Introduction to investment unit2

THE UGANDA INSTITUTE OF BANKING & FINANCIAL SERVICES

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ISO 9001:2008 CERTIFIED

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The nature and principles of investment

Types of Investments In Uganda

Capital Markets Operations

MODULE COVERAGE


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Financial Investment is an investment where the purchases of financial assets are carried out with the objective of earning a better return in the future.

• These financial assets are new in the investment market such as new shares, bonds debentures etc and not already existing financial (instruments) assets such as old bonds, old shares.

• The money used to purchase already existing financial assets is not regarded an investment but a mere transfer of financial asset from the old holder of the asset to a new holder of the asset. The investment in financial asset is related to the primary purchase of the asset and the secondary purchase of the asset.

Induced Investment. This is an investment which changes with level of income changes. This type of investment is positively related to the income levels of the prospect investors. For example at high levels of income, entrepreneurs are induced to invest more in their business and the converse holds.

• At high levels of income, consumption expenditure increases which positively drive the investment in capital goods to produce more consumer goods to meet the increased demand.

Real Investment. This is an investment where an actual purchase of new plant, equipment, and; the construction of factories and public utilities (schools, roads, hospitals etc) takes place takes place


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Autonomous Investment. This type of investment is not positively related to income levels. The investor’s aim objective is not financial gain or return in the future but rather to stimulate the production in other sectors of the economy with the main objective of boosting the production and economic growth of the country. This type of investment is mainly carried out by the governments such as in infrastructural development

Planned investment. This investment where carried out with a concrete investment plan outlining the specific objectives and activities, implementation and review plan, budget etc. This type of investment is carried out by governments and corporations.

Gross Investment and Net Investment Gross investment is the total amount of money used to create new capital assets such plant and machinery, factory buildings. This is the total expenditure in acquiring a new capital asset in a period. The Net investment on the other hand is the value of the gross investment less the capital consumption during a period. The consumption capital referred to is termed depreciation

From above, we can confirm John Keynes concept that an Investment refers to real investment and not financial investment, which implies that investment is the production of new capital goods, plants and equipment to further production.


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Investment banking An investment bank is a financial institution that assists individuals, corporations and

governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities.

An investment bank may also assist companies involved in mergers and acquisitions and provide ancillary services such as market making trading of derivatives, fixed income instruments, foreign exchange commodities, and equity securities.

Unlike commercial banks and retail banks, investment banks do not take deposits. There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-

making), or the promotion of securities i.e., underwriting, research, etc. which is the "sell side “.

Dealing with pension funds, mutual funds hedge funds , and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) which constitutes the " buy side ". Many firms have buy and sell side components.


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Fixed Income SecuritiesThere are two basic securities that most people invest that is equity and debt (known as

stocks and bonds), many investments however fall into one of these two categories. However there are also alternative investments vehicles such as options, futures, forex, gold etc.

These alternative investments are more speculative than the plain stocks and bonds. They are high rewarding or pay high returns.

For the purposes of this course will discuss the most common types of investment Bonds A bond is a promise by a borrower to pay a lender a certain amount called the principal at a

specified date called the maturity date of the bond and in the mean time to pay a given amount of money to the lender called interest per year. A bond is a fixed income security issued by many types of borrowers i.e. government, municipalities, public corporations and companies.

Bonds are issued by governments, municipalities and companies to provide needed capital to fund short- and long-term operations or specific projects. When investors purchase bonds, they are essentially loaning money to the borrowing entity, and receive periodic interest in the form of coupons in return.


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Components of a BondA bond issue is generally advertised, offered to the public and actually sold off to many

different investors through the normal floatation procedure on the Stock Exchange.The primary components of a bond are; the Principal, Bid price, Interest and Market price• The Principal - This is the amount invested in a bond. When one invests Ugx.1,

000,000/= in a bond, she/he will receive coupon income throughout the term of the bond and thenUgx.1,000,000/= upon maturity. Ugx.1,000, 000 is the principal or the bond’s face value also known as par value.

