Strategic Corporate Finance LECTURER NOTES F

STRATEGIC COORPORATE FINANCE
70% Quantitative 30% Theory
Contents
1. Sources of Finance
2. Cost of Capital
3. Investment Decision May cover 70% of exam
4. Mergers & Acquisition
5. Hedging
6. Portfolio Theory & Management
7. Financial Distress & Reconstruction
8. Working Capital Management
9. Financial Analysis
10. Dividend Decision
11. Introduction to Coorporate Finance
12. Capital Structure
1. Sources of Finance
The sources of finance are clasified into 2 that is
a) Short term sources :

These are sources bellow 5 years, they include
1. Bank overdraft:
this is when the bank allows to overwithdraw money from the account
Advantages Desadventages
Easy to get High interest rate
Does not require collateral It Has no fixed payment period
can be used to finance working capital
2. Trade credit
This is when an entity purchase on credit
Easy to get Prices are always high
Does not require collateral Busines forgone cash discount
3. Short term loans

These are borrowing bellow 5 years
Finance the Working capital It requires a security
Interest is lower compared to overdraft Hight transaction cost
It has a fixed payment period
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3. Lease
This is clasified into : 1. Operating Lease
2. Finance Lease
4. Sale & Lease Back
Leasing is about renting an asset. You can sell and rent it back again
Help in solving cash flow problems No full ownership of the Asset
4. Factoring
It is composed of : 1. Invoice Discounting
2. Factor company
1. Invoice Discounting: this is selling the receivable invoice at a discount
2. Factor company: a factor company is hired to manage the ledger on yr behalf
the factor company give you advance
The business can finance its growth using
Charges by factor company
internal sources (Sales)
It help to solve the cash flow problem Distrast to customers
Note:
Short term sources should be used to finance working capital, not long term projects
b) Long Term sources

1. Debt
Debt are classified into 2: 1. Tradable or flotted
2. Untraded or unflotted
1. Tradable or flotted: these are debt which are tradable in an open
1.Bond
2. Debentures
Types of bonds:
Redeemable It is a bond with a maturity period
Irredeemable It is a bond without a maturity period
Is a bond with an option to convert into shares at maturity: you compare the
Convertible conversion value with the market value (Conversion value should be high market price
as a basis to accept the conversion)
Zero Coupon It is a bond without a coupon rate
Deep Discount
It is a bond which is sold bellow its face value but redeemed at face value
bond
Conversion Value: is a value at which the bond is converted into shares
CV = Conversion ratio x Exercise(Conversion) Price

Conversion Ratio= Number that can be converted into each bond
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Conversion Premium : it is the difference between the market value of the bond
and the conversion value
CP = MV - CV
If the premium is negative, convert and don't in the other way round
eg:
Co.X issued a bond with a face value of RWF 1 each, each 2 bond are equivalent to 5
ordinary shares, the Bond can be converted at RWF 400 per shares and the current market
prices of the bond is RWF 1100
Required:
Advise the investor of the bond on whether to convert or not
Solution:
CR (Conversion Ration) = 2 to 5 (5/2) = ` 2.50
Exercise Price 400
MV (Market Value) 1,100
CV (Conversion Value) = EP*CR (400*2.5) 1,000
CP (Conversion Price) = 1100 - 1000 100
Terms in BOND MARKETS:

1. FACE VALUE / NORMINAL/PER VALUE : (these terms are the sames) It is the value at which the bond is
issued
2. REDEEMABLE VALUE : Value at which the bond is paid at maturity date
There are:
Reedemable at per: Here Redeemable value is equal to face value
Reedemed at premiun : Here redeemable value greater than face value
Redeemed at Discount: Here redeemable value is bellow face value
3. COUPON RATE: is the interest of the bond
4. YIELD RATE : IT is the IRR (INTERNAL RATE OF RETURN OF THE DEDT)
Note: Interest on bond are always calculated on face value
2. Untraded or unflotted
It is a bedt which is not tradable in the market
example:
* Bank loan
Tax saving on interest It Requires collateral
Debt holders are not involved in the
Fixed interests charges
management of the loan
It can be used to finance long term it increases the gearing level of the business which leads to
investment high financial risks
The cost of debt is lower than the cost of Debt covenants : conditions imposed by debts holders such
equity as prevention to pay dividends, change of managements, etc
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2. Common/Ordinary Stockor share capital
These are share which give right to ownership
Raising the share capital:

Share capital can be raised in 3 ways: 1. Initial Public Offering
2. Private Placement
3. Right Issue
1. Initial Public Offering
Under this, the company issues new shares and the shares are sold to the general public through the
capital markets
2. Private Placement
Under this, the company issue new shares but the shares are sold to sellected investors
3. Right Issue
Under this the company, issue new shares but the shares are sold to existing investors
TERP
Teoritical Ex-Right Price
it is the price after the right to share has expired
Value of Shares in issue

TERP =
No of Shares in Issue
Value of the Right = TERP - Right Issue
Ex:
Co X made a right issue of 5 shares for every 3 shares held in the company at RWF 220
per shar. The current Market price of shares is RWF 340 per share.
Mr. Thom is an existing shareholder with a 100,000 shares has come to you for advise
on wheather to exercise his right or not. advice Mr. Thom on the best
alternative to gain from the right issue.
Price No of Shares Value
Existing Shares 340 3.00 1,020
Right Issue 220 5.00 1,100
TOTALS 8.00 2,120
TERP = 2120/8 = 265

Value of the Right = 265 - 220 = 45
Option 1: Exercise the Right & buy shares

Value of Shares [100,000 + (100,000 *5/3)]*265 = 70,666,667
Less Purchase of new shares (100,000*5/3)*220= (36,666,667)
Wealth 34,000,000
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Option 2: Exercise the Right & sell the right
Value of Shares 100,000 *265 = 26,500,000
Value of Right 45 * 100,000 4,500,000
Wealth 31,000,000
Advantages of ordirnary shares capital

1. The principal amount is not repaid back, therefore it can be used to finance long term capital
2. It has no fixed charges
Desadvantages of Ord. Shares

1. It has high cost of capital, compaired to debt
2. Share holders can get involved in the management of the company
3. Defered stock
4. Venture Capital
These organisation that finance start up business. They also called business angels
5. Internal Sources(Retained Earnings)

If question ask to evaluete you should give Advantages & Disavantages
COST OF CAPITAL
Is the minimum return that should be generated on each source of finance that is used to invest
Application of COST OF CAPITAL in finance

1. It is used when evaluating investment proposals as a discounting factor
2. it used in evaluation of performance when determining economic value added
EVA = Profit - COST OF CAPITAL
3. It is in the valuation of business as a discounting factor
Ve= D/ke * FCF/-WACC
Computation of Cost of Capital

First we compute:
1. Specific cost of capital
2. Then We compute WACC
1. Specific cost of capital:

Cost of Equity/Common stock
Preference stock
Cost of Debt
Retained Earning
They average gives WACC
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1. Cost of Equity/Common stock
It is the minimum return to be generated on the equity sources of finance
there 2 methods followed when computing cost if equity, that is:
* the dividend model
* and CAPEM Capital Asset pricing model
When there is no grow:
𝐷
Ke=
𝑃𝑜
When there is grow
𝐷1
Ke= +g
𝑃𝑜
When:
D1= expected Divident
Po = Ex-Div Price
Do: Current Dividend
Ex-Div Price = Cum Div - DV Price
Determination of Growth Rate

There are 2 methods:
1. Aritmetic Model
𝑛 𝐷𝑜/𝐷𝑖
g= -1
⬚
Co X gave a dividend of 26 FRW per share in 2015 and 30 FRW per share in 2022
Do= 30, D1=26, n=7
7 30/26
g= - 1 = 2.06%
⬚
2. Gordon Growth Model
g = br Where:
b = reintention rate
r = Return on renvestment
Ex:
Co has EAT on 20m and give dividend equal to 15m
r = 15/20 = 75%
Pay out is = 25%
FLOTATION COST 𝐷1
Ke= +g
these are cost incured when new shares are issued: 𝑃𝑜 −𝐹
eg: Commission paid to underwiters,
The flotation costs reduced the current price of share,
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WEAKNESS OF THE DIVIDEND MODEL
1. Caiptal Gain are ignored
2. It does not consider risks associated with the investment
3. Determination of the growth rate is subjective
CAPM (CAPITAL PRICING MODEL)

This theory assume 2 risk, which are: 1. The systenatic risk
2. & Unsystematich risk
1. The systenatic risk
The systenatic risk ,are within the market or the economic and can not be diversified by the
firm such as, interest rate, inflation, level of unmployment, political factors, etc.
2. & Unsystematich risk

Unsystematich risk, are those risk whithin the industry or the firm which are diversified by the
firm such as; labor skills, level of of competition, etc.
Ke = RFR +B(Rm-RFR)
(Rm-RFR) = Market risk premium
COST OF PREFERENCE SHARE 𝐷

Kp=
𝑃𝑜
COST OF DEBT
There are:
1. Tradable debt
2. & Untradable or unflotted debt
1. Tradable debt are made of:
a) Redeemable dedt
b) Iredeemable debt
c) Convertible debt
a) Cost of Redeemable dedt
The cost of reedeemable is the IRR of the debt at maturity
Ex:
Co X has a debanture with face value of 1000 at an interest rate of 10% redeemed after
5 years at a premium of 10%, the current market price is 1050
Coorporate tax is 30%
Determine the cost of the debt
I = (1000*10%)(1-0.3) 70.00
Redeemable Value = 1000+(1000*10%) = 1100
Items period Cash flows DF @ 10% PV

Markets Value o (1,050) 1.000 (1,050)
Interest 1-5 70 3.791 265
PV 5 1,100 0.621 683
NPV (102)
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Markets Value o (1,050) 1.000 (1,050)
Interest 1-5 70 4.329 303
PV 5 1,100 0.784 862
NPV 115
IRR = a+ [NPVa/(NPVa - NPVb)] (b-a)

IRR = 10% + [-101.63/(-101.63 - 114.94)] (5%-10%) 7.65%
b) Cost of Redeemable dedt

I= Interest rate x Face Value 𝐼(1−𝑇)
Po: Ex interest market price Kd=
𝑃𝑜
c) Convertible debt
The cost of converted debt is computed similar to a redeemable debt, the only difference
is the redeemable value which is considered as the:
HIGHER OF CONVERSION VALUE OF THE DEBT AT MATURITY
d) Cost of untradable debt
Kd = I (1-T)
e) Cost of untradable debt

The cost of retained earning is similar to the cost of common stock, except that in
there is no flotation cost
𝐷1
Kp= +g
𝑃𝑜
Ex:
Bellow is the sumirised SOFP of KKT Ltd, as at 31st December 2022:
PPE 500,000
CA 250,000
TOTAL ASSETS 750,000
Equity & Liabilities
Equity
Ord. Share Capital @100 Frw 200,000
8% Preference Share C @50Frw 100,000
300,000
Currents liabilities
10% Redeemable bond@1000Frw 100,000
13% Iredeemable debenture@1000Frw 100,000
15% Bank Loan 150,000
Currents liabilities 100,000
750,000
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Other relevant information
1. The current Market price of ordinary shares is 120 Frw per shares, the Co initial Divident
in 2016 of 8Frw/Share and it expected a dividend in 2022 of 10Frw/share
The preference share are currently trading at 65FRW
2. The redeemable bond has a current market price of 1100frw, and it will be redeemed after 5 yrs
at a premium of 20%
3. The Iredeemable debanture is currently trading at 900

4. Coorporate income tax is 30%
Required
Determine the cost of each source and the WACC
Solution
Cost of Bank Loan

Data
I = 15%
T=30%
Kbl = i(1-T) = 0.15(1-0.3) 10.5%
Cost of Iredeemable debenture@1000Frw

Data
I=13% x 1000 = 130
Po = 900
T = 30%
𝐼 (1−𝑇) 130(1−0.3)
Kid = = = 10.1%
𝑃𝑜 900
Cost of Preference Shares (Kp)
Data
D= 8%x50=4
Po = 65
𝐷 4
Kp= = = 6.15%
𝑃𝑜 65
Cost of Equity (ke)
Data
Di=8 Do=10
Cum-Div Price = 120
Ex-Div Price=(Po)= 120-10= 110
𝑛 𝐷𝑜/𝐷𝑖 6 10/8
g= -1 g=
⬚
- 1 = 3.8%
⬚
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D1=Do(1-g) = 10(1+0.038) = 10.4
𝐷1 10.4
Ke= +g= 110 + 0.038 = 13.3%
𝑃𝑜
Cost of Redeemable debanture (Krd)
Data
I=(10%*1000)(1-0.3)=70
Rv= 1000*1.2=1200
n=5
MV= 1100
Tax = 30%

Markets Value o (1,100) 1.000 (1,100)
Interest 1-5 70 3.791 265
PV 5 1,200 0.621 745
NPV (90)
Markets Value o (1,100) 1.000 (1,100)
Interest 1-5 70 4.329 303
PV 5 1,200 0.784 940
NPV 143
IRR = a + [NPVa/(NPVa - NPVb)] (b-a) 8.08%
WACC
There are different formula to determine WACC:
𝑉𝑒∗𝐾𝑒 𝑉𝑑∗𝐾𝑑 (1−𝑇)

WACC = +
𝑉𝑒+𝑉𝑑 𝑉𝑒+𝑉𝑑
WACC =KeWe + KpWp+KdWd

Market Weighted
Source Cost
Value cost
Bank Loan 150,000 0.105 15,750
Irredeemable deb = (100,000/1000*90) 90,000 0.101 9,090
Preference Share = (100,000/50 * 65) 130,000 0.062 7,995
Equity = (200,000/100*110) 220,000 0.133 29,260
Redeemable debanture= (100,000/1000*1100) 110,000 0.080 8,800
TOTAL 700,000 70,895
WACC= 70,895/700,000 10.1%
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MARGINAL COST OF CAPITAL (MCC)
the MCC is the cost of capital for the additional sources of funds raised
Change in Weighted
MCC =
Change in market
Assume that KKT needs additional finance to invest in a new projects, the funds will be
raised by issuing a bank loan at cost of 2% post Tax, and Common stock at cost of 4%
The investment requires 200,000,000 FRW, 60% will be raised through common stock
while 40% will be raised using bank loand
Required:
Compute the MCC
Solution
Source Market Value Cost Weighted cost
Bank Loan = 150,000 + (200,000*40%) 230,000 0.125 28,750
Irredeemable deb = 100,000/1000*90 90,000 0.101 9,090
Preference Share = 100,000/50 * 65 130,000 0.062 7,995
Equity = 220,000 + (200000*60%) 340,000 0.173 58,820
Redeemable debanture= 100,000/1000*1100 110,000 0.080 8,800
900,000 113,455
WACC = 12.6%
Change in Weighted
MCC =
Change in market
113,455 - 70,895 42,560

MCC = 21%
900,000 -700,000 200,000
DEBT RATING & COST OF DEDT

A debt is rated according to the probability of default; the hight the probability of default
the higher the risk of the debt and the lower the rating
Kd = RFR + Spread (1-T)

The Spread measure the level of risk of debt
MOORDER Rating
DEBT SPEAD
RATE 5 YRS 10YRS 20YRS Comment
AAA 1.00 2.50 5.500 Spread are given in %
AA
A
BBB
BB
B
CCC
CC
C
DDD
DD
D
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For example the Kd of a loan that will be paid in 10 years will be calculated as bellow
Kd = RFR + 0.025(1-0.3)
Factors influancing the date rating:
1. Probability of default
2. Maturity period; the higher the period the higher the risk
3. Economic condition: if economic conditions are good, chances of paying are also hihg
Weakness of cost
of capital
1. Complicated to calculate
2. It assumes that the level of risk do not change
3. it assumes constant capital strusture
ONLINE CLASS
ADVANCED INVESTMENT APPRAISAL
a. Relevant cash flows:

These are cash flows which affects the investment decision.
Characteristics of relevant cash flows

1. There are future cash flows
2. There are incremental cash flows
3. They are cash flows
Other aspects of relevant cash flows

a. Working capital: Investment in working capital is an outflow at the time of
investment and an inflow at the end of the project
b. Opportunity cost: The revenue foregone to implement a new project is recognised
as an opportunity cost to the new project.
b. Irrelevant cash flows

i. sunk or the past cost
ii. Depreciation
iii. Commited costs
iv. Re-alocation of an existing fixed cost
c. Investment appraisal techniques

i. Non discounted cash flow techniques
ii. Discounted cash flow techniques
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i. Non discounted cash flow techniques
a. Payback period
b. Accounting rate of return/Return on capital employed
Payback period
It shows the period it takes for the cash inflows to cover the initial investment.
If the cash flows are constant, then :
payback period = initial investment / annual cash flows
When the cash flows are not constant the payback period is determined by accumulating
the cash flows until the initial investment is covered.
Decision rule:
Accept an investment when the payback period is below the target, otherwise reject
Example: The management of company X are evaluating a project which requires an initial
investment of 50,000,000 and it will generate the following cash flows.
1 10,000,000
2 15,000,000
3 22,000,000
4 20,000,000
5 25,000,000
The management can accept a project if it pays in four years. Advise the management on
whether to undertake theproject using payback period.
Period Cash flows accumulated

0 (50,000,000) (50,000,000)
1 10,000,000 (40,000,000)
2 15,000,000 (25,000,000)
3 22,000,000 (3,000,000)
4 20,000,000 17,000,000
5 25,000,000
PBP = 3+ (3,000,000/20,000,000)*12 = 1.8
PBP = 3yrs and 2 month

Since the payback period is the below the target, the management can
invest in the project
Advantages Disadvantages
1. It uses cash flows 1. It ignores time value of money
2. it is easy to compute and interprete 2. Cash flows after the payback period are ignored
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Accounting rate of return (ARR)
It is the rate of return generated on the average investment.
ARR = Average profit/ Average investment.
Average investment = (Initial investment + Residual value)/2
Average profit = (Total profit- accumulated depreciation)/number of years
Decision rule: Accept an investment where the ARR is above the target otherwise reject
Example:
Company X is evaluating acquisition of new machine. The cost of the machine is 50,000,000
and will have a residual value of 10,000,000 at the end of year 5. Below are the expected
revenues from the project . The target ARR is 25%
1 10,000,000
2 15,000,000
3 22,000,000
4 20,000,000
5 25,000,000
Average investment = (50m+10m)/2 = 30,000,000

Accumulated depreciation (50m-10) 40,000,000
Total profits 92,000,000
Average profit (92m-40m)/5 10,400,000
ARR = (10,400,000/30,000,000) 34.7%
Advantages of ARR
a. It is easy to compute and interprete
b. It shows the profit earned on every investment
Disadvantages
i. It uses accounting profists
ii. It ignores the time value of money
Discounted cash flow techniques

These are techniques which considers the effect of time value of money
i. Net present value (NPV)

ii. Internal rate of return (IRR)
iii. Profitability index (PI)
iv. Modified payback period (MPBP)
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1. Net present value (NPV):
It is the summation of the present value of cash in flows less the present value of the initial
investment
𝐶1 𝐶2 𝐶𝑛
NPV = + .......
(1+𝑟)^𝑛
- Io=
(1+𝑟)^1 (1+𝑟)^2
where C1…Cn are cash flows, r is the cost of capital and IO is initial outlay/invetsment
Decision rule:
Accept an investment when NPV is positive otherwise reject
Example: Company X is evaluating a project that requires an initial investment of

100,000,000 and it will generate the following cash flows for a period of five years
1 30,000,000
2 25,000,000
3 40,000,000
4 55,000,000
5 48,000,000
The invetsors require a return of of 12% on the investment
Required:
Advise the management on whether to undertake the project or not
Period Cash flows DF12%(1+r)^-n PV

0 (100,000,000) 1.000 (100,000,000)
1 30,000,000 0.893 26,785,714
2 25,000,000 0.797 19,929,847
3 40,000,000 0.712 28,471,210
4 55,000,000 0.636 34,953,494
5 48,000,000 0.567 27,236,489
NPV 37,376,755
Management should undertake the project since the NPV is positive
2. Internal rate of return (IRR)

It is the return at which NPV is equal to 0
Decision rule: Accept an investment where the IRR is above the cost of capital or the target
𝑁𝑃𝑉𝑎
IRR = 𝑎 + ( )(b − a)
𝑁𝑃𝑉𝑎 − 𝑁𝑃𝑉𝑏
Where a is the cost of capital, b is the estimate rate NPVa is the NPV at cost of capital
and NPVb is the NPV at estimated rate
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Example: From the example above determine the IRR
Period Cash flows DF 40% PV

