KCE

COLLEGE

ADVANCED FINANCIAL MANAGEMENT

SECTION FIVE
Capital budgeting
1. Consider a project whose initial investment is 636,000 and the company expects to
generate annual cash flows of 240,000 p.a. for a period of 5 years. The present cash flows
can be re-invested at the rate of 16% pa and the cost of capital is 14%. Determine the
MIRR.
2. Consider the following projects.
Project Initial investment Annual cash flows Economic life
A 10,000 2191.2 7years
B 20,000 5427.84 6years
C 20,000 4500 8years
Required: Determine the IRR for each project.
3. Consider a one year project whose initial investment is 100M. The project is expected to
generate sh.125M at the end of the year.
Required: Compute the IRR of the project.

4. Consider a project whose initial investment is sh 250M. It is expected to generate annual

cash inflows of sh 45M until infinity
Determine the IRR of the project.
5. Consider the following information.
Period cashflows
1 60,000
2 40,000
3 30,000
Assuming the cost of capital is 10 % and initial investment was 100,000.
Required: Determine the IRR of the project.
6. A company has 4 independent projects with the following features.
A B C D
PVCIF 53 63 103 80
PVCOF 35 40 65 48
NPV 18 23 38 32
The company has a capital limitation of sh 100M. The cost of capital is 10% and any surplus
fund can be invested at a rate of return of 12% pa until infinity. All the 4 projects are indivisible.
Determine the optimal project combination.

RISK ANALYSIS IN CAPITAL BUDGETING

Question one
Consider a 5 year project whose initial investment is sh.120M. The annual cash flows to be
generated by the project is estimated using probabilities as follows.

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 Annual Cash prob
flows
40M 0.3
50M 0.4
60M 0.3
If the cost of capital is 12%, determine:
a) EMV
b) NPV of the project.
c) Standard deviation
d) Coefficient of variation
Question two
ABC ltd is planning advertising campaign in 3 different markets as follows
Market 1 Market 2 Market 2
Fair 10,000 0.4 5,000 0.2 16,000 0.5
Normal 18,000 0.5 8,000 0.6 20,000 0.3
Excellent 25,000 0.1 12,000 0.2 25,000 0.2

 Compute the expected value and the standard deviation for the 3 markets
 Rank the projects according to the coefficient of variation
Question 4
Bora manufacturer’s ltd intends to purchase a processing machine costing sh 40 million. The
machine is expected to have an economic life of 2 years with a nil salvage value at the end of its
life.
To adjust for risk on this investment, probabilities have been attached to the expected cashflows
over the two year period as shown below.
Year 1 Year 2
cashflows probability cashflows
Conditional
probability
12 million 0.2
25 million 0.4 16 million 0.3
22 million 0.5
20 million 0.4
30 million 0.6 25 million 0.5
30 million 0.1
Additional information.
1. The cashflows in year 2 are conditional on the cashflows in year 1. All cashflows have
been reported on an after tax basis.
2. The cost of capital is 10%.
3. Ignore depreciation.
Required:
i) Present the above information on a decision tree.
ii) The best NPV and its probability of occurrence.
iii) Expected NPV.
iv) Advice the management on whether to purchase the processing machine.

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Question 4
BEP analysis-sensitivity analysis
Consider the following information about project X
 The initial investment is sh. 100,000
 Annual revenue 200,000.
 The operating expenses excluding depreciation is sh. 170,000
 The economic life of the project is 5 years and it is being depreciated using straight line
method and the cost of capital is 10%.
 The corporate tax rate is 30%
Required:
Carry out the sensitivity analysis in respect of each key variable in isolation. (Initial investment
revenue and operating expenses)
Question 5 (CEC)
Consider a project whose initial investment is sh. 100,000 and it’s expected to generate the
following cash flows.
Year 1 2 3 4 5
Cash flow 35,000 35,000 35,000 35,000 35,000
CEF 0.9 0.8 0.7 0.3 0.2
The cost of capital is 10% and the risk free rate is 8%.
Required; evaluate the project using the equivalent coefficient factor.
QUESTION 6
Simulation
Consider a project whose initial investment is 40M and the cost of capital is 12%. Its economic
life is 5 years and the following costs and revenues are provided.
Revenues Costs
Amount prob Amount prob
40M 0.15 25M 0.10
50M 0.40 30M 0.25
55M 0.30 35M 0.35
60M 0.15 40M 0.30
Random no of revenue : 37, 20, 56, 19, 47
Random no of costs : 84, 01, 89, 18, 48
Required: Evaluate the project using the simulation analysis.

REPLACEMENT ANALYSIS
Question one
Replication chain method. (LCM)
Consider the following 2 mutually exclusive projects.
Project X Project Y
Initial cost 100,000 100,000
Cost of capital 10% 10%
Economic life 2 years 3 years
Annual cash flows
1 60,500 60,000
2 60,500 44,000
3 ------ 20,000

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Required
a. Determine the NPV of each project
b. Evaluate the project using the replacement chain analysis

Bond refinancing
QUESTION ONE
Mac ltd issued a 100M par value 16%, 10-year bond five years ago. The bond was issued at a 2%
discount and issuing costs amount to 2M.

Due to the decline in Treasury bill rates in the recent past, interest rates in the money market
have been falling presenting favorable opportunities for the refinancing.

A financial analyst engaged by the company to assess the possibilities of refinancing the debt
reports that a new 100M par value, 12%, 5 years’ bond can be issued by the company. Issuing
cost for the new bond will be 5% of the par value and a discount of 3% will have to be given to
attract investors.
The old bond can be redeemed at 10%premium and in addition, two months’ interest penalty will
have to be paid on redemption.

All bond issue expenses (including the interest penalty) are amortization on a straight line basis
over the life of the bond and are allowable for corporate tax purposes.
The applicable tax rate is 40% and the after tax cost of the debt to the company is approximately
7%
Required:
a. Cash investment required for the refinancing decision (9 marks)
b. Annual cash benefits (savings) of the refinancing decision (6marks)
c. NPV of refinancing decision (3marks)
d. Is it worthwhile to issue the new bond (2marks)

PORTFOLIO AND CAPM

Question one
Consider the following 2 securities X and Y which have the following features.
Prob Return of X% Return of Y%
0.3 25 18
0.4 20 14
0.3 15 10
Compute the standard deviation and co-variance btw security X and Y
CAPITAL MARKET LINE
QUESTION TWO
The following information is provided about securities of the company forming the portfolio.
Portfolio ERP % Standard
deviation %
1 19 8
2 25 12
3 16 6

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 4 32 16
5 22.5 10
6 8 2
The Expected Return on the market portfolio is 12% and the standard deviation of the market is
4%. The risk free rate is 5%.
Required;
(a) Using the capital market line advice the investor on which of the above portfolio are
efficient, super-efficient and inefficient
(b) In case of inefficient portfolio in 1 above, determine the standard deviation of the
portfolio for the efficiency to be achieved within the expected returns.

Question two
APM
The shares of XYZ ltd are influenced by the following micro-economic factors as follows.
Factors ER Beta
Inflation 13% 0.95
Industry 10% 1.32
Default premium risk 6% -0.8

The risk free rate is 8%, determine the return of security using APM.
QUESTION THREE
Performance measures.
Consider a company holding portfolio A & B, the risk free rate is 8% and the expected return of
the market (ERM) is 12% and the standard deviation of the market is 8%.
The following details are also provided.
Portfolio BP std deviation % ERP %
A 1 15 13
B 2 12 18
Required: Evaluate the portfolio using
(a) Sharpe’s measure
(b) Treynors measure
(c) Jensen’s measure
QUESTION FOUR
Leverage
The following data is available for company A
Quantity 20,000 units
Selling price sh.20
Variable cost sh.15
Fixed cost sh.40, 000
Interest sh.10, 000
Pref dividends sh.5, 000
Tax rate 30%
Required:
a. The BEP in units
b. DOL
c. DFL

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 d. DCL

RIGHT ISSUE.
This is a method of raising equity finance by issuing additional shares to the existing
shareholders at a price below the market price.
Advantages of right issue.
1. It involves less floatation cost since shares are issued to the existing shareholders who
already know the company.
2. It involves less formalities and administration procedures i.e. there is no need for
preparing the prospectus since the shares are sold to the existing shareholders.
3. It increases equity capital and hence reducing the gearing level of the company
4. Ownership and control of the company will not be diluted.
5. It enables the existing shareholders to enjoy the discount offered by the company.
6. There are minimum legal and administration measures compared to the public issue.
Disadvantages of right issues.
1. If the shares are not correctly valued, the shareholders may end up paying additional
price.
2. If the shareholders ignores the right issue, his % of ownership will decrease.
The success of the right issue depends on the following factors.
 The current market price of the share.
 The offer price
 Efficiency of the stock market
 The number of right issue required to acquire one new share

ILLUSTRATIONS.
QUESTION 1
Laura ltd intends to raise sh.25 million to finance new project through the right issue. The project
has a 10 year economic life with no salvage value and it is expected to generate cash inflows of
sh.7, 372,280 per annum. The company has 4 million issued shares. The cost of capital is 15%
and before the announcement of the right issue. The market price per share was sh. 18.
Required:
The cum-rights market price per share.

QUESTION 2
Mhusika ltd is an all equity finance with market capitalization of sh. 720 million. The company
intends to raise sh. 120 million through the right issue to finance a new project. The current
market price per share of the company prior to the announcement of the right issue is sh.30

The proposed offer price is sh.25. The new project is expected to generate cash-flows of sh 16.8
million per annum to perpetuity. For the year just ended, the company paid a dividend per share
of sh. 2.83. The project’s cash flows and dividend per share have a growth rate of 6% per annum.
Required:
(i) The cum-right market price per.
(ii) The number of right.
(iii) The theoretical ex-right MPS
(iv) The value of each right

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QUESTION 3
Latex ltd has a paid up ordinary share capital of sh. 4.5 million represented by 6 million ord
shares of sh. 0.75 each. The company has no loan capital. During the last financial year, EAT
were sh. 3.6 million. The P/E ratio is 15 and the company is planning to make a large investment
which will cost sh.10.5 million and is considering to raise the finance through the right issue with
a price of sh. 8 per share.
Required:
(i) Current market price per share.
(ii) The number of rights
(iii) The theoretical ex-right price per share.

QUESTION FIVE [adjusted NPV)

The management of J ltd is investigating a potential 24M investment. The investment would be a
diversification away from the mainstream activities and into printing industries.5M of the
investment would come from internal funds, 10M by the right issue and 9M through debt
financing.

The project will generate before tax cash flows of 5M pa ,for the 10 years period .The residual
value at the end of the 10th year is forecasted to be 5 M after tax, as the investment is in an area
that the government wishes to develop , a subsidized loan od 4M out of the total 9M debt is
available. This will cost 2% below the normal cost of long term debt finance which is 8%.
J ltd equity beta is 0.85 and its financial gearing is 60% equity and 40% debt by market values.

The average equity beta in the printing industry is 1.2 and the average gearing, 50% equity and
50% debt by market value.
The risk free rate is 5.5% per annum and the market returns 12% per annum. Issue cost are
estimated to be 1% for the debt financing (excluding the subsidized loan), and 4% for equity
financing. These costs are tax allowable. The tax rate is 30%.
Required.
a. Estimated Adjusted Present Value of the proposed investment (16 marks)
b. State the circumstances which the above method is preferred (4 marks)
COMPANY RESTRUCTURING
QUESTION ONE.
A company has the following for the last 5 years
Period 2010 2011 2012 2013 2014
Dividend per share 5 5.5 6 6.5 7.3
The co has just paid the dividend for the year 2014.The cost of equity is 16%
Required:
Using constant dividend growth model, determine the price of the share as at 31 st Dec 2014.

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 REAL OPTIONS
OPTION TO DELAY THE PROJECT
QUESTION 1
K ltd is planning to invest in the expansion of its existing production capacity. The company has
estimated 20M as an initial investment. The expansion is expected to generate 5M after tax cash
flows each year for the next 5 years. Assume cost of capital of 10%.
Required;
a. Calculate the NPV
b. Compute the value of option to delay the project assuming the risk free rate is 7% and
standard deviation of the cash flows of 30%.
Question 2
Option to withdraw
A co is considering opening a new branch which will require an initial investment of 1M. The
PV of the cash flows from the project is expected to be 4.2M and the company has an option to
withdraw the project at any time during the next 5 years. If the company withdraws from the
project it will realize 2M. Assuming the standard deviation of the cash flows is 30% and the risk
free rate is 9%, determine the value of the option to withdraw from the project within the next 5
years.

