MAKERERE UNIVERSITY

MAKERERE UNIVERSITY BUSINESS SCHOOL

MASTER OF SCIENCE IN BANKING AND INVESTMENT
MANAGEMENT

SEMESTER II, 2020/2021

YEAR ONE

COURSE: CORPORATE FINANCE

COURSE CODE: MBI 7107

GROUP COURSE WORK

COURSE WORK ONE (TAKE HOME)

GROUP NAMES: REG. NUMBER:

KADDE CHARLES 2020/HD10/16921U
SEBUFU GEOFREY 2020/HD10/16917U
KALINDA ISAAC 2020/HD10/23998X
Question one

A) i. Distinguishes between capital structure and financial structure and Compare

and contrast the Modigliani and Miller and traditional theories as they relate to
capital structure of a company of your choice.
Funds are the basic need of every firm to fulfill long term and working capital
requirement. Enterprise raises these funds from long term and short term sources. In
this context, capital structure and financial structure are often used. Capital
Structure covers only the long term sources of funds, whereas financial
structure implies the way assets of the company are financed, i.e. it represents the
whole liabilities side of the Position statement, i.e. Balance Sheet, which includes
both long term and long term debt and current liabilities.
Capital Structure is a combination of different types of long-term sources of funds, i.e.
equity capital, preference capital, retained earnings and debentures in the firm’s
capital is known as Capital Structure. It focuses on choosing such a proposal which
will minimize the cost of capital and maximize the earnings per share.
For this purpose a company can opt for the following capital structure mix:
 Equity capital only
 Debt only
 A mix of equity and debt capital.
 A mix of debt and preference capital.
 A mix of equity and preference capital.
 A mix of equity, preference and debt capital in different proportions

Modigliani and Miller (MM) Approach

The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates
the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant
to the capital structure of a company. Whether a firm is high on leverage or has a lower debt
component has no bearing on its market value. Rather, the market value of a firm is solely
dependent on the operating profits of the company.

Assumptions of Modigliani and Miller Approach

 There are no taxes.

 Transaction cost for buying and selling securities, as well as the bankruptcy cost,
is nil.
 There is a symmetry of information. This means that an investor will have access
to the same information that a corporation would and investors will thus behave
rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to
merchant bankers, advertisement expenses, etc.
 There is no corporate dividend tax.

The Modigliani-Miller theorem (M&M) states that the market value of a company is
correctly calculated as the present value of its future earnings and its underlying assets, and
is independent of its capital structure.
The traditional theory of capital structure says that a firm's value increases to a certain level
of debt capital, after which it tends to remain constant and eventually begins to decrease if
there is too much borrowing. This decrease in value after the debt tipping point happens
because of overleveraging. On the other hand, a company with zero leverage will have a
WACC equal to its cost of equity financing and can reduce its WACC by adding debt up to
the point where the marginal cost of debt equals the marginal cost of equity financing. In
essence, the firm faces a trade-off between the value of increased leverage against the
increasing costs of debt as borrowing costs rise to offset the increase value. Beyond this
point, any additional debt will cause the market value and to increase the cost of capital. A
blend of equity and debt financing can lead to a firm's optimal capital structure.

Graph
Assumptions of the Modigliani-Miller theory without taxes are presented in the figure below.

Debt ratio is used to measure financial leverage

Modigliani and Miller suggest that the weighted average cost of capital remains fixed because
the risk is growing by an increase in financial leverage, and investors will claim a higher return to
compensate for it. In other words, the required rate of return on equity will increase as financial
leverage increases. Therefore, increasing cheaper debt will be offset by a higher required rate of
return on equity. This relationship is described by the following equation

Modigliani-Miller theory of capital structure with taxes

The theory was further developed by its authors in 1963 by excluding the no taxation
assumption.
The main point of the improved theory of capital structure is the hypothesis that valuation of
a levered firm will be higher than the valuation of an unlevered firm within the same class of
business risk. The reason is that interest expense is an allowable deduction from taxable
income; thus, levered firms have a tax shield.
Formula
The equation describing the relationship between the market value of a levered and an
unlevered firm is as follows:
VL = VU + T×D
Where: T is the corporate tax rate, and D is the market value of debt.
In other words, the market value of a levered firm exceeds the market value of an unlevered
firm by the amount of tax shield (T×D), assuming the debt is perpetual.
Graph
The propositions of the Modigliani-Miller theory of capital structure without taxes are
illustrated in the figure below.

*Debt ratio is used to measure financial leverage

As far as the cost of debt is actually lower by the amount of tax shield, an increase in its
proportion results in a decrease in the weighted average cost of capital. This relationship can
be described by the following equation:
D
keL = keU +   (keU - kD)(1 - T)
E
Thus, optimal capital structure exists when the capital of a firm is represented by debt only!
Therefore, firms should replace equity by cheaper debt to reduce their WACC and maximize
market value.

Optimal capital structure is referred to as the perfect mix of debt and equity financing that
helps in maximising the value of a company in the market while at the same time minimises
its cost of capital.
Capital structure varies across industries. For a company involved in mining or petroleum
and oil extraction, a high debt ratio is not suitable, but some industries like insurance or
banking have a high amount of debt as part of their capital structure.
Financial leverage is defined as the proportion of debt which is part of the total capital of the
firm. It is also known as capital gearing. A firm having a high level of debt is called a highly
levered firm while a firm having a lower ratio of debt is known as a low levered firm.
The argument of capital structure is that there is maximization of the company value while
reducing the cost of capital at optimum point.

ii. As a finance manager of a company you selected I b) above explain factors that you
should consider when undertaking capital structure decisions of your firm
Factors Determining Capital Structure
Following are the factors that play an important role in determining the capital structure:
Costs of capital: It is the cost that is incurred in raising capital from different fund sources.
A firm or a business should generate sufficient revenue so that the cost of capital can be met
and growth can be financed.
Degree of Control: The equity shareholders have more rights in a company than the
preference shareholders or the debenture shareholders. The capital structure of a firm will be
determined by the type of shareholders and the limit of their voting rights for fear of dilution
of shares
Trading on Equity: For a firm which uses more equity as a source of finance to borrow
new funds to increase returns. Trading on equity is said to occur when the rate of return on
total capital is more than the rate of interest paid on debentures or rate of interest on the new
debt borrowed.
Government Policies: The capital structure is also impacted by the rules and policies set by
the government. Changes in monetary and fiscal policies result in bringing about changes in
capital structure decisions.
Flexibility: Any firm cannot survive if it has a rigid financial composition. So the financial
structure should be such that when the business environment changes structure should also
be adjusted to cope up with the expected or unexpected changes.
Solvency: The financial structure should be such that there should be no risk of getting
insolvent.
Availability of alternative cheap sources of funds
Degree of competition in the industry
Stage of the life cycle
Corporate tax
State of the capital market

iii. Explain the Criticisms of the Modigliani and Miller and traditional two theories on
capital structure.