0 (100,000,000) 1.000 (100,000,000)
1 30,000,000 0.714 21,428,571
2 25,000,000 0.510 12,755,102
3 40,000,000 0.364 14,577,259
4 55,000,000 0.260 14,316,951
5 48,000,000 0.186 8,924,853
(27,997,263)
37,376,755
IRR = 0.12 + 0.4 − 0.12 = 28%
37,376,755 − −27,997,263
Since the IRR is above the cost of capital, then accept the project
3. Profitability Index (PI)

It shows the profit generated on an investment
Present value of cash flows

PI =
Initial investment
NPV
PI = +1
Initial investment
Present value of cash flows 137,376,755

Initial investment 100,000,000
PI = (137,376,755/100m) 1.37
NPV 37,376,755
PI = (37,376,755)
+1 1.37
100,000,000
Decision rule:
Accept an investment when the PI is above the 1 otherwise reject
4. Modified payback period
This involves first discounting the cash flows and then after accumulate to determine
the payback period
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Example
Discounted cash
Period Cash flows Accumulate Accumulate
flows
0 (100,000,000) (100,000,000) (100,000,000) (100,000,000)
1 30,000,000 (70,000,000) 26,785,714 (73,214,286)
2 25,000,000 (45,000,000) 19,929,847 (53,284,439)
3 40,000,000 (5,000,000) 28,471,210 (24,813,229)
4 55,000,000 50,000,000 34,953,494 10,140,265
5 48,000,000 27,236,489
3yrs + (5/55)*12 3yrs and 1 month

MPBP 3yrs and 9month
MPBP = 3Yrs + (24,813,299/34,953,494)*12

Decision rule: Accept the project where the pMPBP is below the target otherwise reject
B. Incorporating Inflation and Tax in investment appraisal
1. Incorprate inflation :
The effect of inflation should incorprated in investment appraisal
Key terms
a. Norminal/money cash flows: These are cash flows after adjusting for the effect
of inflation.
b. Real/Current cash flow: These are cash flows which in the current terms that they have
not been adjusted for inflation.
c. Norminal rate: It is rate which has been adjusted for inflation.
d. Real rate: It is the rate which is in the current terms
Note: Norminal cash flows should be discounted using the norminal rate while real cash flows
shouls discounted using a real rate.
Relationship between norminal rate, real rate and inflation rate
(1 +i) = (1+r)(1+h)
where I is the norminal rate, r is the real rate and h is the inflation rate
I = (1+r)(1+h) - 1
(1+𝑖) (1+𝑖)
𝑖 = (1+ℎ) - 1 h= (1+𝑟) - 1
Incorprating Tax in investment appraisal
Tax has got two major effect on the investment appraisal that is:
1. The amount of tax paid on the profit generated which should be considered as a cash outflow.
2. Tax allowable depreciation/Tax saving: If depreciation is allowed for tax, it reduces the amount
of tax to be paid from the profit generated thus creating a tax saving which is a cash inflow.
Page 17 of 127
Aproaches to adjust the cash flows
o 1 2 3
Revenues XXX XXX XXX
Less variable cost (XXX) (XXX) (XXX)
Less fixed cost (XXX) (XXX) (XXX)
EBDT XXX XXX XXX
Income tax (XXX) (XXX) (XXX)
EAT XXX XXX XXX
Initial investment (XXXX) XXX
Working capital (XX) XXX
Opprtunity cost (XXX) (XXX) (XXX)
Tax saving (TAD) XXX XXX XXX
Net cash flows (XXXX) XXX XXX XXX
DF XXX XXX XXX XXX
PV XXX XXX XXX XXX
Approach two
0 1 2 3
EBDT XXX XXX XXX
Less depreciation (XXX) (XXX) (XXX)
EBT XXX XXX XXX
Income tax (XXX) (XXX) (XXX)
EAT XXX XXX XXX
Add back depreciation XXX XXX XXX
Initial investment (XXXX) XXX
Working capital (XX) XXX
Opprtunity cost (XXX) (XXX) (XXX)
Net cash flows (XXXX) XXX XXX XXX
DF XX XXX XXX XXX
PV
working capital analysis
- 1.00 2.00 3.00
20,000 25,000 32,000
incremental (20,000) (5,000) (7,000) 32,000
Example:
Company X is evaluating expanding its current production capacity in order to meet the
current demand. The project requires an initial investment of 400,000,000 of which 300,000,000
will be investment in new machines while 100,000,000 in the working capital. The machines
have got a useful life of 5 years and a residual value of 80,000,000 at the end.
The machine attract a tax allowable depreciation of 25% reducing balance.
The marketing department has made the following demand for the product
1 2 3 4 5
Demand in units 100,000 120,000 145,000 150,000 180,000
Page 18 of 127
The selling price has been estimated at 1000frw per unit while the variable cost has been
estimated at 400FRW per unit. Due to inflation, selling price is expected to increase by
4% while variable cost will increase by 3%. Incremental fixed production cost are expected
to be 20,000,000 per year and they will increase by 2% due to inflation. The current pre-tax
cost of debt is 8% . The risk free rate is 10%, equity beta is 1.2 while the market return is 14%
after considering the effect of inflation. The proposed investment will be financed 60% debt
and 40% equity. The corporate income tax is 30% paid in the same year of cash flows.
The target pay back period is 4 years while the target accounting rate of return is 25%
Required: Evaluate the acceptability of the project using

a. Pay back period
b. accounting rate of return
c. NPV
d. IRR
e. PI
f. MPBP
Workings (W)
W1 Revenues
1 2 3 4 5
Demand (Units) 100 120 145 150 180
Selling price 1,000 1,000 1,000 1,000 1,000
Inflation (1+0.04)^n 1.040 1.082 1.125 1.170 1.217
Revenues 104,000 129,792 163,105 175,479 218,998
W2 Variable costs
1 2 3 4 5
Demand (Units) 100 120 145 150 180
Variables/unit 400 400 400 400 400
Inflation (1+0.03)^n 1.030 1.061 1.093 1.126 1.159
Variable cost 41,200 50,923 63,378 67,531 83,468
W3 Incremental fixed cost

1 2 3 4 5
Fixed cost 20,000 20,000 20,000 20,000 20,000
Inflation (1+0.02)^n 1.020 1.040 1.061 1.082 1.104
20,400 20,808 21,224 21,649 22,082
W4 Tax allowable depreciation/ Tax saving
Cost 300,000
Residual value 80,000
Dep 25% reducing
Page 19 of 127
TAD/tax
period Depreciation NBV
saving @30%
1 75,000 225,000 22,500
2 56,250 168,750 16,875
3 42,188 126,563 12,656
4 31,641 94,922 9,492
5loss 14,922 80,000 4,476.56
NBV at the beginning of year 5 94,922 94,922

Value of asset at end year 5 80,000 100,000
Loss 14,922 -5,078
W5 Cost of capital
Pre- tax cost of debt 8% Be = 1.2
RFR 10%
RM 14%
Wd 0.6
WE 0.4
T 30%
Kd = 0.08(1- 0.3) = 0.056 6%

Ke = 0.1 + 1.2 (0.14 - 0.1) 14.8%
WACC = Ke*We + Kd*Wd
WACC= 0.148*0.4 +0.056*0.6 = 9.28%
Cash flow analysis

0 1 2 3 4 5
Revenues W1 104,000 129,792 163,105 175,479 218,998
Variable cost W2 (41,200) (50,923) (63,378) (67,531) (83,468)
Fixed cost W3 (20,400) (20,808) (21,224) (21,649) (22,082)
EBDT 42,400 58,061 78,503 86,300 113,448
Income tax @30% (12,720) (17,418) (23,551) (25,890) (34,034)
EAT 29,680 40,643 54,952 60,410 79,414 265,098
Tax saving W3 22,500 16,875 12,656 9,492 4,477
Investment (300,000) 80,000
Working capital (100,000) 100,000
Net cash flows (400,000) 52,180 57,518 67,608 69,902 263,890
PBP Cash Flows Acc. Cash flows

0 (400,000) (400,000) PBP = 4 years and 7 months
1 52,180 (347,820) Target payback is 4 years
2 57,518 (290,302) Therefore we reject the project
3 67,608 (222,694)
4 69,902 (152,792)
5 263,890 111,098
Page 20 of 127
b. Accounting rate of return
Average investment (300,000 +80,000)/2 190,000

Total profit 265,098
Accumulated depreciation (300,000-80,000) 220,000
Average profit = (265,098-220,000)/5 9,020
ARR = (9019.615/190,000)*100 4.7%
Target ARR 25%
Reject the project
c. Decision under NPV
NPV 0 1 2 3 4 5
Net cash flows (400,000) 52,180 57,518 67,608 69,902 263,890
DF 9.28% (1+0.092)^-n 1.000 0.915 0.837 0.766 0.701 0.642
PV (400,000) 47,749 48,164 51,806 49,015 169,325
NPV = (33,942)
Since NPV is negative reject the project
d. Decision under IRR
NPV @ 2% 0 1 2 3 4 5
Net cash flows (400,000) 52,180 57,518 67,608 69,902 263,890
DF 2% (1 +0.02)^-n 1.000 0.980 0.961 0.942 0.924 0.906
PV (400,000) 51,157 55,284 63,709 64,579 239,014
NPV = 73,742
−33,942
IRR = 0.0928 + −33,942−73,742
0.02 − 0.0928 = 7%
Cost of capital (ke) is 9.28%
Reject the project since IRR is below the cost of capital
Decision under PI
Total present value of cash flows 366,058

Initial investment 400,000
PI = 366,058/400,000) 0.92
Since PI is below 1 we reject the investment
f. Modified payback period
cash flows Acc. Cash flows

0 (400,000) (400,000)
1 47,749 (352,251)
2 48,164 (304,087)
3 51,806 (252,282)
4 49,015 (203,267)
5 169,325 (33,942) Reject the project
Page 21 of 127
Approach two
- 1 2 3 4 5
Revenues W1 104,000 129,792 163,105 175,479 218,998
Variable cost W2 (41,200) (50,923) (63,378) (67,531) (83,468)
Fixed cost W3 (20,400) (20,808) (21,224) (21,649) (22,082)
EBDT 42,400 58,061 78,503 86,300 113,448
Less depreciation (75,000) (56,250) (42,188) (31,641) (14,922)
EBT (32,600) 1,811 36,315 54,659 98,526
Income @30% 9,780 (543) (10,895) (16,398) (29,558)
EAT (22,820) 1,268 25,421 38,261 68,968
Add back depreciation 75,000 56,250 42,188 31,641 14,922
Earnings 52,180 57,518 67,608 69,902 83,890
Investment (300,000) 80,000
Working capital (100,000) 100,000
Net cash flows (400,000) 52,180 57,518 67,608 69,902 263,890
DF
- - - - -
C Specific investment decision
a. Buy or make
b. Capital rationing
c. Replacement decision
d. Incorporating risks
D. Adjusted present value (APV)
SPECIFIC INVESTMENT DECESION
Lease and Buy

This involves evaluating whether to acquire an asset through lease or buy. The decision is made by
compairing the Present Value Cost of lease to the present value cost of buying,
Relevant Cash flow on purchase:
*Purchase Cost
*Residuel Value
*Maintenance Cost
*TAD - Tax Allowable Depreciation (Tax should be given in a question, if tax is not given
then TAD became irrelevent)
Relevant Cash flow on Lease:

* Lease rental
* TAD - In case u have Tax Saving, if not ignore
Page 22 of 127
Discounting Factor
The discounting depends on how the asset is financed
eg: If you finance using both Equity & Debt then WACC will be yr Discounting factor
If you use only Equity then Ke will be your Discounting Factor
eg:
Co X is evaluating the decision to acquire a machine, the cost of the machine is 100m
and it will have a residuel value of 30m at the end the year 5.
If the machine is acquired, the following cash flows will be generated:
000"
Year 1 25,000
Year 2 30,000
Year 3 40,000
Year 4 50,000
Year 5 48,000
The management is undecided on how the machine should be acquired, same members
prefer to acquire the machine through a lease in order not to affect the camponies cashflows
while others, prefer to buy the machine in order to enjoy the ownership.
If the decision is to buy, the machine will be financed by 60% equity & 40% debt
the current cost of equity is 12%, while the pre-tax cost of debt is 10%
If the machine is leased, the company will pay annual lease payment of 25m for a
period of 5 years. The current corporate income is 30% paid one year in earliers
The TAD is 25% Reducing
Required
1. Evaluate whether the machine should be acquired
2. Advise the management on whether to acquire the machine on lease or through purchase
Solution
W1. WACC Data: Ve=0.6 Vd=0.4 Ke=12% Kd=10%

WACC = + =
𝑉𝑒+𝐾𝑒 𝑉𝑑+𝐾𝑑
0.6∗0.12 0.4∗0.1 (1−0.3)
WACC = + = 10%
1 1
W2. TAD
Cost Deprecition NBV TAD
Year 1 100,000 25,000 75,000 7,500
Year 2 75,000 18,750 56,250 5,625
Year 3 56,250 14,063 42,188 4,219
Year 4 42,188 10,547 31,641 3,164
Year 5 31,641 1,641 30,000 492
Page 23 of 127
Years - 1 2 3 4 5 6
Cash Flows 25,000 30,000 40,000 50,000 48,000
Income Tax (7,500) (9,000) (12,000) (15,000) (14,400)
EAT 25,000 22,500 31,000 38,000 33,000 (14,400)
Initial Investment (100,000) 30,000
Tax Saving 7,500 5,625 4,219 3,164 492
Net Cash Flows (100,000) 25,000 30,000 36,625 42,219 66,164 (13,908)
DF @ 10% (WACC) 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV (100,000) 22,727 24,793 27,517 28,836 41,083 (7,851)
NPV = 37,106
Decision: The machine should be acquired as the NPV is positive
Option 1: Acquiring the machine on lease

* First Check the relevant cash flows
In this case, only lease rental are relevent
Years - 1 2 3 4 5 6
Lease rental (25,000) (25,000) (25,000) (25,000) (25,000)
Tax Saving 7,500 7,500 7,500 7,500 7,500
Net Cash Flows (25,000) (17,500) (17,500) (17,500) (17,500) 7,500
DF 0.909 0.826 0.751 0.683 0.621 0.564
PV (22,727) (14,463) (13,148) (11,953) (10,866) 4,234
PV of cost of Lease (68,923)
Option 2: Acquiring through purchase
Relevent cash flows are

* Machine cost
* Residuel Value
* Maintenance cost
*TAD
Years - 1 2 3 4 5 6
Machine Cost (100,000) 30,000
Tax Savings 7,500 5,626 4,219 3,164 492
Net Cash Flows (100,000) 7,500 5,626 4,219 33,164 492
DF 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV (100,000) - 6,198 4,227 2,882 20,592 278
PV of Purchase Cost (65,823)
Page 24 of 127
CAPITAL RATIONING
Capital rationing is a situation where a company does not have suffients funds to invest
Types of capital Rationing:
1. Soft captal rationing
This is where the company is facing a challenge of insufficient funds, mainly caused by
internal factors such as:
* Limitation of the amount to invest
* Improper budgeting
2. Hard captal rationing
This is where the company is facing challenges of insuffient funds to invest mainly caused by
external factors, such as:
* Low share price of the company shares
* Limitations to debt financing
* Investors are unwilling to invest more money
Investment decision under Capital Rationing
When doing capital rationing you need to identify Divisible and Indivisible projects.
Under Capital rationing, the investment projects are classified into 2: that is :
* Divisible projects
*None divisible projects
1. Divisible projects
Divisible Projects: are those projects which can be implimented in phases

if the projects are divisible, the investment decision is made by RANKING the projects
according to the their profitability index
2.None divisible projects
These are projects which can not be implimented in phases. For non divisible projects,
the imvestment decision is made by sellecting a combination of projects that gives the
highest NPV and exhaust the available resources as much as possible.
Page 25 of 127
eg:
The management of Co X have submitted the following projects for the next year
Initial
Project NPV
Investment
A 120,000 80,000
B 200,000 250,000
C 100,000 120,000
D 150,000 50,000
E 300,000 180,000
F 250,000 60,000
G 220,000 170,000
H 100,000 (5,000)
J 140,000 160,000
K 80,000 100,000
The board members have aproved a budget of 700 M for the next years investments.
While analysing the differents investment projects, the following information was obtained:
1. Project A&K are mutually exclusive,

2. Project E & G are mutually dependant
3. Other projects are mutually independents
Required:
Advise the management on efficient allocation of resources if the projects:
1. are divisible
2. not Divisible
Solution
Initial PI = (NPV/Io)
Project
Investment
NPV
+1
Ranking
A 120,000 80,000 1.67 5
B 200,000 250,000 2.25 1
C 100,000 120,000 2.20 2
D 150,000 50,000 1.33 7
E 300,000 180,000 1.60 6
F 250,000 60,000 1.24 8
G 220,000 170,000 1.77 4
H 100,000 (5,000) 0.95 Automatically rejected as PI is bellow 1
J 140,000 160,000 2.14 3

K 80,000 100,000 2.25 1
Page 26 of 127
Resources Allocation under divisible
Amount Amount
Project NPV
Required Available
K 80,000 80,000 100,000
B 200,000 200,000 250,000
C 100,000 100,000 120,000
J 140,000 140,000 160,000
D 150,000 150,000 50,000
F 250,000 30,000 7,200
920,000 700,000 687,200
Resources Allocation when project are not divisible

Amount
Project NPV
Required
K+B+C+J+D 670,000 680,000
E+G+K+C 700,000 570,000
A+B+C+D 570,000 500,000
INCORPORATING RISK IN INVESTMENT APRASAL
The following methods can be used on incorporating risks in investment apprasal:

1. Expected Value
2. Certainty equivalent factor
3. sensitivity analysis
4. Simillation
1. Expected Value
This involves incorporating probabilities in order to determine the expected value
EV = 𝐶1𝑃1, +𝐶2𝑃2 … . . 𝐶𝑛𝑃𝑛 =
Where: C1 ……Cn= are Cash Flows

P1 ………Pn are Probability
Eg
Co X is evaluating investment in a new project, the project requires an initial investment of
100M There is a lot of uncertainties which were caused by COVID-19, the following Cash Flows
and respectived probabilities where estimated; The cost of Capital is 10%
Year One Year 2 Required

Probability Cash Flow Probability Cash Flow 1. Advise the management on whether to
invest in the project
0.30 50,000
0.60 85,000,000 0.20 65,000
0.50 40,000
2. Determine the probability of having a
0.35 20,000
negative NPV
0.40 120,000,000 0.25 30,000
0.40 40,000
Page 27 of 127
Solution
Decision Three method
PV of Cash Flows in Year 1
Years Cash Flows DF @ 10% PV

1 85,000 0.909 77,273
1 120,000 0.909 109,091
PV of Cash Flows in Year 2

Years Cash Flows DF @ 10% PV
2 50,000 0.826 41,322
2 65,000 0.826 53,719
2 40,000 0.826 33,058
2 20,000 0.826 16,529
2 30,000 0.826 24,793
2 40,000 0.826 33,058
41,300
0.30
EPV if prob=0.6 70,148 39,648 0.20 53,690
0.50 33,040
77,265
Total EPV 0.60
123,857
109,080 16,520
0.40 0.35
25,193
EPV if prob=0.4 53,709 0.25 24,780
0.40
ENPV=TEPV-Io = 123,857 - 100,000 = 23,857 33,040
PAY OFF TABLE

Year One Year 2
Totoal Cash Joint EPV (Expected
Probability Cash Flow Probability Cash Flow
flows Probability PV)
0.30 41,300 118,565 0.18 21,342
0.60 77,265 0.20 53,690 130,955 0.12 15,715
0.50 33,040 110,305 0.30 33,092
0.35 16,520 125,600 0.14 17,584
0.40 109,080 0.25 24,780 133,860 0.10 13,386
0.40 33,040 142,120 0.16 22,739
TEPV 123,857
Io (100,000)
NPV 23,857
Page 28 of 127
CERTAINTY EQUIVALENT FACTO
Certainty equivelent factor shows the level of cash flows that are considered to be risk free
For certaintny equivalent factor the flows are adjusted with the certainty equivalent factor
and then discounted using a risk free rate
Eg:
Co X is evaluating an investment, the investment requires a 100M and it will generate the
following cash flows
Years 1 2 3
cash flows 60,000 40,000 80,000
The management has assess the environment and considers the following levels of cash
flows to accepted: Year one 80%, Year two 75%, year three 70%
The risk freen rate is 12%,
Required
Assess the acceptability of the investment
Cash Cash Risk Free

