TOPIC 1

OVERVIEW OF CORPORATE FINANCE

INTRODUCTION:
Definition

CORPORATE FINANCE
Corporate finance is the study of the relationship between corporate decisions and value of the
firm.

CORPORATE DECISIONS
The decisions can be divided into:
1. Long-term corporate decisions
• long term corporate decisions involve
a) Investment decisions
• It is the purchasing of Non-current assets made by the financing manager
• It is also known as acquisition of Non-current assets
• Example
➢ Purchasing/construction of premises
➢ Purchasing of land
➢ Purchasing of equipments
➢ Purchasing of machines

b) Financing decisions.
• This is issuing of shares
• It happens when a company capital is not enough to run a business
• The aim of financing decision is to build the capital structure of a business
• Financing decisions can be done by the following ways:
➢ Issuing shares
➢ Lending from lenders (financial institutions)

c) Dividend decisions
• Is the distribution of dividend and retained profit to shareholders
Where:
Dividend:
Refers to a reward, cash or otherwise, that a company gives to its shareholders.
Retained profit
Is the amount remained after providing dividend to shareholders

2. Short-term decisions and techniques.

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 • The short term corporate decision is concerned with working capital management decisions.
• Working capital management decisions has two elements
i. Current assets
ii. Current liabilities

i. Current assets
• Managing the inventory
• Managing cash at bank and cash in hand
• Managing accounts receivables

ii. Current liabilities

• Managing accounts payables
• Managing accruals/outstanding expenses

VALUE OF THE FIRM

The value of the firm is maintained by two things:
i. Increase the profit value through increasing sales and reducing expenses
ii. Reducing Weighted Average Cost of Capital (WACC)

NB: The primary goal of corporate finance is to maximize corporate value.

THE FINANCIAL MANAGER

• The financial manager must be concerned with three basic types of questions.
1. Capital budgeting
2. Capital structure
3. Working capital management

1. Capital Budgeting
• The first question concerns the firm’s long-term investments.
• It is the process of planning and managing a firm’s long-term investments
• In capital budgeting, the financial manager tries to identify investment opportunities
that are worth more to the firm than they cost to acquire.

2. Capital Structure
• A firm’s capital structure refers to the specific mixture of long-term debt and equity
the firm uses to finance its operations.
• It is the second question for the financial manager concerns ways in which the firm
obtains and manages the long-term financing it needs to support its long-term
investments.

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 3. Working Capital Management
• The third question concerns working capital management.
Working capital refers to a firm’s short-term assets, such as inventory, and its
short-term liabilities, such as money owed to suppliers. The current assets and current
liabilities
• Managing the firm’s working capital is a day-to-day activity that ensures the firm has
sufficient resources to continue its operations and avoid costly interruptions.

AGENCY THEORY AND AGENCY PROBLEM

Agency theory
Is the theory explaining the relationship between the agents and principles
Where:
i. Agents who are managers, their aim is to maximize shareholders wealth
ii. Principles are the owners of the company also known as providers of funds

AGENCY PROBLEM:
It is a conflict of interest between the agents and the principles when the agents fail to maintain
the agency theory.

The ways to minimize agency problem

i. Provision of appropriate incentives to agents
ii. Monitoring of agents or managers

i. Incentives to the agents;

• The incentives given to the agents/managers are of different types.
• Some of them are as follows:
a) Stock options:
In this incentives, management having the right to acquire the shares of
the enterprise at a concessional price.

b) Cash bonus:
It is linked to the performance target.

c) Perquisites: Perquisites such as company car, expensive offices and other

fringe benefits. These incentives promote the congruence between the
personal goals of management and the interests of the
owners/shareholders.

ii. Monitoring of Agents

• There is a greater need for the monitoring the Agents by the Shareholders.
• Monitoring can be done by:
a) Auditing the financial statements and limiting decision making by the
management.

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 b) Bonding the agents

FORMS OF BUSINESS ORGANISATION

A. SOLE PROPRIETORSHIP:
• This form of the business organisation is owned by the single person.
• A sole proprietorship business and its owner are treated as one and the same and there is no
separate existence for the owner from the business.
• The owner himself is responsible for the losses and at the same time, he himself is entitled for
the profits.

Advantages of sole proprietorship

i. The owner can start the business with very little legal formalities.
ii. The owner can take the decisions connected with the business himself which results into very
fast decision-making.
iii. The running of the firm can be very smooth as there is no possibility of differences opinion
among different persons because of the single owner.

Disadvantages of the proprietorship business

i. The personal liability of the owner is unlimited, which means that if assets of the firm are not
sufficient to pay off the business liabilities, personal assets of the owner are utilised for the
payment of the business debts.
ii. The sole proprietorship firm has no separate status from that of the owner. This means that
the business will cease to exist if there is the death of the owner.
iii. The incidence of taxation is very high because personal income and firm’s income are treated
separately.

B. PARTNERSHIP FIRMS
• A partnership firm is a business by two or more persons.
• The partnership comes into existence according to the partnership agreement/deed.
• The rights, duties and obligations of the partners are also governed by the Partnership
agreement.

Advantages of partnership firms

i. Like the sole proprietorship, it is easy for formation and comparatively free form
government regulations.
ii. The partners are coming from the various backgrounds and therefore, the benefit of their
experiences is available for the firm.

Limitations of partnership firms

i. Unlimited liability of the partners prevents the firm from taking the risk.
ii. The firms do not have any perpetual succession and, therefore, the death, insolvency or
retirement of the partner may threaten the very existence of the firm.

C. LIMITED COMPANY:
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 • A limited company registered under Companies Act of the respective country.

Unique features of limited company

i. Perceptual Succession
• A limited company has perpetual succession which implies that a company has a
separate existence from its owners i.e. shareholders.
• Even though the shareholders can keep on changing the existence of the firm is not
threatened.

ii. Limited Liability

• The liabilities of the shareholders are limited.

iii. Transferability of the shares

• Subject to the limitations mentioned in the Article of Association, the shares of a
limited freely transferable.