INTERNATIONAL ARBITRAGE
Consider the following actual exchange rates.
1 Ksh =0.015 dollars
1 TSH =0.0008 dollars
1 Ksh =TSH 20
Required; Compute the gain from triangular arbitrage to an investor with 200,000 dollars to
invest.

MODIGLIANI AND MILLER (JUNE 2005 Q1)

(A)Two firms A ltd and B ltd operates in the same industry. The two firms are similar in all
aspect except for their capital structure.
The following additional information is available:
1. A ltd is financed using sh. 100 million worth of ordinary shares.
2. B ltd is financed using sh 50 million in ordinary share and sh. 50 million in 7%
debentures.
3. The annual earnings before interest and tax are sh 10 million for both firms. These
earnings are expected to remain constant indefinitely.
4. The cost of equity in A ltd is 10%.
5. The corporate tax rate is 30%.
Required:
Using Modigliani and miller (MM) model, determine the following:
a) The market value of A ltd and B ltd (6 marks)
b) The weighted average cost of capital of A ltd and B ltd (4 marks)

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(B)
Proton ltd has a capital structure consisting of sh 250 million in 12% debentures and sh. 150
million in ordinary share capital of sh. 10 each.
The finance manager of proton ltd intends to raise an additional sh. 50 million to finance an
expansion programme and is considering three financing options.
 Option one: issue an 11% debenture stock.
 Option two: issue 13% cumulative preference shares.
 Option three: issue additional ordinary shares of sh. 10 par value
The corporate tax rate is 30%.
Required:
Calculate the EBIT and EPS at the point of indifference between the following financing options:
a) Option one and option three (6 marks)
b) Option two and option three (4 marks)

COST OF CAPITAL REVISION QUESTION.(JUNE 2007 Q2)

The management of Mapema ltd is in the process of determining the optima capital budget of the
company for the year ended 30 June 2020. The following information is available:
1. The profit after tax for the year ended 30 June 2020 is estimated to be sh 22,500,000.
2. The dividend payout ratio is 40%.
3. The ordinary share of the company are currently trading on the stock exchange at sh 80
per share.
4. Ordinary shareholders expect a dividend of sh 6 per share for the year ending 30 June
2020.
5. The annual growth rate in dividend is 6% per annum.
6. Floatation costs amount to sh 8 per ordinary share issued.
7. The company could issue an unlimited number of 11% preference shares at sh 96 per
share. The par value per share is sh 100.
8. The company could obtain bank loan of upto sh 24 million at a pre-tax interest rate of
10% per annum. Thereafter, an unlimited amount of bonds could be issued under the
following terms:
 Coupon interest rate 12% per annum.
 Par value sh 1,000 per bond.
 Discount sh 30 per bond.
 Floatation cost sh 20 per bond.
 Maturity period 10 years..
9. The optimal capital structure of the company comprises 15% debt, 40% preference share
capital and 45% equity.
10. Corporation tax rate is 30%.
Required:
a) The cost of capital for each source of finance available to Mapema ltd. (5 marks)
b) The break point in the marginal cost of capital (MCC) schedule with respect to retained
earnings and debt. (4 marks)
c) The marginal cost of capital at each break point identified in (b) above (4 marks)

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 d) The company has the following investment opportunities available for the year ended 30
June 2020:

investment Cost (sh million) Internal rate of return (IRR)

I 10 11.2%
II 50 9.7%
III 15 12.9%
IV 20 16.5%
V 45 11.8%
VI 60 10.1%
VII 30 10.5%
All the projects are divisible.
(i) With the aid of IRR/WMCC schedule, determine the project(s) that should be accepted
by the company. (5 marks)
(ii) Determine the company’s optimal capital budget for the year ending 30 June 2020
(2 marks

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 ADVANCED FINANCIAL MANAGEMENT THEORIES.
FINANCE- Is a branch of economics which deals with generating and allocation of the
company’s scarce resources amongst the competing needs of the company.
OBJECTIVE OF THE BUSINESS ENTITY
 Profit maximization
 Shareholders wealth maximization.
 Social responsibility.
 Business ethics.
 growth
The function of the finance manager can be categorized into 2 categories as follows:

1. Managerial functions.
2. Routine functions.

1. Managerial function.
They are functions that require technical expertise, knowledge of a finance manager and they
include:
 Liquidity and working capital management.
 Financing function.
 Investment or capital budgeting functions.
 Dividend policy decision/ Profit allocation function.
2. Routine functions.
This functions o not requires technical skills and knowledge of the finance manager.

Agency theory
An agency relationship exist where one party known as the principal appoints other known as the
agent and gives him the authority to act on his behalf. There are various type of agency
relationship which include;
(a) Shareholders vs. management.
(b) Creditors vs. shareholders
(c) Government vs. shareholders
(d) Auditors vs. shareholders.
Shareholders VS Management/Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is managed by a
board of directors appointed by the shareholders. This is because:
a) There are very many shareholders who cannot effectively manage the firm all at the same
time.
b) Shareholders may lack the skills required to manage the firm.
c) Shareholders may lack the required time.
Conflicts of interest usually occur between managers and shareholders in the following
ways:
1. Managers may not work hard to maximize shareholders wealth if they perceive that they
will not share in the benefit of their labour.
2. Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable
3. Managers may maximize leisure time at the expense of working hard.

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 4. Manager may undertake projects with different risks than what shareholders would
consider reasonable.
5. Manager may undertake projects that improve their image at the expense of profitability.
6. Where management buyout is threatened. ‘Management buyout’ occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.
Solutions to this Conflict
In general, to ensure that managers act to the best interest of shareholders, the firm will:
1. Incur Agency Costs in the form of:
a. Monitoring expenses such as audit fee;
b. Expenditures to structure the organization so that the possibility of undesirable
management behavior would be limited. (This is the cost of internal control)
c. Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the case
if manager were also owners. This is the cost of delaying decision.
2. The Shareholder may offer the management profit-based remuneration. This
remuneration includes:
a. An offer of shares so that managers become owners.
b. Share options: (Option to buy shares at a fixed price at a future date).
c. Profit-based salaries e.g. bonus

3. Threat of firing: Shareholders have the power to appoint and dismiss managers which is
exercised at every Annual General Meeting (AGM). The threat of firing therefore
motivates managers to make good decisions.
4. Threat of Acquisition or Takeover: If managers do not make good decisions then the
value of the company would decrease making it easier to be acquired especially if the
predator (acquiring) company beliefs that the firm can be turned round.

ETHICAL ISSUES IN FINANCIAL MANAGEMENT

Ethic in finance is an act of applied ethics that examines ethical principle and moral or ethical
problems. Business ethics should govern conduct of corporate policy in all functional area.
1. Ethical objective of the firm.
These are social responsibilities of the company and they include:
 Welfare of employees/workers.
 Serving customers.
 Welfare of the management
 Relationship with the supplier
 Responsibility to the society.
ETHICAL FUNDERMENTAL PRINCIPLES IN FINANCIAL MANAGEMENT
1. Integrity-a member should be honest, straight forward and sincere in his approach to
professional work.
2. Confidentiality-members should maintain top secrecy during and after engagement
regarding the client business.
3. Professional Competence and due care-member should demonstrate his skills,
knowledge and expertise.
4. Technical standards-a member should perform his work with professional skills.

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 5. Independence-a member should be free from any form of influence from the
management or any other party.
Independence of mind-is how the practitioner operates without any influence or bias
from any party.
Independence of appearance-relates to how the 3rd party will view the practitioner.
6. Clients’ money-a member should not participate in misappropriation of the clients’
money.
7. Objectivity.
8. Professional behavior.

CAPITAL BUDGETING /INVESTMENT DECISIONS.

This involves commitment of funds in long term assets/projects which will generate benefits in
the future.
Features/characteristic of capital budgeting.
 They are irreversible projects-once the project is undertaken it will be difficult to
abandon.
 They are long term projects.
 Requires huge initial capital investments.
 The benefits are realized in the future.
 They are risky projects.
Types of capital budgeting projects.
1. Mutually exclusive project-these are projects which are alternate of each other. Ie they
compete against each other and they are therefore substitutes. When one is undertaken,
the others are rejected automatically.
2. Independent projects-they are projects which serve different purpose. They do not
compete against each other.
3. Dependent project/complementary/contingent project-they are projects which depend
on each other and therefore if one project is undertaken, the other project must also be
undertaken.
4. Divisible project-is a project that can start generating inflows even before they are
complete.
5. Indivisible project-Is a project that cannot generate income before they are fully
completed.
Features of an ideal investment appraisal method.
1. It should consider all cash flows.
2. It should give a clear decision on whether to accept or reject a project.
3. It should help in ranking the projects.
4. It should take into consideration time value of money.
5. It should use cash flows rather than profits.
Advantages of using NPV/IRR as a project evaluation method.
1. It takes into account time value of money.
2. It uses cash flows in evaluating the projects.
3. It gives a decision whether to accept or reject a project.
4. It uses all cash flows of the project.
5. It is consistence with shareholders wealth maximization goal.

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Disadvantages of using NPV.
1. Cash flows used in evaluating projects are usually estimates.
2. It assumes the cost capital will remain constant during the period of analysis.

DIFFERENCES BETWEEN IRR AND ARR.

IRR ARR
It is a discounting technique It is a non-discounting technique.
It uses cash flows to evaluate a project. It uses accounting profit to evaluate.
It uses all cash flows to evaluate It uses the average accounting profit.
It gives a decision for accepting or rejecting a It does not give the decision of either
single project accepting or rejecting.

Causes of conflict between NPV and IRR.

1. In case of the difference in the timing of cash flows of mutually exclusive projects.
2. In case of the difference in the size of mutually exclusive projects
3. Difference in economic life of the projects
4. In case of non-convectional income.
CAPITAL RATIONING.
This occurs when there is scarcity of the investment fund i.e. the company has no sufficient
money to undertake all viable projects.
There are normally two types of capital rationing.

1. Soft/internally generated capital rationing.

This occurs when the shortage of the investment fund is as a result of actions of the management
i.e. the shortage is within the control of the management.it occurs due to the following:

 Where the management may refuse to raise additional funds through issues of new shares
to avoid dilution.
 To avoid commitment of large payment of interest or installment of the principle amount
in case the company borrows funds.
 Where the management has set a limit on the budget.
 Where the project can only be financed by internally generated funds.
2. Hard/externally generated capital rationing.
This occurs due to factors not within the control of the management (external factors).it occurs as
a result of the following:
 When the capital market is depressed thereby making it impossible to raise finances.
 Cost of capital of issuing new shares may be too high thereby affecting borrowing.
 High demand of investment fund by well established companies.
 Lack of security/collateral when borrowing funds.
 Due to credit policy of the government thereby restricting financial institution to lend
money.

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REAL OPTIO IN CAPITAL BUDGETING.
Real options are right but not obligation to make a business decision. The concept of real option
is crucial to the business success and the ability to choose the right business opportunity bears a
significant effect on the company’s profitability and growth.
A real option allows the management team to analyze and evaluate business opportunity and
choose the right one.
Types of real options.
 Option to expand.
 Option to abandon.
 Option to delay/wait.
 Option to switch
 Buy or lease options

RISK ANALYSIS IN CAPITAL BUDGETING.

RISK-is a chance that some unfavorable event will occur in the future.
Types of risks facing the company.
1. Financial risk
This risk arises as a result of company borrowing funds.
2. Business risk
This refers to fluctuations of the companies’ earnings/declining profits. It is grouped into
2 as follows:

a. Systematic risk- is a type of business risk that affects all the companies in the
industry e.g. inflation, interest rate, political instability.
b. Unsystematic risk-this is a risk which affects a specific company in the industry
e.g. strikes, weather.
Sensitivity analysis.
Under this analysis the key financial variables which influence the profitability of the project are
identified and subjected to adverse changes in order to determine their sensitivity.it is carried out
into 2 perspectives:
1. Break even analysis.
2. The impact analysis.
Advantages of sensitivity analysis.
1. It identifies the key financial variables which require further analysis.
2. It improves management by exemption i.e. the finance manager will focus on the critical
key financial variables.
3. It provides more information about the risk of the project by identifying the key factors.
4. It enables the decision maker to identify and analyses how one factor will affect the
overall profitability.
Disadvantages.
1. Each key financial variable is analyzed in isolation while all other key financial variable
are held constant, however in practice the key financial variables are inter-related.
2. It does not indicate the profitability of a given change in the variable.
3. It’s difficult to determine and interprets the relationship between the key financial
variables
4. It ignores the risk of the cash-flows.

