ACT06206; PRINCIPLE OF CORPORATE FINANCE.ppt

Need for study

1. TOPIC 1: CORPORATE FINANCE
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2. 26/05/2024 2

3. Instructor: Mr. Jumanne Basesa

5. Corporate Finance Mind Map
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SHAREHOLDER
VALUE
CAPITAL
STRUCTURE
DIVIDEND POLICY
AGENCY THEORY
PORTFOLIO THEORY
INVESTMENTS
COST OF CAPITAL
NPV
MARKETS

6. Meaning and Scope of Financial
Management
Corporatefinanceismainlyconcernedwith
procurementandallocationoffundstovarious
areaswithinthefirm.
Corporatefinancesometimesisreferredtoas
managerialfinanceorfinancialmanagement.
Generally,Financialmanagementcanbedefined
asthemanagementofthefinancesofabusinessor
organisationinordertoachievefinancial
objectives.
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7. The role of the Financial Manager
Usuallythefinancialmanagerisinvolvedin
manyfinancialdecisionsbutthekeyaspectsof
financialdecision-makingrelateto:
Investment,
Financingand
Dividenddecisions.
a)TheInvestmentDecision:
Investinassetsandprojectsthatyieldareturn
greaterthantheminimumacceptablehurdle
rate.
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8. The Investment Decision(Cont…..)
Thehurdlerateshouldbehigherforriskier
projectsandshouldreflectthefinancingmix
used-owners’funds(equity)orborrowedmoney
(debt).
Withregardtothistypeofdecision,thefinancial
managerneedstoidentifytheprofitable
investmentopportunities.
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9. b) The Financing Decision:
Chooseafinancingmix(debtandequity)that
maximizesthevalueoftheinvestmentsmade
andmatchthefinancingtonatureoftheassets
beingfinanced.
financialmanagerisfacedwithchallengesof
determininghowtheinvestmentsofthefirmwill
befinanced.
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10. c) The Dividend Decision:
Iftherearenoprofitableinvestments,returnthe
cashtotheownersofthebusiness.Inthecaseof
apubliclytradedfirm,theformofthereturn-
dividendsorstockbuybacks-willdependupon
whatstockholdersprefer.
Thefinancialmanagerneedstotakeinto
considerationsthefollowingquestionsinorder
toformulatethedividendpayoutdecisions.
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11. c) The Dividend Decision(Cont…)
Shouldthefirmdistributehighdividendsand
financethebusinessgrowththroughnewissues
ofequitiesordebt?
Shouldthefirmdistributelowdividendsanduse
theretainedearningstofinancethebusiness
expansions?or
Shouldthefirmpayzerodividendsandusethe
wholeearningsforprofitableinvestment
opportunities?
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12. Forms of Business Organization
Three forms namely:
sole proprietorship,
partnership and
a company.
Finddetailsonthefirsttwoforms
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13. Corporation
Acorporation(company)isalegalentity
which,whilebeingcomposedofnatural
persons,existscompletelyseparatelyfrom
them.Thisseparationgivesthecorporation
uniquepowerswhichotherlegalentitieslack.
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14. Corporation...
Acorporationorcompanyiscollectivelyownedby
theshareholders,butmanagedbydirectors.
Acompanymustpaytaxesonitsprofits.
AcompanymaybecategorisedasaPubliclimited
company(plc)oraPrivatelimitedcompany(Ltd).
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15. Difference Between PLC vs. Ltd
PLCmeansPublicLimitedCompanyandLtd
meansaPrivateLimitedCompany.
PLCcanquotethesharesinastockexchange
whereastheLtdCompanycannot.
ThesharesinaPLCcanbeboughtandsold
throughthestockexchangeandthereisnoneedto
consulttheownersforsellingandbuyingshares.
Ontheotherhand,thesharesofLtdCompanyare
normallysoldtoclosefriendsandothersandthat
canonlybedoneifalltheshareholdersagree.
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16. Difference Between PLC vs. Ltd...
While an Ltd company thinks more of profit from
the business, the Public Limited Company cares
less of profit as it is concerned with services and
goods for the public.
If something goes wrong with a Public Limited
Company, it has very adverse impact on the public.
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17. The Objectives of The Firm
Differentorganisationshavedifferent
objectivestoaccomplishdependinguponthe
natureandsituationofthebusiness.The
followingcanbeconsideredastheobjectivesof
thefirm;
Maximizationofshareholderswealth
Maximizationofprofits
Maximizationofsales
Minimizingcosts
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18. Objectives (cont…..)
Survivalofthefirm
Creatinganeverexpandingempire
Maximizationofmanagerialsalaries
Maximizationofpersonalobjectives
Achievingthetargetmarketshare,etc
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19. Objectives (Cont…..)
Inpractice,itisquiteimpossibleforcompanies
tohavealltheseobjectivesinplaceatonce.
Inordertoattainthegoalcongruence,the
mostwidelyacceptedobjectiveofthefirmis
themaximizationofshareholderswealth
whichispracticallyachievedbyincreasingthe
marketvalueofshare.
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20. The Agency Problem
Thisconstitutes:
Agencyproblem
Agencytheory
Agencycosts
Agencyproblemsarisewhenthereisaconflict
betweentheinterestsoftheagent(e.g.themanagers)
andthoseoftheprincipal(e.g.shareholders).
Agencycostsarethecostsassociatedwiththeagency
problemandarisemainlyduetotheconflictofinterest
betweenthemanagersandtheshareholders.
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21. Agency Theory
Anagencyrelationshipexistswhenoneormore
persons,calledprincipals(shareholders),
hiresoneormorepersons,calledagents(directors),to
performsomeservice,
Anddelegatesdecision-makingauthoritytothem.
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22. Ways to reduce agency conflict:
Mitigate agency problems through:
ThreatoffiringorSackings
Threatoftakeoverandsellingshares
Grantingshareoptionstodirectorsandsenior
managers
Maintaininggoodrelationship
Profitrelatedpay
Directinterventionbyshareholders.
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23. TOPIC 2: TIME VALUE OF MONEY
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24. BasicProblem:
Howtodeterminevaluetodayofcashflowsthat
areexpectedinthefuture?
Timevalueofmoneyreferstothefactthatadollar
inhandtodayisworthmorethanadollar
promisedatsometimeinthefuture
Whichwouldyouratherhave[TZS1,000,000today
orTZS1,000,000in5years]?
Obviously,TZS1,000,000today;why?
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Time Value of Money

25. Time Value of Money…
Adollarreceivedtodayisworthmorethanadollar
receivedtomorrow:
Thisisbecauseadollarreceivedtodaycanbeinvestedto
earninterest
Anotherreasonbehindthisconceptisthat,futurecash
flowsarenotonlysubjecttoriskbutalsoinflation.
Moneyreceivedsoonerratherthanlaterallowsone
tousethefundsforinvestmentorconsumption
purposes.ThisconceptisreferredtoastheTime
valueofmoney!!
TIMEallowsonetheopportunitytopostpone
consumptionandearnInterest.
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26. SimpleInterest
Isinterestpaidorearnedonlyontheprincipal.
ThePrincipalistheoriginalamountofmoney
youdepositorborrow.RefertoQM711notes.
CompoundInterest
Isinterestearnednotonlyontheprincipal,but
alsoontheinterestthathasalreadybeen
earned,i.e.earninginterestoninterest.
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Simple and Compound Interests

27. TherearemanytypesofTVMcalculations
Thebasictypesthatwillbecoveredinthisclass
include:
Presentvalueofalumpsum
Futurevalueofalumpsum
Presentandfuturevalueofcashflowstreams
Presentandfuturevalueofannuities
Keepinmindthattheseformscan,should,and
willbeusedincombinationtosolvemorecomplex
TVMproblems.
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Types of TVM Calculations

28. Compounding is the way to determine the future value
of a sum of money invested now:
For example in a bank account, where interest is left in
the account after it has been paid.
Interest is earned on re-invested interest in the future.
Future value is calculated using the formula:
or
Where: (1+r)
n
is called the compounding factor
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Compounding and Future valuet
t rPFV )1(
0 trt FVIFPFV
,0

