FINANCIAL MANAGEMENTLECTURE NOTES CLIFF OUKO ONSONGO @2013 i TABLE OF CONTENTS TABLE OF CONTENTS.......................................................................................ii TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT....................................1 Definition of Financial Management................................................................................1 Finance Functions..................................................................................................................1 Objectives of a Business Entity.........................................................................................2 Agency Theory........................................................................................................................5 TOPIC 2: SOURCES OF FINANCE.....................................................................10 Internal Sources...................................................................................................................10 External Sources..................................................................................................................12 Factors to Consider In Choice of source of finance................................................20 TOPIC 3: KENYAN FINANCIAL SYSTEM............................................................21 Financial intermediaries....................................................................................................21 Functions of Financial Markets/Institutions in the Economy...............................22 Capital Market......................................................................................................................22 Money/discount markets..................................................................................................23 Financial Instruments in Money market include:....................................................23 Primary Markets...................................................................................................................24 Economic Advantage/Role of Secondary Markets in the Economy..................24 Types of Stock Markets.....................................................................................................24 Financial intermediaries....................................................................................................25 The Stock Exchange Market............................................................................................26 Rules for floatation of new shares on NSE.................................................................38 Capital Market Authority (Cma).....................................................................................40 Central Depository System (C.D.S)..............................................................................41 Development Banks and Specialized Financial Institutions................................43 Banking Institutions............................................................................................................45 Central Banks...................................................................................................................46 Commercial Banks..........................................................................................................47 TOPIC 4: CAPITAL BUDGETING DECISIONS.....................................................51 Investment Evaluation Criteria......................................................................................52 Capital Budgeting Techniques........................................................................................52 Discounted Cashflow Methods........................................................................................53 Non-Discounted Cashflow Methods...............................................................................55 Projects Selection under Capital Rationing.................................................................62 Risk Analysis in Capital Budgeting.................................................................................64 Actual Measurement of Risk.............................................................................................66 Incorporating Risk in Capital Budgeting.......................................................................69 Sensitivity Analysis..............................................................................................................75 Break-Even Analysis............................................................................................................78 Utility Theory.........................................................................................................................84 TOPIC 5: COST OF CAPITAL............................................................................90 Importance of cost of finance.........................................................................................90 Factors that will influence the Cost of Finance........................................................91 Cost of Different Types of Funds....................................................................................93 ii The Wacc – Weighted Average Cost of Capital......................................................100 Marginal cost of finance.................................................................................................107 TOPIC 6: MEASURING BUSINESS PERFORMANCE.........................................112 Users of Ratios....................................................................................................................112 Yard Stick Used In Ratio Analysis................................................................................114 Classification of Ratios....................................................................................................115 Importance Of Ratio Analysis.......................................................................................121 Limitations in Using Ratio Analysis.............................................................................121 TOPIC 7: DIVIDEND POLICIES AND DECISIONS.............................................128 Does the change in dividend policy affect the value of the firm?..................129 How Much to Pay: Alternative Dividends Policies..................................................133 When to Pay........................................................................................................................134 Dividends Theories (Why Pay Dividends)................................................................134 How to pay dividends (mode of paying dividends)..............................................138 Factors to consider in paying dividends (factors influencing dividend).......142 TOPIC 8: FINANCIAL PLANNING....................................................................146 Operating Financial Plans...............................................................................................146 Importance of financial planning................................................................................146 Financial Planning Process.............................................................................................148 Barriers to Financial Planning.......................................................................................150 Why people fail in financial planning.........................................................................151 Preparing Financial Forecasts.......................................................................................152 Cash Receipts.....................................................................................................................153 Cash Disbursement..........................................................................................................153 Benefits/advantages Cash budget..............................................................................158 Cost-Volume Profit (C-V-P)..............................................................................................169 Assumptions Required In C-V-P....................................................................................170 Analyzing the Cost-Volume Relationship..................................................................170 Algebraic Analysis.............................................................................................................171 GRAPHIC ANALYSIS...........................................................................................................173 Break Even Analysis.........................................................................................................175 C-V-P Analysis – Multiple Products..............................................................................178 C-V-P Analysis Under Uncertainty...............................................................................181 Point Estimate of Probabilities......................................................................................182 TOPIC 10: WORKING CAPITAL MANAGEMENT...............................................187 Introduction.........................................................................................................................187 Working Capital Management Decisions..................................................................187 Overcapitalization and Overtrading...........................................................................188 Indicators of over-capitalization..............................................................................188 Symptoms of over-trading.............................................................................................188 Financing Current Assets................................................................................................189 Determinants Of Working Capital Needs.................................................................191 Importance Of Working Capital Management........................................................191 Cash And Marketable Securities Management......................................................192 Cash Cycle and Cash Turnovers...................................................................................193 Setting The Optimal Cash Balance.............................................................................195 iii Management of Accounts Receivable.......................................................................209 TOPIC 11:MERGERS AND TAKE- OVERS.................................................215 Types Of Mergers...............................................................................................................215 Reasons For Mergers........................................................................................................215 The Overall Merger Process..........................................................................................217 Reasons Behind Failed Mergers...................................................................................220 Due Diligence.....................................................................................................................222 The Role Of Investment Bankers In Mergers............................................................231 Anti-Takeover Defenses...................................................................................................232 Corporate Alliance.............................................................................................................236 iv TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT Definition of Financial Management Financial Management is a discipline concerned with the generation and allocation of scarce resources (usually funds) to the most efficient user within the firm (the competing projects) through a market pricing system (the required rate of return).A firm requires resources in form of funds raised from investors. The funds must be allocated within the organization to projects which will yield the highest return. Finance Functions The functions of Financial Manager can broadly be divided into two: The Routine functions and the Managerial Functions. Managerial Finance Fu nctions Require skilful planning, control and execution of financial activities. There are four important managerial finance functions. These are: (a) Investment of Long-term asset-mix decisions These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects. They refer to the firm's decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of both risk and expected return. Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is referred to as replacement decision. (b) Financing decisions Financing decision refers to the decision on the sources of funds to finance investment projects. equity and debt. The finance manager must decide the proportion of The mix of debt and equity affects the firm's cost of financing as well as the financial risk. This will further be discussed under the risk return trade-off. (c) Division of earnings decision 1 It can also be referred as current assets management. however. routine functions have to be performed. (d) Liquidity decision The firm's liquidity refers to its ability to meet its current obligations as and when they fall due. The more current assets a firm has. or distribute a portion and retain a portion. Investment in current assets affects the firm's liquidity. profitability and risk. These decisions concern procedures and systems and involve a lot of paper work and time.payout ratio so as to maximize the value of the firm. Some of the important routine functions are: (a) Supervision of cash receipts and payments (b) Safeguarding of cash balance (c) Custody and safeguarding of important documents (d) Record keeping and reporting The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm. The firm's divided policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend . supervise the activities of these junior staff. The converse will hold true.The finance manager must decide whether the firm should distribute all profits to the shareholder. The earnings must also be distributed to other providers of funds such as preference shareholder.The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets. the more liquid it is. Routine functions For the effective execution of the managerial finance functions. This implies that the firm has a lower risk of becoming insolvent but since current assets are nonearning assets the profitability of the firm will be low. In most cases these decisions are delegated to junior staff in the organization. 2 He must . and debt providers of funds such as preference shareholders and debt providers. retain them. It should be noted however. -The definition of the term profit is ambiguous: . This could be achieved by either increasing sales revenue or by reducing expenses. -The precise meaning of profit maximization objective is unclear.Objectives of a Business Entity Any business firm would have certain objectives which it aims at achieving. It suffers from the following limitations: o It is vague. It fails to serve as an operational criterion for maximizing owners’ economic welfare. that maximizing sales revenue may at the same time result to increasing the firm's expenses. Profit maximization refers to achieving the highest possible profits during the year. this was considered to be the major goal of the firm. Note that: Profit = Revenue – Expenses. The pricing mechanism will however.Does it mean short or long term profit? . Objections to Profit Maximization Profit maximization objective has however been criticized in recent years. It gives no consideration to the 3 . The major goals of a firm are: Profit maximization Shareholders' wealth maximization Social responsibility Business Ethics Growth (a) Profit maximization Traditionally. help the firm to determine which goods and services to provide so as to maximize profits of the firm.Does it refer to total profits or profit per share? .Does it refer to profit after taxes? .Does it mean operating profit or profit accruing to shareholders? o It ignores the timing of returns Profit maximization does not make distinction between returns received in different time periods. The sales revenue can be increased by either increasing the sales volume or the selling price. Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision. while a decision with a negative net present value will reduce the wealth of the shareholders. (c) Social responsibility The firm must decide whether to operate strictly in their shareholders' best interests or be responsible to their employers. Shareholder wealth maximization helps to solve the problems with profit maximization. (b) Shareholders' wealth maximization Shareholders' wealth maximization refers to maximization of the net present value of every decision made in the firm. The firm may be involved in activities which do not directly benefit the shareholders. Under this goal.time value of money. A financial action with a positive net present value will maximize the wealth of the shareholders. it will be more risky. Two firms may have same total expected earnings but if the earnings of one firm fluctuate considerably as compared to the other. (d) Business Ethics 4 . their customers. but which will improve the business environment. o It ignores risk The stressors of benefits may possess different degrees of certainty. and it values benefits received today and benefits received after a period as the same. a firm will only take those decisions that result in a positive net present value. the goal: Considers time value of money by discounting the expected future cash flows to the present. This is because. and the community in which they operate. This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized. It recognizes risk by using a discount rate (which is a measure of risk) to discount the cash flows to the present. Related to the issue of social responsibility is the question of business ethics. A firm's commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to: i. Shareholders and management 2. Fair marketing and selling practices iv. customers. The use of confidential information for personal gain Illegal political involvement bribery or illegal payments to obtain business (e) Growth This is a major objective of small companies which may even invest in projects with negative NPV so as to increase their size and enjoy economies of scale in the future. that is. its employees. Agency Theory An agency relationship may be defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some services on their behalf. High standards of ethical behaviour demand that a firm treat each of these constituents in a fair and honest manner. Shareholders and creditors 3. creditors. and shareholders. community in general. and delegate some decision making authority to that agent. THERE ARE THREE MAIN FORMS OF AGENCY RELATIONSHIP: 1. Ethics are defined as the "standards of conduct or moral behaviour". It can be thought of as the company's attitude toward its stakeholders. Fair employment practices iii. suppliers. Shareholders and the government SHAREHOLDERS AND MANAGEMENT 5 . Product safety and quality ii. Excessive expenditure by the management 2. The management may award themselves high salaries and allowances therefore affecting the profitability of the firm. iv) They may be too many to manage a single firm. The management may be involved in frauds and irregularities 4. 5. The manager may prioritize individual goals which will be in conflict with the goals of the firm especially in investment evaluation The following means or approaches may assist in solving one agency problem. The shareholders may not be competent enough to manage the firm. Problem of accessibility As a result the shareholders delegated authority and responsibility to the managers who are expected to manage the firm on their behalf. There may arise the problem of lack of goal congruence. 3. iii) They may be geographically dispersed to manage the firm. The shareholders though they own the firm are not able to manage the firm due to the following reasons: management of running of the firm for a number of reasons. This constitutes divergence or disparity between the goals of the firm and personal goals. (a) Threat of firing (b)Contractual based employment 6 . ii) They may not have them to run the firm. 2. This may lead to the following problem: 1.In this case the shareholders accounts as a principal while the management accounts as their agents. 1. Problem of proximity 3. Lack of required skills. i) They may not have the necessary skills and expenditure of managing the firm. The relationships arises from the fact that though the creditors. This may affect the firm’s ability to meet arising obligations. 3. 1. The above problems may be solved through the following means.g internal auditing SHAREHOLDERS AND CREDITORS/BOND HOLDERS In this case the shareholders act as the agent and the creditors acts as the principal. Disposal of assets. Use of restrictive covenants. The shareholders may pass resolutions for dividend payment ignoring the liquidity position in the firm. i. SHAREHOLDERS AND THE GOVERNMENT 7 . 2. They therefore expect the shareholders to consider their interest while making relevant decisions. ii.g Non-disposal of assets. Provide debt capital to the various operations of the firm. The shareholders may decide to dispose some of the assets ignoring the fact they provide security to the amounts borrowed. The lender may threaten the firm with non-provision of funds in case their interests are not made. This agency relationship may lead to the following problems. This is agreements entered into between the lender and the borrower with a specific aim of protecting the lenders and the borrower with a specific aim of protecting the lenders interest e. The shareholders may decide to borrow additional from other parties. (d)Allowing Managers to own a proportion off ordinary shares thus increasing their stake in the firm.(c) Ensuring that remuneration is based on individual performance as a means of motivating efficient managers. (e) Development of internal control e. In this case the government will act as the principal and the shareholder will act as the agency who expected to consider the interests of the government in making relevant decisions. /Options Available to Motivate Managers i) Incurring agency costs e.g. The shareholders may engage in activities leading to environmental pollution. The shareholders may evade or avoid tax 4. The owner may engage in activities which are non-governmental. Resolution of the Agency problem between owners and the management. Establishment of regulatory agencies e. The following problems may arise:1. Establishment of legal and regulatory framework 2.g. audit fee paid to auditors and investigators. In this regards the government expects the owner to reciprocate by avoiding engagement in activities which would be in conflict with societal expectations.Any shareholders will rely on the establishment existing in a specific country in undertaking any form of business and reliance will be made on the government services. changing high prices 3.g. use of audit firm for tax purposes 3. Imposition of heavy penalties for the offenders’ e. The following may assist in solving agency related problems 1. penalties on nonremittance of tax or under-declaration of tax. The shareholders may not practice good consumerism e.g. 2. 8 . Threat of firing. threat of firing (sacking) becomes a right option when the ownership is in the hands of people. The c) firm became illiquid. having tight internal controls. Even if they managed to hold on to their jobs they will not be as powerful as they used to be. Therefore managers of the firm should to keep the stock price of the firm high so as to avoid a hostile take-over. Counter-actions of the threatened management by Hostile take-over i)Poison Pill This is action that management of a firm takes that practically kills the firm and therefore makes it unattractive to potential acquirers. iii) iv) v) The This Restructuring the firm in order to prevent undesirable managerial activities e. Threat of Hostile take-over Is a situation in which a firm is taken over by another and at the same time the management of the taken over firm is opposed to the takeover. For example:a) To sell large blocks/units of shares at low prices to friendly b) parties. 2. To make old debts of the firm immediately payable. Threat of hostile takeover. This implies that in the event of take over the management of the taken-over firm will be sacked. This implies that Managers must perform otherwise be replaced.g. Restructuring managerial incentives. Thus becoming technically insolvent.ii) 1. This most likely occurs when a firms stock is undervalued relative to its potential. iii) Green Mail (Black Mail) 9 . To give huge retirement benefits to management if the firm is taken over ii)Divestiture/spin-of A business sells or spins-off some of its business so as to reduce the attractiveness of the company. A potential form (acquirer) will buy a block of stock in the target company. 4. White Knight The management of the target company offer to be acquired by a friendly company so as to avoid a hostile takeover. Therefore to head off or avoid the takeover the management offers to pay Green Mail. In the short run research and development could be discontinued. That means buying the stock owned by the potential acquirer at a price above the existing market price without offering the same deal to other iii) stock holders. Once we have our financial statements. a) To remunerate management on the basis of achieving specific certain financial targets. Disadvantages i) Management may be compelled to make sub-optimal decisions e.g. b) Offering shares to Management Thus they may be more diligent. The better the target the better the remuneration. In the short run it may get a very high profit. Proxy Fight This is the process of getting stockholders to vote out the management in the AGM. In the long run. c) Offer deferred equity to Management 10 . 3. we come up with absolute values that help in making investment decisions. The target company becomes frightened that the acquirer will make a tender offer and gain control of the company. it has adverse effects. buying cheapest items thus losing customers ii) at the end. Compensation How to motivate the management to act on the How to remunerate the management so as to motivate their act in the interest of shareholders. Promise management that if you perform well they’ll be given some ownership in future. 11 . We hope that they’ll concentrate. 2. to increase levels of stocks and debtors 3. reserves. plant and machinery to expand business 2.TOPIC 2: SOURCES OF FINANCE Funds are needed for. To maintain real value of working capital in times of high inflation. sale and lease back 1. Investing in new fixed assets e.g.g. 1. provisions. for immediate cash and renting it back. Advantages 12 . Depreciation is charged to profit and loss account but does not involve cash payments. Sale and lease back A company or partnership owning premises or fixed assets can obtain finance by selling the property to an insurance co. Internal Sources These are sources generated within the business e. A company should enter into this if it cannot raise capital in any other way. Provision for Depreciation Depreciation is cost of wear and tear of machinery and other fixed assets. Financing additional working capital as business expands i. 3. Provision for depreciation leaves cash at the disposal of the business which can be utilized for further expansion of the business.e. Provision for taxation Funds set aside for payment of corporation tax by a company can be used for business expansion if the corporation tax is not immediately payable. easy to obtain. iii) Less freedom to modify the premises iv) The finance is Ltd to the value of the asset leased so it may not be enough for the company to expand its operations. It is convenient Main disadvantage: . Trade credit . ii) Reduction in the company's future borrowing powers as the property could be used as security. Disadvantages of sale & lease back .i) Higher charge for the lease is available expense for the purpose ii) Finance obtained can be used to expand company's operations iii) Does not entail the risk of receiverships iv) Mostly lessor & lessee know each other so it does not entail any restrictions on the part of the lessee. flexible source of financing. Has double edge significance for a firm.Loss of cash discount If lost cash discount is lower than interest paid on other sources of finance.Firm finances credit sales to customers The difference between credit purchase and credit sales is known as net credit. but a company should avoid overtrading. then trade credit will be beneficial and vice versa. Important to small growing firms . 13 . i) The firm loses a valuable asset which is certain to appreciate with inflation.A source of credit for financing purchase .The use of credit from suppliers.Cheap source of finance. 4. . FACTORING Factoring Means selling debts for immediate cash to a factor who charges commission.An organization will find it convenient to use trade credit under the following circumstances i. When difficult to get credit facilities from commercial banks ii. It acts as the agent’s of the seller. No need to offer any asset as security. More flexible and can be used by small firms as well as large firms v. i. salary cost. When a firm has insufficient assets to offer as security iv. Possible to get even during periods of credit restrictions by bank iv. 14 . phone. Trade credit can be obtained more easily as compared to bank credit due to the following reasons. INVOICE DISCOUNTING Almost similar to factoring Definition: Assignment of debts whereas factoring is selling of debts Characterized by the fact that lender not only has lien on the debts but also has recourse to the borrower (seller) if the firm of person that bought the goods does not pay. The factor must bear loss if the person/firm that bought the goods does not pay. In this case the loss is borne by the selling firm. Factoring can result in savings to management in forms of savings in bad debt loses. When cheaper than other alternative sources of finance iii. he pays 80% of its value in cash immediately. When the factor receives each batch of invoices from his client. Easy to negotiate with suppliers as compared to commercial banks iii. postage etc. When the terms of credit are more favourable. Does not involve many formalities ii. e. 15 . ORDINARY SHARE CAPITAL Contributed by real owners of a Ltd Company Not redeemable.Main advantages of factoring & Invoice discounting i) They are flexible methods i. Can raise large amounts of capital if the company is quoted on the stock exchange. larger volume of invoices is generated with increase in sales ii) Invoices provide a security Main disadvantages i) Inconvenient and expensive when invoices are numerous and relatively ii) small in value. . hence permanent source Ordinary shares carry voting rights Ordinary share holders receive dividend on their shareholding Advantages of ordinary Shares No fixed charges attached to them company's dividend payment is not a legal obligation Carry no fixed maturity date. External Sources 1. The firm uses high liquid asset as security The two are also called Financing of Trade debtors. they can be used permanently Can be sold more easily to investors because they give voting powers to the investors. Voting power not affected More flexible than debentures if redeemable (ii) From view point of investor: 16 .Disadvantage Their sale extends control to new shareholders.Preference shares carry no voting power. Types of preference share Cumulative Non-cumulative Participating Redeemable Non-convertible Convertible Advantages of preference share capital (i) From the view point of issuer Obligation to pay a fixed rate of dividend is not binding. Dividends payable to ordinary shareholders are not available expense for tax Purposes Under writing cost is higher. PREFERENCE SHARE CAPITAL . 2.Contributed by preference shareholders . and firms with surplus funds to invest for short period with minimum risk. Advantages Cost of debt is low Interest payment is deductible for tax purposes ` Control of the company is not diluted.banks. DEBENTURES A debenture is a long-term promissory note for raising capital. insurance companies. Cost 17 . unit trusts. COMMERCIAL PAPER This is a form of unsecured promissory note issued by firms to raise short term funds. Buyers of commercial papers include . Preference dividend not available for tax purposes Cost of issue is higher than debentures Limited returns to investor Yields sometimes lower than debentures Dividend arrears not paid in full M These cannot be secured against assets 3. Funds can be raised within certain limits only. 4. Purchasers of debentures are called debenture holders. Its maturity ranges from 1 to 270 days. Disadvantages Debt interest is a fixed charge It increases a firm's financial risk Involves substantial cash out-flow since it must be paid on maturity. The firm promises to pay interest and principal as stipulated. 5% of the size of the issue.35%.1157 or 11.35 x 1000 = 13.? The discount is Sh. It is a cheaper source of finance compared to credit.35% and stamp duty is 0.5 x 360 = 0.985) = Sh. interest yield on CP is less than a prime rate of interest. Issuing and paying The cost of commercial paper is also called interest yield. Limitations of commercial paper It is an impersonal method of financing. 5 Issuing and stamp duty charges are 0.5%. Usually. The credit rating expenses are 0. Thus the cost is 1. 1000 at Sh.35% + 0.6% 985 90 Advantages of CP From issuing firm's point of view It is an alternative source of raising short-term finance.sale price + other costs x 360 Sale Price Days of maturity Example A company issues a 90 . and proves to be handy during periods of tight bank credit. Discount Rating charges Stamp duty. 985. 18 .35 percent = 1.5% + 0. issuing charge are 0.The cost of commercial paper will include.5 Cost of CP = 15 x 13. (1000 . What is the cost of CP.5% = 1. Cost of commercial Paper = (Face value .day commercial paper (CP) of a face value Sh. Agent charges. Advantages The firm avoids expenses such as registration in stock exchange Less time is required to complete arrangements to obtain a term loan than is involved in bond issues. The amount of loanable funds available in the commercial paper market is limited to the amount of excess liquidity of the various purchases of commercial paper. It is always available to the financially sound and highest rated companies. 5. It cannot be redeemed until maturity. Disadvantages . it cannot repay it until maturity and will have to incur interest costs. 19 . LOAN FINANCE Is a direct business loan with a maturity of more than 1 year but less than 15 years.If a firm is unable to redeem its paper due to financial difficulties it may not be possible for it to get the maturity of the paper extended. A firm facing temporary liquidity problems may not be able to raise funds using commercial paper. They have a provision for a specific amortization during the right time of the loan. It is possible to modify loan indenture since only one member is involved than many stockholders. They are mainly obtained from commercial banks and issuance companies. Thus if a firm doesn't need the funds any more. the borrowing firm experiences a continuous cash drain. owner who must give consent. It provides for regular amortization and thus. When the company’s market share guarantees stable sales. 20 . Names. The company must be able to repay the principal and the interest. Boom conditions are ideal for debt. ages. justify such borrowing. Nature of the products and product lines. Sometimes. When the company’s anticipated future expansion programs. The company must have a long-term forecast of the prevailing economic condition. The company’s future cash flows (inflows and their stability) must be assured. and qualifications of the company’s directors. Conditions under Which Loans Are Ideal When the company’s gearing level is low (the level of outstanding loans is low. high valued collateral required by the financier may be difficult to get when a firm raises funds by issuing share it raises its publicity.e. Economic conditions prevailing. Requirements for Raising Loan History of the company and its subsidiaries. The interest rate may be higher than that of short term loans. This is not possible with loan finance. The names of major shareholders – 51% plus i. Publicity of the product. Cash flow forecast. Under this gives right to lessee to use specific asset for a prescribed period against the payment of the lease rental. On long-term lease contracts. Lease agreement is for a specific period e. Commercial banks do credit analysis that is limited to short term situations. This is because interest is high as in overdrafts. 6. quarterly. 