KENYATTA UNIVERSITY

BACHELOR OF COMMERCE
BAC 203 – BUSINESS FINANCE 1

COURSES Description
This course has been designed to act as a catalytic agent among commerce students as a
pre – requirement to meeting and coping with the present and future challenges in the
over dynamic world of Finance and Banking.
Course Outline

Topic Brief outline

1. Introduction -goals of a firm
-agency theory
- functions of financial manager
2. Sources of finance Specific sources of finance
-Short-term sources
- long-term sources
-formal and informal business finance
3. Risk and return trade off (single - types of risks
securities) - making decision in the face of
uncertainty
-measurement of risks and returns
[Link] value of money - concept of future and present value
- discounting and compounding
- annuities e.g. ordinary annuities,
annuities due deferred annuities
-perpetuities and intra-annual
compounding
5. Valuation of securities - ordinary share valuation
- preference shares
- valuation of bonds (perpetuities and
fixed
term bonds
6. Cost of capital. - factors affecting the cost of capital
- determination of different costs of
capital
- calculation of the WACC
- limitation of the WACC
7. Introduction to financial statements Types of financial analysis techniques and
analysis analysis of non-financial information
- component of financial statements
- use of various methods of analysis
- limitations of financial statements
- various financial ratios

Mode of instruction and assessment

Course instruction will lecture and discussions.

Assessment will comprise of continuous assessment, attendance and assignments which

will count 30% of the total mark.
The university Examination will account for 70% totaling to 100%.

Reference Books
1. Wetson J F, (1993). Essential of managerial Finance 10th edition, the Dryden Press
Publisher
2. Bringham E.F. (2012). Fundamental of Financial Management, The Dryden press.
3. Van Horne, J. C. &J.M Wachowiez, (2004). fundamental of financial management,
Prentice Hall
4. Schall, D.C & C.W. (n.d). Haley. Introduction to Financial Management,
McGraw-Hill
5. Gitman, L. J.(2012). Principals of management Finance, Harper Collins
6. Eddie, M. (2011). Business Finance, Theory and practice, 8th edition , Prentice Hall
Publisher
7. Bill N &Trefor M, (2011). Business Finance, a value based approach. Prentice
Hall P
SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine functions an
Managerial Functions.

Managerial Finance Functions

Require skilful planning, control and execution of financial activities. There are four important
managerial finance functions. These are:

a) Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of fu
investment projects. They refer to the firm’s decision to commit current funds to the purcha
assets in expectation of future cash inflows from these projects. Investment proposals are ev
terms of both risk and expected return.

Investment decisions also relates to recommitting funds when an old asset becomes less produc
is referred to as replacement decision.

b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance investment pro
finance manager must decide the proportion of equity and debt. The mix of debt and equity
firm’s cost of financing as well as the financial risk. This will further be discussed under the
trade-off.

c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the sharehol
them, or distribute a portion and retain a portion. The earnings must also be distributed to othe
of funds such as preference shareholder, and debt providers of funds such as preference shareh
debt providers. The firm’s dividend policy may influence the determination of the value of th
therefore the finance manager must decide the optimum dividend – payout ratio so as to ma
value of the firm.
 THE CONCEPT OF TIME VALUE OF MONEY
The preference for money is a concept which attempts to explain why individuals and
prefer cash now rather than in the future. By the virtue of passage of time, the value
will change. Individuals prefer current cash instead of future cash for the following reas
(a) Availability of investment opportunities
The cash received today can be invested to generate extra income e.g. interest in the
(b) Subjective preference of money by individuals
Individuals prefer the money now for various reasons:
 Urgency of the current consumption e.g. the need for money to pay for foo
clothing, education etc.
 There is uncertainty whether the individuals will be there in future to enjoy th
be received in future.
(c) Uncertainty of future cash flows
It is uncertain whether the cash will be available in future to be received
Individuals therefore prefer the cash now when there is certainty of receiving it.
(d) To take advantage of cash discounts
Trading firm will prefer to have cash now in order to receive cash discounts offer
suppliers since if they do not have cash now, they will forego the discounts.

Importance of the concept of the time value of money

The concept of the time value of money is important due to its application in the follow
(a) Determination of effective cost of borrowing: This is done by comparing the a
cash to be received today in form of a loan and the future benefits derived from
of such a loan.
(b) Determination of the true rate of return on investment: The time value of
used to determine the yield to various investors such as preference shareho
ordinary shareholders.
(c) Valuation of business: Time value of money is used to determine the maximum
should be paid for a business by computing the present value of the expected futu
from such a business.
(d) Selection of the best source of finance: This is done be selecting the source wh
the highest benefit in present value terms.
(e) Determination of loan repayment arrangements: Time value of money i
determine the installments to be paid per period in order to liquidate / rep
borrowed loan.

Compound Value of a Single Amount

The compound value refers to the future value of an amount called the principal w
invested over a specified number of periods and earning interest at a particular inte
Compounding refers to the inclusion of the interest earned at the end of one period as p
principal in the next period.
 THE CONCEPT OF TIME VALUE OF MONEY
The preference for money is a concept which attempts to explain why individuals and
investors prefer cash now rather than in the future. By the virtue of passage of time, the
value of money will change. Individuals prefer current cash instead of future cash for the
following reasons:
(a) Availability of investment opportunities
The cash received today can be invested to generate extra income e.g. interest in the
future
(b) Subjective preference of money by individuals
Individuals prefer the money now for various reasons:
 Urgency of the current consumption e.g. the need for money to pay for food,
shelter, clothing, education etc.
 There is uncertainty whether the individuals will be there in future to enjoy the
cash to be received in future.
(c) Uncertainty of future cash flows
It is uncertain whether the cash will be available in future to be received and used.
Individuals therefore prefer the cash now when there is certainty of receiving it.
(d) To take advantage of cash discounts
Trading firm will prefer to have cash now in order to receive cash discounts offered
by the suppliers since if they do not have cash now, they will forego the discounts.

Importance of the concept of the time value of money

The concept of the time value of money is important due to its application in the
following areas:
(a) Determination of effective cost of borrowing: This is done by comparing the
amount of cash to be received today in form of a loan and the future benefits
derived from utilization of such a loan.
(b) Determination of the true rate of return on investment: The time value of
money is used to determine the yield to various investors such as preference
shareholders and ordinary shareholders.
(c) Valuation of business: Time value of money is used to determine the maximum
price that should be paid for a business by computing the present value of the
expected future benefit from such a business.
(d) Selection of the best source of finance: This is done be selecting the source which
gives the highest benefit in present value terms.
(e) Determination of loan repayment arrangements: Time value of money is used to
determine the installments to be paid per period in order to liquidate / repay some
borrowed loan.

Compound Value of a Single Amount

The compound value refers to the future value of an amount called the principal when it
is invested over a specified number of periods and earning interest at a particular interest
rate. Compounding refers to the inclusion of the interest earned at the end of one period
as part of the principal in the next period.
Illustration:
An investor puts Sh. 10,000 in a bank for four years. The interest rate is 10%. Compute
the future or compound value of this investment.

The following formula can be used to determine the future value

FV = PV(1+r)n Where FV= Future Value PV = Principal (present
Value)
r = interest rate n = number of periods
n
The function (1+r ) is called the Future Value Interest Factor (FVIF). When expressed
in terms of a particular interest rate (%) and a certain number of periods, it is written as
FVIF r%, n

Compound Value of an Annuity

An annuity refers to payments or receipts of equal streams of benefits. These equal
streams can also be called installments. Examples of installments are salaries, rent,
insurance premiums, retirement benefits etc. The future value of an annuity refers to the
amount to be received in future if a deposit is made each and every year of an equal
amount. When deposits are made at the end of every year the number of years of earning
interest will be n-1.
The following formula can be used to compute the future value of an annuity

Future value of an annuity

= Annuity*
r (
( 1+r )n −1
)
. The function
(
( 1+r )n −1
r is called
)
the future value Annuity factor (FVAF) usually written as FVAF r%, n.

