FINANCIAL MANAGEMENT NOTES

.1. Meaning of Financial Management

What is Finance?

Finance is a word that comes from the Latin word “finis”, which means “fine” or “end.” It was later used
in French to mean “payment” and “ending.” Thus, finance means to complete or end a contract. It is also
used in English to mean the management of money.

Finance can be defined as the “application of and optimal utilization of scarce resources.” It also refers to
the process of managing a large amount of money to meet individual or organizational needs. Finance
involves the processes of investment, lending, borrowing, saving, budgeting, spending, and forecasting.

Examples of finance include:

 Investing personal income in stocks, bonds, or other financial assets

 Borrowing money for personal or business use from a bank
 Lending money through mortgages or loans to individuals and businesses
 Creating a budget or financial model for a company or a government institution
 Saving personal income in interest-earning bank accounts
 Forecasting monetary needs of an organization and developing a budget for the same.

What is Financial Management?

Financial management is defined as the process of raising and allocating funds to the most productive end
user so as to achieve the objectives of a business, an individual, or a government institution.

It also means the planning, organizing, controlling and directing of financial activities to ensure efficient
utilization of resources in an organization. Financial managers apply the general principles of
management to financial resource planning and control in an organization.

1.2. Nature and Scope of Financial Management

Financial management can be broken down into several types, elements or decision areas. These decision
areas or types of financial management include:

 Investment Decisions/Capital Budgeting: investment decisions involve the allocation of financial

resources to fixed assets. In this case, the role of the financial manager tries to identify investment
opportunities that are worth more (benefits) than they cost to acquire. Capital budgeting is used to
evaluate investment risks and returns to enable an organization to make the best financing or investment
decisions, or to allocate money to viable investment projects.
 Working Capital Decisions: this involves the investment in current assets such as cash, inventory, and
receivables. It involves making decisions on how to allocate financial resources to immediate needs of the
company, such as operations and payments for daily transactions. It involves managing funds to support
current operations and meet day-to-day financial obligations.
 Dividend Decisions: This has to do with financial decisions that relate to the distribution of profits to
investors or owners of the company. Every year, a company has to make decisions on how much money
to pay to shareholders as dividends. Net profit can be distributed in two ways: first as dividends to
shareholders and secondly, as retained profits to be used in expansion and growth of the business.
 Capital Structure Decisions: Capital structure refers to the financial decisions made to determine how
investments should be funded. When choosing the methods of raising funds, the company decides on
various alternatives such as equity and loans. Capital structure refers to the ratio of debts to equity; how
much debt is used to fund investments compared to equity. A company that utilizes more debts than
equity means that they have a high leverage.

1.3. Importance of Financial Management

Financial management plays a critical role in promoting effective investment decisions and efficient
operations in an organization. It allows managers to make appropriate decisions with regard to resource
allocation to achieve organizational objectives. Financial managers are important in an organization
because they make critical decisions on how funds should be spent in line with the organization’s
strategic goals. They choose whether to invest in long term projects, pay dividends, fund daily operations,
etc.

Objectives of Financial Management

 To ensure regular and adequate provision of funds for investment and operations
 To generate returns for shareholders by focusing on earnings, share prices and shareholder expectations
 To promote optimal allocation and utilization of resources within an organization – gaining maximum
returns at the least cost.
 To ensure safe and viable investment decisions are made – achieving a good rate of returns on investment
 To ensure that the organization has the right mix of debt and equity in its capital structure
 To promote proper estimation of financial requirements by establishing financial needs and determining
whether the organization has a shortage or surplus of funds.
 To ensure timely payment of financial obligations to creditors and lenders – being able to repay debts and
promote financial commitment with lenders and creditors.

Functions of Financial Management

 Estimation of Capital Requirements: companies use financial management to estimate their capital
requirements, based on their expected income and expenditure.
 Making capital structure decisions: Financial management is used to make decisions with regards to the
short-term and long-term debts, equity, and other ways of funding investments. It helps a company to
determine the proportion of equity and debt that is appropriate for their investment decisions.
 Choosing Sources of Funds: Financial management helps a company to choose appropriate sources of
funds such as long term debts, shares, loans, or bonds.
 Investment of Funds: Financial management is also necessary to understand how firms make investment
decisions; how to allocate funds to investment projects that give the best returns.
 Disposal of Funds: Sometimes a company may have surplus money. Financial management concepts
will help them to determine the best ways of disposing them e.g. through dividend payment to
shareholders or through retained earnings for future growth and expansion.
 Cash Management: Businesses also need to make appropriate decisions on how to utilize cash to ensure
proper cash flows to manage operations, while at the same time ensuring that cash does not lie idle. Cash
is used to pay wages, bills, and current liabilities. It is also needed for the maintenance of inventory and
purchase of raw materials. Therefore, cash should be managed efficiently to ensure that the company does
not run into shortage of funds or have too much surplus that could otherwise be used to generate more
income.
 Financial Controls: Another function of financial management is to plan, acquire and utilize funds
appropriately to meet the organization’s long term goals.
 1.4. The role of financial management in production, marketing and finance

Production

Knowledge of financial management can be used in planning, organizing, and controlling resources
during the stage or production

Production department is concerned with the processes of turning inputs into finished products for sale.
Financial managers work with the production department to manage costs and set prices appropriately.

Financial management is used to determine the costs of inputs and compare with the price of output,
hence determining the pricing model of the company. Setting product prices and controlling costs helps a
company to manage profits effectively.

Marketing

Financial management is also used in marketing to control advertising costs and create budgets for
marketing initiatives. An organization may need to launch marketing and advertising campaigns for
creating brand awareness. Sometimes they want to outsmart the competition and emerge and gain top of
mind awareness. At other times, organization looks to support the sales teams by generating more sales
leads through its campaigns. Financial management helps managers to:

 Plan and acquire funds to implement marketing campaigns at the right time
 Keep marketing budgets for various marketing campaigns such as ads
 Analyze the financial feasibility of marketing campaigns.
 Prevent misuse of company’s resources through marketing activities
 Create sales forecast and estimate future financial needs of the marketing department

Finance

Financial management is also necessary to gain knowledge about an organization’s finance. Financial
managers have a critical role in managing the overall financials of a company and ensure that the
company’s financial health is good for current business operations and future growth.

Financial management is used in a finance department to monitor cash flows, determine profitability, and
manage expenses. These activities are generally aimed at creating accurate financial information for to be
used by management in decision making. For instance, finance departments can create cash flow
statements and profit and loss accounts which show whether the company can be profitable to pursue
future growth opportunities.

Financial management knowledge is also important for finance department because it enables financial
managers to manage credit, establish investments, and manage financial risks and losses.

1.5. Relationship between financial management with other disciplines

Financial management is a multidisciplinary concept that can be applied in various disciplines such as
production, marketing, and human resource management. The relationship between financial management
and other disciplines can be explained as follows:

 Financial Management and Economics: Investment decisions, micro & macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the economic
 equations like money value discount factor, economic order quantity etc. Financial economics is one of
the emerging area, which provides immense opportunities to finance, and economical areas
 Financial Management and Accounting: Financial management and accounting are interrelated because
financial management involves keeping accounting records including the financial information of the
business concern.
 Financial Management and Production: Production department is concerned with the processes of
turning inputs into finished products for sale. Financial managers work with the production department to
manage costs and set prices appropriately. Financial management is used to determine the costs of inputs
and compare with the price of output, hence determining the pricing model of the company. Setting
product prices and controlling costs helps a company to manage profits effectively.
 Financial Management and Marketing: Financial management is also used in marketing to control
advertising costs and create budgets for marketing initiatives. An organization may need to launch
marketing and advertising campaigns for creating brand awareness. Sometimes they want to outsmart the
competition and emerge and gain top of mind awareness
 Financial Management and Human Resources: Financial management is also related with human
resource department, which provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration, commission, bonus, pension &
other monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.

