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MOHAMED HABEL JUMA
CORPORATE FINANCE AND PRINCIPLES OF CAPITAL STRUCTURE IN PROJECTS
VALUATION OF FINANCIAL ASSETS & SOURCES OF FUNDS
A
...

Valuation is the process of determining the true worth of a security or a business using the available
financial data
...

Valuation is carried out in the market by financial experts and the value attached to a security is known as
the theoretical value or intrinsic value
...

Theories of valuation
1
...

The intrinsic value of a security is therefore equal to the total present value of all the expected future
benefits to be realized from the security
...

According to this theory the value of a security will be influenced by other factors such as:
















Capital structure including gearing level
...

Price-Earnings ratio and Earning per share of a firm
...








Economic conditions
...




2
...

It is based on the belief that history shall repeat itself i
...
past price patterns or trends will be repeated in the
future
...

The price patterns can be divided into the following:











Primary trend: Price pattern observed and recorded for a period of 1 or more years
...
Mainly seasonal

prices e
...
monthly price patterns
...
E
...
daily
...


3
...

It is based on the idea that information released in the market is received at different times by investors and
there is random reaction by the investors in the market
...

Due to continuous trading the intrinsic value will always revolve around a particular value (market value)
...

It has the support of E
...
H
...

To facilitate for company accounts disclosure
For purposes of acquisitions or disposal of blocks of shares
...


Parties interested in the value of shares and securities
a
...

b
...

c
...

d
...

e
...

Types of valuation
1
...
Preference shares
3
...
Valuation of bonds
This is a promissory note issued by organization in acknowledgement of indebtedness
...

Bonds may be traded in the capital market or untraded and may be secured or unsecured
...

Characteristics / Features of Bonds
a
...
It is the value on which interest is
payable
...
Coupon rate: The rate of interest payable on the debenture
...

c
...
Redeemable bonds are issued for a specified
period of time
...
Irredeemable bonds
have a perpetual life
...
Bond Indenture: An indenture or bond trust deed is a legal agreement between the issuing company and
the bond trustee who represents the bond holders
...
It is the responsibility of the trustee to protect the interest of bondholders’ obligations
...
The indenture
provide the specific terms of the agreement including description of debentures ,the rights of the
bondholders ,the rights of the issuing company and the responsibility of the trustee
...
Security: Bonds are either secured or unsecured
...
Unsecured bond is covered by any assets of the company which are otherwise not
charged
...
Claim on assets and income: Bond interest must be paid before any dividends are paid
...

Advantages of Bond financing
i
...


Less Costly than equity financing because:





Interest payment are tax deductible expenses
Lesser issue costs are involved
...




No Dilution of Ownership: bondholders do not have voting rights therefore a bond issue does not cause
dilution of ownership
...


Fixed Interest payment: Bondholder does not participate in higher earning of the firm as their return is
fixed
...


Financial leverage: The use of bond financing magnifies the return to equity holders thus bond financing
provides a beneficial effect on equity returns
...


It involves fewer formalities than issue of ordinary shares and can be used during emergency financing
needs
...


Obligatory Payments: Debenture interest and principal must be paid
...


ii
...


iii
...


iv
...
If a firm is unable to service its debt obligations bond holders may put the firm to liquidation to
recover their money and in the process equity holders may lose their money in whole or in part
...


Debentures: A debenture is an unsecured long term debt instrument
...
Debenture holders are creditors protected
by assets which are not otherwise charged
...


ii
...
The borrowing
company pledges the assets as security for the borrowed money
...


iii
...
By offering convertible debentures a company is issuing
equity shares in future-deferred equity
...


Advantages of convertible debentures
i
...


ii
...
This avoids immediate dilution in EPS

iii
...
Debt interest is a tax deductible expense thus financing using convertible
bonds a firm lowers its cost by the interest tax saving up to and until the conversion time

Fixed rate bond: A bond whose coupon rate is remains constant throughout the term of the bond
...
An initial interest rate is set which is adjusted periodically in line with the
prevailing market conditions
...
The coupon rate on a floater may be specified as: coupon=Treasury bill rate+5%
...


Advantages of Floating Rate bond



Floating rate bonds protect the borrowers from having to pay high rates of interest on the debentures when
the market rate of interest has fallen
...


 Thus lender is protected from decline in purchasing power
...


iv
...
They provide a
capital gain rather than interest income, investors benefit by the discount
...

