HBC 2202: INTRODUCTION TO FINANCIAL MANAGEMENT (45 LECTURE HOURS)
Prerequisite – HBC 2107 Introduction to Accounting II
COURSE PURPOSE
To equip the students with knowledge that enables them to understand and appreciate financial
decision making process, empowering them to explain and predict the impact of financing,
investing, risk management, dividend and liquidity decisions.
COURSE OBJECTIVES
At the end of this course students should be able to:
1. Identify and Evaluate sources of long term, medium term and long term sources of finance.
2. Recognize the principles and concepts of the three main decision making areas of finance
i.e. investing, financing and asset management
3. Solve problems relating to time value of money.
COURSE OUTLINE
LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT
LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…)
LESSON 3: SOURCES OF FINANCE
LESSON 4: SOURCES OF FINANCE (CONT…)
LESSON 5: WORKING CAPITAL MANAGEMENT
LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…)
LESSON 7: TIME VALUE OF MONEY
LESSON 8: COST OF CAPITAL
LESSON 9: INTRODUCTION TO FINANCIAL MARKETS
LESSON 10: INTRODUCTION TO FINANCIAL MARKETS (CONT…)
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LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT
1.1Definition of financial management
Financial Management is that specialised function of general management which is related to the
procurement of finance and its effective utilisation for the achievement of common goal of the
organisation.
It includes each and every aspect of financial activity in the business. Financial Management has
been defined differently by different scholars. A few of the definitions are being reproduced
below:“Financial Management is an area of financial decision making harmonizing individual motives
and enterprise goals.”- Weston and Brigam.
“Financial Management is the application of the planning and control functions to the finance
function.”- Howard and Upton.
“Financial Management is the operational activity of a business that is responsible for obtaining
and effectively, utilizing the funds necessary for efficient operations.”- Joseph and Massie.
From the above definitions, it is clear that financial management is that specialised activity which
is responsible for obtaining and affectively utilizing the funds for the efficient functioning of the
business and, therefor, it includes financial planning, financial administration and financial control.
Financial Management is a discipline concerned with the generation and allocation of scarce
resources (usually fund) 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.
We shall refer to this definition as we go through the subject.
1.2 Required Rate of Return (Ri)
The required rate of return (Ri) is the minimum rate of return that a project must generate if it has
to receive funds. It’s therefore the opportunity cost of capital or returns expected from the second
best alternative. In general,
Required Rate of Return = Risk free rate + Risk premium
Risk free is compensation for time and is made up of the real rate of return (Ri)and the inflation
premium (IRp). The risk premium is compensation for risk of financial actions reflecting:
- The riskiness of the securities caused by term to maturity
- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.
The required rate of return can therefore be expressed as follows:
Rj = Rr + IR∞ + DR∞ + MR∞ + LR∞ + ER∞ +SR∞ + OR∞
Where:
 Rr is the real rate of return that compensate investors for giving up the use of their funds in
an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for the decrease in
purchasing power of money caused by inflation.
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





DRp is the Default Risk Premium which compensates the investor for the possibility that
users of funds would be unable to repay the debts.
MRp is the Maturity Risk Premium which compensates for the term to maturity
LRp is the Liquidity Risk Premium which compensates the investor for the possibility that the
securities given are not easily marketable (or convertible to cash)
ERp is the Exchange Risk Premium which compensates the investors for the fluctuation in
exchange rate. This is mainly important if the funds are denominated in foreign currencies.
SRp is the Soverign Risk Premium which compensates the investors for the possibility of
political instability in the country in which the funds have been provided.
ORp is the Other Risk Premium e.g the type of product, the type of market, etc.
1.2 Distinction between Financial Accounting and Financial Management
Financial Accounting
Financial Management
(i) It is a statutory requirement
(i) It is not a statutory requirement
(ii) It is carried out according to the
(ii) It is just conducted according to the
General
Accepted
Acoounting
management decisions
Principles (GAAP)
(iii) It deals with historical transactions
(iii) It deals with future planning
(iv) It is both for internal and external
users
(iv) It is for internal users i.e
(v) It deals with recording financial
management
transactions in a systematic manner
(v) It deals with the procurement and
for a particular period
allocation of fianancial resources
(vi) Where finacial accounting ends
financial management starts
(vi) finacial accounting comes before
financial management
1.3 Scope of finance functions.
The functions of Financial Manager can broadly be divided into two. The Routine functions and the
Managerial Functions.
1.3.1Managerial Finance Functions
Require skillful 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
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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
shareholder, 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 fund such as preference shareholders and debt providers. The firm’s divided
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 maximize 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 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 sine
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 not unnecessary funds are invested in current assets.
1.3.2 Routine functions
For the effective execution of the managerial finance functions, routine functions have to be
performed. These decision 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 routing functions will
carried out by junior staff in the firm .
He must however ,supervise the activities of the junior staff .
1.4 objectives of a business entity
Any business firm would have certain objectives which it aims at achieving .The major goal of a
firm are :
 Profit maximization
 Shareholder wealth maximization
 Social responsibility
 Business ethics
 Growth
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1.4.1 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:
(a)
(b)
(c)
(d)
It ignores time value of money
It ignores risk and uncertainties
it is vague
it ignores other participants in the firm rather than the shareholders
1.4.2 Shareholders' wealth maximization
Shareholders' wealth maximization refers to maximization 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. 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 maximization helps to solve the problems with profit maximization. This is
because, the goal:
i.
considers time value of money by discounting the expected future cashflows to the
present.
ii.
it recognises risk by using a discount rate (which is a measure of risk) to discount
the cashflows to the present.
1.4.3 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.
1.4.4 Business Ethics
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 thought 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 of these
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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:
i.
ii.
iii.
iv.
v.
vi.
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
1.4.5 Growth
This is a major objective of small companies which may even invest in projects with negative NPV so
as to increase their size and enjoy economies of scale in the future.
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LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…)
1.5 AGENCY THEORY
An agency relationship may be defined as a contract under which one or more people (the
principals) hire another person (the agent) to perform some services on their behalf, and delegate
some decision making authority to that agent. Within the financial management framework, agency
relationship exists between:
a) Shareholders and Managers
b) Debt holders and Shareholders
c) Shareholders and the government
d) Shareholders and auditors
1.5.1 Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is managed by a board
of directors appointed by the shareholders. This is because:
i)
There are very many shareholders who cannot effectively manage the firm all at the same
time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.
Conflict of interest usually occur between managers and shareholders in the following ways:
i)
ii)
iii)
iv)
v)
vi)
Managers may not work hard to maximize shareholders wealth if they perceive that they
will not share in the benefit of their labour.
Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable
Managers may maximize leisure time at the expense of working hard.
Manager may undertake projects with different risks than what shareholders would consider
reasonable.
Manager may undertake projects that improve their image at the expense of profitability.
Where management buy out is threatened. ‘Management buy out’ occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.
Solutions to this Conflict
In general, to ensure that managers act to the best interest of shareholders, the firm will:
(a)
Incur Agency Costs in the form of:
i)
ii)
iii)
Monitoring expenses such as audit fee;
Expenditures to structure the organization so that the possibility of undesirable
management behaviour would be limited. (This is the cost of internal control)
Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the case if
manager were also owners. This is the cost of delaying decision.
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(b)
The Shareholder may offer the management profit-based remuneration. This remuneration
includes:
i)
ii)
iii)
(c)
An offer of shares so that managers become owners.
Share options: (Option to buy shares at a fixed price at a future date).
Profit-based salaries e.g. bonus
Threat of firing: Shareholders have the power to appoint and dismiss managers which is
exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates
managers to make good decisions.
Threat of Acquisition or Takeover: If managers do not make good decisions then the value of
the company would decrease making it easier to be acquired especially if the predator
(acquiring) company beliefs that the firm can be turned round.
(d)
1.5.2 Debt holders versus Shareholders
A second agency problem arises because of potential conflict between stockholders and creditors.
Creditors lend funds to the firm at rates that are based on:
i.
ii.
iii.
iv.
Riskiness of the firm's existing assets
Expectations concerning the riskiness of future assets additions
The firm's existing capital structure
Expectations concerning future capital structure changes.
These are the factors that determine the riskiness of the firm's cashflows and hence the safety of its
debt issue. Shareholders (acting through management) may make decisions which will cause the
firm's risk to change. This will affect the value of debt. The firm may increase the level of debt to
boost profits. This will reduce the value of old debt because it increases the risk of the firm.
Creditors will protect themselves against the above problems through:
a. Insisting on restrictive covenants to be incorporated in the debt contract. These covenants may
restrict:




The company’s asset base
The company’s ability to acquire additional debts
The company’s ability to pay future dividend and management remuneration.
The management ability to make future decision (control related covenants)
b. if creditors perceive that shareholders are trying to take advantage of them in unethical
ways, they will either refuse to deal further with the firm or else will require a much higher
than normal rate of interest to compensate for the risks of such possible exploitations.
It therefore follows that shareholders wealth maximization require fair play with creditors. This is
because shareholders wealth depends on continued access to capital markets which depends on fair
play by shareholders as far as creditor's interests are concerned.
1.5.3 Shareholders and the government
The shareholders operate in an environment using the license given by the government. The
government expects the shareholders to conduct their business in a manner which is beneficial to
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the government and the society at large.
The government in this agency relationship is the principal and the company is the agent. The
company has to collect and remit the taxes to the government. The government on the other hand
creates a conducive investment environment for the company and then shares in the profits of the
company in form of taxes. The shareholders may take some actions which may conflict the interest
of the government as the principal. These may include;
(a) The company may involve itself in illegal business activities
(b) The shareholders may not create a clear picture of the earnings or the profits it generates
in order to minimize its tax liability.(tax evasion)
(c) The business may not response to social responsibility activities initiated by the government
(d) The company fails to ensure the safety of its employees. It may also produce sub standard
products and services that may cause health concerns to their consumers.
(e) The shareholders may avoid certain types of investment that the government covets.
Solutions to this agency problem
(i)
The government may incur costs associated with statutory audit, it may also order
investigations under the company’s act, the government may also issue VAT refund
audits and back duty investigation costs to recover taxes evaded in the past.
(ii)
The government may insure incentives in the form of capital allowances in some
given areas and locations.
(iii)
Legislations: the government issues a regulatory framework that governs the
operations of the company and provides protection to employees and customers
and the society at large.ie laws regarding environmental protection, employee
safety and minimum wages and salaries for workers.
(iv)
The government encourages the spirit of social responsibility on the activities of the
company.
(v)
The government may also lobby for the directorship in the companies that it may
have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc
1.5.4 Shareholders and auditors
Auditors are appointed by shareholders to monitor the performance of management.
They are expected to give an opinion as to the true and fair view of the company’s financial
position as reflected in the financial statements that managers prepare. The agency conflict arises
if auditors collude with management to give an unqualified opinion (claim that the financial
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statements show a true and fair view of the financial position of the firm) when in fact they should
have given a qualified opinion (that the financial statements do not show a true and fair view).
The resolution of this conflict could be through legal action, removal from office, use of
disciplinary actions provided for by regulatory bodies such as ICPAK.
1.6 CORPORATE GOVERNANCE
1.6.1 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 longterm value while taking into account the interests of other stakeholders.
1.6.2 Rationale for corporate governance
The organization of the world economy (especially in current years) has seen corporate
governance gain prominence mainly because:
 Institutional investors, as they seek to invest funds in the global economy, insist on high
standard of Corporate Governance in the companies they invest in.
 Public attention attracted by corporate scandals and collapses has forced stakeholders to
carefully 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
1.6.3 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:
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


