FINANCIAL MANAGEMENT

LECTURE NOTES

CLIFF OUKO ONSONGO

@2013

TABLE OF CONTENTS
TABLE OF CONTENTS.......................................................................................ii
TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT....................................1
Definition of Financial Management................................................................................1
Finance Functions..................................................................................................................1
Objectives of a Business Entity.........................................................................................2
Agency Theory........................................................................................................................5
TOPIC 2: SOURCES OF FINANCE.....................................................................10
Internal Sources...................................................................................................................10
External Sources..................................................................................................................12
Factors to Consider In Choice of source of finance................................................20
TOPIC 3: KENYAN FINANCIAL SYSTEM............................................................21
Financial intermediaries....................................................................................................21
Functions of Financial Markets/Institutions in the Economy...............................22
Capital Market......................................................................................................................22
Money/discount markets..................................................................................................23
Financial Instruments in Money market include:....................................................23
Primary Markets...................................................................................................................24
Economic Advantage/Role of Secondary Markets in the Economy..................24
Types of Stock Markets.....................................................................................................24
Financial intermediaries....................................................................................................25
The Stock Exchange Market............................................................................................26
Rules for floatation of new shares on NSE.................................................................38
Capital Market Authority (Cma).....................................................................................40
Central Depository System (C.D.S)..............................................................................41
Development Banks and Specialized Financial Institutions................................43
Banking Institutions............................................................................................................45
Central Banks...................................................................................................................46
Commercial Banks..........................................................................................................47
TOPIC 4: CAPITAL BUDGETING DECISIONS.....................................................51
Investment Evaluation Criteria......................................................................................52
Capital Budgeting Techniques........................................................................................52
Discounted Cashflow Methods........................................................................................53
Non-Discounted Cashflow Methods...............................................................................55
Projects Selection under Capital Rationing.................................................................62
Risk Analysis in Capital Budgeting.................................................................................64
Actual Measurement of Risk.............................................................................................66
Incorporating Risk in Capital Budgeting.......................................................................69
Sensitivity Analysis..............................................................................................................75
Break-Even Analysis............................................................................................................78
Utility Theory.........................................................................................................................84
TOPIC 5: COST OF CAPITAL............................................................................90
Importance of cost of finance.........................................................................................90
Factors that will influence the Cost of Finance........................................................91
Cost of Different Types of Funds....................................................................................93
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The Wacc Weighted Average Cost of Capital......................................................100

Marginal cost of finance.................................................................................................107
TOPIC 6: MEASURING BUSINESS PERFORMANCE.........................................112
Users of Ratios....................................................................................................................112
Yard Stick Used In Ratio Analysis................................................................................114
Classification of Ratios....................................................................................................115
Importance Of Ratio Analysis.......................................................................................121
Limitations in Using Ratio Analysis.............................................................................121
TOPIC 7: DIVIDEND POLICIES AND DECISIONS.............................................128
Does the change in dividend policy affect the value of the firm?..................129
How Much to Pay: Alternative Dividends Policies..................................................133
When to Pay........................................................................................................................134
Dividends Theories (Why Pay Dividends)................................................................134
How to pay dividends (mode of paying dividends)..............................................138
Factors to consider in paying dividends (factors influencing dividend).......142
TOPIC 8: FINANCIAL PLANNING....................................................................146
Operating Financial Plans...............................................................................................146
Importance of financial planning................................................................................146
Financial Planning Process.............................................................................................148
Barriers to Financial Planning.......................................................................................150
Why people fail in financial planning.........................................................................151
Preparing Financial Forecasts.......................................................................................152
Cash Receipts.....................................................................................................................153
Cash Disbursement..........................................................................................................153
Benefits/advantages Cash budget..............................................................................158
Cost-Volume Profit (C-V-P)..............................................................................................169
Assumptions Required In C-V-P....................................................................................170
Analyzing the Cost-Volume Relationship..................................................................170
Algebraic Analysis.............................................................................................................171
GRAPHIC ANALYSIS...........................................................................................................173
Break Even Analysis.........................................................................................................175
C-V-P Analysis Multiple Products..............................................................................178
C-V-P Analysis Under Uncertainty...............................................................................181
Point Estimate of Probabilities......................................................................................182
TOPIC 10: WORKING CAPITAL MANAGEMENT...............................................187
Introduction.........................................................................................................................187
Working Capital Management Decisions..................................................................187
Overcapitalization and Overtrading...........................................................................188
Indicators of over-capitalization..............................................................................188
Symptoms of over-trading.............................................................................................188
Financing Current Assets................................................................................................189
Determinants Of Working Capital Needs.................................................................191
Importance Of Working Capital Management........................................................191
Cash And Marketable Securities Management......................................................192
Cash Cycle and Cash Turnovers...................................................................................193
Setting The Optimal Cash Balance.............................................................................195
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Management of Accounts Receivable.......................................................................209

TOPIC 11:MERGERS AND TAKE- OVERS.................................................215
Types Of Mergers...............................................................................................................215
Reasons For Mergers........................................................................................................215
The Overall Merger Process..........................................................................................217
Reasons Behind Failed Mergers...................................................................................220
Due Diligence.....................................................................................................................222
The Role Of Investment Bankers In Mergers............................................................231
Anti-Takeover Defenses...................................................................................................232
Corporate Alliance.............................................................................................................236

iv

TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT

Definition of Financial Management
Financial Management is a discipline concerned with the generation and
allocation of scarce resources (usually funds) to the most efficient user within
the firm (the competing projects) through a market pricing system (the
required rate of return).A firm requires resources in form of funds raised from
investors. The funds must be allocated within the organization to projects
which will yield the highest return.
Finance Functions
The functions of Financial Manager can broadly be divided into two:

The

Routine functions and the Managerial Functions.

Managerial Finance Fu nctions
Require skilful planning, control and execution of financial activities. There are
four important managerial finance functions. These are:
(a)

Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the

allocation of funds among investment projects.

They refer to the firm's

decision to commit current funds to the purchase of fixed assets in

expectation of future cash inflows from these projects. Investment proposals
are evaluated in terms of both risk and expected return.
Investment decisions also relates to recommitting funds when an old asset
becomes less productive. This is referred to as replacement decision.
(b)

Financing decisions

Financing decision refers to the decision on the sources of funds to finance

investment projects.
equity and debt.

The finance manager must decide the proportion of

The mix of debt and equity affects the firm's cost of

financing as well as the financial risk. This will further be discussed under the
risk return trade-off.
(c)

Division of earnings decision

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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 funds 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 since current assets are nonearning assets the profitability of the firm will be low. The converse will hold
true.The finance manager should develop sound techniques of managing
current assets to ensure that neither insufficient nor unnecessary funds are
invested in current assets.
Routine functions
For the effective execution of the managerial finance functions, routine
functions have to be performed.

These decisions concern procedures and

systems and involve a lot of paper work and time.

In most cases these

decisions are delegated to junior staff in the organization.

Some of the

important routine functions are:

(a)

Supervision of cash receipts and payments

(b)

Safeguarding of cash balance

(c)

Custody and safeguarding of important documents

(d)

Record keeping and reporting

The finance manager will be involved with the managerial functions while the
routine functions will be carried out by junior staff in the firm.
however, supervise the activities of these junior staff.
2

He must

Objectives of a Business Entity

Any business firm would have certain objectives which it aims at achieving.
The major goals of a firm are:

Profit maximization

Shareholders' wealth maximization

Social responsibility

Business Ethics

Growth

(a) Profit maximization

Traditionally, this was considered to be the major goal of the firm.

Profit

maximization refers to achieving the highest possible profits during the year.
This could be achieved by either increasing sales revenue or by reducing
expenses. Note that: Profit =

Revenue Expenses. The sales revenue can

be increased by either increasing the sales volume or the selling price.

It

should be noted however, that maximizing sales revenue may at the same
time result to increasing the firm's expenses.

The pricing mechanism will

however, help the firm to determine which goods and services to provide so
as to maximize profits of the firm.
Objections to Profit Maximization
Profit maximization objective has however been criticized in recent years. It
fails to serve as an operational criterion for maximizing owners economic
welfare. It suffers from the following limitations:
o It is vague.
-The precise meaning of profit maximization objective is unclear.
-The definition of the term profit is ambiguous:
- Does it mean short or long term profit?
- Does it refer to profit after taxes?
- Does it refer to total profits or profit per share?
- Does it mean operating profit or profit accruing to shareholders?
o It ignores the timing of returns
Profit maximization does not make distinction between returns
received in different time periods. It gives no consideration to the
3

time value of money, and it values benefits received today and

benefits received after a period as the same.
o It ignores risk
The stressors of benefits may possess different degrees of certainty.
Two firms may have same total expected earnings but if the
earnings of one firm fluctuate considerably as compared to the
other, it will be more risky.
(b)

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:

Considers time value of money by discounting the expected future cash

flows to the present.

It recognizes risk by using a discount rate (which is a measure of risk) to

discount the cash flows to the present.

(c)

Social responsibility

The firm must decide whether to operate strictly in their shareholders' best
interests or be responsible to their employers, their customers, and the
community in which they operate.

The firm may be involved in activities

which do not directly benefit the shareholders, but which will improve the
business environment.

This has a long term advantage to the firm and

therefore in the long term the shareholders wealth may be maximized.

(d)

Business 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 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.

Product safety and quality

ii.

Fair employment practices

iii.

Fair marketing and selling practices

iv.

The use of confidential information for personal gain

Illegal political involvement

bribery or illegal payments to obtain business
(e) 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.
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. THERE ARE THREE MAIN FORMS OF AGENCY RELATIONSHIP:
1. Shareholders and management
2. Shareholders and creditors
3. Shareholders and the government
SHAREHOLDERS AND MANAGEMENT

In this case the shareholders accounts as a principal while the management

accounts as their agents. The shareholders though they own the firm are not
able to manage the firm due to the following reasons:
management of running of the firm for a number of reasons.
i) They may not have the necessary skills and expenditure of managing the
firm.
ii) They may not have them to run the firm.
iii) They may be geographically dispersed to manage the firm.
iv) They may be too many to manage a single firm.
1. Lack of required skills.

The shareholders may not be competent

enough to manage the firm.

2. Problem of proximity
3. Problem of accessibility
As a result the shareholders delegated authority and responsibility to the
managers who are expected to manage the firm on their behalf. This may
lead to the following problem:
1. Excessive expenditure by the management
2. The management may award themselves high salaries and allowances
therefore affecting the profitability of the firm.
3. The management may be involved in frauds and irregularities
4. There may arise the problem of lack of goal congruence.

This

constitutes divergence or disparity between the goals of the firm and

personal goals.
5. The manager may prioritize individual goals which will be in conflict
with the goals of the firm especially in investment evaluation
The following means or approaches may assist in solving one agency
problem.
(a) Threat of firing
(b)Contractual based employment
6

(c) Ensuring that remuneration is based on individual performance

as a means of motivating efficient managers.
(d)Allowing Managers to own a proportion off ordinary shares thus
increasing their stake in the firm.
(e) Development of internal control e.g internal auditing
SHAREHOLDERS AND CREDITORS/BOND HOLDERS
In this case the shareholders act as the agent and the creditors acts as the
principal. The relationships arises from the fact that though the creditors.
Provide debt capital to the various operations of the firm.

They therefore

expect the shareholders to consider their interest while making relevant

decisions.
This agency relationship may lead to the following problems.
1. Disposal of assets. The shareholders may decide to dispose some of
the assets ignoring the fact they provide security to the amounts
borrowed.
2. The shareholders may decide to borrow additional from other parties.
This may affect the firms ability to meet arising obligations.
3. The shareholders may pass resolutions for dividend payment ignoring
the liquidity position in the firm.
The above problems may be solved through the following means.
i.

Use of restrictive covenants. This is agreements entered into between

the lender and the borrower with a specific aim of protecting the
lenders and the borrower with a specific aim of protecting the lenders
interest e.g Non-disposal of assets.

ii.

The lender may threaten the firm with non-provision of funds in case
their interests are not made.

SHAREHOLDERS AND THE GOVERNMENT

Any shareholders will rely on the establishment existing in a specific country

in undertaking any form of business and reliance will be made on the
government services.
In this regards the government expects the owner to reciprocate by avoiding
engagement

in

activities

which

would

be

in

conflict

with

societal

expectations. In this case the government will act as the principal and the
shareholder will act as the agency who expected to consider the interests of
the government in making relevant decisions.
The following problems may arise:1. The owner may engage in activities which are non-governmental.
2. The shareholders may not practice good consumerism e.g. changing
high prices
3. The shareholders may evade or avoid tax
4. The shareholders may engage in activities leading to environmental
pollution.
The following may assist in solving agency related problems
1. Establishment of legal and regulatory framework
2. Establishment of regulatory agencies e.g. use of audit firm for tax
purposes
3. Imposition of heavy penalties for the offenders e.g. penalties on nonremittance of tax or under-declaration of tax.
Resolution

of

the

Agency

problem

between

owners

and

the

management. /Options Available to Motivate Managers

i)
Incurring agency costs e.g. audit fee paid to auditors and
investigators.

ii)

1.

iii)
iv)
v)
The
This

Restructuring the firm in order to prevent undesirable managerial

activities e.g. having tight internal controls.
Restructuring managerial incentives.
Threat of firing.
Threat of hostile takeover.
threat of firing (sacking)
becomes a right option when the ownership is in the hands of

people.
2.

This implies that Managers must perform otherwise be

replaced.
Threat of Hostile take-over
Is a situation in which a firm is taken over by another and at the same
time the management of the taken over firm is opposed to the
takeover. This most likely occurs when a firms stock is undervalued
relative to its potential.
This implies that in the event of take over the management of the
taken-over firm will be sacked. Even if they managed to hold on to
their jobs they will not be as powerful as they used to be. Therefore
managers of the firm should to keep the stock price of the firm high so
as to avoid a hostile take-over.
Counter-actions of the threatened management by Hostile take-over
i)Poison Pill
This is action that management of a firm takes that practically
kills the firm and therefore makes it unattractive to potential
acquirers. For example:a)
To sell large blocks/units of shares at low prices to friendly
b)

parties.
To make old debts of the firm immediately payable. The

c)

firm became illiquid. Thus becoming technically insolvent.

To give huge retirement benefits to management if the firm

is taken over
ii)Divestiture/spin-of
A business sells or spins-off some of its business so as to reduce
the attractiveness of the company.
iii) Green Mail (Black Mail)

A potential form (acquirer) will buy a block of stock in the target

company.

The target company becomes frightened that the

acquirer will make a tender offer and gain control of the

company.

Therefore to head off or avoid the takeover the

management offers to pay Green Mail. That means buying the

stock owned by the potential acquirer at a price above the
existing market price without offering the same deal to other
iii)

stock holders.
White Knight
The management of the target company offer to be acquired by
a friendly company so as to avoid a hostile takeover.

3.

4.

Proxy Fight
This is the process of getting stockholders to vote out the management
in the AGM.
Compensation
How to motivate the management to act on the
How to remunerate the management so as to motivate their act in the
interest of shareholders.
a) To remunerate management on the basis of achieving
specific certain financial targets.

Once we have our financial

statements, we come up with absolute values that help in making

investment decisions.

The better the target the better the

remuneration.
Disadvantages
i)
Management may be compelled to make sub-optimal
decisions e.g. buying cheapest items thus losing customers
ii)

at the end.
In the short run research and development could be
discontinued. In the short run it may get a very high profit.
In the long run, it has adverse effects.

b) Offering shares to Management

Thus they may be more diligent.
c) Offer deferred equity to Management
10

Promise management that if you perform well theyll be given some

ownership in future. We hope that theyll concentrate.

11

TOPIC 2: SOURCES OF FINANCE

Funds are needed for;
1. Investing in new fixed assets e.g. plant and machinery to expand business
2. Financing additional working capital as business expands i.e. to increase
levels of
stocks and debtors
3. To maintain real value of working capital in times of high inflation.
Internal Sources
These are sources generated within the business e.g. reserves, provisions,
sale and lease back
1. Provision for Depreciation
Depreciation is cost of wear and tear of machinery and other fixed assets.
Depreciation is charged to profit and loss account but does not involve cash
payments.
Provision for depreciation leaves cash at the disposal of the business which
can be utilized for further expansion of the business.
2. Provision for taxation
Funds set aside for payment of corporation tax by a company can be used
for business expansion if the corporation tax is not immediately payable.
3. Sale and lease back
A company or partnership owning premises or fixed assets can obtain
finance by selling the property to an insurance co. for immediate cash and
renting it back. A company should enter into this if it cannot raise capital in
any other way.
Advantages
12

i)

Higher charge for the lease is available expense for the purpose

ii)

Finance obtained can be used to expand company's operations

iii)

Does not entail the risk of receiverships

iv)

Mostly lessor & lessee know each other so it does not entail any
restrictions
on the part of the lessee.

Disadvantages of sale & lease back .

i)

The firm loses a valuable asset which is certain to appreciate

with inflation.

ii)

Reduction in the company's future borrowing powers as the

property could be used as security.

iii)

Less freedom to modify the premises

iv)

The finance is Ltd to the value of the asset leased so it may not
be enough for the company to expand its operations.

4. Trade credit
- The use of credit from suppliers. Important to small growing firms
- Cheap source of finance, easy to obtain, flexible source of financing, but a
company should avoid overtrading.
Has double edge significance for a firm.
- A source of credit for financing purchase
- Firm finances credit sales to customers
The difference between credit purchase and credit sales is known as net
credit. It is convenient
Main disadvantage:
- Loss of cash discount If lost cash discount is lower than interest paid on
other sources of finance, then trade credit will be beneficial and vice versa.

13

An organization will find it convenient to use trade credit under the following
circumstances
i.

When difficult to get credit facilities from commercial banks

ii.

When cheaper than other alternative sources of finance

iii.

When a firm has insufficient assets to offer as security

iv.

When the terms of credit are more favourable.

Trade credit can be obtained more easily as compared to bank credit due to
the following reasons.
i.

Does not involve many formalities

ii.

Easy to negotiate with suppliers as compared to commercial banks

iii.

Possible to get even during periods of credit restrictions by bank

iv.

More flexible and can be used by small firms as well as large firms

v.

No need to offer any asset as security.

FACTORING
Factoring Means selling debts for immediate cash to a factor who charges
commission. When the factor receives each batch of invoices from his client,
he pays 80% of its value in cash immediately. Factoring can result in savings
to management in forms of savings in bad debt loses, salary cost, phone,
postage etc. The factor must bear loss if the person/firm that bought the
goods does not pay.
INVOICE DISCOUNTING
Almost similar to factoring
Definition:
Assignment of debts whereas factoring is selling of debts
Characterized by the fact that lender not only has lien on the debts but also
has recourse to the borrower (seller) if the firm of person that bought the
goods does not pay. In this case the loss is borne by the selling firm.
It acts as the agents of the seller.
14

Main advantages of factoring & Invoice discounting

i)

They are flexible methods i.e. larger volume of invoices is

generated with
increase in sales

ii)

Invoices provide a security

Main disadvantages
i)

Inconvenient and expensive when invoices are numerous and

relatively
ii)

small in value.
The firm uses high liquid asset as security

The two are also called Financing of Trade debtors.

External Sources

1. ORDINARY SHARE CAPITAL

Contributed by real owners of a Ltd Company

Not redeemable, hence permanent source

Ordinary shares carry voting rights

Ordinary share holders receive dividend on their shareholding

Advantages of ordinary Shares

No fixed charges attached to them company's dividend payment is not

a legal
obligation

Carry no fixed maturity date, they can be used permanently

Can be sold more easily to investors because they give voting powers

to the

investors. .
Can raise large amounts of capital if the company is quoted on the
stock
exchange.
15

Disadvantage

Their sale extends control to new shareholders.

Dividends payable to ordinary shareholders are not available expense

for tax
Purposes

Under writing cost is higher.

2. PREFERENCE SHARE CAPITAL

- Contributed by preference shareholders - Preference shares carry no voting
power.
Types of preference share

Cumulative

Non-cumulative

Participating

Redeemable

Non-convertible

Convertible

Advantages of preference share capital

(i) From the view point of issuer

Obligation to pay a fixed rate of dividend is not binding.

Voting power not affected

More flexible than debentures if redeemable

(ii) From view point of investor:

16

Preference dividend not available for tax purposes

Cost of issue is higher than debentures

Limited returns to investor

Yields sometimes lower than debentures

Dividend arrears not paid in full M

These cannot be secured against assets

3. DEBENTURES
A debenture is a long-term promissory note for raising capital.
The firm promises to pay interest and principal as stipulated.
Purchasers of debentures are called debenture holders.
Advantages

Cost of debt is low

Interest payment is deductible for tax purposes `

Control of the company is not diluted.

Disadvantages

Debt interest is a fixed charge

It increases a firm's financial risk

Involves substantial cash out-flow since it must be paid on maturity.

Funds can be raised within certain limits only.

4. COMMERCIAL PAPER
This is a form of unsecured promissory note issued by firms to raise short
term funds. Buyers of commercial papers include - banks, insurance
companies, unit trusts, and firms with surplus funds to invest for short period
with minimum risk.
Its maturity ranges from 1 to 270 days.
Cost
17

The cost of commercial paper will include;

Discount

Rating charges

Stamp duty.

Agent charges.

Issuing and paying

The cost of commercial paper is also called interest yield.

Cost of commercial Paper = (Face value - sale price + other costs x 360
Sale Price

Days of maturity

Example
A company issues a 90 - day commercial paper (CP) of a face value Sh. 1000
at Sh. 985. The credit rating expenses are 0.5% of the size of the issue,
issuing charge are 0.35% and stamp duty is 0.5%. What is the cost of CP.?
The discount is Sh; (1000 - 985) = Sh. 5
Issuing and stamp duty charges are 0.5% + 0.35% + 0.5% = 1.35 percent =
1.35%.
Thus the cost is 1.35 x 1000 = 13.5
Cost of CP = 15 x 13.5 x 360 = 0.1157 or 11.6%
985 90
Advantages of CP
From issuing firm's point of view

It is an alternative source of raising short-term finance, and proves to

be handy during periods of tight bank credit.

It is a cheaper source of finance compared to credit. Usually, interest

yield on CP

is less than a prime rate of interest.

Limitations of commercial paper

It is an impersonal method of financing.

18

If a firm is unable to redeem its paper due to financial difficulties it may

not be

possible for it to get the maturity of the paper extended.

It is always available to the financially sound and highest rated

companies.
A firm facing temporary liquidity problems may not be able to raise

funds using

commercial paper.

The amount of loanable funds available in the commercial paper

market is limited to the amount of excess liquidity of the various
purchases of commercial paper.

It cannot be redeemed until maturity.

Thus if a firm doesn't need the funds any more, it cannot repay it until

maturity

and will have to incur interest costs.

5. LOAN FINANCE
Is a direct business loan with a maturity of more than 1 year but less than 15
years. They have a provision for a specific amortization during the right time
of the loan. They are mainly obtained from commercial banks and issuance
companies.
Advantages

The firm avoids expenses such as registration in stock exchange

Less time is required to complete arrangements to obtain a term loan

than is
involved in bond issues.

It is possible to modify loan indenture since only one member is

involved than
many stockholders.

Disadvantages .
19

It provides for regular amortization and thus, the borrowing firm

experiences a
continuous cash drain.

The interest rate may be higher than that of short term loans.

Sometimes, high valued collateral required by the financier may be

difficult to
get when a firm raises funds by issuing share it raises its publicity. This

is not

possible with loan finance.

Conditions under Which Loans Are Ideal

When the companys gearing level is low (the level of outstanding

loans is low.

The companys future cash flows (inflows and their stability) must be
assured.

The company must be able to repay the principal and the

interest.

Economic conditions prevailing. The company must have a long-term

forecast of the prevailing economic condition.

Boom conditions are

ideal for debt.

When the companys market share guarantees stable sales.

When the companys anticipated future expansion programs, justify

such borrowing.

Requirements for Raising Loan

History of the company and its subsidiaries.

Names, ages, and qualifications of the companys directors.

The names of major shareholders 51% plus i.e. owner who must
give consent.

Nature of the products and product lines.

Publicity of the product.

20

Nature of the loan either secured, floating or unsecured.

Cash flow forecast.

Reasons Why Commercial Banks Prefer To Lend Short Term Loans

Long-term

forecasts

are

not

only

difficult

but

also

vague

as

uncertainties tend to jeopardize planning e.g. political and economic

factors.

Commercial banks are limited by the Central Bank of Kenya in their

long term lending due to liquidity considerations.

Short-term loans are profitable. This is because interest is high as in

overdrafts.

Long term finance loses value with time due to inflation.

Cost of finance in the long term, the cost of finance may increase
and yet they cannot pass such a cost to borrowers since the interest
rate is fixed.

Commercial banks do credit analysis that is limited to short term

situations.

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

6. LEASE FINANCE
Is a contract between owner (Lessor) and the users (Lessee) of the asset.
Under this gives right to lessee to use specific asset for a prescribed period
against the payment of the lease rental.
Lessee pays the lease rental on monthly, quarterly, 2yearly or yearly.
Lease agreement is for a specific period e.g. 5yrs, 10yrs etc.
On long-term lease contracts, lease period or renew the lease lessee is
entitled to claim wear & tear allowance for the leased asset.

21

TYPES:
1. Operating lease
Are those contracts which are for short-term and can be cancelled at a shortnotice e.g. lease contract for computers, office equipment, renting a car by a
tourist etc. Under this, rental charges are written off as an expense on a
straight line basis over lease period.

Lessor is responsible for maintenance and insurance of asset.

2. Financial lease.
A lease that transfers substantially all the risks and rewards of ownership of
an asset to a lessee.
Should be recorded in balance sheet of a lessee as an asset and as an
obligation to pay future rentals
These are long-term & non-cancelable contacts example: Leases amortize
cost of the asset over lease period
Lessee bears risk of obsolescence.
3. Equipment Lease.
To obtain equipment on lease - hire basis.
Equipment is leased for a specific period against some payments called lease
-hire charges.
Equipment remains the property of the lessor/owner and the lessee/tenant is
entitled to use it for production purpose.
At the lessee, lease - hire charges are allowable expenses for taxation.
Lessor can claim capital allowance for it.
Advantages of lease finance

Lease rentals are an allowable expense for tax purposes

22

Company can acquire expensive equipments without incurring capital

expenditure.

This source is very suitable if the assets become Obsolete very fast
e.g. computers, aircraft etc

Ideal if assets are needed for a short period only.

If asset is not profitable lease can be cancelled by lessee.

Disadvantages

Is a risky source because lessor may refuse to renew the agreement

Rental charges may be too high and lessee may pay money in rental
charges than
the cost of the asset.

The terms and conditions of the lease agreement may be unfavorable

to the lessee
and (s)he may not be able to utilize this asset conveniently.

Lease finance is available for fixed assets only thus not useful for all
financial requirements of the company.

Reserves/Retained Earnings
These are undistributed profits. It is the cheapest and painless method of
raising more capital.
Advantages

Cheapest method since it does not involve any credit

High retained earnings reduce shareholders' tax liability

If the firm is unable to raise long term loans due to insufficient assets
for security, these are the only source

They do not affect the control of the company

Disadvantages

23

High retained earnings are possible only when dividends are declared
at a low rate.

The fall in dividends results in the fall of share prices.

If retained earnings are invested carelessly, then the company's

profitability will be affected adversely.

Factors to Consider In Choice of source of finance

1. Time factor
A business may need finance for a short period or long period
If finance is needed to make up working capital deficiency then short-term
sources of finance e.g. overdraft, trade credit etc must be selected.
If need to acquire Fixed assets, Long-term sources must be used e.g. issue of
debenture, mortgage etc.
2. Cost of finance
Cost of finance should be less than the expected return from the projects for
which this finance is needed
3. Size of Business.
Large companies can acquire finance in the form of proceeds from ordinary
share and debentures, mortgage and other Long Term loans.
Small business units can obtain finance from banks in form of small loans,
old, trade credit, personal sources
4. Availability of finance
The readily available source of finance should be used e.g. If banks do not
give old facilities, trade credit may be used.
5. Flexibility
The source of finance that is more flexible should be used
Thus a company can use a particular source of finance if need arise and
repay the money when not needed any mo bank credit is flexible if easy to
get.
6. Mode of payment
24

- A business enterprise will prefer that mode of finance which allows the
repayments of the principal and interest in easy and convenient installments.

TOPIC 3: KENYAN FINANCIAL SYSTEM

The financial system can be described as a whole system of all institutions,
individuals, markets and regulatory authorities that exist and interact in a
given economy. The institutions and individuals form the participants in
various markets; money (including foreign exchange) and capital markets
(including security) markets. The participant buy (borrow) and sell (lend)
money to different parties at a price (interest or dividend) within the market,
which is determined by the forces of demand and supply. The main
regulatory are the Central Bank and Capital Market Authority
Financial intermediaries
Financial intermediaries are financial institutions that accept money from
savers and use
these funds to make loans and other financial investments in their own
names.

Others

include, saving institutions, insurance companies, pension funds, finance

companies

and

mutual funds. Their role is to assist in the transfer of savings from savings
surplus

units

to savings deficit units so that savings can be re-distributed into their most
productive
uses. These intermediaries come between ultimate borrowers and lenders by
transforming
direct claims into indirect claims. Financial intermediaries purchase direct (or
primary)
securities and, in turn, issue their own indirect (or secondary) securities to
the

public.

For
25

example, the direct security that a savings and loans association purchases
is

mortgage,

the indirect claim issued is a savings account or a deposit certificate.

The financial intermediaries performs many of the tasks that were initially
perfumed by lenders and borrower- task of gathering funds, credit analysis,
evaluation of risk, and handling of administrative and legal details. These
takes involve real costs and the intermediary can perform them much more
efficiently and much lower total cost than it can be done by an individual
lender and borrower. In the jargon of an economist, financial intermediaries
exhibit economies of scale with respect to costs of search, acquisition,
analysis and diversification.
By their actions, financial intermediaries provide a higher return to lenders
for

given

degree of risk and lower costs of borrowing than would be possible with
direct

finance.

Higher

savings

rate

encourage

savings

permit

and

lower

borrowing

costs

greater

investments. Savings and investments are equated more rapidly thus there
is

faster

economic growth.
Functions of Financial Markets/Institutions in the Economy
1.

Distribution of financial resources to the most productive units.

Savings are transferred to economic units that have channels of
alternative investments. (Link between buyers and sellers).

2.

Allocation of savings to real investment.

3.

Achieving real output in the economy by mobilizing capital for

investment.
4.

Enable companies to make short term and long term investments and
increase liquidity of shares.

5.

Provision of investment advice to individuals through financial experts.

26

6.

