initial flow

Sh 000 Shs.000 Sh 000 Sh.000

A 37% 11,000 10,000 C 42,000 30,000

B 28 30,000 30,000 B 15.000 35,000

C 26 25,000 25,000 57,000 65,000

54,000 65,000

Using the PI
Project PI NPV Initial outlay

Sh000 Sh000

C 2.40 42,000 30,000

G 2.30 13,000 10,000

F 2.10 11,000 10,000

E 1.67 10,000 15,000

76,000 65,000

With capital rationing you would accept projects C,E,F and G which deliver an NPV of Sh.76million.
The universal rule to follow is “When operating under a constraint, select the projects that deliver the
highest return per shilling of the constraint (the initial investment outlay)”. Put another way, select that
mix of projects that gives you “the biggest bang for the buck”. We achieve this buy employing the
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profitability index which ranks projects on the basis of the return per shilling of initial investment

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outlay.

Under conditions of capital rationing it is evident that the investment policy is less than optimal –
Optimal policy requires that no positive NPV projects be rejected.

Difficulties in Ranking

Conflicts in ranking may arise due to one or a combination of the following factors:

2. Capital rationing: funds are not adequate to undertake all positive NPV projects
3. Scale of investment: initial costs of projects differ.
4. Cash flows patterns: cash flows of one project may increase while those of another may decrease
with time.
Project life: projects may have unequal useful lives.

Scale Differences
Example
Suppose a firm has two mutually exclusive projects that are expected to generate following Cash
flows

End of Year Project A Project B

Cash flows (Sh) Cash flows (Sh)

0 -1000,000 -100,000,000

1 0 0

2 400,000 156,250,000

If the required rate of return is 10% the NPV, IRR and PI of the projects are as below:

IRR NPV PI

Sh000
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Project A 100% 231 3.31

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Project B 25% 29,132 1.29

Ranking of projects based on our results

RANKING IRR NP PI

1st A B A

2nd B A B

Using the IRR and PI shows preference for project A, while NPV indicates preference for Project B.
Because IRR and PI are expressed as a proportion the scale of the project is ignored. In contrast
results of NPV are expressed in absolute shilling increases in value of the firm. With regard to
absolute increase in value of the firm, NPV is preferable.

Differences in Cash Flow Patterns (Multiple IRR)

Example
Assume a firm is facing two mutually exclusive projects with following cash flow patterns.

End of year Project C Project D

Cash flows Cash flows

Sh000 Sh000

0 -1,200 -1,200

1 1,000 100

2 500 600

3 100 1,080
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Note that project C’s cash flows decrease while those of project D increase over time.

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∑ The IRR for projects are as follows
Project C - 33%

Project D - 17%

∑ For every discount rate> 10% project C’s NPV and PI will be> than project D’s.
∑ For every discount rate < 10% project D’s NPV and PI will > project C’s.

K<10% K>10%

RANKING IRR NPV PI NPV PI

1st C D D C C

2nd D C C D D

When we examine the NPV profiles of the two projects, 10% represents the discount rate at which the
two projects have identical NPVs. This discount rate is referred to as Fisher’s rate of intersection. On
one side of the Fisher’s rate it will happen that the NPV and PI on one hand, and the IRR on the other
give conflicting rankings.

We observed conflict is due to the different implicit assumption with respect to the reinvestment rate
on intermediate cash flows released from the project. The IRR implicitly assumes that funds can be
reinvested at the IRR over the remaining life of the project. With the IRR the implicit reinvestment rate
will differ from project to project unless their IRRs are identical.
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For the NPV and PI methods assume reinvestment at a rate equal to the required rate of return as the

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discounts factor. The rate will be the same for all projects.

Since the reinvestment rate represents the minimum return on opportunities available to the firm, the
NPV ranking should be used. In this way, we identify the project that contributes most to shareholder
wealth.

Differences in Project Life

When projects have different lives, a key question is what happens at the end of the short-lived
project? Two alternatives assumptions can be considered. (1) Replace with (a) identical project or (b)
a different project. (2) Do not replace. The Do not replace alternative is considered first.
Example

Suppose you are faced with choosing between 2 mutually exclusive investments X and Y that have
the following Cash flows.

End of year Project X Project Y

Cash flows Cash flows

Sh. ‘000’ Sh. ‘000’

0 - 1000 - 1000

1 0 2000

2 0 0

3 3,375 0

If the required rate of return is 10% we can summarize our investment appraisal results as follows:

IRR NPV PI

Sh000
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X 50% 1536 2.54

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Y 100% 818 1.82

RANKING
Rank IRR NPV PI

1st Y X X

2nd X Y Y

Once again a conflict in ranking arises. Both the NPV and the PI prefer project X to Y, while The IRR
criterion choose Y over X.

Again, in this case of no replacement, the NPV method should be used because it will choose
projects that add the greatest absolute increment in value to the firm.

Replacement Chain When faced with a chose between mutually exclusive investments having
unequal life that will require replacement, we can view the decision as one involving a series of
replications – or a replacement chain – of respective alternatives over some common investment
horizon.

Repeating each project until the earliest rate that we can terminate each project in the same year
results in a multiple like-for-like replacement chains covering the shortest common life. We solve the
NPV for each replacement chain as follows:

NPV chain =

Where n = single replication project life in years

NPV= singe replication NPV for a project with n- year

R = umber of replications needed

K= discount rate
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The value of each replacement chain therefore is simply the PV of the sequenced of NPV , generated

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by the replacement chain.

Example
Assume the following regarding mutually exclusive investments alternatives A and B, both of which
requires future replacement

Project A project B

Single replication life (n) 5 years 10 years

Single replication PV calculated at project

Specific required rate of return (NPVn) Sh. 5,328 Sh. 8000

Number of replication to provide shortest common life 2 1

Project specific discount rate 10% 10%

At first glance project B looks better than project A (8000 Vs 5328). However the need to make future
replacements dictates that we consider values provided over same common life i.e. 10 years. The
NPV can then be re-worked as follows

NPV for first 5 years = 5328

NPV for replicated project=5328* PVIF 10%,5 yrs

= 3303

NPV of chain 8638

The NPV of project B is already known i.e. Sh. 8000. Comparing with Sh. 8638 present value of the
replacement chain, project A is preferred.
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Reinforcement questions

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1. (a) Briefly explain the importance of capital budgeting in a business organization. (4 marks)

(b) Describe in brief the greatest difficulties faced in capital budgeting in the real world.

(c) Several methods exist for evaluating investment projects under capital budgeting.

Identify and explain three features of an ideal investment appraisal method. ( 6 marks)

(d) In evaluating investment decisions, cash flows are considered to be more relevant than
profitability associated with the project.

Explain why this is the case. (3 marks)

(2.) 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 -
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7 3,600,000 -

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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. (3 marks)

(b) The net present value of each project. (6 marks)

(c) The Internal Rate of return (IRR) of the projects. (Rediscount cash flows at 24%

for project X and 25% for Project Y). (6 marks)

(d) Briefly comment on your results in (b) and (c) above. (2 marks)

(e) 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.

3. The Weka Company Ltd. has been considering the criteria that must be met before a capital
expenditure proposal can be included in the capital expenditure programme. The screening criteria
established by management are as follows:

1. No project should involve a net commitment of funds for more than four years.
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2. Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the

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estimated cost of capital. Present estimates are that cost of capital as 15 percent per annum
after tax.
3. Accepted proposals should average over the life time, an unadjusted rate of return on assets
employed (calculated in the conventional accounting method) at least equal to the average
rate of return on total assets shown by the statutory financial statements included in the annual
report of the company.

A proposal to purchase a new lathe machine is to be subjected to these initial screening processes.
The machine will cost Sh.2,200,000 and has an estimated useful life of five years at the end of which
the disposal value will be zero. Sales revenue to be generated by the new machine is estimated as
follows:

Year Revenue (Sh.’000’)

1 1,320
2 1,440
3 1,560
4 1,600
5 1,500

Additional operating costs are estimated to be Sh.700,000 per annum. Tax rates may be assumed to
be 35% payable in the year in which revenue is received. For taxation purpose the machine is to be
written off as a fixed annual rate of 20% on cost.

The financial accounting statements issued by the company in recent years shows that profits after
tax have averaged 18% on total assets.

Required:

Present a report which will indicate to management whether or not the proposal to purchase the lathe
machine meets each of the selection criteria. (19 marks)
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4. The following six … have been submitted for inclusion in 1998 capital expenditure budget for

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Limuru Ltd.

Year A B C D E F

Sh. Sh. Sh. Sh. Sh. Sh.

Investment 0(1998) 250,000 250,000 500,000 500,000 500,000 125,000

1 0 50,000 175,000 0 12,500 57,500

2 25,000 50,000 175,000 0 37,500 50,000

3 50,000 50,000 175,000 0 75,000 25,000

4 50,000 50,000 175,000 0 125,000 25,000

5 50,000 50,000 175,000 0 125,000

Per year 6-9 50,000 50,000 500,000 125,000

10 50,000 50,000 125,000

Per year 11 – 15 50,000 50,000

Internal rate
of return
14% ? ? ? 12.6% 12.0%

Required:

(a) Rates of return (to the nearest half percent) for projects B, C and D and a ranking of all
projects in descending order. (6 marks)

(b) Compute the payback reciprocal for projects B and C. (4 marks)

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(c) Compute the N.P.V of each project using 16% as discount rate and rank all projects.

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(10 marks)

CHAPTER 6 :
BASIC VALUATION MODELS

Objectives
At the end of this chapter, you should be able to:
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1. Distinguish among the various valuation concepts.

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2. Describe the key inputs in, and the basic valuation model.
3. Apply the basic valuation model to the valuation of bonds, preferred stock, and ordinary
shares

Introduction.
The value of any asset is the present value of all future cash flows it is expected to provide over the
relevant period.

CF + CF CF
V = 1 2
+ ... + n
(4.1)
(1+ k ) (1+ k ) (1+ k )
0 1 2 n

Where V0 = the current value of asset (at time 0)

CF t
= Cash flow expected at end of time period t

k = required return

n = relevant time period

Using PVIF notation the basic valuation equation can be stated as;

v 0
= CF1 x (PVIFk,1) + CF2 x (PVIFk,2) +…+ CFn x (PVIFk,n)

Firm’s long term securities include bonds, preferred stock and ordinary shares. This topic focuses on
the mechanics of valuing each of these financial assets. We start first with bonds, followed by
preference shares and end with the ordinary shares, which poses the most challenging valuation
difficulties.
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BOND VALUATION

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Bonds are long-term debt instruments used by business and government to raise money. Most pay
interest semi annually at a slated coupon interest rate, have an initial maturity of 10-30 years and
have a par or face value of Sh.1000 that must be repaid at maturity.

The simplest and common type of bond is one that pays the bondholder two forms of cash flows if
held to maturity i.e. periodic interest and the bonds face value at maturity. The interest is an annuity
and the face value is a single payment received at a specified future date.

The basic equation for the value of a bond with n years to maturity and which pays interest ,I ,
annually is;

I I I M
B = + + ... + + .
(1+ k d ) (1+ k d ) (1+ k d ) (1+ k d )
0 1 2 n n

Where

B0 = current value of the bond (at time zero).

I = annual interest paid in shillings (coupon interest x face value)

n = number of years to maturity

M = par value (face value) in shillings

k d
= required return on a bond

The interest payments can be discounted using PVIFA tables while the payment at maturity will be
discounted using PVIF tables. The discounting notation is;

B 0
= I * ( PVIFA ) + M * ( PVIF )
k d ,n k d ,n

Example
Mills Co has issued a 10% coupon interest rate, 10 year bond with a Sh. 1000 par value, which pays
interest annually. The required rate of return of similar bonds is 10%. What is the value of the bond?

The values of the variables are;

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I = per value x coupon rate = 1000*10% = Sh 100

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M = 1000

kd = 10%

n = 10 years

Substituting the values in the valuation formula for bonds leads to,

B0 = 100 x (PVIFA10%,10yrs) + 1000x (PVIF10%,10yrs)

= 1000 x 6.145 + 1000 x .386 =Sh.1000.50.

The answer is the same as the par value of Sh.1000 except for rounding differences

In practice, however, the value of a bond in the market place is rarely equal to its par value. Some
may be quoted above their par value, and some below: It all depends on the bond’s required return
and the time to maturity. We will discuss the effect of these two on the value of bonds.

Required Returns and Bond Values

Whenever the required return on bond differs from its coupon interest rate the bonds value will differ
from its par value. (The required return may differ for two reasons:

1. Economic conditions may have changed since the bond was issued, causing a shift in cost of
long term funds
2. The firm’s risk class may change.
When the required return is greater the coupon interest rate, the bond value, B0, will be less than its
par value M, and the bond sells at a discount M-B0. When the required return falls below the coupon
interest rate, the bond value, B0, will be greater than par, M, and the bond sells at a premium equal to
B0-M.

Example
In the preceding example of Mills Company, the required return equalled the coupon interest rate and
the bonds value equalled its Sh.1000 par value.
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If required return were greater than the coupon rate of 10% i.e. 12%, the value of the bond would be

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as follows;
B0 = 100 x (PVIFA12%,10yrs) + 1000x (PVIF12%,10yrs)

= 100 x 5.650 + 1000 x .322 = Sh.887.00.

The bond will sell at a discount of Sh.113 (1000-887) and is said to be a discount bond. Conversely,
if the bond’s required return fell to say, 8%, the bond’s value would be:

B0 = 100 x (PVIFA8%,10yrs) + 1000x (PVIF8%,10yrs)

= 100 x 6.710 + 1000 x .463 = Sh.1134.00

The bond will sell at a premium of Sh.134 (1134 – 1000). The bond is called a premium bond

Figure 4.1 The relationship between value of a bond and the required rate of return. The graph is
downward sloping, implying that bas interest rates rise bonds lose value.
Market value
of bonds (Sh.)
1200

1100

1000

2 4 6 8 10 12 14

Required return, kd%

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Time to Maturity and Bond Values

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The value of bond will approach par value as the message of time moves the bond’s value closer to
maturity (when required return equals the coupon rate the bond’s value remains at par until it
matures).
Market value of
bonds

1200 premium bond

1100

1000 required return = par value

900

800 discount bond

Time to maturity

10 9 8 7 6 5 4 3 2 1 0

Relationship between maturity and value of a bond

Interest Rate Risk

The chance that interest rate will change and thereby change the required return and bond value is
called interest rate risk. How much interest rate risk a bond has depends on how sensitive its price is
to changes in interest rates This sensitivity directly depends on two things: the time to maturity and
the coupon rate. Investors in bonds should keep in mind the following;

1. All other things equal, the longer the time to maturity, the greater the interest rate risk.
2. All other things equal, the lower the coupon rate, the greater the interest rate risk.
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Bondholders are more concerned with rising rates which decrease bond values. The shorter the

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amount of time until maturity the less responsive is the bonds market value to a given change in the
required.

Also, if two bonds with different coupon rates have the same maturity, then the value of the one with
lower coupon is more dependent on the face amount to be received at maturity. As a result its value
will fluctuate more as interest rates change. In other words, the bond with the higher coupon has a
larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.

If time will return when interest rates are volatile financiers prefer lining shorter to hedge against
interest rate risk.

Perpetual Bonds
This is a bond that never matures- a perpetuity. A consol is an example. The present value of a
perpetual bond is equal to the capitalized value of an infinite stream of interest payments. If a bond
promises, fixed annual interest payment, I, forever its value at investors required rate of return, kd, is,

I I I
B = + + ... a
(1+ k d ) (1+ k d ) (1+ k d )
0 1 2

This should reduce to

I
B = (4.3)
0
k d

Example
You intend to buy a bond that pays Sh. 500 per year forever. If your required rate of return is 12%,
what is the maximum you should pay for the bond?
The PV of the security would be
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B0 = 500/0.12 = Sh.4166.7

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This is the amount you will be willing to pay for this bond.

Zero Coupon Rate Bonds

Zero coupon rate bonds make no periodic interest payment but instead the bond is sold at a deep
discount from its face value. The bond is then redeemed at face value on its maturity. The valuation
formula for a zero coupon bonds is truncated version of that used for normal interest paying bond.
The present value of interest payment is loped off leaving only the payment at maturity.
Therefore,
M
B = (4.4)
(1+ k d )
0 n

= M ( PVIF )
k d ,n

Example
ABC Ltd., issues a zero coupon bond having a 10 year maturity and a face value of Sh. 1000.
Investors require a return of 12%. How much should an investor pay for the bond?

B0 = 1000/(1.12)10

= 1000 (PVIF12%,10yrs)

= 1000 x 0.322

= Sh 322

The bond is worth Sh.322.

Semi – Annual Compounding Interest

Most bonds pay interest twice a year. As a consequence the valuation equation changes
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2n
I /2 M
B0 = Â + (4.5)
(1+ k d / 2) (1+ k d / 2)
t 2n
t =1

1
2 PVIFA 2 k d , 2 n
= B0 = I* 1 + M * PVIF 1 , 2 n
2k d

Notice that the assumption of semi- annual accounting once taken applies even to the maturity value.

Example

10% coupon bonds of ABC Ltd., have 12 years to maturity and annual required rate of return is 14%.
What is the value of a Sh.1000 par value bond that pays interest semi-annually?

I
2 PVIFA7%,24
B 0
= *( ) + M * ( PVIF 7%,24)

= 50 (11.469) + 1000 (.197) = Sh.770.4

Yield to Maturity (YTM)

When investors evaluate and trade bonds, they consider yield to maturity (YTM), which is the rate of
return investors earn if they buy a bond at a specific price and hold it until maturity. The YTM is
analogous to the Internal rate of return from an investment in the bond. The yield to maturity on a
bond with current price equal to its par value (i.e. B0 =M) will always equal the coupon rate. When the
bond value differs from par, the yield to maturity will differ from the coupon rate.
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The yield to maturity on a bond can found by sowing equation for kd in the equation below.

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n
I M
B0 = Â + (4.6)
(1+ k d ) (1+ k d )
t n
t =1

The required return is the bond’s yield to maturity. The YTM can be found by trial and error
procedures.

Example

Mills Company bond which currently sells for Sh.1080, has a 10% coupon rate and Sh.1000 par
value, pays interest annually and has 10 years to maturity. Find YTM of the bond.

10
100 1000
1080 = Â + or,
(1+ k d ) (1+ k d )
t 10
t =1

1080 = 100 * PVIFA ,10 + 1000 * PVIF ,10

kd kd

Trial and error

We know that when Kd = 10% (equal coupon rate), then B0 = 1000. Thus the discount rate to result in
1080 must be less than 10%. (Try a lower rate if the PV of cash flows at a given rate is lower than the
market price of the bond).

Try 9% = 100 x 6.418 + 1000 x .422 = 1063.80 (The 9% rate is not low enough to get
Sh.1080).

Next try 8% = 100 x 6.710 + 1000 x .463 = 1134

Because 1080 lies between 1063.80 and 1134 the YTM must be between 8% and 9%. Because 1080
is closer to 1063.80, the YTM to the nearest whole per cent is 9%.
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By using interpolation, we find the more precise YTM value to be 8.77% as follows;

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Interpolation
1134 – 1063.80 = 70.20

1080 – 1063.80 = 16.20

YTM = 9% - 16.20 = 9% - 0.2307692

70.20

= 8.77%)

Using a financial calculator, we get 8.766%.

PREFERENCE SHARES VALUATION

This is a type of stock that promises a fixed dividend but at the discretion of the Board of directors. It
has preference over ordinary shares in the payment of dividends and claims on the assets it has no
maturity date (unless redeemable) and give the fixed nature of the dividend is similar to a perpetuity.

Thus the PV of a preferred stock, V p , is

D p
V = (4.7)
p
k p

Where Dp is the stated annual dividend, per share and kp is the appropriate discount rate.

Example
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A company had issued a 9% Sh.100 par value preference shares and an investors require a rate of

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return of 14% on this investment. Find the value of a preference share to investors.

Dp = 9%*100 = Sh.9

kp = 14

The value of the preference share is,

Vp = 9/0.14 = Sh.64.29

Example

A preferred stock paying a dividend of Sh. 5 and having a required return of 13% will have a value of
Sh.38.46 (5÷0.13)

VALUATION OF ORDINARY SHARES

Common shareholders expect to be rewarded through periodic cash dividends and an increasing
share value. It is the expectation of future to dividends and a future selling price (which itself is based
on future dividends) that gives value to a share. Cash dividends are broadly defined to mean all cash
distributions and are the foundation for valuation of shares.
Dividend discount models are designed to compute the intrinsic value of a share under specific
assumptions as to the expected growth patterns of future dividends and the appropriate discount rate
to apply.

Basic stock valuation equation

The value of a share is equal to the PV of all future dividends it is expected to provide over an infinite
time horizon (from a valuation viewpoint only dividends are relevant).

D + D ... Da
P = 1 2
a
(4.7)
(1+ k s) (1+ k s) (1+ k s
0 1 2
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Where P0 = current value of ordinary share

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ks = required return on ordinary shares

Dt = per share dividend at end of year t.

We illustrate the use of this formula to estimate the value of ordinary stock under three dividend
growth assumptions i.e. zero growth in dividends, constant growth in dividends, and variable growth
phases.

Zero growth assumes a constant, non-growing dividend stream i.e. D1 = D2 = … = Dα = D. The

dividend stream is a perpetuity and can be valued as such i.e.

D
P = (4.8)
0
k s

Example
The dividend of Den Company is expected to remain constant at Sh. 3 indefinitely. If required return
3
on its stock is 15% the value of its ordinary share would be Sh.20 ( i.e. = 20 )
0.15

Constant Growth
The constant growth model, assumes that dividends will grow at a constant rate, g. If we let D0 equal
the most recent dividend, then

a
D (1+ g ) + D (1+ g ) D 0(1+ g )
1 2
0 0
P= +---+
a
or, (4.9)
(1+ k s) (1+ k s)
0 1 2
(1+ k s)
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D + D Da

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P = 1 2
+---+
(1+ k s) (1+ k s) (1+ k s)a
0 1 2

The equation can be simplified and rewritten as

D
P = 1
(4.10)
0
k -g
s

(D1 is the coming year’s dividend, ks is the required return on the stock and g is the constant growth
rate in dividends). Gordon’s model is a common name for the constant growth model.

Example
Lama Company has paid the following dividends over the past years
Year div per share
1999 1.00
2000 1.05
2001 1.12
2002 1.20
2003 1.29
2004 1.40

The average growth of dividends for the past five years is expected to persist in the foreseeable
future. You are required to determine the value of the company’s shares after payment of the
dividend of 2004.
First find the average rate of growth in dividend over last five years. Let the average growth rate be
g. Then the dividend of year 2004 denoted by D2004 is found by growing the dividend of year 1999 as
follows:
D2004 = D1999 x (1+g)5
(1+g) 5 = D2004/D1999
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1.40
FVIF =

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g %,5
= 1.40
1.00

By looking across the table for FVIFs (in the 5-year row) the factor closest to 1.40 for 5 years is 7%.
Therefore, g is 0.07.

D = 1.50 =Sh.18.75
P = 1
0
k - g 0.15 - 0.07
s

The value of the stock is Sh.18.75

Variable Growth Model

The dividend valuation approach can be manipulated to allow for changes in the dividend growth
rates. For instance the model could be based on the assumptions that dividends initially grow at a
supernormal rate for a number of years followed by normal growth rate into the foreseeable future. In
such a situation our dividend model can be modified as follows.