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
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of a financially sound corporation while ensuring that the rights of the stakeholders are respected,
recognized and protected.
1.7 Self Review Questions
1. Define the term Agency relationship as it applies in Co-operatives and describe its
structure.
2. Discuss FIVE goals of financial Management and their applications in Co-operatives
3. State FIVE shortcomings of profit maximization objective.
4. Outline FIVE areas of conflict between managers and shareholders and the solutions to
counter the conflict.
5. Discuss authority and duties of members as a principle of corporate governance.
6. In what ways is wealth maximization objective superior to the profit maximization
objective? Explain.
7. Outline FOUR functions of the Financial Manager.
8. Briefly discuss the following principles of corporate governance.
a) Authority and duties of members
b) Strategy and Values
c) Internal Control procedures
d) Structure and organization
9. What roles should the financial manager play in the modern Co-operative set up?
10. Explain the key issues to be considered by a Financial Manager in the day to day
operating of saving and credit Co-operative.
11. Discuss the merits of the notion that the Financial Manager’s aim is to
maximize the value of
the firm in light of the views expressed under agency theory.
12. State FIVE shortcomings of profit maximization objective.
13. Outline FIVE areas of conflict between managers and shareholders and the solutions to
counter the conflict.
14. Discuss authority and duties of members as a principle of corporate governance
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LESSON 3: SOURCES OF FINANCE
Sources from which a firm may obtain its funds to finance its operations can be classified in four
different way as this include :
1. Classification according to the duration over which the funds will be retained.
These sources include
(a) long term sources of fundsThey are refundable after a long period of time i.e. after 12 years
(b)Short term sources of funds
These funds are refundable after a short period of time i.e. a period of 3 years
(c) Permanent sources of funds
These funds are not refundable as long as the business remains a going concern for example
ordinary share capital
2. Classification according to origin
These sources include;a) External sources of funds -They are raised from outside the organization
b) Internal sources of fund-These are funds that are raised from within the firm
3. Classification according to the relationship between the firm and parties providing the
funds
These sources include:a) Common equity capital -These are funds provided by the real owners of the business i.e.
ordinary share capital; it is the total of the ordinary capital and the reserves
b) Quasi capital these are funds that are provided by the preference shareholders
c) Debt finance -They are funds provided by the creditors i.e. debentures
4. Classification to the rate of return
These sources include:a) Capital with affixed rate of return -This is capital that is paid a certain prespecified rate
of return each year i.e. preference capital and long term debts
b) Capital with a variable rate of return-This is capital that is paid a different rate o0f
return each year depending on the firm’s performance.
5. A business may obtain funds from various sources which may be either:
a) Long term sources which are repaid after a long period of time.
b) Short term sources which are repaid after a short period even less than a year.
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Sources of Finance
1. Equity finance
This is finance from the owners of the company (shareholders).it is generally made up of ordinary
share capital and reserves (both revenue and capital reserves)
Ordinary share capital
The true owners of business forms are the ordinary shareholders. Sometimes referred to as
residual owners, they receive what is left after satisfaction of all other claims.
The ordinary share capital is raised by the shareholders through the purchase of common shares
through the capital markets.
This form of long term capital is only accessible to limited companies who have met the
requirements of the capital market authority for listing before floating the shares.
Features of ordinary share capital.
Ownership
The ordinary shares of a firm may be owned privately (family) or publicly with shares being
traded in the stock exchange.
Par value
The par value of an ordinary share is relatively useless value, established in the firm’s corporate
charter (memorandum). It is generally very low- Sh.5or less.
Pre-emptive rights
Allow shareholders to maintain their proportionate ownership in the corporation when new shares
are issued. The feature maintains voting control and protects against dilution.
Rights offering
The firm grants rights to its shareholders to purchase additional shares at a price below market
price, in direct proportion to their existing holding.
Authorized, outstanding and issued shares
Authorized shares are the number of shares of common stock that the firm’s charter (articles)
allows without further shareholders’ approval.
Outstanding shares is the number of shares held by the public
Issued shares are the number of share that has been put in circulation; they represent the sum of
outstanding and treasury stock.
Treasury stock is the number of shares of outstanding stock that have been repurchased by the
firm (not allowed by the Companies Act of Kenya Laws).
Dividends
The payment of corporate dividends is at the discretion of the Board of Directors. Dividends are
paid usually semi- annually (interim and final dividends). Dividends can be paid in cash, stock
(bonus issues) and merchandise.
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Voting rights
Generally each ordinary share entitled the holder to one vote at the Annual General Meeting for
the election of directors and on special issues. Shareholders can either vote in person or in proxy
i.e. appoint a representative to vote on his behalf .Shareholders can vote through two main
systems,
1. Majority voting system.
2. Cumulative system.
Majority voting system
Under this system , shareholders receive a vote for every share held. Decisions to be made must
therefore be supported by over 50% of the votes in a company .Under this system any
shareholder or group pf shareholders owning more than 50% of the company’s shares will make
all the decisions. The minority shareholders have no say.
Cumulative voting system.
Under this system, shareholders receive one vote for every share held times the number of similar
decisions to be made. This system is appropriate for making decisions that are similar and is
mainly used in the election of directors.
Example.
Assume that there are 10,000 shares outstanding and you own 1001v shares .Their are 9
directors to be elected and therefore you would have (1001×9)= 9009 votes .How many
directors can you elect.
A.1001 shares = 1001×9 =9009
B. 10,000 – 1001 = 8999 × 9 = 80,991
Share holder A has 9009 votes and with 9 directors to be elected , there is no way for the
owners of the remaining shares to exclude A from electing a person to one of the top 9 positions.
The majority shareholder would control 8999 shares thus thus entitling them to 80991 votes .The
80991 vote cannot be spread thinly enough over the nine candidates to stop shareholder A
from electing one director.
The number of shares required to elect a give number of directors is given as follows.
R= d (n) + 1
Nd + 1
Where,
R- Number of shares required to elect a desired number of directors.
d- Number of directors shareholders desire to elect.
n- Total number of common shares outstanding.
Nd- Total number of directors to be elected.
Example
A company will elect 6 directors and their ae 100,000 shares entitled to vote,
Required.
a. If a group desires to elect two directors, how many shares must they have.
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b. Shareholder A owns 10,000 shares, shareholder B owns 40,000 shares how many
directors can each elect.
Solution.
a) R =2 (100,000) + 1
6+1
=28571.6 + 1=28573
b) A. 10,000= d (100,000) +1
6+1
10,000=14285.7d + 1
d= 9999/14285.7
d=0.7
Therefore zero directors.
B. 40,000=d (100,000) + 1
6+1
d=2
Therefore 2 directors.
Advantages of equity financing accruing to shareholders
1. Shares can be used as security for loans.
2. Providers of these funds can participate in the supernormal earnings of the firm
3. The shares are easily transferable
4. Return in form of a share price appreciation (capital gain) and dividends.
5. The following rights of ordinary shareholders can be viewed as advantages:
Rights of ordinary shareholders.
i.
Right to vote-shareholders have the right to vote on a number of issues in a
company such as election of directors, changes in the Memorandum of Association
and Articles of Association. Shareholders can vote either in person or by proxy
that is, by appointing someone to represent them and vote on their behalf.
ii.
Pre-emptive rights- Allow shareholders to maintain their proportionate ownership
in the corporation when new shares are issued. The feature maintains voting
control and protects against dilution.
iii.
Right to appoint another auditor
iv.
Right to approve dividend payments
v.
Right to approve merger acquisition
vi.
Right to residual assets claim
Disadvantages accruing to shareholders
1. The ordinary share dividend is not an allowable deduction for tax purposes
2. The dividend is paid after claims for other providers of capital are satisfied
3. Ordinary shares carry the highest risk because of the uncertainty of return(company has
the discretion to declare dividend or not)and incase of liquidation the holders have a
residual claim on assets
Advantages of using ordinary share capital to a company
1. It is a permanent source of capital hence facilitates long term projects
2. Use of equity lowers the gearing level hence a company has a broader borrowing
capacity
3. The shareholders may provide valuable ideas to the company’s operation
16
4. A company is not legally obliged to pay dividend especially if it is facing financial
difficulty these funds would serve better if retained.
5. It enables a company to get the opinion of the public through the movement in share
prices.
6. This source can be raised in very large amounts
7. It does not require any collateral as security.
8. The funds are provided without conditions hence are flexible.
Disadvantages of using ordinary share capital to a company
1. The floatation costs are higher than those of debt
2. It is only accessible to companies that have fulfilled the capital markets authority
requirements
3. It can lead to dilution of ownership of control of the firm by the shareholders
4. Since the dividend payment is not tax allowable then the company does not enjoy a tax
saving
5. The cost of this source of fund(dividend) is perpetual as ordinary shares are not
redeemable securities
6. The firm has to follow set guidelines on disclosure and publishing of financial statements.
Methods of issuing common shares
 Through a public issue
 Private placement
 Through a rights issue
 Employee stock option plans (ESOP)
 Bonus issue
Public issue
Ordinary shares are offered to the general public. The issuing company engages an investment
banker who will undertake the issue. The investment will set the securities issue price and will sell
the shares to the investors. The issuing firm can enter into an arrangement with the investment
banker where the investment banker will underwrite shares, that is, buy any shares not taken up
by the public.
Private placement
Under this method securities are sold to a few, usually chosen investors mainly institutional
investors. The advantages of this method is that the firm gets to decide who will take up there
shares, it can be used as part of strategic partnership, it will also lead to less floatation cost as no
advertisement is necessary. It also takes less time to raise funds through a private placement than
a public issue which involves a number of requirements to be fulfilled. A major disadvantage is
that the share is not as liquid-transferability is made difficult.
Rights issue
This is an option offered to already existing shareholders to buy common shares of the company
at a price (subscription price) which is less than the market price. The subscription price is set a
lower price than the market price so as to make it attractive for the existing shareholders to buy
the common shares; also it acts as a safeguard against any reduction in share price in the market.
When a rights issue is declared every outstanding share receives one right however, a
shareholder needs to have a number of rights in order to buy one new share.
17
A rights issue involves selling of common shares to existing shareholders of the company on a
prorata basis. Shares becoming available on account of non-exercise of rights are allotted to
shareholders who have applied for additional shares on a pro-rata basis. Any balance of
shares can be sold in the open market.
When rights are issued the shareholder has three options available:
(a)
(b)
(c)
He can exercise the rights and therefore buy the new shares
He can sell the rights in the market
He can ignore the rights
The number of rights required to buy one new share can be given by the following formula
N
=
Where
So
S
So is the number of existing shares
S is the number of new shares to be sold
N is the number of rights required to buy one new share
The ex-right price of shares can be given by:
Px
=
So Po + S Ps
So + S
Where:
Px is the ex-right price of shares
Po is the cum-right price (current market prices of shares)
So is the number of existing shares
S is the number of new shares
Ps is the subscription price of rights
It can also be given by:
Px
=
Ps + (Po - Ps)
N
N+1
Rights have value and the value of each right can be given by the following formulae:
R
=
Px - Ps
N
Where R is the theoretical value of rights Px, Ps and N have previously been defined.
It can also be given by:
R
=
Po - Px
18
or R =
Po - Ps
N+1
Note:
All the above formulae give the same value and the student should use whichever is most
convenient.
Illustration:
XYZ Ltd has 900,000 shares outstanding at current market price of Sh 130 per share. The
company needs Sh 22,500,000 to finance its proposed expansion. The board of directors
has decided to issue rights for raising the required funds. The subscription price has been
fixed at Sh 75 per share.
Required:
(a)
(b)
(c)
(d)
How many rights are required to purchase one new share?
What is the price of one share after the rights issue (Ex-right price)?
Compute the theoretical value of each right
Consider the effect of the rights issue on the shareholders' wealth under the three
options available to the shareholders (Assume he owns 3 shares and has Sh 75 cash on
hand).
Solution:
(a)
To compute the number of rights required to buy one new share, we must first compute
the number of new shares to be issued.
No. of shares
=
Desired funds
Subscription price
=
22,500,000
75
=
300,000 shares
N
=
So
S
So
S
=
=
N
=
900,000
300,000
=
3
900,000 shares
300,000 shares
Therefore a shareholder will require 3 rights to buy one new share in the company.
Notes
19
The shareholder will receive one right for each share held and therefore a total of
900,000 rights will be issued by the company.
(b)
The price of the shares after the rights issue will be lower than the price before the rights issue
because the new shares are usually sold at a price which is below the market price.
Px
=
Ps + (Po - Ps)
Ps
Po
N
Px
=
=
=
=
=
N
N+1
75
130
3
75 + (130 - 75) 3/4
Sh 116.25
After the rights issue the price of the shares would fall from Sh 130 to Sh 116.25.
However, in an inefficient market, this may not be the case.
(c)
Value of each right
R
=
Po - Ps
N + 1
=
130 - 75
3 + 1
=
Sh 13.75
Each right will therefore have a theoretical value of Sh 13.75.
(d)
To consider the effects of the rights issue on the shareholders wealth, we need to
consider the current wealth of the shareholder.
Current Wealth
Wealth in the company (3 x 130)
Cash in hand
Total Wealth
Sh
390
75
465
Option 1 - Exercise the rights
Wealth in the company 4 x 116.25
Cash in hand (75 - 75)
Total Wealth
Sh
465
0
465
Therefore, the wealth remains constant if the shareholder exercises the rights and buys
the new shares.
Option 2 - Sell the rights at their theoretical value
Wealth in the company 3 x 116.25
Cash in hand - previous
From sale of rights 3 x 13.75
Sh
348.75
75
41.25
20
116.25
Total Wealth
465.00
The wealth also remains constant if the shareholder sells the rights at their theoretical
value.
Option 3 - Ignore the rights
Wealth in the company
Cash in hand
Total Wealth
3 x 116.25
Sh
348.75
75.00
423.75
The wealth declines by Sh 41.25 from Sh 465 to Sh 423.75 if the shareholder ignores
the rights. The shareholder should therefore never ignore a rights issue because his
wealth will decline.
Note:
In an inefficient capital market the announcement of the rights issue may carry additional
information not yet known by the market and therefore the share price may increase or decrease
depending on the informational content of the rights issue.
The major advantage of a rights issue is that the shareholders maintain their proportionate
ownership of the company.
Bonus issue
This is an issue of additional shares to existing shareholders in lieu of a cash dividend. Companies
may choose a bonus issue if it wants to give dividends but not in the form of cash so as to retain
the cash say for investment, it is not taxable as cash dividends would be taxed. A bonus issue is
expected to have no effect on the shareholders wealth and may have the following benefits,
Tax benefit –If a company declares such an issue. It Is not taxable as in the case of Cash
dividends .The share holder can therefore sale the new shares in the market to make capital gain
which is not taxable.
It can result into conservation of cash especially if a company is facing financial constrains.
If the market is inefficient, a bonus issue maybe regarded as signaling important information and
may result in an increase in the share price because a bonus issue is interpreted to mean high
profits.
Increase in future dividends .This occurs especially if a company follows a policy of paying a
constant mount of dividends per share and continues with this policy even after the bonus issue.
2. Term loan
Medium term & long term loans are obtained from commercial banks and other financial
institutions. This funds are mainly used to finance major expansions or profit financing.
Features of term loans
1. Direct negotiation – A firm negotiates a term loan directly with a bank of financial
institution. I.e. a private placement.
2. Security – term loans are usually secured specifically by the assets acquired using the
funds. (Primary security). This is said to create a fixed charge on the company’s assets. A
fixed charge can also be referred to as specific charge.
21
3. Restrictive covenant – financial institutions usually restrict the firms so as to safeguard their
funds. They do this by way of restrictive covenants which include asset based covenant,
cashflow, liability etc.
4. Convertibility – they are usually not convertible to common shares unless under special
cases. E.g. a financial institution may agree to restructure the firms capital structure.
5. Repayment schedule – this indicates the time schedule for payment of interest and
principle. It may occur.
i)
Where interest & principle are paid on equal periodic instalments.
ii)
Where principles is paid on equal periodic instalments & interest on the outstanding
balance of the loan.
Example
A company negotiates a Sh.30 million loan at 14% pa from a financial institution. Acquired;
prepare the loan prepayment schedule assuming that:
(i) Interest & principle paid in 8 equal year end installment’s
(ii) Principle is paid in 8 equal instalments
i) 30,000,000
=
A x PVIFA
14% 8 years
30,000,000
A
=
4.6389A
=
6,46,050.0378
Schedule of Repayment
Year Bal. b/d
Instalment
Interest 14%
Principle
Bal b/d
1
30,000,000
6,467,050
4,200,000
2,267,050
27,732,950
2.
27,732,950
6,467,050
3,882,613
2584437
25148513
3.
25148513
6,467,050
3520792
2946258
22202254.8
4.
22202255
6,467,050
3108316
3358734.3
18843521
5.
18843521
6,467,050
2638093
3828957
15014564
6.
150145639
6,467,050
2102039
4365011
10649553
7.
10649553
6,467,050
1490937.4
4976112.6
5673440.4
8.
56734404
6,467,050
794282
5672768.4
672.1
iii)
8 equal principle – 30n/8 = 3,750,000
YR Bal b/d inst. Int. primar
22
Year Bal. b/d
Instalment
Interest 14%
Principle
Bal b/d
1
30,000,000
7950000
4200000
3750000
26250000
2.
26250000
7425000
3675000
3750000
22500000
3.
22500000
6900000
3150000
3750000
18750000
4.
18750000
6375000
2625000
3750000
15000000
5.
150000000
5850000
2100000
3750000
11250000
6.
11250000
5325000
1575000
3750000
7500000
7.
7500000
4800000
1050000
3750000
3750000
8.
3750000
4275000
525000
3750000
0
3. Preference shares (quasi-equity)
Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the right to an
unpaid dividend is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary shareholders.
Characteristics of preference shares
1.
2.
3.
4.
They have a fixed dividend
Dividends can be paid in arrears
They can be converted to ordinary shares
They have a claim on assets before the ordinary shareholders
Types of preference shares
1.
2.
3.
4.
Redeemable verses Irredeemable
Cumulative verses non- cumulative
Participative verses non-participative
Convertible verse non-convertible
From the company's point of view, preference shares are advantageous in that:
with interest payments on long term debt (loans or debentures).
shareholders while an issue of equity shares would not.
ference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.
23
sense that preference share capital is not secured against assets in the business.
-payment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is normally given to debenture holders.
However, dividend payments on preference shares are not tax deductible in the way that interest
payments on debt are. Furthermore, for preference shares to be attractive to investors, the level
of payment needs to be higher than for interest on debt to compensate for the additional risks.
For the investor, preference shares are less attractive than loan stock because:
provide an attractive investment compared with the interest yields on loan stock in view of the
additional risk involved.
4. Venture capital
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A
businessman starting up a new business will invest venture capital of his own, but he will probably
need extra funding from a source other than his own pocket. However, the term 'venture capital' is
more specifically associated with putting money, usually in return for an equity stake, into a new
business, a management buy-out or a major expansion scheme.
The institution that puts in the money recognises the gamble inherent in the funding. There is a
serious risk of losing the entire investment, and it might take a long time before any profits and
returns materialise. But there is also the prospect of very high profits and a substantial return on
the investment. A venture capitalist will require a high expected rate of return on investments, to
compensate for the high risk.
