FINANCIAL MANAGEMENT -It is argued that profit maximized maximizes social economic welfare.

This is because profit

__________________________________________________________________________________ maximization ensures economic natural selection which leads to weeding out economically
FM > Is the operational activity of business that is concerned with obtaining and effectively utilizing inefficient firms since only maximisers survive.
funds in an efficient and appropriate manner.
It is concerned with the managerial activities related to procurement and utilization of funds for SHORTCOMINGS/LIMITATIONS OF PROFIT MAXIMASATION GOAL
business purposes. 1. It is a selfish and inadequate goal.
It is the management for finances of an organization in order to achieve the financial objectives of the -Only secures the interest of the shareholders and ignores other interested parties such as the
organization management, customers, society, lenders etc.
2. It is vague and unclear.
ROLES OF THE FINANCE MANAGER IN AN ORGANISATION -The definition of the term profit is ambiguous. It may be refer to short-term or long-term
1. Financial Planning And Forecasting profits, profit before after tax, total profits or profit per share, operational profit or profit
It is the role of the finance manager to plan and estimate the firm’s future financial attributable to ordinary shareholders.
requirements, cash budget and proformer financial statements enable the finance manager to 3. It is short-term
perform toward financial planning. A firm may maximize its short-term profits at the expense of its long-term profitability.
-A firm may for instance postpone major repairs or replacements although such
2. Coordination And Control postponement has adverse effect on its long-term profitability.
>All the firms’ decisions have financial implication. 4. It ignores timing of returns (Time value money)
The decisions should therefore be co-ordinated and c controlled centrally by the finance - Returns occurring at different time periods are compared directly irrespective of their
manager. differences in Value.
5. It ignores risks
3. Investment Decisions -An enterprise may show a higher return but a much higher level of risk.
>It is the role of the finance manager to decide the firm’s optimal investment in both short- 6. It uses profits and not cash flows
term and long-term assets. -It is therefore unrealistic because it can be achieved through creative or manipulative
accounting.
4. Financial Decisions 7. It assumes that perfect market exists and there is perfect competition.
>It is the role of the finance manager to raise the required funds from the most appropriate 8. Increase in profits may not necessarily lead to increase in earnings per share and share prices.
sources. He should therefore be conversant with the financial market and should understand
the implications of various sources of funds to the firm. (b) Wealth Maximization Goal
-This is the main goal of the firm.
5. Risk Management -Under the objectives benefit are measured in terms of cash flows and not profits. Decisions are made
>The firm is exposed to various risks. on a net present value basis (NPV). NPV is the difference between the present value of cash inflows
>It is the role of the finance manager to design investment lodging strategies to ensure that and the present value of cash outflows.
the risks are managed to the company’s advantage. -A course of action or a project with a positive NPV creates additional wealth and is therefore accepted
on the other hand. A course of action or a project with a negative NPV reduces shareholders wealth
6. Liquidity Management and is therefore rejected.
>Financial spend most of their time on management of working capital. -Wealth maximization objective is consistent with the objective of maximizing owners’ economic
>The finance manager should ensure that the firm’s level of working capital is adequate and welfare.
there is proper management of each of the working capital items. Wealth maximization principle implies that the fundamental at objective of a firm should be to
maximize the market value of its shares.
OBJECTIVES (GOALS) OF BUSINESS ORGANIZATIONS
The objectives of a business organization may be grouped into two categories: 2. NON-FINANCIAL OBJECTIVES
1. Financial Objectives -A firm may have important non-financial objectives which may limit th4e achievement of financial
2. Non-financial Objectives objectives. Examples of these non-financial objectives are;
1. FINANCIAL OBJECTIVES 1. Welfare of Employees
(a) Profit Maximization Goal -The welfare of employees can be achieved by;
-A firm is viewed as a vehicle for entrepreneurship and the entrepreneurs reward (a) Paying reasonable salaries i.e.Salaries that are commensurate to their qualification
is profit. and experience.
-Profit is viewed by the entrepreneur as a measure of satisfaction (utility) and a (b)Providing transport facilities to and from the employees’ place of work.
rational entrepreneur seeks to maximize utility hence the goal of profit (c)Providing medical facilities.
maximization (d)Providing recreation facilities.
-Profit is maximized in terms of marginal analysis where marginal revenue is equal to marginal cost (e)Providing training and career DVP opportunities.
i.e. MR=MS. (f)Assuring employees of their terminal benefit.

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 2. Customer Satisfaction -It is assumed that the management and the shareholders left on their own will each attempt to act in
-Responsibilities towards customers include; their own selfish interest.
(a)Providing in good time a product or service e of a quality that customers -The managers may pursue goals which only cater for their interest to a conflict between them and
expect and dealing honestly and fairly with customers. the shareholders. Example of actions by management which would result to a conflict t between
(b) Reliable supply arrangements and after sales service arrangements are also them and the shareholders are;
important. (i) Managers may arbitrary award themselves generous pay.
(ii) Managers may use corporate resources for personal gains.
3. Welfare of the society (iii) Managers may take holidays to fund resort locations and have all the expenses financed by
-A firm has to exercise co9rporate social responsibility because it is a member of the company.
the society in which it operates. It should participate in deserving such cases (iv) Managers may arrange mergers or take-overs which are only intended to benefit them.
such as; (v) Managers may organize good retirement packages for themselves.
-Conservation of environment, promotion of sports, sponsoring needy students in (vi) Managers may borrow from the firm at non-economic rates.
the society, contribution towards a deviation of national disasters etc. (vii) Managers may apply discriminatory employment practices.
(viii) Managers may lead luxurious lifestyles which are fully financed by the company.
4. Responsibility towards creditors
-The firm should honor its obligation and pay creditors promptly or on the due Ways of Minimizing or Preserving Agency Conflict between Shareholders and Management
dates. Default in payment would ruin its reputation and credit w3orth payment 1. Use of performance based reward e.g.
would ruin its reputation and credit worthiness. (a) Pay bonus at the end of the year based on the firm’s performance.
(b) Adopt stock option plans i.e. issue certificates that enable managers to acquire a
5. Fair dealings with competitors specified number of shares from the firm at a specified price.
-A firm is obliged to employ fair dealings with its competitors. It should avoid (c) Issue of performance shares – These are shares given to the management upon
using unethical methods to win customers from its c competitors instead, it attaining a certain level of performance. The performance could be measured in terms
should employ any advantages it has over its competitors including technological of profit before tax, earnings per share or other appropriate basics.
knowhow marketing skills, public relations etc. 2. Threat of firing
-A number of firms have fired C.E.O’s and the strategic management team due to poor
6. Responsibility should ensure that it pays tax performance.
-An organization should ensure that it pays tax promptly and is not involved in 3. Hostile take-over
tax evasion. It should at all times try to operate within the country’s legal frame -This is most likely where the firm’s shares are undervalued relative to its potential. In a
work. Its activities and operations should also be within the government overall hostile takeover, managers of the acquired firm are generally fired and those who stay loose
development plan. the autonomy (power) they had prior to the takeover. Managers therefore have strong
incentives to take actions which maximize the value of the firm.