Years CEF DF @ 12% PV
flows Cash Flows
- (100,000) 1.00 (100,000) 1.000 (100,000)
1.00 60,000 0.80 48,000 0.893 42,857
2.00 40,000 0.75 30,000 0.797 23,916
3.00 80,000 0.70 56,000 0.712 39,860
NPV 6,633
Sensitivity analysis
Shows the level at which one variable used in the computation of one NPV should
change before affecting the NPV
𝑵𝑷𝑽
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 = 𝐱 𝟏𝟎𝟎
𝑷𝑽 𝒐𝒇 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆𝒔
Eg:
Io = 400,000
NPV = -33,942
𝟑𝟑,𝟗𝟒𝟐 8.5%
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 = 𝐱 𝟏𝟎𝟎 =
𝟒𝟎𝟎,𝟎𝟎𝟎
Eq
Years - 1 2 3
Revevues 50,000 30,000 60,000
Variable cost (10,000) (5,000) (8,000)
Fixed Cost (1,000) (1,000) (1,000)
EBT 39,000 24,000 51,000
TAX (11,700) (7,200) (15,300)
EAT 27,300 16,800 35,700
Io (50,000)
Net Cash Flows (50,000) 27,300 16,800 35,700
DF @ 10% 1.000 0.909 0.826 0.751
PV (50,000) 24,818 13,884 26,822
NPV 15,524
Page 29 of 127
Sensitivity of Initial Investmet
15,422
Sensitivity of Initial Investmet 30.8%
50,000
Sensitivity of Revenues
Years Revenues DF @ 10% PV
1 50,000 0.909 45,455
2 30,000 0.826 24,793
3 60,000 0.751 45,079
NPV 115,327
15,524
Sensitivity of Initial Investmet 13.5%
115,327
Revenues are more risky than Io Investment
SIMILITION
Under this, all the variables used in the computation of NPV are combined together
and assess their effect on NPV
REPLACEMENT DECISION
This involves analysing when to replace an asset, replacing an existing asset with a new asset
and evaluating the asset to be replaced
WHEN TO REPLACE AN ASSET

the asset should be replaced in a period where the company in incuring the lowest EAC
(Equivalent Annual Cost)
EAC = Average cost for all periods
Step 1: Determine the PV cost for each Cycle

Step 2: Determine the EAC
PV Cost of Cycle
EAC
Annuity Foctor
Step 3:
Eg
Co X is evaluating when to replace a motovehicle, the cost of MV is 50 M with a usiful life of 4yrs
bellow is the maintenance cost and residual value of each period
Maintenance Residual
Period Cost Value
- The required cost of capital is 10%
1.00 5,000 30,000
Required: Assess when the company should replace the vehicle
2.00 11,000 21,000
3.00 15,000 18,000
3.00 20,000 10,000
Page 30 of 127
Solution
PV of Cycle 4
Period Cost Value
PV
- (50,000) 1.000 (50,000)
1 (5,000) 0.909 (4,545)
2 (11,000) 0.826 (9,091)
3 (15,000) 0.751 (11,270)
4 (20,000) 0.683 (13,660)
4 10,000 0.683 6,830
(81,736)
PV of Cycle 3
Period Cost Value
PV
- (50,000) 1.000 (50,000)
1 (5,000) 0.909 (4,545)
2 (11,000) 0.826 (9,091)
3 (15,000) 0.751 (11,270)
3 18,000 0.751 13,524
(61,382)
PV of Cycle 2
Period Cost Value
PV
- (50,000) 1.000 (50,000)
1 (5,000) 0.909 (4,545)
2 (11,000) 0.826 (9,091)
2 21,000 0.826 17,355
(46,281)
PV of Cycle 1
Period Cost Value
PV
- (50,000) 1.000 (50,000)
1 (5,000) 0.909 (4,545)
1 30,000 0.909 27,273
(27,273)
EAC
CYCLE PV CYCLE AF @ 10% EAC
1 27,273 0.909 30,000
2 46,281 1.736 26,667
3 61,382 2.487 24,683 replacement will be in year 3 where cost are low
4 81,736 3.170 25,785
-
Page 31 of 127
REPLACING AN EXISTING ASSET WITH NEW ASSET
This involve evaluating whether an existing asset should be replaced by new asset
the decision is made by appraising the relevant cash flows associated with a new assets
Using any investment apraisal techniques
Identifying the relevant cash flows associated with the new asset
1. Increamental Investment Cost

Cost of new asset xxx
Less: Market Value of old Asset (xxx)
Tax Saving (Payment) +/- xxx
Increamental Cost xxx
Tax Saving
MV of Old Asset xxx
Less: Book Value (xxx)
Gain/Loss xxx
2. Increamental Depreciation
Depreciaition new asset xxx
Less: Depreciation old asset (xxx)
Increamental Depreciation xxx
Note: is there is no tax, depreciation is irrelevant. Same goes to Increamental Inv. Cost
3. Increamental Residual Value
Residuel Value of new asset xxx

Less: Residual Value of old Asset (xxx)
Increamental Residual Value xxx
4. Increamental Cash Flow From Operations
Items New Asset Old Asset Increamental
Sales 200,000 180,000 20,000

Maintenance cost 5,000 10,000 (5,000)
Variable Cost 100,000 130,000 (30,000)
See Past Paper 2021 Q1:
Page 32 of 127
Eg:
Company X is evaluating whether to replace an existing machine of high capacity
the current machine, was purchase 5 years ago, at a 100 M, with expected usiful life of 15 yrs
and a residual value of 10M at the end.
The old machine has got a current market value of 65M, the new machine will cost the
company 250 M, and has got a usiful life of 10 yrs with a residual value of 25 M at the end
if the new machine not purchased, the old machine will require to be renovated and
this will cost the company 20 M.
Bellow are the operating costs of the old machine per year:
000
Maintenance cost 100,000
Other Variable Cost 15,000
It is expected that the new machine will have a maintenance cost of 2M per year and
a variable cost of 5 million per year. The current sales million is 50M and is expected
to increase by 20% per year as a results of installing the new machine.
The Current investment in working capital is 10 M and this will increase by 10% due to the
high capacity of the new machine.
The Corporate incame tax rate is 30% paid in the same year of cash flows. Cost of capital is 10%
Required:
Evaluate whether the existing machine should be replace by a new machine
1. Increamental Investment Cost

Cost of new asset 250,000
Less: Market Value of old Asset (65,000)
Saving in renovation of old machine (20,000)
Tax Saving (Payment) +/- xxx (1,500)
Increamental Cost 163,500
Tax Saving
MV of Old Asset 65,000
Less: Book Value (70,000)
Gain/Loss (5,000)
Tax Saving (1,500)
2. Increamental Depreciation
Depreciaition new asset 22,500
Less: Depreciation old asset (6,000)
Increamental Depreciation 16,500
3. Increamental Residual Value
Residuel Value of new asset 25,000

Less: Residual Value of old Asset (10,000)
Increamental Residual Value 15,000
Page 33 of 127
4. Increamental Cash Flow From Operations
Items Old Asset New Asset Increamental
Maintenance cost 10,000 2,000 8,000

Variable Cost 15,000 5,000 10,000
Sales 50,000 60,000 10,000
Woring Capital 10,000 11,000 (1,000)
Increamental Cash Flows 27,000
Cash flow analysis

Sales 10,000
Saving in Maintenance Cost 8,000
Saving In variable cost 10,000
Earnings 28,000
Less Depreciation (W2) (16,500)
EBT 11,500
TAX 30% (3,450)
EAT 8,050
ADD Back Depreciation 16,500
24,550
Working Capital (1,000)
Net Cash Flows 23,550
Item Period Cash Flows Df @ 10% PV

Increamental Investment Cost 0 (163,500) 1.00 (163,500)
Net Cash Flows 1-10 23,550 6.145 144,705
Increamental Residual Value 10 15,000 0.386 5,783
NPV (13,012)
The machie should not be replaced
EVALUATING THE ASSET TO REPLACE
This involves computing the PV cost of each asset at the end of its usiful life
and the EAC of each asset. The asset with the lowest EAC should be the one to be replaced
TERMINAL VALUE
It is the value of the project after the planning time horizon
CFt(1+g)
Terminal Value =
WACC - g
Where: CFt = Cash flows in last period

g= growth rate
Page 34 of 127
CAPITAL STRUCTURE & GEARING
This involves different sources of finance

capital structre is a combination of debt & Equity
Capital Structure theory

It tries to answer the questions whether the way the business is financed matter
the answer to this question is assed by analysing the effect of capital structure on the companies
Value or cost of capital
Traditional Theory
According to this theory; capital structure & Value of the firm are related. The optimum capital
Structure is at the minimum cost of capital.
As kd & Ke increases the overall WACC increases, therefore, at the minimum point of WACC
That’s where the company maximise the value
Assmptions of the Theory

1. All earning are distrubed as dividends
2. The market is perfect
3. Investors are rational 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑘𝑒 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑟𝑦
Co X is finance through Equity only. Bellow in the P&L Acount
Sales 300,000
COS (200,000)
Gross P 100,000
Operating Expenses (60,000)

40,000
Tax (12,000)
EAT 28,000
The company has 1,000,000 share in issue with a per value of 100
the current market price of shares is 150 per share. The company has introduced irredeemable
debanture with a per value of 1000 and the current market price is 1050
The interest rate on the debanture is 6%. 50,000 debantures where issued.
Required:
Assess the effect of issuing a debanture on the cost of capita. Tax is 30%
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑘𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑟𝑦
Dividend 28,000 28000

Market Value (150*1000) 150,000
𝑘𝑒 = 150∗1000 = 18%
Page 35 of 127
Cost of Irrideemable debanture
𝐼 (1−𝑇)
𝑘𝑖 =
𝑃𝑜
I=(6%*1000) 60
Po 60 (1−0.3)
1,050 𝑘𝑖 = 1050
= 4%
T 30%
Market Value = (1050*50) 52,500
𝑉𝑒∗𝐾𝑒 𝑉𝑑∗𝐾𝑑
WACC = + =
150,000∗0.18 52,500∗0.04
WACC = + = 14%
150,000+52500 150,000+52,500
Introduction of debt to the cost of capital has reduced by 4%, because it was 18% before
introduction of debt.
Modigline & Miller theory

This is made of two theory:
1. MM in TAX Free Economy
2. MM in a Tax Economy
In each theory we have 2 proposition:

a) MM 1 with no tax
b) MM 2 with no tax
1. MM in TAX Free Economy

Under this thoery, MM assumed an economy where there is no tax. They developed 2
preposition, which are:
a) MM 1 with no tax
b) MM 2 withtax
In both prepositions, MM concluded that Capital Structure, Value of Firm and Cost of Capital
are not related
Vg=Vu
Vg= Value of geared business, Vu= Value of Ungeared Business
Ex:
A B
Debt 100.00 20.00
Equity - 80.00
TOTAL 100.00 100.00
In MM 1 with no tax, MM analyse the effect of captital structure on the value the business
After the analysis they concluded that capitalm structure and the value of firm are
not related. As long the two business are in the same risk prifile. Therefore, the value of Vg
is equal to the value on Vu (Ungeared Business).
Page 36 of 127
b) MM 2 with no tax
This preposition analyses the effect of capital structure on cost of capital
Cost D Ke = Ku + [ Ku-kd ] D/E
WACC
kd
Gearing
Ke= Cost of Equity of a geared business
Ku= Cost of Ungeared business
D= Value of Debt
E= Value of Equity
As the company introduces a debt, the Cost of Equity will increase due to exposure of financial
Risk. But since equity holders are compansated with benefit of using a cheap debt (Ku-Kd),
The Overall Cost of capital does not change.
Therefore Capital Structure & Cost of Capital Are not related
Ex:
Co X, is all equity financed with current cost of equity of 10%, the company has 1,000,000 shares
and the current market price is Frw 50 per share. The company has introduced a new bank loan
of 100,000,000 at annual interest rate of 6%,
Required:
Asses the effect of introducing the bank loan on the cost of capital ?
Ku = 10%
Mv = (50*1000) = 50,000
Kd= 6% (no Adjustment for tax because tax was not given)
MV of debt = 100,000
Ke=Ku+[Ku-kd]D/E
Ke=0.1+[0.1-0.6]100,000/50,000 =18%
𝑉𝑒∗𝐾𝑒 𝑉𝑑∗𝐾𝑑
WACC = + =
50,000∗0.18 100,000∗0.06
WACC = + = 10%
50,000+100,000 50,000+100,000
There is no effect on the cost of Equity because both COE & WACC = 10%
Page 37 of 127
Assumption is MM in a Tax Free Economy:
1. There is not tax (Personal or Coorporate)
2. It Assumes a perfect Market
3. No Transaction Cost
4. Investors are Rational
2. MM in a Tax Economy
Un this theory MM incorporated the effect of tax on debt. MM devolopped 2 prepositions:
a) MM 1 with Tax
b) MM 2 with Tax
In both prepositions, MM concludes that Capital Structure, Cost of Capital and Value of Firm
Are related.
a) MM 1 with Tax
This preposition asseses the effect of capital structure on the value of the business
after the analysis. MM concludes that the value of a "Geared business" is ABOVE the Value of
"Ungeared Business" with a DTS (Debt Tax Schield)
Vg = Vu + PVDTS
𝐷∗𝐼∗𝑇
PVDTS= = DT
𝐼
Then: Vu = 𝑉𝑢 + 𝐷𝑇
a) MM 2 with Tax
This analysis the effect of CS on cost of Capital; after the analysis, MM concluded that Capital
structure and Cost of capital are related
Cost D Ke = Ku + [ Ku-kd ] (1-T) D/E
WACC
kd
Gearing
Ke= Cost of Equity of a geared business

Ku= Cost of Ungeared business
D= Value of Debt
E= Value of Equity
Page 38 of 127
Ex
The followill draft SOFP related to KKT Investment Ltd as at 31st December 2022
PPE 400,000
CA 100,000
Total Assets 500,000
Liabilities
Ord Shares @ 100 each 300,000
R/E 200,000
500,000
Relevant Information:
1. The current market price of ordinary shares is Frw 180 per share
2. The Company has just given a dividend of Frw 20 per share to the shareholders. The dividend
Is expected to grow a rate of 2% per year.
3. The company has identified a new investment ventures, which requires FRW 300 millions
The management have decided to finance the new venture by issuing a redeemable debanture
with a FACE VALUE of 1000 and the market price of Frw 1100. The Debanture has an interest
rate of 5%. And it will be redeemed after 4 years at premium of 20%.
4. The Current Coorporate income tax is 30%
Required:
1. Determine the effect of introducing a debt on the value of Equity
2. Asses the effect of introducing a debt on WACC
Solution:
1. Determine the effect of introducing a debt on the value of Equity

Cost of Ungeared Business = Ku
Do=20
g=2%
Po= 180
𝐷1
Ke = +g
𝑃𝑜
D1 = 20(1+0.02) 20.40
20.4
Ku = + 0.02 = 13.3%
180
300,000 ∗
Introducing a DEDT Vu= *180 = 540,000
100
Debt Value = 300m
Page 39 of 127
Vu = 𝑉𝑢 + 𝐷𝑇
Vu = 540,000 + (300,000 ∗ 30%)=630,000
Vg= 𝑉𝑢 − 𝑉𝑑 = 630,000 − 300,000 = 330,000

Conclusion:
Introducing the "DEBT" reduces the value of Equity
2. Asses the effect of introducing a debt on WACC

WACC after introducing the a bebt;
Ku = 13.3%
Kd (Cost of Debt)
Per Value = 1000
I = 5% * 1000 = 50
Redeemable Value (RV) = [1.2 *1000] = 1200
Mp = 1100
Period Cash Flows DF @ 10% PV
MP o (1,100) 1.00 (1,100)
Interest 1-4 50 3.170 158
Rv 4 1,200 0.683 820
NPV (121.89)
Period Cash Flows DF @ 4% PV

MP o (1,100) 1.00 (1,100)
Interest 1-4 50 3.630 181
RV 4 1,200 0.855 1,026
NPV 107.26
𝑵𝑷𝑽𝒂
𝐈𝐑𝐑 = 𝒂 + ( )(𝐛 − 𝐚)
𝑵𝑷𝑽𝒂 − 𝑵𝑷𝑽𝒃
−𝟏𝟐𝟏. 𝟗
𝐈𝐑𝐑 = 𝟎. 𝟏 + 𝟎. 𝟎𝟒 − 𝟎. 𝟏
−𝟏𝟐𝟏. 𝟗 − 𝟏𝟎𝟕. 𝟓
Ke = Ku + [ Ku-kd ] (1-T) D/E
Ke = 0.133 + [ 0.133 - 0.068 ] (1 - 0.3) 300/330 = 17.4%

WACC = + =
330,00∗0.174 300,000∗0.068 (1−0.3)

WACC = + = 11.3%
630,000 630,000
Page 40 of 127
See or taxt your understanding on
PAST PAPER 2022 APRIL Q3 b
PECKING ORDER THEORY
ASSUMPTIONS:
1. no threat to bankrupts
2. Personal tax are ignored, only coorporate tax are considered (CIT)
3. Perfect Market,
According to this theory, the sources of finance are selected in a given order, starting with:
1. the Internal Sources : R/E
2. Debts
3. Preference Share Capital
4. Common Stock
MODRN TRADE OFF THEORY
Vakue Vg = Vu + DTS
Vg = Vu + DTS - PVBC
Vg = Vu + DTS - PVBC -PVAC
kd
Vy Vx 100% Gearing
MISSED NOTES
Asset & Equity Beta
Asset B is the Beta of ungeared business
𝑉𝑒 𝐵𝑒
𝐵𝑎 = 𝑉𝑒+𝑉𝑑(1−𝑇)
Ve= Value of Equity

Be= Equity Beta
𝐵𝑎[ 𝑉𝑒+𝑉𝑑 1−𝑇 ]
Ba= Asset Beta 𝐵𝑒 = 𝑉𝑒
T = Tax
Equity Beta
Equity Beta is a better of a geared busis
Page 41 of 127
APV - ADJUSTED PRESENT VALUE
It is an investment approsal technique that considers the financing effect of the project
This technique works with MM 1 With Tax
Steps in APV:
Step 1: Determine the NPV of ungeared business:
Under this, the cash flows should be discounted using the cost of ungeared business
Step 2: Determine the PV of debt benefits

interst
Issue Cost
Subsidised:
*Tax savings
*Saving on Low interest rate
*Oportinity cost forgone
Step 3: Compute the APV which is
𝑨𝑷𝑽 = 𝑼𝑷𝑽 𝒐𝒇 𝒖𝒏𝒈𝒆𝒂𝒓𝒆𝒅 𝑩𝒊𝒔𝒊𝒏𝒆𝒔𝒔 + 𝑷𝑽 𝒐𝒇 𝒅𝒆𝒃𝒕 𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔

Ex:
Akandi Rwanda Ltd is experiencing a rapid growth, the current company capacity
can not meet the current demand. The board meeting that sat on 1st January 2023
approved increasing the production capacity.
This project will require investment in new asset and working capital.
The investment analyst has forecasted that the company will invest in new asset equal to 500 M
and Working Capital of 100M.
The Asset have got a residual value of a 100 M at the end of year 5. the markerting department
has made the following forecasts of the companies demand:
Years 1 2 3 4 5
Demand 100 150 250 300 400
The selling price has been estimated at Frw 600 per unit. While the Variable cost has been
estimated at Frw 200 per unit. Fixed cost are estimated to 10 M per year.
Currently, the level of gearing is 60%. The new proposed investment will be financed using
a loan. Due to the financial crisis thar many companies face; 40% of the required investment
will be subsidised at an interest rate of 4% while the balance will be acquired at a market rate of
14%. Both Loans will be paid in a period of 5 yrs making equal instalment at the end of the year.
The makert loan will attract an issue cost of 3% and the issue cost are not allowable for tax.
The current companies equity beta is 1.5. The risk free rate is 8%, while the market return is 12%
It is expected that, after the time horizon. The cash flows will continue to grow at a GDP rate of 7%
Tax Allowable Depreciation is 20% reducing balance. And Tax is 30% in the same tax Period
Required:
Advise the management on whether to undtake the project using APV
Page 42 of 127
Solution
W1. Contribution
Years 1 2 3 4 5
Selling Price 600 600 600 600 600
V Cost/Unit (200) (200) (200) (200) (200)
400 400 400 400 400
Demand 100 150 250 300 400
Contribution 40,000 60,000 100,000 120,000 160,000
W2. Tax Saving

