Financial Management

KENYATTA UNIVERSITY
INSTITUTE OF OPEN DISTANCE & e-LEARNING

IN COLLABORATION WITH
SCHOOL OF BUSINESS
DEPARTMENT ACCOUNTING AND FINANCE
MODULE: BAC 502

FINANCIAL MANAGEMENT
WRITTEN BY MR. A. K. THUO

MR. J. M. THEURI
MR. J.M. MUTURI
VETTED BY EDDIE SIMIYU
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Contents
LESSON ONE .............................................................................................................................................. 8
FINANCIAL MANAGEMENT: AN OVERVIEW ..................................................................................... 8
1.0 INTRODUCTION .................................................................................................................................. 8
1.1 OBJECTIVES ......................................................................................................................................... 8
1.2 EVOLUTION OF FINANCIAL MANAGEMENT ............................................................................... 9
1.3 FINANCIAL DECISIONS IN A FIRM ............................................................................................... 10
1.4 EXECUTIVE FINANCE FUNCTION ................................................................................................. 10
1.5 CAPITAL BUDGET/INVESTMENT DECISIONS (LONG TERM ASSET MIX) ........................... 10
1.6 CAPITAL STRUCTURE/FINANCING DECISIONS......................................................................... 11
1.7 DIVIDEND DECISION ....................................................................................................................... 11
1.8 WORKING CAPITAL MANAGEMENT/LIQUIDITY DECISIONS ................................................ 12
1.9 FINANCIAL PROCEDURES AND SYSTEMS (ROUTINE FUNCTIONS INCIDENTAL

FUNCTIONS. ............................................................................................................................................. 12
1.11 MAIN FUNCTIONS/ROLES OF FINANCIAL MANAGER ........................................................... 13
1.12 THE KEY CHALLENGES FOR THE FINANCIAL MANAGER APPEAR TO BE IN THE
FOLLOWING AREAS:.............................................................................................................................. 14
1.13 GOAL OF FINANCIAL MANAGEMENT ....................................................................................... 14
1.14 AGENCY PROBLEM ........................................................................................................................ 17
1.15 SHAREHOLDERS AND MANAGERS ............................................................................................ 17
1.16 EXECUTIVE CONTRACTS AND BONUS PLANS ........................................................................ 18
1.17 SPECIFIC FORMS OF MONETARY COMPENSATION PLANS ................................................. 19
1.18 IDEAL CONDITIONS FOR THE USE OF INCENTIVE SYSTEM ................................................ 19
1.19 CONDITIONS MAKING IT DIFFICULT FOR A FIRM TO APPLY EXECUTIVE INCENTIVE

PLANS ........................................................................................................................................................ 20
1.20 ACTIONS THAT CAN INCREASE REPORTED EARNINGS THROUGH ACTIONS THAT DO
NOT BENEFIT THE FIRM. ...................................................................................................................... 20
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1.21 AREAS WHERE CONTROL COULD BE EXERCISED TO DETECT SUB-OPTIMAL
DECISIONS ................................................................................................................................................ 20
1.22 CONFLICT BETWEEN SHARE HOLDERS AND CREDITORS ................................................... 20
1.23 CONFLICT BETWEEN SHAREHOLDERS AND AUDITORS ...................................................... 21
1.24 SUMMARY ........................................................................................................................................ 21
1.25 ACTIVITIES....................................................................................................................................... 21
1.26 SELF TESTING QUESTION ............................................................................................................. 22
1.27 FURTHER READING ....................................................................................................................... 22
LESSON TWO ........................................................................................................................................... 23
THE TIME VALUE OF MONEY .............................................................................................................. 23
2.0 INTRODUCTION ................................................................................................................................ 23
2.1 LEARNING OBJECTIVES.................................................................................................................. 23
2.2 TIME LINES AND NOTATION ......................................................................................................... 24
2.2.1 COMPOUND VALUE .................................................................................................................. 24
2.2.2 DISCOUNT VALUE/PRESENT VALUE .................................................................................... 29
2.2.3 PRESENT VALUE FOR UNEQUAL PERIODIC SUM .............................................................. 30
2.2.4 COMPOUND OR FUTURE VALUE OF AN ANNUITY .......................................................... 30
2.2.5 SINKING FUND ........................................................................................................................... 32
2.3 CAPITAL RECOVERY AND LOAN AMORTIZATION .................................................................. 34
2.3.1 PRESENT VALUE OF A GROWING ANNUITY ...................................................................... 36
2.4 DETERMINING THE PERIODIC WITHDRAWAL ........................................................................ 38
2.5 SUMMARY .......................................................................................................................................... 44
2.6 ACTIVITIES......................................................................................................................................... 44
2.7 SELF TESTING QUESTIONS ............................................................................................................ 44
2.8 FURTHER READINGS ....................................................................................................................... 45
LESSON THREE........................................................................................................................................ 46
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RISK AND RETURN ................................................................................................................................. 46
3.0 INTRODUCTION ................................................................................................................................ 46
3.2 RISK AND RETURN OF A SINGLE ASSET..................................................................................... 46
3.3 CALCULATING EXPECTED RETURN AND RISK USING FORECASTED DATA .................... 49
3.4 PORTFOLIO THEORY AND RISK DIVERSIFICATION ................................................................ 51
3.5 CORRELATION OF INVESTMENTS................................................................................................ 53
3.7 THE RETURN ON MARKET PORTFOLIO ...................................................................................... 66
3.8 PORTFOLIO THEORY AND FINANCIAL MANAGEMENT.......................................................... 68
3.9 SUMMARY .......................................................................................................................................... 70
3.10 ACTIVITIES....................................................................................................................................... 70
3.11 SELF TESTING QUESTIONS .......................................................................................................... 70
3.12 FURTHER READING ....................................................................................................................... 71
LESSON FOUR .......................................................................................................................................... 72
COST OF CAPITAL .................................................................................................................................. 72
4.0 INTRODUCTION ................................................................................................................................ 72
4.2 ELEMENTS OF COST OF CAPITAL ................................................................................................ 72
4.3 BETA FACTOR ................................................................................................................................... 74
4.4 FLOATATION COST AND COST OF CAPITAL ............................................................................. 87
4.5 CAPITAL STRUCTURE THEORIES ................................................................................................. 89
4.6 TRADITIONAL APPROACH TO CAPITAL STRUCTURE ............................................................. 90
4.7 SUMMARY .......................................................................................................................................... 97
4.8 ACTIVITIES......................................................................................................................................... 97
4.9 SELF TESTING QUESTIONS ............................................................................................................ 97
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4.10 FURTHER READINGS ..................................................................................................................... 98
LESSON FIVE............................................................................................................................................ 99
MARKET FOR FUNDS ............................................................................................................................. 99
5.0 INTRODUCTION ................................................................................................................................ 99
5.2 MARKET FOR FUNDS AND FINANCIAL INSTITUTIONS IN KENYA ...................................... 99
5.3 CAPITAL MARKET .......................................................................................................................... 100
5.4 FINANCIAL INTERMEDIARIES..................................................................................................... 102
5.5 THE SECURITIES EXCHANGE MARKET .................................................................................... 103
5.6 SECURITIES MARKET TERMINOLOGY ...................................................................................... 106
5.7 STOCK MARKET INDEX ................................................................................................................ 109
5.8 STOCK EXCHANGE INDEX (SEI) ................................................................................................. 109
5.9 CAPITAL MARKET AUTHORITY (CMA) ..................................................................................... 113
5.10 CENTRAL DEPOSITORY SYSTEM (CDS) .................................................................................. 115
5.11 BANKING INSTITUTIONS ............................................................................................................ 117
5.12 SUMMARY ...................................................................................................................................... 120
5.13 ACTIVITIES..................................................................................................................................... 120
5.14 SELF TESTING QUESTION ........................................................................................................... 120
LESSON SIX ............................................................................................................................................ 122
WORKING CAPITAL MANAGEMENT................................................................................................ 122
6.0 INTRODUCTION .............................................................................................................................. 122
6.1 LEARNING OBJECTIVES................................................................................................................ 122
6.2 WORKING CAPITAL CHARACTERISTICS OF DIFFEENT BUSINESSES ................................ 123
6.3 FINANCING CURRENT ASSETS.................................................................................................... 123
6.4 DETERMINANTS OF WORKING CAPITAL NEEDS ................................................................... 126
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6.5 IMPORTANCE OF WORKING CAPITAL MANAGEMENT ......................................................... 127
6.6 CASH AND MARKETABLE SECURITIES MANAGEMENT....................................................... 127
6.7 CASH OPERATING CYCLE ............................................................................................................ 128
6.8 SETTING THE OPTIMAL CASH BALANCE ................................................................................. 130
6.9 MANAGING INVENTORIES ........................................................................................................... 139
6.10 INVENTORY COSTS ...................................................................................................................... 140
6.11 JUST IN TIME (JIT) PROCUREMENT ....................................................................................... 144
6.12 CREDIT STANDARDS ................................................................................................................... 145
6.13 SUMMARY ...................................................................................................................................... 148
6.14 ACTIVITIES..................................................................................................................................... 148
6.15 SELF TESTING QUESTIONS ........................................................................................................ 149
6.16 FURTHER READINGS ................................................................................................................... 149
LESSON SEVEN...................................................................................................................................... 150
CAPITAL BUDGETING ......................................................................................................................... 150
7.0 INTRODUCTION .............................................................................................................................. 150
7.2 CAPITAL BUDGETING PROCESS ................................................................................................. 151
7.3 TYPES OF INVESTMENT DECISIONS .......................................................................................... 153
7.4 CAPITAL BUDGETING TECHNIQUES OR INVESTMENT APPRAISAL TECHNIQUES .... 154
7.5 SUMMARY ........................................................................................................................................ 185
7.6 ACTIVITIES....................................................................................................................................... 186
7.7 SELFTESTING QUESTIONS ........................................................................................................... 186
7.8 FURTHER READINGS ..................................................................................................................... 187
LESSON EIGHT ...................................................................................................................................... 188
VALUATION OF BONDS AND STOCKS ............................................................................................ 188
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8.0 INTRODUCTION .............................................................................................................................. 188
8.2 TERMINOLOGY USED IN BOND VALUATION .......................................................................... 189
8.3 VALUATION MODEL ...................................................................................................................... 190
8.4 BONDS VALUES WITH SEMI ANNUAL INTEREST ................................................................... 191
8.5 RELATIONSHIP BETWEEN COUPON RATE, REQUIRED YIELD AND PRICE ...................... 192
8.6 RELATIONSHIP BETWEEN BOND PRICE AND TIME ............................................................... 193
8.8 BOND MARKET ............................................................................................................................... 197
8.9 EQUITY VALUATION ..................................................................................................................... 198
8.10 IMPACT OF GROWTH ON PRICE, RETURNS AND PRICE EARNINGS RATIO ................... 205
8.11 SUMMARY ...................................................................................................................................... 208
8.12 ACTIVITIES..................................................................................................................................... 208
8.13 SELF TESTING QUESTION ........................................................................................................... 208
8.14 FURTHER READINGS ................................................................................................................... 209
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LESSON ONE
FINANCIAL MANAGEMENT: AN OVERVIEW
1.0 INTRODUCTION
The modern day financial manager is instrumental to a companys success. As

cash flows pulsate through the organization, this individual is at the heart of what is
happening. If finance is to play a general management in role in the organization, the
financial manager must be a team player who is constructively involved in operations,
marketing and the companys overall strategy. Where once the financial manager was
charged only with such tasks as keeping record, preparing financial reports, managing the
companys cash position, paying bill, and, on occasion, obtaining funds, the broad domains
today includes (i)investments in assets and new products and (ii) determining the best mix
of financing and dividends in relations to the companys overall valuation.
Invest of funds in assets and people determine the size of the firm, its profit from operation,
its business risk and its liquidity. Obtaining the best mix of financing and dividends
determines the firms financial charges and its financial risk; it also impacts its valuation. All
of this demands a broad outlook and an alert creativity that will influence almost all facets
of the enterprise.
1.1 OBJECTIVES
Explain the nature of finance and its interaction with other management functions
Review the changing role of finance manager and his/her position in the management
hierarchy
Focus on the Shareholders Wealth Maximization (SWM) principle as an
operationally desirable finance decision criterion
Discuss agency problem arising from the relation between shareholders and
managers
Illustrate the organization of finance function
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Financial management is a branch of economics concerned with the generation and allocation of
scarce resources to the most efficient user within the economy or the firm.
1.2 EVOLUTION OF FINANCIAL MANAGEMENT

Financial management emerged as a distinct field of study at the turn of the 20th Century. Its
evolution may be divided into three broad phases (though the demarcating lines between these
phases are somewhat arbitrary); the traditional phase, the transitional phase and the modern
phase.
Traditional Phase
It lasted for about four decades. The important features of this phase are:
(i) The focus of financial management was mainly on certain episodic events like
formation, issuance of capital, major expansion, merger, reorganization and
liquidation in the life cycle of the firm.
(ii) The approach was mainly descriptive and institutional. The instruments of
financing, the institutions and procedures used in capital markets and the legal
aspects of financial events formed the core of financial management.
(iii) The outsiders point of view was viewed mainly from the point of view of the
investment bankers, lenders and other outside interests.
The Transitional Phase
Began around the early 1940s and continued though the early 1950s. Though the nature of
financial management during this phase was similar to that of the traditional phase, greater
emphasis was placed on the day-to-day problems faced by financial managers in the areas of
funds analysis, planning and control. The focus shifted to working capital management.
The Modern Phase
Began in the mid 1950s and has witnessed an accelerated pace of development with the infusion
of ideas from economic theory and application of quantitative methods of analysis. The
distinctive features of the modern phase are:
(i) The central concern of financial management is considered to be a rational

matching of funds to their uses to maximize the wealth of current shareholders.
(ii) The approach of financial management has become more analytical and
quantitative.
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Note:
Since the beginning of the modern phase many significant and seminal developments have
occurred in the fields of capital budgeting, asset pricing theory, valuation models, divided
policy, working capital management, financial modeling and behavioral finance. Many
more exciting developments are in the offing making finance a fascinating and challenging
field.
1.3 FINANCIAL DECISIONS IN A FIRM

It is difficult to separate finance functions from production marketing and other functions
through these functions can themselves be readily identified. Finance function or decisions can
be classified into two groups.
(i) Executive finance function
(ii) Incidental finance function (Financial procedures and systems).
1.4 EXECUTIVE FINANCE FUNCTION

The executive function is so called because it requires administrative skills in planning and
execution. There are four broad areas of executive finance decisions namely:
(i) Capital budgeting decisions/investment decisions
(ii) Capital structure/financing decisions.
(iii) Working capital management/liquidity decisions.
(iv) Dividend decisions
A firm performs finance functions simultaneously and continuously in the normal course of the
business. Finance manager should make financial decisions that increase the value of the
shareholders. Thus while performing the finance functions, the finance manager should strive to
maximize the market value of the shares.
1.5 CAPITAL BUDGET/INVESTMENT DECISIONS (LONG TERM ASSET MIX)

The first and perhaps the most important decision that any firm has to make is to define the
business or businesses that it want to be in. This is referred to as strategic planning and it has a
significant bearing on how capital is allocated in the firm. As strategic planning calls for
evaluating costs and benefits spread out over time, it is essentially a financial decision making
process.
Once the managers of a firm choose the business or businesses they want to be in, they have to
develop a plan to invest buildings, machineries, equipment, research and development, go
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downs, showrooms, distributions, network, information infrastructure, brands and other long-
lived assets. This is the capital budgeting process.
Considerable managerial time, attention and energy is devoted to identify, evaluate and
implement investment projects. When you look at an investment project from the financial point
of view, you should focus on the magnitude, timing and riskiness of cash flows associated with
it. In addition consider the options embedded in the investment projects.
Investment decisions also relates to recommitting funds when an old asset becomes less
productive. This is referred to as replacement decisions.
1.6 CAPITAL STRUCTURE/FINANCING DECISIONS

Once a firm has decided on the investment projects it wants to undertake it has to figure out ways
and means of financing them. Finance decision refers to the decision on the sources of funds to
finance investment projects. Finance manager must decide when, where and how to acquire
funds to meet the firms investment needs. The key issues in capital structure are:
What is the optimal debt-equity ratio for the firm?
Which specific instruments of equity and debt finance should the firm employ?
At what price should the firm offer its securities?
Should the firm buy back its own shares?
1.7 DIVIDEND DECISION

Dividend is the third major finance decision. The finance manager must decide whether the firm
should distribute all profits or retain them or distribute some and retain the balance. The earnings
must also be distributed to other providers of funds such as preference shareholder and debt
providers. The dividend policy should be determined in terms of impact on the shareholders
value. Finance manager must decide the optimum dividend payout ratio so as to maximize the
value of the firm. The payout ratio is the percentage of dividends paid or recommended for
payment to the earning s available to shareholders.
Pay-out Ratio = Proposed/paid dividends

Earnings available to shareholder
Finance manager should also consider the questions of dividend stability, bonus shares and cash
dividends in practice
Note:
Capital structure and dividend decisions should be guided by

considerations of cost and flexibility. The objective should be to minimize the cost of
financing without impairing the ability of the firm to raise finances required for value
creating investment projects.
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1.8 WORKING CAPITAL MANAGEMENT/LIQUIDITY DECISIONS
Working capital management also referred to as short-term financial management, refers to the
day-to-day financial activities that deal with current assets (Inventories, debtors, short term
holdings of market securities and cash) and current liabilities (short-term debt, trade creditors,
accruals and provisions).
The key issues in working capital management are:-
What is the optimal level of inventory for the operations of the firm?
Should the firm grant credit to its customers and if so, on what terms?
How much cash should the firm carry on hand?
What sources of short term finance are appropriate for the firm?
1.9 FINANCIAL PROCEDURES AND SYSTEMS (ROUTINE FUNCTIONS

INCIDENTAL FUNCTIONS.
For effective execution of the executive functions certain other functions have to be routinely
performed. They concern procedures and systems and involve a lot of paperwork and time. They
do not require specialized skills of finance. Some of the most important routine finance functions
are;
(i) Supervision of cash receipts and payments.
(ii) Safeguarding of cash balances.
(iii) Custody and safeguarding of securities, insurance policies and other valuable
papers.
(iv) Taking care of the mechanical details of new outside financing.
(v) Record keeping and reporting and so on.
Note:
Manager in the modern enterprises is mainly involved in the

managerial finance functions; the routine functions are carried out by executives at
lower levels. The manager of finance must however supervise the activities of
these junior or lower level executives.
1.10
FINANCIAL MANAGERS ROLE
A financial manager is a person who is responsible in a significant way to carry out the finance
functions. He occupies a key position and thus a member of the top management team and his or
her role day-by-day is becoming more pervasive, intensive and significant in solving the
complex management problems.
Now his or her functions are neither confined to that of a score-keeper maintaining records,
preparing reports and raising funds when needed, nor is he or she a staff officer in a pervasive
role of an advisor. He/she is now responsible for shaping the fortunes of the enterprise and is
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involved in the most vital decision of the allocation of the capital. He must realize that his or her
actions have fare reaching consequences for the firm because they influence.
(i) Size of the firm
(ii) The profitability of the firm
(iii)Risk of the firm
(iv) The growth of the firm and
(v) The survival of the firm
1.11 MAIN FUNCTIONS/ROLES OF FINANCIAL MANAGER

Raising of Funds
It is the traditional approach which dominated the scope of the financial management and limited
the role of the financial manager simply to raising of funds. It was during the major events, such
as promotion, re-organization, expansion or diversification in the firm that the financial manager
was called upon to raise funds. His/her significant duty was to see that the firm had enough cash
to meet its obligations. The notable feature of the traditional view of the financial management
assumption is that financial Manager had no concern with the decision of allocating the firms
funds.
This traditional approach has been criticized because it failed to consider the day-to-day
managerial problems relating to financing of the firm. The traditional approach of looking at the
role of the financial manager lacked a conceptual framework for making financial decisions,
misplaced emphasis on rising of funds and neglected the real issues relating to the allocation and
management of funds.
Allocation of Funds
The traditional approach outlived its utility in the changed business situation since the mid
1950s. A number of economic and environment factors such as the increasing pace of
industrialization, technology innovations and inventions, intense competition management
inefficiency and failure, population growth and widened markets during and after mid 1950s
necessitated efficient and effective utilization of the firms resources including financial
resources.
The development of a number of management skills and decision making techniques facilitated
the implementation of a system of optimum allocation of the firms resources and as a result the
approach to and the scope of financial management also changed. The emphasis shifted from
the episodic financing to the managerial financial problems, from raising of funds to efficient
and effective use of funds. The new approach is embedded in sound conceptual and analytical
theories.
According to Ezra Solomon the central issue of financial policy is the wise use of funds and
central process involved is a rational matching of the advantages of potential uses against the
cost of alternative potential sources so as to achieve the broad financial goals which an enterprise
sets for itself. Thus the financial manager in his/her new role is concerned with the efficient
allocation of funds. The financial manager must find a rationale for answering the following
three questions:
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(i) How large should an enterprise be and how fast should it grow?
(ii) In what form should it hold its assets?
(iii) How should the funds required be raised?
The question above relate to three broad decision areas of financial management of investment,
financing and dividend decisions. Finance manager must help in making these decisions in the
most rational way.
Profit Planning
The term profit planning refers to the operating decisions in the area of pricing, costs, volume of
output and the firms selections of product lines. Profit planning is therefore a prerequisite for
optimizing investment and financing decisions. The cost structure of the firm i.e. the mix of fixed
and variable costs have a significant influence on the firms profitability.
Fixed cost remains unchanged or constant while variable costs change in direct proportion to
volume changes. Because of the fixed costs, profits fluctuate at a higher degree than the
fluctuation in sales. Profit planning helps to anticipate the relationships between volume, costs
and profits and develop action plans to face unexpected surprises.
Understanding Capital Markets
The finance manager has to deal with capital markets where the firms securities are traded. He
or she should fully understand the operations of capital markets and the way in which securities
are valued. He or she should also know how risk is measured in capital markets and how to cope
with it as investments and financing decisions often involve considerable risk e.g. if a firm uses
excessive debt to finance its growth, investors may perceive it as risky and therefore the value of
the firm may decline.
1.12 THE KEY CHALLENGES FOR THE FINANCIAL MANAGER APPEAR TO BE IN

THE FOLLOWING AREAS:
(i) Investment planning

(ii) Financial structure
(iii) Mergers, acquisitions and restructuring
(iv) Working capital management
(v) Performance management
(vi) Risk management
(vii) Investor relations
1.13 GOAL OF FINANCIAL MANAGEMENT

Much of the theory in corporate finance is based on the assumption that the goal of the firm
should be to maximize the wealth of its current shareholder. This goal has been eloquently
defended by distinguished finance scholars, economists and practitioners. The following are the
goals of a business.
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Profit Maximization
This is a traditional and a cardinal objective of a business. This is so for the following reasons.
(i) To earn acceptable returns to its owners; the return must be not less than the bank
interest rate + inflation +risk premium.
(ii) To meet its day- to-day obligations.
(iii)So as to survive in the long run through ploughing back of profits.
Firms produced goods and services. They may function in a market economy or a government
controlled economy. In a market economy prices of goods and services are determined in
competitive markets. Firms in the market economy are expected to produce goods and services
desired by society as efficiently as possible.
Price system direct managerial efforts towards more profitable goods and services. Prices are
determined by the demand and supply conditions as well as the competitive forces and they
guide the allocation of resources for various productive activities. Maximization of profit is not
as inclusive a goal as maximization of shareholders wealth. It is objected on several grounds
which include.
i) It is argued that profit maximization assumes perfect competition and in the face
of imperfect modern markets, it cannot be a legitimate objective of the firm.
ii) It is argued that profit maximization as a business objective developed in the early
19th century when the characteristics features of the business structure were self-
financing private property and single entrepreneurship. Modern business
environment is characterized by a limited liability and the divorce between the
management and ownership.
iii) It is also feared that profit maximization behavior in a market economy may tend
to produce goods and services that are wasteful and unnecessary to the societys
point of view. Also it may lead to unequal distributions of income and wealth.
iv) Profit maximization fails to provide an operationally feasible measure for ranking
alternative courses of action in terms of their economic efficiency.
Limitations of Profit Maximization
(i) Profit in absolute terms is not a proper guide to decision making. It should be
expressed either on a per share basis or in relation to investment after or before
tax profits etc. hence profit maximization is vague.
(ii) It leaves considerations of timing and duration undefined. There is no guide for
comparing profit now with profits in the future for comparing profit streams of
different duration i.e. ignores time value of money.
(iii)If profits are uncertain and described by a probability distribution the meaning of
profit maximization is not clear i.e. it ignores risk e.g. where two firms have same
total expected earnings but if the earnings of one firm fluctuate considerably as
compared to the firm would prefer smaller but surer profits to potentially larger
but less certain stream of benefits.
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Shareholders Wealth Maximization
It is an appropriate and operationally feasible criterion to choose among the
alternative financial actions. It provides unambiguous measure of what financial
manager should seek to maximize in making investment and financing decisions on
behalf of owners or shareholders.
Shareholders wealth maximization means maximizing the net present value (NPV) of
a course of action to shareholders. NPV of a course of action is the difference
between the present value of its benefits and the present value of its costs.
Where A1, A2 An represent the stream of benefits expected to occur if a course

of action is adopted.
Co is cost of a course of action
K Appropriate discount rate/interest rate.
If NPV is positive it creates wealth for shareholders and therefore is desirable. The
opposite is true.
Strengths of shareholders wealth maximization objective
i) It takes care of the timing i.e. time value of money and risk through discounting.
ii) Maximizing the shareholders economic welfare is equivalent to maximizing the
utility of their consumption overtime. The wealth created by the company through
its actions can be reflected in the market value of the companys shares. Therefore
wealth maximization of the shareholders becomes the fundamental objective of a
firm.
Other Goals/Objective of a Firm
Business firms often pursue several goals. They seek to achieve a high:
(i) Achieve a high rate of growth
(ii) Enjoy a substantial market share
(iii) Attain product and technological leadership
(iv) Promote employee welfare
(v) Further customer satisfaction
(vi) Support education and research
(vii) Improve community life and solve societal problems
(viii) Pay government taxes promptly, go by government plans and operate
within legal framework.
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1.14 AGENCY PROBLEM
In proprietorships, partnerships and co-operative societies owners are actively involved in
management. But in companys particularly public limited companies, owners typically are not
active managers. Instead they entrust this responsibility to professional managers who may have
little or no equity stake in the firm.
Reasons for separation of ownership
(i) Most enterprises require large sums of capital to achieve economies of scale. Hence it
becomes necessary to pool capital from thousands or even hundreds of thousands of
owners. It is impractical for many owners to participate actively in management.
(ii) Professional managers may be more qualified to run the business because of their
technical expertise, experience and personality traits.
(iii)Separation of ownership and management permits unrestricted change in owners through
share transfers without affecting the operations of the firm. It ensures that the knowhow
of the firm is not impaired, despite changes in ownership.
(iv) Given economic uncertainties, investors would like to hold a diversified portfolio of
securities such diversification is achievable only when ownership and management are
separated.
While there are compelling reasons for separation of ownership and management, a separated
structure leads to a possible conflict of interest between managers (agents) and shareholders
(principals). Though managers are the agents of shareholders they are likely to act in ways that
may lead not to maximize the welfare of shareholder.
Note:
Where shareholders contribute capital which is given to the directors

which they utilize and at the end of each accounting period renders an explanation at the
Annual General Meeting (AGM) of how the financial resources are utilized this is known
as stewardship accounting.
Types of Agency Relationships in Finance

There are various types of Agency relationships which include
(a) Shareholders acting as principal in appointing Managements agents.
(b) Creditors as principal and shareholders as agents.
(c) Shareholders as principal and auditors as agents.
1.15 SHAREHOLDERS AND MANAGERS

Whenever Ownership is separate from control, the following conflict of interest can arise:
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(i) Managers may not strive hard to improve shareholders wealth since that wealth
will not accrue to them.
(ii) Managers can take non-optimal decisions in investment, financing or labor
recruitment.
(iii) Managers can take expensive business trips wholly financed by shareholders.
(iv) Managers spending unreasonable amounts of money on office renovations
financed by shareholders.
Ways of resolving agency problem between shareholders and management.
(i) Incur costs in monitoring management actions by regular audits.
(ii) Restructure the organization in such a way as to limit management behavior e.g.
appoint outside investors who are non-shareholders to the board of directors.
(iii) Putting restrictions such as requiring shareholders to vote on certain issues which can
limit the ability of management to take action that can affect the shareholders wealth.
This is an opportunity lost since managers hands are tied.
(iv) Performance based compensation- design the remuneration of managers as salary plus
bonuses paid at year end based on profits earned.
(v) Grant managers Stock options. Stock options are certificates given to the managers
entitling them to purchase a specified number of shares in the firm at a price below
market price. In future the managers will have the incentive to improve market prices
because they will gain.
(vi) Direct intervention by shareholders Institutional investors and shareholders can
intervene and insist on better ways of managing the firm by:
Discussing with management and putting recommendations on how business should
be run.
Sponsoring a proposal to be voted for at the Annual General Meeting (AGM).
(vii) Threat of firing top management team should be made aware that they can be fired
for poor performance.
(viii) Threat of hostile takeover- This occurs where the shares of a company are selling at a
price which is below the potential price due to mismanagement. Such a company can be
taken over and the management is fired. Managers will strive to maximize share prices
so as to minimize possibility of takeover.
1.16 EXECUTIVE CONTRACTS AND BONUS PLANS