21 . LEASE FINANCE Is a contract between owner (Lessor) and the users (Lessee) of the asset. Nature of the loan – either secured. Short-term loans are profitable.g. Lessee pays the lease rental on monthly. Commercial banks are limited by the Central Bank of Kenya in their long term lending due to liquidity considerations. political and economic factors.g. floating or unsecured. Reasons Why Commercial Banks Prefer To Lend Short Term Loans Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardize planning e. Usually security market favours short term loans because there are very few long term securities and as such commercial banks prefer to lend short term due to security problems. 2yearly or yearly. the cost of finance may increase and yet they cannot pass such a cost to borrowers since the interest rate is fixed. Cost of finance – in the long term. Long term finance loses value with time due to inflation. 10yrs etc. lease period or renew the lease lessee is entitled to claim wear & tear allowance for the leased asset. 5yrs. . Financial lease. A lease that transfers substantially all the risks and rewards of ownership of an asset to a lessee. Under this. Equipment remains the property of the lessor/owner and the lessee/tenant is entitled to use it for production purpose.g. 3. To obtain equipment on lease . Lessor is responsible for maintenance and insurance of asset. Equipment Lease. Lessor can claim capital allowance for it. Should be recorded in balance sheet of a lessee as an asset and as an obligation to pay future rentals These are long-term & non-cancelable contacts example: Leases amortize cost of the asset over lease period Lessee bears risk of obsolescence.hire basis. 2.hire charges are allowable expenses for taxation. rental charges are written off as an expense on a straight line basis over lease period. Advantages of lease finance Lease rentals are an allowable expense for tax purposes 22 . Equipment is leased for a specific period against some payments called lease -hire charges. lease contract for computers.TYPES: 1. office equipment. lease . At the lessee. Operating lease Are those contracts which are for short-term and can be cancelled at a shortnotice e. renting a car by a tourist etc. these are the only source They do not affect the control of the company Disadvantages 23 . If asset is not profitable lease can be cancelled by lessee. Company can acquire expensive equipments without incurring capital expenditure. This source is very suitable if the assets become Obsolete very fast e. Reserves/Retained Earnings These are undistributed profits. Disadvantages Is a risky source because lessor may refuse to renew the agreement Rental charges may be too high and lessee may pay money in rental charges than the cost of the asset. The terms and conditions of the lease agreement may be unfavorable to the lessee and (s)he may not be able to utilize this asset conveniently.g. Lease finance is available for fixed assets only thus not useful for all financial requirements of the company. It is the cheapest and painless method of raising more capital. computers. Advantages Cheapest method since it does not involve any credit High retained earnings reduce shareholders' tax liability If the firm is unable to raise long term loans due to insufficient assets for security. aircraft etc Ideal if assets are needed for a short period only. The fall in dividends results in the fall of share prices. Large companies can acquire finance in the form of proceeds from ordinary share and debentures. Cost of finance Cost of finance should be less than the expected return from the projects for which this finance is needed 3. mortgage etc. 2. Factors to Consider In Choice of source of finance 1. 6. trade credit etc must be selected. trade credit. Flexibility The source of finance that is more flexible should be used Thus a company can use a particular source of finance if need arise and repay the money when not needed any mo bank credit is flexible if easy to get.g. Long-term sources must be used e. issue of debenture. personal sources 4. If banks do not give old facilities. then the company's profitability will be affected adversely. 5. Time factor A business may need finance for a short period or long period If finance is needed to make up working capital deficiency then short-term sources of finance e. trade credit may be used.g. old. Availability of finance The readily available source of finance should be used e.g. High retained earnings are possible only when dividends are declared at a low rate. mortgage and other Long Term loans. Small business units can obtain finance from banks in form of small loans. Size of Business. If retained earnings are invested carelessly. Mode of payment 24 . If need to acquire Fixed assets. overdraft. A business enterprise will prefer that mode of finance which allows the repayments of the principal and interest in easy and convenient installments. Others include. Financial intermediaries purchase direct (or primary) securities and. These intermediaries come between ultimate borrowers and lenders by transforming direct claims into indirect claims. The participant buy (borrow) and sell (lend) money to different parties at a price (interest or dividend) within the market. markets and regulatory authorities that exist and interact in a given economy. saving institutions. issue their own indirect (or secondary) securities to the public. The main regulatory are the Central Bank and Capital Market Authority Financial intermediaries Financial intermediaries are financial institutions that accept money from savers and use these funds to make loans and other financial investments in their own names. in turn. TOPIC 3: KENYAN FINANCIAL SYSTEM The financial system can be described as a whole system of all institutions. pension funds. finance companies and mutual funds. which is determined by the forces of demand and supply. Their role is to assist in the transfer of savings from savings surplus units to savings deficit units so that savings can be re-distributed into their most productive uses. For 25 . The institutions and individuals form the participants in various markets. individuals. money (including foreign exchange) and capital markets (including security) markets. insurance companies.. Savings and investments are equated more rapidly thus there is a faster economic growth.example. credit analysis. Functions of Financial Markets/Institutions in the Economy 1. 5. acquisition. By their actions. The financial intermediaries performs many of the tasks that were initially perfumed by lenders and borrower. and handling of administrative and legal details. the direct security that a savings and loans association purchases is a mortgage. Higher savings rate encourage savings permit and lower borrowing costs greater investments. financial intermediaries provide a higher return to lenders for a given degree of risk and lower costs of borrowing than would be possible with direct finance. Provision of investment advice to individuals through financial experts. (Link between buyers and sellers). financial intermediaries exhibit “economies of scale” with respect to costs of search. Savings are transferred to economic units that have channels of alternative investments. Distribution of financial resources to the most productive units. Allocation of savings to real investment. Achieving real output in the economy by mobilizing capital for investment. These takes involve real costs and the intermediary can perform them much more efficiently and much lower total cost than it can be done by an individual lender and borrower. In the jargon of an economist.task of gathering funds. 2. analysis and diversification. Enable companies to make short term and long term investments and increase liquidity of shares. evaluation of risk. 4. 3. the indirect claim issued is a savings account or a deposit certificate. 26 . E. Primary market Secondary market Capital Market These are markets for long term funds with maturity period of more than one year. Means of pricing of securities e. Financial markets are broadly classified into two: 1.g mortgage. Provide investment opportunities.E.g. b) Non-security/instrument market e. Capital Markets 2. debentures etc. commercial banks.6.The capital market serves as a way of allocating the available capital to the most efficient users. SACCOS. 27 . Money Markets E. loans.g N. Enables companies to raise short term and long term capital/funds 7. preference shares. Capital markets are sub-divided into 2: a) Security markets e. terms. ordinary shares etc. 8. foreign exchange market.S. merchant banks etc. Savers can hold financial instrument for investment made. security market is sub-divided into 2.g of Financial instruments used here are debentures. index shares indicate changes in share prices. bonds.g stock exchange dealing with instruments such as shares. warrants. Capital market financial institution includes: Stock exchange Development bank Hire purchase companies Building societies Leasing firms Functions of Capital Markets are: Providing long term funds which are necessary for investment decisions. capital leases. as the transfer between shareholders is facilitated. Money market works through financial institutions. The money market or discount market is the market for short term loans. merchant banks. Provide advice to investors as to which investments are viable. Money/discount markets Are discount and acceptance financial institutions This is a market for S. The transfer can be direct (from saver to investor) and indirectly through an intermediary).T funds maturing in one year. Foreign exchange market is also part of money market. and government. It facilitates transfer of capital between savers and users. 28 . Facilitating the liquidation and marketing of a long term Acting as a channel through which foreign investments find their way into the market. Facilitates the international capital inflow. Financial Instruments in Money market include: Commercial paper Treasury bills Bills of exchange Promissory notes Bank overdrafts Bankers certificate of deposit These instruments are sold by commercial banks. Long term investments are made liquid. acceptance houses. discounting houses. They facilitate capital formation. Types of Stock Markets 1. Increases diversification of investments Improves corporate governance through separation of ownership and realize their investments through disposal of management.Primary Markets These are markets that deal with securities that have been issued for the first time. Kenya Airways. Parameter for healthy economy and companies Provides investment opportunities for companies and small investors. The money flows directly from transferor (saver of money) to transferee (investing person). This increases higher standards of accounting. Enable investors securities. Over the Counter Market (OTC) 29 This . This gives individuals a chance for ownership in large companies. resource management and transparency.g.e control of excess liquidity in the economy It is a vehicle for direct foreign investment. 2. Mobilising savings Government can raise capital through sale of Treasury bonds Open market operation to effect monetary policy of the government i. system is called “open outcry”. Privatization of parastatals e. Organised Exchange and Over the Counter (OTC) market This is where the buying and selling of securities is done by buyers and sellers are not present but only the agents (brokers) internet. Economic Advantage/Role of Secondary Markets in the Economy It gives people a chance to buy shares hence distribution of wealth in economy. Economic Advantage of Primary Markets Raising capital for business. Savings and Credit Associations These are firms that take the funds of many savers and then give the money as a loan in form of mortgage and to other types of borrowers. Treasury bonds etc. Features of OTC Markets 1. Usually deal with new securities of firms 3. OTC is underdeveloped in Kenya. The savings of the member are loaned 30 . Is composed of small and closely held firms. fax etc. Credit Unions These are cooperative associations whose members have a common bond e. Trading may be done through telephones. 1. They act as intermediary between savers and users (investment) of funds. Commercial Banks. equity securities.g employees of the same company. 2. OTC specializes in securities such as corporate bonds. computer networks. Prices are relatively low 2. They maintain a reasonable balance between demand and supply and observe price movements to determine profit margins on sale. 3. The dealers/participants set the trading rules. They provide credit analysis services.Provides an opportunity for unlisted/unquoted firms to sell their security OTC is usually organized by the dealers or stock brokers who buy securities themselves and then sell them. Financial intermediaries These are institutions which mediate/link between the savers and investors: Examples of financial intermediaries in Kenya. They act on behalf of members of public who are buying and selling shares of quoted companies. Giving advice to the investors 2. 4. Pension Funds These are retirement schemes or plans funded by firms or government agencies for their workers. SACCOS charge p.g. Giving defensive tactics incase of forced takeover 5. Brokers These are people who facilitate the exchange of securities by linking the buyer and the seller.m interest on outstanding balance of loan. NHIF and other registered pension funds of individual firms. 7. Investment Bankers These are institutions that buy new issue of securities for resale to other investors. Underwriting of securities. Savers will receive annuities in future. 5. They perform the following functions: 1. Examples of pension funds are NSSF. 31 . Giving advice to firms which wants to 3. Valuation of firms which need to merge 4.only to the members at a very low interest rate e. bonds or in real assets. 6. these funds in securities such as shares. Life Insurance Companies These are firms that take savings in form of annual premium from individuals and them invest. They are administered mainly by the trust department of commercial banks or life insurance companies. very transferable and can be bought and resold by other individuals and organizations. meaning that once it has sold them. Stock exchanges developed along with. shares. however. a financial institution. and are an essential part of the free enterprises system. unless and until the company is winding up and liquidates. The need for this kind of market came about as a result of two major characteristics of joint stock company (Public Limited Company).The Stock Exchange Market The Idea and Development of a Stock Exchange Stock exchange (also known as stock markets) are special “market places” where already held stocks and bonds are bought and sold. These two characteristics of joint company shares brought about the necessity for an organized and centralized place where organizations and private individuals with money to spare (investors). which provides the facilities and regulations needed to carry out such transactions quickly. and Taiwan which is also claimed by China). and satisfy their individual needs. 1. Stock exchanges were the result emerging to provide a 32 . these shares are irredeemable. conveniently and lawfully. the only requirement being the filling and signing of a document known as a share transfer form by the previous shareholder. They are. 2. The second characteristic is that these shares are. First of all. in effect. The document will then facilitate the updating of the issuing companies shareholders register. the company can never be compelled by the shareholder to take back its shares and give back a cash refund. (No stock exchanges exist in the communist world outside Hong Kong and Macao – which have special status. freely. While this basic function is extremely important and is the engine through which stock exchanges are driven. The check against flight of capital which takes place because of local inflation and currency depreciation. The growth of related financial services sector e. Improvement of access to finance for new and smaller companies. an unfortunate situation. there are also other quite important functions.continuous auction market for securities. Encouragement of the divorcement of the owners of capital from the managers of capital. Encouragement of public floatation of private companies which in turn allows greater growth and increase of the supply of assets available for long term investment. with the laws of supply and demand determining the prices. 33 . Debt financing has been the undoing of many enterprises in both developed and developing countries especially in recessionary periods. resource management and public disclosure which in turn affords greater efficiency in the process of capital growth. Functions of the Nairobi Stock Exchange The basic function of a stock exchange is the raising of funds for investment in long-term assets. Facilitation of equity financing as opposed to debt financing. pension and provident fund schemes which nature the spirit of savings. Encouragement of higher standards of accounting. This is futuristic in most developing countries because venture capital is mostly unavailable. The mobilization of savings for investment in productive enterprises as an alternative to putting savings in bank deposits. insurance. a very important process because owners of capital may not necessarily have the expertise to manage capital investment efficiently.g. purchase of real estate and outright consumption. the stock market helps to reduce large income inequalities because many people get a chance to share in the profits of business that were set up by other people. 34 . Mobilising Savings for Investment When people draw their savings and invest in shares. 5. Raising Capital for Businesses The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public. corporate organizations and even the The government for example could raise long term finance locally by issuing various types of bond through the stock exchange and thus be less inclined to foreign borrowing. investing in shares is open to both the large and small investors because a person buys the number of shares they can afford. Individuals. There are many other less general benefits which stock exchanges afford to. Redistribution of Wealth By giving a wide spectrum of people a chance to buy shares and therefore become part-owners of profitable enterprises. it leads to a more rational allocation of resources because funds which could have been consumed. government. The Role Of Stock Exchange In Economic Development 1. Stock exchanges. 3. Therefore the Stock Exchange provides an extra source of income to small savers. 2. especially in developing countries have not always played the full role in economic development. or kept in idle deposits with banks are mobilized and redirected to promote commerce and industry. Creates Investment Opportunities for Small investors As opposed to other business that require huge capital outlay. companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholder. It is evident that generally. Improving Corporate Governance By having a wide and varied scope of owners. public companies tend to have better management records than private companies. 4. 4. These bonds can be raised through the Stock Exchange whereby members of the public buy them. Income in form of dividends When you have shares of a company you become a part-owner of that company and therefore you will be entitled to get a share of the profit of the company which come in form of dividends. 2. Government Raises Capital for Development Projects The Government and even local authorities like municipalities may decide to borrow money in order to finance huge infrastructural projects such as sewerage and water treatment works or housing estates by selling another category of shares known as Bonds. share prices rise and fall depending. 3. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability. When the Government or Municipal Council gets this alternative source of funds. on market forces.6. Barameter of the Economy At the Stock Exchange. largely. shareholders could take advantage of this increase and set their shares at a profit. Therefore their movement of share prices can be an indicator of the general trend in the economy. Capital gains are not taxed in Kenya. dividends attract a very low withholding tax of 5% only. Therefore this certificate is a valuable property which is acceptable to many banks and financial institutions as security. it no longer has the need to overtax the people in order to finance development. Furthermore. Share Certificate can be used as a Collateral Share certificate represents a certain amount of assets of the company in which a shareholder has invested. 7. Shares are easily transferable 35 . or collateral against which an investor can get a loan. Advantages of Investing In Shares 1. and therefore when prices of given shares appreciate. Profits from Capital Appreciation Shares prices change with time. Positive advise and guidance could be provided by the stockbrokers and other investment advisors. whereby the voting power is determined by the number of shares an investor holds since the general rules is that one share is equal to one vote. Availability of Investment Advice Although the stick market may appear complex and remote to many people. Therefore. a shareholder gets the right to participate in making decisions about how the company is managed. He doesn’t buy or sell shares in his own right hence he cannot be a market marker. He must maintain standards set by the stock exchange.The process of acquiring or selling shares is fairly simple. STOCK MARKET TERMINOLOGY 1. 6. Shareholders elect the directors at the Company’s Annual. He is authorized by CMA and NSE He obtains the suitable deal for his clients/investors. 5. BROKER A dealer at the market who buys and sells securities on behalf of the public investors. General meetings. gives financial advice and charges commission for his services. inexpensive and swift and therefore an investor can liquidate shares at any moment to suit his convenience. an investor can still benefit from trading in shares even though he may not be having the technical expertise relevant to the stock market. He is an agent of investors He is the only authorized person to deal with the quoted securities. 36 . Participating in Company Decisions By buying shares and therefore becoming a part-owner in an enterprise. He does not deal with members of the public unlike brokers. He can set prices and activate the market through his own buying and selling hence he is a market maker.2. It signifies investors pessimism about the future prospects of the economy. It signifies investors confidence/optimism in the future of economy. Therefore the market is characterized by an upward trend in security prices. The share prices are generally rising. The intention is to buy same securities at lower prices in future thereby making a gain. c) Stags This is a jobber found in primary markets He buys new securities offered to the public and believes that they are undervalued. JOBBERS/SPECULATORS This is a dealer who trades in securities in his own right as a principal. He engages in speculation and earns profit called Jobbers’ turn (selling price – buying price). When a market is dominated by bulls (buyers predominate sellers). When market is dominated by bears (sellers predominate buyers) it is said to be bearish. brokers can buy and sell shares through jobbers. It is characterized by general downward trend in share prices. it is said to be bullish. However. There are 3 types of jobbers a) Bulls A jobber buy shares when prices are low and hold them in anticipation that the price will rise and sell them at gain. b) Bears A speculator/jobber who sells security on expectation of decline in prices in future. 37 . The aim is to make gain from assumed change in the market value of shares. under a commission to take up any shares not bought by the public. Blue Chips Are first class securities of firms which have sound share capital and are internationally reputable. They therefore ensure that all new issues are successful Underwriters are very important in pry markets and play the following roles: Advice firms on most suitable issue price Ensure shares are fully subscribed by taking up all unsubscribed shares Advice the firms on where to source funds to finance floatation costs. It is aided by brokers in countries where it is practiced. Individuals holding such securities are reluctant to sell them because of their high value. Underwriting This is the assumption of risk relating unsubscribed shares When new shares are issued.He believes the price will rise and sell them at a gain to the ultimate investors Stags are vital because they ensure full subscription of the share issue. 4. 5. A merchant banker agrees. 38 . Investors going short or long are required to pay a premium called margin on the transaction. This practice is not allowed in Kenya.They have very good dividend record and are highly demanded in the markets. AT NSE An investor approaches a broker who takes his bid/offer to the trading floor. 3. Going short or long on a share This is the process of selling (going short) or buying (going long) on a share that one does not have/own. they may be underwritten/unsubscribed. TRADING MECHANISM 1. g is the product vulnerable to weather conditions? Is it subject to restrictions? Marketability of the shares – how fast or slowly can the shares of the firm be sold? Diversification i. Settlement is made through the brokers.g multi-products so that if one line of business declines. the other increases and the overall position is profitable. unfavourable climatic conditions and diseases which may lead to low productivity and poor earnings. 3.D. and key management personnel of repute? They should be trusted and run the company honestly and successfully.g.O. Nature of the product dealt in and its market share e. 4. 5. The note is sent to buying and selling investors.g are the B. The note contains details such as: Number of shares bought or sold Buying/selling price Charges/commission payable etc.2. The investor is informed of what happened/transpired at the trading floor through a contract note. At the trading floor. 39 . Factors to Consider when Buying Shares of a Company Economic conditions of the country and other non-economic factors e. State of management of the company e. Company’s trading partners (local and abroad) and its competitors. Old share certificate is cancelled (for selling investor) and a new one is issued in the name of buying investor.e does the company have a variety of operations e. the buying and selling brokers meet and seal the deal. Foreign political developments where the economy heavily depends on world trade. General elections and new president will cause anxiety and uncertainty and adversely affect share prices. Exchange rates will also encourage or discourage foreign investment in shares.g spending. share prices could rise. Industrial relations eg strikes and policies of other firms. firms would have high profits hence rise in prices. Change on Government economic policy e. Rumours and announcement of mergers and take-over bids. Change in company’s management e.e. Rumour and announcements of impending political changes eg. If the shareholders are offered generous terms/prices in a take-over. The publication of a company’s financial results i. The general economic conditions situations e. 40 .g entry and exit of prominent corporate personalities. These influences include: The recent profit record of the company especially the recent dividend paid to shareholders and the prospects of their growth and stability. Prospects of growth of the firm due to expected growth in demand of products of the firm. taxes. Balance Sheet and profit and loss statement. The growth prospects of the industry in which the company operates. Factors Affecting/Influencing Share Prices All sorts of influences affect share prices. monetary policy etc.g during boom. Changes in the rate of interest on Government securities such as Treasury Bills may make investors switch to them.g boom and recession e. These changes influence investors’ expectations. 30 M x 100 = 120 Year 2000 sales Shs. The stock index is computed using Geometric mean (G.M) as follows: 41 .25 M and for year 2001 Shs. The value of assets and the earnings from utilization of such assets will also influence share prices. year 2000 is called Base year. The NPV of such investment would be reflected in share prices.30 M. the sales index would be as follows: Sales index = year 2001 sales = Shs. The NSE has its base year as 1966. 20 companies constitute the index. Announcement of good news eg that a major oil field has been struck or a major new investment has been undertaken. Examples If sales in year 2000 are equal to Kshs. STOCK MARKET INDEX Definition An index is a numerical figure which measures relative change in variables between two periods. A stock index therefore measures relative changes in prices or values of shares. Institutional buyers such as insurance companies can influence share prices by their actions. The views of experts e.g articles by well-known financial writers can persuade people to buy shares hence pushing the prices up.25 M Year 2001 sales are 120% of year 2000 sales. P1 x P2 x P3 x P4 ------.. Company Today’s share price A 20 B 52 C 83 D 12 E 78 F 10 Yesterday’s share price 25 53 83 10 75 0 96 index the Compute the stock market index for today.M.. Stock market index therefore is an indicator of investors confidence in the economy.. Where G.M = n P1xP2 xP3 xP4 x.Todays stock index = (Today’s share price G. N = number of companies When stock prices are rising.. Illustration The following 6 companies constitute the index of democratic republic of Kusadikika.xPn Where G...M.M)2 x 100 Yesterday’s share price G. stock market index will rise and vice versa.. Choice of base year on which to base the price changes 42 should be .Pn = share price of companies that constitute stock index. In construction/computation of stock following considered: 1. 5. Use of suitable weight to be attached to the securities depending on their relative importance.2. To gauge price (wealth movement in the stock market 2.From 25 most active companies in a given period (weekly basis) Computation of price index. 4. The selection of representative securities/firms 3. LEVEL OF TRADING ACTIVITIES IN THE NAIROBI STOCK EXCHANGE The activities in NSE are normally low due to: Few Listed companies Economy is made up of small firms which are family owned or sole proprietorship. STOCK EXCHANGE INDEX (SEI) Stock Exchange Index is a measure of relative changes in prices of stocks from one period to another indices. The weights/number of firms in a sector is kept constant over a reasonably long period. Assist in examining and identifying the factors that underlie the price movements.Nairobi Stock Exchange 20 . May be used to predict future stock prices 5. Combining the securities/firms to construct the index eg use of geometric mean 4.share Index (20 companies) (Daily basis) Stanchart Index . 43 . Uses of Stock Exchange Index 1. To assess performance of specific portfolio using SEI as a benchmark. Level of awareness among the population is low Few instruments traded Low dividend payout to those already holding shares. To assess overall returns in the market portfolio 3. Limitations/Drawback of NSE index The 20 companies sample whose share prices are used to compute the index are not true representatives. ATH. Dormant firms – Some of the 20 firms used are dormant or have very small price changes. Thinness of the market – small changes in the active shares tend to be significantly magnified in the index The weights used and the method of computation of index may not give a truly representative index. They may use such information to dispose off share to make capital gains or avoid capital loss TIMING OF INVESTMENT A STOCK EXCHANGE The ideal way of making profits at the stock exchange is to buy at the bottom of the market (lowest M. If the price is not consistent with the activities of the firm e.g a decline in share price of a firm with very good growth prospects.g top management and director take advantage of the information available to them which has not been released to the public. The base year of 1996 is too far in the past New companies are not included in the index yet other firms have been suspended/deregistered e. When is a share price said to be unfair? Where the price is not determined by demand and supply forces.P. KFB etc. Price is not compatible with the price of other similar shares of firms in the same industry If there is insider trading: This situation arises where individuals within the firm in privileged positions e.g.S) and sell at the top of the market (highest 44 . Dow Theory This theory depends on profiting of secondary movement of prices of a chart. Systems have been developed to indicate when shares should be purchased and when they should be sold. This system can be applied to an index of a group of shares or shares of dividends companies eg Dow Jones and Nasdaq index of America. 2. Illustration 1 45 . they are bearish. the rise of prices is greater than the fall of prices. The principal objective is to discover when there is a change in the primary movement. they are doing as well as can reasonably be expected. the signs are bullish and if the volume increases with falling prices.P. In a bear market the opposite is the case ie the fall is greater than the rise In a bear market. This is determined by the behaviour of secondary movement but tertiary movements are ignored. Basically. Hatch System This is an automatic system based on the assumption that when investors sell at a certain % age below the top of the market and buys at a certain percent above the market bottom. 1. the volume of the business being done at a certain stage can also be used to interpret the state of the market. These systems are Dow theory and Hatch system. it is maintained that if the volume increases along with rising prices.S).M. The greatest problem however is that no one can be sure when the market is at its bottom or at its top (prices are lowest and highest). Eg in a bull market. The company must have made profits during the last 3 years. Number of shares to be issued 2. The dates during which the other is valid or open 46 . determine the amount of capital gain on these shares. Compute his shilling return in %. It must provide details on 1.An investor uses the hatch system to determine when to buy and sell his shares.P. the share price was 200/=. iii) The investor had D.S of 3.20 M. At least 20% of issued capital (capital to be issued) should be offered to the public The firm must issue a prospectus which will give more information to investors to enable them to make informed judgement The market price of the companies share must be determined by the market forces of demand and supply The company should be registered under Cap. i) Determine the buying and selling price of the shareholders ii) If the shareholder had 10.00 at the end of the year.000 shares. At the beginning of January. He sells the shares when prices are 15% less of the top price and buy the shares when prices are 15% less of the top price and buy the shares when prices are 15% more of the bottom price. At the end of the year the share price was Shs. Rules for floatation of new shares on NSE The company must have an issued share capital of at least Kshs.320. Offer/issue price per share 3. 486 with registrar of companies. The greater marketability and hence lower risk attached to a market listing will lead to a lower cost of equity and also to a weighted average cost of capital.4. making a company less dependent upon retained earnings and banks. For this reason the shares are likely to be perceived as a less risky investment and hence will have a higher value. Action may be taken against the directors if the prospectus is fraudulent. The wider share ownership which results will increase the likelihood of being able to make rights issues. The company may increase its standing by being quoted and it may obtain greater publicity. The share price can be used by management as an indicator of performance. 47 . 