We gratefully acknowledge permission to quote from the past examination papers of the following bodies: Kenya Accountants and Secretaries National Examination Board (KASNEB); Chartered Institute of Management Accountants (CIMA); Association of Chartered Certified Accountants (ACCA).
We also wish to express our sincere gratitude and deep appreciation to Mr. Geoffrey Ngene MBA, B.COM (Finance), CPA (finalist), CFA (East Africa). He is a senior lecturer at Strathmore University, School of Accountancy. He has generously given his time and expertise and skilfully co-ordinated the detailed effort of reviewing this study pack.
This study guide is intended to assist distance-learning students in their independent studies. In addition, it is only for the personal use of the purchaser, see copyright clause. The course has been broken down into eight lessons each of which should be considered as approximately one week of study for a full time student. Solve the reinforcement problems verifying your answer with the suggested solution contained at the back of the distance learning pack. When the lesson is completed, repeat the same procedure for each of the following lessons.
At the end of lessons 2, 4, 6 and 8 there is a comprehensive assignment that you should complete and submit for marking to the distance learning administrator.
1. After you have completed a comprehensive assignment clearly identify each question and number your pages.
2. If you do not understand a portion of the course content or an assignment question indicate this in your answer so that your marker can respond to your problem areas. Be as specific as possible.
3. Arrange the order of your pages by question number and fix them securely to the data sheet provided. Adequate postage must be affixed to the envelope.
4. While waiting for your assignment to be marked and returned to you, continue to work through the next two lessons and the corresponding reinforcement problems and comprehensive assignment.
On the completion of the last comprehensive assignment a two-week period of revision should be carried out of the whole course using the material in the revision section of the study pack. At the completion of this period the final Mock Examination paper should be completed under examination conditions. This should be sent to the distance-learning administrator to arrive in Nairobi at least five weeks before the date of your sitting the KASNEB Examinations. This paper will be marked and posted back to you within two weeks of receipt by the Distance Learning Administrator
Business Finance is an introductory course in finance a pre-requisite for financial Management of section six finance managers makes four crucial decisions of the firm
Financing decision concened with the sources of funds, cost of capital, mix of various capital components and evaluation of capital markets for long and short term financing
Investment in long-term investment decisions involving derivation of future cashflows and appraising projects and how securities of the firm may be valued
Working capital management which involves management of current assets to meet short termliquidity needs of the firm
Divisions of earnings between payment of dividends and retention for the purpose of financing future projects.
Business Finance course explore these four main decisions under conditions of certainty this is in addition to evaluating the performance of the firm using ratio analysis .Basic tools of finance are also introduced at this level.
The overall place of the course in C.P.A Syllabus is a bridge between accounting and Finance functions within the organization before critical evaluation of finance under condition of uncertainty in financial management.
It also gives an overview of how various stakeholders of the firm have divergent objectives which impact on the goal of shareholders wealth maxmisation this is covered
Under agency theory.
LESSON 1: Nature of Business Finance
LESSON 2: Sources of Funds
Comprehensive Assignment 1
LESSON 3: Measuring Business Performance: Financial Statements Analysis
LESSON 4: Capital Structure and Cost of Funds
Comprehensive Assignment 2
LESSON 5: Capital Investment Decisions
LESSON 6: Valuation Concepts in Finance
LESSON 7: Dividend Policies and Decisions
Comprehensive Assignment 3
LESSON 8: Working Capital Management
LESSON 9: Market for Funds
Comprehensive Assignment 4
LESSON 10: Revision Aid: KASNEB Syllabus. Model answers to reinforcing questions. Selected
past papers with model answers. Work through model answers ensuring they are understood. On completion submit final assignment to the University.
Mock Examination Paper
Read Chapter 1 of Financial Management textbook by I.M. Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Relationship between business finance and financial management.
Scope of Finance functions.
Goals/Objectives of the firm.
Risk-return Trade off.
Types of business organization
RELATIONSHIP BETWEEN BUSINESS FINANCE AND FINANCIAL MANAGEMENT
Business finance is the process by which a financial manager/accountant provides finance for business use as and when it is needed. This provision has to be undertaken on the basis of the needs of a company. On the other hand, Financial Management is a branch of economies concerned with the generation and allocation of scarce resources to the most efficient user within the economy (or the firm). The allocation of these resources is done through a market pricing system. A firm requires resources in form of funds raised from investors. The funds must be allocated within the organisation to projects that will yield the highest return.
1. Needs Consequent on the Operations of a Company (Basic Needs)
These have to be financed in so far as they arise out of the company’s operations e.g. salaries.
2. Shortages of Cash Brought About By Unforeseeable Circumstances E.G Non Payment By Debtors
These needs have to be financed by short term finances e.g. overdrafts, but this may be against financial prudence rather such needs should be financed by revolving finances in the circular flow. However, the financial manager must manage his finances using such tools as:
Cash budget – statement of expected receipts and payments over a projected period of time – a forecast.
Funds flow statement – (Actual).
Variance between actual funds flow with cash budget. The variance must be managed to keep the company liquid. On the other hand a financial manager has to meet the company’s strategic/long term needs (long term investment) are useful to the company because:
It influences the company size (assets)
It influences its growth (plough back)
Finances incidental needs.
It influences the company’s long-term survival – this is through continuous investment.
These investments will call for long term financing in form of owners finance (Ordinary Share Capital and Revenue reserves). This is a base on which other finances are raised. The company will also use external financing e.g. debts, loans, debentures, mortgages, lease finance etc. These finances have to be used in acceptable/reasonable financial mix. This implies that the company’s gearing level is kept low i.e. the relationship between owners and creditors finance. This should be below 67% otherwise the company may be forced into receivership and subsequently liquidation. Even then, when using creditors finances a company must consider:
That cost of finance is less than the Return which implies the rate should not be less than the bank interest + inflation + risk.
Economic conditions prevailing – use debt under boom conditions.
Present gearing – if high this will lead to:
Low credit rating
Lowering of the company’s share prices especially to less than Par value – this leads to mass sale of shares – creditors rush to draw their finances and therefore receivership.
Long term ventures have to call for independent feasibility studies before funds are committed i.e.
Assessment of the return – at least should be greater than minimum return + risk + inflation.
Economic life – if uncertain, the return ought to be higher. Such life must allow the company to pay off the loan.
The financial manager must be guided by principles of financial prudence i.e.
He has to consult experts.
He has to involve investment committee
He has to ascertain whether everyone involved in the implementation of the venture has not been left out either during the planning phase or implementation phase.
SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine functions and the
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 funds among investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of both risk and expected return.
Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is referred to as replacement decision.
b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance investment projects. The finance manager must decide the proportion of equity and debt. The mix of debt and equity affects the firm’s cost of financing as well as the financial risk. This will further be discussed under the risk return trade-off.
c) Division of earnings decision
The finance manager must decide whether the firm should distribute all profits to the shareholders, retain them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt providers. The firm’s dividend policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximise the value of the firm.
d) Liquidity decision
The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be referred to as current assets management. Investment in current assets affects the firm’s liquidity, profitability and risk. The more current assets a firm has, the more liquid it is. This implies that the firm has a lower risk of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low. The converse will hold true.
The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets.
For the effective execution of the managerial finance functions, routine functions have to be performed. These decisions concern procedures and systems and involve a lot of paper work and time. In most cases these decisions are delegated to junior staff in the organization. Some of the important routine functions are:
a) Supervision of cash receipts and payments
b) Safeguarding of cash balance
c) Custody and safeguarding of important documents
d) Record keeping and reporting
The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm. He must however, supervise the activities of these junior staff.
THE OBJECTIVES/GOALS OF A BUSINESS
1. Profit maximization – This is a traditional and a cardinal objective of a business. This is so for the following reasons:
To earn acceptable returns to its owners. (i.e. Must not be less than bank rates + inflation + risk)
So as to survive (through plough backs)
To meet its day to day obligations.
2. To maximize the net worth i.e. the difference between total assets and total liabilities. This is important because:
It influences company’s share prices.
It facilitates growth (plough backs).
It boosts the company’s credit rating.
This is what owners claim from the company.
3. To maximize welfare of employees – Happy employees will contribute to the profitability. This includes:
Medical facilities for the employee and his family
Recreation facilities (sporting facilities).
4. Interests of customers – the company has to provide quality goods at fair prices and have honest dealings with customers.
5. Welfare of the society – the company has to maintain sound industrial relations with the society:
Contribution to social causes e.g. Harambee contributions, building clinics etc.
6. Fair dealing with suppliers. A company must:
Meet its obligations on time
Avoid dishonor of obligations.
7. Duty to the government: A company should:
Pay taxes promptly
Go by government plans
Operate within legal framework.
OVERLAPS AND CONFLICTS
Overlaps – when achieving ONE MEANS achieving the other
Conflicts – when achieving ONE CANNOT allow the achievement of the other.
Nos. 4 & 5 – Some of the customers will be members of the Society.
Nos. 1 & 2 – If a company is profitable it will in most cases increase its net worth.
Nos. 1 & 6 – if a company maximises its profits, then it will be able to honour its obligations
Nos. 2 & 5 – Net worth & the society.
Nos. 3 & 5 – Employees may be the society.
Nos. 1 & 5 – Profits vs. Society
Nos. 1 & 4 – Profits vs. Costs
Nos. 1 & 3 – Profits vs. Costs
Nos. 1 & 7 – Profits vs. Costs
Nos. 5 & 7 – High taxes will reduce social benefits
Nos. 3 & 5 – Costs vs. Appropriated profits
Nos. 4 & 6 – Better credit terms to customers will not enable the company to pay its creditors
The Main objectives of a business entity are explained in detail below
Any business firm would have certain objectives, which it aims at achieving. The major goals of a firm are:
Shareholders’ wealth maximisation
a) Profit maximization
Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to achieving the highest possible profits during the year. This could be achieved by either increasing sales revenue or by reducing expenses. Note that:
Profit = Revenue – Expenses
The sales revenue can be increased by either increasing the sales volume or the selling price. It should be noted however, that maximizing sales revenue may at the same time result to increasing the firm’s expenses. The pricing mechanism will however, help the firm to determine which goods and services to provide so as to maximize profits of the firm.
The profit maximization goal has been criticized because of the following:
It ignores time value of money
It ignores risk and uncertainties
It is vague
It ignores other participants in the firm rather than shareholders
b) Shareholders’ wealth maximisation
Shareholders’ wealth maximisation refers to maximisation of the net present value of every decision made in the firm. Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision. (Note this will be discussed further in Lesson 2).
A financial action with a positive net present value will maximize the wealth of the shareholders, while a decision with a negative net present value will reduce the wealth of the shareholders. Under this goal, a firm will only take those decisions that result in a positive net present value.
Shareholder wealth maximisation helps to solve the problems with profit maximisation. This is because, the goal:
Considers time value of money by discounting the expected future cash flows to the present.
It recognizes risk by using a discount rate (which is a measure of risk) to discount the cash flows to the present.
c) Social responsibility
The firm must decide whether to operate strictly in their shareholders’ best interests or be responsible to their employers, their customers, and the community in which they operate. The firm may be involved in activities which do not directly benefit the shareholders, but which will improve the business environment. This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized.
d) Business Ethics
Related to the issue of social responsibility is the question of business ethics. Ethics are defined as the “standards of conduct or moral behaviour”. It can be though of as the company’s attitude toward its stakeholders, that is, its employees, customers, suppliers, community in general creditors, and shareholders. High standards of ethical behaviour demand that a firm treat each o these
constituents in a fair and honest manner. A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to:
Product safety and quality
Fair employment practices
Fair marketing and selling practices
The use of confidential information for personal gain
Illegal political involvement
Bribery or illegal payments to obtain business.
THE AGENCY THEORY AND PROBLEM
An agency relationship arises where one or more parties called the principal contracts/hires another called an agent to perform on his behalf some services and then delegates decision making authority to that hired party (Agent) In the field of finance shareholders are the owners of the firm. However, they cannot manage the firm because:
They may be too many to run a single firm.
They may not have technical skills and expertise to run the firm
They are geographically dispersed and may not have time.
Shareholders therefore employ managers who will act on their behalf. The managers are therefore agents while shareholders are principal.
Shareholders contribute capital which is given to the directors which they utilize and at the end of each accounting year render an explanation at the annual general meeting of how the financial resources were utilized. This is called stewardship accounting.
In the light of the above shareholders are the principal while the management are the agents.
Agency problem arises due to the divergence or divorce of interest between the principal and the agent. The conflict of interest between management and shareholders is called agency problem in finance.
There are various types of agency relationship in finance exemplified as follows:
Shareholders and Management
Shareholders and Creditors
Shareholders and the Government
Shareholders and Auditors
Headquarter office and the Branch/subsidiary.
1. Shareholders and Management
There is near separation of ownership and management of the firm. Owners employ professionals (managers) who have technical skills. Managers might take actions, which are not in the best interest of shareholders. This is usually so when managers are not owners of the firm i.e. they don’t have any shareholding. The actions of the managers will be in conflict with the interest of the owners. The actions of the managers are in conflict with the interest of shareholders will be caused by:
i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and maximize shareholders wealth. This is because irrespective of the profits they make, their reward is fixed. They will therefore maximize leisure and work less which is against the interest of the shareholders.
ii) Consumption of “Perquisites”
Prerequisites refer to the high salaries and generous fringe benefits which the directors might award themselves. This will constitute directors remuneration which will reduce the dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth.
iii) Different Risk-profile
Shareholders will usually prefer high-risk-high return investments since they are diversified i.e they have many investments and the collapse of one firm may have insignificant effects on their overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable). This difference in risk profile is a source of conflict of interest since shareholders will forego some profits when low-return projects are undertaken.
iv) Different Evaluation Horizons
Managers might undertake projects which are profitable in short-run. Shareholders on the other hand evaluate investments in long-run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short-term profitability while shareholders prefer long term profitability.
v) Management Buy Out (MBO)
The board of directors may attempt to acquire the business of the principal. This is equivalent to the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency relationship and contract etween the shareholders and the managers.
vi) Pursuing power and self esteem goals
This is called “empire building” to enlarge the firm through mergers and acquisitions hence increase in the rewards of managers.
vii) Creative Accounting
This involves the use of accounting policies to report high profits e.g stock valuation methods, depreciation methods recognizing profits immediately in long term construction contracts etc.
Solutions to Shareholders and Management Conflict of Interest
Conflicts between shareholders and management may be resolved as follows:
1. Pegging/attaching managerial compensation to performance
This will involve restructuring the remuneration scheme of the firm in order to enhance the alignments/harmonization of the interest of the shareholders with those of the management e.g. managers may be given commissions, bonus etc. for superior performance of the firm.
2. Threat of firing
This is where there is a possibility of firing the entire management team by the shareholders due to poor performance. Management of companies have been fired by the shareholders who have the right to hire and fire the top executive officers e.g the entire management team of Unga Group, IBM, G.M. have been fired by shareholders.
3. The Threat of Hostile Takeover
If the shares of the firm are undervalued due to poor performance and mismanagement. Shareholders can threatened to sell their shares to competitors. In this case the management team is fired and those who stay on can loose their control and influence in the new firm. This threat is adequate to give incentive to management to avoid conflict of interest.
4. Direct Intervention by the Shareholders
Shareholders may intervene as follows:
Insist on a more independent board of directors.
By sponsoring a proposal to be voted at the AGM
Making recommendations to the management on how the firm should be run.
5. Managers should have voluntary code of practice, which would guide them in the performance of their duties.
6. Executive Share Options Plans
In a share option scheme, selected employees can be given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price.
The value of an option will increase if the company is successful and its share price goes up. The theory is that this will encourage managers to pursue high NPV strategies and investments, since they as shareholders will benefit personally from the increase in the share price that results from such investments.
However, although share option schemes can contribute to the achievement of goal congruence, there are a number of reasons why the benefits may not be as great as might be expected, as follows:
Managers are protected from the downside risk that is faced by shareholders. If the share price falls, they do not have to take up the shares and will still receive their standard remuneration, while shareholders will lose money.
Many other factors as well as the quality of the company’s performance influence share price movements. If the market is rising strongly, managers will still benefit from share options, even though the company may have been very successful. If the share price falls, there is a downward stock market adjustment and the managers will not be rewarded for their efforts in the way that was planned.
The scheme may encourage management to adopt ‘creative accounting’ methods that will distort the reported performance of the company in the service of the managers’ own ends.
The choice of an appropriate remuneration policy by a company will depend, among other things, on:
Cost: the extent to which the package provides value for money
Motivation: the extent to which the package motivates employees both to stay with the company and to work to their full potential.
Fiscal effects: government tax incentives may promote different types of pay. At times of wage control and high taxation this can act as an incentive to make the ‘perks’ a more significant part of the package.
Goal congruence: the extent to which the package encourages employees to work in such a way as to achieve the objectives of the firm – perhaps to maximize rather than to satisfy.
7. Incurring Agency Costs
Agency costs are incurred by the shareholders in order to monitor the activities of their agent. The agency costs are broadly classified into 4.
a) The contracting cost. These are costs incurred in devising the contract between the managers and shareholders.
The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on the other hand undertake to compensate the management for their effort.
Examples of the costs are:
The legal costs of drawing the contracts fees.
The costs of setting the performance standard,
b) Monitoring Costs This is incurred to prevent undesirable managerial actions. They are meant to ensure that both parties live to the spirit of agency contract. They ensure that management utilize the financial resources of the shareholders without undue transfer to themselves.
External audit fees
Legal compliance expenses e.g. Preparation of
Financial statement according to international accounting standards, company law, capital market authority requirement, stock exchange regulations etc.
Financial reporting and disclosure expenses
Investigation fees especially where the investigation is instituted by
Cost of instituting a tight internal control system (ICS).
c) Opportunity Cost/Residual Loss This is the cost due to the failure of both parties to act optimally e.g.
Lost opportunities due to inability to make fast decision due to tight internal control system
Failure to undertake high risk high return projects by the manager leads to lost profits when they undertake low risk, low return projects.
d) Restructuring Costs – e.g. new I.C.S., business process reengineering etc.
2. SHAREHOLDERS AND CREDITORS/bond/debenture holders
Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to the firm on the strength of the following factors:
The existing asset structure of the firm
The expected asset structure of the firm
The existing capital structure or gearing level of the firm
The expected capital structure of gearing after borrowing the new
In raising capital, the borrowing firm will always issue the financial securities in form of debentures, ordinary shares, preference shares, bond etc.
In case of shareholders and bondholders the agent is the shareholder who should ensure that the debt capital borrowed is effectively utilized without reduction in the wealth of the bondholders. The bondholders are the principal whose wealth is influenced by the value of the bond and the number of bonds held.
Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
An agency problem or conflict of interest between the bondholders (principal) and the shareholders (agents) will arise when shareholders take action which will reduce the market value of the bond and by extension, the wealth of the bondholders. These actions include:
a) Disposal of assets used as collateral for the debt in this.
In this case the bondholder is exposed to more risk because he may not recover the loan extended in case of liquidation of the firm.
b) Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project. However, this project may be substituted with a high risk project whose cash flows have high standard deviation. This exposes the bondholders because should the project collapse, they may not recover all the amount of money advanced.
c) Payment of High Dividends
Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to low level of capital and investment thus reduction in the market value of the shares and the bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no returns are expected. This will reduce the value of the firm and bond.
d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital in the entire project if there is expectation that most of the returns from the project will benefit the bondholders. This will lead to reduction in the value of the firm and subsequently the value of the bonds.
e) Borrowing more debt capital
A firm may borrow more debt using the same asset as a collateral for the new debt. The value of the old bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is liquidated. This exposes the first bondholders/lenders to more risk.
Solutions to agency problem
The bondholders might take the following actions to protect themselves from the actions of the shareholders which might dilute the value of the bond. These actions include:
1. Restrictive Bond/Debt Covenant
In this case the debenture holders will impose strict terms and conditions on the borrower. These restrictions may involve:
a) No disposal of assets without the permission of the lender.
b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities.
d) Restrictions on mergers and organisations
e) No borrowing of additional debt, before the current debt is
f) The bondholders may recommend the type of project to be
undertaken in relation to the riskness of the project.
2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant.
3. Transfer of Asset
The bondholder or lender may demand the transfer of asset to him on giving debt or loan to the company. However the borrowing company will retain the possession of the asset and the right of utilization.
On completion of the repayment of the loan, the asset used as a collateral will be transferred back to the borrower.
The lender or bondholder may demand to have a representative in the board of directors of the borrower who will oversee the utilization of the debt capital borrowed and safeguard the interests of the lender or bondholder.
5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the debt capital borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its investments needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.
6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds into ordinary shares.
3. Agency Relationship Between Shareholders And The Government
Shareholders and by extension, the company they own operate within the environment using the charter or licence granted by the government. The government will expect the company and by extension its shareholders to operate the business in a manner which is beneficial to the entire economy and the society.
The government in this agency relationship is the principal while the company is the agent. It becomes an agent when it has to collect tax on behalf of the government especially withholding tax and PAYE.
The company also carries on business on behalf of the government because the government does not have adequate capital resources. It provides a conducive investment environment for the company and share in the profits of the company in form of taxes.
The company and its shareholders as agents may take some actions that might prejudice the position or interest of the government as the principal. These actions include:
Tax evasion: This involves the failure to give the accurate picture of the earnings or profits of the firm to minimize tax liability.
Involvement in illegal business activities by the firm.
Lukewarm response to social responsibility calls by the government.
Lack of adequate interest in the safety of the employees and the products and services of the company including lack of environmental awareness concerns by the firm.
Avoiding certain types and areas of investment coveted by the government.
Solutions to the agency problem
The government can take the following actions to protect itself and its interests.
1. Incur monitoring costs
E.g. the government incurs costs associated with:
Investigations of companies under Company Act
Back duty investigation costs to recover tax evaded in the
VAT refund audits
2. Lobbying for directorship (representation)
The government can lobby for directorship in companies which are deemed to be of strategic nature and importance to the entire economy or society e.g directorship in KPLC, Kenya Airways, KCB etc.
3. Offering investment incentives
To encourage investment in given areas and locations, the government offers investment incentives in form of capital allowances as laid down in the Second schedule of Cap 470.
The government has provided legal framework to govern the operations of the company and provide protection to certain people in the society e.g. regulation associated with disclosure of information, minimum wages and salaries, environment protection etc.
5. The government can incalculate the sense and spirit of social responsibility on the activities of the firm, which will eventually benefit the firm in future.
4. Agency Relationship between Shareholders and Auditors
Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies Act. The auditors are supposed to monitor the performance of the management on behalf of the shareholders. They act as watchdogs to ensure that the financial statements prepared by the management reflect the true and fair view of the financial performance and position of the firm.
