LAIKIPIA UNIVERSITY

BACHELOR OF COMMERCE
BCOM 230: BUSINESS FINANCE
LECTURER: ANDREW OSUMBA
CELL PHONE: 0713309816
EMAIL: andrewosumba2005@yahoo.com

COURSE OBJECTIVE
The purpose of the Course is to equip students with necessary knowledge of the financial forces
that influence the business activities
EXPECTED LEARNING OUTCOMES
By the end of the course unit, the learner should be able to;
 Appreciate the financial environment of business
 Assess the sources of business finance
 Understand the operation of stock exchange
 Develop skills in working capital management, capital budgeting, ratio analysis and
determine cost of finance
COURSE CONTENT
Scope and nature of business finance, forms of business organizations and their financial
implications; sources of business finance; short term, intermediate, long term; Kenya financial
market; money and capital market; commercial banks, merchant banks, development banks,
other non-banking financial institutions, micro-finance institutions, central bank of Kenya;
Nairobi stock exchange; working capital management; inventory management; cash
management; debtors/credit management; break-even analysis.
COURSE OUTLINE
Week Topic Subtopic

1 Scope and Nature of  Introduction

Business Finance  Meaning of business finance
 History of finance
 Types of finance

2 Forms of Business  Introduction to business forms

Organization  Sole tradership & Partnerships
 Companies & Corporations
 Converting from one form to another
 Alliances: joint ventures, Mergers & Acquisitions

3 Sources of Finance  Capital markets, risk and return

 Sources of equity finance
 Sources of debt finance

4 Sources of Finance  Financing problems of small firms

5 Sources of Long term
finance
 International money markets
 Capital market efficiency
 Shareholders’ funds: ordinary, preference & reserves
 Raising share capital: the stock market, new issue, right
issue, bonus issue and share splits.

6 CAT 1 Sit in

7 Sources of Long term  Debt finance: bonds, debt yields & warrants
finance  Medium term financing: term loans, mezzanine finance,
lenders assessment of credit worthiness, leasing, lease or
buy decisions and factoring
 Financing small profit making entities: venture capital,
business ‘angels’, government assistance
8 Kenya Financial  Nature and role of financial markets
Markets  Capital markets; the stock exchange, terminologies
 Practices & functions including quotations, dealings,
parties and documents used
 Market efficiency
 Computation and interpretation of stock index

9 Financial Markets &  Money market

NSE  Capital or securities market
 The foreign exchange market
 Derivatives markets
 Nairobi Stock Exchange
10 Working Capital  Meaning of working capital
Management  Balancing short term & long term finance for working
capital
  The cash operating cycle
 Managing inventory

11 CAT 2 Sit in

12 Working Capital  Managing trade payables and trade receivables

Management  Inventory management
 Cash management
 Working capital policies
13 Treasury  Treasury Management
Management and  The banking systems
Banking systems  The bank & customer relationship

14 Banking Institutions  Central bank of Kenya

exchange  Commercial, Development & Merchant banks
 Micro-finance & other non-banking financial institutions
 Break even analysis
15 End of semester
examination

TEACHING / LEARNING METHODOLOGIES

Lectures and tutorials, Group discussion, Demonstration, Individual assignment, Case studies of
critical and scientific reading, writing and listening in the field of Business and technology
INSTRUCTIONAL MATERIALS AND EQUIPMENT
Textbooks, equipment, handouts, pens and chalkboard
COURSE ASSESSMENT
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total -
100%
RECOMMENDED TEXT BOOKS
1) Pandey, I.M. (2007). Financial Management 8th ed. McGraw Hill
2) Rose, P. S. and Hudgins, S.C. (2007). Bank management and financial services with
standard and poor Bind – in card 7th ed. McGraw-Hill
3) Business and Finance Study Manual: ACA Professional Stage Knowledge Level Institute
of Chartered Accountants. 2nd Edition, 2008.
4) Financial Management: Study manual: ACA Professional Stage Application Level
Institute of Chartered Accountants. 2nd Edition, 2008.
5) Management Accounting Financial Strategy CIMA Official: Learning System. 2008
Edition.

INTRODUCTION
An individual, business firm and government organization do need to implement a number of
programs to attain their goals. Implementing programs require resources such as natural
resources, human resource and financial resource. Effectiveness in the management of financial
resource is key to optimize the use of natural and human resource. In the case of an individual,
management of financial resource (funds) is called by personal finance; the same is called by
public finance in government organizations. Business finance is frequently used to refer to the
same thing, i.e. management of funds in the context of a business firm. Thus broadly, finance as
a discipline is categorized in to three domains, public finance, business finance and personal
finance. Public finance is the management of funds for government; both local government units
and central government .Traditionally, it deals with the management of revenue and expenditure
of government. Personal finance refers to the management of funds of an individual. Since public
finance and personal finance are beyond the scope of this unit, only business finance will be
discussed.
Nowadays, business finance, corporate finance, financial management, and managerial finance
are used as synonym of each other. At the early stage of the development of finance as a separate
discipline, academics and practitioners used business finance. And latter on they used corporate
finance or business finance. The rationale behind the use of corporate finance was the dominance
of corporate form of business organization in the business world. Traditionally, business finance
used to focus only on the procurement of funds required to set up a corporation (company) and
expansion of its activities. Accordingly, the responsibility of financial manager was limited only
to estimate the financial requirements of a corporation and raise the funds to meet the projected
financial requirement of a corporation.

Meaning of Business Finance

1. Business Finance is that business activity which is concerned with the acquisition and
conservation of capital funds in meeting financial needs and overall objectives of
business enterprises.

Finance; meaning, concept and types

Meaning of finance
Finance is a broad term that describes two related activities: the study of how money is managed
and the actual process of acquiring needed funds. Because individuals, businesses and
government entities all need funding to operate, the field is often separated into three sub-
categories: personal finance, corporate finance and public finance.

Why Do Businesses Need Finance?

For starting up, Everyday bill payments, Businesses Expansion, Takeover bid, and internal
Growth, Replace machinery/equipment, Starting Up (working capital), acquisitions of Buildings
& machinery, acquisition of inventories, raw materials and office equipment. Term finance
required for the day-to-day running of a business, Unforeseen Events – Sudden decline in sales,
large customer fails to pay on time and pay expenses quickly.

History of finance
If we trace the origin of finance, there is evidence to prove that it is as old as human life on earth.
The word finance was originally a French word. In the 18th century, it was adapted by English
speaking communities to mean “the management of money.” Since then, it has found a
permanent place in the English dictionary. Today, finance is not merely a word it has emerged
into an academic discipline of greater significance. Finance is now organized as a branch of
Economics.

TYPES OF FINANCE
1. Public Finance
Public Finance is the study of the income and expenditure of the State. It deals only with the
finances of the Government. Scope of Public Finance consists in the study of the collection of
funds and their allocation between various branches of state activities which are regarded as
essential duties or functions of the State.
Public Finance may be divided into following three parts: Public expenditure, Public Revenue
and Public Debt.
What public finance includes;
Public Expenditure is the end (usage) and aim of the collection of State revenues. It involves the
judicious expenditure of public funds on the most important and socially and economically
relevant activities of the State. The term ‘Public Expenditure’ refers to the expenses incurred by
the Government for its own maintenance and also for the preservation and welfare of society and
economy as a whole. It refers to the expenses of the public authorities, Central, State and Local
Governments, for protecting the citizens and for promoting their economic and social welfare.
Public Revenues In a broad sense, ‘Public Revenues’ includes all the income and receipts,
irrespective of their source and nature, which the Government obtains during any given period of
time. It will include even the loans raised by the Government. In a narrow sense, it will include
only those sources of income of Government which are described as revenue resources. The
sources include Taxes, Fees, Price, Fines and Penalties, Gifts etc.
Public debt is the loans raised by and is a source of public finance which carries with it the
obligation of repayment to the individuals, along with interest, from whom the debt was raised.

Private Finance
Private finance is an alternative corporate finance method that helps an organization raise cash to
avoid limited time frame monetary shortfalls. This method typically serves a firm that is not
listed on a securities exchange or is unable to seek financing on such markets. A private
financing plan also may be suitable for a nonprofit entity.

2. Corporate finance
The financial activities related to running a corporation. A division or department that oversees
the financial activities of a company. Corporate finance is primarily concerned with maximizing
shareholder value through long-term and short-term financial planning and the implementation
of various strategies. Everything from capital investment decisions to investment banking falls
under the domain of corporate finance.

What Corporate Finance Includes?

1. Planning the finance: The finance manager plans the finance of the company. He takes
decisions on questions like: - a) How much finance is required by the company? b) What are the
sources of finance? c) How to use the finance profitably?

2. Raising the finance: The finance manager raise (collects) finance for the company. Finance
can be collected from many sources, viz., shares, debentures, banks, financial institutions,
creditors, etc.

3. Investing the finance: The finance manager uses the finance to achieve the objectives of the
company. There are two types of corporate finance, viz., fixed capital and working capital. Fixed
capital is used to purchase fixed assets like land, buildings, machinery, etc. While working
capital is used to purchase raw materials. It is also used to pay the day-to-day expenses like
salaries, rent, taxes, electricity bills, etc.

4. Monitoring the finance: The finance manager monitors (i.e. controls and manages) the finance
of the company. He has to minimize the cost of finance. He has to minimize the wastage and
misuse of finance. He has to minimize the risk of investment of finance. He also has to get
maximum return on the finance. Monitoring the finance is an art and science. It is a very
complex job.

3. Personal Finance
Personal finance is the application of the principles of finance to the monetary decisions of an
individual or family unit. It addresses the ways in which individuals or families obtain, budget,
save and spend monetary resources over time, taking into account various financial risks and
future life events.

Area of focus
Financial position: is concerned with understanding the personal resources available by
examining net worth and household cash flow. Net worth is a person's balance sheet, calculated
by adding up all assets under that person's control, minus all liabilities of the household, at one
point in time. Household cash flow totals up all the expected sources of income within a year,
minus all expected expenses within the same year. From this analysis, the financial planner can
determine to what degree and in what time the personal goals can be accomplished.

Adequate protection: the analysis of how to protect a household from unforeseen risks. These
risks can be divided into liability, property, death, disability, health and long term care. Some of
these risks may be self-insurable, while most will require the purchase of an insurance contract.
Determining how much insurance to get, at the most cost effective terms requires knowledge of
the market for personal insurance.

Tax planning: typically the income tax is the single largest expense in a household. Managing
taxes is not a question of if you will pay taxes, but when and how much. Government gives many
incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax
burden. Most modern governments use a progressive tax. Typically, as one's income grows, a
higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax
breaks when planning one's personal finances can make a significant impact.
Investment and accumulation goals: planning how to accumulate enough money for large
purchases, and life events is what most people consider to be financial planning. Major reasons
to accumulate assets include, purchasing a house or car, starting a business, paying for education
expenses, and saving for retirement. This asset allocation will prescribe a percentage allocation
to be invested in stocks, bonds, cash and alternative investments. The allocation should also take
into consideration the personal risk profile of every investor, since risk attitudes vary from
person to person.

Retirement planning is the process of understanding how much it costs to live at retirement and
coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement
plan include taking advantage of government allowed structures to manage tax liability
including: individual structures, or employer sponsored retirement plans.

Estate planning: involves planning for the disposition of one's assets after death. You can leave
your assets to family, friends or charitable groups.

Forms of Business Organization

One of the first decisions that you will have to make as a business owner is how the business
should be structured. All businesses must adopt some legal configuration that defines the rights
and liabilities of participants in the business’s ownership, control, personal liability, life span,
and financial structure. This decision will have long-term implications, so you may want to
consult with an accountant and attorney to help you select the form of ownership that is right for
you. In making a choice, you will want to take into account the following:
•Your vision regarding the size and nature of your business.
•The level of control you wish to have.
•The level of “structure” you are willing to deal with.
•The business’s vulnerability to lawsuits.
•Tax implications of the different organizational structures.
•Expected profit (or loss) of the business.
•Whether or not you need to re-invest earnings into the business.
•Your need for access to cash out of the business for yourself.
The form its owners choose will affect the company's and owners' legal liability and income tax
treatment. Here are the most common options and their major defining characteristics.
An overview of the four basic legal forms of organization: Sole Proprietorship; Partnerships;
Corporations and Limited Liability Company follows.

Sole Proprietorship
The vast majority of small businesses start out as sole proprietorships. These firms are owned by
one person, usually the individual who has day-to-day responsibility for running the business.
Sole proprietorships own all the assets of the business and the profits generated by it. They also
assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the
public, you are one in the same with the business. The business is structured in such a manner
that legal documents are not required to determine how profit-sharing from business operations
will be allocated. In a sole proprietorship all profits, losses, assets and liabilities are the direct
and sole responsibility of the owner. Also, the sole proprietor will pay self-employment tax on
income. Sole proprietorships are not ideal for high-risk businesses because they put your
personal assets at risk. If you are taking on significant amounts of debt to start your business, if
you've gotten into trouble with personal debt in the past or if your business involves an activity
for which you might potentially be sued, then you should choose a legal structure that will better
protect your personal assets.
If the risks in your line of work are not very high, a good business insurance policy can provide
protection and peace of mind while allowing you to remain a sole proprietor. One of the biggest
advantages of a sole proprietorship is the ease with which business decisions can be made.

Advantages of a Sole Proprietorship

• Easiest and least expensive form of ownership to organize.
• Sole proprietors are in complete control, and within the parameters of the law, may make
decisions as they see fit.
• Profits from the business flow-through directly to the owner’s personal tax return.
• The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship

• Sole proprietors have unlimited liability and are legally responsible for all debts against the
business. Their business and personal assets are at risk.
• May be at a disadvantage in raising funds and are often limited to using funds from personal
savings or consumer loans.
• May have a hard time attracting high-caliber employees, or those that are motivated by the
opportunity to own a part of the business.
• Some employee benefits such as owner’s medical insurance premiums are not directly
deductible from business income only partially as an adjustment to income.

Partnerships
In a Partnership, two or more people share ownership of a single business. Like proprietorships,
the law does not distinguish between the business and its owners. The Partners should have a
legal agreement that sets forth how decisions will be made, profits will be shared, disputes will
be resolved, how future partners will be admitted to the partnership, how partners can be bought
out, or what steps will be taken to dissolve the partnership when needed; Yes, it’s hard to think
about a “break-up” when the business is just getting started, but many partnerships split up at
crisis times and unless there is a defined process, there will be even greater problems. They also
must decide up front how much time and capital each will contribute, etc.

In a general partnership, all the partners share in gains or losses, and all have unlimited liability
for all partnership debts, not just some particular share. The way partnership gains (and losses)
are divided is described in the partnership agreement. A limited partnership, one or more
general partners will run the business and have unlimited liability, but there will be one or more
limited partners who will not actively participate in the business. A limited partner's liability for
business debts is limited to the amount that partner contributes to the partnership. This form of
organization is common in real estate ventures,

In a general partnership, all partners are personally liable for business debts, any partner can be
held totally responsible for the business and any partner can make decisions that affect the whole
business.
In a limited partnership, one partner is responsible for decision-making and can be held
personally liable for business debts. The other partner merely invests in the business. Although
the general structure of limited partnerships can vary, each individual is liable only to the extent
of their invested capital. Limited Liability Partners (LLP) are most commonly used by
professionals such as doctors and lawyers. The LLP structure protects each partner's personal
assets and each partner from debts or liability incurred by the other partners. Different states
have varying regulations regarding these establishments of which business owners must take
note.

A sole proprietorship is a business owned by one person. This is the simplest type of business
to start and is the least regulated form of organization. Depending on where you live, you might
be able to start a proprietorship by doing little more than getting a business license and opening
your doors. For this reason, there are more proprietorships than any other type of business, and
many businesses that later become large corporations start out as small proprietorships.

The owner of a sole proprietorship keeps all the profits. That's the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look
beyond business assets to the proprietor's personal assets for payment. Similarly, there is no
distinction between personal and business income, so all business income is taxed as personal
income.

The life of a sole proprietorship is limited to the owner's life span, and the amount of equity that
can be raised is limited to the amount of the proprietor's personal wealth. This limitation often
means that the business is unable to exploit new opportunities because of insufficient capital.
Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the
sale of the entire business to a new owner.

Advantages of a Partnership
• Partnerships are relatively easy to establish; however time should be invested in developing the
partnership agreement.
• With more than one owner, the ability to raise funds may be increased.
• The profits from the business flow directly through to the partners’ personal tax return.
• Prospective employees may be attracted to the business if given the incentive to become a
partner.
• The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership
• Partners are jointly and individually liable for the actions of the other partners.
• Profits must be shared with others.
• Since decisions are shared, disagreements can occur.
• Some employee benefits are not deductible from business income on tax returns.
• The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

Types of Partnerships that should be considered:

1. General Partnership
Partners divide responsibility for management and liability, as well as the shares of profit or loss
according to their internal agreement. Equal shares are assumed unless there is a written
agreement that states differently.

2. Limited Partnership and Partnership with limited liability

“Limited” means that most of the partners have limited liability (to the extent of their
investment) as well as limited input regarding management decision, which generally encourages
investors for short term projects, or for investing in capital assets. This form of ownership is not
often used for operating retail or service businesses. Forming a limited partnership is more
complex and formal than that of a general partnership.

3. Joint Venture
Acts like a general partnership, but is clearly for a limited period of time or a single project. If
the partners in a joint venture repeat the activity, they will be recognized as an ongoing
partnership and will have to file as such, and distribute accumulated partnership assets upon
dissolution of the entity.

Company
A company is owned by shareholders and managed by directors (the directors and shareholders
are often the same people). It is a legal entity in its own right and so allows you to keep your
business separate from your personal affairs. This means that the company can borrow any
finance needed, and your own liability will be limited to the amount you invest in the company.
The exception to this is if you need to give personal guarantees, for example, to your bank.

Using a company can be seen as more formal and there is increased administration with
certain information needing to be filed at Companies House (so becoming publicly available). It
is possible to keep some information private by using a shareholders' agreement to govern
certain terms; and as with a partnership you will probably want to set out what happens if one
shareholder leaves the company.

Tax is payable at two points; there will be corporation tax on profits at the company level and
there will then be income tax on those profits when they are paid out to the shareholders. This
may not be so bad if you intend to keep your money in the company, but if you want to take out
money for your personal living costs then using a company could be an expensive option.

One other thing to think about with a company is that it will be run by directors, who may or
may not be the same people as the shareholders. Directors have various obligations and
liabilities of their own which means you need to comply with certain strict requirements for the
management of the company.

Corporations
A Corporation, chartered by the state in which it is headquartered, is considered by law to be a
unique entity, separate and apart from those who own it. A Corporation can be taxed; it can be
sued; it can enter into contractual agreements. The owners of a corporation are its shareholders.
The shareholders elect a board of directors to oversee the major policies and decisions. The
corporation has a life of its own and does not dissolve when ownership changes.

A corporation is a legal “person” separate and distinct from its owners, and it has many of the
rights, duties, and privileges of an actual person. Corporations can borrow money and own
property, can sue and be sued, and can enter into contracts. A corporation can even be a general
partner or a limited partner in a partnership, and a corporation can own stock in another
corporation.

Forming a corporation involves preparing articles of incorporation (or a charter) and a set of
bylaws. The articles of incorporation must contain a number of things, including the
corporation's name, its intended life (which can be forever), its business purpose, and the number
of shares that can be issued.

A large corporation, the stockholders and the managers are usually separate groups. The
stockholders elect the board of directors, who then select the managers. Managers are charged
with running the corporation's affairs in the stockholders' interests. In principle, stockholders
control the corporation because they elect the directors.

Ownership (represented by shares of stock) can be readily transferred, and the life of the
corporation is therefore not limited. The corporation borrows money in its own name. As a
result, the stockholders in a corporation have limited liability for corporate debts. The most they
can lose is what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the
unlimited life of the business are why the corporate form is superior for raising cash. If a
corporation needs new equity, for example, it can sell new shares of stock and attract new
investors.

The Apple Computer is an example. Apple was a pioneer in the personal computer business. As
demand for its products exploded, Apple had to convert to the corporate form of organization to
raise the capital needed to fund growth and new product development. The number of owners
can be huge; larger corporations have many thousands or even millions of stockholders. For
example, in 2006, General Electric Corporation (better known as GE) had about 4 million
stockholders and about 10 billion shares outstanding. In such cases, ownership can change
continuously without affecting the continuity of the business.
Like the LLC, the corporate structure distinguishes the business entity from its owner and can
reduce liability. However, it is considered more complicated to run a corporation because of tax.
Unless you want to have shareholders The steps for establishing a corporation are very similar to
the steps for establishing an LLC. You will need to choose a business name, appoint directors,
file articles of incorporation, pay filing fees and follow any other specific state/national
requirements.

There are two types of corporations: C corporations (C corps) and S corporations (S corps). C
corporations are considered separate tax-paying entities. C corps file their own income tax
returns, and income earned remains in the corporation until it is paid as a salary or wages to the
corporation's officers and employees. Corporate income is often taxed at lower rates than
personal income, so you can save money on taxes by leaving money in the corporation.

If the corporation has shareholders, corporate earnings become subject to double taxation in the
sense that income earned by the corporation is taxed and dividends distributed to shareholders
are also taxed. However, if you are a one-person corporation, you don't have to worry about
double taxation.

S corporations are pass-through entities, meaning that their income, losses, deductions and
credits pass through the company and become the direct responsibility of the company's
shareholders. The shareholders report these items on their personal income tax returns, thus S
corps avoid the income double taxation that is associated with C corps.
The IRS also requires S corps to meet the following requirements:
 Be a domestic corporation
 Have only allowable shareholders, including individuals, certain trusts and estates
 Not include partnerships, corporations or non-resident alien shareholders
 Have no more than 100 shareholders
 Have one class of stock
 Not be an ineligible corporation (i.e., certain financial institutions, insurance companies
and domestic international sales corporations).

Advantages of a Corporation
• Shareholders have limited liability for the corporation’s debts or judgments against the
corporation.
• Generally, shareholders can only be held accountable for their investment in stock of the
company. (Note however, that officers can be held personally liable for their actions, such as the
failure to withhold and pay employment taxes).
• Corporations can raise additional funds through the sale of stock.
• A Corporation may deduct the cost of benefits it provides to officers and employees.
• Can elect S Corporation status if certain requirements are met. This election enables company
to be taxed similar to a partnership.

Disadvantages of a Corporation
• The process of incorporation requires more time and money than other forms of organization.
• Corporations are monitored by federal, state and some local agencies, and as a result may have
more paperwork to comply with regulations.
• Incorporating may result in higher overall taxes. Dividends paid to shareholders are not
deductible from business income; thus this income can be taxed twice.

C Corporation
C Corporations are completely different on both issues. In C Corporations, the owners are
protected from liability. The business truly is a separate entity so in the event of bankruptcy or
lawsuit, the owners’ assets are protected. The C Corporation is also considered a taxpaying
entity. This means that earnings for the corporation are taxed at the corporate level. Then, when
any earnings are dispersed to owners as dividends, they are taxed again at the individual level.
This is commonly referred to as double taxation and is a downside of this legal form.

S Corporation
An S corporation is a special type of Small Corporation that is essentially taxed like a partnership
and thus avoids double taxation. A tax election only; this election enables the shareholder to treat
the earnings and profits as distributions, and have them pass through directly to their personal tax
return. The catch here is that the shareholder, if working for the company, and if there is a profit,
must pay his/herself wages, and it must meet standards of “reasonable compensation”. This can
vary by geographical region as well as occupation, but the basic rule is to pay yourself what you
would have to pay someone to do your job, as long as there is enough profit. If you do not do
this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all
of the payroll taxes on the total amount.

S Corporations are a sort of hybrid between a C Corporation and a Partnership. They have the
same tax status as a partnership, but they are protected from legal liability. Thus, the owners’
personal assets are safe from any action against the company. S Corporations do have some
specific restrictions though.
 They can only have one classification of stock
 They have to be wholly owned by US citizens and get at most 80% of their revenue from
outside the US
 They can only have up to 75 stockholders
 They can get up to 25% of revenue from passive investments
 They can only have individuals, estates and certain trusts as shareholders

Limited Liability Company (LLC)

The LLC is a relatively new type of hybrid business structure that is now permissible in most
states. It is designed to provide limited liability features of a corporation and the tax efficiencies
and operational flexibility of a partnership. Formation is more complex and formal than that of a
general partnership.
The owners are members, and the duration of the LLC is usually determined when the
organization papers are filed. The time limit can be continued if desired by a vote of the
members at the time of expiration. LLC’s must not have more than two of the four
characteristics that define corporations: Limited liability to the extent of assets; continuity of
life; centralization of management; and free transferability of ownership interests.

An LLC is a limited liability company. This business structure protects the owner's personal
assets from financial liability and provides some protection against personal liability. There are
situations where an LLC owner can still be held personally responsible, such as if he
intentionally does something fraudulent, reckless or illegal, or if she fails to adequately separate
the activities of the LLC from her personal affairs. An LLC must elect to be taxed as an
individual, partnership or corporation. In some states, there is an additional annual fee for being
an LLC.

An LLP is a hybrid between a partnership and a company. It is made up of individual partners

but is a legal entity with a separate identity from those partners. This means that on the one hand
it offers its partners limited liability as if it were a company; and on the other hand it
allows money to go direct to the individual partners as if it were a normal partnership.

LLCs are a lot like S Corporations in that they get the limited liability that a corporation offers
while they get the tax status of a partnership. LLCs have operating agreements that are
effectively the same as a partnership’s partnership agreement. One thing to be aware of, though,
is that LLCs are state-level organizations and the regulations surrounding their formation and
operation can vary from state to state.

Federal Tax Forms for LLC

Taxed as a partnership in most cases; corporation forms must be used if there are more than 2 of
the 4 corporate characteristics, as described above. In summary, deciding the form of ownership
that best suits your business venture should be given careful consideration. Use your key
advisors to assist you in the process.

Forms of Business Organization

Concept Questions

1.2a What are the three forms of business organization?

1.2b What are the primary advantages and disadvantages of sole proprietorships and
partnerships?
1.2c What is the difference between a general and a limited partnership?
1.2d Why is the corporate form superior when it comes to raising cash?

Joint Venture
A business arrangement in which two or more parties agree to pool their resources for the
purpose of accomplishing a specific task. This task can be a new project or any other business
activity. In a joint venture (JV), each of the participants is responsible for profits, losses and
costs associated with it. However, the venture is its own entity, separate and apart from the
participants' and other business interests.
A joint venture (JV) is a business agreement in which the parties agree to develop, for a finite
time, a new entity and new assets by contributing equity. They exercise control over the
enterprise and consequently share revenues, expenses and assets.

Mergers and Acquisitions

Acquisitions
Acquisition is a corporate action in which a company buys most, if not all, of the target
company's ownership stakes in order to assume control of the target firm. An acquisition is the
purchase of one company by another in which no new company is formed. Acquisitions are often
made as part of a company's growth strategy whereby it is more beneficial to take over an
existing firm's operations and niche compared to expanding on its own. Acquisitions are often
paid in cash, the acquiring company's stock or a combination of both.

In an acquisition, a company can buy another company with cash, stock or a combination of the
two, or even one company acquiring all the assets of another company. Company X buys all of
Company Y's assets for cash, which means that Company Y will have only cash (and debt, if
they had debt before). Of course, Company Y becomes merely a shell and will eventually
liquidate or enter another area of business.

Like mergers, acquisitions are actions through which companies seek economies of scale,
efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm
purchasing another - there is no exchange of stock or consolidation as a new company.
Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times,
acquisitions are more hostile.

Another type of acquisition is a reverse merger, a deal that enables a private company to get
publicly-listed in a relatively short time period. A reverse merger occurs when a private company
that has strong prospects and is eager to raise financing buys a publicly-listed shell company,
usually one with no business and limited assets. The private company reverse merges into the
public company, and together they become an entirely new public corporation with tradable
shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal:
they are all meant to create synergy that makes the value of the combined companies greater than
the sum of the two parts. The success of a merger or acquisition depends on whether this synergy
is achieved.

Merger is a combination of two companies to form a new company, while. A Merger is the
combining of two or more companies, generally by offering the stockholders of one company
securities in the acquiring company in exchange for the surrender of their stock.
Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate
finance world. Every day, Wall Street investment bankers arrange M&A transactions, which
bring separate companies together to form larger ones. When they're not creating big companies
from smaller ones, corporate finance deals do the reverse and break up companies through
spinoffs, carve-outs or tracking stocks.
The key principle behind buying a company is to create shareholder value over and above that of
the sum of the two companies. Two companies together are more valuable than two separate
companies - at least, that's the reasoning behind M&A. M&A is a general term used to refer to
the consolidation of companies. Not surprisingly, these actions often make the news. Deals can
be worth hundreds of millions, or even billions, of dollars. They can dictate the fortunes of the
companies involved for years to come. This rationale is particularly alluring to companies when
times are tough. Strong companies will act to buy other companies to create a more competitive,
cost-efficient company. The companies will come together hoping to gain a greater market share
or to achieve greater efficiency.
Distinction between Mergers and Acquisitions
Although they are often uttered in the same breath and used as though they were synonymous,
the terms merger and acquisition mean slightly different things. When one company takes over
another and clearly established itself as the new owner, the purchase is called an acquisition.
From a legal point of view, the target company ceases to exist, the buyer "swallows" the business
and the buyer's stock continues to be traded.
In the pure sense of the term, a merger happens when two firms, often of about the same size,
agree to go forward as a single new company rather than remain separately owned and operated.
This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks
are surrendered and new company stock is issued in its place.
In practice, however, actual mergers of equals don't happen very often. Usually, one company
will buy another and, as part of the deal's terms, simply allow the acquired firm to proclaim that
the action is a merger of equals, even if it's technically an acquisition. Being bought out often
carries negative connotations, therefore, by describing the deal as a merger, deal makers and top
managers try to make the takeover more palatable.
A purchase deal will also be called a merger when both CEOs agree that joining together is in the
best interest of both of their companies. But when the deal is unfriendly - that is, when the target
company does not want to be purchased - it is always regarded as an acquisition.
Whether a purchase is considered a merger or an acquisition really depends on whether the
purchase is friendly or hostile and how it is announced. In other words, the real difference lies in
how the purchase is communicated to and received by the target company's stakeholders.

Synergy
Synergy is the magic force that allows for enhanced cost efficiencies of the new business.
Synergy takes the form of revenue enhancement and cost savings. By merging, the companies
hope to benefit from the following:
  Staff reductions - As every employee knows, mergers tend to mean job losses. Consider
all the money saved from reducing the number of staff members from accounting,
marketing and other departments. Job cuts will also include the former CEO, who
typically leaves with a compensation package.
 Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new
corporate IT system, a bigger company placing the orders can save more on costs.
Mergers also translate into improved purchasing power to buy equipment or office
supplies - when placing larger orders, companies have a greater ability to negotiate prices
with their suppliers.
 Acquiring new technology - To stay competitive, companies need to stay on top of
technological developments and their business applications. By buying a smaller
company with unique technologies, a large company can maintain or develop a
competitive edge.
 Improved market reach and industry visibility - Companies buy companies to reach new
markets and grow revenues and earnings. A merge may expand two companies'
marketing and distribution, giving them new sales opportunities. A merger can also
improve a company's standing in the investment community: bigger firms often have an
easier time raising capital than smaller ones.
That said, achieving synergy is easier said than done - it is not automatically realized once two
companies merge. Sure, there ought to be economies of scale when two businesses are
combined, but sometimes a merger does just the opposite. In many cases, one and one add up to
less than two.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal
makers. Where there is no value to be created, the CEO and investment bankers - who have
much to gain from a successful M&A deal - will try to create an image of enhanced value. The
market, however, eventually sees through this and penalizes the company by assigning it a
discounted share price. We'll talk more about why M&A may fail in a later section of this
tutorial.

Varieties of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a
few types, distinguished by the relationship between the two companies that are merging:
 Horizontal merger - Two companies that are in direct competition and share the same
product lines and markets.
 Vertical merger - A customer and company or a supplier and company. Think of a cone
supplier merging with an ice cream maker.
 Market-extension merger - Two companies that sell the same products in different
markets.
 Product-extension merger - Two companies selling different but related products in the
same market.
 Conglomeration - Two companies that have no common business areas.
There are two types of mergers that are distinguished by how the merger is financed. Each has
certain implications for the companies involved and for investors:
  Purchase Mergers - As the name suggests, this kind of merger occurs when one company
purchases another. The purchase is made with cash or through the issue of some kind of
debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger
because it can provide them with a tax benefit. Acquired assets can be written-up to the
actual purchase price, and the difference between the book value and the purchase price
of the assets can depreciate annually, reducing taxes payable by the acquiring company.
We will discuss this further in part four of this tutorial.
 Consolidation Mergers - With this merger, a brand new company is formed and both
companies are bought and combined under the new entity. The tax terms are the same as
those of a purchase merger.

Mergers and Acquisitions: Break Ups

As mergers capture the imagination of many investors and companies, the idea of getting smaller
might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive
options for companies and their shareholders.

Advantages
The rationale behind a spinoff, tracking stock or carve-out is that "the parts are greater than the
whole." These corporate restructuring techniques, which involve the separation of a business unit
or subsidiary from the parent, can help a company raise additional equity funds. A break-up can
also boost a company's valuation by providing powerful incentives to the people who work in the
separating unit, and help the parent's management to focus on core operations.

Most importantly, shareholders get better information about the business unit because it issues
separate financial statements. This is particularly useful when a company's traditional line of
business differs from the separated business unit. With separate financial disclosure, investors
are better equipped to gauge the value of the parent corporation. The parent company might
attract more investors and, ultimately, more capital.

Also, separating a subsidiary from its parent can reduce internal competition for corporate funds.
For investors, that's great news: it curbs the kind of negative internal wrangling that can
compromise the unity and productivity of a company.

For employees of the new separate entity, there is a publicly traded stock to motivate and reward
them. Stock options in the parent often provide little incentive to subsidiary managers, especially
because their efforts are buried in the firm's overall performance.

Disadvantages
That said, de-merged firms are likely to be substantially smaller than their parents, possibly
making it harder to tap credit markets and costlier finance that may be affordable only for larger
companies. And the smaller size of the firm may mean it has less representation on major
indexes, making it more difficult to attract interest from institutional investors.

Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm
divides itself into smaller units, it may be losing the synergy that it had as a larger entity. For
instance, the division of expenses such as marketing, administration and research and
development (R&D) into different business units may cause redundant costs without increasing
overall revenues.

Restructuring Methods
There are several restructuring methods: doing an outright sell-off, doing an equity carve-out,
spinning off a unit to existing shareholders or issuing tracking stock. Each has advantages and
disadvantages for companies and investors. All of these deals are quite complex.

Sell-Offs
A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally,
sell-offs are done because the subsidiary doesn't fit into the parent company's core strategy. The
market may be undervaluing the combined businesses due to a lack of synergy between the
parent and subsidiary. As a result, management and the board decide that the subsidiary is better
off under different ownership.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay
off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance
acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to
service the debt. The raiders' method certainly makes sense if the sum of the parts is greater than
the whole. When it isn't, deals are unsuccessful.

Equity Carve-Outs
More and more companies are using equity carve-outs to boost shareholder value. A parent firm
makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a
partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake
in the newly traded subsidiary.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing
faster and carrying higher valuations than other businesses owned by the parent. A carve-out
generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks
the value of the subsidiary unit and enhances the parent's shareholder value.

The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent
retains some control. In these cases, some portion of the parent firm's board of directors may be
shared. Since the parent has a controlling stake, meaning both firms have common shareholders,
the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it's doing well, but because it
is a burden. Such an intention won't lead to a successful result, especially if a carved-out
subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is
lacking an established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can
arise as managers of the carved-out company must be accountable to their public shareholders as
well as the owners of the parent company. This can create divided loyalties.
 Spinoffs
A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes
shares of the subsidiary to its shareholders through a stock dividend. Since this transaction is a
dividend distribution, no cash is generated. Thus, spinoffs are unlikely to be used when a firm
needs to finance growth or deals. Like the carve-out, the subsidiary becomes a separate legal
entity with a distinct management and board.

Like carve-outs, spinoffs are usually about separating a healthy operation. In most cases, spinoffs
unlock hidden shareholder value. For the parent company, it sharpens management focus. For the
spinoff company, management doesn't have to compete for the parent's attention and capital.
Once they are set free, managers can explore new opportunities.

Investors, however, should beware of throw-away subsidiaries the parent created to separate
legal liability or to off-load debt. Once spinoff shares are issued to parent company shareholders,
some shareholders may be tempted to quickly dump these shares on the market, depressing the
share valuation.

Tracking Stock
A tracking stock is a special type of stock issued by a publicly held company to track the value
of one segment of that company. The stock allows the different segments of the company to be
valued differently by investors.

Let's say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to
have a fast growing business unit. The company might issue a tracking stock so the market can
value the new business separately from the old one and at a significantly higher P/E rating.

Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth
business for shareholders? The company retains control over the subsidiary; the two businesses
can continue to enjoy synergies and share marketing, administrative support functions, a
headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the
parent company can use the tracking stock it owns to make acquisitions.

Still, shareholders need to remember that tracking stocks are class B, meaning they don't grant
shareholders the same voting rights as those of the main stock. Each share of tracking stock may
have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all.

Mergers and Acquisitions: Valuation Matters

Investors in a company that are aiming to take over another one must determine whether the
purchase will be beneficial to them. In order to do so, they must ask themselves how much the
company being acquired is really worth.
Naturally, both sides of an M&A deal will have different ideas about the worth of a target
company: its seller will tend to value the company at as high of a price as possible, while the
buyer will try to get the lowest price that he can. There are, however, many legitimate ways to
value companies. The most common method is to look at comparable companies in an industry,
but deal makers employ a variety of other methods and tools when assessing a target company.
Here are just a few of them:
1. Comparative Ratios - The following are two examples of the many comparative metrics
on which acquiring companies may base their offers:
o Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring
company makes an offer that is a multiple of the earnings of the target company.
Looking at the P/E for all the stocks within the same industry group will give the
acquiring company good guidance for what the target's P/E multiple should be.
o Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring
company makes an offer as a multiple of the revenues, again, while being aware
of the price-to-sales ratio of other companies in the industry.
2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the
target company. For simplicity's sake, suppose the value of a company is simply the sum
of all its equipment and staffing costs. The acquiring company can literally order the
target to sell at that price, or it will create a competitor for the same cost. Naturally, it
takes a long time to assemble good management, acquire property and get the right
equipment. This method of establishing a price certainly wouldn't make much sense in a
service industry where the key assets - people and ideas - are hard to value and develop.
3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow
analysis determines a company's current value according to its estimated future cash
flows. Forecasted free cash flows (net income + depreciation/amortization - capital
expenditures - change in working capital) are discounted to a present value using the
company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to
get right, but few tools can rival this valuation method.

Synergy: The Premium for Potential Success

For the most part, acquiring companies nearly always pay a substantial premium on the stock
market value of the companies they buy. The justification for doing so nearly always boils down
to the notion of synergy; a merger benefits shareholders when a company's post-merger share
price increases by the value of potential synergy.
Let's face it; it would be highly unlikely for rational owners to sell if they would benefit more by
not selling. That means buyers will need to pay a premium if they hope to acquire the company,
regardless of what pre-merger valuation tells them. For sellers, that premium represents their
company's future prospects. For buyers, the premium represents part of the post-merger synergy
they expect can be achieved. The following equation offers a good way to think about synergy
and how to determine whether a deal makes sense. The equation solves for the minimum

required synergy:

In other words, the success of a merger is measured by whether the value of the buyer is
enhanced by the action. However, the practical constraints of mergers, which we discuss in part
five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised
by deal makers might just fall short.
What to Look For
It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the
acquiring company. To find mergers that have a chance of success, investors should start by
looking for some of these simple criteria:
Mergers are awfully hard to get right, so investors should look for acquiring companies with a
healthy grasp of reality.

Mergers and Acquisitions: Doing The Deal

Start with an Offer
When the CEO and top managers of a company decide that they want to do a merger or
acquisition, they start with a tender offer. The process typically begins with the acquiring
company carefully and discreetly buying up shares in the target company, or building a position.
Once the acquiring company starts to purchase shares in the open market, it is restricted to
buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the
company must formally declare how many shares it owns and whether it intends to buy the
company or keep the shares purely as an investment.

Working with financial advisors and investment bankers, the acquiring company will arrive at an
overall price that it's willing to pay for its target in cash, shares or both. The tender offer is then
frequently advertised in the business press, stating the offer price and the deadline by which the
shareholders in the target company must accept (or reject) it.

The Target's Response

Once the tender offer has been made, the target company can do one of several things:

 Accept the Terms of the Offer - If the target firm's top managers and shareholders are
happy with the terms of the transaction, they will go ahead with the deal.
 Attempt to Negotiate - The tender offer price may not be high enough for the target
company's shareholders to accept, or the specific terms of the deal may not be attractive.
In a merger, there may be much at stake for the management of the target - their jobs, in
particular. If they're not satisfied with the terms laid out in the tender offer, the target's
management may try to work out more agreeable terms that let them keep their jobs or,
even better, send them off with a nice, big compensation package.