6. being based upon expectations. A market-determine price means that shareholders will know the value of their investment at all times. The transfer of shares becomes easier. Financial statements of the firm showing EPS and DPS for the last 5 years 5. Less of a commitment is necessary on the part of shareholders. particularly since the share price is forward looking. The Advantages and Disadvantages of a Listing Advantages It facilitates the issue of securities to raise new finance. whilst other objectives measures are backward looking. Action report etc. The shares of a quoted company can be used more readily as consideration in takeover bids. etc. Management conditions. This is because substantial costs are fixed and hence are relatively greater for small companies. Also. There will be a greater likelihood of being the subject of a takeover bid and it may be difficult to defend it with wide share ownership. ROLE OF CMA To remove bottlenecks and create awareness for investment in long term securities 48 . Capital Market Authority (Cma) Was established in 1990 by an Act of Parliament ot assist in creation of a conducive environment for growth and development of capital markets in Kenya. management employees give themselves more salaries due to prosperity obtained. Control of a particular group of shareholders may be diluted by allowing a proportion of shares to be held by the public. printing more annual reports. Disadvantages The cost of obtaining a quotation is high. maintaining a larger share register. the annual cost of maintaining the quotation may be high due to such things as increased disclosure. Obtaining a quotation provides an entrepreneur with the opportunity to realize part of his holding in a company. The market-determined price and the greater accountability to shareholders that comes with its concerning be the disliked by company’s performance may not be liked by management. particularly when a new issue of shares is made and the company is small. The increased disclosure requirements may management. To serve as efficient bridge between the public and private sectors Create an environment which will encourage local companies to go public To grant approvals and licences to brokers To operate a compensation fund to protect investors from financial losses should licenced brokers fail to meet their contractual obligation Act as a watchdog for the entire capital market system To establish operational rules and regulations on placement of securities To implement government programs and policies with respect to the capital markets. CMA may: 4.S) It’s a computerized ledger system that enable the holding or transfer of securities without the need for physical movement. The ownership of security or shares is through a book entry instead of physical exchange CDS is for security what a bank is for cash transfer between banks.D. Central Depository System (C. Alert the investors if it feels that the issue price of certain securities is not in their interest 6. However. Eg A and B 49 . The prices of such securities is determined by the demand and supply mechanism 3. Advice the company on the issue price of new securities 5. 2. The CMA does not in any way influence share price of quoted companies. It guards against manipulation of share prices and insider trading. Role of CMA in determination of share prices 1. Its faster and less risky settlement of securities which make the market more attractive for investors e.are 2 shareholders of XYZ Ltd.e. 3. 6. 4.g instances of fraud will be reduced since there is no physical share certificate which may be forged. Functions of CDS 1. 5. does not need to deliver the share certificate to A or B but a ledger account for both shareholders would be maintained at the CDS. Immobilisation of securities ie elimination of physical movement of securities. It shortens the registration process in the stock exchange i. 2. Advantages of CDS 1. Dematerialisation i. It improves the liquidity of stock exchange than increase the turnover of the equity shares in the market. 50 . high speed of registering shareholders. XYZ Ltd. payment (DVP) ie simultaneous delivery and payment between the 2 parties exchanging or transferring securities. There will be improved and timely communication between company and the investors hence reduced delay in receiving dividends and right issues and improve information dissemination concerning a company.e elimination of physical certificates or documents showing entitlement to a security so that ownership exists only as computer records. Their accounts will be credited with the number of shares. It will lower the clearing and settlement cost eg no need to prepare share certificates and seal them (putting a seal). Effective Delivery Vs. If A want to sell shares to B the CDS will debit A’s account and credit B’s account. 3. 2. It will lead to an efficient and transparent securities market to adhere to International Standards for the benefit of all stakeholders. 5. For faster settlements and ownership transfer and reduced cost of transfer through reduced paper work and labour intensive activities.g CBK. Parties Involved In CDS 1.This can be done without delay if CDS is linked to the central payment clearing system e. Brokers Reduces paper work. Provision of book entry account ie electronic exchange of ownership of securities and payment of cash. 4. 3. forgery and improved efficiency 6. 2. private investors and market professionals. Capital Market Authority To improve the transparency of market and reduce instances of fraud. interests. 5. Effective Distribution of Dividends. 4. Government For the purpose of attracting foreign investors and supporting the infrastructure of capital markets. rights issues and bonus issues.Nairobi Stock Exchange Bear transactions costs and improve liquidity of the market investors. Investors Institutions.g ordinary shares. Banks 51 . preference shares. Provision of detailed listings of investors according to the type of securities they hold e. 6. Development Banks and Specialized Financial Institutions There are some sectors in the economy that may not secure adequate funds from commercial banks for various reasons. They include: Industrial development bank (IDB) – give loans for industrial development in Kenya. Such sector e.g Jua Kali etc. Development Finance Company of Kenya (DFCK) – To finance various project will spur economic development and create employment.g agriculture and tourism are essential for a balanced economic growth and development. 52 .Ease of clearing and settling of payments. The government has thus established financial institutions to cater specifically for these otherwise unattractive but essential sector. a) May take a long time to realize returns b) High risk associated with such sectors c) unattractive/low return d) Uncertainty or highly volatile returns e) Require heavy investment in infrastructure These sectors include: Tourism Rural housing Agriculture Rural enterprise Small commercial businesses e. They increase government spending. Banking Institutions The Central Bank 53 . Advantages/Functions/Case for Development Financial Institutions They provide venture capital They provide facilities for large lending They provide technical expertise and support emerging projects transferable from other sectors of development economies. Kenya Tourism Development Cooperation (KTDC) for promotion of Tourism in Kenya. They carry out feasibility study to evaluate viability of projects. Commercial banks have now matured up to provide capital for all sectors. Agriculture Finance Co-operation (AFC) Post Bank – To mobilize rural savings National Housing Cooperation – for development of houses to ensure shelter for everyone. They are risk capital providers in areas which are not attractive to commercial banks and other major lenders due to risk involved. Case against Specialized Institutions and Development Banks They are being phased out by Globalization and liberalization where needy sectors can easily get expertise from outside. cKenya Industrial Estate (KIE) – this is a branch of Industrial and Commercial development cooperation (ICDC) dealing with industrial development. They were only useful during periods of foreign exchange restriction They are risk capital providers in areas which are not attractive to commercial banks and other major lenders due to risk involved. when offering services to difference parties. Responsibility of maintaining financial soundness of the economy. Establishment of Central Bank of Kenya Established by Central Banking Act. 1966. To act as a commercial bank. A copy of the return to be submitted to Finance Minister. Deputy Governor. It is therefore entrusted with two objectives: 1. 4. and the Banking Act 1968. The Governor of the Central Bank is the executive head of the bank. It therefore has to operate profitability 5. The bank has also to prepare and publish an annual report within 3 months of the end of fiscal year. Lender to the government 54 . Fiscal year ends 30th June. The 2. The Governor in charge today is Michael Cheserem.This is a bank which is entrusted with the responsibility of maintaining economic stability and financial soundness of a country. Banker to the government 2. bank has therefore to identify gaps in financial markets and to seek 3. Statutory Information and Accounts The bank is required to publish a return of its assets and liabilities every month. Management of the Bank Management and policy entrusted to a Board of Directors. solutions to these gaps. Central Banks Functions of Central Bank 1. and Ps to treasury. comprising of seven members including the Governor. Treasury bonds. safeguard the deposits and make them available to their owners when need arises. Commercial Banks These are financial are financial institutions that accept deposits of money from the general public. banks lend loans to customers from which they earn interest Facilitate international trade by issuing letter of credit and undertake foreign exchange transactions on behalf of their customers 55 . safeguard the deposits and make them available to their owners when need arises.3. Commercial banks operate under the Banking Act 1968 Functions of Commercial Banks Accepting deposits for safe keeping and for interest Collecting money on behalf of customers and credit this money in customers accounts Transferring of money from individual to another person‟ s accounts through credit transfer. Ensure Economic stability 4. Fiscal policies e. Monetary policies e. Printing of currency notes 5. Supply of foreign currency are obtainable at commercial banks Lending money. Reserve ratio etc 2.g taxation Commercial Banks These are financial institutions that accept deposits of money from the general public. Lender of last resort Tools Used To Control The Level Of Money In Circulation 1.g Treasury bills. commercial banks facilitate and increase the speed of commercial and industrial activities. International exchange is similarly enhanced. commercial banks relieve savers of the risk of loss. By use of cheques. which commercial form part banks create additional of the total money supplies in the economy. Act as trustees and executives of wills if one wants to make a will he/she writes and appoints a commercial bank as the trustee and executor of the will Provision of safer keeping of valuables like title deeds. and letters of credit. If savers were to lend individually directly to and borrowers. gold certificates etc Making decision affecting development. commercial banks are very careful and strict so as to give loans to investment in viable sector of the economy Role of commercial banks in a country’s economy Exchange and trade: commercial banks facilitate the process of exchange deposits. they would 56 have to carry the risk of . By providing overdraft facilities. Before advancing loans to prospective customer. through lending. By so doing. They (banks) play the role of “middlemen” in the lendingborrowing cycle. Intermediaries: commercial banks connect savers of surplus funds to borrowers. which may result when borrowers default in paying their loans. holders of demand deposits accounts are able to transact business and exchange goods and services. possible loss personally. Sometimes. It can be said therefore. and other valuables with commercial banks for safety. Features 57 . Safety: Commercial banks are also used as “strong boxes” for keeping valuable assets in documents safety. Other assets may be used as security for funding of another asset. oil drilling and many more would have been very difficult if investors were to rely on personal savings. the By necessary aggregating savings into commercial banks. Mortgages An arrangement where the property being purchased provides the security for funding. Many rich people deposit jewellery. Large enterprises like hotels. Economies of scale: Commercial savings and investment individual banks economies provide of scale. that commercial banks play an important role in the process of capital formation. heavy machinery. they become key agents of capital formation and economic development. It can be said that commercial banks harness society‟ s saving potential and direct these savings to infrastructure and capital assets. Other Financial Institutions 1. like shipping lines. it is the main consideration in the minds of users of banks. Money is sometimes deposited into banks for no other objective than safekeeping. Estate. Experiences with mortgage arrangements have been discouraging. 4. 3. Interest rate fluctuations make planning uncertain 2. Mortgagor and mortgagee agree on a long term financing arrangement 2. Repayment is over a specified long term period. Difficulties in mortgage arrangements 1. Housing Finance Company of Kenya This is the largest mortgage company in Kenya. 5.g. 3. a) Enhancement of acquisition of skills necessary for industrial development 58 .1. Nyayo Highrise 2. Mortgagor provides a contribution which is paid up-front. Interest rate is stated with provision for variations of the determination of the finance. Kenya Industrial Estate This is a body established by the government for the purpose of promoting industrial development. Initial contribution is not affordable by majority of the population e. It is registered under the Building Society Act but operates as a finance company under the Banking Act. Financing relates to acquisition of specific asset 3. It implements the government’s policy of stimulating house ownership. Potential participants avoid getting tied up in long term loans 4. 5. 59 . The main objectives of KTDC are: 1. Kenya Tourist Development Corporation This was established by the Government specifically to promote tourism. It provides capital necessary for industrial development It provides guarantees for loans to be used for industrial development especially for small scale industries. Industrial and Commercial Development Cooperation (ICDC) This was incorporated in 1954 by the Kenya Government The main objective is to facilitate industrial development. Merchant banks accept bills of exchange which deal in the leasing of industrial equipment.Technological innovations. 5. The body is concerned with the provision of a base that will be considered necessary for technology development e. through research. 4. To provide assistance for establishment of tourism projects 2. Merchant Banks Merchant Banks begun life as merchants and begun to operate in financial firms. The merchant banks act as a principal when they buy share from the company before the issue is made. 6. To provide financial assistance for the establishment of hotels and tourism lodgings 3. within the 19th Century.g. To provide equity finance on joint venture basis in international hotel organizations. It concentrates on projects requiring financial participation and active extension of services Funds provided are from the Government and commercial banks. 60 . research and development programme.TOPIC 4: CAPITAL BUDGETING DECISIONS As a firm/business expands it becomes necessary to invest in fixed assets so to increase the volume of production. acquisition. or even divestment (sale of a business or its division). to increase production where a company invests in plant and machinery to 61 . Types of Investment Decisions Expansion of existing business Expansion of new business Replacement & Modernization Expansion & Diversification Expansion involves a company lending capital to its existing product lines. Investment decisions of a firm are generally known as capital budgeting or capital expenditure decisions. analyzing and selecting investment project whose returns (cash flows) will extend beyond one year. Capital budgeting can be defined as the process of identifying. modernization and replacement of the long term assets. Features of investment decisions The exchange of current funds for future benefits The funds are invested in long-term assets Future benefits will occur to the firm over a series of years Importance of investment decisions They influence the firm’s growth in the long run They effect the risk of the firm They involve commitment of large amounts of funds They are irreversible or reversible at substantial loss They are among the most difficult decisions to make Majority of firms have scarce capital resources. Investment decisions would include expansion. Investment Evaluation Criteria Steps involved in the evaluation of investment Estimation of cash flows Estimation of the required rate of return Application of a decision rule for making the choice The various investment decision rules may be regarded as capital budgeting techniques or investment criteria. This is necessary because money loses value with time and the method must accommodate this phenomenon. Replacement & Modernization The main objective of these is to improve operating efficiency and reduce costs. This is reflected in increase profits. Any appraisal method to be used to assess the viability of a venture must fulfill the following requirements: It should appreciate that bigger returns are preferable to small ones and early returns are preferable to later benefits. Capital Budgeting Techniques Any investment to be undertaken will need to be assessed as regards its viability using an acceptable approach.produce items which it has not manufactured before. 62 . The firm replaces obsolete assets with those that operate more economically. this represents expansion of new business of Diversification. Profitability index (b) Non-discounted cashflow method i. (a) Discounted Cashflow methods i. Payback period Discounted Cashflow Methods 1. and why. Net Present Value (NPV) This is defined mathematically as the present value of cashflow less the initial outflow. The method should be able to rank various ventures available in the investment market in order of their profitability. These are. Net present value method ii. Internal rate of return iii. There are two methods of assessing the viability of an investment. The method should distinguish which investment ventures are acceptable and which ones should be rejected. The method should be able to be used for gauging the viability of any other investment ventures as and when they arise. Accounting rate of return ii. n Ct t Io t=1 (1 + K ) NPV = Where Ct is the cashflow K is the opportunity cost of capital 63 . =0 t Io t=1 (1+ r ) NPV = Where r = internal rate of return Note that IRR is that ratio of return that causes the present value of cashflows to be equal to the initial cash outflow. Internal Rate of Return (IRR) The internal rate of return of a project is that rate of return at which the projects NPV = 0 Therefore IRR occurs where: n Ct . Decision Rule under IRR If IRR > opportunity cost of capital . 2. use other methods to make the decision.accept the project 64 .Io is the initial cash outflow n is the useful life of the project Decision Rule using NPV The decision rule under NPV is to: - Accept the project if the NPV is positive - Reject the project if NPV is negative Note: if the NPV = 0. It is given by the following formula. Accounting rate of return (ARR) ARR = Average annual income Average investment 65 . - IRR < opportunity cost of capital .Reject the project PI = 1 . n (1+CK ) t t PI = t=1 Io Decision Rule If PI > 1 .3.Accept the project PI < 1 .Be indifferent Non-Discounted Cashflow Methods 1.be indifferent Profitability Index This is a relative measure of projects profitability.reject the project - IRR = opportunity cost of capital . Payback Period This is defined as the time taken by the project to recoup the initial cash outlay. The before depreciation and taxes cashflows expected to be generated by the projects are as follows.000 4.000 5.000 Required: 66 .000 4.000 each and with a useful life of 5 years.000 2. The projects will be depreciated on a straight line basis.Where Average annual income = Average cashflows .000 4.e. 2.000 3.Average Depreciation Average investment = 1/2 (Cost of investment . ILLUSTRATION A company is considering two mutually exclusive projects requiring an initial cash outlay of Sh 10. Projects with higher ARR are preferable. the maximum period beyond which the project should not be accepted.000 Project B Shs 6.000 5.Salvage value) (assuming straight line depreciation method).000 4. YEAR 1 2 3 4 5 Project A Shs 4. The decision rule depends on the firms target payback period (i. The company required rate of return is 10% and the appropriate corporate tax rate is 50%. 000 2. The net present value iv.000 . Profitability index v.000 5 Project A Annual Cashflow Cashflows before depreciation Less Depreciation 4. The internal rate of return Which project should be accepted? Why? Suggested Solution Computation of after tax cashflows Depreciation = 10.000 Less depreciation 2.000 2.Calculate for each project i.000 3.000 Profits after tax 1.000 Add back depreciation 2.000 2.000 5.000 5.000 2.000 Less taxes (50%) 1.000 67 . The average rate of return iii.0 = Sh 2.000 2.000 2.000 Cashflows after taxes 3. The payback period ii.000 Profits before taxes 2.000 Project B Year 3 1 4 2 5 Cashflow before depreciation 6. The remaining amount of Sh 10.500 1.000 .000 Less taxes (50%) 2.000 + Sh 2.000= Shs 1.500 i. Payback Period (PB) Project A = 10. ii.000 3.500 is to be recovered in the fourth year.000 Net cashflows after taxes 4.500 According to PB Project A is better.000 3.000 2.000 2.500 is recovered in three years.000 0 3.500 3.500 1.500 = 1.000 2.000 = Sh 8.500 Add back depreciation 2.Profits before taxes 4.000 1.500 = 3 3/7 years 3.000 500 0 1.8.000 2.000 = 3 1/3 years 3.000 500 0 1.500 + Sh 2. Thus PB = 3 years + 1.000 Project B Sh 4.000 .000 5 Average investment = 10.000/2 = 68 Shs 5. Average Rate of Return (ARR) Project A Average income = 5 x 1.500 2.000 2.500 Profits after taxes 2. 500 5 = 5. Net Present Value Method Project A NPV = Annual Cashflows x PVIFA 10%.100 = 0.791 .000 + 500 + 0 + 1. 5 years .500 = Shs 1.000 = Sh 1.500 + 1.20 or 20% 5.000 According to ARR Project B is better.ARR = 1.000 Project B Average income = 2.000 x 3. iii.10.100 5 ARR = 1.Initial Cost (where PVIFA is the Present Value Interest Factor of annuity) = 3.22 or 22% 5.000 = 0.373 Project B NPV can be computed using the following table: 69 . Profitability index (PI) Project A PI = 11.000 X PVIFA r%. iv.000 0.636 2 2.10.Year CashflowsPV.621 2.767 Project B is better because it has a higher NPV.173. v.065 3 2.000 Project B is better since it has a higher PI.500 0.767 Less initial cost 10.000 = 0 70 .8262. The Internal Rate of Return Project A NPV = 3.7511.9093.000 0.373 = 1.6832.000 Project B PI = 11.500 0.1373 = 1.000 NPV 1.767 10.390.500 0.1767 10. 5years .F 10% 1 4.5 PV Total PV 11.502 4 3.5 5 3. 019) = = 3. We use linear interpolation to compute the exact rate.352 PVIFA required = 3.000 71 = (39.000 From the table r lies between 15% and 16%.PVIFA r%.10.5) .24% 0.333 3.5 . 5years = 10.078 Project B We use trial and error method since the cashflow are uneven: NPV at 16% = 10.186 .15) 16% (0.019 Difference IRR = 15% + (16 .333 PVIFA Difference 0. PVIFA 15% = 3.10.960.000 NPV at 17% = = 186 9.000 = 3.078 15.352 PVIFA 15% = 3.274 0. 8% Project B is better because it has a higher IRR. Project B should be selected because the discounted cashflow methods supports this decision.16 = 17 . Generally.5 39.186 IRR 225.5 IRR IRR = 3. this is not the case and therefore we shall consider risk and other complications in the following sections.IRR) 39.IRR 186 39.Note: The methods discussed so far assume that investment decisions are made under conditions of certainty.794 16. 72 .5 (IRR .632 = 3.16) = 186 (17 .5 IRR . In real life.162 .Using Similar Triangle IRR . however. Illustration Management is faced with eight projects to invest in. The objective should be to select projects subject to the capital rationing constraint such that the sum of the projects NPVs is maximized. 73 .000 20 58.000 28.802) Required: Determine the optimal investment sets.000 15 12.000 10 41.Projects Selection under Capital Rationing If a firm rations capital its value is not being maximised.600 98.000 87. A value maximizing firm would invest in all projects with positive NPV.000 3.951 3 100. The firm may however want to maximize value subject to the constraint that the capital ceiling is not to be exceeded.927 8 250.071 7 250.000 8 24.000 (3.000 6 18. The capital expenditures during the year has been rationed to Sh 500.000 and the projects have equal risk and therefore should be discounted at the firm's cost of capital of 10%.273 5 75.000 3 99.000 3.038 4 75.895 2 250.000 16.000 10 55.395 6 50. Project Cost Project t = 0(Shs) Life CashflowNPV at the per year 10% cost 1 400.A linear programming method can be used to solve constrained maximization problems.000 1.000 5 14. 000 X8 St 1 = 500.273 X3 + . market value (Abandonment value) has also been given.951 X2 + 28.000 28. this may not be the best option .it may be better to abandon a project prior to the end of potential life.000 87..657 ABANDONMENT VALUE It has been assumed so far that the firm will operate a project over its full physical life.273 5 75. Year Cash Abandonment flow value Sh`000' Sh`000' 74 The .000 X2 + 100... However.038 4 75..Max Z = 98.. X2.951 3 100.000 X3 + . Consider the following example: Project A has the following cashflows over its useful life of 3 years.395 500. X8 > 0 The Optimal Budget: Project Cost NPV 2 250. X3 .000 135.000 3. + 250.038 X3 + 16.000 X1 + 250. Any project should be abandoned when the net abandonment value is greater than the present value of all cash flows beyond the abandonment year.802) X8 400.895 X1 + 87..000 16.000 2 = 1 < X1. + (3. discounted to the abandonment decision point. 750 X PVIF 10%.800 Sh -255 If abandoned after 2 years NPV = 2.750 x 0. 2years + 1.000 x 0.751 .800 = Shs -119 The project should not be accepted.826 . Suggested Solution: If the project is used over its life.909 + 1.000 x PVIF 10%.800) 4.909 + 3.875 X PVIF 10%. if the project is abandoned after 1 year the NPV would be NPV = = 2.0 (4.875 1.875 x 0.4.909 + 1.750 0 Required: Determine when to abandon the project assuming a discount rate of 10%.826 + 1.900 x 0.800 = 2.000 x 0.875 x 0. 2 yrs - 4. the NPV is negative as shown below: NPV = 2.4.000 2 1.826 + 1.909 . 1year + 1.800 = Sh 136 75 .000 x 0.4.000 3.800 1 2.000 x 0. However.900 3 1. as our example illustrates. The basic assumption in financial theory is that most investors and managers are risk averse. Attitudes towards Risk Three possible attitudes towards Risk can be identified. Note that abandonment value should be considered in the capital budgeting process because. Given a choice between more and less risky investments with identical expected monetary returns. Risk Analysis in Capital Budgeting The Risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project. These are: (a) Risk aversion (b) Desire for Risk (c) Indifference to Risk A Risk averter is an individual who prefers less risky investment. there are cases in which recognition of abandonment can make an otherwise unacceptable project acceptable. Risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently. they would prefer the riskier investment. This type of analysis is required to determine projects economic life. 76 .Risk seekers on the other hand are individuals who prefer risk.The NPV is positive if the project is abandoned after 2 years and therefore this is the optimal decision. cannot make any correct prediction about the cashflow sequence. 2) Sh 600.000 (0. However. Project B on the other hand is a less risky project since we are sure that Sh 600. 77 .The person who is indifferent to risk would not care which investment he or she received.000.000 600.000 (0.000 600.2 Moderate prediction 600.6 Pessimistic prediction 300.000 600.000 0.000 (0.000 will be received.2 Optimistic prediction The expected cashflow would be computed as follows: Project A Expected cashflow = = 900.000).6) + 600.000 0. Project A is a riskier project since there is a chance that the cashflow will be Sh 300. To illustrate the attitudes towards risk assume two projects are available.000 Project B Expected cashflow = = 600.000 0.000 (0.000 Therefore. States of nature Project A's Project B'sProbability cashflow cashflow Sh 900. The cashflows are not certain but we can assign probabilities to likely cashflows as shown below.000 (0.2) + 600.000 (0.2) Sh 600. the two projects have the same expected cashflows (Sh 600.2) + 600.6) + 300. 2 The expected value which is a weighted average of the outcomes times their probabilities can be computed as follows: 78 . Two important measures are: (a) Standard deviation of cashflows (b) Coefficient of variation (c) The Beta (ß) can also be used and is dealt with under Portfolio Analysis To illustrate the first two methods.6 Optimistic 900 0. A risk neutral decision maker would be indifferent between the two projects since the expected cashflows are equal. Assumptions (states of nature) Outcome Sh`000' Probability Pessimistic 300 0. let us assume that we are examining an investment with the possible outcomes and probability of outcomes as shown below: Note: the outcome could either be cashflow or NPV. Actual Measurement of Risk A number of basic statistical devices may be employed to measure the extent of Risk Inherent in any given situation.A risk seeker would choose Project A while a risk averter would choose Project B.2 Moderately successful 600 0. 6 0 0 0 900 0.000.000 18.Expected value (D)= ΣDP Where D is the outcome P is the probability D is the expected outcome Figures in `000' D P DP 300 0.2 -300 90. Standard Deviation ( ) = (D .000 600 0.000 79 .D ) (D .D )† P Computation of standard deviation D P (D .000 18.2 180 ΣDP 600 The expected value is therefore Sh 600. which is given by the following formula.000 36.D )2 x P 300 0.D )2 (D .2 60 600 0.2 300 90.6 360 900 0. We can therefore compute the standard deviation. 000=SH 190. However.000 gives a rough average measure of how far each of the three outcomes falls away from the expected value. 80 . Generally.Standard Deviation ( ) = = (D .V) The coefficient of variation is a relative measure and is given by the following formula. Project Expected value Standard deviation A Sh 6. the greater the risk. Consider. we need a different measure since standard deviation would not do. is a more risky project we need to compute the coefficient of variation (C.000 600 B Sh 600 190 To decide which of the two projects. to compare projects of unequal size.000 The standard deviation of Sh 190. for example two projects with the following expected outcome and standard deviation.D )† P 36. the larger the standard deviation. Project B carries a greater risk than Project A. on an individual stock relative to a stock market index of returns. Another risk measure. the coefficient of variation can be computed as follows:Project A CV = 600 = 0. Beta measures the volatility of returns. Some of these methods are: (a) Payback period (b) Risk-adjusted discount rate 81 .317 600 Generally. Incorporating Risk in Capital Budgeting Several methods can be used to incorporate risk into capital budgeting decisions. the beta (ß) is widely used with portfolios of common stock.For investments Projects A and B discussed earlier. (Note: Beta will be discussed under portfolio analysis).100 6.000 Project B CV = 190 = 0. Therefore. the greater the risk. the larger the coefficient of variation. say three or five years. This method suffers from the following limitations: (a) It ignores the time value of cashflows (b) It does not make any allowance for the time pattern of the initial capital recovered (c) Setting the maximum payback period as two. firms using Payback period usually prefer short payback to longer ones.The NPV of the project will be given by the following formula. As discussed earlier. and often establish guidelines such that the firm accepts only investments with some maximum payback period. three or five years usually has little logical relationship to risk preferences of individuals or firms. A project that carries a normal amount of risk and does not change the overall risk composure of the firm should be discounted at the cost of capital. 2. Investments carrying greater than normal risk will be discounted at a higher discount rate.(c) Certainty equivalents (d) Sensitivity analysis (e) Statistical techniques 1. Payback Payback period is an attempt to allow for risk in capital budgeting. 82 . Risk-adjusted discount rate This approach uses different discount rates for proposals with different risk levels. C.V) 83 . Risk is assumed to be measured by the coefficient of variation.n Ct t Io t=1 (1+ K ) NPV = Where Ct is cashflows at period t K is the risk adjusted discount rate Io is initial cash outflow (cost of project) Note that Kf + φ Where Kf = the risk-free rate = the risk premium φ The following diagram shows a possible risk-discount rate trade off scheme. (c) It incorporates an attitude (risk-aversion) towards uncertainty.20.0.90. Advantages of Risk-adjusted discount rate (a) It is simple and can be easily understood. of 1. This is an example of being increasingly risk averse at higher levels of risk and potential return.V. for example. of 0. of 0. of 0.V.V.90 0. it will now add another 5% risk premium for this additional C. a risk premium of 5% is added for an increase in C.20 .30.60 (0. a C. 84 .30). (b) It has a great deal of intuitive appeal for risk-averse businessmen.V.30 (1.90). As the firm selects riskier projects with. If the firm selects a project with a C. Notice that the same risk premium was added for a smaller increase in risk.The normal risk for the firm is represented by a coefficient of variation of 0. An investment with this risk will be discounted at the firm's normal cost of capital of 10%. The coefficient are subjectively established by the decision maker and represents the decision maker's confidence in obtaining a particular cashflow in period t. Therefore. (b) It does not make any risk adjustments in the numerate . a lower αt will be used if greater risk is perceived and a higher αt if lower risk is anticipated.for the cashflows that are forecast over the future years. 3. 85 .The certainty equivalent coefficient can be determined by the following formula. Certainty Equivalent Using this method the NPV will be given by the following formula: n t Ct t Io (1 + Kf ) t=0 NPV = Where Ct αt = = Forecasted cashflows (without risk adjustment) the risk-adjusted factor or the certainty equivalent coefficient Io = Initial cash outflow (cost of project) Kf = risk-free rate (assumed to be constant for all period).Disadvantages (a) There is no easy way of deriving a risk-adjusted discount rate. The certainty equivalent coefficient assumes a value between 0 and 1 and varies inversely with risk. (Not all investors are risk averse as discussed earlier). (c) It is based on the assumption that investors are risk averse. 8 100.30 The risk-free discount rate is given as 10% Required 86 .αt = certain net cashflow risky net cashflow For example.50 α4 = 0.90 α2 = 0.000 Assume also that the certainty equivalent coefficients have been estimated as follows: α0 = 1.000 Illustration: Assume a project costs Sh 30.000 = 0. the αt will be: αt = 80.000 and yields the following uncertain cashflows: Year Cashflow 1 12.000 2 14. if an investor expects a risky cashflow of Sh 100.000 in period t and considers a certain cashflow of Sh 80.70 α3 = 0.000 3 10.000 4 6.000 equally desirable.00 α1 = 0. 5 (10.826 8.000) 30.751 3.8 3 0.000) + 0.000 1 + 0.7 (14.1)4 Using the present value interest factor tables: Year Certain Cashflows PVIF10% 0 (30.3 (6.229.000) 1 PV 1.909 9.000) + 0.9 (12. Merits of certainty equivalent approach 87 .080 and the project would have been accepted.9 (12.103.0 4 0.00 (30.5 (10.000) 0.000) 0.755.3 (6.4 NPV (7.000) 0.1 (1 + 0.1)² (1 + 0.817.Compute the NPV of the project Solution: n t Ct t Io t=0 (1+ Kf ) NPV = = - 0.683 1.2 2 0. Note that if risk was ignored the NPV would have been Sh 4.000) + 0.7 (14.000) 0.1)3 (1 + 0.6) The project has a negative NPV and therefore should not be undertaken.000) 0.094. the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. may inflate them in anticipation. 3. Definition of the underlying (mathematical) relationship between variables. Identification of all those variables which have an influence on the projects NPV. the more critical the variable. 88 . Sensitivity Analysis Sensitivity Analysis is a way of analysing change in the project's NPV for a given change in one of the variables affecting the NPV. 2. This method explicitly recognises risk. It recognises that cashflows further away into the future are less certain (therefore a lower αt) Demerits 1. When forecasts have to pass through several layers of management. Steps followed in use of Sensitivity Analysis 1. 2. Sensitivity Analysis allows the decision maker to ask "what if" questions. 2.1. It indicates how sensitive the NPV is to changes in particular variables. The forecaster. expecting the reduction that will be made to his forecasts. 3. Analysis of the impact of the change in each of the variables on the projects NPV. The method of determining αt is subjective and is likely to differ from project to project. The more sensitive the NPV. 000 Before tax profit 30.000 = Sh 34. In order to do so we must obtain pessimistic and optimistic estimates of the underlying variables.000 After tax profits 15.000 Tax (50%) 15.000. price.000 x PVIFA 10%. 10 yrs . However.145 . The NPV of the project is: NPV = 30. cost etc.000 = 30.000 x 6.To illustrate let us consider an example.000 Add back depreciation 15. 