29. Futurevaluedeterminestheamountthata
sumofmoneyinvestedtodaywillgrowtoin
agivenperiodoftime
Theprocessoffindingafuturevalueis
called“compounding”(hint:itgetslarger)
Example
How much money will you have in 5 years if
you invest $100 today at a 10% rate of return?
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Future Value of a Lump Sum

30. Formula: FV
t= P
0×(1+r)
t
FV
5= $100 ×(1+0.1)
5
FV
5= $161.051
1.Kathywantstoknowhowlargeherdepositof$10,000todaywill
becomeatacompoundannualinterestrateof10%for5years.
2.Ifyouinvest$1,000todayataninterestrateof10percent,how
muchwillitgrowtobeafter5years?
3.Ifyouinvest$11,000inamutualfundtoday,anditgrowstobe
$50,000after8years,whatcompounded,annualizedrateofreturn
didyouearn?
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Future Value of a Lump Sum
Example

31. Presentvaluecalculationsdeterminewhatthe
valueofacashflowreceivedinthefuturewouldbe
worthtoday(time0)
Theprocessoffindingapresentvalueiscalled
“discounting”(hint:itgetssmaller)
Theinterestrateusedtodiscountcashflowsis
generallycalledthediscountrate
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Present Value of a Lump Sumt
t
r
FV
PV
)1(
 trtPVIFFVPV
,

32. How much would $100 received five years from
now be worth today if the current interest rate is
10%?
PV = FV
t/ (1+r)
t
PV = 100 / (1 + .1)
5
PV = $62.09
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Present Value of a Lump Sum
Example

33. 1.Assumethatyouneedtohaveexactly$4,000
saved10yearsfromnow.Howmuchmustyou
deposittodayinanaccountthatpays6%
interest,compoundedannually,sothatyou
reachyourgoalof$4,000?
2.Joannneedstoknowhowlargeofadepositto
maketodaysothatthemoneywillgrowto
$2,500in5years.Assumetoday’sdepositwill
growatacompoundrateof4%annually
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Present Value of a Lump Sum
More Examples

34. Acashflowstreamisafinitesetofpaymentsthatan
investorwillreceiveorinvestovertime.
ThePVofthecashflowstreamisequaltothesumof
thepresentvalueofeachoftheindividualcashflows
inthestream.
ThePVofacashflowstreamcanalsobefoundby
takingtheFVofthecashflowstreamanddiscounting
thelumpsumattheappropriatediscountrateforthe
appropriatenumberofperiods.
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Present Value of a Cash Flow Stream

35. Joemadeaninvestmentthatwillpay$100thefirst
year,$300thesecondyear,$500thethirdyearand
$1000thefourthyear.Iftheinterestrateisten
percent,whatisthepresentvalueofthiscashflow
stream?
You can use a timeline:
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Example of PV of a Cash Flow Stream

36. Draw a timeline:
PV = $90.91 + $247.93 + $375.66 + $683.01
PV = $1397.51
PV= [FV
1/(1+r)
1
]+[FV
2/(1+r)
2
]+[FV
3/(1+r)
3
]+[FV
4/(1+r)
4
]
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PV of a Cash Flow Stream
Example …
0
1
2
3
4
100
300 500 1000
?
?
?
?
r = 10%

37. Thefuturevalueofacashflowstreamisequalto
thesumofthefuturevaluesoftheindividualcash
flows.
With unequal periodic cash flows, treat each of the
cash flows as a lump sum and calculate its future
value over the relevant number of periods.
Sum up the individual future values to get the
future value of the multiple payment streams.
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Future Value of a Cash Flow Stream

38. 26/05/2024 16:54 38
FV of a Cash Flow Stream
Time Line

39. Example: Future Value of an Uneven Cash Flow
Stream
Jim deposits $3,000 today into an account that pays
10% per year, and follows it up with 3 more deposits at
the end of each of the next three years. Each
subsequent deposit is $2,000 higher than the previous
one. How much money will Jim have accumulated in
his account by the end of three years?
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FV of a Cash Flow Stream

40. FV of Cash Flow at T
0= $3,000 x (1.10)
3
= $3,000 x 1.331= $3,993.00
FV of Cash Flow at T
1= $5,000 x (1.10)
2
= $5,000 x 1.210 = $6,050.00
FV of Cash Flow at T
2= $7,000 x (1.10)
1
= $7,000 x 1.100 = $7,700.00
FV of Cash Flow at T
3= $9,000 x (1.10)
0
= $9,000 x 1.000 = $9,000.00
Total = $26,743.00
Note:
BeawarethatsomeCFsoccuratthebeginningof
eachperiodwhileothersoccurattheendofeach
period.
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FV of a Cash Flow Stream
Example…

41. Joemadeaninvestmentthatwillpay$100thefirst
year,$300thesecondyear,$500thethirdyearand
$1000thefourthyear.Iftheinterestrateisten
percent,whatisthefuturevalueofthiscashflow
streamifeachcashflowoccur
i.Atthebeginningofeachperiod
ii.Attheendofeachperiod
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FV of a Cash Flow Stream
Exercise

42. Anannuityisacashflowstreaminwhichthecash
flowsareallequalandoccuratregularintervals.
Annuitycanbecategorizedas:
AnnuityDue:Paymentsorreceiptsoccuratthe
beginningofeachperiod;e.g.houserent
OrdinaryAnnuity:Paymentsorreceiptsoccur
attheendofeachperiod;e.g.salary.
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Annuity Streams

43. Compoundingandsummingforeachpayment.
Theformulaforcalculatingthefuturevalueofan
annuitystreamisasfollows:
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Future Value of Ordinary Annuity]
1)1(
[
r
r
AFV
n
A

 nrA FVIFAAFV
,

44. Example: Future Value of an Ordinary Annuity
Stream
Jillhasbeenfaithfullydepositing$2,000attheendof
eachyearfor10yearsintoanaccountthatpays8%per
year.Howmuchmoneywillshehaveaccumulatedin
theaccount?
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FV of Ordinary Annuity
example

45. Future Value of Payment One = $2,000 x 1.08
9
= $3,998.01
Future Value of Payment Two = $2,000 x 1.08
8
= $3,701.86
Future Value of Payment Three = $2,000 x 1.08
7
= $3,427.65
Future Value of Payment Four = $2,000 x 1.08
6
= $3,173.75
Future Value of Payment Five = $2,000 x 1.08
5
=$2,938.66
Future Value of Payment Six = $2,000 x 1.08
4
= $2,720.98
Future Value of Payment Seven = $2,000 x 1.08
3
= $2,519.42
Future Value of Payment Eight = $2,000 x 1.08
2
= $2,332.80
Future Value of Payment Nine = $2,000 x 1.08
1
= $2,160.00
Future Value of Payment Ten = $2,000 x 1.08
0
= $2,000.00
Total Value of Account at the end of 10 years$28,973.13
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FV of Ordinary Annuity
solution

46. Using the formula
26/05/2024 16:54 46]
08.0
1)08.01(
[000,2
10


AFV 1250.973,28$
4866.14000,2$


FV of Ordinary Annuity
solution using formula

47. Supposeyouwanttoaccumulate$500,000atthe
endof30yearsasyourretirementmoney.The
interestrateyoucanmakeannualdepositsis8%.
Howmuchshouldyoudepositeachyear,sothat
youwillhave$500,000attheendof30years?
AssumethatSallyownsaninvestmentthatwill
payher$100eachyearfor20years.Thecurrent
interestrateis15%.WhatistheFVofthisannuity?
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FV of Ordinary Annuity
Exercise

48. Discounting and summing for each payment.
The generalized formula is
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Present Value of Ordinary Annuity]
)1(1
[
r
r
APV
n
A


 PVIFAAPV
A

49. 26/05/2024 16:54 49
PV of Ordinary Annuity
time line at r = 8%

50. Example:PresentValueofanAnnuity.
Johnwantstomakesurethathehassavedup
enoughmoneypriortotheyearinwhichhis
daughterbeginscollege.Basedoncurrent
estimates,hefiguresthatcollegeexpenseswill
amountto$40,000peryearfor4years(ignoring
anyinflationortuitionincreasesduringthe4
yearsofcollege).HowmuchmoneywillJohnneed
tohaveaccumulatedinanaccountthatearns7%
peryear,justpriortotheyearthathisdaughter
startscollege?
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PV of Ordinary Annuity
example

