Fundamentals of Finance

ATD
ACCOUNTING TECHNICIAN DIPLOMA

LEVEL II
FUNDAMENTALS OF FINANCE
STUDY TEXT
KASNEB JULY 2018 SYLLABUS
Revised on: January 2019
www.someakenya.com Contact: 0707 737 890 Page 1

KASNEB SYLLABUS
GENERAL OBJECTIVES
This paper is intended to equip the candidate with knowledge. skills and attitudes that will enable
him/her to apply the principles of finance in business decision making
8.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
 Identify various sources of finance for organisations

 Calculate non-complex risk and return measures
 Make basic dividend decisions for a firm
 Determine the cost of capital for an organization
 Apply basic valuation models to determine value of financial securities
 Evaluate the viability of capital investments using appropriate appraisal techniques
 Advise on various forms of dividends payable by an organisation
 Apply basic concepts of Islamic Finance.
CONTENT
8.1 Overview of finance
 Nature and scope of finance

 Relationship between accounting and finance
 Finance functions
 Roles Of a finance manager
 Goals of a firm
 Agency theory : conflicts and resolutions
8.2 Sources of finance
 Factors to consider when choosing the source of finance

 Internally Generated and externally generated sources of finance
 Short term, Medium and Long term sources of Finance
8.3 Financial markets and systems
 Roles and importance of of financial markets and systems

 Markets participants and financial innovation
 Types of financial markets
 Characteristics of a good market
 Functions of financial markets
 The flow of funds and the financial system
 Organisation and structure of securities markets
 Automation of securities exchanges; automated trading system (ATS). Central depository
system(CDS)
 Role of government in the financial system; capital markets authority, central bank, central
depository and settlement company
8.4 Time value of money
 Time value versus time preference for money

 The relevance of time value of money
 Discounting techniques
 Compounding techniques
 Preparation of Loan amortisation schedules
8 5 Introduction to Risk and return
 Components of risk and return

 Sources of risk
 Measures of risk and return for a single asset
 Distinction between risk- free and risky assets
 Relationship between risk and return on investments
8.6 Cost of capital
 Significance of cost of capital to firms

 Factors influencing a firm’s cost of capital
 Components of cost capital
 Weighted average cost of capital
 Marginal cost of capital
8.7 Working capital management
 Nature and importance of working capita!

 Determinants of working capital
 Working capital operating cycle
 Working capital financing policies
 Cash management
 Accounts receivable management
 Accounts payable management
 Management of inventory, debtors and creditors
8.8 Capital Budgeting decisions under certainty
 Importance, characteristics and types of capita! investment decisions

 Capital investment cash flows; total initial cash outlay, the total terminal cash flows and
annual net operating cash flows
 Investment evaluation criteria
 Features of an ideal capital budgeting technique
 Investment appraisal techniques; Accounting Rate of Return (ARR), Payback period. Internal
Rate of Return, Net Present Value, and Profitability index
8.9 Dividend decisions
 Factors influencing the dividend decision of a firm

 Forms of dividend payment
 The dividend policies; pay-out ratio policy, residual policy, stable predictable policy, low
regular plus extra policy
 Dividend payment chronology- declaration date, holder of record date, ex-dividend date and
payment date
8.10 Fundamentals of Islamic finance
 Principles and trends in Islamic banking

 Differences between Islamic and conventional banking
 The concept of interest (riba) and how returns are made by Islamic financial securities
 Sources of finance in Islamic financing: muhabaha, sukuk
8.11 Emerging issues and trends

CONTENT PAGE
Chapter 1: Nature and purpose of finance………………………………………………………...6

Chapter 2: Sources of finance…………………………………………………………………….20
Chapter 3: Financial markets and systems…………………………………………………..…...33
Chapter 4: Time value of money…………………………………………………………….…...67
Chapter 5: Risk and return…………………………………………………………….….………87
Chapter 6: Cost of capital……………………………………………………………………….101
Chapter 7: Working capital management……………………………………………….………111
Chapter 8: Capital budgeting decisions under certainty………………………………..……….146
Chapter 9: Dividend decisions…………………………………………………………..………169
Chapter 10: Fundamentals of Islamic finance…………………………………………..………180

CHAPTER 1
OVERVIEW OF FINANCE
Meaning of finance
The term finance should be understood in two perspectives - finance as a resource and finance as a
discipline. Finance, as a resource, refers to monetary means of financing assets of an entity. Finance
as a discipline or subject of study, describes how individuals , governments and corporate
organizations manage the flows of money through an organization. In other words, finance tells how
people make decisions about the collection and allocation of resources in organizations like
corporation, school, bank or government agency. Therefore, it is important for all individuals,
businesses, governments and non-government organizations to appreciate the significance of finance
in their day-to-day businesses.
Finance was a branch of economics till the closure of nineteenth century. Finance as a separate
academic discipline is still evolving. Practicing managers and academicians have been contributing
in its expansion and enrichment.
NATURE AND SCOPE OF FINANCE
At the present state, the academic discipline of finance includes the following specialized areas in its
scope.
1. Public Finance
Like business organizations, governments (local, state or federal) raise and spend large sum of
money, but unlike business organizations, they pursue non-profit goals. To deal with governmental
financial matters, a separate and specialized field of finance has emerged as public finance.
2. Securities and Investment Analysis

This area is of interest to individuals and institutional investors. It covers mainly measurement of
risk and return on investment in securities.
3. Institutional Finance
Institutional finance deals with issues of capital formation and the organizations that perform the
financing function of the economy. Therefore, it mainly studies saving and capital formation and
institutions involved in this process such as banks, insurance companies, provident and pension
funds, etc.

4. International Finance
International finance studies economic transactions among nations, corporations and individually
internationally. It is concerned with flows of money across international boundaries.
5. Financial Management
Business firms face problems dealing with acquisition of funds and optimum methods of employing
the funds. Thus, financial management studies financial problems in individual firms, seeks low-cost
funds and seeks profitable business activities.
RELATIONSHIP BETWEEN FINANCE AND ACCOUNTING
Finance and accounting are two closely related activities in a company.
Finance includes activities that help a company fund its activities and operations.
Accounting is the process of recording and reporting financial figures from business transactions.
The relationship between finance and accounting exists because the former activity often uses
figures from the latter. In other cases, finance analysts review accounting information to determine
the efficiency and effectiveness of operations.
A company often separates its finance and accounting functions among several workers. This
ensures the company has the proper segregation of duties to prevent employees from manipulating
information. The company also needs to create specific job responsibilities to further define roles.
Large companies may also need to have two separate departments in order to process their financial
data. In many cases, the finance department will have fewer employees than the accounting
department.
Financial statements are typically the final output from a company’s accounting department. These
statements present a record for a specific period in a company’s life. Finance and accounting
personnel work together to present the financial statements to upper management. For example,
finance personnel may review and make suggestions on correcting the financial statements. Finance
personnel may also create ratios in addition to statements to provide additional insight into the data.
Another relationship between finance and accounting is the creation of a company’s budget or
working capital analysis. Finance personnel often create budgets to present the expected financial
outlays in the future. Accountants prepare information at the end of each month that affects current
budgets. Finance personnel ensure the company maintains its budget and all figures are in proper
accounts. Creating new budgets also requires the use of current accounting information.
Working capital analysis and other uses of accounting information also extend the relationship
between finance and accounting. Finance personnel must ensure the company has enough cash to
operate. A mix of debt or equity financing is often necessary to overcome any cash shortfalls as
computed by a working capital or cash budget. Without accounting information, these budgets and
the related shortfalls are nearly impossible to determine. Finance personnel can also make other
recommendations for working capital adjustments.
Other possible decisions that result from corporate finance include business valuation, investment
decisions, and dividend planning. These decisions are all a working part of the relationship between
finance and accounting. Companies can also create other relationships based on their need for
financial data.
FINANCE FUNCTIONS
The following explanation will help in understanding each finance function in detail
1. Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets.
This activity is also known as capital budgeting. It is important to allocate capital in those long term
assets so as to get maximum yield in future. Following are the two aspects of investment decision
a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along
with uncertainty comes the risk factor which has to be taken into consideration. This risk factor
plays a very significant role in calculating the expected return of the prospective investment.
Therefore while considering investment proposal it is important to take into consideration both
expected return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less profitable and
less productive. It wise decisions to decompose depreciated assets which are not adding value and
utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be
calculating while dissolving such assets. The correct cut off rate is calculated by using this
opportunity cost of the required rate of return (RRR)

2. Financial Decision
Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds.
Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an
equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s
capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes this not only is
a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of
debt affects the risk and return of a shareholder. It is more risky though it may increase the return on
equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders return with
minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum
capital structure would be achieved. Other than equity and debt there are several other tools which
are used in deciding a firm capital structure.
4. Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits to
the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain
the other half in the business.
It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the
market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common
practice to pay regular dividends in case of profitability Another way is to issue bonus shares to
existing shareholders.
5. Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

profitability, liquidity and risk all are associated with the investment in current assets. In order to
maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in
current assets. But since current assets do not earn anything for business therefore a proper
calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once they become non
profitable. Currents assets must be used in times of liquidity problems and times of insolvency.

ROLE OF A FINANCE MANAGER
Some of the major functions of a financial manager are as follows:
1. Estimating the Amount of Capital Required

2. Determining Capital Structure
3. Choice of Sources of Funds
4. Procurement of Funds
5. Utilisation of Funds
6. Disposal of Profits or Surplus
7. Management of Cash
8. Financial Control.
Financial Manager is the executive who manages the financial matters of a business.
The functions of Financial Manager are discussed below:
1. Estimating the Amount of Capital Required:
This is the foremost function of the financial manager. Business firms require capital for:
i. purchase of fixed assets,

ii. meeting working capital requirements, and
iii. modernisation and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision regarding the kind and
proportion of various sources of funds has to be taken. For this, financial manager has to determine
the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve
minimum cost of capital and maximise shareholders wealth.
3. Choice of Sources of Funds:
Before the actual procurement of funds, the finance manager has to decide the sources from which
the funds are to be raised. The management can raise finance from various sources like equity
shareholders, preference shareholders, debenture- holders, banks and other financial institutions,
public deposits, etc.

4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the business. It might require
negotiation with creditors and financial institutions, issue of prospectus, etc. The procurement of
funds is dependent not only upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.
5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in various assets so as to
maximise the return on investment: While taking investment decisions, management should be
guided by three important principles, viz., safety, profitability, and liquidity.
6. Disposal of Profits or Surplus:
The financial manager has to decide how much to retain for ploughing back and how much to
distribute as dividend to shareholders out of the profits of the company. The factors which influence
these decisions include the trend of earnings of the company, the trend of the market price of its
shares, the requirements of funds for self- financing the future programmes and so on.
7. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It involves
forecasting the cash inflows and outflows to ensure that there is neither shortage nor surplus of cash
with the firm. Sufficient funds must be available for purchase of materials, payment of wages and
meeting day-to-day expenses.
8. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The overall
measure of evaluation is Return on Investment (ROI). The other techniques of financial control and
evaluation include budgetary control, cost control, internal audit, break-even analysis and ratio
analysis. The financial manager must lay emphasis on financial planning as well.

GOALS OF A FIRM
Goals of a firm are divided into financial and non-financial goals
Financial goals of the firm
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also functioning
mainly for the purpose of earning profit. Profit is the measuring techniques to understand the
business efficiency of the concern. Profit maximization is also the traditional and narrow approach,
which aims at, maximizes the profit of the concern. Profit maximization consists of the following
important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the business
concern:
i. Main aim is earning profit.

ii. Profit is the parameter of the business operation.
iii. Profit reduces risk of the business concern.
iv. Profit is the main source of finance.
v. Profitability meets the social needs also.
Unfavourable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
i. Profit maximization leads to exploiting workers and consumers.
ii. Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.
iii. Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:

i. It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
ii. It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the
actual cash inflow and net present cash flow during a particular period.
iii. It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or the
wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth maximization. This
objective is an universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
i. Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
ii. Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.
iii. Wealth maximization considers both time and risk of the business concern.
iv. Wealth maximization provides efficient allocation of resources.
v. It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization
i. Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
ii. Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.
iii. Wealth maximization creates ownership-management controversy.
iv. Management alone enjoy certain benefits.
v. The ultimate aim of the wealth maximization objectives is to maximize the profit.
vi. Wealth maximization can be activated only with the help of the profitable position of the
business concern.
Non-financial goals
 Social Responsibility and Ethics

It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies
unscrupulous, anti social, enhances wealth inequalities and harms the environment. The proponents
of this position argue that maximizing shareholders wealth should not be pursued without regard to a
firm’s corporate social responsibility. The argument goes that the interest of stakeholders other than
just shareholders should be taken care of. The other stakeholders include creditors, employees,
consumers, communities in which the firm operates and others. The firm will protect the consumer;
pay fair wages to employees while maintaining safe working conditions, support education and be
sensitive to the environment concerns such as clean air and water. A firm must also conduct itself
ethically (high moral standards) in its commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of shareholders
wealth maximization. So the question frequently posed is: is ethical behavior and corporate social
responsibility inconsistent with shareholder wealth maximization?
In the long run, the firm has no choice but to act in socially responsible ways. It is argued that the
corporation’s very survival depend on it being socially responsible. The implementation of a pro-
active ethics ad corporate social responsibility (CSR) program is believed to enhance corporate
value. Such a program can reduce potential litigation costs, maintain a positive corporate image,
build shareholder confidence, and gain the loyalty, commitment and respect of firm’s stakeholders.
Such actions conserve firm’s cash flows and reduce perceived risk, thus positively effecting firm
share price. It becomes evident that behavior that is ethical and socially responsible helps achieve
firm’s goal of owner wealth maximization.

 Growth and expansion.
This is a major objective for small companies which seek to expand operations so as to enjoy
economies of scale.
Difficulty of Achieving Shareholders Wealth Maximization

Two difficulties complicate the achievement of the goal of shareholder wealth maximization in
modern corporations. These are caused by the agency relationships in a firm and the requirements of
corporate social responsibility (As discussed above).
AGENCY THEORY
An agency relationship is created when one party (principal) appoints another party (agent) to act on
their (principals) behalf. The principal delegates decision making authority to the agent. In a firm
agency relationship exists between;
1 Shareholders and management
2 Shareholders and creditors
3 Shareholders and the government
4 Shareholders and auditors
Shareholders and management

The separation of ownership and control in most modern corporations’ causes a conflict of interest
between the personal interest of appointed managers (agent) and the interests of the owners of the
firms (principals).this conflict is known as the agency conflict.
The following are some decisions by managers which would result in a conflict with shareholders:
1. Managers may use corporate resources for personal use.
2. Managers may award themselves hefty pay rises
3. Managers may organize mergers which are intended for their benefit only and not for the benefit
of shareholders.
4. Managers may take holidays and spend huge sums of company money.
5. Managers may use confidential information for their benefit(insider trading)
Resolution of conflict
1. Performance based remuneration

This will involve remunerating managers for actions they take that maximize shareholders wealth.
The remuneration scheme should be restructured in order to enhance the harmonization of the
interest of shareholders with those of management. Managers could be given bonuses, commissions
for superior performance in certain periods.

2. Incurring agency costs
Agency costs refer to costs incurred by shareholders in trying to control management behavior and
actions and therefore minimize agency conflicts.
These costs include:
i. Monitoring costs. They arise as a result of mechanisms put in place to ensure interests of
shareholders are met. They include cost of hiring external auditors, bonding assurance
which is insurance taken out where the firm is compensated if manager commits an
infringement, internal control system implementation.
ii. Opportunity costs which are incurred either because of the benefit foregone from not
investing in a riskier but more profitable investment or in the due to the delay in decision
making as procedures have to be followed(hence, a timely decision will not be made)
iii. Restructuring costs are those costs incurred in changing or altering an organizations
structure so as to prevent undesirable management activities.
iv. Board of directors- a properly constituted board plays the oversight role on management
for the shareholders.
3. Threat of corporate takeover

When management of a firm under performs this result in the shares of that firm being undervalued
there is the threat of a hostile takeover. This threat acts to force managers to perform since should
the firm be taken over they will be replaced.
4. Shareholders intervention
The shareholders as owners of the company have a right to vote. Hence, during the company’s AGM
the shareholders can unite to form a bloc that will vote as one for or against decisions by managers
that hurt the company. This voting power can be exercised even when voting for directors.
Shareholders could demand for an independent board of directors.
5. Legal protection
The companies act and bodies such as the capital markets authority have played their role in
ensuring trying to minimize the agency conflict. Under the companies act, management and board of
directors owe a duty of care to shareholders and as such can face legal liability for their acts of
omission or commission that are in conflict with shareholders interests. The capital market authority
also has corporate governance guidelines.
6. Use of corporate governance principles which specify the manner in which organizations are
controlled and managed. The duties and rights of all stakeholders are outlined.
7. Stock option schemes for managers could be introduced. These entitle a manager to purchase
from the company a specified number of common shares at a price below market price over
duration. The incentive for managers to look at shareholders interests and not their own is that, if

they deliver and the company’s share price appreciates in the stock market then they will make a
profit from the sale.
8. Labour market actions such as hiring tried and tested professional managers and firing poor
performers could be used. The concept of 'head hunting' is fast catching on in Kenya as a way of
getting the best professional managers and executives in the market but at a fee of course.
Shareholders vs. creditors

In this relationship the shareholders (agent) are expected to manage the credit funds provided by the
creditors (principal). The shareholders manage these funds through management.
Debt providers/creditors are those who provide loan and credit facilities to the firm. They do this
after gauging the riskiness of the firm.
The following actions by shareholders through management could lead to a conflict between them
and creditors
1. Shareholders could invest in very risky projects-The management under the directive of the
shareholders may undertake highly risky investments than those anticipated by the providers
of long term debt finance. The creditors would not be interested in highly risky projects
because they stand to lose their funds when the investments collapse. Even if the risky
projects succeed they would not benefit because they only get a fixed rate of return.
2. The dividend payments to shareholders could be very high-An increase in the dividend rate in
most cases is financed by a decrease in investments. This in turn reduces the value of bonds.
If the firm is liquidating and it pays a liquidating dividend to its shareholders, the providers of
capital could be left with worthless claims.
3. Default on interest payments to bondholders
4. Shareholders could organize mergers which are not beneficial to creditors
5. Shareholders could acquire additional debt that increases the financial risk of the firm
6. Manipulation of financial statements so as to mislead creditors
7. Shareholders could dispose of assets which are security for the credit given
8. Under investments -The shareholders may invest in projects with a negative net present value.
9. The shareholders may adopt an aggressive management of working capital. This may bring
conflicts in liquidity position of the firm and would not be in the interest of the debt holders
Resolution of this conflict
1. Restrictive covenants- these are agreements entered into between the firm and the creditors to
protect the creditor’s interests.
These covenants may provide restrictions/control over:

i. Asset based covenants- These states that the minimum asset base to be maintained by
the firm.
ii. Liability based covenant- This limits the firm’s ability to incur more debt.
iii. Cashflow based covenant- States minimum working capital to be held by the firm.
This may restrict the amount of dividends to be paid in future.
iv. Control based covenant – Limits management ability to make various decisions e.g.
providers of debt fund may require to be represented in the BOD meetings.
2. Creditors could also offer loans but at above normal interest rates so as to encourage prompt
payment
3. Having a callability clause to the effect that a loan could be re-called if the conflict of interest
is severe
4. Legal action could also be taken against a company
5. Incurring agency costs such as hiring external auditors
6. Use of corporate governance principles so as to minimize the conflict.
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
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
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.

CHAPTER 2
SOURCES OF FINANCE
Introduction
Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern.
Sources of finance state that, how the companies are mobilizing finance for their requirements. The
companies belong to the existing or the new which need sum amount of finance to meet the long-
term and short-term requirements such as purchasing of fixed assets, construction of office building,
purchase of raw materials and day-to-day expenses.
Sources of finance may be classified under various categories according to the following important
heads:
1. Based on the Period – short term, Medium and Long term
2. Based on Sources of Generation – Internally and externally generated
FACTORS TO CONSIDER WHEN CHOOSING THE SOURCE OF FINANCE
1. Cost
Every source of finance carries some cost with it, known as cost of capital. While we talk
about debt financing, other than lenders expectation, advantage of tax deductibility indirectly
lowers down the cost of debt. The interest rate or coupon rate is the cost paid by the business
for using the debt capital. When the costs of two broad sources are compared, debt turns out
to be a cheaper source of finance, since the financial charges of debt is a tax deductable
expense whereas dividend is not
For e.g. If the Interest paid for long term debt is 10% (D) and tax rate is 50%(t), the effective
cost for such debt to business is:
D (1-t) = 10(1-50%) = 5%
2. Risk
A business is exposed to various kinds of risks. These risks should be considered while
deciding on source of finance. For e.g. in case, a firm relies majorly on debt financing, then
they are said to be highly leveraged as it bears high financial risk. That is, if debt repayments
are not made on time this can lead to legal action and hence there is a risk of bankruptcy.
High financial leverage also effects the earning per share. So, for deciding an optimal capital
structure a company should analyze the degree of leverage that it can tolerate.

3. Controlling
Controlling and management in the hands of the owner dilutes with more and more equity
introduced from outside in business. Promoters or owners who do not want to lose the control
of business and prefer to keep major decision making in their hand, will consider equity
financing only up to certain level.
4. Flexibility
It plays an important role in deciding the capital structure. A firm functions in a dynamic
business environment today. It should be able to respond to sudden shocks to its cash flows
stream. A highly leveraged firm may face shortage of cash during adverse conditions, which
may lead to sale of assets etc for generation of cash. Also, in extreme cases, a firm may have
to take a step of capital restructuring or even liquidation on the worst side.
5. Floatation cost
This is the costs incurred by a publicly traded company when it issues new securities.
Flotation costs are paid by the company that issues the new securities and includes expenses
such as underwriting fees, legal fees and registration fees. Companies must consider the
impact these fees will have on how much capital they can raise from a new issue.
6. Regulatory rules
Regulatory rules of various bodies also need to be adhered. In case of market listing (IPO),
rules framed by respective legal bodies of different countries have to comply by. For instance,
the legal body in Kenya is Nairobi Securities Exchange (NSE) and in the US is SEC.
INTERNALLY AND EXTERNALLY GENERATED FINANCES
Sources of Finance may be classified into various categories based on the period.
INTERNAL SOURCES
Internal Sources of Finance are the sources of finance or capital for business firms which are
generated by the business itself in its normal course of operations.
Internal source of finance includes

● Retained earnings
● Depreciation funds
● Surplus

EXTERNAL SOURCES
This is the money raised from outside the business
External sources of finance may be include

● Share capital
● Debenture
● Public deposits
● Loans from Banks and Financial institutions
Ordinary shares
Equity Shares also known as equity shares, which means, other than preference shares. Equity
shareholders are the real owners of the company. They have a control over the management of the
company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share
capital cannot be redeemed during the lifetime of the company. The liability of the equity
shareholders is the value of unpaid value of shares.
Features of Equity/ordinary Shares
Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital, which has no
maturity period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying
fixed rate of dividend to preference shareholder. The earnings or the income available to the
shareholders is equal to the profit after tax minus preference dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders
have the right to get the claims on assets. These rights are only available to the equity
shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have
power to control the management of the company and they have power to take any decision
regarding the business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the
help of voting right power; they can change or remove any decision of the business concern.
Equity shareholders only have voting rights in the company meeting and also they can
nominate proxy to participate and vote in the meeting instead of the shareholder.
6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal
right of the existing shareholders. It is attested by the company in the first opportunity to
purchase additional equity shares in proportion to their current holding capacity.
7. Limited liability: Equity shareholders are having only limited liability to the value of shares
they have purchased. If the shareholders are having fully paid up shares, they have no
liability. For example: If the shareholder purchased 100 shares with the face value of Rs. 10
each. He paid only Sh. 900. His liability is only Sh. 100.
Total number of shares 100 Face value of

shares Sh. 10
Total value of shares 100 × 10 = 1,000
Paid up value of shares 900
Unpaid value/liability 100
Liability of the shareholders is only unpaid value of the share (that is Sh. 100).
Advantages of Equity Shares
Equity shares are the most common and universally used shares to mobilize finance for the
company. It consists of the following advantages.
1. Permanent sources of finance: Equity share capital is belonging to long-term permanent

nature of sources of finance; hence, it can be used for long-term or fixed capital requirement
of the business concern.
2. Voting rights: Equity shareholders are the real owners of the company who have voting
rights. This type of advantage is available only to the equity shareholders.
3. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of dividend.
If the company earns profit, equity shareholders are eligible for profit, they are eligible to get
dividend otherwise, and they cannot claim any dividend from the company.
4. Less cost of capital: Cost of capital is the major factor, which affects the valueof the
company. If the company wants to increase the value of the company, they have to use more
share capital because, it consists of less cost of capital (Ke) while compared to other sources
of finance.
5. Retained earnings: When the company have more share capital, it will be suitable for
retained earnings which is the less cost sources of finance while compared to other sources of
finance.
Disadvantages of Equity Shares
1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business concern.
It is the most dangerous thing of over capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in management by
manipulation and organizing themselves. Because, they have power to contrast any decision
which are against the wealth of the shareholders.
3. Leads to speculation: Equity shares dealings in share market lead to secularism during
prosperous periods.
4. Limited income to investor: The Investors who desire to invest in safe securities with a
fixed income have no attraction for equity shares.
5. No trading on equity: When the company raises capital only with the help of equity, the
company cannot take the advantage of trading on equity.
PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is the shares, which have
preferential right to get dividend and get back the initial investment at the time of winding up of the
company. Preference shareholders are eligible to get fixed rate of dividend and they do not have
voting rights.
Preference shares may be classified into the following major types:
1. Cumulative preference shares: Cumulative preference shares have right to claim dividends
for those years which have no profits. If the company is unable to earn profit in any one or
more years, C.P. Shares are unable to get any dividend but they have right to get the
comparative dividend for the previous years if the company earned profit.
2. Non-cumulative preference shares: Non-cumulative preference shares have no right to
enjoy the above benefits. They are eligible to get only dividend if the company earns profit
during the years. Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When, the preference shares have a fixed maturity period it
becomes redeemable preference shares. It can be redeemable during the lifetime of the
company. The Company Act has provided certain restrictions on the return of the redeemable
preference shares.
Irredeemable Preference Shares
Irredeemable preference shares can be redeemed only when the company goes for liquidator. There
is no fixed maturity period for such kind of preference shares.
Participating Preference Shares

Participating preference shareholders’ have right to participate extra profits after distributing the
equity shareholders.
Non-Participating Preference Shares

Non-participating preference shareholders’ are not having any right to participate extra profits after
distributing to the equity shareholders. Fixed rate of dividend is payable to the type of shareholders.
Convertible Preference Shares
Convertible preference shareholders’ have right to convert their holding into equity shares after a
specific period. The articles of association must authorize the right of conversion.
Non-convertible Preference Shares

There shares, cannot be converted into equity shares from preference shares.
Features of Preference Shares
The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity period except in the
case of redeemable preference shares. Preference shares can be redeemable only at the time
of the company liquidation.
2. Residual claims on income: Preferential shareholders have a residual claim on income.
Fixed rate of dividend is payable to the preference shareholders.
3. Residual claims on assets: The first preference is given to the preference shareholders at the
time of liquidation. If any extra Assets are available that should be distributed to equity
shareholder.
4. Control of Management: Preference shareholder does not have any voting rights. Hence,
they cannot have control over the management of the company.
Advantages of Preference Shares
Preference shares have the following important advantages.

1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is called as
fixed income security because it provides a constant rate of income to the investors.
2. Cumulative dividends: Preference shares have another advantage which is called cumulative
dividends. If the company does not earn any profit in any previous years, it can be
cumulative with future period dividend.
3. Redemption: Preference Shares can be redeemable after a specific period except in the case
of irredeemable preference shares. There is a fixed maturity period for repayment of the
initial investment.
4. Participation: Participative preference shareholders can participate in the surplus profit after
distribution to the equity shareholders.
5. Convertibility: Convertibility preference shares can be converted into equity shares when the
articles of association provide such conversion.

Disadvantages of Preference Shares
1. Expensive sources of finance: Preference shares have high expensive source of finance
while compared to equity shares.
2. No voting right: Generally preference shareholders do not have any voting rights. Hence
they cannot have the control over the management of the company.
3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They may not
enjoy more profits of the company.
4. Permanent burden: Cumulative preference shares become a permanent burden so far as the
payment of dividend is concerned. Because the company must pay the dividend for the
unprofitable periods also.
5. Taxation: In the taxation point of view, preference shares dividend is not a deductible
expense while calculating tax. But, interest is a deductible expense. Hence, it has
disadvantage on the tax deduction point of view.
DEFERRED SHARES
Deferred shares also called as founder shares because these shares were normally issued to founders.
The shareholders have a preferential right to get dividend before the preference shares and equity
shares. According to Companies Act 1956 no public limited company or which is a subsidiary of a
public company can issue deferred shares.
These shares were issued to the founder at small denomination to control over the management by
the virtue of their voting rights.
NO PAR SHARES
When the shares are having no face value, it is said to be no par shares. The company issues this
kind of shares which is divided into a number of specific shares without any specific denomination.
The value of shares can be measured by dividing the real net worth of the company with the total
number of shares.
Value of no. per share

ℎ ℎ=
Total no. of shares
Debentures
A Debenture is a document issued by the company. It is a certificate issued by the company under its
seal acknowledging a debt.
According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other
securities of a company whether constituting a charge of the assets of the company or not.”

Types of Debentures
Debentures may be divided into the following major types:

1. Unsecured debentures: Unsecured debentures are not given any security on assets of the
company. It is also called simple or naked debentures. These types of debentures are treated
as unsecured creditors at the time of winding up of the company.
2. Secured debentures: Secured debentures are given security on assets of the company. It is
also called as mortgaged debentures because these debentures are given against any mortgage
of the assets of the company.
3. Redeemable debentures: These debentures are to be redeemed on the expiry of a certain
period. The interest is paid periodically and the initial investment is returned after the fixed
maturity period.
4. Irredeemable debentures: These kind of debentures cannot be redeemable during the life
time of the business concern.
5. Convertible debentures: Convertible debentures are the debentures whose holders have the
option to get them converted wholly or partly into shares. These debentures are usually
converted into equity shares. Conversion of the debentures may be:
Non-convertible debentures Fully convertible
debentures Partly convertible debentures
6. Other types: Debentures can also be classified into the following types. Some of the
common types of the debentures are as follows:
1. Collateral Debenture
2. Guaranteed Debenture
3. First Debenture
4. Zero Coupon Bond
5. Zero Interest Bond/Debenture
Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period. Normally,

debentures consist of 10–20 years maturity period and are repayable with the principle
investment at the end of the maturity period.
2. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at
every end of the accounting period. Debenture holders have priority of claim in income of the
company over equity and preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on Assets of the
company over equity and preference shareholders. The Debenture holders may have either
specific change on the Assets or floating change of the assets of the company. Specific
change of Debenture holders are treated as secured creditors and floating change of
Debenture holders are treated as unsecured creditors.
4. No voting rights: Debenture holders are considered as creditors of the company. Hence they
have no voting rights. Debenture holders cannot have the control over the performance of the
business concern.
5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period. Hence
the business will not affect the yield of the debenture.
Advantages of Debenture
Debenture is one of the major parts of the long-term sources of finance which of consist the
following important advantages:
1. Long-term sources: Debenture is one of the long-term sources of finance to the company.
Normally the maturity period is longer than the other sources of finance.
2. Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it is most
suitable of the companies earn higher profit. Generally, the rate of interest is lower than the
other sources of long-term finance.
3. Trade on equity: A company can trade on equity by mixing debentures in its capital
structure and thereby increase its earnings per share. When the company applies the trade on
equity concept, cost of capital will reduce and value of the company will increase.
4. Income tax deduction: Interest payable to debentures can be deducted from the total profit
of the company. So it helps to reduce the tax burden of the company.
5. Protection: Various provisions of the debenture trust deed and the guidelines issued by the
SEB1 protect the interest of debenture holders.
Disadvantages of Debenture
Debenture finance consists of the following major disadvantages:

1. Fixed rate of interest: Debenture consists of fixed rate of interest payable to securities. Even
though the company is unable to earn profit, they have to pay the fixed rate of interest to
debenture holders; hence, it is not suitable to those company earnings which fluctuate
considerably.
2. No voting rights: Debenture holders do not have any voting rights. Hence, they cannot have
the control over the management of the company.
3. Creditors of the company: Debenture holders are merely creditors and not the owners of the
company. They do not have any claim in the surplus profits of the company.
4. High risk: Every additional issue of debentures becomes more risky and costly on account of
higher expectation of debenture holders. This enhanced financial risk increases the cost of
equity capital and the cost of raising finance through debentures which is also high because
of high stamp duty.
5. Restrictions of further issues: The company cannot raise further finance through debentures
as the debentures are under the part of security of the assets already mortgaged to debenture
holders.
INTERNAL FINANCE
A company can mobilize finance through external and internal sources. A new company may not
raise internal sources of finance and they can raise finance only external sources such as shares,
debentures and loans but an existing company can raise both internal and external sources of finance
for their financial requirements. Internal finance is also one of the important sources of finance and
it consists of cost of capital while compared to other sources of finance.
Internal source of finance may be broadly classified into two categories:

A. Depreciation Funds
B. Retained earnings
Depreciation Funds
Depreciation funds are the major part of internal sources of finance, which is used to meet the
working capital requirements of the business concern. Depreciation means decrease in the value of
asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. Generally
depreciation is changed against fixed assets of the company at fixed rate for every year. The purpose
of depreciation is replacement of the assets after the expired period. It is one kind of provision of
fund, which is needed to reduce the tax burden and overall profitability of the company.
Retained Earnings
Retained earnings are another method of internal sources of finance. Actually is not a method of
raising finance, but it is called as accumulation of profits by a company for its expansion and
diversification activities.
Retained earnings are called under different names such as; self finance, inter finance, and plugging
back of profits. According to the Companies Act 1956 certain percentage, as prescribed by the
central government (not exceeding 10%) of the net profits after tax of a financial year have to be
compulsorily transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a part of the total profits is transferred to various
reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds
and secrete reserves, etc.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:

1. Useful for expansion and diversification: Retained earnings are most useful to expansion
and diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the least costly sources of
finance since it does not involve any floatation cost as in the case of raising of funds by
issuing different types of securities.
3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the
companies use debt finance, they have to pay interest. But if the company uses retained
earnings as sources of finance, they need not pay any fixed obligation regarding the payment
of dividend or interest.
4. Flexible sources: Retained earnings allow the financial structure to remain completely
flexible. The company need not raise loans for further requirements, if it has retained
earnings.
5. Increase the share value: When the company uses the retained earnings as the sources of
finance for their financial requirements, the cost of capital is very cheaper than the other
sources of finance; Hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in
a company when it has small number of shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is
most suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:

1. Misuses: The management by manipulating the value of the shares in the stock market can
misuse the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of
the company.
3. Over capitalization: Retained earnings lead to over capitalization, because if the company
uses more and more retained earnings, it leads to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden
through the retained earnings.
5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder
can’t get more dividends. So, the shareholder does not like to use the retained earnings as
source of finance in all situations.
LOAN FINANCING
Loan financing is the important mode of finance raised by the company. Loan finance may be
divided into two types:
(a) Long-Term Sources
(b) Short-Term Sources

Loan finance can be raised through the following important institutions.
Loan Financing Institutions
Commercial Development Specialist

Banks Banks Institutions
Foreign
Short-term Long-term Direct Indirect Domestic
Currency
Advance Loans Finance Finance Finance
Finance
Financial Institutions
With the effect of the industrial revaluation, the government established nationwide and state wise
financial industries to provide long-term financial assistance to industrial concerns in the country.
Financial institutions play a key role in the field of industrial development and they are meeting the
financial requirements of the business concern. IFCI, ICICI, IDBI, SFC, EXIM Bank, ECGC are the
famous financial institutions in the country.
Commercial Banks
Commercial Banks normally provide short-term finance which is repayable within a year. The major
finance of commercial banks is as follows:
Short-term advance: Commercial banks provide advance to their customers with or without
securities. It is one of the most common and widely used short-term sources of finance, which are
needed to meet the working capital requirement of the company.
It is a cheap source of finance, which is in the form of pledge, mortgage, hypothecation and bills
discounted and rediscounted.

