Question 1 (a) explain six solutions to the Agency problem between shareholders and management An agency relationship is defined

as one in which one or more persons (the principal(s) engages another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. The interests of principals and agents diverge primarily because these different groups have different utility functions. A conflict of interest will therefore arise between creditors, shareholders and management because of differing goals. Some of the solutions to the agency problem include:
1. Alignment of interests of the principal and agents. One way of

doing this is to give the agents a stake in the organization through stock options which serve to induce managers and employees to pay more attention to maximizing stockholder wealth, since that will simultaneously maximize their own wealth.
2. Using the law as a deterrent. Certain laws like those that are against

insider trading may be used to deter agents from using their position to the detriment of the principals or share holders.
3. Exit as a deterrent. Principals or shareholders who are dissatisfied

with the performance of the firm can always sell their stock and invest elsewhere. This threat of exit puts in check the management.
4. Proper remuneration. When the agents are well paid, they are

motivated to work hard and thus assist the principal attain his goal and in the process there is no conflict between the shareholders and the agents
5. Delinking of ownership and management: This will lead to the

division of functions between the shareholders and the agents. An arrangement where some functions are left with the shareholders while others are left with the agents will help solve the agency problem especially where the shareholders maintain the supervisory role over the managers.

6. Initiation and ratification: This is a governance strategy that expands

the power of principals to intervene in the firms management. These are decision rights, which grant principals the power to initiate or ratify management decisions.
7. The trusteeship strategy: This works on a quite different principle. It

seeks to remove conflicts of interest ex ante to ensure that an gent will not obtain personal gain from disserving her principal. This strategy assumes that, in the absence of strongly focusedor high-powered monetary incentives to behave opportunistically, agents will respond to the low-powered incentives of conscience, pride, and reputation.

b) Explain five characteristics of a good capital budgeting

technique (5 marks) Capital budgeting is a process of evaluating and planning expenditure on assets that will provide future cash flows. It consists in employment of available capital for the purposes of maximizing the long term (return on investment) of the firm.

A good capital budgeting technique should posses the following characteristics; 1. It should consider all cash flows to determine the true profitability of the project. 2. It should provide for an objective and unambiguous way of separate good projects from bad projects. 3. It should help ranking of projects according to their true profitability. 4. It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. 5. It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth. 6. It should be a criterion which is applicable to any conceivable investment project independent of others.

c) State five sources of long-term funds ( 5 marks)

Firms can raise long term funds from; a) The capital markets: i) new share issues, for example, by companies acquiring a stock market listing for the first time ii) b) c) d) e) f) g) rights issues Loan stock Retained earnings Bank borrowing Government sources Business expansion scheme funds Venture capital

d) Discuss the essence of Nairobi stock exchange in the Kenyan

developing economy (6marks)

Nairobi Stock Exchange, like any other security trading market, provides a platform for the individuals or the organizations for the trading and investing their savings through the purchase of shares and other securities. This promotes a culture of savings in a developing economy. The Nairobi Stock Exchange provides a platform where public awareness about a listed company and its products increases. Increase in the market capitalization of the companies make them strong and help in the economic growth by providing employment and by production etc. If the circulation of money will stop then the money will be plunged in the hands of the people, the growth will be stopped, so the Stock exchange play an important role in any economy. It gives companies listed companies an opportunity to raise funds for expansion and growth without the interest burden of funds borrowed from lending institutions. It encourages public floatation of private companies thereby increasing the supply of assets available for long term investment.

It makes the movement of money into the system. People invest to make profit and to beat the inflation.

Question 3 a) distinguish between Weighted Average cost capital and Marginal Cost of Capital Weighted Average Cost of Capital is the total average cost of capital to a company which is calculated by taking into account the weights of all type of capital that exist at a particular date in the capital structure of the company (Equity, Debt, bonds, debentures etc). - The Marginal Cost of Capital is the incremental cost of capital which arises when fresh capital is raised. It will depend on the type of capital raised, its weight and its cost.
-

b) explain the factors that affect the dividend policy of an organization ( 6 marks) i) Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been

abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organization. ii) Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. iii) Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend iv) Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. v) Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasize to distribute higher dividend. vi) Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programs. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.

vii) Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. viii) Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises. c) Explain why mergers and acquisitions are common in the Business World today A merger is the joining of two similar companies to from one bigger company while an acquisition is the actual purchase of one company by another. The reasons why mergers and acquisitions are common in the business world today include;
i) Economies of scale: A combined company can usually cut its

fixed costs by removing duplicate departments, teams and operations, thus lowering the companys costs relative to the same revenue stream, which would result in increasing profit margins ii) Increased revenue and/or market share: This would typically occur when the buyer takes over a major competitor, reducing its competition and thus building up its market power by capturing increased market share. If it has a dominant enough position, it could then exercise greater power in setting prices as well. iii) Cross-selling: This refers to the complementary products an acquiring company can sell to the customers of its acquired company. As an example, a bank buying a stock broker could sell its banking products to the stock broker's customers. At the same time, the broker could poach the bank's customers for brokerage accounts. iv) Geographical, product, or other diversification: Diversification of any kind can usually smooth the earnings results of a company. This, in turn, smooths the stock price of a company,

giving conservative investors more confidence in investing in the company. v) Synergy: Often, managerial economies such as the increased chances of managerial specialization. Another example would be the purchasing economies due to larger order size and bulkbuying discounts. vi) Absorption of similar businesses under single management: So if complementary companies can come together, they can often save considerable money by spreading management over a wider scope of employees and operations. vii) Tax Consequences: A money-making company can buy a money- losing and use the target's loss as their advantage by reducing their tax liability. Some governments have cottoned onto this tactic and seek to minimize it. In the United States and many other countries, laws have been enacted to limit the ability of profitable companies to buy loss making companies, limiting the tax motive of an acquiring company.