Types of limited company

a) Private Company:
• A private company is that company which satisfies the following criteria.
• Minimum numbers of members are two and maximum numbers of the members
are fifty.
• No public invitation is allowed for the subscription of shares and debentures.

b) Public Company:
• A public limited company is a form of organisation that has a minimum of seven
members while there is no restriction on maximum number of members.
• A public company is allowed to invite the public for subscription to its shares and
debentures.
• There is no any restriction on the transfer of the shares.

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 TOPIC 2
THE COST OF CAPITAL
Cost of Capital
• It is the required rate of return on the various sources of financing of company.
• It is obtained from the following source of finance
a. Equity (given by shareholders)
b. Debentures (obtained from lenders)
c. Preferred shares (given by stock holders / preferred shareholders)
• These sources of finance are also known as provider of fund, they form a capital structure.
Where equity and debentures make a good capital structure

Components of cost of capital

There are three components of cost of capital
i. Cost of equity (Ke)
It is the required rate of return on investment of the ordinary shareholders of the company

ii. Cost of debt

It is the required rate of return on investment of long term lenders of the firm.

iii. Cost of preferred stock

It is the rate of return on the investment of the preferred stock holders of the firm

I. COST OF EQUITY (Ke)

• It is the required rate of return on investment of common shareholders/ordinary
shareholders/ owners
• In the agreement it should be in percentage, then later it should be distributed in terms of
money, i.e. the percentage times the profit obtained
• There are two methods involved in cost of equity
1. Dividend Discount model
2. Capital asset pricing model (CAPM)

1. DIVIDEND DISCOUNT MODEL (Gordon Model)

• Also known as dividend growth model or Gordon model
• The method is stimulated by person called Gordon.
• Assumption of Gordon model is that the dividend is grown up by constant
growth rate (g)

Mathematically:

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 𝐃𝟏
𝑲𝒆 = ( + 𝒈 ) × 𝟏𝟎𝟎
𝐏𝐨 − 𝐅𝐜

Where:
K e = cost of equity

D1 = expected dividend

D0 = paid dividend

P1 = expected price per share

Po = current market price per share

Fc = Flotation cost per share

g = constant growth rate

Flotation cost
• Is the cost incurred by the company during initial public offering (IPO), where IPO
is the issuing of shares at primary market participants being the company and the
investors

• Example of floatation costs

❖ Audit fee
❖ Legal fee
❖ Registration fee
❖ Underwriting fees

From
𝐃𝟏
𝑲𝒆 = ( + 𝒈 ) × 𝟏𝟎𝟎
𝐏𝐨 − 𝐅𝐜
𝐷1 = 𝐷𝑜 (1 + 𝑔

Then:
𝐷𝑛 = 𝐷𝑜 (1 + 𝑔)𝑛

Since
𝐷1 = 𝐷𝑜 (1 + 𝑔)

Then:
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 𝐃 𝐨 (𝟏 + 𝐠)
𝑲𝒆 = ( + 𝒈 ) × 𝟏𝟎𝟎
𝐏𝐨 − 𝐅𝐜
NOTE:
When shares are issued in the secondary market we use the formula below:
𝐃 𝐨 (𝟏 + 𝐠)
𝑲𝒆 = ( + 𝒈 ) × 𝟏𝟎𝟎
𝐏𝐨
Reason:
There will be no flotation costs, because flotation costs are only applied when shares
are issued for the first time

2. CAPITAL ASSET PRICING METHOD (CAPM) 𝑲𝒆

• This method involves risks this is the systematic risk and unsystematic risk
• It is another method of obtaining cost of equity (Ke)
• Mathematically:
𝐊 𝐞 = 𝐑 𝐟 + 𝛃(𝐑 𝐦 − 𝐑 𝐟 )

Where:
K e = cost of equity

R f = Risk free Rate or treasury bills rate

β = Beta (reduces systematic risk or eliminate unsystematic risk)

R m = Return on market

R m − R f = Risk premium

NOTE:
𝐑𝐦 > 𝐑𝐟

Risk premium
• Is the difference between risk free rate and return on market
• It should be in percentage.
• Mathematically

𝐑𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 = 𝐑 𝐦 − 𝐑 𝐟

3. COST OF PREFERRED STOCK (KP)

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 • External shareholders are person providing fund and help to run the business, and
they own an amount after a certain periods of time. The amount of money is
called preferred stock

Cost of preferred stock

• Is the required rate of return on investment of stockholders/ preference
shareholders/external shareholders

Types of cost of preferred stock

i. Irredeemable preferred stock
ii. Redeemable preferred stock

I. IRREDEEMABLE PREFERRED STOCK

• It is the preferred stock without maturity time.
• The maturity time is the fixed time to pay divided to stock holders
• Mathematically

𝐃𝐏
𝐊𝐏 = × 𝟏𝟎𝟎
𝐏𝟎

Where
𝐊 𝐏 = 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐩𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐬𝐭𝐨𝐜𝐤
𝐃𝐏 = 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐏𝟎 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

Now:
If you are not provided with dividend per share

𝐃𝐏 = 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐫𝐚𝐭𝐞 × 𝐩𝐚𝐫 𝐯𝐚𝐥𝐮𝐞 𝐨𝐫 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞 𝐨𝐫 𝐟𝐚𝐜𝐞 𝐯𝐚𝐥𝐮𝐞

And if you are provided with flotation cost

Then:

𝑫𝑷
𝑲𝑷 = ( ) × 𝟏𝟎𝟎
𝑷𝟎 − 𝑭 𝑪

REDEEMABLE PREFERRED STOCK

It is a preferred stock with a maturity time
Mathematically

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 𝐅 −𝐏
𝐃𝐏 + 𝐕 𝐧 𝟎
𝐊𝐏 = ( ) × 𝟏𝟎𝟎
𝐅𝐕 + 𝐏𝟎
𝟐