Enables companies to raise short term and long term capital/funds

7.

Means of pricing of securities e.g N.S.E. index shares indicate changes

in share prices.
8.

Provide investment opportunities. Savers can hold financial instrument

for investment made.

Financial markets are broadly classified into two:

1. Capital Markets
2. Money Markets
E.g. commercial banks, SACCOS, foreign exchange market, merchant banks
etc.
Capital markets are sub-divided into 2:
a) Security markets e.g stock exchange dealing with instruments such as
shares, debentures etc.
b) Non-security/instrument market e.g mortgage, capital leases, security
market is sub-divided into 2.

Primary market

Secondary market

Capital Market
These are markets for long term funds with maturity period of more than one
year. E.g of Financial instruments used here are debentures, terms, loans,
bonds, warrants, preference shares, ordinary shares etc.The capital market
serves as a way of allocating the available capital to the most efficient users.
Capital market financial institution includes:

Stock exchange
Development bank
Hire purchase companies
Building societies
Leasing firms

Functions of Capital Markets are:

Providing long term funds which are necessary for investment

decisions.
27

Provide advice to investors as to which investments are viable.

Long term investments are made liquid, as the transfer between

shareholders is facilitated.
Facilitates the international capital inflow.
Facilitating the liquidation and marketing of a long term
Acting as a channel through which foreign investments find their way
into the market.

Money/discount markets

Are discount and acceptance financial institutions

This is a market for S.T funds maturing in one year. Money market works
through financial institutions.

It facilitates transfer of capital between

savers and users.

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

Foreign exchange market is also part of money market.

The money market or discount market is the market for short term loans.

Financial Instruments in Money market include:

Commercial paper

Treasury bills

Bills of exchange

Promissory notes

Bank overdrafts

Bankers certificate of deposit

These instruments are sold by commercial banks, merchant banks,

discounting houses, acceptance houses, and government.

28

Primary Markets
These are markets that deal with securities that have been issued for the
first time.

The money flows directly from transferor (saver of money) to

transferee (investing person). They facilitate capital formation.

Economic Advantage of Primary Markets

Raising capital for business.

Mobilising savings
Government can raise capital through sale of Treasury bonds
Open market operation to effect monetary policy of the government i.e

control of excess liquidity in the economy

It is a vehicle for direct foreign investment.

Economic Advantage/Role of Secondary Markets in the Economy

It gives people a chance to buy shares hence distribution of wealth in

economy.
Enable investors

securities.
Increases diversification of investments
Improves corporate governance through separation of ownership and

realize

their

investments

through

disposal

of

management. This increases higher standards of accounting, resource

management and transparency.

Privatization of parastatals e.g. Kenya Airways. This gives individuals a

chance for ownership in large companies.

Parameter for healthy economy and companies
Provides investment opportunities for companies and small investors.

Types of Stock Markets

1.

Organised Exchange and Over the Counter (OTC) market

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

2.

Over the Counter Market (OTC)

29

This

Provides an opportunity for unlisted/unquoted firms to sell their

security
OTC is usually organized by the dealers or stock brokers who buy
securities themselves and then sell them.
They maintain a reasonable balance between demand and supply and
observe price movements to determine profit margins on sale.
Trading may be done through telephones, computer networks, fax etc.
The dealers/participants set the trading rules. OTC specializes in
securities such as corporate bonds, equity securities, Treasury bonds
etc.
OTC is underdeveloped in Kenya.
Features of OTC Markets
1. Prices are relatively low
2. Usually deal with new securities of firms
3. Is composed of small and closely held firms.
Financial intermediaries
These are institutions which mediate/link between the savers and investors:
Examples of financial intermediaries in Kenya.
1. Commercial Banks.
They act as intermediary between savers and users (investment) of funds.
2. Savings and Credit Associations
These are firms that take the funds of many savers and then give the money
as a loan in form of mortgage and to other types of borrowers. They provide
credit analysis services.
3. Credit Unions
These are cooperative associations whose members have a common bond
e.g employees of the same company. The savings of the member are loaned
30

only to the members at a very low interest rate e.g. SACCOS charge p.m
interest on outstanding balance of loan.
4. Pension Funds
These are retirement schemes or plans funded by firms or government
agencies for their workers.

They are administered mainly by the trust

department of commercial banks or life insurance companies. Examples of

pension funds are NSSF, NHIF and other registered pension funds of
individual firms.
5. Life Insurance Companies
These are firms that take savings in form of annual premium from
individuals and them invest, these funds in securities such as shares, bonds
or in real assets. Savers will receive annuities in future.
6. Brokers
These are people who facilitate the exchange of securities by linking the
buyer and the seller.

They act on behalf of members of public who are

buying and selling shares of quoted companies.

7. Investment Bankers
These are institutions that buy new issue of securities for resale to other
investors.
They perform the following functions:
1. Giving advice to the investors
2. Giving advice to firms which wants to
3. Valuation of firms which need to merge
4. Giving defensive tactics incase of forced takeover
5. Underwriting of securities.
31

The Stock Exchange Market

The Idea and Development of a Stock Exchange
Stock exchange (also known as stock markets) are special market places
where already held stocks and bonds are bought and sold.

They are, in

effect, a financial institution, which provides the facilities and regulations

needed to carry out such transactions quickly, conveniently and lawfully.
Stock exchanges developed along with, and are an essential part of the free
enterprises system.

(No stock exchanges exist in the communist world

outside Hong Kong and Macao which have special status, and Taiwan which
is also claimed by China).
The need for this kind of market came about as a result of two major
characteristics of joint stock company (Public Limited Company), shares.
1.

First of all, these shares are irredeemable, meaning that once it has

sold them, the company can never be compelled by the shareholder to take
back its shares and give back a cash refund, unless and until the company is
winding up and liquidates.
2.

The second characteristic is that these shares are, however, very

transferable and can be bought and resold by other individuals and

organizations, freely, the only requirement being the filling and signing of a
document known as a share transfer form by the previous shareholder. The
document will then facilitate the updating of the issuing companies
shareholders register.
These two characteristics of joint company shares brought about the
necessity for an organized and centralized place where organizations and
private individuals with money to spare (investors), and satisfy their
individual needs.

Stock exchanges were the result emerging to provide a

32

continuous auction market for securities, with the laws of supply and
demand determining the prices.
Functions of the Nairobi Stock Exchange

The basic function of a stock exchange is the raising of funds for

investment in long-term assets. While this basic function is extremely
important and is the engine through which stock exchanges are driven,
there are also other quite important functions.

The mobilization of savings for investment in productive enterprises as

an alternative to putting savings in bank deposits, purchase of real
estate and outright consumption.

The growth of related financial services sector e.g. insurance, pension

and provident fund schemes which nature the spirit of savings.

The check against flight of capital which takes place because of local
inflation and currency depreciation.

Encouragement of the divorcement of the owners of capital from the

managers of capital; a very important process because owners of
capital may not necessarily have the expertise to manage capital
investment efficiently.

Encouragement

of

higher

standards

of

accounting,

resource

management and public disclosure which in turn affords greater

efficiency in the process of capital growth.

Facilitation of equity financing as opposed to debt financing.

Debt

financing has been the undoing of many enterprises in both developed

and developing countries especially in recessionary periods.

Improvement of access to finance for new and smaller companies.

This is futuristic in most developing countries because venture capital
is mostly unavailable, an unfortunate situation.

Encouragement of public floatation of private companies which in turn

allows greater growth and increase of the supply of assets available for
long term investment.
33

There are many other less general benefits which stock exchanges
afford

to.

government.

Individuals,

corporate

organizations

and

even

the

The government for example could raise long term

finance locally by issuing various types of bond through the stock

exchange and thus be less inclined to foreign borrowing.

Stock exchanges, especially in developing countries have not always

played the full role in economic development.

The Role Of Stock Exchange In Economic Development

1. Raising Capital for Businesses
The Stock Exchange provides companies with the facility to raise capital for
expansion through selling shares to the investing public.
2. Mobilising Savings for Investment
When people draw their savings and invest in shares, it leads to a more
rational allocation of resources because funds which could have been
consumed, or kept in idle deposits with banks are mobilized and redirected to
promote commerce and industry.
3. Redistribution of Wealth
By giving a wide spectrum of people a chance to buy shares and therefore
become part-owners of profitable enterprises, the stock market helps to
reduce large income inequalities because many people get a chance to share
in the profits of business that were set up by other people.
4. Improving Corporate Governance
By having a wide and varied scope of owners, companies generally tend to
improve on their management standards and efficiency in order to satisfy the
demands of these shareholder. It is evident that generally, public companies
tend to have better management records than private companies.
5. Creates Investment Opportunities for Small investors
As opposed to other business that require huge capital outlay, investing in
shares is open to both the large and small investors because a person buys
the number of shares they can afford.

Therefore the Stock Exchange

provides an extra source of income to small savers.

34

6. Government Raises Capital for Development Projects

The Government and even local authorities like municipalities may decide to
borrow money in order to finance huge infrastructural projects such as
sewerage and water treatment works or housing estates by selling another
category of shares known as Bonds. These bonds can be raised through the
Stock Exchange whereby members of the public buy them.

When the

Government or Municipal Council gets this alternative source of funds, it no

longer has the need to overtax the people in order to finance development.
7. Barameter of the Economy
At the Stock Exchange, share prices rise and fall depending, largely, on
market forces. Share prices tend to rise or remain stable when companies
and the economy in general show signs of stability.

Therefore their

movement of share prices can be an indicator of the general trend in the

economy.
Advantages of Investing In Shares
1. Income in form of dividends
When you have shares of a company you become a part-owner of that
company and therefore you will be entitled to get a share of the profit of the
company which come in form of dividends. Furthermore, dividends attract a
very low withholding tax of 5% only.
2. Profits from Capital Appreciation
Shares prices change with time, and therefore when prices of given shares
appreciate, shareholders could take advantage of this increase and set their
shares at a profit. Capital gains are not taxed in Kenya.
3. Share Certificate can be used as a Collateral
Share certificate represents a certain amount of assets of the company in
which a shareholder has invested.

Therefore this certificate is a valuable

property which is acceptable to many banks and financial institutions as

security, or collateral against which an investor can get a loan.
4. Shares are easily transferable
35

The process of acquiring or selling shares is fairly simple, inexpensive and

swift and therefore an investor can liquidate shares at any moment to suit
his convenience.
5. Availability of Investment Advice
Although the stick market may appear complex and remote to many people.
Positive advise and guidance could be provided by the stockbrokers and
other investment advisors.

Therefore, an investor can still benefit from

trading in shares even though he may not be having the technical expertise
relevant to the stock market.
6. Participating in Company Decisions
By buying shares and therefore becoming a part-owner in an enterprise, a
shareholder gets the right to participate in making decisions about how the
company is managed.

Shareholders elect the directors at the Companys

Annual.
General meetings, whereby the voting power is determined by the number of
shares an investor holds since the general rules is that one share is equal to
one vote.
STOCK MARKET TERMINOLOGY
1. BROKER
A dealer at the market who buys and sells securities on behalf of the public
investors.
He is an agent of investors
He is the only authorized person to deal with the quoted securities. He is
authorized by CMA and NSE
He obtains the suitable deal for his clients/investors, gives financial advice
and charges commission for his services.
He doesnt buy or sell shares in his own right hence he cannot be a market
marker.
He must maintain standards set by the stock exchange.
36

2. JOBBERS/SPECULATORS
This is a dealer who trades in securities in his own right as a principal.
He can set prices and activate the market through his own buying and selling
hence he is a market maker.
He engages in speculation and earns profit called Jobbers turn (selling price
buying price).
He does not deal with members of the public unlike brokers.

However,

brokers can buy and sell shares through jobbers.

There are 3 types of jobbers
a)

Bulls

A jobber buy shares when prices are low and hold them in anticipation that
the price will rise and sell them at gain.
When a market is dominated by bulls (buyers predominate sellers), it is said
to be bullish. The share prices are generally rising.
Therefore the market is characterized by an upward trend in security prices.
It signifies investors confidence/optimism in the future of economy.
b)

Bears

A speculator/jobber who sells security on expectation of decline in prices in

future.
The intention is to buy same securities at lower prices in future thereby
making a gain.
When market is dominated by bears (sellers predominate buyers) it is said to
be bearish.
It is characterized by general downward trend in share prices.

It signifies

investors pessimism about the future prospects of the economy.

c)

Stags

This is a jobber found in primary markets

He buys new securities offered to the public and believes that they are
undervalued.
37

He believes the price will rise and sell them at a gain to the ultimate
investors
Stags are vital because they ensure full subscription of the share issue.
3,

Underwriting

This is the assumption of risk relating unsubscribed shares

When new shares are issued, they may be underwritten/unsubscribed.

merchant banker agrees, under a commission to take up any shares not

bought by the public.
They therefore ensure that all new issues are successful
Underwriters are very important in pry markets and play the following roles:
Advice firms on most suitable issue price
Ensure shares are fully subscribed by taking up all unsubscribed shares
Advice the firms on where to source funds to finance floatation costs.
4.

Blue Chips

Are first class securities of firms which have sound share capital and are
internationally reputable.They have very good dividend record and are highly
demanded in the markets. Individuals holding such securities are reluctant
to sell them because of their high value.
5.

Going short or long on a share

This is the process of selling (going short) or buying (going long) on a share
that one does not have/own. The aim is to make gain from assumed change
in the market value of shares. This practice is not allowed in Kenya. It is
aided by brokers in countries where it is practiced. Investors going short or
long are required to pay a premium called margin on the transaction.
TRADING MECHANISM
1.

AT NSE

An investor approaches a broker who takes his bid/offer to the trading

floor.

38

2.

At the trading floor, the buying and selling brokers meet and seal the

deal.
3.

The investor is informed of what happened/transpired at the trading

floor through a contract note.

The note is sent to buying and selling

investors.
The note contains details such as:
Number of shares bought or sold
Buying/selling price
Charges/commission payable etc.
4.

Settlement is made through the brokers.

5.

Old share certificate is cancelled (for selling investor) and a new one is

issued in the name of buying investor.

Factors to Consider when Buying Shares of a Company

Economic conditions of the country and other non-economic factors

e.g. unfavourable climatic conditions and diseases which may lead to
low productivity and poor earnings.

State of management of the company e.g are the B.O.D. and key
management personnel of repute? They should be trusted and run the
company honestly and successfully.

Nature of the product dealt in and its market share e.g is the product
vulnerable to weather conditions? Is it subject to restrictions?

Marketability of the shares how fast or slowly can the shares of the
firm be sold?

Diversification i.e does the company have a variety of operations e.g

multi-products so that if one line of business declines, the other
increases and the overall position is profitable.

Companys trading partners (local and abroad) and its competitors.

39

Prospects of growth of the firm due to expected growth in demand of

products of the firm.

Factors Affecting/Influencing Share Prices

All sorts of influences affect share prices. These influences include:

The recent profit record of the company especially the recent dividend
paid to shareholders and the prospects of their growth and stability.

The growth prospects of the industry in which the company operates.

The publication of a companys financial results i.e. Balance Sheet and

profit and loss statement.

The general economic conditions situations e.g boom and recession e.g
during boom, firms would have high profits hence rise in prices.

Change in companys management e.g entry and exit of prominent

corporate personalities.

Change on Government economic policy e.g spending, taxes, monetary

policy etc. These changes influence investors expectations.

Rumour and announcements of impending political changes eg.

General elections and new president will cause anxiety and uncertainty
and adversely affect share prices.

Rumours and announcement of mergers and take-over bids.

If the

shareholders are offered generous terms/prices in a take-over, share

prices could rise.

Industrial relations eg strikes and policies of other firms.

Foreign political developments where the economy heavily depends on

world

trade.

Changes in the rate of interest on Government securities such as

Treasury Bills may make investors switch to them. Exchange rates will
also encourage or discourage foreign investment in shares.
40

Announcement of good news eg that a major oil field has been struck
or a major new investment has been undertaken.

The NPV of such

investment would be reflected in share prices.

The views of experts e.g articles by well-known financial writers can

persuade people to buy shares hence pushing the prices up.

Institutional buyers such as insurance companies can influence share

prices by their actions.

The value of assets and the earnings from utilization of such assets will
also influence share prices.

STOCK MARKET INDEX

Definition
An index is a numerical figure which measures relative change in variables
between two periods.
Examples
If sales in year 2000 are equal to Kshs.25 M and for year 2001 Shs.30 M, the
sales index would be as follows:
Sales index =

year 2001 sales = Shs.30 M x 100 = 120

Year 2000 sales

Shs.25 M

Year 2001 sales are 120% of year 2000 sales, year 2000 is called Base year.
A stock index therefore measures relative changes in prices or values of
shares. The NSE has its base year as 1966. 20 companies constitute the
index.
The stock index is computed using Geometric mean (G.M) as follows:

41

Todays stock index

(Todays share price G.M)2 x 100

Yesterdays share price G.M.

Where G.M =

P1xP2 xP3 xP4 x........xPn

Where G.M. P1 x P2 x P3 x P4 ------- Pn = share price of companies that

constitute stock index.

N = number of companies

When stock prices are rising, stock market index will rise and vice
versa.

Stock market index therefore is an indicator of investors confidence in

the economy.

Illustration
The following 6 companies constitute the index of democratic republic of
Kusadikika.
Company
Todays share price

A
20

B
52

C
83

D
12

E
78

F
10

Yesterdays share price

25

53

83

10

75

0
96

index

the

Compute the stock market index for today.

In

construction/computation

of

stock

following

considered:
1. Choice of base year on which to base the price changes
42

should

be

2. The selection of representative securities/firms

3. Combining the securities/firms to construct the index eg use of geometric
mean
4. Use of suitable weight to be attached to the securities depending on their
relative importance.
5. The weights/number of firms in a sector is kept constant over a
reasonably long period.
LEVEL OF TRADING ACTIVITIES IN THE NAIROBI STOCK EXCHANGE
The activities in NSE are normally low due to:

Few Listed companies

Economy is made up of small firms which are family owned or sole

proprietorship.

Level of awareness among the population is low

Few instruments traded

Low dividend payout to those already holding shares.

STOCK EXCHANGE INDEX (SEI)

Stock Exchange Index is a measure of relative changes in prices of stocks from
one period to another indices.Nairobi Stock Exchange 20 - share Index (20
companies) (Daily basis) Stanchart Index - From 25 most active companies in
a given period (weekly basis) Computation of price index.
Uses of Stock Exchange Index
1. To gauge price (wealth movement in the stock market
2. To assess overall returns in the market portfolio
3. To assess performance of specific portfolio using SEI as a

benchmark.

4. May be used to predict future stock prices

5. Assist in examining and identifying the factors that underlie the price
movements.

43

Limitations/Drawback of NSE index

The 20 companies sample whose share prices are used to compute the
index are not true representatives.

The base year of 1996 is too far in the past

New companies are not included in the index yet other firms have been
suspended/deregistered e.g. ATH, KFB etc.

Dormant firms Some of the 20 firms used are dormant or have very
small price changes.

Thinness of the market small changes in the active shares tend to be

significantly magnified in the index

The weights used and the method of computation of index may not
give a truly representative index.

When is a share price said to be unfair?

Where the price is not determined by demand and supply forces.

If the price is not consistent with the activities of the firm e.g a decline
in share price of a firm with very good growth prospects.

Price is not compatible with the price of other similar shares of firms in
the same industry

If there is insider trading:

This situation arises where individuals within the firm in privileged
positions e.g top management and director take advantage of the
information available to them which has not been released to the
public.
They may use such information to dispose off share to make capital
gains or avoid capital loss

TIMING OF INVESTMENT A STOCK EXCHANGE

The ideal way of making profits at the stock exchange is to buy at the
bottom of the market (lowest M.P.S) and sell at the top of the market (highest
44

M.P.S). The greatest problem however is that no one can be sure when the
market is at its bottom or at its top (prices are lowest and highest).
Systems have been developed to indicate when shares should be purchased
and when they should be sold. These systems are Dow theory and Hatch
system.
1. Dow Theory
This theory depends on profiting of secondary movement of prices of a chart.
The principal objective is to discover when there is a change in the primary
movement.
This is determined by the behaviour of secondary movement but tertiary
movements are ignored. Eg in a bull market, the rise of prices is greater
than the fall of prices.
In a bear market the opposite is the case ie the fall is greater than the rise
In a bear market, the volume of the business being done at a certain stage
can also be used to interpret the state of the market.
Basically, it is maintained that if the volume increases along with rising
prices, the signs are bullish and if the volume increases with falling prices,
they are bearish.
2. Hatch System
This is an automatic system based on the assumption that when investors
sell at a certain % age below the top of the market and buys at a certain
percent above the market bottom, they are doing as well as can reasonably
be expected. This system can be applied to an index of a group of shares or
shares of dividends companies eg Dow Jones and Nasdaq index of America.
Illustration 1
45

An investor uses the hatch system to determine when to buy and sell his
shares. He sells the shares when prices are 15% less of the top price and
buy the shares when prices are 15% less of the top price and buy the shares
when prices are 15% more of the bottom price. At the beginning of January,
the share price was 200/=.

At the end of the year the share price was

Shs.320.
i)

Determine the buying and selling price of the shareholders

ii)

If the shareholder had 10,000 shares, determine the amount of capital

gain on these shares.

iii)

The investor had D.P.S of 3.00 at the end of the year. Compute his

shilling return in %.

Rules for floatation of new shares on NSE

The company must have an issued share capital of at least Kshs.20 M.

The company must have made profits during the last 3 years.

At least 20% of issued capital (capital to be issued) should be offered

to the public

The firm must issue a prospectus which will give more information to
investors to enable them to make informed judgement

The market price of the companies share must be determined by the

market forces of demand and supply

The company should be registered under Cap. 486 with registrar of

companies.

It must provide details on

1. Number of shares to be issued
2. Offer/issue price per share
3. The dates during which the other is valid or open
46

4. Financial statements of the firm showing EPS and DPS for the last 5
years
5. Action report etc.
6. Action may be taken against the directors if the prospectus is
fraudulent.
The Advantages and Disadvantages of a Listing
Advantages

It facilitates the issue of securities to raise new finance, making a

company less dependent upon retained earnings and banks.

The wider share ownership which results will increase the likelihood of

being able to make rights issues.

The transfer of shares becomes easier.

Less of a commitment is

necessary on the part of shareholders. For this reason the shares are
likely to be perceived as a less risky investment and hence will have a

higher value.
The greater marketability and hence lower risk attached to a market
listing will lead to a lower cost of equity and also to a weighted

average cost of capital.

A market-determine price means that shareholders will know the value
of their investment at all times.

The share price can be used by management as an indicator of

performance, particularly since the share price is forward looking,
being based upon expectations, whilst other objectives measures are

backward looking.
The shares of a quoted company can be used more readily as

consideration in takeover bids.

The company may increase its standing by being quoted and it may
obtain greater publicity.
47

Obtaining a quotation provides an entrepreneur with the opportunity to

realize part of his holding in a company.

Disadvantages

The cost of obtaining a quotation is high, particularly when a new issue

of shares is made and the company is small.

This is because

substantial costs are fixed and hence are relatively greater for small
companies. Also, the annual cost of maintaining the quotation may be
high due to such things as increased disclosure, maintaining a larger

share register, printing more annual reports, etc.

The increased disclosure requirements may

management.
The market-determined price and the greater accountability to
shareholders

that

comes

with

its

concerning

be

the

disliked

by

companys

performance may not be liked by management.

Control of a particular group of shareholders may be diluted by

allowing a proportion of shares to be held by the public.

There will be a greater likelihood of being the subject of a takeover bid

and it may be difficult to defend it with wide share ownership.

Management conditions, management employees give themselves
more salaries due to prosperity obtained.

Capital Market Authority (Cma)

Was established in 1990 by an Act of Parliament ot assist in creation of a
conducive environment for growth and development of capital markets in
Kenya.
ROLE OF CMA

To remove bottlenecks and create awareness for investment in long

term securities
48

To serve as efficient bridge between the public and private sectors

Create an environment which will encourage local companies to go

public

To grant approvals and licences to brokers

To operate a compensation fund to protect investors from financial

losses should licenced brokers fail to meet their contractual obligation

Act as a watchdog for the entire capital market system

To establish operational rules and regulations on placement of

securities

To implement government programs and policies with respect to the

capital markets.

Role of CMA in determination of share prices

1. The CMA does not in any way influence share price of quoted
companies.
2. The prices of such securities is determined by the demand and supply
mechanism
3. However, CMA may:
4. Advice the company on the issue price of new securities
5. Alert the investors if it feels that the issue price of certain securities is
not in their interest
6. It guards against manipulation of share prices and insider trading.

Central Depository System (C.D.S)

Its a computerized ledger system that enable the holding or transfer of
securities without the need for physical movement.

The ownership of

security or shares is through a book entry instead of physical exchange CDS

is for security what a bank is for cash transfer between banks. Eg A and B
49

are 2 shareholders of XYZ Ltd. XYZ Ltd. does not need to deliver the share
certificate to A or B but a ledger account for both shareholders would be
maintained at the CDS. Their accounts will be credited with the number of
shares. If A want to sell shares to B the CDS will debit As account and credit
Bs account.
Advantages of CDS
1.

It shortens the registration process in the stock exchange i.e. high

speed of registering shareholders.

2.

It improves the liquidity of stock exchange than increase the turnover

of the equity shares in the market.

3.

It will lower the clearing and settlement cost eg no need to prepare

share certificates and seal them (putting a seal).

4.

Its faster and less risky settlement of securities which make the market
more attractive for investors e.g instances of fraud will be reduced
since there is no physical share certificate which may be forged.

5.

There will be improved and timely communication between company

and the investors hence reduced delay in receiving dividends and right
issues and improve information dissemination concerning a company.

6.

It will lead to an efficient and transparent securities market to adhere

to International Standards for the benefit of all stakeholders.

Functions of CDS
1.

Immobilisation of securities ie elimination of physical movement of

securities.
2.

Dematerialisation i.e elimination of physical certificates or documents

showing entitlement to a security so that ownership exists only as
computer records.

3.

Effective Delivery Vs. payment (DVP) ie simultaneous delivery and

payment between the 2 parties exchanging or transferring securities.

50

This can be done without delay if CDS is linked to the central payment
clearing system e.g CBK.
4.

Provision of detailed listings of investors according to the type of

securities they hold e.g ordinary shares, preference shares.

5.

Effective Distribution of Dividends, interests, rights issues and bonus

issues.
6.

Provision of book entry account ie electronic exchange of ownership of

securities and payment of cash.

Parties Involved In CDS

1. Government
For the purpose of attracting foreign investors and supporting the
infrastructure of capital markets.
2. Capital Market Authority
To improve the transparency of market and reduce instances of fraud.

3.Nairobi Stock Exchange

Bear transactions costs and improve liquidity of the market investors.
4. Investors
Institutions,

private

investors

and

market

professionals.

For

faster

settlements and ownership transfer and reduced cost of transfer through

reduced paper work and labour intensive activities.
5. Brokers
Reduces paper work, forgery and improved efficiency
6. Banks
51

Ease of clearing and settling of payments.

Development Banks and Specialized Financial Institutions
There are some sectors in the economy that may not secure adequate funds
from commercial banks for various reasons.
a)

May take a long time to realize returns

b)

High risk associated with such sectors

c)

unattractive/low return

d)

Uncertainty or highly volatile returns

e)

Require heavy investment in infrastructure

These sectors include:

Tourism

Rural housing

Agriculture

Rural enterprise

Small commercial businesses e.g Jua Kali etc.

Such sector e.g agriculture and tourism are essential for a balanced
economic growth and development.

The government

has thus

established financial institutions

to cater

specifically for these otherwise unattractive but essential sector.

They

include:

Industrial development bank (IDB) give loans for industrial

development in Kenya.
Development Finance Company of Kenya (DFCK) To finance
various project will spur economic development and create
employment.
52

cKenya Industrial Estate (KIE) this is a branch of Industrial and

Commercial

development

cooperation

(ICDC)

dealing

with

industrial development.
Agriculture Finance Co-operation (AFC)
Post Bank To mobilize rural savings
National Housing Cooperation for development of houses to

ensure shelter for everyone.

Kenya Tourism Development Cooperation (KTDC) for promotion of
Tourism in Kenya.

Advantages/Functions/Case for Development Financial Institutions

They provide venture capital

They provide facilities for large lending
They provide technical expertise and support emerging projects

transferable from other sectors of development economies.

They are risk capital providers in areas which are not attractive to

commercial banks and other major lenders due to risk involved.

They carry out feasibility study to evaluate viability of projects.

Case against Specialized Institutions and Development Banks

They are being phased out by Globalization and liberalization

where needy sectors can easily get expertise from outside.

Commercial banks have now matured up to provide capital for all

sectors.
They were only useful during periods of foreign exchange

restriction
They are risk capital providers in areas which are not attractive to

commercial banks and other major lenders due to risk involved.

They increase government spending.

Banking Institutions
The Central Bank
53

This is a bank which is entrusted with the responsibility of maintaining

economic stability and financial soundness of a country. It is therefore
entrusted with two objectives:
1. Responsibility of maintaining financial soundness of the economy. The
2. bank has therefore to identify gaps in financial markets and to seek
3. solutions to these gaps.
4. To act as a commercial bank. It therefore has to operate profitability
5. when offering services to difference parties.
Establishment of Central Bank of Kenya
Established by Central Banking Act, 1966, and the Banking Act 1968.
Management of the Bank
Management and policy entrusted to a Board of Directors, comprising of seven
members including the Governor, Deputy Governor, and Ps to treasury. The
Governor of the Central Bank is the executive head of the bank. The Governor
in charge today is Michael Cheserem.
Statutory Information and Accounts
The bank is required to publish a return of its assets and liabilities every
month. A copy of the return to be submitted to Finance Minister. The bank has
also to prepare and publish an annual report within 3 months of the end of
fiscal year. Fiscal year ends 30th June.

Central Banks
Functions of Central Bank
1. Banker to the government
2. Lender to the government
54

3. Ensure Economic stability

4. Printing of currency notes
5. Lender of last resort
Tools Used To Control The Level Of Money In Circulation
1. Monetary policies e.g Treasury bills, Treasury bonds, Reserve ratio etc
2. Fiscal policies e.g taxation
Commercial Banks
These are financial institutions that accept deposits of money from the
general public, safeguard the deposits and make them available to their
owners when need arises.

Commercial Banks
These are financial are financial institutions that accept deposits of money
from the general public, safeguard the deposits and make them available to
their owners when need arises.

Commercial banks operate under the

Banking Act 1968

Functions of Commercial Banks

Accepting deposits for safe keeping and for interest

Collecting money on behalf of customers and credit this money in

customers accounts
Transferring of money from individual to another person s accounts

through credit transfer.

