FINANCIAL MANAGEMENT UMI

INTRODUCTION TO STRATEGIC FINANCIAL MANAGEMENT

1.1 FINANCIAL MANAGEMENT

1.2 Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the
financial activities of an organization. It means applying general management
principles to financial resources of the enterprise.

1.3 Financial Management Decisions

(i) Financing Decisions

 Where do I get funds to run my institution?

 What should be the composition of the various sources of funds in my

enterprise

(ii) Investment Decisions

 What long-term assets do I need;

 Which are the profitable assets to put money in;

(iii) Working Capital Decisions

 How will I handle the day to day financial activities of my organization;

 How do I profitably manage my debtors, inventory, creditors and cash

(iv) Dividend Decisions

 What do I do with the surpluses generated in a given period;

 Should I distribute the surplus to shareholders or reinvest

1.4 Functions of Financial Management

(i) Estimation of capital requirements

A Finance Manager has to make estimation with regard to capital

requirements of the entity. This will depend on expected costs and revenues
and future programs and policies of the concern.

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(ii) Determination of Capital Composition

Once the estimation of capital requirements has been done, the composition
of the capital structure has to be decided.

(iii) Choice of sources of funds

The company has to make a choice between raising funds internally by issue
of shares or borrowing from outsiders or a combination of both

(iv) Investment of Funds

The finance manager has to decide to allocate the funds into profitable
ventures so that there is safety on investments and regular and adequate
return on the investments.

(v) Disposal of Surplus

The finance manager has to decide as to whether profits should be distributed

to shareholders as dividends or reinvested in the business or what portion of
the profits will be distributed as dividends and what portion to be reinvested
in the business

(vi) Management of Working Capital

The finance manager has to decide the level of working capital required to
operate the entity and ensure regular and adequate supply of such working
capital. Working capital includes inventory, debtors/receivables, cash, and
creditors.

(vii) Financial Controls

The finance manger has to exercise control over utilization of funds to ensure
that objectives are achieved. This can be done by several techniques like
budgeting and budgetary control, ration analysis, cash forecasting, internal
controls etc.
1.5 Financial Planning

Financial Planning is an ongoing process that helps an organization make sensible

decisions about financial aspects of its operations in order to achieve organizational
goals. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise. Financial Planning is
carried out through the following steps:

(i) Establishment of organizational goals – short, medium and long term;

(ii) Determining the financial requirements to achieve those goals;
(iii) Determination of the sources of funds;
(iv) Allocation of funds to various activities;
(v) Utilization of funds;
(vi) Monitoring and reviewing funds utilization - Control of funds

A major tool used by Finance Manager in Financial Planning is Budgeting and

Budgetary Control.

PORTFOLIO THEORY AND CAPITAL ASSET PRICING MODEL

1.1 PORTFOLIO THEORY

1.2 Definition of Portfolio and Portfolio Theory

Investment Portfolio is a group or a collection of different investments in securities

that an investor holds at any one point in time.

Portfolio Theory, on the other hand, is a theory of finance that attempts to explain:

 how to maximize portfolio expected return for a given amount of portfolio risk,
or

 how to minimize portfolio risk for a given level of portfolio expected return,

by carefully choosing the proportions of various assets in the portfolio.

Portfolio Theory is a mathematical formulation of the concept of diversification in

investing, with the aim of selecting a collection of investment assets that has
collectively lower risk than any individual asset. This is possible, intuitively
 speaking, because different types of assets often change in value in opposite ways.
For example, to the extent prices in the stock market move differently from prices in
the bond market, a collection of both types of assets can in theory face lower
overall risk than either individually.

Portfolio Theory defines risk as the standard deviation of return, and models a
portfolio as a weighted combination of assets, so that the return of a portfolio is the
weighted combination of the assets' returns. By combining different assets whose
returns are not perfectly positively correlated, Portfolio Theory seeks to reduce the
total variance (risk) of the portfolio return.

1.3 Portfolio Theory Concept

The fundamental concept behind Portfolio Theory is that the assets in an investment
portfolio should not be selected individually, each on its own merits. Rather, it is
important to consider how each asset changes in price relative to how every other
asset in the portfolio changes in price.

Investing is a tradeoff between risk and expected return. In general, assets with
higher expected returns are riskier. For a given amount of risk, Portfolio Theory
describes how to select a portfolio with the highest possibleexpected return. Or, for
a given expected return, Portfolio Theory explains how to select a portfolio with the
lowest possible risk (the targeted expected return cannot be more than the highest-
returning available security, of course, unless negative holdings of assets are
possible.

Therefore, Portfolio Theory is a form of diversification. Under certain assumptions

and for specific quantitative definitions of risk and return, Portfolio Theory explains
how to find the best possible diversification strategy.

1.4 Relationship between risk and return

(i) Investors purchase securities because they expect returns from them;

(ii) Return on a security is the gain or loss on the security in a particular

period. The return consists of the income and the capital gains related to an
investment. It is usually quoted as a percentage

(iii) The risk of a security is the probability that the returns expected from a
security by an investor may not be received. Securities are risky because
their returns are variable;

(iv) The most commonly used measure of risk in financial management is the
Standard Deviation;

(v) The risk of a security can be split into two parts namely unique risk and
 market risk;

(vi) Unique risk stems from the firm-specific factors whereas market risk stems
from the economy-wide factors;

(vii) Portfolio diversification washes away unique risk but not market risk;

(viii) The risk of a fully diversified portfolio is its market risk;

(ix) The contribution of a security to the risk of a fully diversified portfolio is

measured by its beta, which reflects its sensitivity to the general market
conditions
(x) The higher the returns the higher the risk.

1.5 Risk and Expected Return of a Portfolio

Portfolio Theory assumes that investors are risk averse. Meaning that given two
portfolios that offer the same expected return, investors will prefer the less risky one.
Thus, an investor will take on increased risk only if compensated by higher expected
returns. Conversely, an investor who wants higher expected returns must accept
more risk. The exact trade-off will be the same for all investors, but different
investors will evaluate the trade-off differently based on individual risk aversion
characteristics. The implication is that a rational investor will not invest in a portfolio
if a second portfolio exists with a more favorable risk-expected return profile – i.e., if
for that level of risk an alternative portfolio exists that has better expected returns.

Under the model:

 Portfolio Return is the proportion-weighted combination of the constituent or

individual assets' returns.

The expected return of portfolio with two assets A and B is given by: where:

is the expected return of the portfolio; is

the return of asset A

is the return of asset B

is the weight of asset A in the portfolio; and is

the weight of asset B in the portfolio.

 Portfolio volatility (risk) is a function of the volatility (risk) of the individual assets in
 the portfolio, the proportion of each asset in the portfolio and the correlations
between the returns of the assets in the portfolio.

Portfolio risk of a two asset portfolio is given by:

where:

is the risk of the portfolio;

is the weight of asset A in the portfolio; is

the weight of asset B in the portfolio; is the

risk of asset A;

is the risk of asset B; and

is the correlation coefficient between the returns of the two assets in

the portfolio.

1.6 The Efficient Frontier of a two security portfolio

Suppose an investor is evaluating two securities with the following parameters:

Security A Security B

Expected Return 12% 20%

Standard Deviation of returns 20% 40%

Coefficient of correlation -0.2

For different proportions of A and B plot the efficient frontier.

