BUSINESS FINANCE.

DENIS LESLEY 21/08392

1.
a.) Outline THREE limitations of retained earnings as a source of finance. (3 marks)
i.)Limited availability: Retained earnings are limited by the profitability of the firm. If a company has a
low profit margin or has not accumulated sufficient profits in previous years, it may not have sufficient
retained earnings to finance its future projects or investments.

ii.)Lack of diversification: Since retained earnings come from the profits of the company, it is limited to
the performance of that specific business. This means that if the company's industry or sector
experiences a downturn, the company may not have enough retained earnings to support its operations
or expansion plans.

iii.)Opportunity cost: Retained earnings represent an opportunity cost to the company, as the funds that
are kept in the business are not being used for alternative investments or purposes. If the company has
more attractive investment opportunities outside the business, then the opportunity cost of retaining
earnings becomes significant.

b.) Explain THREE non-financial goals of a firm. (6 marks)

i.)Social Responsibility: One of the non-financial goals of a firm is social responsibility. This involves
taking actions that are in the best interest of society, such as reducing the firm's carbon footprint or
supporting charitable causes.

ii.)Employee Satisfaction: Another non-financial goal of a firm is employee satisfaction. This involves
creating a work environment that fosters employee satisfaction and engagement, which in turn can lead
to increased productivity and reduced turnover rates.

iii.)Customer Satisfaction: A third non-financial goal of a firm is customer satisfaction. This involves
providing high-quality products and services that meet or exceed customer expectations, which can lead
to increased loyalty and repeat business.

(c) Heko Ltd. has the following capital structure which is considered optimal:
Sh.“000”
Debt (par value Sh.1,000) 300,000
Preference shares (par value Sh.100) 180,000
Ordinary shares (par value Sh.100) 720,000
Additional information:The investors of Heko Ltd. expect earnings and dividends to grow at a constant
rate of 9% in the future.
2. The company has just paid ordinary shareholders dividend of Sh.4.2 per share.
3. The current market price of ordinary shares of Heko Ltd. is Sh.80 each.
4. The firm will incur a floatation cost of Sh.4 per share to issue new shares.
5. New preference shares can be sold at Sh.105 per share with a dividend of Sh.11 per share and
floatation cost of Sh.10 per share.
6. The company will issue debenture under the following terms:
• The coupon rate 12% per annum
• Discount Sh.30 per debenture
• Floatation cost Sh.20 per debenture
• The par value is Sh.1,000
• Maturity period of ten years
7. The corporate tax rate is 30%.

Required:
(i) The cost of ordinary share capital. (2 marks)
(ii) The cost of preference share capital. (2 marks)
(iii) The cost of debenture capital. (3 marks)
(iv) The weighted average cost of capital (WACC) using market value weights. (4 marks)

(i) The cost of ordinary share capital can be calculated using the dividend growth model as follows:

Cost of equity = (Dividend per share / Market price per share) + Growth rate
= (4.2 / 80) + 0.09
= 0.057 + 0.09
= 0.147 or 14.7%

(ii) The cost of preference share capital can be calculated using.

Cost of preference share capital = (Dividend per share / Net proceeds per share) + Flotation cost per
share
= (11 / (105 - 10)) + 10
= 0.1238 or 12.38%

(iii) The cost of debenture capital can be calculated as follows:

Effective cost of debt = (Coupon rate * (1 - Tax rate)) * (1 - Discount rate) + Flotation cost
= (0.12 * (1 - 0.3)) * (1 - (30 / (1 - 0.3))) + 20
= 0.0756 or 7.56%

(iv) The weighted average cost of capital (WACC) using market value weights can be calculated as
follows:

WACC = (Weight of debt * Cost of debt) + (Weight of preference shares * Cost of preference share
capital) + (Weight of ordinary shares * Cost of ordinary share capital)
= ((300,000 / 1,000,000) * 0.0756) + ((180,000 / 1,200,000) * 0.1238) + ((720,000 / 1,200,000) * 0.147)
= 0.0527 + 0.0186 + 0.08825
= 0.15945 or 15.945%

Therefore, the WACC using market value weights is 15.945%.

2.
(a) Explain the term “venture capitalist” as used in finance. (2 marks)
(b) Identify THREE differences between “factoring” and “invoice discounting”. (6 marks)

(a) Venture capitalist is a type of private equity investor who provides funding to startups and early-
stage companies that have high growth potential but are deemed too risky by traditional financing
sources. Venture capitalists typically provide not only financial support but also mentorship, industry
connections, and strategic guidance to help the company grow and succeed.

(b) The three differences between factoring and invoice discounting are:

i.)Ownership of Receivables: In factoring, the factoring company purchases the receivables from the
seller, whereas in invoice discounting, the seller retains ownership of the receivables.
ii.)Responsibility for Collections: In factoring, the factoring company assumes responsibility for collecting
payments from customers, whereas in invoice discounting, the seller retains responsibility for
collections.

iii.)Disclosure to Customers: In factoring, the factoring company discloses its involvement to the
customers of the seller, whereas in invoice discounting, the seller typically maintains control over the
relationship with its customers and does not disclose the involvement of the invoice discounter.
c.) Erick Nandwa borrowed Sh.250,000 from Pritt Sacco at a monthly interest rate of 3%. The loan is
to be amortised using the reducing balance method and be repaid in 6 equal monthly instalments,
payable at the end of each month.
Required:
Prepare a loan amortisation schedule. (6 marks)
(b) Paul Kalama is considering investing in a five-year Sh.1,000 par value bond bearing a coupon rate
of 7%. Paul Kalama’s required rate of return is 8%. The bond is quoted at Sh.950 in the bond market. The
bond will be redeemed at par value.