Not surprisingly, highly sought-after target companies that are the object of several
bidders will have greater latitude for negotiation. Furthermore, managers have more
negotiating power if they can show that they are crucial to the merger's future success.
 Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill
scheme can be triggered by a target company when a hostile suitor acquires a
predetermined percentage of company stock. To execute its defense, the target company
grants all shareholders - except the acquiring company - options to buy additional stock at
a dramatic discount. This dilutes the acquiring company's share and intercepts its control
of the company.
 Find a White Knight - As an alternative, the target company's management may seek
out a friendlier potential acquiring company, or white knight. If a white knight is found, it
will offer an equal or higher price for the shares than the hostile bidder.
Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two
biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would
require approval from the Federal Communications Commission (FCC). The FCC would
probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a
threat to competition in the industry.

Closing the Deal

Finally, once the target company agrees to the tender offer and regulatory requirements are met,
the merger deal will be executed by means of some transaction. In a merger in which one
company buys another, the acquiring company will pay for the target company's shares with
cash, stock or both.
A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash
payment for each share purchased. This transaction is treated as a taxable sale of the shares of the
target company.
If the transaction is made with stock instead of cash, then it's not taxable. There is simply an
exchange of share certificates. The desire to steer clear of the tax man explains why so many
M&A deals are carried out as stock-for-stock transactions.
When a company is purchased with stock, new shares from the acquiring company's stock are
issued directly to the target company's shareholders, or the new shares are sent to a broker who
manages them for target company shareholders. The shareholders of the target company are only
taxed when they sell their new shares.
When the deal is closed, investors usually receive a new stock in their portfolios - the acquiring
company's expanded stock. Sometimes investors will get new stock identifying a new corporate
entity that is created by the M&A deal.

Examples of MERGERS & ACQUISITIONS

China's Haier buying GE appliance unit for $5.4 billion
Chinese appliance maker Haier is buying General Electric Co.'s appliance unit for $5.4 billion to
expand its global presence. Haier and GE announced the sale and said they agreed to form a
strategic partnership to cooperate in areas such as the Internet, healthcare, and advanced
manufacturing. Haier, headquartered in the eastern Chinese city of Qingdao, is the world's
biggest appliance maker, with 2014 revenue of $32.6 billion. GE's sale of its appliance unit
comes in the midst of an effort by the company to shift its focus to higher-technology and
higher-profit areas such as medical equipment.

Give more examples of M&A at local and international scene.

What legal form should the business take?

One of the first things to decide when setting up a new business is the legal form that business
should take. There are essentially four basic forms that a business can operate through. These are
sole trader, partnership, limited liability partnership and limited company.
Each structure has implications in relationship to the ownership of assets, liability and taxation. It
is important that these issues are considered in conjunction with your own particular
circumstances in order to decide which structure is most suitable for your business.
The forms of business structure are considered in more detail in the business section of the
website. Below is a brief summary of each type of business structure and its characteristics.

The decision as to which structure is the most suitable for your business will depend on the type
and size of your business and your long terms plans. It can seem overwhelming with so much to
think about, but hopefully we can give you a better understanding of the options available to you
and what they all mean. Most businesses take one of five forms. And which one is right for your
business depends on what your goals are.

So if you are starting a business, it’s likely that it’ll take one of the following five forms.

Sole trader
The most basic form of business structure is that of a sole trader, whereby an individual simply
commences carrying on a business in his or her own name. There are no legal formalities to be
complied with and, as such, it can be a very cost-effective format. All income generated by the
business will be taxed as the individual's income and the individual will also bear personal
liability for the business's debts and contracts. This form is not suitable where more than one
person is involved in the ownership of the business.

This is the simplest structure, being the easiest to start up and to run. As a sole trader you will be
in business on your own, operating as self-employed and paying income tax and national
insurance contributions (NICs) based on your own net profits. If you have employees you will
also need to deduct tax and NICs from their salaries.

This type of business comes into existence when a single person decides to start doing business.
There are no formalities required to start one of these. The business and the owner are treated as
one entity for both taxes and liability. This means that first, the owner is taxed for all earnings in
the business, whether they take them out of the business or not. And second, the owner is liable
for anything that the business does. So if the business is sued or goes bankrupt, the owner’s
personal assets can be lost

As a sole trader you will be personally responsible for all liabilities of the business and the only
way that you will get credit for your business is in your own name. You are at risk of bankruptcy
if anything goes wrong and creditors can claim against your personal possessions.

Partnership
Where two or more people are involved in setting up a business a partnership is automatically
formed. It is advisable that a formal partnership agreement is drafted to regulate the relationship
between the various partners (e.g. how much money each partner puts in and how much each can
take out, which partners will be responsible for doing what and what happens if the partners fall
out.) The partnership will be taxed on the basis of each partner receiving a slice of the profits (as
determined by the partnership agreement) and paying personal income tax on that sum. Each
partner will be responsible for the actions of every other partner and will be personally liable for
all debts incurred by the business and any other obligations entered into by it.
A partnership can arise where two or more people are in business together, dividing the profits
and losses of the business between them. If you run your business through a partnership then
profits will go directly to each partner (in other words they don't accrue to the partnership first,
as happens with a company) and each of you will pay tax on your share of the profits as a self-
employed person.

A partnership is just a business entity that is owned by two or more people. They should consist
of a written agreement between the partners on how the business will be run, how profits will be
distributed, salaries, responsibilities, and how and when the business will be dissolved. But this
agreement typically exists between the partners.

Partnerships suffer the same disadvantage as sole traders in that the partners have to raise credit
in their personal capacities and they are personally liable for the debts of the
business. This liability is joint and several between the partners so if one cannot cover his share
of the debts the other partners will be responsible for them.

There are no particular requirements needed to set up a partnership, although it is recommended

that you have a Partnership Agreement at the start so that all the partners are clear on their rights
and responsibilities. In particular you ought to agree what happens if one partner leaves the
business. Like sole proprietorships, partnerships are considered pass-through entities for taxes.
The partners are taxed on business earnings. In addition, the partners are liable for the business
and their personal assets can be pursued.

Limited liability partnership

This is the same as a straightforward partnership with the exception that the partnership
agreement governing it and its annual accounts must be open for inspection by the public. This is
done by lodging the documents at Companies House. In return for this openness the partnership
can limit the liability of each individual partner to a set amount.

Limited company
A limited company has its own legal identity and is owned by its shareholders. The running of
the business by the company is governed by its Board of Directors and all income generated by
the company is subject to corporation tax as opposed to income tax. It is the company itself that
is responsible for any liabilities it incurs and the only thing its shareholders have to lose are their
shares.

{With reference to what form your business should take, explains the pro's and con's of the four
main business structures: sole trader, partnership, company and limited liability partnership?}
 CONVERTING A BUSINESS ENTITY TO ANOTHER

How to Change Your Business Entity

When you are starting a business, you select what appears to be the best structure for your
company, whether this is a corporation or an LLC. However, once the business is up and
running, what was once a shrewd decision, no longer seems the best course of action. This can
be particularly true if the business is growing rapidly and needs significant infusions of capital or
there are new tax planning strategies that can benefit the business and its owners. In these cases,
the owners may want to change from one business type to another. For example, the owners may
wish to change from a corporation to an LLC.

This process of changing formal entity types is known as a “conversion.” A conversion is a

statutory transaction in which one type of business entity becomes a different type of business
entity—such as an LLC becoming a Limited Partnership.

In a conversion, all assets, property, debts, and liabilities of the converting entity vest in the
converted entity. The converted entity is for all purposes the same entity as existed before the
conversion, just in a different form.

All state LLC Acts have provisions that permit an LLC to convert to another business entity and
authorize another business entity (such as a corporation) to convert to a limited liability
company. However, the rules vary widely from state/nations, so it is important to work with an
experienced business professional to make sure that all the statutory nuances are covered.

Tip: Although a conversion involves only one entity, it involves two state statutes—the
one governing the company’s existing business structure (e.g., an LLC), and the other
governing the entity into which it will convert (e.g., a corporation). It is important to check
both statutes—to make sure they each authorize the proposed conversion and to find out
what steps have to be taken to complete the transaction.

Steps Required for Conversion

In general, an LLC may convert to another business entity by approving a plan of conversion that
contains the terms and conditions of the conversion and the manner and basis of converting the
membership interests into interests of the converted entity. The members must approve the plan.
The vote required for approval (unanimous, two-thirds) should be set forth in the LLC’s
operating agreement. If it is not, then the default provisions of the formation state statute govern.

Tip: Converting from one entity type to another can have significant tax ramifications. Before
proceeding with a plan of conversion, it is wise to work with a tax professional who can map out
the short- and long-term consequences and help structure the transaction to maximize the savings
and minimize the risks.

Once the plan has been approved, then the converting LLC must file articles of conversion. If the
LLC is converting to another statutory entity, such as a limited partnership or a corporation, it
will have to file the appropriate formation documents for that type of business. If the company
has registered to do business outside of its formation state, then it will be necessary to file
documents with each of those states indicating that a conversion has occurred.

A similar process will apply if a corporation or other formal statutory entity wants to convert to
an LLC. The owners of the converting company must approve the plan of conversion; the
converting entity must file articles of conversion and then file the appropriate formation
documents for the new entity. And, similar procedures for each state where it is registered to do
business.

Whether you started your business as a Sole Proprietorship, an LLC or another type of business
entity, as things change, sometimes it makes sense to convert to a different type. Remember that
the process for changing your business entity varies by state. In some cases, it's necessary to
dissolve the existing business entity and then form a new one, while in other states, there's a
simplified conversion process.

Note: Changing your business entity is a significant decision that may affect your legal liability
and your taxes. You can always get free legal advice from a lawyer when you have questions
about your business.

Changing from a Sole Proprietorship to Anything Else

Since you become a sole proprietor by default when you start doing business as an individual,
you change a business entity by simply forming a new business entity and contributing capital.
For partnerships, this process can be as simple as signing a Partnership Agreement, while more
advanced business organizations, such as Corporations (including S- and C-Corporations), or
Limited Liability Companies, will require more effort and paperwork. At a minimum, Articles of
Incorporation or Organization will have to be filed with the appropriate state authorities.
Corporations must also establish Bylaws and conduct a formal meeting of shareholders, while
LLCs are often less strictly regulated.

Converting a Partnership or Limited Liability Company to a Corporation

The situation is different when you want to change a business entity from one formalized type to
another, such as when switching from a Partnership or a Limited Liability Company to a
Corporation. To accomplish this, generally you will have to form a new Corporation and then
dissolve the old business entity, but check with your registrar of companies because some allow
you to convert the business instead. The transfer of assets and liabilities from the old company to
the new one is usually done through one of the following three methods: by directly transferring
assets and liabilities from the old entity into the new Corporation, distributing assets and
liabilities to the owners who then transfer them to the new Corporation, or contributing
partnership or LLC shares to the Corporation. All three exchanges trade capital interest in the old
business for corporate stock in the current one. The old Partnership or LLC is considered
terminated upon the liquidation of its assets. Note that while the conversion is technically tax
free, gains made through the process, such as reduced liability, have to be reported and may be
taxed.

Converting a Corporation to an LLC

One of the potentially most expensive conversions is one that changes a C-Corporation into a
Limited Liability Company. The exact cost is determined by the value of company assets and
whether or not a loss is being generated. The conversion can be accomplished by dissolving the
corporation and forming an LLC with the assets of the liquidated corporation, although some
states offer a simplified conversion process. Note that any reorganization that does not liquidate
the original corporation entirely may be scrutinized by the IRS with all the consequences that
entails.

Converting a Corporation or LLC to a Partnership or Sole Proprietorship

Often, the simplest way to convert a business is to dissolve, and totally liquidate the assets of, a
corporation or LLC, distributing the assets to shareholders and/or owners. Sole proprietor status
is conferred immediately upon beginning business, while Partnership hinges on the Partnership
Agreement being signed. Check with your Secretary of State to find out the exact process,
because you may be able to convert to a different business entity instead of dissolving it in some
cases.

Considerations
Note that changing your business entity may have additional consequences. For example, if
you are running a business that requires licensing, you will have to apply for a new license for
the new business entity. Always make sure to review and comply with local and state
regulations, preferably by consulting a qualified lawyers and checking the rules with your
Secretary of State. Ask a lawyer now to get the personalized guidance you need to change your
business entity the right way. Choosing and converting to different business entities

One of the most important decisions that new business owners make is selecting their ownership
structure. When determining what type of entity will fit your business best—limited liability
company (LLC), partnership, S corporation, or C corporation—consider such factors as raising
capital, control, legal liability, and tax benefits. Also, establish a back-up plan because once you
have made your decision regarding which entity to choose, changes in ownership, tax law, or the
economy may make it necessary to convert to an entirely new type of entity.

Raising capital
An essential job for every new business owner is raising capital. S corporations and C
corporations allow for the sale of stock, which can be a quick and effective means of raising
capital. Unfortunately, S corporations have a number of constraints, including being limited to
one type of stock, having at most 100 shareholders, and restricting the type of shareholders they
can have. For partnerships and LLCs that are taxed as partnerships, they raise capital by
admitting additional partners or having current partners put more capital into the partnership.
While there is no limit on the number of partners a partnership can have, from a tax perspective,
having a partner buy into a partnership generally is more complex than a stock transaction.

Control

Another significant consideration for new owners is the amount of control they want to retain in
their business. No matter the entity, with the right amount of planning and proper organizational
documents, it can be controlled as desired. A single-member LLC or sole shareholder of an S
corporation provides 100 percent control over your entity, but if you were to bring in new
members to an LLC or add shareholders to an S corporation, you may dilute your control.
Arrangements can be made to help you retain majority ownership. S corporations sell not only
voting shares, but also nonvoting shares, which can help to mitigate any loss of control as new
members join the S corporation. Also, partnerships can write their partnership agreement in any
number of ways to ensure the control stays with the desired parties. Partners can be brought in
with a profits interest or as an equity partner.

Legal liability

Having legal protection within your new entity is a necessity and can make a business more
attractive for investors as most require some form of legal liability protection. S corporations, C
corporations, limited partnerships, and LLCs are popular because they have limited personal
liability for debts and other actions undertaken against the entity. Even though true sole
proprietorships and general partnerships expose owners to liability, it can be prevented through
proper planning.

Tax benefits

Tax benefits should not be overlooked or underestimated when organizing a new business since
each entity type has tax opportunities as well as consequences. For example, a multimember
LLC can choose to be taxed either as a partnership or as a corporation, while a single member
LLC can choose to be taxed as a C corporation, S corporation, or as a disregarded entity. S
corporations, partnerships, and LLCs taxed as partnerships are pass-through entities, which mean
they "pass through" taxable income, interest, dividends, deductions, and credits to the
shareholders or partners responsible for paying tax. This avoids the double taxation associated
with C corporations that pay entity-level taxes and then distribute dividends that are subject to
individual taxes. The following illustrates using the highest marginal federal tax rates:

Though both provide pass-through taxation, S corporations and LLCs taxed as partnerships have
slight differences in the advantages and disadvantages they offer. S corporation income is not
subject to self-employment tax because it is limited to wages that are subject to withholding,
FICA, and Medicare. This gives S corporations a small advantage over guaranteed payments
from partnerships and other partnership income subject to self-employment taxes. However, the
IRS has challenged positions where the S corporation did not pay “reasonable compensation."

Partnerships provide tax advantages by allowing more freedom with distributions, whereas S
corporation distributions are pro rata, based on ownership percentages. Partnerships also provide
flexibility to specially allocate income and loss to its members; S corporations must allocate on a
per-share, per-day basis. Partnerships and LLCs taxed as partnerships allow their partners to treat
debts in the partnership as basis, unlike an S corporation. Partners in a partnership have the
ability to use IRC section 754 to take a step-up in basis on assets when partners transfer in and
out. Using a 754 election allows new partners to have more basis in their share of partnerships
assets, thus more deductible expenses.

Entity conversions

Converting from one type of entity to another can have varying tax consequences depending on
the beginning entity and the ending entity. Some conversions may be tax-free to the owners and
the entity, but others may trigger income tax consequences. In practice, there are three main
conversion strategies: (1) converting a C corporation to an S corporation, (2) converting an LLC
to an S corporation, and (3) converting a corporation (C or S corporation) to an LLC.

Converting from a C corporation to an S corporation

Often owners of C corporations will consider converting to an S corporation. The main reason
for converting is changing from a double layer of tax to a single layer. If the corporation meets
all the requirements to elect S status described above, all shareholders must agree to change.
Although, infrequent an S corporation can become a C corporation, either because they lose their
S status or by choice.

Unlike some entity conversions, a change from a C corporation to an S corporation is not

generally subject to immediate taxation. However, the newly converted S corporation will be
subject to two different taxes: the built-in gains tax and the excess net-passive income tax. The
built-in gains tax is tax on the sale of corporate property. If you sell property in 2012 or beyond,
the built-in gains recognition period will be within 10 years of conversion. The measuring point
is the fair market value on the date of conversion less the adjusted tax basis on the date of
conversion. It is highly recommended that a corporation electing to S status obtain a valuation of
its tangible and intangible assets and have adequate documentation of its basis records. The
excess net-passive income tax applies to S corporations with earnings and profits and that have
income derived from passive sources, such as interest, dividends, and rentals. Through proper
planning, the S corporation conversion taxes often are minimized.

Converting from an LLC to an S corporation

Unlike converting from a C corporation to an S corporation, converting an LLC to an S

corporation does not create any built-in gains or excess net-passive income tax issues. It is
generally a tax-free exchange. The main advantage of converting to an S corporation relates to
the self-employment savings.

To convert to an S corporation, LLC members are recommended to contribute their LLC units to
a newly formed S corporation rather than creating a corporation underneath the LLC and then
distributing the stock or distributing operating assets to the members. This strategy helps insulate
the owners from liabilities from the business because they never had direct ownership of the
LLC assets. Additionally, this strategy eliminates the possibility of an ineligible shareholder
owning the S corporation stock (i.e., an LLC taxed as a partnership).

Converting from a C or S corporation to an LLC

The last commonly contemplated conversion is a corporation to an LLC. This strategy creates an
immediate taxable transaction at the entity level (for a C corporation) and the shareholder level
(for both a C corporation and S corporation). Most often, this form of conversion is executed
when a new purchaser of the business prefers to buy assets. Rarely will an existing owner of a
business prefer to accelerate a taxable gain in order to gain the benefits of an LLC.
If you are interested in starting a new business or changing your current business entity, contact
your Baker Tilly tax advisor to help you determine the ownership structure that is best for you.

SOURCES OF FINANCE
Introduction
It is rightly said that finance is the life-blood of business. No Business can be carried on without
source of finance. There are several sources of Finance and as such the finance has to be raised
from the right kind of source.

Sources of finance
Sources of finance can be classified into three. Security financing or External financing, internal
financing and Loan financing.
1. Security financing
This includes; Ownership securities or capital stock and Creditorship securities or debt capital

a) Ownership securities. Kinds of ownership securities are shares & include i. Equity shares ii.
Deferred shares iii. Sweat equity shares iv. Preference shares • cumulative preference shares •
Non-cumulative preference shares • Redeemable preference shares • Irredeemable preference
shares • Participating preference shares • Non-participating preference shares • Convertible
preference shares • Non-convertible preference shares.

b) Creditorship securities: Debentures just like shares, are also instruments for raising long term
finance “Debenture is a document that either creates a debt or acknowledges it, & is a debt
without collateral”. Types of debentures; 1) Simple, Naked or unsecured debentures 2) Secured
or Mortgaged debentures 3) Bearer debentures 4) Registered debentures 5) Redeemable
debentures 6) Irredeemable debentures 7) Convertible debentures 8) Zero interest Bonds/
debentures 9) Zero coupon bonds 10) First debentures and second debentures 11)Guaranteed
debentures.

2. Internal Financing
Internal Sources of Finance is Finance which is raised internally; it does not increase the debts of
the business. Examples include; Depreciation as a source of finance and Retained Earnings or
ploughing back of profit, Personal savings, Sale of unwanted assets. Sale and leaseback are some
of the examples of Internal Long-term Finance.

3. External Financing
External Sources of Finance; Finance provided by people or institutions outside the business,
creates a debt that will require payment. Examples: Loans Overdraft, Shares & Debentures.
External short-term finance includes hire purchase, overdraft. External medium term finance
include leasing.

4. Loan Financing
This includes; short term loans and credits, and term loans including medium and long term
loans.
Short term loans and credits; this includes •Indigenous banker •Trade credit •Installment credit
•Advances •Accounts receivable credit or factorings •Accrued expenses or outstanding expenses
•Deferred incomes or Income received in advance •Commercial paper •Commercial bank •Public
deposits.
Term loans also known as term finance is loan made by a bank/financial institution to a business
having an initial maturity of more than 1 yr and generally repayable in less than 10 yrs. •
Features of Term Loans• Maturity• Negotiated• Security• Covenants – Negative & Positive•
Repayment Schedule/Loan Amortization. •Specialized financial institutional bank i.e. KCB,
NBK, Corporative Bank, Equity, CFC Bank, NIC Bank, Family Bank, KWFT, AFC, Bank of
Baroda, Bank of India, Barclays, Faulu, IDBI, Exim Bank, SIDBI, SFC’s, State industrial
development corporations, LIC, GIC, UTI, Infrastructure Finance company Ltd etc •Term
financing by commercial banks.
Some other innovative sources of finance 1. Venture capital 2. Seed capital 3. Bridge finance 4.
Lease financing 5. Euro-issues.
1.Venture capital (VC) is money provided to seed early-stage, emerging and emerging growth
companies. Venture capital funds invest in companies in exchange for equity in the companies
they invest in, which usually have a novel technology or business model in high technology
industries, such as biotechnology and IT. Its Money provided by investors to startup firms and
small businesses with perceived long-term growth potential. This is a very important source of
funding for startups that do not have access to capital markets.

'Seed Capital' The initial capital used to start a business. Seed capital often comes from the
company founders' personal assets or from friends and family. The amount of money is usually
relatively small because the business is still in the idea or conceptual stage.
Seed Capital is a venture capital fund investing in medical and other technology
companies.

A bridge loan is a type of short-term loan, typically taken out for a period of 2 weeks to 3 years
pending the arrangement of larger or longer-term financing. It is usually called a bridging loan
in the United Kingdom, also known as a "caveat loan," and also known in some applications as a
swing loan. 'Bridge Financing' In investment banking terms, it is a method of financing used by
companies before their IPO, to obtain necessary cash for the maintenance of operations. Bridge
financing is designed to cover expenses associated with the IPO and is typically short-term in
nature. A bridge loan is a type of short-term loan, typically taken out for a period of 2 weeks to 3
years pending the arrangement of larger or longer-term financing. It is usually called a bridging
loan in the United Kingdom, also known as a "caveat loan," and also known in some applications
as a swing loan..

Euro issues: The Euro issues means that the issues is listed on a European stock
Exchange. A loan made or security issued in a currency outside that of its country

Sources of Short-Term Finance

Short-term Finance is needed for the day-to-day running of a business and is usually for a period
of up to 3 months. In order to understand short-term finance it is necessary to understand the
concept of cash flow. A business needs sufficient inflows of cash to finance its day-to-day
outgoings. Inflows refer to money received by the business i.e. sales revenue and grants.
Outflows are money paid out by business: examples include Purchases, Capital, Rent & Rates,
Loans, and Wages & Salaries.

Sources of Long-Term Finance

Long-term sources of finance are those that are needed over a longer period of time - generally
over a year. Its types are:-Share, Debenture, Venture Capital, Government Grant, Bank Loan
Mortgage, Owner Capital, and Internal Accrual. Long term finance may be needed for:
modernization, fund expansion projects, diversification; huge quantities reqd., irreversible
decision• Asset-liability mismatch, interest rate risk, liquidity risk.

Other Sources Of Long Term Finance• Initial Public Offer (IPO)• Securitization• Government
Subsidies/Grant• Supplier’s Credit• Private Placement• Venture Capital/ Private Equity• Bank
Loan• Mortgage
Finance Review Questions
1. Define different sources of finance. What are the Advantages and Disadvantages of
different sources of finance? Exam Q – Anne wanted to raise Ksh.6,000,000 of start-up
capital from a venture capitalist rather than arranging a bank loan. To what extent do you
agree with her?
2. “Different sources of finance have different implications for a business, so it is important
that the most appropriate method of finance is chosen for the purpose that the business
has in mind.” Discuss.
3. Why is Cash Flow Important? Think of a business as a bath without a plug… If the bath
is ever empty the business is in TROUBLE – it therefore should have a CASH FLOW,
though there will always be cash PROBLEM. If this is not the case the business needs
short-term finance to overcome its problem! Discuss.

Advantages and disadvantages of debt financing

1.1 Disadvantages of debt financing to the company
Financial risk could be to some extent affected by the gearing rate. According to David Needham
(1999, p.112), when a business has stable operating profits which is largely depending on the
nature of the industry and nature business that the company is engaging in, a low gearing rate
would result in a low financial risk while a higher gearing rate tend to contribute to a medium
financial risk; when the business has a volatile operating profit generation because of the nature
of the business, the company would still have a medium financial risk with a low gearing rate of
the company and volatile operating profit generation and a high gearing rate together make a
high financial risk. Based on this table, because high financial risk is not anticipated or desired
by the companies, the more volatile the level of business profits, the more marked with will be
the effects of gearing. Business that are heavily influenced by economic cycles, such as capital
goods suppliers would not normally wish to be highly geared, on the other hand, stable industries
such as food producers may be able to provide adequate interest cover at all stages of the
economic cycle; they are unlikely to make losses for ordinary shareholders even if highly geared.

1.2 Advantages of debt financing to the owners / shareholders

A key advantage of debt finance to the shareholder is the maintaining of the ownership and
control of the firm. If a company issue additional common stocks, then in return for the new
equity existing owners must give up a portion of their ownership and open up the election of
board members, key business decision and potentially the appointment of management to outside
investors. This trade-off can be difficult for an entrepreneur who is used to exercising control
over the business and has a strong vision for the enterprise (Seidman 2005, p.27). The loss of
control in much profitable business is very sensitive and undesirable by the owners. Hence the
debt finance is sometimes more favorable to the shareholders.

1.3 Disadvantages of debt financing to owners / shareholders

The impact of debt financing is also known as the impact of the gearing; it has impact on the
ordinary shareholder on the risk profile. If a highly geared company puts its borrowing to good
use, therefore, it will generate enough cash not only to pay the interest on the debt but also to
boost earning. However if the company get into difficulties and profit fall it still has to make the
interest payments. There may be little or even no money left over for the ordinary shareholders.
Shares of highly geared companies are a riskier investment in the sense that the returns are more
variable (Chisholm 2002, p.147). The probability of the loss of the profits is the disadvantage of
debt financing to the shareholders, the key point here is whether the shareholders have
confidence on the long term success of the companies, if the answer is yes then the beginning
loss of a project investment could be accepted by the shareholders because anticipated future
income should be able to offset the current loss.

1.4 Advantages of debt financing to the lender

One major advantage of debt financing to the lender is that the debt financing provides more
liquidity in the market. Debt finance and equity finance have different natures. Debt finance, if
the obligor has a strong financial position and reliable rating, will give the liquidity to the lender
especially if the lending instrument is marketable such as the sovereign bonds and syndication
loans. In comparison, equity finance may give access to the management but has more
involvement in the borrower’s daily operation which is more time consuming (Huang 2007).

1.5 Disadvantages of debt financing to lender

Conflicts between debt holders and shareholders arise because the debt contract gives
shareholders an incentive to invest sub-optimally. If an investment yields large returns that are
well above the face value of the debt, shareholders capture most of the gains. In addition, if an
investment turns out to be a loss, debt holders must bear the consequences. As a result,
shareholders may take on very risky projects at the expense of the debt holders (Baker & Martin
2011, p.80). This effect is also known as “asset substitution effect” and it is a defect of
approaching to the debt financing.

What is a 'Money Market'

A money market is a segment of the financial market in which financial instruments with high
liquidity and very short maturities are traded. The money market is used by participants as a
means for borrowing and lending in the short term, from several days to just under a year.
Money market securities consist of negotiable certificates of deposit (CDs), bankers
acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and
repurchase agreements (repos).

Whenever a bear market comes along, investors realize (yet again!) that the stock market is a
risky place for their savings. It's a fact we tend to forget while enjoying the returns of a bull
market! Unfortunately, this is part of the risk-return tradeoff. To get higher returns, you have to
take on a higher level of risk. For many investors, a volatile market is too much to stomach - the
money market offers an alternative to these higher-risk investments.
The money market is better known as a place for large institutions and government to manage
their short-term cash needs. However, individual investors have access to the market through a
variety of different securities. In this tutorial, we'll cover various types of money market
securities and how they can work in your portfolio.
 Money Market
The money market is a subsection of the fixed income market. We generally think of the term
fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income
security. The difference between the money market and the bond market is that the money
market specializes in very short-term debt securities (debt that matures in less than one year).
Money market investments are also called cash investments because of their short maturities.

Money market securities are essentially IOUs issued by governments, financial institutions and
large corporations. These instruments are very liquid and considered extraordinarily safe.
Because they are extremely conservative, money market securities offer significantly lower
returns than most other securities.

One of the main differences between the money market and the stock market is that most money
market securities trade in very high denominations. This limits access for the individual investor.
Furthermore, the money market is a dealer market, which means that firms buy and sell
securities in their own accounts, at their own risk. Compare this to the stock market where a
broker receives commission to acts as an agent, while the investor takes the risk of holding the
stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange.
Deals are transacted over the phone or through electronic systems.

The easiest way for us to gain access to the money market is with a money market mutual
funds, or sometimes through a money market bank account. These accounts and funds pool
together the assets of thousands of investors in order to buy the money market securities on their
behalf. However, some money market instruments, like Treasury bills, may be purchased
directly. Failing that, they can be acquired through other large financial institutions with direct
access to these markets.

There are several different instruments in the money market, offering different returns and
different risks. In the following sections, we'll take a look at the major money market
instruments.

Money Market: Treasury Bills (T-Bills)

Treasury Bills (T-bills) are the most marketable money market security. Their popularity is
mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise
money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government,
but many other governments issue T-bills in a similar fashion.

T-bills are short-term securities that mature in one year or less from their issue date. They are
issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that
is less than their par (face) value; when they mature, the government pays the holder the full par
value. Effectively, your interest is the difference between the purchase price of the security and
what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until
maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay
interest semi-annually.

Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at
auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively
or competitively. In non-competitive bidding, you'll receive the full amount of the security you
want at the return determined at the auction. With competitive bidding, you have to specify the
return that you would like to receive. If the return you specify is too high, you might not receive
any securities, or just a portion of what you bid for.

The biggest reasons that T-Bills are so popular is that they are one of the few money market
instruments that are affordable to the individual investors. T-bills are usually issued in
denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other
positives are that T-bills (and all Treasuries) are considered to be the safest investments in the
world because the U.S. government backs them. In fact, they are considered risk-free.
Furthermore, they are exempt from state and local taxes.

The only downside to T-bills is that you won't get a great return because Treasuries are
exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often
give higher rates of interest. What's more, you might not get back all of your investment if you
cash out before the maturity date.

Money Market: Certificate Of Deposit (CD)

A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by
commercial banks but they can be bought through brokerages. They bear a specific maturity date
(from three months to five years), a specified interest rate, and can be issued in any
denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on
demand like those in a checking account.

CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a
bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the
amount of interest you earn depends on a number of other factors such as the current interest rate
environment, how much money you invest, the length of time and the particular bank you
choose. While nearly every bank offers CDs, the rates are rarely competitive, so it's important to
shop around.

A fundamental concept to understand when buying a CD is the difference between annual

percentage yield (APY) and annual percentage rate (APR). APY is the total amount of
interest you earn in one year, taking compound interest into account. APR is simply the stated
interest you earn in one year, without taking compounding into account.

The difference results from when interest is paid. The more frequently interest is calculated, the
greater the yield will be. When an investment pays interest annually, its rate and yield are the
same. But when interest is paid more frequently, the yield gets higher. For example, say you
purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you'll receive an
interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding
starts. The $25 payment starts earning interest of its own, which over the next six months
amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%, but its yield is
5.06. It may not sound like a lot, but compounding adds up over time.

The main advantage of CDs is their relative safety and the ability to know your return ahead of
time. You'll generally earn more than in a savings account, and you won't be at the mercy of the
stock market. Plus, in the U.S. the Federal Deposit Insurance Corporation guarantees your
investment up to $100,000.

Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry
compared to many other investments. Furthermore, your money is tied up for the length of the
CD and you won't be able to get it out without paying a harsh penalty.

Money Market: Commercial Paper

For many corporations, borrowing short-term money from banks is often a laborious and
annoying task. The desire to avoid banks as much as possible has led to the widespread
popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by
a corporation, typically for financing accounts receivable and inventories. It is usually issued at
a discount, reflecting current market interest rates. Maturities on commercial paper are usually
no longer than nine months, with maturities of between one and two months being the average.

For the most part, commercial paper is a very safe investment because the financial situation of a
company can easily be predicted over a few months. Furthermore, typically only companies with
high credit ratings and credit worthiness issue commercial paper. Over the past 40 years, there
have only been a handful of cases where corporations have defaulted on their commercial paper
repayment. Commercial paper is usually issued in denominations of $100,000 or more.
Therefore, smaller investors can only invest in commercial paper indirectly through money
market funds.

Breaking down 'Money Market'

The money market is used by a wide array of participants, from a company raising money by
selling commercial paper into the market to an investor purchasing CDs as a safe place to park
money in the short term. The money market is typically seen as a safe place to put money due
the highly liquid nature of the securities and short maturities, but there are risks in the market
that any investor needs to be aware of including the risk of default on securities such as
commercial paper.

The International Money Market

A money market is one of the safest financial markets available for currency transactions. It is
often used by the big financial institutions, large corporations, and national governments. The
investments made in money markets are usually for a very short period of time and therefore
they are commonly known as cash investments.
The international money market is a market where international currency transactions between
numerous central banks of countries are carried on. The transactions are mainly carried out using
gold or in US dollar as a base. The basic operations of the international money market include
the money borrowed or lent by the governments or the large financial institutions.

The International Monetary Market (IMM) was introduced in December 1971 and formally
implemented in May 1972, although its roots can be traced to the end of Bretton Woods through
the 1971 Smithsonian Agreement and Nixon's suspension of U.S. dollar's convertibility to gold.
The IMM Exchange was formed as a separate division of the Chicago Mercantile Exchange, and
as of 2009, was the second largest futures exchange in the world. The primary purpose of the
IMM is to trade currency futures, a relatively new product previously studied by academics as a
way to open a freely traded exchange market to facilitate trade among nations.

The first futures experimental contracts included trades against the U.S. dollar such as the
British pound, Swiss franc, German deutschmark, Canadian dollar, Japanese yen and in
September 1974, the French franc. This list would later expand to include the Australian dollar,
the euro, emerging market currencies such as the Russian ruble, Brazilian real, Turkish lira,
Hungarian forint, Polish zloty, Mexican peso and South African rand. In 1992, the German
deutschmark/Japanese yen pair was introduced as the first futures cross rate currency. But these
early successes didn't come without a price.

The international money market is governed by the transnational monetary transaction policies of
various nations’ currencies. The international money market’s major responsibility is to handle
the currency trading between the countries. This process of trading a country’s currency with
another one is also known as forex trading.

Unlike share markets, the international money market sees very large funds transfer. The players
of the market are not individuals; they are very big financial institutions. The international
money market investments are less risky and consequently, the returns obtained from the
investments are less too. The best and most popular investment method in the international
money market is via money market mutual funds or treasury bills.

Note − The international money market handles huge sums of international currency trading on a
daily basis. The Bank for International Settlements has revealed that the daily turnover of a
traditional exchange market is about $1880 billion.
Some of the major international money market participants are −
 Citigroup
 Deutsche Bank
 HSBC
 Barclays Capital
 UBS AG
 Royal Bank of Scotland
 Bank of America
 Goldman Sachs
 Merrill Lynch
 JP Morgan Chase
The international money market keeps track of the exchange rates between currency- pairs on a
regular basis. Currency bands, fixed exchange rate, exchange rate regime, linked exchange rates,
and floating exchange rates are the common indices that govern the international money market
in a subtle manner.

The Drawbacks of Currency Futures

The challenge of the IMM was in connecting the values of IMM foreign exchange contracts to
the interbank market, which is the prominent means of currency trading in the 1970s. The other
aspect was how to allow the IMM to become the best and a free-floating exchange.

To contain these aspects, clearing member-firms were allowed to act as the arbitrageurs between
central banks and the IMM to allow orderly markets between the bid and ask spreads. Later on,
the Continental Bank of Chicago was incorporated as a delivery agent for contracts. These initial
successes led to fierce competition for new futures products.

The Chicago Board Options Exchange was a competitor. It had received the right to trade US 30-
year bond futures while the IMM obtained the official right to trade Eurodollar contracts. The
Eurodollars were a 90-day interest rate contract settled in cash and not in any physical delivery.

Eurodollars later became the "Eurocurrency Market," which were mainly used by the
Organization for Petroleum Exporting Countries (OPEC). OPEC required payment for oil in US
dollars. This cash settlement aspect later introduced index futures known as IMM Index. Cash
settlements also allowed the IMM to later known as a "cash market" because the trades were
interest rate sensitive instruments of short-term.

A System for Transactions

As competition grew, a transaction-system to handle the transactions in IMM was required. The
CME and Reuters Holdings introduced Post Market Trade (PMT) for worldwide electronic
automated transactions. The system became the single clearing entity to link the major financial
centers like Tokyo and London.

Now, PMT is called Globex, which deals not only in clearing but also in electronic trading for
traders around the world. In 1976, US T-bills began trading on the IMM. T-bill futures were
introduced in April 1986 that was approved by the Commodities Futures Trading Commission.

Financial Crises and Liquidity

In financial crises, central banks need to provide liquidity to stabilize markets, as risks may trade
at premiums (money rates) to a bank's target rates. Central bankers then need to infuse liquidity
to the banks that trade and control rates. These are known as repo rates, and these are traded via
IMM. Repo markets allow the participating banks to offer rapid refinancing in the interbank
market that is independent of any credit limits to smoothen the market. A borrower has to pledge
for securitized assets, such as equity, in exchange for cash to allow its operations to continue.

The Drawbacks of Currency Futures

The challenging aspects were how to connect values of IMM foreign exchange contracts to the
interbank market - the dominant means of currency trading in the 1970s - and how to allow the
IMM to be the free-floating exchange envisioned by academics. Clearing member firms were
incorporated to act as arbitrageurs between banks and the IMM to facilitate orderly markets
between bids and ask spreads. The Continental Bank of Chicago was later hired as a delivery
agent for contracts. These successes bred an unforeseen level of competition for new futures
products.

The Chicago Board Options Exchange competed and received the right to trade U.S. 30-year
bond futures while the IMM secured the right to trade eurodollar contracts, a 90 day interest rate
contract settled in cash rather than physical delivery. Eurodollars came to be known as the
"eurocurrency market," which is used mainly by the Organization for Petroleum Exporting
Countries (OPEC), which always required payment for oil in U.S. dollars. This cash settlement
aspect would later pave the way for index futures such as world stock market indexes and the
IMM Index. Cash settlement would also allow the IMM to later become known as a "cash
market" because of its trade in short-term, interest rate sensitive instruments.

A System for Transactions

With new competition, a transaction system was desperately needed. The CME and Reuters
Holdings created the Post Market Trade (PMT) to allow a global electronic automated
transaction system to act as a single clearing entity and link the world's financial centers like
Tokyo and London. Today, PMT is known as Globex, which facilitates not only clearing but
electronic trading for traders around the world. In 1975, U.S. T-bills were born and began
trading on the IMM in January 1976. T-bill futures began trading in April 1986 with approval
from the Commodities Futures Trading Commission.

The Rise of the Forex Market

The real success would come in the mid 1980s when options began trading on currency futures.
By 2003, foreign exchange trading had hit a notional value of $347.5 billion. The 1990s were a
period of explosive growth for the IMM due to three world events:
1. Basel I in July 1988
The 12 nation European Central Bank governors agreed to standardize guidelines for
banks. Bank capital had to be equal to 4% of assets.
2. 1992 Single European Act
This not only allowed capital to flow freely throughout national borders but also allowed
all banks to incorporate in any EU nation.
3. Basel II
This is geared to control risk by preventing losses, the realization of which is still a work
in progress.

A bank's role is to channel funds from depositors to borrowers. With these news acts, depositors
could be governments, governmental agencies and multinational corporations. The role for
banks in this new international arena exploded in order to meet the demands of financing capital
requirements, new loan structures and new interest rate structures such as overnight lending
rates; increasingly, IMM was used for all finance needs.

Plus, a whole host of new trading instruments was introduced such as money market swaps to
lock in or reduce borrowing costs, and swaps for arbitrage against futures or hedge risk.
Currency swaps would not be introduced until the 2000s. (Find out how tools magnify your
gains and losses.

Financial Crises and Liquidity

In financial crisis situations, central bankers must provide liquidity to stabilize markets because
risk may trade at premiums to a bank's target rates, called money rates, that central bankers can't
control. Central bankers then provide liquidity to banks that trade and control rates. These are
called repo rates, and they are traded through the IMM. Repo markets allow participants to
undertake rapid refinancing in the interbank market independent of credit limits to stabilize the
system. A borrower pledges securitized assets such as stocks in exchange for cash to allow its
operations to continue.

Asian Money Markets and the IMM

Asian money markets linked up with the IMM because Asian governments, banks and
businesses needed to facilitate business and trade in a faster way rather than borrowing U.S.
dollar deposits from European banks. Asian banks, like European banks, were saddled with
dollar-denominated deposits because all trades were dollar-denominated as a result of the U.S.
dollar's dominance. So, extra trades were needed to facilitate trade in other currencies,
particularly euros. Asia and the E.U. would go on to share not only an explosion of trade but
also two of the most widely traded world currencies on the IMM. For this reason, the Japanese
yen is quoted in U.S. dollars, while eurodollar futures are quoted based on the IMM Index, a
function of the three-month LIBOR.

