2013

FINANCIAL MANAGEMENT

M O SE S O CH I E N G
G W E YI
T H E CO -
O P E R AT I VE
U N I VE R SI T Y
CO L L E G E
 CHAPTE R ONE
NATURE OF FINANCIAL MANAGE MENT
1.1 DE FINITION OF FINANCIAL MANAGE MENT
Financial Management is a discipline concerned with the generation and allocation of scarce resources (usually
funds) to the most efficient user within the firm (the competing projects) through a market pricing system (the
required rate of return).
A firm requires resources in form of funds raised from investors. The funds must be allocated within the
organization to projects which will yield the highest return.

1.2 FINANCE FUNCTIONS

The functions of Financial Manager can broadly be divided into two: The Managerial Functions and the
Routine functions.

1.2.1 Managerial Finance Functions

Require skilful planning, control and execution of financial activities. There are four important managerial
finance functions. These are:

a) Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among
investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets
in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of
both risk and expected return.

Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is
referred to as replacement decision.

b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance investment projects. The finance
manager must decide the proportion of equity and debt. The mix of debt and equity affects the firm’s cost of
financing as well as the financial risk. This will further be discussed under the risk return trade-off.

c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the shareholders, retain
them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of
funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt
providers. The firm’s dividend policy may influence the determination of the value of the firm and therefore
the finance manager must decide the optimum dividend – payout ratio so as to maximise the value of the
firm.

d) Liquidity decision
The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be
referred to as current assets management. Investment in current assets affects the firm’s liquidity, profitability
and risk. The more current assets a firm has, the more liquid it is. This implies that the firm has a lower risk
of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low.
The converse will hold true.
The finance manager should develop sound techniques of managing current assets to ensure that neither
insufficient nor unnecessary funds are invested in current assets.
1.2.2 Routine functions
For the effective execution of the managerial finance functions, routine functions have to be performed.
These decisions concern procedures and systems and involve a lot of paper work and time. In most cases
these decisions are delegated to junior staff in the organization. Some of the important routine functions are:

a) Supervision of cash receipts and payments

b) Safeguarding of cash balance
c) Custody and safeguarding of important documents
d) Record keeping and reporting

The finance manager will be involved with the managerial functions while the routine functions will be
carried out by junior staff in the firm. He must however, supervise the activities of these junior staff.

1.3 THE OBJE CTIVE S/ GOALS OF A BUSINE SS

The Main objectives of a business entity are explained in detail below
Any business firm would have certain objectives, which it aims at achieving. The major goals of a firm are:



Profit maximisation


Shareholders’ wealth maximisation


Social responsibility
Business Ethics

a) Profit maximization
Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to achieving
the highest possible profits during the year. This could be achieved by either increasing sales revenue or by
reducing expenses. Note that:

Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price. It should be
noted however, that maximizing sales revenue may at the same time result to increasing the firm’s expenses.
The pricing mechanism will however, help the firm to determine which goods and services to provide so as to
maximize profits of the firm.

The profit maximization goal has been criticized because of the following:



It ignores time value of money


It ignores risk and uncertainties


It is vague
It ignores other participants in the firm rather than shareholders

b) Shareholders’ wealth maximisation

Shareholders’ wealth maximisation refers to maximisation of the net present value of every decision made in
the firm. Net present value is equal to the difference between the present value of benefits received from a
decision and the present value of the cost of the decision. (Note this will be discussed further in Lesson 2).
A financial action with a positive net present value will maximize the wealth of the shareholders, while a
decision with a negative net present value will reduce the wealth of the shareholders. Under this goal, a firm
will only take those decisions that result in a positive net present value.
Shareholder wealth maximisation helps to solve the problems with profit maximisation. This is because, the
goal:



Considers time value of money by discounting the expected future cash flows to the present.
It recognizes risk by using a discount rate (which is a measure of risk) to discount the cash flows to
the present.

c) Social responsibility
The firm must decide whether to operate strictly in their shareholders’ best interests or be responsible to their
employers, their customers, and the community in which they operate. The firm may be involved in activities
which do not directly benefit the shareholders, but which will improve the business environment. This has a
long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized.

d) Business E thics
Related to the issue of social responsibility is the question of business ethics. Ethics are defined as the
“standards of conduct or moral behaviour”. It can be though of as the company’s attitude toward its
stakeholders, that is, its employees, customers, suppliers, community in general creditors, and shareholders.
High standards of ethical behaviour demand that a firm treat each o these
constituents in a fair and honest manner. A firm’s commitment to business ethics can be measured by the
tendency of the firm and its employees to adhere to laws and regulations relating to:



Product safety and quality


Fair employment practices


Fair marketing and selling practices


The use of confidential information for personal gain


Illegal political involvement
Bribery or illegal payments to obtain business.

1.4 THE AGE NCY THE ORY

An agency relationship arises where one or more parties called the principal contracts/hires another called an
agent to perform on his behalf some services and then delegates decision making authority to that hired party
(Agent) In the field of finance shareholders are the owners of the firm. However, they cannot manage the
firm because:



They may be too many to run a single firm.


They may not have technical skills and expertise to run the firm
They are geographically dispersed and may not have time.

Shareholders therefore employ managers who will act on their behalf. The managers are therefore agents
while shareholders are principal.
Shareholders contribute capital which is given to the directors which they utilize and at the end of each
accounting year render an explanation at the annual general meeting of how the financial resources were
utilized. This is called stewardship accounting.



In the light of the above shareholders are the principal while the management are the agents.
Agency problem arises due to the divergence or divorce of interest between the principal and the
agent. The conflict of interest between management and shareholders is called agency problem in
finance.
  There are various types of agency relationship in finance exemplified as follows:

1. Shareholders and Management

2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary.

1. Shareholders and Management

There is near separation of ownership and management of the firm. Owners employ professionals
(managers) who have technical skills. Managers might take actions, which are not in the best interest of
shareholders. This is usually so when managers are not owners of the firm i.e. they don’t have any
shareholding. The actions of the managers will be in conflict with the interest of the owners. The actions of
the managers are in conflict with the interest of shareholders will be caused by:

i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and maximize
shareholders wealth. This is because irrespective of the profits they make, their reward is
fixed. They will therefore maximize leisure and work less which is against the interest of the
shareholders.

ii) Consumption of “Perquisites”

Prerequisites refer to the high salaries and generous fringe benefits which the directors might
award themselves. This will constitute directors remuneration which will reduce the
dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is
against the interest of shareholders since it reduces their wealth.

iii) Different Risk-profile

Shareholders will usually prefer high-risk-high return investments since they are diversified
i.e they have many investments and the collapse of one firm may have insignificant effects
on their overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a
personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable).
This difference in risk profile is a source of conflict of interest since shareholders will forego
some profits when low-return projects are undertaken.

iv) Different E valuation Horizons

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

v) Management Buy Out (MBO)

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

vii) Creative Accounting

This involves the use of accounting policies to report high profits e.g stock valuation
methods, depreciation methods recognizing profits immediately in long term construction
contracts etc.

Solutions to Shareholders and Management Conflict of Interest

Conflicts between shareholders and management may be resolved as follows:

1. Pegging/ attaching managerial compensation to performance

This will involve restructuring the remuneration scheme of the firm in order to enhance the
alignments/harmonization of the interest of the shareholders with those of the management e.g. managers
may be given commissions, bonus etc. for superior performance of the firm.

2. Threat of firing
This is where there is a possibility of firing the entire management team by the shareholders due to poor
performance. Management of companies have been fired by the shareholders who have the right to hire and
fire the top executive officers e.g the entire management team of Unga Group, IBM, G.M. have been fired by
shareholders.

3. The Threat of Hostile Takeover

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

4. Direct Intervention by the Shareholders

Shareholders may intervene as follows:



Insist on a more independent board of directors.


By sponsoring a proposal to be voted at the AGM
Making recommendations to the management on how the firm should be run.

5. Managers should have voluntary code of practice, which would guide them in the performance of
their duties.

6. E xecutive Share Options Plans

In a share option scheme, selected employees can be given a number of share options, each of which gives
the holder the right after a certain date to subscribe for shares in the company at a fixed price.
The value of an option will increase if the company is successful and its share price goes up. The theory is
that this will encourage managers to pursue high NPV strategies and investments, since they as shareholders
will benefit personally from the increase in the share price that results from such investments.
However, although share option schemes can contribute to the achievement of goal congruence, there are a
number of reasons why the benefits may not be as great as might be expected, as follows:
Managers are protected from the downside risk that is faced by shareholders. If the share price falls, they do
not have to take up the shares and will still receive their standard remuneration, while shareholders will lose
money.
Many other factors as well as the quality of the company’s performance influence share price movements. If
the market is rising strongly, managers will still benefit from share options, even though the company may
have been very successful. If the share price falls, there is a downward stock market adjustment and the
managers will not be rewarded for their efforts in the way that was planned.

The scheme may encourage management to adopt ‘creative accounting’ methods that will distort the reported
performance of the company in the service of the managers’ own ends.

Note
The choice of an appropriate remuneration policy by a company will depend, among other things, on:



Cost: the extent to which the package provides value for money
Motivation: the extent to which the package motivates employees both to stay with the company and


to work to their full potential.
Fiscal effects: government tax incentives may promote different types of pay. At times of wage
control and high taxation this can act as an incentive to make the ‘perks’ a more significant part of


the package.
Goal congruence: the extent to which the package encourages employees to work in such a way as to
achieve the objectives of the firm – perhaps to maximize rather than to satisfy.

7. Incurring Agency Costs

Agency costs are incurred by the shareholders in order to monitor the activities of their agent. The agency
costs are broadly classified into 4.

a) The contracting cost. These are costs incurred in devising the contract between the managers and
shareholders.
The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on
the other hand undertake to compensate the management for their effort.

Examples of the costs are:



Negotiation fees


The legal costs of drawing the contracts fees.
The costs of setting the performance standard,

b) Monitoring Costs This is incurred to prevent undesirable managerial actions. They are meant to ensure
that both parties live to the spirit of agency contract. They ensure that management utilize the financial
resources of the shareholders without undue transfer to themselves.


Examples are:


External audit fees


Legal compliance expenses e.g. Preparation of
Financial statement according to international accounting standards, company law, capital


market authority requirement, stock exchange regulations etc.
Financial reporting and disclosure expenses
  Investigation fees especially where the investigation is instituted by


the shareholders.
Cost of instituting a tight internal control system (ICS).

c) Opportunity Cost/ Residual Loss This is the cost due to the failure of both parties to act optimally e.g.



Lost opportunities due to inability to make fast decision due to tight internal control system
Failure to undertake high risk high return projects by the manager leads to lost profits when
they undertake low risk, low return projects.

d) Restructuring Costs – e.g. new I.C.S., business process reengineering etc.

2. SHARE HOLDE RS AND CRE DITORS/ bond/ debenture holders

Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to the firm
on the strength of the following factors:



The existing asset structure of the firm


The expected asset structure of the firm


The existing capital structure or gearing level of the firm
The expected capital structure of gearing after borrowing the new
debt.

Note
 In raising capital, the borrowing firm will always issue the financial securities in form of debentures,


ordinary shares, preference shares, bond etc.
In case of shareholders and bondholders the agent is the shareholder who should ensure that the debt
capital borrowed is effectively utilized without reduction in the wealth of the bondholders. The
bondholders are the principal whose wealth is influenced by the value of the bond and the number of


bonds held.


Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
An agency problem or conflict of interest between the bondholders (principal) and the shareholders
(agents) will arise when shareholders take action which will reduce the market value of the bond and by
extension, the wealth of the bondholders. These actions include:

a) Disposal of assets used as collateral for the debt in this.

In this case the bondholder is exposed to more risk because he may not recover the loan extended in case of
liquidation of the firm.

b) Assets/ investment substitution

In this case, the shareholders and bond holders will agree on a specific low risk project. However, this
project may be substituted with a high risk project whose cash flows have high standard deviation. This
exposes the bondholders because should the project collapse, they may not recover all the amount of money
advanced.

c) Payment of High Dividends

Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an
internal source of finance. The payment of high dividends will lead to low level of capital and investment
thus reduction in the market value of the shares and the bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no returns are expected.
This will reduce the value of the firm and bond.

d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital in the entire
project if there is expectation that most of the returns from the project will benefit the bondholders. This
will lead to reduction in the value of the firm and subsequently the value of the bonds.

e) Borrowing more debt capital

A firm may borrow more debt using the same asset as a collateral for the new debt. The value of the old
bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is liquidated.
This exposes the first bondholders/lenders to more risk.

Solutions to agency problem

The bondholders might take the following actions to protect themselves from the actions of the shareholders
which might dilute the value of the bond. These actions include:

1. Restrictive Bond/ Debt Covenant

In this case the debenture holders will impose strict terms and conditions on the borrower. These restrictions
may involve:

a) No disposal of assets without the permission of the lender.

b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities.
d) Restrictions on mergers and organisations
e) No borrowing of additional debt, before the current debt is
fully serviced/paid.
f) The bondholders may recommend the type of project to be
undertaken in relation to the riskness of the project.

2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry of the maturity
period if there is breach of terms and conditions of the bond covenant.

3. Transfer of Asset
 The bondholder or lender may demand the transfer of asset to him on giving debt or loan to the
company. However the borrowing company will retain the possession of the asset and the right of

 On completion of the repayment of the loan, the asset used as a collateral will be transferred back to
utilization.

the borrower.
4. Representation
The lender or bondholder may demand to have a representative in the board of directors of the borrower
who will oversee the utilization of the debt capital borrowed and safeguard the interests of the lender or
bondholder.
5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the debt capital
borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its investments
needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.

6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds into
ordinary shares.

3. Agency Relationship Between Shareholders And The Government

Shareholders and by extension, the company they own operate within the environment using the charter or
licence granted by the government. The government will expect the company and by extension its
shareholders to operate the business in a manner which is beneficial to the entire economy and the society.

The government in this agency relationship is the principal while the company is the agent. It becomes an
agent when it has to collect tax on behalf of the government especially withholding tax and PAYE.

The company also carries on business on behalf of the government because the government does not have
adequate capital resources. It provides a conducive investment environment for the company and share in
the profits of the company in form of taxes.

The company and its shareholders as agents may take some actions that might prejudice the position or
interest of the government as the principal. These actions include:

 Tax evasion: This involves the failure to give the accurate picture of the earnings or profits of the


firm to minimize tax liability.


Involvement in illegal business activities by the firm.


Lukewarm response to social responsibility calls by the government.
Lack of adequate interest in the safety of the employees and the products and services of the


company including lack of environmental awareness concerns by the firm.
Avoiding certain types and areas of investment coveted by the government.

Solutions to the agency problem

The government can take the following actions to protect itself and its interests.

1. Incur monitoring costs

 Statutory audit
E.g. the government incurs costs associated with:

 Investigations of companies under Company Act

 Back duty investigation costs to recover tax evaded in the

 VAT refund audits

past

2. Lobbying for directorship (representation)

The government can lobby for directorship in companies which are deemed to be of strategic nature and
importance to the entire economy or society e.g directorship in KPLC, Kenya Airways, KCB etc.
3. Offering investment incentives
To encourage investment in given areas and locations, the government offers investment incentives in form
of capital allowances as laid down in the Second schedule of Cap 470.

4. Legislations
The government has provided legal framework to govern the operations of the company and provide
protection to certain people in the society e.g. regulation associated with disclosure of information, minimum
wages and salaries, environment protection etc.

5. The government can incalculate the sense and spirit of social responsibility on the activities of the
firm, which will eventually benefit the firm in future.

4. Agency Relationship between Shareholders and Auditors

Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies Act. The
auditors are supposed to monitor the performance of the management on behalf of the shareholders. They
act as watchdogs to ensure that the financial statements prepared by the management reflect the true and fair
view of the financial performance and position of the firm.

Since auditors act on behalf of shareholders they become agents while shareholders are the principal. The
auditors may prejudice the interest of the shareholders thus causing agency problems in the following ways:

a) Colluding with the management in performance of their duties whereby their independence is
compromised.
b) Demanding a very high audit fee (which reduces the profits of the firm) although there is
insignificant audit work due to the strong internal control system existing in the firm.
c) Issuing unqualified reports which might be misleading the shareholders and the public and which
may lead to investment losses if investors rely on such misleading report to make investment and
commercial decisions.
d) Failure to apply professional care and due diligence in performance of their audit work.

Solutions to the conflict

1. Firing: The auditors may be removed from office by the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors who issue
misleading reports leading to investment losses.
3. Disciplinary Action – ICPAK.
Professional bodies have disciplinary procedures and measures against their members who are
involved in un-ethical practices. Such disciplinary actions may involve:



Suspension of the auditor


Withdrawal of practicing certificate


Fines and penalties
Reprimand

4. Use of audit committees and audit reviews.

5. HE AD OFFICE AND SUBSIDIARY/ BRANCH

MNC has diverse operations set up in different geographical locations.
The HQ acts as the principal and the subsidiary as an agent thus creating an agency relationship.
The subsidiary management may pursue its own goals at the expense of overall corporate goals. This will lead
to sub-optimisation and conflict of interest with the headquarter.
This conflict can be resolved in the following ways:

a) Frequent transfer of managers

b) Adopt global strategic planning to ensure commonality of vision
c) Having a voluntary code of ethical practices to guide the branch managers

An elaborate performance reporting system providing a 2-way feedback mechanism.

Performance contracts with managers with commensurate compensation package for the same.

CORPORATE GOVE RNANCE

1.5 Definition of corporate governance

Corporate governance can be defined in various ways, for example:

The Private Sector Corporate Governance Trust (PSCGT) states that corporate governance, “Refers to the
manner in which the power of the corporation is exercised in the stewardship of the corporation total
portfolio of assets and resources with the objective of maintaining and increasing shareholders value through
the context of its corporate vision” (PSCGT, 1999)
The Cadbury Report (1992) defines corporate governance as the system by which companies are directed and
controlled.
The Capital Market Authority (CMA) in year 2000 defined corporate governance as the process and
structures used to direct and manage business affairs of the company towards enhancing prosperity and
corporate accounting with the ultimate objective of realizing shareholders long-term value while taking into
account the interests of other stakeholders.

Rationale for corporate governance

The organization of the world economy (especially in current years) has seen corporate governance gain

 Institutional investors, as they seek to invest funds in the global economy, insist on high standard of
prominence mainly because:

 Public attention attracted by corporate scandals and collapses has forced stakeholders to carefully
Corporate Governance in the companies they invest in.

consider corporate governance issues.

Corporate governance is therefore important as it is concerned with:



Profitability and efficiency of the firm.


Long-term competitiveness of firms in the global economy.
The relationship among firm’s stakeholders

Principles of corporate governance

There are 22 principles of Corporate Governance as given by the Common Wealth Association of Corporate
Governance (CACG) in1999 and the Private Sector Corporate Governance Trust (PSCGT) in 1999 also. The
first ten principles are summarized below.

1. The authority and duties of members (shareholders)

Members and shareholders shall jointly and severally protect, preserve and actively exercise the supreme
authority of the corporation in general meeting (AGM). They have a duty to exercise that supreme authority
to:
 Ensure that only competent and reliable persons who can add value are elected or appointed to the board
of directors (BOD).
 Ensure that the BOD is constantly held accountable and responsible for the efficient and effective
governance of the corporation so as to achieve corporate objective, prospering and sustainability.
 Change the composition of the BOD that does not perform to expectation or in accordance with
mandate of the corporation

2. Leadership
Every corporation should be headed by an effective BOD, which should exercise leadership, enterprise,
integrity and judgements in directing the corporation so as to achieve continuing prosperity and to act in the
best interest of the enterprise in a manner based on transparency, accountability and responsibility.

3. Appointments to the BOD

It should be through a well managed and effective process to ensure that a balanced mix of proficient
individuals is made and that each director appointed is able to add value and bring independent judgment on
the decision making process.
4. Strategy and Values
The BOD should determine the purpose and values of the corporation, determine strategy to achieve that
purpose and implement its values in order to ensure that the corporation survives and thrives and that
procedures and values that protect the assets and reputation of the corporation are put in place.

5. Structure and organization

The BOD should ensure that a proper management structure is in place and make sure that the structure
functions to maintain corporate integrity, reputation and responsibility.

6. Corporate Performance, Viability & Financial Sustainability

The BOD should monitor and evaluate the implementation of strategies, policies and management
performance criteria and the plans of the organization. In addition, the BOD should constantly revise the
viability and financial sustainability of the enterprise and must do so at least once in a year.

7. Corporate compliance
The BOD should ensure that corporation complies with all relevant laws, regulations, governance practices,
accounting and auditing standards.

8. Corporate Communication
The BOD should ensure that corporation communicates with all its stakeholders effectively.

9. Accountability to Members
The BOD should serve legitimately all members and account to them fully.

10. Responsibility to stakeholders

The BOD should identify the firm’s internal and external stakeholders and agree on a policy (ies) determining
how the firm should relate to and with them, increasing wealth, jobs and sustainability of a financially sound
corporation while ensuring that the rights of the stakeholders are respected, recognized and protected.
 CHAPTE R TWO
SOURCE S OF FUNDS
E QUITY FINANCE
For small companies, this is personal savings (contribution of owners to the company). For large companies
equity finance is made of ordinary share capital and reserves; (both revenue and capital reserves). Equity
finance is divided into the following classes:

a) Ordinary share capital – this is raised from the public from the sale of ordinary shares to the
shareholders. This finance is available to limited companies. It is a permanent finance as the
owner/shareholder cannot recall this money except under liquidation. It is thus a base on which
other finances are raised.