51. For; r = 7% and n = 4, PVIFA =3.3872
PV
A= A*PVIFA = 40,000 ×3.3872
= $135,488
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PV of Ordinary Annuity
solution

52. Acashflowstreamsuchasrent,lease,and
insurancepayments,whichinvolvesequalperiodic
cashflowsthatbeginrightawayoratthe
beginningofeachtimeinterval,isknownasan
annuitydue.
Anannuitydueiscalculatedinreferencetoan
ordinaryannuity.Inotherwords,tocalculate
eitherthepresentvalue(PV)orfuturevalue(FV)
ofanannuity-due:
AnnuityDue=Ordinaryannuityx(1+r)
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Annuity Due

53. Example: Annuity Due versus Ordinary Annuity
Let’ssaythatyouaresavingupforretirementand
decidetodeposit$3,000eachyearforthenext20
yearsintoanaccountthatpaysarateofinterestof
8%peryear.Byhowmuchwillyouraccumulated
nesteggvaryifyoumakeeachofthe20depositsat
thebeginningoftheyear,startingrightaway,rather
thanattheendofeachofthenexttwentyyears?
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Annuity Due
example

54. FV ordinary annuity = $3,000 ×[((1.08)
20
-1)/.08]
= $3,000 ×45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity ×(1+r)
FV of annuity due = $137,285.89 ×(1.08)
= $148,268.76
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Annuity Due
solution

55. Aseriesofconstantcashflowsexpectedtooccurat
theendofeachyearforeverandeverintothe
futureisknownasaperpetuity.
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Evaluating Perpetuitiesr
C
PV
A


56. Example5:PVofaPerpetuity
Ifyouareconsideringthepurchaseofaconsolthat
pays$60peryearforever,andtherateofinterest
youwanttoearnis10%peryear,howmuchmoney
shouldyoupayfortheconsol?
Answer:
r=10%,A=$60,andPV=($60/0.1)=$600.
So$600isthemostyoushouldpayfortheconsol.
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Perpetuity
Example

57. TOPIC 3: RISK & RETURN
RELATIONSHIP

58. Chapter objectives
At the end of this subtopic students should be able
to understand The following.
•Meaning of Risk and Return
•Total Risk
•Risks associated with investments
•Risk relationship between Different stocks
•Portfolio
•Diversification of Risk.

59. RISK
Is the variability of returns from those that
are expected. Or is a probability of an
uncertainty over the future to get a return
on security.
TOTAL RISK
Thetotalvariabilityinreturnsofasecurityrepresents
thetotalriskofthatsecurity.Systematicriskand
unsystematicriskarethetwocomponentsoftotal
risk.Thus
Totalrisk=Systematicrisk+Unsystematicrisk
ItmeasuredbyStandardDeviation(SD)indecimal
orpercentage.

60. Risks associated with investments
1–60
Risks
Non –
systematic OR
diversifiable
Systematic OR
Non
diversifiable

61. Systematic Risk
Theportionofthevariabilityofreturnofa
securitythatiscausedbyexternalfactors,is
calledsystematicrisk.
Itisalsoknownasmarketriskornon-
diversifiablerisk.
Economicandpoliticalinstability,economic
recession,macropolicyofthegovernment,etc.
affectthepriceofallsharessystematically.Thus
thevariationofreturninshares,whichiscaused
bythesefactors,iscalledsystematicrisk.

62. Systematic Risks
1–62
Risk
due to
inflation
Interest
rate risk
Political
risk
Market
risk
Risk due to
govt.
policies
Natural
calamities
scams
monsoon
Industrial
growth
International
events
War like
situation

63. Non-Systematic Risk
Thereturnfromasecuritysometimesvaries
becauseofcertainfactorsaffectingonlythe
companyissuingsuchsecurity.Examplesare
rawmaterialscarcity,Labourstrike,
managementefficiencyetc.
Whenvariabilityofreturnsoccursbecauseof
suchfirm-specificfactors,itisknownas
unsystematicrisk.

64. Non –Systematic Risks
Non
systematic
risks
Business
risks
Financial
risks
Risks due
to
uncertainty
Disputes

65. RISK RETURN RELATIONSHIP
OF DIFFERENT STOCKS
Rate of
Return Risk
Premium
Market Line E(r)
Degree of Risk
Mortage loan
Government stock (risk-free)
Ordinary shares
Subordinate loan stock
Preference shares
Debenture with floating charge
Unsecured loan
Risk return relationship of different stocks

66. Certainty Equivalent (CE)
is the amount of cash someone would require with
certainty at a point in time to make the individual in
different between that certain amount and an
amount expected to be received with risk at the
same point in time.
CAPITAL ASSERTS PRICING MODEL (CAPM)
is the model that describe the relationship between
risk and expected (required) return.
"Security's expected return (required) = Risk-free
rate + Premium based on the systematic risk of the
security"

67. Assumptions of CAPM
i.Capital markets are efficient.
ii.Homogeneous investor expectations over a given
period.
iii.Risk-freeasset return is certain.
iv.Market portfolio contains onlysystematic risk.
Beta -measures the sensitivity and weighted
rateof a stock's returns to changes in returns on
market portfolio.

68. Return
is the income from a security after a defined period
either in the Form of interest, dividend, or market
appreciation in security value.
Expected Return
is the profit or loss that an investor anticipates or
total amount of money he/she expect to gain or lose
on a particular an investment or portfolio that has
known historical rates of return (RoR)

69. Expected Return
•For an individual assets -it is the sum of the
product of returns and the corresponding
probability of returns.
•For a portfolio assets -The expected rate of return
for a portfolio of investments is simply the
weighted average of the expected rates of return
for the individual investments in the portfolio.

70. Risk & Return Analysis
Return on security(single asset) consists of
two parts:
Return = dividend + capital gain rate
R = D1+ (P1–P0)
P0
WHERE R = RATE OF RETURN IN YEAR 1
D1= DIVIDEND PER SHARE IN YEAR 1
P0 = PRICE OF SHARE IN THE BEGINNING OF THE YEAR
P1 = PRICE OF SHARE IN THE END OF THE YEAR

71. Average rate of return
R =1 [ R1+R2+……+Rn]
n
R =1ΣRt
nt=1
Where
R = average rate of return.
Rt= realisedrates of return in periods 1,2, …..t
n = total no. of periods
n

72. Risk
Risk refers to dispersion of a variable.
It is measured by variance or SD.
Variance is the sum of squares of the
deviations of actual returns from average
returns .
Variance = Σ (Ri–R)
2
SD = (variance
2
)
1/2

73. Expected rate of return
It is the weighted average of all possible
returns multiplied by their respective
probabilities.
E(R) = R1P1+ R2P2+ ………+ RnPn
E(R)= ΣRiPi
i=1
Where R
iis the outcome i, P
iis the probability
of occurrence of i.
n

74. Variance is the sum of squares of the deviations
of actual returns from expected returns weighted
by the associated probabilities.
Variance = Σ(Ri–E(R) )
2*
P
i
i=1
SD= (variance
2
)
1/2
n

75. Portfolio
Aportfolioisabundleofindividualassetsor
securitiesonfinancialtermdenotinga
collectionofinvestmentsheldbyinvestment
company,hedgefund,financialinstitution.
Allinvestorsholdwelldiversifiedportfolioof
assetsinsteadofinvestinginasingleasset.
Iftheinvestorholdswelldiversifiedportfolioof
assets,theconcernshouldbeexpectedrate
ofreturn&riskofportfolioratherthan
individualassets.

