1.

1Definition of financial management

Financial Management is that specialized function of general management which is related to the
procurement of finance and its effective utilisation for the achievement of common goal of the
organisation.

It includes each and every aspect of financial activity in the business. Financial Management has
been defined differently by different scholars. A few of the definitions are being reproduced
below:-

“Financial Management is an area of financial decision making harmonizing individual motives

and enterprise goals.”- Weston and Brigam.

“Financial Management is the application of the planning and control functions to the finance
function.”- Howard and Upton.

“Financial Management is the operational activity of a business that is responsible for obtaining
and effectively, utilizing the funds necessary for efficient operations.”- Joseph and Massie

From the above defi niti ons, it is clear that fi nancial management is that specialised
acti vity which is responsible for obtaining and aff ecti vely uti lizing the funds for the
effi cient functi oning of the business and, therefor, it includes fi nancial planning, fi nancial
administrati on and fi nancial control.

Financial Management is a discipline concerned with the generation and allocation of scarce
resources (usually fund) to the most efficient user within the firm (the competing projects)
through a market pricing system (the required rate of return).
A firm requires resources in form of funds raised from investors. The funds must be allocated
within the organization to projects which will yield the highest return.
We shall refer to this definition as we go through the subject.
1.2 Required Rate of Return (Ri)
The required rate of return (Ri) is the minimum rate of return that a project must generate if it has
to receive funds. It’s therefore the opportunity cost of capital or returns expected from the second
best alternative. In general,
Required Rate of Return = Risk free rate + Risk premium
Risk free is compensation for time and is made up of the real rate of return (Ri)and the inflation
premium (IRp). The risk premium is compensation for risk of financial actions reflecting:
- The riskiness of the securities caused by term to maturity
- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.

The required rate of return can therefore be expressed as follows:

Rj = Rr + IR∞ + DR∞ + MR∞ + LR∞ + ER∞ +SR∞ + OR∞
Where:

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  Rr is the real rate of return that compensate investors for giving up the use of their funds
in an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for the decrease in
purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for the possibility that
users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to maturity
 LRp is the Liquidity Risk Premium which compensates the investor for the possibility
that the securities given are not easily marketable (or convertible to cash)
 ERp is the Exchange Risk Premium which compensates the investors for the fluctuation
in exchange rate. This is mainly important if the funds are denominated in foreign
currencies.
 SRp is the Soverign Risk Premium which compensates the investors for the possibility of
political instability in the country in which the funds have been provided.
 ORp is the Other Risk Premium e.g the type of product, the type of market, etc.

1.2 Distinction between Financial Accounting and Financial Management

Financial Accounting Financial Management

(i) It is a statutory requirement (i) It is not a statutory requirement
(ii) It is carried out according to the (ii) It is just conducted according to the
General Accepted Acoounting management decisions
Principles (GAAP)
(iii) It deals with historical (iii) It deals with future planning
transactions
(iv)It is both for internal and external (iv)It is for internal users i.e
users management
(v) It deals with recording financial (v) It deals with the procurement and
transactions in a systematic manner allocation of fianancial resources
for a particular period
(vi)Where finacial accounting ends (vi)finacial accounting comes before
financial management starts financial management

1.3 Scope of finance functions.

The functions of Financial Manager can broadly be divided into two. The Routine functions and
the Managerial Functions.
1.3.1Managerial Finance Functions
Require skillful planning control and execution of financial activities. There are four important
managerial finance functions. These are:
(a) Investment of Long-term asset-mix decisions
These decisions (also referred to as capital budgeting decisions) relates to the allocation
of funds among investment projects. They refer to the firm’s decision to commit current
funds to the purchase of fixed assets in expectation of future cash inflows from these

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 projects. Investment proposals are evaluated in terms of both risk and expected
return.Investment decisions also relates to recommitting funds when an old asset becomes
less productive. This is referred to as replacement decision.

(b) Financing decisions

Financing decision refers to the decision on the sources of funds to finance investment
projects. The finance manager must decide the proportion of equity and debt. The mix of
debt and equity affects the firm’s cost of financing as well as the financial risk. This will
further be discussed under the risk return trade off.
(c) Division of earnings decision
The finance manager must decide whether the firm should distribute all profits to the
shareholder, retain them, or distribute a portion and retain a portion. The earnings must
also be distributed to other providers of funds such as preference shareholder, and debt
providers of fund such as preference shareholders and debt providers. The firm’s divided
policy may influence the determination of the value of the firm and therefore the finance
manager must decide the optimum dividend – payout ratio so as to maximize the value of
the firm.
(d) Liquidity decision
The firm’s liquidity refers to its ability to meet its current obligations as and when they
fall due. It can also be referred as current assets management. Investment in current assets
affects the firm’s liquidity, profitability and risk. The more current assets a firm has, the
more liquid it is. This implies that the firm has a lower risk of becoming insolvent but
sine current assets are non- earning assets the profitability of the firm will be low. The
converse will hold true.
The finance manager should develop sound techniques of managing current assets to
ensure that neither insufficient not unnecessary funds are invested in current assets.
1.3.2 Routine functions
For the effective execution of the managerial finance functions, routine functions have to be
performed. These decision concern procedures and systems and involve a lot of paper work and
time. In most cases these decisions are delegated to junior staff in the organization. Some of the
important routine functions are:
(a) Supervision of cash receipts and payments
(b) Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d) Record keeping and reporting

The finance manager will be involved with the managerial functions while the routing functions
will carried out by junior staff in the firm .
He must however ,supervise the activities of the junior staff .

1.4 objectives of a business entity

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Any business firm would have certain objectives which it aims at achieving .The major goal of a
firm are :
 Profit maximization
 Shareholder wealth maximization
 Social responsibility
 Business ethics
 Growth

1.4.1 Profit maximization

Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to
achieving the highest possible profits during the year. This could be achieved by either increasing
sales revenue or by reducing expenses. Note that:

Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price. It
should be noted however, that maximizing sales revenue may at the same time result to increasing
the firm's expenses.
The pricing mechanism will however, help the firm to determine which goods and services to
provide so as to maximize profits of the firm.

The profit maximization goal has been criticized because of the following:

(a) It ignores time value of money

(b) It ignores risk and uncertainties
(c) it is vague
(d) it ignores other participants in the firm rather than the shareholders

1.4.2 Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present value of every
decision made in the firm. Net present value is equal to the difference between the present value of
benefits received from a decision and the present value of the cost of the decision. A financial
action with a positive net present value will maximize the wealth of the shareholders, while a
decision with a negative net present value will reduce the wealth of the shareholders. Under this
goal, a firm will only take those decisions that result in a positive net present value.

Shareholder wealth maximization helps to solve the problems with profit maximization. This is
because, the goal:

i. considers time value of money by discounting the expected future cashflows to

the present.
ii. it recognises risk by using a discount rate (which is a measure of risk) to discount
the cashflows to the present.

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1.4.3 Social responsibility
The firm must decide whether to operate strictly in their shareholders' best interests or be
responsible to their employers, their customers, and the community in which they operate. The
firm may be involved in activities which do not directly benefit the shareholders, but which will
improve the business environment. This has a long term advantage to the firm and therefore in the
long term the shareholders wealth may be maximized.

1.4.4 Business Ethics

Related to the issue of social responsibility is the question of business ethics. Ethics are defined as
the "standards of conduct or moral behaviour". It can be thought of as the company's attitude
toward its stakeholders, that is, its employees, customers, suppliers, community in general,
creditors, and shareholders. High standards of ethical behaviour demand that a firm treat each of
these constituents in a fair and honest manner. A firm's commitment to business ethics can be
measured by the tendency of the firm and its employees to adhere to laws and regulations relating
to:

i. Product safety and quality

ii. Fair employment practices
iii. Fair marketing and selling practices
iv. The use of confidential information for personal gain
v. Illegal political involvement
vi. bribery or illegal payments to obtain business

1.4.5 Growth
This is a major objective of small companies which may even invest in projects with negative NPV
so as to increase their size and enjoy economies of scale in the future.

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LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…)
1.5 AGENCY THEORY
An agency relationship may be defined as a contract under which one or more people (the
principals) hire another person (the agent) to perform some services on their behalf, and delegate
some decision making authority to that agent. Within the financial management framework,
agency relationship exists between:
a) Shareholders and Managers
b)Debt holders and Shareholders
c)Shareholders and the government
d)Shareholders and auditors

1.5.1 Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is managed by a
board of directors appointed by the shareholders. This is because:

i) There are very many shareholders who cannot effectively manage the firm all at the same
time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.

Conflict of interest usually occur between managers and shareholders in the following ways:

i) Managers may not work hard to maximize shareholders wealth if they perceive that they
will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.

6
iv) Manager may undertake projects with different risks than what shareholders would
consider reasonable.
v) Manager may undertake projects that improve their image at the expense of profitability.
vi) Where management buy out is threatened. ‘Management buy out’ occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.

Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders, the firm will:

(a) Incur Agency Costs in the form of:

i) Monitoring expenses such as audit fee;

ii) Expenditures to structure the organization so that the possibility of undesirable
management behaviour would be limited. (This is the cost of internal control)
iii) Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the case if
manager were also owners. This is the cost of delaying decision.

(b) The Shareholder may offer the management profit-based remuneration. This remuneration
includes:

i) An offer of shares so that managers become owners.

ii) Share options: (Option to buy shares at a fixed price at a future date).
iii) Profit-based salaries e.g. bonus

(c) Threat of firing: Shareholders have the power to appoint and dismiss managers which is
exercised at every Annual General Meeting (AGM). The threat of firing therefore
motivates managers to make good decisions.
(d) Threat of Acquisition or Takeover: If managers do not make good decisions then the value
of the company would decrease making it easier to be acquired especially if the predator
(acquiring) company beliefs that the firm can be turned round.

1.5.2 Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and creditors.
Creditors lend funds to the firm at rates that are based on:

i. Riskiness of the firm's existing assets

ii. Expectations concerning the riskiness of future assets additions
iii. The firm's existing capital structure
iv. Expectations concerning future capital structure changes.

These are the factors that determine the riskiness of the firm's cashflows and hence the safety of its
debt issue. Shareholders (acting through management) may make decisions which will cause the
firm's risk to change. This will affect the value of debt. The firm may increase the level of debt to
boost profits. This will reduce the value of old debt because it increases the risk of the firm.

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Creditors will protect themselves against the above problems through:

a. Insisting on restrictive covenants to be incorporated in the debt contract. These covenants

may restrict:

 The company’s asset base

 The company’s ability to acquire additional debts
 The company’s ability to pay future dividend and management remuneration.
 The management ability to make future decision (control related covenants)

b. if creditors perceive that shareholders are trying to take advantage of them in unethical ways,
they will either refuse to deal further with the firm or else will require a much higher than
normal rate of interest to compensate for the risks of such possible exploitations.