Criticism of the Modigliani and Miller hypothesis:

On the basis of the arbitrage process, M-M conclude that the market value of firms are not
affected by leverage but due to the existence of imperfections in the capital market, arbitrage
may fail to work and may give rise to differences between the market values of levered and
unlevered firms. The arbitrage process may fail to bring equilibrium in the capital market for
the following reasons: UKEssays. (November 2018).

Arbitrage process: Arbitrage process is based on the principle that Proposition 1 is based on
the assumption that 2 firms are identical except for their capital structure which cannot
command different market value and have different cost of capital. Modigliani and Miller do
not accept the net income approach on the fact that two identical firms except for the degree
of leverage, have different market values. Arbitrage process will take place to enable
investors to engage in personal leverage to offset the corporate leverage and thus restoring
equilibrium in the market.

Lending and borrowing rates differences: Based on the assumption that firms and
individuals can borrow and lend at the same rate of interest does not hold well in practice.
This is so because firms which hold a substantial amount of fixed assets will have a higher
credit standing, thus they will be able to borrow at a lower rate of interest than individuals.

Non-substitutability of personal and corporate leverages: It is incorrect to say that

personal leverage and corporate leverage are perfect substitute because of the existence of
limited liability a firms hold compare to the unlimited liability of individuals hold. For
examples, if a levered firm goes bankrupt, all investors will lose the amount of the purchase
price of the shares. But if an investor creates personal leverage, in the event of a unlevered
firm’s insolvency, he would lose not only his principal in the shares but also be liable to
return the amount of his personal loan.

Transaction costs: Transaction cost interfere with the working of the arbitrage. Due to the
cost involved in the buying and selling of securities, it is necessary to invest a larger amount
in order to earn the same return. As a result, the levered firm will have a higher market value.

Institutional restrictions: Personal leverage are not feasible as a number of investors would
not be able to substitute personal leverage for corporate leverage and thus affecting the work
of arbitrage process.

Corporate taxation and personal taxation: M-M theory is also criticized for the reason
that it ignores the corporate taxation and personal taxation.

Retained earnings: It also ignores personal aspect of financing through retained earnings. In
real world, corporates will not pay out the entire earnings in the form of dividends.

Investor’s willingness: Investors will not show much interest in purchasing low rated issued
by highly geared firms.

Critic: The traditional theory can be contrasted with the Modigliani and Miller (MM) theory,
which argues that if financial markets are efficient, then debt and equity finance will be
essentially interchangeable and that other forces will indicate the optimal capital structure of
a firm, such as corporate tax rates and tax deductibility of interest payments.
 B) You are the finance manager of Builders Ltd with a total capital of SHS.10
Billion composed as follows:
20% bank loan from Stan bic bank ltd 4 billion
12% preferred stock 1billion
Common stock 3 billion
Retained earnings 2 billion
The business anticipates that dividends on ordinary shares will be SHS.15, 000 per share and
the market value of the shares is SHS. 25,000 per share. The dividends are expected to grow
at 8% per year forever and the company is in a 30% corporation tax bracket.
Your boss the managing director has directed you to determine the Weighted Average
Cost of Capital to enable him make informed decisions for the company. How would
you respond to your boss’ directive if you are to factor in the dividend growth rate?
WACC is calculated with the following equation:

WACC = wD × rD × (1−t) + wP × rP + wE × rE

where:
w = the respective weight of debt, preferred stock/ equity, and equity
in the total capital structure
t = tax rate rD = cost of debt rP = cost of preferred stock/ equity
rE = cost of equity

wD = 4m/10m x 100 =40% wP = 1m/10m x 100 = 10%

wE = (3m + 2m)/10m x 100 = 50% t = 30% D = 20% (Bank Loan)
P = 12% (Pref Stocks)

E = Cost of Equity (TBD)

Cost of Equity = (DPS/CMV) + GRD

where:
DPS = Dividend per share for next year = 15,000
CMV = Current Market value of stock = 25,000
GRD = Growth rate of Dividends = 8%

Assumption for the dividend is it is for the next

rE = (15,000/25,000) + 0.08 = 0.6 + 0.08 = 0.68 x 100 = 68%

WACC = 40% × (20% × (1−0.3)) + (10% × 12%) + (50% × 68%)

WACC = 5.6 + 1.2 + 34 = 40.8%

This means that the argument that debt leads to reduced weighted cost of capital
Question Two

a) Quality (u) ltd is a private limited company trading in shares and bonds. Management
has adopted the Capital Asset Pricing Model to always be used in determining a
theoretically appropriate required rate of return of an asset if that asset is to be added
to an already well-diversified portfolio; given that assets non-diversifiable risk. The
selected model based on a series of assumptions some of which are restrictive unlike
Arbitrage Pricing Theory.The Director Finance has provided an extract of the
following information regarding its four asset portfolio. Management wishes to invest
company savings worth SHS.100, 000,000 into that four Asset portfolio.

Asset Expected return Beta Funds invested in each Asset

HERO SHARES 15.4% 1.6 40,000,000
BAIYUN SHARES 16.8% 1.2 20,000,000
RALLEY SHARES 11.8% 0.7 30,000,000
BONDS 8% 0.1 10,000,000

Required:
i) Describe the assumptions upon which the Capital Assets Pricing Model is based and why
you think it is of any practical use to the Finance Manager XYZ a private limited liability
company.