76. Portfolio return-two asset
case
Theexpectedreturnfromaportfoliooftwoormore
securitiesisequaltotheweightedaverageofthe
expectedreturnsfromtheindividualsecurities.
 =WA(RA)+WB(RB)
Where,
 =Expectedreturnfromaportfoliooftwo
securities
 WA=ProportionoffundsinvestedinSecurityA
 WB=ProportionoffundsinvestedinSecurityB
 RA=ExpectedreturnofSecurityA
 RB=ExpectedreturnofSecurityB
 WA+WB=1
Σ(Rp)
Σ(Rp)

77. Portfolio risk-two asset
Sincethesecuritiesassociatedinaportfolio
areassociatedwitheachother,portfolioriskis
associatedwithcovariancebetweenreturnsof
securities.
Covariance
xy= Σ(Rxi–E(Rx) (Ryi–E(Ry)*P
i
i=1
n

78. Correlation
is a measure of the relationship between two
variables. eg. A and B.

79. Correlation
To measure the relationship between returns of
securities.
Corxy= Covxy
SDX SDY
the correlation coefficient ranges between –1 to
+1.
The diversification has benefits when correlation
between return of assets is less than 1.

80. Correlation Coefficient
•Perfect negative correlation -This occurs when a
correlation coefficient between two assets is -1, Here,
there is a possibility of eliminating risk.
•Perfect positive correlation -This occurs when a
correlation coefficient between two assets is +1, Here
there is no possibility of eliminating risk.
•No correlation (independent assets) -This occurs
when a correlation coefficient between two assets is
zero 0, Here, there is possibility of reducing risk but
not eliminating it all.

81. Diversification of Risk
is a risk management technique that mitigates risk by
and allocating investments across different financial
instructions, industries, and several other categories.
The main purpose of this technique is (a) to
maximize returns by investing in different areas that
would yield higher and long term return, (b) to
minimize risk of portfolio through correlation assets.
Wehaveseenthattotalriskofanindividual
securityismeasuredbythestandarddeviation
(σ),whichcanbedividedintotwopartsi.e.,
systematicriskandunsystematicrisk
TotalRisk(σ)=SystematicRisk+Unsystematic
risk

82.  Unsystematic Risk

 Systematic Risk
 Number of security
 Figure 1: Reduction of Risk through Diversification
Risk

83. Onlytoincreasethenumberofsecuritiesintheportfoliowillnot
diversitytherisk.Securitiesaretobeselectedcarefully.
Iftwosecurityreturnsarelessthanperfectlycorrelated,an
investorgainsthroughdiversification.
If two securities M and N are perfectly negatively correlated, total
risk will reduce to zero.
Suppose return are as follows:
t
1 t
2 t
3 t
4
M 10% 20% 10% 20%
N 20% 10% 20% 10%
Mean
Return
15% 15% 15% 15%

84. 20% M
10% N
Figure 2
If r = -1 (perfectly negatively correlated), risk is completely
eliminated (σ = 0)
If r = 1, risk can not be diversified away
If r < 1 risk will be diversified away to some extent.

85. TWO IMPORTANT FINDINGS:
Morenumberofsecuritieswillreduceportfolio
risk
Securitiesshouldnotbeperfectlycorrelated.
Covariance-isameasureofthedegreetowhich
twovariables"movetogether"relativetotheir
individualmeanvaluesovertime.

86. Returns distribution for two perfectly
negatively correlated stocks (ρ= -1.0)
-10
15
A
n
n
u
i
t
y
s
o
l
u
t
i
o
n
25 2525
15
0
-10
Stock W
0
Stock M
-10
0
Portfolio WM

87. Returns distribution for two perfectly
positively correlated stocks (ρ= 1.0)
Stock M
0
15
25
-10
Stock M’
0
15
25
-10
Portfolio MM’
0
15
25
-10

88. Diversification….does it always work?
•Diversificationis enhanced depending upon the extent to
which the returns on assets “move” together.
•This movement is typically measured by a statistic
known as “correlation”as shown in the figure below.

89. •Eveniftwoassetsarenotperfectlynegatively
correlated,aninvestorcanstillrealizediversification
benefitsfromcombiningtheminaportfolioasshown
inthefigurebelow.

90. TOPIC 4: CAPITAL
STRUCTURE
26/05/2024 16:54:16 90

91. OUTLINE
•Introduction and Rationale
•Capital Structure Components: Advantages
and Dis advantanges.
•Capital Structure Theories.
•Determinants of Capital Structure
•Applications.
26/05/2024 16:54:16 91

92. INTRODUCTION
•CapitalStructureisamixtureoffundsafirm
usestofinancebusinessoperations.
•Capitalstructuredecisionisoneofthemain
decisionsinfinancialmanagement;others
beingdividendpolicyandinvestment
decisions.Itisafinancingdecision.
•Themaincomponentsofcapitalstructureare;
equityanddebt.
26/05/2024 16:54:16 92

93. INTRO (CONT.)
•Theamountofdebtafirmusestofinanceitsassetsis
calledaleverage.Thus,afirmwithleverageiscalleda
leveredfirmwhiletheonewithoutaleverage(anall-
equityfirm)isanunleveredfirm.Thevalueoflevered
firmisgreaterthanthevalueofunleveredfirmi.e.
•V
L=V
UL+TDwhere,V
Listhevalueofleveredfirm,
V
UListhevalueofunleveredfirm,TistaxrateandDis
debt.
•Thecapitalstructurechoicemattersespeciallywhenthe
firmwantstominimizethecostofcapitaland
maximizethevalueofthefirm.
26/05/2024 16:54:16 93

94. Components of Capital Structure
(i)DEBT
Advantages
•Interestistaxdeductible(lowerstheeffective
costofdebt).
•Debt-holdershaveafixedrateofreturn.
26/05/2024 16:54:16 94

95. Components of Capital Structure
Disadvantages
(i)Debt holders do not have voting rights.
(ii)Higherdebtratiosmayleadto;
•greaterriskand
•higherrequiredinterestrates(tocompensatefor
theadditionalrisk)
26/05/2024 16:54:16 95

96. Components of Capital Structure
(ii) EQUITY
Advantages
•Ownershiprights
•Votingrights
•Resourcesraisedthroughequitycanbecash,
propertyorservices.
Disadvantages
•Lossofmoneyincasethecompanyfailsto
performorduringliquidation.
26/05/2024 16:54:16 96

97. THEORIES
(i) Modigliani and Miller (MM, 1958). MMI
proposes that, the overall value of the firm is
independent of its capital structure. This theory
is also referred to as a Capital Structure
Irrelevance Theory.
Assumptions
(i)No taxation
(ii)Capital markets are perfect
26/05/2024 16:54:16 97

98. THEORIES
Assumptions
(iii) No financial distress and Liquidation costs
(iv) Firms can be classified into distinct risk
classes
(v) Individuals can borrow as cheaply as firms.
26/05/2024 16:54:16 98

99. THEORIES
(ii)MMII(1961):Theexpectedrateofreturn
increasesproportionallywiththegearingratio.
Inotherwords,theoverallvalueofthefirmis
dependentonitscapitalstructure.Thisisalso
referredtoascapitalstructurerelevancetheory.
Assumptions
(i)There is taxation
(ii)Capital markets are imperfect
26/05/2024 16:54:16 99

100. Assumptions
(iii) There are financial distress and Liquidation
costs
(iv) Firms can not be classified into distinct risk
classes
(v) Individuals can not borrow as cheaply as
firms.
26/05/2024 16:54:16 100

101. (iii)Pecking Order Theory-POT
(Information Asymmetry Theory-IAT)
•ThistheorywasputforwardbyMyersandMajluf
(1984).
•ItsupportsMM1theorybyarguingthatthereis
nooptimalcapitalstructure.
•Whenconsideringfinancingdecision,firms
shouldfirstlookforinternallygeneratedfunds
(e.g.retainedearnings)beforetheycanlookfor
externallygeneratedfunds(i.e.borrowings,
preferencesharesandnewissuesofequity).
26/05/2024 16:54:16 101

102. POT (IAT)-CONT.
•Thepeckingordershouldbeasfollows;
RetainedEarnings(RE)-IGF(Internallygenerated
funds.
Borrowings-EGF
Preferenceshares-EGF
Newissuesofequity-EGF
Why pecking order?
•Equity issue is perceived as bad news by the
market.
•Transaction and floatation costs
26/05/2024 16:54:16 102