1.6. Financial Goal(s) of a firm

Businesses often exist to make profits and satisfy human needs, which the government is not able to
provide. The mission statement of a firm highlights its core business, which means that a company
pursues certain financial goals that are specific to their mission. However, most firms have the financial
goal of maximizing shareholders’ wealth through sound financial decisions. This requires firms to
promote efficiency, profitability, liquidity, and stability.

The major financial goals of a firm are:

 Profit Maximization
 Value Maximization

Profit Maximization

Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion:
markets managers of firms direct their efforts toward areas of attractive profit potential using market
prices as their signals. Choices and actions that increase the firm’s profit are undertaken while those that
decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce
resources, or equivalently, minimize the cost of producing a given output.

Applying Profit-Maximization Criterion in Financial Management

Financial management is concerned with the efficient use of one economic resource, namely, capital
funds. The goal of profit maximization in many cases serves as the basic decision criterion for the
financial manager but needs transformation before it can provide the financial manager with an
operationally useful guideline.
 As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not
take account of risk; it does not take account of time value of money; it is ambiguous and sometimes
arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable events.

 Uncertainty (Risk): The microeconomic theory of the firm assumes away the problem of uncertainty:
When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it
is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing
capital are risk averse. A good decision criterion must take into consideration such risk
 Timing: Another major shortcoming of simple profit maximization criterion is that it does not take into
account of the fact that the timing of benefits expected from investments varies widely. Simply
aggregating the cash flows over time and picking the alternative with the highest cash flows would be
misleading because money has time value. This is the idea that since money can be put to work to earn a
return, cash flows in early years of a project’s life are valued more highly than equivalent cash flows in
later years. Therefore the profit maximization criterion must be adjusted to account for timing of cash
flows and the time value of money.
 Subjectivity and ambiguity: A third difficulty with profit maximization concerns the subjectivity and
ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many,
some subjective, choices of accounting standards and methods with the result that profit figure produced
from a given data base could vary widely.
 Qualitative information: Finally many events relevant to the firms may not be captured by the profit
number. Such events include the death of a CEO, political development, and dividend policy changes.
The profit figure is simply not responsive to events that affect the value of the investment in the firm. In
contrast, the price of the firms share (which measures wealth of the shareholders of the company) will
adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in
profits.

Value Maximization

Because of the reasons stated above, Value-maximization has replaced profit-maximization as the
operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids
much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound
interest, Value maximization takes account of both risk and the time value of money. By using the market
price as a measure of value the value maximization criterion ensures that (in an efficient market) its
metric is all encompassing of all relevant information qualitative and quantitative, micro and macro. Let
us note here that value maximization is with respect to the interests of the providers of capital, who
ultimately are the owners of the firm. – The maximization of owners’ wealth is the principal goal to be
aimed at by the financial manager.

In many cases the wealth of owners will be represented by the market value of the firm’s shares – that is
the reason why maximization of shareholders wealth has become synonymous with maximizing the price
of the company’s stock. The market price of a firms stocks represent the judgment of all market
participants as to the values of that firm – it takes into account present and expected future profits, the
timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on
the viability and health of the firm. Management must focus on creating value for shareholders. This
requires Management to judge alternative investments, financing and assets management strategies in
terms of their effects on shareholders’ value (share prices).

1.7. Ethical Challenges In Financial Management

 Ethics is more than simply obeying laws; it involves doing the right thing as well as the legal thing.
Financial managers are required to behave ethically to enhance fairness and equity in distribution of
resources. There several ethical challenges that affect financial management in an organization:

 Conflict of Interest: managers are required to act in the best interest of their employers and clients – this
is known as fiduciary duty – to ensure that financial resources are utilized efficiently to achieve business
objectives and not for personal use.
 Security and Privacy: Managers also face ethical challenges related to security and privacy of consumers’
information. Security breach may lead to credit fraud and loss of financial resources. For example, a
hacker may access personal information of a customer and use their details to steal their money.
 Corruption and Bribes: Some managers may accept bribes and engage in corrupt practices in financial
management. For example, accountants may be given bribes to create false information about the
company’s financial health for selfish reasons. This always leads to scandals and loss of reputation in an
organization.
 Unfair/Unequal compensation: Another ethical challenge in financial management occurs when a
company pays its employees different salaries based on sex, age, or race without consideration their job
or qualifications.
 Dishonesty/Misrepresentation of Information: Misrepresentation of financial information is a serious
ethical challenge. Some managers may try to provide false information about their financial performance
to influence investment decisions.

To address these ethical challenges, companies need to develop ethical codes that specify the right
conduct for all managers and employees. Some of the ethical behaviors and values that should be
encouraged in financial management are:

 Honesty and integrity

 Avoiding conflicts of interest
 Serving the best interest of all stakeholders
 Providing accurate, objective, reliable, and relevant financial information
 Compliance with relevant laws and regulations
 Acting in good faith and making independent judgments
 Not sharing confidential information or using it for personal gain
 Maintaining internal control systems to safeguard ethical accounting practices
 Reporting incidences of unethical behavior or violations of the company’s code.
 Chapter 2: Financing Decisions

Finance plays a critical role in every organization or institution. It serves as the means by which economic
decisions are made and enables organizations to run operations successfully. Therefore, the financing
decisions of a firm affect their short term and long term success. This chapter explores the objectives of
making financial decisions, the criteria used to choose sources of finance, methods of raising finance, and
evaluation of such methods to enhance effective financing decisions.

2.1. Objective of Financing Decisions

Financing decision is concerned with the methods of acquiring funds to support various business
operations and investments. Financing decision is one of the four functions of finance, which we explored
briefly in chapter 1. The other three functions are: working capital decisions, investment decisions, and
dividend decisions. Finance managers have the role to decide when, where, and how to acquire business
funds – whether through the bank or through shareholders. It is important for the company to maintain a
good ratio of equity and debt in their capital structure.

Financing decision often comes from two sources of funds: internal sources which include share capital
and retained earnings (from profits); while external sources include borrowings from outside providers
such as loans, bonds, debentures, and venture capital.

A firm tends to benefit most when the market value of a company’s share maximizes this not only is a
sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt
affects the risk and return of a shareholder. It is more risky though it may increase the return on equity
funds.

A sound financial structure is said to be one which aims at maximizing shareholders

return with minimum risk. In such a scenario the market value of the firm will maximize and hence an
optimum capital structure would be achieved.