Ordinary share capital carries a return that is variable (ordinary dividends). These shares carry voting
rights and can influence the company’s decision making process at the AGM.

These shares carry the highest risk in the company (high securities – documentary claim to) because of:

a) Uncertainty of return
b) Cannot ensure refund
c) Have residual claims – claim last on profits, claim last on assets.

However this investment grows through retention.

Rights of ordinary shareholders
1. Right to vote

a. elect BOD
b. Sales/purchase of assets

2. Influence decisions:

a) Right to residual assets claim

b) Right to amend company’s by-laws
c) Right to appoint another auditor
d) Right to approve merger acquisition
e) Right to approve payment of dividends

Reasons why ordinary share capital is attractive despite being risky



Shares are used as securities for loans (a compromise of the market price of a share).


Its value grows.


They are transferable at capital gain.


They influence the company’s decisions.


Carry variable returns – is good under high profit


Perpetual investment – thus a perpetual return
Such shares are used as guarantees for credibility.

Advantages of using ordinary share capital in financing.



They facilitate projects especially long-term projects because they are permanent..
Its cost is not a legal obligation.
 

It lowers gearing level – reduces chances of receivership/liquidation.


Used with flexibility – without preconditions.


Such finances boost the company’s credibility and credit rating.
Owners contribute valuable ideas to the company’s operations (during AGM by professionals).

b) RE TAINE D E ARNINGS

i) Revenue Reserves
These are undistributed earnings. Such reserves are retained for the following reasons:



To make up for the fall in profits so as to sustain acceptable risks.
. To sustain growth through plough backs. They are cheap source of


finance.
. They are used to boost the company’s credit rating so they enable further finance to be


obtained.
. It lowers the company’s gearing ratio – reduces chances of receivership/liquidation.

ii) Capital Reserves

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

c) PRE FE RE NCE SHARE CAPITAL (Quasi-E quity)

It is also called quasi-equity because it combines features of equity and those of debt. It is preference because
it is preferred to ordinary share capital that is:

i) It is paid dividends first – preferred to dividend

ii) It is paid asset proceeds first – preferred to assets.

Unlike ordinary share capital, it has a fixed return. It carries no voting rights. It is an unsecured finance and
it increases the company’s gearing ratio.

CLASSIFICATION
i) Redeemable Class
Redeemable preferential shares are bought back by issuing company after minimum redemption period but
before expiring of maximum redemption period after which they become creditors. (Can sue the company).

ii) Irredeemable Preference Shares

Are perpetual preference shares as they will not be redeemed in the company’s lifetime unless it is under
liquidation, (it is permanent).

iii) Non-Participative Preference Shares

These do not claim any money over and above their par value, but are usually cumulative and redeemable.

V) Cumulative Preference Shares

These can claim arrears e.g. if a company sold 10% Shs.20 preference shares and did not pay dividends for
the next two years, then in the third year shareholders will claim:

10% x 20 x 3yrs = Shs 6 less withholding tax:

= Shs 6 less 5% of Shs 0.30
= Shs 5.70 net

vi) Non-Cumulative Preference Shares

These cannot claim interest in arrears.

vii) Convertible
These can be converted into ordinary shares (which is optional).

Conversion ratio = par value of ordinary share/par value of preference shares e.g if par value of ordinary

10 1
shares is Sh.10 and that of preference shares is Sh.20, then conversion ratio = i.e for every preference
20 2
share you get 2 ordinary shares.

Conversion price par value of preference shares/no. of ordinary shares to be acquired.

 Shs10
20
=
2

E xample
Company XYZ Ltd has sold 10,000 ordinary shares of Shs.30 (partly called up) plus 20,000 Shs.45 preference
shares, which are convertible. Compute the total number of ordinary shares after conversion.

Solution
Conversion ratio = 30/45 = 2/3 for every 2 preference shares you get 3 ordinary shares.

20,000 3
x = 30,000 ordinary shares.
1 1
 Shs.30
45
Conversion price =
3/ 2

Total = 40,000 ordinary shares after conversion.

viii) Non-Convertible Preference Shares.

These cannot be converted into ordinary shares.

2. DE BT FINANCE
Debt finance is a fixed return finance as the cost (interest) is fixed on the par value (face value of debt). It is
ideal to use if there’s a strong equity base. It is raised from external sources to qualifying companies and is
available in limited quantities. It is limited to:

i) Value of security.
ii) Liquidity situation in a given country. It is ideal for companies where gearing allows them to
raise more debt and thus gearing level.
Classification of Debt Finance
Loan finance – this is a common type of debt and is available in different terms usually short term. Medium
term loans vary from 2 - 5 years. Long-term loans vary from 6 years and above

The terms are relative and depend on the borrower. This finance is used on the basis of Matching approach
i.e. matching the economic life of the project to the term of the loan. It is prudent to use short-term loans
for short-term ventures i.e. if a venture is to last 4 years generating returns, it is prudent to raise a loan of 4
years maturity period.

Conditions under Which Loans Are Ideal

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

Requirements for Raising Loan

a) History of the company and its subsidiaries.
b) Names, ages, and qualifications of the company’s directors.
c) The names of major shareholders – 51% plus i.e. owner who must give consent.
d) Nature of the products and product lines.
e) Publicity of the product.
f) Nature of the loan – either secured, floating or unsecured.
g) Cash flow forecast.

Reasons Why Commercial Banks Prefer To Lend Short Term Loans

a) Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardise planning
e.g. political and economic factors.
b) Commercial banks are limited by the Central Bank of Kenya in their long term lending due to
liquidity considerations.
c) Short-term loans are profitable. This is because interest is high as in overdrafts.
d) Long term finance loses value with time due to inflation.
e) Cost of finance – in the long term, the cost of finance may increase and yet they cannot pass such a
cost to borrowers since the interest rate is fixed.
f) Commercial banks do credit analysis that is limited to short term situations.

g) Usually security market favours short term loans because there are very few long term securities and
as such commercial banks prefer to lend short term due to security problems.

Advantages of Using Debt Finance

 Interest on debt is a tax allowable expense and as such it is reduced by the tax allowance.

E xample
Interest = 10% tax rate = 30%
The effective cost of debt (interest) = Interest rate(1 – T)
= 10%(1-0.30)
 = 7%

Consider companies A and B

Company A B
Sh.’000’ Sh.’000’
10% debt 1,000 -
Equity - 1,000
1,000 1,000

The tax rate is 30% and earnings before interest and tax amount to Ksh.400,000. All earnings are paid out as
dividends. Compute payable by each firm.

Company A B
Sh.’000’ Sh.’000’
EBIT 400 400
Less interest 10% x 1,000 (100) -
EBT 300 400
Less tax @ 30% (90) (120)
Dividends payable 210 280

Company A saves tax equal to Sh.30,000(120,000 – 90,000) since interest charges are tax allowable and reduce
taxable income.

 The cost of debt is fixed regardless of profits made and as such under conditions of high profits the


cost of debt will be lower.


It does not call for a lot of formalities to raise and as such its ideal for urgent ventures
It is usually self-sustaining in that the asset acquired is used to pay for its cost i.e. leaving the company


with the value of the asset.
In case of long-term debt, amount of loan declines with time and repayments reduce its burden to the


borrower.
Debt finance does not influence the company’s decision since lenders don’t participate at the AGM.
Disadvantages
 It is a conditional finance i.e. it is not invested without the approval of lender.
 Debt finance, if used in excess may interrupt the companies decision making process when gearing level
is high, creditors will demand a say in the company i.e. and demand representation in the BOD.
 It is dangerous to use in a recession as such a condition may force the company into receivership through
lack of funds to service the loan.
 It calls for securities which are highly negotiable or marketable thus limiting its availability.
 It is only available for specific ventures and for a short term, which reduces its investment in strategic
ventures.
 The use of debt finance may lower the value of a share if used excessively. It increases financial risk and
required rate of return by shareholders thus reduce the value of shares.

Differences between Debt Finance and Ordinary Share Capital (E quity Finance)

Ordinary share capital Debt

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

Similarities between Preference and E quity Finance

a) Both may be permanent if preference share capital is irredeemable (convertible).

b) Both are naked or unsecured finances.
c) Both are traded at the stock exchange
d) Both are raised by public limited companies only
e) Both carry residue claims after debt.
f) Both dividends are not a legal obligations for the company to pay.
Differences between Preference and E quity Finance
Ordinary share capital Preference share capital
a) Has a residue claim both on assets and profit a) Has a superior claim
b) Carries voting rights b) No voting rights
c) Reduces the gearing ratio c) Increases the gearing ratio
d) Variable dividends hence grow over time d) Fixed dividends hence no growth
e) Permanent finance e) Usually redeemable
f) Easily transferable. f) Not easily transferable

Similarities between Debt and Preference Share Capital

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

Differences between Preference Share Capital and Debt

DE BT PRE FE RENCE SHARE CAPITAL
a) Interest is tax allowable a) Dividends are not tax allowable
b) Interest is a legal obligation b) Dividends are not a legal obligation
c) Debt finance is always secured c) Preference is not secured finance
d) Debt finance is a pre-conditional d) Is not conditional finance
e) Has a superior claim e) Has a residue claim (after debt)

Why It May Be Difficult For Small Companies To Raise Debt Finance In Kenya (Say Jua Kali

 Lack of security
Companies)

 Ignorance of finances available

  Most of them are risky businesses as there are no feasibility studies done (chances of failure have


been put to 80%).
Their size being small tends to make them UNKNOWN i.e. they are not a significant competitor to


the big companies.


Cost of finance may be high – their market share may not allow them to secure debt.


Small loans are expensive to extend by bank i.e. administration costs are very high.
Lack of business principles that are sound and difficult in evaluating their performance.

Solutions to the Above Problems



There should be diversification of securities e.g. to accept guarantees.


Education of such businessmen on sound business principles.


The government should set up a special fund to assist the jua kali businessmen.


Encourage formation of co-operative societies.
To request bankers to follow up the use of these loans.

3. Bills of E xchange
Bills of Exchange are a source of finance in particular in the export trade. A Bill of Exchange is an
unconditional order in writing addressed by one person to another requiring the person to whom it is
addressed to pay to him as his order a specific sum of money. The commonest types of bills of exchange
used in financing are accommodation bills of exchange. For a bill to be a legal document; it must be

a) Drawn by the drawer.

b) Bear a stamp duty
c) Acceptable by the drawee
e) Mature in time.

It is used to raise finance through:

i) Discounting it.
ii) Negotiating
iii) Giving it out as security.

Advantages of Using a Bill as a Source of Finance



They are a faster means of raising finance (if drawer is credible).


Is highly negotiable/liquid investment


Does not require security


Does not affect the gearing level of the company


It is unconditional and can be invested flexibly


It is useful as a source of finance to finance working capital
It is used without diluting capital.

4 Lease Finance
Leasing is a contract between one party called lessor (owner of asset) and another called lessee where the
lessee is given the right to use the asset (without legal ownership) and undertakes to pay the lessor periodic
lease rental charges due to generation of economic benefits from use of the assets. Leases can be short term
(operating leases) in which case the lessor incurs the operating and maintenance costs of the assets or long
term (finance leases) in which the lessee maintains and insure the assets.

Lease finance is ideal under the following conditions:

a) When the asset depreciates faster.

b) When the asset is subject to obsolescence
c) When the available asset cannot meet the contemplated expansion program
d) When the asset’s cost is prohibiting
e) If the asset is required seasonally
f) If the asset can generate returns to pay off lease charges in the short run.

Advantage of Leasing an Asset



It does not tie up the company’s funds in an asset.
The arrangement may ensure lessor bears the maintenance costs reducing the companies operating


costs.
The company has the option to purchase assets at the expiry of the lease period at which time it will


know the viability of the asset.
The company (lessee) will enjoy the lease charges as allowable expenses thus reducing taxable income


and tax liability.
Lease finance enables the lessee to use the asset to create financial surpluses which may then be used


to buy assets.
It is usually a long-term arrangement which enables the company to plan returns expected and
operations which may be carried out.

Disadvantage of Leasing an Asset



It is a pre-conditional finance (as on the use of asset)


In the long term the lease charges may out-weigh the cost of buying own asset.


It is available for a selected asset and this limits flexibility.


It is useful for financing fixed assets and not working capital


Lease finance may not be renewed leading to loss of business.
Lease financing lowers the company’s credit rating (i.e. the asset in the balance
sheet is shown as leased asset).

Reasons Why Lease Finance Is Not Well Developed In Kenya



Lease charges are usually prohibitive i.e. the cost of finance is excessive.


It may not be known to businessmen.
Uncertainty as to returns from such assets i.e. the returns from such assets leased may not encourage


the growth of lease finance.
There is an imperfect market as a number of companies lease assets on basis of credibility of the


lessee.


Lack of flexibility i.e. a number of assets which are ideal for leasing are unavailable.


Kenya’s financial markets are underdeveloped and this has affected the development of lease finance.
After lease service is poor and this leads to loss of revenue.

5. Overdraft Finance
This finance is ideal to use as bridging finance in sense that it should be used to solve the company’s short
term liquidity problems in particular those of financing working capital (w.c.). It is usually a secured finance
unless otherwise mentioned. Overdraft finance is an expensive source of finance and the over-reliance on it
is a sign of financial imprudence as it indicates the inability to plan or forecast financial needs.

Advantages of Overdraft Finance

 It is useful in financial crisis which an accountant cannot forecast due to abrupt fall in profits thus


liquidity problems.


In some cases it may be secured on goodwill thus making it flexible finance.
It does not entail preconditions and is therefore investible in high-risk situations when the firm


would not have finance in normal circumstances.
It is raised faster and as usual is ideal to invest in urgent ventures e.g. documentary investments e.g.


treasury bonds, shares, treasury bills, housing bonds etc.
If not used for a long period of time – it does not affect the company’s gearing level and therefore


does not relate to company’s liquidation or receivership.
Less formalities/procedures involved.

Disadvantages of Overdraft Finance



It is expensive as the interest rates of overdrafts are much higher than bank rates.


The use of this finance is an indication of poor financial management principle.


It may be misused by management because it does not carry pre-conditions
Being a short-term financial arrangement, it can be recalled at short notice leaving the company in
financial crisis.

6. Plastic Money (Credit Card Finance)

This is finance of a kind whereby a company will make arrangements for the use of the services of a credit
card organisations (through the purchase of credit cards) in return for prompt settlement of bills on the card
and a commission payable on all credit transactions. This is used to finance goods and services of working
capital in nature such as the payment of fuel, spare-

parts, medical and other general provisions and it is rare for it to finance raw materials or capital items.

Reasons behind the Fast Development of This Finance (Plastic Money) In Kenya
a) High incidences of fraud by dishonest employees has been responsible for development of this
finance as it minimises chances of this fraud because it eliminates the use of hard cash in the
execution of transactions.
b) Risk associated with carrying of huge amounts of cash for purchases which cash is open to theft and
misuse has also been responsible for development of this finance.
c) Credit cards have boosted the credibility of holder companies which enables them to obtain trade
credits under conditions which would have otherwise been difficult.
d) Of late, Kenya has experienced emergence of elite, middle and high-income groups’ in particular
professionals who tend to use these cards as a symbol of status in execution of day to day
transactions.
e) These cards have been used by financial institutions and banks to boost their deposit and attract long
term clienteles e.g. Royal Card Finance, Standard Chartered.
f) A number of companies and establishments have acquired such cards as a means of settling their bills
under certain times when their liquidity is low or when in financial crisis.
Limitations of Credit Cards as a Source of Finance
i) These cards leads to overspending on the part of the holder and as such may disorganise the
organisation’s cash budget and cash planning.
ii) Limited as to the activities they can finance as they are ideal for financing working capital items and
not fixed assets in which case they are not a profitable source of finance.
iii) They are expensive to obtain and maintain because of associated cost such as ledger fees, registration,
insurance, commission expenses, renewal fees etc.
iv) It is a short-term source and is open only to a few establishments in which case a company can
obtain goods and services from those establishments that can accept them.
v) Entail a lot of formalities to obtain e.g. guarantees, presentation of bank statements and even
charging assets that are partially pledged to secure expenses that may be incurred using these cards.
vi) They may be misused by dishonest employees who may use them to defraud the organisation off
goods and services which may not benefit such organisations.
vii) Credit card organisation may suspend the use of such cards without notice and this will
inconvenience the holder who may not meet his/her ordinary needs obtained through these cards.

7. Debenture Finance
A form of long term debt raised after a company sells debenture certificates to the holder and raises finance
in return. The term debenture has its origin from ‘DEBOE’ which means ‘I owe’ and is thus a certificate or
document that evidences debt of long term nature whereby the person named therein will have given the
issuing company the amount usually less than the total par value of the debenture. These debentures usually
mature between 10 to 15 years but may be endorsed, negotiated, discounted or given as securities for loans in
which case they will have been liquidated before their maturity date. The current interest rate is payable twice
a year and it is a legal obligation.

Classification
i) Secured Debentures
These are those types of debentures which a company will secure usually in two ways, secured with a fixed
charge or with a floating charge.

a) Fixed Charge – a debenture is secured with a fixed charge if it can claim on a specific asset.
b) Floating charge – if it can claim from any or all of the assets which have not been pledged as
securities for any other form of debt.

ii) Naked Debentures

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

iii) Redeemable Debentures

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

iv) Irredeemable Debentures (perpetuities)

These are never bought back in which case they form permanent source of finance for the company.
However, these are rare and are usually sold by company’s with a history of stable ordinary dividend record.

v) Classification according to convertibility

Convertible debentures – Can be converted into ordinary shares although they can also be converted into
preference shares.

Conversion price = par value of a debenture/No. of shares to be received.

Conversion ratio = Par value of debenture

Par value of ordinary shares

vi) Non-convertible debentures

These cannot be converted into ordinary preference shares and they are usually redeemable.

vii) Sub-ordinate debentures

Usually last for as long as 10 years and they are sold by financially strong companies. Such are not secured
and they rank among general creditors in claiming on assets during liquidation. This means that they are sub-
ordinate to senior debt but superior to ordinary and preference share capital.

Reasons behind Unpopularity of Debentures of Kenya’s Financial Market:

i) Their par value is an extremely high value and as such they are unaffordable to purchase by would be
investors.
ii) They are in most cases secured debt and as such constrain the selling company in so far as getting
sufficient securities is difficult.
iii) Most of the would-be sellers have low credit worthiness which is difficult.
iv) Kenya’s capital markets are not developed and as such there is no secondary debenture market where
they can be discounted or endorsed.
v) Debentures finance is not known among the general business community and as such many would
be sellers and buyers are ignorant of its existence.
vi) Being long term finance there are a few buyers who may be willing to stake their savings for a long
period of time.
vii) Such finance calls for a fixed return, which in the long rum will be eroded by inflation.

8. Venture Capital
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 therefore investment specialists who raise pools of
capital to fund new ventures which are likely to become public corporations in return for an ownership
interest. They buy part of the stock of the company at a low price in anticipation that when the company
goes public, they would sell the shares at a higher price and therefore make a considerably high profit.

Venture capitalists also provide managerial skills to the firm. Example of venture capitalists are pension
funds, wealthy individuals, insurance companies, Acacia fund, Rock fella, etc.

Since the goal of venture capitalists is to make quick profits, they will invest only in firms with a potential for
rapid growth.
Venture capitalists, will only invest in a company if there is a reasonable chance that the company will be
successful. Their publicity material states that successful investments have three common characteristics.
a) There is a good basic idea, a product or service which meets real customer needs.
b) There is finance, in the right form to turn the idea into a solid business.
c) There is the commitment and drive of an individual or group and the determination to succeed.

Attributes of venture capital

i) Equity participation – Venture Capital participate through direct purchase of shares or fixed return
securities (debentures and preference shares)
ii) Long term investment – venture capital is an investment attitude that necessitates the venture
capitalists to wait for a long time (5 – 10 years) to make large profits (capital gains).
iii) Participation in Management – Venture capitalists give their Marketing, Planning and Management
Skills to the new firm. This hands – on Management enable them protect their investment.

Role of Venture Capital in Economic Development

The types of venture that capitalists might invest will involve:

a) Business start-ups – When a business has been set up by someone who has already put time and
money into getting it started, the group may be willing to provide finance to enable it to get off the
ground. With start-ups, venture capital often prefers to be one of several financial institutions
putting in venture capital.
b) Business development – The group may be willing to provide development capital for a company
which wants to invest in new products or new markets or to make a business acquisition, and so
which so needs a major capital injection.
c) Management buyout – A management buyout is the purchase of all or parts of a business from its
owners by its managers.
d) Helping a company where one of its owners wants to realize all or part of his investment. The
venture capital may be prepared to buy some of the company’s equity.

Funding Venture Capital

When a company’s directors look for help from a venture capital institution, they must recognize that:

a) The institution will want an equity stake in the company.

b) It will need convincing that the company can be successful (management buyouts of companies
which already have a record of successful trading have been increasingly favored by venture
capitalists in recent years.
c) It may want to have a representative appointed to the company’s board, to look after its interests.

The directors of the company then contract venture capital organizations, to try to find one or more which
would be willing to offer finance. A venture capital organization will only give funds to a company that it
believes can succeed.

Reasons for Significant Growth in Venture Capital in the Developed Countries

i) Public attitude i.e a favourable attitude by the public at large towards entrepreneurship, success as
well as failure.
ii) Dynamic financial system e.g efficient stock exchange and a competitive banking system.
iii) Government support – e.g taxation system to encourage venture capital e.g tax concessions and
investment allowance taxes.
iv) Establishment of venture capital institutions e.g investors in the industry.
v) Growth in the number of Management buyers (MBO) which have created a demand for equity
finance.
Constraints of Venture Capital in Kenya
1. Lack of rich investors in Kenya, hence inadequate equity capital.
2. Inefficiencies of stock market – NSE is inefficient and investors cannot sell the shares in future.
Prices do not reflect all the available information in the market.
3. Infrastructural problems – this limits the growth rate of small firms which need raw materials and
unlimited access to the market factors of production.
4. Lack of managerial skills on part of venture capitalists and owners of the firm.

