KENYATTA UNIVERSITY

BACHELOR OF COMMERCE
BAC 203 – BUSINESS FINANCE 1

COURSES Description
This course has been designed to act as a catalytic agent among commerce students as a
pre – requirement to meeting and coping with the present and future challenges in the
over dynamic world of Finance and Banking.
Course Outline

Topic Brief outline

1. Introduction
2. Sources of finance
3. Risk and return trade off (single
securities)
4.Time value of money
5. Valuation of securities
6. Cost of capital.
7. Introduction to financial statements Types of financial analysis techniques and
analysis
-goals of a firm
-agency theory
- functions of financial manager
Specific sources of finance
-Short-term sources
- long-term sources
-formal and informal business finance
- types of risks
- making decision in the face of
uncertainty
-measurement of risks and returns
- concept of future and present value
- discounting and compounding
- annuities e.g. ordinary annuities,
annuities due deferred annuities
-perpetuities and intra-annual
compounding
- ordinary share valuation
- preference shares
- valuation of bonds (perpetuities and
fixed
term bonds
- factors affecting the cost of capital
- determination of different costs of
capital
- calculation of the WACC
- limitation of the WACC
analysis of non-financial information
- component of financial statements
- use of various methods of analysis
- limitations of financial statements
- various financial ratios

Mode of instruction and assessment

Course instruction will lecture and discussions.
Assessment will comprise of continuous assessment, attendance and assignments which
will count 30% of the total mark.
The university Examination will account for 70% totaling to 100%.

Reference Books
1. Wetson J F, (1993). Essential of managerial Finance 10th edition, the Dryden Press
Publisher
2. Bringham E.F. (2012). Fundamental of Financial Management, The Dryden press.
3. Van Horne, J. C. &J.M Wachowiez, (2004). fundamental of financial management,
Prentice Hall
4. Schall, D.C & C.W. (n.d). Haley. Introduction to Financial Management,
McGraw-Hill
5. Gitman, L. J.(2012). Principals of management Finance, Harper Collins
6. Eddie, M. (2011). Business Finance, Theory and practice, 8th edition , Prentice Hall
Publisher
7. Bill N &Trefor M, (2011). Business Finance, a value based approach. Prentice
Hall P
SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine functions an
Managerial Functions.

Managerial Finance Functions

Require skilful planning, control and execution of financial activities. There are four important
managerial finance functions. These are:

a) Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of fu
investment projects. They refer to the firm’s decision to commit current funds to the purcha
assets in expectation of future cash inflows from these projects. Investment proposals are ev
terms of both risk and expected return.

Investment decisions also relates to recommitting funds when an old asset becomes less produc
is referred to as replacement decision.

b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance investment pro
finance manager must decide the proportion of equity and debt. The mix of debt and equity
firm’s cost of financing as well as the financial risk. This will further be discussed under the
trade-off.

c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the sharehol
them, or distribute a portion and retain a portion. The earnings must also be distributed to othe
of funds such as preference shareholder, and debt providers of funds such as preference shareh
debt providers. The firm’s dividend policy may influence the determination of the value of th
therefore the finance manager must decide the optimum dividend – payout ratio so as to ma
value of the firm.
 THE CONCEPT OF TIME VALUE OF MONEY
The preference for money is a concept which attempts to explain why individuals and
prefer cash now rather than in the future. By the virtue of passage of time, the value
will change. Individuals prefer current cash instead of future cash for the following reas
(a) Availability of investment opportunities
The cash received today can be invested to generate extra income e.g. interest in the
(b) Subjective preference of money by individuals
Individuals prefer the money now for various reasons:
 Urgency of the current consumption e.g. the need for money to pay for foo
clothing, education etc.
 There is uncertainty whether the individuals will be there in future to enjoy th
be received in future.
(c) Uncertainty of future cash flows
It is uncertain whether the cash will be available in future to be received
Individuals therefore prefer the cash now when there is certainty of receiving it.
(d) To take advantage of cash discounts
Trading firm will prefer to have cash now in order to receive cash discounts offe
suppliers since if they do not have cash now, they will forego the discounts.