In summary, the objective of the financing decision is to achieve a balance between debt and equity,
which leads to an optimum capital structure. An optimal capital structure occurs when company gets the
best mix of debt and equity to maximize the value of the firm and minimize its cost of capital. So,
financial managers require sound financing decisions to achieve the following objectives:

 Profit maximization
 Cost minimization and risk reduction
 Maximizing value of the firm
 Long term growth of the firm
 Smooth operations for the business
 Ensuring liquidity and effective cash flow
 Proper asset management and efficient utilization of resources
 Adequate access to capital and funding

2.2. Criteria Used to Choose Sources of Finance

When making its financing decisions, a company considers various factors that determine their choices in
terms of sources of finance. Firms have to make a choice between internal and external sources, debt and
equity, and/or where to get the funding. To make such decisions, financial managers should be aware of
their current financing needs, financial position, availability of funds, cost of financing, leverage position,
business risks, security, duration of loan if any, and other factors.
 The criteria used can also be defined as the factors to consider when choosing the source of finance. The
following factors or criteria must be considered before choosing the best source of finance to use:

 The Amount Required/Capital Requirement: Before choosing a source of finance, the company should
first assess its financial requirements to determine the amount of funding required. Some funding sources
require a large amount of money to be raised. For instance, share capital is appropriate when raising a
large amount of capital. Debentures and venture capital are other sources of finance that are suitable for
raising large amounts of capital to meet long term investment needs. On the other hand, short term loans
and bank overdrafts are used for small capital requirements, especially when funding working capital or
raising money for daily business operations.
 Purpose/Type of Expenditure: Financing decisions are affected by the type of expenditure of the
organization. Finance managers should consider the type of expenditure or the purpose for which the
funds are raised. Long term sources of finance are better suited to finance capital expenditure projects for
example building a new textile factory. On the other hand, Short term sources of finance are more suited
to finance operations such as paying suppliers.
 Time/Duration: The matching accounting principle states that assets and liabilities should be matched
based on the maturity period of assets. When a company decides to raise funds, they must consider the
timelines involved or duration of the funding. For instance, the company can decide to borrow a bank
loan that has a duration of 10 years to finance a long term investment project. It is not prudent to borrow a
long term debt to acquire an asset that has a short maturity period.
 Cost: The cost of capital is also an important criteria or factor to be considered when choosing an
appropriate source of finance. The cost of capital becomes a factor in deciding which financing track to
follow: debt, equity, or a combination of the two. For example, the cost of accessing long term loan is the
interest charged by the bank. There are also transaction costs and time involved in acquiring the loan.
Another cost is the collateral required by the before acquiring a loan. A company that is in its early stage
may not have enough assets to be used as collateral for loans, which means that they will choose equity
and/or other alternative sources of finance.
 Risk: Every investment involves risks. A company risks losing money and not being able to pay back
debts, which calls for equity as an alternative source of capital. Even so, equity capital has its own risks
involved such as market risks and loss of share value, which reduces the company’s returns in the long
run.
 Control: When a company acquires funds from an external source, it is bound to lose control of some
business operations or management. The firm may lose more control in one source of finance than
another. For instance, the company loses control of its business and when equity capital and venture
capital are involved. However, the company retains much control of its operations when using debt
capital. Companies must decide how much control they are willing to lose in order to acquire the right
amount of capital.

2.3. Methods of Raising Finance

A company or business person can choose various methods of acquiring funds to finance their business
operations and investments. The major methods of acquiring funds in the corporate world include:
venture capital, shares, debentures, bonds, debts/loans, lease financing, trade credits, and retained
earnings.

1) Venture Capital

Venture capital (VC) refers to an investment fund provided by investors to businesses in their early
stages, where the investor gets some stake (ownership rights) in the business. Usually, an entrepreneur
comes up with a promising business idea but may lack the financial resources to put their ideas into
action. Venture capitalists come in to provide the required capital and management support to the new
 business. Venture capital firms usually invest in start-ups that have the potential to grow substantially and
generate good returns in the future. Apart from supplying funds, venture capitalists also provide advice on
various issues including management, marketing, product development, and staffing. Thus, venture
capitalists (VCs) are usually involved in business aspects of the companies they sponsor.

The major difference between venture capital and shares is that venture capital is a private equity
investment that cannot be traded in public exchanges such as the Nairobi Stock Exchange. Institutional
and individual investors usually invest in private equity through limited partnership agreements, which
allow investors to invest in a variety of venture capital projects while preserving limited liability

Pros and Cons of Venture Capital

The advantages of venture capital are:

 Venture capitalists provide start-up businesses with valuable information, guidance, consultation and
advice on various aspects of the business. This can help in improving business outcomes and decisions,
including in human resources and financial management.
 They provide additional resources and support on areas such as legal, tax, and personnel.
 Networking and business connections – venture capitalists are resourceful networks for companies
because they are often connected in the business community; so they can even be an important source of
knowledge, information, technology, and connection with customers in the community.
 Limited liability – business owners are not liable for any losses or liabilities incurred in the business; so
they are not liable to refund venture capitalists if the business results are not achieved as planned.

The disadvantages of using venture capital may include:

 Loss of control: the business owner or entrepreneur loses control of the company because venture
capitalists demand rights in the company before providing the required funds.
 Expensive: The services and processes leading up to the provision of venture capital are quite costly.
Those services may include negotiations in the presence of an attorney as well as due diligence and
documentations.
 Loss of Ownership: venture capitalists may demand too much ownership during negotiations, leading to
the owner’s loss of majority control. In fact, the start-up founder or founders may become minority
owners with less than 50% of ownership.

Finance managers ask the following questions before making the decision to acquire finance through
venture capital:

 Are you open to more active input from a venture capital firm?
 Do you appreciate the additional expertise and resources a VC firm could provide?
 Is loss of ownership and control an issue for you?
 Could you gain through a VC firm’s business connections?

2) Shares

Shares refer to interests or stake held by individuals or corporations in a company, which allows them to
share the profits or losses of the firm. They represent the ownership of a company. The company issues
shares, also known as stock, in exchange for money. Those who buy shares of stock are known as
shareholders, and they represent ownership of the firm. Thus, a person who buys and owns 100% of a
company’s shares is said to own the entire company.
 Investors purchase shares to become part owners of the company, and get share of profits through
dividends. Shareholders expect to receive a rate of return in two forms: dividends and/or capital gain.
Dividends are direct payments made to shareholders from the company’s profits while capital gains refer
to the increase in value of stock or shares when it is sold.

The company then uses the money raised to invest in various projects, which are expected to generate
returns for the shareholders. The funds raised through shares is known as equity capital. When making
financing decision regarding shares, finance managers ask the following:

 How and when does the company get money from the sale of its stock?
 What rate of return does the company promise to pay when it sells stock?
 Who makes decisions in a company owned by a large number of shareholders?

Types of shares

There are different types of shares or stock that a company can issue to raise funds. The three major types
of shares are ordinary shares, preference shares, and deferred shares.

1. Preference shares

Also known as preferred stock, this is a type of shares which enables the shareholder to receive a fixed
rate of dividend. They are the first in line to be paid dividends before any amount is paid to ordinary
shareholders. When the company goes bankrupt, preference shareholders are paid first before common
stockholders. However, preference shares do not have voting rights like ordinary shares, which means
that preferred stockholders do not vote on issues in the company such as election of CEO. Preference
shares are in two types: cumulative and non-cumulative preference shares.

 Cumulative preference shares allow shareholders to receive their current dividends from next year’s
profits if this year’s profits are not sufficient to pay dividends.
 Non-cumulative preference shares are those that do not allow shareholders to get dividends from next
year’s profits even if there is little profit to pay dividends in the current year.

2. Ordinary shares:

These are shares that receive dividends only after the fixed dividends on preference shares have been
paid. Ordinary shareholders have no limit on dividends; they can earn higher dividends if profits are
large. This type of shares does not give stockholders any dividend if the company experiences a loss or
bankruptcy.

3. Deferred Shares:

These shares come last in the order of dividend payment. They only receive their dividends after all other
classes of shares have received theirs. Generally these shares are issued to the promoters and to the
persons who have helped in the formation of the company.