7. Strategic objectives 4. Contractual based employment
Strategic objectives should be a major goal four government owned institutions Managers are employed on a contract basis so that contracts for the managers whose
and co-operations. These institutions should try to serve the purposes for which performance is not impressive are not renewed.
they were established. 5. Introduction of share ownership plans for employees.
6. Incurring agency costs. These are costs incurred by the shareholders in an attempt to
monitor and control the behavior of the management. This may involve ;
(a) Monitoring every managerial activity closely.
STAKEHOLDERS (b) Limiting the amount of funds that the managers can commit without shareholders’
These are interested parties in an organization who are always affected by the decisions of the firm. approval.
The whole concept of the stakeholders is well illustrated using agency theory. (c) Regular audit by external auditors.
(d) Demanding regular managerial reports.
AGENCY THEORY 7. Direct intervention by the shareholders
-An agency relationship arises whenever one or more individuals called principal (s) hire other -The shareholders can pass a vote of no confidence in the current management and insist on
individuals called agent (s) to perform same services or tasks on their behalf. The principal delegate a change of the B.O.D.s.
decision making authority to the agent (s). 8. Application of corporate governance guidelines or principles. Corporate governance
-In the context of a public limited company, agency relationship may take two main forms; guidelines specify the manner in which firms should be managed and controlled. Well
1. Agency relationship between the shareholders and the management. specified corporate governance guidelines or principles defines the roles and duties, rights
2. Agency relationship between the shareholders and the providers of long-term debt finance and obligations of all the stakeholders in a business and eliminate potential conflicts of
(creditors). interest.
Agency Relationship between Shareholders and Management
AGENCY COSTS

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-These are the costs incurred by the shareholders as a result of not being involved in direct Restrictive covenants contained in the loan agreement deeds are used by the creditors to
management of the company. protect their wealth from management and shareholders. These restrictive debts covenants
-The directors may fake decisions that only cater for their interest and not the interest of the include the following;
shareholders. The shareholders therefore incur costs in trying to monitor and control the behavior of 1. Covenants restricting investment in highly risky projects.
the management. -The aim of this covenant is to maintain the firms risk at the current level.
-Examples of agency cost are; 2. Covenant restricting disposal of assets.
(i) Cost of incentives such as bonuses and performance shares given to the management. -This covenant restricts the firm from disposing substantial parts of its properties and
(ii) Cost of external audit. assets.
(iii)Cost of installing systems of internal check. 3. Covenants securing debt
(iv)Opportunity costs on investment forgone by the management after being considered to be too -This covenant gives the debt holders title to the pledged assets until the debt is paid.
risky. 4. Covenants restricting payment of dividend
(v)Restructuring costs i.e. costs incurred to change or alter organization str5uctures so as to prevent -This restriction aims at preventing payment of dividend from capital.
undesirable management activities or decisions e.g. appointment of non-executive directors to the 5. Covenants restricting subsequent financing through issue of additional debts.
board. -This covenant aims at maintaining the firm’s current level of financial risk.
6. Covenants restricting mergers
Agency relationship between shareholders and the providers of long term finance (creditors) -Mergers may affect the value of the creditors’ claims.
-The creditors are the contributors of debt capital. They are not involved in the company management. 7. Covenants modifying the pattern of pay off to the creditors
The shareholders are expected to manage the creditor’s funds through the management. -This can be done through sinking funds or convertibility provisions.
The creditors therefore are the principle write the shareholder are the agents. 8. Above normal interest rates may be charged to discourage additional borrowing.
9. Loans may be related on short notice if unethical behavior is persistent or if conflicts
Agency conflict between shareholders and the providers of long term finance (creditors) of interest are too secure.
Examples of actions or decisions by the shareholders through the management, which can result to a 10. Application of corporate governance principles or guidelines.
conflict t between them and the creditors, are; -Well specified corporate governance e guidelines eliminate conflict t of interest since
1. Undertaking of highly risky projects. the roles, duties, obligations and rights of all the stakeholders are clearly spelt over.
-Shareholders through the management may undertake projects with a higher risk than that
anticipated by the creditors. Should the risky project succeed, all the benefits would go to 3. Agency relationship between shareholders and external auditors
the shareholders since creditors get a fixed return. However if the risky project fails, both -Auditors are appointed by the shareholders to monitor the activities of the
shareholders and creditors would experience the loss. Creditors would therefore not be management and also to express an opinion on the financial statements prepared by the
interested in highly, risky project. management.
2. Dividend payment -The shareholders are the principles and the external auditors are the agents.
-The firm can finance an increase in dividend rate through a reduction in its investment. -Due to conflicts of interest, auditors may basically collude with management to
This would reduce the value of the creditors’ claims. At the extreme limit, if the firm sells mislead the shareholders by either failing to disclose vital information or simply
all its assets and pays a liquidating dividend to the shareholders the creditors will be left starting the wrong facts.
with worthless claims.
3. Under investment Resolution of the conflict
-A firm with outstanding debts may reject projects which have a positive (NPN) value if the (1) Auditors are hired and dismissed by the shareholders. In case of conflict auditors
benefits from such projects mainly accrue to the creditors. may be fired before their time of office expires.
4. Inadequate disclosure (2) The institute governing the profession e.g. (ICPAK)
-The firm may fail to make four disclosure to the creditors. In this case, the creditors could -Normally have disciplinary procedures against creditors who are found to have
be unable to make an informed decision regarding their investment in the firm. acted in a professionally negligent manner. This includes suspension, warning
5. Sale of assets used secure creditors withdrawal of practicing certificates, issue of a guide to professional ethics etc.
-This action by the shareholders reduces the creditors’ claims.
6. The shareholders may incur additional debt (3) Legal Action
-Additional borrowing increases the firms risk and would not be in the interest of the -Auditors can be taken to by parties who server losses after making decisions
creditors. based on a misleading
7. The shareholders can arrange corporate restructuring or reorganizations which may not be Or inaccurate report or opinion. Courts can impose heavy penalties to discourage
beneficial to the creditors. professional Misconduct.
8. The shareholders may adopt a very aggressive management of working capital approach. (4) Agency relationship between the top management and subordinates
-This jeopardizes the firm’s liquidity position and would not be in the interest of the -In order to achieve some goals, the top management delegate power and
creditors. authority to their subordinates.
-The top management is therefore the principles while the subordinates are the
Ways of resolving agency conflicts between shareholders and creditors agents. However, due to conflict of interest, the subordinates may engage in
activities that make attainment of wealth maximization not possible. Examples of
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 these activities are; collision, embezzlement of funds, lack of seriousness oat (b) Internal sources of fund
work, use of corporate resources for personal gains etc. These funds are raised from within the firm.
N/B: In measuring managerial performance we evaluate the extent to which the non financial 3. Classification according to the relationship between the firm and third party providing the funds.
objectives have been achieved. These are;
TOPIC TWO: SOURCES OF FUNDS TO THE ORGANISATION (a) Common equity capital
-This is the capital provided by the real owners of the firm i.e.the ordinary shareholders.
-Common equity capital is the total of ordinary share capital and all the reserves.
Factors to consider when selecting source of funds: (b)Quasi equity
-This is the capital provided by the preference shareholders.