The efficient frontier shows all possible (feasible) portfolios that can be built given
the expected return, standard deviation and correlation above. But which of these
portfolios is the optimal portfolio?

1.7 Capital Market Line

 Capital Market Line (CML) is a straight line drawn from the point of the risk-free
asset to the efficient frontier of risky assets (feasible region for risky assets). Where
the CML is a tangent to the Efficient Frontier is the optimal portfolio of risky assets.
The tangency point M represents the optimal (market) portfolio since all rational
investors (minimum variance criterion) should hold their risky assets in the same
proportions as their weights in the market portfolio.

The CML results from the combination of the market portfolio and the risk- free
asset. All points along the CML have superior risk-return profiles to any portfolio
on the efficient frontier, with the exception of the Market Portfolio, the point on the
efficient frontier to which the CML is the tangent. From a CML perspective, this
portfolio is composed entirely of the risky asset, the market, and has no holding of
the risk free asset, i.e., money is neither invested in, nor borrowed from the money
market account.

1.8 The risk-free asset and the Capital Allocation Line/CML

The risk-free asset is the (hypothetical) asset that pays a risk-free rate. In practice,
short-term government securities (such as Bank of Uganda treasury bills) are used
as a risk-free asset, because they pay a fixed rate of interest and have exceptionally
low default risk. The risk-free asset has zero variance in returns (hence is risk-free);
it is also uncorrelated with any other asset (by definition, since its variance is
zero). As a result, when it is combined with any other asset or portfolio of assets,
the change in return is linearly related to the change in risk as the proportions in the
combination vary.

1.9 Systematic and Unsystematic (Specific) Risk

Specific risk is the risk associated with individual assets - within a portfolio these
risks can be reduced through diversification (specific risks "cancel out"). Specific
risk is also called diversifiable, unique or unsystematic.

Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all
securities. Systematic risk cannot be diversified away (within one market). Within
the market portfolio, asset specific risk will be diversified away to the extent
possible. Systematic risk is therefore equated with the risk (standard deviation) of
the market portfolio.

Since a security will be purchased only if it improves the risk-expected return

characteristics of the market portfolio, the relevant measure of the risk of a security
is the risk it adds to the market portfolio, and not its risk in isolation. In this
context, the volatility of the asset, and its correlation with the market portfolio, are
historically observed and are therefore given.

1.10 Diversification
 An investor can reduce portfolio risk simply by holding combinations of
instruments that are not perfectly positively correlated. In other words, investors can
reduce their exposure to individual asset risk by holding a diversified portfolio of
assets. Diversification may allow for the same portfolio expected return with
reduced risk. These ideas were started by Markowitz and then reinforced by other
economists and mathematicians such as Andrew Brennan who have expressed ideas
in the limitation of variance through portfolio theory.

If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the
portfolio's return variance is the sum over all assets of the square of the fraction
held in the asset times the asset's return variance (and the portfolio standard
deviation is the square root of this sum).

1.11 Covariance

Covariance is a measure of the degree to which returns on two risky assets move in
relation to each other. A positive covariance means that asset returns move together.
A negative covariance means returns move inversely. For example, if stock A's return
is high whenever stock B's return is high and the same can be said for low returns,
then these two stocks are said to have a positive covariance. If an investor wants a
portfolio whose assets have diversified earnings, he or she should pick financial assets
that have low covariance to each other. Covariance can be computed in any one of the
following ways:

(i) Covariance is the sum of the product of the deviations of the individual asset
returns from their average returns and their respective probabilities.
 Compute the average returns for each asset;
 Compute the deviations of the average asset returns from their average
returns;
 Compute the product of the deviations of the two assets;
 Multiply the product of the deviations of the returns of the two assets by
their respect probabilities and get the sum. This is the Covariance
between the two assets.
Example:

The returns of two assets A and B under four different states of nature are
given below:

State of
Probability Return on assets
nature
A B
 1 0.10 5% 0%
2 0.30 10 8%
%
3 0.50 15 18%
%
4 0.10 20 26%
%

Required:
(a) What is the covariance between the returns of assets A and B?

First compute the expected (average) return on each asset.

Expected return on A = (0.1X5) + (0.3X10) + (0.5X15) + (0.1X20) = 13%

Expected return on B = (0.1X0) + (0.3X8) + (0.5X18) + (0.1X26) = 14%

Computation of Covariance

Deviatio Deviation Product of

State Retur n Retur s
Probability Deviations
of n on of the n on of the and
natur A Return B return Probabilitie
e (%) on A (%) on B s
(%)
(i) (ii) (iii) (iv) (v) (vi) (vii)
(iii) - 13 (v) - 14 {(ii)X(iv)X(vi)
}
1 0.10 5 -8 0 -14 11.2
2 0.30 10 -3 8 -6 5.4
3 0.50 15 2 18 4 4
4 0.10 20 7 26 12 8.4
29
 Covariance = 29.

(ii) Covariance between the returns of any two assets is also given by the product of
the correlation coefficient between the two assets and their respective standard
deviations.

Financial assets that have positive covariance with each other will not provide very
much diversification benefit.

2.1 THE CAPITAL ASSET PRICING MODEL

2.2 MEANING

CAPM is a Financial Management Model used to predict the

relationship between the risk of an asset and its expected return.

2.3 ASSUMPTIONS

The framework of Portfolio Theory makes many assumptions about investors and
markets. Some are explicit in the equations, such as the use of Normal
distributions to model returns. Others are implicit, such as the neglect of taxes and
transaction fees. None of these assumptions are entirely true, and each of them
compromises Portfolio Theory to some degree. These assumptions include:

 Investors are interested in the optimization problem that is maximizing the return
and minimizing risk.

 Correlations between assets are fixed and constant forever.

 All investors aim to maximize economic utility (in other words, to make as much
money as possible, regardless of any other considerations).

 All investors are rational and risk-averse.

 All investors have access to the same information at the same time.

 Investors have an accurate conception of possible returns, i.e., the probability

beliefs of investors match the true distribution of returns.
  There are no taxes or transaction costs.

 All investors are price takers, i.e., their actions do not influence prices.

 Any investor can lend and borrow an unlimited amount at the risk free rate of
interest.

 All securities can be divided into parcels of any size.

 Risk/Volatility of an asset is known in advance and is constant.

Given the above assumptions, the CAPM is usually expressed as:

Where,
 is the measure of asset sensitivity to a movement in the overall market; Beta is
usually found via regression on historical data. Betas exceeding one signify
more than average "riskiness" in the sense of the asset's contribution to overall
portfolio risk; betas below one indicate a lower than average risk contribution.

 is the risk free rate ie the return on government securities;

 is the market return or average return

 is the market premium, the expected excess return of the market portfolio's
expected return over the risk-free rate.

2.4 SECURITIES MARKET LINE (SML)

One of the important ideas that come with CAPM is the Securities Market Line
(SML). The securities market line is a graphical representation of the CAPM model.
Along the x-axis of the graph we have the Beta, while on the y-axis we have the
expected return for a given level of risk. The idea is that any security that falls
exactly at any point on the line is fairly valued.
  If the security is at any point above the line we would basically know that the
security is undervalued as it offers a greater return for the given level of risk.

 If the security is below the line we know that the security is overvalued as the
return it offers is not adequate for the given level of risk. You can see a image
below which shows the security market line, the red line is the plot of the
securities market line in the diagram below.

