HBC 2202: INTRODUCTION TO FINANCIAL MANAGEMENT (45

LECTURE HOURS)
Prerequisite – HBC 2107 Introduction to Accounting II
COURSE PURPOSE
To equip the students with knowledge that enables them to understand and
appreciate financial decision making process, empowering them to explain
and predict the impact of financing, investing, risk management, dividend
and liquidity decisions.

COURSE OBJECTIVES
At the end of this course students should be able to:
1. Identify and Evaluate sources of long term, medium term and long
term sources of finance.
2. Recognize the principles and concepts of the three main decision
making areas of finance i.e. investing, financing and asset
management
3. Solve problems relating to time value of money.
COURSE OUTLINE
LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT
LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…)
LESSON 3: SOURCES OF FINANCE
LESSON 4: SOURCES OF FINANCE (CONT…)
LESSON 5: WORKING CAPITAL MANAGEMENT
LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…)
LESSON 7: TIME VALUE OF MONEY
LESSON 8: COST OF CAPITAL
LESSON 9: INTRODUCTION TO FINANCIAL MARKETS
LESSON 10: INTRODUCTION TO FINANCIAL MARKETS (CONT…)

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LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT

1.1Definition of financial management

Financial Management is that specialised function of general management
which is related to the procurement of finance and its effective utilisation for
the achievement of common goal of the organisation.

It includes each and every aspect of financial activity in the business.

Financial Management has been defined differently by different scholars. A
few of the definitions are being reproduced below:-

“Financial Management is an area of financial decision making harmonizing

individual motives and enterprise goals.”- Weston and Brigam.

“Financial Management is the application of the planning and control

functions to the finance function.”- Howard and Upton.

“Financial Management is the operational activity of a business that is

responsible for obtaining and effectively, utilizing the funds necessary for
efficient operations.”- Joseph and Massie.

From the above definitions, it is clear that financial management is that

specialised activity which is responsible for obtaining and affectively utilizing
the funds for the efficient functioning of the business and, therefor, it
includes financial planning, financial administration and financial control.

Financial Management is a discipline concerned with the generation and

allocation of scarce resources (usually fund) to the most efficient user within
the firm (the competing projects) through a market pricing system (the
required rate of return).
A firm requires resources in form of funds raised from investors. The funds
must be allocated within the organization to projects which will yield the
highest return.
We shall refer to this definition as we go through the subject.
1.2 Required Rate of Return (Ri)

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The required rate of return (Ri) is the minimum rate of return that a project
must generate if it has to receive funds. It’s therefore the opportunity cost of
capital or returns expected from the second best alternative. In general,
Required Rate of Return = Risk free rate + Risk premium
Risk free is compensation for time and is made up of the real rate of return
(Ri)and the inflation premium (IRp). The risk premium is compensation for risk
of financial actions reflecting:
- The riskiness of the securities caused by term to maturity
- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.

The required rate of return can therefore be expressed as follows:

Rj = Rr + IR∞ + DR∞ + MR∞ + LR∞ + ER∞ +SR∞ + OR∞
Where:
 Rr is the real rate of return that compensate investors for giving up the
use of their funds in an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for
the decrease in purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for
the possibility that users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to
maturity
 LRp is the Liquidity Risk Premium which compensates the investor for
the possibility that the securities given are not easily marketable (or
convertible to cash)
 ERp is the Exchange Risk Premium which compensates the investors
for the fluctuation in exchange rate. This is mainly important if the
funds are denominated in foreign currencies.
 SRp is the Soverign Risk Premium which compensates the investors for
the possibility of political instability in the country in which the funds
have been provided.
 ORp is the Other Risk Premium e.g the type of product, the type of
market, etc.

1.2 Distinction between Financial Accounting and Financial

Management

Financial Accounting Financial Management

(i) It is a statutory requirement (i) It is not a statutory
(ii) It is carried out according to requirement
the General Accepted (ii) It is just conducted
Acoounting Principles according to the

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 (GAAP) management decisions
(iii) It deals with historical
transactions (iii) It deals with future
(iv) It is both for internal planning
and external users
(v) It deals with recording (iv) It is for internal users
financial transactions in a i.e management
systematic manner for a (v) It deals with the
particular period procurement and allocation
(vi) Where finacial of fianancial resources
accounting ends financial
management starts (vi) finacial accounting
comes before financial
management

1.3 Scope of finance functions.

The functions of Financial Manager can broadly be divided into two. The
Routine functions and the Managerial Functions.
1.3.1Managerial Finance Functions
Require skillful planning control and execution of financial activities. There
are four important managerial finance functions. These are:
(a) Investment of Long-term asset-mix decisions
These decisions (also referred to as capital budgeting decisions)
relates to the allocation of funds among investment projects. They
refer to the firm’s decision to commit current funds to the purchase of
fixed assets in expectation of future cash inflows from these projects.
Investment proposals are evaluated in terms of both risk and expected
return.Investment decisions also relates to recommitting funds when
an old asset becomes less productive. This is referred to as
replacement decision.

(b) Financing decisions

Financing decision refers to the decision on the sources of funds to
finance investment projects. The finance manager must decide the
proportion of equity and debt. The mix of debt and equity affects the
firm’s cost of financing as well as the financial risk. This will further be
discussed under the risk return trade off.
(c) Division of earnings decision
The finance manager must decide whether the firm should distribute
all profits to the shareholder, retain them, or distribute a portion and
retain a portion. The earnings must also be distributed to other
providers of funds such as preference shareholder, and debt providers
of fund such as preference shareholders and debt providers. The firm’s
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 divided policy may influence the determination of the value of the firm
and therefore the finance manager must decide the optimum dividend
– payout ratio so as to maximize the value of the firm.
(d) Liquidity decision
The firm’s liquidity refers to its ability to meet its current obligations as
and when they fall due. It can also be referred as current assets
management. Investment in current assets affects the firm’s liquidity,
profitability and risk. The more current assets a firm has, the more
liquid it is. This implies that the firm has a lower risk of becoming
insolvent but sine current assets are non- earning assets the
profitability of the firm will be low. The converse will hold true.
The finance manager should develop sound techniques of managing
current assets to ensure that neither insufficient not unnecessary funds
are invested in current assets.
1.3.2 Routine functions
For the effective execution of the managerial finance functions, routine
functions have to be performed. These decision concern procedures and
systems and involve a lot of paper work and time. In most cases these
decisions are delegated to junior staff in the organization. Some of the
important routine functions are:
(a) Supervision of cash receipts and payments
(b)Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d)Record keeping and reporting

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

1.4 objectives of a business entity

Any business firm would have certain objectives which it aims at achieving
.The major goal of a firm are :
 Profit maximization
 Shareholder wealth maximization
 Social responsibility
 Business ethics
 Growth

1.4.1 Profit maximization

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

Profit = Revenue – Expenses

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

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

(a) It ignores time value of money

(b) It ignores risk and uncertainties
(c) it is vague
(d) it ignores other participants in the firm rather than the shareholders

1.4.2 Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present
value of every decision made in the firm. Net present value is equal to the
difference between the present value of benefits received from a decision and
the present value of the cost of the decision. A financial action with a positive
net present value will maximize the wealth of the shareholders, while a
decision with a negative net present value will reduce the wealth of the
shareholders. Under this goal, a firm will only take those decisions that result
in a positive net present value.

Shareholder wealth maximization helps to solve the problems with profit

maximization. This is because, the goal:

i. considers time value of money by discounting the expected

future cashflows to the present.
ii. it recognises risk by using a discount rate (which is a measure
of risk) to discount the cashflows to the present.
1.4.3 Social responsibility
The firm must decide whether to operate strictly in their shareholders' best
interests or be responsible to their employers, their customers, and the
community in which they operate. The firm may be involved in activities
which do not directly benefit the shareholders, but which will improve the
business environment. This has a long term advantage to the firm and
therefore in the long term the shareholders wealth may be maximized.

1.4.4 Business Ethics

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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
v. Illegal political involvement
vi. bribery or illegal payments to obtain business

1.4.5 Growth
This is a major objective of small companies which may even invest in projects
with negative NPV so as to increase their size and enjoy economies of scale in
the future.

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LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…)
1.5 AGENCY THEORY
An agency relationship may be defined as a contract under which one or more
people (the principals) hire another person (the agent) to perform some
services on their behalf, and delegate some decision making authority to that
agent. Within the financial management framework, agency relationship
exists between:
a) Shareholders and Managers
b) Debt holders and Shareholders
c) Shareholders and the government
d) Shareholders and auditors

1.5.1 Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is
managed by a board of directors appointed by the shareholders. This is
because:

i) There are very many shareholders who cannot effectively manage the
firm all at the same time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.

Conflict of interest usually occur between managers and shareholders in the

following ways:

i) Managers may not work hard to maximize shareholders wealth if they

perceive that they will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more
than what a shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what
shareholders would consider reasonable.

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v) Manager may undertake projects that improve their image at the
expense of profitability.
vi) Where management buy out is threatened. ‘Management buy out’
occurs where management of companies buy the shares not owned by
them and therefore make the company a private one.

Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders,
the firm will:

(a) Incur Agency Costs in the form of:

i) Monitoring expenses such as audit fee;

ii) Expenditures to structure the organization so that the possibility of
undesirable management behaviour would be limited. (This is the
cost of internal control)
iii) Opportunity cost associated with loss of profitable opportunities
resulting from structure not permit manager to take action on a
timely basis as would be the case if manager were also owners.
This is the cost of delaying decision.

(b) The Shareholder may offer the management profit-based remuneration.

This remuneration includes:

i) An offer of shares so that managers become owners.

ii) Share options: (Option to buy shares at a fixed price at a future
date).
iii) Profit-based salaries e.g. bonus

(c) Threat of firing: Shareholders have the power to appoint and dismiss
managers which is exercised at every Annual General Meeting (AGM).
The threat of firing therefore motivates managers to make good
decisions.
(d) Threat of Acquisition or Takeover: If managers do not make good
decisions then the value of the company would decrease making it
easier to be acquired especially if the predator (acquiring) company
beliefs that the firm can be turned round.

1.5.2 Debt holders versus Shareholders

A second agency problem arises because of potential conflict between
stockholders and creditors. Creditors lend funds to the firm at rates that are
based on:

i. Riskiness of the firm's existing assets

ii. Expectations concerning the riskiness of future assets additions

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iii. The firm's existing capital structure
iv. Expectations concerning future capital structure changes.

These are the factors that determine the riskiness of the firm's cashflows and
hence the safety of its debt issue. Shareholders (acting through
management) may make decisions which will cause the firm's risk to change.
This will affect the value of debt. The firm may increase the level of debt to
boost profits. This will reduce the value of old debt because it increases the
risk of the firm.
Creditors will protect themselves against the above problems through:

a. Insisting on restrictive covenants to be incorporated in the debt contract.

These covenants may restrict:

 The company’s asset base

 The company’s ability to acquire additional debts
 The company’s ability to pay future dividend and management
remuneration.
 The management ability to make future decision (control related
covenants)

b. if creditors perceive that shareholders are trying to take advantage of

them in unethical ways, they will either refuse to deal further with the
firm or else will require a much higher than normal rate of interest to
compensate for the risks of such possible exploitations.

It therefore follows that shareholders wealth maximization require fair play

with creditors. This is because shareholders wealth depends on continued
access to capital markets which depends on fair play by shareholders as far as
creditor's interests are concerned.
1.5.3 Shareholders and the government
The shareholders operate in an environment using the license given by the
government. The government expects the shareholders to conduct their
business in a manner which is beneficial to the government and the society
at large.
The government in this agency relationship is the principal and the company
is the agent. The company has to collect and remit the taxes to the
government. The government on the other hand creates a conducive
investment environment for the company and then shares in the profits of
the company in form of taxes. The shareholders may take some actions

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which may conflict the interest of the government as the principal. These
may include;
(a) The company may involve itself in illegal business activities
(b)The shareholders may not create a clear picture of the earnings or the
profits it generates in order to minimize its tax liability.(tax evasion)
(c) The business may not response to social responsibility activities
initiated by the government
(d)The company fails to ensure the safety of its employees. It may also
produce sub standard products and services that may cause health
concerns to their consumers.
(e) The shareholders may avoid certain types of investment that the
government covets.
Solutions to this agency problem
(i) The government may incur costs associated with statutory audit,
it may also order investigations under the company’s act, the
government may also issue VAT refund audits and back duty
investigation costs to recover taxes evaded in the past.
(ii) The government may insure incentives in the form of capital
allowances in some given areas and locations.
(iii) Legislations: the government issues a regulatory framework that
governs the operations of the company and provides protection
to employees and customers and the society at large.ie laws
regarding environmental protection, employee safety and
minimum wages and salaries for workers.
(iv) The government encourages the spirit of social responsibility on
the activities of the company.
(v) The government may also lobby for the directorship in the
companies that it may have interest in. i.e. directorship in
companies such as KPLC, Kenya Re. etc

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1.5.4 Shareholders and auditors

Auditors are appointed by shareholders to monitor the performance of

management.
They are expected to give an opinion as to the true and fair view of the
company’s financial position as reflected in the financial statements that
managers prepare. The agency conflict arises if auditors collude with
management to give an unqualified opinion (claim that the financial
statements show a true and fair view of the financial position of the firm)
when in fact they should have given a qualified opinion (that the financial
statements do not show a true and fair view). The resolution of this conflict
could be through legal action, removal from office, use of disciplinary actions
provided for by regulatory bodies such as ICPAK.

1.6 CORPORATE GOVERNANCE

1.6.1 Definition of corporate governance

Corporate governance can be defined in various ways, for example:
The Private Sector Corporate Governance Trust (PSCGT) states that
corporate governance, “Refers to the manner in which the power of the
corporation is exercised in the stewardship of the corporation total portfolio
of assets and resources with the objective of maintaining and increasing
shareholders value through the context of its corporate vision” (PSCGT,
1999)
The Cadbury Report (1992) defines corporate governance as the system by
which companies are directed and controlled.
The Capital Market Authority (CMA) in year 2000 defined corporate

governance as the process and structures used to direct and manage

business affairs of the company towards enhancing prosperity and corporate

accounting with the ultimate objective of realizing shareholders long-term

value while taking into account the interests of other stakeholders.

1.6.2 Rationale for corporate governance

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

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 Institutional investors, as they seek to invest funds in the global economy,
insist on high standard of Corporate Governance in the companies they
invest in.
 Public attention attracted by corporate scandals and collapses has forced
stakeholders to carefully consider corporate governance issues.

Corporate governance is therefore important as it is concerned with:

 Profitability and efficiency of the firm.
 Long-term competitiveness of firms in the global economy.
 The relationship among firm’s stakeholders
1.6.3 Principles of corporate governance
There are 22 principles of Corporate Governance as given by the Common
Wealth Association of Corporate Governance (CACG) in1999 and the Private
Sector Corporate Governance Trust (PSCGT) in 1999 also. The first ten
principles are summarized below.

1. The authority and duties of members (shareholders)

Members and shareholders shall jointly and severally protect, preserve and
actively exercise the supreme authority of the corporation in general
meeting (AGM). They have a duty to exercise that supreme authority to:

 Ensure that only competent and reliable persons who can add value are
elected or appointed to the board of directors (BOD).
 Ensure that the BOD is constantly held accountable and responsible for
the efficient and effective governance of the corporation so as to achieve
corporate objective, prospering and sustainability.
 Change the composition of the BOD that does not perform to expectation
or in accordance with mandate of the corporation

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

3. Appointments to the BOD

It should be through a well managed and effective process to ensure that a
balanced mix of proficient individuals is made and that each director
appointed is able to add value and bring independent judgment on the
decision making process.