1) Risk (c) Debt capital
Risk is an important element to consider. We must consider what will happen if we are unable to meet -This is the capita provided by the firm’s creditors.
the financial commitments relating to that particular source of finance.When it comes to choosing 4. Classification according to the rate of return. These sources are;
suitable funding, we must strive to minimise the overall risk., banks are more cautious about where the (a) Capital with fixed return (CWFR)
money is going. Especially when considering a loan to new businesses with no track record. Therefore, -This capital is paid a presprecified rate of return each year. I.e. Preference share capital and long term
guarantors or a letter of guarantee are often required on startup loans. debt.
(b) Capital with variable rate of return (CWVR)
2) Cost -This capital is paid different rate of return each year depending on the firm’s performance. i.e.
The cost of finance and its effect on income will play a fundamental role in the financing decision. the (common equity capital)
overall aim is to minimise the cost of finance and maximise owners wealth. Therefore, it is essential to
consider the cost implications of choosing one source of funding over another. LONG TERM SOURCES OF FUND
Ordinary Share Capital
3) Control Advantages to the company (Coordinating share capital)
Control is another factor that plays an important role when choosing a source of finance. Issuing 1. It is a permanent service of income.
additional shares (equity) will result in a dilution of control among existing shareholders/owners. -It is therefore available for use by the company as long as the company is a going concern.
If the existing sharehoders do not want to lose control of their business, preferring to keep major 2. It is provided without conditions regarding its use.
decision-making in their own hands, they will only consider loan capital as a source of financing. -It is therefore a flexible source of funds.
3. It is not secured
4) Long term versus short term borrowing -It can therefore be raised even when the firm does not have sufficient assets to pledge as
When sourcing finance, we also need to consider whether we should obtain long term or short term collateral security.
funding. In many cases, it may be appropriate to match the type of funding to the nature of the asset to 4. The company is under no legal obligation to pay dividend.
be financed.If we are obtaining a noncurrent asset such as a piece of machinery then we would -Nonpayment of the dividend cannot therefore lead to liquidation of the company.
consider using a long term source of finance to fund this asset. 5. It reduces the company’s gearing and financial risk.
-It therefore improves the company’s capital base and enhances the capacity to borrow more
5) Availability of assets to pledge as collateral funds.
A company that has disposable assets that can be used as scurity for a loan can raise additional funds 6. Providers of the capital contribute valuable ideas towards the running of the company
through debt unlike a company without such a facility which can only utilize equity. during the A.G.M.
7. It gives the company a feedback on the opinion of the investing public.
6) Quotation at the stock market -Continuous decline in the market price of the shares may be an indication that the investing
A firm that is listed at the securities market can raise more funds from the public by issuing more public is not happy with the current management team.
shares or debentures to the public though the market. This is not enjoyed by firms which are not listed. 8. It can be raised in large amounts.
-Sources from which a business organization may obtain funds for its operations can be classified in -It can therefore be invested in long term projects requiring colossal amount of cash.
four different ways as follows; 9. There are no cash outflows associated with this capital since it is not redeemable.
1. Classification according to the duration ever which the funds will be retained. These sources are 10. It enhances corporate governance. This is because this capital can only be raised by listed
(a) Long term sources of funds. companies which have to apply corporate governance principle its guidelines.
-These funds are refundable after a long period of time.
(b) Short term sources of funds DISADVANTAGES OF ORDINARY SHARE CAPITAL TO THE COMPANY
-These funds are refundable after a short period of time; usually within two years. 1. It involves higher floatation costs when compared to long term debt finance.
(c) Permanent sources of funds 2. Ordinary share dividends are not an allowable deduction of tax purposes. Use of ordinary
-These funds are not refundable as long as the firm is going shareholders does not therefore provide the company with tax savings.
2. Classification according to origin. These sources are; 3. It leads to dilution of ownership and control of the firm by the existing shareholders. This is
(a) External sources of funds because; providers of this capital get ownership and voting rights.
-These funds are raised from outside the firm. 4. Providers of the capital participate in the supernormal earnings of the firm. This rescues the
common shareholders earnings.
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5. It is not accessible to all companies. Only listed companies can appeal for funds from the 9. The guiders may insist that the assets pledged as collateral security should be fully insured
public by floating shares. and well maintained. These are additional implied costs.
6. It may lead to dilution of firms earning per share. A decline in earnings per share leads to 10. Protective covenants contained in the loan agreement deed may limit the firms operating
decline in market price of the shares. flexibility.
7. It cannot be raised as fast as long term debt capital. The process of raising this capital is
long and involves a lot of formalities. Summary of the long term sources of funds
8. It can disorganize the company’s policies. This can happen if the new shareholders vote 1. Ordinary share capital
against the company’s existing policies. 2. Preference share capital
9. The cost associated with this capital i.e. Ordinary share dividends, is experienced by the 3. Long term debt
company perpetually. This is because ordinary shares are not redeemable securities. (i) Long term loan
10. It is inconvenient because the firm has to publish its annual financial statements. This may (ii) Mortgage loan
be dangerous from the competition point of view. -A mortgage is a property loan
-The property acquired acts as the security for the loan.
LONG TERM DEBT CAPITAL (iii) Bonds/Debentures
Advantages of long term debt capital from the borrowers’ point of view -Debentures refer to the unsecured debt.
1. Interest on debt is an allowable deduction for tax purposes of debt capital therefore provider -Bonds refer to both secured and unsecured debt. Both are papers acknowledging debt. They are long
the company with tax savings. term debt instruments that promise to pay interest periodically and the principal sum eventually upon
2. It does not involve dilution of ownership and control of the firm by the existing maturity.
shareholders. This is because providers of this capital do not have ownership and voting (a) Floating rate bonds
rights. The coupon rate on these bonds is not fixed but fluctuates from time to time so as to reflect the current
3. Providers of this capital do not participate in the supernormal earning of the firm. Payment market rate of interest. When the market interest rates fall in the coupon rates of adjusts downwards.
to them is limited to the amount of interest. The borrower benefits because the cost of fund go down.
4. Involves low floatation – costs when compared to ordinary share capital. It is therefore -If the4 mar4ket rates go up the coupon rate adjusts upwards. The lender benefits because he is able to
cheaper to rise. participate in higher interest rates.
5. It does not lead to dilution of the firms earnings per share. -Due to the matching of the coupon rates and the market rate of interest, market prices of the
6. It can be raised faster than ordinary share capital. The process of raising this capital does debentures become much more stable.
not involve a lot of formalities. -Floating rate bonds are beneficial to both the lenders and the borrower during periods when market
7. The cost of servicing the capital, i.e. interest, is not experienced by the company interest rates are volatile.
perpetually. This is because debt securities are redeemable. (b) Zero coupon bonds
8. Use of long term debt capital is beneficial to the company during periods where market -No interest is payable on these bonds before maturity o9r disposal interest is effectively accrued and
interest rates are raising. The firm continues to pay a low fixed rate of interest even after a accounted for in the redemption value of the bonds or reflected in its current m market value. The
must interest rates go up. lender is not locked into a low fixed rate of interest but is able to participate in higher rates.