Compensation contracts particularly incentive and bonus plans provide important direction
and motivation for corporate executives. Decentralized firms have incentive compensation
contracts for their top management group to encourage profit maximization decisions at the
division and corporate levels and to stimulate individuals to higher levels of performance.
Executive plans should:
1. Be competitive to attract and retain high quality managers.
18
2. Communicate and reinforce the key priorities in the firm and tie bonuses to key indices of
performance.
3. Foster the development of performance oriented climate within the firm by rewarding
good performance relative to potential.
1.17 SPECIFIC FORMS OF MONETARY COMPENSATION PLANS

1. Cash bonus, profit sharing and stock bonus.
These are based on corporate profit and individual performance during a specific period.
The scheme relates to short run performance and could be detrimental to the long-run
interests of the firm.
2. Deferred Bonus and Compensation
The benefit is payable in a specific future period. The scheme is called GOLDEN
HAND CUFFS because they make it very expensive for key executives to leave a
company.
3. Stock options
Gives executives the right to purchase company stock at a price established when the
option was granted. The price is usually the current market price or 95% of market price;
this scheme usually encourages executives to reduce the risk averse behavior that would
otherwise accompany their ownership of stock and to undertake riskier projects with
higher pay-offs.
4. Performance shares or units
The scheme awards company stock (shares) for achieving a specified usually long term
performance targets. This may encourage management to improve accounting results that
may not necessarily improve economic worth of the firm.
5. Stock appreciation rights and phantom stock.
These are deferred cash payments based on the increase of stock price from the time of
award to the time of payment. Phantom stock plans are awards in units of number of
shares of stock. After qualifying for receipt of the vested units, executive receives in cash
the number of units multiplied by the current market price of the stock.
1.18 IDEAL CONDITIONS FOR THE USE OF INCENTIVE SYSTEM

i) Where profits are affected by numerous short term decisions.
ii) Where managers are expected to be entrepreneurial and ambitious.
iii) Where the managers have the authority to make decisions e.g. in a decentralized
organization, managers make decisions on operations of product lines.
iv) The control system is well defined and performance is evaluated on a systematic basis
either by comparison to a plan or by comparison to the performances of similar firms.
19
1.19 CONDITIONS MAKING IT DIFFICULT FOR A FIRM TO APPLY EXECUTIVE
INCENTIVE PLANS
i) Budgets are difficult to develop or data does not exist about competitors to judge the
adequacy of managerial performance.
ii) Where profit are most affected by a few long-term decisions.
iii) Where the company is organized on a functional basis e.g. marketing, production,
finance etc.
iv) Where decision making need not be rapid or responsive.
1.20 ACTIONS THAT CAN INCREASE REPORTED EARNINGS THROUGH

ACTIONS THAT DO NOT BENEFIT THE FIRM.
1. Providing goods in excess of demand in order to absorb fixed costs into inventory and
thereby increase reported income.
2. Repurchasing debt or preferred stock selling at a discount.
3. Switching to straight line method of depreciation or the financial reporting.
4. Purchase other companies under terms that allow use of pooling of interest methods.
5. Selling off assets whose market value is well in excess of book value.
6. Increase the leverage of the firm by issuing debt and acquiring assets whose returns
exceed the after tax debt cost but are below the risk adjusted cost of capital.
1.21 AREAS WHERE CONTROL COULD BE EXERCISED TO DETECT SUB-

OPTIMAL DECISIONS
(i) Increase or decrease in profits caused by the accounting conventions rather than operating
performance.
(ii) Increase in profits caused by failure to adjust for price level changes.
(iii)Increase in profits not commensurate with performance of similar companies in the same
industry.
(iv) Increase in profits caused by concentration of short term rather than long term
performance measures.
(v) Actions that maximize divisional performance measures at the expense of overall
corporate welfare.
1.22 CONFLICT BETWEEN SHARE HOLDERS AND CREDITORS

Creditors lend funds to the firm at rates of interest which reflect their perceived risk. The
shareholders through management may take on new ventures which have higher risks than
anticipated by creditors. If the high risk venture succeeds the higher benefit goes to the
shareholder since creditors will only get fixed return. In case of loss, creditors also share in
the loss.
Ways to solve shareholders and creditors conflict
(i) Restrictions in credit agreements on how funds are to be used.
20
(ii) Loans can be recalled at a short notice if unethical practices are noticed.
(iii)Interest rates above normal rates can be charged to discourage borrowing.
1.23 CONFLICT BETWEEN SHAREHOLDERS AND AUDITORS

Auditors are appointed by shareholders to monitor operations of management and to provide
evidence to financial reports. Due to conflict of interest, the auditor may give misleading reports
or failure to notify the shareholders an impending problem.
Ways of resolving shareholders Vs Auditor conflict
(i) Disciplinary action by professional body e.g. ICPAK.
(ii) Legal action against auditors if one can show that they suffered a loss as a result of
reliance on the audit report.
(iii)Threat of firing by shareholders even before the end of the year.
1.24 SUMMARY
In this lesson we provided an overview of financial management and of the

financial environment we have discussed the financial decision, financial managers role in
the organization, objectives of financial management and agency problem
1.25 ACTIVITIES
Visit any company of your choice and find out how does it organise its finance
functions
21
1.26 SELF TESTING QUESTION
1. Define the scope of financial management. What role should financial managers
play in a modern enterprise?
2. What are the basic financial decisions? How do they involve risk/return trade-off?
3. The profit maximization is not an operationally feasible criterion. Do you agree?

Illustrate your views.
1.27 FURTHER READING
1. Pandely I. M (2009); Financial Management 10th Edition, Vikers publishing house, new Delhi
2. Home, V. J (2009); Financial Management 12th Ed, Prentice Hall
3. Brigham, E. F. & Ehrhardt ,M. C (2005); Financial management(Text and Cases),Cengage Learning
4. Eun, C. S. & Resnick, B. G (2009);International Financial Management 5th Ed, Singapore
5. Pandey, I. M (2010) Financial Management 10th Ed, Vikas Publishing House
22
LESSON TWO
THE TIME VALUE OF MONEY
2.0 INTRODUCTION
Money has time value. A shilling today is more valuable than a shilling in a year hence.
Why? There are several reasons which include:
Individuals in general prefer current consumption to future consumption.

Capital can be employed productively to generate positive returns. An
investment of one shilling today would grow to (1+r) a year hence (r is the
rate of return earned on the investment).
In an inflationary period a shilling today represents a greater real purchasing
power than a shilling a year hence.
Most financial problems involve cash flows occurring at different points of time. These
cash flows have to be brought to the same point of time for the purposes of comparison
and aggregation.
2.1 LEARNING OBJECTIVES
Understand what gives you money its time value

Explain the methods of calculating present and future values
Highlight the use of present value technique (discounting) in financial decisions
Introduce the concept of internal rate of return
23
2.2 TIME LINES AND NOTATION
When cash flows occur at different points in time, it is easier to deal with them using time line.
Thus a cash flow stream of Kshs 10,000,000 at the end of each of the five years can be depicted
on a time line like the one shown below. Assume a discount rate of 12%.
Time line
0 2 3 4 5
12% 12% 12% 12% 12% Part A
1
Sh. 10M Sh. 10M Sh. 10M Sh. 10M Sh. 10M
0 1 2 3 4 5
Part B
Sh. 10M Sh. 10M Sh. 10M Sh. 10M Sh. 10M Sh. 10M
A cash flow that occurs at time 0 is already in present value terms and hence does not require
any adjustment for time value of money. We must not distinguish between a period of time and a
point in time. Period 1 which is the first year is the portion at time line between point O and
point 1. The cash flow occurring at point 1 is the cash that occurs at the end of period 1. If cash
flow occurs at the beginning, rather than the end of each year the time line would be shown in
part B.
(i) Note that a cash flow occurring at the end of year 1 is equivalent to a cash flow occurring
at the beginning of year 2.
(ii) Cash flows can be positive or negative. A positive cash flow is called a cash inflow; a
negative cash flow is called a cash outflow.
(iii)The following notations will be used in our discussion.
PV: Present value
FVn: Future value n years hence
Ct: Cash flow occurring at the end of year t.
A: A stream of constant periodic cash flow over a given time.
r: Interest rate or discount rate
g: Expected growth rate in cash flows
n: Number of periods over which the cash flows occur.
There are two most common methods of adjusting cash flows for time value of money. They
include:
(i) Compounding
(ii) Discounting
2.2.1 COMPOUND VALUE

The process of finding the future value of a payment or series of payments or receipts when
applying the concept of compound interest is known as compounding. Although future has
greater intuitive appeal, the concept of present value is more useful in making financial
24
decisions. Future value refers to the value at a given future date of the present amount placed
on deposit today and earning interest at a specified interest rate. Future value depends on the
rate of interest earned and also on the length of time a given amount is left on deposit.
Compound Value (Future Value) of a Lump sum
Compound interest indicates that amount of interest earned on a given deposit becomes part
of the principal at the end of a specified period. The term principal denotes the amount of
money on which interest is paid. The future value of a present sum of money is found by
applying compound interest over a specified period of time. Amount received or paid once is
referred to as a lump sum.
Example 1
Suppose you invest Shs 100,000 for three years in a saving account that pays 10% interest
per year. If you let your interest income to be re-invested your investment will grow as
follows:
1st Year: Principal at the beginning of the year 100,000

Interest for the year (10% x Shs 100,000=) 10,000
Principal at the end. 110,000
2nd Year: Principal at the beginning of the year 110,000

Interest for the year (Sh 1100 x 10%) 11,000
Principal at the year 121,000
3rd year Principal at the beginning of the year 121,000

Interest for the year (Sh 1210 x 10%) 12,100
Principal at the year 133,100
Note
The process of investing money as well as re-investing the interest earned

thereon is called compounding. The future value of compound value of an investment offer
n years when interest rate is % is:
(1+ ) n = is called the future value of interest factor (FVIF) or simply the future value factor
(FVF) or compound value factor (CVF).
25
Example 2
Suppose your mother gave you Kshs 100,000 on your 15th birthday. You deposited this
amount in a bank at 10% value of interest for one year. How much future sum would you
receive on your birthday?
Solution
FVn = PV (1+ ) n PV=Present value/principal
1
= 100, 000 (1+10%) n = number of years = 1 yrs
= 110,000
Note
You can consult a future value interest factor (FVIF) table. From the table (1+10%) 3 =
1.331
FVn = PV x FVIF r%, n years.
FVn = 100,000 x 1.331 = 133,100

Compound and Simple Interest
So far we assumed that money is invested to earn further interest in the future periods by
contrast if no interest is earned on interest the investment earns only simple interest. In such a
case the investment grows as follows.
FVn = [PV x Interest rate x Years] + Present value (PV).
Example 3
An investment of Shs 1000, if invested at 12% simple interest rate will in 5 years became:
Solution
FV = 1000 x 12% x 5 Years + PV
= Shs 1,600
Value of Shs 1000 invested at 10 simple and compound.

Year Simple interest Compound interest
Starting balance + interest = Starting balance + interest = Ending
Ending bal balance
1 1000 + 100 = 1000 + 100 = 1100
5 1100 1464 + 146 = 1610
10 1400 + 100 = 2358 + 236 = 2594
20 1500 6116 + 612 = 6728
50 1900 + 100 = 106719 + 10672 =
100 2000 117,391
2900 + 100 = 12,527,829 + 1,252,783 =
3000 13,780,612
5900 + 100 =
26
6000
10900 + 100 =
11000
Note:
Under simple interest the growth is linear and under compound interest the growth is
exponential.
Future Compound Interest

Value
Simple Interest
Doubling period
Investors commonly ask the question: How long would it take to double the amount at a given
rate of interest? There is a rule of thumb that can be used to calculate the period it would take to
double the amount at a given interest rate. This rule is called 72 rule. According to this value, the
doubling is obtained by dividing 72 by the interest rate.
Example 4
If interest rate is 8% the doubling period is about 9 years i.e. 72/8 = 9 years. Likewise if the
interest rate is 4% the doubling period is about 18 years 72/4.
Though the method is somewhat crude, it is a handy and useful rule of thumb. If you are inclined
to do a slightly more involving calculation, a more accurate rule of thumb is the rule of 69.
According to this rule of thumb, the doubling period is equal to:
Doubling period = 0.35 + 69
Interest rate
Example 5
The doubling period for amount invested on interest rate of 10% and 15% is
Interest rate doubling period
10% 0.35 + 69 = 7.25 years
10
27
15% 0.35 + 69 = 4.95 years
15
Alternative method
You can use financial tables of FVIF calculate the period it would take to double the amount.
Example 6
Period 6% 8% 12% 14%
interest
2
4
6 1.974
8
10
12 2.012
When the interest rate is 12% it takes about 6 years to double the amount, when the interest is
6% it takes about 12 years to double the amount so on and so forth.
Finding the Growth Rate
Suppose your company currently has 5000 employees and this number is expected to grow by
5% per year, how many employees your company will have in 10 years?
Solution
5000 x (1.05)10 = 5.000 x 1.629 = 8145
Example 7
Phoenix limited had revenues of Kshs 100m in 1990 which increased to Shs 1000m in 2000.
What was the compound growth rate of revenues?
Solution
28
2.2.2 DISCOUNT VALUE/PRESENT VALUE
Present value is the current shilling value of the future amount; the amount of money that would
be invested today at a given interest rate over a specified period so as to equal the future amount.
The present value mainly depends on the investment opportunities and the point in time at which
the money is to be received. The process of finding present values is usually referred to as
discounting. Discounting is the process of determining the present value of future payments or
receipts or a series of future payments receipts. The interest rate used for discounting cash flows
is called the discount rate, cost of capital or sometimes the required rate of return.
Present Value of a Single Amount
The present value factor is used to calculate the present value of an amount to be received in the
future.
or is the present value interest factor (PVIF).
The present value factor can also be obtained from the present value tables.
Example 8
Suppose someone promises to give you Shs 1,000,000 three years hence. What is the present
value of this amount if the interest rate 10%?
Solution
Where
r = 10%
FV = Shs 1,000,000
n = 3 years
Exercise 1
Suppose that an investor wants to find out the present value of Shs 50,000 to be received after 15
years. The interest rate is 9% per annum. What is the equivalent of the Shs 50,000 to be received
in 15 years now?
29
2.2.3 PRESENT VALUE FOR UNEQUAL PERIODIC SUM
In the investment decisions of the firm, one would not frequently get a constant periodic sum i.e.
annuity. In most cases the firm receives a stream of uneven cash inflows. The procedure is to
calculate the present value of each cash flow and aggregate all the present values.
Example 9
Consider that an investor has an opportunity of receiving Shs 10,000, Shs 15,000, Shs 8,000, Shs
11,000 and Shs 4,000 respectively at the end of one year through five. Find out the present
values of this stream of cash flows if the investors interest rate is 8%.
General Solution
Solution
Year Cash flows PVIF 8% n PV
1 10,000 0.926 9,260
2 15,000 0.857 12,855
3 8,000 0.794 6,360
4 11,000 0.735 8,085
5 4,000 0.681 2,724

39,284
2.2.4 COMPOUND OR FUTURE VALUE OF AN ANNUITY

An annuity is a stream of constant cash flows (payments or receipts) occurring at regular
intervals of time. The premium payment of a life insurance policy, for example are annuities.
When the cash flows occur at the end of each period the annuity is called an ordinary annuity or
a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is
called an annuity due.
30
Example 10
Suppose you deposit Shs 100,000 annually in a bank for 5 years and your deposits earn a
compound interest rate of 10%. What will be the value of this series of deposits (an annuity) at
the end of 5 years?
Formula
Where is the compound value factor for Annuity CVAF/FVAF
Solution
Note:
The CVAF can be found from the financial tables of Future Value of Annuity
Interest Factor.
The above is an example of a deferred/ordinary annuity.
Time line for an annuity
0 1 2 3 4 5
(1.1)0 = 1.000 1.000 x 100,000 = 100,000

1
(1.1) = 1.100 1.100 x 100,000 = 110,000
2
(1.1) = 1.210 1.210 x 100,000 = 121,000
(1.1)3 = 1.331 1.331 x 100,000 = 133,100

(1.1)4 = 1.464 1.464 x 100,000 = 146, 400
6.105 x 100,000 = 610,500
31
2.2.5 SINKING FUND
Sinking fund is a fund which is created out of fixed payments each period to accumulate to a
future sum after a specified period. The factor used to calculate the annuity for a given future
sum is called the Sinking Fund Factor, SFF. SFF ranges between zero and one. It is equal to the
reciprocal of the compound value of annuity factor.
In the above example of the compound value of annuity the reciprocal of CVAF of 6.105 is
If the future sum of Shs 610,500 is multiplied by SFF of 0.164, we obtain the annuity of Shs
100,000.
Sinking fund factor is useful in determining the annual amount to put in a fund to repay bonds or
debentures at the end of a specified period.
2.2.6 PRESENT VALUE OF AN ANNUITY

Present value of annuity (PVAIF) is used to calculate the present value of an annuity.
Example 11
Suppose that you expect to receive Shs 100,000 annuities for 3 years, each receipt occurring at
the end of the year. What is the present value of the stream of benefits if the discount rate is
10%?
Note
The present value of this annuity is simply the sum of the present of all the inflows of this
annuity
32
Solution
A = 100,000
= 10%
n = 3years
Time line
0 1 2 3
1
0.909 /(1-1)1
1
0.826 /(1-1)2 Present value of the annuity
1
0.751 /(1-1)3 0.909 x 100,000 = 90,900
2.486 0.826 x 100,000 = 82,600
03751 x 100,000 = 248,600
Example 12
After receiving your budget you have determined that you can afford to pay Shs 120,000 per
month for 3 years toward a new car. You call a finance company and learn that the going rate of
interest on car finance is 1.5% per month for 36 months. How much can you borrow?
33
Solution
2.3 CAPITAL RECOVERY AND LOAN AMORTIZATION

Most loans are rapid in equal periodic installments (monthly quarterly or annually), which cover
interest as well as principal repayment. Such loans are referred to as amortized loans. For an
amortized loan we would like to know;
(a) The periodic installment payment and
(b) The loan amortization schedule showing the break-up of the periodic installment
payments between the interest component and the principal repayment component.
Capital recovery is the annuity of an investment for a specified time at a given rate of interest.
The reciprocal of the PVIAF is called the Capital Recovery Factor CRF r% n years.
Example 13
You want to borrow Kshs 1,080,000 to buy a flat. You approach a house hence company which
charges 12.5% interest. You can pay Shs 180,000 per year toward loan amortization. What
should be the maturity period of the loan?
Solution
The PVA of annuity of Shs 180,000 is set equal to Shs 1,080,000
34
You can perhaps request for a maturity of 12 years.
Example 14
Suppose a firm borrows Shs 1,000,000 at an interest rate of 15% and loan is to be repaid at the
end of each of the next 5 years. What is the annual installment? Prepare of loan amortization
schedule.
35
b) Loan amortization schedule
4=2-3 5=1-4
1 2 3=1x0.15 Principal Remaining
Year Beginning Amount Annual Interest Repayment balance
installment
0 1,000,000
1 1,000,000 298,329 150,000 148,329 851,671
2 851,671 298,329 127,751 170,578 681,092
3 681,092 298,329 102,164 196,165 484,927
4 484,927 298,329 72,739 225,590 259,337
5 259,337 298,329 38,900 259,428 -91
2.3.1 PRESENT VALUE OF A GROWING ANNUITY

A cash flow that grows at a constant rate for a specified period of time is a growing annuity. The
time line for a growing annuity is as follows.
1 2 3 4 n
A(+g) A(1+g) A(1+g) A(1+g) A(1+g)
0 1 2 3 4 n
PV of a growing annuity
The above formula can be used when the growth rate is less than the discount rate (g<r) as well
as when the growth rate is more that the discount rate ( > ). However it does not work when
the growth rate is equal to the discount rate ( = ). Where = the present value is simply equal
to nA.
36
Example 15
Suppose you have the right to harvest a teak plantation for the next 20 years over which you
expect to get 100,000 cubic feet of teak per year. The current price per cubic feet of is Kshs
5000, but it is expected to increase at a rate of 8% per year. The discount rate is 15% per year.
The discount rate is 15%.
Required
The present value of the teak that you can harvest from the teak forest
Alternative Method
Where is adjusted discounted rate
37
2.4 DETERMINING THE PERIODIC WITHDRAWAL
Example 16
Suppose your father deposits Kshs 300,000 on retirement in a bank which pays 10% annual
interest. How much can be withdrawn annually for a period of 10 years.
Finding Interest Rate
Example 17
Suppose someone offer the following financial contract. If you deposit Kshs 10,000,000 with
him he promises to pay 2,500,000 annually for six years. What interest rate do you earn on this
deposit?
Solution
In the tables 4 lies in the middle of
AND ie
4.111 and 3.889 respectively
38
Valuing an Infrequent Annuity
Example 16
Raphael will receive an annuity of Kshs 500,000 payable one every two years. The payment will
stretch out over 30 years. The first payment will be received at the end of two years. If the annual
interest rate is 8%, what is the present value of the annuity?
Solution
The interest rate over a two-year period is
Equiting Present Value of Two Annuities
Example 18
Ravi wants to save for the college education of his son, Deepak. Ravi estimates that college
education will be Ksh.10,000,000 for four years when his son reaches college in 16 years the
expenses will be payable at the beginning of the years. He expects annual interest rates of 8%
over the next two decades. How much money should he deposit in the bank each year for the
next 15 years (Assume that the deposit is made at the end of the year) to take care of his sons
college education expenses?
Solution
Present value of the college expenses when his son becomes 15 years old
39
The annual deposit to be made so that the future value of the deposits at the end of 15 years is
Sh.3, 312,000
Annuity Due
There is a variation which is fairly common in which ash flows occur at the beginning of each
period such an annuity is called an annuity due.
(a) The future value for annuity due
(b) Present value of annuity due
Present Value of Perpetuity

Perpetuity is an annuity of infinite duration. For example, the Kenya Government has issued
bonds called consols which pay yearly interest forever.
Example 19
An investor expects a personal sum of Kshs 50,000 annually from his investment. What is the
present of this perpetuity if interest rate is 10%.
Solution
40
Growing Perpetuity
Example 20
An office complex is expected to generate a net rental of Kshs 3 million next year, which is
expected to increase by 5 percent every year. If we assume that the increase will continue
indefinitely, the rental stream is a growing annuity if the discount rate is 10% the present value
of the rental stream is:
Intra Year Compounding And Discounting
This is where the compounding or discounting is done more frequently as opposed to annually.
Example 21
Suppose you deposit Kshs 100,000 with a finance company which advertises that it pays 12%
interest semi-annually what would be the value after 1 year.
Continuous Compounding
Sometimes compounding may be done continuously. For example bonus may pay interest
continuously they call of daily compounding. It can be mathematically proved that the
continuous compounding function will reduce to the following:
Example 22
Find the compound value of Shs 1000 interest rate being 12 percent per annum if compounded
continuously for 2 years.
41
The formula for continuous compounding can be transformed into a formula for calculating
present value under continuous compounding.
Thus if Kshs 1271.30 is due 2 years, discount rate being 12 percent the present value of the
future sum is;
Effective versus Stated Rate

In example 20, above that Shs. 100,000 grow to Shs 126,248 at the year end if the stated rate of
interest is 12% and compounding is done semi-annually. This means that Shs 100,000 grows at
the rate of 12.36 per cent per annum. That is
Is called the effective rate. The rate of interest under annual compounding which produces the
same result as that produced by an interest rate 12% under semiannual compounding.
The general relationship between the effective interest rate and the stated annual interest rate is
as follows.
Where m is the frequency of compounding per year
Example 23
Suppose a bank offers 12% stated annual interest rate. What will be the effective rate when
compounding is done annually, semi-annually and quarterly?
Solution
42
Effective interest rate with annual compounding
When compounding is semi-annuity
Effective interest rate with quarterly compounding
Shorter Discounting Periods

Sometimes cash flows have to be discounted more frequently than once a year; semi annually,
quarterly, monthly or daily. As in the case of intra year compounding, the shorter discounting
period implies that:
(i) The number of periods in the analysis increases and
(ii) The discount rate applicable per period decreases.
Formula
Where PV is present value

FVn is the cash flow after n years
M is the number times per year discounting is done
= Discount rate
Example 24
Consider a cash flow of Shs 10,000 to be received at the end of four years. What is the present
value of this cash flow if compounding is done quarterly?
43
2.5 SUMMARY
Most financial decisions involve situations in which someone pays money at one point in
time and receives money at some later time. Money paid and received at two different points
in time are different, and this difference is recognized and accounted for by time value of
money (TVS) analysis. Therefore the above lesson has discussed the methods of finding the
value of money.
2.6 ACTIVITIES
Establish how institutions, especially banks in your country deal with the issue of time value
of money.
2.7 SELF TESTING QUESTIONS
1. Generally individuals show a time preference for money. Give reason for such
preference.
2. An individuals time preference for money may be expressed as a rate explain.
3. You expect to receive Ksh. 100,000 after five years. If your required rate of return is 10%,
what is the present value of Ksh. 100,000?
44
2.8 FURTHER READINGS
45
LESSON THREE
RISK AND RETURN
3.0 INTRODUCTION
Risk and return are most important concepts in finance. They are the foundation of the
modern finance theory. In this lesson we start from the basic premise that investors like
returns and dislike risk. With most investments, an individual or business spends money
today with expectation of earning even more money in the future. The concept of return
provides investors in a convenient way to express the financial performance of an
investment.
1. Define risk and return concept

2. Be able to measure risk using measures of dispersion.
3. Be able to select the most efficient investment or portfolio.
3.2 RISK AND RETURN OF A SINGLE ASSET

The rate of the return on a share consists of its dividend yield and the capital gain percentage.
Return = Dividend + Capital gain
Where R is the rate of return
The dividend yield
Is the percentage of capital gain
46
Example
Suppose you buy one share on 2008 for Kshs. 225. You expect to receive a dividend of Kshs.2.5
and sell the share for Kshs. 272 after one year. Calculate the return on the share.
The return is made up of 1.1% dividend yield and 20.9 % capital gain.
Suppose the market price of the above share was Sh.200 instead of Sh. 272. What is the expected
return?
Average Rate of Return

The rate of return of a share may be calculated for a period longer than one year. The average
return is the sum of the various one-period rates of return divided by the number of periods.
Where is the average rate of return.R1 R2 R3--- Rn, the observed rates of return in periods 1, 2,
3---n and n the total number of periods?
Variability of Rates of Return

The variability of rates of return is the extent of deviations (dispersions) of individual rates of
return from the average rate of return.
There are two measures of variability i.e. dispersion. They include:
i) Variance
ii) Standard deviation
Steps of calculating variance and standard deviation of rates of return of assets or
securities using historical returns
1) Calculate the average rate of return
2) Calculate the deviation of individual rate of return from the average rate of return and
square it.
47
3) Calculate the sum of squares of the deviations as determined in second step and divide it
by the number of periods (or observations) to obtain variance i.e.
Variance =
4) Calculate the square root of the variance to determine the standard deviation i.e.
Standard deviation
Illustration
J&N a paint company has the following dividend per share (Div) and the price per share (MPS)
for the period 1997-2002.
Year Div (sh.) MPS
1997 1.53 31.25
1998 1.53 20.75
1999 1.53 30.88
2000 2.00 67.00
2001 2.00 100.00
2002 3.00 154.00
Calculate the annual rates of return of J&Ns share for the last 5 years.
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or = = 48.28
The of J&Ns share returns are quite high. The share is very risky.
3.3 CALCULATING EXPECTED RETURN AND RISK USING FORECASTED DATA

Instead of using historical data for calculating return and risk, we may use forecasted data. The
expected return and risk depend on dividend per share and the market price per share at which
you could sell the share. Both the outcomes i.e. dividend per share and the market price per share
are not known and will depend on the economy conditions, the performance of the company and
49
other factors. Outcome of dividend and the share price will depend on possible economic
scenarios to arrive at judgment about the expected return.
Example
The shares of the hypothetical company Limited has the following anticipated returns with
associated probabilities.
Return (%) Probability
-20 0.05
-10 0.10
10 0.20
15 0.25
20 0.20
25 0.15
30 0.05
The expected rate of return is;
Where is the expected rate of return, Ri the outcome i, Pi is the possibility of the occurrence
of i and n the number of outcomes
The information about the expected return and standard deviation helps an investor to make
decision about investments. A risk averse investor will prefer investments with higher rates of
return and lower standard deviations. If two investments have the same return, the investor will
choose the investment with lower standard deviation. On the other hand, if these investments
have same standard deviation, the investor would prefer the one with higher return.
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3.4 PORTFOLIO THEORY AND RISK DIVERSIFICATION
A portfolio is a combination of assets held by the investor for investment purpose. Portfolio
theory therefore attempts to show an investor how to combine a set of assets to maximize the
assets returns as well as minimize the assets risk i.e. risk diversification.
Diversification is combining assets whose returns are not perfectly corrected to reduce the
aggregate risk of the total asset holding or the portfolio.
Factors to consider in the choice of investment
1) Security Maintenance of capital-value