Supply of foreign currency are obtainable at commercial banks
Lending money, banks lend loans to customers from which they earn

interest
Facilitate international trade by issuing letter of credit and undertake
foreign exchange transactions on behalf of their customers

55

Act as trustees and executives of wills if one wants to make a will

he/she writes and appoints a commercial bank as the trustee and

executor of the will

Provision of safer keeping of valuables like title deeds, gold certificates

etc
Making decision affecting development. Before advancing loans to
prospective
customer, commercial banks are very careful and strict so as to give
loans

to

investment in viable sector of the economy

Role of commercial banks in a countrys economy

Exchange and trade: commercial banks facilitate the process of

exchange
deposits,

through

lending;

which

commercial

form

part

banks

create

additional

of

the

total

money supplies in the economy. By use of cheques, holders of demand

deposits
accounts are able to transact business and exchange goods and
services.

By

providing overdraft facilities, and letters of credit, commercial banks

facilitate

and

increase the speed of commercial and industrial activities. International

exchange

is similarly enhanced.
Intermediaries: commercial banks connect savers of surplus funds to
borrowers. They (banks) play the role of middlemen in the lendingborrowing

cycle.

By

so

doing, commercial banks relieve savers of the risk of loss, which may
result

when

borrowers default in paying their loans. If savers were to lend

individually
directly

to

and
borrowers,

they

would
56

have

to

carry

the

risk

of

possible

loss

personally.
Economies of scale:

Commercial

savings and investment

individual

banks

economies

provide

of

scale.

the
By

necessary
aggregating

savings

into

commercial banks. Large enterprises like hotels, heavy machinery, like

shipping
lines, oil drilling and many more would have been very difficult if
investors

were

to rely on personal savings. It can be said therefore, that commercial

banks

play

an important role in the process of capital formation. It can be said

that
commercial banks harness society s saving potential and direct these
savings

to

infrastructure and capital assets, they become key agents of capital

formation

and

economic development.
Safety: Commercial banks are also used as strong boxes for keeping
valuable assets in
documents

safety. Many rich

people deposit

jewellery,

and other valuables with commercial banks for safety.

Money is sometimes deposited into banks

for

no

other

objective

than safekeeping. Sometimes, it is the main consideration in the

minds of users of banks.
Other Financial Institutions
1.

Mortgages
An arrangement where the property being purchased provides the
security for funding. Other assets may be used as security for funding
of another asset.
Features
57

1. Mortgagor

and

mortgagee

agree

on

long

term

financing

arrangement
2. Financing relates to acquisition of specific asset
3. Mortgagor provides a contribution which is paid up-front.
4. Repayment is over a specified long term period.
5. Interest

rate

is

stated

with

provision

for

variations

of

the

determination of the finance.

Difficulties in mortgage arrangements
1. Initial contribution is not affordable by majority of the population e.g.
Nyayo Highrise
2. Estate.
3. Potential participants avoid getting tied up in long term loans
4. Experiences with mortgage arrangements have been discouraging.
5. Interest rate fluctuations make planning uncertain
2.

Housing Finance Company of Kenya

This is the largest mortgage company in Kenya.

It implements the

governments policy of stimulating house ownership. It is registered

under the Building Society Act but operates as a finance company
under the Banking Act.
3.

Kenya Industrial Estate

This is a body established by the government for the purpose of
promoting industrial development.

a)

Enhancement of acquisition of skills necessary for industrial

development

58

Technological innovations. The body is concerned with the provision of

a base that will be considered necessary for technology development
e.g. through research.
It provides capital necessary for industrial development
It provides guarantees for loans to be used for industrial development
especially for small scale industries.
4.

Industrial and Commercial Development Cooperation (ICDC)

This was incorporated in 1954 by the Kenya Government
The main objective is to facilitate industrial development.

It

concentrates on projects requiring financial participation and active

extension of services
Funds provided are from the Government and commercial banks.
5.

Kenya Tourist Development Corporation

This was established by the Government specifically to promote
tourism. The main objectives of KTDC are:
1. To provide assistance for establishment of tourism projects
2. To provide financial assistance for the establishment of hotels and
tourism lodgings
3. To provide equity finance on joint venture basis in international hotel
organizations.

6.

Merchant Banks
Merchant Banks begun life as merchants and begun to operate in
financial firms, within the 19th Century.
The merchant banks act as a principal when they buy share from the
company before the issue is made.

Merchant banks accept bills of

exchange which deal in the leasing of industrial equipment.

59

60

TOPIC 4: CAPITAL BUDGETING DECISIONS

As a firm/business expands it becomes necessary to invest in fixed assets so
to increase the volume of production.

Investment decisions of a firm are

generally known as capital budgeting or capital expenditure decisions.

Capital budgeting can be defined as the process of identifying, analyzing and
selecting investment project whose returns (cash flows) will extend beyond
one year. Investment decisions would include expansion, acquisition,
modernization and replacement of the long term assets; or even divestment
(sale of a business or its division), research and development programme.
Features of investment decisions

The exchange of current funds for future benefits

The funds are invested in long-term assets

Future benefits will occur to the firm over a series of years

Importance of investment decisions

They influence the firms growth in the long run

They effect the risk of the firm

They involve commitment of large amounts of funds

They are irreversible or reversible at substantial loss

They are among the most difficult decisions to make

Majority of firms have scarce capital resources.

Types of Investment Decisions

Expansion of existing business

Expansion of new business

Replacement & Modernization

Expansion & Diversification

Expansion involves a company lending capital to its existing product lines, to
increase production where a company invests in plant and machinery to
61

produce items which it has not manufactured before, this represents

expansion of new business of Diversification.

Replacement & Modernization

The main objective of these is to improve operating efficiency and reduce
costs. This is reflected in increase profits. The firm replaces obsolete assets
with those that operate more economically.
Investment Evaluation Criteria
Steps involved in the evaluation of investment

Estimation of cash flows

Estimation of the required rate of return

Application of a decision rule for making the choice

The various investment decision rules may be regarded as capital budgeting

techniques or investment criteria.

Capital Budgeting Techniques

Any investment to be undertaken will need to be assessed as regards its

viability using an acceptable approach. Any appraisal method to be used to
assess the viability of a venture must fulfill the following requirements:
It should appreciate that bigger returns are preferable to small ones
and early returns are preferable to later benefits. This is necessary
because money loses value with time and the method must
accommodate this phenomenon.

62

 The method should be able to rank various ventures available in the

investment market in order of their profitability.
The method should distinguish which investment ventures are
acceptable and which ones should be rejected, and why.
The method should be able to be used for gauging the viability of any
other investment ventures as and when they arise.
There are two methods of assessing the viability of an investment. These
are;
(a) Discounted Cashflow methods
i.

Net present value method

ii.

Internal rate of return

iii.

Profitability index

(b) Non-discounted cashflow method

i.

Accounting rate of return

ii.

Payback period

Discounted Cashflow Methods

1.

Net Present Value (NPV)

This is defined mathematically as the present value of cashflow less
the initial outflow.

Ct
t Io
t=1 (1 + K )

NPV =

Where

Ct is the cashflow
K is the opportunity cost of capital
63

Io is the initial cash outflow

n is the useful life of the project
Decision Rule using NPV
The decision rule under NPV is to:
-

Accept the project if the NPV is positive

Reject the project if NPV is negative

Note: if the NPV = 0, use other methods to make the decision.

2.

Internal Rate of Return (IRR)

The internal rate of return of a project is that rate of return at which
the projects NPV = 0

Therefore IRR occurs where:

Ct
- =0
t Io
t=1 (1+ r )

NPV =

Where r = internal rate of return

Note that IRR is that ratio of return that causes the present value of
cashflows to be equal to the initial cash outflow.
Decision Rule under IRR
If IRR > opportunity cost of capital - accept the project
64

3.

IRR < opportunity cost of capital - reject the project

IRR = opportunity cost of capital - be indifferent

Profitability Index
This is a relative measure of projects profitability. It is given by the
following formula.

(1+CK )
t

PI =

t=1

Io

Decision Rule
If

PI > 1 - Accept the project

PI < 1 - Reject the project
PI = 1 - Be indifferent

Non-Discounted Cashflow Methods

1.

Accounting rate of return (ARR)

ARR =

Average annual income

Average investment

65

Where Average annual income = Average cashflows - Average

Depreciation
Average investment = 1/2 (Cost of investment - Salvage value)
(assuming straight line depreciation method).
Projects with higher ARR are preferable.
2.

Payback Period
This is defined as the time taken by the project to recoup the initial
cash outlay.
The decision rule depends on the firms target payback period (i.e.
the maximum period beyond which the project should not be
accepted.

ILLUSTRATION
A company is considering two mutually exclusive projects requiring an initial
cash outlay of Sh 10,000 each and with a useful life of 5 years. The company
required rate of return is 10% and the appropriate corporate tax rate is 50%.
The projects will be depreciated on a straight line basis.

The before

depreciation and taxes cashflows expected to be generated by the projects

are as follows.
YEAR

Project A Shs 4,000

4,000

4,000

4,000

4,000

Project B Shs 6,000

3,000

2,000

5,000

5,000

Required:

66

Calculate for each project

i.

The payback period

ii.

The average rate of return

iii.

The net present value

iv.

Profitability index

v.

The internal rate of return

Which project should be accepted? Why?

Suggested Solution
Computation of after tax cashflows
Depreciation =

10,000 - 0

Sh 2,000

5
Project A

Annual Cashflow

Cashflows before depreciation

Less Depreciation

4,000
2,000

Profits before taxes

2,000

Less taxes (50%)

1,000

Profits after tax

1,000

Add back depreciation

2,000

Cashflows after taxes

3,000

Project B
Year
3

1
4

Cashflow before depreciation

6,000 3,000 2,000 5,000 5,000

Less depreciation

2,000 2,000 2,000 2,000 2,000

67

Profits before taxes

4,000 1,000

0 3,000 3,000

Less taxes (50%)

2,000

500

0 1,500 1,500

Profits after taxes

2,000

500

0 1,500 1,500

Add back depreciation

2,000 2,000 2,000 2,000 2,000

Net cashflows after taxes

4,000 2,500 2,000 3,500 3,500

i.

Payback Period (PB)

Project A =

10,000

3 1/3 years

3,000
Project B
Sh 4,000 + Sh 2,500 + Sh 2,000 = Sh 8,500 is recovered in three years. The
remaining amount of Sh 10,000 - 8,500 = 1,500 is to be recovered in the
fourth year.
Thus PB =

3 years +

1,500

3 3/7 years

3,500
According to PB Project A is better.
ii.

Average Rate of Return (ARR)

Project A
Average income

5 x 1,000=

Shs 1,000

5
Average investment

= 10,000/2

68

Shs 5,000

ARR =

1,000

0.20 or 20%

5,000
Project B
Average income = 2,000 + 500 + 0 + 1,500 + 1,500
5
=

5,500

Shs 1,100

5
ARR

1,100

0.22 or 22%

5,000
According to ARR Project B is better.
iii. Net Present Value Method
Project A
NPV =

Annual Cashflows x PVIFA

10%, 5 years

- Initial Cost (where

PVIFA is the Present Value Interest Factor of annuity)

=

3,000 x 3.791 - 10,000 = Sh 1,373

Project B
NPV can be computed using the following table:

69

Year

CashflowsPV.F

10%

4,000

0.9093,636

2,500

0.8262,065

2,000

0.7511,502

3,500

0.6832,390.5

3,500

0.621 2,173.5

PV

Total PV 11,767
Less initial cost 10,000
NPV 1,767
Project B is better because it has a higher NPV.
iv.

Profitability index (PI)

Project A
PI

11,373

1.1373

1.1767

10,000
Project B
PI

11,767
10,000

Project B is better since it has a higher PI.

v.

The Internal Rate of Return

Project A
NPV =

3,000

PVIFA

r%, 5years

- 10,000 = 0
70

PVIFA

r%, 5years

10,000

3.333

3,000
From the table r lies between 15% and 16%. We use linear interpolation to
compute the exact rate.
PVIFA

15%

3.352

PVIFA

15%

3.352

PVIFA required =

3.333

PVIFA

Difference

0.019

Difference

IRR =

15% + (16 - 15)

16%

(0.019) =

3.274
0.078

15.24%

0.078
Project B
We use trial and error method since the cashflow are uneven:
NPV at 16% =

10,186 - 10,000

NPV at 17% =

186

9,960.5 - 10,000

71

(39.5)

Using Similar Triangle

IRR - 16 =

17 - IRR

186

39.5

39.5 (IRR - 16) =

186 (17 - IRR)

39.5 IRR - 632 = 3,162 - 186 IRR

225.5 IRR
IRR

3.794

16.8%

Project B is better because it has a higher IRR.

Generally, Project B should be selected because the discounted cashflow
methods supports this decision.Note: The methods discussed so far assume
that investment decisions are made under conditions of certainty. In real life,
however, this is not the case and therefore we shall consider risk and other
complications in the following sections.

72

Projects Selection under Capital Rationing

If a firm rations capital its value is not being maximised. A value maximizing
firm would invest in all projects with positive NPV. The firm may however want
to maximize value subject to the constraint that the capital ceiling is not to be
exceeded.A linear programming method can be used to solve constrained
maximization problems. The objective should be to select projects subject to
the capital rationing constraint such that the sum of the projects NPVs is
maximized.
Illustration
Management is faced with eight projects to invest in.

The capital

expenditures during the year has been rationed to Sh 500,000 and the
projects have equal risk and therefore should be discounted at the firm's cost
of capital of 10%.
Project

Cost

Project

t = 0(Shs) Life

CashflowNPV at the
per year

10% cost

400,000

20

58,600

98,895

250,000

10

55,000

87,951

100,000

24,000

28,038

75,000

15

12,000

16,273

75,000

18,000

3,395

50,000

14,000

3,071

250,000

10

41,000

1,927

250,000

99,000

(3,802)

Required:
Determine the optimal investment sets.
73

Max Z = 98,895 X1 + 87,951 X2 + 28,038 X3 + 16,273 X3 + ... + (3,802)

X8
400,000 X1 + 250,000 X2 + 100,000 X3 + ... + 250,000 X8

St 1 =
500,000
2 =

1 < X1, X2, X3 ... X8 > 0

The Optimal Budget:

Project Cost

NPV

250,000

87,951

100,000

28,038

75,000

16,273

75,000

3,395

500,000

135,657

ABANDONMENT VALUE
It has been assumed so far that the firm will operate a project over its full
physical life. However, this may not be the best option - it may be better to
abandon a project prior to the end of potential life. Any project should be
abandoned when the net abandonment value is greater than the present
value of all cash flows beyond the abandonment year, discounted to the
abandonment decision point. Consider the following example:
Project A has the following cashflows over its useful life of 3 years.
market value (Abandonment value) has also been given.
Year

Cash Abandonment
flow

value

Sh`000'

Sh`000'
74

The

(4,800)

4,800

2,000

3,000

1,875

1,900

1,750

Required:
Determine when to abandon the project assuming a discount rate of 10%.
Suggested Solution:
If the project is used over its life, the NPV is negative as shown below:
NPV =

2,000 x PVIF

10%, 1year

+ 1,875 X PVIF

10%, 2years

+ 1,750 X PVIF

10%, 2 yrs

4,800
=

2,000 x 0.909 + 1,875 x 0.826 + 1,750 x 0.751 - 4,800

Shs -119

The project should not be accepted.

However, if the project is abandoned

after 1 year the NPV would be

NPV =
=

2,000 x 0.909 + 3,000 x 0.909 - 4,800

Sh -255

If abandoned after 2 years

NPV =

2,000 x 0.909 + 1,875 x 0.826 + 1,900 x 0.826 - 4,800

=

Sh 136
75

The NPV is positive if the project is abandoned after 2 years and therefore this
is the optimal decision.
Note that abandonment value should be considered in the capital budgeting
process because, as our example illustrates, there are cases in which
recognition of abandonment can make an otherwise unacceptable project
acceptable. This type of analysis is required to determine projects economic
life.
Risk Analysis in Capital Budgeting

The Risk associated with a project may be defined as the variability that is
likely to occur in the future returns from the project. Risk arises in investment
evaluation because we cannot anticipate the occurrence of the possible future
events with certainty and consequently, cannot make any correct prediction
about the cashflow sequence.
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a) Risk aversion
(b) Desire for Risk
(c)

Indifference to Risk

A Risk averter is an individual who prefers less risky investment. The basic
assumption in financial theory is that most investors and managers are risk
averse.Risk seekers on the other hand are individuals who prefer risk. Given a
choice between more and less risky investments with identical expected
monetary returns, they would prefer the riskier investment.

76

The person who is indifferent to risk would not care which investment he or
she received.
To illustrate the attitudes towards risk assume two projects are available. The
cashflows are not certain but we can assign probabilities to likely cashflows as
shown below.
States of nature

Project A's Project B'sProbability

cashflow

cashflow

Sh 900,000

600,000

0.2

Moderate prediction

600,000

600,000

0.6

Pessimistic prediction

300,000

600,000

0.2

Optimistic prediction

The expected cashflow would be computed as follows:

Project A
Expected cashflow =
=

900,000 (0.2) + 600,000 (0.6) + 300,000 (0.2)

Sh 600,000

Project B
Expected cashflow =
=

600,000 (0.2) + 600,000 (0.6) + 600,000 (0.2)

Sh 600,000

Therefore, the two projects have the same expected cashflows (Sh
600,000). However, Project A is a riskier project since there is a chance
that the cashflow will be Sh 300,000. Project B on the other hand is a
less risky project since we are sure that Sh 600,000 will be received.

77

A risk seeker would choose Project A while a risk averter would choose
Project B. A risk neutral decision maker would be indifferent between the
two projects since the expected cashflows are equal.

Actual Measurement of Risk

A number of basic statistical devices may be employed to measure the

extent of Risk Inherent in any given situation. Two important measures
are:
(a) Standard deviation of cashflows
(b) Coefficient of variation
(c)

The Beta () can also be used and is dealt with under Portfolio
Analysis

To illustrate the first two methods, let us assume that we are examining
an investment with the possible outcomes and probability of outcomes as
shown below:
Note: the outcome could either be cashflow or NPV.
Assumptions (states of nature)

Outcome Sh`000'

Probability
Pessimistic

300

0.2

Moderately successful

600

0.6

Optimistic

900

0.2

The expected value which is a weighted average of the outcomes times their
probabilities can be computed as follows:

78

Expected value (D)=

DP

Where D is the outcome

P is the probability
D is the expected outcome
Figures in `000'
D

DP

300

0.2

60

600

0.6

360

900

0.2

180
DP 600

The expected value is therefore Sh 600,000. We can therefore compute

the standard deviation, which is given by the following formula.

Standard Deviation ( ) =

(D - D ) P

Computation of standard deviation

D

(D - D )

(D - D )2

(D - D )2 x P

300

0.2

-300

90,000

18,000

600

0.6

900

0.2

300

90,000

18,000
36,000

79

Standard Deviation ( ) =

(D - D ) P

36,000=SH 190,000

The standard deviation of Sh 190,000 gives a rough average measure of

how far each of the three outcomes falls away from the expected value.
Generally, the larger the standard deviation, the greater the risk.
However, to compare projects of unequal size, we need a different
measure since standard deviation would not do. Consider, for example
two projects with the following expected outcome and standard
deviation.
Project

Expected value

Standard deviation

Sh 6,000

600

Sh 600

190

To decide which of the two projects, is a more risky project we need to

compute the coefficient of variation (C.V)
The coefficient of variation is a relative measure and is given by the
following formula.

80

For investments Projects A and B discussed earlier, the coefficient of

variation can be computed as follows:Project A
CV =

600

0.100

6,000
Project B
CV =

190 =

0.317

600
Generally, the larger the coefficient of variation, the greater the risk.
Therefore, Project B carries a greater risk than Project A.
Another risk measure, the beta () is widely used with portfolios of
common stock. Beta measures the volatility of returns, on an individual
stock relative to a stock market index of returns.
(Note: Beta will be discussed under portfolio analysis).
Incorporating Risk in Capital Budgeting

Several methods can be used to incorporate risk into capital budgeting

decisions. Some of these methods are:
(a) Payback period
(b) Risk-adjusted discount rate
81

(c)

Certainty equivalents

(d) Sensitivity analysis

(e) Statistical techniques
1.

Payback
Payback period is an attempt to allow for risk in capital budgeting.
As discussed earlier, firms using Payback period usually prefer short
payback to longer ones, and often establish guidelines such that the
firm accepts only investments with some maximum payback period,
say three or five years.

This method suffers from the following

limitations:
(a) It ignores the time value of cashflows
(b) It does not make any allowance for the time pattern of the
initial capital recovered
(c)

Setting the maximum payback period as two, three or five years

usually has little logical relationship to risk preferences of
individuals or firms.

2.

Risk-adjusted discount rate

This approach uses different discount rates for proposals with different risk
levels. A project that carries a normal amount of risk and does not change the
overall risk composure of the firm should be discounted at the cost of capital.
Investments carrying greater than normal risk will be discounted at a higher
discount rate.The NPV of the project will be given by the following formula.

82

Ct
t Io
t=1 (1+ K )

NPV =

Where Ct is cashflows at period t

K is the risk adjusted discount rate
Io is initial cash outflow (cost of project)
Note that Kf +
Where Kf =

the risk-free rate

the risk premium

The following diagram shows a possible risk-discount rate trade off scheme.
Risk is assumed to be measured by the coefficient of variation, C.V)

83

The normal risk for the firm is represented by a coefficient of variation of 0.30.
An investment with this risk will be discounted at the firm's normal cost of
capital of 10%. As the firm selects riskier projects with, for example, a C.V. of
0.90, a risk premium of 5% is added for an increase in C.V. of 0.60 (0.90 0.30). If the firm selects a project with a C.V. of 1.20, it will now add another
5% risk premium for this additional C.V. of 0.30 (1.20 - 0.90). Notice that the
same risk premium was added for a smaller increase in risk.

This is an

example of being increasingly risk averse at higher levels of risk and potential
return.
Advantages of Risk-adjusted discount rate
(a) It is simple and can be easily understood.
(b) It has

a great

deal

of

intuitive

appeal

for

risk-averse

businessmen.
(c)

It incorporates an attitude (risk-aversion) towards uncertainty.

84

Disadvantages
(a) There is no easy way of deriving a risk-adjusted discount rate.
(b) It does not make any risk adjustments in the numerate - for the
cashflows that are forecast over the future years.
(c)

It is based on the assumption that investors are risk averse.

(Not all investors are risk averse as discussed earlier).

3.

Certainty Equivalent

Using this method the NPV will be given by the following formula:

t Ct t Io
(1
+
Kf
)
t=0

NPV =

Where Ct
t

Forecasted cashflows (without risk adjustment)

the risk-adjusted factor or the certainty equivalent

coefficient
Io

Initial cash outflow (cost of project)

Kf

risk-free rate (assumed to be constant for all period).

The certainty equivalent coefficient assumes a value between 0 and

1 and varies inversely with risk. Therefore, a lower t will be used if
greater risk is perceived and a higher t if lower risk is anticipated.
The coefficient are subjectively established by the decision maker and
represents the decision maker's confidence in obtaining a particular cashflow
in period t.The certainty equivalent coefficient can be determined by the
following formula.

85

certain net cashflow

risky net cashflow

For example, if an investor expects a risky cashflow of Sh 100,000 in period t

and considers a certain cashflow of Sh 80,000 equally desirable, the t will be:
t

80,000 =

0.8

100,000
Illustration:
Assume a project costs Sh 30,000 and yields the following uncertain
cashflows:
Year

Cashflow

12,000

14,000

10,000

6,000

Assume also that the certainty equivalent coefficients have been estimated as
follows:
0

1.00

0.90

0.70

0.50

0.30

The risk-free discount rate is given as 10%

Required
86

Compute the NPV of the project

Solution:

t Ct t Io
t=0 (1+ Kf )

NPV =
=
-

0.9 (12,000)

0.7 (14,000)

0.5 (10,000)

0.3 (6,000)

30,000
1 + 0.1

(1 + 0.1)3

(1 + 0.1)

(1 + 0.1)4

Using the present value interest factor tables:

Year

Certain Cashflows PVIF10%

(30,000)

PV

1.00

(30,000)

0.9 (12,000)

0.909

9,817.2

0.7 (14,000)

0.826

8,094.8

0.5 (10,000)

0.751

3,755.0

0.3 (6,000)

0.683

1,229.4
NPV (7,103.6)

The project has a negative NPV and therefore should not be undertaken.
Note that if risk was ignored the NPV would have been Sh 4,080 and the
project would have been accepted.
Merits of certainty equivalent approach

87

1.

This method explicitly recognises risk.

2.

It recognises that cashflows further away into the future are less
certain (therefore a lower t)

Demerits
1.

The method of determining t is subjective and is likely to differ from

project to project.

2.

The forecaster, expecting the reduction that will be made to his

forecasts, may inflate them in anticipation.

3.

When forecasts have to pass through several layers of management,

the effect may be to greatly exaggerate the original forecast or to
make it ultra conservative.

Sensitivity Analysis
Sensitivity Analysis is a way of analysing change in the project's NPV for a
given change in one of the variables affecting the NPV. It indicates how
sensitive the NPV is to changes in particular variables.

The more

sensitive the NPV, the more critical the variable.

Steps followed in use of Sensitivity Analysis
1.

Identification of all those variables which have an influence on the

projects NPV.

2.

Definition of the underlying (mathematical) relationship between

variables.

3.

Analysis of the impact of the change in each of the variables on the

projects NPV.

Sensitivity Analysis allows the decision maker to ask "what if" questions.
88

To illustrate let us consider an example. A project has annual cashflows

of Sh 30,000 and an initial cost of Sh 150,000.

The useful life of the

project is 10 years. The cashflows can further be broken as follows:

Sh
Revenue

375,000

Variable costs 300,000

Fixed costs

30,000

Depreciation

15,000

345,000

Before tax profit

30,000

Tax (50%)

15,000

After tax profits

15,000

Add back depreciation

15,000

Net annual cashflows

30,000

The cost of capital is 10% and depreciation method is straight line.

The NPV of the project is:
NPV =

30,000 x PVIFA

10%, 10 yrs

- 150,000

30,000 x 6.145 - 150,000

Sh 34,350

The NPV is positive and therefore the project is acceptable. However, the
investor should consider how confident he is about the forecast and what
would happen if the forecast goes wrong. A sensitivity can be conducted
with regard to volume, price, cost etc. In order to do so we must obtain
pessimistic and optimistic estimates of the underlying variables.

89

Assume that in the above example, the variables used in the forecasts
are:
(a) Volume of sale ( = market size x market share)
(b) Unit price
(c)

Unit variable costs

(d) Fixed costs

Assume further that the pessimistic, expected and optimistic estimates
are:
Variable

Pessimistic

Expected

Optimistic

Market Size

9,000

10,000

11,000

Market Share

0.004

0.01

0.016

Unit price (Sh)

3,500

3,750

3,800

3,000

2,750

30,000

20,000

Unit variable costs (Sh)3,600

Fixed costs (Sh)

40,000

The resulting NPVs would be:

NPV in shillings
Pessimistic

Expected

Optimistic

Market size

11,306.25

34,350

57,393.75

Market share

-103,912.5

34,350

172,612.5

Unit price

-42,462.5

34,350

49,712.5

Unit variable cost

-150,000

34,350

11,162.5

3,625

34,350

65,075

Fixed costs

90

Note that NPV under this category is:

Revenue =

Sh

3,750(9,000 x 0.01) = 90 x 3,750337,500

Variables cost = 3,000 (9,000 x 0.01) = 90 x 3,000270,000

Contribution margin

67,500

Less Fixed costs + Depreciation

45,000
22,500
11,250

Less tax

11,250

Add back depreciation

15,000

Net cashflows

26,250

NPV =
=

26,250 X 6.145 - 150,000

Sh 11,306.25

It is important to note that only one variable is allowed to vary at a time

and all the others are held constant (at their expected values).
It has been assumed that a negative pre-tax profit will be reduced by tax
credit from the government.
From the project the most dangerous variables appear to be market share
and unit variable cost.

If the market share is 0.004 (and all other

variables are as expected), then the project's NPV is -Sh 103,912.5. If

unit variable cost is Sh 3,600 (and all other variables are as expected),
then the project has an NPV of -150,000. Therefore the most sensitive
factor is the unit variable cost, followed by market share and unit price
follows. Market size and fixed costs are not very sensitive.

91

Break-Even Analysis

Sensitivity analysis is a variation of the break-even analysis.

In sensitivity

analysis we are asking; for example, what shall be the consequences if

volume or price or cost changes? This question can be asked differently: How
much lower the sales volume can become before the project becomes
unprofitable? To answer this question we shall require the Breakeven point.
Continuing with the above example, let us compute the level of units variable
costs above which the NPV is negative.
NPV =

Annual cashflows x PVIFA

10%, 10 yrs

- 150,000

But
Annual cashflows = Revenue - variable costs - Fixed costs - depreciation Tax + depreciation.
Let variable cost per unit be V
Annual cashflows = (375,000 - 100 (V) - 45,000)0.5 + 15,000
Therefore NPV = [(330,000 - 100 V) 0.5 + 15,000] x 6.145 - 150,000
At Break even point NPV = 0
Therefore (165,000 - 50 V + 15,000) 6.145 = 150,000
1,106,100 - 307.25v

= 150,000

307.25 V = 956,100
V

= 3,111.8

92

Therefore the point above which the variable cost per unit will cause the
NPV to be negative is about Sh 3,112.
To prove if variable unit cost is Sh 3,112 the NPV will be computed as
follows:
Sh
Revenue

375,000

Variable costs 311,200

Fixed cost

30,000

Depreciation

15,000

356,200
18,800

Tax

9,400
9,400

Add back depreciation

15,000

Net cashflows

24,400

NPV = 24,400 x 6.145 - 150,000

= -62
Note: The NPV is not equal to zero due to rounding off effects.
Advantages and disadvantages of Sensitivity Analysis
Advantages
1.

It compels the decision maker to identify the variables which affect

the cashflow forecasts.

This helps him in understanding the

investment project in totality.

93

2.

It indicates the critical variables for which additional information may

be obtained. The decision maker can consider actions which may
help in strengthening the "weak spots" in the project.

3.

It helps to expose inappropriate forecasts and thus guides the

decision maker to concentrate on relevant variables.

Disadvantages
1.

It does not provide clear cut results.

The terms optimistic and

pessimistic could mean different things to different people.

2.

It fails to focus on the interrelationship between underlying

variables. For example sales volume may be related to price and
cost but we analyse each variable differently.