103. (iv) Static Trade off Theory ( Tax-Based
Theory)
•ThistheorysupportsMMIItheorybyarguingthat
thereisanoptimalcapitalstructure.
•Accordingtothistheory,theoptimalcapital
structureisobtainedwhenthenetadvantageof
debtfinancingbalancestheleveragerelatedcosts
suchasbankruptcyandfinancialdistresses.
•Thetheoryarguesthatcapitalstructureisbased
onatrade-offbetweentaxsavingsanddistress
costsofdebt.
26/05/2024 16:54:16 103

104. Agency Cost Theory of Capital
Structure
•ThepioneersofthistheoryareJensenand
Meckling(1976)andfirstputforwardby
AdamSmith(1776).
•Itstatesthattheoptimalcapitalstructureis
determinedbythecostsarisingconflicts
betweenagents(managers)andprincipals
(owners).
26/05/2024 16:54:16 104

105. Determinants of Capital Structure
Extantresearchpointsoutthefollowingas
factorsordeterminantsofcapitalstructure;
•Profitability-Higherprofitlevelgivesrisetoa
higherdebtcapacityandaccompanyingtax
shields.
•Tangibility-Firmswithhigherleveloftangible
assetsaremorelikelytobeinapositionto
provideforcollaterals.
26/05/2024 16:54:16 105

106. Applications
•Used in determining the financing needs of the
firm.
•Helps managers to find the appropriate mix of
the sources of funds.
26/05/2024 16:54:16 106

107. Questions
1.Whatiscapitalstructure?
2.Assumingtaxesexist,whythevalueof
leveredfirmisalwaysgreaterthanthevalue
ofunleveredfirm?
3.Discuss advantages and disadvantages of
using equity and debt in the capital structure.
4.Discuss at least fivedeterminants of capital
structure.
26/05/2024 16:54:16 107

108. Questions
5.Identifyanddiscussvarioussourcesoffundsafirm
mayusetofinanceitsbusinessoperations.
6.ThecostofMamboleoLtd,anallequityfirmis14%.
WhatistheWACCofthefirm?
7.(a)Definethefollowingtermsastheyareusedin
capitalstructure;
(i)leverage
(ii)Gearing
(iii)Leveredfirm
(iv)Unleveredfirm
(v)Optimalcapitalstructure
26/05/2024 16:54:16 108

109. Questions
(b)Explaintherelationshipbetweenthevalueof
leveredfirmandunleveredfirm.
(c)Whydoyouthinkitisimportantfor
financialmanagerstounderstandthecapital
structureandvalueofthefirmconcepts?
8.Thefollowingaretheestimationsofthecost
ofdebtandequityforvariousfinancialgearing
levelsforTBLLtd.Determinetheoptimal
capitalstructure.
26/05/2024 16:54:16 109

110. Questions
Proportion of Debt Required Rate of Return
Debt, Equity,
% %
0.80 9.0 35.0
0.70 7.5 28.0
0.60 6.8 21.0
0.50 6.4 17.0
0.40 6.1 14.5
0.30 6.0 13.5
0.20 6.0 13.2
0.10 6.0 13.1
0.00 - 13.0DE
D
VV
V
 DATk Ek
26/05/2024 16:54:16 110

111. Questions
9.TENDONplchasacapitalstructurewhichis
30percentdebtand70percentequity.Thecost
ofdebt(i.e.borrowings)beforetaxesis9per
centandforequityis15percent.Thefirm's
futurecashflows,aftertaxbutbeforeinterestare
expectedtobeaperpetuityof£750,000.Thetax
rateis30percent.CalculatetheWACCandthe
valueofthefirm.
26/05/2024 16:54:16 111

112. Solution
Given
Vd = 30%, Ve = 70%, Kd = 9%, Ke = 15%
Kd = C/Po -Annual coupon payment/Before tax of
debt/cost of redeemable debt
Consffar = 750,000
Tax rate = 30%
WACC = ?
We = Ve/Ve + Vd = 70/100 = 0.7
V = C/r =750,000/12.39% = 6,053,268.7
26/05/2024 112

113. Now,
WACC = WaKe + WdKd
WACC = 0.7 + 15% + 0.3 * 9% (1-30%)
WACC = 12.39%
26/05/2024 113

114. Questions
10.(a)Discussthefollowingtheoriesofcapital
structure;
(i)MMI(withoutTaxation)Theory
(ii)MMII(withtaxes)Theory
(iii)PeckingOrderTheory
(iv)StaticTradeoffTheory
26/05/2024 16:54:16 114

115. Questions
(b)Giventhefollowinginformationabout
TATEPA,whatwouldthecostofcapitalbeifit
wastransformedfromitscurrentgearingto
havingnodebt,ifModiglianiandMiller̓smodel
withnotaxapplied?
=30%
=9%
=0.6Ek Dk ED
D
VV
V
 ED
D
VV
V

26/05/2024 16:54:16 115

116. TOPIC 5: COST OF CAPITAL
26/05/2024 16:54:16 116

117. CONTENTS
Terms related to cost of capital
Computation of cost of debt
Computation of cost of equity
Computation of preferred stock
Weighted average cost of capital
26/05/2024 16:54:16 117

118. INTRODUCTION COST OF CAPITAL
•CostofCapitalistherateofreturnrequiredby
capitalorfundsꞌproviderstoinducethemtobuy
andholdafinancialsecurity.
•Examplesofcostofcapitalinclude;interest
expensepaidforborrowedcapital,cashdividend
paymentsthatastockissuerpaystoitsstock
holders,andopportunitycost.
•Sourcesoffundsinclude;Equity,Preference
shares,DebtsandRetainedEarnings.
•Eachofthesesourceshasdifferentcostofcapital
duetodifferentassociatedrisk.
26/05/2024 16:54:16 118

119. INTRODUCTION (CONT)
•The minimum rate of return is the risk free rate
every investor can attain by investing in risk
free assets plus risk premium.
•That’s, R = R
f+ Risk Premium
•R = R
f+ R
m-R
f
•Where, R is the required rate of return, R
f=
risk free rate, R
m= market return and R
m-R
f
= risk premium.
26/05/2024 16:54:16 119

120. ESTIMATING THE COST OF CAPITAL
Cost of Equity Capital
Two Common Approaches
1.DividendGrowthModel(DGM)orMyron
GordonModel
2.CapitalAssetPricingModel(CAPM)or
SecurityMarketLine(SML).
26/05/2024 16:54:16 120

121. ESTIMATING THE COST OF CAPITAL
1. Dividend Growth Model or Gordon Model
K
e= D
1/ P
o+ g
Where,
•K
e= the cost of equity capital,
•D
1= one year ahead dividend per share,
•P
o= Intrinsic (true) value of share or price per
share.
•g = the constant growth rate of earnings and
dividends
26/05/2024 16:54:16 121

122. Advantages & Disadvantages of DGM
Advantages
•Easy to understand
•Simple to use
Disadvantages
•Applicable to only companies which pay dividends
•Assume dividends grow at a constant rate
•Does note take into account the risk associated with
a security.
26/05/2024 16:54:16 122

123. Advantages & Disadvantages of DGM
•Theestimatedcostofequityissensitivetothe
estimatedgrowthrate,thusmightaffectit.
•Itisabackwardlookingapproachasituses
pastdata.
•The model only makes sense when K
e> g
26/05/2024 16:54:16 123

124. THE COST OF EQUITY
Capital Asset Pricing Model (CAPM) or Security Market
Line (SML), or Sharpe, Lintner and Black Model.
R = R
f+ β(R
m-R
f)
Where,
•β=Betameasuringthesystematicriskofasecurity.
Systematicrisksarethemarketriskswhichcannotbe
diversifiedawayoreliminatede.g.interestrates,recessions
andwars.
•Betacanbemeasuredbyβ
i=
•R=Expectedrateofreturn 
2
,
2
,
m
mimi
m
mi
RRCOV