89 .000 and an initial cost of Sh 150. A project has annual cashflows of Sh 30.000 345. The useful life of the project is 10 years.150. the investor should consider how confident he is about the forecast and what would happen if the forecast goes wrong.000 The cost of capital is 10% and depreciation method is straight line.000 Depreciation 15.000 Variable costs 300.000 Fixed costs 30.150.000 Net annual cashflows 30. The cashflows can further be broken as follows: Sh Revenue 375.350 The NPV is positive and therefore the project is acceptable. A sensitivity can be conducted with regard to volume. 712.000 Unit variable costs (Sh)3.000 11.000 10.393.750 3.004 0.5 34.462.350 57.625 34.000 2.600 Fixed costs (Sh) 40.912. the variables used in the forecasts are: (a) Volume of sale ( = market size x market share) (b) Unit price (c) Unit variable costs (d) Fixed costs Assume further that the pessimistic.000 The resulting NPVs would be: NPV in shillings Pessimistic Expected Optimistic Market size 11.5 3.162.500 3.075 Fixed costs 90 .5 Unit variable cost -150.350 49.016 Unit price (Sh) 3. expected and optimistic estimates are: Variable Pessimistic Expected Optimistic Market Size 9.01 0.75 Market share -103.Assume that in the above example.350 65.000 Market Share 0.750 30.350 172.800 3.306.350 11.5 Unit price -42.612.000 34.25 34.5 34.000 20. 250 NPV = = 26.000270. Therefore the most sensitive factor is the unit variable cost.Note that NPV under this category is: Revenue = Sh 3.150.000 (9.000 22.5. 91 .250 Add back depreciation 15.600 (and all other variables are as expected). then the project has an NPV of -150.500 Variables cost = 3.004 (and all other variables are as expected). If the market share is 0.25 It is important to note that only one variable is allowed to vary at a time and all the others are held constant (at their expected values).500 11. followed by market share and unit price follows. It has been assumed that a negative pre-tax profit will be reduced by tax credit from the government.750(9.250 Less tax 11.750337.250 X 6.01) = 90 x 3.000 x 0.912.01) = 90 x 3.000 Sh 11.000 Net cashflows 26.000.500 Less Fixed costs + Depreciation 45.145 .000 x 0.306. Market size and fixed costs are not very sensitive. If unit variable cost is Sh 3.000 Contribution margin 67. From the project the most dangerous variables appear to be market share and unit variable cost. then the project's NPV is -Sh 103. 100 V) 0. 10 yrs .000) 6.000 .50 V + 15.000 At Break even point NPV = 0 Therefore (165.000 .106.000)0.depreciation Tax + depreciation. what shall be the consequences if volume or price or cost changes? This question can be asked differently: How much lower the sales volume can become before the project becomes unprofitable? To answer this question we shall require the Breakeven point.5 + 15. Let variable cost per unit be V Annual cashflows = (375. let us compute the level of units variable costs above which the NPV is negative.145 .100 V = 3.variable costs .150.111.150.Break-Even Analysis Sensitivity analysis is a variation of the break-even analysis. In sensitivity analysis we are asking.8 92 .000 307. NPV = Annual cashflows x PVIFA 10%. for example.000] x 6.5 + 15.25 V = 956.307.Fixed costs .100 .000 Therefore NPV = [(330.000 1.145 = 150.25v = 150. Continuing with the above example.100 (V) .000 .45.000 But Annual cashflows = Revenue . 000 Variable costs 311.000 356.145 .112 the NPV will be computed as follows: Sh Revenue 375.112.400 NPV = 24. It compels the decision maker to identify the variables which affect the cashflow forecasts.800 Tax 9.000 = -62 Note: The NPV is not equal to zero due to rounding off effects.200 Fixed cost 30.000 Net cashflows 24.400 9. Advantages and disadvantages of Sensitivity Analysis Advantages 1. 93 . To prove if variable unit cost is Sh 3.400 x 6.150.400 Add back depreciation 15. This helps him in understanding the investment project in totality.Therefore the point above which the variable cost per unit will cause the NPV to be negative is about Sh 3.200 18.000 Depreciation 15. 2.Fixed costs ix. we can use simulation to approximate the expected return for an investment proposal. Market growth rate iv. Useful life of project 94 . Market size ii. Selling price iii. The terms optimistic and pessimistic could mean different things to different people. Disadvantages 1. It helps to expose inappropriate forecasts and thus guides the decision maker to concentrate on relevant variables. Thus simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions. It does not provide clear cut results. A SIMULATION APPROACH TO CAPITAL BUDGETING UNDER RISK In considering risky investments. 3. Share of market v. 2. The decision maker can consider actions which may help in strengthening the "weak spots" in the project. It fails to focus on the interrelationship between underlying variables. For example sales volume may be related to price and cost but we analyse each variable differently. Cost of the project vi.The results of an investment proposal are tested before it actually occurs. Example of these factors are: i. Operating costs viii. It indicates the critical variables for which additional information may be obtained. Each of the factors affecting the projects NPV are assigned probability distributions. Residual value vii. 3 80.000 0.5 100.000 0.000 0. the average rate of return resulting from a random combination of the above nine factors is determined.5 120.000 0.000 0.Required: Determine: (a) The projects expected monetary value (EMV) (b) The projects NPV 95 .000 0. A simulation model relies on repetition of the same random process as many times as possible.000 0.3 60.000 0. DECISION TREE FOR SEQUENTIAL DECISIONS Illustration: A project has the following cashflows Year 1 Year 2 Cashflow Probability 60.3 0.2 80.000 with a cost of capital of 12%.2 The projects initial cash outlay is Sh 100.000 0.3 100. This sensitivity testing allows the planner to ask "what if" questions.5 70.Once the probability distributions are determined.3 Cashflow Probability 50.2 60. A computer can be used to carry out simulation trials for each of the above factors.4 0.000 100.000 80.000 0. One of the benefits of simulation is its ability to test various possible combination of events. 96 . 2. Utility Theory When discussing the expected value and the standard deviation we noted that decision makers can either be risk seekers. or a project with comparatively low expected return and low standard deviation. analytical form. It clearly brings out the implicit assumptions and calculations for all to see.7 . The decision tree can become more and more complicated as more alternatives are included. The decision tree allows a decision maker to visualise assumptions and alternatives in graphic form.7 Merits of decision tree 1. which is usually much easier to understand than more abstract.Utility theory aims at incorporating the decision maker's preference explicitly into the decision procedure. We can graphically demonstrate the three attitudes towards risk as follows: 97 . 2. Demerits 1. risk averse or risk neutral. We assume that a rational decision maker maximises his utility and therefore would accept the investment project which yields maximum utility to him. we cannot be able to tell with certainty whether a decision maker will choose a project with a high expected return and a high standard deviation. so that they may be questioned and revised.000 = 33. Therefore.NPV = 133.850.100. It cannot be used for dependent variables.850. 98 . and that each successive identical increment of wealth is worth less to him than the preceding one . For a risk neutral decision maker. Illustration: Derivation of utility functions 99 .For a risk seeker.in other words. This curve indicates that an investor always prefer a higher return to a lower return.Note that utiles is a relative measure of utility. the marginal utility for money is positive but declining. we let him consider a group of lotteries within boundary limits. For the risk averse decision maker. To derive the utility function of an individual. the marginal utility is positive but constant. the marginal utility is positive and increasing. the utility for wealth curve is upward-sloping and is convex to the origin. 7(0.6 chance of receiving Sh 100.3 chance of receiving Sh 0 and a 0. The utile value for Sh 21. Sh 0 and Sh 100.5 chance of receiving Sh 100.4 U(Sh 33.000 is U(Sh 63.000 for this lottery.7 chance of receiving Sh 33. The utile value of Sh 63.000.5) = 0. U (Sh 21.000) = 0.000. Next.Assume that utiles of 0 and 1 are assigned to a pair of wealth representing two extremes (say.5 + 0.6 U(Sh 100. consider a lottery providing a 0.4 x 0. Assume that the decision maker is willing to buy this lottery at Sh 63.000) + 0.000).000 is also offered.000 can be computed as follows.3 U(Sh 0) + 0.000.8 Assume also a lottery providing a 0.5 chance of receiving no money and 0.7 U(Sh 33.000 respectively).5 utile = Sh 33.6 x 1 = 0. (Therefore 0.4 chance of receiving Sh 33.3 x (0) + 0.000) = (0.000) = 0. To determine the utility function of a decision maker. 12. we offer him a lottery with 0. The decision maker is willing to pay Sh 21.000) = 0.000 and a 0.35 Note that other lotteries can be provided to the decision maker until we have enough points to construct his utility function. Assume he is willing to pay Sh 33.2 Expected utility of an investment 100 .000 for this lottery. 60 0. Illustrations: Consider two investments that have cashflow streams and assonated probabilities. Using the utility values (utiles) the expected utility value is computed as follows: 101 .60 80.000 0.000 For Project B -25. Cashflows 0.20 Project B Utiles -0.80 0.20) + 50.000 Prob. we can calculate the expected utility of an investment.10 0 0.20) = Sh 42.000 (0.50 100.000 (0.20 The expected monetary value for Project A is -20.000 (0. 0.6) + 80.50 0. This calculation involves multiplying the utile value of a particular outcome by the probability of its occurrence and adding together the product for all probabilities.000 0.000 1. Project A is preferred then Project B. Project A Cashflows Utiles Sh-20.500 Using the expected monetary value.000 (0.000 0 0.000 x (0.10) + 0(0.10) + 60.Once your utility function is specified.10) + 0 (0.000 0.50 0 -0.10 0 60.50) + 100.00 0.10 Sh -25.20) = Shs 50.000 (0.25 Prob.20 50. Advantages of utility approach 1.10 Prob.20 0.80 0.10 0 0 0.Project A Utile Project B Prob. If the decision is taken by a group of people it is hard to determine the utility functions since individuals differ in their risk preferences. 2.25 0.25 0.02 -0.50 0. It facilitates the process of delegating the authority for decision.60 0.Weighted Utile Utility -0. It is hard to determine the utility function (it is subjective).20 0.025 0 0. The risk preferences of the decision maker are directly incorporated in the capital budgeting analysis.16 1. 102 . Limitations 1.20 0. 3.425 Using utility values Project A should be accepted since it has a higher utility value.20 0 0.60 0.20 Expect utility value 0.54 0. 2.36 0.00 0.10 -0. The derived utility function is only valid at a point of time.50 0.Weighted Utility -0. e. Therefore the firms cost of capital will be the overall. It is a yard-stick against which the viability of an investment is measured. Therefore the firms cost of capital is not the same thing as the projects cost of capital. Cost of finance will also be used to assess the company’s 103 . The cost of capital is the discount rate used for evaluating the desirability of an investment project in the IRR . It is the minimum required rate of return on the investment project. 2. If the cost of finance is more than the return expected from such a venture. or required rate of return on the collection of investment projects. or average. the firm aims to minimizing the overall cost of capital. proportion of debt and equity in the capital structure. EVALUATING INVESTMENT DECISION 1. The investment project is accepted if the NPV is +ve in this case the COC is the minimum required rate of return on an investment project or the certificate or the target or the handle rate. It keeps the present wealth of shareholders unchanged. such a venture is deemed to be not viable and the reverse is true. Thus the cost of capital is the required rate of return on the various type of financing the overall cost of capital is the weighted average of the individual rate of return (costs) Importance of cost of finance The cost of capital is a useful standard for: 1.TOPIC 5: COST OF CAPITAL A firm can be viewed as a collection of projects undertaken by it. DESIGNING A FIRMS DEBT POLICY In designing the financing policy i. In other words. 3.capital structure and whether this is optimum capital at which the cost of finance is lowest or optimum. 4. GAUGING THE AVAILABILITY OF FINANCE The average cost of finance is used to gauge the availability of finance. DETERMINING A COMPANY’S SHARE PRICES The cost of finance in particular dividends on share capital will have a lot of influence on the company’s share prices which will be high if the dividends are high and this will affect the company’s ability to raise extra finance be it in form of debt or equity finance 5. This means that if the cost is quite high. Factors that will influence the Cost of Finance 1. The term of finance Usually short-term sources of finance are more expensive than longterm source of finance. APPRAISING THE FINANCIAL PERFORMANCE OF THE TOP MANAGEMENT This will involve a comparison of actual profit abilities of the investment projects undertaken by the firm with the projected overall cost of capital and the appraisal of the actual costs incurred by management in raising the required funds. 2. Economic conditions prevailing 104 . OR It is used to assess the ability of the company’s management to utilize the financial resources at its disposal to generate profits. this will make it difficult to raise the necessary finance needed for the company’s operations. This situation will affect the company’s investments and thus its growth. Due to these risky situations to which they are exposed. lenders will charge high rates of interest to make up for the risk they have exposed their investments to. lenders view small firms as very risky given that most of them are sole proprietors which close down the death of the owners. On the other hand the effective cost of share capital is not tax allowable and as such will be relatively higher than of that of debt finances. Nature and size of the business Small firms usually lack of the necessary securities/good will to allow them to negotiate for better terms. This will make the cost of debt finance expensive. The Government through the Central Bank will also influence the cost of finance in particular debt finance this may be done to control liquidity in the hands of the public in a bid to contain inflation. Under these conditions. e.Usually during inflation the cost of finance in particular debt will be high.g. lenders will charge high interest rate to avail such scarce finances. 4. 105 . 5. the central bank may instruct the commercial bank to increase the bank rates so as to make borrowing very expensive so as to encourage customers deposit in terms of saving. if interest rate is 12% and a tax is 50%. Effect of taxation debt finance carries an interest rate which is an expense chargeable to the company’s profit and loss account and as such the effective cost of debt will be lower by the much of tax interest. 6. This is so because banks will usually adjust their rates of interest to accommodate the loss of value of the purchasing power of a given currency due to the effects of inflation. 3. then the effect cost of debt will be equal to 12% less 50% of 12% = 6%. moreover. Availability of Finance Under conditions of credit squeeze or other conditions that limit the availability of finance. Nature of security This will affect the implicit costs. The cost of debt capital already issued is the rate of interest (IRR) which equates the current market price with the discounted future cash receipts of the security. Cost of Different Types of Funds 1. A debenture may be issued at per or at a discount or premium. such implicit cost will not be warranted. these will have to insured comprehensively and this will increase the implicit cost of such finance. On the other hand.7. COST OF DEBT Debt may be raised through. Will go into perpetuity. mature companies will pay high dividends as they will have reached their highest level of growth and thus profitability. (i) Irredeemable debt This is a debt with no maturity. 8. On the other hand if the security was land. borrowing funds from financial institutions or debentures (bonds) for a specified period of time at a certain rate of interest. Recall that MV i r MV OR i Kd Therefore : Kd i MV Where Kd = cost of debt MV = issue price of debt/market price of debt. 106 . Usually if the security is a depreciable asset like buildings. Growth stage of the company Growing company will pay fewer dividends and will retain more so as to plough back retained profit to acquire fixed assets. ... if the debenture is redeemable after 10years.650 100 0. calculate the cost of this capital... i £10 x 100 =£ 10 £100 £10 x 100 £90 = 11..00 107 .+ (1 K d ) (1 K d ) (1 K d ) n MVn = Amount Payable on redemption on year n...... YEAR Discount factor.......000 10 5.. MV i MVn i i 1 + 2 +………….. like getting the IRR....322 (90. 0 Cash Flow Try 12% PV (£) Market Value (90) 1.....i = interest = issue price x interest rate EXAMPLE 1 Owen Allot Ltd has issued 10% debentures on of a nominal value of £100.. we get the Kd using trial and error. The market price is £ 90..50 10 Capital Repayment 32.. (1 K d ) (1 K d )2 (1 K d )10 Here...1% (ii) Redeemable Debt Here the interest will be received in the year of redemption plus the amount payable On redemption..00) 1.10 Interest 56. Calculate the cost of debt if the debenture is irredeemable Kd i MV i MV Kd Interest. Using example 1 above. 90 10 10 10 100 ... Example 108 .09 4.30) Try 11% Discount factor PVs (£) (90) 1. Kd 1 1 ( FV MV ) 10 (100 90) 11 n 10 X 100 11.56% 1 1 95 ( FV MV ) (100 90) 2 2 i Debt capital and taxation Interest on debt capital is an allowable deduction for taxation.09 1.interest i.30) (12 11) 11.89 100 0.76% Short cut. K d 11 ( 4. t = rate of corporation tax.e.20 4.000 (90.09 Thus the cost of debt. This is a tax relief on interest.00) 10 5.352 35. after payment of current interest.889 58. (iii) After tax cost of irredeemable debt capital is Kd i (1 T ) MV Where Kd = cost of debt capital i = Annual Interest payment MV= Current market price of debt capital ex.(1. A company pays £10,000 p.a interest on irredeemable Debt Stock with a nominal value of £100,000 and market price of£ 80,000 and corporation tax rate is 35%. Calculate the cost of debentures? Kd i (1 T ) 10,000(1 0.35) 1(0.65) 0.08125 8.125% = 80,000 8 MV The higher the corporation tax the greater the tax benefits having debt finance compared with equity finance. N.B In the case of redeemable debenture, capital repayment is not allowable for tax. Example Assume the same facts as example 1 for Owen PLC except that the market price is 95% and the debentures are redeemable at per after 3yrs. Calculate the Kd assuming corporation tax 35%. Yr MV (£) Interest (£) Tax Relief (£) Flow (£) 0 (95) (95) 1 10 2 10 (3.5) 6.5 10 (3.5) 106.5 - (3.5) (3.5) 3 100 4 10 COST OF PREFERENCE CAPITAL. (i) Irredeemable preference share Cost kp; Kp PDiv Po Where Kp = Cost of preference share PDIV = Expected preference divi dend 109 Net Cash Po= Issue of preference share Example A company issues 10% irredeemable preference share. The face value per share is £ 100 but the issue price is £ 95. What is cost of preference share? RECALL, MV D r And r Div Kp (ii) D MV 10 x 100 £10 100 10 0.1053 95 Therefore, or 10.53% Redeemable Preference Shares This is a preference share with finite maturity. A formula similar to the one for calculation of the market value of redeemable debt is used: n MV Po t 1 DIVt Pn t (1 K p ) (1 K p ) n The cost of preference share is not adjusted for taxes are because preference dividend is paid after the corporate taxes have been paid. COST OF EQUITY CAPITAL. New funds from equity shareholders are obtained in one of two ways; (a) from a new issue of share }External Equity (b) from retained earnings }Internal Equity (c) (i) Cost of Retained Earnings ( Internal Equity) The opportunity cost of capital of internal equity is the dividend foregone by stockholders. The cost of retained earnings will be the same as shareholders required rate of return. 110 The dividend – valuation model for a firm whose dividends are expected to grow at a constant rate g , is as follows, MV Do (1 g ) Ke g DIV1 Ke g NB: D1 = Do (1+g)1 D2 = Do (1+g) 2 Dn = Do (1+g)n Where D1 = dividend at the end of year 1 Ke = shareholders required rate of return/Cost of Equity g = growth rate in dividends Thus, Ke DIV1 g MV Ke DIV1 MV Where there is no growth in div, This growth model is called Gordon’s growth model Example The share of a company is currently selling for Kshs. 100. The company wants to finance its capital expenditure of Kshs. 10,000 either by retaining earnings or selling new shares. If the Company sells new shares, the issue price will be Kshs. 95, the div per share next year, DIV 1 is Sh.4.75 and it is expected to grow at 6%. Calculate:(i) The cost of internal equity (retained earnings) Ke = DIV1 + g = sh.4.75 + 0.06 = 0.1075 or 10.75% MV (ii) Sh.100 Cost of External Equity This is the minimum required rate of return by equity shareholders. 111 Ke = DIV1 +g MV NB: Shareholders required rate of return from retained earnings and external equity is the same! However, the cost of external equity is greater because of floatation cost/issue costs. Thus the selling price of new shares may be less than the market price. Thus the cost of external equity can be written as;Ke = DIV1 +g where f = floatation cost. MV-f Ke = DIV1 +g where Io= Issue price of new equity. Io Example In the example above calculate the cost of external equity; Ke= 4.75 + 0.06 95 = 0.05 + 0.06 = 0.11 or 11% Estimating growth rate Recall that, Ke = DIV1 + g Ke = Do(1+g) + g MV Thus, MV DIV1 = Do (1+g)1 112 Therefore DIV2= Do (1+g)2 DIVn = Do (1+g)n Where DIVn = dividend in year n And n = No of years before the dividend is paid g= growth rate Example: The dividend earnings of HL Ltd over the last 5 years is as follows; Year Dividend (E) Earnings (t) 1991 150,000 400,000 1992 192,000 510,000 1993 206,000 550,000 1994 245,000 650,000 1995 262,350 700,000 The company is financed entirely by equity and there are 1 million shares is issued cash with a market value of £3.35 ex-div (i) What is the cost of equity Solution Ke = DIV1 +g MV DIV in 1991 x (1+g)4 = DIV in 1995 150,000 (1+g)4 = 262,350 113 26235(1 0.0.350 = 1.14999 g = 1.749 1+g = (1. Expected Return = Rf rate + Rp Thus. = Rf + (Rm – Rf) Bi Therefore Ke = Rf + (Rm – Rf) Bi This is because the shareholders required rate of return is also the firm’s cost of equity.14999 – 1 g = 0.24 or 24% COST OF EQUITY CAPITAL AND CAPM Based on the CAPM.15 3.35 262350 1000 000 = 0.14999 = 14.749) ¼ = 1+g = 1. The Wacc – Weighted Average Cost of Capital Once the component costs have been calculated.Therefore (1+g)4 = 262. they are multiplied by the weights of the various sources of proportions of each source of fund in the capital structure. 114 . Ri.15) 0.000 (1+g)4= 1.749 150.999% or 15% Ke DO (1 g ) g MV DO DIVIDEND PER SHARE . is financed partly by equity and partly by debentures. iii) WACC = K1 W1 + K2 W2 + K3 W3 + --------------------------- Where k1 and K2 are component costs and W1 and W2 are the weights of various types of capital employed by the company. Calculate the WACC. etc) ii) Multiply the cost of each source by its proportion in the K structures. Kd. Source of capital Proportion Cost Weighted Cost WACC Equity Debt 2/3 1/3 18% 12% 2/3 x 18 1/3 x 12 = WACC= Or WACC= = 12% 4% 16% Wd Kd + WeKe = 1/3 x 12 + 2/3 x 18 = 4 + 12 = 16% EXAMPLE 3 The following is the capital structure of a firm: Source Amount (sh) Equity Share capital 450. The equity proportion is always kept at 2/3 of the total.000 45% Retained earnings 150.000 10% 115 Proportion (%) .000 15% Preference share capital 100. EXAMPLE 1 Prudence Co.STEPS INVOLVED IN CALCULATING WACC i) Calculate the cost of specific sources of funds ie (Ke. The cost of Equity is 18% and that of debt is 12%. Cost of Preference Shares= Cp= DP x 100 PP Dp =1 x100=6.a. 2 per share is expected by shareholders. 10/- Shs. 15 Shs. a geared company has financed its activities as follows.000 Revision Questions Company XYZ. 25 Shs.e weighting approach and percentage approach) Answer Weighting Approach The company’s capital structure is as follows (currently) .Debt 300. 400.Ordinary shares. These dividends have been growing at 3% p.67%. 15.Ordinary shares are currently quoted at Shs.100 000 shares @ Shs 10 40 000 8% debentures (par value Shs. 000 10% preference shares 50 000 @ Shs.650. 750 000 Total Capital Employed (TCE) Shs 3. Preference Shares currently sell at Shs.000 30% 1. 116 .000 Cost of equality= Ce = Do x 100 +g Po = 2 x 100 +3% 25 =8+3=11%. 10 Also the following information is provided. Tax=40% REQUIRED Compute the weighted average cost of capital using the two methods (i.Ordinary shares. 25 and dividend of Shs. 10/) 50 000 10% preference share of Shs.100 000 @ Shs. 000 8% 40 000 debentures @ Shs.000. 2 500. 000 20.650.4307 Percentage approach Cost of equity = 2.6) X 100 Kd 0.000 68. 000 x 6.55% 6.8 % = 19. 500.500.048 OR 4. it is assumed that the company has been in existences for sometimes which implies that floatation costs were incurred at the time of issuing the shares All the formulae will give percentage costs where the g = Ce =% of total equity (i.8% Source amount proportion after tax Weighted Cost Ordinary 2. in this case where there the no is cost of ordinary share capital) 117 .4) X 100 100 (0.8% 0.4308% 3650000 Current Retained Earning Opening equity x 100 NOTE: where there is growth in equity.8(1 0.5261% 3.e. 025 Cost of debentures = 400. 000 Cost of preference share capital =750.15 Cost of debentures = Cd = bcd (1-t) x 100 Kd Bcd 8 x10 80cts 100 0. 200 344 245 TCCE TCE WACC= To get g = X 100 = 344225 X 100 = 9.000 100% 9.49% 11% 7.67% 1. 000 x 11% = 275. 000 10.8 X 0.5339% Preference 750.3707% Debentures 400. 000 x 4.67 % = 50.96% 4. then the cost of preference share capital will be: = Cp =DP x 100 where f = floatation cost pp – f Cost of debt (before tax) = bcd = I x debt finance used where tax is ignored giving allowance for tax = Cd = bcd I – t x 100 OR bcd (I x 100 (I .(d) Cost of retained earning has no explicit cost but opportunity cost which is that dividend the shareholders have forgone to allow retention .thus the cost of retained earnings will be the same as the cost of equity: Cr Do X 100 g Po where Cr = cost of retained earning (e) In case Ey is given then the cost of ordinary share =EPS x 100 => Ey approach Po . This is the dividends due to preference shareholders. but these are fixed.f Loan finance = Kd = I (1-t) =% cost (a) Cost of preference share capital.t)) pd – t Pd – f Where cd = after tax cost of debt bcd = before tax cost debt Pd = market price of debt 118 . Thus the cost of preference of shares: = Kp Pdiv X 100 Pp Where Kp = cost of preference share Pdiv =dividend for preference share pp = price per share (market) (b) If the company has incurred floatation costs to raise preferences shares. 150 which carry a dividend of 16% 3. 100 with a floating cost of shs.4) x 100 Pd 80 bcd = 10% of 100 = Shs.667% Pp 150 Cost of debentures = Cd = bcd (1-t) x 100 = Cd = 10(1-0.5% 80 119 retention.000 shs. 12% debentures with issue cost of shs. 1. Example 3 Information obtained from the books of Havabley and Edwin Ltd indicated that. This company sold 10. 50. 15 This company hopes to earn a return on the above finances of 18%.000 preferences shares of shs. Tax = .000 shs. 100 at shs. 20 each 2. It sold 10. 10 = 10 (0. Required: Compute the total cost of ordinary share capital assuming that there will be 40% Answer Cost of preference share capital DP= 16% of 100 = Shs. it is advisable to combine them into equity. It sold 5.6) x 100 = 7. 100 10% debentures at shs.I = interest rate This formula is used to determine the cost of debenture finance Cost of loan finance = cd = I(I-t)=% Where I = interest rate. t = tax NOTE In case computing the cost of ordinary share capital and reserve. using the market approach. 80 4. It sold 5.000 ordinary shares at shs. 16 PP= 150 = Cp = Dp x 100 = Cp = 16 x 100 = 10. 2857% 1.30% 10.9399% 2.090% + 0.99% .15 = 6(0.86% 10.000 28.377x% Preference 750.09% 7. Cost Cost Ordinary 1.9094% =31.Pd=80 Cd= bcd (1-t) x 100 Pd-f bcd = 12% of 50= 6 pd = 50 f = 15 cd= 6(1-0.3774x = 11.000 6.5% 500.000 15.556% 0.2857% 35 Source Amount proportion Weighted After tax Shs.6) x 100 = 10. 000 37.3774 x = 18% 0.131% 12 debentures 1.0906% + 0. 000 18.090% 0.4) x 100 50.667% 3.3774% Proof 120 99.650.9094 % X = 11.000.74% x% 0.0189% 10% Debentures 400.377% 6.3774x= 18% -6. 556% 28.025 of 750.5% 1. 000 3.9399% 2.000 = 30.74% 31. 560 = 31.67 % = 80.86% 10.000. cost cost Ordinary 1.0189% 10% debentures 400.000 15.5 % of 400.1318% 12 debentures 500.2587% 1.09% 7.9998% =18% Using Percentage Approach Shs Cost of ordinary shares = 315.667% 11. 428.9092% Preference 750. 000 37.000.5 Total Cost of Capital Employed 477.556% of 1.2857% of 500. 650.30% 10.000 Cost of preference shares = 10. 0135 (TCCE) The Weighted Average Cost of Capital (WACC) = Total Cost of Capital Employed x 100 Total Capital Employed 121 .Source Amount proportion Weighted After tax Shs. 99% 17. 000 Cost of debt = 7.000 Cost of debt = 10. 000 18.000 99.000 = 51. Marginal cost of equity MCE = D1 x100 Po f (for zero growth firm) Also cost of equity Ke = D1 Po f (for normal growth firm) 122 . ii) The weights based on the amount to raise from each source.650.00509 18. 013. the cost of finance to the company must be weighted against expectations based on the market conditions. b) Investors purchase their investment at market value and as such.5 x 100 =18.=477. 1. Investors usually compute their return basing their figures on market values or cost of investment. c) Investments appreciate in the stock market and as such the cost must be adjusted to reflect such a movement in the value of an investment.000 Marginal cost of finance This is cost of new finances or additional cost a company has to pay to raise and use additional finance is given by:- Total cost of marginal finance x 100 Cost of finance (COF) Cost of finance may be computed using the following information: a) i) Marginal cost of each capital component.001% 2. Just like WACC. Cost of preference share capital: Kp = Dp x100 Po f Where: Kp = Cost of preference Dp = Dividend per share Po = MPS (Market price per share) F = Flotation costs 3. Cost of debenture Kd Int(1 T) Vd f Where: Kd = Cost of debt Int = interest Po = Market price for debenture (at discount) f = flotation costs t = Tax rate 4.Where: d1 = expected DPS = d0(1+g) P0 = current MPS f = floation costs g = growth rate in equity 2. weighted marginal cost of capital can be computed using: i) Weighted average cost method ii) Percentage method 123 . 18 (150. 75.000. 50.000 shares @ Sh.000 ) Loan Less floatation costs Total capital raised 124 .350.000.80 Floatation costs 1.000 3.000 shares @ Sh.000 75.16 with Sh.800 (200.000 -____ 50.16 200. The firm will issue 200.1 floatation costs per share.200.000.’000’ shares 200.150.200.000 18% loan paying total floatation costs of Sh.20 par value) at Sh.000 ordinary shares (Sh.000 12.000 Less floatation costs 200.000 1. The company paid 28% ordinary dividends which is expected to grow at 4% p.000 ) 3.000 18% debentures (sh.18 with sh.000.200 4.000 5.5.a.100 par) at Sh.000 12% preference shares (Sh.000 total floatation costs.000 3.000 Less floatation cost Debentures 3.000 debentures @ Sh. Required a) Determine the total capital to raise net of floatation costs b) Compute the marginal cost of capital Solution a) Ordinary Sh.10 par value) at Sh.80 and raised a Sh.1 Preference shares shares @ Sh. Assume 30% corporate tax rate.Example XYZ Ltd wants to raise new capital to finance a new project. 000 shares Kp = 2.04 16 1 = 0.80(1.04) 0.2.000 = Sh.20 par = Sh.1.10 par = g = 4% f = Sh.150.40 P0 = Sh.234 = 23.15 = 18 – 2 Marginal cost of debenture Kd: Kd = Int (1-t) Vd-f f = 0 125 15% .b) Marginal cost of equity Ke Ke d 0 (1 g ) g P0 f d0 = 28% x Sh.4% Marginal cost of preference share capital Kp Kp = dp P0-f dp = 12% x Sh.80 2.16 Therefore marginal = Ke Sh.2.00 P0 = Sh.00 75.40 = 0.18 f = Floatation cost per share = Sh.2. 200 23.75% 80 Marginal cost of loan Kd Kd = Int (1-t) Vd-f T = 30% Vd = Sh.Vd = Sh.9 (1-0.000 13.2 Source Amount to % Maturity raise cost before marginal f. cost costs Sh.0.9M Kd = 0.5 Ordinary Debenture 12.13% .3) = 0.2 million Int = 18% x Sh.0.0% 203.1575 = 15.550 2.’000’ Sh.3 Loan 126 13.5 million f = Sh.4% 748.5 shares 5.080.000 15.100 par= T = 30% Kd = 18(1-0.5 Preference 3.8 shares 1.80 Int = 18% x Sh.13125 = 5 – 0.13% 656.350 15.18 0.3) = Sh.75% 472.5M = Sh.’000’ 3. e. The common ratios include earning yield (E/Y).58% 12.Weighted marginal cost = 2.080. Price earning ratio.3 x 100 = 16. Shareholders – Actual owners are interested in the company’s both short and long term survival.550 TOPIC 6: MEASURING BUSINESS PERFORMANCE FINANCIAL RATIO ANALAYSIS Financial ratio analysis is a process by which finance identifies the company’s financial performances by comparing the entities in the balance sheet and those in the profit and loss account (P&L). dividend yield. Dividend pay out ratio (DPO). Users of Ratios This analysis is important to various parties with a financial stake in the company. These include: 1. assets shown in the balance sheet are responsible for sales. revenue and expenses to be found in the P&L. For this reason they will use ratio’s such as: a) Profitability ratios – which seek to establish viability. all of which will measure return to owner. 127 . This is so because balance sheet entities are usually responsible for those to be found in the P&L i. b) Dividend ratios – which seek to establish return to owners in form of dividends. 128 . For this reason they will use ratios such as: a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid test ratio. d) Investment coverage ratio – shows the company’s safety as regards the payment of interest to the lenders of the debt. The company’s viability from the investor’s point of view and the company’s ability to generate sufficient returns to investors. 3. Directors and management of company – They will therefore be interest in: a) b) Efficiency of the company in generating profits. b) Profitability ratios – used to ascertain whether the company can pay its principal back. c) Gearing ratio – used to gauge the company’s risk in the investment. Long term lenders – These include finances through loans. c) Gearing ratio to gauge the safety and risk associated with the company. mortgages and debenture holders. 4. These have both short and long term interest in the company and its ability to pay not only interest on debt but also principal as and when it falls due. These parties are interested in the following: a) Liquidity ratios – used to assess short-term liability to meet current obligations.2. Creditors (trade) – these are interested in the company’s ability to meet their short-term obligations as and when they fall due. b) Current ratio – which is a measure of company’s quantity of current assets against current liabilities. 5. Therefore. General public – Customers and potential customers – These are interested in the ability of the company to provide good services both in the short and long run. KPLC. Potential investors – these parties are interested in a company in total both on short and long term basis in particular the company’s ability to generate acceptable return on their money. profitability ratios.g. sales and returns ratio etc. To gauge the company’s ability to provide goods and services on short and long term basis. a) Dividend ratios b) Return ratios c) Gearing ratios Government – The Government is interested mostly in utility companies (e. 8. It may be interested in taxation derived from these companies which is used for development. a) Profitability ratios b) Return ratios Competitors – These are interested in the company’s performance from the market share point of view and will use the ratios that enable them to ascertain company’s competitive strength e. they will use: 6. Government may also be interested in employment level and as such it will use those ratios that can enable it to achieve such objectives of particular importance are: 7.g. We have: a) Returns ratio 129 . KPTC) and those that will provide public services – in this case the government will be interested in their survival and thus ability to provide those services. Such comparison is then used to interpret the company’s performance bearing in mind the factors that influenced the present and past performances. for this yardstick to be useful the term average should include those companies which are not extremely. Average industry ratios These are useful as they indicate the average performance of various companies in a given industry i. Private Eyes Ltd. However. same or even worse than the past. I. it gives the minimum performance of a number of companies in a given industry. 