Cost Dep NBV Tax Saving
500,000 100,000 400,000 30,000
400,000 80,000 320,000 24,000
320,000 64,000 256,000 19,200
256,000 51,200 204,800 15,360
204,800 104,800 100,000 31,440
W3. Cost of Ungeared

Be=1.5 Vd= 60% Ve=40% RFR=8% RM= 12% 𝑉𝑒 𝐵𝑒
𝐵𝑎 =
𝑉𝑒+𝑉𝑑(1−𝑇)
0.4∗1.5
𝐵𝑎 = = 0.7
0.4+0.6(1−0.3)
Ku = RFR + Ba (Rm - RFR)
Ku = 0.08 + 0.7 (0.12 - 0.08) = 10.8%
NPV Of Ungeared
Years - 1 2 3 4 5
Contribution 40,000 60,000 100,000 120,000 160,000
Less Fixed Cost (10,000) (10,000) (10,000) (10,000) (10,000)
EBT 30,000 50,000 90,000 110,000 150,000
Tax @ 30% (9,000) (15,000) (27,000) (33,000) (45,000)
EAT 21,000 35,000 63,000 77,000 105,000
Assets (500,000) 100,000
Work Capital (100,000) 100,000
Tax Savings 30,000 24,000 19,200 15,360 31,440
Net Cash Flows (600,000) 51,000 59,000 82,200 92,360 336,440
DF @ 10.8% 1.000 0.903 0.815 0.735 0.664 0.599
PV (600,000) 46,029 48,059 60,430 61,281 201,469
NPVu (182,732)
W4. Terminal Value
𝐹𝐶𝐹(1+𝑔) 336,440(1+7%)
𝑇𝑉 = = 𝑇𝑉 = 0.108 −0.07
= 9,473,442
𝐾𝑢 −𝑔
PV of TV = 9,473,442*0.599= 5,674,592
Page 43 of 127
𝑨𝑷𝑽 = 𝑼𝑷𝑽 𝒐𝒇 𝒖𝒏𝒈𝒆𝒂𝒓𝒆𝒅 𝑩𝒊𝒔𝒊𝒏𝒆𝒔𝒔 + 𝑷𝑽 𝒐𝒇 𝒅𝒆𝒃𝒕 𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔
NPVu= 5,672,951 + (182,732) = 5,491,860
W5. PV of debt benefit

Total loan Required (500+100wc) 600,000
Subsidised 40% 240,000
Market Loan 360,000
Armotisation of Subsidized Loan
N=5 r=4% pmt=?
𝑝𝑚𝑡[1−(1+𝑟)
𝑃𝑉 = 𝑟
=
−
5
𝑝𝑚𝑡[1− 1+0.04
240,000 = = 53,908
0.04
Period Bal B/d Constant Interest Principal Bal C/d

1 240,000 53,905 9,600 44,305 195,695
2 195,695 53,905 7,828 46,077 149,618
3 149,618 53,905 5,985 47,920 101,698
4 101,698 53,905 4,068 49,837 51,860
5 51,860 53,905 2,074 51,831 30
Market Loan 360,000

Issue Cost 3/97*360000 11,134
Total Market Loan 371,134
Period Bal B/d Constant Interest Principal Bal C/d

1 371,134 108,105 51,959 56,146 314,988
2 314,988 108,105 44,098 64,007 250,981
3 250,981 108,105 35,137 72,968 178,013
4 178,013 108,105 24,922 83,183 94,830
5 94,830 108,105 13,276 94,829 2
PV of Subsidised Laon
Yrs Interest DF @ 14% PV
1.00 9,600.00 0.877 8,421
2.00 7,827.80 0.769 6,023
3.00 5,984.71 0.675 4,040
4.00 4,067.90 0.592 2,409
5.00 2,074.42 0.519 1,077
21,970
Page 44 of 127
PV of DTS of Market Loan
Yrs Interest DF @ 14% PV
1 51,959 0.877 45,578
2 44,098 0.769 33,932
3 35,137 0.675 23,717
4 24,922 0.592 14,756
5 13,276 0.519 6,895
124,878
Pv of Interest Saved
Market Loan = 14%

Subsidised = 4%
Interest Saving = 10%
Period Bal B/d Constant Interest DF 10% PV

1 240,000 53,905 24,000 0.877 21,053
2 195,695 53,905 19,570 0.769 15,058
3 149,618 53,905 14,962 0.675 10,099
4 101,698 53,905 10,170 0.592 6,021
5 51,860 53,905 5,186 0.519 2,693
54,924
Pv of Tax Benefit forgone
Interest
yrs Tax 30% DF 14%
Saved
1.00 24,000.00 7,200 0.877 6,316
2.00 19,569.50 5,871 0.769 4,517
3.00 14,961.78 4,489 0.675 3,030
4.00 10,169.75 3,051 0.592 1,806
5.00 5,186.04 1,556 0.519 808
16,477
NPVu 5,491,860
PVDTS On Subsidized Loan 21,970
PVDTS On Market Loan 124,878
PV of Interest Saved 54,924
PV Tax Forgone (16,477)
Issue Cost (11,134)
NPVu 5,666,020
Try
April 2022 Q 1
December 2020 Q1
Page 45 of 127
DIVIDEND POLICY
A dividend is a distribution to the owner. The dicision links the investment and the
financing decision.
Types of dividends:
1. Cash dividend:
Under this type the company gives cash to the shareholders as dividend
Advantages
1. Communicating good information to the shareholders (signalling effect)
2. Shareholders are able to get a return from their investment.
Disadvantages
1. It affect the company’s cash flows
2. It limits the company to finance internally
2. Scrip/Stock dividend
Under this type the company gives shares to the shareholders as the dividend
Advantages
1. It does not affect the company's cash flows
2. The company can be able to finance internally
Disadvantages
a. It reduces the EPS of the company
b. Signalling effect (communication bad information)
Share repurchase:
Under this the company purchaes back shares from the market
Types of dividend policy

1. Stable dividend policy:
Under this policy, the company pays a constant amount per share as a dividend to
the shareholders.
Advantages
a. Shareholders are able to predict their incomes
b. In case a company generates high profits it can finance internally
Disadvantages
a. In case a company has not generated profits, the cash flows of the company will be
affected
2. Constant payout policy:

Under this policy the company pays a constant percentage from the profit as a dividend
Advantages
a. The company's cash flows are not affected .
b. Shareholders return will increase in case of high profits
c. The company can be able to finance internally
Page 46 of 127
Disadvantages
a. Signalling effect (communicating poor information)
b. Shareholders cannot predict their return
3. Stable with moderate payout (compromise policy):

This policy combines both the stable and a constant payout policy. Under this policy
a constant amount per share is given plus a certaing percentage on the company's profits.
4. Residual policy
Under this policy, the compay only pay dividends if it has generated enough profit
and has no investment opportunities.
Advantages
a. The company's cash flows are not affected.
b. The company can be able to finance internally
Disadvantage
Shareholders are not able to predict their return
2018 december question two
2019 December
Page 47 of 127
Dividend policy fo Ngoro ltd
2014 2015 2016 2017
Earnings 150 160 190 195
Dividend 70 70 70 70
Div pay out 47% 44% 37% 36%
Expenditure 40 60 50 45
27% 38% 26% 23%
Ngoro limited is apply a stable policy
Advantage and disavantage
Dividend policy fo Huye limited

2014 2015 2016 2017
Earnings 190 -20 220 240
Dividend 79.8 30 92.4 100.8
Div pay out 42% -150% 42% 42%
32% -150% 39% 25%
A constant pay out with stable policy
Dividend policy fo Gitarama limited
2014 2015 2016 2017
Earnings 150 175 235 265
Dividend 70 35 80 85
Div pay out 47% 20% 34% 32%
50% 74% 64% 64%
Residual policy
Page 48 of 127
Rugarama
2017 2018 2019
Net profit 150 25 600
DPS 300 500 900
No. shares 0.3 0.3 0.4
Dividend paid 90 150 360
Payout 60% 600% 60%
Investment
Constant payout with a moderate policy
Bravo
2017 2018 2019
DPS 200 160 320
No. shares 0.25 0.25 0.25
Dividend paid 50 40 80
Payout 50% 33% 67%
Investment 50 80 40
Proportion 50% 67% 33%
Page 49 of 127
Residual policy
Carmillette
2017 2018 2019
DPS 180 0 150
No. shares 0.4 0.4 0.35
Dividend paid 72 0 52.5
Payout 0.9 0 0.375
Investment
Proportion
Residual policy
Dividend decision theory

Irrelevance theory by MM
According to this theory the decision to pay or not to pay dividend is irrelevant.
Assumption of the theory:

1. It assumes a parfect marketv
2. There no transaction cost in the market
3. No taxes
4. Investors are rational
2. relevance theory by Godorn and Walters

According to this theory the dividend decision and the value of the firm are related.
Dividend capacity
It is the capacity of the company to pay dividends. This is reflected on the availability of
cash flows to the shareholders.
Dividend capacity = Free cashflows to equity/Dividend paid
Free cash flows to equity
EBIT XXX
Less interest (XX)
EBT XXX
Less tax (XX)
EAT XXX
add back depreciation XXX
Less net capital investment (XX)
Less net debt (XX)
Free cash flows to equity XXX
Page 50 of 127
MERGER & ACQUITION
There are two ways under which companies grow: that is:
1. Organic Grow
2. Merger & Acquisition
1. Organic Growth
The entity graw by investing internally
The organic grow is valid using any investment apraisal technique
Advantages or Organic Grow
2. Merger & Acquisition

Under this type of growth, the company grow by either combining with other companies
or by acquiring other companies;
Types of Mergers:
1. Horisontal Merger
2. Vertical Mergers
3. Conglomerante
1. Horisontal Merger
Two companies of same industry and same product line, combine together and form a
new company. The objective here is to reduce the competition,
2. Vertical Mergers
Two companies of same industry but with different product line combine together to form
a new company. One company is complimenting onather, or provide a substute to the other,
3. Conglomerante
Two companies in unrelated industry and product they combine together to form a new company
Advantages of Mergers
Diversification
Easy to enter a new market
Economies of Scale: negociate economie of scale, purcher materials price,
debt capacity
Synergy : It Is the value which is created out of the business combination
Types of synergy"
Revenue Synergy
Cost Synergy
Financial Synergy: Tax saving, debt capacity
Page 51 of 127
VALUATION OF MERGERS
Method of valuation:
1. Assets based method
2. Dividend Based method
3. Cash flow based method,
4. Earnings based method,
1. Assets based method

This method involves determining the net asset value of the entity,
NAV = Total Assets - Total Liability - Preference Share Capital

𝑁𝐴𝑉
𝑃𝑜 = 𝑁𝑜 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 Po = Price per share
Rules:
1. Assets Sould be recognised at their realisable or fair value,
2. Intengible assets are only recognised if their market value can be ascertained,
Ex
December 2018 Q1:
Land & Building 900+1500 2,400
Plant & Machinery 740-140 640
Motor Vehicle 160
Goodwill (FV was not provided, so we ignore it) -
3,200
CA
Inventory 1,040
Inventory 1/4*1040 (260)
Scrap Value 20% *260 52
832
Recevables 85%*760 646
Short term investment 180
Cash 120
1,778
Liabilities
Payables 520
Tax 380
Bank Loan 520

Deffered Tax 200
360
1,980
Net Asset Value 2,998
Premium of 10% 300
Required Sales Value 3,298
Offer Price 3,800
GTL Should accept the offer because it is higher than the premium
Page 52 of 127
Weakness of the asset based method"
1. same intengible assets are ignored, eg: Knowledge and skills of key employees
2.It uses past information
3. It uses accunting information, which is subject to manupilation
2. DIVIDEND BASED METHOD

This methods involves discounting the expected dividends in order to determine the value of
the business.
There are 3 models, used under this method;
1. Super normal Dividend growth,
Under this model, the dividends are expected to grow at a given rate for a given period
of time. The price per share is determined by discounting the expected dividends using
the cost of equity.
𝐷1 𝐷2
𝑃𝑜 = (1+𝑘𝑒)^1 + (1+𝑘𝑒)^2 +
D1 to Dn = Expected dividends DPS

Ke: Cost of Equity 𝐷1 = 𝐷𝑜 1 + 𝑔
Do = Current Dividend
Vb = Po x No of Share
Ex
Company X is evaluating the acquisition of company Y, Company Y has just given a dividend
of 50 Francs per share. The Dividend is expected to grow at a rate of 2% per year for a
period of 4 yrs. The risk free rate is 8%, the market return is 10%, while Beta is 0.9
Required:
Determine the maximum price we should pay to the shares of company Y.
Do = 50
g = 2%
n=4
RFR = 8%
RM=10% 𝐷𝑜 = 𝐷𝑜 1 + 𝑔 = 50(1+0.02)
B = 0.9
Discount
Ex. Div PV
@ 9.8%
1 D1 50(1+0.02) 51.00 0.911 46.448
2 D2 51(1+0.02) 52.02 0.829 43.148
3 D3 52.02(1+0.02) 53.06 0.755 40.083
4 D4 53.06(1+0.02) 54.12 0.688 37.236
167
ke = 0.08 + 0.9(0.1-0.08) = 9.8%
Page 53 of 127
2. CONSTANT DIVIDEND MODEL
The dividend will grow for constant rate for ever
𝐷𝑜 (1+𝑔)
𝑃𝑜 = 𝐾𝑒 −𝑔
3. NON CONSTANT GROWTH MODEL

Under this model, dividends are expected to grow at a given rate for a given period of time
and there after is grows at a constant rate for ever.
𝐷1 𝐷2 𝑃𝑛
𝑃𝑜 = + + ...
(1+𝑘𝑒)^1 (1+𝑘𝑒)^2 (1+𝑘𝑒)^𝑛
𝐷𝑛 (1+𝑔)
𝑃𝑛 =
𝐾𝑒 −𝑔
Pn = the price at constant growth
Company X is evaluating 100% acquisition of company Y, company Y has just given a dividend
of 20 Frw per share which is expected to grow at rate of 5% per year for a period of 3 yrs
After 3 yrs dividends is expected to grow at a rate of 2% for a foreseeble future.
The cost of equity required by the investors is 11%.
Required:
Determine the maximum amount tomthe shares of company Y
Data: Do = 20 g= 5% n= 3 yrs gc = 2% Ke= 11%
Discount
Period Dividends PV
@ 11%
1 21.00 0.901 18.919
2 22.05 0.812 17.896
3 23.15 0.731 16.929
3 262.37 0.731 191.843
Po = 245.59
𝐷𝑛 (1+𝑔𝑐) 23.15 (1+0.02)

𝑃3 = 𝑃3 =
0.11 −0.02
= 262.37
𝐾𝑒 −𝑔𝑐
WEAKNESS OF THE DIVIDEND MODEL 𝐷+𝑃1 −𝑃𝑜)

1. It is based on assumption that Ke is above G 𝑆𝐻𝑅 =
2. It assumes a positive growth rate
𝑃𝑜
3. It ignore the capital gain SHR = Shareholders return
Page 54 of 127
3. EARNINGS BASED METHOD
This methods uses the companies earning to determine the share price and the value of
business. The key tools used under this method includes:
1. Price earnings ration (P/E Ratio)
2. Dividend Yield
3. Earnings Yield
1. Price earnings ration (P/E Ratio)

This shows the relationship between the earnings per share and the price per share
𝑃𝑜 𝑃𝑜 = 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜𝑛 ∗ 𝐸𝑃𝑆
𝑃/𝐸 = 𝐸𝑃𝑆
𝑉𝑏 = 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜𝑛 ∗ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑑
Vb = Value of the business
DIVIDENDS YIELD
This shows the relationsip between dividend per share and the price per share
𝐷𝑃𝑆 𝐷𝑃𝑆
𝐷𝑌 = 𝑃𝑜 =
𝑃𝑜 𝐷𝑌
EARNING YIELD
It is the inverse of P/E Ration. Its shows the earning of each share investment
𝐸𝑃𝑆 𝐸𝑃𝑆
𝐸𝑌 = Po=
𝑃𝑜 𝐸𝑌
When valuing unlisted company, IT SHOULD BE BENCHMARKED to the listed companies
ADJUSTING FOR NON MARKERTABILITY

When benchmarking a listed company, to unlisted company, the shares of unlusted compny
should be adjusted for non markertability.
VALUATION OF A GROUP
The value of a group is determined using the combined earnings and the PE after the merger.
Ex:
Company X is evaluating a merger with Co Y, the earning after tax are 20 M and 15 M
for companies X & Y respectively. The current PE of the 2 companies is 14 and 12 for X & Y
respectively. It is expected that after the merger, the operating cost will reduce by 2 million and
the PE of the combined companies will be 16.
Required:
1. Determine the value of the group
2. Determine the maximum & minimum value of company Y
Page 55 of 127
1. Determine the value of the group
EATx = 20M
EATy = 15m
Pex = 14
Pey = 12
Combined P/E=16
Synergy = 2m
Combined earnings = [20+15+2] =37
Value of Group = 37m*16 = 592m
2. Maximum Value of the target

Value of the Group - Value of the acquirer
Value of Acquirer = P/Ex * EATx = 20*14 = 280m

Value of Target = 592 - 280 = 312
Minimum Value
P/Ey * EATy = 12 * 15m = 180m
WEAKNESS OF THE EARNING BASED MODEL

1. they are only used for companies that are listed,
2. Benchmarking a listed to unlisted company may not provide the appropriete value
4. CASH FLOW BASED METHOD

These methods uses the free cash flows or the free cash flows to equity to determine the
value of the business:
a) Free Cash Flows
b) Free Cash Flows to Equity
a) Free Cash Flows

These are cash flows which are available to both equity and the debt holders
the free cash flows should be discounted using WACC.
Value of Equity = Value of Business - Value of Debt
Free Cash Flows Computation:

EBIT xxx
less: TAX (xxx)
xxx
Add: Depreciation xxx
Capital Investment (xxx)
Working Capital investment +- xx
FREE CASH FLOWS xxx
Page 56 of 127
FREE CASH FLOWS TO EQUITY
these are cash flows which are available to equity holders only
the free cash flow to equity should be discounted using the cost of equity
Free Cash Flows to Equity Computation:

EBIT xxx
less: Interest (xxx)
EBT xxx
LESS: TAX (xxx)
EAT xxx
Add: Depreciation xxx
Capital Investment (xxx)
Working Capital investment +- xx
FREE CASH FLOWS xxx
PRINCIPALS OF VALUATION for Cash Flow based methods
1. The acquirer neither exposed to business nor financial risks

under this principal, the value of the target company is determined using the NPV method
The cash flows are discounted using the cost of capital of the acquirer.
2. The acquirer is exposed to financial risks but not business risks

Under this principal, the target company is valued using APV
3. The acquirer is exposed to both financial & business risks

Under this method the value of the business is determined by discounting the combined eaning
Using a combined WACC.
Steps to get the combined WACC:
Step 1: Determine the Asset Beta of Each Company

Step 2: Determine the Average Asset Beta of the 2 companies
𝐵𝑎𝑋∗𝑉𝑥 𝐵𝑎𝑌∗𝑉𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑎 = +
𝑉𝑥+𝑉𝑦 𝑉𝑥+𝑉𝑦
Step 3: regear the Asset Betta using the new capital Structure to get Equity Beta
Step 4: Determine the cost of equity using the new equity betta
Step 5: Determine the combined WACC
Page 57 of 127
2021 december question one
Page 58 of 127
Akanoze (000) Kabore (000)
No. shares 30,000 4,600
Po 250
Debt 740,000
EBIT 195,000
Dep 26,000
Capital investment 23,000
g 5%
Ko(WACC) 13%
Value Equity of Akanoze

No. shares 30,000
Po 250
Value of equity 7,500,000
ii. Value of Kabore Ltd

EBIT 195,000
Less tax @30% (58,500)
EAT 136,500
Add back depreciation 26,000
Less capital investment (23,000)
Free cash flows 139,500
139,500 ( 1 + 0.05 )
Terminal value = = 1,830,938
0.13 - 0.05
Value of equity of Kabore = Value of business - Value of debt
Ve = (1830,937.5 - 740,000) = 1,090,938
Figures are millions