The IMM Index base of 100 is subtracted from the three-month LIBOR to ensure that bid prices
are below the ask price. These are normal procedures used in other widely traded instruments on
the IMM to insure market stabilization.

Final Notes
As of June 2000, the IMM switched from a nonprofit to a profit, membership and shareholder-
owned entity. It opens for trading at 8:20 Eastern Time to reflect major U.S. economic releases
reported at 8:30am. Banks, central bankers, multinational corporations, traders, speculators and
other institutions all use its various products to borrow, lend, trade, profit, finance, speculate and
hedge risks.

CAPITAL MARKETS

The Nature and Role of Financial Markets and Institutions

what is money?
In general money is anything accepted as payment for goods and services or repayment of debts.
In a developed environment money has two main components; 1) notes and coins and 2) banks
deposits.

 A medium of exchange: Money can be exchanged for other assets.

 A store of wealth: Money can be used for savings.
 A unit of value: Asset can be valued as an amount of money.

Explain how is it that banks have the power to create new money (new spending power in
the economy)?
Banks lend money to customers, not necessarily money they have borrowed or money the
customer deposited – they create new money- but in order to do this they must have reserves.
This is why bank runs result in bank failures.

What are Capital Markets?

Capital markets are markets where financial instruments are traded. There are two types of
instruments traded on two separate markets. There is the stock market where share of companies
are traded and the bond market where bonds are traded. Each market has two separate
operations; the primary market where new issues are traded and the secondary market where
existing stocks or bonds are traded. The secondary market is the exit route for persons who have
bought securities in primary market.

What is a Bond?
 Bonds are debt securities
 This is where the issuer issues the bond to the lender
 It is a contract that specifies the rate of interest and the repayment terms
What are Money Markets?
The money market is a market for short term borrowing and lending, and trade of financial
instruments.
Global markets
The Capital Market and the Money Market are global markets. Government and Companies can
trade freely on these markets. Individual countries have their own stock markets or financial
centers where these activities take place.

What is Financial Intermediation?

Financial intermediation is a system whereby a financial institution/person mediates between two
other institutions/persons in order to facilitate a transaction. Banks are examples of financial
intermediaries an Institution may wish to lend money to another Institution using the Bank to
facilitate the transaction.
What are the functions of a Financial Intermediary?
There may be a situation where there are many lenders who all wish to lend different relatively
small amounts of money for different periods of time. On the other hand there may be a situation
where there are few borrowers who all want to borrow large sums of money for a fixed period of
time thus a financial intermediary can thus be seen to perform the following functions:
 Borrowing varying amounts of money from lenders and reform them into an amount suitable
for the final borrower
 Borrowing various amounts of money with different maturity dates and reform them into an
amount with a maturity suitable for the final borrower
What are the advantages of financial intermediaries in an economy?
 Lenders do not have to search the markets for suitable borrowers
 Borrows do not have to search for lenders
 Risk is reduced for lenders because the intermediary bears the risk
 The system allows for flexibility because lenders are able to vary the terms on which they have
lent to the intermediary without the intermediary or final borrower being disadvantage.

Capital markets are financial markets for the buying and selling of long-term debt or equity-
backed securities. These markets channel the wealth of savers to those who can put it to long-
term productive use, such as companies or governments making long-term investments. Capital
markets are defined as markets in which money is provided for periods longer than a year.

A financial market that works as a conduit for demand and supply of debt and equity capital. It
channels the money provided by savers and depository institutions (banks, credit unions,
insurance companies, etc.) to borrowers and investees through a variety of financial instruments
(bonds, notes, shares) called securities. A capital market is not a compact unit, but a highly
decentralized system made up of three major parts: (1) stock market, (2) bond market, and (3)
money market. It also works as an exchange for trading existing claims on capital in the form of
shares.

Capital markets are markets for buying and selling equity and debt instruments. Capital markets
channel savings and investment between suppliers of capital such as retail investors and
institutional investors, and users of capital like businesses, government and individuals. Capital
markets are vital to the functioning of an economy, since capital is a critical component for
generating economic output. Capital markets include primary markets, where new stock and
bond issues are sold to investors, and secondary markets, which trade existing securities.

The difference between a capital market and the stock market

Capital market is a broader term that includes the stock market and other venues for trading
financial products. The stock market allows investors and banking institutions to trade stocks,
either publicly or privately. Stocks are financial instruments that represent partial ownership of a
company. These documents are used extensively by companies as a means of raising necessary
capital. Within the stock market itself are primary and secondary markets that trade among banks
underwriting stock and public investors trading stock, respectively. Capital markets may trade in
other financial securities including bonds, derivative contracts such as options, various loans and
other debt instruments, and commodity futures. Other financial instruments may be sold in
capital markets and these products are becoming increasingly sophisticated. Some capital
markets are available to the public directly while others are closed to everyone except large
institutional investors. Private trade, mostly between large institutions with high-volume trades,
occurs via secured computer networks at very high speeds. These market all trade financial
securities, so they are all capital markets. The stock market is a very significant portion of the
total volume of capital market trades.

The stock market has several very popular markets available for public trading. The Nasdaq,
Dow Jones, and the S&P 500 trade in considerable volume every day within the United States
and are the most significant stock markets. Other countries have popular stock markets, such as
the Nikkei 225 in Japan. Each market has specific times during the day when it remains open. By
trading through different markets, it is possible for investors to actively trade stocks throughout
the day.

BREAKING DOWN 'Capital Markets'

Capital markets are a broad category of markets facilitating the buying and selling of financial
instruments. In particular, there are two categories of financial instruments that capital in which
markets are involved. These are equity securities, which are often known as stocks, and debt
securities, which are often known as bonds. Capital markets involve the issuing of stocks and
bonds for medium-term and long-term durations, generally terms of one year or more.

Capital markets are overseen by CMA & the Securities and Exchange Commission in the United
States or other financial regulators elsewhere. Though capital markets are generally concentrated
in financial centers around the world, most of the trades occurring within capital markets take
place through computerized electronic trading systems. Some of these are accessible by the
public and others are more tightly regulated.

Other than the distinction between equity and debt, capital markets are also generally divided
into two categories of markets, the first of which being primary markets. In primary markets,
stocks and bonds are issued directly from companies to investors, businesses and other
institutions, often through underwriting. Primary markets allow companies to raise capital
without or before holding an initial public offering so as to make as much direct profit as
possible. After this point in a company’s development, it may choose to hold an initial public
offering so as to generate more liquid capital. In such an event, the company will generally sell
its shares to a few investment banks or other firms.

At this point the shares move into the secondary market, which is where investment banks, other
firms, private investors and a variety of other parties resell their equity and debt securities to
investors. This takes place on the stock market or the bond market, which take place on
exchanges around the world, like the New York Stock Exchange or NASDAQ; though it is often
done through computerized trading systems as well. When securities are resold on the secondary
market, the original sellers do not make money from the sale. Yet, these original sellers will
likely continue to hold some amount of stake in the company, often in the form of equity, so the
company’s performance on the secondary market will continue to be important to them.

Capital markets have numerous participants including individual investors, institutional investors
such as pension funds and mutual funds, municipalities and governments, companies and
organizations, banks and financial institutions. While many different kinds of groups, including
governments, may issue debt through bonds (these are called government bonds), governments
may not issue equity through stocks. Suppliers of capital generally want the maximum possible
return at the lowest possible risk, while users of capital want to raise capital at the lowest
possible cost.

The size of a nation’s capital markets is directly proportional to the size of its economy. The
United States, the world’s largest economy, has the largest and deepest capital markets. Because
capital markets move money from people who have it to organizations who need it in order to be
productive, they are critical to a smoothly functioning modern economy. They are also
particularly important in that equity and debt securities are often seen as representative of the
relative health of markets around the world.

On the other hand, because capital markets are increasingly interconnected in a globalized
economy, ripples in one corner of the world can cause major waves elsewhere. The drawback of
this interconnection is best illustrated by the global credit crisis of 2007-09, which was triggered
by the collapse in U.S. mortgage-backed securities. The effects of this meltdown were globally
transmitted by capital markets since banks and institutions in Europe and Asia held trillions of
dollars of these securities.

Capital Market History - Capital Market Efficiency

An important debate among stock market investors is whether the market is efficient - that is,
whether it reflects all the information made available to market participants at any given time.
The Efficient Market Hypothesis (EMH) maintains that all stocks are perfectly priced according
to their inherent investment properties, the knowledge of which all market participants possess
equally. At first glance, it may be easy to see a number of deficiencies in the efficient market
theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to
explore its relevancy in the modern investing environment.

Behavioral Finance

Financial theories are subjective. In other words, there are no proven laws in finance, but rather
ideas that try to explain how the market works. Here we'll take a look at where the efficient
market theory has fallen short in terms of explaining the stock market's behavior.

EMH Tenets and Problems with EMH – Assumptions of EMH

First, the efficient market hypothesis assumes that all investors perceive all available information
in precisely the same manner. The numerous methods for analyzing and valuing stocks pose
some problems for the validity of the EMH. If one investor looks for undervalued market
opportunities while another investor evaluates a stock on the basis of its growth potential, these
two investors will already have arrived at a different assessment of the stock's fair market value.
Therefore, one argument against the EMH points out that since investors value stocks differently,
it is impossible to ascertain what a stock should be worth in an efficient market.

Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater
profitability than another with the same amount of invested funds: their equal possession of
information means they can only achieve identical returns. But consider the wide range of
investment returns attained by the entire universe of investors, investment funds and so forth. If
no investor had any clear advantage over another, would there be a range of yearly returns in the
mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if
one investor is profitable, it means the entire universe of investors is profitable, isn’t the case in
reality.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no
investor should ever be able to beat the market, or the average annual returns that all investors
and funds are able to achieve using their best efforts. This idea would naturally imply, as many
market experts often maintain, that the absolute best investment strategy is simply to place all of
one's investment funds into an index fund, which would increase or decrease according to the
overall level of corporate profitability or losses.

Qualifying the EMH

Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of
course, it's impossible for the market to attain full efficiency all the time, as it takes time for
stock prices to respond to new information released into the investment community. The efficient
hypothesis, however, does not give a strict definition of how much time prices need to revert to
fair value. Moreover, under an efficient market, random events are entirely acceptable but will
always be ironed out as prices revert to the norm.
It is important to ask whether EMH undermines itself in its allowance for random occurrences or
environmental eventualities. There is no doubt that such eventualities must be considered under
market efficiency but, by definition, true efficiency accounts for those factors immediately. In
other words, prices should respond nearly instantaneously with the release of new information
that can be expected to affect a stock's investment characteristics. So, if the EMH allows for
inefficiencies, it may have to admit that absolute market efficiency is impossible.

Increasing Market Efficiency?

Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance
may actually be growing. With the rise of computerized systems to analyze stock investments,
trades and corporations, investments are becoming increasingly automated on the basis of strict
mathematical or fundamental analytical methods. Given the right power and speed, some
computers can immediately process any and all available information, and even translate it into
execution.
Despite the increasing use of computers, most decision-making is still done by human beings and
is therefore subject to human error. Even at an institutional level, the use of analytical machines
is anything but universal. While the success of stock market investing is based mostly on the
skill of individual or institutional investors, people will continually search for the surefire
method of achieving greater returns than the market averages.

If the EMH is accurate, however, it would have the following implications for investors:

EMH and Technical Analysis

Technical analysis bases decisions on past results. EMH, however, believes past results cannot
be used to outperform the market. As a result, EMH negates the use of technical analysis as a
means to generate investment returns.

With respect to fundamental analysis, the EMH also states that all publicly available information
is reflected in security prices and as such, abnormal returns are not achievable through the use of
this information. This negates the use of fundamental analysis as a means to generate investment
returns.

EMH and the Portfolio Management Process

As we have discussed, the portfolio management process begins with an investment policy
statement, including an investor's objectives and constraints. Given EMH, the portfolio
management process should not focus on achieving above-average returns for the investor. It
should focus purely on risks given that above-average returns are not achievable. A portfolio
manager's goal is to outperform a specific benchmark with specific investment ideas. The EMH
implies that this goal is unachievable, and a portfolio manager should not be able to achieve
above average returns.

Why Invest in Index Funds?

Given the discussion on the EMH, the overall assumption is that no investor is able to generate
an abnormal return in the market. If that is the case, an investor can expect to make a return
equal to the market return. An investor should thus focus on the minimizing his costs to invest.
To achieve a market rate of return, diversification in a numerous amounts of stocks is required,
which may not be an option for a smaller investor. As such, an index fund would be the most
appropriate investment vehicle, allowing the investor to achieve the market rate of return in a
cost effective manner.

Is The Market Truly Efficient?

It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater
efficiency to occur, the following criteria must be met: (1) universal access to high-speed and
advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing
stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the
willingness of all investors to accept that their returns or losses will be exactly identical to all
other market participants. It is hard to imagine even one of these criteria of market efficiency
ever being met.

THE ROLE OF CAPITAL MARKET IN AN ECONOMY

Capital market is defined as the market where medium and long terms finance can be raised
(Akingbohungbe, 1996). Capital market offers a variety of financial instruments that enable
economic agents to pool, price and exchange risk. Through assets with attractive yields, liquidity
and risk characteristics, it encourages saving in financial form. This is very essential for
government and other institutions in need of long term funds (Nwankwo, 1999). According to Al-
Faki (2006), the capital market is a network of specialized financial institutions, series of
mechanism, processes and infrastructure that, in various ways facilitate the bringing together of
suppliers and users of medium to long term capital for investment in economic developmental
project”.

Taking into account the role in the market economy, the capital market occupies an important
place, through their specific mechanisms, succeeding to give its contribution to the economic
development of the society. In consequence, the public authorities must notice the importance of
the capital market in the national economy and, on the other hand, to make the efforts for
insuring the necessary framework for the normal functioning of its specific mechanisms. The
valences of the capital could be even more interesting in the case of emerging markets being
well-known its contribution in reorienting financial resources to efficient activities, contributing
to the economic reform, but also being interesting in the privatization process.

Again the capital market was instrumental to the initial twenty five Banks that were able to meet
the minimum capital requirement of N25 billion during the banking sector consolidation in 2005.
The stock market has helped government and corporate entities to raise long term capital for
financing new projects, and expanding and modernizing industrial/commercial concerns
(Nwankwo, 1991).

Introduction
Economic growth in a modern economy hinges on an efficient and effective financial sector that
pools domestic savings and mobilizes capital for productive projects. Absence of effective
capital market could leave most productive projects which carry developmental agenda
unexploited. Capital market connects the monetary sector with the real sector and therefore
facilitates growth in the real sector and economic development.

The fundamental channels through which capital market is connected to the economy, economic
growth and development can be outlined as follows:

The contact between agents with deficit of money and the ones with monetary surplus can take
place in a direct way (direct financing), but also by the means of any financial intermediation
form (indirect financing), situation in which specific operators realize the connection between
the real economy and the financial market. In this case, the financial intermediaries could be
banks, investment funds, pension funds, insurance companies or other non-bank financial
institutions.
Even if, traditionally, the companies appeared only as agents with deficit of money, in the last
two or three decades it could be noticed a change in the financial behavior of the modern firms:
these are not considering anymore the financial market (both the capital and the monetary
market) only as sources for rising funds (as issuers of financial assets), but appears more often as
buyers of financial assets. The capital market fulfills the transfer function of current purchasing
power, in monetary form, from companies which have a surplus of funds to those which have a
deficit, in exchange for reimbursing a greater purchasing power in the future; in this way the
capital market makes possible to separate the saving act from the investment one. Capital market
has played major roles during the privatization of public owned enterprises, recent
recapitalization of the banking sector and avenue of long term funds to various government
agencies and companies in Nigeria.

Capital market increases the proportion of long-term savings (pensions, funeral covers, etc.) that
is channeled to long-term investment. Capital market enables contractual savings industry
(pension and provident funds, insurance companies, medical aid schemes, collective investment
schemes, etc.) to mobilize long-term savings from small individual household and channel them
into long-term investments. It fulfills the transfer function of current purchasing power, in
monetary form, from surplus sectors to deficit sectors, in exchange for reimbursing a greater
purchasing power in future. In this way, capital market enables corporations to raise
capital/funds to finance their investment in real assets.

The implication will be an increase in productivity within the economy leading to more
employment, increase in aggregate consumption and hence growth and development. It also
helps in diffusing stresses on the banking system by matching long-term investments with long-
term capital. It encourages broader ownership of productive assets by small savers. It enables
them to benefit from economic growth and wealth distribution, and provides avenues for
investment opportunities that encourage a thrift culture critical in increasing domestic savings
and investment ratios that are essential for rapid industrialization.

In addition, the capital market mechanism allows not only an efficient allocation of the financial
resources available at a certain moment in an economy – from the market’s point of view – but
also permits to allot funds according the return and the risk – from the investor’s point of view –
offering a large variety of financial instruments with different profitableness-risk characteristics,
suitable for saving or risk covering. Nowadays, the protection against financial risks becomes a
necessity, imposed by the transformations in the global economy, by the accented instability and
the financial crisis that affects without discrimination both developed and emerging stock
markets.

Covering the risk, that could be realized by the help of different operations, market orders or
derivatives, defines the function of insurance against risks, specific function of the capital
markets. The capital market allows risk dispersion between investors (of the diversifiable risk),
exactly in the same measure in which each of them is willing to assume it, too.

From the issuers’ point of view, the money which is necessary for the development or the
unfolding of their activity can be mobilized by the help of the capital market at accessible costs,
theoretically speaking smaller than those possibly obtained by the help of the banks or by other
financial intermediaries.

Capital market also provides equity capital and infrastructure development capital that has strong
socio-economic benefits through development of roads, water and sewer systems, housing,
energy, telecommunications, public transport, etc. These projects are ideal for financing through
capital market via long dated bonds and asset backed securities. Infrastructure development is a
necessary condition for long-term sustainable growth and development. In addition, capital
market increases the efficiency of capital allocation by ensuring that only projects which are
deemed profitable and hence successful attract funds. This will, in turn, improve competitiveness
of domestic industries and enhance ability of domestic industries to compete globally, given the
current momentum towards global integration. The result will be an increase in domestic
productivity which may spill over into an increase in exports and, therefore, economic growth
and development.

Moreover, capital market promotes public-private sector partnerships to encourage participation

of private sector in productive investments. The need to shift economic development from public
to private sector to enhance economic productivity has become inevitable as resources continue
to diminish. It assists the public sector to close resource gap, and complement its effort in
financing essential socio-economic development, through raising long-term project based capital.
It also attracts foreign portfolio investors who are critical in supplementing the domestic savings
levels. It facilitates inflows of foreign financial resources into the domestic economy.

Recent empirical research linking capital market development and economic growth suggests
that capital market enhances economic growth and development. Countries with well-developed
capital markets experience higher economic growth than countries without. Evidence indicates
that, while most capital markets in African countries are relatively underdeveloped, those
countries which introduced reforms that are geared towards development of capital markets have
been able to grow at relatively higher and sustainable rates. A study in 2011 showed that South
Africa, the country whose capital market is the largest and most developed in Africa, in terms of
market capitalization and trading volume, has been growing significantly since 2000.

Its average per capita real GDP over the last 8 years has been at 3.2 %. Countries like Egypt,
Ghana, Tanzania, Botswana and Mauritius, whose capital markets have been developing
recently, were able to realize average per capita growth rates of more than 2.8% for the past 8
years. However, some economies which did not have formal or effective capital market like
Lesotho, Seychelles and Ethiopia could not manage to realize average per capita growth rates
above 2.7 % over the past 8 years. Even those countries with small and less developed capital
market like Swaziland and Uganda did not manage to realize average per capita growth rates
above 2.7 % during the past 8 years (CBL Economic Review, August 2009, No. 109).

The role of capital markets is vital for inclusive growth in terms of wealth distribution and
making capital safer for investors. Capital markets can create greater financial inclusion by
introducing new products and services tailored to suit investors’ preference for risk and return as
well as borrowers’ project needs and risk appetite. Innovation, credit counseling, financial
education and proper segment identification constitute the possible strategies to achieve this.
A well-developed capital market creates a sustainable low-cost distribution mechanism for
multiple financial products and services across the country. This writing has sought to
demonstrate an important role played by capital market in economic growth and development.
Capital market enhances efficient financial intermediation. It increases mobilization of savings
and therefore improves efficiency and volume of investments, economic growth and
development.

Capital markets, their structure, and their function.

Capital markets provide a wide range of products and services that are related to financial
investments. Capital markets include the stock market, commodities exchanges, the bond market,
and just about any physical or virtual service or intermediary where debt and equity securities
can be bought or sold. Their primary purpose is to raise funds and channel investors’ money to
areas where there is a deficit or need for investment. They play a vital role as intermediaries
between governments and companies, which use them to finance a myriad of activities.

The capital markets can be broken down into the primary market, where new stocks and bonds
are issued to investors, and the secondary market, where existing stocks and bonds are traded.

In the primary market, governments, companies, or public sector organizations can obtain
funding through the sale of a new stock or bonds. These are normally issued through securities
dealers and banks, which underwrite the offered stocks or bonds. The issuers earn a commission,
which is built into the price of the security offering.

In the secondary market, stocks and shares in publicly traded companies are bought and sold
through one of the major stock exchanges, which serve as managed auctions for stock. A stock
exchange, share market, or bourse is a company, corporation, or mutual organization that
provides facilities for stockbrokers and traders to trade stocks and other securities. Stock
exchanges also provide facilities for the issue and redemption of securities, trading in other
financial instruments, and the payment of income and dividends.

Advantages

 Capital markets provide the lubricant between investors and those needing to raise
capital.
 Capital markets create price transparency and liquidity. They provide a safe platform for
a wide range of investors —including commercial and investment banks, insurance
companies, pension funds, mutual funds, and retail investors—to hedge and speculate.
 Holding different shares or bonds allows an investor to spread investment risk.
 The secondary market gives important pricing information that permits efficient use of
limited capital.
Disadvantages

 In capital markets, bond prices are influenced by economic data such as employment,
income growth/decline, consumer prices, and industrial prices. Any information that
implies rising inflation will weaken bond prices, as inflation reduces the income from a
bond.
 Prices for shares in capital markets can be very volatile. Their value depends on a number
of external factors over which the investor has no control.
 Different shares can have different levels of liquidity, i.e. demand from buyers and
sellers.

Action Checklist

 When placing a buy or sell order, there are two ways you can trade. Shares can be traded
at market order, which means buying at the prevailing market price. The alternative is the
limit order, in which you set the minimum or maximum price.
 What are interest rates going to do? Investors who buy and sell bonds before maturity are
exposed to many risks, most importantly changes in interest rates. When interest rates
increase, new issues will pay a higher yield and the value of existing bonds will fall.
When interest rates decline, the value of existing bonds will rise as new issues pay a
lower yield.

Dos and Don’ts

Do
 Before you buy, check how quickly you will be able to sell if necessary, and at what
discount and dealing fee.
Don’t
 Don’t, unless you are completely confident, invest in only one type of bond or security.
An exchange-traded fund or an index fund might be a much safer bet.

Differentiation from 'Money Markets'

People often confuse or conflate capital markets with money markets, though the two are distinct
and differ in a few important respects. Capital markets are distinct from money markets in that
they are exclusively used for medium-term and long-term investments of a year or more. Money
markets, on the other hand, are limited to the trade of financial instruments with maturities not
exceeding one year. Money markets also use different financial instruments than capital markets
do. Whereas capital markets use equity and debt securities, money markets use deposits,
collateral loans, acceptances and bills of exchange.

Because of the significant differences between these two kinds of markets, they are often used in
different ways. Due to the longer durations of their investments, capital markets are often used to
buy assets that the buying firm or investor hopes will appreciate in value over time so as to
generate capital gains, and are used to sell those assets once the firm or investor thinks the time
is right. Firms will often use them in order to raise long-term capital.

Money markets, on the other hand, are often used to general smaller amounts of capital or are
simply used by firms as a temporary repository for funds. Through regularly engaging with
money markets, companies and governments are able to maintain their desired level of liquidity
on a regular basis. Moreover, because of their short-term nature, money markets are often
considered to be safer investments than those made on the equities market. Due to the fact that
longer terms are generally associated with investing in capital markets, there is more time during
which the security in question may see improved or worsened performance. As such, equity and
debt securities are generally considered to be riskier investments than those made on the money
market.

Capital Market History - Risk and Returns

Returns are the gains or losses from a security in a particular period and are usually quoted as a
percentage. What kind of returns can investors expect from the capital markets? A number of
factors influence returns.
Risk: is the chance that an investment's actual return will be different than expected. Risk means
you have the possibility of losing some, or even all, of your original investment. Low levels of
uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high
risk) are associated with high potential returns. The risk/return tradeoff is the balance between
the desire for the lowest possible risk and the highest possible return. Investment risks can be
divided into two categories: systematic and unsystematic.

Systematic Risk: Also known as "market risk" or "un-diversifiable risk", systematic risk is the
uncertainty inherent to the entire market or entire market segment. Also referred to as volatility,
systematic risk is the day-to-day fluctuations in a stock's price. Volatility is a measure of risk
because it refers to the behavior, or "temperament," of your investment rather than the reason for
this behavior. Because market movement is the reason why people can make money from stocks,
volatility is essential for returns, and the more unstable the investment the more chance there is
that it will experience a dramatic change in either direction.
Interest rates, recession and wars all represent sources of systematic risk because they affect the
entire market and cannot be avoided through diversification. Systematic risk can be mitigated
only by being hedged.
Unsystematic Risk: Also known as "specific risk," "diversifiable risk" or "residual risk," this type
of uncertainty comes with the company or industry you invest in and can be reduced through
diversification. For example, news that is specific to a small number of stocks, such as a sudden
strike by the employees of a company you have shares in, is considered to be unsystematic risk.

Credit or Default Risk: Credit risk is the risk that a company or individual will be unable to pay
the contractual interest or principal on its debt obligations. This type of risk is of particular
concern to investors who hold bonds in their portfolios. Government bonds, especially those
issued by the federal government, have the least amount of default risk and the lowest returns,
while corporate bonds tend to have the highest amount of default risk but also higher interest
rates. Bonds with a lower chance of default are considered to be investment grade, while bonds
with higher chances of default are considered to be junk bonds. Bond rating services, such as
Moody's, allows investors to determine which bonds are investment-grade and which bonds are
junk.

Country Risk: Country risk refers to the risk that a country won't be able to honor its financial
commitments. When a country defaults on its obligations it can harm the performance of all
other financial instruments in that country as well as other countries it has relations with.
Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a
particular country. This type of risk is most often seen in emerging markets or countries that
have a severe deficit.

Foreign-Exchange Risk: When investing in foreign countries you must consider the fact that
currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies
to all financial instruments that are in a currency other than your domestic currency. As an
example, if you are a resident of America and invest in some Canadian stock in Canadian dollars,
even if the share value appreciates, you may lose money if the Canadian dollar depreciates in
relation to the American dollar.

Interest Rate Risk: Interest rate risk is the risk that an investment's value will change as a result
of a change in interest rates. This risk affects the value of bonds more directly than stocks.

Political Risk: Political risk represents the financial risk that a country's government will
suddenly change its policies. This is a major reason why developing countries lack foreign
investment. Some additional factors that influence actual returns are as follows:

Taxes: Different types of investments are taxed differently. The type of account an investment is
held in and a taxpayer's tax bracket also affect the amount by which taxes diminish investment
returns. For example, the interest paid on municipal bond investments is generally not taxable,
and gains on investments held in a retirement account are not taxable until the money is
withdrawn.

Fees: Investors pay brokerage fees to buy and sell certain investments. They also pay
management fees. These fees diminish investment returns.

Compounding: As we discussed in Section 4, the frequency with which your investment returns
are reinvested and able to earn additional returns can significantly impact your total returns. The
more frequently earnings are compounded, the better. Daily compounding is better than annual
compounding. Now that we understand the major factors that influence returns, let's look at the
historical returns, average returns and variability of returns from investing in the stock and bond
markets.

Capital Market History - Capital Market Efficiency

An important debate among stock market investors is whether the market is efficient - that is,
whether it reflects all the information made available to market participants at any given time.
The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to
their inherent investment properties, the knowledge of which all market participants possess
equally. At first glance, it may be easy to see a number of deficiencies in the efficient market
theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to
explore its relevancy in the modern investing environment. (For background reading, see What Is
Market Efficiency?)

Tutorial: Behavioral Finance

Financial theories are subjective. In other words, there are no proven laws in finance, but rather
ideas that try to explain how the market works. Here we'll take a look at where the efficient
market theory has fallen short in terms of explaining the stock market's behavior.

EMH Tenets and Problems with EMH

First, the efficient market hypothesis assumes that all investors perceive all available information
in precisely the same manner. The numerous methods for analyzing and valuing stocks pose
some problems for the validity of the EMH. If one investor looks for undervalued market
opportunities while another investor evaluates a stock on the basis of its growth potential, these
two investors will already have arrived at a different assessment of the stock's fair market value.
Therefore, one argument against the EMH points out that since investors value stocks differently,
it is impossible to ascertain what a stock should be worth in an efficient market.

Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater
profitability than another with the same amount of invested funds: their equal possession of
information means they can only achieve identical returns. But consider the wide range of
investment returns attained by the entire universe of investors, investment funds and so forth. If
no investor had any clear advantage over another, would there be a range of yearly returns in the
mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if
one investor is profitable, it means the entire universe of investors is profitable. In reality, this is
not the case.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no
investor should ever be able to beat the market, or the average annual returns that all investors
and funds are able to achieve using their best efforts. This idea would naturally imply, as many
market experts often maintain, that the absolute best investment strategy is simply to place all of
one's investment funds into an index fund, which would increase or decrease according to the
overall level of corporate profitability or losses. There are, however, many examples of investors
who have consistently beat the market - you need look no further than Warren Buffett to find an
example of someone who's managed to beat the averages year after year. (To learn more about
Warren Buffett and his style of investing, see Warren Buffett: How He Does It and The Greatest
Investors. For more reading on beating the market, see the frequently asked question What does
it mean when people say they "beat the market"? How do they know they've done so?)

Qualifying the EMH

Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of
course, it's impossible for the market to attain full efficiency all the time, as it takes time for
stock prices to respond to new information released into the investment community. The efficient
hypothesis, however, does not give a strict definition of how much time prices need to revert to
fair value. Moreover, under an efficient market, random events are entirely acceptable but will
always be ironed out as prices revert to the norm.

It is important to ask whether EMH undermines itself in its allowance for random occurrences or
environmental eventualities. There is no doubt that such eventualities must be considered under
market efficiency but, by definition, true efficiency accounts for those factors immediately. In
other words, prices should respond nearly instantaneously with the release of new information
that can be expected to affect a stock's investment characteristics. So, if the EMH allows for
inefficiencies, it may have to admit that absolute market efficiency is impossible.

Increasing Market Efficiency?

Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance
may actually be growing. With the rise of computerized systems to analyze stock investments,
trades and corporations, investments are becoming increasingly automated on the basis of strict
mathematical or fundamental analytical methods. Given the right power and speed, some
computers can immediately process any and all available information, and even translate such
analysis into an immediate trade execution.

Despite the increasing use of computers, most decision-making is still done by human beings and
is therefore subject to human error. Even at an institutional level, the use of analytical machines
is anything but universal. While the success of stock market investing is based mostly on the
skill of individual or institutional investors, people will continually search for the surefire
method of achieving greater returns than the market averages.

If the EMH is accurate, however, it would have the following implications for investors.

EMH and Technical Analysis

Technical analysis bases decisions on past results. EMH, however, believes past results cannot
be used to outperform the market. As a result, EMH negates the use of technical analysis as a
means to generate investment returns.

With respect to fundamental analysis, the EMH also states that all publicly available information
is reflected in security prices and as such, abnormal returns are not achievable through the use of
this information. This negates the use of fundamental analysis as a means to generate investment
returns.

EMH and the Portfolio Management Process

As we have discussed, the portfolio management process begins with an investment policy
statement, including an investor's objectives and constraints. Given EMH, the portfolio
management process should not focus on achieving above-average returns for the investor. It
should focus purely on risks given that above-average returns are not achievable.

A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas.
The EMH implies that this goal is unachievable, and a portfolio manager should not be able to
achieve above average returns.

Why Invest in Index Funds?

Given the discussion on the EMH, the overall assumption is that no investor is able to generate
an abnormal return in the market. If that is the case, an investor can expect to make a return
equal to the market return. An investor should thus focus on the minimizing his costs to invest.
To achieve a market rate of return, diversification in a numerous amounts of stocks is required,
which may not be an option for a smaller investor. As such, an index fund would be the most
appropriate investment vehicle, allowing the investor to achieve the market rate of return in a
cost effective manner.

Is The Market Truly Efficient?

It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater
efficiency to occur, the following criteria must be met: (1) universal access to high-speed and
advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing
stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the
willingness of all investors to accept that their returns or losses will be exactly identical to all
other market participants. It is hard to imagine even one of these criteria of market efficiency
ever being met.

Capital Market History - Variability of Returns

The actual returns you experience from investing in stocks and bonds will not necessarily reflect
historical or average returns. As you'll read in any investment prospectus, past performance is
not a guarantee of future returns. No one can really predict what will happen in the markets; the
past is only a guide. Earlier we discussed the different types of risk and other factors that can
affect returns. In this section we'll discuss some of the factors that affect the variability of
returns.

Predicting Market Performance

There are two prices that are critical for any investor to know: the current price of the investment
he or she owns or plans to own, and its future selling price. Despite this, investors are constantly
reviewing past pricing history and using it to influence their future investment decisions. Some
investors won't buy a stock or index that has risen too sharply because they assume that it's due
for a correction, while other investors avoid a falling stock because they fear that it will continue
to deteriorate. Does academic evidence support these types of predictions, based on recent
pricing? In this section, we'll look at four different views of the market and learn more about the
associated academic research that supports each view. The conclusions will help you better
understand how the market functions and perhaps eliminate some of your own biases.

Momentum
"Don't fight the tape." This widely quoted piece of stock market wisdom warns investors not to
get in the way of market trends. The assumption is that the best bet about market movements is
that they will continue in the same direction. This concept has its roots in behavioral finance.
With so many stocks to choose from, why would investors keep their money in a stock that's
falling, as opposed to one that's climbing? (For more insight, see the Behavioral Finance
tutorial.)
Studies have found that mutual fund inflows are positively correlated with market returns.
Momentum plays a part in the decision to invest and when more people invest, the market goes
up, encouraging even more people to buy. It's a positive feedback loop.
A 1993 study by Narasimhan Jegadeesh and Sheridan Titman, in their book "Returns to Buying
Winners and Selling Losers," suggests that individual stocks have momentum. They found that
stocks that have performed well during the past few months are more likely to continue their
outperformance next month. The inverse also applies; stocks that have performed poorly are
more likely to continue their poor performance.
However, this study only looked ahead a single month. Over longer periods, the momentum
effect appears to reverse. According to a 1985 study by Werner DeBondt and Richard Thaler,
"Does the Stock Market Overreact?" stocks that have performed well in the past three to five
years are more likely to underperform the market in the next three to five years and vice versa.
This suggests that something else is going on: mean reversion.

Mean Reversion
Experienced investors who have seen many market ups and downs often take the view that the
market will even out over time. Historically high market prices often discourage these investors
from investing, while historically low prices may represent an opportunity.
The tendency of a variable, such as a stock price, to converge on an average value over time is
called mean reversion. The phenomenon has been found in several economic indicators,
including exchange rates, gross domestic product (GDP), interest rates and unemployment. (For
more insight, check out Economic Indicators To Know and Economic Indicators For The Do-It-
Yourself Investor.)
The research is still inconclusive about whether stock prices revert to the mean. Some studies
show mean reversion in some data sets over some periods, but many others do not. For example,
in 2000, Ronald Balvers, Yangru Wu and Erik Gilliland found some evidence of mean reversion
over long investment horizons in the relative stock index prices of 18 countries, which they
described in the "Journal of Finance."
However, even they weren't completely convinced. They wrote in their study, "A serious
obstacle in detecting mean reversion is the absence of reliable long-term series, especially
because mean-reversion, if it exists, is thought to be slow and can only be picked up over long
horizons."
Given that academia has access to at least 80 years of stock market research, this finding
suggests that if the market does have a tendency to mean revert, it is a phenomenon that happens
slowly and almost imperceptibly over many years or even decades.

Martingales
Another possibility is that past returns just don't matter. In 1965, Paul Samuelson studied market
returns and found that past pricing trends had no effect on future prices and reasoned that in an
efficient market, there should be no such effect. His conclusion was that market prices are
martingales.
A martingale is a mathematical series in which the best prediction for the next number is the
current number. The concept is used in probability theory to estimate the results of random
motion. For example, suppose that you have $50 and bet it all on a coin toss. How much money
will you have after the toss? You may have $100 or you may have $0 after the toss, but
statistically the best prediction is $50, your original starting position. The prediction of your
fortunes after the toss is a martingale.
In stock option pricing, stock market returns could be assumed to be martingales. According to
this theory, the valuation of the option does not depend on the past pricing trend, or on any
estimate of future price trends. The current price and the estimated volatility are the only stock-
specific inputs.
A martingale in which the next number is more likely to be higher is known as a sub-martingale.
In popular literature, this motion is known as a random walk with upward drift. This description
is consistent with the more than 80 years of stock market pricing history. Despite many short-
term reversals, the overall trend has been consistently higher. (To learn more about random walk,
read Financial Concepts: Random Walk.)
If stock returns are essentially random, the best prediction for tomorrow's market price is simply
today's price, plus a very small increase. Rather than focusing on past trends and looking for
possible momentum or mean reversion, investors should instead concentrate on managing the
risk inherent in their volatile investments.

Value Investing
Value investors purchase stock cheaply and expect to be rewarded later. Their hope is that an
inefficient market has underpriced the stock, but that the price will adjust over time. The
question is does this happen and why would an inefficient market make this adjustment?
Research suggests that this mispricing and readjustment consistently happens, although it
presents very little evidence for why it happens.
In 1964, Gene Fama and Ken French studied decades of stock market history and developed the
three-factor model to explain stock market prices. The most significant factor in explaining
future price returns was valuation, as measured by the price-to-book ratio. Stocks with low price-
to-book ratios delivered significantly better returns than other stocks.
Valuation ratios tend to move in the same direction, and in 1977, Sanjoy Basu found similar
results for stocks with low price-earnings (P/E) ratios. Since then, the same effect has been found
in many other studies across dozens of markets.
However, studies have not explained why the market is consistently mispricing these "value"
stocks and then adjusting later. The only conclusion that could be drawn is that these stocks have
extra risk for which investors demand additional compensation.
Price is the driver of the valuation ratios; therefore, the findings do support the idea of a mean-
reverting stock market. As prices climb, the valuation ratios get higher and, as a result, future
predicted returns are lower. However, the market P/E ratio has fluctuated widely over time and
has never been a consistent buy or sell signal.
Even after decades of study by the brightest minds in finance, there are no solid answers. The
only conclusion that can be drawn is that there may be some momentum effects in the short term
and a weak mean reversion effect in the long term.
The current price is a key component of valuation ratios such as P/B and P/E that have been
shown to have some predictive power on the future returns of a stock. However, these ratios
should not be viewed as specific buy and sell signals, just as factors that have been shown to play
a role in increasing or reducing the expected long-term return.

Does Higher Risk Really Lead to Higher Returns?

Many widely accepted financial models are built around the premise that investors should expect
higher returns if they are willing to accept more risk. But will investing in a portfolio of risky
stocks really help increase your investment returns over time?
The Low Down on Low-Volatility Stocks
If modern portfolio theory holds true, a portfolio of risky, highly-volatile stocks should have
higher returns than a portfolio of safer, less-volatile stocks. However, stock market researchers
are discovering that this may not always be the case. A March 2010 study by Malcolm Baker,
Brendan Bradley and Jeffrey Wurgler, published in the Jan/Feb 2011 Financial Analysts Journal
and titled, "Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,"
demonstrated that from January 1968 to December 2008, portfolios of low-risk stocks actually
outperformed portfolios of high-risk stocks by a whopping margin.
The study sorted the largest 1,000 U.S. stocks monthly into five different groups based on two
widely accepted measures of investment risk. The authors ran the study once using trailing total
volatility as a proxy for risk, and again using trailing beta. Over the 41-year period, a dollar
invested in the lowest-volatility portfolio of stocks grew to $53.81, while a dollar invested in the
highest-volatility portfolio grew to only $7.35. The findings were similar when they grouped
stocks based on trailing beta. Over the same period, a dollar invested in the lowest-beta portfolio
of stocks grew to $78.66, whereas a dollar invested in the highest-beta portfolio grew to a paltry
$4.70. The study assumed no transaction costs.
These results fly in the face of the notion that risk (volatility) and investment returns are always
joined at the hip. Over the study period, a low-risk stock investor would have benefited from a
more consistent compounding scenario with less exposure to the market's most overvalued
stocks.

