Financial Accounting DEFINITION OF FINANCIAL MANAGEMENT

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Financial Management is a discipline concerned with the generation and allocation of scarce resources (usually funds) to the most efficient user within the firm (the competing projects) through a market pricing system (the required rate of return). A firm requires resources in form of funds raised from in estors. !he funds must "e allocated within the organi#ation to projects which will yield the highest return. $e shall refer to this definition as we go through the su"ject. 1. 2 Required Rate of Return (Ri)

!he required rate of return (Ri) is the minimum rate of return that a project must generate if it has to recei e funds. %t&s therefore the opportunity cost of capital or returns e'pected from the second "est alternati e. %n general( )equired )ate of )eturn * )isk+free rate , )isk premium )isk free rate is compensation for time and is made up of the real rate of return ()r) and the inflation premium (%)p). !he risk premium is compensation for risk of financial actions reflecting!he riskiness of the securities caused "y term to maturity !he security marketa"ility or liquidity !he effect of e'change rate fluctuations on the security( etc. !he required rate of return can therefore "e e'pressed as followsRj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp. $here )r is the real rate of return that compensate in estors for gi ing up the use of their funds in an inflation free and risk free market. %)p is the %nflation )isk .remium which compensates the in estor for the decrease in purchasing power of money caused "y inflation.

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Financial Accounting 2.

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/)p is the /efault )isk .remium which compensates the in estor for the possi"ility that users of funds would "e una"le to repay the de"ts. M)p is the Maturity )isk .remium which compensates for the term to maturity. 0)p is the 0iquidity )isk .remium which compensates the in estor for the possi"ility that the securities gi en are not easily marketa"le (or con erti"le to cash). 1)p is the 1'change )isk .remium which compensates the in estors for the fluctuation in e'change rate. !his is mainly important if the funds are denominated in foreign currencies. 2)p is the 2o ereign )isk .remium which compensates the in estors for the possi"ility of political insta"ility in the country in which the funds ha e "een pro ided. 3)p is the 3ther )isk .remium e.g. the type of product( the type of market( etc. SCO E OF FINANCE F!NCTIONS

!he functions of Financial Manager can "roadly "e di ided into two- !he )outine functions and the Managerial Functions. 2.1 Mana"eria# Finan$e Fun$tion%

)equire skilful planning( control and e'ecution of financial acti ities. !here are four important managerial finance functions. !hese are(a) In&e%t'ent of Lon"(ter' a%%et('i) de$i%ion%

!hese decisions (also referred to as capital "udgeting decisions) relates to the allocation of funds among in estment projects. !hey refer to the firm4s decision to commit current funds to the purchase of fi'ed assets in e'pectation of future cash inflows from these projects. %n estment proposals are e aluated in terms of "oth risk and e'pected return. %n estment decisions also relates to recommitting funds when an old asset "ecomes less producti e. !his is referred to as replacement decision. (") Finan$in" de$i%ion%

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Financial Accounting

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Financing decision refers to the decision on the sources of funds to finance in estment projects. !he finance manager must decide the proportion of equity and de"t. !he mi' of de"t and equity affects the firm4s cost of financing as well as the financial risk. !his will further "e discussed under the risk return trade+off. (c) Di&i%ion of earnin"% de$i%ion

!he finance manager must decide whether the firm should distri"ute all profits to the shareholder( retain them( or distri"ute a portion and retain a portion. !he earnings must also "e distri"uted to other pro iders of funds such as preference shareholder( and de"t pro iders of funds such as preference shareholders and de"t pro iders. !he firm4s di ided policy may influence the determination of the alue of the firm and therefore the finance manager must decide the optimum di idend + payout ratio so as to ma'imi#e the alue of the firm. (d) Liquidit* de$i%ion

!he firm4s liquidity refers to its a"ility to meet its current o"ligations as and when they fall due. %t can also "e referred as current assets management. %n estment in current assets affects the firm4s liquidity( profita"ility and risk. !he more current assets a firm has( the more liquid it is. !his implies that the firm has a lower risk of "ecoming insol ent "ut since current assets are non+ earning assets the profita"ility of the firm will "e low. !he con erse will hold true. !he finance manager should de elop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are in ested in current assets. 2.2 Routine fun$tion%

For the effecti e e'ecution of the managerial finance functions( routine functions ha e to "e performed. !hese decisions concern procedures and systems and in ol e a lot of paper work and time. %n most cases these decisions are delegated to junior staff in the organi#ation. 2ome of the important routine functions are(a) (") (c) (d) 2uper ision of cash receipts and payments 2afeguarding of cash "alance 6ustody and safeguarding of important documents )ecord keeping and reporting 7 .er"#

Financial Accounting

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!he finance manager will "e in ol ed with the managerial functions while the routine functions will "e carried out "y junior staff in the firm. He must howe er( super ise the acti ities of these junior staff. +. O,-ECTI.ES OF A ,!SINESS ENTIT/

Any "usiness firm would ha e certain o"jecti es which it aims at achie ing. !he major goals of a firm are (a) .rofit ma'imi#ation 2hareholders4 wealth ma'imi#ation 2ocial responsi"ility 8usiness 1thics 9rowth rofit 'a)i'i0ation

!raditionally( this was considered to "e the major goal of the firm. .rofit ma'imi#ation refers to achie ing the highest possi"le profits during the year. !his could "e achie ed "y either increasing sales re enue or "y reducing e'penses. :ote that.rofit * )e enue ; 1'penses

!he sales re enue can "e increased "y either increasing the sales olume or the selling price. %t should "e noted howe er( that ma'imi#ing sales re enue may at the same time result to increasing the firm4s e'penses. !he pricing mechanism will howe er( help the firm to determine which goods and ser ices to pro ide so as to ma'imi#e profits of the firm. !he profit ma'imi#ation goal has "een critici#ed "ecause of the following(a) .er"# %t ignores time alue of money <

Financial Accounting (") (c) (d) (") %t ignores risk and uncertainties it is ague it ignores other participants in the firm rather than the shareholders S1are1o#der%2 3ea#t1 'a)i'i0ation

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2hareholders4 wealth ma'imi#ation refers to ma'imi#ation of the net present alue of e ery decision made in the firm. :et present alue is equal to the difference "etween the present alue of "enefits recei ed from a decision and the present alue of the cost of the decision. (:ote this will "e discussed further in 0esson 5). A financial action with a positi e net present alue will ma'imi#e the wealth of the shareholders( while a decision with a negati e net present alue will reduce the wealth of the shareholders. =nder this goal( a firm will only take those decisions that result in a positi e net present alue. 2hareholder wealth ma'imi#ation helps to sol e the pro"lems with profit ma'imi#ation. !his is "ecause( the goali. ii. considers time alue of money "y discounting the e'pected future cashflows to the present. it recognises risk "y using a discount rate (which is a measure of risk) to discount the cashflows to the present. (c) So$ia# re%4on%i5i#it*

!he firm must decide whether to operate strictly in their shareholders4 "est interests or "e responsi"le to their employers( their customers( and the community in which they operate. !he firm may "e in ol ed in acti ities which do not directly "enefit the shareholders( "ut which will impro e the "usiness en ironment. !his has a long term ad antage to the firm and therefore in the long term the shareholders wealth may "e ma'imi#ed. (d) ,u%ine%% Et1i$% > .er"#

Financial Accounting

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)elated to the issue of social responsi"ility is the question of "usiness ethics. 1thics are defined as the ?standards of conduct or moral "eha iour?. %t can "e thought of as the company4s attitude toward its stakeholders( that is( its employees( customers( suppliers( community in general( creditors( and shareholders. High standards of ethical "eha iour demand that a firm treat each of these constituents in a fair and honest manner. A firm4s commitment to "usiness ethics can "e measured "y the tendency of the firm and its employees to adhere to laws and regulations relating toi. ii. iii. i . . i. .roduct safety and quality Fair employment practices Fair marketing and selling practices !he use of confidential information for personal gain %llegal political in ol ement "ri"ery or illegal payments to o"tain "usiness

(e) Gro3t1 !his is a major o"jecti e of small companies which may e en in est in projects with negati e :.@ so as to increase their si#e and enjoy economies of scale in the future.