Combined 1 2 3 4
Sales 9,520 10,091 10,697 11,338
grow 6% 1.06 1.124 1.419
EBT @ 17% 1,618 1,716 1,818 1,928
Tax @30% (486) (515) (546) (578)
EAT 1,133 1,201 1,273 1,349
Capital investment (62) (86) (91) (96)
Free cash flows 1,071 1,115 1,182 1,253
DF 11% 0.901 0.812 0.731 0.659
PV 965 905 864 825
Total PV = 3,559.58
1253 (1+0.03)
Terminal value = = 16,132.4
0.11 - 0.03
Page 59 of 127
PV of terminal value (16,132.4*0.659) 10,627
Total value of business =(3559.58+10627)
Value after merger/acquisition 14,186
Value of equity (14,186.49*70%) 9,931
Value before merger/acquisition (7500 + 1091) 8,591
Kanoze should acquire kabore
W1 Increase in sales 1 2 3 4
9,520 10,091 10,697 11,338
Increase in sales 571 605 642
Capital investment (increase in sales*15/100) 85.68 90.82 96.27
5.71
85.68
March 2022 question one
Page 60 of 127
APV = NPVu + DTS
NPVu (free cash cash flows)

Ku (Vd 60, Ve 40, RFR 10%, Rm 15% , Pre Kd 8% Be 1.7)
1.7 * 40
Ba = = 0.83
40 + 60 (1-0.3)
Ku = 0.1 + 0.83 (0.15 -0.1) = 14.2%
0 1 2 3 4 5
Free cash flows 80,000 120,000 180,000 160,000 195,000
Investment (500,000)
DF 14.2% 1.000 0.876 0.767 0.671 0.588 0.515
PV (500,000) 70,053 92,013 120,858 94,071 100,393
NPVu= (22,613)
DTS
Total Loan 350,000
Issue cost on loan (5/95*350,000) 18,421
Total gross loan 368,421
Subsdised loan (40%*368,421) @8% 147,368
Market loan @ 12% 221,053
a. DTS on the market loan

Interest (12%*221,053) 26,526
Tax shield (26,526*30%) 7,958
Annuaty factor @ 12% 3.605
PVDTS 28,686
b. DTS on the subsidsed loan

Interest (147,368 *8%) 11,789
DTS (11,789.47*30%) 3,537
Annuaity factor 3.605
PVDTS 12,750
Page 61 of 127
c. Interest saving
Interest (12%- 8%)*147,368 5,895
Annuaity factor 3.605
PV on interest saved 21,249
PV of tax foregone
Interest saved 5,895
Tax on interest saved 1,768
Annuity factor 3.605
PV of tax foregone 6,375
APV
NPVu= (22,613)
PVDTS market loan 28,686
PVDTS subsdised loan 12,750
PV of interest saving 21,249
PV tax foregone (6,375)
Issue cost (18,421)
APV 15,277
A B
Ba 1.2 1.8
A is financing a merger using debt of 200m

Issue cost 18,421
Tax 5,526
PV tax (5526*0.893) 4,935
2017 june
Page 62 of 127
Dividend based model
Current dividend (D0)
EPS 50
No shares 10,000,000
EAT (EPS*No.shares) 500,000,000
Pay out 45% (dividend) 225,000,000
DPS = 23
growth rate in dividend

Do 25
Di 20
g = (25/20)^1/2 - 1 12%
Ke = 0.05 + 1.5 (0.11 - 0.05) = 14%
P= Do (1+g)/Ke -g
Po = 22.5 (1+0.12)/(0.14 - 0.12) 1260
Value = 1260 *10,000,000 12,600,000,000

Current market value = (420 - 22.5)*10,000,000 3,975,000,000
The shares of kamanzi are under valued in the amrket

P/E ratio
EPS 50
P/E 12
Po = P/E*EPS 600
Value (10,000,000*600) 6,000,000,000
Page 63 of 127
FINANCING THE MERGERS AND ACQUISITIONS
There are four methods used when financing mergers and acquisitions
a. cash offer
b. Share offer
c. Debt offer
d. Hybrid/mixed offer
Cash offer
Under this type the acquirer offers cash to the shareholders of the target as the purchase
consideration. In this method, the number of shares of the acquirer does not increase
Purchase consideration/purchase cost = number of shares* price per share
Example:
Company X is evaluating the acquisition of 100% shares of company Y. Below is the detailled
information relating to the two companies
X Ltd Y Ltd
EAT 20,000,000 10,000,000
Number shares 400,000 250,000
P/E 15 12
EPS 50 40
Po (P/E* EPS) 750 480
Required: Determine the purchase consideration and evaluate whether

company Y should accept the offer or company X should acquire company Y
i. Purchase consideration ( 250,000*750) 187,500,000
Evaluating the offer for the target company

Current market price of target 480
Offer price 750
gain 270
ii. Purchase consideration and current value of the target

Purchase consideration (250,000*750) 187,500,000
Current market value of target (12*10m) 120,000,000
67,500,000
Conclusion" The target company should accept the offer
Evaluating for the acquirer

Value after acqusition
combined earnings (10m+20m)*15 450,000,000
Less purchase consideration (187,500,000)
Value after acqusition 262,500,000
Value before acqusition(15 *20m) 300,000,000
loss 37,500,000
Conclusion: Company should not acquire company Y
Page 64 of 127
Advantages
It is less expensive
it does not lead to dilution in the EPS
Disadvantages
i. It can have an effect on the cash flows of the company
2. Share offer
Under this the acquirer offers shares to the target company as the purchase consideration
The number of shares will increase
Exchange ratio: These are number of shares to be issued for the shares of the target
offer price or market value of the shares of the target

Exchange ratio =
Market value of the shares of the acquirer
Purchase consideration = No. of shares issued * offer price/market price of the acquirer
Example: Company X is evaluating the acquisition of company Y. Company X will issue shares
to the shareholders of company. Below is a detailled information for the two companies
X ltd Y lTd
EAT 15,000,000 10,000,000
No. Shares 1,000,000 800,000
P/E 14 13
EPS 15 13
Po 210 163
Exchange ratio = (162.5/210) = 0.77
New shares to issue (800,000*0.774) 619,200

Purchase consideration (619200*210) 130,032,000
Evaluate the offer the target company

Purchase consideration 130,032,000
Current value (13*10m) 130,000,000
Gain 32,000
Comparing the price

Offer price (210*0.774) 163
Current market price 163
Gain 0
Comparing the EPS

EPS after merger 15.44
EPS before merger 12.50
Gain (15.44 - 12.5) 2.94
Page 65 of 127
EPS after merger
Combined earnings (15m+10m) 25,000,000
Combinedshares (1m+619200)
shares of the acquirer+ new shares 1,619,200
Combined earnings
Combined EPS = = 15.44
Combined shares
Evaluating the acquirer

a. Comparing the EPS before and after
EPS after merger 15.44
EPS before merger 15.00
Gain 0.44
b. Compare the price before and the price after

Price before the merger 210
price after the merger
Price after merger = Combined EPS * P/E after merger
c. Value before and after merger

Value before (14*15m) 210,000,000
Value after merger (Combined earnings *P/E after merger)
Example: Company X is evaluating an acquisition of company company Y. Company X

issue shares to the shareholders of company Y at an offer price of 250 FRW per share.
It is expected that after the merger, the debt capacity of the two companies will increase
by 2,000,000 and the P/E after the merger is 17.
X ltd Y lTd
EAT 15,000,000 10,000,000
No. Shares 1,000,000 800,000
P/E 14.00 13.00
EPS 15.00 12.50
Po 210.00 162.50
Required:
a. Determine the purchase consideration
b. Evaluate whether company X should go on with the merger or company Y should accept
the merger
Exchange ratio = (250/210) = 1.19

New shares to be issued (1.19*800000) 952,381
Purchase consideration (952381*250) 238,095,238
Page 66 of 127
Evaluating the offer for the target
Offer price 250
Gain 88
Evaluating for the aquirer

Current value of the acquirer (14*15m) 210,000,000
Value after merger (17*27m) 459,000,000
Gain 249,000,000
Value after
Combined earnings (15m+10m+ 2m) 27,000,000
Combined shares (1m+952,381) 1,952,381
Combined EPS 13.83
P/E after merger 17.00
price before merger 210.00

price after merger (13.83*17) 235.10
Gain 25.10
WORKING CAPITAL MANAGEMENT

it is the management of current assets and current liabilties
Net working capital = Current assets - Current liabilities
Importance of managing working capital

1. Working defines the liquidity position of the entity
2. Working capital determines the profitability of the entity
Cash operating cycle/ working capital cycle:

It is the period between when the entity starts to invest in production until it collects
money from customers. The longer the cycle, the more the entity needs to invest in working capital
Days raw material remain in stock XXX Inventory period XXX

Days raw WIP remain in stock XXX
Days finished goods remain stock XXX
Days to collect from customers XXX Receivable period XXX
Less days to pay supplies (XX) Payable period (XXX)
Cash operating cycle XXX CCC
Working capital Ratios/Liquidity ratios

These are used to assess the liquidity of the entity and whether the business is overtrading or not
Current ratio: It shows whether the entity has ability to pay the current obligation
Page 67 of 127
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐫𝐚𝐭𝐢𝐨 = (𝟐: 𝟏)
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Quick Ratio: This shows whether the entity can pay the current liabilities without relying on stock
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

𝐐𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨/𝐀𝐜𝐢𝐝 𝐭𝐞𝐬𝐭 𝐫𝐚𝐭𝐢𝐨 =
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Receivable turnover: It measures the number times receivables are turned into sales
𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = (𝐓𝐢𝐦𝐞𝐬)
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐩𝐞𝐫𝐢𝐨𝐝 = ∗ 𝟑𝟔𝟓 (𝐝𝐚𝐲𝐬)
Inventory turnover: It shows the number of times invetory is turned into sales
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐩𝐞𝐫𝐢𝐨𝐝 = *365
𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞/𝐜𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
𝐑𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫/𝐩𝐞𝐫𝐢𝐨𝐝 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐫𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥

𝐑𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐩𝐞𝐫𝐢𝐨𝐝 = *365
𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐨𝐟 𝐫𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥/𝐜𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
𝐅𝐢𝐫𝐧𝐢𝐬𝐡𝐞𝐝 𝐠𝐨𝐨𝐝𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐟𝐢𝐧𝐢𝐬𝐡𝐞𝐝 𝐠𝐨𝐨𝐝𝐬
Page 68 of 127
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐟𝐢𝐧𝐢𝐬𝐡𝐞𝐝 𝐠𝐨𝐨𝐝𝐬
𝐅𝐢𝐧𝐢𝐬𝐡𝐞𝐝 𝐠𝐨𝐨𝐝𝐬 𝐩𝐞𝐫𝐢𝐨𝐝𝐬 = *365
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐖𝐈𝐏

𝐖𝐈𝐏 𝐩𝐞𝐫𝐢𝐨𝐝 = *365
Payable turnover: This shows the number times payables are paid
𝐂𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞
𝐏𝐚𝐲𝐚𝐛𝐥𝐞 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐚𝐲𝐚𝐛𝐥𝐞
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐚𝐲𝐚𝐛𝐥𝐞𝐬
𝐏𝐚𝐲𝐚𝐛𝐥𝐞 𝐩𝐞𝐫𝐢𝐨𝐝 = *365
𝐂𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞
2021 April
Page 69 of 127
share capital 750,000,000
par value 2,000
Current number shares 375,000
market price before right issue 3,500
right issue price 2,750
Ratio (1:4)
Items No. shares Price Amount

Existing shares 4 3100 12,400
Right issue 1 2750 2,750
TOTAL 5 15,150
TERP = Value of shares in issue/no. shares =(15150/5) 3,030
New shares to be issued (375,000/4) 93,750

Right issue price 2,750
Cash to be raised 257,812,500
c. Data
Credit sales 25,000,000
Purchase of raw material 12,000,000
Director labor 15,000,000
Production overheads 6,000,000
Cost of goods 33,000,000
Material period 21
Finished goods period 28
WIP days (5*7) 35
Payable period 24
Receivable period (7*7) 49
Working capital - Current assets - current liabilities
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Inventory + Receivables + cash - Payables
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐨𝐟 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥

𝐑𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐩𝐞𝐫𝐢𝐨𝐝 = *365
𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐨𝐟 𝐫𝐚𝐰 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥/𝐜𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
𝐒𝐭𝐨𝐜𝐤 𝐨𝐟 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥
𝟐𝟏 = *365 =
𝟏𝟐,𝟎𝟎𝟎,𝟎𝟎𝟎
𝐒𝐭𝐨𝐜𝐤 𝐨𝐟 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥
𝟐𝟏 = *365 =
𝟏𝟐,𝟎𝟎𝟎,𝟎𝟎𝟎
Stock of raw material = (21*12,000,000)/365 = 690,411
Stock of finished goods = (28*33,000,000)/365 2,531,507
Stock of WIP = (35*33000,000)/365 3,164,384

Total inventory 6,386,301
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐩𝐞𝐫𝐢𝐨𝐝 = ∗ 𝟑𝟔𝟓 (𝐝𝐚𝐲𝐬)
Receivable = (25,000,000*49)/365 3,356,164
Cash 257,812,500
Total current assets 267,554,966
Payables = (12,000,000*24)/365 (789,041)
Working capital 266,765,925
2020 2021
Period = number days in year/turnover
payable turnover 25 10
Period = number days in year/turnover 14.6 36.5
Overtrading and Overcapitalisation
Overtrading is a sitiuation where the company finances most of its activities using
the short term sources of finance.
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Symptoms/indicators of overtrading
1. Rapid increase in the sales not supported by the increase in the non current assets
2. Rapid increase in the current assets
3. Decrease in inventory and account receivable turnover
4. Decrease in the payable turnover
5. Increase in the bank overdraft
6. Small increase in equity capital
7. A fall in the equity to asset ratio but an increase in the debt to asset ratio
8. Decrease in current and quick ratio
Overcapitalisation: This is when the entity is having too much current assets than the payables
Management of Receivables
The purpose of managing receivables is to minimise costs that are related to receivables.
The receivable costs includes
1. Bad debt
2. Administration of the receivable ledger
3. Interest cost to finance the receivables
4. Opportunity cost
Receivable management process

1, Credit Analysis: This involves analysing the credit worthness of the client
2. Collection from customers
3, Credit control: This is to ensure compliance with the set policy
Analysing the credit policy

1. Extending a credit period
Benefit of the policy:
Increase in the sales XXX
Costs associated with the policy

a. Increase in the bad debt (XXX)
b. Increase in the financing costs (XXX)
c. Increase administration costs (XXX) (XXX)
2. Introducing a discount
Benefits
Saving in interest cost XXX
Decrease in bad debt XXX
Total benefits XXX
Costs associated with a discount
Discount cost (XXX)
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3. Employing a factor company
A factor company is an external company that is employed to manage the receivable ledger.
Advantages of factor company"
1. The receivable ledger is managed by experts
2. The company can finance its growth using the internal sources
3. It helps in solving the cash problem
4. It provide protection against bad debt in case of non recourse factor company
Types of factor company

1. Non recourse factor company: They assume a risk of bad debt
2. Recourse factor company: They don’t take risk of bad debt
Analysis of factor company

Benefits of factor company
1. Saving in administration cost XXX
2. Decrease in the finance cost XXX
3. decrease in bad debt (non recourse) XXX
Total benefits XXX
Cost of factor company
Comission (XXX)
Interest on advance payment (XXX)
2022 March
Page 73 of 127
Total annual sales 400,000,000
Cash sales @10% 40,000,000

Credit sales 360,000,000
Current credit policy 15 days

customer pay 60 days
New credit period 90 days
Discount 4%
Increase credit sales (360m*1.25) 450,000,000
Increase in sales (450m-360m) 90,000,000
Gross profit margin @28% 25,200,000
Benefit of the policy

Increase in gross profit 25,200,000
Cost of the policy

Discount (4%*450m)*20% 3,600,000
Bad debt (3%*450m)-(2%*360m) 6,300,000
Extra finance cost W1 4,160,959
Total cost for the policy 14,060,959
Net benefit 11,139,041
The company should change the credit policy
W1 Finance cost
Current receivables (360m*60/365) 59,178,082
New receivables:
Discount (450m*15/365)*20% 3,698,630
Pay 90 days (450m*90/365)*65% 72,123,288
Pay 60 days (450m*60/365)*15% 11,095,890
Total new receivables 86,917,808
Increase in receivable 27,739,726
Finance cost @15% 4,160,958.90
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2019 december
Page 75 of 127
Page 76 of 127
current receivable days (295890411/7200,000,000)*365
Current receivable days
New receivable days 15
offer a discount 60
10%
Increase in sales (25%*7200000000) 1,800,000,000
70% will pay in 60days

30% will accept a discount
Operating cost will increase by 600,000,000
Finance cost is 20%
Overtrading
1. Current ratio
2. Quick ratio
3. Inventory and debtors turnover
4. Payable turnover
5. Equity to assets
6. Debt to assets
7. overdraft
Increase in sales
Less operating costs 1,800,000,000
Profit (600,000,000)
1,200,000,000
Costs
Discount cost (
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Arbitrage Pricing Theory (APT)
The APT it is a pricing technique that determines the expected return of an asset
by eliminating the all the arbitrage opportunities.
Difference between APT and CAPM

APT CAPM
1. It shows how the return of the 1. The risk in the market is combined into one factor
asset is sensitive to each factor that is the the systematic risk (beta)
in the industry
2. It fallows a quadratic function
2. It is a linear function
Similarities
1. They assume a perfect market
2. They assume that investors are rational
Assumption of APT
1. The capital is perfectly competetive
2. Investors prefer more wealth to less wealth
3. It is a linear function that follows a stochastic process
Expected return €
E = α0 +α1b1 +α2b2 +α3b3 + ...αnbn
where α0 is the expected where the systematic is 0 (RFR) α1 ---- αn is the sensitivity
of the return due to changes in the market factors and b1 ….. Bn are the market factors
The market factors include: inflation, interest rate GNP, political factor
Example:
Assume that the investor wants to invest in two assets that X and Y. The expected return
at 0 systematic risk id 5%. Both assets are affected by inflation, interest and the GNP.
The sensitivity (risk premium) of asset X to inflation is 0.2, to Interest rate is 0.4 and to
political factor is 0.3. the current inflation is 0.06, interest is 0.1 and political factor is 0.15
Required: Determin the expected return of asset X using the APT
Level of
Senstivity of market
return factors
Inflation 0.2 0.06 0.012 RISK PREMIUM/SENSITIVITY = (RM -RFR)
Interest 0.4 0.1 0.04
Political 0.3 0.15 0.045
SUM 0.097 0.147
RFR 0.05 0.15 rm - RFR
E= 0.05 + (0.2*0.06) + (0.4*0.1) + (0.3*0.15)

E = 0.15 = 15%
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Measuring the portfolio performance
The purpose of measuring a portfolio performance is to establish whether ther
return is above or below the market. There are three methods used in measuring
the portfolio performance
Rm - RFR
Treynor Value (T) =
Beta
where Rm is the market return
Beta = systematic risks
RFR is the risk free rate
T- value is compared with the expected of the portfolio using CAPM
ER= RFR + B(RM- RFR)
Rm - RFR
Sharpe value (S) =
SD
SD is the standard devistion of the portfolio
Jensen =RFR + B(RM- RFR)
Take in portfolio theory

1. Risk and return of individual assets
2. Covariance and coefficient of correlation
3. Apply CAPM in determining return of an asset (SML, CML)
4. Application of CAPM and portfolio theory in practice
5. APT
FINANCIAL STATEMENT ANALYSIS
RATIO ANALYSIS:
It is the process of establishing a relationship between the various items
of financial statements.
Trend analysis: This involves comparing the current performance to the previous performance of
the entity in order establish an increase or a decrease in the performance.
Industrial Analysis: It involves comparing the performance of the entity with other entity
in the industry
TYPES OF RATIOS
Ratios are classified into five major categories:
1. Profitability ratio: This aims at assessing whether the entity is earning enough profit
from operations.
The key ratios used include:

a. Gross profit Margin (GPM): This assesses the profit margin earned on sales after paying
the variable costs
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Gross profit *100
GPM =
Sale
b. Net profit margin (NPM): This assesses the profit earned on sales after paying all expenses
Net profit *100
NPM =
Sale
c. Return on capital employed (ROCE): This assesses whether the entity generates enough profit
fromoperations to pay the cost of capital to support the further borrowings of the entity
EBIT *100
ROCE =
capital employed
Capital employed= Total assets - current liabilities or Total equity + NCL
d. Return on asset (ROA): This measures whether the assets generates enough profit
Net profit *100
ROA =
Total assets
c. Return on equity (ROE): It shows the return generated on the shareholder's funds in
order to determin whether the shareholder's funds are well employed or not
ROE = Net profit *100
Total equity
2. Liquidity ratios
These are used to measure whether the entity has enough cash to meet its
obligations as the fall due.
a. Current ratio (CR): This measures the ability of the entity to pay its current obligations
using the current assets
current assets
CR =
current liabilities
b. Quick/Acid test ratio (QR): It measures whether the entity can pay the current obligations
without relying on stock
Current assets - stock