Let gs equal the initial growth rate (supernormal growth for n years),and gn equal the subsequent
growth rate (normal growth to infinity) and Dt be the dividend paid at end of time period t
The formula for the value of the share, P0, is

D0 (1+ g
t

s) D * 1
n

P = Â + n +1

(k - g ) (1+ )
(4.11)
(1+ k s)
0 t n
t =1
s ks
n

The first term on the left hand side, represents the present value of dividends during the initial phase
of supernormal growth; the second term, Dn+1/( ks-gs)*1/(1+ks),represent the present value of the price
of the stock at the end of the initial growth period.
STEPS
1. Find the value of dividends at the end of each year Dt, during the initial growth years 1 to n by
Dt = D0 x (1 + gs)t
2. Find present value of the dividends expected during the initial growth phase i.e.
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D (1+ g s)
t

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n n

  D ( PVIF k
0
= )
(1+ k s)
t t ,t
s
t =1 t =1

3. Find value of stock at the end of the initial growth phase i.e.

= D
P n +1
(Same as Gordon’s constant growth model)
k -g
n
s n

Next we discount P n
to the present i.e. P * PVIF k
n
s
,n

4. Add the PVs in 2 and 3 to find the value of stock.

Example
Weka Industries has just paid the 2004 annual dividend of Sh. 1.50 per share. The firm’s financial
manager expects that these dividends will increase at 10% annual rate over the next 3 years. At the
end of the3 years, (end of 2007) the growth rate will decline to 5% for the foreseeable future. The
firm’s required rate of return is15%. Estimate the current value of Weka share i.e. the value at end of
2004 (P0 = P2004).

Solution
Find value of cash dividends in each of the next 3 years and their PVs at end of year 2004 as below:
Remember D0 =D2004 =Sh.1.50

Year(t) End of year Dividend PVIF Present

15%,t
=D0 (1.1)t value
1 2005 1.65 0.870 1.44
2 2006 1.82 0.756 1.38
3 2007 2.00 0.658 1.32
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Present value of dividends during initial growth phase Sh.4.14

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Next the price of the stock at the end of the initial growth phase (at the end of 2007) can be found first
by calculating the dividend to be paid at end of the year 2008 ( Dn +1 = D 2008)

D2008 = D2007 x (1 + 0.05) = 2.00 x 1.05= Sh.2.10.

Using Gordon’s constant growth model, the price of the stock at end of 2007 is calculated as follows;

D 2.10
P = 20081
= = Sh.21
k -g 0.15 - 0.05
2007
s n

The value of Sh.21 at end of year 2007 must be converted into PV (end of 2004). Using 15% as the
required return, (PVIF 15%,3yrs) x 21 = 0.658 x 21 = Sh.13.82.

Finally, we add the present values to get the value of the stock i.e.
P2004 = 4.14 + 13.82 = Sh.17.96

REINFORCING QUESTIONS
1. a) The valuation of ordinary shares is more complicated than the valuation of bonds and
preference shares. Explain the factors that complicate the valuation of ordinary shares.

b) The most recent financial data for the Rare Watts disclose the following:

Dividend per share Sh.3.00

Expected annual dividend growth rate 6 percent

Current required rate of return 15 percent

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The company is considering a variety of proposals in order to redirect the firm’s activities. The

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following four alternatives have been suggested:

1. Do nothing in which case the key financial variables will remain unchanged.
2. Invest in venture that will increase the dividend growth rate to 7% and lower the
required rate of return to 14%.
3. Eliminate an unprofitable product line. The action will increase the dividend growth rate
to 8% and raise the required rate of return to 17%.
4. Acquire a subsidiary operation from another company. This action will increase the
dividend growth rate to 9% and required rate of return to 18%.

Required:

For each of the proposed actions, determine the resulting impact price and recommend the
best alternative. (14 marks)

2. (a) State the circumstances under which it would be advantageous to lenders and to borrowers
from the issue of:

(i) Debentures with a floating rate of interest. (4 marks)

(ii) Zero-coupon bonds. (4 marks)

(Ignore taxation)

(b) (i) Briefly discuss the disadvantages of the constant growth dividend model as a
valuation model. (4 marks)
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(ii) The dividend per share of Mavazi Limited as at 31 December 2000 was Sh.2.50. The

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company’s financial analyst has predicted that dividends would grow at 20% for five
years after which growth would fall to a constant rate of 7%. The analyst has also
projected a required rate of return of 10% for the equity market. Mavazi’s shares have a
similar risk to the typical equity market.

Required:

The intrinsic value of shares of Mavazi Ltd. As at 31 December 2000.

(8 marks)

(Total: 20 marks)

Other revision questions

1(a) Bima Company presently pays a dividend of shs 1.60 per share on its ordinary share capital. The
company expects to increase the dividend at a 20% annual rate the first four years and then
grow the dividend at 7% rate thereafter. This phased growth pattern is in keeping with the
expected life cycle ear4nigs. You require a 16% return to invest in this stock. What value
should you place on a share of this stock?
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CHAPTER 7:
WORKING CAPITAL MANAGEMENT

Content.
∑ Introduction to Working capital management.
∑ Importance of working capital management.
∑ Determinants of working capital.
∑ Inventory, Cash and Accounts receivable and accounts payable management.
∑ Other sources of short term funds.

Introduction.
Gross working capital refers to total current assets and these are those assets that can be converted
to cash within an accounting year e.g. stock receivables, cash short-term securities and so on.

Net working capital refers to current assets less current liabilities. Current liabilities are those claims
of outsiders which are expected to mature for payment within an accounting year e.g. bank overdraft,
payables, short term loans, accruals etc.

Management of working capital refers to management of cash, receivables, inventory and current
liabilities.

The management of current assets is similar to that of fixed assets in the sense that in both cases,
the firm analyses their effect on risk and return of currents fixed assets, however, differs in 3
important ways

a) In management of fixed assets, time is very important, the compounding and discounting
effects play a major role in capital budgeting are a minor role in current assets.
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b) The large holding of current assets, especially cash strengthens a firms liquidity position,

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however, it reduces profitability
c) Levels of fixed as well as current assets depend on expected sales but it is only current assets
which can be adjusted with sales in the short term.

Working capital might therefore refer to the management of both current assets and current
liabilities involve 2 major decisions.
1. Target levels of each category (optional current assets).

2. How these assets will be financial.

3.

1. Optional Current Assets

Optional investment in current assets i.e. liquidity management is important because current
assets are non-earning assets.

- Current assets affect the firm’s financial risk.

The consideration of the level of investment in current assets should avoid 2danger point’s i.e.
excessive and inadequate investment in current assets.

Excessive investment in current assets impairs profitability because idle cash earns nothing.
Inadequate investment can threaten the solvency of the firm if it fails to meet its current
obligations.

2. Financing Current Assets.

Current assets can either be financed by use of short-term on long-term finds. For every firm, there is
a minimum level of net working capital that is permanent. The magnitude of current assets needed is
not always the same. It increases and decreases with time but this are always a minimum level of
current assets which is continuously required by the firm to carry on its business operational. This
minimum level is referred to as permanent fixed current assets.

Approaches to Financing Current Assets.

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There are 3 main approaches to financing current assets:

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(i) Matching/hedging approach.
(ii) Aggressive approach
(iii) Conservative approach.

a) Matching/hedging Approach

In this approach the firm adapts a financial plan which involves the matching of the expected life of
the asset with the expected life of the funds used such that short-term funds are used to finances
temporary assets and long-term funds for long-term assets. This approach can be show be below

b) Aggressive Approach

Under this approach, the firm uses more of short-term finds in the financing mix such that short-term
funds are used to finance all short-term plus a portion of permanent current assets.

And long –term finds used to finance a part of permanent current assets.
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A very aggressive firm may finance all its current assets using short-term finds. This is especially the

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case for small firms which have united access to capital markets.

c) Conservative Approach

Under this approach, a firm uses more of its long-term funds for financing its needs. The firm uses
long-term finds to finance fixed assets, permanent current assets and a part of the temporary current
assets.

A firm using this approach has low risk and low return because it uses long-term finds to finance its
short-term needs. At times, the firm may have excess liquidity which should be invested in marketable
securities.

Example:

Nagaya Company is an investment group which has projected the following capital requirements for
the next 12 months as follows;

Month Amount Month Amount

sh.000 sh.000

Jan 2,800 Jul 16,800

Feb 2,800 Aug 19,400

Mar 4,200 Sep 12,600

Apr 5,600 Oct 7,000

May 8,400 Nov 5,600

Jun 12,600 Dec 4,200

The cost of shorter and long-term funds per annum is projected at 20% and 25% respectively during
the same period.

Required,
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a. Prepare a schedule showing the amount of permanent and seasonal funds requirement each

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month.
b. What is the average amount of long-term and short-term financing that will be required each
month?
c. Calculate the total cost of working capital financing if the firm adopts
i. An aggressive financing strategy.
ii. A conservative financing strategy.
Solution:

a. )

Month Permanent Funds Seasonal Funds

sh.000 sh.000

Jan 2,800 0

Feb 2,800 0

Mar 2,800 1,400

Apr 2,800 2,800

May 2,800 5,600

Jun 2,800 9,800

Jul 2,800 14,000

Aug 2,800 16,600

Sep 2,800 9,800

Oct 2,800 4,200

Nov 2,800 2,800

Dec 2,800 1,400

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b.) Average long-term financing = (2,800,000×12 months)/ 12

= Sh. 2,800,000

Average short-term financing =

(1,400+2,800+5,600+9,800+14,000+16,600+9,800+4,200+2,800+1,400)/ 12

=Sh.5, 700,000

c.)

MONTH Short term (Aggressive) MONTH Long-term (Conservative)

x 20% ÷ 12
JAN 2800 = 46.67 JAN 2800 x 25% ÷ 12= 58.33

x 20% ÷ 12
FEB 2800 = 46.67 FEB 2800 x 25% ÷ 12= 58.33

x 20% ÷ 12
MAR 4200 = 70 MAR 4200 x 25% ÷ 12= 87.5

x 20% ÷ 12
APRIL 5600 = 93.33 APRIL 5600 x 25% ÷ 12= 116.67

x 20% ÷ 12
MAY 8400 = 140 MAY 8400 x 25% ÷ 12= 175

x 20% ÷ 12
JUNE 12600 = 210 JUNE 12600 x 25% ÷ 12= 262.5

JULY 16800 280 JULY 16800 x 25% ÷ 12= 350

x 20% ÷ 12
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=

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x 20% ÷ 12
AUG 19400 = 323.33 AUG 19400 x 25% ÷ 12= 404.17

x 20% ÷ 12
SEP 12600 = 210 SEP 12600 x 25% ÷ 12= 262.5

x 20% ÷ 12
OCT 7000 = 116.67 OCT 7000 x 25% ÷ 12= 145.83

x 20% ÷ 12
NOV 5600 = 93.33 NOV 5600 x 25% ÷ 12= 116.67

x 20% ÷ 12
DEC 4200 = 70 DEC 4200 x 25% ÷ 12= 87.5

1700 2125

(2.8+ 5.7) = 8.5m

Long term = 8.5 x 20%=

short term = 8.5 x 20 % = 1.7 m 2.125m.

Determinants of Working Capital Requirements of a firm

1. Nature of the Firm: A trading firm will usually require more working capital than a firm in
the service industry e.g. a supermarket and a law firm

2. Size of the Firm: A larger firm would require comparatively more working capital than a
smaller firm.
3. Business fluctuation : During times of high demand, affirm would require higher levels
of working capital as compared to periods of low demand.
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4. Growth stage of the firm: a mature firm requires less working capital than a firm in the

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infant stage.
5. Availability of credit from suppliers affects accounts payable.
6. The credit policy of the firm would affect accounts receivable.

Importance of Working capital Management.

The management of working capital is important because of the following reasons:

1. The time devoted to working capital management A large position of the finance
manger’s time is devoted to the day to day operations of the firm: a lot of this time is
spent on working capital decisions.
2. Investment in current assets represents a large portion of the total assets of many
business firms therefore these assets need to be properly managed as they can easily
be misappropriated by the firm’s employee’s since they are relatively volatile assets.
3. Importance to small firms: A small firm can minimize its investments in fixed assets by
renting or leasing these assts but these is no way they can avoid investments in current
assets. A small firm has relatively limited access to capital markets and therefore must
rely on short-term funds to finance these operations therefore management of small
firms is equivalent to management of working capital.
4. Relationship between sales and currents assets. This is a direct relationship between
sales and current assets such that changes in working capital affect sales revenue and
therefore profitability of the firm.

Working Capital Management Strategies

Working capital management interrelated goals:

(1) How to accelerate the collection of cash

(2) How to control cash disbursements
(3) How the appropriate working balance is determined
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(4) How to invest any temporary idle funds in interest bearing marketable securities.

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(5) How to forecast and manage cash shortages.
(6) Pay accounts payable as late as possible without damaging the firm’s credit rating. The
firm should, however, take advantage of any favorable cash discounts.

ACCELERATING COLLECTION OF CASH

Quick movement of remittances from dispersed locations to central management prevents the build
up of idle or lazy cash balances. Good cash management practice would aim at reducing the time by
between

(1) When payment is initiated by a debtor sending a cheque in payment and

(2) The time when funds become available for use in the recipients bank account.

Three contributors to a lengthy time lag, which need attention, are:

- Transmission delay, when payment is sent through post.

- Lodgment delay, by the payee in presenting, after receipt.
- Clearance delay, by the bank after receipt of cash or cheque.
Measures to reduce the time lag will target these contributory factors and include
1 Payee setting up efficient cheque handling procedures to eliminate lodgment delays.
2 Automation; Facilities such as Bankers Automated Clearing Services (BACS) enable speedy
computerized transfer of funds between banks.
3 For regular payments, standing orders or direct debits may be arranged.
4 Concentration Banking. Firms with regional sales outlets often designate certain of these
offices as regional collection centers. Customers within each region are instructed to remit
payment to these offices, which deposit these receipts in local banks. The funds are
transferred later from these bank branches to a concentration or disbursing bank from which
bill payments are dispatched. The purpose is to limit mail time. Concentration banking also
permits the firm to reduce the idle balances by storing its cash more efficiently in one (few)
concentration account(s) rather than in many dispersed accounts. This reduces the
requirement for large working balances.
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5 Lock Box System The purpose is to eliminate the time between the receipt of remittances by

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the company and their deposit in the bank. In this system the customer sends the payments to
a post office box, which is emptied at least daily by the firm’s bank. The bank opens the
payment envelopes, deposits the checks in the firm’s account and sends deposit slip to the
firm. The lock boxes are normally geographically dispersed and funds are ultimately
transferred to a disbursing bank.
6 Personal collection of checks by messengers. A messenger shuttles around collecting checks
from customers whose accounts are due.
7 Establishing good bank relations to expedite cheque clearance.

Operating and Cash Conversion Cycle (CCC)

Investment in working capital is needed because sales do not convert into cash instantaneously.
There is always a cycle in conversion of sales into cash. An investment in current assets is realized
within the operating year unlike fixed assets such as plant & machinery which may require many
years to recover the initial investment. An operating cycle is the time duration required to convert
sales after the conversion of resources into inventories, into cash. The conversion cycle of a
manufacturing company involves three phases:

1. Acquisition of resources such as raw materials, power and labour.

2. Manufacture of the product which involves conversion of the raw material into Work-in-
Progress and into finished goods.

3. Sale of the product either for cash or on credit. Credit sales create accounts receivable for
collection.

The firm should therefore invest in current assets for a smooth un-interrupted functioning. It needs to
maintain liquidity to purchase raw materials and pay expenses. Cash is also held to meet any future
needs. Stocks of raw material and Work-in-Process are kept to ensure smooth production and to
guard against shortage of raw materials and other components. The firm needs to hold stock of
finished goods to meet the demands of customers continuously. Debtors arise due to sale of goods
on credit for marketing and competitive reasons.

Calculation of Operating Cycle

The length of the operating cycle of a manufacturing firm is the sum of:
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i) Inventory conversion period

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ii) Receivables/debtors’ conversion period

The inventory conversion period is the total time needed to produce and sell the product. It includes:
a) Raw material conversion period.
b) Work-in-Process conversion period.
c) 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.
Formulae.

Raw material conversion period = Raw material inventory / (Raw material consumption/ 360)

Working in process conversion period. - It is the average time taken to complete the semi-finished
or work in process.

Formulae.

Work in process conversion period = Working process inventory / (Cost of production /360)

Finished goods conversion period.- It is the time taken to sale the finished goods .

Formulae.
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Finished goods conversion period = Finished goods inventory/ (cost of sales/ 360)

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2. Debtors conversion period.

It is the time taken to convert the debtors to cash. It represents the aver age collection period.

Formulae.

Debtors conversion period = Debtors / (Credit sales/360)

3. Payables deferral period.

It is the average time taken by the firm to pay its suppliers / creditors.

Formulae.

Creditor deferral period = Creditors / (Credit purchase/ 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.

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Required:
The length of the operating cash cycle.

Solution.

Raw material conversion period = Raw material inventory / (Raw material consumption/ 360)

= (1,200/6,500) × 365

= 67days

Work in process conversion period = Working process inventory / (Cost of production /360)

= (1000/18000) × 365

=20 days

Finished goods conversion period = Finished goods inventory/ (cost of sales/ 360)

= (2100/18000) × 365

=43 days

Debtors conversion period = Debtors / (Credit sales/360)

= (4700/25000) × 365

=69 days

Creditor deferral period = Creditors / (Credit purchase/ 360)

= (1400/6700) × 365

= 76 days
Length of operating cycle.
Inventory conversion period.
Raw material conversion 67
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period

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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

MANAGEMENT OF INVENTORY
There are three types of inventory:

∑ raw material
∑ work-in-progress
∑ Finished goods.

These are 4 types of costs associated with inventory management:

(i) Holding (carrying) cost

(ii) Ordering cost
(iii) Purchase cost
(iv) Stock out costs

i) Holding Costs
These include warehousing costs, security, maintenance, administrative, insurance, cost of capital
tied up in inventory and so on. Generally such costs increase in direct proportion to the amount of
inventory held.

ii) Ordering Costs

These are costs of placing an order which may include transport costs, clerical costs fo preparing
and placing an order, insurance in transit, clearing and forwarding costs etc.
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iii) Purchase Cost

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This is the cost of purchasing cash unit of stock.

Iv) Stock out cost.

These include loss of customer goodwill, lost sales, cost of processing back orders and so on.

If we assume certainty, the relevant costs for decision making would be the holding and ordering
costs. The objective of inventory management is too minimizing these relevant costs. This occurs
when the company orders an economic order quantity.

Basic Inventory Management Model

This is the economic order quantity model which helps to manage inventory by minimizing the
ordering and holding costs. Smaller inventories reduce holding or carrying costs but since smaller
inventories imply more request orders they therefore involve high ordering costs.

Example.

A company requires 2000 units of items costing shs. 50 each. These forms have a lead time of 7
days. Each order costs shs. 50 to prepare and process and the holding cost is shs. 15 per unit p a for
storage costs of 10% of the purchase price. Management has set up a safety stock level of 10 units
and these units are on hand at the beginning of the year. This is the minimum or butter stock which
acts as a cushion against any increase in usage or delay in deliver at time.

Required:

a) How many units should be ordered each time an order is made

b) What is the reorder level
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c) Determine total relevant costs.

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d) What is the inventory turnover?

Solution.

a) Q= √2×2000×50/(15+0.1×50)
=100

b) Reorder level = (Annual demand ×Lead time)/Number of days in a year + Safety stock.
=7×2000/365 +10

=48 units.

c) Total relevant cost = Co D/Q + Ch Q/2

=50×2000/100 + 20×100/2

=1000+1000

=2000

d) Inventory turnover =Annual Demand/ EOQ

=2000/100

=20

Assumption of EOQ Model

1. There is complete certainty of all the variables affecting the model re demand, ordering
cost, holding cost and lead time.

The usage of stock is uniform.

2. the ordering cost is constant regardless of the no. of units ordered

3. Holding cost per unit per annum is constant regardless of the number of units held.
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4. The purchase price is constant regardless of the no. of units purchased i.e. it ignores quantity

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discounts.

Exceptional to the assumption: - where quantity discounts are offered by the supplier.

The purchase price becomes a relevant cost because quantity discounts reduce the total
purchase cost; reduces total ordering costs and increases total holding cost.

Example.

Using previous example assume a 5% discount is given if 200 or more than 200 units are
ordered. Determine whether the discounts should be taken.

Total Cost without Discount

Purchase price = 2000 x 50 = 100 000

Holding and ordering costs = 2000 + (10% x 50) + 15) x 10

TOTAL COSTS = 100,000 + 2000 + 200 = 102,200

Total costs with discount

Purchase price = 2000 x 50 ( 100% – 5% ) = 95,000

Holding cost = 15 + 10% x 50(0.95) x 200/2

= 2172.5

Ordering cost = 50 x 2000/200

= 500

Total Cost = 500 + 95,000 + 2172.50

= 97672.5
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Therefore discount should be taken as the total relevant costs are lower with the discounts.

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Using the previous illustration assume the following discounts have been offered.

Units discounts Price Total Relevant Cost

0-199 0 50 102 200

200-299 5% 47.50 97,672

300-499 6% 47 97,485

500 and over 6.2 % 46.90 99,119

The best quantity to order is between 300 and 499 at a discount of 6% .at this level the relevant cost
is the least as shown on the above computations.

Overcapitalization and Overtrading

The finance manager must be wary of two polar extremes in working capital management. These
extremes are, (1) over-capitalization and, (2) over-trading.

Over Capitalization (Conservative Financing Strategy)

If a company manages its working capital, so that there are excessive stocks, debtors and cash and
very few creditors, there will be an over-investment by the company in current assets. Working capital
will be excessive and the company is said to be overcapitalized (i.e. the company will have too much
capital invested in unnecessarily high levels of current assets). The result of this would be that the
return on investment will be lower than it should, with long-term funds unnecessarily tied up when
they could be more profitably invested elsewhere.
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Indicators of over-capitalization

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Accounting ratios can assist in judging whether over capitalization is present.
(1) Sales/Working capital ratio: - the volumes of sales as a multiple of working capital
should indicate whether the total volume of working capital is too high (compared to the
past and industry norms).
(2) Liquidity ratio. A current ratio and a quick ratio in excess of the industry norm or past
ratios will indicate over-investment in current assets
(3) Turn-over periods. Excessive stock and debtors’ turnover periods or too short creditor
payment period might indicate that the volume of debtors and stocks is unnecessarily
high, or creditors’ volume too low.

Over-trading (Aggressive Financing Strategy)

Overtrading occurs when a business tries to do too much too quickly with too little long-term capital:
The capital resources at hand are not sufficient for the volume of trade. Though initially an over-
trading business may operate at a profit, liquidity problems could soon set in, disrupting operations
and posing insolvency problems.

Symptoms of over-trading
Accounting indicators of overtrading include:
(1) Rapid increases in turn-over ratios (over-heating)
(2) Stock turnover and debtor’s turnover might slow down with consequence that there is a rapid
increase in current assets.
(3) The payment period to trade creditors lengthens
(4) Bank over-drafts often reach or exceed the limit of facilities offered by the bank.
(5) The debt ratios rise
(6) The current ratio and quick ratio fall and the net working capital (NWC) could be negative.
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B. MANAGEMENT OF CASH

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Cash is the ready currency to which all liquid assets can be reduced. Marketable securities are short
term, interest-earning money market instruments. The level of cash and money and marketable
securities held by firms is determined by the motives of holding them.

Transaction Motive - this motive requires a firm to hold cash to conduct its normal businesses .the
firm needs cash to make payments for purchases, wages and salaries and other operating expenses
taxes and dividends etc.

Precautionary Motive - Balances held mainly in highly liquid marketable securities to cater for
unexpected demand for cash or emergencies.

Speculative Motive – A firm may want ready funds at hand to quickly take advantage of any
opportunities that may arise.

.The working balance of cash is maintained for transaction purposes. If the firm has too small a
working balance, it may run out of cash. It then liquidates marketable securities or borrows both
involving transaction costs. If on the other hand the firm maintains too high working balance it
foregoes the opportunity to earn interest on marketable securities – an opportunity cost. The optimal
working balance occurs when total costs (transaction costs plus opportunity cost) are at a minimum.
Finding the optimum involves a trade-off between falling transaction costs against rising opportunity
costs.

Costs Total relevant cost

Opportunity cost (interest rate)

Transaction cost
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Optimal cash balance Cash balance.

To determine the optimal cash balance, the firm uses some deterministic and stochastic models.

Deterministic models assume certainty of variables whereas stochastic models assume uncertainty in
cash management. The 2 main cash management models are:

(i) Baumol models

(ii) Miller Orr model,

Baumol Model

The Baumol model is a deterministic model which assumes certainty of variables. It considers cash
management similar to an inventory management problem. Thus the firm attempts to minimize the
sum of the costs of holding cash and the cost of converting marketable securities to cash. (EOQ
model in cash management.)