The capital asset pricing model (CAPM) is a finance theory that establishes a linear
relationship between the required return on an investment and risk. The model is based on the
relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and
the equity risk premium, or the expected return on the market minus the risk-free rate.
At the heart of the model are its underlying assumptions, which many criticize as being
unrealistic and which might provide the basis for some of its major drawbacks.
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm − Rf )
Where:
ERi = expected return of investment Rf = risk-free rate
βi = beta of the investment (ERm − Rf) = market risk premium

E(ri) = Rf   +  βi (E(rm) − Rf)

Where:
E(ri) = return required on financial asset i 
Rf = risk-free rate of return
βi = beta value for financial asset i 
E(rm) = average return on the capital market
No model is perfect, but each should have a few characteristics that make it useful and
applicable.

 The CAPM is a widely-used return model that is easily calculated and stress-tested.
 Despite these criticisms, the CAPM provides a more useful outcome than either the
DDM or the WACC models in many situations.
 It is criticized for its unrealistic assumptions.

Like many scientific models, the CAPM has its drawbacks. The primary drawbacks are
reflected in the model's inputs and assumptions, including:

Risk-Free Rate (Rf) - The commonly accepted rate used as the Rf is the yield on short-term
government securities. The issue with using this input is that the yield changes daily,
creating volatility.

Return on the Market (Rm) - The return on the market can be described as the sum of
the capital gains and dividends for the market. A problem arises when, at any given time, the
market return can be negative. As a result, a long-term market return is utilized to smooth the
return. Another issue is that these returns are backward-looking and may not be
representative of future market returns. 

Ability to Borrow at a Risk-Free Rate - CAPM is built on four major assumptions,

including one that reflects an unrealistic real-world picture. This assumption—that investors
can borrow and lend at a risk-free rate—is unattainable in reality. Individual investors are
unable to borrow (or lend) at the same rate as the U.S. government. Therefore, the minimum
required return line might actually be less steep (provide a lower return) than the model
calculates. 

Determination of Project Proxy Beta - Businesses that use the CAPM to assess an
investment need to find a beta reflective of the project or investment. Often, a proxy beta is
necessary. However, accurately determining one to properly assess the project is difficult and
can affect the reliability of the outcome.

The CAPM is based on the following assumptions.

1. Risk-averse investors - The investors are basically risk averse and diversification is
necessary to reduce their risks.
2. Maximising the utility of terminal wealth - An investor aims at maximizing the utility of
his wealth rather than the wealth or return. The term ‘Utility’ describes the differences in
individual preferences. Each increment of wealth is enjoyed less than the last as each
increment is less important in satisfying the basic needs of the individual. Thus, the
diminishing marginal utility is most applicable to wealth.

There are also other forms of utility functions. Some investors showing a preference for
larger risks are those who have increasing marginal utility for wealth. In such cases, each
increase in wealth prompts the individual to acquire more wealth. For a risk-neutral investor,
each increment in wealth is equally attractive.  In other words, each increment would have
the same utility for him.
3. Choice on the basis of risk and return - Investors make investment decisions on the basis
of risk and return. Risk and return are measured by the variance and the mean of the portfolio
returns. CAPM assumes that the rational investors put away their diversifiable risk, namely,
unsystematic risk. But only the systematic risk remains which varies with the Beta of the
security.

Some investors use the beta only to measure the risk while other investors use both beta and
variance of returns as the sources of reward. As individuals have varying perceptions towards
risk and reward, CAPM gives a series of efficient frontlines.

4. Similar expectations of risk and return - All investors have similar expectations of risk
and return. In other words, all investors’ estimates of risk and return are the same. When the
expectations of the investors differ, the estimates of mean and variance lead to different
forecasts.

As a result, there will be innumerable efficient frontiers and the efficient portfolio of each
will be different from that of the others. Varying preferences also imply that the price of an
asset will be different for different investors.

5. Identical time horizon - The CAPM is based on the assumption that all investors have
identical time horizon. The core of this assumption is that investors buy all the assets in their
portfolios at one point of time and sell them at some undefined but common point in future.
This assumption further implies that investors form portfolios to achieve wealth at a single
common terminal rate.
This single common horizon enables one to construct a single period model. This assumption
is highly unrealistic as investors are short-term speculators. Further, the horizon is chosen on
the basis of the characteristics of an asset. So investors have different time horizons and their
estimates of stock value vary even when the estimated earnings remain constant. Instead of
single period model, investors generally adopt continuous time models as if they make a
series of reinvestments.

6. Free access to all available information - One of the important assumptions of the
CAPM is that investors have free access to all the available information at no cost. Supposing
some investors alone are able to have access to special information which is not readily
available to all, then the markets would not be regarded efficient. In other words, if the
available information has not reached all, it will be difficult to draw a common efficient
frontier line.

7. There is risk-free asset and there is no restriction on borrowing and lending at the
risk free rate - This is a very important assumption of the CAPM. The risk free asset is
essential to simplify the complex pairwise covariance of Markowitz’s theory. The risk free
asset makes the curved efficient frontier of MPT to the linear efficient frontier of the CAPM
simple.
As a result, the investors will not concentrate on the characteristics of individual assets. By
adding a portion of risk-free assets to the portfolio and borrowing the additional funds needed
at a risk free rate, the risk is either decreased or increased.
8. There are no taxes and transaction costs - According to Roll, there must be either a risk
free asset or a portfolio of short sold securities. Then only the capital Market Line (CML)
will be straight. When there are no risk free assets, the investor could not create a proxy risk
free asset. As a result, the capital market line would not be linear and the direct linear
relationship between risk and return would not exist.