4. Strategy and Values

The BOD should determine the purpose and values of the corporation,
determine strategy to achieve that purpose and implement its values in

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order to ensure that the corporation survives and thrives and that
procedures and values that protect the assets and reputation of the
corporation are put in place.

5. Structure and organization

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

6. Corporate Performance, Viability & Financial Sustainability

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

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

8. Corporate Communication
The BOD should ensure that corporation communicates with all its
stakeholders effectively.
9. Accountability to Members
The BOD should serve legitimately all members and account to them fully.

10. Responsibility to stakeholders

The BOD should identify the firm’s internal and external stakeholders and
agree on a policy (ies) determining how the firm should relate to and with
them, increasing wealth, jobs and sustainability of a financially sound
corporation while ensuring that the rights of the stakeholders are respected,
recognized and protected.

1.7 Self Review Questions

1. Define the term Agency relationship as it applies in Co-operatives and
describe its structure.
2. Discuss FIVE goals of financial Management and their applications in
Co-operatives
3. State FIVE shortcomings of profit maximization objective.
4. Outline FIVE areas of conflict between managers and shareholders and
the solutions to counter the conflict.
5. Discuss authority and duties of members as a principle of corporate
governance.
6. In what ways is wealth maximization objective superior to the profit
maximization objective? Explain.
7. Outline FOUR functions of the Financial Manager.

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 8. Briefly discuss the following principles of corporate governance.
a) Authority and duties of members
b) Strategy and Values
c) Internal Control procedures
d) Structure and organization
9. What roles should the financial manager play in the modern Co-
operative set up?
10. Explain the key issues to be considered by a Financial Manager
in the day to day operating of saving and credit Co-operative.

11. Discuss the merits of the notion that the Financial Manager’s aim is to
maximize the value of the firm in light of the views expressed under
agency theory.
12. State FIVE shortcomings of profit maximization objective.
13. Outline FIVE areas of conflict between managers and shareholders
and the solutions to counter the conflict.
14. Discuss authority and duties of members as a principle of corporate
governance

LESSON 3: SOURCES OF FINANCE

Sources from which a firm may obtain its funds to finance its operations can
be classified in four different way as this include :
1. Classification according to the duration over which the funds will
be retained.

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These sources include
(a) long term sources of funds-
They are refundable after a long period of time i.e. after 12 years
(b)Short term sources of funds
These funds are refundable after a short period of time i.e. a period of 3
years
(c) Permanent sources of funds
These funds are not refundable as long as the business remains a going
concern for example ordinary share capital
2. Classification according to origin
These sources include;-
a) External sources of funds -They are raised from outside the
organization

b) Internal sources of fund-These are funds that are raised from within the
firm

3. Classification according to the relationship between the firm and

parties providing the funds

These sources include:-

a) Common equity capital -These are funds provided by the real owners
of the business i.e. ordinary share capital; it is the total of the ordinary
capital and the reserves

b) Quasi capital these are funds that are provided by the preference
shareholders

c) Debt finance -They are funds provided by the creditors i.e. debentures

4. Classification to the rate of return

These sources include:-

a) Capital with affixed rate of return -This is capital that is paid a certain
prespecified rate of return each year i.e. preference capital and long
term debts

b) Capital with a variable rate of return-This is capital that is paid a

different rate o0f return each year depending on the firm’s
performance.

5. A business may obtain funds from various sources which may be

either:
a) Long term sources which are repaid after a long period of time.

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 b) Short term sources which are repaid after a short period even less than
a year.

Sources of Finance

1. Equity finance

This is finance from the owners of the company (shareholders).it is generally

made up of ordinary share capital and reserves (both revenue and capital
reserves)

Ordinary share capital

The true owners of business forms are the ordinary shareholders. Sometimes
referred to as residual owners, they receive what is left after satisfaction of
all other claims.
The ordinary share capital is raised by the shareholders through the
purchase of common shares through the capital markets.
This form of long term capital is only accessible to limited companies who
have met the requirements of the capital market authority for listing before
floating the shares.
Features of ordinary share capital.
Ownership
The ordinary shares of a firm may be owned privately (family) or publicly
with shares being traded in the stock exchange.

Par value
The par value of an ordinary share is relatively useless value, established in
the firm’s corporate charter (memorandum). It is generally very low- Sh.5or
less.

Pre-emptive rights
Allow shareholders to maintain their proportionate ownership in the
corporation when new shares are issued. The feature maintains voting
control and protects against dilution.

Rights offering
The firm grants rights to its shareholders to purchase additional shares at a
price below market price, in direct proportion to their existing holding.

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Authorized, outstanding and issued shares
Authorized shares are the number of shares of common stock that the
firm’s charter (articles) allows without further shareholders’ approval.
Outstanding shares is the number of shares held by the public
Issued shares are the number of share that has been put in circulation; they
represent the sum of outstanding and treasury stock.
Treasury stock is the number of shares of outstanding stock that have
been repurchased by the firm (not allowed by the Companies Act of Kenya
Laws).
Dividends
The payment of corporate dividends is at the discretion of the Board of
Directors. Dividends are paid usually semi- annually (interim and final
dividends). Dividends can be paid in cash, stock (bonus issues) and
merchandise.

Voting rights
Generally each ordinary share entitled the holder to one vote at the Annual
General Meeting for the election of directors and on special issues.
Shareholders can either vote in person or in proxy i.e. appoint a
representative to vote on his behalf .Shareholders can vote through two
main systems,
1. Majority voting system.
2. Cumulative system.
Majority voting system
Under this system , shareholders receive a vote for every share held.
Decisions to be made must therefore be supported by over 50% of the votes
in a company .Under this system any shareholder or group pf shareholders
owning more than 50% of the company’s shares will make all the decisions.
The minority shareholders have no say.
Cumulative voting system.
Under this system, shareholders receive one vote for every share held times
the number of similar decisions to be made. This system is appropriate for
making decisions that are similar and is mainly used in the election of
directors.
Example.
Assume that there are 10,000 shares outstanding and you own 1001v shares
.Their are 9 directors to be elected and therefore you would have (1001×9)=
9009 votes .How many directors can you elect.
A.1001 shares = 1001×9 =9009
B. 10,000 – 1001 = 8999 × 9 = 80,991

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Share holder A has 9009 votes and with 9 directors to be elected , there is no
way for the owners of the remaining shares to exclude A from electing a
person to one of the top 9 positions. The majority shareholder would control
8999 shares thus thus entitling them to 80991 votes .The 80991 vote cannot
be spread thinly enough over the nine candidates to stop shareholder A
from electing one director.
The number of shares required to elect a give number of directors is given as
follows.

R= d (n) +1
Nd + 1
Where,
R- Number of shares required to elect a desired number of directors.
d- Number of directors shareholders desire to elect.
n- Total number of common shares outstanding.
Nd- Total number of directors to be elected.

Example
A company will elect 6 directors and their ae 100,000 shares entitled to vote,
Required.
a. If a group desires to elect two directors, how many shares must they
have.
b. Shareholder A owns 10,000 shares, shareholder B owns 40,000 shares
how many directors can each elect.
Solution.
a) R =2 (100,000) + 1
6+1
=28571.6 + 1=28573
b) A. 10,000= d (100,000) +1
6+1
10,000=14285.7d + 1
d= 9999/14285.7
d=0.7
Therefore zero directors.
B. 40,000=d (100,000) + 1
6+1
d=2
Therefore 2 directors.

Advantages of equity financing accruing to shareholders

1. Shares can be used as security for loans.
2. Providers of these funds can participate in the supernormal earnings of
the firm
3. The shares are easily transferable

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 4. Return in form of a share price appreciation (capital gain) and
dividends.
5. The following rights of ordinary shareholders can be viewed as
advantages:

Rights of ordinary shareholders.

i. Right to vote-shareholders have the right to vote on a number of
issues in a company such as election of directors, changes in the
Memorandum of Association and Articles of Association.
Shareholders can vote either in person or by proxy that is, by
appointing someone to represent them and vote on their behalf.
ii. Pre-emptive rights- Allow shareholders to maintain their
proportionate ownership in the corporation when new shares are
issued. The feature maintains voting control and protects
against dilution.
iii. Right to appoint another auditor
iv. Right to approve dividend payments
v. Right to approve merger acquisition
vi. Right to residual assets claim

Disadvantages accruing to shareholders

1. The ordinary share dividend is not an allowable deduction for tax
purposes
2. The dividend is paid after claims for other providers of capital are
satisfied
3. Ordinary shares carry the highest risk because of the uncertainty of
return(company has the discretion to declare dividend or not)and
incase of liquidation the holders have a residual claim on assets

Advantages of using ordinary share capital to a company

1. It is a permanent source of capital hence facilitates long term projects
2. Use of equity lowers the gearing level hence a company has a broader
borrowing capacity
3. The shareholders may provide valuable ideas to the company’s
operation
4. A company is not legally obliged to pay dividend especially if it is
facing financial difficulty these funds would serve better if retained.
5. It enables a company to get the opinion of the public through the
movement in share prices.
6. This source can be raised in very large amounts
7. It does not require any collateral as security.
8. The funds are provided without conditions hence are flexible.

Disadvantages of using ordinary share capital to a company

1. The floatation costs are higher than those of debt

20
 2. It is only accessible to companies that have fulfilled the capital markets
authority requirements
3. It can lead to dilution of ownership of control of the firm by the
shareholders
4. Since the dividend payment is not tax allowable then the company
does not enjoy a tax saving
5. The cost of this source of fund(dividend) is perpetual as ordinary
shares are not redeemable securities
6. The firm has to follow set guidelines on disclosure and publishing of
financial statements.

Methods of issuing common shares

 Through a public issue
 Private placement
 Through a rights issue
 Employee stock option plans (ESOP)
 Bonus issue

Public issue
Ordinary shares are offered to the general public. The issuing company
engages an investment banker who will undertake the issue. The investment
will set the securities issue price and will sell the shares to the investors. The
issuing firm can enter into an arrangement with the investment banker
where the investment banker will underwrite shares, that is, buy any shares
not taken up by the public.

Private placement
Under this method securities are sold to a few, usually chosen investors
mainly institutional investors. The advantages of this method is that the firm
gets to decide who will take up there shares, it can be used as part of
strategic partnership, it will also lead to less floatation cost as no
advertisement is necessary. It also takes less time to raise funds through a
private placement than a public issue which involves a number of
requirements to be fulfilled. A major disadvantage is that the share is not as
liquid-transferability is made difficult.

Rights issue
This is an option offered to already existing shareholders to buy common
shares of the company at a price (subscription price) which is less than the
market price. The subscription price is set a lower price than the market
price so as to make it attractive for the existing shareholders to buy the
common shares; also it acts as a safeguard against any reduction in share
price in the market.
When a rights issue is declared every outstanding share receives one right
however, a shareholder needs to have a number of rights in order to buy one
new share.

21
A rights issue involves selling of common shares to existing shareholders of
the company on a prorata basis. Shares becoming available on account
of non-exercise of rights are allotted to shareholders who have applied
for additional shares on a pro-rata basis. Any balance of shares can be
sold in the open market.

When rights are issued the shareholder has three options available:

(a) He can exercise the rights and therefore buy the new shares
(b) He can sell the rights in the market
(c) He can ignore the rights

The number of rights required to buy one new share can be given by the
following formula

N = So
S

Where So is the number of existing shares

S is the number of new shares to be sold
N is the number of rights required to buy one new share

The ex-right price of shares can be given by:

Px = So Po + S Ps
So + S

Where:

Px is the ex-right price of shares

Po is the cum-right price (current market prices of shares)
So is the number of existing shares
S is the number of new shares
Ps is the subscription price of rights

It can also be given by:

Px = Ps + (Po - Ps) N
N+1

Rights have value and the value of each right can be given by the
following formulae:

R = Px - Ps
N

22
Where R is the theoretical value of rights Px, Ps and N have previously
been defined.

It can also be given by:

R = Po - Px

or R = Po - Ps
N+1

Note:

All the above formulae give the same value and the student should use
whichever is most convenient.

Illustration:

XYZ Ltd has 900,000 shares outstanding at current market price of Sh

130 per share. The company needs Sh 22,500,000 to finance its
proposed expansion. The board of directors has decided to issue rights
for raising the required funds. The subscription price has been fixed at
Sh 75 per share.

Required:

(a) How many rights are required to purchase one new share?
(b) What is the price of one share after the rights issue (Ex-right price)?
(c) Compute the theoretical value of each right
(d) Consider the effect of the rights issue on the shareholders' wealth
under the three options available to the shareholders (Assume he
owns 3 shares and has Sh 75 cash on hand).

Solution:

(a) To compute the number of rights required to buy one new share, we
must first compute the number of new shares to be issued.

No. of shares = Desired funds

Subscription price

= 22,500,000
75

= 300,000 shares

23
 N = So So = 900,000 shares
S S = 300,000 shares

N = 900,000 = 3
300,000

Therefore a shareholder will require 3 rights to buy one new share in

the company.

Notes

The shareholder will receive one right for each share held and
therefore a total of 900,000 rights will be issued by the company.

(b) The price of the shares after the rights issue will be lower than the price
before the rights issue because the new shares are usually sold at a
price which is below the market price.

Px = Ps + (Po - Ps) N
N+1
Ps = 75
Po = 130
N = 3

Px = 75 + (130 - 75) 3/4

= Sh 116.25

After the rights issue the price of the shares would fall from Sh 130
to Sh 116.25. However, in an inefficient market, this may not be the
case.

(c) Value of each right

R = Po - Ps = 130 - 75
N + 1 3 + 1

= Sh 13.75

Each right will therefore have a theoretical value of Sh 13.75.

24
 (d) To consider the effects of the rights issue on the shareholders
wealth, we need to consider the current wealth of the shareholder.

Current Wealth Sh
Wealth in the company (3 x 130) 390
Cash in hand 75
Total Wealth 465

Option 1 - Exercise the rights Sh

Wealth in the company 4 x 116.25 465
Cash in hand (75 - 75) 0
Total Wealth 465

Therefore, the wealth remains constant if the shareholder exercises

the rights and buys the new shares.

Option 2 - Sell the rights at their theoretical value Sh

Wealth in the company 3 x 116.25 348.75

Cash in hand - previous 75
From sale of rights 3 x 13.75 41.25 116.25
Total Wealth 465.00

The wealth also remains constant if the shareholder sells the rights
at their theoretical value.

Option 3 - Ignore the rights Sh

Wealth in the company 3 x 116.25348.75
Cash in hand 75.00
Total Wealth 423.75

The wealth declines by Sh 41.25 from Sh 465 to Sh 423.75 if the

shareholder ignores the rights. The shareholder should therefore
never ignore a rights issue because his wealth will decline.
Note:
In an inefficient capital market the announcement of the rights issue may
carry additional information not yet known by the market and therefore the
share price may increase or decrease depending on the informational content
of the rights issue.
The major advantage of a rights issue is that the shareholders maintain their
proportionate ownership of the company.