Advantages


The advantage for borrowers is that Zero coupon Bond can be used to raise cash immediately and there is no

 cash repayment-interest and principal until redemption date
...




v
...
Capital gains are often

tax exempts or taxed at marginally lower tax rate
...
It is mainly used to finance buy-outs or merges
or complex risky business activities
...


Eurobond

A bond issued in a currency other than the currency of the country or market in which it is issued
...
A Eurodollar bond that is denominated in U
...
dollars and issued in Kenya by an Australian
company would be an example of a Eurobond
...
S
...
They may also denominate their Eurobond in their preferred currency
...

vii
...

The foreign currency used will most likely be a hard currency, and may represent significantly more risk to the
bondholder
...
Because of default risk, sovereign bonds tend to be offered at a
discount
...
A hard currency is expected to remain relatively stable through a short
period of time, and to be highly liquid in the forex market
...
The U
...
dollar and the British pound
are good examples of hard currencies
...
Brady bonds are some of the most liquid emerging market securities
...
S
...
The price movements of Brady bonds provide an accurate indication of market sentiment toward
developing nations
...
It is a standard process of grading or
assigning quality ratings reflecting the probability of default
...
Credit rating is done by specialized institutions which analyze
company financial information and other information including general economic information to determine the
grading/ quality of a firm’s debt
...
A firm with high rating can

 access debt capital at lower interest rates
...
Firms with good credit standing will be able

 to attract capital easily
...


Investment constraints: Most investors’ especially institutional investors such as pension funds require that

their portfolios should only contain bonds with a specific rating level
...


Most of would be sellers have low creditworthiness making it difficult to create sufficient public confidence

 to invest in the bond
...
The absence of a robust

 secondary market limits trading in bonds
...


Being long term finance there are a few buyers who may be willing to stake their savings for a long period

of time
...




B
...
Sources from which a business
enterprise may obtain finances can be classified into four different ways as follows:
1
...
e
...
20years
...
g
...


According to origin
This includes:

a) Internal sources: They are raised from within the company
...
g
...
According to the relationship between the company and the party providing the funds
a) Common equity capital: These funds are provided by the proprietors of the firm who are the ordinary
share holders
b) Quasi equity capital: These are funds provided by preference shareholders

c) Debt finance
These are the funds provided by the firm’s creditors e
...
debenture capital
4
...
g
...
g
...
Need for finance: When the company requires funds to finance working capital requirement it may use
overdraft, short term loan etc when the company wants to finance non-current assets it may raise fund from
long term sources e
...
share capital, long term debt etc
2
...
It is affected by government fiscal and monetary policies e
...
selective credit controls,
credit squeeze and requirements of companies depending on their nature and volume of operation
3
...
e
...
g
...
Such cost must be incurred to retain existing
capital and attract new finance into the business
b) Implicit costs: These are not paid directly to the sources but must be incurred to obtain finance e
...

insurance, floatation cost in raising share capital etc
4
...
Excessive use of debt finance increases the firms gearing level making it risky and
impossible to raise further debts when need arises
...

5
...
Consideration on the ability of the investment to pay back is very important because it enables the
company to test on its ability to repay the loan
...
Size of financial and technical capacity of the company: Large and strong companies can raise share
capital and sale debentures more easily than small and financially weak companies
...

Long term sources
A
...
They are entitled to dividends and also bear the risk of ownership
...

2) Claim on assets: Common shareholders have a residual claim on the company’s assets
...


3) Right to control: Common shareholders have the legal power to control operations and make decisions of
the firm
...
They are required
to vote for a number of issues in the firm e
...
election of directors or change of the memorandum of
association
...
If the share holders have already fully paid up for
their shares then they have nothing more to contribute in the event of financial distress or liquidation
...
e
...

Methods of issuing common shares
1
...
To the general public through public issue
3
...
To existing share holders through a dividend re-investment scheme (bonus issue)
5
...
e
...
Shares becoming available on account of non exercise of the rights are allotted to
share holders who have applied for additional shares on a pro rata basis and any balance of the share can be sold
to the general public
...
e
...


10

Advantages of private placement
i) Low floatation cost
ii) Greater speed since the share will not have to go to through the capital market authority
...
They are therefore liquid
...

The existing share holders of the company are rewarded by being granted new shares for free on pro rata basis
...
Provided without preconditions and therefore it’s a flexible source of capital to the company
2
...
It is available for use permanently by the company as long as it is a going concern
4
...
It lowers the company’s gearing level and financial risk
6
...
It can be raised in large amounts and can therefore be applied in long term projects which require huge
initial cash outflows
8
...