A venture capital organisation will not want to retain its investment in a business indefinitely, and
when it considers putting money into a business venture, it will also consider its "exit", that is, how
it will be able to pull out of the business eventually (after five to seven years, say) and realise its
profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and
Anglo American Corporation Services Ltd.
When a company's directors look for help from a venture capital institution, they must recognise
that:
y can be successful
interests.
The directors of the company must then contact venture capital organisations, to try and find one
or more which would be willing to offer finance. A venture capital organisation will only give
24
funds to a company that it believes can succeed, and before it will make any definite offer, it will
want from the company management:
a) a business plan
b) details of how much finance is needed and how it will be used
c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a
profit forecast
d) details of the management team, with evidence of a wide range of management skills
e) details of major shareholders
f) details of the company's current banking arrangements and any other sources of finance
g) any sales literature or publicity material that the company has issued.
A high percentage of requests for venture capital are rejected on an initial screening, and only a
small percentage of all requests survive both this screening and further investigation and result in
actual investments.
Venture capital is a form of investment in new and risky small enterprises which is required to get
them started. Venture capitalists are therefore investment specialist who raises pools of capital to
fund new ventures which are likely to become public companies in return for an ownership interest.
They therefore buy part of the stools of the company at a low price in anticipation that when the
company goes public, they would sale the shares at a high price and make considerable capital
gains, venture capitalists also provide managerial skills to the firm examples of venture capitalists
are:
Pension funds, insurance companies and also individuals.
Since the goal of venture capital is to make a profit, they will only invest in that have a potential
for growth.
Constraints in the development of a venture capital market in Kenya.
i)
The few promoters of venture capital are risk averse and therefore are discouraged
by the level of risk, the length of investment and the liquidity of investment.
ii)
The nature of firms in Kenya is such that they are privately owned and therefore do
not dillusion of ownership through use of venture capital.
iii)
The poor infrastructure in the country also discourages venture capitalists.
25
iv)
They are not enough incentives for the development of venture capital and the
government is discriminative against venture capital. The tax laws favour debt over
equity.
v)
There is a general shortage of venture capitalists.
Importance of venture capital market in small and medium scale business development
i)
Venture capitalists provide the much needed finance to tour small businesses which lack
access to capital markets due to their size.
ii)
Small medium scale businesses may lack managerial skills. Venture capitalists sere as
active partners through involvement in this businesses and therefore provide marketing
and planning skills as the also want to see their investments succeed.
iii)
Venture capitalists encourage tree spirit of entrepreneurship therefore small businesses
are encouraged to see their ideas through as they know they will get start up capital.
iv)
Venture capitalists provide improved technology so that small and medium scale
business are in line with changes in technology and are therefore able to compete with
other firms of the same level.
26
LESSON 4: SOURCES OF FINANCE (CONT…)
5. Lease financing
This is an agreement where the right repossession and enjoyment of an asset is transferred for a
definite period of time. The person transferring the right i.e. the owner of the asset is referred to
as leasor. The recipient of the asset is the lessee.
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a
capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the
lease to the lessor, for a specified period of time.
Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars
and commercial vehicles, but might also be computers and office equipment. There are two basic
forms of lease: "operating leases" and "finance leases".
Operating leases
Operating leases are rental agreements between the lessor and the lessee whereby:
a) the lessor supplies the equipment to the lessee
b) the lessor is responsible for servicing and maintaining the leased equipment
c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end
of the lease agreement, the lessor can either
i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.
Finance leases
Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.
Suppose that a company decides to obtain a company car and finance the acquisition by means
of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in
a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the
company. The company will take possession of the car from the car dealer, and make regular
payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of the
lease.
Other important characteristics of a finance lease:
a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is
not involved in this at all.
27
b) The lease has a primary period, which covers all or most of the economic life of the asset. At
the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset
would be worn out. The lessor must, therefore, ensure that the lease payments during the primary
period pay for the full cost of the asset as well as providing the lessor with a suitable return on his
investment.
c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the
lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and
to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor.
Requirements of a Long Term lease
1. The present value of lease rentals must be greater than 90% the year value of the asset.
2. 75% of the assets life is the lease term.
3. It is non-cell unsalable
4. Maintenance costs, insurance and taxes are paid by the lessee.
According to terms of payment
1. Net lease
This is on in which the leasee pays all or a substantial part of the maintenance cost. It is
therefore where the lessee pays for all the expenses except taxes, insurances and
exterior repairs.
2. Flat Lease
This is one which opts for periodic payment for use of the asset over the term of the lease.
Such a lease is usually made for such periods of time since inflation can easily erode the
buying power of the fixed rentals.
3. Step Up lease
This provides for the fixed payments to be adjusted periodically. This adjustments can be
made either b new rentals taking effect after the passages of a certain period of time or
by periodically adjusting the fixed payments for inflation. The term of a stepup lease is
usually longer than a flat lease.
4. Percentage lease
This is where the lessee is required to pay a fixed basic percentage rate and a
designated percentage of sales volume. The percentage factor acts as an inflation gauge
as well as a means of Keeping lease rentals in line with the market conditions.
28
5. Escalator lease
This calls for an increase in taxes insurance and operating costs to be paid for the lessee.
6. Sandwich lease
This refers to a multiple lease in which the lessee in turn sub-lease to a sub-lessee who in
turn sub-leases to another sub-lessee. Example: A the original owner of an asset leases to
B. B executes a sub-lease to C who then sub-leases to D.
This is a sandwich lease between B & C, B being the sandwich lessor and C the sandwich
lessee.
Advantages of lease
i)
To avoid the risk of ownership. When a firm purchases an asset, it has to bear the risk
of obsolescence especially if the asset is vulnerable to technological changes e.g.
computers.
ii)
Avoidance of investment outlay. Leasing enables a firm to make full use of an asset
without making an immediate investment in the form of initial cash outflow.
iii)
Increased flexibility. A St. lease is a cancelable lease especially when the asset is
needed for a short period of time e.g. during construction, equipment can be leased
on a seasonal basis after which the lease can be cancelled.
iv)
Lease charges are tax allowable expenses. This therefore reduces the tax liability.
6. Hire purchase
This is arrangement whereby a company acquires an asset on making a down payment or deposit
and paying the balance over a period of time in installments. This source of finance is more
expensive than a bank loan and companies that use this source need guarantors since it does not
require security or collateral. The company hiring the asset will be required to honour the terms of
the agreement which means that any term in violated, the selling firm may repossess the asset.
This is therefore finance in kind and the hirer will not get title to the asset until he clears the final
installment and any charges thereof.
Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception
that ownership of the goods passes to the hire purchase customer on payment of the final credit
instalment, whereas a lessee never becomes the owner of the goods.
Hire purchase agreements usually involve a finance house.
i) The supplier sells the goods to the finance house.
ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.
29
The finance house will always insist that the hirer should pay a deposit towards the purchase
price. The size of the deposit will depend on the finance company's policy and its assessment of
the hirer. This is in contrast to a finance lease, where the lessee might not be required to make
any large initial payment.
An industrial or commercial business can use hire purchase as a source of finance. With industrial
hire purchase, a business customer obtains hire purchase finance from a finance house in order to
purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles,
plant and machinery, office equipment and farming machinery.
7.Mortgages
A Mortgage can be defined as a pledge of security over property or an interest therein created
by a formal written agreement for the repayment of monetary debt.
Minimum mortgage requirements
1. All mortgages should be in writing.
2. All parties must have contractual capacity.
3. Interest in the property being mortgaged should be specific e.g. rental income
lease hold etc.
4. A description of true loan or obligation secured by the mortgage should appear in
the mortgage agreement.
5. A legal description of the mortgage must be included in the documents.
6. The mortgage must be signed by the mortgagor
7. The mortgage must be acknowledged and delivered to the mortgagee.
8.Debentures
A debenture is a long-term promissory note used to raise debt funds. The firm promises to pay
periodic interest and principal at maturity. Ideally, a debenture is a long-term bond that is not
secured by a pledge of a specific property. However, like other general creditors claims, its
secured by a pledge of a specific property not otherwise pledged.
Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt
incurred by a company, normally containing provisions about the payment of interest and the
eventual repayment of capital.
Debentures with a floating rate of interest
These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders and
borrowers when interest rates are volatile.
30
Security
Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.
a) Fixed charge; Security would be related to a specific asset or group of assets, typically land
and buildings. The company would be unable to dispose of the asset without providing a
substitute asset for security, or without the lender's consent.
b) Floating charge; With a floating charge on certain assets of the company (for example, stocks
and debtors), the lender's security in the event of a default payment is whatever assets of the
appropriate class the company then owns (provided that another lender does not have a prior
charge on the assets). The company would be able, however, to dispose of its assets as it chose
until a default took place. In the event of a default, the lender would probably appoint a
receiver to run the company rather than lay claim to a particular asset.
Features of debenture
(a)
(b)
(c)
Interest rate
The interest rate on a debenture is fixed and known. It is called the contractual or
coupon interest rate. It indicates the percentage of the par value that will be paid out
annually (or semi-annually) in form of interest. The interest must be paid whether the
firm makes profit or not. However, debenture interest is tax deductible on the part of
the company.
Maturity
Debentures are usually issued for a specific period of time. The maturity of a
debenture indicates the length of time the debenture remains outstanding before the
company redeems it. However, there are debentures that have no maturity period.
Redemption
The redemption of debentures can be accomplished either through a sinking fund or call
provision.
A sinking fund is cash set aside periodically for retiring the debentures. The fund is
placed under the control of the trustee who redeems the debenture either by purchasing
them in the market or calling them in an acceptable manner. The advantage of a
sinking fund is that it reduces the amount required to redeem the remaining debt at
maturity. Particularly when the firm faces temporary financial difficulties at the time of
debt maturity, the repayment of huge amount of principal could endanger the firm's
financial viability.
Call provisions enable the company to redeem debentures at a specific price before
the maturity date. The call price is usually higher than the par value, the difference
being a call premium.
(d)
(e)
Security
Debentures are either secured or unsecured. A secured debenture is secured by a claim
on the company's specific assets. When debentures are not protected by any security,
they are known as unsecured or naked debentures.
Convertibility
31
A convertible debenture is one which can be converted, fully or partly into shares at a
specified price at a given date. Debentures without a conversion feature are called
non-convertible or straight debentures.
(f)
Yield
We can distinguish two types of yield: the current yield and the yield to maturity. The
current yield on a debenture is the ratio of the annual interest payment to the
debentures market price.
Current yield
=
Annual interest
Market price
The yield to maturity takes into account the payments of interest and principal over the
life of the debenture. It is an internal rate of return on the debenture and is given by
the following formula.
M - PX
n
YIELD T0 MATURITY =
(M + P)/2
C+
Where
C is the annual interest
M is the maturity value = Face Value
P is the current market value
n is the number of periods to maturity
Claim on Assets and Income
Debentures have a claim on the company's earnings prior to that of the shareholders since
their interest has to be paid before paying any dividend to preference and common
shareholders.
In case of liquidation, the debenture holders have a claim on assets prior to that of
shareholders. The secured debentures will have priority over the unsecured debentures
Types of debentures
1. Subordinated debentures
2. Redeemable debentures
3. Irredeemable debentures
Advantages of debentures
It involves less cost to the firm than the equity financing because:
i.
ii.
iii.
Investors consider debentures as a relatively less risky investment alternative and therefore
require a lower rate of return.
Interest payments are tax deductible.
The floatation costs on debentures is usually lower than floatation costs on common shares.
(b) Debenture holders do not have voting rights and therefore, debenture issue does not
cause dilution of ownership.
(c) Debenture holders do not participate in extraordinary earnings of the company. Thus
their payments are limited to interest.
32
(d)
During periods of high inflation, debenture issue benefits the company. Its
obligations of paying interest and principal, which remain fixed, decline in real
terms.
Disadvantage of debentures
(a)
(b)
(c)
(d)
Debentures issue results in legal obligation of paying interest and principal, which, if not
paid can force the company into liquidation.
Debenture issue increases the firm's financial leverage and reduces its ability to borrow
in future.
Debentures must be paid at maturity and therefore at some point, it involves substantial
cash outflows.
Debentures may contain restrictive covenants which may limit the firm's operating
flexibility in future
9. Retained earnings
For any company, the amount of earnings retained within the business has a direct impact on the
amount of dividends. Profit re-invested as retained earnings is profit that could have been paid
as a dividend. The major reasons for using retained earnings to finance new investments, rather
than to pay higher dividends and then raise new equity for the new investments, are as follows:
a) The management of many companies believes that retained earnings are funds which do not
cost anything, although this is not true. However, it is true that the use of retained earnings as a
source of funds does not lead to a payment of cash.
b) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment projects can
be undertaken without involving either the shareholders or any outsiders.
c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.
d) The use of retained earnings avoids the possibility of a change in control resulting from an issue
of new shares.
Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a
capital profit (which will only be taxed when shares are sold) than receive current income, then
finance through retained earnings would be preferred to other methods.
A company must restrict its self-financing through retained profits because shareholders should be
paid a reasonable dividend, in line with realistic expectations, even if the directors would rather
keep the funds for re-investing. At the same time, a company that is looking for extra funds will
not be expected by investors (such as banks) to pay generous dividends, nor over-generous
salaries to owner-directors.
33
10. Franchising
Franchising is a method of expanding business on less capital than would otherwise be needed.
For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include
Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.
Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local
business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for
architect's work, establishment costs, legal costs, marketing costs and the cost of other support
services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the
subsequent regular payments by the franchisee for an operating profit. These regular payments
will usually be a percentage of the franchisee's turnover.
Although the franchisor will probably pay a large part of the initial investment cost of a
franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself.
The franchisor may well help the franchisee to obtain loan capital to provide his-share of the
investment cost.
The advantages of franchises to the franchisor are as follows:
ss is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.
The advantage of a franchise to a franchisee is that he obtains ownership of a business for an
agreed number of years (including stock and premises, although premises might be leased from
the franchisor) together with the backing of a large organisation's marketing effort and
experience. The franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and developed a scheme
that works.
Self Assessment Questions
QUESTION ONE
(a) Differentiate the following:(i)
Participative and non-participative preference shares.
(ii)
Subordinated and naked debentures
(iii)
invoice discounting and factoring
(b) List the functions of a factor
QUESTION TWO
Maendeleo Ltd has 900,000 shares outstanding the current price is Ksh. 130. The company needs
cash, Ksh 22,500,000 to finance a new project. The Board of directors have decided to declare
rights issue at a subscription price of Ksh. 85.
Required:
34
(a) Compute the number of rights required to buy one share.
(b) Compute the Ex-rights price of the shares of the rights.
(c) Compute the theoretical value of each right.
QUESTION THREE
State and explain any FIVE sources of external finance to a Co-operative Society, giving two
advantages and two disadvantages of each.
QUESTION FOUR
ABC ltd is incorporated under the companies Act with a total of 100, 000 0rdianry shares
outstanding and eligible to vote at all the AGMs. The Company is controlled by 5 directors who
are usually electe3d at every AGM.
Mr. King has approached you for advice on the following issues:(i)
He bought 25,000 ordinary shares from the company and therefore wants to know
the number of directors he can elect.
(ii)
He has a friend who to indirectly control the company by electing single handedly 3
directors and wishes to know the number of shares he must buy at the stock market so
as to elect the directors,
Advise him.
QUESTION FIVE
As a finance manager of Kasuku products ltd, you decide to raise sufficient capital in the next five
years to enable your company to expand. You decide to raise the capital by combining both
internal and external opportunities
Required:(a)Explain the major internal sources of capital to an organisation
(b) In details, explain the main disadvantages of sourcing funds externally. .(20Mks)
QUESTION SIX
State and explain any FIVE sources of external finance to a Co-operative Society, giving two
advantages and two disadvantages of each.
QUESTION SEVEN
(i) Maendeloeo Ltd has 900,000 shares outstanding the current price is kshs. 130. The company
needs cash, ksh 22,500,000 to finance a new project. The Board of directors have share decided
to declare rights issue at a subscription price of ksh. 85.
Required:
a) Compute the number of rights required to buy one share.
b) Compute the Ex-rights price of the shares of the rights.
c) Compute the theoretical value of each right.
35
LESSON 5: WORKING CAPITAL MANAGEMENT
5.1 Introduction
Working capital is a financial metric which represents operating liquidity available to a business,
organization, or other entity, including governmental entity. Along with fixed assets such as plant
and equipment, working capital is considered a part of operating capital. Net working capital is
calculated as current assets minus current liabilities. It is a derivation of working capital that is
commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are
less than current liabilities, an entity has a working capital deficiency, also called a working
capital deficit.
Working Capital = Current Assets
Net Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and
upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable and cash.
Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt
and upcoming operational expenses.
By definition, working capital management entails short term decisions - generally, relating to the
next one year period - which is "reversible". These decisions are therefore not taken on the same
basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on
cash flows and / or profitability.