Bonus issue
This is an issue of additional shares to existing shareholders in lieu of a cash
dividend. Companies may choose a bonus issue if it wants to give dividends
but not in the form of cash so as to retain the cash say for investment, it is

25
not taxable as cash dividends would be taxed. A bonus issue is expected to
have no effect on the shareholders wealth and may have the following
benefits,
Tax benefit –If a company declares such an issue. It Is not taxable as in the
case of Cash dividends .The share holder can therefore sale the new shares
in the market to make capital gain which is not taxable.
It can result into conservation of cash especially if a company is facing
financial constrains.
If the market is inefficient, a bonus issue maybe regarded as signaling
important information and may result in an increase in the share price
because a bonus issue is interpreted to mean high profits.
Increase in future dividends .This occurs especially if a company follows a
policy of paying a constant mount of dividends per share and continues with
this policy even after the bonus issue.

2. Term loan
Medium term & long term loans are obtained from commercial banks and
other financial institutions. This funds are mainly used to finance major
expansions or profit financing.
Features of term loans
1. Direct negotiation – A firm negotiates a term loan directly with a bank
of financial institution. I.e. a private placement.
2. Security – term loans are usually secured specifically by the assets
acquired using the funds. (Primary security). This is said to create a
fixed charge on the company’s assets. A fixed charge can also be
referred to as specific charge.
3. Restrictive covenant – financial institutions usually restrict the firms so
as to safeguard their funds. They do this by way of restrictive
covenants which include asset based covenant, cashflow, liability etc.
4. Convertibility – they are usually not convertible to common shares
unless under special cases. E.g. a financial institution may agree to
restructure the firms capital structure.
5. Repayment schedule – this indicates the time schedule for payment of
interest and principle. It may occur.
i) Where interest & principle are paid on equal periodic instalments.

26
 ii) Where principles is paid on equal periodic instalments & interest on
the outstanding balance of the loan.
Example
A company negotiates a Sh.30 million loan at 14% pa from a financial
institution. Acquired; prepare the loan prepayment schedule assuming
that:
(i) Interest & principle paid in 8 equal year end installment’s
(ii) Principle is paid in 8 equal instalments

i) 30,000,000 = A x PVIFA
14% 8 years
30,000,000 = 4.6389A
A = 6,46,050.0378
Schedule of Repayment
Yea Bal. b/d Instalmen Interest Principle Bal b/d
r t 14%
1 30,000,000 6,467,050 4,200,000 2,267,050 27,732,95
0
2. 27,732,950 6,467,050 3,882,613 2584437 25148513
3. 25148513 6,467,050 3520792 2946258 22202254
.8
4. 22202255 6,467,050 3108316 3358734. 18843521
3
5. 18843521 6,467,050 2638093 3828957 15014564
6. 150145639 6,467,050 2102039 4365011 10649553
7. 10649553 6,467,050 1490937. 4976112. 5673440.
4 6 4
8. 56734404 6,467,050 794282 5672768. 672.1
4

iii) 8 equal principle – 30n/8 = 3,750,000

YR Bal b/d inst. Int. primar
Yea Bal. b/d Instalmen Interest Principle Bal b/d

27
r t 14%
1 30,000,000 7950000 4200000 3750000 26250000
2. 26250000 7425000 3675000 3750000 22500000
3. 22500000 6900000 3150000 3750000 18750000
4. 18750000 6375000 2625000 3750000 15000000
5. 150000000 5850000 2100000 3750000 11250000
6. 11250000 5325000 1575000 3750000 7500000
7. 7500000 4800000 1050000 3750000 3750000
8. 3750000 4275000 525000 3750000 0

3. Preference shares (quasi-equity)

Preference shares have a fixed percentage dividend before any dividend is

paid to the ordinary shareholders. As with ordinary shares a preference
dividend can only be paid if sufficient distributable profits are available,
although with 'cumulative' preference shares the right to an unpaid dividend
is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary
shareholders.

Characteristics of preference shares

1. They have a fixed dividend

2. Dividends can be paid in arrears
3. They can be converted to ordinary shares
4. They have a claim on assets before the ordinary shareholders

Types of preference shares

1. Redeemable verses Irredeemable

2. Cumulative verses non- cumulative
3. Participative verses non-participative
4. Convertible verse non-convertible

From the company's point of view, preference shares are advantageous in

that:

 Dividends do not have to be paid in a year in which profits are poor, while
this is not the case with interest payments on long term debt (loans or
debentures).

 Since they do not carry voting rights, preference shares avoid diluting the
control of existing shareholders while an issue of equity shares would not.

28
 Unless they are redeemable, issuing preference shares will lower the
company's gearing. Redeemable preference shares are normally treated as
debt when gearing is calculated.

 The issue of preference shares does not restrict the company's borrowing
power, at least in the sense that preference share capital is not secured
against assets in the business.

 The non-payment of dividend does not give the preference shareholders

the right to appoint a receiver, a right which is normally given to debenture
holders.

However, dividend payments on preference shares are not tax deductible in

the way that interest payments on debt are. Furthermore, for preference
shares to be attractive to investors, the level of payment needs to be higher
than for interest on debt to compensate for the additional risks.

For the investor, preference shares are less attractive than loan stock
because:

 they cannot be secured on the company's assets

 the dividend yield traditionally offered on preference dividends has been
much too low to provide an attractive investment compared with the interest
yields on loan stock in view of the additional risk involved.

4. Venture capital

Venture capital is money put into an enterprise which may all be lost if the
enterprise fails. A businessman starting up a new business will invest
venture capital of his own, but he will probably need extra funding from a
source other than his own pocket. However, the term 'venture capital' is
more specifically associated with putting money, usually in return for an
equity stake, into a new business, a management buy-out or a major
expansion scheme.

The institution that puts in the money recognises the gamble inherent in the
funding. There is a serious risk of losing the entire investment, and it might
take a long time before any profits and returns materialise. But there is also
the prospect of very high profits and a substantial return on the investment.
A venture capitalist will require a high expected rate of return on
investments, to compensate for the high risk.

A venture capital organisation will not want to retain its investment in a

business indefinitely, and when it considers putting money into a business
venture, it will also consider its "exit", that is, how it will be able to pull out of
the business eventually (after five to seven years, say) and realise its profits.

29
Examples of venture capital organisations are: Merchant Bank of Central
Africa Ltd and Anglo American Corporation Services Ltd.

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

 the institution will want an equity stake in the company

 it will need convincing that the company can be successful
 it may want to have a representative appointed to the company's board, to
look after its interests.

The directors of the company must then contact venture capital

organisations, to try and find one or more which would be willing to offer
finance. A venture capital organisation will only give funds to a company that
it believes can succeed, and before it will make any definite offer, it will want
from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the most recent trading figures of the company, a balance sheet, a cash
flow forecast and a profit forecast

d) details of the management team, with evidence of a wide range of

management skills

e) details of major shareholders

f) details of the company's current banking arrangements and any other

sources of finance

g) any sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial

screening, and only a small percentage of all requests survive both this
screening and further investigation and result in actual investments.

Venture capital is a form of investment in new and risky small enterprises

which is required to get them started. Venture capitalists are therefore
investment specialist who raises pools of capital to fund new ventures which
are likely to become public companies in return for an ownership interest.
They therefore buy part of the stools of the company at a low price in

30
anticipation that when the company goes public, they would sale the shares
at a high price and make considerable capital gains, venture capitalists also
provide managerial skills to the firm examples of venture capitalists are:
Pension funds, insurance companies and also individuals.
Since the goal of venture capital is to make a profit, they will only invest in
that have a potential for growth.
Constraints in the development of a venture capital market in
Kenya.
i) The few promoters of venture capital are risk averse and therefore
are discouraged by the level of risk, the length of investment and
the liquidity of investment.
ii) The nature of firms in Kenya is such that they are privately owned
and therefore do not dillusion of ownership through use of venture
capital.
iii) The poor infrastructure in the country also discourages venture
capitalists.
iv) They are not enough incentives for the development of venture
capital and the government is discriminative against venture
capital. The tax laws favour debt over equity.
v) There is a general shortage of venture capitalists.

Importance of venture capital market in small and medium scale

business development
i) Venture capitalists provide the much needed finance to tour small
businesses which lack access to capital markets due to their size.
ii) Small medium scale businesses may lack managerial skills. Venture
capitalists sere as active partners through involvement in this
businesses and therefore provide marketing and planning skills as
the also want to see their investments succeed.

31
 iii) Venture capitalists encourage tree spirit of entrepreneurship
therefore small businesses are encouraged to see their ideas
through as they know they will get start up capital.
iv) Venture capitalists provide improved technology so that small and
medium scale business are in line with changes in technology and
are therefore able to compete with other firms of the same level.

LESSON 4: SOURCES OF FINANCE (CONT…)

5. Lease financing
This is an agreement where the right repossession and enjoyment of an
asset is transferred for a definite period of time. The person transferring the
right i.e. the owner of the asset is referred to as leasor. The recipient of the
asset is the lessee.

A lease is an agreement between two parties, the "lessor" and the "lessee".
The lessor owns a capital asset, but allows the lessee to use it. The lessee
32
makes payments under the terms of the lease to the lessor, for a specified
period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant
and machinery, cars and commercial vehicles, but might also be computers
and office equipment. There are two basic forms of lease: "operating leases"
and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee
whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased

equipment

c) the period of the lease is fairly short, less than the economic life of the
asset, so that at the end of the lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset
(the lessee) and a provider of finance (the lessor) for most, or all, of the
asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the
acquisition by means of a finance lease. A car dealer will supply the car. A
finance house will agree to act as lessor in a finance leasing arrangement,
and so will purchase the car from the dealer and lease it to the company.
The company will take possession of the car from the car dealer, and make
regular payments (monthly, quarterly, six monthly or annually) to the finance
house under the terms of the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the
asset. The lessor is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic
life of the asset. At the end of the lease, the lessor would not be able to lease
the asset to someone else, as the asset would be worn out. The lessor must,

33
therefore, ensure that the lease payments during the primary period pay for
the full cost of the asset as well as providing the lessor with a suitable return
on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to
continue to lease the asset for an indefinite secondary period, in return for a
very low nominal rent. Alternatively, the lessee might be allowed to sell the
asset on the lessor's behalf (since the lessor is the owner) and to keep most
of the sale proceeds, paying only a small percentage (perhaps 10%) to the
lessor.

Requirements of a Long Term lease

1. The present value of lease rentals must be greater than 90% the year
value of the asset.
2. 75% of the assets life is the lease term.
3. It is non-cell unsalable
4. Maintenance costs, insurance and taxes are paid by the lessee.
According to terms of payment
1. Net lease
This is on in which the leasee pays all or a substantial part of the
maintenance cost. It is therefore where the lessee pays for all the
expenses except taxes, insurances and exterior repairs.
2. Flat Lease
This is one which opts for periodic payment for use of the asset over
the term of the lease. Such a lease is usually made for such periods of
time since inflation can easily erode the buying power of the fixed
rentals.

3. Step Up lease
This provides for the fixed payments to be adjusted periodically. This
adjustments can be made either b new rentals taking effect after the
passages of a certain period of time or by periodically adjusting the

34
 fixed payments for inflation. The term of a stepup lease is usually
longer than a flat lease.
4. Percentage lease
This is where the lessee is required to pay a fixed basic percentage
rate and a designated percentage of sales volume. The percentage
factor acts as an inflation gauge as well as a means of Keeping lease
rentals in line with the market conditions.
5. Escalator lease
This calls for an increase in taxes insurance and operating costs to be
paid for the lessee.
6. Sandwich lease
This refers to a multiple lease in which the lessee in turn sub-lease to a
sub-lessee who in turn sub-leases to another sub-lessee. Example: A
the original owner of an asset leases to B. B executes a sub-lease to C
who then sub-leases to D.
This is a sandwich lease between B & C, B being the sandwich lessor
and C the sandwich lessee.
Advantages of lease
i) To avoid the risk of ownership. When a firm purchases an asset, it
has to bear the risk of obsolescence especially if the asset is
vulnerable to technological changes e.g. computers.
ii) Avoidance of investment outlay. Leasing enables a firm to make full
use of an asset without making an immediate investment in the
form of initial cash outflow.
iii) Increased flexibility. A St. lease is a cancelable lease especially
when the asset is needed for a short period of time e.g. during
construction, equipment can be leased on a seasonal basis after
which the lease can be cancelled.
iv) Lease charges are tax allowable expenses. This therefore reduces
the tax liability.
6. Hire purchase

35
This is arrangement whereby a company acquires an asset on making a
down payment or deposit and paying the balance over a period of time in
installments. This source of finance is more expensive than a bank loan and
companies that use this source need guarantors since it does not require
security or collateral. The company hiring the asset will be required to
honour the terms of the agreement which means that any term in violated,
the selling firm may repossess the asset. This is therefore finance in kind and
the hirer will not get title to the asset until he clears the final installment and
any charges thereof.

Hire purchase is a form of instalment credit. Hire purchase is similar to

leasing, with the exception that ownership of the goods passes to the hire
purchase customer on payment of the final credit instalment, whereas a
lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually
purchase them.
iii) The hire purchase arrangement exists between the finance house and the
customer.

The finance house will always insist that the hirer should pay a deposit
towards the purchase price. The size of the deposit will depend on the
finance company's policy and its assessment of the hirer. This is in contrast
to a finance lease, where the lessee might not be required to make any large
initial payment.

An industrial or commercial business can use hire purchase as a source of

finance. With industrial hire purchase, a business customer obtains hire
purchase finance from a finance house in order to purchase the fixed asset.
Goods bought by businesses on hire purchase include company vehicles,
plant and machinery, office equipment and farming machinery.

7.Mortgages
A Mortgage can be defined as a pledge of security over property or an
interest therein created by a formal written agreement for the repayment of
monetary debt.
Minimum mortgage requirements

36
 1. All mortgages should be in writing.
2. All parties must have contractual capacity.
3. Interest in the property being mortgaged should be specific e.g.
rental income lease hold etc.
4. A description of true loan or obligation secured by the mortgage
should appear in the mortgage agreement.
5. A legal description of the mortgage must be included in the
documents.
6. The mortgage must be signed by the mortgagor
7. The mortgage must be acknowledged and delivered to the
mortgagee.
8.Debentures
A debenture is a long-term promissory note used to raise debt funds. The
firm promises to pay periodic interest and principal at maturity. Ideally, a
debenture is a long-term bond that is not secured by a pledge of a specific
property. However, like other general creditors claims, its secured by a
pledge of a specific property not otherwise pledged.

Debentures are a form of loan stock, legally defined as the written

acknowledgement of a debt incurred by a company, normally containing
provisions about the payment of interest and the eventual repayment of
capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed
by the issuer, in accordance with changes in market rates of interest. They
may be attractive to both lenders and borrowers when interest rates are
volatile.

Security

Loan stock and debentures will often be secured. Security may take the form
of either a fixed charge or a floating charge.

37
a) Fixed charge; Security would be related to a specific asset or group of
assets, typically land and buildings. The company would be unable to
dispose of the asset without providing a substitute asset for security, or
without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the

company (for example, stocks and debtors), the lender's security in the
event of a default payment is whatever assets of the appropriate class the
company then owns (provided that another lender does not have a prior
charge on the assets). The company would be able, however, to dispose of
its assets as it chose until a default took place. In the event of a default, the
lender would probably appoint a receiver to run the company rather than lay
claim to a particular asset.