It involves higher floatation cost when compared to long term debt finance

2
...
It involves dilution of ownership and control of the company
4
...
Ordinary dividends is not allowable for tax purposes hence no tax advantage to the company
6
...
Listed companies are provided with strict rules and regulations by the NSE

B
...
It is also referred to as project
financing

Characteristics of term loans
i
...
Security: Term loans are usually secured especially by assets acquired using the fund i
...
primary security
...
e
...
The
provider of the fund may create either a fixed or floating charge against the company’s assets
...
Restrictive covenants: Financial institutions normally have a number of restrictive covenants to protect the
loan
...
e
...
Convertibility: Term loans are usually not convertible to ordinary shares unless under special cases where
the bank agrees to the restructuring of the firm capital structure
2) Bonds: These are long term promissory notes issued by accompany to raise funds
...

3) Mortgage: A mortgage represents a pledge of a designated property for a loan
...
It’s therefore secured by the real property
...
The mortgage differs from the normal
bank loan in the following aspects:













The property acquired acts as security to the mortgage while any other asset can be used as securities to

a normal loan
The mortgage is strictly a property loan while a normal bank loan need not be
Interested rates for mortgages are usually higher than a normal loans





In financial markets institutions usually specialize such that a normal loan is given by banks while

mortgage loans are given by mortgage companies e
...
housing finance corporation of Kenya

4) Subordinated debentures
The term subordinated means below or inferior and therefore subordinated debts have claims on assets after
subordinated debentures in the event of liquidation
...
Subordinated debts cannot be paid until senior debts as

named in the indenture have been paid
...
The document discusses a number of factors important
to the contracting parties such as:
a) The form of the bond and the instrument
b) A complete description of the property pledged
c) The authorized amount of bond issued
d) Detailed protective clauses or covenants
e) Minimum current ratio required
f) Provision for redemption or call privileges
5) Income bond
Income bonds provide that interests are paid only if the earnings of the firm are sufficient to give the interest
obligation
...
The main advantage is that interest is not a fixed
charge and is not payable if the company does not make profits
...

6) Floating rate bonds
When inflation forces interest to high levels borrowers are reluctant to commit themselves to long term debts
...

The main reason is that borrowers would rather pay a premium for short term loans than lock themselves in
high long term rates
...
In floating rate interest rates vary at a given
percent above prevailing long term or short term treasury bonds or bills
...
Interest rates: The interest rate indicates the percentage of the par value that will be paid out annually inform
of interest
...
Maturity period: Debt instruments are issued for a specific period of time after which the company redeems
them
...

3
...

a) Call provision
This gives the issuing company power to call the debt instrument for redemption
...

Call provisions enable companies to substitute bond paying lower interest for bonds paying higher
interest

b) Sinking fund
A sinking fund is a provision that facilitates the orderly retirement of bond issue or in some cases
preference share issue
...
If it is compulsory, then a failure to meet the payment will cause the
bond to be thrown into default and can lead the company into bankruptcy
...


It is secured i
...
assets must be pledged as collaterals against the loan

5
...
It increases the gearing level and financial risk of the company
7
...
Debt interest is an allowable deduction for tax purposes
9
...
It does not involve dilution of ownership and control of the company
2
...
Interest on debt is an allowable deduction for tax purpose hence provide tax advantage to the company
4
...
It may not dilution in the firm earning per share
6
...
The capital is cheap and convenient to manage because all the required capital can be provided by one
lender
Disadvantages from the company’s point of view
1
...
It requires collateral security
3
...
It is not available to all firms i
...
only financially companies known to the lender can access this fund
5
...
Cash outflow associated with redemption of this capital may leave the company in a very unhealthy
liquidity position

C
...
Bond rating provides the fundamental analysis for thousand of issues
...
The primary question in bond rating is whether the company can
service its debts in a timely manner over the life of the issue along with historical and current financial position
of the company
...

D
...
The person transferring the right is called the lesser and the person in whose favor the transfer is
being made is called the lessee
...
Net lease: This is one in which the lessee pays all the operating and maintenance cost
2
...
It is usually made for a short period of time mainly because the inflation may erode the purchasing
power of money
...
Step up lease: This provides for the fixed payment to be adjusted periodically
...
The increase is meant to cover appreciation
in property, increase in insurance, taxes and maintaining costs
...
Percentage lease: This is one where the lease is required to pay a fixed basic rent plus a percentage of sales
volume
...

5
...
Sandwich lease
This refers to a multiple lease situation in which the lease in turn sub leases the property to a sub lessee for a
higher sum than what is paid to the original lesser
...