One measure of cash flow is provided by the cash conversion cycle - the net number of
days from the outlay of cash for raw material to receiving payment from the customer. As
a management tool, this metric makes explicit the inter-relatedness of decisions relating to
inventories, accounts receivable and payable, and cash. Because this number effectively
corresponds to the time that the firm's cash is tied up in operations and unavailable for
other activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12 months
by capital employed; Return on equity (ROE) shows this result for the firm's shareholders.
Firm value is enhanced when, and if, the return on capital, which results from working
capital management, exceeds the cost of capital, which results from capital investment
decisions as above. ROC measures are therefore useful as a management tool, in that
they link short-term policy with long-term decision making.
Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. These policies aim at managing the

36
current assets (generally cash and cash equivalents, inventories and debtors) and the short
term financing, such that cash flows and returns are acceptable.
Approaches used to finance current assets
1. Matching or hedging approach
2. Conservative approach
3. Aggressive approach
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.
37
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.
DETERMINANTS OF WORKING CAPITAL NEEDS
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)
b)
c)
d)
e)
f)
g)
Nature and size of the business.
Firm’s manufacturing cycle
Business fluctuations
Production policy
Firm’s credit policy
Availability of credit
Growth and expansion activities.
Factors which determine working capital needs of a firm
(1) Availability of Credit: The amount of credit that a firm can obtain, as also the length of the
credit period significantly affects the working capital requirement. The greater the prospects of
getting credit, the smaller will be its requirement of working capital because it can easily
purchase raw materials and other requirements on credit.
Creditworthiness can also the interpreted to mean that the firm can function smoothly even with a
smaller amount of working capital if it is assured that it can obtain loans from the bank
immediately and easily. The firm does not need then to keep a wide margin of safety.
(2) Growth and Expansion: The working capital requirements increase with growth and
expansion of business. Hence planning of the working capital requirements and its procurement
must go hand in hand with the planning of the growth and expansion of the firm. The
implementation of the production plan that aims at the growth or expansion of the unit
necessitates more of fixed capital and working capital both.
Even the expansion of the volume of sales increases the requirements of working capital. Of
course, it is difficult to establish a quantitative relationship between them. An important point to
be noted is that the requirements of working capital emerge before the growth or expansion
actually takes place.
(3) Profit and its Distribution: The net profit of a firm is a good index of the resources available
to it to meet its capital requirements. But, from the viewpoint of working capital requirement, it is
the profit in the form of cash which is important, and not the net profit. The profit available in the
38
form of cash is called cash profit and it can be assessed by adding or deducting non-cash items
from the net profit of the firm. The larger the amount of cash profit, the greater will be the
possibility of acquiring working capital.
But, in fact the entire amount of cash profit may not be available to meet working capital needs.
The portion of cash profit which is available for this purpose depends on the profit distribution
policy. The policies with regard to distribution of dividends, ploughing back of profit and tax
payments will determine the portion of cash profit which the firm can use to meet its working
capital needs. Even depreciation policy can influence the amount of cash available, as
depreciation of capital assets is deductible item of expenditure and it reduces tax liability.
(4) Price Level Fluctuations: A general statement may be made that with price rise, a firm will
require more funds to purchase its current assets. In other words, the requirements of working
capital will increase with the rise in prices. But all firms may not be affected equally. The prices of
all current assets never go up to the same extent. Price of some current assets rise less rapidly
than those of the others. Hence for the firms which use such current assets, the working capital
need will increase by a smaller amount. Besides, if it is possible to pass on the burden of high
prices of raw materials to the customers by raising the prices of final product, then also there will
be no increase in working capital requirements.
(5) Operating Efficiency: If a firm is efficient, it can use its resources economically, and thereby it
can reduce cost and earn more profit. Thus, the working capital requirement can be reduced by
more efficient use of the current assets.
Importance of working capital management
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 shortterm 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.
39
LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…)
1.0 Cash management.
It helps to identify the cash balance which allows for the business to meet day to day expenses,
but reduces cash holding costs.
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.
40
Solution
The following chart can help further understand the question:
Inventory Conversion period (85 days)
Receivable collection
Period (70 days)
Payable deferral
Period (35 days)
Purchase of
raw materials
Payment for the
raw materials
Sale of
Finished goods
Cash conversion cycle = 85
+
70
-
35
=
Collection of
receivables
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 =
Cash turnover =
85 + 70 – 35 = 120 days
360
Cash conversion cycle
=
360
120
=
3 times
Note also that cash conversion cycle can be given by the following formulae:
Cash conversion cycle =
NB:
 inventory receivables
Payables Accruals 
360 



costofsale
s
sales
Cashoperat
ingexpenses

In this chapter we shall assume that a year has 360 days.
41
Setting the optimal cash balance
Cash is often called a non-earning asset because holding cash rather than a revenue-generating
asset involves a cost in form of foregone interest. The firm should therefore hold the cash balance
that will enable it to meet its scheduled payments as they fall due and provide a margin for
safety. There are several methods used to determine the optimal cash balance. These are:
a) The Cash Budget
The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period.
This method has already been discussed in other earlier courses. The student should however
revise the cash budget.
Working capital requirements of a business should be monitored at all times to ensure that there
are sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash.
The cash budget has the following six main sections:
1. Beginning Cash Balance - contains the last period's closing cash balance.
2. Cash collections - includes all expected cash receipts (all sources of cash for the period
considered, mainly sales)
3. Cash disbursements - lists all planned cash outflows for the period, excluding interest
payments on short-term loans, which appear in the financing section. All expenses that do
not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs
are determined by the total cash disbursements plus the minimum cash balance required
by company policy. If total cash available is less than cash needs, a deficiency exists.
5. Financing - discloses the planned borrowings and repayments, including interest.
6. Ending Cash balance - simply reveals the planned ending cash balance.
Reasons for keeping cash




Cash is usually referred to as the "king" in finance, as it is the most liquid asset.
The transaction motive refers to the money kept available to pay expenses.
The precautionary motive refers to the money kept aside for unforeseen expenses.
The speculative motive refers to the money kept aside to take advantage of suddenly
arising opportunities.
Advantages of sufficient cash







Current liabilities may be catered for meeting the current obligations of the company
Cash discounts are given for cash payments.
Production is kept moving
Surplus cash may be invested on a short-term basis.
The business is able to pay its accounts in a timely manner, allowing for easily obtained
credit.
Liquidity
Quick upfront pay.
42
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)
b)
c)
d)
Determine the optimal amount of marketable securities to be converted into cash every
time the company makes the transfer.
Determine the total number of transfers from marketable securities to cash per year.
Determine the total cost of maintaining the cash balance per year.
Determine the firm’s average cash balance.
Solution
a)
C*
2bT
i
Where:b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%
43
C* 
2x 20x520,000
 Sh.13,166
0.12
Therefore the optimal amount of marketable securities to be converted to cash every time a sale
is made is Sh.13,166.
b)
c)
Total no. of transfers =
TC 
T
C*
=
520,000
13,166
=
39.5
≈
40 times
1
T
Ci  b
2
C
=
13,166x0.12 520,000x 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:
44
1/ 3

2
Z   3B 
4i 


L
and the highest limit, H, is given by:
H
=
3Z - 2L
The average cash balance
=
4Z  L
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)
b)
c)
d)
Calculate the target cash balance
Calculate the upper limit
Calculate the average cash balance
Calculate the spread
45
Solution
a)
c)
Z
 3b² 