2) Liquidity If made with short term funds should be convertible into cash with short
notice.
3) Return Obtain highest return compatible with safely.
4) Spreading of risks Spread risks over several investments, so losses on some are offset
by gains on others
5) Growth prospectus Investment in steadily growing businesses.
Expected Return and Risk
When an investor has portfolio of securities, he will expect the portfolio to provide a certain
return on his investment. The expected return of a portfolio will be a weighted average of the
expected returns of the investments in the portfolio, weighted by the proportion of total funds
invested in each.
The risk is an investment, or in a portfolio of investment, is the risk that the actual return will not
be the same as the expected return. The actual return may be higher, but it may be lower.
Example
Returns %
State of economy Probability X Y
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20
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1.0
Suppose the investor invests 50% of his wealth in X and 50% in Y calculate the expected return
of the portfolio.
Alternative Method
Combined return (%) Expected return (%)
State of eco Probability X 50% and Y 50%
A 0.1 (0.5-8) + (0.514) = 3 (0.13) = 0.3
B 0.2 (0.5 10) + (0.5 - 4) = 3 (0.2 3) = 0.6
C 0.4 (0.5 8) + (0.5 6) = 7 (0.4 7) = 2.8
D 0.2 (0.5 5) + (0.5 15) = 10 (0.2 10) = 2.0
E 0.1 (0.1 -4) + (0.5 20) = 8 (0.1 8) = 0.8
6.5%
Note
The expected return on a portfolio will depend on the percentage of wealth

invested in each asset e.g. If the investor invests 20% of wealth in X and the rest in Y, what
would be the
The advantage of investing your wealth in both assets X and Y is that when you could expect a
maximum return of 8% by investing entire wealth in Y, and 6.5% in the portfolio, the risk is
higher. Under the unfavorable economic condition, Y may yield a negative return of 4%. When
you combine X and Y, the probability of negative return is eliminated and also portfolio returns
are expected to fluctuate within a narrow range of 3% to 10%.
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3.5 CORRELATION OF INVESTMENTS
Portfolio theory states that individual investments cannot be viewed simply in terms of their risk
and return. The relationship between the return from one investment and return from other
investments is just as important. The relationship between investments can be one of three types.
a) Positive Correction
When there is positive correlation between investments, if one investment does well it is
likely that the other will do well. Thus if you buy shares in one company making
umbrellas and in another which sells raincoats you would expect both companies to do
badly in dry weather.
b) Negative Correlation
If one does well the other will do badly and vice versa. Thus if you hold shares in one
company making umbrellas and in another which sells ice cream, the weather will affect
the companies differently.
c) No Correlations
The performance of one investment will be independent of how the other performs. If
you hold shares in a mining company and in a leisure company, it is likely that there
would be no relationship between the profits and returns from each.
The relationship between the returns from different investments is measured by

correlation coefficient. A figure close to +1 indicates high positive correlation and a
figure close to -1 indicates high negative correlation. A figure of 0 indicates no
correlation. If investments show high negative correlation, then by combining them in a
portfolio overall risk would be reduced. Risk would also be reduced by combining in a
portfolio of investments which have no significant correlation.
Example
Security A and security B have the following expected returns
Probability Security A Return Security B Return
0.1 15% 10%
0.8 25% 30%
0.1 35% 50%
a) Calculate the standard deviation of each security

b) Calculate the expected risk when assuming
i) Positive correlation
ii) Negative correlation
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iii) No correlation
Assume that the investor invest equal wealth in each asset.
The variance of the expected return for each security
Prob Return (%) A Security Variance Return B (%) Variance
0.1 15 15-25=-10 -1020.1=10 10 10-30=-202=400 4000.1=40
0.8 25 25-25=0 020.8= 0 30 30-30-02=0 0
0.1 35 35-25=10 10 50 50-30=20=400 4000.1=40
20 80
Security B offers higher return than security A, but at a greater risk.
a) Perfect positive correlation

Prob Return Return Combined Portfolio
from 50% A from 50% B return
0.1 (150.5) =7.5 (100.5) =5 7.5+5=12.5 12.5-27.5=-15 0.1152=22.5
0.8 (250.5) = 12.5 (300.5) = 15 12.5+15 = 27.5 27.5-27.5 = 0 0
0.1 (3 50.5) = 17.5 (500.5) = 25 17.5+25 = 42.5 42.5-27.5 = 15 0.1152=22.5
Variance 45.0
Standard deviation of a portfolio
54
b) Perfect negative correlation
The standard deviation given the expected return of 27.5% is
Prob Return Return Combined
From 50% A from 50% B ref (X) %
0.1 7.5% 25% 7.5+25 = 32.5% (32.5-27.5)2=25 250.1=2.5

0.8 12.5% 15% 12.5+15=27.5% 27.5-27.5 = 0 0
0.1 17.5% 5% 17.5+5 = 22.5% 22.5-27.5 = 2.5 2.5
5.0
c) No correlation
Prob Return from Return from Combined return
50% A (%) 50% B (%) of portfolio X (%) Pi
(0.10.1)=0.01 7.5 5 7.5+5=12.5 12.5-27.5=225 2250.01=2.25
(0.10.8)=0.08 7.5 15 7.5+15=22.5 22.5-27.5= 25 250.08=2.00
(0.10.1)=0.01 7.5 25 7.5+25=32.5 32.5-27.5= 25 250.01=0.25
(0.80.1)=0.08 12.5 5 12.5+5=17.5 17.5-27.5=100 1000.08=8.0
(0.80.8)=0.64 12.5 15 12.5+15=27.5 27.5-27.5= 0 00.64 = 0.0
(0.80.1)=0.08 12.5 25 12.5+25=37.5 37.5-27.5=100 1000.8=8.0
(0.10.1)=0.01 17.5 5 17.5+5=22.5 22.5-27.5= 25 250.01=0.25
(0.10.8)=0.08 17.5 15 17.5+15=32.5 32.5-27.5= 25 250.08=2.00
(0.10.1)=0.01 17.5 25 17.5+24=42.5 42.5-27.5=225 2250.01=2.25
= 25
Conclusion
You should notice that for the same expected return of 27.5%, the standard deviation (the risk);
i) Is highest when there is perfect positive correlation between the returns of the individual
securities portfolio.
ii) Is lower when there is no correlation.
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iii) Is lowest when there is perfect negative correlation the risk is then less than for either
individual security taken on its own.
Calculating the Standard Deviation of A Portfolio Using Formula
The variance or standard deviation of a portfolio is not simply the weighted average of variances
or standard deviations of individual securities. The portfolio variance or portfolio standard
deviation is affected by the association of movement of returns of two securities.
Covariance of two securities measures their co-movement. Calculating covariance of two
securities
Steps
i) Determine the expected returns for securities
ii) Determine the deviation of possible returns from the expected returns for each security
iii) Determine the sum of the product of each deviation of returns of two securities and
probability
Example
From the information given, calculate covariance of securities X and Y
State of Deviations from Product of Deviations
economy Prob Returns (%) expected return and probability
X Y X Y
A 0.1 -8 14 (-8-5) = - 13 14-8= 6 0.1 (-136) = - 7.8
B 0.2 10 -4 (10-5) = 5 -4-8 = -12 0.2 (5-12) = - 12.0
C 0.4 8 6 (8-5) = 3 6-8 = -2 0.4 (3-2) = - 2.4
D 0.2 5 15 (5-5) = 0 15-8 = 7 0.2 (07) = 0.0
E 0.1 -4 20 (-4-5) = - 9 20-8 = 12 0.1 (-912) = -10.8
-33.0
Expected returns
Where is the covariance of returns of securities X and Y
Rx and Ry returns of securities X and Y respectively
56
and expected returns of X and Y respectively and
Pi probability of occurrence of the state of economy
Where is the correlation of securities X and Y. Correlation measures the linear

relationship between two variable i.e. in case of two securities X and Y.
Example
Using the previous example calculate the correlation of X and Y
Standard deviations for the two securities
Securities X and Y are negatively correlated. If an investor invests in the combination of these
securities, he or she can reduce risk.
Therefore using formula, variance of portfolio is;
57
Example
Assume the previous example except that the investor invested 50% of wealth in X and 50% in
Y
3.6 MINIMUM VARIANCE PORTFOLIO

A portfolio that has the lowest level of variance (risk) is referred to as the optimal portfolio. A
risk averse investor will have a trade-off between risk and return.
Formula
What is the best combination of X and Y in the above example so that portfolio variance is
minimum?
Thus the weight of Y will be 1-0.578 = 0.422

Weight X = 0.578 or 57.8%
Y = 0.422 or 42.2 %
Risk
Note
Any other combination of X and Y will yield a higher variance.
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The Three Asset Portfolio
Usually investors will not hold only two assets. If the assets held in the portfolio are more than 2
then the formula used is as follows
Where
n Is total number of securities in the portfolio
Each is obtained by substituting one of the possible pairs of values for i and j into the
expression.
Example
Consider the following three securities and the relevant data on each.
Stock 1 Stock 2 Stock 3
Expected return 10% 12% 8%
Standard deviation 10% 15% 5%
Correlation Coefficients
Stocks 1, 2 = 0.3
2, 3 = 0.4
1, 3 = 0.5
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Required
What are portfolio risk and return if the following proportions are assigned to each stock?
Stock 1 = 0.2, Stock 2 = 0.4 and Stock 3 = 0.4
= 10%
Note
If a number of assets in the portfolio are uncorrelated, then the formula

to find the risk of the portfolio becomes.
Where
N-Security Portfolio
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Investors Preferences
Investors must choose a portfolio which gives them a satisfactory balance between the expected
returns from the portfolio and the risk that actual returns from the portfolio will be higher or
lower than expected. Some portfolio will be more risky than others. Traditional investment
theory suggests that rational investors wish to maximize return and minimize risk. Thus if two
portfolio has the same element of risk, the investor will choose the one yielding the higher return.
Similarly, if two portfolios offer the same return, the investor will select the portfolio with the
lesser risk as illustrated by the diagram below.
Expected
F
Return
A
C B
Risk
Portfolio A is preferred to portfolio B because it offers a higher expected return for the same
level of risk. Similarly, portfolio C will be preferred to portfolio B because it offers the same
return for lower risk. A and C are said to dominate portfolio B.
But whether an investor chooses portfolio A or portfolio C will depend on the individuals
attitude to risk, whether he wishes to accept a greater risk for a greater expected return.
It is the investors indifference curve. The investor will have no preference between any
portfolios which give a mix of risk and return which lies on the curve, since he derives equal
utility from each of them thus, to the investor the portfolio A, C, D, E and F are all just as good
as each other and all of them are better than portfolio B. Therefore portfolio B is said to be dis-
preferred on the grounds of mean-variance inefficiency.
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Consider the following
Expected
A
Return
B
Y1
Y2
X1 X2 (Risk)
An investor would prefer combinations of return and risk on the indifference curve A to those on
curve B, because curve A offers higher returns for the same degree of risk (and a less risk for the
expected returns) e.g. for the same amount of risk X2, the expected return on curve A is Y1
whereas on curve B it is only Y2.
Efficient Portfolios
If we drew a graph to show the expected return and the risk of the many possible portfolios of
investments, we could according to portfolio theory plot an egg-shaped cluster of dots on a
scathe graph.
Expected
Return
* Efficient frontier
*
*
Risk
In the graph, there are some portfolios which could not be as good as others.
1. However, there are other portfolios which are neither better nor worse than each other,
because they have either a higher expected return but a higher risk or a lower expected
62
return but a lower risk. These portfolios lie along the so called efficient frontier of
portfolios.
When an investors indifference curve are placed on the same graph as the possible portfolios of
investment. i.e. the egg-shaped scatter graph in the previous graph.
A B C D
Expected
Return Efficient frontier
M *
Available Portfolio
*
Risk
An investor would prefer a portfolio of investments on indifference curve A to a portfolio on

curve B, which in turn is preferable to a portfolio on curve C which is in turn is preferable to
curve D. No portfolio exists, however, which is on curve A and curve B.
The optimum portfolio (or portfolios) to select is one where an indifference curve touches the
efficient frontier at a tangent. Any portfolio on the indifference curve to the right of curve C,
such as one on curve D, would be worse than M.
Risk-Free Investments
The efficient frontier is a curved line, not a straight line. This is because the additional return for
accepting a greater level of risk will not be constant. The curve eventually levels off because a
point will be reached where no more return can be offered to an investor for accepting additional
or more risk.
Note
All the portfolios under consideration carry some degree of risk. But some
investments are risk-free. It is extremely unlikely that the Kenyan government would
default on any payment of interest and capital on its stock. Thus government stocks can be
taken to be risk-free investments. If we introduce a risk-free investment into the analysis,
the old efficient frontier is superseded.
63
E
E* Capital Market Line
M* Efficient frontier of
Z* portfolio
X P
risk
The straight line XZME is drawn at a tangent to the efficient frontier and cuts the Y axis at the
point of risk-free investments return. The line is known as capital market line.
Portfolio M is the same as previously described. It is the efficient portfolio consisting entirely of
risky investments which will appeal to the investor most. Portfolio Z is a mixture of the
investments in portfolio M and risk-free investments. Investors will prefer portfolio Z (a mixture
of risky portfolio M and the risk-free investment) to portfolio P because a higher return is
obtained for the same level of risk.
- One portfolio on the capital market line is as attractive as another to a rational investor.
One investor may wish to hold portfolio Z, which lies of the way along the capital
market line between risk-free investment X and portfolio M (i.e. a holding comprising
portfolio M and risk-free securities)
- An investor may wish to hold portfolio E, which entails putting all funds in portfolio M
and borrowing money at risk-free rate to acquire more of portfolio M.
- Portfolio M is the market portfolio and each investors portfolio will contain a proportion
of it. Although in the real world, investors do not hold every quoted security in their
portfolio, in practice a well-diversified portfolio will mirror the whole market in terms of
weightings given to a particular sectors, high income and high capital growth and so on.
Illustration
The following data relate to four different portfolios of securities
Portfolio Expected Rate Standard deviation
of Return(%) of return at the portfolio
K 11 6.7
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L 14 7.5
M 10 3.3
N 15 10.8
The expected rate of return on the market portfolio is 8.5% with a standard deviation of 3%. The
risk-free rate is 5%. Identify which of these portfolios can be regarded as efficient.
Solution
To answer this question, we can start by drawing the CML
a) When risk is 0, return is 15%
b) When risk is 3%, return is 8.5%
Return CML
15
N*
*L
10 M* *K
2 3% 4 6 8 12 Risk
Summary
a) Portfolio M is very efficient
b) Portfolio L is just efficient
c) Portfolio K and N are inefficient
Alternative methods
Let the standard deviation of a portfolio be X
65
Let the return from a portfolio be Y
The capital market line equation is
Where is the risk-free rate of return = 5%
Using high-low method the value b (gradient /slope) of capital market line can be calculated as
follows;
When X = 3, Y = 8.5
X = 0, Y = 5%
The CML is Y = 5% + 1.16667X
Portfolio CML Return Actual Expected Efficient or inefficient
Return Portfolio
K 6.7 5+6.7(1.16667) = 12% 11% Inefficient
L 7.5 5+7.5(1.6667) = 13.8% 14% Just efficient
M 3.3 5+3.3(1.16667) = 8.9% 10% Efficient
N 10.8 5+10.8(1.16667) = 17.6% 15% Inefficient
3.7 THE RETURN ON MARKET PORTFOLIO

The expected returns from portfolio M will be higher than the return from risk-free investments
because the investors expected a greater return for accepting a degree of investment risk. The
size of the risk premium will increase as the risk of the market portfolio increases.
Example
= return from portfolio M = risk of returns of portfolio P.

= risk-free return = the return on portfolio P, which is a mixture of
= risk of the portfolio M Investments in portfolio M
66
Return
Risk
The gradient of CML therefore becomes
This represents the extent to which the required returns from a portfolio should exceed the risk-
free rate of return, to compensate investors for risk.
The beta factor
The equation of CML =
Gradient of CML
Therefore is the risk premium that an investor should require as compensation
for accepting portfolio risk
Note
A high level of diversification leads to an investor holding the market

portfolio, with investments reflecting the risk and return characteristics of all shares in the
market. In practice, 10 to 12 or so diverse shares are needed to reach this position, at which
67
Where is referred to as a beta factor stated as
The above equation forms the basis of the CAPM.
Note
Capital market line shows total risk whereas security market line shows the
systematic risk on X-axis.
Beta factor In portfolio theory, a measure of the vitality of the price of a security and that
of its systematic risk, used to calculate appropriate discount rates in the CAPM.
3.8 PORTFOLIO THEORY AND FINANCIAL MANAGEMENT

Our discussion of portfolio theory has concentrated mainly on portfolios of stocks and shares.
Investor can reduce their investment risk by diversifying, but what about individual companies
choosing a range of businesses or projects to invest in.
Just as an investor can reduce the risk of variable returns by diversifying into a portfolio of
different securities, a company can reduce its own risk and so stabilize its profitability if it
invests in a portfolio of different projects or operations, assuming that any positive correlation
between returns is weak.
Advantages of Diversification
a) Internal cash flows will become less volatile. This makes it less risky to service the
companys current level of debt and may consequently allow the company to make use of
debt without additional risk. This could reduce the cost of capital generally, increasing
the wealth of shareholders.
b) Diversification into foreign markets may enable shareholders to reduce the level of their
systematic risk where exchange control or other barriers to direct investment exist. The
diversifying company can enable this to occur by investing in markets which have a
combination of risk and return which shareholders would not otherwise be able to obtain.
c) A diversified company may have a lower probability of corporate failure because of the
reduced total risk for the company.
This will reduce the likely impact of insolvency costs. However, there are a number of
reasons why a company should not try to diversify too far.
i- A company may employ people with particular skills, and it will get the best out of its
employees by allowing them to stick to doing what they are good at. A manager with
68
expert knowledge of the electronics business, for example, might not be good at the
managing a retailing business. Some managers can adapt successfully to running a
diversified business.
ii- When companies try to grow, they will often find the best opportunities to make extra
profits are in industries or markets with which they are familiar. If a market opens up for
say, a new electronic consumer product, the companies which are likely to exploit the
market most profitably are those which already have experience in producing electronic
consumer products.
iii- Except where restrictions apply to direct investment, investors can probably reduce
investment risk more efficiently than companies. They have a wider range of investment
opportunities. Investment with uncorrelated or negatively correlated returns will be easier
to identify. Estimates of beta factors will be reliable for quoted companies shares than
for companies capital expenditure projects.
iv- Conglomerates are vulnerable to take over bids where the buyer plans to unbundle the
companies in the group and sell them off individually at a profit, particularly because
their returns will often be mediocre rather high and so the stock market will value the
shares on fairly low P/E ratio. Separate companies within the group would be valued
according to their individual performance and prospects, offer at P/E ratios that are much
higher than for the conglomerate as a whole.
Limitations of Portfolio Analysis for The Financial Manager
Portfolio analysis is useful for diversifying through the firms investment decisions. Applied to
the selection of investment proposal, portfolio theory has a number of limitations.
a) Probabilities of different outcomes must be estimated; fairly easy e.g. machine

replacement; more difficult e.g. new product development.
b) Shareholders preferences between risk and returns may be difficult to know and personal
taxes may impact.
c) Portfolio theory is based on the ideas of managers assessing the relevant probabilities and
deciding the combination of activities for the business. Managers have their job security
to consider, while the shareholders can easily buy and sell securities. Mangers may
therefore be more risk-averse than shareholders and this might distort managers
investment decisions i.e. the agency problem.
d) Projects may be of such a size that they are not easy to divide on accordance with
recommended diversification principles.
e) The theory assumes that there are constant returns to scale, in other words that the
percentage returns provided by a project are the same however much is invested in it. In
practice, there may be economies of scale to be gained from making a larger investment
in a single project.
f) Other aspects of risk not covered by the theory may need to be considered e.g.
bankruptcy costs.
International Portfolio Diversification
Approximately 7% of total world equities have been estimated to comprise cross-border
holding. Even so, it is arguable that there remains a domestic bias among many types of investor
which can be attributed to a number of barriers to international investment, including the
following;
69
- Legal restrictions exist in some markets, limiting ownership of securities by foreign
investors.
- Foreign exchange regulations may prohibit international investment or make it more
expensive.
- Double taxation of income from foreign investment may deter investors.
- There are likely to be higher information and transaction costs associated with investing
in foreign securities.
3.9 SUMMARY
In the above lesson we have described the trade off between risk and returns. We have also
discussed how to calculate risks and returns for both individual assets and portfolios.
Find out from assets managers how they construct efficient portfolios for their clients or
investors.
3.10 ACTIVITIES
1. Define the following terms using graphs or equations to illustrate your answers
whenever possible (a) Expected rate of returns (b) Standard deviation (c) Capital
asset pricing model (d) Continuous probability distribution
2. If a companys Beta were to be doubled, would its expected returns double?
3. Is it possible to construct a portfolio of stocks

70
which has an expected return equal
to the risk-free rate?
71
LESSON FOUR
COST OF CAPITAL
4.0 INTRODUCTION
The cost of capital is a central concept in financial management. It is used for

evaluating investment project for determining the capital structure, for assessing leasing
proposals, for settling the rates that regulated organizations like electric utilities can charge to
their customers so on and so forth.
The cost of capital is the rate of return that an enterprise must pay to satisfy the providers of
funds and it reflects the riskiness of providing funds.
Cost of capital is an opportunity cost of finance because it is the minimum return that
investors require. If they do not get this return they will transfer some or all of their
investment somewhere else.
Explain the general concept of the opportunity cost of capital

Distinguish between the project cost of capital and the firms cost of capital
Learn about methods of calculating component cost of capital and the weighted
average cost of capital
Illustrate the cost of capital calculation for a real company.
4.2 ELEMENTS OF COST OF CAPITAL

Cost of capital has three elements. They are:
i. Risk free rate of return
ii. Premium for business risk
iii. Premium for financial risk
Risk Free Rate of Return

It is the return which would be required from an investment if it were completely free from risk.
Typically a risk free rate or yield would be the yield on government securities.
72
Premium for Business Risk
This is an increase in the required rate of return due to the existence of uncertainty about the
future and about the firms business prospects. Business risk will be higher for some firms than
for other types of the projects that it undertakes.
Premium for Financial Risk
This relates to the danger of high debt levels (high gearing), the higher the gearing of a
companys capital structure, the greater will be the financial risk to ordinary shareholders and
this should be reflected in the higher risk premium and therefore a higher cost of capital.
Company Cost Of Capital and Project Cost Of Capital
The company cost of capital is the rate of return expected by the existing capital providers. It
reflects the business risk of existing assets and the capital structure recently employed.
The project cost of capital is the rate of return expected by capital providers for a new project or
investment the company proposes to undertake. It will depend on the business risk and financial
risk (the debt capacity of the new project).
Costs of Sources of Finance
Different sources of finance will have different costs. The cost of debts is likely to be lower than
the cost of equity because;
1) Debt in the event of liquidation, the lender/ creditor will be paid off before equity. This
makes the debt a safer investment than equity and hence debt investors demand a lower
rate of return than equity investors.
2) Debt interest is also corporate tax deductible unlike equity dividends making it even
cheaper to a tax paying company.
3) Arrangement costs are usually lower on debt finance than equity finance and once again,
unlike equity arrangement costs, tax deductible.
The Cost of Ordinary Share Capital

New equity finance can be obtained in two ways:
a. Retention of earnings and
b. Issue of additional equity
The cost of equity or the required return by equity shareholders is the same in both cases.
Retained earnings have an opportunity cost involved. Shareholders could receive the earnings as
dividends and invest the same in alternative investments of comparable risk to earn a return. So
irrespective of whether a firm raises equity shares, the cost of equity is the same. The only
difference is in floatation costs. There are no floatation costs for retained earnings whereas there
are floatation costs of additional equity.
Note:
While the cost of debt and preference can be determined fairly easily, the cost
of equity is rather difficult to estimate. This difficulty stems from the fact that there is no
definite commitment on the part of the firm to 73 pay dividends. There are various methods
that are employed to estimate the cost of equity
They include:
a) The security market line(SML)
This uses the Capital Asset Pricing Model (CAPM) to estimate or calculate cost of equity. It
incorporates risk. The CAPM is based on a comparison of the systematic risk of individual
investments with the risks of all shares in the market.
Systematic Risk and Unsystematic Risk

The risk involved in holding securities can be divided into risk specific to the company
(unsystematic) and the risk due to variation in the market activity (systematic). Unsystematic or
business risk can be diversified away while systematic or market risk cannot. The CAPM is
mainly concerned with how systematic risk is measured and how systematic risk affects required
returns and share prices. Systematic risk is measured using beta factors.
4.3 BETA FACTOR

It is the measure of the systematic risk of a security relative to the market portfolio. If a share
price were to rise or fall at double the market rate, it would have a beta factor of 2.0. Conversely,
if the share price moved at half the market rate, the beta factor would be 0.5.
CAPM theory is based on the following assumption:
i. Investors are rational and they choose among alternative portfolios on the basis of
each portfolio`s expected return and standard deviation.
ii. Investors are risk averse.
iii. Investors maximize the utility of end of period wealth. Thus CAPM is a single
period model.
iv. Investors have homogeneous expectations with regard to asset return. Thus all
investors will perceive the same efficient set.
v. There exist a risk free asset and all investors can borrow and lend at this rate.
vi. All assets are marketable and perfectly divisible.
vii. The capital market is efficient and perfect.
Market Risk and Return
Market risk (systematic) is the average risk of the market as a whole. Taking all the shares on a
stock market together, the total expected return from the market becomes:
where Ke= expected cost of equity capital
Rf =risk free rate
Rm= market rate
*= beta factor of the stock
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( Rm-Rf)= market risk premium
Example 1
Investors have an expected rate of return of 8% from ordinary shares in ABC Ltd. ABC Ltd have
a beta factor of 1.2. The expected returns to the market are 7%. What will be the expected rate
of return from ordinary shares in RST Ltd which have a beta of 1.8?
ABC Ltd
RST
b) Dividend growth model approach.