Short-term Loans
Commercial banks also provide loans to the business concern to meet the short-term financial
requirements. When a bank makes an advance in lump sum against some security it is termed as
loan. Loan may be in the following form:
(a) Cash credit: A cash credit is an arrangement by which a bank allows his customer to borrow
money up to certain limit against the security of the commodity.
(b) Overdraft: Overdraft is an arrangement with a bank by which a current accountholder is
allowed to withdraw more than the balance to his credit up to a certain limit without any
securities.
Development Banks
Development banks were established mainly for the purpose of promotion and development the
industrial sector in the country. Presently, large numbers of development banks are functioning with
multidimensional activities. Development banks are also called as financial institutions or statutory
financial institutions or statutory non-banking institutions. Development banks provide two
important types of finance:
(a) Direct Finance

(b) Indirect Finance/Refinance
Presently the commercial banks are providing all kinds of financial services including development-
banking services. And also nowadays development banks and specialisted financial institutions are
providing all kinds of financial services including commercial banking services. Diversified and
global financial services are unavoidable to the present day economics. Hence, we can classify the
financial institutions only by the structure and set up and not by the services provided by them.

CHAPTER 3
FINANCIAL MARKETS AND SYSTEMS
Financial Market, in very crude terms, is a place where the savings from various sources like
households, government, firms and corporates are mobilized towards those who need it.
Alternatively put, financial market is an intermediary which directs funds from the savers (lenders)
to the borrowers.
In other words, financial market is the place where assets like equities, bonds, currencies, derivatives
and stocks are traded.
Some of the salient features of financial market are:
 Transparent pricing
 Basic regulations on trading
 Low transaction costs
 Market determined prices of traded securities
ROLES AND IMPORTANCE OF FINANCIAL MARKETS AND SYSTEM
One of the important sustainability requisite for the accelerated development of an economy is the
existence of a dynamic financial market. A financial market helps the economy in the following
manner.
 Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments etc. is
an important role played by financial markets.
 Investment: Financial markets play a crucial role in arranging to invest funds thus collected
in those units which are in need of the same.
 National Growth: An important role played by financial market is that, they contribute to a
nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds
for productive purposes is also made possible.
 Entrepreneurship growth: Financial market contribute to the development of the
entrepreneurial claw by making available the necessary financial resources.
 Industrial development: The different components of financial markets help an accelerated
growth of industrial and economic development of a country, thus contributing to raising the
standard of living and the society of well-being.

MARKET PARTICIPANTS:
The principle participants in the financial market are as follows:
Banks: largest provider of funds to business houses and corporates through accepting deposits.
Banks are the major participant in the financial market.
Insurance companies: issue contracts to individuals or firms with a promise to refund them in
future in case of any event and thereby invest these funds in debt, equities, properties, etc.
Finance companies: engages in short to medium term financing for businesses by collecting funds
by issuing debentures and borrowing from general public.
Merchant banks: funded by short term borrowings; lend mainly to corporations for foreign currency
and commercial bills financing.
Companies: the surplus funds generated from business operations are majorly invested in money
market instruments, commercial bills and stocks of other companies.
Mutual funds: acquire funds mainly from the general public and invest them in money market,
commercial bills and shares. Mutual fund is also principle participant in financial market.
Government: authorized dealers basically look after the demand-supply operations in financial
market. Also works to fill in the gap between the demand and supply of funds.
FINANCIAL INNOVATION
Miller, Silber and Van Horme characterize and describe financial innovations as an unanticipated
improvement in the array of financial products and instruments that are stimulated by unexpected
tax or regulatory impulses.
They cite the following examples;
1) The Eurobond market emerged in response to a 30% withholding tax imposed by the US
government on interest payment on bonds sold in the US to overseas investors.
2) Zero coupon bonds were offered to exploit the mistake of the internal revenue service in the
US which permitted deduction of the same amount each year for tax purposes. (the tax
authority employed simple interest and not compound interest)
3) Financial futures came into being when Bretton woods system of fixed exchange rates was
abandoned in the early 1970s.
4) Paper currency was invented when the British government prohibited the minting of coins by
the colonial North America.
5) The euro dollar market was developed in response to the regulation in the US that imposed a
ceiling on the interest rate payable on time deposits with commercial banks.

6) Financial swaps emerged initially in response to a restriction imposed by the British
government on dollar financing by British firms and sterling financing by non British
Financial innovations refer to development of new products, formation of new institutions,

embracing new technology and other aspects that portray newness in the financial markets.
The common types of financial innovations in regard to development of new products are swaps,
Eurobonds, Zero coupons bonds, portfolio insurance, and options.
Factors responsible for financial innovations;
i. High level of transaction costs

ii. Need to reduce agency costs
iii. Existing opportunities to increase liquidity of assets for example, factoring of debts.
iv. Regulatory and legislative changes which leads to volatility of interest and exchange rates.
v. The move to floating exchange rates; the major fluctuations in exchange rates have added
uncertainty to all international transactions
vi. Computers and information technology- computers can be used to design and develop new
products and strategies since they can provide for a large data processing capacity
vii. The world economic growth: - evidence has it that the growth in the world economy can be
attributed to improvement in financial performance.
viii. Regulations and deregulations: some innovations are propelled by government regulations for
example swaps
ix. Cross listing of securities across stock exchanges.
Other activities that portray financial innovations include; Strategic decision making, system
realignment, institutional setting, injecting new management, expanding to new markets
Financial innovations enable institutions to raise their competitive strengths, improve their risk
management skills and better satisfy the needs of their customers and market requirements.
The main types of financial innovations include;
a) Institutional innovations
b) Process innovations
c) Product innovations
Institutional Innovations
-Includes, changes in business structure, establishment of new types of financial intermediaries, or

changes in the legal and supervisory framework. For example; introduction of Credit Reference
Bureaus
-Mobile banking involves provision and availing banking and financial services with the help of
mobile telecommunication devices.
-Banks getting into investment banking services – Commercial banks are moving to acquire stock
brokerage and investment banks to get involved in the stock market activity.
-Banks offering insurance services on behalf of insurance companies
-Islamic Banking – Banking that is guided by Islamic law or Islamic Sharia Law
Process Innovations
These innovations include the introduction of new business processes leading to increased efficiency
and market expansion. Among the main process innovations include; office automation, use of
computers in accounting systems and client data management software.
Among the main innovations include;
-Electronic Banking – Mainly takes the form of Automated Teller Machines (ATM), Internet
Banking and telephone transactions. Access to the banking services is thus convenient, fast and
available throughout the clock. Banks are also able to provide services more efficiently and at
relatively low cost. Transactions are effected in batches
-Real Time Gross Settlement (RTGS)
RTGS system is a funds transfer mechanism where transfer of money takes place from one bank to
another on a “real time” and Gross basis. Real time means the transactions are processed as they are
received. Gross settlement means the transactions are settled on one to one basis without bunching
with any other transaction.
RTGS system is primarily for large value transactions. As soon as transactions are remitted by the
paying bank they are credited in the receiving bank. Transactions are effected continuously
Product Innovations
Include introduction of new deposit accounts, new credit arrangement, credit cards, debit cards,
insurance and other financial products. Product innovations are introduced to respond better to
changes in market demand or to improve efficiency.
Among the main product innovations include;
- Business Club concept

- Personal unsecured loans
- Money transfer services
- Products tailored to favour certain groups; Diva, X bank accounts of Standard Chartered

The Role of the State in Financial Innovations
-Influences financial innovations through regulations

-Government should actively drive the construction of a market environment that is
suitable for financial innovations, promote the formation of fair trading rules for financial
innovation activities, create a market environment for fair competition, and establish a
good order for financial competition
Benefits of Financial Innovations
-Greater efficiency and diversity in financial intermediation as a result of financial

innovation which increase productivity and growth potential of the economy
-Funds are made available at lower costs
-Many financial products are available to investors and depositors
-Enhances financial stability
Demerits of Financial Innovations

-Financial institutions engage in high risk behaviour
-Some risks may not be visible or may be unknown which can expose the financial system
to shocks
-Promotes Money laundering
-May course moral hazard especially if too much credit is extended
- Increased Crime rates through the ATMs, mobile banking and so on.
Financial innovation and flow of funds
In modern economy funds flow from savers i.e. those having surplus to financial institutions that
facilitate the transactions. Then from this financial institution e.g. banks funds moves to investors
i.e. deficit units who identify long term investment opportunities therefore the deficit unit get direct
external finance due to flow of funds in the market therefore facilitate innovation and flow of funds
intermediaries i.e. financial institutions are necessary between surplus unit and deficit units.
Financial intermediation is the process of linking deficit units to surplus units.
Innovation in credit derivatives has made it easier to trade and hedge credit risk. Access to credit
was extended on a dramatic scale to less credit worth borrowers without a commensurate increase in
the risk premiums on the securities increase that embedded this more risky credit.
As a consequence of this basic evolution of financial system a large share of financial assets ended
up in institutions in many cases these assets are being funded with short term obligations. Just like
banks are vulnerable to erosion in market liquidity. Changes in the structure of financial will cause
finance boom in many respects financial innovation have outpaced the system’s capacity to measure
and limit risk to manage the incentive problems in the securitization process. We would rather have
today’s financial system however fraud is about 97.3% of all financial innovations are just new ways
to fleece customers/hide risk and all wages financial crises have been associated with this.
Financial intermediation and Dis-intermediation
Financial intermediation is the process of linking the public and financial markets players. Financial
dis-intermediation is the removal of the link. Financial intermediaries (stock brokers) are middle
men between investing public on one hand and securities exchange on the other hand. They: -
1. Act on the behalf of the public

2. Provide information to potential shareholders
3. They mediate between savers and investors. Examples of intermediaries are: commercial
banks, Sacco’s, credit unions, pension funds, life insurance companies and investment banks
among others
4. Give advice to investors and firms
5. They also do valuation funds which need to merge
6. They give defensive tactics in case of forced takeovers
7. Also underwrites securities
Depository financial market intermediates firms and accepts market deposits, transfer loans, from
buyers to sellers of securities, they avail loans in addition to managing investments and providing
advices.
Non-depository financial market intermediaries collect surplus funds and channel them to co-
operation and individuals with deficit. They collect fund from many individuals aggregate them and
channel them to corporations and individuals that need them.
Challenges of financial intermediation and regularities of markets
This linking process has faced challenges which affect the functioning of the S.E markets e.g.
1. There is a failure to mobilize saving for investment in the productive enterprises.

2. Also the growth of related financial sector such as micro-finances has reduced the players in
the market to the funds.
3. The process is also faced by flight of capital which takes place because of local inflation and
currency depreciation.
4. The market environment is unpredictable hence difficult to give proper advice to investors.
5. Market regulators such as capital market authority, central bank, retirement benefit authority
and insurance regulatory authority have failed to regulate trading in securities hence the
public/investors are left in the hands of unqualified intermediaries therefore gaining very little
from the transaction

TYPES OF FINANCIAL MARKETS
Within the financial sector, the term "financial markets" is often used to refer just to the markets that
are used to raise finance: for long term finance, the Capital markets; for short term finance, the
Money markets. Another common use of the term is as a catchall for all the markets in the financial
sector, as per examples in the breakdown below.
 Capital markets which consist of:

o Stock markets, which provide financing through the issuance of shares or common
stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of financial risk.
 Futures markets, which provide standardized forward contracts for trading products at some
future date; see also forward market.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign exchange.
CHARACTERISTICS OF A GOOD MARKET

Financial markets have been found to be fairly good (perfect) in the advanced economies as well as
many number of emerging capital markets. The following are characteristics of a good market
1. No entry barriers
Anyone can participate in the market therefore the suppliers/users of funds can enter the market and
deal with each other
2. Large no. of buyers and sellers

The market is ensured by the presence of large number of buyers and sellers of securities. No single
market participant should be large enough to influence the security prices.
3. Divisibility of financial asset

Financial assets are divisible and therefore affordable investments are made by all participants.
4. Absence of transaction cost

Participants can buy and sell securities with care and without much cost.
5. No tax differences
Ideally there are no taxes; one set of investors should not be favored over others
6. Free trading-Anyone is free to trade in securities.

FUNCTIONS OF FINANCIAL MARKETS
 Intermediary Functions: The intermediary functions of a financial markets include the

following:
o Transfer of Resources: Financial markets facilitate the transfer of real economic
resources from lenders to ultimate borrowers.
o Enhancing income: Financial markets allow lenders to earn interest or dividend on
their surplus invisible funds, thus contributing to the enhancement of the individual
and the national income.
o Productive usage: Financial markets allow for the productive use of the funds
borrowed. The enhancing the income and the gross national production.
o Capital Formation: Financial markets provide a channel through which new savings
flow to aid capital formation of a country.
o Price determination: Financial markets allow for the determination of price of the
traded financial assets through the interaction of buyers and sellers. They provide a
sign for the allocation of funds in the economy based on the demand and to the supply
through the mechanism called price discovery process.
o Sale Mechanism: Financial markets provide a mechanism for selling of a financial
asset by an investor so as to offer the benefit of marketability and liquidity of such
assets.
o Information: The activities of the participants in the financial market result in the
generation and the consequent dissemination of information to the various segments of
the market. So as to reduce the cost of transaction of financial assets.
 Financial Functions
o Providing the borrower with funds so as to enable them to carry out their investment
plans.
o Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.
o Providing liquidity in the market so as to facilitate trading of funds.
o Providing liquidity to commercial bank
o Facilitating credit creation
o Promoting savings
o Promoting investment
o Facilitating balanced economic growth
o Improving trading floors

FLOWS OF FUNDS AND THE FINANCIAL SYSTEMS
In every country, the general flows of funds through the financial system can be represented
like this:
(Note: sometimes the counterpart to a (blue) security flow can also a security flow rather than
(yellow) money.)
The above flows represent only financial investments. They are funneled directly by financial
markets, and indirectly by banks and other financial intermediaries, from lenders to borrowers.
Terminology
The lenders are also called:
 the investors
 the buyers of financial securities
 the savers
Conversely, the borrowers are also called:
 the sellers
 the issuers of financial securities
 the spenders
The other big flows

There are several other big pictures of flows, of an economic nature, in society:
1. the flows of purchases of goods and services by households:

o money: households -> firms
o goods and services: firms -> households
2. the flows of work, sold by individuals to firms (in other words, the labor market)

o work: individuals -> firms
o salaries (money): firms -> individuals
3. the flows of other purchases by firms
4. the flows of physical investments by firms
5. the flows of repayments of loans by borrowers to lenders
6. the flows of taxes of various sorts (VAT, indirect taxes) etc
Flows of liabilities
The characteristic of the flows of funds and of financial securities (as counterparts) is that there is no
tangible goods or services or any other tangible values involved. It is only a flow of liabilities. (It is
also the case of items 5 and 6 in the above list.)
Liabilities are financial securities and have value

When studying financial markets, one must keep in mind this fundamental fact: money and other
financial securities are only signs of liabilities between economic agents. When I owe you $100 (or
whatever, for that matter) to be paid in some specified future, it is a liability (linking me to you),
which is an asset for you (an asset of a financial nature) and a pure liability for me.
The role of money, financial products, and financial markets is to distribute these liabilities (by
definition, involving time) among economic agents, to make the economic system function.
ORGANISATION AND STRUCTURE OF SECURITIES MARKETS

Securities market can be divided into three categories: -
a) Capital and money markets.

b) Primary and secondary markets
c) Organized and over — the counter markets.
Primary and secondary market

Primary financial markets are those markets where there is transfer of new financial instruments.
Financial instruments constitute assets, which are used in the financial markets. They consists of
cash, shares and debt capital both long term and short-term e.g. commercial paper.
The primary financial markets trade is for securities which have not been issued e.g. if a company
wants to make an issue of ordinary share capital issue of commercial paper, issues of preference
shares, debentures etc, offers and purchase will be through the primary etc.
Secondary markets — the secondary financial markets are for already issued securities. After a
thorough issue of new securities in the primary market later trading of the securities will take place
in secondary market e.g. if a company is to make public issue of ordinary share capital the issue will
take place in primary market. If the initial purchasers wish to dispose off the shares, trading will take
place in the secondary market. The only distinction between primary and secondary markets is the
form of security being traded but there is no physical separation of the markets.
Capital and money markets
This classification is based on the maturity of financial instruments. The capital market is a financial
market for long-term securities. The securities traded in these markets include shares and bonds.
The money market is market for short-term securities. The securities traded in these markets include
promissory notes, commercial paper, treasury bills and certificates of deposits while capital market
is regulated by capital authority; the money market is regulated by central banks.
Organized and over- counter markets

An organized market is a market which is a specified place of security trading, defined rules,
regulations and procedures for security trading. Only listed securities trade in organized market,
where exchange is through licensed brokers who are members of exchange
Conducted by accountants, auctioneers, estate agents and lawyers who were engaged in other areas
of specializations.
In 1951 an estate agent (Francis Drummond) established the first stock broking firm. He then
approached the finance minister of Kenya with an idea of setting up a stock exchange in East Africa.
in 1953 he too approached London Stock Exchange Officer and London accepted to recognize the
setting up of Nairobi Stock Exchange as an oversee stock exchange. The major reorganization
emerged in 1954 when stockbrokers emerged and registered the NSE as a voluntary association
under society’s Act. It was registered as a limited liability company.
Stock exchange terms

1. Broker
Is an agent who buys and sells securities in the Market on behalf of his client on a commission basis.
He also gives advice to his client and at times manages the portfolio for his client. In connection
with the new issue, a broker will advise on price to be charged, will submit the necessary documents
to the quotation department the stock exchange and the capital market authority. He may be
involved in arranging for funds or for the purchase of shares and may underwrite the issue (assure
the company that shares are sold if not broker will buy them).
2. Jobber:
He is a dealer. He is not an agent but a principal who buys and sells securities in his own name. His
profit is referred to as Jobber’s turn. Since they are experts in the markets, they are not allowed to
deal with general public but only with brokers or other jobbers to avoid exploitation of individual
investors. A Jobber will quote two prices for a share.
The bid price-which is the price at which he is willing to buy securities
Offer price-price at which he is willing to sell the shares.

The difference between offer price and the bid price is called spread price = Ask price - Bid price. A
Jobber will take stocks in his books (also called along sale) when brokers have predominantly
selling orders, and will also sell short (Short sale) when brokers are engaged in buying.
3. Bulls
Speculators in the market who believe that the main market movement is upwards and therefore buy
securities now hoping to sell them at a higher price in the future
4. Bears
These are speculators in the market who believe that the main market movement is downwards
therefore securities now hoping to buy them back later at a lower price.
5. Stags
These are speculators in the market who buy new shares because they believe that the price Set by
issuing company is usually lower than the theoretical value and that when shares are later dealt with
in the stock-exchange the share price will increase and they will be able to sell them at profit.
CAPITAL MARKET INSTRUMENTS

This is a market for issuing long-term funds.
They include:
i) Common share/ordinary share
ii) Preference share
iii) Debentures
iv) Treasury Municipal bonds
v) Warrants & Convertible
vi) Terms loans
vii) Mortgages
Services rendered by capital markets
1. It offers long term finance which is necessary for acquisition of fixed assets of companies and
for development purpose generally.
2. Market provides permanent finance necessary for a strong financial base of going concerns
e.g. share capital, irredeemable preference shares, convertible debentures and convertible
preference shares.
3. The market provide services in the form of advice to investors as to which investments are
viable and can answer their investment needs e.g. advice given by stock exchange brokers to
their investing public
4. Enables companies and individuals to obtain long term finance which they can then sale in
the money market in form of short term loans therefore serving as a source of livelihoods to
such party
5. The market acts as a channel through which foreign investment find their way into Kenya in
form of foreigners buying shares in Kenya which they have to buy using their currencies
which brings in need foreign exchange.
6. The market is responsible for an orderly secondary market which facilitates the liquidation of
long term investments.
Reasons why capital markets are more developed in Kenya than money market
1. It’s easier to get access to capital market because in most cases the goodwill of the borrower
may not be necessary and at the same time such finance may not call for security as the asset
in question acts as its own security e.g. mortgage finance
2. There less risks of misuse of funds from this market because these are available in form of
fixed asset whose title remains with the lender, therefore less chances of
manipulation/misappropriation which is a characteristic of finance from money market.
3. Long term finances available in this market are relatively cheaper because inflation reduces
the latter payments of interest and principle in real monetary funds
4. Long term investments using permanent long term finance are capable for paying for
themselves which may not entail further financial strain on the borrower therefore making it
attractive finance.
5. Kenya as a developing country requires long term investment for accumulation of fixed asset
and other long term resources all of which necessitates the development of this capital market
as a base for the development of the economy in general
6. CBK has facilitated the development of this market by providing a conducive atmosphere for
setting up financial institutions which avail finance on long term basis such as building
societies, mortgage houses etc
7. Agriculture has and will remain the main stay of Kenyan market economy and this has led to
faster growth of agro-business industry which necessitates long term investment, this creation
of such institutions as agricultural on development of this market by instructing such financial
institutions as insurance companies to channel all their savings into long term finances and
also to avoid finance on long term basis to industries and buildings constructions.

Differences between money and capital market
Capital market Money market

In this market goodwill is not important but Goodwill of the borrower qualifies him for
rather the ability to raise security is what this finance
matters
Finance is obtained in kind e.g. in form of Finance is obtained in cash
assets
Finance is usually cheaper due to the Finance is usually more expensive
effects of inflation on this money
The market acts as channel through which Usually the market does not deal in foreign
foreign exchange gets its way into the exchange for investment reasons
country
Finance is secured against a fixed asset Finance is usually unsecured
Finance usually takes long time to raise due Finance takes short time to raise
to lot of formalities
Finance calls for intermediaries in form of Finance does not call for intermediaries
brokers when raising
Funds are not highly negotiable Funds from this market are highly
negotiable
Central bank controls this market , this is The market is not influenced very much by
done through selective credit control and the central bank through credit squeeze and
credit squeeze selective credit control
Serves big companies more than small Open to all companies regardless of their
companies size
History and organization of Nairobi securities exchange

In Kenya, dealing in shares and stocks started in the 1920's when the country was still a British
colony. However the market was not formal as there did not exist any rules and regulations to
govern stock broking activities. Trading took place on a ‘gentleman's agreement.’ Standard
commissions were charged with clients being obligated to honor their contractual commitments of
making good delivery, and settling relevant costs. At that time, stock broking was a sideline business
conducted by accountants, auctioneers, estate agents and lawyers who met to exchange prices over a
cup of coffee. Because these firms were engaged in other areas of specialization, the need for
association did not arise.
In 1951, an Estate Agent by the name of Francis Drummond established the first professional stock
broking firm. He also approached the then Finance Minister of Kenya, Sir Ernest Vasey and
impressed upon him the idea of setting up a stock exchange in East Africa. The two approached
London Stock Exchange officials in July of 1953 and the London officials accepted to recognize the
setting up of the Nairobi Stock Exchange as an overseas stock exchange.
In 1954 the Nairobi Stock Exchange was then constituted as a voluntary association of stockbrokers
registered under the Societies Act. Since Africans and Asians were not permitted to trade in
securities, until after the attainment of independence in 1963, the business of dealing in shares was
confined to the resident European community. At the dawn of independence, stock market activity
slumped, due to uncertainty about the future of independent Kenya.
1988 saw the first privatization through the NSE, of the successful sale of a 20% government stake
in Kenya Commercial Bank. The sale left the Government of Kenya and affiliated institutions
retaining 80% ownership of the bank.
Notably, on February 18, 1994 the NSE 20-Share Index recorded an all-record high of 5030 points.
The NSE was rated by the International Finance Corporation (IFC) as the best performing market in
the world with a return of 179% in dollar terms. The NSE also moved to more spacious premises at
the Nation Centre in July 1994, setting up a computerized delivery and settlement system (DASS).
For the first time since the formation of the Nairobi Stock Exchange, the number of stockbrokers
increased with the licensing of 8 new brokers.
In 1996, the largest share issue in the history of NSE, the privatization of Kenya Airways, came to
the market. Having sold a 26% stake to KLM, the Government of Kenya proceeded to offer
235,423,896 shares (51% of the fully paid and issued shares of Kshs.5.00 each) to the public at
Kshs.11.25 per share. More than 110,000 shareholders acquired a stake in the airline and the
Government of Kenya reduced its stake from 74% to 23%. The Kenya Airways Privatization team
was awarded the World Bank Award for Excellence for 1996 for being a model success story in the
divestiture of state-owned enterprises.
On Monday 11 September 2006 live trading on the automated trading systems of the Nairobi Stock
Exchange was implemented.
The East African Securities Exchanges Association came into being in 2004, following the signing
of a Memorandum of Understanding between the Dar-es-Salaam Stock Exchange, the Uganda
Securities Exchange and the Nairobi Stock Exchange.
In May 2006, NSE formed a demutualization committee to spearhead the process of

demutualization. A demutualization consultant (Ernst and Young) was appointed to advice on the
process.
In September 2006 live trading on the automated trading systems of the Nairobi Stock Exchange
was implemented. The ATS was sourced from Millennium Information Technologies (MIT) of
Colombo, Sri Lanka, who are also the suppliers of the Central Depository System (CDS). MIT have
also supplied similar solutions to the Colombo Stock Exchange and the Stock Exchange of

Mauritius. The NSE ATS solution was customized to uphold the spirit of the Open Outcry Trading
Rules in an automated environment.
In the same breadth, trading hours increased from two (10:00 am – 12:00 pm) to three hours (10:00
am – 1:00 pm). Other innovations included the removal of the block trades board and introduction of
the functionality for the trading of rights in the same manner as equities. Besides trading equities,
the ATS is also fully capable of trading immobilized corporate bonds and treasury bonds.
An MoU between the Nairobi Stock Exchange and Uganda Securities Exchange was signed in
November 2006 on mass cross listing. The MoU allowed listed companies in both exchanges to
dualist. This will facilitate growth and development of the regional securities markets.
In February 2007 NSE upgraded its website to enhance easy and faster access of accurate, factual
and timely trading information. The upgraded website is used to boost data vending business.
In July 2007 NSE reviewed the Index and announced the companies that would constitute the NSE
Share Index. The review of the NSE 20‐share index was aimed at ensuring it is a true barometer of
the market.
A Wide Area Network (WAN) platform was implemented in 2007 and this eradicated the need for
brokers to send their staff (dealers) to the trading floor to conduct business. Trading is now mainly
conducted from the brokers' offices through the WAN. However, brokers under certain
circumstances can still conduct trading from the floor of the NSE.
In 2008, the NSE All Share Index (NASI) was introduced as an alternative index. Its measure is an
overall indicator of market performance. The Index incorporates all the traded shares of the day. Its
attention is therefore on the overall market capitalization rather than the price movements of select
counters.
In April 2008, NSE launched the NSE Smart Youth Investment Challenge to promote stock market
investments among Kenyan Youths. The objective of the challenge is threefold:
 To occupy the minds of the youth positively and draw them away from the negative energy
created by the current political, economic and social situation in the country;
 Encourage the culture of thrift and saving funds amongst the university students;
 Encourage the youth to invest their savings in the capital markets.
After the resignation of Mr. Chris Mwebesa, the NSE Board appointed Mr. Peter Mwangi to be the
New NSE Chief Executive in November 2008.
The Complaints Handling Unit (CHU) was launched in August 2009 to bridge the confidence gap
with NSE retail investors. CHU provides a hassle free and convenient way to have any concerns

processed and resolved. Investors, both local and in the Diaspora can forward their issues via e‐mail,
telephone, fax, or SMS and have the ability to track progress on‐line.
The Nairobi Stock Exchange marked the first day of automated trading in government bonds
through the Automated Trading System (ATS) in November 2009. The automated trading in
government bonds marked a significant step in the efforts by the NSE and CBK towards creating
depth in the capital markets by providing the necessary liquidity.
In December 2009, NSE marked a milestone by uploading all government bonds on the Automated
trading System (ATS). Also in 2009, NSE launched the Complaints Handling Unit (CHU)
SMS System to make it easier for investors and the general public to forward any queries or
complaints to NSE
In July 2011, the Nairobi Stock Exchange Limited changed its name to the Nairobi Securities
Exchange Limited. The change of name reflected the strategic plan of the Nairobi Securities
Exchange to evolve into a full service securities exchange which supports trading, clearing and
settlement of equities, debt, derivatives and other associated instruments. In the same year, the
equity settlement cycle moved from the previous T+4 settlement cycles to the T+3 settlement cycle.
This allowed investors who sell their shares, to get their money three (3) days after the sale of their
shares. The buyers of these shares will have their CDS accounts credited with the shares, in the same
time.
In September 2011 the Nairobi Securities Exchange converted from a company limited by guarantee
to a company limited by shares and adopted a new Memorandum and Articles of Association
reflecting the change.
In October 2011, the Broker Back Office commenced operations. The system has the capability to
facilitate internet trading which improved the integrity of the Exchange trading systems and
facilitates greater access to our securities market.
In November 2011 the FTSE NSE Kenya 15 and FTSE NSE Kenya 25 Indices were launched. The
launch of the indices was the result of an extensive market consultation process with local asset
owners and fund managers and reflects the growing interest in new domestic investment and
diversification opportunities in the East African region.
As of March 2012, the Nairobi Securities Exchange became a member of the Financial Information
Services Division (FISD) of the Software and Information Industry Association (SIIA).
In March 2012 the delayed index values of the FTSE NSE Kenya 15 Index and the FTSE NSE
Kenya 25 Index were made available on the NSE website www.nse.co.ke. The new initiative gives
investors the opportunity to access current information and provides a reliable indication of the
Kenyan equity market’s performance during trading hours.

