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Private Bag 00217 Limuru Tel: 020-2020505/510, 0728-669000, 0736424440 Email: Website:

DATE: 19TH AUGUST 2011 5.30 PM – 8.30 PM TIME:

Instructions to Candidates:
1. Answer ANY FIVE questions. All questions carry equal

marks 2. Write your registration number on all sheets of the answer book used. 3. Use a new page for every question attempted and indicate the question number on the space provided on each page of the answer sheet. 4. Fasten together all loose answer sheets used.

Switch off all Mobile Phones and PDAs.5. .

As tax rates increase. the cost of debt decreases. the cost of equity increases. both the cost of debt and cost of equity change. Dividend Policy Given that the firm has control over its payout ratio. the cost of debt increases. For example. Tax rates 1. Capital Structure Policy. decreasing the cost of capital. and as more equity is issued. the breakpoint of the MCC schedule can be changed. As more debt is issued. Discuss the typical sources of financing used at the outset of a new business venture marks) Page 3 of 11 . the company is making investments with similar degrees of risk. Investment Policy It is assumed that. as the payout ratio of the company increases the breakpoint between lowercost internally generated equity and newly issued equity is lowered. QUESTION 1 a. 3. For example. a firm has control over its capital structure. potentially. which increases the cost of capital. targeting an optimal capital structure. If a company changes its investment policy relative to its risk.Financing small businesses ANSWER ANY FIVE (5) QUESTIONS {20 MARKS EACH}. Uncontrollable Factors Affecting the Cost of Capital These are the factors affecting cost of capital that the company has no control over: 1. when making investment decisions. Describe how the nature of a firm’s affects its financing sources. b. Level of Interest Rates The level of interest rates will affect the cost of debt and. 2. (8marks) 1. Tax Rates Tax rates affect the after-tax cost of debt. when interest rates increase the cost of debt increases. 2. As we have been discussing above. Level of interest rates 2. the cost of equity.

although this security normally comes in the form of personal guarantees provided by the entrepreneur. Opinions differ on whether friends and family should be encouraged to invest in a start-up company.g. with the bank stating the fixed period over which the loan is provided (e. However. They may be prepared to invest substantial amounts for a longer period of time. Both of these are positives for the entrepreneur. 5 years). Angels tend to have made their money by setting up and selling their own business – in other words they have proven entrepreneurial expertise. An overdraft is really a loan facility – the bank lets the business “owe it money” when the bank balance goes below zero. Business angels are the other main kind of external investor in a start-up company. In addition to their money.g. there are pitfalls. A bank loan provides a longer-term kind of finance for a start-up. This is a common method of financing a start-up. they may not want to get too involved in the day-to-day operation of the business. the rate of interest and the timing and amount of repayments. a major customer fails to pay on time). Two further loan-related sources of finance are worth knowing about: Share capital – outside investors For a start-up. Business angels are professional investors who typically invest £10k . As a result. They prefer to invest in businesses with high growth prospects. retaining 100% control over the business. Almost inevitably. tensions develop with family and friends as fellow shareholders. founded for the purpose of forming the start-up.£750k. in the sense that it is only used when needed.Financing small businesses Internal sources The main internal sources of finance for a start-up are as follows: Personal sources These are the most important sources of finance for a start-up. in return for charging a high rate of interest. Bank loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a bank overdraft. The bank will usually require that the start-up provide some security for the loan. Angels often make their Page 4 of 11 . they don’t provide much flexibility. A bank overdraft is a more short-term kind of finance which is also widely used by start-ups and small businesses. The founder provides all the share capital of the company. However. Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e. an overdraft is a flexible source of finance. the main source of outside (external) investor in the share capital of a company is friends and family of the entrepreneur. Share capital – invested by the founder The founding entrepreneur (/s) may decide to invest in the share capital of a company. and we deal with them in more detail in a later section. External sources Loan capital This can take several forms. but the most common are a bank loan or bank overdraft.

