KABARAK

UNIVERSITY

OF BUSINESS
SCHOOL ----------------------------------------------------------P.O Private Bag 20157, KABARAK, KENYA

FNCE 413
FINANCIAL MANAGEMENT
Course code ---------------------- Course Name-------------------------------------------Credit Hour----3-------

COURSE OUTLINE
Lecturer; MR KAIBOS MOSES.
Cell phone;0722909421.....
Email;mkaibos@kabarak.ac.ke.
Course description
An overview of financial management, Working capital management, financial planning and
forecasting, profit planning, capital structure, dividend policy, expansion and restructuring
Purpose of the course
This unit is designed to develop the learner with knowledge, skills and understanding of financial
management methods for analyzing the various sources of financial and capital investment
opportunities and of the application of the tools and techniques of financial management and
controls.
Expected Learning outcomes
By the end of the lesson the learners should be able to:
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1. Explain the role and purpose of financial management

2. Evaluate the overall management of working capital.
3. Understand the sources of finance and evaluate the appropriate sources for particular
situations.
4. Appraise investment decisions, their risks and costs through the use of appropriate
methods.
5. Prepare budgets and use them to control and evaluate organization performance.
6. Appraise the performance of business using financial tools
7. Make appropriate decision on financial planning investment and use of funds
Learning approaches
E.g. Lectures, discussions in class and groups, short presentations, individual exercises and
structured activities.
Teaching Methodology
The unit utilizes the following approaches.
Lectures
Group/ class presentations
Assignments
Case studies
Weeks
Week 1

Dates

Detailed course content

1. An overview of financial management
Meaning and definition of financial management
Objectives of financial management
Scope of financial management
Importance of financial management
Approaches to financial management
Functions of financial management

Week 2
2. Working capital management
Inventory management
Cash management
Accounts receivables management

Week 3
Week 4
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Working capital management

Accounts receivables management
Cat 1
Page 2

Week 5
3. Financial planning and forecasting
The assessment of planning process
Procedure
Time frame
Implementation
Evaluation
Assessment of resources required

Calculation of profit and capital employed /sales

forecast
Limitation of financial planning.

Week 6
Week 7
4. Profit planning.
Objectives of budgeting and budgetary control
Essential of budgeting and budget administration
Types of budgets and preparation of budgets.
Calculations and cause of variances as aid to
controlling performance.
Advantages and limitations of budgetary control.
Objective of cost-volume-profit analysis
Breakeven point
Margin of safety
Target profit
Profit volume ratio
Impact of changing factors on profit. (price, variable
cost, volume, fixed cost)
CVP analysis for multi-product and multi-service
firms.
Importance and limitation of cost volume profit analysis
Week 8
Week 9
Week 10

Cat 2

5. Capital structure
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Week 11

Meaning of capital structure

Factors determining capital structure
Theories of capital structure
Meaning of leverage

Types of leverage (a) operating leverage (b)

financial leverage

Week 12
6. Dividend policy
Dividend decision and valuation of firm
Dividend relevance, Water`s and Gordon
contribution
Dividend irrelevance: Modigliani and Miller
hypothesis.
Aspect of dividend policy
Practical consideration in dividend policy.
Stability of dividends
Forms of dividends
Corporate dividend behavior
Week 13
7. Expansion and restructuring
Types of combination.
Motives and benefits of mergers
Analysis of mergers and acquisition
Evaluation of mergers
Mergers negotiations; significance of P/E and EPS
analysis.
Leveraged buy-outs
Problems associated with mergers and their
solutions
Financial reconciliation.
Legal procedure.

Week 14
Week 15

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Revision
Exams

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1 Course assessment
Continuous assessment tests (CATS)
Final examination
Total
Core Reading Texts

30
70
100

1. Pandey I. M,(2005) Financial Management,Vikas Publishing House PVT ltd.

2. Lawrence D. Schall and Charles W. Hailey (1991) Introduction to Financial Management
6th Edition McGraw-Hill, INC. New York.
3. James C. Van Horne (2003) Financial Management and Policy 12 th edition, Prentice
Hall Inc Publishing.
4. Albert Slavin, Isaac N. Reynolds and Lawrence H. Malchman (1968) Basic Accounting
For Management And Financial Control: Riehart and Winston
E Books (At least 3)
1.
2.
3.
Journals (At least 2)
1.
2.
Other reading texts. (At least 3)

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TOPIC 1: AN OVERVIEW OF FINANCIAL MANAGEMENT

Definition of financial management
Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm.
The term financial management has been defined by Solomon, It is concerned with the efficient
use of an important economic resource namely, capital funds.
The most popular and acceptable definition of financial management as given by S.C. Kuchal is
that Financial Management deals with procurement of funds and their effective utilization in the
business.
Howard and Upton: Financial management as an application of general managerial principles
to the area of financial decision-making.
Weston and Brigham: Financial management is an area of financial decision-making,
harmonizing individual motives and enterprise goals.
Joshep and Massie: Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
Scope of financial management
Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches.
The following are the important scope of financial management.
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and 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.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
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olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management accounting because this part is very much helpful to
finance manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.
3. Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiply
the money into profit. Profit of the concern depends upon the production performance.
production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department.
The financial manager must be aware of the operational process and finance required for each
process of production activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
6. Financial Management and Human Resource
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 and other
monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.
Objectives of financial management
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management.
Objectives of Financial management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
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Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern.
Profit maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible ways
to increase the profitability of the concern. Objectives
3. Profit is the parameter of measuring the efficiency of the business concern.
So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Unfavourable arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.
(iii) Profit maximization objectives leads to inequalities among the stakeholders such as
customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations
and improvements in the field of the business concern. The term wealth means shareholder
wealth or the wealth of the persons those who are involved in the business concern.
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Wealth maximization is also known as value maximization or net present worth maximization.
This objective is a universally accepted concept in the field of business.
Favourable arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aim
of the business concern under this concept is to improve the value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business operation. It
provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv)Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavourable arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern.
Approaches to financial management
Financial management approach measures the scope of the financial management in various
fields, which include the essential part of the finance.
Financial management is not a revolutionary concept but an evolutionary. The definition and
scope of financial management has been changed from one period to another period and applied
various innovations. Theoretical points of view, financial management approach may be broadly
divided into two major parts.
(i)
(ii)

Traditional Approach
Modern Approach

Traditional Approach
Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and the
traditionally accepted methods. Main part of the traditional approach is raising of funds for the
business concern.
Traditional approach consists of the following important area.
Arrangement of funds from lending body.
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Arrangement of funds through various financial instruments.

Finding out the various sources of funds.

The traditional approach to the scope of financial management refers to its subject matter
in the academic literature in the initial stages of its evolution as a separate branch of
study.
According to this approach, the scope of financial management is confined to the raising
of funds. Hence, the scope of finance was treated by the traditional approach in the
narrow sense of procurement of funds by corporate enterprise to meet their financial
needs. Since the main emphasis of finance function at that period was on the procurement
of funds, the subject was called corporation finance till the mid-1950's and covered
discussion on the financial instruments, institutions and practices through which funds are
obtained. Further, as the problem of raising funds is more intensely felt at certain episodic
events such as merger, liquidation, consolidation, reorganization and so on. These are the
broad features of the subject matter of corporation finance, which has no concern with the
decisions of allocating firm's funds. But the scope of finance function in the traditional
approach has now been discarded as it suffers from serious criticisms.

Again, the limitations of this approach fall into the following categories.

(i) The emphasis in the traditional approach is on the procurement of funds by the corporate
enterprises, which was woven around the viewpoint of the suppliers of funds such as
investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies that the
traditional approach was the outsider-looking-in approach. Another limitation was that
internal financial decision-making was completely ignored in this approach.
(ii) The second criticism leveled against this traditional approach was that the scope of financial
management was confined only to the episodic events such as mergers, acquisitions,
reorganizations, consolation, etc. The scope of finance function in this approach was
confined to a description of these infrequent happenings in the life of an enterprise. Thus, it
places over emphasis on the topics of securities and its markets, without paying any attention
on the day to day financial aspects.
(iii)

Another serious lacuna in the traditional approach was that the focus was on the long-term
financial problems thus ignoring the importance of the working capital management. Thus,
this approach has failed to consider the routine managerial problems relating to finance of the
firm.
During the initial stages of development, financial management was dominated by the traditional
approach as is evident from the finance books of early days. The traditional approach was found
in the first manifestation by Green's book written in 1897, Meades on Corporation Finance, in
1910; Doing's on Corporate Promotion and Re-organization, in 1914, etc.
As stated earlier, in this traditional approach all these writings emphasized the financial problems
from the outsiders' point of view instead of looking into the problems from managements, point
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of view. It over emphasized long-term financing lacked in analytical content and placed heavy
emphasis on descriptive material. Thus, the traditional approach omits the discussion on the
important aspects like cost of the capital, optimum capital structure, valuation of firm, etc. In the
absence of these crucial aspects in the finance function, the traditional approach implied a very
narrow scope of financial management. The modern or new approach provides a solution to all
these aspects of financial management.

Modern Approach
After the 1950's, a number of economic and environmental factors, such as the technological
innovations, industrialization, intense competition, interference of government, growth of
population, necessitated efficient and effective utilization of financial resources. In this context,
the optimum allocation of the firm's resources is the order of the day to the management. Then
the emphasis shifted from episodic financing to the managerial financial problems, from raising
of funds to efficient and effective use of funds.
Thus, the broader view of the modern approach of the finance function is the wise use of funds.
Since the financial decisions have a great impact on all other business activities, the financial
manager should be concerned about determining the size and nature of the technology, setting
the direction and growth of the business, shaping the profitability, amount of risk taking,
selecting the asset mix, determination of optimum capital structure, etc.
The new approach is thus an analytical way of viewing the financial problems of a firm.
According to the new approach, the financial management is concerned with the solution of the
major areas relating to the financial operations of a firm, viz., investment, and financing and
dividend decisions.
The modern financial manager has to take financial decisions in the most rational way. These
decisions have to be made in such a way that the funds of the firm are used optimally. These
decisions are referred to as managerial finance functions since they require special care with
extraordinary administrative ability, management skills and decision - making techniques, etc.
Functions of finance manager
Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function.

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He must have entire knowledge in the area of accounting, finance, economics and management.
His position is highly critical and analytical to solve various problems related to finance. A
person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.
4. Cash Management
Present days cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
Importance of financial management
Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their
smooth running of the business concern and also maintain the business carefully to achieve the
goal of the business concern. The business goal can be achieved only with the help of effective
management of finance. We cant neglect the importance of finance at any time at and at any
situation.
Some of the importance of the financial management is as follows:
(i)
Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
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(ii)
Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.
(iii)
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
(iv)
Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct
relationship with various department functions such as marketing, production personnel, etc.
(v)
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.
(vi)
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the investors and
the business concern. Ultimate aim of any business concern will achieve the maximum profit and
higher profitability leads to maximize the wealth of the investors as well as the nation.
(vii) Promoting Savings
Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings.
Nowadays financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of
the financial management.

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TOPIC 2: WORKING CAPITAL MANAGEMENT

INVENTORY MANAGEMENT
Introduction
Inventories constitute the most significant part of current assets of the business concern. It is also
essential for smooth running of the business activities.
A proper planning of purchasing of raw material, handling, storing and recording is to be
considered as a part of inventory management.
Inventory management means, management of raw materials and related items.
Inventory management considers what to purchase, how to purchase, how much to purchase,
from where to purchase, where to store and when to use for production etc.
Meaning
The dictionary meaning of the inventory is stock of goods or a list of goods. In accounting
language, inventory means stock of finished goods. In a manufacturing point of view, inventory
includes, raw material, work in process, stores, etc.
Kinds of Inventories
Inventories can be classified into five major categories.
A. Raw Material
It is basic and important part of inventories. These are goods which have not yet been committed
to production in a manufacturing business concern.
B. Work in Progress
These include those materials which have been committed to production process but have not yet
been completed.
C. Consumables
These are the materials which are needed to smooth running of the manufacturing process.
D. Finished Goods
These are the final output of the production process of the business concern. It is ready for
consumers.
E. Spares
It is also a part of inventories, which includes small spares and parts.
Objectives of Inventory Management
Inventories occupy 3080% of the total current assets of the business concern. It is also very
essential part not only in the field of Financial Management but also it is closely associated with
production management. Hence, in any working capital decision regarding the inventories, it will
affect both financial and production function of the concern. Hence, efficient management of
inventories is an essential part of any kind of manufacturing process concern.
The major objectives of the inventory management are as follows:
To efficient and smooth production process.
To maintain optimum inventory to maximize the profitability.
To meet the seasonal demand of the products.
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 To avoid price increase in future.

To ensure the level and site of inventories required.
To plan when to purchase and where to purchase
To avoid both over stock and under stock of inventory.
Techniques of Inventory Management
Inventory management consists of effective control and administration of inventories. Inventory
control refers to a system which ensures supply of required quantity and quality of inventories at
the required time and at the same time prevent unnecessary investment in inventories.
Inventory management techniques may be classified into various types:
Inventory Management Technique
(i)
Techniques Based on Order Quantity
(ii)
Techniques Based on the Records
(iii)
Techniques Based on the Classification
Techniques based on the order quantity of Inventories
Order quantity of inventories can be determined with the help of the following techniques:
(a) Stock Level
Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock for the smooth running of
the business process. Different level of stock can be determined based on the volume of the
stock.
(b) Minimum Level
The business concern must maintain minimum level of stock at all times. If the stocks are less
than the minimum level, then the work will stop due to shortage of material.
Min level = Re-order level (Normal consumption Normal delivery period)
(c) Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is the
level when the business concern makes fresh order at this level.
Re-order level = maximum consumption maximum Re-order period.
(d) Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain.
If the quantity exceeds maximum level limit then it will be overstocking.
Maximum level = Re-order level + Re-order quantity
(Minimum consumption Minimum delivery period)
(e) Danger Level
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It is the level below the minimum level. It leads to stoppage of the production process.
Danger level=Average consumption Maximum re-order period for emergency purchase
(f) Average Stock Level
It is calculated such as,
Average stock level= Minimum stock level + of re-order quantity maximum level
Fig: determining the stock level

Maximum level
75
Optimum level /re-order level
500
Stock
Level

Average stock level

Minimum level
Danger level

10
0
Time
(g) Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with suppliers.
The time taken in processing the order and then executing it is known as lead time.
(h) Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/ or
usage rates are greater than expected. Safety stocks are determined by opportunity cost and
carrying cost of inventories. If the business concerns maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying
costs.
(i) Economic Order Quantity (EOQ)

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One of the major inventory management problems to be resolved is how much inventory
should be added when inventory is replenished. If the firm is buying raw materials, it has
to decide lots in which it has to be purchased on each replenishment. These problems are
called order quantity problems and the task of the firm is to determine the economic order
quantity.
EOQ refers to the level of inventory at which the total cost of inventory comprising
ordering cost and carrying cost. Determining an optimum level involves two types of cost
such as ordering cost and carrying cost. The EOQ is that inventory level that minimizes
the total of ordering of carrying cost.
Types of costs in inventory management
(i) Ordering costs
- Relating to purchased items would include expenses on the following:
requisitioning, set up, and receiving and placing in storage
(ii) Carrying costs
- Include expenses on the following: interest on capital locked up in inventory,
storage, insurance, obsolescence, and taxes. Carrying costs are about 20% of the
value of inventories held.
(iv)
Shortage costs
- Arise when inventories are short of requirement for meeting the needs of
production or the demand of customers. Inventory shortages may result in one or
more of the following: high costs concomitant with crash procurement, less
efficient and uneconomic production schedules and customer dissatisfaction and
loss of sales.
EOQ can be calculated with the help of the mathematical formula:
EOQ = 2ao/c
Where,
a = Annual usage of inventories (units)
o = Buying cost per order
c = Carrying cost per unit

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Total cost
Minimum
Total cost
Carrying cost
Cost

Ordering cost

Q
Order size

Fig: Economic Order Quantity

NB: carrying costs varies directly with the order size (since the average level of inventory is onehalf of the order size), whereas the ordering costs varies inversely with the order size.
The total cost of ordering and carrying is minimized when
EOQ =
(v)

or Q=

2 FU
PC

It is inventory useful tool for inventory management. It tells us what should be the
order size for purchased items and what should be the size of production run for
manufactured items.

Example:
U Annual sales
F Fixed cost per order
P Purchase price per unit
C Carrying cost
Q=

2 AO

20,000 units
sh.2, 000
sh.12
25% of inventory value

2 FU = 2 x 20,000 x 2000 12 x .25 = 5,164

PC

Example
The finance department of PT Corporation gathered the following information:
The carrying cost per unit of inventory sh.10
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The fixed costs per order sh. 20

The number of units required per year 30,000
The variable cost per unit ordered sh.2
The purchase cost price per unit sh.30
Required: determine the economic order quantity (EOQ), total number of orders in a year,
and the time gap between two orders

Solution
Annual usage (U) = 30,000 units
Fixed cost per order (F) = sh. 20
Price per unit(p) = purchase price per unit + variable cost per unit ordered
= sh.30 + sh.2 = sh.32
Percent Carrying cost(C) = carrying cost per unit / price per unit =sh.10/ sh.32 = 0.3125
Q=

2 FU
PC

2 x 20 x 30,000/32 x 0.3125 = 346 units

Total number of orders in a year = 30,000/ 346 = 87

Time gap between two orders = 365/87 = about 4 days
Example
A Modern enterprise requires 90,000 units of a certain item annually. It costs sh.3 per unit. The
cost per purchase order is sh.300 and the inventory carrying cost is 20% per year.
Required: what is the EOQ?
Solution
Annual usage (U)
Purchase cost per unit (P)
Cost per purchase order (F)
Carrying cost
Q=

2 FU
PC

= 90,000
= sh.3
= sh.300
= sh.20% p.a.