9. This capital is applied in ventures which have been approved by the leaders. It is therefore The cost of funds to the borrower reflects the interest rates prevailing.
unlikely to be invested in unprofitable projects. (c) Convertible bonds
10. During periods of high inflation the company benefits from debt capital because the These are bonds that may be converted into ordinary shares or other form of security at the option of
obligations to pay remains fixed but decline in value. the holder at a specified price within a specified period.

Disadvantages of long term capital from the borrowing point of view (5) Lease
1. The company is under legal obligation to pay interest. Nonpayment of interest will lead to -A lease is an agreement whereby the lesser grants the right to use an asset to the lesser in return for
liquidation of the company. regular payment of rentals.
2. It is provided with conditions regarding its use. It is therefore not a flexible source of funds. There are two types of leases namely;
3. It is usually secured. The company must have sufficient assets to pledge as collateral for the (a) Finance lease
loan/debt. -This is a lease that substantially transfers all the risks and rewards associated to the asset to
4. It increases the company’s gearing and financial risk. the lessee. Insurance and maintenance of the asset is the responsibility of the lessee. The
5. Use of long term debt is disadvantageous to the company during period when market lessee also claims capital allowances.
interest rates are falling. The firm is locked into a higher fixed rate of interest and does not -Finances leases are usually long term sources of funds.
benefit from the falling market interest rates. (b) Operating lease
6. It is not accessible to all the companies. It can only be raised by financially sound -This is a lease that does not substantially transfer all the risks and rewards incidence to the
companies which are well known to the lenders. ownership of the lessee insurance and maintenance of the asset is the responsibility of the
7. Cash outflows associated with redemption of this capital may leave the company in a lesser.
financial constraint. -The lesser also claims the capital allowances.
8. Providers of this capital are entitled to interest of claim on the company’s assets in priority -Operating leases are usually short term sources of funds.
to ordinary shareholders.
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 Operating leases are referred to as off balance sheet financing because the least asset is not -The debtors are not made aware of the arrangement.
reflected in the lessees books either as an asset or as an obligation to pay. -This service is less comprehensive than factoring.
5. Bill of exchange
(5)Sale of fixed asset 6. Trade credit
(6) Sale and leaseback 7. Accrued expenses
-This is an arrangement whereby a firm sells its own asset to another firm and the leases back the same 8. Operating leases
asset immediately. 9. Hire purchase
-The purpose of a sales and leaseback is to enable the firm to raise funds. 10. Treasury bills

SHORT TERM SOURCES OF FUNDS -These are short term debt instruments issued by the government through the central bank.
1. Bank overdraft -They are issued at a discount.
Advantages -They are used as a measure of the risk free rate of economy and check inflation.
1. It can be raised very fast. It can therefore be used for emergency financing. -May enable the government to borrow funds from the public.
2. It is usually not secured.
3. It is provided without conditions. Difference between treasury bills and Treasury bond
4. It involves no floatation costs. (i) Treasury bills are short term debt investments while treasury bonds are long term debt
5. Its costs and financial constraints are short lived. investment, both issued by the government through the treasury.
6. It does not affect the firms gearing and financial risk. (ii) Treasury bills are issued at a discount while treasury bonds are issued at per.
7. It can be applied without the consent of the shareholders. It can therefore meet the (iii) Treasury bills are not transferable while Treasury bond is transferable.
immediate needs. (iv) Treasury bills have a lower rate of interest than treasury bonds.

Disadvantages EXTERNAL SOURCES OF FUNDS

1. It is very expensive. -These are funds raised from outside the firm. Examples of external sources of funds are;
2. Its constant use is a sign of poor financial management. 1. Ordinary share capital
3. It is not accessible to all firms. It can only be raised by financially sound firms which are 2. Leases
well known to the lenders. 3. Trade credit
4. It is open to misuse because it can be used without shareholders consent. 4. Commercial, paper
5. It is available in small quantities. It cannot therefore be invested in long term projects 5. Hire purchase
which are more profitable. 6. Long term loans
6. It can be recalled at any time or on short notice. This may leave the company in financial
constant. INTERNAL SOURCES OF FUNDS
These are funds raised from within the firm. Examples of internal sources of funds are;
2. Commercial paper (i) Retained earnings i.e. profits after interest of tax plus provision for depreciation less cash
-This is a short term debt instrument issued by financially sound companies to enable them dividend.
to raise funds to finance their working capital needs. It is usually not secured. (ii) Provision for depreciation – Provision for depreciation is an internal source of fund in the
-It carries a fixed rate of interest. sense.
-It is issued at a discount. (a) It is a charge to the income statement but does not involve outflow of cash.
-Its effective costs are the difference between the discounted sum and the face value of the (b) Depreciation is an allowable deduction for far purposes. It therefore the company
debt instrument. with tax saving.
-It can be issued through commercial banks or the stock exchange. (c) Depreciation reduces the earnings attributable to the ordinary shareholders and
3. Factoring of debtors (Receivables) consequently the cash dividend payable.
-Factoring refers to the sale of firms’ debtors to a financial institution known as a factor. (iii) Sale of fixed assets
-The firm and the factor agree on the basic credit terms for each customer. (iv) Sale and lease back.
-The customers are made aware of the factoring arrangements. (v) Adjustments in working capital items.
The factor gives immediate cash to the firm against the asset of debtors.
-The factor takers over administration of the firms credit department. -If the firm is over capitalized it can reduce its investments in current assets and release some cash
-The debtors pay directly to the factor and the factor is responsible for any bad debt losses. previously tied in current asset.
-The factor charger interest on the advance and service fee for other services provided.
4. Invoice discounting Sources of funds for small business enterprises
-This is the sale of some selected quantity invoices to a factor. 1. Personal savings.
-The firm receives some cash immediately and more cash received by the firm after the 2. Contribution from people of good will.
debtors have paid. 3. Youth development fund.
-The firm does not realize the fact value of the invoice. 4. Women fund.
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 5. Bank loan. CAPITAL MARKET
6. Loan from savings and credit cooperative societies. These are markets for long term funds with maturity period of more than one year. Example of
7. Loan from micro finance institutions and NGO’s. financial instruments used here are debentures, long term loans, bonds, warrants, preferences shares,
8. Venture capital. ordinary shares and so on.
The capital market serves as a way of allocating the available capital to the most efficient users.
-This is the capital raid to start new small risky projects. It is provided by specialists’ organizations Capital market financial institution includes:
known as venture capitalist. (a) Stock exchange
-It is provided at the initial stages of the business when the risk of default is very high and when funds (b) Development bank
from other sources are not forthcoming. It is provided inform of debt or equity. (c) Hire purchase companies
-The aim of the venture capitalist is to withdraw his funds after the business has taken off. (d) Building societies
-The withdrawn funds are then provided to another new small risky venture. (e) Leasing firms
-The venture capitalists assume high risks and therefore demand high returns.
-This market is under developed in Kenya. Functions of Capital Markets are:
-Example of venture capitals in Kenya is –Acacia Funds a) Providing long term funds which are necessary for investment decisions.
b) Provide advice to investors as to which investments are viable.