The underlying assumptions of this model are:

a) The firm is able to forecast its cash needs with certainty.

b) The opportunity cost of holding money is known and constant.
c) Transaction costs are known and constant. These are costs incurred by the firm inflow and
outflow occurs at a steady rate.
d) The firms’ cash payments occur uniformly over a period of time.
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The firm incurs holding cost for keeping the cash balance. It is an opportunity costs that is , the

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return foregone on the marketable securities .

The firm incurs a transaction whenever it converts a marketable security to cash.

Let Q = amount converted into cash by selling securities or borrowing

d = Total cash outflow (demand) per period (year)

c = Transaction costs of each sale of securities or borrowing

i = the interest rate that can be earned per period (year) i.e. the cost of

Holding cash rather than investing it.(opportunity cost)

Then Q* (Optimal size of cash transfer) = ÷ (2dc/i)

Example:

A Company anticipates Sh.150 million in cash outlays during the next year. The outlays are expected
to occur equally throughout the year. The company’s treasurer reports that the firm can invest in
marketable securities yielding 8% and the cost of shifting funds from marketable securities portfolio to
cash is Sh.7, 500 per transaction. Assume the company will meet its cash demands by selling
marketable securities. Using the Baumol model:

(a) Determine optimal size of the company’s transfer of funds from marketable securities to cash.
(b) What will be the company’s average cash balance?
(c) How many transfers from marketable securities to cash will be required during the year?
(d) What will be the total cost associated with the company’s cash requirements?
(e) How would your answers to (a) and (b) change if transaction cost could be reduced to Sh.5,
000 per transaction? Or if Triad could invest in marketable securities to yield 10%?
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SOLUTION

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(a) Q* (Optimal size of cash transfer) = ÷ (2dc/i)

We can determine that; d = 150 million; i = 0.08; c = 7500.

Therefore,

Q* = ÷(2 x 150,000,000 x 7500)/0.08

= Sh.5, 303,301
(b) Triad’s average cash balance = Q*/2 = 5,303,301/2 = Sh.2, 651,650
(c) Cash turnover/ Number of transfers =Q/Q*

=150,000,000/5, 303,301

=28.28427

=28.3 times

Cash conversion cycle=Number of days in the year/cash turnover

=365/28
=13
(d)Total costs = holding cost + transaction cost
= 2,651,650 x 0.08 + 28.3 x 7,500
= 212,132 + 212,250
= Sh.424, 381.

Miller Orr. Model/ Stochastic model

This is a stochastic or a probabilistic model which assumes uncertainty in cash management. It

assumes that the daily cash flows are uncertain and therefore follow a trendless random walk. This
model therefore sets limits within which cash should be managed. These limits are:

(a) An upper limit, which is the maximum amount of cash to be held (H)
(b) Lower limit, which is the minimum amount of cash to be held (assumed to be zero) (L)
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(c) Return point, which is the target cash balance considered optimal.(Z)

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Cash
H = Upper limit/balance
Z = Optimal cash balance
L = Lower cash balance

Time.

A firm will always attempt to maintain the optional balance (Z) but because of uncertainty, cash
balances will fluctuate between the upper cash limit (H) and the lower cash limit (L). The difference
between H and L is known as the spread.

The important implication of the model is that the greater the variability of a firm’s cash flow the higher
should be the minimum balance.

When cash balances move from Z to H, it means that the firm has idle cash which it needs to invest
and generate some interest income therefore to revert to the target level Z the firm needs to buy
marketable securities valued at H-Z.
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When cash balance hit the lower limit, L, it means that the firm has deficit cash balances therefore to

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revert to Z; the firm should sell marketable securities amounting to Z-L.

This would enable the firm to realize cash.

Setting the Return and Upper Point

The return point is estimated by:

Return Point = 3 ÷ [(3 x conversion cost x variance of daily net cash flows)/ (4×daily
Opportunity cost)] + Lower cash limit (L)
The upper limit for cash balance in this model is always set at three times the return point. Therefore
Upper limit = 3 x Return point.

Note: The lower cash limit (L) is set by management and since this model assumes uncertainty, it
states that the optimal cash balance is influenced by 3 factors

(1) Conversion costs,

(2) The daily opportunity cost of funds, and

(3) The variance of daily net cash flows. The variance is estimated by using daily net flows (i.e.
Inflows minus outflows).

Example 1:

It costs Wetika Company Sh. 3,000 to convert marketable securities to cash and vice versa; the firm’s
marketable securities portfolio earns an 8% annual return. The variance of Wetika Company’s daily
net cash flows is estimated to be Sh. 2, 7000,000.
Determine the return point and the upper limit.
Solution
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3

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(i) Return point (Z) = √ [(3 x 3000 x 2, 700, 000/ (4×0.00022)] = Sh.13, 990

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(ii) The upper limit line (H) =3 x return point = 3 x 13,990 = Sh.41, 970
NB: Daily opportunity cost = 8%/360 = 0.00022

MANAGEMENT OF RECEIVABLES
Account Receivables are amounts of money owed to a firm by customers who have bought goods
and services on credit. Management of receivables aims at determining the optimal level of
investment in receivables, which maximizes the benefits and minimizes the costs of holding
receivables.

Economic conditions, competition, product pricing, product quality and the firm’s accounts receivables
management policies are the chief influences on the level of a firms accounts receivable. Of all these
factors, the last one is under the control of the finance manager. Our concern is to focus on this last
factor.

As with other current assets, the manager can vary the level of accounts receivable in keeping with
the trade-off between profitability and risk.

The firm’s financial manager controls accounts receivable through the establishments and
management of:

(2) credit policy, which is determination of credit selection, credit standards and credit
terms, and
(3) Collection policy.
Let us consider these management variables.

ÿ Credit selection
This is the decision whether to extend credit to a customer and how much credit to extend. A credit
investigation is first carried out on the prospective customer in whom the five Cs of credit are
employed. The five Cs of credit are key dimensions – Character, Capacity, Capital Collateral and
Conditions – used by the credit analysts to focus their analysis on an applicant’s credit worthiness. A
brief discussion of these characteristics follows.
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Character This refers to the creditor’s willingness to honor obligations. The applicants record of

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meeting past obligations – financial, contractual, and moral - is closely scrutinized. Any past litigation
against the applicant would also be relevant.

Capacity This considers the applicants ability to generate cash to repay the requested credit.
Financial statement analysis, especially liquidity and debt rations are useful in assessing capacity.

Capital Considers the financial strength of the applicant as reflected by his net worth position. The
applicant’s debts relative to equity and the profitability ratios will be used in this assessment.

Collateral Looks at the amount of assets the applicant can pledge to secure the credit to be
advanced. The asset structure as revealed in the balance sheet and record of any legal claims
against the applicant will be helpful in this assessment.

Conditions The prevailing economic and business climate as well as unique circumstance affecting
the applicant will be considered.

Character and Capacity receive primary attention; capital, collateral and conditions play a
supplementary role.

Sources of Information on the Debtor

The evaluation of an applicant begins when he fills a form providing basic financial and credit data
and references. Additional information will be obtained from other sources depending on time and
expense and size of credit involved. The credit analyst may obtain information from the following
sources.

Financial Statements The seller may request the audited financial statements of the applicant for a
number of years. The trends shown by the statements would help gauge financial strengths.

Credit Rating And Reports Credit rating agencies provide subscribers with credit rating and estimates
of overall financial strength for many companies (Dun & Bradstreet is the largest mercantile credit
reporting agency in the world. In Kenya, the industry is in its infancy with Metropol Rating Agency one
among the very few firms active).
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Bank Checking The applicant’s bank could be a good source of information for the credit analyst.

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The credit analyst can obtain information such as average cash balance carried, loan granted and
recovery of loan experience. Despite existence of banking secrecy laws, the credit applicant will allow
his bank to provide the information in order to facilitate his being granted credit.

Trade checking Credit information is frequently exchanged among companies selling to the same
customer. Companies can ask other supplies about their experience with an account.

ÿ Credit Analysis
Having collected information, the credit analyst must conduct a credit analysis of the applicant. The
analyst must decide on the applicant’s credit worthiness and the maximum amount of credit the
applicant can support – the line of credit (maximum amount a credit customer can owe the selling firm
at any one time). Two approaches to credit analysis are discussed below.

(a) Investigations Procedures

The following ad hoc procedures are usually employed by small firms and by big firms on small
accounts

(1) Applicant’s financial statements and accounts payable ledger can be used to calculate the
“average payment period”
(2) Consult past experience to see whether the firm has sold previously to the account (applicant)
and whether that experience has been satisfactory.
(3) A through ratio analysis of the accounts liquidity activity, debt and profitability.
(4) A credit rating agency’s recommendation could be obtained and used to estimate the
maximum line of credit to extend.
(5) Time series comparison should be performed to uncover any trends.
(6) The credit analyst's own subjective judgment of a firm’s credit worthiness could be decisive.
(a) Credit scoring systems
These systems employ quantitative approaches to decide whether or not to grant credit, by
assigning numerical scores to various characteristics related to the applicant’s credit worthiness.
The credit score is a weighted average of scores obtained on key financial and credit
characteristics. In consumer credit, plastic credit cards are often given out on the basis of a
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credit-scoring system that rates such things as occupation, duration of employment, home

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ownership, years of residence and annual income. Numerical rating systems are also used by
some companies extending trade credit (credit granted from one business to another).

Example:

Factor Score weighting factor

Home ownership 90 0.2 18

Salary range 75 0.2 15

Bank references 80 0.1 8

Credit references 60 0.15 9

Marital status 90 0.15 13.5

Age bracket 85 0.05 4.25

Financial statements 75 0.15 11.25

79

if the minimum score is 70, then grant credit since 79 > 70

Credit Decision and Line Of Credit

Once the analyst has marshaled the necessary evidence and analyzed it, two decisions must be
made:

(1) Whether to extend the credit

(2) Whether to establish a line of credit. A line of credit is used where repeat sales are expected.
It is the maximum limit on the amount the firm will permit to be owed at any one time by the
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applicant. In essence it is the maximum risk exposure that the firm will allow itself to undergo

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for an account.

ÿ Credit standards
Credit standards define the minimum criteria for the extension of credit to a customer. Extension
of credit has its costs (risks) even as it has benefits. In determining the optimal credit standards,
marginal costs of credit should be related to the marginal profits from the increased sales.

Key variables that should be considered in evaluating relaxation or tightening of credit standards
are:

(a) Clerical and collection expenses – If credit standards are relaxed / tightened more/less credit is
offered and a bigger/smaller credit department is needed to service accounts.
(b) Investment in Receivable – The higher the firm’s average accounts receivables are, the more
expensive they are to carry, and vice versa. Thus a relaxation of credit standards can be
expected to result in higher carrying costs and a tightening of credit standards results in a lover
carrying costs.
(c) Default and Bad date Expenses: the probability of (risk) of acquiring a bad debt increases as
credit standards are relaxed and decreases as the standards become more restrictive.
(d) Sales Volume and contribution margin: it is expected that as credit standards are relaxed,
sales (contribution margin) will be expected to increase; a tightening of credit standards is
expected to reduce sales (contribution margin).

The table below summarizes the basic change and effects on profit expected to result from relaxation
of credit standards.

Effect of a relaxation of credit standards (Danger of lenient credit policy)

Item Direction of Change Effect on Profits

Sales volume (contribution) + +

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Average Collection period + -

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Bad debt expense + -

Example
XY Co. is currently making annual sales of 120,000 units at Sh.10 per unit. The variable cost per
unit is Sh.6 and average cost per unit, given the current sales volume is Sh.8.

The firm is contemplating a relaxation of credit standards that is expected to result in 15% increase in
unit sales, an increase in average collection period from 30 days to 45 days, and an increase in bad
debt loss rate from 2% to 3% of total sales. Additional working capital (apart from accounts
receivable) needed will remain at 25% of sales even if the credit standards are relaxed. The firm has
excess capacity and can increase sales without a corresponding increment in Fixed Assets. The
firm’s cost of capital is 12%. Determine whether it is advisable for the firm to relax its credit
standards. Assume 360-day year.

Solution
Additional Profit Contributions from Sales

Current plan
Sales revenue (120,000 x 10) 1,200,000

Less costs

Variable (120,000 x 6) 720,000

Fixed (8-6) x 120,000) 240,000

Total costs 960,000

Net profit 240,000

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Proposed Plan

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Sales revenue (120,000 x 115% x 10) 1,380,000

Less: Costs

Variables (138,00 x 6) 828,000

Fixed (no change) 240,000

Total costs 1,068,000

Net profit 312,000

Addition profit contribution with new plan = 312,000 – 240,000 = Sh.72, 000

Other costs of new plan

Cost of the investment in Accounts receivables (A/R)

Under the current plan:

Average A/R = 1,200,000 x 30 = Sh.100, 000

360

Average Investment in A/R = variable cost ratio(VC ratio) x Average A/R

=( 6/10) x 100, 000 = 60,000

Cost of Investment in A/R = 60,000 x 15% = Sh.9,000

Under proposed Plan:

1,380,000 x( 45/360)*VC ratio = 172,500 x 0.60 = 103,500

Cost of investment in A/R = 103,500 x 15% = Sh.15,525

Incremental cost of investment in A/R = 15525-9,000 = Sh. 6,525

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Cost of additional working capital (WC) under proposed plan

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Current plan’s WC needs = 25% x 1,200,000 = 300,000

Cost working capital = 15% x 300,000 = Sh.45,000

Proposed plan’s WC needs = 25% x 1,380,000 = 345,000

Cost of WC = 15% x 345,000 = Sh.51,750

Marginal increment in cost of WC =51,750-45.000 = Sh.6,750

Bad debt losses

Current plan = 2% x 1,200,000 24,000

Proposed Plan = 3% x 1,380,000 41,000

Marginal increment in bad debts 17,400

Overall benefits of relaxation in credit standards = 72,000 – 6,525 – 6,750 – 17,400 = Sh.41.325.
Therefore a relaxation in credit standards is advisable.

. CREDIT TERMS (TERMS OF SALE)

Credit terms specify the repayment terms required of all credit customers ( i.e. 2/10,net 30. Credit
terms make specification on three issues:

(1) the cash discount (2)%

(2) the cash discount period (10 days)

(3) the credit period (30 days)

Changes in any aspect of the firm’s credit terms may have an effect on its overall profitability of the
company.

Cash Discounts
The effects of a n increase in cash discounts granted on the financial variable . A decrease will have
the opposite effects.
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Item Direction of change Effect on profits

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Sales volume + +

Average Collection period - +

Bad debt expenses - +

Profit per unit - -

The sales volume increases since the cash discount effectively reduces the price for those firms
ready to pay within the discount period. (assuming demand is elastic). The Average collection period
decreases because the discount acts as an inducement for early payment. The bad debt expense
falls because as people pay earlier, the risk of a bad debt decreases. The increase in sales, and the
decrease in average collection period and bad debt expense have a positive effect on net profits.
Increased cash discount has however the negative effect of a decreased profit margin per unit as
more people take the discount and pay the reduced price.

Example
XYZ Co. is contemplating initiating a cash discount of 2% for payment within 10 days of purchase.
The firm’s current average collection period is 30 days.. Credit sales of 120,000 units at a price of
Sh.10 are made annually. Variable cost per unit is Sh.6, and average cost per unit is Sh.8. If the
discount is initiated 70% of sales will be on discount and sales will increase by 10%. The average
collection period will drop to 15 days. Bad debt expenses currently at 2% of sales will fall to 1%.
Total working capital needed will not be affected by the cash discount. The firms required return on
investment is 12%. Assume no additional capital investment will be necessary.

Evaluate the proposal to initiate a discount.

Solution
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An additional (10% x 120,000) 12,000 units will be sold whose contributions to profit is 12,000 x 4 =

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Sh.48, 000

Average Investment in A/R (receivables).

Current plan (30 days) – 120,000/12 = 100,000

Proposed plan (15 days) = 1,320,000/24 = 55,000

Reduction in Average A/R = 45,000

Savings = 45,000 x 12% = Sh.5, 400

Bad debts Expenses

Current plan = 2% x 1,200,000 = 24,000

Proposed plan = 1% x 1,320,000 = 13,200

Saving in bad debt losses sh.10,800

Cash discount costs

Cash discount 2% x 1,320,000 x 70% = Sh.18, 480

Net benefit of cash discount =48,000 + 5,400 + 10,800 – 18,480 = Sh.45,720

Eg of an aging analysis

Days due Action

0 No action
0-10 Send statements/call to remind them to pay
10-30 Call again
30-60 Write letter demanding payment/make provision for bad debt
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60-90 Ask lawyer to write

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90-120 if material, take action

Financing accounts receivable.

This involves either Assigning/Pledging of Accounts Receivable or Selling/factoring of accounts

Receivable

Assigning/Pledging of Accounts Receivable

This involves borrowing form a financial institution and offering accounts receivable as security.
Under this arrangement, the customer is not notified and the risk of default remains with the
company. The financial institution requires full payment of the loan, whether the customer pays or not
for this reason, the company must carry out a credit analysis to determine the customers credit
worthiness.

Selling/factoring of Accounts Receivable

This involves selling of accounts receivable to a financial institutions referred to as a factor. This
occurs without recourse to the company i.e. if the customer falls to pay. It is the duty of the factor to
follow up. The customer is usually notified of this arrangement and is therefore required to pay
directly to the financial institution.

The financial institution therefore assumes the risk of default and must therefore carry out a credit
analysis. The financial institution would, however, charge a commission for this service.

Procedures for Factoring

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An agreement between the company and the factor is usually made to specify the legal obligations of

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this agreement. Upon receipt of application from the customer, the co prepared a credit approval slip
and sends it to the financial institution. If credit is approved, then shipment of the goods is made and
an invoice sent to the customer notifying him to make payments directly to the company after
deducting of commission for credit analysis, interest for risk bearing and a restrive for damaged or
returned goods.

Example:

A company factors Shs. 10 000 of its accounts receivable, terms n/30. The factoring commission is
2.5% of the invoice value and interests is 9% per annum. The factor charges a reserve of 5% for
damaged and or returned goods. The interest and commission are other discounted.

Required:

i. Show the accounting entry made by the company.

ii. Complete the effective cost of the arrangement

Solution Working

Commission = 2.5% x 1000 =250 Interest = x

Reserve = 5% x 10 000 = 500 x = 9% (10 000 – 250 – x)

12

Accounting entries

DR: Bank / Cash (9677.4 – 500) 9177.4 x = 0.0075 (9750 – x)

Commission 250 x = 73.125-0.0075x

Interest 72.6 1.0075x = 73.125

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Reserve 500 z = 72.6

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CR: Accounts receivable 10 000

Amount received

= 10 000 – Commission – interest

= 10 000 – 250 – 72.6

= 9677.4

ii) Effective Cost = Total Charges x months

Amounts receivable

= 72.6 + 250 X 12

9677.4

= 40%

June 94 Q 1 Pg 6

a) Pledging A/Cs receivable > 256 000 (80% x 320 00)

Compensating balance 15 360 x = 0.025 (30%/12)

Interest = 30% (256 000 – 15360 – x)

12

1.025x = 6016

= -5869.27

Advance = 256 000 – 15 360 – 586.27

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= 234 770 73

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Factoring

Commission = 2% 320 000 = 6400

Interest = x

Reserve = 5% x 320 000 = 16 000

Interest = x

X = 15% (320 000 – 64-- - x)

12

x = 0.0125 (313 600 – x)

1.0125 x = 3920

x = 3871.64

MANAGEMENT OF CURRENT LIABLITIES

Current liabilities are sources of short term financing which assist firms finance current assets and
meet other short term financing needs. The three broad categories of short term financing are:

1. Spontaneous sources
2. unsecured sources
3. secured sources
The following are brief characteristics of each of these sources.

Spontaneous Sources
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Spontaneous financing arises automatically from the day-to-day operations of the firm. The most

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common forms of spontaneous financing come from trade credit from suppliers, and accrued
expenses. This financing is interest free and requires no collateral.

Creditors Management (Account Payable)

The purchaser obtains goods and services, agreeing to pay later in accordance with the credit terms
stated on supplier’s invoice. Trade credit is credit extended in connection with goods purchased for
resale. It is this qualification that distinguishes trade credit from other forms of credit.

Suppliers often give cash discounts on open accounts for payment within a specified period. The
credit terms specify the credit period, the size of the cash discount, the cash discount period, and the
date the credit period begins , which is usually at the end of each month (EOM). For example, terms
of 2/10, net 30 EOM, mean a discount of 2% may be taken if the invoice is paid within 10 days of the
invoice date; otherwise the full payment is due within 30 days from the end of the month of purchase.
If the EOM is not part of the terms then counting begins from the date of the invoice. Prompt-payment
cash discounts are to be distinguished from quantity (bulk) discounts given for purchase of large
quantities, and also from trade discounts given at different points in the distribution chain (wholesale
versus retail, etc.). Proper management of credit offered by suppliers requires that:

1. The firm takes the cash discounts by paying on the last day of the discount period. The annual
percentage cost of giving up cash discounts is quite high. This cost can be estimated using the
following equation.
Cost of giving up discount = CD/(100%-CD)*365/N (12.4)

Where CD = stated cash discount as a percentage

N = number of days payment can be delayed by giving up the cash discount

Example
ABC Ltd. purchased Sh.100,000 worth of merchandise on 27 February from a supplier
extending credit terms of 2/10, net 30 EOM. Calculate the cost of giving up the cash discount.

Solution
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The annualized effective cost of giving the discount = CD/(100%- CD)*(365/N)

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= 2%/(100%-2%)*(365/20)

= 37.24%

This is a very high cost indeed and is equivalent borrowing at 37.24%. (NB If we were to take
the discount the firm would pay on 10 March. By giving up the discount it costs the firm
Sh.2,000 (100,000-98,000)).

2. Stretch accounts payable The firm should pay its bills as late as possible without damaging its
credit rating. The full extent of the credit period should be utilized in the case where cash
discounts are not offered. Caution is to be exercised in stretching payments as this may harm
the firm’s reputation and at worst can cot the firm its sources of supply.
Accruals

Accruals are the other major source of spontaneous financing. Accrued expenses arise when a firm
consumes services (other than trade services) without having to make immediate payment for them
.Typical expenses that generate accrued financing include wages and salaries, utilities, rent, etc.

Unsecured sources of short term financing

Unsecured source of financing is one against which no specific assets are pledged as collateral.
Businesses obtain unsecured short term credit from three sources i.e. trade credit, banks and
commercial paper.

Trade credit Most trade credit is extended via the open account that results in accounts payable
discussed in the preceding section. There are however two other less common sources of trade
credit; The promissory note (trade) and the trade acceptances.
1. Promissory note Is usually called a note payable (trade) on the balance sheet. Such notes
bear interest and have specified maturity date. They are used in situations in which a
purchaser of goods on credit has failed to meet the terms of an open credit agreement and the
supplier wishes a formal acknowledgement of the debt and a specific agreement on a future
payment date.
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2. Trade acceptances Under this arrangement the purchaser acknowledges the debt formally by

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accepting a draft drawn by then seller calling for payment on a specified date at a designated
bank. After acceptance, the draft is returned to the seller and the goods are shipped.
Bank loans Commercial banks are by far the largest suppliers of unsecured loans to businesses.
Businesses need to establish a cordial relationship with their bank that can facilitate lending
transactions. For a successful relationship to blossom banks will generally look for honesty and
integrity ,managerial competence and frank communication in their clients. In addition detailed and
specific information regarding the nature of the financing requirement, the amounts and timing of the
need, the uses to which the funds will be put, and when and how the bank will be repaid may be
needed.

Banks lend unsecured short term loans in three forms: a line of credit, a revolving credit agreement,
and a single payment note.