Since auditors act on behalf of shareholders they become agents while shareholders are the principal. The auditors may prejudice the interest of the shareholders thus causing agency problems in the following ways:
a) Colluding with the management in performance of their duties whereby their independence is compromised.
b) Demanding a very high audit fee (which reduces the profits of the firm) although there is insignificant audit work due to the strong internal control system existing in the firm.
c) Issuing unqualified reports which might be misleading the shareholders and the public and which may lead to investment losses if investors rely on such misleading report to make investment and commercial decisions.
d) Failure to apply professional care and due diligence in performance of their audit work.
Solutions to the conflict
1. Firing: The auditors may be removed from office by the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors who issue misleading reports leading to investment losses.
3. Disciplinary Action – ICPAK.
Professional bodies have disciplinary procedures and measures against their members who are involved in un-ethical practices. Such disciplinary actions may involve:
Suspension of the auditor
Withdrawal of practicing certificate
Fines and penalties
4. Use of audit committees and audit reviews.
5. HEAD OFFICE AND SUBSIDIARY/BRANCH
MNC has diverse operations set up in different geographical locations.
The HQ acts as the principal and the subsidiary as an agent thus creating an agency relationship.
The subsidiary management may pursue its own goals at the expense of overall corporate goals. This will lead to sub-optimisation and conflict of interest with the headquarter.
This conflict can be resolved in the following ways:
a) Frequent transfer of managers
b) Adopt global strategic planning to ensure commonality of vision
c) Having a voluntary code of ethical practices to guide the branch managers
An elaborate performance reporting system providing a 2-way feedback mechanism.
Performance contracts with managers with commensurate compensation package for the same.
THE RISK-RETURN TRADE-OFF
Most financial decisions involve alternative courses of action. The alternatives have different returns and risk. For example, should we buy a replacement machine now or should we wait until next year, should we set the debt-to-assets ratio at 20%, 40% or any other ratio?
The higher the risk on any decision, the higher the required return to compensate for this risk. The relationship between Return and Risk can be expressed as follows:
Required Rate of Return = Risk-free rate + Risk premium.
Risk free rate is compensation for time and risk premium is compensation for risk of financial actions. It can be seen that the relationship is direct.
The finance manager should avoid decisions with unnecessary risk. In making financing decisions for example, the finance manager must decide whether to finance with equity alone or to use debt as well. The expected return when debt is used is high since the cost of debt is low. However, since payment of interest on debt is compulsory, the risk involved is high. On the other hand the cost of equity is high and therefore the return is low. The risk is also low since payment of ordinary dividend is not compulsory. The firm’s liquidity decisions will also affect the risk and the return of the firm.
TYPES OF BUSINESS ORGANISATIONS
1. Sole proprietorships
3. Joint stock companies or Public/Private limited companies.
Accounts do not have to be audited
It caters for personal attention of customers
Limited to such finances as:
Loans from relatives & friends
Short-term loans from banks.
Trade credit from suppliers.
Less legal formalities to form.
Highly flexible (and adaptable)
Highly flexible decision-making process.
Sole trade usually skilled in the business (good for competition)
Profits motivates owners
High supervision of employees
Low bureaucracy (less time wasted)
Short economic life therefore does not attract long-term finance, therefore, limited expansion and growth.
Success depends on ability or judgement of owner
Most sole traders do not employ professional advice which implies less growth and stagnation.
Limited sources of finance.
Limited accounts knowledge.
“The relationship, which exists between persons carrying on a business in common with a view of profit.”
Formation of a partnership
2. Actions of the person concerned
3. Agreement in writing.
4. By a deed i.e. an agreement under seal.
In case the partners want to run their business under a name which does not disclose true surname of all partners, such a firm must be registered under the registration of Business Names Act.
Types of Partners
1. General Partners – Unlimited liability and active in participation in partnership activities.
2. Limited partners – Limited liability and does not participate in the management of partnerships.
3. Sleeping partners – has no active role, nevertheless, such a partner will have contributed to the capital of the partnership business and will thus share in the profits although at a lower proportion in most cases.
A partnership deed constitutes a legal contract among the partners. The articles of partnerships must contain eleven clauses.
1. Nature of business.
2. Profit sharing ratio
3. Capital contribution
4. Rates of interest on both capital and drawings
5. The provision for proper accounts and their audit.
6. Powers of each partner.
7. Grounds of dissolution.
8. Determination of Goodwill
9. Determination of amount payable to outgoing partners.
10. Expulsion procedures.
11. The arbitration clause.
JOINT STOCK COMPANIES
Initiators contribute to the capital base of such companies through the purchase of shares of such companies. These companies are governed by the Companies Act (Cap. 486) of 1948.
Such must be registered with the Registrar of Companies after which it is issued with a certificate of incorporation which indicates the Birth of the company.
Perpetual existence (or going concern) which allows the company to make strategic plans to raise finance in Capital Markets more easily.
The company can own assets and incur liabilities on its own accord.
Title to share is freely transferable which makes these shares more of an investment.
Exception – Private limited companies whose transfer of shares needs the consent of its members.
Shares may be used as securities.
Large sources of finance.
Loss of secrecy – poor competition
Many formalities in forming the company
Heavy initial capital outlay.
Difficult to reconstruct the capital
Bureaucracies especially in decision making processes.
Inflexibility and thus low adaptability.
They cannot participate in the activities outside the scope of their “objective clause”.
Differences between a company and a partnership occur under the following factors:
Legal view (entity)
Title of shares (transferability)
Going concern (dissolution)
One which holds more than a half of the equity share capital of another company or is a member and/or controls a big percentage of the Board of Directors of one or more of other companies which in this case are called subsidiaries for such a holding company.
A holding company may be viewed as a “financial institution” in the sense that it uses shareholders capital to acquire controlling interests in other companies by acquiring up to 51% of the other company’s shares or even more. If such a holding company hold 51% of the shares of another
company, it means that it is the majority shareholder and has substantial influence on the operations of its subsidiary. It will almost be like a sole owner of such a company by virtue of such share holding.
PUBLIC LIMITED COMPANIES
These are joint stock companies which have sold shares to general public and thus have attracted public money in form of share capital. Such companies are usually quoted on the stock exchange. These companies usually raise large sums of money from the public and in order to do so, such companies must:
Obtain permission from the capital market development authority also known as New Issue Committee.
The company in need of public money will have to obtain permission from the NSE Council before it can be allowed to have its shares “dealt-in”.
The law requires such a company to have a minimum of seven shareholders and there is no upper limit.
PRIVATE LIMITED COMPANIES
These are NOT allowed to advertise their shares so as to attract public money and as such they sell their shares privately (known as private placing) to interested members of the public.
Their shares are not freely transferable as these are not quoted on the stock exchange and they can only be transferred with the consent of the directors.
Differences between the two above lies on:
Number of shares
Transfer of shares
Methods of raising funds from the public
Number of directors
Retirement age of directors.
Outline FOUR main objectives, which conflict and at the same time overlap – explain these overlap and conflicts.
Discuss the main problems sole traders’ encounter in a bid to raise finance on Kenya’s financial markets.
Within a business finance context, discuss the problems that might exist in the relationships (sometimes referred to as agency relationships) between:
a) Shareholders and managers, and
b) Shareholders and creditors.
Two neighboring countries have chosen to organize their electricity supply industries in different ways. In country A, electricity supplies are provided by a nationalised industry. On the other hand in country B electricity supplies are provided by a number of private sector companies.
a) Explain how the objectives of the nationalised industry in country A might differ from those of the private sector companies in country B.
b) Briefly discuss whether investment planning and appraisal techniques are likely to differ in he nationalised industry and private sector companies.
Check your answers with those given in Lesson 10 of the Study Pack.
Read Chapter 28 and 31 of Financial Management text book by I.M. Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Bills of exchange
Plastic money – Debenture finance
1. EQUITY FINANCE
For small companies, this is personal savings (contribution of owners to the company). For large companies equity finance is made of ordinary share capital and reserves; (both revenue and capital reserves). Equity finance is divided into the following classes:
a) Ordinary share capital – this is raised from the public from the sale of ordinary shares to the shareholders. This finance is available to limited companies. It is a permanent finance as the owner/shareholder cannot recall this money except under liquidation. It is thus a base on which other finances are raised.
Ordinary share capital carries a return that is variable (ordinary dividends). These shares carry voting rights and can influence the company’s decision making process at the AGM.
These shares carry the highest risk in the company (high securities – documentary claim to) because of:
a) Uncertainty of return
b) Cannot ensure refund
c) Have residual claims – claim last on profits, claim last on assets.
However this investment grows through retention.
Rights of ordinary shareholders
Right to vote
Sales/purchase of assets
2. Influence decisions:
a) Right to residual assets claim
b) Right to amend company’s by-laws
c) Right to appoint another auditor
d) Right to approve merger acquisition
e) Right to approve payment of dividends
Reasons why ordinary share capital is attractive despite being risky
Shares are used as securities for loans (a compromise of the market price of a share).
Its value grows.
They are transferable at capital gain.
They influence the company’s decisions.
Carry variable returns – is good under high profit
Perpetual investment – thus a perpetual return
Such shares are used as guarantees for credibility.
Advantages of using ordinary share capital in financing.
They facilitate projects especially long-term projects because they are permanent..
Its cost is not a legal obligation.
It lowers gearing level – reduces chances of receivership/liquidation.
Used with flexibility – without preconditions.
Such finances boost the company’s credibility and credit rating.
Owners contribute valuable ideas to the company’s operations (during AGM by professionals).
b) RETAINED EARNINGS
i) Revenue Reserves
These are undistributed earnings. Such reserves are retained for the following reasons:
To make up for the fall in profits so as to sustain acceptable risks.
. To sustain growth through plough backs. They are cheap source of
. They are used to boost the company’s credit rating so they enable further finance to be
. It lowers the company’s gearing ratio – reduces chances of receivership/liquidation.
ii) Capital Reserves
1. It is raised by selling shares at a premium. (The difference between the market price (less floatation costs) and par value is credited to the capital reserve).
2. Through revaluation of the company’s assets. This leads to a fictitious entry which is of the nature of a capital reserve.
3. By creation of a sinking fund.
c) PREFERENCE SHARE CAPITAL (Quasi-Equity)
It is also called quasi-equity because it combines features of equity and those of debt. It is preference because it is preferred to ordinary share capital that is:
i) It is paid dividends first – preferred to dividend
ii) It is paid asset proceeds first – preferred to assets.
Unlike ordinary share capital, it has a fixed return. It carries no voting rights. It is an unsecured finance and it increases the company’s gearing ratio.
i) Redeemable Class
Redeemable preferential shares are bought back by issuing company after minimum redemption period but before expiring of maximum redemption period after which they become creditors. (Can sue the company).
ii) Irredeemable Preference Shares
Are perpetual preference shares as they will not be redeemed in the company’s lifetime unless it is under liquidation, (it is permanent).
Company XYZ Limited has the following capital structure:
10,000 Sh.10 ordinary shares
10,000 Sh.20 preference shares
Total share capital
If the company’s assets proceeds were Sh.400,000 show how this would be shared under:
Share participation taking into account the par value.
i)If the preference shareholders are participative:
Less preference claims
Less ordinary shareholders claim
Total share capital =
Participative claim of ordinary shareholders is given by:
ii) Sharing under ratio
Less preference claim
Less ordinary share capital
Preference share capital claim =
= = Shs.33,000
Ordinary share capital claim =
= = 16,667%
iii) Non-Participative Preference Shares
These do not claim any money over and above their par value, but are usually cumulative and redeemable.
V) Cumulative Preference Shares
These can claim arrears e.g. if a company sold 10% Shs.20 preference shares and did not pay dividends for the next two years, then in the third year shareholders will claim:
10% x 20 x 3yrs = Shs 6 less withholding tax:
= Shs 6 less 5% of Shs 0.30
= Shs 5.70 net
vi) Non-Cumulative Preference Shares
These cannot claim interest in arrears.
These can be converted into ordinary shares (which is optional).
Conversion ratio = par value of ordinary share/par value of preference shares e.g if par value of ordinary shares is Sh.10 and that of preference shares is Sh.20, then conversion ratio = i.e for every preference share you get 2 ordinary shares.
Conversion price par value of preference shares/no. of ordinary shares to be acquired.
Company XYZ Ltd has sold 10,000 ordinary shares of Shs.30 (partly called up) plus 20,000 Shs.45 preference shares, which are convertible. Compute the total number of ordinary shares after conversion.
Conversion ratio = 30/45 = 2/3 for every 2 preference shares you get 3 ordinary shares.
= 30,000 ordinary shares.
Conversion price =
Total = 40,000 ordinary shares after conversion.
viii) Non-Convertible Preference Shares.
These cannot be converted into ordinary shares.
2. DEBT FINANCE
Debt finance is a fixed return finance as the cost (interest) is fixed on the par value (face value of debt). It is ideal to use if there’s a strong equity base. It is raised from external sources to qualifying companies and is available in limited quantities. It is limited to:
i) Value of security.
ii) Liquidity situation in a given country. It is ideal for companies where gearing allows them to raise more debt and thus gearing level.
Classification of Debt Finance
Loan finance – this is a common type of debt and is available in different terms usually short term. Medium term loans vary from 2 - 5 years. Long-term loans vary from 6 years and above
The terms are relative and depend on the borrower. This finance is used on the basis of Matching approach i.e. matching the economic life of the project to the term of the loan. It is prudent to use short-term loans for short-term ventures i.e. if a venture is to last 4 years generating returns, it is prudent to raise a loan of 4 years maturity period.
Conditions under Which Loans Are Ideal
a) When the company’s gearing level is low (the level of outstanding loans is low.
b) The company’s future cash flows (inflows and their stability) must be assured. The company must be able to repay the principal and the interest.
c) Economic conditions prevailing. The company must have a long-term forecast of the prevailing economic condition. Boom conditions are ideal for debt.
d) When the company’s market share guarantees stable sales.
e) When the company’s anticipated future expansion programs, justify such borrowing.
Requirements for Raising Loan
a) History of the company and its subsidiaries.
b) Names, ages, and qualifications of the company’s directors.
c) The names of major shareholders – 51% plus i.e. owner who must give consent.
d) Nature of the products and product lines.
e) Publicity of the product.
f) Nature of the loan – either secured, floating or unsecured.
g) Cash flow forecast.
Reasons Why Commercial Banks Prefer To Lend Short Term Loans
a) Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardise planning e.g. political and economic factors.
b) Commercial banks are limited by the Central Bank of Kenya in their long term lending due to liquidity considerations.
c) Short-term loans are profitable. This is because interest is high as in overdrafts.
d) Long term finance loses value with time due to inflation.
e) Cost of finance – in the long term, the cost of finance may increase and yet they cannot pass such a cost to borrowers since the interest rate is fixed.
f) Commercial banks do credit analysis that is limited to short term situations.
g) Usually security market favours short term loans because there are very few long term securities and as such commercial banks prefer to lend short term due to security problems.
Advantages of Using Debt Finance
Interest on debt is a tax allowable expense and as such it is reduced by the tax allowance.
Interest = 10% tax rate = 30%
The effective cost of debt (interest) = Interest rate(1 – T)
Consider companies A and B
Company A B
10% debt 1,000 -
Equity - 1,000
The tax rate is 30% and earnings before interest and tax amount to Ksh.400,000. All earnings are paid out as dividends. Compute payable by each firm.
Company A B
EBIT 400 400
Less interest 10% x 1,000 (100) -
EBT 300 400
Less tax @ 30% (90) (120)
Dividends payable 210 280
Company A saves tax equal to Sh.30,000(120,000 – 90,000) since interest charges are tax allowable and reduce taxable income.
The cost of debt is fixed regardless of profits made and as such under conditions of high profits the cost of debt will be lower.
It does not call for a lot of formalities to raise and as such its ideal for urgent ventures
It is usually self-sustaining in that the asset acquired is used to pay for its cost i.e. leaving the company with the value of the asset.
In case of long-term debt, amount of loan declines with time and repayments reduce its burden to the borrower.
Debt finance does not influence the company’s decision since lenders don’t participate at the AGM.
It is a conditional finance i.e. it is not invested without the approval of lender.
Debt finance, if used in excess may interrupt the companies decision making process when gearing level is high, creditors will demand a say in the company i.e. and demand representation in the BOD.
It is dangerous to use in a recession as such a condition may force the company into receivership through lack of funds to service the loan.
It calls for securities which are highly negotiable or marketable thus limiting its availability.
It is only available for specific ventures and for a short term, which reduces its investment in strategic ventures.
The use of debt finance may lower the value of a share if used excessively. It increases financial risk and required rate of return by shareholders thus reduce the value of shares.
Differences between Debt Finance and Ordinary Share Capital (Equity Finance)
Ordinary share capital
It is a permanent finance
Return paid when available
Dividends are not tax allowable
Carry voting rights
Reduces gearing ratio
No legal obligation to pay
Has a residue claim
It is refundable (redeemable)
It is fixed return capital
Interest on debt is a tax allowable expense
No voting right
Increases gearing ratio
A legal obligation to pay
Carries a superior claim
Similarities between Preference and Equity Finance
a) Both may be permanent if preference share capital is irredeemable (convertible).
b) Both are naked or unsecured finances.
c) Both are traded at the stock exchange
d) Both are raised by public limited companies only
e) Both carry residue claims after debt.
f) Both dividends are not a legal obligations for the company to pay.
Differences between Preference and Equity Finance
Ordinary share capital
Preference share capital
Has a residue claim both on assets and profit
Carries voting rights
Reduces the gearing ratio
Variable dividends hence grow over time
Has a superior claim
No voting rights
Increases the gearing ratio
Fixed dividends hence no growth
Not easily transferable
Similarities between Debt and Preference Share Capital
a) Both have fixed returns.
b) Both will increase the company’s gearing ratio.
c) Both are usually redeemable.
d) Both do not have voting rights.
e) Both may force the company into receivership
f) Both have superior claims over and above owners.
g) Both are external finances.
h) There is no growth with time.
Differences between Preference Share Capital and Debt
PREFERENCE SHARE CAPITAL
Interest is tax allowable
Interest is a legal obligation
Debt finance is always secured
Debt finance is a pre-conditional
Has a superior claim
Dividends are not tax allowable
Dividends are not a legal obligation
Preference is not secured finance
Is not conditional finance
Has a residue claim (after debt)
Why It May Be Difficult For Small Companies To Raise Debt Finance In Kenya (Say Jua Kali Companies)
Lack of security
Ignorance of finances available
Most of them are risky businesses as there are no feasibility studies done (chances of failure have been put to 80%).
Their size being small tends to make them UNKNOWN i.e. they are not a significant competitor to the big companies.
Cost of finance may be high – their market share may not allow them to secure debt.
Small loans are expensive to extend by bank i.e. administration costs are very high.
Lack of business principles that are sound and difficult in evaluating their performance.
Solutions to the Above Problems
There should be diversification of securities e.g. to accept guarantees.
Education of such businessmen on sound business principles.
The government should set up a special fund to assist the jua kali businessmen.
Encourage formation of co-operative societies.
To request bankers to follow up the use of these loans.
3. Bills of Exchange
Bills of Exchange are a source of finance in particular in the export trade. A Bill of Exchange is an unconditional order in writing addressed by one person to another requiring the person to whom it is addressed to pay to him as his order a specific sum of money. The commonest types of bills of exchange used in financing are accommodation bills of exchange. For a bill to be a legal document; it must be
a) Drawn by the drawer.
b) Bear a stamp duty
c) Acceptable by the drawee
e) Mature in time.
It is used to raise finance through:
i) Discounting it.
iii) Giving it out as security.
Advantages of Using a Bill as a Source of Finance
They are a faster means of raising finance (if drawer is credible).
Is highly negotiable/liquid investment
Does not require security
Does not affect the gearing level of the company
It is unconditional and can be invested flexibly
It is useful as a source of finance to finance working capital
It is used without diluting capital.
4 Lease Finance
Leasing is a contract between one party called lessor (owner of asset) and another called lessee where the lessee is given the right to use the asset (without legal ownership) and undertakes to pay the lessor periodic lease rental charges due to generation of economic benefits from use of the assets. Leases can be short term (operating leases) in which case the lessor incurs the operating and maintenance costs of the assets or long term (finance leases) in which the lessee maintains and insure the assets.
Lease finance is ideal under the following conditions:
a) When the asset depreciates faster.
b) When the asset is subject to obsolescence
c) When the available asset cannot meet the contemplated expansion program
d) When the asset’s cost is prohibiting
e) If the asset is required seasonally
f) If the asset can generate returns to pay off lease charges in the short run.
Advantage of Leasing an Asset
It does not tie up the company’s funds in an asset.
The arrangement may ensure lessor bears the maintenance costs reducing the companies operating costs.
The company has the option to purchase assets at the expiry of the lease period at which time it will know the viability of the asset.
The company (lessee) will enjoy the lease charges as allowable expenses thus reducing taxable income and tax liability.
Lease finance enables the lessee to use the asset to create financial surpluses which may then be used to buy assets.
It is usually a long-term arrangement which enables the company to plan returns expected and operations which may be carried out.
Disadvantage of Leasing an Asset
It is a pre-conditional finance (as on the use of asset)
In the long term the lease charges may out-weigh the cost of buying own asset.
It is available for a selected asset and this limits flexibility.
It is useful for financing fixed assets and not working capital
Lease finance may not be renewed leading to loss of business.
Lease financing lowers the company’s credit rating (i.e. the asset in the balance
sheet is shown as leased asset).
Reasons Why Lease Finance Is Not Well Developed In Kenya
Lease charges are usually prohibitive i.e. the cost of finance is excessive.
It may not be known to businessmen.
Uncertainty as to returns from such assets i.e. the returns from such assets leased may not encourage the growth of lease finance.
There is an imperfect market as a number of companies lease assets on basis of credibility of the lessee.
Lack of flexibility i.e. a number of assets which are ideal for leasing are unavailable.
Kenya’s financial markets are underdeveloped and this has affected the development of lease finance.
After lease service is poor and this leads to loss of revenue.
5. Overdraft Finance
This finance is ideal to use as bridging finance in sense that it should be used to solve the company’s short term liquidity problems in particular those of financing working capital (w.c.). It is usually a secured finance unless otherwise mentioned. Overdraft finance is an expensive source of finance and the over-reliance on it is a sign of financial imprudence as it indicates the inability to plan or forecast financial needs.
Advantages of Overdraft Finance
It is useful in financial crisis which an accountant cannot forecast due to abrupt fall in profits thus liquidity problems.
In some cases it may be secured on goodwill thus making it flexible finance.
It does not entail preconditions and is therefore investible in high-risk situations when the firm would not have finance in normal circumstances.
It is raised faster and as usual is ideal to invest in urgent ventures e.g. documentary investments e.g. treasury bonds, shares, treasury bills, housing bonds etc.
If not used for a long period of time – it does not affect the company’s gearing level and therefore does not relate to company’s liquidation or receivership.
Less formalities/procedures involved.
Disadvantages of Overdraft Finance
It is expensive as the interest rates of overdrafts are much higher than bank rates.