Features of debenture

(a) Interest rate

The interest rate on a debenture is fixed and known. It is called the
contractual or coupon interest rate. It indicates the percentage of
the par value that will be paid out annually (or semi-annually) in
form of interest. The interest must be paid whether the firm makes
profit or not. However, debenture interest is tax deductible on the
part of the company.
(b) Maturity
Debentures are usually issued for a specific period of time. The
maturity of a debenture indicates the length of time the debenture
remains outstanding before the company redeems it. However,
there are debentures that have no maturity period.
(c) Redemption
The redemption of debentures can be accomplished either through a
sinking fund or call provision.
A sinking fund is cash set aside periodically for retiring the
debentures. The fund is placed under the control of the trustee who
redeems the debenture either by purchasing them in the market or
calling them in an acceptable manner. The advantage of a sinking
fund is that it reduces the amount required to redeem the remaining
debt at maturity. Particularly when the firm faces temporary
financial difficulties at the time of debt maturity, the repayment of
huge amount of principal could endanger the firm's financial
viability.

Call provisions enable the company to redeem debentures at a

specific price before the maturity date. The call price is usually
higher than the par value, the difference being a call premium.

(d) Security

38
 Debentures are either secured or unsecured. A secured debenture
is secured by a claim on the company's specific assets. When
debentures are not protected by any security, they are known as
unsecured or naked debentures.
(e) Convertibility
A convertible debenture is one which can be converted, fully or
partly into shares at a specified price at a given date. Debentures
without a conversion feature are called non-convertible or straight
debentures.

(f) Yield
We can distinguish two types of yield: the current yield and the yield
to maturity. The current yield on a debenture is the ratio of the
annual interest payment to the debentures market price.

Current yield = Annual interest

Market price

The yield to maturity takes into account the payments of interest

and principal over the life of the debenture. It is an internal rate of
return on the debenture and is given by the following formula.

M - PX
C+
n
YIELD T0 MATURITY =
(M + P)

Where C is the annual interest

M is the maturity value = Face Value
P is the current market value
n is the number of periods to maturity

Claim on Assets and Income

Debentures have a claim on the company's earnings prior to that of the
shareholders since their interest has to be paid before paying any
dividend to preference and common shareholders.
In case of liquidation, the debenture holders have a claim on assets
prior to that of shareholders. The secured debentures will have priority
over the unsecured debentures
Types of debentures

1. Subordinated debentures
2. Redeemable debentures
3. Irredeemable debentures

39
Advantages of debentures
It involves less cost to the firm than the equity financing because:

i. Investors consider debentures as a relatively less risky investment

alternative and therefore require a lower rate of return.
ii. Interest payments are tax deductible.
iii. The floatation costs on debentures is usually lower than floatation costs
on common shares.
(b) Debenture holders do not have voting rights and therefore,
debenture issue does not cause dilution of ownership.
(c) Debenture holders do not participate in extraordinary earnings of
the company. Thus their payments are limited to interest.
(d) During periods of high inflation, debenture issue benefits the
company. Its obligations of paying interest and principal, which
remain fixed, decline in real terms.
Disadvantage of debentures

(a) Debentures issue results in legal obligation of paying interest and

principal, which, if not paid can force the company into liquidation.
(b) Debenture issue increases the firm's financial leverage and reduces
its ability to borrow in future.
(c) Debentures must be paid at maturity and therefore at some point, it
involves substantial cash outflows.
(d) Debentures may contain restrictive covenants which may limit the
firm's operating flexibility in future

9. Retained earnings

For any company, the amount of earnings retained within the business has a
direct impact on the amount of dividends. Profit re-invested as retained
earnings is profit that could have been paid as a dividend. The major reasons
for using retained earnings to finance new investments, rather than to pay
higher dividends and then raise new equity for the new investments, are as
follows:

a) The management of many companies believes that retained earnings are

funds which do not cost anything, although this is not true. However, it is
true that the use of retained earnings as a source of funds does not lead to a
payment of cash.

b) The dividend policy of the company is in practice determined by the

directors. From their standpoint, retained earnings are an attractive source
of finance because investment projects can be undertaken without involving
either the shareholders or any outsiders.

40
c) The use of retained earnings as opposed to new shares or debentures
avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control

resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation

position of the company's shareholders. If, for example, because of taxation
considerations, they would rather make a capital profit (which will only be
taxed when shares are sold) than receive current income, then finance
through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because

shareholders should be paid a reasonable dividend, in line with realistic
expectations, even if the directors would rather keep the funds for re-
investing. At the same time, a company that is looking for extra funds will
not be expected by investors (such as banks) to pay generous dividends, nor
over-generous salaries to owner-directors.

10. Franchising

Franchising is a method of expanding business on less capital than would

otherwise be needed. For suitable businesses, it is an alternative to raising
extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy,
Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right

to operate a local business, under the franchisor's trade name. The
franchisor must bear certain costs (possibly for architect's work,
establishment costs, legal costs, marketing costs and the cost of other
support services) and will charge the franchisee an initial franchise fee to
cover set-up costs, relying on the subsequent regular payments by the
franchisee for an operating profit. These regular payments will usually be a
percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial
investment cost of a franchisee's outlet, the franchisee will be expected to
contribute a share of the investment himself. The franchisor may well help
the franchisee to obtain loan capital to provide his-share of the investment
cost.

The advantages of franchises to the franchisor are as follows:

41
 The capital outlay needed to expand the business is reduced substantially.
 The image of the business is improved because the franchisees will be
motivated to achieve good results and will have the authority to take
whatever action they think fit to improve the results.

The advantage of a franchise to a franchisee is that he obtains ownership of

a business for an agreed number of years (including stock and premises,
although premises might be leased from the franchisor) together with the
backing of a large organisation's marketing effort and experience. The
franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and
developed a scheme that works.

Self Assessment Questions

QUESTION ONE

(a) Differentiate the following:-

(i) Participative and non-participative preference shares.
(ii) Subordinated and naked debentures
(iii) invoice discounting and factoring
(b) List the functions of a factor

QUESTION TWO

Maendeleo Ltd has 900,000 shares outstanding the current price is Ksh. 130.
The company needs cash, Ksh 22,500,000 to finance a new project. The
Board of directors have decided to declare rights issue at a subscription price
of Ksh. 85.
Required:
(a) Compute the number of rights required to buy one share.
(b)Compute the Ex-rights price of the shares of the rights.
(c) Compute the theoretical value of each right.

QUESTION THREE
State and explain any FIVE sources of external finance to a Co-operative
Society, giving two advantages and two disadvantages of each.

QUESTION FOUR
ABC ltd is incorporated under the companies Act with a total of 100, 000
0rdianry shares outstanding and eligible to vote at all the AGMs. The
Company is controlled by 5 directors who are usually electe3d at every AGM.

Mr. King has approached you for advice on the following issues:-

42
 (i) He bought 25,000 ordinary shares from the company and therefore
wants to know the number of directors he can elect.
(ii) He has a friend who to indirectly control the company by electing
single handedly 3 directors and wishes to know the number of
shares he must buy at the stock market so as to elect the directors,
Advise him.

QUESTION FIVE
As a finance manager of Kasuku products ltd, you decide to raise sufficient
capital in the next five years to enable your company to expand. You decide
to raise the capital by combining both internal and external opportunities

Required:-
(a)Explain the major internal sources of capital to an organisation
(b) In details, explain the main disadvantages of sourcing funds externally. .
(20Mks)

QUESTION SIX
State and explain any FIVE sources of external finance to a Co-operative
Society, giving two advantages and two disadvantages of each.

QUESTION SEVEN
(i) Maendeloeo Ltd has 900,000 shares outstanding the current price is kshs.
130. The company needs cash, ksh 22,500,000 to finance a new project. The
Board of directors have share decided to declare rights issue at a
subscription price of ksh. 85.
Required:
a) Compute the number of rights required to buy one share.
b) Compute the Ex-rights price of the shares of the rights.
c) Compute the theoretical value of each right.

LESSON 5: WORKING CAPITAL MANAGEMENT

5.1 Introduction

Working capital is a financial metric which represents operating liquidity

available to a business, organization, or other entity, including governmental
entity. Along with fixed assets such as plant and equipment, working capital
is considered a part of operating capital. Net working capital is calculated as
current assets minus current liabilities. It is a derivation of working capital
that is commonly used in valuation techniques such as DCFs (Discounted

43
cash flows). If current assets are less than current liabilities, an entity has a
working capital deficiency, also called a working capital deficit.

Working Capital = Current Assets

Net Working Capital = Current Assets − Current Liabilities

A company can be endowed with assets and profitability but short of liquidity
if its assets cannot readily be converted into cash. Positive working capital is
required to ensure that a firm is able to continue its operations and that it
has sufficient funds to satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital involves
managing inventories, accounts receivable and payable and cash.

Decisions relating to working capital and short term financing are referred to
as working capital management. These involve managing the relationship
between a firm's short-term assets and its short-term liabilities. The goal of
working capital management is to ensure that the firm is able to continue its
operations and that it has sufficient cash flow to satisfy both maturing short-
term debt and upcoming operational expenses.

By definition, working capital management entails short term decisions -

generally, relating to the next one year period - which is "reversible". These
decisions are therefore not taken on the same basis as Capital Investment
Decisions (NPV or related, as above) rather they will be based on cash flows
and / or profitability.

 One measure of cash flow is provided by the cash conversion cycle -

the net number of days from the outlay of cash for raw material to
receiving payment from the customer. As a management tool, this
metric makes explicit the inter-relatedness of decisions relating to
inventories, accounts receivable and payable, and cash. Because this
number effectively corresponds to the time that the firm's cash is tied
up in operations and unavailable for other activities, management
generally aims at a low net count.

 In this context, the most useful measure of profitability is Return on

capital (ROC). The result is shown as a percentage, determined by
dividing relevant income for the 12 months by capital employed;
Return on equity (ROE) shows this result for the firm's shareholders.
Firm value is enhanced when, and if, the return on capital, which
results from working capital management, exceeds the cost of capital,
which results from capital investment decisions as above. ROC
measures are therefore useful as a management tool, in that they link
short-term policy with long-term decision making.
 Guided by the above criteria, management will use a combination of
policies and techniques for the management of working capital. These
44
 policies aim at managing the current assets (generally cash and cash
equivalents, inventories and debtors) and the short term financing,
such that cash flows and returns are acceptable.

Approaches used to finance current assets

1. Matching or hedging approach

2. Conservative approach
3. Aggressive approach

a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this
approach, the firm adopts a financial plan which involves the matching of the
expected life of assets with the expected life of the source of funds raised to
finance assets.
The firm, therefore, uses long term funds to finance permanent assets and
short-term funds to finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This
approach can be shown by the following diagram.

b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the
asset may not be possible. A firm that follows the conservative approach
depends more on long-term funds for financing needs. The firm, therefore,
finances its permanent assets and a part of its temporary assets with long-
term funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:

45
It should be noted that short-term funds are cheaper than long-term funds.
(Some sources of short-term funds such as accruals are cost-free). However,
short-term funds must be repaid within the year and therefore they are
highly risky. With this in mind, we can consider the risk-return trade off of
the three approaches.

The conservative approach is a low return-low risk approach. This is because

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

DETERMINANTS OF WORKING CAPITAL NEEDS

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

a) Nature and size of the business.

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

Factors which determine working capital needs of a firm

(1) Availability of Credit: The amount of credit that a firm can obtain, as
also the length of the credit period significantly affects the working capital
requirement. The greater the prospects of getting credit, the smaller will be
its requirement of working capital because it can easily purchase raw
materials and other requirements on credit.

Creditworthiness can also the interpreted to mean that the firm can function
smoothly even with a smaller amount of working capital if it is assured that it
can obtain loans from the bank immediately and easily. The firm does not
need then to keep a wide margin of safety.

(2) Growth and Expansion: The working capital requirements increase

with growth and expansion of business. Hence planning of the working
capital requirements and its procurement must go hand in hand with the

46
planning of the growth and expansion of the firm. The implementation of the
production plan that aims at the growth or expansion of the unit necessitates
more of fixed capital and working capital both.

Even the expansion of the volume of sales increases the requirements of

working capital. Of course, it is difficult to establish a quantitative
relationship between them. An important point to be noted is that the
requirements of working capital emerge before the growth or expansion
actually takes place.

(3) Profit and its Distribution: The net profit of a firm is a good index of
the resources available to it to meet its capital requirements. But, from the
viewpoint of working capital requirement, it is the profit in the form of cash
which is important, and not the net profit. The profit available in the form of
cash is called cash profit and it can be assessed by adding or deducting non-
cash items from the net profit of the firm. The larger the amount of cash
profit, the greater will be the possibility of acquiring working capital.

But, in fact the entire amount of cash profit may not be available to meet
working capital needs. The portion of cash profit which is available for this
purpose depends on the profit distribution policy. The policies with regard to
distribution of dividends, ploughing back of profit and tax payments will
determine the portion of cash profit which the firm can use to meet its
working capital needs. Even depreciation policy can influence the amount of
cash available, as depreciation of capital assets is deductible item of
expenditure and it reduces tax liability.

(4) Price Level Fluctuations: A general statement may be made that with
price rise, a firm will require more funds to purchase its current assets. In
other words, the requirements of working capital will increase with the rise in
prices. But all firms may not be affected equally. The prices of all current
assets never go up to the same extent. Price of some current assets rise less
rapidly than those of the others. Hence for the firms which use such current
assets, the working capital need will increase by a smaller amount. Besides,
if it is possible to pass on the burden of high prices of raw materials to the
customers by raising the prices of final product, then also there will be no
increase in working capital requirements.

(5) Operating Efficiency: If a firm is efficient, it can use its resources

economically, and thereby it can reduce cost and earn more profit. Thus, the
working capital requirement can be reduced by more efficient use of the
current assets.

Importance of working capital management

47
The finance manager should understand the management of working capital
because of the following reasons:

a) Time devoted to working capital management

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

b) Investment in current assets

Current assets represent more than half of the total assets of many business
firms. These investments tend to be relatively volatile and can easily be
misappropriated by the firm’s employees. The finance manager should
therefore properly manage these assets.
c) Importance to small firms
A small firm may minimise its investments in fixed assets by renting or
leasing plant and equipment, but there is no way it can avoid investment in
current assets. A small firm also has relatively limited access to long term
capital markets and therefore must rely heavily on short-term funds.

d) Relationship between sales and current assets

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

LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…)

1.0 Cash management.

It helps to identify the cash balance which allows for the business to meet
day to day expenses, but reduces cash holding costs.

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

Illustration
XYZ Ltd. currently purchases all its raw materials on credit and sells its

merchandise on credit. The credit terms extended to the firm currently

48
requires payment within thirty days of a purchase while the firm currently

requires its customers to pay within sixty days of a sale. However, the firm

on average takes 35 days to pay its accounts payable and the average

collection period is 70 days. On average, 85 days elapse between the point

a raw material is purchased and the point the finished goods are sold.

Required

Determine the cash conversion cycle and the cash turnover.