It is used to estimate the cost of equity on the assumption that the market value of share is
directly related to the expected future dividends from shares.
i) Zero growth
The cost of equity of a share on which a constant amount of dividend is expected perpetually is
Where D1- expected dividend at the end of year 1

P0- is the market price per share.
Example 2
A firm is currently earning Kshs 100,000 and its shares are selling at a market price of Kshs 80.
The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable and it has a payout ratio of 100%. What is the cost of equity?
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Solution
ii) Constant growth/ Normal growth
Dividend valuation model can be applied to calculate cost of equity for a firm whose dividends
are expected to grow at a constant rate of return g% as follows
The model is based on:

i. Market price of the ordinary share (P0) is a function of expected dividends.
ii. The initial dividend Div1 is positive i.e. Div1>0
iii. The dividend grows at a constant rate (g).
Example 3
Suppose that the current market price of a companys share is sh.90 and the expected dividend
per share next year is sh. 4.50. If the dividends are expected to grow at a constant rate of 8%,
what is shareholders required rate of return?
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iii) Supernormal growth
Dividends may grow at different rates in future. The growth rate may be very high for a few
years and afterwards it may become normal indefinitely in the future. The dividend valuation
model can be also used to calculate the cost of equity under different growth assumption.
Where Pn is the discounted value of the dividends for the year when dividends become normal
indefinitely.
Ke is calculated by trial and error method or extrapolation. It is the internal rate of return.
Example 4
Use the following information to calculate the growth.
Year Dividends Earnings

2001 150,000 400,000
2002 192,000 510,000
2003 206,000 550,000
2004 245,000 650,000
2005 262,350 700,000
Growth rate
Dividends have risen from sh. 150,000 in 2001 to 262,500 in 2005. The increase represents 4
year growth.
Dividend (1+g) 4 = Dividend in 205
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The growth rate over the last four years is assumed to be expected by shareholders into the
indefinite future. If the company is financed entirely by equity and there are 1,000,000 shares in
issue, each with a market value of sh 3.35 ex-dividends, calculate the cost of equity.
Example 5
Assume that a company s share is currently selling for Ksh.134 current dividend is Ksh. 3. 50 per
share and are expected to grow at 15% over the next 6 years and then at a rate of 8% forever.
What is the company cost of capital?
Using trial and error method
Try Ke=10%
3.91+3.83+3.98+4.18+4.37+4.57+245.55=270.39
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Is higher than Po=134
Try 12%
3.84+3.69+3.77+3.89+3.99+4.10+2.17.5(05066) =133.472
Ke =12% since
Po=134 at 12%
Solution
Earning- Price Ratio Approach
According to this approach the cost of equity is equal to:
Where E 1 is the expected earnings per share for the next year and P0 is the current market value
per share.
E1= (1+growth rate of earnings per share) current earnings per share
This approach provides an accurate measure of the rate of return required by equity investors in
the following two cases.
1) When the earnings per share are expected to remain constant and the dividend payout
ratio is 100%
2) When the retained earnings are expected to earn a rate of return required by equity
investors.
Note:
The first case is rarely encountered in real life and the second case also
somewhat unrealistic. Hence the earnings- price ratio should not be used indiscriminately
as the measure of cost of equity capital.
Example 6
A firm is currently earning Kshs. 100,000 and its shares are selling at a market price of Kshs 80.
The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable and it has a payout ratio of 100%. What is the cost of equity? If the firm`s pay-out
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ratio is assumed to be 60%and that it earns 15% rate of return on its investment opportunities,
then, what would be the firm`s cost of equity?
Solution
i) Cost of equity when pay-out ratio is 100%
ii) If the pay-out is 60%
Expected return on investment=15%Retention Ratio

15%40%=6%
Cost of Debt and Preference Capital

Since debt and preference stock entails more or less fixed payments, estimating the cost of debt
and preference is relatively ease. Cost of debt represents:
1) The cost of continuing to use the finance rather than redeem the securities at their current
market price.
2) The cost of raising additional fixed interest capital. Different types of debt have different
cots.
Irredeemable Debt Capital
Cost of irredeemable debts capital paying interest in perpetuity and having a current ex-interest
price
(P0).
If the interest on loan capital is paid other than annually:
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Example 7
H Ltd has 12% irredeemable debentures issue with a nominal value of sh 100. The market price
is sh 95 ex-interest. Calculate the cost of capital if interest is paid half yearly.
Redeemable Debt
If the debt is redeemable then in the year of redemption the interest payment will be received by
the holder as well as the amount payable on redemption, so:
Where M is the amount payable on redemption in year n. The above equation cannot be
simplified so Kd will have to be calculated by trial and trial and error as an internal rate of return
(IRR).
Example 8
Owen has in issue 10% loan notes of a nominal value of Kshs 100. The market price is sh 90 ex-
interest. Calculate the cost of this capital if the debenture is:
I. Irredeemable
II. Redeemable at par after 10 years
Ignore taxation.
i) Irredeemable
ii) Redeemable
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Year cash flow
0 (90)
1-10 years sh 10
Use trial & error.
To estimate the Kd.
Capital gain that will be made from now to be the date of redemption sh 100- sh 90 = sh 10. This
profit will be made over a period of 10 years which gives annualized profit of
Which is about Current market value the best rate to start with is
Year cash flow PVIF12% PV

0 (90) 1 (90.00)
1-10 (10) 5.650 (56.50)
10 Years (100) 0.322 (32.20)
(1.3)
Year cash flow PVIF11%, n PV

0 (90) 1.0 (90)
1-10 yrs (10) 5.889 58.89
10 years 100 0.352 35.22
4.11
Through interpolation
(A) 11% = 4.11(P)
11% + X%= 0
(B) 12%= -1.3(N)
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Debt Capital and Taxation
Interest on debt is allowable deduction for purposes of taxation and so the of debt capital should
be adjusted for tax relief. The after tax cost of irredeemable debt capital is:
Where Kdnet- is the cost of debt capital

I - Interest payment
P0- Ex-interest market price
T- Is the corporation rate of tax
Example 9
If a company pays Kshs 10,000 a year interest on irredeemable stock with nominal value of sh
100,000 and a market price of Kshs 80,000 and the rate of tax is 30%, the cost of debt would be:
Example 10
a) A company has outstanding Kshs 660,000 of 8% loan notes on which the interest is
payable annually on 31 December. The debt is due for redemption at par on 1 January
2006. The market price of the note at 28 December 2002 was Kshs 103 cum interest.
Ignoring any question of personal taxation. What do you estimate to be the current cost of
debt? Nominal value is Kshs 100.
b) If a new expectation emerged that the cost of debt would rise to 12% during 2003 and
2004, what effect might this have in theory on the market price at 28 December 2002?
c) If the effective rate of tax was 30%, what would be after tax cost of debt of the loan notes
in (a) above? Tax is paid each 31 December on profits earned in the year ended on the
previous 31 December.
a) Solution
Starting rate =
Item & date year cash flow PVIF 10%, n

Present value
Market value (ex-int) 0 103-(8%100) = (95) 1.0
(95)
(28/12/02)
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Interest 31/12/03 1 8 0.909
7.3
Interest 31/12/04 2 8 0.826
6.6
Interest 31/12/05 3 8 0.751
6.0
Maturity 31/12/05 3 100 0.751
75.1
000
By coincidence, the cost of debt is 10% since the NPV of the cash flows above is zero.
b) Solution
Item and date year cash flow Discount factor 12%
present value
Interest 31/12/02 0 8 1.000
8 31/12/03 1 8 0.893
7.1 /12/04 2 8 0.797
6.4 31/12/05 3 8 0.712
5.7 31/12/05 3 100 0.712
71.2
98.4
The estimated market price would be sh 98.4 per cum- interest.
Item& date year cash flow PVIF 7%

Present value
Market value ex-interest 0 (95.0) 1.0
(95)
Interest (31.12.03) 1 5.6=8(1-0.3) 0.935
5.234
2 5.6 0.873
4.891
3 5.6 0.816
4.571
4 100 0.816
81.600
+ 1.296
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Try 8%
Item& date year cash flow PVIF 7%
Present value
Market value ex-interest 0 (95.0) 1.0
(95)
Interest (31.12.03) 1 5.6=8(1-0.3) 0.926
5.185
2 5.6 0.857
4.801
3 5.6 0.794
4.445
4 100 0.794
79.400
-1.169
A) 7% = 1.296. P
7%+ X= 0
B) 8%= -1.169 N
Cost of Preference Share

Preference capital carries a fixed rate of dividend and is redeemable in nature. Even though the
obligation of a company towards its preference shareholders are not as firm as those towards its
debenture holders, we will assume that preference dividend will be paid regularly and preference
capital will be redeemed as per the original intent.
Example
Consider the preference stock of multiple limited for which the following data is available:
Face value sh 100
Dividend rate- 11%
Maturity period- 5 years
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Market price- 95
Using trial & error method

Starting rate=
11.6% +1%= 12.6%
Try 13%
Year cash flow PVIF13%, n Present value

0 (95) 1.000 (95)
1-5 11 3.517 38.69
5 100 0.543 54.28
-2.03
Try 12%
Year cash flow PVIF13%, n Present value
0 (95) 1.000 (95)
1-5 11 3.605 39.655
5 100 0.567 56.70
+1.355
A) 12% = 1.355p
12% + r%= 0
13%= -2.03
Where the preference shares are irredeemable, the cost of preference share capital is:
Note
Therefore
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4.4 FLOATATION COST AND COST OF CAPITAL
When a firm raises finance by issuing equity and debt, it almost invariably incurs floatation or
issue costs, comprising of items like underwriting costs, brokerage expenses, fees of merchant
bankers, advertising expenses, under-pricing cost, so on and so forth.
Exercise
a) Explain why the weighted average cost of capital of a firm that uses relatively more debt
capital is generally lower than that of a firm that uses relatively less debt capital.
b) The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2009 was sh
100,000,000. The company wishes to raise additional funds to finance a project within the
next one year in the following manner.
Sh30,000,000 from debt
Sh 20,000,000 from selling new ordinary shares
The following items make up the equity of the company:
sh
3,000,000 fully paid up ordinary shares 30,000,000
Accumulated retained earnings 20,000,000
1,000,000 10% preference shares 20,000,000
2,000,000 6% long term debentures 30,000,000
The current market value of the companys ordinary shares is sh 30. The expected dividend on
ordinary shares by 30 April 2010 is forecasted at sh 1.20 per share. The average growth rate
in both earnings and dividends has been 10% over the last 10 years and this growth is
expected to be maintained in the foreseeable future.
The debentures of the company have a face value of sh 150. However they currently sell for
sh 100 the debentures will mature in 100 years.
The preference shares were issued four years ago and still sell at their face value. Assume a
tax rate of 30%
Required:
I. The expected rate of return on ordinary shares
II. The effective cost to the company of:
1. Cost of equity
2. Debt capital
3. Preference share capital
III. The companys existing weighted average cost of capital
IV. The companys marginal cost of capital if it raised the additional sh 50,000,000 as
intended.
Solution
a) At initial stages of debt capital the WACC will be declining up to a point where the
WACC will be minimum. This is because:
Debt capital provides tax shield to the firm and after tax cost of debt is low.
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The cost of debt is naturally low because it is contractually fixed and certain.
b) Cost of equity( Ke)
Debt
Cost of preference shares ( Kp)
Dividend per share= 10 20= sh 2

100
Weighted average cost of capital (WACC)
Market value of equity (Ve) =3,000,000sharessh 30= 90,000,000

Market value of pref. shares (Vp) =1,000,000sharessh20=20,000,000
Market value of debentures (Vd) = 200,000sharessh100=20,000,000
130,000,000
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No floatation costs are given hence marginal cost of debt and equities are 5.44% and 14%
respectively.
Amount to be raised is sh 50M.
Marginal cost of capital
4.5 CAPITAL STRUCTURE THEORIES

The Net Income Approach (NI)
The essence of the NI approach is that the firm can increase its value or lower the overall cost of
capital by increasing the proportion of debt in the capital structure. The crucial assumptions of
this approach are:
The use of debt does not change the risk perception of the investor. Thus Kd and Ke remain
constant with changes in leverage.
The debt capitalization rate is less than equity capitalization rate (i.e. Kd<Ke).
The implications of these assumptions are that with constant Kd and Ke, increases use of debt, by
magnifying the shareholders earnings will result in a higher value of the firm via higher value of
equity. The overall cost of capital will therefore decrease. If we consider the equation for the
overall cost of capital,
K0 decreases as D/V increases because Ke and Kd are constant as per our assumptions and Kd is
less than Ke. This also implies that K0 will be equal to Ke if the firm does not employ any debt
(i.e when D/V=0) and that K0 will approach Kd as D/V approaches 1. This argument can be
illustrated graphically as follows.
Net Operating Income (NOI) Approach

The critical assumptions of this approach are:
i. The market capitalizes the value of the firm as a whole.
ii. K0 depends on the business risk. If the business risk is assumed to remain constant then
K0 will also remain constant.
iii. The use of less costly debt increases the risk of the shareholders. This causes Ke to
increase and thus offset the advantage of cheaper debt.
89
iv. Kd is assumed to be constant.
v. Corporate income taxes are ignored.
The implications of the above assumptions are that the market value of the firm depends on the
business risk of the firm and is independent of the financial mix. This can be illustrated as
follows:
4.6 TRADITIONAL APPROACH TO CAPITAL STRUCTURE

The traditional approach to the valuation and leverage assumes that there is an optimal capital
structure and that the firm can increase total value through the judicious use of leverage. It is a
compromise between the net income approach and the net operating income approach. It implies
that the cost of capital declines with increase in leverage (because debt capital is cheaper) within
a reasonable or acceptable limit of debts and then increases with increase in leverage.
The optimal capital structure is the point at which K0 bottoms out. Therefore this approach
implies that the cost of capital is not independent of the capital structure of the firm and that
there is an optimal capital structure. Graphically this approach can be depicted as follows:
The traditional approach has been criticized as follows:
The market value of the firm depends on the net operating income and the risk attached to it, but
not how it is distributed.
The approach implies that totality of risk incurred by all security holders of a firm can be altered
by changing the way this totality or risk is distributed among the various classes of securities. In
a perfect market this argument is not true.
The traditional approach however has been supported due to tax deductibility of interest charges
and market imperfections.
The Modigliani- Miller Hypothesis

The MM, in their first paper (in 1958) advocated that the relationship between leverage and the
cost of capital is explained by the net operating income approach. They argued that in the
absence of taxes, a firms market value and the cost of capital remains invariant to the capital
structure changes. The arguments are based on the following assumptions:
a) Capital markets are perfect and thus there are no transaction costs.
b) The average expected future operating earnings of a firm are represented by subjective
random variables.
c) Firms can be categorized into equivalent return classes and that all firms within a class
have the same degrees of business risk.
d) They also assumed that debt, both firms and individuals is riskless.
e) Corporate taxes are ignored.
90
Proposition 1
The value of any firm is established by capitalizing its expected net operating income (If tax=0)
VL = VU = EBIT = EBIT
WACC K0
The value of a firm is independent of its leverage.
The weighted cost of capital to any firm, levered or not is
Completely independent of its capital structure and
Equal to the cost of equity to an unlevered firm in the same risk class
Proposition 11
The cost of equity to unlevered firm in the same risk class plus
A risk premium whose size depends on both the differential between the cost of equity and debt
to an unlevered firm and the amount of leverage used.
As a firms use of debt increases, its cost of equity also arises. The MM showed that a firm s
value is determined by its real assets, not the individual securities and thus capital structure
decisions are irrelevant as long as the firms investment decisions are taken as given. This
proposition allows for complete separation of the investment and financial decisions. It implies
that any firm could use the capital budgeting procedures without worrying where the money for
capital expenditure comes from. The proposition is based on the fact that, if we have two streams
of cash. A and B, then the present value of A+B is equal to the present value of A plus the
present value of B. This is the principle of value additivity. The value of an asset is therefore
preserved regardless of the nature of the nature of the claim against it. The value of the firm
therefore is determined by the assets of the firm and not the proportion of debt and equity issued
by the firm.
The MM further supported their arguments by the idea that investors are able to substitute
personal for corporate leverage, thereby replicating any capital structure the firm might
undertake. They used the arbitrage process to show that two firms alike in every respect except
for capital structure must have the same total value. If they dont, arbitrage process will drive the
total value of the two firms together.
Illustration
Assume that two firms the levered firm (L) and the unlevered firm (U) are identical in all
important respects except financial structure.
Firm L has sh 4 million of 7.5% debt, while firm U uses only equity. Both firms have EBIT of sh
900,000 and the firms are in the same business risk class. Initially assume that both firms have
the same equity capitalization rate Ke(U)= Ke(L)=10%.
Under these conditions the following situation will exist.
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Firm U
Value of the firm U`s equity= EBIT-KD = 900,000-0

Ke 0.1
=sh 9,000,000
Total market value= DU+EU
=0+9,000,000 = sh 9,000,000
Firm L
Value of firm L`s equity= EBIT-KdD

Ke
= 900,000-0.075(4,000,000)
0.10
=sh 6,000,0000.
Total market value=DL+EL
=sh 4,000,000+ sh 6,000,000
= sh 10,000,000.
Thus the value of levered firm exceeds the value of the unlevered firm. The arbitrage process
occurs as shareholders of the levered firm sell their shares so as to invest in the unlevered firm.
Assume an investor owns 10% of L`s stock. The market value of this investment is sh 600,000.
The investor could sell this investment for sh 600,000, borrow an amount equal to 10% of L`s
debt (sh 400,000) and buy 10% of U`s shares for sh 900,000. The investor would remain with sh
100,000 which he can invest in 7.5% debt. His income position would be:
SH SH
Old income 10% of L`s sh 600,000 equity income 60,000
New income 10% of U`s income 90,000
Less 7.5% interest on sh 400,000 (30,000) 60,000
Plus 7.5% interest on extra sh 100,000 7,500
Total new investment income 67,500
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The investor has therefore increased his income without increasing risk. As investors sell L`s
shares, their prices would decrease while the purchaser of U will push its prices upward until an
equilibrium position is established.
Conclusion:
Taken together, the two MM proposition imply that the inclusion of more debt in the capital
structure will not increase the value of the firm, because the benefits of cheaper debt will be
exactly offset by an increase in the riskiness, and hence the cost of equity.
MM theory states that in a world without taxes, both the value of a firm and its overall cost of
capital are unaffected by its capital structure.
Capital Structure under Imperfections:

The irrelevance of capital structure as discussed above rests on the absence of the market
imperfections. However, with introduction of imperfections, it is possible for the value of the
firm and its cost of capital to change with changes in its capital structure. These imperfections
are:
a) Corporate income taxes
In a world with corporate taxes, where interest payments are tax deductible, it was
recognized by MM that the issuance of debt can enhance the value of the firm. This is
because the levered firm will pay less corporate taxes than the unlevered firm since the
dividend payments are not tax deductible. The total amount of payments available for both
debt holders and stockholders is greater if debt is employed. If the debt used is perpetual then
the present value of the tax shield is given by:
Where t0= is the corporate tax rate
I= is the interest rate on debt
B= is the market value of debt.
The value of the firm will be:
Value of the firm= value of unlevered firm+ value of the tax shield.
From this formulae it can be seen that the greater the amount of debt, the greater the tax
shield and thus the greater the value of the firm, other things remaining constant. MM
therefore concluded that the optimal capital structure is one with maximum amount of
leverage.
b) Personal taxes
The above arguments may not hold in the presence of personal taxes as well. It was
shown by Merton Miller (M) in 1977 that when personal taxes are present, the present
value of the tax shield is given by:
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Where tc and B are as before, tpd is the personal income tax rate applicable to common
stockholders income. Miller argued that where tpd = tps the present value of the tax shield
remains as before (tcB) and under this condition the levered firm has a higher value than
the the unlevered firm. However, the overall tax advantages associated with corporate
debt is reduced by the fact that overall stock income is taxed at a lower personal rate than
is debt income. This is so because stock income is divided into capital gain and dividend
(capital gains tax has been suspended in Kenya). Note that in a case where tc =tpd and
tps=0 then the tax shield will be equal to zero.
c) Financial distress and Agency costs.

Use of debt in the capital structure has a limit after which it becomes very hard to acquire
more debt. Furthermore, the probability of the firm failing increases with increase in the use
of debt. If such a situation would occur. Then the firm would incur extra cost in the form of
lawyers fee. accountant and other court fees which would absorb part of the firms value.
The process of liquidation usually involves a lot of legal processes which result in the firms
loss of value. In some cases managers in a bid to guard against losing their jobs may make
poor decisions so as to delay the process of bankruptcy. Such decisions may dilute the future
value of the assets. Therefore, the levered firm should consider the cost of bankruptcy and
financial distress.
An agency cost is the cost incurred by one party to monitor the activities of another.
Protective covenants can be thought of as a way for the creditors to monitor the actions of
stakeholders, to preclude the erosion in value of their interest and this reduces the value of
the firm to its shareholders. The value of the levered firm will therefore be:
VL=VU+TcB-COD-AC
Where COD is the present value of the expected financial distress cost and AC is the
expected value of agency costs.
d) Asymmetric information theory.

In early 1960s, Prof. Donaldson (Harvard University) conducted an extensive survey on
how corporations actually establish their capital structure. Prof. Stewart Myers used the
conclusion of Donaldson to advance a theory on asymmetry information.
Illustration
Assume that a firm has 10,000 shares outstanding at a current price of Sh 19 per share.
Managers have better information about the firms prospects than shareholders, and
managers believe that the actual share value based on existing assets is sh 21 giving the
equity a total value of sh 210,000. Suppose further that the firm identifies a new project
which require external financing of sh 100,000 and which has an estimated net present
value (NPV) of sh 5,000. This project is unanticipated by the firms investors and hence
sh 5,000 NPV has not been incorporated into the firms sh 190,000 market value of equity.
94
The firm wants to sell new equity to raise sh 100,000 to finance the project. Several
possibilities are available.
1. Symmetric information: first, consider a situation where management can convey its
information to the public and hence all investors do have the same information as
management regarding existing assets values. Under these conditions, the stock
would be selling at sh 21 per share, so the firm would have to sell 100,000/21 = 4,462
new shares
The new share price= 210,000+ 100,000+ 5,000 = sh 21.34

10,000 + 4,762
Both old and new shareholders would benefit.
2. Asymmetric information: assume that the firms management can in no way inform
investors about the shares true value. In this situation, new shares would be sold for
only sh 19 per share.
No. of new shares= 100,000 = 5,263 shares

19
New share price= New market value + new money raised + NPV
Original shares + new shares
= 210,000 + 100,000 + 5,000 = sh 20.64

10,000 + 5,263
Under this condition the project should not be undertaken. This is because if the shares were not
sold and the information asymmetry was removed, then the share price would rise to sh 21.
The sale of new shares at sh 9 leads to a sh 0.36 loss to the firms existing shareholders and a sh
1.64 gain to the new shareholders.
A more profitable project
Assume that the project had an NPV of sh 20,000 and other conditions were unchanged.
New share prices= = 210,000 + 100,000 + 20,000 = sh 21.62

10,000 + 5,263
The firm should take the project. However, the new shareholders gain more than the existing
shareholders. Sh 2.62 vs. sh 0.62.
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Dark clouds on the horizon
Suppose that the shareholders think that the firm is worth sh 19 per share but the firms managers
think:
a) That outsiders are entirely too optimistic about the firms growth opportunities and
b) That investors are not properly recognizing profound legislation which will require large
non-earning investment in pollution control equipment. Faced with these problems
managers conclude that the true value of the firms stock is only sh 17 per share. Assume
that the managers issue 10,000 new shares to raise sh 190,000 to retire debt or support
these years capital budget.
New true value= 0ld true value + new money

Original share + new shares
= 170,000 + 190,000 = sh 18
10,000 + 10,000
Current shareholders will lose when the information is released but the sale of shares reduces the
loss.
If debt was used:
New share price = 210,000 + 5,000 sh 21.50

10,000
All the true value of firms existing assets plus the NPV of the new project goes to the existing
shareholders.
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4.7 SUMMARY
This lesson, examined the concept of cost of capital; cost of equity capital, preference shares
capital, debt capital, weighted average cost of capital and marginal cost of capital. Also
theories of cost of capital structure have been discussed.
4.8 ACTIVITIES
Find out why debt is the cheapest source of funds for businesses
1. How would you apply the cost of capital concept when projects with different risks
are evaluated?
2. A company sells a new issue of 10 year, 12% per bonds of Ksh. 100, each at par. It
will pay interest annually and repays bonds at par on maturity. What is the cost of
bonds? If the tax rate is 30%, what is the after- tax cost of bonds?
3. A company sells a new issue of 10 year, 12% bonds of Ksh. 100 each, at par. It
will pay interest annually and repay bonds at 10 premiums on maturity. What is the
cost of bonds? If the tax rate is 30%, what is the after-tax cost of the bonds?
4. A bond of Ksh. 1000 is currently sold for Ksh. 200. It will be fully repaid after 25
years. The tax rate is 30%. What is the after-tax cost of the bonds?
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LESSON FIVE
MARKET FOR FUNDS
5.0 INTRODUCTION
In a market economy, the allocation of economic resources is driven by the outcome

of many private decisions. Prices are the signals that direct economic resources of their best
use. The types of markets in an economy can be divided into (1) the market for products
(manufactured goods and services), or the product market; and (2) the market for the factors
of production (labor and capital), or the factor market. In this lesson, we focus on one part of
the factor market, the market for financial assets, or, more simply, the financial market. This
market determines the cost of capital. In this lesson we look at the basic characteristics and
functions of financial assets and financial markets.
1. The different way to classify financial markets

2. The principal economic functions of financial markets
3. The roles of capital market authority
4. Functioning of central depository system (CDS)
5.2 MARKET FOR FUNDS AND FINANCIAL INSTITUTIONS IN KENYA

Financial markets refers to an elaborate system of the financial institution and intermediaries and
arrangement put in place and developed to facilitate the transfer of funds from surplus economic
units (savers) to deficit economic units (investors). Savers include individuals, small businesses,
family units savings through institutions such as Savings and Credit Cooperative Societies,
banks, insurance firms, pension schemes, etc. Investors include government, companies, family
units, etc.
Note:
Physical or commodity markets deal with real assets such as tea, coffee,
wheat, automobile etc.
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Functions of Financial Markets/Institutions in the Economy
1. Distribution of financial resources to the most productive units. Savings are transferred
to economic units that have channels of alternative investments. (Link between buyers
and sellers).
2. Allocation of savings to real investment.
3. Achieving real output in the economy by mobilizing capital for investment.
4. Enable companies to make short term and long term investments and increase liquidity of
shares.
5. Provision of investment advice to individuals through financial experts.
6. Enables companies to raise short term and long term capital/funds.
7. Means of pricing of securities e.g. Nairobi Stock Exchange index shares indicate changes
in share prices.
8. Provide investment opportunities. Savers can hold financial instrument for investment
made.
Kenya Financial System

Financial markets are broadly classified into two:
1. Capital Markets
2. Money Markets
Capital markets are sub-divided into two:
a) Security market e.g. stock exchange dealing with instruments such as shares, debentures,
etc. and non security
b) Non-security/instrument market e.g. mortgage, capital leases etc.
Security market is further sub-divided into two.
(a) Primary market

(b) Secondary market
5.3 CAPITAL MARKET

These are markets for long term funds with maturity period of more than one year. Example of
financial instruments used here are debentures, long term loans, bonds, warrants, preferences
shares, ordinary shares and so on.
The capital market serves as a way of allocating the available capital to the most efficient users.
Capital market financial institution includes:
(a) Stock exchange

(b) Development bank
(c) Hire purchase companies
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(d) Building societies
(e) Leasing firms
Functions of Capital Markets are:
a) Providing long term funds which are necessary for investment decisions.
b) Provide advice to investors as to which investments are viable.
c) Long term investments are made liquid, as the transfer between shareholders is
facilitated.
d) Facilitates the international capital inflow.
e) Facilitating the liquidation and marketing of a long term.
f) Acting as a channel through which foreign investments find their way into the market.
Money/discount markets
This is a market for short term funds maturing in one year. Money market works through
financial institutions. It facilitates transfer of capital between savers and users. The transfer can
be direct (from saver to investor) or indirect (through an intermediary). Foreign exchange market
is also part of money market. Money or discount markets include acceptance and discount
financial institutions. The money market or discount market is the market for short term loans.
Financial Instruments in Money market include:
(a) Commercial paper

(b) Treasury bills
(c) Bills of exchange
(d) Promissory notes
(e) Bank overdrafts
(f) Bankers certificate of deposit
These instruments are sold by commercial banks, merchant banks, discounting houses,
acceptance houses, and government.
Primary Markets
These are markets that deal with securities that have been issued for the first time. The money
flows directly from transferor (saver of money) to transferee (investing person). They facilitate
capital formation.
Economic Advantage of Primary Markets
1. Raising capital for business

2. Mobilizing savings
3. Raising capital by government through sale of Treasury bonds, stocks etc.
4. Open market operation to effect monetary policy of the government i.e. control of excess
liquidity in the economy
5. It is a vehicle for direct foreign investment.
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Secondary Markets
These are markets that deal with securities that are already issued i.e. after the initial public offer,
the market in which shares are subsequently traded.
Economic Advantage/Role of Secondary Markets in the Economy
1.It gives people a chance to buy shares hence distribution of wealth in economy
2.Enable investors realize their investments through disposal of securities
3.Increases diversification of investments
4.Improves corporate governance through separation of ownership and management. This
increases higher standards of accounting, resource management and transparency.
5. Privatization of parastatals e.g. Kenya Airways. This gives individuals a chance for
ownership in large companies.
6. Parameter for health economy and companies
7. Provides investment opportunities for companies and small investors.
Types of Stock Markets
1. Organized Exchange
This is where the buying and selling of securities is done by buyers and sellers who are
not present but only the agents (brokers) internet. This system is called open outcry.
2. Over the Counter Market (OTC)

Provides an opportunity for unlisted/unquoted firms to sell their security. OTC is usually
organized by dealers or stock brokers who buy securities themselves and then sell them.
They maintain a reasonable balance between demand and supply and observe price
movements to determine profit margins on sale. Trading may be done through
telephones, computer networks, fax etc. The dealers/participants set the rules. OTC
specializes in securities such as corporate bonds, equity securities, Treasury bonds, etc.
OTC is underdeveloped in Kenya.
Features of OTC Markets
1. Prices are relatively low

2. Usually deal with new securities of firms
3. Is composed of small and closely held firms
5.4 FINANCIAL INTERMEDIARIES

These are institutions which mediate/link between the savers and investors.
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Examples of Financial Intermediaries in Kenya
Commercial Banks
They act as intermediary between savers and users (investors) of funds.
Savings and Credit Associations

These are firms that take the funds of many savers and then give the money as a loan in
form of mortgage and to other types of borrowers. They provide credit analysis services.
Credit Unions
These are cooperative associations whose members have a common bond e.g. employees
of the same company. The savings of the member are loaned only to the members at a
very low interest rate e.g. SACCOs charge per month interest on outstanding balance of
loan.
Pension Funds
These are retirement schemes or plans funded by firms or government agencies for their
workers. They are administered mainly by the trust department of commercial banks or
life insurance companies. Examples of pension funds are NSSF, NHIF and other
registered pension funds of individual firms.
Life Insurance Companies

These are firms that take savings in form of annual premium from individuals and then
invest these funds in securities such as shares, bonds or in real assets. Savers will receive
annuities in future.
Brokers
These are people who facilitate the exchange of securities by linking the buyer and the
seller. They act on behalf of members of public who are buying and selling shares of
quoted companies.
Investment Bankers
These are institutions that buy new issue of securities for resale to other investors. They
perform the following functions:
(a) Giving advice to the investors

(b) Giving advice to firms which wants to go public
(c) Valuation of firms which need to merge
(d) Giving defensive tactics incase of forced takeover
(e) Underwriting of securities
5.5 THE SECURITIES EXCHANGE MARKET

The Idea and Development of a Stock Exchange
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Stock exchanges (also known as stock markets) are special market places where already held
stocks and bonds are bought and sold. They are, in effect, a financial institution, which provides
the facilities and regulations needed to carry out such transactions quickly, conveniently and
lawfully. Stock exchanges developed along with, and are an essential part of the free enterprises
system. (No stock exchanges exist in the communist world outside Hong Kong and Macao
which have special status and Taiwan which is also claimed by China). The need for this kind of
market came about as a result of two major characteristics of joint stock company (Public
Limited Company), shares.
First of all, these shares are irredeemable, meaning that once it has sold them, the
company can never be compelled by the shareholder to take back its shares and give back
cash refund, unless and until the company is winding up and liquidates.
The second characteristic is that these shares are, however, very transferable and can be
bought and resold by other individuals and organizations, freely, the only requirement
being the filling and signing of a document known as a share transfer form by the
previous shareholder.
These two characteristics of joint company shares brought about the necessity for an organized
and centralized place where organizations and private individuals with money to spare
(investors), and satisfy their individual needs. Stock exchanges were the result emerging to
provide continuous auction market for securities, with the laws of supply and demand
determining the prices.
Functions of the Nairobi Securities Exchange