Illustrations:
1. An investor deposits Sh. 20,000 at the beggining of every year for four years. The
interest rate is 12%. Compute the future value of the annuity.
2. K.J. wishes to deposit Sh. 100,000 per annum for the next five years. The deposit is
made at the end of each year. The interest rate is 10%. Compute the future value of
the annual deposit.
Present Value of a Single Amount
This refers to the amount, which requires to be deposited today (principal) and be
invested over a specified number of periods at a particular interest rate. The process of
computing the present value is called discounting. The interest rate used in computing the
present value is called the discount rate or required rate of return or cost of capital or
opportunity cost.
1
n
FV ∗
Since the FV = PV(1+r) then the present value (PV) = ( 1+ r )n . The function
1
( 1+ r )n is called the present value interest factor (PVIF) which is always expressed as
PVIF r%, n..
Illustrations
1. Mr. Onyango expects to receive Sh. 40,000 in four years time. The discount rate is
14%. Compute the amount he requires to deposit today.
2. Mrs. Kamau expects to receive Sh. 300,000 at the end of five years. The discounting
rate is 13%. Compute the present value of this amount.
3. Ms. Mwangi expects to receive Sh. 750,000 at the end of the four-year contract with
her employer. The discounting rate is 8%. Compute the present value of this
amount.
Present Value of an Annuity
This refers to an amount, which is required to be deposited now and in subsequent years
in equal installments for a specified number of periods and at a particular discounting rate
for it to yield a particular future value.
Illustration
Mrs. Kamau has been depositing Sh. 30,000 p.a. at the end of each year for the last five
years. The discounting rate is 16%. Compute the present value of these annuities.

The present value of an annuity = annuity * PVAF r%, n.

=
1−
[ 1
( 1+r )n ] =
1−( 1+ r )−
n

Where the PVAF r r

The PVAF = PVIF when they are added together.

Illustration
1. An investor expects to deposit Sh. 15,000 each year for the next 10 years. The
discounting rate is 10%. Compute the present value of these annuities.
2. Mrs. Hesabu has taken a loan of Sh. 400,000 form sweet waters Ltd. She expects to
liquidate the loan in 20 years time. The discounting rate is 12%. Compute the
amount she has to pay each year in order to liquidate the loan.

Present Value of Unequal Cash Flows / Benefits

1. XYZ Ltd has a four year project which is expected to generate the following cash
flows
Year 1 2 3 4
Cash flows 20,000 60,000 50,000 30,000
The cost of capital is 10%. Compute the present value of the cash flows.
2. ABC Ltd has a five year project which is expected to generate the following cash
flows:
Year 1 2 3 4 5
Cash flows (Sh. ‘000) 300 180 240 200 170
The cost of capital is 15%. Compute the present value of these cash flows.
Present value of deferred annuity
Deferred annuities refers to a situation where the cashflows in early years are unequal
but become annuities (equal installments)in later years. When computing the present
value of deferred annuities the following steps should be followed:
i. Compute the present value of the unequal cashflows in the early years in the
normal way
ii. Get the present annuity factor at the discounting rate for the number of periods
iii. Get the present value annuity factor at the discounting rate for the period where
the cashflows are unequal
iv. Compute the present value of the annuities between equal and unequal cashflows
=Annuity(PVAFr% n-PVAFr% n)
v. Add the present value of step one to step four to get the total
Illustration
1. ABC Limited has an eight year contract which is expected to generate the
following cashflows

Year 1 2 3 4 5 6 7 8

Cashflows’000’ 600 750 500 550 550 550 550 550

The discounting rate is 14%.Compute the present value of the cashflows

2. Thika Limited has a ten year project which is expected to generate the following
cashflows

Year 1-4 5-8 9-10

Cashflows 300 200 100

The discount rate is 10% compute the present value of the cashflow

Present Value of an Annuity in Perpetuity

An annuity in perpetuity refers to the receipt or payment of equal amounts from one year
to another indefinitely, forever i.e. a company is assumed to be a going concern and
therefore if it pays a constant dividend per share of Sh. 3 p.a. the amount is viewed to be
received in perpetuity.
A
Therefore the present value of an annuity in perpetuity = r where A is the annuity
received in perpetuity and r the discount rate.

Illustrations
1. An investor expects to receive Sh. 800 p.a. dividends from a company in
perpetuity. The cost of capital is 15%. Compute the present value of the annuity in
perpetuity.
2. XYZ Ltd has a project which is expected to generate the following cash flows
Year 1–8 9-∞
Cash flows (Sh. ‘000) 450 500
Compute the present value of these cash flows. Discounting rate is 12%.
3. ABC Ltd wants to acquire a new firm which when acquired will generate the
following incremental cash flows:
Year 1–5 6 - 10 11- ∞
Cash flows (Sh. ‘000) 50 90 130
The discount rate is 13%. Compute the maximum price ABC Ltd should be
willing to pay for the new firm.
Present value of a growing annuity in perpetuity

This refers to a constant amount paid from year to another in perpetuity but growing or
increasing at a particular growth rate. Example a company may be paying a dividend per
share of sh 4 per annum which is expected to grow or increase by 10% per annum in
perpetuity (the going concern of a firm)

A
Present value of a growing annuity in perpetuity=
r−g

Where r is discounting rate

g is the constant growth rate in perpetuity

Illustration

1. Safaricom limited expects to pay a dividend per share of sh 5 at the end of the
year. The dividends are expected to grow by 10%per annum in perpetuity. The
cost of capital of the firm is 14%.Compute the theoretical value of the ordinary
share of safaricom limited
2. Mr Kamau has secured a part time job on contract. The annual salary is sh
100,000 per annum which is expected to increase by 10%per annum in perpetuity.
The discounting rate is 12%.Compute the present value of the annuities

Present value of a growing annuity (annuity with definite period not perpetuity)

This refers to equal receipts of payments which will increase or grow by a certain
percentage within a definite time period.

Illustration

1. Simon has just secured a job whose annual salary is sh 200,[Link] job is of a
four year contract. The salary is expected to increase by 12% p.a during the
contract period. The discounting rate is 16% the salary is received at the end of
each year. Compute the present value of the growing annuity
2. Kamau has secured a ten year contract with Mumias sugar. The annual salary is
sh 300,000 which is expected to increase by 15% p.a during the ten year contract.
The appropriate discounting rate is 20%.Compute the present value of the
growing annuity

Present Value of annuity due

Annuity due refers to equal receipts of benefits at the beginning of the year/period. When
computing the present value of annuity due the PVAF is multiplied by (1+r)

Present value of annuity due=Annuity (PVAFr% n) (1+r)

Illustration

1. Joseph is saving sh 150,000 p.a for the next five years for his trip to USA.
Savings are made at the beginning of each year. The appropriate discounting rate
is 10%.Compute the present value of the savings
2. Njuguna construction limited has undertaken an eight year contract which is
expected to generate the following cash flows

Year 1-3 4-8

Cashflows’000’ 168 210

The appropriate discounting rate is 14%.The cashflows are received at the

beginning of each year. Compute the present value of the cashflows

Multi – Period Compounding

A year is taken to be a standard measure of time. It is equivalent to one standard
period. Within this one period of one year, there could be many periods depending on
how many times in a year interest or returns are paid. Multi-period compounding
refers to a situation where interest is paid or received more than once in a year.

The effective annual interest rate of an investment

( )
= 1+
r m
m
−1
where r is the
nominal interest rate and m the number of periods in a year. the nominal interest rate
refers to the interest rate p.a. if the interest is paid or received only once in a year.

Illustration
Mr. Mohammed has an investment which has a nominal interest rate of 16% p.a.
required:
(a) Compute the effective annual interest rate if interest is received:
i. Semi annually
ii. Quarterly
iii. After every four months
iv. Monthly
v. Weekly
(b) The amount of money invested is Sh. 100,000. It is invested over 4 years.
Compute the future value of this investment in relation to cases (i) to (v) in (a)
above.

Growing Annuity
A growing annuity, is a stream of cash flows for a fixed period of time, t, where
the initial cash flow, C, is growing (or declining, i.e., a negative growth rate) at
a constant rate g. If the interest rate is denoted with r, we have the following
formula for the present value (=price) of a growing annuity:

PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],
where:

PV = Present Value of the growing annuity

C = Initial cash flow
r = Interest rate
g = Growth rate
t = # of time periods

Example I:

Suppose you have just won the first prize in a lottery. The lottery offers you
two possibilities for receiving your prize. The first possibility is to receive a
payment of $10,000 at the end of the year, and then, for the next 15 years this
payment will be repeated, but it will grow at a rate of 5%. The interest rate is
12% during the entire period. The second possibility is to receive $100,000
right now. Which of the two possibilities would you take?