2 x 300 x 90,000/3 x 0.2 = 9487 units

Example
Cheran Corporation requires 2,000 units of a certain item per year. The purchase price per unit is
sh.30; the carrying cost of inventory is 25% of the inventory value and the fixed cost per order is
sh.1, 000.
Required:
(a) determine the economic order quantity
(b) What will be the total cost of carrying and ordering inventories when 4 orders of equal
size are placed?
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(a) Q=

2 FU
PC

2 x 1,000 x 2,000 = 730 units

30 x 0.25

(b) If four orders of 500 units each are placed the total cost of carrying and ordering
inventories will be:
TC = U/Q x F + Q/2 x p x c
= 2,000/500 x 1,000 + 500/2 x 30 x 0.25
= 4,000 + 1,875
= sh.5, 875
Exercise 1
(a) Find out the economic order quantity and the number of orders per year from the following
information:
Annual consumption: 36,000 units
Purchase price per units: Rs. 54
Ordering cost per order: Rs. 150
Inventory carrying cost is 20% of the average inventory.
Solution

(a) Inventory = 2AO/C = 2 x 36000 x 150 0.2 x 54 = 1,000 units

(b) Number of orders per year = 36,000/ 1000 = 36
Exercise 2
From the following information calculate, (1) Re-order level (2) Maximum level
(3) Minimum level (4) Average level
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum usage: 50 units per week
Re-order quantity (EOQ) 500: units
Log in time: 5 to 7 weeks
Solution
(1) Re-order Level
= Maximum consumption Maximum Re-order period
= 1507=1050 units
(2) Maximum Level
= Re-order level+ Re-order quantity (Minimum consumption Minimum delivery
period)
= 1050 + 500 (50 5) = 1300 units
(3) Minimum Level
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= Re-order level (Normal consumption Normal delivery period)

= 1050 (100 6) = 450 units
(4) Average Level
= Maximum level + Minimum level
2
= 1300 + 450
2
= 875 units.
Re-order point is given as;
Re- order point = safety stock + lead time x usage
The inventory turnover is given as:
Inventory turnover = Annual demand / EOQ
The inventory conversion is given as:
Inventory conversion = No of days x EOQ / Annual demand
Example
A manufacturing firm has an expected usage of 50,000 units of certain product during the next
year. The cost of processing an order is Ksh.20 and carrying cost per unit is Ksh.0.50 for year
one. Lead time on order is five days and the company will keep a reserve supply of two days
usage.
Required:
(a) calculate the economic order quantity
(b) the re-order point(assume 365 day year)
Solution
(a) EOQ =

2 AO

= 2 x 50,000 x 20/0.50 = 2,000 units

C
(b) The re-order point
Daily usage = 50,000 / 365 days = 137 units
Re-order point = safety stock + lead time x usage
= 2(137) + 5(137) = 959 units
Example
ABC ltd requires 2,000 units of a component costing Ksh.50 each. The items are
available locally and therefore the lead time is 7 days. Each order cost Ksh.50 to
process and carrying cost is Ksh.20 per unit per annum. The management has set the
safety stock to be 10 units. (Assume a 360 day year).
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Required:
(a) No of units to be ordered each time an order is placed
(b) Compute the re-order level , inventory conversion and inventory turnover
Solution
(a)

EOQ =

2 AO

= 2 x 2000 x 50/20 = 100 units

C
(b) Inventory conversion = 360 x EOQ/A = 360 x 100/ 2000 = 18 days
(c) Re-order level
Daily usage = 2000 360 = 5.6 units
Re-order point = safety stock + lead- time x usage
= 10 + 7(5.6) = 49.20 units = 50 units
The firm should therefore place an order every time they have 50 units in the store
(d) Inventory turnover = Annual demand /EOQ = 2000/100 = 20 times
Valuation of Inventories
Inventories are valued at different methods depending upon the situation and nature of
Manufacturing process. Some of the major methods of inventory valuation are mentioned as
follows:
1. First in First Out Method (FIFO)
2. Last in First Out Method (LIFO)
3. Highest in First Out Method (HIFO)
4. Nearest in First Out Method (NIFO)
5. Average Price Method
6. Base Stock Method
7. Standard Price Method
8. Market Price Method
Example
From the particulars given below write up the stores ledger card:
2008 January 1, Opening stock 1,000 units at Rs. 26 each.
5 Purchased 500 units at Rs. 24.50 each.
7 Issued 750 units.
10 Purchased 1,500 units at Rs. 24 each.
12 Issued 1,100 units.
15 Purchased 1,000 units at Rs. 25 each.
17 Issued 500 units.
18 Issued 300 units.
25 Purchased 1,500 units at Rs. 26 each.
29 Issued 1,500 units.
Adopt the FIFO and LIFO method of issue and ascertain the value of the closing stock.
FIFO METHOD

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Date
2008
Jan. 1
Jan. 5

Receipts
Qty
Rate/uni
(units) t
Sh.
500
24.50

Amoun
t
Sh.
12,250

Jan. 7
Jan. 10 1500

24

Issues
Qty
(units)

Rate
Sh.

Amoun
t
Sh.
-

750

26

19,500

36,000

Jan. 12

250
500
350

Jan. 15 1000

25

26
24.50
24

6,500
12,250
8,400

25,000

Jan.17

500

24

12,000

Jan.18

300

24

7,200

350
1,000
150

24
25
26

8,400
25,000
3,900

Jan.25

1500

26

39,000

Jan. 29

DATE
2008
Jan 1
Jan 5

RECEIPTS
Qty
(units)
500

Rate
Sh.
24.50

LIFO METHOD
ISSUES
Amount
Sh.
12,250

Jan 7
Jan 10

1500

24

Jan 15

Qty
(units)
-

Rate
Sh.
-

Amount
Sh.
-

500
250

24.50
26

12,250
6,500

1,100
1,000

KAIBOS MOSES

25

Amount
Sh.

1000
1,000
500

26
26
24.50

26,000
26,000
12,250

250
500

26
24.50

6,500
12,250

250
500
1500
1150

26
24.50
24
24

6,500
12,250
36,000
27,600

1150
1,000
650
1,000
350
1,000
350
1,000
1500
1,350

24
25
24
25
24
25
24
25
26
26

27,600
25,000
15,600
25,000
8,400
25,000
8,400
25,000
39,000
35,100

BALANCE

36,000

Jan 12

Balance
Qty
Qty
(units) Sh.

24

25,000
Page 23

26,400

Qty
(units)
1,000
1,000
500
750

Rate
Sh.
26
26
24.50
26

Amount
Sh.
26,000
26,000
12,250
19,500

750
1500
750
400
750

26
24
26
24
26

19,500
36,000
19,500
9,600
19,500

Jan 17

500

25

12,500

Jan 18

300

25

7,500

1500

26

39,000

Jan 25

1,500

Jan 29

26

39,000

400
1,000
750
400
500
750
400
200
750
400
200
1,500
750
400
200
1,350

24
25
26
24
25
26
24
25
26
24
25
26
26
24
25

9,600
25,000
19,500
9,600
12,500
19,500
9,600
5,000
19,500
9,600
5,000
39,000
19,500
9,600
5,000
34,100

CASH MANAGEMENT
Business concern needs cash to make payments for acquisition of resources and services
for the normal conduct of business. Cash is one of the important and key parts of the
current assets.
Cash is the money which a business concern can disburse immediately without any
restriction. The term cash includes coins, currency, cheques held by the business concern
and balance in its bank accounts.
Management of cash consists of cash inflow and outflows, cash flow within the concern
and cash balance held by the concern etc.
- Cash, the most liquid, is of vital importance to the daily operations of business firms.
It is generally referred to as the life blood of a business enterprise.(1 4% is crucial
to the solvency of the business because in a very important sense cash is focal point
of funds flows in a business)
- Why does a firm need cash? As John Maynard Keynes put forth, there are three
possible motives for holding cash.
(i)

Transaction motive It is a motive for holding cash or near cash to meet routine cash
requirements to finance transaction in the normal course of business. Cash is needed
to make purchases of raw materials, pay expenses, taxes, dividends etc.

(ii)

Precautionary motive there may be some uncertainty about the magnitude and
timing of cash inflows from the sale of goods and services sale of assets, and issuance
of securities; to meet unexpected contingencies. Cash is needed to meet the
unexpected situation like, floods, strikes etc.

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(iii)

Speculative motive firms would like to tap profit making opportunities arising from
fluctuations in commodity prices, security prices, interest rates and foreign exchange
rates. Certain amount of cash is needed to meet an opportunity to purchase raw
materials at a reduced price or make purchase at favorable prices.
-

Cash budgeting
Cash budgeting or short term cash forecasting is the principal tool of cash
management.
Cash budgets are helpful in;
(i)
Estimating cash requirements
(ii)
Planning short- term financing
(iii)
Scheduling payments in connection with capital expenditure projects
(iv)
Planning, purchases of materials
(v)
Developing credit policies
(vi)
Checking the accuracy of long term forecasts

Cash Management Techniques

(Cash collection and disbursement)
Managing cash flow constitutes two important parts:
A. Speedy Cash Collections.
B. Slowing Disbursements.
Float
The cash balance shown by on its books is called the book, or ledger, balance whereas
the balance shown in its bank account is called the available, or collected, balance.
The difference between the available balance and the ledger balance is referred to as
the float. There are two kinds of float: disbursement float and collection float.
Cheques issued by a firm create disbursement float. Cheques received by a firm lead
to collection float.
Disbursement float = firms available balance firms book balance
The net float is the sum of disbursement float and collection float. It is simply the
difference between the firms available balance and its book balance. If the net float is
positive (negative) it means that the available balance is greater (lesser) than the book
balance.
Collection float = firms available balance- firms book balance
Since what matters is the available balance, as a financial manager you should try to
maximize the net float. This means that you should strive to speed up collections and
delay disbursements.
Speedy Cash Collections

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Business concern must concentrate in the field of Speedy Cash Collections from
customers.
For that, the concern prepares systematic plan and refined techniques. These techniques
aim at, the customer who should be encouraged to pay as quickly as possible and the
payment from customer without delay.
Speed up collections
Speeding up collection time comprises mailing time, cheque processing delay, and banks
availability delay is shown below:
Customer mails
the cheque

company receives
the cheque

company deposits
the cheque

cash

available
Time
Mailing time

processing

availability delay

When a company receives payments through cheques that arrive by mail, all the three
components of collection time are relevant. To speed up collection, companies often use
lockboxes and concentration banking which are essentially systems for expeditious decentralized
collection.
Speedy Cash Collection business concern applies some of the important techniques as follows:
(i)
Lock Box System
It is a collection procedure in which payers send their payment or cheques to a nearby post box
that is cleared by the firms bank. Several times that the bank deposits the cheque in the firms
account. Under the lock box system, business concerns hire a post office lock box at important
collection centers where the customers remit payments. The local banks are authorized to open
the box and pick up the remittances received from the customers.
As a result, there is some extra savings in mailing time compared to concentration bank.
The lock box system
(i)
Cuts down mailing time, because cheques are received at nearby post office
instead of at corporate headquarters
(ii)
It reduces the processing time because the company does not have to open the
envelope
(iii)
Shortens the availability delay because the cheques are typically drawn on
local banks
When is it worthwhile to have a lock box? The answer depends on the costs and benefits of
maintaining the lock box. Suppose that your company is thinking of setting up a lock box. You
gather the following information:
Average number of daily payments
50
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 Average size of payment

sh.8,000
Savings in mailing and processing time
2 days
Annual rental for the lock box
sh.3,000
Bank charges for operating the lock box
sh. 72,000
Interest rate
15%
The lock box will increase your companys collected balance by:
50 items a day x sh. 8,000 per item x2 days saved = sh. 800,000
The annual benefit in the form of interest saving on account of this is:
Sh.800, 000 x 0.15 = sh. 120,000
The annual cost of the lock box is:
Sh.3, 000 (rental) + sh. 72,000(bank charges) = sh.75, 000
Since the interest saving exceeds the cost of the lock box, it is advantageous to set up the lock
box. More so because your company also saves on the cost of processing the cheques internally.
(ii)
Concentration Banking
It is a collection procedure in which payments are made to regionally dispersed collection
centers, and deposited in local banks for quick clearing. It is a system of decentralized billing and
multiple collection points. The cheques received by the local branch office are deposited for
collection into a local bank account. Surplus funds from various local bank accounts are
transferred regularly (mostly daily) to a concentration account at one of the companys principal
banks.
Concentration banking can be combined with lock box arrangement to ensure that the funds are
pooled centrally as quickly as possible.
(iii)
Prompt Payment by Customers
Business concern should encourage the customer to pay promptly with the help of offering
discounts, special offer etc. It helps to reduce the delaying payment of customers and the firm
can avoid delays from the customers. The firms may use some of the techniques for prompt
payments like billing devices, self address cover with stamp etc.
(iv)
Early Conversion of Payments into Cash
Business concern should take careful action regarding the quick conversion of the payment into
cash. For this purpose, the firms may use some of the techniques like postal float, processing
float, bank float and deposit float.
Slowing Disbursement
An effective cash management is not only in the part of speedy collection of its cash and
receivables but also it should concentrate to slowing their disbursement of cash to the customers
or suppliers. Slowing disbursement of cash is not the meaning of delaying the payment or
avoiding the payment. Slowing disbursement of cash is possible with the help of the following
methods:
(i)
Avoiding the early payment of cash
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The firm should pay its payable only on the last day of the payment. If the firm avoids early
payment of cash, the firm can retain the cash with it and that can be used for other purpose.
(ii)
Centralized disbursement system
Decentralized collection system will provide the speedy cash collections. Hence centralized
disbursement of cash system takes time for collection from our accounts as well as we can pay
on the date.
Cash Management Models
The cash budget of the firm indicates periods when the firm is expected to have shortage of
funds and surplus funds. If a shortage is expected, ways and means of overcoming the shortage
must be explored.
On the other hand, if a surplus is projected, it has to be determined how it should be split
between marketable securities and cash holdings.
Cash management models analyze methods which provide certain framework as to how the cash
management is conducted in the firm. Cash management models are the development of the
theoretical concepts into analytical approaches with the mathematical applications. There are
three cash management models which are very popular in the field of finance:
Baumol model
(The basic objective of the Baumol model is to determine the minimum cost amount of cash
conversion and the lost opportunity cost.
It is a model that provides for cost efficient transactional balances and assumes that the
demand for cash can be predicated with certainty and determines the optimal conversion size.
Total conversion cost per period can be calculated with the help of the following formula)
William J. Baumol proposed a model which applies the economic order quantity (EOQ) concept,
commonly used in inventory management, to determine the cash conversion size (which in turn
influences the average cash holding of the firm). The purpose of such an analysis is to balance
the income foregone when the firm holds cash balances (rather than invests in marketable
securities) against the transaction costs incurred when marketable securities are converted into
cash.
Illustration of Zeta Company limited.
Zeta requiressh.1.5 million in cash for meeting its transaction needs (represented by T)
over the next three months, its planning period for liquidity decisions. This amount is
available with Zeta in the form of marketable securities.
To meet the projected cash needs, zeta can sell its marketable securities in any of the five
lot sizes: 100,000, 200,000, 300,000, 400,000, and 500,000. These cash conversion sizes
(C).
The number of times marketable securities will be converted into cash is simply T/C. the
value of T/C, given T= sh.1.5m and C varying in the range sh.100,000 sh.500,000
Cash payments are made evenly over the three months planning period. This means that
the cash balance of the firm behaves in the saw tooth manner. Hence the average balance
is simply C2. The average cash balances corresponding to the different cash conversion
sizes
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Zeta can earn 16% annual yield on its marketable securities. This implies that the interest
rate for the three months planning period is 4% (represented by I ). Since the average
cash balance holding is C/2,the interest income foregone is C2 x 0.04
The conversion of marketable securities into cash entails a fixed cost (represented by b)
of sh.500 per transaction. b is independent of the size of the cash conversion. The total
conversion cost during the planning period will be equal to: number of cash orders x cost
per transaction. In general, the total conversion cost is (T/C) b.
The total cost of ordering and holding T/C
Table: Establishing the optimal cash conversion size
1. Cash conversion
size ( the amount
of
marketable
securities
that
will be converted
into cash)
2. Number
of
conversions
during
the
planning period
of the three
months
(1,500,000 line
1)
3. Average
cash
balance
(line 1 2)
4. interest income
foregone
( line 3 x 0.04)
5. cost of cash
conversion
(sh.500 x line 2)
6. total cost of
ordering
and
holding cash
( line 4 + line 5)

Sh.100,000

200,000

300,000

400,000

500,000

15

7.5

3.75

50,000

100,000

150,000

200,000

250,000

2000

4,000

6,000

8,000

10,000

7,500

3,750

2,500

1,875

1,500

9,500

7,750

8,500

9,875

11,500

Fig: Cash balance according to the Baumol model

KAIBOS MOSES
Cash
Bal.

C
/

Page 29
Time

Looking at the total costs (line 6), we find that it is minimized when C, the conversion order, is
sh.200, 000. This means that at the beginning of the planning period Zeta should convert only sh.
200,000 of its marketable securities into cash. The remaining amount should be converted into
cash in lots of sh.200, 000 as dictated by the disbursal needs of the firm.
General model employing the following symbols developed in our illustration:
C Amount of marketable securities converted into cash per order
I interest rate earned per planning period on investment in marketable securities
T Projected cash requirements during the planning period
S Sum of conversion and holding costs
The sum of conversion and holding costs (S) can be expressed as follows:
S=

I(C/2) + b (T/C)

Interest income
Foregone

conversion costs

The value of C which minimizes S can be found from the following equation
C=

2bT / I

Applying equation to the situation of Zeta limited we get:

C=

2 x 500 x 1,500,000/ 0.004

= sh.193, 600

Miller and Orr Model

Expanding on the Baumol model, Miller and Orr consider a stochastic generating process for
periodic changes in cash balance. Miller and Orr assume that the changes in cash balance over a
given period are random, in size as well as direction.
Given the behavior of cash balance changes, Miller and Orr model seeks to answer the following
questions:
When should transfers be effected between marketable securities and cash?
What should be the magnitude of these transfers?
2. Miller-Orr model
This model was suggested by Miller Orr. This model is to determine the optimum cash
balance level which minimizes the cost of management of cash.