1. Nature of small business in Kenya. There are 3 categories.

a. Large MNC – these are established firms and can raise funds easily.
b. Asian owned small businesses – They are family owned hence do not require interference of
venture capitalists because they are not ready to share profits.
c. African – owned business – need venture capital but have little potential for growth.

6. Focus on low risk ventures e.g confining to low technology, low growth sectors with minimum
investment risks.
7. Conservative approach by the venture capitalists.
8. Delay in project evaluation e.g months or more hence entrepreneurs loose interest in the project.
9. Lack of government support and inefficient financial system.

Summary
In sum, venture capital, by combining risk financing with management and marketing assistance, could
become an effective instrument in fostering developing countries. The experiences of developed countries
and the detailed case study of venture capital however, indicate that the following elements are needed for the
success of venture capital in any country.

 A broad-based (and less family based) entrepreneurial traditional societies and government
encouragement for innovations, creativity and enterprise.
 A less regulated and controlled business and economic environment where attractive customer
opportunities exists or could be created from high-tech and quality products.
 Existence of disinvestments mechanisms, particularly over-the counter stock exchange catering for the
needs of venture capitalists.
 Fiscal incentives which render the equity investment more attractive and develops ‘equity cult’ in
investors.
 A more general, business and entrepreneurship oriented education system where scientists and
engineers have knowledge of accounting, finance and economics and accountants understand
engineering or physical sciences.
 An effective management education and training programme for developing professionally competent
and committed venture capital managers; they should be trained to evaluate and manage high
technology, high risk ventures.
 A vigorous marketing thrust, promotional efforts and development strategy, employing new concepts
such as venture fair clubs, venture networks, business incubators etc. for the growth of venture capital.
 Linkage between universities/technology institutions, R & D. Organisations, industry, and financial
institutions including venture capital firms.
 Encouragement and funding or R & D by private public sector companies and the government for
ensuring technological competitiveness.

Disadvantages of Venture Capital

 Dilute ownership position of a firm
 Dilute control of a firm
 CHAPTER THREE
FINANCIAL STATEMENT ANALYSIS
Definition
Financial analysis is a process by which finance identifies the company’s financial performances by comparing
the entities in the balance sheet and those in the profit and loss account (P&L). This is so because balance
sheet entities are usually responsible for those to be found in the P&L i.e. assets shown in the balance sheet
are responsible for sales, revenue and expenses to be found in the P&L. This analysis is important to various
parties with a financial stake in the company. These include:

1. Shareholders – Actual owners are interested in the company’s both short and long term survival. For
this reason they will use ratio’s such as:

a) Profitability ratios – which seek to establish viability.

b) Dividend ratios – which seek to establish return to owners in form of dividends. The
common ratios include earning yield (E/Y), Dividend pay out ratio (DPO), dividend yield,
Price earning ratio, all of which will measure return to owner.

2. Creditors (trade) – these are interested in the company’s ability to meet their short-term obligations
as and when they fall due. For this reason they will use ratios such as:

a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid test
ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against current
liabilities.

3. Long term lenders – These include finances through loans, mortgages and debenture holders. These
have both short and long term interest in the company and its ability to pay not only interest on debt
but also principal as and when it falls due. These parties are interested in the following:

a) Liquidity ratios – used to assess short-term liability to meet current obligations.

b) Profitability ratios – used to ascertain whether the company can pay its principal back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment of interest
to the lenders of the debt.

4. Directors and management of company – They will therefore be interest in:

a) Efficiency of the company in generating profits.

b) The company’s viability from the investor’s point of view and the company’s ability to
generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.

5. Potential investors – these parties are interested in a company in total both on short and long term
basis in particular the company’s ability to generate acceptable return on their money.

Therefore, they will use:

 a) Dividend ratios
b) Return ratios
c) Gearing ratios

6. Government – The Government is interested mostly in utility companies (e.g. KPLC, KPTC) and
those that will provide public services – in this case the government will be interested in their survival
and thus ability to provide those services. It may be interested in taxation derived from these
companies which is used for development. Government may also be interested in employment level
and as such it will use those ratios that can enable it to achieve such objectives of particular
importance are:

a) Profitability ratios
b) Return ratios

7. Competitors – These are interested in the company’s performance from the market share point of
view and will use the ratios that enable them to ascertain company’s competitive strength e.g.
profitability ratios, sales and returns ratio etc.

8. General public – Customers and potential customers – These are interested in the ability of the
company to provide good services both in the short and long run. To gauge the company’s ability to
provide goods and services on short and long term basis. We have:

a) Returns ratio
b) Sales ratio

YARD STICK USED IN RATIO ANALYSIS

1. Past performance of the company
The company’s past performance (past ratio) is used to measure or gauge the company’s performance and in
particular the change in performance whether good (favourable), better, same or even worse than the past.
Such comparison is then used to interpret the company’s performance bearing in mind the factors that
influenced the present and past performances.

2. Average industry ratios

These are useful as they indicate the average performance of various companies in a given industry i.e. it gives
the minimum performance of a number of companies in a given industry. These ratios are useful in so far as
to enable the analyst to make a reasonable comparison of the company’s performance vis-à-vis other
companies in the same industry. However, for this yardstick to be useful the term average should include
those companies which are not extremely. I.e. very strong and very weak companies – which should be
excluded to arrive at industry average figures.

3. Ratio of successful companies

Useful if the company can get figures of competitors who are leading in the market so as to enable it to gauge
its performance against better performance. However this information is difficult to obtain and sometimes it
calls for private investigators e.g. Private Eyes Ltd.

4. Ratio of budgeted performance

These are compared with actual performance ratios and investigations are made of any unfavorable variance
which should be explained.
Classification of Ratios
Ratios are broadly classified into 5 categories:

1. Liquidity ratios
2. Turnover ratios
3. Gearing ratios
4. Profitability ratios
5. Growth and valuation ratios

1. Liquidity Ratios
Also called working capital ratios. They indicate ability of the firm to meet its short term maturing financial
obligation/current liabilities as and when they fall due.

The ratios are concerned with current assets and current liabilities. They include:

a) Current ratio = Current Assets

Current liabilities

This ratio indicates the No. of times the current liabilities can be paid from current assets before this assets
are exhausted.

The most recommended ratio is 2.0 i.e. the current asset must at least be twice as high as current liabilities

b) Quick/acid test ratios = Current Asset - Stock

Current liabilities

Is a more refined current ratio which exclude amount of stock of the firm. Stocks are excluded for two basic
reasons.

i) They are valued on historical cost basis

ii) They may not be converted into cash very quickly

The ratio therefore indicates the ability of the firm to pay its current liabilities from the more liquid assets of
the firm.

c) Cash ratio = Cash in hand/bank + short term marketable securities

Current liabilities

This is a refinement of the acid test ratio indicating the ability of the firm to meet its current liabilities from its
most liquid resources.
Short term marketable securities refers to short term investment of the firm which can be converted into cash
within a very short period e.g commercial paper and treasury bills.

d) Net working capital Ratio = Networking Capital x 100

Net Assets

Where Net Assets or Capital employed = Total Assets – Current liability

This ratio indicates the proportions of total net assets which is liquid enough to meet the current liabilities of
the firm.
It is expressed in % term.

2. Turnover Ratios/ efficiency/ asset management ratio

Turnover ratio indicate the efficiency with which the firm utilised the asset or resources at its disposal to
generate sales revenue or turnover.

This ratio includes:

a) Stock/inventory turnover = Cost of Sales

Average stock

The ratio indicate number of times the stock was turned into sales in a year i.e how many times did the ‘buy-
sell’ process occur during the year. The higher the stock turnover, the better the firm and more likely the
higher the sales.

b) Stock holding period = 365 days

Stock turnover

= 365 x Average stock i.e 365

Cost of sales Stock turnover

The ratio indicates number of days the stock was held in the warehouse before being sold.

The higher the stock turnover, the lower the stock holding period and vice versa.

c) Debtors/accounts receiver turnover = Annual credit sales

Average debtor

The ratio indicate the number of times/frequency with which credit customers or debtors were turned into
sale i.e the number of times they come to buy on credit per year after paying their dues to the firm.
The higher the debtors turnover the better the firm indicating that customers came to buy on credit many
times thus they paid within a short period.

d) Debtors collection period = 365

Debtors turnover

or 365 x Average debtors

Annual credit sales

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

The shorter the collection period/credit period the higher the debtors turnover and vice versa.

If no opening debtors are given use the closing debtors to represent average debtors.

e) Creditors/accounts payable turnover = Annual credit purchases

Average creditors
  The firm buy goods on credit from suppliers.
 The ratio indicate number of times p.a. the firm bought goods on credit after paying the
suppliers.
 If the creditors turnover is high, this indicates that the payment was made
 within a short period of time.

f) Creditors payment period = 365

Creditors turnover

= 365 x Average creditors

Annual credit purchases

 The ratio indicate the credit period granted by the suppliers i.e. the period
 within which the firm should pay its liabilities to the suppliers.
 The shorter the period the higher the creditors turnover and vice-versa.

g) Fixed asset turnover = Annual Sales

Fixed Assets

 This ratio indicate the efficiency with which, the fixed assets were utilised to generate sales
revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilised to generate Sh.1.4 of
sales.

h) Total asset turnover = Annual sales

Total assets

 The ratio indicate amount of sales revenue generated from utilisation of one shilling of total
asset.

The Concept of Working Capital/Cash Operating Cycle

Working capital cycle refers to period that elapses between the payment for raw materials bought on credit
(cash outflows) and the receipts of cash from finished goods sold on credit (cash inflows).

The working capital cycle will involve the following:

a) Purchase of raw materials on credit from suppliers

b) Payment of raw materials after the lapse of credit period
c) Conversion of raw materials into finished goods
d) Sale of finished goods to creditors
e) Receipt of cash from debtors.

This can be illustrated using a diagram as follows:

 Raw material stock conversion period

A B C D
Creditors Payment Period Debtors Collection Period

Purchase of Payment of Finished goods Receipts of

Raw materials raw materials sold on credit cash goods
On credit cash outflow sold on credit
Cash inflows

Working Capital Cycle

Working capital cycle = Stock conversion + debtors collection – Creditors payment

From the diagram the working capital cycle of a period will be determined as follows:

Stock conversion period + Debtors collection period – Creditors payment period

Note
A lengthy working capital cycle is an indicator of poor management of stock and debtors reflecting low
turnover of stock and debtors and lengthy stockholding period and debtors collection period.

The working capital cycle can be reduced in any of the following ways:

1. Negotiate for a longer credit period with the suppliers

2. Reduce the stock conversion period or manufacturing period.
3. Reduce the debtors collection period by granting short crediting period. This can be achieved
through offering discounts to customers to encourage them to pay earlier.
4. Holding fast moving goods to ensure high turnover.
5. Timely delivery of raw materials by suppliers especially if any delay in delivery will lengthen the raw
materials holding period.
3. Gearing/Leverage/Capital Structure Ratio

 The ratio indicate the extent in which the firm has borrowed fixed charge capital to finance the
acquisition of the assets or resources of the firm.
 The two basic gearing ratios are:

a) Debt/equity ratio = Fixed charge capital

Equity (net worth)

This ratio indicate the amount of fixed charge capital in the capital structure of the firm for every one shilling
of owners capital or equity e.g a ratio of 0.78 means for every Sh.1 of equity there is Sh.0.78 fixed charge
capital.

b) Fixed charge to total capital ratio = Fixed charge capital x 100

Total capital employed
Where total capital employed = Fixed charge capital + equity relative to total capital employed by the firm e.g
a ratio of 0.38 means that, 38% of the capital employed is fixed charge capital.

Other leverage or gearing ratios are

a) Debt ratio = Total debts

Total assets

Where total debt = fixed charge capital + liabilities.

The ratio indicate the proportion of total assets that has been financed using long term and current liabilities
e.g a debt ratio of 0.45 mean 45% of total asset has been financed with debt while the remaining 55% was
financed with owners equity/capital.

b) Times interest earned ratio = Operating profit (earning before interest and tax
Interest Charges

TIER also called interest coverage ratio.

This ratio indicate the number of times interest charges can be paid from operating profit. The higher the
TIER, the better the firm indicating that either the firm has high operating profits or its interest charges are
low.

If TIER is high due to low interest charges, this indicates low level of gearing/debt capital of the firm.

4. Profitability Ratio

This ratio indicate the performance of the firm in relation to its ability to derive returns or profit from
investment or from sale of goods i.e profit margin or sales.

1. Profitability in relation to sales

 The ratio indicate the ability of the firm to control its cost of sales, operating and financing
expenses.
 They include:

a) Gross profit margin = Gross profit x 100

Sales

The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit margin of 40%
means 60% of sales revenue was taken up by cost of sales while 40% was the gross profit.

b) Operating profit margin = Operating profit/Earning before interest & tax

Sales

The ratio indicates ability of the firm to control its operating expenses such as distribution cost, salaries and
wages, travelling, telephone and electricity charges etc. e.g a ratio of 20% means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit

c) Net profit margin = Net profit x 100 (earning after tax) + interest
 Sales

This ratio indicates the ability of the firm to control financing expenses in particular interest charges e.g. Net
profit margin of 10% indicate that:

i) 90% of sales were taken up by cost of sales, operating and financing expenses
ii) 10% remained as net profits.

2. Profitability in relation to investment

a) Return on Investment (ROI) = Net profit x 100

or return on total asset (ROTA) Total asset

The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of 20% means Sh.10
of total asset generated Sh.2 of net profit.

b) Return on equity (ROE) = Net profit x 100

or Return on net worth (RONW) equity
or Return on shareholders equity (ROSE)

The ratio indicate the return of profitability for every one shilling of equity capital contributed by the
shareholders e.g a ratio of 25% means one shilling of equity generates Sh.0.25 profit attributable to ordinary
shareholders.

c) Return on capital employed ROCE = Net profit x 100

or Return on net asset (RONA) Net Asset (Capital employed)

This ratio indicate the returns of profitability for every one shilling of capital employed in the firm.
5. The Growth and Valuation Ratio

This ratio indicates the growth potential of the firm in addition to determining the value of the firm and
investment made by various investors. They include the following:

a) Earnings per share EPS = Earnings to Ordinary shareholders

No. of ordinary shares

This ratio indicate 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.

b) Earnings yield (EY) = Earnings per share x 100

Market price per share



The market price per share (MPS) is the price at which new shares can be bought from the stock market.
These ratios therefore indicate the returns or earnings for every one shilling invested in the firm.

c) Dividends per share (DPS) = Dividend paid

No. of ordinary shares

- This indicates the cash dividend received for every share held by an investor. If all the earnings
attributable to ordinary shareholders were paid out as dividend, then EPS = DPS.

d) Dividend Yield (DY) = Dividend per share x 100

 Market price per share

Or Dividend paid
Market value of equity

Where market value of equity = No. of shares x MPS

 This ratio indicates the cash dividend returns for every one shilling invested in the firm.

e) Price earnings (P/E) = Market price per share (MPS)

Ratio Earning per share
OR
= Market value of equity
Earning to Ord. Shareholders

 P/E ratio is a reciprocal of earning yield (EY). The MPS is the price at which a new share can be bought


i.e investment per share. The EPS is the annual income/earnings from each share.
PE therefore indicate the payback period i.e number of years it will take to recover MPS from the annual
earnings per share of the firm.

f) Dividend cover = EPS = Earning to ordinary shares

DPS Dividend paid

 This indicate the number of times dividend can be paid from earnings to ordinary shareholders. The
higher the DPS the lower the dividend cover and vice-versa e.g consider the following two firms X and Y

X Y
EPS 12/= 12/=
DPS 3/= 5/=
Dividend cover 12 = 4 12 = 2.4 times
3 5

g) Dividend pay out ratio = DPS x 100 = Dividend paid

EPS Earning to ordinary shareholder

 This is the reciprocal of dividend cover. It indicates the proportion of earnings that was paid out as
dividend e.g a payout ratio of 40% means 60% of earnings were retained while 40% was paid out as
dividend, therefore retention ratio = 1 – dividend payout ratio

h) Book value per share = Networth Equity

(BVPS) No. of ordinary shares

 This is also called liquidity ratio which indicates the amount attributable to each share if the firm was


liquidated and all asset sold at their book value.
The ratio is based on the residual amount which would remain after paying all liabilities from the sales
proceeds of the assets.

i) Market to book value per share = MPS

BVPS
 This ratio indicates the amount of goodwill attached to the firm i.e the price in excess of the sales value
of the assets of the firm. If the ratio is greater 1(MBVPS >1) this indicate a positive goodwill while if less
than 1 a –ve goodwill.

Uses/ Application of Ratios

Ratios are used in the following ways by managers in various firms.

1. Evaluating the efficiency of assets utilisation to generate sales revenue i.e turnover ratio.
2. Evaluating the ability of the firm to meet its short term financial obligation as and when they fall due
(liquidity ratios).
3. To carry out industrial analysis i.e compare the firm’s performance with the average industrial
performance of the firm with that of individual competitors in the same industry.
4. For cross sectional analysis i.e compare the performance of the firm with that of individual
competitors in the same industry.
5. For trend/time series analysis i.e evaluate the performance of the firm over time.
6. To establish the extent which the assets of the firm has been financed by fixed charge capital i.e use
of gearing ratio
7. To predict the bankruptcy of the firm i.e use of selected ratios to determine the overall ratio usually
called Z-score. The Z-score when compared with a pre-determined acceptable a Z-score will
indicate the probability of the bankruptcy of the firm in future.

Limitations of Ratios

Ratios have the following weaknesses:

1. They ignore the size of the firm being compared e.g in cross-sectional analysis, the firm being
compared might be of different size, technology and product diversification.
2. Effect of inflation:
Ratio ignores the effect of inflation in performance e.g increase in sales might be due to increase in
selling price caused by inflationary pressure in the economy.
3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g important assets such as
corporate image, efficient management team, customer loyalty, quality of product, technological
innovation etc are not captured in ratio analysis.
4. Ratios are computed only at one point in time i.e they are subject to frequent changes after
computation e.g liquidity ratios will constantly change as the cash, debtors and stock level changes.
5. Monopolistic firms
It is difficult to carry out industrial and cross-sectional analysis for monopolistic firms since they do
not have competitors and they are the only firms in the whole industry e.g Telkom-Kenya, East
Africa Brewery etc.
6. Historical Data – Ratios are computed in historical information or financial statement thus may be
irrelevant in future decision-making of
7. Computation and interpretation
Generally some ratios do not have an acceptable standard of computation. This may differ from one
industry to another. E.g the return on investment may be computed as:

Return on investment = EBIT or EAT

Total assets Total assets

8. Different accounting policies – Different firms in the same industry use different accounting policies
e.g methods of depreciation and stock valuation. This makes comparison difficult.
 REINFORCING QUESTIONS
QUE STION ONE
An extract from the finance statements of Kenyango Fisheries Ltd is shown below:

Shs.
Issued share capital:
150,000 ordinary shares of Sh.10 each fully paid 1,500,000
10% loan stock 1999 2,000,000
Share premium 1,500,000
Revenue Reserve 7,000,000
Capital employed 12,000,000



The profits after 30% tax is Sh.600,000. However, interest charge has not been deducted.


Ordinary dividend payout ratio is 40%.
The current market value of ordinary shares Shs.36

Required
a) Return on capital employed
b) Earnings per share
c) Price earnings ratio
d) Book value per share
e) Gearing ratio
f) Market to book value per share

QUE STION TWO

The following financial statements relate to the ABC Company:

Assets Shs. Liabilities & Net worth Shs.

Cash 28,500 Trade creditors 116,250
Debtors 270,000 Notes payable (9%) 54,000
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 expenses 498,750
Earning before interest and tax 105,750
Interest expense 34,500
71,250
Estimated taxation (40%) 28,500
Earnings after interest and tax 42,750
Required
a) Calculate:
i) Inventory turnover ratio; (3 marks)
ii) Times interest earned ratio; (3 marks)
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.

QUE STION THREE

The following information has been extracted from the published accounts of Pesa Corporation Limited, a
company quoted on the Nairobi Stock Exchange.

Shs.
Net profit after tax and interest 990,000
Less: dividends for the period 740,000
Transfer to reserves 250,000
Accumulated reserves brought forward 810,000
Reserves carried forward 1,060,000

Share capital (Sh.10 par value) Sh.8,000,000

Mar02ket price per share now 12%

Required
a) What is meant by a company quoted on the Nairobi Stock Exchange?
(6 marks)

b) Calculate for Pesa Corposation Limited the following ratios and indicate the importance of
each to Miss Hisa, a Shareholder:

i) Earnings per share. (4 marks)

ii) Price earnings ratio (4 marks)
iii) Dividend yield (4 marks)
iv) Dividend cover (4 marks)
(Total: 22 marks)
 CHAPTER FOUR
WORKING CAPITAL MANAGEMENT

CONTE NTS


Introduction


Financing of Working Capital /Current Assets


Determinants of Working Capital needs


Importance of working capital management


Management of Short term investment


Working capital cycle
Management of cash , stock and Accounts Receivable

WORKING CAPITAL
a) Working capital (also called gross working capital) refers to current assets.
b) Net working capital refers to current assets minus current liabilities.
c) Working capital management refers to the administration of current assets and current liabilities.