Solution
The following chart can help further understand the question:

Inventory Conversion period (85 days)

Receivable collection
Payable Period (70 days)
deferral

49
Purchase Payment for Sale of Collection
of raw the raw Finished of
materials

Cash conversion cycle = 85 + 70 -

35 = 120

The cash conversion cycle is given by the following formula:

Cash conversion = Inventory conversion + Receivable collection – Payable

deferral
Cycle period period period

For our example:

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

Cash turnover = 360

Cash conversion cycle

360
= 120

= 3 times

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

inventory receivables Payables+Accruals

Cash conversion cycle =
3 60
[ +
costofsales sales
−
Cashoperatingexpenses ]
NB: 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

50
are several methods used to determine the optimal cash balance. These
are:
a) The Cash Budget
The Cash Budget shows the firm’s projected cash inflows and outflows over
some specified period. This method has already been discussed in other
earlier courses. The student should however revise the cash budget.

Working capital requirements of a business should be monitored at all times

to ensure that there are sufficient funds available to meet short-term
expenses.

The cash budget is basically a detailed plan that shows all expected sources
and uses of cash. The cash budget has the following six main sections:

1. Beginning Cash Balance - contains the last period's closing cash

balance.
2. Cash collections - includes all expected cash receipts (all sources of
cash for the period considered, mainly sales)
3. Cash disbursements - lists all planned cash outflows for the period,
excluding interest payments on short-term loans, which appear in the
financing section. All expenses that do not affect cash flow are
excluded from this list (e.g. depreciation, amortization, etc.)
4. Cash excess or deficiency - a function of the cash needs and cash
available. Cash needs are determined by the total cash disbursements
plus the minimum cash balance required by company policy. If total
cash available is less than cash needs, a deficiency exists.
5. Financing - discloses the planned borrowings and repayments,
including interest.
6. Ending Cash balance - simply reveals the planned ending cash
balance.

Reasons for keeping cash

 Cash is usually referred to as the "king" in finance, as it is the most

liquid asset.
 The transaction motive refers to the money kept available to pay
expenses.
 The precautionary motive refers to the money kept aside for
unforeseen expenses.
 The speculative motive refers to the money kept aside to take
advantage of suddenly arising opportunities.

Advantages of sufficient cash

51
  Current liabilities may be catered for meeting the current obligations of
the company
 Cash discounts are given for cash payments.
 Production is kept moving
 Surplus cash may be invested on a short-term basis.
 The business is able to pay its accounts in a timely manner, allowing
for easily obtained credit.
 Liquidity
 Quick upfront pay.

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

1. The firm uses cash at a steady predictable rate

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

Under these assumptions the following model can be stated:

2bT
C¿ =
√ 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:

1 T
TC= Ci + b
2 C

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

Required

52
a) Determine the optimal amount of marketable securities to be
converted into cash every time the company makes the transfer.
b) Determine the total number of transfers from marketable securities to
cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.

Solution
2bT
a)
C∗
√ i

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

2 x20 x520 ,000

C∗¿
√ 0.12
=Sh.13,166

Therefore the optimal amount of marketable securities to be converted to

cash every time a sale is made is Sh.13,166.

T
¿
b) Total no. of transfers = C∗¿

520, 000
= 13,166

= 39.5

≈ 40 times

1 T
TC= Ci + b
c) 2 C

13,166 x 0.12 520,000 x20

+
= 2 13,166

= 790 + 790 = Shs.1,580

Therefore the total cost of maintaining the above cash balance is

Sh.1,580.

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

53
 13,166
= 2

= Shs.6,583

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

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

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

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

1/3
3 Bδ 2
Z= [ ]
4i
+L

and the highest limit, H, is given by:

H = 3Z - 2L

4 Z−L
The average cash balance = 3

Where: Z = target cash balance

H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
δ² = variance of net daily cash flows

54
Illustration
XYZ’s management has set the minimum cash balance to be equal to
Sh.10,000. The standard deviation of daily cash flow is Sh.2,500 and the
interest rate on marketable securities is 9% p.a. The transaction cost for
each sale or purchase of securities is Sh.20.

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

Solution
1/3
3 bδ ²
a)
Z= [ ]
4i
+L

3 x20 x(2,500)²

=
[ 4x
9%
360 ]+10,000

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

b) H = 3Z – 2L
= 3 x 17,211 – 2(10,000)
= Shs.31,633

55
 4 Z−L
c) Average cash balance = 3
4 x17 ,211−10,000
= 3

d) The spread = H–L

= 31,633 – 10,000
= Shs.21,633

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

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

Cash 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

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

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

a) Concentration Banking
b) Lock-box system.

a) Concentration Banking
Firms with regional sales outlets can designate certain of these as
regional collection centre. Customers within these areas are required

56
 to remit their payments to these sales offices, which deposit these
receipts in local banks. Funds in the local bank account in excess of a
specified limit are then transferred (by wire) to the firms major or
concentration bank.
Concentration banking reduces the amount of time that elapses
between the customer’s mailing of a payment and the firm’s receipt of
such payment.

b) Lock-box system.
In a lock-box system, the customer sends the payments to a post office
box. The post office box is emptied by the firm’s bank at least once or
twice each business day. The bank opens the payment envelope,
deposits the cheques in the firm’s account and sends a deposit slip
indicating the payment received to the firm. This system reduces the
customer’s mailing time and the time it takes to process the cheques
received.

2.0 Inventory management.

It helps to identify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials - and minimizes
reordering costs - and hence increases cash flow. Besides this, the lead times
in production should be lowered to reduce Work in Progress (WIP) and
similarly, the Finished Goods should be kept on as low level as possible to
avoid over production - see Supply chain management; Just In Time (JIT);
Economic order quantity (EOQ); Economic quantity

Manufacturing firms have three major types of inventories:

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

The firm must determine the optimal level of inventory to be held so as to

minimize the inventory relevant cost.

BASIC EOQ MODEL

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

2 DC o
Q=
√ Cn

Where: Q is the economic order quantity

57
 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
C
TC = ½QCn + Q o

Where: Total holding cost = ½QCn

D
C
Total ordering cost = Q 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

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
R= 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

58
 ii) The ordering cost is constant per order and certain
iii) The holding cost is constant per unit per year
iv) The purchase cost is constant (Thus no quantity discount)
v) Back orders are not allowed.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in

the coming year which costs Sh.50 each. The items are available locally and

the leadtime in one week. Each order costs Sh.50 to prepare and process

while the holding cost is Shs.15 per unit per year for storage plus 10%

opportunity cost of capital.

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

Suggested Solution:

2 DC o
a)
Q=
√ Cn

Where: D = 2,000 units

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

2x 2, 000 x50
Q=
√ 20
=100 units

DL
b) R = 360

2 ,000 x7
= 360

59
 = 39 units

D
c) No. of orders = Q

2 ,000
= 100

= 20 orders

D
C
d) TC = ½QCn + Q o

2 ,000
(50)
= ½(100)(20) + 100

= 1,000 + 1,000

= Sh.2,000

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

3.0 Debtors’ management.

It helps Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash
conversion cycle will be offset by increased revenue and hence Return on
Capital (or vice versa); see Discounts and allowances.

In order to keep current customers and attract new ones, most firms find it
necessary to offer credit. Accounts receivable represents the extension of
credit on an open account by a firm to its customers. Accounts receivable
management begins with the decision on whether or not to grant credit.

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

by:

a) The volume of credit sales

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

Accounts receivables = Credit sales per day x Length of

collection period

60
The average collection period depends on:

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

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

a) 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

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

1. Estimation of incremental operating profits from increased sales

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

b) 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.

61
c) Discounts
Varying the discount involves an attempt to speed up the payment of
receivables. It can also result in reduced bad debt losses.

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

As saturation point increased expenditure in collection efforts does not result

in reduced bad debt and therefore the firm should not spend more after
reaching this point.

Evaluation of the credit applicant

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

a) The applicant’s financial statement

b) Credit ratings and reports from experts
c) Banks
d) Other firms
e) The company’s own experience

Application of discriminant analysis to the selection of applicants

Discriminative analysis is a statistical model that can be used to accept or

reject a prospective credit customer. The discriminant analysis is similar to

regression analysis but it assumed that the observations come from two

different universal sets (in credit analysis, the good and bad customers). To

illustrate let us assume that two factors are important in evaluating a credit

applicant the quick ratio and net worth to total assets ratio.

The discriminant function will be of the form.

ft = a1(X1) + a2(X2)

62
Where: X1 is quick ratio
X2 is the network to total assets
a1 and a2 are parameters

The parameters can be computed by the use of the following equations:

a1 = Szz dx – Sxzdz
Sxx Sxx – Sxz²

a2 = Szz dx – Sxzdz
Szz Sxx – Sxz²

Where: Sxx represents the variances of X1

Szz represents the variances of X2
Sxz is the covariance of variables of X1 and X2
dx is the difference between the average of X1’s bad accounts and X2’s
good accounts
dz represents the difference between the average of X’s bad accounts
and X’s good accounts.

The next step is to determine the minimum cut-off value of the function
below at which credit will not be given. This value is referred to as the
discriminant value and is denoted by f*.

Once the discriminant function has been developed it can then be used to
analyse credit applicants. The important assumption here is that new credit
applicants will have the same characteristics as the ones used to develop the
mode.

More than two variables can be used to determine the discriminant function.
In such a case the discriminant function will be of the form.

ft = a1x1 + a2x2 + … + anxn

Self Assessment Questions

QUESTION ONE

The management of Beardy Limited has ascertained that the company will
require ksh. 2,500,000 in cash for transaction purposes during the coming
financial year. The interest rate on the marketable securities is currently 10%
per annum and is expected to remain constant over the next one year. The
cost of converting securities to cash is ksh. 50 per transaction.

63
Required:

Using the Baumol cash management model, determine the following:

(i) Optimal cash size
(ii) Average cash balance
(iii) Cash turnover
(iv) Total cost of managing the optimal cash balance

QUESTION TWO

PKG Ltd maintains a minimum cash balance of Ksh. 500,000.00. The

deviation of the company’s daily cash changes is ksh. 200,000.00. the
annual interest rate is 14%. The transaction cost of buying and selling
securities is kshs. 150.00 per transaction.

Required:
Using Miller-Orr cash management model, determine the following:
(i) Upper cash limit
(ii) Average cash balance
(iii) Spread

QUESTION THREE
Mutongoi Ltd in Matuu requires 500,000 units of a component each year at a
cost of ksh. 100 each. The items are obtained from Machakos and therefore
it takes 3 days from the time or ordering to the time of delivery. Each order
costs the company ksh. 300 to process while hoarding cost per annum is ksh
200 plus 15% opportunity cost of capital. To operate prudently the company
is safe with 2000 units.

Required:
(i) Economic order quantity
(ii) Reorder level
(iii) Total relevant cost

QUESTION FOUR
(a) Differentiate between Hedging approach and conservative approach
under management of working capital.
(b) Explain four importance of working capital management.
( c) Define overcapitalization and outline the indicators of overcapitalization.
(d) Explain the determinants of working capital requirements.

QUESTION FIVE
Ukaguzi Ltd has a total annual sales of 3,000,000. its discounted interest rate
is 15 % p.a . it is considering to factor its debtor where the factor charges a

64
service fees of 1.2% of debtors factored. 12% reserve is required by the
factor. Ukaguzi limited has a credit policy of 72 days.

Required:
(i) the amount Ukaguzi will receive from the factor.
(ii) The percentage annual cost
(a) Reserve
(b) Service charges
© Interest charges p.a
(d) Interest charges for 72 days

QUESTION SIX
(a) Discuss the THREE approaches used to finance current assets.
(b) State and explain any FOUR importance of working capital
management.
(c) Jitihidi wholesalers had total sales of sh. 3 million in the year ended
2008. its average collection period is 27 days. Due to unforeseen
liquidity problems, it pledged its debtors and was charged interest at
18% p.a. The interest was discounted. Some of the goods were
damaged and therefore the factor charged 6% reserve.
Required:
Calculate the amount that was advanced to the firm.

QUESTION SEVEN
(a) Maintain only “Enough” Levels of inventory in your business. Discuss
FIVE Costs that would be avoided by maintaining “Enough” inventory level
(b) Credit sales is a strategy used by traders to mitigate the effects of high
competition. Discuss the FIVE Cs of a good debtor

65
LESSON 7: TIME VALUE OF MONEY

This concept attempts to explain why investors will prefer money now rather
than in the future. The purchasing power of money generally decreases as
time goes by.

(1) Future value of a single amount

This is the compound value of a single amount invested over a given number
of periods for earning a given interest.

Consider an investor who has invested Ksh. 100,000 in a bank over a period
of 3 years earning an interest of 10% p.a. Determine the future on this
amount?

Alternative 1

peri amount at interes amount

od start t at end

10,000. 110,000.0
1 100,000.00 00 0

11,000. 121,000.0
2 110,000.00 00 0

12,100. 133,100.0
3 121,000.00 00 0

Alternative 2
using formulae
FV=PV(1+r)
^n

FV=100,000(1+0.1)^3
FV=133,100

(2) Present value of a single amount

FV=PV(1+r)
^n
PV= FV

(1+r)^n

66
 FV(1+r)
PV= ^-n

Assume that you expect to receive Ksh. 2.5 million five year from now. If the
cost of capital in the market is 16%. Determine the present value of this
amount.
FV=PV(1+r
)^n
PV= FV
(1+r)^n

PV= 2,500,000.00
(1+0.16)^5
= 1,190,282.54

PV= FV(1+r)^-n

2,500,000(1+0.
16)^-5
= 1,190,282.54
Using financial tables
FV X PVIF r% n
PV= years
2,500,000 X
0.4761
= 1,190,282.54

Consider a project which is expected to generate the following cash flows

Year cash flows

1 90,000.00

2 120,000.00

3 140,000.00

4 150,000.00
If the cost of capital is 10%, determine the total present value of these cash
flows
Present
Year Cash flows PVIF 10% Value

67
 1 90,000.00 0.9091 81,819.00

2 120,000.00 0.8264 99,168.00

3 140,000.00 0.7513 105,182.00

4 150,000.00 0.6830 102,450.00

Total Present 388,619.0

Value 0
(3) Present value of an Annuity
An Annuity refers to equal amounts received or paid after equal periods e.g.
salary, rent, retirement benefits, insurance premiums e.t.c.
There are normally two types of annuities
1. An ordinary annuity- this is where cash flows occurs at the end of each
period e.g. salary, retirement benefits e.t.c.
2. An annuity due- this is where cash flows occur at the beginning of each
period e.g. rent, insurance premiums e.t.c.
Ordinary annuity

Assume that you expect to receive Ksh. 15,000 at the end of each year for
the next 4 years. If the cost of capital is 10%. Determine the total present
value of this cash flows

Present
Year Cash flows PVIF 10% Value

1 15,000.00 0.9091 13,636.50

2 15,000.00 0.8264 12,396.00

3 15,000.00 0.7513 11,269.50

4 15,000.00 0.6830 10,245.00

Total Present Value 47,547.0

Annuity 0
The present of an ordinary annuity is calculated using a formula

PV 1- (1+r)^-
= Annuities X n
r

1-
15,000 X (1+0.1)^-4
0.1

68
 15,000 X
= 3.1699
PV
= 47,547.98

Annuity due
Now assume that you were to receive the cash floes at the beginning of each
year. Determine the present value of this annuity due
The present value of annuity due is calculated using the formula

PV Annuity
due = PVA ord X (1+r)
15,000 X
3.1699(1+0.1)

52,303.35
Present
Year Cash flows PVIF 10% Value

0 15,000.00 1.0000 15,000.00

1 15,000.00 0.9091 13,636.50

2 15,000.00 0.8264 12,396.00

3 15,000.00 0.7513 11,269.50

Total Present Value 52,302.0

Annuity Due 0

Assume that you have a charity sweepstakes lottery which promises to pay
Ksh 50,000 at the beginning of each year for the next 20 years. The
government has announced this to be 1,000,000 lottery i.e. 50,000 X 20. If
the cost of capital for the next 20 years is expected to be 19% p.a. Advice on
the current value of this lottery
PV Annuity A X PVA ord X
due = (1+r)
50,000 X
5.1009(1+0.19)

303,501.29

(4) Present value of an annuity until perpetuity

They are equal cash flows received or paid until infinity.