• The “Bid” Price – This is the price offered for every unit of face value of a bond (e.g. UGX 100,000). The bid price can be at ‘par’, ‘discount’ or ‘premium’. When the bond issuer offers a bond at Ugx. 98.751, it means that for every Ugx.100 of face value Ugx.98.751 should be paid. The implication is that a bond whose value at maturity is Ugx.1,000,000 will have a current value of 987,510/=

(1,000,000 ×98.751)/100=987,510• The Interest - Also known as the coupon, it is the ongoing income realized until the

bond matures. Interest rates can be fixed or floating.


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The Market Price - If you want to sell your bond before maturity, the price will depend on market conditions. If the general interest rates are falling, the bond prices rise and investors make money and vice versa.

Once a bond is issued the issuing corporation must pay to the bondholders the bond’s stated interest for the life of the bond. While the bond’s stated interest rate will not change, the market interest rate will be constantly changing due to global events, perceptions about inflation, and many other factors which occur both inside and outside of the corporation.

The following terms are often used to mean market interest rate: Effective interest rate , Yield to maturity , Discount rate , Desired rate

Market Interest RatesMarket interest rates are likely to increase when bond investors believe that inflation will

occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power.

Let’s examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond's stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000.


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Next, let’s assume that after the bond had been sold to investors, the market interest rate increased to 10%. The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months.

However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year). The existing bond’s semi-annual interest of $4,500 is $500 less than the interest required from a new bond. Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline.

An existing bond’s market value will decrease when the market interest rates increase. The reason is that an existing bond’s fixed interest payments are smaller than the interest payments now demanded by the market.

Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.

Let’s examine the effect of a decrease in the market interest rates. First, let’s assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000.


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Next, let’s assume that after the bond had been sold to investors, the market interest rate decreased to 8%. The corporation must continue to pay $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six months.

Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable.

In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000.

The yield on the bond is the return per UGX that the holder of the bond receives periodically. The yield on say savings accounts paying 5% interest p.a is just obviously 5%. Someone paying say UGX 2.5 million for bond that has a coupon of UGX 250,000,000 obtains a yield of 10%:

Yield= 250,000/2,500,000%=10%


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• The yield on a bond and its price are related in a way. Let the price of the bond be denoted by p, the coupon by C. As illustrated from above the yield (the effective rate of interest) y is given by the formula; y=C/p.

• This equation denotes that yield on a bond is the coupon divided by the price of the bond. So if you are given the coupon and the yield you can derive the price and so on. The face value of the bond at the time of issue represents its market price, while the yield is equal to the market price rate of interest at the date of issue.


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Market Interest Rates Vs a Bond’s Market Value • The market value of an existing bond will move in the opposite direction of the change in

market interest rates. When market interest rates increase, the market value of an existing bond decreases and when the market interest rates decrease, the market value of an existing bond increases.

• The relationship between market interest rates and the market value of a bond is referred to as an inverse relationship. Perhaps you have heard or read financial news that stated “Bond prices and bond yields move in opposite directions” or “Bond prices rallied, lowering their yield...” or “The rise in interest rates caused the price of bonds to fall.”

• If you were the treasurer of a large corporation and could predict interest rates, you would Issue bonds prior to market interest rates increasing in order to lock-in smaller interest payments.

• If you were an investor and could predict interest rates, you would purchase bonds prior to market interest rates dropping. You would do this in order to receive the relatively high current interest amounts for the life of the bonds. (However, be aware that bonds are often callable by the issuer.). Sell bonds that you own before market interest rates rise.

• You would do this because you don’t want to be locked-in to your bond’s current interest amounts when higher rates and amounts will be available soon.