Pros and Cons of Shares

There are several and advantages and disadvantages of shares as a source of finance. Some of the
advantages of using shares as a method of financing include:
 No repayment required. Unlike bank loans and debts which must be repaid in full with some interest on
top, a company does not need to repay shares since they are only bought and sold in the stock market. The
company may decide to distribute some portion of its profits as dividends to shareholders, but it is not
mandatory to do so if the business is not doing well. This creates flexibility for a company to invest its
profits on promising projects.
 Lower Risk: Shares involve little risk on the part of the company issuing them. Corporations that use
more equity than debt in their capital structure have a lower risk of bankruptcy. Investors are not able to
force a company into bankruptcy for failing to pay dividends, but creditors will go for the company’s
assets if it is not able to pay its debts.
 Equity Partners: Shares allows a company to bring in equity partners who have interest in the success of
the company. These partners could have a great deal of knowledge, connections, and expertise that could
benefit the business. Equity partners can also pull more resources into the company for future growth.

Some of the disadvantages associated with the use of shares as a source of capital include the following:

 Dilution of ownership: one of the major disadvantages shares as a method of acquiring capital is that the
owner loses control of their company. Shareholders are considered as owners of the company with the
right to vote on major decisions of the organization. With every share of stock you sell to investors, you
dilute, or reduce, your ownership stake in your small business. So let’s say for example that the original
owners of Safaricom lost some control of the company when they issued shares in 2008 at the Nairobi
Stock Exchange. If a business owner sells all shares of the firm, it is like selling the entire company.
 High Cost: shares also come at a high cost. This disadvantage emerges from the fact that the company has
to pay its shareholders with a high rate of return in order to continue selling shares. Shares tend to lose
value and sell at a low price when the company is not performing well.
 Time and Effort: Another great disadvantage of shares is that it takes time and effort to get investors who
are willing to buy shares. It typically takes the right connections and a powerful pitch deck to get the
equity you need.

3) Debentures

A debenture is a type of long-term debt issued by a company to the public to raise capital for various
investments. It is usually used when the company has a solid financial position and does not want to
dilute its ownership through the issuance of shares. Let’s say it is a long-term financial instrument issued
by a company to meet their financial requirements, where investors are compensated with a fixed interest
income. It is like a company is borrowing a long-term loan from the public or from investors. The holders
of debentures are creditors to the company.

Companies generally have powers to borrow and raise loans by issuing debentures as securities of
specified face value. The rate of interest payable is fixed at the time of issue, and they are recovered by a
charge on the property or assets of the company, which provide the necessary security for payment.
Debentures are mostly issued to finance the long-term requirements of business.

Advantages of Debentures

There are certain advantages of issuing debentures:

 Because of the fixed interest on debentures, companies with stable income can secure higher returns on
equity capital by trading on equity.
 The rate of interest is usually lower than the expected rate of return on share capital. This is because
debenture holders do not bear any risk.
 Debentures do not carry any voting right. Hence management by promoters or existing directors remains
unaffected.

Disadvantages of Debentures

 If the earnings of the company are uncertain or unpredictable, issue of debentures may pose serious
problems for the company due to the fixed obligation to pay interest and repay the principle
 The company is liable to pay interest even if there is no profit
 If there is default in payment of interest or repayment of the principle, assets can be attached by order of
the court
 Trading companies which generally do not have large fixed assets cannot provide adequate security for
issue of debentures.

4) Bonds

Another source of financial capital is a bond. A bond is a financial contract: a borrower agrees to repay
the amount that was borrowed and also a rate of interest over a period of time in the future. A corporate
bond is issued by firms, but bonds are also issued by various levels of government.

A large company, for example, might issue bonds for $10 million; the firm promises to make interest
payments at an annual rate of 8%, or $800,000 per year and then, after 10 years, will repay the $10
million it originally borrowed. When a firm issues bonds, the total amount that is borrowed is divided up.
A firm seeks to borrow $50 million by issuing bonds, might actually issue 10,000 bonds of $5,000 each.
Anyone who owns a bond and receives the interest payments is called a bondholder.

The difference between bonds and debentures is that bonds are backed by collateral or physical assets as
security, while debentures are not backed by collaterals.

5) Loans

An organization or business can also acquire finance by borrowing money from a financial institution
such as a bank. Loans can be long-term or short-term debts depending on the firm’s financial needs.
Short-term loans usually last for 1 year and are used to finance the company’s daily operations. On the
other hand, long term debts are payable beyond 1 year and are used to finance the firm’s investment
projects.

Loans are similar to bonds in that they both involve borrowing funds which should be repaid with
interest. However, loans are borrowed from banks and other financial institutions, while bonds are
borrowed from bondholders in the money market. Individuals and companies borrow money from a bank
using the same procedure, but firms borrow a larger amount of money with an agreement to repay at an
agreed upon rate of interest over a given period of time.

Advantages and Disadvantages of Loans

As a source of capital, loans have certain advantages and disadvantages.

The advantages/cons of loans as a method of financing include the following:

 Keeping control of the company. Unlike shares which give more control and ownership of the
organization to shareholders, loans allow the owner(s) to utilize its funds as they wish and still retain
 control of the company. The bank assesses the creditworthiness and ability of the firm to service the loan,
but they do not take ownership or have any interest in the company.
 Temporary Relationship: The firm has a temporary with the bank as a result of taking a loan. The
borrower and the lender only engage for as long as the term of the loan is still payable. Once the loan is
paid in full, the company ceases making payments to the bank. This is contrary to equity or shares where
the company continues to pay dividends to shareholders for as long as the business exists.
 Interest is Tax Deductible: Interest on a loan is deductible for tax purposes. Fixed-rate loans are
specifically known for not changing in terms of interest throughout the lifetime of the loan. These benefits
reduce costs and make it easy for a company to plan for its finances effectively.
 Advisory Services: Some financial institutions provide advisory services to the business or individual
taking a loan.
 Easy Planning: As the repayment of interest and the principal amount is prefixed, one could easily plan
their expenses and funds accordingly.

There are also several disadvantages of using loans as a source of capital:

 Difficult process: Perhaps the biggest problem with a bank loan, especially the long-term ones, is that it is
difficult and takes time to get loan approval if the business does not have a historical business relationship
with the bank. There are procedures and requirements that the company must fulfil before getting a loan.
Lenders are careful to lend money to only firms that can repay to minimize defaults.
 High Interest Rate: Another disadvantage of a bank loan is that it carries high interest, which must be
paid by the company in addition to the principal amount. This adds financial costs and expenses to the
company’s books, leading to reduced profit margins. However, the borrowed funds can generate more
returns if they are utilized well.
 Loss of Assets: In extreme cases, the company may have to sell its assets to repay the loan and honor the
agreement with the bank. If the business fails, the bank will take possession of the company’s assets.

6) Leasing

Another important method of financing a business is leasing. Lease financing is one of the important
sources of medium-and long-term financing where the owner of an asset gives another person, the right to
use that asset in exchange for periodical payments. The owner of the asset is known as lessor and the user
is called lessee. The periodic payments are lease rentals. During the lease period, the lessee gets the right
to use the asset, but its ownership remains with the lessor. At the end of the contract, the lessor and the
lessee may agree to transfer the asset back to the lessor; extend the lease agreement; or the lessee may buy
the asset and take full ownership.

It is an alternative way of obtaining the use of assets if the company does not have enough money to buy
the asset completely. In most cases, companies lease space for manufacturing, warehousing, and business
operations. A lease can be used in relation to real estate – land and buildings; but nowadays even capital
equipment are leased.

Types of Leases

There are two types of leases, which are based on how risks and rewards are shared between the lessee
and the lessor, the lease period, and number of parties involved.