Answer:

You want to compare the PV of the growing annuity to the PV of receiving

$100,000 right now (which is, obviously just $100,000). So, here are the
numbers:

C = $10,000
r = 0.12
g = 0.05
t = 16

PV = 10,000 [(1/0.07) - (1/0.07)*(1.05/1.12)16] = $91,989.41 < $100,000,

therefore, you would prefer to be paid out right now.

Valuation of Securities
Valuation is the process of determining the worth of a security or business using the
available financial data. Securities include ordinary shares, preference shares, debentures
etc. valuation is carried out by financial experts in the market and the worth or value they
attach to a security is called intrinsic / theoretical / real value. Theoretical value forms the
basis of determining whether a security is under or overvalued in the market. The market
price of a security is determined by demand and supply mechanism in the security
exchange. This market value will either be higher or lower than the theoretical value
computed. Under or over valuation is thus determined as follows:-
 If Market value is greater than theoretical value, then security is overvalued by the
market forces
 If Market value is less than theoretical value, then security is undervalued by the
market forces
 If Market value is equal to theoretical value, then security is correctly valued
Reasons for valuation
Physical assets and financial assets may be valued for various reasons:-
1. Liquidation – assets may be valued when a firm has been liquidated to determine the
amount to be realized from sale of assets and how much can be attached to each
ordinary share
2. Mergers and Acquisitions – there is need to determine the real value of firms which
are merging in order to determine the potential synergistic effects of mergers and
acquisitions
3. Use of securities as a collateral – there is need to value ordinary shares, preference
shares etc where an investor is using these securities as a collateral or security for a
loan
4. Sale of shares - Institutional investors will require to value their shares or securities
when they want to sell them in the market
5. Quotation or listing of companies - securities are valued especially ordinary shares
when a firm is being quoted on the security exchange
6. Sale of a subsidiary or a branch - a firm will value its subsidiaries and branches when
they have to be sold to external buyers or management team
7. Tax and insurance purpose - physical assets will be valued for tax purposes e.g. in
granting capital allowances and when insuring such assets to ensure they are not
under valued

Theories / views of valuation

1. Fundamental theory
This theory states that the theoretical / intrinsic / real value of a security is equal to the
total present value of all expected future benefits from a security. The future benefits are
inform of dividends and interest. According to this theory, the value of a share will also
be influenced by other factors such as:-
 Past dividend and earnings record of the firm
 Future expected dividend pattern and activities of the firm
 The most current published financial statements and ratio analysis
 Economic conditions in the country
 Political stability in the country

2. Technical /Chartist Theory

This theory is premised on the fact that history shall repeat itself. It states that the past
price pattern /treads shall be repeated in future. The past price patterns or movement re
charted / plotted on a graph and the trend shown by the graph is expected to occur again
in future. The theory identifies three types of price patterns / trends:-
 Primary trends – this are past price movement which have been observed and plotted
for a period of more than one year
 Secondary price patterns - this are price movement which are seasonal and has been
observed for a period of less than one year e.g. on quarterly and monthly basis
 Tertiary trends – this are price patterns observed and plotted / charted for a very short
period e.g. weekly or daily price movements

3. Random Walk Theory

This theory is based on the importance of information in valuation of shares when
information relating to dividends, mergers and acquisition, financial performance of the
firm, future capital investments etc is released in the market. It is received at different
times (randomly) by the investors. Investors will also react to this information differently.
Random walk theory states that the theoretical value of a security can never be an exact
figure due to random receipt and reaction to information once it is released in the market.
Theoretical value will always revolve around particular value. It is therefore very difficult
to predict the exact price of a share. The theory leads to efficient market hypothesis
which states that when information is received in the market, it is fully and
instantaneously incorporated / integrated in the share or security prices.

Efficient Market Hypothesis (EMH)

The hypothesis dictates that should a company release bad news, this should lead to a
decline in the share price. Conversely, positive news e.g. declaration of very high
dividends should lead to an increase in share price. The speed with which this
information is reflected fully and instantaneously is used to determine the efficiency of
the security market. An efficient market should have the following features or
characteristics:-
 The share or security price should be randomly determined i.e. it is difficult to predict
the price of a security by looking at its past features or characteristics
 Information whether good or bad should be fully and quickly reflected in the security
price
 Knowledgeable or experts in the market cannot get higher or superior returns than
unknowledgeable investors. This is because trading risks fail to produce higher
returns
 Transaction costs e.g. commission paid to stock brokers are very low such that they
do not discourage buying and selling of shares

Types of efficiency
There are three types of stock market efficiency
1. Informational processing efficiency – This efficiency deals with information
contents to determine the efficiency of the market i.e. information once processed and
released in the market should be fully and instantaneously reflected in the share price
2. Allocative Efficiency – This refers to a mechanism in the economy which should
allow investors to channel their capital or funds or allocate their investments to the
most profitable opportunities. These opportunities and investments will yield
optimum returns which will eventually lead to economic prosperity
3. Operational Efficiency – this efficiency states that the transaction or trading cost
should be so low such that they do not discourage buying and selling of securities
Levels / Forms / Degrees of Efficiency
The levels of efficiency are defined by the type of information that is released in the
market. There are three levels / degrees of efficiency
1. Weak form efficiency - this is where the share price fully and instantaneously reflect
the past and historical information that has been released in the market e.g.
publication of financial reports and performance relating to the previous accounting
period
2. Semi-strong form efficiency – this is where the share prices fully and
instantaneously reflect both past and present information that has been released in the
market. Examples of present information include declaration of right issue, exit of a
particular management team / persons, declaration of dividends etc
3. Strong form efficiency – This is where the share price fully and instantaneously
reflect past, present and future information that has been released in the market.
Future information may be in form of announcement of mergers and acquisitions,
announcement of major capital investment and other major activities of the firm.
Strong form of efficiency also captures information from public and private source of
the firm or investment managers.

Methods / models of valuation of ordinary shares and business

There are various methods of valuing both public and private companies. However, the
valuation of unquoted companies is difficult unlike the valuation of quoted companies
due to the following reasons:- There is an active security exchange for quoted companies
and also there is easily available and accessible information for quoted companies due to
legal disclosure requirements by various authorities. The various methods for valuation of
ordinary shares are:-
1. Dividend yield / Gordon’s Model
2. Capital Asset Pricing Model (CAPM)

1. Dividend Yield / Gordon’s Model

This model was formulated by Myron Gordon and furthered by John Litner. It is strictly
based on the dividends paid by the firm and utilizes fundamental theory of valuation i.e.
the intrinsic value of a share is equal to the present value of the expected dividends
benefits from the share. It is usually used by small investors who are interested in
dividends and the value of their shares since they cannot influence management and
control decisions of the firm at the AGM with their small shareholding. They are
therefore interested with their value of investment and expected income from the
investment.
For the purpose of valuation of ordinary shares, the model identifies three types of firms:-
i. Zero growth firms: this is a firm whose earnings and dividends are not expected to
increase or grow in future. Therefore the DPS will be constant p.a. (annuity) in
perpetuity. The theoretical value (P0) of a share is thus determined as follows:-

d 0 (annuity )
P0  PV of annuity in perpetuity 
K e (Discountin g rate)
Where d 0  DPS of the last accounting year
K e  Required rate of return by ordinary shareholde rs
 ii. Constant / Normal growth firm: This is a firm whose earnings and dividends are
expected to grow or increase at a constant rate p.a. in perpetuity. The theoretical
value of a share is determined as follows:-

d 0 (1  g)
P0  P.V. of the firms annuity in perpetuity 
Ke - g
where d 0  DPS in the last accounting year
g  constant growth rate p.a. in perpetuity
K e  Re quired rate of return by ordinary shareholde rs
Computation of growth rate
Growth rate can be computed using two methods:-
a) Compounding method