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3. Orglers model
Orgler model provides for integration of cash management with production and other
aspects of the business concern. Multiple linear programming is used to determine the
Optimal cash management.
Orglers model is formulated, based on the set of objectives of the firm and specifying the
set of constrains of the firm.

ACCOUNTS RECEIVABLE MANAGEMENT

The term receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business. Receivables are also one of the major parts
of the current assets of the business concerns. It arises only due to credit sales to customers,
hence, it is also known as Account Receivables or Bills Receivables.
Management of account receivable is defined as the process of making decision resulting to the
investment of funds in these assets which will result in maximizing the overall return on the
investment of the firm.
The objective of receivable management is to promote sales and profit until that point is reached
where the return on investment in further funding receivables is less than the cost of funds raised
to finance that additional credit.
The costs associated with the extension of credit and accounts receivables are identified as
follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.
Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales have
been made.
Capital Cost
This is the cost on the use of additional capital to support credit sales which alternatively could
have been employed elsewhere.
Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of
salaries to the staff kept for maintaining accounting records relating to customers, cost of
investigation etc.
Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be able to
recover the over dues because of the inability of the customers.
Factors Considering the Receivable Size
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Receivables size of the business concern depends upon various factors. Some of the
important factors are as follows:
1. Sales Level
Sales level is one of the important factors which determine the size of receivable of
the firm. If the firm wants to increase the sales level, they have to liberalize their
credit policy and terms and conditions. When the firms maintain more sales, there
will be a possibility of large size of receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from
firm to firm or even some times product to product in the same industry. Liberal
credit policy leads to increase the sales volume and also increases the size of
receivable. Stringent credit policy reduces the size of the receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon
the credit terms, size of the receivables may increase or decrease. Hence, credit term
is one of the factors which affect the size of receivable.
4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales.
Normally it is expressed in terms of Net days.
5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due
date. A special discount will be provided to the customer for his payment before the
due date.
6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce
the size of receivable.
Accounts receivables represent the extension of open- account credit by one firm to other firms
and to individuals. For most companies, accounts receivable are an extremely important
investment and require careful analysis.
Trade credit is considered as an essential marketing tool. Firms grant credit for the following
reasons:
(i)
Competition generally, the higher the degree of completion, the more the credit
granted by the firm
(ii)
Firms bargaining power if a firm has a higher bargaining power vis-a- vis its
buyers, it may grant no or less credit. The company will have a strong bargaining
power if it has a strong product, monopoly power, brand image, large size o strong
financial position.
(iii)
Buyers status large buyers demand easy credit terms because of bulk purchases and
higher bargaining power. Some companies follow a policy of not giving much credit
to small retailers since it is quite difficult to collect dues from them.
(iv)
Relationship with dealers firms sometimes extend credit to dealers to build long
term relationships with them or to reward them for their loyalty

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(v)
(vi)

Marketing tool credit is used as a marketing tool, particularly when a new product is
launched or when a firm wants to push its weak product.
Industry practice small firms have been found guided by industry practice or norm
more than the large firms. Sometimes, firms continue giving credit because of past
practice rather than industry practice.

Firms must establish credit policies with a goal to maximize the value of the firm. To achieve
this goal, the evaluation of investment in account receivables should involve the following steps:
(i)
Estimation of incremental operating profit
(ii)
Estimation of incremental investment in account receivables
(iii)
Estimation of the incremental rate of return of investment
(iv)
Comparison of the incremental rate of return with the required rate of return
Example
Xx Company is considering increasing its credit period from a net of 35 days to a net of 50 days.
The firm expects sales to increase fromKsh.120, 000 to Ksh.180, 000. The average collection
period is to increase from 35 days to 50 days. The bad debts ratio and collection cost ratio are
expected to remain as 5% and 6% respectively. The firm variable cost ratio is 85% and
corporation tax is 50%. After tax rate of return is 20% on its investment. (Assume a year has 360
days).
Required: Advice the firm whether it should change its credit policy.
Solution
Step 1
Increase in sales ( 180,000 120,000)
Less:VC ( 85% x sh.60,000)
Increase in profit
Less: bad debt ( 5% x sh.60,000)
Less: collection cost ( 6% x sh.60,000)
Profit before tax(PBT)
Less: tax ( 505 x sh. 2,400)
PAT

60,000
(51,000)
9,000
(3,000)
(3,600)
2,400
(1,200)
1,200

Step 2: Opportunity cost of capital

Initial debtors
Net period = debtor/sales x 360
Debtors = 120,000 x 35/ 360
Debtors = sh.11,667

New debtors
Net period = debtors/sales x 360
Debtors = 180,000 x50 /360
Debtors = sh.25,000

Step 3:
Increase in debtors (sh.25, 000 - 11,667) = sh.13, 333
Rate of return
(20% x sh.13, 333) = sh. 2,667
Step 4:
PAT
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sh.1, 200
Page 33

Less: required rate of return

Surplus/loss

sh. (2,667)
sh. (1467)

Advice: the firm should not change its credit policy.

Example:
A firm has current sales of Ksh.7.2 million. The firm has an unutilized capacity and therefore has
a view to boost its sales. It is considering lengthening the credit period from 30 days to 45 days
these should increase sales by Ksh.360, 000. Bad-debts losses are expected to increase from 3%
to 4% of sales. The variable costs are 70% of sales. The firm corporate tax rate is 30% and its
required after tax rate of return is 10% on its investment.
Required: advice the firm on whether to change its credit period
Solution
Step 1
sh
360,000
(252,000)
108,000
(14,400)
93,600
(28,030)
65,520

Increase in sales
Less:VC (70% x sh.360,000)
Increase in profits
Less:bad debts( 4% x sh.360,000)
PAT
Less: tax (30% x sh.93,600)
PAT
Step 2: Opportunity cost of capital
Initial debtors
Net period = debtors/sales x 360
Debtors = 7200,000x 30 / 360
Debtors = sh.600,000

New debtors
Net period = debtors /sales
x 360
Debtors= 7560,000x45/360
Debtors = sh.945,000

Step 3
Increase in debtors (945,000- 600,000) = sh.345, 000
Rate of return (10% x 345,000) = sh.34, 500
Step 4
PAT
sh.65520
Less: Opportunity cost (rate of return) (34,500)
Surplus/loss
sh.30, 020
Advice: The firm should adopt the new credit policy

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TOPIC 3: FINANCIAL PLANNING AND FORECASTING

Meaning and importance
Planning business finances and carrying out financial plans is a continuous process in the day to
day administration of a business. It is essentially concerned with the economical procurement
and profitable use of funds a use which is determined by realistic investment decisions.
Financial planning is deciding in advance the course or line of action of business in respect of the
financial management of a concerned primary advantage of financial planning is the elimination
of waste resulting from complexity of operation.
It helps to avoid waste by providing policies and procedures which make a closer coordination
between various functions of the business enterprise.
Example: technological advancement, higher taxes, increasing cost of social legislation,
fluctuation of interest rates and pressures resulting from increasing completion tend to cause the
management to exert wasteful effort. To plan effectively requires that forecasts be made of future
trends, and when these are used as a basis for plans, many unprofitable ventures are eliminated.
Financial planning should achieve a total integration and coordination of all the plans of the
other functions
The success of failure of production and distribution functions of firms depend upon the manner
in which the finance function. Financial planning should achieve a total integration and
coordination of all the plans of the other functions of the firm. Financial planning is the
responsibility of the top management. Financial planning is part of large planning process in an
organization
Financial Plan
A financial plan is a statement estimating the amount of capital and determining its
`
`
composition. The quantum of funds needed will depend upon the assets requirement of the
business. The time at which the funds will be needed should be carefully decided so that finances
are raised at a time when these are needed.
The next aspect of a financial plan is to determine the pattern of financing. These are a
member of ways for raising funds. The selection of various securities should be done carefully.
Example: the funds may be raised by issuing shares, debentures.
Steps in financial planning
(a) Establishing objectives
Business enterprise operate in a dynamic society and in order to takeadvantage of the
charging economic conditions, financial planning shouldestablish both short term and
long term objectives
(b) Formulating objectives
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Financial policies guide all actions. Policies may be classified into:

(i)Policies governing the amount of capital required by the firm to achieve the
financial objectives
(ii) Policies which guide management in selection of source of funds
(iii)

Policies which act as guide in the use of debt or equity capital

(iv)

Policies which govern credit collection of activities of an enterprise

(c) Forecasting
Financial management is required to forecast the future in order to predict the
variability of factors influencing the type of policies the enterprise formulates. This
involves a thorough study of the companys past performance to identify trends.
These trends are projected into the future and modified taking into accounts events or
trends expected to occur in the future
(d) Formulation of policies
If a policy is to raise short term funds from banks, then a procedure should be laid to
approach the lenders and the persons authorized to initiate such actions.
(e) Providing for flexibility
The financial planning should ensure proper flexibility in objectives, policies and
procedures to adjust according to the changing economic situations. The changing
economic environment may offer new opportunities. The business should be able to
make use of such situations for the benefits of the concern.
Benefits of financial planning

(i)Identifies advance actions to be taken in various areas

(ii) Seeks to develop a number of options in various areas that can be exercised under
different conditions.
(iii) Facilitates a systematic exploration of interaction between investment and financing
decisions
(iv) Clarifies the links between present and future decisions
(v)

Forecasts what is likely to happen in future and hence help in avoiding surprises.

(vi)

Ensures that the strategic plan of the firm is financially viable

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(vii)

Provides benchmarks against which future performance may be measured

A business-plan time frame

Time frame represents how far out into the future you want to plan for your business.
You want your business to grow successfully for years and years into the future, but that goal
doesnt mean your current business plan goes all the way to forever.
Each business plan covers a unique planning period.
Some are designed to get a company to a defined sales level, a funding objective, or the
achievement of some other growth goal.
A good business plan covers a time frame that has a realistic start and finish, with a number of
measurable checkpoints in between.
Typical business plans, however, tend to use one-year, three-year, or five-year benchmarks. (Odd
numbers are popular, for some reason.)
Business planning is an ongoing process. From year to year and sometimes more often than
that companies review, revise, and even completely overhaul their plans.
As you establish your time frame, dont worry about casting it in cement. Instead, think of your
schedule as something you commit to follow unless and until circumstances change and you
make a conscious decision to revise it.
Implementing a financial plan
To this point the financial planning data has been gathered and analyzed, financial planning
statements have been created, goals and objectives have been measured and financial gaps found.
The next step in the financial planning process is implementing the financial plans
recommendations. Though this is not the last step in the process, most of the hard work is behind
you. With that said, the best financial plan is worthless if it is not implemented.
(a) Financial Planning Action Plan
To help with the implementation of a financial plan, many Advisors will create an
Action Plan. Your financial planning action plan should include all of the tasks that you
will need to accomplish in order to improve your financial situation.
(i)

Recommended Action Your action plan is a list of all of the recommendations that
you should accomplish in order to strengthen your financial plan. There are two ways
of looking at your list. Depending on the situation you can list them by importance or
chronologically (desired date of accomplishment).

(ii)

Purpose of Accomplishing Goal Next your financial planning action plan should
include a description of what the recommended action accomplishes. This helps
communicate the importance of accomplishing the recommendation and provides an
audit trail of sorts. This will come in handy if you change financial planners or want
to refresh your financial plan.

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(iii)

Target Date All great goals and objectives are time driven. This means choosing a
reasonable amount of time in which to implement the recommendation. This is the
easiest way to keep everyone on track.

(b) Finding Professionals and Specialists

When implementing a financial plan you will probably need to rely on the expertise of a
few specialists. These professionals can help you draft legal documents, find the right
service for your needs and help leverage a specific program or opportunity.
(i)

Certified Public Accountant A CPA can help with the preparation of financial
statement and budgets. In addition they will also help prepare your taxes and suggest
opportunities to reduce your tax liability.

(ii)

Insurance and Brokerage Services Insurance and investing are two pillars of sound
financial planning. As part of your financial planning action plan you many need to
open a brokerage account and request a consultation from an insurance professional.
Estate Planning Lawyers Estate planning is predominately based in law and
property rights. Finding a good Lawyer will help you navigate the complexities of the
law and help determine the best services for your situation.

(iii)

(c) Automate as Much as Possible

I have always been a fan of making life simple. This is why I try to automate as much of my
budget as possible. Automating a budget is extremely easy thanks to online banking and direct
deposit. When you choose to implement one of the most challenging parts of your financial plan,
the budget, you are increasing the probability of financial success.
Estimating the long term and short term financial needs
Before raising capital, it is essential to make estimates for long term and short term financial
needs. I n the absence of correct estimates, the business may suffer either from inadequate or
from excess capital. If there is a shortage of funds then the business will struggle for existence.
On the other hand, if capital is in excess of needs, then it will remain idle and may reduce
earnings in comparison to investment. So, the estimates should be such that all financial needs
are properly satisfied.
The finance required for a business is broadly classified into two main categories:
(a) Fixed capital requirements
(b) Working capital requirements
Fixed capital

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Stands for that amount of capital which is required for long term to create production facilities
through purchase of fixed assets such as plant, machinery, land, building, furniture etc.
The business does not intend to dispose of these assets and for this reason fixed capital is also
known as block capital.
Investment in non-current assets such as long-term receivables, goodwill, patents, copyrights,
long term investments etc also form part of fixed capital.
Fixed capital is also required for development, expansion and permanent working capital.
Importance of fixed capital
Capital is the life blood and nerve centre of a business. Capital is vey essential to maintain the
smooth running of the business. No business can be started without an adequate amount of fixed
capital.
Assessment of fixed capital requirements
Hence, the assessment of the total amount of fixed capital required in a business involves:
(a) Estimation of fixed assets requirements
(b) Estimation of intangible assets requirements
Factors affecting the estimation of fixed assets requirements. These can be studied under two
heads:
(i)

Internal factors

(ii)

External factors

Internal factors
(a) Nature or character of business
The fixed assets requirements of a business basically depends upon the nature of its
business
Public utility undertakings such as electricity, water supply and railways require huge
funds to be invested in fixed assets
Trading and financial firms have very less requirements for fixed assets but have to invest
large amounts in current assets.
(b) size of business
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the larger the size of a business unit, the greater is the requirement of fixed assets needed
to set up the business operations.
(c) Activities undertaken by the enterprise or scope of business
The requirement of fixed capital depends upon number of activities undertaken by the
enterprise.
For example, if a concern manufactures and markets its products itself, it needs more
fixed capital as compared to a concern that undertakes only manufacturing activities or
only marketing activities.
(d) Production techniques
Use of automatic machinery calls for larger investment in fixed assets.
On the other hand, if production methods are simple, which do not require such
equipments, less amount of fixed capital shall be needed.
(e) Mode of acquisition of fixed assets( extent of lease or hire)
Fixed assets may be purchased out rightly or acquired on lease or hire basis.
If an outright purchase of fixed assets is to be made, larger amount of fixed capital shall
be required in comparison to the acquisition of fixed assets on leasehold basis or on hire.
It is therefore essential to decide in advance as to which assets are to be acquired on
leasehold basis and which are to be purchased out rightly.
(f) Acquisition of old equipment and plant
In certain industries, old plant and machinery or equipments may be available at prices
much below the prices of the new plant and machinery.
If old plant and machinery could be satisfactorily used in the business, especially in the
areas where the technological change in production method is moderate or slow, it would
substantially reduce the required investment in fixed assets.
(g) Decision as regards ancillary units
In certain industries, there may be a possibility of carrying out certain processes through
ancillary units or subcontracts without compromising with the quality and cost of the
product. If it s so, the requirements of fixed assets can be decreased.
(h) Availability of fixed assets at concessional rates

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In some cases, the government provides land and other materials or facilities at
concessional rates to promote balanced industrial growth and regional development of
industries.
Further, plant and machinery may be available on installment basis.
Such concessions induce the promoters to establish business in these areas reducing their
investment in fixed assets.
External factors
The decisions relating to investment in fixed assets involve large amount of funds and are
of irreversible nature. Such decisions have a long term and significant effect on the
profitability of a business concern.
Thus, such decisions have to be carefully taken after considering the various factors
affecting future requirements of fixed assets as given below:
(a) International conditions and economic outlook
While taking decision relating to involvement in fixed assets, particularly in a large
concern, the general economic and international conditions also play an important role.
For example, if the level of business activity is expected to increase, the needs for fixed
assets and funds to finance their acquisition will also grow. In the same manner,
companies expecting war may commit large investment in fixed assets before there is a
shortage of such materials.
(b) population trends and its composition
if a firm is planning for national market for its products, national population trends
must be evaluated while forecasting for fixed asset requirements.
The age and sex composition of the population may also be important for certain
businesses
(c) Shift in consumer preferences
Another factor that affects the requirements of fixed assets is shift in consumer
preferences. Fixed assets requirements should be planned in a manner so as to provide
goods or services that consumers will accept.
(d) competitive factors
The decision making process on planning future requirements of fixed assets is also
influenced by competitive factors. For example, if an existing company shifts to a
particular line of business, then others may also follow the lead.
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(e) Shift in technology

Future improvements and shifts in technology have also to be considered while
deciding about the future requirements of fixed assets. The financial plan should
allow a scope for adjustments as and when new situations emerge.
(f) Government regulations
There may be certain Government regulations affecting the size and the direction of a
certain enterprise. Hence, these should also be considered while assessing
requirements of fixed assets. Although, it may not be possible to forecast changes in
Government policy, a margin should be provided to absorb the impact of such
changes.
WORKING CAPITAL
Working capital refers to that part of the firms capital which is required for financing short
term or current assets such as cash, marketable securities, debtors and inventories.
Funds thus invested in current assets keep revolving fast and are being constantly converted into
cash and these cash flows out again in exchange for other current assets. Hence, it also known as
revolving or circulating capital or short term capital.
The working capital requirements of a business concern depend upon a large number of factors
as:
(i)

Nature or character of business

(ii)

Size of business/ scale of operations

(iii)

Production policy

(iv)

Manufacturing process/ length of production cycle

(v)

Seasonal variations

(vi)

Working capital cycle

(vii)

Rate of stock turnover

(viii)

Credit policy

(ix)

Business cycles

(x)

Rate of growth of business

(xi)

Earning capacity and dividend policy

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(xii)

Price level changes

To avoid the shortage of working capital, an estimate of working capital requirements should be
made in advance so that arrangements can be made to procure adequate working capital
The working capital should be determined by estimating the investment in current assets minus
money expected from current liabilities
The following factors should be taken into consideration while making an estimate of working
capital requirements:
(i)

total costs incurred on material, wages and overheads

(ii)

the length of time for which raw materials are to remain in stores before they are
issued for production

(iii)

the time taken for conversion of raw material into finished goods

(iv)

the length of sales cycle during which finished goods are to be kept waiting for
sale

(v)

the average period of credit allowed to customers

(vi)

the amount of cash required to pay day to day expenses of the business

(vii)

the average amount of cash required to make advance payments, if any

(viii)

the average credit period expected to be allowed by suppliers

(ix)

time lag in payment of wages and other expenses

Limitations of financial planning

1. Difficulty of forecasting
Plans are decisions and decisions require facts about the future. Financial plans are
prepared by taking into account the expected situations in the future, which is always
uncertain. since future conditions cannot be forecasted accurately, the adaptability of
planning is seriously limited.
One way to offset the limitation is to improve forecasting techniques
Another way to overcome this limitation is to revise plans periodically
The development of variables plans, which take changing conditions into consideration,
will go a long way in eliminating this limitation
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2. Difficulty in change
another serious difficulty in planning is the reluctance or inability of the management to
change a plan once it has been made, for several reasons. Assets may have to be
purchased again; raw materials and cost may have to be incurred

3. Rapid change
The growing mechanism of industry is bringing rapid changes in industrial processes.
The methods of production, marketing devices, consumer preferences, create new
demand every time
The incorporation of new changes requires a change in financial plan every time. Once
investments are made in fixed assets, then these decisions cannot be reversed. It becomes
very difficult to adjust in the financial plan for incorporating fast changing solutions.
Unless a financial plan helps the adoption of new techniques, its utility becomes limited.