The use of this finance is an indication of poor financial management principle.
It may be misused by management because it does not carry pre-conditions
Being a short-term financial arrangement, it can be recalled at short notice leaving the company in financial crisis.
6. Plastic Money (Credit Card Finance)
This is finance of a kind whereby a company will make arrangements for the use of the services of a credit card organisations (through the purchase of credit cards) in return for prompt settlement of bills on the card and a commission payable on all credit transactions. This is used to finance goods and services of working capital in nature such as the payment of fuel, spare-
parts, medical and other general provisions and it is rare for it to finance raw materials or capital items.
Reasons behind the Fast Development of This Finance (Plastic Money) In Kenya
a) High incidences of fraud by dishonest employees has been responsible for development of this finance as it minimises chances of this fraud because it eliminates the use of hard cash in the execution of transactions.
b) Risk associated with carrying of huge amounts of cash for purchases which cash is open to theft and misuse has also been responsible for development of this finance.
c) Credit cards have boosted the credibility of holder companies which enables them to obtain trade credits under conditions which would have otherwise been difficult.
d) Of late, Kenya has experienced emergence of elite, middle and high-income groups’ in particular professionals who tend to use these cards as a symbol of status in execution of day to day transactions.
e) These cards have been used by financial institutions and banks to boost their deposit and attract long term clienteles e.g. Royal Card Finance, Standard Chartered.
f) A number of companies and establishments have acquired such cards as a means of settling their bills under certain times when their liquidity is low or when in financial crisis.
Limitations of Credit Cards as a Source of Finance
i) These cards leads to overspending on the part of the holder and as such may disorganise the organisation’s cash budget and cash planning.
ii) Limited as to the activities they can finance as they are ideal for financing working capital items and not fixed assets in which case they are not a profitable source of finance.
iii) They are expensive to obtain and maintain because of associated cost such as ledger fees, registration, insurance, commission expenses, renewal fees etc.
iv) It is a short-term source and is open only to a few establishments in which case a company can obtain goods and services from those establishments that can accept them.
v) Entail a lot of formalities to obtain e.g. guarantees, presentation of bank statements and even charging assets that are partially pledged to secure expenses that may be incurred using these cards.
vi) They may be misused by dishonest employees who may use them to defraud the organisation off goods and services which may not benefit such organisations.
vii) Credit card organisation may suspend the use of such cards without notice and this will inconvenience the holder who may not meet his/her ordinary needs obtained through these cards.
7. Debenture Finance
A form of long term debt raised after a company sells debenture certificates to the holder and raises finance in return. The term debenture has its origin from ‘DEBOE’ which means ‘I owe’ and is thus a certificate or document that evidences debt of long term nature whereby the person named therein will have given the issuing company the amount usually less than the total par value of the debenture. These debentures usually mature between 10 to 15 years but may be endorsed, negotiated, discounted or given as securities for loans in which case they will have been liquidated before their maturity date. The current interest rate is payable twice a year and it is a legal obligation.
i) Secured Debentures
These are those types of debentures which a company will secure usually in two ways, secured with a fixed charge or with a floating charge.
a) Fixed Charge – a debenture is secured with a fixed charge if it can claim on a specific asset.
b) Floating charge – if it can claim from any or all of the assets which have not been pledged as securities for any other form of debt.
ii) Naked Debentures
These are not secured by any of the company’s assets and as such they are general creditors.
iii) Redeemable Debentures
These are the type of debentures, which the company can buy back after the minimum redemption period and before the maximum redemption period (usually 15 years) after which holders can force the company to receivership to redeem their capital and interest outstanding.
iv) Irredeemable Debentures (perpetuities)
These are never bought back in which case they form permanent source of finance for the company. However, these are rare and are usually sold by company’s with a history of stable ordinary dividend record.
v) Classification according to convertibility
Convertible debentures – Can be converted into ordinary shares although they can also be converted into preference shares.
Conversion price = par value of a debenture/No. of shares to be received.
Conversion ratio = Par value of debenture
Par value of ordinary shares
ABC Company Ltd books:
10.000, Sh.20 ordinary share capital
10,000, Shs.10 8% preference share capital
5,000, Shs.100 12% debentures
The above debentures are due for conversion:
i) Compute the conversion price
ii) Compute the conversion ratio
iii) Compute new capital structure.
i) Conversion price = par value of debenture/No. of shares to be received.
No. of shares to be received = 100:20 = 5:1
ii) Conversion ratio = par value of debenture/par value of share =
Receive 5 ordinary shares for every 1 debenture held.
iii) New capital structure
No. of new ordinary shares = 5000 x 5 = 25,000
35,000, Shs.20 ordinary shares 700,000
10,000, Shs.10, 8% preference shares 100,000
Total capital 800,000
vi) Non-convertible debentures
These cannot be converted into ordinary preference shares and they are usually redeemable.
vii) Sub-ordinate debentures
Usually last for as long as 10 years and they are sold by financially strong companies. Such are not secured and they rank among general creditors in claiming on assets during liquidation. This means that they are sub-ordinate to senior debt but superior to ordinary and preference share capital.
Reasons behind Unpopularity of Debentures of Kenya’s Financial Market:
i) Their par value is an extremely high value and as such they are unaffordable to purchase by would be investors.
ii) They are in most cases secured debt and as such constrain the selling company in so far as getting sufficient securities is difficult.
iii) Most of the would-be sellers have low credit worthiness which is difficult.
iv) Kenya’s capital markets are not developed and as such there is no secondary debenture market where they can be discounted or endorsed.
v) Debentures finance is not known among the general business community and as such many would be sellers and buyers are ignorant of its existence.
vi) Being long term finance there are a few buyers who may be willing to stake their savings for a long period of time.
vii) Such finance calls for a fixed return, which in the long rum will be eroded by inflation.
8. Venture Capital
Venture capital is a form of investment in new small risky enterprises required to get them started by specialists called venture capitalists. Venture capitalists are therefore investment specialists who raise pools of capital to fund new ventures which are likely to become public corporations in return for an ownership interest. They buy part of the stock of the company at a low price in anticipation that when the company goes public, they would sell the shares at a higher price and therefore make a considerably high profit.
Venture capitalists also provide managerial skills to the firm. Example of venture capitalists are pension funds, wealthy individuals, insurance companies, Acacia fund, Rock fella, etc.
Since the goal of venture capitalists is to make quick profits, they will invest only in firms with a potential for rapid growth.
Venture capitalists, will only invest in a company if there is a reasonable chance that the company will be successful. Their publicity material states that successful investments have three common characteristics.
a) There is a good basic idea, a product or service which meets real customer needs.
b) There is finance, in the right form to turn the idea into a solid business.
c) There is the commitment and drive of an individual or group and the determination to succeed.
Attributes of venture capital
i) Equity participation – Venture Capital participate through direct purchase of shares or fixed return securities (debentures and preference shares)
ii) Long term investment – venture capital is an investment attitude that necessitates the venture capitalists to wait for a long time (5 – 10 years) to make large profits (capital gains).
iii) Participation in Management – Venture capitalists give their Marketing, Planning and Management Skills to the new firm. This hands – on Management enable them protect their investment.
Role of Venture Capital in Economic Development
The types of venture that capitalists might invest will involve:
a) Business start-ups – When a business has been set up by someone who has already put time and money into getting it started, the group may be willing to provide finance to enable it to get off the ground. With start-ups, venture capital often prefers to be one of several financial institutions putting in venture capital.
b) Business development – The group may be willing to provide development capital for a company which wants to invest in new products or new markets or to make a business acquisition, and so which so needs a major capital injection.
c) Management buyout – A management buyout is the purchase of all or parts of a business from its owners by its managers.
d) Helping a company where one of its owners wants to realize all or part of his investment. The venture capital may be prepared to buy some of the company’s equity.
Funding Venture Capital
When a company’s directors look for help from a venture capital institution, they must recognize that:
a) The institution will want an equity stake in the company.
b) It will need convincing that the company can be successful (management buyouts of companies which already have a record of successful trading have been increasingly favored by venture capitalists in recent years.
c) It may want to have a representative appointed to the company’s board, to look after its interests.
The directors of the company then contract venture capital organizations, to try to find one or more which would be willing to offer finance. A venture capital organization will only give funds to a company that it believes can succeed.
Reasons for Significant Growth in Venture Capital in the Developed Countries
i) Public attitude i.e a favourable attitude by the public at large towards entrepreneurship, success as well as failure.
ii) Dynamic financial system e.g efficient stock exchange and a competitive banking system.
iii) Government support – e.g taxation system to encourage venture capital e.g tax concessions and investment allowance taxes.
iv) Establishment of venture capital institutions e.g investors in the industry.
v) Growth in the number of Management buyers (MBO) which have created a demand for equity finance.
Constraints of Venture Capital in Kenya
1. Lack of rich investors in Kenya, hence inadequate equity capital.
2. Inefficiencies of stock market – NSE is inefficient and investors cannot sell the shares in future. Prices do not reflect all the available information in the market.
3. Infrastructural problems – this limits the growth rate of small firms which need raw materials and unlimited access to the market factors of production.
4. Lack of managerial skills on part of venture capitalists and owners of the firm.
Nature of small business in Kenya. There are 3 categories.
Large MNC – these are established firms and can raise funds easily.
Asian owned small businesses – They are family owned hence do not require interference of venture capitalists because they are not ready to share profits.
African – owned business – need venture capital but have little potential for growth.
6. Focus on low risk ventures e.g confining to low technology, low growth sectors with minimum investment risks.
7. Conservative approach by the venture capitalists.
8. Delay in project evaluation e.g months or more hence entrepreneurs loose interest in the project.
9. Lack of government support and inefficient financial system.
In sum, venture capital, by combining risk financing with management and marketing assistance, could become an effective instrument in fostering developing countries. The experiences of developed countries and the detailed case study of venture capital however, indicate that the following elements are needed for the success of venture capital in any country.
A broad-based (and less family based) entrepreneurial traditional societies and government encouragement for innovations, creativity and enterprise.
A less regulated and controlled business and economic environment where attractive customer opportunities exists or could be created from high-tech and quality products.
Existence of disinvestments mechanisms, particularly over-the counter stock exchange catering for the needs of venture capitalists.
Fiscal incentives which render the equity investment more attractive and develops ‘equity cult’ in investors.
A more general, business and entrepreneurship oriented education system where scientists and engineers have knowledge of accounting, finance and economics and accountants understand engineering or physical sciences.
An effective management education and training programme for developing professionally competent and committed venture capital managers; they should be trained to evaluate and manage high technology, high risk ventures.
A vigorous marketing thrust, promotional efforts and development strategy, employing new concepts such as venture fair clubs, venture networks, business incubators etc. for the growth of venture capital.
Linkage between universities/technology institutions, R & D. Organisations, industry, and financial institutions including venture capital firms.
Encouragement and funding or R & D by private public sector companies and the government for ensuring technological competitiveness.
Disadvantages of Venture Capital
Dilute ownership position of a firm
Dilute control of a firm
a) What are the practical difficulties of a small scale enterprise wishing to obtain credit to expand production? (10 marks)
b) Distinguish between internal and external sources of finance for a limited liability company. (10 marks)
a) Why do different sources of finance have different costs? (8 marks)
b) What are the advantages of having a farmers’ bank compared with an ordinary commercial bank in the provision of services to farmers? (12 marks)
a) What is venture capital? (4 marks)
b) Why is the market for venture capital not yet well developed in Kenya or your country? (16 marks)
a) Distinguish between debt and equity capital. (10 marks)
b) What are the advantages of leasing an asset compared to borrowing to buy an asset?
CHECK YOUR ANSWERS WITH THOSE GIVEN IN LESSON 10 OF THE STUDY PACK
COMPREHENSIVE ASSIGNMENT 1
TO BE SUBMITTED AFTER LESSON 2
To be carried out under Examination condition and sent to the Distance Learning Adminstrator for marking by the University.
ANSWER ALL QUESTIONS. TIME ALLOWED: THREE HOURS
a) Why does ordinary share capital have a high cost relative to debt capital? (6 marks)
b) Identify the various methods of issuing new ordinary shares to shareholders.
a) Outline the functions of a financial manager in a contemporary corporate set-up.
b) What are the weaknesses associated with profit maximisation goal? (8 marks)
a) Explain the types of agency costs that arise in agent-principal relationship that exist between shareholders and managers. (10 marks)
b) Why does Financial management in private (commercial firms) differ from financial management in government/public sector. (10 marks)
a) What are the disadvantages of Hire purchase as a source of finance? (6 marks)
b) Outline the necessary conditions for success of venture capital financing in Kenya.
c) Why is operating lease called off-balance sheet financing? (4 marks)
The Chuma Ngumu Company needs to finance a seasonal rise in inventories of Sh.4
million. The funds are needed for six months. The company is considering using the following possibilities to finance the inventories:
i) A warehouse loan from a finance company. The terms are 18 per cent annualised with an 80% advance against the value of the inventory. The warehousing costs are Sh.350,000 for the six-month period. The residual financing requirement which is Sh.4 million less the amount advanced will need to be financed by forgoing cash discounts on its payables. Standard terms are 2/10 net 30; however the company feels it can postpone payment until the fortieth day without adverse effect.
ii) A floating lien arrangement from the supplier of the inventory at an effective interest rate of 24 per cent. The supplier will advance the full value of the inventory.
iii) A bank loan from the company’s bank for Sh.4 million. The bank can lend at the rate of 22%. In addition, a 10% compensating balance will be required which otherwise would not be maintained by the company.
iv) Establish a one year line of credit. The commitment fees is 5% of the total borrowings. The interest rate is 17% p.a.
Explain which is the cheapest option for the company? (20 marks)
END OF COMPREHESIVE ASSIGNMENT 1
NOW SEND TO DISTANCE LEARNING FOR MARKING
Read Chapter 3 of Financial Management textbook by I.M Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Definition and Users of Financial Statements
Yard Stick Used In Ratio Analysis
Classification Computation and interpretation of ratios
Uses /Applications and limitation of ratios
Financial analysis is a process by which finance identifies the company’s financial performances by comparing the entities in the balance sheet and those in the profit and loss account (P&L). This is so because balance sheet entities are usually responsible for those to be found in the P&L i.e. assets shown in the balance sheet are responsible for sales, revenue and expenses to be found in the P&L. This analysis is important to various parties with a financial stake in the company. These include:
1. Shareholders – Actual owners are interested in the company’s both short and long term survival. For this reason they will use ratio’s such as:
a) Profitability ratios – which seek to establish viability.
b) Dividend ratios – which seek to establish return to owners in form of dividends. The common ratios include earning yield (E/Y), Dividend pay out ratio (DPO), dividend yield, Price earning ratio, all of which will measure return to owner.
2. Creditors (trade) – these are interested in the company’s ability to meet their short-term obligations as and when they fall due. For this reason they will use ratios such as:
a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid test ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against current liabilities.
3. Long term lenders – These include finances through loans, mortgages and debenture holders. These have both short and long term interest in the company and its ability to pay not only interest on debt but also principal as and when it falls due. These parties are interested in the following:
a) Liquidity ratios – used to assess short-term liability to meet current obligations.
b) Profitability ratios – used to ascertain whether the company can pay its principal back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment of interest to the lenders of the debt.
4. Directors and management of company – They will therefore be interest in:
a) Efficiency of the company in generating profits.
b) The company’s viability from the investor’s point of view and the company’s ability to generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.
5. Potential investors – these parties are interested in a company in total both on short and long term basis in particular the company’s ability to generate acceptable return on their money.
Therefore, they will use:
a) Dividend ratios
b) Return ratios
c) Gearing ratios
6. Government – The Government is interested mostly in utility companies (e.g. KPLC, KPTC) and those that will provide public services – in this case the government will be interested in their survival and thus ability to provide those services. It may be interested in taxation derived from these companies which is used for development. Government may also be interested in employment level and as such it will use those ratios that can enable it to achieve such objectives of particular importance are:
a) Profitability ratios
b) Return ratios
7. Competitors – These are interested in the company’s performance from the market share point of view and will use the ratios that enable them to ascertain company’s competitive strength e.g. profitability ratios, sales and returns ratio etc.
8. General public – Customers and potential customers – These are interested in the ability of the company to provide good services both in the short and long run. To gauge the company’s ability to provide goods and services on short and long term basis. We have:
YARD STICK USED IN RATIO ANALYSIS
1. Past performance of the company
The company’s past performance (past ratio) is used to measure or gauge the company’s performance and in particular the change in performance whether good (favourable), better, same or even worse than the past. Such comparison is then used to interpret the company’s performance bearing in mind the factors that influenced the present and past performances.
2. Average industry ratios
These are useful as they indicate the average performance of various companies in a given industry i.e. it gives the minimum performance of a number of companies in a given industry. These ratios are useful in so far as to enable the analyst to make a reasonable comparison of the company’s performance vis-à-vis other companies in the same industry. However, for this yardstick to be useful the term average should include those companies which are not extremely. I.e. very strong and very weak companies – which should be excluded to arrive at industry average figures.
3. Ratio of successful companies
Useful if the company can get figures of competitors who are leading in the market so as to enable it to gauge its performance against better performance. However this information is difficult to obtain and sometimes it calls for private investigators e.g. Private Eyes Ltd.
4. Ratio of budgeted performance
These are compared with actual performance ratios and investigations are made of any unfavorable variance which should be explained.
Classification of Ratios
Ratios are broadly classified into 5 categories:
1. Liquidity ratios
2. Turnover ratios
3. Gearing ratios
4. Profitability ratios
5. Growth and valuation ratios
1. Liquidity Ratios
Also called working capital ratios. They indicate ability of the firm to meet its short term maturing financial obligation/current liabilities as and when they fall due.
The ratios are concerned with current assets and current liabilities. They include:
a) Current ratio = Current Assets
This ratio indicates the No. of times the current liabilities can be paid from current assets before this assets are exhausted.
The most recommended ratio is 2.0 i.e. the current asset must at least be twice as high as current liabilities
b) Quick/acid test ratios = Current Asset - Stock
Is a more refined current ratio which exclude amount of stock of the firm. Stocks are excluded for two basic reasons.
i) They are valued on historical cost basis
ii) They may not be converted into cash very quickly
The ratio therefore indicates the ability of the firm to pay its current liabilities from the more liquid assets of the firm.
c) Cash ratio = Cash in hand/bank + short term marketable securities
This is a refinement of the acid test ratio indicating the ability of the firm to meet its current liabilities from its most liquid resources.
Short term marketable securities refers to short term investment of the firm which can be converted into cash within a very short period e.g commercial paper and treasury bills.
d) Net working capital Ratio = Networking Capital x 100
Where Net Assets or Capital employed = Total Assets – Current liability
This ratio indicates the proportions of total net assets which is liquid enough to meet the current liabilities of the firm.
It is expressed in % term.
2. Turnover Ratios/efficiency/asset management ratio
Turnover ratio indicate the efficiency with which the firm utilised the asset or resources at its disposal to generate sales revenue or turnover.
This ratio includes:
a) Stock/inventory turnover = Cost of Sales
The ratio indicate number of times the stock was turned into sales in a year i.e how many times did the ‘buy-sell’ process occur during the year. The higher the stock turnover, the better the firm and more likely the higher the sales.
b) Stock holding period = 365 days
= 365 x Average stock i.e 365
Cost of sales Stock turnover
The ratio indicates number of days the stock was held in the warehouse before being sold.
The higher the stock turnover, the lower the stock holding period and vice versa.
c) Debtors/accounts receiver turnover = Annual credit sales
The ratio indicate the number of times/frequency with which credit customers or debtors were turned into sale i.e the number of times they come to buy on credit per year after paying their dues to the firm.
The higher the debtors turnover the better the firm indicating that customers came to buy on credit many times thus they paid within a short period.
d) Debtors collection period = 365
or 365 x Average debtors
Annual credit sales
This refers to credit period that was granted to the debtors on the period within which they were supposed to pay their dues to the firm.
The shorter the collection period/credit period the higher the debtors turnover and vice versa.
If no opening debtors are given use the closing debtors to represent average debtors.
e) Creditors/accounts payable turnover = Annual credit purchases
The firm buy goods on credit from suppliers.
The ratio indicate number of times p.a. the firm bought goods on credit after paying the suppliers.
If the creditors turnover is high, this indicates that the payment was made
within a short period of time.
f) Creditors payment period = 365
= 365 x Average creditors
Annual credit purchases
The ratio indicate the credit period granted by the suppliers i.e. the period
within which the firm should pay its liabilities to the suppliers.
The shorter the period the higher the creditors turnover and vice-versa.
g) Fixed asset turnover = Annual Sales
This ratio indicate the efficiency with which, the fixed assets were utilised to generate sales revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilised to generate Sh.1.4 of sales.
h) Total asset turnover = Annual sales
The ratio indicate amount of sales revenue generated from utilisation of one shilling of total asset.
The Concept of Working Capital/Cash Operating Cycle
Working capital cycle refers to period that elapses between the payment for raw materials bought on credit (cash outflows) and the receipts of cash from finished goods sold on credit (cash inflows).
The working capital cycle will involve the following:
a) Purchase of raw materials on credit from suppliers
b) Payment of raw materials after the lapse of credit period
c) Conversion of raw materials into finished goods
d) Sale of finished goods to creditors
e) Receipt of cash from debtors.
This can be illustrated using a diagram as follows:
Raw material stock conversion period
Creditors Payment Period Debtors Collection Period
A B C D
Purchase of Payment of Finished goods Receipts of
Raw materials raw materials sold on credit cash goods
On credit cash outflow sold on credit
Working Capital Cycle
Working capital cycle = Stock conversion + debtors collection – Creditors payment
From the diagram the working capital cycle of a period will be determined as follows:
Stock conversion period + Debtors collection period – Creditors payment period
A lengthy working capital cycle is an indicator of poor management of stock and debtors reflecting low turnover of stock and debtors and lengthy stockholding period and debtors collection period.
The working capital cycle can be reduced in any of the following ways:
1. Negotiate for a longer credit period with the suppliers
2. Reduce the stock conversion period or manufacturing period.
3. Reduce the debtors collection period by granting short crediting period. This can be achieved through offering discounts to customers to encourage them to pay earlier.
4. Holding fast moving goods to ensure high turnover.
5. Timely delivery of raw materials by suppliers especially if any delay in delivery will lengthen the raw materials holding period.
3. Gearing/Leverage/Capital Structure Ratio
The ratio indicate the extent in which the firm has borrowed fixed charge capital to finance the acquisition of the assets or resources of the firm.
The two basic gearing ratios are:
a) Debt/equity ratio = Fixed charge capital
Equity (net worth)
This ratio indicate the amount of fixed charge capital in the capital structure of the firm for every one shilling of owners capital or equity e.g a ratio of 0.78 means for every Sh.1 of equity there is Sh.0.78 fixed charge capital.
b) Fixed charge to total capital ratio = Fixed charge capital x 100
Total capital employed
Where total capital employed = Fixed charge capital + equity relative to total capital employed by the firm e.g a ratio of 0.38 means that, 38% of the capital employed is fixed charge capital.