 Finance Lease: a financial lease is a type of lease in which the lessor transfers all the risks and rewards to
the lessee in exchange for lease rentals. This puts the lessee in the same condition as he would have been
if he or she had bought the asset. This type of lease non-cancellable until a certain period when the lessor
has recovered all his investments.
 Operating Lease: on the other hand, an operating lease is a type of lease in which the lessor does not
transfer all rewards and risks to the lessee, which means that the lessee does not take full ownership of the
asset. An operating lease lasts for a term that is much less than the economic life of the asset. The lessor
does not recover all his investments during this primary period.

Features of a Financial Lease

Based on the above description of a financial lease, the following features can be derived:

 A finance lease is a device that gives the lessee a right to use an asset.
 The lease rental charged by the lessor during the primary period of lease is sufficient to recover his/her
investment.
 The lease rental for the secondary period is much smaller. This is often known as peppercorn rental.
 Lessee is responsible for the maintenance of asset.
 No asset-based risk and rewards is taken by lessor.
 Such type of lease is non-cancellable; the investment of the lessor is assured.

Features of an Operating Lease

The features of an operating lease are listed below:

 The lease term is much lower than the economic life of the asset
 The lessee has the right to terminate the lease through a short notice and no penalty is charged for that
 The lessor provides technical knowhow of the leased asset to the lessee.
 Risks and rewards incidental to the ownership of the asset are borne by the lessor.
 Lessor has to depend on leasing of an asset to different lessee for recovery of his/or her investment.

Advantages and Disadvantages of Lease Financing

Lease financing is increasingly becoming a popular way of acquiring assets. It is a cost-effective

financing option for any firm that wants to acquire the use of assets at a lower cost. This method of
financing has several advantages and disadvantages.

Advantages:

To the lessor, the lease financing:

 Has an assured regular income – the lessor gets lease rentals for the entire period of the lease, which is
assured and regular income.
 Preservation of Ownership: the lessor retains ownership of the asset, especially for a finance lease which
involves the transfer of risk and rewards without the transfer of ownership to the lessee.
 Tax Benefits: The tax benefit associated with the depreciation of the leased asset remains with the lessor.
 High Profitability: The rate of return from a lease is higher than interest payable on financing the asset;
hence leasing is a highly profitable business.
 Potential for Growth: the lessor has a high potential for growth due to the rising demand for leasing as a
cost efficient method of financing.
 Full Recovery of Investment: through a finance lease, the lessor can recover all investments on the leased
asset through lease rental.

To the Lessee, the following benefits of a lease can be identified:

 Use of capital goods: The lessee gets the chance to use an asset and pay small regular rentals.
 Tax Benefits: the lessee also enjoys a tax advantage because lease rentals are often deducted as business
expenses.
 Cheap: Leasing is a cheaper or less expensive source of financing; cheaper than other sources of
financing.
 Technical Assistance: for an operating lease, the lessee can get technical assistance from the lessor in
respect to the leased asset.
 Inflation Friendly: The lessee pays fixed amounts of lease rentals even if inflation rises.
 Ownership: the lessee may purchase the leased asset at the end of the lease period and take full ownership
of the asset.

Disadvantages of Lease Financing

Disadvantages to the Lessor:

 Less profits in case of inflation – the lessor gets constant amounts even when inflation rises
 Double Taxation: sales tax on the leased asset may occur twice – at the time of purchase and the time of
leasing.
 Chance of Damage: the asset may be damaged while it is still being used by the lessee during the lease
period.

Disadvantages to the Lessee:

 Compulsory payments: the lessee is required to make regular payments of lease rentals even when the
asset is not in use.
 Ownership: the lessee does not usually take ownership of the asset at the end of lease agreement unless
they purchase it.
 Costly: leasing can be costly to the lessee because it involves the payment of lease rentals and other
expenses incidental to the ownership of the asset.

7) Factoring

Factoring is a method of acquiring short term capital. It is a type of financing in which a company sells its
outstanding debt dues or accounts receivables to a third party to meet short-term financial obligations. In
most cases, customers may buy goods from a company on debt (debtors). The amount that customers owe
the company on credit remain outstanding until the end of the credit period. However, the company may
run short of funds before all the dues have been collected from debtors.

Such debts may be transferred to a third party, which is usually a bank, in exchange for cash. The bank
charges the company a specified amount of fees for the transfer of credit. It helps companies to secure
finance against debtors’ balances before the debts are due for realisation, and incidentally also helps in
saving the effort of collecting the book debts.

The advantages of factoring include: saving time and effort of collecting debts; minimizing risks of bad
debts; increasing liquidity; and meeting immediate financial obligations.

The disadvantage of this method of financing is that customers who are in genuine difficulty do not get
the facility of delaying payment which they might have otherwise got from the company. This may affect
the relationship between the company and its customers negatively.

8) Discounting Bills of Exchange

A discounting bill of exchange is another important source of capital, which is used to raise short-term
finance. When goods are sold on credit, bills of exchange are generally drawn for acceptance by the
buyers of goods. The bills so drawn are payable after 3 or 6 months depending on the prevailing practice
among traders. Instead of holding the bills till the date of maturity, companies generally prefer to discount
them with commercial banks on payment of a charge known as bank discount.

In other words, this method of financing occurs when a bank buys a trade bill (bill of exchange) from the
company (payee) before it reaches its maturity date. A trade bill is a document that allows a customer to
take possession of goods and services and pay for them at a later date. The company can sell the bill of
exchange to a bank, which pays the bill and charges service fees. The bank then recovers the said amount
after the maturity of the bill. This allows the company to access money to meet its financial obligations as
they fall due.

If any bill is dishonored on maturity, the bank returns it to the company which then becomes liable to pay
the amount to the bank. The cost of raising finance by this method is the discount charged by the bank.

9) Trade Credits

Another source of short-term financing for a corporation is trade credit. This method of financing allows a
company to take possession of goods from suppliers on credit.

Just as companies sell goods on credit, they also buy raw materials, components, stores and spare parts on
credit from different suppliers. Hence, outstanding amounts payable to trade creditors as well as bills
payable relating to credit purchases are regarded as sources of finance.

Generally suppliers grant credit for a period of 3 to 6 months, and thus provide short-term finance to the
company. Availability of this type of finance is closely connected with the volume of business. When the
production and sale of goods increase, there is automatic increase in the volume of purchases, and more
of trade credit is available. On the other hand, if sales decline there is a corresponding decline in
purchases of materials, and consequent decline in trade credit as a source of finance.

Thus, creditors, balances (account payable) and bills payable help companies to finance current assets,
i.e., stock of materials and finished goods as well as book debts. However, trade credit also involves loss
of cash discount which could be earned if payments were made within 7 to 10 days from the date of
purchase. This loss is regarded as the cost of trade credit.

10) Bank Overdraft

Cash credit and bank overdraft are other important methods of raising finance. Bank overdraft is a short
term source of capital which allows a company to overdraw money from its bank account above what it
has in the bank. Cash credit refers to an arrangement on a continuing basis whereby the commercial bank
allows money to be drawn as advance from time to time within a specified limit known as cash credit
limit. Bank overdraft and cash credit are granted against securities such as stock, government bonds, or a
promissory note.

The rate of interest charged on cash credit and overdraft is relatively much higher than the rate of interest
on bank deposits. But this method of financing has the flexibility of allowing funds to be drawn for short-
term purposes according to changing needs which depend on business conditions.