6. 7 AGENC/ T8EOR/ An agency relationship may "e defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some ser ices on their "ehalf( and delegate some decision making authority to that agent. $ithin the financial management framework( agency relationship e'ist "etween(a) (") 6.1 2hareholders and Managers /e"t holders and 2hareholders S1are1o#der% &er%u% Mana"er%

A 0imited 0ia"ility company is owned "y the shareholders "ut in most cases is managed "y a "oard of directors appointed "y the shareholders. !his is "ecauseA .er"#

Financial Accounting i) time. ii) 2hareholders may lack the skills required to manage the firm. iii) 2hareholders may lack the required time.

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!here are ery many shareholders who cannot effecti ely manage the firm all at the same

6onflict of interest usually occur "etween managers and shareholders in the following waysi) ii) iii) i ) ) i) Managers may not work hard to ma'imi#e shareholders wealth if they percei e that they will not share in the "enefit of their la"our. Managers may award themsel es huge salaries and other "enefits more than what a shareholder would consider reasona"le Managers may ma'imi#e leisure time at the e'pense of working hard. Manager may undertake projects with different risks than what shareholders would consider reasona"le. Manager may undertake projects that impro e their image at the e'pense of profita"ility. $here management "uy out is threatened. BManagement "uy out& occurs where management of companies "uy the shares not owned "y them and therefore make the company a pri ate one.

So#ution% to t1i% Conf#i$t %n general( to ensure that managers act to the "est interest of shareholders( the firm will(a) %ncur Agency 6osts in the form ofi) ii) iii) Monitoring e'penses such as audit feeC 1'penditures to structure the organi#ation so that the possi"ility of undesira"le management "eha iour would "e limited. (!his is the cost of internal control) 3pportunity cost associated with loss of profita"le opportunities resulting from structure not permit manager to take action on a timely "asis as would "e the case if manager were also owners. !his is the cost of delaying decision.

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Financial Accounting (") includesi) ii) iii) (c) An offer of shares so that managers "ecome owners. 2hare options- (3ption to "uy shares at a fi'ed price at a future date). .rofit+"ased salaries e.g. "onus

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!he 2hareholder may offer the management profit+"ased remuneration. !his remuneration

!hreat of firing- 2hareholders ha e the power to appoint and dismiss managers which is e'ercised at e ery Annual 9eneral Meeting (A9M). !he threat of firing therefore moti ates managers to make good decisions.

(d)

!hreat of Acquisition or !akeo er- %f managers do not make good decisions then the alue of the company would decrease making it easier to "e acquired especially if the predator (acquiring) company "eliefs that the firm can "e turned round.

6.2

De5t 1o#der% &er%u% S1are1o#der%

A second agency pro"lem arises "ecause of potential conflict "etween stockholders and creditors. 6reditors lend funds to the firm at rates that are "ased oni. ii. iii. i . )iskiness of the firm4s e'isting assets 1'pectations concerning the riskiness of future assets additions !he firm4s e'isting capital structure 1'pectations concerning future capital structure changes.

!hese are the factors that determine the riskiness of the firm4s cashflows and hence the safety of its de"t issue. 2hareholders (acting through management) may make decisions which will cause the firm4s risk to change. !his will affect the alue of de"t. !he firm may increase the le el of de"t to "oost profits. !his will reduce the alue of old de"t "ecause it increases the risk of the firm. 6reditors will protect themsel es against the a"o e pro"lems througha. %nsisting on restricti e co enants to "e incorporated in the de"t contract. !hese co enants may restrict .er"# !he company&s asset "ase !he company&s a"ility to acquire additional de"ts E

Financial Accounting !he company&s a"ility to pay future di idend and management remuneration. !he management a"ility to make future decision (control related co enants)

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". %f creditors percei e that shareholders are trying to take ad antage of them in unethical ways( they will either refuse to deal further with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such possi"le e'ploitations. %t therefore follows that shareholders wealth ma'imi#ation require fair play with creditors. !his is "ecause shareholders wealth depends on continued access to capital markets which depends on fair play "y shareholders as far as creditor4s interests are concerned. 9.7 COR ORATE GO.ERNANCE 9.1 Definition of $or4orate "o&ernan$e 6orporate go ernance can "e defined in arious ways( for e'ample!he .ri ate 2ector 6orporate 9o ernance !rust (.269!) states that corporate go ernance( F)efers to the manner in which the power of the corporation is e'ercised in the stewardship of the corporation total portfolio of assets and resources with the o"jecti e of maintaining and increasing shareholders alue through the conte't of its corporate isionG (.269!( 1HHH) !he 6ad"ury )eport (1HH5) defines corporate go ernance as the system "y which companies are directed and controlled. !he 6apital Market Authority (6MA) in year 5III defined corporate go ernance as the process and structures used to direct and manage "usiness affairs of the company towards enhancing prosperity and corporate accounting with the ultimate o"jecti e of reali#ing shareholders long+ term alue while taking into account the interests of other stakeholders. 9.2 Rationa#e for $or4orate "o&ernan$e !he organi#ation of the world economy (especially in current years) has seen corporate go ernance gain prominence mainly "ecause-

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Financial Accounting

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%nstitutional in estors( as they seek to in est funds in the glo"al economy( insist on high standard of 6orporate 9o ernance in the companies they in est in. .u"lic attention attracted "y corporate scandals and collapses has forced stakeholders to carefully consider corporate go ernance issues.