A SIMULATION APPROACH TO CAPITAL BUDGETING UNDER RISK

In considering risky investments, we can use simulation to approximate the
expected return for an investment proposal. Thus simulation is one way of
dealing with the uncertainty involved in forecasting the outcomes of capital
budgeting projects or other types of decisions.The results of an investment
proposal are tested before it actually occurs. Each of the factors affecting the
projects NPV are assigned probability distributions. Example of these factors
are:
i.

Market size

ii. Selling price

iii. Market growth rate
iv. Share of market
v. Cost of the project
vi. Residual value
vii. Operating costs
viii.Fixed costs
ix. Useful life of project
94

Once the probability distributions are determined, the average rate of return
resulting from a random combination of the above nine factors is determined.
A computer can be used to carry out simulation trials for each of the above
factors. A simulation model relies on repetition of the same random process
as many times as possible. One of the benefits of simulation is its ability to
test various possible combination of events. This sensitivity testing allows the
planner to ask "what if" questions.
DECISION TREE FOR SEQUENTIAL DECISIONS
Illustration:
A project has the following cashflows
Year 1

Year 2

Cashflow Probability
60,000

80,000

100,000

0.3

0.4

0.3

Cashflow

Probability

50,000

0.3

60,000

0.5

70,000

0.2

60,000

0.3

80,000

0.5

100,000

0.2

80,000

0.3

100,000

0.5

120,000

0.2

The projects initial cash outlay is Sh 100,000 with a cost of capital of

12%.Required:
Determine:
(a) The projects expected monetary value (EMV)
(b) The projects NPV

95

96

NPV =

133,850.7 - 100,000 = 33,850.7

Merits of decision tree

1.

It clearly brings out the implicit assumptions and calculations for all
to see, so that they may be questioned and revised.

2.

The decision tree allows a decision maker to visualise assumptions

and alternatives in graphic form, which is usually much easier to
understand than more abstract, analytical form.

Demerits
1.

The decision tree can become more and more complicated as more
alternatives are included.

2.

It cannot be used for dependent variables.

Utility Theory

When discussing the expected value and the standard deviation we noted that
decision makers can either be risk seekers, risk averse or risk neutral.
Therefore, we cannot be able to tell with certainty whether a decision maker
will choose a project with a high expected return and a high standard
deviation, or a project with comparatively low expected return and low
standard deviation.Utility theory aims at incorporating the decision maker's
preference explicitly into the decision procedure. We assume that a rational
decision maker maximises his utility and therefore would accept the
investment project which yields maximum utility to him.
We can graphically demonstrate the three attitudes towards risk as follows:
97

98

Note that utiles is a relative measure of utility.

For the risk averse

decision maker, the utility for wealth curve is upward-sloping and is

convex to the origin. This curve indicates that an investor always prefer
a higher return to a lower return, and that each successive identical
increment of wealth is worth less to him than the preceding one - in other
words, the marginal utility for money is positive but declining.For

risk

seeker, the marginal utility is positive and increasing. For a risk neutral
decision maker, the marginal utility is positive but constant. To derive the
utility function of an individual, we let him consider a group of lotteries
within boundary limits.
Illustration: Derivation of utility functions

99

Assume that utiles of 0 and 1 are assigned to a pair of wealth

representing two extremes (say, Sh 0 and Sh 100,000 respectively). To
determine the utility function of a decision maker, we offer him a lottery
with 0.5 chance of receiving no money and 0.5 chance of receiving Sh
100,000.

Assume he is willing to pay Sh 33,000 for this lottery.

(Therefore 0.5 utile = Sh 33,000).

Next, consider a lottery providing a 0.4 chance of receiving Sh 33,000
and a 0.6 chance of receiving Sh 100,000.

Assume that the decision

maker is willing to buy this lottery at Sh 63,000. The utile value of Sh

63,000 is
U(Sh 63,000) = 0.4 U(Sh 33,000) + 0.6 U(Sh 100,000)
= 0.4 x 0.5 + 0.6 x 1
= 0.8
Assume also a lottery providing a 0.3 chance of receiving Sh 0 and a 0.7
chance of receiving Sh 33,000 is also offered.

The decision maker is

willing to pay Sh 21,000 for this lottery. The utile value for Sh 21,000 can
be computed as follows.
U (Sh 21,000) = (0.3 U(Sh 0) + 0.7 U(Sh 33,000)
= 0.3 x (0) + 0.7(0.5)
= 0.35
Note that other lotteries can be provided to the decision maker until we
have enough points to construct his utility function.
12.2

Expected utility of an investment

100

Once your utility function is specified, we can calculate the expected

utility of an investment.

This calculation involves multiplying the utile

value of a particular outcome by the probability of its occurrence and

adding together the product for all probabilities.
Illustrations:
Consider two investments that have cashflow streams and assonated
probabilities.
Project A
Cashflows Utiles
Sh-20,000

Prob.

Cashflows

0.10

Sh -25,000

0.10

60,000

0.60

0.60

80,000

0.80

0.50

-0.20

Project B
Utiles
-0.25

Prob.
0.10

0.20

50,000

0.50

0.50

100,000

1.00

0.20

The expected monetary value for Project A is

-20,000 (0.10) + 0(0.10) + 60,000 x (0.6) + 80,000 (0.20)
= Shs 50,000
For Project B
-25,000 (0.10) + 0 (0.20) + 50,000 (0.50) + 100,000 (0.20)
= Sh 42,500
Using the expected monetary value, Project A is preferred then Project B.
Using the utility values (utiles) the expected utility value is computed as
follows:

101

Project A
Utile

Project B

Prob.Weighted

Utile

Utility
-0.20

0.10

Prob.Weighted
Utility

-0.02

-0.25

0.10

-0.025

0.10

0.20

0.60

0.60

0.36

0.50

0.50

0.25

0.80

0.20

0.16

1.00

0.20

0.20

Expect utility value

0.54

0.425

Using utility values Project A should be accepted since it has a higher

utility value.
Advantages of utility approach
1.

The risk preferences of the decision maker are directly incorporated

in the capital budgeting analysis.

2.

It facilitates the process of delegating the authority for decision.

Limitations
1.

It is hard to determine the utility function (it is subjective).

2.

The derived utility function is only valid at a point of time.

3.

If the decision is taken by a group of people it is hard to determine

the utility functions since individuals differ in their risk preferences.

102

TOPIC 5: COST OF CAPITAL

A firm can be viewed as a collection of projects undertaken by it. Therefore
the firms cost of capital will be the overall, or average, or required rate of
return on the collection of investment projects. Therefore the firms cost of
capital is not the same thing as the projects cost of capital. Thus the cost of
capital is the required rate of return on the various type of financing the
overall cost of capital is the weighted average of the individual rate of return
(costs)

Importance of cost of finance

The cost of capital is a useful standard for:
1. EVALUATING INVESTMENT DECISION
1. The cost of capital is the discount rate used for evaluating the
desirability of an investment project in the IRR . The investment project
is accepted if the NPV is +ve in this case the COC is the minimum
required rate of return on an investment project or the certificate or
the target or the handle rate. It is the minimum required rate of return
on the investment project. It keeps the present wealth of shareholders
unchanged. In other words, It is a yard-stick against which the viability
of an investment is measured. If the cost of finance is more than the
return expected from such a venture, such a venture is deemed to be
not viable and the reverse is true.
2. DESIGNING A FIRMS DEBT POLICY
In designing the financing policy i.e. proportion of debt and equity in
the capital structure, the firm aims to minimizing the overall cost of
capital. Cost of finance will also be used to assess the companys

103

capital structure and whether this is optimum capital at which the cost
of finance is lowest or optimum.
3. APPRAISING

THE

FINANCIAL

PERFORMANCE

OF

THE

TOP

MANAGEMENT
This will involve a comparison of actual profit abilities of the
investment projects undertaken by the firm with the projected overall
cost of capital and the appraisal of the actual costs incurred by
management in raising the required funds. OR It is used to assess the
ability of the companys management to utilize the financial resources
at its disposal to generate profits.
4. DETERMINING A COMPANYS SHARE PRICES
The cost of finance in particular dividends on share capital will have a
lot of influence on the companys share prices which will be high if the
dividends are high and this will affect the companys ability to raise
extra finance be it in form of debt or equity finance
5. GAUGING THE AVAILABILITY OF FINANCE
The average cost of finance is used to gauge the availability of finance.
This means that if the cost is quite high, this will make it difficult to
raise the necessary finance needed for the companys operations. This
situation will affect the companys investments and thus its growth.

Factors that will influence the Cost of Finance

1. The term of finance
Usually short-term sources of finance are more expensive than longterm source of finance.
2. Economic conditions prevailing
104

Usually during inflation the cost of finance in particular debt will be

high. This is so because banks will usually adjust their rates of interest
to accommodate the loss of value of the purchasing power of a given
currency due to the effects of inflation.
3. Nature and size of the business
Small firms usually lack of the necessary securities/good will to allow
them to negotiate for better terms; moreover, lenders view small firms
as very risky given that most of them are sole proprietors which close
down the death of the owners. Due to these risky situations to which
they are exposed, lenders will charge high rates of interest to make up
for the risk they have exposed their investments to.
4. Availability of Finance
Under conditions of credit squeeze or other conditions that limit the
availability of finance, lenders will charge high interest rate to avail
such scarce finances.
5. The Government through the Central Bank will also influence the
cost of finance in particular debt finance this may be done to control
liquidity in the hands of the public in a bid to contain inflation. Under
these conditions, the central bank may instruct the commercial bank to
increase the bank rates so as to make borrowing very expensive so as
to encourage customers deposit in terms of saving. This will make the
cost of debt finance expensive.
6. Effect of taxation
debt finance carries an interest rate which is an expense chargeable to
the companys profit and loss account and as such the effective cost of
debt will be lower by the much of tax interest, e.g. if interest rate is
12% and a tax is 50%, then the effect cost of debt will be equal to 12%
less 50% of 12% = 6%. On the other hand the effective cost of share
capital is not tax allowable and as such will be relatively higher than of
that of debt finances.
105

7. Nature of security
This will affect the implicit costs. Usually if the security is a depreciable
asset like buildings, these will have to insured comprehensively and
this will increase the implicit cost of such finance. On the other hand if
the security was land, such implicit cost will not be warranted.
8. Growth stage of the company
Growing company will pay fewer dividends and will retain more so as
to plough back retained profit to acquire fixed assets. On the other
hand, mature companies will pay high dividends as they will have
reached their highest level of growth and thus profitability.

Cost of Different Types of Funds

1. COST OF DEBT
Debt may be raised through, borrowing funds from financial institutions or
debentures (bonds) for a specified period of time at a certain rate of interest.
A debenture may be issued at per or at a discount or premium. The cost of
debt capital already issued is the rate of interest (IRR) which equates the
current market price with the discounted future cash receipts of the security.
(i)

Irredeemable debt

This is a debt with no maturity. Will go into perpetuity.

Recall that
MV

i
r

MV

OR
i
Kd

Therefore :
Kd

i
MV

Where Kd = cost of debt

MV = issue price of debt/market price of debt.
106

i = interest = issue price x interest rate

EXAMPLE 1
Owen Allot Ltd has issued 10% debentures on of a nominal value of 100.
The market price is 90.

Calculate the cost of debt if the debenture is

irredeemable
Kd

i
MV

i
MV

Kd

Interest, i

10
x 100 = 10
100

10
x 100
90

= 11.1%
(ii) Redeemable Debt
Here the interest will be received in the year of redemption plus the
amount payable
On redemption.
MV

i MVn
i
i
1 +
2 +..+
(1 K d )
(1 K d )
(1 K d ) n

MVn = Amount Payable on redemption on year n.

Using example 1 above, calculate the cost of this capital, if the debenture is
redeemable after 10years.
90

10
10
10 100

..................................
(1 K d ) (1 K d )2
(1 K d )10

Here, we get the Kd using trial and error, like getting the IRR.
YEAR
Discount factor.
0

Cash Flow

Try 12%

PV ()
Market Value

(90)

1.000

10

5.650

100

0.322

(90.00)
1- 10

Interest

56.50
10

Capital Repayment

32.00
107

(1.30)
Try 11%

Discount factor

PVs ()

(90)

1.000

(90.00)

10

5.889

58.89

100

0.352

35.20
4.09
4.09

Thus the cost of debt, K d 11 ( 4.09 1.30) (12 11) 11.76%

Short cut;
Kd

1
1
( FV MV ) 10 (100 90)
11
n
10

X 100 11.56%
1
1
95
( FV MV )
(100 90)
2
2

Debt capital and taxation

Interest on debt capital is an allowable deduction for taxation. This is a tax
relief on interest.
(iii)

After tax cost of irredeemable debt capital is

Kd

i (1 T )
MV

Where Kd = cost of debt capital

i = Annual Interest payment
MV= Current market price of debt capital ex- interest i.e. after
payment of current interest.
t = rate of corporation tax.
Example

108

A company pays 10,000 p.a interest on irredeemable Debt Stock with a

nominal value of 100,000 and market price of 80,000 and corporation tax
rate is 35%.
Calculate the cost of debentures?
Kd

i (1 T ) 10,000(1 0.35) 1(0.65)

0.08125 8.125%
=
80,000
8
MV

The higher the corporation tax the greater the tax benefits having debt
finance compared with equity finance.
N.B
In the case of redeemable debenture, capital repayment is not allowable for
tax.
Example
Assume the same facts as example 1 for Owen PLC except that the market
price is 95% and the debentures are redeemable at per after 3yrs. Calculate
the Kd assuming corporation tax 35%.
Yr

MV ()

Interest ()

Tax Relief ()

Flow ()
0

(95)

(95)

10

10

(3.5)

6.5

10

(3.5)

106.5

(3.5)

(3.5)

100

10

COST OF PREFERENCE CAPITAL.

(i)

Irredeemable preference share

Cost kp;

Kp

PDiv
Po

Where Kp = Cost of preference share

PDIV = Expected preference divi dend
109

Net

Cash

Po= Issue of preference share

Example
A company issues 10% irredeemable preference share. The face value per
share is 100 but the issue price is 95. What is cost of preference share?
RECALL,
MV

D
r

And r
Div

Kp

(ii)

D
MV

10
x 100 10
100

10
0.1053
95

Therefore,

or 10.53%

Redeemable Preference Shares

This is a preference share with finite maturity. A formula similar to the one
for calculation of the market value of redeemable debt is used:
n

MV Po
t 1

DIVt
Pn

t
(1 K p )
(1 K p ) n

The cost of preference share is not adjusted for taxes are because preference
dividend is paid after the corporate taxes have been paid.
COST OF EQUITY CAPITAL.
New funds from equity shareholders are obtained in one of two ways;
(a)

from a new issue of share }External Equity

(b)

from retained earnings }Internal Equity

(c)
(i)

Cost of Retained Earnings ( Internal Equity)

The opportunity cost of capital of internal equity is the dividend foregone by

stockholders.
The cost of retained earnings will be the same as shareholders required rate
of return.

110

The dividend valuation model for a firm whose dividends are expected to
grow at a constant rate g , is as follows,
MV

Do (1 g )
Ke g

DIV1
Ke g

NB: D1 = Do (1+g)1
D2 = Do (1+g)

Dn

Do

(1+g)n

Where D1 = dividend at the end of year 1

Ke = shareholders required rate of return/Cost of Equity
g

= growth rate in dividends

Thus,
Ke

DIV1
g
MV

Ke

DIV1
MV

Where there is no growth in div,

This growth model is called Gordons growth model

Example
The share of a company is currently selling for Kshs. 100. The company
wants to finance its capital expenditure of Kshs. 10,000 either by retaining
earnings or selling new shares. If the Company sells new shares, the issue
price will be Kshs. 95, the div per share next year, DIV 1 is Sh.4.75 and it is
expected to grow at 6%. Calculate:(i)

The cost of internal equity (retained earnings)

Ke = DIV1 + g = sh.4.75 + 0.06 = 0.1075 or 10.75%
MV

(ii)

Sh.100

Cost of External Equity

This is the minimum required rate of return by equity shareholders.

111

Ke = DIV1

+g

MV
NB:

Shareholders required rate of return from retained earnings and

external equity is the same!

However, the cost of external equity is greater because of floatation
cost/issue costs. Thus the selling price of new shares may be less than the
market price.
Thus the cost of external equity can be written as;Ke = DIV1

+g

where f = floatation cost.

MV-f
Ke = DIV1

+g

where Io= Issue price of new equity.

Io
Example
In the example above calculate the cost of external equity;
Ke= 4.75 + 0.06
95
= 0.05 + 0.06
= 0.11 or 11%
Estimating growth rate
Recall that, Ke = DIV1 + g

Ke = Do(1+g) + g

MV
Thus,

MV

DIV1 = Do (1+g)1

112

Therefore

DIV2= Do (1+g)2
DIVn = Do (1+g)n

Where DIVn = dividend in year n

And

n = No of years before the dividend is paid

g= growth rate

Example:
The dividend earnings of HL Ltd over the last 5 years is as follows;
Year

Dividend (E)

Earnings (t)

1991

150,000

400,000

1992

192,000

510,000

1993

206,000

550,000

1994

245,000

650,000

1995

262,350

700,000

The company is financed entirely by equity and there are 1 million shares is
issued cash with a market value of 3.35 ex-div
(i)

What is the cost of equity

Solution
Ke = DIV1

+g

MV
DIV in 1991 x (1+g)4 = DIV in 1995
150,000 (1+g)4 = 262,350
113

Therefore (1+g)4 = 262,350 = 1.749

150,000
(1+g)4= 1.749
1+g = (1.749)

= 1+g = 1.14999
g = 1.14999 1
g = 0.14999
= 14.999% or 15%

Ke

DO (1 g )
g
MV

DO DIVIDEND PER SHARE

.0.26235(1 0.15)
0.15
3.35

262350
1000 000

= 0.24 or 24%

COST OF EQUITY CAPITAL AND CAPM

Based on the CAPM, Expected Return = Rf rate + Rp
Thus, Ri, = Rf + (Rm Rf) Bi
Therefore Ke = Rf + (Rm Rf) Bi
This is because the shareholders required rate of return is also the firms cost
of equity.

The Wacc Weighted Average Cost of Capital

Once the component costs have been calculated, they are multiplied by the
weights of the various sources of proportions of each source of fund in the
capital structure.

114

STEPS INVOLVED IN CALCULATING WACC

i)

Calculate the cost of specific sources of funds ie (Ke, Kd, etc)

ii)

Multiply the cost of each source by its proportion in the K structures.

iii)

WACC = K1 W1 + K2 W2 + K3 W3 + ---------------------------

Where k1 and K2 are component costs and W1 and W2 are the weights of
various types of capital employed by the company.
EXAMPLE 1
Prudence Co. is financed partly by equity and partly by debentures.

The

equity proportion is always kept at 2/3 of the total. The cost of Equity is
18% and that of debt is 12%. Calculate the WACC.
Source of capital

Proportion

Cost

Weighted

Cost

WACC
Equity
Debt

2/3
1/3

18%
12%

2/3 x 18
1/3 x 12

WACC=
Or

WACC=

12%

4%
16%

Wd Kd + WeKe
=

1/3 x 12 + 2/3 x 18

4 + 12

16%

EXAMPLE 3
The following is the capital structure of a firm:

Source

Amount (sh)

Equity Share capital

450,000

45%

Retained earnings

150,000

15%

Preference share capital

100,000

10%

115

Proportion (%)

Debt

300,000

30%

1,000,000
Revision Questions
Company XYZ, a geared company has financed its activities as follows;Ordinary shares- 100 000 shares @ Shs 10
40 000 8% debentures (par value Shs. 10/)
50 000 10% preference share of Shs. 10
Also the following information is provided;Ordinary shares are currently quoted at Shs. 25 and dividend of
Shs. 2 per share is expected by shareholders. These dividends have been
growing at 3% p.a.
Preference Shares currently sell at Shs. 15. Tax=40%
REQUIRED
Compute the weighted average cost of capital using the two methods (i.e
weighting approach and percentage approach)
Answer
Weighting Approach
The companys capital structure is as follows (currently) ;Ordinary shares- 100 000 @ Shs. 25

Shs. 2 500, 000

8% 40 000 debentures @ Shs. 10/-

Shs. 400, 000

10% preference shares 50 000 @ Shs. 15

Shs. 750 000

Total Capital Employed (TCE)

Shs 3,650,000

Cost of equality= Ce = Do x 100 +g

Po
= 2 x 100 +3%
25
=8+3=11%.
Cost of Preference Shares= Cp= DP x 100
PP
Dp =1 x100=6.67%.
116

15
Cost of debentures = Cd = bcd (1-t) x 100
Kd
Bcd

8 x10
80cts
100

0.8(1 0.4)
X 100
100
(0.8 X 0.6) X 100

Kd

0.048 OR 4.8%

Source

amount

proportion

after tax

Weighted

Cost
Ordinary

2,500,000

68.49%

11%

7.5339%

Preference

750,000

20.55%

6.67%

1.3707%

Debentures

400, 000

10.96%

4.8%

0.5261%

3,650,000

100%

9.4307

Percentage approach
Cost of equity = 2, 500, 000 x 11%

= 275, 000

Cost of preference share capital

=750, 000 x 6.67 %

= 50, 025

Cost of debentures = 400, 000 x 4.8 %

19, 200
344 245

TCCE
TCE

WACC=

To get g =

X 100 =

344225
X 100 = 9.4308%
3650000

Current Retained Earning

Opening equity

x 100

NOTE: where there is growth in equity, it is assumed that the company

has been in existences for sometimes which implies that floatation costs
were incurred at the time of issuing the shares
All the formulae will give percentage costs where the g = Ce =% of
total equity (i.e. in this case where there the no is cost of ordinary share
capital)
117

(d) Cost of retained earning has no explicit cost but opportunity cost which is
that dividend the shareholders have forgone to allow retention - thus the
cost of retained earnings will be the same as the cost of equity:
Cr

Do
X 100 g
Po

where Cr = cost of retained earning

(e) In case Ey is given then the cost of ordinary share
=EPS

x 100 => Ey approach

Po - f
Loan finance = Kd = I (1-t) =% cost
(a) Cost of preference share capital. This is the dividends due to preference
shareholders, but these are fixed. Thus the cost of preference of shares:
= Kp

Pdiv
X 100
Pp

Where Kp = cost of preference share

Pdiv =dividend for preference share
pp = price per share (market)
(b) If the company has incurred floatation costs to raise preferences shares,
then the cost of preference share capital will be:
= Cp =DP

x 100 where f = floatation cost

pp f
Cost of debt (before tax)
= bcd = I x debt finance used where tax is ignored giving allowance for
tax
= Cd = bcd I t

x 100

OR bcd (I x 100 (I - t))

pd t

Pd f

Where cd = after tax cost of debt

bcd = before tax cost debt
Pd = market price of debt
118

I = interest rate
This formula is used to determine the cost of debenture finance
Cost of loan finance = cd = I(I-t)=%
Where I = interest rate,

t = tax

NOTE
In case computing the cost of ordinary share capital and reserve, using
the market approach, it is advisable to combine them into equity.
Example 3
Information obtained from the books of Havabley and Edwin Ltd indicated
that;
1. This company sold 10,000 ordinary shares at shs. 100 with a
floating cost of shs. 20 each
2. It sold 5,000 preferences shares of shs. 100 at shs. 150 which carry
a dividend of 16%
3. It sold 5,000 shs. 100 10% debentures at shs. 80
4. It sold 10,000 shs. 50, 12% debentures with issue cost of shs. 15
This company hopes to earn a return on the above finances of 18%.
Required:

Compute the total cost of ordinary share capital

assuming that there will

be

40%
Answer
Cost of preference share capital
DP= 16% of 100 = Shs. 16
PP= 150
= Cp = Dp x 100 = Cp = 16 x 100 = 10.667%
Pp

150

Cost of debentures
= Cd = bcd (1-t) x 100 = Cd = 10(1-0.4) x 100
Pd

80

bcd = 10% of 100 = Shs. 10 = 10 (0.6) x 100 = 7.5%

80
119

retention.

Tax

Pd=80
Cd= bcd (1-t) x 100
Pd-f
bcd = 12% of 50= 6
pd = 50
f = 15
cd= 6(1-0.4) x 100
50.15

= 6(0.6) x 100 = 10.2857%

35

Source

Amount

proportion

Weighted

After tax
Shs.

Cost

Cost
Ordinary

1,000, 000

37.74%

x%

0.377x%
Preference

750,000

28.30%

10.667%

3.0189%
10% Debentures

400,000

15.09%

7.5%

500, 000

18.86%

10.2857%

1.131%
12 debentures
1.9399%

2,650,000

6.0906%
+ 0.377%
6.090% + 0.3774 x = 18%
0.3774x= 18% -6.090%
0.3774x = 11.9094 %
X = 11.9094% =31.556%
0.3774%
Proof

120

99.99%

Source

Amount

proportion

Weighted

After tax
Shs.

cost

cost
Ordinary

1,000, 000

37.74%

31.556%

28.30%

10.667%

11.9092%
Preference

750, 000

3.0189%
10% debentures

400,000

15.09%

7.5%

1.1318%
12 debentures

500, 000

18.86%

10.2587%

1.9399%
2, 650,000

99, 99%

17.9998%
=18%
Using Percentage Approach
Shs
Cost of ordinary shares

315, 560

= 31.556% of 1,000,000
Cost of preference shares
= 10.67 %

80,025

of 750, 000

Cost of debt
= 7.5 % of 400,000

30,000

Cost of debt
= 10.2857% of 500,000

51, 428.5

Total Cost of Capital Employed

477, 0135

(TCCE)
The Weighted Average Cost of Capital (WACC) =
Total Cost of Capital Employed x 100
Total Capital Employed
121

=477, 013.5 x 100 =18.00509

18.001%

2,650,000

Marginal cost of finance

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

Total cost of marginal finance x 100

Cost of finance (COF)

Cost of finance may be computed using the following information:

a)

i)

Marginal cost of each capital component.

ii)

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

Investors usually compute their return basing their figures on market

values or cost of investment.

b)

Investors purchase their investment at market value and as such, the

cost of finance to the company must be weighted against expectations
based on the market conditions.

c)

Investments appreciate in the stock market and as such the cost must
be adjusted to reflect such a movement in the value of an investment.
1.

Marginal cost of equity

MCE =

D1
x100
Po f

(for zero growth firm)

Also cost of equity

Ke =

D1
Po f

(for normal growth firm)

122

Where:

d1 = expected DPS = d0(1+g)

P0 = current MPS
f = floation costs
g = growth rate in equity
2.

Cost of preference share capital:

Kp =

Dp
x100
Po f

Where:

Kp = Cost of preference

Dp = Dividend per share

Po = MPS (Market price per share)
F = Flotation costs
3.

Cost of debenture

Kd

Int(1 T)
Vd f

Where:

Kd = Cost of debt

Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate
4.

Just like WACC, weighted marginal cost of capital can be

computed using:
i)

Weighted average cost method

ii)

Percentage method
123

Example
XYZ Ltd wants to raise new capital to finance a new project. The firm will
issue 200,000 ordinary shares (Sh.10 par value) at Sh.16 with Sh.1 floatation
costs per share, 75,000 12% preference shares (Sh.20 par value) at Sh.18
with sh.150,000 total floatation costs, 50,000 18% debentures (sh.100 par)
at Sh.80 and raised a Sh.5,000,000 18% loan paying total floatation costs of
Sh.200,000.

Assume 30% corporate tax rate.

The company paid 28%

ordinary dividends which is expected to grow at 4% p.a.

Required
a)

Determine the total capital to raise net of floatation costs

b)

Compute the marginal cost of capital

Solution
a)
Ordinary

Sh.000
shares

200,000 3,200,000

shares @ Sh.16

200,000

3,000

Less floatation costs 200,000 1,350,000

shares @ Sh.1
Preference

shares

shares @ Sh.18

(150,000
75,000 )
3,000,000

Less floatation cost

Debentures

3,000

-____
50,000 5,000,000

debentures @ Sh.80
Floatation costs

1,200

4,800

(200,000 12,000
)

Loan
Less floatation costs
Total capital raised

124

b)

Marginal cost of equity Ke

Ke

d 0 (1 g )
g
P0 f

d0

28% x Sh.10 par =

4%

Sh.1.00

P0

Sh.16

Therefore marginal

Ke

Sh.2.80

2.80(1.04)
0.04
16 1

= 0.234 = 23.4%

Marginal cost of preference share capital Kp

Kp

dp
P0-f

dp

12% x Sh.20 par =

Sh.2.40

P0

Sh.18

Floatation cost per share

Sh.150,000 = Sh.2.00

75,000 shares
Kp

2.40 =

0.15 =

18 2
Marginal cost of debenture Kd:
Kd

Int (1-t)
Vd-f

0
125

15%

Vd

Sh.80

Int

18% x Sh.100 par=

30%

Kd

18(1-0.3)

Sh.18

0.1575

15.75%

80
Marginal cost of loan Kd
Kd

Int (1-t)
Vd-f

30%

Vd

Sh.5 million

Sh.0.2 million

Int

18% x Sh.5M = Sh.0.9M

Kd

0.9 (1-0.3)

0.13125

5 0.2
Source

Amount to %

Maturity

raise

cost

before

marginal
f. cost

costs

Sh.000

Sh.000
3,200

23.4%

748.8

shares

1,350

15.0%

203.5

Preference

3,000

15.75%

472.5

shares

5,000

13.13%

656.5

Ordinary

Debenture

12,550

2,080.3

Loan
126

13.13%

Weighted marginal cost =

2,080.3 x 100

16.58%

12,550

TOPIC 6: MEASURING BUSINESS PERFORMANCE

FINANCIAL RATIO ANALAYSIS
Financial ratio analysis is a process by which finance identifies the companys
financial performances by comparing the entities in the balance sheet and
those in the profit and loss account (P&L). This is so because balance sheet
entities are usually responsible for those to be found in the P&L i.e. assets
shown in the balance sheet are responsible for sales, revenue and expenses
to be found in the P&L.

Users of Ratios
This analysis is important to various parties with a financial stake in the
company. These include:
1.

Shareholders Actual owners are interested in the companys both

short and long term survival. For this reason they will use ratios such as:
a)

Profitability ratios which seek to establish viability.

b)

Dividend ratios which seek to establish return to owners in form of

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

127

2.

Creditors (trade) these are interested in the companys ability to

meet their short-term obligations as and when they fall due. For this reason
they will use ratios such as:
a)

Liquidity ratio a qualitative measure of companys liquidity position

measured by acid test ratio.

b)

Current ratio which is a measure of companys quantity of current

assets against current liabilities.

3.