4.g. Ratio of successful companies Useful if the company can get figures of competitors who are leading in the market so as to enable it to gauge its performance against better performance. better. very strong and very weak companies – which should be excluded to arrive at industry average figures.b) Sales ratio Yard Stick Used In Ratio Analysis 1.e. 2. However this information is difficult to obtain and sometimes it calls for private investigators e. 3. Ratio of budgeted performance These are compared with actual performance ratios and investigations are made of any unfavorable variance which should be explained. These ratios are useful in so far as to enable the analyst to make a reasonable comparison of the company’s performance vis-à-vis other companies in the same industry. Past performance of the company The company’s past performance (past ratio) is used to measure or gauge the company’s performance and in particular the change in performance whether good (favourable).e. 130 . Profitability ratios 5. ACTIVITY RATIOS 5. Liquidity ratios 2. Gearing ratios 4. does the firm suffer from lack of liquidity/or insolvency? Or does the firm hold excess liquidity? NB: Short term obligations are the current liabilities 1. Quick/Acid Test Ratio = CurrentAss ets Inventory CurrentLia bilities (CL) 131 . Current Ratio = CurrentAss ets (CA) CA or CurrentLia bilities (CL ) CL It indicates the availability of current assets in shillings/ dollars for every one dollar/shilling of current liability. PROFITABILITY RATIOS Liquidity Ratios: Measure a firms ability to meet short-term/current obligations.e. Growth and valuation ratios INCOME STATEMENT AND INCOME STATEMENT/BALANCE SHEET RATIOS BALANCE SHEET RATIOS DEBT RATIOS LIQUIDITY RATIOS (a) 3. They asses the liquidity position of a firm i. Turnover ratios 3. 2. COVERAGE RATIOS 4.Classification of Ratios Ratios are broadly classified into 5 categories: 1. 3. TotalDebt Debt to Equity Ratio = Shareholde r ' sEquity This ratio tells creditors contribution for each sh. 2. Capital Employed – to – Net worth) = (share and reserve) 132 CapitalEmployed Networth . Net Working Capital Ratio Net Working Capital (NWC) = CA – CL NWC Ratio = (b) NWC Net Assets Leverage Ratios/Capital Structure Ratios/Debt Ratios These are ratios that show the extent to which the firm is financed by debt.This shows the firm’s ability to meet current liabilities with the most liquid (quick) assets. Debt Ratio = TotalDebt TD TotalDebt (TD) CapitalEmp loyed NA TotalDebt Networth It shows the proportion of finance provided by lender. of owners’ contribution. 3. Cash Ratio = Cash Marketable sec urities x% Current Liabilities Cash is the most liquid asset and its equivalent may be compared with current liabilities 4. The lower the ratio the higher the level of the firm’s financing that is being provided by shareholders … and the happier the creditor. 1. (c) Coverage Ratios These are ratios that indicate a firm’s ability to service or cover interest and other fixed charges. Interest Coverage Ratio = Earning Before Interest and Taxes ( EBIT ) Interest Expenses = x times Shows the number of times the interest charges are covered by funds that are ordinarily available for their payment. Debtors Turnover = Average Debtors x times Credit Sales Average Debtors = Debtors at the beg. Fixed EBDIT Sinking Fund Payment Charge Coverage Ratio = Interest Lease Payments 1-tax rate (d) Activity Ratios/Turnover Ratios/Efficiency Ratio Ratios that measure how effectively a firm is using its assets. Cost of Goods sold Inventory Turnover Ratio = Average Inventory x times Average Inventory = Beginning Inventory Ending inventory 2 It gives the number of times inventory of financial goods is turned into sales. They indicate the speed with which assets are being converted into sales. Fixed Charges Coverage Ratio = Interest ( ) 1 tax rate NB: EBDIT => Earning Before Depreciation. Days of Inventory Holding= Inventory turnover x days 3. EBDIT Loan Re payment 2. 360 2. of period Ending Debtors 2 133 . 1. 1. Interest and Taxes The above ratio is extended to cover other fixed obligations. Net Assets Turnover = Sales xtimes Net Assets Net Assets = Net Fixed Assets + Net Current Assets (CA-CL) Sales xtimes Net Fixed Assets 7. Gross Profit Margin = Gross Profit x 100 Net Sales 134 . Profitability in relation to sales Profitability in relation to investment PROFITABILITY IN RELATION TO SALES: 1.4. Profitability Ratios: These are calculated to show the operating efficiency of a company. Sales x times Total Assets NFS CA Total Assets Turnover = This shows the firm’s ability in generating sales from all financial resources committed to total assets. 6. The major types of profitability ratios are calculated: I. 5. Average Collection Period = Average Debtors x 365 x days Credit Sales Gives the average number of times for which debtors remain outstanding in a year. 9. Current Assets Turnover = Sales xtimes Current Assets The above two ratios measure the efficiency of utilizing both current assets and fixed assets. Fixed Assets Turnover = 8. Average Creditors payment period = Average Creditors x363 xdays Credit Purchase e. Return on Net profit after tax x100 x% total asets (FA CA) Shareholders Net profit after tax . It tells of the earning power of shareholder’s book value investments. PROFITABILITY IN RELATION TO INVESTMENT 1. 2. Return on Equity (ROE) = Profit after tax x100 x % Net worth It indicates how well the firm has used the resources owned. divid. Shareholders fund (Equity Capital) 135 funds = . of sales. Return on Investment (RO1) = Net profit after taxes x100 x% Total assets It gives the profitability per sh. 3. Return on Assets = 4. dist exp. Contribution Ratio = Sales Variable exp enses Contributi on Sales Sales This ratio is also called profit/volume or PV ratio 4.Reflects the efficiency with which the management produces each unit of product 2. 3. Operating Expenses Ratio = Operating (cost sell.) exp. Net Profit Margin = Net Profit Profit after tax x100 x% Net Sales Sales Measures a firm’s profitability of sales after taking account of all expenses and income taxes.prefer. II. Sales This is a yardstick for operating efficiency – Explains the As in II margin (EBIT) to sales ratio. Dividend per share(DPS)= Earnings paid to sharholders (Dividends) Number of ordinary shares outstanding DPS Divident per share Dividend payout ratio = EPS Earning per share x100 3. Pr ofit After Tax 1. 136 . Earnings per share = Total Number of Shares Shows the profitability of a firm on a per share basis.5. Earning Yield = Market value per share MV x100 Earning per share EPS The above two ratios evaluate the shareholders return in relation to market value of the shares. Dividend Yield = Market Value per share MV x100 5. 2. They show how the firm does in the stock market. Basic Earnings Power= EBIT (Earning before interest and tax) Total Assets MARKET VALUE RATIOS These reflect the risk and return. Price-Earnings Ratio = Market Value per share MV Earning per share EPS It reflects investors’ expectations about the growth in the firm’s earnings. g = Retention ratio X return on Equity (ROE) Divident per share DPS 4. NB: 1 - DPS Retention Ratio EPS Retention Earning .Dividends Growth in equity. 6. 5. 8. Market value of assets Torbin’s q = Replacement cost of assets Firms will have incentive to invest when q is greater than 1. Torbin’s q -> this is the ratio of the market value of a firm’s asset or (equity and debt) to its assets replacement costs. Inter firm comparisons of data. It is difficult to decide on the proper basis of comparison. 2. perspective or meaning to the data and it brings out information not otherwise apparent. 4. It guides management in formulating future financial policies. Permits the data to be measured against yardsticks of performance or sound financial controls. It ensures effective cost control. 3. It throws light on the efficiency of the business organizations. Helps in investment decisions 7. 137 . Limitations in Using Ratio Analysis 1. Importance Of Ratio Analysis 1. Market value per share MV Market to Book Value Ratio = Book value per share BV Net worth Book value = No of ordianry shares It measures the difference between the company’s worth and the funds the shareholders have put in it. It provides greater clarity.7. It measures profitability and solvency of a concern 6. Lacks standard values for ratio and therefore scientific analysis not possible.600 158.170 261. ‘000 Sh. 6. Seasonal factors can affect ratio analysis. 5. 8.400 Accounts receivable 80.600 Machinery 33. It fails to indicate immediately where the mistake/error lies. The comparison is difficult because of differences in situations of two companies or one company over years.800 26.920 28.120 343.000 Land and buildings 25.230 27.2. The basis of asset valuation can be misleading 9.250 24.200 138 . Price-level changes make interpretations difficult. ‘000’ Cash 15. KAMWERETHO Ltd.800 Total current assets 194.200 Total assets 268.800 Inventory 98. Ratios are generally calculated from past financial statements and thus are no indicators of future. 7. 3.400 Other fixed assets 14. QUESTION One a) KAMWERETHO Ltd.320 77. A set of accounts never shows a complete picture of a company’s activities. 4. Balance sheet as at 31 October 2006 2007 Sh. A medium sized company has just released its financial results for the ending financial year alongside the results for the previous financial year. ‘000’ Sales (all on credit) 827.000 Retained earnings 42.400) (31.858 Ordinary share capital 115.600 42.800) Net income before taxes 63.854) Net income 38.936 Interest expenses (12. income statement for the year ending 31 October 2006 Shs.000 115.000 General and administration expenses (63.282 Number of shares issued 4.760 Accruals 15. ‘000’ 2007 Shs.700 34.350 Total current liabilities 59.800) Earnings before interest and tax (EBIT) 76.400 68.920 107.Accounts and notes payable 34.200 25.582 268.600.760 Long term debt 60.000 Cost of sales (661.600.136 Taxes (25.000 858.000 Per share data: 139 4.120 343.220 73.000) Gross profit 165.600) (47.800) (26.850 60.264) Other operating expenses (25.600) (710.400 148.000 49.000 .400) (16.200 KAMWERETHO Ltd. 1. ‘000 .8.75 Required: Calculate for each year: i.13. Amanita Limited Trading Profit and loss Account for the year ended 31 st December 2008 Kshs.30 Shs. iii. ii.Earnings per share (EPS) Shs. Quick ratio Inventory turnover ratio Average collection period Fixed assets turnover Price earnings ratio Debt/Equity ratio QUESTION (2marks) (2marks) (2marks) (2marks) (2marks) (2marks) Two The following information represents the financial position and financial results of Aminata limited for the year ended 31st December 2006.25 Shs.75 Market price (average) Shs.1. vi.90 Shs.50 Dividend per share (DPS) Shs.’000 140 Kshs.48. 5. v. iv. 000 Less: cost of sales 900 .000) Preference dividend 127 Ordinary dividend .000 210.000 180.000 Depriciation 20.000 (38.000 720 .100 141 .000 - 600 Credit .100) 88 .000 Less: closing stock Gross Profit 13. 000 General expenses Interest on loan Net profit before tax Corporation tax at 30% 4.800 74 .900 Directors emoluments 4.800 10.Sales - 300 Cash .000 (53.000 opening sock 150.000 660.100 Less expenses 15.900 14 .000 870. 000 205. Kshs.000 Current assets Stocks 150.900 Cash 20.300 .800 67.000 Debtors 35.’000 ‘000 Kshs.Aminata limited Balance sheet as at 31st December 2008 Kshs.500 Proposed Dividend 14.000 Corporation tax 63.900 Current Liabilities Trade Creditors 60.500 Financed by: 142 138. ‘000 Fixed assets 213.600 281. 000 281. 2. Required a) Determine the following ratios i) Acid test ratio (2 Marks) ii) Operating ratio (2 Marks) iii) Return on capital employed (2 Marks) iv) Price earning ratio (2 Marks) v) Interest coverage ratio (2 Marks) vi) Total assets turnover (2 Marks) vii) Debtors collection period (2 Marks) 143 .500 Additional Information 1. The company’s ordinary shares are selling Kshs 20 in the stock market.Ordinary Share capital (Kshs 10 par value) 8% Preference shares 100. The company has a constant dividend payout of 10%.500 10% Bank Loan 40.000 Revenue reserves 81.000 60. b) Outline any six limitations of using ratios as a basis for financial analysis (6 Marks) 144 . : Residual dividend theory Dividend irrelevance theory (MM) Signalling theory Bird in hand theory Clientele theory Agency theory iv) How to pay: cash or stock dividends. increase its gearing level. 145 This will .e. Importance of Dividend Decisions Dividends decisions are integral part of a firm’s strategic financing decision. Constant Amount Of Dividend Per Share Constant Payout Ratio Fixed Dividend Plus Extra Residual Dividend Policy ii) When to pay – paying interim or final dividends iii) Why dividends are paid – this is explained by the various theories which has to determine the relevance of dividend payment i.TOPIC 7: DIVIDEND POLICIES AND DECISIONS Dividend policy determines the division of earnings between payments to stock holders’ ad re-investment in the firm. How much to pay – this encompassed in the four major alternative dividend policies.g payment of high dividends means less retained earnings and the firm may have to go to the market to borrow for investment purposes. It is therefore a plan of action adopted by management e. It therefore looks at the following aspects: i). Constant return and cost of capital: The firms rate of return. k. WALTER’S MODEL OF DIVIDEND RELEVANCE According to Prof James E Walter. r. others consider it irrelevant. are constant 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately. and its cost of capital. in determining the dividend policy that will maximise the wealth of shareholders. dividend policies almost always affect the value of the firm. k. ASSUMPTIONS OF WALTERS MODEL Internal Financing: The firm finances are investment through retained earnings. The managers therefore requires to formulate an optimal dividend policy which will maximize the wealth of the shareholders (value of shares). Infinite time: The firm has a very long infinite time. His model clearly shows the importance of the relationship between the firm’s rate of return. r and its cost of capita. Some consider dividend decision relevant. Debt or new equity is not issued. 146 .Solution to the Dividend Puzzle A firm’s dividend decision may have some relevance to the firm’s share value. Does the change in dividend policy affect the value of the firm? Different theories have been advance to answer this question. Constant EPS and DPS (Dividend per Share): Any given values of EPS and DPS are assumed to remain constant forever. the value of a share is the PV of all dividends plus the PV of all capital gains as shown above. DPS/k (ii) PV of infinite streams of capital gains {r (EPS-DPS)/k} Thus. These 147 .Walter’s formula to determine the market price per share is as follows: P DPS r ( EPS DPS ) / k k k Where P = Market price per share DPS = Div per share EPS = Earning per share R = Firm’s average rate of return k = Firm’s cost of capital or capitalization rate The equation above reveals that the market price per share is the sum of the present value of two sources of income (i) The PV of the infinite stream of constant dividends. This can be simplified to: P DPS r / k ( EPS DPS ) k WALTERS MODEL CAN BE SUMMARIZED AS FOLLOW: i) Growth Firm: r>k Growth firms are those firms expanding rapidly because of investment opportunities yielding higher return than opportunity cost of capital. firms will maximise the value per share if they follow a policy of retaining all earnings for investment. Market Price per Share (MPS) increase as POR (Payout Ratio) declines. Investors on such firms could like earnings to be distributed to them so as to spend it or invest it elsewhere to get a higher rate of return than that earned by declining firms. Illustration: The EPS of a company are Sh 8. It has an internal rate of return of 17% and a capitalization rate of its risk class is 16%. Thus dividend policy in Walters Model depends on: Availability of investment opportunities Relationship between the firms’s IRR. Therefore. r and cost of capital k. the market value per share of such a firm is maximum when it retains all the earnings. What should be the optimum payout ratio? What will be the price of the share at this payout? How shall the price of the share be affected if a different payout were employed? 148 . Optimum POR=100% Market value per share increases as POR increases. If Walters model is used. The optimum POR for a growth firm is zero. dividend policy has no effect on market value per share in Walters model Declining firms: r<k These are firms with no profitable investment opportunities to invest in the earnings. Its market value will be higher if it does not retain anything at all. ii) Normal firms: r=k For a normal firm with r=k. Retained earnings used to finance expansion. k>b According to Gordon’s dividend. of a firm is constant. However. The firm and its strings of earnings are perpetual Corporate taxes do not exist retention ratio is constant cost of capital is greater than growth rate. does not remain constant since it changes directly with the firm’s risk.CRITICISMS OF WALTER’S MODEL The model assumes no external financing and shareholders wealth is maximized when total earnings are retained. the market value of a share is equal to the PV of an infinite stream of dividend to be received by the shareholders.. in a more comprehensive model. No external financing is available. and has no debt. k. GORDON’S MODEL OF DIVIDEND RELEVANCE This model relating the market value of firm to dividend policy was developed by Myron Gordon. Firms cost of capital or discount rate. Cost of capital remains constant. Po = DIV1 + DIV2 (1+K)1 +……………. Thus. + DIV (1+K) (1+K)2 149 = t 1 DIV (1 g ) t (1 k ) t . capitalisation model. outside financing would raise new funds to finance investment. It is an erroneous policy that investment stops. When r=k as it will fail to optimise shareholders wealth. The internal rate or return. It is based on the following assumptions: The firm is an all equity firm. r. DPS = P O R x E P S This allows earnings to grown at a rate of g. = b x r b=retention ratio r= rate or return Thus. PO t 1 DIV (1 g )1 DIV (1 g ) 2 + (1 k )1 (1 k ) 2 DIV (1 g ) 3 (1 k ) 3 +……………+ DIV (1 g ) (1 k ) = DIV (1 g ) t (1 k ) t This equation becomes PO DIV1 (k g ) or EPS (1 b) k br Under Gordon’s model: The market value of the share.Divided per share is expected to grow when earnings are retained. Gordon’s model conclusions are similar to those of Walter’s model and thus both suffer similar limitations. b for growing firms is r>k The market value of the share Po increases with POR (1-b) for declining firms with r<k The market value of the shares is not affected by dividend policy when r=k Thus. How Much to Pay: Alternative Dividends Policies a) Constant payout ratio 150 . P0 increases with retention ratio. It is 151 .S. The DPS could be increased to a higher level if earnings appear relatively permanent and sustainable. However extra dividends are paid in years of supernormal earnings.This is where the firm will pay a fixed dividend rate e. DPS at a low level.P. b) Constant amount per share (fixed D. This policy creates uncertainty to ordinary shareholders especially who rely on dividend income and they might demand a higher required rate of return.g. It gives the firm flexibility to increase dividends when earnings are high and the shareholders are given a chance to participate in super normal earnings The extra dividends is given in such a way that it is not perceived as a commitments by the firm to continue the extra dividend in the future. This policy treats all shareholders like preferred shareholders by giving a fixed return. Dividends are directly dependent on the firms earnings ability and if no profits are made no dividend is paid.) The DPS is fixed in amount irrespective of the earnings level. 40% of earnings. This creates certainty and is therefore preferred by shareholders who have a high reliance on dividend income. It protects the firm from periods of low earnings by fixing. c) Constant DPS plus Extra/Surplus Under this policy a constant DPS is paid every year. The DPS would therefore fluctuate as the earnings per share changes. This is because no floatation costs are involved in use of retained earnings to finance new investments. 152 It will not . When to Pay Firms pay interim or final dividends. the first claim on earnings after tax and preference dividends will be a reserve for financing investments.e. affect the value of the firm. a firm will pay dividends from residual earnings i. Interim dividends are paid at the middle of the year and are paid in cash. However. It assumes that retained earnings is the best source of long term capital since it is readily available and cheap.g agricultural sector.applied by the firms whose earnings are highly volatile e. The policy is consistent with shareholders wealth maximization. earnings remaining after all suitable projects with positive NPV has been financed. Dividends Theories (Why Pay Dividends) The main theories are: 1. Final dividends are paid at year end and can be in cash or bonus issue. investment decisions will. Therefore. Dividend will only be paid if there are no profitable investment opportunities available. Dividend policy is irrelevant and treated as a passive variable. Residual dividend theory Under this theory. d) Residual dividend policy Under this policy dividend is paid out of earnings left over after investment decisions have been financed. It does not matter how the earnings are divided between dividend payment to shareholders and retention. ii) MM Dividend Irrelevance Theory Was advanced by Modiglian and Miller in 1961. They argued that the firm’s value is primarily determined by: Ability to generate earnings from investments Level of business and financial risk According to MM dividend policy is a passive residue determined by the firm’s need for investment funds. 3. Saving on floatation costs No need to raise debt or equity capital since there is high retention of earnings which requires no floatation costs. dividend decision is a mere detail without any effect on the value of the firm. The theory asserts that a firm’s dividend policy has no effect on its market value and cost of capital. optimal dividend policy does not exist.Advantages of Residual Theory 1. Tax position of shareholders High-income shareholders prefer low dividends to reduce their tax burden on dividends income. They prefer high retention of earnings which are reinvested. increase share value and they can gain capital gains which are not taxable in Kenya. A high retention policy may enable financing of firms with rapid and high rate of growth. Since when investment decisions of the firms are given. This will be avoided if retention is high. Avoidance of dilution of ownership New equity issue would dilute ownership and control. Therefore. 153 . 2. Dividends payments are more certain than capital gains which rely on demand and supply forces to determine share prices. iii) Bird-in-hand theory Advanced by John Litner (1962) and furthered by Myron Gordon (1963). Therefore.e required rate of return (r) = cost of capital (k). They maintained that an investor can realize capital gains generated by reinvestment of retained earning. Therefore. MM argued against the above proposition. investors would be indifferent between cash dividends and capital gains.They base on their arguments on the following assumptions: No corporate or personal kites No transaction cost associated with share floatation A firm has an investment policy which is independent of its dividend policy (a fixed investment policy) Efficient market – all investors have same set of information regarding the future of the firm No uncertainty – all investors make decisions using the same discounting rate at all time i. They argued that the required rate of return is independent of dividend policy. a firm paying high dividends (certain) will have higher value since shareholders will require to use lower discounting rate. If this is possible. iv) Information signaling effect theory 154 . one bird in hand (certain dividends) is better than two birds in the bush (uncertain capital gains). Argues that shareholders are risk averse and prefer certainty. if they sell shares. The managers can only send true signals even if they are bad signals. Example – If the management pays high dividends. v) Tax differential theory Advanced by Litzenberger and Ramaswamy in 1979 They argued that tax rate on dividends is higher than tax rate on capital gains. Therefore. The theory is based on the following four assumptions: The sending of signals by the management should be cost effective. MM attacked this position and suggested that the change in share price following the change in dividend amount is due to informational content of dividend policy rather than dividend policy itself. No company can imitate its competitors in sending the signals. the higher the value of the firm. The signals should be correlated to observable events (common trend in the market). management can use dividend policy to signal important information to the market which is only known to them. dividends are irrelevant if information can be given to the market to all players. This would increase the share price/value and vice versa. Dividend decisions are relevant in an inefficient market and the higher the dividends. it signals high expected profits in future to maintain the high dividend level. a firm that pays high dividends have lower value since shareholders pay more tax on dividends. He argued that in an inefficient market.Advanced by Stephen Ross in 1977. 155 . Sending untrue signals is financially disastrous to the survival of the firm. Dividend decisions are relevant and the lower the dividend the higher the value of the firm and vice versa. Therefore. suppliers etc. investors. Therefore. Low. vi) Clientele effect theory Advance by Richardson Petit in 1977 It stated that different groups of shareholders (clientele) have different preferences for dividends depending on their level of income from other sources. managers are required to raise additional equity capital to finance investment.g. Each fresh equity issue will expose the managers financing decision to providers of capital e. bankers. At equilibrium. vii) Agency theory The agency problem between shareholders and managers can be resolved by paying high dividends. dividend policy will be consistent with clientele of shareholders a firm has. dividends attract a withholding tax of 5% which is final and capital gains are tax exempt. Low income earners prefer high dividends to meet their daily consumption while high income earners prefer low dividends to avoid payment of more tax. If retention is low. 156 .Note In Kenya. Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors. when a firm sets a dividend policy. Managers will thus engage in activities that are consistent with maximization of shareholders wealth by making full disclosure of their activities. income shareholders will shift to firms paying high dividends and high income shareholders to firms paying low dividends. there’ll be shifting of investors into and out of the firm until an equilibrium is achieved. a firm can pay stock dividend (Bank issue) Bonus issue involves issue of additional shares for free (instead of cash) to existing shareholders in their shareholding proportion. This is because dividend policy can be used to reduce agency problem by reducing agency costs. it should have adequate liquid funds. and generate cash in form of capital gains which is tax exempt unlike cash dividends which attract 5% withholding tax which is final 157 . Cash and Bonus issue 2. Advantages of Bonus Issue a) Tax advantages Shareholders can sell new shares. Stock split and reverse split 3. How to pay dividends (mode of paying dividends) 1. Stock dividend/Bonus issue involves capitalization of retained earnings and does not increase the wealth of shareholders. Cash and bonus issue For a firm to pay cash dividends.This is because they know the firm will be exposed to external parties through external borrowing. This is because R. under conditions of liquidity and financial constraints. Agency costs will be reduced since the firm becomes self-regulating. Earnings is converted into shares. However. The theory implies that firms adopting high dividend payout ratio will have a higher value due to reduced agency costs. Dividend policy will have a beneficial effect on the value of the firm. Stock repurchase 4. Consequently. Stock rights/rights issue (to discuss in class) 1. R. Stock split is meant to make the shares of a company more affordable by low income investors and increase their liquidity in the market.P. Stock Split and Reverse Split This is where a block of shares is broken down into smaller units (shares) so that the number of ordinary shares increases and their respective par value decreases at the stock split factor. Ordinary share capital (par value) A firm can also make a script issue where bonus shares are directly from capital reserve.S is not diluted. Journal entry in case of bonus issue NB: Dr.P. d) Increase in future dividends If a firm follows a fixed/constant D. then total future dividend would increase due to increase in number of shares after bonus issue. Earnings (par value) Cr.b) Indication of high profits in future: A Bonus issue.S policy. c) Conservation of cash Bonus issue conserves cash especially if the firm is in liquidity problems. Illustration 158 . It is declared when management expects increase in earning to offset additional outstanding shares so that E. in an inefficient market conveys important information about the future of the company. 2. 1000 stocks x 4 = 4000 shares par value = 40 = Sh.e.S.ABC Company has 1000 ordinary shares of Sh.e one stock is split into 4. Assuming repurchase does not adversely affect firm’s earnings. Stock Repurchase The company can also buy back some of its outstanding shares instead of paying cash dividends. 2. It is meant to attract high income clientele shareholders.P.g incase of 20.40 par. so that capital gain is substituted for dividends. of share would increase.20 = x 2 = 40/= 3.20 par value and a split of 1:4 i.P. fewer shares would remain outstanding.000 x ½) = 10. E. I. inefficient markets.20. The par value is divided by 4.000 shares of Shs. E.000 A reverse split is the opposite of stock split and involves consolidation of shares into bigger units thereby increasing the par value of the shares. they can be consolidated into 10. (20.20 par. It may be seen as a true signal as repurchase may be motivated by management belief that firm’s shares are undervalued. (bought back) are called treasury Stock. If some outstanding shares are repurchased.S. This would result in an increase in M.000 shares @ Shs.000 and Sh. Utilization of idle funds 159 This is true in . Advantages of Stock Repurchase 1.5 5 Ordinary share capital = 4000 x 5 = Shs. This is known as stock repurchase and shares repurchased. experience an increase in market price of the shares. However. and E. There is a tendency for more mature firms to continue with investment plan even when E (K) is lower than cost of capital. as a means of correcting what they perceive to be an unbalanced capital structure. Continuing to carry excess cash may prompt management to invest unwisely as a means of using excess cash. If shares are repurchased from cash reserves.S. would increase in future. which have accumulated cash balances in excess of future investments. transferring value to another group of shareholders entirely.S is a bookkeeping increase since total earnings remaining constant. 4. This is partly explained by increase in total earnings having less and/or market signal effect that shares are under value. Enhanced Share Price Companies that undertake share repurchase.P. 160 .S. Capital structure A company’s managers may use a share buy back or requirements.P. Enhanced dividends and E. 3. the number of shares issued would decrease and therefore in normal circumstances both D. 5.S. Example A firm may invest surplus cash in an expensive acquisition. Following a stock repurchase. might find share reinvestment scheme a fair method of returning cash to shareholders.P. equity would be reduced and gearing increased (assuming debt exists in the capital structure). the increase in E.P.Companies. shareholders with no strong loyalty to company since repurchase would induce them to sell. Market Signaling Despite director’s effort at trying to convince markets otherwise.e. Reduced take over threat A share repurchase reduces number of share in operation and also number of ‘weak shareholders’ i. High price A company may find it difficult to repurchase shares at their current value and price paid may be too high to the detriment of remaining shareholders. 6. a share repurchase may be interpreted as a signal suggesting that the company lacks suitable investment opportunities. This helps to reduce threat of a hostile takeover as it makes it difficult for predator company to gain control. huge cash outflow or borrowing huge long term debt to increase gearing Disadvantages of stock repurchase 1. 7.Alternatively a company may raise debt to finance a repurchase. 2. (This is referred as a poison pill) i. This may be interpreted as a sign of management failure. Employee incentive schemes Instead of cancelling all shares repurchase. 161 . 3.’s value is reduced because of high repurchase price.e. Loss of investment income The interest that could have been earned from investment of surplus cash is lost. Co. Replacing equity with debt can reduce overall cost of capital due to tax advantage of debt. a firm can retain some of the shares for employees share option or profit sharing schemes. Investment opportunity 162 . from sale of ssets.e. Taxation position of shareholders Dividend payment is influenced by tax regime of a country e. Profitability and liquidity A company’s capacity to pay dividend will be determined primarily by its ability to generate adequate and stable profits and cash flow. Insolvent company is one where assets are less than liabilities. 3. it may be unable to pay cash dividend and result to paying stock dividend. (This is explained by tax differential theory). c) Insolvency rule: prohibits payment of dividend when company is insolvent. Legal rules a) Net purchase rule States that dividend may be paid from company’s profit either past or present. In such a case all earnings and assets of company belong to debt holders and no dividends is paid. b) Capital impairment rule: prohibits payment of dividends from capital i. Insolvent company is one where assets are less than liabilities. 2. while capital are tax exempt.g in Kenya cash dividend are taxable at source. 4. This is liquidating the firm.Factors to consider in paying dividends (factors influencing dividend) 1. The effect of tax differential is to discourage shareholders from wanting high dividends. If the company has liquidity problem. they may pay low dividends and allow reserves to accumulate until a more optimal/appropriate capital structure is restored/achieved. However in a large quoted public company dividend payout are significant because the owners are not the managers. if they consider gearing to be too high. Ownership Structure A dividend policy may be driven by Time Ownership Structure e. If a firm has many investment opportunities.e.V. 7.g in small firms where owners and managers are same. 5. Industrial Practice Companies will be resistant to deviation from accepted dividend or payment norms within the industry. those with positive returns (N. dividend payout are usually low. 163 .P. 8. Growth Stage Dividend policy is likely to be influenced by firm’s growth stage e. 6. However.).g a young rapidly growing firm is likely to have high demand for development finance and therefore may pay low dividend or a defer dividend payment until company reaches maturity. It will retain high amount. Capital Structure A company’s management may wish to achieve or restore an optimal capital structure i. it will pay low dividends and have high retention.e.Lack of appropriate investment opportunities i. the values and preferences of small group of owner managers would exert more direct influence on dividend policy. may encourage a firm to increase its dividend distribution. 9. Shareholders expectation Shareholder clientele that have become accustomed to receiving stable and increasing div. Will expect a similar pattern to continue in the future. Any sudden reduction or reversal of such a policy is likely to dissatisfy the shareholders and may result in a fail in share prices. 10. Access to capital markets Large, well established firms have access to capital markets hence can get funds easily They pay high dividends thus, unlike small firms which pay low dividends (high retention) due to limited borrowing capacity. 11. Contractual obligations on debt covenants They limit the flexibility and amount of dividends to pay e.g. no payment of dividends from retained earnings. Dividend ratios 1. Dividend per shares (DPS) = Earnings to ordinary shareholders Number of ordinary shares Indicate cash returns received fro every share holder. 