d1v0 (1  g ) n  d1v n
Where d1v0= Dividend paid / DPS at the beginning of the first year of growth
d1vn= Dividend paid / DPS at the last year of growth
b) Retention ratio method
g  ROE * retention ratio
Example 1
The following dividend pattern relates to XYZ Ltd for the last five years
Year 2012 2013 2014 2015 2016
DPS (Sh.) 1.95 2.20 2.55 2.80 3.10
The required rate of return on equity is 18%. The shares of the firm are currently selling
at Sh. 35 in the market. Compute the theoretical value of a share and advice an investor
Madam Hesabu whether to buy the shares or not.
Example 2
XYZ limited has a dividend payout ratio of 40% and the return on equity is 15%.
Compute the growth rate
iii. Supernormal growth firm
This is a firm whose earnings and dividends are expected to grow or increase at a higher
rate in the earlier years and then stagnate at a particular growth rate in perpetuity e.g.
dividends may grow at 20% p.a. in the first five years, 15% for the next three years and
10% p.a. from year nine to infinity. The theoretical value of a share is equal to the total
PV of dividends during the supernormal growth period and after supernormal growth
period to infinity. Dividends are discounted at the required rate of return by ordinary
shareholders. The dividends being discounted are the expected dividends per period.
Examples
1. Maji maji Limited had earnings attributable to ordinary shareholders equal to Ksh.
8,800,000. The firm has 1,100,000 ordinary shares outstanding and a payout policy of
60%. The required rate of return by ordinary shareholders is16%. Required:-
a) Compute the theoretical value of a share in case of a zero growth firm
b) The value of a share if a growth rate of 7% p.a. in perpetuity is expected
c) The firm expects a growth rate of 20% p.a. for the first three years, 10% for the next
four years and 7% p.a. from year 8 to perpetuity
 2. XYZ ltd pays a DPS of Shs. 5 in the last accounting period. The DPS is expected to
grow at 10% p.a. for the next 3 years and then 8% p.a. thereafter in perpetuity. The
discounting rate is 12%. Compute the theoretical value of the share.

3. XYZ Limited paid a DPS of Sh. 10 in the last accounting period. The DPS is
expected to grow at 10% for the next three years and 8% for the next two years. An
investor expects to sell the share at the end of year five for Sh. 53. The share is
currently selling at Sh.90 in the market. Determine whether it is overvalued or
undervalued urgently for an investor who intends to dispose the share at the end of
year five. Assume cost of equity is 14%.

4. The dividend per share of Mavazi Limited as at 31 December 2016 was Sh.2.50. The
company’s financial analyst has predicted that dividends would grow at 20% for five
years after which growth would fall to a constant rate of 7%. The analyst has also
projected a required rate of return of 10% for the equity market. Mavazi’s shares
have a similar risk to the typical equity market. Determine the intrinsic value of
shares of Mavazi Ltd. As at 31 December 2016.
2. Capital Assets Pricing Models (CAPM)
CAPM is used to establish the relationship between the risks and returns of a particular
security or instrument. It is used in conjunction with Gordon’s model of valuation.
CAPM is only used to establish the required rate of return or the discounting rate in an
efficient market using the following formula:
K e  R f  ( Rm  R f )  e
where R f  Risk free rate  interest rate on treasur y bills
 e  equity beta factor whi ch is used to measure systematic risks
R m  Market rate of return of an efficient portfolio i.e. a combinatio n of invetsment s
that yield the highest return at a particular level or risk
K e  required rate of return on equity capital
CAPM assumes that the market is efficient and hence unsystematic risks does not exist. It
is therefore only concerned with systematic risks which is measured by beta factor.

Example
XYZ Limited had the following amount o earnings after tax for the last five years
Year 2012 2013 2014 2015 2016
Earnings after tax ‘000’ 3000 3240 3420 3816 4000
st
The firm does not have preference share capital. For the year ending 31 December 2016,
the firm had 800,000 ordinary shares outstanding and has always retained 20% of its
earnings after tax. The rest is paid out as dividends. In the year 2016, dividends are
expected to grow at a constant growth rate p.a. in perpetuity equal to th growth rate in the
last five years. Interest rate on treasury bills is 10% and the average market return is 15%.
The equity beta for the firm is 0.8. Required: Compute the theoretical value of each
ordinary share.
Basic assumptions of CAPM
1. Investors are rational and they choose among alternative portfolios on the basis of
each portfolio's expected return and standard deviation.
2. Investors are risk averse.
3. Investors maximise the utility of end of period wealth. Thus CAPM is a single period
model.
4. Investors have homogeneous expectations with regard to asset return. Thus all
investors will perceive the same efficient set.
5. There exist a risk-free asset and all investors can borrow and lend at this rate.
6. All assets are marketable and perfectly divisible.
7. The capital market is efficient and perfect.

Limitations of CAPM
CAPM has several weaknesses e.g.
a. It is based on some unrealistic assumptions such as:

i. Existence of Risk-free assets

ii. All assets being perfectly divisible and marketable (human capital is not
divisible)
iii. Existence of homogeneous expectations about the expected returns
iv. Asset returns are normally distributed.
b. CAPM is a single period model—it looks at the end of the year return.
c. CAPM cannot be empirically tested because we cannot test investors expectations.
d. CAPM assumes that a security's required rate of return is based on only one factor
(the stock market—beta). However, other factors such as relative sensitivity to inflation
and dividend payout, may influence a security's return relative to those of other securities.

VALUATION OF FIXED RETURN SECURITIES

These are instruments which have a fixed rate of return which is determined at the time
when they are purchased. They include debentures and bonds and preference shares. The
fixed rate of return on these securities is called the coupon rate. The benefits or income
from these securities is based on the coupon rate and the par value.
Valuation of preference shares
Preference shares are usually perpetual since they do not have a definite maturity period.
They remain outstanding as long as the firm is a going concern. The constant preference
dividend per share is an annuity and hence the theoretical value of a preference share can
be determined as follows:-
dp Constant DPS Annuity
P0     PV of annuity in perpetuity
k p Discountin g Rate Kp
where d p  preference DPS p.a. in perpetuity
Kp  Required rate of return by preference shareholde rs
Valuation of debentures
A debenture is a long term promising note issued by the borrower of money to the lender
stating the borrower’s indebtness to the lender. It forms the basis of a loan agreement and
it is a legal document which the lender will use as a supporting legal document and
 evidence in case the borrower defaults on the payments of periodic interest and the
principal at maturity. Debentures are of two types:-
i. Irredeemable / perpetual debentures
Their valuation is similar to that of perpetual preference shares. These debentures pay an
equal periodic interest income which is an annuity. Their theoretical value (V d) can thus
be determine as follows:-
interest
Vd  present va lue of annuity in perpetuity 
Kd
where interest  is the constant fixed interest income
K d  required rate of return by debenture / bond holders
ii. Redeemable debentures
This has a definite maturity period and their theoretical value is equal to the total present
value of periodic interest income and maturity / redemption value. The two streams of
income are disounted at the market yield / interest rate. E.g. debenture denoted as 15%, 5
years Shs. 1000 means coupon rate = 15%, maturity period = 5 years, par value = Sh.
1000 and periodic interest income = 1000*0.15= 150 p.a. for 5 years.
The valuation of ordinary shares is more complicated than the valuation of bonds and
preference shares. The following factors complicate the valuation of ordinary shares.
 Uncertainty of dividend unlike interest charges and preference dividends which
are certain
 The data for valuation of ordinary shares is historical which may not reflect
future expectations.
 A constant stream of dividends per share is assume
 The growth rate is assumed constant and is computed from past dividends.
 The cost of equity/required rate of return on equity is assumed to be constant
though it changes over time.

Examples
1. Mr. X is holding a five year 13% Sh.1000 debenture and the current market yield is
10%. Compute the issue price of the bond

2. ABC limited has a 10 year 12% Sh. 1000 bonds. The interest is paid semi-annually and
the current market interest rate is 16% p.a. compute the theoretical value of the bond
3. The most recent financial data for the Rare Watts disclose the following:

Dividend per share Sh.3.00

Expected annual dividend growth rate 6 percent
Current required rate of return 15 percent

The company is considering a variety of proposals in order to redirect the firm’s

activities. The following four alternatives have been suggested:

1. Do nothing in which case the key financial variables will remain

unchanged.
 2. Invest in venture that will increase the dividend growth rate to 7% and
lower the required rate of return to 14%.
3. Eliminate an unprofitable product line. The action will increase the
dividend growth rate to 8% and raise the required rate of return to 17%.
4. Acquire a subsidiary operation from another company. This action will
increase the dividend growth rate to 9% and required rate of return to
18%.
Required
For each of the proposed actions, determine the resulting impact price and recommend
the best alternative.