The basic function of a securities exchange is the raising of funds for investment in long-term
assets. While this basic function is extremely important and is the engine through which stock
exchanges are driven, there are also other quite important functions.
The mobilization of savings for investment in productive enterprises as an alternative to
putting savings in bank deposits, purchase of real estate and outright consumption.
The growth of related financial services sector e.g. insurance, pension and provident fund
schemes which nature the spirit of savings.
The check against flight of capital which takes place because of local inflation and
currency depression.
Encouragement of the divorcement of the owners of capital from the managers of capital;
a very important process because owners of capital may not necessarily have the
expertise to manage capital investment efficiently.
Encouragement of higher standards of accounting, resource management and public
disclosure which in turn affords greater efficiency in the process of capital growth.
Facilitation of equity financing as opposed to debt financing. Debt financing has been
the undoing of many enterprises in both developed and developing countries especially in
recessionary periods.
Improvement of access to finance for new and smaller companies. This is futuristic in
most developing countries because venture capital is mostly unavailable, an unfortunate
situation.
Encouragement of public floatation of private companies which in turn allows greater
growth and increase of the supply of assets available for long term investment.
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There are many others less general benefits which securities exchanges afford to; individuals,
corporate organizations and even the government. The government for example could raise long
term finance locally by issuing various types of bond through the securities exchange and thus be
less inclined to foreign borrowing.
The Role of Securities Exchange in Economic Development
Raising Capital for Businesses

The Stock Exchange provides companies with the facility to raise capital for expansion
through selling shares to the investing public.
Mobilizing Savings for Investment

When people draw their savings and invest in shares, it leads to a more rational allocation of
resources because funds which could have been consumed or kept in idle deposits with banks
are mobilized and redirected to promote commerce and industry.
Redistribution of Wealth
By giving a wide spectrum of people a chance to buy shares and therefore become part of
owners of profitable enterprises, the stock market helps to reduce large income inequalities
because many people get a chance to share in the profits of business that were set up by other
people.
Improving Corporate Governance

By having a wide and varied scope of owners, companies generally tend to improve on their
management standards and efficiency in order to satisfy the demands of these shareholders.
It is evident that generally public companies tend to have better management records than
private companies.
Creates Investment Opportunities for Small Investors

As opposed to other business that requires huge capital outlay, investing in shares is open to
both the large and small investors because a person buys the number of shares they can
afford. Therefore the Stock Exchange provides an extra source of income to small savers.
Government Raises Capital for Development Projects

The Government and even local authorities like municipalities may decide to borrow money
in order to finance huge infrastructural projects such as sewerage and water treatment works
or housing estates by selling another category of shares known as Bonds. These bonds can
be raised through the Stock Exchange whereby members of the public buy them. When the
Government or Municipal Council gets this alternative source of funds, it no longer has the
need to overtax the people in order to finance development.
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Barometer of the Economy
At the Stock Exchange share prices rise and fall depending largely on market forces. Share
prices tend to rise or remain stable when companies and the economy in general show signs
of stability. Therefore their movement of share prices can be an indicator of the general
trend in the economy.
Advantages of Investing in Shares
Income in form of dividends

When you have shares of a company you become a part owner of that company and therefore
you will be entitled to get a share of the profit of the company which comes in form of
dividends. Furthermore dividends attract a very low withholding tax of 5% only.
Profits from capital appreciation

Share prices change with time and therefore when prices of given shares appreciate,
shareholders could take advantage of this increase and sell their shares at a profit.
Share Certificate can be used as a Collateral

Share certificate represents a certain amount of assets of the company in which a shareholder
has invested. Therefore this certificate is valuable property which is acceptable to many
banks and financial institutions as security, or collateral against which an investor can get a
loan.
Shares are easily transferable

The process of acquiring or selling shares is fairly simple, inexpensive and swift and
therefore an investor can liquidate shares at any moment to suit his convenience.
Availability of Investment Advice

Although the stock market may appear complex and remote to many people, positive advice
and guidance could be provided by the stock brokers and other investment advisors.
Therefore an investor can still benefit from trading in shares even though he may not be
having the technical expertise relevant to the stock market.
Participating in Company Decisions

By buying shares and therefore becoming a part owner in an enterprise, a shareholder gets
the right to participate in making decisions about how the company is managed.
Shareholders elect the directors at the Companys Annual General Meetings, whereby the
voting power is determined by the number of shares an investor holds since the general rules
is that one share is equal to one vote.
5.6 SECURITIES MARKET TERMINOLOGY

Broker
A broker is a dealer at the market who buys and sells securities on behalf of the public investors.
He is an agent of investors. He is the only authorized person to deal with quoted securities by the
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Capital Market Authority and Nairobi Stock Exchange. He also performs the following
functions:
(a) He obtains the suitable deal for his clients/investors, gives financial advice and charges
commission for his services
(b) He doesnt buy or sell shares in his own right hence he cannot be a market maker.
(c) He must maintain standards set by the Securities Exchange.
Jobbers/Speculators
This is a dealer who trades in securities in his own right as a principal. He can set prices and
activate the market through his own buying and selling hence he is a market maker. He engages
in speculation and earns profit called Jobbers turn (selling price buying price)
He does not deal with members of the public unlike brokers. However, brokers can buy and sell
shares through jobbers.
There are 3 types of Jobbers
Bulls
A bull jobber buys shares when prices are low and holds them in anticipation that the price will
rise and sell them at a gain. When a market is dominated by bulls (buyers predominate sellers), it
is said to be bullish. The share prices are generally rising. Therefore the market is characterized
by an upward trend in security prices which signifies investors confidence/optimism in the
future of economy.
Bears
A bearer is a jobber who speculates or sells security on expectation of decline in prices in future.
The intention is to buy same securities at lower prices in future thereby making a gain. When
market is dominated by bears (sellers pre-dominate buyers) it is said to be bearish. It is
characterized by general downward trend in share prices. It signifies investors pessimism about
the future prospects of the economy.
Stags
This is a jobber found in primary markets. He buys new securities offered to the public
and believes that they are undervalued. He believes the price will rise and sell them at a
gain to the ultimate investors. Stags are vital because they ensure full subscription of the
share issue.
Underwriting
Underwriters assume the risk relating to unsubscribed shares. When new shares are issued, they
may be unsubscribed. A merchant banker agrees, under a commission to take up any shares not
bought by the public. They therefore ensure that all new issues are successful. Underwriters are
very important in primary markets and play the following roles:
(a) Advice firms on most suitable issue price.
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(b) Ensure shares are fully subscribed by taking up all unsubscribed shares.
(c) Advice the firms on where to source funds to finance floatation costs.
Blue Chips
These are first class securities of firms which have sound share capital and are recognized
internationally. They have very good dividend record and are highly demanded in the markets.
Individuals holding such securities are reluctant to sell them because of their high value.
Going Short or Long on A Share

This is the process of selling (going short) or buying (going long) on a share that one does not
have/own. The aim is to make gain from assumed change in the market value of shares. This
practice is not allowed in Kenya. It is aided by brokers in countries where it is practiced.
Investors going short or long are required to pay a premium called margin on the transaction.
Trading Mechanism at NSE
(a) An investor approaches a broker who takes his bid/offer to the trading floor.
(b) At the trading floor, the buying and selling brokers meet and seal the deal.
(c) The investor is informed of what happened/transpired at the trading floor through a
contract note. The note is sent to buying and selling investors.
(d) The note contains details such as:
a. Number of shares bought or sold
b. Buying/selling price
c. Charges/commission payable etc
(e) Settlement is made through the brokers
(f) Old share certificate is cancelled (for selling investor) and a new one is issued in the
name of buying investor. (this has been eliminated with the automation of share selling in
the NSE)
Factors to Consider when Buying Shares of a Company
All sorts of influences affect share prices.
These influences include:
The recent profit record of the company especially the recent dividend paid to
shareholders and the prospects of their growth and stability.
The growth prospects of the industry in which the company operates.
The publication of a companys financial results i.e. Balance Sheet and Profit and Loss
statement.
The general economic conditions or situations such as boom and recession e.g. during
boom, firms would have high profits hence rise in prices.
Change in companys management e.g. entry and exit of prominent corporate
personalities.
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Change on Government economic policy e.g. spending, taxes, monetary policy etc.
These changes influence investors expectations.
Rumours and announcements of impending political changes e.g. general elections and
new president will cause anxiety and uncertainty and adversely affect share prices.
Rumours and announcement of mergers and take-over bids. If the shareholders are
offered generous terms/prices in a take-over, share prices could rise.
Industrial relations e.g. strikes and policies of other firms.
Foreign political developments where the economy heavily depends on world trade.
Changes in the rate of interest on Government securities such as Treasury Bills may make
investors switch to them. Exchange rates will also encourage or discourage foreign
investment in shares.
Announcement of good news e.g. that a major oil field has been struck or a major new
investment has been undertaken. The net present value of such investment would be
reflected in share prices.
The views of experts e.g. articles by well known financial writers can persuade people to
buy shares hence pushing the prices up.
Institutional buyers such as insurance companies can influence share prices by their
actions.
The value of assets and the earnings from utilization of such assets will also influence
share prices.
5.7 STOCK MARKET INDEX

An index is a numerical figure which measures relative change in variables between two periods.
Level of Trading Activities in the Nairobi Stock Exchange

The activities in NSE are normally low due to:
(a) Few Listed companies
(b) Economy is made up of small firms which are family owned or sole
proprietorship
(c) Level of awareness among the population is low
(d) Few instruments traded
(e) Low dividend payout to those already holding shares
5.8 STOCK EXCHANGE INDEX (SEI)

Stock Exchange Index is a measure of relative changes in prices of stocks from one period to
another.
Nairobi Stock Exchange 20-share index (20 companies) (Daily basis) Stanchart Index From 25
most active companies in a given period (weekly basis) Computation of price index.
Uses of Stock Exchange Index
(a) To gauge price (wealth) movement in the stock market

(b) To assess overall returns in the market portfolio
(c) To assess performance of specific portfolio using SEI as a benchmark
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(d) May be used to predict future stock prices
(e) Assist in examining and identifying the factors that underlie the price
movements
Limitations/Drawback of NSE Index
The 20 companies sample whose share prices are used to compute the index are not true
representatives.
The base year of 1966 is too far in the past.
New companies are not included in the index yet other firms have been suspended or
deregistered.
Dormant firms Some of the 20 firms used are dormant or have very small price changes
Thinness of the market Small changes in the active shares tend to be significantly
magnified in the index
The weights used and the method of computation of index may not give a truly
representative index.
When is a share price said to be unfair?
(a) Where the price is not determined by demand and supply forces.
(b) If the price is not consistent with the activities of the firm e.g. a decline in share price of a
firm with very good growth prospects.
(c) Price is not compatible with the price of other similar shares of firms in the same industry.
(d) If there is insider trading; this situation arises where individuals within the firm in
privileged positions e.g. top management and director take advantage of the information
available to them which has not been released to the public. They may use such
information to dispose off share to make capital gains or avoid capital loss.
Example Where individuals (insiders) are aware that a firm has made a loss in a year
and such information, if released to the public, would cause a crash on share price, the
information may be leaked to certain people who could sell the shares in advance.
Timing of Investment in a Stock Exchange

The ideal way of making profits at the Securities Exchange is to buy at the bottom of the market
i.e. at lowest market price per share and sell at the top of the market i.e. highest market price per
share. The greatest problem however is that no one can be sure when the market is at its bottom
or at its top (prices are lowest and highest).
Systems have been developed to indicate when shares should be purchased and when they should
be sold. These systems are Dow Theory and Hatch system.
Dow Theory
This theory depends on profiting of secondary movement of prices of a chart. The principal
objective is to discover when there is a change in the primary movement. This is determined by
the behaviour of secondary movement but tertiary movements are ignored, e.g. in a bull market,
the rise of prices is greater than the fall of prices. In a bear market the opposite is the case i.e.
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the fall is greater than the rise. In a bear market, the volume of the business being done at a
certain stage can also be used to interpret the state of the market.
Basically it is maintained that if the volume increases along with rising prices, the signs are
bullish and if the volume increases with falling prices, they are bearish.
Hatch System
This is an automatic system based on the assumption that when investors sell at a certain
percentage below the top of the market and buys at a certain percent above the market bottom
they are doing as well as can reasonably be expected. This system can be applied to an index of
a group of shares or shares of dividends companies e.g. Dow Jones and Nasdaq index of
America.
Rules for Floatation of new shares on NSE
(a) The company must have an issued share capital of at least Kshs. 20M
(b) The company must have made profits during the last 3 years
(c) At least 20% of issued capital (capital to be issued) should be offered to the public
(d) The firm must issue a prospectus which will give more information to investors to enable
them to make informed judgment
(e) The market price of the companies share must be determined by the market forces of
demand and supply.
(f) The company should be registered under Cap. 486 with registrar of companies.
Note
A prospectus is a legal document issued by a company wishing to raise funds

from the public through issue of shares or bonds.
It is prepared by directors of the company and submitted to Capital Market Authority and
Nairobi Stock Exchange for approval.
The Capital Market Authority has issued rules relating to the design and contents of the
prospectus, in addition to those contained in the Companies Act.
It must provide details on:
(a) Number of shares to be issued.

(b) Offer or issue price per share.
(c) The dates during which the other is valid or open.
(d) Financial statements of the firm showing earnings per share and dividend per share for the
last 5 years.
(e) Action may be taken against the directors if the prospectus is fraudulent
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The Advantages and Disadvantages of Listing
Advantages
a) It facilitates the issue of securities to raise new finance, making a company less
dependent upon retained earnings and banks
b) The wider share ownership which results will increase the likelihood of being able to
make rights issues
c) The transfer of shares becomes easier. Less of a commitment is necessary on the part of
shareholders. For this reason the shares are likely to be perceived as a less risky
investment and hence will have a higher value.
d) The greater marketability and hence lower risk attached to a market listing will lead to a
lower cost of equity and also to a weighted average cost of capital.
e) A market-determined price means that shareholders will know the value of their
investment at all times.
f) The share price can be used by management as an indicator of performance, particularly
since the share price is forward looking, being based upon expectations, whilst other
objectives measures are backward looking.
g) The shares of a quoted company can be used more readily as consideration in takeover
bids.
h) The company may increase its standing by being quoted and it may obtain greater
publicity.
i) Obtaining a quotation provides an entrepreneur with the opportunity to realize part of his
holding in a company.
Disadvantages
a) The cost of obtaining a quotation is high, particularly when a new issue of shares is made
and the company is small. This is because substantial costs are fixed and hence are
relatively greater for small companies. Also, the annual cost of maintaining the quotation
may be high due to such things as increased disclosure, maintaining a larger share
register, printing more annual reports, etc.
b) The increased disclosure requirements may be disliked by management.
c) The market-determined price and the greater accountability to shareholders that comes
with it concerning the companys performance may not be liked by management
d) Control of a particular group of shareholders may be diluted by allowing a proportion of
shares to be held by the public.
e) There will be a greater likelihood of being the subject of a takeover bid and it may be
difficult to defend it with wide share ownership.
f) Management conditions, management employees give themselves more salaries due to
prosperity obtained.
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5.9 CAPITAL MARKET AUTHORITY (CMA)
It was established in 1990 by an Act of Parliament to assist in creation of a conducive
environment for growth and development of capital markets in Kenya.
Role of Capital Market Authority
(a) To remove bottlenecks and create awareness for investment in long term securities.
(b) To serve as efficient bridge between the public and private sectors.
(c) Create an environment which will encourage local companies to go public.
(d) To grant approvals and licences to brokers.
(e) To operate a compensation fund to protect investors from financial losses should licenced
brokers fail to meet their contractual obligations
(f) Act as a watchdog for the entire capital market system.
(g) To establish operational rules and regulations on placement of securities.
(h) To implement government programs and policies with respect to the capital markets.
Note
Apart from the above roles, Capital Market Authority can undertake the
following steps to encourage development of stock exchanges in Kenya or other countries.
(a) Removal of Barriers on security transfers.

(b) Introduce wider range of instruments in the market.
(c) Decentralization of its operations.
(d) Encourage development of institutional investors such as pension funds, insurance
firms etc.
(e) Provide adequate information to players in the market in order to prevent insider
trading.
(f) Licence more brokers.
5.9.1 Role of Capital Market Authority in determination of share prices
(a) The Capital Market Authority does not in any way influence share price of quoted
companies
(b) The prices of such securities are determined by the demand and supply mechanism.
(c) However, Capital Market Authority may; advice the company on the issue price of new
securities.
(d) Alert the investors if it feels that the issue price of certain securities is not in their interest.
(e) It guards against manipulation of share prices and insider trading.
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Other Terminologies
a) ACCOUNTS 14 day period into which the stock exchange trading calendar is divided.
b) ACCOUNTS DAY Sixth or seventh day following the expiry of an accounts period on
which settlement on all period deals must be completed.
c) BACKWARDATION Where stock cannot be delivered on settlement date although it
has been paid for, a third party is found who owns and will lend similar stock. As a
security measure, this stock is paid for in full. When the original stock that cannot be
delivered on time is finally available, the lender will be given back his stock and will
refund monies paid to him less backwardation which is a commission for the loan.
d) BONUS SHARES Additional shares issued to shareholders at no additional cost to
themselves as a form of extra dividend. Also known as Scrip Issue.
e) CALL-OVER Bargaining and closing deals in a stock exchange without a formal floor
and position dealings, where the secretary reads, calls out each security to be dealt, one at
a time.
f) CARRY-OVER When a deal has been arranged but for some valid reason either the
buyer cannot pay on time, or the Jobber may not be able to deliver stock on time. In this
case, a third party can be introduced to solve the problem.
g) CONTANGO Is interest charged a client by his broker to cover the costs of borrowing
money from a third party so as to pay for stock bought on his behalf. This happens when
a client has commissioned his broker to purchase securities but for some reason, cannot
pay on time.
h) CUM AND EX These prefixes are written in front of other words such as capital, rights
and dividends to qualify them. Cum is short for cumulative, which means inclusive
of. Ex on the other hand is short for excluding, which is the opposite of including.
In commerce these terms refer to rights of buyers and sellers of securities when these are
sold before a dividend has been affected but after it has been declared. These terms are
necessitated by the fact that shares are bought and sold throughout the year, but
companies only declare dividends after the end of their financial year when profits can be
determined, and moreover, payment of dividends may take place long after they have
been declared.
Thus Ex Capital infers that the seller of shares has sold them excluding their right to
receive a bonus share issue which has been declared at the time of sale. Cum Capital
then means he sells them inclusive of this right.
Ex Rights Cum Rights The term Rights refers to the decision by the directors to raise
new share capital at current market rates but to give a prior option to existing
shareholders to purchase a fixed number of shares at preferential rates below market
values. Ex and cum proceeding it refers to the sale of shares decision, but before the
dividend.
Cum Dividend These terms simply mean that the seller of shares retain his right to
receiving the dividend on the shares he sells although the title to the shares has passed to
the buyer reserve.
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P.S.: Cum anything shares give the buyer above par value because his purchase comes
inclusive of the rights to collect on prior earnings. They are therefore sold at higher
prices than Ex shares.
i) FLOOR Loose term referring to the trading area of a stock exchange. This
encompasses all the position dealings or markets of the exchange.
j) GILT-EDGED SECURITIES These are loan securities that are issued by Governments
and because they are backed by the Governments continuity, they are considered
perfectly safe, giving regular periodic interest payments, a fixed rate of interest, and
guaranteed capital redemption at the expiry of the loan term e.g. Treasury bonds.
Similar securities issued by public corporations are called Bonds. If they are issued by
public companies they are called Debentures.
5.10 CENTRAL DEPOSITORY SYSTEM (CDS)

It is a computerized ledger system that enables the holding or transfer of securities without the
need for physical movement. The ownership of security or shares is through a book entry
instead of physical exchange. Central depository system is for security in the same way a bank is
for cash transfer between banks, e.g. A and B are 2 shareholders of XYZ Ltd. XYZ Ltd does not
need to deliver the share certificate to A or B but a ledger account for both shareholders would
be maintained at the Central depository system. Their accounts will be credited with the number
of shares. If A wants to sell shares to B Central depository system will debit As account and
credit Bs account.
Advantages of CDS
(a) It shortens the registration process in the stock exchange i.e. high speed of registering
shareholders
(b) It improves the liquidity of stock exchange than increase the turnover of the equity shares
in the market.
(c) It will lower the clearing and settlement cost e.g. no need to prepare share certificates and
seal them (putting a seal).
(d) It is faster and less risky settlement of securities which make the market more attractive
for investors e.g. instances of fraud will be reduced since there is no physical share
certificate which may be forged.
(e) There will be improved and timely communication between company and the investors
hence reduced delay in receiving dividends and right issues and improve information
dissemination concerning a company.
(f) It will lead to an efficient and transparent securities market to adhere to International
Standards for the benefit of all stakeholders.
Functions of Central Depository System
(i) Immobilization of securities i.e. elimination of physical movement of securities.

(ii) Dematerialization i.e. elimination of physical certificates or documents showing
entitlement to a security so that ownership exists only as computer records.
(iii) Effective Delivery vs. Payment (DVP) i.e. simultaneous delivery and payment
between the 2 parties exchanging or transferring securities. This can be done without
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delay if Central Depository System is linked to the central payment clearing system
e.g. Central bank of Kenya.
(iv) Provision of detailed listings of investors according to the type of securities they hold
e.g. ordinary shares, preference shares.
(v) Effective Distribution of Dividends, interests, rights issues and bonus issues.
(vi) Provision of book entry account i.e. electronic exchange of ownership of securities
and payment of cash.
Parties involved in Central Depository System
Government
For the purpose of attracting foreign investors and supporting the infrastructure of capital
markets
Capital Market Authority
To improve the transparency of market and reduce instances of fraud
Nairobi Stock Exchange
Bear transactions costs and improve liquidity of the market investors.
Investors
Institutions, private investors and market professionals. For faster settlements and ownership
transfer and reduced cost of transfer through reduced paper work and labour intensive activities.
Brokers
Reduces paper work, forgery and improved efficiency
Banks
Ease of clearing and settling of payments.
Development Banks and Specialized Financial Institutions
There are some sectors in the economy that may not secure adequate funds from commercial
banks for various reasons:
(a) May take a long time to realize returns.

(b) High risk associated with such sectors.
(c) Unattractive or low return.
(d) Uncertainty or highly volatile returns.
(e) Require heavy investment in infrastructure.
These sectors include: tourism, rural housing, agriculture, rural enterprise, small commercial
businesses e.g. Jua Kali, etc. Such sector e.g. agriculture and tourism are essential for a balanced
economic growth and development.
The government has thus established financial institutions to cater specifically for these
otherwise unattractive but essential sectors. They include:
(a) Industrial Development Bank (IDB) which give loans for industrial development in
Kenya.
(b) Development Finance Company of Kenya (DFCK) To finance various projects which
will spur economic development and create employment.
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(c) Kenya Industrial Estate (KIE) This is a branch of Industrial and Commercial
Development Cooperation (ICDC) dealing with industrial development.
(d) Agriculture Finance Co-operation (AFC).
(e) Post Bank To mobilize rural savings.
(f) National Housing Cooperation For development of houses to ensure shelter for
everyone.
(g) Kenya Tourism Development Cooperation (KTDC) for promotion of tourism in Kenya.
Advantages/Functions/Case for Development Financial Institutions
(a) They provide venture capital

(b) They provide facilities for large lending
(c) They provide technical expertise and support to emerging projects transferable from other
sectors of development economies.
(d) They are risk capital providers in areas which are not attractive to commercial banks and
other major lenders due to risk involved.
(e) They carry out feasibility study to evaluate viability of projects.
Case against Specialized Institutions and Development Banks
(a) They are being phased out by Globalization and liberalization where needy sectors can
easily get expertise from outside.
(b) Commercial banks have now matured up to provide capital for all sectors.
(c) They were only useful during periods of foreign exchange restriction.
(d) They are risk capital providers in areas which are not attractive to commercial banks and
other major lenders due to risk involved.
(e) They increase government spending.
5.11 BANKING INSTITUTIONS

The Central Bank
This is a bank which is entrusted with the responsibility of maintaining economic stability and
financial soundness of a country. It is therefore entrusted with two objectives:
(a) Responsibility of maintaining financial soundness of the economy. The bank has
therefore to identify gaps in financial markets and to seek solutions to these gaps.
(b) To act as a commercial bank. It therefore has to operate profitability when offering
services to different parties.
Establishment of Central Bank of Kenya
Central Bank of Kenya was established by Central Banking Act, 1966, and the Banking Act,
1968.
Management of the Bank
Management and policy entrusted to a Board of Directors, comprising of seven members
including the Governor, Deputy Governor, and Permanent Secretary to treasury. The Governor
of the Central Bank is the executive head of the bank. The Governor in charge today is Professor
Njuguna Ndungu.
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Statutory Information and Accounts
The bank is required to publish a return of its assets and liabilities every month, a copy of the
return to be submitted to Finance Minister. The bank has also to prepare and publish an annual
report within 3 months of the end of fiscal year. Fiscal year ends 30th June.
Functions of Central Bank
(a) Banker to the government.

(b) Lender to the government.
(c) Ensure Economic stability.
(d) Printing of currency notes.
(e) Lender of last resort.
Tools Used to Control the Level of Money in Circulation
(a) Monetary policies e.g. Treasury bills, Treasury bonds, Reserve ratio etc.
(b) Fiscal policies e.g. taxation
Commercial Banks
These are financial institutions that accept deposits of money from the general public, safeguard
the deposits and make them available to their owners when need arises.
Establishment
Established under the Banking Act 1968
Functions of Commercial Banks
(a) Accepting deposits.