26/05/2024 16:54:16 124

125. THE COST OF EQUITY
Advantages of CAPM
•It is easy to understand
•It is simple to use
•It takes into account the risks associated with capitals.
•Applicabletobothdividendsandnon-dividendspaying
companies.
Disadvantages
•Itisrelativelydifficulttomeasurebeta(Thesystematicrisk
ofasecurity).Thatis;itisunreliable.
•Economicconditionschangequickly,thusdatausedmaynot
reflecttruepicture.
•Difficultinobtainingtheriskfreerate.
26/05/2024 16:54:16 125

126. THE COST OF EQUITY
Example
TBLhasbeta=1.2,marketriskpremiumis8%,
andriskfreerateis6%.TBL̓slastdividendwas
Tsh.500pershareanddividendisexpectedto
growat8%indefinitely.Thecurrentpriceper
shareisTsh.1500.WhatisTBL̕scostofequity
using;(i)DGMand(ii)SML?
26/05/2024 16:54:16 126

127. THE COST OF EQUITY
Suggested Solution
Rf = 6, B = 1.2, Risk Pm = 8%, DPS = 500, KC
= ?
(i)K
e= 500 (1.08)/ 1500 + 0.08
= 0.44
(ii) R = 0.06 + 1.2 x 0.08
= 0.156
26/05/2024 16:54:16 127

128. Calculation
DGM = Ke = D1/Po + g = 540/1500 + 0.08 = 44%
CAPM = Ke = Rf + B (Rm -Rf)
= 44% = 6% + 0.08 (8% -6%) = 15%
26/05/2024 128

129. COST OF DEBT
•It is the required rate of return on the
investment of the long term lenders of the
firm.
•We may distinguish between the before tax
cost of debt (Kd) and after tax cost of debt
(Ki).
•Before Tax Cost of Debt (Kd)
•In computing the before tax cost of debt, we
need to distinguish between:
26/05/2024 16:54:16 129

130. COST OF DEBT
•Before Tax cost of Redeemable Debt
Before Tax Cost of Irredeemable Debt
•Irredeemable debt is the debt that never
matures (perpetual bonds). Before Tax cost of
an irredeemable debt can be determined by
the following formula.
•Kd = C / Pd
•Where: C = annual interest amount or annual
coupon payment
26/05/2024 16:54:16 130

131. COST OF DEBT
•Pd= Market price per debt (debenture) Ex
interest
•Annual Coupon amount = Coupon rate *
Nominal value of Debt Example
•Calculate the before tax cost of irredeemable
debt with the following features: Nominal
value of the debt is 10,000. Market value ex
interest is 9,000 and coupon rate is 10%.
26/05/2024 16:54:16 131

132. COST OF DEBT
•Cost of Redeemable Debt
•Redeemable debt is a debt with definite
maturity. Before tax cost of a redeemable debt
is that discount rate which equate the current
market price of debt ex-interest with the
present value of the future interest payment
to the date of redemption and the maturity
value of the debt.
26/05/2024 16:54:16 132

133. COST OF DEBT
•There are four ways of estimating the (Kd) of
redeemable debt, these are:
•1. Using computer software
•2. Financial calculator
•3. Trial and error method
•4. Approximation formula
26/05/2024 16:54:16 133

134. COST OF DEBT
•The Approximation Formula will be used here
•Before tax cost of Redeemable Debt can be
approximated by using the following formula
26/05/2024 16:54:16 134

135. THE COST OF DEBT
Fromequation2aboveandusinglinear
interpolation,thebeforetaxcostofcapitalwhich
istheequivalenttotheYieldtoMaturity(YTM)
canbecalculatedasfollows;
K
d=YTM=
Where,INT=periodicdollarcouponpayment=ix
M,nisthenumberofperiodsuntilthematurity
ofthedebt,Misthematurityorfacevalueofthe
debt,V
disthepresentormarketvalueofthedebt.2/)(
/)(
d
d
VM
nVMINT


26/05/2024 16:54:16 135

136. COST OF DEBT
•AFTER TAX COST OF DEBT (Ki)
•Is the cost of debt after taking into account
the effect of corporate tax on the cost of debt.
•Adjusting before tax cost of debt for corporate
tax purposes.
•After tax cost of debt Ka = Kd *(1-tc )
•Where: tc = tax rate
26/05/2024 16:54:16 136

137. COST OF PREFERRED STOCK
It is the rate of return on the investment of the
preferred stock holders of the firm.
•We may distinguish between:
•1. Cost of irredeemable preferred stock
•2. Cost of a redeemable preferred stock
26/05/2024 16:54:16 137

138. COST OF DEBT
•Cost of Irredeemable Preferred Stock
•This can be calculated as;
•Kp = Dp / Po
•Where: Dp = preferred dividend
•Po= Market price per share ex dividend
26/05/2024 16:54:16 138

139. COST OF DEBT
•Cost of Redeemable Preferred Stock
•The cost of redeemable preferred stock is
given by:
•The same approximation formula can be used
to determine the cost of redeemable
preferred stock
26/05/2024 16:54:16 139

140. THE COST OF THE FIRM(WACC)
•Afirm'scostofcapitalistheaverageofthe
costsofdifferenttypesofsecuritiesusedto
financethefirm'sinvestments.
•TheWeightedAverageCostofCapital
(WACC)iscalculatedbyweightingthecostof
debtandequityinproportiontotheir
contributiontothetotalcapitalofthefirm.
•Theweightsusedarebasedonthefirmstarget
capitalstructureandisbasedonmarketvalues.
26/05/2024 16:54:16 140

141. THE COST OF THE FIRM
•WACC=k
eW
e+k
d(1-t)W
D.Thisisfor
capitalstructurewithtwocomponents.
•WACC=
•WACCisminimizedwhenthereisaproper
mixofdebtandequityi.e.OptimalCapital
Structure.)()(
de
d
d
de
e
eo
VV
V
k
VV
V
kk




26/05/2024 16:54:16 141

142. APPLICATIONS OF WACC
•Usedforcapitalstructuredecisions
•Usedinvaluationofshares,bondsanddebts.
•Usedincomputingpresentandfuturevalues
ofcashflows.
•Appraisingcapitalprojects(Capital
Budgeting)
26/05/2024 16:54:16 142

143. Questions
1.Whatisacostofcapital?
2.Whyisacostofcapitalimportant?
3.Discusstheadvantagesanddisadvantagesof
DGMandCAPMinestimatingthecostof
equity.
26/05/2024 16:54:16 143

144. Questions
5.AssumethatTCChas$20,000,000intotal
assetsandcapitalstructurecomponentsaresuch
that;equity=$10million,anddebt=
$6millionandpreferredstock$4million
TCCafter-taxcostofdebt=8%,thecostof
equityis14%andcostofpreferredstockis9%
CalculateWACC.
26/05/2024 16:54:16 144

145. Questions
7.(i)ExplaintherelationshipbetweenCostof
CapitalandGearing.
(ii).WhenisWACCminimized?
8.TheBBC̕snextexpecteddividend=£3per
share.Dividendsgrowattherateof7%andis
expectedtoremainconstantindefinitely.The
currentmarketpricepershareis£45and
flotationcostspershare=£5.Calculatethecost
ofequity.
26/05/2024 16:54:16 145

146. TOPIC 5: DIVIDEND POLICY
Lecturer: Dr. Jumanne Basesa

147. An outline
•Introduction
•Conceptualize the dividend policy
•Factors influencing dividend policy
•Dividend mechanics
•Some dividend policy theories

148. Dividend Policy
Introduction
•Theultimategoaloffinancialmanagersshould
bethemaximizationofshareholders’wealth.
•Shareholderwealthcanbemaximizedby
maximizingthepriceofthestock.
•Thetermdividendreferstothatpartofprofitsof
acompanywhichisdistributedamongits
shareholders.
•Dividenddistributedtoshareholdersmaximize
theirwealth.
•Thedecisiontodistributedividendsissolelythe
responsibilityoftheboardofdirectors.

149. What is Dividend Policy
•Whenacorporationearnsaprofitorsurplus,that
moneycanbeputtotwouses:
▫caneitherbere-investedinthebusiness(called
retainedearnings),
▫orcanbepaidtotheshareholdersasadividend.
•Manycorporationsretainaportionoftheir
earningsandpaytheremainderasadividend.
•Shareholderreceivesadividendinproportionto
theirshareholding.