COST OF CAPITAL

Cost of capital refers to the required rate of return by various investors who have
contributed capital to the company. These investors include preference shareholders,
ordinary shareholders and debenture holders. The cost is paid by the firm in form of
dividends and interests to various investors. The cost of capital or required rate of return
consists of three elements or components: Real rate of return (R r), Inflation premium (Ip)
and risk premium (Rp).
R f  Rr  I p
Cost of capital / required rate of return  Rr  I p  R p  R f  R p
where
Rf 
Risk free rate which refers to interest rate in riskless investments or securities
such as government treasure bills and bonds
Rr  This is the risk free rate if there was no inflation in the economy
I P  This is the inflation premium added to real rate in order to compensate the investors
for the decline in purchasing power of money caused by inflation
Rp 
Is a rate added to the risk free rate for an investor taking a risk to invest in a firm
which :-
 Can be liquidated hence lose this investments
 Can default in payment of periodic interest and principal on maturity
 Bring uncertainty with regard to the expected returns e.g. ordinary dividends

Method of computing cost of capital

1. Dividends yield / Gordon’s Model
This is based on the principles of valuation where the required rate of return used in
valuation of various securities becomes the subject matter of the formulae. It can be used
to determine the required rate of return or cost of capital of:-
i. Ordinary share capital for zero and constant growth firms
[Link] share capital
[Link] / irredeemable debentures
[Link] of retained earnings

(a) Ordinary share capital for zero and constant growth firms
 i. Zero growth firm

d 0 (annuity ) d
P0  Ke  0
K e (Discountin g rate) P0
ii. Cost of ordinary share capital for normal / constant growth firm

d 0 (1  g) d 0 (1  g )
P0  Ke  g
Ke - g P0
(b) preference share capital

dP dp
Pp  Kp 
Kp Pp
Where dp – preference DPS per annum in perpetuity, P p – MP of preference shares and K p
– required rate of return on preference share capital
(c) Cost of perpetual debentures
interest Interest
Vd  Kd  1  T 
Kd Vd
Where int – interest changes p.a. in perpetuity, K d – cost of debt capital and Vd – MV of
debenture unit.
The cost of debt capital is subjected to the factor (1-T) where T is corporate tax rate.
Because interest charges are tax allowable or deductible hence gives the firm the benefit
of paying less tax which is called interest tax shield. Interest tax shield = interest charges
* corporate tax rates
Example
Two firms Kip Ltd and Limo Ltd has their capital structure as follows:-
Kip ‘000’ Limo ‘000’
Ordinary share capital 2000 1500
Retained earnings 1000 1000
10% long term debt - 1000
Total capital 3000 3500
Both firms made operating profits of Sh. 1,000,000 and they are in 30% corporate tax
brackets. Determine the interest tax shield enjoyed by Limo Ltd for use of debt capital.
(d) Cost of retained Earnings (Kr)
Ideally, the firm should pay all its earnings after tax as dividends. However, they pay
only a portion of EAT or dividends and retain the rest for future investments. When a
shareholder receives the dividends it is invested in other investments to generate a
particular rate of return.
The amount invested by the firm i.e. retained earnings should generate a return at least
equal to the return of the shareholder from investment of dividend. Essentially, the cost of
retained earnings is the opportunity cost to ordinary shareholders for not getting the
dividends and hence foregoing the returns associated with the retained earnings. The cost
of retained earnings (Kr) is thus equal to the cost of ordinary share capital in case of a
zero and constant growth firm.

i. Zero growth firm

 d0
Kr 
P0
ii. For constant growth firm

d 0 (1  g )
Kr  g
P0
Cost of redeemable debentures
The cost of perpetual securities is called current yield/ flat yield / running yield. It does
not take into consideration the capital gains associated with a security. The cost of
redeemable securities e.g. debentures is called yield to maturity or redemption yield. It
considers the capital gains or loss associated with a security. It is equivalent to the IRR
and can be determined using two methods:-
i. Approximation method
The yield to maturity (YTM) or (RV)
1
The yield to maturity (YTM) or (RV = Int + (M-Vd) n (1-T)
1
(M+Vd) 2
Where Int – period interest charges M – maturity / redemption value
Vd – market value of a debenture unit n – number of years to maturity
T – Corporate tax rate
Example
XYZ Limited has a 3 year 12% Sh. 1000 debenture which is redeemable at par. The
current market value of debenture unit is Sh. 950. Compute the yield to maturity
assuming a corporate tax of 30%.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
This is also called the overall or composite cost of capital. It is based on two elements
/components: cost of each component of capital and weight or proportion of each of the
component to total capital. Alternatively,
Total cost of all sources / components of capital
WACC 
Total Capital
Example
The following relates to XYZ Limited as at 31st December 2016
Sh. ‘000’
Ordinary share capital 5,000
10% preference share capital 3,000
12% debenture 2,000
10,000
Assume the cost of equity (ke) is 15% and the firm has a corporate tax rate of 40%.
Compute WACC using the book values given in the capital structure .
What values should be used to determine the weights and cost of capital
There are three types of values of capital that may be used to determine the cost of capital
and the respective proportions or weights in the capital structure.
i. Book values
Book values reflect the value of capital when it was raised in the past. It is therefore
historical and the % costs do not reflect the current market conditions under which new
capital may be raised. They are not popular since they are historical.
ii. Market values
These are most popular for determining WACC since reflect the market conditions under
which new capital may be raised. However, market values keep on changing from one
day to another according to demand and supply forces in the security exchange e.g.
 Market value of equity (ordinary share capital +retained earnings) = number of
ordinary shares * MPS (ex-div)
 Market value of preference share capital = Number of preference shares * market
price per preference share (ex-div\0
 Market value of debt capital = number of debenture unit *market value of debt
unit (ex-interest)
Note: when using market values to compute the cost of equity of capital and WACC, the
cost of retained earnings is not computed on its own but included in the cost of ordinary
share capital since the market value (MPS) in the security exchange already reflects the
effects of retained earnings in the capital structure.

iii. Target market values

These are based on the projected market price per share. They are not popular because it
is difficult to predict future market value of a firm since the factors that influence MPS
keep on changing
Examples
1. The following information was obtained from the books of Mwangi ltd for the
year ended 31st December 2018.

Capital structure
As at 31.12.2018
Ksh
Ordinary share capital(par value ksh 30)
4,600,000
8% preference shares (par value ksh 25)
3,400,000
15% debentures stock (issue price ksh 100)
800,000
20% bank loan
2,200,000
Additional information;
i. The market price is as follows
 Ordinary shares ksh 50
 8% preference shares ksh 22
 15% debentures ksh 90
 ii. The company has maintained a dividend per share of ksh 5 per annum and it is
expected to grow in perpetuity at 2%
iii. Corporation tax is at 30%.

Required
a) Compute the cost of each source of capital
b) Calculate the Weighted Average Cost of Capital
2. A local company XYZ ltd. has a capital structure of KShs. 19,200,000 composed
of ordinary share capital, preference shares, bank Loan and Debentures as shown
below.

Source of capital Amount

Ordinary shares capital (par value Shs. 20) 9,600,000
8% preference share capital (par Value 12) 3,840,000
18% Bank Loan 3,360,000
20% Debenture (par value shs. 90) 2,400,000
The market price of the company securities is given as below:
Source of Capital MPS(Shs)
Ordinary Shares 64.00
8% preference shares 30.00
20% Debenture 90.00
The company has maintained payment of ordinary share dividend of Kshs. 4 per share
and this is expected to grow at a constant rate into perpetuity. The company has a policy
of a constant payout ratio of 60% and a return on equity of 12%. Assuming a tax rate of
40%.
Required
i. Cost of ordinary share capital
ii. Cost of 8% preference share capital
iii. Cost of 18% bank loan
iv. Cost of 20% debentures
v. Determine the weighted average cost of capital (WACC) for the company
3. The following is the capital structure of XYZ Ltd as at 31/12/2016.

