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(a) Outline THREE limitations of retained earnings as a source of finance. (3 marks) (b) Explain THREE
non-financial goals of a firm. (6 marks)

(a)

1. Limited availability: Retained earnings are limited by the profitability of the firm. If a
company has a low profit margin or has not accumulated sufficient profits in previous
years, it may not have sufficient retained earnings to finance its future projects or
investments.
2. Lack of diversification: Since retained earnings come from the profits of the company, it
is limited to the performance of that specific business. This means that if the company's
industry or sector experiences a downturn, the company may not have enough retained
earnings to support its operations or expansion plans.
3. Opportunity cost: Retained earnings represent an opportunity cost to the company, as the
funds that are kept in the business are not being used for alternative investments or
purposes. If the company has more attractive investment opportunities outside the
business, then the opportunity cost of retaining earnings becomes significant.

(b)

1. Social Responsibility: One of the non-financial goals of a firm is social responsibility.

This involves taking actions that are in the best interest of society, such as reducing the
firm's carbon footprint or supporting charitable causes.
2. Employee Satisfaction: Another non-financial goal of a firm is employee satisfaction.
This involves creating a work environment that fosters employee satisfaction and
engagement, which in turn can lead to increased productivity and reduced turnover rates.
 3. Customer Satisfaction: A third non-financial goal of a firm is customer satisfaction. This
involves providing high-quality products and services that meet or exceed customer
expectations, which can lead to increased loyalty and repeat business.

(c) Heko Ltd. has the following capital structure which is considered optimal: Sh.“000” Debt (par value
Sh.1,000) 300,000 Preference shares (par value Sh.100) 180,000 Ordinary shares (par value Sh.100)
720,000 Additional information: 1. The investors of Heko Ltd. expect earnings and dividends to grow at a
constant rate of 9% in the future. 2. The company has just paid ordinary shareholders dividend of Sh.4.2
per share. 3. The current market price of ordinary shares of Heko Ltd. is Sh.80 each. 4. The firm will incur
a floatation cost of Sh.4 per share to issue new shares. 5. New preference shares can be sold at Sh.105
per share with a dividend of Sh.11 per share and floatation cost of Sh.10 per share. 6. The company will
issue debenture under the following terms: • The coupon rate 12% per annum • Discount Sh.30 per
debenture • Floatation cost Sh.20 per debenture • The par value is Sh.1,000 • Maturity period of ten
years 7. The corporate tax rate is 30%. Required: (i) The cost of ordinary share capital. (2 marks) (ii) The
cost of preference share capital. (2 marks) (iii) The cost of debenture capital. (3 marks) (iv) The weighted
average cost of capital (WACC) using market value weights. (4 marks)

(i) The cost of ordinary share capital can be calculated using the dividend growth model as
follows:

Cost of equity = (Dividend per share / Market price per share) + Growth rate = (4.2 / 80) + 0.09
= 0.057 + 0.09 = 0.147 or 14.7%

(ii) The cost of preference share capital can be calculated using the following formula:

Cost of preference share capital = (Dividend per share / Net proceeds per share) + Flotation cost
per share = (11 / (105 - 10)) + 10 = 0.1238 or 12.38%

(iii) The cost of debenture capital can be calculated as follows:

Effective cost of debt = (Coupon rate * (1 - Tax rate)) * (1 - Discount rate) + Flotation cost =
(0.12 * (1 - 0.3)) * (1 - (30 / (1 - 0.3))) + 20 = 0.0756 or 7.56%

(iv) The weighted average cost of capital (WACC) using market value weights can be calculated
as follows:

WACC = (Weight of debt * Cost of debt) + (Weight of preference shares * Cost of preference
share capital) + (Weight of ordinary shares * Cost of ordinary share capital) = ((300,000 /
1,000,000) * 0.0756) + ((180,000 / 1,200,000) * 0.1238) + ((720,000 / 1,200,000) * 0.147) =
0.0527 + 0.0186 + 0.08825 = 0.15945 or 15.945%

Therefore, the WACC using market value weights is 15.945%.

(a) Explain the term “venture capitalist” as used in finance. (2 marks) (b) Identify THREE differences
between “factoring” and “invoice discounting”. (6 marks)

(a) Venture capitalist is a type of private equity investor who provides funding to startups and
early-stage companies that have high growth potential but are deemed too risky by traditional
financing sources. Venture capitalists typically provide not only financial support but also
mentorship, industry connections, and strategic guidance to help the company grow and succeed.