TOPIC THREE: FINANCIAL MARKET c) Long term investments are made liquid, as the transfer between shareholders is facilitated.
d) Facilitates the international capital inflow.
e) Facilitating the liquidation and marketing of a long term.
MARKET FOR FUNDS AND FINANCIAL INSTITUTIONS IN KENYA f) Acting as a channel through which foreign investments find their way into the market.
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 Money/discount markets
(savers) to deficit economic units (investors). Savers include individuals, small businesses, family This is a market for short term funds maturing in one year. Money market works through financial
units‟ savings through institutions such as Savings and Credit Cooperative Societies, banks, insurance institutions. It facilitates transfer of capital between savers and users. The transfer can be direct (from
firms, pension schemes, etc. Investors include government, companies, family units, etc. saver to investor) or indirect (through an intermediary). Foreign exchange market is also part of money
Note: market. Money or discount markets include acceptance and discount financial institutions. The money
1. The different way to classify financial markets market or discount market is the market for short term loans.
2. The principal economic functions of financial markets
3. The roles of capital market authority Financial Instruments in Money market include:
4. Functioning of central depository system (CDS) (a) Commercial paper
(b) Treasury bills
Functions of Financial Markets/Institutions in the Economy (c) Bills of exchange
1. Distribution of financial resources to the most productive units. Savings are transferred to economic (d) Promissory notes
units that have channels of alternative investments (e) Bank overdrafts
2. Allocation of savings to real investment. (f) Bankers certificate of deposit
3. Achieving real output in the economy by mobilizing capital for investment. These instruments are sold by commercial banks, merchant banks, discounting houses, acceptance
4. Enable companies to make short term and long term investments and increase liquidity of shares. houses, and government.
5. Provision of investment advice to individuals through financial experts.
6. Enables companies to raise short term and long term capital/funds. Primary Markets
7. Means of pricing of securities e.g. Nairobi Stock Exchange index shares indicate changes in share These are markets that deal with securities that have been issued for the first time. The money flows
prices. directly from transferor (saver of money) to transferee (investing person). They facilitate capital
8. Provide investment opportunities. Savers can hold financial instrument for investment made. formation.
Economic Advantage of Primary Markets
Kenya Financial System Financial markets are broadly classified into two: 1. Raising capital for business
1. Capital Markets 2. Mobilizing savings
2. Money Markets 3. Raising capital by government through sale of Treasury bonds, stocks etc.
Capital markets are sub-divided into two: 4. Open market operation to effect monetary policy of the government i.e. control of excess liquidity in
a) Security market e.g. stock exchange dealing with instruments such as shares, debentures, etc. and the economy
non security 5. It is a vehicle for direct foreign investment.
b) Non-security/instrument market e.g. mortgage, capital leases etc.
Security market is further sub-divided into two. Secondary Markets
(a) Primary market These are markets that deal with securities that are already issued i.e. after the initial public offer, the
(b) Secondary market market in which shares are subsequently traded.
Economic Advantage/Role of Secondary Markets in the Economy
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1. It gives people a chance to buy shares hence distribution of wealth in economy (a) Giving advice to the investors
2. Enable investors realize their investments through disposal of securities (b) Giving advice to firms which want to go public
3. Increases diversification of investments (c) Valuation of firms which need to merge
4. Improves corporate governance through separation of ownership and management. This increases (d) Giving defensive tactics in case of forced takeover
higher standards of accounting, resource management and transparency. (e) Underwriting of securities
5. Privatization of parastatals e.g. Kenya Airways. This gives individuals a chance for ownership in
large companies. THE SECURITIES EXCHANGE MARKET
6. Parameter for health economy and companies The Idea and Development of a Stock Exchange
7. Provides investment opportunities for companies and small investors. Stock exchanges (also known as stock markets) are special “market places” where already held stocks
and bonds are bought and sold. They are, in effect, a financial institution, which provides the facilities
Types of Stock Markets and regulations needed to carry out such transactions quickly, conveniently and lawfully. Stock
1. Organized Exchange exchanges developed along with, and are an essential part of the free enterprises system.
This is where the buying and selling of securities is done by buyers and sellers who are not present but
only the agents (brokers) internet. This system is called “open outcry”. Functions of the Nairobi Securities Exchange
The basic function of a securities exchange is the raising of funds for investment in long-term assets.
2. Over the Counter Market (OTC) While this basic function is extremely important and is the engine through which stock exchanges are
Provides an opportunity for unlisted/unquoted firms to sell their security. OTC is usually organized by driven, there are also other quite important functions.
dealers or stock brokers who buy securities themselves and then sell them. 1.The mobilization of savings for investment in productive enterprises as an alternative to putting
They maintain a reasonable balance between demand and supply and observe price movements to savings in bank deposits, purchase of real estate and outright consumption.
determine profit margins on sale. Trading may be done through telephones, computer networks, fax 2. The growth of related financial services sector e.g. insurance, pension and provident fund schemes
etc. The dealers/participants set the rules. OTC specializes in securities such as corporate bonds, equity which nature the spirit of savings.
securities, Treasury bonds, etc. 3. The check against flight of capital which takes place because of local inflation and currency
OTC is underdeveloped in Kenya. depression.
Features of OTC Markets 4. Encouragement of the divorcement of the owners of capital from the managers of capital; a very
1. Prices are relatively low important process because owners of capital may not necessarily have the expertise to manage capital
2. Usually deal with new securities of firms investment efficiently.
3. Is composed of small and closely held firms 5. Encouragement of higher standards of accounting, resource management and public disclosure
which in turn affords greater efficiency in the process of capital growth.
FINANCIAL INTERMEDIARIES 6. Facilitation of equity financing as opposed to debt financing. Debt financing has been the undoing
These are institutions which mediate/link between the savers and investors. of many enterprises in both developed and developing countries especially in recessionary periods.
Examples of Financial Intermediaries in Kenya 7. Improvement of access to finance for new and smaller companies. This is futuristic in most
1. Commercial Banks developing countries because venture capital is mostly unavailable, an unfortunate situation.
They act as intermediary between savers and users (investors) of funds. 8. Encouragement of public floatation of private companies which in turn allows greater growth and
2. Savings and Credit Associations increase of the supply of assets available for long term investment.
These are firms that take the funds of many savers and then give the money as a loan in form of There are many others less general benefits which securities exchanges afford to; individuals,
mortgage and to other types of borrowers. They provide credit analysis services. corporate organizations and even the government. The government for example could raise long term
3. Credit Unions finance locally by issuing various types of bond through the securities exchange and thus be less
These are cooperative associations whose members have a common bond e.g. employees of the same inclined to foreign borrowing.
company. The savings of the member are loaned only to the members at a very low interest rate e.g.
SACCOs charge per month interest on outstanding balance of loan. The Role of Securities Exchange in Economic Development
4. Pension Funds
These are retirement schemes or plans funded by firms or government agencies for their workers. They 1. Raising Capital for Businesses
are administered mainly by the trust department of commercial banks or life insurance companies. The Stock Exchange provides companies with the facility to raise capital for expansion through selling
Examples of pension funds are NSSF, NHIF and other registered pension funds of individual firms. shares to the investing public.