1. Single payment note This is a short term , one-time-loan, payable as a single amount at its
maturity. It generally has a maturity of 30-daysto 9 months and may have either a fixed or
floating rate.
2. Lines of credit A line of credit is an agreement between a business and a bank showing the
maximum amount the business could borrow and owe the bank at any point in time. Lines of
credit are not contractual and legally binding upon the bank, but they are nearly always
honored. The major benefit, to a business, of a line of credit is its convenience and
administrative simplicity. From the bank’s point of view the major attraction of a line of credit is
that it eliminates the need to examine the creditworthiness of a customer each time the
customer wants to borrow. The terms of a credit line may require a floating interest rate,
operating change restrictions, compensating balances, and annual cleanup provisions ( a
period usually of 1or 2 months during which the loan is completely paid off). A line of credit is
often used to finance seasonal working capital needs or other temporary requirements.
3. Revolving credit agreement Involve a contractual and binding commitment by the bank to
provide funds during a specified period of time. Because the bank legally guarantees the
availability of funds, the borrower pays a commitment fee of ¼ or ½ percent per year on the
average unused portion of the commitment. Revolving credit agreement, like a line of credit,
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permit the firm to borrow up to a certain maximum amount; but unlike a line of credit, are not

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subject to ‘clean-up ‘ provisions.
Commercial Paper

A commercial paper is a form of financing that consists of short term promissory notes issued by firms
with high credit standing. Commercial paper is typically sold at a discount from its par value.
Consequently, the interest charged is determined by the size of the discount and the time to maturity.
Commercial paper distributed through the stock exchange is known as a money market instrument.

The use of commercial paper to raise funds is advantageous because the cost is lower relative to
bank loans and the borrower avoids the cost of maintaining compensating balances required on bank
loans. Additionally , borrowers who need to raise huge amounts of money can satisfy their needs
more conveniently by issuing commercial paper.

Example
A company has issued a Sh.100,000,000 par value worth of commercial paper with a 90-day
maturity, for Sh.98,000,000. Find the effective annual rate of interest on the paper.

Solution
The effective annual rate = (1+D/N‫)م‬ⁿ -1 (12.1)
Where D = discount

N‫ = م‬net proceeds from issue

n = 365/time to maturity

The effective 90-day rate is = D/Np = 2,000,000/98,000,000 = 0,0204

Therefore ,effective annual rate = (1+0.0204) ⁿ - 1 = 0.0841 = 8.41%

(n =365/90 = 4)

Secured Sources Of Short Term Financing

A loan is one obtained by a borrower pledging specific asset(s) as security. In the case of shot term
loans, lenders insist on collateral that is reasonably liquid. Inventory, accounts receivable, and
marketable securities are the assets commonly used as security. Usually the interest on secured
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loans is higher than interest on unsecured loans because of the perceived risk and the costs of

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negotiation and administration. The primary sources of secured loans are the commercial banks and
non-bank financial institutions.

In considering the use of a company’s asset as security we should keep in mind the adverse effect of
such action on unsecured creditors who may take them into account in any future transactions.

Reinforcement questions:

1 (a) What is meant by the term “matching approach” in financing fixed and current assets?

(4 marks)

(b) Briefly explain how the Miller-Orr cash management model operates. (4 marks)

(c) (i) What is a Commercial Paper? (3 marks)

(ii) State and explain the advantages of using commercial paper by businesses to raise
funds (4 marks)

(d) In working capital management,

a. Distinguish between a credit policy and a working capital policy.

b. Give factors to be considered in establishing an effective credit policy.
c. How does a company’s working capital policy impact on its liquidity – profitability
position? Explain with reference to the strategies available to the firm for financing its
working capital.
(e) A co has set the minimum cash balance at Sh.10, 000. The interest rate on marketable able
securities is 9% p.a. standard deviation of daily cash flows is sh.2500 and transaction costs.
For every sale or purchase of marketable securities is sh. 20.

Assume a 360 days year.

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Required

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(i) Compute the target cash balance.
(ii) Compute the upper-limit, average cash
(iii) State the company’s cash decision rule.
(2.) The management of Furaha Packers Ltd. is planning to carry out two activities at the same
time to:

(i) determine the best credit policy for its customers

(ii) find out the optimal level of ordering orange juice from its suppliers.

The following data have been collected to assist in making the decisions:

1. Annual requirements of orange juice are 2,100,000 litres

2. The carrying cost of the juice is Sh.8 per litre per year

3. The cost of placing an order is Sh.1,400.

4. The required rate of return for this type of investment is 18% after tax.

5. Debtors currently are running at Sh.60 million and have an average

collection period of 40 days.

6. Sales are expected to increase by 20% if the credit terms are relaxed and
to result in an average collection period of 60 days.

7. 60% of sales are on credit.

8. The gross margin on sales is 30% and is to be maintained in future.

Required:

(i) Use the inventory (Baumol) model to determine the economic order quantity and the
ordering and holding costs at these levels per annum. ( 8 marks)
(ii) Determine if the company should switch to the new credit policy. ( 4 marks)
3. a) A firm may adopt a conservative policy or an aggressive policy in financing its working capital
needs.
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Clearly distinguish between:

i) A conservative policy and (3 marks)

ii) An aggressive policy. (3 marks)

b) The following information relates to the current trading operations of Maji Mazuri Enterprises
(MME) Ltd:

- Level of annual sales (uniform per month) - Sh.600 million

- Contribution to sales ratio - 15%

- Debtors recovery period:

Percentage Average collection

of debtors period (days)

25 32
60 50
15 80
- Credit sales as a percentage of total sales - 60%

- Required return on investments - 15%

- Level of bad debts (2% of credit sales) - Sh.7,200,000

The management of the company is in the process of reviewing the company’s credit
management system with the objectives of reducing the operating cycle and improving the
firm’s liquidity. Two alternative strategies, now being considered by management are detailed
as follows:

Alternative A: change of credit terms:

The proposal requires the introduction of a 2% cash discount which is expected to have the
following effects:
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∑ 50 per cent of the credit customers (and all cash customers) will take advantage of the 2

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per cent cash discount.
∑ There will be no change in the level of annual sales, the percentage of credit sales and
the contribution of sales ratio.
∑ There will be savings in collection expenses of Sh.2,750,000 per month.
∑ Bad debts will remain at 2 per cent of total credit sales.
∑ The average collection period will be reduced to 32 days.

Alternative B: contracting the services of a factor:

The factor would charge a fee of 2% of total credit sales and advance MME Ltd. 90% of total
credit sales invoiced by the end of each month at an interest rate of 1.5% per month.

The effects of this alternative are expected to be as follows:

∑ No change is expected in the level of annual sales, proportion of credit sales and
contributions margin ratio.
∑ Savings on debt administration expenses of Sh.1,400,000 per month will result
∑ All bad debt losses will be eliminated
∑ The average collection period will drop to 20 days.

Required:

i) Evaluate the annual financial benefits and costs of each alternative (Assume 360 –day
year) (8 marks)

ii) Advise MME Ltd. management on the alternative to implement. (2 marks)

iii) Explain briefly other factors that should be considered in reaching the decision in (ii)
above. (4 marks)
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4. The following information is provided in respect to the affairs of Pote Limited which prepares its

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account on the calendar year basis.

1995 1994

Shs. Shs.

Sales 600,000 500,000

Purchases 400,000 350,000

Cost of goods sold 360,000 330,000

Stock at 31 December 100,000 60,000

Debtors at 31 December 98,000 102,000

Creditors at 31 December 40,000 25,000

Total assets at 31 December 300,000 185,000

Stock and debtors at 1 January 1994 amounted to Sh.70,000 and Sh.98,000 respectively.

Required:

a) Calculate the rate of stock turnover expressed:

i) as a ratio; (3 marks)

ii) in days, for each of the years 1994 and 1995. (3 marks)

b) Calculate the rate of collection of debtors, in days, for each of the years 1994 and 1995.
(3 marks)

c) Calculate the rate of payment to creditors, in days, for each year 1994 and 1995.

(3 marks)
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d) Show the cash operating cycle for each year. (6 marks)

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e) Comment on the results. (6 marks)

REVISION QUESTIONS

1. PKG Ltd. maintains a minimum cash balance of Sh.500,000. The deviation of the company’s daily
cash changes is Sh.200,000. The annual interest rate is 14%. The transaction cost of buying
or selling securities is Sh.150 per transaction.

Required:

Using the Miller-Orr cash management model, determine the following:

(i) Upper cash limit ( 4 marks)

(ii) Average cash balance ( 2 marks)
(iii) The return point. ( 2 marks)

(b) Explain briefly the meaning of the terms (i) overtrading

(ii) Overcapitalization

CHAPTER: 8

SOURCES OF FUNDS

Objectives
(i) To classification different sources of funds
(ii) Evaluation of the advantages and disadvantages of the different funds

Introduction
Sources from which a firm may obtain its funds to finance its operations can be classified in four
different way as this include
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1. Classification according to the duration over which the funds will be retained. These

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sources include (a) long term sources of funds-

They are refundable after a long period of time i.e. after 12 years

Short term sources of funds

These funds are refundable after a short period of time i.e. a period of 3 years

(c) Permanent sources of funds

These funds are not refundable as long as the business remains a going concern for example
ordinary share capital

2. Classification according to origin

These sources include;-

(a) External sources of funds

They are raised from outside the organization

(b) Internal sources of funds

These are funds that are raised from within the firm

3. Classification according to the relationship between the firm and parties providing the funds

These sources include:-

(a) Common equity capital

These are funds provided by the real owners of the

business i.e. ordinary share capital; it is the total of the
ordinary capital and the reserves

(b) Quasi capital these are funds that are provided by the
preference shareholders

(c) Debt finance

They are funds provided by the creditors i.e. debentures

4. Classification to the rate of return

These sources include:-

(a) Capital with affixed rate of return

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This is capital that is paid a certain prespecified rate

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of return each year i.e. preference capital and long
term debts

(b) Capital with a variable rate of return

(c) This is capital that is paid a different rate o0f return

each year depending on the firm’s performance.

A business may obtain funds from various sources which may be either:

ÿ Long term sources which are repaid after a long period of time.

ÿ Short term sources which are repaid after a short period even less than a year.

Long term sources of funds

They include: -

1. Equity finance
2. Debentures
3. Preference share capital
4. Long term loans
5. Leases and sale and lease back
6. Sale of fixed assets

EQUITY FINANCE
This is finance from the owners of the company (shareholders).it is generally made up of ordinary
share capital and reserves (both revenue and capital reserves)

A) Ordinary share capital

The true owners of business forms are the ordinary shareholders. Sometimes referred to as residual
owners, they receive what is left after satisfaction of all other claims.
The ordinary share capital is raised by the shareholders through the purchase of common shares
through the capital markets.
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This form of long term capital is only accessible to limited companies who have met the requirements

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of the capital market authority for listing before floating the shares.

Features of ordinary share capital.

Ownership

The ordinary shares of a firm may be owned privately (family) or publicly with shares being traded in
the stock exchange.
Par value
The par value of an ordinary share is relatively useless value, established in the firm’s corporate
charter (memorandum). It is generally very low- Sh.5or less.
Pre-emptive rights
Allow shareholders to maintain their proportionate ownership in the corporation when new shares are
issued. The feature maintains voting control and protects against dilution.
Rights offering
The firm grants rights to its shareholders to purchase additional shares at a price below market price,
in direct proportion to their existing holding.

Authorized, outstanding and issued shares

Authorized shares are the number of shares of common stock that the firm’s charter (articles) allows
without further shareholders’ approval.
Outstanding shares is the number of shares held by the public

Issued shares are the number of share that has been put in circulation; they represent the sum of
outstanding and treasury stock.

Treasury stock is the number of shares of outstanding stock that have been repurchased by the firm
(not allowed by the Companies Act of Kenya Laws).

Dividends
The payment of corporate dividends is at the discretion of the Board of Directors. Dividends are paid
usually semi- annually (interim and final dividends). Dividends can be paid in cash, stock (bonus
issues) and merchandise.

Voting rights
Generally each ordinary share entitled the holder to one vote at the Annual General Meeting for the
election of directors and on special issues. Shareholders can either vote in person or in proxy i.e.
appoint a representative to vote on his behalf .Shareholders can vote through two main systems,
1. Majority voting system.
2. Cumulative system.

Majority voting system

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Under this system , shareholders receive a vote for every share held. Decisions to be made must

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therefore be supported by over 50% of the votes in a company .Under this system any shareholder or
group pf shareholders owning more than 50% of the company’s shares will make all the decisions.
The minority shareholders have no say.

Cumulative voting system.

Under this system, shareholders receive one vote for every share held times the number of similar
decisions to be made. This system is appropriate for making decisions that are similar and is mainly
used in the election of directors.

Example.
Assume that there are 10,000 shares outstanding and you own 1001v shares .Their are 9 directors to
be elected and therefore you would have (1001×9)= 9009 votes .How many directors can you elect.
A.1001 shares = 1001×9 =9009
B. 10,000 – 1001 = 8999 × 9 = 80,991

Share holder A has 9009 votes and with 9 directors to be elected , there is no way for the owners of
the remaining shares to exclude A from electing a person to one of the top 9 positions. The majority
shareholder would control 8999 shares thus thus entitling them to 80991 votes .The 80991 vote
cannot be spread thinly enough over the nine candidates to stop shareholder A from electing one
director.
The number of shares required to elect a give number of directors is given as follows.

R= d (n) + 1
Nd + 1
Where,

R- Number of shares required to elect a desired number of directors.

d- Number of directors shareholders desire to elect.

n- Total number of common shares outstanding.

Nd- Total number of directors to be elected.

Example

A company will elect 6 directors and their ae 100,000 shares entitled to vote,

Required.

a. If a group desires to elect two directors, how many shares must they have.
b. Shareholder A owns 10,000 shares, shareholder B owns 40,000 shares how many directors
can each elect.
Solution.
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a) R =2 (100,000) + 1

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6+1

=28571.6 + 1=28573

b) A. 10,000= d (100,000) +1
6+1

10,000=14285.7d + 1

d= 9999/14285.7

d=0.7

Therefore zero directors.

B. 40,000=d (100,000) + 1

6+1

d=2

Therefore 2 directors.

Advantages of equity financing accruing to shareholders

1. Shares can be used as security for loans.

2. Providers of these funds can participate in the supernormal earnings of the firm
3. The shares are easily transferable
4. Return in form of a share price appreciation (capital gain) and dividends.
5. The following rights of ordinary shareholders can be viewed as advantages:

Rights of ordinary shareholders.

i. Right to vote-shareholders have the right to vote on a number of issues in a company

such as election of directors, changes in the Memorandum of Association and Articles
of Association. Shareholders can vote either in person or by proxy that is, by appointing
someone to represent them and vote on their behalf.
ii. Pre-emptive rights- Allow shareholders to maintain their proportionate ownership in the
corporation when new shares are issued. The feature maintains voting control and
protects against dilution.
iii. Right to appoint another auditor
iv. Right to approve dividend payments
v. Right to approve merger acquisition
vi. Right to residual assets claim
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Disadvantages accruing to shareholders

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1. The ordinary share dividend is not an allowable deduction for tax purposes
2. The dividend is paid after claims for other providers of capital are satisfied
3. Ordinary shares carry the highest risk because of the uncertainty of return(company has the
discretion to declare dividend or not)and incase of liquidation the holders have a residual claim
on assets

Advantages of using ordinary share capital to a company

1. It is a permanent source of capital hence facilitates long term projects

2. Use of equity lowers the gearing level hence a company has a broader borrowing capacity
3. The shareholders may provide valuable ideas to the company’s operation
4. A company is not legally obliged to pay dividend especially if it is facing financial difficulty
these funds would serve better if retained.
5. It enables a company to get the opinion of the public through the movement in share prices.
6. This source can be raised in very large amounts
7. It does not require any collateral as security.
8. The funds are provided without conditions hence are flexible.

Disadvantages of using ordinary share capital to a company

1. The floatation costs are higher than those of debt

2. It is only accessible to companies that have fulfilled the capital markets authority requirements
3. It can lead to dilution of ownership of control of the firm by the shareholders
4. Since the dividend payment is not tax allowable then the company does not enjoy a tax saving
5. The cost of this source of fund(dividend) is perpetual as ordinary shares are not redeemable
securities
6. The firm has to follow set guidelines on disclosure and publishing of financial statements.

Methods of issuing common shares

ß Through a public issue

ß Private placement
ß Through a rights issue
ß Employee stock option plans (ESOP)
ß Bonus issue

Public issue

Ordinary shares are offered to the general public. The issuing company engages an investment
banker who will undertake the issue. The investment will set the securities issue price and will sell the
shares to the investors. The issuing firm can enter into an arrangement with the investment banker
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where the investment banker will underwrite shares, that is, buy any shares not taken up by the

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public.

Private placement

Under this method securities are sold to a few, usually chosen investors mainly institutional investors.
The advantages of this method is that the firm gets to decide who will take up there shares, it can be
used as part of strategic partnership, it will also lead to less floatation cost as no advertisement is
necessary. It also takes less time to raise funds through a private placement than a public issue
which involves a number of requirements to be fulfilled. A major disadvantage is that the share is not
as liquid-transferability is made difficult.

Rights issue

This is an option offered to already existing shareholders to buy common shares of the company at a
price (subscription price) which is less than the market price. The subscription price is set a lower
price than the market price so as to make it attractive for the existing shareholders to buy the
common shares; also it acts as a safeguard against any reduction in share price in the market.

When a rights issue is declared every outstanding share receives one right however, a shareholder
needs to have a number of rights in order to buy one new share.

A shareholder has 3 options available during a rights issue. He can exercise, ignore or sell the rights.

Computations under rights issue

Po = cum rights price (price of the share with the rights)

Px = ex rights price (price of the share without the rights)

Ps = subscription price

So = number of outstanding shares before the rights issue

S = number of new shares

N = number of rights required to buy one new share

R = theoretical value of the rights

The formula to be applied is as a follows:

N = So

S
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P x = Po x So + Ps x S

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So + S

R = Px – Ps (ex rights) = Po - Ps (cum rights)

N N+1

Example

A company has 900000 shares outstanding whose current market price is 130. The company needs
22.5 million to finance a proposed expansion. The BOD has declared that rights be issued at sh.75
per share to raise he required finance.

Required,

Calculate;

The number of rights required to buy one new share.

The price of the share after the rights issue (ex rights price).

The theoretical value of the right.

Consider the effect of the rights issue on a share holder under the three options available. Assume he
has 3 shares sh.75 cash in hand.

Solution

N= So ÷S

S= 22500000÷300000

=300000

N=900000÷300000

=3

Px= 130×900000 +75×300000

900000 ÷ 300000

=116.25

R = 116.25 – 75

3
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=13.75(Ex Rights)

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130 -75

=13.75(Cum Rights)

3 shares

3×130= 390

Cash = 75

Total wealth before = 465

Alternatives:

Exercise his rights

3 share = 3 rights = 1 share.

3 old shares + 1 new share= 4×116.25

Total wealth after rights issue= 465 therefore wealth remains constant.

Sell his Rights

3share = 3 rights @ 13.75 (13.75 ×3) = 41.25

Cash in Hand 75

3 shares @ 116.25 348.75

Total wealth 465.0

Total wealth after rights issue= 465 therefore wealth remains constant.

Ignore his rights.

3 shares @ 116.25 348.75

Cash in Hand 75.0

Total wealth 423.75

The shareholders wealth decreases by 41.25 which is the value of the rights ignored.
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Dates of a rights issue

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There are 4 important dates in a rights issue:

1. Announcement date.

2. Register of members date (Record date)

3. Issue date.

4. Expiry date.

Announcement date: This is the date when the company announces that it is going to issue the rights
to those shareholders whose names appear in the register at a certain date.

Register of members date: Also know as record date .This is the date when the company is supposed
to close the register .This is the last day that members are registered so that members whose names
appear in the register as at that date will receive the rights. (Practically this date is earlier so that
records of new shareholders can be recorded)

Issue date: This is the date when the company mails the certificate of rights to shareholders.

Expiry date: This is the date after which the rights cannot be exercised as the rights have lapsed.

Employee stock option plans

These are schemes that allow employees of a company to purchase shares of the company under
specific conditions usually at a lower price than the market price.

Bonus issue

This is an issue of additional shares to existing shareholders in lieu of a cash dividend. Companies
may choose a bonus issue if it wants to give dividends but not in the form of cash so as to retain the
cash say for investment, it is not taxable as cash dividends would be taxed. A bonus issue is
expected to have no effect on the shareholders wealth and may have the following benefits,

Tax benefit –If a company declares such an issue. It Is not taxable as in the case of Cash dividends
.The share holder can therefore sale the new shares in the market to make capital gain which is not
taxable.

It can result into conservation of cash especially if a company is facing financial constrains.

If the market is inefficient, a bonus issue maybe regarded as signaling important information and may
result in an increase in the share price because a bonus issue is interpreted to mean high profits.
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Increase in future dividends .This occurs especially if a company follows a policy of paying a constant

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mount of dividends per share and continues with this policy even after the bonus issue.

2. TERM LOAN
Medium term & long term loans are obtained from commercial banks and other financial institutions.
This funds are mainly used to finance major expansions or profit financing.

Features of term loans

1. Direct negotiation – A firm negotiates a term loan directly with a bank of financial institution. I.e.
a private placement.
2. Security – term loans are usually secured specifically by the assets acquired using the funds.
(Primary security). This is said to create a fixed charge on the company’s assets. A fixed
charge can also be referred to as specific charge.
3. Restrictive covenant – financial institutions usually restrict the firms so as to safeguard their
funds. They do this by way of restrictive covenants which include asset based covenant,
cashflow, liability etc.
4. Convertibility – they are usually not convertible to common shares unless under special cases.
E.g. a financial institution may agree to restructure the firms capital structure.
5. Repayment schedule – this indicates the time schedule for payment of interest and principle. It
may occur.
i) Where interest & principle are paid on equal periodic instalments.
ii) Where principles is paid on equal periodic instalments & interest on the outstanding
balance of the loan.

Example

A company negotiates a Sh.30 million loan at 14% pa from a financial institution. Acquired;
prepare the loan prepayment schedule assuming that:
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(i) Interest & principle paid in 8 equal year end installment’s

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(ii) Principle is paid in 8 equal instalments

i) 30,000,000 = A x PVIFA

14% 8 years

30,000,000 = 4.6389A

A = 6,46,050.0378

Schedule of Repayment

Year Bal. b/d Instalment Interest Principle Bal b/d

14%

1 30,000,000 6,467,050 4,200,000 2,267,050 27,732,950

2. 27,732,950 6,467,050 3,882,613 2584437 25148513

3. 25148513 6,467,050 3520792 2946258 22202254.8

4. 22202255 6,467,050 3108316 3358734.3 18843521

5. 18843521 6,467,050 2638093 3828957 15014564

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6. 150145639 6,467,050 2102039 4365011 10649553

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7. 10649553 6,467,050 1490937.4 4976112.6 5673440.4

8. 56734404 6,467,050 794282 5672768.4 672.1

iii) 8 equal principle – 30n/8 = 3,750,000

YR Bal b/d inst. Int. primar

Year Bal. b/d Instalment Interest Principle Bal b/d

14%

1 30,000,000 7950000 4200000 3750000 26250000

2. 26250000 7425000 3675000 3750000 22500000

3. 22500000 6900000 3150000 3750000 18750000

4. 18750000 6375000 2625000 3750000 15000000

5. 150000000 5850000 2100000 3750000 11250000

6. 11250000 5325000 1575000 3750000 7500000

7. 7500000 4800000 1050000 3750000 3750000

8. 3750000 4275000 525000 3750000 0

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3. PREFERENCE SHARES (QUASI-EQUITY)

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Preference shares are considered as hybrid securities since they are similar to both common shares
and debentures. They are similar to common shares in the following ways.

i) They are perpetual securities and therefore have no maturity date.

ii) Dividends are not tax deductible.
iii) The non-payment or dividends does not force the company into liquidation.
They are similar to debentures on the following ways:

i) The dividend rate is fixed i.e. it is a % of the pa. Value.

ii) Preference shareholders do not have voting rights unless dividends are in arrears for
several years.
iii) Preference shareholders do not share in the extraordinary income of the company.
Preference shareholders have a claim on income and assets prior to that of common share holders.

Preference shares may have several distinguishing features such as;

Cumulation

Most preferences shares are cumulative with respect to any dividend passed over. Dividend in
arrears together with current dividends must be paid first before distribution is made to ordinary
shareholders.

Callable (redeemable)
The issuer can retire outstanding stock within a certain period of time at a specific price.