4. Problem of coordination
Financial function is the most important of all functions. Other functions also influence a
decision about financial plan. While estimating financial means, production policy,
personal requirements, marketing possibilities are all taken into account.
Unless there is proper coordination among all the functions, preparing of financial plan
becomes difficult. Often there is a lack of coordination among different functions. Even
indecision among personnel disturbs the process of financial planning.
SALES FORECAST
-

The sales forecast is typically the starting point of the financial forecasting exercise. Most
of the financial variables are projected in relation to the estimated level of sales. Hence,
the accuracy of the financial forecast depends critically on the accuracy of the sales
forecast.

Sales forecast may be prepared for varying planning horizons to serve different purposes.
A sales forecast for a period of 3-5 years, of for even larger durations, may be developed
mainly to aid investment planning.

A sales forecast for a period of one year (and in some cases two years) is the primary
basis for the financial forecasting.

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Sales forecasting for shorter durations (6 months,3 months, 1month) may be prepared for
facilitating working capital planning and cash budgeting.

A wide range of sales forecasting techniques and methods are available. They may be
divided into three broad categories:
(a) Qualitative techniques these techniques rely essentially on the judgment of experts
to translate qualitative information into quantitative estimates
(b) Time series projection methods these methods generate forecasts on the basis of an
analysis of the past behavior of time series.
(c) Casual models these techniques to develop forecasts based on cause effect
relationships expressed in an explicit, quantitative manner.

PRO FORMA PROFIT AND LOSS ACCOUNT

There are two methods used for preparing the pro- forma profit and loss account the percent of
sales method and the budgeted expense method.
(i) Percent of sales method
-

The percent of sales method for preparing the pro forma profit and loss account is fairly
simple. Basically, this method assumes that the future relationship between various
elements of costs to sales will be similar to their historical relationship. When using this
method, a decision has to be taken about which historical cost ratios to be used. Should
these ratios pertain to the previous year, or the average of two or more previous years?

The following example illustrates the application of the percent of sales method of
preparing the pro- forma profit and loss account of SS electronics for the year 2012.

In this table, historical data is given for two previous years, 2010 and 2011. For
projection purposes, a ratio based on the average of two previous years has been used.
The forecast value of each item is obtained as the product of the estimated sales and the
average percent of sales ratio applicable to that item.
(ii)

Budgeted expense method

We assume that all elements of costs and expenses bore a strictly proportional
relationship to sales. The budgeted expense method, calls for estimating the value of each
item on the basis of expected developments in the future period for which the pro- forma
profit and loss account is being prepared.
(iii) a combination method
Described above. For certain items, which have a fairly stable relationship with sales, the
percent of sales method is quite adequate. For other items, where future is likely to be

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very different from the past, the budgeted expense method, which calls for managerial
assessment of expected future developments, is eminently suitable.
Example: pro- forma P & L account of SS electronics for 2012 based on percentage of sales
method.

Historical data

Net sales
Cost of goods
sold
Gross profit
Selling expenses
General &
administration
expenses
Depreciation
Operating profit
Non-operating
surplus/deficit
PBIT
Interest on bank
borrowings
Interest on
debentures
PBT
Tax
PAT
Dividends
Retained
earnings

Pro forma profit

& loss account of
2012 assuming
sales of 1400

2010

2011
1280
837

Average percent
of sales
100.0
65.0

1200
775

1400.0
910.0

425
25
53

443
27
54

35.0
2.1
4.3

490.0
29.4
60.2

75
272
30

80
282
32

6.3
22.3
2.5

88.2
312.2
35.0

302
60

314
65

24.8
5.0

347.2
70.0

58

60

4.8

67.2

184
82
102
60
42

189
90
99
63
36

15.0
6.9
8.1

210.0
96.6
113.4
-

Example: Pro-forma P & L account for SS electronics, constructed by using a combination of the
percentage of sales and the budgeted expense method. Cost of goods sold, selling expenses and
interest on bank borrowings are assumed to change proportionately with sales, the proportions
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being average of the two preceding years. All the remaining items have been budgeted on some
specific basis.
Fig. Pro- forma P & L account of SS electronics for 2012 using the combination method
Historical data

Net sales
Cost of goods
sold
Gross profit
Selling expenses
General &
administration
expenses
Depreciation
Operating profit
Non-operating
surplus/deficit
PBIT
Interest on bank
borrowings
Interest on
debentures
PBT
Tax
PAT
Dividends
Retained
earnings

Pro forma profit

& loss account of
2012

2010

2011
1280
837

Average percent
of sales
100.0
65.0

1200
775

1400.0
910.0

425
25
53

443
27
54

35.0
2.1
Budgeted

490.0
29.4
56.0

75
272
30

80
282
32

Budgeted
@
2.5

85
319.6
35.0

302
60

314
65

@
5.0

354.6
70.0

58

60

Budgeted

65.0

184
82
102
60
42

189
90
99
63
36

@
Budgeted
@
Budgeted
@

219.6
90.0
129.6
70.0
59.6

@ - These items are obtained using accounting identities

PRO- FORMA BALANCE SHEET
The projections of various items on the assets side and liabilities side of the balance sheet may be
derived as follows:
1. Employ the percentage of sales method to project the items on the assets side, except
investments and miscellaneous expenditure and losses
2. Estimate the expected values for investments and miscellaneous expenditure and losses,
using specific information applicable to them.
3. Use the percentage of sales method to derive the projected values of current liabilities and
provisions (referred to as spontaneous liabilities).
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4. Obtain the projected value of reserves and surplus by adding the projected retained
earnings (from the pro-forma P & L statement) to the reserves and surplus figure of the
previous period.
5. Set the projected values for equity and preference capital to be tentatively equal to their
previous values
6. Assume that the projected values for loan funds will be tentatively equal to their previous
levels less repayments or retirements as per terms and conditions applicable to them
7. Compare the total of the assets side with that of the liabilities side and determine the
balancing item (if assets exceed liabilities, the balancing item represents the external
funds required. If the liabilities exceed assets, the balancing item represents the surplus
available funds.)
Example: to illustrate the preparation of the pro- forma balance sheet, SS electronics.
The balance sheets of SS for 2010 & 2011
Fig. Pro forma balance sheet of SS electronics for December 31. 2012

Net sales
Assets
Fixed assets(net)
Investments
Current assets, loans &
advances:
Cash & bank
Receivables
Inventories
Pre-paid
expenses
Miscellaneous
expenditure & losses
Total
Liabilities:
Share capital:
Equity
Preference
Reserves & surplus

Historical data
Dec.31,2010

Dec.31,2011

1280

Average of
percentage of
sales or some
other basis
100.0

Projection for
Dec. 31, 2012
based on a
forecast sales
of 1400
1400.0

1200
800
30

850
30

66.5
No change

931.0
30

25
200
375
50

28
212
380
55

2.1
16.6
30.4
4.2

29.4
232.4
425.0
58.8

20

20

No change

20

1500

1575

250
50
250

250
50
286

Secured loans:
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1727.2
No change
No change
Pro-forma
income
statement

250.0
50.0
345.6

Debentures
Bank
borrowings
Unsecured loans:
Bank
borrowings
Current liabilities &
provisions
Trade creditors
Provisions
External funds
requirement
Total

KAIBOS MOSES

400
300

400
305

No change
24.4

400
341.6

100

125

9.1

127.4

100
50

112
47

8.5
3.9
Balancing
figure

119.0
54.6
39.0

1500

1575

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1727.2

TOPIC 4: PROFIT PLANNING

Profit Planning and Budgeting:
Profit plan is the steps taken by the business to achieve their planned levels of profits.
Budget is a quantitative plan for acquiring and using resources over a specific time period
to achieve its goals and objectives.
Budget is a financial and /or quantitative statement, prepared and approved prior to a
defined period of time, of the policy to be pursued during that period for the purpose
claiming a given objective.
Budgets help to:
(i)
Communicate managements plans throughout the organizations
(ii)
Force managers to think and plan for future
(iii)
Allocate resources where they can be used most effectively
(iv)
Uncover potential bottlenecks.
(v)
Coordinate the activities of the entire organization
(vi)
Serve as benchmarks for evaluating subsequent performance.
Operating budgets ordinarily cover a one-year period corresponding to the companys fiscal year.
Organization may also divide their budget year into quarters and the quarters into months with
operating budgets for each period.
OBJECTIVES OF BUDGETING AND BUDGETARY CONTROL
Budgets have a key function in that they also serve a number of useful purposes which are key to
an organizations success, i.e.

Planning;

Co-ordination;

Communication;

Motivation;

Control;

Evaluation.

Planning
Managers are required to produce detailed plans to enable the implementation of the long term or
strategic plan. The annual budgeting process encourages managers to plan for future operations,
refine existing strategic plans and consider how they can respond to changing circumstances.
This encourages managers to anticipate problems before they arise and ensures reasoned decision
making. Without this incentive the pressures of day to day operations may tempt managers not to
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plan for future operations and hasty decisions based on expediency rather than reasoned
judgement will be minimized.
Co-ordination
Budgeting facilitates consolidation and co-ordination and allows the actions of the different parts
of the organization to be brought into a common plan. It also compels managers to examine the
relationship between the different parts of an organization when making decisions and in assists
in identifying and resolving conflicts.
Examples of the type of conflicts which could arise in a manufacturing setting for example
would be between a purchasing manager who buys in bulk to obtain large discounts, a
production manager who wishes to avoid large stock levels and an accountant who is concerned
about the impact on the businesss cash resources. Budgeting aims to reconcile these differences.
Communication
All managers within the organization must have a clear understanding of the role which they are
required to play in ensuring budgetary compliance. This ensures that the most appropriate
individuals are made accountable for budget implementation. Senior management can also use
budgets to communicate corporate objectives downwards and ensure that other employees
understand them and co-ordinate their activities to attain them. The act of preparation as well as
the budget itself will also improve communication.
Participation in budget setting relates to the extent that subordinates are able to influence the
figures incorporated in their targets. Participation is often referred to as bottom-up budget setting
whereas a non participatory approach whereby subordinates have little influence on the target
setting process is sometimes called top-down budget setting.
Motivation
Budgets can also provide a motivation for managers to perform in line with organizational
objectives. It therefore sets a standard which under circumstances managers may be motivated to
achieve. It is important, however, that managers are involved in the budget setting process and
that budgets are used as a tool to assist them in managing their departments. With top-down
approaches there is a risk that dysfunctional motivational will occur.
Control
Managers can also use budgets to control the activities for which they are responsible. Analyses
of variances allow managers to identify those costs which do not conform to the long term plan
and therefore may require alteration. By investigating the reasons for budget deviations
managers may also be able to identify inefficiencies.
Budgetary control highlights variations from the expected in order that management can take
remedial action to ensure that the policy objectives set in the budget can be met. It is a constant
monitoring process and requires continual updating and amendment of the budget through
operational feedback. This also allows for performance against objectives or targets to be
measured.
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Evaluation
Budgeting can also be used as an effective management tool. It provides an important
mechanism for informing managers as to how well they are performing in meeting targets they
have previously helped to set.
An employee's ability to meet agreed targets is used is many organizations to determine
promotions and bonuses. In this circumstance budgets will therefore influence human behaviour.
ESSENTIALS OF BUDGETTING AND BUDGET ADMINISTRATION
Essentials of Budgetary control:
(i)
(ii)
(iii)
(iv)

Establishment of budgets for each function and section of the organization.

Continuous comparison of the actual performance with that of the budget so as to
know the variations from budget and placing the responsibility of executives for
failure to achieve the desires results as given in the budget.
Taking suitable remedial action to achieve the desires objective if there is a variation
of the actual performance from the budgeted performance.
Revision of budgets in the light of changed circumstances.
TYPES OF BUDGETS AND PREPARATION OF BUDGETS

Preparation of budgets
In small organizations, the accountant is responsible for preparing the budget. He collects
all relevant information from all sections to enable him draw up the budget.
In large organizations, preparation of the budget is usually the responsibility of a budget
committee which reports directly to top management.
The budget committee is composed of executives in charge of major functions of the
business organization e.g. the sales manager, personnel manager, finance manager,
production manager, the chief engineer, the treasurer and the chief accounts officer.
The principal functions of the budget committee are:
(i)
Decide the companys general policies and objectives
(ii)
Receive and review individual budget estimates concerning different
departments /divisions
(iii)
Suggest changes, modifications in accordance with organizational objectives
(iv)
Approve budgets which act as an authority/target for departmental action
(v)
Receive and analyze performance reports regarding the implementation of
budgets
(vi)
Suggest corrective action to improve efficiency and achieve budgetary goals.
Budget manual

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A document which defines the responsibilities of persons engaged in a budgetary

programme and sets out the routine, the forms and records required under budgeting.
Budget manual specify the procedure to be followed in developing the budget.
The budget period
The budget period in an import factor in developing a comprehensive budgeting
programme. The length of the budget period depends on the type of business, the length
of the manufacturing cycle from raw material to finished product, the ease of difficulty of
forecasting future market conditions etc.
However, a business enterprise generally prepares a short-range budget and a long
range budget.
Short range budget
It may cover periods of three, six or twelve months depending upon the nature of the
business. Most manufacturing firms use one year as the planning period.
Wholesale and retail firms usually employ a six- month budget which is related to their
selling seasons.
Long- range budget
A long range budget or planning is defined as a systematic and formalized process for
directing, controlling future operations towards a desired objective for periods extending
beyond one year.
Such budgets cover a specific areas e.g. future sales, future production, long term
capital expenditures, extensive research and development programmes, financial
requirement, profit forecast etc
They evaluate the future implications associated with present decisions and help
management in making present decisions and select the most profitable alternative.
TYPES OF BUDGETS
Budgets are the end product of the budgeting process.
Sales budget, production budget, cash budget, master budget etc.
Master Budget:
This includes a number of separate but interdependent budgets that formally report the
companys sales, production, and financial goals.
The starting point of the master budget is the sales budget.
The ending point of the master budget is the budgeted financial statements.
Since the budgeted financial statements include both an income statement and balance
sheet, each step in the master budget has both an income statement and balance sheet
component. Sometimes they are presented in the same budget and other times they are
presented as separate budgets.
Sales and Cash Collections Budget
The sales budget is the foundation and starting point for the master budget.

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It determines the anticipated unit and sales in shillings for the budgeted income
statement.
This may also include a schedule of expected cash collections which determines
the amount of expected cash collections from customers for each period based on an
expected collections pattern.
Example
(a) A bakery is expecting to sell 200,000 loaves of bread in January, 400,000 loaves in
February and 600,000 in March of year 2. Selling price per loaf sh.50. All the sales are on
credit. The sales are collected 60% in the month of sale and 40% in the month following
sale. December sales totaled sh. 100,000. Bad debts are negligible and can be ignored.
Required:
(i)
Prepare the sales budget
JAN.

