SOURCES OF FUNDS

Objectives

(i) To classification different sources of funds (ii) Evaluation of the advantages and disadvantages of the different funds Introduction Sources from which a firm may obtain its funds to finance its operations can be classified in four different way as this include 1. Classification according to the duration over which the funds will be retained. These sources include (a) long term sources of fundsThey are refundable after a long period of time i.e. after 12 years Short term sources of funds These funds are refundable after a short period of time i.e. a period of 3 years (c) Permanent sources of funds These funds are not refundable as long as the business remains a going concern for example ordinary share capital 1.Classification according to origin These sources include;(a) (b) External sources of funds They are raised from outside the organization Internal sources of funds These are funds that are raised from within the firm 2.Classification according to the relationship between the firm and parties providing the funds These sources include:(a) Common equity capital These are funds provided by the real owners of the business i.e. ordinary share capital; it is the total of the ordinary capital and the reserves
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(b)

Quasi capital these are funds that are provided by the preference shareholders

(c)

Debt finance They are funds provided by the creditors i.e. debentures

3.Classification to the rate of return These sources include:(a) Capital with affixed rate of return This is capital that is paid a certain prespecified rate of return each year i.e. preference capital and long term debts (b) Capital with a variable rate of return (c) This is capital that is paid a different rate o0f return each year depending on the firms performance. A business may obtain funds from various sources which may be either: Long term sources which are repaid after a long period of time. Short term sources which are repaid after a short period even less than a year. Long term sources of funds They include: 1. Equity finance 2. Debentures 3. Preference share capital 4. Long term loans 5. Leases and sale and lease back 6. Sale of fixed assets
Market for Funds and Financial Institutions in Kenya Page 2 of 13

Financial markets refers to an elaborate system of the financial institution and

intermediaries and arrangement put in place and developed to facilitate the transfer of funds from surplus economic units (savers) to deficit economic units (investors). Note Physical or commodity markets deal with real assets such as tea, coffee, wheat, automobile etc. Functions of Financial Markets/Institutions in the Economy 1. Distribution of financial resources to the most productive units. Savings are transferred to economic units that have channels of alternative investments. (Link between buyers and sellers). 2. 3. 4. 5. 6. 7. 8. Allocation of savings to real investment. Achieving real output in the economy by mobilizing capital for investment. Enable companies to make short term and long term investments and increase liquidity of shares. Provision of investment advice to individuals through financial experts. Enables companies to raise short term and long term capital/funds Means of pricing of securities e.g N.S.E. index shares indicate changes in share Provide investment opportunities. Savers can hold financial instrument for investment made. Kenya Financial System Financial markets are broadly classified into 2: 1. 2. Capital Markets Money Markets Savers include individuals, small businesses, family units savings through Investors include government, companies, family units etc. institutions such as SACCOs, banks, insurance firms, pension schemes etc.

prices.

e.g. commercial banks, SACCOS, foreign exchange market, merchant banks etc.

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Capital markets are sub-divided into 2: a) Security markets e.g stock exchange dealing with instruments such as shares, debentures etc. b) Non-security/instrument market e.g mortgage, capital leases, security market is sub-divided into 2. Primary market Secondary market

CAPITAL MARKET These are markets for long term funds with maturity period of more than one year. E.g of Financial instruments used here are debentures, terms, loans, bonds, warrants, preference shares, ordinary shares etc. The capital market serves as a way of allocating the available capital to the most efficient users. Capital market financial institution includes: 1. Stock exchange 2. Development bank 3. Hire purchase companies 4. Building societies 5. Leasing firms Functions of Capital Markets are: a) b) c) d) e) f) Providing long term funds which are necessary for investment decisions. Provide advice to investors as to which investments are viable. Long term investments are made liquid, as the transfer between shareholders is facilitated. Facilitates the international capital inflow. Facilitating the liquidation and marketing of a long term Acting as a channel through which foreign investments find their way into the

market. Money/discount markets Are discount and acceptance financial institutions

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This is a market for S.T funds maturing in one year. Money market works through financial institutions. It facilitates transfer of capital between savers and users. The transfer can be direct (from saver to investor) and indirectly through an intermediary). Foreign exchange market is also part of money market. The money market or discount market is the market for short term loans. 1. Commercial paper 2. Treasury bills 3. Bills of exchange 4. Promissory notes 5. Bank overdrafts 6. Bankers certificate of deposit

Financial Instruments in Money market include:

These instruments are sold by commercial banks, merchant banks, discounting houses, acceptance houses, and government. Primary Markets These are markets that deal with securities that have been issued for the first time. The money flows directly from transferor (saver of money) to transferee (investing person). They facilitate capital formation. Economic Advantage of Primary Markets 1. 2. 3. 4. 5. 1. 2. 3. Raising capital for business. Mobilising savings Government can raise capital through sale of Treasury bonds Open market operation to effect monetary policy of the government i.e control of excess liquidity in the economy It is a vehicle for direct foreign investment. It gives people a chance to buy shares hence distribution of wealth in Enable investors realize their investments through disposal of securities. Increases diversification of investments Page 5 of 13 Economic Advantage/Role of Secondary Markets in the Economy economy.

