1. THE COST OF CAPITAL
OPTIMAL CAPITAL BUDGETING
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2. INTRODUCTION BUDGETING
We have already discussed the capital structure
of a firm as well as Capital budgeting and risk
We have also discussed the capital budgeting
techniques
Through the discussions, we have mentioned cost
of capital including the following
 The importance of cost of capital
 The cost of capital : cost of debt; preferred stock;
retained earnings
 The Weighted average cost of capital (WACC
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3. Factors affecting WACC
Factors affecting cost of capital
I do not indent to repeat any of these
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4. BUDGETING
 A budget is defined as a financial implementation tool.
 What is being implemented is the project identified
 The project should be the best after FORCASTING
 Need to differentiate budgeting and forecasting
 Forecasting is the process of evaluating various options
of implementing a particular project.
 The best forecast becomes the budget
 BUT a budget is better defined as a set of activities for
implementation
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5. CRITICS
Critics of the budgeting process dismiss it and
say:
 Takes too long to prepare.
 Doesn't help us run our business.
 Budgets are out-of-date by the time we get them.
 Too much playing with the numbers.
 Too many iterations / repetitive tasks within the
process
 Budgets are cast in stone in a constantly changing
business environment
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6. Too many people are involved in the
budgeting process.
Unable to control budget allocations.
By the time budgets are complete, I don't
recognize the numbers.
Budgets do not match the strategic goals and
objectives of the organization
Introduction of a slack
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7. BUDGETING IS IMPORTANT
Financial Planning is a continuous process that
flows with strategic decision making
The Operating Plan and the Financial Plan will
both support the Strategic Plan.
we have to take into account numerous factors
before we can finalize our budgets
Budgeting should be flexible, allowing
modification when something changes
For example, the following will impact budgeting:
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8.  Life cycle of the business
 Financial conditions of the business
 General economic conditions
 Competitive situation
 Technology trends
 Availability of resources
Budgeting should be both top down and bottom
up; i.e. upper level management and middle level
management will both work to finalize a budget
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9. We can streamline the budgeting process by
developing a financial model.
Financial models can facilitate "what if" analysis
so we can assess decisions before they are made
This can dramatically improve the budgeting
process.
One of the biggest challenges within financial
planning and budgeting is how do we make it
value-added
Budgeting requires :
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10.  clear channels of communication,
 support from upper-level management,
 participation from various personnel, and
 predictive characteristics
Budgeting should not strive for accuracy, but
should strive to support the decision making
process
If we focus too much on accuracy, we will end-up
with a budgeting process that incurs time and
costs in excess of the benefits derived
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11. The challenge is to make financial planning a
value-added activity that helps the organization
achieve its strategic goals and objectives
NOTE Budgeting is most useful when done as an
integral part of an organizations strategic analysis
Strategic analyses consider how an organization
combines its own capabilities with the
opportunities in the marketplace to accomplish
its overall objectives.
The following questions may be asked:
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12.  What are the overall objectives of the
organization?
 Are the markets for its products local, regional,
national or global? What trends will affect its
markets? How do the economy, its industry and
its competitor affect the organization?
 What forms of organizational and financial
structure serve the organization best?
 What are the risks of the alternative strategies
and what are the organizations contingency plans
if its preferred plan fails
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13. WHO IS INVOLVED
Need for a budget committee consisting of
Top management
Cost center/line managers (budget owners)
The budget clerk (the accountant-keeps the
time schedule and records events)
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14. THE PROCESS
Zero based budgeting (ZBB)
 Also referred to as priority based budgeting
 It requires that all activities are justified and
prioritized before decisions are taken relating to
the amount of resources to be allocated to each
activity.
 It is a method of budgeting, which requires each
cost element to be specifically justified as though
the activities to which the budget relates were
being undertaken for the first time
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15.  Without approval the budget allowance is zero.
 It is an attempt to overcome the disadvantage of
incremental budgeting by treating each budget period
as though it were independent of past periods
 It is cost benefits exercise which:
 Asks fundamental questions about existing cost levels
and the way in which existing operations are carried
out.
 Examines the existing budget model
 Critically evaluates the viability of cost centers in the
future.
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16. Incremental budget
 Also referred to as traditional budgeting method
 It is a method of budget setting in which the prior
period budget is used as a base for the current
budget
 set by adjusting the prior period budget to take
account of any anticipated changes in activity
levels and inflation.
 The disadvantage of this approach is that it
perpetuates any past inefficiency
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17. It may however be appropriate in cases such
as staff salaries, which may be estimated on
the basis of current salaries plus an increment
for inflation.