Securities Market Line

2.5 CRITICISMS

Despite its theoretical importance, critics of Portfolio Theory question whether it is

an ideal investing strategy, because its model of financial markets does not match
the real world in many ways.

Portfolio Theory does not really model the market

(i) The risk, return, and correlation measures used by Portfolio Theory are based
on expected values which means that they are mathematical statements
about the future. In practice, investors must substitute predictions based on
historical measurements of asset return and volatility for these values in the
equations. Very often such expected values fail to take account of new
circumstances that did not exist when the historical data were generated.

(ii) More fundamentally, investors are stuck with estimating key parameters from
past market data because Portfolio Theory attempts to model risk in terms
of the likelihood of losses, but says nothing
 about why those losses might occur. The risk measurements used are
probabilistic in nature, not structural. This is a major difference as compared
to many engineering approaches to risk management.

(iii) Essentially, the mathematics of Portfolio Theory views the markets as a

collection of dice. By examining past market data we can develop hypotheses
about how the dice are weighted, but this isn't helpful if the markets are
actually dependent upon a much bigger and more complicated chaotic system
—the world. For this reason, accurate structural models of real financial
markets are unlikely to be forthcoming because they would essentially be
structural models of the entire world. Nonetheless there is growing awareness
of the concept of systemic risk in financial markets, which should lead to
more sophisticated market models.

(iv) Portfolio Theory does not account for the personal, environmental, strategic,
or social dimensions of investment decisions. It only attempts to maximize
risk-adjusted returns, without regard to other consequences. In a narrow
sense, its complete reliance on asset prices makes it vulnerable to all the
standard market failures such as those arising from information asymmetry,
externalities, and public goods. It also rewards corporate fraud and dishonest
accounting. More broadly, a firm may have strategic or social goals that
shape its investment decisions, and an individual investor might have
personal goals. In either case, information other than historical returns is
relevant.

(iv) Diversification eliminates non-systematic risk. As unsystematic risk is not

associated with increased expected return, this is considered one of the few
"free lunches" available. Following Portfolio Theory means portfolio
managers can invest in assets without analyzing their fundamentals,
specially weighting each asset by the markets weight in the asset. Because
the investor purchases assets in proportion to their market weights, there is
no relative increase in demand for one asset versus another, and thus no
impact on the expected returns of the portfolio.

(v) General the limitations of the CAPM stems from the assumptions on which
the theory is based. The assumptions are too simplistic and unrealistic.
 EXERCISES IN PORTFOLIO THEORY AND CAPM

Question 1

What do you understand by the following terms:

(i) Efficient Frontier;

(ii) Capital Market Line;

(iii) Security Market Line;

(iv) Capital Asset Pricing Model

Question 2

(i) What is the risk of a two asset portfolio?

(ii) What is covariance and coefficient of correlation?

(iii) What is an efficient portfolio?

(iv) What is the efficient frontier when investors can lend or borrow at the risk free rate?

(v) What are the assumptions underlying the CAPM?

(vi) What do you understand by the capital market line and the security market line?

Question 3

Ojok has just received payment of Shs. 75,000,000 from NSSF being the savings he made
with the fund during his employment with Uganda Revenue Authority. Ojok is considering
two alternative investments portfolios where he can put his savings to generate more
income. The two alternative investments portfolios are:

(i) Invest Shs. 60,000,000 in shares of DFCU Bank and the balance in Shares of
Western Cattle Traders Limited. Shares in DFCU Bank give a return of 25% with
volatility of 20%. Shares in Western Cattle Traders pay a return of 35% with
volatility of 30%. The correlation between the returns of Western Cattle Traders
Limited and the returns of DFVU Bank Limited is -0.30.
(ii) Ojok’s son who has just graduated with an MBA from Uganda Management
Institute is however proposing that the father invests Shs. 30,000,000 in shares of
UAP Insurance and the balance in Shares of Maganjo Millers. Shares in UAP
Insurance pays a return of 20% with volatility of 10% while shares of Maganjo
Millers pays a return of 25% with volatility of 20%. The correlation between the
returns of Maganjo Millers and Shares of UAP Insurance Compamy is -0.4

Advise Ojok as to which portfolio is the best.

Question 5

You are a Stock Broker operating in Kampala Stock Exchange. Serena Hotel is to float
shares at the Kampala Stock Exchange to obtain funds for further expansion. The risk of
Serena Hotel as compared to the risk in Kampala Stock Exchange is 1.5 and the market
return in Kampala Stock Exchange is 25%. Bank of Uganda currently pays 12% p.a on
Treasury Bills.

Jambaka, a prominent investor in Kampala comes to you for advise on whether or not he
should buy shares of Serena Hotel when put in the Kampala Stock Exchange. Jambaka
wants a return of at least 21%. Would you advise him to buy shares of Serena Hotel?

Question 6
a) Describe the expected relationship between risk and return to a rational investor.

b) Why is it that certain levels of risk cannot be avoided even in a well-diversified

portfolio?

c) A company is set to decide on two investments whose returns are as indicated below
for the different economic states.
Economic state Probability Returns P Returns M
Recession 0.1 4% 16%
Below average growth 0.2 8% 10%
Average growth 0.4 12% 4%
Above average growth 0.2 18% 18%
Boom 0.1 20% 12%
Advise the company on the following

i) The investment with a higher average return.

 ii) The expected return from a portfolio made up of 20% security P and 80% security M

iii) The investment with a higher individual risk

iv) The viability of holding a portfolio made up of securities P and M

Question 7
The financial management team of Kakanyero Investments Limited (KIL) are concerned
that the company is not adequately taking account of risk when evaluating investment
projects. They have undertaken a study to investigate different ways of reflecting risk in
the evaluation process. As part of their study, KIL have estimated figures having a bearing
on the risk of three investment projects that are currently under consideration. These
figures, together with the capital investment and estimated returns on projects, are shown
below:

Project Investment (Shs million) Return (r) δp ρp,m

P 3,000 7% 10% 0.1
Q 4,000 13% 5% 1.0
R 5,000 12% 4% 0.8

The values of δp have been estimated to provide a measure of risk and represent the
standard deviation of the return (measured in the same units as return, r). The values of
ρp,m represents the correlation between the return on a project and the market return. The
market return is 14% (with a standard deviation, δm of 5%) and the risk-free rate of
return is 5.5%.

Required:
(a) Compute the beta for each of the three projects.
(b) Using the capital asset pricing model (CAPM), show for each project whether its
return justifies its risk, and use the results of your computations to recommend the
best investment.
(c) Explain the difference between business risk, financial risk and systematic risk.
(d) Evaluate the major implications of an efficient market to financial managers of listed
companies.
Question 8

(a) What is Capital Asset Pricing Model?

(b) Discuss the assumptions underlying the Capital Asset Pricing Model.
(c) The following data was obtained from the Kampala Stock Exchange in respect of
two securities, A and B.
Security A Security B
Expected Return 16% 12%
Standard Deviation 15% 8%
Coefficient of Correlation between the two securities 0.60

Required:

(i) Determine the Covariance between the two securities.

(ii) If a portfolio is made up of 60% of stock A and 40% of stock B, what would be
the expected return of the portfolio?
(iii) What would be the risk of the portfolio in (b) above?