Fast Money?
Proponents of behavioral finance have presented the idea that low-risk stocks are a bargain over
time because investors irrationally shun them, preferring stocks with a more volatile "lottery
style" payoff. Backers of this school of thought also believe that investors have a tendency to
identify great "stories" with great stocks. Not surprisingly, these highly touted "story stocks" tend
to be among the market's most expensive and most volatile. Overconfidence plays a role here,
too. As a whole, investors misjudge their ability to assess when stocks will "pop or drop,"
making highly volatile stocks appear like a better proposition than they really are. Even the so
called "smart money" has a tendency to gravitate toward risky stocks.
Many institutional investors are compensated based on short-term investment performance and
their ability to attract new investors. This gives them an incentive to pass up less volatile stocks
for riskier ones, especially in the midst of a raging bull market. Whether it is bad habits or
disincentives, investors have a tendency to pile into the market's riskiest stocks, which drive
down their potential for future gains relative to less volatile ones. Consequently, low-risk stocks
tend to outperform over time.
Before You Bet the Farm on Low-Volatility

Before you trade all of your technology stocks in for a portfolio of utilities, keep in mind that
like most stock market anomalies, this one probably exists because it is not easy to exploit. A
study published in September 2011 by Rodney Sullivan and Xi Li, "The Limits to Arbitrage
Revisited: The Low-Risk Anomaly," explored the viability of actually trading the low-volatility
stock anomaly from 1962 to 2008. Over the 45-year study period, Sullivan and Li found that "the
efficacy of trading the well-known low-volatility stock anomaly is quite limited." Issues cited in
the study include the need for frequent portfolio rebalancing and the high transaction costs
associated with trading illiquid stocks. According to the study, illiquid stocks are where most of
the abnormal returns associated with the low-volatility anomaly are concentrated.
There are a few other issues associated with investing in low-volatility stocks. First, low-
volatility stock investing strategies can suffer long periods of underperformance relative to the
broader stock market. They also have a tendency to be heavily concentrated in a few sectors like
utilities and consumer staples.

The positive relationship between risk and expected returns may hold true when investing across
different asset classes, but the same may not always be true when investing within a particular
asset class, like stocks. While it is dangerous to assume that you can boost your investment
returns simply by investing in a portfolio of risky stocks, it can be equally as dangerous to
assume that researchers of the low-volatility stock anomaly have somehow discovered a silver
bullet to achieving higher returns.

Stock investors shouldn't overlook the importance of consistency when attempting to compound
their investment returns. They should also take into account that the stability of a company's
stock price is often a reflection of the true quality of its underlying earnings stream.

Making Sense of Market Anomalies

In the non-investing world, an anomaly is a strange or unusual occurrence. In financial markets,
anomalies refer to situations when a security or group of securities performs contrary to the
notion of efficient markets, where security prices are said to reflect all available information at
any point in time.

With the constant release and rapid dissemination of new information, sometimes efficient
markets are hard to achieve and even more difficult to maintain. There are many market
anomalies; some occur once and disappear, while others are continuously observed.
Can anyone profit from such strange behavior? Let's look at some popular recurring anomalies
and examine whether any attempt to exploit them could be worthwhile.

Calendar Effects
Anomalies that are linked to a particular time are called calendar effects. Some of the most
popular calendar effects include the weekend effect, the turn-of-the-month effect, the turn-of-the-
year effect and the January effect.
 Weekend Effect: The weekend effect describes the tendency of stock prices to decrease on
Mondays, meaning that closing prices on Monday are lower than closing prices on the
previous Friday. For some unknown reason, returns on Mondays have been consistently
lower than every other day of the week. In fact, Monday is the only weekday with a
negative average rate of return.
Years Monday Tuesday Wednesday Thursday Friday
1950-
-0.072% 0.032% 0.089% 0.041% 0.080%
2004
Source: Fundamentals of Investments, McGraw Hill, 2006

 Turn-of-the-Month Effect: The turn-of-the-month effect refers to the tendency of stock

prices to rise on the last trading day of the month and the first three trading days of the
next month.
Years Turn of the Month Rest of Days
1962-2004 0.138% 0.024%
Source: Fundamentals of Investments, McGraw Hill, 2006
  Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased
trading volume and higher stock prices in the last week of December and the first two
weeks of January.
Years Turn of the Year Rest of Days
1950-2004 0.144% 0.039%
Source: Fundamentals of Investments, McGraw Hill, 2006

 January Effect: Amid the turn-of-the-year market optimism, there is one class of
securities that consistently outperforms the rest. Small-company stocks outperform the
market and other asset classes during the first two to three weeks of January. This
phenomenon is referred to as the January effect.
Occasionally, the turn-of-the-year effect and the January effect may be addressed as the
same trend, because much of the January effect can be attributed to the returns of small-
company stocks.

Why Do Calendar Effects Occur?

So, what's with Mondays? Why are turning days better than any other days? It has been jokingly
suggested that people are happier heading into the weekend and not so happy heading back to
work on Mondays, but there is no universally accepted reason for the negative returns on
Mondays.
Unfortunately, this is the case for many calendar anomalies. However, the January effect may
have the most valid explanation. It is often attributed to the turn of the tax calendar; investors sell
off stocks at year's end to cash in gains and sell losing stocks to offset their gains for tax
purposes. Once the New Year begins, there is a rush back into the market and particularly into
small-cap stocks.
Announcements and Anomalies
Not all anomalies are related to the time of week, month or year. Some are linked to the
announcement of information regarding stock splits, earnings, and mergers and acquisitions.
 Stock Split Effect: Stock splits increase the number of shares outstanding and decrease the
value of each outstanding share, with a net effect of zero on the company's market
capitalization. However, before and after a company announces a stock split, the stock
price normally rises. The increase in price is known as the stock split effect.
Many companies issue stock splits when their stock has risen to a price that may be too
expensive for the average investor. As such, stock splits are often viewed by investors as
a signal that the company's stock will continue to rise. Empirical evidence suggests that
the signal is correct.
 Short-Term Price Drift: After announcements, stock prices react and often continue to
move in the same direction. For example, if a positive earnings surprise is announced, the
stock price may immediately move higher. Short-term price drift occurs when stock price
movements related to the announcement continue long after the announcement.
 Short-term price drift occurs because information may not be immediately reflected in the
stock's price.
 Merger Arbitrage: When companies announce a merger or acquisition, the value of the
company being acquired tends to rise while the value of the bidding firm tends to fall.
Merger arbitrage plays on potential mispricing after the announcement of a merger or
acquisition.
The bid submitted for an acquisition may not be an accurate reflection of the target firm's
intrinsic value; this represents the market anomaly that arbitrageurs aim to exploit.
Arbitrageurs aim to take advantage of the pattern that bidders usually offer premium rates
to purchase target firms.
 Indicators Superstitious: aside from anomalies, there are some nonmarket signals that
some people believe will accurately indicate the direction of the market. Here is a short
list of superstitious market indicators:
 The Super Bowl Indicator: When a team from the old American Football League
wins the game, the market will close lower for the year. When an old National
Football League team wins, the market will end the year higher. Silly as it may
seem, the Super Bowl indicator was correct more than 80% of the time over a 40-
year period ending in 2008. However, the indicator has one limitation: it contains
no allowance for an expansion-team victory.
 The Hemline Indicator: The market rises and falls with the length of skirts.
Sometimes this indicator is referred to as the "bare knees, bull market" theory. To
its merit, the hemline indicator was accurate in 1987, when designers switched
from miniskirts to floor-length skirts just before the market crashed. A similar
change also took place in 1929, but many argue as to which came first, the crash
or the hemline shifts.
 The Aspirin Indicator: Stock prices and aspirin production are inversely related.
This indicator suggests that when the market is rising, fewer people need aspirin
to heal market-induced headaches. Lower aspirin sales should indicate a rising
market.

Why Do Anomalies Persist?

These effects are called anomalies for a reason: they should not occur and they definitely should
not persist. No one knows exactly why anomalies happen. People have offered several different
opinions, but many of the anomalies have no conclusive explanations. There seems to be a
chicken-or-the-egg scenario with them too - which came first is highly debatable.

Profiting From Anomalies

It is highly unlikely that anyone could consistently profit from exploiting anomalies. The first
problem lies in the need for history to repeat itself. Second, even if the anomalies recurred like
clockwork, once trading costs and taxes are taken into account, profits could dwindle or
disappear. Finally, any returns will have to be risk-adjusted to determine whether trading on the
anomaly allowed an investor to beat the market.

CENTRAL BANK OF KENYA

1. The Central Bank of Kenya promote the development of robust and vibrant financial
markets in the country through contracting the government’s domestic debt for budgetary
requirements through issuance and redemption of Treasury Securities, implementation of
monetary policy through Open Market Operations (OMO), accumulate, and management
of official foreign exchange reserves.
2. Domestic debt management involves, among other functions, issuance and redemption of
government securities comprising of Treasury bills, Treasury bonds and infrastructure
bonds which present investment opportunities for existing and potential investors.
Treasury bonds and Infrastructure bonds are tradable at the Nairobi Stock Exchange
(NSE).These securities are issued to the market through an auction process and investors
can invest in government securities through auction bidding following prescribed
guidelines provided in this website. All investors MUST first open a CDS account at
CBK or through authorized agents of the CBK comprising of local commercial banks,
stock brokers and investment bankers and advisors.
3. Foreign Exchange reserves held by the Central Bank of Kenya (CBK) are a national asset
held as a safeguard to ensure availability of foreign exchange to meet the country’s
external obligations, including imports and external debt service. The primary objective
in the management of these reserves is therefore capital preservation. With respect to
income, the Department invests the reserves to earn reasonable returns while maintaining
adequate liquidity. The principal objective of OMO is to maintain optimal liquidity in the
domestic market to support business and household transactions guided by the prescribed
monetary policy stance.

CBK Role: Fiscal Agent of the Government

1. SERVICES TO THE GOVERNMENT
(a) Manage the Treasury Exchequer Account
The Central Bank of Kenya is the banker to the government and is mandated by law to maintain
the Exchequer Account. The Exchequer Account is where all government revenue is deposited
before being spent. This account is then used to fund government ministries’ recurrent and
development votes, and constitutional offices to the extent of voted amount by parliament.

(b) Manage Government Ministries’ and Departments’ Accounts

The Central Bank of Kenya maintains various accounts for Government ministries which
include: Recurrent accounts Development accounts Projects accounts Donor funds accounts
Treasury accounts Public entities accounts i.e., Parastatals Government departments that hold
accounts in the Central Bank for purposes of funding by the Exchequer Accounts include the
Judiciary, Public Prosecution, Kenya Anti-Corruption Commission (KACC), Independent
Electoral and Boundaries Commission (IEBC), Teachers Service Commission (TSC), Public
Service Commission of Kenya, Commission on Revenue Allocation (CRA), Truth, Justice and
Reconciliation Commission (TJRC) and Parliamentary Service Commission (PSC).
 (c) Government payment through G-Pay System
The G-pay is an electronic payment system used by the government and CBK clients to effect
payments. To facilitate the electronic payments, Central Bank is linked to Ministry of Finance
via fiber cable then the Government ministries and departments are linked to the Ministry of
Finance platform. All government payments from accounts held in Central Bank are made
through an electronics payment method known as Real Time Gross Settlement System (RTGS)
irrespective of amount involved whether a small or large payment.
From the government side, payments are processed through an electronic payment system known
as IFMIS (Integrated Financial Management Information System) that is interfaced with the
Central Bank‘s G-Pay system to facilitate payments directly into customers’ accounts in local
commercial banks.

(d) Government inter-account funds movement

This service enables account holders to transfer funds from one account to another account in the
Central Bank systems without having to instruct the bank to effect the transfer using the G-pay
system. The inter-account transfer of funds is real time and unlike the RTGS, the instruction is
effected immediately the customer sends the instruction to the bank.

(e) Confirmation of balances in customer accounts

The Central Bank of Kenya customer can obtain confirmation on their account balances upon
request. Independent confirmation of balances is also given to auditors of customers directly on
customer request. Special Project financiers or Bilateral Donors may also request confirmation of
their Account balances directly.

2. SERVICE TO KENYA REVENUE AUTHORITY

The Central Bank of Kenya holds main tax collection accounts for Kenya Revenue Authority
(KRA) who is the principal collector of tax revenue for the Government of Kenya. KRA also
holds collection accounts in selected commercial banks on agency basis.
All tax collection by agency banks must be remitted to Central Bank the same day it is collected
or as soon as possible. Management of Kenya Revenue Authority Accounts The Central Bank
holds the following categories of accounts for Kenya Revenue Authority:
o Tax Collection Accounts – These accounts contain all main tax collection accounts
o Tax Refunds Accounts – These accounts are used by KRA to make refunds to tax payers
who either have overpaid tax, or have paid while they are exempted from paying.
o Agency Collection Accounts – the KRA Act allows the authority to act as an agent for
body corporate, including parastatals to collect revenue on their behalf for purpose of
achieving economies of scale.
For this reason a number of government agencies have appointed KRA their agent for collecting
revenue due to them. Periodically, balances in the tax collection accounts are given to Treasury
to enable them make timely decisions on revenue allocations for voted expenditure.

3. SERVICES TO THE COMMERCIAL BANKS

The Central Bank provides the following services to Commercial Banks:-
o Maintenance of Clearing and Settlement Accounts for Kenya Shillings & Domestic
Foreign Currency Cheques
 o Provision of Specimen Signature Mandate cards for nomination and authorization of A/C
Authorizers & Signatories
o Intra-bank Lending Facility – These are loans backed by Government’s Securities
Provision of Overnight Lending - to enable commercial banks to borrow cash to meet
Cash Ratio Requirements (CRR)
o Confirmation of balances in their accounts in our books T24 Information on Cash
Reserves Ratios. Commercial Banks are required to maintain statutory Daily Cash Ratio
of 3% and Monthly 5.25% of customer deposits
o Provision of Daily Money Market Report - These are Interbank Rates for the Banking
Industry Housing of Kenya Bankers Association’s Automated Clearing House (ACH)
Housing of Kenya Bankers Association’s Disaster Recovery Site (DRS)

4. SERVICES TO THE EAST AFRICAN COMMUNITY CENTRAL BANKS

The Central Bank of Kenya provides the following services for the EAC Central banks:-
o Maintenance of E.A.C. Central Banks’ A/Cs Facilitating of payment instructions
o Confirmation of balances in their accounts in our books - T24
o Provision of Specimen Signature Mandate cards for nomination and authorization of A/C

5. SERVICES TO FOREIGN CORRESPONDENT BANKS

The Central Bank maintenance of Accounts does verification of transaction documents and
confirmation of balances in their accounts in our books - T24 for foreign correspondent banks.

Mandate and Objectives OF CBK

Sections 4 and 4A of the CBK Act set out the Bank’s objects as follows:
 To formulate and implement Monetary policy directed to achieving and maintaining
stability in the general level of prices.
 To foster the liquidity, solvency and proper functioning of a stable market-based financial
system.
 Subject to subsections (1) and (2), the Bank shall support the economic policy of the
Government, including its objectives for growth and employment.
Without prejudice to the generality of the above, other objects of the Bank are;
 To formulate and implement foreign exchange policy.
 To hold and manage its foreign exchange reserves. To license and supervise authorized
dealers.
 To formulate and implement such policies as best promote the establishment, regulation
and supervision of efficient and effective payment, clearing and settlement systems.
 To act as banker and adviser to, and as fiscal agent of the Government.
 To issue currency notes and coins.

Management OF CBK
The executive management team comprises the Governor, two Deputy Governors and heads of
department. The Governor and Deputy Governors are appointed by the President through a
transparent and competitive process and with the approval of Parliament. The Governor and
Deputy Governors hold office for a term of four years, but are eligible for re-appointment for one
further term of four years.
The Governor is the chief executive officer of the Bank and, subject to the general policy
decisions of the Board, is responsible for the management of the Bank, including the
organization, appointment and dismissal of the staff in accordance with the general terms and
conditions of service established by the Board, the Governor has authority to incur expenditure
for the Bank within the administrative budget approved by the Board.

About CBK
Establishment
The Central Bank of Kenya was established in 1966 through an Act of Parliament - the Central
Bank of Kenya Act of 1966. The establishment of the Bank was a direct result of the desire
among the three East African states to have independent monetary and financial policies. This
led to the collapse of the East Africa Currency Board (EACB) in mid 1960s.
Following the promulgation of the new constitution on August 27th, 2010, the Central Bank of
Kenya (CBK) is now established under Article 231 of the Constitution, 2010. Under this Article
the Central Bank has the responsibility of formulating monetary policy, promoting price stability,
issuing currency and performing any other functions conferred on it by an Act of Parliament.
The Constitution guides that “the Central Bank shall not be under the direction or control of any
person or authority in the exercise of its powers or performance of its functions”.

Head Office, Branches and Currency Centres

The Bank operates from its Head Office in Nairobi and has branch offices in Mombasa, Kisumu
and Eldoret. The Bank also runs Currency Centres in Nyeri, Nakuru and Meru. The Bank also
has a major stake in the Kenya School of Monetary Studies (KSMS) which is headed by an
executive director answerable to the Governor.

Board of Directors
Role and Legal Status
Under the Central Bank of Kenya Act (Cap. 491), the responsibility for determining the policy of
the Bank, other than the formulation of monetary policy, is given to the Board of Directors. The
Board of Directors of the Central Bank of Kenya are responsible for:
(a) Determining the policy of the Bank, other than the formulation of monetary policy;
(b) Determining the objectives of the Bank, including oversight for its financial management and
strategy;
(c) Keeping under constant review the performance of the Bank in carrying out its functions;
(d) Keeping under constant review the performance of the Governor in discharging the
responsibility of that office;
(e) Keeping under constant review the performance of the Governor in ensuring that the Bank
achieves its Objectives;
(f) Determining whether the policy statements made are consistent with the Bank’s primary
function and policy objectives of the Bank
(g) Keeping under constant review the use of Bank’s resources.

Membership
The Board comprises 11 members consisting of the Chairperson, the Governor; the Permanent
Secretary to the National Treasury or his representative who shall be a non-voting member, and
eight other non-executive directors.
The chairperson and directors are appointed by the President with the approval of Parliament and
hold office for a period of four years but shall be eligible for re-appointment for one further term
of four years. Persons eligible to be appointed to the Board must be citizens of Kenya who are
knowledgeable or experienced in monetary, financial, banking and economic matters or other
disciplines relevant to the functions of the Bank.

Meetings
The Chairperson convenes the meetings of the Board not less than once in every two months, or
whenever the business of the Bank so requires, or whenever he is so requested in writing by at
least three directors. In the absence of the Chairperson at a meeting, the members present shall
elect one of the members appointed under paragraph to preside at that meeting of the Board.
A quorum for any meeting of the Board shall be the Chairperson, the Governor and three
directors. Decisions of the Board are adopted by a majority of the votes of those present at that
meeting and in case of an equality of votes the Chairperson or the person presiding at the
meeting shall have a second or casting vote. The Board may delegate to any committee of the
Board or to any member thereof, or to any officer, employee or agent of the Bank the exercise of
any of the powers or the performance of any of the functions or duties of the Board under the
CBK Act or any other written law.

Mission, Vision and Values of CBK

Vision
To be a World Class Modern Central Bank.

Mission
To formulate and implement monetary policy for price stability and foster a stable market-based
inclusive financial system.

IdentityStatement
The CBK strives to be a World class modern Central Bank, by using robust monetary policy
tools to maintain stable market prices. The Bank embraces innovation, encourages peer review
and endeavors to ensure financial stability in a free market economy.

Values
The CBK Board and staff embrace the following core values in delivery of its mandate:
 Commitment: The Board and staff are committed to implementing the Bank’s mandate as
stipulated in the Constitution of Kenya and the CBK Act.
 Professionalism and relevance: The Board and staff will always endeavor to offer quality
services to its internal and external customers, diligently observing high professional
standards at all times and respecting the rules and regulations set by the Bank. All the
activities being undertaken in the Bank will always be relevant to the strategies of the
Bank in pursuing its core mandates.
 Efficiency and Effectiveness: The Bank will at all times undertake its operations in the
most cost efficient and effective manner while maintaining high standards of
performance in execution of its mandate.
  Transparency, accountability and integrity: The Board and staff will always act in a
transparent and accountable manner when handling all the affairs of the Bank both
internally and with external parties so as to uphold the Bank’s image at all times. In
addition, the Bank will uphold high standards of ethics, integrity and honesty as guided
by the Constitution, act in an ethical manner as guided by the Leadership and Integrity
Act and the Public Officers’ Ethics Act and observe high moral standards.
 Innovativeness: The Bank will encourage, nurture and support creativity and the
development of new ideas and processes for the continued improvement of organizational
performance.
 Mutual Respect and Teamwork: The act of mutual respect shall at all times be observed
internally amongst colleagues and when dealing with the Bank’s external clients. In
addition, the Board and staff will cooperate and collaborate to enhance performance and
create a healthy work environment.
 Diversity and Inclusiveness: The Bank appreciates and embraces the differences in its
employees skills sets and abilities and encorages consultations and inclusivesness in
pursuit of its mandate across departments. This is aimed at maximising productivity and
enhancing the Bank’s overall performance.

Functions of the Central bank of Kenya

The attainment of political independence in Kenya in 1963 provided a strong impetus in favor of
the establishment of the Central Bank as the National Monetary authority, which would use a
variety of monetary controls in order to ensure efficiency of operations of the monetary system.
The legislation that established the Central Bank of Kenya Act received presidential assent on
14th September 1966, when the first Kenyan currency went into circulation.
Functions of the Central Bank of Kenya
1. It acts as a banker’s bank.
2. It serves as a lender of last resort to commercial banks and also to the government.
3. It encourages the adoption of the financial system according to the changing needs of the
markets.
4. It administers external reserves; exchange controls and handles external financial relations.
5. It manages the national reputation. It takes into account accumulated borrowings undertaken
by the government to finance its expenditure.
6. It has the sole responsibility of issuing currency. It regulates the issue of notes and coins.
7. The bank is a government banker. It does not maintain the accounts of businesses and
individuals in the private sector. It only maintains the accounts of governmental departments.
This usually starts in a bank returns as public deposit.
8. Important of all is that it acts as an agent to the government. This is seen when it implements
the monetary policy in the pursuit of the government's national economic development. As part
of this process, the bank acts as a medium for a two-way transmission between the government
and the financial markets. Among other things, it collects extensive statistical information on all
financial institutions. The information is usually about the following:
• The volume of business.
• The sectors of the economy that may need financial assistance inform of lending.
• Who is providing deposits to financial institutions?
9. The Central Bank of Kenya has a duty to supervise the banking industry in general. The bank
can issue directives to commercial banks and other financial institutions indicating how much
they should be lending (quantitative directives). This has been done through what is known as
moral persuasion (friendly persuasion). The bank is mandated to inspect and supervise the
directives given to non-bank financial institutions and commercial bank.

Structure of the Bank

Responsibility for determining the policy of the Central Bank is given by the Central Bank of
Kenya Act to the Board of Directors. The Board consists of seven members:
- the Governor, who is also its chairman
- the Deputy Governor, who is deputy chairman
- the Permanent Secretary to the Treasury who is a non-voting member
- five other non executive directors
All members are appointed by the President to hold office for a term of four years and are
eligible for reappointment. In the case of the Governor, appointment is for a maximum of two
terms of four years each and can only be terminated by a tribunal appointed by the President to
investigate his conduct.
The executive management team comprises the Governor, the Deputy Governor and nine heads
of department who report to the Governor. The Bank operates from its head office in Nairobi and
has branch offices in Mombasa, Kisumu and Eldoret.

The Central Bank Act and its relations with the Government
The Central Bank of Kenya Act of 1966 set out objectives and functions and gave the Central
Bank limited autonomy. Since the amendment of the Central Bank of Kenya Act with effect
from April 1997, the Central Bank operations have been brought into line with the changed
situation in Kenya caused by economic reforms. There is now greater monetary autonomy.
Though required to support the general economic policy of the Government, the Central Bank of
Kenya is not subject to any directive from the Government in exercising the powers conferred on
it by the Central Bank of Kenya (Amendment) Act, 1996. However, both the Government and
the Central Bank make mutual consultations on important policy matters.
The Central Bank, for example, is required to advise the Government on monetary policy matters
of major importance and to provide information at the Governments’ request. The Government
in turn invites the Governor of the Central Bank to advice on fiscal issues that may have
important ramifications on the Bank's monetary policy.

Mission of the Bank

The Central Bank plays a unique role in the economy and performs various functions not
normally carried out by commercial banks. The functions of the Bank have changed over time
depending on the changing economic conditions. Currently its main task, as stipulated in the
Central Bank of Kenya (Amendment Act), 1996 is that of "maintaining price stability and
fostering liquidity, solvency and proper functioning of a stable market-based financial system".
As such it is responsible for formulating and executing monetary policy, supervising and
regulating depository institutions, assisting the Kenya Government’s financing operations and
serving as Kenya Government banker. This is very much in line with contemporary central
banking practice the world over.

Importance of Maintaining Price Stability

Maintaining price stability is crucial for a proper functioning market-based economy. Low and
stable inflation reduces the continuous rise in the general price level to such a level that it no
longer adversely influences the decisions of consumers and producers. While, high rate of
inflation inevitably give rise to a decline in the efficient working of a market economy and in the
medium to longer term to a lower rate of growth of the economy as a whole.

How the Bank Ensures Price Stability

As movements in the general price level are influenced by the amount of money in circulation,
the Central Bank of Kenya operates in a way that restricts the growth of the total money stock
available in the economy to predetermined growth target (See Monetary Policy Statement).
There are three major tools the Bank uses to implement monetary policy:
Open Market Operations: through open market operations, the Bank buys or sells Kenya
Government Treasury Bills both in the primary and secondary market in order to produce a
desired level of Bank reserves. These securities are held in the Bank, which currently has a value
of roughly Kshs 120bn. The Bank therefore injects money to the economy when it buys Treasury
Bills, and drains money when it sells it. As the law of supply and demand takes over in the
money market, the cost of loanable funds (interest rates) adjusts itself to the desired level.

Discount window operations

The Bank, as lender of last resort, may provide secured short-term loans to commercial banks
temporarily in need of funds, but only after they have exhausted their market sources of funds.
The discount rate is set by the Central Bank to reflect the monetary policy objectives.

Reserve Requirements
The Central Bank is empowered by the Act to demand a certain proportion of commercial banks’
deposits to be held as non-interest bearing reserves at the Central Bank. An increase in reserve
requirements would be regarded as an attempt to restrict bank credit. A reduction in the reserve
ratio would be viewed as a expansion of credit as it increases the credit creation power of the
banks.

Other Functions of the Bank

In addition to these primary tasks, the Central Bank performs other specific functions which have
evolved with the changing economic environment since it's inception in 1966:
Issue of notes and coins: The Central Bank of Kenya is entrusted with the making, issuing and
destroying notes and coins in Kenya Shillings. The monopoly of issuing notes and coins enables
it to exercise control over the money in circulation and thereby fulfill its primary task of
safeguarding the domestic value of the Kenya shilling.

Six denominations of notes

At present, the Central Bank issues six denominations of notes: Kshs 20, Kshs 50, Kshs 100,
Kshs 200, Kshs 500 and Kshs 1,000. While, new generation coins are in denominations of: 10
cents, 50 cents, Kshs 1, Kshs 5 and Kshs 10.

Provision of Banking services to Banks

The Central Bank provides commercial banks clearing facilities of their cashless payments, a
task laid down in the CBK amendment Act of promoting the smooth operation of payments,
clearing and settlement systems. The Bank is also entrusted with the supervision of commercial
banks in order to ensure efficient and sound financial system in the interest of depositors and the
economy as a whole.

Provision of Banking Services to Government: As banker and fiscal agent of Government, the
Bank accepts deposits and effects payments on behalf of Government. It also maintains and
operates special accounts for the Government. This function has, however, been circumscribed in
the recent Central Bank (Amendment) Act of 1997 to prevent any erosion of the Bank's
independence. Section 18(3) of the new Act limits access by the government to Central Bank
credit, as this has been the major cause of monetary expansion in the economy [see the Monetary
Policy Statement]. The Central Bank also administers the public debt, i.e. effecting issuance,
payment of interest on, and redeeming of bonds and other securities of the Government.

Foreign Exchange Operations

The Central Bank holds official foreign exchange reserves of the country for the purposes of:
repaying and servicing the country's public external debt; and intervening in the interbank
foreign exchange market largely to smooth out erratic exchange rate fluctuations, thus helping to
maintain orderly market conditions crucial for the shilling exchange rate stability.

Functions of Branches
To provide an efficient service to the banks and satisfy their requirements for bank notes, the
Central Bank has opened branches in various regions of the country. The branch responsibility is
to ensure that there is an adequate supply of new notes available to meet the demand, and to
replace unfit notes.

Commercial Banks & Mortgage Finance Institutions

Commercial Banks and Mortgage Finance Institutions are licensed and regulated pursuant to
the provisions of the Banking Act and the Regulations and Prudential Guidelines issued there
under. They are the dominant players in the Kenyan Banking system and closer attention is paid
to them while conducting off-site and on-site surveillance to ensure that they are in compliance
with the laws and regulations.
Currently there are 43 licensed commercial banks and 1 mortgage finance company.

Out of the 44 institutions, 31 are locally owned and 13 are foreign owned. The locally owned
financial institutions comprise 3 banks with significant shareholding by the Government and
State Corporations, 27 commercial banks and 1 mortgage finance institution. The ownership
structure of the commercial banks and mortgage finance company is as depicted in the chart
below:
Microfinance Institutions
The Microfinance Act, 2006 and the Microfinance (Deposit Taking Institutions)
Regulations 2008 issued there under sets out the legal, regulatory and supervisory framework for
the microfinance industry in Kenya. The Microfinance Act became operational with effect from
2nd of May 2008.
The principal object of the Microfinance Act is to regulate the establishment, business and
operations of microfinance institutions in Kenya through licensing and supervision. The Act
enables Deposit Taking Microfinance Institutions licensed by the Central Bank of Kenya to
mobilize savings from the general public, thus promoting competition, efficiency and access.

It is, therefore, expected that the microfinance industry will play a pivotal role in deepening
financial markets and enhancing access to financial services and products by majority of the
Kenyans.
Other financial institutions
Non Bank Financial Institutions
Non Bank Financial Institutions (NBFI) are licensed under the Banking Act and are obligated to
comply with all requirements required of Banks subject to any qualifications stipulated for them.
Currently, there are no NBFIs licensed in Kenya.

Building Societies
Building Societies are licensed under the Building Societies Act. Currently there is no licensed
Building Society in Kenya.

Legislation
Legislation (or "statutory law") is law which has been promulgated (or "enacted") by a
legislature or other governing body. Before an item of legislation becomes law it may be known
as a bill, and may be broadly referred to as "legislation" while it remains under consideration to
distinguish it from other business.
The Central Bank of Kenya is in various ways guided by the following pieces of legislation:
 Constitution of Kenya 2010
 Central Bank of Kenya Act (2015)
 Banking Act (2015)
 Microfinance Act (2006)
 The National Payment System Act (2011)
 Kenya Deposit Insurance Act 2012

FINANCIAL MARKETS

Opening of Central Depository System (CDS) accounts for Kenya government securities.
1. Prospective investors wishing to buy or trade in any Kenya Government securities are required
to open a CDS account with the Central Bank of Kenya. The CDS account acts as the investor’s
securities holding and trading account.
2. Investors may choose to open the CDS accounts directly with the Central Bank of Kenya or
open a client account through an authorized agent which includes, commercial banks,
investments banks, stock brokers and investment advisors. It should however be noted that no fee
is charged for opening and maintenance of the CDS accounts opened directly at the Central Bank
of Kenya.
3. CDS accounts may be opened in the names of individual investors or corporate entities.
Individual investors may open CDS accounts either singly or jointly, while the corporate
investors include companies, co-operatives and other societies, insurance companies, banks ,
non- Bank financial institutions, NGO’S and entities established by statutes, which are mainly
State Corporations.
Requirements
 Requirements for opening or changing details for individuals/ joint CDS accounts
 Requirements for opening or changing details for the CDS accounts for corporate entities
(i.e. companies, co-operatives and other societies, insurance companies, banks & non-
banking financial institutions, NGO's, and corporate entities established by statutes.

Procedures for Processing Third Party Claims Relating to Deceased Investors’ Investments
1. Claimant(s) to notify the Central Bank of Kenya of the death of the deceased in writing.
2. The Bank will advise the claimant(s) on the prerequisite documents to submit to facilitate
processing of any payment of funds withheld and also to aid in subsequent payments for interest
or redemption for outstanding government securities. The claimant should forward the following
under-listed original and copies of documents:
  Original and copy of the Certificate of Confirmation of Grant from the High Court which
should explicitly specify the CDS account amongst the properties described in the
schedule of assets
 Original and copy of letter of Administration from the High Court
 Original and copy of the claimant(s) Identity card
 Original and copy of the Claimant(s) Pin Certificate
 Details of the claimant(s) bank account including bank name, branch and account number
 Indemnity form duly completed by the claimant(s) and signed off by a Commissioner of
Oaths(form issued by the Central Bank of Kenya)

NB. The copies of the attached documents to be verified & certified as true copies of the
original by the Front Office staff and the Branch Manager( if the documents are presented at
the branches or currency centers) then the documents are to be forwarded to MO&DM
division for processing. The original documents shall be released back to the claimant upon
certification.
3. After the documents have been successfully verified by our legal division, the claimant(s) will
receive payment for withheld funds while payments for outstanding securities will be paid after
each interest/redemption payment. For further questions and clarification kindly visit the
following link https://www.centralbank.go.ke/index.php/frequently-asked-question
4. In order to better manage long term outstanding securities the claimant(s) is advised to open a
CDS account in their own name where the securities from the deceased investor’s account can be
transferred. This will enable the claimant to liquidate the security before maturity.

Treasury Bill
What is a Treasury Bill?
A treasury bill is a paperless short-term borrowing instrument issued by the Government through
the Central Bank of Kenya (as a fiscal agent) to raise money on short term basis – for a period of
up to 1 year. Treasury bills are issued in maturities of 91, 182 and 364 days. Treasury bills are
sold at a discounted price to reflect investor’s return and redeemed at face (par) value.

Who Can Invest in Treasury Bills in Kenya?

1Resident or non-resident individuals and/or corporate bodies who hold an account with a local
commercial bank
 Resident or non-resident individuals and/or corporate bodies who may not have an
account with a local commercial bank but invests as a nominee of a commercial bank or
investment bank in Kenya
 Resident or non-resident individual and/or corporate bodies that has CDS Account with
Central Bank of Kenya
 Must have minimum face value of Ksh.100, 000. Any additional amounts MUST be in
multiples of Kshs. 50,000.

NB Please note that a non-Kenyan investor who is NOT domiciled in Kenya can invest in
Kenya Government Treasury bills as a NOMINEE of either a local commercial bank,
investment bank or stock broker. Non-Kenyan investors domiciled in Kenya can however
invest directly by opening CDS account at CBK.
How and When do I Invest?
1. Any potential investor must have an active and updated CDS account at Central Bank of
Kenya.
2. With exception of the 364-days paper which is on offer once every month, 91- and 182 -days
Treasury bills are sold weekly. Each new offer is advertised in the Daily Nation Newspaper on
Fridays
3.Investors MUST correctly and appropriately complete Treasury Bills application form
available at the Central Bank of Kenya head office Nairobi or any of its branches in Eldoret,
Kisumu and Mombasa or currency centres in Meru, Nyeri and Nakuru or can be downloaded
on the website. The duly completed application form must be submitted to Central Bank (or
branches) on or before 2.00pm on Thursdays for 91-days and on Wednesdays for the 182- and
364-days papers.
4. Investors may place their application either as competitive or non-competitive (average) bids.
Competitive bidders MUST indicate the desired price/yield and usually monitor and understand
the movements in interest rates and market conditions. However, such bids may either be
accepted or rejected depending on interest rates and liquidity levels. Non-competitive bidders on
the other hand only indicate ‘Average’ or ‘Non-Competitive’ in the place of offer price per Ksh
100 in the application forms. Since this category is a price-taker of market outcome (successful
weighted average rate/price), their placement is guaranteed. However, maximum amount one can
invest per CDS account per issue/tenor is Ksh 20,000,000.
5. Application forms should be deposited in the blue tender boxes marked “Treasury bills” at any
branch (or currency centre) of Central Bank by 2.00p.m on Wednesday for 182- and 364-days
papers and on Thursday for the 91-days paper.

How Do I Determine my Return on a Treasury Bill?

Treasury bills are sold at discounted price (a price less than par price of Ksh 100) and therefore
the discount is the only return an investor earns on Treasury bills. The price is computed per
Kshs 100 depending on the interest rate/yield quoted by investor using the following formula:

Where,
P = Price per Ksh 100 which investor will pay
r = interest rate or yield per annum quoted by the investor
d = days to maturity or tenor (91, 182 and later 364 days)

Illustration
An investor intents to place Ksh 12,000,000 in the 91 days Treasury bill at a quoted rate/yield of
7.65% p.a. What is his/her return, if s/he is withholding tax-payer or non-withholding taxpayer?

Solution
Using the formula above already inputted in Treasury bills calculator on the Central Bank
website published as the ‘Treasury bills pricing calculator’, by clicking on the link
www.centralbank/securities/bills/TreasuryBillsCalculator , the investor’s return will be as
follows:
 For Non-Withholding Tax payer at 15%;

This implies for every Ksh 100 investor wishes to lend to the Government, s/he will pay Ksh
98.128 on the value date (the day the government borrows) and receive Ksh 100 on maturity date
(the 91st day). This translates to a net return of Ksh 1.872 per Ksh 100. Therefore for Ksh
12,000,000, the investor will pay the Government a total of

Implying investor’s total return/interest amount is Ksh (12,000,000 – 11,775,360) = Ksh 224,640
in 3-months period.

 For Withholding Tax payer at 15%, the investor’s total return/interest amount will be
Ksh (12,000,000 – 11,775,360) = Ksh 224,640 in 3-months period.

But 15% withholding tax =

Then investor pays =

Implying, the investor’s return is Ksh 190,944 for 3-months investment of Ksh 12mn.

Note: An investor will be exempt from paying withholding Tax on presentation of Tax
Exemption Certificate from the Kenya Revenue Authority (KRA).

When Do I Know what Amounts to Pay Central Bank after Application?

 The Auction Management Committee (AMC) meets every Thursday at 4.00pm to

conduct the auction of the 91-days paper and on Wednesday for the 182- and 364-days
papers.
 After considering all bids received, competitive and non-competitive, AMC arrives at a
cut-off rate based on among other considerations, amounts advertised.
 The successful weighted average rate derived from competitive bids is applied to all non-
competitive bids and is published with the results in Daily newspaper.
  The Central Bank reserves the right to allocate equal or lower amount of Treasury Bills
applied for by an investor.

When Do I Make Payment and Where?

 Investors call or visit the Central Bank or its branches or currency centres a day after the
auction date to know how much to pay for individual successful bids. Payment MUST be
done not later than 2.00pm on the following Monday (Value Date), provided it is a
working day. If Monday is NOT a working day, then Tuesday 2.00pm becomes the
deadline for making payments.
 Successful bidder MUST pay total amount given to him/her by any officer from Central
Bank by 2.00pm on the value date, usually on Mondays unless it is a holiday. Any
Investor who defaults in payment may be suspended from participating in future auctions
for some specified period.
 Payments can be made in Cash or Bankers cheques for amounts less than Kshs 1 mn,
Direct debits (Banks only) or Rollover of funds on matured securities. Amounts equal to
or more than Kshs 1 mn can only be paid by electronic transfer using Real Time Gross
System (RTGS) known as Kenya Electronic Payment and Settlement System (KEPSS)
through commercial banks. Please provide the following details with each payment:
Name, Reference No., CDS account No., and include 'Government Treasury Bills
Suspense A/c no. 01-070-0001' when using RTGS.

What is the Evidence of Payment on the Part of the Investor?

Being paperless securities, implying no physical certificate is issued; investors receive a
statement showing their holdings as registered on the Central Depository Securities (CDS)
Registry at the Central Bank of Kenya. Physical CDS account Statements are sent to investors on
quarterly basis and also at request provided the accounts show outstanding securities.

Can I Trade my Treasury Bill in the Secondary Market (Read Nairobi Stock Exchange)?
No. Treasury Bills are not traded at the Nairobi Stock Exchange. However, investors may pledge
them as collateral (or for lien creation) security against credit facilities (loans), and may also be
transferred among holders of CDS accounts. CDS Statements are adjusted accordingly to reflect
these transactions. Commercial banks also use them as collateral for liquidity management
through Repurchase Agreements (Repos) and Intraday Liquidity Facility (ILF). It is however
important to note that the non-listed 364-days Treasury bill is tradable Over The Counter (OTC)
with transactions processed at the CBK.

What Option do I have in Case I want my Money back Before Maturity of my Bills?
Investors who do not wish to hold their investments until maturity are allowed to sell back
(rediscount) their Treasury Bills to Central Bank as a last resort. This is however punitive to the
investor as a way of discouraging the practice. The following formula is used to calculate
amounts receivable (A) by investor:
Where,
RP = Rediscount Price per Ksh 100 which investor will receive
R = Rediscount interest rate or yield per annum
d = days to maturity or tenor (91, 182 and later 364 days)
Note:
R is prevailing weighted average interest rate of the respective tenor plus 3% margin.

Where;
A = Amount receivable
F.V. = Face value Invested
RP = Rediscount Price

What Happens When my Treasury Bills Mature?