6orporate go ernance is therefore important as it is concerned with 9.+ .rofita"ility and efficiency of the firm. 0ong+term competiti eness of firms in the glo"al economy. !he relationship among firm&s stakeholders rin$i4#e% of $or4orate "o&ernan$e

!here are 55 principles of 6orporate 9o ernance as gi en "y the 6ommon $ealth Association of 6orporate 9o ernance (6A69) in1HHH and the .ri ate 2ector 6orporate 9o ernance !rust (.269!) in 1HHH also. !he first ten principles are summari#ed "elow. 1. T1e aut1orit* and dutie% of 'e'5er% (%1are1o#der%) Mem"ers and shareholders shall jointly and se erally protect( preser e and acti ely e'ercise the supreme authority of the corporation in general meeting (A9M). !hey ha e a duty to e'ercise that supreme authority to1nsure that only competent and relia"le persons who can add alue are elected or appointed to the "oard of directors (83/). 1nsure that the 83/ is constantly held accounta"le and responsi"le for the efficient and effecti e go ernance of the corporation so as to achie e corporate o"jecti e( prospering and sustaina"ility. 6hange the composition of the 83/ that does not perform to e'pectation or in accordance with mandate of the corporation 2. Leader%1i4

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Financial Accounting

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1 ery corporation should "e headed "y an effecti e 83/( which should e'ercise leadership( enterprise( integrity and judgments in directing the corporation so as to achie e continuing prosperity and to act in the "est interest of the enterprise in a manner "ased on transparency( accounta"ility and responsi"ility. +. A44oint'ent% to t1e ,OD %t should "e through a well managed and effecti e process to ensure that a "alanced mi' of proficient indi iduals is made and that each director appointed is a"le to add alue and "ring independent judgment on the decision making process. 6. Strate"* and .a#ue% !he 83/ should determine the purpose and alues of the corporation( determine strategy to achie e that purpose and implement its alues in order to ensure that the corporation sur i es and thri es and that procedures and alues that protect the assets and reputation of the corporation are put in place. 9. Stru$ture and or"ani0ation !he 83/ should ensure that a proper management structure is in place and make sure that the structure functions to maintain corporate integrity( reputation and responsi"ility. :. Cor4orate erfor'an$e; .ia5i#it* < Finan$ia# Su%taina5i#it* !he 83/ should monitor and e aluate the implementation of strategies( policies and management performance criteria and the plans of the organi#ation. %n addition( the 83/ should constantly re ise the ia"ility and financial sustaina"ility of the enterprise and must do so at least once in a year. =. Cor4orate $o'4#ian$e !he 83/ should ensure that corporation complies with all rele ant laws( regulations( go ernance practices( accounting and auditing standards. >. Cor4orate Co''uni$ation !he 83/ should ensure that corporation communicates with all its stakeholders effecti ely.

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Financial Accounting ?. A$$ounta5i#it* to Me'5er% !he 83/ should ser e legitimately all mem"ers and account to them fully. 17. Re%4on%i5i#it* to %ta@e1o#der%

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!he 83/ should identify the firm&s internal and e'ternal stakeholders and agree on a policy (ies) determining how the firm should relate to and with them( increasing wealth( jo"s and sustaina"ility of a financially sound corporation while ensuring that the rights of the stakeholders are respected( recogni#ed and protected. :.7 EFFICIENT MARAET 8/ OT8ESIS (EM8) :.1 T*4e% of Effi$ien$* 1fficient market hypothesis can "e e'plained in 7 waysa) A##o$ati&e Effi$ien$* A market is allocati ely efficient if it directs sa ings towards the most efficient producti e enterprise or project. %n this situation( the most efficient enterprises will find it easier to raise funds and economic prosperity for the whole economy should result. Allocati e efficiency will "e at its optimal le el if there is no alternati e allocation of funds channeled from sa ings that would result in higher economic prosperity. !o "e allocati ely efficient( the market should ha e fewer financial intermediaries such that funds are allocated directly from sa ers to users( therefore financial disintermediation should "e encouraged. 5) O4erationa# Effi$ien$* !his concept relates to the cost( to the "orrower and lender( of doing "usiness in a particular market. !he greater the transaction cost( the greater the cost of using financial market and therefore the lower the operational efficiency. !ransaction cost is kept as low as possi"le where there is open competition "etween "roker and other market participants. For a market to "e operationally efficient( therefore( we need to ha e enough market markers who are a"le to play continuously. 15 .er"#

Financial Accounting $) Infor'ation Effi$ien$*

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!his reflects the e'tent to which the information regarding the future prospect of a security is reflected in its current price. %f all known (pu"lic information) is reflected in the security price( then in esting in securities "ecomes a fair game. All in estors ha e the same chances mainly "ecause all the information that can "e known is already reflected in share prices. %nformation efficiency is important in financial management "ecause it means that the effect of management decision will quickly and accurately "e reflected in security prices. 1fficient market hypothesis relates to information processing efficiency. %t argues that stock markets are efficient such that information is reflected in share prices accurately and rapidly. :.2 For'% of Effi$ien$* %nformational efficiency is usually "roken down into 7 different le els (forms)a. $eak form le el of efficiency

!his le el states that share prices fully reflect information in historic share price mo ement and patterns (past informationJhistoric information). %f this hypothesis is correct( then( it should "e possi"le to predict future share price mo ement from historical patterns. 1.g. %f the company&s shares ha e increased steadily o er the past few months to the current price of 2hs.7I( then this price will already fully reflect the information a"out the company&s growth and therefore the ne't change in share prices could either "e upward( downward or constant with equal pro"a"ility. %t therefore follows that technical analysis or 6hartism will not ena"le in estors to make ar"itrage profits. %n markets that ha e achie ed this le el then security prices follow a trendles random walk. 2tudies to test this le el ha e "een "ased on the principle that !he share price changes are random !hat there is no connection "etween share price mo ement and new share price changes. %t is possi"le to pro e statistically that there is no correlation "etween successi e changes in price of shares and therefore trend in share price changes cannot "e detected. !his can "e done "y using serial correlation (or auto+correlation) test such as /ur"in $atson 2tatistics. 17 .er"#

Financial Accounting

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2emi+2trong form le el of 1fficiency

!his le el states that share prices reflects all a aila"le pu"lic information. (past and present information). %f the market has achie ed this le el( then fundamental analysis will not ena"le in estors to earn consistently higher than a erage returns. Fundamental analysis in ol es the study of company&s accounts to determine its theoretical alue and there"y find any under alued share. Fundamental theory states that e ery share in the market has an intrinsic alue( which is equal to the present alue of cash flows e'pected from the security. !ests to pro e semi+strong form of efficiency ha e concentrated on the a"ility of the market to anticipate share price changes "efore new information is formally announced. !hese tests are referred to as 1 ent 2tudies. 1.g. if two companies plans to merge( share prices of the 5 companies will change once the merger plans are made pu"lic. !he market would show semi+ strong form of efficiency if it were a"le to anticipate such changes so that share prices of the company would change in ad ance of the merger plans "eing confirmed. 3ther e ents that can affect share prices area) 2tock splits ") /eath of 613 of company c) %n estment in major profita"le projects d) 6hanges in di idend policy( etc c) 2trong form le el of 1fficiency !his le el states that price reflects all the a aila"le pu"lic and pri ate information (past( present and future information). %f the hypothesis is correct( then( the mere pu"lication of information that was pre iously confidential should not ha e impact on share prices. !his implies that insider trading is impossi"le. %t follows therefore( that in order to ma'imi#e shareholders& wealth( managers should concentrate on ma'imi#ing the :.@ of each in estment. !ests that ha e "een carried out on this le el ha e concentrated on acti ities of fund managers and indi idual in estors. %f the markets ha e reached the strong form le els( then fund managers cannot consistently perform "etter than indi idual in estors in the market. 1< .er"#