Conversion
This feature allows holders to change each share into a stated number of ordinary shares.

4. VENTURE CAPITAL
Venture capital is a form of investment in new and risky small enterprises which is required to get
them started. Venture capitalists are therefore investment specialist who raises pools of capital to
fund new ventures which are likely to become public companies in return for an ownership interest.
They therefore buy part of the stools of the company at a low price in anticipation that when the
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company goes public, they would sale the shares at a high price and make considerable capital

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gains, venture capitalists also provide managerial skills to the firm examples of venture capitalists are:

Pension funds, insurance companies and also individuals.

Since the goal of venture capital is to make a profit, they will only invest in that have a potential for
growth.

Constraints in the development of a venture capital market in Kenya.

i) The few promoters of venture capital are risk averse and therefore are discouraged by the
level of risk, the length of investment and the liquidity of investment.
ii) The nature of firms in Kenya is such that they are privately owned and therefore do not
dillusion of ownership through use of venture capital.
iii) The poor infrastructure in the country also discourages venture capitalists.
iv) They are not enough incentives for the development of venture capital and the government
is discriminative against venture capital. The tax laws favour debt over equity.
v) Lack of efficient capital markets also discourages venture capital development because
there is no channeled for disinvestment i.e. selling off the venture interest once it has
succeeded.
vi) There is a general shortage of venture capitalists.

Importance of venture capital market in small and medium scale business development

i) Venture capitalists provide the much needed finance to tour small businesses which lack
access to capital markets due to their size.
ii) Small medium scale businesses may lack managerial skills. Venture capitalists sere as
active partners through involvement in this businesses and therefore provide marketing and
planning skills as the also want to see their investments succeed.
iii) Venture capitalists encourage tree spirit of entrepreneurship therefore small businesses are
encouraged to see their ideas through as they know they will get start up capital.
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iv) Venture capitalists provide improved technology so that small and medium scale business

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are in line with changes in technology and are therefore able to compete with other firms of
the same level.

LEASE FINANCING
This is an agreement where the right repossession and enjoyment of an asset is transferred for
a definite period of time. The person transferring the right i.e. the owner of the asset is referred
to as leasor. The recipient of the asset is the lessee.

Classification of Leases

A lease can be classified according to term or according to terms of payment.

- According to term

There are two types of leases: -

1. The short term operating or finance lease

2. Long term capital or finance lease

Long term lease

A long term lease can be defined as a contract whereby the lessee has substantially all the risks and
rewards associated with the asset except legal title.

Requirements of a Long Term lease

1. The present value of lease rentals must be greater than 90% the year value of the asset.
2. 75% of the assets life is the lease term.
3. It is non-cell unsalable
4. Maintenance costs, insurance and taxes are paid by the lessee.
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According to terms of payment

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1. Net lease
This is on in which the leasee pays all or a substantial part of the maintenance cost. It is
therefore where the lessee pays for all the expenses except taxes, insurances and exterior
repairs.

2. Flat Lease
This is one which opts for periodic payment for use of the asset over the term of the lease.
Such a lease is usually made for such periods of time since inflation can easily erode the
buying power of the fixed rentals.

3. Step Up lease
This provides for the fixed payments to be adjusted periodically. This adjustments can be
made either b new rentals taking effect after the passages of a certain period of time or by
periodically adjusting the fixed payments for inflation. The term of a stepup lease is usually
longer than a flat lease.

4. Percentage lease
This is where the lessee is required to pay a fixed basic percentage rate and a designated
percentage of sales volume. The percentage factor acts as an inflation gauge as well as a
means of Keeping lease rentals in line with the market conditions.

5. Escalator lease
This calls for an increase in taxes insurance and operating costs to be paid for the lessee.

6. Sandwich lease
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This refers to a multiple lease in which the lessee in turn sub-lease to a sub-lessee who in turn

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sub-leases to another sub-lessee. Example: A the original owner of an asset leases to B. B
executes a sub-lease to C who then sub-leases to D.

This is a sandwich lease between B & C, B being the sandwich lessor and C the sandwich
lessee.

Example.

Dereva and Makanga are considering purchasing the new 30 passenger coach to engage in transport
business .They have two alternatives of financing the purchase as shown below.

Alternative 1.

Purchase the vehicle whose current cash price is sh. 2,400,000 through a finance lease from Matatu
Auto Company. The terms of the lease will require 4 equal payments per year for each of the three
years .No deposit is required.

Alternative 2.

Obtain the vehicle through Equal’s Bank loan scheme being advertised in the papers .Dereva and
Makanga will be required to make a down payment of sh .900,000 and then meet four equal yearly
payments of sh. 153,436 each for the three years.

The market rate of interest is currently 16% per annum.

Dereva and Makanga have been informed that as part of your social responsibility, you provide free
consultancy service to small scale businessmen.

Required.

a. The finance lease payment to be made by Dereva and Makanga if they opt for finances from
Matatu Auto Company Limited.

b. The present value of the payment scheme of Equal Bank.

c. The interest expense charged by Matatu Auto Company on the third installment.
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d. Give reasons why finance leases are referred to as “off- balance sheet” finance.

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e. Which of the two alternatives –Finance lease or Bank loan scheme is better in financial terms?
Why?

f. Give a reason why the better alternative may not necessarily be chosen by persons in Dereva
and Makanga’s circumstance.

a) Finance lease payment to be made by D & M 1st Option 2,400,000 = A x PVIFA

16% 12years

A = Sh. 255,724.5

b) PV of the payment scheme of Equal Bank

PV = Initial down payment + PVIFA

16% 12 periods

= 900,000 + 153,436 (9.3851)

= 2,340,012.204

Year Bal. b/d Installment Interest Principle Bal b/d

14%

1st 2,400,000 255,724.5 96,000 159,724.5 2,240,275.5

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2nd

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2,240,275.5 255,724.5 89,611.02 16,6113.48 20,74162.02

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3rd 2074162.02 255,724.5 82,966.48 172,758 1,901,404

Interest expense 3rd Installment = 82,966.48

e) The loan is cheaper than the lease.

f) They may not have Sh. 900,000 because they are small scale businessmen.

Advantages of lease

i) To avoid the risk of ownership. When a firm purchases an asset, it has to bear the risk of
obsolescence especially if the asset is vulnerable to technological changes e.g. computers.
ii) Avoidance of investment outlay. Leasing enables a firm to make full use of an asset without
making an immediate investment in the form of initial cash outflow.
iii) Increased flexibility. A St. lease is a cancelable lease especially when the asset is needed
for a short period of time e.g. during construction, equipment can be leased on a seasonal
basis after which the lease can be cancelled.
iv) Lease charges are tax allowable expenses. This therefore reduces the tax liability.

HIRE PURCHASE
This is arrangement whereby a company acquires an asset on making a down payment or
deposit and paying the balance over a period of time in installments. This source of finance is
more expensive than a bank loan and companies that use this source need guarantors since it
does not require security or collateral. The company hiring the asset will be required to honour
the terms of the agreement which means that any term in violated, the selling firm may
repossess the asset. This is therefore finance in kind and the hirer will not get title to the asset
until he clears the final installment and any charges thereof.
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Example:

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Assume that a customer wants to acquire an asset costing Shs. 160,000. The customer is
required to make a 50% down payment and the balance in installments. The installments will
be paid annually for 8 years at a flat rate of 14% pa. The calculation of interest and
installments would be as follows: -

Cash Shs. 160,000 x 50% = 80,000

Installments =80,000

14% x 80,000 = 11200 x 8 = 89,600

80,000 + 89,600 = 169,600÷8 =21,200 (Interest & principles)

One of the must common methods sued to compute the interest amount is the sum of years digit
methods:

Year Bal. b/d Installment Interest Principle Bal b/d

14%

1 80,000 21,200 19,911 1289 78,711

2. 78,711 21,200 17,422 3778 74,933

3. 74,933 21,200 14,933 6267 68,666

4. 68,666 21,200 12,444 8756 59,910

5. 59,910 21,200 9956 11244 48,666

6. 48,666 21,200 7467 13,733 34,933

7. 34,933 21,200 4978 16,222 18711

8. 18,711 21,200 2489 18,711 0

80,000 = 1,200 PVIFA r% 8 years

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80,000 = PVIFA r% 8 years

21,200

= 3.7734

From Table A – 1 Present value at the Appendix.

24% 20%

3.4212 3.8372

r – 20 = 24 – r

0.0636 0.3522

0.3522r – 7.044 = 1.5264 – 0.0636r

0.4158r = 8.5704

Effective rate of interest r = 20.6%

Although Hire purchase is an expensive source of financing, it has its benefits which include:

1. The customer is able to avoid the purchase price immediately.

2. The customer does not require security or collateral
3. The customer will save on taxes on the interest payments.

Compound rate =

42007.5 = 7841.4 PVIFA

r%, 6 periods
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42007.5 = 5.3571

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7841.4

3% 4%

5.4172 5.2421

r–3 = 4–r

0.06 0.115

0.115r – 0.345 = 0.24 – 0.06r

0.175r = 0.585

0.175

Month Bal. b/d Installment Interest Principle Bal. c/d

1. 42007.5 7841.4 1403 6438.35 35569.15

2. 35569.15 7841.4 1188 6653.39 28915.75

3. 28915.76 7841.4 965.79 6875.61 22040.15

4. 22040.15 7841.4 736.14 7105.26 14934.89

5. 14934 7841.4 498.83 7342.57 7591.43

6. 7591.43 7841.4 253.55 7587.8 3.5

b) How long will it take a given amount earning 6% pa to double if no withdrawal is much.
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X PVIFA = 2x

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6% n years

PVIFA

6% n years = 2x

2 3

1.8334 2.673 1.8458 = 0.8396r

= 2 years

r–2 = 3–r

0.1666 0.673

0.673r – 1.346 = 0.4998 – 0.1666r

Mortgages
A Mortgage can be defined as a pledge of security over property or an interest therein created by a
formal written agreement for the repayment of monetary debt.

8. MINIMUM MORTGAGE REQUIREMENTS

1. All mortgages should be in writing.

2. All parties must have contractual capacity.
3. Interest in the property being mortgaged should be specific e.g. rental income lease
hold etc.
4. A description of true loan or obligation secured by the mortgage should appear in the
mortgage agreement.
5. A legal description of the mortgage must be included in the documents.
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6. The mortgage must be signed by the mortgagor

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7. The mortgage must be acknowledged and delivered to the mortgagee.

Reinforcing questions.

1. (a) List and explain five factors that should be taken into account by a businessman in making the
choice between financing by short-term and long-term sources. (10 marks)

(b) Mombasa Leisure Industries is already highly geared by industry standards, but wishes to
raise external capital to finance the development of a new beach resort.

Outline the arguments for and against a rights issue by Mombasa Leisure Industries.

(c) Examine the relative merits of leasing versus hire purchase as a means of acquiring capital
assets. (6 marks)

(d) Identify four factors that have limited the development of the venture capital market in your
country. (4 marks 2.

2. (a) Hesabu Limited has 1 million ordinary shares outstanding at the current market price of Sh.50
per share. The company requires Sh.8 million to finance a proposed expansion project. The
board of directors has decided to make a one for five rights issue at a subscription price of
Sh.40 per share.

The expansion project is expected to increase the firm’s annual cash inflow by Sh.945,000.
Information on this project will be released to the market together with the announcement of
the rights issue.

The company paid a dividend of Sh.4.5 in the previous financial year. This dividend, together
with the company’s earnings is expected to grow by 5% annually after investing in the
expansion project.

Required:

(i) Compute the price of the shares after the commencement of the rights issue but before
they start selling ex-rights. (4 marks)

(ii) Compute the theoretical ex-rights price of the shares. (2 marks)

(iii) Calculate the theoretical value of the rights when the shares are selling rights on.
(2 marks)
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(iv) What would be the cum-rights price per share if the new funds are used to redeem a

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Sh.8 million 10% debenture at par? (Assume a corporation tax rate of 30%).
(6 marks)

3. Equator Ltd. has been in operation for the last eight years. The company is all equity financed with
6 million ordinary shares with a par value of Sh.5 each. The current market price per share is
Sh.8.40, which is in line with the price/earnings (P/E) ratio in the industry of 6.00. The
company has been consistent in paying a dividend of Sh.1.25 per share during the last five
years of its operations, and indications are that the current level of operating income can be
maintained in the foreseeable future. Tax has been at a rate of 30%.

The management of Equator Ltd. is contemplating the implementation of a new project which
requires Sh.10 million. Since no internal sources of funds are available, management is to
decide on two alternative sources of finance, namely:

Alternative A

To raise the Sh.10 million through a rights issue. Management is of the opinion that a price of
Sh.6.25 per share would be fair.

Alternative B

To obtain the Sh.10 million through a loan. Interest is to be paid at a rate of 12% per annum
on the total amount borrowed.

The project is expected to increase annual operating income by Sh.5.6 million in the
foreseeable future.

Irrespective of the alternative selected in financing the new project, corporation tax is expected
to remain at 30%.

Required:

(i) Determine the current level of earnings per share (EPS) and the operating income of
the company. (3 marks)

(ii) If Alternative A is selected, determine the number of shares in the rights issue and the
theoretical ex-rights price. (3 marks)
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(iii) Calculate the expected earnings per share (EPS) for each alternative, and advise

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Equator Ltd. on which alternative to accept. (6 marks)

(iv) “It is always better for a company to use debt finance since lower cost of debt results in
higher earnings per share”.

Briefly comment on this statement. (4 marks)

CHAPTER 9:

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 pay out 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.
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c) Constant amount plus extra

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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.
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 is 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
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and treated as a passive variable. It will hence not affect the value of the

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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.

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 andfinancial 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 therefor divided policy does
not exist . When investment decisions are made dvident decision is a
mere detail without any effect on the value opf the firm
C)

The main dividend theories are:

i. Residual dividend theory
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ii. MM dividend irrelevance theory

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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 cadsh to the exixsting shareholders prorate to
their share holding in the company. Astock dividend / bonus issue involves capitalization of
retaoined earnings therefore does not increasew the wealth of the shareholders. This is
because retained earnings is converted into share capital.

Adnvantages of a bonus issue

i. To indicaes that the foirm plans to retain a portion of earnings permanenbtly 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 generatae cash in the
form of capital gains which are tax exempt unlike cash dividends whiccjh 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 an

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inefficient market survey b importsant 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 effects 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 clientel.
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
Retained earnings 2400
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14000

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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.

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
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ii)

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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 ba,lance s in excess of future investments might
find a share re-invest\ment scheme a fair mewthod of returning cash to sshareholders
.Continuing to csrry excess cash may prompt managementto invest unwiselyas a meanssof
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.
2. Enhanced dividends and EPS.

Following a stock repurchase, the numer of shares issued would decrease therefore in
ni\ormal 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.
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4. Capital structure.

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A company’s managers may use a shae buy-back or repurchase as a meansof
correctingwhat 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 structureal termnatively , a company may raise debt to finance a repurchase .
Replacing equity with debt can reduce the overall cost of capital.
5. Reducing take over 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 .Ths helps to reduce the threat of as host\ile take over as it makes it
difficultfor a predator company to gain control .This is also refered to as a poison pill i.e. a
company’s value is reduced because of huge cash outflow or borrowing huge long-term dept
to increase gearing.

Disadvantages of a stock repurchase.

1. High price.

A company may find it difficult to repurchase\se at thei current value or the price pid
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 bre 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.
Factors that would affect dividend policy.

1. Legal rules:
a. Net profit rule- This states that the dividends may be paid from company profits, either
past or present.
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b. Capital impairment rule- This prohibits payment of dividends from capital i.e. from the

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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 it’s 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.

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 pay out is usually low. However, in large quoted public
companies, dividends are significant since the owners are not the managers. The value and
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preferences of a small group of owner managers would exert more direct influence on the dividend

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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:

Dividend pay-out ratio = Dividends per ordinary share / Earnings per share

Where ordinary dividends per share = Ordinary dividends/ Number of ordinary shares

Dividend Yield Ratio

This shows the dividend return being provided by the share. It is given by

Dividend yield = Dividends per share / Market price per share

Reinforcing questions
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1. (b) Kathonzweni Holdings Limited has investment interests in three companies. Kanzokea Video

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Limited (KVL), Kithuki Hauliers Limited (KHL) and Mbuvo Fisheries Limited (TFL). The
following financial data relate to these companies.

1. As at 31 December 2001, the financial statements of two of the companies revealed the
following information:

Company Price of Earnings per Dividend per

share share share

Sh. Sh. Sh.

Kanzokea Video Ltd. 160 8 8

(KVL)
270 18 9
Kithuki Hauliers Ltd.
(KHL)

2. Earnings and dividend information for Mbuvo Fisheries Ltd. (TFL) for the

past five years is given below:

Year ended 31 1997 1998 1999 2000 2001

December
Sh. Sh. Sh. Sh. Sh.

Earnings per share 5.0 6.0 7.0 10.0 12.0

Dividend per share 3.0 3.0 3.5 5.0 5.5

The estimated return on equity before tax required by investors in Turkana Fisheries
Ltd.’s shares is 20%.

Required:

(i) For Kanzokea Video Ltd. (KVL) and Kithuki Hauliers Ltd. (KHL), determine
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and compare:

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ß Dividend yields
ß Price/Earnings ratios
Dividend covers.
(ii)Using the dividends growth model, determine the market value of 1,000 shares held in Mbuvo
Fisheries Ltd. (TFL) as at 31 December 2001.

Discussion questions

(4) Discuss the nature of the factors which influence the dividend policy of a firm

(5) What is a stock split? Explain why it is used and how does it differ from bonus shares?

(6) Explain the different payout methods and how the shareholders react to the methods

(7) Explain the effects of a bonus issue and a share split on the earnings per share and
the market price of the share

(8) What is a stable dividend policy? Why should it be followed? What are the
consequences of changing a stable dividend policy?

CHAPTER 10:

FINANCIAL MARKETS
Objectives
At the end of this chapter you should be conversant with:

1. Meaning of financial markets.

2. Difference between money market and capital market.
3. Discuss the Nairobi Stock Exchange.
4. Terminologies used in the stock exchange market.
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5. Capital market authority (CMA)

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6. Money market instruments
7. The Dow theory.
8. Special financial institutions

FINANCIAL MARKETS
MEANING OF A FINANCIAL MARKET
A market can be defined as an organizational device, which brings together buyers and sellers. A
financial market is a market for funds. It brings together the parties willing to trade in a commodity,
which constitutes fluids. The respective parties in financial markets are known as demanders of funds
(borrowers) and suppliers of fluids (lenders) who come together to trade so as to meet financial
needs. The level of economic development of any country will be affected by the ability of the
financial markets to move surplus funds from certain economic units, which constitutes individuals
and corporate bodies to other economic units in need of additional funds.
Financial market can be divided into three categories: -

1. Capital and money markets.

2 Primary and Secondary markets
3. Organized and over — the counter markets.

I. 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
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place in the secondary market. The only distinction between primary and secondary markets is the

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form of security being traded but there is no physical separation of the markets.

2. 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.

3. 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 registered the NSE as a voluntary association
under society’s Act. It was registered as a limited liability company.

Advantages of stock exchange quotations

1. It’s easy for quoted companies to obtain underwriters when issuing shares. This is as a result of
wide market quoted for company shares. This is because of easier transferability of shares through
use of brokers.
2. Quotations attract investors in a share issue since they can easily dispose their shares.
3. It enhances public confidence. A quoted company is considered stable by investors and other
stakeholders; this can be useful in borrowing or other transactions relating to the company.
4 A quoted company will be able to get access to relevant information through the
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NSE and also able to get comparative data e.g. reflecting performance of other

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quoted companies.
5. In an inefficient market, a quoted company will be able to obtain up to date information or feedback
regarding share prices in stock exchange. Changes in
stock market prices will act as a signal as regard perceptions of the company.

ROLE OF NAIROBI STOCK EXCHANGE

I. NSE provides a market of securities. It provides a media through which securities can be bought
and sold.
2. Stock exchange enhances share price discovery through interaction of demand and supply forces
in the trading floor.
3 Stock exchange share index acts as indicator of economic performance.
4. Stock exchange allows provision of information both to the investors and industry. This is both for
quoted companies or other issues within the stock
market. This information is for investor decisions.
5. It enhances the transfer of share ownership among investors through financial facilitation’s role
played by the brokers

TERMINOLOGIES USED TN THE STOCK EXCHANGE

1. Cum dividend and Ex-dividend:
These prices are quoted when the company which has declared dividends has not paid
price per share is cum-div, this price include the additional value in form of
If the sellers offer the same cum-dividend then it means that the buyer will get both share to be sold
and dividend declared on it. A cum-dividend share is more expensive as compared to an ex- dividend
share. Ex-dividend means without dividend. In this case the buyer only gets the share sold. The
dividend declared on the share belongs to the seller.

2. Cum-rights and Ex-rights price

These prices are quoted where a company has declared a right issue. If the sellers have offered to
sell his share cum-right, it means that the buyer will be entitled not only to receive shares being
purchased but also rights declared not yet issued. Share prices are high at that issue. If the seller
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sold his shares ex-right it means that the buyer will only receive original shares and the sellers will not

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be entitled to receive each right issue on share.

3. Cum-cap and ex-cap.

The word cap stands for capital. This price applies when a company has announced a bonus issue
but it is not yet issued. If the buyer buys shares cum-cap he will be entitled not only to receive shares
being purchased but also right declared not yet issued. Share prices are high at that issue. If the
seller sold his shares ex-RIGHTS it means that the buyer will only receive original shares and the
sellers will be entitled to receive each right issue on share.

4 Cum - all price or ex- all price

Cum all means with dividends, with bonus or with rights. The purchaser of the security will be entitled
to dividends: declared bonus shares, and has a right to subscribe for additional shares. The share
price will thus reflect this additional value otherwise; share will sell at ex-all price.

5 Insider trading:

An insider is an individual who has access to such confidential information that is not yet available to
the public and which may be considered useful when making investments decision regarding the
company. Insider trading constitutes use of confidential information about listed company which is not
yet made public so as to take advantage himself or for other person connected directly or indirectly
with the company e.g. a managing director who has access to company’s information may get
information that the company is about to make huge losses and as a result dispose his shares or
advice another person accordingly before this information is made public. An insider is prohibited by
aw to use his privilege positions to make gains or manipulate the prices of the company’s securities
for personal gains.

6. Active securities
These are securities, which are most frequently traded at the stock exchange in Kenya.
Exchange constitutes the 20 most active companies in the NSE capitalization
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7. Bid and offer price
A bid is the highest price a security purchaser will be willing to purchase the security
whereas offer price is price at which the seller is wiling to sell the security.

8. Odd Lots
This arises when the number of share fall below the stipulated limit in NSE the minimum
Number is 100 shares. Below this, they are regarded as odd lots.
9. 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
.
10 Futures and Options.
These are instruments, which provide a means of hedging. Hedging is the process undertaking an
activity so as to minimize risk. Financial futures and options provide a means of reducing the risks
inherent within the financial market. A future is a contractual agreement entered between two parties
where one party promises to provide a security and the other party promises to buy the security at
some time in future. A future leads to an obligation(s).

ILLUSTRATIONS ON USE OF A FUTURE

(a) Future:
A has acquired a share in X limited at price of Shs. 50. He intends to sell the share after 12 months
but he fears that the market forces will make the prices fall below Kshs. 50 per share. He enters a
future contract with B where B promises to buy the share after 12 months at shs. 51 share. At the
material dates the price per share is shs. 54. A must deliver shares to B at Shs 51 as agreed.
However if the price is below shs. 51 per share B must buy the share at shs. 51. By use of future
contract A is guaranteed shs. 51 per share. The minimizes risks associated with future price
fluctuations.
(b) Options
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An option is a right to either buy or sell the security in future at a specified price. The buyer of the

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options has a right to exercise the options or otherwise ignore the option. there are two main types of
options:
i. Call option
This is a right to buy a security at a specified date within a specified period of time and at specified
place
A call option will be relevant if expectations are that the market prices will decline. He
will exercise the call option only if the market price exceeds the exercise price.
ii Put options:
This constitutes a right to sell a security at a specified price and at specified date or within a specified
period in future. A put option is relevant if the purchaser expects the market no to begged. He will
exercise the option only if markets price is less than the exercise price.
NB Exercise price is agreed at which the share will be purchased or sold.