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 LEVERAGE.
This refers to the use of the debt in the company’s capital structure. There are normally 3 types
of leverage:
 Operating leverage.
 Financial leverage
 Combined/total leverage

1. OPERATING LEVERAGE.
This is the use of the operating costs in order to improve the profitability of the company
2. FINANCIAL LEVERAGE
This is the use of the financing cost in-order to improve the EPS of the company.
3. COMBINED /TOTAL LEVERAGE.
This is the use of both operating and financial leverage in-order to increase the
profitability of the company.

SIMULATION ANALYSIS.
Advantages.
1. It is the most suitable method for analyzing long term project where other techniques may
not be applicable.
2. It enables the decision analyst to evaluate various possible combination through the use
of random number.
3. Each key variable factor can be analyzed independently.
Disadvantages.
1. Practically simulation requires the use of computer programme therefore it may take
significant resources.
2. Simulation is not an optimizing technique because it does not give optimal results of
whether to accept or reject a project.
3. It deals with total risk.
4. The probability distribution is usually estimates.
BOND REFINANCING
Is the process of retiring the old bond and issuing a new bond at lower interest rate. During the
period of the declining interest rate, a company might find itself with a fixed interest security
which was issued some years back when the interest rate were very high.
Reasons for bond refinancing
1. Because of declining in the interest rates.
2. Because the company is in better position to repay now compared with the future.
3. Changes in the tax rate leading to change in interest tax shield.
4. Because of less restriction terms and conditions associated with new bond.
5. Because of the capital structure decisions.

Key terms.
1. CALL PREMIUM-this is the penalty for retiring tr bond before maturity period.
2. OVERLAPPING INTEREST CHARGE/EXPENSE-the interest which is paid on the
existing bond after the re-financing but before the amount is received back.is the interest
paid for both bonds.

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 PORTFOLIO AND CAPM
Portfolio in financial term refers to the collection of investment opportunities or securities with
an aim of minimizing risk. There are normally 2 types of risk facing the company:
1. Financial risk
This is a risk associated with borrowing funds in the company structure of the company.
2. Business/operating/total risk
This is the risk associated with declining company’s earnings due to the nature of the
industry. They are either systematic or unsystematic risk
(a) Systematic risk
This is fluctuations of the company’s earnings due to factors affecting all the
companies in the industry e.g. political risk, inflation.
(b) Unsystematic risk
This is fluctuations of the company’s earnings due to factors which affect specific
industry in the market e.g. strike, change in product price.
ASSUMPTIONS OF PORTFOLIO THEORY.
1. Investors prefer more wealth.
2. Investors are risk averse.
3. Returns on portfolio follow normal distribution.
4. It assumes only one existing security.
5. It assumes business risks.
6. It assumes there are no economies of scale.
Limitation of portfolio theory.
1. It deals with total risk as measured using standard deviation; however risk can be
minimized by holding a portfolio.
2. It uses historical data to analyze the portfolio and the probability assigned to each
outcome is subjective.
3. It assumes there is no economies of scale which is not correct.
4. It assumes investors are risk averse, however in practice they are risk takers.
5. It assumes all the projects are divisible however in practice indivisible project exist.
6. It can be used to analyze one security.
Investing concepts.
Investing-refers to the employment of funds in an investment during a given period of time with
an aim of enhancing investor’s wealth.

Types of investments.
1. Real investment
This is the investment in the tangible assets such as machinery, land, factories etc.
2. Financial investments
This involves contracts which are written on papers or in electronic forms e.g. contract to
purchase a stock, bond, fixed deposit account.
3. Direct investment
This involves investor’s buys and sells financial assets and manages them individually for
themselves.
4. Indirect investing
Here investor’s buy shares in an intermediary company and the intermediary company or
the brokers invests on behalf of the shareholders.(involving financial intermediary).

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 Types of investors.
There are 2 types of investors namely;
1. Individual investors-are individuals who invest on their own.
2. Institutional investors-they are entities such as investment companies, commercial
banks, pension funds, which invest on behalf of the shareholders.

Types of investment vehicles/avenues.

These are the investment instruments available to an investor.
1. Financial securities-they are investments which are freely tradable and negotiable. They
include; equity shares, debentures, bonds and money market securities.
2. Non-securitized financial securities-they investment which are not tradable,
transferable nor negotiable e.g. bank deposit, post office deposits, fixed deposits, life
insurance etc.
3. Mutual fund scheme.
4. Real assets-they are tangible assets such as building, land, machinery etc.
Factors to consider when making investment decisions/investment attributes.
1. Rate of return.
2. Risk.
3. Marketability-the higher the marketability of the financial asset, the better the asset.an
instrument is considered to be marketable if it can be transacted quickly at a lower cost.
4. Taxes.
5. Convenience-this is the ease with which an investment can be made and managed.

Factors influencing the efficiency of a portfolio.

1. Risk exposure.
2. Economic condition.
3. Return.
4. Risk diversification.
CAPITAL ASSET PRICING MODEL (CAPM)
Is a model used to determine the appropriate required rate of return of an asset to make decision
about adding asset to a well-diversified portfolio.

Assumption of CAPM.
1. Investors are rational and they prefer greater returns for taking greater risk.
2. The borrowing rate is equal to the lending rate.
3. There are no transaction costs.
4. There are no market imperfections i.e. it assumes the market is perfect.
5. The model ignores the risk of insolvency.
6. There is no inflation.
7. The return of the security has a normal distribution.
8. Assumes beta factor is constant.
Limitations of CAPM
1. It considers systematic risk alone.
2. It assumes risk free rate will remain constant.
3. CAPM is a single period method therefore cannot be extended.
4. Assumes beta will remain constant.

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 5. It ignores the risk of insolvency but in real sense the company can enter into bankruptcy.
Application of CAPM
1. In evaluation of securities.
CAPM is used to determine whether the financial securities are either, correctly valued,
undervalued or correctly valued. This forms the basis on decision on whether to buy or
sell the securities at prevailing market forces.
2. To determine the cost of security.
CAPM is used to determine the cost of capital ie cost of equity, cost of the debt.
3. To determine the WACC.
CAPM is used to determine the cost of capital ie cost of equity, cost of the debt and
hence overall cost of capital (WACC).
4. Evaluation of portfolio performance.
CAPM is applied to evaluate performance of the portfolio. The treynor’s measure of
portfolio performance is based on the background of CAPM
5. Used in capital budgeting.
CAPM is applied to determine the discounting rate used to evaluate capital investment. It
is also used to determine the risk adjusted discounting rate.

Difference between portfolio theory and CAPM.

PORTFOLIO THORY CAPM
1. It deals with total risk i.e. It deals with systematic risk i.e. diversified
undiversified portfolio portfolio
2. Risk is measured using standard Risk is measured using beta factor.
deviation.
3. It uses capital market line equation. It uses security market line equation
4. The standard deviation of the market The beta factor of the market is always 1
is not equal to 1
THE ARBITRAGE PRICING MODEL (APM).
This model was developed due to limitations of CAPM, unlike CAPM the model is a multi-
factor model i.e. the model assumes that there are several factors which will influence the return
of the security. The model is also a multi period model.it is based on the following assumptions:
1. The capital market is perfect and efficient.
2. Investors prefer more returns.
3. Return of a security is generated through continuous buying and selling of security.
Differences between CAPM and APM
APM CAPM
1. It’s a multi factor model It’s a single factor model.
2. It’s a multi period model. Is a single period model
3. Return of the security does not follow The security return follows normal
normal distribution. distribution.

LEASING
This is a contract between two parties where one party known as lessor (owner) gives another
party known as lessee the right to use the asset and enjoy the benefits and risk associated with the
utilization of the asset.

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Types of leases.
(a) Operating lease.
(b) Finance lease.
(c) Sell and leaseback lease.
(d) Leverage lease
.
(a) Operating lease/off balance sheet lease.
This is a short term lease.it has the following characteristics:
 The lease period is very short relative to the economic life of the asset.
 The lease contract can be cancelled by either party any time before end of lease period.
 The owner (lessor) incurs maintenance, operating and insurance expenses of the asset.
 The lessee is not given an option to buy the asset at the end of lease period.
(b) Finance lease/capital lease.
This is long-term in nature and the lease period is almost equal to the economic life of the asset.
Characteristics.
 The lease period should be at least equal to 75% of the asset economic life.
 The lease contract cannot be cancelled by either party before lease period matures.
 The lessee incurs all maintenance cost.
 The lessee is given an option to buy the asset at the end of lease period.
Advantages of leases.
1. Lease do not involve strict terms and conditions associated with long term debts.
2. Leasing has lower effective cost compared to long term debts.
3. It does not require a significant initial capital investment compared with cost of buying
new asset.
4. It reduces the risk of obsolescence.
5. It provides off-balance sheet financing i.e. operating lease are shown as foot notes to the
financial statements.

FINANCIAL DISTRESS.

This refers to the events that occur when the company is facing financial problems. They include
bankruptcy, where the company is unable to meet its financial obligations. A firm going through
financial distress may not necessarily fail but may survive or may be in position to identify
surviving strategies.
Forms of financial distress.
1. Technical insolvency.
Refers to a situation where the company is unable to meet its current financial obligation.
2. Legal bankruptcy.
This is where the company is declared bankrupt by the company’s act, hence it will be
taking liquidation process under receivership.
3. Economic failure.
The company’s revenue is insufficient to cover all costs incurred on the capital
expenditures.
4. Business failure.
Refers to any businesses that have terminated its operations due to accumulated losses.
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 5. Flow based insolvency.
It occurs when the operating cash-flows of the form are not enough to meet its
obligations.
Types of financial distress cost.
1. Direct distress cost
2. Indirect distress cost
3. Agency costs.
DIRECT DISTRESS COST.
These costs include
 Sale of the company assets so s to improve the financial position of the company.
 Changing the dividend policy of the company, so as to meet the financial difficulties of
the company.
 Avoiding investing in profitable projects considered to be risky.
 If the company is put under receivership, the bankruptcy cost will include legal fees and
the management expenses.
INDIRECT DISTRESS COST.
THEY INCLUDE:
 High cost of borrowing.
 High labour turnover which will affect the company’s productivity.
 Lost sales due to fear or lack of trust from the customers
 Mangers may take some actions to save the company which may affect the company in
the long run.
AGENCY COST.
These are costs incurred by the company as a result of the conditions set by the debt holders in
order to protect their interest in the company. They include conditions like:
1. No payment of dividend unless the earnings of the company exceeds a particular limit.
2. No additional loan capital that should be raised by the company unless the current
borrowed amount has been reduced to a particular amount.
3. The cost of the capital and other costs paid to the agent who are appointed to the
company’s BOD in order to protect the interest of the debt holders.
4. No investments in particular projects which are considered to be risky by debt holders.
Indicators of financially distressed company.
1. Reduction I the dividends per share.
2. Closing down the branches of the company.
3. Retrenchment of staffs.
4. Accumulated losses
5. Top managers resigning from the company.
6. Operational inefficiencies.
7. Slow moving items leading to obsolescence.
8. Frequent losses.
9. Loss of key customer/staff/supplier.
10. Inability to meet clients demand.