SALES BUDGET
FEB

BUDGETED 200,000
SALES
X SELLING 50
PRICE
TOTAL
10,000,000
SALES
(ii)

MAR

400,000

600,000

QUARTER
(TOTAL)
1200,000

50

50

50

20,000,000

30,000,000

60,000,000

Prepare a schedule of expected cash collections from sales, by month and in total
from the 1st quarter.
SCHEDULE OF CASH COLLECTIONS
JAN 000
FEB000
MAR000
DEC SALES 40
(SH.100X
60% , 40%)
JAN SALES
6000
FEB SALES
MAR SALES
TOTALCASH 6040
CLLECTION
S

4000
12,000
16,000

8,000
18,000
26,000

QUARTER
(TOTAL)000
40
10,000
20,000
18,000
48040

(iii) Assume that the bakery will prepare a budgeted balance sheet on March 30.
Determine the accounts receivable as of that date.
Accounts receivable = sh.12, 000,000

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Production Budget
Determines the number of units of finished goods that must be produced each budget
period to satisfy expected sales needs (from the sales budget) and to provide for the
desired finished ending inventory.
Although it is prepared in units of finished goods, the production budget may be used to
determine several items on the budgeted financial statements:
Budgeted cost of goods sold by multiplying units sold by cost per unit
Budgeted beginning and ending finished goods inventory by multiplying units in
inventory by the cost per unit
Budgeted cost of goods manufactured by multiplying units produced by the cost per unit.
Example
Bell Telecom has budgeted sales of its innovative mobile phone for next four month as
follows:
Sales Budget in Units
July
30,000
August
45,000
September
60,000
October
50,000
The company is now in the process of preparing a production budget for the third quarter. Ending
inventory level must equal 10% of the next months sales.
Required:
a) Calculate the ending inventory as of June 30.
b) Prepare a production budget for the third quarter, in your budget show the number of units to
be produced each month and for the quarter in total.
Solution
a) Since the ending inventory level must equal 10% of the next months sales, the ending
inventory for the month of June must be 10% of Julys sales of 30,000 which equals 3,000 units
PRODUCTION BUDGET
July
Budgeted sales(units) 30,000
+ ending inventory
4500
Total needs
34,500
- Beginning
3,000
inventory
Required production 31,500

Aug
45,000
6000
51,000
4500

Sept
60,000
5000
65,000
6000

Quarter
Total
135,000
5000
140,000
3000

46,500

59,000

137,000

Cash Budget
Cash budget is composed of four major sections:
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Oct
50,000
5000

Cash Receipts
Cash Disbursements
Cash Excess or Deficiency
Financing
The cash budget uses information from all of the other budgets: cash receipts from the
sales budget, cash disbursements from direct materials budget, cash disbursements from
the direct labor, manufacturing overhead and selling administrative expense budget.
It may also include other sources of cash receipts such as proceeds from the sale of plant
assets, issuance of stock or issuance of bonds.
It may also include other sources of cash disbursements such as the purchase of plant
assets and the payment of cash dividends.
The company may also have to meet a minimum balance requirement for its cash
account which is imposed by the bank. If the cash balance falls short of the minimum
required, the company will have to borrow money to increase the cash balance to the
minimum. If the company has cash in excess of the minimum balance required, it is
obligated to pay off any outstanding borrowings and the related interest payable. After the
borrowings and interest have been paid off, the company may leave the excess cash in
the cash account.

Budgeted Financial Statements

- Budgeted financial statements are prepared after all of the other budgets, including
the cash budget, have been prepared.
- They serve as a benchmark against which subsequent actual company performance can
be measured.
ADVANTAGES AND LIMITATIONS OF BUDGETARY CONTROL
Advantages of budgeting and budgetary control
(i)
Compels management to think about the future, which is probably the most important
feature of a budgetary planning and control system. Forces management to look
ahead, to set out detailed plans for achieving the targets for each department,
operation and (ideally) each manager, to anticipate and give the organisation purpose
and direction.
(ii)
Promotes coordination and communication.
(iii)

Clearly defines areas of responsibility. Requires managers of budget centers to be

made responsible for the achievement of budget targets for the operations under their
personal control.

(iv)

Provides a basis for performance appraisal (variance analysis). A budget is basically a

yardstick against which actual performance is measured and assessed. Control is
provided by comparisons of actual results against budget plan. Departures from
budget can then be investigated and the reasons for the differences can be divided into
controllable and non-controllable factors.

(v)

Enables remedial action to be taken as variances emerge.

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(vi)

Motivates employees by participating in the setting of budgets.

(vii)

Improves the allocation of scarce resources.

(viii)

Economizes management time by using the management by exception principle.

Problems in budgeting (disadvantages) budgeting and budgetary control

Whilst budgets may be an essential part of any marketing activity they do have a number of
disadvantages, particularly in perception terms.
(a) budgets can be seen as pressure devices imposed by management, thus resulting in:
-

bad labour relations

inaccurate record keeping

(iii)

departmental conflict arises due to:

(a) disputes over resource allocation
(b) departments blaming each other if targets are not attained

(iii) It is difficult to reconcile personal/individual and corporate goals.

(iv)Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This
is often coupled with "empire building" in order to enhance the prestige of a department.
Responsibility versus controlling, i.e. some costs are under the influence of more than one
person, e.g. power costs.
(v)Managers may over-estimate costs so that they will not be blamed in the future should they
overspend.
OBJECTIVES OF COST- VOLUME- PROFIT ANALYSIS
Meaning of costvolumeprofit (CVP) analysis
CostVolumeProfit (CVP) Analysis is the study of the effects on future profit of changes in
Fixed Cost, Variable Cost, sale price, quantity and mix.
-

There is a direct relationship between the cost, volume of output and profit. The Total
Cost of a product depends on its volume of the output.
On the other hand, profit from the product depends on its Total sales and Total Cost.
Therefore, profitability of a product depends on its Total Cost and the volume of

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production. CVP Analysis examines the relationship of costs and profit to the volume of
production to maximize the profit of the firm.

(i)
(ii)
(iii)
(iv)
(v)

FEATURES OF CVP ANALYSIS

CVP Analysis has the following distinguished features:
It evaluates the behaviour of cost in relation to production or sales volume.
It exhibits the effect on profit due to the changes in cost and volume of output.
It evaluates the amount of projected profit for a projected sales value or volume.
It evaluates the amount and quantity of production and sales needed to achieve a target
profit level.
It evaluates the value and volume of sales needed to achieve BE.
CVP ANALYSIS HAS THE FOLLOWING OBJECTIVES:
(i)

(ii)
(iii)
(iv)
(v)
(vi)
(vii)

It helps to forecast the profit fairly and accurately.

It acts as an effective tool of profit planning to the management.
It helps in ascertaining the BE Point (BEP) of the product produced and sold.
It is very much useful in setting up the flexible budget, which ascertains cost, profit
and sales at different levels of activity.
It assists the management in the process of performance evaluation for the purpose of
control.
It helps in formulating the price policies by projecting the effect of different price
structures on the costs and profits.
It helps in determining the amount of overhead cost to be charged to the product at
different levels of operation, as overhead rates are generally predetermined on the basis of a
selected volume of production

ELEMENTS OF CVP ANALYSIS

CVP Analysis establishes a relationship between cost, volume of output and profit. It evaluates
the effect on profit due to changes in cost and volume of output. This analysis consists of several
integral parts or components which are as follows:
(i)
(ii)
(iii)
(iv)
(v)

Marginal Cost Equation.

Contribution.
Profitvolume (P/V) Ratio.
Break-Even Point (BEP).
Margin of Safety (MS).

BREAK-EVEN ANALYSIS (BE ANALYSIS)

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CVP Analysis is popularly known as Break-Even (BE) Analysis, even though there exists a
narrow difference between the terms CVP Analysis and BE Analysis. CVP Analysis refers to the
study of the effect on profit due to the changes in cost and volume of output, whereas BE
Analysis refers to the study of determination of that level of activity where the total sales is equal
to the Total Cost and also the study of determination of profit at any level of activity. BE
Analysis is an integral part of CVP Analysis. CVP Analysis includes the entire study of profit
planning, whereas BE Analysis is one of the techniques used in the study of profit planning by
CVP Analysis. However, the technique of BE Analysis is so popular for studying CVP Analysis
C-V-P ANALYSIS ASSUMPTIONS
(i) all costs can be resolved into fixed and variable costs
(ii) fixed costs will remain constant and variable costs vary proportionately with activity
(iii) over the activity range being considered costs and revenues behave in a linear fashion
(iv)That the only factor affecting costs and revenue is volume.
(v) That technology, production methods and efficiency remain unchanged
(vi)Particularly for graphical methods, that the analysis relates to one product only.
(vii) There is no stock level changes or that stocks are valued at marginal cost only
(viii)
There is assumed to be no uncertainty
Marginal cost of a product is its variable cost i.e. it includes direct labour, direct materials, direct
expenses and the variable parts of overheads.
Marginal cost = variable cost
Break-even point is the level of sales at which profit is zero
C-V-P ANALYSIS BY FORMULA
(a) break even point ( in units) = FC/ contribution/unit
(b) C/S ratio (P/V ratio)= contribution/unit / sales price /unit x 100
(c) Break -even point( sales sh.) = FC / contribution/ unit x sales price /unit
= FC x 1/C/S ratio
(d) Level of sales to result in target profit(in units)
= (FC + target profit) / contribution/unit
(e) Level of sales to result in target profit after tax ( in units)
= (FC + (target profit/ 1 tax rate)) / Contribution / unit
(f) Level of sales to result in target profit (sales sh.)
= ((FC + target profit) x sales price/ unit) / contribution/ unit
NB: The above formulae relate to a single product firm or one with an unvarying mix of sales.
With a multi product firm it is possible to calculate the breakeven point as follows:
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Break even point (sales sh.) = (FC x sales value) / contribution

Example
A company makes a single product with a sales price of sh.10 and a marginal cost of sh.6.
Fixed costs are sh.60,000 p.a.
Calculate
(a) number of units to break even
(b) sales at breakeven point
(c) C/S ratio
(d) What number of units will need to be sold to achieve a profit of sh.20, 000 p.a.?
(e) What level of sales will achieve a profit of sh.20, 000 p.a.?
(f) As (d) with a 40% tax rate
(g) Because of increasing costs the marginal cost is expected to rise to sh.6.50 per unit and
fixed costs to sh.70, 000 p.a. If the selling price cannot be increased what will be the
number of units required to maintain a profit of sh.20, 000 p.a. (ignore tax)?
Solution
Contribution = selling price marginal cost
= sh.10 sh. 6
= sh. 4
(a) Break- even point ( units)
= sh.60,000 /sh. 4 = 15,000 units
(b) Break =even point (sales sh.) = 15,000 x sh.10 = sh.150,000
(c) C/S ratio
= sh.4 / sh.10 x 100 = 40%
(d) Number of units for target profit = (sh.60,000 + sh.20,000) / sh.4
= 20, 000 units
(e) Sales for target profit = 20,000 x sh.10 = sh.200,000
(Alternatively: total units = 15,000 + 5,000 = 20,000 x sh.10 = sh.200, 000)
(f) Number of units for target profit with 40% tax = (sh.60000 + ( sh.20,000 / 1-.4)) / sh.4
= 23,333
(g) Note that the fixed costs, marginal cost and contribution have changed
No. of units for target profit = (sh.70, 000 + sh. 20,000) / sh.3.50
= 25,714 units
Note: The C/S ratio is sometimes known as the P/V ratio (profit volume ratio)
MARGIN OF SAFETY
The excess of budgeted (or actual) sales (sh.) over the break even volume of sales (sh.). It is the
amount by which sales can drop before losses are incurred. The higher the margin of safety, the
lower the risk of not breaking even and incurring losses.
Margin of safety = total budgeted (or actual) sales break even sales
Margin of safety = margin of safety (sh) / total budgeted (or actual) sales (sh)
Or
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Margin of safety = (expected sales break-even sales) / expected sales X 100

NB: The margin of safety indicated on the chart is the term given to the difference between the
activity level selected and break even point. In this case the margin of safety is 100,000 litres
(300,000 200,000)
Example:
A company makes a single product with a total capacity of 400,000 litres p.a.
Costs and sales data are as follows:
Selling price
sh.1 per litre
Marginal cost
sh. 0.50 per litre
Fixed costs
sh. 100,000
Draw a traditional break even chart showing the likely profit at the expected production level of
300,000 units.
CVP ANALYSIS FOR MULTI PRODUCT AND MULTI-SERVICE FIRMS
A firm has FCs of sh.50, 000 and has three products, the sales and contribution of which are
shown below.
Product
sales
contribution
C/S ratio (P/V ratio)
Sh.
Sh.
A
B
C

150,000
40.000
60,000

Determine the break- even sales.

Solution
Product
sales
A
B
C

sh
150,000
40.000
60,000
250,000

30,000
20,000
25.000

20%
50%
42%

contribution
sh
30,000
20,000
25.000
75,000

Overall C/S = sh.75, 000 / sh. 250,000

= 30%
BEP = FC/ C/S ratio = sh.50, 000 / 0.3 = sh. 166, 667
Formula for multi product firm
Break even point (sales sh.) = (FC x sales value) / contribution
BEP (sh.) = (sh.50, 000 X sh.250, 000) / sh.75, 000 = sh. 166, 667
IMPORTANCE AND LIMITATIONS OF COST VOLUME PROFIT ANALYSIS
1. Fixed costs are likely to change at different activity levels

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2. VCs and sales are unlikely to be linear. Extra discounts, overtime payments, the effect of
learning curve, special price contracts etc make it likely that the VC and revenue lines are
some form of curve rather than a straight line.
3. CVP analysis, like marginal costing, makes the assumptions that changes in the level of
output are the sole determinant of cost and revenue changes. This is over-simplification in
practice although volume changes, of course, do have a significant effect on costs and
revenues.
4. It is assumed that there is a single product or a constant mix of product or a constant rate of
mark- up on marginal cost.
5. Risk and uncertainty are ignored and perfect knowledge of cost and revenue functions is
assumed
6. It is assumed that the firm is a price taker, i.e. a perfect market is deemed to exist.
7. It is assumed that revenues and all forms of variable cost (materials, labour and all the
components of variable overheads) vary in accordance with the same activity. This indicates
over- simplification in most realistic situations.
TOPIC 5: CAPITAL STRUCTURE
Meaning of capital structure
- Capital structure is used to represent the proportionate relationship between the various long
term funds of financing such as ordinary share capital including reserves and retained earnings,
preference share capital and debentures.
- Capital structure refers to different forms of capital employed.
- Capital structure is made up of equity securities and debt and refers to permanent financing of a
firm.
- When a company raises higher proportion of funds through loans (debt financing) the company
is said to be high gear.
- When it has a proportionality larger issue of equity shares, it is said to be in low gear.
- Poor capital structure can decision can result in a high cost of capital and hence low net present
values of investment projects.
- An optimum capital structure should be planned for every firm. This is the mix of debt and
equity that minimizes the overall cost of capital and simultaneously maximizes firms value.
Factors to be considered when making a capital structure decision
(a) Cost of each specific component the company should use that source that has the lowest
cost
(b) Nature of assets a company with more tangible assets which it can pledge as a security
to obtain debt may end up having more debt in its capital structure and vice versa
(c) Size of the company large and well established companies would have a wide access to
capital markets and vice versa. Large companies may therefore have a higher gearing
ratio and vice versa.
(d) Control the capital structure should have minimal loss of control of the company. This
is especially important to small closely held firms as opposed to large widely held firms
such as public corporations.
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(e) Corporate tax rates in economies where corporate taxes are high, companies may be
encouraged to use more debt in order to enjoy interest tax shield benefit
(f) Industrial norms a company may adapt a capital structure which is similar to that of its
competitors or similar to an industry where it operates.
(g) Management attitude towards work if the companies management is composed of risk
averse managers then the company will end up using less debt in its capital structure to as
to reduce its financial risk
(h) Flexibility the firm should be able to alter or change its capital structure to meet
changing conditions with minimum cost and delay.
THEORIES OF CAPITAL STRUCTURE
A capital structure decision can affect firms value either by changing the expected earnings, cost
of capital or both. The use of leverage (debt) increases earnings per share (EPS). If leverage
affects cost of capital, then an optimal capital structure exists. This is the combination of debt
and equity that simultaneously minimizes the weighted average cost of capital and maximizes
firms value. This existence of an optimal capital structure is however not accepted by all hence
the capital structure theories.
The capital structure story
In the 1950s it was believed that leverage (debt) increased the firms value. This was supported
by the net income approach which operated under the following assumptions.
General assumptions:
(a) Only two types of capital are used i.e. debt and equity
(b) There are no taxes on corporate income
(c) All earnings are paid out as dividends
(d) The expected earnings before interest and tax (EBIT) is the same for all future periods
(e) The firm is expected to continue indefinitely
Specific assumptions relevant to net income approach (NIA) approach:
(a) Debt is cheaper than equity
(b) Use of debt does not change the risk perception of the investor
(c) Cost of equity (Ks) and cost of debt (Kd) remain constant with change of leverage
Recall
(i) D = I/Kd
Hence,
Kd = I/D
I= interest
Kd = cost of debt
D= market value of debt
(ii) Ks = div/po and Po = market price per share hence, Po = D/Ks
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(iii) Also, Ks = (EBIT I) /S

S- Market value of equity
S = (EBIT I)/ Ks
EBIT earnings before interest and tax
(iv) WACC = KsWs + KdWd
(v) Firms value, V= D + S
D =market value of debt
S = market value of equity
Example
Consider two firms L and U with the following characteristics
L
U
EBIT
900,000
900,000
Ks
10%
10%
7.5% debt
2000,000
Required
(a) Calculate the value of each firm using net income approach(NIA)
(b) Calculate the WACC of U and L
Solution
(a) Value of firm, VF = D+ S
S = (EBIT I)/Ks
S for firm U = 900,000 /0.1 = 9,000,000
VU = D+ S = 9M + 0 = 9M
S for firm L = (900,000- 150,000) / 0.1 = 750,000/0.1= sh.7, 500,000
VL = value of levered firm = 7.5M + 2M = 9.5M
(b) WACC = KsWs + KdWd
For firm U
WACC= 0.1x 9m/9m + 0.075 x 0m/9m = 10%
For firm L
WACC = 0.1 x 7.5m/9.5m + 0.075 x 2m/9.5m = 9.47%
Summary
Firm
WACC
Firms value