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The main advantage of bonds is their safety and provide steady stream of return (income). For example when buy a bond from a stable government, your investment is guaranteed and risk free. This risk free and safety comes with a cost that is low return to this type of investment

Some of the primary risks associated with purchasing a bond are;Market Risks - The market value of bonds will raise and fall as a function of interest rate

fluctuations. This matters if you have to sell your bond before maturity. The shorter the life of the bond the safer it is because it will fluctuate less in price.

Holding period risk - The longer the term of the bonds, the greater the risk that you’ll have to sell them before maturity

and possibly at a loss.Inflation risk – In times of rapid or substantive inflation, both the bond interest and principal lose

purchasing power.Default risk – This is the likelihood that the issuer might not pay on time or at all, in case the

company’s loans need to be restructured or it goes bankrupt. Although debt instruments are normally paid in preference to equity instruments in cases of liquidation, the law prescribes many other preferential debts that rank before bonds in case the investee company is being wound up.

Credit Risk – This refers to the stability, earnings quality and therefore the suitability of the bond issuer as an investee for the public.


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Relevance to the economyThere is certainly a connection between an active bond market and a developing economy

such as Uganda. Issuance of long-term debt security is relevant to the Ugandan economy because it helps

raise funds for projects that require long-term financing. This could be in the public sector infrastructure such as roads, bridges, low income housing, building hospitals, schools or providing other local services.

It could also be in the private sector for acquisitions, expansion, new ventures, equipment leasing/ purchasing or upgrade materials utilized in their manufacturing processes.

Bonds can also be used as part of fiscal and monetary policy.Why issue bonds?i. It is sometimes more cost effective to issue bonds than to contract large, long term

debt in the market. ii. Generally has easier processes and less stringent requirements than a share/ stock

floatationiii. Does not result into ownership dilution or change of governance/ control structureiv. There are certain tax benefits to bond holders


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Why invest in bonds?• Income from bonds can supplement one’s income while attempting to ‘hedge’ the risks

on the market.• Long term bonds are not always very liquid and thus they are a good form of savings.• Bonds are not subject to market volatilities and swings that are common with shares or

stocks. Generally, bond interest and yields are higher than the interest that banks offer on savings.

Stocks or equitiesWhen you purchase stocks or equities you become part of the owner of the business. This

entitles you to vote at the shareholders’ meetings and allows you to receive any profits that the company allocates to its owners.

These profits referred to are known as dividends.Stocks provide relatively high return and this comes with a price of assuming the risk of

losing some or all of your investment.


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Collective Investments SchemesThis is an investment that involves collecting money from different investors and pooling the

money to fund the investments. This also sometimes called mutual fund and comprises of two types in Uganda:

The Money Fund (MF). The investor invests in money market instruments with a maturity of less thirteen months i.e. 12 months

The Balanced Investment Fund (BIF). This is an investment in securities such as equity and corporate bonds listed in the Uganda securities Exchange as well as government bonds

Mutual fundsA mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are

pooling your money with a number of other investors, which enables you as part of the group of investors, to pay the professional manager to selectively invest your funds in specific profitable security.

The mutual funds are set with a specific strategy in mind and their distinct focus can be large stocks, small stocks, bonds from government or companies, stocks in certain industries or countries etc.

The primary advantage of mutual fund is you can invest your money without time or experience in choosing the sound investment to place you funds.


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Mutual funds can be grouped 2 categories:i. Equity funds are made up of investment of only common stock, more riskier though has

good return than other types of fund.ii. Fixed- income funds. These are made up of government and corporate securities that

provide fixed income return. This type of fund is usually rated low risk.Mutual funds are not yet popular in Uganda although they are popular and numerous in other

countries, especially the developed ones. As the economy grows and the international economy gets more integrated, however, mutual funds are likely to become a feature of Uganda’s financial sector in the future.

Stock market investmentsThe capital of the company can be divided into different units with definite value called

shares. Holders of these shares are called shareholders or members of the company. There are two types of shares which a company may issue (1) Preference Shares (2) Equity Shares.