Importance of the concept of the time value of money

The concept of the time value of money is important due to its application in the follow
(a) Determination of effective cost of borrowing: This is done by comparing the
cash to be received today in form of a loan and the future benefits derived from
of such a loan.
(b) Determination of the true rate of return on investment: The time value of
used to determine the yield to various investors such as preference shareho
ordinary shareholders.
(c) Valuation of business: Time value of money is used to determine the maximum
should be paid for a business by computing the present value of the expected futu
from such a business.
(d) Selection of the best source of finance: This is done be selecting the source wh
the highest benefit in present value terms.
(e) Determination of loan repayment arrangements: Time value of money i
determine the installments to be paid per period in order to liquidate / re
borrowed loan.

Compound Value of a Single Amount

The compound value refers to the future value of an amount called the principal w
invested over a specified number of periods and earning interest at a particular int
Compounding refers to the inclusion of the interest earned at the end of one period as p
principal in the next period.
 THE CONCEPT OF TIME VALUE OF MONEY
The preference for money is a concept which attempts to explain why individuals and
investors prefer cash now rather than in the future. By the virtue of passage of time, the
value of money will change. Individuals prefer current cash instead of future cash for the
following reasons:
(a) Availability of investment opportunities
The cash received today can be invested to generate extra income e.g. interest in the
future
(b) Subjective preference of money by individuals
Individuals prefer the money now for various reasons:
 Urgency of the current consumption e.g. the need for money to pay for food,
shelter, clothing, education etc.
 There is uncertainty whether the individuals will be there in future to enjoy the
cash to be received in future.
(c) Uncertainty of future cash flows
It is uncertain whether the cash will be available in future to be received and used.
Individuals therefore prefer the cash now when there is certainty of receiving it.
(d) To take advantage of cash discounts
Trading firm will prefer to have cash now in order to receive cash discounts offered
by the suppliers since if they do not have cash now, they will forego the discounts.

Importance of the concept of the time value of money

The concept of the time value of money is important due to its application in the
following areas:
(a) Determination of effective cost of borrowing: This is done by comparing the
amount of cash to be received today in form of a loan and the future benefits
derived from utilization of such a loan.
(b) Determination of the true rate of return on investment: The time value of
money is used to determine the yield to various investors such as preference
shareholders and ordinary shareholders.
(c) Valuation of business: Time value of money is used to determine the maximum
price that should be paid for a business by computing the present value of the
expected future benefit from such a business.
(d) Selection of the best source of finance: This is done be selecting the source which
gives the highest benefit in present value terms.
(e) Determination of loan repayment arrangements: Time value of money is used to
determine the installments to be paid per period in order to liquidate / repay some
borrowed loan.

Compound Value of a Single Amount

The compound value refers to the future value of an amount called the principal when it
is invested over a specified number of periods and earning interest at a particular interest
rate. Compounding refers to the inclusion of the interest earned at the end of one period
as part of the principal in the next period.
Illustration:
An investor puts Sh. 10,000 in a bank for four years. The interest rate is 10%. Compute
the future or compound value of this investment.

The following formula can be used to determine the future value

FV = PV(1+r)n Where FV= Future Value PV = Principal (present
Value)
r = interest rate n = number of periods
n
The function (1+r ) is called the Future Value Interest Factor (FVIF). When expressed
in terms of a particular interest rate (%) and a certain number of periods, it is written as
FVIF r%, n

Compound Value of an Annuity

An annuity refers to payments or receipts of equal streams of benefits. These equal
streams can also be called installments. Examples of installments are salaries, rent,
insurance premiums, retirement benefits etc. The future value of an annuity refers to the
amount to be received in future if a deposit is made each and every year of an equal
amount. When deposits are made at the end of every year the number of years of earning
interest will be n-1.
The following formula can be used to compute the future value of an annuity

Future value of an annuity

= Annuity* ( r )
( 1+r )n −1
. The function
(
( 1+r )n −1
r )
is called
the future value Annuity factor (FVAF) usually written as FVAF r%, n.