NSE SHARES INDEX

An index is a measure of relative changes in s specified phenomena’s. It indicates changes in

variable over given period of time or between 2 periods. 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.
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Drawbacks of stock indices

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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.

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
THE ROLE OF CAPITAL MARKET AUTHORITY
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.
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
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4. The CMA acts as a watchdog for shareholders of listed company’s. This is through regulating the

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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.

OTHER STOCK EXCHANGE TERMS

I. BROKER:
Is an agent who buys and sells securities in the Market on behalf of his client on a commission basis.
He also gives advise 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 and 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:
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These are speculators in the market who believe that the main market movement is downwards

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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.

TRADING MECHAMSM IN NSE (NAIROBI STOCK EXCHANGE)

- NSE is dominated by brokers who are the investors link with the stock exchange.
- Potential investors approach brokers who guide them on the securities to invest in helps them to
determine the price they should pay for such
securities, and the most appropriate time to acquire them.
- Stock brokers bids for the share at the stock market on behalf of the investors.
The brokers then refer investors to the selling broker if the order is executed
- The stock broker thereafter send s a contract note to the buyer showing him the number of shares
purchased, the price per share, commission
chargeable and the total amount payable.
- A sale contract note is sent by selling broker to the seller of the shares.
The stockb1okers forwards to the buyer a transfer deed k for signature. The buyer signs the transfer
deed and returns it to the stock broker who sends it to the company registrar. The Registrar issues a
new share certificate on the name of the buyer through the stock
broker.

METHODS OF OBTAINING LISTING IN THE STOCK EXCHANGE

Methods of obtaining listing in the stock exchange are:
1. Offer satisfaction; Can be fixed or by tender and occurs where the issuing authority offers the
shares directly to the public using an intermediary.
2. Placing:
A sponsor buys the whole issue and then determines terms for sale to its own clients. Any unplaced
shares are sold to a second broker known as an intermediary.
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3. Introduction: Method available to companies that already have a good spread of share-holders or

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companies already quoted on an overseas exchange.
4 Tender offer.
Where shares are subscribed for using a bidding system.

INTERPRETATION OF STOCK EXCHANGE REPORTS:

WHY THE PRICE OF A SHARE CHANGES
Due to changes in supply and demand of shares:
The price of a share change would be as a result of the change of demand and supply of the
respective share. An increase in demand would lead to an increase in the price of the share and vice
- versa. An increase in supply leads to a reduction in the market price and vice-versa .The demand
and supply changes may be as a result of the following:

(a) Past performance of the company - This depends on the reported profit and loss levels of the
company. If a company reports enormous Losses, demand for the share will go down and supply will
increase and therefore price will fall.
(b) Expected performance of the company- This is normally used on shareholders (both existing and
potential) perception i.e. their expectation regarding the performance of the company in future e.g.
future profitability level.
(c) Economic level of performance - Economic factors that make individual ability to buy shares e.g.
income or exchange rates.
(d) Political climate in the country: This is normally relevant to the foreign investors. Lack of conducive
political climate may make purchases of a share risky investment thus reducing the demand.
(e) Rate of Return on alternative form of investments: - e.g. return on Treasury bill and fixed deposits
among others. A high alternative rate of
return will reduce demand of a share due to high opportunity costs.
i) CD against Kakuzi means that the shares were selling Cum-Dividend i.e. with dividend.
ii.) Das (-) implies that there was no trading on Express Kenya Ltd’s shares
iii) A Co may be suspended from the stock exchange because of the following reasons:-
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(a) Lack of adherence to set conditions: e.g. share capital maintenance i.e. if the company is not able

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to maintain the minimum authorized and issued
capital.
(b) Non-remittance of subscription to the NSE or CMA.
(c) Gross irregularities in the performance of company e.g. because of insider dealings.
(d) Non-provisions of quarter reports to the NSE or CMA i.e. lack of submission of financial
statements as required
NOTE: Suspension in the process through which company share are not quoted. If a company is
suspended from the NSE shares will not trade in the NSE for the period that the suspension is in
force i.e. in the period shares cannot be bought or sold through a broker.

iv) CB means share were sold Cum-Bonus.

v) Meaning of ordinary sh 10 means the par value of the shares.

MONEY MARKET INSTRUMENTS

These are instruments used to raise short-term funds from the market. They include
(a) TREASURY BILLS
These are government securities issued to:
(i) Cover government deficit
(j) Finance maturity debts
(k) Control inflation
These are usually sold on auction system at a discount which depends on the value and it maximum
period.
Yield in Treasury bills = face value— market value x 360
Face value No of days maturity

Main features.
1 .Maturity period is usually 1 year or less. If the period is more than one
year, then it is a treasury bond. In Kenya we have Treasury bill of 28 days (I month), 91 days
(3months) and 182 days (6 months).
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2 .Treasury Bills, in Kenya are denominated in terms of 50,000, 100,000,

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1,000,000 — 20,000,000 shillings etc.
3 .The yield on treasury bills is determined by the market forces through
competitive bidding.
4. Increase from the T.B’s is usually taxed at normal tax rate on interest on the part of the receiver.
5. They are usually risk-free securities because they are guaranteed by the government.
(b) CERTIFICATE OF DEPOSITS
These are certificates issued by a bank or non banking financial institution indicating that
a specified sum of money has been deposited there in:
The certificate bears the maturity date and a specified interest rate and can be issued in
any denomination.
They can be issued in bearer or non-bearer from:
(a) Bearer>. Any one who bears the certificate has a right to the money even if it has no name.
(b) Non bearer> has a name on it of the person to whom the money belongs i.e. depositor and may
not be transferable.
Tile interest rate on these is usually paid after maturity and the finds deposited
can be withdrawn before maturity but at a penalty.
Types of certificate of deposits:
(a) Normal CD — Issued by commercial banks
(b) Euro dollar CD — Dominated in US dollars/or foreign currency & issued by banks.
(c) Yankee CD — Denominated in US dollars and issued by a foreign bank having a branch in the
US.
(d) Thrift CD — issued by a non - banking financial institution.
(C) COMMERCIAL PAPERS
Consist of promissory notes issued by financially stable companies and sold to investors in the
market. They usually have a maturity period of less than one year and mainly sold on discount basis,
which has the effect of increasing the effective rate of interest.
Effect yield: = face value— market value x 360
Face value No of days maturity
Illustration:
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A company sells 120 days commercial paper with par value of shs. 10,000 but at shs.

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9.700 compute the effective yield on the paper
10000-9700 x 360/120 =9.3%
9700

- They can be discounted before maturity.

- They are negotiable due to the credit worthiness of the issuing co.
(D) BANKERS ACCEPTANCES
These are bills of exchange drawn in and accepted by the bank Usually, a bank’s customer under an
agreement with the bank draws a bill on the bank and the bank accept it. The bill becomes a banker’s
acceptance.
The bank charges acceptance commission and the drawer will have a two name bill,
i.e. his own and that of bank. This makes the bill a highly negotiable instrument.
Main features:
(i) Highly required because they can be discounted at any time especially by the accepting bank.
(ii) Usually sold on discounted basis
(iii) usually unsecured.
(iv) Mainly used to finance international transaction/trade due to the fact that there my not be enough
trust between the parties.
(v) Usually have a maturity period of less than one year, mostly 6 months or 3 months.
(E) INTER-BANK OVERNIGHT LOANS:
- This arises from the central bank’s requirement that Commercial Banks hold a specified level of
liquidity everyday. Commercial banks to meet at the clearing house (which is managed by the Kenya
Banker’s Association) and the bank with insufficient funds to borrow from those with excess and the
one with deficit to approach these with excess and negotiable terms of the loan.
Lending Banks instructs clearing house through a cheque or telephone to transfer some of its
deposits to the borrowing bank. Since these loans are authorized the borrowing bank serves on order
the following day transferring ownership back to the lending bank. Incase of illiquidties, the bank can
borrow from central bank.
- These are usually un-secured loans.
(F)RE-PURCHASE AGREEMENTS
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- Government security dealers may use repurchase agreements to increase their level of liquidity. Re-

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purchase agreement is a sale of short-term government security by the dealer to the investor where
the dealer agrees to re-purchase the securities at a specified future time.
- The investor receives a specified yield while holding the security.
- The maturity period may be fixed or left open in which case either the borrower or lender can
terminate the agreement at any time. Most re-purchase agreements are overnight although once for
as long as 6 months can be made.
(H)CAPITAL MARKET INSTRUMENTS
For issuing long-term funds.
They include:
i) Common share/ordinary share
(j) Preference share
(k) Debentures
(I) Treasury Municipal bonds
(m) Warrants & Convertible
(n) Terms loans
(o) Mortgages
STOCK MARKET EFFICIENCY
This refers the degree to which the securities reflect the market information in their prices. It’s the
capability of the securities to show and reflect all the relevant information. There are 3 forms of
market efficiency namely-
(i) The weak form efficiency
This type of market efficiency says that current share prices fully reflect all the information contained
in first price movements. The sequence of the price changes contains no information about the future
price changes. The prices of securities change in a random manner.
(ii) Semi strong form efficiency
The semi strong form of efficient market hypothesis states that current share prices show both the
past price movements and also the publicly available information. No trading strategies based on the
release of any public information ie earnings will enable an investor to generate abnormal returns.
Except by chance if the market is efficient in the semi strong sense a public announcement will some
reaction from the market and will highly affect the market prices.
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(iii) Strong form efficiency

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This type of market states that security prices reflect all the information available both public and
private at each point in time. The consequence of this is that no investor Even when the investor has
some inside information can device trading strategies based on such information so as to consistently
earn abnormal returns. This form of efficiency states that people such as stock specialists security
brokers and dealers who often have insider information cannot on average earn greater profits than
investors who don’t have have such information.

THE DOW THEORY

Charles dow the founder or the wall street journal developed among others the dow theory in the
early part of the century. According to Dow Theory the stock market is characterized by three trends
namely
1. Primary trend
2. The intermediate trend
3. Tertiary trends

Primary trend
This is the most important it refers to the long term movement in share prices i.e. movement in share
prices over a period of more than one year.
The intermediate trend
This trend runs for weeks or months before being reversed by another intermediate trend in the
opposite direction. If an intermediate trend is in the opposite direction to the primary trend, it is called
a secondary reversal or reaction. A primary trend is normally interrupted by a series of information
reversals.
Tertiary trends.
They last for a few days and are less important.
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SPECIAL FINANCIAL INSTITUTIONS.

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The major financial institutions in Kenya economy are commercial banks, savings and loans, credit
unions, savings banks, life insurance companies, pension funds, and mutual funds. These institutions
attract funds from individuals, businesses, and governments, combine them, and make loans
available to individuals and businesses. A brief description of the major financial institutions follows.

Institution Description

Commercial bank Accepts both demand (checking) and time (saving) deposits. Also offers
negotiable order of withdrawal (NOW), and money market deposit accounts.
Commercial banks also make loans directly to borrowers or through the financial
markets.

Saving and loan These are similar to a commercial bank except chat it may not hold demand
(checking) deposits. They obtain funds from savings, negotiable order of
withdrawal (NOW) accounts, and money market deposit accounts. They lend
primarily to individuals and businesses in the form of real estate mortgage loans.
Credit union Commonly known as Savings co-operative societies (Saccos), credit unions deal
primarily in transfer of funds between members. Membership in credit unions is
generally based on some common bond, such as working for a given employer.
Credit unions accept members’ savings deposits, NOW account deposits, and
money market account deposits and lend funds to members, typically to finance
automobile or appliance purchase, or home improvements.

Savings banks These are similar to a savings and loan in that it holds savings, NOW, and
money market deposit accounts. Savings banks lend or invest funds through
financial markets, although some mortgage loans are made to individuals.
Life insurance

Company It is the largest type of financial intermediary handling individual savings. It

receives premium payments and invests them to accumulate funds to cover future
benefit payments. It lends funds to individual, businesses, and governments,
typically through the financial markets.
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Pension fund Pension funds are set up so that employees can receive income after retirement.

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Often employers match the contribution of their employees. The majority of funds
is lent or invested via the financial market.

Mutual fund Pools funds from the sale of shares and uses them to acquire bonds and stocks
of business and governmental units. Mutual funds create a professionally
managed portfolio of securities to achieve a specified investment objective, such
as liquidity with a high return. Hundreds of funds, with a variety of investment
objectives exist. Money market mutual funds provide competitive returns with
very high liquidity.

Unit trusts

Financial Markets
Financial markets provide a forum in which suppliers of funds and demanders of funds can transact
business directly. Whereas the loans and investments of intermediaries are made without the direct
knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their
funds are being lent or invested. It is important to understand the following distinctions in the market.
Money versus Capital markets. The two key financial markers are the money market and the capital
market. Transactions in the money market take place in short-term debt instruments, or marketable
securities, such as Treasury bills, commercial paper, and negotiable certificates of deposit. The
market brings together government units, households, businesses and financial institutions who have
temporary idle funds, and those in need of temporary or seasonal financing.
Long-term securities—bonds and stocks—are traded in the capital market. The main actor in the
capital markets is the securities exchanges, which provide the market place in which demanders can
raise long-term funds and investors can maintain liquidity by being able to sell securities easily. The
Nairobi Stock Exchange (NSE) was established in 1954 and is one of the most active stock markets
in sub-Saharan Africa. It currently (2005) has 48 companies listed and 20 brokerage company
members.
Private placements versus Public offerings. To raise money, firms can use either private placements
or public offerings. Private placement involves the sale of a new security issue, typically bonds or
preferred stock, directly to an investor or group of investors, such as an insurance company or
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pension fund. However, most firms raise money through a public offering of securities, which is the

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nonexclusive sale of either bonds or stocks to the general public,
Primary market versus Secondary market. All securities, whether in the money or capital market, are
initially issued in the primary market (Initial public offerings ( IPOs) and seasoned equity offerings
(SEOs)). This is the only market in which the corporate or government issuer is directly involved in
the transaction and receives direct benefit from the issue. That is, the company actually receives the
proceeds from the sale of securities. Once the securities begin to trade in the stock exchange,
between savers and investors, they become part of a secondary market. The primary market is the
one which “new” securities are sold; the secondary market can be viewed as “used,” or “pre-owned,”
securities market.

OTHER SPECIALISED FINANCIAL INSTITUTIONS

1 .Industrial and commercial Development Corporation (LC.D.C)
I. C.D.C was established in 1954 by the government. Its main objective was to promote industrial &
commercial development in Kenya.
Its specifically provides financial or technical assistance to small enterprises. Financial assistance
may be in the form of working capital financing or purchase of fixed assets. This may take the form of
equity or debt financing. Equity is provided by large-scale enterprises with more than 50 employees.
Loans are given to both small and medium
sized enterprise. Long-term loans repayment period is 6 years for industrial and up to 10 years for
commercial loans
2 ) Agricultural finance corporation (AFC)
it was established by the government in 1963. The main objective is to provide support for the
agricultural sector. This is through provision of short term and long-term loans. The loans must be for
a defined project by a farmer. Loans may be short term or long term and there exist flexibility to allow
its repayment.
3) Kenya Industrial Estate (KIE)
It was established in 1967
At inception it was a wholly owned subsidiary of ICDC. However in 1978 it was separated from ICDC
and become an independent body as a parastatal under the ministry of industry.
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The main objective of K1E is to assist in the development of new projects and the expansion and

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modernization of new business enterprise. This is through the provision of finds and technical
assistance. They provide both debt and equity finance.
4) Kenya Tourist Development Corporations: (KTDC)
The KTDC was established in 1960’s. Its main responsibility was carrying out Investigations,
formulation and study of projects development of the tourism industry
KTDC Provides financial assistance in forms of loan, for tourism related enterprises. It has substantial
share —holdings in local hotels, which includes Hilton, Serena, and Pan Africa etc.
5) Industrial Development Bank (IDB)
Was established in 1963 as a limited company. The main objective of setting this
Institution was to promote industrial development in Kenya through the establishment promotion and
expansion of small or large-scale enterprises. This is through financial assistance .n the form of
loans, provision of guarantee and securities and underwriting
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6) Hire — purchase financial companies
These are institutions, which provides assets on credit with an arrangement to pay the principal and
interest in installment basis. However, the legal ownership of the assets remains with the hire-
purchase company. The title is transferred when the last installment is made. Hire Purchase
Company’s in Kenya include- Kenya finance corporation (KFC), Pan-Afric credit finance Ltd,
Investment and mortgage Ltd. etc.
7) Insurance Companies
The main role of insurance companies is to assist individuals and corporate bodies safeguard against
future risks. May also engage in other activities. The main capital for insurance companies is the
premium paid by the policy holders.
Forms of Insurance Company’s in Kenya includes: - Life Insurance, Third party insurance etc.
Examples of Insurance company’s in Kenya include: jubilee insurance company, pan African
insurance company, Blue shield insurance Co. Ltd. etc.
8) Building societies/Housing finance Co:
These ale financial institution, which provide finance to the public so as to purchase or construct
houses. The individual or corporate bodies make deposit upon which they later receive loan for
acquiring or constructing house. Some buildings societies in Kenya include: Housing finance
corporation (HFC), East African building society and Pioneer building society.
9) Pension and provident scheme institution
These institutions obtain funds from both employees and employers of contribution. They manage
and invest these funds so as to meet the current and future obligations of the pension scheme to its
members.
10) Merchant Banks
It originated and also derives its name from the activities of wealth merchants who provided credit for
the trading ventures. The ventures were for small-scale merchants. Before the establishment of
banking systems in the 19th century, the merchants changed their role of merchants and started
offering financial service. Today merchant banks performs the role of underwriting and assisting
companies to raise capital in the financial markets They underwrite the security issues, buy and sell
securities and provide advice in Investment in securities.
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Reinforcing questions
1. (a) (i) What is financial intermediation? (3 marks)

(ii) Identify any five services that financial intermediaries provide. (5 marks)

(b) What economic advantages are created by the existence of:

(i) Primary markets. ( 3 marks)

(ii) Secondary markets ( 3 marks)
(iii) Portfolio management firms. ( 4 marks)

(c) Explain how the Capital Authority can ensure:

(i) Faster growth and development of the Nairobi Stock Exchange or Stock Exchange in
your country. (6 marks)

(ii) Development of other stock exchanges in Kenya or in your country. (4 marks)

(d) (i) What is a stock exchange index? (2 marks)

(ii) Outline four drawbacks of the Nairobi Stock Exchange index. (4 marks)

(e) Highlight four advantages and disadvantages to a company of being listed on a stock
exchange. (8 marks)

(f) In relation to the stock exchange”

(i) Explain the role of the following members:

∑ Floor brokers ( 2 marks)

∑ Market makers ( 2 marks)
∑ Underwriters ( 2 marks)

(ii) Explain the meaning of the following terms:

∑ Bull and bear markets ( 2 marks)

∑ Bid-ask spread ( 2 marks)
∑ Short selling ( 2 marks)
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ANSWERS TO REINFORCING QUESTIONS
Chapter 1.

Nature of business Finance

1.
(a An agent is an individual or party acting on behalf. In the context of public
) limited agency relationship may take two main forms.

(i) Agency relationship between Shareholders and Management.

The shareholders are the owners of the company through equity capital
contribution. However, they may not be involved in management. The
shareholders may not have the necessary skills or time required. As a
result, they appoint other parties to run the company on their behalf
(managers). The shareholders are the principles and the management
constitutes the agents.

(ii) Agency relationship between the shareholders and creditors.

The creditors are the contributors of debt capital They are not allowed to
be involved in management of the company directly. After provision of
funds the shareholders are expected to manage the funds along with the
management on behalf of the creditors. The creditors constitute the
principles and the shareholders the agents.

The management may be involved in funds and irregularities. This will

reduce the net earnings accruing to the shareholders.
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(iii) Other agency relationship is between shareholders and government

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auditors, employees and consumers.

(b - Use of performance based reward/compensation

) - Threats of firing
- Contractual based employment
- Introduction of share ownership plans for employees
- Incurring agency costs or monitoring costs to avoid or minimize agency
problem – eg audit fees.
- Threat of takeover

(2i) Borrowing additional debt capital which take priority charge in case of
liquidation

(ii) Disposal of assets used as collateral for loans

(iii) Payment of high dividends which reduce the cash for investment.

(iv) Asset substitution

If a firm sells bonds for the stated purposes of engaging in low variance
projects, the value of the shareholders equity rises and the value of
bondholders claim is reduced by substituting projects which increase
the time variance rate.

(v) Under investment

A firm with outstanding bonds can have incentive to reject projects

which have a positive NPV if the benefit form accepting the project
accrues to the bondholders.

Inadequate disclosure

Sale of assets used to secure creditors

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Restructure bond covenants include the following:

(i) Restriction on investments, flats profits movement in such risky

ventures. The aim to discourage assets substitution.

(ii) Restriction to disposition of assets require that the firm should not
dispose of substantial part of its properties and assets.

(iii) Securing debts give bondholders title to pledge bonds until assets are
paid.

(iv) Restrictions on mergers. Mergers may affect the value of claims.

(v) Covenants restricting payments of dividends a limit in distribution is

placed.

(vi) Covenants restricting subsequent financing restrict issue of additional

debt

(vii) Covenants modifying pattern of payment to bondholder

∑ Sinking fund
∑ Convertibility provisions
∑ Collability provisions

(viii) Bonding requirement

∑ Purchase of insurance
∑ Certificates of compliance
∑ Specification of accounting technique.

3.

(a) Agency costs

These are cost borne by shareholders of an organization as a result of not

being directly involved in decision making, when the decisions are made by
the directors. Agency costs are incurred when management decisions are
based on the interests of directors rather than shareholders.

Examples of agency costs.

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(i) Expenditure for external audit incurred by the organization

(ii) Installation of systems of internal control and internal audit

(iii) Opportunity costs of foregone projects which are perceived by

management to be too risky.

(iv) ‘Perks” and incentives paid by the organization to make directors act
the best interests of shareholders.

4. (a) Agency relationships

Shareholders and management

In this case the shareholders act as the principal while the management acts as their agents.
The shareholders provide equity capital while the managers provide managerial skill.

Shareholders and creditors

In this case the shareholders act as the agent and the creditors act as the principal.

The relationship arises from the fact that though the creditors provide debt capital to the
various operations of the firm, they do not make decisions.

Shareholders and the government

Any shareholder will rely on the establishment existing in a specific country in undertaking any form of
business and reliance will be made on the government services. In this case the government expects
the owners to reciprocate by avoiding engagement in activities which would be in conflict with societal
expectations. The government will act as the principal and the shareholders will act as the agent who
is expected to consider the government interests.

(b) (i) The goal of profits maximization involves maximizing the accounting
profits by either increasing sales (selling price) or reducing costs

- Profits = Sales revenue – Costs

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- In a competitive environment, firms are operating at 100%

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capacity hence volume/ production cannot be increased thus
sales revenue can be increased through increase in selling price
∑ Shareholding wealth maximization includes maximizing the
share price by undertaking all projects yielding the highest net
present value (N.P.V)
- The focus is to maximize the P.V of Cashflow where
n

N.P.V = Â Ct /( 1 + K)n - Io

t =1

Where Ct = cashflows during period t

K = Discounting rate

Io = Initial capital

Limitations of profit maximization goal

- It’s vague or unclear: does it refer to gross profits, operating

profits, net profits, long term or short term profits e.t.c
- It ignores the time value of money
- It ignores risk and uncertainty of benefits/ profits received in
future
- It ignores the plight of other stakeholders such as consumers
(ii) and employees and only consider the owners
- It is a short term goal e.g. cost reduction or increase in selling
5. price is short term measure

(a) ß Welfare of employees. A company might try to provide

good wages and salaries, comfortable and safe
working conditions, good training and career
development etc.

ß Welfare of management. Managers will often take

decisions to improve their own circumstances. Their
decisions have the effect of incurring expenditure and
reducing profits.

ß Welfare of society as a whole. Many companies

participate in social and environmental activities which
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are meant to improve the social welfare of the society

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as a whole. Such activities incur costs.

ß Fulfillment of responsibilities towards customers and

suppliers.