11) Public Deposits

Another important source of finance is public deposit, which refers to funds raised through deposits made
by shareholders, employees and the general public. Members of the general public are invited to deposit
their savings with the company, which the company invests in various projects. Thus, public deposits can
be a raised by companies to meet their short-term and medium –term financial needs. It is a simple
method of raising finance for which the company has only to advertise in the newspapers giving
particulars about its financial position as prescribed by the Companies Act.

The advantage of public deposits is that they allow the company to access money for short term and
medium term financial obligations. The disadvantage is that a company is not allowed to raise unlimited
amounts of money through public deposits.

12) Retained Earnings/Profits

Retained earnings are also known as retained profits, reinvestment or ploughed back profit. It is an
internal source of finance which allows a company to use some of its profits for capital investments. After
distributing some of the profits to shareholders as dividend, another proportion is transferred to reserves
and used by the company as additional capital.

The main advantage is that there is no legal formality involved, nor does the company have to depend on
external investors to raise capital. Another advantage is that it does not involve difficult or lengthy
procedures to acquire finance. The third advantage of retained profits as a method of financing is that it
promotes organic growth in the company since the company does not need to borrow external funds.

However, this method of raising finance has some disadvantages. One of the disadvantages is that only
the on-going profitable companies can make use of this source of finance. Start-up companies do not have
an ongoing source of profit to reinvest. Furthermore, the amount of money raised through this method is
limited because the company can only transfer a certain percentage of profits to reserves, such as 10%.

Summary Table: Types and Methods of Raising Finance

Long-term Capital Medium-Term Capital Short-term Capital

Equity Shares Bank Loans Factoring

Preference Shares Public Deposits Trade Credit

Debentures Discounting Bills of Exchange

Retained Earnings Bank Overdraft

Leasing

2.4. Choice of Preferred Financial Mix

Financial mix often consists of two important sources of finance: equity and debt. Most companies use
bank loans, bonds and debentures as part of their debt capital. On the other hand, equity can be raised
through preference shares, venture capital, and private equity funds.

When choosing the right balance between debt and equity, one must consider the risks and benefits
involved in each option. Debt is appropriate when the company does not want its ownership to be diluted.
Using debt as a method of raising finance also has tax advantages to the business. However, it may lead to
bankruptcy if the business does not honour its debt obligations. Equity has less risk of bankruptcy because
the company does not need to repay it.

To maximize the value of your business, you should try to find a financial mix that minimizes both the
cost of capital and the risk of bankruptcy. Your capital structure can quickly be evaluated by calculating
your debt-to-equity ratio. This ratio refers to the proportion of debt in the company’s capital structure as
compared to the proportion of equity.

The degree of stability in your business, its ability to provide suitable collateral as security, the interest
rate you are charged as well as legal or contractual restrictions on debt are all factors that will influence
your optimal debt-to-equity ratio.

For example, a company operating in an unpredictable business environment where a future downturn
could impact its ability to repay lenders should have a low debt-to-equity ratio.

Conversely, a company with long-term capital assets, such as buildings or equipment, and predictable
cash flows can be more highly leveraged.

The optimal debt-to-equity ratio may vary from one industry to another, but the general consensus is that
it should not be above a level of 2.0. This means that debt contributes two-thirds of the company’s
financial mix. It also means that the proportion of debt in the capital financing mix of the company is
twice that of equity. Most managers suggest that debt should not be more than twice the amount of equity.

While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may
have ratios higher than 2, these are the exception rather than the rule. The less the value of the debt-
equity-ratio, the better for the company. It is important to have more equity in the capital structure, but
too much of it also dilutes the company’s ownership.
 Chapter 3: Capital Structure and Cost of Financing

3.1. Definition of Finance

In relation to capital structure, finance can be defined as the process of raising money or capital to meet
certain types of expenditure. For example, finance in government may include tax revenue and debt used
to fund development projects. In a company, finance involves raising funds from sources such as equity,
bank loans, and retained profits to fund business operations and investments.

Business people, government departments, organizations and consumers are not always endowed with
enough resources to meet their expenditure, pay debts and complete other transactions. There are also
savers and investors accumulate their funds in interest-earning deposits, shares, shares, or insurance
claims.

Finance is the process of channeling these funds through loans, equity capital, or credit to economic
entities or companies that need them and can put them into productive use. The institutions that facilitate
this process of financing various entities are referred to as financial intermediaries. They connect
borrowers with lenders to ensure that funds are channeled to areas that need them the most.

The three broad areas of finance are:

 Personal Finance: concerned with how individuals acquire and use funds through personal savings,
expenditure and investment.
 Business Finance: concerned with how companies or business entities acquire and spend money for
various business operations and investments.
 Public Finance: This covers government spending and other ways in which governments manage public
funds raised though taxation, internal borrowing, and external borrowing.

3.2. Meaning of Capital Structure

Capital structure refers to the mix of equity and debt that a company uses to finance its operations and
assets. For a company to continue operating normally while still growing, it needs capital. This comes
primarily from debt or equity or both. Some of the advantages of using debt financing include: (1) debt
interests are tax deductible, while dividends from shares are not deductible; this lowers the overall cost of
debt. (2) Debt has a fixed return, such that the company does not need to share profits with shareholders.

Debt as a source of financing also has several disadvantages: (1) It increases risks for the company, and
(2) the bank may go bankrupt if it is not able to repay its debts during hard economic times.

Companies that have relatively little business risks can use more debt, but if the business operates in a
risky and volatile environment it should minimize the use of debts to finance its operations.

When Safaricom entered into a licensing deal to enter Ethiopia in 2022, it had the decision to use either
equity or debt to finance its operations in Ethiopia. The company did not have enough reserves to invest
in the project, but it was able to borrow a bank loan of $400 million to finance the project. By September
2022, Safaricom’s total debt amounted to KSH76.9 billion, against cash and cash equivalents of KSH26.4
billion. Within the same year, the company had a total of KES139.5 billion. This shows that the company
has more equity than debt in its capital structure at 64% equity and 36% debt.

Due to the high equity investment and huge profits, Safaricom has been paying 80% of its net income to
shareholders as dividends, while 20% is reinvested in infrastructure and retained earnings.
 An optimal capital structure refers to the structure which enables a company to maximize stock price.
Some companies have a target capital structure of 45% debt and 55% equity; others that have a stable
business can take 60% debt and 40% equity. The trade-off theory of capital structure suggests that
managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost
of capital, which in turn maximizes company value. An optimal capital structure seeks a balance between
the cost-effectiveness of borrowing and risk minimization of equity.

3.3. Determinants of Capital Structure

Determinants of capital structure are the factor that affect the decisions of a finance manager when
choosing the mix of equity and debt to finance their operations and assets. Several qualitative and
quantitative factors affect the firm’s capital structure.