9. Total availability of assets is fixed and assets are marketable and divisible - This
assumption holds the view that the total asset quantity is fixed and all assets are marketable.
However, models have been developed to include unmarketable assets which are more
complex than the basic CAPM.
Assumptions of Capital Asset Pricing Model (accountlearning.com)

ii) To discuss the shortcomings of Capital Asset Pricing Model and why you think that it
still prevails over Arbitrage Pricing Model despite its shortcomings?
Like many scientific models, the CAPM has its drawbacks. The primary drawbacks are
reflected in the model's inputs and assumptions, including:

Risk-Free Rate (Rf) - The commonly accepted rate used as the Rf is the yield on short-term
government securities. The issue with using this input is that the yield changes daily,
creating volatility.
Return on the Market (Rm) - The return on the market can be described as the sum of
the capital gains and dividends for the market. A problem arises when, at any given time, the
market return can be negative. As a result, a long-term market return is utilized to smooth the
return. Another issue is that these returns are backward-looking and may not be
representative of future market returns. 
Ability to Borrow at a Risk-Free Rate - CAPM is built on four major assumptions,
including one that reflects an unrealistic real-world picture. This assumption—that investors
can borrow and lend at a risk-free rate—is unattainable in reality. Individual investors are
unable to borrow (or lend) at the same rate as the U.S. government. Therefore, the minimum
required return line might actually be less steep (provide a lower return) than the model
calculates. 
Determination of Project Proxy Beta - Businesses that use the CAPM to assess an
investment need to find a beta reflective of the project or investment. Often, a proxy beta is
necessary. However, accurately determining one to properly assess the project is difficult and
can affect the reliability of the outcome.
The Single factor model is also a challenge
The assumption that the market is dominated by only irrational investors
The assumption that all investors are risk averse
The information asymmetry still miss leading
The use of Beta
iii) Using the information provided by the Director Finance, calculate and interpret the
portfolio return and portfolio beta to enable management make meaningful finance and
investment decisions of XYZ ltd.

Asset Expected Beta Funds invested Weight Weighted

return in each Asset Beta
HERO SHARES 15.4% 1.6 40,000,000 0.4 0.64
BAIYUN SHARES 16.8% 1.2 20,000,000 0.2 0.24
RALLEY SHARES 11.8% 0.7 30,000,000 0.3 0.21
BONDS 8% 0.1 10,000,000 0.1 0.01
1.1

Portfolio return: Rp = ∑ (wi * ri)

Where: Wi: Defines the associated weight to the asset

Ri: It is the asset’s return
Portfolio Return  = (15.4% x 0.4) + (16.8% x 0.2) + (11.8% x 0.3) + (8% x 0.1)
Portfolio Return  = 6.16% + 3.36% + 3.54% + 0.8%

Portfolio Return  = 13.86%

Portfolio beta = 0.64 + 0.24 + 0.21 + 0.01 =1.1

As you can see, adding up the weighted beta figures in the right column results in a beta of
about 1.01. That means this portfolio’s volatility is very much in line with XYZ Ltd
Investment

b) Quality (u) ltd is an all equity company with an equilibrium market value of USHS.
65billion and a cost of capital of 18% per year. The company proposes to make a repurchase
of USHS. 10 billion of equity and to replace it with 13% irredeemable debt. Quality’s
earnings before interest and tax are expected to be constant for the fore seeable future.
Corporation tax is charged at a rate of 30% and all profits are paid out as dividends to
shareholders.

Required:
Using the assumptions of MM explain and demonstrate how this change in capital structure
will affect (to add in the other argument of the traditional theory)
i. The market value

The Modigliani-Miller theorem (M&M) states that the market value of a company is
correctly calculated as the present value of its future earnings and its underlying assets, and
is independent of its capital structure.

 The Modigliani-Miller theorem states that a company's capital structure is not a

factor in its value.
 Market value is determined by the present value of future earnings, the theorem
states.
A company’s capital structure — essentially, its blend of equity and debt financing — is a
significant factor in valuing the business. The relative levels of equity and debt affect risk and
cash flow and, therefore, the amount an investor would be willing to pay for the company or
for an interest in it.

This suggests that the valuation of a firm is irrelevant to the capital structure of a company.
Whether a firm is high on leverage or has a lower debt component has no bearing on its
market value. Rather, the market value of a firm is solely dependent on the operating profits
of the company.

ii. The cost of equity

 The M&M theorem holds that the average cost of capital to the firm does not depend
on its capital structure (ratio of equity finance to debt finance), because any reduction
in capital cost from switching to higher leverage using lower-cost debt is exactly
offset by an induced increase in the unit cost of higher-cost equity capital as a
consequence of the associated rise in risk

iii. The cost of capital, of quality (u) ltd

 The theory suggests that a company’s capital structure and the average cost of capital
do not have an impact on its overall value. 
 The company’s value is impacted by its operating income or by the present value of
the company’s future earnings.
 It doesn’t matter whether the company raises capital by borrowing money, issuing
new shares, or by reinvesting profits in daily operations.
Question three

a) Explain the different Forms of loan capital available to finance corporate ventures

Loan Capital refers to that amount of capital which is required to manage the operations of
the business raised from the external sources of the company such as financial institutions, by
issuing debentures, etc. It is one of the option of raising fund as it only includes long term
funds which can be utilized by the company for the goal of business by bearing some sort of
interest or charge.

Loan capital is considered where funds are required by the business for a longer period i.e.
they are not preferable for a shorter duration, they carry periodic payment of interest or some
charges and do not have any involvement in the profits of the company. They are of various
types amongst all of which the debentures are considered the safest and less riskiest way to
provide fund as it can be seen that bank overdraft or bank loan does not secure the lender
fully, by taking the funds from loan capital and timely repayment of such amounts will create
the goodwill in the eyes of bank and the lender which helps the business in the long run so
that we get the funds as and when required.

Loan capital is funding that must be repaid. This form of funding is comprised of loans,
bonds, and preferred stock that must be paid back to investors. Unlike common stock, loan
capital requires some type of periodic interest payment back to investors for use of the funds.
However, these investors do not share in the profits earned by the organization, though they
have payment preference over shareholders in the event of a business default and the
following are some of the examples of loan capital

Debentures

These are the instruments that are liabilities to the company and are required to be repaid
along with the payment of fixed interest thereupon. The debenture-holders will earn a fixed
interest on the amount advanced to the company and they do not have any decision making
right in the company. Debentures are medium- to long-term debt instruments used by large
corporations to borrow money at a fixed rate of interest.

A debenture, like a loan bond or certificate of loan, is evidence that the company is liable to
pay a certain amount with interest, even though the money raised by the debentures becomes
part of its capital structure (rather than share capital).

Those who buy debentures (debenture holders) have no rights to vote in a company’s general
meeting of shareholders. However, debenture holders have separate votes, depending on the
rights attached to the document. The interest paid to debenture holders is a charge against
profit in the firm’s financial statements. In order to secure their loan in the event of the
company’s collapse, bondholders may take a charge over some or all of its assets.