Target levels of each category of current assets
How current assets will be financed

d) Liquidity management involves the planned acquisition and use of liquid resources over time to meet
cash obligations as they become due. The firm’s liquidity is measured by liquidity ratio such as
current ratio, quick (or acid test) ratio, cash ratio, etc.

FINANCING CURRENT ASSE TS

Current Assets require financing by use of either current funds or long term funds. There are three major
approaches to financing current assets. These are:

a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this approach, the firm adopts a
financial plan which involves the matching of the expected life of assets with the expected life of the source
of funds raised to finance assets.
The firm, therefore, uses long term funds to finance permanent assets and short-term funds to finance
temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This approach can be shown by the
following diagram.
b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the asset may not be possible. A
firm that follows the conservative approach depends more on long-term funds for financing needs. The firm,
therefore, finances its permanent assets and a part of its temporary assets with long-term funds. This
approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds. (Some sources of short-term
funds such as accruals are cost-free). However, short-term funds must be repaid within the year and
therefore they are highly risky. With this in mind, we can consider the risk-return trade off of the three
approaches.

The conservative approach is a low return-low risk approach. This is because the approach uses more of
long-term funds which are now more expensive than short-term funds. These funds however, are not to be
repaid within the year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach. However it is also a high return
approach the reason being that it relies more on short-term funds that are less costly but riskier.
The matching approach is in between because it matches the life of the asset and the life of the funds
financing the assets.

DE TE RMINANTS OF WORKING CAPITAL NEE DS

There are several factors which determine the firm’s working capital needs. These factors are
comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406). They however
include:

a) Nature and size of the business.

b) Firm’s manufacturing cycle
c) Business fluctuations
d) Production policy
e) Firm’s credit policy
f) Availability of credit
g) Growth and expansion activities.

IMPORTANCE OF WORKING CAPITAL MANAGE ME NT

The finance manager should understand the management of working capital because of the following
reasons:

a) Time devoted to working capital management

A large portion of a financial manager’s time is devoted to the day to day operations of the firm and
therefore, so much time is spent on working capital decisions.

b) Investment in current assets

Current assets represent more than half of the total assets of many business firms. These investments tend to
be relatively volatile and can easily be misappropriated by the firm’s employees. The finance manager should
therefore properly manage these assets.

c) Importance to small firms

A small firm may minimise its investments in fixed assets by renting or leasing plant and equipment, but there
is no way it can avoid investment in current assets. A small firm also has relatively limited access to long term
capital markets and therefore must rely heavily on short-term funds.

d) Relationship between sales and current assets

The relationship between sales volume and the various current asset items is direct and close. Changes in
current assets directly affects the level of sales. The finance management must therefore keep watch on
changes in working capital items.

CASH AND MARKE TABLE SE CURITIE S MANAGE ME NT

The management of cash and marketable securities is one of the key areas of working capital management.
Since cash and marketable securities are the firm’s most liquid assets, they provide the firm with the ability to
meet its maturing obligations.

Cash refers to cash in hand and cash on demand deposits (or current accounts). It therefore excludes cash in
time deposits (which is not immediately available to meet maturing obligations).

Marketable securities are short-term investments made by the firm to obtain a return on temporary idle funds.
Thus when a firm realises that it has accumulated more cash than needed, it often puts the excess cash into an
interest-earning instrument. The firm can invest the excess cash in any (or a combination) of the following
marketable securities.

a) Government treasury bills

b) Agency securities such as local governments securities or parastatals securities
c) Banker’s acceptances, which are securities, accepted by banks
d) Commercial paper (unsecured promissory notes)
e) Repurchase agreements
f) Negotiable certificates of deposits
 g) Eurocurrencies etc.

CASH CYCLE AND CASH TURNOVE RS

Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash outlay to
purchase raw materials to the point when cash is collected from the sale of finished goods produced using
those raw materials.
Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year.

Illustration
XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on credit. The credit
terms extended to the firm currently requires payment within thirty days of a purchase while the firm
currently requires its customers to pay within sixty days of a sale. However, the firm on average takes 35 days
to pay its accounts payable and the average collection period is 70 days. On average, 85 days elapse between
the point a raw material is purchased and the point the finished goods are sold.

Required
Determine the cash conversion cycle and the cash turnover.

Solution
The following chart can help further understand the question:

Inventory Conversion period (85 days)

Receivable collection
Payable deferral Period (70 days)
Period (35 days)

Purchase of Payment for the Sale of Collection of

raw materials raw materials Finished goods receivables

Cash conversion cycle = 85 + 70 - 35 = 120

The cash conversion cycle is given by the following formula:

Cash conversion = Inventory conversion + Receivable collection – Payable deferral

 Cycle period period period

For our example:

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

Cash turnover = 360

Cash conversion cycle

360
=
120

= 3 times

Note also that cash conversion cycle can be given by the following formulae:

 inventory Payables Accruals 

360    
receivables
 ingexpenses 
Cash conversion cycle =
costofsales sales Cashoperat

NB: In this chapter we shall assume that a year has 360 days.
SE TTING THE OPTIMAL CASH BALANCE
Cash is often called a non-earning asset because holding cash rather than a revenue-generating asset involves
a cost in form of foregone interest. The firm should therefore hold the cash balance that will enable it to
meet its scheduled payments as they fall due and provide a margin for safety. There are several methods used
to determine the optimal cash balance. These are:

a) The Cash Budget

The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period. This
method has already been discussed in other earlier courses. The student should however revise the cash
budget.

b) Baumol’s Model
The Baumol’s model is an application of the EOQ inventory model to cash management. Its assumptions
are:

1. The firm uses cash at a steady predictable rate

2. The cash outflows from operations also occurs at a steady rate
3. The cash net outflows also occur at a steady rate.

Under these assumptions the following model can be stated:

C*  2bT
i

Where: C* is the optimal amount of cash to be raised by selling marketable securities or by borrowing.
b is the fixed cost of making a securities trade or of borrowing
T is the total annual cash requirements
i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the cost of
borrowing)
The total cost of holding the cash balance is equal to holding or carrying cost plus transaction costs and is
given by the following formulae:

TC  1 Ci  T b
2 C

Illustration
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable securities is 12%
and every time the company sells marketable securities, it incurs a cost of Shs.20.

Required
a) Determine the optimal amount of marketable securities to be converted into cash every time the
company makes the transfer.
b) Determine the total number of transfers from marketable securities to cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.

Solution
2bT
a) C*
i

Where: b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%

C*   Sh.13,166
2 x 20 x 520,000
0.12

Therefore the optimal amount of marketable securities to be converted to cash every time a sale is made is
Sh.13,166.

T
b) Total no. of transfers =
C*

520,000
=
13,166

= 39.5
 ≈ 40 times

TC  Ci  b
1 T
c)
2 C


13,166x 0.12 520,000x 20
=
2 13,166

= 790 + 790 = Shs.1,580

Therefore the total cost of maintaining the above cash balance is Sh.1,580.

d) The firm’s average cash balance = ½C

13,166
=
2

= Shs.6,583
c) Miller-Orr Model
Unlike the Baumol’s Model, Miller-Orr Model is a stochastic (probabilistic) model which makes the more
realistic assumption of uncertainty in cash flows.

Merton Miller and Daniel Orr assumed that the distribution of daily net cash flows is approximately normal.
Each day, the net cash flow could be the expected value of some higher or lower value drawn from a normal
distribution. Thus, the daily net cash follows a trendless random walk.

From the graph below, the Miller-Orr Model sets higher and lower control units, H and L respectively, and a
target cash balance, Z. When the cash balance reaches H (such as point A) then H-Z shillings are transferred
from cash to marketable securities. Similarly, when the cash balance hits L (at point B) then Z-L shillings are
transferred from marketable securities cash.

The Lower Limit is usually set by management. The target balance is given by the following formula:

Z   3B 
 2
1/ 3
L

4i 


and the highest limit, H, is given by:

H = 3Z - 2L

4Z  L
The average cash balance=
3

Where: Z = target cash balance

H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
δ² = variance of net daily cash flows
Illustration
XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The standard deviation of
daily cash flow is Sh.2,500 and the interest rate on marketable securities is 9% p.a. The transaction cost for
each sale or purchase of securities is Sh.20.

Required
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread

Solution

 3b² 
Z  L
1/ 3

 4i 
a)

 
 3x 20 x ( 2,500)² 
   10,000
 
=
 
9%
4x
360

= 7,211 + 10,000 = Sh.17,211

b) H = 3Z – 2L
= 3 x 17,211 – 2(10,000)
= Shs.31,633
 4Z  L
c) Average cash balance =
3

4 x17,211  10,000
=
3

d) The spread = H– L
= 31,633 – 10,000
= Shs.21,633

Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 (31,633 – 17,211) in marketable
securities and if the balance falls to Shs.10,000, the firm should sell Shs.7,211(17,211 – 10,000) of marketable
securities.

Other Methods
Other methods used to set the target cash balance are The Stone Model and Monte Carlo simulation.
However, these models are beyond the scope of this manual.

CASH MANAGE MENT TE CHNIQUE S

The basic strategies that should be employed by the business firm in managing its cash are:

i) To pay account payables as late as possible without damaging the firm’s credit rating. The firm
should however take advantage of any favourable cash discounts offered.
ii) Turnover inventory as quickly as possible, but avoid stockouts which might result in loss of sales or
shutting down the ‘production line’.
iii) Collect accounts receivable as quickly as possible without losing future sales because of high pressure
collection techniques. The firm may use cash discounts to accomplish this objective.

In addition to the above strategies the firm should ensure that customer payments are converted into
spendable form as quickly as possible. This may be done either through:

a) Concentration Banking
b) Lock-box system.

a) Concentration Banking
Firms with regional sales outlets can designate certain of these as regional collection centre.
Customers within these areas are required to remit their payments to these sales offices, which
deposit these receipts in local banks. Funds in the local bank account in excess of a specified limit
are then transferred (by wire) to the firms major or concentration bank.
Concentration banking reduces the amount of time that elapses between the customer’s mailing of a
payment and the firm’s receipt of such payment.

b) Lock-box system.

In a lock-box system, the customer sends the payments to a post office box. The post office box is
emptied by the firm’s bank at least once or twice each business day. The bank opens the payment
envelope, deposits the cheques in the firm’s account and sends a deposit slip indicating the payment
received to the firm. This system reduces the customer’s mailing time and the time it takes to
process the cheques received.
MANAGE ME NT OF INVENTORIE S
Manufacturing firms have three major types of inventories:

1. Raw materials
2. Work-in-progress
3. Finished goods inventory

The firm must determine the optimal level of inventory to be held so as to minimize the inventory relevant
cost.

BASIC E OQ MODE L
The basic inventory decision model is Economic Order Quantity (EOQ) model. This model is given by the
following equation:

Q
2DCo
Cn

Where: Q is the economic order quantity

D is the annual demand in units
Co is the cost of placing and receiving an order
Cn is the cost of holding inventories per unit per order

The total cost of operating the economic order quantity is given by total ordering cost plus total holding
costs.

D
TC = ½QCn + Co
Q

Where: Total holding cost = ½QCn

D
Total ordering cost = Co
Q

The holding costs include:

1. Cost of tied up capital

2. Storage costs
3. Insurance costs
4. Obsolescence costs

The ordering costs include:

1. Cost of placing orders such as telephone and clerical costs

2. Shipping and handling costs
Under this model, the firm is assumed to place an order of Q quantity and use this quantity until it reaches
the reorder level (the level at which an order should be placed). The reorder level is given by the following
formulae:

R
D
L
360

Where: R is the reorder level

D is the annual demand
L is the lead time in days

E OQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:

i) The demand is known and constant over the year

ii) The ordering cost is constant per order and certain
iii) The holding cost is constant per unit per year
iv) The purchase cost is constant (Thus no quantity discount)
v) Back orders are not allowed.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming year which costs
Sh.50 each. The items are available locally and the leadtime in one week. Each order costs Sh.50 to prepare
and process while the holding cost is Shs.15 per unit per year for storage plus 10% opportunity cost of
capital.

Required
a) How many units should be ordered each time an order is placed to minimize inventory costs?
b) What is the reorder level?
c) How many orders will be placed per year?
d) Determine the total relevant costs.

Suggested Solution:

Q
2DCo
a)
Cn

Where: D = 2,000 units

Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days

Q  100unit s
2 x 2,000x 50
20
 DL
b) R =
360

2,000x 7
=
360

= 39 units

D
c) No. of orders =
Q

2,000
=
100

= 20 orders

D
d) TC = ½QCn + Co
Q

2,000
= ½(100)(20) + (50)
100

= 1,000 + 1,000

= Sh.2,000

Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is received.

E XISTE NCE OF QUANTITY DISCOUNTS

Frequently, the firm is able to take advantage of quantity discounts. Because these discounts affect the price
per unit, they also influence the Economic Order Quantity.

If discounts exists, then usually the minimum amount at which discount is given may be greater than the
Economic Order Quantity. If the minimum discount quantity is ordered, then the total holding cost will
increase because the average inventory held increases while the total ordering costs will decrease since the
number of orders decrease. However, the total purchases cost will decrease.

Illustration
Consider illustration one and assume that a quantity discount of 5% is given if a minimum of 200 units is
ordered.

Required
Determine whether the discount should be taken and the quantity to be ordered.

Suggested Solution
We need to consider the saving in purchase costs; savings in ordering costs and increase in holding costs.

Savings in purchase price:

New purchase price = 50 x 95% = Sh.47.50 per unit

Savings in purchase price per unit = 50 – 47.50
= Sh.2.50
Total units per year = 2,000
Total savings = 2,000 x 2.50 = Sh.5,000

Savings in Ordering Cost

Assuming an order quantity of 200 units per order, the total ordering cost will be:

2,000
(50) = Sh.500
100

Ordering cost if 100 units is ordered

2,000
(100) = Sh.1,000
100

Therefore savings in ordering costs = 1,000 – 500 = Sh.500

Increase in holding costs

Holding cost if 200 units are ordered

½(200)19.75 = Sh.1,975

holding costs if 100 units are ordered

½(100(20) = Sh.1,000

Increase in holding costs = 1,975 – 1,000 = Sh.975

The Net Effect therefore:

Shs.
Savings in purchases costs 5,000
Savings in ordering costs 500
Total savings 5,500
Less increase in holding costs 975
Net savings 4,525

Qd 
2DCo
Cn

Qd 
2 x 2,000x 50
19.75

Cn = 15 + 10% x 4.75 = Shs.19.75

The discount should be taken because the net savings is positive. To determine the number of units to order
we recomputed Q with discount Qd.

= 100.6 units
Decision rule:
If Qd < minimum discount quantity, then order the minimum discount quantity.
If Qd < minimum discount quantity, then order Qd.

UNCE RTAINTY AND SAFE TY STOCKS

Usually demand requirements may not be certain and therefore the firm holds safety stock to safeguard stock
out cases. The existence of safety stock can be illustrated by Figure 5.7.

The safety stock guards against delays in receiving orders. However, carrying a safety stock has costs (it
increases the average stock).

Illustration
Consider illustration one and assume that management desires to hold a minimum stock of 10 units (this
stock is in hand at the beginning of the year).

Required
a) Determine the re-order level
b) Determine the total relevant costs

Suggested solution

S
DL
a) R =
360

Where: S is the safety stock

x 7  10
2,000
=
360

= 49 units

b) The average inventory = ½Q + S

TC = (½Q + S)Cn + D/QCo

2,000
= [½(100) + 10]20 + (50)
100

= 1,200 + 1,000

= Shs.2,200
MANAGE ME NT OF ACCOUNT RE CE IVABLE
In order to keep current customers and attract new ones, most firms find it necessary to offer credit.
Accounts receivable represents the extension of credit on an open account by a firm to its customers.
Accounts receivable management begins with the decision on whether or not to grant credit.

The total amount of receivables outstanding at any given time is determined by:

a) The volume of credit sales

b) The average length of time between sales and collections.

Accounts receivables = Credit sales per day x Length of collection period

The average collection period depends on:

a) Credit standards which is the maximum risk of acceptable credit accounts

b) Credit period which is the length of time for which credit is granted
c) Discount given for early payments
d) The firm’s collection policy.

a) CRE DIT STANDARDS

A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends to sell
on credit to customers on a very liberal terms and credit is granted for a longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a highly selective basis only to
those customers who have proven credit worthiness and who are financially strong.

A lenient credit policy will result in increased sales and therefore increased contribution margin. However,
these will also result in increased costs such as:

1. Increased bad debt losses

2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments

The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the evaluation
of investment in receivables should involve the following steps:

1. Estimation of incremental operating profits from increased sales

2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs

b) CRE DIT TE RMS

Credit terms involve both the length of the credit period and the discount given. The terms 2/10, n/30
means that a 2% discount is given if the bill is paid before the tenth day after the date of invoice otherwise
the net amount should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability caused by longer credit and
discount period or a higher rate of discount against increased cost.
c) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of receivables. It can also result in
reduced bad debt losses.

d) COLLE CTION POLICY

The firm’s collection policy may also affect our analysis. The higher the cost of collecting account receivables
the lower the bad debt losses. The firm must therefore consider whether the reduction in bad debt is more
than the increase in collection costs.

As saturation point increased expenditure in collection efforts does not result in reduced bad debt and
therefore the firm should not spend more after reaching this point.

Illustration
Riffruff Ltd is considering relaxing its credit standards. The firms current credit terms is net 30 but the
average debtors collection period is 45 days. Current annual credit sales amounts to Sh.6,000,000. The firm
wants to extend credit period net 60. Sales are expected to increase by 20%. Bad debts will increase from 2%
to 2.5% of annual credit sales. Credit analysis and debt collection costs will increase by Sh.4,000 p.a. The
return on investment in debtors is 12% for Sh.100 of sales, Sh.75 is variable costs. Assume 360 days p.a.
Should the firm change the credit policy?

Suggested Solution
Current sales = Sh.6,000,000
New sales = Sh.6,000,000 x 1.20 = Sh.7,200,000
Contribution margin = Sh.100 – Sh.75 = Sh.25
Sh.25
Therefore contribution margin ratio = x100 = 25%
Sh.100

Cost benefit analysis

Contribution Margin
New policy 25% x 7,200,000 = 1,800
Current policy 25% x 6,000,000 = 1,500 = 300

Credit analysis and debt collection costs (84)

Bad debts
New bad debts = 2.5% x 7,200,000 = 180
Current bad debts = 2% x 6,000,000 = 120 (60)
Debtors
Cr .period
New debtors = x cr. Sales p.a.
360days

60
= x 7,200,000 = 1,200
360

45
Current debtors = x 6,000,000 = 750
360
Increase in debtors (tied up capital) 450
Forgone profits = 12% x 450 (54)
Net benefit (cost) 102
Therefore, change the credit policy.

E VALUATION OF THE CREDIT APPLICANT

After establishing the terms of sale to be offered, the firm must evaluate individual applicants and consider
the possibilities of bad debt or slow payments. This is referred to as credit analysis and can be done by using
information derived from:

a) The applicant’s financial statement

b) Credit ratings and reports from experts
c) Banks
d) Other firms
e) The company’s own experience
 REINFORCING QUESTIONS
QUE STION ONE
Wema Ltd has estimated that the standard deviation of its daily net cash flows is Sh.2,500. The firm pays
Sh.50 in transaction costs to transfer funds into and out of this money market. The rate of interest in the
money market is 7.465% p.a. Wema uses the Miller-Orr Model to set its target cash balances.

Required
a) What is Wema’s target cash balance?
b) What are the lower and upper cash limit?
c) What are the Wema’s decision rules?
d) Determine Wema’s expected average cash balance.

QUE STION TWO

Mama Star Enterprises is a distributor or air filters to retail shops. It buys its filters from several
manufacturers. Filters are ordered in lot sizes of 100 and each order costs Sh.400 to place. Demand from
retail shops is 200,000 filters per month and the carrying cost is Sh.10 per filter per month.

Required
a) What is the optimal order quantity with respect to so many lot sizes”
b) If a safety stock of 2,000 filters is desired what is the total relevant costs?
c) A certain manufacturer offers a discount of 2% for purchases of 50 lot sizes or more. Should the
discount be taken? (Assume that each filter costs Sh.100).
QUE STION THREE
a) Explain why proper working capital management is important for the financial success of a
company.
b) At a recent seminar on “Gender Empowerment in Business’ the invited financial consultant,
Madame Hesabu Advised the participants that extending credit is one of the comerstone of modern
business. Madame Biashara, the managing director of Biashara Limited took note of this important
fact. After the seminar, she authorised a review of the credit system of her company. The following
facts are relevant.
(8 marks)

a) Annual sales of the company are Sh.5,000,000

b) Credit sales are 25 per cent of all sales
c) Bad debts average 2% of all credit sales
d) Average collection period for debtor is 40 days
e) The company’s cost of capital is 14 per cent per annum
f) Net profit on sales is 15 per cent.

Based on these facts, she is recommending a thorough revamping of the credit policy of the company. The
expected outcome of this action will be:

a) Increase in total sales by 30 per cent

b) Credit sales will be 40 per cent of all sales
c) Average collection period will decrease to 35 days
d) Bad debts will increase to 3 per cent of credit sales
e) An additional part time credit control assistant will be hired for Sh.50,000 per annum.