Shs.M
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par 100
value 200
12% debenture Sh.100 par value 900
Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS =
Par value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the
market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected
to grow at 5% p.a. in future. The current MPS is Sh.40.
Required
a) Determine the WACC of the firm.
4. Biashara Ltd. has the following capital structure:

Sh.’000’
Long-term debt 3,600
Ordinary share capital 6,500
Retained earnings 4,000
The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45
million. He has proposed the following method of raising the funds:
 Utilise all the existing retained earnings
 Issue ordinary shares at the current market price.
 Issue 100,000 10% preference shares at the current market price of Sh.100
per share which is the same as the par value.
 Issue 10% debentures at the current market price of Sh.1,000 per
debenture.
Additional information:
1. Currently, Biashara Ltd. pays a dividend of Sh.5 per share which is
expected to grow at the rate of 6% due to increased returns from the
intended project. Biashara Ltd.’s price/earnings (P/E) ratio and earnings
per share (EPS) are 5 and Sh.8 respectively.
2. The ordinary shares would be issued at a floatation cost of 10% based in
the market price.
3. The debenture par value is Sh.1,000 per debenture.
4. The corporate tax rate is 30%.
Required: Biashara Ltd.’s weighted average cost of capital (WACC).
5. Zatex Ltd. had the following capital structure as at 31 March 2017:

Shs.
Ordinary share capital (200,000 shares) 4,000,000
10% Preference share capital 1,000,000
14% Debenture capital 3,000,000
8,000,000

Additional information:
1. The market price of each ordinary share as at 31 March 2017 was Shs. 20.
2. The company paid a dividend of Shs. 2 for each ordinary share for the year
ended 31 March 2017.
3. The annual growth rate in dividends is 7%.
4. The corporation tax rate is 30%.

Required:
(i) Compute the weighted average cost of capital of the company as at 31
March 2017.
(ii) The company intends to issue a 15% Shs. 2 million debenture during the
year ending 31 March 2018. The existing debentures will not be affected
by this issue. The dividend per share for the year ending 31 March 2018 is
expected to be Shs. 3 while the average market price per share over the
same period is estimated to be Shs. 15. The average annual growth rate in
 dividends is expected to remain at 7%. Compute the expected
weighted average cost of capital as at 31 March 2018.

Weaknesses of WACC as a discounting rate

WACC/Overall cost of capital has the following problems as a discounting rate:
 It can only be used as a discounting rate assuming that the risk of the project is equal
to the business risk of the firm. If the project has higher risk then a percentage
premium will be added to WACC to determine the appropriate discounting rate.
 It assumes that capital structure is optimal which is not achievable in real world.
 It is based on market values of capital which keep on changing thus WACC will
change over time but is assumed to remain constant throughout the economic life of
the project.
 It is based on past information especially when determining the cost of each
component e.g in determining the cost of equity (Ke) the past year’s DPS is used
while the growth rate is estimated from the past stream of dividends.
Note
When using market values to determine the weight/proportion in WACC, the cost of
retained earnings is left out since it is already included or reflected in the MPS and thus
the market value of equity. Retained earnings are an internal source of finance thus,
when they are high there is low gearing, lower financial risk and thus highest MPS.

ANALYSIS OF FINANCIAL STATEMENTS

Financial analysis is a process by which finance identifies the company’s financial
performances by comparing the entities in the financial statements and those in the
income statements. This analysis is important to various parties with a financial stake in
the company. These include:
1. Shareholders – Actual owners are interested in the company’s both short and long
term survival. For this reason they will use ratio’s such as:

i. Profitability ratios – which seek to establish viability.

ii. Dividend ratios – which seek to establish return to owners in form of

dividends. The common ratios include earning yield (E/Y), Dividend pay out
ratio (DPO), dividend yield, Price earnings ratio, all of which will measure
return to owner.

2. Creditors (trade) – these are interested in the company’s ability to meet their short-
term obligations as and when they fall due. For this reason they will use ratios such
as:

i. Liquidity ratio – a qualitative measure of company’s liquidity position

measured by acid test ratio.
 ii. Current ratio – which is a measure of company’s quantity of current assets
against current liabilities.

3. Long term lenders – These include finances through loans, mortgages and debenture
holders. These have both short and long term interest in the company and its ability
to pay not only interest on debt but also principal as and when it falls due. These
parties are interested in the following:

i. Liquidity ratios – used to assess short-term liability to meet current

obligations.

ii. Profitability ratios – used to ascertain whether the company can pay its
principal back.

iii. Gearing ratio – used to gauge the company’s risk in the investment.

iv. Investment coverage ratio – shows the company’s safety as regards the
payment of interest to the lenders of the debt.

4. Directors and management of company – They will therefore be interest in:

i. Efficiency of the company in generating profits.

ii. The company’s viability from the investor’s point of view and the company’s
ability to generate sufficient returns to investors.

iii. Gearing ratio to gauge the safety and risk associated with the company.

5. Potential investors – these parties are interested in a company in total both on short
and long term basis in particular the company’s ability to generate acceptable return
on their money. Therefore, they will use:

a) Dividend ratios
b) Return ratios
c) Gearing ratios
6. Government – The Government is interested mostly in utility companies (e.g. KPLC,
KPTC) and those that will provide public services – in this case the government will
be interested in their survival and thus ability to provide those services. It may be
interested in taxation derived from these companies which is used for development.
Government may also be interested in employment level and as such it will use those
ratios that can enable it to achieve such objectives of particular importance are:

a) Profitability ratios
b) Return ratios
7. Competitors – These are interested in the company’s performance from the market
share point of view and will use the ratios that enable them to ascertain company’s
competitive strength e.g. profitability ratios, sales and returns ratio etc.
8. General public – Customers and potential customers – These are interested in the
ability of the company to provide good services both in the short and long run. To
gauge the company’s ability to provide goods and services on short and long term
basis. We have:

a) Returns ratio

b) Sales ratio

Yard Stick Used In Ratio Analysis

1. Past performance of the company: The company’s past performance (past ratio) is
used to measure or gauge the company’s performance and in particular the change in
performance whether good (favourable), better, same or even worse than the past.
Such comparison is then used to interpret the company’s performance bearing in
mind the factors that influenced the present and past performances.

2. Average industry ratios: These are useful as they indicate the average performance
of various companies in a given industry i.e. it gives the minimum performance of a
number of companies in a given industry. These ratios are useful in so far as to
enable the analyst to make a reasonable comparison of the company’s performance
vis-à-vis other companies in the same industry. However, for this yardstick to be
useful the term average should include those companies which are not extremely. I.e.
very strong and very weak companies – which should be excluded to arrive at
industry average figures.

3. Ratio of successful companies: Useful if the company can get figures of competitors
who are leading in the market so as to enable it to gauge its performance against
better performance. However this information is difficult to obtain and sometimes it
calls for private investigators e.g. Private Eyes Ltd.

4. Ratio of budgeted performance: These are compared with actual performance ratios
and investigations are made of any unfavorable variance which should be explained.

Classification of Ratios
Ratios are broadly classified into 5 categories:
1. Liquidity ratios
2. Turnover ratios
3. Gearing ratios
4. Profitability ratios
5. Growth and valuation ratios

1. Liquidity Ratios
They are also called working capital ratios. They indicate ability of the firm to meet its
short term maturing financial obligation/current liabilities as and when they fall due. The
ratios are concerned with current assets and current liabilities. They include:
a) Current ratio = Current Assets
Current liabilities
This ratio indicates the No. of times the current liabilities can be paid from current assets
before this assets are exhausted. The most recommended ratio is 2.0 i.e. the current asset
must at least be twice as high as current liabilities

b) Quick/acid test ratios = Current Asset - Stock

Current liabilities
Is a more refined current ratio which exclude amount of stock of the firm. Stocks are
excluded for two basic reasons i.e. they are valued on historical cost basis and they may
not be converted into cash very quickly. The ratio therefore indicates the ability of the
firm to pay its current liabilities from the more liquid assets of the firm.

c) Cash ratio = Cash in hand/bank + short term marketable

securities
Current liabilities
This is a refinement of the acid test ratio indicating the ability of the firm to meet its
current liabilities from its most liquid resources. Short term marketable securities refers
to short term investment of the firm which can be converted into cash within a very short
period e.g commercial paper and treasury bills.

d) Net working capital Ratio = Net working Capital x 100

Net Assets
Where Net Assets or Capital employed = Total Assets – Current liability
This ratio indicates the proportions of total net assets which is liquid enough to meet the
current liabilities of the firm. It is expressed in % term.