In Uganda, the Stamp Duty (Amendment) Act 2020 which came into force on 1st July 2020
has revised the rate of stamp duty payable on debentures, equitable mortgages and further
charges
Effective 1st July 2020, stamp duty was waived on debentures, equitable mortgages and
further charges. Previously, a stamp duty of 0.5% was payable on debentures. Under the now
repealed item 27, 30 and item 33 of the 2014 Stamp Duty Amendment Act, stamp duty of
0.5% of the value of the facility was payable on debentures, equitable mortgages and further
charges.

The stamp duty payable on an instrument for all loans is now nil compared to the now
repealed item 37 of the 2014 Stamp Duty Amendment Act for which nil stamp duty applied
only to instruments for loans not exceeding Uganda Shillings Three Million. Given the
current situation in light of the COVID19, the aim is to make it less financially burdensome
for companies to borrow and thereby facilitate economic transactions.

Bank Overdraft

These are the agreements entered into by the banks and the person seeking such a facility.
The bank after examining the creditworthiness of the person or entity grants them a fixed
limit and the person can use such limit funds and in return, they have to pay a fixed amount
of interest on the amount which they have used from the limit.

An overdraft occurs when you withdraw money from your bank account and the available
balance goes into negative numbers (below zero) – the account is overdrawn. If you already
have an agreement with your bank for an overdraft, and your balance is within the authorized
limit, you will normally be charged interest at the agreed rate. But if you exceed the limit,
additional fees will be charged, as well as possibly higher interest rates. NatWest Bank in the
UK calls this an ‘Unarranged Overdraft’, and says that if the account holder goes more than
£10 over the agreed limit, he or she will be charged an Unarranged Overdraft Usage Fee of
£6 per day until the position is rectified (this is capped at £90 per charging period).

For example: Centenary Bank provides short-term credit for financing urgent cash
requirements.

Product Features include

 Minimum amount offered is UGX 100,000 or its equivalent in USD.

 The facility period is up to a maximum of 12 months
 Repayable through good account deposits.
 Interest is linked to the bank’s prime lending rate and charged on declining balance.

Benefits include

 Faster loan processing speed.

 Multiple disbursements allowed.
 Offers greater financial flexibility to the customer.

Requirements

 Hold a Current account with the bank.

 Completed overdraft facility application form.
 Good account turnover.
 Payment of loan processing fees.
  Financial Card.
 Collateral for securing the Overdraft. (info@centenarybank.co.ug)

Bank Loan

This is the most commonly used type of raising funds by a business which is granted by the
business by taking something valuable as collateral, the funds used costs the company some
fixed rate of interest which usually is lower as compared to the other two sources of raising
funds.

Businesses most commonly borrow capital through bank loans. They provide medium- or
long-term finance. The lender sets the fixed period over which the loan is provided, the rate
of interest and the repayment schedule. In most cases the bank will ask for some kind of
security (collateral) for the loan. If it is a start-up company this security will probably be an
asset owned by the entrepreneur.

Bank loans are generally cheaper than overdrafts, i.e. interest rates tend to be
lower. However, a bank loan is less flexible than an overdraft – the business is committed to
a repayment schedule over a fixed period with a bank loan. And the following are some
categories of loans

Secured Bank Loan. This is a loan which uses an asset as collateral. A good example is a
mortgage loan. For this type of large loan, the Bank secures the house as collateral. If people,
defer on their loan, the bank is able to legally possess the home to pay off the outstanding
debt.

Unsecured Bank loan. This is a loan given without any asset for collateral. These tend to be
for smaller amounts and typically attract a higher interest rate because of the perceived risk.

Inter Bank Loan. Often commercial banks are short of money and so are forced to borrow
money on the money markets. These are typically short term loans and can be interbank or
direct to the Central Bank.

A syndicated loan is a loan extended by a group of financial institutions (a loan syndicate) to

a single borrower. Syndicates often include both banks and non-bank financial institutions,
such as collateralized loan obligation structures (CLOs), insurance companies, pension funds,
or mutual funds

b) What are internally Generated Funds explain reasons why corporate managers may
or may not prefer internally generated funds as their major sources of finance

Internally Generated Funds means funds not generated from the proceeds of any Loan,
Debt Issuance, Equity Issuance, Disposition, insurance recovery or Indebtedness (in each
case without regard to the exclusions from the definition thereof (other than sales of
inventory in the ordinary course of business)). Business firms provide financial capital from
within the firm by keeping profits generated.

These funds represent the positive difference between the spending of the organization
(Transaction costs, interest payments, tax payments, dividend payments or renewal of fixed
Assets), and of the income it generates. One source of internal financing that is often
overlooked, are generated savings through more efficient management of working capital.
This capital is melted in the short-term assets and liabilities. Efficient management of claims
from buyers, obligations to suppliers, stocks of goods, and cash reserves, can reduce the
overdraft from the bank account and interest burdens and increase cash reserves. And another
source of internal financing of great importance is depreciation funds of fixed assets and
equipment of the firm.

Firms prefer to use retained earnings as sources to financing investment projects because they
appear as inexpensive resources, but the amount of the retained earnings is limited. However,
these resources can be used depending on the financial situation of the business and its
previous financial performance. Thus, if the business has accumulated reserves and has not
Distributed all profits, can utilize the internal resources to finance its needs (Fisman & Love,
2003). finances can also be generated from within the business. This is known as internal
financing and examples include;

Owner's Investment. At the beginning of a business, most of the funding usually comes
from owner investment. Beginning with adequate capital is imperative for all businesses. One
of the most important reasons for failure is that the business began without sufficient capital
to continue operating until it reached profitability.
Internal Funding From Retained Profits. Once a business is up and running, a primary
source of funding continued growth is from the retained profits also known as retained
earnings (RE). RE differs from revenue. Revenue is your total income from the sale of your
services or product to your customer. RE is the sum that the company keeps or saves for
future use.

Retained earnings are a better source of capital for a company than debt or equity. It is a
positive operating income accumulated from quarter to quarter. The company is generating
that positive operating income from its successful business operations. Operating income is
also known as earnings before interest and taxes or EBIT. Operating income or EBIT is
commonly used to determine the overall success of the business. 