QR =
Current liabilities
c. Cash cover (CC): This measures whether the entity has enough liquid cash to pay the current
liabilities
cash and cash equivellents
CC =
current liabilities
3. Actvity or effeciency ratios

This is used to assess how the organisation resources are managed.The key ratios include
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a. Inventory turnover/Inventory period: It measure the number of times inventory is
converted into sales or the period it takes to convert stock into sales.
Cost of sales
Inventory turnover =
Average stock
Average stock
Inventory period = *365
Cost of sales
b. Debtors/Receivable turnover/Period: It measure the number of times the entity collects

from customers or the number days it takes to collect from customers.
Credit sales
Debtors' turnover =
Average debtors
Average debtors*365
Debtors' period =
Credit sales
c. Payable turnover or period: It shows the number of times suppliers are paid or the number
days it takes to pay the supplier.
Credit purchase
Payable turnover =
Average payables
Average payable *365

Payable period=
Credit purchases
d. Asset turnover: It shows the level at which the assets are contributing to the company's sales
Sales
Asset turnover =
Total assets
4. Gearing or Leverage ratios: This is used to assess the level of debt in the capital structure and
the solvency of the business. The key ratios used include
a. Debt ratio: It measures the ability of the entity to pay its liabilities using the available assets
and the level of debt in the capital structure.
Total liabilities
debt ratio=
Total assets
b. Debt to equty ratio: It shows the proportion of debt and equity in the capital structure or
equity can pay the liabilities
Total liabilities
Debt to equity =
Total equity
c. Interest earnings ratio/Interest cover: It measures the numbers the profit generated from
operations can pay the interest expenses
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EBIT
Interest cover =
interest expenses
MVD MVD is market value of debt

d. Gearing =
MVD +MVE MVE is market value of equity
5. Market/Investors Ratios
This is used by investors when evaluating the value of the firm in the market.
The key ratios used include
a. EPS
b. P/E
c. Dividend yield
d. Dividend shares
Dupoint analysis
This involves decomposing the ROE in order to determine the characteristics that makes
it up over a time.
Net income Revenues Average total assets

ROE =
Revenues Average total assets Share holders' funds
ROE = Net profit Margin * Asset turn over * Finance leverage/Equity multiplier
FINANCIAL DISTRESS AND RESTRUCTURING/RECONSTRUCTION
Financial distress is a situation where the entity may be facing financial challenges
to meet its obligations.
Corporate Failure
Financial distress is a sign of corprate failures but it does not mean that the business has failled.
Symptoms/indicators of corporate failures

1. Failure to control cash
2. Failure to control costs
3. Failure of the company's products to adapt to the market
4. Failure to carry out market research
5. failure to pay taxes
Causes of Business failure

1. Insufficient utilisation of the economic resources
2. Insufficient financial managament
3. Insufficient human resources
4. Insifficient marketing
5. Continued operation in losses
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Preventing business failure
1. Restructuring/reconstruction
2. Selling redundant assets
Predicting the corporate failure

There are two models used when predicting a corporate failure that the quantitative
and qualitative model
Quantitative model by Alt-man

This model uses the items of financial statement to predict the corporate failure. It forecats the
the corporate failure therough computing the Z-score. If the Z-score is below 1.86 the business
is likely to failure.
Z -score = 1.2X1 + 1.4X2 + 3.3X3 +0.6X4 + X5
Where: X1 = Working capital/total assets

X2 = Retained earnings/total assets
X3= EBIT/total assets
X4= Market value of equity/total liabilities
X5 = Sales/Total assets
Qualitative model: This uses qualitative factors to asssess whether the business is likely to fail
or not. The qualitative factors are classified into two:
1. Management weaknesses
a. Seperation of roles of CEO and chairman board
b. Balance of skills of board
c. Board committes
2. Accounting weaknesses
a. Preparation of budgets
b. Control of cash
d. Control of costs
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RESTRUCTURING/RECONSTRUCTION
It is the process of redesigning the business activities in order to avoid a corporate failure
Methods of financial reconstruction
1. Portfolio restructuring/Reconstruction
It is the process of changing/redesigning the assets mix of the entity in order to avoid a
corporate failure. The main techniques used include:
a. Unbundling: It is the sale of a disposal of assets or some assets in order to avoid a failure
b. Divestment: It is a part of unbundling which involves selling some assets or part of assets.
c. Demerger: It is splitting companies that were previously combined.
d. Sell offs: This involves selling off part of the company to the third party
e. Liquidation: It is terminating the business activities.
f. Spin-off: It is about creating a new company but with the same existing shareholders
g. Management buy out (MBO) and Management buy in (MBI)
MBO the company sell part of its assets to the existing management team while MBI the
assets are sold to the mgt team outside the entity
2. Financial Reconstruction/Retructuring
This involves chaning the capital mix of the entity in order to avoid a corporate failure.
The key tools used include:
1. Leveraged recapitalisation: This involves changing the equity capital into a debt.
The purpose is to make the the entity untractive for a takeover.
2. Debt to Equity swap: This involves changing the debt into equity in order to reduce the level
gearing
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3. Leveraged buy out (LBO): This involves selling the business or part of business but the
purchase consideration is financed by a debt
4. Dividend policy: Revising the dividend policy
3. Business reorganisation:
It invoves redisigning the operating activities of the entity. The aim is reduce costs
a. Employee restructuring
b. business re engineering
INTRODUCTION TO CORPORATE FINANCE
Corporate finance is about allocation and utlisation of financial resources. The aim is
to maximise the financial objectives of the entity
a. profit maximisation:
b. Wealth maximisation
Non financial ojectives

a. Welfare condition of employees
b. Welfare conditions of the management
c. Responsibilities towards customers
d. Responsibilities towards suppliers
e. Responsibilities towards the government
f. Responsibilities towards the community
Corporate governance
It is the companies are directed and controlled.
principles of corporate govrnance
1. Integrity
2. Fairness
3. Responsibility
4. Accountability
Basic conduct of the board /best prictice of the board

a. Composition of the board members (executive directors and non executive directors)
non executive should be 1/3
b. Board size
c. Independence of the board
d. Balance of skills
e. Existance of board committees (member on the comittees)
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INTERNATIONAL INVESTMENT AND FINANCE DECESIONS
INTERNATIONAL INVESTMENT DECISION

It is about evaluating international investment projects. The factors that influence an
international investment appraisal include:
a. Foreign exchange rate
b. Local taxes Ug
c. Double tax agreement Cash 4m
d. Political skills WHT 20%
net cash flows (80%*4m) = 3.2m
Purchasing power parity (PPP)

It is used to predict the exchange at the end of given period basing on the level of inflation
in the different countries
Forward/Future spot rate (S1) = Current spot rate (So) (1+Hc)
(1+Hb)
where: Hc is the level inflation in the foreign country and Hb is the inflation in the home country
Example: A rwanda company is evaluating an investment project in Uganda.

The current spot rate 1FRW = 3.2 Ugshs and the inflation in Uganda is 7% while the inflation
in Rwanda is 6.5%. Determine the spot rate at the end
So = 3.2 , Hc 0.07 and Hb = 0.065
3.2(1+0.07) 1Frw = 3.22

S1 =
(1+0.065)
3.22(1+0.07) 0 1 2 3
S1 =
1+0.065) 3.2 3.22 3.24
Interest rate parity (IRP)

This is used to predict the future spot rate using the interest rates in the two countries
Forward/Future spot rate (S1) = Current spot rate(So)(1+Ic)

(1+Ib)
Where Ic is the interest rate in the foreign country and Ib is the interest in the home country
International Fisher's effect

1 +Ic = (1+hc)
1+Ib (1+hb)
where Ic is the norminal rate in the foreign country and Ib is the norminal rate in
the home country, hc is the inflation rate in the foreign country and hb is inflation
in the home country
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Example: A rwandan company is evaluation an international project. The norminal rate in
Rwanda is 10% whilethe inflation rate is 8.6%. The inflation in Kenya is 6%.
Determine the norminal rate in Kenya
Data Ib = 0.1, hb = 0.086, hc = 0.06 and Ic= ?
1 +Ic = (1+0.06)
(1+0.1) (1+0.086)
Ic = 0.073 = 7.3%
It is the cost of capital to be used when evaluating cash flows in Kenya.
Steps in Evaluating International investment projects
method 1:
1. Forecast the foreign cash flows in the foreign currency
2. Forecast the exchange rate and use it to convert the foreign cash flows into local currency
3. Discount the cash flows using the local cost capital
Method 2:
1. Forecast the foreign cash flows in the foreign currency
2. Determine the foreign cost of capital using the Fisher's effect and use it to discount the cash flows
in the foreign currency
3. Convert the NPV using the current spot rate into the local currency
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Home country is US and foreign country is UK
Initial capital exP 1250 W1 TAD Dep TAD@40%
Scrap value 0 1 250 100
Initial working capita 500 2 250 100
Initial investment 1750 3 250 100
Pre tax in flows 800 4 250 100
project life 5 5 250 100
Tax in UK 40%
Depreciation straight line (1250/5) 250
Exchange rate (1USD = 0.625 pounds)
Inflation rate in USA 3% and in UK 4.5%
Cost of capital 10%
- 1 2 3 4 5
Pre-tax cash inflows 800 800 800 800 800
Tax @40% (320) (320) (320) (320) (320)
EAT 480 480 480 480 480
Tax saving W1 100 100 100 100 100
Initial capital Exp (1,250) -
Working capital (500) 500
Net cash flows (1,750) 580 580 580 580 1,080
Exchange rate W2 0.625 0.634 0.643 0.652 0.661 0.671
Net cash flows in USD (2,800) 915 902 890 877 1,610
DF @10% 1.000 0.909 0.826 0.751 0.683 0.621
PV (2,800) 832 745 668 599 999
NPV 1,044
W2 Exchange rate
Period Spot at start PPP(1+hc)/(1+hb) Spot at end
0 0.625 0.625
1 0.625 (1+0.045)/1+0.03) 0.634
2 0.634 (1+0.045)/1+0.03) 0.643
3 0.643 (1+0.045)/1+0.03) 0.652
4 0.652 (1+0.045)/1+0.03) 0.661
5 0.661 (1+0.045)/1+0.03) 0.671
Method 2
- 1 2 3 4 5
Pre-tax cash inflows 800 800 800 800 800
Tax @40% (320) (320) (320) (320) (320)
EAT 480 480 480 480 480
Tax saving W1 100 100 100 100 100
Initial capital Exp (1,250) -
Working capital (500) 500
Net cash flows (1,750) 580 580 580 580 1,080
DF in UK W3 (11.6%) 1.000 0.896 0.803 0.719 0.645 0.578
PV (1,750) 520 466 417 374 624
NPV= 650
Convert NPV at spot rate = (650/0.625)
NPV= 1,040
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W2 DF in UK (International Fisher's effect)
(1+Ic) = Ic
(1+hc)
=? Hc 0.045
(1+Ib) Ib=
(1+hb)
0.1 and hb = 0.03
1+Ic = (1+0.045)
(1+0.1) (1+0.03)
Ic = 11.6%
International Financing Decision
This is about raising the required funds to be used by the entity. The entity
can raise funds through participating in the finacial market
Financial market:
It is a platform where financial securities are traded. The financial market
is divided into two that is the money market and the capital market.
Money Market: Is the market where short term securities are traded. The
players in the money market are the financial institutions. The financial
instruments include:
a. Certificate of deposite
b. Bank's acceptance
c. Commercial papers
d. Treasury bills
e. Repurchase agreements
f. Forward and future contracts
Capital markets: It is a market where long term securities are traded. The key instruments
are:
1. Bonds and debenture
2. Common stock
3.Preference shares.
The capital market is classfied into two that the primary market and secondary market
Primary market: It is when an entity issue new security
Secondary market: It is market where securities that were purchsed in primary are retraded
Internationational Financial market

a. International money market
b. International capital market
a. Euro bond/
Page 89 of 127
INTRODUCTION TO CORPORATE FINANCE
Corporate finance is the allocation and utilisation of financial resources in order to achieve
the financial objectives of the entity
Financial objectives
1. Profit maximisation profit = TR -TC
2. Wealth maximisation
Non financial objectives

a. Welfare condition of the employees
b. Welfare condition of the mgt
c. Responsibilities towards customers
d. Responsibilities towards Suppliers
e. Responsibilities towards Government
f. Responsibilities towards community
Corporate governance
It is the way entities are directed and controlled.
Principles of corporate governance
a. Integrity: It means that the board members should be honest and straight forward
b. Fairness: The board should be fair when persuing their obligations.
c. Responsibility: The board members should be held responsible for their actions
d. Accountability: The board members should be held accountable for they have done.
e. Transpancy:
Best practice of corporate governance
1. Composition of the board members: (The board should be composed of both the
executive and non executive directors)
2. Board size: The number of the board should be large enough and at least 1/3 should be
non executive directors
3. Independence of the board: The board members should independent when taking decisions.
4. Balance of skills: The board should have sufficient and diversity of skills
5. Seperation of roles of the chairman board and CEO
6. Existence of board comittees and the chairs of the board committee
a. audit committee it should headed by non executive director
b. remuneration committee
c. appoitment committee
Agency Theory
The agency theory arises due to the fact that the owners of the firm are not the
one who manages the company. The owner appoints directors to manage the
the firm on their behalf and the directors appoit managers to assist them
in the management. Therefore, is an agency relationship between the managers and
the directors and an agency relationship between the shareholders and the managers.
Page 90 of 127
Agency problem
The agency problem arises due to the conflict of interest between the principal and the agent
Agency costs
They arise due the agency problems and they include:
a. Monitoring costs
b. Accounting costs
b. Legal costs
Resolving the agency problem:

a. Goal congruence: Having common purpose and objective
b. Profit bonus related pay
c. Share options schemes ( to management and key employees)
d. Value added bonus related pay
Stakeholders
a. Internal stakeholders (employees and management)
b. Connected stakeholders( shareholders, customers, suppliers ect)
3. External stakeholders (Government, community)
Note: The agency relationship with the different stakeholders arises due the influnce
of the agent on the companies activities or how the companies actvities can affect the
agent
Corporate social responsibility (CSR)

There are four level of CSR which are:
a. Economic responsibility: The economic responsibility is to give a sufficient return to the owners
b. legal responsibility: Abiding to the rules and regulation of the country
c. Ethical responsibilities: Abiding to the social ethical values of the community
d.Philanthropic responsibility: Giving back to the community
Advantages of CSR
RISK & HEDGING
RISK
Risk is a negative deviation from expected result
Types of risk:
Foreign currencies risk Political Risk
Transaction risk Interest Risk
Translation risk Financial Risk
Economic Risk Business Risk
HEDGING
Is the mecanism or process of transfering risk from one patry to another
Page 91 of 127
Foreign Currency risk hedging
This involves hedging the volotarity or the movement of foreigh exchange
Key Term (most examined)
Exchange Rate: it is the rate at which one currency can be converted into onather currency
Sport Rate: Is the current exchange rate in the market
Buying Rate: Is the rate at which the bank buys a foreign currency,
Selling Rate: Is the rate at which the bank sell the foreign currency,
QUOTATION OF FOREIGN CURRENCY

There are:
1. Direct Quotation
2.Indirect Quotation
1. Direct Quotation : The Home currency is variable but the foreign currency is stable
2. Indirect Quotation: The Home currency is stable but the foreign currency is variable
Direct = 1/Indirect eg: USD/FRW 1,000 1,020

FRW/USD 1,000 1,020
Buying Selling
Rules: the home currency is the one that is changing
Inderect quotation
Under this a currency is quoted as a fraction

Under this the home currency is stable while the foreign currency is variable
FRW/USD 0.001 0.009

Selling Buying
Methods of foreign currency Hedging
Invoicing in local currency
Matching
Netting
Leading & Lagging
Forward Contact
Money Market
Future Currency
Option Currency
Swaps
1. Invoicing in local currency

This involves invoicing both the receipts and payment in a local currency,
Page 92 of 127
2. Matching
Involves matching the receipt and payment which occur in the same period
3. Netting
Is clasified into two:
Bireteral Netting
Multirateral Netting
Bireteral Netting : this involves matching the receipts and payment of two companies which are in a
group
Multirateral Netting: It involves matching receipt and payment of more than 2 companies which are
in a the same group which trade together
Steps in Multirateral Netting:
Step 1: Constract a table showing a paying company a cross and a receiving company downwards
Step 2: Add across to determine the total receipts and downwards to get the total payments
Step 3: Net the receipt and the payment
Company X has a head office in Rwanda and 2 branches one in Uganda and another I Kenya
All companies are trading together. The following transaction took place for the period
ended June
1. A Rwanda Company sold goods of FRW 50 and FRW 70 to Ungandan and Kenya Subsidiary respectivelly
2. The Ugandian Company Sold goods of UGS 100M and UGS 120M to Kenya and Rwanda Co respectivelly
3. The Kenya subsidiary sold goods of KSH 10M and KSH 20M to Rwanda and Uganda Co Respectivelly
Exchange Rate
1KSH = 8.5 FRW
1FRW = 4.5 UGS
Determine the Nett Hedging Effect and Comment on your answer
Solution
FRW UGS KSH TOTAL RECEIPT

TOTAL PYMNTNEETING
FRW 50,000 70,000 120,000 111,667 8,333
UGS 26,667 22,222 48,889 220,000 (171,111)
KSH 85,000 170,000 255,000 92,222 162,778
NETTING EFFECT -
Comments: Since UG has negative effect, Uganda need father hedging
Ex 2
Company X has a head office in Rwanda and 2 branches one in Uganda and another I Kenya
All companies are trading together. The following transaction took place for the period
ended June
Page 93 of 127
1. A Rwanda Company sold goods of FRW 100 and FRW 50 to Ungandan and Kenya Subsidiary respectivelly
3. The Kenya subsidiary sold goods of KSH 5M and KSH 10M to Rwanda and Uganda Co Respectivelly
2. The Ugandian Company Sold goods of UGS 200M and UGS 150M to Rwanda and Kenya Co respectivelly
The mgnt In the headquorter they want to hedge risks associate with the transaction:
Exchange Rate
1KSH = 8.5 9. 0 FRW
1FRW = 3.5 4.0 UGS
Buying Silling
Required
Evaluate which transaction require more hedging
FRW KSH UGS TOTAL RECEIPT

TOTAL PYMNTNEETING
FRW 50,000 100,000 150,000 95,000 55,000
KSH 45,000 90,000 135,000 87,500 47,500
UGS 50,000 37,500 87,500 190,000 (102,500)
NETTING EFFECT -
We should hedge the risk with UGS because that’s where we have negative effect
4. leading and lagging

this involves accelerating or delay a payment in order to avoid a risks of loss in foreign exchange
Forward Contract: Is a contract to buy or sell foreign currency at future date

Forward Contract can be quotated at either a premium or at a discount. If a contract is
quotated at premium a forward rate is equal to:
A forward contract can either be quotated at a premium or at

If it is quated at a premium; then:
Forward Rate = Sport Rate - Premium

On the other hand if it is quoted at discount the forward rate will be equal to
Forward Rate = Sport Rate + Discount
Forward Contract Value = Contract Value + Forward Rate
5. Money
This involves borrowing in one currency and depositting in onather currency
If a company expect a payment it will borrow in local currency and deposit in foreign currency
Similary the company expect a foreign receipt, it will borrow in foreign currency and
deposit in local currency.
Page 94 of 127
june 2015 Q3
Three months transaction
Receipt 197,000
Payment (116,000)
Net Receipt 81,000
Selling buying
Sport Rate 0.125 0.159
Sport Premium (0.008) (0.0077)
Forward Rate 0.117 0.151
Forward Market
Transaction Value 81,000