 The Central Bank remits electronically the face value of maturing bills directly to the
investor’s commercial bank account on due date. The investor’s CDS account is debited
by the same value of the security and statements are sent to the investor showing new
position.
 Investors may however choose to rollover their securities into a new forthcoming issue
and in this case, they have to complete application form giving rollover instructions and
submit to Central Bank before set deadline specified in the results of the preceding
auction. The maturity date of the maturing security (investment) and the value date of the
new Treasury bill MUST match for rollover instruction to be successful. The Bank
therefore does not remit maturing proceeds into investor’s bank account but rather send
only refund amounts generated from the new investment.
If the security is still held under lien on maturity date, the Bank will remit funds in the account of
the holder of the security (the lender of cash).

Treasury Bonds

What is a Treasury bond?

Treasury Bonds are medium to long term debt instruments, usually longer than one year issued
by the government to raise money in local currency. Maturities of Treasury Bonds that have been
issued so far range from 1-30 years.
What Types of Treasury Bonds are issued by Government of Kenya?
The types of Treasury bond may be defined by the purpose, interest rate structure, maturity
structure, and even by issuer. So far, the Government has issued Fixed Coupon/Rate Bonds, Zero
Coupon, Floating Rate, Infrastructure (project specific), Restructuring/Special bonds, and
Amortized and savings development bonds. Most commonly issued bonds are fixed coupon
bonds which have huge investor demand. Treasury bonds are issued monthly.

Fixed coupon Treasury bonds – Bear predetermined or market derived fixed coupon (interest)
which is paid semiannually on the face value held during the life of the bond. When bought at a
discount (required yield higher than coupon), investor benefits from discount (capital gain)
which is critical for secondary market trading and regular interest payment.
Infrastructure bonds – Proceeds are used to fund specific infrastructure/projects specified in the
prospectus.

Floating Rate Bonds – Pay semiannual interest based on a benchmark rate, for example average
rate of 91-days or 182-days Treasury bill plus some margin. They are on high demand in high
inflationary environment. They are no longer issued by the Government since 2001, most
corporate bodies issue them.

Zero Coupon Bonds – Do not have fixed interest and investor’s return is only the discount
amount equivalent to the yield quoted. Mostly short term and most taken up by commercial
banks.
Who can invest in Treasury bonds in Kenya?
 Resident or non-resident individuals and/or corporate bodies who hold an account with a
local commercial bank.
 Resident or non-resident individuals and/or corporate bodies who may not have an
account with a local commercial bank but invest as a nominee of a commercial bank or
investment bank in Kenya.
 Resident or non-resident individual and/or corporate body that has CDS Account with
Central Bank of Kenya
 Minimum face value of Ksh 50, 000, additional values MUST be in multiples of Ksh.
50,000 except for Infrastructure bonds whose minimum investible amount is Ksh
100,000.
 Must complete Treasury Bonds application form and submit to Central Bank (or
branches) on or before 2.00pm on Tuesdays of the last week of bond (s) sale period. The
closing date of the sale period is indicated in the bond prospectus.

Please note that a non-Kenyan investor who is NOT domiciled in Kenya can invest in Kenya
Government Treasury bonds as a NOMINEE of a local commercial bank, investment bank or
stock broker. Non-Kenyan investors domiciled in Kenya can however invest directly by opening
CDS account at CBK.

How Can an Investor Determine the Price Payable and Return on T.bonds?
The price of a bond is determined by the time to maturity (t), the coupon rate and the quoted
yield to maturity.
 Discount price- This is when the offer price falls below face/par value. In this case, the
quoted yield is higher than the coupon rate.
 Premium – This is when the offer price is above the face/par value. In this case, the
quoted yield is lower than the coupon rate. Investors paying premium price pay more at
initial investment.
 Par price – This is when the offer price equals the face value. In this case, the quoted
yield equals the coupon rate
 Capital gain/loss – Since Treasury bonds trade at the Nairobi Stock Exchange (NSE),
investors may sell/buy them when prices become favorable. A capital gain is realized
when the selling price at secondary market is higher than the buying price at primary
(secondary) market. The reverse is true for capital loss.
  Reinvestment income - Assuming semi-annual coupons are re-invested at same or better
yields than the coupon rate; the return generated from reinvestment at the favorable yield
is the reinvestment income.

Yield Curve
The term 'Yield' in the context of debt markets refers to the annualized percentage increase in the
value of a debt instrument. The percentage depends on the time of the instrument remaining to
maturity such that for a bond t years to maturity, yield is represented as Y (t). For instance, a
bond whose value increases by 10% p.a. is said to have a 10% yield.
A yield curve is a relationship between the interest rate and the time to maturity of the debt
instrument denominated in a given currency. For the issuer, an interest rate is the cost of
borrowing while for the investor; the rate represents a measure of return from investment.
The Kenya Government securities yield curve is derived from the relation between interest rates
of Treasury bills/bonds and the time to maturities of bonds of different tenors. The interest rates
for Treasury bills are the prevailing weighted average rates for both 91-day and 182-day and
364-day papers while interest rates for Treasury bonds are the average prevailing secondary
market yields for bonds based on years to maturity. In a developing market, the estimation of the
yield curve entails use of only a few known yields for certain maturities while yields for other
maturities are estimated by interpolation.
For the investor, a yield curve is useful for understanding conditions in the financial markets
with an aim to seeking trading opportunities, measuring expected returns on bonds and acting as
an indicator for interest rates and inflation expectations. For issuers, the yield curve acts as a
benchmark for pricing other financial instruments in the market as well as predicting the
yield/prices of future government issuances.

BREAK-EVEN-ANALYSIS

Definition
It’s an analysis to determine the point at which revenue received equals the costs associated with
receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the
amount that revenues exceed the break-even point.
Breakeven analysis is used to determine when your business will be able to cover all its
expenses and begin to make a profit. It is important to identify your startup costs, which will help
you determine your sales revenue needed to pay ongoing business expenses.

Variable unit cost: cost associated with producing an additional unit.

Fixed cost: the sum of all costs required to produce any product. The amount does not change as
production increases or decreases.
Expected unit sales: the number of units that are expected to be sold
Price per unit: price you will be able to receive per unit
Total variable cost: the product of units produced and variable cost
Total cost: sum of fixed costs and variable costs
Total revenue: product of price and expected sales unit sales
Profit: total revenue minus total costs
Break-even: number of units required to sell to make a profit of zero
Breakeven Analysis: How to Know When You Can Expect a Profit
For instance, if you have $5,000 of product sales, this will not cover $5,000 in monthly overhead
expenses. The cost of selling $5,000 in retail goods could easily be $3,000 at the wholesale price,
so the $5,000 in sales revenue only provides $2,000 in gross profit. The breakeven point is
reached when revenue equals all business costs.
To calculate your breakeven point, you will need to identify your fixed and variable costs. Fixed
costs are expenses that do not vary with sales volume, such as rent and administrative salaries.
These expenses must be paid regardless of sales, and are often referred to as overhead costs.
Variable costs fluctuate directly with sales volume, such as purchasing inventory, shipping, and
manufacturing a product. To determine your breakeven point, use the equation below:
Breakeven point = fixed costs/ (unit selling price – variable costs)

Understanding break-even analysis

The break-even analysis is not our favorite analysis because:
 It is frequently mistaken for the payback period, the time it takes to recover an
investment. There are variations on break even that make some people think we have it
wrong. The one we do use is the most common, the most universally accepted, but not
the only one possible.
 It depends on the concept of fixed costs, a hard idea to swallow. Technically, a break-
even analysis defines fixed costs as those costs that would continue even if you went
broke. Instead, you may want to use your regular running fixed costs, including payroll
and normal expenses. This will give you a better insight on financial realities. We call
that “burn rate” these post-Internet days.
 It depends on averaging your per-unit variable cost and per-unit revenue over the whole
business.
However, whether we like it or not, this table is a mainstay of financial analysis. You may
choose to leave it out, but really, a business plan would not be complete without it. And,
although there are some other ways to do a break-even analysis, this is the most standard.

Breaking down 'Break-Even Analysis'

Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It
does not analyze how demand may be affected at different price levels. For example, if it costs
$50 to produce a widget, and there are fixed costs of $1,000, the break-even point for selling the
widgets would be:
If selling for $100: 20 Widgets (Calculated as 1000/(100-50)=20)
If selling for $200: 7 Widgets (Calculated as 1000/(200-50)=6.7)

In this example, if someone sells the product for a higher price, the break-even point will come
faster. What the analysis does not show is that it may be easier to sell 20 widgets at $100 each
than 7 widgets at $200 each. A demand-side analysis would give the seller that information.
Most businesses have fixed costs such as rent and salaries, as well as costs for raw materials.
Break-even analysis shows how many sales it takes to pay off the costs of doing business, and
“break even.” After that point, additional sales would bring profit.
It is important to understand the difference between revenue and profit. Every sale brings
revenue. But only after sufficient sales are made to pay off all fixed costs—such as rent, interest
payments and salaries—do additional sales revenues bring profit.
To do a break-even analysis you must first know a business's:
 fixed costs
 price per unit charged to customers and
 variable cost to produce each unit
Break-even is equal to fixed costs divided by the sum of the retail price per unit, minus the
variable cost per unit:
Break-even = FC / (P – VC)
For example, Fern’s Furniture wants to begin selling a new type of table, and does a break-even
analysis to determine the table’s profitability.
Say it costs $20,000 to prepare the additional retail space to sell the product, plus $30,000 in
additional one-time set-up costs. These are the total fixed costs. Each table costs $100 in
materials and labor. Fern plans to sell each table for $250.
Break-even = $50,000/($250-$100) = 333.33.
Therefore, Fern must sell 334 tables before breaking even. Each additional table sold will make
$150 in profit.

A Quick Guide Break Even Analysis

In a world of Excel spreadsheets and online tools, we take a lot of calculations for granted. Take
breakeven analysis. You’ve probably heard of it. Maybe even used the term before, or said: “At
what point do we break even?” But because you may not entirely understand the math — and
because understanding the formula can only deepen your understanding of the concept — here’s
a closer look at how the concept works in reality.
Managers typically use breakeven analysis to set a price to understand the economic impact of
various price- and sales-volume scenario. Pricing matters. Having the right price for a product or
service can boost profit much faster than increasing volume. Setting a price is, of course,
complicated but breakeven analysis can help.
It’s a simple calculation to determine how many units must be sold at a given price to cover
one’s fixed costs. You’re typically solving for the Break-Even Volume (BEV).

To show how this works, let’s take the hypothetical example of a high-end kite maker. Assume
she must incur a fixed cost of $25,500 to produce and sell a kite. These costs might cover the
software needed to design the kite and be sure it is sufficiently aerodynamic, the fee paid to a
graphic designer to design the look and feel of the kite, and the development of promotional
materials used to advertise the kite. These costs are fixed because they will not change with the
number of kites sold.
The variable costs include the materials used to make each kite — special string for $3, the fabric
for the body for $6, wooden dowels for $7, a special plastic handle for $4 — and the labor
required to assemble the kite, which amounted to one and a half hours for a worker earning $20
per hour. Therefore, the unit variable costs to make a single kite is: $50 ($20 in materials and $30
in labor). If she sells the kite for $75, she’ll make a unit margin of $25.
Given the $25 unit margin she’ll receive for each kite sold, she will cover her $25,500 in total
fixed costs if she sells:

Using the interactive illustration below, you can enter each figure and see the output on the right.
Put the Revenue per Unit Sold slider (r) at $75, Variable Cost per Unit Sold (v) slider at $50, the
Fixed Costs (C) slider at $25,500 and set the actual output at 0.
Note: It may be easier to fine-tune precise input values in the interactive illustration using the
arrow keys on your keyboard.
You can see on the right-hand side that the Breakeven Volume is 1,020 units. In other words, if
this kite maker sells 1,020 units of this particular kite over the lifetime of the operation, she will
fully recover the $25,500 in fixed costs she invested in production and selling. If she sells fewer
than 1,020 units, she will lose money. And if she sells more than 1,020 units, she will turn a
profit. That’s the breakeven point. This is the basic breakeven assessment. Now, using the
interactive illustration, you can construct a number of informative “what if” scenarios.
What if we change the price?
Suppose our kite maker is worried about current demand for kites and has concerns about her
firm’s marketing capabilities, calling into question her ability to sell 1,020 units at a price of $75.
What would be the implication of raising the price to $90, which would increase the unit margin
to $40? Using the interactive illustration (moving the Revenue per Unit Sold slider to $100),
you’ll see that breakeven sales would decline to 638 units. With this information, the kite maker
could assess whether she was better off trying to sell 1,020 kites at $75 or 638 kits at $90, and
price accordingly.

What if we want to make an investment and increase the fixed costs?

Breakeven analysis also can be used to assess how sales volume would need to change to justify
other potential investments. For instance, consider the possibility of keeping the price at $75, but
having a celebrity endorse the kite (think Mary Poppins!) for a fee of $21,000. This would be
worthwhile if the kite maker believed that the endorsement would result in total sales of $46,000
(the original fixed cost plus the $21,000 for Ms. Poppins).
Using the interactive illustration, you can slide the Fixed Costs slider to $46,000 and see that it
would be only be worthwhile if the kite maker believed that the endorsement would result in
total sales of 1,840 units. In other words, if the endorsement led to incremental sales of 820 kites
units, the endorsement would break-even. If it led to incremental sales of greater than 820 kites,
it would increase profits.

What if we change the variable cost of producing a good?

Breakeven also can be used to examine the impact of a potential change to the variable cost of
producing a good. Imagine that our kite maker could switch from using a rather plain $6 fabric
for the kite to a higher-end $16 fabric, thereby increasing the variable cost of the kite from $50 to
$60 and decreasing the unit margin from $25 to $15. How much would sales need to increase to
compensate for the extra cost?
Adjust the slider to Variable Cost slider to $60 (and put the Fixed Costs slider back to the
original $25,500 – our kite maker can’t afford to have nice fabric AND get Mary Poppins).
You’ll see the switch to the nicer fabric would make sense if the kite maker thought it would
result in sales of 1,700 units, an additional 680 kites.

You can use the sliders in the interactive illustration to adjust revenue, costs and output. The
graph on the right side will display the output needed to fully cover the fixed and variable costs
in that scenario. Using the sliders, you can see what happens when output rises above or falls
below the breakeven volume. Or how changes in total fixed costs impact the breakeven point.
You likely aren’t a kite maker or able to get a celebrity endorsement from Mary Poppins, but you
can use breakeven analysis to figure out how the various inputs on your product — revenue,
costs, and output sold — impact your business’s profitability.

Three assumptions of the break-even analysis

The break-even analysis depends on three key assumptions:
1. Average per-unit sales price (per-unit revenue):
This is the price that you receive per unit of sales. Take into account sales discounts and special
offers. Get this number from your sales forecast. For non-unit based businesses, make the per-
unit revenue one dollar and enter your costs as a percent of a dollar. The most common questions
about this input relate to averaging many different products into a single estimate.
The analysis requires a single number, and if you build your sales forecast first, then you will
have this number. You are not alone in this, the vast majority of businesses sell more than one
item, and have to average for their break-even analysis.

2. Average per-unit cost:

This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale,
this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs
you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a
units-based sales forecast table (for manufacturing and mixed business types), you can project
unit costs from the sales forecast table. If you are using the basic sales forecast table for retail,
service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50
percent margin would have a per-unit cost of .5, and a per-unit revenue of 1.

3. Monthly fixed costs:

Technically, a break-even analysis defines fixed costs as costs that would continue even if you
went broke. Instead, we recommend that you use your regular running fixed costs, including
payroll and normal expenses (total monthly operating expenses). This will give you a better
insight on financial realities. If averaging and estimating is difficult, use your profit and loss
table to calculate a working fixed cost estimate—it will be a rough estimate, but it will provide a
useful input for a conservative break-even analysis.
Illustration 2 shows a break-even chart. As sales increase, the profit line passes through the zero
or break-even line at the break-even point.
Illustration 2: Break-even chart

The illustration shows that the company needs to sell approximately 1,222 units in order to cross
the break-even line. This is a classic business chart that helps you consider your bottom-line
financial realities. Can you sell enough to make your break-even volume?

The break-even analysis depends on assumptions made for average per-unit revenue, average
per-unit cost, and fixed costs. These are rarely exact. We recommend that you do the break-even
table twice; first, with educated guesses for assumptions, as part of the initial assessment, and
later on, using your detailed sales forecast and profit and loss numbers. Both are valid uses.

FINANCING CHALLENGES OF SMALL FIRMS

From a lack of access to capital and underestimating cash needs to burning through existing cash
reserves, financial knowledge and strategic planning are essential for long-term success. Most
importantly, gaining straightforward answers can give you the courage to overcome common
financial problems in business. With this in mind, let’s empower your financial success in years
to come with viable solutions to ten common financial challenges you may experience in
business:

1. We don’t have enough cash to maintain daily operations.

As entrepreneurs we know first-hand, that it takes money to make money! Typical expenses
range from marketing and merchant fees to payroll, rent and production costs. Ultimately, your
cash position is a sign of financial strength and liquidity.
So, if you have been strapped for cash lately, look for new ways to maximize reserves. Start with
streamlining payment collection processes to settle payments faster and then review payment
disbursement schedules to optimize terms with vendors.

2. Our sales are good, but our profits are really low.
Generally, this indicates over-spending or hidden costs eating away at your bottom line — your
expenses could be out of control. Reign in expenditures by proactively creating a purchasing
policy and system to ensure that you are buying the right materials at competitive prices from
vendors that add value. Gain visibility into your expenses and clearly define purchasing (i.e.
procurement) goals with a strict budget. Then ensure there is supervision of policies, ordering,
receiving and reporting. Don’t hesitate to revisit vendor selection and old contracts to start price
negotiations. Lastly, if you frequently make online purchases, use free apps like Slice to track
spend, hunt bargains and streamline online purchasing.

3. We experience cash shortages on a regular basis; we weren’t ready for the seasonal sales
slump that just hit.
According to venture capitalist Fred Destin, you should always keep your eye on cash –
dynamically. Destin suggests, that “in startups the only real sin is running out of cash, and the
cardinal sin is running out of cash unexpectedly. So whilst you may not need a CFO, you sure
need someone who understands cash flow and can give you the confidence to know when it’s
running out.” One sure fire way to prevent unexpected cash shortages is to hire a CPA to
regularly prepare key financial statements (e.g. balance sheet, income statement, cash flow
statement) to forecast cash needs. Most importantly, gain a working knowledge of your finances.
If you prefer a DIY approach to financial education, take online courses via Coursera and
Udemy.

4. Managing company’s finances is a nightmare – should we hire someone?

Many small businesses hire outside help to manage “numbers nightmares.” Like most startups
you likely started managing your finances in QuickBooks or Excel. Often the next step is to do
the books yourself or hire a bookkeeper to regularly maintain your records.
But did you know you can cost-effectively hire a temp CFO to look over your numbers and make
sure you’re doing things correctly? In fact, outsourcing a CFO can improve your company’s
financial discipline, planning and analysis while providing a more strategic vision to shape long-
term financial goals. Interim CFO services and part-time CFO companies (e.g. The CFO
Connection, B2B CFO etc.) can be cost-effective and well worth the investment.

5. A large majority of our clients pay late on a regular basis.

The check is (not really) in the mail. In fact, you may not be at the top of your customer’s
payment list. Did you know that 80% of small businesses are still plagued by late payments? If
you are one of them, it’s time to tighten up credit terms or create policies and processes to
manage the situation.
For example, pull business credit for new customers, communicate payment policies early and
often, incentivize early payments, make it convenient for customers to pay and enforce late
payment penalties. Most importantly, do it all with a smile. Please and thank you can go a long
way when it comes to getting paid on-time.

6. We need to raise capital, but we’re not sure which funding option to choose?
First, become crystal clear on why you need cash in the first place. A variety of funding options
are available to small businesses: bootstrapping, friends and family, crowd funding, business
loans, grants, venture capital, angel money, etc.
Not every option is viable for your business. This is why you should have clarity on your current
financial picture and assess risk tolerance for each funding vehicle. Carefully research and
consider the upside and downside of each option and choose wisely.

7. Business is slow; we have lowered prices and launched numerous sales promotions,
coupons and markdowns just to stay afloat.
If sales are slow, offering excessive discounts is not the answer. Consumer-oriented sales
promotions can drive short-term sales to offset competitive pressure, yet threaten the long-term
survival of your brand. Price wars come with high casualties – most notably, reduced profit
margins. Instead, revisit your business and revenue model (i.e. how you monetize your business).
Seek to provide more value to current customers by up selling and cross-selling. Fear-based
tactics are rarely profitable or sustainable long-term.

8. Cash flow management is complicated; how can I manage cash better?

Simply put, cash flow is “money in, money out.” How you manage this dynamic of your
business over time impacts every area of your operations. Consider this: monitoring cash flow
can forewarn you of a need for cash and reveal cycles in your business; better preparing you for
the financial road ahead. Staying on top of your cash flow position can be tedious. Thankfully
there are free templates, cash flow calculators and paid apps like FreeAgent, Enloop and Pulse to
monitor the lifeblood of your business.

9. We pay creditors and expenses late on a regular basis. How can we gain control of
payables?
Do you have a budget? If not, it’s time to create one.
Every small business should create an operating budget to prepare for regular expenses such as
utilities, rent and wages. Your operating budget is comprised of several sub-budgets and acts as a
projection of income and expenses for a certain period of time. First, prepare your sales budget
by referring to historical sales reports, if applicable. Then, estimate your costs and set aside cash
each month to pay them. Budgeting will help you gauge targets and prepare to meet your
commitments on a regular basis.

10. How can I improve my overall knowledge of our company’s finances?

In retrospect, when you first started a business you immediately sought out great business books.
One book in particular helped us to understand our financial picture as female entrepreneur:
Minding Her Own Business: The Self-Employed Woman’s Essential Guide to Taxes and
Financial Records.

Internal Rate of Return - IRR

What is 'Internal Rate Of Return - IRR'
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability
of potential investments. Internal rate of return is a discount rate that makes the net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same
formula as NPV does. The following is the formula for calculating NPV:

where:

Ct = net cash inflow during the period t

Co= total initial investment costs
r = discount rate, and
t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be
calculated analytically, and must instead be calculated either through trial-and-error or using
software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake the project. IRR is uniform for investments of varying types and, as such, IRR can be
used to rank multiple prospective projects a firm is considering on a relatively even basis.
Assuming the costs of investment are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first. IRR is sometimes
referred to as "economic rate of return” (ERR).

Breaking down 'Internal Rate of Return - IRR'

You can think of IRR as the rate of growth a project is expected to generate. While the actual
rate of return that a given project ends up generating will often differ from its estimated IRR rate,
a project with a substantially higher IRR value than other available options would still provide a
much better chance of strong growth. One popular use of IRR is in comparing the profitability of
establishing new operations with that of expanding old ones. For example, an energy company
may use IRR in deciding whether to open a new power plant or to renovate and expand a
previously existing one. While both projects are likely to add value to the company, it is likely
that one will be the more logical decision as prescribed by IRR.

In theory, any project with an IRR greater than its cost of capital is a profitable one, and thus it is
in a company’s interest to undertake such projects. In planning investment projects, firms will
often establish a required rate of return (RRR) to determine the minimum acceptable return
percentage that the investment in question must earn in order to be worthwhile. Any project with
an IRR that exceeds the RRR will likely be deemed a profitable one, although companies will
not necessarily pursue a project on this basis alone. Rather, they will likely pursue projects with
the highest difference between IRR and RRR, as chances are these will be the most profitable.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm
can't find any projects with IRRs greater than the returns that can be generated in the financial
markets, it may simply choose to invest its retained earnings into the market. Although IRR is an
appealing metric to many, it should always be used in conjunction with NPV for a clearer picture
of the value represented by a potential project a firm may undertake.

Issues with 'Internal Rate of Return (IRR)'

While IRR is a very popular metric in estimating a project’s profitability, it can be misleading if
used alone. Depending on the initial investment costs, a project may have a low IRR but a high
NPV, meaning that while the pace at which the company sees returns on that project may be
slow, the project may also be adding a great deal of overall value to the company.
A similar issue arises when using IRR to compare projects of different lengths. For example, a
project of a short duration may have a high IRR, making it appear to be an excellent investment,
but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns
slowly and steadily, but may add a large amount of value to the company over time.
Another issue with IRR is not one strictly inherent to the metric itself, but rather to a common
misuse of IRR. People may assume that, when positive cash flows are generated during the
course of a project (not at the end), the money will be reinvested at the project’s rate of return.
This can rarely be the case. Rather, when positive cash flows are reinvested, it will be at a rate
that more resembles the cost of capital. Miscalculating using IRR in this way may lead to the
belief that a project is more profitable than it actually is in reality. This, along with the fact that
long projects with fluctuating cash flows may have multiple distinct IRR values, has prompted
the use of another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR
to correct these issues, incorporating cost of capital as the rate at which cash flows are
reinvested, and existing as a single value. Because of MIRR’s correction of the former issue of
IRR, a project’s MIRR will often be significantly lower than the same project’s IRR.

The internal rate of return (IRR) is frequently used by corporations to compare and decide
between capital projects. The IRR is the interest rate (also known as the discount rate) that will
bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the
current value of cash invested). Using IRR to obtain net present value is known as the discounted
cash flow method of financial analysis.
For example, a corporation will evaluate an investment in a new plant versus an extension of an
existing plant based on the IRR of each project. In such a case, each new capital project must
produce an IRR that is higher than the company's cost of capital. Once this hurdle is surpassed,
the project with the highest IRR would be the wiser investment, all other factors (including risk)
being equal.

Calculation Complexities
The IRR formula can be very complex depending on the timing and variances in cash flow
amounts. Without a computer or financial calculator, IRR can only be computed by trial and
error. One of the disadvantages of using IRR is that all cash flows are assumed to be reinvested
at the same discount rate, although in the real world these rates will fluctuate, particularly with
longer term projects. IRR can be useful, however, when comparing projects of equal risk, rather
than as a fixed return projection.

Calculating IRR
Many accounting software programs now include an IRR calculator, as do Excel and other
programs. A handy alternative for some is the good old HP 12c financial calculator, which will
fit in a pocket or briefcase. The simplest example of computing an IRR is a mortgage with even
payments. Assume an initial mortgage amount of $200,000 and monthly payments of $1,050 for
30 years. The IRR (or implied interest rate) on this loan annually is 4.8%.
Because the stream of payments is equal and spaced at even intervals, an alternative approach is
to discount these payments at a 4.8% interest rate, which will produce a net present value of
$200,000. Alternatively, if the payments are raised to, say $1,100, the IRR of that loan will rise
to 5.2%. The formula for IRR, using this example, is as follows:
 Where the initial payment (CF1) is $200,000 (a positive inflow)
  Subsequent cash flows (CF 2, CF 3, CF N) are negative $1,050 (negative because it is
being paid out)
 Number of payments (N) is 30 years times 12 = 360 monthly payments
 Initial Investment is $200,000
 IRR is 4.8% divided by 12 (to equate to monthly payments) = 0.400%
Using the numbers from this example, the formula for calculating IRR is as follows:

IRR = .400%

Power of Compounding
IRR is also useful in demonstrating the power of compounding. For example, if you invest $50
every month in the stock market over a 10-year period, that money would turn into $7,764 at the
end of the 10 years with a 5% IRR. In other words, to get a future value of $7,764 with monthly
payments of $50 per month for 10 years, the IRR that will bring that flow of payments to a net
present value of zero is 5%.
Compare this investment strategy to investing a lump-sum amount; to get the same future value
of $7,764 with an IRR of 5%, you would have to invest $4,714 today, in contrast to the $6,000
invested in the $50-per-month plan. So, one way of comparing lump-sum investments versus
payments over time is to use the IRR.

Other IRR Uses

Another common use of IRR is in the computation of portfolio, mutual fund or individual stock
returns. In most cases, the advertised return will include the assumption that any cash dividends
are reinvested in the portfolio or stock. Therefore, it is important to scrutinize the assumptions
when comparing returns of various investments.
What if you don't want to reinvest dividends, but need them as income when paid? And if
dividends are not assumed to be reinvested, are they paid out or are they left in cash? What is the
assumed return on the cash? IRR and other assumptions are particularly important on
instruments like whole life insurance policies and annuities, where the cash flows can become
complex. Recognizing the differences in the assumptions is the only way to compare products
accurately. In capital budgeting, the IRR rule is as follows:
IRR > cost of capital = accept project
IRR < cost of capital = reject project

In the example below, the IRR is 15%. If the firm's actual discount rate for discounted cash flow
models is less than 15%, the project should be accepted.
 Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
-1,000,000 300,00 300,000 300,000 300,000 300,000

The primary advantage of implementing the internal rate of return as a decision-making tool is
that it provides a benchmark figure for every project that can be assessed in reference to a
company's capital structure. The IRR will usually produce the same types of decisions as net
present value models, and it allows firms to compare projects on the basis of returns on invested
capital.

Although IRR is easy to compute with either a financial calculator or computer software, there
are some downfalls to using this metric. Similar to the PB method, the IRR does not give a true
sense of the value that a project will add to a firm - it simply provides a benchmark figure for
what projects should be accepted based on the firm's cost of capital. The internal rate of return
does not allow for an appropriate comparison of mutually exclusive projects; therefore managers
might be able to determine that project A and project B are both beneficial to the firm, but they
would not be able to decide which one is better if only one may be accepted.

Another error arising with the use of IRR analysis presents itself when the cash flow streams
from a project are unconventional, meaning that there are additional cash outflows following the
initial investment. Unconventional cash flows are common in capital budgeting since many
projects require future capital outlays for maintenance and repairs. In such a scenario, an IRR
might not exist, or there might be multiple internal rates of return. In the example below two
IRRs exist - 12.7% and 787.3%.

Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
-1,000,000 10,000,000 -10,000,000 0 0 0

The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not
those which are mutually exclusive. It provides a better valuation alternative to the PB method,
yet falls short on several key requirements. Now that you're familiar with both NPV and IRR and
understand the shortcomings of PB period and ARR, let's compare the advantages and
disadvantages of NPV and IRR.
Advantages:
 The NPV method is a direct measure of the dollar contribution to the stockholders.
 The IRR method shows the return on the original money invested.
Disadvantages:
 The NPV method does not measure the project size.
 The IRR method can, at times, give you conflicting answers when compared to NPV for
mutually exclusive projects. The "multiple IRR problem" can also be an issue, as
discussed below.

The Multiple IRR Problem

A multiple IRR problem occurs when cash flows during the project lifetime are negative (i.e. the
project operates at a loss or the company needs to contribute more capital). This is known as a
"non-normal cash flow," and such cash flows will give multiple IRRs.

Why Do NPV and IRR Methods Produce Conflicting Rankings?

When a project is an independent project, meaning the decision to invest in a project is
independent of any other projects, both the NPV and IRR will always give the same result, either
rejecting or accepting a project. While NPV and IRR are useful metrics for analyzing mutually
exclusive projects - that is, when the decision must be one project or another - these metrics do
not always point you in the same direction. This is a result of the timing of cash flows for each
project. In addition, conflicting results may simply occur because of the project sizes.

The timing of cash flows as well as project sizes can produce conflicting results in the NPV
and IRR methods.

Example: NPV and IRR Analysis

Assume once again that Newco needs to purchase a new machine for its manufacturing plant.
Newco has narrowed it down to two machines that meet its criteria (Machine A and Machine B),
and now it has to choose one of the machines to purchase. Further, Newco has assumed the
following analysis on which to base its decision:

We first determine the NPV for each machine as follows:

NPVA = ($5,000) + $2,768 + $2.553 = $321
NPVB = ($10,000) + $5,350 + $5,106 = $456

According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to
purchase. The next step is to determine the IRR for each machine using our financial calculator.
The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.
According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to
purchase. The NPV and IRR analysis for these two projects give us conflicting results. This is
most likely due to the timing of the cash flows for each project as well as the size difference
between the two projects.

Real Rate of Return

Real rate of return is the percentage return on some investments that has been adjusted for
inflation. It is calculated simply by taking the gross return and subtracting the inflation rate.
A real rate of return is a return on an investment that is adjusted for inflation, taxes or other
external factors.
A real rate of return is the annual percentage return realized on an investment, which is adjusted
for changes in prices due to inflation or other external effects. This method expresses the
nominal rate of return in real terms, which keeps the purchasing power of a given level of capital
constant over time.
Breaking down 'Real Rate of Return'
Adjusting the nominal return to compensate for factors such as inflation allows investors to
determine how much of their nominal return actually real return is.

How it works (Example):

1. Let's say John Doe opens a savings account that offers a 2.5% interest rate (this is called the
nominal rate). This sounds like a nice deal, until you consider the 3% inflation rate and the 28%
tax John must pay on the interest. Accordingly, John's real rate of return is negative (2.5% - 3%
loss for inflation – 28% tax on interest income).

2. For example, if the return on an investment is 7% and the inflation rate is 4%, the real rate of
return is 3%.
3. For example, let's say your bank pays you interest of 5% per year on the funds in your savings
account. If the inflation rate is currently 3% per year, then the real return on your savings today
would be 2%. In other words, even though the nominal rate of return on your savings is 5%, the
real rate of return is only 2%, which means that the real value of your savings only increases by
2% during a one-year period.
4. You find the real rate of return on an investment by subtracting the rate of inflation from the
nominal, or named, rate of return. For example, if you have a return of 6% on a bond in a period
when inflation is averaging 2%, your real rate of return is 4%. But if inflation were 4%, your real
rate of return would be only 2%.

The real rate of return formula is the sum of one plus the nominal rate divided by the sum of one
plus the inflation rate which then is subtracted by one. The formula for the real rate of return can
be used to determine the effective return on an investment after adjusting for inflation. The
nominal rate is the stated rate or normal return that is not adjusted for inflation.

The rate of inflation is calculated based on the changes in price indices which are the price on a
group of goods. One of the most commonly used price indices is the consumer price index (CPI).
Although the consumer price index is widely used, a company or investor may want to consider
using another price index or even their own group of goods that relates more to their business
when calculating the real rate of return. For quick calculation, an individual may choose to
approximate the real rate of return by using the simple formula of nominal rate - inflation rate.

Example of Real Rate of Return Formula

An example of the real rate of return formula would be an individual who wants to determine
how much goods they can buy at the end of one year after leaving their money in a money
market account that earns interest.
For this example of the real rate of return formula, we must assume that the individual wants to
purchase the exact same goods and same proportion of goods that the consumer price index uses
considering that it is used often to measure inflation.

For this example of the real rate of return formula, the money market yield is 5%, inflation is
3%, and the starting balance is $1000. Using the real rate of return formula, this example would
show

which would return a real rate of 1.942%. With a $1000 starting balance, the individual could
purchase $1,019.42 of goods based on today's cost. This example of the real rate of return
formula can be checked by multiplying the $1019.42 by (1.03), the inflation rate plus one, which
results in a $1050 balance which would be the normal return on a 5% yield.

Why it Matters:

It is critical to consider the real rate of return on an investment before investing. Inflation, which
is often 2% or 3% per year, reduces the value of money as time passes, and taxes certainly take a
chunk away too. What's left -- the real rate of return -- often can be unimpressive after
considering these adjustments. Accordingly, investors must consider whether the risk associated
with the investment is appropriate given the real rate of return.

How to Calculate Real Rates of Return

How to Calculate Real Rates of Return. Many investors measure the success or failure of
investments by the rate of return that the investment yields. The nominal rate of return measures
the return without taking into account inflation. However, rates of return can be influenced by
inflationary pressures, so some people prefer to measure the rate of return after inflation, also
known as the real rate of return. To calculate the real rate of return, you need to know the price
you paid for the investment, the price you sold the investment for and the inflation rate during
the time you held the investment.

Step 1

Subtract the final value of your investment from the initial cost of the investment. For example,
if invested $10,000 in a mutual fund and sold it a year later for $11,000, you would subtract
$10,000 from $11,000 to get $1,000.

Step 2

Divide the result from step 1 by the initial value of the investment. Continuing this example, you
would divide $1,000 by $10,000 to get 0.1.
Step 3

Multiply the result from step 2 by 100 to convert from a decimal to a percent to calculate the
nominal rate of return. In this example, you would multiply 0.1 by 100 to get 10 percent.

Step 4

Look up the rate of inflation over the time period that your investment took place. You can use
an online calculator (see resources). For example, if your mutual fund investment took place
between Jan. 2007 and Jan. 2008, inflation was 4.28 percent.

Step 5

Subtract the inflation rate from the nominal rate of return to find the real rate of return. Finishing
this example, you would subtract the inflation rate of 4.28 percent from the nominal rate of
return of 10 percent to find your real rate of return equals 5.72 percent.

Investment Returns
An investment return on a financial instrument is the amount of money earned by the
instrument over a given time period. A financial instrument, such as a stock or bond, may pay
dividends or interest, and may appreciate or depreciate in price in the secondary market. Hence,
the investment return equals income received minus its cost. Income received would include any
current income, such as dividends or interest payments, plus any capital gain or loss if the
instrument is sold in the secondary market or, in the case of debt securities, if any principal
payment is greater or less than its initial cost. Hence:

Total Return = Current Income + Capital Gains - Capital Losses

However, the rate of return will depend on the total return divided by the amount invested.

Rate of Return = (Current Income + Capital Gains - Capital Losses) / Amount Invested

Real Rate of Return and the Inflation Premium

Inflation is the general increase in prices of goods and services, and reduces the purchasing
power of the dollar. Deflation is the opposite, but generally happens only for short periods of
time—most of the time, inflation prevails.

If an investment only yielded the inflation rate, then there would be no increase in purchasing
power for the investor. There would be little incentive to invest except for the inflation
premium, which is the part of the return necessary to maintain purchasing power parity for the
future. However, without a real return, money would mostly be spent rather than invested.
Hence, investors demand a real rate of return that is greater than the inflation premium.
Real Rate of Return = Total Rate of Return – Inflation Rate

Thus, investment returns must be at least as great as the expected inflation premium, which is
the amount of return necessary to cover the expected rate of inflation for the near future.

Investment Risk and the Risk Premium

Different investments differ in their risk. Some securities, such as U.S. Treasuries are considered
risk-free, at least of credit default, whereas with other investments, such as options, an investor
will often lose all invested capital.

Generally, higher risk investments potentially yield a higher return. For instance, U.S. Treasuries
yield the lowest returns because they are considered free of credit default risk, since they are
backed by the full faith and credit of the United States government. Small company stocks, on
the other hand, have historically yielded much greater returns, but many of them lose money.

People expect riskier investments to have higher expected returns. This expectation is
reasonable because if investments that differed only in their risk yielded the same returns, people
would only invest in the safer securities. Consider 2 bonds with different amounts of expected
risks, but paying the same nominal yield of 6%: corporate bond A has a credit rating of AAA and
corporate bond B has a credit rating of BBB. Both issuers offer their bonds for $1,000. Their
credit ratings differ because a credit rating agency decided that the risk of default for Corporation
B is greater than it is for Corporation A, which is why its bonds have a lower credit rating. But
why would an investor buy Corporation B’s bond over Corporation A’s for the same price with
the same nominal yield? The result would be that corporation A probably could sell all of its
bonds, whereas Corporation B would have to lower its price to sell its bonds. By lowering the
price below $1,000, its bonds will have a true yield that is higher than its nominal yield, and the
price differential between the 2 bonds, and therefore, the differential between their true yields
must be great enough to compensate investors for the greater expected risk of Corporation B’s
bonds over that of Corporation A’s. Hence, investors require a return that is commensurate with
the risk of the investment.

The risk premium depends not only on the issuer of the security, but also on the type of
security. Bonds issued by a corporation, for instance, are considered safer than its stock because
the corporation has a legal obligation to pay interest and principal, and if the corporation goes
bankrupt, then bondholders have a priority claim over the stockholders to the residual assets of
the corporation. Therefore, stockholders bear greater risk of losing their investment, so they will
only buy or hold the stock if they think that it will yield a return greater than its bonds.

Because U.S. Treasuries are considered free of default risk, the market rates of Treasuries are
considered the risk-free rate. All other investments pay a higher rate to compensate investors
for the greater risk of default, or loss of capital. So investors demand a required return that is
equal to the risk-free rate plus the amount necessary to compensate investors for the increased
risk—the risk premium.
Required Return = Risk-Free Rate + Risk Premium
Since the risk-free rate is the sum of the real rate of return plus the expected inflation premium,
the required return can be expressed thus:

Required Return = Real Rate of Return + Expected Inflation Premium + Risk Premium

Holding Period Return

The holding period is the time interval that an investment is held. The holding period return is
the investment return during the holding period. The realized return is the income received over
the holding period, whereas a paper return is the potential return that would be earned if the
investment were liquidated now.

The calculation for holding period returns is generally used for investments held for less than 1
year, and for which the time value of money is insignificant and the reinvestment of current
income is not considered, which simplifies calculations.

Holding Period Return = (Current Income + Capital Gain or Loss) / Amount Invested

If a financial instrument pays current income, then the maximum return can only be earned if the
current income is reinvested at the highest rate. The reinvestment rate is the rate that can be
earned from income received from an investment that is reinvested; otherwise, the current
income is not compounded. A compounded rate of return is earned when all current income is
reinvested, yielding a higher return for the holding period. For instance, a 10-year corporate bond
paying 6% would pay $30 in interest twice a year for 10 years, with the final payment including
the principal of $1,000. At the end of 10 years, the bondholder would have received a total of
$1,600—a total of $600 in interest plus the $1,000 principal. However, an investment of $1,000
in a savings account paying 6% compounded semiannually would yield $1,806.11 at the end of
10 years, which is slightly more than an 8% bond would pay over the same period. Of course,
this comparison disregards the opportunity cost incurred by reinvesting the money, which is not
being able to spend it for 10 years.