It therefore follows that shareholders wealth maximization require fair play with creditors. This is
because shareholders wealth depends on continued access to capital markets which depends on fair
play by shareholders as far as creditor's interests are concerned.
1.5.3 Shareholders and the government
The shareholders operate in an environment using the license given by the government. The
government expects the shareholders to conduct their business in a manner which is beneficial to
the government and the society at large.
The government in this agency relationship is the principal and the company is the agent. The
company has to collect and remit the taxes to the government. The government on the other hand
creates a conducive investment environment for the company and then shares in the profits of the
company in form of taxes. The shareholders may take some actions which may conflict the
interest of the government as the principal. These may include;
(a) The company may involve itself in illegal business activities
(b) The shareholders may not create a clear picture of the earnings or the profits it generates
in order to minimize its tax liability.(tax evasion)
(c) The business may not response to social responsibility activities initiated by the
government
(d) The company fails to ensure the safety of its employees. It may also produce sub standard
products and services that may cause health concerns to their consumers.
(e) The shareholders may avoid certain types of investment that the government covets.
Solutions to this agency problem
(i) The government may incur costs associated with statutory audit, it may also order

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 investigations under the company’s act, the government may also issue VAT
refund audits and back duty investigation costs to recover taxes evaded in the
past.
(ii) The government may insure incentives in the form of capital allowances in some
given areas and locations.
(iii) Legislations: the government issues a regulatory framework that governs the
operations of the company and provides protection to employees and customers
and the society at large.ie laws regarding environmental protection, employee
safety and minimum wages and salaries for workers.
(iv) The government encourages the spirit of social responsibility on the activities of
the company.
(v) The government may also lobby for the directorship in the companies that it may
have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc

1.5.4 Shareholders and auditors

Auditors are appointed by shareholders to monitor the performance of management.

They are expected to give an opinion as to the true and fair view of the company’s financial
position as reflected in the financial statements that managers prepare. The agency conflict arises
if auditors collude with management to give an unqualified opinion (claim that the financial
statements show a true and fair view of the financial position of the firm) when in fact they
should have given a qualified opinion (that the financial statements do not show a true and fair
view). The resolution of this conflict could be through legal action, removal from office, use of
disciplinary actions provided for by regulatory bodies such as ICPAK.

1.6 CORPORATE GOVERNANCE

1.6.1 Definition of corporate governance

Corporate governance can be defined in various ways, for example:
The Private Sector Corporate Governance Trust (PSCGT) states that corporate governance,
“Refers to the manner in which the power of the corporation is exercised in the stewardship of
the corporation total portfolio of assets and resources with the objective of maintaining and
increasing shareholders value through the context of its corporate vision” (PSCGT, 1999)
The Cadbury Report (1992) defines corporate governance as the system by which companies are
directed and controlled.
The Capital Market Authority (CMA) in year 2000 defined corporate governance as the process

9
and structures used to direct and manage business affairs of the company towards enhancing

prosperity and corporate accounting with the ultimate objective of realizing shareholders long-

term value while taking into account the interests of other stakeholders.

1.6.2 Rationale for corporate governance

The organization of the world economy (especially in current years) has seen corporate
governance gain prominence mainly because:
 Institutional investors, as they seek to invest funds in the global economy, insist on high
standard of Corporate Governance in the companies they invest in.
 Public attention attracted by corporate scandals and collapses has forced stakeholders to
carefully consider corporate governance issues.

Corporate governance is therefore important as it is concerned with:

 Profitability and efficiency of the firm.
 Long-term competitiveness of firms in the global economy.
 The relationship among firm’s stakeholders
1.6.3 Principles of corporate governance
There are 22 principles of Corporate Governance as given by the Common Wealth Association
of Corporate Governance (CACG) in1999 and the Private Sector Corporate Governance Trust
(PSCGT) in 1999 also. The first ten principles are summarized below.

1. The authority and duties of members (shareholders)

Members and shareholders shall jointly and severally protect, preserve and actively exercise the
supreme authority of the corporation in general meeting (AGM). They have a duty to exercise
that supreme authority to:

 Ensure that only competent and reliable persons who can add value are elected or appointed
to the board of directors (BOD).
 Ensure that the BOD is constantly held accountable and responsible for the efficient and
effective governance of the corporation so as to achieve corporate objective, prospering and
sustainability.
 Change the composition of the BOD that does not perform to expectation or in accordance
with mandate of the corporation

2. Leadership
Every corporation should be headed by an effective BOD, which should exercise leadership,
enterprise, integrity and judgements in directing the corporation so as to achieve continuing
prosperity and to act in the best interest of the enterprise in a manner based on transparency,
accountability and responsibility.

3. Appointments to the BOD

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It should be through a well managed and effective process to ensure that a balanced mix of
proficient individuals is made and that each director appointed is able to add value and bring
independent judgment on the decision making process.

4. Strategy and Values

The BOD should determine the purpose and values of the corporation, determine strategy to
achieve that purpose and implement its values in order to ensure that the corporation survives
and thrives and that procedures and values that protect the assets and reputation of the
corporation are put in place.

5. Structure and organization

The BOD should ensure that a proper management structure is in place and make sure that the
structure functions to maintain corporate integrity, reputation and responsibility.

6. Corporate Performance, Viability & Financial Sustainability

The BOD should monitor and evaluate the implementation of strategies, policies and
management performance criteria and the plans of the organization. In addition, the BOD should
constantly revise the viability and financial sustainability of the enterprise and must do so at least
once in a year.

7. Corporate compliance
The BOD should ensure that corporation complies with all relevant laws, regulations,
governance practices, accounting and auditing standards.

8. Corporate Communication
The BOD should ensure that corporation communicates with all its stakeholders effectively.
9. Accountability to Members
The BOD should serve legitimately all members and account to them fully.

10. Responsibility to stakeholders

The BOD should identify the firm’s internal and external stakeholders and agree on a policy (ies)
determining how the firm should relate to and with them, increasing wealth, jobs and
sustainability of a financially sound corporation while ensuring that the rights of the stakeholders
are respected, recognized and protected.

1.7 Self Review Questions

1. Define the term Agency relationship as it applies in Co-operatives and describe its
structure.
2. Discuss FIVE goals of financial Management and their applications in Co-operatives
3. State FIVE shortcomings of profit maximization objective.
4. Outline FIVE areas of conflict between managers and shareholders and the solutions to
counter the conflict.
5. Discuss authority and duties of members as a principle of corporate governance.
6. In what ways is wealth maximization objective superior to the profit maximization
objective? Explain.
7. Outline FOUR functions of the Financial Manager.

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 8. Briefly discuss the following principles of corporate governance.
a) Authority and duties of members
b) Strategy and Values
c) Internal Control procedures
d) Structure and organization
9. What roles should the financial manager play in the modern Co-operative set up?
10. Explain the key issues to be considered by a Financial Manager in the day to day
operating of saving and credit Co-operative.
11. Discuss the merits of the notion that the Financial Manager’s aim is to maximize the value
of the firm in light of the views expressed under agency theory.
12. State FIVE shortcomings of profit maximization objective.
13. Outline FIVE areas of conflict between managers and shareholders and the solutions to
counter the conflict.
14. Discuss authority and duties of members as a principle of corporate governance

LESSON 3: SOURCES OF FINANCE

Sources from which a firm may obtain its funds to finance its operations can be classified in four
different way as this include :
1. Classification according to the duration over which the funds will be retained.
These sources include
(a) long term sources of funds-
They are refundable after a long period of time i.e. after 12 years
(b)Short term sources of funds
These funds are refundable after a short period of time i.e. a period of 3 years
(c) Permanent sources of funds

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These funds are not refundable as long as the business remains a going concern for example
ordinary share capital
2. Classification according to origin
These sources include;-
a) External sources of funds -They are raised from outside the organization

b) Internal sources of fund-These are funds that are raised from within the firm

3. Classification according to the relationship between the firm and parties providing the
funds

These sources include:-

a) Common equity capital -These are funds provided by the real owners of the business i.e.
ordinary share capital; it is the total of the ordinary capital and the reserves

b) Quasi capital these are funds that are provided by the preference shareholders

c) Debt finance -They are funds provided by the creditors i.e. debentures

4. Classification to the rate of return

These sources include:-

a) Capital with affixed rate of return -This is capital that is paid a certain prespecified rate of
return each year i.e. preference capital and long term debts

b) Capital with a variable rate of return-This is capital that is paid a different rate o0f return
each year depending on the firm’s performance.

5. A business may obtain funds from various sources which may be either:
a) Long term sources which are repaid after a long period of time.

b) Short term sources which are repaid after a short period even less than a year.

Sources of Finance

1. Equity finance

This is finance from the owners of the company (shareholders).it is generally made up of
ordinary share capital and reserves (both revenue and capital reserves)

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Ordinary share capital
The true owners of business forms are the ordinary shareholders. Sometimes referred to as
residual owners, they receive what is left after satisfaction of all other claims.
The ordinary share capital is raised by the shareholders through the purchase of common shares
through the capital markets.
This form of long term capital is only accessible to limited companies who have met the
requirements of the capital market authority for listing before floating the shares.
Features of ordinary share capital.
Ownership
The ordinary shares of a firm may be owned privately (family) or publicly with shares being
traded in the stock exchange.

Par value
The par value of an ordinary share is relatively useless value, established in the firm’s corporate
charter (memorandum). It is generally very low- Sh.5or less.

Pre-emptive rights
Allow shareholders to maintain their proportionate ownership in the corporation when new
shares are issued. The feature maintains voting control and protects against dilution.

Rights offering
The firm grants rights to its shareholders to purchase additional shares at a price below market
price, in direct proportion to their existing holding.

Authorized, outstanding and issued shares

Authorized shares are the number of shares of common stock that the firm’s charter (articles)
allows without further shareholders’ approval.
Outstanding shares is the number of shares held by the public
Issued shares are the number of share that has been put in circulation; they represent the sum of
outstanding and treasury stock.
Treasury stock is the number of shares of outstanding stock that have been repurchased by the
firm (not allowed by the Companies Act of Kenya Laws).
Dividends
The payment of corporate dividends is at the discretion of the Board of Directors. Dividends are
paid usually semi- annually (interim and final dividends). Dividends can be paid in cash, stock
(bonus issues) and merchandise.

Voting rights
Generally each ordinary share entitled the holder to one vote at the Annual General Meeting for
the election of directors and on special issues. Shareholders can either vote in person or in proxy
i.e. appoint a representative to vote on his behalf .Shareholders can vote through two main
systems,
1. Majority voting system.