(b) Collecting money on behalf of customers and credit this money in customers account.
(c) Transferring of money from individual accounts to another persons accounts through
credit transfer.
(d) Supply currency foreign currency obtainable at commercial bank.
(e) Lending money the bank lend loans to customers from which they earn interest.
(f) Facilitate International Trade issue letters of credit and undertake foreign exchange
transactions on behalf of their customers.
(g) Act as trustees and executors of wills. If one wants to make a will he or she writes one and
appoints a commercial bank as the trustee and executor of the will.
(h) Provision of safer keeping of valuables like title deeds, gold, certificates.
(i) Making decision affecting development. Before advancing loan to a prospective customer
commercial banks are very careful and strict so as to give loans to invest in viable sector
of the economy.
(j) Provision of safes for keeping money and other valuables over night.
Other Financial Institutions
Mortgages
A mortgage is an arrangement where the property being purchased provides the security for
funding. Other assets may be used as security for funding of another asset. Features:
(a) Mortgagor and mortgagee agree on a long term financing arrangement.
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(b) Financing relates to acquisition of specific asset.
(c) Mortgagor provides a contribution which is paid up-front.
(d) Repayment is over a specified long term period.
(e) Interest rate is stated with provision for variations of the determination of the finance.
Difficulties in Mortgage Arrangements
(a) Initial contribution is not affordable by majority of the population e.g. Nyayo Highrise
estate
(b) Potential participants avoid getting tied up in long term loans.
(c) Experiences with mortgage arrangements have been discouraging.
(d) Interest rate fluctuations make planning uncertain.
Housing Finance Company of Kenya

This is the largest mortgage company in Kenya. It implements the governments policy of
stimulating house ownership. It is registered under the Building Society Act but operates as a
finance company under the Banking Act.
Kenya Industrial Estate

This is a body established by the government for the purpose of promoting industrial
development and enhancement of acquisition of skills necessary for Industrial Development
Technological innovations; the body is concerned with the provision of a base that will be
considered necessary for technology development e.g. through research.
It provides capital necessary for industrial development. It provides guarantees for loans to be
used for industrial development especially for small scale industries.
Industrial and Commercial Development Cooperation (ICDC)

This was establish by the Government with a main objective is to facilitate industrial
development. It concentrates on projects requiring financial participation and active extension of
services. Funds provided are from the government and commercial banks.
Kenya Tourism Development Corporation (KTDC)
This was established by the Government specifically to promote tourism. The main objectives of
KTDC are:
(a) To provide assistance for establishment of tourism projects.
(b) To provide financial assistance for the establishment of hotels and tourism lodgings.
(c) To provide equity finance on joint venture basis in international hotel organizations.
Merchant Banks
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Merchant banks began life as merchants and begun to operate is financial firms within the 19 th
Century. The Merchant banks act as a principal when they buy shares from the company before
the issue is made. Merchant banks accept bills of exchange which deal in the leasing of
industrial equipment.
5.12 SUMMARY
In this lesson we explained the characteristics of financial markets and financial

institutions. Also we examined functioning of capital markets and the regulatory role of the
capital market authority.
Find out how the Nairobi Securities Exchange functions and also establish the challenges
faced by the CMA in its regulatory mandate
5.13 ACTIVITIES
1. Give three reasons for the greater integration of financial markets throughout the
world
2. Explain how the household sector participates as both a borrower and lender of
funds in the financial markets.
3. What entities are included in the nonfinancial business sector of the financial
market?
4. Explain why some subsidiaries of a nonfinancial business may be classified as
financial business
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LESSON SIX
WORKING CAPITAL MANAGEMENT
6.0 INTRODUCTION
The management of current assets is similar to that of fixed assets in the sense that in both
cases a firm analysis their effects on its return and risk. The management of fixed and current
assets, however, differs in three important ways: First, in managing fixed assets, time is a
very important factor; consequently, discounting and compounding techniques play a
significant role in capital budgeting and a minor one in the management of current assets.
Second, the large holding of current assets, especially cash, firms liquidity position (and
reduces riskiness), but also reduces the overall profitability. Thus, a risk-return trade-off is
involved in holding current assets. Third, levels of fixed as well as current assets depend
upon expected sales, but it is only the current assets which can be adjusted with sales
fluctuations in the short run. Thus, the firm has greater degree of flexibility in managing
current assets
Underline the need for investing in current asset, and elaborate the concept of
operating cycle.
Highlight the necessity of managing current asset and current liabilities
Explain current asset investment and financing
Focus on the proper mix of short-term and long-term financing for current assets.
Working capital management refers to the administration of current assets and current liabilities.
Liquidity management involves the planned acquisition and use of liquid resources over time to
meet cash obligations as they become due. The amount tied up in working capital is equal to the
value of raw materials work-in progress, finished goods inventories and accounts receivable
less accounts payable. The size of this net figure has a direct effect on the liquidity of an
organization.
Net working capital of a business is its current assets less current liabilities.
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6.2 WORKING CAPITAL CHARACTERISTICS OF DIFFEENT BUSINESSES
Different businesses will have different working capital characteristics. There are three main
aspects of these differences:
a) Holding inventory (from their purchase from external suppliers, through the production
and warehousing of finished goods, up to the time of sale)
b) Taking time to pay suppliers and other accounts payable.
c) Allowing customers (accounts receivable) time to pay.
6.3 FINANCING CURRENT ASSETS

Current assets require financing by use of either current funds or long term funds. There are 3
major approaches to financing current assets there are;
a) Matching approach
This approach is also known as hedging 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 asset.
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
approach can be shown by the following diagram.
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Short-term
funds
Assets Temporary Current Assets
Permanent Current Assets Long-term

funds
Fixed Assets
Time
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. Under a conservative plan, the firm finances its permanent assets and also of
temporary current assets with long-term financing. In the periods when the firm has no need for
temporary current assets, the idle long-term funds can be invested in tradable securities to
conserve liquidity. The conservative plan relies heavily on long-term financing and therefore the
firm has less risk of facing the problem of shortage of funds. The conservative financing policy
is shown diagrammatically below;
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Assets Temporary Current Assets Short-term
financing
(b)
(a)
Permanent Current Assets

Long-term
financing
Fixed Assets
Time
Note:
when the firm has no temporary current assets e.g. (a) and (b) points in the
figure, the long term funds released can be invested in marketable securities to build up the
liquidity position of the firm.
The conservative approach is a low return 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 paid within one year and therefore less risky.
c) The aggressive approach/high risky approach

An aggressive policy is said to be followed by the firm when it uses more short term financing
than warranted by the matching plan. Under this policy, the firm finances a part of its permanent
current assets with short-term financing. Some extremely aggressive firms may even finance a
part of their fixed assets with short term financing. The relatively use of short term financing
makes the firm more risky. It is also a high return approach the reason being that it relies more
on short term funds that are less costly but riskier.
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Short-term
Assets Temporary Current Assets
financing
Permanent Current Assets

Long-term
financing
Fixed Assets
Time
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 paid with one year and are therefore less risky.
6.4 DETERMINANTS OF WORKING CAPITAL NEEDS

a) Nature and size of the business
b) Firms manufacturing cycle
c) Business fluctuations
d) Production policy
e) Firms credit policy
f) Availability of credit
g) Growth and expansion
h) Credit policy
i) Price level changes
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6.5 IMPORTANCE OF WORKING CAPITAL MANAGEMENT
The firm 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 managers
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- Represent a 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 firms employees. Finance manager should therefore properly
manage these assets.
c) Importance to small firm- A small firm may minimize its investments in fixed assets by
renting or leasing plant and equipments, but there is no way it can avoid investment in
current assets. A small firm also has a relatively limited access to long term capital
markets and therefore must rely heavily on short term funds.
d) Relationship between sales and current assets- Relationship between sales volume and
the various current asset items is direct and close. Changes in current assets directly
affect the level of sales. The finance manager should therefore keep watch on changes in
working capital items.
e) Growth- The need for working capital is directly related to the firms growth
6.6 CASH AND MARKETABLE SECURITIES MANAGEMENT

Cash and marketable securities are the firms 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 realizes that it has accumulated more cash than needed,
it often puts excess cash into an interest bearing or earning instruments. A firm can invest the
excess cash in any or a combination of the following marketable securities.
- Government treasury bills.

- Agency securities such as local governments securities or parastatals securities
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- Commercial paper (unsecured promissory notes)
- Bankers acceptances, which are securities acceptable by banks
- Repurchase agreements
- Negotiable certificate of deposits
- Euro currencies etc.
6.7 CASH OPERATING CYCLE

The cash operating cycle is the period of time which elapses between the point at which cash
begins to be expended on the production of a product and the collection of cash from a
purchaser. The connection between investment in working capital and cash flow may be
illustrated by means of the cash operating cycle also called leading cycle or working capital
cycle.
The cash operating cycle in a manufacturing business equals,
The average time that raw materials remain in inventory less the period of credit taken
from suppliers plus the time taken to produce goods, plus the time taken by customers to
pay for the goods.
If the turnover periods for inventories and accounts receivable lengthen, or the payment period to
accounts payable shortens, then the operating cycle will lengthen and the investment in working
capital will increase.
Example 2
XYZ Ltd currently purchases all its raw materials on credit and sells its merchandise on credit.
The terms extended to the firm 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.
Required Determine the cash conversion cycle and the cash turnover.
Inventory conversion period (85 days)
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Receivable collection period (70
days)
Payables deferral period (35 days)
Payment of
Purchase of Sale of finished Collection of
the raw
raw materials goods receivables
materials
Cash conversion 85 35 +70 = 120 days

Period
Cash conversion = Inventory conversion + Receivables collection - Payables deferral

Period Period period period
= 85 + 70 -35 = 120 days
Cash turnover = 360 days = 360 days =3 times

Cash conversion period 120 days
Conversion cycle = 360 Inventory+Receivables- Payables + Accruals

Cost of sales SalesCash operating expenses
EXAMPLE 2
Wines Company buys raw materials from suppliers that allow wines 2.5 months credit. The raw
materials remain in inventory for one month and it takes 2 months to produce the goods. The
goods are sold within a couple of days production being completed and customers take an
average 1.5 months to pay.
Required
Calculate wines cash operating cycle
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Solution
Months
The average time that raw materials remain in inventory 1.0
Less. Time taken to pay suppliers (2.5)
The time taken to produce the goods 2.0
Time taken by customers to pay for the goods 1.5
2.0
The companys cash operating cycle is 2 months
0 2.5 3.0 4.5
Goods sold to
Goods customers Cash received from customers
Suppliers
purchased
paid Working capital cycle: 2 months
4.5 2.5 = 2 months
We can ignore the time finished goods are in inventory as it is no more than a couple of days.
6.8 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 cash balance. These include:
a) Cash budget
The cash budget shows the forms projected cash inflows and outflows over some specified
period.
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Example
The opening cash balance on 1st January was expected to be sh. 30,000. The sales budgeted were
as follows
November 80,000
December 90,000
January 75,000
February 75,000
March 80,000
Analysis of records shows that debtors settle according to the following pattern: 60% within the
month of sale, 25% the following month 15% next month but one.
Extracts from the purchases budget were as follows
December 60,000
January 55,000
February 45,000
March 55,000
All purchases are on credit and past experience shows that 90% are settled in the month of
purchase and the balance settled the month after. Wages are Shs. 15,000 per month and
overheads of Shs. 20,000 per month including Shs. 5,000 depreciation are settled monthly.
Taxation of Shs. 8,000 has to be settled in February and the company will receive settlement of
an insurance claim Shs. 25,000 in March.
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Prepare a cash budget for January, February and March
Workings
January
November (15% X 80,000) = 12,000
December (25% x 90,000) = 22,500
January (60% x 75,000) = 45,000
79,500
February
December (15% x 90,000) = 13,500
January (25% x 75,000) = 18,750
February ( 60% x 75,000) = 45,000
77, 250
March
January (15% 75,000) = 11,250
February (25% x 75,000) = 18,750
March (60% x 80,000) = 48,000
78,000
Payments for purchase
January
December (10% x 60,000) = 6,000
January (90% x 55,000) = 49,500
55,500
February
January (10% x 55,000) = 5,500
February (90% x 45,000) = 40,500
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46,000
March
February (10% x 45,000) = 4,500
March (90% x 55,00) = 49,500
54,000
Cash budget for the month of
January February March
Opening balance 30,000 24,000 17,250
Receipts from sales 79,500 77,250 78,000
Total cash available - - 25,000
109, 500 101, 250 120, 250
Payments
Purchases 55,500 46,000 54,000
Wages 15,000 15,000 15,000
Overheads less depreciation 15,000 15,000 15,000
Taxation 8, 000 -
85,500 84,000 84,000
Closing balance C/F 24,000 17,250 36,250
b) Baumols Model
It is an application of the Economic Order Quantity (EOQ) inventory model to cash
management. Its assumptions are;
a. The firm uses cash at a steady predictable rate.
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b. The cash outflows from operations also occur at a steady rate.
c. The cash net outflows also occur at a steady rate
Under these assumptions the following model can be stated
2bt
C* =
i
Where C* is the optimal cash discount 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 borrowings)
Total cost of holding the cash balance is equal to carrying/holding cost plus transactions costs
and is as follows.
TC 1 C + T b
2 C
Example
Multi link, a trading company currently has negligible cash holdings but expects to make a series
of cash payment totaling sh. 150 million over the forth coming year. These payments will
become due at a steady rate. Two alternative ways have been suggested of meeting these
obligations.
Alternative 1
The company can make periodic sales from existing holdings of short- term securities. The
average percentage rate of return on these securities is 12% over the forthcoming year.
Whenever multi-link Ltd sells the securities, it will incur a transaction fee of sh. 15,000. The
proceeds from the sale of the securities are placed on short term deposit at 7% per annum interest
until needed.
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Alternative II
The company can arrange for a secured loan amounting to sh. 150 million for one year at an
interest rate of 18% per annum based on the initial balance of the loan. The lender also imposes a
flat arrangement fee of sh. 50,000 which would be met out of existing balances. The sum
borrowed could be placed in a notice deposit at 9% per annum and drawn down at no cost as and
when required. Multi-link ltds treasurer believes that cash balances will be run down at an even
rate throughout the year.
Required
i. Explain the weaknesses of the Baumol model in the management of cash.

ii. Advise multi-link ltd as to the better alternative for managing its cash.
i. Weaknesses if the Baumol (EOQ) model are inherent in its assumptions which are:
- The annual cash requirement is known and constant
- Transaction/transfer or conversion costs are known and fixed.
- The firm as a steady cash inflow and outflow.
- The interest rate on short term marketable securities remain constant over cash planning
period
Baumol Model is a deterministic model which assumes certainty of parameters of the models.
ii. Alternative I
To determine the total cost of holding cash under this alternative.
a) Lost interest income 12% x 150m x = 9,000,000

b) Optimal cash balance
C* = 2TC
i
= 2 x 15,000 x 150 = 6,123,724

0.12
Total cost = D x Tc + Q x h
Q 2
Conversion cost = 150,000,000 x 15,000 = 367,425
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6,123,724
Interest income on short term deposit =
= Cid (id interest rate on short term
deposits)
= x 6,123,724 x 7%
= 214,330
Summary
Lost income 9,000,000
Conversion cost 375,000
Less interest income (214,300)
9,160,670
Alternative II
Interest paid 150,000,000 x 18% = 27,000,000
Less interest received (13,500,000)
Add arrangement fees 50,000
13,550,000
The policy of selling short term securities result in lower cost thus preferable
b. Miller- Orr model
This is a stochastic/probabilistic model which makes more realistic assumption of uncertainty in

cash flows. This model assumed that the distributing of daily net cash flows is approximately
normal. Each day, the net cash flow could be the expected value of some higher or lower value
drawn from normal distribution. Thus the daily net cash flows are trendless random for example,
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A
H Upper limit
Z Target
Lower limit
L B
Where;
Z Is target cash
H Upper Limit
L Lower limit
b- Fixed transaction cost
i-Opportunity cost on daily basis.
2 Variance of net daily cash flows
From the graph, the miller Orr model sets higher and lower control limits H and L respectively
and the target cash balance Z. When the cash balance reaches H such as point A then H-Z
shillings are transferred from cash to marketable securities. Similarly, when the cash balance hits
L at point B then Z-L shillings are transferred from marketable securities to cash.
1
Z=
3 2 3
+L
4i
The highest limit H is given by
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H= 3Z -2L
The average cash balance
= 4Z L
EXAMPLE
Lynx Services Ltd; a debt collection agency, has estimated that the standard deviation of its daily
net cash flow is sh. 22,750. The company pays sh. 120 in transaction cost every time it transfers
funds into and out of the money market. The rate of interest in the money market is 9.46%.
Minimum cash balance has been set at sh. 87,500.
Required
i. The companys target cash balance

ii. The lower and upper cash limit
iii. Lynx services Ltds decision rules
Solution
Using Miller-Orr (stochastic model)
i. Optimal cash balance

B = 120
1
Z=
3 2 3
+L = (22750)2
4i
L = 87500
i = 9.46%
= 3 X 120 X (22, 7502) 1/

3 + 87,500
4 X 0.0946
365 days
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= 56,770 + 87,500
= 144,270
ii. H = 3Z -2L = (3 x 144,720) (2 x 87,500)

= 257,810
Lower limit (L). This is given in the question as sh. 87,500.

iii. Decision rule
- If the cash balance increases from optimal balance Z to upper limit H, buy short term
marketable securities worth H-Z i.e. 257,810 144,270 = 113, 540 to return to balance Z.
- If the cash balance falls to L, sell marketable securities equal to Z-L 144, 270 87,500 =
56,770
- The firm should hold a cash balance with a spread between H and L (H-L)
257,810 87,500 = 170,130
6.9 MANAGING INVENTORIES

According to IAS 2 inventories include;
- Raw materials
- Work in progress
- Finished goods
Some businesses attempt to control inventories on a scientific basis by balancing the costs of
inventory shortages against those of inventory holding. The scientific control of inventories may
be analyzed into three parts.
i. The economic Order Quantity (E.O.Q) model- can be used to decide the optimum order
size for inventories which will minimize the cost of ordering inventories plus inventory
holding cost..
ii. If discounts for bulk purchases are available, it may be cheaper to buy inventories in large
order size so as to obtain the discounts.
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iii. Uncertainty in the demand for inventories and/or the supply lead time may lead a
company to decide to hold buffer inventories in order to reduce or eliminate the risk of
stock outs (running out of inventory).
6.10 INVENTORY COSTS

a. Holding costs The cost of capital tied in inventories, warehousing and handling costs,
deterioration, obsolescence, insurance and pilferage.
b. Procuring costs Ordering costs, delivery costs etc.
c. Shortage costs/stock out costs - Contribution from lost sales, extra cost of emergency
inventory, cost of lost production and sales in an inventory- out.
d. Cost of inventory Relevant particularly when calculating discount.
APPLICATION OFE.O.Q IN INVENTORY MANAGEMENT
It is the basic inventory management model;
Assumptions
i. The demand is known and constant

ii. The ordering cost is constant for order and certain
iii. The holding cost is constant per unit per year.
iv. The purchase cost is constant (Thus no quantity discount)
v. Back orders are not allowed
E.O.Q (Q) = 2 D Co
Ch
Q = is E.O.Q
D= annual demand
Co = cost of placing and receiving an order
Ch = is the cost of holding inventories per unit.
Illustration
The demand for a commodity is 4,000,000 units a year at a steady rate. It costs sh. 2,000 to place
an order and sh. 40 to hold a unit for a year. Find the order size to minimize inventory costs, the
number of orders placed each year, the length of the inventory cycle and the total costs of
holding inventory for the year.
140
E.O.Q = 2 x 2,000 x 4,000,000
40
= 20,000 Units
Number of orders = 4,000,000 = 200 Orders
20000
Inventory cycle = 52 weeks = 0.26 weeks or 1.82 days
200 orders
Total cost = (2,000 x 200 orders) + 20,000 x 40
= 400,000 + 400,000
= 800,000.
Uncertainties in demand and lead times: a re-order level system
Uncertainties in demand and lead times taken to fulfill orders meant that inventory will be
ordered once it reaches re-order level.
Re-order level = maximum usage x maximum lead time
The re-order level is the measure of inventory at which a replenishment order should be made. If
an order is placed too late, the organization may run out of inventory, a stock-out, resulting in a
loss of sales and/or a loss of production. If an order is placed too soon the organization will hold
too much inventory and holding costs will be excessive.
Quantity of safety inventory (in units) x inventory holding cost per unit
The graph shows how the inventory level might fluctuate with the re-order level system. Points
x1 to x6 shows the re-order level at which a new order is placed. Units are ordered via E.O.Q.
Actual inventory levels fall below the safety inventory level and sometimes the re-supply.
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Stock
Levels
x1 x2 x3 x4 x5 x6
Time
Arrives before inventories have fallen to the safety level

Note: The size of the safety inventory will depend on whether stock outs are allowed or not.
Illustration
The following data relate to a given stock item
Normal usage 1,300 per day
Minimum usage 400 per day
Maximum usage 2,000 per day
Lead time 15 20 days
EOQ 30,000 units
Calculate various control levels
i. Re-order level = Maximum usage x maximum lead time

= 2,000 x 20 = 400,000 units
ii. Minimum level = Re-order level (average usage x average lead time)
= 40,000 (1,300 x 17.5 days) = 17,250 units
iii. Maximum level = re-order level +E.O.Q (minimum usage x minimum lead time)
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= 40,000 + 30,000 900 x 15
= 56,500 units
iv. Average inventory = Minimum level + Re-order level

2
= 17,250 + 40,000 = 37,250 units
2
POSSIBILITY OF STOCK OUTS
Illustration
If re-order level is 4 units but there was a probability of 0.2 that demand during the lead time
would be 5 units and 0.05 that during the lead time would be 6 units, then expected number of
stock outs
= (5-4) x 0.2 = 0.2
= (6-4) x 0.05 = 0.1
=0.3
The Effect of discounts

Price discounts for quantity purchases have three financial effects, two of which are beneficial
and one adverse
Beneficial effects
Savings coming from;
i. Lower price per item

ii. The larger order quantity means that fewer orders need to be placed so that total ordering
costs are reduced.
Adverse Effect
Increased costs arise from the extra stock holding costs caused by the average stock level being
higher due to the larger order quantity
143
Illustration
The annual demand for an item of inventory is 125 units. The item costs $200 a unit to purchase,
the holding cost for one unit for one year is 15% of the unit cost and ordering costs are $300 per
order. The supplier offers a 3% discount for orders of 60 units or more and a discount of 5% for
order of 90 units or more. What is the cost minimizing order size?
a) The EOQ ignoring discounts is
2 x 300 x 125 = 75,000 = 50 units

15% x 200 30
Cost analysis for the EOQ unit

Purchases (no discount) 125 units x 200 = 25,000
Holding cost (50/2) 25 units x (15% x 200)830 = 750
Ordering cost (125 / 50 x $300) = 750
26,500
b) With discount 3% and an order quantity of 60 units
Purchases 25,000 x 97% = 24,250
Holding cost 90/2 (95% x 15% x $200 = 873
Ordering cost (125/90 x 300) = 625
= 25,748
c) With a discount of 5% and an order quantity of 90 units
Purchases 25,000 x 95% = 23,750
Holding cost = 1282.5
Ordering cost = 416.7
25,449.2
The cheapest option is to order 90 units at a time.
6.11 JUST IN TIME (JIT) PROCUREMENT

Some manufacturing companies have sought to reduce their inventories of raw materials and
components to as low level as possible. Just in-time procurement is a policy of obtaining goods
from suppliers at the latest possible time i.e. when they are needed and so avoiding the need to
carry any materials or components inventory.
144
Benefits of JIT
- Reduction in inventory holding costs

- Reduced manufacturing lead time
- Improved labour, productivity
- Reduced scrap/rework/warranty costs
Managing Accounts Receivable

Offering credit has a cost, however; in order to keep current customers and attract new ones,
most firms find it necessary to offer credit. The costs involved are: The value of interest charged
on an overdraft to fund the period of credit or the interest lost on the cash not received and
deposited in the bank. An increase in profit from extra sales resulting from offering credit could
off-set this cost.
The total amount of receivables outstanding at any given time is determined by;
a) The volume of credit sales

b) The average length of time between sales and collection
Accounts receivables = credit sales per day x length of collection period
Average collection period depends on;
- Credit standards which is the maximum risk acceptable on credit sales

- Credit period which is the length of time for which credit is granted
- Discount given for early payments
- The firms collection policy
6.12 CREDIT STANDARDS

A firm may adopt
i. Lenient credit policy- tends to sell a credit to customers on a very liberal terms and credit
is granted for a longer period. This credit policy will result in increased sales and
therefore increased contribution margin. However, these will also result in increased
costs such as:
- Increased bad debts
- Opportunity cost of tied up capital in receivables
- Increased cost of carrying out credit analysis
- Increased discount costs to encourage early payments
ii. Stringent credit policy- a firm sells on credit on a selective basis only to those customers
who have proven credit worthiness and who are financially strong.
Factors to consider in formulating a credit policy
- The administrative cost of debt collection
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- The procedures for controlling credit to individual customers and for debt collection.
- The amount of extra capital required to finance an extension of total credit there might be
an increase in accounts receivable, inventories and accounts payable and the net increase
in working capital must be financed.
- The cost of additional finance required for any increase in the volumes of accounts
receivable (or savings from a reduction n accounts receivable), this cost may be bank
overdraft interest or the cost of long term funds such as equity or loan.
- Any savings or additional expenses in operating the credit policy e.g. the cost of pursuing
slow payers.
- The ways in which the credit policy could be implemented e.g.
(i) Credit could be eased by giving accounts receivable a longer period in which to
settle their accounts
(ii) A discount could be offered for early payment.
- The effects of easing credit which might be to encourage a higher proportion of bad debts
and an increase in sales volume.
CREDIT TERMS
This involve both the length of credit period and the discount given e.g. the terms 2/10, n/30
means that a 2% discount is given if the bill is settled on or before the tenth day, otherwise, net
amount should be paid by the 30th day.
DISCOUNTS
Early settlement discounts may be employed to shorten average credit periods and to reduce the
investments in accounts receivable and therefore interest cost. The benefit in interest cost saved
should exceed the cost of discounts allowed.
Illustration
Low and Price Co. has annual credit sales of $12,000,000 and three months are allowed for
payment. The company decides to offer a 2% discount for payments made within ten days of the
invoice being sent and to reduce the maximum time allowed for payment to two months. It is
estimated that 50% of customers will take the discount. If the company requires a 20% return on
investments, what will be the effect of the discount?
Assume that the volume of sales will be unaffected by the discount.
Solution
(a) The profits forgone by giving the discounts

(b) The interest charges saved or incurred as a result of the changes in the cash flows of the
company.
(a)The volume of accounts receivable, If the company policy remains unchanged.
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3
/12 x 12,000,000 = $ 3,000,000
(b) If policy is changed, the volume of accounts receivable would be:
10
/ 365 x 50% x 12,000,000) + (2/12 x 50% x 12,000,000) =
164,384 + 1,000,000 = 1,164, 384
There will be a reduction in accounts receivable of $1,835,616
3,000,000 1,164,384 = 1,835,616
The company invests at 20%
Summary
Value of reduction in accounts receivable (1,835,616 x 20%) = 367,123
Less: discount allowed (2% x 50% x 12,000,000) = 120,000
Net benefit of new discount policy = 247,123
The new policy should be introduced.
Illustration
A company offers its goods to customers on 30 days credit, subject to satisfactory trade
references. It also offers a 2% discount if payment is made within 10 days of the invoice date.
Required:
The cost of the company of offering the discount assuming a 365 day year
365
20
The % cost of the discount = 1 100
100 d2
= 1 1.0204118.25
=1 1.446
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=44.6%
The percentage cost of an easy settlement discount to the company giving it can be estimated by
the following formula:
% cost of discount = 1 100 365
100-d t
Where: d = the discount offered
t = the reduction in the period in days that is necessary to obtain the early payment
discount
6.13 SUMMARY
This lesson discussed working capital management and short-term financing. Management of
cash and cash equivalent, inventories and accounts receivables have been explained in details
6.14 ACTIVITIES
Find out what kind of firms in your country can use commercial paper to raise finance and
why
148
1. What are the four elements of a firms credit policy? To what extent can firms sets
their own credit policies as opposed to having to accept policies that are dictated by
the competition?
2. A firms credit sales are Ksh. 300.Its average collection period is 45 days. What is
the firms average investment in accounts receivables?
3. Williams & Sons last year reported sales of Ksh. 10 million and inventory turnover
ratio of 2. The company is now adopting a new inventory system. If the new
system is able to reduce the firms inventory level and increase the firms inventory
turnover ratio to 5, while maintain the same level of sales, how much cash will be
freed up?
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LESSON SEVEN
CAPITAL BUDGETING
7.0 INTRODUCTION
An efficient allocation of capital is the most important finance function in the modern times.
It involves decisions to commit the firms funds to long-term assets. Capital budgeting or
investment decisions are considerable importance to the firm, since they tend to determine its
value by influencing its growth, profitability and risk. In this lesson we focus on the nature
and evaluation of capital budgeting decisions.
Understand the nature and importance of investment decisions

\Explain the methods of calculating net present value (NPV) and internal rate of
return (IRR)
Show the implications of net present value (NPV) and internal rate of return (IRR)
Describe the non-DCF evaluation criteria: payback and accounting rate of return
Illustrate the computation of the discounted payback
Compare and contrast NPV and IRR and emphasize the superiority of NPV rule
The basic characteristic of capital expenditure also referred to as capital investment or capital
project is that it typically involves a current outlay (or current and future outlays) of funds in the
expectation of a stream of benefits extending far into to the future. Capital budgeting (investment)
decisions may be defined as the firm's decisions to invest its current funds most efficiently in the
long-term assets in anticipation of an expected flow of benefit over a series of years. The firm
therefore:
Exchanges current funds for future benefits

