Financial Management Topic 2



  • Explain three factors that might influence the capital structure decision.
  • Two firms, Alpha Ltd. and Beta Ltd., operate in the same industry. The two firms are similar in all aspects except for their capital structures.

The following additional information is available:

  • Alpha Ltd. is financed using Sh. 120 million worth of ordinary shares.
  • Beta Ltd. is financed using Sh.70 million in ordinary shares and Sh.50 million in 8% debentures.
  • The annual earnings before interest and tax are Sh.10 million for both firms. These earnings are expected to remain constant indefinitely.
  • The cost of equity of Alpha Ltd. is 10%.
  • The corporate tax rate is 30%.


Using the Modigliani and Miller (MM) model, compute:

The market values of Alpha Ltd. and Beta Ltd.

  • The weighted average cost of capital (WACC) of Alpha Ltd. and Beta Ltd
    1. a) Factors that might influence the capital structure decision:
    • Business risk – This is the risk that a firm is exposed to due to its operations.
    • Finance flexibility – This refers to the ability to raise capital in different economic conditions.
    • Company’s tax exposure – The higher the tax rate the more debt a firm uses and vice versa.
    • Industrial norms – A firm will adopt a capital structure similar to other firms in the same industry.
    • Control – A firm whose owner wants to maintain control will use more debt and less equity.
    • Market value of Alpha Ltd and Beta Ltd.




Discuss any four factors that a company should consider when choosing between equity and debt as sources of finance.


  Factors to consider when choosing between debt and equity: 

  • Gearing and Financial risk

The company needs to consider what level of financial risk is desirable from both corporate and stakeholder perspective.

  • Target capital structure

The company should achieve an optimum capital structure at which it’s able to minimise its weighted average cost of capital.  –        Availability of security 

Debt will usually need to be secured by either fixed charge on specific assets or floating charge on specific class of assets.

  • Economic expectations

This will depend on projected returns expected from the project being financed.  – Control issues 

The extent to which the source of finance will affect the existing patterns of ownership and the restrictive covenants usually written on debt documents.



Summarize four reasons that might lead to soft capital rationing in a limited company.


Reasons for soft capital rationing in a limited company

  • Management may be reluctant to raise more capital for investment by issuing new shares due to fear of loss of control.
  • Management might be unwilling to issue additional share capital if it will lead to dilution of earnings per share (EPS)
  • Management might not want to issue shares to avoid large fixed interest payments Desire to limit investment to a level that can be financed solely from retained earnings.
  • The capital expenditure budget might set a restriction on capital spending.



  • Briefly explain the meaning of the term “deep-discounted rights issue”.
  • Latex Ltd. has a paid up ordinary share capital of Shs. 4,500,000 represented by 6 million shares of Sh.0.75 each. The company has no loan capital. During the last financial year, earnings after tax were Sh.3, 600.000.

The price earnings (P/E) ratio is 15. The company is planning to make a large investment which will cost Sh.10, 500,000 and is considering to raise this finance through a rights issue with a price of Sh.8 per share.


  • The current market price per share.
  • The theoretical ex-rights price per share


Meaning of deep-discounted rights issue

In deep discounted rights issue, the new shares are priced at a large discount to the current market price per share (MPS). The purpose is to ensure that the issue is well subscribed and thus attractive when the market is volatile.

The disadvantage is that a large number of shares will need to be issued in order to raise the required finance, and this will lead to a large dilution of earnings per share (EPS) and dividend per share (DPS).


 Market price per share (MPS) = P/E × EPS


EPS =  = Shs. 0.6


MPS = 15 × 0.6 = Shs. 9


  Shares required raising Sh 10.5 million at Sh 8


Existing shares         = 6,000,000

Total shares in issues        7,312,500

Total value of the company    = (6 million× Shs. 9) + 10,500,000

= 54,000,000 + 10,500,000

= 64,500,000

Theoretical-ex-rights price     = 64,500,000



= Shs. 8.82



Outline five advantages of going public to a company;


  • Advantages of going public to a company
  • New funds may be easily obtained from the stock exchange
  •       Pricing of shares is made easy
  • Transfer of ownership of shares is made easier
  • Valuation of the company for take-over or acquisition purposes is made easier
  • Wide ownership of the company in enhanced      There is reduction in risk as perceived by the inventors

vii. The greater prominence and status given to listed companies create good will for the company


  1. a) The management of Swere Ltd wishes to establish the amount of financing needs for the next two years ending 30 June 2012 and 2013. The statement of financial position of the company for the year ended 30 June 2011 is as follows:
Net non-current assets


Trade receivables




Financed by:

Ordinary share capital

Retained earnings

12% long term debt

Trade payables

Accrued expenses

187,200 57,600






126,000 52,800



35,000 298,800

Additional information;-


  • For the year ended 30 June 2011, sales amounted to Sh.360, 000,000. Sales are projected to rise by 15% in the year ending 30 June 2012 and by 20% in the year ending 30 June 2013.
  • The after tax return on sales is 8%, which shall be maintained in future.
  • The company intends 10 maintain a dividend payout ratio of 80%.
  • Any additional financing from external sources will be affected through the issue of commercial paper by the company.