Other leverage or gearing ratios are
a) Debt ratio = Total debts
Where total debt = fixed charge capital + liabilities.
The ratio indicate the proportion of total assets that has been financed using long term and current liabilities e.g a debt ratio of 0.45 mean 45% of total asset has been financed with debt while the remaining 55% was financed with owners equity/capital.
b) Times interest earned ratio = Operating profit (earning before interest and tax
TIER also called interest coverage ratio.
This ratio indicate the number of times interest charges can be paid from operating profit. The higher the TIER, the better the firm indicating that either the firm has high operating profits or its interest charges are low.
If TIER is high due to low interest charges, this indicates low level of gearing/debt capital of the firm.
4. Profitability Ratio
This ratio indicate the performance of the firm in relation to its ability to derive returns or profit from investment or from sale of goods i.e profit margin or sales.
1. Profitability in relation to sales
The ratio indicate the ability of the firm to control its cost of sales, operating and financing expenses.
a) Gross profit margin = Gross profit x 100
The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit margin of 40% means 60% of sales revenue was taken up by cost of sales while 40% was the gross profit.
b) Operating profit margin = Operating profit/Earning before interest & tax
The ratio indicates ability of the firm to control its operating expenses such as distribution cost, salaries and wages, travelling, telephone and electricity charges etc. e.g a ratio of 20% means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit
c) Net profit margin = Net profit x 100 (earning after tax) + interest
This ratio indicates the ability of the firm to control financing expenses in particular interest charges e.g. Net profit margin of 10% indicate that:
i) 90% of sales were taken up by cost of sales, operating and financing expenses
ii) 10% remained as net profits.
2. Profitability in relation to investment
a) Return on Investment (ROI) = Net profit x 100
or return on total asset (ROTA) Total asset
The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of 20% means Sh.10 of total asset generated Sh.2 of net profit.
b) Return on equity (ROE) = Net profit x 100
or Return on net worth (RONW) equity
or Return on shareholders equity (ROSE)
The ratio indicate the return of profitability for every one shilling of equity capital contributed by the shareholders e.g a ratio of 25% means one shilling of equity generates Sh.0.25 profit attributable to ordinary shareholders.
c) Return on capital employed ROCE = Net profit x 100
or Return on net asset (RONA) Net Asset (Capital employed)
This ratio indicate the returns of profitability for every one shilling of capital employed in the firm.
5. The Growth and Valuation Ratio
This ratio indicates the growth potential of the firm in addition to determining the value of the firm and investment made by various investors. They include the following:
a) Earnings per share EPS = Earnings to Ordinary shareholders
No. of ordinary shares
This ratio indicate earnings power of the firm i.e how much earnings or profits are attributed to every share held by an investor. The higher the ratio the better the firm.
b) Earnings yield (EY) = Earnings per share x 100
Market price per share
The market price per share (MPS) is the price at which new shares can be bought from the stock market.
These ratios therefore indicate the returns or earnings for every one shilling invested in the firm.
c) Dividends per share (DPS) = Dividend paid
No. of ordinary shares
- This indicates the cash dividend received for every share held by an investor. If all the earnings attributable to ordinary shareholders were paid out as dividend, then EPS = DPS.
d) Dividend Yield (DY) = Dividend per share x 100
Market price per share
Or Dividend paid
Market value of equity
Where market value of equity = No. of shares x MPS
This ratio indicates the cash dividend returns for every one shilling invested in the firm.
e) Price earnings (P/E) = Market price per share (MPS)
Ratio Earning per share
= Market value of equity
Earning to Ord. Shareholders
P/E ratio is a reciprocal of earning yield (EY). The MPS is the price at which a new share can be bought i.e investment per share. The EPS is the annual income/earnings from each share.
PE therefore indicate the payback period i.e number of years it will take to recover MPS from the annual earnings per share of the firm.
f) Dividend cover = EPS = Earning to ordinary shares
DPS Dividend paid
This indicate the number of times dividend can be paid from earnings to ordinary shareholders. The higher the DPS the lower the dividend cover and vice-versa e.g consider the following two firms X and Y
EPS 12/= 12/=
DPS 3/= 5/=
Dividend cover 12 = 4 12 = 2.4 times
g) Dividend pay out ratio = DPS x 100 = Dividend paid
EPS Earning to ordinary shareholder
This is the reciprocal of dividend cover. It indicates the proportion of earnings that was paid out as dividend e.g a payout ratio of 40% means 60% of earnings were retained while 40% was paid out as dividend, therefore retention ratio = 1 – dividend payout ratio
h) Book value per share = Networth Equity
(BVPS) No. of ordinary shares
This is also called liquidity ratio which indicates the amount attributable to each share if the firm was liquidated and all asset sold at their book value.
The ratio is based on the residual amount which would remain after paying all liabilities from the sales proceeds of the assets.
i) Market to book value per share = MPS
This ratio indicates the amount of goodwill attached to the firm i.e the price in excess of the sales value of the assets of the firm. If the ratio is greater 1(MBVPS >1) this indicate a positive goodwill while if less than 1 a –ve goodwill.
Uses/Application of Ratios
Ratios are used in the following ways by managers in various firms.
1. Evaluating the efficiency of assets utilisation to generate sales revenue i.e turnover ratio.
2. Evaluating the ability of the firm to meet its short term financial obligation as and when they fall due (liquidity ratios).
3. To carry out industrial analysis i.e compare the firm’s performance with the average industrial performance of the firm with that of individual competitors in the same industry.
4. For cross sectional analysis i.e compare the performance of the firm with that of individual competitors in the same industry.
5. For trend/time series analysis i.e evaluate the performance of the firm over time.
6. To establish the extent which the assets of the firm has been financed by fixed charge capital i.e use of gearing ratio
7. To predict the bankruptcy of the firm i.e use of selected ratios to determine the overall ratio usually called Z-score. The Z-score when compared with a pre-determined acceptable a Z-score will indicate the probability of the bankruptcy of the firm in future.
Limitations of Ratios
Ratios have the following weaknesses:
1. They ignore the size of the firm being compared e.g in cross-sectional analysis, the firm being compared might be of different size, technology and product diversification.
2. Effect of inflation:
Ratio ignores the effect of inflation in performance e.g increase in sales might be due to increase in selling price caused by inflationary pressure in the economy.
3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g important assets such as corporate image, efficient management team, customer loyalty, quality of product, technological innovation etc are not captured in ratio analysis.
4. Ratios are computed only at one point in time i.e they are subject to frequent changes after computation e.g liquidity ratios will constantly change as the cash, debtors and stock level changes.
5. Monopolistic firms
It is difficult to carry out industrial and cross-sectional analysis for monopolistic firms since they do not have competitors and they are the only firms in the whole industry e.g Telkom-Kenya, East Africa Brewery etc.
6. Historical Data – Ratios are computed in historical information or financial statement thus may be irrelevant in future decision-making of
7. Computation and interpretation
Generally some ratios do not have an acceptable standard of computation. This may differ from one industry to another. E.g the return on investment may be computed as:
Return on investment = EBIT or EAT
Total assets Total assets
8. Different accounting policies – Different firms in the same industry use different accounting policies e.g methods of depreciation and stock valuation. This makes comparison difficult.
Financial forecasting refers to determination of financial requirements of the firm in advance. This requires financial planning using budgets.
The financial planning and forecasting will also determined the activities the firm should undertake in order to achieve its financial targets.
Financial forecasting is important in the following ways:
1. Facilitate financial planning i.e determination of cash surplus or deficit that are likely to occur in future.
2. Facilitate control of expenditure. This will minimise wastage of financial resources in order to achieve financial targets.
3. It avoids surprise to the managers e.g any cash deficit is known well in advance thus the firm can plan for sources of short term funds such as bank drafts or short term loans.
4. Motivation to the employees – Financial forecasting using budgets and targets will enhance unity of purpose and objectives among employees who are determined to achieve the set target.
Methods/Techniques of Financial Forecasting
1. Use of Cash Budgets
A cash budget is a financial statement indicating:
a) Sources of revenue and capital cash inflows
b) How the inflows are expended to meets revenue and capital expenditure of the firm.
c) Any anticipated cash deficit/surplus at any point during forecasting period.
2. Regression Analysis
This is a statistical method which involves identification of dependant and independent variable to form a regression equation *y = a + bx) on which forecasting will be based.
3. Percentage of Sales Method
This method involves expressing various balance sheet items that are directly related to sales as a percentage of sales. It involves the following steps:
i) Identify various balance sheet items that are directly with sales this items include:
a) Net fixed asset – If the current production capacity of the firm is full an increase in sales will require acquisition of new assets e.g. machinery to increase production.
b) Current Asset – An increase in sales due to increased production will lead to increase in stock of raw materials, finished goods and work in progress. Increased credit sales will increase debtors while more cash will be required to buy more raw materials in cash.
c) Current liabilities – Increased sales will lead to purchase of more raw materials
d) Retained earnings – This will increase with sales if and only if, the firm is operating profitability and all net profits are not paid out as dividend.
The increase in sales does not require an increase in ordinary share capital, preference share capital and debentures since long term capital is used to finance long term project.
ii) Express the various balance sheet items varying with sales as percentage of sales e.g. assume for year 2002 stock and net fixed assets amount to Sh.12M and 18M respectively sales amount to Sh.40M. Therefore stock as percentage of sales”
Fixed asset =
iii) Determine the increase in total asset as a result of increase in sales e.g suppose sales increases from Sh.40 M to Sh.60 M during year 2003. The additional stock and net fixed asset required would be determined as follows:
Increase in stock = % of sales x increase in sales
= 30% (60 – 40) = Sh.6M
Increase in fixed asset = % of sales x increase in sales
= 45%(60 – 40) = Sh.9 M
iv) Determine the total increase in assets which will be financed by:
a) Spontaneous source of finance i.e increase in current liabilities
Where Increase = % of sales x increase in sales
b) Retained earnings for the forecasting period
Retained earnings = Net profit – Dividend paid
Net profit margin = Net profit
Therefore: Net profit = Net profit margin (%) x sales
Generally Net profit margin is called after tax return on sales.
Out of the total assets that are required as a result of increase in sales, the financing will come from the two sources identified. Any amount that cannot be met from the two sources will be borrowed externally on short term basis which will be a current liability.
Assumptions underlying % of sales method
The fundamental assumption underlying the use of % of sales method is that, there is no inflation in the economy i.e the increase in sales is caused by increase in production and not increase in selling price.
Other assumptions include:
1. The firm is operating at full or 100% capacity. Therefore the increase in production will require acquisition of new fixed assets.
2. The firm will not issue new ordinary shares or debenture or preference shares thus this capital will remain constant during the forecasting period.
3. The relationship between balance sheet item and sales i.e balance sheet items as % of sales will be maintained during forecasting period.
4. The after tax, profit on sale or net profit margin will be achieved and shall remain constant during the forecasting period.
The following is the balance sheet of XYZ Ltd as at 31st December 2002:
Net fixed asset
Ordinary share capital
1. The sales for year 2002 amounted to Sh.500,000. The sales will increase by 15% during year 2003 and 10% during year 2004.
2. The after tax return on sales is 12% which shall be maintained in future.
3. The company’s dividend payout ratio is 80%. This will be maintained during forecasting period.
4. Any additional financing from external sources will be affected through the issue of commercial paper by company.
a) Determine the amount of external finance for 2 years upto 31st December 2004.
b) Prepare a proforma balance as at 31 December 2004
Identify various items in balance sheet directly with sales:
Net fixed assets = 300M x 100 = 60%
Current Assets = 100M x 100 = 20%
Trade creditors = 50 x 100 = 10%
Accrued expenses = 30 x 100 = 6%
c) Compute the increase in sales over the 2 years.
Year 2002 sales =
Year 2003 sales =
Increase in sales in 2003-03-26= 632.5 – 500 = 132.5M
d) Compute the amount of external requirement of the firm over the 2 years of forecasting period.
i) Increase in F. Assets = % of sales x increase in sales
= 60% x 132.5 = 79.5M
ii) Increase in C. Assets = % of sales x increase in sales
= 20% of 132.5 = 26.5M
Total additional investment/asset required 106M
For the company to earn increase in sales of 132.5M it will have to acquire additional assets costing 106M.
Additional investment/asset required 106,000
Less: Spontaneous source of finance
Increase in creditors = % of sales x increase in sales
= 132,500 x 10% (13,250)
Increase in accrued expenses = % of sales x increase in sales
= 132,500 x 6% (7,950)
Less: Retained earnings during 2 years of operation (initial sources)
Net profit for 2003 = Net profit margin x sales of 2003
= 12% of 575,000 = 69,000
Less: Dividend payable 80% of 69,000 = 55,200 (13,800)
Net profit for 2004 = Net profit margin x sales of 2004
= 12% of 632,500 = 75,900
Less: dividend payable 80% of 75,900 = 60,720 (15,180)
External financial needs (commercial paper) 55,820
Proforma Balance Sheet
This refers to the projected balance sheet at the end of forecasting period. The items in the proforma balance which vary with sales would be determined in any of the following two ways:
i) % of sales x sales at last year of forecasting (2004); or
ii) Balance sheet item before forecasting plus increase in balance sheet item as a result of increase in sales.
Proforma balance sheet as at 31st December 2004
Net fixed assets 60% x 632.5 or 300 + 79.5
Current Assets 20% x 632.5 or 100 + 26.5
Ordinary shares (will remain constant)
Retained earning 70 + 13.8 + 15.18
10% debenture (remain constant)
Trade creditor 10% x 632.5 or 50 + 13.25
Accrued expenses 6% x 632.5 or 30 + 7.95
External borrowing – commercial
An extract from the finance statements of Kenyango Fisheries Ltd is shown below:
Issued share capital:
150,000 ordinary shares of Sh.10 each fully paid
10% loan stock 1999
The profits after 30% tax is Sh.600,000. However, interest charge has not been deducted.
Ordinary dividend payout ratio is 40%.
The current market value of ordinary shares Shs.36
a) Return on capital employed
b) Earnings per share
c) Price earnings ratio
d) Book value per share
e) Gearing ratio
f) Market to book value per share
The following financial statements relate to the ABC Company:
Liabilities & Net worth
Total current assets
Net fixed assets
Notes payable (9%)
Other current liabilities
Long term debt (10%)
Income Statement for the year ended 31 March 1995
Less cost of sales
Selling and administration expenses
Earning before interest and tax
Estimated taxation (40%)
Earnings after interest and tax
i) Inventory turnover ratio; (3 marks)
ii) Times interest earned ratio; (3 marks)
iii) Total assets turnover; (3 marks)
iv) Net profit margin (3 marks)
(Note: Round your ratios to one decimal place)
b) The ABC Company operates in an industry whose norms are as follows:
Ratio Industry Norm
Inventory turnover 6.2 times
Times interest earned ratio 5.3 times
Total assets turnover 2.2 times
Net profit margin 3%
Comment on the revelation made by the ratios you have computed in part (a) above when compared with the industry average.
The following information has been extracted from the published accounts of Pesa Corporation Limited, a company quoted on the Nairobi Stock Exchange.
Net profit after tax and interest 990,000
Less: dividends for the period 740,000
Transfer to reserves 250,000
Accumulated reserves brought forward 810,000
Reserves carried forward 1,060,000
Share capital (Sh.10 par value) Sh.8,000,000
Mar02ket price per share now 12%
a) What is meant by a company quoted on the Nairobi Stock Exchange? (6 marks)
b) Calculate for Pesa Corposation Limited the following ratios and indicate the importance of each to Miss Hisa, a Shareholder:
i) Earnings per share. (4 marks)
ii) Price earnings ratio (4 marks)
iii) Dividend yield (4 marks)
iv) Dividend cover (4 marks)
(Total: 22 marks)
The executive director of Pesa Ltd has circulated the following information as part of board paper:
Financial Performance for the year ended 31 March:
Return on investment
Gross profit on sales
Number of days credit given
Administrative cost of sales
a) Brief report on each of the above 4 ratios indicating the reservation, if any, you may have or judging them as improvement in performance.
b) Tajiri Ltd has sales of Sh.20,000,000 in 1998. Beginning and closing stock was Sh.800,000 and Sh.2,200,000 respectively. G.P. margin is usually 25% of sales.
i) Stock turnover ratio
ii) Number of days stock held
iii) Brief explanation on how the ratio computed in (i) above can be improved and financial
Consequences of such action.
CHECK YOUR ANSWERS WITH THOSE PVOVIDED IN LESSON 10 OF THE STUDY PACK
Read Chapter 13 of Financial Management text book by I.M. Pandey
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Cost of Capital Structure Decisions
Term Structure of interest rate
Models of computing cost of capital
The weighting Average cost of capital
Marginal cost of capital
Factors That Affect Capital Structure
1. Availability of securities – This influences the company’s use of debt finance which means that if a company has sufficient securities, it can afford to use debt finance in large capacities.
2. Cost of finance (both implicit and explicit) – If low, then a company can use more of debt or equity finance.
3. Company gearing level – if high, the company may not be able to use more debt or equity finance because potential investors would not be willing to invest in such a company.
4. Sales stability – If a company has stable sales and thus profits, it can afford to use various finances in particular debt in so far as it can service such finances.
5. Competitiveness of the industry in which the company operates – If the company operates in a highly competitive industry, it may be risky to use high levels of debt because chances of servicing this debt may be low and may lead a company into receivership.
COST OF FINANCE
This is the price the company pays to obtain and retail finance. To obtain finance a company will pay implicit costs which are commonly known as floatation costs. These include: Underwriting commission, Brokerage costs, cost of printing a prospectus, Commission costs, legal fees, audit costs, cost of printing share certificates, advertising costs etc. For debt there are legal fees, valuation costs (i.e. security, audit fees, Bankers commission etc.) such costs are knocked off from:
i) The market value of shares if these have only been sold at a price above par value.
ii) For debt finance – from the par value of debt.
I.e. if flotation costs are given per share then this will be knocked off or deducted from the market price per share. If they are given for the total finance paid they are deducted from the total amount paid.
Cost of Retaining Finance
This will include dividends for share capital and interest for debt finance (tax deducted) or effective cost of debt. However, when computing the cost of finance apart from deducting implicit costs, explicit costs are the most central elements of cost of finance.
Importance of Cost of Finance
The cost of capital is important because of its application in the following areas:
i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the cost of capital is used to discount the cash flows. Under IRR method the cost of capital is compared with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is determined by the cost of each capital component.
iii) Evaluation of performance of management – A high cost of capital is an indicator of high risk attached to the firm. This is usually attributed to poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is low compared to the cost of new ordinary share capital, the firm will retain more and pay less dividend. Additionally, the use of retained earnings as an internal source of finance is preferred because:
It does not involve any floatation costs
It does not dilute ownership and control of the firm, since no new shares are issued.
v) Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt (interest rate on loan borrowed) is used as the discounting rate.
Factors That Influence the Cost of Finance
1. Terms of reference – if short term, the cost is usually low and vice versa.
2. Economic conditions prevailing – If a company is operating under inflationary conditions, such a company will pay high costs in so far as inflationary effect of finance will be passed onto the company.
3. Risk exposed to venture – if a company is operating under high risk conditions, such a company will pay high costs to induce lenders to avail finance to it because the element of risk will be added on the cost of finance which may compound it.
4. Size of the business – A small company will find it difficult to raise finance and as such will pay heavily in form of cost of finance to obtain debt from lenders.
5. Availability – Cost of finance (COF) prices will also be influenced by the forces of demand and supply such that low demand and low supply will lead to high cost of finance.
6. Effects of taxation – Debt finance is cheaper by the amount equal to tax on interest and this means that debt finance will entail a saving in cost of finance equivalent to tax on interest.
7. Nature of security – If security given depreciates fast, then this will compound implicit costs (costs of maintaining that security).
8. Company’s growth stage – Young companies usually pay less dividends in which case the cost of this finance will be relatively cheaper at the earlier stages of the company’s development.
Term Structure of Interest Rates
The term structure of interest rate describes the relationship between interest rates and the term to maturity and the differences between short term and long term interest rates.
The relationship between short and long interest rates is important to corporate managers because:
1. They must decide whether to buy long term or short term bonds and whether to borrow by issuing long-term or short-term bonds.
2. It enables them to understand how long term and short term rates are related and what causes the shift in their relative positions.
Several theories had been advanced to explain the nature of yield curve – These are:
1. Liquidity preference theory
2. Expectation theory
3. Market segmentation theory
1. Liquidity Preference Theory
This theory states that short term bonds are more favourable than long term bonds for 2 reasons.
i) Investors generally prefer short term bonds to long-term securities because such securities are more liquid in the sense that they can be converted to cash with little danger of loss of principal. Therefore – investors will accept lower yields on short term securities.
ii) At the same time borrowers react in exactly the opposite way.
Generally borrowers prefer long term debt because short-term debt exposes them to the risk of having to repay the debt under adverse. Conditions, accordingly borrowers are willing to pay higher rate other things held constant for long-term process than short ones.
Taking together this two sets of preferences implies that under normal conditions, a positive maturity risk premium exist which increases with maturity thus the yield curve should be upward sloping. Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and are willing to pay a “premium” for long term borrowing.
2. Expectation Theory
This theory states that the yield curve depends on the expectation about future inflation rates. If inflation rate is expected to increase, then the rate on long-term bonds will exceed that of short-term loan. The expected future interest rates are equal to forward rates computed from the expectations with regard to future interest rates are. Other factors which affect the expectations with regard to future interest rates are:
Monetary policy of the government
Fiscal policy of the government (government expedition)
Other economic related factors including social factors.
The following conditions are necessary for the expectation theory to hold.
i) Perfect capital markets exists where there are many buyers and sellers of security with non having a significant influence on the interest rates.
ii) Investors have homogeneous expectations about future interest rates and returns on all investments.
iii) Investors are rational wealth maximizers
iv) Bankruptcy of firms due to use of borrowing is unlikely.
3. Market Segmentation Theory
This theory states that the major investors (borrowers and lenders) are confined to a particular segment of the market and will not change even if the forecast of the likely future interest rates changes.
The lenders and borrower thus have a preferred maturity e.g a person borrowing to buy a house or a company borrowing to build a power plant would want a long term loan. However a retailer borrowing to build up stock in readiness for a peak reason would prefer a short term loan. Similar differences exist among savers e.g a person saving to pay school fees for next semester would want to lend on in the short-term market. A person saving for retirement 20 years ahead would probably buy long-term security in L.T market.
The thrust of market segmentation theory is that the slope of yield curve depends on demand and supply mechanism. An upward sloping curve would occur if there was a large supply of funds relative to demand in the short term marketing but a relative shortage of funds in the long-term market would produce an upward sloping curve.