2. Dividend yield (DY) = DPS MPS Indicate dividend returns for every shilling invested in the firm. 3. Dividend cover = DPS DPS 164 Indicate the number of times dividends can be paid out of earnings of shareholders. The higher the DPS the lower the dividend cover. 4. Dividend Payout Ratio =DPS EPS Shows the proportion of Earnings which was paid out as dividends and how much was retained. 165 TOPIC 8: FINANCIAL PLANNING In this lecture we will discuss short-term financial planning which aim at projecting future profits and future cash needs. The key outputs of the financial planning process are the cash budget, pro-forma income statement, pro-forma balance sheet, and a number of operating budgets. Operating Financial Plans The financial planning process begins with long term plans, which are based on the firm’s long term strategic goals. Short financial plans (operating plans) implement as much as possible the long term strategies. The focus in this lesson is on the operating (short term) budgets. A key task of financial management is to look ahead – to plan. An operating plan of action is a statement of what is to be done in some future period, how it is to be done, and the likely impact of the actions. Importance of financial planning Planning confers the following rewards to an organization: Insurance against risk Careful planning helps a firm identify likely future contingency and prepare for them. Plans are not only helpful as a guide to action but may be required by external parties when they have to deal with the firm (i.e. lenders) Decision making Planning, essentially, is making decisions in advance about what is to be done in future. Financial planning helps a firm make decisions in advance on how to deal with the uncertainties regarding the amounts, timing and nature of future financing requirements Communication 166 Plans are useful in the communication with important outside parties, including investors and other suppliers of funds. By coming to the bargaining table with a comprehensive plan, a firm’s management sends a confidence invoking signal and gains a psychological advantage in the bargaining process. Co-ordination A planning system improves co-ordination in an organization. The basic elements of the financial plan are the cash budget and the projected income statement and the balance sheet. The building blocks for these three are myriad detailed operating budgets (including personnel budget, production budget, purchasing budget) representing time-phased schedule of the expenditures, people, material and activities required to accomplish the objectives set forth in the overall financial plan. Without co-ordination such meshing could be a daunting task. Control Management control systems are based on comparisons of actual data versus plans. By comparing actual versus plan data at frequent intervals, deviations can be detected as events unfold, and timely corrective action can be taken. Production schedules can be modified, advertising budgets increased, collection efforts intensified or expenses cut. In sum, cash budgets and pro-forma financial statements are indispensable in achieving good control. Time frame for financial planning Regardless of the kind of plan a manager is developing recognition of the importance of time is essential. Plans either fall under long range, intermediate or short range plans. 167 Long range financial planning: Covers several time periods, from five years to as long as several decades. Long range plans are mainly associated with activities such as major expansion of products or facilities, development of top managers, large issues of stocks or change of manufacturing systems. Top managers are responsible for long range financial planning in most organizations. Intermediate financial planning: range in time from one year to five years. Because of the uncertainties associated with long range plans, intermediate plans are the primary concern of most organizations. They are usually developed by both top and middle management. They are the building blocks in the pursuit of long range plans. Short range financial planning: covers time periods of one year or less. They focus on day to day activities and provide a concrete base for evaluating progress towards the achievement of intermediate and long range plans. Financial Planning Process The process of generating short-term financial forecasts is depicted in Figure 11.1 below. A systems approach is necessary for development of the budgets. They input is the sales forecast, from productions are prepared then the cash budget and the pro-forma income statement and finally the proforma balance sheet. The steps are summarized as: 1. Establish a sales projection. The key input to preparation of cash budgets is the firms revenue (sales) forecast. It is on the basis of this forecast that the manager predicts cash receipts, cash outlays, fixed asset requirements and the amount of outside financing that will be necessary. The sales forecast could be eternally based (i.e. on the national GDP) internally based or a combination of the two. 168 labour. Figure 11.2. Finally. and the desired level of ending inventory 3. 4. the sales projections.1 Short term financial planning process 169 . develop the pro-forma balance sheet. The number of units produced will depend on the beginning inventory. Prepare the pro-forma income statement and the cash budget. Determine a production schedule and the associated use of raw materials. overheads and operating expenses. Plans may become obsolete even before they are executed.g. These changes make it harder to develop effective plans. technology. (b) Poor Goal Setting 170 . politics and economic conditions.Current period balance sheet Sales projection Production plans Pro-forma income statement Pro-forma balance sheet Cash budget Other supportive budgets Barriers to Financial Planning (a) Environmental Barriers Most organizations operate in environments that are complex and dynamic where the environmental factors keep changing rapidly e. This will hinder effective financial planning. financial planning involves change. Financial planning has limits and cannot be done with absolute precision. government regulations. Fear of the unknown. Top management committed is crucial for any plan to actualise. (c) Communication Vertical communication within the organization hierarchy can facilitate financial planning. These include: (a) Financial planning should start at the top Top managers should set the goals and strategies that lower level managers will follow. People should be let to know what is expected of them at all times. scarce resources. (d) Time and Expense Lack of time or financial resources can limit financial planning. (e) Other Constraints Various situational constraints such as labour contracts. natural factors and disasters may all affect financial planning. (b) Planners should recognize the limits Managers must recognize that no financial planning system is perfect. preferences for status quo and economic insecurity causes organizational members including managers to resist change and as such resist financial planning that might cause such change. Avoiding the Barriers Certain guidelines if followed by managers can help them deal with the roadblocks to financial planning. (c) Resistance to Change By its very nature. 171 .The beginning step in financial planning is goal setting. If the goals set are unrealistic either they are unattainable or too low. Financial planning takes time and the managers face many pressures and these pressures may cause them to resist financial planning. Lack of top management support x. (f) Contingency financial planning Managers should develop alternative actions that a company might follow if conditions change. (e) Integration As much as possible the long term. Lack of meaningful objectives and goals v. The following guidelines could help managers to establish a climate conducive to financial planning 172 . Excessive reliance on experience ix. Confusion of financial planning studies with plans iii. Underestimation of the importance of financial planning premises vi. Failure to develop and implement sound strategies iv. Lack of commitment to financial planning ii. intermediate and short range plans must be properly integrated and the better they are integrated. Why people fail in financial planning Besides the barriers outlined above there are several other reasons why people fail in financial planning. Failure to see the scope of plans vii.(d) Participation Managers who are involved in financial planning are more likely to know what is going on and therefore be motivated to contribute. Failure to see financial planning as a rational process viii. the more effective the organizations overall financial planning system. Lack of adequate control measures NB: Managers should remove obstacles to financial planning and try and establish a climate in which subordinates must plan. Summarized these reasons are as follows: i. divided into smaller time intervals. strategies. Its main uses are enable the firm foresee any future deficits in cash and hence make prior arrangement to obtain necessary bridging short term financing (overdraft and short term loans): in the case of a surplus cash.i. Goals. Financial planning must be organized iv. Managers must participate in financial planning vii. policies and premises must be communicated clearly vi. Financial planning should start at the top iii. Financial planning must not be left to chance ii. Financial planning must be clear and definite v. Financial planning must include awareness and acceptance of change Preparing Financial Forecasts Two key outputs of short-term financial planning are:(i) cash budgeting (ii) Pro-forma financial statements We will from now hence in this lecture concentrate on the preparation of these statements. Cash Budgets The cash budget is a statement of the firm’s planned cash inflows and outflows over a period of time. Typically a cash budget may be for a year.The general format of a cash budget is as follows:Cash receipts Less JANUARY XXX cash XXA FEBRUARY XXG XXH disbursements 173 . a plan can plan for beneficial short term investments (marketable securities). Net cash flow Add beginning XXB cash XXC XXI XXD balance Ending cash balance XXD Less minimum XXE XXJ XXK balance Required XXL total financing Excess cash balance XXF Let’s now examine the two main components of the cash budget. collections from debtors. Depreciation and other non cash charges are not included in the cash budget. repayment of loans and payment of taxes. interest payments. purchase of fixed assets. payment of expenses like rent. borrowings and issue of shares. 2005 through April. other operating receipts and capital receipts from sales of fixed assets. Example The actual sales and purchases for Sirikwa Importers Ltd. and utilities. wages. Depending on the credit terms offered to customers. payment to creditors. along with its forecast sales and purchases for the period November. The most common sources of cash are cash sales. dividend distributions. for September and October 2005. 2006. follows:174 .. Cash Disbursement The most common cash disbursements are cash purchases of stock. Cash Receipts Cash receipts include all of a firm’s cash inflows during the period. a schedule for collections from debtors could be necessary working for the preparation of the budget. and their payment habits. 000 250.000 80. Sh.25 million cash purchase of fixed assets in December.10 million are due in January and April. The firm had a cash balance of Sh. Wages and salaries amount to 20% of the preceding months sales. The firm expects to pay cash dividends of Sh. A principal payment of Sh.80 million are due in April.000 100. Rent of Sh. Taxes of Sh. 15 million.000 180. 12 million in September and April.15 million Required: (a) A cash budget for the six months November through April 175 .22 million at the beginning of November and wishes to maintain a minimum balance of Sh.000 (actual) October 250.000 150. It pays for 50% of its purchases in the following month and for 40% of its purchases 2 months later. in January and March and Sh.000 110. The firm pays cash for 10% of its purchases. Interest payments of Sh. The firm also expects to make a Sh.000 90.‘000’ 120.000 (actual) November December January February March April 170.20 million per month must be paid.MONTH SALES PURCHASES September Sh. 27 million in February.000 200.000 100.20 million in January and April.000 140.30 million is also one in April.0000 The firm makes 20% of all sales for cash and collects on 40% of its sales in each of the 2 months following the sale.‘000’ 210.000 Sh. Other cash inflows are expected to be Sh.000 140.000 160. (b) If the firm were requesting a line of credit to cover needed financing for the period November to April, how large would this line of credit have to be? Explain. Solution (a) SIRIKWA IMPORTERS LTD CASH BUDGET FOR NOVEMBER TO APRIL Novemb Decemb Januar Februar March April er er y y Sh Sh ‘000 Sh ‘000 Sh ‘000 Sh Sh ‘000 ‘000 156,000 168,00 202,000 27,000 0 15,000 12,000 175,00 183,00 183,0 214,00 0 0 00 0 140,000 114,00 91,000 97,000 103,000 34,000 20,000 0 32,000 20,000 10,000 28,000 20,000 30,000 20,000 40,000 20,000 10,000 30,000 20,000 80,000 ‘000 Cash Receipts Receipt from 218,000 sales Other 200,000 160,00 0 15,000 cash inflows 218,000 200,000 Cash Disburseme nts Payment for 137,000 purchases Wages 50,000 Rent 20,000 Interest Principal Dividend Taxes Purchase of 20,000 25,000 Fixed assets 207,000 Net cash flow 11,000 219,000 196,00 139,00 153,0 303,00 (19,000) 0 0 (21,000 44,000 00 30,000 0 (89,000) ) 176 Add 22,000 33,000 14,000 (7,000) 37,000 67,000 balance Ending cash 33,000 14,000 (7,000 37,000 67,00 (22,000 Less 15,000 15,000 ) 15,000 15,000 0 15,000 ) 15,000 1,000 22,000 beginning minimum balance Required 37,000 total financing Excess cash 18,000 22,000 balance (b) 52,00 0 The company should ask for a line of credit of Sh.37 million to cater for the biggest cash requirement of Sh.37 million in the month of April, 2006. WORKINGS Collection from debtors Cash Novemb Decemb Januar Februar March April er er y y Sh.‘00 Sh.‘00 Sh.‘000’ Sh.‘000’ Sh.‘00 Sh.‘000 0’ 0’ 32,000 0’ 28,000 ’ 36,000 40,000 50,000 68,000 64,000 56,000 72,000 80,000 100,000 68,000 64,000 56,000 72,000 sales 34,000 (20%) First month 100,000 after sales (40%) Second month 84,000 after sales (40%) 177 218,000 Payment 200,000 160,00 156,00 168,00 202,00 0 0 0 0 to creditors Novemb Decemb Januar Februar March April er er y y Sh.‘00 Sh.‘00 Sh.‘000’ Sh.‘000’ Sh.‘00 Sh.‘000 0’ 0’ 14,000 10,000 0’ 8,000 ’ 11,000 10,000 9,000 (10%) One month 75,000 70,000 50,000 40,000 55,000 50,000 60,000 56,000 40,000 32,000 44,000 140,000 114,00 91,000 97,000 103,00 Cash purchase after purchase (50%) Two months 48,000 after purchase (40%) 137,000 0 0 Coping With Uncertainty In Budgets Two ways of coping with uncertainty is budgets are: 1) Prepare several budgets based on pessimistic, most likely ad optimistic forecasts. This is a sensitivity analysis or a “what of” approach that can give a financial manager a sense of the riskiness of alternatives. 1) Simulation By simulating the occurrence of sales and other uncertain events the firm develops a probability distribution of the ending cash 178 flow for each period. The amount of financing necessary during the period can then be determined. Exercise The following information related to the proposed budget for K.K Ltd for the months ending 31 December 1996. Material Production Administrati Sales Purchas Wage Overheads on Overheads Sh. es Sh. s Sh. Sh. ‘000’ Sh. ‘000’ ‘000’ ‘000’ ‘000’ July August Septemb 72000 97000 86000 25000 31000 25500 10000 12100 10600 6000 6300 6000 5500 6700 7500 er October Novemb 88600 102500 30600 37000 25000 22000 6500 8000 8900 11000 er Decemb 108700 38800 23000 18200 11500 Month er Additional Information 1. Depreciation expenses are expected to be 0.5%of sales. 2. Expected cash balance in hand on 1 July 1996 is Sh. 72,500,000 3. 50% of total sales are cash sales 4. Assets are to be acquired in the months of August and October at Shs. 8,000,000 and Shs. 25,000,000 respectively 179 5. An application has been made to the bank for the grant of a loan of Shs. 30,000,00 and it is hoped that it will be received in the month of November 6. It is anticipated that a dividend of Shs. 35,000,000 will be paid in December 7. Debtors are allowed one month’s credit 8. Sales commission at 3% on sales is paid to the salesmen each month Required A cash budget for the six months ending 31 December 1996. Benefits/advantages Cash budget It records the cash inflows and outflows, which are expected to take place in respect of each functional budget. It may be prepared for a period span of one week, month or quarter of the budget period. It has the following benefits/advantages: It ensures that sufficient cash is available when required. It shows whether capital expenditure projects can be financed internally. It indicates the cash needed for current operating activities. It indicates the effect the position of each seasonal requirements, large stocks, unusual receipts and laxity in collecting account receivable. It indicates the availability of cash for taking advantage of discounts. It reveals the availability of excess cash so that short-term investments may be considered. It serves as a basis for evaluating the actual cash management performance of responsible managers. PROFIT PLANNING AND PROFORMA STATEMENTS 180 expenses. assets and equities using a variety of procedures as shown in Figure 11.1.Profit planning relies in accrual concepts to project the firm’s profit and financial position. Figure 11.2 Development process of the pro-forma income statement Sales Proforma Production plan Production income statement Figure 11. Pro-forma statements represent the goals and objectives of a firm for a planning period.3 Development of a pro-forma balance sheet 181 . They are a guide to action and are used in controlling operations. The projection requires the determination of various account balances for revenues. Mr. 182 . He has collected the following information to help him project the financial needs and position of the company for the first quarter of the year just started .Current Balance Sheet Pro-forma balance sheet Pro-forma income statement analysis Cash budget analysis The three basic inputs necessary for preparing pro-forma financial statements are: 1) Financial statement information for the proceeding year.1.550.Lopos is the majority owner and manages the inventory and finances of the company. 2) The sales forecast for the coming year 3) The assumption that financial relationships reflected in the firm’s financial statements will remain unchanged in the coming year Example Loitokitok Manufacturing Company Limited (LMCL) makes retread tires which it sells for Sh. at the end of each month.000. Last year the average cost of worn-out tires was Sh. Overhead is allocated at Sh. Past history shows that LMCL collects 50 per cent of its accounts receivable in the month following the month of sale.600 per tire. while interest and taxes are paid quarterly. and it invests its excess cash into marketable securities at the beginning of the 183 .400 tires April 2. and other 50 per cent in second month after the month of sale.500 tires.2.325.520 per tire .000 in November while December sales amounted to Sh. In general. Inventory at the beginning of December was 2. which are passed through a red hot chemically treated solution.500 tires Last year LMCL’s sales were Sh. Labour and overheads are direct cash expenses paid in the month incurred.250.750.Sales for the following five months are estimated to be as follows: January 1.100 per tire.600 units.200 tires March 1. hardened and finished in the same month the scrap tires are received. formed. The company uses FIFO inventory accounting.000 tires May 2.1.700 tires February 1. (This was not equal to the desired two-month supply) The major cost of production is the purchase of inventory worn-out second hand tires. The company usually maintains a minimum cash balance of Sh. and selling and administrative expenses are 20 per cent of sales. Lopos has just been notified that the scrap tires now have alternative uses. Lopos likes to keep inventory enough to supply the anticipated sales for the following two months ales.000 on 1. Labor cost s are relatively stable at Sh200 per tire since workers are paid on a piecework basis. The company pays for its materials 30 days after receipt. and their cost will rise effective beginning of January to Sh. but Mr.. As of year just ended.000 13. 5.378. and the company’s dividend pay-out ratio is 50 per cent.900.000 13.000 Inventory 2.000 Sh. The average tax rate is 40 per cent. 3.878.000 4.000 dep’n Total assets LIABILITIES AND OWNERS EQUITY Accounts payable Notes payable Lon-term debt: 9 per Sh.000 8. Marketable securities are sold before funds are borrowed at the beginning of the month.000 Accounts receivable 3.042.000. 184 .000. when a cash shortage is faced.following month. cent Ordinary share capital Retained earnings Total liabilities and 936.000. 300.878.000 owners equity Required (a) Monthly cash budget (b) Monthly and quarterly pro-forma statement. LCML’s balance was as follows: Loitokitok Manufacturing Company Limited Balance Sheet As at 31 December 2006 ASSETS Current Assets Cash Sh.000 Total current assets Fixed Assets Plant and equipment 10.000.000.200.000 5.000 Less: Accumulated 2. Dividends are paid at the end of each quarter.878. 000.000 4.378. cent Ordinary share capital Retained earnings Total liabilities and 1.000 425.850.042.000 15.000 Sh.000. 250.000 Accounts receivable 3.000 5.000 Total current assets Fixed Assets Plant and equipment 10.000.850.500.000 dep’n Total assets LIABILITIES AND OWNERS EQUITY Accounts payable Notes payable Lon-term debt: 9 per Sh.000.200.(c) Pro-forma quarterly balance sheet.200 15.045.000 Less: Accumulated 2. 4.200 owners equity Future Financial Needs and Pro-forma Statements 185 - . 7.000 8.000.100. Solution (c) Loitokitok Manufacturing Company Limited Pro-forma balance sheet As at 31 March 2007 ASSETS Current Assets Cash Sh.000 Inventory 4. 1. (c) Long-term financing (share capital and debt capital) is assumed not to have a clearly discernible link to sales volume. positive relationship with sales volume. The following steps could be of help in determining future financial requirements and resultant pro-forma statements. They will be assumed to be unchanged.A simple method for developing a pro-forma income statement is to use the percent-of sales method. or ii) Use an equation Equation As sales increase the external funds needed to support sales level will be determined as follows:- 186 . They (unless otherwise stated) are expected to vary in direct proportion with sales (b)Spontaneous sources of financing (account payable and accrued expenses) will vary in direct proportion with sales. 2. Sales are the most important variable in influencing a firm’s financial requirements. (d)Retained earnings will rise so long as the company is profitable and the overall dividend payout ratio is less than 100%. The percent of sales method uses the simplifying assumption that items on the balance sheet and the income statement have stable relationship to sales – a given % change in sales will elicit a corresponding % change in the item. Establish the relationship between sales and other accounts (a) All asset items have a stable. To determine the external financing required we could use two approaches: i) Prepare a pro-forma balance sheet. as at 31 December 2004 is given below: Assets Liabiliti es Cash Sh 5.000 Accounts Sh 40.000 187 .000 b\debto 40.bc(1 + g)/g (11. (S1 – S0)/S0.000.000. we can derive the following estimate Percent of sales of external funds required (PEFR) = A/S0 .Additional outside financing required Funds from Additional = assets - required Re tained spon tan eous sources profits - for period The equation is derived as follows:Let A = Total value of assets that change with sales SL = Spontaneous liabilities c = % of after tax earnings to sales (net profit margin) b = % of net profit retained (100 .2) Example The balance sheet of Mars Ltd.000.000.SL / S0 .SL /S0*(S1 – S0) .1) If g is the growth in sales i.pay-out ratio) S0 S1 = the current level of sales = Projected future sales level External Financing Required (EFR) = A/S0*(S1 – S0) .000 payable Accrued 10.bc S1 (11.e. 000.000 50.5% Accounts 40/200 = 20% 20% payable Accrued 10/200 = 5% 188 .000.000.000 payable Share 10.r Invento ry Fixed 25. Solution (a) i) Prepare percent of sales table Cash 5/200 Debtor = 40/20 2.000 -------------- capital Retained 45.0 00 00 Sales for year ended 31 December 2004 were Sh. accounts payable and accrued expenses are expected to maintain the current relationships to sales as sales volume increases.000.000. All assets. The net profit margin is 6% and dividend payout ratio is 40%.000 expenses Notes 15.300 million.200 million.000.000. Projected sales for 2005 amount to Sh. (b) Using the equation approach determine the amount of external funds required for the year 2005.0 120. Required (a) Prepare a pro-forma balance sheet as at 31 December 2005 with the item “external funds required” as the balancing account.000 assets earnings 120. 6 10.580.000 x 300) Notes payable 15.5% 300) Fixed expenses Sh 60.0 curren % t assets Fixed 50/20 assets 0= 25 Retained 0.06 x0.000 x 300) Inventory (12.000.800.0 earnings x 00 = 300millio n= Total 60% assets ii) Mars Ltd Pro-forma balance Sheet as at 31 December 2005 Assets Liabilities Sh.000.000.5 expenses Total ry 0= % spontane 25% ous Total 35.5% 7.000 x 189 .000.000 (20% 15.000 Share capital 10.000 75.500.000.s Invento 0= 25/20 12.000 Accounts x 300) payable Debtors x 300) Accrued (20% 60.000. Cash (2.000 (5% 37. 06 x 300 = 0.6 x 100 .000.0.0 00 00 Equation External Financing Required (EFR) = A/S0*(S1 – S0) .0.000 190 .SL/S0*(S1 – S0) .50/200*(300 – 200) .8) 155.24.00 financing 0 required (Balancing) b) 180.10.800.bcs1 = 120/200*(300 – 200) .200.000.800.assets (25% x 300) Retained (45 + 55.0 -------------- External 00 24.6 x 0.800.200.000 = Sh.0 180.25 x 100 .000 10. Semivariable Cost. each unit produced requires production material and labor. 191 . Examples include: Supervision and utilities. Utilities typically have a minimum service fee. Costs may increase in steps or increase relatively smoothly from a fixed base. neither cost is necessary or incurred. facility rent. Total fixed costs remain constant as volume varies in the relevant range of production. Semivariable costs include both fixed and variable cost elements. Examples include: Fire insurance. and property taxes. depreciation. such as electricity. activity level and the profit. Supervision costs tend to increase in steps as a supervisor's span of control is reached.TOPIC 9: PROFIT PLANNING Cost-Volume Profit (C-V-P) CVP Analysis examines the relationship between cost. Total variable cost increases as the number of units increases. and telephone. with costs increasing relatively smoothly as more of the utility is used.CVP Analysis assists in a wide range of profit planning and decision making situations including The effect of production method changes The effect of changes in product mix The viability of special sales promotion campaign The level at which service must be utilized to break-even The impact of price changes on profit as price changes In the short run. costs can be of three general types: Fixed Cost. Variable Cost. gas. However. Fixed cost per unit decreases as the cost is spread over an increasing number of units. Variable cost per unit remains constant no matter how many units are made in the relevant range of production. Examples include: Production material and labor. If no units are made. 192 . As unit costs decline. As that direct cost is spread over an increasing volume unit costs should decline. How will an increase in contract effort increase contract price? Some costs will increase others will not. Many indirect costs are fixed or Semivariable. The behaviour of total cost and total revenue has reliably been determined and is lineal within the relevant range. The principles of cost-volume-profit analysis can be used in indirect cost analysis. This assumption can be used to explain price changes as well as cost changes. the vendor can reduce prices and same make the same profit per unit.Cost-volume-profit analysis is an estimating concept that can be used in a variety of pricing situations. As the volume being acquired increases unit costs decline. Assumptions Required In C-V-P The main assumptions required in C-V-P analysis are: The relationship holds only within the relevant range. You can use the cost-volume relationship for: Evaluating item price in price analysis. indirect cost rates typically decline because fixed costs are spread over an increasing production volume. Evaluating direct costs in pricing contract changes. The relevant range is a band of activity within which a given cost behaviour is defined. Cost-volume-profit analysis assumes that total cost is composed of fixed and variable elements. Evaluating indirect costs. The concepts of cost-volume-profit analysis can be an invaluable aid in considering the effect of the change on contract price. Quantity differences will often affect direct costs -. As overall volume increases. Direct material requirements often include a fixed component for development or production operation set-up.particularly direct material cost. Evaluating direct costs in pricing new contracts. All costs can be divided into fixed and variable such that mixed costs are decomposed into their fixed and their variable components. some costs are variable. Selling prices are constant therefore we ignore quantity discounts. The variable component can be treated like any other variable cost. In analysis. Algebraic Analysis The assumption of linear cost behavior permits use of straight-line graphs and simple linear algebra in cost-volume analysis. Efficiency and productivity remain the same so that we therefore ignore the learning curve effect.Total cost is a semi-variable cost—some costs are fixed. As a result. There are no limiting factors Analyzing the Cost-Volume Relationship This section examines algebraic and graphic analysis of the cost-volume relationship. and others are semivariable. we can say that: Total Cost = Fixed Cost + Variable Cost Using symbols: C=F+V Where: C = Total cost F = Fixed cost V = Variable cost Total variable cost depends on two elements: Variable Cost = Variable Cost per Unit x Volume Produced Using symbols: 193 . Prices of factors of production remain constant. the fixed component of a semi-variable cost can be treated like any other fixed cost. Any change in total cost is the result of a change in total variable cost. variable cost per unit is Sh.000 units. C = F + Vu (Q) = 500 + 10 (1000) = Sh. as long as production remains within the relevant range of available cost information. Remember that: Fixed costs do NOT change no matter what the volume. you can calculate variable cost per unit.V = Vu (Q) Where: VU = Variable cost per unit Q = Quantity (volume) produced Substituting this variable cost information into the basic total cost equation. we have the equation used in cost-volume analysis: C = F + VU (Q) Illustration 2.1 If you know that fixed costs are Sh. As a result. Variable cost per unit does NOT change in the relevant range of production.500.10.10500 Given total cost and volume for two different levels of production. you can calculate the total cost of production. and the volume produced is 1. and using the straight-line assumption. we can calculate variable cost per unit (V U) using the following equation: VU = Change in Total Cost Change in Volume 194 . 000 units for Sh. You should always graph the data before performing an algebraic analysis. you can calculate fixed cost using the basic total cost equation.60. When you get more data.000. you must generally assume a linear relationship.50.= C2 – C1 Q2 – Q1 Where: C1 = Total cost for Quantity 1 C2 = Total cost for Quantity 2 Q1 = Quantity 1 Q2 = Quantity 2 Illustration You are analyzing an offeror's cost proposal. GRAPHIC ANALYSIS Introduction to Graphic Analysis When you only have two data points.000. you can examine the data to determine if there is truly a linear relationship.000 units of a key part for Sh. What is the apparent variable cost per unit? Vu = C2 – C1 Q2 – Q1 = 60000 . The same quote offered 4. 10 If you know total cost and variable cost per unit for any quantity. As part of the proposal the offeror shows that a supplier offered 5. 195 .50000 5000 – 4000 = Sh. Find the related cost on the vertical axis and draw an imaginary horizontal line from that point. and small enough to permit the graphing of all available data and anticipated data estimates. Fit a straight line to the data. Steps of Graphic Analysis There are four steps in using graph paper to analyze cost-volume relationships: Step 1. (If you do not feel comfortable with imaginary lines you may draw dotted lines to locate the intersection. Step 2. Graphic analysis is useful in analyzing cost-volume relationships. Step 3. Plot the available cost-volume data. when the cost and volume numbers involved are relatively small. Determine the scale that you will use. Each scale should be large enough to permit analysis. However. The scales on the two axes do not have to be the same. Volume is considered the independent variable and will be graphed on the horizontal axis. on each axis one block must represent the same amount of change as every other block of the same size on that axis. Cost is considered the dependent variable and will be graphed on the vertical axis. Even when actual analysis is performed algebraically you can use graphs to demonstrate cost-volume analysis to others. Find the volume given for one of the data points on the horizontal axis. 196 . particularly. Draw an imaginary vertical line from that point.) Repeat this step for each data point. The point where the two lines intersect represents the cost for the given volume. Graphic analysis is the best way of developing an overall view of costvolume relationship. Step 4. all data points will fall on a straight line. Draw an imaginary vertical line from the given volume to the point where it intersects the straight line that you fit to the data points.000 197 .000 500 $175. Then move horizontally until you intersect the vertical axis. Estimate the cost for a given volume. Assume that you have been asked to estimate the cost of 400 units given the following data: Units Cost 200 $100. Most analysts use regression analysis to fit a straight line when all points do not fall on the line. The four steps of cost-volume-profit analysis can be used to graph and analyze any cost-volume relationship. Example of Graphic Analysis. All that you have to do to fit a straight line is connect the data points.In this section of text. That point is the graphic estimate of the cost for the given volume of the item.000 600 Solution $200. To compute the break even point we let S be selling price per unit Vu be variable cost per unit Q be break-even quantities F be total fixed costs At Break even point: Total revenue (TR) = Total Cost (TC) Total revenue will be given by SQ while Total cost (TC) = Vu Q + F 198 . Break Even Analysis Break even analysis is mainly used to explain the relationship between the cost incurred.The estimated cost will be $ 150.000. the volume operated at and the profit earned. 5 to produce and you incur Sh.Vu B. The badges cost Sh.Vu Illustration Assume that you are planning to sell badges at the forthcoming Nairobi Show at Sh.At break-even point (BEP) therefore: SQ = Vu Q + F Q = ___F___ S.E.1640.9 each.2000 to rent a booth in the Show ground. = 500 x 9 = 4500/b) Margin of safety 199 .P (in units) = F S. Solution a) Break even point BEP units = 2000/(9-5) = 500 units BEP Sh. Required: a) Compute the breakeven point b) Compute the margin of safety c) Compute the number of units that must be sold to earn a before tax profit of 20% d) Compute the number of units that must be sold to earn an after tax profit of Sh. assuming that the tax rate is 30%. 2 (9X) 9-5 X= 2000 + 1. It is a measure of the risk that the company might make a loss if it fails to achieve the target.The margin of safety is the amount by which actual output or sales may fall short of the budget without the company incurring losses.Vu X = 2000 + 0.09 approximately 910 units. A high margin of safety means high profit expectation even if the budget is not achieved.Break even sales Expected sales = 600-500 = 16.8X 4 X = 909.7% 600 c) Target before tax profit (Y) Let X be the number of units to produce X=F + Y S . Margin of safety (MOS) can be computed as follows: MOS = Expected sales . d) After Tax profit Let Z be the after tax profit 200 . Vt is the variable cost of product t.3 9-5 X = 1085. n is the number of units of product t sold BEPt units = αt (Total BEPunits) 201 .71 Approximately 1086 units. St is the selling price of product t. The objective in such a case is to produce a mix that maximises total contribution.Y = Z__ I–t Therefore X = F + z/1-t S – Vu = 2000 + 1640 1-0. C-V-P Analysis – Multiple Products The simple product CVP analysis can be extended to handle the more realistic situations where the firm produces more than one product. Total BEP = units Total fixed cost Average CM n Average CM= (S t 1 t Vt ) t where αt is the sales mix of product t. 40 1 n Average CM= (S t 1 t Vt ) t = 0.000 Sh.000 120.000 400.000 100. product A and B and the following budget has been prepared. 