  • Determine the amount of external financial requirements for the two years ending 30 June 2013.
  • A profoma statement of financial position as at 30 June 2013.QUESTION 6(a)   External financial requirements for the two years ending 30 June 2013
    Sh. ‘000’ Sh. ‘000’
    Incremental Total Assets  𝑥 136,800

    Incremental Current liabilities:  𝑥 136,800

    Incremental Net Assets


    Retained Earnings (June 2012) Profit after tax  𝑥 414,000

    Dividends proposed  𝑥 33,120


    Retained earnings (June 2013)

    Profit after tax  𝑥 496,800

    Dividends proposed  𝑥 39,744

    External financial requirement-issue of commercial paper





























    S Were Ltd

    A proforma statement of financial position as at 30th June 2013

    Sh. “000” Sh. “000”
    Non-Current Assets

    Total fixed assets (NBV) Current assets

    Inventory  𝑥 496,800

    Trade receivables  𝑥 496,800

    Cash  𝑥 496,800

    Total assets

    Financed by: Equity and liabilities

    Ordinary share capital

    Retained earnings (52,800 + 6,624 + 7,948.8)


    12% long term debt



    Current liabilities

    Trade payables:  𝑥 496,800

    Accrued expenses  𝑥 496,800

    Issue of commercial paper

    Total current liabilities












































    Incremental sales Sh. ‘000’
    Sales (2011)

    Sales (2012) –  𝑥 360,000

    Sales (2013) –  𝑥 414,000

    Incremental sales: (496,800 – 360,000)




    496,000 136,800



  •  Outline four motives of leasing an asset from the point of view of a company.
    • d) The motives of leasing an asset from the point of view of management
    • Agency costs- large and high growth companies are likely to lease their own assets.
    • Taxation effect-leasing gives rise to substantial tax advantages.
    • Debt capacity- leasing promotespreservation of existing ways of credit.
    • Cheaper option especially when the asset is expected to become obsolete


  •  Distinguish between “sale and lease back” transactions and “sale and manage back” transactions.
    • Distinguish between ‘sale and lease back’ transactions and ‘sale and manage back’ transactions

    Leaseback, short for sale-and-leaseback, is a financial transaction, where one sells an asset and leases it back for the long-term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done for fixed assets, notably real estate and planes, trains and automobiles, and the purposes are varied, including financing, accounting, and taxing.


    Sale and manage back

    Is a financial arrangement in which a property is sold, then managed by its former owner for a cut of profits


Sh. “000”
Total assets 2,400,000
Accounts payable 750,000
Sales revenue (year ended 31 December 2008) 5,000,000
Ordinary share capital 850,000
Retained earnings 590,000
  1.  The following information was extracted from the accounting records of Karibu Ltd. As at 31 December 2008.


Sales revenue for the year ending 31 December 2009 is expected to increase by 25% . Total assets and accounts payable are proportional to sales and that relationship will be maintained in future. The company raised sh. 150 million by floating new ordinary shares on 1 January 2009. The company’s profit margin on sales is 6 percent. 60 per cent of the earnings attributable to ordinary shareholders will be paid out as dividends.



  1. Total debt for Karibu Ltd. as at 31 December 2008.
  2. The new long term – debt financing that will be needed in the year 2009.QUESTION 9Assets = capital + liabilities

    2400000 = Accounts payables + OSC + Retained earnings + Long term debt

    2,400,000,000 = 750,000,000 + 850,000,000 + 590,000,000+x  x = sh. 210,000,000

    Total debt=long term debt+Accounts payables=210,000,000+750,000,000



    Increase in sales (5,000,000) (1.25) -5,000,000


    Increase in total assets 48% × 1,250,000

    Increase in accounts payable (15% ×1,250,000)

    Retained earnings (5,000,000) (0.06) (0.4) (1.25)


    Less: Ordinary Share Capital  raised

    New long term debt











  • Explain the factors that influence the type of finance sought by a manufacturing company
    •  Factors that influence the type of finance sought by a manufacturing company
    •  Leverage level:
    • A company that is highly geared may not be able to access more debt.
    • Such a company will be forced to rely on other sources of finance. ii) Company policy may determine the level of financing the company uses e.g. a company may have a policy of relying on internal finance instead of external sources of finance

    Industry norm:

    • The industry in which the firm operates can also affect the type of finance sought by a company e.g. agricultural firms are likely to have a low gearing due to high business risk.
    • iv) Nature of the assets of the firm:
    • g. a firm with valuable assets such as land and buildings can use these assets as collateral or security for new debt capital.
    • v) Cost of capital:
    • The lower the cost of capital the higher the amount of that capital component in the financial structure.




  • “Since debt capital is cheaper than equity, companies should resort to one hundred percent use of debt to finance the investment”.