2. Turnover Ratios/efficiency/asset management ratio

Turnover ratio indicate the efficiency with which the firm utilized the asset or resources
at its disposal to generate sales revenue or turnover. This ratio includes:
a) Stock/inventory turnover = Cost of Sales
Average stock

The ratio indicate number of times the stock was turned into sales in a year i.e how many
times did the ‘buy-sell’ process occur during the year. The higher the stock turnover, the
better the firm and more likely the higher the sales.

b) Stock holding period = 365 days

Stock turnover

= 365 x Average stock i.e 365

Cost of sales Stock turnover

The ratio indicates number of days the stock was held in the warehouse before being sold.
The higher the stock turnover, the lower the stock holding period and vice versa.
 c) Debtors/accounts receivables turnover = Annual credit sales
Average debtor
The ratio indicate the number of times/frequency with which credit customers or debtors
were turned into sale i.e the number of times they come to buy on credit per year after
paying their dues to the firm. The higher the debtors turnover the better the firm
indicating that customers came to buy on credit many times thus they paid within a short
period.

d) Debtors collection period = 365

Debtors turnover

or 365 x Average debtors

Annual credit sales

This refers to credit period that was granted to the debtors on the period within which
they were supposed to pay their dues to the firm. The shorter the collection period/credit
period the higher the debtors turnover and vice versa. If no opening debtors are given use
the closing debtors to represent average debtors.

e) Creditors/accounts payable turnover = Annual credit purchases

Average creditors
The firm buy goods on credit from suppliers. The ratio indicate number of times p.a. the
firm bought goods on credit after paying the suppliers. If the creditors turnover is high,
this indicates that the payment was made within a short period of time.

f) Creditors payment period = 365

Creditors’ turnover

= 365 x Average creditors

Annual credit purchases
The ratio indicates the credit period granted by the suppliers i.e. the period within which
the firm should pay its liabilities to the suppliers. The shorter the period, the higher the
creditors turnover and vice-versa.

g) Fixed asset turnover = Annual Sales

Fixed Assets
This ratio indicate the efficiency with which, the fixed assets were utilized to generate
sales revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilized to generate
Sh.1.4 of sales.

h) Total asset turnover = Annual sales

Total assets
The ratio indicate amount of sales revenue generated from utilization of one shilling of
total asset.

The Concept of Working Capital/Cash Operating Cycle

Working capital cycle refers to period that elapses between the payment for raw materials
bought on credit (cash outflows) and the receipts of cash from finished goods sold on
credit (cash inflows). The working capital cycle will involve the following:
a) Purchase of raw materials on credit from suppliers
b) Payment of raw materials after the lapse of credit period
c) Conversion of raw materials into finished goods
d) Sale of finished goods to creditors
e) Receipt of cash from debtors.

This can be illustrated using a diagram as follows:

Raw material stock conversion period

Creditors Payment Period Debtors Collection Period

A B C D
Purchase of Payment of Finished goods Receipts
of
Raw materials raw materials sold on credit cash goods
On credit cash outflow sold on credit
Cash inflows

Working Capital Cycle

Working capital cycle = Stock conversion + debtors collection – Creditors payment

From the diagram the working capital cycle of a period will be determined as follows:

Stock conversion period + Debtors collection period – Creditors payment period

Note
A lengthy working capital cycle is an indicator of poor management of stock and debtors
reflecting low turnover of stock and debtors and lengthy stockholding period and debtor’s
collection period.

The working capital cycle can be reduced in any of the following ways:
1. Negotiate for a longer credit period with the suppliers
2. Reduce the stock conversion period or manufacturing period.
3. Reduce the debtors’ collection period by granting short crediting period. This can
be achieved through offering discounts to customers to encourage them to pay
earlier.
4. Holding fast moving goods to ensure high turnover.
5. Timely delivery of raw materials by suppliers especially if any delay in delivery
will lengthen the raw materials holding period.
3. Gearing/Leverage/Capital Structure Ratio

The ratio indicates the extent in which the firm has borrowed fixed charge capital to
finance the acquisition of the assets or resources of the firm. The two basic gearing ratios
are:

a) Debt/equity ratio = Fixed charge capital

Equity (net worth)
This ratio indicate the amount of fixed charge capital in the capital structure of the firm
for every one shilling of owners capital or equity e.g. a ratio of 0.78 means for every Sh.1
of equity there is Sh.0.78 fixed charge capital.
b) Fixed charge to total capital ratio = Fixed charge capital
x 100
Total capital
employed
Where total capital employed = Fixed charge capital + equity relative to total capital
employed by the firm e.g. a ratio of 0.38 means that, 38% of the capital employed is fixed
charge capital.

Other leverage or gearing ratios are

a) Debt ratio = Total debts

Total assets
Where total debt = fixed charge capital + liabilities.
The ratio indicate the proportion of total assets that has been financed using long term
and current liabilities e.g a debt ratio of 0.45 mean 45% of total asset has been financed
with debt while the remaining 55% was financed with owners equity/capital.

b) Times interest earned ratio (TIER) = Operating profit (earnings before interest
and tax
Interest Charges

TIER also called interest coverage ratio. This ratio indicates the number of times interest
charges can be paid from operating profit. The higher the TIER, the better the firm,
indicating that either the firm has high operating profits or its interest charges are low. If
TIER is high due to low interest charges, this indicates low level of gearing/debt capital
of the firm.

4. Profitability Ratio
This ratio indicates the performance of the firm in relation to its ability to derive returns
or profit from investment or from sale of goods i.e profit margin or sales.

1. Profitability in relation to sales

The ratio indicates the ability of the firm to control its cost of sales, operating and
financing expenses. They include:

a) Gross profit margin = Gross profit x 100

Sales

The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit
margin of 40% means 60% of sales revenue was taken up by cost of sales while 40% was
the gross profit.

b) Operating profit margin = Operating profit/Earning before interest &

tax
Sales
The ratio indicates ability of the firm to control its operating expenses such as distribution
cost, salaries and wages, travelling, telephone and electricity charges etc. e.g a ratio of
20% means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit

c) Net profit margin = Net profit x 100 (earning after tax) + interest
Sales
This ratio indicates the ability of the firm to control financing expenses in particular
interest charges e.g. Net profit margin of 10% indicate that:
i) 90% of sales were taken up by cost of sales, operating and financing expenses
ii) 10% remained as net profits.

2. Profitability in relation to investment

a) Return on Investment (ROI) = Net profit x 100

or return on total asset (ROTA) Total asset
The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of
20% means Sh.10 of total asset generated Sh.2 of net profit.

b) Return on equity (ROE) = Net profit x 100

or Return on net worth (RONW) equity
or Return on shareholders equity (ROSE)
The ratio indicate the return of profitability for every one shilling of equity capital
contributed by the shareholders e.g a ratio of 25% means one shilling of equity generates
Sh.0.25 profit attributable to ordinary shareholders.

c) Return on capital employed ROCE = Net profit x 100

or Return on net asset (RONA) Net Asset (Capital employed)
This ratio indicates the returns of profitability for every one shilling of capital employed
in the firm.