Where;
𝐊 𝐏 = 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐩𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐬𝐭𝐨𝐜𝐤
𝐃𝐏 = 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐅𝐕 = 𝐅𝐚𝐜𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐫 𝐩𝐚𝐫 𝐯𝐚𝐥𝐮𝐞𝐨𝐫 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞
𝐏𝟎 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐧 = 𝐦𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐭𝐢𝐦𝐞 (𝐢𝐭 𝐬𝐡𝐨𝐮𝐥𝐝 𝐛𝐞 𝐢𝐧 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝐧𝐨𝐭 𝐦𝐨𝐧𝐭𝐡𝐥𝐲

Now:
If you are not provided with 𝐃𝐏

Then:
𝑫𝑷 = 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒓𝒂𝒕𝒆 × 𝒏𝒐𝒎𝒊𝒏𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 𝒐𝒓 𝒑𝒂𝒓 𝒗𝒂𝒍𝒖𝒆

COST OF DEBT (Kd)

• Debt is a liability
• Also known as debentures
• Therefore the cost of debt can be called or termed as cost of debentures

Now:
Cost of debt
• Can be defined as required rate of return on investment of lenders

Types of cost of debts

a) Irredeemable debt
b) Redeemable debt

A. Irredeemable debt
• It is a debt without maturity time as a company pays until we finish the
principal and the interest
• It is charged tax (t)
• Mathematically

𝐈(𝟏 − 𝐭)
𝐊𝐝 = ( ) × 𝟏𝟎𝟎
𝐏𝟎

Where
𝐾𝑑 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
𝐼 = 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑟 𝑐𝑜𝑢𝑝𝑜𝑛
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 𝑡 = 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥
𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑒𝑟 𝑏𝑜𝑛𝑑

Now: if you are not provided with I (interest)

Then:
𝐈 = 𝐂𝐨𝐮𝐩𝐨𝐧 𝐫𝐚𝐭𝐞 × 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞

B. Redeemable debt
• Is a debt with a maturity time (n)
• It is charged tax (t)
• Mathematically

𝐹𝑉 − 𝑃0
𝐼+
𝐾𝑑 = ( 𝑛 ) × 100
𝐹𝑉 + 𝑃0
2
This is before tax

Where:
𝐾𝑑 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
𝐼 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡
𝐹𝑉 = 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑏𝑜𝑛𝑑
𝑛 = 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠

Now:
If you are not provided with interest amount (I)

Then:
𝐼 = 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

But:
Cost of debt after tax will be:
𝐾𝑑 = 𝐾𝑑 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 × (1 − 𝑡)

Where:
𝑡 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥
(1 − 𝑡) = 𝑡𝑎𝑥 𝑓𝑎𝑐𝑡𝑜𝑟

Remember:
• Tax will be provided in percentage form, you will have to change it into
decimal place while using it.

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 WACC (WEIGHTED AVERAGE COST OF CAPITAL)
• WACC is also known as over cost of capital or total cost of capital
• Its abbreviation is ‘WACC”
• It is made up of two components
i. Weights of source of financing
ii. Cost of capital’s element

I. Weights of source of financing

• This includes
❖ W e,
❖ W d,
❖ W p.

Where
𝐕𝐞
𝐖𝐞 =
𝐓𝐯

Here:
Ve = value of equity
Tv = total value

𝐕𝐝
𝐖𝐝 =
𝐓𝐯

Here:
Vd = value ofdebts
Tv = total value

𝐕𝐩
𝐖𝐩 =
𝐓𝐯

Here:
Vp = value of preffered stocks
Tv = total value

II. Cost of capital elements

• This includes the following
❖ Cost of equity (Ke)
❖ Cost of debentures (Kd)
❖ Cost of preferred stock (Kp)

NOW:

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WACC is calculated mathematically:

𝐖𝐀𝐂𝐂 = 𝐊 𝐞 𝐖𝐞 + 𝐊 𝐝 𝐖𝐝 + 𝐊 𝐩𝐖𝐩

ADVANTAGES/ USES OF WACC

i. It is used in time value of money (TVM)
i.e.: from: 𝐏𝐯 = 𝐅𝐯 (𝟏 + 𝐫)−𝐧 here, “r” is the WACC

ii. It is used in capital structure, since in WACC we have equity, preferred stock, and debentures
iii. It is used in capital budgeting
iv. It is used in project appraisal

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 TOPIC 3
RISK AND RETURN
INTRODUCTION
Return
• It is a gain or loss on an investment, where loss is the result when the expenses is greater
than income and gain is the result when income is greater than expenses

Components of returns
i. Dividend income or interest received
ii. Capital gain or loss

Calculating Returns
• There are two formulas for finding returns
a) Returns in terms of currency
Mathematically:
𝐑𝐞𝐭𝐮𝐫𝐧𝐬 = 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐢𝐧𝐜𝐨𝐦𝐞 + 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐠𝐚𝐢𝐧 𝐨𝐫 𝐥𝐨𝐬𝐬

Or

𝐑𝐞𝐭𝐮𝐫𝐧𝐬 = 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐫𝐞𝐜𝐞𝐢𝐯𝐞𝐝 + 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐠𝐚𝐢𝐧 𝐨𝐫 𝐥𝐨𝐬𝐬

b) Returns in terms of percentage (%)

Mathematically
𝐃 + 𝐏𝟏 − 𝐏𝟎
𝐑𝐞𝐭𝐮𝐫𝐧𝐬(%) = ( ) × 𝟏𝟎𝟎
𝐏𝟎

Where:
D = Dividend income
P1 = Market price per share att closing (future time)
P0 = current market price per share at starting

OR

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐢𝐧𝐜𝐨𝐦𝐞 + 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐠𝐚𝐢𝐧/𝐥𝐨𝐬𝐬

𝐑𝐞𝐭𝐮𝐫𝐧𝐬(%) = ( ) × 𝟏𝟎𝟎
𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Therefore:
𝐏𝟏 − 𝐏𝟎 = capital gain, incase positive

And
𝐏𝟏 − 𝐏𝟎 = capital loss, incase negative

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EXAMPLE 1
Suppose you bought a bond for $1050 a year ago, you have received two semiannual
coupons/interest for $50 each. The Market price of the bond today is %110. What is your return?
a. In dollar$
b. In percentage (%)