Question 9

(a) Distinguish between:

(i) Risk and Return;

(ii) Capital Market Line and Security Market Line;
(iii) Systematic Risk and Unsystematic Risk
(iv) Market Return and Risk-free rate

(b) Mzee Ongom Patrick, a retired teacher, has just received payment of Shs.
100,000,000 from Public Service being gratuity paid to him in respect of the period
he served on contract as a head teacher of Lango College. Mzee Ongom is now
considering two alternative investments portfolios where he can put his savings to
generate more income. The two alternative investments portfolios are:

(i) Invest Shs. 60,000,000 in shares of Crane Bank and the balance in Shares of
Northern Cattle Traders Limited. Shares in Crane Bank give a return of
25% with volatility of 20%. Shares in Northern Cattle Traders pay a return of
35% with volatility of 30%. The correlation between the returns of Northern
Cattle Traders Limited and the returns of Crane Bank Limited is -0.30.

(ii) Ongom’s daughter, Amule Harriet, who has just graduated with a Post
Graduate Diploma in Financial Management from Uganda
 Management Institute, is however proposing that the father invests Shs.
50,000,000 in shares of Kakanyero Investments and the balance in shares of
Boma Hotels. Shares in Kakanyero Investments Limited pay a return of 20%
with volatility of 10% while shares of Boma Hotels Limited pay a return of
25% with volatility of 20%. The correlation between the returns of Boma
Hotels and the returns of Kakanyero Investments Limited is -0.4

Required:

Advise Mzee Ongom Patrick as to which portfolio is the best.

Question 6

Timothy has been reading the “Pakasa” pull-out of the New Vision. He was particularly
impressed by the investment in Shares by Dr. Aliker. He has been collecting information
about the shares on the market and he now comes to you to assist him assess where he
should put his money. He provides you with the following information.

Economy state Probability of Return on Return on

occurrence Share A share B
Recession 0.3 -10% 10%
Normal 0.4 20% 10%
Boom 0.3 50% 10%

You are required to advise Timothy on his investment adventure by:

i) Determining the expected return and risk associated with each of the shares
ii) Determining the expected return and risk of an equally weighted portfolio of the
two
Shares
iii) Writing an investment advisory report to Timothy on what He should do for the
above and explain the factors to consider before he makes the final decision.

Question 7
(a) Distinguish between Systematic and Unsystematic risk
(4 Marks)
(b) Safina, an investor in Mbarara Municipality, is considering investing in two
securities M and N available on Mbarara Stock Market. The returns of the two
securities under four different states of nature are given below:
 State of
nature Probability Return of M Return of N
1 0.10 5% 0%
2 0.30 10% 8%
3 0.50 15% 18%
4 0.10 20% 26%

Required:

(i) Advise Safina, based on expected returns alone, as to which security she
should invest in.
(4 Marks)

(ii) Advise Safina, based on the volatility alone, as to which security she should
invest in.
(4 Marks)

(iii) Advise Safina, based on both expected returns and volatility, as to which
security she should invest in.
(4 Marks)

(iv) Determine for Safina the correlation between the returns of the two
securities.
(4 Marks)
(TOTAL 20 MARKS)
 CAPITAL STRUCTURE DECISIONS AND COST OF CAPITAL

1.1 CAPITAL STRUCTURE

1.2 Definitions

The capital structure is how a firm finances its overall operations and growth by
using different sources of funds. The capital structure of a firm is a mix of the
firm’s long-term debt, common equity and preferred equity. A company's
capital structure is the method a company uses to finance its operations and growth
utilizing various sources of funding.

Debt comes in the form of bond issues or long-term notes payable, while equity
comprises common stock, preferred stock or retained earnings. Short-term debt such
as working capital requirements is also considered to be part of the capital
structure.

1.3 Factors that influence a firm’s capital structure

(i) Business Risk

Business risk is the basic risk of a firm's operations without factoring in debt.
Greater business risk should be countered by a lower debt ratio in a firm's
capital structure. For example, a beauty business has more risk than a
utility company. A beauty business is subject to changing trends and
economic conditions, which make the potential of losing higher. Therefore,
it is advisable for businesses in the beauty industry to have a lower debt
ratio. The utility company, on the other hand, has a more stable revenue
stream.

(ii) Tax Exposure

Applicable tax laws and regulations may also play an important role in
capital structure decisions. Since debt payments are tax deductible, if a
company's tax rate is high, it may make sense to use debt as a means of
financing. The tax deductibility of debt payments will protect some income
from taxation.

(iii) Financial Flexibility

The lower a firm's debt ratio, the more flexibility the company has during
difficult economic periods. Financial flexibility is a company's ability to raise
capital during slow-growth periods. The airline industry is known to have
poor financial flexibility in a stagnant economy.
 (iv) Management Style

Preference in management style may affect what type of capital structure

business owners choose. Conservative managers are less likely to use debt to
raise funds. On the other hand, aggressive management styles attempt to
create rapid growth, which may require larger amounts of debt.

(v) Growth Stage

A business firm's capital structure may also depend upon the enterprise's
current growth stage. Companies in the initial growth stages may tend to take
on more debt in order to facilitate growth. However, many times firms may
grow too rapidly, which causes their growth to be unstable. Firms that are
more stable usually require less debt, due to more stable revenue streams.

(vi) Market Conditions

Market conditions are a significant factor in making capital structure

decisions. In a stagnant market, investors may be less likely to invest capital;
therefore, interest rates may be significantly higher. Therefore, companies
may tend to avoid a high debt ratio during a struggling market..

2.1 COST OF CAPITAL

2.2 Definition

Cost of capital is the cost of funds used for financing a business. Cost of capital is the
return paid to the providers of capital to induce them to part with the resources to
somebody who wants to use them. Cost of capital depends on the mode of financing
used – it refers to the cost of equity if the business is financed solely through equity or
to the cost of debt if it is financed solely through debt. Many companies use a
combination of debt and equity to finance their businesses, and for such companies,
their overall cost of capital is derived from a weighted average of all capital sources,
widely known as the weighted average cost of capital (WACC). Since the cost of
capital represents a hurdle rate that a company must overcome before it can generate
value, it is extensively used in the capital budgeting process to determine whether the
company should proceed with a project.
2.3 Cost of Debt

The cost of debt for a business firm is usually cheaper than the cost of equity
capital. Why is this? Because the interest expense on debt is a tax- deductible
expense for the business firm. This is why many small business firms, unless they
have investors, use debt financing.

Cost of debt is given by:

Cost of debt = Pre-tax cost of firm's bonds or short-term debt (1 - marginal tax rate)

2.4 Cost of Equity

In financial theory, Cost of Equity is the return that stockholders require from a
company. It is the rate of return required by the common stock holders. It is more
difficult to estimate the cost of equity than the cost of debt. Cost of equity can be
determined either by the Dividend Valuation Model or the Capital Asset Pricing
Model.

(a) Cost of Equity – Dividend Valuation Model

Using the Dividend Valuation Model, Cost of Equity is given by:

(b) Cost of Equity – Capital Asset Pricing Model

Most businesses use the Capital Asset Pricing Model (CAPM) to estimate the
cost of equity. Here are the steps to estimate the cost of equity or retained
earnings using CAPM:

(i) Estimate the economy's risk free rate.

The risk-free rate is usually the rate of return on Government Treasury

Bills.

(ii) Estimate the stock market's current rate of return.

You can usually look at a broad stock market index, like the Uganda
Securities Index and use the rate of return of that index as an
approximation for the market rate of return.