Invests the funds in long-term assets
Expects future benefit over a series of years
Net working capital of a business is its current assets less current liabilities.
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7.2 CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process which may be divided into following phases:
i. Identification of potential investment opportunities
ii. Assembling of proposed investments
iii. Decision making
iv. Preparation of capital budget and appropriations
v. Implementation
vi. Performance review
1. Identification of potential investment opportunities
The capital budgeting process begins with the identification of potential investment opportunities.
Typically, the planning body (it may be an individual or a committee organized formally or
informally) develops estimates of future sales which serve as the basis for setting production targets.
This information in turn, is helpful in identifying required investments in plant and equipment.
For imaginative identification of investment ideas it is helpful to:
i. Monitor external environment regularly to scout investment opportunities.
ii. Formulate a well define corporate strategy based on a thorough analysis of strength,
weaknesses, opportunities and threats.
iii. Share corporate strategy and perspectives with persons who are involved in the process of
capital budgeting and
iv. Motivate employees to make suggestions.
2. Assembly of investment proposals
Investment proposals identified by the production departments and other departments are usually
submitted in a standardized capital investment proposal form.
Before the proposals reach the capital budgeting committee or somebody who assembles them, they
are routed through several persons. The purpose of routing a proposal through several persons is
primarily to ensure that the proposal is viewed from different angles. It also helps in creating a
climate for bring about coordination of interrelated activities.
Investment proposals are usually classified in to various categories for facilitating decision-making,
budgeting and control e.g.
Replacement investments
Expansion investments
New product investment
Obligatory and welfare investment
3. Decision making
Executives are vested with powers to okay investment proposal up to certain limits. For example, in
one company the plant superintendent can okay investment outlays up to Sh 2 million, the works
manager up to Sh 5million, and managing director up to Sh 20 million. Investments requiring higher
outlays need the approval of the board of directors.
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4. Preparations of capital budget and appropriations
Projects involving smaller outlays and which can be decided by executives at lower levels are often
covered by a blanket appropriation for expeditions action, projects involving larger outlays are
include in the capital budget after necessary approvals. Before undertaking such projects an
appropriation order is usually required. The purpose of check is mainly to ensure that the funds
position of the firm is satisfactorily at the time of implementation, further, it provides an opportunity
to review the project at the same time of implementation.
5. Implementation
Translating an investment proposal into a concrete project is complex, time consuming, and risk
fraught task. Delays in implementation, which are common, can lead to substantial cost overruns,
for expeditions implementation at a reasonable cost the following are helpful:
a) Adequate formulation of projects: - the major reason for delay is inadequate formulation of
projects i.e. If necessary homework in terms of preliminary studies and comprehensive and
detailed formulation of the project is not done, many surprises and shocks are likely to
spring on the way. Hence, the need for adequate formulation of the project cannot over-
emphasize.
b) Use of the principle of responsibility accounting:- assigning a specific responsibilities to
project manager for completing the project within the defined time frame and cost limits is
helpful for expeditious executions and cost control.
c) Use of network techniques:- for project planning and control several networks techniques like
PERT( project evaluation and review technique) and CPM (critical path method) are
available. With the help of these techniques, monitoring becomes easier.
6. Performance review
Performance review, or post-completion audit, is a feedback device. It is a means for comparing
actual performance with projected performance. It may be conducted, most appropriately, when the
operations of the project have stabilized. It is useful in several ways;
i. It throws light on how realistic were the assumptions under the project;
ii. It provides a documented log of experience that is highly valued for decision making.
iii. it helps in uncovering judgmental biases:
iv. It induces a desired caution among project sponsors
Importance of investment decisions
Capital budgeting requires special attention because of:
i. They influence the firms growth in the long-run
ii. They affect the risk of the firm
iii. They involve commitment of a large amount of funds
iv. They are irreversible or revisable at substantial loss
v. They are among the most difficult decision to make are an assessment of the future events
which are difficult to predict.
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7.3 TYPES OF INVESTMENT DECISIONS
Project analysis entails time and effort. The costs incurred in this exercise must be justified by the
benefits from it. Certain projects given their complex and magnitude may warrant a detailed
analysis; others may call for a relatively simple analysis. Hence firms normally classify their
investment projects into various categories. Each category is then analyzed somewhat differently.
The various classifications include:
a) Expansion of existing business- a company may add capacity to its existing product lines to
expand existing operations.
b) Replacement and modernization- the main objective of modernization and replacement is to
improve operating efficiency and reduce costs.
c) Expansion projects: - these investments are meant to increase capacity and /or widen the
distribution network. Such investments call for an explicit forecast of growth. Since this can
be risky and complex, expansion projects usually warrant more careful analysis than
replacement projects. Decisions relating to such projects are taken by the top management.
d) Mandatory investment: - these are expenditure required to comply with statutory
requirements. Examples are pollution control equipments, medical dispensary, fire fighting
equipments and so on. These are often non-revenue producing investments. In analyzing
such investments the focus is mainly on finding the most cost-effective way of fulfilling a
give statutory need.
e) Diversification projects: - these investments are aimed at producing new products or services
or entering in to entirely new geographical areas. Often diversification projects entail
substantial risks, involve large outlays and require considerable managerial effort and
attention. Given their strategic importance, such projects call for very thorough evaluation
both quantitative and qualitative. Further, they require a significant involvement of the board
of directors.
f) Research and development projects:-Traditional, R&D projects absorbed a very small
proportion of capital budget in most of the countries. Things however are changing.
Companies are now allocating more funds to R&D projects more so in knowledge intensive
industries. R&D projects are characterized by numerous uncertainties and typically involve
sequential decision making. Hence the standard discounted cash flow (DCF) analysis is not
applicable to them. Such projects are decided on the basis of managerial judgment. Firms
which rely more on quantitative methods use decisions tree analysis and option analysis to
evaluate R&D projects
g) Miscellaneous projects:-This is catch-all category that includes items like interior decoration,
recreational facilities executive aircrafts, and landscaped gardens and so on. There is no
stand approach for evaluating these projective and decisions regarding them are based on
personal preferences of top managements.
Another classification of capital budget is:
a) Mutually exclusive investment serve the same purpose and compete with each other i.e. if one
investment is undertaken, others will have to be excluded.
b) Independent investments:-serve different purposes and do not compete with each other.
Depending on their profitability and availability of funds, the company can undertake both
investments.
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c) Contingents investments;- are dependent projects; the choice of one investment necessities
undertaking one or more other investments e.g. if a company decides to build a factory in a
remote backward area, it may have to invest in houses, roads, hospitals, school etc for
employees to attract labor force.
Investment criteria
A wide range of investment criteria has been suggested to judge the worth whileness of investment
projects. There steps are involved in the evaluation of an investment. These include:
i. Estimation of cash flows
ii. Estimation of the required rate of return
iii. Application of decision rule for making the choice.
The investment decision rules may be referred to as capital budgeting techniques or investment
criteria. A sound appraisal technique should be used to measure the economic worth of an
investment project. The essential property of a sound technique is that it should maximize the
shareholders wealth. The following other characteristics should be possessed by a sound investment
evaluation criterion:
i. It should consider all cash flows to determine the true profitability of the project.
ii. It should provide for an objective and an unambiguous way of separating good projects from
bad projects.
iii. It should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones
iv. It should help to choose among mutually exclusive projects that project which maximizes the
shareholders wealth.
v. It should be a criterion which is applicable to any conceivable investment project independent
of others.
7.4 CAPITAL BUDGETING TECHNIQUES OR INVESTMENT APPRAISAL

TECHNIQUES
The investment appraisal techniques can be categorized into two groups:
(a) Discounted Cash flow methods
i. Net present value method
ii. Internal rate of return
iii. Profitability index
(b) Non-discounted cash flow method
i. Accounting rate of return
ii. Payback period
DISCOUNTED CASHFLOW METHODS

1. Net Present Value (NPV)
154
This is defined mathematically as the present value of cash flow less the initial outflow.
n
NPV =
Ct
-
t Io
t=1 (1+ K )
Where Ct is the cash flow

K is the opportunity cost of capital
Io is the initial cash outflow
n is the useful life of the project
Decision Rule using NPV

The decision rule under NPV is to:
- Accept the project if the NPV is positive
- Reject the project if NPV is negative
Note:
Note:
If the NPV = 0, use other methods to make the decision.
2. Internal Rate of Return (IRR)

The internal rate of return of a project is that rate of return at which the projects NPV = 0
Therefore IRR occurs where:
n
NPV =
Ct
- =0
t Io
t=1 (1+ r )
Where r = internal rate of return

Note that IRR is that ratio of return that causes the present value of cash flows to be
equal to the initial cash outflow.
Decision Rule under IRR

If IRR > opportunity cost of capital - accept the project
- IRR < opportunity cost of capital - reject the project
155
- IRR = opportunity cost of capital - be indifferent
3. Profitability Index
This is a relative measure of projects profitability. It is given by the following formula.
(1+CK )
t=1
t
t
PI =
Io
Decision Rule
If PI > 1 - Accept the project
PI < 1 - Reject the project
PI = 1 - Be indifferent
NON-DISCOUNTED CASHFLOW METHODS

1. Accounting rate of return (ARR)
ARR = Average annual income
Average investment
Where Average annual income = Average cash flows - Average Depreciation
Average investment = 1/2 (Cost of investment - Salvage value)
(assuming straight line depreciation method).
Projects with higher ARR are preferable.
2. Payback Period
This is defined as the time taken by the project to recoup the initial cash outlay.
The decision rule depends on the firms target payback period (i.e. the maximum period
beyond which the project should not be accepted.
Illustration
A company is considering two mutually exclusive projects requiring an initial cash outlay of Sh
10,000 each and with a useful life of 5 years. The company required rate of return is 10% and the
appropriate corporate tax rate is 50%. The projects will be depreciated on a straight line basis.
The before depreciation and taxes cashflows expected to be generated by the projects are as
follows.
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YEAR 1 2 3 4 5
Project A Shs 4,000 4,000 4,000 4,000 4,000
Project B Shs 6,000 3,000 2,000 5,000 5,000
Required:
Calculate for each project
i. The payback period
ii. The average rate of return
iii. The net present value
iv. Profitability index
v. The internal rate of return
Which project should be accepted? Why?
Suggested Solution
Computation of after tax cashflows
Depreciation = 10,000 - 0 = Sh 2,000
5
Project A Annual Cashflow
Cashflows before depreciation 4,000
Less Depreciation 2,000
Profits before taxes 2,000
Less taxes (50%) 1,000
Profits after tax 1,000
Add back depreciation 2,000
Cashflows after taxes 3,000
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Project B
Year 1 2 3 4 5
Cash flow before depreciation 6,000 3,000 2,000 5,000 5,000
Less depreciation 2,000 2,000 2,000 2,000 2,000
Profits before taxes 4,000 1,000 0 3,000 3,000
Less taxes (50%) 2,000 500 0 1,500 1,500
Profits after taxes 2,000 500 0 1,500 1,500
Add back depreciation 2,000 2,000 2,000 2,000 2,000
Net cash flows after taxes 4,000 2,500 2,000 3,500 3,500
i. Payback Period (PB)

Project A = 10,000 = 3 1/3 years
3,000
Project B
Sh 4,000 + Sh 2,500 + Sh 2,000 = Sh 8,500 is recovered in three years. The remaining amount of
Sh 10,000 - 8,500 = 1,500 is to be recovered in the fourth year.
Thus PB = 3 years + 1,500 = 3 3/7 years

3,500
According to PB Project A is better.
ii. Average Rate of Return (ARR)

Project A
Average income = 5 x 1,000 = Shs 1,000
5
Average investment = 10,000/2 = Shs 5,000

ARR = 1,000 = 0.20 or 20%
5,000
Project B
Average income = 2,000 + 500 + 0 + 1,500 + 1,500
5
= 5,500 = Shs 1,100
5
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ARR = 1,100 = 0.22 or 22%
5,000
According to ARR Project B is better.
iii. Net Present Value Method

Project A
NPV = Annual Cashflows x PVIFA 10%, 5 years - Initial Cost (where PVIFA is
the Present Value Interest Factor of annuity)
= 3,000 x 3.791 - 10,000 = Sh 1,373

Project B
NPV can be computed using the following table:
Year Cash flows PV.F 10%PV

1 4,000 0.909 3,636
2 2,500 0.826 2,065
3 2,000 0.751 1,502
4 3,500 0.683 2,390.5
5 3,500 0.621 2,173.5
Total PV 11,767
Less initial cost 10,000
NPV 1,767
Project B is better because it has a higher NPV.
iv. Profitability index (PI)

Project A
PI = 11,373 = 1.1373
10,000
Project B
PI = 11,767 = 1.1767
10,000
Project B is better since it has a higher PI.
v. The Internal Rate of Return

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Project A
NPV = 3,000 X PVIFA r%, 5years - 10,000 = 0
PVIFA r%, 5years = 10,000 = 3.333
3,000
From the table r lies between 15% and 16%. We use linear interpolation to compute the exact rate.
PVIFA 15% = 3.352 PVIFA 15% = 3.352
PVIFA required = 3.333 PVIFA 16% = 3.274
Difference 0.019 Difference 0.078
IRR = 15% + (16 - 15) (0.019) = 15.24%
0.078
Project B
We use trial and error method since the cashflow are uneven:
NPV at 16% = 10,186 - 10,000 = 186

NPV at 17% = 9,960.5 - 10,000 = (39.5)
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Using Similar Triangle
IRR - 16 = 17 - IRR
186 39.5
39.5 (IRR - 16) = 186 (17 - IRR)

39.5 IRR - 632 = 3,162 - 186 IRR
225.5 IRR = 3.794
IRR 16.8%
Project B is better because it has a higher IRR.
Generally, Project B should be selected because the discounted cashflow method
supports this decision.
Note: The methods discussed so far assume that investment decisions are made
under conditions of certainty. In real life, however, this is not the case and
therefore we shall consider risk and other complications in the following
sections.
3. PROJECTS SELECTION UNDER CAPITAL RATIONING
If a firm rations capital its value is not being maximized. A value maximizing firm would
invest in all projects with positive NPV. The firm may however want to maximize value
subject to the constraint that the capital ceiling is not to be exceeded.
A linear programming method can be used to solve constrained maximization problems.
The objective should be to select projects subject to the capital rationing constraint such that
the sum of the projects NPVs is maximized.
Illustration
Management is faced with eight projects to invest in. The capital expenditures during the
year has been rationed to Sh 500,000 and the projects have equal risk and therefore should be
discounted at the firm's cost of capital of 10%.
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Project Cost Project Cash flow NPV at the
t = 0(Shs) Life per year 10% cost
1 400,000 20 58,600 98,895
2 250,000 10 55,000 87,951
3 100,000 8 24,000 28,038
4 75,000 15 12,000 16,273
5 75,000 6 18,000 3,395
6 50,000 5 14,000 3,071
7 250,000 10 41,000 1,927
8 250,000 3 99,000 (3,802)
Required:
Determine the optimal investment sets.
Max Z = 98,895 X1 + 87,951 X2 + 28,038 X3 + 16,273 X3 + ... + (3,802) X8
St 1 = 400,000 X1 + 250,000 X2 + 100,000 X3 + ... + 250,000 X8 500,000

2 = 1 < X1, X2, X3 ... X8 > 0
The Optimal Budget:
Project Cost NPV

2 250,000 87,951
3 100,000 28,038
4 75,000 16,273
5 75,000 3,395
500,000 135,657
4. ABANDONMENT VALUE
It has been assumed so far that the firm will operate a project over its full physical life.
However, this may not be the best option - it may be better to abandon a project prior to the
end of potential life. Any project should be abandoned when the net abandonment value is
greater than the present value of all cash flows beyond the abandonment year, discounted to
the abandonment decision point. Consider the following example:
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Project A has the following cashflows over its useful life of 3 years. The market value
(Abandonment value) has also been given.
Year Cash Abandonment

flow value
Sh`000' Sh`000'
0 (4,800) 4,800
1 2,000 3,000
2 1,875 1,900
3 1,750 0
Required:
Determine when to abandon the project assuming a discount rate of 10%.
Suggested Solution:
If the project is used over its life, the NPV is negative as shown below:
NPV = 2,000 x PVIF 10%, 1year + 1,875 X PVIF 10%, 2years + 1,750 X PVIF 10%, 2 yrs - 4,800
= 2,000 x 0.909 + 1,875 x 0.826 + 1,750 x 0.751 - 4,800
= Shs -119
The project should not be accepted. However, if the project is abandoned after 1 year the NPV
would be
NPV = 2,000 x 0.909 + 3,000 x 0.909 - 4,800
= Sh -255
If abandoned after 2 years
NPV = 2,000 x 0.909 + 1,875 x 0.826 + 1,900 x 0.826 - 4,800
= Sh 136
The NPV is positive if the project is abandoned after 2 years and therefore this is the optimal
decision.
Note that abandonment value should be considered in the capital budgeting process because, as our
example illustrates, there are cases in which recognition of abandonment can make an otherwise
unacceptable project acceptable. This type of analysis is required to determine projects economic
life.
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5. RISK ANALYSIS IN CAPITAL BUDGETING
The Risk associated with a project may be defined as the variability that is likely to occur in
the future returns from the project. Risk arises in investment evaluation because we cannot
anticipate the occurrence of the possible future events with certainty and consequently,
cannot make any correct prediction about the cashflow sequence.
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a) Risk aversion
(b) Desire for Risk
(c) Indifference to Risk
A Risk averter is an individual who prefers less risky investment. The basic assumption in
financial theory is that most investors and managers are risk averse.
Risk seekers on the other hand are individuals who prefer risk. Given a choice between more
and less risky investments with identical expected monetary returns, they would prefer the
riskier investment.
The person who is indifferent to risk would not care which investment he or she received.
To illustrate the attitudes towards risk assume two projects are available. The cashflows are
not certain but we can assign probabilities to likely cashflows as shown below.
States of nature Project A's Project B's Probability

cashflow cashflow
Optimistic prediction Sh 900,000 600,000 0.2
Moderate prediction 600,000 600,000 0.6
Pessimistic prediction 300,000 600,000 0.2
The expected cashflow would be computed as follows:
Project A
Expected cashflow = 900,000 (0.2) + 600,000 (0.6) + 300,000 (0.2)
= Sh 600,000
Project B
Expected cashflow = 600,000 (0.2) + 600,000 (0.6) + 600,000 (0.2)
= Sh 600,000
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Therefore, the two projects have the same expected cashflows (Sh 600,000). However,
Project A is a riskier project since there is a chance that the cashflow will be Sh 300,000.
Project B on the other hand is a less risky project since we are sure that Sh 600,000 will be
received.
A risk seeker would choose Project A while a risk averter would choose Project B. A risk
neutral decision maker would be indifferent between the two projects since the expected
cashflows are equal.
6. ACTUAL MEASUREMENT OF RISK

A number of basic statistical devices may be employed to measure the extent of Risk
Inherent in any given situation. Two important measures are:
(a) Standard deviation of cashflows
(b) Coefficient of variation
(c) The Beta () can also be used and is dealt with under Portfolio Analysis
To illustrate the first two methods, let us assume that we are examining an investment with
the possible outcomes and probability of outcomes as shown below:
Note: the outcome could either be cashflow or NPV.
Assumptions (states of nature) Outcome Sh`000'
Probability
Pessimistic 300 0.2
Moderately successful 600 0.6
Optimistic 900 0.2
The expected value which is a weighted average of the outcomes times their probabilities can
be computed as follows:
Expected value (D) = DP
Where D is the outcome
P is the probability
D is the expected outcome
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Figures in `000'
D P DP
300 0.2 60
600 0.6 360
900 0.2 180
DP 600
The expected value is therefore Sh 600,000. We can therefore compute the standard
deviation, which is given by the following formula.
Standard Deviation ( ) = (D - D ) P
Computation of standard deviation
D P (D - D ) (D - D )2 (D - D )2 x P
300 0.2 -300 90,000 18,000

600 0.6 0 0 0
900 0.2 300 90,000 18,000
36,000
Standard Deviation ( ) = (D - D ) P
= 36,000
= SH 190,000
The standard deviation of Sh 190,000 gives a rough average measure of how far each of the
three outcomes falls away from the expected value. Generally, the larger the standard
deviation, the greater the risk.
However, to compare projects of unequal size, we need a different measure since standard
deviation would not do. Consider, for example two projects with the following expected
outcome and standard deviation.
Project Expected value Standard deviation
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A Sh 6,000 600
B Sh 600 190
To decide which of the two projects is a more risky project we need to compute the
coefficient of variation (C.V)
The coefficient of variation is a relative measure and is given by the following formula.
For investments Projects A and B discussed earlier, the coefficient of variation can be
computed as follows:-
Project A
CV = 600 = 0.100
6,000
Project B
CV = 190 = 0.317
600
Generally, the larger the coefficient of variation, the greater the risk. Therefore, Project B
carries a greater risk than Project A.
Another risk measure, the beta () is widely used with portfolios of common stock. Beta
measures the volatility of returns, on an individual stock relative to a stock market index of
returns.
(Note: Beta will be discussed under portfolio analysis).
7. INCORPORATING RISK IN CAPITAL BUDGETING

Several methods can be used to incorporate risk into capital budgeting decisions. Some of
these methods are:
(a) Payback period
(b) Risk-adjusted discount rate
(c) Certainty equivalents
(d) Sensitivity analysis
(e) Statistical techniques
1. Payback
Payback period is an attempt to allow for risk in capital budgeting. As discussed
earlier, firms using Payback period usually prefer short payback to longer ones, and
often establish guidelines such that the firm accepts only investments with some
maximum payback period, say three or five years. This method suffers from the
following limitations:
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(a) It ignores the time value of cashflows
(b) It does not make any allowance for the time pattern of the initial capital
recovered
(c) Setting the maximum payback period as two, three or five years usually has little
logical relationship to risk preferences of individuals or firms.
2. Risk-adjusted discount rate
This approach uses different discount rates for proposals with different risk levels. A
project that carries a normal amount of risk and does not change the overall risk
composure of the firm should be discounted at the cost of capital. Investments
carrying greater than normal risk will be discounted at a higher discount rate.
The NPV of the project will be given by the following formula.
(1+ K
Ct
NPV = t
- Io
t=1 )
Where Ct is cashflows at period t

K is the risk adjusted discount rate
Io is initial cash outflow (cost of project)
Note that Kf +
Where Kf = the risk-free rate
= the risk premium
The following diagram shows a possible risk-discount rate trade off scheme. Risk is
assumed to be measured by the coefficient of variation, C.V)
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The normal risk for the firm is represented by a coefficient of variation of 0.30. An
investment with this risk will be discounted at the firm's normal cost of capital of 10%.
As the firm selects riskier projects with, for example, a C.V. of 0.90, a risk premium of
5% is added for an increase in C.V. of 0.60 (0.90 - 0.30). If the firm selects a project
with a C.V. of 1.20, it will now add another 5% risk premium for this additional C.V.
of 0.30 (1.20 - 0.90). Notice that the same risk premium was added for a smaller
increase in risk. This is an example of being increasingly risk averse at higher levels of
risk and potential return.
Advantages of Risk-adjusted discount rate

(a) It is simple and can be easily understood.
(b) It has a great deal of intuitive appeal for risk-averse businessmen.
(c) It incorporates an attitude (risk-aversion) towards uncertainty.
Disadvantages
(a) There is no easy way of deriving a risk-adjusted discount rate.
(b) It does not make any risk adjustments in the numerate - for the cashflows that are
forecast over the future years.
(c) It is based on the assumption that investors are risk averse. (Not all investors are
risk averse as discussed earlier).
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3. Certainty Equivalent
Using this method the NPV will be given by the following formula:
t Ct
n
NPV = (1+ Kf
t=0
t
)
- Io
Where Ct = Forecasted cashflows (without risk adjustment)

t = the risk-adjusted factor or the certainty equivalent coefficient
Io = Initial cash outflow (cost of project)
Kf = risk-free rate (assumed to be constant for all period).
The certainty equivalent coefficient assumes a value between 0 and 1 and varies
inversely with risk. Therefore, a lower t will be used if greater risk is perceived and a
higher t if lower risk is anticipated.
The coefficient are subjectively established by the decision maker and represents the
decision maker's confidence in obtaining a particular cashflow in period t.
The certainty equivalent coefficient can be determined by the following formula.
t = certain net cashflow
risky net cashflow
For example, if an investor expects a risky cashflow of Sh 100,000 in period t and
considers a certain cashflow of Sh 80,000 equally desirable, the t will be:
t = 80,000 = 0.8
100,000
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Illustration:
Assume a project costs Sh 30,000 and yields the following uncertain cashflows:
Year Cashflow
1 12,000
2 14,000
3 10,000
4 6,000
Assume also that the certainty equivalent coefficients have been estimated as follows:
0 = 1.00
1 = 0.90
2 = 0.70
3 = 0.50
4 = 0.30
The risk-free discount rate is given as 10%
Required
Compute the NPV of the project
Solution:
t Ct
n
NPV = (1+ Kf
t=0 )
t
- Io
= 0.9 (12,000) + 0.7 (14,000) + 0.5 (10,000) + 0.3 (6,000) - 30,000

1 + 0.1 (1 + 0.1) (1 + 0.1)3 (1 + 0.1)4
Using the present value interest factor tables:
Year Certain Cashflows PVIF10% PV

0 (30,000) 1.00 (30,000)
1 0.9 (12,000) 0.909 9,817.2
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2 0.7 (14,000) 0.826 8,094.8
3 0.5 (10,000) 0.751 3,755.0
4 0.3 (6,000) 0.683 1,229.4
NPV (7,103.6)
The project has a negative NPV and therefore should not be undertaken.
Note that if risk was ignored the NPV would have been Sh 4,080 and the project would have
been accepted.
Merits of certainty equivalent approach

1. This method explicitly recognises risk.
2. It recognises that cashflows further away into the future are less certain (therefore a
lower t)
Demerits
1. The method of determining t is subjective and is likely to differ from project to
project.
2. The forecaster, expecting the reduction that will be made to his forecasts, may inflate
them in anticipation.
3. When forecasts have to pass through several layers of management, the effect may be
to greatly exaggerate the original forecast or to make it ultra conservative.
8. SENSITIVITY ANALYSIS
Sensitivity Analysis is a way of analysing change in the project's NPV for a given change in
one of the variables affecting the NPV. It indicates how sensitive the NPV is to changes in
particular variables. The more sensitive the NPV, the more critical the variable.
Steps followed in use of Sensitivity Analysis
1. Identification of all those variables which have an influence on the projects NPV.
2. Definition of the underlying (mathematical) relationship between variables.
3. Analysis of the impact of the change in each of the variables on the projects NPV.
Sensitivity Analysis allows the decision maker to ask "what if" questions.
To illustrate let us consider an example. A project has annual cashflows of Sh 30,000 and an
initial cost of Sh 150,000. The useful life of the project is 10 years. The cashflows can
further be broken as follows:
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Sh
Revenue 375,000
Variable costs 300,000
Fixed costs 30,000
Depreciation 15,000 345,000
Before tax profit 30,000
Tax (50%) 15,000
After tax profits 15,000
Net annual cashflows 30,000
The cost of capital is 10% and depreciation method is straight line.
The NPV of the project is:
NPV = 30,000 x PVIFA 10%, 10 yrs - 150,000
= 30,000 x 6.145 - 150,000
= Sh 34,350
The NPV is positive and therefore the project is acceptable. However, the investor should
consider how confident he is about the forecast and what would happen if the forecast goes
wrong. A sensitivity can be conducted with regard to volume, price, cost etc. In order to do
so we must obtain pessimistic and optimistic estimates of the underlying variables.
Assume that in the above example, the variables used in the forecasts are:
(a) Volume of sale ( = market size x market share)
(b) Unit price
(c) Unit variable costs
(d) Fixed costs
Assume further that the pessimistic, expected and optimistic estimates are:
Variable Pessimistic Expected Optimistic

Market Size 9,000 10,000 11,000
Market Share 0.004 0.01 0.016
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Unit price (Sh) 3,500 3,750 3,800
Unit variable costs (Sh) 3,600 3,000 2,750
Fixed costs (Sh) 40,000 30,000 20,000
The resulting NPVs would be:
NPV in shillings
Pessimistic Expected Optimistic
Market size 11,306.25 34,350 57,393.75
Market share -103,912.5 34,350 172,612.5
Unit price -42,462.5 34,350 49,712.5
Unit variable cost -150,000 34,350 11,162.5
Fixed costs 3,625 34,350 65,075
Note that NPV under this category is: Sh
Revenue = 3,750(9,000 x 0.01) = 90 x 3,750 337,500
Variables cost = 3,000 (9,000 x 0.01) = 90 x 3,000 270,000
Contribution margin 67,500
Less Fixed costs + Depreciation 45,000
22,500
11,250
Less tax 11,250
Net cashflows 26,250
NPV = 26,250 X 6.145 - 150,000

= Sh 11,306.25
It is important to note that only one variable is allowed to vary at a time and all the others are
held constant (at their expected values).
It has been assumed that a negative pre-tax profit will be reduced by tax credit from the
government.
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From the project the most dangerous variables appear to be market share and unit variable
cost. If the market share is 0.004 (and all other variables are as expected), then the project's
NPV is -Sh 103,912.5. If unit variable cost is Sh 3,600 (and all other variables are as
expected), then the project has an NPV of -150,000. Therefore the most sensitive factor is
the unit variable cost, followed by market share and unit price follows. Market size and
fixed costs are not very sensitive.
9. BREAK-EVEN ANALYSIS
Sensitivity analysis is a variation of the break-even analysis. In sensitivity analysis we are
asking; for example, what shall be the consequences if volume or price or cost changes?
This question can be asked differently: How much lower the sales volume can become
before the project becomes unprofitable? To answer this question we shall require the
Breakeven point.
Continuing with the above example, let us compute the level of units variable costs above
which the NPV is negative.
NPV = Annual cashflows x PVIFA 10%, 10 yrs - 150,000
But
Annual cashflows = Revenue - variable costs - Fixed costs - depreciation - Tax +
depreciation.
Let variable cost per unit be V
Annual cashflows = (375,000 - 100 (V) - 45,000)0.5 + 15,000
Therefore NPV = [(330,000 - 100 V) 0.5 + 15,000] x 6.145 - 150,000
At Break even point NPV = 0
Therefore (165,000 - 50 V + 15,000) 6.145 = 150,000
1,106,100 - 307.25v = 150,000
307.25 V = 956,100
V = 3,111.8
Therefore the point above which the variable cost per unit will cause the NPV to be negative
is about Sh 3,112.
To prove if variable unit cost is Sh 3,112 the NPV will be computed as follows:
Sh
Revenue 375,000
Variable costs 311,200
175
Fixed cost 30,000
Depreciation 15,000 356,200
18,800
Tax 9,400
9,400
Net cashflows 24,400
NPV = 24,400 x 6.145 - 150,000

= -62
Note: The NPV is not equal to zero due to rounding off effects.
Advantages and disadvantages of Sensitivity Analysis

Advantages
1. It compels the decision maker to identify the variables which affect the cashflow
forecasts. This helps him in understanding the investment project in totality.
2. It indicates the critical variables for which additional information may be obtained.
The decision maker can consider actions which may help in strengthening the "weak
spots" in the project.
3. It helps to expose inappropriate forecasts and thus guides the decision maker to
concentrate on relevant variables.
Disadvantages
1. It does not provide clear cut results. The terms optimistic and pessimistic could mean
different things to different people.
2. It fails to focus on the interrelationship between underlying variables. For example
sales volume may be related to price and cost but we analyse each variable differently.
10. A SIMULATION APPROACH TO CAPITAL BUDGETING UNDER RISK
In considering risky investments, we can use simulation to approximate the expected return
for an investment proposal. Thus simulation is one way of dealing with the uncertainty
involved in forecasting the outcomes of capital budgeting projects or other types of
decisions.
The results of an investment proposal are tested before it actually occurs. Each of the factors
affecting the projects NPV are assigned probability distributions. Example of these factors
are;
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i. Market size
ii. Selling price
iii. Market growth rate
iv. Share of market
v. Cost of the project
vi. Residual value
vii. Operating costs
viii. Fixed costs
ix. Useful life of project
Once the probability distributions are determined, the average rate of return resulting from a
random combination of the above nine factors is determined.
A computer can be used to carry out simulation trials for each of the above factors. A
simulation model relies on repetition of the same random process as many times as possible.
One of the benefits of simulation is its ability to test various possible combination of events.
This sensitivity testing allows the planner to ask "what if" questions.
11. DECISION TREE FOR SEQUENTIAL DECISIONS

Illustration:
A project has the following cash flows
Year 1 Year 2
Cash flow Probability Cash flow Probability
60,000 0.3 50,000 0.3
60,000 0.5
70,000 0.2
80,000 0.4 60,000 0.3
80,000 0.5
100,000 0.2
100,000 0.3 80,000 0.3
100,000 0.5
120,000 0.2
The projects initial cash outlay is Sh 100,000 with a cost of capital of 12%.Required:
Determine:
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(a) The projects expected monetary value (EMV)
(b) The projects NPV
178
179
180
NPV = 133,850.7 - 100,000 = 33,850.7
Merits of decision tree