Market segments and eligibility requirements for listing of securities at Nairobi securities
exchange
The Official list is categorized into three different market segments approved by the Authority. The
segments have different eligibility and disclosure requirements prescribed by the Authority under
The Capital Markets (Securities) (Public Offers, Listing and Disclosures) Regulations, 2002 and
provided under Part V as appendices to these rules.
These market segments are:
(i) Main Investment Market Segment (MIMS)
(ii) Alternative Investment Market Segment (AIMS)
(iii) Growth Enterprise Market Segment (GEMS)
(iv) Fixed Income Securities Market Segment (FISMS)
Eligibility requirements for public offering of shares and listing
Main Investment Market Segment (MIMS
1. Incorporation status- The issuer to be listed shall be a public company limited by shares and
registered under the Companies Act (Cap. 486 of the Laws of Kenya).
2. Size: Share capital- The issuer shall have a minimum authorized issued and fully paid up
ordinary share capital of fifty million shillings
3. Net assets- Net assets immediately before the public offering or listing of shares should not
be less than one hundred million shillings.
4. Free transferability of share- Shares to be listed shall be freely transferable and not subject
to any restrictions on marketability or any pre-emptive rights.
5. Availability and reliability of financial records- The issuer shall have audited financial
statements complying with International Financial Reporting Standards (IFRS) for an
accounting period ending on a date not more than four months prior to the proposed date of
the offer or listing for issuers whose securities are not listed at the securities exchange, and
six months for issuers whose securities are listed at the securities exchange.
The Issuer must have prepared financial statements for the latest accounting period on a going
concern basis and the audit report must not contain any emphasis of matter or qualification in
this regard
6. Competence and suitability of directors and management - At the date of the application,
the issuer must not be in breach of any of its loan covenants particularly in regard to the
maximum debt capacity.
As at the date of the application and for a period of at least two years prior to the date of the
application, no director of the issuer shall have-any petition under bankruptcy or insolvency
laws in any jurisdiction pending or threatened against the director (for director (for
individuals), or any winding-up petition pending or threatened against it (for corporate
bodies);

- any criminal proceedings in which the director was convicted of fraud or any criminal
offence, nor be named the subject of pending criminal proceeding, or any other offence or
action either within or outside Kenya; or been the subject of any ruling of a court of
competent jurisdiction or any governmental body in any jurisdiction, that permanently or
temporarily prohibits such director from acting as an investment adviser or as a director or
employee of a Stockbroker, dealer, or any financial service institution or engaging in any type
of business practice or activity in that jurisdiction.
The issuer must have suitable senior management with relevant experience for at least one
year prior to the listing, none of whom shall have committed any serious offence in any
jurisdiction that may be considered inappropriate for the management of a listed company.
The issuer shall ensure continued retention of suitably qualified management during listing
and no change of management for a period of twelve months following the listing other than
for reason of a serious offence that may be considered to affect the integrity or be
inappropriate for management of a listed company.
The issuer must have at least a third of the Board as non-executive directors.
7. Dividend policy- The issuer must have a clear future dividend policy.
8. Solvency and adequacy of working capital- The issuer should not be insolvent. The issuer
should have adequate working capital.
9. Share ownership structure- Following the public share offering or immediately prior to
listing in the case of an introduction, at least twenty five per centum of the shares must be
held by not less than one thousand shareholders excluding employees of the issuer.
In the case of a listing by introduction, the issuer shall ensure that the existing shareholders,
associated persons or such other group of controlling shareholders who have influence over
management shall give an undertaking not to sell their shareholding before the expiry of a
period of twenty four months following listing and such undertaking shall be disclosed in the
Information Memorandum
10. Certificate of comfort- If the issuer is listed in a securities exchange outside Kenya or is
license by any regulator the Authority shall obtain a certificate of no objection from that
foreign securities exchange and from the relevant regulators.
Alternative Investment Market Segment (AIMS)
2. Size: Share capital- The issuer shall have a minimum authorized issued and fully paid up
ordinary share capital of twenty million shillings.
3. Net assets- Net assets immediately before the public offering or listing of shares should not
be less than twenty million shillings.
4. Free transferability of share - Shares to be listed shall be freely transferable and not subject

5. Availability and reliability of financial records- The issuer shall have audited financial
statements complying with International Financial Reporting Standards (IFRS) for an
accounting period ending on a date not more than four months prior to the proposed date of
the offer or listing for issuers whose securities are not listed at the securities exchange, and
six months for issuers whose securities are listed at the securities exchange.
The Issuer must have prepared financial statements for the latest accounting period on a going
concern basis and the audit report must not contain any emphasis of matter or qualification in
this regard.
6. Competence and suitability of directors and management - At the date of the application,
the issuer must not be in breach of any of its loan covenants particularly in regard to the
maximum debt capacity. As at the date of the application and for a period of at least two
years prior to the date of the application, no director of the issuer shall have-
any petition under bankruptcy or insolvency laws in any jurisdiction pending or threatened
against the director (for individuals), or any winding-up petition pending or threatened
against it (for corporate bodies); any criminal proceedings in which the director was
convicted of fraud or any criminal offence, nor be named the subject of pending criminal
proceeding, or any other offence or action either within or outside Kenya; or been the subject
of any ruling of a court of competent jurisdiction or any governmental body in any
jurisdiction, that permanently or temporarily prohibits such director from acting as an
investment adviser or as a director or employee of a Stockbroker, dealer or any financial
service institution or engaging in any type of business practice or activity in that jurisdiction.
The issuer must have suitable senior management with relevant experience for at least one
year prior to the listing, none of whom shall have committed any serious offence in any
jurisdiction that may be considered inappropriate for the management of a listed company.
The issuer shall ensure continued retention of qualified management during listing and no
change of management for a period of twelve months following the listing other than for
reason of a serious offence that may be considered to affect the integrity or be inappropriate
for management of a listed company.
The issuer must have at least a third of the Board as non-executive directors
7. Dividend policy- The issuer must have a clear future dividend policy.
9. Share ownership structure- Following the public share offering or immediately prior to
listing in the case of an introduction, at least twenty per centum of the shares must be held by
not less than one hundred shareholders excluding employees of the issuer or family members
of the controlling shareholders.
No investor shall hold more than t existing shareholders, associated persons or such other
group of controlling shareholders who have influence over management shall give an
undertaking to the Authority not to sell their shareholding before the expiry of a period of
twenty four months following listing and such undertaking shall be disclosed in the
Information Memorandum.
10. Certificate of comfort- If the issuer is listed in a securities exchange outside Kenya or is
licensed by any regulator the Authority shall obtain a certificate of no objection from that
foreign securities exchange and the relevant regulators.
Growth Enterprise Market Segment (GEMS)
2. Size: Share capital-. The issuer shall have a minimum authorized and fully paid up ordinary
share capital of ten million shillings.
3. Net assets- The issuer must have not less than one hundred thousand shares in issue.
4. Free transferability of share - Shares to be listed shall be freely transferable and not subject
5. Availability and reliability of financial records-
6. Competence and suitability of directors and management- The issuer must have a minimum
of five directors, with a least a third of the Board as non- executive directors As at the date of
the application and for a period of at least two years prior to the date of the application, no
director of the issuer shall have-
(i) Any petition under bankruptcy or insolvency laws in any jurisdiction pending or
threatened against any director (for individuals), or any winding- up petition pending or
threatened against it (for corporate bodies)
(ii) any criminal proceedings in which the director was convicted of fraud or any criminal
offence, nor be named the subject of pending criminal proceeding, or any other offence or
action within or outside Kenya; or
(iii) been the subject of any ruling of a court of competent jurisdiction or any government
body in any jurisdiction, that permanently or temporarily prohibits such director from acting
as an investment advisor or as a director or employee of a stockbroker, dealer, or any
financial service institution or engaging in any type of business practice or activity in that
jurisdiction.
The Directors of the Issuer shall give an opinion on the adequacy of working capital for at
least twelve months immediately following the share offering, and the auditors of the issuer
shall confirm in writing the adequacy of that capital.
8. Share ownership structure- The Issuer must ensure at least fifteen per cent of the issued
shares (excluding those held by a controlling shareholder or people associated or acting in
concert with him; or the Company's Senior Managers) are available for trade by the public.
An issuer shall cease to be eligible for listing upon the expiry of three months of the listing
date, if the securities available for trade by the public are held by less than twenty-five
shareholders (excluding those held by a controlling shareholder or people associated or acting
in concert with him, or the Company's Senior Managers.)
The issuer must ensure that the existing shareholders, associated persons or such other group
of controlling shareholders who have influence over management shall give an undertaking in
terms agreeable to the Authority and the Securities Exchange restricting the sale of part or the
whole of their shareholding before the expiry of a period of twenty four months following
listing and such undertaking shall be disclosed in the listing statement.
9. Listed shares to be immobilized- All issued shares must be deposited at a central depository
established under the Central Depositories Act, 2000 (No. 4 of 2000).
10. Nominated Advisor- The issuer must appoint a Nominated Adviser in terms of a written
contract and must ensure that it has a Nominated Adviser at all times.
Reasons behind low quotation at Nairobi securities exchange

1. Most companies operating in Kenya are owned by families who value their control and as
such cannot go public as this will entail dilution of their control by the incoming
shareholders.
2. Quotation at NSE is supposed to be a means of raising finance from the public and most of
companies operating in Kenya have access to cheap finance and as such this motive does not
hold.
3. Going public does not entail a lot of formalities.
4. Going public also entails a loss of secrecy to the public because annual reports have to be
published. Such information is accessed by the competitors.
5. Some companies in Kenya are subsidiaries of multinational companies and are already quoted
at home and the original owners may not be willing to sell their interest to the public.
6. Going public is expensive as a company is required to pay floatation fee among other costs
such as underwriting commission, brokerage fee, cost of printing prospectus, advertising cost,
legal fee, audit fee etc.
7. Some companies choose to remain private to avoid/evade corporate tax
8. Some companies that make high profits prefer investing those profits instead of sharing them
out, going public require profits to be given out to shareholders in form of dividends.
Incentives that government has given companies to induce them to go public

1. it has offered tax holidays for companies going public in particular those investing in specific
areas e.g. agro-based company
2. has offered has offered preferential treatment to companies in allocation of foreign exchange in
importation of raw materials
3. Government is willing through quasi governmental body to participate in the equity of such
companies going public.
4. It has bank capital gain tax on sale of shares and tax on share transfer and its intended to make
shares attractive to investors
5. Offered protection against importation of similar products to those currently manufactured by
Kenya quoted companies.

6. Embarked on promotional activities of product of these companies abroad in a bid to secure
them foreign market and this is done free of charge through trade fairs and exhibitions in
international market
7. Provided such facilities as good infrastructure and communication facilitates which provide
easy accessibility to sources of materials and markets to these companies’ goods has subsidized
no. of products in a bid to make them affordable by majority of consumers.
8. Has also given a tax deduction an concession to inputs of agro-based industries and
manufactured goods aimed at making them affordable to consumers
9. Given guarantees on repatriation of dividend and interest to non-resident investors in a bid to
attract their investment in Kenyan quoted companies.
Reasons why parastatals cannot be quoted
1. Most parastatals are not profit making organization and as such are supposed to maximize
society welfare in an objective cannot appeal to the public so as to buy share e.g. national
irrigation boards, K.T.D.A, K.P.C.U
2. Some parastatals give services which are crucial to the state and control to the public interest
which if they go public will prejudice such sensitive roles as this may not be taken care of by
profit oriented investors
3. Most of parastatals are government subsidies and also have access to foreign aid further they can
borrow from abroad using government guarantee and such no need for finance from the public in
form of share capital e.g. Kenya airways
4. Most parastatals has bad financial performance and for sometime been operating on loses and as
such this bad performance cannot make their shares attractive and also not qualify for quotation
e.g. Kenya railways, KMC, KCC, uplands
5. Some of the parastatals are so highly geared that no potentials investors can strive to invest his
money in such if they went public.
6. Some parastatals are geared towards achievements of short term objectives and as such may not
be willing to go public so as to be able to attract public investors e.g. Tana and Athi river
development authority.
Advantages of being quoted
1. A quoted company is able to raise finance in good terms because it will be able to reduce its
floatation cost its shares at a premium
2. It will be able to obtain underwriting facilitates because it can negotiate with strength for good
underwriter as its shares are likely to be sold out
3. Shareholders of a quoted company are open to a ready market from the stock exchange through
which they can sell their shares which allows them to gauge the worthiness of their investment
and which increases the goodwill to the company.

4. Quoted company will be able to raise permanent finance by way of selling certain security to the
public as ordinary shares.
5. It will be to enjoy national and international prestige that boosts its goodwill.
6. The NSE will approve for quotation only these companies which in their opinion are viable
hence an assurance to potential shareholders that it is financial stable.
7. Quoted company is viewed as credit worthy from the creditors from the creditors point of view
8. Quoted company is open to read up to date information which will come inform of feedback
regarding its share prices in the stock exchange
9. Quoted company will be able to get comparative figures from NSE
10. Being quoted will necessitate companies to operate within ethical guidelines and this will
prevent quoted companies from engaging in unethical activities and unfair practices during the
course of operations.
11. Quoted companies are allowed to enjoy privileges given by the government to induce others to
be quoted e.g. tax allowances and occasion of foreign exchange protection from competitors etc
Limitations of being quoted
1. The company loses its secrets to competitors who may not have been quoted e.g. publication
of company’s accounts which threatens its survived
2. In case the company’s profit trend declines, such will be revealed to the public hence
lowering share prices of such company and its goodwill
3. Companies which profit records are not impressive maybe deregistered and dropped out stock
quotation which will be dangerous to such company as it will have lost its secret to the public
and may in the extreme lead such a company into receivership as creditors will also lose
confidence in it
4. Being quoted in the SE entails loss of control to incoming shareholders who acquire votes in
the company.
5. Quotation is expensive because the company will have to pay high floatation cost such as
underwriting commission
6. A company to be quoted is supposed to undergo tedious formalities such as getting
permission from the capital issue committee and S.E.C
7. In the short run the share prices of a quoted company may be low in the SE due to oversupply
of those shares in particular. If there has been a new issue and it will lower share prices of the
company and this in turn will lower its credibility from creditors point of view.
8. Quoted company is committed to the payment of a permanent cost inform of ordinary
dividend which more over its not a tax allowable expense therefore compounding the cost of
the finance to the company
9. Quoted company will face problems of takeovers bids as a result of competitors who may
have had a chance to buy such shares in large blocks and this may dissolve the company if
they acquire a major shareholders.

SPECIAL FINANCIAL INSTITUTIONS
The major financial institutions in Kenya economy are commercial banks, savings and loans,
credit unions, savings banks, life insurance companies, pension funds, and mutual funds. These
institutions attract funds from individuals, businesses, and governments, combine them, and make
loans available to individuals and businesses. A brief description of the major financial institutions
follows.
Institution Description
Commercial bank Accepts both demand (checking) and time (saving) deposits. Also offers
negotiable order of withdrawal (NOW), and money market deposit accounts.
Commercial banks also make loans directly to borrowers or through the
financial markets.
Saving and loan These are similar to a commercial bank except chat it may not hold demand
(checking) deposits. They obtain funds from savings, negotiable order of
withdrawal (NOW) accounts, and money market deposit accounts. They lend
primarily to individuals and businesses in the form of real estate mortgage
loans.
Credit union they are commonly known as Savings co-operative societies (Sacco’s), credit
unions deal primarily in transfer of funds between members. Membership in
credit unions is generally based on some common bond, such as working for a
given employer. Credit unions accept members’ savings deposits, NOW
account deposits, and money market account deposits and lend funds to
members, typically to finance automobile or appliance purchase, or home
improvements.
Savings banks these are similar to a savings and loan in that it holds savings, NOW, and
money market deposit accounts. Savings banks lend or invest funds through
financial markets, although some mortgage loans are made to individuals.
Life insurance
Company It is the largest type of financial intermediary handling individual savings. It

receives premium payments and invests them to accumulate funds to cover
future benefit payments. It lends funds to individual, businesses, and
governments, typically through the financial markets.
Pension fund Pension funds are set up so that employees can receive income after retirement.
Often employers match the contribution of their employees. The majority of
funds is lent or invested via the financial market.

Mutual fund Pools funds from the sale of shares and uses them to acquire bonds and stocks
of business and governmental units. Mutual funds create a professionally
managed portfolio of securities to achieve a specified investment objective,
such as liquidity with a high return. Hundreds of funds, with a variety of
investment objectives exist. Money market mutual funds provide competitive
returns with very high liquidity.
OTHER SPECIALISED FINANCIAL INSTITUTIONS
1) .Industrial and commercial Development Corporation (LC.D.C)

I. C.D.C was established in 1954 by the government. Its main objective was to promote industrial &
commercial development in Kenya.
Its specifically provides financial or technical assistance to small enterprises. Financial assistance
may be in the form of working capital financing or purchase of fixed assets. This may take the form
of equity or debt financing. Equity is provided by large-scale enterprises with more than 50
employees. Loans are given to both small and medium
sized enterprise. Long-term loans repayment period is 6 years for industrial and up to 10 years for
commercial loans
2) Agricultural finance corporation (AFC)

It was established by the government in 1963. The main objective is to provide support for the
agricultural sector. This is through provision of short term and long-term loans. The loans must be
for a defined project by a farmer. Loans may be short term or long term and there exist flexibility to
allow its repayment.
3) Kenya Industrial Estate (KIE)

It was established in 1967. At inception it was a wholly owned subsidiary of ICDC. However in
1978 it was separated from ICDC and become an independent body as a parastatal under the
ministry of industry.
The main objective of K1E is to assist in the development of new projects and the expansion and
modernization of new business enterprise. This is through the provision of finds and technical
assistance. They provide both debt and equity finance.
4) Kenya Tourist Development Corporations: (KTDC)

The KTDC was established in 1960’s. Its main responsibility was carrying out Investigations,
formulation and study of projects development of the tourism industry
KTDC Provides financial assistance in forms of loan, for tourism related enterprises. It has
substantial share —holdings in local hotels, which includes Hilton, Serena, and Pan Africa etc.

5) Industrial Development Bank (IDB)
It was established in 1963 as a limited company. The main objective of setting this
Institution was to promote industrial development in Kenya through the establishment promotion
and expansion of small or large-scale enterprises. This is through financial assistance .n the form of
loans, provision of guarantee and securities and underwriting
6) Hire — purchase financial companies

These are institutions, which provide assets on credit with an arrangement to pay the principal and
interest in installment basis. However, the legal ownership of the assets remains with the hire-
purchase company. The title is transferred when the last installment is made. Hire Purchase
Company’s in Kenya include- Kenya finance corporation (KFC), Pan-Africa credit finance Ltd,
Investment and mortgage Ltd. etc.
7) Insurance Companies
The main role of insurance companies is to assist individuals and corporate bodies safeguard against
future risks they may also engage in other activities. The main capital for insurance companies is the
premium paid by the policy holders.
Forms of Insurance Company’s in Kenya includes: - Life Insurance, Third party insurance etc.
Examples of Insurance Company’s in Kenya include: jubilee insurance company, pan African
insurance company, Blue shield insurance Co. Ltd. etc.
8) Building societies/Housing finance Co:
These are financial institutions, which provide finance to the public so as to purchase or construct
houses. The individual or corporate bodies make deposit upon which they later receive loan for
acquiring or constructing house. Some buildings societies in Kenya include: Housing finance
corporation (HFC), East African building society and Pioneer building society.
9) Pension and provident scheme institution

These institutions obtain funds from both employees and employers of contribution. They manage
and invest these funds so as to meet the current and future obligations of the pension scheme to its
members.
10) Merchant Banks

It originated and also derives its name from the activities of wealth merchants who provided credit
for the trading ventures. The ventures were for small-scale merchants. Before the establishment of
banking systems in the 19th century, the merchants changed their role of merchants and started
offering financial service. Today merchant banks performs the role of underwriting and assisting
companies to raise capital in the financial markets They underwrite the security issues, buy and sell
securities and provide advice in Investment in securities.

The organic theory of financial markets/system
A market is anyone of a variety of different systems, institutions procedures social nations and
instructions whereby person’s trade, and goods and services are exchanged forming part of the
economy.
The growth rate that the financial markets can achieve by increasing output and enhancing sales of
securities lies in the efficiency take-over’s, acquisitions/mergers. Take-over’s, acquisitions/mergers
do not bring about profits generated in the financial market and therefore are not considered organic.
Organic growth of financial market represents the true growth for care of the markets. It’s a good
indicator of how well management has used its exchange of securities to expand. Organic growth of
financial markets also identifies whether the intermediaries have used their skills to improve the
business.
Definitive approaches to financial markets
The Kenya and global financial systems are going through a very challenging period of adjustments.
The forces that make the system vulnerable build up for a long time. Kenya government has to
undertake substantial reforms to the frameworks policy, regulations and oversight of financial
system.
Financial system plays a vital role in long term economic growth by helping to efficiently allocate
the resources of savers to those individuals and firms with ideas into action.
Financial system plays a critical role in economic stability by affecting the capacity of the real
economy to withstand shocks and the ability of macro-economic policy to mitigate the impact of
those shocks.
Our system was once organized around banks i.e. defined narrowly or institutions that take deposits
and give loans over time there has been a gradual but pronounced decline in the share of financial
assets. Organized and held by banks and corresponding increase in the share of financial assets held
across a variety of non-bank financial institution funds and complex financial structures.
The lines between banks, investment banks and other institutions have eroded over time, as have the
lines between institutions and markets. Banks made by both and non-banks were increasingly sold
by originating institutions and packaged into securities.
Decimal pricing
Kenya stocks, derivative linked to stocks and some bonds trades in decimals or shillings and cents.
This means that the spread between the Bid and Ask prices can be as small as 1 cent. The switch to
decimal stock trading which was completed in year 2001 was the final stage. Trading in decimals
originated in the 16th century when North America settlers cut European coins into use as currency.
In an intermediary phased during the 1990’s trading way handled in sixteenth (1/16)

Organization of securities market
Securities include shares, debentures, treasury bills, municipal bonds etc
1. An investor approaches a broker who takes his bid or offer to the trading floor.
2. At the trading floor buying and selling brokers meet and seal the deal.
3. The investor is informed of what happened/transpired at the trading floor through a contract
note. The note is sent to buying and selling investors. The note contains details e.g. buying
and selling price, charges or commission payable, number of shares bought or sold.
4. Settlement is made through a broker
5. Old share certificate is cancelled (for selling investor) and a new one issued in the name of
buying investor.
Factors to consider when buying and selling securities of a company or government
1. Economic conditions of a country and other non-economic factors

2. State of the management of the company.
3. Nature of the product dealt in and its market share
4. Marketability of the securities
5. Diversification
6. Companies trading partners and its competitors
7. Prospects of the growth of the firm due to expected growth in demand of products of the firm.
AUTOMATION OF SECURITIES EXCHANGES
i. Automated trading system (ATS)/mechanical trading system

Automated system also refers to mechanical trading system. It’s a set of trading rules which gives
entry points and exit points automatically to investors. Automated trading system/Auto trading and
robo-trading form a strategy for trading as it allows the computer to figure out what trade to make
and actually execute the trade. It can trade a large array of assets. This includes stocks, options etc.
ATS typically use artificial intelligence and develop their strategies through trial and error. In theory
the trial and error happens during development face. Computers are better at trading than human
being. The challenge is that successful ATS are few and far. ATS will become a standard throughout
the world in future since human beings simply do not make good traders and most so called
investors lose money.
In addition the current stock market downtown has left millions of stock and mutual fund holders
losing 50% of their portfolios with a little bit of luck, the trade will turn and everybody in the world
can benefit from ATS.

Advantages of computers over human beings
i. Computers have no emotions to cloud its judgment. 90% of traders and investors lose money
because of their emotions fear causes us to sell a stock and greed causes us to buy into
market. Most people have a strong desire to be right and this is their ego getting the best of
them.
ii. Computers have ability to process information faster and it can process all sorts of data in
contrast human beings can only take in a small amount of information at a time.
iii. Computers have a large memory so that they can track many positions and pieces of data
simultaneously.
iv. Computers are consistent and are totally immune to moods and therefore can perform more
consistently than human beings.
v. Computers do not embezzle. Scandals have made many people to question whether they can
trust financial managers/government to protect them.
When ATS becomes more popular people will consider it a viable alternative to traditional way of
investing. ATS will become more effective and successful human beings hence it will become
industry standard.
ii. Central Depository system (CDS)

It acts as a means of representing ownership and movements of securities. CDA account holders
enjoy the convenience of obtaining electronic securities transfer and trade settlement.
Who may open CDS account?
1. An individual who has reached the age of 18 years.

2. A corporation within the context of a company’s Act.
3. Any corporate body that is incorporated within Kenya.
4. A society under any written law relating to co-operative society.
5. Any society registered under societies Act
6. Statutory bodies incorporated under an act of parliament.
Need to open a CDS account.
It will facilitate buying and selling of shares and also to carry out other CDS transactions on all
equity and non-equity counters (bonds, warrants etc) which have been prescribed into CDS.
How to open a CDS account
One can open a CDS account with any authorized depository agents. All stock broking companies in
Kenya are currently ATS. If you are an individual investor you may go to an ADA of your choice.
Procedure: -
a. Complete opening of your account form and two specimen signatures.

b. For Kenyans submit the documents together with two certified copies of your Kenya national
identity card as for foreigners you need to pay accounts opening fee and submit two certified
copies of your passport.
If you are a corporate investor:
a. Complete opening of accounts form and two specimen signature

b. Certificate of incorporation.
Your ADA will then open your CDS account and give you your CDS account number.
ROLE OF GOVERNMENT IN THE FINANCIAL SYSTEMS
CAPITAL MARKET AUTHORITY (CMA)

The Kenyan capital market has attained a remarkable degree of growth are poised for further leap
forward in the current world. The process of modernization and computerization has rendered the
market not only abroad and liquid but also fair efficient. All concerned with the market. The
investors, the issuers, market players and more importantly the regulators play a vital role. The stock
exchange authority i.e. C.M.A, N.S.E council, the Retirement Benefit Authority, Insurance
Regulatory Authority and above all the Kenyan government are the regulators of capital market.
CMA was established in 1989 through the market authority Act Sec ii which includes the principles
and objectives of the authority.
The act provide for:
Development of all aspects of the capital Market and in particular it emphasizes on the removal of
impediments and creation of incentives for long-term investment productive enterprises.
The creation, maintenance and regulation of the CMA through the implementation of system in
which the market participants are self regulatory and the creation of a market in which securities can
be issued and traded in an orderly, fair and efficient manner.
Protection of investor’s interests
Roles of capital markets authority
1. The CMA has the responsibility of licensing and regulating stockbrokers, investment
advisers, security dealers and the authority depositories.
2. The capital market authority is involved in the process of listing of new companies. Any
company, intending to be quoted in the NSE must apply through
CMA.
3. CMA is involved in the making of policies that would enhance the development of the capital
market e.g. policy regarding the buying and selling of securities, policies on admission of
individual and institutions to the capital market and generally policies on the introduction of
securities and their regulations
4. The CMA acts as a watchdog for shareholders of listed companies. This is through regulating
the operations of the listed company’s so as to protect investors against penalty, insider
trading or suspensions.
5. The authority assists in the development of new securities in the market. This is through
research and evaluations of various recommendations of stakeholders in the NSE. It is the
responsibility of the CMA to evaluate whether there is need of new security and develop on
appropriate policy
6. The CMA acts as a government advisor through the ministry of finance regarding policies
affecting the capital markets.
7. Removes bottlenecks and creates awareness for investment in long term securities.
8. Serves as efficient bridge between the public and private sector.
9. Creates an environment which will encourage local companies to go public..
10. Implements government’s programmes and policies with respect to capital market.
Roles to stock exchange in Kenya

1. Removes barriers on security transfer.
2. Introduce wide range of instruments in the market.
3. Decentralizations of its operations.
4. Encourage development of institutional investors such as pension firms and insurance firms.
5. Provide adequate information to players in the market. In order to prevent insider trading.
6. License more bankers.
Role of capital market authority in determination of share prices

i) The CMA does not in any way influence share price of quoted security.
ii) The prices of such securities are determined by the demand and supply mechanism.
iii) The CMA may: - Advice the company on the issue price of new securities.
- Alert investors if it feels that the issue price of certain securities is not in their interest.
- It guides against manipulation of share prices and insider trading.

CENTRAL BANK
The Central Bank These are usually owned and operated by governments and their functions are:
i. Government’s banker: Government’s need to hold their funds in an account into which they
can make deposits and against which they can draw cheques. Such accounts are usually held
by the Central Bank
ii. Banker’s Bank: Commercial banks need a place to deposit their funds; they need to be able
to transfer their funds among themselves; and they need to be able to borrow money when
they are short of cash. The Central Bank accepts deposits from the commercial banks and will
on order transfer these deposits among the commercial banks. Consider any two banks A and
B. On any given day, there will be cheques drawn on A for B and on B for A. If the person
paying and the person are paid bank with the same bank, there will be a transfer of money
from the account or deposit of the payee. If the two people do not bank with the same bank,
such cheques end up in the central bank. In such cases, they cancel each other out. But if
there is an outstanding balance, say in favour of A, then A‟s deposit with the central bank
will go up, and B‟s deposit will go down. Thus the central bank acts as the Clearing House of
commercial banks.
iii. Issue of notes and coins: In most countries the central bank has the sole power to issue and
control notes and coins. This is a function it took over from the commercial banks for
effective control and to ensure maintenance of confidence in the banking system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and one way of
getting it is to borrow from the central bank. If all other sources failed, the central bank would
lend money to commercial banks with good investments but in temporary need of cash. To
discourage banks from over-lending, the central bank will normally lend to the commercial
banks at a high rate of interest which the commercial bank passes on to the borrowers at an
even higher rate. For this reason, commercial banks borrow from the central bank as the
lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities or Treasury
Bills, the payment of interests on them and their redeeming when they mature.
vi. Banking supervision: In liberalized economy, central banks usually have a major role to play
in policing the economy.
vii. Operating monetary policy: Monetary policy is the regulation of the economy through the
control of the quantity of money available and through the price of money i.e. the rate of
interest borrowers will have to pay. Expanding the quantity of money and lowering the rate of
interest should stimulate spending in the economy and is thus expansionary, or inflationary.

Conversely, restricting the quantity of money and raising the rate of interest should have a
restraining, or deflationary effect upon the economy.
CENTRAL DEPOSITORY & SETTLEMENT CORPORATION LIMITED (CDSC)
The Central Depository & Settlement Corporation Limited (CDSC) is a limited liability Company
approved by the Capital Markets Authority under Section 5 of the Central Depositories Act, 2000 to
establish and operate a system for the central handling of deliveries and settlement of securities in
the Capital Markets in Kenya. It commenced its operations as a central depository on 10th
November 2004.
The Central Depository & Settlement Corporation Limited (CDSC) was incorporated on 23rd March
1999 under the Companies Act, 2000.
The business of the Company is to establish and operate a central depository system and provide
central clearing, settlement and depository services for securities initially in Kenya in respect to
securities listed on the Nairobi Stock Exchange. The central depository system provides a
centralized system for the transfer and registration of securities in electronic format without the
necessity of physical certificates.
Objectives of applying Central Depository System
 Eliminate risks resulting from trading of material securities in the Capital Market. i.e. damage
or loss or forgery.
 Get hold of all material securities at the central level through gradual withdrawal of securities
traded in the markers and relieve issuers from printing securities certificates in the other hand.
 Simplify the process of trading in stock exchange as a result of dealing on balances and book
entries instead of material securities.
 Increase the securities turnover due to completion of ownership transfer within a specified
timeframe.
 Increase the market liquidity.
 Operating Settlement system according to Delivery Versus Payment (DVP) system.
 Relieve the issuers from cost, effort, time they take to print certificates for the original capital
or any amendment thereon and print one certificate with total issuing value.
 Establish a database for all the securities issued and traded in the Egyptian Capital Market.
 Establish a database for securities owners and their relevant data.
 Foster investor’s confidence through adhering to international standards.

CHAPTER 4
TIME VALUE OF MONEY

What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a
long time to wait. Why would any rational person defer payment into the future when he or she
could have the same amount of money now? For most of us, taking the money in the present is just
plain instinctive. So at the most basic level, the time value of money demonstrates that, all things
being equal, it is better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can do much more with the money if you have it now
because over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future value of your
money by investing and gaining interest over a period of time. For Option B, you don't have time on
your side, and the payment received in three years would be your future value. To illustrate, we have
provided a timeline:
If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the
three years. The future value for Option B, on the other hand, would only be $10,000. So how can
you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look.
Future Value Basics

If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value
of your investment at the end of the first year is $10,450, which of course is calculated by
multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest
gained to the principal amount:
Future value of investment at end of first

year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation of the
above equation:
 Original equation: ($10,000 x 0.045) + $10,000 = $10,450
 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
 Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the principal
amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched and you
invested it at 4.5% for another year, how much would you have? To calculate this, you would take
the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have
$10,920:
Future value of investment at end of second year:

= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x

(1+0.045)
Think back to math class and the rule of exponents, which states that the multiplication of like terms
is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and
the exponent on each is equal to 1. Therefore, the equation can be represented as the following:
We can see that the exponent is equal to the number of years for which the money is earning interest
in an investment. So, the equation for calculating the three-year future value of the investment would
look like this:
This calculation shows us that we don't need to calculate the future value after the first year, then the
second year, then the third year, and so on. If you know how many years you would like to hold a
present amount of money in an investment, the future value of that amount is calculated by the
following equation:

Present Value Basics
if you received $10,000 today, the present value would of course be $10,000 because present value
is what your investment gives you now if you were to spend it today. If $10,000 were to be received
in a year, the present value of the amount would not be $10,000 because you do not have it in your
hand now, in the present. To find the present value of the $10,000 you will receive in the future, you
need to pretend that the $10,000 is the total future value of an amount that you invested today. In
other words, to find the present value of the future $10,000, we need to find out how much we
would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the
(hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future
payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is
rearranging the future value equation above so that you may solve for P. The above future value
equation can be rewritten by replacing the P variable with present value (PV) and manipulated as
follows:
Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received
in three years is really the same as the future value of an investment. If today we were at the two-
year mark, we would discount the payment back one year. At the two-year mark, the present value
of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of

year two:
Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future
value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000
in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment
expected in two years would be the following:
Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the
investment every year counting back from the $10,000 investment at the third year. We could put
the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's
present value of the $10,000 expected from a three-year investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are
4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it
for three years. The equations above illustrate that Option A is better not only because it offers you
money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash!
Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a
future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.
Present Value of a Future Payment

Let's add a little spice to our investment knowledge. What if the payment in three years is more than
the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four
years. Which would you choose? The decision is now more difficult. If you choose to receive
$15,000 today and invest the entire amount, you may actually end up with an amount of cash in four
years that is less than $18,000. You could find the future value of $15,000, but since we are always
living in the present, let's find the present value of $18,000 if interest rates are currently 4%.
Remember that the equation for present value is the following:
In the equation above, all we are doing is discounting the future value of an investment. Using the
numbers above, the present value of an $18,000 payment in four years would be calculated as the
following:
Present Value
From the above calculation we now know our choice is between receiving $15,000 or $15,386.48
today. Of course we should choose to postpone payment for four years!