5. The Growth and Valuation Ratio

This ratio indicates the growth potential of the firm in addition to determining the value
of the firm and investment made by various investors. They include the following:

a) Earnings per share EPS = Earnings to Ordinary shareholders

No. of ordinary shares
This ratio indicates earnings power of the firm i.e how much earnings or profits are
attributed to every share held by an investor. The higher the ratio, the better the firm.

b) Earnings yield (EY) = Earnings per share x 100

Market price per share
The market price per share (MPS) is the price at which new shares can be bought from
the stock market. These ratios therefore indicate the returns or earnings for every one
shilling invested in the firm.

c) Dividends per share (DPS) = Dividend paid

No. of ordinary shares
This indicates the cash dividend received for every share held by an investor. If all the
earnings attributable to ordinary shareholders were paid out as dividend, then EPS =
DPS.

d) Dividend Yield (DY) = Dividend per share x 100

Market price per share
Or Dividend paid
Market value of equity

Where market value of equity = No. of shares x MPS

This ratio indicates the cash dividend returns for every one shilling invested in the firm.

e) Price earnings (P/E) = Market price per share (MPS)

Ratio Earning per share
OR
= Market value of equity
Earning to Ord. Shareholders
P/E ratio is a reciprocal of earning yield (EY). The MPS is the price at which a new
share can be bought i.e investment per share. The EPS is the annual income/earnings
from each share. PE therefore indicate the payback period i.e number of years it will
take to recover MPS from the annual earnings per share of the firm.

f) Dividend cover = EPS = Earning to ordinary shares

DPS Dividend paid

This indicate the number of times dividend can be paid from earnings to ordinary
shareholders. The higher the DPS the lower the dividend cover and vice-versa e.g
consider the following two firms X and Y

X Y
EPS 12/= 12/=
DPS 3/= 5/=
Dividend cover 12 = 4 12 = 2.4 times
 3 5

g) Dividend payout ratio = DPS x 100 = Dividend paid

EPS Earning to ordinary
shareholder
This is the reciprocal of dividend cover. It indicates the proportion of earnings that was
paid out as dividend e.g a payout ratio of 40% means 60% of earnings were retained
while 40% was paid out as dividend, therefore retention ratio = 1 – dividend payout ratio

h) Book value per share = Net worth Equity

(BVPS) No. of ordinary shares
This is also called liquidity ratio which indicates the amount attributable to each share if
the firm was liquidated and all asset sold at their book value. The ratio is based on the
residual amount which would remain after paying all liabilities from the sales proceeds of
the assets.

i) Market to book value per share = MPS

BVPS
This ratio indicates the amount of goodwill attached to the firm i.e. the price in excess of
the sales value of the assets of the firm. If the ratio is greater 1(MBVPS >1) this indicate
a positive goodwill while if less than 1 a negative goodwill.

Uses/Application of Ratios
Ratios are used in the following ways by managers in various firms.
1. Evaluating the efficiency of assets utilization to generate sales revenue i.e.
turnover ratio.

2. Evaluating the ability of the firm to meet its short term financial obligation as and
when they fall due (liquidity ratios).

3. To carry out industrial analysis i.e. compare the firm’s performance with the
average industrial performance of the firm with that of individual competitors in
the same industry.

4. For cross sectional analysis i.e. compare the performance of the firm with that of
individual competitors in the same industry.

5. For trend/time series analysis i.e. evaluate the performance of the firm over time.

6. To establish the extent which the assets of the firm has been financed by fixed
charge capital i.e. use of gearing ratio

7. To predict the bankruptcy of the firm i.e. use of selected ratios to determine the
overall ratio usually called Z-score. The Z-score when compared with a pre-
determined acceptable a Z-score will indicate the probability of the bankruptcy of
the firm in future.
Limitations of Ratios
Ratios have the following weaknesses:
1. They ignore the size of the firm being compared e.g in cross-sectional analysis,
the firm being compared might be of different size, technology and product
diversification.
2. Effect of inflation:
Ratio ignores the effect of inflation in performance e.g increase in sales might be
due to increase in selling price caused by inflationary pressure in the economy.
3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g important
assets such as corporate image, efficient management team, customer loyalty,
quality of product, technological innovation etc are not captured in ratio analysis.
4. Ratios are computed only at one point in time i.e they are subject to frequent
changes after computation e.g liquidity ratios will constantly change as the cash,
debtors and stock level changes.
5. Monopolistic firms
It is difficult to carry out industrial and cross-sectional analysis for monopolistic
firms since they do not have competitors and they are the only firms in the whole
industry e.g Telkom-Kenya, East Africa Brewery etc.
6. Historical Data – Ratios are computed in historical information or financial
statement thus may be irrelevant in future decision-making of
7. Computation and interpretation
Generally some ratios do not have an acceptable standard of computation. This
may differ from one industry to another. E.g the return on investment may be
computed as:

Return on investment = EBIT or EAT

Total assets Total assets

8. Different accounting policies – Different firms in the same industry use different
accounting policies e.g methods of depreciation and stock valuation. This makes
comparison difficult.
EXAMPLES
1. Rafiki Hardware Tools Company Limited sells plumbing fixtures on terms of
2/10 net 30. Its financial statements for the last three years are as follows:

2015 2016 2017

Sh’000’ Sh’000’ Sh’000’

Cash 30,000 20,000 5,000

Accounts receivable 200,000 260,000 290,000

Inventory 400,000 480,000 600,000

Net fixed assets 800,000 800,000 800,000

1,430,000 1,560,000 1,695,000

 Accounts payable 230,000 300,000 380,000

Accruals 200,000 210,000 225,000

Bank loan, short term 100,000 100,000 140,000

Long term debt 300,000 300,000 300,000

Common stock 100,000 100,000 100,000

Retained earnings 500,000 550,000 550,000

1,430,000 1,560,000 1,695,000

Additional information:

Sales 4,000,000 4,300,000 3,800,000

Cost of goods sold 3,200,000 3,600,000 3,300,000

Net profit 300,000 200,000 100,000

Required
Evaluate the financial position of Rafiki hardware tools company

(i) Liquidity ratios

(ii) Activity ratios

(iii) Profitability ratios

2. The following financial statements relate to the ABC Company:

Assets Shs. Liabilities & Net Shs.

worth
Cash 28,500 Trade creditors 116,250
Debtors 270,000 Notes payable (9%) 54,000
Stock 649,500 Other current liabilities 100,500
 Total current assets 948,800 Long term debt (10%) 300,000
Net fixed assets 285,750 Net worth 663,000
1,233,750 1,233,750

Income Statement for the year ended 31 March 2017

Shs.
Sales 1,972,500
Less cost of sales 1,368,000
Gross profit 604,500
Selling and administration 498,750
expenses
105,750
Earnings before interest and tax
34,500
Interest expense
71,250
28,500
Estimated taxation (40%)
42,750
Earnings after interest and tax
Required
a) Calculate:
i. Inventory turnover ratio;

ii. Times interest earned ratio;

iii. Total assets turnover;

iv. Net profit margin

b) The ABC Company operates in an industry whose norms are as follows:

Ratio Industry Norm
Inventory turnover 6.2 times
Times interest earned ratio 5.3 times
Total assets turnover 2.2 times
Net profit margin 3%
Required
Comment on the revelation made by the ratios you have computed in part (a) above when
compared with the industry average.
3. The following information has been extracted from the published accounts of
Pesa Corporation Limited, a company quoted on the Nairobi Stock Exchange.
Shs.
Net profit after tax and interest 990,000
Less: dividends for the period 740,000
Transfer to reserves 250,000
Accumulated reserves brought forward 810,000
Reserves carried forward 1,060,000

Share capital (Sh.10 par value) Sh.8,000,000

Market price per share now 12%

Required
Calculate for Pesa Corposation Limited the following ratios and indicate the importance
of each to Miss Hisa, a Shareholder: Earnings per share, Price earnings ratio, Dividend
yield, Dividend cover and Book Value per share
4. The executive director of Pesa Ltd has circulated the following information as
part of board paper:
Pesa Ltd.
Financial Performance for the year ended 31 March:
2017 2016
i) Return on investment 12% 10%
ii) Gross profit on sales 25% 20%
iii) Number of days credit given 30 days 45 days
iv) Administrative cost of sales 7% 10%
Required
a) Brief report on each of the above 4 ratios indicating the reservation, if any,
you may have or judging them as improvement in performance.
b) Tajiri Ltd has sales of Sh.20,000,000 in 1998. Beginning and closing
stock was Sh.800,000 and Sh.2,200,000 respectively. G.P. margin is
usually 25% of sales.
Required
i. Stock turnover ratio

ii. Number of days stock held

iii. Brief explanation on how the ratio computed in (i) above can be improved and
financial consequences of such action.