Preferences Shares The shareholders enjoy the preferential rights as to dividend and repayment of capital in the event of winding up of the company over the equity shares The holder of preference shares will get a fixed rate of dividend. Preference shares may be Cumulative Preference Share.


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Non-cumulative Preference Shares The holders of non-cumulative preference shares no doubt will get a preferential right in

getting a fixed dividend it is distributed to quality shareholders. The fixed dividend is to be paid only out of the divisible profits but if in a particular year

there is no profit as to distribute it among the shareholders, the non-cumulative preference shareholders, will not get any dividend for that year and they cannot claim it in the next year during which period there might be profits.

If it is not paid, it cannot be carried forward. These shares will be treated on the same footing as other preference shareholders as regards payment of capital in concerned.

Redeemable Preference Shares Capital raised by issuing shares, is not to be repaid to the shareholders (except buy back of shares in certain conditions) but capital raised through the issue of redeemable preference shares is to be paid back by the raised thought the issue of redeemable preference shares is to be paid back to the company to such shareholders after the expiry of a stipulated period, whether the company is wound up or not.


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Participating or Non-participating Preference Shares The preference shares which are entitled to a share in the surplus profit of the company in

addition to the fixed rate of preference dividend are known as participating preference shares.

After the payment of the dividend a part of surplus is distributed as dividend among the quality shareholders at a particulate rate.

The balance may be shared both by equity shareholders at a particular rate. The balance may be shared both by equity and participating preference shares.

Thus participating preference shareholders obtain return on their capital in two forms (i) fixed dividend (ii) share in excess of profits. Those preference shares which do not carry the right of share in excess profits are known as non-participating preference shares.

Equity Shares Equity shares will get dividend and repayment of capital after meeting the claims of preference

shareholders. There will be no fixed rate of dividend to be paid to the equity shareholders and this rate may vary from year to year.

This rate of dividend is determined by directors and in case of larger profits; it may even be more than the rate attached to preference shares. Such shareholders may go without any dividend if no profit is made.


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• In case of winding up of the company, equity capital can be paid back only after every other claim including the claim of preference shareholders has been settled.

• The most outstanding feature of equity capital is that its holders control the affairs of the company and have an unlimited interest in the company's profits and assets.

• They enjoy voting right on all matters relating to the business of the company. They may earn dividend at a higher rate and have the risk of getting nothing.

• The importance of issuing ordinary shares is that no organisation for profit can exist without equity share capital. This is also known as risk capital.


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Advantages of equity shares: The advantages to the company that issues equity shares may be summarised as below:

• Long-term and Permanent Capital: A company is not required to pay-back the equity capital during its life-time and so, it is a source of finance and a permanent source of capital.

• No Fixed Burden: unlike preference shares, equity shares pose a fixed burden on the company's resources, because the dividend on these shares is subject to availability of profits and the intention of the board of directors. They may not get the dividend even when company has profits. Thus they provide a cushion of safety against unfavorable development

• Credit worthiness: Issuance of equity share capital creates no change on the assets of the company. A company can raise further finance on the security of its fixed assets.

• Risk Capital: Equity capital is said to be the risk capital. A company can trade on equity in bad periods on the risk of equity capital.

• Dividend Policy: A company may follow an elastic and rational dividend policy and may create huge reserves for its developmental programmes.


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Advantages to equity shareholders/ investors may enjoy the following advantages:• Income: Equity shareholders are the residual claimant of the profits after meeting all the

fixed commitments. The company may add to the profits by trading on equity. Thus equity capital may get dividend at high in boom period.

• Right to Control and Manage the company: Equity shareholders have voting rights and elect competent persons as directors to control and manage the affairs of the company.

• Capital profits: The market value of equity shares fluctuates directly with the profits of the company and their real value based on the net worth of the assets of the company. An appreciation in the net worth of the company's assets will increase the market value of equity shares. It brings capital appreciation in their investments.

