`BAF 2104: FINANCIAL MANAGEMENT 1

CAT
INSTRUCTIONS TIME 1 HOUR

QUESTION ONE
a) With the aid of a diagram explain the risk-return relationship in financial decisions (4
marks).

High high risk high return

Return

Low risk low return

Risk High

There is a positive correlation between risk and return, the greater the risk, the higher the
potential for profit or loss. This helps investors balance risk and possible money made. it
helps them pick investments that match the level of risk they are willing to take

b) Describe any FOUR sources of finance and show clearly why they are advantageous
(8 marks)
i. Owner’s capital- this is the investment that the entrepreneur brings into the
business mostly from personal savings. This is the least expensive as there are
no interest
ii. Retained profits- this occurs when a business makes a profit so it can reinvest
it into the business if it decides to expand. It is advantageous since no interest
charges, it is also quick and convenient
 iii. Selling of assets – thus is money raised from sale of fixed assets in the
business which may not be required anymore. This can lead to creation of
space for more profitable uses and also has a quick access
iv. Bank loan – its sum of money borrowed by a customer from a bank often for a
specific use, its advantageous in that you can get a significant amount of
money at one time.
c) Describe the agency relationship that may exist between the owners of a manufacturing
firm in Kenya and the managers of the business (4
marks).
Here agency relationship exists as a contract between owners and managers of the firm where
the owners appoint agents (managers) to manage the firm on their behalf. As part of the
agreement owners delegate decision making authority to the management.
Owners expect their managers to act in the best interest of the owners

QUESTION TWO
(7 marks)
a) You are provided with the following information relating to V ltd
Equity and liabilities
12% debentures (shs1000 at par) 16,000
10% preferences share 6,250
Ordinary shares (Shs 10 par) 12,500
Retained earnings 28,125
Additional information
i. The debentures are currently selling at Shs 950 in the market
ii. Company paid a dividend of Shs 5.00 per ordinary share and they are expected to grow at
a rate of 10% per annum.
iv. The corporation tax is 40%
Required
Effective Cost of debt (4 marks)
Interest on debentures= 1000*12% =Shs 120
Tax rate = 40%
Current price = 950
CoD= interest * (1-tax)Price
=120*(1-40%)/950
=7.58%
Cost of equity (3 marks)
D1 = Dividend in year 1 = 5*(1+10%) = 5.50
P0 = Price at year 0 = 100
g = Growth Rate = 10%
Cost of Equity = (D1/P0) + g
= (5.50/100) +10% = 15.50%