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 2. Cumulative system.
Majority voting system
Under this system , shareholders receive a vote for every share held. Decisions to be made must
therefore be supported by over 50% of the votes in a company .Under this system any
shareholder or group pf shareholders owning more than 50% of the company’s shares will make
all the decisions. The minority shareholders have no say.
Cumulative voting system.
Under this system, shareholders receive one vote for every share held times the number of
similar decisions to be made. This system is appropriate for making decisions that are similar and
is mainly used in the election of directors.
Example.
Assume that there are 10,000 shares outstanding and you own 1001v shares .Their are 9 directors
to be elected and therefore you would have (1001×9)= 9009 votes .How many directors can you
elect.
A.1001 shares = 1001×9 =9009
B. 10,000 – 1001 = 8999 × 9 = 80,991

Share holder A has 9009 votes and with 9 directors to be elected , there is no way for the owners
of the remaining shares to exclude A from electing a person to one of the top 9 positions. The
majority shareholder would control 8999 shares thus thus entitling them to 80991 votes .The
80991 vote cannot be spread thinly enough over the nine candidates to stop shareholder A from
electing one director.
The number of shares required to elect a give number of directors is given as follows.

R= d (n) +1
Nd + 1
Where,
R- Number of shares required to elect a desired number of directors.
d- Number of directors shareholders desire to elect.
n- Total number of common shares outstanding.
Nd- Total number of directors to be elected.

Example
A company will elect 6 directors and their ae 100,000 shares entitled to vote,
Required.
a. If a group desires to elect two directors, how many shares must they have.
b. Shareholder A owns 10,000 shares, shareholder B owns 40,000 shares how many
directors can each elect.
Solution.
a) R =2 (100,000) + 1
6+1

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 =28571.6 + 1=28573
b) A. 10,000= d (100,000) +1
6+1
10,000=14285.7d + 1
d= 9999/14285.7
d=0.7
Therefore zero directors.
B. 40,000=d (100,000) + 1
6+1
d=2
Therefore 2 directors.

Advantages of equity financing accruing to shareholders

1. Shares can be used as security for loans.
2. Providers of these funds can participate in the supernormal earnings of the firm
3. The shares are easily transferable
4. Return in form of a share price appreciation (capital gain) and dividends.
5. The following rights of ordinary shareholders can be viewed as advantages:

Rights of ordinary shareholders.

i. Right to vote-shareholders have the right to vote on a number of issues in a
company such as election of directors, changes in the Memorandum of
Association and Articles of Association. Shareholders can vote either in person
or by proxy that is, by appointing someone to represent them and vote on their
behalf.
ii. Pre-emptive rights- Allow shareholders to maintain their proportionate ownership
in the corporation when new shares are issued. The feature maintains voting
control and protects against dilution.
iii. Right to appoint another auditor
iv. Right to approve dividend payments
v. Right to approve merger acquisition
vi. Right to residual assets claim

Disadvantages accruing to shareholders

1. The ordinary share dividend is not an allowable deduction for tax purposes
2. The dividend is paid after claims for other providers of capital are satisfied
3. Ordinary shares carry the highest risk because of the uncertainty of return(company has
the discretion to declare dividend or not)and incase of liquidation the holders have a
residual claim on assets

Advantages of using ordinary share capital to a company

1. It is a permanent source of capital hence facilitates long term projects
2. Use of equity lowers the gearing level hence a company has a broader borrowing capacity
3. The shareholders may provide valuable ideas to the company’s operation
4. A company is not legally obliged to pay dividend especially if it is facing financial
difficulty these funds would serve better if retained.

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 5. It enables a company to get the opinion of the public through the movement in share
prices.
6. This source can be raised in very large amounts
7. It does not require any collateral as security.
8. The funds are provided without conditions hence are flexible.

Disadvantages of using ordinary share capital to a company

1. The floatation costs are higher than those of debt
2. It is only accessible to companies that have fulfilled the capital markets authority
requirements
3. It can lead to dilution of ownership of control of the firm by the shareholders
4. Since the dividend payment is not tax allowable then the company does not enjoy a tax
saving
5. The cost of this source of fund(dividend) is perpetual as ordinary shares are not
redeemable securities
6. The firm has to follow set guidelines on disclosure and publishing of financial statements.

Methods of issuing common shares

 Through a public issue
 Private placement
 Through a rights issue
 Employee stock option plans (ESOP)
 Bonus issue

Public issue
Ordinary shares are offered to the general public. The issuing company engages an investment
banker who will undertake the issue. The investment will set the securities issue price and will
sell the shares to the investors. The issuing firm can enter into an arrangement with the
investment banker where the investment banker will underwrite shares, that is, buy any shares
not taken up by the public.

Private placement
Under this method securities are sold to a few, usually chosen investors mainly institutional
investors. The advantages of this method is that the firm gets to decide who will take up there
shares, it can be used as part of strategic partnership, it will also lead to less floatation cost as no
advertisement is necessary. It also takes less time to raise funds through a private placement than
a public issue which involves a number of requirements to be fulfilled. A major disadvantage is
that the share is not as liquid-transferability is made difficult.

Rights issue
This is an option offered to already existing shareholders to buy common shares of the company
at a price (subscription price) which is less than the market price. The subscription price is set a
lower price than the market price so as to make it attractive for the existing shareholders to buy
the common shares; also it acts as a safeguard against any reduction in share price in the market.
When a rights issue is declared every outstanding share receives one right however, a
shareholder needs to have a number of rights in order to buy one new share.

17
A rights issue involves selling of common shares to existing shareholders of the company on a
prorata basis. Shares becoming available on account of non-exercise of rights are allotted to
shareholders who have applied for additional shares on a pro-rata basis. Any balance of
shares can be sold in the open market.

When rights are issued the shareholder has three options available:

(a) He can exercise the rights and therefore buy the new shares
(b) He can sell the rights in the market
(c) He can ignore the rights

The number of rights required to buy one new share can be given by the following formula

N = So
S

Where So is the number of existing shares

S is the number of new shares to be sold
N is the number of rights required to buy one new share

The ex-right price of shares can be given by:

Px = S o P o + S Ps
So + S

Where:

Px is the ex-right price of shares

Po is the cum-right price (current market prices of shares)
So is the number of existing shares
S is the number of new shares
Ps is the subscription price of rights

It can also be given by:

Px = Ps + (Po - Ps) N
N+1

Rights have value and the value of each right can be given by the following formulae:

R = P x - Ps
N

Where R is the theoretical value of rights Px, Ps and N have previously been defined.

18
It can also be given by:

R = P o - Px

or R = P o - Ps
N+1

Note:

All the above formulae give the same value and the student should use whichever is most
convenient.

Illustration:

XYZ Ltd has 900,000 shares outstanding at current market price of Sh 130 per share. The
company needs Sh 22,500,000 to finance its proposed expansion. The board of directors has
decided to issue rights for raising the required funds. The subscription price has been fixed
at Sh 75 per share.

Required:

(a) How many rights are required to purchase one new share?
(b) What is the price of one share after the rights issue (Ex-right price)?
(c) Compute the theoretical value of each right
(d) Consider the effect of the rights issue on the shareholders' wealth under the three
options available to the shareholders (Assume he owns 3 shares and has Sh 75 cash on
hand).

Solution:

(a) To compute the number of rights required to buy one new share, we must first compute
the number of new shares to be issued.

No. of shares = Desired funds

Subscription price

= 22,500,000
75

= 300,000 shares

N = So So = 900,000 shares
S S = 300,000 shares

N = 900,000 = 3
300,000

19
 Therefore a shareholder will require 3 rights to buy one new share in the company.

Notes

The shareholder will receive one right for each share held and therefore a total of
900,000 rights will be issued by the company.

(b) The price of the shares after the rights issue will be lower than the price before the rights
issue because the new shares are usually sold at a price which is below the market
price.

Px = Ps + (Po - Ps) N
N+1
Ps = 75
Po = 130
N = 3

Px = 75 + (130 - 75) 3/4

= Sh 116.25

After the rights issue the price of the shares would fall from Sh 130 to Sh 116.25.
However, in an inefficient market, this may not be the case.

(c) Value of each right

R = P o - Ps = 130 - 75
N + 1 3 + 1

= Sh 13.75

Each right will therefore have a theoretical value of Sh 13.75.

(d) To consider the effects of the rights issue on the shareholders wealth, we need to
consider the current wealth of the shareholder.

Current Wealth Sh
Wealth in the company (3 x 130) 390
Cash in hand 75
Total Wealth 465

Option 1 - Exercise the rights Sh

Wealth in the company 4 x 116.25 465
Cash in hand (75 - 75) 0

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 Total Wealth 465

Therefore, the wealth remains constant if the shareholder exercises the rights and buys
the new shares.

Option 2 - Sell the rights at their theoretical value Sh

Wealth in the company 3 x 116.25 348.75

Cash in hand - previous 75
From sale of rights 3 x 13.75 41.25 116.25
Total Wealth 465.00

The wealth also remains constant if the shareholder sells the rights at their theoretical
value.

Option 3 - Ignore the rights Sh

Wealth in the company 3 x 116.25 348.75
Cash in hand 75.00
Total Wealth 423.75

The wealth declines by Sh 41.25 from Sh 465 to Sh 423.75 if the shareholder ignores
the rights. The shareholder should therefore never ignore a rights issue because his
wealth will decline.
Note:
In an inefficient capital market the announcement of the rights issue may carry additional
information not yet known by the market and therefore the share price may increase or decrease
depending on the informational content of the rights issue.
The major advantage of a rights issue is that the shareholders maintain their proportionate
ownership of the company.

Bonus issue
This is an issue of additional shares to existing shareholders in lieu of a cash dividend.
Companies may choose a bonus issue if it wants to give dividends but not in the form of cash so
as to retain the cash say for investment, it is not taxable as cash dividends would be taxed. A
bonus issue is expected to have no effect on the shareholders wealth and may have the following
benefits,
Tax benefit –If a company declares such an issue. It Is not taxable as in the case of Cash
dividends .The share holder can therefore sale the new shares in the market to make capital gain
which is not taxable.
It can result into conservation of cash especially if a company is facing financial constrains.
If the market is inefficient, a bonus issue maybe regarded as signaling important information and
may result in an increase in the share price because a bonus issue is interpreted to mean high
profits.
Increase in future dividends .This occurs especially if a company follows a policy of paying a
constant mount of dividends per share and continues with this policy even after the bonus issue.

