a) Practical difficulties faced by small scale enterprises in obtaining credit:

  • Lack of collateral/security for new credit/loan facilities

  • Restrictive terms and conditions including formalities involved for instance, in obtaining loan facilities.

  • Existence of financial system which cater for large borrowers only. Such financial systems e.g. banks view small businesses as risky.

  • High cost of borrowing i.e interest rate which is usually prohibitive because of high perceived risk of small enterprises.

  • Poor managerial skills such that no financial records are maintained and it is difficult to assess cash flows of such enterprises.

  • Underdeveloped capital markets which caters for large firms. May be the formation of alternative investment market segments (AIMS) at the NSE is an attempt to accommodate small firms.

b) Internal sources of finance:

- This refers to sources of finance which arise from internal operations of the firm. Examples of internal sources of finance are:

  • Depreciation which yield tax shield and is a provision/transfer to a sinking fund for future asset replacement.

  • Retained earnings – profits not paid out as dividends but retained to financial future investment needs.

  • Deferred tax is a liability to the government which is a source of financial before its paid up by the firms.

  • Usually, the cost of depreciation and deferred tax are not computed. They are usually cost-free sources of finance. The cost of retained earnings is the foregone benefits/dividends by ordinary shareholders.

- External sources of finance is the capital (either long or short term) borrowed from sources external to the firm. The cost of such capital may be high thus may restrict the firm to use internal sources of financing only in particular retained earnings. Examples of external sources of financing are:

    • short term loans

    • bank overdraft

    • debt capital using debentures or corporate bonds

    • preference shares capital

    • issue of new ordinary shares.


a) Why different sources of capital have different costs.

Different sources have different costs because of:

  • Duration of lending e.g. long term loans will earn a higher interest rate than short term loans due to the maturity risk premium.

  • Size of loan – usually, large borrowers will be charged higher interest rates than their small borrowers.

  • Uncertainty of returns e.g interest charges are fixed hence lower cost of debt compared to dividends which are uncertain thus higher cost of equity.

  • Different types of financial assets some borrowers e.g building societies will offer higher yields to depositors to attract them. Their bonds have high interest rate.

  • Perceived risk by lenders:

- Borrowers who are perceived by different market segments to be high risk will have to incur higher cost of capital.

  • Need to make profit margin:

- Depending on the source of funds for lending, different sources of capital will add a % profit margin thus different cost of capital.

b) Advantages of having a farmer’s bank:

  • No need for a collateral in securing a loan to. Only a guarantor may be required.

  • Less formalities in borrowing of loans.

  • Minimum deposits will be low according to the savings ability of farmers

  • Other standing charges such as ledger fees withdrawal and deposit fees etc will be eliminated.

  • It would meet the unique finance needs of the farmers including giving advise on how to invest the money borrowed.

  • Lower cost of borrowing compared to the punitive interest rate charged by banks.


a) Venture Capital

  • Form of financing given to new, small risky business by specialised organisations called venture capitalists.

  • Venture capitalists e.g. Rockfeller and Acacia fund provide long term debt or equity capital in return for ownership interest in the firms. They also provide managerial skills for the business.

  • Usually, financing is at the early stage of business development when risk of business failure is high.

b) Reasons why venture capital market is not developed in Kenya:

  • Ignorance – Majority of small scale business owners are not aware of existence of venture capital hence underdevelopment of this market in Kenya.

  • Firms may prefer other forms of financing for fear of being dominated by financiers in profit sharing and decision making.

  • Almost all small firms are not quoted on stock exchange and their activities are not known by venture capitalists.

  • Lack of adequate competent managers to evaluate small businesses which may be viable for venture capital financing.

  • There are very few venture capitalists in Kenya. They also have conservative financing approach hence not many people would approach them for financing.

  • Lack o institutional framework and government support to develop venture capital market in Kenya.

  • Inefficient financial system and stock market which is not well developed to support venture capital development in Kenya.

  • Venture capitalists may not have adequate capital and managerial skills to undertake venture capital financing.


a) Distinguish between debt and equity.




- Carries a fixed rate of return.


- Interest is tax allowable


- Debenture holders/lenders are creditors

of the firm


- No residual claim on the income of the



- No right to vote or attend AGM




- Debenture holders provide long term

debt capital

- Have a variable rate of return


- Dividends are not tax allowable


- Ordinary shareholders are owners of

the firms


- Shareholders have residual claim on

the profits and assets of the firm


- Shareholders have voting right and

attend AGM to vote on important

management issues.


- Shareholders provide permanent


b) Advantages of leasing:

  • Lease charges are tax allowable hence a tax shield/saving for the firms

  • No risk of obsolescence – the firm can revoke the lease e.g in case of operating leasing thus it avoids risk of ownership

  • Increased flexibility – Short term/operating leases are cancellable hence convenient when the asset is needed temporary.

  • Avoidance of investment initial outlay – The firm is able to secure full use of the asset without immediate heavy initial capital investment.

  • Off-balance sheet financing – In case of operating lease, lease obligations are not shown in the balance sheet. They do not affect the gearing of the firm. The firm’s borrowing position is thus not affected. Operating leases is thus called off-balance sheet financing.

  • Leasing does not require a collateral – It is also less expensive compared to a bank loan. In long term (finance) leases, the lessor is given a chance to buy the asset.