Other classifications
a) Finance /capital lease
This is a lease where exclusive rights of use and ownership are substantially transferred to the lessee
The lease is regarded as a capital lease if it meets the following conditions:
i) Transfers title of asset at the end of the lease period i
...
it contains an option to purchase the lease at a
bargain price

ii) The lease period is equal to or greater than 75% of the fair value of the asset
b) Operating lease
This is a short term and therefore gives the lessee the right to use the lease property but do not give the
lessee all benefits and risks associated with ownership
...
It is the duty of the lesser to maintain and service the leased property
...

d) Leveraged lease
This is a special type of finance lease that has become popular in financing of big ticket assets e
...
railway
equipments, ship, aero plane etc
...
e
...

The lesser may contribute as little as 20% of the machine and the balance is provided by a creditor
Reasons for leasing



 Short term leases are convenient
Assume you want to use an asset for a short period e
...
a car for a week could you buy the car and sale it

after seven days?



 Cancellation options are available
Equipments are frequently leased at a short term cancellable basis because it is difficult to estimate how
rapidly equipment will become absolute because of change in technology
...
Many leasers are very equipped

to provide efficient maintenance



 Low administration and transaction cost
Leasing is often a relatively cheaper source of finance for small companies
...






 Tax shield can be used
Sometimes the lesser can make better use of depreciation tax shield generated by the asset than the asset
user
...
They are reflected as

 foot notes

Leasing avoids restrictive covenants: When a company borrows money it must certainly consent to certain

 restrictions on future borrowings
...

Leasing can be seen as a way of circumventing restrictive covenants
...
It’s therefore able to

 record higher returns on its asset than the company which buys the equipment

Leasing avoids capital expenditure controls: In some companies lease proposals are not subject to the

 elaborate capital expenditure approval procedures needed to buy an asset
...
g
...
By passing such control it may result to poor investment decisions in some companies

Leasing preserves capital: Leasing companies provides 100% financing i
...
they advance the full cost of

 leased asset
...
Preference shares
A preference share is a hybrid security as it has features of both ordinary shares and debentures
Similarities with ordinary shares



 Non payment of dividends does not force a company into insolvency




Dividends are not deductible for tax purposes



In some cases its permanent capital i
...
irredeemable preference shares



Similarities with debentures



 Dividend rate is fixed






preference share holders do not share in the residual earning except for participatory preference shares
Preference share holder has claims on income and assets prior to ordinary shares
Usually they do not have voting rights







Characteristics of preference shares
1
...
e
...
Fixed dividends
Preference shares earn a fixed rate of dividends and preference dividends are not taxed deductible
...
Cumulative dividends
Most preference shares have cumulative right to dividend requiring that all past unpaid dividends to be paid
before any ordinary dividends are paid
4
...
Participation feature
Some preference shares are participatory allowing holders to participate in extra ordinary profit earned by
the company
...
Voting right
Preference shares do not have any voting right
7
...
Preference shares allow the holder to convert his
preference shares into ordinary shares at a specified during a given period of time
Advantages of preference shares
1
...
This is because they can post pone payment of
dividends
2
...
Fixed dividends
Preference dividends payments are restricted to the stated amount
...
Limited voting rights
Preference share holders do not have voting rights except in case of dividends in arrears
...
Non deductibility of dividends
Preference dividends are not tax deductible expenses hence making preference shares more expensive than
debentures
2
...
Nonpayment of preference dividends can adversely affect the image of the company

SHORT TERM SOURCES
1
...
It is unsecured hence the firm does not need to sorry about assets to pledge as securities
ii
...
It does not involve floatation cost
iv
...
Used without the consent of the share holder
vi
...
Interest rates on overdraft are higher than on long term loans
ii
...
It is open to misuse because the shareholders consent is not required to use this fund
iv
...
Commercial paper (iou)
 This is a short term debt instrument used by financially sound companies to enable them raise capital to
finance their working capital needs 

 It carries a fixed rate of return and its usually not secured 

 It is issued at a discount 

 The effective cost of this finance is the difference between the discounted sum and the face value of the debt
instrument 

 It can be issued through commercial banks or stock exchange 

 Interest rate of the commercial papers is at premium above the treasury bill rate 

3
...
Provision for depreciation
This can be said to be source of capital because of the following reasons:
i
...
It is an allowable deduction for the tax purposes hence provide the company with tax saving
iii
...

This reduction will be seen as a source of capital
2
...
Retained profits
ii
...
Sale of idle fixed assets
iv

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