21
2. Term loan
Medium term & long term loans are obtained from commercial banks and other financial
institutions. This funds are mainly used to finance major expansions or profit financing.
Features of term loans
1. Direct negotiation – A firm negotiates a term loan directly with a bank of financial
institution. I.e. a private placement.
2. Security – term loans are usually secured specifically by the assets acquired using the
funds. (Primary security). This is said to create a fixed charge on the company’s assets. A
fixed charge can also be referred to as specific charge.
3. Restrictive covenant – financial institutions usually restrict the firms so as to safeguard
their funds. They do this by way of restrictive covenants which include asset based
covenant, cashflow, liability etc.
4. Convertibility – they are usually not convertible to common shares unless under special
cases. E.g. a financial institution may agree to restructure the firms capital structure.
5. Repayment schedule – this indicates the time schedule for payment of interest and
principle. It may occur.
i) Where interest & principle are paid on equal periodic instalments.
ii) Where principles is paid on equal periodic instalments & interest on the outstanding
balance of the loan.
Example
A company negotiates a Sh.30 million loan at 14% pa from a financial institution. Acquired;
prepare the loan prepayment schedule assuming that:
(i) Interest & principle paid in 8 equal year end installment’s
(ii) Principle is paid in 8 equal instalments

i) 30,000,000 = A x PVIFA
14% 8 years
30,000,000 = 4.6389A
A = 6,46,050.0378
Schedule of Repayment
Year Bal. b/d Instalment Interest 14% Principle Bal b/d
1 30,000,000 6,467,050 4,200,000 2,267,050 27,732,950

22
 2. 27,732,950 6,467,050 3,882,613 2584437 25148513
3. 25148513 6,467,050 3520792 2946258 22202254.8
4. 22202255 6,467,050 3108316 3358734.3 18843521
5. 18843521 6,467,050 2638093 3828957 15014564
6. 150145639 6,467,050 2102039 4365011 10649553
7. 10649553 6,467,050 1490937.4 4976112.6 5673440.4
8. 56734404 6,467,050 794282 5672768.4 672.1

iii) 8 equal principle – 30n/8 = 3,750,000

YR Bal b/d inst. Int. primar
Year Bal. b/d Instalment Interest 14% Principle Bal b/d
1 30,000,000 7950000 4200000 3750000 26250000
2. 26250000 7425000 3675000 3750000 22500000
3. 22500000 6900000 3150000 3750000 18750000
4. 18750000 6375000 2625000 3750000 15000000
5. 150000000 5850000 2100000 3750000 11250000
6. 11250000 5325000 1575000 3750000 7500000
7. 7500000 4800000 1050000 3750000 3750000
8. 3750000 4275000 525000 3750000 0

3. Preference shares (quasi-equity)

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the right to an
unpaid dividend is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary shareholders.

Characteristics of preference shares

1. They have a fixed dividend

2. Dividends can be paid in arrears
3. They can be converted to ordinary shares
4. They have a claim on assets before the ordinary shareholders

Types of preference shares

1. Redeemable verses Irredeemable

2. Cumulative verses non- cumulative
3. Participative verses non-participative
4. Convertible verse non-convertible

From the company's point of view, preference shares are advantageous in that:

23
 Dividends do not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debt (loans or debentures).

 Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.

 Unless they are redeemable, issuing preference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.

 The issue of preference shares does not restrict the company's borrowing power, at least in the
sense that preference share capital is not secured against assets in the business.

 The non-payment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is normally given to debenture holders.

However, dividend payments on preference shares are not tax deductible in the way that interest
payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of
payment needs to be higher than for interest on debt to compensate for the additional risks.

For the investor, preference shares are less attractive than loan stock because:

 they cannot be secured on the company's assets

 the dividend yield traditionally offered on preference dividends has been much too low to
provide an attractive investment compared with the interest yields on loan stock in view of the
additional risk involved.
4. Venture capital

Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A
businessman starting up a new business will invest venture capital of his own, but he will
probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an
equity stake, into a new business, a management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a
serious risk of losing the entire investment, and it might take a long time before any profits and
returns materialise. But there is also the prospect of very high profits and a substantial return on
the investment. A venture capitalist will require a high expected rate of return on investments, to
compensate for the high risk.

A venture capital organisation will not want to retain its investment in a business indefinitely,
and when it considers putting money into a business venture, it will also consider its "exit", that
is, how it will be able to pull out of the business eventually (after five to seven years, say) and
realise its profits. Examples of venture capital organisations are: Merchant Bank of Central
Africa Ltd and Anglo American Corporation Services Ltd.

24
When a company's directors look for help from a venture capital institution, they must recognise
that:

 the institution will want an equity stake in the company

 it will need convincing that the company can be successful
 it may want to have a representative appointed to the company's board, to look after its
interests.

The directors of the company must then contact venture capital organisations, to try and find one
or more which would be willing to offer finance. A venture capital organisation will only give
funds to a company that it believes can succeed, and before it will make any definite offer, it will
want from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a
profit forecast

d) details of the management team, with evidence of a wide range of management skills

e) details of major shareholders

f) details of the company's current banking arrangements and any other sources of finance

g) any sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial screening, and only a
small percentage of all requests survive both this screening and further investigation and result in
actual investments.

Venture capital is a form of investment in new and risky small enterprises which is required to
get them started. Venture capitalists are therefore investment specialist who raises pools of
capital to fund new ventures which are likely to become public companies in return for an
ownership interest. They therefore buy part of the stools of the company at a low price in
anticipation that when the company goes public, they would sale the shares at a high price and
make considerable capital gains, venture capitalists also provide managerial skills to the firm
examples of venture capitalists are:
Pension funds, insurance companies and also individuals.
Since the goal of venture capital is to make a profit, they will only invest in that have a potential
for growth.

25
Constraints in the development of a venture capital market in Kenya.
i) The few promoters of venture capital are risk averse and therefore are discouraged by
the level of risk, the length of investment and the liquidity of investment.
ii) The nature of firms in Kenya is such that they are privately owned and therefore do
not dillusion of ownership through use of venture capital.
iii) The poor infrastructure in the country also discourages venture capitalists.
iv) They are not enough incentives for the development of venture capital and the
government is discriminative against venture capital. The tax laws favour debt over
equity.
v) There is a general shortage of venture capitalists.

Importance of venture capital market in small and medium scale business development
i) Venture capitalists provide the much needed finance to tour small businesses which
lack access to capital markets due to their size.
ii) Small medium scale businesses may lack managerial skills. Venture capitalists sere as
active partners through involvement in this businesses and therefore provide
marketing and planning skills as the also want to see their investments succeed.
iii) Venture capitalists encourage tree spirit of entrepreneurship therefore small
businesses are encouraged to see their ideas through as they know they will get start
up capital.
iv) Venture capitalists provide improved technology so that small and medium scale
business are in line with changes in technology and are therefore able to compete with
other firms of the same level.

26
LESSON 4: SOURCES OF FINANCE (CONT…)

5. Lease financing
This is an agreement where the right repossession and enjoyment of an asset is transferred for a
definite period of time. The person transferring the right i.e. the owner of the asset is referred to
as leasor. The recipient of the asset is the lessee.

A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a
capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the
lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars
and commercial vehicles, but might also be computers and office equipment. There are two basic
forms of lease: "operating leases" and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

27
c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end
of the lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means of
a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a
finance leasing arrangement, and so will purchase the car from the dealer and lease it to the
company. The company will take possession of the car from the car dealer, and make regular
payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of
the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is
not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At
the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset
would be worn out. The lessor must, therefore, ensure that the lease payments during the primary
period pay for the full cost of the asset as well as providing the lessor with a suitable return on
his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the
lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and
to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor.

Requirements of a Long Term lease

1. The present value of lease rentals must be greater than 90% the year value of the asset.
2. 75% of the assets life is the lease term.
3. It is non-cell unsalable
4. Maintenance costs, insurance and taxes are paid by the lessee.
According to terms of payment
1. Net lease

28
 This is on in which the leasee pays all or a substantial part of the maintenance cost. It is
therefore where the lessee pays for all the expenses except taxes, insurances and exterior
repairs.
2. Flat Lease
This is one which opts for periodic payment for use of the asset over the term of the
lease. Such a lease is usually made for such periods of time since inflation can easily
erode the buying power of the fixed rentals.

3. Step Up lease
This provides for the fixed payments to be adjusted periodically. This adjustments can be
made either b new rentals taking effect after the passages of a certain period of time or by
periodically adjusting the fixed payments for inflation. The term of a stepup lease is
usually longer than a flat lease.
4. Percentage lease
This is where the lessee is required to pay a fixed basic percentage rate and a designated
percentage of sales volume. The percentage factor acts as an inflation gauge as well as a
means of Keeping lease rentals in line with the market conditions.
5. Escalator lease
This calls for an increase in taxes insurance and operating costs to be paid for the lessee.
6. Sandwich lease
This refers to a multiple lease in which the lessee in turn sub-lease to a sub-lessee who in
turn sub-leases to another sub-lessee. Example: A the original owner of an asset leases to
B. B executes a sub-lease to C who then sub-leases to D.
This is a sandwich lease between B & C, B being the sandwich lessor and C the sandwich
lessee.
Advantages of lease
i) To avoid the risk of ownership. When a firm purchases an asset, it has to bear the risk
of obsolescence especially if the asset is vulnerable to technological changes e.g.
computers.

29
 ii) Avoidance of investment outlay. Leasing enables a firm to make full use of an asset
without making an immediate investment in the form of initial cash outflow.
iii) Increased flexibility. A St. lease is a cancelable lease especially when the asset is
needed for a short period of time e.g. during construction, equipment can be leased on
a seasonal basis after which the lease can be cancelled.
iv) Lease charges are tax allowable expenses. This therefore reduces the tax liability.
6. Hire purchase
This is arrangement whereby a company acquires an asset on making a down payment or deposit
and paying the balance over a period of time in installments. This source of finance is more
expensive than a bank loan and companies that use this source need guarantors since it does not
require security or collateral. The company hiring the asset will be required to honour the terms
of the agreement which means that any term in violated, the selling firm may repossess the asset.
This is therefore finance in kind and the hirer will not get title to the asset until he clears the final
installment and any charges thereof.

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the
exception that ownership of the goods passes to the hire purchase customer on payment of the
final credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.

The finance house will always insist that the hirer should pay a deposit towards the purchase
price. The size of the deposit will depend on the finance company's policy and its assessment of
the hirer. This is in contrast to a finance lease, where the lessee might not be required to make
any large initial payment.

An industrial or commercial business can use hire purchase as a source of finance. With
industrial hire purchase, a business customer obtains hire purchase finance from a finance house
in order to purchase the fixed asset. Goods bought by businesses on hire purchase include
company vehicles, plant and machinery, office equipment and farming machinery.

7.Mortgages
A Mortgage can be defined as a pledge of security over property or an interest therein created by
a formal written agreement for the repayment of monetary debt.

30
Minimum mortgage requirements
1. All mortgages should be in writing.
2. All parties must have contractual capacity.
3. Interest in the property being mortgaged should be specific e.g. rental income
lease hold etc.
4. A description of true loan or obligation secured by the mortgage should appear in
the mortgage agreement.
5. A legal description of the mortgage must be included in the documents.
6. The mortgage must be signed by the mortgagor
7. The mortgage must be acknowledged and delivered to the mortgagee.
8.Debentures
A debenture is a long-term promissory note used to raise debt funds. The firm promises to pay
periodic interest and principal at maturity. Ideally, a debenture is a long-term bond that is not
secured by a pledge of a specific property. However, like other general creditors claims, its
secured by a pledge of a specific property not otherwise pledged.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt
incurred by a company, normally containing provisions about the payment of interest and the
eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders and
borrowers when interest rates are volatile.

Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.

a) Fixed charge; Security would be related to a specific asset or group of assets, typically land
and buildings. The company would be unable to dispose of the asset without providing a
substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example, stocks
and debtors), the lender's security in the event of a default payment is whatever assets of the

31
appropriate class the company then owns (provided that another lender does not have a prior
charge on the assets). The company would be able, however, to dispose of its assets as it chose
until a default took place. In the event of a default, the lender would probably appoint a receiver
to run the company rather than lay claim to a particular asset.

Features of debenture

(a) Interest rate

The interest rate on a debenture is fixed and known. It is called the contractual or
coupon interest rate. It indicates the percentage of the par value that will be paid out
annually (or semi-annually) in form of interest. The interest must be paid whether the
firm makes profit or not. However, debenture interest is tax deductible on the part of
the company.
(b) Maturity
Debentures are usually issued for a specific period of time. The maturity of a
debenture indicates the length of time the debenture remains outstanding before the
company redeems it. However, there are debentures that have no maturity period.
(c) Redemption
The redemption of debentures can be accomplished either through a sinking fund or
call provision.
A sinking fund is cash set aside periodically for retiring the debentures. The fund is
placed under the control of the trustee who redeems the debenture either by purchasing
them in the market or calling them in an acceptable manner. The advantage of a
sinking fund is that it reduces the amount required to redeem the remaining debt at
maturity. Particularly when the firm faces temporary financial difficulties at the time
of debt maturity, the repayment of huge amount of principal could endanger the firm's
financial viability.

Call provisions enable the company to redeem debentures at a specific price before the
maturity date. The call price is usually higher than the par value, the difference being a
call premium.

(d) Security
Debentures are either secured or unsecured. A secured debenture is secured by a claim
on the company's specific assets. When debentures are not protected by any security,
they are known as unsecured or naked debentures.
(e) Convertibility
A convertible debenture is one which can be converted, fully or partly into shares at a
specified price at a given date. Debentures without a conversion feature are called
non-convertible or straight debentures.

(f) Yield
We can distinguish two types of yield: the current yield and the yield to maturity. The
current yield on a debenture is the ratio of the annual interest payment to the
debentures market price.

32
 Current yield = Annual interest
Market price

The yield to maturity takes into account the payments of interest and principal over the
life of the debenture. It is an internal rate of return on the debenture and is given by
the following formula.

M - PX
C+
n
YIELD T0 MATURITY =
(M + P)

Where C is the annual interest

M is the maturity value = Face Value
P is the current market value
n is the number of periods to maturity

Claim on Assets and Income

Debentures have a claim on the company's earnings prior to that of the shareholders since
their interest has to be paid before paying any dividend to preference and common
shareholders.
In case of liquidation, the debenture holders have a claim on assets prior to that of
shareholders. The secured debentures will have priority over the unsecured debentures
Types of debentures

1. Subordinated debentures
2. Redeemable debentures
3. Irredeemable debentures

Advantages of debentures
It involves less cost to the firm than the equity financing because:

i. Investors consider debentures as a relatively less risky investment alternative and therefore
require a lower rate of return.
ii. Interest payments are tax deductible.
iii. The floatation costs on debentures is usually lower than floatation costs on common shares.
(b) Debenture holders do not have voting rights and therefore, debenture issue does not
cause dilution of ownership.
(c) Debenture holders do not participate in extraordinary earnings of the company. Thus
their payments are limited to interest.
(d) During periods of high inflation, debenture issue benefits the company. Its
obligations of paying interest and principal, which remain fixed, decline in real
terms.
Disadvantage of debentures

33
 (a) Debentures issue results in legal obligation of paying interest and principal, which, if
not paid can force the company into liquidation.
(b) Debenture issue increases the firm's financial leverage and reduces its ability to borrow
in future.
(c) Debentures must be paid at maturity and therefore at some point, it involves substantial
cash outflows.
(d) Debentures may contain restrictive covenants which may limit the firm's operating
flexibility in future

9. Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on the
amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as
a dividend. The major reasons for using retained earnings to finance new investments, rather than
to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not
cost anything, although this is not true. However, it is true that the use of retained earnings as a
source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment projects can
be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an
issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a
capital profit (which will only be taxed when shares are sold) than receive current income, then
finance through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should
be paid a reasonable dividend, in line with realistic expectations, even if the directors would
rather keep the funds for re-investing. At the same time, a company that is looking for extra
funds will not be expected by investors (such as banks) to pay generous dividends, nor over-
generous salaries to owner-directors.

10. Franchising

34
Franchising is a method of expanding business on less capital than would otherwise be needed.
For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include
Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local
business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for
architect's work, establishment costs, legal costs, marketing costs and the cost of other support
services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on
the subsequent regular payments by the franchisee for an operating profit. These regular
payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of a
franchisee's outlet, the franchisee will be expected to contribute a share of the investment
himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share
of the investment cost.

The advantages of franchises to the franchisor are as follows:

 The capital outlay needed to expand the business is reduced substantially.

 The image of the business is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an

agreed number of years (including stock and premises, although premises might be leased from
the franchisor) together with the backing of a large organisation's marketing effort and
experience. The franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and developed a scheme
that works.

Self Assessment Questions

QUESTION ONE

(a) Differentiate the following:-

(i) Participative and non-participative preference shares.
(ii) Subordinated and naked debentures
(iii) invoice discounting and factoring
(b) List the functions of a factor

QUESTION TWO

Maendeleo Ltd has 900,000 shares outstanding the current price is Ksh. 130. The company needs
cash, Ksh 22,500,000 to finance a new project. The Board of directors have decided to declare
rights issue at a subscription price of Ksh. 85.
Required:

35
 (a) Compute the number of rights required to buy one share.
(b) Compute the Ex-rights price of the shares of the rights.
(c) Compute the theoretical value of each right.

QUESTION THREE
State and explain any FIVE sources of external finance to a Co-operative Society, giving two
advantages and two disadvantages of each.

QUESTION FOUR
ABC ltd is incorporated under the companies Act with a total of 100, 000 0rdianry shares
outstanding and eligible to vote at all the AGMs. The Company is controlled by 5 directors who
are usually electe3d at every AGM.

Mr. King has approached you for advice on the following issues:-
(i) He bought 25,000 ordinary shares from the company and therefore wants to know the
number of directors he can elect.
(ii) He has a friend who to indirectly control the company by electing single handedly 3
directors and wishes to know the number of shares he must buy at the stock market so
as to elect the directors,
Advise him.

QUESTION FIVE
As a finance manager of Kasuku products ltd, you decide to raise sufficient capital in the next
five years to enable your company to expand. You decide to raise the capital by combining both
internal and external opportunities

Required:-
(a)Explain the major internal sources of capital to an organisation
(b) In details, explain the main disadvantages of sourcing funds externally. .(20Mks)

QUESTION SIX
State and explain any FIVE sources of external finance to a Co-operative Society, giving two
advantages and two disadvantages of each.

QUESTION SEVEN
(i) Maendeloeo Ltd has 900,000 shares outstanding the current price is kshs. 130. The company
needs cash, ksh 22,500,000 to finance a new project. The Board of directors have share decided
to declare rights issue at a subscription price of ksh. 85.
Required:
a) Compute the number of rights required to buy one share.
b) Compute the Ex-rights price of the shares of the rights.
c) Compute the theoretical value of each right.

36
LESSON 5: WORKING CAPITAL MANAGEMENT

5.1 Introduction

Working capital is a financial metric which represents operating liquidity available to a business,
organization, or other entity, including governmental entity. Along with fixed assets such as
plant and equipment, working capital is considered a part of operating capital. Net working
capital is calculated as current assets minus current liabilities. It is a derivation of working capital
that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current
assets are less than current liabilities, an entity has a working capital deficiency, also called a
working capital deficit.

Working Capital = Current Assets

Net Working Capital = Current Assets − Current Liabilities

A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable and cash.

Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.

By definition, working capital management entails short term decisions - generally, relating to
the next one year period - which is "reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based
on cash flows and / or profitability.

 One measure of cash flow is provided by the cash conversion cycle - the net number of
days from the outlay of cash for raw material to receiving payment from the customer. As
a management tool, this metric makes explicit the inter-relatedness of decisions relating
to inventories, accounts receivable and payable, and cash. Because this number
effectively corresponds to the time that the firm's cash is tied up in operations and
unavailable for other activities, management generally aims at a low net count.

 In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12
months by capital employed; Return on equity (ROE) shows this result for the firm's
shareholders. Firm value is enhanced when, and if, the return on capital, which results

37
 from working capital management, exceeds the cost of capital, which results from capital
investment decisions as above. ROC measures are therefore useful as a management tool,
in that they link short-term policy with long-term decision making.
 Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. These policies aim at managing the
current assets (generally cash and cash equivalents, inventories and debtors) and the short
term financing, such that cash flows and returns are acceptable.

Approaches used to finance current assets

1. Matching or hedging approach

2. Conservative approach
3. Aggressive approach

a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this approach, the firm
adopts a financial plan which involves the matching of the expected life of assets with the
expected life of the source of funds raised to finance assets.
The firm, therefore, uses long term funds to finance permanent assets and short-term funds to
finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This approach can be shown
by the following diagram.

Temporay Current
Assets

Permanent Current Assets

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

38
financing needs. The firm, therefore, finances its permanent assets and a part of its temporary
assets with long-term funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds. (Some sources of
short-term funds such as accruals are cost-free). However, short-term funds must be repaid
within the year and therefore they are highly risky. With this in mind, we can consider the risk-
return trade off of the three approaches.

The conservative approach is a low return-low risk approach. This is because the approach uses
more of long-term funds which are now more expensive than short-term funds. These funds
however, are not to be repaid within the year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach. However it is also a high
return approach the reason being that it relies more on short-term funds that are less costly but
riskier.
The matching approach is in between because it matches the life of the asset and the life of the
funds financing the assets.

DETERMINANTS OF WORKING CAPITAL NEEDS

There are several factors which determine the firm’s working capital needs. These factors are
comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406).
They however include:

a) Nature and size of the business.

b) Firm’s manufacturing cycle
c) Business fluctuations
d) Production policy
e) Firm’s credit policy
f) Availability of credit
g) Growth and expansion activities.

Factors which determine working capital needs of a firm

(1) Availability of Credit: The amount of credit that a firm can obtain, as also the length of the
credit period significantly affects the working capital requirement. The greater the prospects of
getting credit, the smaller will be its requirement of working capital because it can easily
purchase raw materials and other requirements on credit.