 Leverage: this refers to the use of debt to finance an investment or business operations. A company that
uses more debt in its capital structure is said to be having high leverage.
 Business Growth and Stability: A company that is operating in a relatively stable environment can use
more debt to finance its assets and operations. If the company’s sales and growth are not predictable,
using debts will increase the firm’s risks. Stability in sales ensures that the company is able to meet its
financial obligations and fixed costs even during hard economic times.
 Cost of Capital: Cost of capital refers to the minimum returns expected by the providers of finance such
as banks and investors. The expected return depends on the degree of risk as estimated by the investor or
bank. A company’s capital structure should give provide the least cost of capital; the company should
focus on minimizing the cost of capital. In other words, the company should have a capital structure that
minimizes the cost of acquiring funds.
 Risk: When planning a company’s capital structure, two sources of risks must be considered: business
risk and financial risk. Business risk occurs when earnings vary – the risk of not getting the earnings the
organization expected. Poor strategy, low demand, and low quality products can contribute to reduced
earnings; hence causing business risks. As a general unwritten rule for managers, debt capital should be
reduced where business risks are high.
 Cash Flow: The amount of cash inflows versus outflows determine the choice of components within the
capital structure. A more conservative approach uses less debt in the capital structure to ensure that the
firm does not incur fixed charges that may affect their cash flows. Therefore, before a company thinks
about raising more capital, it should first assess its cash flows and ensure that it will be able to generate
more cash flows in the future to pay for the fixed charges.
 Nature and Size of the Firm: the size of the firm is also an important determinant of capital structure.
Large companies basically use equity financing due to its ability to attract investors. Furthermore, large
companies have more flexibility to choose between debt and equity because they can easily obtain long-
term loans. It is difficult for small firms to raise long term loans. The nature of the company also
determines the company’s capital structure. Public entities often have more stability, so they can employ
more debt in their capital structure.
 Control: Another important determinant of capital structure is control. A company looking for financial
capital considers the level of control that each option offers. Equity funding leads to significant loss of
control over the firm, but debt financing does not make the management to lose control of the company.
Thus, managers create a capital structure by considering their need for control in the business.
 Flexibility: Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing
conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or
sources of funds. Whenever needed the company should be able to raise funds without undue delay and
cost to finance the profitable investments.
 Market Conditions: Market conditions, including inflation and timing can also be good determinants of a
firm’s capital structure. When there is depression, debt financing may not be appropriate. The company
 may also be unable to raise investment funds through shares when the business is not doing well as a
result of a depressed economy.

3.4. Concept of Cost of Finance

The cost finance refers to the price that a company pays to obtain financing for their business operations
and assets. It is also called financing cost or cost of capital. Businesses and financial analysts use the cost
of capital to determine if funds are being invested effectively. If the return on an investment is greater
than the cost of capital, that investment will end up being a net benefit to the company’s balance sheets.
To get finance, a company must incur implicit costs, which are often referred to as floatation costs.
Financing cost or cost of finance refers to the costs, interests and other charges involved in raising finance
to purchase assets or run business operations. Costs of finance include underwriting commission,
brokerage costs, cost of printing a prospectus, commission costs, legal fees, audit costs, and cost of
printing certificate shares. There are also certain costs incurred when obtaining debt financing such as
legal fees, valuation costs, banker’s commission, audit fees, etc.

The cost of finance is often influenced by security, credit rating, timing, and availability. Short term
finances incur costs such as interest charge on loans. Banks often offer loans at fixed charges as interests,
which are calculated as a percentage of the loan value. For example, a company that borrows KSH10
million at an interest rate of 10% will have to pay KSH1 million in addition to the principal amount. A
bank overdraft also incurs annual maintenance fee on top of the interests charged. The interest charged on
any type of short term loan varies based on the risk of default.

Interest is also the primary cost of a long term loan, which is lower if the loan is secured. Arrangement
and maintenance fees, insurance, and transaction costs are also some of the costs associated with a long
term loan. Equity finance also incurs costs such as flotation costs, which include the legal fees paid to
financial advisers. A company looking for listing in a stock market requires the services of a corporate
adviser, stockbroker, corporate lawyer, accounting, and public relations firms. These advisers charge
significant fees for the company, which is then considered to be part of the financing costs of the
company. Further direct costs of listing are the admission and annual fees payable to the stock market.
The admission fee is based on the market capitalisation of the company on the day of admission while the
annual fee is fixed for all companies.

3.5. Importance of Cost of Finance

The cost of finance or cost of capital is used by managers to make important decisions regarding
investments and business operations. It is important for various reasons:

 Evaluating Investments/Capital budgeting decisions: The cost of capital is used in various methods of
evaluating investment projects such as IRR and NPV. In regards to the NPV method, cost of capital is
used to calculate discounted cash flows and compare cash inflows and outflows. In terms of IRR,
managers choose projects that have a higher internal rate of return than the cost of finance.
 Designing Capital Structure: The cost of finance is one of the most effective factors used in designing an
optimal capital structure of a company. While designing a capital structure, the company considers the
maximizing the value of the firm and minimizing cost of finance. By comparing the costs of different
sources of capital, the managers can choose the least expensive methods and design an optimal capital
structure.
 Evaluating Financial Performance: Companies can use the cost of finance or cost of capital concept to
evaluate the performance of various investment projects. This includes comparing profits and costs of
particular projects. The importance of cost of finance is that it allows the company to calculate its
financial performance in terms of profits and costs.
 Creating Debt Policy: Firms consider the cost of finance to create the right debt policy which ensures
that the company has the right leverage. Excess debts may cause harm to shareholders’ wealth. The cost
of capital is also used to determine the right proportion of debt and equity for the company.
 Choosing the Method of Investment: Financing costs can be used to compare different methods of
raising finance. For example, the costs of leasing and borrowing can be compared to choose one of the
two methods which incurs less costs than the other.
 Performance Appraisal: Another important use of cost of capital is to carry out performance appraisal –
evaluating the performance of top managers. In this case, the appraisal of actual costs is carried out and
compared to profitability. If the company has more profits than costs from financing, then the managers
have made the best choices.
 Dividend Decisions: Another importance of cost of capital is to make decisions regarding dividend
payments. Firms create dividend policy based on the returns and costs of their investments. A company
that incurs high costs of finance may have little profits to pay as dividends.

3.6. Components of Cost of Capital

Cost of capital refers to the rate of return that a firm needs from its investments to maximize its value.
The Cost of Capital consists of two categories:

1. Cost of Equity

This refers to the cost of leveraging financial capital or equity provided by shareholders, which are
repayable in capital gains and higher share price. The cost of equity can be determined using the dividend
price approach or the earning price approach.

The dividend price approach involves calculating the expected future dividend payments. In this
approach, the cost of equity refers to the discount rate that equates the present value of all expected future
dividends per share with the net proceeds of the sale (or the current market price) of a share. The cost of
equity using dividend price approach can be calculated as follows:

KE = (Dividend per share / Market price per share) x 100; where:

 KE = Cost of Capital

On the other hand, the earning price approach is used to calculate the future stream of earnings from
shareholders’ investments. The formula for calculated the cost of equity using the earning price approach
is given as:

KE = E / MP; where:

 E = Earnings per share

 MP = Market price

2. Cost of Debt:

This is the cost incurred when borrowing funds from a bank or financial institution for investment
purposes. The financing institution recovers its principal amount and earns profit by charging interest on
the borrowed amount. This interest contributes to the total cost of debt. The cost of debt when issued at
par is calculated as follows:
 KD= [(1 – T) x R] x 100; where

 KD = Cost of Debt
 T = Tax Rate
 R = Rate of interest on debt capital

When debt is issued at premium, the cost of debt can be calculate as follows:

KD = [1 / NP x (1 -T) x 100]; where:

 KD = Cost of Debt
 NP = Net proceeds of debt
 T = Tax Rate
 R = Rate of interest on debt capital

3. Cost of Preference Capital:

The cost of preference capital refers to the sum of dividends paid and expenses incurred to raise
preference shares. The dividend paid on preference shares is not deducted from tax, as dividend is an
appropriation of profit and not considered as an expense. Cost of preference share can be calculated as
follows:

Kp = [{D + F / N (1 – T) + RP / N} / {P + NP / 2}] x 100; where:

 KP = Cost of preference share

 D = Annual preference dividend
 F = Expenses including underwriting commission, brokerage, and discount
 N = Number of years to maturity
 RP = Redemption premium
 P = Redeemable value of preference share
 NP = Net proceeds of preference shares

3.7. Weighted Average Cost of Capital (WACC)

Definition of WACC

The Weighted Average Cost of Capital (WACC) refers to a firm’s average cost of finance from all
sources including equity, preferred shares, and debt. It can also be defined as the average rate of return
that is expected to be paid to stakeholders, debt holders, and preferred shareholders. Another definition of
WACC is: the weighted average cost of a company’s equity and debt. One of the assumptions of the
WACC is that the market for debt and equity requires a rate of return that reflects the investment risks of
the company.