DISCOUNTING TECHNIQUES
The process of finding present values is referred to as discounting. It is the inverse of compounding
and seeks to answer the question. “If I can earn k% on my money, what is the most I will be willing
to pay now for an opportunity to receive FV shillings n periods from now?” The annual rate of
return k% is referred to as the discount rate, required rate of return, cost of capital, or opportunity
cost.
The present value as the name suggests, is the value today of a given future amount. Recall the
basic compounding formula for a lump sum;
FVn = Po (1+k)1 Therefore making P the subject
Example:
Assume you were to receive sh. 172,800 three years from now on an investment and the required
rate of return is 20 %. What amount would you receive today to be indifferent?
Solution.
Recall previous example on FV
PV20%,3yrs= 172,800/( 1 + 0.20)3 =172,800/1.728 = Sh.100,000
PV=Sh.100,000
FV5 = Sh.172800
Using Present Value Interest Factor (PVIF) Tables
The factor denoted by
As above is called the present value interest factor (PVIF). The PVIF is the multiplier used to
calculate at a specified discount rate the present value of an amount to be received at a future date.
The PVIFk,n is the present value of one shilling discounted

discou at k% for n-periods.
periods.
Therefore the present value (PV) of a future sum ( FVn ) can be found by
Factor (PVIF). The PVIF is the multiplier used to calculate at a specified discount rate the present
In the preceding example the PV could be found by multiplying Sh. 172,800 by the relevant PVIF.
Table A - 1 Present Value of $1 Due at the End of n Periods gives a factor of 0.5787for 20% and
3 years.
PV = 172800 x 0.5787 = Sh.99, 999.36
= sh. 100,000
Present Value of a Mixed Cashflows

We determine the PV of each future amount and then add together all the individual PVs
Example
The following is a mixed stream of cash flows occurring at the end of year
Year Cash flow

sh.000
1 400
2 800
3 500
4 400
5 300
If a firm has been offered the opportunity to receive the above amounts and if it
it‟s required rate of
return is 9% what is the most it should pay for this opportunities?
Solution
Year (n) Cash flow PVIF9%, n PV
1 400,000 0.917 366,800
2 800,000 0.842 673,600
3 500,000 0.775 386, 000
4 400,000 0.708 283,200
5 300,000 0.65 195,000
PV 1,904,600

Present Value of an Annuity
The current value of a set of cash flows in the future, given a specified rate of return or discount rate.
The future cash flows of the annuity are discounted at the discount rate, and the higher the discount
rate, the lower the present value of the annuity.
C = Cash flow per period

i = Interest rate
n = Number of payments
This calculates the present value of

of an ordinary annuity. To calculate the present value of an annuity
due, multiply the result by (1+i). (The payments start at time zero instead of one period into the
future.)
Present Value of an Annuity provides the PVIFAk,n, which can be used in calculat
calculating the present
value of an annuity (PVA) as follows:
Example
Assume that a project will give you sh. 1000 at the end of each year for 4 years .What is the
maximum amount would you be willing to pay for that project if the required rate of return is 10%.
Solution
The PVIFA at 10% for 4 years (PVIFA10%, 4yrs) from Table A-2 is 3.1699.
Therefore, PVA = 3.1699X 1000 = Sh.3, 169.9
(Confirm the answer with the above equation).
Present Value of an Annuity Due.
From the above example, assume that the project gives you sh. 1000 at the beginning of each year
for 4 years.
PVIFAk,n(annuity due) = PVIFk,n(ordinary annuity) x ( 1 +k)
= 3.1699 × (1+0.1)
=3.48689
Therefore future value of the annuity due = 1000 x 3.48689
=Sh.3, 486.89
Present Value of Perpetuity
Perpetuity is an annuity with an infinite life – never stops producing a cash flow at the end of each
year forever.
The PVIF for a perpetuity discounted at the rate k is
Example
Wetika wishes to determine the PV of a Sh.1000 perpetuity discounted at 10%.
The present value of the perpetuity is 1000 x PVIFAk, α = 1000 x 1/0.1= Sh.10, 000.
This implies that the receipt of Sh.1,000 for an indefinite period is worth only Sh .10,000 today if
Wetika can earn 10% on her investments (If she had Sh.10,000 and earned 10% interest on it each
year, she could withdraw Sh.1000 annually without touching the initial Sh.10,000).
Deposits to Accumulate a Future Sum
It may be necessary to find out the periodic deposits that should lead to the built of a needed sum of
money in future.
We can use the expression below, which is a rewriting of FVn= Po × FVIFk,n.
PMT = FVAn/FVIFAk n
Where PMT is the periodic deposit, FVAn is the future sum m to be accumulated, and FVIFAk n is the
future value interest factor of an n-year
n annuity discounted at k%.
Example
Ben needs to accumulate Sh. 5 million at the end of 5 years to purchase a company. He can make
deposits in an account that pays 10% interest
interest compounded annually. How much should he deposit in
his account annually to accumulate this sum?
Solution
PMT = FVAn/FVIFAk n = 5,000,000/6.105= Sh.819,000
Example
Suppose you want to buy a house in 5 years from now and estimate that the initial down payment of
Sh. 2 million will be required at that time. You wish to make equal annual end of year deposits in an
account paying annual interest of 6%. Determine the size of the annual deposit.
FVAN = PMT X FVIFAK, N
PMT = FVAn/ FVIFAk n
PMT = 2,000,000/5.637= Sh.354,799

Finding unknown Interest Rate
A situation may arise in which we know the future value of a present sum as well as the number of
time periods involved but do not know the compound interest rate implicit in the situation. The
following example illustrates how the interest rate can be determined.
Example
Suppose you are offered an opportunity to invest Sh.100‟000 today with an assurance of receiving
exactly Sh.300,000 in eight years. The interest rate implicit in this question can be found by
rearranging FVn= Po × FVIFk,n as follows.
FV8 = P0 (FVIF k, 8 )
300,000 = 100,000 (FVIFKk,8)
FVIFk, 8 = 300,000 / 100,000 = 3.000
Reading across the 8-period row in the FVIFs table (Table A-3) we find the factor that comes closest
to our value of 3 is 3.059 and is found in the 15% column. Because 3.059 is slightly larger than 3 we
conclude that the implicit interest rate is slightly less than 15 percent.
To be more accurate, recognize that
FVIFk,8 = (1+k)8
(1+k)8 = 3
(1+k) = 31/8 = 30.125
1+k = 1.1472
k = 0.1472 = 14.72%

COMPOUNDING TECHNIQUES
Two forms of treatment of interest are possible. In the case of simple interest
interest, interest is paid
(earned) only on the original amount (principal) borrowed. In the case of compound interest
interest,
interest is paid (earned) on any previous interest earned as well as on the principal borrowed (lent).
Compound interest is crucial to the understanding
understanding of the mathematics of finance. In most situations
involving the time value of money compounding of interest is assumed. The future value of present
amount is found by applying compound interest over a specified period of time
The equation for finding

nding future values of a single amount is derived as follows:
Let
FVn= future value at the end of period n
PV (Po) =Initial principal, or present value
k= annual rate of interest
n = number of periods the money is left on deposit.
The future value (FV), or compound value, of a present amount, Po, is found as follows.
At end of Year 1, FV1 =Po (1+k) = Po (1+k)1

= Po (
At end of Year 2, FV2=FV1 (1+k) = Po(1+k) (1+k) 1+k)2
At end of Year 3, FV3 = FV2 (1+k) = Po ( 1+k) ( 1+k) (1+k) = Po (1+k)3
A general equation for the future value at end of n periods can therefore be formulated as,
Example:
Assume that you have just invested Ksh100, 000. The investment is expected to earn interest at a
rate of 20% compounded annually. Determine the future value of the investment after 3 years.
Solution:
At end of Year 1,
FV1 =100,000 (1+0.2) =120,000
At end of Year 2,
FV2 =120,000 (1+0.2) OR { 100,000(1+0.2) (1+0.2)}=144,000
At end of Year 3, = 144,000(1+0.2) =100,000 ( 1+0.2) ( 1+0.2) (1+0.2) =
FV3 172,800

Alternatively,
FVn = Po ( 1+k)n
At the end of 3 years, FV3= 100,000 ( 1+0.2)3= Sh.172,800
Using Tables to Find Future Values
Unless you have financial calculator at hand, solving for future values using the above equation
can be quite time consuming because you will have to raise (1+k) to the nthth power.
Thus we introduce tables giving values of (1+k)n for various values of k and n.
The future value interest factor for an initial investment of Sh.1 compounded at k percent for n
periods is referred to as FVIFk n.
Future value interest factors = FVIFk n. = (1+k)n.
FVn = Po * FVIFk,n
A general equation for the future value at end of n periods using tables can therefore be formulated
as,
The FVIF for an initial principal of Sh.1 compounded at k percent for n periods can be found in
Appendix Table A-3 3 by looking for the intersection of the nth
th row and the k % column. A future
value interest factor is the multiplier used to calculate at the specified rate the future value of a
present amount as of a given date.
From the example above, FV3 = 100,000 × FVIF20%, 3 years
=100,000 × 1.7280 =sh.172,

800
Future value of an annuity
So far we have been looking at the future value of a simple, single amount which grows over a given
period at a given rate. We will now consider annuities.
An annuity is a series of payments or receipts of equal amounts (i.e. a pensioner receiving
Sh.100,000 per year for ten years after his retirement). The two basic types of annuities are the

ordinary annuity and the annuity due. An ordinary annuity is an annuity where the cash flow
occurs at the end of each period. In an annuity due the cash flows occur at the beginning of each
period. This means that cash flows are sooner received with an annuity due than for a similar
ordinary annuity. Consequently, the future value of an annuity due is higher than that of an ordinary
annuity because the annuity due’s cash flows earn interest for one more year.
Example:
Determine the future value of a shs100, 000 investment made at the end of every year for 5 years
assume the required rate of return is 12% compounded annually.
Solution
The future value interest factor for an n-year,
n year, k%, ordinary annuity (FVIFA) can be found by adding
the sum of the first n-1
1 FVIFs to 1.000, as follows;
The Time line and Table below shows the future value of a Sh.100,000 5-year
5 year annuity
(Ordinary annuity) compounded at 12%.

The formula for the future value interest factor for an annuity when interest is compounded annually
at k percent for n periods (years) is
Using Tables to Find Future Value of an Ordinary Annuity
Annuity calculations can be simplified by using an interest

i table.
The value of an annuity is founding by multiplying the annuity with an appropriate multiplier called
the future value interest factor for an annuity (FVIFA) which expresses the value at the end of a
given number of periods of an annuity of Sh.1 per period invested at a stated interest rate.
The future value of an annuity (PMT) can be found by,
Where FVAn is the future value of an n-period

n period annuity, PMT is the periodic payment or cash flow,
and FVIFAk,n is the future value interest factor of an annuity. The value FVIFAk,n can be accessed in
appropriate annuity tables using k and n. The Table A-44 gives the PVIFA for an ordinary annuity
given the appropriate k percent and n-periods.

From the above example,
FVA5 =100,000×FVIFA12%, 5 years
=100,000×6.35280
=sh.635280
Finding Value of an Annuity Due
Assuming in the above example the investment is made at the beginning of the year rather than at
the end.
annuall at the beginning of each of the next 5 years at

What is the value of Sh.100,000 investment annually
an interest of 12%.
The Time line and Table below shows the future value of a Sh.100, 000 5-year
5 year annuity due
compounded at 12%.
Timeline

Using Tables to Find Future Value of an Annuity Due
A simple conversion can be applied to use the FVIFA (ordinary annuity)in Table A-4 with annuities
due. The Conversion is represented by Equation below.
, ( ) = , ( ) ( + )
From the above example,

FVIFA12%, 5yrs (annuity due) =FVIFA12%,5yrs(ordinary) x ( 1 + k)
=6.35280 x (1+.12)
=7.115136
Therefore future value of the annuity due = 100, 000 x 7.115136

=sh.711, 511.36
Compounding More Frequently
Interest is often compounded more frequently than once a year. Financial institutions compound
interest semi-annually, quarterly, monthly, weekly, daily or even continuously.
Semi Annual Compounding
This involves the compounding of interest over two periods of six months each within a year.
Instead of stated interest rate being paid once a year one half of the stated interest is paid twice a
year.
Example
Sharon decided to invest Sh.100,000 in savings account paying 8% interest compounded semi
annually. If she leaves the money in the account for 2 years how much will she have at the end of

the two years?
She will be paid 4% interest for each 6-months period. Thus her money will amount to.
FV4 = 100,000 ( 1+.08/2)2*2 =100,000(1+.04)4 =Sh.116,990

Or
Using tables = 100,000 x FVIF 4%,4periods =100,000 x 1.17 = Sh.117,000
Quarterly Compounding
This involves compounding of interest over four periods of three months each at one fourth of stated
annual interest rate.
Example
Suppose Jane found an institution that will pay her 8% interest compounded quarterly. How
much will she have in the account at the end of 2 years?
FV8 = 100,000(1+.08/4)4*2=100,000(1+.02)8 =100,000 x
1.1716 = 117,160
Or,
Using tables 100,000 x FVIF 2%, 8periods= 100,000*1.172 = 117,200
As shown by the calculations in the two preceding examples of semi-annual and quarterly
compounding, the more frequently interest is compounded, the greater the rate of growth of an initial
deposit. This holds for any interest rate and any period.
General Equation for compounding more frequently than annually

Let;
m = the number of times per year interest is compounded n=

number of years deposit is held.
k= annual interest rate.
FV = PV*(1 + )n*m
(where m is the frequency of compounding)
Continuous Compounding
This involves compounding of interest an infinite number of times per year, at intervals of
microseconds - the smallest time period imaginable. In this case m approaches infinity and through
calculus the Future Value equation 2.1 would become,

Where theree is the exponential function, which has a value of 2.7183. The FVIFk,n (continuous
compounding) is therefore ekn , which can be found on calculators.
Example
If Jane deposited her 100,000/= in an institution that pays 8% compounded continuously, what
would be the amount on the account after 2 years?
Amount = 100,000 x 2.718.08*2 = 100,000 x 2.7180.16 =100,000*1.1735 =117,350
PREPARATION OF LOAN AMORTIZATION SCHEDULE
An important application of discounting and compounding concepts is in determining the payments

required for an installment – type loan. The distinguishing features of this loan is that it is repaid in
equal periodic (monthly, quarterly, semiannually or annually) payments that include both interest
and principal. Such arrangements
ments are prevalent in mortgage loans, auto loans, consumer loans etc.
Amortization Schedule.
An amortization schedule is a table showing the timing of payment of interest and principal
necessary to pay off a loan by maturity.
Example
Determine the equal

al end of the year payment necessary to amortize fully a Sh.600,000, 10% loan
over 4 years. Assume payment is to be rendered (i) annually, (ii) semi-annually.
semi annually.
Solution
(i) Annual repayments
First compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.
Using tables we find the PVIFA10%,4yrs = 3.170, and we know that PVAn = Sh.600,000
PMT = 600,000/3.170 = Sh.189, 274 per year.

Loan Amortization schedule
Payments
End of Beg. of End of

year Loan year Interest Principal year
payment principal principal
[10%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 189,274 600,000 60,000 129,274 470,726
2 189,274 470726 47,073 142,201 328,525
3 189,274 328525 32,853 156,421 172,104
4 189,274 172104 17,210 172,064 -
(ii) Semi-annual repayments

For semi-annual repayments the number of periods, n, is 8 and the discount rate is 5%.
Lets compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.

Using tables we find the PVIFA5%,8periods =6.4632, and we know that PVAn = Sh.600,000
PMT = 600,000/6.4632 = Sh.92,833 per year.

Loan Amortization schedule
Payments
End of Loan Beg. Of year Interest Principal End of

period payment principal period
(6months) principal
[5%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 92833 600,000 30,000 62,833 537,167
2 92,833 537,167 26,858 65,975 471,192
3 92,833 471,192 23,559 69,274 401918
4 92,833 401, 918 20,096 72,737 329,181
5 92,833 329,181 16,459 76,374 252,807
6 92,833 252,807 12,481 80,192 172,615
7 92,833 172,615 8,631 84,202 88,413
8 92,833 88,413 4,421 88,412 -
Determining Interest or Growth Rate
It is often necessary to calculate the compound annual interest or growth rate implicit in a series of
cash flows. We can use either PVIFs or FVIFs tables. Let’s proceed by way of the following
illustration.
Example
Roy wishes to find the rate of interest or growth rate of the following series of cash flows
Cash flow
Year (Sh.)
2004 1,520,000
2003 1,440,000
2002 1,370,000
2001 1,300,000
2000 1,250,000

Solution
Using 2000 as base year, and noting that interest has been earned for 4 years, we proceed as follows:
Divide amounts received in the earliest year by amount received in the latest year.
1,250,000/1,520,000 = 0.822. This is the PVIFk,4yrs . We read across row for 4 years for
the interest rate corresponding to factor 0.822. In the row for 4 year in table of Table A-3 of PVIFs,
the factor for 5% is .823, almost equal to 0.822. Therefore interest or growth rate is approximately
5%.
Note that the FVIFk,4yrs (1,520,000/1,250,000) is 1.216. . In the row for 4 year in table of
Table A-1 of FVIFs, the factor for 5% is 1.2155 almost equal to 1.216.We estimate the growth rate
to be 5% as before.

CHAPTER 5
INTRODUCTION TO RISK AND RETURN
Risk
It refers to deviation or variations of the actual outcome from the expected. It’s the possibility of
things happening than they are expected.
Risk can be measured for either a single or a gap of project (portfolio-collection of securities)
Return
It is the anticipated gain or earnings on any investment. These investments returns could be positive
or negative outcomes.
Risk-Return Tradeoff'
It’s the principle that the potential return rises with an increase in risk. Low levels of uncertainty
(low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk)
are associated with high potential returns. According to the risk-return tradeoff, invested money can
render higher profits only if it is subject to the possibility of being lost.
Expected Return
The future is uncertain. Investors do not know with certainty whether the economy will be growing
rapidly or be in recession. As such, they do not know what rate of return their investments will yield.
Therefore, they base their decisions on their expectations concerning the future.
The expected rate of return on a stock represents the mean of a probability distribution of possible
future returns on the stock. The table below provides a probability distribution for the returns on
stocks A and B.
Return on Return on
State Probability Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
3 20% 20% -10%
In this probability distribution, there are four possible states of the world one period into the future.
For example, state 1 may correspond to a recession. A probability is assigned to each state. The
probability reflects how likely it is that the state will ocurr. The sum of the probabilities must equal
100%, indicating that something must happen. The last two columns present the returns or outcomes
for stocks A and B that will occur in the four states.
Given a probability distribution of returns, the expected return can be calculated using the following
equation:
where
 E[R] = the expected return on the stock,

 N = the number of states,
 pi = the probability of state i, and
 Ri = the return on the stock in state i.
Expected Return on Stocks A and B
Stock A
Stock B
So we see that Stock B offers a higher expected return than Stock A. However, that is only part of
the story; we haven't yet considered risk.
MEASURING RETURNS:
1. Total Return:
Percentage measure relating all cash flows on a security for a given time period 10 its purchase
price
A correct returns measure must incorporate the two components of return, yield and price change, as
discussed earlier. Returns across time or from different securities can be measured and compared
using the total return concept. Formally, the total return (TR) for a given holding period is a decimal

(or percentage) number relating all the cash flows received by an investor during any designated
time period to the purchase price of the asset. Total return is defined as:
= Any cash payments received + Price changes over the period
The dollar price change over the period, defined as the difference between the beginning (or
purchase) price and, the ending (or sale) price, can be either positive (sales price exceeds purchase
price), negative (purchase price exceeds sales price), or zero. The cash payments can be either
positive or zero. Netting the two items in the numerator together and dividing by the purchase price
results in a decimal return figure that can easily be converted into percentage form. Note that in
using the TR, the two components of return, yield and price change, have been measured.
The general equation for calculating TR is;
+ ( − )
=
+
=
Where;
CFt = cash flows during the measurement period t
PE = price at the end of period t or sale price
PB = purchase price of the asset or price at the beginning of the period
PC = change in price during the period, or PE minus PB
The cash flow for bond pomes from the interest payments received, and that for a stock comes from
the dividends received. For some assets, such as a warrant or a stock that pays no dividends, there is
only a price change.
2. Return Relative:
It is often necessary to measure returns on a slightly different basis than TRs. This is particularly
true when calculating either a cumulative wealth index or a geometric mean, both of which are
explained below, because negative returns cannot be used in the calculation. The return relative (RR)
solves this problem by adding 1.0 to the total return.
RR = TR in decimal form + 1.0

TR in decimal form = RR - 1.0

Although return relatives may be less than 1.0, they will be greater than zero, thereby eliminating
negative numbers.
3. Cumulative Wealth Index:

Cumulative wealth over time given an initial wealth and a series of returns on some asset
Return measures such as TRs measure changes in the level of wealth. At times, however, it is more
desirable to measure levels of wealth {or prices) rather than changes. In other words, we measure the
cumulative effect of returns over time given some stated beginning dollar amount invested, which
typically is shown as $1 for convenience. Having calculated ending wealth (cumulative wealth) over
some period on the base of a beginning $1, it is simple enough to multiply by the actual beginning
amount, such as $10,000 or $100,000 or whatever the number is. The value of the cumulative wealth
index, CWIn is computed, as:
CWIn = WI0 (1 + TR1) (1 + TR2) ... (1 + TRn)
Where;
CWIB = the cumulative wealth index as of the end of period n

WI0 = the beginning index value, typically $1
TR1, n = the periodic TRs in decimal form
Taking a Global Perspective:

International investing offers potential return opportunities and potential reduction in risk through
diversification. Based on the historical record, investments in certain foreign markets would have
increased investor returns during certain periods-of time. However, investors need to understand
how these-returns are calculated and the risk they are taking.
Geometric Mean the arithmetic mean return is an appropriate measure of the central tendency of a
distribution consisting of returns calculated for a particular time" period, such as 10 years. However,
when percentage changes in value over time are involved, as a result of compounding, the arithmetic
mean of these changes can be misleading. A different mean, the geometric mean, is needed to
describe accurately the "true" average rate of return, over multiple periods.
The geometric mean return measures the compound rate of growth over time. It is often used in
investments and finance to reflect the steady growth rate of invested funds over some past period;
that is, the uniform rate at which money actually few over time per period. Therefore, it allows us to
measure the realized change in wealth over multiple periods.
.
The geometric mean is defined as the nth root of the product resulting from multiplying a series of
return relatives together,

G = [(1 + TR1) (1 + TR2)... (1 + TRn)]1/n – 1 where TR is a series of total returns in decimal form.
Note that adding 1.0 to each total return produces a return relative. Return relatives are used in
calculating geometric mean returns, because TRs, which can be negative, cannot be used.
Arithmetic Mean versus Geometric Mean:

When should we use the arithmetic mean and when should we use the geometric mean to describe
the returns from financial assets? The answer depends on the investor's objective:
The arithmetic mean is a better measure of average (typical) performance over single periods. It is
the best estimate of the expected return for next period.
The geometric mean is a better measure of the change in wealth over the past (multiple periods). It is
a backward-looking concept, measuring the realized compound rate of return at which money grew-
over a specified period.
SOURCES OF RISK:
What makes a financial asset risky? Traditionally, investors have talked about several sources of
total risk, such as interest rate risk and market risk, which are explained below, because these terms
are used so widely, Following this discussion, we will define the modern portfolio sources of risk,
which will be used later when we discuss portfolio and capital market theory.
1. Interest Rate Risk:

The variability in a security's return resulting from changes in the level of interest rates is referred to
as interest rate risk. Such changes generally affect securities inversely; that is, other things being
equal, security prices move inversely to interest rates. Interest rate risk affects bonds more directly
than common stocks, but it affects both and is a very important consideration for most investors.
2. Market Risk:
The variability in returns resulting from fluctuations in the overall market that is, the aggregate stock
market is referred to as market risk. All securities are exposed to market risk, although it affects
primarily common stocks.
Market risk includes a wide range of factors exogenous to securities themselves, including
recessions, wars, structural changes in the economy, and changes in consumer preferences.
3. Inflation Risk:
A factor affecting all securities is purchasing power risk, or the chance that the purchasing power of
invested dollars will decline/With uncertain inflation, the real (inflation-adjusted) return involves
risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk,

since interest rates generally rise as inflation increases, because lenders demand additional inflation
premiums to compensate for the loss of purchasing power
4. Business Risk:
The risk of doing business in a particular industry or environment is called business risk.
For example, AT&T, the traditional telephone powerhouse, faces major changes today in the rapidly
changing telecommunications industry.
5. Financial Risk:
Financial risk is associated with the use of debt financing by companies. The larger the proportion of
assets financed by debt (as opposed to equity), the larger the variability in the returns, other things
being equal. Financial risk involves the concept of financial leverage, which is explained in
managerial finance courses.
6. Liquidity Risk:
Liquidity risk is the risk associated with the particular secondary market in which a security trades.
An investment that can be bought or sold quickly and without significant price concession is
considered to be liquid. The more uncertainty about the time element arid the price concession, the
greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small over-the-
counter (OTC) stock may have substantial liquidity risk.
7. Exchange Rate Risk:

All investors who invest internationally in today's increasingly global investment arena face the
prospect of uncertainty in the returns after they-convert the foreign gains back to their own currency
Unlike the past when most U.S. investors ignored international investing alternatives, investors
today must recognize and understand exchange rate risk, which can be defined as the variability in
returns on securities caused by currency fluctuations.
Exchange rate risk is sometimes called currency risk.
For example, a U.S. investor who buys a German stock denominated in marks must ultimately
convert the returns from this stock back to dollars. If the exchange rate has moved against the
investor, losses from these" exchange rate' movements can partially or totally negate the original
return earned.
8. Country Risk:
Country risk, also referred to as political risk, is an important risk for investors today probably more
important now than in the past. With mote investors investing internationally, both directly and
indirectly, the political, and therefore economic, stability and viability of a country's economy need
to be considered. The United States arguably has the lowest country, risk, and other countries can be
judged on a-relative basis using the United States as a benchmark. Examples-of countries that
needed careful monitoring in the 1990s because of country risk included the, former Soviet Union
^and Yugoslavia, China, Hong Kong, and Smith Africa. In the-early part of the twenty-first century,
several countries in South America, Turkey, Russia, and Hong Kong, among others, require careful
attention.
TYPES OF RISK:
Thus far, our discussion has concerned the total risk of an asset, which is one important
consideration in investment analysis. However, modern investment analysis categorizes the
traditional sources of risk identified previously as .causing variability in returns into two general
types: those that are pervasive in nature, such as market risk or interest rate risk, and those that are
specific to a particular security issue, such as business or financial risk.
Therefore, we must consider these two categories of total risk.
Dividing total risk into its two components, a general (market) component and a specific (issuer)
component, we have systematic risk and nonsystematic risk, which are additive:
Total risk = General risk + Specific risk

= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk
Systematic (Market) Risk:
Risk attributable to broad macro factors affecting all securities

Systematic Risk is an investor can construct a diversified portfolio and eliminate pan of the total
risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the market
risk. Variability in a security's total returns that is directly associated with overall movements in the
general market or economy is called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk
directly encompasses the interest rate, market, and inflation risks. The investor cannot escape this
part of the risk, because no matter how well he or she diversifies, the risk of the overall market
cannot be avoided. If the stock market declines sharply, most stocks will be adversely affected; if it
rises strongly, as in the last few months of 1982, most stocks will appreciate in value. These
movements occur regardless of what any single investor does. Clearly, market risk is critical to all
investors.
Nonsystematic (Non-market) Risk:
Risk attributable to factors unique to the security

Nonsystematic Risk is the variability in a security's total returns not related to overall market
variability is called the nonsystematic (non-market) risk. This risk 1s unique to a particular security

and is associated with such factors as business and financial risk as well as liquidity risk. Although
all securities tend to have some nonsystematic risk, it is generally connected with common stocks.
Single Asset Risk
Standard Deviation and Coefficient of Variation
The return of any investment has an average, which is also the expected return, but most returns
will be different from the average: some will be more, others will be less. The more individual
returns deviate from the expected return, the greater the risk and the greater the potential reward.
The degree to which all returns for a particular investment or asset deviate from the expected return
of the investment is a measure of its risk.
Standard Deviation: Measure of Absolute Risk
If you recorded the returns of a sample population of investors who invested in 5-year Treasury
notes (T-notes), you would note that everyone received a constant rate of return that didn’t deviate,
since, once bought, T-notes pay a constant rate of interest with no credit risk. On the other hand, if
you had recorded the returns of a sample of investors who had invested in small stocks at the same
time, you would see a much wider variation in their returns—some would have done much better
than the T-note investors, while others would have done worse, and each of their returns would vary
over time. This variability can be measured with statistical methods, because investment returns
generally follow a normal distribution, which shows the probability of each deviation from the
mean, which is the average return, or the expected return, for a particular asset.
The sum of the deviations, both positive and negative, forms a normal distribution about the mean.
The normal distribution describes the variation of many natural quantities, such as height and
weight. It also describes the distribution of investment returns. The normal distribution has the
property that small deviations from the mean are more probable than larger deviations. When
graphed, it forms a bell-shaped curve.
The mean is subtracted from each deviation, then squared to ensure that all deviations are positive
numbers, then divided by the number of returns minus 1, which is the degrees of freedom for a small
sample. This is called the variance. The square root of the variance is the standard deviation,
which is simply the average deviation from the expected return. Standard deviations can measure the
probability that a value will fall within a certain range. For normal distributions, 68% of all values
will fall within 1 standard deviation of the mean, 95% of all values will fall within 2 standard
deviations, and 99.7% of all values will fall within 3 standard deviations.
A normal distribution can be completely described by its mean and standard deviation. The extent of
the deviation of investment returns is referred to as the volatility, which is, thus, measured by the
standard deviation of the investment returns for a particular asset. Volatility differs according to the
type of asset, such as stocks and bonds. Individual assets also differ in volatility, such as the stocks
of different companies and bonds by different issuers. Volatility is commensurate with the
investment’s risk, and this risk can be quantified by calculating the standard deviation for particular
investments, which is done by measuring the historical variation in the investment returns of
particular assets or classes of assets. The greater the standard deviation, the greater the volatility,
and, therefore, the greater the risk. More volatile assets have a wider bell-shaped curve, reflecting a
greater dispersion in their returns. Likewise, 1 standard deviation will cover a wider dispersion of
investment returns for a volatile asset than for a nonvolatile asset. Hence, more volatile assets are
more likely to outperform or underperform less volatile assets.
Standard Deviation Formula for Investment Returns
s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample size)
Coefficient of Variation: Measure of Relative Risk
The greater the standard deviation, the greater the risk of an investment. However, the standard
deviation cannot be used to compare investments unless they have the same expected return. For
instance, consider the following table.
Sample 1 Sample 2
Return 11 6 9
Return 2 4 11
Return 3 6 9
Return 4 4 11
Expected Return 5 10
Standard Deviation 1.154700538 1.154700538
Coefficient of Variation 0.230940108 0.115470054
On the left hand side, you have an investment with an expected return of $5 where each specific
return deviates by $1 from the expected return. On the right hand side, the specific returns also
deviate by $1, but the expected return is $10. Because the difference between the expected returns
and the specific returns for each sample is 1, the standard deviation is the same, but, nonetheless, the
risk is not the same, because $1 is only 10% of $10, but 20% of $5.
The coefficient of variation is a better measure of risk, quantifying the dispersion of an asset’s
returns in relation to the expected return, and, thus, the relative risk of the investment. Hence, the
coefficient of variation allows the comparison of different investments.
Coefficient of Variation = Standard Deviation / Average Return
In the above case, both samples have the same standard deviation, but have a significant difference
in the coefficient of variation. It is obvious that the investment with the smaller return has the greater
risk in this case.
So while the standard deviation measures the dispersion of returns, the coefficient of variation
measures their relative dispersion.
Example — Calculating the Standard Deviation and Coefficient of Variation

Using the data from Sample 1 in the above table, where the average or expected return = 5, and the
formulas for the standard deviation and coefficient of variation and remembering that x1/2 = √x, we
find that:
= ((6 - 5)2 + (4 - 5)2 + (6 - 5)2 + (4 - 5)2 / 4 - 1)1/2

Standard Deviation
= (4/3)1/2 = 1.154700538
= STDEV(6,4,6,4) = 1.154700538
Coefficient of Variation
= 1.154700538 / 5 = 0.230940108
Quantitative Measures Return

A. Holding Period Returns
 The total holding period return consists of two components: (1) capital appreciation
and (2) income.
 The capital appreciation component of a return, RCA:
Capital Appreciation P1 - P0 P
R CA =  
Initial Price P0 P0
Cash Flow CF1
 The income component of a return RI: R I = 
Initial Price P0
P CF1 P + CF1
 The total holding period return is simply R T = R CA + R I =   .
P0 P0 P0
B. Expected Returns
 Expected value represents the sum of the products of the possible outcomes and the
probabilities that those outcomes will be realized.