5. Life Insurance Companies
These are firms that take savings in form of annual premium from individuals and then invest these 2. Mobilizing Savings for Investment
funds in securities such as shares, bonds or in real assets. Savers will receive annuities in future. When people draw their savings and invest in shares, it leads to a more rational allocation of resources
6. Brokers because funds which could have been consumed or kept in idle deposits with banks are mobilized and
These are people who facilitate the exchange of securities by linking the buyer and the seller. They act redirected to promote commerce and industry.
on behalf of members of public who are buying and selling shares of quoted companies. 3. Redistribution of Wealth
7. Investment Bankers By giving a wide spectrum of people a chance to buy shares and therefore become part of owners of
These are institutions that buy new issue of securities for resale to other investors. They perform the profitable enterprises, the stock market helps to reduce large income inequalities because many people
following functions: get a chance to share in the profits of business that were set up by other people.
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4. Improving Corporate Governance (a) He obtains the suitable deal for his clients/investors, gives financial advice and charges commission
By having a wide and varied scope of owners, companies generally tend to improve on their for his services
management standards and efficiency in order to satisfy the demands of these shareholders. (b) He doesn’t buy or sell shares in his own right hence he cannot be a market maker.
It is evident that generally public companies tend to have better management records than private (c) He must maintain standards set by the Securities Exchange.
companies. 2. Jobbers/Speculators
5. Creates Investment Opportunities for Small Investors This is a dealer who trades in securities in his own right as a principal. He can set prices and activate
As opposed to other business that requires huge capital outlay, investing in shares is open to both the the market through his own buying and selling hence he is a market maker. He engages in speculation
large and small investors because a person buys the number of shares they can afford. Therefore the and earns profit called Jobbers‟ turn (selling price – buying price)
Stock Exchange provides an extra source of income to small savers. He does not deal with members of the public unlike brokers. However, brokers can buy and sell shares
6. Government Raises Capital for Development Projects through jobbers.
The Government and even local authorities like municipalities may decide to borrow money in order There are 3 types of Jobbers
to finance huge infrastructural projects such as sewerage and water treatment works or housing estates a. Bulls
by selling another category of shares known as Bonds. These bonds can be raised through the Stock A bull jobber buys shares when prices are low and holds them in anticipation that the price will rise
Exchange whereby members of the public buy them. When the Government or Municipal Council gets and sell them at a gain. When a market is dominated by bulls (buyers predominate sellers), it is said to
this alternative source of funds, it no longer has the need to overtax the people in order to finance be bullish. The share prices are generally rising. Therefore the market is characterized by an upward
development. trend in security prices which signifies investors‟ confidence/optimism in the future of economy.
7. Barometer of the Economy b. Bears
At the Stock Exchange share prices rise and fall depending largely on market forces. Share prices tend A bearer is a jobber who speculates or sells security on expectation of decline in prices in future.
to rise or remain stable when companies and the economy in general show signs of stability. Therefore The intention is to buy same securities at lower prices in future thereby making a gain. When market is
their movement of share prices can be an indicator of the general trend in the economy. dominated by bears (sellers pre-dominate buyers) it is said to be bearish. It is characterized by general
Advantages of Investing in Shares downward trend in share prices. It signifies investors‟ pessimism about the future prospects of the
1. Income in form of dividends economy.
When you have shares of a company you become a part owner of that company and therefore you will c. Stags
be entitled to get a share of the profit of the company which comes in form of dividends. Furthermore This is a jobber found in primary markets. He buys new securities offered to the public and believes
dividends attract a very low withholding tax of 5% only. that they are undervalued. He believes the price will rise and sell them at a gain to the ultimate
2. Profits from capital appreciation investors. Stags are vital because they ensure full subscription of the share issue.
Share prices change with time and therefore when prices of given shares appreciate, shareholders 3. Underwriting
could take advantage of this increase and sell their shares at a profit. Underwriters assume the risk relating to unsubscribed shares. When new shares are issued, they may
3. Share Certificate can be used as Collateral be unsubscribed. A merchant banker agrees, under a commission to take up any shares not bought by
Share certificate represents a certain amount of assets of the company in which a shareholder has the public. They therefore ensure that all new issues are successful. Underwriters are very important in
invested. Therefore this certificate is valuable property which is acceptable to many banks and primary markets and play the following roles:
financial institutions as security, or collateral against which an investor can get a loan. (a) Advice firms on most suitable issue price.
4. Shares are easily transferable (b) Ensure shares are fully subscribed by taking up all unsubscribed shares.
The process of acquiring or selling shares is fairly simple, inexpensive and swift and therefore an (c) Advice the firms on where to source funds to finance floatation costs.
investor can liquidate shares at any moment to suit his convenience. 4. Blue Chips
These are first class securities of firms which have sound share capital and are recognized
5. Availability of Investment Advice internationally. They have very good dividend record and are highly demanded in the markets.
Although the stock market may appear complex and remote to many people, positive advice and Individuals holding such securities are reluctant to sell them because of their high value.
guidance could be provided by the stock brokers and other investment advisors. 5. Going Short or Long on a Share
Therefore an investor can still benefit from trading in shares even though he may not be having the This is the process of selling (going short) or buying (going long) on a share that one does not
technical expertise relevant to the stock market. have/own. The aim is to make gain from assumed change in the market value of shares. This practice
6. Participating in Company Decisions is not allowed in Kenya. It is aided by brokers in countries where it is practiced.
By buying shares and therefore becoming a part owner in an enterprise, a shareholder gets the right to Investors going short or long are required to pay a premium called margin on the transaction.
participate in making decisions about how the company is managed.
Shareholders elect the directors at the Company’s Annual General Meetings, whereby the voting Trading Mechanism at NSE
power is determined by the number of shares an investor holds since the general rules is that one share (a) An investor approaches a broker who takes his bid/offer to the trading floor.
is equal to one vote. (b) At the trading floor, the buying and selling brokers meet and seal the deal.
(c) The investor is informed of what happened/transpired at the trading floor through a contract note.
5.6 SECURITIES MARKET TERMINOLOGY The note is sent to buying and selling investors.
1. Broker (d) The note contains details such as:
A broker is a dealer at the market who buys and sells securities on behalf of the public investors. a. Number of shares bought or sold
He is an agent of investors. He is the only authorized person to deal with quoted securities by the b. Buying/selling price
Capital Market Authority and Nairobi Stock Exchange. He also performs the following functions: c. Charges/commission payable etc
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(e) Settlement is made through the brokers (e) Assist in examining and identifying the factors that underlie the price movements
(f) Old share certificate is cancelled (for selling investor) and a new one is issued in the name of
buying investor. (This has been eliminated with the automation of share selling in the NSE) Limitations/Drawback of NSE Index
1. The 20 companies sample whose share prices are used to compute the index are not true
Factors to Consider when Buying Shares of a Company representatives.
All sorts of influences affect share prices. 2. The base year of 1966 is too far in the past.