Sale of Stock. Although not an option for most startups and not available until a business
incorporates, company stock can be another form of internal funding. Other than a large
infusion of venture capital, stock offerings are the fastest way for a successful business to
scale up. 
Sale of Fixed Assets The sale of a firm's assets is the most profitable internal funding option
for a mature firm. A firm, for example, can sell older assets that have been replaced by others
or that are no longer needed for operations. If these assets have been fully depreciated and
have little or no book value, you will have a taxable gain from the sale.

Nevertheless, such sales can add to your bottom line. In other instances, and increasingly so
in the largest coastal cities, the rapid appreciation of real estate assets has meant that a
business such as a restaurant may hold real estate assets that far exceed the value of the
business as an ongoing operation.

In these instances, the business can multiply its capital simply by selling the business and the
underlying real estate in its present high-value real estate location and relocating in an area
that has not yet benefited from the real estate boom.
Debt Collection. Sometimes businesses and smaller businesses particularly allow customers
to let their agreed-upon payments slide. It is certainly a bad business practice on a number of
grounds, and the appropriate remedy is to put more effort into collections. Doing so also
increases available capital. 

ADVANTAGES & DISADVANTAGES OF INTERNAL FINANCING

The advantages of internal source of financing are as follows:

1) No Dilution of Ownership and Control

The biggest advantage of internal sources of finance is that it avoids the dilution of ownership
and control. A business, by using an internal source of financing, retains its ownership. For
example, if a business funds its finance through equity finance, the new equity holders will
have to be given some form of control over the decisions of the business for the capital they
have invested in the business.

Generally, equity instruments also come with voting rights for companies. This means that
new investors coming into the company will also get to make and contribute to the decision-
making process of a business. This may prove bad for a business as it may cause conflicts
between existing owners and new owners. New owners of the business may not share the
same ideas and vision for the business as the old owners. On the other hand, debt finance may
require a business to offer an asset as security in exchange for the finance provided. This
finance may come with some sort of restrictions on the use of the asset. This means the asset
will no longer be in the full control of the business.

2) No Legal Obligations

Internal source of finance comes with no legal obligations to pay anyone. This is different
from other sources of finance such as debt finance where the business is legally obliged to
pay the debt providers. In case these obligations are not paid on time, the business may also
have to face legal actions. Businesses also have to pay interest to the debt providers for the
finance they have provided to the company. The same does not apply to internal financing.

3) Lower Cost

The cost of capital of internal financing is also lower as compared to other sources of finance.
For example, if a company wants to obtain equity finance, it will have to comply with stock
market regulations and also pay fees involved with issuing shares, etc. Similarly, the
company has to pay interest fees and offer assets as security to obtain debt finance. Both of
these costs are avoided when internal financing is used. When you’re using external sources
of finance, then the lending generates interest payments that can make borrowing expensive.
This happens on the individual level as well. Imagine that you’re purchasing an asset that is
$21,000. If you use internal sources of finance for the purchase, you pay the expense and that
completes the transaction. Then you can repay the cost monthly, if needed, from other budget
lines. With external sources, at a 4% interest rate over 6 years, you’d pay almost $10,000 in
interest that wouldn’t be required with internal sources.
4) No Approvals Needed

When funds are generated internally, the business does not need permission of equity or debt
holders to use these funds. A business that uses equity or debt finance generated externally
instead of internally generated finance is forced to wait for approval of the equity or debt
providers for decision. This can also make the decision-making process of a business slower
and vital opportunities might be missed waiting for approval.

5) Improves the Value of the Business

Internally generated funds also help improve the value of the business. These funds retained
in the business help increase the value of the equity instruments of the business. Furthermore,
internally generated finance, unlike debt finance, improve the gearing ratio of a business
which makes investment in the business attractive for potential investors.

Investors don’t like to see a lot of external debt with a company. High debt levels indicate
more risk, which reduces the overall value of the company. You’ll also see improvements in
the credit score of your business if you are utilizing less debt too. Internal financing resources
may create expenditures that may be difficult to manage in the short-term sometimes, but
from a long-term perspective, managing debt levels will always create long-term financial
health for most companies.

6) Helps Improve Business Credit Rating

When a business generates internal funds and uses those funds in daily operations, it helps
establish the business’ credit ratings. Financial institutions are more likely to give loans to a
business that can show the potential to generate finance to repay the loan. Moreover, unlike
debt finance, it does not adversely affect the credit rating of a business.

It improves the planning process.

Firms tend to be more careful when planning new projects when using internal financing
compared to external financing. There is no illusion that you have cash to spare when using
internal sources of finance. You’re only spending the money that your company has earned or
set aside for a project just like the one being considered. That makes it less likely that
spending on extraneous things will occur, which creates positive spending habits over time.

Disadvantages:

Internal financing can also have some disadvantages, as below:

1) Not Ideal for Long-term Projects

When internal finance is used to fund the activities of the business, the growth is limited by
the rate at which the business can generate internal finance. A business is highly unlikely to
generate enough internal finance to fund long-term projects at a constant rate. Therefore,
external finance is always needed and preferred when investing in long-term projects.
In addition, using internally generated funds to finance long-term projects needs proper
planning and forecasting. This requires accurate forecasting to predict the exact returns and
time of those returns for it to be effective. Once internal financing is used for a long-term
project, the business also needs to keep tight control over the project to ensure the funds are
recovered. If the spending is not closely controlled, the business might have to face
bankruptcy threats.

Effects of Other Business Operations

If an internal source of finance is used to fund a long-term project, this may adversely affect
the daily operations of the business. Using internal finance to fund a long-term project means
the internal finance has to be generated from somewhere.

This finance may then be generated by cutting the budgets of other departments of the
business. This can further affect the ability of the business to generate more funds to finance
the project.

3) Loss of Tax Benefits

Debt financing comes with the benefit of tax deductions for the interest payments made by a
business. When internal finance is used, this tax benefit is lost. For businesses that pay a high
tax percentage based on their income, an internal source of finance may not be beneficial.

4) No External Expertise or Networks

External sources of finance may also bring expertise or networking opportunities to

businesses. For example, when venture capitalists invest in a business, they bring expertise
and networking to businesses, which is invaluable in itself for startups. When the internal
source of finance is used, this advantage is lost.