(b) The three differences between factoring and invoice discounting are:

1. Ownership of Receivables: In factoring, the factoring company purchases the receivables

from the seller, whereas in invoice discounting, the seller retains ownership of the
receivables.
2. Responsibility for Collections: In factoring, the factoring company assumes responsibility
for collecting payments from customers, whereas in invoice discounting, the seller retains
responsibility for collections.
3. Disclosure to Customers: In factoring, the factoring company discloses its involvement to
the customers of the seller, whereas in invoice discounting, the seller typically maintains
control over the relationship with its customers and does not disclose the involvement of
the invoice discounter.

(a) Erick Nandwa borrowed Sh.250,000 from Pritt Sacco at a monthly interest rate of 3%. The loan is to
be amortised using the reducing balance method and be repaid in 6 equal monthly instalments, payable
at the end of each month. Required: Prepare a loan amortisation schedule. (6 marks) (b) Paul Kalama is
considering investing in a five-year Sh.1,000 par value bond bearing a coupon rate of 7%. Paul Kalama’s
required rate of return is 8%. The bond is quoted at Sh.950 in the bond market. The bond will be
redeemed at par value. Required: (i) Compute the intrinsic value of the bond. (4 marks) (ii) Advise Paul
Kalama on whether he should purchase the bond based on your computation in (d) (i) above. (2 marks)

(a) Loan Amortization Schedule:

Opening Closing
Month Balance Payment Interest Principal Balance

1 250,000 47,128 7,500 39,628 210,372

2 210,372 47,128 6,312 40,816 169,556

 Opening Closing
Month Balance Payment Interest Principal Balance

3 169,556 47,128 5,087 42,041 127,515

4 127,515 47,128 3,826 43,302 84,213

5 84,213 47,128 2,526 44,602 39,611

6 39,611 47,128 1,188 45,940 0

(b) (i) The intrinsic value of the bond can be calculated as the present value of the bond's future
cash flows. Using the bond's coupon rate of 7%, its par value of Sh.1,000, and a required rate of
return of 8%, we can calculate the bond's intrinsic value as follows:

PV of annuity = (1 - (1 + r)^-n) / r PV of bond = PV of annuity + PV of par value

Where: r = required rate of return = 8% / 2 = 4% n = number of semi-annual periods = 5 x 2 = 10

PV of annuity = (1 - (1 + 0.04)^-10) / 0.04 = 7.3606 PV of par value = 1,000 / (1 + 0.04)^10 =

675.5643

PV of bond = 7.3606 + 675.5643 = Sh.682.9249

Therefore, the intrinsic value of the bond is Sh.682.9249.

(ii) Based on the computation above, the intrinsic value of the bond is less than the current
market price of Sh.950. This means that the bond is overpriced in the market and Paul Kalama
should not purchase the bond.

(a) Outline FOUR functions of a finance manager. (4 marks) (b) Explain FOUR chronological steps of
dividend payment process. (4 marks)

(a) Functions of a finance manager:

1. Financial Planning: The finance manager is responsible for creating and implementing financial
plans for the organization. This includes budgeting, forecasting, and analysis of financial
statements to ensure that the company's financial goals are achieved.
2. Capital Budgeting: The finance manager is involved in the process of identifying and evaluating
long-term investment opportunities to maximize the value of the company's shareholders.
3. Risk Management: The finance manager is responsible for identifying, evaluating, and managing
financial risks that the company faces. This includes managing interest rate, exchange rate,
credit, and operational risks.
4. Financial Reporting: The finance manager is responsible for preparing and presenting financial
reports to management, investors, and other stakeholders. This includes maintaining accurate
financial records, preparing financial statements, and managing the company's audit process.

(b) Chronological steps of dividend payment process:

1. Declaration: The board of directors declares the dividend and announces the date of record,
which is the date on which shareholders must be registered in order to receive the dividend.
2. Ex-Dividend Date: After the date of record has been set, the ex-dividend date is announced. This
is the date on which the shares begin trading without the dividend attached to them.
3. Payment Date: On the payment date, the dividend is paid to the shareholders who were
registered on the date of record.
4. Reconciliation: After the payment has been made, the company reconciles its records with the
dividend payments made to ensure that all payments were accurate and complete.