69
Therefore present value of Annuity (PVAα) is normally equal to 1/ r

PVIFA 10% α = I/0.1 = 10

PVIFA 16% α = I/0.16 = 6.25

If a company is considered to a going concern and it promises to pay

constant dividends each year then this constant dividends can be considered
to be annuity until infinity

(5) Present value of differential annuity

This are equal cash flows which occurs in between the economic life of the
project

Consider a five year project which is expected to generate the following cash
flows

Year 1 2 3 4 5
Cash 9 70, 30,0 30,00 30,00
flows 0,000.00 000.00 00.00 0.00 0.00

Cash PVIF Present

Year flows 12% Value

1 90,000.00 0.8929 80,361.00 136,165

2 70,000.00 0.7972 55,804.00

3 30,000.00 0.7118 21,354.00

4 30,000.00 0.6355 19,065.00 57,441

5 30,000.00 0.5674 17,022.00

Total Present 193,606.

value 00

The PV of differential annuities is calculated using the following steps:

1. Calculate the PV of the unequal cash flows in the earliest periods in the
normal way i.e using the financial tables e.g. Ksh. 136,165
2. (a) Determine the PVIFA at a given discount rate at the end of annuity
period i.e. PVIFA 12% 5year = 3.6048
(b) Determine the PVIFA at a given discount rate at the start of annuity
period i.e. PVIFA 12% 2year = 1.6901

70
 3. Calculate the PV of differential Annuity using the following formulae
= A X (PVIFA end – PVIFA start)
= 30,000 X (3.6048-1.6901)
= 30,000 X 1.9147
= 57,441
4. Sum the PV obtained in step 1 and step 3 above in order to obtain the
total present value
= 136,165 + 57,441
= 193,606

Consider a project which is expected to generate the following cash flows

each year

Year 1-5 6-10 11-20

Cash 50 60, 100,
flows ,000.00 000.00 000.00
If the cost of capital is 10% determine the total present value of this cash
flows

period formula Workings

1-5 A X PVIF 10% 5 YRS =50,000 X 3.7908 =189,540
A X (PVIFA 10% 10 YRS - =60,000 X
6-10 PVIFA 10% 5 YRS) (6.1446-3.7908) =141,228
A X (PVIFA 10% 20 YRS - =100,000 X
11-20 PVIFA 10% 10YRS) (8.5136-6.1446) =236,900

=567,668

Consider a project which is expected to generate the following cash flows

each year
Year 1-5 6-10 11-α
100,
Cash flows 70,000.00 90,000.00 000.00
If the cost of capital is 13%. Determine the total present value of this cash
flows
period formula workings

=246,206.
1-5 A X PVIF 13% 5 YRS =70,000 X 3.5172 19
A X (PVIFA 13% 10 YRS - =90,000 X
6-10 PVIFA 10% 5 YRS) (5.4262-3.5172) =171,810

A X (PVIFA 10% 20 YRS - =100,000 X =67,983.2

11-20 PVIFA 10% 10YRS) (7.6923-5.4262) 3

71
 =485,999
.42

(6) Loan amortization schedule

This is a loan repayment schedule which will indicate the amount borrowed
and the amount outstanding at the end of each period. The amount of loan
borrowed today will represent the present value of an annuity while the
periodic payment will represent an annuity. The periodic payment
(instalment) will constitute two elements i.e. the principal and the interest
element

Recall PVA = A X PVIFA r% n

Amount borrowed = Instalment payment X PVIFA r% n

Instalment payment = Amount borrowed

PVIFA r% n

Consider an investor who intends to borrow Ksh. 450,000 at an interest rate

of 10% p.a. the loan is to be repaid within a period of four years
Required
Determine the periodic instalment payment
Prepare the loan repayment schedule
Instalment payment = Amount borrowed
PVIFA r% n

= 450,000
3.1699
= 141,960

perio Amt at instalme principa Amt at

d start interest nt l end

141,960.0 96,960.0 353,040.

1 450,000.00 45,000.00 0 0 00

141,960.0 106,656. 246,384.

2 353,040.00 35,304.00 0 00 00

141,960.0 117,321. 129,062.

3 246,384.00 24,638.40 0 60 40

141,960.0 129,062.
4 129,062.40 12,906.24 0 40 -

72
Consider an investor who intends to borrow Ksh. 1 million at an interest rate
of 12% p.a. for a period of 5 years. The loan will be repaid semi annually
Required
Determine the interest expense on the third instalment
Instalment payment = Amount borrowed
PVIFA r% n

= 1,000,000
7.3601
= 135,868

perio Amt at instalmen princip Amt at

d start interest t al end

1,000,000.0 135,868.0 75,868. 924,132.

1 0 60,000.00 0 00 00

135,868.0 80,420. 843,711.

2 924,132.00 55,447.92 0 08 92

135,868.0 85,245. 758,466.

3 843,711.92 50,622.72 0 28 64

135,868.0 90,360. 668,106.

4 758,466.64 45,508.00 0 00 63

A company intends to borrow Ksh. 9 million at an interest of 10% p.a. the

loan will be repaid over a period of 8 years. The loan principal will be repaid
in equal instalment of Ksh. 1,125,000 p.a.

Required
Prepare the loan amortization schedule

perio Amt at instalmen Amt at

d start interest t principal end

9,000,000.0 900,000.0 225,000.0 1,125,000. 7,875,000.

1 0 0 0 00 00

7,875,000.0 787,500.0 141,960.0 1,125,000. 6,750,000.

2 0 0 0 00 00

6,750,000.0 675,000.0 141,960.0 1,125,000. 5,625,000.

3 0 0 0 00 00

73
 5,625,000.0 562,500.0 141,960.0 1,125,000. 4,500,000.
4 0 0 0 00 00

4,500,000.0 450,000.0 141,960.0 1,125,000. 3,375,000.

5 0 0 0 00 00

3,375,000.0 337,500.0 141,960.0 1,125,000. 2,250,000.

6 0 0 0 00 00

2,250,000.0 225,000.0 141,960.0 1,125,000. 1,125,000.

7 0 0 0 00 00

1,125,000.0 112,500.0 141,960.0 1,125,000.

8 0 0 0 00 -

Self Review Questions

QUESTION ONE
(a) Discuss the phrase Time Value of Money”
(b) Umoja co-operative Society approached a commercial bank which agreed
to advance a loan of ksh 600,000 under the following terms:-
(i) Equal annual installment
(i) Repayment period of 6years
(iii) Interest rate of 12% p.a.
Required:-
Prepare the co-operative loan amortization schedule showing how the loan
will be reduced up to the 6th year.

QUESTION TWO
(a) You are the financial manager of Pamoja Sacco. You advised your Sacco
to take a loan from the Co-operative bank of Kenya ksh 10,000,000 which
was granted. The Executive management of the Sacco wants you to advice
them how the loan will be amortised. The period of repayment is 5yrs at an
interest rate of 15% p.a.
Advice them assuming equal principal repayment.

QUESTION THREE
a) General individuals show a time preference for money. Give reason for
such a preference.
b) You are the Loan Officer of Matata Sacco Ltd. Prepare a Loan schedule
for a member who has taken a loan of Ksh. 100,000. The loan requires

74
 12% interest per annum and 12 monthly installments.

QUESTION FOUR
(a) After cleaning training and obtained a Diploma in Co-operative
Management, you successfully got a job as a Finance assistant in
Jitihada Sacco Ltd. The gross salary is Kshs. 25,000. because of your
training, you know that if you invest in a savings account, you will have
enough money for your dream house. You opened a savings account in
Okoa Nyumba Bank Ltd and you deposit shs. 120,000 every year end
and will continue to save for the nest 10 years. If your dream house
will cost sh 2 million after 10 years;
(i) will you have meet the target? (5 Marks)
(ii) If not, how much more money will you add so as to own the dream
house? (2 Marks)
Assume the savings account will earn an interest of 10% p.a. over the 10
years period)
(b) Company pays dividend per share at the end of every year of sh 10
into perpetuity. If the required rate of return is 12%, what is the
maximum price an investor would willing to pay for the share? (3
Marks)
(c) Mrs Morgan, an employee of Pamoja Sacco Ltd started an M-Pesa
business to supplement her Meagre salary. The business is projected
to bring in cashflows as follows:

Year cash flow sh ‘000’

1 155
2 149
3 172
4.10 180

Required:
Determine the present value of the projected cash flows from the business if
the cost of capital is 10%

QUESTION FIVE
Mr Mali Mingi deposited 100,000 with Co-operative bank of Kenya. The
interest rate for the deposit was agreed to be 13% per annum.
Required:
Determine the compound sum at the end of the fourth year if compounding
occurs as follows:-
(i) Semi annually - (4 Marks)
(ii) Annually - (4 Marks)
(iii) Quarterly -(4 Marks)
(iv) Weekly - (4 Marks)

75
(v) Daily - (4 Marks)

76
LESSON 8: COST OF CAPITAL
Definition
This is the price the company pays to obtain and retail finance. To obtain
finance a company will pay implicit costs which are commonly known as
floatation costs. These include: Underwriting commission, Brokerage costs,
cost of printing a prospectus, Commission costs, legal fees, audit costs, cost
of printing share certificates, advertising costs etc. For debt there are legal
fees, valuation costs (i.e. security, audit fees, Bankers commission etc.) such
costs are knocked off from:

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

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

Cost of Retaining Finance

This will include dividends for share capital and interest for debt finance (tax
deducted) or effective cost of debt. However, when computing the cost of
finance apart from deducting implicit costs, explicit costs are the most
central elements of cost of finance.

Importance of Cost of Finance

The cost of capital is important because of its application in the following
areas:

i) Long-term investment decisions – In capital budgeting decisions, using

NPV method, the cost of capital is used to discount the cash flows.
Under IRR method the cost of capital is compared with IRR to
determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various
components of capital is determined by the cost of each capital
component.

iii) Evaluation of performance of management – A high cost of capital is an

indicator of high risk attached to the firm. This is usually attributed to
poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is
low compared to the cost of new ordinary share capital, the firm will
retain more and pay less dividend. Additionally, the use of retained
earnings as an internal source of finance is preferred because:

77
  It does not involve any floatation costs
 It does not dilute ownership and control of the firm, since no new
shares are issued.

v) Lease or buy decisions – A firm may finance the acquisition of an asset

through leasing or borrowing long-term debt to buy an asset. In lease
or buy decisions, the cost of debt (interest rate on loan borrowed) is
used as the discounting rate.

Factors That Influence the Cost of Finance

1. Terms of reference – if short term, the cost is usually low and vice
versa (i.e. time).
2. Economic conditions prevailing – If a company is operating under
inflationary conditions, such a company will pay high costs in so far as
inflationary effect of finance will be passed onto the company.
3. Risk exposed to venture – if a company is operating under high risk
conditions, such a company will pay high costs to induce lenders to
avail finance to it because the element of risk will be added on the cost
of finance which may compound it.
4. Size of the business – A small company will find it difficult to raise
finance and as such will pay heavily in form of cost of finance to obtain
debt from lenders.
5. Availability – Cost of finance (COF) prices will also be influenced by the
forces of demand and supply such that low demand and low supply will
lead to high cost of finance.
6. Effects of taxation – Debt finance is cheaper by the amount equal to
tax on interest and this means that debt finance will entail a saving in
cost of finance equivalent to tax on interest.
7. Nature of security – If security given depreciates fast, then this will
compound implicit costs (costs of maintaining that security).
8. Company’s growth stage – Young companies usually pay less dividends
in which case the cost of this finance will be relatively cheaper at the
earlier stages of the company’s development.

Term Structure of Interest Rates

The term structure of interest rate describes the relationship between
interest rates and the term to maturity and the differences between short
term and long term interest rates.

The relationship between short and long interest rates is important to

corporate managers because:

1. They must decide whether to buy long term or short term bonds and
whether to borrow by issuing long-term or short-term bonds.

78
2. It enables them to understand how long term and short term rates
are related and what causes the shift in their relative positions.

Several theories had been advanced to explain the nature of yield curve –
These are:

1. Liquidity preference theory

2. Expectation theory
3. Market segmentation theory

1. Liquidity Preference Theory

This theory states that short term bonds are more favourable than long
term bonds for 2 reasons.

i) Investors generally prefer short term bonds to long-term securities

because such securities are more liquid in the sense that they can be
converted to cash with little danger of loss of principal. Therefore –
investors will accept lower yields on short term securities.
ii) At the same time borrowers react in exactly the opposite way.
Generally borrowers prefer long term debt because short-term debt
exposes them to the risk of having to repay the debt under adverse.
Conditions, accordingly borrowers are willing to pay higher rate
other things held constant for long-term process than short
ones.

Taking together this two sets of preferences implies that under normal
conditions, a positive maturity risk premium exist which increases with
maturity thus the yield curve should be upward sloping. Lenders prefer
liquidity (short term hands) while borrowers prefer long term bonds and are
willing to pay a “premium” for long term borrowing.

2. Expectation Theory
This theory states that the yield curve depends on the expectation about

future inflation rates. If inflation rate is expected to increase, then the

rate on long-term bonds will exceed that of short-term loan. The expected

future interest rates are equal to forward rates computed from the

expectations with regard to future interest rates are. Other factors which

affect the expectations with regard to future interest rates are:

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  Political stability
 Monetary policy of the government
 Fiscal policy of the government (government expedition)
 Other economic related factors including social factors.

The following conditions are necessary for the expectation theory to hold.
i) Perfect capital markets exists where there are many buyers and
sellers of security with non having a significant influence on the
interest rates.
ii) Investors have homogeneous expectations about future interest
rates and returns on all investments.
iii) Investors are rational wealth maximizers
iv) Bankruptcy of firms due to use of borrowing is unlikely.

3. Market Segmentation Theory

This theory states that the major investors (borrowers and lenders) are
confined to a particular segment of the market and will not change
even if the forecast of the likely future interest rates changes.

The lenders and borrower thus have a preferred maturity e.g a person
borrowing to buy a house or a company borrowing to build a power plant
would want a long term loan. However a retailer borrowing to build up stock
in readiness for a peak reason would prefer a short term loan. Similar
differences exist among savers e.g a person saving to pay school fees for
next semester would want to lend on in the short-term market. A person
saving for retirement 20 years ahead would probably buy long-term security
in L.T market.