OPTIONS AT THE TIME OF FINANCIAL DISTRESS

1. Disposing off some unnecessary assets
2. Mergers

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 3. Making special arrangement with the creditors.
4. Issuing more shares.
5. Liquidation.
6. Retrenchment.
7. Delay payments as much as possible.
8. Merging of departments.
Causes of financial distress/corporate failure
 Mismanagement.
 Competition
 Technological innovation.
 Political instability.
 Government policies-tax structure, labour laws.
 Operational inefficiencies.
 Resignation of top management personnel.
PREDICTIONS OF THE CORPORATE FAILURE.
 Continuous decline of the share price of the company’s stock.
 Delay/default in the repayment of the bank loan.
 Delay/default in payment of creditors.
 Legal cases pending in the court
 Poor maintenance of company’s assets/facility.
MODELS OF PREDICTING CORPORATE FAILURE.
1. ALTMAN Z-SCORE MODEL.
This model combines various ratios in order to determine whether the company is a
going concern.
The decision criteria is made as follows:
 A company with a Z score of less than 1.8 indicates failure.
 A company with Z score of greater than 2.7 indicates success or non-failure.
 A company with Z score between 1.8-2.7 indicates equal chances of success
or failure.
Applications of Z score model.
1. To evaluate the performance of the company’s manager.
2. To predict the corporate failure in the local companies.
3. To determine whether a company is a going concern.
4. To determine whether the company can enter into strategic alliances or mergers.
Weaknesses of Z- score /limitations.
1. It does not take into account all ratios that measures the company performance ie
profitability ratios, gearing ratios, liquidity ratios etc.
2. It uses historical data which may not be accurate in predicting current and future
performance.
3. It uses financial data which are likely to be manipulated by the management in order to
reflect the favorable picture of the company.
4. The sample of the variable may not be random.
5. There is not cost function for type one error and type two error.
6. It does not consider the tax effect when evaluating the performance.
2. BEAVER’S MODEL.

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This uses the ratios to identify companies which are likely to fail within the next five years of
their operation. The key ratio is.
Operating cash-flows
Long term and short term liabilities
If the ratio is less than 0.3 there is 70% chance that the company is likely to fail in the next five
years.
3. ARGENTIS’ MODEL.
This model is based on the calculation of scores related to company defects, management
mistakes and symptoms failure. This model was developed by Argentis .According to him, there
are 3 types of classifications of firms
(a).TYPE I ERROR-
This is where the firm fails to start and it is usually encountered by small firms.
(b).TYPE II ERROR-
This is where the manager of the firm are too much ambitious or charismatic beyond the capacity
of the firm. This will cause the firm to fail.
(c).TYPE III ERROR-
In this case big companies fail because they are unable to adopt the new technology or new
environment.
4. TAFFLER’S MODEL.
This model is based on the following series of ratios.
 Sales/total asset
 The current ratio.
 The reciprocal of the current ratio.
 Earning before tax/current liabilities.
There is yet insufficient evidence to determine this model predictive qualities.
5. FULMER MODEL
6. ZETA MODEL
7. SPRINGATE MODEL
This model was developed in 1973 and the developer comes up with the following ratios:
SP=1.03A+3.07B+0.66C+0.4D

Where: A=working capital /total assets

B=EBIT /Total asset.
C=EBT /total current liabilities
D=sales /total asset
If SP<0.862……..FAILURE
8.CONDITIONAL PROBABILITY MODELS.
Use of conditional probability model to replace discriminate analysis.
9. THE USE OF CAPITAL MARKET DATA.
Lack of relevance, reliability, timeliness and consistency in accounting variables diversification
in failure prediction models.
10. INFLATION ACCOUUNTING AND FAILURE PREDICTION.
11. THE USE OF NON-FINANCIAL INDICATORS.

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 MERGER AND ACQUISTION

MERGER is a combination of 2 or more equally companies to form a new entity. The original
companies will lose their original identity after the other and none of them will dominate the
other.
ACQUISITION or TAKE OVER is the situation where one company known as Predator will
acquire the other company known as the Target. After the acquisition the target will lose its
identity but predator will maintains its identity.

TYPES OF MERGER AND ACQUISITION.

1. Horizontal merger/acquisition
This is the combination of 2 or more companies in the same line and type of business.
The main purpose of horizontal merger is to improve the market share of the 2
companies.eg ICEA & LION were all insurance companies.
2. Vertical merger.
This is the combination of 2 or more companies which are in different level of production
but in the same industry.eg vehicle assembling company with tyre manufacturing
company.
3. Conglomerate merger
Its combination of 2 or more companies which are unrelated. They are from different
industries and different level of production. The purpose for this is for risk
diversification.eg Sameer group of companies.
4. Concentric merger/congeneric merger. This happens when a company merges with
another company in the same industry that sells products to the same customers, though they sell
different products, making them indirect competitors
REASONS FOR MERGER & ACQUISITION/ADVANTAGES OF MERGER.
1. Risk diversification
Especially for a conglomerate merger where 2 companies merge forming a portfolio that
will maximize returns and minimize risk.
2. Asset acquisition/asset backing.
Where a merger takes place or an acquisition, the assets of other companies belongs to
the same group of companies .This makes it cheaper instead of purchasing new assets and
this includes human resource.
3. Asset breakup value
This is where a predator acquires the target and starts selling the assets of the target to
realize more value.
4. Empire building.
Top management or shareholders of the company would be assumed to be having a big
impact economically when they control big companies as a result they increase the
market share and works toward monopoly.
5. Tax saving
Companies would have tax shield benefits when they acquire company with large losses,
these losses will offset the profit of the acquired thus reduce the tax payment.
6. Management acquisition

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 Companies would acquire or merge with other for the purpose of owning the top
management of the other company since some top management may not be ready to
move to other company regardless of the offer given.
7. Defensive merger.
Companies merge or acquire other in-order to avoid a hostile takeover.
8. Financing and liquidity.
Companies merge with other in-order to improve their liquidity especially when the
company to be acquired is financially stable.
9. Synergy
This is the additional benefit associated with economies of scale after the merger and the
acquisition synergy is divided into 4 as follows:
 Operational synergy-this will result from the economies of scale and
complementary resources which can be shared among the two companies.
 Managerial synergy-this will result from the combination of the management
teams.
 Financial synergy-this will lead to a decrease in the fluctuation of the cash flows
and the cost of borrowing.
 Combinations of operational, managerial and financial
Synergy is not always achieved in practice due to the following reasons.
 Lack of complete information before merger and acquisition.
 Inability to accurately take and measure the synergy.
 Because of being too optimistic about the potential benefits of the merger and acquisition.
 Lack of motivation on the part of managers to achieve the additional benefits.
 Because of the payment of the high premiums on the acquisition of the target
 Integration problems such as cultural differences.
Steps used in merger and acquisition.
1. Merger and acquisition strategies
2. Merger and acquisition criteria to be used.
3. Identification or searching for a possible target.
4. Merger and acquisition planning.
5. Evaluation of a merger including identification of possible benefits.
6. Negotiation of the merger and acquisition agreements.
7. Due diligence on the target.
8. Purchase and sell of contract/assets.
9. Financing strategy planning.
10. Closing and integration of the merger and acquisition.

HOSTILE TAKEOVER
This is where one company known as predator takes over target and in this case target would be
unwilling on the takeover strategy.
Indicators of the hostile takeover in a target company.
1. Resource mismatch hypothesis.
In this case the target company will have a potential of good performance but due to
unavailability of sufficient resources the company becomes an easy target for a hostile
takeover.
2. Size hypothesis.

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 In a highly competitive market, bigger company will easily take over small companies.
When a company is smaller in size ten it becomes an easy target for a hostile takeover.
3. Price earnings ratio hypothesis
When the P/E ratio of a company is small, Then it means that the market value of that
company is also small and this makes it an easy and cheap target for a hostile takeover.
4. Industrial disturbances hypothesis.
Companies may have frequent industrial disturbances e.g. frequent employees strikes or
gov’t disturbances.
5. Management inefficiencies hypothesis.
Top management may be unable to develop strategies to avoid a hostile takeover or may
be unable to identify the signs of a hostile takeover.

STRATEGIES TO AVOID A HOSTILE TAKEOVER.

1. Sell of crown jewel.
This is where the target company would sell the most attractive assets leaving them a
skeleton and unattractive.
2. Use of packman defense
This is where the target gives a counter offer to acquire the predator and in the process
the predator would back down because of the threat of being taken over by the perceived
small company.
3. Use of white knight/white squire.
This is where the target company would be taken over by a friendlier company to avoid a
hostile takeover or merge with a friendlier company i.e. have a defensive merger.

4. Use of golden parachute.

In this case the target company would give attractive retirement package to top
management and employees upon retirement or resignation. This would scare the
predator since the predator would fear taking over the target and all over the sudden
required to pay pension benefits to employee who would decide to resign and this would
leave the target company a skeleton.
5. Use of poison pills.
In this case the target would use mainly borrowing to finance its assets and this would
make the target unattractive since the capital structure mix would have more leverage
than use of equity.
6. Share repurchase option
In this case the target would repurchase shares issued to the public that the original
shareholders owns the share through a repurchase scheme. This would protect the target
from predator who held the major shareholders.
7. Use of dividend policy
The target company may set a very costly dividend policy that the predator would be
unable to maintain. This would scare away the predator.
8. Use of legal redress.
This involves seeking court protection against a hostile takeover and the court would give
the required protection.
9. Issue of frequent profit forecasts.

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 In this case the target company will issue profits warning which will increase their market
value of the same time and hence becomes unattractive to the predator.
10. Use of shark repellant.
This is the use of super majority where the target would amend the AOA to ensure that a
super majority or an achievable majority of vote would have to decide whether the
takeover would be necessary or not.
FORMS OF CONSIDERATION IN CASE OF MERGER OR ACQUISITION.
1. Cash payment.
This is where the predator will pay cash to acquire the shares or the assets of the target.
2. Share for share exchange.
In this case, there is no actual cash flows but the shareholders of the target will surrender
a given number of their shares in order to acquire a given no. of the predator’s shares.
This is known as EXCHANGE RATIO. This has the following implications:
 It conserves cash on the predators company.
 There will be increase in the equity capital of the predator company leading to the
decrease in the financial risk.
 It will dilute the ownership and control of the predator’s company.
 The shareholders of the target company will gain control in the predator’s
company.
3. Use of convertible securities.
This is where the predator will use convertible securities such as debentures or the
convertible preference shares. This will have the following implications:
 It conserves cash on the predators company.
 It will not dilute the ownership and control of the predator company.
 It will lead to an increase in the financial risk of the company.
VALUE GAPS
This arises from the face that the value of the company acquired is different from the true market
value.it can either be higher or lower depending on the market circumstances. If it’s higher than
the shareholders of the target will get additional benefits. It is also refers to a situation where the
amount paid for the merger/acquisition of the target is more than its true current market value.
Causes that gives rise to value gaps in merger.
 Poor parenting by headquarter.
 Poor financial management.
 The stock market inefficiencies.
 Over-enthusiastic bidding-this normally occurs when the management accepts the highest
offer in order to acquire their businesses. This may not be the market value of the
company.
This is analyzed as follows. (JUNE 2013 Q5C)
The minimum amount to accept by target=P/E ratio ×EPS
Total value of shares (target) =P/E ratio × total earnings.
9×390=3510.

Maximum amount to pay by predator.

= (combined P/E ratio × total combined earnings) –current market value of predator
12× (390+693+125) – (13 × 693) =5487

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CAUSES/REASONS WHY MERGERS FAILS.
 Cultural differences after merger and acquisition.
 Lack of time after merger on part of managers.
 General fear-this might arise due to technological development.
 Expected synergy may not occur.
 Political interferences
 Failure in coordination and communication
 Social differences
 Value gap
 Poor corporate parenting.
 Lack of experienced experts in mergers and acquisition.

BUSINESS RESTRUCTURING AND REORGANIZATION

RESTRUCTURING-is the process of changing the capital structure of the company and it’s
carried out as part of corporate restructuring.
Corporate restructuring is categorized into 3 as follows:
1. Financial restructuring.
2. Portfolio restructuring.
3. Organizational restructuring.

FINANCIAL RESTRUCTURING
This is where the capital structure of the company is changed and its normally carried out by
companies that are facing financial problem.

Reasons for financial restructuring.

a. To reduce the debt of the company to a manageable level.
b. To stabilize the company so that investors will inject more capital.
c. To enable the company to concentrate on its core business activities
d. To avoid liquidation of the company.
e. To revalue the assets of the company in order to determine whether the company is
undervalued or overvalued.
Types of financial restructuring skills.
1. Internal scheme.
2. External scheme.
3. Debt-equity swaps.
4. Equity-debt scheme.
5. Share repurchase scheme.
BUSINESS REORGANIZATION.
This is the process which involves a change in the organization of the business in order to
improve on operations of the company.it has the following importance;
a. Enhance the performance of the business.
b. Tackles competition in the market.
c. Reduces the operating costs of the business.
d. Solves the existing problems in the functioning of the organization.