Illustrations:
1. An investor deposits Sh. 20,000 at the beggining of every year for four years. The
interest rate is 12%. Compute the future value of the annuity.
2. K.J. wishes to deposit Sh. 100,000 per annum for the next five years. The deposit is
made at the end of each year. The interest rate is 10%. Compute the future value of
the annual deposit.
Present Value of a Single Amount
This refers to the amount, which requires to be deposited today (principal) and be
invested over a specified number of periods at a particular interest rate. The process of
computing the present value is called discounting. The interest rate used in computing the
present value is called the discount rate or required rate of return or cost of capital or
opportunity cost.
1
n
FV ∗
Since the FV = PV(1+r) then the present value (PV) = ( 1+ r )n . The function
1
( 1+ r )n is called the present value interest factor (PVIF) which is always expressed as
PVIF r%, n..
Illustrations
1. Mr. Onyango expects to receive Sh. 40,000 in four years time. The discount rate is
14%. Compute the amount he requires to deposit today.
2. Mrs. Kamau expects to receive Sh. 300,000 at the end of five years. The discounting
rate is 13%. Compute the present value of this amount.
3. Ms. Mwangi expects to receive Sh. 750,000 at the end of the four-year contract with
her employer. The discounting rate is 8%. Compute the present value of this
amount.
Present Value of an Annuity
This refers to an amount, which is required to be deposited now and in subsequent years
in equal installments for a specified number of periods and at a particular discounting rate
for it to yield a particular future value.
Illustration
Mrs. Kamau has been depositing Sh. 30,000 p.a. at the end of each year for the last five
years. The discounting rate is 16%. Compute the present value of these annuities.

The present value of an annuity = annuity * PVAF r%, n.

=
1−
[ 1
( 1+r )n ] =
1−( 1+ r )−
n

Where the PVAF r r

The PVAF = PVIF when they are added together.

Illustration
1. An investor expects to deposit Sh. 15,000 each year for the next 10 years. The
discounting rate is 10%. Compute the present value of these annuities.
2. Mrs. Hesabu has taken a loan of Sh. 400,000 form sweet waters Ltd. She expects to
liquidate the loan in 20 years time. The discounting rate is 12%. Compute the
amount she has to pay each year in order to liquidate the loan.

Present Value of Unequal Cash Flows / Benefits

1. XYZ Ltd has a four year project which is expected to generate the following cash
flows
Year 1 2 3 4
Cash flows 20,000 60,000 50,000 30,000
The cost of capital is 10%. Compute the present value of the cash flows.
2. ABC Ltd has a five year project which is expected to generate the following cash
flows:
Year 1 2 3 4 5
Cash flows (Sh. ‘000) 300 180 240 200 170
The cost of capital is 15%. Compute the present value of these cash flows.
Present value of deferred annuity
Deferred annuities refers to a situation where the cashflows in early years are unequal
but become annuities (equal installments)in later years. When computing the present
value of deferred annuities the following steps should be followed:
i. Compute the present value of the unequal cashflows in the early years in the
normal way
ii. Get the present annuity factor at the discounting rate for the number of periods
iii. Get the present value annuity factor at the discounting rate for the period where
the cashflows are unequal
iv. Compute the present value of the annuities between equal and unequal cashflows
=Annuity(PVAFr% n-PVAFr% n)
v. Add the present value of step one to step four to get the total
Illustration
1. ABC Limited has an eight year contract which is expected to generate the
following cashflows

Year 1 2 3 4 5 6 7 8

Cashflows’000’ 600 750 500 550 550 550 550 550

The discounting rate is 14%.Compute the present value of the cashflows

2. Thika Limited has a ten year project which is expected to generate the following
cashflows

Year 1-4 5-8 9-10

Cashflows 300 200 100

The discount rate is 10% compute the present value of the cashflow

Present Value of an Annuity in Perpetuity

An annuity in perpetuity refers to the receipt or payment of equal amounts from one year
to another indefinitely, forever i.e. a company is assumed to be a going concern and
therefore if it pays a constant dividend per share of Sh. 3 p.a. the amount is viewed to be
received in perpetuity.
A
Therefore the present value of an annuity in perpetuity = r where A is the annuity
received in perpetuity and r the discount rate.

Illustrations
1. An investor expects to receive Sh. 800 p.a. dividends from a company in
perpetuity. The cost of capital is 15%. Compute the present value of the annuity in
perpetuity.
2. XYZ Ltd has a project which is expected to generate the following cash flows
Year 1–8 9-∞
Cash flows (Sh. ‘000) 450 500
Compute the present value of these cash flows. Discounting rate is 12%.
3. ABC Ltd wants to acquire a new firm which when acquired will generate the
following incremental cash flows:
Year 1–5 6 - 10 11- ∞
Cash flows (Sh. ‘000) 50 90 130
The discount rate is 13%. Compute the maximum price ABC Ltd should be
willing to pay for the new firm.
Present value of a growing annuity in perpetuity