Required
The effectiveness or otherwise of the proposed revamping of credit policy. (Show all your workings).
(8 marks)
Who should determine credit policy? (2 marks)
(Total: 18 marks)
 CHAPTER FIVE
COST CAPITAL

COST OF CAPITAL
Definition
This is the price the company pays to obtain and retail finance. To obtain finance a company will pay implicit
costs which are commonly known as floatation costs. These include: Underwriting commission, Brokerage
costs, cost of printing a prospectus, Commission costs, legal fees, audit costs, cost of printing share
certificates, advertising costs etc. For debt there are legal fees, valuation costs (i.e. security, audit fees,
Bankers commission etc.) such costs are knocked off from:

i) The market value of shares if these have only been sold at a price above par value.
ii) For debt finance – from the par value of debt.

I.e. if flotation costs are given per share then this will be knocked off or deducted from the market price per
share. If they are given for the total finance paid they are deducted from the total amount paid.

ME THODS/ MODE LS OF COMPUTING COST OF CAPITAL

The following models are used to establish the various costs of capital or required rate of return by the
investors:



Risk adjusted discounting rate


Market model/investors expected yield


Capital asset pricing model (CAPM)
Dividend yield/Gordon’s model.

i) Risk adjusted discounting rate – This technique is used to establish the discounting rate to be used
for a given project. The cost of capital of the firm will be used as the discounting rate for a given project
if project risk is equal to business risk of the firm. If a project has a higher risk than the business risk of
the firm, then a percentage risk premium is added to the cost of capital to determine the discounting rate
i.e. discounting rate for a high risk project = cost of capital + percentage risk premium.
Therefore a high risk project will be evaluated at a higher discounting rate.

ii) Market Model – This model is used to establish the percentage cost of ordinary share capital cost of
equity (Ke). If an investor is holding ordinary shares, he can receive returns in 2 forms:



Dividends
Capital gains

Capital gain is assumed to constitute the difference between the buying price of a share at the beginning of
the (P0), the selling price of the same share at the end of the period (P1). Therefore total returns = DPS +
Capital gains = DPS + P1 – P0.
The amount invested to derive the returns is equal to the buying price at the beginning of the period (P0)
therefore percentage return/yield =

Total returns x 100 = DPS + P1 – P0 x 100

Investment P0

Illustration:
For the past 5 years, the MPS and DPS for XYZ Ltd were as follows:

1998 1999 2000 2001 2002

Shs. Shs. Shs. Shs. Shs.
MPS as at 31st Dec 40 45 53 50 52
DPS for the year - 3 4 3 -

Required
Determine the estimated cost of equity/shareholders percentage yield for each of the years involved.

Solution

Year MPS Capital gain DPS % Return

1998 40 - - -

53
x100  x100  20%
1999 45 5 3 8
40 40

8  4 12
 x100  27%
2000 53 8 4
45 45

3  3
 x100  0%
2001 50 -3 3 0
53 53

20
 x100  4%
2002 52 2 - 2
50 50

iii) Capital asset pricing model (CAPM) – CAPM is a technique that is used to establish the required
rate of return of an investment given a particular level of risk. According to CAPM, the total
business risk of the firm can be divided into 2:

Systematic Risk – This is the risk that affects all the firms in the market. This risk cannot be
eliminated/diversified. It is thus called undiversifiable risk. Since it affects all the firms in the market, the
share price and profitability of the firms will be moving in the same direction i.e. systematically. Examples of
systematic risk are political instability, inflation, power crisis in the economy, power rationing, natural
calamities – floods and earthquakes, increase in corporate tax rates and personal tax rates, etc. Systematic risk
is measured by a Beta factor.

Unsystematic risk – This risk affects only one firm in the market but not other firms. It is therefore
unique to the firm thus unsystematic trend in profitability of the firm relative to the profitability trend of
other firms in the market. The risk is caused by factors unique to the firm such as:



Labour strikes by employees of the firm;


Exit of a prominent corporate personality;


Collapse of marketing and advertising programs of the firm on launching of a new product;
Failure to make a research and development breakthrough by the firm, etc

CAPM is only concerned with systematic risk. According to the model, the required rate of return will be
highly influenced by the Beta factor of each investment. This is in addition to the excess returns an investor
derives by undertaking additional risk e.g cost of equity should be equal to Rf + (Rm – Rf)BE
Cost of debt = Rf + (Rm – Rf)Bd

Where: Rf = rate of return/interest rate on riskless investment e.g T. bills

Rm = Average rate of return for the entire stock as shown by average
Percentage return of the firms that constitute the stock index.
Be = Beta factor of investment in ordinary shares/equity.
Bd = Beta factor for investment in debentures/long term debt capital.

Illustration
KK Ltd is an all equity firm whose Beta factor is 1.2, the interest rate on T. bills is currently at 8.5% and the
market rate of return is 14.5%. Determine the cost of equity Ke, for the company.

Solution
Rf = 8.5% Rm = 14.5% Beta of equity = 1.2

Ke = Rf + (Rm – Rf)BE
= 8.5% + (14.5% - 8.5%) 1.2
= 8.5% + (6%)1.2
= 15.7%

iv) Dividend yield/ Gordon’s Model – This model is used to determine the cost of various capital
components in particular:



Cost of equity - Ke


Cost of preference share capital (perpetual) – Kp
Cost of perpetual debentures – Kd

a) Cost of equity (Ke)– This can be determined with respect to:

d0
Zero growth firm – P0 = d0 Therefore =
P0

R = Ke

Where: d0 = DPS
R0 = Current MPS

d0 1  g
Constant growth firm – P0 =
Ke g

d0 1  g
Therefore Ke  g
P0
b) Cost of perpetual preference share capital (Kp)

Recall, value of a preference share (FRS) = Constant DPS

Kp

Therefore: dp = Preference dividend per share

Pp = Market price of a preference share

c) Cost of perpetual debenture (Kd) – Debentures pay interest charges, which an allowable expenses for
tax purposes.

Recall, Value of a debenture (Vd) = Interest charges p.a. in ∞

Cost of debt Kd

Therefore Kd =
Int .
1  T
Vd

Where: Kd = % cost of debt

T = Corporate tax rate
Vd = Market value of a debenture

Cost of Redeemable Debentures and Preference Shares

Redeemable fixed return securities have a definite maturity period. The cost of such securities is called yield
to maturity (YTM) or redemption yield (RY). For a redeemable debenture Kd (cost of debt) = YTM = RY,
can be determined using approximation method as follows:

Int 1  T  M  Vd 
1
Kd / VTM / RY 
M  Vd  2
n
1

Where: Int. = Interest charges p.a.

T = Corporate tax rate
M = Par or maturity value of a debenture
Vd = Current market value of a debenture
n = Number of years to maturity

WE IGHTED AVE RAGE COST OF CAPITAL (W.A.C.C.)

This is also called the overall or composite cost of capital. Since various capital components have different
percentage cost, it is important to determine a single average cost of capital attributable to various costs of
capital. This is determined on the basis of percentage cost of each capital component.

Market value weight or proportion of each capital component.

 = Ke  E   Kp  P   Kd 1  T  D 
 V  V  V
W.A.C.C

Where: Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital respectively
E, P and D = Market value of equity, preference share capital and debt capital respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.
Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.

Shs.M
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par value 100
12% debenture Sh.100 par value 200
900

Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to grow at 5%
p.a. in future. The current MPS is Sh.40.

Required
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
c) What are the weaknesses associated with WACC when used as the discounting rate, in project
appraisal.

a) i) Compute the cost of each capital component

Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth rate
dividend model to determine the cost of equity.

d0 = Sh.5 P0 = Sh.40 g = 5%

d0 1  g 51  0.05
Ke  g   0.05  0.18125  18.13%
P0 40

Cost of perpetual preference share capital (Kp) – preference shares are still selling at par thus MPS =
par value. If this is the case, Kp = coupon rate = 10%.

MPS = Par value = Sh.20

Dp = 10% x Sh.20 = Sh.2

Kp     10%
DPS dp Sh.2
MPS Pp Sh.20
Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a redeemable fixed
return security thus the cost of debt is equal to yield to maturity.

Redemption yield:

Interest charges p.a. = 12% x Sh.100 par value = Sh.12

Maturity period (n) = 10 years
Maturity value (m) = Sh.100
Current market value (Vd) = Sh.90
Corporate tax rate (T) = 30%

Int 1  T  M  Vd 
1
Kd  YTM  RY 
M  Vd ½
n

Sh.12(1  0.3)  (100  90)

1
10  9.9%  10%
(100  90)½
=

ii) Compute the market value of each capital component

Market value of Equity (E) = MPS x No. of ordinary shares
Sh.400 MDSC
= Sh.40x = 1,600
Sh.10parvalue

Market value of preference share capital (P)

= Par value, since MPS = Par value per share = 100

Market value of debt (D) = Vd x No. of debentures

Sh.200 Mdebent ures

= Sh.90 x = 180
Sh.100parvalue

E + P + D = V = total Market Value = 1,880

iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%

a) Using weighted average cost method,, WACC =

Ke    Kp    Kd 1  T  
 E  P  D
 V  V  V
=

 1,600   100   180 

18.13%   10% 1,880   10% 1,880 
     
=
1,880

= 15.43 + 0.5319 + 0.9574

= 0.169193

≈ 16.92%

b) By using percentage method,

WACC = Total monetary cost
 Total market value (V)

Where: Monetary cost = % cost x market value of capital

Monetary cost of E = 18.13% x 1,600 = 290.08
Monetary cost of P = 10% x 100 = 10.00
Monetary cost of D = 10% x 180 = 18.00
318.08

Total market value (V) 1,880

318.08
Therefore WACC = x100 = 16.92%
1,880

b) In computation of the weights or proportions of various capital components, the following values
may be used:



Market values


Book values


Replacement values
Intrinsic values

Market Value – This involves determining the weights or proportions using the current market values of the
various capital components. The problems with the use of market values are:

The market value of each security keep on changing on daily basis thus market values can be computed only
at one point in time.

The market value of each security may be incorrect due to cases of over or under valuation in the market.
Book values – This involves the use of the par value of capital as shown in the balance sheet. The main
problem with book values is that they are historical/past values indicating the value of a security when it was
originally sold in the market for the first time.

Replacement values – This involves determining the weights or proportions on the basis of amount that
can be paid to replace the existing assets. The problem with replacement values is that assets can never be
replaced at ago and replacement values may not be objectively determined.

Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic value of a given
security. Intrinsic values may not be accurate since they are computed using historical/past information and
are usually estimates.

e) Weaknesses of WACC as a discounting rate

WACC/Overall cost of capital has the following problems as a discounting rate:

 It can only be used as a discounting rate assuming that the risk of the project is equal to the business risk
of the firm. If the project has higher risk then a percentage premium will be added to WACC to


determine the appropriate discounting rate.


It assumes that capital structure is optimal which is not achievable in real world.
It is based on market values of capital which keep on changing thus WACC will change over time but is
assumed to remain constant throughout the economic life of the project.
 It is based on past information especially when determining the cost of each component e.g in
determining the cost of equity (Ke) the past year’s DPS is used while the growth rate is estimated from
the past stream of dividends.

Note
When using market values to determine the weight/proportion in WACC, the cost of retained earnings is left
out since it is already included or reflected in the MPS and thus the market value of equity. Retained earnings
are an internal source of finance thus, when they are high there is low gearing, lower financial risk and thus
highest MPS.

Marginal cost of finance

This is cost of new finances or additional cost a company has to pay to raise and use additional finance
is given by:

Total cost of marginal finance x 100

Cost of finance (COF)

Cost of finance may be computed using the following information:

i) Marginal cost of each capital component.

ii) The weights based on the amount to raise from each source.

a) Investors usually compute their return basing their figures on market values or cost of investment.
b) Investors purchase their investment at market value and as such, the cost of finance to the company
must be weighted against expectations based on the market conditions.
c) Investments appreciate in the stock market and as such the cost must be adjusted to reflect such a
movement in the value of an investment.

1. Marginal cost of equity

D1
Po  f
MCE = x100 (for zero growth firm)

Also cost of equity

D1
Po  f
Ke = (for normal growth firm)

Where: d1 = expected DPS = d0(1+g)

P0 = current MPS
f = floation costs
g = growth rate in equity

2. Cost of preference share capital:

Dp
Po  f
Kp = x100

Where: Kp = Cost of preference

 Dp = Dividend per share
Po = MPS (Market price per share)
F = Flotation costs

3. Cost of debenture

Int (1  T)
Kd 
Vd  f

Where: Kd = Cost of debt

Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate

4. Just like WACC, weighted marginal cost of capital can be computed using:

i) Weighted average cost method

ii) Percentage method

E xample
XYZ Ltd wants to raise new capital to finance a new project. The firm will issue 200,000 ordinary shares
(Sh.10 par value) at Sh.16 with Sh.1 floatation costs per share, 75,000 12% preference shares (Sh.20 par value)
at Sh.18 with sh.150,000 total floatation costs, 50,000 18% debentures (sh.100 par) at Sh.80 and raised a
Sh.5,000,000 18% loan paying total floatation costs of Sh.200,000. Assume 30% corporate tax rate. The
company paid 28% ordinary dividends which is expected to grow at 4% p.a.

Required
a) Determine the total capital to raise net of floatation costs
b) Compute the marginal cost of capital

Solution
a) Sh.’000’
Ordinary shares 200,000 shares @ Sh.16 3,200,000
Less floatation costs 200,000 shares @ 200,000 3,000
Sh.1 1,350,000
Preference shares 75,000 shares @ Sh.18 (150,000) 1,200
Less floatation cost 3,000,000
Debentures 50,000 debentures @ Sh.80 -____ 3,000
Floatation costs 5,000,000
Loan (200,000) 4,800
Less floatation costs 12,000
Total capital raised

b) Marginal cost of equity Ke

d0 (1  g)
g
P0  f
Ke
 d0 = 28% x Sh.10 par = Sh.2.80
g = 4%
f = Sh.1.00
P0 = Sh.16
Ke   0.04
2.80(1.04)
16  1
Therefore marginal = = 0.234 = 23.4%

Marginal cost of preference share capital Kp

Kp = dp
P0-f

dp = 12% x Sh.20 par = Sh.2.40

P0 = Sh.18
f = Floatation cost per share = Sh.150,000 = Sh.2.00
75,000 shares
Kp = 2.40 = 0.15 = 15%
18 – 2

Marginal cost of debenture Kd:

Kd = Int (1-t)
Vd-f

f = 0
Vd = Sh.80
Int = 18% x Sh.100 par = Sh.18
T = 30%

Kd = 18(1-0.3) = 0.1575 = 15.75%

80

Marginal cost of loan Kd

Kd = Int (1-t)
Vd-f

T = 30%
Vd = Sh.5 million
f = Sh.0.2 million
Int = 18% x Sh.5M = Sh.0.9M

Kd = 0.9 (1-0.3) = 0.13125 = 13.13%

5 – 0.2

Source Amount to % marginal Maturity cost

raise before f. cost
costs Sh.’000’
Sh.’000’
Ordinary shares 3,200 23.4% 748.8
Preference shares 1,350 15.0% 203.5
Debenture 3,000 15.75% 472.5
 Loan 5,000 13.13% 656.5
12,550 2,080.3

Weighted marginal cost = 2,080.3 x 100 = 16.58%

12,550
 CHAPTER SIX
CAPITAL BUDGETING
INVE STME NT ANALYSIS
Any company will invest finance for the sake of deriving a return which is useful for four main reasons:

1. To reward the shareholders or owners of the business for staking their money and by foregoing their
current purchasing power for the sake of current and future return.
2. To reward creditors by paying them regular return in form of interest and repayment of their
principal as and when it falls due.
3. To be able to retain part of their earnings for plough back purposes which facilitates not only the
companies growth present and the future but also has the implication of increasing the size of the
company in sales and in assets.
4. For the increase in share prices and thus the credibility of the company and its ability to raise further
finance.
Such a return is necessary to keep the company’s operations moving smoothly and thus allow the
above objective to be achieved.

A financial manager with present investment policies will be concerned with how efficiently the company’s
funds are invested because it is from such investment that the company will survive. Investments are
important because:

i) They influence company’s size

ii) Influence growth
iii) Influence company’s risks

In addition, this investment decision making process also known as capital budgeting, involves the decision to
invest the company’s current funds in viable ventures whose returns will be realised for long term periods in
future. Capital budgeting as financial planning is characterised by the following:

1. Decisions of this nature are long term i.e. extending beyond one year in which case they are also
expected to generate returns of long term in nature.
2. Investment is usually heavy (heavy capital injection) and as such has to be properly planned.
3. These decisions are irreversible and any mistake may cause the company heavy losses.

Importance of Investment Decisions

a) Such decisions are importance because they will influence the company’s size (fixed assets, sales, and
retained earnings).
b) They increase the value of the company’s shares and thus its credibility.
c) The fact that they are irreversible means that they have to be made carefully to avoid any mistake
which can lead to the failure of such investment.
d) Due to heavy capital outlay, more attention is required to avoid loss of huge sums of money which in
the extreme may lead to the closure of such a company. However, these decisions are influenced by:

i) Political factors – Under conditions of political uncertainty, such decisions cannot be made as it will
entail an element of risk of failure of such investment. Thus political certainty has to be analysed
before such decisions are made, such factors must be taken into account such that the company
forecasts the inflows and outflows within given
limitations such as the degree of competition, performance of economy, changing tastes etc. which
influence ability to generate sufficient return from a venture which will pay not only interest but
principal on such funds invested.
ii) Technological factors – These influence the returns of the company because such technology will
affect the company’s ability to utilise its assets to the utmost ability in particular if such assets become
obsolete and cannot generate good returns or the output of such machines may be low with time and
may not meet planned expectations which in most cases will have an impact on inflows from a
venture.

Methods of Analyzing Investment

Capital Budgeting Methods.
There are two methods of analyzing the viability of an investment:

a) Traditional methods



Pay back period method
Accounting rate of return method

b) Modern methods (Discounted cash flow techniques)



NPV – Net present value method


IRR – Internal rate of return method
PI – Profitability index method

For the above two (a & b) methods to be used, they have to meet the following:

i) They should rank ventures available in the investment market according to their viability i.e. they
should identify which method is more viable than others.
ii) They should rank a venture first if the venture brings in return earlier and in large lumpsums than if a
venture brought in late and less inflows over the same period.
iii) Should rank any other projects as and when it is available in the investment market. Such methods
should take into account that all returns (inflows), must be cash returns as it is necessary to be able to
finance the cost of the venture.

TRADITIONAL ME THODS
Pay back period method
This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how
soon a venture can payback and for this reason PBP (or payout period or payoff) is that period of time or duration
it will take an investment venture to generate sufficient cash inflows to payback the cost of such investment. This is a popular
approach among the traditional financial managers because it helps them ascertain the time it will take to
recoup in form of cash from operations the original cost of the venture. This method is usually an important
preliminary screening stage of the viability of the venture and it may yield clues to profitability although in
principle it will measure how fast a venture may payback rather than how much a venture will generate in
profits and yet the main objectives of an investment is not to recoup the original cost but also to earn a profit
for the owners or investors.
Computation of payback period:

1. Under uniform annual incremental cash inflows – if the venture or an asset generates uniform
cash inflows then the payback period (PBP) will be given by:

PBP = Initial cost of the venture

Annual incremental cost

e.g. If a venture costs 37,910/= and promises returns of 10,000/= per annum indefinitely then the
PBP =

37,910
= 3.79 years
10,000

The shorter the PBP the more viable the investment and thus the better the choice of such
investments.

2. Under non-uniform cash inflows:

Under non-uniformity PBP computation will be in cumulative form and this means that the net cash
inflows are accumulated each year until initial investment is recovered.

E xample
Assume a project costs Sh.80,000 and will generate the following cash inflows:

Cash inflows Accumulated inflows

Inflows year 1 = 10,000 10,000
Inflows year 2 = 30,000 40,000
Inflows year 3 = 15,000 55,000
Inflows year 4 = 20,000 75,000
Inflows year 5 = 30,000 105,000

The Sh.80,000 cost is recovered between year 4 and 5. During year 5 (after year 4) Sh.5,000 is
(80,000 – 75,000) is required out the total year 5 cash flows of 30,000.
Therefore the PBP = 4yrs
5,000
= 4.17 years
30,000

E xample
Cedes limited has the following details of two of the future production plans. Only one of these
machines will be purchased and the venture would be taken to be virtually exclusive. The Standard
model costs £50,000 and the Deluxe cost £88,000 payable immediately. Both machines will require
the input of the following:

i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe
ii) A £10,000 working capital through their working lives.

Both machines have no expected scrap value at end of their expected working lives of 4 years for the
Standard machine and six years for the Deluxe. The operating pre-tax net cash flows associated with
the two machines are:
 Year 1 2 3 4 5 6

Standard 28,500 25,860 24,210 23,410 - -

Deluxe 36,030 30,110 28,380 25,940 38,500 35,100

The deluxe machine has only been introduced in the market and has not been fully tested in the operating
conditions, because of the high risk involved the appropriate discount rate for the deluxe machine is believed
to be 14% per annum, 2% higher than the rate of the standard machine. The company is proposing the
purchase of either machine with a term loan at a fixed rate of interest of 11% per annum, taxation at 30% is
payable on operating cash-flows one year in arrears and capital allowance are available at 25% per annum on a
reducing balance basis.

Required
For both the Standard and the Deluxe machines, calculate the payback period.

Solution
Establish the cash flows as follows:

Pre-tax inflows (EBDT) XX

Less depreciation = capital allowance (XX)
Earnings before tax XX
Less tax (XX)
Earnings after tax XX
Add back capital allowance/depreciation XX
Operating cash flows XX

Note
Capital allowance/depreciation is a non-cash item thus when deducted for tax purposes, it should be added
back to eliminate the non-cash flow effects.