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Objectives of business re-organization.
1. In order to reduce the after tax cost of borrowing.
2. Improve the security of finance.
3. To clean the balance sheet of the organization.
4. Settle loan immediately.
5. Improve the financial image of the company.
Types of business reorganization.
1. Portfolio reorganization.
This entails the change in the balance sheet and the business structure through a change
in the asset mix, business units, lines of operation in order to improve the performance of
the company.it also involves the acquisition of the new assets or disposing off non-
performing assets to enhance and improve the returns on the assets. This process is
known as unbundling.

UNBUNDLING-it’s a strategy of portfolio reconstruction where the assets of the

company, the line of production and the operating branches are disposed off or separated
from the parent company in order to improve the performance of the existing company.
The process is divided into as follows:
(a) Voluntary unbundling
This may be undertaken for the following reasons.
 Improving the performance of the existing company.
 Enhance value of the existing company.
 To dispose off underperforming or non-performing assets of the business.
 To improve the functioning of the division.

(b) Compulsory unbundling

This is necessary in the case of hostile takeover or government policy decision. The
following are some ways of unbundling the company:
a) Divestment.
b) Mergers/demerger
c) Spin-off
d) Sell-off
e) Equity
f) Liquidation
g) Management buy out
h) Management but in.
1. DIVESTMENT.
This is the withdrawal of investment in the business. This can be achieved either by securing the
entire business or part of the business.
2. MERGER AND DEMERGER.
Demerger is where the company is now split into 2 or more separate business entities.it aims to
create a new business entry which will enhance the value of the original company.
Reasons for demerger.
 Focus on the core business activity.
 To create separate business entity that will specialize in the respective business.
 To comply with the regulations in the industry.

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  To increase the total returns of each individual unit.
3. SPIN-OFF
It involves the creation of one or more new independent business entity from the existing
company without transferring the ownership to the outsiders. Spin-off is made due to the
following reasons:
(a) To improve the efficiency in the operation of the separate business entity.
(b) Diversify business operations.
(c) To enhance business to perform better by allowing them to concentrate on core activities.
4. SELL OFF
Is a type of divestment which involves sell-off part of assets/division of the company for cash.
It’s made due to the following reasons.
a) To realize cash to meet the current obligation when they fall due.
b) To improve the performance of the entire group by eliminating the loss making units.
c) To make the company unattractive on the hostile takeover
5. EQUITY/CURVE OUT.
This involves creating a new company separating the existing assets of the company in order to
create new equity shares which are then issued to the public through the stock exchange.
6. MANAGEMENT BUY-OUT
This occurs when the executive managers of the business joins the financing institutions in order
to buy the business they are currently managing.
It is also the process which takes place when the business units or the subsidiary is sold to the
executive managers of the company.
It is therefore a form of investment in the company by managers who acquires the shares of the
company.

7. MANAGEMENT BUY-IN.
This is where a group of managers outside the business acquire the business.it takes place when a
business is sold to a team of professionals outside the management team.

ORGNIZATIONAL RESTRUCTURING/RE-ORGANIZATION
It entails the change in the organizational structure of the company so as to change the following:
I. Management hierarchy.
II. Workforce of the company.
III. Decision making process.
IV. Supply chain.
It’s normally undertaken in order to:
 To make the decision making process less complicated.
 To reduce the misuse of the company’s resources.
 To improve coordination between various departments.
 To enhance overall performance of the company.

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 INTERNATIONAL FINANCIAL MARKETS AND
INSTITUTIONS
International money market.
This is the market with partied located outside the country domicile.it is also known as Euro
currency market, where large companies are able to borrow.
EURO CURRENCY MARKET.
It is a market where borrowing and lending is through the bank of currencies other than the bank
of the home currency. These loans are generally short term, usually between the banks.
The main function of this market is to finance the international trade.
The euro currencies are currencies held outside the country of origin.
INTERNATIONAL CAPITAL MARKET.
These are integrated capital market that deals with the international stock bonds and foreign
currencies which are part of their transactions. Therefore these markets assist larger companies to
raise fund to finance long-term projects. They include:
(a) Euro bond-they are bonds that are dominated in a currency, different from that of the
country in which they are issued.
(b) Foreign bonds-they are bonds that are dominated in the currency of the country in which
a foreign entity issues the bond.
(c) Euro equity-they issues securities which are exchanged in the listed companies across
the world.
Primary drivers of the international capital market.
1. Advancement of technology-the use of internet and computer to facilitate the growth of
the capital market
2. Deregulation-deregulation of the market by allowing not only domestic investors to
investing the foreign market, has facilitated the growth of the capital market.
3. Development of financial institutions-new financial institutions like the forward market
and future market have contributed to the growth of the capital market.
Motives for investing in the international capital market
1. To take advantage of favorable economic conditions.
2. To take advantages of appreciation of the foreign currency against the domestic currency.
3. To benefit from international diversification.
4. Access to foreign commodities or product.
Aims of regulating financial market.
1. To prevent cases of market manipulation such as insider trading.
2. To ensure competence of the providence of financial services.
3. To protect clients interest and investigate their complaints.
4. To maintain confidence in the financial system.
5. To reduce violation of the financial laws.
Benefits accruing from international trade and cross boarder investment
1. Financial integration.
2. Benefits for competition in the international market.
3. Aid in the benefits of economies of scale.
4. Benefit for the consumers-consumer has a wide access to variety of products.
Benefits of mobile money transfer.
1. Security.
2. Convenience.

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 3. Reduced cash in the economy.
4. Low cost
5. Financial inclusion.
6. Mobility.
MARKET SEGMENTATION.
It is a financial market imperfection caused mainly by government constraint institutional
practices and investors’ perceptions. Therefore, they are event which make the market to be
inefficient.

Causes of capital market segmentation.

1. Lack of transparency.
2. High securities transaction costs.
3. Foreign exchange risks.
4. Political risks
5. Corporate governance differences.
6. Regulation barriers
7. Asymmetrical information between the domestic and foreign based investors.
INTERNATIONAL MONETARY FUND (IMF)
Benefits of IMF
1. To promote international monetary cooperation.
2. Assisting in stabilizing the currencies.
3. To facilitate the expansion and balanced growth of the international trade.
4. To promote the exchange rate stability.
5. To shorten the duration in the international balance of payment of the members.
6. To make resources available to its member who are experiencing BOP difficulties.
Activities of IMF
1. Financial assistance-this includes the credit and loan extended to the IMF member
countries.
2. Technical assistance-this consists of the expertise and procedure which are extended to
the members in handling the accounting transaction.
3. Training official in financial matters for member countries.
FUNCTIONS OF WORLD BANK/IMF
Enhancement of financial stability.
Stabilizing economies.
Providing credit facilities to the members state.
Offering technical assistance and expertise.
Facilitating international trade.
Promoting foreign investments to other organizations by guaranteeing the loans..
Providing economic, monetary and technical advice to the member countries for any of their
projects.
WORLD BANK
It was established as a multi-lateral lending agencies focusing on the projects with long-term
implications.
The objective was to promote economic and social progress in developing nations by helping to
raise the productivity so that their people can live better lives. The sources of finance for the
bank include:

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 1. Equity-this was capital contributed by member countries when joining the association.
2. Bonds-this was the amount raised from the world financial markets.
3. Private markets-these were finances from investment banks and commercial banks who
were lending money to the institution.

Reasons for the success in raising borrowed funds in the institution.

1. Supportive conservative lending policies.
2. Strong financial backing by its members.
3. Prudent financial management.
Types of projects assisted by the bank.
 Health care. .education
 Family planning assistance .housing
 Nutrition .infrastructure

FINANCIAL INNOVATION.
This can be defined as an act of creating and then popularizing new financial instrument as well
as new financial technologies.
Factors that have led to financial innovation/engineering
1. Increased interest rate fluctuations.
2. Frequency of tax and regulation changes.
3. Deregulation of financial service industry.
4. Increased competition within the investment banking.
5. Technological advancement.
6. Accounting benefits.
7. Changes in prices.
8. Opportunities to increase the asset liquidity.
9. Opportunity to reduce risk
10. Transaction cost
Types of financial innovation.
1. Security innovation.
2. Financial process innovation.
3. Creative solutions to the corporate finance problems.

1. SECURITY INNOVATIONS.
It is the development of the innovation financial instrument for consumer type
applications and the corporate finance application. Examples include.
 New bank accounts for customer’s e.g. personal loan, credit cards, savings
account.
 Swaps using caps and floors.
2. FINANCIAL PROCESS INNOVATION
This aims at to reflect the effort in reducing the transaction costs and the steps taken to
reduce the idle cash balance and the availability of inexpensive computer technology to
facilitate transaction.
Examples of process innovation include.
 Online banking.

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  Use of ATM’s
3. CREATIVE SOLUTIONS TO CORPORATE FINANCE PROBLEMS.
This involves corporate restructuring, which aim at managing the financial issues.it
involves tax effect cash management strategies. Examples include.
 Leases.
 Project finance.
 Corporate restructuring.
FINANCIAL ENGINEERING.
It is defined as application of technical methods especially from mathematical finance.

FINANCIAL INTERMEDIERIES.
These are institutions which an act as mediators between two parties in a financial transaction.it
normally occurs between borrowers and lenders. Examples of financial intermediaries will
include:
 Banks
 Insurance companies
 Pension funds
 Mutual funds
 Government saving department
Functions of financial intermediaries.
1. Information
2. Regulation
3. Convenience-they are convenient.
4. Maturity transformation.
5. Risk reduction.
Benefits of financial intermediaries in the economy.
1. Facilitation of flow of funds.
2. Efficient allocation of funds.
3. Assistance in price discovery.
4. Money creation.
5. Enhanced liquidity for lenders.
6. Improve diversification for lenders.
7. Economies of scale.
8. Payment system.
9. Risk alleviation.
10. Money policy function.
THE FINANCIAL SYSTEM.
This is a system that allows the exchange of funds between lenders, borrowers and investors.
FUNCTIONS OF THE FINANCIAL SYSTEM.
1. Saving function.
2. Wealth function-money and capital market provides an excellent way to store wealth
until fund are needed for spending.
3. Liquidity function.
4. Credit function-the financial system provides a credit supply to support both consumption
and investment spending in the economy.

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 5. Risk function.
6. Payment function-provides a mechanism for making payment for goods and services e.g.
debit and credit card.
7. Policy function.
FINANCIAL MARKET-this is a mechanism that allows people to buy and sell financial
securities such as bonds and stocks.
Types of financial markets.
The global financial system fulfills its various roles mainly through markets where financial
claims and financial services are traded.
The financial markets can be divided into different sub-markets as follows.
1. Primary versus secondary market.
Primary market are those financial markets in which financial instruments are issued for
the first time in the market e.g. a company being listed in the stock for the first time.
Advantages of primary market.
 Firms can raise capital in the primary market.
 Helps in mobilizing savings.
 It is a vehicle for direct foreign investment.
 The government can raise fund through sale of treasury bonds in primary market
Secondary financial market is a market for subsequent selling and purchase of the
financial securities.
Advantages /role of secondary markets.
 It gives investors a chance to buy or dispose their shares.
 It increases the divestments of investments.
 It improves corporate governance through separation of ownership and
management.
 It provides investment opportunities for companies and small investors.
2. Organized exchange versus over the counter market (OTC)
Organized exchange is where trading of securities is done by brokers and the buyers and
sellers need not to be present. Trading is done electronically or via internet.
Over the counter is where trading is usually organized by dealers or stock brokers
themselves who buys the securities themselves and then sell them.
Features of the OTC markets.
 Prices are relatively low.
 It usually deals with new securities of the firm.
 It is composed of small and closely held firms.
3. Open versus negotiated market
An open financial market is where the instruments are sold to the highest bidder openly
in the market.
Negotiated market is where securities are sold to one entity or a few entities under
private contract i.e. private placement.
4. Money and capital market.
Money market is a market concerned with short-term financial securities. Financial
instrument in money market includes commercial papers, treasury bills, and bill of
exchange.
Functions of money market.
 It provides finance to solve the liquidity problems of the company.