What is a financial intermediary (2 marks Definition Financial institution (such as a bank. experience and contacts available to the company. Savings and other “nest-eggs” An entrepreneur will often invest personal cash balances into a start-up. stock exchange. although the entrepreneur needs to accept a loss of control over the business. Also referred to as "systematic risk". extra expense and the depletion of financial assets.Financing small businesses own skills. They involve the possibility of the co reduction of earned income. QUESTION 3 a. Define business risks and explains its two dimensions. Re-mortgaging is the most popular way of raising loan-related capital for a start-up. This is a cheap form of finance and it is readily ava decision to start a business is prompted by a change in the personal circumstances of the entrepreneur – e. Property Risks Page 5 of 11 . Getting the backing of an Angel can be a significant advantage to a start-up. then the property will b c. finance company. b.g. List and explain the basic types of pure risks Personal Risks: (6m The risks that directly affect an individual are known as personal risks. if the business fails. brokerage company) which acts as the 'middleman' between those who want to lend and those who want to borrow. insurance company. The use like this provides access to relatively low-cost finance. (5 the possibility of losses associated with the asstes and earnings potential of The risk that a company will not have adequate cash flow to meet its operating expenses. The entr out a second or larger mortgage on a private property and then invests some or all of this money into the business. although the risk is that. Market risk is the uncertainity associated wth an investment decision. The way this works is simple. credit union. redundancy or a Investing personal savings maximises the control the entrepreneur keeps over the business. Pure risk wer only loss or no loss can occur-there is no potential gain. It is also a strong signal of comm outside investors or providers of finance.

List down the role of the Retirement Benefit Authority (RBA). protect bz aganst death or disability of key employees product financial loss as a result of defect or body harmed professional liability protect bz against malpractice. even when the suit is without merit. More than ever. Real state land and building. Business interruption event of any disaster or continuity arrangement Commercial vehicle arrangement protects legal requirement of vehicle QUESTION 4 a. To promote the development of the retirement benefits industry. Liability risks are another important type of pure risk that many people face. marks) To regulate and supervise the establishment and management of retirement benefits schemes.Financing small businesses All non living things owned by persons are property. errors n negligence in pr services to customers. Discuss the role of savings and credit co-operative organizations (Sacco’s) in the development of small businesses in Kenya. health insurance. One has to defend himself when sued. c. To protect the interest of members and sponsors of retirement benefit schemes. life and disability. marks) property insurance tolocation and its contents liability insures. List the major functions of the Nairobi stock exchange (NSE) marks) b. Page 6 of 11 . (15 QUESTION 5 a. workers compensation insurer policy. Discuss the common types of business insurance covers in Kenya. we are living in a litigious society. One can be sued for any frivolous reason. vehicles machines and equipments goods raw materials furniture etc are the common examples of property damaged or lost from numerous causes.

the interest on debt capital must be repaid in full before any dividends are paid to any suppliers of equity. Such loans and advances are given to Page 7 of 11 . It is a loan made to a company that is normally repaid at some future date. marks) i) Primary functions. and ii) Secondary functions including agency functions. funds deposited with bank also earn interest. b) Grant of loans and advances The second important function of a commercial bank is to grant loans and advances. c. but are merely creditors. Distinguish between equity capital and debt capital. marks) is capital raised from owners in the company. i. b. and b) granting loans and advances. to investors. Ensure schemes come into compliance with the Act. and this is known as the coupon rate. i) Primary functions: The primary functions of a commercial bank include: a) accepting deposits. Debt capital differs[1] from equity or share capital because subscribers to debt capital do not become part owners of the business. People who have surplus income and savings find it convenient to deposit the amounts with banks. a) Accepting deposits The most important activity of a commercial bank is to mobilise deposits from the public.Financing small businesses To advise the Minister for Finance on the national policy to be followed with regard to the retirement benefit To implement all government policies relating to it. Equity capital is used to get companies off the ground is the capital that a business raises by taking out a loan. Owners can choose to sell equity in the compan stock. Debt capital ranks higher than equity capital for the repayment of annual returns. Depending upon the nature of deposits. Receiving and addressing members¡¦ complaints with regard to their schemes or benefits. This is different from debt capital which is money raised by inc through the issuance of debentures and other types of bonds. This means that legally. This is usually done through a direct offering to the public or through an underwriter like bank. Discuss the FIVE core functions of commercial banks. and the suppliers of debt capital usually receive a contractually fixed annual percentage return on their loan.e. the Retirement Benefits Authority.