Nominal and Real Interest Rates

Interest is the amount of money charged for the borrowing of money to compensate the lender
for the lost opportunity cost of not having the money and to compensate the lender for the
various risks of lending money, such as inflation risk and credit default risk. Indeed, the word
risk is derived from the Tuscan word rischio, which the Tuscans considered the amount
necessary to compensate for the lending of money. Usually, the amount of interest being charged
is expressed as an interest rate, which is a percentage of the principal or balance per unit of time.

The concept of interest has a long history. Aristotle thought interest was evil, and according to
the Koran, God condemned the charging of interest. The earliest known examples of interest
were in ancient Mesopotamia, beginning in the 3rd millennium B.C., when an interest rate of
either 20% or 33% was charged depending on whether the loan was paid in silver or barley.
However, the interest rate did not depend on the amount of time. [No doubt this simplified
calculations that required using a sexagesimal (base 60) numbering system and pressing wedge-
shaped (cuneiform) styles into wet clay tablets.]

Interest and Interest Rates

Interest rates are the rate of growth of money per unit of time. It is one of the most fundamental
factors in investments, since so many financial assets depend on its value. It is used to determine
the present and future value of money and of annuities. Many securities either pay interest or the
payoff depends on the interest rate. Whether a business will invest in capital or issue securities
depends on the interest rate. Hence, the interest rate allocates economic resources more
efficiently. Governments control their economies by adjusting key interest rates through
monetary and fiscal policies.

Interest is the cost of money, in the form of a loan, and like the price of virtually everything
else, it is determined by supply and demand. In the United States and most other developed
countries, the government has a major influence on the interest rate, adjusting it higher to cool
the economy and adjusting it lower to stimulate it. The government can also increase the money
supply by printing money, or through other monetary and fiscal policies. Another source of
supply is the savings of people, businesses, and other organizations. The main demand for
money is for loans by people and businesses. Demand can also be affected by the monetary
policies of the government.

Charging interest on a loan is sometimes called usury, although in more recent times, it has
acquired a negative connotation of excessively high or illegal interest rates being charged. In
fact, when the usury rate is limited by law, the rate is referred to as a usury ceiling. However, at
least 2 states in the United States do not have usury limits: Delaware and South Dakota, which is
why many credit card issuers are located in those states.

Nominal and Real Interest Rates

The nominal interest rate is the stated interest rate. If a bank pays 5% annually on a savings
account, then 5% is the nominal interest rate. So if you deposit $100 for 1 year, you will receive
$5 in interest. However, that $5 will probably be worth less at the end of the year than it would
have been at the beginning. This is because inflation lowers the value of money. As goods,
services, and assets, such as real estate, rise in price, it takes more money to buy them.
The real interest rate is the nominal rate of interest minus inflation, which can be expressed
approximately by the following formula:

Real Interest Rate = Nominal Interest Rate – Inflation Rate = Growth of Purchasing Power.

For low rates of inflation, the above equation is fairly accurate. However, the actual growth of
your purchasing power is equal to the nominal interest rate divided by the inflation rate:
Formula Relating the Real Interest Rate,
Nominal Interest Rate, and Inflation Rate
1 + N R = Real Interest Rate
1+R=
N = Nominal Interest Rate
 1 + I I = Inflation Rate
The above equation can be solved for the real interest rate.

Solving for the Real Interest Rate

(1 + R)(1 + I) = 1 + N Multiply both sides by (1 + I).
1 + I + R + RI = 1 + N Multiply out left-hand side to get terms.
R + RI = R(1 + I) = N - I Subtract 1 and I from both sides.
R = (N – I)/(1 + I) Divide both sides by 1 + I.
Real Interest Rate Formula
N - I R = Real Interest Rate
R= N = Nominal Interest Rate
1 + I I = Inflation Rate

Because people invest to earn more purchasing power, they will only invest or lend money that
pays more than the expected inflation rate. In this case, the nominal rate equals the real interest
rate plus the expected inflation.

Nominal Interest Rate Equilibrium

Although there are many different interest rates, their differences result mainly from risk, but
they all move up or down along with the prevailing rates. Thus, these rates can be abstracted as a
single interest rate—the prevailing interest rate. Generally, as interest rates increase, saving
increases and borrowing decreases, and vice versa. If investments pay higher interest, then more
people, businesses, and other organizations will invest to earn more money. If interest rates
decline, then the motivation to invest declines also, but borrowing increases, which increases
demand for money. There is a point where supply equals demand—this is the observed or
nominal interest rate.
Irving Fisher looked at interest rate equilibrium as the desire for a specific real rate of return plus
the expected inflation rate:
Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate.

If the expected inflation rate was high, then people would demand a higher nominal rate for their
investments; for why would anyone invest if they did not expect a real return? Although no one
can really know what future interest rates will be, the nominal interest rate can be somewhat
indicative of the expected interest rates.

The Taxation of Nominal Interest Rates

Most earned interest, or any positive return from investments, is taxed. However, taxes currently
apply to the nominal rate of return, not the real rate—thus, the tax rate on the real rate of return is
greater than the published tax rate.

Real Rate of Return = Nominal Interest Rate × (1 – Your Tax Bracket) - Inflation Rate
Example — Calculating the Real Interest Rate after Taxes
If you earned 5% nominal interest on your money with 3% inflation, and you are in the 25% tax
bracket, what is your real interest rate after taxes?

Solution:
Using the above formula:
Real Rate of Return = 5% × .75 - 3%. = .75%

As you can see from the above, if you are in a high tax bracket, you will have to earn
significantly more than 5% to earn a decent real return. If you are in the 35% bracket, given the
above nominal interest rate and inflation rate, your real interest rate would be 0! You can see
why the wealthy invest in tax-free municipal bonds.

Simple Interest
Simple interest, often called the nominal annual percentage rate (APR), is uncompounded
interest, which is calculated by multiplying the principal times the interest rate. The earned
interest is not added to the principal, so the amount of interest earned is always the same for a
given interest rate.

Simple Interest = Principal × Interest Rate

A good example of simple interest is the interest earned by bonds. Most bonds pay a coupon rate,
which is simply the stated interest rate of the bond when it is first issued. When the interest is
earned, it is sent to the bondholder—it is not added to the bond's principal and the interest earns
no additional interest unless the bondholder reinvests the interest in another investment, such as a
savings account.

Compounding Interest

Compounded interest is calculated using the principal plus previously earned interest. For
instance, if you deposit $100 in a savings account that pays 6% interest, compounded
semiannually, then this means that you are actually earning 3% every 6 months, so that at the end
of 6 months, you would have $103. But in the next 6 months, there would be $103 earning
interest instead of just $100, so $103 × 3% = $3.09. Add this to the 1st $3 already earned will
yield a total of $6.09 for the 1st year, which is 9 cents more than if the interest rate was simple
interest. This would be equivalent to a simple interest rate of 6.09% per year. Because money
earns interest, it has a future value that is greater than its present value by the amount of the
interest earned—this is referred to as the future value of money or the future value (FV) of a
dollar. The future value can be expressed as:

Future Value = Principal × (1 + Interest Rate per Compounding Period)Number of Compounding Periods
or
Future Value of a Dollar (FVD)
FV = Future Value
FV = P(1+r)n P = Principal
r = interest rate per compounding period
 n = number of compounding periods
Using the above example: $100 × (1+.03)2 = $106.09. Interest rates are often used to compare
investments, but not all investments have the same compounding period, or it may not be
compounded at all, as is the case for a zero coupon bond, which pays no interest. The interest is
earned by buying the bond at a discount and receiving face value at maturity. However, an
effective compounded interest rate can be found even for a discounted bond, because it is
possible to convert compounding interest rates into other rates with different periods of
compounding. Most investments that pay interest normalize the interest rate to an annual rate—
the APR. Thus, using the above example, a savings deposit that pays 6% compounded
semiannually is equivalent to 6.09% compounded annually. By normalizing interest rates to an
effective annual percentage rate, different investments can be easily compared.

Rule of 70 — Quick Method to Find Doubling Time

The Rule of 70 is a simple method to find how quickly a principal that is earning a compounding
interest rate will take to double: divide 70 by the interest rate for the compounding period.
Time to Double = 70 / Interest Rate

Examples: How long will a savings account paying 5% compounded annually take to double?
70/5 = 14 years. As a check, using part of the formula for future value listed above, (1.05)14 ≈
1.98, so the Rule of 70 is a close approximation. Note, however, that the Rule of 70
approximation becomes less accurate for higher interest rates. For instance, if the interest rate is
14%, then 70/14 = 5, but (1.14)5 ≈ 1.93

Effective Interest Rate

An effective interest rate is one that is calculated for a standard time, usually 1 year, in which
case, it is known as an effective annual rate. Investments can more easily be compared using
effective interest rates.
Solving for the Effective Interest Rate in Terms of a More Frequently Compounded Rate
Equalize the annual rate (i) to the compounded rate (r),
1 + i = (1 + r/n)n
with n = number of compounding periods.
1/n
(1 + i) = 1 + r/n Take the nth root of both sides.
r/n = (1 + i) – 1
1/n
Subtract 1 from both sides and transpose sides.
r = n × [(1 + i) – 1]
1/n
Multiply both sides by n.
Effective Interest Rate Formula
i = effective interest rate
r = n × (1 + i)1/n – 1 r = interest rate per compounding period
n = number of compounding periods

Example: So if a bank wants to advertise a 10% interest rate that is compounded quarterly, then
what is the nominal interest rate, compounded quarterly, that will yield 10% annually? The
solution:
r = 4 × (1 + 10%)1/4 – 1 = 4 × [(1.1)1/4 – 1] = 4 × [1.024 – 1] = 4 × 0.024 = 0.096 = 9.6%
So 9.6% compounded quarterly will yield 10% compounded annually.

Example: A coupon bond pays 6% annually in semiannual payments. What is the interest rate
compounded semiannually?

r = 2 × (1 + 0.06%)1/2 – 1 = 2 × [(1.06)1/2 – 1] = 2 × [1.0296 – 1] = 2 × 0.0296 = 0.0592 = 5.92%

Continuous Compounding Interest

Many portfolio simulations and pricing models for derivatives use a continuously compounded
interest rate formula. If a savings account paid a nominal interest rate of 6%, that was
compounded semiannually, the real compounded rate can be found using the following formula:
1. Formula For Finding the Compounded Interest Rate from a Nominal Interest Rate
r .06 C = Compounded Interest Rate
C = ( 1 + ─ ) n - 1 = ( 1 + ─ ) 2 - 1 = 0.0609 = 6.09% r = Nominal Interest Rate
n 2 n = number of compounding periods
To find the daily compounded rate for a nominal annual interest rate of 6%, divide the interest
rate by 365, and raise the quantity in parentheses to the 365th power. We note that as n increases,
the increase in the 1st term becomes less and less, reaching a limit as n increases to infinity. This
limit is the natural logarithm base e:
2. Formula For Finding the Natural Logarithm Base e
1
As n → ∞, ( 1 + ─ ) n → e = 2.718281828... n = number of compounding periods
n

As a corollary of the above equation, we arrive at Formula 3:

r
r = Rate of growth or interest rate
As n → ∞, ( 1 + ─ ) n → er
n = number of compounding periods
n
Thus, by substituting the result of Formula 3 into Formula 1, we see that:
Continuous Compounded Interest Rate = er - 1

Example — Calculating the Continuously Compounded Interest Rate or the Effective Annual
Percentage Rate
If a bank advertises a savings account that pays a 6% nominal interest rate that is compounded
continuously, what is the effective annual percentage rate?

Solution:
Using the above formula:
Continuously Compounded Interest Rate = e.06 - 1 = 1.061837 - 1 ≈ 6.1837%

Although it sounds like you'll make a lot of money by having it continuously compounded, it's
not much more than the daily compounded rate of:
6% Compounded Daily = (1 + .06/365)365 ≈ 0.061831 ≈ 6.1831%
Note that since 1 + Growth Factor = e(Growth Factor), we can simplify the 1st formula relating real
interest rates, nominal interest rates, and inflation rates by the following equation:
Formula Relating the Real Interest Rate, Nominal Interest Rate,
and Inflation Rate Using Continuously Compounded Rates
eN R = Real Interest Rate
R (N-I)
e = =e N = Nominal Interest Rate
eI I = Inflation Rate
Taking the natural logarithm of both sides, simplifies the above equation even further:
R=N-I
Thus, for continuously compounded rates, the approximation formula for relating the real interest
rate to the nominal interest rate and inflation rate becomes exact.

Minimum / Required Rate of Return (RRR)

The minimum expected yield by investors require in order to select a particular investment.
In securities, the minimum acceptable rate of return at a given level of risk. Different investors
have different reasons for choosing their required returns. Normally, it is determined by a
person's or institution's cost of capital. For example, an investor may also carry a debt with a
high interest rate; if an investment does not meet a required rate of return, it would make more
sense for the investor to pay down his/her debt. The required return is also related to the amount
of risk an investor is willing to accept. One with a portfolio consisting largely of bonds will
generally have a lower required return than one whose portfolio contains mainly stocks.

The minimum annual percentage earned by an investment that will induce individuals or
companies to put money into a particular security or project. The required rate of return (RRR) is
used in both equity valuation and in corporate finance.
Investors use the RRR to decide where to put their money. They compare the return of an
investment to all other available options, taking the risk-free rate of return, inflation and liquidity
into consideration in their calculation. For investors using the dividend discount model to pick
stocks, the RRR affects the maximum price they are willing to pay for a stock. The RRR is also
used in calculations of net present value in discounted cash flow analysis.
Corporations use the RRR to decide if they should pursue a new project or business expansion;
in corporate finance, the RRR is equal to the weighted average cost of capital (WACC).

Breaking down 'Required Rate Of Return - RRR'

You might require a return of 9% per year to consider a stock investment worthwhile, assuming
that you can easily sell the stock and inflation is 3% per year. Your reasoning is that if you don't
receive a 9% return, which is really a 6% return after inflation, then you'd be better off putting
your money in a CD that earns a risk-free 3% per year (really 0% after inflation). You aren't
willing to take on the additional risk of investing in stocks, which can be volatile and whose
returns are not guaranteed, unless you can earn a 6% premium over the risk-free CD. The RRR
will be different for every individual and every company depending on their risk tolerance,
investment goals and other unique factors.

1. The minimum rate of return that an investment must provide or must be expected to provide
in order to justify its acquisition. For example, an investor who can earn an annual return of 11%
on certificates of deposit may set a required rate of return of 15% on a more risky stock
investment before considering a shift of funds into stock. An investment's required return is a
function of the returns available on other investments and of the risk level inherent in a particular
investment.
2. The minimum rate of return required by an investor, a stipulation that limits the types of
investments the investor can undertake. For example, a person with a required rate of return of
15% would generally have to invest in relatively risky securities.

The required rate of return (RRR) is a component in many of the metrics and calculations used in
corporate finance and equity valuation. It goes beyond just identifying the return of the
investment, and factors in risk as one of the key considerations to determining potential return.
The required rate of return also sets the minimum return an investor should accept, given all
other options available and the capital structure of the firm. To calculate the required rate, you
must look at factors such as the return of the market as a whole, the rate you could get if you
took on no risk (the risk-free rate of return), and the volatility of the stock or the overall cost of
funding the project. Here we examine this metric in detail and show you how to use it to
calculate the potential returns of your investments.

Discounting Models

One particularly important use of the required rate of return is in discounting most types of cash
flow models and some relative value techniques. Discounting different types of cash flow will
use slightly different rates with the same intention - finding the net present value.
Common uses of the required rate of return include:
 Calculating the present value of dividend income for the purpose of evaluating stock
prices
 Calculating the present value of free cash flow to equity
 Calculating the present value of operating free cash flow

Equity, debt and corporate expansion decisions are made by placing a value on the periodic cash
received and measuring it against the cash paid. The goal is to receive more than what you paid.
In corporate finance, the focus is on the cost of funding projects compared to the return; in
equities, the focus is on the return given compared to the risk taken on.

Equity and Debt

In equities the required rate of return is used in various calculations. For example the dividend
discount model uses the RRR to discount the periodic payments and calculate the value of the
stock. Finding the required rate of return can be done by using the capital asset pricing model
(CAPM).
The CAPM will require that you find certain inputs:
 the risk free rate (RFR)
 the stock's beta
 the expected market return.
Start with an estimate of the risk free rate. You could use the current yield to maturity of a 10
year T-bill - let's say it's 4%.
Then, take the expected market risk premium for this stock. This can have a wide range of
estimates. For example, it could range between 3% to 9%, based on factors such as business risk,
liquidity risk, financial risk. Or, you can simply derive it from historical yearly market returns.
Let's use 6%, rather than any of the extreme values. Often, the market return will be estimated by
a brokerage, and you can just subtract the risk-free rate

Last of all, get the beta of the stock. To calculate beta manually, use the following regression
model:
Return of Stock = α + βstock Rmarket
Where:
 βstock is the beta coefficient for the stock, meaning it is the covariance between the stock
and the market divided by the variance of the market. We will assume the beta is 1.25.
 Rmarket is the return expected from the market. For example, the return of the S&P 500
can be used for all stocks trading on it - and even some stocks not on the index, but
related to businesses that are.
 α is a constant that measures excess return for given level of risk .Now we put together
these three numbers using the capital asset pricing model:

E(R) = RFR + βstock (Rmarket – RFR)

E(R) = 0.04 + 1.25 (6)

E(R) = 11.5%
Where:
 E(R) = the required rate of return, or expected return
 RFR = the risk free rate
 βstock = beta of the stock
 Rmarket = return of the market as a whole
 (Rmarket – RFR) = the market risk premium, or the return above the risk-free rate to
accommodate additional unsystematic risk

Dividend Discount Approach

An investor could also use the dividend discount model, also known as the Gordon growth
model. By finding the current stock price, the dividend payment and an estimate of the growth
rate for dividends, you can rearrange the formula into:
k=(D/S)+g
Where:
 k = required rate of return
 D = dividend payment (expected to be paid next year)
 S = current stock value (if using the cost of newly issued common stock you will need to
minus the flotation costs)
  g = growth rate of the dividend
Again, it is important to note that there needs to be some assumptions, particularly the continued
growth of the dividend at a constant rate.

Required Rate of Return in Corporate Finance

Investment decisions are not limited to stocks; every time money is risked for something like
expansion or a marketing campaign an analyst can look at the minimum return these
expenditures demand. If the current project will give a lower return than other potential projects,
then it will not be done. Other factors do go into these decisions, such as risk, time horizon and
available resources, among others, but the required rate of return is the basis for deciding
between multiple investments. When looking at an investment decision in corporate finance, the
overall required rate of return will be the weighted average cost of capital (WACC).

Capital Structure
The WACC is the cost of financing new projects based on how a company is structured. If a
company is 100% debt then it would be easy: just find the interest on the issued debt and adjust
for taxes (because interest is tax deductible). In reality, a corporation is much more complex.
Finding the true cost of capital requires a calculation based on a combination of sources. Some
would even argue that, under certain assumptions, the capital structure is irrelevant, as outlined
in the Modigliani-Miller theorem.

To calculate the WACC simply take the weight of the source of financing and multiply it by the
corresponding cost. There is one exception: you should multiply the debt portion by one minus
the tax rate. Then sum the totals. The equation looks something like this:
WACC = Wd [kd(1-t)] + Wps(kps) + Wce(kce)
Where:
 WACC = weighted average cost of capital (firm wide required rate of return)
 Wd = weight of debt
 kd = cost of debt financing
 t = tax rate
 Wps = weight of preferred shares
 kps = cost of preferred shares
 Wce = weight of common equity
 kce = cost of common equity
When dealing with internal corporate decisions to expand or take on new projects, the required
rate of return is used as a minimum acceptable return benchmark - given the cost and returns of
other available investment opportunities.

The Bottom Line

The required rate of return is a difficult metric to pinpoint due to the various estimates and
preferences from one decision maker to the next. The risk return preferences, inflation
expectations and the firm's capital structure all play a role in determining the required rate. Any
one of the many factors can have major effects on an asset's intrinsic value. As with many things,
practice makes perfect. As you refine your preferences and dial in estimates, your investment
decisions become dramatically more predictable.
 Cost of Capital
The primary meaning of cost of capital is simply the cost an entity must pay to raise funds. The
term can refer, for instance, to the financing cost (interest rate) a company pays when securing a
loan. Cost of capital is the cost an organization pays to raise funds, e.g., through bank loans or
issuing bonds. Cost of capital is expressed as an annual percentage.
What it is:
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with
equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make
a given investment.

It is the cost of funds used for financing a business. Cost of capital depends on the mode of
financing used – it refers to the cost of equity if the business is financed solely through equity, or
to the cost of debt if it is financed solely through debt. Many companies use a combination of
debt and equity to finance their businesses, and for such companies, their overall cost of capital
is derived from a weighted average of all capital sources, widely known as the weighted average
cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must
overcome before it can generate value, it is extensively used in the capital budgeting process to
determine whether the company should proceed with a project.

A firm's cost of capital is the cost it must pay to raise funds—either by selling bonds, borrowing,
or equity financing. Organizations typically define their own cost of capital in one of two ways:

1. Cost of capital may be taken simply as the financing cost the organization must pay when
borrowing funds, either by securing a loan or by selling bonds, or equity financing. In
either case, cost of capital would be expressed as an annual interest rate, such as 6%, or
8.2%.
2. Alternatively, when evaluating a potential investment (e.g., a major purchase), the cost of
capital is considered to be the return rate the company could earn if it used money for an
alternative investment with the same risk. That is, the cost of capital is essentially the
opportunity cost of investing capital resources for a specific purpose.

In many organizations cost of capital (or, more often weighted average cost of capital) serves as
the discount rate for discounted cash flow analysis of proposed investments, actions or business
case cash flow scenarios. Cost of capital (or weighted average cost of capital) is also
used sometimes to set the hurdle rate, or threshold return rate that a proposed investment must
exceed in order to receive funding.

Cost of capital percentages can vary greatly between different companies or organizations,
depending on such factors as the organization's credit worthiness and perceived prospects for
survival and growth. In 2011, for example, a company with an AAA credit rating, or the US
treasury, can sell bonds with a yield somewhere between 4% and 5%, which might be taken as
the cost of capital for these organizations. At the same time, organizations with lower credit
ratings—organizations whose future prospects are viewed as "speculative" by the bond market—
might have to pay 10% - 15%, or even more. Other related costs includes:-
Weighted average cost of capital WACC is the arithmetic average (mean) capital cost, where
the contribution of each capital source is weighted by the proportion of total funding it provides.
WACC is usually expressed as an annual percentage.

Cost of borrowing simply refers to the total amount paid by a debtor to secure a loan and use
funds, including financing costs, account maintenance, loan origination, and other loan-related
expenses. A cost of borrowing sum will most likely be expressed in currency units such as
dollars, pounds, euro, or yen.

Cost of debt is the overall average rate an organization pays on all its debts, typically consisting
primarily of bonds and bank loans. Cost of debt is expressed as an annual percentage.

Cost of equity COE is a part of a company's capital structure. COE measures the
returns demanded by stock market investors who will bear the risks of ownership. COE is
usually expressed as an annual percentage.

Cost of Funds refers to the interest cost that financial institutions pay for the use of money,
usually expressed as an annual percentage.

A Cost of Funds Index (COFI) refers to an established Cost of Funds rate for a region. In the
United States, for instance, a regional COFI might be set by a Federal Home Loan Bank.

Breaking down 'Cost of Capital'

The cost of various capital sources varies from company to company, and depends on factors
such as its operating history, profitability, credit worthiness, etc. In general, newer enterprises
with limited operating histories will have higher costs of capital than established companies with
a solid track record, since lenders and investors will demand a higher risk premium for the
former.

Every company has to chart out its game plan for financing the business at an early stage. The
cost of capital thus becomes a critical factor in deciding which financing track to follow – debt,
equity or a combination of the two. Early-stage companies seldom have sizable assets to pledge
as collateral for debt financing, so equity financing becomes the default mode of funding for
most of them.

The cost of debt is merely the interest rate paid by the company on such debt. However, since
interest expense is tax-deductible, the after-tax cost of debt is calculated as: Yield to maturity of
debt x (1 - T) where T is the company’s marginal tax rate.

The cost of equity is more complicated, since the rate of return demanded by equity investors is
not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the
Capital Asset Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk Premium).

Companies strive to attain the optimal financing mix, based on the cost of capital for various
funding sources. Debt financing has the advantage of being more tax-efficient than equity
financing, since interest expenses are tax-deductible and dividends on common shares have to be
paid with after-tax dollars. However, too much debt can result in dangerously high leverage,
resulting in higher interest rates sought by lenders to offset the higher default risk.

Why it Matters:

Cost of capital is an important component of business valuation work. Because an investor

expects his or her investment to grow by at least the cost of capital, cost of capital can be used as
a discount rate to calculate the fair value of an investment's cash flows.

Investors frequently borrow money to make investments, and analysts commonly make the
mistake of equating cost of capital with the interest rate on that money. It is important to
remember that cost of capital is not dependent upon how and where the capital was raised. Put
another way, cost of capital is dependent on the use of funds, not the source of funds.

Cost of Capital Formula

The cost of capital formula is the blended cost of debt and equity that a company has acquired in
order to fund its operations. It is important, because a company’s investment decisions related to
new operations should always result in a return that exceeds its cost of capital – if not, then the
company is not generating a return for its investors.

How to Calculate the Cost of Capital

The cost of capital is comprised of the costs of debt, preferred stock, and common stock. The
formula for the cost of capital is comprised of separate calculations for all three of these items,
which must then be combined to derive the total cost of capital on a weighted average basis. To
derive the cost of debt, multiply the interest expense associated with the debt by the inverse of
the tax rate percentage, and divide the result by the amount of debt outstanding. The amount of
debt outstanding that is used in the denominator should include any transactional fees associated
with the acquisition of the debt, as well as any premiums or discounts on sale of the debt. These
fees, premiums, or discounts should be gradually amortized over the life of the debt, so that the
amount included in the denominator will decrease over time. The formula for the cost of debt is
as follows:

(Interest Expense x (1 – Tax Rate)

Amount of Debt – Debt Acquisition Fees + Premium on Debt – Discount on Debt

The cost of preferred stock is a simpler calculation, since interest payments made on this form of
funding are not tax-deductible. The formula is as follows:

Interest Expense
Amount of Preferred Stock

The calculation of the cost of common stock requires a different type of calculation. It is
composed of three types of return: a risk-free return, an average rate of return to be expected
from a typical broad-based group of stocks, and a differential return that is based on the risk of
the specific stock in comparison to the larger group of stocks. The risk-free rate of return is
derived from the return on a U.S. government security. The average rate of return can be derived
from any large cluster of stocks, such as the Standard & Poor’s 500 or the Dow Jones
Industrials. The return related to risk is called a stock’s beta; it is regularly calculated and
published by several investment services for publicly-held companies, such as Value Line. A
beta value of less than one indicates a level of rate-of-return risk that is lower than average, while
a beta greater than one would indicate an increasing degree of risk in the rate of return. Given
these components, the formula for the cost of common stock is as follows:

Risk-Free Return + (Beta x (Average Stock Return – Risk-Free Return))

Once all of these calculations have been made, they must be combined on a weighted average
basis to derive the blended cost of capital for a company. We do this by multiplying the cost of
each item by the amount of outstanding funding associated with it, as noted in the following
table:
Total Debt Funding x Percentage Cost = Dollar Cost of Debt
Total Preferred Stock Funding x Percentage Cost = Dollar Cost of Preferred Stock
Total Common Funding x Percentage Cost = Dollar Cost of Common Stock
= Total Cost of Capital
Cost of Capital Examples

Cost of capital is determined by the market and represents the degree of perceived risk by
investors. When given the choice between two investments of equal risk, investors will generally
choose the one providing the higher return.

1. The firm’s overall cost of capital is based on the weighted average of these costs. For example,
consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of
equity is 10% and after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3
x 7%) = 9.1%. This is the cost of capital that would be used to discount future cash flows from
potential projects and other opportunities to estimate their Net Present Value (NPV) and ability
to generate value.

2. Let's assume Company XYZ is considering whether to renovate its warehouse systems. The
renovation will cost $50 million and is expected to save $10 million per year over the next 5
years. There is some risk that the renovation will not save Company XYZ a full $10 million per
year. Alternatively, Company XYZ could use the $50 million to buy equally risky 5-year bonds
in ABC Co., which return 12% per year.

Because the renovation is expected to return 20% per year ($10,000,000 / $50,000,000), the
renovation is a good use of capital, because the 20% return exceeds the 12% required return
XYZ could have gotten by taking the same risk elsewhere.

The return an investor receives on a company security is the cost of that security to the company
that issued it. A company's overall cost of capital is a mixture of returns needed to compensate
all creditors and stockholders. This is often called the weighted average cost of capital and refers
to the weighted average costs of the company's debt and equity.
3. An investment analyst wants to determine the cost of capital of the Jolt Electric Company, to
see if it is generating returns that exceed its cost of capital. The return it reported for its last
fiscal year was 11.8%. The company’s bonds are currently priced on the open market at a total
price of $50,800,000, its preferred stock at $12,875,000, and its common stock at $72,375,000.
Its incremental tax rate is 34%. It pays $4,625,000 in interest on its bonds, and there is an
unamortized debt premium of $1,750,000 currently on the company’s books. The preferred
stock pays interest of $1,030,000. The risk-free rate of return is 5%, the return on the Dow Jones
Industrials is 12%, and Jolt’s beta is 1.5. To calculate Jolt’s cost of capital, we first determine its
cost of debt, which is as follows:
($4,625,000 Interest Expense) x (1 - .34 Tax Rate)
----------------------------------------------------------------
$50,800,000 Debt + $1,750,000 Unamortized Premium

= 5.8%

The investment analyst then proceeds to the cost of preferred stock, which is calculated as
follows:

$1,030,000 Interest Expense

------------------------------------
$12,875,000 Preferred Stock

= 8.0%

Finally, the analyst calculates the cost of common stock, which is as follows:

5% Risk-Free Return + (1.5 Beta x (12% Average Return – 5% Risk-Free Return) = 15.5%

The analyst then creates the following weighted-average table to determine the combined cost of
capital for Jolt:

Funding Type Funding Amount % Cost Dollar Cost

Debt $50,800,000 5.8% $2,946,400
Preferred Stock $12,875,000 8.0% $1,030,000
Common Stock $72,375,000 15.5% $11,218,125
Totals $136,050,000 11.2% $15,194,525

Based on these calculations, Jolt’s return of 11.8% is a marginal improvement over its cost of
capital of 11.2%.
 What is weighted average cost of capital WACC?
Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any other long-term
debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of
return on equity increase, as an increase in WACC denotes a decrease in valuation and an
increase in risk.

WACC is a calculation of a firm's cost of capital in which each category of capital is

proportionately weighted. All capital sources - common stock, preferred stock, bonds and any
other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm
increases as the beta and rate of return on equity increases, as an increase in WACC notes a
decrease in valuation and a higher risk.

A firm's cost of capital from various sources usually differs somewhat between the different
sources of capital used. Cost of capital may differ, that is, for funds raised with bank loans, sale
of bonds, or equity financing. In order to find the appropriate cost of capital for the firm as a
whole, weighted average cost of capital (WACC) is calculated. This is a simply the arithmetic
average (mean) capital cost, where the contribution of each capital source is weighted by the
proportion of total funding it provides.

WACC is not the same thing as cost of debt, because WACC can include sources of equity
funding as well as debt financing. Like cost of debt, however, the WACC calculation is
usually shown on an after-tax basis when funding costs are tax deductible.

Calculating WACC is a matter of summing the capital cost components, where each is multiplied
by its proportional weight. For example, in simplest terms:

WACC = (Proportion of total funding that is equity funding ) x (Cost of equity)

+ (Proportion of total funding that is debt funding) x (Cost of Debt)
x (1 – Corporate tax rate)

In brief, WACC shows the overall average rate the company pays (average interest rate)
for funds it raises. In many organizations, WACC is the rate of choice to use for discounted cash
flow (DCF) analysis to evaluate potential investments and business cash flow scenarios.
However, financial officers may choose to use a higher discount rate for DCF analysis of
investments and actions that are perceived riskier than the firm's own prospects for survival and
growth.

How Do We Calculate a Company's Weighted Average Cost of Capital?

We calculate a company's weighted average cost of capital using a 3 step process:
1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the
enterprise uses, namely debt and equity.

A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the
company's debt, adjusted for the tax-deductibility of interest expenses. Specifically:

The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the
marginal tax rate in %)

B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on
their capital. However, equity shareholders do face an implicit opportunity cost for investing in a
specific company, because they could invest in an alternative company with a similar risk
profile. Thus, we infer the opportunity cost of equity capital.

We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity
shareholders demand a minimum rate of return equal to the return from a risk-free investment
plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and
is equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that
measures how risky a specific security is relative to the total market.

Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium).

2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to
the entire enterprise, using the market values of total debt and equity to reflect the investments
on which those investors expect to earn a minimum return.

3. Weighting the components. Finally, we weight the cost of each kind of capital by the
proportion that each contributes to the entire capital structure. This gives us the Weighted
Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the
business.

The WACC equation is the cost of each capital component multiplied by its proportional weight
and then summed:

To calculate WACC, multiply the cost of each capital component by its proportional weight and
take the sum of the results. The method for calculating WACC can be expressed in the following
formula:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Explanation of Formula Elements

Cost of equity (Re) can be a bit tricky to calculate, since share capital does not technically have
an explicit value. When companies pay debt, the amount they pay has a predetermined associated
interest rate that debt depends on size and duration of the debt, though the value is relatively
fixed. On the other hand, unlike debt, equity has no concrete price that the company must pay.
Yet, that doesn't mean there is no cost of equity. Since shareholders will expect to receive a
certain return on their investment in a company, the equity holders' required rate of return is a
cost from the company's perspective, since if the company fails to deliver this expected return,
shareholders will simply sell off their shares, which leads to a decrease in share price and in the
company’s value. The cost of equity, then, is essentially the amount that a company must spend
in order to maintain a share price that will satisfy its investors.

Calculating cost of debt (Rd), on the other hand, is a relatively straightforward process. To
determine the cost of debt, use the market rate that a company is currently paying on its debt. If
the company is paying a rate other than the market rate, you can estimate an appropriate market
rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which is often to companies’ benefit.
Because of this, the net cost of companies’ debt is the amount of interest they are paying, minus
the amount they have saved in taxes as a result of their tax-deductible interest payments. This is
why the after-tax cost of debt is Rd (1 - corporate tax rate).

Breaking down 'Weighted Average Cost Of Capital - WACC'

In a broad sense, a company finances its assets either through debt or with equity. WACC is the
average of the costs of these types of financing, each of which is weighted by its proportionate
use in a given situation. By taking a weighted average in this way, we can determine how much
interest a company owes for each dollar it finances.

Debt and equity are the two components that constitute a company’s capital funding. Lenders
and equity holders will expect to receive certain returns on the funds or capital they have
provided. Since cost of capital is the return that equity owners (or shareholders) and debt holders
will expect, so WACC indicates the return that both kinds of stakeholders (equity owners and
lenders) can expect to receive. Put another way, WACC is an investor’s opportunity cost of
taking on the risk of investing money in a company.

A firm's WACC is the overall required return for a firm. Because of this, company directors will
often use WACC internally in order to make decisions, like determining the economic feasibility
of mergers and other expansionary opportunities. WACC is the discount rate that should be used
for cash flows with risk that is similar to that of the overall firm.
To help understand WACC, try to think of a company as a pool of money. Money enters the pool
from two separate sources: debt and equity. Proceeds earned through business operations are not
considered a third source because, after a company pays off debt, the company retains any
leftover money that is not returned to shareholders (in the form of dividends) on behalf of those
shareholders.

Suppose that lenders requires a 10% return on the money they have lent to a firm, and suppose
that shareholders require a minimum of a 20% return on their investments in order to retain their
holdings in the firm. On average, then, projects funded from the company’s pool of money will
have to return 15% to satisfy debt and equity holders. The 15% is the WACC. If the only money
in the pool was $50 in debt holders’ contributions and $50 in shareholders’ investments, and the
company invested $100 in a project, to meet the lenders’ and shareholders’ return expectations,
the project would need to generate returns of $5 each year for the lenders and $10 a year for the
company’s shareholders. This would require a total return of $15 a year, or a 15% WACC.

Broadly speaking, a company's assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its respective use
in the given situation. By taking a weighted average, we can see how much interest the company
has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used
internally by company directors to determine the economic feasibility of expansionary
opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that
is similar to that of the overall firm.

Further Understanding WACC

The capital funding of a company is made up of two components: debt and equity. Lenders and
equity holders each expect a certain return on the funds or capital they have provided. The cost
of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC
tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in
other words, represents the investor's opportunity cost of taking on the risk of putting money into
a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from
two sources: debt and equity. Money from business operations is not a third source because, after
paying for debt, any cash left over that is not returned to shareholders in the form of dividends is
kept in the bag on behalf of shareholders. If debt holders require a 10% return on their
investment and shareholders require a 20% return, then, on average, projects funded by the bag
of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.

If the only money the bag held was $50 from debtholders and $50 from shareholders, and the
company invested $100 in a project, to meet expectations the project would have to return $5 a
year to debtholders and $10 a year to shareholders. This would require a total return of $15 a
year, or a 15% WACC.
WACC: An Investment Tool

Securities analysts employ WACC all the time when valuing and selecting investments. In
discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future
cash flows for deriving a business's net present value. WACC can be used as a hurdle rate
against which to assess ROIC performance. It also plays a key role in economic value added
(EVA) calculations.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum
rate of return at which a company produces value for its investors. Let's say a company produces
a return of 20% and has a WACC of 11%. That means that for every dollar the company invests
into capital, the company is creating nine cents of value. By contrast, if the company's return is
less than WACC, the company is shedding value, which indicates that investors should put their
money elsewhere.

WACC serves as a useful reality check for investors. To be blunt, the average investor probably
wouldn't go to the trouble of calculating WACC because it is a complicated measure that
requires a lot of detailed company information. Nonetheless, it helps investors to know the
meaning of WACC when they see it in brokerage analysts' reports.

Be warned: the WACC formula seems easier to calculate than it really is. Just as two people will
hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC.
And even if two people do reach the same WACC, all the other applied judgments and valuation
methods will likely ensure that each has a different opinion regarding the components that
comprise the company's value.

Uses of Weighted Average Cost of Capital (WACC)

Securities analysts frequently use WACC when assessing the value of investments and when
determining which ones to pursue. For example, in discounted cash flow analysis, one may apply
WACC as the discount rate for future cash flows in order to derive a business's net present value.
WACC may also be used as a hurdle rate against which to gauge ROIC performance. WACC is
also essential in order to perform economic value added (EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company
yields returns for its investors. To determine an investor’s personal returns on an investment in a
company, simply subtract the WACC from the company’s returns percentage. For example,
suppose that a company yields returns of 20% and has a WACC of 11%. This means the
company is yielding 9% returns on every dollar the company invests. In other words, for each
dollar spent, the company is creating nine cents of value. On the other hand, if the company's
return is less than WACC, the company is losing value. If a company has returns of 11% and a
WACC of 17%, the company is losing six cents for every dollar spent, indicating that potential
investors would be best off putting their money elsewhere.
WACC can serve as a useful reality check for investors; however, the average investor would
rarely go to the trouble of calculating WACC because it is a complicated measure that requires a
lot of detailed company information. Nonetheless, being able to calculate WACC can help
investors understand WACC and its significance when they see it in brokerage analysts' reports.

Problems with WACC /Limitations of Weighted Average Cost of Capital (WACC)

The WACC formula seems easier to calculate than it really is. Because certain elements of the
formula, like cost of equity, are not consistent values, various parties may report them differently
for different reasons. As such, while WACC can often help lend valuable insight into a company,
one should always use it along with other metrics when determining whether or not to invest in a
company.

The primary variables to be determined in order to calculate weighted average cost of capital are
the relative debt and equity values, the cost of debt, and the cost of equity. While the relative
debt and equity values can be easily determined, calculating the costs of debt and equity can be
problematic. In calculating each component, we are given many different options and proxy
values. For example, to calculate the cost of equity we have at least three methods we can use -
the dividend growth model, the capital asset pricing model, and the bond yield plus risk premium
method. The problem inherent in each of these methods is that at least one component is an
estimate. Therefore, their calculated values will vary depending on differing estimates, which
will subsequently give us varying cost of capital calculations.

While calculating cost of debt is more simplistic, relative to calculating cost of equity, there are
still problems that arise. To calculate cost of debt, we add a default premium to the risk-free rate.
This default premium is the return in excess of the risk free rate that a bond must yield. It will
rise as the amount of debt increases (since, all other things being equal, the risk rises as the
amount of debt rises).
U.S. Treasuries Yield

Yields on 1-mont, 10-year, and 30-year U.S. government debt.

To produce the most accurate result, we must take this risk-free rate from a bond containing a
similar term structure to our company's debt. Risk-free rates are typically approximated from
U.S. Treasury bills, notes, and bonds. Problems can arise because these are issued only in terms
of 2, 3, 5, 10, and 30 years. These terms may not always adequately match the term of our
company's debt.

What is Cost of debt?

An organization's cost of debt is the effective rate (overall average percentage) that it pays on all
its debts, the major part of which typically consist of bonds and bank loans. Cost of debt is a part
of a company's capital structure. (along with preferred stock, common stock, and cost of equity).