(iii) Estimate the risk of the stock of the company as

compared to the market. This measure is called beta.
 The beta (risk) of the market is specified as 1.0. If the company's risk
is greater than the market, its beta is greater than 1.0 and vice versa.
You can use historical stock price information to measure beta. You
can adjust the historical beta for fundamental factors specific to the
company. Often, it is a judgment call on the part of company
management.

(iv) Insert the variables into the CAPM equation.

Cost of Equity = Risk-free rate + Beta (Market Rate of Return - Risk-

Free Rate)

Example

Here is an example. If the risk-free rate on Treasury bonds is 2% and

the current market rate of return is 5% and the beta of a company's
stock is estimated to be 1.5, calculate the company's cost of equity
(retained earnings) capital:

Cost of equity = 2% + 1.5(5% - 2%) = 6.5%

2.5 Cost of Preference Share Capital

Preference Capital is that Capital stock which provides a specific dividend that is
paid before any dividends are paid to common stock holders, and which takes
precedence over common stock in the event of a liquidation. Like common stock,
preference shares represent partial ownership in a company, although preferred
stock shareholders do not enjoy any of the voting rights of common stockholders.
Also unlike common stock, preference shares pay a fixed dividend that does not
fluctuate, although the company does not have to pay this dividend if it lacks the
financial ability to do so. The main benefit to owning preference shares are that
the investor has a greater claim on the company's assets than common stockholders.
Preferred shareholders always receive their dividends first and, in the event the
company goes bankrupt, preferred shareholders are paid off before common
stockholders. In general, there are four different types of preferred stock: cumulative
preferred stock, non-cumulative preferred stock, participating preferred stock, and
convertible preferred stock.

Cost of Preferred Stock = annual dividend of preference shares

market price of the preference share
2.6 The Weighted Average Cost of Capital (WACC)

Broadly speaking, a company's assets are financed by either debt or equity. WACC is
the average of the costs of these sources of financing, each of which is weighted by
its respective use in the given situation. By taking a weighted average, we can see
how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it
is often used internally by company directors to determine the economic feasibility
of expansionary opportunities and mergers. It is the appropriate discount rate to use
for cash flows with risk that is similar to that of the overall firm.

The weighted average cost of capital is the average interest rate a company must
pay to finance its assets. As such, it is also the minimum average rate of return it
must earn on its current assets to satisfy its shareholders or owners, its investors,
and its creditors.

2.5 Calculating the Weighted Average Cost of Capital

Now that we have calculated the cost of capital for all the sources of debt and
equity that you use, it is now possible to calculate the weighted average cost of
capital for a company. The weight is the proportion of each source of funds in the
capital structure. For example the cost of debt capital was 5.85% and the cost of
equity capital was 6.5%. If each made up 50% of the capital structure, here is the
calculation for weighted average cost of capital:

WACC = (Cost of debt X Proportion of debt) + (cost of equity X

Proportion of equity)

= (5.86 X 0 .5) + (6.5 X 0.5)

= 2.93 + 3.25

= 6.18%
 EXERCISES IN COST OF CAPITAL

Question 1

Shumuk Investments is considering to expansion program that will require a substantial

amount of resources. The company can access these required resources from Standard
Chartered Bank at an annual interest of 19%. Shumuk Investments pay corporation tax to
Uganda Revenue Authority at 35%. If the company requires a rate of return of 10%, advise
if the loan from Standard Chartered Bank should be taken.

Question 2

Tororo Cement Ltd is considering the establishment of a new plant in Karamoja to supply
Southern Sudan. The company however does not have the funds for the required
expansion. There are two options opened to the company to raise the required finances: (i)
Borrow money from Uganda Development Bank at annual interest of 12% or (ii) Issue
equity shares to raise the money. The risk free rate in Uganda today is 8%, the company’s
beta is 1,6 and the market return is 10%.

Advise the Directors of Tororo Cement as to which option of raising funds is best.

Question 3

Eastern Corporation Limited (ECL) is a company operating in Eastern Uganda with its
headquarters in Soroti Municipality. The major business of the company is the purchasing
of cattle from farmers in Teso and Karamoja regions and selling them to dealers in
Bukedea Cattle Market. The company is listed on Teso Stock Exchange.

The capital structure of ECL in book value terms as at 31 st December 2015 is as shown
below:

UGX
10,000 8% Preference Shares of Shs. 1,000 each 10,000,000
12% Debentures of Shs. 10,000 each 20,000,000
Ordinary Shares of Shs. 1,000 each 50,000,000
Retained Earnings 20,000,000
100,000,000

Information obtained from Teso Stock Exchange shows the market values of the stocks of
ECL as 8% Preference Shares Shs. 1,600 each, 12% Debentures Shs. 12,000 each and
Ordinary Shares Shs. 1,500 each.
ECL has proposed ordinary share dividend of Shs. 300 per share payable in June 2016 and
this is expected to grow at the rate of 20% per annum. The company pays corporation tax
at 35%.

Required:

(a) Determine the Weighted Average Cost of Capital of Eastern Corporation Limited
using book values of the capital structure;

(b) Determine the Weighted Average Cost of Capital of the company using market
values in the capital structure.

Question 4

a) What do you understand by the term “cost of capital”?

b) In a seminar held at UMI, a representative from Stanbic Bank Ltd made two statements
that left participants of DHRM confused:
Statement one: “Equity capital is not cost free.” Statement
two: “debt is the cheapest source of funds.”
As a student of MBA, explain the meaning of the above two statements.”

c) The capital structure of GKL Co Ltd is as follows:

Description Amount ( UGX ‘000)
Ordinary shares (200,000) 40,000
10% preference shares 10,000
14% debentures 30,000

The ordinary share of the company sells for UGX 20. It is expected that the
company will pay a dividend of UGX 2 per share which will grow at 7%. Assume
30% tax rate.

The dividend per preference share is UGX 10 and the market price of a preference
share is UGX 100. The weights of the components of capital are determined based
on the amount in the mix.

Required:
Compute the cost of capital for GKL.
 STRATEGIC FINANCIAL MANAGEMENT PGDFM/UMI

Question
5

Olam (U) Ltd established last year is currently using the following sources of funds.

Class/item Book value in UGX

Irredeemable Bond 400,000,000
Preference shares 300,000,000
Ordinary shares 500,000,000
Retained earnings 300,000,000
TOTAL 1,500,000,000

The bonds were issued as irredeemable bearing an interest rate of 20% and have a
nominal value/face value of UGX.200,000/= each. The going market rate for each bond is
UGX280,000/=

The preference shares are in denominations of UGX 20, 000/= per share with a dividend
rate of 22%. Ordinary shares were issued at a face value of UGX 80,000/= per. The
ordinary share and initial dividends were 26% of the face value and this is anticipated to
grow at the rate of 8% p.a. The ordinary shares are currently trading for UGX110,000 in
the market. The business is in the 30% tax bracket.