 The expected return, E(RAsset), is an average of the possible returns from an
investment, where each of these returns is weighted by the probability that it will
n
occur: E  R Asset     pi  R i    p1  R1    p2  R 2   ....   pn  R n 
i 1
 If each of the possible outcomes is equally likely (that is, p1 = p2 = p3 = … = pn = p

n
R  i
R1 + R 2 +...+ R n
= 1/n), this formula reduces to: E  R Asset   i 1
 .
n n
The Variance and Standard Deviation as Measures of Risk
A. Calculating the Variance and Standard Deviation

 The variance (2) squares the difference between each possible occurrence and the
mean (squaring the differences makes all the numbers positive) and multiplies each
difference by its associated probability before summing them up:
n

Var (R)   R2   pi   R i  E  R  
i 1
2

 If all of the possible outcomes are equally likely, then the formula becomes:
n
2
 R i  E(R)
 R2  i 1
n
 Take the square root of the variance to get the standard deviation ().
B. Interpreting the Variance and Standard Deviation
 The normal distribution is a symmetric frequency distribution that is completely
described by its mean (average) and standard deviation.
 The normal distribution is symmetric in that the left and right sides are mirror
images of each other. The mean falls directly in the center of the distribution, and
the probability that an outcome is a particular distance from the mean is the same
whether the outcome is on the left or the right side of the distribution.
 The standard deviation tells us the probability that an outcome will fall a
particular distance from the mean or within a particular range:
Number of Standard Fraction of Total
Deviations from the Observations
Mean
1.000 68.26%
1.645 90%
1.960 95%
2.575 99%

Historical Market Performance
 The key point is that, on average, annual returns have been higher for riskier securities.
For instance, Exhibit 7.4 shows that small stocks, which have the largest standard
deviation of total returns, also have the largest average return. On the other end of the
spectrum, Treasury bills have the smallest standard deviation and the smallest average
annual return.
Risk and Diversification

 By investing in two or more assets whose values do not always move in the same
direction at the same time, an investor can reduce the risk of his or her investments, or
portfolio. This is the idea behind the concept of diversification.
A. Single-Asset Portfolios
 Returns for individual stocks from one day to the next have been found to be
largely independent of each other and approximately normally distributed.
 A first pass at comparing risk and return for individual stocks is the coefficient of
variation, CV,
R
CVi  i
.
E (R i )
 A lower value for the CV is what we are looking for.
DISTINCTION BETWEEN RISK- FREE AND RISKY ASSETS

Risk-Free Asset is an asset which has a certain future return. Treasuries (especially T-bills) are considered to be risk-
free because they are backed by the U.S. government.
Risky Asset is an investment with a return that is not guaranteed. Assets carry varying levels of risk. For example,
holding a corporate bond is generally less risky than holding a stock. Government bonds are generally not considered
risky assets. A risky asset should not be confused with a risk asset.
RELATIONSHIP BETWEEN RISK AND RETURN ON INVESTMENT
There are two primary concerns for all investors: the rate of return they can expect on their investments and the risk
involved with that investment. While investors would love to have an investment that is both low risk and high return,
the general rule is that there is a more or less direct trade-off between financial risk and financial return. This does not
suggest that there is some perfect linear relationship between risk and return, but merely that the investments that
promise the greatest returns are generally the riskiest.
Risk-Free Investment
 A risk-free investment is an investment that has a guaranteed rate of return, with no

fluctuations and no chance of default. In reality, there is no such thing as a completely risk-
free investment, but it is a useful tool to understand the relationship between financial risk
and financial return. According to basic concepts of market economics, there would be such a
high demand for a risk-free investment that the institution owning the assets underlying the
investment would set the rate of return to something essentially equal to the time value of that
investment. In other words, if you invested in a risk-free investment, your return would
essentially be based entirely on the value of having money now as opposed to some point in
the future. That is why interest rates on savings accounts are so low. These are virtually risk-
free investments.
Risk Premium
 The calculation of financial return changes when we add risk to the equation. Assume that
there are two investments you can choose from for a five-year investment period. Investment
A is risk-free, and Investment B has a 50 percent chance of being completely worthless in
five years. Obviously, if these two investments promised the same rate of return, no rational
investor would choose Investment B. Instead, there has to be some kind of incentive to
choose this riskier investment. This incentive is generally a higher rate of return or potential
rate of return and is known as the risk premium.
Volatility
 In the debt market context, investors are primarily faced with two scenarios: they will be
compensated at the promised rate of return, no more and no less; or they will lose all of their
investment. With stock investments, the possibilities of returns are virtually infinite. A stock
could become completely worthless or worth an unimaginable amount of money. This is
because the value of a stock is determined by market forces that cause the stock to increase or
decrease in value over time. This is known as volatility. A stock with higher highs and lower
lows is more volatile, and therefore riskier. However, because this stock has higher highs, it
has a higher potential rate of return.
Portfolios and Managing Risk
 A portfolio is a collection of investments. A smart investor will not put all his eggs in one
basket and invest entirely in one stock. Instead, most investors choose a collection of
investments with varying levels of risk and return. By manipulating the proportion of risky
stocks in his portfolio, an investor can manipulate his level of risk and potential return
Relationship between risk and return

Thus, where you invest your money depends on your risk-taking
risk taking capacity as well as your return
expectations. You may tend to think that stocks are high risk investment options and may shy away
from it. But there is a way that you can lower the risk involved in stock investing without lowering
your returns. But before you learn this way, it is important to understand your investment profile
which we will do in the next blog.

CHAPTER 6
COST OF CAPITAL
Introduction of cost of capital

investment decision is major decision for an organization. Under investment decision process, the
cost and benefit of prospective projects is analyzed and the best alternative is selected on the basis of
the result of analysis. The benchmark of computing present value and comparing the profitability of
different investment alternatives is cost of capital. cost of capital is also known as minimum required
rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard return etc. cost of
capital is determined on the basis of component cost of financing and proportion of these sources in
capital structure.
Meaning of cost of capital

Business firms raise the needed fund from internal sources and external sources. Undistributed and
retained profit is the main source of internal fund. External fund is raised either by the issue of
shares or by issue of debenture (debt) or by both means. The fund collected by any means is not cost
free. Interest is to be paid on the fund obtained as debt and dividend is to be paid on the fund
collected through the issue of shares. The average cost rate of different sources of fund is known as
cost of capital.
From the view point of return, cost of capital is the minimum required rate of return to be earned on
investment. In other words, the earning rate of a firm which is just sufficient to satisfy the
expectation of the contributors of capital is called cost of capital. Shareholders and debenture
holders are the contributors of the capital. For example, a firm needs $ 5,00,000 for investing in a
new project. the firm can collect $3,00,000 from shares on which it must pay 12% dividend and $
2,00,000 from debentures on which it must pay 7% interest. if the fund is raised and invested in the
project, the firm must earn at least $50,000 which becomes sufficient to pay $36,000 dividend(12%
of $3,00,000) and $14000 interest(7% of $2,00,000). The required earning $50,000 is 12% of the
total fund raised. This 12% rate of return is called cost of capital.
In this way, cost of capital is only minimum required rate of return to earn on investment and it is
not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10%.
All the earnings will go in the hands of contributors of capital and nothing will be left in the
business. Therefore, any business firm should try to maximize the earning rate by investing in the
projects that can provide the rate of return which is more than the cost of capital.

SIGNIFICANCE AND COMPONENTS OF COST OF CAPITAL
Significance of cost of capital

cost of capital is considered as a standard of comparison for making different business decisions.
Such importance of cost of capital has been presented below.
1. Making investment decision

cost of capital is used as discount factor in determining the net present value. similarly, the actual
rate of return of a project is compared with the cost of capital of the firm. thus, the cost of capital has
a significant role in making investment decisions.
2. Designing capital structure

the proportion of debt and equity is called capital structure. the proportion which can minimize the
cost of capital and maximize the value of the firm is called optimal capital structure. cost of capital
helps to design the capital structure considering the cost of each sources of financing, investor's
expectation, effect of tax and potentiality of growth.
3. Evaluating the performance

cost of capital is the benchmark of evaluating the performance of different departments. the
department is considered the best which can provide the highest positive net present value to the
firm. The activities of different departments are expanded or dropped out on the basis of their
performance.
4. Formulating dividend policy

out of the total profit of the firm, a certain portion is paid to shareholders as dividend. however, the
firm can retain all the profit in the business if it has the opportunity of investing in such projects
which can provide higher rate of return in comparison of cost of capital. on the other hand, all the
profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore,
cost of capital plays a key role formulating the dividend policy.
COMPONENTS OF COST OF CAPITAL
The individual cost of each source of financing is called component of cost of capital. the
component of cost of capital is also known as the specific cost of capital which includes the
individual cost of debt, preference shares, ordinary shares and retained earnings. Such components
of cost of capital have been presented below:

a) cost of debt
 Cost of perpetual or irredeemable debt

 Cost of non-perpetual or redeemable debt
 Cost of debt issued on redeemable condition
 Cost of callable debt
b) Cost of preference share
 Cost of perpetual preference share

 Cost of redeemable preference share
c) Cost of ordinary/equity shares or common stock
d) Cost of retained earning
Specific costs of capital

Specific costs of capital are the costs of capital of each source of capital such as debt, preference
shares and equity.
a) Cost of debt (kd)

The cost of debt for a perpetual debenture will be;
=
I is the annual interest
Pb is the current market value of a debenture
If the debenture is redeemable after a certain period of time/it has a maturity period the following
formula will be applied to get the cost of debt or yield to maturity;
−
+
=
+
2
I is the annual interest
M is the par value of the debenture
is the current market value of the debenture
n is the period to maturity
The above formula gives the pre-tax cost of debt the after tax cost of debt for which interest paid on
debentures is an allowable expense for tax purposes will therefore be;
(1 − ) T being the tax rate.
b) Cost of preference shares ( )

The required return to the preference shareholders with perpetual preference share capital will be;
Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference share
=
is the preference dividend per share
is the market price per preference share
Where the company incurred floatation cost the
=
−
is the floatation cost
c) Cost of ordinary shares/equity ( )

Equity can be either internally generated (from retained earnings) or externally generated (the
common share capital).
The cost of retained earnings (K ). Retained earnings are an internal financing received without
incurring floatation costs. It can be calculated as follows;
= +
The cost of external equity (K ). can be calculated as follows;
= +
−
Where is the floatation cost which may be given as the percentage of the price or in shilling value.
Weighted average cost of capital (WACC)

This is the overall/composite cost of capital that a firm is currently using. It is calculated by
determining the weighted average cost of each source of capital in the firm’s capital structure.

( ) ( ) ( ) ( )
( ) = + + +
Where;
kd, kp, kr, ks =percentage cost of debt, preference share capital, retained earnings and external
equity respectively
D, P, R, S = total debt, preference, retained and ordinary share capital respectively

V = total value/capital of the firm
Hence, ,, ,, ,, are the proportions or weights of debt, preference capital, retained earnings
and external equity in the capital structure respectively
Example
Bahati Company has the following capital structure.
Source amount
Debentures 8,000,000
Preference capital 2,000,000
Retained earnings 4,000,000
Ordinary share capital 6,000,000
20,000,000
The component costs of capital are; kd is 6%, kp is10.5%, kr is 14%,ks is 17.2%

Compute the WACC.
= + + +
The wd,wp,wr,ws are the weights of the specific sources of capital whose sum is 1.
6(8 ) 10.5(2 ) 14(4 ) 17.2(6 )

= + + +
20 20 20 20
= 11.41%
The weighted average cost of capital can be used to evaluate the performance of management. Since
it is a historic cost it is not useful in investment decisions as it is irrelevant. In making decisions the
future costs are considered and hence the need for the marginal cost of capital (MCC).

MARGINAL COST OF CAPITAL (MCC)
This is the cost of raising an additional shilling. It considers the cost of raising additional or future
financing. An increase in the level of financing increases the cost of various types of finances. As
retained earnings are exhausted there may be a need to issue new ordinary shares which comes with
high floatation costs hence a higher marginal cost of capital.
Example
Mina ltd has 300,000 of retained earnings available. The kr is 13%. If the company exhausts the
retained earnings it can issue equity whose cost is 14%. The firm expects that it can borrow up to
400,000 at 5.6%, beyond that additional debt will have an after tax cost of 8.4%
Unlimited amounts of funds can be raised by issuing preference stock at a current cost of
10.6%.Mina Ltds capital structure is 40% debt, 50% equity,10% preference.
Calculate the marginal cost of capital of the various ranges of total financing.
The Break point reflects the level of total new financing at which the cost of one of the financing
components rises.
AF
BPj =
Wj
Where; AF is the amount of funds available from source j at a given cost before breaking point.
Wj is the capital structure weight of source j
300 000
BP of equity = = 600 000
0.5
400 000
BP of debt = = 1 000 000
0.4
Breaking point MCC

0- 600,000 0.4(5.6)+ 0.1(10.6) +0.5(13) = 9.8%
600,001-1,000,000 0.4(5.6) + 0.1(10.6) + 0.5(14) = 10.8%
Over 1m 0.4(8.4) +0.1(10.6) + 0.5(14) = 11.5%
Preference share capital cost does not change with the breaking points as we are told we can raise
unlimited funds at the same cost. The retained earnings are exhausted at the 600,001 shilling so the
cost increases as new equity is issued at 14%.
The marginal cost of capital schedule shows the relationship between the MCC and the amount of
funds raised by the company.

Weaknesses of WACC as a discounting rate
 It is an historical cost and therefore would not be appropriate t use in investments decision as
only future cash flows should be used. When calculating cost of equity the dividend is used
and so is the growth rate which is gotten from past stream of dividends.
 It assumes that the capital structure is optimal which is not achievable in the real world.
 It can only be used as a discounting rate assuming that the risk of the project is equal to the
business risk of the firm. if the project has higher risk then a percentage premium will be
added to WACC to determine the appropriate discounting rate.
WEIGHTED MARGINAL COST OF CAPITAL (WMCC) SCHEDULE

This is a schedule that shows the relationship between the marginal cost of capital; and the amount
of funds raise d by a company. The marginal cost of capital can either be constant or have breaks or
breaking points.
cost Cost
Kd KpKr and Ks are constant.

Amount
Constant Breaking points.
Constant cost of capital schedule occurs if it is possible to raise a limited amount of funds from each
of the sources at the same cost. A breaking point MCC occurs if additional funds from any of the
sources can only be raised at a higher cost. The most common MCC schedule is one with a break
when retained earnings are exhausted.

Total cheaper funds from a given source
Breaking Point =
Proportion of that source in the capital structure
Example
Makueni Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a
project in the following manner:
Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.
The present capital structure of the company is made up as follows:
1. 600,000 fully paid ordinary shares of Sh.10 each

2. Retained earnings of Sh.4 million
3. 200,000, 10% preference shares of Sh.20 each.
4. 40,000 6% long term debentures of Sh.150 each.
The current market value of the company’s ordinary shares is Sh.60 per share. The expected
ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in
both dividends and earnings has been 10% over the past ten years and this growth rate is
expected to be maintained in the foreseeable future.
The company’s long term debentures currently change hands for Sh.100 each. The
debentures will mature in 100 years. The preference shares were issued four years ago and
still change hands at face value.
Required:
(i) Compute the component cost of:

- Ordinary share capital;
- Debt capital
- Preference share capital.
(ii) Compute the company’s current weighted average cost of capital.
(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10
million as envisaged. (Assume a tax rate of 30%).
Solution
(b) (i) Cost of equity
do(1  g)
= +
Po
do(1+g) = Sh2.40

Po = Sh60
g = 10%
2.40
Ke = + 0.10 = 0.14 = 14%
60
Cost of debt capital (Kd)
Since the debenture has 100years maturity period then Kd = yield to maturity =
redemption.
1
Int(1 - T)  (m - vd)
Kd = n
(m  vd) 1
2
m = Maturity/per value = sh 150
vd = market value = Sh. 100
n = number of years to maturity =100
Int = Interest = 6% x Sh. 150 = Sh.9 p.a
T = Tax rate = 30
1
9(1 - 0.3)  (150 - 100)
Kd = 100  6.8 x 100 = 5.441%
(150  100) 1 125
2
Cost of preference share capital Kp
Kp = Coupon rate = 10% since MPS = par value
(ii) WACC or overall cost of capital Ko
M.V of equity = 600,000 shares x sh 60 MPS 36

M.V of debt = 40,000 debentures x Sh 100 4
4
M.V of preference shares = 200,000 shares x Sh 20
44
Ke = 14% Kd = 5.44% Kp = 10%
36 4 4
Ko = WACC = 14% + 5.44% +10% = 12.86%
44 44 44
The Sh 10M will be raised as follows:
Sh 6M from debt
Sh 4M from shares
Since there are no floatation costs involved then:
Marginal cost of debt = 5.4%
Marginal cost of ordinary share capital = 14%
4 6
Therefore marginal cost of capital = 14% + 5.55% = 8.86%
10 10

CHAPTER 7
WORKING CAPITAL MANAGEMENT

Introduction
Management of Working Capital is also an important part of financial manager. The main objective
of the Working Capital Management is managing the Current Asset and Current Liabilities
effectively and maintaining adequate amount of both Current Asset and Current Liabilities. Simply
it is called Administration of Current Asset and Current Liabilities of the business concern.
Management of key components of working capital like cash, inventories and receivables assumes
paramount importance due to the fact the major portion of working capital gets blocked in these
assets.
Meaning
Working capital management is an act of planning, organizing and controlling the components of
working capital like cash, bank balance inventory, receivables, payables, overdraft and short-term
loans.
Definition
According to Smith K.V, “Working capital management is concerned with the problems that arise
in attempting to manage the current asset, current liabilities and the inter-relationship that exist
between them”.
According to Weston and Brigham, “Working capital generally stands for excess of current assets
over current liabilities. Working capital management therefore refers to all aspects of the
administration of both current assets and current liabilities”.
NATURE AND IMPORTANCE OF WORKING CAPITAL MANAGEMENT
Working capital is the life blood and nerve center of business. Working capital is very essential to
maintain smooth running of a business. No business can run successfully without an adequate
amount of working capital. The main advantages or importance of working capital are as follows:

1. Strengthen The Solvency
Working capital helps to operate the business smoothly without any financial problem for making
the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and
overhead can be made without any delay. Adequate working capital helps in maintaining solvency
of the business by providing uninterrupted flow of production.
2. Enhance Goodwill
Sufficient working capital enables a business concern to make prompt payments and hence helps in
creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating
expenses are paid on time.
 Financial Forecast
 Financial Forecasting
 Advantages of solar panels
 Bond
3. Easy Obtaining Loan

A firm having adequate working capital, high solvency and good credit rating can arrange loans
from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material

Quick payment of credit purchase of raw materials ensures the regular supply of raw materials from
suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials
and continuous production.
5. Smooth Business Operation

Working capital is really a life blood of any business organization which maintains the firm in well
condition. Any day to day financial requirement can be met without any shortage of fund. All
expenses and current liabilities are paid on time.
6. Ability to Face Crisis

Adequate working capital enables a firm to face business crisis in emergencies such as depression.
DETERMINANTS OF WORKING CAPITAL
Requirements Of working capital depend upon various factors such as nature of business, size of
business, the flow of business activities. However, small organization relatively needs lesser
working capital than the big business organization. Following are the factors which affect the
working capital of a firm:

1. Size of Business
Working capital requirement of a firm is directly influenced by the size of its business operation. Big
business organizations require more working capital than the small business organization. Therefore,
the size of organization is one of the major determinants of working capital.
2. Nature of Business
Working capital requirement depends upon the nature of business carried by the firm. Normally,
manufacturing industries and trading organizations need more working capital than in the service
business organizations. A service sector does not require any amount of stock of goods. In service
enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales
and advance related transactions are in large amount. So, they need more working capital.
3. Storage Time or Processing Period

Time needed for keeping the stock in store is called storage period. The amount of working capital is
influenced by the storage period. If storage period is high, a firm should keep more quantity of
goods in store and hence requires more working capital. Similarly, if the processing time is more,
then more stock of goods must be held in store as work-in-progress.
4. Credit Period
Credit period allowed to customers is also one of the major factors which influence the requirement
of working capital. Longer credit period requires more investment in debtors and hence more
working capital is needed. But, the firm which allows less credit period to customers’ needs less
working capital.
5. Seasonal Requirement
In certain business, raw material is not available throughout the year. Such business organizations
have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them
during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which
gives rise to more working capital requirements.
6. Potential Growth or Expansion Of Business

If the business is to be extended in future, more working capital is required. More amount of
working capital is required to meet the expansion need of business.
 Classifications
 Small business loan
 Small Business
 Small business owner

7. Changes in Price Level
Change in price level also affects the working capital requirements. Generally, the rise in price will
require the firm to maintain large amount of working capital as more funds will be required to
maintain the sale level of current assets.
8. Dividend Policy
The dividend policy of the firm is an important determinant of working capital. The need for
working capital can be met with the retained earning. If a firm retains more profit and distributes
lower amount of dividend, it needs less working capital.
9. Access to Money Market

If a firm has good access to capital market, it can raise loan from bank and financial institutions. It
results in minimization of need of working capital.
10. Working Capital Cycle

when the working capital cycle of a firm is long, it will require larger amount of working capital.
But, if working capital cycle is short, it will need less working capital.
11. Operating Efficiency

The operating efficiency of a firm also affects the firm's need of working capital. The operating
efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in
turn results in more fund release for working capital.
WORKING CAPITAL MANAGEMENT POLICIES
Working capital policy of a company refers to the level of investment in current assets for attaining
their targeted sales. It can be of three types viz. restricted, relaxed, and moderate. Relaxed policy has
higher and restricted has lower levels of current assets whereas moderate places itself between
relaxed and restricted. Commonly, these policies are also named as aggressive, conservative and
hedging policy.
2 Important Decisions in Working Capital Management – Level of Current Asset and their
Means of Financing.
Working capital management has two main decisions at two consecutive stages. They are as follows:
1. Level of Current Assets – How much to invest in Current Assets to achieve the Targeted
Revenue?
2. Means of Financing Current Assets – How should the above Current Asset Investment be
financed i.e. the mix of long and short term finance?

Difference between Working Capital Policies and Working Capital Financing Strategies
Commonly, policies of working capital and strategies (approaches) of working capital financing are
interchangeably used and which is not correct. There is a thin line of difference between the two.
Working capital management policy deals with the first decision and working capital management
strategies or approaches deal with the second decision. Working capital policies are restricted,
relaxed and moderate whereas the working capital strategies are aggressive, conservative and
hedging (Maturity Matching).
Types of Working Capital Policies
Based on the attitude of the finance manager towards risk, profitability and liquidity, the working
capital policies can be divided into following three types.
1. Restricted Policy/ aggressive working capital policy:
In restricted policy, the estimation of current assets for achieving targeted revenue is done very
aggressively without considering for any contingencies and provisions for any unforeseen event.
After deciding, these policies are forcefully implemented in the organization without tolerating any
deviations. In the diagram, point R represents the restricted policy which attains the same level of
revenues with lowest current assets.
Adopting this policy would result into an advantage of lower working capital requirement due to
lower level of current assets. This saves the interest cost to the company and which in turn produces

higher profitability i.e. higher return on investment (ROI). On the other hand, there is disadvantage
in the form of high risk due to very aggressive policy. That is why; it is also called as aggressive
working capital policy.
2. Relaxed Policy/ conservative working capital policy
Relaxed policy is just the opposite of restricted policy. In this policy, the estimation of current
assets for achieving the targeted revenue is prepared after careful consideration of uncertain events
such as seasonal fluctuations, sudden change in level of activities or sales etc. After the reasonable
estimates also, a cushion to avoid any unforeseen circumstances is left to avoid the maximum
possible risk. In the diagram, it represents the point Rx which uses highest level of current assets for
achieving the same level of sales.
The companies having relaxed working capital policies assume an advantage of almost no risk or
low risk. This policy guarantees the entrepreneur of the smooth functioning of the operating cycle.
We know that earnings are more important than higher earnings. On the other hand, there is a
disadvantage of lower return on investment because higher investment in the current assets attracts
higher interest cost which in turn reduces profitability. Because of its conservative nature, this policy
is also called as conservative working capital policy.
3. Moderate Policy
Moderate policy is a balance between the two policies i.e. restricted and relaxed. It assumes
characteristics of the both the policies. To strike a balance, moderate policy assumes risk which is
lower than restricted and higher than conservative. In profitability front also, it lies between the two.
The biggest benefit of this policy is that it has reasonable assurance of smooth operation of
working operating capital cycle with moderate profitability.
Working capital policies can be further framed for each component of net working capital i.e. cash,
accounts receivable, inventory and accounts payable. Cash policies can be to maintain appropriate
level of cash. When level is high, it should be invested in liquid investments for short term and vice
versa. Accounts receivable policy may state about payment terms, credit period, credit limit, etc.
Inventory policy may speak of minimizing the levels of inventory till the point it pose any risk to
satisfaction of customer demands. Accounts payable policies include policies of payment terms,
quality terms, return policies, etc.

CASH MANAGEMENT
Cash is a key part of working capital management.

Companies need to carry sufficient levels of cash in order to ensure they can meet day-to-day
expenses. Cash is also required to be held as a cushion against unplanned expenditure, to guard
against liquidity problems. It is also useful to keep cash available in order to be able to take
advantage of market opportunities.
The cost of running out of cash may include not being able to pay debts as they fall due which can
have serious operational repercussions, including the winding up of the company if it consistently
fails to pay bills as they fall due.
However, if companies hold too much cash then this is effectively an idle asset, which could be
better invested and generating profit for the company.
Balancing Act
The firm faces a balancing act between liquidity and profitability.
Cash budgets and cash flow forecasts
Cash forecast
Cash forecast is an estimate of cash receipts and payments for a future period under existing
conditions. Every type of cash inflow and receipt, along with their timings,must be forecast. Cash
receipts and payments differ from sales and cost of sales in the income statement because:
 not all cash receipts or payments affect the income statement
 some income statement items are derived from accounting conventions and are not cash flows
 the timing of cash receipts and payments does not coincide with the income statement
accounting period
Cash budget
A cash budget is a commitment to a plan for cash receipts and payments for a future period after
taking any action necessary to bring the forecast into line with the overall business plan.
Cash budgets are used to:

 assess and integrate operating budgets
 plan for cash shortages and surpluses
 compare with actual spending.
Companies are likely to prepare a cash budget as part of the annual master budget, but then to
continually prepare revised cash forecasts throughout the year, as a means of monitoring and
managing cash flows.

Proforma cash forecast
Preparing a cash flow forecast from working capital ratios Working capital ratios can be used to
forecast future cash requirements, by using the working capital ratios to work out the working
capital requirement. This technique can be used to help forecast overall cash flow.
Treasury management
Treasury management is heavily concerned with liquidity and covers the following activities:
 banking and exchange
 cash and currency management
 investment in short-term assets
 risk and insurance
 Raising finance.
All treasury management activities are concerned with managing the liquidity of a business, the
importance of which to the survival and growth of a business cannot be over-emphasised.
Need for a treasury department
The functions carried out by the treasurer have always existed, but have been absorbed historically
within other finance functions. A number of reasons may be identified for the modern development
of separate treasury departments:
 size and internationalisation of companies: these factors add to both the scale and the
complexity of the treasury functions

 Size and internationalisation of currency, debt and security markets: these make the
operations of raising finance, handling transactions in multiple currencies and investing,
much more complex. They also present opportunities for greater gains
 Sophistication of business practice: this process has been aided by modern communications,
and as a result the treasurer is expected to take advantage of opportunities for making profits
or minimising costs which did not exist a few years ago.
For these reasons, most large international corporations have moved towards setting up a separate
treasury department. Treasury departments tend to rely heavily on new technology for information.
Responsibilities of a treasury management function
The treasurer will generally report to the finance director, with a specific emphasis on borrowing and
cash and currency management. The treasurer will have a direct input into the finance director's
management of debt capacity, debt and equity structure, resource allocation, equity strategy and
currency strategy.
The treasurer will be involved in investment appraisal, and the finance director will often consult the
treasurer in matters relating to the review of acquisitions and divestments, dividend policy and
defence from takeover.
Short-term investment and borrowing solutions
A company must choose from a range of options to select the most appropriate source of
investment/funding.
Short-term cash investments
Short-term cash investments are used for temporary cash surpluses.To select an investment, a
company has to weigh up three potentially conflicting objectives and the factors surrounding them:

 Liquidity: the cash must be available for use when needed.
 Safety: no risk of loss must be taken.
 Profitability: subject to the above, the aim is to earn the highest possible after-tax returns.
Each of the three objectives raises problems.
The liquidity problem
At first sight this problem is simple enough. If a company knows that it will need the funds in three
days (or weeks or months), it simply invests them for just that period at the best rate available with
safety. The solution is to match the maturity of the investment with the period for which the funds
are surplus. However there are a number of factors to consider:
The exact duration of the surplus period is not always known. It will be known if the cash is needed
to meet a loan instalment, a large tax payment or a dividend. It will not be known if the need is
unidentified, or depends on the build-up of inventory, the progress of construction work, or the
hammering out of an acquisition deal.

The safety problem
Safety means there is no risk of capital loss. Superficially this again looks simple. The concept
certainly includes the absence of credit risk. For example, the firm should not deposit with a bank
which might conceivably fail within the maturity period and thus not repay the amount deposited.
However, safety is not necessarily to be defined as certainty of getting the original investment repaid
at 100% of its original home currency value. If the purpose for which the surplus cash is held is not
itself fixed in the local currency, then other criteria of safety may apply.
The profitability problem
The profitability objective looks deceptively simple at first: go for the highest rate of return subject
to the overriding criteria of safety and liquidity. However, here there are complications.

Short-term borrowing
Short-term cash requirements can also be funded by borrowing from the bank. There are two main
sources of bank lending:
 bank overdraft
 bank loans.
Bank overdrafts
A common source of short-term financing for many businesses is a bank overdraft. These are mainly
provided by the clearing banks and represent permission by the bank to write cheques even though
the firm has insufficient funds deposited in the account to meet the cheques.
An overdraft limit will be placed on this facility, but provided the limit is not exceeded, the firm is
free to make as much or as little use of the overdraft as it desires. The bank charges interest on
amounts outstanding at any one time, and the bank may also require repayment of an overdraft at
any time.
The advantages of overdrafts are the following.
 Flexibility as they can be used as required.

 Cheapness as interest is only payable on the finance actually used, usually at 2-5% above
base rate (and all loan interest is a tax deductible expense).
The disadvantages of overdrafts are as follows.
 Overdrafts are legally repayable on demand. Normally, however, the bank will give
customers assurances that they can rely on the facility for a certain time period, say six
months.
 Security is usually required by way of fixed or floating charges on assets or sometimes, in
private companies and partnerships, by personal guarantees from owners.
 Interest costs vary with bank base rates. This makes it harder to forecast and exposes the
business to future increases in interest rates.

Bank loans
Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed
rate of interest. They are less flexible and more expensive than overdrafts but provide greater
security.
A bank loan represents a formal agreement between the bank and the borrower, that the bank will
lend a specific sum for a specific period (one to seven years being the most common). Interest must
be paid on the whole of this sum for the duration of the loan.
This source is, therefore, liable to be more expensive than the overdraft and is less flexible but, on
the other hand, there is no danger that the source will be withdrawn before the expiry of the loan
period. Interest rates and requirements for security will be similar to overdraft lending.
CASH MANAGEMENT MODELS
Cash management models are aimed at minimising the total costs associated with movements
between a company's current account (very liquid but not earning interest) and their short-term
investments (less liquid but earning interest).
The models are devised to answer the questions:
 at what point should funds be moved?

 how much should be moved in one go?
The Baumol cash management model
Baumol noted that cash balances are very similar to inventory levels, and developed a model based
on the economic order quantity (EOQ).Assumptions:
 cash use is steady and predictable

 cash inflows are known and regular
 day-to-day cash needs are funded from current account
 Buffer cash is held in short-term investments.
The formula calculates the amount of funds to inject into the current account or to transfer into
short-term investments at one time:

where:
CO = transaction costs (brokerage,commission, etc.)

D = demand for cash over the period
CH = cost of holding cash.
The model suggests that when interest rates are high, the cash balance held in non-interest-bearing
current accounts should be low. However its weakness is the unrealistic nature of the assumptions
on which it is based.
Example using the Baumol model
A company generates $10,000 per month excess cash, which it intends to invest in short-term
securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs
associated with each separate investment of funds is constant at $50.
Required:
a) What is the optimum amount of cash to be invested in each transaction?

b) How many transactions will arise each year?
c) What is the cost of making those transactions pa?
d) What is the opportunity cost of holding cash pa?
Solution:

The Miller-Orr cash management model
The Miller-Orr model is used for setting the target cash balance for a company.
The diagram below shows how the model works over time.
 The model sets higher and lower control limits, H and L, respectively, and a target cash
balance, Z.
 When the cash balance reaches H, then (H-Z) dollars are transferred from cash to marketable
securities, i.e. the firm buys (H-Z) dollars of securities.
 Similarly when the cash balance hits L, then (Z-L) dollars are transferred from marketable
securities to cash.
The lower limit, L is set by management depending upon how much risk of a cash shortfall the firm
is willing to accept, and this, in turn, depends both on access to borrowings and on the consequences
of a cash shortfall.

The formulae for the Miller-Orr model are:
Return point = Lower limit + (1/3 × spread)
Spread = 3 [ (3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3
Note: variance and interest rates should be expressed in daily terms. Variance = standard deviation
squared.
Example using the Miller-Orr model
The minimum cash balance of $20,000 is required at Miller-Orr Co,and transferring money to or
from the bank costs $50 per transaction. Inspection of daily cash flows over the past year suggests
that the standard deviation is $3,000 per day, and hence the variance (standard deviation squared) is
$9 million. The interest rate is 0.03% per day.
Calculate:
(i) The spread between the upper and lower limits

(ii) The upper limit
(iii) The return point.
Solution:
(i) Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3 = $31,200
(ii) Upper limit = 20,000 + 31,200 = $51,200
(iii) Return point = 20,000 + 31,200/3 = $30,400
ACCOUNTS RECEIVABLES MANAGEMENT
Receivables, also termed as trade credit or debtors are component of current assets. When a firm
sells its product in credit, account receivables are created.
Account receivables are the money receivable in some future date for the credit sale of goods and
services at present. These days, most business transactions are in credit. Most companies, when they
face competition, use credit sales as an important tool for sales promotion. As a sales promotion
tool, credit sale enhances firm's sales revenue and ultimately pushes up the profitability. But after the
credit sale has been made, the actual collection of cash may be delayed for months. As these late
payments stretch out over time, they may cause substantial drop in a company's profit margin. Since
the extension of credit involves both cost and benefits, the firm's manager must be able to measure
them to determine the ultimate effect of credits sales. In this prospective, we define the receivable
management as the aspect of a firm's current assets management, which is concerned with

determining optimum credit policy associated to a firm, such that the benefit from extension of
credit is greater than the cost of maintaining investment in accounts receivables.
Significance and Purpose of Receivable Management

The basic purpose of firm's receivable management is to determine effective credit policy that
increases the efficiency of firm's credit and collection department and contributes to the
maximization of value of the firm. The specific purposes of receivable management are as follows:
1. To evaluate the creditworthiness of customers before granting or extending the credit.

2. To minimize the cost of investment in receivables.
3. To minimize the possible bad debt losses.
4. To formulate the credit terms in such a way that results into maximization of sales revenue
and still maintaining minimum investment in receivables.
5. To minimize the cost of running credit and collection department.
6. To maintain a tradeoff between costs and benefits associated to credit policy.
Areas covered by receivables management
The Following are the areas covered by receivables management:

- Credit Analysis
- Credit Terms
- Financing of Receivables
- Credit Collection
- Monitoring of Receivables
Credit selection
This is the decision whether to extend credit to a customer and how much credit to extend. A credit
investigation is first carried out on the prospective customer in whom the 5 Cs of credit are
employed.
The five Cs of credit are key dimensions
1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions
They are used by the credit analysts to focus their analysis on an applicant’s credit worthiness. A
brief discussion of these characteristics follows.