Cash flows for standard machine:

Year 1 2 3 4 5

Pretax inflow 28,500 25,850 24,210 23,410 -

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

Add back capital allowance 17,500 13,125 9,844 7,383 -

Operating cash flows 28,500 22,560 20,389 19,100 (4,808)
Add working capital realised - - - 10,000 -
Total cash flows 28,500 22,560 20,389 29,100 (4,808)
Cash flows for Deluxe machine

Year 1 2 3 4 5 6 7

Pretax inflows 36,030 30,110 28,380 25,940 38,560 35,100 -

Less (depreciation) 32,000 24,000 18,000 13,500 10,125 7,594 -
4,030 6,110 10,380 12,440 28,435 27,506 -
Tax @ 30% in - (1,209) (1,833) (3,114) (3,732) (8,531) (8,252)
arrears
4,030 4,901 8,547 9,326 24,703 18,975 (8,252)
Inflows after tax
Add back capital 32,000 24,000 18,000 13,500 10,125 7,594 -
Allowance 28,901 26,547 22,826 34,828 26,569 (8,252)
- - - - - 10,000 -
Add back 36,030 28,599 26,547 22,826 34,828 36,569 (8,252)
w/capital
Total cash flows

Standard Deluxe
Cost 50,000 + 20,000 70,000 88,000 + 40,000 128,000

Year Cash flows Accumulated Cash flows Accumulated

1 28,500 28,500 36,030 36,030
2 22,560 51,060 28,901 64,931
3 20,389 71,449 26,547 91,478
4 29,100 100,549 22,826 114,304
5 (4,808) 95,741 34,828 149,132
6 - - 36,569 185,701
7 - - ( 8,252) 179,449

* Pay back period for standard: Initial capital of Sh.7,000 is recovered during year 3. After year 2, we
require 70,000 – 9,060 = 18,940 to recover initial capital out of year 3 cash flows of Sh.20,389.

* Applying the same concept for Deluxe, payback period would be:
128,000  114,304
4 = 4.39 years
34,828

Accounting Rate of Return Method (ARR)

This method uses accounting profits from financial status to assess the viability of investment proposal by
diving the average income after tax by average investment. The investment would be equal to either the
original investment plus the salvage value divided by two or the initial investment divided by two or dividing
the total of the investment book value after depreciating by the life of the project. This method is also
known as financial statement method or book value method. The rate of return on asset method or adjusted
rate of return method is given by:

ARR = Average income x 100 or Average income – Average depreciation

Average investment Initial investment
Unlike PBP, this method will ascertain the profitability of an investment and it will give results which are
consistent with those given by return ratios e.g.

Shs.
Project X cost 500,000
Scrap value 100,000

Stream of income before depreciation and taxes are as follows:

Shs.
Year 1 100,000
Year 2 120,000
Year 3 140,000
Year 4 160,000
Year 5 200,000

Let tax = 50% and depreciation straight line. Calculate the accounting rate of return.

Solution
Depreciation = 500,000 – 100,000 = Shs.80, 000
5 years

Year 1 2 3 4 5

Income 100,000 120,000 140,000 160,000 200,000

Less depreciation 80,000 80,000 80,000 80,000 80,000
Earnings before tax EBT 20,000 40,000 50,000 80,000 120,000
Less tax @ 50% (10,000) (20,000) (30,000) (40,000) (60,000)
EAT 10,000 20,000 30,000 40,000 60,000

Average income (EAT) = 32,000

Average investment = (500,000 + 100,000) ½ = 300,000

Or ARR = Average income x 100 = 32,000 x 100 = 10.67%

Average investment 300,000

Note
The best method of depreciation to use should be that which will produce larger depreciation changes in the
1st few years of the assets life and lesser changes in the later years because this will produce a higher tax shield
to the company with higher value of inflows. Thus reducing balance is preferred as compared to sum of
digits and straight line method.

The salvage value should be treated as follows:

If the asset produces a salvage value at the end of the year, this will increase inflows for payback period. This
value is only used to ascertain how much the company will reduce original cost of investment to obtain
average investment.
Acceptance Rule of Payback Period (Pbp)
Using PBP method a company will accept all those ventures whose payback period is less than that set by the
management and will reject all those ventures whose PBP is more than that set by the management.
Alternatively, PBP may be gauged against the term of the loan in which case the PBP method will give a high
ranking to all those ventures paying back before the term of the loan and the highest ranking will be given to
those projects with shortest PBP. However, in assessing the viability of a venture it is also important to see
which venture brings returns earlier, other things being equal.

Advantages of Payback Period

1. Simple to use and understand and this has made it popular among executives especially traditional
financial managers in ascertaining the viability of a venture.
2. Ideal under high-risk investments because it will identify which venture will payback earlier thus
minimising the risks with a venture.
3. Advantageous when choosing between mutually exclusive projects because it will give a clue as to
which venture is viable if one considers the shortest PBP and the highest inflow of a venture.

Disadvantages of Payback Period

1. Does not take into account time value of money and assumes that a shilling received in the 1st year
and in the Nth year have the same value so as to rank them together to ascertain the PBP which is
unrealistic given that a shilling now is valuable than a shilling N years from now.
2. PBP method does not measure the profitability of a venture but rather measures the period of time a
venture takes to pay back the cost. The method is outside looking (lender oriented rather than
owner oriented).
3. PBP method ignores inflows after PBP and as such, it does not accommodate the element of return
to an investment.
4. This method will not have any impact on the company’s share prices because profitability which is
one of the most important factors in gauging the company’s value of shares is not a function of PBP
and as such the method fall short of meeting the criteria of investment appraisal.

Acceptance Rule of Accounting Rate of Return (Arr)

ARR method will accept those projects whose ARR is higher than that set by management or bank rate and it
will give highest ranking to ventures with highest ARR and vice versa.

Advantages
1. Simple to understand and use.
2. Readily computed from accounting data thus much easier to ascertain.
3. It is consistent with profitability objectives as it analyses the return from entire inflows and as such it
will give a clue or a hint to the profitability of venture.

Disadvantages
1. It ignores time value of money.
2. It does not consider how soon the investment should recover the cost (it is owner looking than
creditor oriented approach).
3. It uses accounting profits instead of cash inflows some of which may not be realisable.

MODE RN ME THODS OR DCF i.e. Discounted Cash Flow Techniques

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

2. Present Value of a Lumpsum

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

Pv 
1  Kn
L

Where: Pv = Present value

L = Lumpsum
K = Cost of finance or time preference rate
n = given year.

This implies that if the time preference rate is 10%, the present value of 1/= to e received at the end of year 1
is:

Pv   0.909
1
1. 1

The present value of inflows to be received in the 2nd year to Nth year, will be equal to:

Pv 
1  KN
A

Where: A = annual cash flows

N = Number of years

Also, the present value of a shilling to be received at a given point in time can in addition to using the above
formula, be found using the present value tables.

Suppose that an investor can expect to receive:

40,000 at the end of year 2

70,000 at the end of year 6
100,000 at the end of year 8

Compute his present (value) if his time preference is 12%.

 Pv   
1  KN 1.12 2 1.126 1.12 8
L 40,000 70,000 100,000
_

= Kshs.107,740.26

Using tables:

= 40,000(0.7992) + 70,000(0.5066) + 100,000(0.4039)

= 107,820

3. Present Value of an Annuity

An individual investor may not necessarily get a lumpsum after some years but rather get a constant periodic
amount i.e. an annuity for certain number of years. The present value of an annuity receivable where the
investor time preference is 10% equal to:

Pv ( A) 
1  i 
A
I = time preference rate

E.g. Pv of 1/= to be received after 1 year if time preference rate is 10%.

 0.909
1
1  0.1
=

  0.8264
1  i 2 1.12
A 1
After 2 years it will be:

1st year - 0.9090

2nd year - 0.8264
3rd year - 0.7513
4th year - 0.6830
Total - 3.1697

4. Present Value of Uneven Periodic Sum

In investment decisions it is very rare to get even periodic returns and in most cases a company will generate
a stream of uneven cash inflows from a venture and the present value of those uneven periodic sums is equal
to:

Pv     ..... 
1  K 1  K 1  K 1  KN
A1 A2 A3 AN
1 2 3

 1  K
equation
Pv 
At
t

Where: At = Uneven cash inflows at time t

Pv = Present value
K =Cost of finance

A company contemplates to receive Shs.:

 20,000 in year 1
18,000 in year 2
24,000 in year 3
Nil in year 4
40,000 in year 5

Cost of this finance is 12%

Required
Compute present value of that finance

Solution

Pv    
1.12  1.12 1.12 1.125
30,000 18,000 24,000 40,000
1 2 3

= 80,915.004

5. Net Present Value Method

The method discounts inflows and outflows and ascertains the net present value by deducting discounted
outflows from discounted inflows to obtain net present cash inflows i.e the present value method will involve
selection of rate acceptable to the management or equal to the cost of finance and this will be used to
discount inflows and outflows and net present value will be equal to the present value of inflow minus
present value of outflow. If net present value is positive you invest, If NPV is negative you do not invest.

Pv(inflow) – Pv(outflows) = NPV

Note
Initial outflow is at period zero and their value is their actual present value. With this method, an investor can
ascertain the viability of an investment by discounting outflows. In this case, a venture will be viable if it has
the lowest outflows.

 A1 AN 
NPV      .....   C
 1  K 1  K 1  K 1  KN 
A2 A3
1 2 3

Where: A = annual inflow

K = Cost of finance
C = Cost of investment
N = Number of years

E xamples
Cost of investment = 100,000/=, interest rate = 10%, inflows year 1 = 80,000/= year 2 = 50,000/=
  100,000
1.12
80,000 50,000
NPV =
1.1
= 14,049 positive hence invest.
E xample
Jeremy limited wishes to expand its output by purchasing a new machine worth 170,000 and installation costs
are estimated at 40,000/=. In the 4th year, this machine will call for an overhaul to cost 80,000/=. Its
expected inflows are:

Shs.
Year 1 60,000
Year 2 72,650
Year 3 35,720
Year 4 48,510
Year 5 91,630
Year 6 83,715

This company can raise finance to purchase machine at 12% interest rate.
Compute NPV and advise management accordingly.

Solution
Shs.
Cost of machine at present value 170,000
Installation cost 40,000
210,000

Overhaul cost in the 4th year = 80,000

Discounting factor = (1.12)4

Therefore present value = 80,000 = Shs.50,841.446

(1.12)4

Total present value of investment = 260,841.45

    
(1.12) 1.12 2 1.12K3 (1.12) 4 1.12 5 1.126
60,000 72,650 35,720 48,510 91,630 83,715
PV inflows =

= 262,147.28

Therefore: NPV = 262,147.28 – 260,841.45

NPV = 1,305.83

The NPV is positive and I would advise the management to invest.

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

Solution

Year 1 2 3 4 5
Saving 800,000 350,000 - 680,000 775,000
Scrap value - - - - 200,000
Total amount 800,000 350,000 - 680,000 975,000

    1,500,000
1.14  1.14 1.14  1.14 5
800,000 350,000 680,000 975,000
NPV = 1 2 4

= 1,880,067.1 – 1,500,000
= 380,067.07

380,067.0
Return = x100 = 25.337% > 12% hence invest.
1,500,000

NB: Assuming that the salvage will be realised.

E xample
A section of a roadway pavement costs £400 per year to maintain. What new expenditure of a new pavement
is justified if no maintenance will be required for the 1st five years then £100 for the next 10 years and £400 a
year thereafter? Assume cost of finance to be 5%.

Solution
Total present value of maintenance costs under the re-surfacing scheme.

 £8,000
400
Maximum expenditure =
0.05

Present value of an Annuity for n years is given by the formula:

 
1 
1  K n 
1

PV  A 
 
 
K
 

Whereby: PV is Present value

A is annuity
K is cost of finance
n is number of year
Present value of an annuity to perpetuity is given by the formula

A
Pv =
K
Whereby: PV is Present value
A is annuity
K is cost of finance

 £8,000
400
Therefore PV maximum expenditure =
0.05

PV = Minimum expenditure = £[4,453]

= Justified expenditure = £3,547

     
1  1 
1.0515   100 1.05
   
1 1

PV  100    400 
 1.0515
5

    0.5 
400 1

     
0.5 0.5
     0.5 

= £4,453

1
(1  r )n
NB: The present value interest factors PVIF = and present value
n
Annuity factors, PVAF = 1  (1  r ) can be read from tables provided at the point of interseption between
r
the discounting rate and number of periods.

ACCE PT OR RE JE CT RULE OF NPV

Under this method, a company should accept an investment venture if N.P.V. is positive i.e. if present value
of cash outflows exceeds that of cash inflows or at least is equal to zero. (NPV ≥0). This will rank ventures
giving the highest rank to that venture with highest NPV because this will give the highest cash inflow or
capital gain to the company.

Advantages of NPV
 It recognises time value of money and such appreciates that a shilling now is more valuable than a


shilling tomorrow and the two can only be compared if they are at their present value.
It takes into account the entire inflows or returns and as such it is a realistic gauge of the profitability


of a venture.
It is consistent with the value of a share in so far as a positive NPV will have the implication of
increasing the value of a share.

4. It is consistent with the objective of maximising the welfare of an owner because a positive NPV will
increase the net worth of owners.

Disadvantages of NPV
 It is difficult to use.
  Its calculation uses cost of finance which is a difficult concept because it considers both implicit and


explicit whereas NPV ignores implicit costs.
It is ideal for assessing the viability of an investment under certainty because it ignores the element of


risk.
It may not give good assessment of alternative projects if the projects are unequal lives, returns or


costs.
It ignores the PBP.

Irr (Internal Rate Of Return)

This method is a discounted cash flow technique which uses the principle of NPV. It is defined as the rate
which equates the present value of cash outflows of an investment to the initial capital.

IRR = Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0.

It is also called internal rate of return because it depends wholly on the outlay of investment and proceeds
associated with the project and not a rate determined outside the venture.

IRR  C     ..... 
1  r  1  r  1  r  1  r N
A1 A2 A3 AN
1 2 3

A = inflow for each period

C = Cost of investment

The value r can be found by:

i) Trial and error

ii) By interpolation
iii) By extrapolation

i) Trial and error method

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

Compute the IRR of this venture.

Solution
1st choice 10%

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

 
1.14 1.14  1.14 3
8,000 7,000 6,000
1 2
= 16,453.646

3rd choice 15%

 
1.15 1.15 1.153
8,000 7,000 6,000
1 2
= 16,194.625

IRR lies between 14% and 15%.

ii) Interpolation method

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

Therefore, r denotes required rate of return

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

Acceptance Rule of IRR

IRR will accept a venture if its IRR is higher than or equal to the minimum required rate of return which is
usually the cost of finance also known as the cut off rate or hurdle rate, and in this case IRR will be the
highest rate of interest a firm would be ready to pay to finance a project using borrowed funds and without
being financially worse off by paying back the loan (the principal and accrued interest) out of the cash flows
generated by that project. Thus, IRR is the break-even rate of borrowing from commercial banks.

Advantages of IRR
 It considers time value of money
 It considers cash flows over the entire life of the project.
 It is compatible with the maximisation of owner’s wealth because, if it is higher than the cost of finance,
owners’ wealth will be maximised.

 Unlike the NPV method, it does not use the cost of finance to discount inflows and for this reason it will
indicate a rate of return of interval to the project against which various ventures can be assessed as to
their viability.

Disadvantages of IRR


Difficult to use.
Expensive to use because it calls for trained manpower and may use computers especially where


inflows are of large magnitude and extending beyond the normal limits.
It may give multiple results some involving positive IRR in which case it may be difficult to use in
choosing which venture is more viable.
PROFITABILITY INDEX (P.I.)
P.I. (benefit-cost ratio) = Present value of inflows
Present value of cash outlay

If P.I. is greater than 1.0, invest. If less than 1.0, reject.

E xample
The following information was from XYZ feasibility studies. It has studied two ventures:

a) Cost 100,000/= and 160,000/= at the beginning of the 4th year and it will generate inflows 1-3rd year
80,000/= and from 4-6th year 50,000/= per annum.

b) Initial cost 200,000/= and 80,000/= at the beginning of the 4th year and it will generate the following
inflows:

1st – 2nd year -> Shs.100,000 per annum

3rd – 6th year -> Shs.70,000 per annum

Using the cost of finance of 12% compute the P.I. of these two ventures, advise the company
accordingly.

Solution

1.12 3
100,000 160,000
a) Outflows: = 100,000 + 113,887 = 213,885
1

    
1.12  1.12 1.12  1.12 1.12  1.12 6
80,000 80,000 80,000 50,000 50,000 50,000
Inflows: 1 2 3 4 5
= Shs.277,626

277,626
P.I. =
213,885

P.I. = 1.298


1.12 3
200,000 80,000
b) Outflows: = = 256,944
1

    
1.12 1 1.12 2 1.12 3 1.124 1.125 1.12 6
100,000 100,000 70,000 70,000 70,000 70,000
Inflows = = Shs.338,501

338,501
P.I. =
256,944
= 1.32

E xample
A company is faced with the following 5 investment opportunities:

Cost NPV P.I = Total P.v___ P.I Ranking

Initial capital
1. 500,000 150,000 1.3 4
2. 100,000 40,000 1.4 3
3. 400,000 40,000 1.1 5
4. 200,000 100,000 1.5 2
5. 160,000 90,000 1.6 1

This company has 750,000/= available for investment projects, 3 and 4 are mutually exclusive. All of the
projects are divisible. Which group should be selected in order to maximise the NPV. Indicate this NPV
figure.

Solution
Using P.I. to rank the projects in order of preference 5, 4, 2, 1, 3.

In order to maximise NPV, the following projects combination should be selected:

Shs.
Funds available for investment 750,000
Cost of project: 5 160,000
4 200,000
2 100,000
1 290,000 (750,000)
NIL

290,000
NPV = 90,000 + 100,000 + 40,000 + x150,000 = 317,000
500,000

Advantages of profitability index

a) Simple to use and understand.

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

Disadvantages of profitability index

a) It may be useful under conditions of uncertain cost of finance used to discount inflows and yet this
cost is a complex item due to the implicit and explicit element.

b) It may be difficult to ascertain if the economic life of a venture is long and it yields large inflows
because their discounting may call for use of computers that are expensive.
COMPARISON OF ME THODS
Both traditional and modern methods will show or indicate strong weaknesses such that a company cannot
use either to select a viable venture and for this reason the selection of the investment will depend on which
method the company has identified it can meet its investment needs. The choice should not be limited to
one method but at least 2 modern methods. In all, when ranking projects, a conflict will rise between IRR
and NPV especially under the following conditions:

i) If the lives of the projects are different.

ii) Where the cash outlay is larger than the other.
iii) When the cash flow pattern differs i.e the cash flows of one project may overtime increase while
those of the other decrease. In this case NPV may give consistently correct solution especially so
because it does not yield multiple rates.

PBP RE CIPROCAL
PBP expresses the profitability of a project in terms of years. It does not show any return as measure of
investment. The PBP reciprocal has been utilised to rectify the situation, but it is only of value where the
pattern of cash flow is relatively consistent and where the life of the asset is at least double the payback period
of the asset. The payback period is expressed as:

Investment
Annual cash flows

This PBP reciprocal is often used as a guide to ascertain the discount factor in discounted cash flow
calculations i.e. to approximate IRR.

1
Payback period reciprocal = x100
PBP

RE PLACE MENT OF ASSE TS

E xample
Estate Developers purchased a machine five years ago at a cost of £7,500. The machine had an expected
economic life of 15 years at the time of purchase and a zero estimated salvage value at the end of 15 years. It
is being depreciated on a straight line basis and currently has a book value of £5,000. The Financial Manager
has conducted a feasibility study aimed at acquiring a new machine for £12,000 and is depreciated over its 10
years useful life. The new machine will expand sales from £10,000 to £11,000 per annum and will reduce
labour and materials usage sufficiently to cut operating cost from £7,000 to £5,000. The salvage value of the
new machine is £2,000 at the end of useful life. The current market value of the old machine is £1,000 and
tax is 40%. The firms cost of capital is 10%. The financial manager wishes to make a decision on whether to
replace the old machine with a new one and he seeks your held.
N.B. The decision to replace takes into account the following:

a) Estimate the actual cash outlay attributable to the new machine

b) Determine the incremental cash flows.
c) Compute the NPV of incremental cash flows.
d) Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.
e) Ascertain whether the NPV (net present value) is positive or whether the IRR (internal rate of return)
exceed the cost in which case invest if its positive.
Solution
a) Initial capital for new machines £
Cash price of new machine 12,000
Less market value of old machine (1,000)
Less tax shield on sale of old machine:
Market value 1,000
Less net book value 5,000
Loss on disposal 4,000
Tax shield = 40% x 4,000 (6,000)
Increamental initial capital 9,400

12,000  2,000
b) Depreciation of new machine = = 1,000
10 yrs
5,000  0
Depreciation of old machine = = 500
10 yrs
Increamental depreciation 500

NB: The NBV of old machine after 5 years is £5,000. This NBV will be depreciated over the remaining
10 years.

Determine operating cash flows:

Increamental sales = 11,000 – 10,000 1,000
Savings in labour costs = 5,000 – 7,000 2,000
Increamental EBDT 3,000
Less increamental depreciation (non-cash item) (500)
Increamental EBT 2,500
Less tax @ 40% 1,000
Increamental EAT 1,500
Add back increamental depreciation 500
Annual cash flow 2,000

Terminal cash flows at end of year 10 is equal to increamental salvage value.