It is a temporary arrangement. Overdraft facility with a specified limit is allowed either on the security of assets. b) Overdraft Overdraft is also a credit facility granted by bank. The customer can withdraw this amount as and when he requires. that is. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per agreed terms and conditions with the customers. The amount is credited to the account of the customer. but advances are normally granted for a short period of time. period and the mode of repayment. day to day operations of your working capital is needed by the business to: Page 8 of 11 . ii) Advances An advance is a credit facility provided by the bank to its customers. the bank can recover the amount from the customer. A customer who has a current account with the bank is allowed to withdraw more than the amount of credit balance in his account. The party gets the funds without waiting for the date of maturity of the bills.Financing small businesses members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. Describe the working-capital cycle of a small business. or on personal security. In case any bill is dishonoured on the due date. (10 Working capital is the money needed to fund the normal. It differs from loan in the sense that loans may be granted for longer period. QUESTION 6 a. The rate of interest charged on loans and advances varies depending upon the purpose. making payment of the amount before the due date of the bills after deducting a certain rate of discount. 24 :: Business Studies c) Discounting of Bills Banks provide short-term finance by discounting bills. short-term financial assistance a) Cash Credit Cash credit is an arrangement whereby the bank allows the borrower to draw amounts upto a specified limit. or both.

Conversion of work-in-progress into finished stock. less the credit period allowed by the suppliers. b. the operating cycle process can be expressed as follows : Operating Cycle = R + W + F + D – C R = Raw material storage period W = Work-in-progress holding period F = Finished goods storage period D = Debtors collection period C = Credit period availed. Discuss the role of microfinance in development of rural areas in Kenya.Financing small businesses • • • • Pay suppliers and other creditors Pay employees Pay for stocks Allow for customers who are allowed to buy now. Conversion of finished stock into accounts receivables through sales. Conversion of raw-materials into work-in-progress. Improves country infrastructure Promote tradeEmployment Women empowerment Page 9 of 11 . but pay later (so-called “trade debtors”) The operating cycle (working capital cycle) consists of the following event which continues throughout the life of business. Contribute 2 improvement of resource allocation n ultimately economic growth. marks) efficient provision of savings credit n insurance facilities enable pple 2 smoothen their consumption and enhance income earning capacity. In the form of an equation. The duration of the operating cycle for the purpose of estimating working capital is equal to the sum of the durations of each of the above said events. • • • • • Conversion of cash into raw-materials. and Conversion of account receivables into cash.

thus we are interested in incremental cash flows. Housing finance Standard chartered bank kenya ltd b. in general. A mortgage loan uses the property as collateral to guarantee rep loan. these methods may be categorized into 2 areas: _ Non-discounted cash flow methods (NCF) _Payback _Average return on book value (not to be covered) _ Discounted cash flow methods (DCF) _NPV _IRR DCF methods properly focus on opportunity cost of money for firm! Concentrate on cash flows rather than on accounting profits PROJECT CASH FLOWS Goal is to Identify & Value Cash Flows Once we have the cash flows we can value the project or company! c. The borrower gives the lender a lien against the property. Marks) A mortgage is a loan to purchase a property. Relevant Cash Flows: WHAT ARE THESE? _ Relevant cash flows are those that come into or out of being because a project is undertaken. marks) Valuation of Investment _ Many methods used in investment appraisal but. B. _ Incremental cash flows – Any and all changes in the firm’s future cash flows that are a direct consequence of taking the project. Page 10 of 11 . What is a mortgage? List TWO mortgage houses in Kenya. The Stand-Alone Principle Viewing projects as “mini-firms” with _ their own assets. Discuss the techniques commonly used in making capital budgeting decisions.Financing small businesses Education QUESTION 7 a. and the lender can foreclose on the property i does not repay the loan per the agreed terms.

Describe the role of financial intermediaries in poverty reduction in the 21st century. PROFORMAS: Start with pro forma (forecasted) income statement and balance sheet (don’t include interest for valuation. include to estimate funds needed). costs and thus profit for the life of the project. _ The proforma income statement forecasts sales. marks) loans employment development of private sectors encourage gvnments donours n instituitions 2 b more accountable 2 d poor infrastructure technology food security gender equality access to education n communication programs fair distribution of income End of Exam Page 11 of 11 . PRO FORMA FINANCIAL STATEMENTS AND PROJECT CASH FLOWS Getting Started: Pro Forma Financial Statements Treat the project as a mini-firm: (This section initially ASSUMES that you know you have a good project/ business!) d. c.Financing small businesses _ revenues and _ costs Allows us to evaluate the investments separate from the other activities of the firm.