1. It clearly brings out the implicit assumptions and calculations for all to see, so that they
may be questioned and revised.
2. The decision tree allows a decision maker to visualise assumptions and alternatives in
graphic form, which is usually much easier to understand than more abstract, analytical
form.
Demerits
1. The decision tree can become more and more complicated as more alternatives are
included.
2. It cannot be used for dependent variables.
12. UTILITY THEORY

When discussing the expected value and the standard deviation we noted that decision
makers can either be risk seekers, risk averse or risk neutral. Therefore, we cannot be able to
tell with certainty whether a decision maker will choose a project with a high expected return
and a high standard deviation, or a project with comparatively low expected return and low
standard deviation.
Utility theory aims at incorporating the decision maker's preference explicitly into the
decision procedure. We assume that a rational decision maker maximises his utility and
therefore would accept the investment project which yields maximum utility to him.
We can graphically demonstrate the three attitudes towards risk as follows:
181
182
Note that utiles is a relative measure of utility. For the risk averse decision maker, the utility
for wealth curve is upward-sloping and is convex to the origin. This curve indicates that an
investor always prefer a higher return to a lower return, and that each successive identical
increment of wealth is worth less to him than the preceding one - in other words, the
marginal utility for money is positive but declining.
For a risk seeker, the marginal utility is positive and increasing. For a risk neutral decision
maker, the marginal utility is positive but constant. To derive the utility function of an
individual, we let him consider a group of lotteries within boundary limits.
Illustration: Derivation of utility functions

Assume that utiles of 0 and 1 are assigned to a pair of wealth representing two extremes (say,
Sh 0 and Sh 100,000 respectively). To determine the utility function of a decision maker, we
offer him a lottery with 0.5 chance of receiving no money and 0.5 chance of receiving Sh
100,000. Assume he is willing to pay Sh 33,000 for this lottery. (Therefore 0.5 utile = Sh
33,000).
Next, consider a lottery providing a 0.4 chance of receiving Sh 33,000 and a 0.6 chance of
receiving Sh 100,000. Assume that the decision maker is willing to buy this lottery at Sh
63,000. The utile value of Sh 63,000 is
U(Sh 63,000) = 0.4 U(Sh 33,000) + 0.6 U(Sh 100,000)
= 0.4 x 0.5 + 0.6 x 1
= 0.8
Assume also a lottery providing a 0.3 chance of receiving Sh 0 and a 0.7 chance of receiving
Sh 33,000 is also offered. The decision maker is willing to pay Sh 21,000 for this lottery.
The utile value for Sh 21,000 can be computed as follows.
183
U (Sh 21,000) = (0.3 U(Sh 0) + 0.7 U(Sh 33,000)
= 0.3 x (0) + 0.7(0.5)
= 0.35
Note that other lotteries can be provided to the decision maker until we have enough points
to construct his utility function.
Expected utility of an investment
Once your utility function is specified, we can calculate the expected utility of an investment.
This calculation involves multiplying the utile value of a particular outcome by the
probability of its occurrence and adding together the product for all probabilities.
Illustrations:
Consider two investments that have cashflow streams and assonated probabilities.
Project A Project B
Cash flows Utiles Prob. Cash flows Utiles Prob.
Sh -20,000 -0.20 0.10 Sh -25,000 -0.25 0.10
0 0 0.10 0 0 0.20
60,000 0.60 0.60 50,000 0.50 0.50
80,000 0.80 0.50 100,000 1.00 0.20
The expected monetary value for Project A is

-20,000 (0.10) + 0(0.10) + 60,000 x (0.6) + 80,000 (0.20)
= Shs 50,000
For Project B
-25,000 (0.10) + 0 (0.20) + 50,000 (0.50) + 100,000 (0.20)
= Sh 42,500
Using the expected monetary value, Project A is preferred then Project B.
Using the utility values (utiles) the expected utility value is computed as follows:
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Project A Project B
Utile Prob. Weighted Utile Prob. Weighted
Utility Utility
-0.20 0.10 -0.02 -0.25 0.10 -0.025
0 0.10 0 0 0.20 0
0.60 0.60 0.36 0.50 0.50 0.25
0.80 0.20 0.16 1.00 0.20 0.20
Expect utility value 0.54 0.425
Using utility values Project A should be accepted since it has a higher utility value.
Advantages of utility approach

1. The risk preferences of the decision maker are directly incorporated in the capital
budgeting analysis.
2. It facilitates the process of delegating the authority for decision.
Limitations
1. It is hard to determine the utility function (it is subjective).
2. The derived utility function is only valid at a point of time.
3. If the decision is taken by a group of people it is hard to determine the utility functions
since individuals differ in their risk preferences.
7.5 SUMMARY
This lesson has described six techniques (Payback, discounted payback, NPV,
IRR, MIRR and PI) that are used in capital budgeting analysis. Each approach provides a
different piece of information, so in this age of computers, managers often look at all of them
when evaluating projects. However, NPV is the best single measure, and almost all firms
now use NPV.
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7.6 ACTIVITIES
Using a firm of your choice in your country, identify how it classifies its
investments projects and whether it uses the capital budgeting process to make its
investments decisions
7.7 SELFTESTING QUESTIONS
1. Edelman Engineering is considering including two pieces of equipment, a truck and an

overhead pulley system, in this years capital budget. The projects are independent. The
cash outlay for the truck is Ksh. 17,100, and that for the pulley system is Ksh. 22,430.
The firms cost of capital is 14%. After-tax cash flows, including depreciation, are as
follows;
Year Truck Pulley

Ksh Ksh
1 5,100 7,500
2 5,100 7,500
3 5,100 7,500
4 5,100 7,500
5 5,100 7,500
Calculate the IPR, the NPV and the MIRR for each project, and indicate the correct
accept/reject decision for each.
2. Your division is considering two investment projects, each of which requires an up-front
expenditure of Ksh. 15 million. You estimate that the investment will produce the
following net cash flows;
Year Project A Project B

Ksh Ksh
1 5,000,000 20,000,000
2 10,000,000 10,000,000
3 20,000,000 6,000,000
186
What are the two projects net present values, assuming the cost of capital is 10%? 5%?
15%?
3. Project K has a cost of Ksh. 52,125, its expected net cash inflows are Ksh. 12,000 per
year for 8 years, and its cost of capital is 12%. (Hint: Begin by constructing a time line)
a. What is the projects payback period (to the closest year)?
b. What is the projects discounted payback period?
c. What is the projects NPV?
d. What is the projects IRR?
e. What is the projects MIRR
187
LESSON EIGHT
VALUATION OF BONDS AND STOCKS
8.0 INTRODUCTION
Assets can be real or financial; securities, like shares and bonds are called financial
assets, while physical assets like plant and machinery are called real assets. The concept of
return and risk, as the determinants of value, are as fundamentals and valid to the valuation of
securities as to that of physical assets. We must clarify at the outset that there is no easy way
to predict the price of shares and bands and thus, to become rich by a superior performance in
the stock exchange. The unpredictable nature of the security price is, in fact, a logical and
necessary consequence of efficient capital markets. Efficient capital market implies a well-
informed, properly functioning capital market. We show why some securities are priced
higher than others by using the concept of present value. This will help financial manager to
know the variables, which influence the security prices. He/she can then design his/her
investment and financing activities in a manner, which exploits the relevant variables to
maximise the market value shares.
It should also be noted that ordinary shares are riskier than bonds (or debentures), and also
that some shares are more risky than others. It, therefore, naturally follows that investor
would commit funds to shares only when they expect that rates of returns are commensurate
with risk. We know from our earlier discussion in the preceding lesson that the present value
formulae are capable of taking into account both time and risk in the evaluation of assets and
securities. What they cannot do is measure the degree risk. For the purpose of our discussion,
we shall assume risk as known. A detailed analysis of risk is deferred in the next lesson.
Explain the fundamentals characteristics of ordinary shares, preference shares and

bonds (or debentures)
Show the use of the present value concepts in the valuation of shares and bonds
Learn about the linkage between the share values, earnings and dividends and the
required rate of return on the share
Focus on the uses and misuses of price-earnings (P/E) ratio.
188
The word value is often used in different context, depending on its application. There exists
difference between the concepts of value
. This includes;
LIQUIDATION VERSUS GOING CONCERN VALUE
The liquidation value is the amount that can be realized when an asset or a group of assets
representing a part or even the whole of a firm is sold separately from the operating organization
to which it belongs.
In contrast, the going concern value represents the amount that can be realized if the firm is sold
as a continuing operating entity.
In general security valuation models assume the going concern, an operating business entity that
generates cash flows to its security holders. When going concern assumptions is not appropriate
as in the case of an impending bankruptcy, liquidation value of the asset is more relevant in
determining the worth of the firms financial securities.
BOOK VALUE VERSUS MARKET VALUE

The book value of an asset is the accounting value of an asset, which is simply the historical cost
of the asset less accumulated depreciation or amortization as the case may be. The book value of
a firms equity is equal to the book value of its assets less the book value of liabilities.. Because
book value reflects a historical accounting value it may diverge significantly from the market
value.
The market value of an asset is simply the market price at which the asset trades in the market
place. Often the market is greater than the book value.
MARKET VALUE VERSUS INTRISIC VALUE

As the nomenclature suggests the market value of a security is the price at which the security
trades in the financial market, the intrinsic value of a security is the present value of the cash
flow stream expected from the security, discounted at a rate of return appropriate for the risk
associated with the security.
Also intrinsic value is economic value. If the market is reasonably efficient, the market price of
the security should hover around its intrinsic value.
BOND VALUATION
A bond represents a contract under which a borrower promises to pay interest and principal on
specific states to the holders of the bonds are issued by various organizations, public sector
undertakings and private sector companies.
8.2 TERMINOLOGY USED IN BOND VALUATION

a) Par Value- This is the value stated on the face of the bond. It represents the amount the
firm borrows and promises to repay at the time of maturity. Eg A Ksh. 1 million par
value bond
189
b) Coupon Rate and Interest A bond carries a specific interest rate which is called the
coupon rate. The interest payable to the bond holder is simply;
Par value of the bond Coupon rate
c) Maturity PeriodTypically bonds have a maturity period 1-15 years. Sometimes they
have longer maturity. At the time of maturity the par (face) value plus perhaps a nominal
premium is payable to the bondholder.
8.3 VALUATION MODEL

The value of the bond or any asset, real or financial-is equal to the present value of the cash
flows expected from it. Hence determining the value of a bond requires;
i) Estimates of expected cash flows.
ii) An estimate of required Rate of return
For the purpose of our analysis the following key assumptions are made;
i) The coupon interest rate is fixed for the term of the bond.
ii) The coupon payments are made annually and the next coupon payment is receivable
exactly a year from now.
iii) The bond will be redeemed at par on maturity.
Therefore value of a non-callable bond i.e. a bond that cannot be prematurely retired is
Where p = the value of the bond

n = the number of years to maturity
c = the annual coupon payment
= the periodic required return
t = time when the payment is received.
Example 1
Consider 10 years, 12% coupon bond with a par value of Ksh. 1000. Let us assume that the
required yield on this bond is 13%. What is the value of the bond.
= 13%
C = 12% 1000 = sh. 120

m = 10 years
p=
190
=
= 651.44+294.6
= 945.744
8.4 BONDS VALUES WITH SEMI ANNUAL INTEREST

Most of the bonds pay interest semi-annually. The bond valuation equation has to be modified as
follows;
Example 2
Consider an 8 year, 12% coupon with a par value Sh. 10,000 on which interest is payable semi-
annually. The required rate of return on this bond is 14%. What is the value of the bond?
191
8.5 RELATIONSHIP BETWEEN COUPON RATE, REQUIRED YIELD AND PRICE
A basic property of a bond is that its price varies inversely with yield. As the required yield
decreases, the present value of the cash flows increases, hence the price increases conversely.
When the required yield increases, the present value of the cash flows decreases
Example 3
Consider a bond carrying a coupon rate of 14% issued 3 years ago for Ksh.100, 000 (its par
value) by signal corporation. The original maturity interest rate has fallen in the last 3 years and
investors now expect a return of 10% from this bond. What would be the price of the bond?
Example 4
Assume that because of a rise in interest rates, investors now expect a return of 18% from the
signal corporation bond. What would be the price of the bond?
Why does the price increase with decrease in expected yield?
The fact that required return on such a bond has fallen to 10% means that if you had sh.100, 000
to invest, you can buy new bonds like signals except that these new bonds would pay
(100,00010%) 10,000 rather than 14,000 by way of interest. Naturally, as an investor you
would be willing to pay more than Ksh.100, 000 for signal bond to enjoy its higher coupon.
All investors would behave similarly and consequently the bond of signal would be bid up in
price to Ksh.119, 472. At that price it would provide a return of 10%, the rate the new bond
offers.
192
Price Price-Yield Relationship
Premium
Par
Discount
Yield
10% 14% 18%
Summary
1. Coupon rate Required rate Price Par (Premium bond)

2. Coupon rate = Required Yield Price = Par
3. Coupon rate Required yield Price Par (Discount Bond)
8.6 RELATIONSHIP BETWEEN BOND PRICE AND TIME

Since the price of a bond must be equal to its par value at maturity (assuming that there is no risk
of default), bond prices change with time. For example, a bond that is redeemable for Ksh.1,000
(which is its par value) after 5 years when it matures, will have a price of Ksh.1, 000 at maturity,
no matter what the current price is. If its current price is say, 1,100 it is said to be a premium
bond. If the required yield does change between now and the maturity date, the premium will
decline over time as shown in curve A Below. On the other hand, if the bond has a current price
of say Sh.900, it is said to be a discount bond. The discount too will disappear over time as
shown by curve B. Only when the current price is equal to par value in such a case the bond is
said to be a par value bond there is no change in the price as time passes, assuming that the
193
required yield does not change between now and the maturity date. This is shown by the dotted
line in figure below.
Price of the bond
Ksh.11, 000 A Premium bond =11%
Par value bond =13%

1000
Discount bond =15%
900 B
Z
8 7 6 5 4 3 2 1 0 Years of maturity
8.7 BONDS YIELD

The commonly employed yield measures are;
i) Current yield
ii) Yield to maturity and
iii) Yield to call
a) Current Yield
The current yield relates the annual coupon interest to the market price. It is expressed as
Example 5
The current yield of a 10 year, 12% coupon bond with a par of Ksh.1,000 and selling for Ksh.950
is ;
194
Note:
The current yield calculation reflects only the coupon interest. It does not
consider the capital gain/loss that an investor will realize if the bond is purchased at a
discount (or premium) and held till maturity. It ignores time value of money.
Hence it is an incomplete and simplistic measure of yield.
b) Yield to Maturity
The yield to maturity (YTM) of a bond is the interest rate that makes the present value of the
cash flows receivable from owning the bond equal to the price of the bond. It is the rate that
satisfies the following equations;
Where P = the price of the bond

C = the annual interest
M = the maturity value
n = number of years left to maturity
Example 6
Consider a Ksh.1, 000 par value bond carrying a coupon rate of 9% maturing after 8% years. The
bond is currently selling at Ksh.800
Using trial and error method
Try 12%
195
Since the value of Sh.851 is higher than sh.800 we will try a rate higher than 12%
Try 14%
Therefore the rate lies between 12% and 14%
12% = 851
12% + % = 800
14% = 769
Therefore YTM which equates the of the cash flows to the price is 125+1.24=13.4%
Alternative method
Where C is the annual interest

M is the maturity value of the bond
P is the present price of the bond
n is number of year to maturity
196
The YTM calculation considers the current coupon income as well as the capital gain or loss the
investor will realize by holding the bond to maturity. In additional, it takes into account the
timing of the cash flows
c) Yield to call
Some bonds carry a call feature that entitles the issuer to call (buy back), the bond prior to the
stated maturity date in accordance with a call schedule (which specifies a call price for each call
date). For such bonds, it is a practice to calculate the yield to call (YTC) as well as YTM
Where is the call price

is the number of years until the assumed call date
`
Note: YTC is calculated in the same way as the YTM
8.8 BOND MARKET

Valuation of Preference Stock
Preference stock generally pays a regular, fixed dividend. Preference dividends are not increased
when profit of the firm rise nor are they lowered or suspended unless the firm faces financial
difficulties. If preference dividends are cut or suspended for some time, the firm is normally
required to pay the arrears before paying equity dividends.
Preference shares may be perpetual or redeemable. While the former has no maturity period, the
latter is expected to be redeemed after its limited life.
- If preference stock pays fixed annual dividends during its life and principal amount on
maturity, its value is;
Where is the Current price of the preference shares

D is the annual dividends
n is residual life on the preference stock
197
is required rate of return on the preference stock
M is the maturity value
Example 7
Consider an 8 years, 10% preference stock with a par value of Ksh.1, 000. The required rate of
return on this preference stock is 9%
For perpetual preference shares
8.9 EQUITY VALUATION

Dividend Discount Model
According to the above model, the value of an equity shares is equal to the present value of
dividends expected from its ownership plus the present value of the sale price expected when the
equity share is sold. The following assumptions are required for applying the dividend discount
model;
i. Dividends are paid annually
ii. The first dividend is received one year after the equity share is bought.
a) Single-Period Valuation Model

This is where the investor expects to hold the equity share for one year. The price of the equity
shall be;
198
Where is the current price of the equity share
is the dividend expected a year hence
is the price of the share expected a year hence,
is the rate of required on the equity share
Example 8
Prestiges equity share is expected to provide a dividend of Ksh.2 and fetch a price of Ksh.18 a
year hence. What price would it sell for now if investors required rate of return is 12%?
The current price will be
If the price of equity share is expected to grow at grow at a rate of % annually, then
When the above equation is simplified, it becomes
Example 9
The expected dividend per share on the equity share of Road King Limited is Ksh2. The
dividend per share of Road King Limited has grown over the past 5 years at the rate of 5% per
year. This growth rate will continue in future. Further, the market price of the equity share of
Road King Limited too is expected to grow at the same rate. What is a fair estimate of the
intrinsic value of the equity share of Road king Limited if the required rate of return is 15%.
199
EXPECTED RATE OF RETURN
Expected rate of return is the rate that the investor expects given the current market price and
forecast values of dividend and share price. The expected rate of return is equal to;
Example 10
The expected dividend per share of Broadband Limited is Sh.5.00. The dividend is expected to
grow at the rate of 6% per year. If the price per share now is sh.5.00 what is the expected rate of
return.
b) Multi-Period Valuation Model

Since equity shares have no maturity period, they may be expected to bring a dividend stream of
infinite duration. Hence the value of an equity share may be put as;
Where is price of the share today

is the dividend expected two years hence
is the dividend expected three years hence
is the dividend expected at the end of infinity and
is the expected return
200
The multi-period valuation model can also be applied for finite investment horizon
Assumption for multi-period valuation model

i) The dividend per share remains constant forever, implying that the growth rate is nil (the
zero growth model)
ii) The dividends per share grows at a constant rate per year forever (the constant growth
model)
iii) The dividend per share grows at a constant rate for a finite period, followed by a constant
normal rate of growth forever thereafter (the two stage model)
iv) The dividend per share, currently growing at an above-normal rate, experiences a
gradually declining rate of growth for a while. Thereafter, it grows at a constant normal
rate (the H model)
ZERO GROWTH MODEL
If we assume that the dividend per share remains constant year after at a value of D, the value of
share becomes
On simplification
CONSTANT GROWTH MODEL

Assume that dividend per share grows at a constant rate . The value of a share, therefore
becomes
Example 11
Ramesh Building Limited is expected to grow at the rate of 6% per annum. The dividend
expected on Rameshs equity share a year hence is Ksh.2.00. What price will you put on if your
required rate of return for this share is 14%?
201
TWO STAGE GROWTH MODEL
The simplest extension of the constant growth model assume that the extraordinary growth (bad
or good) will continue for a finite number of years and thereafter the normal growth rate will
prevail indefinitely.
Assuming that dividends move in line with the growth rate, the price of equity will be
Where is the current price of the equity

is the extraordinary growth rate applicable for n years
is the price of the equity share at the end of year n
The first term on the right hand side of the above equation is the present value of a growing
annuity. Its value is equal to;
Hence
Since the two stage growth model assumes that growth rate after n year remains constant, will
be equal to;
Where is the dividend for year and

is the growth rate in the second period.
may be expressed in terms of the dividend in the first stage.
202
Substituting the above expression
Example 12
The current dividend on an equity share of Vertigo Limited is Sh.2. Vertigo is expected to enjoy
an above-normal growth rate of 20% for a period of 6 years. Thereafter the growth rate will fall
and stabilize of 10%. Equity investors require a return of 15%. What is the instinct value of the
equity share of vertigo?
Solution
= 20%
= 10%
n= 6 years
= 15%
203
H-MODEL
The H- model of equity valuation of based on the following assumptions.
i) While the current dividend growth rate, is greater than , the normal long-run growth
rate, the growth rate declines linearly for 2 H years.
ii) After 2H years the growth rate becomes
iii) At H years the growth rate is exactly halfway between and
Graphical representation of the dividend growth rate for the H- model is
Growth
Rate
H 2H Time
H valuation model is
Where is intrinsic value of the share

is the current dividend per share
is the rate of return expected by investors
is the normal long-return growth rate
is the current growth rate
H is one half of the period during which , will level off to
Above equation can be re-arranged as follows
204
The first term on the left hand side represents the value based on the normal growth
rate, whereas the second term
reflects the premium due to abnormal growth rate.
Example 13
The current dividend on an equity share of international computer Limited is Ksh.3.00. The
present growth rate is 50%. However, this will decline linearly over a period of 10 years and then
stabilizes at 12%. What is the intrinsic value per share of international Computers Limited? it
investors require a return of 16%.
Solution;
= Sh.300
= 50%
H = 5 years
= 12%
= 16%
8.10 IMPACT OF GROWTH ON PRICE, RETURNS AND PRICE EARNINGS RATIO

The expected growth rates of the companies differ widely. Some companies are expected to
remain virtually stagnant or grow slowly; other companies are expected to show normal growth;
still others are expected to achieve supernormal growth rate.
Assuming a constant total required return, differing expected growth rate means differing stock
prices, dividend yields, capital gains yields and price earnings ratios.
Illustration
Growth rate%
Low growth rate 5
Normal growth rate 10
205
Supernormal growth 15
The expected earnings per share and dividend per share of each of the three firms are Ksh.3 and
12 respectively. Investors required total return from equity investments is 12%
Price Dividend Capital gain Price earning

Yield Yield ratio (P/E)
Note;
i. Total Return = Dividend yield+ Capital gains
ii. The result above suggest the following

a) As the expected growth increases, other things being equal, the expected return depends
more on capital gains yield and less on the dividend yield
b) As the expected growth rate in dividend increases, other things being equal, the price-
earnings ratio increases
c) High dividend yield and low price-earnings ratio imply limited growth prospectus
d) Low dividend yield and high price-earnings ratio imply considerable growth prospectus
EQUITY VALUATION USING THE PRICE-EARNING RATIO APPROACH

It is valuation approach practiced widely by investment analysts. The value of the stock under
this approach is estimated as follows;
206
Where is the estimated price
is estimated earnings per share
is the justified price earnings ratio
DETERMINANTS OF THE PRICE-EARNING RATIO
The determinants of the P/E ratio can be derived from the dividend discounting model which is
the foundation for valuing equity stocks.
Using the constant growth dividend discount model
In the above
stands for the plough back ratio, and
= ROE b
Note:
ROE is the return on equity. Substituting and then the constant growth dividend discount model
becomes
Dividing the above sides by the equation becomes
The above equation indicates that the factors that determine the P/E ratio are;
i) Dividend payout ratio
ii) The required rate of return
iii) The expected growth rate
207
8.11 SUMMARY
In this lesson we have discussed how security values are determined and also how investors
go about estimating the rates of return they expect to earn
8.12 ACTIVITIES
Find out why bonds market in Kenya is not developed fully compared to equity market
1. Illustrate with the help of an example the linkage between share price and earnings.
What is the importance of the price-earning (P/E) ratio? What are its limitations?
2. Suppose you buy a one- year government bond that has a maturity value of Ksh.
1,000. The market interest rate is 8%. (a) How much will you pay for the bond?
(b) If you purchased the bond for Ksh. 904.98, what interest rate will you earn on
your investment?
3. The Brightways Company has a perpetual bond that pays Ksh. 140 interest
annually. The current yield on this type of bond is 13%. (a) At what price will it
sell? (b) If the required yield rises to 15% what will be the new price?
208
209

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KENYATTA UNIVERSITY

INSTITUTE OF OPEN DISTANCE & e-LEARNING

MODULE: BAC 502

WRITTEN BY MR. A. K. THUO

VETTED BY EDDIE SIMIYU

FINANCIAL MANAGEMENT: AN OVERVIEW ..................................................................................... 8

1.0 INTRODUCTION .................................................................................................................................. 8

1.1 OBJECTIVES ......................................................................................................................................... 8

1.2 EVOLUTION OF FINANCIAL MANAGEMENT ............................................................................... 9

1.3 FINANCIAL DECISIONS IN A FIRM ............................................................................................... 10

1.4 EXECUTIVE FINANCE FUNCTION ................................................................................................. 10

1.5 CAPITAL BUDGET/INVESTMENT DECISIONS (LONG TERM ASSET MIX) ........................... 10

1.6 CAPITAL STRUCTURE/FINANCING DECISIONS......................................................................... 11

1.7 DIVIDEND DECISION ....................................................................................................................... 11

1.8 WORKING CAPITAL MANAGEMENT/LIQUIDITY DECISIONS ................................................ 12

1.9 FINANCIAL PROCEDURES AND SYSTEMS (ROUTINE FUNCTIONS INCIDENTAL

1.11 MAIN FUNCTIONS/ROLES OF FINANCIAL MANAGER ........................................................... 13

1.13 GOAL OF FINANCIAL MANAGEMENT ....................................................................................... 14

1.14 AGENCY PROBLEM ........................................................................................................................ 17

1.15 SHAREHOLDERS AND MANAGERS ............................................................................................ 17

1.16 EXECUTIVE CONTRACTS AND BONUS PLANS ........................................................................ 18

1.17 SPECIFIC FORMS OF MONETARY COMPENSATION PLANS ................................................. 19

1.18 IDEAL CONDITIONS FOR THE USE OF INCENTIVE SYSTEM ................................................ 19

1.19 CONDITIONS MAKING IT DIFFICULT FOR A FIRM TO APPLY EXECUTIVE INCENTIVE

1.22 CONFLICT BETWEEN SHARE HOLDERS AND CREDITORS ................................................... 20

1.23 CONFLICT BETWEEN SHAREHOLDERS AND AUDITORS ...................................................... 21

1.24 SUMMARY ........................................................................................................................................ 21

1.26 SELF TESTING QUESTION ............................................................................................................. 22

1.27 FURTHER READING ....................................................................................................................... 22

LESSON TWO ........................................................................................................................................... 23

THE TIME VALUE OF MONEY .............................................................................................................. 23

2.0 INTRODUCTION ................................................................................................................................ 23

2.1 LEARNING OBJECTIVES.................................................................................................................. 23

2.2 TIME LINES AND NOTATION ......................................................................................................... 24

2.2.1 COMPOUND VALUE .................................................................................................................. 24

2.2.2 DISCOUNT VALUE/PRESENT VALUE .................................................................................... 29

2.2.3 PRESENT VALUE FOR UNEQUAL PERIODIC SUM .............................................................. 30

2.2.4 COMPOUND OR FUTURE VALUE OF AN ANNUITY .......................................................... 30

2.2.5 SINKING FUND ........................................................................................................................... 32

2.3 CAPITAL RECOVERY AND LOAN AMORTIZATION .................................................................. 34

2.3.1 PRESENT VALUE OF A GROWING ANNUITY ...................................................................... 36

2.4 DETERMINING THE PERIODIC WITHDRAWAL ........................................................................ 38

2.5 SUMMARY .......................................................................................................................................... 44

2.7 SELF TESTING QUESTIONS ............................................................................................................ 44

2.8 FURTHER READINGS ....................................................................................................................... 45

3.0 INTRODUCTION ................................................................................................................................ 46

3.1 LEARNING OBJECTIVES.................................................................................................................. 46

3.2 RISK AND RETURN OF A SINGLE ASSET..................................................................................... 46

3.4 PORTFOLIO THEORY AND RISK DIVERSIFICATION ................................................................ 51

3.5 CORRELATION OF INVESTMENTS................................................................................................ 53

3.7 THE RETURN ON MARKET PORTFOLIO ...................................................................................... 66

3.8 PORTFOLIO THEORY AND FINANCIAL MANAGEMENT.......................................................... 68

3.9 SUMMARY .......................................................................................................................................... 70

3.11 SELF TESTING QUESTIONS .......................................................................................................... 70

3.12 FURTHER READING ....................................................................................................................... 71

LESSON FOUR .......................................................................................................................................... 72

COST OF CAPITAL .................................................................................................................................. 72

4.0 INTRODUCTION ................................................................................................................................ 72

4.1 LEARNING OBJECTIVES.................................................................................................................. 72

4.2 ELEMENTS OF COST OF CAPITAL ................................................................................................ 72

4.3 BETA FACTOR ................................................................................................................................... 74

4.4 FLOATATION COST AND COST OF CAPITAL ............................................................................. 87

4.5 CAPITAL STRUCTURE THEORIES ................................................................................................. 89

4.6 TRADITIONAL APPROACH TO CAPITAL STRUCTURE ............................................................. 90