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18. Kaizen Budgeting
Kaizen is the Japanese term for continuous
improvement
Kaizen budgeting is a budgetary approach that
explicitly incorporates continuous
improvement during the budget period into
the resultant budget number
This may be achieved by continuous cost
reduction.
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19. TYPES of Budget
Sales budget-literally the first budget
 What products are going to be sold
 What is the maximum size of the market
 What portion of the market can be captured
 Who is going to the sell the products
 In what geographical areas are the products going
to be sold
 When will the products be sold
 What price will be charged for each unit
 How many units will be sold
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20. The production budget
General and administrative budget
The cash budget
The capital expenditure budget
The master budget
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21. BUDGET STATEMENTS
Budget Balance sheet
Budget Profit and loss
Budget cash statement (EXAMPLE)
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22. ADVANTAGES OF BUDGETING
Motivation to workers particularly line managers
Approval for expenditure hence saves time
There is better management, coordination of
work and communication
Managers are continuously thinking about the
future strategic direction
Holds managers to account since it clearly defines
areas of duty and responsibility
Variance analysis enhances control
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23.  scarce resources are efficiently and effectively
applied
Managers are able to pick and focus on
priority areas accordingly
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24. MARGINAL COST OF CAPITAL
 The marginal cost of capital (MCC) is the cost of the
last dollar of capital raised, essentially the cost of
another unit of capital raised.
 As more capital is raised, the marginal cost of capital
rises.
 A company’s cost of capital will remain unchanged as
new debt, preferred stock and retained earnings are
issued until the company’s retained earnings are
depleted.
 Once retained earnings are depleted, the company will
determine to access the capital markets to raise new
equity
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25. This effectively raises the company’s WACC
Pleas refer to the WACC (and the formula of
computation)
Again remember the factors affecting the WACC
of a firm as follows:
FACTORS A FIRM WILL NOT CONTROL
The level of interest rates
Market risk premium
Taxation rates
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26. FACTORS A FIRM WILL CONTROL
 Capital structure policy
 Dividend policy
 Investment policy
MCC VERSUS WACC
 The marginal cost of capital is simply the weighted
average cost of the last dollar of capital raised.
 As mentioned previously, in making capital decisions, a
company keeps with a target capital structure.
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27. There comes a point, however, when retained
earnings have been depleted and new common
stock has to be used
When this occurs, the company’s cost of capital
increases. This is known as the "breakpoint" and
can be calculated as follows:
Breakpoint for retained earnings =
retained earnings
wce
WHERE wce WEIGHT FOR COMMON EQUITY
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28. EXAMPLE
Assume a company expect to earn KSH50 million
next year. Assume further that the said
company’s payout ratio is 30%. Lets assume wce =
55%?
REQUIRED
What is the company’s breakpoint on the
marginal cost curve,
SOLUTION
breakpoint = KSH50 million (1-0.3) = SH63.6 million
0.55
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29. LETS REVIST THE OPTIMAL CAPITAL
STRUCTURE
This simply means that managers should choose
a capital structure that maximises the
shareholder’s wealth.
This process may involve a trial capital
structure, based on the market values of the debt
and equity, and then an estimation of the wealth
of the shareholders under this particular capital
structure.
The idea is to repeat the process until an
optimum capital structure is determined
FIVE STEPS HERE INCLUDE:
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30. 1. Estimate the interest rate the entity will pay
2. Estimate the cost of equity
3. Estimate the weighted average cost of capital
4. Estimate the free cash flows and their present
value, which is the value of the firm
5. Deduct the value of the debt to find the
shareholders’ wealth, which is what we want to
maximize
NOTE: FURTHER READING PG 504-513 MAIN TEXT
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31. THE INVETMENT OPPORTUNITY
SCHEDULE
The concept behind the IOS is very similar to that
of the MCC schedule
The MCC schedule represents the cost of capital
faced by the firm (ranking from the cheapest to
the most expensive)
The IOS represents the projects that are available
to the firm (ranking them from the most
desirable to the least desirable).
In order to construct the IOS, the firm needs to
first estimate the IRR of each of the project it is
considering.
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32. Once that is accomplished, the financial
manager can plot the IOS, which is a chart of
the IRRs of the firm’s projects arranged from
the highest IRR to the lowest IRR
FOR EXAMPLE
Lets say a firm is interested in five independent
projects, and the financial information
regarding those projects is presented in the
following table.