Suggested solution
Given
P0 = $1050
P1 = $1100
I = $50 + $50 = $100

Therefore
Returns = interst received + capital gain

Returns = $100 + P1 − P0

Returns = $100 + ($1100 − $1050

Returns = $150

Returns in %
interst received + capital gain
Returns% = × 100
initial cost of investment

$100 + $50
Returns% = × 100
$1050

Returns% = 14.28%

EXAMPLE 2
If you purchase share of ODBF 2 PLC for TZs 500 at the beginning of year and paid a dividend of TZs
30. At the end of the year the price is TZS 570. What is the dividend yield, capital gain yield and the
percentage returns and the returns in TZS

Suggested solutions:
Given:
P0 = 500 (Price at starting)
P1 = 570
D = 30 (Dividend income)

Required:
✓ Dividend yield

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 D
dividend yield = × 100
P0

30
dividend yield = × 100
500

dividend yield = 6%

✓ Capital gain yield

P1 − P0
Capital gain yield = × 100
P0

570 − 500
Capital gain yield = × 100
500

70
Capital gain yield = × 100
500

Capital gain yield = 14%

✓ Percentage returns
Percentage returns = Capital gain yield + capital gain yield

Percentage returns = 6% + 14%

Percentage returns = 20%

✓ Returns in TZS
Returns = dividend income = capital gain

Returns = 30 + (570 − 500)

Returns = 30 + 70

Returns = 100TZS

EXPECTED RETURNS (𝑹 ̅ ) or E(R)

Expected return
Is a mean probability distributions of possible future returns on the stocks (shares or bonds)

• Probability means a chance of occurrence

• Mathematically:

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 𝑛

𝑅̅ = ∑ 𝑃𝑖 𝑅𝑛
𝑖=1

• In a prolonged way
𝑅̅ = 𝑃𝑖 𝑅1 + 𝑃𝑖 𝑅2 + 𝑃𝑖 𝑅3 + ⋯ 𝑃𝑖 𝑅𝑛

• Where:
𝑅̅ = expected return
𝑃𝑖 = Probability of the state
𝑅𝑛 = return of stocks

EXAMPLE 4:
The following are the information of ODBF 2 investors
States Probability Returns on stock Returns on stock B
A
Boom 0.2 5% 50%
Recession 0.3 10% 30%
Recovery 0.3 15% 10%
Depression 0,2 20% -10%
Required:
Calculate the expected returns of cash stocks A and B

Suggested solutions
𝑛

𝑅̅𝐴 = ∑ 𝑃𝑖 𝑅𝐴
𝑖=1

𝑅̅𝐴 = ∑ 𝑃𝑖 𝑅𝐴
𝑖=1

𝑅̅𝐴 = (0.2 × 5) + (0.3 × 10) + (0.3 × 15) + (0.2 × 20)

𝑅̅𝐴 = 1 + 3 + 4.5 + 4

𝑅̅𝐴 = 12.5%

And
4

𝑅̅𝐵 = ∑ 𝑃𝑖 𝑅𝐵
𝑖=1

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 4

𝑅̅𝐵 = ∑ 𝑃𝑖 𝑅𝐵
𝑖=1

𝑅̅𝐵 = (0.2 × 50) + (0.3 × 30) + (0.3 × 10) + (0.2 × −10)

𝑅̅𝐵 = 10 + 9 + 3 − 2

𝑅̅𝐵 = 20%

RISKS
• It means future uncertainty
• It is measured by standard deviations (SD) or
• Mathematically
𝐧
̅ )𝟐
𝐑𝐈𝐒𝐊 = √∑ 𝐏𝐢 (𝐑 − 𝐑
𝐢=𝟏

• NOTE:
Standard deviation is the square root of variance:

EXAMPLE 4 (Expected returns and risk) of individual stocks

The following are the information of ODBF 2 investors
States Probability Returns on stock A Returns on stock B
Boom 0.2 5% 50%
Recession 0.3 10% 30%
Recovery 0.3 15% 10%
Depression 0,2 20% -10%
Required:
a. Calculate expected returns of each stocks
b. Calculated the risk of each stock

Suggested solution for (part B)

For stock A
𝑹𝑨 % ̅𝑨
𝑹𝑨 − 𝑹 ̅ 𝑨 )𝟐
(𝑹𝑨 − 𝑹 𝑷𝒊 ̅ 𝑨 )𝟐
𝑷𝒊 (𝑹𝑨 − 𝑹
5 -7.5 56.25 0.2 11.25
10 -2.5 6.25 0.3 1.87

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 15 2.5 6.25 0.3 1.87
20 7.5 56.25 0.2 11.25

∑ 26.24
Therefore;
n
̅ )2
RISK = √∑ Pi (R − R
i=1

RISK = √26.24

RISK = 5.12%

For stock B
𝑹𝑩 % ̅𝑩
𝑹𝑩 − 𝑹 ̅ 𝑩 )𝟐
(𝑹𝑩 − 𝑹 𝑷𝒊 ̅ 𝑩 )𝟐
𝑷𝒊 (𝑹𝑩 − 𝑹
50 30 900 0.2 180
30 10 100 0.3 30
10 -10 100 0.3 30
-10 -30 900 0.2 180

∑ 420

Therefore:

n
̅ )2
RISK = √∑ Pi (R − R
i=1

RISK = √420

RISK = 20.49%

INVESTMENT PORTFOLIO

Introduction:

Investment portfolio is the combination or grouping of financial assets like shares, bonds etc

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 • Example: Stock A and Stock B
• Key points here are:
a) Expected return portfolio
b) Risk of portfolio or standard deviation portfolio

̅ 𝒑)
A. EXPECTED RETURN OF PORTFOLIO (𝑹

Criterias

• Weight of each stocks (Wa and Wb)

• Expected return of each return (𝑅̅𝐴 𝑎𝑛𝑑 ̅
𝑅𝐵 )