U
10%
9m

L
9.47%
9.5m

Conclusion there exists an optimal capital structure that minimizes WACC and maximizes
firms value. The capital structure decision in therefore relevant.
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Ke
Cost of capital
WACC
Kd

Gearing (D/E)
The net income approach remains the same even after incorporating taxes
NET OPERATING INCOME APPROACH (NOI)
According to this theory, leverage does not affect the value of the firm. Two identical firms will
command the same value irrespective of the way they are financed. The capital structure
financing decisions is therefore irrelevant.
According to this approach, the market value of the firm is found by dividing the net operating
income with the overall cost of capital i.e.
VF= EBIT/WACC
The value of equity is residual and is found by subtracting the value of the debt from overall
firms value.
I.e. S = VF D
Ks = (EBIT I) /S
Example:
Consider two firms L and U with the following characteristics
L
U
EBIT
900,000
900,000
7.5% debt
2,000,000
Ka = WACC
10%
10%
Required:
(a) Calculate the value of each firm using net operating income approach
(b) Confirm the WACC for each firm
Solution
For each firm
For U:
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VF = EBIT/WACC= 900,000/0.1 = 9,000,000

S = VF- D = 9m- 0 = 9,000,000
For L
VF = EBIT/WACC= 900,000/0.1 = 9,000,000
S = VF- D = 9,000,000- 2,000,000 = 7M
Confirm WACC for U
Ks = (EBIT I)/ S = (900,000 0) / 9000,000 = 10%
WACC= KsWs + KdWd = 10 x 9/9 + 0 x0/9 = 10%
Confirm WACC for L
Ks = (EBIT I)/S = (900,000 7.5% of sh.2m)/ 7m = 10.714%
Kd = 7.5%
WACC = ksWs +KdWd = 10.714 x 7/9 + 7.5 x 2/9 = 10%
Summary
U
WACC
10%
VF (firm value)

L
10%

9m

9m

Conclusion
It is not possible to have an optimal capital structure that minimizes WACC and maximizes
firms value. The capital structure financing decision is therefore irrelevant.
Modern capital structure theories
Modern capital structure theories began in 1958, when professors Franco Modigliani and Merton
Miller published what has been referred to as the most influential finance article ever written.
Initially they supported the net income approach. They argued that if two firms are identical in
all respects but only differ in their total market value and in the way that they are financed,
investors will sell shares of the overvalued firm, buy shares of the undervalued firm and continue
this process until the two firms command the same value. This is known as arbitrage process.
MM proposition I
MM proposition I states that the value of a firm does not depend on its capital structure. For
example think of 2 firms that have the same business operations, and same kind of assets. Thus,
the left side of their balance sheets looks exactly the same. The only thing different between the
2 firms is the right side of the balance sheets, i.e. the liabilities and how they finance their
business activities.
MM proposition I therefore says how the debt and equity is structured in a corporation is
irrelevant. The value of the firm is determined by real assets and not its capital structure.
MM Proposition II
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MM Proposition II states that the value of the firm depends on three things:
(i) Required rate of return on the firms assets (Ks)
(ii) Cost of debt of the firm (Kd)
(iii) debt/Equity ratio of the firm (D/E)
Hence:
Where:
KeL = cost of equity of the levered firm
KeU = cost of equity of unlevered firm
Kd
= cost of debt
D
= debt
S
= equity
t
= tax rate
In the absence of taxes
KeL = Keu + (Keu Kd) D/S
According to MM Proposition II, as debt increases, the cost of equity of the levered firm
also increases. Using more debt in the capital structure will not increase the value of the
firm because the benefits of cheaper debt will be exactly offset by an increase in the
riskiness of the equity and hence its cost. However in the absence of taxes, increase in
debt leads to an increase in cost of equity to offset the advantage of reduced cost of debt
to keep the value of the firm constant.
Example:
Consider two firms L and U with the following characteristics
L
U
EBIT
900,000
900,000
7.5% debt
2,000,000
Cost of equity (Ks)
10%
10%
Where: L = levered firm
U = unlevered firm
Ks = cost of equity
Required:
(a) Calculate the value of each firm using net income approach
(b) Demonstrate the arbitrage opportunity available to an investor who owns 10% of the
overvalued firm
Solution
S = (EBIT I)/ Ks = (900,000- 7.5% x 2,000,000) /0.1 = 7.5m
VL = D + S = 2m+ 7.5m = 9.5m
VU = (EBIT I) /Ks = 900,000/0.1 = 9m
VU value of unlevered firm
Hence, the levered firm has a higher value than unlevered firm
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Suppose an investor held 10% of firm L.

His total wealth= 10% of 7.5m in equity capital.
If he borrows the same percentage the firm borrowed on his behalf (10% of 2m) = 0.2m
Total cash available for investment = sh.0.95m
He could then invest it in U
His new percentage holding = 0.95m/9m = 10.55%
His income for the year will be:
Old income = 10% if (EBIT I) = 10% of 0.75m
New income= (10.55% of 900,000)
Less interest on personal loan (7.5% of 200,000)
Net income

sh. 75,000
sh.95, 000
sh. 15,000
sh. 80,000

Arbitrage profit = 80,000 75,000 =5,000

(a) If he maintains the same percentage ownership as before
He needs to invest 10% of sh. 9,000,000
Old income = 10% of (EBIT I) = 10% of 750,000
New income = 10% of 900,000
Less interest on personal loan (7.5% of 200,000)
Net income

sh.900, 000
sh. 75,000
sh. 90,000
sh.15, 000
sh.75, 000

Savings = sh.950, 000 900,000 = sh. 50,000

In 1963, they modified MM proposition I to incorporate taxes. The financing decision now
became relevant. MM now argued that a levered firm commands a higher value because interest
on debt is a tax allowable expense to the debt issuing firm whereas dividends are not.
VL= VU+ DT
DT is pv of tax shield benefit = KdDT/ Kd treated as a consul
Where:
VL = value of a levered firm
VU = value of unlevered firm
D = value of debt
T = tax rate
Arbitrage process with taxes
The net income approach does not change even when the corporate taxes are incorporated.
Levered firms will still commands a higher value than an equivalent unlevered firm. This can be
demonstrated by the following example:
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Consider two firms which are similar in all respects except for their capital structures. Firm L has
sh.4m of 7.5% debt while firm U is all equity financed. Both firms have EBIT of sh.900, 000.
The equity capitalization rate (Ks) 10% and the corporate tax rate is 40%.
Required:
(a) Calculate the value of the two firms using the net income approach
(b) Using MMs model, calculate the equilibrium value of the levered firm
(c) Show how an investor in the overvalued firm can increase his returns without increasing
risk(arbitrage process)
Solution
(a) Value of the firm
Firm U
S= (EBIT (1 T))/ Ks = (900,000(1-0.4)) / 0. 1 = sh.5.4m
VF = S + D = sh.5.4 + 0 = sh.5.4m
Firm L
VF = S+ D
S = (EBIT- I)(1-T)) /Ks = (900,000 ( 7.5% x 4m)(1 0.4)) / 0.10 = sh. 3.6m
VF = S + D = 3.6m + 4m = 7.6m
(b) According to MMs model, VL = VU + DT
VU = (EBIT I)(1- T) / Ks = (900,000 (1-0.4)) / 0.1 = 5.4m
D = 4m
VL = 5.4m + 4mx 0.4 = 7m
(c) According to MM the valuation according to net income approach of sh.7.6m and
sh.5.4m represents a dis-equilibrium. Investors will therefore attempt to sell the
shares of the overvalued firm and buy those of the undervalued firm and continue this
process until equilibrium is restored.
Arbitrage process
Consider an investor who owns 10% of Ls stock
Suppose he disposes his investment. This will fetch 10% of 3,600,000 = sh.360, 000
If he borrows an amount equal to 10% that had been borrowed on his behalf, the net borrowing
will be 10% x sh. 4,000,000 PV of interest tax shield benefit (DT)
= 10% x 4,000,000 (400,000 x0.4) = sh.240, 000

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Or
(10% of 4,000,000)(1 0.4) that is he borrows sh.240, 000
Total amount available for investment = 360,000 + 240,000= 600,000
If he invests this in firm U his % holding = 600,000/5,400,000 x 100 = 11.11%
Old profit = 10% of (EBIT 1) (1-T) (i.e.10% of earnings after tax) = 10% of 360,000 =36,000
Net profit = 11.11% of (EBIT 1) (1 T) = (11.11% of earnings after tax)
= 11.11% of 540,000
= 60,000
Less interest on personal loan (7.5% x 240,000)
= 18,000
Net income
= 42,000
Arbitrage profit 42,000 36,000 = 6,000
MM argued that the arbitrage process will cease when the value of the levered firm is as per
MMs model i.e.
VL = VU + DT = sh. 7m
MM proposition I was modified in 1977 to incorporate personal taxes. In his keynote address,
Merton Miller the then president of the American finance association sated that the 1977 model
was a special case of the general case they gave in 1963. The model now became:
VL= VU + D (( 1 (1- Tc)(1 Tpe))/ 1 Tpd)
Where: TC= corporate taxes
Tpe = personal tax on equity
Tpd = personal taxes on debt
In 1884 the proposition incorporated bankruptcy and agency costs. MM worked with Myers and
Majluf. The model became:
VL = VU + D ( 1- (1 Tc) ( 1- Tpe) / 1 Tpd) Pv of BAC
Where pv of BAC = present value of bankruptcy and agency cost
THEORIES EXPLAINING THE CHOICES OF CAPITAL STRUCTURE
1. PECKING ORDER THEORY
The theory states that there is an order of financing which goes as follows:
Internal finance (retained earnings)
Debt finance
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External equity finance

Firms should first use retained earnings as it comes from profits and not much effort is
required to obtain them. In addition, capital markets do not view retained earnings
negatively. When the firm financing needs exceed retentions it could issue debt as there is
very little scope for debt being mispriced. Furthermore debt issue does not cause concern
to equity investors since it prevents dilution of control. External equity finance appears to
be the last choice since a great deal of effort may be required in obtaining it and it may
affect control.
The theory explains why highly profitable firms generally borrow less as they do not
need much external finance. On the other hand, less profitable firms borrow more
because their financing needs exceed their retentions and debt finance comes before
external equity in pecking order.
2. TRADE OFF HEORY
This states that when considering debt to equity ratio the finance manager should
consider the tradeoff between the tax shield provided by the debt and the cost of financial
distress. According to the theory profitable firms with stable tangible assets use higher
leverage as their financial distress cost are generally low whereas unprofitable firms with
risky assets tends to lower their debt to equity ratios since the financial distress costs
would be much higher for any additional debt used.
Graphically demonstrated as follows:

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VL
Value of
the firm

VL in the presence of bankruptcy

and agency costs

Vu

Optimum debt capital

Leverage / gearing
LEVERAGE AND RISK
Leverage refers to the use of fixed costs to magnify profitability. There are three types of
leverage:
(a) Operating leverage
(b) Financial leverage
(c) Combined / total leverage
Operating leverage
This refers to use of fixed operating costs in an attempt to magnify or increase
profitability (EBIT). Operating leverage cost is incurred in the hope that revenues
realized from sales will more than cover operating costs. As opposed to variable costs,
operating leverage costs (fixed costs) remain constant within the relevant range.
Examples of operating leverage costs include depreciation, rent, insurance and
management fees. The potential effect caused by the presence of operating leverage
(fixed operating costs) is that a change in volume of sales results in a more than
proportionate change in profits.
DOL sales = % change in profit (EBIT) / % change in sales
DOL = degree of operating leverage
Example:
Consider three firms with the following results:
Sales (sh.000)
Operating costs (sh.000):
Fixed costs
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A
10,000

B
10,000

C
10,000

7,000

2,000

nil

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Variable costs
EBIT (sh.000)

2,000
1,000

7,000
1,000

9,000
1,000

Suppose sales for each firm increases by 50% next year. Calculate the percentage change
in EBIT and comment on your results.
Solution
A
B
C
Sales (sh.000)
15,000
15,000
15,000
Operating costs:
Fixed costs
7,000
2,000
nil
Variable costs
3,000
10,500
13,500
EBIT
5,000
2,500
1,500
% change in profits

(5,000 1,000)/1000 (2,500- 1,000)/1000

= 400%
= 150%

(1500 1,000)/1000
= 50%

DOL = % change in EBIT / % change in sales

400%/50%
=8

150%/50%
=3

50%/50%
=1

Comment: the firm with the highest use of fixed operating costs had the highest
magnification with 400% change. Whereas the firm with no fixed operating costs has the
least magnification of 50% in profitability. If DOL is say 8, if sales were to change by
10% then operating profit will change by 80%.
Also DOL = Q(p v) / (Q(p-v) FC) = total contribution / EBIT
Whereas:
Q is the quantity produced and sold
P is the unit selling price
V is the unit variable cost
FC is the fixed cost
PD is the preference dividends
EBIT is the earnings before interest and tax
Example:
Given P = sh.50, V= sh.25, FC = sh.100, 000, Q = 5,000 units, calculate the degree of
operating leverage (DOL)
Solution
Also DOL = Q(p-v) / Q(p-v) FC = (5,000(50 -25) / 5,000(50- 25) ) 100,000 = 5

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Financial leverage
The use of fixed financing costs to magnify the effect of changes in EBIT on a firms
EPS. The firm uses financial leverage in the hope that the funds obtained at fixed
financing costs are used to generate a return higher than the fixed financing cost paid.
Effect of financial leverage is such that an increase in the firms EBIT results in a more
than proportionate increase in the firms EPS.
Degree of financial leverage (DFL)
This is a quantitative measure of the sensitivity of a firms EPS to changes in operating
profit.
DFL = % change in EPS / % change in EBIT
Interpretation: if say DFL is 2.5, then if EBIT changes by any percentage EPS will
change by 2.5 times the percentage change in EBIT.
DFL Q = (Q(p v) FC ) / (Q(p- v) FC I (PD/1 T))
Example: given P = sh.50, V = sh.25, Q = 5,000, I = 2, 000, PD = 2,400, t = 40%, FC =
sh.100, 000
Required: calculate DFL (5,000)
Solution
DFL Q = Q(p v) / ( Q(p v) FC- I (PD/1- T))
DFL(5,000) = (5,000(50- 25) / (5,000(50 25) 100,000- 2,000 (2400 /1-0.4)) = 1.315

Exercise
The following information relates to the operations and capital structure of Mulwa limited.
Actual production
Selling price per unit
Variable cost per unit

= 80,000 units
= sh. 1,500
= sh.1, 000

Fixed cost
Situation A
Situation B
Situation C

sh. 10m
sh. 20m
sh. 30m

Capital structure
Financial plan
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Equity
Debt
cost of debt for all the plans

1
sh. 50m
sh. 50m

2
sh.75m
sh.25m

3
sh.75m
sh. 25m

12%

Required
(a) Determine the operating leverage under situations A, B and C respectively
(b) Determine the financial leverage under financial plans 1, 2 and 3 respectively
(20 marks)

TOPIC 6: DIVIDEND POLICY

Objectives of dividend policy
A firms dividend policy has the effect of dividing its net earnings into two parts: retained
earnings and dividends. The retained earnings provide funds to finance the firms long term
growth. It is the most significant source of financing a firm investment in practice.
Dividends are paid in cash. Thus, the distribution of earnings uses the available cash of the firm.
A firm which intends to pay dividends and also needs funds to finance its investment
opportunities will have to use external sources of financing, such as the issue of debt or equity.
The factors that generally influence the dividend policy of the firm in practice:
(i)
Investment opportunities available to the firm and financial needs
Firms which have good investment opportunities often attempt to conserve their cash
flows. They will therefore only pay a dividend if all the profitable investment
opportunities have been exploited.

(ii)
(iii)
(iv)

Growth firms have a large number of investment opportunities requiring substantial

amounts of funds. Hence they will give precedence to retention of earnings over the
payment of dividends in order to finance its expanding activities.
For mature firms, investment opportunities occur most infrequently. These firms may
distribute most of the earnings.
Alternative source of finance
If a firm is able to raise capital easily and cheaply from external sources it can
distribute more dividends since it will not rely heavily on retained earnings.
Loan covenants
A firm may be restricted by loan covenants from paying dividends unless the retained
earnings exceed certain levels.
Legal requirements
According to the companies Act dividends are paid out of current period profits after
providing for capital allowances. However, when it is for public interest the company
may be forced to pay dividends even before providing for capital allowances.

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(v)
(vi)
(vii)

(viii)

(ix)

Profit stability
Companies with a stable pattern of profits are in better position to pay high dividends
than firms with varied profits.
Control
Low dividend policy hence high profit retention can help a firm to avoid the need of
issuing new shares implying that the control of the shareholders is not diluted.
Preferred stock restrictions
Common dividends cannot be paid if the company has omitted payment of preferred
dividends. All the preference dividends arrears must be settled before any common
dividends can be paid.
The impairment of capital rule
Common dividends cannot legally exceed the retained earnings. This legal restriction
is designed to protect the creditors. Without this rule a firm in financial difficulty i.e.
may distribute most of its assets to the shareholders as dividends.
Shareholders expectations
Legally, the board of directors has discretion to decide the distribution of earnings of
a company. Shareholders are the legal owners of the company .and the director
appointed by them are their agents. Therefore, directors should give due importance
to the expectations of shareholders in the matter of dividend decision.
Shareholders preference for dividends or capital gain may depend on their economic
status and the effect of tax differential on dividends and capital gain.
A wealthy shareholder in a high income tax bracket may be interested in capital gain
than current dividends.