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33. PRO1 PRO 2 PRO 3 PRO 4 PRO5
KSH KSH KSH KSH KSH
Outlay 250,000 100,000 100,0000 120,000 200,000
IRR 34.54% 39.03% 33.87% 14.28% 16.41%
Payback 2.21 1.5 1.83 3.5 4.33
Using this information, the projects can be arranged
from the highest IRR to the lowest IRR as follows:
Projects 2, 1, 3, 5 and 4
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34. IRR 39.03
34.54
33.87
16.41
14.28
100,000 350,000 450,000 650,000 770,000 NEW CAPITAL
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35. EXPLANATIONS
 From the IOS above, we know that if the firm decides
to undertake all five projects, it will need an
investment budget of $770,000
 However, the firm does not know if this is advisable
because it does not know if all the projects will be able
to generate a high enough return (i.e. IRR) to cover the
cost of raising the new capital)
 In order to make the correct decisions, the firm needs
to combine its IOS with its MCC schedule to determine
which project it should undertake and which project it
should reject.
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36. CAPITAL RATIONING
 The act or practice of limiting company's investment
 Capital rationing occurs when a company's
management places a maximum amount on new
investments it can make over a given period of time
 The two methods of capital rationing are :
 forbidding investments over a certain amount
 or increasing the cost of capital for such investments
 Capital rationing is most common when a company's
previous investments have not performed well.
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37. THE DIVIDEND POLICY
What is dividend?
 A dividend is the distribution of profits to a
company's shareholders
 The primary purpose of any business is to create
profit for its owners, and the dividend is the most
important way the business fulfils this mission.
 When a company earns a profit, some of this
money is typically reinvested in the business and
called retained earnings, and some of it can be
paid to its shareholders as a dividend
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38.  Paying dividends reduces the amount of cash
available to the business, but the distribution of
profit to the owners is, after all, the purpose of
the business.
Some companies pay "stock dividends" rather
than cash dividends, in which case shareholders
receive additional stock shares.
The amount of the dividend is determined every
year at the company's annual general meeting,
and declared as either a cash amount or a
percentage of the company's profit
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39. The dividend is the same for all shares of a given
class (that is, preferred shares or common stock
shares)
Once declared, a dividend becomes a liability of
the firm.
When a share is sold shortly before the dividend
is to be paid, the seller rather than the buyer is
entitled to the dividend
At the point at which the buyer is not entitled to
the dividend if the share is sold, the share is said
to go ex-dividend
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40. This is usually two business days before the
dividend is to be paid, depending on the rules
of the stock exchange
When a share goes ex-dividend, its price will
generally fall by the amount of the dividend.
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41. HOW DIVIDEND DETERMINED
 The dividend is calculated mainly on the basis of the
company's un-appropriated profit and its business
prospects for the coming year
 It is then proposed by the Executive Board and the
Supervisory Board to the annual general meeting
 At most companies, however, the amount of the
dividend remains constant.
 This helps to reassure investors, especially during
phases when earnings are low, and sends the message
that the company is optimistic with respect to its
future performance.
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42. Some companies have dividend-reinvestment
plans.
These plans allow shareholders to use
dividends to systematically buy small amounts
of stock often at no commission
Dividends are not yet paid in gold certificates
although this idea has been discussed by
mining companies such as Goldcorp.
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43. WHY COMPANIES AVOID DIVIDEND
PAYMENT
 Companies have often avoided paying dividends for several
reasons:
 To reinvest to grow: Company management and the board
believe that it is important for the company to take
advantage of opportunities before it, and reinvest its recent
profits in order to grow, which will ultimately benefit
investors more than a dividend payout at present.
 Double taxation: When dividends are paid, shareholders in
many countries, including the United States, suffer from
double taxation of those dividends: the company pays
income tax to the government when it earns any income,
and then when the dividend is paid, the individual
shareholder pays income tax to the government on the
dividend payment.
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44. -This is often used as justification for retaining earnings, or for
performing a stock buyback, in which the company buys
back stock, thereby increasing the value of the stock left
outstanding. The shareholder pays no income tax on this
transaction.
 Microsoft is an example of a company which has historically
been a proponent of retaining earnings; it did so from its
IPO in 1986 until 2003, when it declared it would start
paying dividends. By this point Microsoft had accumulated
over $43 billion in cash, and there had been increasing
irritation from stockholders who believed this large pile of
cash should lie in their hands and not in the company's, YET
Microsoft had no conceivable good reason to have that
much money sitting in the bank!.