Example 01

Given

States Probability Returns on stock A Returns on stock B

Boom 0.2 5% 50%
Recession 0.3 10% 30%
Recovery 0.3 15% 10%
Depression 0,2 20% -10%

AND:

STOCK AMOUNT INVESTED COMPANY

INVESTED

A 20,000,000 CRDB

B 80,000,000 PUMA

TOTAL 100,000,000

REQUIRED:

a) Calculate the weights for each stock

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 b) Calculate the expected returns of each stocks
c) Calculate the expected return of portfolio

SUGGESTED SOLUTION:

STEP 1: CALCULATE THE EXPECTED RETURNS FOR EACH STOCK:

Expected return for stock A

𝑛

𝑅̅𝐴 = ∑ 𝑃𝑖 𝑅𝐴
𝑖=1

𝑅̅𝐴 = ∑ 𝑃𝑖 𝑅𝐴
𝑖=1

𝑅̅𝐴 = (0.2 × 5) + (0.3 × 10) + (0.3 × 15) + (0.2 × 20)

𝑅̅𝐴 = 1 + 3 + 4.5 + 4

𝑅̅𝐴 = 12.5%

Expected return for stock B.

4

𝑅̅𝐵 = ∑ 𝑃𝑖 𝑅𝐵
𝑖=1

𝑅̅𝐵 = ∑ 𝑃𝑖 𝑅𝐵
𝑖=1

𝑅̅𝐵 = (0.2 × 50) + (0.3 × 30) + (0.3 × 10) + (0.2 × −10)

𝑅̅𝐵 = 10 + 9 + 3 − 2

𝑅̅𝐵 = 20%

STEP 2: CALCULATE THE WEIGHTS OF EACH STOCKS

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Weight for stock A

Given:

Value of A = 20m

Total value = 100m

Therefore:

𝑉𝐴
𝑤𝑒𝑖𝑔ℎ𝑡𝑠 =
𝑇𝑉

20𝑀
𝑊𝐴 =
100𝑀
𝑊𝐴 = 20%

𝑊𝐴 = 0.2

Weight of stock B

Given:

Value of B = 80m

Total value = 100m

Therefore:

𝑉𝐵
𝑤𝑒𝑖𝑔ℎ𝑡𝑠 =
𝑇𝑉

20𝑀
𝑊𝐵 =
100𝑀

𝑊𝐵 = 80%

𝑊𝐵 = 0.8

STEP 3: CALCULATE THE EXPECTED RETURN PORTFOLIO

Given:
DC
 𝑊𝐴 = 0.2

𝑊𝐵 = 0.8

𝑅̅𝐴 = 12.5%

𝑅̅𝐵 = 20%

Formular:
𝑛

𝑅̅𝑃 = ∑ 𝑊𝑛 𝑅𝑛
𝑖=1

𝑅̅𝑃 = 𝑊𝐴 𝑅̅𝐴 + 𝑊𝐵 𝑅̅𝐵

𝑅̅𝑃 = (0.2 × 12.5%) + (0.8 × 20%)

𝑅̅𝑃 = 18,5%

B. RISK OF PORTFOLIO (𝜹𝑷 )

• Also known as standard deviation portfolio (𝛿𝑃 )
• Mathematically

(𝛿𝑃 ) = √𝑊𝐴 2 𝛿𝐴 2 + 𝑊𝐵 2 𝛿𝐵 2 + 2𝑊𝐴 𝑊𝐵 . 𝐶𝑂𝑉(𝐴, 𝐵)

• Where:

𝛿𝑃 = 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

𝑊𝐴 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴

𝑊𝐵 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐵

𝛿𝐴 = 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴

𝛿𝐵 = 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐵

𝐶𝑂𝑉(𝐴, 𝐵) = 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴 𝑎𝑛𝑑 𝐵

• Sometimes

DC
 (𝛿𝑃 ) = √𝑊𝐴 2 𝛿𝐴 2 + 𝑊𝐵 2𝛿𝐵 2 + 2𝑊𝐴 𝑊𝐵 . 𝜌(𝐴, 𝐵)𝛿𝐴 𝛿𝐵

COVARIANCE OF STOCKS (𝐂𝐎𝐕(𝐀, 𝐁))

• This is the relationship between returns of stocks

• It can be positive or negative
• It is a huge factor, meaning within 𝐶𝑂𝑉(𝐴, 𝐵) there is 𝜌(𝐴, 𝐵)𝛿𝐴 𝛿𝐵
• Mathematically:
𝑛

𝐶𝑂𝑉(𝐴, 𝐵) = ∑ 𝑃𝑖 (𝑅𝐴 − 𝑅̅𝐴 ) (𝑅𝐵 − 𝑅̅𝐵 )

𝑖=1

• Where

𝐶𝑂𝑉(𝐴, 𝐵) = 𝑐𝑜𝑣𝑎𝑟𝑖𝑒𝑛𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴 𝑎𝑛𝑑 𝐵

𝑃𝑖 = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦

𝑅𝐴 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴

𝑅̅𝐴 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴

𝑅𝐵 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐵

𝑅̅𝐵 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐵

CORRELATION COEFFICIENT

𝐶𝑂𝑉(𝐴, 𝐵)
𝜌(𝐴, 𝐵) =
𝛿𝐴 𝛿𝐵

Later:

𝐶𝑂𝑉 (𝐴, 𝐵) = 𝜌(𝐴, 𝐵)𝛿𝐴 𝛿𝐵

DIVERSIFICATION

Is a process or strategy of investing to different industries for the intention of reducing or

minimizing investment risk

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SYSTEMATIC AND UNSYSTEMATIC RISK

Systematic risk

• This is also known as market risk, uncontrollable risk, non-diversifiable risk

• Are the risk that affect the entire market
• Example: change in exchange rate, change in tax reforms

Unsystematic risk

• Also known as business risk, diversifiable risk or avoidable risk

• Are the risks that affect specific area of the business

EFFICIENT PORTFOLIO

• This is a portfolio with the intention to minimize return for a given risk and minimize risk for a
given return
• Example: treasury bills (risk free assets/risk less assets) short term instrument