Forward Contract Rate 0.151
Forward Contract Value 535,360
Page 95 of 127
Money Market
Rwanda Kenya
Deposit 74,312 Borrow 81,000
Sport Rate 0.159 Borrowing rate 0.09
467,371 81,000
Deposit rate 0.095 (1+0.09) = 74,312
Value 467,371 (1+0.095) 511,771
Six MonthsTransaction
Match
Payment 447,000
Receipt (154,000)
Net Payment 293,000
Forward Contract
Sport Rate 0.125 0.159

S& Months Premium (0.00102) (0.00124)
Forward Rate 0.12399 0.15776
Selling Buying
Transaction Value 293,000

Forward Contract Value 293,000
Forward Contract Rate 0.12399
2,363,189
Money Market
Rwanda Kenya
Deposit 276,415 Borrow 293,000
Sport Rate 0.125 borrowing rate 0.06
2,211,321 PV 293,000
Deposit rate 0.125 (1+0.09) = 276,415
(2,211,321)*(1+0.125) = 2,487,736
Page 96 of 127
PP June 2018 Q2
Solution
Total Payment 2,160,000
Total Receipt 2,000,000
Net Payment 160,000 CHF
Forward Contract
Sport Rate CHF/FRW 897.15 903.7
Buying Selling
Forward Rate Premium 4.5 3.5 Premium

Farward Rate 903.7-3.5 = 900.2
Forward Value 160,000*900.2 = 144,032,000
Borrow Deposit
Rwanda 10% 6%
Switsland 6% 2%
Page 97 of 127
Money Market
Rwanda Switzland
Borrow 156,863 Deposit 160,000
Sport Rate 903.70 Deposit Rate 2% 2%
141,756,863 PV = 160,000/(1+0.02) 156,863
Borrowing Rate 10% 10%
Cost 141,756,863/[1+0.08) 155,932,549
Leading the contract

Sport rate 903.7
Premium 1.5
Forward Rate 902.2
Value 160,000*902.2 144,352,000
Opportinity cost of interests foregone (144,352,000*6%)2/3 5,774,080
Total Leading cost 150,126,080
No date to compute future contract

No data to compute option currency
[1 + 𝑖𝑎]
𝐹 = 𝑆𝑜
1 + 𝑖𝑏
F = Forward rate
So = Sport Rate [1 + 0.08]
𝐹 = 𝑆𝑜
ia = Interest at home rate 1 + 0.04
ib = Interest at Foreign rate
902.2 ∗ 1.04
1.08
Example
Co X import and export differents goods. On 1st Jan 2023 Company import goods from China
Worth USD 500,000 and also exported coffee to China worth USD 1,200,000 when the exchange
rate was FRW/USD 00098 - 000099
The goods are payable after 4 months that is on 31st April 2023. The FRW is appreciating against
the USD and the management are worried on the exchange rates and therefore they want to hedge
the currency receipts using appropriete hedging method.
The finance director has consulted one bank and it quoted aforeward contract at 0.005 - 0.0004
cents. The borrowing and deposit both in china and Rwanda is as below
Borrowing/year Deposit/year
Chine 7% 5%
Rwanda 11% 8%
Page 98 of 127
Required:
Advice the management on the best way to hedge the currency receipt
Solution
Direct Quotation:
0.00098 0.00099
Selling Buying
See PDF Shared to Damascene of Scanned
Page 99 of 127
March 2022 Q2 b
Page 100 of 127

payment 20,000,000
Receipt (9,500,000)
Net Paytment 10,500,000
Forward Contract
Transaction Value 10,500,000
Sport rates 8.50 9.50

Premium (1.20) (1.50)
Forward Rate 7.30 8.00
Forward Contract = 10,500,000 * 8.0 = 84,000,000
Lagg the contract

Sport rate on 30th June 12.50 14.50
Cost = 10,500,000 x 14.5 = 152,250,000
Leading the contract the contract;

28th February
Sport Rate; 10.1 11.5
Lead cost = 10,500,000 x 11.5 = 120,750,000

Interest Forgone =(120,750,000 x 10%)x4/12 4,025,000
124,775,000
Money Market
Rwanda Kenya
Borrow 10,096,154 Deposit 10,500,000
Sport Rate 9.50 Deposit Rate 8%*6/12 4%
95,913,462 PV = 10500000/(1+0.04) 10,096,154
Borrowing Rate 16% x 6/12 8%
Cost 95,913,462[1+0.08) 103,586,538
Future Currency contract
Is a standardised contract to buy or sell foreign currency at future date
The difference between a future contract and a Forward Contract, is that a

"Forward Contract" is customised and sold over the counter.
On the other hands, a "future contract" is standerdised and can be sold both over
the counter and in open market.
Page 101 of 127

Basis Risk
The basis risk is the risk that a future contract price will vary from the sport price.
Step 1: Identify the contract period

Step 2: Identify the type of the contract: If you expect a payment the contract is going
to be a sell and buy On the other hands expecting a receipt the contract is a
buy and sell,
Step 3: Determine the number of contract
Transaction Value
Number of contract =
Size of the contract
Step 4: Determine the hedging outcome
Future Price XX
Sport Price (XX)
Basis Points XX
Month of unxpired
Unexpired Basis = x Basis Point
Total Month
Closing Future Price
Sport at the end of the contract +/- Unxpired Basis Contract
Opening Future contract Price XX

Closing future contract Price XX
Profit on Contracy XX
No of contract x size of contract x
Example
Co X purchased goods on credit from a Kenyan supplier woth KSH 5 milliom, the
goods are payable in 3 month time that is on 28th February 2023.
The current sport rate is:1Ksh = 9.1 9.5 Frw

and the expected sport rate is 9.8 10.5 Frw
Due to volotarity in the exchange rate, the company entered into a future contract
There current future contract price is 9.3 9.8 FRW
and will expire on 30th Apr. 2023
Each contract, is of KSH 500,000
Required:
Page 102 of 127

Determine the future contract hedging value
Solution:
Contract Period : Selling - Buy
Contract Value 5,000,000
Contract Size 500,000
Number of Contract = 5,000,000/500,000 = 10
December Feb March

Future Price 9.80
Sport Rate 9.50
Basis 0.30 (2/5*0.3)=0.12
Unxperired Period 5.00 2
Closing future price = 10.5 + 0.12 = 10.62

Profit/Loss on contract
Opening future price 9.8 Selling
Closing Future Price 10.62 Buying
Loss (0.82)
Total Profit /Loss on Contract
Number of Contract x Contract Size x Profit per contract
10 x 500,000 x (0.82) (4,100,000)
Net Hedging
Contract Value @ Sport rate
5,000,000 x 10.5 = 52,500,000
Loss 4,100,000
Future Value 56,600,000
Example: New
Company X imported goods from chine at USD 2,000,000 on 1st January 2023
The sport rate on 1st january was USD/RWF 1050 - 1072
The sport rate on 30th June was USD/RWF 1060 - 1079
The company want to hedge the currency risks. Bellow are the relevant information related
to the hedging market;
Forward Market: The forward market is quoted at a premium USD/FRW 2 - 3 FRW
Money Market:
Chine Rwanda
Borrowing 8% 14%
Deposit 6% 10%
Future Market
The current future market is selling at USD /FRW 1058 - 1074 and is of USD 50,000 each
and it will expire on 31st August 2023. the payment are expected on 30th June 2023.
Required:
Advise the company on the most appropriete way to hedge the currency risks,
Page 103 of 127

Solution
Future Market
step 1:
Contract type: buy /sell
Step 2:
Contract Period : 6 months
Number of contract 2,000,000/50,000 = 40 contracts
Janury June
Future price 1074
Sport rate 1072
Basis Point 2
Un expired period (2/8*2) 0.5
Closing future Price 1079+0.05 1079.5
Price per contract

Opening future price 1,074.00
Closing future price 1,079.50
5.50
Market Profit = 40x50,000x5.5 = 11,000,000
Value of Sport [2,000,000*1079] 2,158,000,000

Profit (11,000,000)
Future Contract Cost 2,147,000,000
Option Currency contract

An option is a right but not an obligation to buy or sell currency at future date
Key Terms in Option contract

1. Exercise price
It is the price at which the contract will be exercise
2. A premium
It is the price paid for entering into an option contract
3. Call option
Is a contract to buy a currency at future date
3. Put Option
It is a contract to sell currency at future date
Steps
Step 1: Identify the contract period
Step 2: Identify a contract type
Step 3: Determine no of contract
Step 4: Determine contract premium = No of contract*Contract Size*Primium per contract
Step 5: get the hedging effect = Value at exercise Price + Premium
Page 104 of 127

Value of a Call
− 𝑖𝑡
𝐶 = 𝑃𝑎 𝑁 𝑑𝑟 − 𝑃𝑒𝑁 𝑑2 𝑒
C= Value of Call
Pa= Market Price
N(dr)d2= are Normal distribution
Pe= Exercise Price
e=exponantial f(x)
r = risk
t=period
𝑃𝑎
𝑑𝑟 = +(r+
𝑝𝑒
CURRENCY SWAP
It is an agreement to exchange currency at future date
INTERST RISK HEDGING

Arises in the volotarity in the interest rate
The following method are used in interest risk hedging:

Methods:
1. Matching 4. Option Interest Contract
2. FRA Forward rate agreements 5. Swaps
3. Future interest Contract
1. Matching
Envolves matching the assets and liabilities
2. FRA Forward rate agreements
It is a contract to buy or sell interests at future date
It is only traded over the counter
Example:
March 2022 Q2
Quotation of Interest
Interest are quoted in index
To get the interest rate it will be 100 - Index
Page 105 of 127

Page 106 of 127
PP December 2021 Q2
NBK rate 3.5
Loan 450,000,000
Basis Point (50/100) 0.50
Interest 3.5+0.5+0.9 4.90
Refer to PP correction
MOCK CORRECTION A2.1
Page 107 of 127

A. CAPITAL RATIONING PROJECT DIVISABLE
MANGO JUICE Period cash flows D.F 12% PV
0 (250,000) 1.000 (250,000)
1 80,000 0.893 71,429
2 100,000 0.797 79,719
3 58,000 0.712 41,283
4 120,000 0.636 76,262
5 78,000 0.567 44,259
NPV = 62,953
PI = 1
Bitoki wine Period cash flows D.F 12% PV
0 (150,000) 1.000 (150,000)
1 80,000 0.893 71,429
2 50,000 0.797 39,860
3 40,000 0.712 28,471
4 65,000 0.636 41,309
5 100,000 0.567 56,743
NPV = 87,811
PI = 2
Orange wine Period cash flows D.F 12% PV

0 (200,000) 1.000 (200,000)
1 50,000 0.893 44,643
2 40,000 0.797 31,888
3 70,000 0.712 49,825
4 30,000 0.636 19,066
5 20,000 0.567 11,349
NPV = (43,231)
PI = 1
Apple Juice Period cash flows D.F 12% PV

0 (400,000) 1.000 (400,000)
1 150,000 0.893 133,929
2 100,000 0.797 79,719
3 90,000 0.712 64,060
4 120,000 0.636 76,262
5 80,000 0.567 45,394
NPV = (636)
PI = 1
Page 108 of 127

Mineral Water Period cash flows D.F 12% PV
0 (100,000) 1.000 (100,000)
1 60,000 0.893 53,571
2 50,000 0.797 39,860
3 35,000 0.712 24,912
4 70,000 0.636 44,486
5 60,000 0.567 34,046
NPV = 96,875
PI = 2
Lion Gin Period cash flows D.F 12% PV

0 (250,000) 1.000 (250,000)
1 100,000 0.893 89,286
2 120,000 0.797 95,663
3 80,000 0.712 56,942
4 50,000 0.636 31,776
5 90,000 0.567 51,068
NPV = 74,736
PI = 1
Acceptable projects
Project Io PI Rank
MANGO JUICE 250,000 1,252 4
Bitoki wine 150000 1.585 2
Mineral Water 100,000 1.969 1
Lion Gin 250,000 1.299 3
Allocation of resource to projects

Amt
projects Allocated NPV
required
Mineral water 100,000 100,000 96,875
Bitoki wine 150,000 150,000 87,811
Lion Gin 250,000 250,000 74,736
Mango juice 250,000 100,000 25,181
750,000 600,000 284,603
Projects not divisable

Combination IO NPV
Mi +Bi +Li 500,000 259,422
Ma+ Li + Mi 600,000 234,564
Mi+BI+Ma 500,000 247,639
Page 109 of 127

iii. Sensntivity analysis
Sensitivity of mango project
Sensitivity of intial investment = NPV/PV Io
NPV 62,953
IO 250,000
Sensitivity 25%
Sensitivity of PV of cash inflows = NPV/PV cash inflow
Sensitivity = 20%
PV of cash inflows = (62,953+250,000) 312,953
NPV = PV cash in flows - IO
Sensitivity of Bitoki wine

Io 150,000
NPV 87,811
Sensitivity of IO= 59%
Sensitivity of cash inflo 37%
Required
b. Using NPV evaluate whether the old machine should be replaced (8 marks)
Page 110 of 127

Replacement decision
Old machice
Cost 100,000,000
Useful life 15yrs
Residual value 20,000,000
Dep of old machine 5,333,333
ACC depre. (5,333,333*5) 26,666,667
Market value 60,000,000
BV 73,333,333
New machine
cost 250,000,000
Useful life 10
RV 50,000,000
Dep of new machine 20,000,000
W1 Incremental investment cost

cost of new machine 250,000,000
Less market value of old M (60,000,000)
Tax saving (13,333,333*30%) (4,000,000)
186,000,000
W2 Gai/loss on
Market value 60,000,000
Book value 73,333,333
Loss (13,333,333)
W3 Incremental depreciation
Depreciation of new machine 20,000,000
Depreciation of old machine 5,333,333
14,666,667
Note: Depreciation is irrelevant if there is no tax
W4 Incremental Residual value
Residual value of new machine 50,000,000
Residual value of old machine 20,000,000
Incremental 30,000,000
Incremental operating cash flows

Old machine New machine incremental
Sales revenue 25,000,000 25,000,000
Operating cost 7,000,000 7,000,000
Mentainance cost 4,000,000 4,000,000
Working capital (8m - 3m) (5,000,000)
Page 111 of 127

Cash flow analysis
Sales revenue 25,000,000
Operating cost 7,000,000
Mentainance cost 4,000,000
EBDT 36,000,000
Less Dep W3 (14,666,667)
EBT 21,333,333
Less tax @30% 6,400,000
EAT 14,933,333
Add back dep 14,666,667
Cash flows 29,600,000
Working capital (5,000,000)
Net cash flows 24,600,000
Items Period Cash flows DF 9.4%

Incre Io 0 (186,000,000) 1 (186,000,000)
Operating cash 1to 10 24,600,000 6 155,132,356
Residual value 10 35,000,000 0 14,252,624
NPV (16,615,020)
The old machine should not be replaced
W5 Cost of capital
Ke = 14%, Kd = 9% Vd 0.6 , Ve 0.4 T = 0.3
Kd = 0.09(1-0.3)= 0.063
Equity 0.4 0.14 0.056
Debt 0.6 0.063 0.038
WACC 9.4%
Page 112 of 127

Required
c Advise the management whether they should go on with diversification by taking over GRL (10 Marks)
W1 EBIT 1 2 3 4 5
EBIT 20,000 22,000 24,200 31,460 40,898
W2 Depreciation 1 2 3 4 5
OC 50,000 55,000 60,500 66,550 73,205
Depreciation 10,000 11,000 12,100 13,310 14,641
W3 Capital investment
0 1 2 3 4 5
Asset 100,000 110,000 121,000 133,100 146,410 161,051
Incremental 10,000 11,000 12,100 13,310 14,641
W4 Working capital
0 1 2 3 4 5
WK 40,000 48,000 57,600 72,000 90,000 9,000
Incremental 8,000 9,600 14,400 18,000 (81,000)
Free cash flows

1 2 3 4 5
EBIT W1 20,000 22,000 24,200 31,460 40,898
Less tax @30% 6,000 6,600 7,260 9,438 12,269
EAT 14,000 15,400 16,940 22,022 28,629
Add back DepW2 10,000 11,000 12,100 13,310 14,641
Less capital W3 (10,000) (11,000) (12,100) (13,310) (14,641)
Less Wk W4 (8,000) (9,600) (14,400) (18,000) 81,000
Free cash flows 6,000 5,800 2,540 4,022 109,629
DF 13% 0.885 0.783 1 0.613 0.543
PV 5,310 4,542 1,760 2,467 59,502
Terminal 109,629(1+0.065)
1,796,229
Value = 0.13 - 0.065
Page 113 of 127

PV of teminal value = 1,796,229*0.543 974,921
Total PV 73,581
Value of business 1,048,502
Value debt (100,000)
Value of Equity 948,502
Required
d. Advise the management on whether ARL should go on with the introduction of a
new product line using IRR (9 marks)
e. Assess whether the machines should be purchased or leased (7 Marks)
Organic growth evaluation using IRR

W1 Revenues 1 2 3 4 5
Units 100 150 140 200 250
Price 800 800 800 800 800
Inflation (1+0.05) 1.050 1.103 1.158 1.216 1.276
Revenues 84,000 132,300 129,654 194,481 255,256
Page 114 of 127

W2 Variable costs 1 2 3 4 5
Units 100 150 140 200 250
VC/U 300 300 300 300 300
Inflation (1+0.04) 1.040 1.082 1.125 1.170 1.217
Variable cost 31,200 48,672 47,244 70,192 91,249
W3 Fixed cost 1 2 3 4 5
Amount 20,000 20,000 20,000 20,000 20,000
1.040 1.082 1.125 1.170 1.217
Inflation 20,800 21,632 22,497 23,397 24,333
W4 Working cap 0 1 2 3 4 5
WK 100,000 104,000 108,160 112,486 116,986
Incremental -100,000 (4,000) (4,160) (4,326) (4,499) 116,986
W5 Tax allowable depreciation (tax saving)
Cost 400,000 DR = 25%
RV 50,000
period depreciationNBV TAD @30%

1 100000 300,000 30,000
2 75000 225,000 22,500
3 56250 168,750 16,875
4 42187.5 126,563 12,656
5 76,563 50,000 22,969
NPV @ 12%
0 1 2 3 4 5 6
Revenues W1 84,000 132,300 129,654 194,481 255,256 -
Variables cost W2 (31,200) (48,672) (47,244) (70,192) (91,249)
Fixed cost W3 (20,800) (21,632) (22,497) (23,397) (24,333)
EBDT 32,000 61,996 59,912 100,892 139,674
Less tax @30% (9,600) (18,599) (17,974) (30,268) (41,902)
EAT 32,000 52,396 41,314 82,919 109,407 (41,902)
Tax saving 30,000 22,500 16,875 12,656 22,969
Capital invest (400,000) 50,000
Working capital (100,000) -4,000 -4,160 -4,326 -4,499 116,986
Net cash flows (500,000) 28,000 78,236 59,487 95,294 289,049 (18,934)
DF 12% 1 0.893 0.797 0.712 0.636 0.567 0.507
PV (500,000) 25,000 62,369 42,342 60,561 164,014 (9,592)
NPV= (155,306)
NPV @ 1%
0 1 2 3 4 5 6
Net cash flows (500,000) 28,000 78,236 59,487 95,294 289,049 (18,934)
DF @ 1% 1.000 0.990 0.980 0.971 0.961 0.951 0.942
PV (500,000) 27,723 76,694 57,738 91,576 275,020 (17,836)
NPV= 10,914
Page 115 of 127

method two 0 1 2 3 4 5 6
Revenues W1 84,000 132,300 129,654 194,481 255,256 -
Variables cost W2 (31,200) (48,672) (47,244) (70,192) (91,249)
Fixed cost W3 (20,800) (21,632) (22,497) (23,397) (24,333)
EBDT 32,000 61,996 59,912 100,892 139,674
Less Dep (100,000) (75,000) (56,250) (42,188) (76,563)
EBT (68,000) (13,004) 3,662 58,705 63,112
Tax @30% 20,400 3,901 (1,099) (17,611) (18,934)
EAT (68,000) 7,396 7,564 57,606 45,500 (18,934)
Add dep 100,000 75,000 56,250 42,188 76,563 -
EA 32,000 82,396 63,814 99,794 122,063
capital -400,000 50,000
Working capial -100,000 (4,000) (4,160) (4,326) (4,499) 116,986 (18,934)
Net cash flows -500,000 28,000 78,236 59,487 95,294 289,049 (18,934)
Purchase option
0 1 2 3 4 5 6
Purchase cost (400,000) 50,000
Tax saving W5 30,000 22,500 16,875 12,656 22,969
net cash flows (400,000) 30,000 22,500 16,875 62,656 22,969
DF 10.5% 1.000 0.905 0.819 0.741 0.671 0.607 0.549
PV (400,000) - 24,570 16,676 11,319 38,032 12,617
PV. Cost of purchase = (296,786)
Note: The DF depends on how the asset is financed
Kd = 0.15(1-0.3) 10.5%
Option two Lease