Example: Suppose a company’s CEO goes to the bank and requests for a loan. The company agrees to
lend the money at an interest rate of 10%, which means the firm has to pay an interest above the principal
amount borrowed. This is called “cost of capital or cost of debt.” When the company grows, the company
decides to offer shares to investors to raise additional funds. The firm has to pay dividends and flotation
 costs incurred through shares. This is also part of the cost of capital, and is known as cost of equity. A
company that has more than one source of capital needs to calculate the weighted average cost of capital.

Formula for Calculating WACC

The Weighted Average Cost of Capital can be calculated as follows:

WACC Formula = (E/V × Re) + (D/V) × Rd × (1 – Tax rate); where:

 E = Market Value of Equity

 V = Total market value of equity & debt
 Re = Cost of Equity
 D = Market Value of Debt
 Rd = Cost of Debt
 Tax Rate = Corporate Tax Rate

Components of WACC

These components of the WACC are explained as follows:

 The market Value of Equity refers to the total value of shares offered by the company. for example, if a
company has 10,000 shares, each valued at a market value of KSH5, the market value of the company’s
equity is 10,000 × KSH 5 = KSH 50,000.
 The market value of debt is the total amount of debt that the company has borrowed from various
sources.
 Adding the market value of debt and market value of equity gives us the total market value of equity and
debt.
 Cost of equity: the minimum return that shareholders demand
 Cost of debt have been explained earlier. Refer to section 3.6.
 Corporate Tax Rate: The cost of debt needs to be adjusted to reflect that interest payments are tax-
deductible. A company’s tax rate is primarily determined by where it operates.

Example of Calculating WACC

Assume Company A has a market value of debt of KSH 1 million and market value of equity (market
capitalization) of KSH 4 million. Further assume that the cost of equity is 10%, cost of debt is 5%, and
tax rate is 25%; calculate the WACC.

WACC = [(E/V × Re)] + [(D/V) × Rd × (1 – Tax rate)];

Answer:

First calculate V (the total market value of debt and equity):

V = 4 million + 1 million = KSH 5 million.

WACC = [(4/5 × 0.1)] + [(1/5) × 0.05 × (1-0.25)]

WACC = 0.08 + 0.0075

WACC = 0.0875 or 8.75%

 To interpret this, the company needs a minimum rate of return of 8.75% from its investments to be able to
give returns to finance providers.

NB: The first part of the formula represents the weighted average cost of equity (E/V × Re); while the
second part represents the weighted average cost of debt [(D/V) × Rd × (1 – Tax rate)]. When you add the
two parts you get the weighted average cost of capital (WACC).

Uses of WACC

There are several uses or importance of WACC in a company.

 WACC is used as the discount rate when calculating the net present value (NPV). This means that it is
used in financial modelling.
 Used as the hurdle rate when analyzing investment projects
 Used to calculate a company’s opportunity costs
 Used to make dividend decisions – whether to pay dividends to shareholders or not.
 Calculation of the economic value added (EVA)
 WACC is also used for the valuation of the company
 It is used to create optimal capital budgets.

3.8. Formulation of Capital Structure Policy

A capital structure policy is a set of guidelines and targets established by a company’s management to
determine the proportion of debt and equity in their capital structure. Policies of capital structure may
specify the following:

 The percentage of debt and capital equity: some companies choose a zero debt policy in which the firm
uses only 100% shareholders’ equity to fund their operations and investments. Other companies may
require 40% debt or more, depending on the company’s financial needs and market conditions.
 Borrowing limits of the firm: a capital structure policy may also specify the limits of using debt as a
source of capital. It states the maximum amount of debt that can be allowed in the company. For example,
the company’s policy may limit its debt to 40% of the total capital.
 Preferred debt-equity ratio: Debt-equity ratio may also be used to specify the proportion of debt and
equity in the capital structure. For example, a company may choose a debt-equity ratio of 1:1 when
pursuing a moderate growth strategy. Most firms use a debt-equity ratio of 2:1, which allows the
company to borrow twice as much money as it raises through equity.

Capital structure policy is a conscious decision making process involving a company’s management. It
ensures that the company sets rules to create the right balance between debt and equity financing. A
capital structure policy that is too aggressive may result in too much borrowing, which leads to
unmanageable debt and financial distress. It provides targets of the firm with regards to debt and equity
mix, which must consider the company’s strategy and prevailing market conditions.

3.9. Dividend Policy and Capital Structure

Dividend policy has a direct connect with the concept of capital structure. Dividend policy is the policy
that a firm uses to determine its dividend payout to shareholders. It establishes the conditions under which
dividends can be paid, and how much dividends must be paid in particular situations. For example,
Safaricom has a dividend policy that requires them to pay out 80% of their profits through dividends to
shareholders. This is a generous dividend policy which allows shareholders to get a large proportion of
 the company’s earnings as dividends. Management must decide on the dividend amount, timing, and
various other factors that influence dividend payments.

Types of Dividend Policy

There are three types of dividend policies: a stable dividend policy, a constant dividend policy, and a
residual dividend policy.

 Stable Dividend Policy: A stable dividend policy involves steady and predictable annual dividend
payments. Whether earnings increase or decrease, investors are assured of a dividend every year. This is
the easiest and most common dividend policy. It aligns the company’s dividend payments with the long
term growth of the firm, rather than focusing on short term fluctuations of earnings. The advantage of this
policy approach is that it enhances certainty to shareholders in terms of amount and timing. However, the
disadvantage of this policy is that shareholders will not get an increase in dividends even when earnings
have increased.
 Constant Dividend Policy: This type of dividend policy enables the company to pay a certain percentage
of its earnings as dividends to shareholders every year. Thus, dividend amounts increase when earnings
increase. The problem of this approach is volatility, which prevents the firm and its shareholders to plan
their financial matters.
 Residual Dividend Policy: Under the residual dividend policy, investors get as dividends whatever
remains after the company pays for capital expenditures and working capital. This approach is volatile,
but it makes the most sense in terms of business operations. Investors do not want to invest in a company
that justifies its increased debt with the need to pay dividends.

3.10. Influence of Taxation on Financing Decision

Tax is an important factor to consider when making corporate financing decisions. If a company is
financed by debt capital, there will be tax relief available on interest payments. Alternatively, if the
company is financed with shareholders’ fund (that is equity capital), then dividend will be paid on the
equity from the profit after tax, which will in turn give rise to a liability for income tax.

If corporate interest payments are priced as if they are untaxed at the personal level, a 50 percent
corporate tax saving on interest deductions can make the cost of debt as little as half that of equity, even
when the equity pays no dividends. In short, good estimates of how the tax treatment of dividends and
debt affects the cost of capital and firm value are a high priority for research in corporate finance. The
corporate and individual income tax can play a significant role in the investment, financing, and dividend
decisions of the firm. In terms of the corporate income tax, distributions to fixed income securities are
generally deductible in computing taxable income, while distributions to residual claims are not.