Discuss the limitations of the above financial policy

  • Distinction between Treasury bills and treasury bonds
    • Disadvantages of using 100% debt to finance investment
      • It will increase the company’s gearing level and investors will perceive the company to be more risky then the equivalent un-geared company.
      • The shareholders will demand a higher expected return in order to compensate them for an increased financial risk.
      • It might give rise to the agency problem between the lenders and the shareholders hence increasing the agency cost.
      • In an environment where there are no taxes it will reduce the earnings available to the ordinary shareholders.
      • It will increase the financial risk of the firm because of the constant interest charges as a result of the use of debt.
      • Due to the increased agency problem it increases the chances of liquidation of the company
      • There may be restrictions on further borrowing contained in the debenture trust deed.


    • Distinction between
    • i) Treasury bills and treasury bonds

    Treasury bills are short-term investments which carry no coupon rate but are sold at a discount. The Treasury bill market is very active and the transaction costs are small in the sale of Treasury bill in secondary market.

    On the other hand treasury bonds are long-term securities with maturity periods of over 10 years. Treasury bonds are coupon issued and there is an active market for the treasury bonds. On the overall the treasury securities are the safest and most marketable investments since they are considered to be risk free securities.



  • What are the differences between an “operating lease” and a “finance lease”
    •  Difference between operating lease and finance lease.

          Operating Lease

    • The lease period is for a short period of time

    Finance Lease

    The lease period is for a long period of time usually more than 75% of the useful economic life of an asset

    • At the end of the lease period there is no purchase option
    • The lessee does not disclose the leased There is a purchase option at the end of lease period

    The Lessee discloses the leased asset in

    asset in his balance sheet (off balance sheet financing)

    • The maintenance cost are incurred by the his balance sheet and an obligation to pay the fixed future lease rentals as liabilities Maintenance costs are incurred by the

    lessor                                                          lessee


  • Discuss the main factors which a company should consider when determining the appropriate mix of long-term and short-term debt in its capital structure.
  • Malindi Leisure Industries is already highly geared by industry standards, but wishes to raise external capital to finance the development of a new beach resort.

Outline the arguments for and against a rights issue by Malindi Leisure Industries.

  • Examine the relative merits of leasing versus hire purchase as a means of acquiring capital assets.
  •  In deciding whether to go for short term rather than long term finance the following would be taken into account.
    • The purpose for which the money is required (matching)

    In general its is preferable that the life of the project under review should not exceed the period for which the money is borrowed. It may be inconvenient for example if an investment if fixed asset having a working life of 20 years was financed by a five year loan.

    • Relative cost of different forms of finance

    This is a question that has to be considered in each case. As a general point, if interest rates generally are high but are expected to fall longer term finance is preferable.

    • Flexibility – Short term loans are more flexible since a firm can react to changes in interest rates unlike long term loans.
    • Repayment pattern – a short term loan may be payable any time cash is available unlike long term debt.
    • Availability of collateral – a security is required for long term debt unlike short term debt.
    • The liquidity of the business

    If the liquid ratio is low, it may not be possible to obtain further finance without causing concern to creditors.

    • Availability – the question of what is available will influence whether the borrow short or long term debt.

    Benefits of a right issue to Malindi Leisure Industries; o The company is highly geared as rights issue would reduce the level of gearing and reduce in the level of financial risk.

    • If the issue is successful it will not significantly change the voting structure. o If underwriters are raised then the amount of finance that will be known and guaranteed
    • If the market is high, Malindi Leisure Industries should be able to achieve a rights issue at a relatively low cost since less shares will be issued. (Lower floatation costs)
    • Less administrative procedures e.g no need for prospectus.


    Drawbacks of rights issue o The issue will need to be priced at a discount to the current share price in order to make it attractive to investors. Thus will result in a dilute in earnings and a fall in price.

    • If the issue is not successful, a significant number of shares may be taken by underwriters thus changing the voting structure
    • Administration and underwriting costs are high o Shareholders may be unable or unwilling to increase their investment in Malindi Leisure Industries


  • List and explain five factors that should be taken into account by a businessman in making the choice between financing by short-term and long-term source


  • Enumerate four advantages of convertible bonds from the point of view of the borrower.


The traditional view is that fixed assets should be financed by term sources of finance and current assets by a mixture of long-term and short-term sources

Cost – he company may find it easier to raise short term finance with low security than long term finance

  • Security –The company may find it easier to raise short term finance with low security than long term finance
  • Risk –In opting for short-term debt, the company faces the risk that it may not be able to renegotiate the loan on such good terms. Long term loans are thus less risky

Flexibility – Short term debt is more flexible since it allows the firm to react to interest rate charges and avoid being locked into an expensive long term fixed rule commitment when rates are falling.

 Advantages of convertible securities

  • Provide lower cost of debt
  • No immediate dilution of ownership and EPS
  • Provides equity finance on conversion
  • Interest charges are tax allowable hence tax shield.

    Advantages of leasing o No risk of obsolescence in the lessee

  • Leasing does not require a down payment to be made at the start of the contract unlike hire purchase. (No heavy initial capital outlay required)
  • Lease finance can be arranged relatively, cheaply, quickly and easily
  • Operating leases are off-balance sheet financing

Advantages of hire purchase o Unlike leasing, hire purchase allows the user of the asset to obtain ownership at the end of the agreement period

The interest element of the payments is allowable against tax o Tax shield on salvage value at the end of economic life of asset

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