- Customers will need to be provided with products

and services of the standard of quality that they
demand. They will also expect the company to
be honest and fair in its dealing with them.
- The company needs to maintain relationships
with suppliers.

ß Business ethics e.g no tax evasion, no bribery, fair

employment practices and policies.

(b) ß Management might learn about the shareholders

preference for either high dividends or high retained
earnings for profits and capital gain.

ß Recent share price movements can be explained by

changes in share holdings.

ß Enables them to know their attitudes towards risks and

gearing.

(c) (a) The range of stakeholders may include: shareholders,

directors/managers, lenders, employees, suppliers and
customers. These groups are likely to share in the wealth
and risk generated by a company in different ways and thus
conflicts of interest are likely to exist. Conflicts also exist not
just between groups but within stakeholder groups. This
might be because sub groups exist e.g. preference
shareholders and equity shareholders. Alternatively it might
be that individuals have different preferences (e.g to risk and
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return, short term and long term returns) within a group.

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Good corporate governance is partly about the resolution of
such conflicts. Stakeholder financial and other objectives
may be identified as follows:

Shareholders

Shareholders are normally assumed to be interested in

wealth maximization. This, however, involves consideration
of potential return and risk. Where a company is listed this
can be viewed in terms of the share price returns and other
market-based ratios using share price (e.g price earnings
ratio, dividend yield, earnings yield).

Where a company is not listed, financial objectives need to

be set in terms of accounting and other related financial
measures. These may include: return of capital employed,
earnings per share, gearing, growth, profit margin, asset
utilization, market share. Many other measures also exist
which may collectively capture the objectives of return and
risk.

Shareholders may have other objectives for the company and

these can be identified in terms of the interests of other
stakeholder groups. Thus, shareholders, as a group, might
be interested in profit maximization; they may also be
interested in the welfare of their employees, or the
environmental impact of the company’s operations.

Directors and managers

While directors and managers are in essence attempting to

promote and balance the interests of shareholders and other
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stakeholders it has been argued that they also promote their

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own interests as a separate stakeholder group.

This arises from the divorce between ownership and control

where the behaviour of managers cannot be fully observed
giving them the capacity to take decisions which are
consistent with their own reward structures and risk
preferences. Directors may thus be interested in their own
remuneration package. In a non-financial sense, they may
be interested in building empires, exercising greater control,
or positioning themselves for their next promotion. Non-
financial objectives are sometimes difficulty to separate from
their financial impact.

Lenders

Lenders are concerned to receive payment of interest and

ultimate repayment of capital. They do not share in the
upside of very successful organizational strategies as the
shareholders do. They are thus likely to be more risk averse
than shareholders, with an emphasis on financial objectives
that promote liquidity and solvency with low risk (e.g gearing,
interest cover, security, cash flow).

Employees

The primary interest of employees is their salary/wage and

security of employment. To an extent there is a direct conflict
between employees and shareholders as wages are a cost to
the company and a revenue to employees.

Performance related pay based upon financial or other

quantitative objectives may, however, go some way toward
drawing the divergent interest together.
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Suppliers and customers

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Suppliers and customers are external stakeholders with their
own set of objectives (profit for the supplier and, possibly,
customer satisfaction with the good or service from the
customer) that, within a portfolio of businesses, are only
partly dependent upon the company in question.
Nevertheless it is important to consider and measure the
relationship in term of financial objectives relating to quality,
lead times, volume of business and a range of other variables
in considering any organizational strategy.

Chapter 2

Financial statement analysis.

1.(a) Limitations of ratios

- They are based on historical data

- They are easy to manipulate due to different accounting policies adapted
by the firms
- They are only quantitative measures but ignore qualitative issues such as
quality of service, technological innovations etc
- They constantly change hence are computed at one point in time e.g.
liquidity ratios change now and then
- They don’t incorporate the effect of inflation
- They don’t have standard computational purposes, firms are of different
sizes

(b) Ratio Formulae Computation

(i) Acid test ratio Current Asset-stock = 205.9 - 150 =

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Current Liabilities 138.3

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(ii) Operating EBIT/Operating profit x 100 = 53 + 4 x 100 =
profit ratio
Sales 900

(iii) Net Profit after Tax x 100 = 88.9 x 100 =

Return on total
capital Sales 900
Employed

(iv) M.P.S = 20
Price Earning EPS (88.9 - 4.8)/10m
ratio shares

= 20/8.41 = 2.38 times

Interest = (53 + 4)/4

(v) coverage ratio EBIT/Interest changes
= 14.25 times

(vi) Total Asset Sales/ Total Assets =900/213.9+205.9

Turnover
= 2.14 times

(c) Working capital Stockholding Debtors Creditors

cycle= period +collection
-payment
period
period

Stockholding Average
period = debts
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Cost of sales x 365 =(210x150)½ x 365 =91.25

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720

Debtors Average x 365 = 35.9 x 365 = 21.84

collection period creditors
= 600
Credit sales

Creditors Average x 365 = 60 x 365 =

payment period creditors (33.18)
= 660
Credit
purchases

79.91
Working capital / Cash operating cycle
80
days

2. Ratio Formular 1998 1999 2000

Acid test/ 30 + 20 + 5 + 290__

CA – Stock 200__ 260__
Quick ratio CL 380 + 225 +
230 + 200 + 300 + 210 + 140
100 100

= 0.396
= 0.43 = 0.46

Av. 200 x 365 260 x 365 290 x 365

Debtors Av. Debtors x
collection 365 4000 4300 3800
period CV sales p.a.

= 18.25 = 22.07 = 27.86

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Inventory 3200 3600 3300

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Turnover Cost of
Sales___ 400 480 600
Av. Closing
stock
=8 = 7.5 5.5

Debt/Equity 350__ 300__ 300__

Fixed charge
capital 100 + 500 100 + 550 100 + 550
Equity

= 0.5 = 0.46 = 0.46

Ratio NP 300x 100 200x 100 100x 100

margin NP x 100 4000 4300 3800
Sales

= 7.5% = 4.7% = 2.63%

ROI = 300 x 100 200 x 100 100 x 100

ROTA NP___
Total Assets 1430 1560 1695

= 20.98% = 12.82% = 5.90%

Note:

(i) All sales are on credit since they are made on terms of 2/10 net 30 i.e pay within 10
days and get a 2% discount or take 30 days to pay without getting any discount.

(ii) Debtors = Account Receivable while ordinary share capital = common stock.
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(iii) Current Asset - Stock = Cash + Accounts receivable

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(b) When commenting on ratios, always indicate the following:

(i) Identify the ratios for a given category e.g when commenting on deficiency, identify
efficiency or turnover ratios.

(ii) State the observation made e.g ratios are declining or increasing in case of trend or
time series analysis.

(iii) State the reasons for the observation.

(iv) State the implications of the observation.

Comment on liquidity position:

- This is shown by acid test/quick ratio

- The ratio improved slightly in 1999 but declined in year 2000.

- The ratio is lower than the acceptable level of 1.0

This is due to poor working capital management policy as indicated by increasing

current liabilities while cash is consistently declining.

- The firms’ ability to meet its set financial obligations is poor due to a very low quick ratio.

Comment on profitability position:

- This is shown by net profit margin and return on total assets.

- Both ratios are declining over time

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- This is particularly due to decline in net profits thus decline in the net profit margin and

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increase in total accounts as net profit decline thus reduction in ROTA.

- The firm’s ability to control its cost of sales and other operating expenses is declining
over time e.g Sales – Net profit will indicate the total costs.

These costs as a percentage of sales are as follows:

1998 Sales – Net profit x 100 = 4,000 – 300 x

100
Sales
4,000

= 92.5%

1999 4,300 – 100 x 100 = 95.3%

3,800

2000 3,800 – 100 x 100 = 97.5%

3,800

Comment on gearing position:

- This is shown by debt/equity ratio

- This was 50% in 1998 and declined to 46.2% in 1999 and 2000

- It has been fairly constant

- This is due to the constant long term debt and ordinary share capital

- The decline in 1999 and 2000 was due to increase in retained earnings

Generally the firm has financed most of its assets with either short term or long term debt i.e
current liabilities + long term debt
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Example: the total liabilities (long term debt + Current liabilities) as a percentage of total assets
are as follows:

3. a) i) Inventory turnover ratio = Cost of sales

Average stock (closing stock)

= 1,368,000 = 2.1 times

649,500

ii) Times interest earned ratio = Operating profit EBIT)

Interest charges

= 105,750 = 3.1 times

34,500

iii) Total assets turnover = Sales

Total Assets

= 1,972,500 = 1.6 times

1,233,750

iv) Net profit margin = Net profit (profit after tax) x 100

Sales

= 42,750 x 100 = 2.2%

1,972,500
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i.e 2.2% is the net profit margin

97.8% is the cost of sales.

b) Industrial analysis

- Industrial analysis involve comparison of firm performance with the industrial average
performance or norms.

- This analysis can only be carried out for a given year. I.e

Times series/trend analysis

- This involve analysis of the performance of a given firm over time i.e ratio of different
year of a given Co. are compared in order to establish whether the performance is
improving or declining and in case a weakness is detected e.g decline in liquidity ratio,
this will force the management to take a corrective action.

- When commenting on industrial and trend analysis the following 4 critical points should
be highlighted:

a) In case of individual ratio classify them in their immediate category e.g when
commenting on TIER indicate this in a gearing ratio.

When commenting on a given category of ratio identify the ratios in that category
e.g if required to comment on liquidity position identify the liquidity ratio from the
ratios computed.
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b) State the observation made e.g total asset turnover is declining or increasing

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over time (in case of trend analysis) or the ratio is lower or higher than the
industrial norms (in case of industrial analysis).

c) State the reason for observation i.e. explain why the ratio is declining or
increasing.

d) State the implication for observation e.g decline in liquidity ratio means that the
ability of the firm to meet in short term financial obligation is declining over time.

ABC Ltd.
Ratio Industrial Norm
Inventory Turnover 2.1 6.2

Times interest earned ratio 3.1 5.3

Total Asset turnover 1.6 2.2

Net profit margin 2.2% 3%

i) Inventory turnover

- This is a turnover or efficiency ratio

- The rate is lower than industrial norm

- A low stock turnover could be attributed to:

i) Charging higher price than competition

ii) Maintenance of slow moving/obsolete goods

iii) Where the firm is selling strictly on cash while

competitors are selling on credit.

- The firm is not efficiently utilising its inventory to generate sales

revenue.
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ii) Times interest earned ratio (TIER)

- This is a gearing ratio

- It is lower than industrial average or norm

- This could be due to low operating profit due to high

operating expenses or high interest charges due to high level of

gearing/debt capital.

- This implies that the firm is using a relatively high level of fixed
charge capital to finance the acquisition of assets.

iii) Total asset turnover

- This is efficiency ratio/activity

- Lower than industrial average

- This could be due to holding large non-operational or fully

depreciated asset which are not utilised by the firms.

- This implies inefficiency in utilisation of total assets to generate

sales revenue.

iv) Net profit margin

- Is a profitability ratio

- Lower than industrial norm

- This could be due to low level of net profit of the firm

relative to sales revenue.

- This implies that the firm has a low ability to control its cost of sales,
operating & financing expenses e.g in case of ABC Ltd selling &
admin expenses are equal to 82.5% of gross profit
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498,750 x 100

604,500

- Also the cost of sales expense is 69.4% of sales i.e

1,368,000 x 100

1,972,000

1998 230+ 200 + 100 + 300 x = 58.04%

100

1,430

1999 300 + 210 + 100 + 300 x = 58.33%

100

1,560

∑ 2000 ∑ 380 + 225 + 140 ∑ = ∑ 61.65%

+ 300 x 100

o 1,695

Chapter 4

COST OF CAPITAL

1. (a) Cost of capital

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∑ This is the rate used to discount the future cash flows of a business, to determine the

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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.

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.
(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.

2.

(a) Cost of debt K1

1000 - N d
1+
Kd = n
N d + 1000
2
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I = 0.1 x 1000 = 100

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Nd = 1000 – 30 discount – 20 floatation costs = 90

n = 10 years

1000 - 950
100 + = 10.8%
10

950 + 1000
2

K1 = Kd(1 – I)0.108(1 – 0.3)

0.108(0.7) = 7.56%

Cost of preferred stock Kp

Dp
Kp =
Np

Dp = 0.11 x 100 = 11

Np = 100 – Sh.4 floatation cost = 96

Kp = 11 = 11.5%
x100
96
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Cost of retained earnings

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Kr = Ks = D1
+g
Po

6 = 7.5% + 6% = 13.5%
x100 + 6%
80

Cost of new common stock Kn

Kn = D1
+g
No

D1 = Sh.6, g = 6%, Nn = 73

Kn = 6 = 8.219% + 6%= 14.219%

x100 + 6%
73

(b) Break occurs at:

225,000 = Sh.450,000
0.5

(c) (i) WACC before exhausting retained earnings.

= 0.4 x 7.56% + 0.1 x 0.5 x 13.5% = 10.9%

(ii) With external equity

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3.024 + 1.15 + 7.11 = 11.28%

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(d) 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.

3.

(a) Real rate = risk free rate – inflation rate.

Risk free rate is the interest rate on Treasury bills

Real rate = 12% - 8% = 4%

(b) The minimum required rate of return for each investor is the cost of each capital component to
the firm.

Cost of preference shares, Kp

Since market price of a preference share is equal to par value

then Kp = coupon rate = 15%.

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Cost of debentures = (Kd)

The debentures have a maturity period of 20 years (1985 – 2005). Therefore Kd is equal to
yield to maturity (YTM)

M = Maturity/redemption value = Sh.1,000

Vd = Market value = Sh.950

n = Interest period = 20 years

Int = Interest after tax = 16%(1 – 0.4) x 1000 = Sh.96

Int + (M - Vd) 1 96 + (1000 - 950) 1

Therefore Kd = n = 20
(M + Vd) 1 (1000 + 950) 1
2 2

101
= x100 = 10%
975

Cost of equity Ke

Since growth rate is given, use dividend yield growth model to determine Ke

d o (1 + g )
Ke = +g
Po

Where: g = growth rate = 10%

Po = Current market price = Sh.75

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do = dividend per share for last year = 2.50 + 3.00 = 5.50

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5.50(1.10)
Ke = + 0.10 = 0.18 x 100 = 18%
75

(c) Overall or composite cost of Capital is the weighted average cost of capital (WACC). It is
based on market values.

Sh.25m
Market value of equity = Sh.75 x (E) Sh.187.5m
Sh.10par

Sh.31.250m
Market value of debentures = Sh.950 x (D) Sh.29.7m
Sh.1000par

Market value of preference shares = Par value (f) = Sh.12.5m

Total market value, V = E + D + P Sh.229.7m

Ke = 18%

Kd = 10%

Kp = 15%

ÊEˆ ÊDˆ ÊPˆ

WACC = Ke Á ˜ + Kd Á ˜ + K p Á ˜
ËV¯ ËV¯ ËV¯

Ê 187.5 ˆ Ê 29.7 ˆ Ê 12.5 ˆ

= 18Á ˜ + 10Á ˜ + 15Á ˜ = 16.80%
Ë 229.7 ¯ Ë 229.7 ¯ Ë 229.5 ¯
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(d) Weaknesses of WACC

- It is based on assumption that the firm has an optimal capital structure (mix of debt and
equity) which is not achievable in real world.

- Market values of capital will constantly change over time hence change in WACC.

- It can be used as a discounting rate on assumption that the projects risk is equal to the
firm’s business risk otherwise it will require some adjustment.

It is based on historical data e.g growth rate in dividends is based on past date. The growth rate
cannot be constant p.a. in perpetuity.

Chapter 5

CAPITAL BUDGETING DECISIONS

1. (a). Importance of capital budgeting decision

- They have long term implications to the firm e.g. they influence long
term variability of cashflows
- They are irreversible and very costly to reverse
- They involve significant amount of initial capital.

(b) Difficulties faced in capital budgeting

- Uncertainty of variables e.g annual cash flows, discounting rates, changes in

technology, inflation rate, changes in tax rates etc.

- Lack of adequate capital to undertake all viable profits (capital rationing)

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- Lack of adequate information on the available investment opportunities e.g in case of

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mutually exclusive profits NPV and IRR will have conflict in banking of profits under
some circumstances.

- Identification of all the quantifiable and non quantifiable costs and benefits association
with a project.

(c) Features of an ideal investment appraisal method

- Should consider time value of money

- Should utilize cash flows in project appraisal
- Should give absolute decision criterion whether to accept or reject a
project
- Should rank independent projects in order of their economic viability
- Should distinguish between acceptable and unacceptable projects if
they are mutually exclusive.

(d) Why cash flows are considered to be more relevant for the following
reasons:

= They are not affected by the accounting policies adopted in preparing

financial statements

= Cash flows rather than profits determine the viability of any project

= Accounting profits include some non-cash items such as depreciation

which are irrelevant in the investment decision.

= Cash flows are not affected by accounting standards. They are also
easier to measure/ascertain.
= It is in line with shareholders wealth maximization objects

do (1 + g)
(2.) (a.) Cost of equity (ke) = +g
Po

6.50
=
50 + 0.07
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= 20%

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(b) Project X

Year Cash flows PVIF20%, n P.V

1 2,000,000 0.833 1,666,000

2 2,200,000 0.694 1,526,800

3 2,080,000 0.579 1,204,320

4 2,240,000 0.482 1,079,680

5 2,760,000 0.402 1,109,520

6 3,200,000 0.335 1,072,000

7 3,600,000 0.279 1,004,400

TOTAL P.V 8,662,720

Less initial capital (8,000,000)

N,P.V. (+ve) 662,720

Project Y

Year Cash flows PVIF20%, n P.V

1 4,000,000 0.833 3,332,000

2 3,200,000 0.694 2,082,000

3 4,800,000 0.579 2,779,200

4 800,000 0.482 385,600

8,578,800

(8,000,000)

578,000

(c) Project X

N.P.V @ 24% = -296,120

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N.P.V @ 20% = 662,720

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662,720
(24% - 20%)
662,720 + 296,120
I.R.R = 20% +
22.8%

= 20% + 2.8 =
-94,400
Project Y
578,000
25% =

N.P.V @ 20% =
Ê 578,000 ˆ
N.PV @ Á ˜(25% - 20%)
Ë 578,000 + 94,400 ¯
20% +

I.R.R =

20 + 4.3 = 24.3%

(d) - N.P.V method ranks project X as number one

- I.RR method ranks project Y as number one

- There is conflict in ranking of mutually exclusive projects

(e) Conflict between N.P.V and I.R.R

- Incase of difference in economic lives of projects

- Incase of difference in size of the projects
- Incase of difference in timing of cash flow
- Incase of non-conventional cash flows

3. Depreciation p.a. = 20% x 2,200,000 = 440,000

Prepare a cash flow schedule:

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1 2 3 4 5
Year
Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’

Sales 1,320 1,440 1,560 1,600 1,500

Less operating costs 700 700 700 700 700

EBPT 620 740 860 900 800

Less depreciation 440 440 440 440 440

EBT 180 300 420 460 360

Less tax @ 35% 63 105 147 161 126

EAT = accounting profits 117 195 273 299 234

Add back depreciation 440 440 440 440 440

Cash flows 557 635 713 739 674

Screening Criteria

1. The net commitment of funds should not exceed 4 years i.e the payback period should at least
be 4 years. Therefore, compute the payback period.

Year Cash flows Accumulated Cash flows

1 557 557

2 635 1,192

3 713 1,905

4 739 2,644

5 674 3,318
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The initial capital of Sh.2,200,000 is recovered after year 3. After year 3 (during year 4) a total

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of Sh.295,000 (2,200 – 1,905) is required out of the total year 4 cash flows of Sh.739,000.
295
Therefore payback period = 3yr s + = 3.4 yrs
739

2. The time adjusted or discounted rate of return is the I.R.R of the project. Discount the cash
flows at 15% cost of capital given:

1
Recall discounting factor (PVIF) = (1 + r ) -n =
(1 + r )n

Cash PVIF15% PVIF14%,n P.V.

Year flows P.V

‘000’

1 557 0.870 484.59 0.877 488.49

2 635 0.756 480.06 0.770 488.95

3 713 0.658 469.15 0.675 481.28

4 739 0.572 422.71 0.592 437.49

5 674 0.497 334.98 0.519 349.81

Total P.V. 2,191.49 2,246.30

Less initial capital 2,200.00 2,200.00

N.P.V. (8.51) 46.30

Since the NPV is negative at 15% cost of capital rediscount the cash flows again at a lower
rate, say 14%, to get a positive NPV.

NPV @ 14% = 46.3

NPV @ I.R.R. = 0
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NPV @ 15% = -8.51

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46.3 - 0
I.R.R. = 14% + ( 15% - 14% )
(
46.3 - - 8.51 )

46.3
= 14% + (1%) = 14.85%
54.81

3. The unadjusted rate of return on assets employed is the accounting rate of return.

ARR = Average accounting profits (EAT) x 100

Average investment

117 + 195 + 273 + 299 + 234

Average accounting profits =
5yr s

= 223.6 p.a.

Average investment = (Initial capital + Salvage value)½

= (2,200 + 0)½

= 1,100

223.6
A.R.R = x100 = 20.3%
1,100
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4. (a) I.R.R. for projects B, C and D

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Project B

This has 15 years economic life and an annuity of Sh.50,000.

Therefore 50 x PVAFr%,15 = 250

250
PVAFr%,15 = =5
50

From PVAF table at 15 period, a PVAF of 5.000 falls between 18% and 20%

Rate PVAF

18% 5.092

I.R.R 5.000

20% 4.676

Ê 5.092 - 5.000 ˆ
I.R.R = 18 + Á ˜(20 - 18 ) = 18 + 0.44 = 18.44%
Ë 5.092 - 4.676 ¯

Project C

175 x PVAFr%,5 = 500

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500
PVAFr%,5 =

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= 2.875
175

At 5 periods, a PVAF of 2.875 falls between 20% and 24%.

Rate PVAF

20% 2.991

I.R.R 2.875

22% 2.864

Ê 2.991 - 2.875 ˆ
I.R.R = 20 + Á ˜(22 - 20 ) = 20 + 1.83 = 21.83%
Ë 2.991 - 2.864 ¯

Project D

Computation of I.R.R of a project whose cash flows do not depict any annuity pattern.

We use the weighted average method e.g Project D does not depict any annuity pattern.

Steps:

1. Compute the weighted average cash flows

Year Cash flows Weights Weighted cash

flows

1 0 9 0
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2 0 8 0

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3 0 7 0

4 0 6 0

5 0 5 0

6 500 4 2000

7 500 3 1500

8 500 2 1000

9 500 1 500

45 5000

Weighted cash inflows:

= Ʃ Weighted cash flows

Sum of the weights

5,000,000
= = 111,111
45

2. Compute the payback using the weighted average cash flows

500,000
Payback = = 4.5
111,111

3. Determine the approximate rate from the PVIFA tables NPV/16%.

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4. Computation of NPV at 16%

500,000 x [4.607 – 3.274] =- 666,500

500,000
(500,000)

166,500

NPV/22%

500,000 x [3.786 – 2.864] = 461,000

(500,000)

(39,000)

NPV/22%

500,000 x [3.786 – 2.864] = 520,000

(500,000)

20,000

Compute IRR

20000
2% + x2%
59000

= 20.678

= 20.5%
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Project IRR Ranking

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A 14% 4

B 18.5 3

C 22.0 1

D 20.5 2

E 12.6 5

F 12.0 6

(b) Payback reciprocals

Project B C

250 500
Payback period =5 = 2.857
50 175

1 1
Payback reciprocal = 20% = 35%
5 2.857

Note: The longer the project life (n>is) the better the payback reciprocals as an estimation of
the IRR of a project whose cash flows depict the perfect annuity pattern.