4.

Improves corporate governance through separation of ownership and management. This increases higher standards of accounting, resource management and transparency.

5. 6. 7.

Privatisation of parastatals e.g. Kenya Airways. This gives individuals a chance for ownership in large companies. Parameter for health economy and companies Provides investment opportunities for companies and small investors.

Types of Stock Markets 1. Organised Exchange and Over the Counter (OTC) market This is where the buying and selling of securities is done by buyers and sellers are not present but only the agents (brokers) internet. This system is called open outcry. 2. Over the Counter Market (OTC) Provides an opportunity for unlisted/unquoted firms to sell their security Otc is usually organized by the dealers or stock brokers who buy securities themselves and then sell them. They maintain a reasonable balance between demand and supply and observe price movements to determine profit margins on sale. Trading may be done through telephones, computer networks, fax etc. The dealers/participants set the treading rulesOTC specialize in securities such as corporate bonds, equity securities, Treasury bonds etc. OTC is underdeveloped in Kenya. Features of OTC Markets 1. Prices are relatively low 2. Usually deal with new securities of firms 3. Is composed of small and closely held firms. FINANCIAL INTERMEDIARIES These are institutions which mediate/link between the savers and investors: Examples of financial intermediaries in Kenya.

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1. Commercial Banks. They act as intermediary between savers and users (investment) of funds. 2. Savings and Credit Associations These are firms that take the funds of many savers and then give the money as a loan in form of mortgage and to other types of borrowers. They provide credit analysis services. 3. Credit Unions These are cooperative associations whose members have a common bond e.g employees of the same company. The savings of the member are loaned only to the members at a very low interest rate e.g. SACCOS charge p.m interest on outstanding balance of loan. 4. Pension Funds These are retirement schemes or plans funded by firms or government agencies for their workers. They are administered mainly by the trust department of commercial banks or life insurance companies. Examples of pension funds are NSSF, NHIF and other registered pension funds of individual firms. 5. Life Insurance Companies These are firms that take savings in form of annual premium from individuals and them invest, these funds in securities such as shares, bonds or in real assets. Savers will receive annuities in future. 6. Brokers These are people who facilitate the exchange of securities by linking the buyer and the seller. They act on behalf of members of public who are buying and selling shares of quoted companies. 7. Investment Bankers These are institutions that buy new issue of securities for resale to other investors. They perform the following functions:

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1. Giving advice to the investors 2. Giving advice to firms which wants to 3. Valuation of firms which need to merge 4. Giving defensive tactics incase of forced takeover 5. Underwriting of securities.

SPECIAL FINANCIAL INSTITUTIONS. The major financial institutions in Kenya economy are commercial banks, savings and loans, credit unions, savings banks, life insurance companies, pension funds, and mutual funds. These institutions attract funds from individuals, businesses, and governments, combine them, and make loans available to individuals and businesses. A brief description of the major financial institutions follows. Institution Commercial bank Description Accepts both demand (checking) and time (saving) deposits. Also offers negotiable order of withdrawal (NOW), and money market deposit accounts. Commercial banks also make loans directly to borrowers or through the financial markets. Saving and loan These are similar to a commercial bank except chat it may not hold demand (checking) deposits. They obtain funds from savings, negotiable order of withdrawal (NOW) accounts, and money market deposit accounts. They lend primarily to individuals and businesses in the form of real estate mortgage loans. Credit union Commonly known as Savings co-operative societies (Saccos), credit unions deal primarily in transfer of funds between members. Membership in credit unions is generally based on some common bond, such as working for a given employer. Credit unions accept members savings deposits,
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NOW account deposits, and money market account deposits and lend funds to members, typically to finance automobile or appliance purchase, or home improvements. Savings banks These are similar to a savings and loan in that it holds savings, NOW, and money market deposit accounts. Savings banks lend or invest funds through financial markets, although some mortgage loans are made to individuals. Life insurance Company It is the largest type of financial intermediary handling individual savings. It receives premium payments and invests them to accumulate funds to cover future benefit payments. It lends funds to individual, businesses, and governments, typically through the financial markets. Pension fund Pension funds are set up so that employees can receive income after retirement. Often employers match the contribution of their employees. The majority of funds is lent or invested via the financial market. Mutual fund Pools funds from the sale of shares and uses them to acquire bonds and stocks of business and governmental units. Mutual funds create a professionally managed portfolio of securities to achieve a specified investment objective, such as liquidity with a high return. Hundreds of funds, with a variety of investment objectives exist. Money market mutual funds provide competitive returns with very high liquidity. Unit trusts Financial Markets Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans and investments of intermediaries are made without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are
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being lent or invested. It is important to understand the following distinctions in the market. Money versus Capital markets. The two key financial markers are the money market and the capital market. Transactions in the money market take place in short-term debt instruments, or marketable securities, such as Treasury bills, commercial paper, and negotiable certificates of deposit. The market brings together government units, households, businesses and financial institutions who have temporary idle funds, and those in need of temporary or seasonal financing. Long-term securitiesbonds and stocksare traded in the capital market. The main actor in the capital markets is the securities exchanges, which provide the market place in which demanders can raise long-term funds and investors can maintain liquidity by being able to sell securities easily. The Nairobi Stock Exchange (NSE) was established in 1954 and is one of the most active stock markets in sub-Saharan Africa. It currently (2005) has 48 companies listed and 20 brokerage company members. Private placements versus Public offerings. To raise money, firms can use either private placements or public offerings. Private placement involves the sale of a new security issue, typically bonds or preferred stock, directly to an investor or group of investors, such as an insurance company or pension fund. However, most firms raise money through a public offering of securities, which is the nonexclusive sale of either bonds or stocks to the general public, Primary market versus Secondary market. All securities, whether in the money or capital market, are initially issued in the primary market (Initial public offerings ( IPOs) and seasoned equity offerings (SEOs)). This is the only market in which the corporate or government issuer is directly involved in the transaction and receives direct benefit from the issue. That is, the company actually receives the proceeds from the sale of securities. Once the securities begin to trade in the stock exchange, between savers and investors, they become part of a secondary market. The primary market is the one which