Financial Accounting :.+ IM LICATIONS OF EM8 FOR FINANCIAL DECISION MAAERS

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a) T1e Ti'in" Of Finan$ia# o#i$* 2ome financial managers argue that there is a right or wrong time to issue securities i.e. new shares should only "e issued when the market is at the top rather than the "ottom. %f the market is efficient( howe er( price follows a trendless random walk and its impossi"le for managers to know whether today&s price is the highest or the lowest. !iming other policies e.g release of financial statements( announcement of stock splits( etc has no effect on share prices. 5) roBe$t E&a#uation ,a%ed !4on N . $hen e aluating new projects( financial managers use the required rate of return drawn from securities traded in the capital market. For e'ample( the rate of return required on a particular project may "e determined "y o"ser ing the rate of return required "y shareholders of firms in esting in projects of similar risk. !his assumes that securities are fairly priced for the risks that they carry (i.e. the market is efficient). %f the market is inefficient( howe er( financial managers could "e appraising projects on a wrong "asis and therefore making "ad in estment decisions since their estimate on :.@ is unrelia"le. $) Creati&e A$$ountin" %n an efficient market( prices are "ased upon e'pected future cash flow and therefore they reflect all current information. !here is no point therefore in firms attempting to distort current information to their ad antage since in estors will quickly see through such attempts. 2tudies ha e "een done for e'ample to show that changes from straight+line depreciation to reducing "alance method( although it may result to increasing profit( may ha e no long+term effect on share prices. !his is "ecause the company&s cash flows remain the same. 3ther studies support the conclusion that in estors cannot "e fooled "y manipulation of accounting profit figure or charges in capital structure of company. 1 entually( the in estors will know the cash flow consequences and alter the share prices consequently. d) Mer"er% and Ta@eo&er% 1> .er"#

Financial Accounting

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%f shares are correctly priced then the purchase of a share is a #ero :.@ transaction. %f this is true then( the rationale "ehind mergers and takeo ers may "e questioned. %f companies are acquired at their correct equity position then purchasers are "reaking e en. %f they ha e to make significant gains on the acquisition( then they ha e to rely on synergy in economies of scale to pro ide the sa ing. %f the acquirer (or the predator) pays the current equity alue plus a premium( then this may "e a negati e :.@ decision unless the market is not fully efficient and therefore prices are not fair. e) .a#idit* of t1e $urrent 'ar@et 4ri$e %f markets are efficient then they reflect all known information in e'isting share prices and in estors therefore know that if they purchase a security at the current market price they are recei ing a fair return and risk com"ination. !his means that under or o er alued shares or market securities do not e'ist. 6ompanies shouldn&t offer su"stantial discounts on security issues "ecause in estors would not need e'tra incenti es to purchase the securities. SO!RCES OF F!NDS

1.

EC!IT/ FINANCE

For small companies( this is personal sa ings (contri"ution of owners to the company). For large companies equity finance is made of ordinary share capital and reser esC ("oth re enue and capital reser es). 1quity finance is di ided into the following classesa) Ordinar* %1are $a4ita# ; this is raised from the pu"lic from the sale of ordinary shares to the shareholders. !his finance is a aila"le to limited companies. %t is a permanent finance as the ownerJshareholder cannot recall this money e'cept under liquidation. %t is thus a "ase on which other finances are raised. 3rdinary share capital carries a return that is aria"le (ordinary di idends). !hese shares carry oting rights and can influence the company&s decision making process at the A9M.

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Financial Accounting "ecause ofa) ") c) =ncertainty of return 6annot ensure refund Ha e residual claims ; claim last on profits( claim last on assets.

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!hese shares carry the highest risk in the company (high securities ; documentary claim to)

Howe er this in estment grows through retention. Ri"1t% of ordinar* %1are1o#der% 1. )ight to ote elect 83/ a. 2alesJpurchase of assets 5. %nfluence decisionsa) ") c) d) e) )ight to residual assets claim )ight to amend company&s "y+laws )ight to appoint another auditor )ight to appro e merger acquisition )ight to appro e payment of di idends

Rea%on% 31* ordinar* %1are $a4ita# i% attra$ti&e de%4ite 5ein" ri%@* 2hares are used as securities for loans (a compromise of the market price of a share). %ts alue grows. !hey are transfera"le at capital gain. !hey influence the company&s decisions. 6arry aria"le returns ; is good under high profit .erpetual in estment ; thus a perpetual return 2uch shares are used as guarantees for credi"ility.

Ad&anta"e% of u%in" ordinar* %1are $a4ita# in finan$in". 1D .er"#

Financial Accounting

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!hey facilitate projects especially long+term projects "ecause they are permanent.. %ts cost is not a legal o"ligation. %t lowers gearing le el ; reduces chances of recei ershipJliquidation. =sed with fle'i"ility ; without preconditions. 2uch finances "oost the company&s credi"ility and credit rating. 3wners contri"ute alua"le ideas to the company&s operations (during A9M "y professionals).

5) RETAINED EARNINGS i) Re&enue Re%er&e% !hese are undistri"uted earnings. 2uch reser es are retained for the following reasons ii) !o make up for the fall in profits so as to sustain accepta"le risks. . !o sustain growth through plough "acks. !hey are cheap source of finance. . !hey are used to "oost the company&s credit rating so they ena"le further finance to "e o"tained. . %t lowers the company&s gearing ratio ; reduces chances of recei ershipJliquidation. Ca4ita# Re%er&e% 1. %t is raised "y selling shares at a premium. (!he difference "etween the market price (less floatation costs) and par alue is credited to the capital reser e). 5. !hrough re aluation of the company&s assets. !his leads to a fictitious entry which is of the nature of a capital reser e. 7. 8y creation of a sinking fund. $) REFERENCE S8ARE CA ITAL (Cua%i(Equit*) %t is also called quasi+equity "ecause it com"ines features of equity and those of de"t. %t is preference "ecause it is preferred to ordinary share capital that is1E .er"#

Financial Accounting i) %t is paid di idends first ; preferred to di idend ii) %t is paid asset proceeds first ; preferred to assets.

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=nlike ordinary share capital( it has a fi'ed return. %t carries no oting rights. %t is an unsecured finance and it increases the company&s gearing ratio. CLASSIFICATION i) Redee'a5#e C#a%% )edeema"le preferential shares are "ought "ack "y issuing company after minimum redemption period "ut "efore e'piring of ma'imum redemption period after which they "ecome creditors. (6an sue the company). ii) Irredee'a5#e referen$e S1are% Are perpetual preference shares as they will not "e redeemed in the company&s lifetime unless it is under liquidation( (it is permanent).