150. What is “dividend policy”?
•It’sthedecisiontopayoutearnings
versusretainingandreinvestingthem.
Includestheseelements:
1.Highorlowpayout?
2.Stableorirregulardividends?
3.Howfrequent?
4.Doweannouncethepolicy?

151. Factors affecting Dividend Policy
•AvailabilityofDivisibleProfits
•AvailabilityofProfitableReinvestmentopportunities
•AvailabilityofLiquidity
•Inflation
•EffectonMarketPrices
•CompositionofShareholding
•Company’sownpolicyregardingstabilityofdividend
•ContractualrestrictionsbyFinancialInstitutions
•Extentofaccesstoexternalsources
•AttitudeandObjectivesofManagement

152. Dividend Mechanics
CaterpillarPressReleaseOctober12,2006
PEORIA,IL--CaterpillarInc.(NYSE:CAT)
todaydeclaredaquarterlycashdividendof
thirtycents($0.30)pershareonitscommon
stock,payableNovember20,2006,to
stockholdersofrecordatthecloseofbusiness
October23,2006.Thethirtycentdividend
maintainsthedividendratefortheprevious
quarterandis20percenthigherthanthe
dividendpaidoneyearagoandis46percent
higherthanthesplit-adjusteddividendpaidtwo
yearsago.
Whatimportantinformationcanyoudeduce
fromthisrelease?

153. Dividend Mechanics
Important Dates
•Dividendsmustbe"declared"(approved)bya
company’sBoardofDirectorseachtimethey
arepaid.
•Forpubliccompanies,therearefourimportant
datestorememberregardingdividends.

154. The Declaration Date
•IsthedaytheBoardofDirectorsannouncesits
intentiontopayadividend(October12in
example).
•Onthisday,aliabilityiscreatedandthe
companyrecordsthatliabilityonitsbooks;it
nowowesthemoneytothestockholders.
•Onthedeclarationdate,theBoardwillalso
announce:adateofrecord,apaymentdateand
theamountofthedividendforeachshareclass.

155. The in-dividend Date
•Thein-dividenddateisthelastday,whichisone
tradingdaybeforetheex-dividenddate,wherethe
stockissaidtobecumdividend(withdividend).
•Inotherwords,existingholdersofthestockand
anyonewhobuysitonthisdaywillreceivethe
dividend,whereasanyholderssellingthestocklose
theirrighttothedividend.Afterthisdatethestock
becomesexdividend

156. The ex-dividend date
•Occurstwobusinessdaysbeforedateofrecord(October
21inexample)
•Ifyoubuystockonorafterthisdate,youwillnotreceive
thedividendi.e.isthedayonwhichallsharesboughtand
soldnolongercomeattachedwiththerighttobepaidthe
mostrecentlydeclareddividend.
•Existingholdersofthestockwillreceivethedividend
eveniftheynowsellthestock,whereasanyonewhonow
buysthestockwillnotreceivethedividend.
•Itisrelativelycommonforastock'spricetodecreaseon
theex-dividenddatebyanamountroughlyequaltothe
dividendpaid.

157. DateofRecord
•isthedateonwhichtheshareholdersregisteris
closedafterthetradingday.(October23in
example)
•Allthosewhoarelistedwillreceivethedividend.
Date of Payment
•isthedatethechequesforthedividendare
mailedouttotheshareholders.Paymentis
normally2-3weeksafterrecording.(November
20inexample).

158. Procedure of Dividend Payment
An Example
•November 11:Boarddeclaresaquarterly
dividendofTZS120persharetoholdersofrecord
asofDecember10.
•December7:Dividendgoeswithstock.
•December8:Ex-dividenddate.
•December10:Holderofrecorddate.
•December 31:Paymentdatetoholdersof
record.

159. Types of Dividends
Commonly three
1.CashDividend
•mostcommon
•portionofearningspaidouttoshareholders
•typicallyonanongoingbasis
2.StockDividend
•giveshareholdersnewsharesofstockinlieuof
cashasadividend
•increasesthenumberofsharesoutstanding
•sameeffectasastocksplit
3.SpecialDividendorStockRepurchase
•specialdividend=alarge,onetimedividend
•stockrepurchase=distributecashto
shareholdersbyfirmbuyingstock

160. Cash Dividend
•Dividendspaidoutofearnings(actually
paidoutoffreecashflow)
▫typically,dividendsarepaidonanongoing
basis,yearafteryear
▫somefirmshavetargetpayoutratios
▫however,despitebeingpaidoutofearnings,
dividendsaretypicallymuchlessvolatile!!
WHY?
Changesindividendsactasasignaltothemarket
aboutthehealthandprospectsofthefirm

161. Cash Dividend…
•Firmdonotliketoreducedividendsunless
absolutelynecessary
•Adividendreductionsendsabadsignaltothe
market(empirically,approx.4%dropon
averageinstockprice)
•Toavoidsendingbadsignal,firmsonlyraise
dividendiftheyareveryconfidentthatthenew
levelcanbemaintainedinthefuture
•Therefore,dividendsare“sticky”

162. Stock Dividend
•Firmdistributesnewsharesofstockto
shareholdersasadividendinsteadofcash
•Onlyrealeffectistoincreasenumberof
sharesanddilutethevalueofeachshare
•Sometimesusedtotryand“fool”investors
intothinkingtheyaregettingadividend
whenthefirmcannotaffordit
•Astocksplitisessentiallyjustalargestock
dividend

163. Stock Dividend
Example:
▫Firmhas100,000shares,eachworthTZS100
▫Doesa2-for-1stocksplit
▫Doublesnumberofshares,butdoesnotchangeanything
aboutfirm
▫Thereshouldnowbe200,000shares,eachworthTZS50
▫Nodifferencetoshareholders
▫However,empiricallyitturnsoutthatthesharesare
worthalittlemorethantheTZS50expected
Onaverage,stockpricesgoupabout2%-3%when
stocksplitsannounced

164. Special Dividends
•Firmswithlargeamountsofexcesscashsometimes
payoutlargedividends
•Firmsarenormallyveryexplicitaboutthelarge
dividendbeingaspecialdividend
▫Noimplicationthatdividendsofthatsizewillcontinue
▫Avoidssignalingproblem
•Anotherwaytodistributecashtoshareholders,
oftenusedwhenfirmhaslargeamountofexcess
cashonhand:repurchaseofstock:
▫Usefirm’sexcesscashtobuystockback
▫Repurchasesareanalternativetodividendsfordistributing
cashtoshareholders,withsomeadvantagesoverpayingcash

165. Dividend Theories
Relevance Theories
(i.e.whichconsider
dividenddecisiontobe
relevantasitaffectsthe
valueofthefirm)
Irrelevance Theories
(i.e.which consider
dividenddecisiontobe
irrelevantasitdoesnot
affectsthevalueofthefirm)
Walter’s Model Gordon’s Model
Modigliani and
Miller’s Model

166. Relevance -Dividend is important states that "a
company Which pay a dividend it's value is increased".
Irrelevance -Dividend is not important states that" a
company's which pay dividend it's value is decreased".

167. Do investors prefer high or low
payouts? Three theories:
•Dividends are irrelevant: Investors don’t
care about payout.
•Bird in the hand: Investors prefer a high
payout.
•Tax preference: Investors prefer a low
payout, hence growth.

168. Dividend Irrelevance Theory
•Investorsareindifferentbetween
dividendsandretention-generatedcapital
gains.Iftheywantcash,theycansell
stock.Iftheydon’twantcash,theycanuse
dividendstobuystock.
•Modigliani-Millersupportirrelevance.
•Theoryisbasedonunrealisticassumptions
(notaxesorbrokeragecosts),hencemay
notbetrue.Needempiricaltest.