• An Attraction of Persons having Limited Income: Equity shares are mostly of lower denomination and persons of limited recourses can purchase these shares.

• Dilution in control: Each sale of equity shares dilutes the voting power of the existing equity shareholders and extends the voting or controlling power to the new shareholders. Equity shares are transferable and may bring about centralization of power in few hands. Certain groups of equity shareholders may manipulate control and management of company by controlling the majority holdings which may be detrimental to the interest of the company.


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Equity Trading. If equity shares alone are issued, the company cannot trade on equity.Capitalisation: Excessive issue of equity shares may result in over-capitalization. Dividend

per share is low in that condition which adversely affects the psychology of the investors. It is difficult to cure.

Non flexibility in capital structure: Equity shares cannot be paid back during the lifetime of the company. This characteristic creates inflexibility in capital structure of the company.

High cost: It costs more to finance with equity shares than with other securities as the selling costs and underwriting commission are paid at a higher rate on the issue of these shares.

Speculation: Equity shares of good companies are subject to hectic speculation in the stock market. Their prices fluctuate frequently which are not in the interest of the company.

Traditional equity investments By “traditional” here, we mean committing capital to new or expanding businesses that

produce goods and services. This differs significantly from the speculative type trading in the capital markets, most of which has a short term focus.


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Government debt securitiesLong term securities type of investment, individuals and organisations give long-term

loans to the Government or corporations for a defined period, by buying clearly priced debt instruments or securities. The lender or debt holder earns interest on the funds for a pre-determined period of time after which the funds are paid back.

Investors earn from long-term debt by receiving regular interest payments which can be fixed or floating. It is fixed when the interest rate does not change throughout the investment period, but floating when the interest rate keeps changing. The principal is repaid at maturity.

Long-term debt securities normally have a minimum life span of ten years. Corporate issuers of such debt instruments, like the case is with equity securities, often seek funds for projects that require long-term financing.

The primary difference between equity financing and debt financing is that under debt financing, the investor receives their principal on the bond maturity date and can no longer benefit from the future growth of the corporation, while an equity investment does not have a due date and the investor will continue to benefit from the dividend and capital appreciation of the corporation.


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Property Property (land and buildings) are the other very attractive investment opportunity in

Uganda. Land appreciates in value far faster than the rate of inflation, hardly depreciates, is quite secure and provides psychological value in terms of a feeling of security and prestige.

Whether the investor buys property to own or to sell, the returns continue to be attractive. This is not an area in which professional investors put emphasis but in Uganda, it is a major investment attraction.

Investment appraisal / valuationThere are many ways of evaluating or appraising proposed or potential investments. The

appraisal is done to inform the investor of the potential returns or profitability of the investment.

Business Valuation has become an intrinsic part of the corporate landscape and professionals in finance have developed detailed methods for such appraisal.

The investor, large or small, must assess the potential of any investment before making a decision. The business world has witnessed dynamic changes in the recent years as mergers and acquisitions, corporate restructurings, IPOs and share trading are happening in record numbers..


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Although there are numerous individual valuation techniques, they are categorized into four standard business valuation approaches applying standard formulas;

Asset-based valuationThe asset approach is based on the premise that it is generally possible to liquidate the

property, plant and equipment (PP&E) assets of a company and after paying off the company's liabilities accrue the net proceeds to the equity holders of the company. Valuation of assets based on liquidation or book value does not yield better results if the fair market value of assets is in excess of value of its assets on a liquidated basis.

Using this approach, the basic formula is;Company value = Total assets – Total liabilitiesYou can then compute the value per share as Market ValuationThis valuation method is applicable for quoted companies only. The market value is

determined by multiplying the quoted share price of the company by the number of issued shares. This valuation reflects the price that the market at a point in time is prepared to pay for the shares. This valuation method broadly takes into account the investors’ perceptions about the performance of the company’s (past and future) and the management’s capabilities to deliver a return on their investments.