Dividend decision and valuation of firm

Dividend irrelevance: Modigliani and Miller hypothesis.
(The Miller Modigliani (MM) hypothesis the dividends irrelevancy theory 1961)
MM argued that dividend policy has no effect on either the price of the firms stock or its cost of
capital. They stated that the dividend policy is therefore irrelevant. They argued that the firms
value is determined by its basic earnings power or cash flows and its risk class.
Dividend policy has therefore no effect on either the manner in which the earnings are split
between dividends and additions to retained earnings.
They based their theory on the following assumptions:
(i)
There are no transaction costs associated with floatation of shares
(ii)
There are no taxes on corporate and personal income (dividends and capital gains)
(iii)
The companys investment policy is independent of its dividend policy.
(iv)
The information known to managers is also known to shareholders
(v)
The stock market is efficient
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Using the above assumptions, MM proved the irrelevancy of dividends as follows:

Let
D1 = DPS payable at the end of year 1
P1 = MPS at the end of year 1
P0 = MPS of the share now
Capital gain = P1 P0
Total returns = Dividend income + capital gain
= D 1 + P1 P0
Required rate of return, r = total investment / investment x 100
Ke = r = (D1 + P1 P0) / P0
r= (D1 + P1 P0) / P0
rp0 = D1 + P1 P0
rp0 + P0 = D1 + P1
P0 (1 + r) = D1 + P1
P0 = (D1 + P1) / (1+ r) = the value of one share.
Hence, N shares,
NP0 = (ND1 +N P1) / (1 + r)
Recall
Pv = FV /(1+ r)n
Therefore the market value of the share today (P 0) is equal to the present value of the dividend
per share and market price per share at the end of the year.
If the company has N number shares, then the market value of equity now will be equal to mps x
No. of shares = P0 x N = NP0
This should be equal to the present value of total dividend ND,
The market value of shares at the end of the year will be equal to NP1
NP0 = ((ND1 +N P1) / (1 + r)
Suppose the company raises new equity from issue of M shares at mps of sh. P1 each,
New capital = M x P1 =MP1 --------- (i)
Assume that the companys profit at the end of the year is
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Retained earnings = profits dividends paid

=

- ND1

If the companys future investment requirements = 1 and this cannot be met by retained earnings
then, the new capital to be raised = 1 retained earnings
I ( - ND1 ) --------------(ii)
Mp1 = I ( - ND1 )
Mp1 = I

+ ND1

The new capital raised becomes a cash inflow when raised and when invested becomes a cash
outflow. Therefore it will increase and reduce the value of the firm as follows:
NP0 = (ND1 + NP1 + MP1 (I + ND1)) / (1+ r)
NP0 = ND1 + (N + M)P1 I +
NP0 = (N + M)P1 I +

-ND1 / ( 1+ r)

/ ( 1+ r)

Hence the dividends disappear from the equation and therefore they are irrelevant in determining
the value of the firm. Therefore the value of the firm will be equal to the total PV of:
(i)
(ii)
(iii)

Profits of the firm

Market value of equity based on new and existing ordinary shares i.e. ( N + M)P1
The cash outflows associated with the investments requirements 1

Example 1
Consider a company with 500,000 shares currently trading at sh. 150 each in the local stock
exchange. Let the dividends to be received in one years time be sh.3 per share, the investment
opportunities be worth sh. 25,000,000, the profit to be earned at the end of the current year be
sh.13, 000,000 and cost of capital be 10%.
Show that the payment of dividends does not affect the value of the firm
Solution
The firm pays dividends then:
P0 = (P1 + D1) / ( 1+ r)
150 = (P1 + 3) / (1+ 0.1) hence, P1 = 162
New capital = MP1 = I - ^ + ND
162M = 25,000,000 15,000,000 + 500,000 x 3
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M = 70,987.65 shares.
VF = NP0 = (N + M) P1 I + ) / (1 + r)
VF = NP0 = ((500,000 + 70,987.65)162 25,000,000 + 15,000,000) / (1 + 0.1) = sh.75m
If the firm does not pay dividends then:
P0 = P1 / (1+ r)
150= P1 / 1 + 0.1 hence, P1 = 165
New capital = MP1 = I -
165M = 25,000,000 15,000,000
M= 60,606.06 shares
VF = NP0 = (N + M) P1 I + ) / (1+ r)
VF = NP0 = ((500,000 + 60,606.06) 165 25,000,000 + 15,000,000 / (1+ 0.1) = sh.75m
Hence the value of the firm does not change with the payment of dividends
Example 2
Bidii limited has a cost of equity of 10%. The company currently has 250,000 shares outstanding
and selling on stock exchange at sh. 120 per share. The companys earnings per share is sh.10
and it intends to maintain a dividend payout ratio of 50% at the end of the current financial year.
The companys expected net income for the current year is sh.3 million and the available
investment proposals are estimated to cost sh. 6 million.
Required:
Use the Modigliani and Miller (MM) model; show that the payment of dividends does not affect
the value of the firm.
Solution
The model:
NP0 = (N + M) P1 I + ) / (1 + r)
N = existing number of shares
M =new shares to be raised
P1 = MPs of the share at the end of year 1
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I = future investments requirements

= profit

List the variables and solve for the unknown

Now, N = 250,000 shares, P0 = sh.120, r = 10%, = ke , M = ?, I = 6 million, P1 = ? ,^ = 3 million
Recall:
P0 = (P1 + D1) / (1+ r)
D1 = 50% x 3000,000 / 250,000 = sh.6 (i.e. dividends per share)
If the firm pays dividends then;
P0 = (P1 + D1) / (1+ r)
120 = (P1 + 6) / (1+0.1) hence P1= 126
New capital = MP1 = I (

- ND1)

126M = 6,000.000 (3,000,000 250,000x 6)

M = 35,714.29 shares
VF = NP0 = (N + M) P1 I + ) / (1 + r)
VF= NP0 = (250,000 + 35714.29) 126 6,000,000 +3,000,000) / (1 +0.1) = sh. 30m
If the firm does not pay dividends then;
P0 = P1 / (1+ r)
120 = P1 / (1+ 0.1)
P1= sh.132
New capital =MP1 = I -
132M = 6000,000 3,000,000
M= 22,727.27 shares
VF = NP0 = (N + M) P1 I + ) / (1 + r)
VF = NP0 = (250,000 +22727.27) 132 6000, 000 +3,000,000) / (1 +0.1) = sh.30m
Hence the value of the firm does not change with the payment of dividends. According to MM
the payment of dividends does not affect the value of the firm
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Dividend relevance (Walter`s and Gordon contribution)

(a) Dividend relevance: Walters model
Prof.James E.Walter argues that the choice of dividend policies always affect the value of the
firm. His model shows the importance of the relationship between the firms rate of return, r, and
cost of capital, k, in determining the dividend policy that will maximize the wealth of
shareholders.
Walters model is based on the following assumptions:
(i)
Internal financing the firm finances all investment through retained earnings, i.e.,
debt or new equity is not issued.
(ii)
Constant return and cost of capital the firms rate of return ,r, and its cost of capital,
k, are constant
(iii)
100% payment or retention. All earnings are either distributed as dividends or
reinvested internally immediately.
(iv)
Constant EPS and DIV. Beginning earnings and dividends never change. The value of
the earnings per share, EPS, and the dividend per share, DIV, may be changed in the
model to determine results, but any given value of EPS or DIV are assumed to remain
constant forever in determining a given value.
(v)
Infinite time the firm has a very long or infinite life
Valuation formula: Walter put forward the following valuation formula:
P = (D + (E- D) r / k) / K
Where p The price per equity share
D The dividend per share
E The earnings per share (EPS)
(E D) The retained earnings per share
r- The rate of return on investments
k The cost of capital
As per equation above, the price per share is a sum of two components:
D/ K + ((E-D) r/k ) / K
Where
D/K the present value of an infinite stream of dividends
((E D)r/k) /K the present value of an infinite stream of returns from retained earnings
Example: The Walter model for three cases: growth firm, normal firm and declining firm
Growth firm: r > k
r=20%; k = 15%; E = sh.4 if D = sh.4
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P =(4 + (4- 4) 20/15) / 15

P = sh. 26.67
If D = sh.2
P = (2 + (4 2) 20/15) / 15
P = sh. 31.11
Normal firm: r = k
r=15%; k = 15%; E = sh.4; If D = sh.4
P= (4 + (4-4) 15/15) / 15
P= sh.26.67
If D = sh.2
P = (2 + (4 2) 15/15) / 15
P = sh.26.67
Declining firm: r < k
r=10%; k = 15%; E = sh.4 If D = sh.4
P = (4 + (4 4) 10/15) / 15
P = 4/15 = sh. 26.67
If D = sh.2
P= (2 + (4 -2) 10/15) / 15
P= sh.22.22
Implications: we find that as per Walters model:
(i)
When the rate of return is greater than the cost of capital( r > k), the price per share
increases as the dividend payout ratio decreases
(ii)
When the rate of return is equal to the cost of capital ( r= k),the price per share does
not vary with changes in dividend payout ratio
(iii)
When the rate of return is less than the cost of capital ( r< k), the price per share
decreases as the dividend payout ratio increases
The Walter model implies that:
(i)
The optimal payout ratio for a growth firm(r < k) is nil
(ii)
The optimal payout ratio for a normal firm ( r = k) is irrelevant
(iii)
The optimal payout ratio for a declining firm( r< k) is 100%
The Walter model is a useful tool to show the effects of dividend policy under varying
profitability assumptions:
Example 1
The following information is available for Swaleh Company limited.
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Earnings per share (EPS)

Rate of return on investments
Rate of return required by shareholders

sh.4.00
18%
15%

What will be the price per share as per the Walter model if the payout ratio is 40% ?; 50?;and
60%?
Solution
The Walter model:
P = (D + (E- D) r / k) / K
E = sh.4; r = 0.18; k =0.15
The value of P for the the three different payout ratio:
Payout ratio
40%
50%
60%

P
= (1.60 + (4 1.60) 0.18/0.15) / 0.15 = sh.29.87
= (2 + (4 2) 0.18/0.15) / 0.15
= sh.29.33
= (2.4+ (4 2.40)0.18/0.15) / 0.15 = sh. 28.80

Example 2
The following data is available for Patel Company limited
Earnings per share
sh. 3.00
Rate of return
15%
Cost of capital
12%
If Walters valuation formula holds, what will be the price per share when the dividend payout
ratio is 50%? 75%? 100%?
(b) Dividend relevance : Gordons model
Myron Gordon (proposed a model of stock valuation using the dividend capitalization approach)
develops one very popular model explicitly relating to the market value of the firm to dividend
policy.
Gordons model is based on the following assumptions:
(i)
All equity firm- the firm is an all equity firm and it has no debt
(ii)
No external financing no external financing is available. Consequently, retained
earnings would be used to finance any expansion. Thus just as Walters model
Gordons model too confounds dividend and investment policies.
(iii)
Constant return the internal rate of return, r, of the firm is constant. This ignores the
diminishing marginal efficiency of investment
(iv)
Constant cost of capital the appropriate discount rate, k for the firm remain
constant. Thus Gordons model also ignores the effect of change in the firms risk
class and its effect on k.
(v)
Perpetual earnings the firm and its stream of earnings are perpetual
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(vi)
(vii)
(viii)

No taxes corporate taxes do not exist

Constant retention the retention ratio, b, once decided upon, is constant. Thus, the
growth rate, g = br, is constant forever.
Cost of capital greater than growth rate the discount rate is greater than the growth
rate, k> br g .if this condition is not fulfilled, we cannot get a meaningful value for
the share.

Valuation formula: Gordons valuation model

P0 = (E1 ( 1 b)) / (k br)
Where: p0 - the price per share at the end of year 0
E1 the earnings per share at the end of year 1
(1 b) The fraction of earnings the firm distributes by way of dividends
b- The fraction of earnings the firm retains
k- The rate of return required by shareholders
r The rate of return earned on investments made by the firm
br the growth rate of earnings and dividends
Example:
Numerical examples for Gordon model:
Growth firm: r > k
r = 20%; k= 15%; E= sh.4.00; b = sh.0.25
P0 = ( 4( 1 0.25)) / (0.15 (0.25 x0.2))

= sh.30

If b = sh.0.50
P0 = (4( 1 0.5)) / (0.15 (0.5x0.2))

=sh. 40

Normal firm: r = k
r= 15%; k=15%; E= sh.4;b= sh.0.25
P0 = (4(1 0.25)) / (0.15 (0.25 x0.15))

= sh. 26.67

If b = sh.0.50
P0 = (4(1 0.50)) / (0.15 (0.50x0.15))

= sh.26.67

Declining firm: r < k

r= 10%; k=15%; E= sh.4; b= 0.25
P0 = (4(1 0.25)) / (0.15 (0.25 x 0.1))
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If b =sh.0.50
P0 = (4( 1 0.50)) / (0.15 (0.50 x 0.1))

= sh.20

Implications: from the example, we find that as per the basic Gordon model:
1. When the rate of return is greater than the discount rate ( r> k),the price per share
increases as the dividend payout decreases
2. When the rate of return is equal to the discount rate (r= k), the price per share remains
unchanged in response to variation in the dividend payout ratio
3. When the rate of return is less than the discount rate ( r< k), the price per share increases
as the dividend payout ratio increases
Thus the basic Gordon model leads to dividend policy implications as that of the Walter model:
(i)
(ii)
(iii)

The optimal payout ratio for a growth firm (r> k) is nil

The payout ratio for a normal firm is irrelevant
The optimal payout ratio for a declining firm (r < k) is 100%

Example:
The following information is available for Kimathi limited:
Earnings per share
sh. 5.00
Rate of return required by shareholders
16%
Assuming that the Gordon valuation model holds, what rate of return should be earned on
investments to ensure that the market price is sh.50 when the dividend payout ratio is 40?
Solution
Gordon model:
P0 = (E1 (1 b)) / (k br)
50 = (5(1 0.6)) / (0.16 0.6r)
50(0.16-0.6r) = 5(0.4)
8 30r = 2
-30r = -6
r= 20%
Kimathi limited must earn a rate of return of 20%on its investments.
Stability of dividends
Stability of dividends is considered a desirable policy by management of most companies in
practice. Shareholders also seem generally to favor this policy and value stable dividends higher
than the fluctuating ones.
All other things being the same, the stable dividend policy may have a positive impact on the
market price of the share.
Stability of dividends also means regularity in paying some dividend annually, even though the
amount of dividend may fluctuate over years, and may not be related with earnings. Stability of
dividends refers to the amounts paid out regularly.
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Forms of stability of dividends

(a) Constant dividend per share or dividend rate or fixed DPS policy
A number of companies follow the policy of paying a fixed amount per share irrespective of the
fluctuations in the earnings. This policy does not imply that the dividends per share or dividend
rate will never be increased.
When the company reaches new levels of earnings and expects to maintain them, the annual
dividend per share or dividend rate may be increased.
A constant dividend per share policy puts ordinary shareholders at par with preference
shareholders irrespective of the firms investment opportunities or the preference of shareholders.
(b) Constant payout
The ratio of dividends to earnings is known as payout ratio. Some companies may follow a
policy of constant payout ratio, i.e. paying a fixed percentage of net earnings every year. With
this policy the amount of dividend will fluctuate in direct proportion to earnings. If a company
adopts a 30% payout ratio, then 30% of every shilling of net earnings will be paid out. E.g. if the
company earns sh.10 per share, the dividend per share will be sh.3.
This policy is related to a companys ability to pay dividends. If the company incurs losses, no
dividends shall be paid regardless of the desires of shareholders.
(c) Constant dividend per share plus extra dividend
For companies with fluctuating earnings, the policy to pay a minimum dividend per share with a
step-up feature is desirable. The small amount of dividend per share is fixed to reduce the
possibility of ever missing a dividend payment. By paying extra dividend (pay an interim
dividend followed by a regular, final dividend) in periods of prosperity, an attempt is made to
prevent investors from expecting that the dividend represents an increase in the established
dividend amount.
(d) Residual dividend policy
In this case dividends are paid out of the earnings left after all the profitable investments
opportunities have been financed. Therefore, out of the earnings attributable to the owners the
first allocation is towards financing all projects yielding a positive NPV.
Dividends are only paid if earnings are not exhausted by the companys financing needs. By first
financing projects which yield positive NPV the policy attempts to maximize the value of the
firm and shareholders wealth.
Forms of dividends, (how should the firm pay dividends?)
(a) Cash dividends/in cash
(b) Payment of the bonus shares (referred to as stock dividend) or scrip issue
(c) Stock split and reserve split
(d) Shares buyback / stock or share repurchase
The share (stock) split is not a form of dividend, but its effects are similar to the effects of the
bonus shares.
(a) Payment of Cash dividends.
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This is the most common mode of dividend payment. However, the payment of dividend
will depend on:
(i)
the companys liquidity position
(ii)
the financing needs of the company
Companies mostly pay dividends in cash. A company should have enough cash in its bank
account when cash dividends are declared. If does not have enough cash an arrangement should
be made to borrow funds. When the company follows a stable dividend policy, it should prepare
a cash budget for the coming period to indicate the necessary funds, which would be needed to
meet the regular dividend payments.
The cash account and reserves account of a company will be reduced when the cash dividend is
paid. Thus, both the total assets and net worth of the company are reduced when the cash
dividend is distributed. The market price of the share drops in most cases by the amount of the
cash dividend distributed.
(b) Bonus or scrip issue/ shares
This is known as the dividend reinvestment scheme. it involves giving free shares to the
existing shareholders instead of cash dividends.
An issue of bonus shares is the distribution of shares free of cost to the existing
shareholders. Issuing bonus shares increases the number of outstanding shares of the
company.
The bonus shares are distributed proportionately to the existing shareholders. Hence there
is no dilution of ownership. E.g. if a shareholder owns 1000 shares at the time when a
10% (1: 100) bonus issue is made, she will receive 100 additional shares. The declaration
of the bonus shares will increase the paid up share capital and reduce the reserves and
surplus (retained earnings) of the company. The total net worth (paid- up capital plus
reserves and surplus) is not affected by the bonus issue. In fact a bonus issue represents a
recapitalization of reserves and surplus. It is merely an accounting transfer from reserves
and surplus to paid up capital.
(c) Stock split and reserve split /Share split
This is the process by which accompany undertakes to reduce the par value of its shares
and to increase the number of ordinary shares by the same proportion. The major reason
for a stock split is to make the shares attractive and more affordable than before.
The stock split has no effect on the net worth of the company ( the shareholders total
funds remain unaltered)
A reverse stock split is the opposite of a stock split and it involves the consolidation of
the shares into bigger units of stocks. In this case the number of ordinary shares is
reduced while the par value of the share is increased by the same proportion that has been
used to reduce the number of the ordinary shares.
Example: Capital structure of WS Company.
Sh.
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Paid up share capital(1 share per sh.10 par)

Share premium
Reserves & surplus
Total net worth

10
15
8
33

WS Company split their shares two- for one.