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  It offers advice to the concerned parties.
 It acts as a channel through which short term investment are offered to the general
public
 It acts as a source of finance to small businesses which are unable to raise funds in
the capital market.
The capital market-is a market for long term sources of finance which are used to
acquire fixed assets for company’s development purposes.
Factors contributing to the slow growth of capital market in emerging markets.
1. Limited number of securities available for investing.
2. Lack of knowledge or lack of interest by ordinary citizen.
3. Low automation-market operation should be highly computerized and online.
4. High taxes on investment income earned in the capital market discourages investor
5. High growth of informal financial schemes as alternative investment avenues.
6. Inadequate legal framework.
7. Lack of transparency in stock exchange.
8. Low numbers of quoted companies due to stringent listing requirement.
FUNCTION OF A NATIONAL SECURITY EXCHANGE e.g. NSE.
1. To aid in the mobilization of savings for investment.
2. To check against capital flight
3. To assist in separation of management from ownership thereby improving corporate
governance.
4. To facilitate equity financing as opposed to debt financing
5. To enhance easier access to finance by new and smaller companies.
6. To encourage the quotation of private companies.
ROLE OF THE SECURITY EXCHANGE IN ECONOMIC DEVELOPMENT
1. Raising capital for business.
2. Mobilizing savings for investments.
3. Redistribution of wealth.
4. Improving corporate governance.
5. Creates investment opportunities.
6. Government source of capital.
7. Barometer of the economy.

THE STOCK MARKET INDEX.

An index is a numerical figure which measures the relative change in variables between two
periods. A stock index is therefore, measure of relative changes in price or values of shares.in
order to construct the index, it is necessary to establish the base year. The NSE20 share index has
1996 as the base year. This index tracks performance of 20 key companies listed on the NSE.
this include:mumias sugar, express Kenya, sasini tea, Kenya airways, KCB, kengen, centum,
KPLC, EABL, bamburi cement, backlays Kenya, safaricom, national media group.
Factors to consider when constructing an index.
1. Need to choose a base year on which the base price changes.
2. The selection of the companies to be used in constructing the index.
3. Use of suitable weights to be attached to the security.

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Limitations/drawbacks of the NSE index.
1. The 20 companies representing the index cannot be a true reflection of all the companies
in Kenya.
2. The base year of 1996 is too far in the past.
3. Dormant firms-some of the companies forming the index are dormant with very little
price changes.
Rules governing floatation of new shares in the NSE.
 The company must have an issued capital of at least sh 20m.
 The company must have made profits during the last 3 years.
 At least 20% of the issued capital should be offered to the public.
 The company should be registered under the companies Act CAP 486.
 The firm must issue the prospectus.
CROSS BOARDER LISTING.
This refers to the listing of securities issued by a foreign issuer on a domestic security exchange.
Reasons for cross boarder quotation by a company.
1. To boost its status as a truly global player.
2. To raise capital through debt or equity.
3. To increase trading volume.
4. To improve shareholders relation.
5. To improve the company’s goodwill.
6. Acquisition of overseas investors and customers.
7. Mobilization of savings across region.
8. Risk diversification.
Disadvantages
1. Greater costs are involved in cross-listing.
2. Cultural and language difference.
3. Exchange rate differences.
4. Vast requirements.
INTEREST RATE.
Function of interest rate in the economy
1. Interest rate determines the propensity of people to either save or consume.
2. Determines the velocity of money-how many times that the money supply turns over
during the year.
3. Also determines which investment should or should not be made. This is according to the
investor’s expected rate of return.
4. Determines the discount rate that the government charges commercial banks.
Determinants of interest rates.
1. Economic condition
Interest rate have a tendency to move up or down with changes in the volume of business
activities.
2. Monetary policy
Monetary policy refers to the policy adopted by the central bank of the country such as
changes in rate of interest and the credit availability.
3. Bank rate
4. Expected rate of inflation
5. Government deficit.

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 6. International capital flow.
THEORIES OF INTEREST RATES.
1. Classical theory.
Classical theory of interest rate compares the supply of savings with the demand for
borrowing.
It is determined by market forces for demand for borrowing and supply of savings.
2. Liquidity preference theory.
Interest rate here is determined by motives for money. There are 3 major motives for
money:
 Transactional motive.
 Precautionary motive
 Speculative motive
3. Loanable fund theory.
The loanable fund market is a hypothetical market that brings savers and borrowers
together. Here the interest rate is determined by the real purchasing power.
4. Market segmentation theory
The interest rate here is determined based on maturity time i.e. the shorter the period the
lower the interest and vice versa.
5. Rational expectation theory.
Theories of the term structure of interest rate.
1. The pure expectation theory.
This theory states that the shape of the yield curve depends on the market expectation
about the future interest rate.
2. The pure liquidation theory.
This theory states that investors prefers to have cash rather than investing even in low
risk investment opportunities.
3. The market segmentation theory.
This states that the market is segmented into 2 categories i.e. market for short-term funds
and market for long-term funds.

CORPORATE VALUATION
Corporate requires regular valuation. This corporate valuation can be possible by use of several
appendices. The most common methods of corporate valuation are:
1. Economic value added (EVA).
2. Enterprise value (EV).
3. Use of free cash flows.
4. Use of valuation models i.e. James Walter model and litners model.

1. ECONOMIC VALUE ADDED (EVA).

Is an economic model developed by Stern & Steward. It uses the residual of wealth to
value the firm.
-The higher the EVA, the better the performance.
-Eva uses cash flows which will be determined by adjusting the profits.
-EVA is the difference between net operating profit after tax (NOPAT) and the return on
capital employed (ROCE).

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 EVA=NOPAT-ROCE.
The following steps are used:
(a) Determine the NOPAT.
(b) Determine the capital employed.
Capital employed=equity=share capital +reserves +retained profit.
(c) Determine the WACC if not provided by either using CAPM or the weighted average.
(d) Determine the return on capital employed.
(e) Determine EVA.
Accounting adjustments;
1. Interest on debt capital should be added back net of tax.
2. Research and development costs and goodwill written off should be added back,
capitalized and then amortized over the period of use.
3. Non-cash expenses should be added back and computed on economic basis.
4. Depreciation and amortization should be added back.
5. Goodwill should be added back to the capital employed.
Advantages of using EVA.
1. It’s a true indicator of the actual wealth created for the shareholders
2. It’s a good measure of performance evaluation.
3. It’s simple to understand and explain to managers.
4. EVA is consistent with the objective of maximizing shareholders wealth.
5. It uses cash flows and hence less easy to be manipulated.
6. It’s widely used to evaluate manager’s performance.
Disadvantages of EVA
1. It’s complex to calculate where large transactions are involved.
2. It’s based on historical information and hence does not consider the future flow.
3. It is not suitable for small enterprises since it doesn’t take into account the size of the
firm.
4. It uses the assumptions of CAPM to determine the required rate of return.
5. It’s not good for comparison since it doesn’t consider the size of the company.
Why EVA has gained prominence.
 It’s less easy to manipulate then accounting figures.
 It takes into account the cost of capital.
 It makes managers accountable.
 It helps the managers to link the balance sheet to the P&L account.
ILLUSTRATION. ( refer NOV 2015 q4)
JM ltd has 2 divisions, J & M which are managed by two different managers. Data from the two
divisions are as follows.
J M
 Total assets 100,000 80,000
 Revenue 107,000 90,000
 Expenses 87,000 70,000
The minimum rate of return on the investment is 12.5%. the corporate tax rate is 35%.expenses
include interest payable on 10% debentures worth 50,000 in J and interest payable on an 11%
loan worth 10,000 in M. The company uses EVA to measure performance of the managers.
Required; compute EVA for each division.

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SOLUTION.
Division J Division M
 Revenue 107,000 90,000
 Less operating expenses (exclude interest) 82,000 68,900
 EBIT 25,000 21,100
 Less tax @ 35% 8,750 7,385
 NOPAT 16,250 13,715
EVA=NOPAT-cost of capital.
Division J EVA=16250-(12.5% × 100,000) =3750
Division M EVA=13715-(12.5% × 80,000) =3715
According to EVA J is performing better than M
2. USE OF ENTERPRISE VALUE.
This is also an economic approach that takes into account the summation of all market value of
those who have a rightful claim to the assets of the firm i.e. ordinary shareholders, preference
SH, debentures holders, NCI.
EV= market value of ordinary shares +market value of Preference shares +market value of
long term debt-cash and cash equivalents.
Advantages.
1. It is simple and easy to understand.
2. It is not affected by the accounting policies and standards.
Disadvantages.
1. Determination of the market value may be subjective.
2. It does not take into account size of the firm and hence no comparison can be made.
3. USE OF FREE CASH FLOWS
Free cash flows are the cash-flows available for distribution to the owners. This is the cash that
can be used for any other use including capital expenditure. This is the cash-flows after adjusting
for all cash payment. Free cash-flow may later be discounted to determine the present value of
free cash-flows.
The higher the PV of cash-flows the better the performance.
Free cash-flows=sales –costs –tax + provisions -capital expenditure.
Advantages.
1. Use cash-flows not profits.
2. It is easier to understand.
Disadvantages.
1. Sometimes re-adjusting the net profit may not be easy.
ILLUSTRATION. DEC 2011Q3B MAY 2019 Q5B)
JM ltd operates a gym in Subukia and another one in shamahoho. The following are transactions
expected in the next 2 years.
Period Year 1 Year 2
Sales 50,000 80,000
Administration expenses 10,000 20,000
Interest expense 5,000 4,000
Capital expenditure 8,000 7,000
Additional information.
1. The corporate tax rate is 40% and the cost of capital is 12%.

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Required: using free cash-flow, determine the minimum amount JM ltd would be willing to sell
the gym.

SOLUTION.
Minimum amount to sell=PV of the free cash-flows
Free cash flow
Period Year 1 Year 2
Sales 50,000 80,000
Less admin expenses (10,000) (20,000)
Less interest (5,000) (4,000)
PBT 35,000 56,000
Tax 40% (14,000) (22,400)
PAT 21,000 33,600
Less capital expenditure (8,000) (7,000)
Free cash-flows 13,000 26,600
PV factor (1+0.12)-1 0.8929 0.7972
PVCF 11,608 21,205
Minimum amount to accept=11,608+21,205=32,813
4. USE OF VALUATION MODELS.
(a). JAMES WALTER MODEL.
James Walter developed a valuation model of determining the value of the share and the value of
the share would be the value of the company.
Assumptions of James Walter model.
1. The form is an all equity financed.
2. The return on investment is constant.
3. The firm will finance all its investments using the retained earnings.
4. The firm is a going concern to infinity.
Based on the above assumptions, James Walter developed the following model.
Po=E + (E-D) r/k PO=value of the share
K E=EPS D=DPS
R=return on equity K=cost of capital
VALUATION OF BUSINESS SECURITIES.
Valuation is the process of determining the worth/value of security using financial information
available.

THEORETICAL VALUE/INTRISIC VALUE-is the value attached to a security.

Reasons for valuation of securities.

1. For liquidation purposes
2. Listing or quotation in the stock exchange.
3. In order to use security as a collateral.
4. In case of selling the security.
5. For tax and insurance purposes.
6. For mergers and acquisition.

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Theories of valuations.
1. FUNDERMENTAL THEORY OF VALUATION
This theory states that that the theoretical value of the security is equal to the present value of
all the future expected benefits to be realized from that security.

Value of the security=present value of the annuity (interest/dividend)+ PV of redemption

value.
ILLUSTRATION
QUESTION ONE
An investor is holding a 10 year, 13% sh 1000 par value debenture which will be redeemed at
10% premium at the end of 10 years. The current market value of the debenture is sh.1200. The
cost of capital is 10%.
Required:
Determine the theoretical value of the debenture.
QUESTION TWO
Akili ltd has issued a debenture whose par value is sh 1000. The debenture can be redeemed at
par after four years or converted to ordinary shares at a conversion rate of sh 100 per share. The
projected market price of the share after the four year period could be either sh 90 or sh 120
based on the company’s performance.
The investors required rate of return is 10%.
Required:
The value of the debenture based on each of the expected share price (8 mks)

2. TECHNICAL /CHARTIST THEORY.

This theory states that the price pattern of the past could repeat itself in the future.
3. RANDOM WALK THEORY.
It states that it is not possible to predict the theoretical value of the security i.e. the value of the
security moves in a random manner depending on the information given to the market.