Creditworthiness can also the interpreted to mean that the firm can function smoothly even with
a smaller amount of working capital if it is assured that it can obtain loans from the bank
immediately and easily. The firm does not need then to keep a wide margin of safety.

(2) Growth and Expansion: The working capital requirements increase with growth and
expansion of business. Hence planning of the working capital requirements and its procurement
must go hand in hand with the planning of the growth and expansion of the firm. The
implementation of the production plan that aims at the growth or expansion of the unit
necessitates more of fixed capital and working capital both.

39
Even the expansion of the volume of sales increases the requirements of working capital. Of
course, it is difficult to establish a quantitative relationship between them. An important point to
be noted is that the requirements of working capital emerge before the growth or expansion
actually takes place.

(3) Profit and its Distribution: The net profit of a firm is a good index of the resources
available to it to meet its capital requirements. But, from the viewpoint of working capital
requirement, it is the profit in the form of cash which is important, and not the net profit. The
profit available in the form of cash is called cash profit and it can be assessed by adding or
deducting non-cash items from the net profit of the firm. The larger the amount of cash profit,
the greater will be the possibility of acquiring working capital.

But, in fact the entire amount of cash profit may not be available to meet working capital needs.
The portion of cash profit which is available for this purpose depends on the profit distribution
policy. The policies with regard to distribution of dividends, ploughing back of profit and tax
payments will determine the portion of cash profit which the firm can use to meet its working
capital needs. Even depreciation policy can influence the amount of cash available, as
depreciation of capital assets is deductible item of expenditure and it reduces tax liability.

(4) Price Level Fluctuations: A general statement may be made that with price rise, a firm will
require more funds to purchase its current assets. In other words, the requirements of working
capital will increase with the rise in prices. But all firms may not be affected equally. The prices
of all current assets never go up to the same extent. Price of some current assets rise less rapidly
than those of the others. Hence for the firms which use such current assets, the working capital
need will increase by a smaller amount. Besides, if it is possible to pass on the burden of high
prices of raw materials to the customers by raising the prices of final product, then also there will
be no increase in working capital requirements.

(5) Operating Efficiency: If a firm is efficient, it can use its resources economically, and
thereby it can reduce cost and earn more profit. Thus, the working capital requirement can be
reduced by more efficient use of the current assets.

Importance of working capital management

The finance manager should understand the management of working capital because of the
following reasons:

a) Time devoted to working capital management

A large portion of a financial manager’s time is devoted to the day to day operations of the firm
and therefore, so much time is spent on working capital decisions.

b) Investment in current assets

Current assets represent more than half of the total assets of many business firms. These
investments tend to be relatively volatile and can easily be misappropriated by the firm’s
employees. The finance manager should therefore properly manage these assets.
c) Importance to small firms

40
A small firm may minimise its investments in fixed assets by renting or leasing plant and
equipment, but there is no way it can avoid investment in current assets. A small firm also has
relatively limited access to long term capital markets and therefore must rely heavily on short-
term funds.

d) Relationship between sales and current assets

The relationship between sales volume and the various current asset items is direct and close.
Changes in current assets directly affects the level of sales. The finance management must
therefore keep watch on changes in working capital items.

LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…)

1.0 Cash management.

It helps to identify the cash balance which allows for the business to meet day to day expenses,
but reduces cash holding costs.

Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash
outlay to purchase raw materials to the point when cash is collected from the sale of finished
goods produced using those raw materials.
Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year.

Illustration
XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on credit.

The credit terms extended to the firm currently requires payment within thirty days of a purchase

while the firm currently requires its customers to pay within sixty days of a sale. However, the

firm on average takes 35 days to pay its accounts payable and the average collection period is 70

days. On average, 85 days elapse between the point a raw material is purchased and the point the

finished goods are sold.

Required

Determine the cash conversion cycle and the cash turnover.

41
 Solution
The following chart can help further understand the question:

Inventory Conversion period (85 days)

Receivable collection
Payable deferral Period (70 days)
Period (35 days)

Purchase of Payment for the Sale of Collection of

raw raw materials Finished goods receivables

Cash conversion cycle = 85 + 70 - 35 =

120

The cash conversion cycle is given by the following formula:

Cash conversion = Inventory conversion + Receivable collection – Payable deferral

Cycle period period period

For our example:

Cash conversion cycle= 85 + 70 – 35 = 120 days

42
Cash turnover = 360
Cash conversion cycle

360
= 120

= 3 times

Note also that cash conversion cycle can be given by the following formulae:

inventory receivables Payables+Accruals

Cash conversion cycle=
3 60 [ +
costofsales sales
−
Cashoperatingexpenses ]
NB: In this chapter we shall assume that a year has 360 days.

Setting the optimal cash balance

Cash is often called a non-earning asset because holding cash rather than a revenue-generating
asset involves a cost in form of foregone interest. The firm should therefore hold the cash
balance that will enable it to meet its scheduled payments as they fall due and provide a margin
for safety. There are several methods used to determine the optimal cash balance. These are:
a) The Cash Budget
The Cash Budget shows the firm’s projected cash inflows and outflows over some specified
period. This method has already been discussed in other earlier courses. The student should
however revise the cash budget.

Working capital requirements of a business should be monitored at all times to ensure that there
are sufficient funds available to meet short-term expenses.

The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The
cash budget has the following six main sections:

1. Beginning Cash Balance - contains the last period's closing cash balance.
2. Cash collections - includes all expected cash receipts (all sources of cash for the period
considered, mainly sales)
3. Cash disbursements - lists all planned cash outflows for the period, excluding interest
payments on short-term loans, which appear in the financing section. All expenses that do
not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs
are determined by the total cash disbursements plus the minimum cash balance required
by company policy. If total cash available is less than cash needs, a deficiency exists.
5. Financing - discloses the planned borrowings and repayments, including interest.
6. Ending Cash balance - simply reveals the planned ending cash balance.

43
Reasons for keeping cash

 Cash is usually referred to as the "king" in finance, as it is the most liquid asset.
 The transaction motive refers to the money kept available to pay expenses.
 The precautionary motive refers to the money kept aside for unforeseen expenses.
 The speculative motive refers to the money kept aside to take advantage of suddenly
arising opportunities.

Advantages of sufficient cash

 Current liabilities may be catered for meeting the current obligations of the company
 Cash discounts are given for cash payments.
 Production is kept moving
 Surplus cash may be invested on a short-term basis.
 The business is able to pay its accounts in a timely manner, allowing for easily obtained
credit.
 Liquidity
 Quick upfront pay.

b) Baumol’s Model
The Baumol’s model is an application of the EOQ inventory model to cash management. Its
assumptions are:

1. The firm uses cash at a steady predictable rate

2. The cash outflows from operations also occurs at a steady rate
3. 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 amount of cash to be raised by selling marketable securities or by

borrowing.
b is the fixed cost of making a securities trade or of borrowing
T is the total annual cash requirements
i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the
cost of borrowing)

The total cost of holding the cash balance is equal to holding or carrying cost plus transaction
costs and is given by the following formulae:

1 T
TC= Ci + b
2 C

44
Illustration
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable
securities is 12% and every time the company sells marketable securities, it incurs a cost of
Shs.20.

Required
a) Determine the optimal amount of marketable securities to be converted into cash every
time the company makes the transfer.
b) Determine the total number of transfers from marketable securities to cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.

Solution
2bT
a)
C∗
√ i

Where:b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%

2 x20 x520 ,000

C∗¿
√ 0.12
=Sh.13,166

Therefore the optimal amount of marketable securities to be converted to cash every time a sale
is made is Sh.13,166.

T
¿
b) Total no. of transfers = C∗¿

520, 000
= 13,166

= 39.5

≈ 40 times

1 T
TC= Ci + b
c) 2 C

13,166 x 0.12 520,000 x20

+
= 2 13,166

= 790 + 790 = Shs.1,580

45
 Therefore the total cost of maintaining the above cash balance is Sh.1,580.

d) The firm’s average cash balance = ½C

13,166
= 2

= Shs.6,583

c) Miller-Orr Model
Unlike the Baumol’s Model, Miller-Orr Model is a stochastic (probabilistic) model which makes
the more realistic assumption of uncertainty in cash flows.

Merton Miller and Daniel Orr assumed that the distribution 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 a normal distribution. Thus, the daily net cash follows a trendless
random walk.

From the graph below, the Miller-Orr Model sets higher and lower control units, H and L
respectively, and a 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 cash.

The Lower Limit is usually set by management. The target balance is given by the following
formula:

1/3
3 Bδ 2
Z= [ ]
4i
+L

and the highest limit, H, is given by:

H = 3Z - 2L

4 Z−L
The average cash balance = 3

Where:Z = target cash balance

H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
δ² = variance of net daily cash flows

46
Illustration
XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The standard
deviation of daily cash flow is Sh.2,500 and the interest rate on marketable securities is 9% p.a.
The transaction cost for each sale or purchase of securities is Sh.20.

Required
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread

Solution
1/3
3 bδ ²
a)
Z=
[ ]
4i
+L

3 x20 x(2,500)²

=
[ 4x
9%
360 ] +10,000

= 7,211 + 10,000 = Sh.17,211

b) H = 3Z – 2L
= 3 x 17,211 – 2(10,000)
= Shs.31,633

47
 4 Z−L
c) Average cash balance = 3
4 x17 ,211−10,000
= 3

d) The spread = H–L

= 31,633 – 10,000
= Shs.21,633

Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 (31,633 – 17,211) in
marketable securities and if the balance falls to Shs.10,000, the firm should sell
Shs.7,211(17,211 – 10,000) of marketable securities.

Other Methods
Other methods used to set the target cash balance are The Stone Model and Monte Carlo
simulation. However, these models are beyond the scope of this manual.

Cash management techniques

The basic strategies that should be employed by the business firm in managing its cash are:

i) To pay account payables as late as possible without damaging the firm’s credit rating.
The firm should however take advantage of any favourable cash discounts offered.
ii) Turnover inventory as quickly as possible, but avoid stockouts which might result in loss
of sales or shutting down the ‘production line’.
iii) Collect accounts receivable as quickly as possible without losing future sales because of
high pressure collection techniques. The firm may use cash discounts to accomplish this
objective.

In addition to the above strategies the firm should ensure that customer payments are converted
into spendable form as quickly as possible. This may be done either through:

a) Concentration Banking
b) Lock-box system.

a) Concentration Banking
Firms with regional sales outlets can designate certain of these as regional collection
centre. Customers within these areas are required to remit their payments to these sales
offices, which deposit these receipts in local banks. Funds in the local bank account in
excess of a specified limit are then transferred (by wire) to the firms major or
concentration bank.
Concentration banking reduces the amount of time that elapses between the customer’s
mailing of a payment and the firm’s receipt of such payment.