Tests of the 3 theories
Various test have been conducted mainly in USA and they indicate that all the 3 theories have some validity and thus the shape of the yield curve of any firm is affected by the following:
1. Supply and demand conditions in the short and long term market.
2. Liquidity preferences of lenders and borrowers
3. Expectation of future inflation. While any of the 3 factors may dominate the market all the 3 effect the term structure of interest rate.
Factors influencing interest rates
There are four most important factors that influence interest rates and the shape of yield curve.
1. CBK – Monetary policy
2. The level of government budget deficit
3. Balance of trade position
4. Business activity (circle) in the economy
1. CBK – Monetary Policy
The money supply in the economy has a major effect on both the level of economic activity and the rate of inflation. The level of money supply is controlled by the CBK.
If the CBK wants to stimulate the economy, it increases the money supply. The initial effect of such an action is to cause interest rates to decline but this may also lead to increase in expected rate of inflation which in turn pushes the interest rates up in the long run. The reverse of this would happen if the CBK tightens the money supply in the economy.
During periods when CBK is directly interfering with the market, the yield curve will be distorted. S.T interests will be too high if the banks are tightening their credit and they could be too low if the banks are easing the credit.
2. Government Budget Deficit
If the Government spends more than it takes in from tax revenue, it runs a budget deficit. This deficit must be covered or financed either by borrowing or printing more money. The Kenya Government has in the past used the two ways of financing its deficit in a balanced manner. The effect in interest rates is whether the deficit is financed through printing or borrowing. The
Government would borrow in the S.T market which increase the demand of available funds for lending which subsequently pushes the interest rates up.
If the Government prints more money this will lead to inflation and the interest rate would eventually rise. Therefore the larger the Government deficit, the higher the level of interest rates.
3. Foreign Trade Balance
If the Government buys (imports) more than it sells (exports) there will be a trade deficit which will require financing. The main source of financing could be debt. This Government would once again go into the market and borrow and cause an upward pressure on funds available for lending.
This causes the interest rates to go up. If there was a favourable balance of trade the Government could not borrow and the interest rates could remain relatively stable.
4. Business activity cycle
The interest rates also depends on business cycles (as above). As the economy moves in the four (4) business cycles, interest rates will shift as well e.g during economic recessions, short-term interest rates experience sharp decline than L.T interest rates. This is because of the following reasons:
The CBK operates mainly in the S.T Sector (market) and its intervention has a major effect on S.T interest rates.
ii) L.T interest rates generally reflect the average expected inflation rate over the next 10 – 20 years.
These expectations do not change generally because L.T interest rates are fixed due to debt covenants entered into during borrowing time.
Other Determinants of Market Interest Rates (Required Rate of Return)
5. Risk free rate – This is the interest rate that would exist on default free securities such as Treasury bills and bonds.
Risk free rate is made up of two components:
Real rate of return – interest rate if there was no inflation
Therefore risk free rate (RF) = Real rate of return + Inflation premium.
If risk premium is added to risk free rate, required rate of return is derived. Therefore required rate of return = real rate + inflation + premium + risk premium = Risk free rate + Risk premium.
6. Inflation premium – Investors are compensated for reduction in purchasing power of money. From point (1) the higher the inflation premium, the higher the market interest rate.
7. Default risk premium (DRP)
This is the rate added to risk free rate for possibility of default in payment of loans. Usually, its added if two securities have equal maturity and marketability.
8. Liquidity premium – This is premium added to equilibrium interest rate on a security if that security cannot be converted to cash on short notice and close to the original cost.
9. Maturity Risk Premium – a premium reflecting interest rate risk i.e risk of capital losses which investors are exposed to because of hanging interest rate over time.
INTEREST RATE LEVELS AND STOCK PRICES
Interest rates have two effects on corporate profits:
a) Because interest rate is a cost, the higher the rate of interest the lower the firm’s profit other things held constant.
b) Interest rates affect the level of economic activities which affect the level of corporate profit.
Interest rates obviously affect stock prices because of the effect on profit but even more importantly they have an effect due to the competition in the market between shares and bonds.
If interest rates rise sharply, investors can get higher returns in the bond (money) market which induces them to sell shares (stocks) and transfer the funds from stock market to money market (Treasury bills).
Such transfers in response to increase in interest rates reduces demand for shares in the stock exchange and this obviously depresses the share prices e.g in mid and late 1993 the CBK intervened in the short term market where it floated Treasury Bills whose interest rate was as high as 88% well above the returns that can be expected from high yield stocks.
Accordingly, investors removed (misdirected) their money (funds) from the stock market into Treasury Bills. The result was a stagnation of stock prices of quoted firms. Accordingly as CBK achieved its objective of reducing the money supply in the economy the interest rates declined well below 30% and the immediate effect was a rebuild in demand for shares and the share prices shot up instantaneously around February 1994.
Importance of Interest Rates
These are of a particular relevance to a finance manager because:
i) They measure the cost of borrowing.
ii) Interest rates in a country influence the foreign exchange rate of the country’s currency.
iii) Interest rates act as a guide to the sort of return that firm’s shareholders might want hence changes in interest rates will affect rates for an approved creditworthy borrower.
Interest may be
a) Base lending rates – Banks lend to individual and small firm’s at certain margins above the base lending rates. It is therefore the rates for an approved creditworthy borrower.
b) Inter-Bank Lending rates
For large loans to big firms, banks will set interest rates at a margin below base rates rather than above base lending rates.
The Treasury Bills Rates – Risk Free
The rates at much central bank sells treasury bills to the market.
Treasury bills are used to raise, short-term funds for the government. Securities issued by the government to raise long term funds are called gilt-edged securities.
Why interest rates differ in different markets segments
Interest rates may differ in different market and market segment because of:
i) Size of the loan: Deposits above certain amounts into the bank might attract higher interest rates than smaller deposits. Consequently, large borrowers would be charged higher interest rates than small borrowers.
ii) Risks: Higher risk borrowers must pay higher rates on their borrowing to compensate lenders for greater risks involved.
iii) The need to make a profit in re-lending: e.g banks borrow for depositors and charge higher interest (profit margin) when they lend to borrowers.
iv) Duration of the lending
The L.T. loans will earn a higher rate of interest than shorter term loans due to the maturity risk premium.
v) International interest rates: This vary from one country to another due to differing rates of inflation and government policies on interest rates and foreign currency exchange rates.
vi) Different types of financial assets:
Building societies must offer higher yields to depositors to attract them using bonds which have high rate of return.
METHODS/MODELS OF COMPUTING COST OF CAPITAL
The following models are used to establish the various costs of capital or required rate of return by the investors:
Risk adjusted discounting rate
Market model/investors expected yield
Capital asset pricing model (CAPM)
Dividend yield/Gordon’s model.
i) Risk adjusted discounting rate – This technique is used to establish the discounting rate to be used for a given project. The cost of capital of the firm will be used as the discounting rate for a given project if project risk is equal to business risk of the firm. If a project has a higher risk than the business risk of the firm, then a percentage risk premium is added to the cost of capital to determine the discounting rate i.e. discounting rate for a high risk project = cost of capital + percentage risk premium. Therefore a high risk project will be evaluated at a higher discounting rate.
ii) Market Model – This model is used to establish the percentage cost of ordinary share capital cost of equity (Ke). If an investor is holding ordinary shares, he can receive returns in 2 forms:
Capital gain is assumed to constitute the difference between the buying price of a share at the beginning of the (P0), the selling price of the same share at the end of the period (P1). Therefore total returns = DPS + Capital gains = DPS + P1 – P0.
The amount invested to derive the returns is equal to the buying price at the beginning of the period (P0) therefore percentage return/yield =
Total returns x 100 = DPS + P1 – P0 x 100
For the past 5 years, the MPS and DPS for XYZ Ltd were as follows:
MPS as at 31st Dec
DPS for the year
Determine the estimated cost of equity/shareholders percentage yield for each of the years involved.
iii) Capital asset pricing model (CAPM) – CAPM is a technique that is used to establish the required rate of return of an investment given a particular level of risk. According to CAPM, the total business risk of the firm can be divided into 2:
Systematic Risk – This is the risk that affects all the firms in the market. This risk cannot be eliminated/diversified. It is thus called undiversifiable risk. Since it affects all the firms in the market, the share price and profitability of the firms will be moving in the same direction i.e. systematically. Examples of systematic risk are political instability, inflation, power crisis in the economy, power rationing, natural calamities – floods and earthquakes, increase in corporate tax rates and personal tax rates, etc. Systematic risk is measured by a Beta factor.
Unsystematic risk – This risk affects only one firm in the market but not other firms. It is therefore unique to the firm thus unsystematic trend in profitability of the firm relative to the profitability trend of other firms in the market. The risk is caused by factors unique to the firm such as:
Labour strikes by employees of the firm;
Exit of a prominent corporate personality;
Collapse of marketing and advertising programs of the firm on launching of a new product;
Failure to make a research and development breakthrough by the firm, etc
CAPM is only concerned with systematic risk. According to the model, the required rate of return will be highly influenced by the Beta factor of each investment. This is in addition to the excess returns an investor derives by undertaking additional risk e.g cost of equity should be equal to Rf + (Rm – Rf)BE
Cost of debt = Rf + (Rm – Rf)Bd
Where: Rf = rate of return/interest rate on riskless investment e.g T. bills
Rm = Average rate of return for the entire stock as shown by average
Percentage return of the firms that constitute the stock index.
Be = Beta factor of investment in ordinary shares/equity.
Bd = Beta factor for investment in debentures/long term debt capital.
KK Ltd is an all equity firm whose Beta factor is 1.2, the interest rate on T. bills is currently at 8.5% and the market rate of return is 14.5%. Determine the cost of equity Ke, for the company.
Rf = 8.5% Rm = 14.5% Beta of equity = 1.2
Ke = Rf + (Rm – Rf)BE
= 8.5% + (14.5% - 8.5%) 1.2
= 8.5% + (6%)1.2
iv) Dividend yield/Gordon’s Model – This model is used to determine the cost of various capital components in particular:
Cost of equity - Ke
Cost of preference share capital (perpetual) – Kp
Cost of perpetual debentures – Kd
Cost of equity (Ke)– This can be determined with respect to:
Zero growth firm – P0 = d0 Therefore =
R = Ke
Where: d0 = DPS
R0 = Current MPS
Constant growth firm – P0 =
b) Cost of perpetual preference share capital (Kp)
Recall, value of a preference share (FRS) = Constant DPS
Therefore: dp = Preference dividend per share
Pp = Market price of a preference share
c) Cost of perpetual debenture (Kd) – Debentures pay interest charges, which an allowable expenses for tax purposes.
Recall, Value of a debenture (Vd) = Interest charges p.a. in ∞
Cost of debt Kd
Therefore Kd =
Where: Kd = % cost of debt
T = Corporate tax rate
Vd = Market value of a debenture
Cost of Redeemable Debentures and Preference Shares
Redeemable fixed return securities have a definite maturity period. The cost of such securities is called yield to maturity (YTM) or redemption yield (RY). For a redeemable debenture Kd (cost of debt) = YTM = RY, can be determined using approximation method as follows:
Where: Int. = Interest charges p.a.
T = Corporate tax rate
M = Par or maturity value of a debenture
Vd = Current market value of a debenture
n = Number of years to maturity
WEIGHTED AVERAGE COST OF CAPITAL (W.A.C.C.)
This is also called the overall or composite cost of capital. Since various capital components have different percentage cost, it is important to determine a single average cost of capital attributable to various costs of capital. This is determined on the basis of percentage cost of each capital component.
Market value weight or proportion of each capital component.
Where: Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital respectively
E, P and D = Market value of equity, preference share capital and debt capital respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.
The following is the capital structure of XYZ Ltd as at 31/12/2002.
Ordinary share capital Sh.10 par value
10% preference share capital Sh.20 par value
12% debenture Sh.100 par value
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to grow at 5% p.a. in future. The current MPS is Sh.40.
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
c) What are the weaknesses associated with WACC when used as the discounting rate, in project appraisal.
a) i) Compute the cost of each capital component
Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth rate dividend model to determine the cost of equity.
d0 = Sh.5 P0 = Sh.40 g = 5%
Cost of perpetual preference share capital (Kp) – preference shares are still selling at par thus MPS = par value. If this is the case, Kp = coupon rate = 10%.
MPS = Par value = Sh.20
Dp = 10% x Sh.20 = Sh.2
Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a redeemable fixed return security thus the cost of debt is equal to yield to maturity.
Interest charges p.a. = 12% x Sh.100 par value
Maturity period (n)
Maturity value (m)
Current market value (Vd)
Corporate tax rate (T)
= 10 years
ii) Compute the market value of each capital component
Market value of Equity (E) = MPS x No. of ordinary shares
= = 1,600
Market value of preference share capital (P)
= Par value, since MPS = Par value per share = 100
Market value of debt (D) = Vd x No. of debentures
= = 180
E + P + D = V = total Market Value = 1,880
iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%
a) Using weighted average cost method,, WACC =
= 15.43 + 0.5319 + 0.9574
b) By using percentage method,
WACC = Total monetary cost
Total market value (V)
Where: Monetary cost = % cost x market value of capital
Monetary cost of E = 18.13% x 1,600 = 290.08
Monetary cost of P = 10% x 100 = 10.00
Monetary cost of D = 10% x 180 = 18.00
Total market value (V) 1,880
Therefore WACC = = 16.92%
b) In computation of the weights or proportions of various capital components, the following values may be used:
Market Value – This involves determining the weights or proportions using the current market values of the various capital components. The problems with the use of market values are:
The market value of each security keep on changing on daily basis thus market values can be computed only at one point in time.
The market value of each security may be incorrect due to cases of over or under valuation in the market.
Book values – This involves the use of the par value of capital as shown in the balance sheet. The main problem with book values is that they are historical/past values indicating the value of a security when it was originally sold in the market for the first time.
Replacement values – This involves determining the weights or proportions on the basis of amount that can be paid to replace the existing assets. The problem with replacement values is that assets can never be replaced at ago and replacement values may not be objectively determined.
Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic value of a given security. Intrinsic values may not be accurate since they are computed using historical/past information and are usually estimates.
e) Weaknesses of WACC as a discounting rate
WACC/Overall cost of capital has the following problems as a discounting rate:
It can only be used as a discounting rate assuming that the risk of the project is equal to the business risk of the firm. If the project has higher risk then a percentage premium will be added to WACC to determine the appropriate discounting rate.
It assumes that capital structure is optimal which is not achievable in real world.
It is based on market values of capital which keep on changing thus WACC will change over time but is assumed to remain constant throughout the economic life of the project.
It is based on past information especially when determining the cost of each component e.g in determining the cost of equity (Ke) the past year’s DPS is used while the growth rate is estimated from the past stream of dividends.
When using market values to determine the weight/proportion in WACC, the cost of retained earnings is left out since it is already included or reflected in the MPS and thus the market value of equity. Retained earnings are an internal source of finance thus, when they are high there is low gearing, lower financial risk and thus highest MPS.
Marginal cost of finance
This is cost of new finances or additional cost a company has to pay to raise and use additional finance
is given by:
Total cost of marginal finance x 100
Cost of finance (COF)
Cost of finance may be computed using the following information:
i) Marginal cost of each capital component.
ii) The weights based on the amount to raise from each source.
a) Investors usually compute their return basing their figures on market values or cost of investment.
b) Investors purchase their investment at market value and as such, the cost of finance to the company must be weighted against expectations based on the market conditions.
c) Investments appreciate in the stock market and as such the cost must be adjusted to reflect such a movement in the value of an investment.
1. Marginal cost of equity
MCE = (for zero growth firm)
Also cost of equity
Ke = (for normal growth firm)
Where: d1 = expected DPS = d0(1+g)
P0 = current MPS
f = floation costs
g = growth rate in equity
2. Cost of preference share capital:
Where: Kp = Cost of preference
Dp = Dividend per share
Po = MPS (Market price per share)
F = Flotation costs
3. Cost of debenture
Where: Kd = Cost of debt
Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate
4. Just like WACC, weighted marginal cost of capital can be computed using:
i) Weighted average cost method
ii) Percentage method
XYZ Ltd wants to raise new capital to finance a new project. The firm will issue 200,000 ordinary shares (Sh.10 par value) at Sh.16 with Sh.1 floatation costs per share, 75,000 12% preference shares (Sh.20 par value) at Sh.18 with sh.150,000 total floatation costs, 50,000 18% debentures (sh.100 par) at Sh.80 and raised a Sh.5,000,000 18% loan paying total floatation costs of Sh.200,000. Assume 30% corporate tax rate. The company paid 28% ordinary dividends which is expected to grow at 4% p.a.
a) Determine the total capital to raise net of floatation costs
b) Compute the marginal cost of capital
Ordinary shares 200,000 shares @ Sh.16
Less floatation costs 200,000 shares @ Sh.1
Preference shares 75,000 shares @ Sh.18
Less floatation cost
Debentures 50,000 debentures @ Sh.80
Less floatation costs
Total capital raised
b) Marginal cost of equity Ke
d0 = 28% x Sh.10 par = Sh.2.80
g = 4%
f = Sh.1.00
P0 = Sh.16
Therefore marginal = = 0.234 = 23.4%
Marginal cost of preference share capital Kp
Kp = dp
dp = 12% x Sh.20 par = Sh.2.40
P0 = Sh.18
f = Floatation cost per share = Sh.150,000 = Sh.2.00
Kp = 2.40 = 0.15 = 15%
18 – 2
Marginal cost of debenture Kd:
Kd = Int (1-t)
f = 0
Vd = Sh.80
Int = 18% x Sh.100 par = Sh.18
T = 30%
Kd = 18(1-0.3) = 0.1575 = 15.75%
Marginal cost of loan Kd
Kd = Int (1-t)
T = 30%
Vd = Sh.5 million
f = Sh.0.2 million
Int = 18% x Sh.5M = Sh.0.9M
Kd = 0.9 (1-0.3) = 0.13125 = 13.13%
5 – 0.2
Amount to raise before f. costs
% marginal cost
Weighted marginal cost = 2,080.3 x 100 = 16.58%
The following is the existing capital structure of Company XYZ Ltd.
Ordinary shares at Shs.10 par
12% preference shares Shs.10 par
16% loan Shs.100 par
Total capital employed
The company’s ordinary shares have a dividend cover of 3 times and pays a dividend of 10% on its ordinary share capital.
Ordinary shares sells at Shs.18
Preference shares sell at Shs.15
Debentures are selling at par. The tax rate is 30%
a) Growth in Equity. (10 marks)
b) W.A.C.C. (10 marks)
Capital structure and financial structure.
Distinguish between Business risk and Financial risk.
What is the effect of introduction of debt capital on weighted average cost of capital (WACC)
Differentiate between marginal weighted cost of capital (MWCC) and WACC
a) Define the term weighted average cost of capital. (3 marks)
b) What is meant by the marginal weighted average cost of capital? (3 marks)
c) Com-Tech Company Ltd. is in the Telecommunications Industry. The company’s balance sheet as at 31 March 2000 is as below:
Liability and Owners Equity
18% debentures (sh.1,000 par)
10% preference shares
Ordinary shares (Sh.10 par)
Net fixed assets
The debentures are now selling at Sh.950 in the market and will be redeemed 10 years from now.
By the end of last financial period, the company had declared and paid Sh.5.00 as dividend per share. The dividends are expected to grow at an annual rate of 10% in the foreseeable future. Currently, the company’s shares are trading at Sh.38 per share at the local stock exchange.
The preference shares were floated in 1995 and their prices have remained constant.
Most banks are lending money at an interest of 22% per annum.
The Corporation tax rate is 40% per annum.
i) Calculate the market weighted cost of capital for this firm. (12 marks)
ii) “The book-value weights should be used discreetly when computing weighted cost of capital”. Why” (2 marks)
Assume that on 31 December 2001 you are provided with the following capital structure of Hatilcure Ltd which is optimal.
Long term debt (16%) 135,000
Ordinary share capital (Sh.10 par) 90,000
Retained earnings 75,000
The company has total assets amounting to sh.360 million but this figure is expected to rise to Sh.500 million by he end of 2002. You are also informed that:
Any new equity shares sold will net 90% after flotation costs.
For the year just ended the company paid Sh.3.00 in dividends per share.
New 16% debt can be raised at par through the stock exchange.
The past and expected earnings growth rate is 10%
The current dividend yield is 12%
The company’s dividend payout ratio of 50% shall be maintained in 2002.
Assume marginal at rate of 40%
The company’s capital structure is optimal
Company’s net amount to the capital budget to be financial with equity if 85% of the asset expansion is included in the 2002 capital budget. (3 marks)
How many shares must be sold to raise the required equity capital? Round your figure o the nearest thousand. (8 marks)
What is the firm’s marginal cost of capital? Show full workings. (10 marks)
CHECK YOUR ANSWERS WITH THOSE GIVEN IN LESSON 10 OF THE STUDY PACK
COMPREHENSIVE ASSIGNMENT 2
TO BE SUBMITTED AFTER LESSON 4
To Be Carried Out Under Examination Condition and Sent to Distance learning Administrator for marking by the University
Answer All Questions Time Allowed: Three Hours
a) How can the action of shareholders reduce the value of the bond held by
debenture holders? (10 marks)
b) State and explain the mechanism of resolving the agency problem
between shareholders and debenture holders. (10 marks)
a) Explain the term ‘gearing’ in relation to the capital structure of a limited liability
company. (4 marks)
b) Ayet Ltd. and Bayet Ltd. are two small size companies operating in Mombasa, Kenya. The following information has been provided for the year ended 30 April 1998:
Ordinary share capital Sh.10 par
10% preference shares of Sh.10 par
Calculate the gearing ratio of each company and state in each case whether the gearing is high or low. (Calculate to 2 decimal places). (6 marks)
Calculate the maximum percentage dividend on ordinary shares which each company could declare, without utilizing, or adding to, accumulated retained profits if profits for the year ended 30 April 1998 was:
Net profit (before Interest and tax)
(Corporation tax rate is 40%)
Comment on the results of b(ii) above. (2 marks)
The following information is provided in respect to the affairs of Pote Limited which prepares its account on the calendar year basis.
Cost of goods sold
Stock at 31 December
Debtors at 31 December
Creditors at 31 December
Total assets at 31 December
Stock and debtors at 1 January 1994 amounted to Sh.70,000 and Sh.98,000 respectively.
a) Calculate the rate of stock turnover expressed:
i) As a ratio; (3 marks)
ii) In days, for each of the years 1994 and 1995. (3 marks)
b) Calculate the rate of collection of debtors, in days, for each of the years 1994 and 1995. (3 marks)
c) Calculate the rate of payment to creditors, in days, for each year 1994 and 1995.
d) Show the cash operating cycle for each year. (6 marks)
e) Comment on the results. (6 marks)
a) Briefly explain the meaning of a “floating rate” bond. (4 marks)
b) From the point of view of a company’s financial manager, outline the merits and demerits, to the company, of issuing floating rate debt as a means of raising capital.