 4i 
1/ 3
L
=


 3x 20x (2,500)² 

  10,000
9%


4x


360
=
7,211 + 10,000 = Sh.17,211
b)
H
=
=
=
3Z – 2L
3 x 17,211 – 2(10,000)
Shs.31,633
Average cash balance =
4Z  L
3
=
d)
The spread
=
=
=
4 x17,211  10,000
3
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 management techniques
The basic strategies that should be employed by the business firm in managing its cash are:
i)
ii)
iii)
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.
Turnover inventory as quickly as possible, but avoid stockouts which might result in loss of
sales or shutting down the ‘production line’.
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:
46
a)
b)
a)
Concentration Banking
Lock-box system.
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.
2.0 Inventory management.
It helps to identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials - and minimizes reordering costs - and hence increases cash flow.
Besides this, the lead times in production should be lowered to reduce Work in Progress (WIP)
and similarly, the Finished Goods should be kept on as low level as possible to avoid over
production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ);
Economic quantity
Manufacturing firms have three major types of inventories:
1. Raw materials
2. Work-in-progress
3. Finished goods inventory
The firm must determine the optimal level of inventory to be held so as to minimize the inventory
relevant cost.
BASIC EOQ MODEL
The basic inventory decision model is Economic Order Quantity (EOQ) model. This model is given
by the following equation:
Q
2DC o
Cn
Where:Q is the economic order quantity
D is the annual demand in units
47
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.
TC = ½QCn +
D
Co
Q
Where:Total holding cost = ½QCn
Total ordering cost = D Co
Q
The holding costs include:
1.
2.
3.
4.
Cost of tied up capital
Storage costs
Insurance costs
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
EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:
i)
ii)
iii)
iv)
v)
The demand is known and constant over the year
The ordering cost is constant per order and certain
The holding cost is constant per unit per year
The purchase cost is constant (Thus no quantity discount)
Back orders are not allowed.
48
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)
b)
c)
d)
How many units should be ordered each time an order is placed to minimize inventory
costs?
What is the reorder level?
How many orders will be placed per year?
Determine the total relevant costs.
Suggested Solution:
a)
Q
2DC o
Cn
Where:D = 2,000 units
Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days
Q
b)
c)
R
2x 2,000x50
 100units
20
=
DL
360
=
2,000 x 7
360
=
39 units
No. of orders =
=
=
D
Q
2,000
100
20 orders
49
d)
TC
D
Co
Q
=
½QCn +
=
½(100)(20) +
=
1,000 + 1,000
=
Sh.2,000
2,000
(50)
100
Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is
received.
3.0 Debtors’ management.
It helps Identify the appropriate credit policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue
and hence Return on Capital (or vice versa); see Discounts and allowances.
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)
b)
The volume of credit sales
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)
b)
c)
d)
Credit standards which is the maximum risk of acceptable credit accounts
Credit period which is the length of time for which credit is granted
Discount given for early payments
The firm’s collection policy.
a) Credit standards
A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy
tends to sell on credit to customers on a very liberal terms and credit is granted for a longer
period.
A firm following a stringent credit policy on the other hand, sell on credit on a highly selective
basis only to those customers who have proven credit worthiness and who are financially strong.
50
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.
2.
3.
4.
5.
Increased bad debt losses
Opportunity cost of tied up capital in receivables
Increased cost of carrying out credit analysis
Increased collection cost
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.
2.
3.
4.
Estimation of incremental operating profits from increased sales
Estimation of incremental investment in account receivable
Estimation of incremental costs
Comparison of incremental profits with incremental costs
b) Credit terms
Credit terms involve both the length of the credit period and the discount given. The terms 2/10,
n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of
invoice otherwise the net amount should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability caused by longer
credit and discount period or a higher rate of discount against increased cost.
c) Discounts
Varying the discount involves an attempt to speed up the payment of receivables. It can also
result in reduced bad debt losses.
d) Collection policy
The firm’s collection policy may also affect our analysis. The higher the cost of collecting account
receivables the lower the bad debt losses. The firm must therefore consider whether the reduction
in bad debt is more than the increase in collection costs.
As saturation point increased expenditure in collection efforts does not result in reduced bad debt
and therefore the firm should not spend more after reaching this point.
Evaluation of the credit applicant
After establishing the terms of sale to be offered, the firm must evaluate individual applicants
and consider the possibilities of bad debt or slow payments. This is referred to as credit analysis
and can be done by using information derived from:
a)
b)
c)
d)
e)
The applicant’s financial statement
Credit ratings and reports from experts
Banks
Other firms
The company’s own experience
51
Application of discriminant analysis to the selection of applicants
Discriminative analysis is a statistical model that can be used to accept or reject a prospective
credit customer. The discriminant analysis is similar to regression analysis but it assumed that the
observations come from two different universal sets (in credit analysis, the good and bad
customers). To illustrate let us assume that two factors are important in evaluating a credit
applicant the quick ratio and net worth to total assets ratio.
The discriminant function will be of the form.
ft
=
a1(X1) + a2(X2)
Where:X1 is quick ratio
X2 is the network to total assets
a1 and a2 are parameters
The parameters can be computed by the use of the following equations:
a1
=
Szz dx – Sxzdz
Sxx Sxx – Sxz²
a2
=
Szz dx – Sxzdz
Szz Sxx – Sxz²
Where:Sxx represents the variances of X1
Szz represents the variances of X2
Sxz is the covariance of variables of X1 and X2
dx is the difference between the average of X1’s bad accounts and X2’s good accounts
dz represents the difference between the average of X’s bad accounts and X’s good
accounts.
The next step is to determine the minimum cut-off value of the function below at which credit will
not be given. This value is referred to as the discriminant value and is denoted by f*.
Once the discriminant function has been developed it can then be used to analyse credit
applicants. The important assumption here is that new credit applicants will have the same
characteristics as the ones used to develop the mode.
More than two variables can be used to determine the discriminant function. In such a case the
discriminant function will be of the form.
ft
=
a1x1 + a2x2 + … + anxn
52
Self Assessment Questions
QUESTION ONE
The management of Beardy Limited has ascertained that the company will require ksh. 2,500,000
in cash for transaction purposes during the coming financial year. The interest rate on the
marketable securities is currently 10% per annum and is expected to remain constant over the
next one year. The cost of converting securities to cash is ksh. 50 per transaction.
Required:
Using the Baumol cash management model, determine the following:
(i) Optimal cash size
(ii) Average cash balance
(iii) Cash turnover
(iv) Total cost of managing the optimal cash balance
QUESTION TWO
PKG Ltd maintains a minimum cash balance of Ksh. 500,000.00. The deviation of the company’s
daily cash changes is ksh. 200,000.00. the annual interest rate is 14%. The transaction cost of
buying and selling securities is kshs. 150.00 per transaction.
Required:
Using Miller-Orr cash management model, determine the following:
(i) Upper cash limit
(ii) Average cash balance
(iii) Spread
QUESTION THREE
Mutongoi Ltd in Matuu requires 500,000 units of a component each year at a cost of ksh. 100
each. The items are obtained from Machakos and therefore it takes 3 days from the time or
ordering to the time of delivery. Each order costs the company ksh. 300 to process while hoarding
cost per annum is ksh 200 plus 15% opportunity cost of capital. To operate prudently the
company is safe with 2000 units.
Required:
(i) Economic order quantity
(ii) Reorder level
(iii) Total relevant cost
QUESTION FOUR
(a) Differentiate between Hedging approach and conservative approach under management of
working capital.
(b) Explain four importance of working capital management.
( c) Define overcapitalization and outline the indicators of overcapitalization.
(d) Explain the determinants of working capital requirements.
53
QUESTION FIVE
Ukaguzi Ltd has a total annual sales of 3,000,000. its discounted interest rate is 15 % p.a . it is
considering to factor its debtor where the factor charges a service fees of 1.2% of debtors
factored. 12% reserve is required by the factor. Ukaguzi limited has a credit policy of 72 days.
Required:
(i) the amount Ukaguzi will receive from the factor.
(ii) The percentage annual cost
(a) Reserve
(b) Service charges
© Interest charges p.a
(d) Interest charges for 72 days
QUESTION SIX
(a) Discuss the THREE approaches used to finance current assets.
(b) State and explain any FOUR importance of working capital management.
(c) Jitihidi wholesalers had total sales of sh. 3 million in the year ended 2008. its average
collection period is 27 days. Due to unforeseen liquidity problems, it pledged its debtors
and was charged interest at 18% p.a. The interest was discounted. Some of the goods
were damaged and therefore the factor charged 6% reserve.
Required:
Calculate the amount that was advanced to the firm.
QUESTION SEVEN
(a) Maintain only “Enough” Levels of inventory in your business. Discuss FIVE Costs that would be
avoided by maintaining “Enough” inventory level
(b) Credit sales is a strategy used by traders to mitigate the effects of high competition. Discuss
the FIVE Cs of a good debtor
54
LESSON 7: TIME VALUE OF MONEY
This concept attempts to explain why investors will prefer money now rather than in the future. The
purchasing power of money generally decreases as time goes by.
(1) Future value of a single amount
This is the compound value of a single amount invested over a given number of periods for
earning a given interest.
Consider an investor who has invested Ksh. 100,000 in a bank over a period of 3 years earning
an interest of 10% p.a. Determine the future on this amount?
Alternative 1
period
amount at start
interest
amount at
end
1 100,000.00
10,000.00 110,000.00
2 110,000.00
11,000.00 121,000.00
3 121,000.00
12,100.00 133,100.00
Alternative 2
using formulae
FV=PV(1+r)^n
FV=100,000(1+0.1)^3
FV=133,100
(2) Present value of a single amount
FV=PV(1+r)^n
PV=
FV
(1+r)^n
PV=
FV(1+r)^n
Assume that you expect to receive Ksh. 2.5 million five year from now. If the cost of capital in the
market is 16%. Determine the present value of this amount.
FV=PV(1+r)^n
PV=
FV
(1+r)^n
PV=
2,500,000.00
(1+0.16)^5
= 1,190,282.54
55
PV=
FV(1+r)^-n
2,500,000(1+0.16)^5
= 1,190,282.54
Using financial tables
FV X PVIF r% n
PV=
years
2,500,000 X 0.4761
= 1,190,282.54
Consider a project which is expected to generate the following cash flows
Year cash flows
1 90,000.00
2 120,000.00
3 140,000.00
4 150,000.00
If the cost of capital is 10%, determine the total present value of these cash flows
Year Cash flows
PVIF 10%
Present Value
1 90,000.00
0.9091
81,819.00
2 120,000.00
0.8264
99,168.00
3 140,000.00
0.7513
105,182.00
4 150,000.00
0.6830
102,450.00
Total Present Value
388,619.00
(3) Present value of an Annuity
An Annuity refers to equal amounts received or paid after equal periods e.g. salary, rent,
retirement benefits, insurance premiums e.t.c.
There are normally two types of annuities
1. An ordinary annuity- this is where cash flows occurs at the end of each period e.g. salary,
retirement benefits e.t.c.
2. An annuity due- this is where cash flows occur at the beginning of each period e.g. rent,
insurance premiums e.t.c.
Ordinary annuity
Assume that you expect to receive Ksh. 15,000 at the end of each year for the next 4 years. If
the cost of capital is 10%. Determine the total present value of this cash flows
56
PVIF 10%
Present
Value
1 15,000.00
0.9091
13,636.50
2 15,000.00
0.8264
12,396.00
3 15,000.00
0.7513
11,269.50
4 15,000.00
0.6830
10,245.00
Year
Cash flows
Total Present Value Annuity
47,547.00
The present of an ordinary annuity is calculated using a formula
PV
=
Annuities X
1- (1+r)^-n
r
1- (1+0.1)^-
15,000 X
4
0.1
=
PV
15,000 X 3.1699
=
47,547.98
Annuity due
Now assume that you were to receive the cash floes at the beginning of each year. Determine the
present value of this annuity due
The present value of annuity due is calculated using the formula
PV Annuity due
=
PVA ord X (1+r)
15,000 X
3.1699(1+0.1)
52,303.35
PVIF 10%
Present
Value
0 15,000.00
1.0000
15,000.00
1 15,000.00
0.9091
13,636.50
2 15,000.00
0.8264
12,396.00
3 15,000.00
0.7513
11,269.50
Year
Cash flows
57
Total Present Value Annuity Due
52,302.00
Assume that you have a charity sweepstakes lottery which promises to pay Ksh 50,000 at the
beginning of each year for the next 20 years. The government has announced this to be
1,000,000 lottery i.e. 50,000 X 20. If the cost of capital for the next 20 years is expected to be
19% p.a. Advice on the current value of this lottery
PV Annuity due
=
A X PVA ord X (1+r)
50,000 X
5.1009(1+0.19)
303,501.29
(4) Present value of an annuity until perpetuity
They are equal cash flows received or paid until infinity.
Therefore present value of Annuity (PVAα) is normally equal to 1/ r
PVIFA 10% α
= I/0.1
= 10
PVIFA 16% α
= I/0.16
= 6.25
If a company is considered to a going concern and it promises to pay constant dividends each
year then this constant dividends can be considered to be annuity until infinity
(5) Present value of differential annuity
This are equal cash flows which occurs in between the economic life of the project
Consider a five year project which is expected to generate the following cash flows
Year
Cash
flows
Year
1
2
90,000.00
70,000.00
30,000.00 30,000.00 30,000.00
PVIF 12%
Present
Value
1 90,000.00
0.8929
80,361.00
2 70,000.00
0.7972
55,804.00
3 30,000.00
0.7118
21,354.00
4 30,000.00
0.6355
19,065.00
5 30,000.00
0.5674
17,022.00
Cash flows
3
58
4
5
136,165
57,441
Total Present value
193,606.00
The PV of differential annuities is calculated using the following steps:
1. Calculate the PV of the unequal cash flows in the earliest periods in the normal way i.e
using the financial tables e.g. Ksh. 136,165
2. (a) Determine the PVIFA at a given discount rate at the end of annuity period i.e. PVIFA
12% 5year = 3.6048
(b) Determine the PVIFA at a given discount rate at the start of annuity period i.e. PVIFA
12% 2year = 1.6901
3. Calculate the PV of differential Annuity using the following formulae
= A X (PVIFA end – PVIFA start)
= 30,000 X (3.6048-1.6901)
= 30,000 X 1.9147
= 57,441
4. Sum the PV obtained in step 1 and step 3 above in order to obtain the total present value
= 136,165 + 57,441
= 193,606
Consider a project which is expected to generate the following cash flows each year
Year
1-5
6-10
11-20
Cash
flows
50,000.00
60,000.00 100,000.00
If the cost of capital is 10% determine the total present value of this cash flows
period
1-5
6-10
11-20
formula
Workings
A X PVIF 10% 5 YRS
=50,000 X 3.7908
A X (PVIFA 10% 10 YRS - PVIFA 10% =60,000 X (6.14465 YRS)
3.7908)
A X (PVIFA 10% 20 YRS - PVIFA 10% =100,000 X (8.513610YRS)
6.1446)
=189,540
=141,228
=236,900
=567,668
Consider a project which is expected to generate the following cash flows each year
11-α
Year
1-5
6-10
Cash flows
70,000.00
90,000.00
100,000.00
If the cost of capital is 13%. Determine the total present value of this cash flows
period
formula
workings
1-5
6-10
11-20
A X PVIF 13% 5 YRS
A X (PVIFA 13% 10 YRS - PVIFA 10%
5 YRS)
A X (PVIFA 10% 20 YRS - PVIFA 10%
10YRS)
=70,000 X 3.5172
=90,000 X (5.42623.5172)
=100,000 X (7.69235.4262)
=246,206.19
=171,810
=67,983.23
=485,999.42
59
(6) Loan amortization schedule
This is a loan repayment schedule which will indicate the amount borrowed and the amount
outstanding at the end of each period. The amount of loan borrowed today will represent the
present value of an annuity while the periodic payment will represent an annuity. The periodic
payment (instalment) will constitute two elements i.e. the principal and the interest element
Recall PVA = A X PVIFA r% n
Amount borrowed = Instalment payment X PVIFA r% n
Instalment payment = Amount borrowed
PVIFA r% n
Consider an investor who intends to borrow Ksh. 450,000 at an interest rate of 10% p.a. the loan
is to be repaid within a period of four years
Required
Determine the periodic instalment payment
Prepare the loan repayment schedule
Instalment payment = Amount borrowed
PVIFA r% n
= 450,000
3.1699
= 141,960
interest
instalment
principal
Amt at
end
1 450,000.00
45,000.00
141,960.00
96,960.00
353,040.00
2 353,040.00
35,304.00
141,960.00
106,656.00 246,384.00
3 246,384.00
24,638.40
141,960.00
117,321.60 129,062.40
4 129,062.40
12,906.24
141,960.00
129,062.40 -
period
Amt at start
Consider an investor who intends to borrow Ksh. 1 million at an interest rate of 12% p.a. for a
period of 5 years. The loan will be repaid semi annually
Required
Determine the interest expense on the third instalment
Instalment payment = Amount borrowed
PVIFA r% n
= 1,000,000
7.3601
= 135,868
60
period
Amt at start
Amt at
end
interest
instalment
principal
1 1,000,000.00
60,000.00
135,868.00
75,868.00 924,132.00
2 924,132.00
55,447.92
135,868.00
80,420.08 843,711.92
3 843,711.92
50,622.72
135,868.00
85,245.28 758,466.64
4 758,466.64
45,508.00
135,868.00
90,360.00 668,106.63
A company intends to borrow Ksh. 9 million at an interest of 10% p.a. the loan will be repaid
over a period of 8 years. The loan principal will be repaid in equal instalment of Ksh. 1,125,000
p.a.
Required
Prepare the loan amortization schedule
period Amt at start
interest
instalment
principal
Amt at end
1 9,000,000.00
900,000.00
225,000.00
1,125,000.00 7,875,000.00
2 7,875,000.00
787,500.00
141,960.00
1,125,000.00 6,750,000.00
3 6,750,000.00
675,000.00
141,960.00
1,125,000.00 5,625,000.00
4 5,625,000.00
562,500.00
141,960.00
1,125,000.00 4,500,000.00
5 4,500,000.00
450,000.00
141,960.00
1,125,000.00 3,375,000.00
6 3,375,000.00
337,500.00
141,960.00
1,125,000.00 2,250,000.00
7 2,250,000.00
225,000.00
141,960.00
1,125,000.00 1,125,000.00
8 1,125,000.00
112,500.00
141,960.00
1,125,000.00 -
Self Review Questions
QUESTION ONE
(a) Discuss the phrase Time Value of Money”
(b) Umoja co-operative Society approached a commercial bank which agreed to advance a loan
of ksh 600,000 under the following terms:(i) Equal annual installment
(i) Repayment period of 6years
(iii) Interest rate of 12% p.a.
Required:Prepare the co-operative loan amortization schedule showing how the loan will be reduced up to
the 6th year.
61
QUESTION TWO
(a) You are the financial manager of Pamoja Sacco. You advised your Sacco to take a loan from
the Co-operative bank of Kenya ksh 10,000,000 which was granted. The Executive management
of the Sacco wants you to advice them how the loan will be amortised. The period of repayment
is 5yrs at an interest rate of 15% p.a.
Advice them assuming equal principal repayment.
QUESTION THREE
a) General individuals show a time preference for money. Give reason for such a
preference.
b) You are the Loan Officer of Matata Sacco Ltd. Prepare a Loan schedule for a member
who has taken a loan of Ksh. 100,000. The loan requires 12% interest per annum and 12
monthly installments.
QUESTION FOUR
(a) After cleaning training and obtained a Diploma in Co-operative Management, you
successfully got a job as a Finance assistant in Jitihada Sacco Ltd. The gross salary is Kshs.
25,000. because of your training, you know that if you invest in a savings account, you
will have enough money for your dream house. You opened a savings account in Okoa
Nyumba Bank Ltd and you deposit shs. 120,000 every year end and will continue to save
for the nest 10 years. If your dream house will cost sh 2 million after 10 years;
(i) will you have meet the target?
(5 Marks)
(ii) If not, how much more money will you add so as to own the dream house?
(2 Marks)
Assume the savings account will earn an interest of 10% p.a. over the 10 years period)
(b) Company pays dividend per share at the end of every year of sh 10 into perpetuity. If
the required rate of return is 12%, what is the maximum price an investor would willing to
pay for the share? (3 Marks)
(c) Mrs Morgan, an employee of Pamoja Sacco Ltd started an M-Pesa business to supplement
her Meagre salary. The business is projected to bring in cashflows as follows:
Year
1
2
3
4-10
cash flow sh ‘000’
155
149
172
180
Required:
Determine the present value of the projected cash flows from the business if the cost of capital is
10%
QUESTION FIVE
Mr Mali Mingi deposited 100,000 with Co-operative bank of Kenya. The interest rate for the
deposit was agreed to be 13% per annum.
Required:
Determine the compound sum at the end of the fourth year if compounding occurs as follows:(i)
Semi annually
- (4 Marks)
62
(ii)
(iii)
(iv)
(v)
Annually
Quarterly
Weekly
Daily
- (4 Marks)
-(4 Marks)
- (4 Marks)
- (4 Marks)
63
LESSON 8: 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)
ii)
The market value of shares if these have only been sold at a price above par value.
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.
Cost of Retaining Finance
This will include dividends for share capital and interest for debt finance (tax deducted) or
effective cost of debt. However, when computing the cost of finance apart from deducting
implicit costs, explicit costs are the most central elements of cost of finance.
Importance of Cost of Finance
The cost of capital is important because of its application in the following areas:
i)
ii)
iii)
iv)
Long-term investment decisions – In capital budgeting decisions, using NPV method, the
cost of capital is used to discount the cash flows. Under IRR method the cost of capital is
compared with IRR to determine whether to accept or reject a project.
Capital structure decisions – The composition/mix of various components of capital is
determined by the cost of each capital component.
Evaluation of performance of management – A high cost of capital is an indicator of high
risk attached to the firm. This is usually attributed to poor performance of the firm.
Dividend policy and decisions – E.g if the cost of retained earnings is low compared to the
cost of new ordinary share capital, the firm will retain more and pay less dividend.
Additionally, the use of retained earnings as an internal source of finance is preferred
because:


v)
It does not involve any floatation costs
It does not dilute ownership and control of the firm, since no new shares are issued.
Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or
borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt
(interest rate on loan borrowed) is used as the discounting rate.
Factors That Influence the Cost of Finance
1.
Terms of reference – if short term, the cost is usually low and vice versa (i.e. time).
64
2.
3.
4.
5.
6.
7.
8.
Economic conditions prevailing – If a company is operating under inflationary conditions,
such a company will pay high costs in so far as inflationary effect of finance will be
passed onto the company.
Risk exposed to venture – if a company is operating under high risk conditions, such a
company will pay high costs to induce lenders to avail finance to it because the element of
risk will be added on the cost of finance which may compound it.
Size of the business – A small company will find it difficult to raise finance and as such will
pay heavily in form of cost of finance to obtain debt from lenders.
Availability – Cost of finance (COF) prices will also be influenced by the forces of
demand and supply such that low demand and low supply will lead to high cost of
finance.
Effects of taxation – Debt finance is cheaper by the amount equal to tax on interest and
this means that debt finance will entail a saving in cost of finance equivalent to tax on
interest.
Nature of security – If security given depreciates fast, then this will compound implicit costs
(costs of maintaining that security).
Company’s growth stage – Young companies usually pay less dividends in which case the
cost of this finance will be relatively cheaper at the earlier stages of the company’s
development.
Term Structure of Interest Rates
The term structure of interest rate describes the relationship between interest rates and the term
to maturity and the differences between short term and long term interest rates.
The relationship between short and long interest rates is important to corporate managers
because:
1.
2.
They must decide whether to buy long term or short term bonds and whether to borrow by
issuing long-term or short-term bonds.
It enables them to understand how long term and short term rates are related and what
causes the shift in their relative positions.
Several theories had been advanced to explain the nature of yield curve – These are:
1.
2.
3.
Liquidity preference theory
Expectation theory
Market segmentation theory
1. Liquidity Preference Theory
This theory states that short term bonds are more favourable than long term bonds for 2
reasons.
i)
ii)
Investors generally prefer short term bonds to long-term securities because such securities
are more liquid in the sense that they can be converted to cash with little danger of loss of
principal. Therefore – investors will accept lower yields on short term securities.
At the same time borrowers react in exactly the opposite way.
65
Generally borrowers prefer long term debt because short-term debt exposes them to the
risk of having to repay the debt under adverse. Conditions, accordingly borrowers are
willing to pay higher rate other things held constant for long-term process than short
ones.
Taking together this two sets of preferences implies that under normal conditions, a positive
maturity risk premium exist which increases with maturity thus the yield curve should be upward
sloping. Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and
are willing to pay a “premium” for long term borrowing.
2. Expectation Theory
This theory states that the yield curve depends on the expectation about future inflation rates. If
inflation rate is expected to increase, then the rate on long-term bonds will exceed that of shortterm loan. The expected future interest rates are equal to forward rates computed from the
expectations with regard to future interest rates are. Other factors which affect the expectations
with regard to future interest rates are:




Political stability
Monetary policy of the government
Fiscal policy of the government (government expedition)
Other economic related factors including social factors.
The following conditions are necessary for the expectation theory to hold.
i) Perfect capital markets exists where there are many buyers and sellers of security with
non having a significant influence on the interest rates.
ii) Investors have homogeneous expectations about future interest rates and returns on all
investments.
iii) Investors are rational wealth maximizers
iv) Bankruptcy of firms due to use of borrowing is unlikely.
3. Market Segmentation Theory
This theory states that the major investors (borrowers and lenders) are confined to a particular
segment of the market and will not change even if the forecast of the likely future interest rates
changes.
The lenders and borrower thus have a preferred maturity e.g a person borrowing to buy a house
or a company borrowing to build a power plant would want a long term loan. However a
retailer borrowing to build up stock in readiness for a peak reason would prefer a short term
loan. Similar differences exist among savers e.g a person saving to pay school fees for next
semester would want to lend on in the short-term market. A person saving for retirement 20 years
ahead would probably buy long-term security in L.T market.
66
The thrust of market segmentation theory is that the slope of yield curve depends on demand and
supply mechanism. An upward sloping curve would occur if there was a large supply of funds
relative to demand in the short term marketing but a relative shortage of funds in the long-term
market would produce an upward sloping curve.
Tests of the 3 theories
Various test have been conducted mainly in USA and they indicate that all the 3 theories have
some validity and thus the shape of the yield curve of any firm is affected by the following:
1. Supply and demand conditions in the short and long term market.
2. Liquidity preferences of lenders and borrowers
3. Expectation of future inflation. While any of the 3 factors may dominate the market
all the 3 effect the term structure of interest rate.
METHODS/MODELS 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
Investment
=
DPS + P1 – P0 x 100
P0
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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%
Ke
Rf + (Rm – Rf)BE
8.5% + (14.5% - 8.5%) 1.2
8.5% + (6%)1.2
15.7%
=
=
=
=
Beta of equity = 1.2
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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:
Zero growth firm – P0 = d0
Therefore =
d0
P0
R = Ke
Where:d0 = DPS
R0 = Current MPS
Constant growth firm – P0 =
Therefore
b)
Ke 
d0 1  g 
K eg
d0 1  g 
g
P0
Cost of perpetual preference share capital (Kp)
Recall, value of a preference share (FRS) = Constant DPS
Kp
Therefore:
c)
dp = Preference dividend per share
Pp = Market price of a preference share
Cost of perpetual debenture (Kd) – Debentures pay interest charges, which an allowable
expenses for tax purposes.
Recall, Value of a debenture (Vd)
Therefore Kd =
=
Interest charges p.a. in ∞
Cost of debt Kd
Int.
1  T 
Vd
Where:Kd = % cost of debt
T = Corporate tax rate
Vd = Market value of a debenture
69
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:
K d / VTM / RY 
Where:Int.
T
M
Vd
n
Int1  T   M  Vd 
1
n
1
M  Vd  2
= Interest charges p.a.
= Corporate tax rate
= Par or maturity value of a debenture
= Current market value of a debenture
= Number of years to maturity
WEIGHTED AVERAGE 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.
W.A.C.C
=
E
P
D
K e    K p    K d 1  T  
V
V
V
Where:Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital
respectively
E, P and D = Market value of equity, preference share capital and debt capital
respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.
Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.
Ordinary share capital Sh.10 par value
Retained earnings
10% preference share capital Sh.20 par
value
12% debenture Sh.100 par value
Shs.M
400
200
100
200
900
Additional information
1.
2.
Corporate tax rate is 30%
Preference shares were issued 10 years ago and are still selling at par value MPS = Par
value
70
3.
4.
The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the
market.
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)
b)
c)
Determine the WACC of the firm.
Explain why market values and not book values are used to determine the weights.
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
Ke 
P0 = Sh.40
g = 5%
d0 1  g 
51  0.05
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 
DPS dp
Sh.2