Long term lenders These include finances through loans, mortgages

and debenture holders. These have both short and long term interest in the
company and its ability to pay not only interest on debt but also principal as
and when it falls due. These parties are interested in the following:
a)

Liquidity ratios used to assess short-term liability to meet

current obligations.
b)

Profitability ratios used to ascertain whether the company can

pay its principal back.

c)

Gearing ratio used to gauge the companys risk in the

investment.
d)

Investment coverage ratio shows the companys safety as

regards the payment of interest to the lenders of the debt.

4.

Directors and management of company They will therefore be

interest in:
a)
b)

Efficiency of the company in generating profits.

The companys viability from the investors point of view and the

companys ability to generate sufficient returns to investors.

c)

Gearing ratio to gauge the safety and risk associated with

the company.

128

5.

Potential investors these parties are interested in a company in total

both on short and long term basis in particular the companys ability to
generate acceptable return on their money.
Therefore, they will use:

6.

a)

Dividend ratios

b)

Return ratios

c)

Gearing ratios

Government

The

Government

is

interested

mostly

in

utility

companies (e.g. KPLC, KPTC) and those that will provide public services in
this case the government will be interested in their survival and thus ability
to provide those services.

It may be interested in taxation derived from

these companies which is used for development. Government may also be

interested in employment level and as such it will use those ratios that can
enable it to achieve such objectives of particular importance are:

7.

a)

Profitability ratios

b)

Return ratios

Competitors These are interested in the companys performance from

the market share point of view and will use the ratios that enable them to
ascertain companys competitive strength e.g. profitability ratios, sales and
returns ratio etc.
8.

General public Customers and potential customers These are

interested in the ability of the company to provide good services both in the
short and long run. To gauge the companys ability to provide goods and
services on short and long term basis. We have:
a) Returns ratio
129

b) Sales ratio

Yard Stick Used In Ratio Analysis

1. Past performance of the company
The companys past performance (past ratio) is used to measure or gauge
the companys performance and in particular the change in performance
whether good (favourable), better, same or even worse than the past. Such
comparison is then used to interpret the companys performance bearing in
mind the factors that influenced the present and past performances.
2. Average industry ratios
These are useful as they indicate the average performance of various
companies in a given industry i.e. it gives the minimum performance of a
number of companies in a given industry. These ratios are useful in so far as
to enable the analyst to make a reasonable comparison of the companys
performance vis--vis other companies in the same industry. However, for
this yardstick to be useful the term average should include those companies
which are not extremely. I.e. very strong and very weak companies which
should be excluded to arrive at industry average figures.
3. Ratio of successful companies
Useful if the company can get figures of competitors who are leading in the
market so as to enable it to gauge its performance against better
performance. However this information is difficult to obtain and sometimes it
calls for private investigators e.g. Private Eyes Ltd.
4. Ratio of budgeted performance
These are compared with actual performance ratios and investigations are
made of any unfavorable variance which should be explained.

130

Classification of Ratios
Ratios are broadly classified into 5 categories:
1.

Liquidity ratios

2.

Turnover ratios

3.

Gearing ratios

4.

Profitability ratios

5.

Growth and valuation ratios

INCOME STATEMENT AND

INCOME STATEMENT/BALANCE
SHEET RATIOS

BALANCE SHEET
RATIOS

DEBT RATIOS
LIQUIDITY RATIOS

(a)

3. COVERAGE RATIOS
4. ACTIVITY RATIOS
5. PROFITABILITY RATIOS

Liquidity Ratios:
Measure a firms ability to meet short-term/current obligations. They
asses the liquidity position of a firm i.e. does the firm suffer from
lack of liquidity/or insolvency? Or does the firm hold excess
liquidity?
NB: Short term obligations are the current liabilities

1. Current Ratio =

CurrentAss ets (CA)

CA
or
CurrentLia bilities (CL )
CL

It indicates the availability of current assets in shillings/

dollars for every one dollar/shilling of current liability.

2. Quick/Acid Test Ratio =

CurrentAss ets Inventory

CurrentLia bilities (CL)

131

This shows the firms ability to meet current liabilities

with the most liquid (quick) assets.

3. Cash Ratio =

Cash Marketable sec urities

x%
Current Liabilities

Cash is the most liquid asset and its equivalent may be

compared with current liabilities
4.

Net Working Capital Ratio

Net Working Capital (NWC) = CA CL
NWC Ratio =

(b)

NWC
Net Assets

Leverage Ratios/Capital Structure Ratios/Debt Ratios

These are ratios that show the extent to which the firm is financed
by debt.
1.

TotalDebt

Debt to Equity Ratio = Shareholde r ' sEquity

This ratio tells creditors contribution for each sh. of
owners contribution. The lower the ratio the higher the
level of the firms financing that is being provided by
shareholders and the happier the creditor.

2.

Debt Ratio =

TotalDebt
TD
TotalDebt (TD)

CapitalEmp
loyed
NA
TotalDebt Networth

It shows the proportion of finance provided by lender.

3.

Capital Employed to Net worth) =

(share and reserve)

132

CapitalEmployed
Networth

(c)

Coverage Ratios
These are ratios that indicate a firms ability to service or cover
interest and other fixed charges.
1. Interest Coverage Ratio =

Earning Before Interest and Taxes ( EBIT )

Interest Expenses

= x times
Shows the number of times the interest charges are covered
by funds that are ordinarily available for their payment.
EBDIT
Loan
Re payment
2. Fixed Charges Coverage Ratio =
Interest (
)
1 tax rate

NB: EBDIT => Earning Before Depreciation, Interest and Taxes

The above ratio is extended to cover other fixed obligations. Fixed
EBDIT
Sinking Fund Payment
Charge Coverage Ratio =
Interest Lease Payments
1-tax rate

(d)

Activity Ratios/Turnover Ratios/Efficiency Ratio

Ratios that measure how effectively a firm is using its assets. They
indicate the speed with which assets are being converted into sales.
1.

Cost of Goods sold

Inventory Turnover Ratio = Average Inventory x times

Average Inventory =

Beginning Inventory Ending inventory

2

It gives the number of times inventory of financial goods is

turned into sales.
360

2.

Days of Inventory Holding= Inventory turnover x days

3.

Debtors Turnover = Average Debtors x times

Credit Sales

Average Debtors =

Debtors at the beg. of period Ending Debtors

2

133

4.

Average Collection Period =

Average Debtors
x 365 x days
Credit Sales

Gives the average number of times for which debtors remain

outstanding in a year.
5.

Sales
x times
Total Assets NFS CA

Total Assets Turnover =

This shows the firms ability in generating sales from all financial
resources committed to total assets.
6.

Net Assets Turnover =

Sales
xtimes
Net Assets

Net Assets = Net Fixed Assets + Net Current Assets (CA-CL)

Sales
xtimes
Net Fixed Assets

7.

Fixed Assets Turnover =

8.

Current Assets Turnover =

Sales
xtimes
Current Assets

The above two ratios measure the efficiency of utilizing both

current assets and fixed assets.
9.

Average

Creditors

payment

period

Average Creditors
x363 xdays
Credit Purchase

e.

Profitability Ratios:
These are calculated to show the operating efficiency of a company.
The major types of profitability ratios are calculated:

I.

Profitability in relation to sales

Profitability in relation to investment

PROFITABILITY IN RELATION TO SALES:

1. Gross Profit Margin =

Gross Profit
x 100
Net Sales

134

Reflects the efficiency with which the management produces each

unit of product

2. Net Profit Margin =

Net Profit Profit after tax

x100 x%
Net Sales
Sales

Measures a firms profitability of sales after taking account of all

expenses and income taxes.

3. Contribution Ratio =

Sales Variable exp enses Contributi on

Sales
Sales

This ratio is also called profit/volume or PV ratio

4. Operating Expenses Ratio =

Operating (cost sell. dist exp.) exp.

Sales

This is a yardstick for operating efficiency Explains the As in II

margin (EBIT) to sales ratio.
II.

PROFITABILITY IN RELATION TO INVESTMENT

1. Return on Investment (RO1) =

Net profit after taxes

x100 x%
Total assets

It gives the profitability per sh. of sales.

2. Return on Equity (ROE) =

Profit after tax

x100 x %
Net worth

It indicates how well the firm has used the resources owned. It
tells

of

the

earning

power

of

shareholders

book

value

investments.

3. Return on Assets =
4. Return

on

Net profit after tax

x100 x%
total asets (FA CA)

Shareholders

Net profit after tax - prefer. divid.

Shareholders fund (Equity Capital)

135

funds

5. Basic Earnings Power=

EBIT (Earning before interest and tax)

Total Assets

MARKET VALUE RATIOS

These reflect the risk and return. They show how the firm does in the stock
market.
Pr ofit After Tax

1.

Earnings per share = Total Number of Shares

Shows the profitability of a firm on a per share basis.

2.

Dividend

per

share(DPS)=

Earnings paid to sharholders (Dividends)

Number of ordinary shares outstanding
DPS

Divident per share

Dividend payout ratio = EPS Earning per share x100

3.

NB: 1 -

DPS
Retention Ratio
EPS Retention Earning - Dividends

Growth in equity, g = Retention ratio X return on Equity (ROE)

Divident per share

DPS

4.

Dividend Yield = Market Value per share MV x100

5.

Earning Yield = Market value per share MV x100

Earning per share

EPS

The above two ratios evaluate the shareholders return in relation

to market value of the shares.

6.

Price-Earnings Ratio =

Market Value per share

MV

Earning per share

EPS

It reflects investors expectations about the growth in the firms

earnings.
136

7.

Market value per share

MV

Market to Book Value Ratio = Book value per share BV

Net worth

Book value = No of ordianry shares

It measures the difference between the companys worth and the
funds the shareholders have put in it.
8.

Torbins q -> this is the ratio of the market value of a firms asset

or
(equity and debt) to its assets replacement costs.
Market value of assets

Torbins q = Replacement cost of assets

Firms will have incentive to invest when q is greater than 1.

Importance Of Ratio Analysis

1. It provides greater clarity, perspective or meaning to the data and it
brings out information not otherwise apparent.
2. It guides management in formulating future financial policies.
3. It throws light on the efficiency of the business organizations.
4. It ensures effective cost control.
5. It measures profitability and solvency of a concern
6. Helps in investment decisions
7. Inter firm comparisons of data.

Permits the data to be measured

against yardsticks of performance or sound financial controls.

Limitations in Using Ratio Analysis

1. It is difficult to decide on the proper basis of comparison.
137

2. The comparison is difficult because of differences in situations of two

companies or one company over years.
3. Price-level changes make interpretations difficult.
4. Ratios are generally calculated from past financial statements and thus
are no indicators of future.
5. Lacks standard values for ratio and therefore scientific analysis not
possible.
6. It fails to indicate immediately where the mistake/error lies.
7. Seasonal factors can affect ratio analysis.
8. The basis of asset valuation can be misleading
9. A set of accounts never shows a complete picture of a companys
activities.

QUESTION One
a) KAMWERETHO Ltd. A medium sized company has just released its
financial results for the ending financial year alongside the results for
the previous financial year.
KAMWERETHO Ltd.

Balance sheet as at 31 October

2006

2007

Sh. 000

Sh. 000

Cash

15,250

24,400

Accounts receivable

80,320

77,800

Inventory

98,600

158,800

Total current assets

194,170 261,000

Land and buildings

25,230

27,600

Machinery

33,800

26,400

Other fixed assets

14,920

28,200

Total assets

268,120 343,200
138

Accounts and notes payable

34,220

73,760

Accruals

15,700

34,000

49,920

107,760

Long term debt

60,850

60,858

Ordinary share capital

115,000 115,000

Retained earnings

42,350

Total current liabilities

59,582

268,120 343,200

KAMWERETHO

Ltd. income statement for the year ending 31

October
2006
Shs. 000

2007
Shs. 000

Sales (all on credit)

827,000

858,000

Cost of sales

(661,600)

(710,000)

Gross profit

165,400

148,000

General and administration expenses

(63,600)

(47,264)

Other operating expenses

(25,400)

(31,800)

Earnings before interest and tax (EBIT)

76,400

68,936

Interest expenses

(12,800)

(26,800)

Net income before taxes

63,600

42,136

Taxes

(25,400)

(16,854)

Net income

38,200

25,282

Number of shares issued

4,600,000

Per share data:

139

4,600,000

Earnings per share (EPS)

Shs.8.30

Shs. 5.50

Dividend per share (DPS)

Shs.1.75

Market price (average)

Shs.48.90 Shs.13.25

Shs.1.75

Required:
Calculate for each year:
i.
ii.
iii.
iv.
v.
vi.

Quick ratio
Inventory turnover ratio
Average collection period
Fixed assets turnover
Price earnings ratio
Debt/Equity ratio

QUESTION

(2marks)
(2marks)
(2marks)
(2marks)
(2marks)
(2marks)

Two

The following information represents the financial position and financial

results of Aminata limited for the year ended 31st December 2006.
Amanita Limited
Trading Profit and loss Account for the year ended 31 st
December 2008
Kshs.000

140

Kshs. 000

Sales

300

Cash

,000
-

600

Credit

,000
210,000
660,000

Less: cost of sales

900
,000

870,000

opening sock

150,000

Less: closing stock

Gross Profit

13,100

Less expenses

15,000

Depriciation

20,900

Directors emoluments

4,000

720
,000
180,
000

General expenses
Interest on loan
Net profit before tax
Corporation tax at 30%

4,800
10,000

(53,000)

Preference dividend

127

Ordinary dividend

,000
(38,100)
88
,900
14
,800
74
,100

141

Aminata limited
Balance sheet as at 31st December 2008

Kshs.000
000

Kshs.

Kshs. 000

Fixed

assets

213,000
Current assets
Stocks

150,000

Debtors

35,900

Cash

20,000

205,900

Current Liabilities
Trade Creditors

60,000

Corporation tax

63,500

Proposed Dividend

14,800

67,600
281,500
Financed by:
142

138,300

Ordinary Share capital (Kshs 10 par value)

8% Preference shares

100,000
60,000

Revenue reserves

81,500

10% Bank Loan

40,000

281,500

Additional Information
1.

The companys ordinary shares are selling Kshs 20 in the

stock market.

2.

The company has a constant dividend payout of 10%.

Required
a) Determine the following ratios
i)

Acid test ratio

(2 Marks)

ii)

Operating ratio

(2 Marks)

iii)

Return on capital employed

(2 Marks)

iv)

Price earning ratio

(2 Marks)

v)

Interest coverage ratio

(2 Marks)

vi)

Total assets turnover

(2 Marks)

vii)

Debtors collection period

(2 Marks)

143

b) Outline any six limitations of using ratios as a basis for financial analysis
(6 Marks)

144

TOPIC 7: DIVIDEND POLICIES AND DECISIONS

Dividend policy determines the division of earnings between payments to
stock holders ad re-investment in the firm. It therefore looks at the following
aspects:
i).

How much to pay this encompassed in the four major alternative

dividend policies.
Constant Amount Of Dividend Per Share
Constant Payout Ratio
Fixed Dividend Plus Extra
Residual Dividend Policy
ii)

When to pay paying interim or final dividends

iii)

Why dividends are paid this is explained by the various theories

which has to determine the relevance of dividend payment i.e.:

Residual dividend theory
Dividend irrelevance theory (MM)
Signalling theory
Bird in hand theory
Clientele theory
Agency theory
iv)

How to pay: cash or stock dividends.

Importance of Dividend Decisions

Dividends decisions are integral part of a firms strategic financing
decision.

It is therefore a plan of action adopted by management e.g

payment of high dividends means less retained earnings and the firm may
have to go to the market to borrow for investment purposes.
increase its gearing level.
145

This will

Solution to the Dividend Puzzle

A firms dividend decision may have some relevance to the firms share
value.

The managers therefore requires to formulate an optimal dividend

policy which will maximize the wealth of the shareholders (value of shares).

Does the change in dividend policy affect the value of the firm?

Different theories have been advance to answer this question.

Some

consider dividend decision relevant; others consider it irrelevant.

WALTERS MODEL OF DIVIDEND RELEVANCE
According to Prof James E Walter, dividend policies almost always affect the
value of the firm. His model clearly shows the importance of the relationship
between the firms rate of return, r, and its cost of capital, k, in determining
the dividend policy that will maximise the wealth of shareholders.
ASSUMPTIONS OF WALTERS MODEL

Internal Financing: The firm finances are investment through retained

earnings. Debt or new equity is not issued.

Constant return and cost of capital: The firms rate of return, r and its
cost of capita, k, are constant

100% payout or retention:

All earnings are either distributed as

dividends or reinvested internally immediately.

Constant EPS and DPS (Dividend per Share): Any given values of EPS
and DPS are assumed to remain constant forever.

Infinite time: The firm has a very long infinite time.

146

Walters formula to determine the market price per share is as follows:

DPS r ( EPS DPS ) / k

k
k

Where

P = Market price per share

DPS = Div per share
EPS = Earning per share
R

= Firms average rate of return

= Firms cost of capital or capitalization rate

The equation above reveals that the market price per share is the sum of the
present value of two sources of income
(i) The PV of the infinite stream of constant dividends. DPS/k
(ii) PV of infinite streams of capital gains {r (EPS-DPS)/k}
Thus, the value of a share is the PV of all dividends plus the PV of all capital
gains as shown above.
This can be simplified to:

DPS r / k ( EPS DPS )

k

WALTERS MODEL CAN BE SUMMARIZED AS FOLLOW:

i)

Growth Firm: r>k

Growth firms are those firms expanding rapidly because of investment

opportunities yielding higher return than opportunity cost of capital. These
147

firms will maximise the value per share if they follow a policy of retaining all
earnings for investment.
Therefore, the market value per share of such a firm is maximum when it
retains all the earnings. The optimum POR for a growth firm is zero. Market
Price per Share (MPS) increase as POR (Payout Ratio) declines.

ii) Normal firms: r=k

For a normal firm with r=k, dividend policy has no effect on market value per
share in Walters model
Declining firms: r<k
These are firms with no profitable investment opportunities to invest in the
earnings.

Investors on such firms could like earnings to be distributed to

them so as to spend it or invest it elsewhere to get a higher rate of return

than that earned by declining firms.
Its market value will be higher if it does not retain anything at all. Optimum
POR=100%
Market value per share increases as POR increases.
Thus dividend policy in Walters Model depends on:

Availability of investment opportunities

Relationship between the firmss IRR, r and cost of capital k.

Illustration:
The EPS of a company are Sh 8. It has an internal rate of return of 17% and a
capitalization rate of its risk class is 16%. If Walters model is used;
What should be the optimum payout ratio?
What will be the price of the share at this payout?
How shall the price of the share be affected if a different payout were
employed?
148

CRITICISMS OF WALTERS MODEL

The model assumes no external financing and shareholders wealth is

maximized when total earnings are retained.

However, in a more

comprehensive model, outside financing would raise new funds to

finance investment.

It is an erroneous policy that investment stops. When r=k as it will fail

to optimise shareholders wealth.

Firms cost of capital or discount rate, k, does not remain constant since
it changes directly with the firms risk.

GORDONS MODEL OF DIVIDEND RELEVANCE

This model relating the market value of firm to dividend policy was
developed by Myron Gordon.
It is based on the following assumptions:

The firm is an all equity firm, and has no debt.

No external financing is available. Retained earnings used to finance

expansion.

The internal rate or return, r, of a firm is constant.

Cost of capital remains constant.

The firm and its strings of earnings are perpetual

Corporate taxes do not exist

retention ratio is constant

cost of capital is greater than growth rate, k>b

According to Gordons dividend, capitalisation model, the market value of a

share is equal to the PV of an infinite stream of dividend to be received by
the shareholders.

Thus, Po = DIV1 + DIV2

(1+K)1

+.. + DIV
(1+K)

(1+K)2
149

=
t 1

DIV (1 g ) t
(1 k ) t

Divided per share is expected to grow when earnings are retained.

DPS = P O R x E P S
This allows earnings to grown at a rate of g, = b x r

b=retention ratio
r= rate or return

Thus;
PO

t 1

DIV (1 g )1 DIV (1 g ) 2

+
(1 k )1
(1 k ) 2

DIV (1 g ) 3
(1 k ) 3

++

DIV (1 g )
(1 k )

DIV (1 g ) t
(1 k ) t

This equation becomes

PO

DIV1
(k g )

or

EPS (1 b)
k br

Under Gordons model:

The market value of the share, P0 increases with retention ratio,

b for

growing firms is r>k

The market value of the share Po increases with POR (1-b) for declining firms
with r<k
The market value of the shares is not affected by dividend policy when r=k
Thus, Gordons model conclusions are similar to those of Walters model and
thus both suffer similar limitations.

How Much to Pay: Alternative Dividends Policies

a) Constant payout ratio

150

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

b) Constant amount per share (fixed D.P.S.)

The DPS is fixed in amount irrespective of the earnings level. This creates
certainty and is therefore preferred by shareholders who have a high reliance
on dividend income.
It protects the firm from periods of low earnings by fixing, DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a
fixed return. The DPS could be increased to a higher level if earnings appear
relatively permanent and sustainable.
c) Constant DPS plus Extra/Surplus
Under this policy a constant DPS is paid every year. However extra dividends
are paid in years of supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and
the shareholders are given a chance to participate in super normal earnings
The extra dividends is given in such a way that it is not perceived as a
commitments by the firm to continue the extra dividend in the future. It is

151

applied by the firms whose earnings are highly volatile e.g agricultural
sector.
d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment
decisions have been financed.

Dividend will only be paid if there are no

profitable investment opportunities available. The policy is consistent with

shareholders wealth maximization.

When to Pay
Firms pay interim or final dividends. Interim dividends are paid at the middle
of the year and are paid in cash. Final dividends are paid at year end and
can be in cash or bonus issue.

Dividends Theories (Why Pay Dividends)

The main theories are:
1. Residual dividend theory
Under this theory, a firm will pay dividends from residual earnings i.e.
earnings remaining after all suitable projects with positive NPV has been
financed.
It assumes that retained earnings is the best source of long term capital
since it is readily available and cheap. This is because no floatation costs are
involved in use of retained earnings to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will
be a reserve for financing investments.
Dividend policy is irrelevant and treated as a passive variable.
affect the value of the firm. However, investment decisions will.

152

It will not

Advantages of Residual Theory

1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of
earnings which requires no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if
retention is high.
A high retention policy may enable financing of firms with rapid and high rate
of growth.
3. Tax position of shareholders
High-income shareholders prefer low dividends to reduce their tax burden on
dividends income.
They prefer high retention of earnings which are reinvested, increase share
value and they can gain capital gains which are not taxable in Kenya.
ii) MM Dividend Irrelevance Theory
Was advanced by Modiglian and Miller in 1961. The theory asserts that a
firms dividend policy has no effect on its market value and cost of capital.
They argued that the firms value is primarily determined by:
Ability to generate earnings from investments
Level of business and financial risk
According to MM dividend policy is a passive residue determined by the
firms need for investment funds.
It does not matter how the earnings are divided between dividend payment
to shareholders and retention. Therefore, optimal dividend policy does not
exist.

Since when investment decisions of the firms are given, dividend

decision is a mere detail without any effect on the value of the firm.
153

They base on their arguments on the following assumptions:

No corporate or personal kites
No transaction cost associated with share floatation
A firm has an investment policy which is independent of its dividend policy (a
fixed investment policy)
Efficient market all investors have same set of information regarding the
future of the firm
No uncertainty all investors make decisions using the same discounting
rate at all time i.e required rate of return (r) = cost of capital (k).
iii) Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty.

Dividends

payments are more certain than capital gains which rely on demand and
supply forces to determine share prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the
bush (uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value
since shareholders will require to use lower discounting rate.
MM argued against the above proposition.

They argued that the required

rate of return is independent of dividend policy.

They maintained that an

investor can realize capital gains generated by reinvestment of retained

earning, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and
capital gains.
iv) Information signaling effect theory

154

Advanced by Stephen Ross in 1977. He argued that in an inefficient market,

management can use dividend policy to signal important information to the
market which is only known to them.
Example If the management pays high dividends, it signals high expected
profits in future to maintain the high dividend level. This would increase the
share price/value and vice versa.
MM attacked this position and suggested that the change in share price
following the change in dividend amount is due to informational content
of dividend policy rather than dividend policy itself. Therefore, dividends
are irrelevant if information can be given to the market to all players.
Dividend decisions are relevant in an inefficient market and the higher the
dividends, the higher the value of the firm.

The theory is based on the

following four assumptions:

The sending of signals by the management should be cost effective.
The signals should be correlated to observable events (common trend in the
market).
No company can imitate its competitors in sending the signals.
The managers can only send true signals even if they are bad signals.
Sending untrue signals is financially disastrous to the survival of the firm.
v) Tax differential theory
Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital
gains. Therefore, a firm that pays high dividends have lower value since
shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the
value of the firm and vice versa.
155

Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital
gains are tax exempt.
vi) Clientele effect theory
Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different
preferences for dividends depending on their level of income from other
sources.
Low income earners prefer high dividends to meet their daily consumption
while high income earners prefer low dividends to avoid payment of more
tax. Therefore, when a firm sets a dividend policy, therell be shifting of
investors into and out of the firm until an equilibrium is achieved. Low,
income shareholders will shift to firms paying high dividends and high
income shareholders to firms paying low dividends.
At

equilibrium,

dividend

policy

will

be

consistent

with

clientele

of

shareholders a firm has. Dividend decision at equilibrium are irrelevant since

they cannot cause any shifting of investors.
vii) Agency theory
The agency problem between shareholders and managers can be resolved
by paying high dividends. If retention is low, managers are required to raise
additional equity capital to finance investment. Each fresh equity issue will
expose the managers financing decision to providers of capital e.g. bankers,
investors, suppliers etc. Managers will thus engage in activities that are
consistent with maximization of shareholders wealth by making full
disclosure of their activities.
156

This is because they know the firm will be exposed to external parties
through external borrowing.

Consequently, Agency costs will be reduced

since the firm becomes self-regulating.

Dividend policy will have a beneficial effect on the value of the firm. This is
because dividend policy can be used to reduce agency problem by reducing
agency costs. The theory implies that firms adopting high dividend payout
ratio will have a higher value due to reduced agency costs.

How to pay dividends (mode of paying dividends)

1.

Cash and Bonus issue

2.

Stock split and reverse split

3.

Stock repurchase

4.

Stock rights/rights issue (to discuss in class)

1. Cash and bonus issue

For a firm to pay cash dividends, it should have adequate liquid funds.
However, under conditions of liquidity and financial constraints, a firm can
pay stock dividend (Bank issue)
Bonus issue involves issue of additional shares for free (instead of cash) to
existing shareholders in their shareholding proportion.
Stock dividend/Bonus issue involves capitalization of retained earnings and
does not increase the wealth of shareholders. This is because R. Earnings is
converted into shares.
Advantages of Bonus Issue
a) Tax advantages
Shareholders can sell new shares, and generate cash in form of capital gains
which is tax exempt unlike cash dividends which attract 5% withholding tax
which is final
157

b) Indication of high profits in future:

A Bonus issue, in an inefficient market conveys important information about
the future of the company.
It is declared when management expects increase in earning to offset
additional outstanding shares so that E.P.S is not diluted.
c) Conservation of cash
Bonus issue conserves cash especially if the firm is in liquidity problems.
d) Increase in future dividends
If a firm follows a fixed/constant D.P.S policy, then total future dividend would
increase due to increase in number of shares after bonus issue.
Journal entry in case of bonus issue

NB:

Dr.

R. Earnings (par value)

Cr.

Ordinary share capital (par value)

A firm can also make a script issue where bonus shares are directly

from capital reserve.

2. Stock Split and Reverse Split
This is where a block of shares is broken down into smaller units (shares) so
that the number of ordinary shares increases and their respective par value
decreases at the stock split factor.
Stock split is meant to make the shares of a company more affordable by low
income investors and increase their liquidity in the market.
Illustration

158

ABC Company has 1000 ordinary shares of Sh.20 par value and a split of 1:4
i.e one stock is split into 4. The par value is divided by 4.
1000 stocks x 4 = 4000 shares
par value = 40 = Sh.5
5
Ordinary share capital = 4000 x 5 = Shs.20,000
A reverse split is the opposite of stock split and involves consolidation of
shares into bigger units thereby increasing the par value of the shares. It is
meant to attract high income clientele shareholders. E.g incase of 20,000
shares @ Shs.20 par, they can be consolidated into 10,000 shares of Shs.40
par. I.e. (20,000 x ) = 10,000 and Sh.20 = x 2 = 40/=
3. Stock Repurchase
The company can also buy back some of its outstanding shares instead of
paying cash dividends.

This is known as stock repurchase and shares

repurchased, (bought back) are called treasury Stock. If some outstanding

shares are repurchased, fewer shares would remain outstanding.
Assuming repurchase does not adversely affect firms earnings, E.P.S. of
share would increase.

This would result in an increase in M.P.S. so that

capital gain is substituted for dividends.

Advantages of Stock Repurchase
1.

It may be seen as a true signal as repurchase may be motivated by

management belief that firms shares are undervalued.

inefficient markets.
2. Utilization of idle funds
159

This is true in

Companies, which have accumulated cash balances in excess of future

investments, might find share reinvestment scheme a fair method of
returning cash to shareholders.
Continuing to carry excess cash may prompt management to invest unwisely
as a means of using excess cash.
Example
A firm may invest surplus cash in an expensive acquisition, transferring value
to another group of shareholders entirely.

There is a tendency for more

mature firms to continue with investment plan even when E (K) is lower than
cost of capital.
3. Enhanced dividends and E.P.S.
Following a stock repurchase, the number of shares issued would decrease
and therefore in normal circumstances both D.P.S. and E.P.S. would increase
in future.

However, the increase in E.P.S is a bookkeeping increase since

total earnings remaining constant.

4. Enhanced Share Price
Companies that undertake share repurchase, experience an increase in
market price of the shares.

This is partly explained by increase in total

earnings having less and/or market signal effect that shares are under value.
5. Capital structure
A companys managers may use a share buy back or requirements, as a
means of correcting what they perceive to be an unbalanced capital
structure.
If shares are repurchased from cash reserves, equity would be reduced and
gearing increased (assuming debt exists in the capital structure).