These influences include: 3. New companies are not included in the index yet other firms have been suspended or
1. The recent profit record of the company especially the recent dividend paid to shareholders deregistered.
and the prospects of their growth and stability. 4. Dormant firms – Some of the 20 firms used are dormant or have very small price changes
2. The growth prospects of the industry in which the company operates. 5. Thinness of the market – Small changes in the active shares tend to be significantly magnified
3. The publication of a company‟s financial results i.e. Balance Sheet and Profit and Loss in the index.
statement. 6. The weights used and the method of computation of index may not give a truly representative
4. The general economic conditions or situations such as boom and recession e.g. during boom, index.
firms would have high profits hence rise in prices. When is a share price said to be unfair?
5. Change in company‟s management e.g. entry and exit of prominent corporate personalities. (a) Where the price is not determined by demand and supply forces.
6. Change on Government economic policy e.g. spending, taxes, monetary policy etc. (b) If the price is not consistent with the activities of the firm e.g. a decline in share price of a firm
with very good growth prospects.
These changes influence investors‟ expectations. (c) Price is not compatible with the price of other similar shares of firms in the same industry.
a. Rumours and announcements of impending political changes e.g. general elections and new (d) If there is insider trading; this situation arises where individuals within the firm in privileged
president will cause anxiety and uncertainty and adversely affect share prices. positions e.g. top management and director take advantage of the information available to them which
b. Rumours and announcement of mergers and take-over bids. If the shareholders are offered have not been released to the public. They may use such information to dispose of share to make
generous terms/prices in a take-over, share prices could rise. capital gains or avoid capital loss.
c. Industrial relations e.g. strikes and policies of other firms. Example – Where individuals (insiders) are aware that a firm has made a loss in a year and such
d. Foreign political developments where the economy heavily depends on world trade. information, if released to the public, would cause a crash on share price, the information may be
f. Changes in the rate of interest on Government securities such as Treasury Bills may make leaked to certain people who could sell the shares in advance.
investors switch to them. Exchange rates will also encourage or discourage foreign
investment in shares. Timing of Investment in a Stock Exchange
g. Announcement of good news e.g. that a major oil field has been struck or a major new investment The ideal way of making profits at the Securities Exchange is to buy at the bottom of the market i.e. at
has been undertaken. The net present value of such investment would be reflected in share prices. lowest market price per share and sell at the top of the market i.e. highest market price per share. The
h. The views of experts e.g. articles by well-known financial writers can persuade people to buy shares greatest problem however is that no one can be sure when the market is at its bottom or at its top
hence pushing the prices up. (prices are lowest and highest).
i. Institutional buyers such as insurance companies can influence share prices by their actions. Systems have been developed to indicate when shares should be purchased and when they should be
j.The value of assets and the earnings from utilization of such assets will also influence share prices. sold. These systems are Dow Theory and Hatch system.

STOCK MARKET INDEX Dow Theory

An index is a numerical figure which measures relative change in variables between two periods. This theory depends on profiting of secondary movement of prices of a chart. The principal objective
Level of Trading Activities in the Nairobi Stock Exchange is to discover when there is a change in the primary movement. This is determined by the behavior of
The activities in NSE are normally low due to: secondary movement but tertiary movements are ignored, e.g. in a bull market, the rise of prices is
(a) Few Listed companies greater than the fall of prices. In a bear market the opposite is the case i.e.
(b) Economy is made up of small firms which are family owned or sole proprietorship A prospectus is a legal document issued by a company wishing to raise funds from the public through
(c) Level of awareness among the population is low issue of shares or bonds.
(d) Few instruments traded It is prepared by directors of the company and submitted to Capital Market Authority and Nairobi
(e) Low dividend payout to those already holding shares Stock Exchange for approval.
The Capital Market Authority has issued rules relating to the design and contents of the prospectus, in
STOCK EXCHANGE INDEX (SEI) addition to those contained in the Companies Act. the fall is greater than the rise. In a bear market, the
Stock Exchange Index is a measure of relative changes in prices of stocks from one period to another. volume of the business being done at a certain stage can also be used to interpret the state of the
Nairobi Stock Exchange 20-share index (20 companies) (Daily basis) Stanchart Index – From 25 most market.
active companies in a given period (weekly basis) Computation of price index. Basically it is maintained that if the volume increases along with rising prices, the signs are bullish and
Uses of Stock Exchange Index if the volume increases with falling prices, they are bearish.
(a) To gauge price (wealth) movement in the stock market
(b) To assess overall returns in the market portfolio Hatch System
(c) To assess performance of specific portfolio using SEI as a benchmark This is an automatic system based on the assumption that when investors sell at a certain percentage
(d) May be used to predict future stock prices below the top of the market and buys at a certain percent above the market bottom they are doing as
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well as can reasonably be expected. This system can be applied to an index of a group of shares or d) Control of a particular group of shareholders may be diluted by allowing a proportion of shares to
shares of dividends companies e.g. Dow Jones and Nasdaq index of America. be held by the public.
e) There will be a greater likelihood of being the subject of a takeover bid and it may be difficult to
Rules for Floatation of new shares on NSE defend it with wide share ownership.
(a) The company must have an issued share capital of at least Kshs. 20M f) Management conditions, management employees give themselves more salaries due to prosperity
(b) The company must have made profits during the last 3 years obtained.
(c) At least 20% of issued capital (capital to be issued) should be offered to the public
(d) The firm must issue a prospectus which will give more information to investors to enable them to Apart from the above roles, Capital Market Authority can undertake the following steps to encourage
make informed judgment development of stock exchanges in Kenya or other countries.
(e) The market price of the companies share must be determined by the market forces of demand and (a) Removal of Barriers on security transfers.
supply. (b) Introduce wider range of instruments in the market.
(f) The company should be registered under Cap. 486 with registrar of companies. (c) Decentralization of its operations.
(d) Encourage development of institutional investors such as pension funds, insurance firms etc.
(e) Provide adequate information to players in the market in order to prevent insider trading.
Note (f) Licence more brokers.
It must provide details on:
(a) Number of shares to be issued. 5.9 CAPITAL MARKET AUTHORITY (CMA)
(b) Offer or issue price per share. It was established in 1990 by an Act of Parliament to assist in creation of a conducive
(c) The dates during which the other is valid or open. environment for growth and development of capital markets in Kenya.
(d) Financial statements of the firm showing earnings per share and dividend per share for the Role of Capital Market Authority
last 5 years. (a) To remove bottlenecks and create awareness for investment in long term securities.
(e) Action may be taken against the directors if the prospectus is fraudulent (b) To serve as efficient bridge between the public and private sectors.
112 (c) Create an environment which will encourage local companies to go public.
(d) To grant approvals and licences to brokers.