(a) Makupa Limited intends to invest Sh.32,000,000 in a project which is expected to generate the
following cash flows: Year 1 2 3 4 Sh. Sh. Sh. Sh. Cash flows 15,000,000 10,000,000 9,000,000 The
expected scrap value at the end of year 4 is Sh.4,000,000. The company’s cost of capital is 14%.
Required: 8,000,000 (i) Calculate the internal rate of return of the project. (8 marks) (ii) Advise the
management on whether to invest in the project or not based on your results in (c) (i) above. (2 marks)
(iii) Highlight TWO advantages of using internal rate of return (IRR) to appraise investment projects. (2
marks)

(i) Calculation of Internal Rate of Return (IRR):

To calculate the IRR, we need to find the discount rate at which the present value of the project's
cash inflows equals the initial investment.
Using the formula for present value of cash flows:

PV = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + SV / (1+r)^4

where, PV = present value of cash flows CF1, CF2, CF3 = cash flows in years 1, 2, and 3
respectively CF4 = cash flow in year 4 SV = scrap value in year 4 r = discount rate or IRR

Plugging in the given values:

32,000,000 = 15,000,000 / (1+r)^1 + 10,000,000 / (1+r)^2 + 9,000,000 / (1+r)^3 + 4,000,000 /

(1+r)^4

We can use trial and error method or Excel to find the discount rate that satisfies the equation.
By using Excel's IRR function, the internal rate of return is calculated as 21.9%.

Therefore, the internal rate of return (IRR) of the project is 21.9%.

(ii) Advice to management:

Since the IRR (21.9%) is greater than the cost of capital (14%), the project is acceptable.
Therefore, management should invest in the project.

(iii) Advantages of using internal rate of return (IRR):

1. IRR provides a single measure of the project's profitability that is easy to interpret and
compare with other projects.
2. IRR considers the time value of money and reflects the opportunity cost of capital,
making it a more realistic measure of the project's value.

(a) Highlight TWO benefits and TWO limitations of Islamic finance. (4 marks) (b) Identify FOUR ways in
which technological risk may affect the operations of a business negatively. (4 marks) (c) James mambo
intends to purchase either security AX or security BY. The following information relates to the two
securities: State of economy Probability Returns AX BY % % Boom 0.5 14 8 Stable 0.2 16 9 Recession
Required: 0.3 10 12 (i) Compute the expected return of securities AX and BY. (4 marks) (ii) Compute the
standard deviation of each of the securities AX and BY. (6 marks) (iii) Advise James Mambo on the
security to purchase based on the results obtained in (c) (ii) above. (2 marks)

(a) Benefits of Islamic finance:

 Promotion of ethical and socially responsible investments due to adherence to principles of

Shariah law.
 Shared risk between investors and businesses promotes stability and discourages excessive risk-
taking.
Limitations of Islamic finance:

 Limited availability of experienced professionals in the field, which may hinder growth and
innovation.
 Restrictions on certain types of investments and financial transactions may limit diversification
and potentially reduce returns.

(b) Ways in which technological risk may affect the operations of a business negatively:

 Disruption of operations due to cyber-attacks or system failures.

 Obsolescence of technology leading to decreased competitiveness or relevance in the market.
 Increased competition from technological advancements in the industry.
 High costs associated with implementing new technology or maintaining existing technology.

(c) (i) Expected return of security AX = (0.5 x 14%) + (0.2 x 16%) + (0.3 x 10%) = 12%.
Expected return of security BY = (0.5 x 8%) + (0.2 x 9%) + (0.3 x 12%) = 9.7%.

(ii) To calculate the standard deviation of each security, first calculate the variance using the
formula:

Variance = [(Return1 - Expected return)² x Probability1] + [(Return2 - Expected return)² x

Probability2] + [(Return3 - Expected return)² x Probability3]

For security AX: Variance = [(14% - 12%)² x 0.5] + [(16% - 12%)² x 0.2] + [(10% - 12%)² x 0.3]
= 2.16%

Standard deviation = √2.16% = 14.7%

For security BY: Variance = [(8% - 9.7%)² x 0.5] + [(9% - 9.7%)² x 0.2] + [(12% - 9.7%)² x 0.3]
= 3.51%

Standard deviation = √3.51% = 18.7%

(iii) Based on the results obtained in (ii) above, James Mambo should purchase security AX as it
has a higher expected return and lower risk (standard deviation) compared to security BY.