Required
a) To determine the weighted average cost of capital for Olam (U) Ltd using
i) Book values
ii) Market values

b) Explain to the Senior management of Olam (U) ltd;

i) Why retained earnings is one of the most popular source of financing for the
companies’ operations among SMEs.
ii) The factors that influence the capital structure of an organization.
 STRATEGIC FINANCIAL MANAGEMENT PGDFM/UMI

Question 6

The capital structure of Demba Investments Limited in book value terms is as

follows:

Shs.
2,000,000 Equity Shares of Shs. 100 each 200,000,000
500,000 12% Preference Shares of Shs. 100 each 50,000,000
Retained Earnings 350,000,000
1,200,000 14% Debentures of Shs. 100 each 120,000,000
Term Loans (13%) 80,000,000
800,000,000

The next expected dividend per share is Shs. 2.00 and the dividend per share is expected to
grow at the rate of 12%. The preference stock is redeemable after ten years and is currently
selling at Shs. 85.00 per share. The debentures are redeemable after 5 years. Demba
Investments Limited pays corporation tax to URA at 30%.

Required:

Determine the Weighted Average Cost of Capital for Demba Investments Limited.

Question 7

(a) What do you understand by “Capital Structure”?. What factors influence the
Capital Structure decisions of a firm?
(4 Marks)
(b) Toyota Uganda has the following book value capital structure as at the close of
business on 30th September 2015.
Shs.
1,000,000 Ordinary Shares of Shs. 100 each. 100,000,000
100,000 12% Preference shares of Shs. 100 each 10,000,000
Retained Earnings 120,000,000
500,000 13.5% Debentures of Shs. 100 each 50,000,000
12% African Development Bank Loan (payable 2020) 80,000,000
360,000,000

The company is listed on the Kampala Stock Exchange and it pays Corporation Tax to
Uganda Revenue Authority at 35%.
 Information obtained from the Kampala Stock Exchange show that the Ordinary
Shares are currently trading at Shs. 135 per share, the Preference Shares are trading
at Shs. 140 per share, the Debentures are trading at Shs. 125 per unit and the East
African Development Bank Loan is currently trading at par. The return of the
market 18%, the risk free rate is 12% and the risk of Toyota Uganda as compared to
the risk of the market as a whole is 1.6.

Required:

(i) Determine the cost of each source of funds in the Capital Structure of the
company.
(4 Marks)

(ii) What is the Weighted Average Cost of Capital of Toyota Uganda in book
value terms?
(4 Marks)

(iii) Determine the market value capital structure of Toyota Uganda.

(4 Marks)

(iv) What is the Weighted Average Cost of Capital of Toyota Uganda in market
value terms?
(4 Marks)
What do we need to know in Capital Budgeting?

(i) Meaning and logical process of capital budgeting

(ii) Features of investment projects;

(iii) Types or classification of investment projects

(iv) Techniques of Investment Appraisal

 The Pay Back Period;

 The Accounting Rate of Return;
 The Net Present Value;
 Profitability Index;

(v) The Internal Rate of Return.

1.1 DEFINITION

Capital Budgeting or Investment Decisions or Investment Appraisal is a

management process of making a choice as to which capital project should be
undertaken or not undertaken. Capital Investment Management is a process that has
a number of activities.

Capital Investment Management process includes the following activities:

(i) Identification of potential investment opportunities;

(ii) Assembling of data in respect of each opportunity

 Cash outflows and outflows associated with each investment
opportunity;
 Cost of funds required for the investments;
 Risks associated with each opportunity

(iii) Analysis of data assembled. Special capital budgeting techniques are used to
analyze data so assembled;
 (iv) Making a choice as to which investment can be undertaken or not
undertaken;

(v) Preparation of the Capital Budget

 Once a decision has been made, the chosen investment is then included
in the capital budget of the organization to enable mobilization of
resources for implementation.

(vi) Resource Mobilization

(vii) Project Implementation

(viii) Continuous review of project implementation.

It is important at this point to make a distinction between capital budgeting and a

capital budget. Capital Budgeting is a decision making process for selecting
investment projects. A capital budget on the other side a budget of investment
projects to be implemented. Once capital budgeting process has been completed, the
chosen investment projects are then budgeted for.

2.1 FEATURES OF INVESTMENT PROJECTS

(i) Involve substantial outlays of resources;

(ii) Benefits from investments projects are not immediate. They take time to be
realized;

(ii) Investments projects normally once chosen and implementation starts are
difficult or expensive to reverse.

3.1 CLASSIFICATION OF INVESTMENT PROJECTS

Investment Projects can be any of the following:

(i) Replacement Investment Projects

(ii) Expansion Investment Projects
(iii) New Product Line investment Projects
(iv) Research and Development Investment Projects; and
(v) Regulatory or Social Responsibility Investment Projects.
4.1 TECHNIQUES OF INVESTMENT OR PROJECT APPRAISAL

This is the analysis of project data with the aim of reaching a decision as to which
investment project should be undertaken. Investment Appraisal involves analysis of
the risks, cash flows associated and cost of capital associated with a project to
enable making a decision as to whether the project can be undertaken or not.

Investment Appraisal is done with the help of a number of techniques. The

following techniques are normally used in investment appraisal:

(i) The Pay Back Period;

(ii) The Accounting Rate of Return;
(iii) Net Present Value;
(iv) Profitability Index;
(v) Internal Rate of Return.

The first two techniques are known as Non-discounted Cash Flow Techniques and
the last two are known as Discounted Cash Flow Techniques.

4.2 The Pay Back period

Any rational investor before sinking large sums of money in a project would want to
know how long it will take to recover the money from such a project. The period
within which the cash inflows from a project equal to the cash outflows of the project
is what is known as the Pay Back period.

The decision rule

 The shorter the pay-back period the better the project;

 When evaluating more than one project, the project with the shortest pay-
back period is preferred over the one with a longer one.

Disadvantages of the technique

 It does not take into account the time value of money. In other words it
assumes that a shilling now is the same as a shilling tomorrow which is not
true in an inflationary economy that we live in.
 The technique also does not take into account all the cash flows associated
with the project. The technique only considers the cash flows up-to the pay
back point.
 Advantages of the Technique

Despite these limitations, this technique is widely used because:

 It is easy to understand and to compute; and

 It is useful for an investor who has cash limitations and would want a
project that generates cash quickly.

4.3 Accounting Rate of Return (ARR)

The accounting rate of return (also known as simple rate of return) is the ratio of
estimated accounting profit of a project to the average investment made in the
project. ARR is used in investment appraisal.

Formula

Accounting Rate of Return is calculated using the following formula: ARR

= Average Accounting Profit

Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be

earned during each year of the project's life time. Average investment may be
calculated as the sum of the beginning and ending book value of the project divided by
2. Another variation of ARR formula uses initial investment instead of average
investment.

Decision Rule

Accept the project only if it’s ARR is equal to or greater than the required accounting
rate of return. In case of mutually exclusive projects, accept the one with highest
ARR.

Example

A company is considering undertaking a investment that will cost $130,000 as an initial

cash outlay. The investment is expected to generate annual cash
 inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of $10,500 at end of the 6th year.
Calculate its accounting rate of return assuming that there are no other expenses on
the project

Advantages

 Like payback period, this method of investment appraisal is easy to

calculate.
 It recognizes the profitability factor of investment.

Disadvantages

 It ignores time value of money. Suppose, if we use ARR to compare two projects
having equal initial investments. The project which has higher annual income in
the latter years of its useful life may rank higher than the one having higher
annual income in the beginning years, even if the present value of the income
generated by the latter project is higher.
 It can be calculated in different ways. Thus there is problem of consistency.
 It uses accounting income rather than cash flow information. Thus it is not
suitable for projects which have high maintenance costs because their viability
also depends upon timely cash inflows.