New machine salvage value 2,000
Less old machine salvage value 0
2,000
Compute the NPV @ 10% cost of capital:
1  (1.1) 10
P.V of cash flows = 2000x  2,000xPVAF10% ,10  2,000 x 6.145 12,290

 
0.10
 2,000 xPVIF10% ,10  2,000 x 0.386
1
P.V of salvage value = 2,000 x 772
1.110
13,062
Less increamental initial capital (9,400)
Increamental N.P.V 3,662
Replace the old machine
 REINFORCING QUESTIONS
QUE STION ONE
What are the advantages of discounted cash flows methods?

QUE STIONTWO
Kiwanda Limited is considering the purchase of a new machine. Two alternative machines, Pesi TZO and
Upesi MO2, which will cost Sh.6,000,000 and Sh.7,000,000 respectively are available in the market. The cash
flow after taxation of each machine are as follows:

Cash flow
Year Pesi TZO Upesi MO2
Sh. Sh.
1 600,000 1,800,000
2 1,800,000 2,400,000
3 2,000,000 3,000,000
4 3,000,000 1,800,000
5 2,400,000 1,600,000

Required
a) Compute the net present value of each machine. (8 marks)

b) Assuming that each machine represents a project:

Compute the return Kiwanda Limited expects to earn from each of the two projects.
(10 marks)
Comment on the use of the results obtained in (a) and (b)(i) above in selecting between the
two projects. (4 marks)
(Total: 22 marks)

QUE STIONTHRE E
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:

No project should involve a net commitment of funds for more than four years.
Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the estimated cost
of capital. Present estimates are that cost of capital as 15 percent per annum after tax.
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’)
1,320
1,440
1,560
1,600
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. (Total: 19 marks)

QUE STION FOUR

a) What are the features of a sound appraisal technique? (6 marks)

b) What practical problems are faced by finance managers in capital budgeting decisions?
(6 marks)

c) Describe the features of long term investment decisions. (8 marks)

QUE STIONFIVE
KK Ltd has six projects available for investment as follows:

Project Initial cost Sh.’M’ NPV @ 15% cost

of capital
1 60 21
2 15 9
3 20 9
4 55 15
5 30 20
6 40 -2

The firm has Sh.100 M available for investment.

Identify which projects should be undertaken. Using P.I and NPV ranking, comment on your
answer.
 CHAPTER SEVEN
FINANCIAL MARKETS
Market for Funds and Financial Institutions in Kenya
 Financial markets refers to an elaborate system of the financial institution and intermediaries and
arrangement put in place and developed to facilitate the transfer of funds from surplus economic units


(savers) to deficit economic units (investors).
Savers include individuals, small businesses, family units savings through institutions such as SACCOs,


banks, insurance firms, pension schemes etc.
Investors include government, companies, family units etc.

Note
Physical or commodity markets deal with real assets such as tea, coffee, wheat, automobile etc.

Functions of Financial Markets/ Institutions in the E conomy

1. Distribution of financial resources to the most productive units. Savings are transferred to economic
units that have channels of alternative investments. (Link between buyers and sellers).
2. Allocation of savings to real investment.
3. Achieving real output in the economy by mobilizing capital for investment.
4. Enable companies to make short term and long term investments and increase liquidity of shares.
5. Provision of investment advice to individuals through financial experts.
6. Enables companies to raise short term and long term capital/funds
7. Means of pricing of securities e.g N.S.E. index shares indicate changes in share prices.
8. Provide investment opportunities. Savers can hold financial instrument for investment made.

Kenya Financial System

Financial markets are broadly classified into 2:

1. Capital Markets
2. Money Markets

e.g. commercial banks, SACCOS, foreign exchange market, merchant banks etc.

Capital markets are sub-divided into 2:

a) Security markets e.g stock exchange dealing with instruments such as shares, debentures etc.
b) Non-security/instrument market e.g mortgage, capital leases, security market is sub-divided into 2.



Primary market
Secondary market

CAPITAL MARKE T
These are markets for long term funds with maturity period of more than one year. E.g of Financial
instruments used here are debentures, terms, loans, bonds, warrants, preference shares, ordinary shares etc.

The capital market serves as a way of allocating the available capital to the most efficient users. Capital
market financial institution includes:
1. Stock exchange
2. Development bank
 3. Hire purchase companies
4. Building societies
5. Leasing firms

Functions of Capital Markets are:

a) Providing long term funds which are necessary for investment decisions.
b) Provide advice to investors as to which investments are viable.
c) Long term investments are made liquid, as the transfer between shareholders is facilitated.
d) Facilitates the international capital inflow.
e) Facilitating the liquidation and marketing of a long term
f) Acting as a channel through which foreign investments find their way into the market.

Money/ discount markets



Are discount and acceptance financial institutions
This is a market for S.T funds maturing in one year. Money market works through financial institutions.


It facilitates transfer of capital between savers and users.


The transfer can be direct (from saver to investor) and indirectly through an intermediary).


Foreign exchange market is also part of money market.
The money market or discount market is the market for short term loans.

Financial Instruments in Money market include:

1. Commercial paper
2. Treasury bills
3. Bills of exchange
4. Promissory notes
5. Bank overdrafts
6. Bankers certificate of deposit

These instruments are sold by commercial banks, merchant banks, discounting houses, acceptance houses,
and government.

Primary Markets
These are markets that deal with securities that have been issued for the first time. The money flows directly
from transferor (saver of money) to transferee (investing person). They facilitate capital formation.

E conomic Advantage of Primary Markets

1. Raising capital for business.
2. Mobilising savings
3. Government can raise capital through sale of Treasury bonds
4. Open market operation to effect monetary policy of the government i.e control of excess liquidity in
the economy
5. It is a vehicle for direct foreign investment.

E conomic Advantage/ Role of Secondary Markets in the E conomy

1. It gives people a chance to buy shares hence distribution of wealth in economy.
2. Enable investors realize their investments through disposal of securities.
3. Increases diversification of investments
4. Improves corporate governance through separation of ownership and management. This increases
higher standards of accounting, resource management and transparency.
5. Privatisation of parastatals e.g. Kenya Airways. This gives individuals a chance for ownership in large
companies.
6. Parameter for health economy and companies
7. Provides investment opportunities for companies and small investors.

Types of Stock Markets

1. Organised E xchange and Over the Counter (OTC) market

This is where the buying and selling of securities is done by buyers and sellers are not present but
only the agents (brokers) internet. This system is called “open outcry”.

2. Over the Counter Market (OTC)

Provides an opportunity for unlisted/unquoted firms to sell their security
Otc is usually organized by the dealers or stock brokers who buy securities themselves and then sell
them.
They maintain a reasonable balance between demand and supply and observe price movements to
determine profit margins on sale.
Trading may be done through telephones, computer networks, fax etc.
The dealers/participants set the treading rulesOTC specialize in securities such as corporate bonds,
equity securities, Treasury bonds etc.
OTC is underdeveloped in Kenya.

Features of OTC Markets

1. Prices are relatively low
2. Usually deal with new securities of firms
3. Is composed of small and closely held firms.

FINANCIAL INTE RME DIARIE S

These are institutions which mediate/link between the savers and investors:

E xamples of financial intermediaries in Kenya.

1. Commercial Banks.
They act as intermediary between savers and users (investment) of funds.

2. Savings and Credit Associations

These are firms that take the funds of many savers and then give the money as a loan in form of mortgage
and to other types of borrowers. They provide credit analysis services.

3. Credit Unions
These are cooperative associations whose members have a common bond e.g employees of the same
company. The savings of the member are loaned only to the members at a very low interest rate e.g.
SACCOS charge p.m interest on outstanding balance of loan.
4. Pension Funds
These are retirement schemes or plans funded by firms or government agencies for their workers. They are
administered mainly by the trust department of commercial banks or life insurance companies. Examples of
pension funds are NSSF, NHIF and other registered pension funds of individual firms.

5. Life Insurance Companies

These are firms that take savings in form of annual premium from individuals and them invest, these funds
in securities such as shares, bonds or in real assets. Savers will receive annuities in future.

6. Brokers
These are people who facilitate the exchange of securities by linking the buyer and the seller. They act on
behalf of members of public who are buying and selling shares of quoted companies.

7. Investment Bankers
These are institutions that buy new issue of securities for resale to other investors.

They perform the following functions:

1. Giving advice to the investors

2. Giving advice to firms which wants to
3. Valuation of firms which need to merge
4. Giving defensive tactics incase of forced takeover
5. Underwriting of securities.

THE STOCK E XCHANGE MARKE T

The Idea and Development of a Stock E xchange
Stock exchange (also known as stock markets) are special “market places” where already held stocks and
bonds are bought and sold. They are, in effect, a financial institution, which provides the facilities and
regulations needed to carry out such transactions quickly, conveniently and lawfully.
Stock exchanges developed along with, and are an essential part of the free enterprises system. (No stock
exchanges exist in the communist world outside Hong Kong and Macao – which have special status, and
Taiwan which is also claimed by China).
The need for this kind of market came about as a result of two major characteristics of joint stock company
(Public Limited Company), shares.

1. First of all, these shares are irredeemable, meaning that once it has sold them, the company can never
be compelled by the shareholder to take back its shares and give back a cash refund, unless and until
the company is winding up and liquidates.

2. The second characteristic is that these shares are, however, very transferable and can be bought and
resold by other individuals and organizations, freely, the only requirement being the filling and
signing of a document known as a share transfer form by the previous shareholder. The document
will then facilitate the updating of the issuing companies shareholders register.

These two characteristics of joint company shares brought about the necessity for an organized and
centralized place where organizations and private individuals with money to spare (investors), and satisfy their
individual needs. Stock exchanges were the result emerging to provide a continuous auction market for
securities, with the laws of supply and demand determining the prices.
Functions of the Nairobi Stock E xchange
The basic function of a stock exchange is the raising of funds for investment in long-term assets. While this
basic function is extremely important and is the engine through which stock exchanges are driven, there are
also other quite important functions.

1. The mobilization of savings for investment in productive enterprises as an alternative to putting

savings in bank deposits, purchase of real estate and outright consumption.
2. The growth of related financial services sector e.g. insurance, pension and provident fund schemes
which nature the spirit of savings.
3. The check against flight of capital which takes place because of local inflation and currency
depreciation.
4. Encouragement of the divorcement of the owners of capital from the managers of capital; a very
important process because owners of capital may not necessarily have the expertise to manage capital
investment efficiently.
5. Encouragement of higher standards of accounting, resource management and public disclosure
which in turn affords greater efficiency in the process of capital growth.
6. Facilitation of equity financing as opposed to debt financing. Debt financing has been the undoing
of many enterprises in both developed and developing countries especially in recessionary periods.
7. Improvement of access to finance for new and smaller companies. This is futuristic in most
developing countries because venture capital is mostly unavailable, an unfortunate situation.
8. Encouragement of public floatation of private companies which in turn allows greater growth and
increase of the supply of assets available for long term investment.

There are many other less general benefits which stock exchanges afford to. Individuals, corporate
organizations and even the government. The government for example could raise long term finance locally
by issuing various types of bond through the stock exchange and thus be less inclined to foreign borrowing.
Stock exchanges, especially in developing countries have not always played the full role in economic
development.

THE ROLE OF STOCK E XCHANGE IN E CONOMIC DEVE LOPME NT

1. Raising Capital for Businesses
The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares
to the investing public.

2. Mobilising Savings for Investment

When people draw their savings and invest in shares, it leads to a more rational allocation of resources
because funds which could have been consumed, or kept in idle deposits with banks are mobilized and
redirected to promote commerce and industry.

3. Redistribution of Wealth
By giving a wide spectrum of people a chance to buy shares and therefore become part-owners of profitable
enterprises, the stock market helps to reduce large income inequalities because many people get a chance to
share in the profits of business that were set up by other people.
4. Improving Corporate Governance
By having a wide and varied scope of owners, companies generally tend to improve on their management
standards and efficiency in order to satisfy the demands of these shareholder. It is evident that generally,
public companies tend to have better management records than private companies.

5. Creates Investment Opportunities for Small investors

As opposed to other business that require huge capital outlay, investing in shares is open to both the large
and small investors because a person buys the number of shares they can afford. Therefore the Stock
Exchange provides an extra source of income to small savers.

6. Government Raises Capital for Development Projects

The Government and even local authorities like municipalities may decide to borrow money in order to
finance huge infrastructural projects such as sewerage and water treatment works or housing estates by selling
another category of shares known as Bonds. These bonds can be raised through the Stock Exchange
whereby members of the public buy them. When the Government or Municipal Council gets this alternative
source of funds, it no longer has the need to overtax the people in order to finance development.

7. Barameter of the Economy

At the Stock Exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to
rise or remain stable when companies and the economy in general show signs of stability. Therefore their
movement of share prices can be an indicator of the general trend in the economy.

Advantages of Investing In Shares

1. Income in form of dividends
When you have shares of a company you become a part-owner of that company and therefore you will be
entitled to get a share of the profit of the company which come in form of dividends. Furthermore,
dividends attract a very low withholding tax of 5% only.

2. Profits from Capital Appreciation

Shares prices change with time, and therefore when prices of given shares appreciate, shareholders could take
advantage of this increase and set their shares at a profit. Capital gains are not taxed in Kenya.

3. Share Certificate can be used as a Collateral

Share certificate represents a certain amount of assets of the company in which a shareholder has invested.
Therefore this certificate is a valuable property which is acceptable to many banks and financial institutions as
security, or collateral against which an investor can get a loan.
4. Shares are easily transferable
The process of acquiring or selling shares is fairly simple, inexpensive and swift and therefore an investor can
liquidate shares at any moment to suit his convenience.

5. Availability of Investment Advice

Although the stick market may appear complex and remote to many people. Positive advise and guidance
could be provided by the stockbrokers and other investment advisors. Therefore, an investor can still benefit
from trading in shares even though he may not be having the technical expertise relevant to the stock market.

6. Participating in Company Decisions

By buying shares and therefore becoming a part-owner in an enterprise, a shareholder gets the right to
participate in making decisions about how the company is managed. Shareholders elect the directors at the
Company’s Annual.
General meetings, whereby the voting power is determined by the number of shares an investor holds since
the general rules is that one share is equal to one vote.

STOCK MARKE T TE RMINOLOGY

1. BROKE R


A dealer at the market who buys and sells securities on behalf of the public investors.


He is an agent of investors
He is the only authorized person to deal with the quoted securities. He is authorized by CMA and


NSE
He obtains the suitable deal for his clients/investors, gives financial advice and charges commission


for his services.


He doesn’t buy or sell shares in his own right hence he cannot be a market marker.
He must maintain standards set by the stock exchange.

2. JOBBE RS/ SPE CULATORS



This is a dealer who trades in securities in his own right as a principal.
He can set prices and activate the market through his own buying and selling hence he is a market


maker.


He engages in speculation and earns profit called Jobbers’ turn (selling price – buying price).
He does not deal with members of the public unlike brokers. However, brokers can buy and sell
shares through jobbers.

There are 3 types of jobbers

a) Bulls
 A jobber buy shares when prices are low and hold them in anticipation that the price will rise and sell


them at gain.
When a market is dominated by bulls (buyers predominate sellers), it is said to be bullish. The share


prices are generally rising.


Therefore the market is characterized by an upward trend in security prices.
It signifies investors confidence/optimism in the future of economy.
b) Bears


A speculator/jobber who sells security on expectation of decline in prices in future.


The intention is to buy same securities at lower prices in future thereby making a gain.


When market is dominated by bears (sellers predominate buyers) it is said to be bearish.
It is characterized by general downward trend in share prices. It signifies investors pessimism about
the future prospects of the economy.

c) Stags


This is a jobber found in primary markets


He buys new securities offered to the public and believes that they are undervalued.


He believes the price will rise and sell them at a gain to the ultimate investors
Stags are vital because they ensure full subscription of the share issue.

3, Underwriting


This is the assumption of risk relating unsubscribed shares
When new shares are issued, they may be underwritten/unsubscribed. A merchant banker agrees,


under a commission to take up any shares not bought by the public.


They therefore ensure that all new issues are successful


Underwriters are very important in pry markets and play the following roles:



Advice firms on most suitable issue price


Ensure shares are fully subscribed by taking up all unsubscribed shares
Advice the firms on where to source funds to finance floatation costs.

4. Blue Chips


Are first class securities of firms which have sound share capital and are internationally reputable.
They have very good dividend record and are highly demanded in the markets. Individuals holding
such securities are reluctant to sell them because of their high value.

5. Going short or long on a share

 This is the process of selling (going short) or buying (going long) on a share that one does not


have/own


The aim is to make gain from assumed change in the market value of shares
This practice is not allowed in Kenya



It is aided by brokers in countries where it is practiced
Investors going short or long are required to pay a premium called margin on the transaction.

TRADING ME CHANISM AT NSE

1. An investor approaches a broker who takes his bid/offer to the trading floor.
2. At the trading floor, the buying and selling brokers meet and seal the deal.
3. The investor is informed of what happened/transpired at the trading floor through a contract note.
The note is sent to buying and selling investors.

The note contains details such as:

 

Number of shares bought or sold


Buying/selling price
Charges/commission payable etc.

4. Settlement is made through the brokers.

5. Old share certificate is cancelled (for selling investor) and a new one is issued in the name of buying
investor.

Factors to Consider when Buying Shares of a Company

1. Economic conditions of the country and other non-economic factors e.g. unfavourable climatic
conditions and diseases which may lead to low productivity and poor earnings.
2. State of management of the company e.g are the B.O.D. and key management personnel of repute?
They should be trusted and run the company honestly and successfully.
3. Nature of the product dealt in and its market share e.g is the product vulnerable to weather
conditions? Is it subject to restrictions?
4. Marketability of the shares – how fast or slowly can the shares of the firm be sold?
5. Diversification i.e does the company have a variety of operations e.g multi-products so that if one
line of business declines, the other increases and the overall position is profitable.
6. Company’s trading partners (local and abroad) and its competitors.
7. Prospects of growth of the firm due to expected growth in demand of products of the firm.

Note
Stock broker can give all the above advice when buying shares.

Factors Affecting/ Influencing Share Prices

All sorts of influences affect share prices. These influences include:

1. The recent profit record of the company especially the recent dividend paid to shareholders and the
prospects of their growth and stability.
2. The growth prospects of the industry in which the company operates.
3. The publication of a company’s financial results i.e. Balance Sheet and profit and loss statement.
4. The general economic conditions situations e.g boom and recession e.g during boom, firms would
have high profits hence rise in prices.
5. Change in company’s management e.g entry and exit of prominent corporate personalities.
6. Change on Government economic policy e.g spending, taxes, monetary policy etc. These changes
influence investors’ expectations.
7. Rumour and announcements of impending political changes eg. General elections and new president
will cause anxiety and uncertainty and adversely affect share prices.
8. Rumours and announcement of mergers and take-over bids. If the shareholders are offered
generous terms/prices in a take-over, share prices could rise.
9. Industrial relations eg strikes and policies of other firms.
10. Foreign political developments where the economy heavily depends on world trade.
11. Changes in the rate of interest on Government securities such as Treasury Bills may make investors
switch to them. Exchange rates will also encourage or discourage foreign investment in shares.
12. Announcement of good news eg that a major oil field has been struck or a major new investment has
been undertaken. The NPV of such investment would be reflected in share prices.
13. The views of experts e.g articles by well-known financial writers can persuade people to buy shares
hence pushing the prices up.
14. Institutional buyers such as insurance companies can influence share prices by their actions.
15. The value of assets and the earnings from utilization of such assets will also influence share prices.
STOCK MARKE T INDE X
Definition
An index is a numerical figure which measures relative change in variables between two periods.

E xamples
If sales in year 2000 are equal to Kshs.25 M and for year 2001 Shs.30 M, the sales index would be as follows:

Sales index = year 2001 sales = Shs.30 M x 100 = 120

Year 2000 sales Shs.25 M

Year 2001 sales are 120% of year 2000 sales, year 2000 is called Base year.

A stock index therefore measures relative changes in prices or values of shares. The NSE has its base year as
1966. 20 companies constitute the index.

The stock index is computed using Geometric mean (G.M) as follows:

Todays stock index = (Today’s share price G.M)2 x 100

Yesterday’s share price G.M.

Where G.M = n P xP xP xP x........xP

1 2 3 4 n

Where G.M. P1 x P2 x P3 x P4 ------- Pn = share price of companies that constitute stock index.

N = number of companies



When stock prices are rising, stock market index will rise and vice versa.
Stock market index therefore is an indicator of investors confidence in the economy.

Illustration
The following 6 companies constitute the index of democratic republic of Kusadikika.

Company A B C D E F
Today’s share price 20 52 83 12 78 100
Yesterday’s share price 25 53 83 10 75 96

Compute the stock market index for today.

In construction/computation of stock index the following should be considered:

1. Choice of base year on which to base the price changes

2. The selection of representative securities/firms
3. Combining the securities/firms to construct the index eg use of geometric mean
4. Use of suitable weight to be attached to the securities depending on their relative importance.
5. The weights/number of firms in a sector is kept constant over a reasonably long period.

LE VE L OF TRADING ACTIVITIE S IN THE NAIROBI STOCK E XCHANGE

The activities in NSE are normally low due to:
 1. Few Listed companies
2. Economy is made up of small firms which are family owned or sole proprietorship.
3. Level of awareness among the population is low
4. Few instruments traded
5. Low dividend payout to those already holding shares.

STOCK E XCHANGE INDE X (SE I)

Stock Exchange Index is a measure of relative changes in prices of stocks from one period to another indices.

Nairobi Stock Exchange 20 - share Index (20 companies) (Daily basis) Stanchart Index - From 25 most active
companies in a given period (weekly basis) Computation of price index.

Uses of Stock E xchange Index

1. To gauge price (wealth movement in the stock market
2. To assess overall returns in the market portfolio
3. To assess performance of specific portfolio using SEI as a benchmark.
4. May be used to predict future stock prices
5. Assist in examining and identifying the factors that underlie the price movements.