VALUATION OF ORDINARY SHARES

Ordinary shares are classified into 3 categories for the purpose of valuation.
(a) Zero dividend growth rate ordinary shares.
In this case the company promises to pay constant dividend per share for each period ie
D0=D1=D2=D3=Dn
In this case the intrinsic value =PVAα=D/Ke
(b)Constant dividend growth rate ordinary share.
This is where the dividend will increase at a constant rate until infinity. In this case
Intrinsic value= PVAgα=Do (1+g)
Ke-g
(c)Non-constant dividend growth rate shares (MAY 2019 Q2B)
This is where the dividend will increase at different rates during the earlier period of the
economic life of the project before the growth rate becomes constant until infinity. The
theoretical value in this case will be calculated as follows:

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Intrinsic value (Po)=Pv of dividend during non-constant period + Pv of dividend during constant
period

PV of dividend during constant period = Do (1+g)

Ke-g
Illustration
QUESTION 1
MNL ltd has current dividend of sh.2 per share. The following are the expected annual growth
rates for the dividend.
Year dividend growth rate (%)
1-3 25
4-5 20
6-8 15
9α 10
The required rate of return is 12%.
Required: determine the value of the ordinary share.
QUESTION 2
Twa ltd generated sh 50 million profit after tax in the previous financial year. The firm adopts
40% payout ratio as its dividend policy. The total number of issued ordinary shares is
10,000,000.
The company has a potential investment opportunity. If undertaken, dividends are expected to
grow at the rate of 10% each year for the first 3 years and then stabilize at the rate of 5% each
year thereafter in perpetuity.
The investors minimum required rate of return is 18%.
Required:
The current intrinsic value of the share
Characteristic of efficient market.
Market is said to be efficient if it has the following features.
 Information once received in the market, it’s immediately incorporated in the security
prices.
 The transaction cost like commission paid to brokers should be minimum to avoid
discouragement.
 There should be continuous trading of securities.
 There should be no speculations in the market.
 No investor should receive information earlier than others i.e. no insider trading.

FORMS OF MARKET EFFICIENCY.

1. WEAK FORM EFFICIENCY-this is where the security price reflects all the historical
information concerning the company’s performance.
2. SEMI-STRONG FORM EFFICIENCY-In this case the share price will reflect all past and
present information concerning the company’s performance.
3. STRONG FORM EFFICIENCY-Security price reflects all the past, present and future
information concerning the company’s performance.
CPAK MR JOHNMARK 0705748300 Page 43
Market anomalies.
These are events which makes the market to be inefficient. They include:
1. Insider trading-this occurs when some investors gets information earlier than others by
their position in the organization.
2. January effect-evidence suggest that market normally performs poorly during the
month of January and therefore this makes the investor to buy securities at the end of
December or at the start of January and sell them during the month of march to realize
abnormal gains.
3. Monday effect-the market prices of the security are normally lower on Monday due to
low demand of securities.
4. Announcement effect-evidence suggests that security prices changes for some time
after the initial announcement.
5. Size effect-small companies’ interms of total asset to the market value are normally
affected by well established companies who dominate the market.

DIVIDEND POLICY IN MULTINATIONAL AND TRANSFER PRICING.

General factors affecting dividend capacity.
 Liquidity.
 Access to sources of finance.
 Profitability.
 Growth
 Inflation
 Legal issues
 Restrictive covenant
 Remittance blocking.
Methods used to avoid blocked remittances.
1. Granting loan to parent company.
2. Making payments to parent company in form of ;
-higher administration charges.
-Royalty payments.
-management charges.
3. Higher transfer prices paid by foreign subsidiary to parent company.
4. Currency SWAs.
Method of flow of remittance from subsidiary to parent company.
1. Cost of goods sold (transfer price)
2. Interest expense.
3. Royalty payment
4. Dividends
5. Management expenses
Methods of setting transfer pricing.
1. Comparable uncontrolled price method.
2. Re-sale price method.
3. Cost plus method.

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 4. Profit split method
5. Transactional net margin method (TNMM)

INTERNATIONAL FINANCIAL MANAGEMENT

FINANCIAL DERIVATIVES
Derivatives are the financial instruments whose value is derived from one or more basic variable
known as the underlying or the asset.
Economic function of derivatives.
1. Determining the prices.
2. To transfer the risk.
3. Checking the speculation.
4. Encouraging the entrepreneurial activities.
5. To encourage savings and investment.
Participant In the derivative markets.
1. Hedgers.
2. Speculators.
3. Arbitrages.
1. HEDGERS
These are participants who enter to the market to reduce the risk. Therefore hedging is a
mechanism to reduce the price risk. They are mostly concerned with savings.
2. SPECULATORS
They are participants who enter the derivative market in order to make profit. Therefore they are
willing to accept the risk.
3. ARBITRAGERS
These are speculators who are interested in the short term gains therefore making profit out of
the fluctuations of the prices.
TYPES OF DERIVATIVES.
They are classified into 4 categories as follows;
 Options
 Swaps
 Future contract
 Forward contract
OPTIONS
An option is a contract which gives the buyer/seller the right but not obligation to buy or sell the
specified asset/security at a specified price on or before the specified future date. The specified
price is known as the exercise price.in this case the parties usually are required to pay a non-
refundable fee known as the premium.

Types of options
(a) Call option
This is a financial contract which gives the buyer the right but not obligation to acquire a given
number of securities in the future at a pre-determined price. The value of the call option is
expressed as follows:
VC= max (MPS – E, 0)
Profit/loss= VC- premium

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The call option can only be exercised if the price of the option at the expiry date is greater than
the exercise/strike price.
(b) Put option
This is a financial contract which gives the seller the right but not obligation to sell a given
number of securities in the future at a pre-determined price. The value of the put option is
expressed as follows:
VP= max (E – MPS, 0)
Profit/loss= VP- premium
The PUT option can only be exercised if the price of the option at the expiry date is lower than
the exercise/strike price.

OPTION STYLE
There are 3 basic types of the option based on their settlement date.
1. European option.
This gives the holder of the option to sell/buy the asset on the expiry date only and
therefore it cannot be exercised earlier.
2. American option.
This option gives the holder the right but not obligation to buy/sell on or before the
expiry date.
3. Bermudian option
Under this option, the option can be exercised any time before maturity date but the date
of exercising is normally specified when the contract was signed.
Options categories based on payoffs.
(a) In the money option.
This is when, if the option is exercised today, a profit will be realized.
(b) Out of the money option.
This is when, if the option is exercised today, a loss will be realized.
(c) At the money option.
This is when the option is exercised now, there will be no loss/gain i.e. break even.

ILLUSTRATION.
Suppose a security has an exercise/strike price of sh.30 with a premium of sh.5.Determine the
value of both call option and put option as well as profit/ loss assuming the following prevailing
market prices (MPS):
SH (20, 25, 30, 35, 40, 45).

PUT CALL PARITY THEOREM.

This is a theory which links the price of the call and put option and therefore it determines the
price of the call and the put option in a manner that the arbitrage opportunities are eliminated.
The theory is expressed as follows:
P=C –Pa + E e-rt
Where: P=price of the put
C=value of the call
Pa=MPS/spot rate
E=exercise price/strike price
e=exponential constant=2.7183

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 .r=risk free rate
.t=time to expiry in years.

OPTIONS PRICING MODEL.

1. Binomial model.
This model is based on the assumption that there are only 2 price that will emerge at the expiry
date of the option. The model is based on the following assumptions:
 A portfolio of the options and assets are in the form of securities.
 The arbitrage opportunities are not possible.
 There are no uncertainties in the outcome of the above portfolio.
The following steps are followed under this model.
1. Compute the option delta of the option as follows.
Option delta= changes in option value
Change in share price
Option value=VC=max (MPS –E, 0)
2. Determine the value of the portfolio.
(MPS × option delta – value of the call option)
3. Determine the present value of the portfolio
Value of the portfolio × e-rt
4. Determine the present value of option portfolio.
PV of the share price – PV of the portfolio.
(Actual MPS × option delta – PV of the portfolio)

2. Black and scholes model

This model is used to derive the fair value of the call option.it is used where the share price at the
end of expiry period can take continuous value rather the two value.
The model is based on the following assumptions.
 The rate of return of the share follows a normal distribution.
 The risk free rate is constant
 The market is efficient and there are no transaction cost and taxes.
 The option is a European option
 There are no restriction/penalties.
 The share price is continuous and random
 There is no dividend payment.
According to black and scholes, the value of the call option is calculated as follows:
VC=PN (d1) – E N (d2)
ert

Factors affecting the value of the call option.

1. The market price of the security (Pa).
The higher the MPS of the security, the higher the value of the call option.
2. Exercise price (E)
It has a negative relationship i.e. the higher the exercise price the lower the VC.
3. Risk free rate.(r)
The higher the risk free rate the higher the value of the call.
4. Time remaining to expiry (T)

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 The longer the remaining time to maturity the higher the value of the call.
5. Standard deviation/volatility.
Normally, the higher the risk the higher the returns hence the higher the standard
deviation the higher the value of the call option.
Limitations of black and scholes model.
1. The model is only applicable in the European option only.
2. It assumes that the risk free rate is known in advance and its constant throughout.
3. It assumes there is no transaction cost or tax effect involved
4. It assumes that there are no dividend paid during the period.

GREEKS.
These are the sophisticated tools used to measure variation in the option premium and they
include:
(a) DELTA
Measures the option sensitizing to change in the price of the asset or security. It’s
therefore the degree to which the option price will change given a change in the share
price or the index price holding other factors constant.
Option delta=change in option value
Change in the share price
(b) GAMMA
The rate at which the delta value of the option increases or decreases due to the changes
in the share price.
Gamma= change in option delta
Change in price of asset
(c) THETA
Measures the change in the option price as the time to expiry increases. The longer the
time to expiry of the option, the greater the value of the delta.

Theta=change in the option premium

Change in expiry time
(d) VEGA
It measures the change in the option price as a result of the changes in the standard
deviation of the share price.as the standard deviation increases, the value of the call and
put will increase.
VEGA= change in option premium
Change in volatility
(e) RHO
Rho= change in option premium
Change in cost of financing the asset
REAL OPTIONS
They are investment projects which gives the management the right but not obligation to delay,
withdraw or expand the project. They are long term projects in nature.
Types of real options.
1. Option to delay the project.
2. Option to expand the project
3. Option to withdraw the project.

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For real options:
P=PVCIF
E= PVCOF/abandonment value/scrap value/salvage value

SWAPS.
This is the arrangement between two parties to exchange the assets or liabilities for the mutual
benefits for each other. It’s therefore an arrangement to exchange a steam of the future payment
concerning the loan and interest.it is flexible private forward contract between 2 parties to
exchange the cash flows.it is classified into as follows:
(a) Interest rate swaps
(b) Currency swaps

1. INTEREST RATE SWAPS

This is an arrangement where 2 parties agree to exchange a stream of interest payment based on
the principle amount which is agreed among the 2 parties over a given period of time. The value
of the interest swap is the net difference between the present value of the expected amount to be
received and the present value of the payment that the parties expected to make.
Characteristics of interest rate swaps.
 Efficient translates the variable rate (floating rate) into the fixed rate.
 There is no exchange of the principle payment obligation.
 Each party has a payment obligation
 It is structured as a separate contract different from the loan agreement.
 It is applicable to the new as well as the existing borrowing.
 It is treated as the off balance sheet transaction.
ILLUSTRATION.
Consider company A which intends to borrow a long term loan at a fixed rate, however this
company cannot be issues with the bond due to its performance in the previous period. It can
only borrow at a fixed rate from the commercial bank at 15.5% p.a. the company can obtain a
bank overdraft of a variable interest rate equal to the base lending rate of +0.5%.consider
company B which can borrow at a fixed interest rate of 14% and can also borrow at a variable
rate equal to the base lending rate only. This information can be summarized as follows:
Firms fixed rate variable rate.
 A 15.5% base lending rate +0.5%
 B 14% base lending rate.
Explain how a swap can be organized between company A & B assuming amount to be
borrowed is sh.1m
Solution.
Firm A will request firm B to borrow sh 1m at a fixed interest rate of 14% pa while firm A will
borrow the same amount on behalf of firm B at a variable interest rate equal to the base lending
rate +0.5%.
At the end of the period, firm A will pay firm B the interest expense incurred on its behalf equal
to (sh 1m × 14%)=140,000. However, firm B will pay A interest expense incurred on its behalf
equal to the base lending rate only. Therefore firm A will incur an extra expense which will not
be paid by firm B equal to (sh1m × 0.5%) =5000.however, if firm A had borrowed on its account
its total cost would have been (sh.1m × 15.5%)=155,000. However, if firm B borrows on his

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behalf the total borrowing cost will be (140,000+5,000=145,000) .Therefore the net gain for firm
A in the swap arrangement will be (155,000-145,000=10,000).
Types of the interest rate SWAPS
1. Variable to the fixed interest swaps.
Variable to the fixed interest swap are used by the company to fix the interest obligation
on their variable rates of borrowing. Under this swap arrangement, companies make fixed
rate payment and they receive the variable rates, therefore the procedure can be used to
offset the variable interest obligation on the corresponding principle amount that has been
borrowed.
Benefits.
 The flexible risk management.
 Independence hedging strategy.