48
 b) Lock-box system.
In a lock-box system, the customer sends the payments to a post office box. The post
office box is emptied by the firm’s bank at least once or twice each business day. The
bank opens the payment envelope, deposits the cheques in the firm’s account and sends a
deposit slip indicating the payment received to the firm. This system reduces the
customer’s mailing time and the time it takes to process the cheques received.

2.0 Inventory management.

It helps to identify the level of inventory which allows for uninterrupted production but reduces
the investment in raw materials - and minimizes reordering costs - and hence increases cash
flow. Besides this, the lead times in production should be lowered to reduce Work in Progress
(WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over
production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ);
Economic quantity

Manufacturing firms have three major types of inventories:

1. Raw materials
2. Work-in-progress
3. Finished goods inventory

The firm must determine the optimal level of inventory to be held so as to minimize the
inventory relevant cost.

BASIC EOQ MODEL

The basic inventory decision model is Economic Order Quantity (EOQ) model. This model is
given by the following equation:

2 DC o
Q=
√ Cn

Where:Q is the economic order quantity

D is the annual demand in units
Co is the cost of placing and receiving an order
Cn is the cost of holding inventories per unit per order

The total cost of operating the economic order quantity is given by total ordering cost plus total
holding costs.

D
C
TC = ½QCn + Q o

Where:Total holding cost = ½QCn

49
 D
C
Total ordering cost = Q o

The holding costs include:

1. Cost of tied up capital

2. Storage costs
3. Insurance costs
4. Obsolescence costs

The ordering costs include:

1. Cost of placing orders such as telephone and clerical costs

2. Shipping and handling costs

Under this model, the firm is assumed to place an order of Q quantity and use this quantity until
it reaches the reorder level (the level at which an order should be placed). The reorder level is
given by the following formulae:

D
R= L
360

Where:R is the reorder level

D is the annual demand
L is the lead time in days

EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:

i) The demand is known and constant over the year

ii) The ordering cost is constant per 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.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming year

which costs Sh.50 each. The items are available locally and the leadtime in one week. Each

50
order costs Sh.50 to prepare and process while the holding cost is Shs.15 per unit per year for

storage plus 10% opportunity cost of capital.

Required
a) How many units should be ordered each time an order is placed to minimize inventory
costs?
b) What is the reorder level?
c) How many orders will be placed per year?
d) Determine the total relevant costs.

Suggested Solution:

2 DC o
a)
Q=
√ Cn

Where:D = 2,000 units

Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days

2x 2, 000 x50
Q=
√ 20
=100units

DL
b) R = 360

2 ,000 x7
= 360

= 39 units

D
c) No. of orders = Q

2 ,000
= 100

= 20 orders

D
C
d) TC = ½QCn + Q o

51
 2 ,000
(50)
= ½(100)(20) + 100

= 1,000 + 1,000

= Sh.2,000

Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is
received.

3.0 Debtors’ management.

It helps Identify the appropriate credit policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue
and hence Return on Capital (or vice versa); see Discounts and allowances.

In order to keep current customers and attract new ones, most firms find it necessary to offer
credit. Accounts receivable represents the extension of credit on an open account by a firm to its
customers. Accounts receivable management begins with the decision on whether or not to grant
credit.

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 collections.

Accounts receivables = Credit sales per day x Length of collection period

The average collection period depends on:

a) Credit standards which is the maximum risk of acceptable credit accounts

b) Credit period which is the length of time for which credit is granted
c) Discount given for early payments
d) The firm’s collection policy.

a) Credit standards
A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit
policy tends to sell on credit to customers on a very liberal terms and credit is granted for a
longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a highly selective
basis only to those customers who have proven credit worthiness and who are financially strong.

A lenient credit policy will result in increased sales and therefore increased contribution margin.
However, these will also result in increased costs such as:
52
 1. Increased bad debt losses
2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments

The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal,
the evaluation of investment in receivables should involve the following steps:

1. Estimation of incremental operating profits from increased sales

2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs

b) Credit terms
Credit terms involve both the length of the credit period and the discount given. The terms 2/10,
n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of
invoice otherwise the net amount should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability caused by longer
credit and discount period or a higher rate of discount against increased cost.

c) Discounts
Varying the discount involves an attempt to speed up the payment of receivables. It can also
result in reduced bad debt losses.

d) Collection policy
The firm’s collection policy may also affect our analysis. The higher the cost of collecting
account receivables the lower the bad debt losses. The firm must therefore consider whether the
reduction in bad debt is more than the increase in collection costs.

As saturation point increased expenditure in collection efforts does not result in reduced bad debt
and therefore the firm should not spend more after reaching this point.

Evaluation of the credit applicant

After establishing the terms of sale to be offered, the firm must evaluate individual applicants
and consider the possibilities of bad debt or slow payments. This is referred to as credit analysis
and can be done by using information derived from:

a) The applicant’s financial statement

b) Credit ratings and reports from experts
c) Banks
d) Other firms
e) The company’s own experience

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Application of discriminant analysis to the selection of applicants
Discriminative analysis is a statistical model that can be used to accept or reject a prospective

credit customer. The discriminant analysis is similar to regression analysis but it assumed that

the observations come from two different universal sets (in credit analysis, the good and bad

customers). To illustrate let us assume that two factors are important in evaluating a credit

applicant the quick ratio and net worth to total assets ratio.

The discriminant function will be of the form.

ft = a1(X1) + a2(X2)

Where:X1 is quick ratio

X2 is the network to total assets
a1 and a2 are parameters

The parameters can be computed by the use of the following equations:

a1 = Szz dx – Sxzdz
Sxx Sxx – Sxz²

a2 = Szz dx – Sxzdz
Szz Sxx – Sxz²

Where:Sxx represents the variances of X1

Szz represents the variances of X2
Sxz is the covariance of variables of X1 and X2
dx is the difference between the average of X1’s bad accounts and X2’s good accounts
dz represents the difference between the average of X’s bad accounts and X’s good
accounts.

The next step is to determine the minimum cut-off value of the function below at which credit
will not be given. This value is referred to as the discriminant value and is denoted by f*.

Once the discriminant function has been developed it can then be used to analyse credit
applicants. The important assumption here is that new credit applicants will have the same
characteristics as the ones used to develop the mode.

More than two variables can be used to determine the discriminant function. In such a case the
discriminant function will be of the form.

ft = a1x1 + a2x2 + … + anxn

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Self Assessment Questions

QUESTION ONE

The management of Beardy Limited has ascertained that the company will require ksh.
2,500,000 in cash for transaction purposes during the coming financial year. The interest rate on
the marketable securities is currently 10% per annum and is expected to remain constant over the
next one year. The cost of converting securities to cash is ksh. 50 per transaction.

Required:

Using the Baumol cash management model, determine the following:

(i) Optimal cash size
(ii) Average cash balance
(iii) Cash turnover
(iv) Total cost of managing the optimal cash balance

QUESTION TWO

PKG Ltd maintains a minimum cash balance of Ksh. 500,000.00. The deviation of the
company’s daily cash changes is ksh. 200,000.00. the annual interest rate is 14%. The transaction
cost of buying and selling securities is kshs. 150.00 per transaction.

Required:
Using Miller-Orr cash management model, determine the following:
(i) Upper cash limit
(ii) Average cash balance
(iii) Spread

QUESTION THREE
Mutongoi Ltd in Matuu requires 500,000 units of a component each year at a cost of ksh. 100
each. The items are obtained from Machakos and therefore it takes 3 days from the time or
ordering to the time of delivery. Each order costs the company ksh. 300 to process while
hoarding cost per annum is ksh 200 plus 15% opportunity cost of capital. To operate prudently
the company is safe with 2000 units.

Required:
(i) Economic order quantity
(ii) Reorder level
(iii) Total relevant cost

QUESTION FOUR
(a) Differentiate between Hedging approach and conservative approach under management of
working capital.

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(b) Explain four importance of working capital management.
( c) Define overcapitalization and outline the indicators of overcapitalization.
(d) Explain the determinants of working capital requirements.

QUESTION FIVE
Ukaguzi Ltd has a total annual sales of 3,000,000. its discounted interest rate is 15 % p.a . it is
considering to factor its debtor where the factor charges a service fees of 1.2% of debtors
factored. 12% reserve is required by the factor. Ukaguzi limited has a credit policy of 72 days.

Required:
(i) the amount Ukaguzi will receive from the factor.
(ii) The percentage annual cost
(a) Reserve
(b) Service charges
© Interest charges p.a
(d) Interest charges for 72 days

QUESTION SIX
(a) Discuss the THREE approaches used to finance current assets.
(b) State and explain any FOUR importance of working capital management.
(c) Jitihidi wholesalers had total sales of sh. 3 million in the year ended 2008. its average
collection period is 27 days. Due to unforeseen liquidity problems, it pledged its debtors
and was charged interest at 18% p.a. The interest was discounted. Some of the goods
were damaged and therefore the factor charged 6% reserve.
Required:
Calculate the amount that was advanced to the firm.

QUESTION SEVEN
(a) Maintain only “Enough” Levels of inventory in your business. Discuss FIVE Costs that
would be avoided by maintaining “Enough” inventory level
(b) Credit sales is a strategy used by traders to mitigate the effects of high competition. Discuss
the FIVE Cs of a good debtor

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LESSON 7: TIME VALUE OF MONEY

This concept attempts to explain why investors will prefer money now rather than in the future.
The purchasing power of money generally decreases as time goes by.

(1) Future value of a single amount

This is the compound value of a single amount invested over a given number of periods for
earning a given interest.

Consider an investor who has invested Ksh. 100,000 in a bank over a period of 3 years earning
an interest of 10% p.a. Determine the future on this amount?