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new securities are sold; the secondary market can be viewed as used, or pre-owned, securities market. OTHER SPECIALISED FINANCIAL INSTITUTIONS 1 .Industrial and commercial Development Corporation (LC.D.C) I. C.D.C was established in 1954 by the government. Its main objective was to promote industrial & commercial development in Kenya. Its specifically provides financial or technical assistance to small enterprises. Financial assistance may be in the form of working capital financing or purchase of fixed assets. This may take the form of equity or debt financing. Equity is provided by large-scale enterprises with more than 50 employees. Loans are given to both small and medium sized enterprise. Long-term loans repayment period is 6 years for industrial and up to 10 years for commercial loans 2 ) Agricultural finance corporation (AFC) it was established by the government in 1963. The main objective is to provide support for the agricultural sector. This is through provision of short term and long-term loans. The loans must be for a defined project by a farmer. Loans may be short term or long term and there exist flexibility to allow its repayment. 3) Kenya Industrial Estate (KIE) It was established in 1967 At inception it was a wholly owned subsidiary of ICDC. However in 1978 it was separated from ICDC and become an independent body as a parastatal under the ministry of industry. The main objective of K1E is to assist in the development of new projects and the expansion and modernization of new business enterprise. This is through the provision of finds and technical assistance. They provide both debt and equity finance. 4) Kenya Tourist Development Corporations: (KTDC)

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The KTDC was established in 1960s. Its main responsibility was carrying out Investigations, formulation and study of projects development of the tourism industry KTDC Provides financial assistance in forms of loan, for tourism related enterprises. It has substantial share holdings in local hotels, which includes Hilton, Serena, and Pan Africa etc. 5) Industrial Development Bank (IDB) Was established in 1963 as a limited company. The main objective of setting this Institution was to promote industrial development in Kenya through the establishment promotion and expansion of small or large-scale enterprises. This is through financial assistance .n the form of loans, provision of guarantee and securities and underwriting 6) Hire purchase financial companies These are institutions, which provides assets on credit with an arrangement to pay the principal and interest in installment basis. However, the legal ownership of the assets remains with the hire-purchase company. The title is transferred when the last installment is made. Hire Purchase Companys in Kenya include- Kenya finance corporation (KFC), Pan-Afric credit finance Ltd, Investment and mortgage Ltd. etc. 7) Insurance Companies The main role of insurance companies is to assist individuals and corporate bodies safeguard against future risks. May also engage in other activities. The main capital for insurance companies is the premium paid by the policy holders. Forms of Insurance Companys in Kenya includes: - Life Insurance, Third party insurance etc. Examples of Insurance companys in Kenya include: jubilee insurance company, pan African insurance company, Blue shield insurance Co. Ltd. etc. 8) Building societies/Housing finance Co:
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These ale financial institution, which provide finance to the public so as to purchase or construct houses. The individual or corporate bodies make deposit upon which they later receive loan for acquiring or constructing house. Some buildings societies in Kenya include: Housing finance corporation (HFC), East African building society and Pioneer building society. 9) Pension and provident scheme institution These institutions obtain funds from both employees and employers of contribution. They manage and invest these funds so as to meet the current and future obligations of the pension scheme to its members. 10) Merchant Banks It originated and also derives its name from the activities of wealth merchants who provided credit for the trading ventures. The ventures were for smallscale merchants. Before the establishment of banking systems in the 19th century, the merchants changed their role of merchants and started offering financial service. Today merchant banks performs the role of underwriting and assisting companies to raise capital in the financial markets They underwrite the security issues, buy and sell securities and provide advice in Investment in securities.

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