Character This refers to the creditor‘s willingness to honor obligations. The applicants recordof
meeting past obligations – financial, contractual, and moral - is closely scrutinized. Any past
litigation against the applicant would also be relevant.
Capacity This considers the applicants ability to generate cash to repay the requested credit.
Financial statement analysis, especially liquidity and debt ratios are useful in assessing capacity.
Capital Considers the financial strength of the applicant as reflected by his net worth position. The
applicant‘s debts relative to equity and the profitability ratios will be used in this assessment.
Collateral Looks at the amount of assets the applicant can pledge to secure the credit to be
advanced. The asset structure as revealed in the balance sheet and record of any legal claims against
the applicant will be helpful in this assessment.
Conditions The prevailing economic and business climate as well as unique circumstance affecting
the applicant will be considered. Character and Capacity receive primary attention; capital, collateral
and conditions play a supplementary role.
Sources of Information on the Debtor
The evaluation of an applicant begins when he fills a form providing basic financial and credit data
and references. Additional information will be obtained from other sources depending on time and
expense and size of credit involved. The credit analyst may obtain information from the following
sources.
Financial Statements -The seller may request the audited financial statements of the applicant for a
number of years. The trends shown by the statements would help gauge financial strengths.
Credit Rating And Reports Credit rating agencies provide subscribers with credit rating and
estimates of overall financial strength for many companies (Dun & Bradstreet is the largest
mercantile credit reporting agency in the world. In Kenya, the industry is in its infancy with
Metropol Rating Agency one among the very few firms active).
Bank Checking The applicant‘s bank could be a good source of information for the credit analyst.
The credit analyst can obtain information such as average cash balance carried, loan granted and
recovery of loan experience. Despite existence of banking secrecy laws, the credit applicant will
allow his bank to provide the information in order to facilitate his being granted credit.
Trade checking Credit information is frequently exchanged among companies selling to the same
customer. Companies can ask other supplies about their experience with an account.

Credit Analysis
Having collected information, the credit analyst must conduct a credit analysis of the applicant. The
analyst must decide on the applicant‘s credit worthiness and the maximum amount of credit the
applicant can support – the line of credit (maximum amount a credit customer can owe the selling
firm at any one time). Two approaches to credit analysis are discussed below.
(a) Investigations Procedures

The following ad hoc procedures are usually employed by small firms and by big firms on small
accounts
1. Applicant‘s financial statements and accounts payable ledger can be used to calculate the
―average payment periodǁ
2. Consult past experience to see whether the firm has sold previously to the account (applicant)
and whether that experience has been satisfactory.
3. A through ratio analysis of the accounts liquidity activity, debt and profitability.
4. A credit rating agency‘s recommendation could be obtained and used to estimate the
maximum line of credit to extend.
5. Time series comparison should be performed to uncover any trends.
6. The credit analyst's own subjective judgment of a firm‘s credit worthiness could be decisive.
(a) Credit scoring systems These systems employ quantitative approaches to decide whether or not
to grant credit, by assigning numerical scores to various characteristics related to the applicant‘s
credit worthiness. The credit score is a weighted average of scores obtained on key financial and
credit characteristics. In consumer credit, plastic credit cards are often given out on the basis of a
credit-scoring system that rates such things as occupation, duration of employment, home
ownership, years of residence and annual income. Numerical rating systems are also used by some
companies extending trade credit (credit granted from one business to another).
Credit Decision and Line Of Credit
Once the analyst has marshaled the necessary evidence and analyzed it, two decisions must be made:
1) Whether to extend the credit

2) Whether to establish a line of credit. A line of credit is used where repeat sales are expected.
It is the maximum limit on the amount the firm will permit to be owed at any one time by the
applicant. In essence it is the maximum risk exposure that the firm will allow itself to
undergo for an account.

Credit standards
Credit standards define the minimum criteria for the extension of credit to a customer. Extension of
credit has its costs (risks) even as it has benefits. In determining the optimal credit standards,
marginal costs of credit should be related to the marginal profits from the increased sales.
Key variables that should be considered in evaluating relaxation or tightening of credit standards
are:
a) Clerical and collection expenses –If credit standards are relaxed / tightened more/less credit
is offered and a bigger/smaller credit department is needed to service accounts.
b) Investment in Receivable – The higher the firm‘s average accounts receivables are, the more
expensive they are to carry, and vice versa. Thus a relaxation of credit standards can be
expected to result in higher carrying costs and a tightening of credit standards results in a
lover carrying costs.
c) Default and Bad date Expenses: the probability of (risk) of acquiring a bad debt increases as
credit standards are relaxed and decreases as the standards become more restrictive.
d) Sales Volume and contribution margin: it is expected that as credit standards are relaxed,
sales (contribution margin) will be expected to increase; a tightening of credit standards is
expected to reduce sales (contribution margin).
CREDIT TERMS (TERMS OF SALE)
Credit terms specify the repayment terms required of all credit customers ( i.e. 2/10,net 30. Credit
terms make specification on three issues:
(1) the cash discount (2)%

(2) the cash discount (10
period days)
(3) the credit period (30
days)
The sales volume increases since the cash discount effectively reduces the price for those firms
ready to pay within the discount period. (assuming demand is elastic). The Average collection
period decreases because the discount acts as an inducement for early payment. The bad debt
expense falls because as people pay earlier, the risk of a bad debt decreases. The increase in sales,
and the decrease in average collection period and bad debt expense have a positive effect on net
profits. Increased cash discount has however the negative effect of a decreased profit margin per unit
as more people take the discount and pay the reduced price.

Example
XYZ Co. is contemplating initiating a cash discount of 2% for payment within 10 days of purchase.
The firm‘s current average collection period is 30 days.. Credit sales of 120,000 units at a price of
Sh.10 are made annually. Variable cost per unit is Sh.6, and average cost per unit is Sh.8. If the
discount is initiated 70% of sales will be on discount and sales will increase by 10%. The average
collection period will drop to 15 days. Bad debt expenses currently at 2% of sales will fall to 1%.
Total working capital needed will not be affected by the cash discount. The firms required return on
investment is 12%. Assume no additional capital investment will be necessary.
Evaluate the proposal to initiate a discount.
Solution
An additional (10% x 120,000) 12,000 units will be sold whose contributions to profit is 12,000 x 4
= Sh.48, 000
Average Investment in A/R (receivables).
Current plan (30 days) – 120,000/12 = 100,000

Proposed plan (15 days) = 1,320,000/24 = 55,000
Reduction in Average 45,000

A/R =
Savings = 45,000 x 12% = Sh.5, 400
Bad debts Expenses
Current plan = 2% x 1,200,000 = 24,000

Proposed plan = 1% x 1,320,000 = 13,200
Saving in bad debt losses sh.10,800
Cash discount costs

Cash discount 2% x 1,320,000 x = Sh.18, 480
70%

Eg of an aging analysis
Days due Action

0 No action
0-10 Send statements/call to remind them to pay
10-30 Call again
30-60 Write letter demanding payment/make provision for bad
debt
60-90 Ask lawyer to write
90-120 if material, take action
Financing accounts receivable

This involves either Assigning/Pledging of Accounts Receivable or Selling/factoring of accounts
Receivable
Assigning/Pledging of Accounts Receivable

This involves borrowing form a financial institution and offering accounts receivable as security.
Under this arrangement, the customer is not notified and the risk of default remains with the
company. The financial institution requires full payment of the loan, whether the customer pays or
not for this reason, the company must carry out a credit analysis to determine the customers credit
worthiness.
Selling/factoring of Accounts Receivable

This involves selling of accounts receivable to a financial institutions referred to as a factor. This
occurs without recourse to the company i.e. if the customer falls to pay. It is the duty of the factor to
follow up. The customer is usually notified of this arrangement and is therefore required to pay
directly to the financial institution. The financial institution therefore assumes the risk of default and
must therefore carry out a credit analysis. The financial institution would, however, charge a
commission for this service.
Procedures for Factoring

An agreement between the company and the factor is usually made to specify the legal obligations
of this agreement. Upon receipt of application from the customer, the co prepared a credit approval
slip and sends it to the financial institution. If credit is approved, then shipment of the goods is made
and an invoice sent to the customer notifying him to make payments directly to the company after
deducting of commission for credit analysis, interest for risk bearing and a restrive for damaged or
returned goods.
Example:
A company factors Shs. 10 000 of its accounts receivable, terms n/30. The factoring commission is
2.5% of the invoice value and interests is 9% per annum. The factor charges a reserve of 5% for
damaged and or returned goods. The interest and commission are other discounted. Required:
i. Show the accounting entry made by the company.
ii. Complete the effective cost of the arrangement
Solution Working
Commission = 2.5% x 1000 =250 Interest = x
Reserve = 5% x 10 000 = 500 x = 9% (10 000 – 250 – x)
12
Accounting entries
DR: Bank / Cash (9677.4 – 9177.4 x = 0.0075 (9750 – x)
500)
Commission 250 x = 73.125-0.0075x
Interest 72.6 1.0075x = 73.125
Reserve 500 z = 72.6
CR: Accounts receivable 10 000
Amount received = 10 000 – Commission – interest = 10 000 – 250 – 72.6 = 9677.4
ii)
Total Charges x months
=
72.6 x 250x12
9677.4
= %
ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are sources of short term financing which assist firms finance current assets and
meet other short term financing needs. The three broad categories of short term financing are:
1. Spontaneous sources
2. unsecured sources
3. secured sources
The following are brief characteristics of each of these sources.
Spontaneous Sources
Spontaneous financing arises automatically from the day-to-day operations of the firm. The most
common forms of spontaneous financing come from trade credit from suppliers, and accrued
expenses. This financing is interest free and requires no collateral.
Creditors Management (Account Payable)
The purchaser obtains goods and services, agreeing to pay later in accordance with the credit terms
stated on supplier‘s invoice. Trade credit is credit extended in connection with goods purchased for
resale. It is this qualification that distinguishes trade credit from other forms of credit.
Suppliers often give cash discounts on open accounts for payment within a specified period. The
credit terms specify the credit period, the size of the cash discount, the cash discount period, and the
date the credit period begins , which is usually at the end of each month (EOM). For example, terms
of 2/10, net 30 EOM, mean a discount of 2% may be taken if the invoice is paid within 10 days of
the invoice date; otherwise the full payment is due within 30 days from the end of the month of
purchase. If the EOM is not part of the terms then counting begins from the date of the invoice.
Prompt-payment cash discounts are to be distinguished from quantity (bulk) discounts given for
purchase of large quantities, and also from trade discounts given at different points in the
distribution chain (wholesale versus retail, etc.). Proper management of credit offered by suppliers
requires that:
1. The firm takes the cash discounts by paying on the last day of the discount period. The annual
percentage cost of giving up cash discounts is quite high. This cost can be estimated using the
following equation.
Cost of giving up discount = CD/(100%-CD)*365/N (12.4)

Where CD = stated cash discount as a percentage
N = number of days payment can be delayed by giving up the cash discount
Example
ABC Ltd. purchased Sh.100,000 worth of merchandise on 27 February from a supplier extending
credit terms of 2/10, net 30 EOM. Calculate the cost of giving up the cash discount.
Solution
The annualized effective cost of giving the discount = CD/(100%- CD)*(365/N)
= 2%/(100%-2%)*(365/20)
= 37.24%
This is a very high cost indeed and is equivalent borrowing at 37.24%. (NB If we were to take the
discount the firm would pay on 10 March. By giving up the discount it costs the firm Sh.2,000
(100,000-98,000)).

2. Stretch accounts payable The firm should pay its bills as late as possible without damaging its
credit rating. The full extent of the credit period should be utilized in the case where cash discounts
are not offered. Caution is to be exercised in stretching
payments as this may harm the firm‘s reputation and at worst can cot the firm its sources of supply.
Accruals
Accruals are the other major source of spontaneous financing. Accrued expenses arise when a firm
consumes services (other than trade services) without having to make immediate payment for them
.Typical expenses that generate accrued financing include wages and salaries, utilities, rent, etc.
Unsecured sources of short term financing
Unsecured source of financing is one against which no specific assets are pledged as collateral.
Businesses obtain unsecured short term credit from three sources i.e. trade credit, banks and
commercial paper.
Trade credit Most trade credit is extended via the open account that results in accounts payable
discussed in the preceding section. There are however two other less common sources of trade
credit; The promissory note (trade) and the trade acceptances.
1. Promissory note Is usually called a note payable (trade) on the balance sheet. Such notes
bear interest and have specified maturity date. They are used in situations in which a
purchaser of goods on credit has failed to meet the terms of an open credit agreement and the
supplier wishes a formal acknowledgement of the debt and a specific agreement on a future
payment date.
2. Trade acceptances Under this arrangement the purchaser acknowledges the debt formally by
accepting a draft drawn by then seller calling for payment on a specified date at a designated
bank. After acceptance, the draft is returned to the seller and the goods are shipped.
Bank loans
Commercial banks are by far the largest suppliers of unsecured loans to businesses. Businesses need
to establish a cordial relationship with their bank that can facilitate lending transactions. For a
successful relationship to blossom banks will generally look for honesty and integrity, managerial
competence and frank communication in their clients. In addition detailed and specific information
regarding the nature of the financing requirement, the amounts and timing of the need, the uses to
which the funds will be put, and when and how the bank will be repaid may be needed. Banks lend

unsecured short term loans in three forms: a line of credit, a revolving credit agreement, and a single
payment note.
1. Single payment note This is a short term , one-time-loan, payable as a single amount
Businesses need to establish a cordial relationship with their bank that can facilitate lending
transactions. For a successful relationship to blossom banks will generally look for honesty and
integrity ,managerial competence and frank communication in their clients. In addition detailed and
specific information regarding the nature of the financing requirement, the amounts and timing of
the need, the uses to which the funds will be put, and when and how the bank will be repaid may be
needed. Banks lend unsecured short term loans in three forms: a line of credit, a revolving credit
agreement, and a single payment note.
1. Single payment note This is a short term , one-time-loan, payable as a single amount at its
maturity. It generally has a maturity of 30-daysto 9 months and may have either a fixed or
floating rate.
2. Lines of credit A line of credit is an agreement between a business and a bank showing the
maximum amount the business could borrow and owe the bank at any point in time. Lines of
credit are not contractual and legally binding upon the bank, but they are nearly always
honored. The major benefit, to a business, of a line of credit is its convenience and
administrative simplicity. From the bank‘s point of view the major attraction of a line of
credit is that it eliminates the need to examine the creditworthiness of a customer each time
the customer wants to borrow. The terms of a credit line may require a floating interest rate,
operating change restrictions, compensating balances, and annual cleanup provisions ( a
period usually of 1or 2 months during which the loan is completely paid off). A line of credit
is often used to finance seasonal working capital needs or other temporary requirements.
3. Revolving credit agreement Involve a contractual and binding commitment by the bankto
provide funds during a specified period of time. Because the bank legally guarantees the
availability of funds, the borrower pays a commitment fee of ¼ or ½ percent per year on the
average unused portion of the commitment. Revolving credit agreement, like a line of credit,
permit the firm to borrow up to a certain maximum amount; but unlike a line of credit, are not
subject to ‗clean-up ‗ provisions.
Commercial Paper
A commercial paper is a form of financing that consists of short term promissory notes issued by
firms with high credit standing. Commercial paper is typically sold at a discount from its par value.
Consequently, the interest charged is determined by the size of the discount and the time to maturity.
Commercial paper distributed through the stock exchange is known as a money market instrument.

The use of commercial paper to raise funds is advantageous because the cost is lower relative to
bank loans and the borrower avoids the cost of maintaining compensating balances required on bank
loans. Additionally , borrowers who need to raise huge amounts of money can satisfy their needs
more conveniently by issuing commercial paper.
Example
A company has issued a Sh.100,000,000 par value worth of commercial paper with a 90-day
maturity, for Sh.98,000,000. Find the effective annual rate of interest on the paper.
Solution
The effective annual rate = (1+D/N‫)م‬ⁿ -1 (12.1)
Where D = discount
N‫ = م‬net proceeds from issue
n =365/time to maturity
The effective 90-day rate is = D/Np = 2,000,000/98,000,000 = 0,0204

Therefore ,effective annual rate = (1+0.0204) ⁿ- 1 = 0.0841 = 8.41% (n =365/90 = 4)
Secured Sources Of Short Term Financing
A loan is one obtained by a borrower pledging specific asset(s) as security. In the case of shot term
loans, lenders insist on collateral that is reasonably liquid. Inventory, accounts receivable, and
marketable securities are the assets commonly used as security. Usually the interest on secured loans
is higher than interest on unsecured loans because of the perceived risk and the costs of negotiation
and administration. The primary sources of secured loans are the commercial banks and non-bank
financial institutions.
In considering the use of a company‘s asset as security we should keep in mind the adverse effect of
such action on unsecured creditors who may take them into account in any future transactions.
STOCK / INVENTORY MANAGEMENT
The management of stock/ inventory is a key aspect of working capital management.
The objectives of inventory management
Inventory is a major investment for many companies. Manufacturing companies can easily be
carrying inventory equivalent to between 50% and100% of the revenue of the business. It is
therefore essential to reduce the levels of inventory held to the necessary minimum.

Importance of inventory management
The challenge of of good inventory management is to determine:
 the optimum re-order level (how many items are left in inventory when the next order is
placed), and
 the optimum re-order quantity (how many items should be ordered when the order is placed)
In practice, this means striking a balance between holding costs on the one hand and stockout and
re-order costs on the other.
Costs of high inventory levels
Keeping inventory levels high is expensive due to:
 purchase costs
 holding cost (storage, stores administration, risk of theft/damage/obsolescence)
Carrying inventory involves a major working capital investment and therefore levels need to be very
tightly controlled. The cost is not just that of purchasing the goods, but also storing, insuring, and
managing them once they are in inventory.
Costs of low inventory levels
If inventory levels are kept too low, the business faces alternative problems:
 stockouts (lost contribution, production stoppages, emergency orders)

 high re-order/setup costs
 lost quantity discounts.
The balancing act: Profitability v Liquidity
The balancing act between liquidity and profitability is key to good inventory management. This
could also be considered to be a trade-off between holding costs and stockout/re-order costs.
Economic Order Quantity (EOQ)
For businesses that do not use just in time (JIT) inventory management systems, there is an optimum
order quantity for inventory items, known as the EOQ.
The aim of the EOQ model is to minimise the total cost of holding and ordering inventory. To do
this, it is necessary to balance the relevant costs.
The challenge of of good inventory management is to determine:

 the optimum re-order level (how many items are left in inventory when the next order is
placed), and
 the optimum re-order quantity (how many items should be ordered when the order is placed)
In practice, this means striking a balance between holding costs on the one hand and stockout and
re-order costs on the other. The economic order quantity formula is one approach to striking this
balance.
Economic order quantity (EOQ)
For businesses that do not use just in time (JIT) inventory management systems, there is an optimum
order quantity for inventory items, known as the EOQ.
The aim of the EOQ model is to minimise the total cost of holding and ordering inventory. To do
this, it is necessary to balance the relevant costs. These are:
 the variable costs of holding the inventory (holding costs)

 the fixed costs of placing the order (ordering costs)
Holding costs
The model assumes that it costs a certain amount to hold a unit of inventory for a year (referred to as
CH in the formula). Therefore, as the average level of inventory increases, so too will the total annual
holding costs incurred.
When new batches or items of inventory are purchased or made at periodic intervals, the inventory
levels are assumed to exhibit the following pattern over time.
If x is the quantity ordered, the annual holding cost would be calculated as:

Holding cost per unit × Average inventory:
X
C =
2
We therefore see an upward sloping, linear relationship between the re-order quantity and total
annual holding costs.
Ordering costs
The model assumes that a fixed cost is incurred every time an order is placed (referred to as COin the
formula). Therefore, as the order quantity increases, there is a fall in the number of orders required,
which reduces the total ordering cost.
If D is the annual expected sales demand, the annual order cost is calculated as:
Order cost per order × no. of orders per annum.
D
C =
2
However, the fixed nature of the cost results in a downward sloping, curved relationship.

Balance between holding costs and ordering costs
Because you are trying to balance these two costs (one which increases as re-order quantity
increases and one which falls), total costs will always be minimised at the point where the total
holding costs equals the total ordering costs. This point will be the economic order quantity (EOQ).
Assumptions
The following assumptions are made:
 demand and lead time are constant and known

 purchase price is constant
 no buffer inventory held (not needed).
The calculation
The EOQ can be more quickly found using a formula:
Where:
CO = cost per order

D = annual demand
CH = cost of holding one unit for one year.

Quantity discounts
Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size
needed for a discount, companies must calculate if the order size should be increased above the
EOQ.
The total inventory cost for the annual level of demand (including holding costs, ordering costs and
purchase costs) should be compared:
 assuming the EOQ is used

 assuming the order size enabling the discount is used
The assumption is that the company would accept the discount and order in the larger quantity if the
overall inventory cost is lower.
Reorder levels
Companies must identify how much inventory to re-order, and when to re-order. To do this the
company needs to identify a level of inventory which can be reached before an order needs to be
placed. This is known as the reorder level.
Calculating the re-order level (ROL)
When demand and lead time (the time to receive inventory from the time it is ordered) are known
with certainty the ROL may be calculated exactly, i.e. ROL = demand in the lead time.
Where there is uncertainty, an optimum level of buffer (or safety) inventory must be carried. This
depends on:
 variability of demand
 cost of holding inventory
 Cost of stockouts.
In reality, demand will vary from period to period, and the reorder level (ROL) must allow some
buffer (or safety) inventory, the size of which is a function of maintaining the buffer (which
increases as the levels increase), running out of inventory (which decreases as the buffer increases)
and the probability of the varying demand levels.
Inventory management systems
A number of systems have been developed to simplify the inventory management process.
 bin systems
 periodic review
 JIT.

Bin systems
A simple visual reminder system for re-ordering is to use a bin system.
Two-bin system
This system utilises two bins, e.g. A and B. Inventory is taken from A until A is empty. An order for
a fixed quantity is placed and, in the meantime, inventory is used from B. The standard inventory for
B is the expected demand in the lead time (the time between the order being placed and the
inventory arriving), plus some 'buffer' inventory.
When the new order arrives, B is filled up to its standard level and the rest is placed in A. Inventory
is then drawn as required from A,and the process is repeated.
One-bin system
The same sort of approach is adopted by some firms for a single bin with a red line within the bin
indicating the ROL.
These methods rely on accurate estimates of:
 lead time
 demand in lead time.
Action must therefore be taken if inventory levels:
 fall below a preset minimum

 exceed a preset maximum.

Control levels
Minimum inventory level usually corresponds with buffer inventory. If inventory falls below that
level, emergency action to replenish maybe required.
Maximum inventory level would represent the normal peak holding, i.e. buffer inventory plus the re-
order quantity. If the maximum is exceeded, a review of estimated demand in the lead time is
needed.
Periodic review system (constant order cycle system)
Inventory levels are reviewed at fixed intervals, e.g. every four weeks. The inventory in hand is then
made up to a predetermined level, which takes account of:
 Likely demand before the next review

 Likely demand during the lead time.
Thus a four-weekly review in a system where the lead time was two weeks would demand that
inventory be made up to the likely maximum demand for the next six weeks.
Just in Time (JIT) systems
JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory levels
and improve customer service by manufacturing not only at the exact time customers require, but
also in the exact quantities they need and at competitive prices.
In JIT systems the balancing act is dispensed with. Inventory is reduced to an absolute minimum or
eliminated altogether.
Aims of JIT are:

 a smooth flow of work through the manufacturing plant
 a flexible production process which is responsive to the customer's requirements
 Reduction in capital tied up in inventory.
This involves the elimination of all activities performed that do not add value = waste.
Examples of waste are:

 raw material inventory
 WIP inventory
 finished goods inventory
 materials handling
 quality problems (rejects and reworks, etc.)
 queues and delays on the shop floor
 long raw material lead times
 long customer lead times
 unnecessary clerical and accounting procedures.

JIT attempts to eliminate waste at every stage of the manufacturing process. Jit should result in:
 a smooth flow of work through the manufacturing plant

 a flexible production process which is responsive to the customer's requirements
 reduction in capital tied up in inventory.
A JIT manufacturer looks for a single supplier who can provide high quality, frequent and reliable
deliveries, rather than the lowest price. In return, the supplier can expect more business under long-
term purchase orders, thus providing greater certainty in forecasting activity levels. Very often the
suppliers will be located close to the company. Smaller, more frequent deliveries are required at
shorter notice.
JIT therefore has inventory holding costs which are close to zero, however, inventory ordering costs
are high.

CHAPTER 8
CAPITAL BUDGETING DECISIONS UNDER CERTAINTY
Introduction
Capital budgeting decision is also known as the investment decision. The capital budgeting process
involves a firms decision to invest its funds in the most viable and beneficial project. It is the process
of evaluating and selecting long term investments consistent with the firm’s goal of owner wealth
maximization.
The firm expects to produce benefits to the firm over a long period of time and encompasses
tangible and intangible assets. For a manufacturing firm, capital investment are mainly to acquire
fixed assets-property, plant and equipment. Note that typically, we separate the investment decision
from the financing decision: first make the investment decision then the finance manager chooses
the best financing method.
These key motives for making capital expenditures are;
1. Expansion: The most common motive for capital expenditure is to expand the cause of
operations – usually through acquisition of fixed assets. Growing firms need to acquire new
fixed assets rapidly.
2. Replacements – As a firm’s growth slows down and it reaches maturity, most capital
expenditure will be made to replace obsolete or worn out assets. Outlays of repairing an old
machine should be compared with net benefit of replacement.
3. Renewal – An alternative to replacement may involve rebuilding, overhauling or refitting an
existing fixed asset.. A physical facility could be renewed by rewiring and adding air
conditioning.
4. Other purposes – Some expenditure may involve long-term commitments of funds in
expectations of future return i.e. advertising, R&D, management consulting and development
of view products. Other expenditures include installation of pollution control and safety
devises mandated by the government.
Features/characteristics of investment decisions

1. The investment requires a high outlay of capital which must be planned.
2. Capital budgeting decisions have an influence on the rate and direction of the growth of the
organization unlike normal operation costs.
3. The investment has long-term implications. I.e. more than 1 year.
4. The decisions are irreversible. This implies that there might be no second hand market for the
assets since it’s usually tailor made for that particular firm.
5. The future expected cash flows from this project are uncertain thus these decisions involve a
high degree of risk.

INVESTMENT EVALUATION CRITERIA
Three steps are involved in the evaluation of an investment:
 Estimation of cash flows

 Estimation of the required rate of return (the cast of capital)
 Application of a decision rule for decision rule for making the choice
Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, or investment
criteria. A sound appraisal technique should be used to measure the economic worth of an
investment project. The essential property of a sound technique is that is should maximize the
shareholders wealth. The following other characteristics should also be possessed by a sound
investment evaluation criterion:
 It should consider all cash flows to determine the true profitability of then project.
 It should provide for an objective and unambiguous way of separate good projects from bad
projects.
 It should help ranking of projects according to their true profitability.
 It should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that project which maximizes the
shareholders wealth.
 It should be a criterion which is applicable to any conceivable investment project independent
of others.
Steps in Capital Budgeting Process

The capital budgeting process consists of five distinct but interrelated steps. It begins with proposal
generation, followed by review and analysis, decision making, implementation and follow-up. These
six steps are briefly outlined below.
1. Proposal generation: Proposals for capital expenditure are made at all levels within a
business organization. Many items in the capital budget originate as proposals from the plant
and division management. Project recommendations may also come from top management,
especially if a corporate strategic move is involved (for example, a major expansion or entry
into a new market). A capital budgeting system where proposals originate with top
management is referred to a top-down system, and one where proposals originate at the plant
or division level is referred to as bottom-up system. In practice many firms use a mixture of
the two systems, though in modern times has seen a shift to decentralization and a greater use
of the bottoms-up approach. Many firm offer cash rewards for proposal that are ultimately
adopted.
2. Review and analysis: Capital expenditure proposals are formally reviewed for two reasons.
First, to assess their appropriateness in light of firm’s overall objectives, strategies and plans
and secondly, to evaluate their economic viability. Review of a proposed project may involve
lengthy discussions between senior management and those members of staff at the division
and plant level who will be involved in the project if it is adopted. Benefits and costs are
estimated and converted into a series of cash flows and various capital budgeting techniques
applied to assess economic viability. The risks associated with the projects are also evaluated.
3. Decision making: Generally the board of directors reserves the right to make final decisions
on the capital expenditures requiring outlays beyond a certain amount. Plant manager may be
given the power to make decisions necessary to keep the production line moving (when the
firm is constrained with time it cannot wait for decision of the board).
4. Implementation: Once approval has been received and funding availed implementation
commences. For minor outlays the expenditure is made and payment is rendered: For major
expenditures, payment may be phased, with each phase requiring approval of senior company
officer.
5. Follow-up: involves monitoring results during the operation phase of the asset. Variances
between actual performance and expectation are analyzed to help in future investment
decision. Information on the performance of the firm’s past investments is helpful in several
respects. It pinpoints sectors of the firm’s activities that may warrant further financial
commitment; or it may call for retreat if a particular project becomes unprofitable. The
outcome of an investment also reflects on the performance of those members of the
management involved with it. Finally, past errors and successes provide clues on the
strengths and weaknesses of the capital budgeting process itself.
This topic will majorly discuss on the second step: Review and analysis.
Estimation of cash flows is one of the most important and challenging step because decisions made
depend on cashflows projected for each proposal. Cashflows must be relevant and therefore need to
have the following criteria,
 They must be future cashflows because cashflows already received or paid are sunk costs
hence irrelevant in decision making.
 Cashflows must be incremental. This enables the firm to analyze cashflows of the firm with
or without the project.
 Cashflows must involve an actual inflow or outflow of cash. Thus expenses which do not
involve a movement of cash e.g. Depreciation are not cashflows.
Cash flow components

The cash flows of any project can include three basic components:
(1) An initial investment
(2) Operating cash flows
(3) Terminal cash flows.

All projects will have the first two; some however, lack the final components.
Initial Investment
The initial investment is the relevant cash outflow for a proposed project at time zero. It is found by
subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero.
Atypical format used to determine initial cash flow is shown below.
Cost on new asset xx

Installation cost xx
Installed cost of new asset xx
Proceeds from sale of old assets xx
+ Tax on sale of old assets xx
After-tax proceeds from sale of old
asset xx
+ Change in Net working

capital xx
Initial Investment xx
The installed cost of new asset = cost of new asset (acquisition cost) + installation cost (additional
cost necessary to put asset into operation) +After-tax proceeds from sale of old asset
Change in networking capital (NWC) Net working capital is the difference between current assets
(CA) and current liabilities (CL) i.e. NWC = CA –CL. Changes in NWC often accompany capital
expenditure decisions. If a company acquires a new machinery to expand its levels of operation,
levels of cash, accounts receivables, inventories, accounts payable, accruals will increase. Increases
in current assets are uses of cash while increases in current liabilities are sources of cash. As long as
the expanded operations continue, the increased investment in current assets (cash, accounts
receivables and inventory) and increased current liabilities (accounts payables and accruals) would
be expected to continue.
Generally, current assets increase by more than the increase in current liabilities, resulting in an
increase in NWC which would be treated as an initial outflow (This is an internal build up of
accounts with no tax implications, and a tax adjustment is therefore unnecessary).
Operating Cash Flows

These are incremental after tax cash during its lifetime. Three points should be noted:-
- Benefits should be measured on after tax basis because the firm will not have the use of any
benefits until it has satisfied the government’s tax claims.
- All benefits must be measured on a cash flow basis by adding back any non-cash charges
(depreciation)

- Concern is only with the incremental (relevant) cash flows. Focus should be only on the
change in operating cash flows as a result of proposed project. The following income
statement format is useful in the determination of the operating cash flows.
General format for estimating operating cash flows:
1. Sh.
Incremental sales over the life of the project xx
Less cost of sales (xx)
Savings before depreciation and tax xx
Less depreciation (xx)
Savings before tax xx
Less Tax(Savings before tax × Tax rate) (xx)
Savings after tax xx
Add back depreciation (xx)
Net incremental cash flows xx
2. OR
(As above)
Savings before depreciation and tax xx
Less tax(Savings before tax & dep. × Tax rate) (xx)
Savings after tax xx
Add depreciation tax shield(Depreciation ×Tax rate) xx
Net incremental cash flows (xx)
Terminal Cash Flows

The cash flows resulting from the termination and liquidation of a project at end of its economic life
are its terminal cash flow. Terminal cash flow is determined as incremental after tax proceeds from
sale or termination of a new asset or project. The format below can be used to determine terminal
cash flows.
Proceeds from sale of new assets Project xx
+ Tax on sale of new asset xx
xx
Proceeds from sale of old asset xx
+ Tax on sale of old asset xx xx
+ Change in NWC xx
Terminal Cash Flow xx
Note that for a replacement decision both the sale proceeds of the old asset and the new asset are
considered. In the case of other decision (other than replacement), the proceeds of an old asset would
be zero. Note also that with the termination of the project the need for the increased working capital
is assumed to end. This will be shown as a cash inflow due to the release of the working capital to be
used business needs. The amount recovered at termination will be equal to the amount shown in the
calculation of the initial investment.

Basic terminologies in capital budgeting.
Independent Vs Mutually Exclusive Projects

Independent projects are those whose cash flows are unrelated or independent of one another; the
acceptance of one does not eliminate the others from further considerations (if a firm has unlimited
funds to invest, all independent project that meet it minimum acceptance criteria will be
implemented i.e. installing a new computer system, purchasing a new computer system, and
acquiring a new limousine for the CEO.
Mutually exclusive projects are projects that compete with one another, no that the acceptance of
one eliminates the acceptance of one eliminate the others from further consideration. For example, a
firm in need of increased production capacity could either,
(1) Expand it plant
(2) Acquire another company, or
(3) Contract with another company for production of required items.
Unlimited Funds Vs Capital Rationing

Unlimited funds- This is the financial situation in which a firm is able to accept all independent
projects that provide an acceptable return (Capital budgeting decisions are simply a decision of
whether or not the project clears the hurdle rate).
Capital rationing This is the financial situation in which the firm has only a fixed number of shillings
to allocate among competing capital expenditures. A further decision as to which of the projects that
meet the minimum requirements is to be invested in has to be taken.
Conventional Versus Non-Conventional Cash flows

Conventional cash flow pattern consists of an initial outflow followed by only a series of inflows. (
For example a firm spends Sh.10 million and expects to receive equal annual cash inflows of Sh.2
million in each year for the next 8 years) The cash inflows could be unequal
Non-conventional cash flows This is a cash flow pattern in which an initial outflow is not followed
only by a series of inflows, but with at least one cash outflow. For example the purchase of a
machine may require Sh.20 million and may generate cash flows of Sh.5million for 4 years after
which in the 5th year an overhaul costing Sh.8million may be required. The machine would then
generate Sh.5 million for the following 5 years.
Relevant Versus Incremental Cash flows
To evaluate capital expenditure alternatives, the firm must determine the relevant cash flows which
are the incremental after-tax initial cash flow and the resulting subsequent inflows associated with a
proposed capital expenditure. Incremental cash flows represent the additional cash flows (inflowing
and outflows) expected to result from a proposed capital expenditure.