(c) To compute NPV if rate of return is 16% for all project:

Project A n = 15 NPV

0 x 0.862 0
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25000 x 0.743 18575

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50000 x (5.575-2.605) 19890

-250000 (250,000)

(32,925)

Project B n = 15 NPV

50000 x 5.575 – 250,000 28750

Project C n = 15 NPV

175000 x 3.274 – 500000 72950

Project D n = 9yrs NPV

500000 x (4.607 – 3.274) – 166,500

500000

Project E n = 10 yrs NPV

12500 x 0.862 10,775

37500 x 0.743 27,862.5

75000 x 0.641 48,075.0

125000 x [4.833 – 2.246] 323,375

(500,000.00)

NPV (89,912.5)
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Project F n = 4 yrs NPV

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57500 x 0.862 49565

50000 x 0.743 37150

25000 x 0.641 16025

25000 x 0.552 13800

(125000)

(8460)

Project NPV Ranking IRR Ranking

A (32950) 5 14% 4

B 28750 3 18.5% 3

C 72950 2 22% 1

D 166500 1 20.5% 2

E (89912.5) 6 12.6% 5

F (8460) 4 12.0% 6

CHAPTER 6

BASIC VALUATION MODELS.

1 (a) Valuation of ordinary shares is more complicated than valuation of bonds and

Preference shares because of

- Uncertainty of dividend unlike interest charges and preference dividends which are
certain
- The data for valuation of ordinary shares is historical which may not reflect future
expectations.
- A constant stream of dividends per share is assume
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- The growth rate is assumed constant and is computed from past dividends.

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The cost of equity/required rate of return on equity is assumed to be constant though it
changes over time
1 (b) i) If they do nothing:

d0 = Shs.3.00

g = 6%

Ke = 15%
d0 (1 + g) 3(1.06)
P0 = = = Sh.35.33
Ke - g 0.15 - 0.06

ii) Invest in a venture

d0 = Shs.3.00

g = 7%

Ke = 14%
d0 (1 + g) 3(1.07)
P0 = = = Sh.45.86
Ke - g 0.14 - 0.07

iii) Eliminate unprofitable product line

d0 = Shs.3.00

g = 8%

Ke = 17%
d0 (1 + g) 3(1.08)
P0 = = = Sh.36.00
Ke - g 0.17 - 0.08

iv) Acquire a subsidiary

d0 = Shs.3.00
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g = 9%

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Ke = 18%
d0 (1 + g) 3(1.09)
P0 = = = Sh.36.33
Ke - g 0.18 - 0.09

The best alternative is to invest in a venture since this option has the highest impact price of
Sh.45.86.

2.(a) i Debenture with floating interest rate:

- A debenture whose interest rate is variable and pegged to charges in interest rate on
Treasury bill e.g. a debenture/bond may have a 3% premium above interest rate on
Treasury bill such that:-

ß If interest rate on treasury bill is 7%, interest rate on the bond is 7% + 3% = 10%
ß If interest rate on Treasury bill rises to 8.5%, the interest rate on the bond rises to
8.5% + 3% = 11.5%.

- Such a bond is advantageous when market interest rates are volatile.

- If market interest rate falls the borrower pays lower interest charges and when it rises,
the lender receives more interest income.

- Since the coupon rate is matched to market interest rate, the intrinsic value of the bond
is usually stable and easy to determine.

(ii) Zero coupon bonds

- The bonds do not pay periodic interest hence the words “zero coupon” bond.
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They are issued at a discount and mature at par.

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- Therefore, interest is accumulated and accounted for in the redemption value of the
bond.

- The lender is not locked into low fixed interest rate while the borrower does not have
fixed financial obligations of paying fixed interest charges.

- The liquidity of the borrower is not affected until the redemption date.

(b) Drawbacks of dividend growth model

- It is only applicable if the cost of equity, Ke is greater than growth rate, in dividends i.e.

do(1 + g)
Po =
Ke - g

If g>ke, then the model would collapse.

- It is based on historical information where “do” is the past dividend per share, and ‘g’ is
based on historical stream of dividends.

- It assumes a constant stream of dividends in future, growth rate and cost of equity all of
which are not achievable in real world.

(ii) Compute the expected DPS at end of each period and discount at 10% rate. Expected
DPS = do (1 + g) n
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Expected DPS PVIF10%,n P.V
End of year
1 2.50(1.2)1 = 3.00 0.909 2.73

2 2.50(1.2)2 = 3.60 0.826 2.97

3 2.50(1.2)3 = 4.32 0.751 3.24

4 2.50(1.2)4 = 5.18 0.683 3.54

5 2.50(1.2)5 = 6.22 0.621 3.86

6-∞ do(1 + g)
Ke - g

16.22(1.07)
= = 221.85 0.621 137.77
0.10 - 0.07

= Intrinsic value = Total present value = 154.11

Chapter 7

WORKING CAPITAL MANAGEMENT.

1. (a) Matching approach

The matching approach to funding is where the maturity structure of the company’s financing
matches the cash-flows generated by the assets employed. In simple terms, this means that
long-term finance is used to fund fixed assets and permanent current assets, while fluctuating
current assets are funded by short-term borrowings.

(b) Miller-Orr cash management model

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In normal circumstances, cash-flows of a business go up and down in fairly random manner.

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Therefore, instead of assuming that daily balances cannot be predicted because they meander
in a random fashion. This gives rise to a cash position like the one below;

Cash
H = Upper limit/balance
Z = Optimal cash balance
L = Lower cash balance

Rather than decide how often to transfer cash into the account, the treasurer sets upper and
lower limits which, when reached, trigger cash adjustments sending the balance back to return
point by selling short-term investments.

In general, the limits will be wider apart when daily cash flows are highly variable, transaction
costs are high and interest on short-term investments are low. The following formulae are used:

Range between

Upper and lower limits = 3(3 x Transaction cost x cash-flow variance)1/3

4 Interest rate
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The return point = Lower limit + Range

As long as the cash balance is between the upper limit and the lower limit, no transaction is
made.

At point (x) the firm buys marketable securities. At point Y, the firm sells securities and deposits
the cash in the account. (4 marks)

(c) (i) A commercial paper is unsecured short term financial instrument

issued at a discount by financially stable and sound firm to raise short
term funds.

(ii) Advantages of Commercial Papers

-Cheap source of funds (low interest rate)

-Improves credit rating of borrower
-Conserves long term sources of funds and attracts other sources
of finance.
(d) Credit policy – a policy of managing debtors or accounts receivable of
. the firm in order to minimize bad debts, debt collection and
administration cost and cost of financing debtors (capital tied up in
debtors)

- Working capital policy – policy of administration of working capital in

particular debtors, cash and stock in order to
(i) Identify the optimal mix of each component of working capital

(ii) Improve the firms liquidity position

Factors to consider in establishing effective credit policy

.
- Administration expenses
- Level of financing debtors
- Amount of discount to give
- Debt collection expenses
- Credit period
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(b) (i) According to Miller Orr Model of cash management:

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Optional cash balance 3Z = 36s
3 +L
4i

Where: b = transfer (conversion cost) = 120

9.465%p.a
i = Interest rate/day on short term securities = = 0.00026
365

σ² = Variance of daily cash flows = (standard deviation)²

= 22.750² = 517,562,500

L = Lower/minimum cash balance = 87,500

3x120x517,562,500
Z = 3 + 87,500
4x0.00026

= 56,373.8 + 87,500

= 143,874

(ii) Lower cash limit = 87,500

Upper cash limit = 3Z – 2L

= 3(143,874) – 2(87,500)

= 256,622

The decision criteria for Baumol Model could be illustrated graphically as follows:
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Upper limit = H
256,622
Buyoff securities
H-Z=256662-143874=112,788

Optimal = 143,874 Z
Z-L=143,874-87,500=56,374

Lower limit =
87,500 L

The decision criteria for this model is:

(i) If the cash balance moves from Z – H, the firm has excess cash = H – Z which should be
invested by buying short term securities.

(ii) The firm should sell short term marketable securities to realize cash if the cash balance
declines to lower limit L. The amount realized = Z - L

(iii) The firm should maintain a cash balance range (spread = H – L) i.e. 255,662 – 87,500

4Z - L
The average cash balance as per the model =
3
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4 (143,874) - 87,500 487,996
= =
3 3

= 162,665

2. (a) The Baumol Model of cash management is the EOQ model for stock management. According
2DC 0
to EOQ model, the optimal stock to hold (EOQ) =
Ch

Where: D = annual demand/requirements = 21,000 litres

Co = ordering cost/order = Sh.1,400

Ch = holding/carrying cash p.a. = Sh.8

2x21,000x1,400
EOQ =
8

= 27,110.9 litres

Holdings cost = ½ x Q x Ch

= ½ x 27,110.9 x 8

= 108,443.6

D
Ordering cost = Co
Q

2,100,000
= x1,400
27,110.9
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= 108,443.4

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If the assumptions of EOQ hold, then holding cost = ordering cost. These assumptions are:

(i) Annual stock requirement/demand is certain/known

(ii) Ordering cost/order is certain

(iii) Holding cost/unit p.a is certain

(iv) There are no quantity discounts on purchase of goods/stock.

(v) Lead time is zero i.e goods are supplied immediately they are ordered such that no time
elapses between placing an order and receipt of goods.

(vi) There is no cost associated with being out of stock.

3.
a A conservative policy and an aggressive policy

(i) A conservative policy

In a conservative working capital management policy, an organization uses more of long-term source
sources are used to finance all permanent working capital (current assets) and part of temporary curr
therefore more liquid but sacrifices profitability as interest charges have to be paid on long term finan
required.

(ii) An aggressive policy

An aggressive policy uses more of short-term finance. All seasonal working capital requirements and
assets are financed from short-term sources. This policy lead to higher levels of profitability at the exp

b (i) Proposal A
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Current average collection period = 0.25(32) + 0.6(50) + 0.15(80)

= 50 days

credit Sales x AcP

360

360m x 50

360

Sh.50 million

After adoption of proposal A

Average debtors 0.6 x 600 million x 32

360

32 m

Therefore

Reduction in investment in debtors(50 – 32) = 18m

Financial effects Sh
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Reduction in operating cost (2,750 x 12) 33

Decrease in bad debts

Current level

With alternative A (2% x 60% x 600,000 x 0.5 (7,200) 3,6

Reduced W capital costs (15% x 18,000) 3,600 2,7

3,9

Costs

Discounts expense

Credit customers (2% x 60% x 600,000 x 50%) 7,200

Cash customers (2% x 40% x 600,000) 4,800

12

Net benefits 24

27

Alternative B:

Average debtors current 50 million

Average adoption of alternative B 360m x 20 20

360

Therefore

Decrease in investment in debtors 30m x 0.85

Monthly sales = 600m/12 = 50 million

Credit sales = 60% x 50m = 30 million
Monthly interest charges = 15% x 30m x 0.9 = Sh.405,000
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Financial effects: Sh.000
Bad debt losses saved 7,200
Savings on debt admn. (140 x 12) 16,800
Savings on debtors investment (15% x 30m x 0.9 = 4,500

28,000

Less costs

Fees charged (2% x 360,000) = 7,200

Interest charges (405 x 12) = 4860

Net benefit 12,060

16,410

(ii) Preferred alternative (alternative A) is to introduce cash discount since it has a higher net benefit.
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(iii Other non-financial factors to consider include

- Effect of each policy on growth of the company

- Reliability of the factor
- How realistic the estimates are
- Reaction of employees and customers
- Expected trends/level of sales in the industry

a) i) Stock Turnover = Cost of sales

Average stock

1994 1995
330 360
Stock turnover = = 5.0times = 4.5times
(70 + 60)½ (60 + 100)½

ii) Stock holding period = 360 days

Stock turnover

1994 1995
360 360
Stock holding period = = 72days = 80days
5 4.5

b) Debtors collection period = Average debtors x 360 days

Credit sales

1994 1995
Average collection period =
(98 + 102)½ x360 = 90days (102 + 98)½ x360 = 60days
500 600

c) Creditors payment period = Average creditors x 360 days

Credit purchases

1994 1995
25 40
Creditors payment period = x 360 = 25days x 360 = 36days
350 400
d) Cash operating cycle (also called working capital cycle) is the time that elapsed between payment of raw mate
of cash on goods sold on credit.

Operating cycle
= Stock holding period + Debtors collection period – Creditors payment period.

1994 = 72 + 90 – 25 = 137 days

1995 = 90 + 60 – 36 = 104 days

e) The cash operating/working capital cycle declined by 33 days due to:

® Significant decline in debtors collection period by 30 days. This means the firm adopted
decline in stock turnover in 1995.
® Increase in creditors payment period which means the firm has to pay supplier after 36 d
1994.
® The decrease in cash operating cycle is meant to improve the liquidity of the firm.
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Chapter 8

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Sources of funds

1.a) In deciding whether to go for short term rather than long term finance the following would be taken into

(i) The purpose for which the money is required (matching)

In general its is preferable that the life of the project under review should not exceed the period fo
money is borrowed. It may be inconvenient for example if an investment if fixed asset having a wo
years was financed by a five year loan.

(ii) Relative cost of different forms of finance

This is a question that has to be considered in each case. As a general point, if interest rates gen
but are expected to fall longer term finance is preferable.

(iii) Flexibility – Short term loans are more flexible since a firm can react to changes in interest rates u
loans.

(iv) Repayment pattern – a short term loan may be payable any time cash is available unlike long term

(v) Availability of collateral – a security is required for long term debt unlike short term debt.

(vi) The liquidity of the business

If the liquid ratio is low, it may not be possible to obtain further finance without causing concern to

(vii) Availability – the question of what is available will influence whether the borrow short or long term
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(b) Benefits of a right issue to Mombasa Leisure Industries;

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The company is highly geared as rights issue would reduce the level of gearing and reduce
financial risk.

If the issue is successful it will not significantly change the voting structure.

If underwriters are raised then the amount of finance that will be known and guaranteed

If the market is high, Mombasa Leisure Industries should be able to achieve a rights issue
low cost since less shares will be issued. (Lower floatation costs)

Less administrative procedures e.g no need for prospectus.

Drawbacks of rights issue

The issue will need to be priced at a discount to the current share price in order to make it
investors. Thus will result in a dilute in earnings and a fall in price.

If the issue is not successful, a significant number of shares may be taken by underwriters
the voting structure

Administration and underwriting costs are high

Shareholders may be unable or unwilling to increase their investment in Mombasa Leisure

(c) Advantages of leasing

No risk of obsolescence in the lessee

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Leasing does not require a down payment to be made at the start of the contract unlike hire
heavy initial capital outlay required)

Lease finance can be arranged relatively, cheaply, quickly and easily

Operating leases are off-balance sheet financing

Advantages of hire purchase

Unlike leasing, hire purchase allows the user of the asset to obtain ownership at the end of
period

The interest element of the payments is allowable against tax

Tax shield on salvage value at the end of economic life of asset

(d) Factors that have limited the development of the venture capital market:

Venture capital is a form of investment in new small risky enterprises

required to get them started by specialists called venture capitalists. Venture
capitalists are investment specialists who raise pools of capital to fund new ventures
which are likely to become public corporations in return for an ownership interest.
Venture capitalists buy part of the stock of the company at a low price in anticipation
that when the company goes public, they would sell the share at a higher price and
therefore make a considerable profit.

∑ Lack of rich investors. This leads to inadequate equity capital.

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∑ Inefficient stock market. This impairs the ability of the company to
dispose of shares at a later date.

∑ Lack of managerial skills by the owners of the firm.

∑ Highly conservative approach by the venture capitalists.

2.(a)

(b) - Cost of equity ke = do(1 + g) + g

Po

- P.V of cashflows 945000

0.1445-0.05

N/B P.V of a growing annuity is xx

N.P.V of the project = 10M – Sh 8M invested = 2M

N.P.V per share = Sh 2 million = Sh 2 per share

1 million share

New price on announcement = Sh 50 + Sh 2

(cum-right M.P.S)

(ii) 5 existing shares @ Sh 52 = 260

1 new share @ Sh 40 = 40
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Ex-right M.P.S = Sh 300 = Sh 50

(iii) Value of a right=cum-right M.P.S–ex-right M.P.S

(iv) Savings in interest changes = 8m x 10%

Less forgive tax shield = 30% x 8000000

Net cash inflows p.a in perpetuity

This is a constant saving p.a in xx (annuity in xx)

P.V @ 14.45% = 560000 = 3,875,433

0.1445

Less initial capital (8,000,000)

N.P.V (4,124,567)

N.P.V per share = Sh - 4,124,567 = - 4.12

1million shares

Cum-right M.P.S = 50 – 4.12 = 45.88

(b) (i) Earnings = Marketing

per share price/share

P/E ratio

= 8.4

6
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= Sh.1.4

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Operating income is the earnings
before interest and tax

= 6 million x 1.4
 0.7 x

= 8,400,000

x
= Sh.8400

0.7

= Sh.12,000,000 or
12 million

(ii) No of = 10,000,000
shares
6.25

= Sh.1,600,000
shares

Theoretical = 6 million x 8.4 +

ex-rights 1.6m x 6.25
price

7.6m

= 50.4 + 10

7.6

= Sh.7.95
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(iii) Alternative A Alternative B

Sh.000 Sh.000

Current level of EBIT 12,000 12,600

New project 5,600 5,600

Operating income 17,600 17,600

Less interest - (12% x 10m)

1,200
Net profit before tax 17,600
16,400
Less: Tax (30%) 5,280
4,920
Profit after tax 12,320
11,480
Earnings/shares 12,320
11,480
7,600
6,000
1.621
Sh.1.913

Chapter 9

DIVIDEND POLICY.

1.(a)

(i) Dividend = 8 x 100 = 5% 9 x 100 = 5%

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160 270

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P/E ratio = 160 = 20 times 270 = 15 times

8 18

Dividend cover = 8 = 1 time 18 = 2 times

EPS
8 9
DPS

- KVL has higher dividend because of the high DPS and lower MPS.

- For P/E ratio an investor will take 20 years to recover his investme
from KVL as compared to 15 years in KHL. KHL is therefore preferabl
because it offers a shorter payback period.

- For dividend cover KHL is better since dividends are more secure sinc
they can be paid twice from earnings attributable to ordinar
shareholders.

KVL has a percentage dividend payout ratio (EPS = DPS = Sh.8) an

thus a lower dividend cover.

(ii) Since we are using dividend growth model specifically, then value of a

share P0 =

d 0 (1 + g )
P0 =
ke - g

d0 = DPS for the year just ended = 5 years

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ke = Cost of equity/estimated return on earnings = 20%

g = constant growth rate in dividends.

This g can be established from the past stream of DPS given usin
compounding method when d0(1+g)n = dn

dn
g=n -1
ds

dn = DPS at end of last year of growth = 5.5

ds = DPS at beginning of first year of growth = 3.0

n = No. of years of growth = 4

5.5
g=4 - 1 = 0.164
3.0

d (1 + g ) 5.5(1.164)
P0 = 0 = = 177.83
ke - g 0.2 - 0.164

With 1,000 shares MV = 177.83 x 1,000

= Sh.177,830
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Chapter 10

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FINANCIAL INTERMEDIARIES.

1.(a) (i) Financial intermediation

Financial markets promote savings and investment by providing mechanisms by wh
requirements of lenders (suppliers of funds) and borrowers (users of funds) can be
institutions (such as pension funds, insurance companies, banks, building societies
specialist investment institutions). These collect funds from savers to lend to thei
other customers through the money and capital markets or directly through loans, le
forms of financing.

(ii) Services that financial intermediaries provide:

The needs of lenders and borrowers rarely match. These differences in require
lenders and borrowers mean that there is an important role for financial intermediarie
markets are to operate efficiently.

1. Re-packaging services

Gathering small amounts of savings from a large number of individuals and re-
packaging them into larger bundles for lending to business.

2 Risk reduction

Placing small sums from numerous individuals in large, well-diversified

investment portfolios, such as unit trust.

3 Liquidity transformation

Bringing together short-term saves and long-term borrowers (e.g. building

societies and banks). Borrowing short and lending long is only acceptable
where relatively few savers will want to withdraw funds any given time.
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4 Cost reduction

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Minimizing transaction costs by providing convenient and relatively
inexpensive services for linking small savers to larger borrowers.

5 Financial advice

Giving advisory and other services to both lender and borrower.

6 Funds transmission (provide payment/settlement mechanisms)

(a) (i) PRIMARY MARKET

- Raising Capital Business

- mobilizing savings
- Government can raise capital (sell bonus)
- Open market operators (control excess liquidity)
- Vehicle for Foreign Direct Investment

(ii) SECONDARY MARKET

- Investment improvement for companies and small investors.

- Barometer for Healthy of economy and companies ( as whole)
- Privatization of parastatals and giving local citizens a chance for
ownership of multi-national companies.
- Realize investments (by disposal in small quantities due to separation
of ownership and control.
- Improves corporate governance
- Diversification of investments hence reduction of risk
- Liquidity of securities improved.
(iii) PORTFOLIO MANAGEMENT FIRMS
(i) Diversification
(ii) Professional advice
(iii) Watchdog for share under/over valuation
(iv) Enhances market efficiency through information.
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(b) (i) Protects investors from financial losses

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(ii) Establishes Rules & Regulations for private placement of securities
(iii) Removal for impendment and creation of incentives for lonf term
investment. of investors.
(iv) Facilitate National wide system of Brokerage services
(v) Creation maintenance and regulation market for securities.
(vi) Creation for environment which will encourage local companies go public.
(vii) Removal of Barriers to security transfers
(viii) Encourage Development of International Investors - eg insurance and
premium co’s
(ix) Introduces wider range of Investments in the market
(x) Decentralize operations of market to Rural Areas.
(xi) Provide adequate information to players in market for efficient pricing of
securities.

(d) (i) An index in general terms is a measure of relative change from one
point in price to another. Stock indices measure changes in price or
value.

(ii) Drawbacks of NSE:

- 20 companies not true representatives

- Thinness of the market – small changes in the active stocks tend
to be considerably magnified in the index.
- 1966 base year too far in the past
- Relatively small price changes – some stock prices do not change
for weeks on end.
- Lack of clear portfolio selection criteria
- Use of arithmetic instead of preferred geometric mean in
computing index.
- New companies have been quoted and others deregistered.

(a) Advantages of being listed

∑ New funds may be easily obtained from the stock exchange

∑ Easy pricing of shares
∑ A better credit standing obtained
∑ Easy share per transfer (ownership)
∑ Buying other companies is easier
∑ Wide ownership of the firm
∑ Reduction in perceived risk by shareholders
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∑ Greater prominence and status given to quoted companies may create

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goodwill for the company.

Disadvantages

∑ Cost of floating
∑ Stringent stock exchange regulation
∑ Agency problem due to divorce of management and ownership
∑ Dilution of control from wider holding of shares
∑ Increased chances of forced take over.
∑ Extra administrative burdens on management
∑ Disclosure requirements
(b) Floor brokers – act on behalf of individuals

(i) Client who are willing to buy or sell some of their shares or
debentures through floor/stock brokers:

∑ Stock brokers acting on behalf of client will deal with one of the
market makers to buy or sell the shares.

∑ Market makers may act as shareholders too, dealing directly with

individual investors.

∑ Stock brokers earn a commission for their service payable by the

client.

(ii) Market makers are dealers in the shares of the selected companies
whose responsibility is to “make a market” in the shares of those
companies. It is noteworthy that a market maker:

∑ Must be a member of the stock exchange

∑ Must announce which company’s shares they are prepared to
market
∑ Must undertake to make a two way prices in the securities for
which they are registered as market makers under any trading
conditions.
∑ Must decide the share price
∑ Brings “new” companies to the market.
∑ Earns a profit being the difference of selling and buying price.

(iii) ∑ Underwriter is an investment banker who performs the insurance

function of bearing the risk of adverse price fluctuating during the
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period in which a new issue of security is being distributed.

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∑ The underwriter underwrites the risk of under-subscription of a
company’s shares during a primary issue.
∑ He ensures that the company gets the targeted funds sometimes
having to take up the shortfall in demand.

(b) (i) Bull and bear markets

A bull market is a market characterized by rising prices, encouraging

people to buy now in the hope of making a profit when they sell later
after prices have climbed up.

A bear market is characterized by falling prices encouraging bears to

sell now in order to avoid future losses when prices would have fallen.

(ii) Bid ask spread

Is the difference between the offer price and the buying price of a
share.

(iii) Short selling

- Is the act of selling a share which one does not already

possess.
- The dealer could “borrow” the shares, sell them when prices are
high and in anticipation of decline in prices, the shares will be
bought back at lower prices and refunded to the “lender”