169. Modigliani & Miller’s Irrelevance
Model
•AccordingtoM-M,underaperfectmarket
situation,thedividendpolicyofafirmis
irrelevantasitdoesnotaffectthevalueofthe
firm.
•Theyarguethatthevalueofthefirmdependson
thefirm’searningsandfirm’searningsare
influencedbyitsinvestmentpolicyandnotby
thedividendpolicy

170. Modigliani & Miller’s Irrelevance
Model
Depends on
Depends on

171. Bird-in-the-Hand Theory
•Investorsthinkdividendsarelessrisky
thanpotentialfuturecapitalgains,
hencetheylikedividends.
•Ifso,investorswouldvaluehighpayout
firmsmorehighly,i.e.,ahighpayout
wouldresultinahighP
0.

172. Tax Preference Theory
•Retainedearningsleadtolong-term
capitalgains,whicharetaxedatlower
ratesthandividends:20%vs.upto
39.6%.Capitalgainstaxesarealso
deferred.
•Thiscouldcauseinvestorstoprefer
firmswithlowpayouts,i.e.,ahigh
payoutresultsinalowP
0.

173. TOPIC6: RATIO ANALYSIS FOR
INVESTMENT MAKING
173

174. FINANCIAL RATIO ANALYSIS
•Ratioanalysisisamethodusedtoassessacompany’s
performanceoveraperiodoftimeortocomparethe
performanceoftwocompanies.
•Incomparingtheperformanceoftwocompaniesyou
mustconsiderthenatureofeachcompany’sbusiness
becausetheratiosofasupermarketwillbesignificantly
differentfromthoseofanengineeringcompany.
174

175. FINANCIAL RATIO ANALYSIS…
InformationusedinRatioanalysiscomesfromthe
company’sFinancialstatements.
oIncomestatement:Providesafinancialsummaryofa
company’soperatingresultsduringaspecifiedperiod.
oBalancesheet:Providesasummaryofafirm’s
financialpositionatagivenpointintime.Balances
thefirm’sassetsanditsfinancing(debt&equity).
oCashflowstatement:Providesasummaryofthe
firm’soperating,investment,andfinancingcash
flows.
175

176. RATIO ANALYSIS –USERS
•Usersoffinancialratiosincludepartiesexternal
andinternaltothecompany:
•Externalusers:Financialanalysts,retail
investors,creditors,competitors,tax
authorities,regulatoryauthorities,andindustry
observers
•Internalusers:Managementteam,employees,
tradeunion,andowners
176

177. RATIO ANALYSIS –DECISION MAKING
Different types of accounting ratios are used for
different purposes:
•Profitability/Performance Ratios –to assess
profitability levels
•Liquidity Ratios –to assess solvency levels
•Gearing Ratio –to assess debt levels
•Financial Efficiency Ratios –to assess efficiency levels
•Shareholder Ratios –to assess equity investments
177

178. PROFITABILITY/PERFORMANCE
RATIOS
•Return On Capital Employed (ROCE)
•Gross Profit Margin
•Net Profit Margin
•Return on asset
•Return on Equity
178

179. RETURN ON CAPITAL EMPLOYED
(ROCE)
This shows a firm’s profitability in relation to
the investor’s capital investment.
ROCE = Profit before taxx 100% = x %
(Total Assets-Current Liabilities)
179

180. GROSS PROFIT MARGIN
This shows the gross profit made relative to
sales revenue/turnover.
Gross Profit Margin = Gross Profit x 100% = x
%
Sales Revenue
A large range of profit may affect the true results
Useful when comparing against the margins of previous years.
180

181. NET PROFIT MARGIN
This indicates amount of profit available, relative to
the sales revenue after deducting trading costs
and business expenses.
This shows how well a business controls its
expenses/ overheads.
Net Profit Margin = Net Profit x 100% = x
%
Sales Revenue
181

182. PROFITABILITY -Exercise
Analysethefollowingtwobusinessesand
assesstheprofitabilityasaresultoftrading.
SupermarketA 2016 2017
Grossprofitmargin 28% 28.2%
Netprofitmargin 4.9% 2.7%
SupermarketB
Grossprofitmargin 32% 32.5%
Netprofitmargin 4.1% 8.9%
182

183. LIQUIDITY RATIOS
•Measures the ability of a business to meet
short-term obligations, collect receivables, and
maintain a cash position
•Indicates how well the business is able to meet
its short-term obligations from cash/near-cash
resources
183

184. LIQUIDITY RATIOS -Exercise
Analysethefollowingtwobusinessesandassess
thehealthoftheirliquidityposition:
Clothes retailer
Current ratio1.8
Acid test ratio1.2
Supermarket
Current ratio2.4
Acid Test ratio0.6
184

185. CURRENT RATIO
•
185

186. GEARING RATIO
•
186

187. FINANCIAL EFFICIENCY
RATIOS
Theseratiosassesshowefficiently
managementoffirmsarecontrolling
operationsandtheday-to-dayrunningof
thebusiness:
Inventory turnover
Thisratiomeasureshowmanytimesayearabusiness
sellsandreplacesitsstock.Ahighinventoryturnover
figuremeansabusinessisfrequentlysellingstockto
generatesalesrevenue.
Inventory turnover= Cost of sales TShs600m
187

188. FINANCIAL EFFICIENCY RATIOS
Trade Receivables Ratio (Debtors Collection):
•Shows length of time taken to recover monies from
debtors
•Trade Receivables Ratio =
Trade Receivables x 365= x days
Sales Revenue 1
•Benchmark –customers are expected to settle their
accounts within 30 days of the date of the invoice
•The shorter the better and a low figure means that
cash is boosted and this can help the liquidity ratios.
188

189. FINANCIAL EFFICIENCY
Trade Payables Ratio (Creditors payment)
•Shows the length of time taken to pay monies to
suppliers
•Trade Payables Ratio =
Trade Payables x 365= x days
Cost of Sales 1
•It must be noted that the business should not pay back
the suppliers too quickly if credit days are available as
this will help their liquidity. However, accounts are
published and any potential suppliers will be aware of
these figures and they will make decisions accordingly.
189

190. FINANCIAL EFFICIENCY
Analysethefollowingtwobusinessesandassess
whichoneisperformingmoreefficiently.
Clothing retailer A
Payable days 58
Receivable days 30
Gearing 65%
Clothing retailer B
Payable days 22
Receivable days 24
Gearing 45%
190

191. SHAREHOLDER RATIOS
•Earnings Per Share (EPS)
•Return On Equity (ROE)
191

192. EARNINGS PER SHARE (EPS)
•This ratio measures how many pence the
company is earning for every share held
•Earnings per Share =
Net Profit after tax
No. of ordinary shares = x pence
•Must be disclosed in the Income Statement
192

193. RETURN ON EQUITY (ROE)
•A measure of how well a company used
reinvested earnings to generate additional
earnings
•Return On Equity =
Net Profit after Tax
Equity x 100 = x
%
193

194. BENEFITS OF USING RATIO
ANALYSIS
•Can assist in interpreting and evaluating the
income statement and statement of financial
position by reducing the amount of data
contained in them to a workable amount
•Can make financial data more meaningful
•Help to determine relative magnitudes of financial
quantities
194

195. BENEFITS OF USING RATIO
ANALYSIS
•Help managers or business analysts make effective
decisions about the firm's credit worthiness
•Can assist with predicting potential business earnings
•Can assist in seeing financial business strengths
•Can assist in spotting business weaknesses
195

196. LIMITATIONS OF USING RATIO
ANALYSIS
•Comparing the ratios with past trends and with
competitors may be inaccurate as the data may not be
easily comparable due to differences in accounting
policies, accounting period etc.
•It is based on current and past trends, but not future
trends.
•Impact of inflation is not properly reflected, as many
figures are taken at historical numbers, several years
old.
196

197. LIMITATIONS OF USING RATIO
ANALYSIS
•There are differences in approach among financial
analysts on how to treat certain items, how to
interpret ratios etc.
•The ratios are only as good or bad as the
underlying information used to calculate them –
“window dressing” may be used by management
to manipulate the financial results
197

198. MAKING RECOMMENDATIONS
•Ratio analysis may be used to make
recommendations for improvement, but will
also depend on other factors such as:
•Inflation
•External factors e.g. changes in interest rates
•Management changes
•Business Performance
•State of the economy
•Performance of competitors
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