4.4 The Net Present Value

A good technique for investment appraisal should have two very important
qualities:

(i) It should recognize that the value of money changes with time. That is a
shilling now is not the same as a shilling tomorrow; and
(ii) It should take into account all the cash flows associated with an investment.

The Net Present value Technique satisfies these conditions. This technique
discounts all future cash flows of a project to their current present values.
 Present Value of future cash flow is dependent on two factors:

 The prevailing interest rate(cost of capital) or inflation rate; and

 The period into the future when the cash flow will be realized.

Net Present Value is the difference between the value of the initial cash outlay on a
project and the present value of the future cash flows associated with the project.

Decision Rule

When using this technique, the decision rule is as follows:

 For a project to be undertaken, the NPV must be greater than zero. If the
NPV of a project is less than zero, the project is not viable.
 When we have more than one investment project, the one with a higher
positive NPV is preferred to the one with a lower positive NPV.
 If a project has a NPV of zero, non financial factors should be considered in
making a decision.

Advantages of NPV Technique

 It takes into account the time value of money;

 It considers all cash-flows associated with a project

Disadvantages of NPV Technique

 Difficult to use;
 Does not take into account the size of the project

4.5 Profitability Index

NPV Technique is a good method of investment appraisal as it addresses the major

weaknesses of the non-discounted cash flow techniques. This technique, however,
does not take into account the amount of resources invested in a project. A project
can give a high NPV simply because large resources have been put in it. The
profitability per unit of money put in a project is also important in determining the
overall profitability of a project.

The technique that addresses the profitability per unit of funds put in a project is the
Profitability Index.

Profitability Index is given by:

PI = NPV/Initial Investment.
 Decision Rule:

The higher the Profitability Index the better the project.

4.6 Internal rate of return (IRR)

Internal Rate of Return (IRR) is the interest rate at which the net present value of all the
cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or

investment. If the IRR of a new project exceeds a company’s required rate of
return or the cost of capital, that project is desirable. If IRR falls below the required
rate of return (cost of capital) the project should be rejected.

A general rule of thumb is that the IRR value cannot be derived analytically.
Instead, IRR must be found by using mathematical trial- and-error to derive the
appropriate rate. However, most business calculators and spreadsheet programs will
automatically perform this function.

Using trial and error method and a mathematical formula, IRR is given by:

IRR = A + C (B-A)
C-D

Where, A is the discount rate of the lower trial; B

is the discount rate of the higher trial;

C is the NPV of the lower trial; and D

is the NPV of the higher trial.

Let's look at an example to illustrate how to use IRR.

Assume Company XYZ must decide whether to purchase a piece of factory

equipment for $300,000. The equipment would only last three years, but it is
expected to generate $150,000 of additional annual profit
during those years. Company XYZ also thinks it can sell the equipment for
scrap afterward for about $10,000. Using IRR, Company XYZ can determine
whether the equipment purchase is a better use of its cash than its other
investment options, which should return about 10%.

Internal Rate of Return (IRR) is the interest rate at which the net present value of all the
cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or

investment. If the IRR of a new project exceeds a company’s required rate of
return or the cost of capital, that project is desirable. If IRR falls below the required
rate of return (cost of capital) the project should be rejected.

A general rule of thumb is that the IRR value cannot be derived analytically.
Instead, IRR must be found by using mathematical trial- and-error to derive the
appropriate rate. However, most business calculators and spreadsheet programs will
automatically perform this function.

Let's look at an example to illustrate how to use IRR.

Assume Company XYZ must decide whether to purchase a piece of factory

equipment for $300,000. The equipment would only last three years, but it is
expected to generate $150,000 of additional annual profit during those years.
Company XYZ also thinks it can sell the equipment for scrap afterward for
about $10,000. Using IRR, Company XYZ can determine whether the equipment
purchase is a better use of its cash than its other investment options, which
should return about 10%.

Why it Matters:

IRR allows managers to rank projects by their overall rates of return rather than
their net present values, and the investment with the highest IRR is usually
preferred. Ease of comparison makes IRR attractive, but there are limits to its
usefulness. For example, IRR works only for
 investments that have an initial cash outflow (the purchase of the
investment) followed by one or more cash inflows.

Also, IRR does not measure the absolute size of the investment or
the return. This means that IRR can favor investments with high
rates of return even if the dollar amount of the return is very
small. For example, a
$1 investment returning $3 will have a higher IRR than a $1 million
investment returning $2 million. Another short-coming is that IRR
can’t be used if the investment generates interim cash flows.
Finally, IRR does not consider cost of capital and can’t compare
projects with different durations.

IRR is best-suited for analyzing venture capital and private equity

investments, which typically entail multiple cash investments
over the life of the business, and a single cash outflow at the end
via IPO or sale.
EXERCISES IN CAPITAL BUDGETING

Question 1
(a) Briefly discuss the features and types of capital investment projects

(b) Nagongera Millers Limited is considering the purchase of a

modern maize milling machine from China that will cost them
US 150,000 inclusive of insurance, transport and installation.

When the machine is purchased, it will generate net cash

inflows as follows:
US $ US $
Year 1 25,000 Year 5 25,000
Year 2 30,000 Year 6 20,000
Year 3 30,000 Year 7 20,000
Year 4 25,000

At the end of year 4, the machine will require a capital overhaul

costing US
$ 10,000 to maintain its operating capacity to be able to
generate cash flows projected above.

The machine is expected to be sold off at the end of year 7 to

realize US $ 25,000.
The funds to be used to purchase the machine will be accessed
from the Uganda Development Bank at annual interest of
10%.

Required:

(i) Using the Net Present Value technique advise the

company management accordingly.

(ii) Using the Internal Rate of Return and advise the

company management accordingly.

Question 2

(a) Outline the logical process of Capital Budgeting

(b) Your company has just received a grant of US $ 80,000

to invest in long-term income generating projects. The
company is considering the purchase of the following
machineries which have the following cash flows:

MACHINERY A B C
Initial investment 80,000 30,000 50,000

Cash inflows
Year 1 24,000 10,000 0
Year 2 24,000 10,000 0
Year 3 24,000 10,000 30,000
Year 4 24,000 10,000 30,000
Year 5 24,000 10,000 30,000

At the end of the 5 th year the equipments will be sold off and
will realize cash as follows: Machinery A US $ 20,000,
machinery B US $ 8,000 and machinery C US $ 15,000.

If the prevailing rate of interest is 15%, using:

1. the pay-back period; and

2. the Net Present Value

advise the company on which machinery they should invest in.

Question 3

Tororo Properties Limited has secured funding to the tune of US

300,000 for assorted long-term investments. The cost of the
capital is 8%. The various investment projects and associated
cash-flows that the company is evaluating are follows:

Project 1: MATOOKE PROJECT

The company has an opportunity to plant 100 acres of

motooke for export to Kenya. This will be done on land that
is to be leased for that purpose for a period of ten years only.
It is projected that this project will initially cost US 100,000
and will generate net cash inflows as follows:

Year Net cash-inflow (US$) Year Net cash-inflow (US$)

1 20,000 6 40,000

2 40,000 7 20,000

3 60,000 8 10,000

4 75,000 9 5,000

5 50,000 10 2,500

At the end of year ten, the plantation will be cut down and the land
reverts to the owner.