The Altman formula for prediction of bankruptcy is given as follows:
Z score = 1.2X1 + 1.4X2 + 3.3X3 + 1X4 + 0.6X5
Where: X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Sales/Total assets
X5 = Market value of Equity/Liabilities
In this model, a Z-score of 2.7 or more indicates non-failure and a Z-score of 1.8 or less indicates failure.
You are provided with the following information in respect of four listed companies.
Earnings before interest and tax
Market value of equity
a) The Z-Score for each of the companies. Comment on the results obtained. (10 marks)
b) It has been suggested that other ratios ought to be incorporated into Altman’s bankruptcy prediction model. What is your opinion on this? (5 marks)
c) List the indicators of possible business failure. (5 marks)
END OF COMPREHENSIVE ASSIGNMENT NO.2
NOW SEND TO DISTANCE LEARNING FOR MARKING
Read Chapters 7, 11 and 12 of Financial Management text book by I.M. Pandey
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Importance of investment analysis
Methods of analysing /evaluating projects
Comparisons of the Methods
Replacement of Assets
Any company will invest finance for the sake of deriving a return which is useful for four main reasons:
1. To reward the shareholders or owners of the business for staking their money and by foregoing their current purchasing power for the sake of current and future return.
2. To reward creditors by paying them regular return in form of interest and repayment of their principal as and when it falls due.
3. To be able to retain part of their earnings for plough back purposes which facilitates not only the companies growth present and the future but also has the implication of increasing the size of the company in sales and in assets.
4. For the increase in share prices and thus the credibility of the company and its ability to raise further finance.
Such a return is necessary to keep the company’s operations moving smoothly and thus allow the above objective to be achieved.
A financial manager with present investment policies will be concerned with how efficiently the company’s funds are invested because it is from such investment that the company will survive. Investments are important because:
i) They influence company’s size
ii) Influence growth
iii) Influence company’s risks
In addition, this investment decision making process also known as capital budgeting, involves the decision to invest the company’s current funds in viable ventures whose returns will be realised for long term periods in future. Capital budgeting as financial planning is characterised by the following:
1. Decisions of this nature are long term i.e. extending beyond one year in which case they are also expected to generate returns of long term in nature.
2. Investment is usually heavy (heavy capital injection) and as such has to be properly planned.
3. These decisions are irreversible and any mistake may cause the company heavy losses.
Importance of Investment Decisions
a) Such decisions are importance because they will influence the company’s size (fixed assets, sales, and retained earnings).
b) They increase the value of the company’s shares and thus its credibility.
c) The fact that they are irreversible means that they have to be made carefully to avoid any mistake which can lead to the failure of such investment.
d) Due to heavy capital outlay, more attention is required to avoid loss of huge sums of money which in the extreme may lead to the closure of such a company. However, these decisions are influenced by:
i) Political factors – Under conditions of political uncertainty, such decisions cannot be made as it will entail an element of risk of failure of such investment. Thus political certainty has to be analysed before such decisions are made, such factors must be taken into account such that the company forecasts the inflows and outflows within given
limitations such as the degree of competition, performance of economy, changing tastes etc. which influence ability to generate sufficient return from a venture which will pay not only interest but principal on such funds invested.
ii) Technological factors – These influence the returns of the company because such technology will affect the company’s ability to utilise its assets to the utmost ability in particular if such assets become obsolete and cannot generate good returns or the output of such machines may be low with time and may not meet planned expectations which in most cases will have an impact on inflows from a venture.
Methods of Analyzing Investment
Capital Budgeting Methods.
There are two methods of analyzing the viability of an investment:
a) Traditional methods
Pay back period method
Accounting rate of return method
b) Modern methods (Discounted cash flow techniques)
NPV – Net present value method
IRR – Internal rate of return method
PI – Profitability index method
For the above two (a & b) methods to be used, they have to meet the following:
i) They should rank ventures available in the investment market according to their viability i.e. they should identify which method is more viable than others.
ii) They should rank a venture first if the venture brings in return earlier and in large lumpsums than if a venture brought in late and less inflows over the same period.
iii) Should rank any other projects as and when it is available in the investment market. Such methods should take into account that all returns (inflows), must be cash returns as it is necessary to be able to finance the cost of the venture.
Pay back period method
This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can payback and for this reason PBP (or payout period or payoff) is that period of time or duration it will take an investment venture to generate sufficient cash inflows to payback the cost of such investment. This is a popular approach among the traditional financial managers because it helps them ascertain the time it will take to recoup in form of cash from operations the original cost of the venture. This method is usually an important preliminary screening stage of the viability of the venture and it may yield clues to profitability although in principle it will measure how fast a venture may payback rather than how much a venture will generate in profits and yet the main objectives of an investment is not to recoup the original cost but also to earn a profit for the owners or investors.
Computation of payback period:
1. Under uniform annual incremental cash inflows – if the venture or an asset generates uniform cash inflows then the payback period (PBP) will be given by:
PBP = Initial cost of the venture
Annual incremental cost
e.g. If a venture costs 37,910/= and promises returns of 10,000/= per annum indefinitely then the PBP =
= 3.79 years
The shorter the PBP the more viable the investment and thus the better the choice of such investments.
2. Under non-uniform cash inflows:
Under non-uniformity PBP computation will be in cumulative form and this means that the net cash inflows are accumulated each year until initial investment is recovered.
Assume a project costs Sh.80,000 and will generate the following cash inflows:
Cash inflows Accumulated inflows
Inflows year 1 = 10,000 10,000
Inflows year 2 = 30,000 40,000
Inflows year 3 = 15,000 55,000
Inflows year 4 = 20,000 75,000
Inflows year 5 = 30,000 105,000
The Sh.80,000 cost is recovered between year 4 and 5. During year 5 (after year 4) Sh.5,000 is (80,000 – 75,000) is required out the total year 5 cash flows of 30,000.
Therefore the PBP = = 4.17 years
Cedes limited has the following details of two of the future production plans. Only one of these machines will be purchased and the venture would be taken to be virtually exclusive. The Standard model costs £50,000 and the Deluxe cost £88,000 payable immediately. Both machines will require the input of the following:
i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe
ii) A £10,000 working capital through their working lives.
Both machines have no expected scrap value at end of their expected working lives of 4 years for the Standard machine and six years for the Deluxe. The operating pre-tax net cash flows associated with the two machines are:
The deluxe machine has only been introduced in the market and has not been fully tested in the operating conditions, because of the high risk involved the appropriate discount rate for the deluxe machine is believed to be 14% per annum, 2% higher than the rate of the standard machine. The company is proposing the purchase of either machine with a term loan at a fixed rate of interest of 11% per annum, taxation at 30% is payable on operating cash-flows one year in arrears and capital allowance are available at 25% per annum on a reducing balance basis.
For both the Standard and the Deluxe machines, calculate the payback period.
Establish the cash flows as follows:
Pre-tax inflows (EBDT) XX
Less depreciation = capital allowance (XX)
Earnings before tax XX
Less tax (XX)
Earnings after tax XX
Add back capital allowance/depreciation XX
Operating cash flows XX
Capital allowance/depreciation is a non-cash item thus when deducted for tax purposes, it should be added back to eliminate the non-cash flow effects.
Cash flows for standard machine:
Less allowance (depreciation)
Taxable cash inflows
Tax @ 30% 1 yr in arrears
Add back capital allowance
Operating cash flows
Add working capital realised
Total cash flows
Cash flows for Deluxe machine
Tax @ 30% in arrears
Inflows after tax
Add back capital
Add back w/capital
Total cash flows
Cost 50,000 + 20,000 70,000 88,000 + 40,000 128,000
* Pay back period for standard: Initial capital of Sh.7,000 is recovered during year 3. After year 2, we require 70,000 – 9,060 = 18,940 to recover initial capital out of year 3 cash flows of Sh.20,389.
* Applying the same concept for Deluxe, payback period would be:
= 4.39 years
Accounting Rate of Return Method (ARR)
This method uses accounting profits from financial status to assess the viability of investment proposal by diving the average income after tax by average investment. The investment would be equal to either the original investment plus the salvage value divided by two or the initial investment divided by two or dividing the total of the investment book value after depreciating by the life of the project. This method is also known as financial statement method or book value method. The rate of return on asset method or adjusted rate of return method is given by:
ARR = Average income x 100 or Average income – Average depreciation
Average investment Initial investment
Unlike PBP, this method will ascertain the profitability of an investment and it will give results which are consistent with those given by return ratios e.g.
Project X cost 500,000
Scrap value 100,000
Stream of income before depreciation and taxes are as follows:
Year 1 100,000
Year 2 120,000
Year 3 140,000
Year 4 160,000
Year 5 200,000
Let tax = 50% and depreciation straight line. Calculate the accounting rate of return.
Depreciation = 500,000 – 100,000 = Shs.80, 000
Earnings before tax EBT
Less tax @ 50%
Average income (EAT) = 32,000
Average investment = (500,000 + 100,000) ½ = 300,000
Or ARR = Average income x 100 = 32,000 x 100 = 10.67%
Average investment 300,000
The best method of depreciation to use should be that which will produce larger depreciation changes in the 1st few years of the assets life and lesser changes in the later years because this will produce a higher tax shield to the company with higher value of inflows. Thus reducing balance is preferred as compared to sum of digits and straight line method.
The salvage value should be treated as follows:
If the asset produces a salvage value at the end of the year, this will increase inflows for payback period. This value is only used to ascertain how much the company will reduce original cost of investment to obtain average investment.
Acceptance Rule of Payback Period (Pbp)
Using PBP method a company will accept all those ventures whose payback period is less than that set by the management and will reject all those ventures whose PBP is more than that set by the management. Alternatively, PBP may be gauged against the term of the loan in which case the PBP method will give a high ranking to all those ventures paying back before the term of the loan and the highest ranking will be given to those projects with shortest PBP. However, in assessing the viability of a venture it is also important to see which venture brings returns earlier, other things being equal.
Advantages of Payback Period
1. Simple to use and understand and this has made it popular among executives especially traditional financial managers in ascertaining the viability of a venture.
2. Ideal under high-risk investments because it will identify which venture will payback earlier thus minimising the risks with a venture.
3. Advantageous when choosing between mutually exclusive projects because it will give a clue as to which venture is viable if one considers the shortest PBP and the highest inflow of a venture.
Disadvantages of Payback Period
1. Does not take into account time value of money and assumes that a shilling received in the 1st year and in the Nth year have the same value so as to rank them together to ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now.
2. PBP method does not measure the profitability of a venture but rather measures the period of time a venture takes to pay back the cost. The method is outside looking (lender oriented rather than owner oriented).
3. PBP method ignores inflows after PBP and as such, it does not accommodate the element of return to an investment.
4. This method will not have any impact on the company’s share prices because profitability which is one of the most important factors in gauging the company’s value of shares is not a function of PBP and as such the method fall short of meeting the criteria of investment appraisal.
Acceptance Rule of Accounting Rate of Return (Arr)
ARR method will accept those projects whose ARR is higher than that set by management or bank rate and it will give highest ranking to ventures with highest ARR and vice versa.
1. Simple to understand and use.
2. Readily computed from accounting data thus much easier to ascertain.
3. It is consistent with profitability objectives as it analyses the return from entire inflows and as such it will give a clue or a hint to the profitability of venture.
1. It ignores time value of money.
2. It does not consider how soon the investment should recover the cost (it is owner looking than creditor oriented approach).
3. It uses accounting profits instead of cash inflows some of which may not be realisable.
MODERN METHODS OR DCF i.e. Discounted Cash Flow Techniques
1. Present Value Concept
This concept acknowledges the fact that a shilling losses value with time and as such if it is to be compared with a shilling to be received in Nth year then the two must be at the same values. This means that an investor’s analytical power is increased by his/her ability to compare cash inflows and outflows separated from each other by time. He/she should be able to work in the reverse direction i.e. from future cash flows to their present values.
2. Present Value of a Lumpsum
Usually an investor would wish to know how much he/she would give up now to get a given amount in year 1, 2, … n. In this situation he would have to decide at what rate of discount also known as time preference rate, he/she will use to discount the anticipated lumpsum using this rate by applying the following formula:
Where: Pv = Present value
L = Lumpsum
K = Cost of finance or time preference rate
n = given year.
This implies that if the time preference rate is 10%, the present value of 1/= to e received at the end of year 1 is:
The present value of inflows to be received in the 2nd year to Nth year, will be equal to:
Where: A = annual cash flows
N = Number of years
Also, the present value of a shilling to be received at a given point in time can in addition to using the above formula, be found using the present value tables.
Suppose that an investor can expect to receive:
40,000 at the end of year 2
70,000 at the end of year 6
100,000 at the end of year 8
Compute his present (value) if his time preference is 12%.
= 40,000(0.7992) + 70,000(0.5066) + 100,000(0.4039)
3. Present Value of an Annuity
An individual investor may not necessarily get a lumpsum after some years but rather get a constant periodic amount i.e. an annuity for certain number of years. The present value of an annuity receivable where the investor time preference is 10% equal to:
I = time preference rate
E.g. Pv of 1/= to be received after 1 year if time preference rate is 10%.
After 2 years it will be:
1st year - 0.9090
2nd year - 0.8264
3rd year - 0.7513
4th year - 0.6830
Total - 3.1697
4. Present Value of Uneven Periodic Sum
In investment decisions it is very rare to get even periodic returns and in most cases a company will generate a stream of uneven cash inflows from a venture and the present value of those uneven periodic sums is equal to:
Where: At = Uneven cash inflows at time t
Pv = Present value
K =Cost of finance
A company contemplates to receive Shs.:
20,000 in year 1
18,000 in year 2
24,000 in year 3
Nil in year 4
40,000 in year 5
Cost of this finance is 12%
Compute present value of that finance
5. Net Present Value Method
The method discounts inflows and outflows and ascertains the net present value by deducting discounted outflows from discounted inflows to obtain net present cash inflows i.e the present value method will involve selection of rate acceptable to the management or equal to the cost of finance and this will be used to discount inflows and outflows and net present value will be equal to the present value of inflow minus present value of outflow. If net present value is positive you invest, If NPV is negative you do not invest.
Pv(inflow) – Pv(outflows) = NPV
Initial outflow is at period zero and their value is their actual present value. With this method, an investor can ascertain the viability of an investment by discounting outflows. In this case, a venture will be viable if it has the lowest outflows.
Where: A = annual inflow
K = Cost of finance
C = Cost of investment
N = Number of years
Cost of investment = 100,000/=, interest rate = 10%, inflows year 1 = 80,000/= year 2 = 50,000/=
= 14,049 positive hence invest.
Jeremy limited wishes to expand its output by purchasing a new machine worth 170,000 and installation costs are estimated at 40,000/=. In the 4th year, this machine will call for an overhaul to cost 80,000/=. Its expected inflows are:
Year 1 60,000
Year 2 72,650
Year 3 35,720
Year 4 48,510
Year 5 91,630
Year 6 83,715
This company can raise finance to purchase machine at 12% interest rate.
Compute NPV and advise management accordingly.
Cost of machine at present value 170,000
Installation cost 40,000
Overhaul cost in the 4th year = 80,000
Discounting factor = (1.12)4
Therefore present value = 80,000 = Shs.50,841.446
Total present value of investment = 260,841.45
PV inflows =
Therefore: NPV = 262,147.28 – 260,841.45
NPV = 1,305.83
The NPV is positive and I would advise the management to invest.
Resilou limited intends to purchase a machine worth Shs.1,500,000 which will have a residue value Shs.200,000 after 5 years useful life. The saving in cost resulting from the use of this machine are:
Year 1 800,000
Year 2 350,000
Year 3 -
Year 4 680,000
Year 5 775,000
Using NPV method, advise the company whether this machine should be purchased if the cut off rate is 14% and acceptable saving in cost is 12% of the cost of the investment.
= 1,880,067.1 – 1,500,000
Return = = 25.337% > 12% hence invest.
NB: Assuming that the salvage will be realised.
A section of a roadway pavement costs £400 per year to maintain. What new expenditure of a new pavement is justified if no maintenance will be required for the 1st five years then £100 for the next 10 years and £400 a year thereafter? Assume cost of finance to be 5%.
Total present value of maintenance costs under the re-surfacing scheme.
Maximum expenditure =
Present value of an Annuity for n years is given by the formula:
Whereby: PV is Present value
A is annuity
K is cost of finance
n is number of year
Present value of an annuity to perpetuity is given by the formula
Whereby: PV is Present value
A is annuity
K is cost of finance
Therefore PV maximum expenditure =
PV = Minimum expenditure = £[4,453]
= Justified expenditure = £3,547
NB: The present value interest factors PVIF = and present value
Annuity factors, PVAF = can be read from tables provided at the point of interseption between the discounting rate and number of periods.
ACCEPT OR REJECT RULE OF NPV
Under this method, a company should accept an investment venture if N.P.V. is positive i.e. if present value of cash outflows exceeds that of cash inflows or at least is equal to zero. (NPV ≥0). This will rank ventures giving the highest rank to that venture with highest NPV because this will give the highest cash inflow or capital gain to the company.
Advantages of NPV
It recognises time value of money and such appreciates that a shilling now is more valuable than a shilling tomorrow and the two can only be compared if they are at their present value.
It takes into account the entire inflows or returns and as such it is a realistic gauge of the profitability of a venture.
It is consistent with the value of a share in so far as a positive NPV will have the implication of increasing the value of a share.
4. It is consistent with the objective of maximising the welfare of an owner because a positive NPV will increase the net worth of owners.
Disadvantages of NPV
It is difficult to use.
Its calculation uses cost of finance which is a difficult concept because it considers both implicit and explicit whereas NPV ignores implicit costs.
It is ideal for assessing the viability of an investment under certainty because it ignores the element of risk.
It may not give good assessment of alternative projects if the projects are unequal lives, returns or costs.
It ignores the PBP.
Irr (Internal Rate Of Return)
This method is a discounted cash flow technique which uses the principle of NPV. It is defined as the rate which equates the present value of cash outflows of an investment to the initial capital.
IRR = Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0.
It is also called internal rate of return because it depends wholly on the outlay of investment and proceeds associated with the project and not a rate determined outside the venture.
A = inflow for each period
C = Cost of investment
The value r can be found by:
i) Trial and error
ii) By interpolation
iii) By extrapolation
i) Trial and error method
a) Select any rate of interest at random and use it to compute NPV of cash inflows.
b) If rate chosen produces NPV lower than the cost, choose a lower rate.
c) If the rate chosen in (a) above gives NPV greater than the cost, choose a higher rate. Continue the process until the NPV is equal to zero and that will be the IRR.
A project costs 16,200/= and is expected to generate the following inflows:
Year 1 8,000
Year 2 7,000
Year 3 6,000
Compute the IRR of this venture.
1st choice 10%
= 17,565.74 > cost, choose a higher rate.
2nd choice 14%
3rd choice 15%
IRR lies between 14% and 15%.
ii) Interpolation method
PV at rate of 14% = 16,453.646
PV required = 16,200.000
PV at rate of 15% = 16,194.625
Therefore, r denotes required rate of return
Therefore, r = 14% + (15% - 14%) x
= 14% + 0.98%
Acceptance Rule of IRR
IRR will accept a venture if its IRR is higher than or equal to the minimum required rate of return which is usually the cost of finance also known as the cut off rate or hurdle rate, and in this case IRR will be the highest rate of interest a firm would be ready to pay to finance a project using borrowed funds and without being financially worse off by paying back the loan (the principal and accrued interest) out of the cash flows generated by that project. Thus, IRR is the break-even rate of borrowing from commercial banks.
Advantages of IRR
It considers time value of money
It considers cash flows over the entire life of the project.
It is compatible with the maximisation of owner’s wealth because, if it is higher than the cost of finance, owners’ wealth will be maximised.
Unlike the NPV method, it does not use the cost of finance to discount inflows and for this reason it will indicate a rate of return of interval to the project against which various ventures can be assessed as to their viability.
Disadvantages of IRR
Difficult to use.
Expensive to use because it calls for trained manpower and may use computers especially where inflows are of large magnitude and extending beyond the normal limits.
It may give multiple results some involving positive IRR in which case it may be difficult to use in choosing which venture is more viable.
PROFITABILITY INDEX (P.I.)
P.I. (benefit-cost ratio) = Present value of inflows
Present value of cash outlay
If P.I. is greater than 1.0, invest. If less than 1.0, reject.
The following information was from XYZ feasibility studies. It has studied two ventures:
a) Cost 100,000/= and 160,000/= at the beginning of the 4th year and it will generate inflows 1-3rd year 80,000/= and from 4-6th year 50,000/= per annum.
b) Initial cost 200,000/= and 80,000/= at the beginning of the 4th year and it will generate the following inflows:
1st – 2nd year -> Shs.100,000 per annum
3rd – 6th year -> Shs.70,000 per annum
Using the cost of finance of 12% compute the P.I. of these two ventures, advise the company accordingly.
a) Outflows: = 100,000 + 113,887 = 213,885
Inflows: = Shs.277,626
P.I. = 1.298
b) Outflows: = = 256,944
Inflows = = Shs.338,501
A company is faced with the following 5 investment opportunities:
P.I = Total P.v___
This company has 750,000/= available for investment projects, 3 and 4 are mutually exclusive. All of the projects are divisible. Which group should be selected in order to maximise the NPV. Indicate this NPV figure.
Using P.I. to rank the projects in order of preference 5, 4, 2, 1, 3.
In order to maximise NPV, the following projects combination should be selected:
Funds available for investment 750,000
Cost of project: 5 160,000
1 290,000 (750,000)
NPV = 90,000 + 100,000 + 40,000 + = 317,000
Advantages of profitability index
a) Simple to use and understand.
b) The element of NPV in the venture will indicate which venture is more powerful as the most profitable venture will have the highest P.I. as the difference or net P.I. will continue to the company’s profitability.
c) It acknowledges time value for money and at the same time the NPV of a venture at its present value which is consistent with investment appraisal requirements.
Disadvantages of profitability index
a) It may be useful under conditions of uncertain cost of finance used to discount inflows and yet this cost is a complex item due to the implicit and explicit element.
b) It may be difficult to ascertain if the economic life of a venture is long and it yields large inflows because their discounting may call for use of computers that are expensive.
COMPARISON OF METHODS
Both traditional and modern methods will show or indicate strong weaknesses such that a company cannot use either to select a viable venture and for this reason the selection of the investment will depend on which method the company has identified it can meet its investment needs. The choice should not be limited to one method but at least 2 modern methods. In all, when ranking projects, a conflict will rise between IRR and NPV especially under the following conditions:
i) If the lives of the projects are different.
ii) Where the cash outlay is larger than the other.
iii) When the cash flow pattern differs i.e the cash flows of one project may overtime increase while those of the other decrease. In this case NPV may give consistently correct solution especially so because it does not yield multiple rates.