Value per share = Total Assets− Total liabilitiesTotal number of shares


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Using this approach, the basic formula is;Company value = Total number of issued shares X market price per share Value per share = Market price per sharePrice /Earnings ratio ValuationThis method bases valuation on a comparison between the company’s market price per

share and its earnings per share. The price-earnings ratio (P/E) is simply the price of a company's share the stock market divided by its earnings per share.

By multiplying this P/E multiple by the net income, the value for the business could be determined.

This valuation method provides a benchmark business valuation as the non-listed companies wishing to use this method; a comparable quoted company/sector should be used.

Using this approach, the basic formula is:Company value = Price /Earnings ratio X net income (for immediate past year) The Price = Market price per shareEarnings per share

Earings per share = Total net income after tax Total no.of ordinary shares


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Discounted cash flowsThis valuation method, based on free cash flow, is considered a strong tool because it

concentrates on cash generation potential of a business. It also discounts the projected free cash flows to cater for both the time value of money and inflation.

Using the discount factor, the net present value is calculated using the formula:

Where n is the number of years/ periods from the time of investment, r is the interest rate , c is the cost

Example: Nile Crane Bus Company Limited plans to invest UGX 800 million in the bus business. The projected free cash-flows over the next 5 years are shown below. What is the net present value of the project? (Use a discount rate of 10%).

Year 0 1 2 3 4 5Free Cash Flow(million) (800) 300 250 270 210 260 NPV= 170 million. A project is attractive if it has a high positive NPV

nc(1+ r)


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Dividend Valuation • How does the financier justify investing in

shares giving him or her a minority stake with no prospect of dividends?

• He may be prepared to pay for the prospect of capital profit on sale or flotation, but it is usually a distant and uncertain prospect, over which he has no control.

• The investment is unlikely to be attractive, and the financier will seek to obtain dividend terms on his shares or at the least a statement of dividend policy by the directors.

• For minority investments, dividend valuation is often applied. The procedure and formula used could be as above, but replacing the earnings per share with dividend per share.


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Project Valuation • An investor’s financial position plays a role on the investment objectives. A

billionaire obviously will have much more different goals than a newly employed executive.

• The general rule in investment is the shorter your time horizon is the more conservative you should be. That is to say if you are investing primarily for retirement and you are at your early 30s, you still have enough to make up for any losses you might incur along the investment way and vice versa.

• As for business entities, the business person who wants to make business decision whether to build and equip a new factory has to first figure out how much it will cost him to get the factory into working order and what will be the return on the investment that the factory will bring each year of operation.

• The business persons use the discounted flow analysis basis to gauge the viability of the project This analysis is based on discounting of the revenue received in the later years to be discounted to the present value to arrive at their present value.


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Let us think of an investment of say US$ 100 invested at 10%. A year from now the investor will earn US$ 10.

This implies the US$100 is worth the same US$110 at the end of the year of investment.

To calculate the value of the project, the organisation will calculate its present discounted value at the interest rate at which it can borrow.

Let us assume the relevant interest rate is 12%.

Consider a project worth UGX 100,000,000 which generated UGX 50,000,000 and UGX 80,000,000 in year two and year three respectively. 2001 2003 2004 2005 2006 2007 2008 2009 2010

0

5

10

15

20

25

30

35

40

45


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Year 1 Year 2 Year3 Present Discounted Value

Cash/ Revenue Present value

-100M 50M 80M

Present Value 1/1.12= 0.893 1/ (1.12)² =0.797

Present value of costs/ Revenue

-100M 50M X 0.893 = 44.65

80M X 0.797=63.76

(-100M+ 44.65 +63.76) =8.41

From the above table, the present value of the net revenue received from the project is UGX 8.41 million which is positive therefore the firm should undertake the project.

Introduction to investment unit2

Business

Transcript of Introduction to investment unit2