Requirement on effective portfolio

a) Expected return of portfolio on risk free assets

b) Variance of portfolio on risk free assets
c) Standard deviation/ risk of portfolio with risk free assets

A. EXPECTED RETURN OF PORTFOLIO ON FREE RISK ASSETS

• It is given by

̅ 𝐩 = (𝟏 − 𝐖)𝐑 𝐟 + 𝐖𝐑
𝐑 ̅𝐀

• Where:

𝑅̅𝑝 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑜𝑛 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

𝑊 = 𝑤𝑖𝑔ℎ𝑡 𝑜𝑓 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

𝑅𝑓 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

DC
 𝑅̅𝐴 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑖𝑠𝑘𝑦 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

B. VARIANCE OF PORTFOLIO ON RISK FREE ASSETS

• It is given by:

𝐕𝐚𝐫(𝐑 𝐏 ) = 𝐖 𝟐 𝐕𝐚𝐫(𝐑 𝐦 )

• Where:

𝑊 = 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

• But:
𝑛

𝑉𝑎𝑟(𝑅𝑚 ) = ∑ 𝑃𝑖 (𝑅_𝑅̅)2
𝑖=1

• Example:

You are provided with: 𝛿𝐴 = 10%, Calculate 𝑉𝑎𝑟(𝑅𝐴 )

Solution:

𝛿𝐴 = √𝑉𝑎𝑟(𝑅𝐴 )

10% = √𝑋
2
(10%)2 = (√𝑋)

𝑋 = 102

𝑋 = 100

• Therefore:

𝑉𝑎𝑟(𝑅𝐴 ) = 100

STANDARD DEVIATION/ RISK OF PORTFOLIO WITH RISK FREE ASSESTS

• This is given by

𝐒𝐃(𝐑 𝐩 ) = 𝐖𝐒𝐃(𝐑 𝐦 )

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 • Where:

𝑊 = 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡𝑠

𝑆𝐷(𝑅𝑚 ) = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠

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 TOPIC 4
WORKING CAPITAL MANAGEMENT
DEFINITION,
Working capital can be defined as assets and liabilities required to operate a business on day to
day operation
• On working capital we look on
i. Current assets
ii. Current liabilities

Current assets
• There are current assets required in working capital
i. Cash in hand
ii. Inventory/ closing assets/ closing stock
iii. Debtors/ accounting receivables

Current liabilities
• There are current liabilities required in working capital
i. Creditors / account payables
ii. Accruals / outstanding expenses

GROSS WORKING CAPITAL

• This is an investment on assets
• Here we look on
i. Current assets
ii. Cash
iii. Inventories
iv. Account receivables/ debtors

NET WOKING CAPITAL

This is the difference between current assets and current liabilities

Mathematically
𝐍𝐖𝐂 = 𝐂𝐔𝐑𝐑𝐄𝐍𝐓 𝐀𝐒𝐒𝐄𝐒𝐓 − 𝐂𝐔𝐑𝐑𝐄𝐍𝐓 𝐋𝐈𝐀𝐁𝐈𝐋𝐈𝐓𝐈𝐄𝐒

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

1. INVENTORY
a) Objectives under higher level
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 Benefits
i. Happy customers, because of quickly supplying of raw materials
ii. Few production delays

Costs
i. High financing costs (fixed interest cost)
ii. High storage cost
iii. Risk of outdated raw materials

b) Objectives under lower level

Benefits
i. Low financing cost
ii. Less risk of outdated raw materials or goods

Cost
i. Shortage on supplying of raw materials/goods
ii. Dissatisfied customers/ unhappy customers because products are not available

2. CASH
a) Objectives under higher level
Benefits
i. Reduces the risk of unable to pay bills

Costs
ii. Increases financing costs

b) Objectives under lower level

Benefits
i. Reduces the financing costs

Cost
i. Increase transaction risk

3. ACCOUNTS RECEIVABLES/DEBTORS
a) Objectives under higher level
Benefits
i. Happy customers (slowly payments)
ii. High credit sales

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 Costs
i. More bad debts
ii. High collection costs
iii. Increased financing costs

b) Objectives under lower level

Benefits
i. Less financing costs

Costs
i. Customers with unhappy payment terms
ii. Lower credit sales

4. PAYABLES AND ACCRUALS

a) Objectives under higher level
Benefits
i. Spontaneous financing reduces need to borrow

Costs
ii. Unhappy suppliers because you pay slowly

b) Objectives under lower level

Benefits
i. Happy suppliers because you always buy in cash basis all time

Costs

WORKING CAPITAL CYCLE/ CASH CONVETION CYCLE (CCC)

Definition
This is a number of days from when cash is first spent on current assets, (To pay suppliers) to the
receipts of the cash from customer who have bought on credit
• Here we look on 3 things
i. Days on inventory
ii. Days on receivables
iii. Days on payables
• This is:
𝐂𝐂𝐂 = (𝐝𝐚𝐲𝐬 𝐨𝐧 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 + 𝐝𝐚𝐲𝐬 𝐨𝐧 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 − 𝐝𝐚𝐲𝐬 𝐨𝐧 𝐩𝐚𝐲𝐚𝐛𝐥𝐞𝐬) × 𝟑𝟔𝟓𝐝𝐚𝐲𝐬
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But:
inventory
days on inventory =
cost of sales

receivables
days on receivables =
credit sales

payable
days on payables =
credit purchases or cost of sales

Therefore:
𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 𝐩𝐚𝐲𝐚𝐛𝐥𝐞
𝐂𝐂𝐂 = + − × 𝟑𝟔𝟓𝐝𝐚𝐲𝐬
𝐜𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 𝐜𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬 𝐨𝐫 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬

BENEFITS AND COSTS OF CARRYING ADEQUATE INVENTORY

BENEFITS
i. Reduces stock outs and back orders
ii. Makes operations run more smoothly
iii. Improves customer relationship
iv. Increases sales