Alternative 1
perio amount at amount at
d start interest end

1 100,000.00 10,000.00 110,000.00

2 110,000.00 11,000.00 121,000.00

3 121,000.00 12,100.00 133,100.00

Alternative 2
using formulae
FV=PV(1+r)^n
FV=100,000(1+0.1)^3
FV=133,100

(2) Present value of a single amount

FV=PV(1+r)^
n
PV= FV
(1+r)^n

FV(1+r)^-
PV= n

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Assume that you expect to receive Ksh. 2.5 million five year from now. If the cost of capital in
the market is 16%. Determine the present value of this amount.
FV=PV(1+r)^
n
PV= FV
(1+r)^n

PV= 2,500,000.00
(1+0.16)^5
= 1,190,282.54

PV= FV(1+r)^-n

2,500,000(1+0.16)^-
5
= 1,190,282.54
Using financial tables
FV X PVIF r% n
PV= years
2,500,000 X 0.4761
= 1,190,282.54

Consider a project which is expected to generate the following cash flows

Year cash flows

1 90,000.00

2 120,000.00

3 140,000.00

4 150,000.00
If the cost of capital is 10%, determine the total present value of these cash flows
Present
Year Cash flows PVIF 10% Value

1 90,000.00 0.9091 81,819.00

2 120,000.00 0.8264 99,168.00

3 140,000.00 0.7513 105,182.00

4 150,000.00 0.6830 102,450.00

Total Present Value

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 388,619.00
(3) Present value of an Annuity
An Annuity refers to equal amounts received or paid after equal periods e.g. salary, rent,
retirement benefits, insurance premiums e.t.c.
There are normally two types of annuities
1. An ordinary annuity- this is where cash flows occurs at the end of each period e.g. salary,
retirement benefits e.t.c.
2. An annuity due- this is where cash flows occur at the beginning of each period e.g. rent,
insurance premiums e.t.c.
Ordinary annuity

Assume that you expect to receive Ksh. 15,000 at the end of each year for the next 4 years. If the
cost of capital is 10%. Determine the total present value of this cash flows

Present
Year Cash flows PVIF 10% Value

1 15,000.00 0.9091 13,636.50

2 15,000.00 0.8264 12,396.00

3 15,000.00 0.7513 11,269.50

4 15,000.00 0.6830 10,245.00

Total Present Value Annuity 47,547.00

The present of an ordinary annuity is calculated using a formula

PV = Annuities X 1- (1+r)^-n
r

1- (1+0.1)^-
15,000 X 4
0.1
= 15,000 X 3.1699

PV = 47,547.98

Annuity due
Now assume that you were to receive the cash floes at the beginning of each year. Determine the
present value of this annuity due
The present value of annuity due is calculated using the formula

PV Annuity due
= PVA ord X (1+r)

59
 15,000 X
3.1699(1+0.1)

52,303.35
Present
Year Cash flows PVIF 10% Value

0 15,000.00 1.0000 15,000.00

1 15,000.00 0.9091 13,636.50

2 15,000.00 0.8264 12,396.00

3 15,000.00 0.7513 11,269.50

Total Present Value Annuity Due 52,302.00

Assume that you have a charity sweepstakes lottery which promises to pay Ksh 50,000 at the
beginning of each year for the next 20 years. The government has announced this to be
1,000,000 lottery i.e. 50,000 X 20. If the cost of capital for the next 20 years is expected to be
19% p.a. Advice on the current value of this lottery
PV Annuity due
= A X PVA ord X (1+r)
50,000 X
5.1009(1+0.19)

303,501.29

(4) Present value of an annuity until perpetuity

They are equal cash flows received or paid until infinity.

Therefore present value of Annuity (PVAα) is normally equal to 1/ r

PVIFA 10% α = I/0.1 = 10

PVIFA 16% α = I/0.16 = 6.25

If a company is considered to a going concern and it promises to pay constant dividends each
year then this constant dividends can be considered to be annuity until infinity

(5) Present value of differential annuity

This are equal cash flows which occurs in between the economic life of the project

Consider a five year project which is expected to generate the following cash flows

Year 1 2 3 4 5

60
 Cash 90,0 70,00 30,000 30,000. 30,000.
flows 00.00 0.00 .00 00 00

PVIF Present
Year Cash flows 12% Value

1 90,000.00 0.8929 80,361.00 136,165

2 70,000.00 0.7972 55,804.00

3 30,000.00 0.7118 21,354.00

4 30,000.00 0.6355 19,065.00 57,441

5 30,000.00 0.5674 17,022.00

Total Present value 193,606.00

The PV of differential annuities is calculated using the following steps:

1. Calculate the PV of the unequal cash flows in the earliest periods in the normal way i.e
using the financial tables e.g. Ksh. 136,165
2. (a) Determine the PVIFA at a given discount rate at the end of annuity period i.e. PVIFA
12% 5year = 3.6048
(b) Determine the PVIFA at a given discount rate at the start of annuity period i.e. PVIFA
12% 2year = 1.6901
3. Calculate the PV of differential Annuity using the following formulae
= A X (PVIFA end – PVIFA start)
= 30,000 X (3.6048-1.6901)
= 30,000 X 1.9147
= 57,441
4. Sum the PV obtained in step 1 and step 3 above in order to obtain the total present value
= 136,165 + 57,441
= 193,606

Consider a project which is expected to generate the following cash flows each year

Year 1-5 6-10 11-20

Cash 50,00 60,00 100,00
flows 0.00 0.00 0.00
If the cost of capital is 10% determine the total present value of this cash flows

period formula Workings

1-5 A X PVIF 10% 5 YRS =50,000 X 3.7908 =189,540
A X (PVIFA 10% 10 YRS - PVIFA =60,000 X (6.1446-
6-10 10% 5 YRS) 3.7908) =141,228

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 A X (PVIFA 10% 20 YRS - PVIFA =100,000 X (8.5136-
11-20 10% 10YRS) 6.1446) =236,900
=567,668

Consider a project which is expected to generate the following cash flows each year
Year 1-5 6-10 11-α
70, 90, 100,00
Cash flows 000.00 000.00 0.00
If the cost of capital is 13%. Determine the total present value of this cash flows
period formula workings
1-5 A X PVIF 13% 5 YRS =70,000 X 3.5172 =246,206.19
A X (PVIFA 13% 10 YRS - PVIFA =90,000 X (5.4262-
6-10 10% 5 YRS) 3.5172) =171,810
A X (PVIFA 10% 20 YRS - PVIFA =100,000 X (7.6923-
11-20 10% 10YRS) 5.4262) =67,983.23
=485,999.42

(6) Loan amortization schedule

This is a loan repayment schedule which will indicate the amount borrowed and the amount
outstanding at the end of each period. The amount of loan borrowed today will represent the
present value of an annuity while the periodic payment will represent an annuity. The periodic
payment (instalment) will constitute two elements i.e. the principal and the interest element

Recall PVA = A X PVIFA r% n

Amount borrowed = Instalment payment X PVIFA r% n

Instalment payment = Amount borrowed

PVIFA r% n

Consider an investor who intends to borrow Ksh. 450,000 at an interest rate of 10% p.a. the loan
is to be repaid within a period of four years
Required
Determine the periodic instalment payment
Prepare the loan repayment schedule
Instalment payment = Amount borrowed
PVIFA r% n

= 450,000
3.1699
= 141,960

Amt at
period Amt at start interest instalment principal end

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 1 450,000.00 45,000.00 141,960.00 96,960.00 353,040.00

2 353,040.00 35,304.00 141,960.00 106,656.00 246,384.00

3 246,384.00 24,638.40 141,960.00 117,321.60 129,062.40

4 129,062.40 12,906.24 141,960.00 129,062.40 -

Consider an investor who intends to borrow Ksh. 1 million at an interest rate of 12% p.a. for a
period of 5 years. The loan will be repaid semi annually
Required
Determine the interest expense on the third instalment
Instalment payment = Amount borrowed
PVIFA r% n

= 1,000,000
7.3601
= 135,868

Amt at
period Amt at start interest instalment principal end

1 1,000,000.00 60,000.00 135,868.00 75,868.00 924,132.00

2 924,132.00 55,447.92 135,868.00 80,420.08 843,711.92

3 843,711.92 50,622.72 135,868.00 85,245.28 758,466.64

4 758,466.64 45,508.00 135,868.00 90,360.00 668,106.63

A company intends to borrow Ksh. 9 million at an interest of 10% p.a. the loan will be repaid
over a period of 8 years. The loan principal will be repaid in equal instalment of Ksh. 1,125,000
p.a.

Required
Prepare the loan amortization schedule
period Amt at start interest instalment principal Amt at end

1 9,000,000.00 900,000.00 225,000.00 1,125,000.00 7,875,000.00

2 7,875,000.00 787,500.00 141,960.00 1,125,000.00 6,750,000.00

3 6,750,000.00 675,000.00 141,960.00 1,125,000.00 5,625,000.00

4 5,625,000.00 562,500.00 141,960.00 1,125,000.00 4,500,000.00

5 4,500,000.00 450,000.00 141,960.00 1,125,000.00 3,375,000.00

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 6 3,375,000.00 337,500.00 141,960.00 1,125,000.00 2,250,000.00

7 2,250,000.00 225,000.00 141,960.00 1,125,000.00 1,125,000.00

8 1,125,000.00 112,500.00 141,960.00 1,125,000.00 -

Self Review Questions

QUESTION ONE
(a) Discuss the phrase Time Value of Money”
(b) Umoja co-operative Society approached a commercial bank which agreed to advance a loan
of ksh 600,000 under the following terms:-
(i) Equal annual installment
(i) Repayment period of 6years
(iii) Interest rate of 12% p.a.
Required:-
Prepare the co-operative loan amortization schedule showing how the loan will be reduced up to
the 6th year.

QUESTION TWO
(a) You are the financial manager of Pamoja Sacco. You advised your Sacco to take a loan from
the Co-operative bank of Kenya ksh 10,000,000 which was granted. The Executive management
of the Sacco wants you to advice them how the loan will be amortised. The period of repayment
is 5yrs at an interest rate of 15% p.a.
Advice them assuming equal principal repayment.

QUESTION THREE
a) General individuals show a time preference for money. Give reason for such a
preference.
b) You are the Loan Officer of Matata Sacco Ltd. Prepare a Loan schedule for a member
who has taken a loan of Ksh. 100,000. The loan requires 12% interest per annum and 12
monthly installments.

QUESTION FOUR
(a) After cleaning training and obtained a Diploma in Co-operative Management, you
successfully got a job as a Finance assistant in Jitihada Sacco Ltd. The gross salary is
Kshs. 25,000. because of your training, you know that if you invest in a savings account,
you will have enough money for your dream house. You opened a savings account in
Okoa Nyumba Bank Ltd and you deposit shs. 120,000 every year end and will continue
to save for the nest 10 years. If your dream house will cost sh 2 million after 10 years;
(i) will you have meet the target? (5 Marks)

64
 (ii) If not, how much more money will you add so as to own the dream house?
(2 Marks)
Assume the savings account will earn an interest of 10% p.a. over the 10 years period)
(b) Company pays dividend per share at the end of every year of sh 10 into perpetuity. If the
required rate of return is 12%, what is the maximum price an investor would willing to
pay for the share? (3 Marks)
(c) Mrs Morgan, an employee of Pamoja Sacco Ltd started an M-Pesa business to
supplement her Meagre salary. The business is projected to bring in cashflows as follows:

Year cash flow sh ‘000’

1 155
2 149
3 172
4.10 180

Required:
Determine the present value of the projected cash flows from the business if the cost of capital is
10%

QUESTION FIVE
Mr Mali Mingi deposited 100,000 with Co-operative bank of Kenya. The interest rate for the
deposit was agreed to be 13% per annum.
Required:
Determine the compound sum at the end of the fourth year if compounding occurs as follows:-
(i) Semi annually - (4 Marks)
(ii) Annually - (4 Marks)
(iii) Quarterly -(4 Marks)
(iv) Weekly - (4 Marks)
(v) Daily - (4 Marks)

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