E)a'4#e 6ompany KLM 0imited has the following capital structure2hs. 1I(III 2h.1I ordinary shares 1I(III 2h.5I preference shares !otal share capital 1II(III 5II(III 7II(III

%f the company&s assets proceeds were 2h.<II(III show how this would "e shared underi) .aripasu ii) N 1H .er"#

Financial Accounting 2hare participation taking into account the par alue. So#ution i)%f the preference shareholders are participati e2h. Asset proceeds 0ess preference claims 0ess ordinary shareholders claim )esidue !otal share capital * .articipati e claim of ordinary shareholders is gi en "y5II(III x1II(III = AA(AAD 7II(III

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<II(III (5II(III) 5II(III (1II(III) 1II(III 7II(III

ii) 2haring under

1 ratio 5

2hs. Asset proceeds 0ess preference claim 0ess ordinary share capital .articipati e claim .reference share capital claim * 7II(III x 5 = 7 *
1 x1II(III * 2hs.77(III 7
5II(III 1 1

<II(III (5II(III) 5II(III (1II(III) 1II(III

5I .er"#

Financial Accounting 3rdinary share capital claim *

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1 x1II(III * 1A(AADO A

iii) Non( arti$i4ati&e referen$e S1are% !hese do not claim any money o er and a"o e their par alue( "ut are usually cumulati e and redeema"le. .) Cu'u#ati&e referen$e S1are% !hese can claim arrears e.g. if a company sold 1IO 2hs.5I preference shares and did not pay di idends for the ne't two years( then in the third year shareholders will claim1IO ' 5I ' 7yrs * 2hs A less withholding ta'-

* 2hs A less >O of 2hs I.7I * 2hs >.DI net &i) Non(Cu'u#ati&e referen$e S1are% !hese cannot claim interest in arrears. &ii) Con&erti5#e !hese can "e con erted into ordinary shares (which is optional). 6on ersion ratio * par alue of ordinary shareJpar alue of preference shares e.g if par alue of ordinary shares is 2h.1I and that of preference shares is 2h.5I( then con ersion ratio * i.e for e ery preference share you get 5 ordinary shares.
1I 1 = 5I 5

51 .er"#

Financial Accounting 6on ersion price par alue of preference sharesJno. of ordinary shares to "e acquired.
5I = Shs1I 5

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E)a'4#e 6ompany KLM 0td has sold 1I(III ordinary shares of 2hs.7I (partly called up) plus 5I(III 2hs.<> preference shares( which are con erti"le. 6ompute the total num"er of ordinary shares after con ersion. So#ution 6on ersion ratio * 7IJ<> * 5J7 for e ery 5 preference shares you get 7 ordinary shares.
5I(III 7 x * 7I(III ordinary shares. 1 1

6on ersion price *

<> = Shs.7I 7J 5

!otal * <I(III ordinary shares after con ersion. &iii) Non(Con&erti5#e referen$e S1are%. !hese cannot "e con erted into ordinary shares.

2. DE,T FINANCE /e"t finance is a fi'ed return finance as the cost (interest) is fi'ed on the par alue (face alue of de"t). %t is ideal to use if there&s a strong equity "ase. %t is raised from e'ternal sources to qualifying companies and is a aila"le in limited quantities. %t is limited toi) ii) @alue of security. 0iquidity situation in a gi en country. %t is ideal for companies where gearing allows them to raise more de"t and thus gearing le el. 55 .er"#

Financial Accounting C#a%%ifi$ation of De5t Finan$e

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Loan finan$e ; this is a common type of de"t and is a aila"le in different terms usually short term. Medium term loans ary from 5 + > years. 0ong+term loans ary from A years and a"o e !he terms are relati e and depend on the "orrower. !his finance is used on the "asis of Matching approach i.e. matching the economic life of the project to the term of the loan. %t is prudent to use short+term loans for short+term entures i.e. if a enture is to last < years generating returns( it is prudent to raise a loan of < years maturity period.

Condition% under D1i$1 Loan% Are Idea# a) $hen the company&s gearing le el is low (the le el of outstanding loans is low. ") !he company&s future cash flows (inflows and their sta"ility) must "e assured. !he company must "e a"le to repay the principal and the interest. c) 1conomic conditions pre ailing. !he company must ha e a long+term forecast of the pre ailing economic condition. 8oom conditions are ideal for de"t. d) $hen the company&s market share guarantees sta"le sales. e) $hen the company&s anticipated future e'pansion programs( justify such "orrowing. Require'ent% for Rai%in" Loan a) History of the company and its su"sidiaries. ") :ames( ages( and qualifications of the company&s directors. c) !he names of major shareholders ; >1O plus i.e. owner who must gi e consent. d) :ature of the products and product lines. e) .u"licity of the product. f) :ature of the loan ; either secured( floating or unsecured. g) 6ash flow forecast. Rea%on% D1* Co''er$ia# ,an@% refer To Lend S1ort Ter' Loan% a) 0ong+term forecasts are not only difficult "ut also jeopardise planning e.g. political and economic factors. 57 .er"# ague as uncertainties tend to

Financial Accounting due to liquidity considerations.

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") 6ommercial "anks are limited "y the 6entral 8ank of Penya in their long term lending c) 2hort+term loans are profita"le. !his is "ecause interest is high as in o erdrafts. d) 0ong term finance loses alue with time due to inflation. e) 6ost of finance ; in the long term( the cost of finance may increase and yet they cannot pass such a cost to "orrowers since the interest rate is fi'ed. f) 6ommercial "anks do credit analysis that is limited to short term situations. g) =sually security market fa ours short term loans "ecause there are ery few long term securities and as such commercial "anks prefer to lend short term due to security pro"lems.

Ad&anta"e% of !%in" De5t Finan$e %nterest on de"t is a ta' allowa"le e'pense and as such it is reduced "y the ta' allowance.

E)a'4#e %nterest * 1IO ta' rate * 7IO !he effecti e cost of de"t (interest) * %nterest rate(1 ; !) * 1IO(1+I.7I) * DO 6onsider companies A and 8 6ompany 1IO de"t 1quity A 2h.&III& 1(III + 1(III + 1(III 1(III 8 2h.&III&

!he ta' rate is 7IO and earnings "efore interest and ta' amount to Psh.<II(III. All earnings are paid out as di idends. 6ompute paya"le "y each firm. 5< .er"#

Financial Accounting Co'4an* 18%! 0ess interest 1IO ' 1(III 18! 0ess ta' Q 7IO /i idends paya"le 51I A 2h.&III& <II (1II) 7II (HI) 5EI <II + <II (15I) , 2h.&III&

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6ompany A sa es ta' equal to 2h.7I(III(15I(III ; HI(III) since interest charges are ta' allowa"le and reduce ta'a"le income. !he cost of de"t is fi'ed regardless of profits made and as such under conditions of high profits the cost of de"t will "e lower. %t does not call for a lot of formalities to raise and as such its ideal for urgent entures %t is usually self+sustaining in that the asset acquired is used to pay for its cost i.e. lea ing the company with the alue of the asset. %n case of long+term de"t( amount of loan declines with time and repayments reduce its "urden to the "orrower. /e"t finance does not influence the company&s decision since lenders don&t participate at the A9M.

Di%ad&anta"e% %t is a conditional finance i.e. it is not in ested without the appro al of lender. /e"t finance( if used in e'cess may interrupt the companies decision making process when gearing le el is high( creditors will demand a say in the company i.e. and demand representation in the 83/. 5> .er"#

Financial Accounting recei ership through lack of funds to ser ice the loan.

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%t is dangerous to use in a recession as such a condition may force the company into %t calls for securities which are highly negotia"le or marketa"le thus limiting its a aila"ility. %t is only a aila"le for specific entures and for a short term( which reduces its in estment in strategic entures. !he use of de"t finance may lower the alue of a share if used e'cessi ely. %t increases financial risk and required rate of return "y shareholders thus reduce the alue of shares.