Results of the split:
Paid up share capital(2 shares per sh.5 par)
Share premium
Reserves & surplus
Total net worth

Sh.
10
15
8
33

The earnings per share will be diluted and the market price per share will fall proportionately
with a share split. But the total value of the holdings of a shareholder remains unaffected.
Reasons for share split
The following are the reasons for splitting of a firms ordinary shares
To make trading in shares attractive
To signal the possibility of higher profits in the future
To give higher dividends to shareholders
(d) Buyback shares or stock or share repurchase
- The buyback of shares is the repurchase of its own shares by a company.

TOPIC 7: EXPANSION AND RESTRUCTURING

Introduction
Mergers and acquisitions
An entrepreneur may grow its business either by internal expansion or by external expansion.
In the case of internal expansion, a firm grows gradually over time in the normal course of the
business, through acquisition of new assets, replacement of the technologically obsolete
equipments and the establishment of new lines of products.
External expansion, a firm acquires a running business and grows overnight through corporate
combinations. These combinations are in the form of mergers, acquisitions, amalgamations and
takeovers and have now become important features of corporate restructuring. They have been
playing an important role in the external growth of a number of leading companies the world
over.
They have become popular because of the enhanced competition, breaking of trade barriers, free
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flow of capital across countries and globalization of businesses.

Mergers and acquisitions are strategic decisions taken for maximization of a company's growth
by enhancing its production and marketing operations. They are being used in a wide array of
fields such as information technology, telecommunications, and business process outsourcing as
well as in traditional businesses in order to gain strength, expand the customer base, cut
competition or enter into a new market or product segment.
TYPES OF COMBINATION.
Mergers or Amalgamations
A merger is a combination of two or more businesses into one business.
Amalgamation as the merger of one or more companies with another or the merger of two or
more companies to form a new company, in such a way that all assets and liabilities of the
amalgamating companies become assets and liabilities of the amalgamated company and
shareholders not less than nine-tenths in value of the shares in the amalgamating company or
companies become shareholders of the amalgamated company.
Thus, mergers or amalgamations may take two forms:Merger through Absorption: - absorption is a combination of two or more companies into an
'existing company'. All companies except one lose their identity in such a merger.
For example, absorption of Tata Fertilizers Ltd (TFL) by Tata Chemicals Ltd. (TCL). TCL, an
acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller),
ceased to exist. TFL transferred its assets, liabilities and shares to TCL.
Merger through Consolidation:- A consolidation is a combination of two or more companies into
a 'new company'.
In this form of merger, all companies are legally dissolved and a new entity is created. Here, the
acquired company transfers its assets, liabilities and shares to the acquiring company for cash or
exchange of shares.
For example, merger of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian Software
Company Ltd and Indian Reprographics Ltd into an entirely new company called HCL Ltd.
NB: A fundamental characteristic of merger (either through absorption or consolidation) is that
the acquiring company (existing or new) takes over the ownership of other companies and
combines their operations with its own operations.
Three major types of mergers:Horizontal merger: - is a combination of two or more firms in the same area of business. For
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example, combining of two book publishers or two luggage manufacturing companies to gain
dominant market share.
Vertical merger: - is a combination of two or more firms involved in different stages of
production or distribution of the same product. For example, joining of a TV manufacturing
(assembling) company and a TV marketing company or joining of a spinning company and a
weaving company.
Vertical merger may take the form of forward or backward merger. When a company combines
with the supplier of material, it is called backward merger and when it combines with the
customer, it is known as forward merger.
Conglomerate merger: - is a combination of firms engaged in unrelated lines of business activity.
For example, merging of different businesses like manufacturing of cement products, fertilizer
products, electronic products, insurance investment and advertising agencies.
Cogeneric merger represents a merger of firms engaged in related lines of business
Acquisitions and Takeovers
An acquisition may be defined as an act of acquiring effective control by one company over
assets or management of another company without any combination of companies. Thus, in an
acquisition two or more companies may remain independent, separate legal entities, but there
may be a change in control of the companies.
When an acquisition is 'forced' or 'unwilling', it is called a takeover. In an unwilling acquisition,
the management of 'target' company would oppose a move of being taken over.
But, when managements of acquiring and target companies mutually and willingly agree for the
takeover, it is called acquisition or friendly takeover.
A company's investment in the shares of another company in excess of 10 percent of the
subscribed capital can result in takeovers. An acquisition or takeover does not necessarily entail
full legal control. A company can also have effective control over another company by holding a
minority ownership.
REASONS FOR MERGERS
Plausible mergers
(i)

Strategic benefit if a firm has decided to enter or expand in a particular industry,

acquisition of a firm engaged in that industry, rather than dependence on internal
expansion, may offer several strategic advantageous e.g. the firm leap frog several

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(ii)

(iii)

(iv)

(v)

(vi)

(vii)

(viii)

(ix)

stages in the process of expansion or it may entail less risk and even less cost.
Economies of scale when two or more firms combine, certain economies are
realized due to the larger volume of operations of the combined entity. These
economies arise because of more intensive utilization of production capacities,
distribution of networks, research and development facilities etc.
Economies of vertical integration when companies engaged at different stages of
production or value chain merge economies of vertical integration maybe realized.
e.g. the merger of a company engaged in oil exploration and production with a
company engaged in refining and marketing may improve coordination and control.
Complementary resources if two firms have complementary resources, it make
sense for them to merger. E.g. A small firm with an innovative product may need the
engineering capability and marketing reach of a big firm. With the merger of the two
firms it may be possible to successfully manufacture and market the innovative
product.
Tax shields when a firm with accumulated losses and or unabsorbed depreciation
merges with a profit making firm, tax shields are utilized better. The firm with
accumulated losses and or unabsorbed depreciation may not be able to derive tax
advantages for a long time. However, when it merges with a profit making firm. Its
accumulated losses and or unabsorbed depreciation can be set off against the profits
of the profit making firm and tax benefits can be quickly realized.
Utilization of surplus funds a firm in a mature industry may generate a lot of cash
but may not have opportunities for profitable investment. Such a firm ought to
distribute generous dividends and even buy back its shares, if the same is possible. A
merger with another firm involving cash compensation often represents a more
efficient utilization of surplus funds.
Managerial effectiveness one of the potential gains of a merger is an increase in
managerial effectiveness. This may occur if the existing management team, which is
performing poorly, is replaced by a more effective management team. Often a firm,
plagued with managerial inadequacies, can gain immensely from the superior
management that is likely to emerge as a sequel to the merger.
Diversification a common stated motive for mergers is to achieve risk reduction
through diversification. The extent, to which risk is reduced, of course, depends on
the correlation between the earnings of the merging entities. While negative
correlation brings greater reduction in risk, positive correlation brings lesser reduction
in risk.
Earnings growth - a merger may create the appearance of growth in earnings. This
may stimulate a price increase if the investors are fooled.

MOTIVES AND BENEFITS OF MERGERS

The most common motives and advantages of mergers and acquisitions are:(i)Accelerating a company's growth, particularly when its internal growth is constrained
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due to paucity of resources. Internal growth requires that a company should develop its
operating facilities- manufacturing, research, marketing, etc. But, lack or inadequacy of
resources and time needed for internal development may constrain a company's pace of
growth. Hence, a company can acquire production facilities as well as other resources
from outside through mergers and acquisitions.
(ii)Enhancing profitability because a combination of two or more companies may result
in more than average profitability due to cost reduction and efficient utilization of
resources. This may happen because of:(a)Economies of scale:- arise when increase in the volume of production leads to a
reduction in the cost of production per unit. This is because, with merger, fixed costs are
distributed over a large volume of production causing the unit cost of production to
decline.
(b)Operating economies:- arise because, a combination of two or more firms may result
in cost reduction due to operating economies. In other words, a combined firm may avoid
or reduce over-lapping functions and consolidate its management functions such as
manufacturing, marketing, R&D and thus reduce operating costs.
(c)Synergy:- implies a situation where the combined firm is more valuable than the sum
of the individual combining firms. It refers to benefits other than those related to
economies of scale. Operating economies are one form of synergy benefits. But apart
from operating economies, synergy may also arise from enhanced managerial
capabilities, creativity, innovativeness, R&D and market coverage capacity due to the
complementarity of resources and skills and a widened horizon of opportunities.
(iii)Diversifying the risks of the company, particularly when it acquires those businesses
whose income streams are not correlated. Diversification implies growth through the
combination of firms in unrelated businesses. It results in reduction of total risks through
substantial reduction of cyclicality of operations. The combination of management and
other systems strengthen the capacity of the combined firm to withstand the severity of
the unforeseen economic factors which could otherwise endanger the survival of the
individual companies.
(iv)A merger may result in financial synergy and benefits for the firm in many ways:

By eliminating financial constraints

By enhancing debt capacity. This is because a merger of two companies can bring
stability of cash flows which in turn reduces the risk of insolvency and enhances
the capacity of the new entity to service a larger amount of debt

By lowering the financial costs. This is because due to financial stability, the

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merged firm is able to borrow at a lower rate of interest.

(v)Limiting the severity of competition by increasing the company's market power. A
merger can increase the market share of the merged firm. This improves the profitability
of the firm due to economies of scale. The bargaining power of the firm vis--vis labour,
suppliers and buyers is also enhanced. The merged firm can exploit technological
breakthroughs against obsolescence and price wars.
ANALYSIS OF MERGERS AND ACQUISITION
Procedure for evaluating the decision for mergers and acquisitions
The three important steps involved in the analysis of mergers and acquisitions are:(i)Planning:- of acquisition will require the analysis of industry-specific and firm-specific
information. The acquiring firm should review its objective of acquisition in the context
of its strengths and weaknesses and corporate goals. It will need industry data on market
growth, nature of competition, ease of entry, capital and labour intensity, degree of
regulation, etc. This will help in indicating the product-market strategies that are
appropriate for the company. It will also help the firm in identifying the business units
that should be dropped or added. On the other hand, the target firm will need information
about quality of management, market share and size, capital structure, profitability,
production and marketing capabilities, etc.
(ii)Search and Screening: - Search focuses on how and where to look for suitable
candidates for acquisition. Screening process short-lists a few candidates from many
available and obtains detailed information about each of them.
(iii)Financial Evaluation:- of a merger is needed to determine the earnings and cash
flows, areas of risk, the maximum price payable to the target company and the best way
to finance the merger. In a competitive market situation, the current market value is the
correct and fair value of the share of the target firm. The target firm will not accept any
offer below the current market value of its share. The target firm may, in fact, expect the
offer price to be more than the current market value of its share since it may expect that
merger benefits will accrue to the acquiring firm.
A merger is said to be at a premium when the offer price is higher than the target firm's
pre-merger market value. The acquiring firm may have to pay premium as an incentive to
target firm's shareholders to induce them to sell their shares so that it (acquiring firm) is
able to obtain the control of the target firm.

EVALUATION OF MERGERS

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Mergers and acquisitions are normally based on the price earnings ratio game theory. This
theory states that the predator will always attempt to acquire a target with a lower price
earnings ratio than itself. Otherwise the post acquisition merger EPS of the predator will
be diluted.
The post acquisition EPS is calculated as:
Post acquisition EPS = combined earnings of predator and target / No. of ordinary shares
in predator + shares issued to acquire target
The new shares to be issued to acquire the target will depend on the exchange ratio i.e.
the number of shares issued by the predator to acquire one share of the target.
Exchange ratio = offer price of predator / market price per share of the predator
In some instances the predator may desire to offer a price which does not dilute its
existing earnings per share
Non- diluting offer price / break even offer = P/E ratio of the predator before acquisition
x EPS of target before acquisition
Premium = offer price of the predator market price per share of target
Example 1
Huge limited is contemplating a complete share acquisition of Tiny limited. Huge limited is
offering three of its shares for every two shares of Tiny ltd. The data relating to the two
companies are shown below:
Earnings to ordinary shareholders
Earnings per share(EPS)
Market price per share(MPS)
The corporate tax rate is 30%

Huge ltd.
5,190,360
14.80
222

Tiny ltd.
2,340,000
29.25
322

Required:
(a) Determine the maximum offer price that will not dilute the EPS of Huge limited
(b) Compute the premium payable to the shareholders of Tiny limited
Solution
(a) Non diluting offer price = P/ E ratio of predator x EPS of target
= 222/14.80 x 29.25 = sh. 438. 75
P/E ratio = MPS / EPS
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(b) Premium = offer price of the predator MPS of target

Predator is offering 3 of its shares for every two of target
Exchange ratio is the number of shares offered for one share held by target shareholders
3 shares offered for 2 held in target
? shares held for 1 share held in target
x 3 = 1.5 exchange ratio.
Exchange ratio = offer price of predator / market price per share of predator
1.5 = x/ 222
X = 1.5 x 222 = 333
Premium per share = 333 322 = 11
Total premium:
Number of shares of target =?
EPS = earnings / number of shares
29.25 = 2,340,000 / x
X = 80,000
Total premium = 11 x 80,000 = sh.880,000
Example 2
Maxi ltd is considering acquiring Mini ltd. Selected financial data for the two companies are as
follows:
Annual sales ( sh. millions)
Net income(sh. Millions)
Ordinary shares outstanding (millions)
Earnings per share(EPS) (sh.)
Market price per share (sh.)

Maxi ltd.
750
60
15
4
44

Mini ltd.
90
7.50
3
2.50
20

Both companies are in 40% tax bracket

Required:
Calculate the maximum exchange ratio Maxi ltd. Should agree if it expects no dilution in
earnings per share
How much premium would the shareholders of the Mini ltd. receive at this exchange ratio?
Solution
(a) Exchange ratio = offer price of predator / market price per share of predator
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Maximum = exchange ratio implies we first establish maximum non diluting offer price
Non- diluting offer price = P/E ratio of predator before acquisition x EPS of target before
acquisition
= 44/4 x 2.50 = sh. 27.50
Maximum exchange ratio = 27.50/44 = 0.625
Premium = offer price of predator market price per share of target = 27.50 -20 = sh.7.50
Total premium = sh.7.50 x 3 000,0000 shares = sh.22.5m
LEGAL PROCEDURE.
Regulations for Mergers & Acquisitions
Mergers and acquisitions are regulated .The objective of the laws is to make these deals
transparent and protect the interest of all shareholders. They are regulated through the provisions
of :1.The companies, Act, 1956
The Act lays down the legal procedures for mergers or acquisitions :(a)Permission for merger:- Two or more companies can amalgamate only when the
amalgamation is permitted under their memorandum of association. Also, the acquiring
company should have the permission in its object clause to carry on the business of the
acquired company. In the absence of these provisions in the memorandum of association, it is
necessary to seek the permission of the shareholders, board of directors and the Company
Law Board before effecting the merger.
(b)Information to the stock exchange:- The acquiring and the acquired companies should
inform the stock exchanges (where they are listed) about the merger.
(c )Approval of board of directors:- The board of directors of the individual companies
should approve the draft proposal for amalgamation and authorize the managements of the
companies to further pursue the proposal.
(d)Application in the High Court:- An application for approving the draft amalgamation
proposal duly approved by the board of directors of the individual companies should be made
to the High Court.
(e)Shareholders' and creditors' meetings: - The individual companies should hold separate
meetings of their shareholders and creditors for approving the amalgamation scheme. At
least, 75 percent of shareholders and creditors in separate meeting, voting in person or by

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proxy, must accord their approval to the scheme.

(f)Sanction by the High Court: - After the approval of the shareholders and creditors, on the
petitions of the companies, the High Court will pass an order, sanctioning the amalgamation
scheme after it is satisfied that the scheme is fair and reasonable. The date of the court's
hearing will be published in two newspapers, and also, the regional director of the Company
Law Board will be intimated.
(g)Filing of the Court order:- After the Court order, its certified true copies will be filed with
the Registrar of Companies.
(h)Transfer of assets and liabilities:- The assets and liabilities of the acquired company will
be transferred to the acquiring company in accordance with the approved scheme, with effect
from the specified date.
(i)Payment by cash or securities:- As per the proposal, the acquiring company will exchange
shares and debentures and/or cash for the shares and debentures of the acquired company.
These securities will be listed on the stock exchange.
2.The competition Act, 2002
The Act regulates the various forms of business combinations through competition
commission. Under the Act, no person or enterprise shall enter into a combination, in the
form of an acquisition, merger or amalgamation, which causes or is likely to cause an
appreciable adverse effect on competition in the relevant market and such a combination
shall be void. Enterprises intending to enter into a combination may give notice to the
Commission, but this notification is voluntary. But, all combinations do not call for scrutiny
unless the resulting combination exceeds the threshold limits in terms of assets or turnover as
specified by the Competition Commission.
The Commission while regulating a 'combination' shall consider the following factors : Actual and potential competition through imports;
Extent of entry barriers into the market;

Level of combination in the market;

Degree of countervailing power in the market;

Possibility of the combination to significantly and substantially increase prices or

profits;

Extent of effective competition likely to sustain in a market;

Availability of substitutes before and after the combination;

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Market share of the parties to the combination individually and as a combination;

Possibility of the combination to remove the vigorous and effective competitor or

competition in the market;

Nature and extent of vertical integration in the market;

Nature and extent of innovation;

Whether the benefits of the combinations outweigh the adverse impact of the
combination.

Thus, the Competition Act does not seek to eliminate combinations and only aims to
eliminate their harmful effects.

END= END = END @ MAY AUGUST 2015

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