3/Contribution @ 1/.BEP tsh. 10/Variable cost @ 4/-.25 1 Sales mix (Shs) 0. B 40.000 100. Total 160.000 Sh. = BEPt(units) xSt Illustration Assume that ABC Ltd produces two products.000 600.7/Total fixed cost Profit A 120.000 400.000 120.05(7) 202 . 600.000 280. Advice the Co. on whether this change is desirable.75 (1) + 0.000 300.75 0.60 0.000 Required: a) Compute the break-even point in total and for each of the products. Solution A B Sales mix (units) 0. Sales in units Sales @5/-.000 480.000 Sh. b) The company proposes to change the sales mix in units to 1:1 for products A and B. = 2.000 = 0. Units A 750000 x 0.4 1000.25 = 30. = Total fixed cost C/S sales ratio C/S ratio = 400. Total BEP Sh.4 = 300000 300000/10= 30000 750000 b) Changing sales mix in units to 1:1 ratio 203 120000 .000 120000 x 0.5 Total BEP units = Total fixed cost = 300000 Average CM 2.000 A B BEP(sh) (90000x5) = 450.000 0.6 = 450000 450000/5 = 90000 B 750000 x 0.4 Sh.000 units BEP (units) 120000 x 0.5 = 120.000 The above question can be solved by computing the BEP Sh first and the using the Sales Mix in Shs.000 Total BEP(sh) = 300000 = 750.75 = 90.000 120.000 (30000 x 10) = 300.000 750. 300000 to sh. A (0.000 Net Profit 340.000 640.5 x 75000) 37500 187.000 units 4 BEP BEP units sh. But for manager of product B.187500 than on sh.375000.000 Sales mix in units is 80000/160000 = 0. 3/- 320000 240000 560000 Contribution 80.The budget can be reproduced as follows: A B Sales in units 80000 Total 80000 sh 160000 sh sh Sale @ 5/-.000 560. the change is good because he now breaks even at sh.c @ 4/-. C-V-P Analysis Under Uncertainty 204 . 10/- 400000 800000 1200000 V.500 B (0.5(1) + 0.5 (7) = 4 Total BEP units = 300.450000.000 = 75.000 75000 562.5 Average CM = 0. the change is not good because BEP has risen from sh.5 x 75000) 37500 375.000 Total fixed cost 300.500 For manager of product line A. These might be values that are reasonably expected to occur but usually 3 values are selected.V. These are: The worst possible outcome The most likely outcome The best possible outcome For each of these 3 values.A major limitation of the basic C. normal distribution Simulation analysis Margin of safety Point Estimate of Probabilities This approach requires a number of different values for each of the uncertain variables to be selected.P analysis is the assumption that the unit variable cost. selling price and the fixed costs are constant and can be predicted with certainty. There are various ways of dealing with uncertainty. Illustration Assume that a Management accountant of a Company that makes and sells product X has made the following estimate: Selling price Unit 205 variable .g. a probability of occurrence will be estimated. Examples include: Sensitivity analysis Point estimate of probabilities Continuous probability distribution e. These factors however are variables with expected values and standard deviations that can be estimated by management. 0.60.09 .3) + (50000 x 0.3) x (4 x 0. that the company will fail to break even c.30 0.240. 45000 Profit 0.000 Required: a.10 Sales demand Condition Unit Worst possible 45000 Most likely 50000 Best possible55000 cost Condition Prob.4. 0.3 3.3 0.075) 49000 – 240000 = Sh.000 what is the probability that the company will not achieve this target. Solution a) E(Demand) = (45000 x 0.6 0. Compute the expected profit b.5 x 0.1 Cost Best possible3.5 Sh.15 Fixed cost = Sh.15) = Sh. Contr G (FxG) Profit Joint weighted Prob. D Unit VC E F Prob.6) + (55000 x 0.55 0.55) + (55 x 0.50325 This can be worked out differently as shown below: A B Demand C Prob.1) = 49000 E(variable cost) = (3. If the Company has a profit target of Sh. Compute the prob.5 Most likely 4.Sh.0 Worst possible 5.30 292500 4725 206 52500 0.5 0.075 E(Profit) = (10-4. 045 (1687.055 4950 0.015 112.3 + 0.165 4950 (37500) 0. The production process is such that at least 9.0 0.15 225000 (15000) 0.55 300000 60000 0.5 50325 The P(Profit <0) = 0.0 0.15 247500 7500 Expected profit b) 0.000 units must be produced during the period.5 0. Production levels must be set at the start of the period and cannot be changed during the period.405 Worked example Thunder manufacturing company produces a toxic product. Thunder can manufacture ‘coros’ itself at a variable cost of Sh40 per unit or they can purchase it from an outside supplier at a cost of Sh70 per unit.5 0.09 (1350) 0.18 15300 55000 4.5 0.045 + 0.33 3525 4.50000 4.5 0. Thunder can sell ‘coros’ at Sh80 per unit.5 0.3 357500 117500 0.55 270000 5.015 = 0.0 0.1 3. Thunder management 207 .135 Note: This can be read from the above table c) P(profit < 60000) = 0.33 19800 5.3 325000 30000 0.5) 85000 0.6 3.55 330000 90000 5.09 = 0. ‘coros’ that must be sold in the month produced or else discarded.09 + 0.15 202500 0. 000 0.5 11. e) Standard deviation of profits from manufacturing and selling.5 3500 11.000 0.4 1600 7000 0. f) Coefficient of variation for each alternative Solution a) Expected demand is computed as follows: Demand (units) Probability Expected demand(units) 4000 0.1 Required: a) Expected demand b) Expected profit from purchasing ‘coros’ from an outside supplier and selling it c) Expected profit from manufacturing and selling d) Standard deviation of profits from purchasing and selling.1 1100 Expected demand 6200 b) The expected profit from purchasing and selling would be equal to the 208 .4 7.000 0.000 0. The possible sales of ‘coros’ and their probabilities are: Demand Probability (units) 4.must decide whether to produce ‘coros’ or whether to purchase it from the outside supplier. 4 456.0 (11.1 440.0 209 .000 d) The standard deviation from purchasing and selling is: I–Ī (I – Ī)² P (million) (4.000 11.000 units must be produced.000 32. Units produced in excess of 9. the cost is really fixed up to that point because of the minimum production constraints.5 360.4 360.000 – 6200) Sh10 – 6200) Sh10 193.000 128.000 440. The expected profit from manufacturing is: Demand (units) Probability Manufacturing costProfit Expected profit (Shs) (Shs) 4000 0.000 44. since a minimum of 9.000200.000) 7000 0.000 – 6200)Sh10 230.000 0.6 (7.000)(16.000100.000 could carry the variable cost of Sh40 each.000(40.unit contribution times the expected quantity or Sh (80 – 70) x 6200 = Sh62.000 c) Even though the production cost is stated as a variable cost. 4 Total 23.289.000 – 128.0 440.354 The standard deviation from manufacturing and selling is I–Ī (I – Ī)²P (million) -40.616.000 210 .000 – 128.0 Standard deviation =√23.e.000 9.734.344 Sh 62.6 200.000 –128.675 f) Coefficient of variation for purchasing and selling is (S/I) i.201 Sh 128.592.000 11.354 = 0.616 million = Sh153.000 For manufacturing and selling is: Sh 153.000 2.675 = 1. Sh 21. Standard √456m e) deviation = = Sh21. d) Target levels of each category of current assets How current assets will be financed Liquidity management involves the planned acquisition and use of liquid resources over time to meet cash obligations as they become due. c) Working capital management refers to the administration of current assets and current liabilities. cash ratio. current asset investment decisions. etc. quick (or acid test) ratio. is to 211 . The firm’s liquidity is measured by liquidity ratio such as current ratio. the NPV approach is rarely used for evaluating working capital investment decisions. calls for a cost-benefit evaluation of a large number of alternatives. commonly used. and the selection of that alternative that produces the greatest net benefit. In practice. as in the case of investment in fixed assets. The typical process will feature the following activities: (1)The financial manager estimates the costs and benefits of each alternative. (2)The net present value (NPV) must be calculated for each alternative given the discount rate approximate to the degree of risk involved (3)The alternative with the highest NPV is chosen and implemented. The alternative approach. Working Capital Management Decisions In principle. however. b) Net working capital refers to current assets minus current liabilities.TOPIC 10: WORKING CAPITAL MANAGEMENT Introduction Working capital a) Working capital (also called gross working capital) refers to current assets. with long-term funds unnecessarily tied up when they could be more profitably invested elsewhere. there will be an over-investment by the company in current assets. Overcapitalization and Overtrading The finance manager must be wary of two polar extremes in working capital management. so that there are excessive stocks. (1) Sales/Working capital ratio:- the volumes of sales as a multiple of working capital should indicate whether the total volume of working capital is too high (compared to the past and industry norms). (2) Liquidity ratio. working capital. Over Capitalization (Conservative Financing Strategy) If a company manages its working capital. A current ratio and a quick ratio in excess of the industry norm or past ratios will indicate over-investment in current assets (3) Turn-over periods.e. the company will have too much capital invested in unnecessarily high levels of current assets). Indicators of over-capitalization Accounting ratios can assist in judging whether over capitalization is present. The management of working capital boils down to balancing the risks and benefits of holding excessive. (2) overtrading. The result of this would be that the return on investment will be lower than it should. debtors and cash and very few creditors. (i) over-capitalization and. Excessive stock and debtors’ turnover periods or too short creditor payment period might indicate that 212 . to those of holding too little. Working capital will be excessive and the company is said to be overcapitalized ( i. These extremes are.maximize average net profit. with the amount invested treated as its equivalent annual cost. (3)The payment period to trade creditors lengthens (4)Bank over-drafts often reach or exceed the limit of facilities offered by the bank. liquidity problems could soon set in. Under this approach. or creditors’ volume too low.the volume of debtors and stocks is unnecessarily high. There are three major approaches to financing current assets. Over-trading (Aggressive Financing Strategy) Overtrading occurs when a business tries to do too much too quickly with too little long-term capital: The capital resources at hand are not sufficient for the volume of trade. (5)The debt ratios rise (6)The current ratio and quick ratio fall and the net working capital (NWC) could be negative. These are: a) Matching Approach This approach is sometimes referred to as the hedging approach. disrupting operations and posing insolvency problems. Though initially an over-trading business may operate at a profit. Symptoms of over-trading Accounting indicators of overtrading include: (1)Rapid increases in turn-over ratios (over-heating) (2)Stock turnover and debtor’s turnover might slow down with consequence that there is a rapid increase in current assets. Financing Current Assets Current Assets require financing by use of either current funds or long term funds. the firm adopts a financial plan which involves the matching of the 213 . therefore. The firm. b) Conservative Approach An exact matching of asset life with the life of the funds used to finance the asset may not be possible. (Some sources of short-term funds such as accruals are cost-free). finances its permanent assets and a part of its temporary assets with longterm funds. The firm. However. uses long term funds to finance permanent assets and short-term funds to finance temporary assets. A firm that follows the conservative approach depends more on long-term funds for financing needs.expected life of assets with the expected life of the source of funds raised to finance assets. Risk-Return trade-off of the three approaches: It should be noted that short-term funds are cheaper than long-term funds. short-term funds must be repaid within the year and therefore they are 214 . therefore. Permanent assets refer to fixed assets and permanent current assets. This approach is illustrated by the following diagram. This approach can be shown by the following diagram. we can consider the risk-return trade off of the three approaches. The conservative approach is a low return-low risk approach. are not to be repaid within the year and are therefore less risky. These funds however. These factors are comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406). They however include: a) Nature and size of the business. b) Firm’s manufacturing cycle c) Business fluctuations d) Production policy e) Firm’s credit policy f) Availability of credit g) Growth and expansion activities. Determinants Of Working Capital Needs There are several factors which determine the firm’s working capital needs.highly risky. The aggressive approach on the other hand is a highly risky approach. Importance Of Working Capital Management The finance manager should understand the management of working capital because of the following reasons: 215 . With this in mind. This is because the approach uses more of long-term funds which are now more expensive than short-term funds. However it is also a high return approach the reason being that it relies more on short-term funds that are less costly but riskier. The matching approach is in between because it matches the life of the asset and the life of the funds financing the assets. The finance management must therefore keep watch on changes in working capital items.a) Time devoted to working capital management A large portion of a financial manager’s time is devoted to the day to day operations of the firm and therefore. Changes in current assets directly affect the level of sales. A small firm also has relatively limited access to long term capital markets and therefore must rely heavily on short-term funds. b) Investment in current assets Current assets represent more than half of the total assets of many business firms. Since cash and marketable securities are the firm’s most liquid assets. d) Relationship between sales and current assets The relationship between sales volume and the various current asset items is direct and close. The finance manager should therefore properly manage these assets. These investments tend to be relatively volatile and can easily be misappropriated by the firm’s employees. they provide the firm with the ability to meet its maturing obligations. c) Importance to small firms A small firm may minimize its investments in fixed assets by renting or leasing plant and equipment. 216 . but there is no way it can avoid investment in current assets. so much time is spent on working capital decisions. Cash And Marketable Securities Management The management of cash and marketable securities is one of the key areas of working capital management. Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year. Cash Cycle and Cash Turnovers Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash outlay to purchase raw materials to the point when cash is collected from the sale of finished goods produced using those raw materials. which are securities. The credit terms extended to the firm currently requires payment within thirty days of a purchase while the firm currently requires its customers to pay within sixty days of a sale. it often puts the excess cash into an interest-earning instrument. currently purchases all its raw materials on credit and sells its merchandise on credit. Thus when a firm realises that it has accumulated more cash than needed. Illustration XYZ Ltd. accepted by banks d) Commercial paper (unsecured promissory notes) e) Repurchase agreements f) Negotiable certificates of deposits g) Eurocurrencies etc. Marketable securities are short-term investments made by the firm to obtain a return on temporary idle funds. However.Cash refers to cash in hand and cash on demand deposits (or current accounts). a) Government treasury bills b) Agency securities such as local governments securities or parastatals securities c) Banker’s acceptances. The firm can invest the excess cash in any (or a combination) of the following marketable securities. the firm on average takes 35 days to pay its accounts payable and the average 217 . It therefore excludes cash in time deposits (which is not immediately available to meet maturing obligations). 85 days elapse between the point a raw material is purchased and the point the finished goods are sold. Solution The following chart can help further understand the question: Inventory Conversion period (85 days) Receivable collection Period (70 days) Payable deferral Purchase of raw Payment for the raw materials Sale of Finished Cash conversion cycle = 85 + 70 Collection of - The cash conversion cycle is given by the following formula: Cash conversion = Inventory conversion + Receivable collection – Payable deferral 218 .collection period is 70 days. On average. Required Determine the cash conversion cycle and the cash turnover. Cycle period period period For our example: Cash conversion cycle = Cash turnover = 85 + 70 – 35 = 120 days 360 Cash conversion cycle = = 360 120 3 times Note also that cash conversion cycle can be given by the following formulae: Cash conversion cycle = NB: inventory receivable s Payables Accruals costofsale s sales Cashoperat ingexpense s 360 In this chapter we shall assume that a year has 360 days. Setting The Optimal Cash Balance Cash is often called a non-earning asset because holding cash rather than a revenue-generating asset involves a cost in form of foregone interest. There are several methods used to determine the optimal cash balance. The firm should therefore hold the cash balance that will enable it to meet its scheduled payments as they fall due and provide a margin for safety. These are: a) The Cash Budget 219 . The firm uses cash at a steady predictable rate 2. Its assumptions are: 1. b) Baumol’s Model The Baumol’s model is an application of the EOQ inventory model to cash management. Under these assumptions the following model can be stated: C* 2bT i Where: C* is the optimal amount of cash to be raised by selling marketable securities or by borrowing. b is the fixed cost of making a securities trade or of borrowing T is the total annual cash requirements i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the cost of borrowing) The total cost of holding the cash balance is equal to holding or carrying cost plus transaction costs and is given by the following formulae: TC 1 Ci T b 2 C Illustration 220 . The cash net outflows also occur at a steady rate. This method has already been discussed in other earlier courses. The cash outflows from operations also occurs at a steady rate 3.The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period. The student should however revise the cash budget. of transfers = T C* 221 .10. Required a) Determine the optimal amount of marketable securities to be converted into cash every time the company makes the transfer. it incurs a cost of Shs.166.13. makes cash payments of Shs.000 per week.20.000 = Shs.000 i = 12% C* 2 x 20 x 520.12 Therefore the optimal amount of marketable securities to be converted to cash every time a sale is made is Sh.000 Sh. d) Determine the firm’s average cash balance.ABC Ltd. c) Determine the total cost of maintaining the cash balance per year.20 T = 52 x 20.13.520.166 0. The interest rate on marketable securities is 12% and every time the company sells marketable securities. b) Total no. Solution a) C* 2bT i Where: b = Shs. b) Determine the total number of transfers from marketable securities to cash per year. the net cash flow could be the 222 .580 Therefore the total cost of maintaining the above cash balance is Sh. Each day.166 = c) TC = 39. Miller-Orr Model is a stochastic (probabilistic) model which makes the more realistic assumption of uncertainty in cash flows.5 ≈ 40 times 1 T Ci b 2 C = 13.1.6.166 x 0. Merton Miller and Daniel Orr assumed that the distribution of daily net cash flows is approximately normal.12 520.1.166 = 790 + 790 = Shs.000 x 20 2 13.520.583 c) Miller-Orr Model Unlike the Baumol’s Model.166 2 = Shs.580. d) The firm’s average cash balance = ½C = 13.000 13. H and L respectively. and a target cash balance. is given by: H = 3Z . the daily net cash follows a trendless random walk. From the graph below. the Miller-Orr Model sets higher and lower control units. Similarly. H. When the cash balance reaches H (such as point A) then H-Z shillings are transferred from cash to marketable securities. The Lower Limit is usually set by management. The target balance is given by the following formula: 1/ 3 2 Z 3B 4 i L and the highest limit. Z. when the cash balance hits L (at point B) then Z-L shillings are transferred from marketable securities cash. Thus.expected value of some higher or lower value drawn from a normal distribution.2L The average cash balance Where: = 4Z L 3 Z = target cash balance H = Upper Limit L = Lower Limit b = Fixed transaction costs i = Opportunity cost on daily basis δ² = variance of net daily cash flows 223 . 10. Required a) Calculate the target cash balance b) Calculate the upper limit c) Calculate the average cash balance d) Calculate the spread Solution a) Z 3b² 4i 1/ 3 L 224 The transaction cost for .000.2.500 and the interest rate on marketable securities is 9% p. each sale or purchase of securities is Sh. The standard deviation of daily cash flow is Sh.Illustration XYZ’s management has set the minimum cash balance to be equal to Sh.20.a. 31.211 + 10. = c) 3x 20 x ( 2.211(17.211) in marketable securities and if the balance falls to Shs.633 Average cash balance d) The spread = 4Z L 3 = 4 x17.7.000 9% 4x 360 = 7.000 = Sh.000 = Shs. However. the firm should sell Shs. Other Methods Other methods used to set the target cash balance are The Stone Model and Monte Carlo simulation.14.000) = Shs.422 (31.500)² 10.633 – 17.000) of marketable securities.633.211 10.10. 225 .211 – 10.000. these models are beyond the scope of this manual.211 b) H = 3Z – 2L = 3 x 17.21.211 – 2(10.633 Note: If the cash balance rises to 31. the firm should invest Shs.17.633 – 10.000 3 = H–L = 31. CASH MANAGEMENT TECHNIQUES The basic strategies that should be employed by the business firm in managing its cash are: i) To pay account payables as late as possible without damaging the firm’s credit rating. which deposit these receipts in local banks. Customers within these areas are required to remit their payments to these sales offices. This may be done either through: a) a) Concentration Banking b) Lock-box system. 226 . The firm may use cash discounts to accomplish this objective. Concentration Banking Firms with regional sales outlets can designate certain of these as regional collection centre. The firm should however take advantage of any favourable cash discounts offered. iii) Collect accounts receivable as quickly as possible without losing future sales because of high pressure collection techniques. but avoid stockouts which might result in loss of sales or shutting down the ‘production line’. Funds in the local bank account in excess of a specified limit are then transferred (by wire) to the firms major or concentration bank. In addition to the above strategies the firm should ensure that customer payments are converted into spendable form as quickly as possible. ii) Turnover inventory as quickly as possible. deposits the cheques in the firm’s account and sends a deposit slip indicating the payment received to the firm. b) Lock-box system. Work-in-progress 3. This model is given by the following equation: 227 . Raw materials 2. The bank opens the payment envelope. This system reduces the customer’s mailing time and the time it takes to process the cheques received. Finished goods inventory The firm must determine the optimal level of inventory to be held so as to minimize the inventory relevant cost.Concentration banking reduces the amount of time that elapses between the customer’s mailing of a payment and the firm’s receipt of such payment. The post office box is emptied by the firm’s bank at least once or twice each business day. In a lock-box system. MANAGEMENT OF INVENTORIES Manufacturing firms have three major types of inventories: 1. BASIC EOQ MODEL The basic inventory decision model is Economic Order Quantity (EOQ) model. the customer sends the payments to a post office box. D TC = ½QCn + Q C o Where: Total holding cost = ½QCn D Total ordering cost = Q C o The holding costs include: 1. Cost of placing orders such as telephone and clerical costs 2.Q 2DCo Cn Where: Q is the economic order quantity D is the annual demand in units Co is the cost of placing and receiving an order Cn is the cost of holding inventories per unit per order The total cost of operating the economic order quantity is given by total ordering cost plus total holding costs. Shipping and handling costs 228 . Insurance costs 4. Obsolescence costs The ordering costs include: 1. Cost of tied up capital 2. Storage costs 3. Required 229 . the firm is assumed to place an order of Q quantity and use this quantity until it reaches the reorder level (the level at which an order should be placed).50 to prepare and process while the holding cost is Shs. The items are available locally and the leadtime in one week. The reorder level is given by the following formulae: R D L 360 Where: R is the reorder level D is the annual demand L is the lead time in days EOQ ASSUMPTIONS The basic EOQ model makes the following assumptions: i) The demand is known and constant over the year ii) The ordering cost is constant per order and certain iii) The holding cost is constant per unit per year iv) The purchase cost is constant (Thus no quantity discount) v) Back orders are not allowed.Under this model.000 units of a component in its manufacturing process in the coming year which costs Sh.50 each. Each order costs Sh.15 per unit per year for storage plus 10% opportunity cost of capital. Illustration ABC Ltd requires 2. 20 L = 7 days b) c) Q 2 x 2. of orders = = D Q 2. Suggested Solution: a) Q 2DCo Cn Where: D = 2.000 x 7 360 = 39 units No.50 Cn = Sh.000 units Co = Sh.000 x 50 100units 20 R = DL 360 = 2.000 100 230 .a) How many units should be ordered each time an order is placed to minimize inventory costs? b) What is the reorder level? c) How many orders will be placed per year? d) Determine the total relevant costs.15 + 10% x 50 = Sh. the total purchases cost will decrease. the firm is able to take advantage of quantity discounts.000 = Sh. then usually the minimum amount at which discount is given may be greater than the Economic Order Quantity. Illustration Consider illustration one and assume that a quantity discount of 5% is given if a minimum of 200 units is ordered. If discounts exists. 231 . If the minimum discount quantity is ordered.2. However.000 + 1. EXISTENCE OF QUANTITY DISCOUNTS Frequently.000 2.000 (50) 100 Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is received.= d) TC 20 orders D = ½QCn + Q C o = ½(100)(20) + = 1. then the total holding cost will increase because the average inventory held increases while the total ordering costs will decrease since the number of orders decrease. they also influence the Economic Order Quantity. Because these discounts affect the price per unit. 000 Total savings = 2.000 (50) = Sh.500 .500 100 Ordering cost if 100 units is ordered 2.000 – 500 = Sh. savings in ordering costs and increase in holding costs.Required Determine whether the discount should be taken and the quantity to be ordered. Savings in purchase price: New purchase price = Savings in purchase price per unit = 50 x 95% = Sh.47.000 x 2.000 Savings in Ordering Cost Assuming an order quantity of 200 units per order.2. Suggested Solution We need to consider the saving in purchase costs.50 Total units per year = 2.5.000 100 Therefore savings in ordering costs = 232 1. the total ordering cost will be: 2.000 (100) = Sh.50 Sh.50 per unit = 50 – 47.1.50 = Sh. 75 The discount should be taken because the net savings is positive. 233 To .1. determine the number of units to order we recomputed Q with discount Qd. Savings in purchases costs 5.975 – 1.000 x 50 19.975 The Net Effect therefore: Shs.000 Increase in holding costs = 1.19.75 = Shs.525 Cn = 15 + 10% x 4.1.975 holding costs if 100 units are ordered ½(100(20) = Sh.000 = Sh.500 Less increase in holding costs Net savings Qd 2DCo Cn Qd 2 x 2.75 975 4.Increase in holding costs Holding cost if 200 units are ordered ½(200)19.75 = Sh.000 Savings in ordering costs 500 Total savings 5. then order Qd. The existence of safety stock can be illustrated by Figure 5. carrying a safety stock has costs (it increases the average stock). Illustration Consider illustration one and assume that management desires to hold a minimum stock of 10 units (this stock is in hand at the beginning of the year).6 units Decision rule: If Qd < minimum discount quantity. If Qd < minimum discount quantity. Required a) Determine the re-order level b) Determine the total relevant costs Suggested solution a) R = DL S 360 Where: S is the safety stock 234 . The safety stock guards against delays in receiving orders. UNCERTAINTY AND SAFETY STOCKS Usually demand requirements may not be certain and therefore the firm holds safety stock to safeguard stock out cases. then order the minimum discount quantity.= 100. However.7. 000 (50) 100 Management of Accounts Receivable In order to keep current customers and attract new ones. The total amount of receivables outstanding at any given time is determined by: a) The volume of credit sales b) The average length of time between sales and collections. Accounts receivable represents the extension of credit on an open account by a firm to its customers.200 + 1. Accounts receivable management begins with the decision on whether or not to grant credit.000 x 7 10 360 49 units The average inventory = TC ½Q + S = (½Q + S)Cn + D/QCo = [½(100) + 10]20 + = 1. most firms find it necessary to offer credit.2.= = b) 2.200 2. 235 .000 = Shs. The firm following a lenient credit policy tends to sell on credit to customers on a very liberal terms and credit is granted for a longer period. A lenient credit policy will result in increased sales and therefore increased contribution margin. sell on credit on a highly selective basis only to those customers who have proven credit worthiness and who are financially strong.Accounts receivables = Credit sales per day x Length of collection period The average collection period depends on: a) Credit standards which is the maximum risk of acceptable credit accounts b) Credit period which is the length of time for which credit is granted c) Discount given for early payments d) The firm’s collection policy. However. these will also result in increased costs such as: 1. Increased discount costs to encourage early payments 236 . A firm following a stringent credit policy on the other hand. Increased cost of carrying out credit analysis 4. a) CREDIT STANDARDS A firm may follow a lenient or a stringent credit policy. Increased bad debt losses 2. Increased collection cost 5. Opportunity cost of tied up capital in receivables 3. The goal of the firm’s credit policy is to maximise the value of the firm. The higher the cost of collecting account receivables the lower the bad debt losses. 237 . In considering the credit terms to offer the firm should look at the profitability caused by longer credit and discount period or a higher rate of discount against increased cost. Comparison of incremental profits with incremental costs b) CREDIT TERMS Credit terms involve both the length of the credit period and the discount given. The terms 2/10. The firm must therefore consider whether the reduction in bad debt is more than the increase in collection costs. Estimation of incremental operating profits from increased sales 2. It can also result in reduced bad debt losses. Estimation of incremental investment in account receivable 3. Estimation of incremental costs 4. n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of invoice otherwise the net amount should be paid by the 30th day. d) COLLECTION POLICY The firm’s collection policy may also affect our analysis. the evaluation of investment in receivables should involve the following steps: 1. c) DISCOUNTS Varying the discount involves an attempt to speed up the payment of receivables. To achieve this goal. Illustration Riffruff Ltd is considering relaxing its credit standards.25 x100 Sh.800 = 1.4.75 is variable costs.5% of annual credit sales.a.000. Assume 360 days p. Current annual credit sales amounts to Sh.100 Sh. Sh.000 p. The firm wants to extend credit period net 60.25 = 25% Cost benefit analysis Contribution Margin New policy Current policy 25% x 7.7.000. Credit analysis and debt collection costs will increase by Sh.000 Sh.6. Sales are expected to increase by 20%.75 Therefore contribution margin ratio = = Sh.000 x 1.000. Bad debts will increase from 2% to 2.000 Credit analysis and debt collection costs Bad debts 238 1.20 Contribution margin = = Sh.200.000 = Sh.000.6.500 = 300 (84) .000. The return on investment in debtors is 12% for Sh.200.6.a.100 – Sh. The firms current credit terms is net 30 but the average debtors collection period is 45 days. Should the firm change the credit policy? Suggested Solution Current sales New sales = Sh.000 = 25% x 6.100 of sales.As saturation point increased expenditure in collection efforts does not result in reduced bad debt and therefore the firm should not spend more after reaching this point. 000. Sales p.000 180 = 120 (60) Debtors New debtors = Current debtors = Cr. 60 x 7.period 360days x cr. This is referred to as credit analysis and can be done by using information derived from: a) The applicant’s financial statement b) Credit ratings and reports from experts c) Banks d) Other firms e) The company’s own experience 239 .200. EVALUATION OF THE CREDIT APPLICANT After establishing the terms of sale to be offered.000.000 360 1. the firm must evaluate individual applicants and consider the possibilities of bad debt or slow payments.5% x 7. change the credit policy.000 360 = = 45 x 6.New bad debts = Current bad debts = 2.200.200 = Increase in debtors (tied up capital) Forgone profits = 750 450 12% x 450 (54) Net benefit (cost) 102 Therefore.a.000 = 2% x 6. To illustrate let us assume that two factors are important in evaluating a credit applicant the quick ratio and net worth to total assets ratio. the good and bad customers). The discriminant function will be of the form.APPLICATION OF DISCRIMINANT ANALYSIS TO THE SELECTION OF APPLICANTS Discriminative analysis is a statistical model that can be used to accept or reject a prospective credit customer. ft = Where: a1(X1) + a2(X2) X1 is quick ratio X2 is the network to total assets a1 and a2 are parameters The parameters can be computed by the use of the following equations: a1 = Szz dx – Sxzdz Sxx Sxx – Sxz² a2 = Szz dx – Sxzdz Szz Sxx – Sxz² Where: Sxx represents the variances of X1 Szz represents the variances of X2 Sxz is the covariance of variables of X1 and X2 dx is the difference between the average of X1’s bad accounts and X2’s good accounts 240 . The discriminant analysis is similar to regression analysis but it assumed that the observations come from two different universal sets (in credit analysis. This value is referred to as the discriminant value and is denoted by f*. The rate of interest in the money market is 7.dz represents the difference between the average of X’s bad accounts and X’s good accounts.465% p. Required a) What is Wema’s target cash balance? b) What are the lower and upper cash limit? c) What are the Wema’s decision rules? d) Determine Wema’s expected average cash balance.a. The firm pays Sh. Wema uses the Miller-Orr Model to set its target cash balances.50 in transaction costs to transfer funds into and out of this money market. ft = a1x1 + a2x2 + … + anxn QUESTION Wema Ltd has estimated that the standard deviation of its daily net cash flows is Sh. In such a case the discriminant function will be of the form.500. More than two variables can be used to determine the discriminant function. Once the discriminant function has been developed it can then be used to analyse credit applicants. 241 . The important assumption here is that new credit applicants will have the same characteristics as the ones used to develop the mode.2. The next step is to determine the minimum cut-off value of the function below at which credit will not be given. 