Sunk Costs Vs Opportunity Cost
Sunk costs are cash outlays that have already been made (past outlays) and therefore have no effect
on the cash flows relevant to a current decision. Therefore sunk costs should not be included in a
project’s incremented cash flows.
Opportunity costs are cash flows that could be realized from the best alternative use of an owned
asset. They represent cash flows that can therefore not be realized, by employing that asset in the
proposed project. Therefore, any opportunity cost should be included as a cash outflow when
determining a project’s incremental cash outflows.
CAPITAL BUDGETING TECHNIQUES.

There are different methods of analyzing the viability of an investment. The preferred technique
should consider time value procedures, risk and return considerations and valuation concepts to
select capital expenditures that are consistent with the firm’s goals of maximizing owner’s wealth.
Capital budgeting techniques are grouped in two:
a) Non-discounted cash flow techniques (traditional methods)

i. Pay back period method(PBP)
ii. Accounting rate of return method(ARR)
b) Discounted cash flow techniques (modern methods)

iii. Net present value method(NPV)
iv. Internal rate of return method(IRR)
v. Profitability index method(PI)
NON-DISCOUNTED CASH FLOW TECHNIQUES
PAY BACK PERIOD METHOD (PBP)

Payback period refers to the number of periods/ years that a project will take to recoup its initial
cash outlay.
This technique applies cash flows and not accounting profits.
I f the project generates constant annual cash inflows, the Payback period will be given by,
PBP=Initial Investment
Annual cash flow
Illustration:
Example
AQMW systems, a medium sized software engineering company that is currently contemplating two
projects: project A requires an initial investment of Sh.42million and project B requires an initial

investment of Sh.45million. The projected relevant cash flows for the two projects are shown
below.
PROJECT A PROJECT B
Initial Investment (yr 0) Sh.42 million Sh.45 million
Operating cash flows
Year 1 Sh.14 million Sh.28 million
Year3 Sh.14 million Sh.10 million
Average Sh.14 million Sh.14 million
For project A, (Annuity cashflows)
42
Pay back period = 14 = 3.0 years
For project B (a mixed cashflows), the initial investment of Sh.45million will be recovered between
the 2nd and 3rd year-ends.
Year Cash flow (Sh) Cumulative cash flow (Sh.)
1 28million 28million
5
2  2.5 years
Pay back period = 10
Only 50% of year 3 cash inflows of Sh.10million are needed to complete the pay back period of the
initial investment ofSh.45million. Therefore pay back period of project B is 2.5 years.
Decision Criteria
If AQMW systems maximum acceptable Payback period was 2.75 years, Project A would be
rejected and project B would be accepted. If projects were being ranked, Project B would be
preferred.
Where the projects are independent the project with the lowest PBP should rank as the first as the
initial outlay is recouped within a shorter time period.
For mutually exclusive projects the project with the lowest PBP should be accepted.

Advantages of PBP
1. It’s simple to understand and use.
2. It’s ideal under high risk investment as it identifies which project will payback as soon as
possible
3. PBP is cost effective as it does not require use of computers and a lot of analysis
4. PBP emphasizes on liquidity hence funds which are released as early as possible can be
reinvested elsewhere
Weaknesses of PBP
1. It does not consider all the cashflows in the entire life of the project.
2. It does not measure the profitability of a project but rather the time it will take to payback the
initial outlay
3. PBP does not take into account the time value of money
4. It does not have clear decision criteria as a firm may face difficulty in determining the
minimum acceptable payback period
5. It is inconsistent with the shareholders wealth maximization objective. Share values do not
depend on the payback period but on the total cashflows.
ACCOUNTING RATE OF RETURN METHOD (ARR)

This is the only method that does not use cashflows but instead uses accounting profits as shown in
the financial statements of a company. It is also known as return on investment (ROI).
The ARR is given by:
ARR= Average annual profit after tax ×100

Average investment
Illustration:
Aqua ltd has a proposal for a project whose cost is Sh.50million and has an economic useful life of 5
years. It has a nil residual value. The earnings before depreciation and tax expected from the project
are as follows:
Year Earnings before depreciation and tax
Sh.’000’
1 12000
2 15000
3 18000
4 20000
5 22000
The corporate tax rate is 30% and depreciation is on straight line basis.
Solution:
Depreciation = 50 m - 0 = 10m
5
Calculation of the average income,
Year
1 2 3 4 5
Earnings before dep. 12000 15000 18000 20000 22000
Less depreciation 10000 10000 10000 10000 10000
Earnings after dep 2000 5000 8000 10000 12000
Tax @ 30% -600 -1500 -2400 -3000 -3600
Profit after tax 1400 3500 5600 7000 8400
Average Income =1400+3500+5600+7000+8400

5
=Ksh. 5,180,000
Average investment=Initial investment + salvage value

2
Average investment=50000000 + 0
2
=2500000
ARR= Average income x100

Average investment
ARR = 5,180,000 × 100

25,000,000
=20.72%
Decision criteria:
If the projects are mutually exclusive the project with the highest ARR is accepted. If projects are
independent, they should be ranked from the one with the highest ARR which should come first to
the one with the lowest as the last.
If the firm has a minimum acceptable ARR, then the decision will be based on the project with a
higher ARR as per their preferred rate.

Advantages of ARR
1. Simple to understand and use.
2. The accounting information used is readily available from the financial statements.
3. All the returns in the entire life of the project are used in determining the project’s
profitability.
Weaknesses of ARR
1. Ignores time value of money.
2. Uses accounting profits instead of cashflows which could have been arbitrarily determined.
3. Growth companies earning very high rates of return on the existing assets may reject
profitable projects as they have set a higher minimum acceptable ARR, the less profitable
companies may set a very low acceptable ARR and may end up accepting bad projects.
4. Does not allow for the fact that profits can be reinvested.
DISCOUNTED CASHFLOW TECHNIQUES
NET PRESENT VALUE (NPV)
This is the difference between the present value of cash inflows and the present value of cash
outflows of a project. To get the present values a discount rate is used which is the rate of return or
the opportunity cost of capital. The opportunity cost of capital is the expected rate of return that an
investor could earn if the money would have been invested in financial assets of equivalent risk.
Hence it’s the return that an investor would expect to earn.
When calculating the NPV the cashflows are used and this implies that any non-cash item such as
depreciation if included in the cashflows should be adjusted for. In computing NPV the following
steps should be followed:
Cashflows of the investment should be forecasted based on realistic assumptions. If sufficient
information is given one should make the appropriate adjustments for non-cash items
Identify the appropriate discount rate. (It is usually provided)

Compute the present value of cashflows identified in step 1 using the discount rate in step2
The NPV is found by subtracting the present value of cash out flows from present value of cash
inflows.
 C C2 C3 Cn 
NPV   1  2
 3
 L  n
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
NPV   t
 C0
t 1 (1  k )

CO Initial investment.
NPV= PV (inflows) –PV (outflows)

Decision Criteria
When NPV is used to make accept – reject decisions, the decision criteria are as follows:
 If the NPV is greater than 0, accept the project
 If the NPV is less than 0, reject the project.
If NPV > 0, the firm will earn a return greater than its cost of capital, thereby enhancing the market
value of the firm and shareholders wealth.
Recall the previous illustration (AQMW systems)
Additional information; the firms required rate of return is 30%.

Compute the NPV of AQMW systems and advise the management of the company
Project A
Annual Cash inflow (annuity) 14million
PVIFA 10%, 5 years (tables) 3.791
PV of cashflows. 53.074million
Less initial Investment 42.million
Net Present Value 11.074million
Project B
Year Cash Inflows PVIF PV
1 28million 0.909 25.452m
2 12m 0.826 9.912m
3 10m 0.751 7.510m
4 10m 0.683 6.830m
5 10m 0.621 6.210m
Present Value 55.914m
Less initial investment(CO) (45.000m)
NPV 10.912m
Decision criteria,
Both projects are acceptable as the NPV is positive.
Project A is preferable to project B as it has a higher NPV of 11million comparing to B of
10.9million.

PROFITABILITY INDEX
It is defined as the ratio of the present value of the cashflows at the required rate of return to the
initial cashout flow on the investment.
PI= Present value of cash inflow

Initial cash outflow.
It is also called the benefit –cost ratio because it shows the present value of benefits per shilling of t
he cost. It is therefore a relative means of measuring a project’s return. It thus can be used to
compare projects of different sizes.
Decision criteria:
If PI > 1 Accept project.

PI < 1 Reject project.
PI = 0 Indifferent.
For example from previous example,
PI= 18,368.98
15,000
= 1.22
Profitability Index is +1.22 >1

Thus the project is viable as PI IS More than 1.
For example if you have two mutually exclusive independent projects with the following NPV and
PI
Project NPV PI
A 6000 1.44
B 5000 1.22
Decision: Using PI, both projects are acceptable as their PI is greater than 1.
Since the projects are mutually exclusive, select Project A as it has a higher than that of B.
Advantages of PI
1. It considers time value of money.
2. It considers all cash flows yielded by the project.
3. It ranks projects in order of the economic desirer ability.
4. It gives a unique decision criterion.

5. It is a relative measure of profitability and therefore can be used to compare projects of
different sizes.
Weaknesses of PI
1. It is not consistent with maximizing shareholders wealth.
2. It assumes the discount rate is known and consistency which might not be the case.
INTERNAL RATE OF RETURN.(IRR)
This is the discounting rate that equates present value of expected future cashflows to the cost of the
investment .It is therefore the discounting rate that equates NPV to zero.
C1 C2 C3 Cn
C0     L 
(1  r ) (1  r ) 2 (1  r )3 (1  r ) n
n
Ct
C0  
t 1 (1  r )t
n
Ct
 (1  r )
t 1
t
 C0  0
Where: Co=initial investment

C1/C2/C3/Cn=cashflow in year1, 2, 3… up to year n
L =cash flows from period 3 to year n
r = is the rate that equates the initial investment to the present value of cash inflows over
the life of the project.(IRR)
The IRR can be found by using the following methods:

i) trial and error
ii) interpolation
i) Trial and error

Decision criteria:
Accept the project when r > k.
Reject the project when r < k.
The investor is indifferent when r = k.
In case of independent projects, IRR and NPV rules will give the same results if the firm has no
shortage of funds.
POTENTIAL DIFFICULTIES IN USING DISCOUNTED CASH FLOW METHODS
1. For a single conventional, independent projects, the IRR, NPV and PI methods lead us to make
similar accept/reject decision. Various types of circumstances and projects differences can cause
ranking difficulties. Two situations that could cause inconsistencies arise when (1) When funds
are limited necessitating capital rationing and, (2) when ranking two or more project proposals
are mutually exclusive.
Capital Rationing
Occurs any time there is a budget constraint or ceiling on the amount of money that can be invested
during a specific period of time (For example, the company has to depend on internally-generated
funds because of borrowing difficulties, or a division can make capital expenditures only up to a
certain ceiling).
With capital rationing, the firm attempts to select the combination of investments that will provide
the greatest increase in the firm of the value subject to the constraining limit.
Example
Assume your firm faces the following investment opportunities:
Project Initial Cash Flows IRR NPV PI
Shs.000 Sh.000
A 50,000 15% 12,000 1.24
B 35,000 19 15,000 1.43
C 30,000 28 42,000 2.40
D 25,000 26 1,000 1.04
E 15,000 20 10,000 1.67
F 10,000 37 11,000 2.10
G 10,000 25 13,000 2.30
H 1,000 18 100 1.10
If the budget ceiling for initial cash flows during the present period is Shs.65,000,000 and the
proposals are independent of each other, your aim should be to select the combination projects that
provide the highest in firm value the Shs.65 m can deliver.
Selecting projects in descending order of profitability according to various discounted cash flows
methods, which exhausts Sh.65 million reveals the following:

Using the IRR Using the NPV
Project IRR NPV Initial outlay Project NPV Initial flow
Sh 000 Shs.000 Sh 000 Sh.000
A 37% 11,000 10,000 C 42,000 30,000
B 28 30,000 30,000 B 15.000 35,000
C 26 25,000 25,000 57,000 65,000
54,000 65,000
Using the PI
Project PI NPV Initial outlay
Sh000 Sh000
C 2.40 42,000 30,000
G 2.30 13,000 10,000
F 2.10 11,000 10,000
E 1.67 10,000 15,000
76,000 65,000
With capital rationing you would accept projects C,E,F and G which deliver an NPV of
Sh.76million. The universal rule to follow is “When operating under a constraint, select the projects
that deliver the highest return per shilling of the constraint (the initial investment outlay)”. Put
another way, select that mix of projects that gives you “the biggest bang for the buck”. We achieve
this buy employing the profitability index which ranks projects on the basis of the return per shilling
of initial investment outlay.
Under conditions of capital rationing it is evident that the investment policy is less than optimal –
Optimal policy requires that no positive NPV projects be rejected.
Difficulties in Ranking
1. Conflicts in ranking may arise due to one or a combination of the following factors:
2. Capital rationing: funds are not adequate to undertake all positive NPV projects
3. Scale of investment: initial costs of projects differ.
4. Cash flows patterns: cash flows of one project may increase while those of another may
decrease with time.
5. Project life: projects may have unequal useful lives.
6. Scale Differences
Example
Suppose a firm has two mutually exclusive projects that are expected to generate following Cash
flows

End of Year Project A Project B
Cash flows (Sh) Cash flows (Sh)
0 -1000,000 -100,000,000
1 0 0
2 400,000 156,250,000
If the required rate of return is 10% the NPV, IRR and PI of the projects are as below:
IRR NPV PI
Sh000
Project A 100% 231 3.31
Project B 25% 29,132 1.29
Ranking of projects based on our results
RANKING IRR NP PI
1st A B A
2nd B A B
Using the IRR and PI shows preference for project A, while NPV indicates preference for Project B.
Because IRR and PI are expressed as a proportion the scale of the project is ignored. In contrast
results of NPV are expressed in absolute shilling increases in value of the firm. With regard to
absolute increase in value of the firm, NPV is preferable.
Differences in Cash Flow Patterns (Multiple IRR)
Example
Assume a firm is facing two mutually exclusive projects with following cash flow patterns.
End of year Project C Project D

Cash flows Cash flows
Sh000 Sh000
0 -1,200 -1,200
1 1,000 100
2 500 600
3 100 1,080
Note that project C’s cash flows decrease while those of project D increase over time.

 The IRR for projects are as follows
Project C - 33%
Project D - 17%
 For every discount rate> 10% project C’s NPV and PI will be> than project D’s.
 For every discount rate < 10% project D’s NPV and PI will > project C’s.
K<10% K>10%
RANKING IRR NPV PI NPV PI
1st C D D C C
2nd D C C D D
When we examine the NPV profiles of the two projects, 10% represents the discount rate at which
the two projects have identical NPVs. This discount rate is referred to as Fisher’s rate of
intersection. On one side of the Fisher’s rate it will happen that the NPV and PI on one hand, and
the IRR on the other give conflicting rankings.
We observed conflict is due to the different implicit assumption with respect to the reinvestment rate
on intermediate cash flows released from the project. The IRR implicitly assumes that funds can be
reinvested at the IRR over the remaining life of the project. With the IRR the implicit reinvestment
rate will differ from project to project unless their IRRs are identical.
For the NPV and PI methods assume reinvestment at a rate equal to the required rate of return as the
discounts factor. The rate will be the same for all projects.
Since the reinvestment rate represents the minimum return on opportunities available to the firm, the
NPV ranking should be used. In this way, we identify the project that contributes most to
shareholder wealth.
Differences in Project Life

When projects have different lives, a key question is what happens at the end of the short-lived
project? Two alternatives assumptions can be considered. (1) Replace with (a) identical project or
(b) a different project. (2) Do not replace. The Do not replace alternative is considered first.

Example
Suppose you are faced with choosing between 2 mutually exclusive investments X and Y that have
the following Cash flows.
End of year Project X Project Y
Cash flows Cash flows
Sh. ‘000’ Sh. ‘000’
0 - 1000 - 1000
1 0 2000
2 0 0
3 3,375 0
If the required rate of return is 10% we can summarize our investment appraisal results as follows:
IRR NPV PI
Sh000
X 50% 1536 2.54
Y 100% 818 1.82
RANKING
Rank IRR NPV PI
1st Y X X
2nd X Y Y
Once again a conflict in ranking arises. Both the NPV and the PI prefer project X to Y, while The
IRR criterion choose Y over X.
Again, in this case of no replacement, the NPV method should be used because it will choose
projects that add the greatest absolute increment in value to the firm.
Replacement Chain When faced with a chose between mutually exclusive investments having
unequal life that will require replacement, we can view the decision as one involving a series of
replications – or a replacement chain – of respective alternatives over some common investment
horizon.
Repeating each project until the earliest rate that we can terminate each project in the same year
results in a multiple like-for-like replacement chains covering the shortest common life. We solve
the NPV for each replacement chain as follows:
NPV chain =
Where n = single replication project life in years
NPV= singe replication NPV for a project with n- year
R = umber of replications needed
K= discount rate

The value of each replacement chain therefore is simply the PV of the sequenced of NPV , generated
by the replacement chain.
Example
Assume the following regarding mutually exclusive investments alternatives A and B, both of which
requires future replacement
Project A project B
Single replication life (n) 5 years 10 years
Single replication PV calculated at project
Specific required rate of return (NPVn) Sh. 5,328 Sh. 8000
Number of replication to provide shortest common life 2 1
Project specific discount rate 10% 10%
At first glance project B looks better than project A (8000 Vs 5328). However the need to make
future replacements dictates that we consider values provided over same common life i.e. 10 years.
The NPV can then be re-worked as follows
NPV for first 5 years = 5328

NPV for replicated project=5328* PVIF 10%, 5 yrs
= 3303
NPV of chain 8638
The NPV of project B is already known i.e. Sh. 8000. Comparing with Sh. 8638 present value of the
replacement chain, project A is preferred.

REVISION QUESTIONS
1. (a) Briefly explain the importance of capital budgeting in a business organization. (4 marks)
(a) Describe in brief the greatest difficulties faced in capital budgeting in the real world.
(b) Several methods exist for evaluating investment projects under capital budgeting.
a. Identify and explain three features of an ideal investment appraisal method. ( 6
marks)
(c) In evaluating investment decisions, cash flows are considered to be more relevant than
profitability associated with the project.
a. Explain why this is the case. (3 marks)
(2.) P. Muli was recently appointed to the post of investment manager of Masada Ltd. a quoted
company. The company has raised Sh.8,000,000 through a rights issue.
P. Muli has the task of evaluating two mutually exclusive projects with unequal economic lives.
Project X has 7 years and Project Y has 4 years of economic life. Both projects are expected to have
zero salvage value. Their expected cash flows are as follows:
Project X Y
Year Cash flows (Sh.) Cash flows (Sh.)
1 2,000,000 4,000,000
2 2,200,000 3,000,000
3 2,080,000 4,800,000
4 2,240,000 800,000
5 2,760,000 -
6 3,200,000 -
7 3,600,000 -
The amount raised would be used to finance either of the projects. The company expects to pay a
dividend per share of Sh.6.50 in one year’s time. The current market price per share is Sh.50.
Masada Ltd. expects the future earnings to grow by 7% per annum due to the undertaking of either
of the projects. Masada Ltd. has no debt capital in its capital structure.
Required:
(a) The cost of equity of the firm. (3 marks)
(b) The net present value of each project. (6 marks)
(c) The Internal Rate of return (IRR) of the projects. (Rediscount cash flows at 24%
for project X and 25% for Project Y). (6 marks)
(d) Briefly comment on your results in (b) and (c) above. (2 marks)
(e) Identify and explain the circumstances under which the Net Present Value (NPV) and the
Internal Rate of Return (IRR) methods could rank mutually exclusive projects in a conflicting way.

3. The Weka Company Ltd. has been considering the criteria that must be met before a capital
expenditure proposal can be included in the capital expenditure programme. The screening criteria
established by management are as follows:
1. No project should involve a net commitment of funds for more than four years.
2. Accepted proposals must offer a time adjusted or discounted rate of return at least
equal to the estimated cost of capital. Present estimates are that cost of capital as 15
percent per annum after tax.
3. Accepted proposals should average over the life time, an unadjusted rate of return on
assets employed (calculated in the conventional accounting method) at least equal to
the average rate of return on total assets shown by the statutory financial statements
included in the annual report of the company.
A proposal to purchase a new lathe machine is to be subjected to these initial screening processes.
The machine will cost Sh.2,200,000 and has an estimated useful life of five years at the end of which
the disposal value will be zero. Sales revenue to be generated by the new machine is estimated as
follows:
Year Revenue (Sh.’000’)

1 1,320
2 1,440
3 1,560
4 1,600
5 1,500
Additional operating costs are estimated to be Sh.700,000 per annum. Tax rates may be assumed to
be 35% payable in the year in which revenue is received. For taxation purpose the machine is to be
written off as a fixed annual rate of 20% on cost.
The financial accounting statements issued by the company in recent years shows that profits after
tax have averaged 18% on total assets.
Required:
Present a report which will indicate to management whether or not the proposal to purchase the lathe
machine meets each of the selection criteria. (19 marks)
4. The following six … have been submitted for inclusion in 1998 capital expenditure budget for
Limuru Ltd.

Year A B C D E F
Sh. Sh. Sh. Sh. Sh. Sh.
Investment 0(1998) 250,000 250,000 500,000 500,000 500,000 125,000
1 0 50,000 175,000 0 12,500 57,500
2 25,000 50,000 175,000 0 37,500 50,000
3 50,000 50,000 175,000 0 75,000 25,000
4 50,000 50,000 175,000 0 125,000 25,000
5 50,000 50,000 175,000 0 125,000
Per year 6-9 50,000 50,000 500,000 125,000
10 50,000 50,000 125,000
Per year 11 – 15 50,000 50,000
Internal rate
of return 14% ? ? ? 12.6% 12.0%
Required:
(a) Rates of return (to the nearest half percent) for projects B, C and D and a ranking of all
projects in descending order. (6 marks)
(b) Compute the payback reciprocal for projects B and C. (4 marks)
(c) Compute the N.P.V of each project using 16% as discount rate and rank all projects.
(10 marks)

CHAPTER 9
DIVIDEND DECISIONS
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may also
be termed as the part of the profit of a business concern, which is distributed among its shareholders.
FACTORS INFLUENCING DIVIDEND DECISION OF A FIRM
1. Legal rules:
a) Net profit rule- This states that the dividends may be paid from company profits, either
past or present.
b) Capital impairment rule- This prohibits payment of dividends from capital i.e. from the
sale of assets. This would be liquidating the firm.
c) Insolvency rule- This prohibits payment of dividends when a company is insolvent .An
insolvent company is one where assets are less than liabilities .In such a case all earnings
and assets belong to debt holders and no dividends are paid.
2. Profitability and liquidity.

A company’s capacity to pay dividends will be determined primarily by its ability to generate
adequate and stable profits and cashflows. If the company has liquidity problems, it may be
unable to pay cash dividends and resort to paying stock dividends.
3. Investment opportunity.
Lack of appropriate investment opportunities i.e. those with positive returns may encourage a
firm to increase its dividend distribution. If a firm has many investments opportunities it will pay
low dividends and have high retention.
4. Tax position of share holder
Dividend payment is influenced by the tax regime of a country e.g. in Kenya cash dividends are
taxed at source, while capital gains are tax exempt. The effect of tax differential is to discourage
shareholders from wanting high dividends.
5. Capital structure.
A company’s management may wish to achieve or restore an optimal capital structure. E.g. If
they consider gearing to be too high they may pay low dividends and allow reserves to
accumulate until a more optimal capital structure is achieved or restored.

6. Industrial practice
Companies will be resistant to deviate from accepted dividend or payment norms in the industry.
7. Growth stage.
Dividend policy is likely to be influenced by the firms growth stage, e.g. a young rapidly
growing firm is likely to have high demand for developing funds therefore may pay low
dividends or differ dividend payment till the company reaches maturity. It will therefore retain
high amounts.
8. Owners hip structure.

A dividend policy may be driven by the ownership structure in affirm e.g. in small firms where the
owners and managers are the same, dividend payout is usually low. However, in large quoted public
companies, dividends are significant since the owners are not the managers. The value and
preferences of a small group of owner managers would exert more direct influence on the dividend
policy.
9. Access to capital markets.

Large well established firms have access to capital markets hence can get funds easily. They
therefore pay high dividends unlike small firms which pay low dividends due to the limited
borrowing capacity.
10. Shareholders expectation.

Shareholder s that have become accustomed to receiving stable and increasing dividends will expect
a similar pattern to continue in to the future .Any sudden reduction or reversal of such a policy is
likely to dissatisfy shareholders and the results in falling share prices.
11. Contractual obligations on debt covenants.
This limits the flexibility and amount of dividends to pay e.g. the cashflow based covenants.
IMPORTANT RATIOS ON DIVIDENDS
Dividend pay-out ratio.
This ratio reflects a company's dividend policy. It indicates the proportion of earnings
per share paid out to ordinary shareholders as divided. It is computed as follows:
ℎ
=
ℎ
ℎ ℎ =

Dividend Yield Ratio
This shows the dividend return being provided by the share. It is given by
ℎ
=
ℎ
Revision questions
1. (b) Kathonzweni Holdings Limited has investment interests in three companies. Kanzokea Video
Limited (KVL), Kithuki Hauliers Limited (KHL) and Mbuvo Fisheries Limited (TFL). The
following financial data relate to these companies.
1. As at 31 December 2001, the financial statements of two of the companies revealed

the following information:
Company Price of Earnings per Dividend per

share share share
2. Sh. Sh. Sh.
Ea Kanzokea Video Ltd. 160 8 8
rnings (KVL) 270 18 9
and Kithuki Hauliers Ltd.
dividend (KHL)
informati
on for Mbuvo Fisheries Ltd. (TFL) for the
past five years is given below:
Year ended 31 1997 1998 1999 2000 2001

December Sh. Sh. Sh. Sh. Sh.
Earnings per share 5.0 6.0 7.0 10.0 12.0
Dividend per share 3.0 3.0 3.5 5.0 5.5
The estimated return on equity before tax required by investors in Turkana Fisheries
Ltd.’s shares is 20%.
Required:
(i) For Kanzokea Video Ltd. (KVL) and Kithuki Hauliers Ltd. (KHL), determine and compare:
 Dividend yields
 Price/Earnings ratios
 Dividend covers.
(ii) Using the dividends growth model, determine the market value of 1,000 shares held in
Mbuvo Fisheries Ltd. (TFL) as at 31 December 2001.
FORMS OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or st

stock. Hence,
Dividends are classified into:
a) Cash dividend
b) Stock dividend
c) Bond dividend
d) Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance.
Under this type,
ype, cash is retained by the business concern. Stock dividend may be bonus issue. This
issue is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have su
sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.

Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under the
exceptional circumstance.
.
DIVIDEND POLICY
Dividend policy determines the division of earnings between payment to shareholders and
reinvestment in the firm. It therefore involves the following four aspects:
1. HOW MUCH TO PAY
It encompasses the 4 major alternative dividend policies.
a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. Dividends will
therefore fluctuate as the earnings change. Dividends are therefore directly dependant on
the firms earning ability. If no profits are made, no dividends are paid. The policy creates
uncertainty in ordinary shareholders especially those who depend on dividend income thus
they may demand a higher required rate of return.
b) Constant amount per share/fixed dividend per share
The dividend per share is fixed in amount irrespective of the earnings level. This creates
uncertainty and is thus preferred by shareholders who have a reliance on dividend income.
It protects the firm from periods of low earnings by fixing dividends per share at a low
level. Thus policy treats all shareholders like preference shareholders by giving a fixed
return. Dividend per share could be increased to a higher level if earnings appear relatively
permanent and sustainable.
c) Constant amount plus extra
Here, a constant dividend per share is paid every year. However, extra dividends are paid
in years of supernormal earnings. This policy gives firms the flexibility to increase
dividends when earnings are high and shareholders are given a chance to participate in the
supernormal profits of the firm. The extra dividends are given in such a way that it is not
seen as a commitment to continue the extra in the future. It is applied by firms whose
earnings are highly volatile e.g. the agricultural sector.

d) Residual amount
Under this policy, dividend is paid out of earnings left over after investment decisions have
been financed. Dividends will therefore only be paid if there are no profitable investment
opportunities available. This policy is consistent with shareholders wealth maximization.
2. WHEN TO PAY
Dividends can either be interim or final.
Interim dividends are paid in the middle of the financial year and are paid in cash.
Final dividends are paid at the year end and can be and can be in cash and stock form (bonus
issue).
3. WHY PAY
a) Residue dividend theory
Under this theory, a firm will pay dividends from residue earnings ie. Earnings remaining
after all suitable projects with a positive NPV have been financed. It assumes that retained
earnings are the best source of long term capital since it is readily available and cheap. This
is because no floatation costs are involved in the use of retained earnings to finance new
investments therefore the first claim on profit after tax and preference dividend. There will
be a reserve for financing investments. Dividend policy is therefore irrelevant and treated as
a passive variable. It will hence not affect the value of the firm. However the investment
decision will .]
Advantages of residual theory
1. Savings on floatation costs

2. There is no need to raise debt or equity capital since there is a high retention of earnings
which require no floatation costs.
3. Avoidance of dilution of ownership. A new equity issue will dilute ownership and control.
This will be avoided if retention is high.
4. Tax position of shareholders. High income shareholders prefer low dividends to reduce their
tax burden from dividend income. They prefer high retention of earnings which are
reinvested. This increase the share value and they make capital gains which are not taxable.
b) MM dividends irrelevance theory.
This was proposed by Modigliani and Muller .This theory asserts that a firms divided policy has
no effect on its market value and cost of capital .They argued that the firm value is primarily
determined by .

(i) Ability to generate earnings from investments .
(ii) Level of business and financial risk .
According to MM dividend policy is a passive residue determined by the firms needs for
investment funds. It does not matter how earnings are divided between divided and retention
therefore divided policy does not exist . When investment decisions are made dividend decision
is a mere detail without any effect on the value opf the firm
C) The main dividend theories are:
i. Residual dividend theory

ii. MM dividend irrelevance theory
iii. Bird in hand theory
iv. Information signaling effect theory
v. Tax differential theory
vi. Clientele effect theory
vii. Agency theory
4. HOW TO PAY DIVIDENDS/ MODE OF PAYING DIVIDENDS
a) Cash or Bonus issue
Ideally, a firm should pay cash dividends, for such a company it must ensure that it that it has
enough liquid funds to make payment. Under conditions of liquidity and financial constraints, a
firm can pay stock dividends (bonus issue ) Bonus issue involves an issue of additional shares
in addition to or instead of cash to the existing shareholders prorate to their share holding in
the company. A stock dividend / bonus issue involves capitalization of retained earnings
therefore does not increase the wealth of the shareholders. This is because retained earnings are
converted into share capital.
Advantages of a bonus issue

i. To indicates that the form plans to retain a portion of earnings permanently in the
business.
ii. To continue dividend distribution s without disbursing cash needed for operation.
iii. T o increase the trading of shares in the market.
iv. Tax advantage. Shareholders can sale the new shares to generate cash in the form of
capital gains which are tax exempt unlike cash dividends which attract a 5% withholding
tax which is final.

v. Indication of higher profits in the future of the company. A bonus issue is inefficient
market survey is important information that the firm expects high profits in future to
offset additional outstanding share so that the earnings per share is not diluted.
b) Stock Splits and reverse split.
A stock split is a change in the number of shares outstanding accompanied by an offsetting

change in the par or stated value per share.
The primary purpose of a stock split is to increase the market activity of the stock.
Example
A company has 1000 ordinary shares of sh.20 each and a share split has been announced of
1:4. The effect on ordinary share capital is a s follows;
New par value = 20/4

=sh.5
Ordinary shares outstanding = 1000×4

=4000
The ordinary share capital remains the same (4000×5=sh. 20,000)
A reverse split is the opposite of a stock split as it involves consolidation of shares into bigger
units thereby increasing the par value of the shares .It is meant to attract high income clientele.
Example
In the case of 20,000 shares at sh.20 par value, they can be considered into 10,000 shares at par
value of sh.40 par value.
Example
Company Z has the following capital structure,
sh.000
Ordinary shares (Sh.20
par) 8000
Share premium 3600
Retained earnings 2400
14000
The company shares have been selling in the market for sh.60. The management has declared a
share split of 4 share for every one share held. Assume that the shares are expected to sell at
sh17 after the stock split.
Required,
i. Prepare the capital structure of the company after the company’s stock split.
ii. Compute the capital gain for a shareholder who held 40,000 shares before the split.
Solution
i)
shares
Number of shares before
split sh.8000,000÷20 400,000
Number of shares after
split 400,000×4 1,600,000
New par value 20/4 sh.5
Capital structure sh.000

Ordinary shares (Sh.5
par) 8,000
Share premium 3,600
Retained earnings 2,400
14,000
ii)
sh.000
Shares before split 40,000×60 2400
Share after split 40,000×4×17 2750
Capital gain 2750 -2400 320
c) Stocks repurchase.
The company can also buy back some of its outstanding shares instead of paying cash
dividends. This is known as a stocks repurchase and the share bought back are known as
treasury stock. If some outstanding shares are repurchased, fewer share s would remain
outstanding .Assuming a repurchase does not adversely affect the firm’s earnings , EPS would
increase .This would result in an increase in the market price per share so that a capital gain is
substituted for dividends.