Cost of debt is expressed as a percentage in either of two ways: Before tax or after tax. In cases
where interest expenses are tax deductible, the after tax approach is generally considered more
accurate or more appropriate. The after-tax cost of debt is always lower than the before-tax
version.

For a company with a marginal income tax rate of 35% and a before tax cost of debt of 6%,
the after tax cost of debt is found as follows:

After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)
= (0.06) x (1.00 – 0.35)
= (0.06) x (0.65)
= 0.039 or 3.9%

As with cost of capital, cost of debt tends to be higher for companies with lower credit ratings—
companies that the bond market considers riskier or more speculative. Whereas cost of capital is
the rate the company must pay now to raise more funds, cost of debt is the cost the company is
paying to carry all debt it has acquired.

Cost of debt becomes a concern for stockholders, bondholders, and potential investors when a
company is highly leveraged (i.e., debt financing is large relative to owner equity). A highly
leveraged position becomes riskier and less profitable in a poor economy (e.g., recession), when
the company's ability to service its large debt load may be questionable.

The cost of debt may also weigh in management decisions regarding asset acquisitions or other
investments acquired with borrowed funds. The additional cost of debt that comes with the
acquisition or investment reduces the value of investment metrics such as return on investment
(ROI) or internal rate of return (IRR).

What is Cost of equity?

A company's cost of equity (COE) is a measure of the returns that the stock market demands for
investors who will bear the risks of ownership. Cost of equity is a part of a company's capital
structure. (along with preferred stock, common stock, and cost of debt).

A high cost of equity indicates that the market views the company's future as risky, thus
requiring greater return rates to attract investments. A lower cost of equity indicates just the
opposite. Not surprisingly, cost of equity is a central concern to potential investors applying the
capital asset pricing model (CAPM), who are attempting to balance expected rewards against the
risks of buying and holding the company's stock.

The two most familiar approaches to estimating cost of equity are illustrated here:

How is Cost of equity found with the dividend capitalization model approach?

One approach to calculating Cost of equity is based on the equity appreciation and dividend
growth.
Cost of equity = (Next year's dividend per share
+ Equity appreciation per share) / (Current market value of stock)
+ Dividend growth

Consider for example, a stock whose current market value is $8.00, paying annual dividend of
$0.20 per share. If those conditions held for the next year, the investor's return would be simply
0.20 / 8.00, or 2.5%. If the investor requires a return of, say 5%, one or two terms of the above
equation would have to change:

 If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return:
(0.20 dividend + 0.20 stock appreciation) / (8.00 current value of stock).
 If, instead, the company doubled the dividend (dividend growth) to 0.40, while the stock
price remained at 8.00, the investor would also experience a 5% return.

How is Cost of equity found with the Capital asset pricing model CAPM approach?

An alternative approach to Cost of equity is based on Capital Asset Pricing Model CAPM
measures:

Cost of equity = (Market risk premium) x ( Equity beta) + Risk-less rate

Consider a situation where the following holds for one company's stock:

Grande Company Common

shares

Market Risk Premium: 4.0%

Equity beta fort his

0.60
stock:

Risk free rate: $1,800

Using these CAPM data and the formula above, Cost of Equity is calculated as:

Cost of equity = (4.0%) x (0.60) + 5.0% = 7.4%

In the CAPM, beta is a measure of the stock's historical price changes compared to price changes
for the market as a whole. A beta of 0 indicates the stock tends to rise or fall independently
from the market. A negative beta means the stock tends to rise when the market falls and the
stock tends to fall while the market rises. A positive beta means the stock tends to rise and fall
with the market.
Cost of borrowing

The term Cost of borrowing might seem to apply to several other terms in this article. As used in
business and especially the financial industries, however, the term refers the total cost a debtor
will pay for borrowing, expressed in currency units such as dollars, euro, pounds, or yen.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Cost of borrowing may include, for instance, interest payments, plus (in some cases) loan
origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As
an example, consider a loan with the following properties:

Loan properties

Amount
borrowed (loan $100,000.00
principle):

Annual interest
6.0%
rate:

Amortization
10 Years
time:

Payment
Monthly
frequency:

Annual borrower
$25.00
insurance

Such a loan calls for 120 monthly payments of $1,110.21. Thus, the borrower who makes all
payments on schedule ends up repaying a total of 120 x $1,110.21, or $133,225. The borrower
will also pay $200 for loan origination, $600 in account maintenance fees (120 x $5), and $250
in borrower insurance. The cost of borrowing may be calculated as:

Cost of borrowing calculation

Total
$133,225.20.00
repayments:

Less principal ($100,000.00)

 repaid:

Total interest
33,225.20
payments::

Loan
200.00
origination fee:

Account
$600.00
maintenance:

Borrower
250.00
insurance fees:

Total cost of
$34,255.20
borrowing:

Over the last few decades, lending institutions everywhere have begun to face increasingly
stringent laws requiring them to disclose total cost of borrowing figures to potential borrowers,
in clear, accurate terms, before signing loan agreements.

Cost of funds / Cost of funds index (COFI)

The term cost of funds, like cost of borrowing (above) might seem to apply to several other
terms in this article, but in practice the proper use of the term refers to the interest cost that
financial institutions pay for the use of money.
Whereas other kinds of businesses (for example, those in product manufacturing or service
delivery) raise funds that ultimately support more product production and/or service delivery in
one way or another, financial institutions make money essentially by making funds available to
individuals, firms, or institutions. The funds used for this purpose are acquired at a cost—the cost
of funds.

 For banks or savings and loan firms, cost of funds is the interest they pay to their
depositors on, for example, certificates of deposit, passbook savings accounts, money
market accounts, The bank uses depositor funds for loans it issues, but the use of those
funds comes with a cost.
 For a brokerage firm, cost of funds represents the firm's interest expense for carrying its
inventory of stocks and bonds.

Besides interest expenses, the cost of funds may also include any non-interest costs required for
the maintenance of debt and equity funds. These non-interest components of cost of funds may
include such things as labor costs or licensing fees, for instance.

A bank's cost of funds is related to the rates it charges for adjustable rate loans and mortgages.
Banks will set interest rates for borrowers based on a cost of funds index (COFI) for their region.
In the United States, for instance, banks set variable mortgage interest rates with reference to the
COFI established for their region by a Federal Home Loan Bank.

Issues with the Cost of Capital

The dollar value of the preferred stock and common stock used in this calculation is based on the
current market price of these items, rather than the price at which they were originally sold. By
using the market rate, you can more accurately determine the assumed rate of return that
investors are expecting at the moment; this is much preferable to using the book rate for either
item, since this fixes the rate of return at the time when the shares were originally sold, and gives
no indication of current market expectations.

Measurement of Overall Cost of Capital

Overall cost of capital means the weighted average of the cost of each component of capital. It
represents the combined cost of capital of various sources such as debt, preference, equity and
retained earnings.
The measurement of overall cost of capital involves the following steps:

Step 1:
Computing specific cost of capital for each source of capital like cost of equity, cost of debt, cost
of retained earnings and cost of preference shares.

Step 2:
Assigning proper weights to specific costs; the weight may be the book value or market value.

Step 3:
Multiplying the cost of each source by appropriate weights to derive total weighted cost.

Step 4:
Dividing the total weighted cost by total weight. We know two types of weights can be used for
computing the overall cost of capital: Book value and market value.

These are discussed below:

i. Book Value:
Under this method, the book value of different sources of finance is used as weight for
computing overall/weighted average cost of capital. Here it has been assumed that new finances
are raised in same proportion as the firm currently has in its capital structure. Book value weight
is the proportion of book value of various sources of capital in the capital structure. So for
example, the weight for equity will be EB/B, where EB is the book value of equity and B is the
total book value of all the sources of capital. Hence overall cost of capital or weighted average
cost of capital (WACC) using book value weight may be calculated as:
Where, KO = Overall cost of capital,
Ke = Cost of equity.
EB = Book value of equity capital.
B = Total book value of all the sources of capital,
Kr = Cost of retained earnings,
RB = Book value of retained earnings,
Kp = Cost of preference shares,
PB = Book value of preference shares,
Kd = Cost of debt, and
DB = Book value of Debt.

i. Market Value:
This method uses the current market price of different sources of capital as weight for computing
overall/weighted average cost of capital. It is a more realistic and reasonable method for
computing overall cost of capital because the market value of various sources of capital closely
approximates the actual amount to be received from issuing such securities and the costs of spe-
cific sources of capital are calculated using market values. Market value weight is the proportion
of market value of various sources of capital in the capital structure. So for example, the weight
for equity will be EM/M where EM is the market value of equity and M is the total market value
of all the sources of capital.

Hence the overall cost of capital or weighted average cost of capital (JV4CC) using market
value weight may be calculated as:
WACC = Ko = Ke EM/M + Kr RM/M + KP PM/M + Kd DM/m
Where, Ko = Overall cost of capital,
Ke = Cost of equity,
EM = Market value of equity capital,
M = Total market value of all the sources of capital,
Kr = Cost of retained earnings.
RM = Market value of retained earnings,
KP = Cost of preference shares,
PM = Market value of preference shares,
Kd = Cost of debt, and
DM = Market value of debt.

Example 4.1:
Capital structure of Anuradha Ltd., along with respective specific cost of capital is given below.
You are required to compute the weighted average cost of capital using:
(a) Book value as weight and
(b) Market value as weight.
So, weighted average cost of capital using book value weight is 13.6% and using market value
weight is 13.89%.

What is the difference between the cost of capital and the discount rate?
The cost of capital refers to the actual cost of financing business activity through either debt or
equity capital. The discount rate is the interest rate used to determine the present value of future
cash flows in standard discounted cash flow analysis. Many companies calculate their weighted
average cost of capital and use it as their discount rate when budgeting for a new project. This
figure is crucial in generating a fair value for the company's equity.

The discount rate might also refer to the interest rate charged by the Federal Reserve Bank to
commercial banks through its discount window.

Cost of Capital

Another way to look at the cost of capital is as the company's required return. The company's
lenders and owners don't extend financing for free; they want to be paid for delaying their own
consumption and assuming investment risk. The cost of capital helps establish a benchmark
return that the company must achieve to satisfy its debt and equity investors.

The most widely used method of calculating capital costs is the relative weight of all capital
investment sources and then adjusting the required return accordingly. If a firm were financed
entirely by bonds or other loans, its cost of capital would be equal to its cost of debt. Conversely,
if the firm were financed entirely through common or preferred stock issues, then the cost of
capital would be equal to its cost of equity. Since most firms combine debt and equity financing,
the weighted average cost of capital helps turn cost of debt and cost of equity into one
meaningful figure.

Discount Rate

It only makes sense for a company to proceed with a new project if its expected revenues are
larger than its expected costs; in other words, it needs to be profitable. The discount rate makes it
possible to estimate how much the project's future cash flows would be worth in the present. The
higher the discount rate, the smaller the present investment needs to be to achieve the revenue
required for the project to succeed.

An appropriate discount rate can only be determined after the firm has approximated the project's
free cash flow. Once the firm has arrived at a free cash flow figure, this can be discounted to
determine net present value.

Setting the discount rate isn't always straightforward. Even though many companies use WACC
as a proxy for the discount rate, other methods are used as well. In situations where the new
project is considerably more or less risky than the company's normal operation, it may be best to
use the capital asset pricing model to calculate a project-specific discount rate. The normal cost
of capital won't act as an effective substitute for risk premium for such a project.

Payback Period
What is the 'Payback Period'
The payback period is the length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions. Calculated as:

Payback Period = Cost of Project / Annual Cash Inflows

Breaking down 'Payback Period'

All other things being equal, the better investment is the one with the shorter payback period. For
example, if a project costs $100,000 and is expected to return $20,000 annually, the payback
period will be $100,000/$20,000, or five years. There are two main problems with the payback
period method:
1. It ignores any benefits that occur after the payback period and, therefore, does not measure
profitability.

2. It ignores the time value of money. Because of these reasons, other methods of capital
budgeting, like net present value, internal rate of return or discounted cash flow, are generally
preferred. In economics, profit maximization is the short run or long run process by which a
firm determines the price and output level that returns the greatest profit.
 Hurdle Rate
A hurdle rate is the minimum rate of return on a project or investment required by a manager or
investor. In order to compensate for risk, the riskier the project, the higher the hurdle rate. In the
hedge fund world, hurdle rate refers to the rate of return that the fund manager must beat before
collecting incentive fees.
Breaking down 'Hurdle Rate'
In capital budgeting, projects are evaluated either by discounting future cash flows to the present
by the hurdle rate, so as to ascertain the net present value of the project, or by computing the
internal rate of return (IRR) on the project and comparing this to the hurdle rate. If the IRR
exceeds the hurdle rate, the project would most likely go ahead.
For example, a company with a hurdle rate of 10% for acceptable projects, would most likely
accept a project if it has an internal rate of return of 14% and does not have a significantly higher
degree of risk. Alternately, discounting the future cash flows of this project by the hurdle rate of
10% would lead to a large and positive net present value, which would also lead to the project's
acceptance.

Profit maximization
The total revenue-total cost perspective and the marginal revenue-marginal cost perspective
are used to find profit maximizing quantities. Utility maximization is the source for the
neoclassical theory of consumption, the derivation of demand curves for consumer goods, and
the derivation of labor supply curves and reservation demand. The profit-maximizing output
level is represented as the one at which total revenue is the height of C and total cost is the
height of B; the maximal profit is measured as CB.
Profit maximization is a process where companies undergo to determine the best output and price
levels in order to maximize its return. The company will usually adjust influential factors such as
production costs, sale prices, and output levels as a way of reaching its profit goal. There are two
main profit maximization methods used; i.e. Marginal Cost-Marginal Revenue Method and Total
Cost-Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
Economic theory is based on the reasonable notion that people attempt to do as well as they can
for themselves, given the constraints facing them. For example, consumers purchase things that
they believe will make them feel more satisfied, but their purchases are limited (at least in the
long run) by the amount of income they earn. A consumer can borrow to finance current
purchases but must (if honest) repay the loans at a later date.
Business owners also attempt to manage their businesses so as to improve their well being. Since
the real world is a complicated place, a business owner may improve his well being in a number
of ways. For example, if the business doesn't lack customers, the owner could respond by
reducing operating hours and enjoying more leisure. Or, the business owner may seek
satisfaction by earning as much profit as possible. This is the alternative we will focus on in class
- for a very good reason. If a business faces tough competition, the only way the business can
survive is to pay attention to revenues and costs. In many industries, profit maximization is not
simply a potential goal; it's the only feasible goal, given the desire of other businesspeople to
drive their competitors out of business.
In economic terms, profit is the difference between a firm's total revenue and its total
opportunity cost. Total revenue is the amount of income earned by selling products. In our
simplified examples, total revenue equals P x Q, the (single) price of the product multiplied
times the number of units sold. Total opportunity cost includes both the costs of all inputs into
the production process plus the value of the highest-valued alternatives to which owned
resources could be put. For example, a firm that has $100,000 in cash could invest in new, more
efficient, machines to reduce its unit production costs. But the firm could just as well use the
$100,000 to purchase bonds paying a 7% rate of interest. If the firm uses the money to buy new
machinery, it must recognize that it is giving up $7000 per year in forgone interest earnings. The
$7000 represents the opportunity cost of using the funds to buy the machinery.
We will assume that the overriding goal of the managers of firms is to maximize profit: P = TR -
TC. The managers do this by increasing total revenue (TR) or reducing total opportunity cost
(TC) so that the difference rises to a maximum.

An Example
Suppose you are running a business that produces and sells office furniture. It's a small
operation, and in a typical day you produce three custom desks. You are able sell these desks for
$500 apiece. You employ five workers, each of whom earns $15 per hour ($120 per day), and
you work alongside them and pay yourself at the same rate. Material inputs cost $150 per desk.
Of course, you have additional "overhead" expenses, including rent, a secretary/bookkeeper,
electricity, etc. This overhead, which we will assume does not vary with the number of desks
produced (i.e., it's a fixed cost) comes to $130 per day. Thus, your company earns a profit of P =
($500 x 3) - ($720 + 450 + 130) = $1500 - $1300 = $200 per day. (Wages for six workers come
to $720. Materials for three desks cost $450. Overhead is $130.) Working five days a week for
50 weeks a year, that comes to an annual profit of $50,000. Pretty nice - but could you do better?

Suppose you decide to increase production to four desks per day. This requires you to hire two
more workers (at another $240) and purchase another $150 worth of materials. Overhead
expense doesn't change. Your total cost rises to $1690. You find that you are able to sell the
fourth desk for $500. Was this a good decision? [Engage brain here.]. You're right. [I'm giving
you the benefit of the doubt here.] Total revenue rises to $2000 per day, while total costs rise to
$1690. Profit increases to $310 per day. Good show, old man/woman/[insert desired politically
correct term here]!
This nice result may lead you to increase production to five desks a day. If you are able to sell all
five desks for $500 each, and if your variable costs of producing the desks - what you pay in
labor and materials - doesn't increase, producing a fifth desk makes sense. TR rises to $2500, TC
rises to $2080, and profit increases to $420. So you sell five desks.
Suppose, however, that you find that the labor market is so tight that you cannot hire another two
workers at $15 per hour. In fact, to hire your ninth and tenth workers, you must pay $20 per
hour. That increases the labor cost of the fifth desk by $80 ($40 per worker times two workers).
TC rises to $2160, which still allows profit to increase to $340. But we have a problem brewing.
Can you really get away with paying your veteran workers $15 an hour, while at the same time
hiring new workers at $20 per hour? Not likely. So when you hire the ninth and tenth workers,
you are forced to raise the wages of your first eight workers (Pay yourself more; hey, you
deserve it.). Let's recalculate profit for Q = 5. TR = $500 x 5 = $2500. TC = ($160 x 10) + ($150
x 5) + $130 = $2480. That leaves a profit of $20. Doesn't look like such a good idea now, does it
Einstein? Thus, if you realize that your costs will rise sharply if you produce a fifth desk each
day, you will decline to produce the desk.
Application
Our little example illustrates the situation every business owner or manager faces.
Businesspeople know what their current position is (revenue and costs) and they can estimate TR
and TC for a higher (or lower) level of production. By actually changing output levels, they learn
by experience what their demand and cost curves look like. In the process, they discover what
happens to profit as they change output levels. Through this discovery process, businesspeople
seek to find the output level that maximizes profit.
As omniscient onlookers, we can describe this process a bit more analytically. A firm should
increase its output so long as the marginal revenue earned from additional units of production is
greater than the marginal cost of those units. Marginal revenue is the additional revenue earned
by selling one more unit of a product. (In our example, MR = $500.) Marginal cost is the
additional cost incurred in producing one more unit of output. So long as MR > MC, profit
grows. However, when MR < MC, profit shrinks. So firms expand output only to the point at
which MR = MC. This point maximizes profit.
The profit-maximization rule applies both to firms that are able to sell their product at a constant
price (as in our example) and to firms that find they must reduce the price of their product to
increase sales. In the real world, firms have to engage in trial-and-error discovery processes,
searching for the profit-maximization point. But the process can be succinctly described by the
marginal revenue-marginal cost rule.
 An assumption in classical economics is firms seek to maximize profits.
 Profit = Total Revenue – Total Costs Therefore, profit maximization occurs at the biggest
gap between Total revenue and total costs.
 A firm can maximize profits if it produces at an output where Marginal revenue (MR) =
Marginal cost (MC)

Diagram of Profit Maximisation

To understand this principle, look at the above diagram. If the firm produces less than Q1, MR is
greater than MC. Therefore, for this extra output, the firm is gaining more revenue than it is
paying in costs. Total revenue will increase. Close to Q1, MR is only just greater than MC,
therefore, there is only a small increase in profit. But, profit is still rising. However, after Q1, the
marginal cost of the output is greater than the marginal revenue. This means the firm will see a
fall in its profit level.

Profit Maximization for a monopoly

In this diagram, the monopoly maximizes profit where MR=MC – at Qm. This enables the firm
to make supernormal profits (green area). Note the firm could produce more and still make
normal profit. But, to maximize profit, it involves setting higher price and lower quantity than a
competitive market. Therefore, for a firm profit maximization involves selling a lower quantity
and at a higher price.
Profit Maximization in Perfect Competition
In perfect competition, the same rule for profit maximization still applies. The firm maximizes
profit where MR=MC. For a firm in perfect competition, demand is perfectly elastic, therefore
MR=AR=D.

Advantages & Disadvantages of Profit Maximization

Maximizing profits as a strategy is fine in the short term, but consequences exist.
When a firm applies profit maximization, it is basically saying that its primary focus is on
profits, and it will use its resources solely to get the biggest profits possible, regardless of the
consequences or the risk involved. Profit maximization is a generally short-term concept.
Application usually lasts less than one year, although some companies employ this strategy
exclusively, constantly jumping on the next big trend.

Risk
Pursuing a profit maximization strategy comes with the obvious risk that the company may be so
entrenched in the singular strategy meant to maximize its profits that it loses everything if the
market takes a sudden turn. For example, a company may find that it gets the most profit selling
the Wii gaming system, so instead of keeping a balanced inventory, it invests solely in buying
Wiis to sell. If the Wii goes out of favor or the makers of the Wii begin to limit the price that can
be charged for the system, the company that relied solely on its investment in Wiis could lose
everything. Similarly, if a company focuses only on maximizing its profit, it may miss
opportunities for investment and expansion.

Expectation and Goodwill

You also need to consider consequences of profit maximization. If a company pursues a profit
maximization strategy, it creates an environment where price is a premium and cutting costs is a
primary goal. This, in turn, creates a perception of the company that could lead to a loss of
goodwill with customers and suppliers; for instance, a company may win subsequent contracts
with a client by bidding the first job low. It also creates an expectation of shareholders to see
immediate gains, rather than realizing profits over time.

Cash Flow
For all its drawbacks, profit maximization carries the big advantage of creating cash flow. When
maximizing profit is the primary consideration, investments, reinvestments and expansions are
typically tabled. The company simply makes do on what it has. This can create a more cost-
efficient environment. In the mean time, the profits keep building, producing a healthy bottom
line and increasing the firm’s amount of available cash. Sometimes profit maximization is used
entirely to create an influx of cash so the firm can reduce its debt or save up for expansion.

Financing and Investors

Some degree of profit maximization is always present. The goal of a company is to create profits.
It has to profit from its business to stay in business. Moreover, investors and financiers in the
company may require a certain level of profits to secure funds for expansion. Further, a company
has to perform well for its shareholders; they expect a return on their investments. As such,
maximizing that profit is always a consideration to some extent.
Criticisms Or Drawbacks / Limitations of Profit Maximization
Although profit maximization objective is widely known objective of a firm, some theorists have
raised doubts on the validity of this objective. They have criticized the profit maximization
objective on the following grounds:
1. The profit maximization objective ignores the timing of returns. It equates a dollar received
today with a dollar received in the future. In fact, $ 100 today is valued more than $ 100 received
after one year. It is because the money received in earlier period may be reinvestable to earn
more.

2. The critics of profit maximization objective argue that it ignores the risk associated with
stream of cash flow of the project. For example, the total profit from two projects may be same
but the profit from one project may be fluctuating widely than the profit from the other project.
The firm with wider fluctuation in profit is riskier. This fact is ignored by profit maximization
objective.
1

3. The profit maximization objective has greater relevance to a perfectly competitive firm than to
a monopoly firm. Critics argue that a monopoly firm would be earning super normal profit more
or less automatically.

4. Today large-scale corporate types of organizations exist. Different stakeholders such as

owners, managers, customers, creditors, and employees are directly connected with the
organization. The interest of each member in this organizational collusion cannot be achieved
with the sole objective of profit maximization.

5. The profit maximization objective of the firm has greater relevance to short-run. In long-run, a
firm cannot survive with this objective.

6. If all firms keep profit maximization as the primary objective, they may commit unfair
practice to maximize profit.

7. In the real world it is not so easy to know exactly your marginal revenue and marginal cost of
last goods sold. For example, it is difficult for firms to know the price elasticity of demand for
their good – which determines the MR. It also depends on how other firms react. If they increase
price, and other firms follow, demand may be inelastic. But, if they are the only firm to increase
price, demand will be elastic.

However, firms can make a best estimation. Many firms may have to seek profit maximization
through trial and error. e.g. if they see increasing price leads to a smaller % fall in demand they
will try increase price as much as they can before demand becomes elastic. It is difficult to
isolate the effect of changing price on demand. Demand may change due to many other factors
apart from price.
Firms may also have other objectives and considerations. For example, increasing price to
maximize profits in the short run could encourage more firms to enter the market; therefore firms
may decide to make less than maximum profits and pursue a higher market share.
 Difference Between Profit Maximization and Wealth Maximization
Financial Management is concerned with the proper utilization of funds in such a manner that it
will increase the value plus earnings of the firm. Wherever funds are involved, financial
management is there. There are two paramount objectives of the Financial Management: Profit
Maximization and Wealth Maximization. Profit Maximization as its name signifies, refers that
the profit of the firm should be increased while Wealth Maximization, aims at accelerating the
worth of the entity.
Comparison chart

Basis for Comparison Profit Maximization Wealth Maximization

The ultimate goal of the concern is
The main objective of a concern is
Concept to improve the market value of its
to earn a larger amount of profit.
shares.
Emphasizes on Achieving short term objectives. Achieving long term objectives.
Consideration of Risks
No Yes
and Uncertainty
Acts as a yardstick for computing
Advantage the operational efficiency of the Gaining a large market share.
entity.
Recognition of Time
No Yes
Pattern of Returns

Profit Maximization Vs Wealth Maximization:

Profit Maximization
The objective of financial management is profit maximization. It cannot be the sole objective of
a company as there is a directs/relationship between risk and profit. If profit maximization is the
only goal, then risk factors ignored.

Sometimes, higher the risk, higher is the possibility of profits. Hence, risk has to be balanced
with the objective of profit maximization. In addition, a firm has to take into account the social
considerations, and normal obligations to the interests of workers, consumers, society,
government, as well as ethical trade practices. However, as profit maximization ignores risk and
uncertainty and timing of returns, a firm can’t solely depend on the objective.

Traditionally organizations were primarily focused on profit maximization. Profit maximization

is short term strategy and focuses on making profits in the short term, which may result in taking
courses of action that could be harmful in the long term. A corporation’s management is
generally interested in profit maximization and strives to reach projected monthly, quarterly, and
annual revenue. The goal of profit maximization is pursued by management because of the
pressure put on them by stakeholders to achieve profit goals set. Management may also be
concerned with profit maximization as this directly influences their remuneration, bonuses, and
benefits.
Wealth Maximization
Hence, the objective of a firm is to maximize its wealth and the value of its shares. According to
van Home value is represented by the market price of the company’s common stock. The market
price of a firm’s stock takes into account present and prospective future earnings per share
(EPS), the timing and risk of these earnings, the dividend policy of the firm and many other
factors that bear upon the market price of the stock.

The concept of wealth in the context of wealth maximization objective refers to the shareholders’
wealth as reflected by the market price of their shares in the share market. Hence, maximization
of wealth means maximization of the market price of the equity shares of the company.

Wealth maximization takes on a different, modern approach where the organization will focus on
maximizing wealth in the long run as opposed to making short term gains. Wealth maximization
focuses on cash flows that a firm receives, instead of looking at profits made during the short
term. Wealth maximization is preferred by most shareholders who are willing to sacrifice short
term profits in order to make longer term returns. Since shareholders are the owners of the firm,
they will focus more on the longer term wealth created by the firm and will like to see greater
reinvestment made presently to achieve greater value in the future. Wealth maximization goal is
achieved when the market value of shares increases; this is one major reason why shareholders
focus on wealth maximization. As market value of shares increase (as a result of the wealth
maximization goal), shareholders can sell their shares at a higher price, thereby making larger
capital gains.

Total profits are not as important as earnings per share. Even maximization of earnings per share
is not enough because it does not specify the timing or duration of expected returns. Further, it
does not consider the risk of uncertainty of the future earnings. Hence, wealth maximization is
appropriate and it is possible by maximizing the market price per share.

According to Prof. Ezra Solomon, wealth maximization also maximizes the achievement of other
objectives. Maximization of wealth of the firm implies maximization of value of owner’s share
capital reflected in the market price of shares. Therefore, the operative objective of financial
management implies maximization of market price of shares.

The financial management has come a long way by shifting its focus from traditional approach to
modern approach. The modern approach focuses on wealth maximization rather than profit
maximization. This gives a longer term horizon for assessment, making way for sustainable
performance by businesses.
A myopic person or business is mostly concerned about short term benefits. A short term horizon
can fulfill objective of earning profit but may not help in creating wealth. It is because wealth
creation needs a longer term horizon Therefore, financial management emphasizes on wealth
maximization rather than profit maximization. For a business, it is not necessary that profit
should be the only objective; it may concentrate on various other aspects like increasing sales,
capturing more market share etc, which will take care of profitability. So, we can say that profit
maximization is a subset of wealth and being a subset, it will facilitate wealth creation.
Giving priority to value creation, managers have now shifted from traditional approach to
modern approach of financial management that focuses on wealth maximization.
This leads to better and true evaluation of business. For e.g., under wealth maximization, more
importance is given to cash flows rather than profitability. As it is said that profit is a relative
term, it can be a figure in some currency, it can be in percentage etc. For e.g. a profit of say
$10,000 cannot be judged as good or bad for a business, till it is compared with investment, sales
etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short
term or long term.

In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate
various alternatives for decision making, cash flows are taken under consideration. For e.g. to
measure the worth of a project, criteria like: “present value of its cash inflow – present value of
cash outflows” (net present value) is taken. This approach considers cash flows rather than
profits into consideration and also use discounting technique to find out worth of a project. Thus,
maximization of wealth approach believes that money has time value.

An obvious question that arises now is that how can we measure wealth. Well, a basic principle
is that ultimately wealth maximization should be discovered in increased net worth or value of
business. So, to measure the same, value of business is said to be a function of two factors –
earnings per share and capitalization rate. And it can be measured by adopting following
relation:

Value of business = EPS / Capitalization rate

At times, wealth maximization may create conflict, known as agency problem. This describes
conflict between the owners and managers of firm. As, managers are the agents appointed by
owners, a strategic investor or the owner of the firm would be majorly concerned about the
longer term performance of the business that can lead to maximization of shareholder’s wealth.
Whereas, a manager might focus on taking such decisions that can bring quick result, so that
he/she can get credit for good performance. However, in course of fulfilling the same, a manager
might opt for risky decisions which can put the owner’s objectives on stake.

Financial management is essential for any organization that seeks to manage their finances in an
orderly manner. Wealth maximization and profit maximization are two important goals of
financial management and are quite different to each other. Profit maximization looks at the
shorter term and focuses on making larger profits in the short term, which could be at the
expense of long term benefits. Wealth maximization, on the other hand, focuses on the long term
and strives at long term value creation. As an example, a company has the option to invest
$200,000 in a new technology to develop its product offering. If the investment is made now, the
current profit levels of $400,000 will be reduced to $200,000. However, once the investment is
made, the product that is currently sold for $10 can be sold for $15 in the future, which will then
result in the market value of shares increasing by 10%. The bargain here is whether the $200,000
investment should be sacrificed for short term profits, or whether the investment should be made
so that the product can be sold at a higher price, which will then increase market value, creating
long term wealth.

Summary:
• There are two forms of financial management; the traditional profit maximization approach and
the more modern wealth maximization approach.
• Profit maximization is short term strategy and focuses on making profits in the short term,
which may result in taking courses of action that could be harmful in the long term.
• Wealth maximization takes on a different, modern approach where the organization will focus
on maximizing wealth in the long run as opposed to making short term gains.

Hence, a manager should align his/her objective to broad objective of organization and achieve a
tradeoff between risk and return while making decision; keeping in mind the ultimate goal of
financial management i.e. to maximize the wealth of its current shareholders.

Minimum Acceptable Return: The least investors can do

The Financial Post takes a weekly look at tools that will help make your investment
decisions. This week: Defining an investor’s minimum acceptable return.

Risk can be defined in many different ways, but for most investors it comes down to how much
they are willing to lose. As such, it has become critical for many professional money managers to
identify the dividing line between good and bad outcomes using a concept known as minimum
acceptable return (MAR).

“A common mistake of investors is setting an initial asset allocation without understanding what
rate of return they need to achieve their goals,” said Susan Mallin, associate portfolio manager
and financial planner at Goodreid Investment Counsel in Toronto. “Ideally, it starts by
recognizing a rate of return that is acceptable for their individual set of circumstances.”

One of the most popular methods for defining risk during the past 60 years has been to use the
standard deviation of the asset’s return over many time periods. This statistical calculation
interprets any difference — above or below — from the average as bad, but that is not how most
investors feel about returns, a report by Unified Trust, a Kentucky-based wealth manager,
indicates.

“The main problem with standard deviation is that it is not a measure of risk. Rather, it is a
measure of uncertainty,” the report said. “Few investors fret about their portfolios doubling; most
only worry about the downside—their returns being below average.”

Risk, the report adds, is a subject where there is widespread agreement on the surface, but little
agreement on the details. More to the point, investors agree they do not like risk, but often
disagree on just how much risk is involved in a particular investment. But investors can
accommodate this diversity in perception by using a minimum acceptable return to assess
downside risk.

For example, if an investor is only worried about losing money, the downside risk would be zero,
and any possibility of negative returns would be viewed as unacceptable, the report said. But if
an investor needs to earn a 7% annual return in order to meet goals, any return under 7% would
be considered risky. Institutional investors, moreover, often view investment risk as the
possibility of underperforming the benchmark, while retail investors view it as the risk of not
accomplishing their goal.

“In the above examples the institutional investor would use the benchmark rate as the minimum
acceptable return, while the [retail investor] would want to know the risk of falling below 7%,”
the report said. The trick for individuals is to figure out what MAR is appropriate in order to still
meet their goals.

Ms. Mallin said investors have to consider several factors, including the value of their portfolio
today, debt levels, taxes, savings capabilities and life expectancy. “From there, it’s a matter of
forecasting what cash will do over the next little while, what fixed income will net and what
equities will earn,” she said. “Based on that, you can dictate how much should be allocated in
each of these buckets.”

AGENCY COST
Agency costs are a type of internal cost that arises from, or must be paid to, an agent acting on
behalf of a principal. Agency costs arise because of core problems such as conflicts of interest
between shareholders and management. Shareholders wish for management to run the company
in a way that increases shareholder value. But management may wish to grow the company in
ways that maximize their personal power and wealth that may not be in the best interests of
shareholders.

Agency costs usually refer to the conflicts between shareholders and their company's managers.
A shareholder wants the manager to make decisions which will increase the share value.
Managers, instead, would prefer to expand the business and increase their salaries, which may
not necessarily increase share value.

Agency costs are internal costs incurred from asymmetric information or conflicts of interest
between principals and agents in an organization. In a corporation, the principals would be the
shareholders and the agents would be the managers. The shareholders want the managers to run
the company in a way that maximizes shareholder value. The managers, on the other hand, may
want to run the company in a way that maximizes the managers’ own personal power or wealth,
even if it lowers the market value of the company. These divergent interests can result in agency
costs. There are three common types of agency costs: monitoring, bonding, and residual loss.

It’s the incremental costs of having an agent make decisions for a principal. Costs that arise
from the inefficiency of a relationship between an agent and a principal. In a publicly-traded
company, agency costs may arise because the company's executives (the agents) may act in their
own interest in a way that is detrimental to shareholders (the principals).

For example, they may raise their own salaries to an unrealistic level. Agency costs are best
reduced by providing appropriate incentives to align the interests of both agents and principals.
It’s the failure of employees (as ‘agents’), hired by the owners (the ‘principals’) of a business, to
fully comply with the terms and responsibilities stipulated in their Contract of employment. For
example, operatives may ‘shirk’, indulging in time wasting (long tea breaks etc) thus leading to a
loss of potential output. The companies executive directors may fail to put shareholder interests
first and pursue other Business Objectives of more ‘value’ to themselves.
Strategists are concerned not only with agency costs (internal to the firm) but also with the
Transaction costs of using external markets. Together these can be important considerations in
influencing the extent of Vertical Integration/Disintergration.

Breaking down 'Agency Costs'

Some common examples of the principal-agent relationship include: management (agent) and
shareholders (principal), or politicians (agent) and voters (principal). Agency costs are
inevitable within an organization whenever the principals are not completely in charge; the costs
can usually be best spent on providing proper material incentives (such as performance bonuses
and stock options) and moral incentives for agents to properly execute their duties, thereby
aligning the interests of principals (owners) and agents.

Monitoring costs are incurred when the principals attempt to monitor or restrict the actions of
agents. For example, the board of directors at a company acts on behalf of shareholders to
monitor and restrict the activities of management to ensure behavior that maximizes shareholder
value. The cost of having a board of directors is therefore, at least to some extent, considered an
agency monitoring cost. Costs associated with issuing financial statements and employee stock
options are also monitoring costs.
Bonding costs are incurred by the agent. An agent may commit to contractual obligations that
limit or restrict the agent’s activity. For example, a manager may agree to stay with a company
even if the company is acquired. The manager must forego other potential employment
opportunities. That implicit cost would be considered an agency bonding cost.
Residual losses are the costs incurred from divergent principal and agent interests despite the use
of monitoring and bonding.

How it works (Example):

In a publicly-held company, agency costs occur when a company's management or "agent"
places his own personal financial interests above those of the shareholder or "principal."
Agency costs can be either:
 The costs incurred if the agent uses to company's resources for his own benefit; or
 The cost of techniques that principals use to prevent the agent from prioritizing his
interests over the shareholders'.
 Employees stock ownership plan for ordinary employees where an employee gets
shares instead of money
 Executive share options for senior management
To prevent the agent from acting to benefit himself, shareholders may offer financial incentives
to keep shareholders' interest as the top priority. This typically means paying bonuses to
management if and when share price increases or by making the management's salary partiall
shares in the company. These monetary incentives are an example of agency costs. If the
incentive plan works correctly, however, these agency costs will be lower than the cost of
allowing the management to act in his own interests.
Why it Matters:
Agency costs really take their toll on a company's share price when there is substantial debt
involved. Shareholders and bondholders have severe conflicts of interest, but shareholders have
administrative power. They will pursue selfish strategies which will impose agency costs and
lower the market value of the whole firm.

Though they are difficult for an accountant to track, agency costs are difficult to avoid as
principals and agents can have separate motivations. Management can have more information
than share holders and can take advantage of their decision-making power over the company.

A non-financial way to consider agency costs is often the conflict of interest between voters and
politicians. Voters select their representatives to act in their best interests, but the representatives
gain the law-making power and will often act to maintain their positions of power instead of to
fulfill their promises to constituents.

The Agency Problem and Control of the Corporation

We've seen that the financial manager acts in the best interests of the stockholders by taking
actions that increase the value of the stock. However, we've also seen that in large corporations
ownership can be spread over a huge number of stockholders. This dispersion of ownership
arguably means that management effectively controls the firm. In this case, will management
necessarily act in the best interests of the stockholders? Put another way, might not
management pursue its own goals at the stockholders' expense? In the following pages, we
briefly consider some of the arguments relating to this question.

AGENCY RELATIONSHIPS
The relationship between stockholders and management is called an agency relationship. Such
a relationship exists whenever someone (the principal) hires another (the agent) to represent
his or her interests. For example, you might hire someone (an agent) to sell a car you own
while you are away at school. In all such relationships, there is a possibility of conflict of
interest between the principal and the agent. Such a conflict is called an agency problemThe
possibility of conflict of interest between the stockholders and management of a firm.

The possibility of conflict of interest between the stockholders and management of a firm.
Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or
she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get
you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a
flat fee, then this problem might not exist. This example illustrates that the way in which an
agent is compensated is one factor that affects agency problems.

MANAGEMENT GOALS
To see how management and stockholder interests might differ, imagine that the firm is
considering a new investment. The new investment is expected to favorably impact the share
value, but it is also a relatively risky venture. The owners of the firm will wish to take the
investment (because the stock value will rise), but management may not because there is the
possibility that things will turn out badly and management jobs will be lost. If management
does not take the investment, then the stockholders may lose a valuable opportunity. This is
one example of an agency cost.

More generally, the term agency costs refer to the costs of the conflict of interest between
stockholders and management. These costs can be indirect or direct. An indirect agency cost is
a lost opportunity, such as the one we have just described.

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits
management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded
corporate jet would fall under this heading. The second type of direct agency cost is an
expense that arises from the need to monitor management actions. Paying outside auditors to
assess the accuracy of financial statement information could be one example.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount
of resources over which they have control or, more generally, corporate power or wealth. This
goal could lead to an overemphasis on corporate size or growth. For example, cases in which
management is accused of overpaying to buy up another company just to increase the size of
the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment
does take place, such a purchase does not benefit the stockholders of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival
to protect job security. Also, management may dislike outside interference, so independence
and corporate self-sufficiency may be important goals.

DO MANAGERS ACT IN THE STOCKHOLDERS' INTERESTS?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors.
First, how closely are management goals aligned with stockholder goals? This question relates,
at least in part, to the way managers are compensated. Second, can managers be replaced if
they do not pursue stockholder goals? This issue relates to control of the firm. As we will
discuss, there are a number of reasons to think that even in the largest firms, management has a
significant incentive to act in the interests of stockholders.

Managerial Compensation Management will frequently have a significant economic

incentive to increase share value for two reasons. First, managerial compensation, particularly
at the top, is usually tied to financial performance in general and often to share value in
particular. For example, managers are frequently given the option to buy stock at a bargain
price. The more the stock is worth, the more valuable is this option. In fact, options are often
used to motivate employees of all types, not just top managers. For example, in 2001 Intel
announced that it was issuing new stock options to 80,000 employees, thereby giving its
workforce a significant stake in its stock price and better aligning employee and shareholder
interests. Many other corporations, large and small, have adopted similar policies.