160

Alternatively a company may raise debt to finance a repurchase. Replacing

equity with debt can reduce overall cost of capital due to tax advantage of
debt.
6. Employee incentive schemes
Instead of cancelling all shares repurchase, a firm can retain some of the
shares for employees share option or profit sharing schemes.
7. Reduced take over threat
A share repurchase reduces number of share in operation and also number of
weak shareholders i.e. shareholders with no strong loyalty to company
since repurchase would induce them to sell.
This helps to reduce threat of a hostile takeover as it makes it difficult for
predator company to gain control. (This is referred as a poison pill) i.e. Co.s
value is reduced because of high repurchase price, huge cash outflow or
borrowing huge long term debt to increase gearing
Disadvantages of stock repurchase
1. High price
A company may find it difficult to repurchase shares at their current value
and price paid may be too high to the detriment of remaining shareholders.
2. Market Signaling
Despite directors effort at trying to convince markets otherwise, a share
repurchase may be interpreted as a signal suggesting that the company
lacks suitable investment opportunities. This may be interpreted as a sign of
management failure.
3. Loss of investment income
The interest that could have been earned from investment of surplus cash is
lost.
161

Factors

to

consider

in

paying

dividends

(factors

influencing

dividend)
1. Legal rules
a)

Net purchase rule

States that dividend may be paid from companys profit either past or
present.
b)

Capital impairment rule: prohibits payment of dividends from capital

i.e. from sale of ssets. This is liquidating the firm.

c)

Insolvency rule: prohibits payment of dividend when company is

insolvent. Insolvent company is one where assets are less than liabilities.
Insolvent company is one where assets are less than liabilities. In such a
case all earnings and assets of company belong to debt holders and no
dividends is paid.
2. Profitability and liquidity
A companys capacity to pay dividend will be determined primarily by its
ability to generate adequate and stable profits and cash flow.
If the company has liquidity problem, it may be unable to pay cash dividend
and result to paying stock dividend.
3. Taxation position of shareholders
Dividend payment is influenced by tax regime of a country e.g in Kenya cash
dividend are taxable at source, while capital are tax exempt.
The effect of tax differential is to discourage shareholders from wanting high
dividends. (This is explained by tax differential theory).
4. Investment opportunity

162

Lack of appropriate investment opportunities i.e. those with positive returns

(N.P.V.), may encourage a firm to increase its dividend distribution. If a firm
has many investment opportunities, it will pay low dividends and have high
retention.
5. Capital Structure
A companys management may wish to achieve or restore an optimal capital
structure i.e. if they consider gearing to be too high, they may pay low
dividends and allow reserves to accumulate until a more optimal/appropriate
capital structure is restored/achieved.
6. Industrial Practice
Companies will be resistant to deviation from accepted dividend or payment
norms within the industry.
7. Growth Stage
Dividend policy is likely to be influenced by firms growth stage e.g a young
rapidly growing firm is likely to have high demand for development finance
and therefore may pay low dividend or a defer dividend payment until
company reaches maturity. It will retain high amount.
8. Ownership Structure
A dividend policy may be driven by Time Ownership Structure e.g in small
firms where owners and managers are same, dividend payout are usually
low.
However in a large quoted public company dividend payout are significant
because the owners are not the managers.

However, the values and

preferences of small group of owner managers would exert more direct

influence on dividend policy.

163

9. Shareholders expectation
Shareholder clientele that have become accustomed to receiving stable and
increasing div. Will expect a similar pattern to continue in the future.
Any sudden reduction or reversal of such a policy is likely to dissatisfy the
shareholders and may result in a fail in share prices.
10. Access to capital markets
Large, well established firms have access to capital markets hence can get
funds easily
They pay high dividends thus, unlike small firms which pay low dividends
(high retention) due to limited borrowing capacity.
11. Contractual obligations on debt covenants
They limit the flexibility and amount of dividends to pay e.g. no payment of
dividends from retained earnings.
Dividend ratios
1.

Dividend per shares (DPS)

Earnings to ordinary shareholders

Number of ordinary shares

Indicate cash returns received fro every share holder.
2.

Dividend yield (DY)

DPS

MPS

Indicate dividend returns for every shilling invested in the firm.

3.

Dividend cover

DPS

DPS
164

Indicate the number of times dividends can be paid out of earnings of

shareholders. The higher the DPS the lower the dividend cover.
4.

Dividend Payout Ratio =DPS

EPS

Shows the proportion of Earnings which was paid out as dividends and how
much was retained.

165

TOPIC 8: FINANCIAL PLANNING

In this lecture we will discuss short-term financial planning which aim at

projecting future profits and future cash needs. The key outputs of the
financial planning process are the cash budget, pro-forma income statement,
pro-forma balance sheet, and a number of operating budgets.
Operating Financial Plans
The financial planning process begins with long term plans, which are based
on the firms long term strategic goals. Short financial plans (operating
plans) implement as much as possible the long term strategies. The focus in
this lesson is on the operating (short term) budgets.
A key task of financial management is to look ahead to plan. An operating
plan of action is a statement of what is to be done in some future period,
how it is to be done, and the likely impact of the actions.
Importance of financial planning
Planning confers the following rewards to an organization:
Insurance against risk
Careful planning helps a firm identify likely future contingency and prepare
for them. Plans are not only helpful as a guide to action but may be required
by external parties when they have to deal with the firm (i.e. lenders)
Decision making
Planning, essentially, is making decisions in advance about what is to be
done in future. Financial planning helps a firm make decisions in advance on
how to deal with the uncertainties regarding the amounts, timing and nature
of future financing requirements
Communication
166

Plans are useful in the communication with important outside parties,

including investors and other suppliers of funds.

By coming to the

bargaining table with a comprehensive plan, a firms management sends a

confidence invoking signal and gains a psychological advantage in the
bargaining process.
Co-ordination
A planning system improves co-ordination in an organization.

The basic

elements of the financial plan are the cash budget and the projected income
statement and the balance sheet. The building blocks for these three are
myriad detailed operating budgets (including personnel budget, production
budget, purchasing budget) representing time-phased schedule of the
expenditures, people, material and activities required to accomplish the
objectives set forth in the overall financial plan. Without co-ordination such
meshing could be a daunting task.
Control
Management control systems are based on comparisons of actual data
versus plans. By comparing actual versus plan data at frequent intervals,
deviations can be detected as events unfold, and timely corrective action
can

be taken. Production schedules can be modified, advertising budgets

increased, collection efforts intensified or expenses cut.

In sum, cash

budgets and pro-forma financial statements are indispensable in achieving

good control.

Time frame for financial planning

Regardless of the kind of plan a manager is developing recognition of the
importance of time is essential. Plans either fall under long range,
intermediate or short range plans.

167

Long range financial planning: Covers several time periods, from

five years to as long as several decades. Long range plans are
mainly associated with activities such as major expansion of
products or facilities, development of top managers, large issues of
stocks or change of manufacturing systems. Top managers are

responsible for long range financial planning in most organizations.

Intermediate financial planning: range in time from one year to five
years. Because of the uncertainties associated with long range
plans, intermediate plans are the primary concern of most
organizations. They are usually developed by both top and middle
management. They are the building blocks in the pursuit of long

range plans.
Short range financial planning: covers time periods of one year or
less. They focus on day to day activities and provide a concrete
base

for

evaluating

progress

towards

the

achievement

of

intermediate and long range plans.

Financial Planning Process
The process of generating short-term financial forecasts is depicted in Figure
11.1 below. A systems approach is necessary for development of the
budgets. They input is the sales forecast, from productions are prepared then
the cash budget and the pro-forma income statement and finally the proforma balance sheet. The steps are summarized as:
1.

Establish a sales projection.

The key input to preparation of cash budgets is the firms revenue
(sales) forecast. It is on the basis of this forecast that the manager
predicts cash receipts, cash outlays, fixed asset requirements and
the amount of outside financing that will be necessary. The sales
forecast could be eternally based (i.e. on the national GDP)
internally based or a combination of the two.

168

2.

Determine a production schedule and the associated use of raw

materials, labour, overheads and operating expenses. The number
of units produced will depend on the beginning inventory, the sales
projections, and the desired level of ending inventory

3.

Prepare the pro-forma income statement and the cash budget.

4.

Finally, develop the pro-forma balance sheet.

Figure 11.1
Short term financial planning process

169

Current
period
balance
sheet

Sales
projection

Production
plans

Pro-forma
income
statement

Pro-forma
balance
sheet

Cash
budget

Other
supportive
budgets

Barriers to Financial Planning

(a) Environmental Barriers
Most organizations operate in environments that are complex and dynamic
where the environmental factors keep changing rapidly e.g. technology,
politics and economic conditions. These changes make it harder to develop
effective plans. Plans may become obsolete even before they are executed.
(b) Poor Goal Setting

170

The beginning step in financial planning is goal setting. If the goals set are
unrealistic either they are unattainable or too low. This will hinder effective
financial planning.
(c) Resistance to Change
By its very nature, financial planning involves change. Fear of the unknown,
preferences for status quo and economic insecurity causes organizational
members including managers to resist change and as such resist financial
planning that might cause such change.
(d) Time and Expense
Lack of time or financial resources can limit financial planning. Financial
planning takes time and the managers face many pressures and these
pressures may cause them to resist financial planning.
(e) Other Constraints
Various situational constraints such as labour contracts, government
regulations, scarce resources, natural factors and disasters may all affect
financial planning.
Avoiding the Barriers
Certain guidelines if followed by managers can help them deal with the
roadblocks to financial planning. These include:
(a) Financial planning should start at the top
Top managers should set the goals and strategies that lower level managers
will follow. Top management committed is crucial for any plan to actualise.
(b) Planners should recognize the limits
Managers must recognize that no financial planning system is perfect.
Financial planning has limits and cannot be done with absolute precision.
(c) Communication
Vertical communication within the organization hierarchy can facilitate
financial planning. People should be let to know what is expected of them at
all times.
171

(d) Participation
Managers who are involved in financial planning are more likely to know
what is going on and therefore be motivated to contribute.
(e) Integration
As much as possible the long term, intermediate and short range plans must
be properly integrated and the better they are integrated, the more effective
the organizations overall financial planning system.
(f) Contingency financial planning
Managers should develop alternative actions that a company might follow if
conditions change.

Why people fail in financial planning

Besides the barriers outlined above there are several other reasons why
people fail in financial planning. Summarized these reasons are as follows:
i.

Lack of commitment to financial planning

ii.

Confusion of financial planning studies with plans

iii.

Failure to develop and implement sound strategies

iv.

Lack of meaningful objectives and goals

v.

Underestimation of the importance of financial planning premises

vi.

Failure to see the scope of plans

vii.

Failure to see financial planning as a rational process

viii.

Excessive reliance on experience

ix.

Lack of top management support

x.

Lack of adequate control measures

NB: Managers should remove obstacles to financial planning and try and
establish a climate in which subordinates must plan. The following guidelines
could help managers to establish a climate conducive to financial planning

172

i.

Financial planning must not be left to chance

ii.

Financial planning should start at the top

iii.

Financial planning must be organized

iv.

Financial planning must be clear and definite

v.

Goals, strategies, policies and premises must be communicated

clearly
vi.

Managers must participate in financial planning

vii.

Financial planning must include awareness and acceptance of

change

Preparing Financial Forecasts

Two key outputs of short-term financial planning are:(i)

cash budgeting

(ii)

Pro-forma financial statements

We will from now hence in this lecture concentrate on the preparation of

these statements.
Cash Budgets
The cash budget is a statement of the firms planned cash inflows and
outflows over a period of time. Typically a cash budget may be for a year,
divided into smaller time intervals. Its main uses are enable the firm foresee
any future deficits in cash and hence make prior arrangement to obtain
necessary bridging short term financing (overdraft and short term loans): in
the case of a surplus cash, a plan can plan for beneficial short term
investments (marketable securities).The general format of a cash budget is
as follows:Cash receipts
Less

JANUARY
XXX
cash XXA

FEBRUARY
XXG
XXH

disbursements
173

Net cash flow

Add beginning

XXB
cash XXC

XXI
XXD

balance
Ending cash balance
XXD
Less
minimum XXE

XXJ
XXK

balance
Required

XXL

total

financing
Excess cash balance

XXF

Lets now examine the two main components of the cash budget.

Cash Receipts
Cash receipts include all of a firms cash inflows during the period. The most
common sources of cash are cash sales, collections from debtors, other
operating receipts and capital receipts from sales of fixed assets, borrowings
and issue of shares. Depending on the credit terms offered to customers, and
their payment habits, a schedule for collections from debtors could be
necessary working for the preparation of the budget..

Cash Disbursement
The most common cash disbursements are cash purchases of stock,
payment to creditors, payment of expenses like rent, wages, and utilities,
purchase

of

fixed

assets,

interest

payments,

dividend

distributions,

repayment of loans and payment of taxes. Depreciation and other non cash
charges are not included in the cash budget.
Example
The actual sales and purchases for Sirikwa Importers Ltd. for September and
October 2005, along with its forecast sales and purchases for the period
November, 2005 through April, 2006, follows:174

MONTH

SALES

PURCHASES

September

Sh.000
210,000

Sh.000
120.000

(actual)
October

250,000

150.000

(actual)
November
December
January
February
March
April

170.000
160.000
140.000
180.000
200.000
250.000

140.000
100.000
80.000
110.000
100.000
90.0000

The firm makes 20% of all sales for cash and collects on 40% of its sales in
each of the 2 months following the sale. Other cash inflows are expected to
be Sh. 12 million in September and April, Sh. 15 million, in January and March
and Sh. 27 million in February. The firm pays cash for 10% of its purchases.
It pays for 50% of its purchases in the following month and for 40% of its
purchases 2 months later.
Wages and salaries amount to 20% of the preceding months sales. Rent of
Sh.20 million per month must be paid. Interest payments of Sh.10 million
are due in January and April. A principal payment of Sh.30 million is also
one in April.

The firm expects to pay cash dividends of Sh.20 million in

January and April. Taxes of Sh.80 million are due in April.

The firm also

expects to make a Sh.25 million cash purchase of fixed assets in December.

The firm had a cash balance of Sh.22 million at the beginning of November
and wishes to maintain a minimum balance of Sh.15 million
Required:
(a)

A cash budget for the six months November through April

175

(b)

If the firm were requesting a line of credit to cover needed financing for
the period November to April, how large would this line of credit have
to be? Explain.

Solution (a)
SIRIKWA IMPORTERS LTD
CASH BUDGET FOR NOVEMBER TO APRIL
Novemb

Decemb

Januar

Februar March

April

er

er

Sh

Sh 000

Sh 000

Sh 000

Sh

Sh 000

000

156,000

168,00

202,000

27,000

0
15,000

12,000

175,00 183,00

183,0

214,00

00

140,000

114,00

91,000

97,000

103,000

34,000
20,000

0
32,000
20,000
10,000

28,000
20,000

30,000
20,000

40,000
20,000
10,000
30,000
20,000
80,000

000
Cash
Receipts
Receipt from 218,000
sales
Other

200,000

160,00
0
15,000

cash

inflows
218,000

200,000

Cash
Disburseme
nts
Payment

for 137,000

purchases
Wages
50,000
Rent
20,000
Interest
Principal
Dividend
Taxes
Purchase of

20,000
25,000

Fixed assets
207,000
Net cash flow

11,000

219,000

196,00 139,00

153,0

303,00

(19,000)

0
0
(21,000 44,000

00
30,000

0
(89,000)

)
176

Add

22,000

33,000

14,000

(7,000)

37,000

67,000

balance
Ending cash

33,000

14,000

(7,000

37,000

67,00

(22,000

Less

15,000

15,000

)
15,000

15,000

0
15,000

)
15,000

1,000

22,000

beginning

minimum
balance
Required

37,000

total
financing
Excess cash 18,000

22,000

balance
(b)

52,00
0

The company should ask for a line of credit of Sh.37 million to cater for
the biggest cash requirement of Sh.37 million in the month of April,
2006.

WORKINGS
Collection
from
debtors

Cash

Novemb

Decemb

Januar

Februar March

April

er

er

Sh.00

Sh.00

Sh.000

Sh.000 Sh.00

Sh.000

32,000

0
28,000

36,000

40,000

50,000

68,000

64,000

56,000

72,000

80,000

100,000

68,000

64,000

56,000

72,000

sales 34,000

(20%)
First
month 100,000
after

sales

(40%)
Second
month

84,000
after

sales (40%)
177

218,000
Payment

200,000

160,00

156,00

168,00

202,00

to

creditors
Novemb

Decemb

Januar

Februar March

April

er

er

Sh.00

Sh.00

Sh.000

Sh.000 Sh.00

Sh.000

14,000

10,000

0
8,000

11,000

10,000

9,000

(10%)
One
month 75,000

70,000

50,000

40,000

55,000

50,000

60,000

56,000

40,000

32,000

44,000

140,000

114,00

91,000

97,000

103,00

Cash
purchase

after
purchase
(50%)
Two
months 48,000
after
purchase
(40%)
137,000

Coping With Uncertainty In Budgets

Two ways of coping with uncertainty is budgets are:
1) Prepare several budgets based on pessimistic, most likely ad optimistic
forecasts. This is a sensitivity analysis or a what of approach that
can give a financial manager a sense of the riskiness of alternatives.
1) Simulation By simulating the occurrence of sales and other uncertain
events the firm develops a probability distribution of the ending cash

178

flow for each period. The amount of financing necessary during the
period can then be determined.

Exercise
The following information related to the proposed budget for K.K Ltd for the
months ending 31 December 1996.

Material

Production

Administrati

Sales

Purchas

Wage

Overheads

on
Overheads

Sh.

es
Sh.

s
Sh.

Sh. 000

Sh. 000

000

000

000

July
August
Septemb

72000
97000
86000

25000
31000
25500

10000
12100
10600

6000
6300
6000

5500
6700
7500

er
October
Novemb

88600
102500

30600
37000

25000
22000

6500
8000

8900
11000

er
Decemb

108700

38800

23000

18200

11500

Month

er
Additional Information
1. Depreciation expenses are expected to be 0.5%of sales.
2. Expected cash balance in hand on 1 July 1996 is Sh. 72,500,000
3. 50% of total sales are cash sales
4. Assets are to be acquired in the months of August and October at Shs.
8,000,000 and Shs. 25,000,000 respectively

179

5. An application has been made to the bank for the grant of a loan of Shs.
30,000,00 and it is hoped that it will be received in the month of
November
6. It is anticipated that a dividend of Shs. 35,000,000 will be paid in
December
7. Debtors are allowed one months credit
8. Sales commission at 3% on sales is paid to the salesmen each month
Required
A cash budget for the six months ending 31 December 1996.

Benefits/advantages Cash budget

It records the cash inflows and outflows, which are expected to take place in
respect of each functional budget. It may be prepared for a period span of
one week, month or quarter of the budget period.

It has the following

benefits/advantages:
It ensures that sufficient cash is available when required.
It shows whether capital expenditure projects can be financed internally.
It indicates the cash needed for current operating activities.

It indicates the effect the position of each seasonal requirements, large

stocks, unusual receipts and laxity in

collecting account receivable.

It indicates the availability of cash for taking advantage of discounts.

It reveals the availability of excess cash so that short-term investments
may be considered.
It serves as a basis for evaluating the actual cash management
performance of responsible managers.
PROFIT PLANNING AND PROFORMA STATEMENTS

180

Profit planning relies in accrual concepts to project the firms profit and
financial position.

The projection requires the determination of various

account balances for revenues, expenses, assets and equities using a variety
of procedures as shown in Figure 11.1. Pro-forma statements represent the
goals and objectives of a firm for a planning period. They are a guide to
action and are used in controlling operations.
Figure 11.2
Development process of the pro-forma income statement

Sales Proforma

Production
plan

Production
income
statement

Figure 11.3
Development of a pro-forma balance sheet

181

Current
Balance
Sheet

Pro-forma
balance
sheet

Pro-forma
income
statement
analysis
Cash
budget
analysis

The

three

basic

inputs

necessary

for

preparing

pro-forma

financial

statements are:
1) Financial statement information for the proceeding year.
2) The sales forecast for the coming year
3) The assumption that financial relationships reflected in the firms
financial statements will remain unchanged in the coming year
Example
Loitokitok Manufacturing Company Limited (LMCL) makes retread tires which
it sells for Sh.1,550. Mr.Lopos is the majority owner and manages the
inventory and finances of the company. He has collected the following
information to help him project the financial needs and position of the
company for the first quarter of the year just started
.
182

Sales for the following five months are estimated to be as follows:

January

1,700 tires

February

1,200 tires

March

1,400 tires

April

2,000 tires

May

2,500 tires

Last year LMCLs sales were Sh.1,750,000 in November while December

sales amounted to Sh.2,325,000 on 1,500 tires.
Past history shows that LMCL collects 50 per cent of its accounts receivable
in the month following the month of sale, and other 50 per cent in second
month after the month of sale. The company pays for its materials 30 days
after receipt. In general, at the end of each month, Lopos likes to keep
inventory enough to supply the anticipated sales for the following two
months ales. Inventory at the beginning of December was 2,600 units. (This
was not equal to the desired two-month supply)
The major cost of production is the purchase of inventory worn-out second
hand tires, which are passed through a red hot chemically treated solution,
formed, hardened and finished in the same month the scrap tires are
received. Last year the average cost of worn-out tires was Sh.520 per tire ,
but Mr. Lopos has just been notified that the scrap tires now have alternative
uses, and their cost will rise effective beginning of January to Sh.600 per tire.
The company uses FIFO inventory accounting. Labor cost s are relatively
stable at Sh200 per tire since workers are paid on a piecework

basis.

Overhead is allocated at Sh.100 per tire, and selling and administrative

expenses are 20 per cent of sales.. Labour and overheads are direct cash
expenses paid in the month incurred, while interest and taxes are paid
quarterly.
The company usually maintains a minimum cash balance of Sh.250,000, and
it invests its excess cash into marketable securities at the beginning of the
183

following month. The average tax rate is 40 per cent, and the companys
dividend pay-out ratio is 50 per cent. Dividends are paid at the end of each
quarter. Marketable securities are sold before funds are borrowed at the
beginning of the month, when a cash shortage is faced.
As of year just ended, LCMLs balance was as follows:

Loitokitok Manufacturing Company Limited

Balance Sheet
As at 31 December 2006
ASSETS
Current Assets
Cash
Sh. 300,000
Accounts receivable
3,200,000
Inventory
2,378,000
Total current assets
Fixed Assets
Plant and equipment
10,000,000
Less: Accumulated
2,000,000
depn
Total assets
LIABILITIES AND OWNERS EQUITY
Accounts payable
Notes payable
Lon-term debt: 9 per

Sh.

5,878,000
8,000,000
13,878,000

Sh.

cent
Ordinary share capital
Retained earnings
Total liabilities and

936,000
4,000,000
5,042,000,
3,900,000
13,878,000

owners equity
Required
(a)

Monthly cash budget

(b)

Monthly and quarterly pro-forma statement.

184

(c)

Pro-forma quarterly balance sheet.

Solution
(c)
Loitokitok Manufacturing Company Limited
Pro-forma balance sheet
As at 31 March 2007
ASSETS
Current Assets
Cash
Sh. 250,000
Accounts receivable
3,100,000
Inventory
4,500,000
Total current assets
Fixed Assets
Plant and equipment
10,000,000
Less: Accumulated
2,000,000
depn
Total assets
LIABILITIES AND OWNERS EQUITY
Accounts payable
Notes payable
Lon-term debt: 9 per

Sh.

7,850,000
8,000,000
15,850,000

Sh.

cent
Ordinary share capital
Retained earnings
Total liabilities and

1,200,000
425,000
4,000,000
5,042,000,
4,378,200
15,045,200

owners equity

Future Financial Needs and Pro-forma Statements

185

A simple method for developing a pro-forma income statement is to use the

percent-of sales method.

Sales are the most important variable in

influencing a firms financial requirements. The percent of sales method uses

the simplifying assumption that items on the balance sheet and the income
statement have stable relationship to sales a given % change in sales will
elicit a corresponding % change in the item. The following steps could be of
help in determining future financial requirements and resultant pro-forma
statements.
1. Establish the relationship between sales and other accounts
(a) All asset items have a stable, positive relationship with sales
volume. They (unless otherwise stated) are expected to vary in
direct proportion with sales
(b)Spontaneous sources of financing (account payable and accrued
expenses) will vary in direct proportion with sales.
(c) Long-term financing (share capital and debt capital) is assumed not
to have a clearly discernible link to sales volume.

They will be

assumed to be unchanged.
(d)Retained earnings will rise so long as the company is profitable and
the overall dividend payout ratio is less than 100%.
2.

To determine the external financing required we could use two

approaches:
i) Prepare a pro-forma balance sheet, or
ii) Use an equation
Equation
As sales increase the external funds needed to support sales level will be
determined as follows:-

186

Additional
outside
financing
required

Funds
from

Additional

= assets

required

Re tained

spon tan eous

sources

profits

for
period

The equation is derived as follows:Let A

= Total value of assets that change with sales

SL

= Spontaneous liabilities

= % of after tax earnings to sales (net profit margin)

= % of net profit retained (100 - pay-out ratio)

S0
S1

= the current level of sales

= Projected future sales level

External Financing Required (EFR) =

A/S0*(S1 S0) - SL /S0*(S1 S0) - bc S1
(11.1)
If g is the growth in sales i.e. (S1 S0)/S0, we can derive the following
estimate
Percent of sales of external funds required (PEFR) =
A/S0 - SL / S0

- bc(1 + g)/g

(11.2)
Example
The balance sheet of Mars Ltd. as at 31 December 2004 is given below:
Assets

Liabiliti
es

Cash

Sh
5,000,000

b\debto 40,000,000

Accounts

Sh
40,000,000

payable
Accrued

10,000,000

187

r
Invento
ry
Fixed

25,000,000

expenses
Notes
15,000,000

50,000,000

payable
Share

10,000,000

--------------

capital
Retained

45,000,000

assets

earnings
120,000,0

120,000,0

00

00

Sales for year ended 31 December 2004 were Sh.200 million.

All assets, accounts payable and accrued expenses are expected to maintain
the current relationships to sales as sales volume increases. Projected sales
for 2005 amount to Sh.300 million. The net profit margin is 6% and dividend
payout ratio is 40%.
Required
(a)

Prepare a pro-forma balance sheet as at 31 December 2005 with the

item external funds required as the balancing account.

(b)

Using the equation approach determine the amount of external funds

required for the year 2005.

Solution
(a)

i) Prepare percent of sales table

Cash

5/200

Debtor

=
40/20

2.5%

Accounts

40/200 =

20%

20%

payable
Accrued

10/200 =

5%

188

s
Invento

0=
25/20

12.5

expenses
Total

ry

0=

spontane

25%

ous
Total

35.0

curren

t
assets
Fixed

50/20

assets

0=

25

Retained

0.06 x0.6

10,800,0

earnings

00

300millio
n=

Total

60%

assets

ii)

Mars Ltd
Pro-forma balance Sheet as at 31 December 2005
Assets

Liabilities

Sh.
Cash (2.5%
7,580,000

Accounts

x 300)

payable

Debtors

x 300)
Accrued

(20%

60,000,000
x

300)
Inventory
(12.5%
300)
Fixed

expenses

Sh
60,000,000
(20%
15,000,000
(5%

37,500,000

x 300)
Notes payable

15,000,000

75,000,000

Share capital

10,000,000

189

assets
(25%

300)
Retained (45 + 55,800,000
10.8)
155,800,0
--------------

External

00
24,200,00

financing

required
(Balancing)

b)

180,000,0

180,000,0

00

00

Equation
External Financing Required (EFR)
= A/S0*(S1 S0) - SL/S0*(S1 S0) - bcs1
= 120/200*(300 200) - 50/200*(300 200) - 0.6 x 0.06 x 300
= 0.6 x 100 - 0.25 x 100 - 10,800,000
= Sh.24,200,000

190

TOPIC 9: PROFIT PLANNING

Cost-Volume Profit (C-V-P)
CVP Analysis examines the relationship between cost, activity level and the
profit.CVP Analysis assists in a wide range of profit planning and decision
making situations including

The effect of production method changes

The effect of changes in product mix

The viability of special sales promotion campaign

The level at which service must be utilized to break-even

The impact of price changes on profit as price changes

In the short run, costs can be of three general types:

Fixed Cost. Total fixed costs remain constant as volume varies in the
relevant range of production. Fixed cost per unit decreases as the cost
is spread over an increasing number of units. Examples include: Fire
insurance, depreciation, facility rent, and property taxes.

Variable Cost. Variable cost per unit remains constant no matter how
many units are made in the relevant range of production. Total variable
cost increases as the number of units increases. Examples include:
Production material and labor. If no units are made, neither cost is
necessary

or

incurred.

However,

each

unit

produced

requires

production material and labor.

Semivariable Cost. Semivariable costs include both fixed and

variable cost elements. Costs may increase in steps or increase
relatively smoothly from a fixed base. Examples include: Supervision
and utilities, such as electricity, gas, and telephone. Supervision costs
tend to increase in steps as a supervisor's span of control is reached.
Utilities typically have a minimum service fee, with costs increasing
relatively smoothly as more of the utility is used.
191

Cost-volume-profit analysis is an estimating concept that can be used in a

variety of pricing situations. You can use the cost-volume relationship for:

Evaluating item price in price analysis. Cost-volume-profit analysis

assumes that total cost is composed of fixed and variable elements.
This assumption can be used to explain price changes as well as cost
changes. As the volume being acquired increases unit costs decline. As
unit costs decline, the vendor can reduce prices and same make the
same profit per unit.

Evaluating direct costs in pricing new contracts. Quantity

differences will often affect direct costs -- particularly direct material
cost. Direct material requirements often include a fixed component for
development or production operation set-up. As that direct cost is
spread over an increasing volume unit costs should decline.

Evaluating direct costs in pricing contract changes. How will an

increase in contract effort increase contract price? Some costs will
increase others will not. The concepts of cost-volume-profit analysis
can be an invaluable aid in considering the effect of the change on
contract price.

Evaluating indirect costs. The principles of cost-volume-profit

analysis can be used in indirect cost analysis. Many indirect costs are
fixed or Semivariable. As overall volume increases, indirect cost rates
typically decline because fixed costs are spread over an increasing
production volume.

Assumptions Required In C-V-P

The main assumptions required in C-V-P analysis are:

The relationship holds only within the relevant range. The relevant range is
a band of activity within which a given cost behaviour is defined.

The behaviour of total cost and total revenue has reliably been determined
and is lineal within the relevant range.

192

All costs can be divided into fixed and variable such that mixed costs are
decomposed into their fixed and their variable components.

Selling prices are constant therefore we ignore quantity discounts.

Efficiency and productivity remain the same so that we therefore ignore the
learning curve effect.

Prices of factors of production remain constant.