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45. Safaricom- the largest telecommunication and
riches company south of the Sahara has
‘increased’ its dividends payout to 2cents per
share! Mockery on stockholders?
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46. PAYMENT PROCEDURES
 Declaration date- the date directors meet and declare
dividend
 Holder-of-record date- the date records are compiled
and closed for dividend purposes. For example say that
date is January 5th- if the company is notified of the
sale before January 5th, 5pm, then the new owner is
paid dividend. If notification to sale is received on
January 6th, the previous owner is paid the dividend
 Ex-dividend date- the securities industry has set up a
convention under which the right to the dividend
remains with the stock until two business days prior to
the holder-of-record date.
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47. Payment date- the date the company mails
out the checks to the holders of record,
usually the payment date
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48. FACTORS INFLUENCING DIVIDEND
PAYMENTS
Constraints on dividend payment
Investment opportunities
Availability and cost of alternative sources of
capital
Effects of dividend policy on rs (required rate
of return on equity)
MORE PAGE 567-568
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49. TYPES OF DIVIDENDS
Cash dividends-the most common
Stock dividends- a ratable distribution of
additional shares of stock
Property (in kind) dividend: Distributed in the
form of assets by the issuing company or a
subsidiary company.
Other types of dividend: Warrants and financial
assets having market value are also distributed in
the form of dividends.
Liquidating Dividends – a distribution of capital assets to
shareholders.
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50. OTHER MATTERS
Stock Splits – each of the outstanding shares is broken
into a greater number of shares.
 Redemption of Shares – a corporation's exercise of the right
to purchase its own shares.
 Acquisition of Shares – a corporation's repurchase of its own
shares.
 Scrip/Bonus issue- Allocation of additional shares to existing
shareholders in proportion of shares held- from retained
earnings or share premium/reserve account
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51. LEGAL RESTRICTIONS
Dividends – dividends may be paid only if the following
tests are satisfied:
Cash Flow Test – a corporation must not be or become
insolvent (unable to pay its debts as they become due in
the usual course of business).
Balance Sheet Test-Means company should not mess
up with approved capital structure varies among the States
and includes the earned surplus test (available in all
States), the surplus test, and the net assets test (used by
the Model and Revised Acts).
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52.  Legal Restrictions on Liquidating Distributions –
States usually permit distribution in partial
liquidation from capital surplus unless the
company is insolvent.
 Legal Restrictions on Redemptions of Shares – in
most States, a corporation may not redeem
shares when insolvent or when such redemption
would render it insolvent
 Legal Restrictions on Acquisition of Shares –
restrictions similar to those on cash dividends
usually apply.
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53. DIVIDEND THEORIES
Dividend irrelevance theory- M&M Merton
Miller and Franco Modigliani argue that a firm’s
value is determined only by its basic earnings
power and its business risk
 This argument effectively meant that a firm’s
value is determined only by the income produced
by its assets, AND NOT HOW THIS INCOME IS
SPLIT BETWEEN DIVIDENDS AND RETAINED
ESRNINGS
 Thus dividend is irrelevant
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54. Bird-in-the-Hand theory- this theory argues in
favour of dividends
Proponents argued that the required rate of
return on equity rs decreases as the dividend
payout is increased because investors are less
certain of receiving the capital gains which are
supposed to result from retaining earnings
than they are of receiving dividend payments.
Thus dividend payment is preferred
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55. Tax-preference theory- this theory deals with tax
reasons that make investors prefer low to higher
dividend payments namely:
 Capital gains have lower tax than dividends-in
Kenya capital gains are tax exempt
 Capital gains tax is not paid until the stock is sold
 Stocks held until death attract no capital gains tax
at all
These reasons make investors prefer to have
companies retain profits
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56. The signalling hypothesis- it is a general business
observation that AN INCREASE IN DIVIDEND
PAYOUT is often accompanied by an INCREASE IN
THE PRICE OF THE STOCK and a dividend cut leads
to a stock price decline
 This may help to conclude that investors prefer
dividends to capital gains
Clientele effect-dividend payout is affected by
clientele needs accordingly
 For example retired people, pension funds and
university endowment funds may prefer dividend
payouts because they are in LOW TAX BRACKETS
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57. On the centrally, individuals at their peak
earnings may prefer capital gains because they
are at the HIGHEST TAXATION brackets.
KENYA
Are Kenya dividend policies any different?