The thrust of market segmentation theory is that the slope of yield curve
depends on demand and supply mechanism. An upward sloping curve would
occur if there was a large supply of funds relative to demand in the short
term marketing but a relative shortage of funds in the long-term market
would produce an upward sloping curve.

Tests of the 3 theories

Various test have been conducted mainly in USA and they indicate that all
the 3 theories have some validity and thus the shape of the yield curve of
any firm is affected by the following:

1. Supply and demand conditions in the short and long term market.
2. Liquidity preferences of lenders and borrowers

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 3. Expectation of future inflation. While any of the 3 factors may
dominate the market all the 3 effect the term structure of interest
rate.

METHODS/MODELS OF COMPUTING COST OF CAPITAL

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

 Risk adjusted discounting rate

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

i) Risk adjusted discounting rate – This technique is used to establish

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

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

 Dividends
 Capital gains

Capital gain is assumed to constitute the difference between the buying

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

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

Investment P0

iii) Capital asset pricing model (CAPM) – CAPM is a technique that is

used to establish the required rate of return of an investment given a
particular level of risk. According to CAPM, the total business risk of
the firm can be divided into 2:

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

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

 Labour strikes by employees of the firm;

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

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

Cost of debt = Rf + (Rm – Rf)Bd

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

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

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

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

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

iv) Dividend yield/Gordon’s Model – This model is used to determine

the cost of various capital components in particular:

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

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

d0
Zero growth firm – P0 = d0 Therefore = P0

R = Ke

Where: d0 = DPS
R0 = Current MPS

d 0 ( 1+g )
Constant growth firm – P0 = Ke g

d 0 (1+ g )
K e= +g
Therefore P0

b) Cost of perpetual preference share capital (Kp)

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

Kp

Therefore: dp = Preference dividend per share

Pp = Market price of a preference share

c) Cost of perpetual debenture (Kd) – Debentures pay interest charges,

which an allowable expenses for tax purposes.

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

∞

83
 Cost of debt Kd

Int .
( 1−T )
Therefore Kd = Vd

Where: Kd = % cost of debt

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

Cost of Redeemable Debentures and Preference Shares

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

1
Int ( 1−T ) + ( M −V d )
n
K d / VTM / RY = 1
( M +V d ) 2

Where: Int. = Interest charges p.a.

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

WEIGHTED AVERAGE COST OF CAPITAL (W.A.C.C.)

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

Market value weight or proportion of each capital component.

W.A.C.C =
Ke ( VE )+K ( VP )+K ( 1−T )( VD )
p d

Where: Ke, Kp and Kd = Percentage cost of equity, preference share

capital and debt capital respectively
E, P and D = Market value of equity, preference share capital and debt
capital respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.

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Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.

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

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

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

a) i) Compute the cost of each capital component

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

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

d 0 (1+ g ) 5 ( 1+0 . 05 )
K e= + g= +0 . 05=0 .18125=18. 13 %
P0 40

Cost of perpetual preference share capital (Kp) – preference shares are

still selling at par thus MPS = par value. If this is the case, Kp = coupon
rate = 10%.

MPS = Par value = Sh.20

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

DPS d p Sh.2
K p= = = =10%
MPS P p Sh. 20

Cost of debentures (Kd) – the debenture has a 10 year maturity period.

It is thus a redeemable fixed return security thus the cost of debt is
equal to yield to maturity.

Redemption yield:

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

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

1
Int ( 1−T ) + ( M −V d )
n
K d =YTM =RY =
( M +V d ) ½

1
Sh.12(1−0.3 )+(100−90)
10
=9 .9 %≈10 %
= (100+90)½

ii) Compute the market value of each capital component

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

Market value of preference share capital (P)

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

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

Sh.200Mdebentures
Sh.90 x
= Sh.100 parvalue = 180

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

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

a) Using weighted average cost method,, WACC =

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 =
Ke ( VE )+K ( VP )+K ( 1−T )( VD )
p d

=
18.13 % ( 1,600
1,880 ) +10 % (
100
1,880 ) +10% (
180
1,880 )

= 15.43 + 0.5319 + 0.9574

= 0.169193

≈ 16.92%

b) By using percentage method,

WACC = Total monetary cost
Total market value (V)

Where: Monetary cost = % cost x market value of

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

Total market value (V) 1,880

318.08
x 100
Therefore WACC = 1,880 = 16.92%

b) In computation of the weights or proportions of various capital

components, the following values may be used:

 Market values
 Book values
 Replacement values
 Intrinsic values

Market Value – This involves determining the weights or proportions using

the current market values of the various capital components. The problems
with the use of market values are:

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

87
The market value of each security may be incorrect due to cases of over or
under valuation in the market.
Book values – This involves the use of the par value of capital as shown in
the balance sheet. The main problem with book values is that they are
historical/past values indicating the value of a security when it was originally
sold in the market for the first time.

Replacement values – This involves determining the weights or proportions

on the basis of amount that can be paid to replace the existing assets. The
problem with replacement values is that assets can never be replaced at ago
and replacement values may not be objectively determined.

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

e) Weaknesses of WACC as a discounting rate

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

 It can only be used as a discounting rate assuming that the risk of the
project is equal to the business risk of the firm. If the project has higher
risk then a percentage premium will be added to WACC to determine the
appropriate discounting rate.
 It assumes that capital structure is optimal which is not achievable in real
world.
 It is based on market values of capital which keep on changing thus
WACC will change over time but is assumed to remain constant
throughout the economic life of the project.
 It is based on past information especially when determining the cost of
each component e.g in determining the cost of equity (Ke) the past year’s
DPS is used while the growth rate is estimated from the past stream of
dividends.

SELF ASSESSMENT QUESTION

QUESTION ONE

Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million

to finance a project in the following manner:

88
 Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.

The present capital structure of the company is made up as follows:

1. 600,000 fully paid ordinary shares of Sh.10 each

2. Retained earnings of Sh.4 million
3. 200,000, 10% preference shares of Sh.20 each.
4. 40,000 6% long term debentures of Sh.150 each.

The current market value of the company’s ordinary shares is Sh.60 per
share. The expected ordinary share dividends in a year’s time is Sh.2.40 per
share. The average growth rate in both dividends and earnings has been
10% over the past ten years and this growth rate is expected to be
maintained in the foreseeable future.

The company’s long term debentures currently change hands for Sh.100
each. The debentures will mature in 100 years. The preference shares were
issued four years ago and still change hands at face value.

Required:
(i) Compute the component cost of:
- Ordinary share capital; (2 marks)
- Debt capital (2 marks)
- Preference share capital. (2
marks)

(ii) Compute the company’s current weighted average cost of

capital. (5 marks)

(iii) Compute the company’s marginal cost of capital if it raised the

additional Sh.10 million as envisaged. (Assume a tax rate of
30%). (5 marks)
(Total: 20 marks)

89
LESSON 9: INTRODUCTION TO FINANCIAL MARKETS

Meaning of a financial market

A market can be defined as an organizational device, which brings together
buyers and sellers. A financial market is a market for funds. It brings
together the parties willing to trade in a commodity, which constitutes fluids.
The respective parties in financial markets are known as demanders of funds
(borrowers) and suppliers of fluids (lenders) who come together to trade so
as to meet financial needs. The level of economic development of any
country will be affected by the ability of the financial markets to move
surplus funds from certain economic units, which constitutes individuals and
corporate bodies to other economic units in need of additional funds.
Financial market can be divided into three categories: -

1. Capital and money markets.

2 Primary and Secondary markets
3. Organized and over — the counter markets.
I. Primary and secondary market
Primary financial markets are those markets where there is transfer of new
financial instruments. Financial instruments constitute assets, which are
used in the financial markets. They consists of cash, shares and debt capital
both long term and short-term e.g. commercial paper.
The primary financial markets trade is for securities which have not been
issued e.g. if a company wants to make an issue of ordinary share capital
issue of commercial paper, issues of preference shares, debentures etc,
offers and purchase will be through the primary etc.
Secondary markets — the secondary financial markets are for already issued
securities. After a thorough issue of new securities in the primary market
later trading of the securities will take place in secondary market e.g. if a
company is to make public issue of ordinary share capital the issue will take
place in primary market. If the initial purchasers wish to dispose off the

90
shares, trading will take place in the secondary market. The only distinction
between primary and secondary markets is the form of security being traded
but there is no physical separation of the markets.
2. Capital and money markets
This classification is based on the maturity of financial instruments. The
capital market is a financial market for long-term securities. The securities
traded in these markets include shares and bonds.
The money market is market for short-term securities. The securities traded
in these markets include promissory notes, commercial paper, treasury bills
and certificates of deposits While capital market is regulated by capital
authority, the money market is regulated by central banks.
3. Organized and over- counter markets
An organized market is a market which is a specified place of security
trading, defined rules, regulations and procedures for security trading. Only
listed securities trade in organized market, where exchange is through
licensed brokers who are members of exchange
Conducted by accountants, auctioneers, estate agents and lawyers who were
engaged in other areas of specializations.
In 1951 an estate agent (Francis Drummond) established the first stock
broking firm. He then approached the finance minister of Kenya with an idea
of setting up a stock exchange in East Africa. in 1953 he too approached
London Stock Exchange Officer and London accepted to recognize the
setting up of Nairobi Stock Exchange as an oversee stock exchange. The
major reorganization emerged in 1954 when stockbrokers emerged and
registered the NSE as a voluntary association under society’s Act. It was
registered as a limited liability company.
Advantages of stock exchange quotations
1. It’s easy for quoted companies to obtain underwriters when issuing
shares. This is as a result of wide market quoted for company shares. This is
because of easier transferability of shares through use of brokers.
2. Quotations attract investors in a share issue since they can easily dispose

91
their shares.
3. It enhances public confidence. A quoted company is considered stable by
investors and other stakeholders; this can be useful in borrowing or other
transactions relating to the company.
4 A quoted company will be able to get access to relevant information
through the
NSE and also able to get comparative data e.g. reflecting performance of
other
quoted companies.
5. In an inefficient market, a quoted company will be able to obtain up to
date information or feedback regarding share prices in stock exchange.
Changes in
stock market prices will act as a signal as regard perceptions of the
company.
Role of nairobi stock exchange
I. NSE provides a market of securities. It provides a media through which
securities can be bought and sold.
2. Stock exchange enhances share price discovery through interaction of
demand and supply forces in the trading floor.
3 Stock exchange share index acts as indicator of economic performance.
4. Stock exchange allows provision of information both to the investors and
industry. This is both for quoted companies or other issues within the stock
market. This information is for investor decisions.
5. It enhances the transfer of share ownership among investors through
financial facilitation’s role played by the brokers

Terminologies used tn the stock exchange

1. Cum dividend and Ex-dividend:
These prices are quoted when the company which has declared dividends
has not paid
price per share is cum-div, this price include the additional value in form of

92
If the sellers offer the same cum-dividend then it means that the buyer will
get both share to be sold and dividend declared on it. A cum-dividend share
is more expensive as compared to an ex- dividend share. Ex-dividend means
without dividend. In this case the buyer only gets the share sold. The
dividend declared on the share belongs to the seller.

2. Cum-rights and Ex-rights price

These prices are quoted where a company has declared a right issue. If the
sellers have offered to sell his share cum-right, it means that the buyer will
be entitled not only to receive shares being purchased but also rights
declared not yet issued. Share prices are high at that issue. If the seller sold
his shares ex-right it means that the buyer will only receive original shares
and the sellers will not be entitled to receive each right issue on share.
3. Cum-cap and ex-cap.
The word cap stands for capital. This price applies when a company has
announced a bonus issue but it is not yet issued. If the buyer buys shares
cum-cap he will be entitled not only to receive shares being purchased but
also right declared not yet issued. Share prices are high at that issue. If the
seller sold his shares ex-RIGHTS it means that the buyer will only receive
original shares and the sellers will be entitled to receive each right issue on
share.
4 Cum - all price or ex- all price
Cum all means with dividends, with bonus or with rights. The purchaser of
the security will be entitled to dividends: declared bonus shares, and has a
right to subscribe for additional shares. The share price will thus reflect this
additional value otherwise; share will sell at ex-all price.
5 Insider trading:
An insider is an individual who has access to such confidential information
that is not yet available to the public and which may be considered useful
when making investments decision regarding the company. Insider trading
constitutes use of confidential information about listed company which is not

93
yet made public so as to take advantage himself or for other person
connected directly or indirectly with the company e.g. a managing director
who has access to company’s information may get information that the
company is about to make huge losses and as a result dispose his shares or
advice another person accordingly before this information is made public. An
insider is prohibited by aw to use his privilege positions to make gains or
manipulate the prices of the company’s securities for personal gains.
6. Active securities
These are securities, which are most frequently traded at the stock exchange
in Kenya.
Exchange constitutes the 20 most active companies in the NSE capitalization

7. Bid and offer price

A bid is the highest price a security purchaser will be willing to purchase the
security
whereas offer price is price at which the seller is wiling to sell the security.
8. Odd Lots
This arises when the number of share fall below the stipulated limit in NSE
the minimum
Number is 100 shares. Below this, they are regarded as odd lots.
9. Market Capitalization
This is market value of a company based on Number of shares issued of a
company and their market price at specified period of time. Market
capitalization may also represent the aggregate volume of transaction within
NSE.
Market capitalization = No of shares traded X market price per share.
The higher the market capitalization the higher the activity of share trading,
and vice versa
10 Futures and Options.
These are instruments, which provide a means of hedging. Hedging is the
process undertaking an activity so as to minimize risk. Financial futures and

94
options provide a means of reducing the risks inherent within the financial
market. A future is a contractual agreement entered between two parties
where one party promises to provide a security and the other party promises
to buy the security at some time in future. A future leads to an obligation(s).

Nse shares index

An index is a measure of relative changes in s specified phenomena’s. It
indicates changes in variable over given period of time or between 2 periods.
Index number classification will depend on variables they are intended to
measure. An index is used to measure changes, which have occurred. Share
indexes are used to measure changes, which have occurred for shares in
specific stock exchange e.g. stock indices measures. The changes of price or
value changes where the value changes are brought about by changes in the
capitalization of the share in the exchange. NSE index is based on share
trading of 20 companies, which are considered very active. The 20
companies’ account nearly 30% of NSE capitalization.
- A fall in NSE share index represents a fall in market price per share. Arise in
NSE index represent arise in the market price per share.
- An index may act as an indicator of activities in NSE the higher the demand
of the share, the higher is it market price and as a result the higher will be
index.
Drawbacks of stock indices
1 .20 company’s not true representation.
2 .Thinness of the market — small changes in the above stocks tend to be
considerably magnified in the index
3 .1966 base year too far in the past.
4 .Relatively small price changes-Some stock prices do not change for
weeks.
5 .Lack of clear portfolio selection criteria.
6 .Use of arithmetic instead of preferred geometric mean in computing the
index.

95
7 .New companies have been quoted and others deregistered.