It increases the risk of a bankruptcy for some businesses.

If a company decides that a reduction in working capital is the best source of internal
financing, then it will assume a higher risk of bankruptcy. When working capital is at very
low levels, all it may take is one unexpected expense to become the tipping point for financial
health. For that reason, even the sale of certain assets may be a better option, even if the
useful life of the asset is still valuable internally, because it does not impact the bankruptcy
risk as working capital reductions do.

Conclusion

Businesses can choose between using internal or external sources of finance for their
activities or upcoming projects. Using an internal source of finance can give the business
many advantages such as avoiding dilution of ownership and control, lower costs, and
improving the business value. However, it may come with some disadvantages such as not
being ideal for long-term projects, loss of tax advantages, and loss of expertise and
networking.
c) Explain how you would carry out an Assessment of Risk in debt versus Equity
decisions

Equity Financing vs. Debt Financing:

To raise capital for business needs, companies primarily have two types of financing as an
option: equity financing and debt financing. Most companies use a combination of debt
and equity financing, but there are some distinct advantages to both. Principal among them
is that equity financing carries no repayment obligation and provides extra working capital
that can be used to grow a business. Debt financing on the other hand does not require
giving up a portion of ownership.

Companies usually have a choice as to whether to seek debt or equity financing. The
choice often depends upon which source of funding is most easily accessible for the
company, its cash flow, and how important maintaining control of the company is to its
principal owners. The debt-to-equity-ratio shows how much of a company's financing is
proportionately provided by debt and equity.

Equity Financing

Equity financing involves selling a portion of a company's equity in return for capital. For
example, the owner of Company ABC might need to raise capital to fund business expansion.
The owner decides to give up 10% of ownership in the company and sell it to an investor in
return for capital. That investor now owns 10% of the company and has a voice in all
business decisions going forward.

The main advantage of equity financing is that there is no obligation to repay the money
acquired through it. Of course, a company's owners want it to be successful and provide the
equity investors with a good return on their investment, but without required payments or
interest charges, as is the case with debt financing.

Equity financing places no additional financial burden on the company. Since there are no
required monthly payments associated with equity financing, the company has more capital
available to invest in growing the business. But that doesn't mean there's no downside to
equity financing.

In fact, the downside is quite large. In order to gain funding, you will have to give the
investor a percentage of your company. You will have to share your profits and consult with
your new partners any time you make decisions affecting the company. The only way to
remove investors is to buy them out, but that will likely be more expensive than the money
they originally gave you.

With equity money from investors, the owner is relieved of the pressure to meet the deadlines
of fixed loan payments. However, he does have to give up some control of his business and
often has to consult with the investors when making major decisions.

Advantages of Equity
  Less risk: You have less risk with equity financing because you don't have any fixed
monthly loan payments to make. This can be particularly helpful with startup
businesses that may not have positive cash flows during the early months.
 Credit problems: If you have credit problems, equity financing may be the only
choice for funds to finance growth. Even if debt financing is offered, the interest rate
may be too high and the payments too steep to be acceptable.
 Cash flow: Equity financing does not take funds out of the business. Debt loan
repayments take funds out of the company's cash flow, reducing the money needed to
finance growth.
 Long-term planning: Equity investors do not expect to receive an immediate return
on their investment. They have a long-term view and also face the possibility of
losing their money if the business fails.

Disadvantages of Equity

 Cost: Equity investors expect to receive a return on their money. The business owner
must be willing to share some of the company's profit with his equity partners. The
amount of money paid to the partners could be higher than the interest rates on debt
financing.
 Loss of Control: The owner has to give up some control of his company when he
takes on additional investors. Equity partners want to have a voice in making the
decisions of the business, especially the big decisions.
 Potential for Conflict: All the partners will not always agree when making decisions.
These conflicts can erupt from different visions for the company and disagreements
on management styles. An owner must be willing to deal with these differences of
opinions.

Debt Financing

Debt financing involves the borrowing of money and paying it back with interest. The most
common form of debt financing is a loan. Debt financing sometimes comes with restrictions
on the company's activities that may prevent it from taking advantage of opportunities outside
the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity
ratio, which benefits the company if it needs to access additional debt financing in the future.

The advantages of debt financing are numerous. First, the lender has no control over your
business. Once you pay the loan back, your relationship with the financier ends. Next, the
interest you pay is tax deductible. Finally, it is easy to forecast expenses because loan
payments do not fluctuate. Borrowing money to finance the operations and growth of a
business can be the right decision under the proper circumstances. The owner doesn't have to
give up control of his business, but too much debt can inhibit the growth of the company.

Advantages of Debt

 Control: Taking out a loan is temporary. The relationship ends when the debt is
repaid. The lender does not have any say in how the owner runs his business.
 Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
  Predictability: Principal and interest payments are stated in advance, so it is easier to
work these into the company's cash flow. Loans can be short, medium or long term.

Disadvantages of Debt

 Qualification: The Company and the owner must have acceptable credit ratings to
qualify.
 Fixed payments: Principal and interest payments must be made on specified dates
without fail. Businesses that have unpredictable cash flows might have difficulties
making loan payments. Declines in sales can create serious problems in meeting loan
payment dates.
 Cash flow: Taking on too much debt makes the business more likely to have
problems meeting loan payments if cash flow declines. Investors will also see the
company as a higher risk and be reluctant to make additional equity investments.
 Collateral: Lenders will typically demand that certain assets of the company be held
as collateral, and the owner is often required to guarantee the loan personally.

When looking for funds to finance the business, an owner has to carefully consider the
advantages and disadvantages of taking out loans or seeking additional investors. The
decision involves weighing and prioritizing numerous factors to decide which method will be
most beneficial in the long-term.

d) Explain what you understand by financing decision and the factors that the finance
manager should consider when undertaking the capital structure decisions

Financing decisions refer to the decisions that companies need to take regarding what
proportion of equity and debt capital to have in their capital structure. This plays a very
important role vis-a-vis financing its assets, investment-related decisions, and shareholder
value creation.

Financing decisions are the financial decisions related to raising of finance. It involves
identification of various sources of finance and the quantum of finance to be raised from
long-term and short-term sources. A firm can raise long term finance either through
shareholders' funds or borrowed capital.