Advantages of stock repurchase.
1. Utilization of idle funds.
Companies which have accumulated cash balances in excess of future investments might find
a share re-investment scheme a fair method of returning cash to shareholders .Continuing to
carry excess cash may prompt management to invest unwisely as a means of using excess
cash e.g. a firm may invest in a tendency for more mature firms to continue in investment
plans even when the expected return is lower than the cost of capital.
2. Enhanced dividends and EPS.
Following a stock repurchase, the number of shares issued would decrease therefore in
normal circumstances , both DPS and EPS would increase in future . However the increase in
EPS is a book-keeping increase since total earnings remain constant.
3. Enhanced share price.
Companies that undertake a stock repurchase experience an increase in the market price of
the share.
4. Capital structure.
A company’s managers may use a share buy-back or repurchase as a means of correcting

what they perceive to be an unbalanced capital structure .If shares are repurchased from cash
reserves, equity would be reduced and gearing increased , assuming debt exists in the capital
structural term natively , a company may raise debt to finance a repurchase . Replacing
equity with debt can reduce the overall cost of capital.
5. Reducing takeover threat.
A share repurchase reduces the number of shares in operation and also the number of weak
shareholders i.e. shareholders with no strong loyalty to the company since a repurchase
would induce them to sell .This helps to reduce the threat of as hostile takeover as it makes it
difficult for a predator company to gain control .This is also referred to as a poison pill i.e. a
company’s value is reduced because of huge cash outflow or borrowing huge long-term debt
to increase gearing.
Disadvantages of a stock repurchase.
1. High price.

A company may find it difficult to repurchase\se at their current value or the price
paid maybe too high to the detriment of the remaining shareholders.
2. Market signaling.
Despite directors efforts at trying to convince markets otherwise, a share repurchase

may be taken as a signal that the company lacks suitable investment opportunities
.This may be interpreted as a sign of management failure.
3. Loss of investment income.
The interest that could have been earned from investment of excess cash is lost.
Discussion questions
1) Discuss the nature of the factors which influence the dividend policy of a firm
2) What is a stock split? Explain why it is used and how does it differ from bonus shares?
3) Explain the different payout methods and how the shareholders react to the methods
4) Explain the effects of a bonus issue and a share split on the earnings per share and the
market price of the share
5) What is a stable dividend policy? Why should it be followed? What are the consequences
of changing a stable dividend policy?

CHAPTER 10
FUNDAMENTALS OF ISLAMIC FINANCE
Introduction
Islamic finance, despite its name, is not a religious product. It is however a growing series of
financial products developed to meet the requirements of a specific group of people.
Conventional finance includes elements (interest and risk) which are prohibited under Shari’ah law.
Developments in Islamic finance have arisen to allow Muslims to invest savings and raise finance in
a way which does not compromise their religious or ethical beliefs.
It is estimated that between 1.5 and 1.8 billion people (one quarter of the world’s population) are
Muslim. Geographically, most Muslims live in Asia (over 60%) or the Middle East and North Africa
(about 20%). Despite these figures, Islamic finance is still very much a niche market, with the vast
majority of Muslims, who have access to finance, using conventional financial products. The
following map shows the geographical spread of the Muslim population throughout the world as a
percentage of each country’s population, with the highest concentrations in the darkest shades of
purple.
The meaning of Islamic finance
Islamic finance is a term that reflects financial business that is not contradictory to the principles of
Shari’ah. Conventional finance, particularly conventional banking business, relies on taking deposits
from, and providing loans to, the public. Therefore, the banker-customer relationship is always a
debtor‑creditor relationship. A key aspect of conventional banking is the giving or receiving of
interest, which is specifically prohibited by Shari’ah. For example a conventional bank’s fixed
deposit product is based on a promise by the borrower that is the bank to repay the loan plus fixed
interest to the lender that is the depositor. Essentially, money deposited will result in more money
which is the basic structure of an interest.
In other non‑banking businesses, conventional products and services, such as insurance and capital
markets could be based on elements that are not approved by Shari’ah principles such as uncertainty
(Gharar) in insurance and interest in conventional bonds or securities. In the case of insurance, the
protection provided by the insurer in exchange for a premium is always uncertain as to its amount as
well as its actual time of happening. A conventional bond normally pays the holder of the bond the
principal and interest.

Conventional practices could also involve selling or buying goods and services that are not lawful
from a Shari’ah perspective. These might be non‑halal foods such as pork, non‑slaughtered animals
or animals not slaughtered according to Islamic principles, alcohol or services related to gambling,
pornography and entertainment. In short, conventional business practices could be non‑compliant
from a contractual structure perspective (if they are based on interest and uncertainty) and / or from
a transactional perspective when they are involved in producing, selling or distributing goods and
services that are not lawful according to Shari’ah.
PRINCIPLES OF ISLAMIC BANKING
What is an Islamic Bank?

There is no standard way of defining what an Islamic bank is, but broadly speaking an "Islamic bank
is an institution that mobilises financial resources and invests them in an attempt to achieve
predetermined islamically -acceptable social and financial objectives. Both mobilisation and
investment of funds should be conducted in accordance with the principles of Islamic Shari'a".
1. Prohibition of Interest or Usury

2. Ethical Standards
3. Moral and Social Values
4. Liability and Business Risk
1- Prohibition of Interest or Usury
The principles of Islamic finance are established in the Qur'an, which Muslims believe are the exact
Words of God as revealed to the Prophet Mohammed. These Islamic principles of finance can be
narrowed down to four individual concepts.
The first and most important concept is that both the charging and the receiving of interest is strictly
forbidden. This is commonly known as Riba1 or Usury. Money, on its own, may not generate
profits. When Riba infects an entire economy, it jeopardises the well-being of everyone living in that
society. When investors are more concerned with rates of interest and guaranteed returns than they
are with the uses to which money is put, the results can only be negative.
Adherents of Islam believe that the Qur'an is the final book of God's word following both the Torah
and the Bible. As a result, there are a number of similarities between the Islamic, Christian and
Jewish faiths.

Quoting Shaikh Saleh Abdullah Kamel, Chairman and Founder of Albaraka Banking Group; Usury
is forbidden in all the three religions, Judaism, Christianity and Islam, but it is the people who forget
the rules of Allah. All societies, nowadays - Muslims, Christians and Jews - deal with Usury.
2- Ethical Standards
The second guiding principle concerns the ethical standards. When Muslims invest their money in
something, it is their religious duty to ensure that what they invest in is good and wholesome. It is
for this reason that Islamic investing includes serious consideration of the business to be invested in,
its policies, the products it produces, the services it provides, and the impact that these have on
society and the environment. In other words, Muslims must take a close look at the business they are
about to become involved in.
In all facets of the financial system, Islam has certain rules, certain regulations as to how Muslims
should go about participating in these activities. For example, in share trading or the securities
market, Islam looks at the activities of the companies, to establish whether or not the companies are
involved in activities which are in line with Sharia'a.
3- Moral and Social Values
The third guiding principle concerns moral and social values. The Qur'an calls on all its adherents to
care for and support the poor and destitute. Islamic financial institutions are expected to provide
special services to those in need. This is not confined to mere charitable donations but has also been
institutionalised in the industry in the form of profit-free loans or Al Quard Al Hasan.
An Islamic bank's business includes certain social projects, as well as charitable donations. Islamic
banks provide profit-free loans. For example, if an individual needs to go to hospital or wants to go
to university, we give what is called Quard Al Hasan. This Quard Hasan is normally given for a
short period of one year and the Islamic bank does not charge anything for that.
4- Liability and Business Risk
The final principle concerns the overarching concept of fairness, the idea that all parties concerned
should both share in the risk and profit of any endeavor. To be entitled to a return, a provider of
finance must either accept business risk or provide some service such as supplying an asset,
otherwise the financier is, from a Sharia'a point of view, not only an economic parasite but also a
sinner. This principle is derived from a saying of the Prophet Mohammed (May Peace be upon Him)
"Profit comes with liability". What this means is that one becomes entitled to profit only when one
bears the liability, or risk of loss. By linking profit with the possibility of loss, Islamic law
distinguishes lawful profit from all other forms of gain.

In order to insure that these principles are followed, each Islamic institution must establish and
provide itself with an advisory council known as a Sharia'a Board. The members of Sharia'a Boards
can include bankers, lawyers or religious scholars as long as they are trained in the Islamic law, or
Sharia'a.
In 2001, the Industry witnessed a remarkable development in this regard by the initiative of the
Accounting and Auditing Organization for the Islamic Financial Institutions or AAOIFI. At that
time, AAOIFI's standards were enhanced to include elements that aim at broadening the role of the
external auditor. Now according to these new developments the external auditor is also required to
look for compliance with Sharia'a rules as defined by the Sharia'a supervisory board of each bank
and in accordance with the Sharia'a standards AAOIFI has begun to issue.
THE COMPONENTS OF ISLAMIC FINANCE
1. Banking and interest (Riba)
Islamic banking is the branch of Islamic finance that has seen the most growth to date. It is also the
branch of finance that needs to be viewed from a different perspective as it cannot replicate
conventional banking. This is because the most important underlying principle of conventional
banking is that money creates money or that money has a premium, known as interest or usury. This
practice (known in Arabic as Riba) is the antithesis of Islamic finance because Islamic law, from the
beginning, has categorically denounced it. Money has never been perceived as a commodity for
which there is a price for its use. Instead, Islamic law consistently views money as a medium of
exchange, a store of value and a unit of measurement.
As money cannot earn money, a link has to be introduced between money and profit as an
alternative to interest. It is against this backdrop that Islamic banking has been primarily involved in
trading, leasing and fee‑based as well as investment activities. Those involved in Islamic banking
are not in a position to either borrow or lend money for interest. Subsequently, the nature of the
Islamic banker‑customer relationship varies according to the different contracts that Islamic banks
and their customers enter into.
Islamic banking – the relationship between the user and the supplier of funds
The relationship of the Islamic bank with the suppliers of funds can be of agent and principal,
depositor and custodian, investor and entrepreneur as well as between fellow partners in a joint
investment project. Similarly, the relationship of the bank with the users of funds can comprise of
vendor and purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor

and transferee, and between partners in a business venture. This is in sharp contrast to that of
conventional banking, which is simply a lender‑borrower relationship.
The difference in relationships between Islamic and conventional banks is demonstrated in the
following table:
Deposit/liability: contractual relationship
Conventional banking Islamic banking

- Lender‑borrower relationship - Depositor‑custodian relationship
- Lender‑borrower relationship
(but free from interest)
- Investor‑entrepreneur relationship
Financing/asset: contractual relationship
Conventional banking Islamic banking

- Borrower‑lender relationship - Purchaser‑seller relationship
- Lessee‑lessor relationship
- Principal‑agent relationship
- Entrepreneur‑investor relationship
The above illustrates that Islamic banking has departed from the concept of loans to use other
contracts which are compliant and free from the element of interest in both deposit taking and
finance provision.
2. Takaful – Islamic insurance
With regards to Islamic insurance, better known as Takaful, the insurer, that is the insurance
company, is prohibited from providing indemnity to the insured, that is, the policyholders, as this is
not acceptable to Shari’ah principles. This is because both the premium paid by policyholders and
the indemnity paid by the insurer are uncertain and therefore not permissible as they contain the
element of uncertainty or Gharar.

Conventional life insurance companies are profit seeking entities and need to allow for things like
average life expectancy and high risk customers when setting their premiums in order to ensure that
it profits from offering life insurance to its customers.
Takaful introduces the contract of donation among the participants/policyholders as a substitute for
the contract of sale of indemnity for a premium as practiced in conventional insurance. This is to
make uncertainty irrelevant because in Islamic terms uncertainty is only tolerable in gratuity or in a
unilateral contract such as a donation. The presence of the element of uncertainty in a donation
contract, which is unilateral in character, does not render it invalid. A donation contract can accept
and tolerate any uncertainty because the purpose of any unilateral contract is not a commercial gain.
3 Islamic capital markets
Islamic capital markets that consist of both equity investments and fixed income instruments must
avoid some conventional elements and principles from both contractual and transactional
perspectives. In addition to interest and uncertainty, issues such as gambling, which is a zero‑sum
game, investments in unlawful activities and capital guarantee elements in equity‑based products are
to be avoided. In short, Islamic finance, unlike conventional finance, must be distinctive in its
contractual and transactional features to render it different from conventional finance although
ultimately, both may achieve the same economic benefits.
The salient features of Islamic finance
As mentioned above, Islamic finance, especially Islamic banking, enjoys certain peculiar features
that are not found in conventional banking. These features are as follows:
1. Interest free
Islamic banking is interest free, meaning that all banking business and activities must prima facie
be free from any element of interest. In Islamic law, interest can arise when there is an exchange of
two similar usurious items or assets such as money for money or main food for main food. In
banking, the leading practice from which interest originates is the exchange of money for money,
that is, money lending. Modern banking is based on the lending of money for a premium – interest.
Islamic banks must eliminate interest in all its forms, be it in cash or kind. A fixed deposit account in
a conventional bank is a good example of how the bank pays interest in cash. A good example of the
avoidance of interest in kind is the prohibition of any advertisement of gifts for prospective saving
and current account holders when these accounts are based on a Wadiah (safekeeping) or Qard
(loan) contract. This is deemed to be promising a form of interest in kind payable to savings and
currents account holders. Although a gift such as a pen or umbrella or savings box is not in monetary
form, it is still deemed as an extra gain for the lender. Interest, be it in cash or in kind is not
permissible.

2. The need for underlying assets
Islamic finance requires that all banking business based on sale or lease must have an underlying
asset. As the Islamic bank either acts as a seller or a service or usufruct vendor, or lessor, the asset or
service is of paramount importance. The absence of an underlying asset will render the contract void
‘ab initio’. This is in contrast to conventional banking where the asset element is not a necessary
requirement. Its importance lies only in terms of collateral security in the sense that the asset
purchased using the loan money may be charged or assigned as security in favour of the bank. The
asset was never part of the loan transaction.
3. The avoidance of uncertainty or gambling
All transactions made by Islamic financial institutions (IFIs) must be free from elements of
uncertainty (Gharar) and gambling (Maisir). This is because Gharar might lead to disputes caused by
an unjustified term in the contract arising from misrepresentation and fraud. Gambling is seen as an
action that always enriches one party at the expense of the other; a zero-sum-game.
4. Profit and loss sharing
Profit and loss sharing is possible in some Islamic banking activities. The bank will share the profit
made with its customers either on a proportionate basis or on an agreed profit sharing ratio. In the
case of a loss, the loss will be borne by the bank under a Mudarabah contract or by both parties
proportionately in the case of a Musharakah contract. This concept is in direct contrast to fixed-
income-based products. Again, the concept of profit and loss sharing is peculiar to Islamic banking
although, strictly speaking, Islamic banking is not an equity market, which is normally represented
by the stock market.
5. Rights and liabilities of banks and customers
The rights and liabilities of both banks and their customers are well documented not only in
conventional banking laws but also the legislation of many countries including Contracts Acts, the
Sale of Goods Acts, Consumer Protection Acts and the Hire Purchase Acts. An important and
significant feature of Islamic banking is the new perspective it gives to this relationship. This has
pushed Islamic banking beyond normal and conventional ‘banking business’. An Islamic bank is
neither a lender nor a borrower, but can instead become a bona-fide trader licensed under banking
law. This aspect of the transaction has not been given proper attention until now, although certain
amendments to various legal systems have been made.
Amendments to the Stamp Duty Act in the UK illustrate this aspect. The buying and selling of
property, for example, would otherwise attract a double stamp duty for the two transactions required
to achieve the financing features of the product. The changes also preclude a gains tax arising from
the sale of the property to the customer by the bank – the second of two sales transactions. The first
transaction occurs when the financier purchases the asset from the vendor. The second transaction

occurs when the financier sells the same asset at a mark up to their customer. Without these
necessary amendments, a gain would result from both transactions.
In practice, this cost or extra tax would have to be borne by the customer making Islamic products
more costly from a customer’s perspective.
6 .Shari’ah compliance
The central focus of Islamic finance is Shari’ah compliance. To ensure compliance a distinctive
feature of Islamic finance is the establishment of a Shari’ah advisory or supervisory board to advise
IFIs, Islamic insurance companies, Islamic funds and any other providers which offer Islamic
financial products. The establishment of a board, the opinions of which are binding on all IFIs, is
required to guide the institutions towards Shari’ah compliance. An institution cannot claim to be
doing Islamic financial business until and unless it sets up a Shari’ah board or committee consisting
of qualified scholars who are of high reputation and who possess the necessary skills.
7. Unlawful goods or services
Another equally important feature is that Islamic finance must not be involved in any activities
pertaining to unlawful goods and services. These prohibited goods and services include, among
others, non halal foods such as pork, non slaughtered animals or animals which were not
slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography,
tobacco related products and weapons. Non involvement is not only limited to buying or selling
but also includes all chains of production and distribution, such as the packaging, transportation,
warehousing and marketing of these prohibited goods and services.
8. Overriding principles of Islamic law
Islamic finance essentially refers to Shari’ah compliant financial activities. In addition to observing
the above mentioned features, Islamic financial products and services must not contain any
principles, terms and conditions which are contradictory to established legal maxims or legal
principles. These legal maxims are the overriding principles and essential parameters of Islamic law,
widely accepted by Muslim jurists. An example would be the principle that that capital in
equity based financing or investment cannot be guaranteed by the manager or other partner.
An equity contract must be free from capital guarantee to reflect the very essence of equity
investment that is equity investors must bear the risk of loss of capital.

RIBA AND GHARAR
As a key to understanding Islamic finance it is important to further explain the meaning of two terms
or concepts that must be avoided by Islamic finance in all circumstances: Riba and Gharar. The
avoidance of these two elements is a basic requirement of all Islamic financial activities.
Riba
Riba is simply translated into English as usury or interest. Any premium charged on money
borrowed is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an
advantage to one party at the expense of another for no appropriate consideration. Islamic
commercial law addresses the issue of this unjustified advantage from two possible transactions,
namely in a loan or currency exchange contract as well as in a barter trading contract.
Muslim jurists have unanimously agreed that two separate classes of assets are susceptible to Riba,
namely currency or money and a few commodities, mainly food items. The requirements of an
exchange involving these two types of assets are the same.
These requirements are only applicable when there is an exchange of one currency for another
currency whether it is the same currency or different currencies. The requirements also apply to the
exchange of a food item for another food item, be it of the same food item or of different types and
kinds.
Riba requires assets to be exchanged within the same class, that is, currency for currency. An equal
amount of the counter value is required in exchange of assets of the same class. Spot exchange, or
the simultaneous delivery of counter values, is also required when one currency is exchanged for
another currency or when a food item is exchanged for another food item, irrespective of whether
these currencies or food items are the same or different types. Any delay in the delivery will render
the exchange tantamount to Riba, known as Riba al-nasiah, that is, Riba by virtue of deferment in
the exchange or delivery of these two counter values.
From another perspective, the exchange of these two assets is also subject to the same amount or
quantity of the two counter values if they are of the same type. The failure to observe this would
lead to the practice of Riba called Riba al-fadl, namely Riba by an excess of one of the counter
values. However, the requirement to have the same quantity is not applicable if they are of different
types such as GBP for USD or wheat for barley.
This Tradition is the foundation of the permissibility of currency exchange, done on the basis of the
prevailing rate of exchange, for example to exchange GBP1,000 for USD3,000, provided this is
done on a spot basis. Any deferment of the exchange or delivery as in the case of a forward currency
exchange is not in line with the requirements of the Tradition, and is thus prohibited. The amount of
exchange is not relevant when the exchange involves two different usurious items such as USD for
GBP.
The theory of Riba could therefore be summarised as follows:

Riba (1) = Exchange of two similar usurious items for different counter values and for deferred
exchange, for example, GBP1,000 for GBP1,200 being exchanged for one another on a deferred
basis.
Riba (2) = Exchange of two dissimilar usurious items for deferred exchange, for example,
GBP1,000 being exchanged for USD1,000 on deferred exchange
From the above, a loan in GBP provided by conventional banks and other institutions that imposes
on the borrower the requirement to repay the principal amount borrowed plus a premium in the same
currency would come under the purview of Riba (interest/usury). This practice of modern Riba in
the banking sector relates to both Riba al nasiah (Riba by deferment) and Riba al fadl (Riba by
excess) because the borrower is obligated to pay more than he borrowed and repayment will take
place in the future. This is the reason why conventional saving accounts and fixed deposit accounts,
as well as all financing modes based on loan for interest are not compliant to Shari’ah principles.
The theory of Riba also applies to currency exchange which can only be done on a spot basis.
Forward or future currency transactions are not allowed.
2. Gharar
Gharar is another element that is to be avoided in any transaction. Gharar simply refers to a lack of
knowledge or uncertainty that could result in an outcome detrimental to one party. This lack of
knowledge, as well as a lack of control of the outcome of any transaction, may stem from
misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of the
parties to the contract.
Gharar in practice relates potentially to issues such as pricing, delivery, quantity and quality of
assets that are transactional based and would affect the degree or quality of consent of the parties to
a contract. For example, one cannot buy an ‘option’ at a certain price to have the right to purchase its
underlying shares, as an ‘option’ is not ascertainable and is thus uncertain. An option is just a right.
It is not an asset whose specifications are clear and attainable. In conventional insurance, the
premium paid by policyholders and the indemnity provided by the insurer upon a claim are equally
uncertain, thus making conventional insurance non compliant from an Islamic legal perspective.
Unlike Riba, which is determined by a fixed formula as previously explained in section 4.1, the
determination of Gharar is based on many aspects. This is because the parameter of knowledge or
consent and the risk tolerance by society is not fixed. Above all, Islamic commercial law has
accepted the distinction between major uncertainty (Gharar fahish), which is to be avoided at all
times, and minor uncertainty (Gharar yasir), which is tolerated by society.
Profit and loss sharing
In addition to the two prohibited items outlined above, Islamic finance is also closely associated
with the practice of profit and loss sharing. This is unique as IFIs will share the profit or loss, as the
case maybe, with depositors as well as fund users if the contracts entered into by the two parties are
based on either Mudarabah or Musharakah. In terms of deposit, IFIs act as the manager while the
depositors are the capital providers who deposit their capital on the basis of a Mudarabah contract
either through their savings or investment account. The depositors will share the profit with the bank
based on a particular ratio. The depositor will also bear the loss entirely under the Mudarabah
contract while the banks will lose their time, work, effort and expected profit.
IFIs may finance their customers using either Mudarabah or Musharakah. Here, the IFIs act as the
capital providers and share the profit with their customers upon its realisation in any business
venture. Loss will be borne by the IFI under the Mudarabah contract, but the loss is to be shared
between the IFI and the customer under the Musharakah contract. This makes Islamic finance
distinctive from that of conventional finance.
ISLAMIC FINANCE COMPARED WITH CONVENTIONAL FINANCE
Islamic financece does not, and should not, deal with money directly as money cannot earn more
money by itself. Money must be put into real business activities to earn extra money. This is the
whole basis of trading. In other words, IFIs facilitate the financing needs of customers by becoming
sellers, lessors or partners as the case may be. The function of money has been transformed from a
commodity into an enabler to facilitate trading, leasing and investment as illustrated in the following
diagram.
The function of money in Islamic finance
The pool of money, collected through various Islamic accounts and or shareholders’ funds, is
channelled to finance trade, lease or investment activities. From a micro perspective, the money has

been transferred into real economic stock in order to generate more income. Thus, the profit
generated by IFIs is the outcome of dealing with a real asset rather than a monetary asset.
SHARI’AH COMPLIANCE AND THE EQUITY MARKET
The distinction between Islamic finance and conventional finance is more obvious in banking and
insurance products as well as in fixed income instruments than it is in the equity market.
Conventional banking and fixed income instruments are essentially based on interest, while the
conventional insurance contract is based on the sale of an indemnity for a premium that contains a
considerable degree of uncertainty. The distinction between the Islamic and conventional equity
markets is however less clear because the prohibited elements are contained not in the structure of
the respective contracts but in transaction-based activities.
There is no Shari’ah issue on the contract of investment in the equity market as it is essentially based
on the principle of profit and loss sharing. In other words, buying a share in any stock exchange is
permissible as this purchase reflects a contract of Musharakah among the shareholders. This
contract, per se, is compliant. However, Shari’ah objections are mainly concerned with the activities
of the companies in which the capital, through subscription to the shares, is put. These activities may
include the sale or purchase of assets and services that are not approved under Shari’ah principles
such as the sale or purchase of non-Halal food and drink. Non-approved activities also include
activities related to the balance sheet of the company such as the borrowing or raising of more
capital through interest-based transactions such as overdrafts and conventional bonds.
KEY ISSUES
Prohibited trading items
In addition to avoiding interest (usury) and profit earned from uncertainty, Islamic finance should
not be invested in activities involving, amongst other things, armaments, the consumption of pork,
intoxicants, entertainment, games of chance or pornography. This prohibition includes the entire
economic chain of activities relating to these activities, including their production, storage,
transportation, marketing and advertising.
For a finance house to be able to trade under the banner of Islamic finance its customers would have
to be not linked to any of the above. In a world dominated by Western financial and business
practices, this is a tall order. Many businesses have either direct or indirect links to some or all of the
prohibited activities (consider your local supermarkets, hotels and restaurants). Such businesses
would not be suitable candidates for raising funds under Islamic finance either through banks or by
issuing financial instruments such as shares or debentures.

Acceptable practice
Subject to the prohibitions mentioned, profit is ok in its own right, but the profit should be earned
fairly (i.e. not at the disadvantage of others) and should result from some form of trading activity.
Additionally
(i) The funder should take part in the risk involved in a project,
(ii) No party to a financial transaction should benefit disproportionately to another,
(iii) Parties should benefit in accordance with their contributions on a predetermined basis,
(iv) Financing projects should require some form of trading or partnership in trade and
(v) Profit should not be earned to the detriment of the environment.
In order to address these restrictions, financiers and insurers have had to develop new Shari’ah
compliant products expressed in Arabic. These new products are based round a series of contracts,
the principles of which most readers will recognise. These contracts completely change the
relationship between the bank and the suppliers of funds which can now be that of agent and
principal, depositor and custodian, investor and entrepreneur as well as between fellow partners in a
joint investment project. Similarly, the relationship of the bank with the users of funds can comprise
of vendor and purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor
and transferee, and between partners in a business.
Major contacts used
The main contracts used in the development of Shari’ah compliant products are:
 Bay’ Mu’ajjal (deferred payment)

 Ijarah (operating lease)
 Istisna’ (construction finance)
 Mudarabah (partnership contract)
 Murabahah (cost‑plus)
 Musharakah (partnership contract where funder has executive involvement)
 Wadiah (safe custody)
 Wakalah (agency)
The two most popular forms of finance are Mudarabah and Murabahah.
Mudarabah
Under a Mudarabah financing contract the bank agrees to finance the entrepreneur on the
understanding that both parties will share the profits of the particular venture being financed.
Deposits made to the bank by individuals under a Mudarabah contract are treated as an investment
in the bank by the individual. The bank will use this investment to help make profits from its trading
activities i.e. financing of individuals and businessmen. Under the Mudarabah contract the bank will

have agreed to give the depositor a share of its profits in return for the investment based on a
pre agreed ratio.
Murabahah
Murabahah financing is a prevalent mode of asset financing and represents a significant portion of
Islamic bank financing of either short-term or long-term assets. A murabahah contract refers to a
cost plus mark up transaction between the parties. Under this contract a three party arrangement is
made where the customer places an order with the financial institution to purchase goods from a
supplier. The customer may pay a security deposit with the financial institution and the amount of
financing outstanding can be secured either in the form of collateral or guarantee. The financial
institution having purchased the goods from the supplier then sells them to the customer at a price
including mark up with a fixed credit period.
Constraints to growth
The development of the industry has taken place in two key geographical areas, South East Asia and
the Middle East, and this has resulted in several key issues arising which have tended to stifle
growth:
 The regions have not always agreed with each other over the direction developments have
taken. In general terms the Middle East applies stricter interpretations of the Qur’an than
countries in South East Asia, particularly Malaysia.
 Sovereign states within the Middle East have developed differently to one another with some
applying more flexible interpretations than others.
 Within sovereign states different factions have developed e.g. Shia and Sunni with both
groups interpreting aspects of the Qur’an differently.
 Most, but not all, countries have left Islamic finance under the legislative umbrella of their
current banking laws, but have required that the industry comply with standards and guidance
coming from such groups as the International Islamic Fiqh Academy (IIFA), an offshoot of
the Organisation of the Islamic Conference (OIC) and the Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI).
Therefore within Islamic finance you have:
 Different interpretations of the Qur’an.

 Different applications of similar contracts.
 Different practices allowed i.e. The opening of ‘Islamic windows’ within conventional banks,
which is acceptable in Malaysia, but not in many Middle Eastern countries.
 Different spellings of the Arabic terms used.

Requirements for sustained growth
There is no doubt that the Islamic finance sector has felt the repercussions of the financial crisis, but
on the whole it has weathered the storm better than conventional finance and its prospects remain
high. Governments are in a position to give a direct impetus to this recovery through their
involvement in the Sukuk market. The UK government has been in discussions for many years over
the issue of a sovereign Sukuk, but deferred action in 2008. For the UK a sovereign Sukuk could be
an ideal platform to help fund the 2012 Olympics. As it stands, 2010 could see several countries
accessing the Sukuk market to help finance major investment projects. Such countries include the
UK, Japan, Turkey and Russia who hope to tap into the massive liquidity which exists in Asia and
the GCC via Shari’ah compliant investment products.
If Islamic finance is to compete with mainstream global finance, the industry needs to improve
transparency and foster credibility by harmonising standards and practices, not least, the variety of
Shari’ah interpretation between regions and even institutions. Regulatory oversight needs to be
sharpened as well. These measures could be critical in broadening the appeal of Islamic finance and
bridging the gap between Islamic and conventional financial systems.
The Islamic finance industry also needs to work on innovation. Shari’ah compliant products can be
more complex than conventional ones because every transaction is based on a trading agreement.
Many equivalents of conventional financial instruments are still lacking, including corporate
treasury and derivative products. At the same time, innovation is hampered by the limited number of
Islamic scholars able to vet financial products for Shari’ah compliance. Finally there is a huge
shortage of suitable skilled employees working within the industry. This dearth of suitably qualified
human capital can only be redressed by increasing the awareness of the career possibilities within
the industry and by the offering of globally accepted qualifications.
What if?
Two key areas of concern in the world today are:
1. The credit crisis caused by the collapse of the sub‑prime market.

2. The increasing cost of food staples around the world.
A question asked by many interested in finance is whether a finance industry based on Islamic
finance principles would have ended up in the same mess.
The credit crisis
Developed countries relaxed mortgage credit criteria based on the view that property prices would
continue to rise to balance the additional risk of lending to individuals with little or no credit
standing. These mortgage obligations were then converted into a variety of securities of differing
tranches and seniority status which had little relationship to the underlying assets. With the fall in

the value of housing stock, panic set in as the finance market realised that such securities were not
underpinned by real assets.
Would this situation have arisen in a Shari’ah compliant financial system?
Under Islamic finance the trading in debt is disallowed. Hence mortgage based securities are classed
as usurious, especially where the link to actual assets is tenuous. This link to assets is key to the
acceptability of Islamic securities. A direct link to such assets should be the way income is earned.
Goods that a seller does not own or cannot deliver cannot form part of an Islamic contract.
The increasing cost of food staples around the world
The current food crisis revolves around the fact that the physical quantity of staple crops (wheat, rice
etc) grown in the world has fallen or is not keeping up with demand. As a result the
price appears to be rising to a stage where much of the poorer population of developing countries,
where these crops form the staple food of many, is finding it hard to afford basic food. The recent
fuel crisis has added to this in that many countries, but particularly the United States which is giving
financial incentives to farmers to grow crops such as maize, which are necessary ingredients in bio
fuels. Transfers to this type of crop means less land is producing staple food crops.
What’s the link with the finance industry? It is generally believed that speculators in the futures
market may have added to the problem. Falling returns in the real estate and equities markets may
have led traders to shift to commodities in the futures market. The view is that a large part of the
price rises we are seeing have been caused by future expectations of price rises.
Would this situation have arisen in a Shari’ah compliant financial system?
Forwards, futures etc. involve risk and trading in that which you do not already possess and cannot
deliver, is specifically prohibited under Shari’ah law, i.e. you can’t sell an unborn calf or grain
which hasn’t been harvested. The effect of the futures market on the price of staple foods (if it is
having an effect) would not have occurred under a financial system applying strict Shari’ah rules.

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ATD

ACCOUNTING TECHNICIAN DIPLOMA

KASNEB JULY 2018 SYLLABUS

Revised on: January 2019

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8.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:

 Identify various sources of finance for organisations

8.1 Overview of finance

 Nature and scope of finance

8.2 Sources of finance

 Factors to consider when choosing the source of finance

8.3 Financial markets and systems

 Roles and importance of of financial markets and systems

8.4 Time value of money

 Time value versus time preference for money

8 5 Introduction to Risk and return

 Components of risk and return

8.6 Cost of capital

 Significance of cost of capital to firms

8.7 Working capital management

 Nature and importance of working capita!

8.8 Capital Budgeting decisions under certainty

 Importance, characteristics and types of capita! investment decisions

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8.9 Dividend decisions

 Factors influencing the dividend decision of a firm

8.10 Fundamentals of Islamic finance

 Principles and trends in Islamic banking

8.11 Emerging issues and trends

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Chapter 1: Nature and purpose of finance………………………………………………………...6

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NATURE AND SCOPE OF FINANCE

2. Securities and Investment Analysis

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RELATIONSHIP BETWEEN FINANCE AND ACCOUNTING

Finance and accounting are two closely related activities in a company.

a. Evaluation of new investment in terms of profitability

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It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

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Some of the major functions of a financial manager are as follows:

1. Estimating the Amount of Capital Required

The functions of Financial Manager are discussed below:

1. Estimating the Amount of Capital Required:

i. purchase of fixed assets,

2. Determining Capital Structure:

3. Choice of Sources of Funds:

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6. Disposal of Profits or Surplus:

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Goals of a firm are divided into financial and non-financial goals

Financial goals of the firm

Favourable Arguments for Profit Maximization

i. Main aim is earning profit.

Unfavourable Arguments for Profit Maximization

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