Introduction to investment unit2

THE UGANDA INSTITUTE
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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 Securities
There 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 Bond
A 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 Rates
Market 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 economy
There 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 floatation
iii. Does not result into ownership dilution or change of governance/ control
structure
iv. 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 equities
When 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 Schemes
This 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 funds
A 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 investments
The 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 securities
Long 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 / valuation
There 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 valuation
The 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 liabilities
You can then compute the value per share as
Market Valuation
This 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.
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Valuepershare=
TotalAssets−Totalliabilities
Totalnumberofshares

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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 share
Price /Earnings ratio Valuation
This 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)
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The Price =
Market price per share
Earnings per share
Earings per share =
Totalnet income aftertax
Totalno.of ordinary shares

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Discounted cash flows
This 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 5
Free Cash Flow(million) (800) 300 250 270 210 260
NPV= 170 million. A project is attractive if it has a high positive NPV
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n
c(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.
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2001 2003 2004 2005 2006 2007 2008 2009 2010

OF BANKING &
FINANCIAL SERVICES
UIBFS
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
31
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

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