The financing decision seeks to optimize the WACC by looking at a company’s capital
structure, specifically the cost of equity and the cost of debt. If a company wants to create
value for shareholders, it needs to ensure that it’s ROIC (Return on Invested Capital) is
greater than the WACC. As part of financing decisions, companies aim to minimize their cost
of funding while maintaining a stable credit rating and the ability to finance new projects.

Size of Business:

Small businesses have to face great difficulty in raising long-term finance. If, it is at all able
to get long-term loan, it has to accept unreasonable conditions and has high rate of interest.
Such restrictive conditions make the capital structure inflexible for small companies and
management cannot freely run the business. Therefore, small businesses rely on share capital
and retained earnings to meet their requirements of long-term funds. Small companies have to
bear greater cost of raising long-term funds as compared to large companies. Besides, issuing
ordinary shares every time to raise long-term funds may result in loss of control by existing
shareholders.

The shares of a small company are not widely held and the dissatisfied class of shareholders
can easily organise to keep the control in their hands. Therefore, small companies do not
allow to expand their business much and manage their funds out of retained earnings. Large
companies are able to raise their long-term loans at comparatively cheaper terms and can
issue ordinary shares and preference shares to the public. Due to issuance of shares of high
amount, the cost of issue is low in comparison to small companies. Therefore, while
preparing capital structure plan, company should make proper use of its size.

Form of Business Organisations:

‘Control’ is much significant in case of private companies, sole traders and partnership firms
because in such businesses, ownership is limited to a few hands. In public limited companies,
ownership is widely spread. Therefore, control can’t be restricted. The sale and stability of
income affects the quantum of leverage. The companies which have stability in income and
sales, can use more amount of debt in their capital structure. They can easily pay their fixed
financial charges. The industries producing consumer goods face more fluctuations in their
sales and, therefore, use lesser amount of debt.

On the other hand, income and sales of public utility institutions are more stable and
therefore, they can use more debts in financing their assets. Expected increase in sales also
affects the amount of leverage. This is the reason that developing companies use more debt in
their capital structure. The companies whose sales are decreasing, should not use debt or
preference share capital because they can face difficulty in the payment of interest and
preference dividend, as a result of which the company could be liquidated.

Degree of Competition:

If in an industry, the degree for competition is high, such companies in that industry should
use greater degree of share capital as compared to the debt capital. On the other hand, the
industries in which the degree of competition is not so high, have a tendency of stable income
and, therefore, they can use more debt.

Stage of Life Cycle

Stage of the life cycle of a firm is also an important factor affecting the capital structure. If a
firm is in its initial stages, there are more chances of its failure. In such case, the use of
ordinary share capital should be emphasized. Firm can work properly if it does not issue such
securities on which it has to pay fixed amount of interest.

In such case, the risk is high. When a firm is passing through the stage of growth, it should
plan its capital structure in a manner that it can raise finance easily whenever it needs. When
a firm enters the stage of maturity, it has to spend more on the development of new products
and, therefore, funds should be raised from ordinary shares because there is uncertainty in the
increase in income of business. If in the long-run, there is possibility of reduction in level of
business activities, the plan of capital structure should be prepared in a manner so as to
facilitate the repayment of surplus funds.
Credit Standing:

The companies whose credit standing is better from the viewpoint of investors and creditors,
are able to raise funds on convenient terms. But in case the credit standing is not good, the
financing decision becomes limited.

Corporation Tax:

Due to the current provisions of tax, the use of debt in the capital structure is cheaper as
compared to the ordinary share capital or preference share capital. Interest is chargeable
expense from the taxable income, whereas dividend is paid out of earnings available after tax.
Hence, level of tax affects the cost of capital. Therefore, to take the advantages of trading on
equity, management uses more loan capital in the capital structure which helps in increasing
the income of the shareholders.

State of Capital Market:

While taking decision on the capital structure, tendencies of the capital market should be
taken into account because these affect the cost of capital and availability of funds from
different sources. Sometimes, company wants to issue ordinary shares but the investors do
not want to invest in that company due to high risk.

In such a situation, company should not issue shares and necessary funds should be raised
from other sources. Therefore, timing of the issuance of securities to the public is an
important factor affecting the capital structure of a company. Government monetary and
taxation policies are also significant in this regard. If the management feels that debt funds
will become costlier in future, it should raise necessary funds from the debt sources soon. If
the rate of interest is expected to be lower, management can raise funds from other sources
and can take the advantage of lower interest rate in future.

Cash Flow Ability of the Company:

Sometimes, the interest coverage ratio of a company is high but it does not have adequate
cash to pay interest or preference dividend. Due to this reason, company can be financially
insolvent. Therefore, a company must have so much cash balance that it can pay its fixed
charges in time.

The amount of fixed charges will be greater if a company uses more debt financing or
preference share capital. Higher the efficiency of cash flow, more will be its ability to use
debt funds. Therefore, whenever a company thinks of using additional debt, it must analyse
its capacity of generating cash flows to pay the fixed charges. The companies which foresee
higher possibility of more and stable cash inflows in future, can use more debt in their capital
structure. The capacity of the firm to pay fixed charges and generate cash flows can be
determined by calculating the ratio of net cash inflows to fixed charges. The greater this ratio,
the higher will be debt capacity of the firm.

Flotation Costs:
These costs are incurred at the time of issue of securities. These costs include commission,
brokerage, stationery and other expenses. Normally the cost of debt is less than cost of
issuing shares. Therefore, the company can be attracted towards the loan funds. In case of
retained earnings, no such issue expenses need to be incurred. But flotation costs are not the
most important factor in capital structure decisions. If the amount of issue is increased, the
percentage of flotation costs can decrease.

Control:

In present times, management wants to maintain its existence continuously and does not want
any outside interference. Ordinary shareholders have got legal right to appoint directors. If
the company is paying interest and instalment of loan in time, the creditors of company can’t
interfere in managerial decisions. Similarly, preference shareholders do not have voting right.
But in case the company is unable to pay dividend to the preference shareholders for certain
period of time, the preference shareholders get a right to participate in the meetings of the
company. Thus, in most of the circumstances, ordinary shareholders have the right to appoint
directors.

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