COSTS
i. Interest on fund used to acquired (buying) inventory
ii. Storage and security cost
iii. Insurance
iv. Taxes
v. Spoilage
vi. Outdates goods cost /obsolescence

INVENTORY CONROL AND MANAGEMENT

Inventory management
This is the overall way a firm controls inventory and its costs
• Controlling inventory with adequate goods or raw materials
• Inventory is controlled to avoid outdated materials
• Controlling costs with purchases of goods or raw materials at an affordable cost
• Costs is controlled to avoid higher cost on purchasing
• The main way of controlling Inventory and costs is by applying a model known as ECONOMIC
ORDER QUANTITY MODEL (EOQ)

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EOQ (ECONOMIC ORDER QUANTY MODEL)
This is a model used to control inventory and cost

Elements of EOQ
i. Annual demand of customers (D)
ii. Carrying cost per unit (C) or Holding cost per Unit (H)
iii. Ordering cost per order (O)

Mathematically

𝟐𝐃𝟎
𝐄𝐎𝐐 = √
𝐇

WHERE:
𝐃 = 𝐀𝐧𝐧𝐮𝐚𝐥 𝐝𝐞𝐦𝐚𝐧𝐝
𝐇 = 𝐇𝐨𝐥𝐝𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
𝐎 = 𝐎𝐫𝐝𝐞𝐫𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐨𝐫𝐝𝐞𝐫

BY APPLYING COST VS QUANTITY

costs

TCC
TC

EOQ (Optimal
quantity)
TOC

Quantity

TOTAL CARRYING COST (TCC)

This is the total carrying cost

Mathematically

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 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲
𝐓𝐂𝐂 = × 𝐜𝐚𝐫𝐫𝐲𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
𝟐

This is:
𝐐
𝐓𝐂𝐂 = ×𝐇
𝟐

OR
𝐐
𝐓𝐂𝐂 = ×𝐂
𝟐

Where:
Q = EOQ = optimal quantity
C = carrying cost per unit
H = holding cost per unit

TOTAL ORDERING COST (TOC)

This is the total ordering cost

Mathematically
annual demand
TOC = × ordering cost per order
quantity

Therefore:
𝐃
𝐓𝐎𝐂 = ×𝐎
𝐐

Where:
Q = EOQ = optimal quantity
D = Annual demand
O = Ordering cost per order

TOTAL COST (TC)

This is the sum of TCC and TOC

Mathematically
𝐓𝐂 = 𝐓𝐂𝐂 + 𝐓𝐎𝐂

Where
TCC = Total Carrying cost per unit
DC
 TOC = Total Ordering Cost per order

Now:
At optimal point
𝑇𝐶𝐶 = 𝑇𝑂𝐶

Therefore
𝐐 𝐃
×𝐇= ×𝐎
𝟐 𝐐

Multiply by 2 both sides:

𝐐 𝐃
𝟐 × ( × 𝐇) = ( × 𝐎) × 𝟐
𝟐 𝐐

𝟐𝐃𝐎
(𝐐𝐇) = ( )
𝐐

Multiply by Q both sides

𝟐𝐃𝐎
𝐐 × (𝐐𝐇) = ( )×𝐐
𝐐

(𝐐𝟐 𝐇) = (𝟐𝐃𝐎)

Divide by H both sides

𝐐𝟐 𝐇 𝟐𝐃𝐎
=
𝐇 𝐇

𝟐𝐃𝐎
(𝐐𝟐 ) =
𝐇

Insert square root both sides to eliminate the square

𝟐𝐃𝐎
√𝐐𝟐 = √
𝐇

THEREFORE:

𝟐𝐃𝐎
𝐄𝐎𝐐 = √
𝐇

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 TOPIC 5
DIVIDEND POLICY
Coverage:
• Theories of investor preferences
• Signaling effects
• Residual model
• Dividend reinvestment plans

Dividend policy:
It’s the decision to pay out earnings versus retaining and reinvesting them.
Includes these elements:
i. High or low payout?
ii. Stable or irregular dividends?
iii. How frequent?
iv. Do we announce the policy?

Types of Dividend
• There are about three types of dividend policies, these are:
1. Stable monetary amount per share
2. Constant payout ratio policy
3. Regular and extra dividend policy

Dividend Theory
Dividend theory describes the relationship between dividend policy or decision and the value of
the firm or wealth of shareholder.

The theories may be grouped into two classes,

• These are
a. Theories which consider dividend decision to be relevant and thus affecting the value of firm
and wealth of shareholder.
b. Theories which consider dividend decision to be irrelevant that having no effect on the value
of firm and wealth of shareholder.

• There are three theories:

1. Dividends are irrelevant:
This are investors don’t care about payout.
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 2. Bird in the hand
These are investors who prefer a high payout.

3. Tax preference:
Investors prefer a low payout, hence growth.

1. DIVIDEND IRRELEVANCE THEORY

• Investors are indifferent between dividends and retention-generated capital gains.
• If they want cash, they can sell stock.
• If they don’t want cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not
be true. Need empirical test.

2. BIRD-IN-THE-HAND THEORY
• Investors think dividends are less risky than potential future capital gains, hence they like
dividends.
• If so, investors would value high payout firms more highly, i.e., a high payout would
result in a high P0.
• M Gordon Support this Theory
• The market value of a share is equal to the present value of an infinite stream of
dividends to be received by the shareholder.
• The model is based on the following assumptions:
i. The firm is an all equity firm
ii. No external financing is available, only retained earnings will be available to
finance business expansion.
iii. The internal rate of return of firm is constant ➢Corporate taxes do not exist
iv. The retention ratio is constant once decided.
v. Growth in dividend is constant.

3. Tax Preference Theory

• Retained earnings lead to long-term capital gains, which are taxed at lower rates than
dividends: 20% vs. up to 39.6%.
• Capital gains taxes are also deferred.
• This could cause investors to prefer firms with low payouts, i.e., a high payout results in a
low P0.

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Implications of 3 Theories for
Managers

Theory Implication

Irrelevance Any payout OK

Bird in the hand Set high payout Tax preference Set low payout
But which, if any, is correct???
Possible Stock Price Effects

Possible Cost of Equity Effects

WHICH THEORY IS MOST CORRECT?