Project 2: BUS PROJECT

The company is also considering buying passenger buses to ply the

Tororo
– Kisumu route. This project requires an initial outlay of US
150,000 and will generate net cash flows as follows:

Year Net cash-inflow (US$) Year Net cash-inflow

(US$)

1 50,000 4 65,000

2 65,000 5 40,000

3 65,000

At the end of year 5, all the buses will be sold off to realize US
50,000 and thereafter the company will consider whether
or not to continue with the bus business.
Project 3: COFFEE PROJECT

There is also an opportunity of planting coffee given the good

soils in Eastern Uganda. The land for coffee will be leased for
a period of twenty years from a landowner in Manafwa
District. If the project is chosen, it will require an initial
outlay of US $ 120,000 and generate annual net cash in- flow
as follows:

Year Net Cash-inflow ($) Year Net Cash-inflow ($)

1 0 6 40,000

2 0 7 40,000

3 5,000 8 40,000

4 10,000 9 40,000

5 30,000 10 40,000

From the 11th year the coffee project is expected to generate

US $ 35,000 per year for the next 10 years when the lease for
the land the company is using will expire. When the lease for
the land expires, the land will revert to the original owner.

The company is free to undertake any of all of the projects

depending on the funds available.

Required:

(a) Using the pay-back period rank the projects in order of

viability;

(b) Using the NPV technique, Internal Rate of Return

Technique, and the Profitability Index advise the company
on how it should allocate its funds among these projects.

Question 4
Kampala City Transporters Limited (KCTL), a transport
management company in Kampala is proposing to purchase
200 buses to provide transport services within Kampala and
its surroundings. The buses are to be supplied by Spear
Motors Limited which has quoted Shs. 200,000,000 per bus
to cover costs, insurance, freight and all taxes. The project
will also require KCTL to hire a piece of land from KCCA to
establish a bus park for their fleet. The cost of hiring the
land is Shs. 189,550,000= paid in advance for five years.
KCTL expects to generate net cash flows Shs.
7,500,000,000= annually for five years. At the end of the
fifth year, the park will revert to KCCA and all the buses will
be sold off at Shs. 50,000,000 each. The current cost of
capital to KCTL is 20%.

Required:

Using each of the following techniques advise UTODA Ltd

whether they should undertake the project.

(a) The Pay Back Period;

(b) The Net Present Value;

(c) The Internal Rate of Return.

Question 5

Makerere University is considering a major investment

project of renovating all Students’ Halls of Residence and
latter hiring them out to a private operator who will provide
accommodation services to students at a commercial rate.

The Estates Department of the University has estimated that

renovating all the University Halls of residence will cost the
University US $ 25,000,000.

Bids have also been obtained from prospective Private

Operators of these facilities and the best evaluated bidder is
proposing to pay the University US $ 3,000,000 per annum.

The University is considering sourcing funding from the East

African Development Bank at an annual interest rate of 8% to
implement this project.

Required:
(i) What is the Pay Back Period of this project?

(ii) Using the Net Present Value technique, advise

the University whether or not the project should be
undertaken.

Question 6

(a) Briefly describe the logical process of capital budgeting.

(b) What are the key features of investment projects?

(c) Kampala Capital City Authority (KCCA) is considering

the construction of Southern Bypass to ease the traffic
jam in the city. When the Bypass is completed it will be
a commercial express highway where the user pays a
service fee for using the facility.

KCCA has approached the African Development Bank

to fund this project with a ten year loan with a cost of
10% per annum. This project is expected to cost US $
250,000,000. When completed, the Bypass will
generate net cash inflows from the user fees as follows:

Year Net cash inflows in US $

Year 1 10,000,000
Year 2 25,000,000
Year 3 40,000,000
Year 4 50,000,000
Year 5 75,000,000
Year 6 75,000,000
Year 7 80,000,000
Year 8 80,000,000
Year 9 80,000,000
Year 10 80,000,000

Required:

(i) What is the Pay Back Period of the project?

(ii) Determine the Net Present Value of the project?
(iii) What is the Profitability Index of the project?
(iv) What advice would you give to KCCA in respect of this
 project?

(d) Briefly discuss any five non-numeric methods of investment

appraisal

Question 7

A company is considering the purchase of an equipment to

save its costs. The relevant data for net present value
analysis of the equipment is given below:

Cost of equipment

Shs. 240,000,000 Expected annual cash

savings before tax

Shs. 100,000,000

Useful life of the equipment 5 years Expected

residual value

Shs. 30,000,000 Corporate Tax Rate

40%

Discount Rate 12%

The equipment is to be depreciated using straight line method

Required:

Determine the Present Value of the equipment.

Question 8

Gulu Investments Limited is considering a project that is

expected to generate Shs. 100,000,000 at the end of each
year for 5 years. The initial outlay required is
Shs. 250,000,000. To fund this
project, Gulu Investments intends to obtain a loan
from Uganda Development Bank at a cost of 9.2%. The
inflation rate in Uganda today is 5% and UDM has taken
this into account in determining its lending rate.

You are the Financial Analyst of Gulu Investment Limited

and you have been asked to evaluate this project.

Advise the management of Gulu Investments Limited accordingly

Question 9

Oyam Holdings is considering whether to invest in a new

product with a product life of four years. The cost of the fixed
asset investment would be Shs.30,000,000 in total, with Shs.
15,000,000 payable at once and the rest after one year. A
further investment of Shs. 6,000,000 in working capital
would be required.

The management of Oyam Holdings expect all their

investments to justify themselves financially within four
years, after which the fixed asset is expected to be sold for
Shs. 6,000,000.

The new venture will incur fixed costs of Shs. 10,400,000 in

the first year, including depreciation of Shs. Shs.
4,000,000. These costs, excluding depreciation, are
expected to rise by 10% each year because of inflation. The
unit selling price and unit variable cost are Shs. 240 and
Shs. 120 respectively in the first year and expected yearly
increases
because of inflation are 8% and 14% respectively. Annual
sales are estimated to be 175,000 units.

Oyam Holdings money cost of capital is 28%.

Required:

Advise the management of Oyam Holdings whether or not to

take up the investment.
PRESENT VALUE TABLE

INTEREST RATE
Year 1% 2% 4% 6% 8% 10% 12% 14% 15% 16% 18% 20% 25%
1 0.990 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.800
2 0.980 0.961 0.925 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694 0.640
3 0.971 0.942 0.889 0.840 0.794 0.751 0.712 0.675 0.658 0.641 0.609 0.579 0.512
4 0.961 0.924 0.855 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482 0.410
5 0.951 0.906 0.822 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402 0.328
6 0.942 0.888 0.790 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.262
7 0.933 0.871 0.760 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.210
8 0.923 0.853 0.731 0.627 0.540 0.467 0.404 0.351 0.327 0.305 0.266 0.233 0.168
9 0.914 0.837 0.703 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.194 0.134
10 0.905 0.820 0.676 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.107
11 0.896 0.804 0.650 0.527 0.429 0.350 0.287 0.237 0.215 0.195 0.162 0.135 0.086
12 0.887 0.788 0.625 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.069
13 0.879 0.773 0.601 0.469 0.368 0.290 0.229 0.182 0.163 0.145 0.116 0.093 0.055
14 0.870 0.758 0.577 0.442 0.340 0.263 0.205 0.160 0.141 0.125 0.099 0.078 0.044
15 0.861 0.743 0.555 0.417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.035