0 1 2 3 4 5 6
Lease rental (100,000) (100,000) (100,000) (100,000) (100,000)
Tax saving 30,000 30,000 30,000 30,000 30,000
Net cash flows (100,000) (100,000) (70,000) (70,000) (70,000) 30,000 30,000
DF 10.5% 1.000 0.905 0.819 0.741 0.671 0.607 1
PV (100,000) (90,498) (57,329) (51,881) (46,951) 18,210 16,480
PV.cost of lease (311,970)
It is cheaper to purchase the asset
Page 116 of 127

Question Four
MTK Rwanda limited has been operating in Rwanda for many years. The company’s management
is worried of the increasing level of gearing. Below are the draft financial reports of the company
for the year ended 31/12/2121
Statement of profit and loss for the year ended 31/12/2021
Items FRW (000)

Gross profit 230,800
Operating expenses (120,000)
EBIT 110,800
Finance cost (80,000)
EBT 30,800
Tax (9,240)
EAT 21,560
EPS 21.56
Statement of financial position as at 31/12/2021
Items FRW (000)

P,PE 500,000
Current assets 200,000
Total assets 700,000
Equity and liabilities
Equity
Ordinary share capital @250 frw each 250,000
10% Redeemable Debenture @1000 frw each 400,000
Current liabilities 50,000
Total equity and liabilities 700,000
Other relevant information
1. The current market price of each ordinary share is 300FRw while the current market price
of debenture is 1050FRW.
2. The redeemable debenture will be redeemed at par after five years
3. The corporate income tax is 30%
Required:
a. Comment on the operating and financial gearing of the company (4 marks)

b. Assess whether the company is threated with a corporate failure (4 marks)
c. Using the traditional theory of capital structure, determine the cost of capital (5 marks)
d. Assuming that the company wants to introduce an additional debenture of
100,000,000FRW at the same cost of capital. Assess the effect of issuing additional
debenture on the value of equity and WACC (4 marks)
Page 117 of 127

a. Operating and financial Gearing
Operating gearing = Contribution/EBIT or EBIT/Contribution
Gross profit 230,800

EBIT 110,800
OG = 110,800/230,800 48%
The fixed costs are only 48% of the contribution
Financial gearing = EBIT/EBT (110,800/30,800)= 3.597

There is high level of financial gearing
b. Assessing the corporate failure
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1 X5
Where X1 = Working capital/total assets

Working capital (200,000- 50,000) 150,000
Total assets 700,000
X1 = 0.214
X2 = Retained earnings/Total assets

Retained earnings 21,560
X2 = 0.031
X3 = EBIT/Total assets
EBIT 110,800
X3= 0.158
X4 = Market value of equity/Book value of liability

market value of equity = (250,000/250)*300 300,000
Book value of liability = (50,000+400,000) 450,000
X4 = 0.667
X5 = Sales/Total assets
Sales 800,000
X5 = 1.143
constant Z-score
X1 1.2 0.214 0.257
X2 1.4 0.031 0.043
X3 3.3 0.158 0.522
X4 0.6 0.667 0.400
X5 1 1.143 1.143
2.365
If the Z-score is 1.8 and above, the company is not threatened with
corporate failure
Page 118 of 127

c. Determining the cost of capital using the tradition theory
Cost of redeemable debenture

Par value 1000
Interest rate 10%
Interest = (10%*1000)(1-0.3) = 70
RV 1000
Market value 1050
n 5
Itemss period cash flow DF 10% PV

Market value 0 -1050 1 (1,050)
Interest 1 to 5 70 3.791 265
rV 5 1000 0.621 621
NPV (164)
Itemss period cash flow DF 5% PV

Market value 0 -1050 1 (1,050)
Interest 1 to 5 70 4.329 303
rV 5 1000 0.784 784
NPV 37
Irr = 0.1 + (-164) (0.05 - 0.1) IRR = 5.9%
(-164-37)
Cost of equity (Ke)
Ke = Dividend/Market value of equity
Market value of equity = (250,000/250*300) 300,000

Dividends 21,560
Ke = 7.2%
Market Weighted
Cost
Source value cost
Equity 300,000 0.072 21,600
Debt 420,000 0.059 24,780
720,000 46,380
WACC = (46,380/720,000) = 6.44%
c. Effect of iisuing additional debt

Vg = Vu + DTS
720,000 = Vu + (420,000*30%)
Vu = 720,000 - 126,000 594,000

Additional debt= 100,000
New debt (100,000 +420,000) 520,000
Page 119 of 127

Vg = Vu + DTS = Vg = 594,000 + (520,000*30%)
Vg =
Ve = Vg - Vd = 750,000 - 520,000= 230,000
Issuing additional will lead to a decrease in the value of equity
Effect of debt on WACC
0.072 = Ku + (ku - 0.059)420/300 = 6.44%
Cost of equity after issuing additional debt
Ke = 0.0644 + (0.0644 - 0.059)*520/230

Ke = 7.70%
Market Weighted
Source cost
value cost
Equity 230,000 0.077 17,710
Debt 520,000 0.059 30,680
750,000 48,390
WACC = (48,390/750,000) = 6.45%
a. Invange International Limited deals in restaurant business with a number of branches

within and outside Rwanda. The novel COVID-19 pandemic has affected many of the
company’s operations which have led the company to start operating in losses.
Furthermore, the company’s gearing level seems to swelling and the company’s share price
is decaying in the market. The senior management are worried of the current situations on
the business and thinks that if the situation is not addressed the company may fail. The
board meeting that sat on 31/12/2021 passed a resolution to restructure some of the
business operations.
Required:
i. Explain the indicators of business failure (4 marks)

ii. Debate on the available options to restructure the business activities (4 marks)
Indicators of corporate failure

1. failure to control costs
2. failure to control cash
3. Failure to pay tax
4. Failure to focus on specific market
Restructuring
Business re-organisation
i. lay off some employees
ii. Business re-engenearing
Financial restructuring
Debt to equity Swap
Page 120 of 127

Dividend policy
Portfolio restructuring
1.Divistement
2, sale off
3. MBO/MBI
4. Spin off
Question five
a) Kazimoto Rwanda limited deals in imports and exports of various items including agriculture and
non-agriculture products. 0n 1/1/2022 the company purchased goods from USA supplier worth
$2,000,000 on credit and also sold goods worth 500,000$ on credit. Both receipts and payments
are expected on 30/4/2022. The spot rate 1/1/2022 is 1$ = Frw1015 – 1030. Due the current
economic crisis, the Rwandan francs are losing against the USD and the management is worried is
that if the situation continues, the company will incur a big loss. The board meeting approved to
hedge the currency risks and therefore tasked the director of finance to find the best alternative to
hedge the risks.
Information about the option market

The current option size in the market is $100,000 options and is selling at 1$ = 1029 -1035 and the
Premium cost per contract
Call Option Put Option

Excise June July August September June July August September
price
1015 5.6 6.2 6.5 7.0 2.5 2.9 3.5 4.2
1020 4.5 5.0 5.3 6.2 2.0 2.5 3.2 4.0
1035 3.8 4.5 4.6 5.1 1.6 2.0 2.6 3.1
1040 4.0 4.8 5.0 6.0 1.5 2.2 2.5 3.0
The spot rate on 30/4/2022 is 1$ = 1027- 1033
Information about money market
Deposit rate per annum Borrowing per annum

Rwanda 9% 16%
USA 5% 9%
Information about future market
The contract size is 200,000USD expiring on 30/6/2022 and is currently selling at 1$= 1028-1039 and
the spot rate on 30/4/2022 is 1$ = 1027- 1033
Information about forward market

The one month forward contract is currently quoted at 1$ = 1.2 – 1.45cents premium while the four
month forward contract is quoted as 1$ = 1.8 – 2.5cents discount
Required
As the director of finance of the company, advise the management on the best market to hedge the
foreign currency risks (15 Marks)
Page 121 of 127

Foreign currency risk hedging
a. Option currency risk hedging
Exercise price1029 - 1035
Matching
Payment 2,000,000
Receipt -500,000
Net payment 1,500,000
Type of the contract = currency call option

Contract period 4 months
Number of contracts = (value/size) = 1,500,000/100,000
No. of contracts = 15
Premium per contract = 5.1
Total premium = No.contract* premium per contract*size of contract

TP = 15*5.1*100,000 = 7,650,000
Value at exercise price (1035*1.5m) 1,552,500,000

Option value 1,560,150,000
Money Market
Rwanda USA
Borrow 1,475,361 Deposit 1,500,000
Spot rate 1030 Dep rat (5%*4/12) = 1.67%
Value 1,519,622,307 PV = 1,500,000/(1+0.0167)
Borrowing rate (16%*4/12) = 5.3% PV = 1,475,361
Fv = 1,519,622,307(1+0.053)
MM value 1,600,162,290
USD/Frw
FRW/USD
Page 122 of 127

Question two
Kamanzi JMV is a Managing Director (MD) Kamanzi International Limited (KIL) one of the
growing companies in Rwanda. The company deals in the manufacturing of alcoholic drinks of
different types. Recently the MD attended the CEOs workshop organized by ICPAR which was
about creating wealth for the owners. The portfolio manager of one of the leading equity
investment company made a presentation on risk diversification through portfolio investment. The
presenter emphasized the only way to go in this period of uncertainties, is to invest in assets with
a negative correlation. Mr. Kamanzi did not understand some of the terms used by the presenter
such as systematic and unsystematic risks, Coefficient of correlation Security market line, efficient
frontier, capital market line and the arbitrage price theory.
On returning, Mr Kamanzi tasked you to explain the terms used by the presenter and to identify
the best portfolio where the company can invest. The investment teams have identified the
following investments where KIL should invest.
Investments Amount required Beta coefficients

Portfolio one
Shares 100,000,000 1.15
Government bond 80,000,000 0
Portfolio two
Real estate 100,000,000 1.25
Shares 80,000,000 1.15
Probability of return Return on Shares (Rs) Probability of real Return Real estates
on shares (Ps) % estates (Pr) (Rr) %
0.3 15 0.4 20
0.25 25 0.2 -10
0.35 -8 0.1 30
0.1 35 0.3 25
The return on government bond is 11%
a. Compute the expected return and risk of each portfolio and comment on which portfolio is
suitable for the company (14 marks)
b. Assume the market return of 13%, use CAPM to compute the return of the portfolio (5
marks)
c. Explain the application of CAPM and EMH in the finance theory
TOTAL 25 MARKS
portfolio 1: (GVt bond risk free asset and shares risky asset)
Erports, b= RFR*Wrf + Ers*Ws
RFR 11%
Ers = ?
Value Weight
Shares 100,000,000 0.56
GV bond 80,000,000 0.44
Total investment 180,000,000
Page 123 of 127

Epected return on shares (Ers)
prob Rs Ers (Rs - Ers)^2*P Rs- Ers
0.3 15 4.5 3.78 3.55
0.25 25 6.25 45.90 13.55
0.35 -8 -2.8 132.41 -19.45
0.1 35 3.5 55.46 23.55
ERS = 11.45 237.548 Var
SDs = 15.41
Erport = (0.11*0.44) + (0.1145*0.56) = 11.25%
Sdports,b = Ws*Sds = 0.56*0.1541) 8.56
Expected return and risk of portfolio of risky assets (shares and real estate)
Erports,r = (Ers*Ws) + (Err*Wr)
Expected return on real estate

prob Rr Err (Rr- Err)^2*P Rr- Err
0.4 20 8 4.9 3.5
0.2 -10 -2 140.45 -26.5
0.1 30 3 18.225 13.5
0.3 25 7.5 21.675 8.5
Err 16.5 185.25
SDr 13.61
Ws (80/180) 0.44
Wr (100/180) 0.56
ERports,r = (0.1145*0.44) + (0.56*0.165)= 14.3%
Ws^2*Sds^2 +Wr^2*Sdr^2 +2WsWr*Covr,s

0.44^2*15.4^2 + 0.56^2*13.61^2 + 2*0.44*0.56*-19.65
Sdport r,s =
Rr,s = Covrs/Sds*sdr Covr,s = Rr,s*SDs*SDr
Probs Prob r Rs- Ers Rr- Err (Rs -Ers)(Rr-Err)*P

0.3 0.4 3.55 3.5 1.49
0.25 0.2 13.55 -26.5 (17.95)
0.35 0.1 -19.45 13.5 (9.19)
0.1 0.3 23.55 8.5 6.01
COVr,s (19.65)
Page 124 of 127

b. Return of Portfolio using CAPM
RFR 11%
RM 13%
Beta shares 1.15
Erport = RFR + Beta (RM - RFR)
Erpot = 0.11 + 1.15 (0.13 - 0.11) 13.30%
Portfolio (shares and real estate)
Beta portfolio = WsBs + Wr*Br = (0.44*1.15) = (0.56*1.25) =1.206

Erports,r = RFR +Betaport (RM-RFR)= 0.11 + 1.206(0.13-0.11)
Erports,r = 13.4%
Application of CAPM in finance: ( Dertemining the required rate of return of individual assets or portfolio)
ii. When incorporating risk in the required rate of return
Application of Efficient Market Hypothesis: When analysing the behaviour of stock market
ii. When forecasting the stock prices
QUESTION THREE
Birakaze Rwanda Limited (BRL) is manufacturer of different products ranging from soft and
alcoholic drinks. Of recent, the company has been facing challenges in the management of its
working capital. The raw material remains in inventory for 20 days while it takes 2 weeks to
produce the goods. Finished goods remain inventory for 30 days and collection from customers
takes 45 days while suppliers are paid in 50 days. Below is draft information from the company’s
financial statements
Items Amount FRW (000)

Annual Credit sales 200,000
Purchases 120,000
Cost of sales 150,000
Cash balances 10,000
The current credit policy of the company is one month but customers always pay in two month.
Although the company is currently facing challenges with cash flows, but the senior management
team is also worried of the low sales, they are therefore proposing changing the current credit
policy. The director of marketing has tabled a proposal to change the credit period from 1 month
to three month; the change in the credit will lead to increase in sales by 30%. In order to ensure
that customers continue paying in one month, a discount of 4% will be introduced. The current
bad debt is 2% of credit sales and this will increase to 3% due to the changes in the credit policy.
Introducing a discount will lead to a decrease in administration cost by 5,000,000. It is expected
that 70% of the customers will accept a discount and pay within one month while 30% will pay in
three month.
The director of finance on the other has proposed employing a factor company instead of
introducing a discount. The factor company will charge a commission of 2% on sales and will be
making a monthly payment. In addition, the factor company will make an advanced payment of
80% of the receivables and charge an interest rate of 4%. The current administration costs of
receivables are 8,000,000FRW. The receivables are financed by an overdraft at 11%
Required
a. Advise the management on the net working capital required (5 marks)

b. Comment on the best credit policy to adopt by the company (8 marks)
c. Explain the indicators of overtrading (5 marks )
d. Evaluate the dividend policy that can be used by the company (7 marks)
TOTAL 25 MARKS
Page 125 of 127

QUESTION THREE
days
Raw material days 20
WIP days 14
Finished good days 30
payable days 50
Receivable days 45
Working capital = Current assets - current liabilities

Inventory + Receivables + cash - Payables
Inventory = RM +WIP +FG
RMP = Av.stock R/m*365

Av.stock R/M = (20*120,000)/365 6,575
Purchase
Stock of finished goods = (30*150,000)/365 12,329
Stock WIP = (14*150,000)/365 = 5,753
Inventory = RM +WIP +FG 24,658
Receivables = (45*200,000)/365 24,658

Cash balance 10,000
Total current assets 59,315
Less payables (50*120,000)/365 (16,438)
Net working capital 42,877
Credit sales 200,000

New sales (1.3*200,000) 260,000
Increase in sales 60,000

gross profit margin = (200,000-150,000)/200,000 25%
Option1: Increase credit period and introduce a discount

Benefits of the new policy
Increase in the gross profit (25%*60,000) 15,000
Decrease in Admin cost 5,000
Total benefit 20,000
Costs for the policy

Discount cost (4%*260,000)*70% 7,280
Increase in bad debt (3%*260) - (2%*200) 3,800
Finance cost W1 147
Total cost 11,227
Net benefit 8,773
Page 126 of 127

W1 Finance cost
Current receivables (2/12*200,000) 33,333
New receivables (1/12*260)*70% +(3/12*260)*30% 34,667
Increase in receivable 1,333.67
Finance cost (11%*1,334) 146.70
Option2: Increase the credit period and employ a factor company

Benefits of the new policy
Increase in the gross profit (25%*60,000) 15,000
Saving admin cost 8,000
Saving in finance cost W2 1,283
Total benefits 24,283
Cost of the policy

Comission (2%*260,000) 5,200
Interest cost W3 630
Increase in bad debt (3%*260) - (2%*200) 3,800
Total costs 9,630
Net benefit 14,653
W2 Finance
Current receivable (2/12*200,000) 33,333
New receivable (1/12*260,000) 21,667
Decrease in receivables 11,666
Saving in finance cost (11%*11,666) 1,283
W3 Interest cost
Interest on advance payment (4%*11,666)*80% 373
Interest on remaining rece (11%*11,666)*20% 257
630
The company should change credit period and employ a factor company
c. Indicators of overtrading
Increase in sales not supported by in assets
Increase in current ratio
Increase in quick ratio
Decrease in inventory turnover
Increase in overdraft
d. Evaluating the dividend policy

i. Stable policy (give adv and dis)
ii. Constant payout (adv and dis)
iii. Stable with constant/constantwith stable (compromise policy)
iv. Residual policy
Page 127 of 127

Strategic Corporate Finance LECTURER NOTES F

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STRATEGIC COORPORATE FINANCE

70% Quantitative 30% Theory

The sources of finance are clasified into 2 that is

a) Short term sources :

3. Short term loans

b) Long Term sources

Conversion Value: is a value at which the bond is converted into shares

CV = Conversion ratio x Exercise(Conversion) Price

Terms in BOND MARKETS:

Raising the share capital:

Value of Shares in issue

Value of the Right = TERP - Right Issue

TERP = 2120/8 = 265

Option 1: Exercise the Right & buy shares

Advantages of ordirnary shares capital

Desadvantages of Ord. Shares

5. Internal Sources(Retained Earnings)

Application of COST OF CAPITAL in finance

EVA = Profit - COST OF CAPITAL

3. It is in the valuation of business as a discounting factor

Ve= D/ke * FCF/-WACC

Computation of Cost of Capital

1. Specific cost of capital:

Ex-Div Price = Cum Div - DV Price

Determination of Growth Rate

CAPM (CAPITAL PRICING MODEL)

2. & Unsystematich risk

(Rm-RFR) = Market risk premium

COST OF PREFERENCE SHARE 𝐷

Items period Cash flows DF @ 10% PV

IRR = a+ [NPVa/(NPVa - NPVb)] (b-a)

b) Cost of Redeemable dedt

d) Cost of untradable debt

e) Cost of untradable debt

3. The Iredeemable debanture is currently trading at 900

Cost of Bank Loan

Cost of Iredeemable debenture@1000Frw

Cost of Preference Shares (Kp)

Cost of Equity (ke)

Items period Cash flows DF @ 10% PV

IRR = a + [NPVa/(NPVa - NPVb)] (b-a) 8.08%

𝑉𝑒∗𝐾𝑒 𝑉𝑑∗𝐾𝑑 (1−𝑇)

WACC =KeWe + KpWp+KdWd

WACC= 70,895/700,000 10.1%

113,455 - 70,895 42,560

DEBT RATING & COST OF DEDT

Kd = RFR + Spread (1-T)

ADVANCED INVESTMENT APPRAISAL

a. Relevant cash flows:

Characteristics of relevant cash flows

Other aspects of relevant cash flows

b. Irrelevant cash flows

c. Investment appraisal techniques

payback period = initial investment / annual cash flows

Period Cash flows accumulated

PBP = 3+ (3,000,000/20,000,000)*12 = 1.8

PBP = 3yrs and 2 month

ARR = Average profit/ Average investment.

Average investment = (Initial investment + Residual value)/2