Capital Market Authority (CMA)

CMA was established in 1989 through the market authority Act Sec ii which
includes the principles and objectives of the authority.
The act provide for:
Development of all aspects of the capital Market and in particular it
emphasizes on the removal of impediments and creation of incentives for
long-term investment productive enterprises.
The creation, maintenance and regulation of the CMA through the
implementation of system in which the market participants are self
regulatory and the creation of a market in which securities can be issued and
traded in an orderly, fair and efficient manner.
Protection of investor’s interests
The role of capital market authority
1 .The CMA has the responsibility of licensing and regulating stockbrokers,
investment advisers, security dealers and the authority depositories.
2. The capital market authority is involved in the process of listing of new
companies. Any company, intending to be quoted in the NSE must apply
through
CMA.
3. CMA is involved in the making of policies that would enhance the
development of the capital market e.g. policy regarding the buying and
selling of securities, policies on admission of individual and institutions to the
capital market and generally policies on the introduction of securities and
their regulations
4. The CMA acts as a watchdog for shareholders of listed company’s. This is
through regulating the operations of the listed company’s so as to protect
investors against penalty, insider trading or suspensions.
5. The authority assists in the development of new securities in the market.
This is through research and evaluations of various recommendations of

96
stakeholders in the NSE. It is the responsibility of the CMA to evaluate
whether there is need of new security and develop on appropriate policy
6. The CMA acts as a government advisor through the ministry of finance
regarding policies affecting the capital markets.
Other stock exchange terms
I. Broker:
Is an agent who buys and sells securities in the Market on behalf of his client
on a commission basis. He also gives advise to his client and at times
manages the portfolio for his client. In connection with the new issue, a
broker will advise on price to be charged, will submit the necessary
documents to the quotation department the stock exchange and the capital
market authority. He may be involved in arranging for funds or for the
purchase of shares and may underwrite the issue (assure the company that
shares are sold if not broker will buy them).
2. Jobber:
He is a dealer. He is not an agent but a principal who buys and sells
securities in his own name. His profit is referred to as Jobber’s turn. Since
they are experts in the markets, they are not allowed to deal with general
public but only with brokers or other jobbers to avoid exploitation of
individual investors. A Jobber will quote two prices for a share. The bid price,
which is the price at which he is willing to buy securities and offer price —
price at which he is willing to sell the shares. The difference between offer
price and the bid price is called spread price = Ask price - Bid price. A Jobber
will take stocks in his books (also called along sale) when brokers have
predominantly selling orders, and will also sell short (Short sale) when
brokers are engaged in buying.
3 . Bulls:
Speculators in the market who believe that the main market movement is
upwards and therefore buy securities now hoping to sell them at a higher
price in the future
4. Bears:

97
These are speculators in the market who believe that the main market
movement is downwards therefore securities now hoping to buy them back
later at a lower price.
5. Stags:
These are speculators in the market who buy new shares because they
believe that the price Set by issuing company is usually lower than the
theoretical value and that when shares are later dealt with in the stock-
exchange the share price will increase and they will be able to sell them at
profit.

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LESSON 10: INTRODUCTION TO FINANCIAL MARKETS (CONT…)

STOCK MARKET EFFICIENCY

This refers the degree to which the securities reflect the market information
in their prices. It’s the capability of the securities to show and reflect all the
relevant information. There are 3 forms of market efficiency namely-
(i) The weak form efficiency
This type of market efficiency says that current share prices fully reflect all
the information contained in first price movements. The sequence of the
price changes contains no information about the future price changes. The
prices of securities change in a random manner.
(ii) Semi strong form efficiency
The semi strong form of efficient market hypothesis states that current share
prices show both the past price movements and also the publicly available
information. No trading strategies based on the release of any public
information ie earnings will enable an investor to generate abnormal returns.
Except by chance if the market is efficient in the semi strong sense a public
announcement will some reaction from the market and will highly affect the
market prices.
(iii) Strong form efficiency
This type of market states that security prices reflect all the information
available both public and private at each point in time. The consequence of
this is that no investor Even when the investor has some inside information
can device trading strategies based on such information so as to consistently
earn abnormal returns. This form of efficiency states that people such as
stock specialists security brokers and dealers who often have insider
information cannot on average earn greater profits than investors who don’t
have have such information.
THE DOW THEORY

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Charles dow the founder or the wall street journal developed among others
the dow theory in the early part of the century. According to Dow Theory the
stock market is characterized by three trends namely
1. Primary trend
2. The intermediate trend
3. Tertiary trends
Primary trend
This is the most important it refers to the long term movement in share
prices i.e. movement in share prices over a period of more than one year.
The intermediate trend
This trend runs for weeks or months before being reversed by another
intermediate trend in the opposite direction. If an intermediate trend is in the
opposite direction to the primary trend, it is called a secondary reversal or
reaction. A primary trend is normally interrupted by a series of information
reversals.
Tertiary trends.
They last for a few days and are less important.
Special financial institutions

The major financial institutions in Kenya economy are commercial banks,

savings and loans, credit unions, savings banks, life insurance companies,
pension funds, and mutual funds. These institutions attract funds from
individuals, businesses, and governments, combine them, and make loans
available to individuals and businesses. A brief description of the major
financial institutions follows.

Institution Description
Commercial bank Accepts both demand (checking) and time (saving)
deposits. Also offers negotiable order of withdrawal (NOW),
and money market deposit accounts. Commercial banks
also make loans directly to borrowers or through the
financial markets.

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Saving and loan These are similar to a commercial bank except chat
it may not hold demand (checking) deposits. They obtain
funds from savings, negotiable order of withdrawal (NOW)
accounts, and money market deposit accounts. They lend
primarily to individuals and businesses in the form of real
estate mortgage loans.
Credit union Commonly known as Savings co-operative societies
(Saccos), credit unions deal primarily in transfer of funds
between members. Membership in credit unions is
generally based on some common bond, such as working
for a given employer. Credit unions accept members’
savings deposits, NOW account deposits, and money
market account deposits and lend funds to members,
typically to finance automobile or appliance purchase, or
home improvements.
Savings banks These are similar to a savings and loan in that it holds
savings, NOW, and money market deposit accounts.
Savings banks lend or invest funds through financial
markets, although some mortgage loans are made to
individuals.
Life insurance
Company It is the largest type of financial intermediary handling
individual savings. It receives premium payments and
invests them to accumulate funds to cover future benefit
payments. It lends funds to individual, businesses, and
governments, typically through the financial markets.
Pension fund Pension funds are set up so that employees can receive
income after retirement. Often employers match the
contribution of their employees. The majority of funds is
lent or invested via the financial market.
Mutual fund Pools funds from the sale of shares and uses them to
acquire bonds and stocks of business and governmental
units. Mutual funds create a professionally managed
portfolio of securities to achieve a specified investment

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 objective, such as liquidity with a high return. Hundreds of
funds, with a variety of investment objectives exist. Money
market mutual funds provide competitive returns with very
high liquidity.
Unit trusts
Financial Markets
Financial markets provide a forum in which suppliers of funds and
demanders of funds can transact business directly. Whereas the loans and
investments of intermediaries are made without the direct knowledge of the
suppliers of funds (savers), suppliers in the financial markets know where
their funds are being lent or invested. It is important to understand the
following distinctions in the market.
Money versus Capital markets. The two key financial markers are the money
market and the capital market. Transactions in the money market take place
in short-term debt instruments, or marketable securities, such as Treasury
bills, commercial paper, and negotiable certificates of deposit. The market
brings together government units, households, businesses and financial
institutions who have temporary idle funds, and those in need of temporary
or seasonal financing.
Long-term securities—bonds and stocks—are traded in the capital market.
The main actor in the capital markets is the securities exchanges, which
provide the market place in which demanders can raise long-term funds and
investors can maintain liquidity by being able to sell securities easily. The
Nairobi Stock Exchange (NSE) was established in 1954 and is one of the most
active stock markets in sub-Saharan Africa. It currently (2005) has 48
companies listed and 20 brokerage company members.
Private placements versus Public offerings. To raise money, firms can use
either private placements or public offerings. Private placement involves the
sale of a new security issue, typically bonds or preferred stock, directly to an
investor or group of investors, such as an insurance company or pension
fund. However, most firms raise money through a public offering of

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securities, which is the nonexclusive sale of either bonds or stocks to the
general public,
Primary market versus Secondary market. All securities, whether in the
money or capital market, are initially issued in the primary market (Initial
public offerings ( IPOs) and seasoned equity offerings (SEOs)). This is the
only market in which the corporate or government issuer is directly involved
in the transaction and receives direct benefit from the issue. That is, the
company actually receives the proceeds from the sale of securities. Once the
securities begin to trade in the stock exchange, between savers and
investors, they become part of a secondary market. The primary market is
the one which “new” securities are sold; the secondary market can be
viewed as “used,” or “pre-owned,” securities market.

Other Specialised Financial Institutions

1 .Industrial and commercial Development Corporation (LC.D.C)
I. C.D.C was established in 1954 by the government. Its main objective was
to promote industrial & commercial development in Kenya.
Its specifically provides financial or technical assistance to small enterprises.
Financial assistance may be in the form of working capital financing or
purchase of fixed assets. This may take the form of equity or debt financing.
Equity is provided by large-scale enterprises with more than 50 employees.
Loans are given to both small and medium
sized enterprise. Long-term loans repayment period is 6 years for industrial
and up to 10 years for commercial loans
2 ) Agricultural finance corporation (AFC)
it was established by the government in 1963. The main objective is to
provide support for the agricultural sector. This is through provision of short
term and long-term loans. The loans must be for a defined project by a
farmer. Loans may be short term or long term and there exist flexibility to
allow its repayment.
3) Kenya Industrial Estate (KIE)

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It was established in 1967
At inception it was a wholly owned subsidiary of ICDC. However in 1978 it
was separated from ICDC and become an independent body as a parastatal
under the ministry of industry.
The main objective of K1E is to assist in the development of new projects and
the expansion and modernization of new business enterprise. This is through
the provision of finds and technical assistance. They provide both debt and
equity finance.
4) Kenya Tourist Development Corporations: (KTDC)
The KTDC was established in 1960’s. Its main responsibility was carrying out
Investigations, formulation and study of projects development of the tourism
industry
KTDC Provides financial assistance in forms of loan, for tourism related
enterprises. It has substantial share —holdings in local hotels, which includes
Hilton, Serena, and Pan Africa etc.
5) Industrial Development Bank (IDB)
Was established in 1963 as a limited company. The main objective of setting
this
Institution was to promote industrial development in Kenya through the
establishment promotion and expansion of small or large-scale enterprises.
This is through financial assistance .n the form of loans, provision of
guarantee and securities and underwriting
6) Hire — purchase financial companies
These are institutions, which provides assets on credit with an arrangement
to pay the principal and interest in installment basis. However, the legal
ownership of the assets remains with the hire-purchase company. The title is
transferred when the last installment is made. Hire Purchase Company’s in
Kenya include- Kenya finance corporation (KFC), Pan-Afric credit finance Ltd,
Investment and mortgage Ltd. etc.
7) Insurance Companies
The main role of insurance companies is to assist individuals and corporate

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bodies safeguard against future risks. May also engage in other activities.
The main capital for insurance companies is the premium paid by the policy
holders.
Forms of Insurance Company’s in Kenya includes: - Life Insurance, Third
party insurance etc. Examples of Insurance company’s in Kenya include:
jubilee insurance company, pan African insurance company, Blue shield
insurance Co. Ltd. etc.
8) Building societies/Housing finance Co:
These ale financial institution, which provide finance to the public so as to
purchase or construct houses. The individual or corporate bodies make
deposit upon which they later receive loan for acquiring or constructing
house. Some buildings societies in Kenya include: Housing finance
corporation (HFC), East African building society and Pioneer building society.
9) Pension and provident scheme institution
These institutions obtain funds from both employees and employers of
contribution. They manage and invest these funds so as to meet the current
and future obligations of the pension scheme to its members.
10) Merchant Banks
It originated and also derives its name from the activities of wealth
merchants who provided credit for the trading ventures. The ventures were
for small-scale merchants. Before the establishment of banking systems in
the 19th century, the merchants changed their role of merchants and started
offering financial service. Today merchant banks performs the role of
underwriting and assisting companies to raise capital in the financial markets
They underwrite the security issues, buy and sell securities and provide
advice in Investment in securities.
Reinforcing questions
1. (a) (i) What is financial intermediation?
(3 marks)
(ii) Identify any five services that financial intermediaries provide.(5
marks)
(b) What economic advantages are created by the existence of:

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 (i) Primary markets. ( 3 marks)
(ii) Secondary markets ( 3 marks)
(iii) Portfolio management firms. ( 4 marks)

(c) Explain how the Capital Authority can ensure:

(i) Faster growth and development of the Nairobi Stock Exchange or
Stock Exchange in your country. (6
marks)
(ii) Development of other stock exchanges in Kenya or in your
country.
(4 marks)
(d) (i) What is a stock exchange index?
(2 marks)
(i) Outline four drawbacks of the Nairobi Stock Exchange index.
(4 marks)
(e) Highlight four advantages and disadvantages to a company of being
listed on a stock exchange. (8
marks)

(f) In relation to the stock exchange”

(i) Explain the role of the following members:
 Floor brokers ( 2 marks)
 Market makers ( 2 marks)
 Underwriters ( 2 marks)

(ii) Explain the meaning of the following terms:

 Bull and bear markets ( 2 marks)
 Bid-ask spread ( 2 marks)
 Short selling ( 2 marks)

Self assessment Questions

QUESTION ONE
(a) What is stock exchange index?
(b) Explain the benefits that will accrue by the implementation of central
depository system (CDS)
(c )What are the roles of Capital Market Authority in the economy?

QUESTION TWO
(a) Distinguish Between:
(i) Business risk and financial risk.
(ii) Money market and capital market
(iii) Bulls and bears

QUESTION THREE
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(a) What are the intermediaries and what roles do they play in the economy.
(b) Foreign Direct Investment (FDI) plays a crucial role in revamping less
developed economies.
Required
Write brief notes on the obstacles to the flow of FDI into the Kenyan
Economy.

QUESTION FOUR
(a) Briefly explain the following stock market terminologies;
(i) Broker
(ii) Bulls
(iii) Underwriting
(iv) Speculator
(b) State and briefly explain the benefits of investing in Market securities.

QUESTION FOUR
(a) Explain how the savings and credit Co-operatives mobilize savings and
Aid Investment.
(b) How do co-operatives (Saccos) who extend credit to small business and
small traders ensure that the level of credit default is low?

(c) How do you convert a merry go round to Sacco (Savings and Credit Co-
operative Society)

QUESTION FIVE
(a) In reference to the stock market, discuss the following:-

(i) Formal Market

(ii) Over the counter Market
(iii) Going short
(iv) Prospectus
(v) Blue chips

(b) Outline FIVE limitations of the stock market price index

QUESTION SIX
(a) Highlight any FOUR advantages of a company being listed on a stock
exchange
(b) List any FOUR incentives provided by Capital Markets authority to
encourage development of capital markets.

(c) In relation to the stock exchange, explain the following terms:-

(i) Brokers
(ii) Primary Markets
(iii) Underwriters
(iv) Secondary Markets

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(d) Outline the drawbacks of Nairobi stock exchange index?

QUESTION FIVE
(a)What are the steps involved in the construction of stock market index
(b) Write short notes on the following:
(a) Over the counter market
(b) Prospectus
© Independent projects
(d) Complimentary projects

QUESTION SIX
(a) What is stock exchange index?
(b) Explain the benefits that will accrue by the implementation of central
depository system (CDS)
© What are the roles of Capital Market Authority in the economy.

QUESTION SEVEN
(a) Distinguish Between:
(i) Business risk and financial risk.
(ii) Money market and capital market
(iii) Bulls and bears

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