The second incentive managers have relates to job prospects. Better performers within the firm
will tend to get promoted. More generally, managers who are successful in pursuing
stockholder goals will be in greater demand in the labor market and thus command higher
salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous
rewards. For example, the best-paid executive in 2005 was Terry Semel, the CEO of Yahoo!;
according to Forbes magazine, he made about $231 million. By way of comparison, Semel
made quite a bit more than George Lucas ($180 million), but only slightly more than Oprah
Winfrey ($225 million), and way more than Judge Judy ($28 million). Over the period 2001–
2005, Oracle CEO Larry Ellison was the highest-paid executive, earning about $868 million.
Information about executive compensation, along with lots of other information, can be easily
found on the Web for almost any public company.

Control of the Firm Control of the firm ultimately rests with stockholders. They elect the
board of directors, who in turn hire and fire managers. The fact that stockholders control the
corporation was made abundantly clear by Steven Jobs's experience at Apple. Even though he
was a founder of the corporation and was largely responsible for its most successful products,
there came a time when shareholders, through their elected directors, decided that Apple would
be better off without him, so out he went. Of course, he was later rehired and helped turn
Apple around with great new products such as the iPod.

An important mechanism by which unhappy stockholders can act to replace existing

management is called a proxy fight. A proxy is the authority to vote someone else's stock. A
proxy fight develops when a group solicits proxies in order to replace the existing board and
thereby replace existing managers. For example, in early 2002, the proposed merger between
Hewlett-Packard (HP) and Compaq triggered one of the most widely followed, bitterly
contested, and expensive proxy fights in history, with an estimated price tag of well over $100
million. One group of shareholders, which included Walter B. Hewlett (a board member and
heir to a cofounder of HP), opposed the merger and launched a proxy fight for control of HP.
Another group, led by HP CEO Carly Fiorina, supported the merger. In a very close vote, Ms.
Fiorina prevailed, the merger went through, and Mr. Hewlett resigned from the board.

Another way that managers can be replaced is by takeover. Firms that are poorly managed are
more attractive as acquisitions than well-managed firms because a greater profit potential
exists. Thus, avoiding a takeover by another firm gives management another incentive to act in
the stockholders' interests. For example, in April 2006, the management of Arcelor SA was
attempting to fight off a bid from rival steelmaker Mittal Steel Co. Arcelor's management
undertook several steps in an attempt to defeat the €20.4 billion ($24.8 billion) bid. First, the
company transferred its lucrative Canadian operations to a Dutch foundation. Next, the
company increased its dividend and promised a special dividend to shareholders when Mittal
dropped its bid or the takeover failed. These payments to shareholders meant that remaining
with current management or siding with Mittal would be financially equivalent.

Conclusion The available theory and evidence are consistent with the view that stockholders
control the firm and that stockholder wealth maximization is the relevant goal of the
corporation. Even so, there will undoubtedly be times when management goals are pursued at
the expense of the stockholders, at least temporarily.
 STAKEHOLDERS

Our discussion thus far implies that management and stockholders are the only parties with an
interest in the firm's decisions. This is an oversimplification, of course. Employees, customers,
suppliers, and even the government all have a financial interest in the firm.

Taken together, these various groups are called stakeholders. Someone other than a
stockholder or creditor who potentially has a claim on the cash flows of the firm. In general, a
stakeholder is someone other than a stockholder or creditor who potentially has a claim on the
cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to
the detriment of the owners.

Someone other than a stockholder or creditor who potentially has a claim on the cash flows of
the firm.

Concept Questions

1.4a What is an agency relationship?

1.4b What are agency problems and how do they come about? What are agency costs?
1.4c What incentives do managers in large corporations have to maximize share value?

CAPITAL GEARING
The term Gearing is used in business studies to refer to the proportion of debt that is used in
the overall financing of a firm. An alternative (and more formal) name for gearing is the “debt-
equity" ratio, and it is one of the most fundamental measures in corporate finance. It is a great
test of the overall financial strength of a firm, but it needs to be used with care. Another problem
is that there are several ways of calculating gearing, which can cause some confusion although
each approach is based on the same principles.
Gearing measures the mix of funds in the balance sheet and makes a comparison between those
funds that have been supplied by the owners (equity) and those which have been borrowed
“debt".

Capital gearing is the degree to which a company acquires assets or to which it funds its
ongoing operations with long- or short-term debt. Capital gearing will differ between companies
and industries, and will often change over time. Capital gearing is also known as "financial
leverage".
Closely related to solvency ratio is the capital gearing ratio. Capital gearing ratio is mainly
used to analyze the capital structure of a company. The term capital structure refers to the
relationship between the various long-term form of financing such as debentures, preference and
equity share capital including reserves and surpluses. Leverage of capital structure ratios are
calculated to test the long-term financial position of a firm.
The term "capital gearing" or "leverage" normally refers to the proportion of relationship
between equity share capital including reserves and surpluses to preference share capital and
other fixed interest bearing funds or loans. In other words it is the proportion between the fixed
interest or dividend bearing funds and non fixed interest or dividend bearing funds. Equity share
capital includes equity share capital and all reserves and surpluses items that belong to
shareholders. Fixed interest bearing funds includes debentures, preference share capital and other
long-term loans.

Breaking down 'Capital Gearing'

In the event of a leveraged buyout, the amount of capital gearing a company will employ will
dramatically increase as the company increases its debt in order to finance the acquisition. When
analyzing a firm undergoing a leveraged buyout, it is important to consider the firm's ability to
service the additional interest payments on an after-tax basis, as well as the likelihood of the firm
paying off the new debt as it matures.

Capital gearing ratio is a useful tool to analyze the capital structure of a company and is
computed by dividing the common stockholders’ equity by fixed interest or dividend bearing
funds. Analyzing capital structure means measuring the relationship between the funds provided
by common stockholders and the funds provided by those who receive a periodic interest or
dividend at a fixed rate.
A company is said to be low geared if the larger portion of the capital is composed of common
stockholders’ equity. On the other hand, the company is said to be highly geared if the larger
portion of the capital is composed of fixed interest/dividend bearing funds.

Preference shares carry a fixed rate of dividend and debentures carry a fixed rate of interest. The
equity shares are paid dividend out of profits left after payment of interest on debentures, and
dividend on preference shares.
Thus, dividend on equity shares may vary year after year. Equity shares are known as variable
return securities and debentures and preference shares as fixed return securities. If the rate of
return on fixed return securities is lower than the rate of earnings of the company, the return on
equity shares will be higher.

This phenomenon is known as financial leverage or capital gearing. Thus, financial leverage is
an arrangement under which fixed return bearing securities (debentures and preference shares)
are used to raise cheaper funds to increase the return to equity shareholders. It may be noted that
a lever is used to lift something heavy by applying less force than required otherwise.

Capital gearing denotes the ratio between various types of securities and Under-Capitalization
total capitalization. Capitalization of a company is highly geared when the proportion of equity
to total capitalization is small and it is low geared when the equity capital dominates the capital
structure. Capital gearing is calculated by determining the ratio between the amount of equity
capital (representing variable income bearing securities) and the total amount of securities
(equity shares, preference shares and debentures) issued by a company.
Formula:

In the above formula, the numerator consists of common stockholders’ equity that is equal to
total stockholders’ equity less preferred stock and the denominator consists of fixed interest or
dividend bearing funds that usually include long term loans, bonds, debentures and preferred
stock etc. All the information required to compute capital gearing ratio is available from the
balance sheet.
Example:
1. The following information have been taken from the balance sheet of PQR limited:
2011 2012
Common stockholders’ equity 3,500,000 2,800,000
Preferred stock – 9% 1,400,000 1,800,000
Bonds payable – 6% 1,600,000 1,400,000
We can compute the capital gearing ratio for the years 2011 and 2012 from the above
information as follows:
For the year 2011:
Capital gearing ratio = 3,500,000 / 3,000,000
= 7 : 6 (Low geared)
For the year 2012:
Capital gearing ratio = 2,800,000 / 3,200,000
= 7 : 8 (Highly geared)
The company has a low geared capital structure in 2011 and highly geared capital structure in
2012. Notice that the gearing is inverse to the common stockholders’ equity.
Highly Less common stockholders’
>>>
geared equity
More common
Low
>>> stockholders’ equity
geared
2. Calculate capital gearing ratio from the following data:
Equity Share Capital 1991 1992
Reserves & Surplus 500,000 400,000
Long Term Loans 300,000 200,000
6% Debentures 250,000 300,000
250,000 400,000
Calculation:

Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 + 250,000)

 = 8 : 5 (Low Gear)

1993 = (400,000 + 200,000) / (300,000 + 400,000)

6 : 7 (High Gear)

It may be noted that gearing is an inverse ratio to the equity share capital.

Highly Geared------------Low Equity Share Capital

Low Geared---------------High Equity Share Capital

3. As shown in Table 9.1 each of the two companies have issued the total securities worth Rs.
20,00,000 and they have equity shares worth Rs. 5,00,000 and Rs. 15,00,000 respectively.
Company A is highly geared as the ratio between equity capital to total capitalization is small,
i.e., 25%. But in case of Company B, this ratio is 75%, so it is low geared.

The various securities issued should bear such ratio to total capitalization that capital structure is
safe and economical. Equity shares should be issued where there is uncertainty of earnings.
Preference shares, particularly the cumulative ones, should be issued when the average earnings
are expected to be fairly good. Debentures should be issued when the company expects fairly
higher earnings in future to pay interest to the debenture holders and increase the return of equity
shareholders.

Significance and interpretation of Capital Gearing

Capital gearing ratio is the measure of capital structure analysis and financial strength of the
company and is of great importance for actual and potential investors.
Borrowing is a cheap source of funds for many companies but a highly geared company is
considered a risky investment by the potential investors because such a company has to pay more
interest on loans and dividend on preferred stock and, therefore, may have to face problems in
maintaining a good level of dividend for common stockholders during the period of low profits.
Banks and other financial institutions reluctant to give loans to companies that are already highly
geared.
Capital gearing ratio is important to the company and the prospective investors. It must be
carefully planned as it affects the company's capacity to maintain a uniform dividend policy
during difficult trading periods. It reveals the suitability of company's capitalization.

In a low geared company, the fixed cost of capital will be lower and the equity shareholders will
get a higher profit by way of dividend and in case of high gearing the fixed cost of capital will be
higher and the profits to be distributed to the equity shareholders will be lower.

The role of capital gearing in a business is as important as gears in an automobile. In an

automobile, gears are used to maintain the desired speed. Initially, an automobile starts with a
low gear, and as soon as it gets momentum, the low gear is changed to high gear. Similarly, a
business is started with a low gear, i.e. high proportion of equity capital and as soon as, the
business gets momentum, it may subsequently issue fixed cost securities, i.e., preference shares
and/or debentures. Thus the process of capital gearing deals with the makes up of capitalization.

The problem of capital gearing is very important from the financial manager's point of view. He
must know, in what securities should the funds for the company be raised and in what
proportion?

It is very important for the success of the company. All concerning parties, i.e. shareholders,
debenture holders, creditors and the concern itself are affected by it. A low geared company can
pay more dividends to its shareholders or a high-geared company also can pay higher dividend to
its shareholders in inflationary conditions of the market if proper capital gearing is maintained.

The Importance of Capital Gearing Finance Essay

Financing and investment are two major decision areas for a company. In the financial decision,
the company concerns with determining the best capital structure. There are only two ways that a
business can raise money - debt or equity. With the right option, the business can minimize its
cost and maximize company value.

Bos and Fetherston (1993) described that determining debt and equity is an important financial
decision faced by companies. The relationship between debt and equity is considered as capital
gearing. Hence, in this report, the gearing ratio and its influence to WACC, company value and
shareholder wealth will be assessed through the two major theories.

A company with low gearing is one that is mainly being funded or financed by share capital
(equity) and reserves, whilst the one with a high gearing is mainly funded by loan capital. Now
the question to address is which of the two (equity and debt) is cheaper to the company? The
answer is that cost of debt is cheaper than cost of equity. This is because debt is less risky than
equity and the tax advantage of debt over equity as discussed below: Risk: debt is less risky than
equity because:
•the required return needed to compensate the debt investors is less than the required return
needed to compensate the equity investors;
•the payment of interest is often a fixed amount and compulsory in nature and it is paid in
priority to the payment of dividends;
•in the event of a liquidation, debt holders would receive their capital repayment before
shareholders as they are higher in the creditor hierarchy (the order in which creditors get repaid),
as shareholders are paid out last. Corporate tax advantage: in the income statement, interest (on
debt) is subtracted before the tax is calculated; thus, companies get tax relief on interest.

However, dividends (on equity) are subtracted after the tax is calculated; therefore, companies do
not get any tax relief on dividends. From the above discussion, we can observe that debt is
cheaper than equity when financing a company. However, there are implications of pursing high
gearing rather than low gearing.
Watzon and Head (2007) described the following as implications of high gearing: Increased
volatility of equity returns: the higher a company’s level of gearing, the more sensitive its
profitability and earnings are to changes in interest rates. The company’s profit and distributable
earnings will be at risk from increases in the interest rate. This risk will be borne by shareholders
as the company may have to reduce dividend payments in order to meet its interest payment as
they fall due.
Benefits of Gearing
 High gearing is bad for shareholders in a business downturn but good for them in a
growth scenario: in the example above the profit of the geared company would rise
proportionately faster than that of the ungeared one for the same increase in operating
profit
 Interest payments on debt are tax-deductible; dividends are paid after tax
 Debt is cheaper than equity: shareholders expect a higher return to compensate for their
higher risk. Lenders have the benefits of contracted interest income as well as seniority
over shareholders in the event of liquidation.
 Gearing can act as protection from unwelcome predators. Some companies fearful of
a takeover bid include so-called poison pill covenants into their borrowing agreements,
where the lender has the right to demand repayment in full in the event of a sale. This
imposes an additional financing burden on the prospective buyer.

Optimal Gearing
The example above illustrates how gearing affects the market risk to equity holders. Moreover,
gearing also increases the risk of the company becoming insolvent, so we would expect the cost
of debt to be affected as well.
Does the level of gearing affect the company's WACC?
Is there an optimal level of gearing?

Advantages and Disadvantages of High Gearing

Advantages of High Gearing

 Borrowing may allow the firm to take on profitable projects.
 Taking on more profitable projects may allow the company to expand and in the future
reduce its Gearing ratio.
 Borrowing may be a quick and cheap form of financing a project compared to other
means such as share issues which may not all be taken up.
 High gearing can also be good for shareholders. Why? Because most shareholders are
looking to maximize the return on their investment. So why should shareholders have to
 provide all the financing for a firm? If borrowing is available at attractive rates, then it
ought to be used (that's how venture capitalists make such high returns).
Disadvantages of High Gearing
 If the company has low profits then it may struggle to meet interest payments, leading to
a higher risk of being liquidated.
 The firm may find it harder to get further loans, since investors will be put off by the high
gearing level.
 High gearing is bad for shareholders in a business downturn but good for them in a
growth scenario: in the example above the profit of the geared company would rise
proportionately faster than that of the ungeared one for the same increase in operating
profit.

Dangers of having high level of gearing- business and financial

Business gearing and financial gearing are terms used to explain the volatility of a company and
its activities. While the business gearing measures the risk that a company will fail as a result of
not making enough contribution to cover for its fixed cost, financial gearing on the other hand is
used to measure the risk that a company cannot meet up with interests associated with its debt.

In as much as businesses try their best to live with these situations, care needs to be taken in
order to avoid the often fatal consequences that come with high level of gearing.

Before I go on pointing out the dangers of having high level of gearing, I would like to explain
these terms in a common language: Business risk and financial risk Business risks are those risks
that are inseparable from business. They are inherent by nature. This refers to the risk of making
low profits, or even losses, due to the nature of the business that the company is involved in. One
way of measuring business risk is by calculating a company’s operating gearing or operational
gearing. The formula is contribution/PBIT (profit before interest and tax).

Financial risks are those risks created by having debt in a company’s capital structure. This is the
risk of a company not being able to meet other obligations as a result of the need to make huge
interest payments.

Dangers of high level of gearing

Operating gearing measures the effects of fixed cost on PBIT and therefore, indirectly measures
the impact of high fixed cost on the going concern of a business (i.e. the business ability to
survive for yet another year).

• Risk of loosing sales revenue. Companies that have fixed cost that are too high may tend to
increase sales price so as to have more contribution that will in turn help reduce fixed cost, and
this may drive their customers to their competitors.
• Risk of incurring the wrath of the law. If a company fails to pay its necessary/obligatory dues,
concerned parties may institute a court case against them. And if not handled well, may result to
the company being forced to liquidation.

Financial gearing measures the effect of interest payment associated with debt on the continued
existence of a company. Some of its dangers are:

• Having a park of unsatisfied shareholders. Since the primary objective of every company is to
maximize its shareholders return, a company that have little or nothing left to distribute to her
shareholders will be having issues with them. And this can be frustrating.

• Low credit rating. Credit rating agencies always work in collaboration with those that associate
with a company. They may give low credit rating to companies that are not being viewed
favourably by those that have been in contact with them

 Unsettled payables: having too much payable is not a good sign in the right direction of
business direction
 Ultimate closure of company: the effects of the above may ultimately culminate into the
closure of a business.

Advantages and Disadvantages of Low Gearing

Advantages of Low Gearing
 Changes in interest rates especially upward trends have a lower effect on the firm.
 Less risk of liquidation occurring due to not being able to pay off interest payments.
 Reduced Interest payments, so more investment can occur elsewhere and the firm can
have more cash flow to take on bigger and potentially more profitable projects.
Disadvantages of Low Gearing
 The firm is expected to make regular dividend payments.
 The higher ratio of Shareholder funds will mean that the company will now be owned by
its shareholders more relatively.
 Net Present Value – NPV

Net Present Value (NPV)

Money now is more valuable than money later on.

Why? Because you can use money to make more money!

You could run a business, or buy something now and sell it later for more, or simply put the
money in the bank to earn interest.

Example: Let us say you can get 10% interest on your money.

So $1,000 now could earn $1,000 x 10% = $100 in a year.

Your $1,000 now would become $1,100 by next year.

So $1,100 next year is the same as $1,000 now.

Present Value
If you understand Present Value, you can skip straight to Net Present Value.

So $1,000 now is the same as $1,100 next year (at 10% interest).

We say the Present Value of $1,100 next year is $1,000

Because we could turn $1,000 into $1,100 in one year (if we could earn 10% interest).

Now let us extend this idea further into the future ...

How to Calculate Future Payments

Let us stay with 10% Interest. That means that money grows by 10% every year, like this:

So:

 $1,100 next year is the same as $1,000 now.

 And $1,210 in 2 years is the same as $1,000 now.
 etc

In fact all those amounts are the same (considering when they occur and the 10% interest).

Easier Calculation

But instead of "adding 10%" to each year it is easier to multiply by 1.10 (explained at Compound
Interest):

So we get this (same result as above):

Future Back to Now

And to see what money in the future is worth now, go backwards (dividing by 1.10 each year
instead of multiplying):

Example: Sam promises you $500 next year, what is the Present Value?

To take a future payment backwards one year divide by 1.10

So $500 next year is $500 ÷ 1.10 = $454.55 now (to nearest cent).

The Present Value is $454.55

Example: Alex promises you $900 in 3 years, what is the Present Value?

To take a future payment backwards three years divide by 1.10 three times

So $900 in 3 years is:

$900 ÷ 1.10 ÷ 1.10 ÷ 1.10

$900 ÷ (1.10 × 1.10 × 1.10)
$900 ÷ 1.331
$676.18 now (to nearest cent).

Better With Exponents

But instead of $900 ÷ (1.10 × 1.10 × 1.10) it is better to use exponents (the exponent says how
many times to use the number in a multiplication).

Example: (continued)

The Present Value of $900 in 3 years (in one go):

$900 ÷ 1.103 = $676.18 now (to nearest cent).

And we have in fact just used the formula for Present Value:

PV = FV / (1+r)n

 PV is Present Value
 FV is Future Value
 r is the interest rate (as a decimal, so 0.10, not 10%)
 n is the number of years

Example: (continued)

Use the formula to calculate Present Value of $900 in 3 years:

PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).
 Exponents are easier to use, particularly with a calculator.

For example 1.106 is quicker than 1.10 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10

What is 'Net Present Value - NPV'

Net present value (NPV) is the present value of an investment's expected cash inflows minus
the costs of acquiring the investment.

Net Present Value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a
projected investment or project.

Net present value is a calculation that compares the amount invested today to the present value of
the future cash receipts from the investment. In other words, the amount invested is compared to
the future cash amounts after they are discounted by a specified rate of return.

NPV is the difference between the present value of the future cash flows from an investment and
the amount of investment. Present value of the expected cash flows is computed by discounting
them at the required rate of return.

The formula for NPV is: The following is the formula for calculating NPV:

NPV = (Cash inflows from investment) – (cash outflows or costs of investment)

where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

or
Net Present Value(NPV) is a formula used to determine the present value of an investment by the
discounted sum of all cash flows received from the project. The formula for the discounted sum
of all cash flows can be rewritten as

When a company or investor takes on a project or investment, it is important to calculate an

estimate of how profitable the project or investment will be. In the formula, the -C0 is the initial
investment, which is a negative cash flow showing that money is going out as opposed to coming
in. Considering that the money going out is subtracted from the discounted sum of cash flows
coming in, the net present value would need to be positive in order to be considered a valuable
investment.

A positive net present value indicates that the projected earnings generated by a project or
investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally,
an investment with a positive NPV will be a profitable one and one with a negative NPV will
result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that
the only investments that should be made are those with positive NPV values.
When the investment in question is an acquisition or a merger, one might also use the
Discounted Cash Flow (DCF) metric.

Breaking down 'Net Present Value - NPV'

To be a Net Present Value you also need to subtract money that went out (the money you
invested or spent):

 Add the Present Values you receive

 Subtract the Present Values you pay

Determining the value of a project is challenging because there are different ways to measure the
value of future cash flows. Because of the time value of money (TVM), money in the present is
worth more than the same amount in the future. This is both because of earnings that could
potentially be made using the money during the intervening time and because of inflation. In
other words, a dollar earned in the future won’t be worth as much as one earned in the present.
The discount rate element of the NPV formula is a way to account for this. Companies may often
have different ways of identifying the discount rate. Common methods for determining the
discount rate include using the expected return of other investment choices with a similar level of
risk (rates of return investors will expect), or the costs associated with borrowing money needed
to finance the project.

Any capital investment involves an initial cash outflow to pay for it, followed by cash inflows in
the form of revenue, or a decline in existing cash flows that are caused by expense reductions.
We can lay out this information in a spreadsheet to show all expected cash flows over the useful
life of an investment, and then apply a discount rate that reduces the cash flows to what they
would be worth at the present date. This calculation is known as net present value analysis.

Why it Matters:

NPV is used to analyze an investment decision and give company management a clear way to tell
if the investment will add value to the company. Typically, if an investment has a positive net
present value, it will add value to the company and benefit company shareholders.

Net present value calculations can be used for either acquisitions (as shown in the example
above) or future capital projects. For example, if a company decides to open a new product line,
they can use NPV to find out if the projected future cash inflows cover the future costs of starting
and running the project. If the project has a positive NPV, it adds value to the company and
therefore should be considered.

Net present value is the traditional approach to evaluating capital proposals, since it is based on a
single factor – cash flows – that can be used to judge any proposal arriving from anywhere in a
company.

Example: A friend needs $500 now, and will pay you back $570 in a year. Is that
a good investment when you can get 10% elsewhere?

Money Out: $500 now

You invested $500 now, so PV = -$500.00

Money In: $570 next year

PV = $570 / (1+0.10)1 = $570 / 1.10 = $518.18 (to nearest cent)

The Net Amount is:

Net Present Value = $518.18 - $500.00 = $18.18

So, at 10% interest, that investment is worth $18.18

(In other words it is $18.18 better than a 10% investment, in today's money.)
A Net Present Value (NPV) that is positive is good (and negative is bad).

But your choice of interest rate can change things!

Example: Same investment, but try it at 15%.

Money Out: $500
You invested $500 now, so PV = -$500.00
Money In: $570 next year:
PV = $570 / (1+0.15)1 = $570 / 1.15 = = $495.65 (to nearest cent)
Work out the Net Amount:
Net Present Value = $495.65 - $500.00 = -$4.35
So, at 15% interest, that investment is worth -$4.35

It is a bad investment. But only because you are demanding it earn 15% (maybe you can get 15%
somewhere else at similar risk).

Side Note: the interest rate that makes the NPV zero (in the previous example it would be around
14%) is called the Internal Rate of Return.

Let us try a bigger example.

Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500
in the 3rd year. Use 10% Interest Rate.

Let us work year by year (remembering to subtract what you pay out):
 Now: PV = -$2,000
 Year 1: PV = $100 / 1.10 = $90.91
 Year 2: PV = $100 / 1.102 = $82.64
 Year 3: PV = $100 / 1.103 = $75.13
 Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29

Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97

Looks like a good investment.

And again, but an interest rate of 6%

Example: (continued) at a 6% Interest Rate.

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.06 = $94.34
 Year 2: PV = $100 / 1.062 = $89.00
 Year 3: PV = $100 / 1.063 = $83.96
 Year 3 (final payment): PV = $2,500 / 1.063 = $2,099.05

Adding those up gets: NPV = -$2,000 + $94.34 + $89.00 + $83.96 + $2,099.05 = $366.35

Looks even better at 6%

Why is the NPV bigger when the interest rate is lower?
Because the interest rate is like the team you are playing against, play an easy team (like a 6%
interest rate) and you look good, a tougher team (like a 10% interest) and you don't look so
good!

You can actually use the interest rate as a "test" or "hurdle" for your investments: demand that an
investment have a positive NPV with, say, 6% interest.
So there you have it: work out the PV (Present Value) of each item, then total them up to get the
NPV (Net Present Value), being careful to subtract amounts that go out and add amounts that
come in. And a final note: when comparing investments by NPV, make sure to use the same
interest rate for each.

In another example, if a retail clothing business wants to purchase an existing store, it would
first estimate the future cash flows that store would generate, and then discount those cash flows
into one lump-sum present value amount of, say $500,000. If the owner of the store were willing
to sell his or her business for less than $500,000, the purchasing company would likely accept
the offer as it presents a positive NPV investment. If the owner agreed to sell the store for
$300,000, then the investment represents a $200,000 net gain ($500,000 - $300,000) during the
calculated investment period. This $200,000, or the net gain of an investment, is called the
investment’s intrinsic value. Conversely, if the owner would not sell for less than $500,000, the
purchaser would not buy the store, as the acquisition would present a negative NPV at that time
and would, therefore, reduce the overall value of the larger clothing company.

Other examples of Net Present Value

1. To provide an example of Net Present Value, consider company Shoes For You's who is
determining whether they should invest in a new project. Shoes for You's will expect to invest
$500,000 for the development of their new product. The company estimates that the first year
cash flow will be $200,000, the second year cash flow will be $300,000, and the third year cash
flow to be $200,000. The expected return of 10% is used as the discount rate.

The following table provides each year's cash flow and the present value of each cash flow.
Year Cash Flow Present Value
0 -$500,000 -$500,000
1 $200,000 $181,818.18
2 $300,000 $247,933.88
3 $200,000 $150,262.96

Net Present Value = $80,015.02

The net present value of this example can be shown in the formula

When solving for the NPV of the formula, this new project would be estimated to be a valuable
venture.
2. Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company
ABC's projections for the next 10 years. It discounts those projected cash inflows back to the
present using its weighted average cost of capital (WACC) and then subtracts the cost of
purchasing Company ABC.

Cost to purchase Company ABC today: $1,000,000

Present value (PV) of cash flows from acquiring Company ABC:

Year 1: $200,000, Year 2: $150,000, Year 3: $100,000, Year 4: $75,000, Year 5: $70,000,

Year 6: $55,000, Year 7: $50,000, Year 8: $45,000, Year 9: $30,000, Year 10: $10,000

Total: $785,000

Now that we know the total cash flow for the next 10 years (the total cash inflows from the
investment), along with total cost of the investment in Company ABC, we can use the formula to
calculate NPV:

Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000

At this point, management for Company XYZ would use the net present value rule to decide
whether or not to pursue the acquisition of Company ABC. Because the NPV is negative, they
should say, "No."

3. An investment of $500,000 today is expected to return $100,000 of cash each year for 10
years. The $500,000 being spent today is already a present value, so no discounting is necessary
for this amount. However, the future cash receipts of $100,000 for 10 years need to be
discounted to their present value. Let's assume that the receipts are discounted by 14% (the
company's required return). This will mean that the present value of the those future receipts will
be approximately $522,000. The $522,000 of present value coming in is compared to the
$500,000 of present value going out. The result is a net present value of $22,000 coming in.

4. An investment of $1,000 today at 10 percent will yield $1,100 at the end of the year; therefore,
the present value of $1,100 at the desired rate of return (10 percent) is $1,000. The amount of
investment ($1,000 in this example) is deducted from this figure to arrive at net present value
which here is zero ($1,000-$1,000).

5. ABC International is planning to acquire an asset that it expects will yield positive cash flows
for the next five years. Its cost of capital is 10%, which it uses as the discount rate to construct
the net present value of the project. The following table shows the calculation:

Year Cash Flow 10% Discount Factor Present Value

0 -$500,000 1.0000 -$500,000
1 +130,000 0.9091 +118,183
2 +130,000 0.8265 +107,445
3 +130,000 0.7513 +97,669
4 +130,000 0.6830 +88,790
5 +130,000 0.6209 +80,717
Net Present Value -$7,196

The net present value of the proposed project is negative at the 10% discount rate, so ABC
should not invest in the project.

The Discount Rate

In the “10% Discount Factor” column, the factor becomes smaller for periods further in the
future, because the discounted value of cash flows are reduced as they progress further from the
present day. The discount factor is widely available in textbooks, or can be derived from the
following formula:
Future cash flow
Present value of a = -------------------------------------------------------------------
future cash flow (1 + Discount rate)squared by the number of periods of
discounting
To use the formula for an example, if we forecast the receipt of $100,000 in one year, and are
using a discount rate of 10 percent, then the calculation is:

$100,000
Present
= -----------
value
(1+.10)1

Present value = $90,909

Contents of a Net Present Value Analysis

A net present value calculation that truly reflects the reality of cash flows will likely be more
complex than the one shown in the preceding example. It is best to break down the analysis into
a number of sub-categories, so that you can see exactly when cash flows are occurring and with
what activities they are associated. Here are the more common contents of a net present value
analysis:

 Asset purchases. All of the expenditures associated with the purchase, delivery,
installation, and testing of the asset being purchased.
 Asset-linked expenses. Any ongoing expenses, such as warranty agreements, property
taxes, and maintenance, that are associated with the asset.
  Contribution margin. Any incremental cash flows resulting from sales that can be
attributed to the project.
 Depreciation effect. The asset will be depreciated, and this depreciation shelters a portion
of any net income from income taxes, so note the income tax reduction caused by
depreciation.
 Expense reductions. Any incremental expense reductions caused by the project, such as
automation that eliminates direct labor hours.
 Tax credits. If an asset purchase triggers a tax credit (such as for a purchase of energy-
reduction equipment), then note the credit.
 Taxes. Any income tax payments associated with net income expected to be derived from
the asset.
 Working capital changes. Any net changes in inventory, accounts receivable, or accounts
payable associated with the asset. Also, when the asset is eventually sold off, this may
trigger a reversal of the initial working capital changes.

By itemizing the preceding factors in a net present value analysis, you can more easily review
and revise individual line items.

Cautions when using Net Present Value

Net present value does not consider the presence of a constraint in the system of generating cash
flow, which could restrict the total amount of cash actually generated. The result can be an
estimated net present value that cannot be realized.

A zero net present value means the project repays original investment plus the required rate of
return. A positive net present value means a better return and Investments with a positive net
present value would be acceptable, and a negative net present value means a worse return &
Investments with a negative net present value would be unacceptable, than the return from zero
net present value.
It is one of the two discounted cash flow techniques (the other is internal rate of return) used in
comparative appraisal of investment proposals where the flow of income varies over time.

Drawbacks and Alternatives

One primary issue with gauging an investment’s profitability with NPV is that NPV relies
heavily upon multiple assumptions and estimates, so there can be substantial room for error.
Estimated factors include investment costs, discount rate and projected returns. A project may
often require unforeseen expenditures to get off the ground or may require additional expenditure
at the project’s end.

Additionally, discount rates and cash inflow estimates may not inherently account for risk
associated with the project and may assume the maximum possible cash inflows over an
investment period. This may occur as a means of artificially increasing investor confidence. As
such, these factors may need to be adjusted to account for unexpected costs or losses or for
overly optimistic cash inflow projections.
Payback period is one popular metric that is frequently used as an alternative to net present
value. It is much simpler than NPV, mainly gauging the time required after an investment to
recoup the initial costs of that investment. Unlike NPV, the payback period (or “payback
method”) fails to account for the time value of money. For this reason, payback periods
calculated for longer investments have a greater potential for inaccuracy, as they encompass
more time during which inflation may occur and skew projected earnings and, thus, the real
payback period as well.

Moreover, the payback period is strictly limited to the amount of time required to earn back
initial investment costs. As such, it also fails to account for the profitability of an investment
after that investment has reached the end of its payback period. It is possible that the
investment’s rate of return could subsequently experience a sharp drop, a sharp increase or
anything in between. Comparisons of investments’ payback periods, then, will not necessarily
yield an accurate portrayal of the profitability of those investments.

Internal rate of return (IRR) is another metric commonly used as an NPV alternative.
Calculations of IRR rely on the same formula as NPV does, except with slight adjustments. IRR
calculations assume a neutral NPV (a value of zero) and one instead solves for the discount rate.
The discount rate of an investment when NPV is zero is the investment’s IRR, essentially
representing the projected rate of growth for that investment. Because IRR is necessarily annual
– it refers to projected returns on a yearly basis – it allows for the simplified comparison of a
wide variety of types and lengths of investments.

For example, IRR could be used to compare the anticipated profitability of a 3-year investment
with that of a 10-year investment because it appears as an annualized figure. If both have an IRR
of 18%, then the investments are in certain respects comparable, in spite of the difference in
duration. Yet, the same is not true for net present value. Unlike IRR, NPV exists as a single value
applying the entirety of a projected investment period. If the investment period is longer than one
year, NPV will not account for the rate of earnings in way allowing for easy comparison.
Returning to the previous example, the 10-year investment could have a higher NPV than will
the 3-year investment, but this is not necessarily helpful information, as the former is over three
times as long as the latter, and there is a substantial amount of investment opportunity in the 7
years' difference between the two investments.

Future Value - FV
Future value (FV) is the value of an asset or cash at a specified date in the future that is
equivalent in value to a specified sum today. There are two ways to calculate FV:
1) For an asset with simple annual interest: = Original Investment x (1+(interest rate*number of
years))
2) For an asset with interest compounded annually: = Original Investment x ((1+interest
rate)^number of years)
Breaking down 'Future Value - FV'
Consider the following examples:
1) $1000 invested for 5 years with simple annual interest of 10% would have a future value of
$1,500.00.

2) $1000 invested for 5 years at 10%, compounded annually has a future value of $1,610.51.

Calculating the Future Value of a Single Amount (FV)

If we know the single amount (PV), the interest rate (i), and the number of periods of
compounding (n), we can calculate the future value (FV) of the single amount. Calculations #1
through #5 illustrate how to determine the future value (FV) through the use of future value
factors.

Calculation #1.

You make a single deposit of $100 today. It will remain invested for 4 years at 8% per year
compounded annually. What will be the future value of your single deposit at the end of 4 years?

The following timeline plots the variables that are known and unknown:

Calculation using an FV factor:

At the end of 4 years, you will have $136 in your account.

Calculation #2.

Paul makes a single deposit today of $200. The deposit will be invested for 3 years at an interest
rate of 10% per year compounded semiannually. What will be the future value of Paul's account
at the end of 3 years?
The following timeline plots the variables that are known and unknown:

Because the interest is compounded semiannually, we convert 3 years to 6 semiannual periods,

and the annual interest rate of 10% to the semiannual rate of 5%.

Calculation using an FV factor:

At the end of 3 years, Paul will have $268 in his account.

Calculation #3.

Sheila invests a single amount of $300 today in an account that will pay her 8% per year
compounded quarterly. Compute the future value of Sheila's account at the end of 2 years.

The following timeline plots the variables that are known and unknown:

Because interest is compounded quarterly, we convert 2 years to 8 quarters, and the annual rate
of 8% to the quarterly rate of 2%.

Calculation using an FV factor:

At the end of 2 years, Sheila will have $351.60 in her account.

Calculation #4.

You invest $400 today in an account that earns interest at a rate of 12% per year compounded
monthly. What will be the future value at the end of 2 years?

The following timeline plots the variables that are known and unknown:

Because the interest is compounded monthly, we convert 2 years to 24 months, and the annual
rate of 12% to the monthly rate of 1%.

Calculation using an FV factor:

At the end of 2 years, you will have $508 in your account.

Mathematics of Future Value

The future value of a present amount can be expressed as:

We will illustrate how this mathematical expression works by using the amounts from the three
accounts in Part 1.

Account #1: Annual Compounding

A single deposit of $10,000 will earn interest at 8% per year and the interest will be deposited at
the end of one year. Since the interest is compounded annually, the one-year period can be
represented by n = 1 and the corresponding interest rate will be i = 8% per year:
The formula shows that the present value of $10,000 will grow to the FV of $10,800 at the end
of one year when interest of 8% is earned and the interest is added to the account only at the end
of the year.

Account #2: Semiannual Compounding

In Account #2 the $10,000 deposit will earn interest at 8% per year, but the interest will be
deposited at the end of each six-month period for one year. With semiannual compounding, the
life of the investment is stated as n = 2 six-month periods. The interest rate per six-month period
is i = 4% (8% annually divided by 2 six-month periods).

The present value of $10,000 will grow to a future value of $10,816 (rounded) at the end of two
semiannual periods when the 8% annual interest rate is compounded semiannually.

Account #3: Quarterly Compounding

In Account #3 the $10,000 deposit will earn interest at 8% per year, but the interest earned will
be deposited at the end of each three-month period for one year. With quarterly compounding,
the life of the investment is stated as n = 4 quarterly periods. The annual interest rate is restated
to be the quarterly rate of i = 2% (8% per year divided by 4 three-month periods).

The present value of $10,000 will grow to a future value of $10,824 (rounded) at the end of one
year when the 8% annual interest rate is compounded quarterly.
Future Values for Greater Than One Year
To be certain that you understand how the number of periods, n, and the interest rate, i, must be
aligned with the compounding assumptions, we prepared the following chart. Note that the
chart assumes an interest rate of 12% per year.

To be certain you understand the information in the chart, let's assume that a single amount of
$10,000 is deposited on January 1, 2015 and will remain in the account until December 31, 2019.
This will mean a total of five years: 2015, 2016, 2017, 2018, and 2019. If the account will pay
interest of 12% per year compounded quarterly, then n = 20 quarterly periods (5 years x 4
quarters per year), and i = 3% per quarter (12% per year divided by 4 quarters per year). The
mathematical expression will be:
Let's try one more example. Assume that a single amount of $10,000 is deposited on January 1,
2015 and will remain in the account until December 31, 2016 (a total of two years). If the
account will pay interest of 12% per year compounded monthly, then n = 24 months (2 years x
12 months per year), and i = 1% per month (12% per year divided by 12 months per year). The
mathematical expression will be:

Future Value Factors

The mathematics for calculating the future value of a single amount of $10,000 earning 8% per
year compounded quarterly for two years appears in the left column of the following table. In
the right column is the formula which uses a future value factor.

Future value factors are available in future value tables, such as the abbreviated version shown
here:
We highlighted the factor used in our computation. As you can see, the future value factor of
1.172 is located where n = 8, and i = 2%.

Our future value of 1 table is unique in that we have an additional row: n = 0. Most FV of 1
tables omit the row for n = 0, and begin with the row n =1. There should be no difference in FV
factors other than minor rounding differences.

To appreciate the usefulness of the FV of 1 table, focus on the column with the heading of i =
10%. This column tells you that the present value of 1.000 is 1.000 at time period 0—the present
time. As you move down the 10% column, the next row (where n = 1) shows that the future
value will increase by 10% to 1.100. Continuing down the 10% column, you see that at the end
of two periods (n = 2) the future value is 1.210, an increase of 0.110 (1.100 x 10%). The next
figure down indicates that at the end of three periods the future value is 1.331, which is an
increase of 0.121 (1.331 – 1.210; and 1.210 x 10%).
The FV of 1 table provides the future amounts at compound interest for a single amount of 1.000
at various interest rates. These factors should make the future calculations a bit simpler than
calculations using exponents.

The 10% column of the future value table can be used to determine the future value of a single
$1.00 invested today at 10% interest compounded annually. The single $1.00 amount will grow
to $3.138 at the end of 12 years. The FV table also provides some insight as to the future cost of
items that are expected to increase at a constant rate. For example, if a cup of coffee presently
costs $1.00 and the cost is expected to increase by 10% per year compounded annually, then a
cup of coffee will cost $3.138 per cup at the end of 12 years.

We can also use the factors for amounts greater than $1. For example, if the monthly cost of a
family's health insurance plan is $1,000 at the present time and it is expected to increase by 10%
per year compounded annually, then the monthly cost at the end of 12 years will be $3,138.