There are no limiting factors

Analyzing the Cost-Volume Relationship

This section examines algebraic and graphic analysis of the cost-volume
relationship.
Algebraic Analysis
The assumption of linear cost behavior permits use of straight-line graphs
and simple linear algebra in cost-volume analysis.Total cost is a semi-variable
costsome costs are fixed, some costs are variable, and others are semivariable. In analysis, the fixed component of a semi-variable cost can be
treated like any other fixed cost. The variable component can be treated like
any other variable cost. As a result, we can say that:
Total Cost = Fixed Cost + Variable Cost
Using symbols:
C=F+V
Where:
C = Total cost
F = Fixed cost
V = Variable cost
Total variable cost depends on two elements:
Variable Cost = Variable Cost per Unit x Volume Produced
Using symbols:
193

V = Vu (Q)
Where:
VU = Variable cost per unit
Q = Quantity (volume) produced
Substituting this variable cost information into the basic total cost equation,
we have the equation used in cost-volume analysis:
C = F + VU (Q)
Illustration 2.1
If you know that fixed costs are Sh.500, variable cost per unit is Sh.10, and
the volume produced is 1,000 units, you can calculate the total cost of
production.
C = F + Vu (Q)
= 500 + 10 (1000)
= Sh.10500
Given total cost and volume for two different levels of production, and using
the straight-line assumption, you can calculate variable cost per unit.
Remember that:

Fixed costs do NOT change no matter what the volume, as long as

production remains within the relevant range of available cost
information. Any change in total cost is the result of a change in total
variable cost.

Variable cost per unit does NOT change in the relevant range of
production.

As a result, we can calculate variable cost per unit (V U) using the following
equation:
VU = Change in Total Cost
Change in Volume
194

= C2 C1
Q2 Q1
Where:
C1 = Total cost for Quantity 1
C2 = Total cost for Quantity 2
Q1 = Quantity 1
Q2 = Quantity 2
Illustration
You are analyzing an offeror's cost proposal. As part of the proposal the
offeror shows that a supplier offered 5,000 units of a key part for Sh.60,000.
The same quote offered 4,000 units for Sh.50,000. What is the apparent
variable cost per unit?
Vu = C2 C1
Q2 Q1
= 60000 - 50000
5000 4000
= Sh. 10
If you know total cost and variable cost per unit for any quantity, you can
calculate fixed cost using the basic total cost equation.

GRAPHIC ANALYSIS
Introduction to Graphic Analysis
When you only have two data points, you must generally assume a linear
relationship. When you get more data, you can examine the data to
determine if there is truly a linear relationship.
You should always graph the data before performing an algebraic analysis.
195

Graphic analysis is the best way of developing an overall view of costvolume relationship.

Graphic analysis is useful in analyzing cost-volume relationships,

particularly, when the cost and volume numbers involved are relatively
small.

Even when actual analysis is performed algebraically you can use

graphs to demonstrate cost-volume analysis to others.

Steps of Graphic Analysis

There are four steps in using graph paper to analyze cost-volume
relationships:
Step 1. Determine the scale that you will use.
Volume is considered the independent variable and will be graphed on the
horizontal axis. Cost is considered the dependent variable and will be
graphed on the vertical axis. The scales on the two axes do not have to be
the same. However, on each axis one block must represent the same amount
of change as every other block of the same size on that axis. Each scale
should be large enough to permit analysis, and small enough to permit the
graphing of all available data and anticipated data estimates.
Step 2. Plot the available cost-volume data.
Find the volume given for one of the data points on the horizontal axis. Draw
an imaginary vertical line from that point. Find the related cost on the
vertical axis and draw an imaginary horizontal line from that point. The point
where the two lines intersect represents the cost for the given volume. (If
you do not feel comfortable with imaginary lines you may draw dotted lines
to locate the intersection.) Repeat this step for each data point.
Step 3. Fit a straight line to the data.
196

In this section of text, all data points will fall on a straight line. All that you
have to do to fit a straight line is connect the data points. Most analysts use
regression analysis to fit a straight line when all points do not fall on the line.
Step 4. Estimate the cost for a given volume.
Draw an imaginary vertical line from the given volume to the point where it
intersects the straight line that you fit to the data points. Then move
horizontally until you intersect the vertical axis. That point is the graphic
estimate of the cost for the given volume of the item.
Example of Graphic Analysis. The four steps of cost-volume-profit analysis
can be used to graph and analyze any cost-volume relationship. Assume that
you have been asked to estimate the cost of 400 units given the following
data:

Units

Cost

200

$100,000

500

$175,000

600
Solution

$200,000

197

The estimated cost will be $ 150.000.

Break Even Analysis
Break even analysis is mainly used to explain the relationship between the cost
incurred, the volume operated at and the profit earned. To compute the break
even point we let
S be selling price per unit
Vu be variable cost per unit
Q be break-even quantities
F be total fixed costs
At Break even point:
Total revenue (TR) = Total Cost (TC)
Total revenue will be given by SQ while Total cost (TC) = Vu Q + F

198

At break-even point (BEP) therefore:

SQ = Vu Q + F
Q = ___F___
S- Vu
B.E.P

(in units)

= F

S- Vu
Illustration
Assume that you are planning to sell badges at the forthcoming Nairobi
Show at Sh.9 each. The badges cost Sh.5 to produce and you incur Sh.2000
to rent a booth in the Show ground.
Required:
a) Compute the breakeven point
b) Compute the margin of safety
c) Compute the number of units that must be sold to earn a before tax profit
of 20%
d) Compute the number of units that must be sold to earn an after tax profit of
Sh.1640, assuming that the tax rate is 30%.
Solution
a) Break even point
BEP units = 2000/(9-5) = 500 units
BEP Sh. = 500 x 9 = 4500/b) Margin of safety

199

The margin of safety is the amount by which actual output or sales may fall
short of the budget without the company incurring losses. It is a measure of
the risk that the company might make a loss if it fails to achieve the target.
A high margin of safety means high profit expectation even if the budget is
not achieved. Margin of safety (MOS) can be computed as follows:
MOS = Expected sales - Break even sales
Expected sales
=

600-500

= 16.7%

600
c) Target before tax profit (Y)

Let X be the number of units to produce

X=F + Y
S - Vu
X = 2000 + 0.2 (9X)
9-5
X= 2000 + 1.8X
4
X = 909.09 approximately 910 units.
d) After Tax profit

Let Z be the after tax profit

200

Y = Z__
It
Therefore
X = F + z/1-t
S Vu
=

2000 + 1640
1-0.3
9-5

X = 1085.71
Approximately 1086 units.
C-V-P Analysis Multiple Products
The simple product CVP analysis can be extended to handle the more realistic
situations where the firm produces more than one product. The objective in such
a case is to produce a mix that maximises total contribution.
Total BEP

units

Total fixed cost

Average CM

Average CM=

(S
t 1

Vt ) t

where t is the sales mix of product t.

St is the selling price of product t.
Vt is the variable cost of product t.
n is the number of units of product t sold
BEPt units = t (Total BEPunits)
201

BEP

tsh.

= BEPt(units) xSt

Illustration
Assume that ABC Ltd produces two products, product A and B and the following
budget has been prepared.

Sales in units
Sales @5/-, 10/Variable cost @ 4/-, 3/Contribution @ 1/- 7/Total fixed cost
Profit

A
120,000
Sh.

B
40,000
Sh.

Total
160,000
Sh.

600,000
480,000
120,000

400,000
120,000
280,000

100,000
600,000
400,000
300,000
100,000

Required:
a) Compute the break-even point in total and for each of the products.
b) The company proposes to change the sales mix in units to 1:1 for products A
and B.
Advice the Co. on whether this change is desirable.
Solution
A

Sales mix

(units)

0.75

0.25

Sales mix

(Shs)

0.60

0.40

Average CM=

(S
t 1

Vt ) t

= 0.75 (1) + 0.05(7)

202

= 2.5
Total BEP

units

= Total fixed cost

300000

Average CM

2.5
= 120,000 units

BEP (units)
120000 x 0.75 = 90,000
120000 x 0.25 = 30,000
120,000

A
B

BEP(sh)
(90000x5) = 450,000
(30000 x 10)
= 300,000
750,000

The above question can be solved by computing the BEP Sh first and the using the
Sales Mix in Shs.
Total BEP

Sh.

= Total fixed cost

C/S sales ratio

C/S ratio

= 400,000 = 0.4
1000,000

Total BEP(sh)

= 300000 =

750,000

0.4
Sh.

Units

750000 x 0.6

450000

450000/5 = 90000

750000 x 0.4

300000

300000/10= 30000

750000
b) Changing sales mix in units to 1:1 ratio

203

120000

The budget can be reproduced as follows:

A

Sales in units

80000

Total
80000

sh

160000

sh

sh

Sale @ 5/-, 10/-

400000

800000

1200000

V.c @ 4/-, 3/-

320000

240000

560000

Contribution

80,000

560,000

640,000

Total fixed cost

300,000

Net Profit

340,000

Sales mix in units is 80000/160000 = 0.5

Average CM =

0.5(1) + 0.5 (7) = 4

Total BEP units = 300,000 = 75,000 units

4
BEP

BEP

units

sh.

A (0.5 x 75000)

37500

187,500

B (0.5 x 75000)

37500

375,000

75000

562,500

For manager of product line A, the change is good because he now breaks even at
sh.187500 than on sh.450000. But for manager of product B, the change is not
good because BEP has risen from sh.300000 to sh.375000.

C-V-P Analysis Under Uncertainty

204

A major limitation of the basic C.V.P analysis is the assumption that the unit
variable cost, selling price and the fixed costs are constant and can be predicted
with certainty.

These factors however are variables with expected values and

standard deviations that can be estimated by management.

There are various ways of dealing with uncertainty. Examples include:

Sensitivity analysis

Point estimate of probabilities

Continuous probability distribution e.g. normal distribution

Simulation analysis

Margin of safety

Point Estimate of Probabilities

This approach requires a number of different values for each of the uncertain
variables to be selected. These might be values that are reasonably expected to
occur but usually 3 values are selected. These are:
The worst possible outcome
The most likely outcome
The best possible outcome
For each of these 3 values, a probability of occurrence will be estimated.
Illustration
Assume that a Management accountant of a Company that makes and sells
product X has made the following estimate:
Selling

price

Unit
205

variable

Sh.10
Sales demand
Condition
Unit
Worst possible
45000
Most likely 50000
Best possible55000

cost
Condition

Prob.
0.3
0.6
0.1

Cost
Best possible3.5
Most likely 4.0
Worst possible
5.5

Sh.
0.30
0.55
0.15

Fixed cost = Sh.240,000

Required:
a.

Compute the expected profit

b.

Compute the prob. that the company will fail to break even

c.

If the Company has a profit target of Sh.60,000 what is the probability

that the company will not achieve this target.

Solution
a)
E(Demand) = (45000 x 0.3) + (50000 x 0.6) + (55000 x 0.1) = 49000
E(variable cost) = (3.5 x 0.3) x (4 x 0.55) + (55 x 0.15) = Sh.4.075
E(Profit) = (10-4.075) 49000 240000 = Sh.50325
This can be worked out differently as shown below:

Demand

Prob.

D
Unit VC

Prob.

Contr

(FxG)
Profit

Joint weighted
Prob.
45000

Profit
0.3

3.5

0.30 292500

4725
206

52500

0.09

50000

4.0

0.55 270000

5.5

0.15 202500

0.6

3.5

0.3

325000

30000

0.165 4950

(37500) 0.045 (1687.5)

85000

0.18

15300

55000

4.0

0.55 300000

60000

0.33 19800

5.5

0.15 225000

(15000)

0.09 (1350)

0.1

3.5

0.3

357500

117500

0.33

3525
4.0

0.55 330000

90000

5.5

0.15 247500

7500

Expected profit
b)

0.055 4950
0.015 112.5
50325

The P(Profit <0) = 0.045 + 0.09

= 0.135
Note:
This can be read from the above table

c)

P(profit < 60000)

= 0.3 + 0.09 + 0.015
= 0.405

Worked example
Thunder manufacturing company produces a toxic product, coros that must
be sold in the month produced or else discarded. Thunder can manufacture
coros itself at a variable cost of Sh40 per unit or they can purchase it from
an outside supplier at a cost of Sh70 per unit. Thunder can sell coros at
Sh80 per unit. Production levels must be set at the start of the period and
cannot be changed during the period. The production process is such that at
least 9,000 units must be produced during the period. Thunder management
207

must decide whether to produce coros or whether to purchase it from the

outside supplier.
The possible sales of coros and their probabilities are:
Demand

Probability

(units)
4,000

0.4

7,000

0.5

11,000

0.1

Required:
a) Expected demand
b) Expected profit from purchasing coros from an outside supplier and
selling it
c) Expected profit from manufacturing and selling
d) Standard deviation of profits from purchasing and selling.
e) Standard deviation of profits from manufacturing and selling.
f) Coefficient of variation for each alternative

Solution
a) Expected demand is computed as follows:
Demand (units)

Probability Expected

demand(units)
4000

0.4

1600
7000

0.5

3500
11,000

0.1

1100
Expected demand

6200

b) The expected profit from purchasing and selling would be equal to the
208

unit contribution times the expected quantity or

Sh (80 70) x 6200 = Sh62,000
c) Even though the production cost is stated as a variable cost, since a
minimum of 9,000 units must be produced, the cost is really fixed up to
that point because of the minimum production constraints.

Units

produced in excess of 9,000 could carry the variable cost of Sh40 each.
The expected profit from manufacturing is:
Demand (units) Probability Manufacturing costProfit

Expected profit

(Shs)

(Shs)

4000

0.4

360,000(40,000)(16,000)
7000

0.5

360,000200,000100,000
11,000
440,000

0.1
440,000 44,000
128,000

d) The standard deviation from purchasing and selling is:

I

(I ) P (million)

(4,000

6200)

Sh10

6200)

Sh10

193.6
(7,000
32.0
(11,000

6200)Sh10

230.4
456.0
209

Standard
456m

e)

deviation

= Sh21,354

The standard deviation from manufacturing and selling is

I

(I )P (million)

-40,000

128,000

128,000

11,289.6
200,000
2,592.0
440,000

128,000
9,734.4
Total 23,616.0

Standard deviation =23,616 million = Sh153,675

f) Coefficient of variation for purchasing and selling is (S/I)
i.e.

Sh 21,354 = 0.344
Sh 62,000

For manufacturing and selling is:

Sh 153,675 = 1.201
Sh 128,000

210

TOPIC 10: WORKING CAPITAL MANAGEMENT

Introduction
Working capital
a)

Working capital (also called gross working capital) refers to current

assets.
b)

Net working capital refers to current assets minus current liabilities.

c)

Working capital management refers to the administration of current

assets and current liabilities.

d)

Target levels of each category of current assets

How current assets will be financed

Liquidity management involves the planned acquisition and use of

liquid resources over time to meet cash obligations as they become
due. The firms liquidity is measured by liquidity ratio such as current
ratio, quick (or acid test) ratio, cash ratio, etc.

Working Capital Management Decisions

In principle, current asset investment decisions, as in the case of investment
in fixed assets, calls for a cost-benefit evaluation of a large number of
alternatives, and the selection of that alternative that produces the greatest
net benefit. The typical process will feature the following activities:
(1)The financial manager estimates the costs and benefits of each
alternative.
(2)The net present value (NPV) must be calculated for each alternative
given the discount rate approximate to the degree of risk involved
(3)The alternative with the highest NPV is chosen and implemented.
In practice, however, the NPV approach is rarely used for evaluating working
capital investment decisions. The alternative approach, commonly used, is to
211

maximize average net profit, with the amount invested treated as its
equivalent annual cost. The management of working capital boils down to
balancing the risks and benefits of holding excessive, to those of holding too
little, working capital.

Overcapitalization and Overtrading

The finance manager must be wary of two polar extremes in working capital
management. These extremes are, (i) over-capitalization and, (2) overtrading.
Over Capitalization (Conservative Financing Strategy)
If a company manages its working capital, so that there are excessive stocks,
debtors and cash and very few creditors, there will be an over-investment by
the company in current assets. Working capital will be excessive and the
company is said to be overcapitalized ( i.e. the company will have too much
capital invested in unnecessarily high levels of current assets). The result of
this would be that the return on investment will be lower than it should, with
long-term funds unnecessarily tied up when they could be more profitably
invested elsewhere.
Indicators of over-capitalization
Accounting ratios can assist in judging whether over capitalization is present.
(1)

Sales/Working capital ratio:-

the volumes of sales as a

multiple of working capital should indicate whether the total

volume of working capital is too high (compared to the past and
industry norms).
(2)

Liquidity ratio. A current ratio and a quick ratio in excess of

the industry norm or past ratios will indicate over-investment in
current assets

(3)

Turn-over periods.

Excessive stock and debtors turnover

periods or too short creditor payment period might indicate that

212

the volume of debtors and stocks is unnecessarily high, or

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

Symptoms of over-trading
Accounting indicators of overtrading include:
(1)Rapid increases in turn-over ratios (over-heating)
(2)Stock

turnover

and

debtors

turnover

might

slow

down

with

consequence that there is a rapid increase in current assets.

(3)The payment period to trade creditors lengthens
(4)Bank over-drafts often reach or exceed the limit of facilities offered by
the bank.
(5)The debt ratios rise
(6)The current ratio and quick ratio fall and the net working capital (NWC)
could be negative.
Financing Current Assets
Current Assets require financing by use of either current funds or long term
funds. There are three major approaches to financing current assets. These
are:
a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this
approach, the firm adopts a financial plan which involves the matching of the
213

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 longterm 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
214

highly risky. With this in mind, we can consider the risk-return trade off of
the three approaches.
The conservative approach is a low return-low risk approach. This is because
the approach uses more of long-term funds which are now more expensive
than short-term funds. These funds however, are not to be repaid within the
year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach.
However it is also a high return approach the reason being that it relies more
on short-term funds that are less costly but riskier.
The matching approach is in between because it matches the life of the
asset and the life of the funds financing the assets.
Determinants Of Working Capital Needs
There are several factors which determine the firms working capital needs.
These factors are comprehensively covered by A Textbook of Business
Finance by Manasseh (Pages 403 406). They however include:
a)

Nature and size of the business.

b)

Firms manufacturing cycle

c)

Business fluctuations

d)

Production policy

e)

Firms credit policy

f)

Availability of credit

g)

Growth and expansion activities.

Importance Of Working Capital Management

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

215

a) Time devoted to working capital management

A large portion of a financial managers 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 firms employees.

The finance manager should

therefore properly manage these assets.

c) Importance to small firms
A small firm may minimize its investments in fixed assets by renting or
leasing plant and equipment, but there is no way it can avoid investment in
current assets. A small firm also has relatively limited access to long term
capital markets and therefore must rely heavily on short-term funds.
d) Relationship between sales and current assets
The relationship between sales volume and the various current asset items is
direct and close. Changes in current assets directly affect the level of sales.
The finance management must therefore keep watch on changes in working
capital items.
Cash And Marketable Securities Management
The management of cash and marketable securities is one of the key areas
of working capital management. Since cash and marketable securities are
the firms most liquid assets, they provide the firm with the ability to meet its
maturing obligations.

216

Cash refers to cash in hand and cash on demand deposits (or current
accounts).

It therefore excludes cash in time deposits (which is not

immediately available to meet maturing obligations).

Marketable securities are short-term investments made by the firm to obtain
a return on temporary idle funds.

Thus when a firm realises that it has

accumulated more cash than needed, it often puts the excess cash into an
interest-earning instrument. The firm can invest the excess cash in any (or a
combination) of the following marketable securities.
a)

Government treasury bills

b)

Agency securities such as local governments securities or parastatals

securities
c)

Bankers acceptances, which are securities, accepted by banks

d)

Commercial paper (unsecured promissory notes)

e)

Repurchase agreements

f)

Negotiable certificates of deposits

g)

Eurocurrencies etc.

Cash Cycle and Cash Turnovers

Cash Cycle refers to the amount of time that elapses from the point when
the firm makes a cash outlay to purchase raw materials to the point when
cash is collected from the sale of finished goods produced using those raw
materials.
Cash turnover on the other hand refers to the frequency of a firms 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
217

collection period is 70 days. On average, 85 days elapse between the point

a raw material is purchased and the point the finished goods are sold.
Required
Determine the cash conversion cycle and the cash turnover.
Solution
The following chart can help further understand the question:
Inventory Conversion period (85 days)

Receivable collection
Period (70 days)

Payable
deferral

Purchase
of raw

Payment for
the raw
materials

Sale of
Finished

Cash conversion cycle = 85

70

Collection
of

The cash conversion cycle is given by the following formula:

Cash conversion = Inventory conversion + Receivable collection Payable
deferral
218

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 receivable
s
Payables
Accruals

costofsale
s
sales
Cashoperat
ingexpense
s

360

In this chapter we shall assume that a year has 360 days.

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

219

The Cash Budget shows the firms projected cash inflows and outflows over
some specified period.

This method has already been discussed in other

earlier courses. The student should however revise the cash budget.
b) Baumols Model
The Baumols 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
220

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

Determine the optimal amount of marketable securities to be

converted into cash every time the company makes the transfer.

b)

Determine the total number of transfers from marketable securities to

cash per year.

c)

Determine the total cost of maintaining the cash balance per year.

d)

Determine the firms average cash balance.

Solution
a)

C*

2bT
i

Where:

b = Shs.20

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

C*

2 x 20 x 520,000
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)

Total no. of transfers

T
C*

221

520,000
13,166

c)

TC

39.5

40 times

1
T
Ci b
2
C

13,166 x 0.12 520,000 x 20

2
13,166

790 + 790 = Shs.1,580

Therefore the total cost of maintaining the above cash balance is

Sh.1,580.
d)

The firms average cash balance

13,166
2

Shs.6,583

c) Miller-Orr Model
Unlike the Baumols 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

222

expected value of some higher or lower value drawn from a normal

distribution. Thus, the daily net cash follows a trendless random walk.
From the graph below, the Miller-Orr Model sets higher and lower control
units, H and L respectively, and a target cash balance, Z. When the cash
balance reaches H (such as point A) then H-Z shillings are transferred from
cash to marketable securities. Similarly, when the cash balance hits L (at
point B) then Z-L shillings are transferred from marketable securities cash.
The Lower Limit is usually set by management. The target balance is given
by the following formula:
1/ 3

2
Z 3B
4
i

and the highest limit, H, is given by:

H

3Z - 2L

The average cash balance

Where:

4Z L
3

Z = target cash balance

H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
= variance of net daily cash flows

223

Illustration
XYZs 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.

each sale or purchase of securities is Sh.20.
Required
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread

Solution
a)

3b

4i

1/ 3

224

The transaction cost for

c)

3x 20 x ( 2,500)

10,000
9%

4x

360

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

b)

3Z 2L

3 x 17,211 2(10,000)

Shs.31,633

Average cash balance

d)

The spread

4Z L
3

4 x17,211 10,000
3

HL

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.
225

CASH MANAGEMENT TECHNIQUES

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

To pay account payables as late as possible without damaging the

firms credit rating. The firm should however take advantage of any
favourable cash discounts offered.

ii)

Turnover inventory as quickly as possible, but avoid stockouts which

might result in loss of sales or shutting down the production line.

iii)

Collect accounts receivable as quickly as possible without losing future

sales because of high pressure collection techniques.

The firm may

use cash discounts to accomplish this objective.

In addition to the above strategies the firm should ensure that customer
payments are converted into spendable form as quickly as possible.

This

may be done either through:

a)

a)

Concentration Banking

b)

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.

226

Concentration banking reduces the amount of time that elapses

between the customers mailing of a payment and the firms 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 firms bank at least once or
twice each business day.

The bank opens the payment envelope,

deposits the cheques in the firms account and sends a deposit slip
indicating the payment received to the firm. This system reduces the
customers mailing time and the time it takes to process the cheques
received.

MANAGEMENT OF INVENTORIES
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:

227

2DCo
Cn

Where:

Q is the economic order quantity

D is the annual demand in units

Co is the cost of placing and receiving an order
Cn is the cost of holding inventories per unit per order
The total cost of operating the economic order quantity is given by total
ordering cost plus total holding costs.
D

TC = QCn + Q C o
Where:

Total holding cost = QCn

D

Total ordering cost = Q C o

The holding costs include:
1. Cost of tied up capital
2. Storage costs
3. Insurance costs
4. Obsolescence costs
The ordering costs include:
1. Cost of placing orders such as telephone and clerical costs
2. Shipping and handling costs

228

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

D
L
360

Where:

R is the reorder level

D is the annual demand

L is the lead time in days

EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:
i)

The demand is known and constant over the year

ii)

The ordering cost is constant per order and certain

iii)

The holding cost is constant per unit per year

iv)

The purchase cost is constant (Thus no quantity discount)

v)

Back orders are not allowed.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in
the coming year which costs Sh.50 each. The items are available locally and
the leadtime in one week. Each order costs Sh.50 to prepare and process
while the holding cost is Shs.15 per unit per year for storage plus 10%
opportunity cost of capital.
Required
229

a)

How many units should be ordered each time an order is placed to

minimize inventory costs?

b)

What is the reorder level?

c)

How many orders will be placed per year?

d)

Determine the total relevant costs.

Suggested Solution:

a)

2DCo
Cn

Where:

D = 2,000 units

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

b)

c)

2 x 2,000 x 50
100units
20

DL
360

2,000 x 7
360

39 units

No. of orders

D
Q

2,000
100

230

d)

TC

20 orders
D

QCn + Q C o

(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.
EXISTENCE OF QUANTITY DISCOUNTS
Frequently, the firm is able to take advantage of quantity discounts. Because
these discounts affect the price per unit, they also influence the Economic
Order Quantity.
If discounts exists, then usually the minimum amount at which discount is
given may be greater than the Economic Order Quantity.

If the minimum

discount quantity is ordered, then the total holding cost will increase because
the average inventory held increases while the total ordering costs will
decrease since the number of orders decrease. However, the total purchases
cost will decrease.
Illustration
Consider illustration one and assume that a quantity discount of 5% is given
if a minimum of 200 units is ordered.
231

Required
Determine whether the discount should be taken and the quantity to be
ordered.
Suggested Solution
We need to consider the saving in purchase costs; savings in ordering costs
and increase in holding costs.
Savings in purchase price:
New purchase price

Savings in purchase price per unit

=

50 x 95% = Sh.47.50 per unit

=

50 47.50

Sh.2.50

Total units per year

2,000

Total savings

2,000 x 2.50 = Sh.5,000

Savings in Ordering Cost

Assuming an order quantity of 200 units per order, the total ordering cost will
be:
2,000
(50) = Sh.500
100

Ordering cost if 100 units is ordered

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

Therefore savings in ordering costs =

232

1,000 500 = Sh.500

Increase in holding costs

Holding cost if 200 units are ordered
(200)19.75 = Sh.1,975
holding costs if 100 units are ordered
(100(20) = Sh.1,000
Increase in holding costs = 1,975 1,000 = Sh.975
The Net Effect therefore:
Shs.
Savings in purchases costs

5,000

Savings in ordering costs

500

Total savings

5,500

Less increase in holding costs

Net savings

Qd

2DCo
Cn

Qd

2 x 2,000 x 50
19.75

975
4,525

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

The discount should be taken because the net savings is positive.
determine the number of units to order we recomputed Q with discount Qd.
233

To

= 100.6 units
Decision rule:
If Qd < minimum discount quantity, then order the minimum discount
quantity.
If Qd < minimum discount quantity, then order Qd.
UNCERTAINTY AND SAFETY STOCKS
Usually demand requirements may not be certain and therefore the firm
holds safety stock to safeguard stock out cases.

The existence of safety

stock can be illustrated by Figure 5.7.

The safety stock guards against delays in receiving orders.

However,

carrying a safety stock has costs (it increases the average stock).
Illustration
Consider illustration one and assume that management desires to hold a
minimum stock of 10 units (this stock is in hand at the beginning of the
year).
Required
a)

Determine the re-order level

b)

Determine the total relevant costs

Suggested solution
a)

DL
S
360

Where:

S is the safety stock

234

=
b)

2,000
x 7 10
360

49 units

The average inventory =

TC

Q + S

(Q + S)Cn + D/QCo

[(100) + 10]20 +

1,200 + 1,000

Shs.2,200

2,000
(50)
100

Management of Accounts Receivable

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

The volume of credit sales

b)

The average length of time between sales and collections.

235

Accounts receivables

Credit sales per day

Length

of

collection period
The average collection period depends on:
a)

Credit standards which is the maximum risk of acceptable credit

accounts
b)

Credit period which is the length of time for which credit is granted

c)

Discount given for early payments

d)

The firms collection policy.

a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The firm following a
lenient credit policy tends to sell on credit to customers on a very liberal
terms and credit is granted for a longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a
highly selective basis only to those customers who have proven credit
worthiness and who are financially strong.
A lenient credit policy will result in increased sales and therefore increased
contribution margin. However, these will also result in increased costs such
as:
1. Increased bad debt losses
2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments

236

The goal of the firms credit policy is to maximise the value of the firm. To
achieve this goal, the evaluation of investment in receivables should involve
the following steps:
1. Estimation of incremental operating profits from increased sales
2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs
b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount
given. The terms 2/10, n/30 means that a 2% discount is given if the bill is
paid before the tenth day after the date of invoice otherwise the net amount
should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability
caused by longer credit and discount period or a higher rate of discount
against increased cost.
c) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of
receivables. It can also result in reduced bad debt losses.
d) COLLECTION POLICY
The firms 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.

237

As saturation point increased expenditure in collection efforts does not result

in reduced bad debt and therefore the firm should not spend more after
reaching this point.
Illustration
Riffruff Ltd is considering relaxing its credit standards.

The firms current

credit terms is net 30 but the average debtors collection period is 45 days.
Current annual credit sales amounts to Sh.6,000,000.

The firm wants to

extend credit period net 60. Sales are expected to increase by 20%. Bad
debts will increase from 2% to 2.5% of annual credit sales. Credit analysis
and debt collection costs will increase by Sh.4,000 p.a.

The return on

investment in debtors is 12% for Sh.100 of sales, Sh.75 is variable costs.

Assume 360 days p.a. Should the firm change the credit policy?
Suggested Solution
Current sales
New sales =

Sh.6,000,000 x 1.20

Contribution margin

Sh.6,000,000

Sh.7,200,000

Sh.100 Sh.75

Therefore contribution margin ratio =

Sh.25
x100
Sh.100

Sh.25
=

25%

Cost benefit analysis

Contribution Margin
New policy
Current policy

25% x 7,200,000

25% x 6,000,000

Credit analysis and debt collection costs

Bad debts
238

1,800
=

1,500 =

300
(84)

New bad debts

Current bad debts =

2.5% x 7,200,000 =
2% x 6,000,000

180
=

120

(60)

Debtors
New debtors

Current debtors

Cr.period
360days

x cr. Sales p.a.