242 . Conglomerate: Two firms in completely different industries merge. such as a gas pipeline company merging with a high technology company. throughout this topic we will loosely refer to mergers and acquisitions ( M & A ) as a business transaction where one company acquires another company. For example. in order to gain an advantage in distributing its products. The acquiring company (also referred to as the predator company) will remain in business and the acquired company (which we will sometimes call the Target Company) will be integrated into the acquiring company and thus. In an acquisition. companies in mature 243 .TOPIC 11:MERGERS AND TAKE. Typically. a large manufacturer of pharmaceuticals. such as a manufacturer merging with a supplier. For example. the merger between Total and ELF will allow both companies a larger share of the oil and gas market. Vertical mergers are often used as a way to gain a competitive advantage within the marketplace. both companies may continue to exist. the acquired company ceases to exist after the merger. we are referring to the joining of two companies where one new company will continue to exist. Conglomerates are usually used as a way to smooth out wide fluctuations in earnings and provide more consistency in long-term growth. Horizontal mergers are often used as a way for a company to increase its market share by merging with a competing company. Vertical: Two firms are merged along the value-chain. Types Of Mergers Mergers can be categorized as follows: Horizontal: Two firms are merged across similar products or services. may merge with a large distributor of pharmaceuticals.OVERS Merger and Acquisition Defined When we use the term "merger". The term "acquisition" refers to the purchase of assets by one company from another company. However. industries with poor prospects for growth will seek to diversify their businesses through mergers and acquisitions. Reasons For Mergers a. Synergy Every merger has its own unique reasons why the combining of two companies is a good business decision. The underlying principle behind mergers and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of Company A is Sh. 2 billion and the value of Company B is Sh. 2 billion, but when we merge the two companies together, we have a total value of Sh. 5 billion. The joining or merging of the two companies creates additional value which we call "synergy" value. Synergy value can take three forms: 1. Revenues: By combining the two companies, we will realize higher revenues than if the two companies operate separately. 2. Expenses: By combining the two companies, we will realize lower expenses than if the two companies operate separately. 3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital. For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the need to cut costs. Cost savings often come from the elimination of redundant services, such as Human Resources, Accounting, Information Technology, etc. However, the best mergers seem to have strategic reasons for the business combination. These strategic reasons include: Positioning - Taking advantage of future opportunities that can be exploited when the two companies are combined. For example, a telecommunications company might improve its position for the future if it were to own a broad band 244 service company. Companies need to position themselves to take advantage of emerging trends in the marketplace. Gap Filling - One company may have a major weakness (such as poor distribution) whereas the other company has some significant strength. By combining the two companies, each company fills-in strategic gaps that are essential for long-term survival. Organizational Competencies - Acquiring human resources and intellectual capital can help improve innovative thinking and development within the company. Broader Market Access - Acquiring a foreign company can give a company quick access to emerging global markets. b. Bargain Purchase It may be cheaper to acquire another company than to invest internally. For example, suppose a company is considering expansion of fabrication facilities. Another company has very similar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities than to go out and build new facilities on your own. c. Diversification It may be necessary to smooth-out earnings and achieve more consistent longterm growth and profitability. This is particularly true for companies in very mature industries where future growth is unlikely. It should be noted that traditional financial management does not always support diversification through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the management of companies since managing a steel company is not the same as running a software company. d. Short Term Growth Management may be under pressure to turnaround sluggish growth and profitability. Consequently, a merger and acquisition is made to boost poor performance. 245 e. Undervalued Target The Target Company may be undervalued and thus, it represents a good investment. Some mergers are executed for "financial" reasons and not strategic reasons. A compay may, for example, acquire poor performing companies and replace the management team in the hope of increasing depressed values. The Overall Merger Process The Merger & Acquisition Process can be broken down into five phases: Phase 1 - Pre Acquisition Review: The first step is to assess your own situation and determine if a merger and acquisition strategy should be implemented. If a company expects difficulty in the future when it comes to maintaining core competencies, market share, return on capital, or other key performance drivers, then a merger and acquisition (M & A) program may be necessary. It is also useful to ascertain if the company is undervalued. If a company fails to protect its valuation, it may find itself the target of a merger. Therefore, the preacquisition phase will often include a valuation of the company - Are we undervalued? Would an M & A Program improve our valuations? The primary focus within the Pre Acquisition Review is to determine if growth targets (such as 10% market growth over the next 3 years) can be achieved internally. If not, an M & A Team should be formed to establish a set of criteria whereby the company can grow through acquisition. A complete rough plan should be developed on how growth will occur through M & A, including responsibilities within the company, how information will be gathered, etc. Phase 2 - Search & Screen Targets: 246 The second phase within the M & A Process is to search for possible takeover candidates. Target companies must fulfill a set of criteria so that the Target Company is a good strategic fit with the acquiring company. For example, the target's drivers of performance should compliment the acquiring company. Compatibility and fit should be assessed across a range of criteria - relative size, type of business, capital structure, organizational strengths, core competencies, market channels, etc. It is worth noting that the search and screening process is performed in-house by the Acquiring Company. Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must be highly guarded and independent. Phase 3 - Investigate & Value the Target: The third phase of M & A is to perform a more detail analysis of the target company. You want to confirm that the Target Company is truly a good fit with the acquiring company. This will require a more thorough review of operations, strategies, financials, and other aspects of the Target Company. This detail review is called "due diligence." Specifically, Phase I Due Diligence is initiated once a target company has been selected. The main objective is to identify various synergy values that can be realized through an M & A of the Target Company. Investment Bankers now enter into the M & A process to assist with this evaluation. A key part of due diligence is the valuation of the target company. In the preliminary phases of M & A, we will calculate a total value for the combined company. We have already calculated a value for our company (acquiring company). We now want to calculate a value for the target as well as all other costs associated with the M & A. Phase 4 - Acquire through Negotiation: 247 Now that we have selected our target company, it's time to start the process of negotiating a M & A. We need to develop a negotiation plan based on several key questions: - How much resistance will we encounter from the Target Company? - What are the benefits of the M & A for the Target Company? - What will be our bidding strategy? - How much do we offer in the first round of bidding? The most common approach to acquiring another company is for both companies to reach agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since having both sides agree to the deal will go a long way to making the M & A work. In cases where resistance is expected from the target, the acquiring firm will acquire a partial interest in the target; sometimes referred to as a "toehold position." This toehold position puts pressure on the target to negotiate without sending the target into panic mode. In cases where the target is expected to strongly fight a takeover attempt, the acquiring company will make a tender offer directly to the shareholders of the target, bypassing the target's management. Tender offers are characterized by the following: - The price offered is above the target's prevailing market price. - The offer applies to a substantial, if not all, outstanding shares of stock. - The offer is open for a limited period of time. - The offer is made to the public shareholders of the target. A few important points worth noting: 248 corporate culture. a much more intense level of due diligence (Phase II) will begin. differences in information systems. The deal is finalized in a formal merger and acquisition agreement. This leads us to the fifth and final phase within the M & A Process.. The integration process can take place at three levels: 249 . will launch a very detailed review to determine if the proposed merger will work. tender offers are more expensive than negotiated M & A's due to the resistance of target management and the fact that the target is now "in play" and may attract other bidders. When an acquiring firm makes a 100% offer for the outstanding stock of the target. Both companies. operations. . As you may recall. assuming we have a negotiated merger.financials. Now all of a sudden we have to bring these two companies together and make the whole thing work. This requires a very detail review of the target company .Post Merger Integration: If all goes well. it is very difficult to turn this type of offer down. As a result. differences in strategies. This requires extensive planning and design throughout the entire organization. Phase I Due Diligence started when we selected our target company.Partial offers as well as toehold positions are not as effective as a 100% acquisition of "any and all" outstanding shares. the Post Merger Integration Phase is the most difficult phase within the M & A Process. Phase 5 .Generally. strategic issues. Another important element when two companies merge is Phase II Due Diligence. etc. etc.differences in culture. Every company is different . Once we start the negotiation process with the target company. the integration of the two companies. the two companies will announce an agreement to merge the two companies. then synergy values can be very elusive. Poorly Managed Integration . etc. Cultural and Social Differences .Due diligence is the "watchdog" within the M & A Process. Both strategic and operating decisions will remain decentralized and autonomous.Full: All functional areas (operations.It has been said that most problems can be traced to "people problems.) will be merged into one new company. then we should generate synergy values. In the words of one CEO.The integration of two companies requires a very high level of quality management. Strategic decisions will be centralized within one company.The two companies have strategies and objectives that are too different and they conflict with one another. perhaps we need to understand the realities of mergers and acquisitions. Minimal: Only selected personnel will be merged together in order to reduce redundancies. As a result. you are in for some serious problems within the M & A Process. "give me some people who know the drill. Some of the reasons behind failed mergers are: Poor strategic fit . Expected synergy values may not be realized and therefore." If the two companies have wide differences in cultures. If you fail to let the watchdog do his job. Reasons Behind Failed Mergers Mergers and acquisitions are extremely difficult. implementation fails. The new company will use the "best practices" between the two companies. before we embark on a formal merger and acquisition program. finance. the merger is considered a failure. However. 250 . marketing. Moderate: Certain key functions or processes (such as production) will be merged together. If post merger integration is successful. Incomplete and Inadequate Due Diligence . human resources. but day to day operating decisions will remain autonomous." Integration is often poorly managed with little planning and design. Just 23% of all M & A's will earn their cost of capital. An overly optimistic forecast or conclusion about a critical issue can lead to a failed merger.What financial resources will be required. 47% of the executives will leave the first year and 75% will leave within the first three years of the merger. then bad decisions will be made within the M & A Process.In today's merger frenzy world. Premiums are paid based on expectations of synergies. what level of risk fits with the new organization.? 251 . we must determine what kind of "fit" exists between the two companies. if synergies are not realized.by the respective Managers.The average financial performance of a newly merged company is graded as C . then the premium paid to acquire the target is never recouped. Galpin and Mark Herndon point out the following: . It is called Due Diligence. Due Diligence There is a common thread that runs throughout much of the M & A Process.Paying too Much . . Due diligence is a very detailed and extensive evaluation of the proposed merger. In acquired companies.Will this merger work? In order to answer this question. productivity may fall by as much as 50%.If the acquiring company is too optimistic in its projections about the Target Company. etc. . In the book The Complete Guide to Mergers and Acquisitions. it is not unusual for the acquiring company to pay a premium for the Target Company. In An over-riding question is . We should also recognize some cold hard facts about mergers and acquisitions. .Synergies projected for M & A's are not achieved in 70% of cases. This includes: Investment Fit .In the first six months of a merger. the authors Timothy J. Overly Optimistic . However. What legal issues can we expect due to an M & A? What liabilities. human resources. etc.Who are the customers? Does our business compliment the target's customers? Can we furnish these customers new services or products? .Strategic Fit . and other claims are outstanding against the Target Company? Another reason why due diligence must be broad and deep is because management is relying on the creation of synergy values. etc.Competition . production.? Financial Fit .Legal . distribution channels.How will products and services compliment one another between the two companies? How well do various components of marketing fit together .How well do financial elements fit together . strategic thinking. etc? Operating Fit .sales.What management strengths are brought together through this M & A? Both sides must bring something unique to the table to create synergies.Who competes with the target company? What are the barriers to competition? How will a merger change the competitive environment? .How large is the target's market? Is it growing? What are the major threats? Can we improve it through a merger? . profitability.? Management Fit . ability to change. return on capital. cash flow.promotion programs.leadership styles.Customer . lawsuits. etc.labor force. Marketing Fit . Some of the risk areas that need to be investigated are: . This is extremely important since due diligence must expose all of the major risk associated with the proposed merger. technologies.? Due diligence is also very broad and deep.How well do the different business units and production facilities fit together? How do operating elements fit together . Much of Phase I Due Diligence is focused on trying to identify and confirm the existence of synergies 252 . brand names.What expertise and talents do both companies bring to the merger? How well do these elements fit together . customer mix.Market .). extending well beyond the functional areas (finance. production capacities. etc. etc. state. This may even require some undercover work. schedules.Regulatory Records: Filings with 253 . Financial Records: Financial statements for at least the past 5 years. i.e. Goals and objectives should be established. minutes of meetings. This information includes: Corporate Records: Articles of incorporation. by laws. etc. and local tax returns for at least the past 5 years. you will need to enlist your best people. Communication channels should be updated continuously so that people can update their work as new information becomes available. it will be necessary to provide summary reports to senior level management. Everyone should have clearly defined roles since there is a tight time frame for completing due diligence. valuation specialist. due diligence must be an iterative process. In some cases. etc. such as sending out people with false identities to confirm critical issues. including outside experts. collecting as much information as possible about the target company. Throughout due diligence. making sure everyone understands what must be done. auditors. Management must know if their expectation over synergies is real or false and about how much synergy can we expect? The total value assigned to the synergies gives management some idea of how much of a premium they should pay above the valuation of the Target Company. working papers. Due diligence must be aggressive. MAKING DUE DILIGENCE WORK Since due diligence is a very difficult undertaking. budgets.between the two companies. A lot of information must be collected in order for due diligence to work. etc. such as investment bankers. shareholder list. Tax Records: Federal. legal council letters. asset schedules. the merger may be called off because due diligence has uncovered substantially less synergies then what management expected. correspondence. suppliers. permits. his response was "detail. site evaluations. We can discuss this through an illustration: Illustration (4. The ratio of exchange can be considered in respect to earnings. Good due diligence is well structured and very pro-active. agreements with consultants. marketing contracts." Due diligence must very in-depth if you expect to uncover the various issues that must be addressed for making the merger work. etc. FINANCIAL TERMS OF EXCHANGE When two companies are combined. Employment Records: Labor contracts. trying to anticipate how customers.1) 254 . pension records. and others will react once the merger is announced. contract forms. Debt Records: Loan agreements. etc. appraisals. mortgages. market prices and the book values of the two companies involved. employee listing with salaries. the acquiring firm must at least consider the effect the merger will have on the earnings per share of the surviving company. employees. detail. denoting the relative weighting of the firms. etc. legal descriptions. etc. owners. a ratio of exchange occurs. When one analyst was asked about the three most important things in due diligence. a. Miscellaneous Agreements: Joint venture agreements. bonus plans. etc. decrees. licenses. reports filed with various governmental agencies. Property Records: Title insurance policies. Earnings In evaluating possible acquisition. and detail. purchase contracts.the NSE. trademarks. agreements with Directors. personnel policies. lease contracts. 546875 shares of Company A's stock for each share of Company B's stock.000 = 1. REQUIRED: Consider the effect of the acquisition to the earnings per share.50 16 12 Sh 64 Sh 30 Company B has agreed to an offer of Shs 35 a share to be paid in Company A shares.000.000.000 + 1.093.000.Company A is considering the acquisition by shares of Company B. Present earnings Company A Company B Shs 20.000 5.000.000 Shs 5.000 2.000 Shares Earnings per share Shs 4 Price/earning ratio Price of shares Shs 2. of shares = 20.000.000. The total number of shares needed to acquire company B's share = 0.546875 X 2. SOLUTION The exchange ratio = 35/64 = 0.000 + 5.093.750 shares of Company A The earnings per share therefore can be computed as follow: EPS combined= Companies Earnings of A + Earnings of B Total No.000 5. The following information is also available.000.000.750 255 . The ratio of exchange of market price is given by the following formula: Market price ratio = Market price per share of acquiring company X No.10. the merger may result in increased future earnings and therefore a high EPS in future. capital structure. asset values and other factors that bear upon valuation. dividends.000. c. of shares offered 256 . Market Value The major emphasis in the bargaining process is on the ratio of exchange of market price per share.546875 X 4. These EPS will be given by 0. However.000 6. due to synergetic effects discussed earlier.750 = Shs 4.093. There is therefore an immediate improvement in earnings per share for Company A as a result of the merger. business risk. However.10 Therefore the earnings for share of the combined firm is Shs 4. Company B's former shareholders experience a reduction in earnings per share.50 Future Earnings If the decision to acquire another company were based solely on the initial impact on earnings per share. = Shs 2.24 from Shs 2. The market price per share reflects the earnings potential of the company.10 b. an initial dilution in earnings per share would stop any company from merging with another.= 25. The market price exchange ratio = 3 257 60 X 0.33 . It is common for the company being acquired to receive a little more than the market price per share. Illustration (4.00 Shs 60.000.00 Shs 30.667 = 1.000 No.of exchange Market price per share of the acquired company Considering the previous example (example 4. of shares Earnings per share Market price per share Shs 3. Shareholders of the acquired company would therefore benefit from the acquisition because their shares were originally worth Shs 30 but they receive Shs 35.33 Shs 3.000 2.00 18 10 Price/earning ratio Company X offers 0.167. Company B receive more than its market price per share.667 shares for each share of Company Y to acquire the company. Present earnings Company X Company Y Shs 20.546875 = 1.000 Shs 6.000 6.000.000.000.2) The following information relates to Company X and Y.000.1) Market price ratio = 64 X 0. 30 Therefore. 1.90 Note: Both companies tend to benefit due to the merger.000. This is due to the assumption that the price earnings ratio of the combined company will remain 18. However.Shareholders of Y are being offered a share with a market value of Shs 40 for each share they own (i. of shares 7. We can consider the combined effect.000 No.) d. They benefit from acquisition with respect to market price because their shares were formerly worth Shs 30. companies with high price/earning ratios can be able to acquire companies with lower price/earnings ratio to obtain an immediate increase in earnings per share (even if they pay a premium for the share.333 X 30).333. Combined Effect Total earnings Shs 26.e. This can be seen by the increased market price per share for both company.333 Earnings per share Shs 3. If this is the case. Book value Book value per share is not a useful basis for valuation in most mergers. it may be important if the purpose of an acquisition is to obtain the liquidity of another company.55 Price/earning ratio 18 Market price per share Shs 63. The ratio of exchange of book value per share of the two companies are calculated in the same manner as is the 258 . CASH FLOW STATEMENTS In a pure financial merger. two key items are needed: a. A discount rate or cost of capital. If the two firm's operations are to be integrated however.3) XYZ Ltd.9 VALUING THE TARGET FIRM To determine the value of the target firm. forecasting future cashflows is a more complex task.050 1. and b. The following illustration can be used to determine the value of target company. is considered acquiring ABC Ltd. 4. to apply to these projected cashflows. Amounts are in Shs `000' Net sales 1994 1995 1996 1997 1998 1.510 1. for the next five years.910 259 .260 1. The corporate tax rate is 40% for both companies.740 1. Illustration: (4. the post-merger cash flows are simply the sum of the expected cashflows of the two firms if they were to continue operating independently. A set of proforma financial statements which develop the incremental cashflows expected from the merger.ratio for market values computed above. The projected financial data are for the post-merger period. The following information relates to ABC Ltd. The application of this ratio in bargaining is usually restricted to situations in which a company is acquired for its liquidity and asset values rather than for its earning power. 057 1.218 1. ii. Determine the maximum amount XYZ would be willing to acquire ABC at. The cost of capital can be assumed to be 18%. b.000 for internal expansion every year. c. REQUIRED: i.Cost of sales 735 882 1. Estimate the annual cash flows. expenses 100 120 130 150 160 50 70 90 110 Interest expenses 40 Other information a. ABC will retain Shs 40.337 Selling & admn. After the fifth year the cashflows available to XYZ from ABC is expected to grow by 10% per annum in perpetuity. SOLUTION: XYZ LTD 260 . 723 261 .2 112. the maximum price of ABC can be determined by computing the PV of the projected cashflows.0 40.2 181.218 1.8 . 91.057 1.1) = Shs 1. Year Cashflow PVIF18% PV 1 65 0. Assuming the discount rate of 18%.886 3 91.18 .75 129.510 1.949.8 151.0 Cash available to XYZ 65 84.10 ii.091.8 129.910 735 882 1.055 2 84.8 91.0 40. Amounts in Shs `000' 1994 1995 1996 1997 1998 1. PROJECTED POST-MERGER CASHFLOWS FOR ABC LTD.8 121.8 0.75 1.050 1.337 315 378 453 522 573 Less selling and admn.8 Less Retention by ABC 40 40.8 0.8 .0. costs 100 120 130 150 160 EBIT 215 258 323 372 413 40 50 70 90 110 175 208 253 282 303 Net sales Less cost of sales Less interest EBT Less tax 40% 70 83.260 1.718 60.55 Computation of terminal value TV = 141. 141.607 55.2 101.2 Net income Add terminal value .847 55.8 169.949.8 (1 + 0.740 1.0 40.75 0. Net cash flows 65 84.i.2 105 124.2 2. along with a law firm that specializes in helping to block mergers.2 0.091.55 0. (b) Trying to convince the target firm's shareholders that the price being offered is too low.570 Note: Estimating the discount rate will be discussed in Lesson 6. 2. (c) Raising antitrust issues between shareholders of the two firms.24 1.437 66.g require special resolution (75%) to approve mergers. They help target companies develop and implement defensive techniques Target firms that do not want to be acquired generally enlist the help of an investment banking firm. Defensive techniques include: (a) Changing the by-laws e.57 The maximum price will therefore be Shs 1.152. 262 . The Role Of Investment Bankers In Mergers The investment banking community is involved with mergers in a number of ways: 1.152.667 914. They help arrange mergers The bankers will identify firms with excess cash that might want to buy other firms.516 5 2.4 129. companies that might be willing to be bought and companies which might be attractive to others. (f) Taking a poison pill (commiting economic suicide) e. They help finance mergers If the acquiring company has cashflow problems. we will look at ways of discouraging the merger and acquisition process. then investment bankers will provide required finance for the merger. executive benefits etc. borrowing on terms that require immediate repayment of all loans if the firm is acquired. most companies concerned about takeovers will closely monitor the trading of their stock for large volume changes. 3. Poison pills represent rights or options issued to shareholders and bondholders. we will do just the opposite. (e) Being acquired by a more friendly firm. several anti-takeover defenses can be implemented. Anti-Takeover Defenses Throughout this entire lesson we have focused our attention on making the merger and acquisition process work.g. If a company is concerned about being acquired by another company. selling off at a bargain the assets that originally made the firm a desirable target. Establishing a fair value Investment bankers are experts that can help the firms determine a fair ratio of exchange that is beneficial (if possible) to both shareholders. 4. As a minimum.(d) Repurchasing shares in an open market in an effort to push the prices above that being offered by the potential acquirer. These 263 . heavy cash overflows in dividends. Poison pill One of the most popular anti-takeover defenses is the poison pill. In this final part. a. They speculate in the shares of potential merger candidates and thereby make arbitrage gains. large principal payments come due and this lowers the value of the Target Company. they are sometimes viewed negatively by shareholders and others. the rights are detached from the security and exercised. By selling off the bonds. Golden Parachutes Another popular anti-takeover defense is the Golden Parachute. Changes to the Corporate Charter If management can obtain shareholder approval. several changes can be made to the Corporate Charter for discouraging mergers. Golden parachutes are large compensation payments to executive management. When an acquiring firm gains control of the Target 264 . payable if they depart unexpectedly. In relation to other types of takeover defenses. This type of issue is designed to reduce the value of the Target Company. allowing them to sell-off bonds in the event that an unfriendly takeover occurs. c. Lump sum payments are made upon termination of employment. Flip-over rights provide for purchase of the Acquiring Company while flip-in rights give the shareholder the right to acquire more stock in the Target Company.rights trade in conjunction with other securities and they usually have an expiration date. When a merger occurs. The rights cannot be exercised unless a tender offer of 20% or more is made by another company. These changes include: Staggered Terms for Board Members: Only a few board members are elected each year. giving the holder an opportunity to buy more securities at a deep discount. golden parachutes are not very effective. stock rights are issued to shareholders. Put options are used with bondholders. For example. Golden parachutes are narrowly applied to only the most elite executives and thus. giving them an opportunity to buy stock in the acquiring company at an extremely low price. b. The amount of compensation is usually based on annual compensation and years of service. the corporate charter can be amended. the company can issue large volumes of debt 265 . held by management. For example. the acquiring firm will be forced to pay a "blended" price for the stock. inclusion of a fair pricing provision in the corporate charter may be a moot point. Re-capitalization One way for a company to avoid a merger is to make a major change in its capital structure. One class of stock. in the case of a two-tiered offer where there is no fair pricing law. d.Company. not requiring a super-majority for mergers that have been approved by the Board of Directors. staggered boards are not a major antitakeover defense. Since acquiring firms often gain control directly from shareholders. management has increased control over the company. Super-majority Requirement: Typically. Dual Capitalization: Instead of having one class of equity stock. the charter can require that minority shareholders receive a fair price for their stock. However. the company has a dual equity structure. the super-majority requirement can discourage the merger. will have much stronger voting rights than the other publicly traded stock. requiring that a super-majority (such as 80%) is required for approval of a merger. However. Fair Pricing Provision: In the event that a partial tender offer is made. A staggered board usually provides that one-third are elected each year for a 3 year term. Since management holds superior voting power. Since many countries have adopted fair pricing laws. important decisions are more difficult since the acquirer lacks full board membership. simple majorities of shareholders are required for various actions. In cases where a partial tender offer has been made. Usually an "escape clause" is added to the charter. Therefore. the Target Company can do things to boost valuations. It is important to emphasize that all restructuring should be directed at increasing shareholder value and not at trying to stop a merger. leveraged re-capitalization require stable earnings and cash flows for servicing the high debt loads. such as stock buy-backs and spinning off parts of the company. Once the additional shares have been issued to the white squire. If the company seeks to buy-back all of its stock. Instead of issuing more debt. And the company should not have plans for major capital investments in the near future. Other Anti Takeover Defenses Finally. the Target Company can issue more stock. the Target Company will have a friendly investor known as a "white squire" which seeks a quality investment and does not seek control of the Target Company. In some cases. This stand still period gives the Target Company 266 . it can go private through a leveraged buy out (LBO). it now takes more shares to obtain control over the Target Company. selling-off assets and paying out a liquidating dividend to shareholders. the target company may want to consider liquidation. Maintaining high debt levels can make it more difficult for the acquiring company since a low debt level allows the acquiring company to borrow easily against the assets of the Target Company.and initiate a self-offer or buy back of its own stock. Stand Still Agreement: The acquiring company and the target company can reach agreement whereby the acquiring company ceases to acquire stock in the target for a specified period of time. if an unfriendly takeover does occur. However. the company does have some defenses to discourage the proposed merger: 1. e. leveraged recaps should stand on their own merits and offer additional values to shareholders. In many cases. Finally. golden parachutes.time to explore its options." The White Knight Company comes in and rescues the Target Company from the hostile takeover attempt. 3. Therefore. Litigation: One of the more common approaches to stopping a merger is to legally challenge the merger. Green Mail: If the acquirer is an investor or group of investors. In order to stop the hostile merger. the White Knight will pay a price more favorable than the price offered by the hostile bidder. this type of targeted repurchase of stock runs contrary to fair and equal treatment for all shareholders. The Target Company will seek an injunction to stop the takeover from proceeding. the target company can make a tender offer to acquire the stock of the hostile bidder. Usually. One very important issue about anti-takeover defenses is valuations. green mail is not a widely accepted antitakeover defense. one option is to seek out another company for a more suitable merger. most stand still agreements will require compensation to the acquiring firm since the acquirer is running the risk of losing synergy values. 267 . However. This gives the target company time to mount a defense. 4. 5. For example. The two parties hold private negotiations and settle for a price. the Target Company will enlist the services of an investment banker to locate a "white knight. This is a very extreme type of anti-takeover defense and usually signals desperation. 2. the Target Company will routinely challenge the acquiring company as failing to give proper notice of the merger and failing to disclose all relevant information to shareholders. Many anti-takeover defenses (such as poison pills. Pac Man Defense: As a last resort. it might be possible to buy back their stock at a special offering price. White Knight: If the target company wants to avoid a hostile merger. However. A joint venture is controlled by management teams consisting of representation of both the two or more parent companies. They simply add to the premiums that acquiring companies must pay for target companies. companies with anti-takeover defenses usually have less upside potential with valuations as opposed to companies that lack anti-takeover defenses. Such deals are called corporate alliances and they take many forms. 268 . most studies show that anti-takeover defenses are not successful in preventing mergers. Consequently. Joint venture is one method of corporate alliance. Additionally. In a joint venture parts of companies are joined to achieve specific limited objectives. from straight forward marketing agreements to joint ownership of world scale operations. Corporate Alliance Mergers are one way for two companies to completely join assets and management but many companies enter into corporate deals which fall short of merging.) have a tendency to protect management as opposed to the shareholder.etc.