Differen$e% 5et3een De5t Finan$e and Ordinar* S1are Ca4ita# (Equit* Finan$e)

a) ") c) d) e) f) g) h) i)

Ordinar* %1are $a4ita# %t is a permanent finance )eturn paid when a aila"le /i idends are not ta' allowa"le =nsecured finance 6arry oting rights )educes gearing ratio :o legal o"ligation to pay Has a residue claim 3wners& money

a) ") c) d) e) f) g) h) i)

De5t %t is refunda"le (redeema"le) %t is fi'ed return capital %nterest on de"t is a ta' allowa"le e'pense 2ecured finance :o oting right %ncreases gearing ratio A legal o"ligation to pay 6arries a superior claim 6reditors finance.

Si'i#aritie% 5et3een referen$e and Equit* Finan$e

a) ") c) d) e) f)

8oth may "e permanent if preference share capital is irredeema"le (con erti"le). 8oth are naked or unsecured finances. 8oth are traded at the stock e'change 8oth are raised "y pu"lic limited companies only 8oth carry residue claims after de"t. 8oth di idends are not a legal o"ligations for the company to pay.

5A .er"#

Financial Accounting

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5D .er"#

Financial Accounting Differen$e% 5et3een referen$e and Equit* Finan$e a) ") c) d) e) f) Ordinar* %1are $a4ita# Has a residue claim "oth on assets and profit 6arries oting rights )educes the gearing ratio @aria"le di idends hence grow o er time .ermanent finance 1asily transfera"le. Si'i#aritie% 5et3een De5t and referen$e S1are Ca4ita# a) ") c) d) e) f) g) h) 8oth ha e fi'ed returns. 8oth will increase the company&s gearing ratio. 8oth are usually redeema"le. 8oth do not ha e oting rights. 8oth may force the company into recei ership 8oth ha e superior claims o er and a"o e owners. 8oth are e'ternal finances. !here is no growth with time. a) ") c) d) e) f) referen$e %1are $a4ita# Has a superior claim :o oting rights %ncreases the gearing ratio

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Fi'ed di idends hence no growth =sually redeema"le :ot easily transfera"le

Differen$e% 5et3een referen$e S1are Ca4ita# and De5t a) ") c) d) e) DE,T %nterest is ta' allowa"le %nterest is a legal o"ligation /e"t finance is always secured /e"t finance is a pre+conditional Has a superior claim REFERENCE S8ARE CA ITAL a) /i idends are not ta' allowa"le " ) d ) e) /i idends are not a legal o"ligation .reference is not secured finance Has a residue claim (after de"t)

c) %s not conditional finance

5E .er"#

Financial Accounting Aa#i Co'4anie%) 0ack of security %gnorance of finances a aila"le

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D1* It Ma* ,e Diffi$u#t For S'a## Co'4anie% To Rai%e De5t Finan$e In Aen*a (Sa* -ua

Most of them are risky "usinesses as there are no feasi"ility studies done (chances of failure ha e "een put to EIO). !heir si#e "eing small tends to make them =:P:3$: i.e. they are not a significant competitor to the "ig companies. 6ost of finance may "e high ; their market share may not allow them to secure de"t. 2mall loans are e'pensi e to e'tend "y "ank i.e. administration costs are ery high. 0ack of "usiness principles that are sound and difficult in e aluating their performance.

So#ution% to t1e A5o&e ro5#e'% !here should "e di ersification of securities e.g. to accept guarantees. 1ducation of such "usinessmen on sound "usiness principles. !he go ernment should set up a special fund to assist the jua kali "usinessmen. 1ncourage formation of co+operati e societies. !o request "ankers to follow up the use of these loans.

+. ,i##% of E)$1an"e 8ills of 1'change are a source of finance in particular in the e'port trade. A 8ill of 1'change is an unconditional order in writing addressed "y one person to another requiring the person to whom it is addressed to pay to him as his order a specific sum of money. !he commonest types of "ills of e'change used in financing are accommodation "ills of e'change. For a "ill to "e a legal documentC it must "e a) /rawn "y the drawer. ") 8ear a stamp duty c) Accepta"le "y the drawee 5H .er"#

Financial Accounting e) Mature in time. %t is used to raise finance throughi) /iscounting it. ii) :egotiating iii) 9i ing it out as security. Ad&anta"e% of !%in" a ,i## a% a Sour$e of Finan$e !hey are a faster means of raising finance (if drawer is credi"le). %s highly negotia"leJliquid in estment /oes not require security /oes not affect the gearing le el of the company %t is unconditional and can "e in ested fle'i"ly %t is useful as a source of finance to finance working capital %t is used without diluting capital.

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Lea%e Finan$e

0easing is a contract "etween one party called lessor (owner of asset) and another called lessee where the lessee is gi en the right to use the asset (without legal ownership) and undertakes to pay the lessor periodic lease rental charges due to generation of economic "enefits from use of the assets. 0eases can "e short term (operating leases) in which case the lessor incurs the operating and maintenance costs of the assets or long term (finance leases) in which the lessee maintains and insure the assets. 0ease finance is ideal under the following conditionsa) ") c) $hen the asset depreciates faster. $hen the asset is su"ject to o"solescence $hen the a aila"le asset cannot meet the contemplated e'pansion program 7I .er"#

Financial Accounting d) e) f) $hen the asset&s cost is prohi"iting %f the asset is required seasonally %f the asset can generate returns to pay off lease charges in the short run.

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Ad&anta"e of Lea%in" an A%%et %t does not tie up the company&s funds in an asset. !he arrangement may ensure lessor "ears the maintenance costs reducing the companies operating costs. !he company has the option to purchase assets at the e'piry of the lease period at which time it will know the ia"ility of the asset. !he company (lessee) will enjoy the lease charges as allowa"le e'penses thus reducing ta'a"le income and ta' lia"ility. 0ease finance ena"les the lessee to use the asset to create financial surpluses which may then "e used to "uy assets. %t is usually a long+term arrangement which ena"les the company to plan returns e'pected and operations which may "e carried out. Di%ad&anta"e of Lea%in" an A%%et %t is a pre+conditional finance (as on the use of asset) %n the long term the lease charges may out+weigh the cost of "uying own asset. %t is a aila"le for a selected asset and this limits fle'i"ility. %t is useful for financing fi'ed assets and not working capital 0ease finance may not "e renewed leading to loss of "usiness. 0ease financing lowers the company&s credit rating (i.e. the asset in the "alance sheet is shown as leased asset).

71 .er"#

Financial Accounting Rea%on% D1* Lea%e Finan$e I% Not De## De&e#o4ed In Aen*a 0ease charges are usually prohi"iti e i.e. the cost of finance is e'cessi e. %t may not "e known to "usinessmen.

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=ncertainty as to returns from such assets i.e. the returns from such assets leased may not encourage the growth of lease finance. !here is an imperfect market as a num"er of companies lease assets on "asis of credi"ility of the lessee. 0ack of fle'i"ility i.e. a num"er of assets which are ideal for leasing are una aila"le. Penya&s financial markets are underde eloped and this has affected the de elopment of lease finance. After lease ser ice is poor and this leads to loss of re enue.

9.

O&erdraft Finan$e

!his finance is ideal to use as "ridging finance in sense that it should "e used to sol e the company&s short term liquidity pro"lems in particular those of financing working capital (w.c.). %t is usually a secured finance unless otherwise mentioned. 3 erdraft finance is an e'pensi e source of finance and the o er+reliance on it is a sign of financial imprudence as it indicates the ina"ility to plan or forecast financial needs.