60
x 7,200,000
360

45
x 6,000,000
360

1,200

Increase in debtors (tied up capital)

Forgone profits

750
450

12% x 450

(54)

Net benefit (cost)

102

Therefore, change the credit policy.

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

a)

The applicants financial statement

b)

Credit ratings and reports from experts

c)

Banks

d)

Other firms

e)

The companys own experience

239

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

Where:

a1(X1) + a2(X2)
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 Sxz

a2

Szz dx Sxzdz
Szz Sxx Sxz

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 X1s bad accounts and X2s
good accounts
240

dz represents the difference between the average of Xs bad accounts

and Xs 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

QUESTION

Wema Ltd has estimated that the standard deviation of its daily net cash
flows is Sh.2,500. The firm pays Sh.50 in transaction costs to transfer funds
into and out of this money market. The rate of interest in the money market
is 7.465% p.a.

Wema uses the Miller-Orr Model to set its target cash

balances.

Required
a)

What is Wemas target cash balance?

b)

What are the lower and upper cash limit?

c)

What are the Wemas decision rules?

d)

Determine Wemas expected average cash balance.

241

242

TOPIC 11:MERGERS AND TAKE- OVERS

Merger and Acquisition Defined
When we use the term "merger", we are referring to the joining of two
companies where one new company will continue to exist. The term
"acquisition" refers to the purchase of assets by one company from another
company. In an acquisition, both companies may continue to exist.
However, throughout this topic we will loosely refer to mergers and acquisitions
( M & A ) as a business transaction where one company acquires another
company. The acquiring company (also referred to as the predator company) will
remain in business and the acquired company (which we will sometimes call the
Target Company) will be integrated into the acquiring company and thus, the
acquired company ceases to exist after the merger.
Types Of Mergers
Mergers can be categorized as follows:
Horizontal: Two firms are merged across similar products or services.
Horizontal mergers are often used as a way for a company to increase its
market share by merging with a competing company. For example, the merger
between Total and ELF will allow both companies a larger share of the oil and
gas market.
Vertical: Two firms are merged along the value-chain, such as a manufacturer
merging with a supplier. Vertical mergers are often used as a way to gain a
competitive

advantage

within

the

marketplace.

For

example,

large

manufacturer of pharmaceuticals, may merge with a large distributor of

pharmaceuticals, in order to gain an advantage in distributing its products.
Conglomerate: Two firms in completely different industries merge, such as a
gas pipeline company merging with a high technology company. Conglomerates
are usually used as a way to smooth out wide fluctuations in earnings and
provide more consistency in long-term growth. Typically, companies in mature
243

industries with poor prospects for growth will seek to diversify their businesses
through mergers and acquisitions.
Reasons For Mergers
a. Synergy
Every merger has its own unique reasons why the combining of two companies
is a good business decision. The underlying principle behind mergers and
acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of Company A is Sh. 2
billion and the value of Company B is Sh. 2 billion, but when we merge the two
companies together, we have a total value of Sh. 5 billion. The joining or
merging of the two companies creates additional value which we call "synergy"
value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues
than if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses
than if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a
lower overall cost of capital.
For the most part, the biggest source of synergy value is lower expenses. Many
mergers are driven by the need to cut costs. Cost savings often come from the
elimination of redundant services, such as Human Resources, Accounting,
Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include:
Positioning - Taking advantage of future opportunities that can be exploited
when the two companies are combined. For example, a telecommunications
company might improve its position for the future if it were to own a broad band

244

service company. Companies need to position themselves to take advantage of

emerging trends in the marketplace.
Gap Filling - One company may have a major weakness (such as poor
distribution) whereas the other company has some significant strength. By
combining the two companies, each company fills-in strategic gaps that are
essential for long-term survival.
Organizational Competencies - Acquiring human resources and intellectual
capital can help improve innovative thinking and development within the
company.
Broader Market Access - Acquiring a foreign company can give a company
quick access to emerging global markets.
b. Bargain Purchase
It may be cheaper to acquire another company than to invest internally. For
example, suppose a company is considering expansion of fabrication facilities.
Another company has very similar facilities that are idle. It may be cheaper to
just acquire the company with the unused facilities than to go out and build new
facilities on your own.
c. Diversification
It may be necessary to smooth-out earnings and achieve more consistent longterm growth and profitability. This is particularly true for companies in very
mature industries where future growth is unlikely. It should be noted that
traditional financial management does not always support diversification
through mergers and acquisitions. It is widely held that investors are in the best
position to diversify, not the management of companies since managing a steel
company is not the same as running a software company.
d. Short Term Growth
Management may be under pressure to turnaround sluggish growth and
profitability. Consequently, a merger and acquisition is made to boost poor
performance.
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e. Undervalued Target
The Target Company may be undervalued and thus, it represents a good
investment. Some mergers are executed for "financial" reasons and not
strategic reasons. A compay may, for example, acquire poor performing
companies and replace the management team in the hope of increasing
depressed values.
The Overall Merger Process
The Merger & Acquisition Process can be broken down into five phases:
Phase 1 - Pre Acquisition Review:
The first step is to assess your own situation and determine if a merger and
acquisition strategy should be implemented. If a company expects difficulty in
the future when it comes to maintaining core competencies, market share,
return on capital, or other key performance drivers, then a merger and
acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to
protect its valuation, it may find itself the target of a merger. Therefore, the preacquisition phase will often include a valuation of the company - Are we
undervalued? Would an M & A Program improve our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth
targets (such as 10% market growth over the next 3 years) can be achieved
internally. If not, an M & A Team should be formed to establish a set of criteria
whereby the company can grow through acquisition. A complete rough plan
should be developed on how growth will occur through M & A, including
responsibilities within the company, how information will be gathered, etc.
Phase 2 - Search & Screen Targets:

246

The second phase within the M & A Process is to search for possible takeover
candidates. Target companies must fulfill a set of criteria so that the Target
Company is a good strategic fit with the acquiring company. For example, the
target's drivers of performance should compliment the acquiring company.
Compatibility and fit should be assessed across a range of criteria - relative size,
type of business, capital structure, organizational strengths, core competencies,
market channels, etc.
It is worth noting that the search and screening process is performed in-house
by the Acquiring Company. Reliance on outside investment firms is kept to a
minimum since the preliminary stages of M & A must be highly guarded and
independent.
Phase 3 - Investigate & Value the Target:
The third phase of M & A is to perform a more detail analysis of the target
company. You want to confirm that the Target Company is truly a good fit with
the acquiring company. This will require a more thorough review of operations,
strategies, financials, and other aspects of the Target Company. This detail
review is called "due diligence." Specifically, Phase I Due Diligence is initiated
once a target company has been selected. The main objective is to identify
various synergy values that can be realized through an M & A of the Target
Company. Investment Bankers now enter into the M & A process to assist with
this evaluation.
A key part of due diligence is the valuation of the target company. In the
preliminary phases of M & A, we will calculate a total value for the combined
company. We have already calculated a value for our company (acquiring
company). We now want to calculate a value for the target as well as all other
costs associated with the M & A.
Phase 4 - Acquire through Negotiation:

247

Now that we have selected our target company, it's time to start the process of
negotiating a M & A. We need to develop a negotiation plan based on several
key questions:
- How much resistance will we encounter from the Target Company?
- What are the benefits of the M & A for the Target Company?
- What will be our bidding strategy?
- How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both
companies to reach agreement concerning the M & A; i.e. a negotiated merger
will take place. This negotiated arrangement is sometimes called a "bear hug."
The negotiated merger or bear hug is the preferred approach to a M & A since
having both sides agree to the deal will go a long way to making the M & A
work. In cases where resistance is expected from the target, the acquiring firm
will acquire a partial interest in the target; sometimes referred to as a "toehold
position." This toehold position puts pressure on the target to negotiate without
sending the target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the
acquiring company will make a tender offer directly to the shareholders of the
target, bypassing the target's management. Tender offers are characterized by
the following:
- The price offered is above the target's prevailing market price.
- The offer applies to a substantial, if not all, outstanding shares of stock.
- The offer is open for a limited period of time.
- The offer is made to the public shareholders of the target.
A few important points worth noting:

248

- Generally, tender offers are more expensive than negotiated M & A's due to
the resistance of target management and the fact that the target is now "in
play" and may attract other bidders.
- Partial offers as well as toehold positions are not as effective as a 100%
acquisition of "any and all" outstanding shares. When an acquiring firm makes
a 100% offer for the outstanding stock of the target, it is very difficult to turn
this type of offer down.
Another important element when two companies merge is Phase II Due
Diligence. As you may recall, Phase I Due Diligence started when we selected
our target company. Once we start the negotiation process with the target
company, a much more intense level of due diligence (Phase II) will begin. Both
companies, assuming we have a negotiated merger, will launch a very detailed
review to determine if the proposed merger will work. This requires a very detail
review of the target company - financials, operations, corporate culture,
strategic issues, etc.
Phase 5 - Post Merger Integration:
If all goes well, the two companies will announce an agreement to merge the
two companies. The deal is finalized in a formal merger and acquisition
agreement. This leads us to the fifth and final phase within the M & A Process,
the integration of the two companies.
Every company is different - differences in culture, differences in information
systems, differences in strategies, etc. As a result, the Post Merger Integration
Phase is the most difficult phase within the M & A Process. Now all of a sudden
we have to bring these two companies together and make the whole thing work.
This requires extensive planning and design throughout the entire organization.
The integration process can take place at three levels:

249

Full: All functional areas (operations, marketing, finance, human resources, etc.)
will be merged into one new company. The new company will use the "best
practices" between the two companies.
Moderate: Certain key functions or processes (such as production) will be
merged together. Strategic decisions will be centralized within one company,
but day to day operating decisions will remain autonomous.
Minimal: Only selected personnel will be merged together in order to reduce
redundancies. Both strategic and operating decisions will remain decentralized
and autonomous.
If post merger integration is successful, then we should generate synergy
values. However, before we embark on a formal merger and acquisition
program, perhaps we need to understand the realities of mergers and
acquisitions.
Reasons Behind Failed Mergers
Mergers and acquisitions are extremely difficult. Expected synergy values may
not be realized and therefore, the merger is considered a failure. Some of the
reasons behind failed mergers are:
Poor strategic fit - The two companies have strategies and objectives that are
too different and they conflict with one another.
Cultural and Social Differences - It has been said that most problems can be
traced to "people problems." If the two companies have wide differences in
cultures, then synergy values can be very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the
"watchdog" within the M & A Process. If you fail to let the watchdog do his job,
you are in for some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires a
very high level of quality management. In the words of one CEO, "give me some
people who know the drill." Integration is often poorly managed with little
planning and design. As a result, implementation fails.

250

Paying too Much - In today's merger frenzy world, it is not unusual for the
acquiring company to pay a premium for the Target Company. Premiums are
paid based on expectations of synergies. However, if synergies are not realized,
then the premium paid to acquire the target is never recouped.
Overly Optimistic - If the acquiring company is too optimistic in its projections
about the Target Company, then bad decisions will be made within the M & A
Process. An overly optimistic forecast or conclusion about a critical issue can
lead to a failed merger.

We should also recognize some cold hard facts about mergers and acquisitions.
In the book The Complete Guide to Mergers and Acquisitions, the authors
Timothy J. Galpin and Mark Herndon point out the following:
- Synergies projected for M & A's are not achieved in 70% of cases.
- Just 23% of all M & A's will earn their cost of capital.
- In the first six months of a merger, productivity may fall by as much as 50%.
- The average financial performance of a newly merged company is graded as C
- by the respective Managers.
In acquired companies, 47% of the executives will leave the first year and 75%
will leave within the first three years of the merger.
Due Diligence
There is a common thread that runs throughout much of the M & A Process. It is
called Due Diligence. Due diligence is a very detailed and extensive evaluation
of the proposed merger. In
An over-riding question is - Will this merger work? In order to answer this
question, we must determine what kind of "fit" exists between the two
companies. This includes: Investment Fit - What financial resources will be
required, what level of risk fits with the new organization, etc.?
251

Strategic Fit - What management strengths are brought together through this
M & A? Both sides must bring something unique to the table to create synergies.
Marketing Fit - How will products and services compliment one another
between the two companies? How well do various components of marketing fit
together - promotion programs, brand names, distribution channels, customer
mix, etc?
Operating Fit - How well do the different business units and production
facilities fit together? How do operating elements fit together - labor force,
technologies, production capacities, etc.?
Management Fit - What expertise and talents do both companies bring to the
merger? How well do these elements fit together - leadership styles, strategic
thinking, ability to change, etc.?
Financial Fit - How well do financial elements fit together - sales, profitability,
return on capital, cash flow, etc.?
Due diligence is also very broad and deep, extending well beyond the functional
areas (finance, production, human resources, etc.). This is extremely important
since due diligence must expose all of the major risk associated with the
proposed merger. Some of the risk areas that need to be investigated are:
- Market - How large is the target's market? Is it growing? What are the major
threats? Can we improve it through a merger?
- Customer - Who are the customers? Does our business compliment the
target's customers? Can we furnish these customers new services or products?
- Competition - Who competes with the target company? What are the barriers
to competition? How will a merger change the competitive environment?
- Legal - What legal issues can we expect due to an M & A? What liabilities,
lawsuits, and other claims are outstanding against the Target Company?
Another reason why due diligence must be broad and deep is because
management is relying on the creation of synergy values. Much of Phase I Due
Diligence is focused on trying to identify and confirm the existence of synergies
252

between the two companies. Management must know if their expectation over
synergies is real or false and about how much synergy can we expect? The total
value assigned to the synergies gives management some idea of how much of a
premium they should pay above the valuation of the Target Company. In some
cases, the merger may be called off because due diligence has uncovered
substantially less synergies then what management expected.
MAKING DUE DILIGENCE WORK
Since due diligence is a very difficult undertaking, you will need to enlist your
best people, including outside experts, such as investment bankers, auditors,
valuation specialist, etc. Goals and objectives should be established, making
sure everyone understands what must be done. Everyone should have clearly
defined roles since there is a tight time frame for completing due diligence.
Communication channels should be updated continuously so that people can
update their work as new information becomes available; i.e. due diligence must
be an iterative process. Throughout due diligence, it will be necessary to provide
summary reports to senior level management.
Due diligence must be aggressive, collecting as much information as possible
about the target company. This may even require some undercover work, such
as sending out people with false identities to confirm critical issues. A lot of
information must be collected in order for due diligence to work. This
information includes:
Corporate Records: Articles of incorporation, by laws, minutes of meetings,
shareholder list, etc.
Financial Records: Financial statements for at least the past 5 years, legal
council letters, budgets, asset schedules, etc.
Tax Records: Federal, state, and local tax returns for at least the past 5 years,
working papers, schedules, correspondence, etc.Regulatory Records: Filings with

253

the NSE, reports filed with various governmental agencies, licenses, permits,
decrees, etc.
Debt Records: Loan agreements, mortgages, lease contracts, etc.
Employment Records: Labor contracts, employee listing with salaries, pension
records, bonus plans, personnel policies, etc.
Property Records: Title insurance policies, legal descriptions, site evaluations,
appraisals, trademarks, etc.
Miscellaneous Agreements: Joint venture agreements, marketing contracts,
purchase contracts, agreements with Directors, agreements with consultants,
contract forms, etc.
Good due diligence is well structured and very pro-active; trying to anticipate
how customers, employees, suppliers, owners, and others will react once the
merger is announced. When one analyst was asked about the three most
important things in due diligence, his response was "detail, detail, and detail."
Due diligence must very in-depth if you expect to uncover the various issues
that must be addressed for making the merger work.
FINANCIAL TERMS OF EXCHANGE
When two companies are combined, a ratio of exchange occurs, denoting the
relative weighting of the firms. The ratio of exchange can be considered in
respect to earnings, market prices and the book values of the two companies
involved.
a.

Earnings
In evaluating possible acquisition, the acquiring firm must at least
consider the effect the merger will have on the earnings per share of the
surviving company. We can discuss this through an illustration:
Illustration (4.1)
254

Company A is considering the acquisition by shares of Company B. The

following information is also available.

Present earnings

Company A

Company B

Shs 20,000,000

Shs 5,000,000

5,000,000

2,000,000

Shares
Earnings per share

Shs 4

Price/earning ratio
Price of shares

Shs 2.50

16

12

Sh 64

Sh 30

Company B has agreed to an offer of Shs 35 a share to be paid in

Company A shares.
REQUIRED:
Consider the effect of the acquisition to the earnings per share.
SOLUTION
The exchange ratio

35/64

0.546875 shares

of Company A's stock for each share of Company B's stock.

The total number of shares needed to acquire company B's share
= 0.546875 X 2,000,000 = 1,093,750 shares of Company A
The earnings per share therefore can be computed as follow:
EPS combined=
Companies

Earnings of A + Earnings of B
Total No. of shares

20,000,000 + 5,000,000
5,000,000 + 1,093,750
255

25,000,000
6,093,750

Shs 4.10

Therefore the earnings for share of the combined firm is Shs 4.10.
There is therefore an immediate improvement in earnings per share for
Company A as a result of the merger.
However, Company B's former shareholders experience a reduction in
earnings per share. These EPS will be given by
0.546875 X 4.10
b.

Shs 2.24 from

Shs 2.50

Future Earnings
If the decision to acquire another company were based solely on the
initial impact on earnings per share, an initial dilution in earnings per
share would stop any company from merging with another.

However,

due to synergetic effects discussed earlier, the merger may result in

increased future earnings and therefore a high EPS in future.
c.

Market Value
The major emphasis in the bargaining process is on the ratio of exchange
of market price per share.

The market price per share reflects the

earnings potential of the company, dividends, business risk, capital

structure, asset values and other factors that bear upon valuation. The
ratio of exchange of market price is given by the following formula:
Market price ratio =

Market price per share of acquiring company X

No. of shares offered

256

of exchange

Market price per share of the acquired

company
Considering the previous example (example 4.1)
Market price ratio =

64 X 0.546875

1.167.

30
Therefore, Company B receive more than its market price per share. It is
common for the company being acquired to receive a little more than the
market price per share.

Shareholders of the acquired company would

therefore benefit from the acquisition because their shares were originally
worth Shs 30 but they receive Shs 35.

Illustration (4.2)
The following information relates to Company X and Y.

Present earnings

Company X

Company Y

Shs 20,000,000

Shs 6,000,000

6,000,000,000

2,000,000

No. of shares
Earnings per share
Market price per share

Shs 3.33

Shs 3.00

Shs 60.00

Shs 30.00

18

10

Price/earning ratio

Company X offers 0.667 shares for each share of Company Y to acquire

the company.
The market price exchange ratio =
3

257

60 X 0.667

1.33

Shareholders of Y are being offered a share with a market value of Shs 40

for each share they own (i.e. 1.333 X 30). They benefit from acquisition
with respect to market price because their shares were formerly worth
Shs 30. We can consider the combined effect.

Combined Effect
Total earnings

Shs 26,000,000

No. of shares

7,333,333

Earnings per share

Shs 3.55

Price/earning ratio

18

Market price per share

Shs 63.90

Note:
Both companies tend to benefit due to the merger. This can be seen by
the increased market price per share for both company. This is due to the
assumption that the price earnings ratio of the combined company will
remain 18. If this is the case, companies with high price/earning ratios
can be able to acquire companies with lower price/earnings ratio to
obtain an immediate increase in earnings per share (even if they pay a
premium for the share.)
d.

Book value
Book value per share is not a useful basis for valuation in most mergers.
However, it may be important if the purpose of an acquisition is to obtain
the liquidity of another company. The ratio of exchange of book value per
share of the two companies are calculated in the same manner as is the
258

ratio for market values computed above. The application of this ratio in
bargaining is usually restricted to situations in which a company is
acquired for its liquidity and asset values rather than for its earning
power.
4.9 VALUING THE TARGET FIRM
To determine the value of the target firm, two key items are needed:
a.

set

of

proforma

financial

statements

which

develop

the

incremental cashflows expected from the merger, and

b.

A discount rate or cost of capital, to apply to these projected

cashflows.

CASH FLOW STATEMENTS

In a pure financial merger, the post-merger cash flows are simply the sum
of the expected cashflows of the two firms if they were to continue
operating independently. If the two firm's operations are to be integrated
however, forecasting future cashflows is a more complex task.
The following illustration can be used to determine the value of target
company.
Illustration: (4.3)
XYZ Ltd. is considered acquiring ABC Ltd.

The following information

relates to ABC Ltd. for the next five years. The projected financial data
are for the post-merger period. The corporate tax rate is 40% for both
companies.
Amounts are in Shs `000'
Net sales

1994

1995

1996

1997

1998

1,050

1,260

1,510

1,740

1,910

259

Cost of sales

735

882

1,057

1,218

1,337

Selling & admn. expenses 100

120

130

150

160

50

70

90

110

Interest expenses

40

Other information
a.

After the fifth year the cashflows available to XYZ from ABC is
expected to grow by 10% per annum in perpetuity.

b.

ABC will retain Shs 40,000 for internal expansion every year.

c.

The cost of capital can be assumed to be 18%.

REQUIRED:
i.

Estimate the annual cash flows.

ii.

Determine the maximum amount XYZ would be willing to acquire

ABC at.

SOLUTION:
XYZ LTD

260

i. PROJECTED POST-MERGER CASHFLOWS FOR ABC LTD.

Amounts in Shs `000'
1994

1995

1996

1997

1998

1,050

1,260

1,510

1,740

1,910

735

882

1,057

1,218

1,337

315

378

453

522

573

Less selling and admn. costs 100

120

130

150

160

EBIT

215

258

323

372

413

40

50

70

90

110

175

208

253

282

303

Net sales
Less cost of sales

Less interest
EBT
Less tax 40%

70

83.2

101.2

112.8

121.2

105

124.8

151.8

169.2

181.8

Less Retention by ABC

40

40.0

40.0

40.0

40.0

Cash available to XYZ

65

84.8

91.8

129.2

Net income

Add terminal value

Net cash flows

65

84.8

.
91.8

141.75
1,949.75

129.2 2,091.55

Computation of terminal value

TV

141.8 (1 + 0.1)

Shs 1,949.75

0.18 - 0.10
ii.

Assuming the discount rate of 18%, the maximum price of ABC can be
determined by computing the PV of the projected cashflows.
Year

Cashflow

PVIF18%

PV

65

0.847

55.055

84.8

0.718

60.886

91.8

0.607

55.723

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129.2

0.516

2,091.55

0.437

66.667
914.24
1,152.57

The maximum price will therefore be Shs 1,152,570

Note:

Estimating the discount rate will be discussed in Lesson 6.

The Role Of Investment Bankers In Mergers

The investment banking community is involved with mergers in a number

of ways:
1.

They help arrange mergers

The bankers will identify firms with excess cash that might want to
buy other firms, companies that might be willing to be bought and
companies which might be attractive to others.

2.

They

help

target

companies

develop

and

implement

defensive techniques
Target firms that do not want to be acquired generally enlist the help
of an investment banking firm, along with a law firm that specializes
in helping to block mergers. Defensive techniques include:

(a) Changing the by-laws e.g require special resolution (75%) to

approve mergers.
(b) Trying to convince the target firm's shareholders that the price
being offered is too low.
(c)

Raising antitrust issues between shareholders of the two firms.

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(d) Repurchasing shares in an open market in an effort to push the

prices above that being offered by the potential acquirer.
(e) Being acquired by a more friendly firm.
(f)

Taking a poison pill (commiting economic suicide) e.g. borrowing

on terms that require immediate repayment of all loans if the
firm is acquired, selling off at a bargain the assets that originally
made the firm a desirable target, heavy cash overflows in
dividends, executive benefits etc.

3.

Establishing a fair value

Investment bankers are experts that can help the firms determine a
fair ratio of exchange that is beneficial (if possible) to both
shareholders.

4.

They help finance mergers

If the acquiring company has cashflow problems, then investment
bankers will provide required finance for the merger.
They speculate in the shares of potential merger candidates and
thereby make arbitrage gains.

Anti-Takeover Defenses
Throughout this entire lesson we have focused our attention on making the
merger and acquisition process work. In this final part, we will do just the
opposite; we will look at ways of discouraging the merger and acquisition
process. If a company is concerned about being acquired by another company,
several anti-takeover defenses can be implemented. As a minimum, most
companies concerned about takeovers will closely monitor the trading of their
stock for large volume changes.
a. Poison pill
One of the most popular anti-takeover defenses is the poison pill. Poison pills
represent rights or options issued to shareholders and bondholders. These
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rights trade in conjunction with other securities and they usually have an
expiration date. When a merger occurs, the rights are detached from the
security and exercised, giving the holder an opportunity to buy more securities
at a deep discount. For example, stock rights are issued to shareholders, giving
them an opportunity to buy stock in the acquiring company at an extremely
low price. The rights cannot be exercised unless a tender offer of 20% or more
is made by another company. This type of issue is designed to reduce the
value of the Target Company. Flip-over rights provide for purchase of the
Acquiring Company while flip-in rights give the shareholder the right to acquire
more stock in the Target Company. Put options are used with bondholders,
allowing them to sell-off bonds in the event that an unfriendly takeover occurs.
By selling off the bonds, large principal payments come due and this lowers
the value of the Target Company.
b. Golden Parachutes
Another popular anti-takeover defense is the Golden Parachute. Golden
parachutes are large compensation payments to executive management,
payable if they depart unexpectedly. Lump sum payments are made upon
termination of employment. The amount of compensation is usually based on
annual compensation and years of service. Golden parachutes are narrowly
applied to only the most elite executives and thus, they are sometimes viewed
negatively by shareholders and others. In relation to other types of takeover
defenses, golden parachutes are not very effective.
c. Changes to the Corporate Charter
If management can obtain shareholder approval, several changes can be
made to the Corporate Charter for discouraging mergers. These changes
include:
Staggered Terms for Board Members: Only a few board members are
elected each year. When an acquiring firm gains control of the Target
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Company, important decisions are more difficult since the acquirer lacks
full board membership. A staggered board usually provides that one-third
are elected each year for a 3 year term. Since acquiring firms often gain
control directly from shareholders, staggered boards are not a major antitakeover defense.
Super-majority Requirement: Typically, simple majorities of shareholders
are required for various actions. However, the corporate charter can be
amended, requiring that a super-majority (such as 80%) is required for
approval of a merger. Usually an "escape clause" is added to the charter,
not requiring a super-majority for mergers that have been approved by
the Board of Directors. In cases where a partial tender offer has been
made, the super-majority requirement can discourage the merger.
Fair Pricing Provision: In the event that a partial tender offer is made, the
charter can require that minority shareholders receive a fair price for their
stock. Since many countries have adopted fair pricing laws, inclusion of a
fair pricing provision in the corporate charter may be a moot point.
However, in the case of a two-tiered offer where there is no fair pricing
law, the acquiring firm will be forced to pay a "blended" price for the
stock.
Dual Capitalization: Instead of having one class of equity stock, the
company has a dual equity structure. One class of stock, held by
management, will have much stronger voting rights than the other
publicly traded stock. Since management holds superior voting power,
management has increased control over the company.
d. Re-capitalization
One way for a company to avoid a merger is to make a major change in its
capital structure. For example, the company can issue large volumes of debt
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and initiate a self-offer or buy back of its own stock. If the company seeks to
buy-back all of its stock, it can go private through a leveraged buy out (LBO).
However, leveraged re-capitalization require stable earnings and cash flows
for servicing the high debt loads. And the company should not have plans for
major capital investments in the near future. Therefore, leveraged recaps
should stand on their own merits and offer additional values to shareholders.
Maintaining high debt levels can make it more difficult for the acquiring
company since a low debt level allows the acquiring company to borrow
easily against the assets of the Target Company.
Instead of issuing more debt, the Target Company can issue more stock. In
many cases, the Target Company will have a friendly investor known as a
"white squire" which seeks a quality investment and does not seek control of
the Target Company. Once the additional shares have been issued to the
white squire, it now takes more shares to obtain control over the Target
Company.
Finally, the Target Company can do things to boost valuations, such as stock
buy-backs and spinning off parts of the company. In some cases, the target
company may want to consider liquidation, selling-off assets and paying out
a liquidating dividend to shareholders. It is important to emphasize that all
restructuring should be directed at increasing shareholder value and not at
trying to stop a merger.
e. Other Anti Takeover Defenses
Finally, if an unfriendly takeover does occur, the company does have some
defenses to discourage the proposed merger:
1. Stand Still Agreement:
The acquiring company and the target company can reach agreement
whereby the acquiring company ceases to acquire stock in the target for a
specified period of time. This stand still period gives the Target Company
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time to explore its options. However, most stand still agreements will
require compensation to the acquiring firm since the acquirer is running
the risk of losing synergy values.
2. Green Mail: If the acquirer is an investor or group of investors, it might
be possible to buy back their stock at a special offering price. The two
parties hold private negotiations and settle for a price. However, this type
of targeted repurchase of stock runs contrary to fair and equal treatment
for all shareholders. Therefore, green mail is not a widely accepted antitakeover defense.
3. White Knight: If the target company wants to avoid a hostile merger,
one option is to seek out another company for a more suitable merger.
Usually, the Target Company will enlist the services of an investment
banker to locate a "white knight." The White Knight Company comes in
and rescues the Target Company from the hostile takeover attempt. In
order to stop the hostile merger, the White Knight will pay a price more
favorable than the price offered by the hostile bidder.
4. Litigation: One of the more common approaches to stopping a merger is
to legally challenge the merger. The Target Company will seek an
injunction to stop the takeover from proceeding. This gives the target
company time to mount a defense. For example, the Target Company will
routinely challenge the acquiring company as failing to give proper notice
of the merger and failing to disclose all relevant information to
shareholders.
5. Pac Man Defense: As a last resort, the target company can make a
tender offer to acquire the stock of the hostile bidder. This is a very
extreme type of anti-takeover defense and usually signals desperation.
One very important issue about anti-takeover defenses is valuations.
Many anti-takeover defenses (such as poison pills, golden parachutes,
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etc.) have a tendency to protect management as opposed to the

shareholder.

Consequently,

companies

with

anti-takeover

defenses

usually have less upside potential with valuations as opposed to

companies that lack anti-takeover defenses. Additionally, most studies
show that anti-takeover defenses are not successful in preventing
mergers. They simply add to the premiums that acquiring companies
must pay for target companies.
Corporate Alliance
Mergers are one way for two companies to completely join assets and
management but many companies enter into corporate deals which fall short
of merging.

Such deals are called corporate alliances and they take many

forms, from straight forward marketing agreements to joint ownership of world

scale operations. Joint venture is one method of corporate alliance. In a joint
venture parts of companies are joined to achieve specific limited objectives. A
joint venture is controlled by management teams consisting of representation
of both the two or more parent companies.

268