The Advantages and Disadvantages of Listing (e) To operate a compensation fund to protect investors from financial losses should licenced brokers
Advantages fail to meet their contractual obligations
a) It facilitates the issue of securities to raise new finance, making a company less dependent upon (f) Act as a watchdog for the entire capital market system.
retained earnings and banks (g) To establish operational rules and regulations on placement of securities.
b) The wider share ownership which results will increase the likelihood of being able to make rights (h) To implement government programs and policies with respect to the capital markets.
issues Note
c) The transfer of shares becomes easier. Less of a commitment is necessary on the part of 5.9.1 Role of Capital Market Authority in determination of share prices
shareholders. For this reason the shares are likely to be perceived as a less risky investment and hence (a) The Capital Market Authority does not in any way influence share price of quoted companies
will have a higher value. (b) The prices of such securities are determined by the demand and supply mechanism.
d) The greater marketability and hence lower risk attached to a market listing will lead to a lower cost (c) However, Capital Market Authority may; advice the company on the issue price of new securities.
of equity and also to a weighted average cost of capital. (d) Alert the investors if it feels that the issue price of certain securities is not in their interest.
e) A market-determined price means that shareholders will know the value of their investment at all (e) It guards against manipulation of share prices and insider trading.
times. Other Terminologies
f) The share price can be used by management as an indicator of performance, particularly since the a) ACCOUNTS – 14 day period into which the stock exchange trading calendar is divided.
share price is forward looking, being based upon expectations, whilst other objectives measures are b) ACCOUNTS DAY – Sixth or seventh day following the expiry of an accounts period on
backward looking. which settlement on all period deals must be completed.
g) The shares of a quoted company can be used more readily as consideration in takeover bids. c) BACKWARDATION – Where stock cannot be delivered on settlement date although it
h) The company may increase its standing by being quoted and it may obtain greater publicity. has been paid for, a third party is found who owns and will lend similar stock. As a
i) Obtaining a quotation provides an entrepreneur with the opportunity to realize part of his holding in security measure, this stock is paid for in full. When the original stock that cannot be
a company. delivered on time is finally available, the lender will be given back his stock and will
refund monies paid to him less backwardation which is a commission for the loan.
Disadvantages d) BONUS SHARES – Additional shares issued to shareholders at no additional cost to themselves as
a) The cost of obtaining a quotation is high, particularly when a new issue of shares is made and the a form of extra dividend. Also known as Scrip Issue.
company is small. This is because substantial costs are fixed and hence are relatively greater for small e) CALL-OVER – Bargaining and closing deals in a stock exchange without a formal floor and
companies. Also, the annual cost of maintaining the quotation may be high due to such things as position dealings, where the secretary reads, calls out each security to be dealt, one at a time.
increased disclosure, maintaining a larger share register, printing more annual reports, etc. f) CARRY-OVER – When a deal has been arranged but for some valid reason either the buyer cannot
b) The increased disclosure requirements may be disliked by management. pay on time, or the Jobber may not be able to deliver stock on time. In this case, a third party can be
c) The market-determined price and the greater accountability to shareholders that comes with it introduced to solve the problem.
concerning the company‟s performance may not be liked by management
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g) CONTANGO – Is interest charged a client by his broker to cover the costs of borrowing money (f) It will lead to an efficient and transparent securities market to adhere to International Standards for
from a third party so as to pay for stock bought on his behalf. This happens when a client has the benefit of all stakeholders.
commissioned his broker to purchase securities but for some reason, cannot pay on time.
h) CUM AND EX – These prefixes are written in front of other words such as capital, rights and Functions of Central Depository System
dividends to qualify them. “Cum” is short for cumulative, which means „inclusive of‟. “Ex” on the (i) Immobilization of securities i.e. elimination of physical movement of securities.
other hand is short for excluding, which is the opposite of including. (ii) Dematerialization i.e. elimination of physical certificates or documents showing entitlement to a
In commerce these terms refer to rights of buyers and sellers of securities when these are sold before a security so that ownership exists only as computer records.
dividend has been affected but after it has been declared. These terms are necessitated by the fact that (iii) Effective Delivery vs. Payment (DVP) i.e. simultaneous delivery and payment between the 2
shares are bought and sold throughout the year, but companies only declare dividends after the end of parties exchanging or transferring securities. This can be done without delay if Central Depository
their financial year when profits can be determined, and moreover, payment of dividends may take System is linked to the central payment clearing system e.g. Central bank of Kenya.
place long after they have been declared. (iv) Provision of detailed listings of investors according to the type of securities they hold e.g. ordinary
Thus “Ex Capital” infers that the seller of shares has sold them excluding their right to receive a bonus shares, preference shares.
share issue which has been declared at the time of sale. “Cum Capital” then means he sells them (v) Effective Distribution of Dividends, interests, rights issues and bonus issues.
inclusive of this right. (vi) Provision of book entry account i.e. electronic exchange of ownership of securities and payment
Ex Rights Cum Rights – The term „Rights‟ refers to the decision by the directors to raise new share of cash.
capital at current market rates but to give a prior option to existing shareholders to purchase a fixed Parties involved in Central Depository System
number of shares at preferential rates below market values. Ex and cum proceeding it refers to the sale Government
of shares decision, but before the dividend. For the purpose of attracting foreign investors and supporting the infrastructure of capital markets
Cum Dividend – These terms simply mean that the seller of shares retain his right to receiving the
dividend on the shares he sells although the title to the shares has passed to the buyer reserve. Capital Market Authority
P.S.: „Cum‟ anything shares give the buyer above par value because his purchase comes To improve the transparency of market and reduce instances of fraud Nairobi Stock Exchange
inclusive of the rights to collect on prior earnings. They are therefore sold at higher Bear transactions costs and improve liquidity of the market investors.
prices than „Ex‟ shares. InvestorsInstitutions, private investors and market professionals. For faster settlements and
i) FLOOR – Loose term referring to the trading area of a stock exchange. This ownershiptransfer and reduced cost of transfer through reduced paper work and labour intensive
encompasses all the position dealings or „markets‟ of the exchange. activities.
j) GILT-EDGED SECURITIES – These are loan securities that are issued by Governments Brokers
and because they are backed by the Government‟s „continuity‟, they are considered perfectly safe, Reduces paper work, forgery and improved efficiency
giving regular periodic interest payments, a fixed rate of interest, and guaranteed capital redemption at Banks
the expiry of the loan term e.g. Treasury bonds. Ease of clearing and settling of payments
Similar securities issued by public corporations are called Bonds. If they are issued by public
companies they are called Debentures.

5.10 CENTRAL DEPOSITORY SYSTEM (CDS)

It is a computerized ledger system that enables the holding or transfer of securities without the need for
physical movement. The ownership of security or shares is through a book entry instead of physical
exchange. Central depository system is for security in the same way a bank is for cash transfer
between banks, e.g. A and B are 2 shareholders of XYZ Ltd. XYZ Ltd does not need to deliver the
share certificate to A or B but a ledger account for both shareholders would be maintained at the
Central depository system. Their accounts will be credited with the number of shares. If A wants to
sell shares to B Central depository system will debit A‟s account and credit B‟s account.

Advantages of CDS
(a) It shortens the registration process in the stock exchange i.e. high speed of registering shareholders
(b) It improves the liquidity of stock exchange than increase the turnover of the equity shares in the
market.
(c) It will lower the clearing and settlement cost e.g. no need to prepare share certificates and seal them
(putting a seal).
(d) It is faster and less risky settlement of securities which make the market more attractive for
investors e.g. instances of fraud will be reduced since there is no physical share certificate which may
be forged.
(e) There will be improved and timely communication between company and the investors hence
reduced delay in receiving dividends and right issues and improve information dissemination
concerning a company.
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