Ad&anta"e% of O&erdraft Finan$e %t is useful in financial crisis which an accountant cannot forecast due to a"rupt fall in profits thus liquidity pro"lems. %n some cases it may "e secured on goodwill thus making it fle'i"le finance. %t does not entail preconditions and is therefore in esti"le in high+risk situations when the firm would not ha e finance in normal circumstances. 75 .er"#

Financial Accounting

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%t is raised faster and as usual is ideal to in est in urgent entures e.g. documentary in estments e.g. treasury "onds( shares( treasury "ills( housing "onds etc. %f not used for a long period of time ; it does not affect the company&s gearing le el and therefore does not relate to company&s liquidation or recei ership. 0ess formalitiesJprocedures in ol ed.

Di%ad&anta"e% of O&erdraft Finan$e %t is e'pensi e as the interest rates of o erdrafts are much higher than "ank rates. !he use of this finance is an indication of poor financial management principle. %t may "e misused "y management "ecause it does not carry pre+conditions 8eing a short+term financial arrangement( it can "e recalled at short notice lea ing the company in financial crisis. :. #a%ti$ Mone* (Credit Card Finan$e) !his is finance of a kind where"y a company will make arrangements for the use of the ser ices of a credit card organisations (through the purchase of credit cards) in return for prompt settlement of "ills on the card and a commission paya"le on all credit transactions. !his is used to finance goods and ser ices of working capital in nature such as the payment of fuel( spare+ parts( medical and other general pro isions and it is rare for it to finance raw materials or capital items. Rea%on% 5e1ind t1e Fa%t De&e#o4'ent of T1i% Finan$e ( #a%ti$ Mone*) In Aen*a a) High incidences of fraud "y dishonest employees has "een responsi"le for de elopment of this finance as it minimises chances of this fraud "ecause it eliminates the use of hard cash in the e'ecution of transactions. ") c) )isk associated with carrying of huge amounts of cash for purchases which cash is open to theft and misuse has also "een responsi"le for de elopment of this finance. 6redit cards ha e "oosted the credi"ility of holder companies which ena"les them to o"tain trade credits under conditions which would ha e otherwise "een difficult. 77 .er"#

Financial Accounting d)

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3f late( Penya has e'perienced emergence of elite( middle and high+income groups& in particular professionals who tend to use these cards as a sym"ol of status in e'ecution of day to day transactions.

e) f)

!hese cards ha e "een used "y financial institutions and "anks to "oost their deposit and attract long term clienteles e.g. )oyal 6ard Finance( 2tandard 6hartered. A num"er of companies and esta"lishments ha e acquired such cards as a means of settling their "ills under certain times when their liquidity is low or when in financial crisis.

Li'itation% of Credit Card% a% a Sour$e of Finan$e i) ii) !hese cards leads to o erspending on the part of the holder and as such may disorganise the organisation&s cash "udget and cash planning. 0imited as to the acti ities they can finance as they are ideal for financing working capital items and not fi'ed assets in which case they are not a profita"le source of finance. iii) i ) ) !hey are e'pensi e to o"tain and maintain "ecause of associated cost such as ledger fees( registration( insurance( commission e'penses( renewal fees etc. %t is a short+term source and is open only to a few esta"lishments in which case a company can o"tain goods and ser ices from those esta"lishments that can accept them. 1ntail a lot of formalities to o"tain e.g. guarantees( presentation of "ank statements and e en charging assets that are partially pledged to secure e'penses that may "e incurred using these cards. i) ii) !hey may "e misused "y dishonest employees who may use them to defraud the organisation off goods and ser ices which may not "enefit such organisations. 6redit card organisation may suspend the use of such cards without notice and this will incon enience the holder who may not meet hisJher ordinary needs o"tained through these cards.

7< .er"#

Financial Accounting =. De5enture Finan$e

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A form of long term de"t raised after a company sells de"enture certificates to the holder and raises finance in return. !he term de"enture has its origin from B/1831& which means B% owe& and is thus a certificate or document that e idences de"t of long term nature where"y the person named therein will ha e gi en the issuing company the amount usually less than the total par alue of the de"enture. !hese de"entures usually mature "etween 1I to 1> years "ut may "e endorsed( negotiated( discounted or gi en as securities for loans in which case they will ha e "een liquidated "efore their maturity date. !he current interest rate is paya"le twice a year and it is a legal o"ligation. C#a%%ifi$ation i) Se$ured De5enture% !hese are those types of de"entures which a company will secure usually in two ways( secured with a fi'ed charge or with a floating charge. a) ") Fi'ed 6harge ; a de"enture is secured with a fi'ed charge if it can claim on a specific asset. Floating charge ; if it can claim from any or all of the assets which ha e not "een pledged as securities for any other form of de"t. ii) Na@ed De5enture% !hese are not secured "y any of the company&s assets and as such they are general creditors. iii) Redee'a5#e De5enture% !hese are the type of de"entures( which the company can "uy "ack after the minimum redemption period and "efore the ma'imum redemption period (usually 1> years) after which holders can force the company to recei ership to redeem their capital and interest outstanding.

i&) Irredee'a5#e De5enture% (4er4etuitie%) 7> .er"#

Financial Accounting

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!hese are ne er "ought "ack in which case they form permanent source of finance for the company. Howe er( these are rare and are usually sold "y company&s with a history of sta"le ordinary di idend record. &) C#a%%ifi$ation a$$ordin" to $on&erti5i#it* 6on erti"le de"entures ; 6an "e con erted into ordinary shares although they can also "e con erted into preference shares. 6on ersion price * par alue of a de"entureJ:o. of shares to "e recei ed. 6on ersion ratio * .ar alue of de"enture .ar alue of ordinary shares E)a'4#e A86 6ompany 0td "ooksS1%. 1I.III( 2h.5I ordinary share capital 1I(III( 2hs.1I EO preference share capital >(III( 2hs.1II 15O de"entures !he a"o e de"entures are due for con ersionRequired i) ii) iii) So#ution i) 6on ersion price * par alue of de"entureJ:o. of shares to "e recei ed. :o. of shares to "e recei ed * .er"# 1II-5I * >-1 7A 6ompute the con ersion price 6ompute the con ersion ratio 6ompute new capital structure. 5II(III 1II(III >II(III

Financial Accounting !herefore *

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ii)

6on ersion ratio * par alue of de"entureJpar alue of share * )ecei e > ordinary shares for e ery 1 de"enture held.

1II = > .I 5I

iii)

:ew capital structure :o. of new ordinary shares * >III ' > * 5>(III 2hs. 7>(III( 2hs.5I ordinary shares 1I(III( 2hs.1I( EO preference shares !otal capital DII(III 1II(III EII(III

&i) Non($on&erti5#e de5enture% !hese cannot "e con erted into ordinary preference shares and they are usually redeema"le. &ii) Su5(ordinate de5enture% =sually last for as long as 1I years and they are sold "y financially strong companies. 2uch are not secured and they rank among general creditors in claiming on assets during liquidation. !his means that they are su"+ordinate to senior de"t "ut superior to ordinary and preference share capital. Rea%on% 5e1ind !n4o4u#arit* of De5enture% of Aen*aE% Finan$ia# Mar@etF i) ii) iii) i ) !heir par alue is an e'tremely high alue and as such they are unafforda"le to purchase "y would "e in estors. !hey are in most cases secured de"t and as such constrain the selling company in so far as getting sufficient securities is difficult. Most of the would+"e sellers ha e low credit worthiness which is difficult. Penya&s capital markets are not de eloped and as such there is no secondary de"enture market where they can "e discounted or endorsed.