PBP expresses the profitability of a project in terms of years. It does not show any return as measure of investment. The PBP reciprocal has been utilised to rectify the situation, but it is only of value where the pattern of cash flow is relatively consistent and where the life of the asset is at least double the payback period of the asset. The payback period is expressed as:
Annual cash flows
This PBP reciprocal is often used as a guide to ascertain the discount factor in discounted cash flow calculations i.e. to approximate IRR.
Payback period reciprocal =
REPLACEMENT OF ASSETS
Estate Developers purchased a machine five years ago at a cost of £7,500. The machine had an expected economic life of 15 years at the time of purchase and a zero estimated salvage value at the end of 15 years. It is being depreciated on a straight line basis and currently has a book value of £5,000. The Financial Manager has conducted a feasibility study aimed at acquiring a new machine for £12,000 and is depreciated over its 10 years useful life. The new machine will expand sales from £10,000 to £11,000 per annum and will reduce labour and materials usage sufficiently to cut operating cost from £7,000 to £5,000. The salvage value of the new machine is £2,000 at the end of useful life. The current market value of the old machine is £1,000 and tax is 40%. The firms cost of capital is 10%. The financial manager wishes to make a decision on whether to replace the old machine with a new one and he seeks your held.
N.B. The decision to replace takes into account the following:
a) Estimate the actual cash outlay attributable to the new machine
b) Determine the incremental cash flows.
c) Compute the NPV of incremental cash flows.
d) Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.
e) Ascertain whether the NPV (net present value) is positive or whether the IRR (internal rate of return) exceed the cost in which case invest if its positive.
a) Initial capital for new machines £
Cash price of new machine 12,000
Less market value of old machine (1,000)
Less tax shield on sale of old machine:
Market value 1,000
Less net book value 5,000
Loss on disposal 4,000
Tax shield = 40% x 4,000 (6,000)
Increamental initial capital 9,400
b) Depreciation of new machine = = 1,000
Depreciation of old machine = = 500
Increamental depreciation 500
NB: The NBV of old machine after 5 years is £5,000. This NBV will be depreciated over the remaining 10 years.
Determine operating cash flows:
Increamental sales = 11,000 – 10,000 1,000
Savings in labour costs = 5,000 – 7,000 2,000
Increamental EBDT 3,000
Less increamental depreciation (non-cash item) (500)
Increamental EBT 2,500
Less tax @ 40% 1,000
Increamental EAT 1,500
Add back increamental depreciation 500
Annual cash flow 2,000
Terminal cash flows at end of year 10 is equal to increamental salvage value.
New machine salvage value 2,000
Less old machine salvage value 0
Compute the NPV @10% cost of capital:
P.V of cash flows = 12,290
P.V of salvage value = 772
Less increamental initial capital (9,400)
Increamental N.P.V 3,662
Replace the old machine
What are the advantages of discounted cash flows methods?
Kiwanda Limited is considering the purchase of a new machine. Two alternative machines, Pesi TZO and Upesi MO2, which will cost Sh.6,000,000 and Sh.7,000,000 respectively are available in the market. The cash flow after taxation of each machine are as follows:
a) Compute the net present value of each machine. (8 marks)
b) Assuming that each machine represents a project:
Compute the return Kiwanda Limited expects to earn from each of the two projects. (10 marks)
Comment on the use of the results obtained in (a) and (b)(i) above in selecting between the two projects. (4 marks)
(Total: 22 marks)
The Weka Company Ltd. has been considering the criteria that must be met before a capital expenditure proposal can be included in the capital expenditure programme.
The screening criteria established by management are as follows:
No project should involve a net commitment of funds for more than four years.
Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the estimated cost of capital. Present estimates are that cost of capital as 15 percent per annum after tax.
Accepted proposals should average over the life time, an unadjusted rate of return on assets employed (calculated in the conventional accounting method at least equal to the average rate of return on total assets shown by the statutory financial statements included in the annual report of the company.
A proposal to purchase a new lathe machine is to be subjected to these initial screening processes. The machine will cost Sh.2,200,000 and has an estimated useful life of five years at the end of which the disposal value will be zero. Sales revenue to be generated by the new machine is estimated as follows:
Year Revenue (Sh.’000’)
Additional operating costs are estimated to be Sh.700, 000 per annum. Tax rates may be assumed to be 35% payable in the year in which revenue is received. For taxation purpose the machine is to be written off as a fixed annual rate of 20% on cost.
The financial accounting statements issued by the company in recent years shows that profits after tax have averaged 18% on total assets.
Present a report which will indicate to management whether or not the proposal to purchase the lathe machine meets each of the selection criteria. (Total: 19 marks)
a) What are the features of a sound appraisal technique? (6 marks)
b) What practical problems are faced by finance managers in capital budgeting decisions? (6 marks)
c) Describe the features of long term investment decisions. (8 marks)
KK Ltd has six projects available for investment as follows:
Initial cost Sh.’M’
NPV @ 15% cost of capital
The firm has Sh.100 M available for investment.
Identify which projects should be undertaken. Using P.I and NPV ranking, comment on your answer.
CHECK YOUR ANSWERS WITH THOSE PROVIDED IN THE LESSON 10
Read Chapter 8 of Financial Management text book by I. M Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Bases and importance of valuation
Valuation of ordinary shares
Valuation of bonds and Debentures
VALUATION OF BUSINESS
A business may be valued for different reasons such as for merger, takeover, acquisition, or outright sale or liquidation. In purchasing a business, a buyer will be interested in not only the assets but also the future income this business is expected to generate.
BASES OF VALUATION
1. Theoretical value – In theory, if a purchaser buys a business, he is simply buying a stream of future income flows and to arrive at the actual purchase price the buyer will:
a) Consider the estimated probable cash flows.
b) Discount cash flows to their present value.
c) Add together the separate amounts to give the present value of income stream. Where future income flows are constant:
Where: PV = Present value of income stream
c = Inflow per annum
r = Discounting rate
n = Number of years the inflows will last
As a result of the purchase of an asset, the income stream will increase by £1,000 per annum for 25 years. Assuming a discount rate of 20%, compute the maximum price to be paid for this asset ignoring taxation.
Maximum price = Present value of all future cash inflows
Maximum price = £10,000 x PVAF20%,25
= £10,000 x = 10,000 x 4.9476
In practice the income streams are never uniform and have to be estimated from existing income shown in the recent accounts.
2. Earning method – The business is valued according to the total stream of income it is expected to generate over its lifetime.
Determination of maintainable earnings
a) The first step in arriving at earning based valuation is to estimate the future maintainable earnings and if the conditions in the future are expected to be similar to those in the past, it is then prudent to face the forecast on the historical figures. However, conditions do change and as such changes in cost and revenue. Therefore, a detailed examination of profits of the most recent profit and loss account will be necessary to estimate the effects of the changes. While the information given will depend upon the nature of the business the general principles to bear in mind must include the trend of sales and gross profit.
b) Analysis of sales and gross profit percentage by:
i) Product lines
iii) Geographical areas
iv) Customer type.
c) Costs as a percentage of total sales.
d) Unusual fluctuations in the ratios.
e) Necessity of expenditure in the business e.g. excessive remuneration on expenses charged.
f) Inclusion of all costs.
g) Effects of external conditions such as inflation or recession.
However, there are several ways of arriving at the value based on the earnings valuation.
i) Earnings yield valuation
ii) Price earnings ratio valuation
iii) Super profits valuation
I) Earnings Yield Valuation
EY is given by the earnings made by the business expressed as a percentage of the market price of the business i.e.
EY = Earnings x 100
Market price of equity
EY = EPS x 100 = Earnings to Shareholders
MPS Market value of equity
Therefore Market Value = Earning to shareholders
Estimated maintainable earnings are £240,000 per annum, rate of return required is 25%.
Compute the value of the business.
Value MV) = E x 100
= 240,000 x 100
M.V. = £960,000
This method can be converted into the theoretical base, especially if the business is going concern.
As N approaches ∞
Pv = C
= 240,000 = £960,000
ii) Price Earning Ratio Valuation
P/E ratio is traditionally used for valuation of shares but it is an important ratio in the valuation of business. The P/E ratio is the measure of how may years earning would ‘purchase’ the market value of the business and is given by:
P/E ratio = MV
MV = P/E x E
NB: The value of the business can be calculated by taking estimated earnings x P/E ratio.
VALUATION OF SECURITIES:
The previous methods were ideal for valuing the entire business but it is also necessary to ascertain the value of part of a business namely shares, or securities or a block of shares in a limited liability company. The valuation of securities and shares in particular is necessary in the following aspects:
i) To facilitate take-over bids
ii) To allow for mergers.
iii) To facilitate for company accounts disclosure
iv) For purposes of acquisitions or disposal of blocks of shares.
v) For purposes of computing capital gains tax (not applicable in Kenya at present)
vi) For tax payers executors in assessing the capital transfers processes
vii) For ascertaining stamp duty payable.
However, a number of parties are interested in the value of shares and securities and such will include:
a) Company shareholders, directors and vendors of the company.
b) The existing and prospective shareholders.
c) Buyers of a company.
d) Transferee and transferor parties, in particular from the point of view of income tax.
e) Income tax department.
In this valuation, it is necessary to look at a company form:
i) Quoted company (quoted shares)
ii) Unquoted company (unquoted shares)
The valuation of shares will also be influenced by ownership of the company. If a company is owned by majority shareholders, its valuation will be different from if it was owned by minority shareholders. In addition, it is necessary to value shares because of:
a) It is a requirement of the Company’s Act 1948 in respect of quoted investments which should state the investment book value, market value and stock exchange value where this differs from market value. In this case, the Act recognises the fact that the value of shares may not always be reflected in the stock exchange price and for disclosure purposes, it must be reflected.
i) In respect of unquoted investments the company must state aggregate amount of the book value and also state either the directors valuation which could be different from investors own valuation. Also the company should give specifications of the earnings and dividends attributed to these shares. These are necessary to enable interested parties to make their own valuations.
ii) In respect of both quoted and unquoted, shares the company should give details of the shares so that they can assist in making a valuation of those shares judged to be significant for owning the company, namely, if individual investments exceed 10% of the issued shares of a given class or where the book value of the investment exceeds 10% of the company’s assets.
b) Capital transfer reasons i.e. the capital transfer requires a valuation of shares whether from one person to another or even if they are transferred at the time of death. Valuation date is important for valuation of companies’ properties.
The main difficulties in valuation of shares are:
i) Existence and method of valuation of goodwill.
ii) Succession of company’s management
iii) Growth in dividend
iv) Growth in equity.
BASES OF SHARE VALUATION
Share valuation can be done on the basis of income and asset values. However, on the basis of income a share will be entitled to two forms of income. For this reason the bases of valuing shares are:
i) Earnings method
ii) Dividend method
iii) Assets method
I) Earnings Method (Or Earning Basis Valuation)
Using the earning valuation method, a company will use its P/E ratio to value its shares.
P/E = MV
MV = E x P/E -> value of ordinary share.
The MV can be determined where the estimated earnings have been established by applying the P/E ratio expected of this type of company.
Company XYZ is expected to generate post tax earnings of Sh.200,000 per annum and companies in the same trade will generally have a P/E ratio of eight (8). On account of company XYZ limited size, a ratio of six (6) is considered more appropriate. The issued share capital is 1,000,000ordinary shares of Sh.50 each.
Value of shares = EPS x P/E
= Earnings per share x P/E
= 200,000 x 6 = Sh.12.00
Value of Business = Earnings x P/E ratio
MV = E x P/E = Sh.200,000 x 6 = Sh.1.2 million
ii) Dividend Basis Valuation
Ownership of shares in entities – The owner to receive a cash flow consisting of future dividends and the value of a share should correspond to the present value of this future cash flow. A shareholder cannot expect cash flows in perpetuity as he will sell his shares at one time.
Po = Do
Note: Where there is growth in equity, P0 =
Company XYZ pays a dividend of 10% on its Sh.60 par value ordinary shares. This company uses a discount rate of 15%. Assuming no growth, compute the value of its ordinary share if there’s growth of 5%, what would be the value of this company’s ordinary shares.
a) Po = Do Po = 6 = Sh.40 (no growth) Ke 15%
b) Po = 6(1.05) = Shs.63 (5% growth rate)
iii) Asset Based Valuation
This method takes into account the entire business with reference to its assets and then divides the resultant value by the number of shares in an issue to give the per share. The principles are the same as those in the valuation of businesses computed already. However, if a historical dividend based on earning based valuation produces a figure which is less than the asset value then there is a possibility that the buyer may be able to improve the management of the asset being taken over. In such a case, a buyer would be prepared to pay a price which though excessive in terms of income might be justified by the underlying assets value.
Information extracted from the books of Kent Limited.
Stock in trade
Stock has a realisable value of Sh.80,000 and land Sh.300,000. This company is assumed to be have a share capital of 20,000 ordinary shares.
Compute the value of its shares.
i) Assets method
Assets = L & B 300,000
Value of shares = 30,000 = Sh.1.50
K & K Company Limited is planning to absorb three other companies so as to realise its sales records of Sh.500,000 per annum. Its accountants have advised the company to maintain such a size that it will enable its shares to sell at a minimum price of Sh.16. The company’s last published balance sheets indicate the following:
Ordinary shares of Sh.10 each 50,000
Current liabilities 40,000
Fixed assets 80,000
Current assets 75,000
Profits for the last 5 years were as follows:
P/E ratio applicable is 12:1
Compute the value of the business indicating the lowest offer price and the highest offer price and the share value thereof whether it would be viable to take on the three companies if its to maintain this share value.
P/E RATIO METHOD
P/E = 12:1 Average profits = 10,000,000
Therefore Value of business = 10,000,000 x 12 = Sh.120,000,000
Value of shares = Sh.120 million = Sh.24
5 million shares
Less: Current liabilities [ 40,000]
Value of shares = Sh.115M = Sh.23
Where: Po = Price of ordinary shares
d = Dividend at the end of year one
P1 = Price of the share at the end of one year.
VALUATION OF BONDS AND DEBENTURES
This will depend on expected cash flows consisting of annual interest plus the principal amount to be received at maturity. The appropriate rate of capitalisation or discount rate to be applied will depend upon the riskiness of the bond e.g. government bonds are less risky and will therefore call for lower discount rates than similar bonds issued by private companies which will call for high rate of discount.
Valuation of bonds with maturity period
When a bond or debenture has reached maturity, its value can be determined by considering annual interest payments plus its terminal or maturity and this is done using the P.V. concept to discount the cash flows and the result will be compared to the market value of the bond to ascertain whether it has overvalued or undervalued.
Where: Int = Annual interest
Kd = Required rate of return
M = Terminal/maturity value
n = Number of years to maturity
K is contemplating purchasing a 3 year bond worth 40,000/= carrying a nominal coupon rate of interest of 10%. K required rate of return is 6%.
What should he be willing to pay now to purchase the bond if it matures at par?
Int = 10% x 40,000 = 4,000 p.a.
n = 3 yrs
Kd = 6%
M = 40,000
= 4,000 x PVAF6%,3 + 40,000 x PVIF6%,3 = (40,000 x 2.673) + (40,000 x 0.840) = 44,292
a) XYZ Ltd is expected to pay a DPS of Sh.6 in one year’s time. The dividend payout ratio is 60% and the Return on Equity is 15%.
Determine whether the share is overvalued if the MPS is Sh.40. (6 marks)
b) What is the significance of valuation securities? (5 marks)
c) ABC Ltd has issued a 5 year zero coupon rate bond with maturity value of Sh.100,000. The bond is issued at a discount of 32%.
Determine the rate of return of the bond. (5 marks)
d) What are the advantages of zero coupon bond? (5 marks)
(Total: 19 marks)
Nyakua Limited is contemplating acquiring Uza Limited.
Incremental cash flows arising from the acquisition are expected to be as follows:
Average of years (in Sh.’000’)
Cash flow after taxes
Net cash flow
Uza Limited has an all equity capital structure. The required rate of return of Uza Limited is always 5 percent above the risk free rate. The risk free rate is 9 percent.
a) Using the information provided, compute the maximum price that Nyakua Limited might pay for Uza Limited. (14 marks)
b) What other factors might influence the management of Nyakua Limited in their decision to purchase Uza Limited? (6 marks)
(Total: 20 marks)
a) Andreas Company Ltd. currently pays a dividend of Sh.2 per share and this dividend is expected to grow at an annual rate of 15% for the first 3 years then at a rate of 10% for the next 3 years after which it is expected to grow at a rate of 5% thereafter.
What value would you place on the stock if an 18% rate of return were required? (7 marks)
Would your valuation change if you expected to hold the stock for only 3 years? Explain. (5 marks)
The stream of dividends of XYZ Ltd for the past 4 years was as follows:
The cost of equity is 14%. Determine the price of a share. (8 marks)
a) The valuation of ordinary shares is more complicated than the valuation of bonds and preference shares. Explain the factors that complicate the valuation of ordinary shares. (6 marks)
The most recent financial data for the Rare Watts disclose the following:
Dividend per share Sh.3.00
Expected annual dividend growth rate 6 percent
Current required rate of return 15 percent
The company is considering a variety of proposals in order to redirect the firm’s activities. The following four alternatives have been suggested:
Do nothing in which case the key financial variables will remain unchanged.
Invest in venture that will increase the dividend growth rate to 7% and lower the required rate of return to 14%.
Eliminate an unprofitable product line. The action will increase the dividend growth rate to 8% and raise the required rate of return to 17%.
Acquire a subsidiary operation from another company. This action will increase the dividend growth rate to 9% and required rate of return to 18%.
For each of the proposed actions, determine the resulting impact price and recommend the best alternative. (Total: 14 marks)
END OF COMPREHESIVE
CHECK YOUR ANSWERS WITH THOSE PROVIDED IN LESSON 10
Read Chapters 20 and 21 of Financial Management text book by I. M Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Dividend Policy and Decisions
Alternative Dividend Policies
Mode of paying Dividends
Factors influencing dividend policies
DIVIDEND POLICIES AND DECISIONS
Dividend policy determines the division of earnings between payment to stock holders ad re-investment in the firm. It therefore looks at the following aspects:
i). How much to pay – this encompassed in the four major alternative dividend policies.
Constant Amount Of Dividend Per Share
Constant Payout Ratio
Fixed Dividend Plus Extra
Residual Dividend Policy
ii) When to pay – paying interim or final dividends
iii) Why dividends are paid – this is explained by the various theories which has to determine the relevance of dividend payment i.e.:
Residual dividend theory
Dividend irrelevance theory (MM)
Bird in hand theory
iv) How to pay: cash or stock dividends.
Importance of Dividend Decisions
Dividends decisions are integral part of a firm’s strategic financing decision. It is therefore a plan of action adopted by management e.g payment of high dividends means less retained earnings and the firm may have to go to the market to borrow for investment purposes. This will increase its gearing level.
Solution to the Dividend Puzzle
A firms dividend decision may have some relevance to the firm’s share value. The managers therefore requires to formulate an optimal dividend policy which will maximize the wealth of the shareholders (value of shares).
i) HOW MUCH TO PAY: ALTERNATIVE DIVIDENDS POLICIES
a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firms earnings ability and if no profits are made no dividend is paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend income and they might demand a higher required rate of return.
b) Constant amount per share (fixed D.P.S.)
The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is therefore preferred by shareholders who have a high reliance on dividend income.
It protects the firm from periods of low earnings by fixing, DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a fixed return. The DPS could be increased to a higher level if earnings appear relatively permanent and sustainable.
c) Constant DPS plus Extra/Surplus
Under this policy a constant DPS is paid every year. However extra dividends are paid in years of supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and the shareholders are given a chance to participate in super normal earnings
The extra dividends is given in such a way that it is not perceived as a commitments by the firm to continue the extra dividend in the future. It is applied by the firms whose earnings are highly volatile e.g agricultural sector.
d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment decisions have been financed. Dividend will only be paid if there are no profitable investment opportunities available. The policy is consistent with shareholders wealth maximization.
ii) WHEN TO PAY
Firms pay interim or final dividends. Interim dividends are paid at the middle of the year and are paid in cash. Final dividends are paid at year end and can be in cash or bonus issue.
iii) DIVIDENDS THEORIES (WHY PAY DIVIDENDS)
The main theories are:
1. Residual dividend theory
Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining after all suitable projects with positive NPV has been financed.
It assumes that retained earnings is the best source of long term capital since it is readily available and cheap. This is because no floatation cash are involved in use of retained earnings to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve for financing investments.
Dividend policy is irrelevant and treated as passive variable. It will not affect the value of the firm. However, investment decisions will.
Advantages of Residual Theory
1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of earnings which requires no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if retention is high.
A high retention policy may enable financing of firms with rapid and high rate of growth.
3. Tax position of shareholders
High-income shareholders prefer low dividends to reduce their tax burden on dividends income.
They prefer high retention of earnings which are reinvested, increase share value and they can gain capital gains which are not taxable in Kenya.
ii) MM Dividend Irrelevance Theory
Was advanced by Modiglian and Miller in 1961. The theory asserts that a firm’s dividend policy has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by:
Ability to generate earnings from investments
Level of business and financial risk
According to MM dividend policy is a passive residue determined by the firm’s need for investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders and retention. Therefore, optimal dividend policy does not exist. Since when investment decisions of the firms are given, dividend decision is a mere detail without any effect on the value of the firm.
They base on their arguments on the following assumptions:
No corporate or personal kites
No transaction cost associated with share floatation
A firm has an investment policy which is independent of its dividend policy (a fixed investment policy)
Efficient market – all investors have same set of information regarding the future of the firm
No uncertainty – all investors make decisions using the same discounting rate at all time i.e required rate of return (r) = cost of capital (k).
iii) Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are more certain than capital gains which rely on demand and supply forces to determine share prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush (uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since shareholders will require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is independent of dividend policy. They maintained that an investor can realize capital gains generated by reinvestment of retained earning, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and capital gains.
iv) Information signaling effect theory
Advanced by Stephen Ross in 1977. He argued that in an inefficient market, management can use dividend policy to signal important information to the market which is only known to them.
Example – If the management pays high dividends, it signals high expected profits in future to maintain the high dividend level. This would increase the share price/value and vice versa.
MM attacked this position and suggested that the change in share price following the change in dividend amount is due to informational content of dividend policy rather than dividend policy itself.Therefore, dividends are irrelevant if information can be given to the market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the value of the firm. The theory is based on the following four assumptions:
The sending of signals by the management should be cost effective.
The signals should be correlated to observable events (common trend in the market).
No company can imitate its competitors in sending the signals.
The managers can only send true signals even if they are bad signals. Sending untrue signals is financially disastrous to the survival of the firm.
v) Tax differential theory
Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital gains.Therefore, a firm that pays high dividends have lower value since shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm and vice versa.
In Kenya, dividends attract a withholding tax of 5% which is final and capital gains are tax exempt.
vi) Clientele effect theory
Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different preferences for dividends depending on their level of income from other sources.