Required:
(i) Compute the intrinsic value of the bond. (4 marks)
(ii) Advise Paul Kalama on whether he should purchase the bond based on your computation in (d)
(i) above.
(2 marks)

(a) Loan Amortization Schedule:

Opening Closing
Month Balance Payment Interest Principal Balance

1 250,000 47,128 7,500 39,628 210,372

2 210,372 47,128 6,312 40,816 169,556

3 169,556 47,128 5,087 42,041 127,515

 Opening Closing
Month Balance Payment Interest Principal Balance

4 127,515 47,128 3,826 43,302 84,213

5 84,213 47,128 2,526 44,602 39,611

6 39,611 47,128 1,188 45,940 0

(b)
(i) The intrinsic value of the bond can be calculated as the present value of the bond's future cash flows.
Using the bond's coupon rate of 7%, its par value of Sh.1,000, and a required rate of return of 8%, we can
calculate the bond's intrinsic value as follows:

PV of annuity = (1 - (1 + r)^-n) / r
PV of bond = PV of annuity + PV of par value

Where:
r = required rate of return = 8% / 2 = 4%
n = number of semi-annual periods = 5 x 2 = 10

PV of annuity = (1 - (1 + 0.04)^-10) / 0.04 = 7.3606

PV of par value = 1,000 / (1 + 0.04)^10 = 675.5643

PV of bond = 7.3606 + 675.5643 = Sh.682.9249

Therefore, the intrinsic value of the bond is Sh.682.9249.

(ii) the intrinsic value of the bond is less than the current market price of Sh.950. This means that the
bond is overpriced in the market and Paul Kalama should not purchase the bond.
3.
(a) Outline FOUR functions of a finance manager. (4 marks)
(b) Explain FOUR chronological steps of dividend payment process. (4 marks)

(a) Functions of a finance manager:

i.)Financial Planning: The finance manager is responsible for creating and implementing financial plans
for the organization. This includes budgeting, forecasting, and analysis of financial statements to ensure
that the company's financial goals are achieved.
ii.)Capital Budgeting: The finance manager is involved in the process of identifying and evaluating long-
term investment opportunities to maximize the value of the company's shareholders.
iii.)Risk Management: The finance manager is responsible for identifying, evaluating, and managing
financial risks that the company faces. This includes managing interest rate, exchange rate, credit, and
operational risks.
iv.)Financial Reporting: The finance manager is responsible for preparing and presenting financial reports
to management, investors, and other stakeholders. This includes maintaining accurate financial records,
preparing financial statements, and managing the company's audit process.
(b) Chronological steps of dividend payment process:

i.)Declaration: The board of directors declares the dividend and announces the date of record, which is
the date on which shareholders must be registered in order to receive the dividend.
ii.)Ex-Dividend Date: After the date of record has been set, the ex-dividend date is announced. This is the
date on which the shares begin trading without the dividend attached to them.
iii.)Payment Date: On the payment date, the dividend is paid to the shareholders who were registered
on the date of record.
iv.)Reconciliation: After the payment has been made, the company reconciles its records with the
dividend payments made to ensure that all payments were accurate and complete.
(a) Makupa Limited intends to invest Sh.32,000,000 in a project which is expected to generate the
following cash flow.
Year 1 2 3 4
Sh. Sh. Sh. Sh.
Cash flows 15,000,000 10,000,000 9,000,000
The expected scrap value at the end of year 4 is Sh.4,000,000.

The company’s cost of capital is 14%.

Required: 8,000,000
(i) Calculate the internal rate of return of the project. (8 marks)
(ii) Advise the management on whether to invest in the project or not based on your results in (c) (i)
above.
(2 marks)
(iii) Highlight TWO advantages of using internal rate of return (IRR) to appraise investment projects.

(2 marks)

(i) Calculation of Internal Rate of Return (IRR):

To calculate the IRR, we need to find the discount rate at which the present value of the project's cash
inflows equals the initial investment.

Using the formula for present value of cash flows:

PV = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + SV / (1+r)^4

32,000,000=15,000,000/(1+r)^1+10,000,000 / (1+r)^2 + 9,000,000 / (1+r)^3 + 4,000,000 / (1+r)^4

By using Excel's IRR function, the internal rate of return is 21.9%.
the internal rate of return (IRR) of the project is 21.9%.

(ii) Advice to management:

Since the IRR (21.9%) is greater than the cost of capital (14%), the project is acceptable. Therefore,
management should invest in the project.

(iii) Advantages of using internal rate of return (IRR):

i.)IRR provides a single measure of the project's profitability that is easy to interpret and compare with
other projects.

ii.)IRR considers the time value of money and reflects the opportunity cost of capital, making it a more
realistic measure of the project's value.