2. Fixed to the variable interest rate swap.

It eliminates the company’s risk to the variable rate therefore it allows the company to
undertake the variable rate which will enable them to achieve immediate interest savings.
Advantages.
1) Ability to obtain finance at a cheaper cost.
2) The opportunity to effectively restructure the company’s capital profile.
3) It is a long term hedging against the interest rate movements.
4) Ability to access the type of finance which could not be accessed directly.
CAP, FLOOR AND COLLAR.
Interest rate CAP
Is a contract that enables the company with the floating or variable rate debt i.e. it limits their
exposure to the rising interest rate.

Benefits of interest rate CAP

 Low protection cost-the company will incur minimum cost to protect its self
 Flexibility-they allow the buyer to continue to benefit from the declining variable rates.
 It facilitates the cash flow planning i.e. the company can learn its cash-flow pattern.
INTEREST RATE FLOOR:
It’s a series of the European put option on a specified interest rate that protects the financier o the
lenders against the declining variable interest rate.
INTEREST RATE COLLAR
It’s a combination of a cap and a floor transacted simultaneously, the buyer of the interest rate
cap will purchase at an interest rate which must be protected by the cap.
Benefits of interest collar.
 Cost reduction.
 Flexibility.
 It creates the certainty about the amount to be received or paid.
 It’s a risk management strategy that protects both the buyer and the seller.

2. CURRENCY SWAPS.
A contract between parties to exchange specific amount of 2 different currencies exchanged
using the market rates.it takes into consideration the transaction between 2 parties in different
currencies.

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Benefits
1. Enables the company to obtain finances at a cheaper rate
2. It enables the company to hedge its currency exposure for a long period.
3. Enables the company to restructure its debt profile by issuing the bond
4. Enables the company to access international capital market
Risk associated with SWAPS.
1. Credit risk.
Risk that one of the parties in the swap arrangement will default at the end of the contract
therefore fails to carry out his financial obligation.
2. Market risk.
Risk that interest rate will move unfavorably against the company thereby affecting its
operation.
3. Mismatch risk
Risk that the intermediary bank may not be able to carry out its obligation as a 3rd party.
4. Sovereign risk
Risk associated with the country in which the currency swap has been organized.

FUTURE AND FORWARD CONTRACT.

FUTURE contract is a legal agreement to buy or sell something at a pre-determined price at a
specified time in the future.
FORWARD contract is a customized contract between two parties to buy or sell an asset at a
specified future time at an agreed price.
Difference between future and forward contract.
FUTURES FORWARD
they are traded in an organized/formal market They are traded on an over the counter
market/informal market
Future involves standardized contracts Forward involves negotiated contract terms
rd
There is need for a 3 party guarantor. There is no 3rd party guarantor
They are quoted in American terms Quoted on any other currency.
Default risk is lower Default risk is higher compared with future
contract.
Size of the contract is fixed Size of the contract keeps on changing

FOREIGN EXCHANGE MARKET.(forex market)

 Is a market where currencies are traded. The principle participant in this market is the
bank.
 Exchange rate refers to the price of one currency expressed in terms of another.in most
cases the exchange rate is determined by the price mechanism (forces of demand and
supply). This is referred as floating exchange rate.
 However exchange rate in some countries are fixed or pegged against either the value of
another currency or another measure of value such as gold.

Exchange rate can be quoted into 2 ways:

1. Direct quote
It refers to the amount of domestic currency required for one unit of foreign currency eg Ksh
103= $1…………….in this case the foreign currency is the commodity.

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2. Indirect quote
It refers to the amount of foreign currency required to purchase one unit of the domestic currency
e.g. Tsh. 18= Ksh 1. In this case home currency is the commodity.
NB/
 INDIRECT QUOTE/home currency is the commodity= payment-bid
 Receipt-ask
 DIRECT QUOTE/foreign currency is the commodity= Payment-ask
Receipt-bid
These markets are usually exposed to 2 major risks.
1. Foreign exchange rate risk.
2. Interest rate risk.
FOREIGN EXCHANGE RATE RISK.
This is the type of risk associated with foreign currency. This risk occurs due a change in the
foreign currency rate and they include:
(a) Transaction risks
Risks that occur in the transaction where the foreign currency is involved i.e. where there
is import and exports. These risks arise from the fact that the exchange rate on the date of
the transaction will be different from the exchange rate on the date of the settlement of
the transaction.
(b) Translation risk.
Refers to the possibility of the accounting loss that will occur as a result of the conversion
of the financial statement items.
(c) Economic risk.
These are long term movements in the exchange rate which puts the company in some
competitive disadvantage due to long term fluctuations in the exchange rates.

THEORIES OF FOREIGN EXCHANGE (FOREX THEORIES)

1. Purchasing power parity (PPP)
This theory states that exchange rates between 2 currencies are the same in equilibrium when the
purchasing power of the currency is the same in each country.
Under PPP, inflation rate is the key consideration. PPP can be expressed using the following
formula:
S1=So 1+hc
1+hf where: S1-futureexpected spot rate
S0-current spot rate
Hc-inflation rate in home currency
Hf-inflation rate in foreign currency
2. Interest rate parity (IRP)
Under IRP, difference between the spot and the forward rate reflects the difference in interest
rates.
This theory predicts exchange rates based on the hypothesis that the difference between 2
countries interest rate should off-set the difference between spot rate and forward exchange rate
over the same period. Interest rate is the key consideration.it is expressed using the following
formula:
FO=So 1+Ih
1+If where: Fo-forward exchange rate.

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 So-current spot rate.
Ic-interest rate in home currency
If-interest rate in foreign currency
3. International fisher effect (IFE)
According to the IFE, interest rate difference between countries provide on unbiased predictor of
future exchange in spot exchange rates. the currency of countries with relatively high interest
rate is expected to depreciate against high interest rate is expected to depreciate against
currencies with lower interest rate.

The international fisher effect can be expressed as:

1+Hh = 1+Ih
1+Hf 1+If

Causes of interest rate fluctuations.

1. Demand and supply of the investment funds.
2. Inflation.
3. Government policy.
4. Political instability.
5. Goodwill of the company.
Techniques which a company can use to hedge against the use of foreign exchange risk
involved in foreign trade.
 Forward market hedge.
 Money market hedge.
 Future market hedge.
 Option market hedge

FUND MANAGEMENT
This is the process of managing the balance sheet and the off-balance sheet instruments to
maximize and maintain the spread between the interests, carried and paid while ensuring that the
bank has the ability to pay off the liabilities and acquire the assets earned.
The best way of evaluating the fund management is by undertaking:
a) Operations of the bans.
b) Customer’s behavior.
c) The asset liability composition
d) The economic and competitive environment under which the banks operate.
Categories of funds.
1. MUTUAL FUND
These are financial intermediaries that pool the financial resource of the investors and
invest these resources in the classified projects which are diversified projects of the
securities.
Mutual funds are classified into 3 categories as follows:
(a) Open-ended funds
This is a fund with the fixed number of shares of the public and to redeem the
outstanding shares on demand at a price equal to the appropriate share of the value of
its portfolio. The price is based on the net asset value which is calculated as follows:

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 NAV=market value of portfolio-liabilities
No. of the funds share outstanding
(b) Closed end funds.
This is a fund with fixed number of shared units. Shares in the closed end fund are
sold in organized security exchange market as the fund do not redeem their shares.
(c) The balanced fund
It is a fund that combines the stock components, the bond and sometimes the market
securities and the money market components.
2. HEDGE FUND
It’s an investment fund that can take a wide area of investment and trading activities than
other funds but which is generally only opened to some type of the investment projects
which are identified by the regulation of the investment fund.
Types of hedge fund.
(a) Equity market neutral hedge fund.
(b) Convertible arbitrage hedge fund.
(c) Fixed income arbitrage hedge fund.
(d) Global hedge fund.
Parties involved in the organization and operation of funds.
1. Fund manager.
2. Custodian.
3. Trustees.
REAL ESTATE FINANCE.
This is the application of financial techniques to real estate markets.
Real estate law recognizes 3 types of properties:
1. Personal property-movables eg furniture’s.
2. Intangible property eg stocks.
3. Real estate-land and permanent structures attached to land.
Participant in real estate markets
Owners/users-both owners and tenants
Pure investors-they lease out or rent the property.
Renters-consumers of the real estate.
Developers-prepare raw land for buildings which results in new product for the market.
Renovators
Facilitators-banks, brokers, lawyers-they facilitate purchase of the real estate.
Characteristics of real estate markets.
1. Durability.
2. Heterogeneity.-long term.
3. Expensive.
4. Time consuming to develop.
5. Immobile/immovable.
Real estate financing.
 Savings and loan associations.
 Commercial banks.
 Savings banks.
 Mortgage banks.
 Life assurance companies.

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  Credit union
 Investment trusts.
PROPERTY VALUATION
Property valuation is the process In which the economic value of a real estate investments is
determined, which often seeks to determine the fair value of a real estate property.
Importance of property valuation.
 Property valuation is a very important concept in real estate’s investing because it is the
main factor that determines how much the property taxes and property insurance to pay.
 In addition, mortgage lenders require a home appraisal before providing a loan. The
reason for this is to protect the potential buyer from paying too much for a real estate
property, as well as protecting the bank from financing a property that is worth less than
the amount it invests in.
 home appraisals are also required to settle down legal matters such as divorce, real estate
settlement, or a lawsuit.
METHOD/PROACHES FOR PROPERTY VALUATION.
1. THE INCOME APPROACH.
The income approach is a property valuation method that is particularly common in
commercial real estate and rental properties. The main idea behind this approach is to
calculate the current value of the real estate property based on the net income it generates
divided by the capitalization rate.
As a start, the appraiser needs to collect income and expenses statement for the subject
real estate property and for similar properties in the same area in order to estimate the net
operating income (NOI).

Steps in estimating the net operating income (NOI)

i. Estimate the gross potential income assuming 100% occupancy.
ii. Estimate the effective gross income.
iii. Estimate property expense.
iv. Calculate NOI
Assumptions of income approach.( nov 2018 q5a)
1. Value is a function of income
People purchase income producing property for the income it will return on the
investment. The income that the property generates may come from many sources such as
rents, royalties, amenities, rents for billboards.
2. Investors will estimate the duration, quantity and quality of the future income
The income approach assumes that the investor in real property will estimate the duration
of the income stream and its risk or likelihood of receipt, when selecting a capitalization
rate to value the property..
3. Future income is less valuable than present income
It provides that the sum of the present worth of the future income payment is always less
than the undiscounted sum of these future payments.

2. THE SALE COMPARISON APPROACH

As the name suggests, the sale comparison approach uses the market data to estimate the
value of a real estate property. This method is done by comparing the property to other
similar properties that have been recently sold.

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 This method is commonly used for single family homes where there are typically many
comparable to analyze.
3. THE COST APPROACH
The cost approach method considers the value of the property as the cost of the land plus
the cost of replacing the property (construction cost) minus the physical and functional
depreciation. This approach is commonly used for real estate’s properties that are not
easily sold like schools, hospitals and government buildings.
REAL ESTATE FINANCE INSTRUMENT.
1. Promissory notes.
2. Security instruments
3. Trust deeds.
4. Mortgages
5. Lien and tittle theory.
Risks associated with investments in real estate trust (REITs) securities.(MAY 2019)
1. General market risk-all markets have ups and down as tied to the economy, interest rate,
inflation or other market trends. Investors cannot eliminate market shock and they can
only hedge their bets against booms and busts with diversified portfolio.
2. Asset-level risk-some risks are share by every investment in an asset class. In real estate
investing, they always demand for asset with diversified risk.
3. Liquidity risk
4. Credit risk
5. Replacement cost risk
6. Leverage risk
7. Structural risk

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