 10%
M PS 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
Maturity period (n)
Maturity value (m)
Current market value (Vd)
Corporate tax rate (T)
K d  YTM  RY 
Int1  T   M  Vd 
M  Vd ½
1
n
71
= Sh.12
= 10 years
= Sh.100
= Sh.90
= 30%
=
ii)
Sh.12(1  0.3)  (100  90)
(100  90)½
1
10  9.9%  10%
Compute the market value of each capital component
Market value of Equity (E) = MPS x No. of ordinary shares
Sh.400M DSC
=
=
1,600
Sh.40x
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.200M debentures
=
Sh.100parvalue
180
E + P + D = V = total Market Value =
1,880
=
Sh.90x
iii)
Compute W.A.C.C using
a)
Using weighted average cost method,, WACC =
b)
Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%
=
E
P
D
K e    K p    K d 1  T  
V
V
V
=
 1,600 
 100 
 180 
  10%
  10%

18.13%
 1,880 
 1,880 
 1,880 
=
15.43 + 0.5319 + 0.9574
=
0.169193
≈
16.92%
By using percentage method,
WACC =
Total monetary cost
Total market value (V)
Where:Monetary cost
Monetary cost of E
Monetary cost of P
Monetary cost of D
=
=
=
=
% cost x market value of capital
18.13% x 1,600
=
290.08
10% x 100 =
10.00
10% x 180 =
18.00
318.08
Total market value (V)
Therefore WACC
1,880
=
318.08
x100
1,880
72
= 16.92%
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.
73
SELF ASSESSMENT QUESTION
QUESTION ONE
Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in
the following manner:
Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.
The present capital structure of the company is made up as follows:
1.
2.
3.
4.
600,000 fully paid ordinary shares of Sh.10 each
Retained earnings of Sh.4 million
200,000, 10% preference shares of Sh.20 each.
40,000 6% long term debentures of Sh.150 each.
The current market value of the company’s ordinary shares is Sh.60 per share. The expected
ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in both
dividends and earnings has been 10% over the past ten years and this growth rate is expected
to be maintained in the foreseeable future.
The company’s long term debentures currently change hands for Sh.100 each. The debentures
will mature in 100 years. The preference shares were issued four years ago and still change
hands at face value.
Required:
(i)
Compute the component cost of:
Ordinary share capital;
Debt capital
Preference share capital.
(2 marks)
(2 marks)
(2 marks)
(ii)
Compute the company’s current weighted average cost of capital. (5 marks)
(iii)
Compute the company’s marginal cost of capital if it raised the additional Sh.10
million as envisaged. (Assume a tax rate of 30%).
(5 marks)
(Total: 20 marks)
74
LESSON 9: INTRODUCTION TO FINANCIAL MARKETS
Meaning of a financial market
A market can be defined as an organizational device, which brings together buyers and sellers. A
financial market is a market for funds. It brings together the parties willing to trade in a
commodity, which constitutes fluids. The respective parties in financial markets are known as
demanders of funds (borrowers) and suppliers of fluids (lenders) who come together to trade so
as to meet financial needs. The level of economic development of any country will be affected by
the ability of the financial markets to move surplus funds from certain economic units, which
constitutes individuals and corporate bodies to other economic units in need of additional funds.
Financial market can be divided into three categories: 1. Capital and money markets.
2 Primary and Secondary markets
3. Organized and over — the counter markets.
I. Primary and secondary market
Primary financial markets are those markets where there is transfer of new financial instruments.
Financial instruments constitute assets, which are used in the financial markets. They consists of
cash, shares and debt capital both long term and short-term e.g. commercial paper.
The primary financial markets trade is for securities which have not been issued e.g. if a company
wants to make an issue of ordinary share capital issue of commercial paper, issues of preference
shares, debentures etc, offers and purchase will be through the primary etc.
Secondary markets — the secondary financial markets are for already issued securities. After a
thorough issue of new securities in the primary market later trading of the securities will take
place in secondary market e.g. if a company is to make public issue of ordinary share capital the
issue will take place in primary market. If the initial purchasers wish to dispose off the shares,
trading will take place in the secondary market. The only distinction between primary and
secondary markets is the form of security being traded but there is no physical separation of the
markets.
2. Capital and money markets
This classification is based on the maturity of financial instruments. The capital market is a financial
market for long-term securities. The securities traded in these markets include shares and bonds.
The money market is market for short-term securities. The securities traded in these markets
include promissory notes, commercial paper, treasury bills and certificates of deposits While
75
capital market is regulated by capital authority, the money market is regulated by central banks.
3. Organized and over- counter markets
An organized market is a market which is a specified place of security trading, defined rules,
regulations and procedures for security trading. Only listed securities trade in organized market,
where exchange is through licensed brokers who are members of exchange
Conducted by accountants, auctioneers, estate agents and lawyers who were engaged in other
areas of specializations.
In 1951 an estate agent (Francis Drummond) established the first stock broking firm. He then
approached the finance minister of Kenya with an idea of setting up a stock exchange in East
Africa. in 1953 he too approached London Stock Exchange Officer and London accepted to
recognize the setting up of Nairobi Stock Exchange as an oversee stock exchange. The major
reorganization emerged in 1954 when stockbrokers emerged and registered the NSE as a
voluntary association under society’s Act. It was registered as a limited liability company.
Advantages of stock exchange quotations
1. It’s easy for quoted companies to obtain underwriters when issuing shares. This is as a result of
wide market quoted for company shares. This is because of easier transferability of shares
through use of brokers.
2. Quotations attract investors in a share issue since they can easily dispose their shares.
3. It enhances public confidence. A quoted company is considered stable by investors and other
stakeholders; this can be useful in borrowing or other transactions relating to the company.
4 A quoted company will be able to get access to relevant information through the
NSE and also able to get comparative data e.g. reflecting performance of other
quoted companies.
5. In an inefficient market, a quoted company will be able to obtain up to date information or
feedback regarding share prices in stock exchange. Changes in
stock market prices will act as a signal as regard perceptions of the company.
Role of nairobi stock exchange
I. NSE provides a market of securities. It provides a media through which securities can be bought
and sold.
2. Stock exchange enhances share price discovery through interaction of demand and supply
forces in the trading floor.
3 Stock exchange share index acts as indicator of economic performance.
4. Stock exchange allows provision of information both to the investors and industry. This is both
76
for quoted companies or other issues within the stock
market. This information is for investor decisions.
5. It enhances the transfer of share ownership among investors through financial facilitation’s role
played by the brokers
Terminologies used tn the stock exchange
1. Cum dividend and Ex-dividend:
These prices are quoted when the company which has declared dividends has not paid
price per share is cum-div, this price include the additional value in form of
If the sellers offer the same cum-dividend then it means that the buyer will get both share to be
sold and dividend declared on it. A cum-dividend share is more expensive as compared to an exdividend share. Ex-dividend means without dividend. In this case the buyer only gets the share
sold. The dividend declared on the share belongs to the seller.
2. Cum-rights and Ex-rights price
These prices are quoted where a company has declared a right issue. If the sellers have offered
to sell his share cum-right, it means that the buyer will be entitled not only to receive shares being
purchased but also rights declared not yet issued. Share prices are high at that issue. If the seller
sold his shares ex-right it means that the buyer will only receive original shares and the sellers will
not be entitled to receive each right issue on share.
3. Cum-cap and ex-cap.
The word cap stands for capital. This price applies when a company has announced a bonus issue
but it is not yet issued. If the buyer buys shares cum-cap he will be entitled not only to receive
shares being purchased but also right declared not yet issued. Share prices are high at that issue.
If the seller sold his shares ex-RIGHTS it means that the buyer will only receive original shares and
the sellers will be entitled to receive each right issue on share.
4 Cum - all price or ex- all price
Cum all means with dividends, with bonus or with rights. The purchaser of the security will be
entitled to dividends: declared bonus shares, and has a right to subscribe for additional shares.
The share price will thus reflect this additional value otherwise; share will sell at ex-all price.
5 Insider trading:
An insider is an individual who has access to such confidential information that is not yet available
to the public and which may be considered useful when making investments decision regarding the
77
company. Insider trading constitutes use of confidential information about listed company which is
not yet made public so as to take advantage himself or for other person connected directly or
indirectly with the company e.g. a managing director who has access to company’s information
may get information that the company is about to make huge losses and as a result dispose his
shares or advice another person accordingly before this information is made public. An insider is
prohibited by aw to use his privilege positions to make gains or manipulate the prices of the
company’s securities for personal gains.
6. Active securities
These are securities, which are most frequently traded at the stock exchange in Kenya.
Exchange constitutes the 20 most active companies in the NSE capitalization
7. Bid and offer price
A bid is the highest price a security purchaser will be willing to purchase the security
whereas offer price is price at which the seller is wiling to sell the security.
8. Odd Lots
This arises when the number of share fall below the stipulated limit in NSE the minimum
Number is 100 shares. Below this, they are regarded as odd lots.
9. Market Capitalization
This is market value of a company based on Number of shares issued of a company and their
market price at specified period of time. Market capitalization may also represent the
aggregate volume of transaction within NSE.
Market capitalization = No of shares traded X market price per share.
The higher the market capitalization the higher the activity of share trading, and vice versa
10 Futures and Options.
These are instruments, which provide a means of hedging. Hedging is the process undertaking an
activity so as to minimize risk. Financial futures and options provide a means of reducing the risks
inherent within the financial market. A future is a contractual agreement entered between two
parties where one party promises to provide a security and the other party promises to buy the
security at some time in future. A future leads to an obligation(s).
Nse shares index
An index is a measure of relative changes in s specified phenomena’s. It indicates changes in
variable over given period of time or between 2 periods. Index number classification will depend
on variables they are intended to measure. An index is used to measure changes, which have
78
occurred. Share indexes are used to measure changes, which have occurred for shares in specific
stock exchange e.g. stock indices measures. The changes of price or value changes where the
value changes are brought about by changes in the capitalization of the share in the exchange.
NSE index is based on share trading of 20 companies, which are considered very active. The 20
companies’ account nearly 30% of NSE capitalization.
- A fall in NSE share index represents a fall in market price per share. Arise in NSE index
represent arise in the market price per share.
- An index may act as an indicator of activities in NSE the higher the demand of the share, the
higher is it market price and as a result the higher will be index.
Drawbacks of stock indices
1 .20 company’s not true representation.
2 .Thinness of the market — small changes in the above stocks tend to be considerably magnified
in the index
3 .1966 base year too far in the past.
4 .Relatively small price changes-Some stock prices do not change for weeks.
5 .Lack of clear portfolio selection criteria.
6 .Use of arithmetic instead of preferred geometric mean in computing the index.
7 .New companies have been quoted and others deregistered.
Capital Market Authority (CMA)
CMA was established in 1989 through the market authority Act Sec ii which includes the principles
and objectives of the authority.
The act provide for:
Development of all aspects of the capital Market and in particular it emphasizes on the removal
of impediments and creation of incentives for long-term investment productive enterprises.
The creation, maintenance and regulation of the CMA through the implementation of system in
which the market participants are self regulatory and the creation of a market in which securities
can be issued and traded in an orderly, fair and efficient manner.
Protection of investor’s interests
The role of capital market authority
1 .The CMA has the responsibility of licensing and regulating stockbrokers, investment advisers,
security dealers and the authority depositories.
79
2. The capital market authority is involved in the process of listing of new companies. Any
company, intending to be quoted in the NSE must apply through
CMA.
3. CMA is involved in the making of policies that would enhance the development of the capital
market e.g. policy regarding the buying and selling of securities, policies on admission of
individual and institutions to the capital market and generally policies on the introduction of
securities and their regulations
4. The CMA acts as a watchdog for shareholders of listed company’s. This is through regulating
the operations of the listed company’s so as to protect investors against penalty, insider trading
or suspensions.
5. The authority assists in the development of new securities in the market. This is through research
and evaluations of various recommendations of stakeholders in the NSE. It is the responsibility of
the CMA to evaluate whether there is need of new security and develop on appropriate policy
6. The CMA acts as a government advisor through the ministry of finance regarding policies
affecting the capital markets.
Other stock exchange terms
I. Broker:
Is an agent who buys and sells securities in the Market on behalf of his client on a commission
basis. He also gives advise to his client and at times manages the portfolio for his client. In
connection with the new issue, a broker will advise on price to be charged, will submit the
necessary documents to the quotation department the stock exchange and the capital market
authority. He may be involved in arranging for funds or for the purchase of shares and may
underwrite the issue (assure the company that shares are sold if not broker will buy them).
2. Jobber:
He is a dealer. He is not an agent but a principal who buys and sells securities in his own name.
His profit is referred to as Jobber’s turn. Since they are experts in the markets, they are not
allowed to deal with general public but only with brokers or other jobbers to avoid exploitation
of individual investors. A Jobber will quote two prices for a share. The bid price, which is the price
at which he is willing to buy securities and offer price — price at which he is willing to sell the
shares. The difference between offer price and the bid price is called spread price = Ask price Bid price. A Jobber will take stocks in his books (also called along sale) when brokers have
predominantly selling orders, and will also sell short (Short sale) when brokers are engaged in
buying.
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3 . Bulls:
Speculators in the market who believe that the main market movement is upwards and therefore
buy securities now hoping to sell them at a higher price in the future
4. Bears:
These are speculators in the market who believe that the main market movement is downwards
therefore securities now hoping to buy them back later at a lower price.
5. Stags:
These are speculators in the market who buy new shares because they believe that the price Set
by issuing company is usually lower than the theoretical value and that when shares are later
dealt with in the stock-exchange the share price will increase and they will be able to sell them at
profit.
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LESSON 10: INTRODUCTION TO FINANCIAL MARKETS (CONT…)
STOCK MARKET EFFICIENCY
This refers the degree to which the securities reflect the market information in their prices. It’s the
capability of the securities to show and reflect all the relevant information. There are 3 forms of
market efficiency namely(i) The weak form efficiency
This type of market efficiency says that current share prices fully reflect all the information
contained in first price movements. The sequence of the price changes contains no information
about the future price changes. The prices of securities change in a random manner.
(ii) Semi strong form efficiency
The semi strong form of efficient market hypothesis states that current share prices show both the
past price movements and also the publicly available information. No trading strategies based on
the release of any public information ie earnings will enable an investor to generate abnormal
returns. Except by chance if the market is efficient in the semi strong sense a public announcement
will some reaction from the market and will highly affect the market prices.
(iii) Strong form efficiency
This type of market states that security prices reflect all the information available both public and
private at each point in time. The consequence of this is that no investor Even when the investor
has some inside information can device trading strategies based on such information so as to
consistently earn abnormal returns. This form of efficiency states that people such as stock
specialists security brokers and dealers who often have insider information cannot on average
earn greater profits than investors who don’t have have such information.
THE DOW THEORY
Charles dow the founder or the wall street journal developed among others the dow theory in the
early part of the century. According to Dow Theory the stock market is characterized by three
trends namely
1. Primary trend
2. The intermediate trend
3. Tertiary trends
Primary trend
This is the most important it refers to the long term movement in share prices i.e. movement in
share prices over a period of more than one year.
The intermediate trend
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This trend runs for weeks or months before being reversed by another intermediate trend in the
opposite direction. If an intermediate trend is in the opposite direction to the primary trend, it is
called a secondary reversal or reaction. A primary trend is normally interrupted by a series of
information reversals.
Tertiary trends.
They last for a few days and are less important.
Special financial institutions
The major financial institutions in Kenya economy are commercial banks, savings and loans,
credit unions, savings banks, life insurance companies, pension funds, and mutual funds. These
institutions attract funds from individuals, businesses, and governments, combine them, and make
loans available to individuals and businesses. A brief description of the major financial institutions
follows.
Institution
Commercial bank
Description
Accepts both demand (checking) and time (saving) deposits. Also offers
negotiable order of withdrawal (NOW), and money market deposit
accounts. Commercial banks also make loans directly to borrowers or
through the financial markets.
Saving and loan
Credit union
These are similar to a commercial bank except chat it may not hold
demand (checking) deposits. They obtain funds from savings, negotiable
order of withdrawal (NOW) accounts, and money market deposit accounts.
They lend primarily to individuals and businesses in the form of real estate
mortgage loans.
Commonly known as Savings co-operative societies (Saccos), credit unions
deal primarily in transfer of funds between members. Membership in credit
unions is generally based on some common bond, such as working for a
given employer. Credit unions accept members’ savings deposits, NOW
account deposits, and money market account deposits and lend funds to
members, typically to finance automobile or appliance purchase, or home
improvements.
Savings banks
These are similar to a savings and loan in that it holds savings, NOW, and
money market deposit accounts. Savings banks lend or invest funds through
financial markets, although some mortgage loans are made to individuals.
Life insurance
Company
It is the largest type of financial intermediary handling individual
savings. It receives premium payments and invests them to accumulate funds
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to cover future benefit payments. It lends funds to individual, businesses, and
governments, typically through the financial markets.
Pension fund
Pension funds are set up so that employees can receive income after
retirement. Often employers match the contribution of their employees. The
majority of funds is lent or invested via the financial market.
Mutual fund
Pools funds from the sale of shares and uses them to acquire bonds and
stocks of business and governmental units. Mutual funds create a
professionally managed portfolio of securities to achieve a specified
investment objective, such as liquidity with a high return. Hundreds of funds,
with a variety of investment objectives exist. Money market mutual funds
provide competitive returns with very high liquidity.
Unit trusts
Financial Markets
Financial markets provide a forum in which suppliers of funds and demanders of funds can
transact business directly. Whereas the loans and investments of intermediaries are made without
the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know
where their funds are being lent or invested. It is important to understand the following distinctions
in the market.
Money versus Capital markets. The two key financial markers are the money market and the
capital market. Transactions in the money market take place in short-term debt instruments, or
marketable securities, such as Treasury bills, commercial paper, and negotiable certificates of
deposit. The market brings together government units, households, businesses and financial
institutions who have temporary idle funds, and those in need of temporary or seasonal financing.
Long-term securities—bonds and stocks—are traded in the capital market. The main actor in the
capital markets is the securities exchanges, which provide the market place in which demanders
can raise long-term funds and investors can maintain liquidity by being able to sell securities
easily. The Nairobi Stock Exchange (NSE) was established in 1954 and is one of the most active
stock markets in sub-Saharan Africa. It currently (2005) has 48 companies listed and 20
brokerage company members.
Private placements versus Public offerings. To raise money, firms can use either private placements
or public offerings. Private placement involves the sale of a new security issue, typically bonds or
preferred stock, directly to an investor or group of investors, such as an insurance company or
pension fund. However, most firms raise money through a public offering of securities, which is the
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nonexclusive sale of either bonds or stocks to the general public,
Primary market versus Secondary market. All securities, whether in the money or capital market,
are initially issued in the primary market (Initial public offerings ( IPOs) and seasoned equity
offerings (SEOs)). This is the only market in which the corporate or government issuer is directly
involved in the transaction and receives direct benefit from the issue. That is, the company actually
receives the proceeds from the sale of securities. Once the securities begin to trade in the stock
exchange, between savers and investors, they become part of a secondary market. The primary
market is the one which “new” securities are sold; the secondary market can be viewed as “used,”
or “pre-owned,” securities market.
Other Specialised Financial Institutions
1 .Industrial and commercial Development Corporation (LC.D.C)
I. C.D.C was established in 1954 by the government. Its main objective was to promote industrial
& commercial development in Kenya.
Its specifically provides financial or technical assistance to small enterprises. Financial assistance
may be in the form of working capital financing or purchase of fixed assets. This may take the
form of equity or debt financing. Equity is provided by large-scale enterprises with more than 50
employees. Loans are given to both small and medium
sized enterprise. Long-term loans repayment period is 6 years for industrial and up to 10 years
for commercial loans
2 ) Agricultural finance corporation (AFC)
it was established by the government in 1963. The main objective is to provide support for the
agricultural sector. This is through provision of short term and long-term loans. The loans must be
for a defined project by a farmer. Loans may be short term or long term and there exist
flexibility to allow its repayment.
3) Kenya Industrial Estate (KIE)
It was established in 1967
At inception it was a wholly owned subsidiary of ICDC. However in 1978 it was separated from
ICDC and become an independent body as a parastatal under the ministry of industry.
The main objective of K1E is to assist in the development of new projects and the expansion and
modernization of new business enterprise. This is through the provision of finds and technical
assistance. They provide both debt and equity finance.
4) Kenya Tourist Development Corporations: (KTDC)
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The KTDC was established in 1960’s. Its main responsibility was carrying out Investigations,
formulation and study of projects development of the tourism industry
KTDC Provides financial assistance in forms of loan, for tourism related enterprises. It has
substantial share —holdings in local hotels, which includes Hilton, Serena, and Pan Africa etc.
5) Industrial Development Bank (IDB)
Was established in 1963 as a limited company. The main objective of setting this
Institution was to promote industrial development in Kenya through the establishment promotion
and expansion of small or large-scale enterprises. This is through financial assistance .n the form
of loans, provision of guarantee and securities and underwriting
6) Hire — purchase financial companies
These are institutions, which provides assets on credit with an arrangement to pay the principal
and interest in installment basis. However, the legal ownership of the assets remains with the hirepurchase company. The title is transferred when the last installment is made. Hire Purchase
Company’s in Kenya include- Kenya finance corporation (KFC), Pan-Afric credit finance Ltd,
Investment and mortgage Ltd. etc.
7) Insurance Companies
The main role of insurance companies is to assist individuals and corporate bodies safeguard
against future risks. May also engage in other activities. The main capital for insurance companies
is the premium paid by the policy holders.
Forms of Insurance Company’s in Kenya includes: - Life Insurance, Third party insurance etc.
Examples of Insurance company’s in Kenya include: jubilee insurance company, pan African
insurance company, Blue shield insurance Co. Ltd. etc.
8) Building societies/Housing finance Co:
These ale financial institution, which provide finance to the public so as to purchase or construct
houses. The individual or corporate bodies make deposit upon which they later receive loan for
acquiring or constructing house. Some buildings societies in Kenya include: Housing finance
corporation (HFC), East African building society and Pioneer building society.
9) Pension and provident scheme institution
These institutions obtain funds from both employees and employers of contribution. They manage
and invest these funds so as to meet the current and future obligations of the pension scheme to its
members.
10) Merchant Banks
It originated and also derives its name from the activities of wealth merchants who provided
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credit for the trading ventures. The ventures were for small-scale merchants. Before the
establishment of banking systems in the 19th century, the merchants changed their role of
merchants and started offering financial service. Today merchant banks performs the role of
underwriting and assisting companies to raise capital in the financial markets They underwrite the
security issues, buy and sell securities and provide advice in Investment in securities.
Reinforcing questions
1. (a) (i)
(b)
What is financial intermediation?
(3 marks)
(ii)
Identify any five services that financial intermediaries provide.(5 marks)
What economic advantages are created by the existence of:
(i)
(ii)
(iii)
Primary markets.
Secondary markets
Portfolio management firms.
( 3 marks)
( 3 marks)
( 4 marks)
(c)
Explain how the Capital Authority can ensure:
(i)
Faster growth and development of the Nairobi Stock Exchange or Stock Exchange
in your country.
(6 marks)
(ii)
Development of other stock exchanges in Kenya or in your country.
(4 marks)
(d)
(i)
What is a stock exchange index?
(2 marks)
(i)
Outline four drawbacks of the Nairobi Stock Exchange index.
(4 marks)
(e)
Highlight four advantages and disadvantages to a company of being listed on a stock
exchange.
(8 marks)
(f)
In relation to the stock exchange”
(i)
Explain the role of the following members:

Floor brokers

Market makers

Underwriters
(ii)
Explain the meaning of the following terms:

Bull and bear markets

Bid-ask spread

Short selling
( 2 marks)
( 2 marks)
( 2 marks)
( 2 marks)
( 2 marks)
( 2 marks)
Self assessment Questions
QUESTION ONE
(a) What is stock exchange index?
(b) Explain the benefits that will accrue by the implementation of central depository system (CDS)
(c )What are the roles of Capital Market Authority in the economy?
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QUESTION TWO
(a) Distinguish Between:
(i) Business risk and financial risk.
(ii) Money market and capital market
(iii) Bulls and bears
QUESTION THREE
(a) What are the intermediaries and what roles do they play in the economy.
(b) Foreign Direct Investment (FDI) plays a crucial role in revamping less developed economies.
Required
Write brief notes on the obstacles to the flow of FDI into the Kenyan Economy.
QUESTION FOUR
(a) Briefly explain the following stock market terminologies;
(i) Broker
(ii) Bulls
(iii) Underwriting
(iv) Speculator
(b) State and briefly explain the benefits of investing in Market securities.
QUESTION FOUR
(a) Explain how the savings and credit Co-operatives mobilize savings and Aid Investment.
(b) How do co-operatives (Saccos) who extend credit to small business and small traders ensure
that the level of credit default is low?
(c) How do you convert a merry go round to Sacco (Savings and Credit Co-operative Society)
QUESTION FIVE
(a) In reference to the stock market, discuss the following:(i)
(ii)
(iii)
(iv)
(v)
Formal Market
Over the counter Market
Going short
Prospectus
Blue chips
(b) Outline FIVE limitations of the stock market price index
QUESTION SIX
(a) Highlight any FOUR advantages of a company being listed on a stock exchange
(b) List any FOUR incentives provided by Capital Markets authority to encourage development of
capital markets.
(c) In relation to the stock exchange, explain the following terms:(i) Brokers
(ii) Primary Markets
(iii) Underwriters
(iv) Secondary Markets
(d) Outline the drawbacks of Nairobi stock exchange index?
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QUESTION FIVE
(a)What are the steps involved in the construction of stock market index
(b) Write short notes on the following:
(a) Over the counter market
(b) Prospectus
© Independent projects
(d) Complimentary projects
QUESTION SIX
(a) What is stock exchange index?
(b) Explain the benefits that will accrue by the implementation of central depository system (CDS)
© What are the roles of Capital Market Authority in the economy.
QUESTION SEVEN
(a) Distinguish Between:
(i) Business risk and financial risk.
(ii) Money market and capital market
(iii) Bulls and bears
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