Low income earners prefer high dividends to meet their daily consumption while high income earners prefer low dividends to avoid payment of more tax. Therefore, when a firm sets a dividend policy, there’ll be shifting of investors into and out of the firm until an equilibrium is achieved. Low, income shareholders will shift to firms paying high dividends and high income shareholders to firms paying low dividends.
At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has. Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors.
vii) Agency theory
The agency problem between shareholders and managers can be resolved by paying high dividends. If retention is low, managers are required to raise additional equity capital to finance investment.Each fresh equity issue will expose the managers financing decision to providers of capital e.g bankers, investors, suppliers etc.Managers will thus engage in activities that are consistent with maximization of shareholders wealth by making full disclosure of their activities.
This is because they know the firm will be exposed to external parties through external borrowing. Consequently, Agency costs will be reduced since the firm becomes self-regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because dividend policy can be used to reduce agency problem by reducing agency costs.The theory implies that firms adopting high dividend payout ratio will have a higher due to reduced agency costs.
How to pay dividends (mode of paying dividends)
1. Cash and Bonus issue
2. Stock split and reverse split
3. Stock repurchase
4. Stock rights/rights issue (to discuss in class)
1. Cash and bonus issue
For a firm to pay cash dividends, it should have adequate liquid funds.
However, under conditions of liquidity and financial constraints, a firm can pay stock dividend (Bank issue)
Bonus issue involves issue of additional shares for free (instead of cash) to existing shareholders in their shareholding proportion.
Stock dividend/Bonus issue involves capitalization of retained earnings and does not increase the wealth of shareholders. This is because R. Earnings is converted into shares.
Advantages of Bonus Issue
a) Tax advantages
Shareholders can sell new shares, and generate cash in form of capital gains which is tax exempt unlike cash dividends which attract 5% withholding tax which is final
b) Indication of high profits in future:
A Bonus issue, in an inefficient market conveys important information about the future of the company.
It is declared when management expects increase in earning to offset additional outstanding shares so that E.P.S is not diluted.
c) Conservation of cash
Bonus issue conserves cash especially if the firm is in liquidity problems.
d) Increase in future dividends
If a firm follows a fixed/constant D.P.S policy, then total future dividend would increase due to increase in number of shares after bonus issue.
Journal entry in case of bonus issue
Dr. R. Earnings (par value)
Cr. Ordinary share capital (par value)
NB: A firm can also make a script issue where bonus shares are directly from capital reserve.
2. Stock Split and Reverse Split
This is where a block of shares is broken down into smaller units (shares) so that the number of ordinary shares increases and their respective par value decreases at the stock split factor.
Stock split is meant to make the shares of a company more affordable by low income investors and increase their liquidity in the market.
ABC Company has 1000 ordinary shares of Sh.20 par value and a split of 1:4 i.e one stock is split into 4. The par value is divided by 4.
1000 stocks x 4 = 4000 shares
par value = 40 = Sh.5
Ordinary share capital = 4000 x 5 = Shs.20,000
A reverse split is the opposite of stock split and involves consolidation of shares into bigger units thereby increasing the par value of the shares. It is meant to attract high income clientele shareholders. E.g incase of 20,000 shares @ Shs.20 par, they can be consolidated into 10,000 shares of Shs.40 par. I.e. (20,000 x ½) = 10,000 and Sh.20 = x 2 = 40/=
3. Stock Repurchase
The company can also buy back some of its outstanding shares instead of paying cash dividends. This is known as stock repurchase and shares repurchased, (bought back) are called treasury Stock. If some outstanding shares are repurchased, fewer shares would remain outstanding.
Assuming repurchase does not adversely affect firm’s earnings, E.P.S. of share would increase. This would result in an increase in M.P.S. so that capital gain is substituted for dividends.
Advantages of Stock Repurchase
1. It may be seen as a true signal as repurchase may be motivated by management belief that firm’s shares are undervalued. This is true in inefficient markets.
2. Utilization of idle funds
Companies, which have accumulated cash balances in excess of future investments, might find share reinvestment scheme a fair method of returning cash to shareholders.
Continuing to carry excess cash may prompt management to invest unwisely as a means of using excess cash.
A firm may invest surplus cash in an expensive acquisition, transferring value to another group of shareholders entirely. There is a tendency for more mature firms to continue with investment plan even when E (K) is lower than cost of capital.
3. Enhanced dividends and E.P.S.
Following a stock repurchase, the number of shares issued would decrease and therefore in normal circumstances both D.P.S. and E.P.S. would increase in future. However, the increase in E.P.S is a bookkeeping increase since total earnings remaining constant.
4. Enhanced Share Price
Companies that undertake share repurchase, experience an increase in market price of the shares. This is partly explained by increase in total earnings having less and/or market signal effect that shares are under value.
5. Capital structure
A company’s managers may use a share buy back or requirements, as a means of correcting what they perceive to be an unbalanced capital structure.
If shares are repurchased from cash reserves, equity would be reduced and gearing increased (assuming debt exists in the capital structure).
Alternatively a company may raise debt to finance a repurchase. Replacing equity with debt can reduce overall cost of capital due to tax advantage of debt.
6. Employee incentive schemes
Instead of cancelling all shares repurchase, a firm can retain some of the shares for employees share option or profit sharing schemes.
7. Reduced take over threat
A share repurchase reduced number of share in operation and also number of ‘weak shareholders’ i.e shareholders with no strong loyalty to company since repurchase would induce them to sell.
This helps to reduce threat of a hostile takeover as it makes it difficult for predator company to gain control. (This is referred as a poison pill) i.e. Co.’s value is reduced because of high repurchase price, huge cash outflow or borrowing huge long term debt to increase gearing
Disadvantages of stock repurchase
1. High price
A company may find it difficult to repurchase shares at their current value and price paid may be too high to the detriment of remaining shareholders.
2. Market Signaling
Despite director’s effort at trying to convince markets otherwise, a share repurchase may be interpreted as a signal suggesting that the company lacks suitable investment opportunities. This may be interpreted as a sign of management failure.
3. Loss of investment income
The interest that could have been earned from investment of surplus cash is lost.
Factors to consider in paying dividends (factors influencing dividend)
1. Legal rules
a) Net purchase rule
States that dividend may be paid from company’s profit either past or present.
b) Capital impairment rule: prohibits payment of dividends from capital i.e. from sale of ssets. This is liquidating the firm.
c) Insolvency rule: prohibits payment of dividend when company is insolvent. Insolvent company is one where assets are less than liabilities. Insolvent company is one where assets are less than liabilities. In such a case all earnings and assets of company belong to debt holders and no dividends is paid.
2. Profitability and liquidity
A company’s capacity to pay dividend will be determined primarily by its ability to generate adequate and stable profits and cash flow.
If the company has liquidity problem, it may be unable to pay cash dividend and result to paying stock dividend.
3. Taxation position of shareholders
Dividend payment is influenced by tax regime of a country e.g in Kenya cash dividend are taxable at source, while capital are tax exempt.
The effect of tax differential is to discourage shareholders from wanting high dividends. (This is explained by tax differential theory).
4. Investment opportunity
Lack of appropriate investment opportunities i.e. those with positive returns (N.P.V.), may encourage a firm to increase its dividend distribution. If a firm has many investment opportunities, it will pay low dividends and have high retention.
5. Capital Structure
A company’s management may wish to achieve or restore an optimal capital structure i.e. if they consider gearing to be too high, they may pay low dividends and allow reserves to accumulate until a more optimal/appropriate capital structure is restored/achieved.
6. Industrial Practice
Companies will be resistant to deviation from accepted dividend or payment norms within the industry.
7. Growth Stage
Dividend policy is likely to be influenced by firm’s growth stage e.g a young rapidly growing firm is likely to have high demand for development finance and therefore may pay low dividend or a defer dividend payment until company reaches maturity. It will retain high amount.
8. Ownership Structure
A dividend policy may be driven by Time Ownership Structure e.g in small firms where owners and managers are same, dividend payout are usually low.
However in a large quoted public company dividend payout are significant because the owners are not the managers. However, the values and preferences of small group of owner managers would exert more direct influence on dividend policy.
9. Shareholders expectation
Shareholder clientele that have become accustomed to receiving stable and increasing div. Will expect a similar pattern to continue in the future.
Any sudden reduction or reversal of such a policy is likely to dissatisfy the shareholders and may result in a fail in share prices.
10. Access to capital markets
Large, well established firms have access to capital markets hence can get funds easily
They pay high dividends thus, unlike small firms which pay low dividends (high retention) due to limited borrowing capacity.
11. Contractual obligations on debt covenants
They limit the flexibility and amount of dividends to pay e.g. no payment of dividends from retained earnings.
1. Dividend per shares (DPS) = Earnings to ordinary shareholders
Number of ordinary shares
Indicate cash returns received fro every share holder.
2. Dividend yield (DY) = DPS
Indicate dividend returns for every shilling invested in the firm.
3. Dividend cover = DPS
Indicate the number of times dividends can be paid out of earnings of shareholders. The higher the DPS the lower the dividend cover.
4. Dividend Payout Ratio = DPS
Shows the proportion of Earnings which was paid out as dividends and how much was retained.
A comparative study of the records of two oil companies, A Ltd and B Ltd., in terms of their asset composition, capital structure and profitability shows that they have been very similar for the past five years. The only significant difference between the two firms is their dividend policy. A Ltd. maintains a constant dividend per share while B Ltd maintains a constant dividend pay-out ratio. Relevant data is as follows:
Earnings per share
Dividend per share
in stock exchange
Earnings per share
Dividend per share
in stock exchange
16 – 18
12 – 15
14 – 20
21 – 26
26 – 40
11 – 15
6 - 14
7 - 16
15 – 23
21 – 44
a) For each company, determine the dividend pay-out ratio and the price earnings ratio for each of the five years. (12 marks)
b) B Ltd’s management is surprised that the shares of this company have not performed as well as A Ltd.’s in the stock exchange. What explanation would you offer for this state of affairs? (4 marks)
Comment on the applicability of the Simple Price/Earnings (P/E) ratio to the typical technology (IT) company with a high valuation and heavy losses.
a) In relation to the financing of a firm, differentiate the following terms:
i) Financial structure from capital structure. (5 marks)
ii) Business risk from financial risk. (5 marks)
b) What is meant by gearing as used in the capital structure of Limited Liability Company? (2 marks)
The following information is on a company in the power generation business:
10% preference shares (Sh.10 par)
Ordinary share capital (Sh.10 par)
i) Calculate the gearing ratio for the above company. (2 marks)
ii) If the company’s net profit (before interest and tax) is Sh.2,000,000,000 and assuming a dividend payout ratio of 60% of the earnings, compute the dividend per share (DPS). (6 marks)
iii) If the market price per share now is Sh.80, compute the dividend yield.
(Total: 22 marks)
Explain the reasons why firms in the same industry with equal earnings and share capital would pay different amount of dividends?
CHECK YOUR ANSWERS WITH THOSE GIVEN IN LESSON 10OF THE STUDY PACK
COMPREHENSIVE ASSIGNMENT NO.3
TO BE SUBMITTED AFTER LESSON 8
To Be Carried Out Under Examination Condition and Sent to Distance learning Administrator for marking by the University
Answer All Questions Time Allowed: Three Hours
The most recent balance sheet for Supremo Ltd is presented here below:
Supremo Ltd Balance Sheet – 30 November 1995
Fixed Assets (net)
The company is about to embark on an advertising campaign which is expected to raise sales from their present level of Sh.27.5 million to Sh.38.5 million by the end of next financial year. The firm is presently operating at full capacity and will have to increase its investment in both current and fixed assets to support the projected level of sales. It is estimated that both categories of assets will rise in direct proportion to the projected increase in sales.
For the year just ended, the firm’s net profits were 6% of the year’s sales but are expected to rise to 7% of projected sales. To help support its anticipated growth in assets needs next year the firm has suspended plans to pay cash dividends to its shareholders. In years past, a dividend of Sh.6.60 per share has been paid annually.
Supremo’s trade creditors and accrued expenses are expected to vary directly with sales. In addition, notes payable will be used to supply the added funds to finance next years operations that are not forthcoming from other sources.
a) i) Estimate the amount of additional funds to be raised through notes
payable. (4 marks)
ii) What one fundamental assumption have you made in making your estimate? (2 marks)
b) Prepare pro-forma balance sheet of Supremo Ltd. on 30 November 1996. (13 marks)
c) i) Calculate and compare Supremo Ltd.’s current and debt ratios before and after growth in sales. (4 marks)
ii) What was the effect of the expanded sales on these two dimensions of Supremo’s financial condition? (2 marks)
(Total: 25 marks)
XYZ Ltd is intending to raise capital to finance a new project. The current M.P.S is Sh.43 cum-div of year 2001 declared but not yet paid. For the past 5 years, the company has paid the following stream of dividends.
Year 1997 1998 1999 2000 2001
D.P.S 1.90 2.25 2.60 2.60 3.00
The existing capital structure of the firm is as follows:
Ordinary share capital Sh.10 par 40
Retained earnings 35
12% Debenture Sh.100 par 25
The debentures are currently selling at Sh.95 ex-interest. The corporate tax rate is 30%.
a) Distinguish between cum-div and ex-div M.P.S. (4 marks)
b) Compute the ex-div M.P.S. (2 marks)
c) Compute the overall cost of capital. Use dividend growth model
to determine the cost of equity. (9 marks)
d) The company wants to raise additional Sh.20 million as follows:
50% from retained earnings
30% from issue of debentures at the current market value
20% from issue of new ordinary shares with 10% floatation costs
i) Compute the number of ordinary shares to issue to raise the amount required. (2 marks)
ii) Compute the marginal cost of capital. (6 marks)
The Kitale Maize Mills is contemplating the purchase of a new high-speed grinder to replace an existing one. The existing grinder was purchased two years ago at an installed cost of Sh.300,000. The grinder was estimated to have an economic life of 5 years but a critical analysis of its performance now shows it is usable for the next five years with no resale value.
The new grinder would cost Sh.525,000 and require Sh.25,000 in installation costs. It has a five year usable life. The existing grinder can currently be sold for Sh.350,000 without incurring any removal costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by Sh.200,000, inventories by Sh.150,000 and trade creditors by Sh.290,000. At the end of 5 years the new grinder would be sold to net Sh.145,000 after removal costs and before taxes. The company provides for 40% taxes on ordinary income. The estimated profit before depreciation and taxes over the five years for both machines are given as follows:
The company uses straight line method of depreciation for both machines.
a) Calculate the initial investment associated with the replacement of the existing grinder with the new one. Show your full workings. (6 marks)
b) Determine the incremental operating cash flows associated with the proposed grinder replacement. (14 marks)
c) Calculate the terminal cash flow expected from the proposed grinder replacement. (2 marks)
(Total: 22 marks)
Dereva and Makanga are considering purchasing the new 30 passenger “wonder coach” to engage in transport business. They have two alternatives of financing the purchase as shown below:
Purchase the vehicle whose current price is Sh.2,400,000 through a finance lease from Kenya Matatu Finance Company Limited. The terms of the lease will require four equal payments per year for each of the three years. No deposit is required.
Obtain the vehicle through Mwananchi’s Bank loan scheme being advertised in the papers. Dereva and Makanga will be required to make a down payment of Sh.900,000 and then meet four equal yearly payments of Sh.153,436 each for the three years.
The market rate of interest is currently 16 per cent per annum.
Dereva and Makanga have been informed that as part of your social responsibility, you provide free consultancy services to small scale businessmen.
a) The finance lease payment to be made by Dereva and Makanga if they opt for finances from Kenya Matatu Finance Company Limited. (4 marks)
b) The present value of the payment scheme of Mwananchi Bank. (4 marks)
c) The interest expense charged by Kenya Matatu Finance Company Limited on the third instalment. (6 marks)
Give reasons why finance leases are referred to as “off-balance sheet” finance.
e) i) Which of the two alternatives – Finance Lease or Bank Loan scheme is
better in financial terms? (2 marks)
ii) Give one reason why the better alternative may not necessarily be chosen by persons in Dereva and Makanga’s circumstances. (2 marks)
(Total: 22 marks)
You are provided with the following information about Marco. Ltd.
i) Number of issued ordinary shares 250,000
ii) Market price per ordinary share Shs.37.50
iii) Total earnings for the year Sh.5,000,000 (before tax).
iv) Rate of corporation tax 30%
v) The total ordinary dividend will be 25% of the earnings for the year after tax.
vi) Preference dividend will be Sh.300,000
From the above information, calculate:
i) Earnings per share
ii) Dividend yield
iii) Earnings yield
iv) Price earnings ratio (P/E) ratio
v) Dividend cover.
END OF COMPREHENSIVE ASSIGNMENT 3
NOW SEND TO DISTANCE LEARNING FOR MARKING
Read Chapters 22, 23, 24 and 25 of Financial Management text book by I. M Pandey.
Complete answers to reinforcement questions at the end of the lesson.
Check model answers given in lesson 10 of the study pack.
Financing of Working Capital /Current Assets
Determinants of Working Capital needs
Importance of working capital management
Management of Short term investment
Working capital cycle
Management of cash , stock and Accounts Receivable
a) Working capital (also called gross working capital) refers to current assets.
b) Net working capital refers to current assets minus current liabilities.
c) Working capital management refers to the administration of current assets and current liabilities.
Target levels of each category of current assets
How current assets will be financed
d) Liquidity management involves the planned acquisition and use of liquid resources over time to meet cash obligations as they become due. The firm’s liquidity is measured by liquidity ratio such as current ratio, quick (or acid test) ratio, cash ratio, etc.
FINANCING CURRENT ASSETS
Current Assets require financing by use of either current funds or long term funds. There are three major approaches to financing current assets. These are:
a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this approach, the firm adopts a financial plan which involves the matching of the expected life of assets with the expected life of the source of funds raised to finance assets.
The firm, therefore, uses long term funds to finance permanent assets and short-term funds to finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This approach can be shown by the following diagram.
b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the asset may not be possible. A firm that follows the conservative approach depends more on long-term funds for financing needs. The firm, therefore, finances its permanent assets and a part of its temporary assets with long-term funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds. (Some sources of short-term funds such as accruals are cost-free). However, short-term funds must be repaid within the year and therefore they are highly risky. With this in mind, we can consider the risk-return trade off of the three approaches.
The conservative approach is a low return-low risk approach. This is because the approach uses more of long-term funds which are now more expensive than short-term funds. These funds however, are not to be repaid within the year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach. However it is also a high return approach the reason being that it relies more on short-term funds that are less costly but riskier.
The matching approach is in between because it matches the life of the asset and the life of the funds financing the assets.
DETERMINANTS OF WORKING CAPITAL NEEDS
There are several factors which determine the firm’s working capital needs. These factors are comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406). They however include:
a) Nature and size of the business.
b) Firm’s manufacturing cycle
c) Business fluctuations
d) Production policy
e) Firm’s credit policy
f) Availability of credit
g) Growth and expansion activities.
IMPORTANCE OF WORKING CAPITAL MANAGEMENT
The finance manager should understand the management of working capital because of the following reasons:
a) Time devoted to working capital management
A large portion of a financial manager’s time is devoted to the day to day operations of the firm and therefore, so much time is spent on working capital decisions.
b) Investment in current assets
Current assets represent more than half of the total assets of many business firms. These investments tend to be relatively volatile and can easily be misappropriated by the firm’s employees. The finance manager should therefore properly manage these assets.
c) Importance to small firms
A small firm may minimise its investments in fixed assets by renting or leasing plant and equipment, but there is no way it can avoid investment in current assets. A small firm also has relatively limited access to long term capital markets and therefore must rely heavily on short-term funds.
d) Relationship between sales and current assets
The relationship between sales volume and the various current asset items is direct and close. Changes in current assets directly affects the level of sales. The finance management must therefore keep watch on changes in working capital items.
CASH AND MARKETABLE SECURITIES MANAGEMENT
The management of cash and marketable securities is one of the key areas of working capital management. Since cash and marketable securities are the firm’s most liquid assets, they provide the firm with the ability to meet its maturing obligations.
Cash refers to cash in hand and cash on demand deposits (or current accounts). It therefore excludes cash in time deposits (which is not immediately available to meet maturing obligations).
Marketable securities are short-term investments made by the firm to obtain a return on temporary idle funds. Thus when a firm realises that it has accumulated more cash than needed, it often puts the excess cash into an interest-earning instrument. The firm can invest the excess cash in any (or a combination) of the following marketable securities.
a) Government treasury bills
b) Agency securities such as local governments securities or parastatals securities
c) Banker’s acceptances, which are securities, accepted by banks
d) Commercial paper (unsecured promissory notes)
e) Repurchase agreements
f) Negotiable certificates of deposits
g) Eurocurrencies etc.
CASH CYCLE AND CASH TURNOVERS
Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash outlay to purchase raw materials to the point when cash is collected from the sale of finished goods produced using those raw materials.
Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year.
XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on credit. The credit terms extended to the firm currently requires payment within thirty days of a purchase while the firm currently requires its customers to pay within sixty days of a sale. However, the firm on average takes 35 days to pay its accounts payable and the average collection period is 70 days. On average, 85 days elapse between the point a raw material is purchased and the point the finished goods are sold.
Determine the cash conversion cycle and the cash turnover.
The following chart can help further understand the question:
Inventory Conversion period (85 days)
Period (70 days)
The cash conversion cycle is given by the following formula:
Cash conversion = Inventory conversion + Receivable collection – Payable deferral
Cycle period period period
For our example:
Cash conversion cycle = 85 + 70 – 35 = 120 days
Cash turnover = 360
Cash conversion cycle
= 3 times
Note also that cash conversion cycle can be given by the following formulae:
Cash conversion cycle =
NB: In this chapter we shall assume that a year has 360 days.
SETTING THE OPTIMAL CASH BALANCE
Cash is often called a non-earning asset because holding cash rather than a revenue-generating asset involves a cost in form of foregone interest. The firm should therefore hold the cash balance that will enable it to meet its scheduled payments as they fall due and provide a margin for safety. There are several methods used to determine the optimal cash balance. These are:
a) The Cash Budget
The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period. This method has already been discussed in other earlier courses. The student should however revise the cash budget.
b) Baumol’s Model
The Baumol’s model is an application of the EOQ inventory model to cash management. Its assumptions are:
The firm uses cash at a steady predictable rate
The cash outflows from operations also occurs at a steady rate
The cash net outflows also occur at a steady rate.
Under these assumptions the following model can be stated:
Where: C* is the optimal amount of cash to be raised by selling marketable securities or by borrowing.
b is the fixed cost of making a securities trade or of borrowing
T is the total annual cash requirements
i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the cost of borrowing)
The total cost of holding the cash balance is equal to holding or carrying cost plus transaction costs and is given by the following formulae:
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable securities is 12% and every time the company sells marketable securities, it incurs a cost of Shs.20.
a) Determine the optimal amount of marketable securities to be converted into cash every time the company makes the transfer.
b) Determine the total number of transfers from marketable securities to cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.