• Empirical testing has not been able to determine which theory, if any, is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.

What’s the “information content,” or “signaling,” hypothesis?

• Managers hate to cut dividends, so won’t raise dividends unless they think raise is
sustainable. So, investors view dividend increases as signals of management’s view of the future.
• Therefore, a stock price increase at time of a dividend increase could reflect higher
expectations for future EPS, not a desire for dividends.
What’s the “clientele effect”?
• Different groups of investors, or clienteles, prefer different dividend policies.
• Firm’s past dividend policy determines its current clientele of investors.
• Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors
who have to switch companies.

• Comment briefly with reference of the applicable theories on each of the following
statements
a) Unlike American firms, which are always being pressured by their shareholders to increase
dividends, Japanese companies pay out a much smaller proportion earnings and their shareholders
enjoy high returns on sales of shares”
b) “Dividend policy is irrelevant” and “Stock price is the present value of expected future
dividends”.
What’s the “residual dividend model”?
• Find the retained earnings needed for the capital budget.
• Pay out any leftover earnings (the residual) as dividends.

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• This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.
Using the Residual Model to Calculate Dividends Paid
(
Target Total
Dividends = incomeNet – [ equityratio )(budgetcapital. )]
Data for SSC
• Capital budget: $800,000. Given.
• Target capital structure: 40% debt, 60% equity. Want to maintain.
• Forecasted net income: $600,000.
• How much of the $600,000 should we pay out as dividends?
▪ Of the $800,000 capital budget,
0.6($800,000) = $480,000 must be equity to keep at target capital structure. [0.4($800,000) =
$320,000 will be debt.]
▪ With $600,000 of net income, the residual is $600,000 – $480,000 = $120,000 = dividends
paid.
▪ Payout ratio = $120,000/$600,000 = 0.20 = 20%.
How would a drop in NI to $400,000 affect the dividend? A rise to $800,000?
• NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends =
0.
• NI = $800,000: Dividends = $800,000 – $480,000 = $320,000. Payout = $320,000/$800,000
= 40%.
Example – Residual Dividend Policy
• Given
• Need $5 million for new investments
• Target capital structure: D/E = 2/3
• Net Income = $4 million
• Finding dividend
• 40% financed with debt (2 million)
• 60% financed with equity (3 million)
• NI – equity financing = $1 million, paid out as dividends
Example 2
• The TNG Corporation practices a strict residual dividend policy and maintains a capital structure of
60 percent debt, 40 percent equity. Earnings for the year are TZS10,000,000.
a) What is the maximum amount of capital spending possible without selling new equity?
b) Suppose that planned investment outlays for the coming year are TZS 24,000,000. Will TNG
be paying a dividend? If so, how much?
Example Three

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a) A substantial percentage of the companies listed on the NYSE and NASDAQ don’t pay
dividends, but investors are nonetheless willing to buy shares in them. How is this possible? (10
Marks)
b) Rocker Fella Co Ltd, predicts that earnings in the coming year will be TZS 80 million. There
are 1 million shares, and Rocker Fella maintains a debt– equity ratio of 1.5.
i. Calculate the maximum investment funds available without issuing new stocks (5 Marks)
ii. Suppose the firm uses a residual dividend policy. Planned capital expenditures total TZS 175
million. Based on this information, what will the dividend per share be? (5 Marks)
iii. Suppose Rocker Fella plans no capital outlays for the coming year. What will the dividend
per share be under a residual policy? (5 Marks)
iv. Assume the Rocker fella plans to have capital outlays of TZS 360,000,000 next year.
Determine how much additional fund will raised by Borrowing and Issuing new equity shares? (5
Marks)
Example 4
Friend hood, predicts that earnings in the coming year will be TZS 56,000,000 million. There are
600,000 shares, and Friend hood maintains a debt–equity ratio of 25%
(i) Calculate the maximum investment funds available without issuing new stocks (4 Marks)
(ii)Suppose the firm uses a residual dividend policy. Planned capital expenditures total TZS 50
million. Based on this information, what will be the dividend payout ratio? (4 Marks)
(iii)Assume Buddies expect to have a total spending of TZS 80 million. Determine additional amount
that will be raised through issue of shares and debt ( 4 Marks)
Example 5
a) Can you provide an answer to the following question: If high-dividend stocks offer is
believed to have low returns to shareholder due to higher personal tax levied, why don’t
corporations simply reduce dividend payments and thus maximize returns to shareholder?” (20
Marks)
b) Buddies Co Ltd, predicts that earnings in the coming year will be TZS 168 million. There are
1.6 million shares, and Buddies maintains a debt–equity ratio of 3/7
(i) Calculate the maximum investment funds available without issuing new stocks (8 Marks)
(ii) Suppose the firm uses a residual dividend policy. Planned capital expenditures total TZS 200
million. Based on this information, what will be the dividend per share? (7 Marks)
(iii)Suppose Buddies plans no capital outlays for the coming year. What will be the dividend per
share under a residual policy? (7 Marks)
(iv)Assume Buddies expect to have a total spending of TZS 300 million. Determine additional
amount that will be raised through issue of shares and debt (8 Marks)

How would a change in investment opportunities affect dividend under the residual policy?

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• Fewer good investments would lead to smaller capital budget, hence to a higher dividend
payout.
• More good investments would lead to a lower dividend payout.

Advantages and Disadvantages of the Residual Dividend Policy

• Advantages: Minimizes new stock issues and flotation costs.

• Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and
doesn’t appeal to any specific clientele.
• Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.
Dividend Payout Ratios for Selected Industries
Industry Payout ratio
Banking 38.29 Computer Software Services 13.70
Drug 38.06 Electric Utilities (Eastern U. S.) 67.09
Internet n/a
Semiconductors 24.91
Steel 51.96 Tobacco 55.00
Water utilities 67.35
*None of the internet companies included in the Value Line Investment Survey paid a dividend.

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