7D .er"#

Financial Accounting ) i) many would "e sellers and "uyers are ignorant of its e'istence.

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/e"entures finance is not known among the general "usiness community and as such 8eing long term finance there are a few "uyers who may "e willing to stake their sa ings for a long period of time.

ii) 2uch finance calls for a fi'ed return( which in the long rum will "e eroded "y inflation. >. .enture Ca4ita# @enture capital is a form of in estment in new small risky enterprises required to get them started "y specialists called enture capitalists. @enture capitalists are therefore in estment specialists who raise pools of capital to fund new entures which are likely to "ecome pu"lic corporations in return for an ownership interest. !hey "uy part of the stock of the company at a low price in anticipation that when the company goes pu"lic( they would sell the shares at a higher price and therefore make a considera"ly high profit. @enture capitalists also pro ide managerial skills to the firm. 1'ample of enture capitalists are pension funds( wealthy indi iduals( insurance companies( Acacia fund( )ock fella( etc. 2ince the goal of enture capitalists is to make quick profits( they will in est only in firms with a potential for rapid growth. @enture capitalists( will only in est in a company if there is a reasona"le chance that the company will "e successful. !heir pu"licity material states that successful in estments ha e three common characteristics. a) ") c) !here is a good "asic idea( a product or ser ice which meets real customer needs. !here is finance( in the right form to turn the idea into a solid "usiness. !here is the commitment and dri e of an indi idual or group and the determination to succeed. Attri5ute% of &enture $a4ita# i) 1quity participation ; @enture 6apital participate through direct purchase of shares or fi'ed return securities (de"entures and preference shares) 7E .er"#

Financial Accounting ii)

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0ong term in estment ; enture capital is an in estment attitude that necessitates the enture capitalists to wait for a long time (> ; 1I years) to make large profits (capital gains).

iii)

.articipation in Management ; @enture capitalists gi e their Marketing( .lanning and Management 2kills to the new firm. !his hands ; on Management ena"le them protect their in estment.

Ro#e of .enture Ca4ita# in E$ono'i$ De&e#o4'ent !he types of enture that capitalists might in est will in ol ea) ,u%ine%% %tart(u4% ; $hen a "usiness has "een set up "y someone who has already put time and money into getting it started( the group may "e willing to pro ide finance to ena"le it to get off the ground. $ith start+ups( enture capital often prefers to "e one of se eral financial institutions putting in enture capital. ") ,u%ine%% de&e#o4'ent ; !he group may "e willing to pro ide de elopment capital for a company which wants to in est in new products or new markets or to make a "usiness acquisition( and so which so needs a major capital injection. c) d) Mana"e'ent 5u*out ; A management "uyout is the purchase of all or parts of a "usiness from its owners "y its managers. Helping a company where one of its owners wants to rea#i0e a## or 4art of 1i% in&e%t'ent. !he enture capital may "e prepared to "uy some of the company&s equity. Fundin" .enture Ca4ita# $hen a company&s directors look for help from a enture capital institution( they must recogni#e thata) ") !he institution will want an equity stake in the company. %t will need con incing that the company can "e successful (management "uyouts of companies which already ha e a record of successful trading ha e "een increasingly fa ored "y enture capitalists in recent years. c) %t may want to ha e a representati e appointed to the company&s "oard( to look after its interests. 7H .er"#

Financial Accounting

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!he directors of the company then contract enture capital organi#ations( to try to find one or more which would "e willing to offer finance. A enture capital organi#ation will only gi e funds to a company that it "elie es can succeed.

Rea%on% for Si"nifi$ant Gro3t1 in .enture Ca4ita# in t1e De&e#o4ed Countrie% i) ii) iii) i ) ) .u"lic attitude i.e a fa oura"le attitude "y the pu"lic at large towards entrepreneurship( success as well as failure. /ynamic financial system e.g efficient stock e'change and a competiti e "anking system. 9o ernment support ; e.g ta'ation system to encourage enture capital e.g ta' concessions and in estment allowance ta'es. 1sta"lishment of enture capital institutions e.g in estors in the industry. 9rowth in the num"er of Management "uyers (M83) which ha e created a demand for equity finance. Con%traint% of .enture Ca4ita# in Aen*a 1. 5. 7. <. 1. 0ack of rich in estors in Penya( hence inadequate equity capital. %nefficiencies of stock market ; :21 is inefficient and in estors cannot sell the shares in future. .rices do not reflect all the a aila"le information in the market. %nfrastructural pro"lems ; this limits the growth rate of small firms which need raw materials and unlimited access to the market factors of production. 0ack of managerial skills on part of enture capitalists and owners of the firm. :ature of small "usiness in Penya. !here are 7 categories. a. 0arge M:6 ; these are esta"lished firms and can raise funds easily. ". Asian owned small "usinesses ; !hey are family owned hence do not require interference of enture capitalists "ecause they are not ready to share profits. c. African ; owned "usiness ; need enture capital "ut ha e little potential for growth. <I .er"#

Financial Accounting A. D. E. H.

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Focus on low risk entures e.g confining to low technology( low growth sectors with minimum in estment risks. 6onser ati e approach "y the enture capitalists. /elay in project e aluation e.g months or more hence entrepreneurs loose interest in the project. 0ack of go ernment support and inefficient financial system.

Su''ar* %n sum( enture capital( "y com"ining risk financing with management and marketing assistance( could "ecome an effecti e instrument in fostering de eloping countries. !he e'periences of de eloped countries and the detailed case study of enture capital howe er( indicate that the following elements are needed for the success of enture capital in any country. A "road+"ased (and less family "ased) entrepreneurial traditional societies and go ernment encouragement for inno ations( creati ity and enterprise. A less regulated and controlled "usiness and economic en ironment where attracti e customer opportunities e'ists or could "e created from high+tech and quality products. 1'istence of disin estments mechanisms( particularly o er+the counter stock e'change catering for the needs of enture capitalists. Fiscal incenti es which render the equity in estment more attracti e and de elops Bequity cult& in in estors. A more general( "usiness and entrepreneurship oriented education system where scientists and engineers ha e knowledge of accounting( finance and economics and accountants understand engineering or physical sciences. An effecti e management education and training programme for de eloping professionally competent and committed enture capital managersC they should "e trained to e aluate and manage high technology( high risk entures. A igorous marketing thrust( promotional efforts and de elopment strategy( employing new concepts such as enture fair clu"s( enture networks( "usiness incu"ators etc. for the growth of enture capital. <1 .er"#

Financial Accounting financial institutions including enture capital firms.

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0inkage "etween uni ersitiesJtechnology institutions( ) R /. 3rganisations( industry( and 1ncouragement and funding or ) R / "y pri ate pu"lic sector companies and the go ernment for ensuring technological competiti eness.

Di%ad&anta"e% of .enture Ca4ita# /ilute ownership position of a firm /ilute control of a firm

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