Limitations/ Drawback of NSE index

1. The 20 companies sample whose share prices are used to compute the index are not true
representatives.
2. The base year of 1996 is too far in the past
3. New companies are not included in the index yet other firms have been suspended/deregistered e.g.
ATH, KFB etc.
4. Dormant firms – Some of the 20 firms used are dormant or have very small price changes.
5. Thinness of the market – small changes in the active shares tend to be significantly magnified in the
index
6. The weights used and the method of computation of index may not give a truly representative index.

When is a share price said to be unfair?



Where the price is not determined by demand and supply forces.
If the price is not consistent with the activities of the firm e.g a decline in share price of a firm with


very good growth prospects.


Price is not compatible with the price of other similar shares of firms in the same industry
If there is insider trading:
This situation arises where individuals within the firm in privileged positions e.g top management and
director take advantage of the information available to them which has not been released to the
public.
They may use such information to dispose off share to make capital gains or avoid capital loss

E xample – where individuals (insiders) are aware that a firm has made a loss in a year and such
information, if released to the public, would cause a crash on share price, the information may be
leaked to certain people who could sell the shares in advance.
TIMING OF INVE STME NT A STOCK EXCHANGE
The ideal way of making profits at the stock exchange is to buy at the bottom of the market (lowest M.P.S)
and sell at the top of the market (highest M.P.S). The greatest problem however is that no one can be sure
when the market is at its bottom or at its top (prices are lowest and highest).

Systems have been developed to indicate when shares should be purchased and when they should be sold.
These systems are Dow theory and Hatch system.

1. Dow Theory
This theory depends on profiting of secondary movement of prices of a chart. The principal objective is to
discover when there is a change in the primary movement.
This is determined by the behaviour of secondary movement but tertiary movements are ignored. Eg in a
bull market, the rise of prices is greater than the fall of prices.
In a bear market the opposite is the case ie the fall is greater than the rise
In a bear market, the volume of the business being done at a certain stage can also be used to interpret the
state of the market.

Basically, it is maintained that if the volume increases along with rising prices, the signs are bullish and if the
volume increases with falling prices, they are bearish.

2. Hatch System
This is an automatic system based on the assumption that when investors sell at a certain % age below the top
of the market and buys at a certain percent above the market bottom, they are doing as well as can reasonably
be expected. This system can be applied to an index of a group of shares or shares of dividends companies
eg Dow Jones and Nasdaq index of America.

Illustration 1
An investor uses the hatch system to determine when to buy and sell his shares. He sells the shares when
prices are 15% less of the top price and buy the shares when prices are 15% less of the top price and buy the
shares when prices are 15% more of the bottom price. At the beginning of January, the share price was
200/=. At the end of the year the share price was Shs.320.

i) Determine the buying and selling price of the shareholders

ii) If the shareholder had 10,000 shares, determine the amount of capital gain on these shares.
iii) The investor had D.P.S of 3.00 at the end of the year. Compute his shilling return in %.

Rules for floatation of new shares on NSE

1. The company must have an issued share capital of at least Kshs.20 M.
2. The company must have made profits during the last 3 years.
3. At least 20% of issued capital (capital to be issued) should be offered to the public
4. The firm must issue a prospectus which will give more information to investors to enable them to
make informed judgement
5. The market price of the companies share must be determined by the market forces of demand and
supply
6. The company should be registered under Cap. 486 with registrar of companies.

Note
 A prospectus is a legal document issued by a company wishing to raise funds from the public
through issue of shares or bonds.
 

It is prepared by directors of the company and submitted to CMA and NSE for approval
The CMA has issued rules relating to the design and contents of the prospectus, in addition to those
contained in the Companies Act.

It must provide details on

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

The Advantages and Disadvantages of a Listing

Advantages

1. It facilitates the issue of securities to raise new finance, making a company less dependent upon
retained earnings and banks.
2. The wider share ownership which results will increase the likelihood of being able to make rights
issues.
3. The transfer of shares becomes easier. Less of a commitment is necessary on the part of
shareholders. For this reason the shares are likely to be perceived as a less risky investment and
hence will have a higher value.
4. The greater marketability and hence lower risk attached to a market listing will lead to a lower cost of
equity and also to a weighted average cost of capital.
5. A market-determine price means that shareholders will know the value of their investment at all
times.
6. The share price can be used by management as an indicator of performance, particularly since the
share price is forward looking, being based upon expectations, whilst other objectives measures are
backward looking.
7. The shares of a quoted company can be used more readily as consideration in takeover bids.
8. The company may increase its standing by being quoted and it may obtain greater publicity.
9. Obtaining a quotation provides an entrepreneur with the opportunity to realize part of his holding in
a company.

Disadvantages
1. The cost of obtaining a quotation is high, particularly when a new issue of shares is made and the
company is small. This is because substantial costs are fixed and hence are relatively greater for small
companies. Also, the annual cost of maintaining the quotation may be high due to such things as
increased disclosure, maintaining a larger share register, printing more annual reports, etc.
2. The increased disclosure requirements may be disliked by management.
3. The market-determined price and the greater accountability to shareholders that comes with its
concerning the company’s performance may not be liked by management.
4. Control of a particular group of shareholders may be diluted by allowing a proportion of shares to be
held by the public.
5. There will be a greater likelihood of being the subject of a takeover bid and it may be difficult to
defend it with wide share ownership.
6. Management conditions, management employees give themselves more salaries due to prosperity
obtained.
CAPITAL MARKE T AUTHORITY (CMA)
Was established in 1990 by an Act of Parliament ot assist in creation of a conducive environment for growth
and development of capital markets in Kenya.

ROLE OF CMA
1. To remove bottlenecks and create awareness for investment in long term securities
2. To serve as efficient bridge between the public and private sectors
3. Create an environment which will encourage local companies to go public
4. To grant approvals and licences to brokers
5. To operate a compensation fund to protect investors from financial losses should licenced brokers
fail to meet their contractual obligation
6. Act as a watchdog for the entire capital market system
7. To establish operational rules and regulations on placement of securities
8. To implement government programs and policies with respect to the capital markets.

Note
Apart from the above roles, CMA can undertake the following steps to encourage development of stock
exchanges in Kenya or other countries.

1. Removal of Barriers on security transfers

2. Introduce wider range of instruments in the market
3. Decentralization of its operations
4. Encourage development of institutional investors such as pension funds, insurance firms etc.
5. Provide adequate information to players in the market in order to prevent insider trading
6. Licence more brokers.

Role of CMA in determination of share prices

1. The CMA does not in any way influence share price of quoted companies.
2. The prices of such securities is determined by the demand and supply mechanism
3. However, CMA may:
4. Advice the company on the issue price of new securities
5. Alert the investors if it feels that the issue price of certain securities is not in their interest
6. It guards against manipulation of share prices and insider trading.

Other Terminologies
1. ACCOUNTS 14 day periods into which the stock exchange
trading calendar is divided.

2. ACCOUNTS DAY Sixth or seventh day following the expiry of an

accounts period on which settlement on all period deals must be completed.

3. BACKWARDATION Where stock cannot be delivered on settlement

date although it has been paid for, a third party is found who owns and will lend similar stock. As a
security measure, this stock is paid for in full. When the original stock that could not be delivered on
time is finally available, the lender will be given back his stock and will refund monies paid to him
less backwardation which is a commission for the loan.
4. BONUS SHARES Additional shares issued to shareholders at no
additional cost to themselves as a form of extra dividend. Also known as scrip issue.
5. CALL-OVER Bargaining and closing deals in a stock
exchange without a formal floor and position dealings, where the secretary reads, calls out each
security to be dealt, one at a time.

6. CARRY-OVER When a deal has been arranged but, for some

valid reason, either the buyer cannot pay on time, or the Jobber may not be able to deliver stock on
time. In this case, a third party can be introduced to solve the problem.

7. CONTANGO Is interest charged a client by his broker to

cover the costs of borrowing money from a third party so as to pay for stock bought on his behalf.
This happens when a client has commissioned his broker to purchase securities but for some reason,
cannot pay on time.

8. CUM. AND EX. hese prefixes are written in front of other

words such as capital, rights and dividends to qualify them. “Cum” is short for cumulative, which
means “inclusive of”. “Ex” on the other hand is short for excluding, which is the opposite of
including.

In commerce these terms refer to rights of buyers and sellers of securities when these are sold before
a dividend has been effected but after it has been declared. These terms are necessitated
by the fact that shares are bought and sold throughout the year, but companies only declare
dividends after the end of their financial year when profits can be determined, and moreover,
payment of dividends may take place long after they have been declared.

Thus “Ex Capital” infers that the seller of shares has sold them excluding their right to receive a
bonus share issue which has been declared at the time of sale. “Cum Capital” then means he sells
them inclusive of this right.
Ex Rights Cum Rights: The Term “Rights” refers to the decision by the directors to raise new share
capital at current market rates but to give a prior option to existing shareholders to purchase a fixed
number of shares at preferential rates below market values. Ex and Cum proceeding it refers to the
sale of shares decision, but before the dividend.
Cum Dividend: These terms simply mean that the seller of shares retain his right to receiving the
dividend on the shares he sells although the title to the shares has passed to the buyer reserve:

P.S. “Cum” anything shares give the buyer above par value because his purchase comes inclusive of
the rights to collect on prior earnings. They are therefore sold at higher prices than “Ex” shares.

9. FLOOR Loose term referring to the trading area of a

stock exchange. This encompasses all the position dealings or “markets” of the exchange.

10. GILT-EDGED SECURITIES These are loan securities that are issued by Governments and
because they are backed by the Governments “continuity”, they are considered perfectly safe, giving
regular periodic interest payments, a fixed rate of interest, and guaranteed capital redemption at the
expiry of the loan term eg Treasury bonds.

P.S.
Similar securities issued by public corporations are called bonds, if they are issued by public
companies they are called debentures.
CE NTRAL DE POSITORY SYSTE M (C.D.S)
It’s a computerized ledger system that enable the holding or transfer of securities without the need for
physical movement. The ownership of security or shares is through a book entry instead of physical
exchange CDS is for security what a bank is for cash transfer between banks. Eg A and B are 2 shareholders
of XYZ Ltd. XYZ Ltd. does not need to deliver the share certificate to A or B but a ledger account for both
shareholders would be maintained at the CDS. Their accounts will be credited with the number of shares. If
A want to sell shares to B the CDS will debit A’s account and credit B’s account.

Advantages of CDS
1. It shortens the registration process in the stock exchange i.e. high speed of registering shareholders.
2. It improves the liquidity of stock exchange than increase the turnover of the equity shares in the
market.
3. It will lower the clearing and settlement cost eg no need to prepare share certificates and seal them
(putting a seal).
4. Its faster and less risky settlement of securities which make the market more attractive for investors
e.g instances of fraud will be reduced since there is no physical share certificate which may be forged.
5. There will be improved and timely communication between company and the investors hence
reduced delay in receiving dividends and right issues and improve information dissemination
concerning a company.
6. It will lead to an efficient and transparent securities market to adhere to International Standards for
the benefit of all stakeholders.

Functions of CDS
1. Immobilisation of securities ie elimination of physical movement of securities.
2. Dematerialisation i.e elimination of physical certificates or documents showing entitlement to a
security so that ownership exists only as computer records.
3. Effective Delivery Vs. payment (DVP) ie simultaneous delivery and payment between the 2 parties
exchanging or transferring securities. This can be done without delay if CDS is linked to the central
payment clearing system e.g CBK.
4. Provision of detailed listings of investors according to the type of securities they hold e.g ordinary
shares, preference shares.
5. Effective Distribution of Dividends, interests, rights issues and bonus issues.
6. Provision of book entry account ie electronic exchange of ownership of securities and payment of
cash.

Parties Involved In CDS

1. Government
For the purpose of attracting foreign investors and supporting the infrastructure of capital markets.

2. Capital Market Authority

To improve the transparency of market and reduce instances of fraud.

3.Nairobi Stock Exchange

Bear transactions costs and improve liquidity of the market investors.

4. Investors
Institutions, private investors and market professionals. For faster settlements and ownership transfer and
reduced cost of transfer through reduced paper work and labour intensive activities.
5. Brokers
Reduces paper work, forgery and improved efficiency

6. Banks
Ease of clearing and settling of payments.

Development Banks And Specialised Financial Institutions

There are some sectors in the economy that may not secure adequate funds from commercial banks for
various reasons.

a) May take a long time to realize returns

b) High risk associated with such sectors
c) unattractive/low return
d) Uncertainty or highly volatile returns
e) Require heavy investment in infrastructure

These sectors include:



Tourism


Rural housing


Agriculture


Rural enterprise


Small commercial businesses e.g Jua Kali etc.
Such sector e.g agriculture and tourism are essential for a balanced economic growth and
development.

The government has thus established financial institutions to cater specifically for these otherwise unattractive
but essential sector. They include:
1. Industrial development bank (IDB) – give loans for industrial development in Kenya.
2. Development Finance Company of Kenya (DFCK) – To finance various project will spur economic
development and create employment.
3. cKenya Industrial Estate (KIE) – this is a branch of Industrial and Commercial development
cooperation (ICDC) dealing with industrial development.
4. Agriculture Finance Co-operation (AFC)
5. Post Bank – To mobilize rural savings
6. National Housing Cooperation – for development of houses to ensure shelter for everyone.
7. Kenya Tourism Development Cooperation (KTDC) for promotion of Tourism in Kenya.

Advantages/ Functions/ Case for Development Financial Institutions

1. They provide venture capital
2. They provide facilities for large lending
3. They provide technical expertise and support emerging projects transferable from other sectors of
development economies.
4. They are risk capital providers in areas which are not attractive to commercial banks and other major
lenders due to risk involved.
5. They carry out feasibility study to evaluate viability of projects.

Case against Specialized Institutions and Development Banks

1. They are being phased out by Globalisation and liberalization where needy sectors can easily get
expertise from outside.
2. Commercial banks have now matured up to provide capital for all sectors.
3. They were only useful during periods of foreign exchange restriction
4. They are risk capital providers in areas which are not attractive to commercial banks and other major
lenders due to risk involved.
5. They increase government spending.

BANKING INSTITUTIONS
The Central Bank
This is a bank which is entrusted with the responsibility of maintaining
economic stability and financial soundness of a country. It is therefore
entrusted with two objectives:

1. Responsibility of maintaining financial soundness of the economy. The

2. bank has therefore to identify gaps in financial markets and to seek
3. solutions to these gaps.
4. To act as a commercial bank. It therefore has to operate profitability
5. when offering services to difference parties.

E stablishment of Central Bank of Kenya

Established by Central Banking Act, 1966, and the Banking Act 1968.

Management of the Bank

Management and policy entrusted to a Board of Directors, comprising of seven
members including the Governor, Deputy Governor, and Ps to treasury. The
Governor of the Central Bank is the executive head of the bank. The Governor
in charge today is Michael Cheserem.

Statutory Information and Accounts

The bank is required to publish a return of its assets and liabilities every
month. A copy of the return to be submitted to Finance Minister. The bank has
also to prepare and publish an annual report within 3 months of the end of
fiscal year. Fiscal year ends 30th June.

Central Banks
Functions of Central Bank
1. Banker to the government
2. Lender to the government
3. Ensure Economic stability
4. Printing of currency notes
5. Lender of last resort

Tools Used To Control The Level Of Money In Circulation

1. Monetary policies e.g Treasury bills, Treasury bonds, Reserve ratio etc
2. Fiscal policies e.g taxation
Commercial Banks
These are financial institutions that accept deposits of money
from the general public, safeguard the deposits and make them available to
their owners when need arises.

E stablishment
Established under the Banking Act 1968.

Functions of Commercial Banks

1. Accepting deposits
2. Collecting money on behalf of customers and credit this money in
customers accounts
3. Transferring of money from individual accounts to another persons
accounts through credit transfer.
4. Supply currency - foreign currency obtainable at commercial bank.
5. Lending money, the banks lend loans to customers from which they earn
interest.
6. Facilitate International Trade - issue letters of credit and undertake foreign exchange transactions on
behalf of their customers.
7. Act as trustees and executives of wills if one wants to make a will
he/she writes one and appoints a commercial bank as the trustee and executor of the bill.
8. Provision of safer keeping of valuables like title deeds, gold, certificates.
9. Making decision affecting development. Before advancing loan to a prospective customer, commercial
banks are very careful and strict so as to give loans to invest in viable sector of the economy.
10. Provision of saves for keeping money and other valuables over night.

Other Financial Institutions

1. Mortgages
An arrangement where the property being purchased provides the security for funding. Other assets
may be used as security for funding of another asset.

Features
1. Mortgagor and mortgagee agree on a long term financing arrangement
2. Financing relates to acquisition of specific asset
3. Mortgagor provides a contribution which is paid up-front.
4. Repayment is over a specified long term period.
5. Interest rate is stated with provision for variations of the determination of the finance.

Difficulties in mortgage arrangements

1. Initial contribution is not affordable by majority of the population e.g. Nyayo Highrise
2. Estate.
3. Potential participants avoid getting tied up in long term loans
4. Experiences with mortgage arrangements have been discouraging.
5. Interest rate fluctuations make planning uncertain
2. Housing Finance Company of Kenya
This is the largest mortgage company in Kenya. It implements the government’s policy of
stimulating house ownership. It is registered under the Building Society Act but operates as a finance
company under the Banking Act.

3. Kenya Industrial E state

This is a body established by the government for the purpose of promoting industrial development.

a) E nhancement of acquisition of skills necessary for industrial development

Technological innovations. The body is concerned with the provision of a base that will be
considered necessary for technology development e.g. through research.
It provides capital necessary for industrial development
It provides guarantees for loans to be used for industrial development especially for small scale
industries.

4. Industrial and Commercial Development Cooperation (ICDC)

This was incorporated in 1954 by the Kenya Government
The main objective is to facilitate industrial development. It concentrates on projects requiring
financial participation and active extension of services
Funds provided are from the Government and commercial banks.

5. Kenya Tourist Development Corporation

This was established by the Government specifically to promote tourism. The main objectives of
KTDC are:

1. To provide assistance for establishment of tourism projects

2. To provide financial assistance for the establishment of hotels and tourism lodgings
3. To provide equity finance on joint venture basis in international hotel organizations.

6. Merchant Banks
Merchant Banks begun life as merchants and begun to operate in financial firms, within the 19th
Century.
The merchant banks act as a principal when they buy share from the company before the issue is
made. Merchant banks accept bills of exchange which deal in the leasing of industrial equipment.

REINFORCING QUESTIONS

QUE STION ONE

The following information is reported in a daily newspaper with respect to shares traded on the Nairobi Stock
Exchange:

Last 12
months Previous Shares
H L Security Yesterday Deal traded
Shs. Shs. Shs. Shs.
 1 200.00 75.00 Kakuzi Limited Ord. Sh.5 120.00 130.00CD 10,000
2 90.50 43.50 Express Kenya Ltd. Ord. Sh.5 43.50
3 40.00 4.00 ATH Ltd. Ord. Sh.10 Suspended
4 362.00 102.00 Unga Ltd. Ord. Sh.5 317.00CB 318.00
5 140.00 90.00 Barclays Bank Ltd. Ord. Sh.10 90.00 90.00

Required

a) Why does the price of a share change? (6 marks)

b) i) What does the CD against Kakuzi’s share price mean? (2 marks)

ii) Under the yesterday’s column for Express Kenya Ltd., there is a dash (-).
Explain. (2 marks)
iii) ATH is indicated as suspended. Explain why a company may be suspended from the
stock exchange. (6 marks)
iv) Explain the CB against the Unga share price. (2 marks)
v) What is the meaning of the Ord. Sh.10 indicated against the Barclays Bank?
2 marks)
(Total: 20 marks)

QUE STION TWO

a) In relation to capital markets, differentiate between the terms stock markets and financial markets.
(4 marks)

b) The Nairobi Stock Exchange is set to undergo major changes in terms of services when the
Central Depository System (CDS) is put in place after the Parliament passes the Bill on the
issue.

i) What is the Central Depository System (CDS)? (4 marks)

ii) How will it benefit the parties to be affected by it? (4 marks)

c) The shares of Ndege Airways Company Ltd. have been trading at Sh.8.00 per share for the last several
months. The existing shareholders argue that such shares are undervalued. They say that, the shares
should normally be trading at around Sh.15 per share.

i) When would a share price said to be unfair? (4 marks)

ii) If the price earnings ratio for Nege Airways Company Ltd. ordinary shares is 2.5
imes while the price earnings ratio of the shares of Piki Piki Company Ltd. is 10 times, which
share is more attractive to a potential investor? Give reasons.
(4 marks)
3. a) With reference to capital market, define the following terms:

i) Contango operation (2 marks)

ii) Backwardation (2 marks)
iii) Stags (2 marks)
iv) Role of investment banker (4 marks)

b) Mr. Castro uses a 20% hatch system of timing when to invest in a stock market. In a given
year, the top of a given share was Sh.150 and its bottom was Sh.90. During the year, the
company paid an interim DPS of Sh.1.50 and a final DPS of Sh.4.50.
 Determine the % return on investment. (4 marks)

4. a) Explain how the savings and credit co-operative societies mobilise savings and aid
investments. (7 marks)

b) How do the Non-Governmental organisations (NGO’s) that extend credit to informal

businesses and small traders ensure that the level of credit default is low? (6 marks)

c) Would you consider it prudent to convert savings and credit co-operative societies and the
institutions which are used by Non-Governmental Organisations in (b) above into banks?
(5 marks)
(Total: 18 marks)