This refers to a constant amount paid from year to another in perpetuity but growing or
increasing at a particular growth rate. Example a company may be paying a dividend per
share of sh 4 per annum which is expected to grow or increase by 10% per annum in
perpetuity (the going concern of a firm)

A
Present value of a growing annuity in perpetuity=
r−g

Where r is discounting rate

g is the constant growth rate in perpetuity

Illustration

1. Safaricom limited expects to pay a dividend per share of sh 5 at the end of the
year. The dividends are expected to grow by 10%per annum in perpetuity. The
cost of capital of the firm is 14%.Compute the theoretical value of the ordinary
share of safaricom limited
2. Mr Kamau has secured a part time job on contract. The annual salary is sh
100,000 per annum which is expected to increase by 10%per annum in perpetuity.
The discounting rate is 12%.Compute the present value of the annuities

Present value of a growing annuity (annuity with definite period not perpetuity)

This refers to equal receipts of payments which will increase or grow by a certain
percentage within a definite time period.

Illustration

1. Simon has just secured a job whose annual salary is sh 200,000.The job is of a
four year contract. The salary is expected to increase by 12% p.a during the
contract period. The discounting rate is 16% the salary is received at the end of
each year. Compute the present value of the growing annuity
2. Kamau has secured a ten year contract with Mumias sugar. The annual salary is
sh 300,000 which is expected to increase by 15% p.a during the ten year contract.
The appropriate discounting rate is 20%.Compute the present value of the
growing annuity

Present Value of annuity due

Annuity due refers to equal receipts of benefits at the beginning of the year/period. When
computing the present value of annuity due the PVAF is multiplied by (1+r)

Present value of annuity due=Annuity (PVAFr% n) (1+r)

Illustration

1. Joseph is saving sh 150,000 p.a for the next five years for his trip to USA.
Savings are made at the beginning of each year. The appropriate discounting rate
is 10%.Compute the present value of the savings
2. Njuguna construction limited has undertaken an eight year contract which is
expected to generate the following cash flows

Year 1-3 4-8

Cashflows’000’ 168 210

The appropriate discounting rate is 14%.The cashflows are received at the

beginning of each year. Compute the present value of the cashflows

Multi – Period Compounding

A year is taken to be a standard measure of time. It is equivalent to one standard
period. Within this one period of one year, there could be many periods depending on
how many times in a year interest or returns are paid. Multi-period compounding
refers to a situation where interest is paid or received more than once in a year.

The effective annual interest rate of an investment

( )
= 1+
r m
m
−1
where r is the
nominal interest rate and m the number of periods in a year. the nominal interest rate
refers to the interest rate p.a. if the interest is paid or received only once in a year.

Illustration
Mr. Mohammed has an investment which has a nominal interest rate of 16% p.a.
required:
(a) Compute the effective annual interest rate if interest is received:
i. Semi annually
ii. Quarterly
iii. After every four months
iv. Monthly
v. Weekly
(b) The amount of money invested is Sh. 100,000. It is invested over 4 years.
Compute the future value of this investment in relation to cases (i) to (v) in (a)
above.

Growing Annuity
A growing annuity, is a stream of cash flows for a fixed period of time, t, where
the initial cash flow, C, is growing (or declining, i.e., a negative growth rate) at
a constant rate g. If the interest rate is denoted with r, we have the following
formula for the present value (=price) of a growing annuity:

PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],
where:

PV = Present Value of the growing annuity

C = Initial cash flow
r = Interest rate
g = Growth rate
t = # of time periods

Example I:

Suppose you have just won the first prize in a lottery. The lottery offers you
two possibilities for receiving your prize. The first possibility is to receive a
payment of $10,000 at the end of the year, and then, for the next 15 years this
payment will be repeated, but it will grow at a rate of 5%. The interest rate is
12% during the entire period. The second possibility is to receive $100,000
right now. Which of the two possibilities would you take?

Answer:

You want to compare the PV of the growing annuity to the PV of receiving

$100,000 right now (which is, obviously just $100,000). So, here are the
numbers:

C = $10,000
r = 0.12
g = 0.05
t = 16

PV = 10,000 [(1/0.07) - (1/0.07)*(1.05/1.12)16] = $91,989.41 < $100,000,

therefore, you would prefer to be paid out right now.