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58. HYBRID FINANCING
Preferred stock
Warrants
Convertibles
Warrants versus convertibles
Outstanding convertibles
Calling convertibles
Innovative new hybrids
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59. PREFERRED STOCK
 This is a hybrid stock
 Because the owner of a preferred stock receives a
promise to pay a stated dividend , usually every
quarter for an infinite period.
 Preferred stock is similar to bonds in some aspects
(receives a known streams of payments) and to
common stocks in other aspects (the issuer does not
have the same legal obligation to pay investors as do
issuers of bonds)
 It imposes a fixed charge and therefore increases the
firm’s financial leverage
 Pays preferred dividend
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60. TYPES
 These stocks having contractual rights superior to those of
common stock and they include:
Dividend Preferences – must receive full
dividends before any dividend may be paid on
common stock
 Liquidation Preferences – priority over common stock in
corporate assets upon liquidation.
 Adjustable rate preferred stock- don't pay fixed dividend
instead dividend tied to the rate of Treasury securities
 Market auction preferred stock- holders have the
right to auction their shared every seven weeks
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61. ADVANTAGES OF PREFERRED STOCK
 In contrast to bonds, the obligation to pay preferred
dividends is not firm, and passing a preferred dividend
can not force a firm into bankruptcy
 By issuing preferred stock, the firm avoids the dilution
of common equity that occurs when common stock is
issued
 Since preferred stock sometimes has no maturity, and
since preferred sinking fund payments, if present, are
typically spread over a long period of time, preferred
issues reduce the cash flow drain from repayment of
principal that occurs with debt issues
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62. DISADVANTAGES
 Preferred stock dividends are not normally deductible
to the issuer, hence the after-tax cost of preferred is
typically higher than the after-tax cost of debt.
However, the tax advantage of preferreds to corporate
purchasers lowers its pre-tax cost and therefore its
effective cost
 Although preferred dividend can be passed, investors
expect them to be paid, and firms intend to pay the
dividend if conditions permit. Thus preferred dividends
are considered to be fixed cost. Therefore their use,
like debt, increases financial risk and consequently the
cost of common equity.
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63. WARRANTS
This is a certificate issued by a company that
gives the holder the RIGHT to buy a stated
number of shares of the company’s stock at a
specified price for some specified length of
time
If all taken, they cause dilution to the earnings
per share of common equity
MORE PG 672-677
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64. CONVERTIBLES
These are bonds or preferred stocks that, under
specified terms and conditions, can be exchanged
for (or converted into) common stock at the
option of the holder.
They do not bring in any additional funds for the
firm- like warrants do-
But they are just a replaced on the balance sheet
by common stock
They too however cause dilution to earnings per
share on common equity
MORE PG 677-687 MAIN TEXT
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65. DIFFERENCE BETWEEN WARRANTS
AND CONVERTIBLES
 Warrants are usually issued privately- most
convertibles are issued publicly
 Warrants can be detached and thus can be sold
separately- convertibles , both the bonds and options
are bundled together and can not be sold separately
 Warrants may be issued on their own and necessarily
in conjunction with other securities- convertibles are
not
 Warrants are exercised for cash- convertibles are not
 A package of bonds and warrants may be taxed
differently- thus there are tax differences between
warrants and convertibles accordingly.
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66. INNOVATIVE HYBRID FINANCING
 A hybrid debt security is a form of debt security, which
is blended with derivatives like swap, forward or
option.
 Previously, the most popular type of hybrid security
was the convertible debenture or convertible bond
 In the earlier part of 1980s, nevertheless, a unique
category of hybrid securities achieved a lot of
recognition, specifically in the United States.
 The hybrid securities are usually fundamental tools
that are utilized for handling risk
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67. EMERGING ONES
Hybrids for handling commodity risk: Oil-indexed
bond, which was issued by Standard Oil in the year
1986. This blended a zero coupon bond along with a
call option on oil with similar maturity period
Hybrids for handling foreign exchange risk: Dual
currency bond, which was issued by Philip Morris
Credit in the year 1985. The coupon payments were
disbursed in Swiss francs and the principal was
disbursed in United States Dollar.
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68. Hybrids for handling interest rate risk: Inverse
floating rate notes. The Student Loan Market
Association or Sallie Mae issued this hybrid
security in the year 1986. They were also known
as yield curve notes. These notes can be broken
down into two portions, i) a plain vanilla interest
rate swap and ii) a variable rate bullet repayment
note
Hybrids for diminishing the differences between
bondholders and stockholders: Variable rate,
rating sensitive note. This was issued by
Manufacturer Hanover in the year 1988
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