Fundamentals of Finance 2024 Board Question Paper

Meaning of Financial Markets:

• Definition: A financial market is an institutional and structural framework or mechanism that brings together suppliers of capital (savers/investors) and demanders of capital (borrowers/firms/governments) to trade financial assets such as stocks, bonds, currencies, and derivatives.
• Economic Function: Efficiently allocates scarce economic capital from surplus units to productive investment opportunities.

Measuring the Liquidity Position of a Company:

A company’s short-term solvency is measured using Liquidity Ratios:

1. Current Ratio:
   $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \quad (\text{Benchmark: } 2:1)$$
2. Quick (Acid-Test) Ratio:
   $$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory} - \text{Prepaid Expenses}}{\text{Current Liabilities}} \quad (\text{Benchmark: } 1:1)$$

Meaning of Financial Statements:

• Definition: Financial statements are structured, formal records that summarize the operational performance, financial health, and cash flows of an enterprise over an accounting period.
• Core Set: Balance Sheet, Income Statement, Statement of Cash Flows, and Statement of Changes in Equity.

Yield on 5-Year Securities:

Given:

• Real risk-free rate ($r^*$) = $4\%$
• Average inflation premium for 5 years ($IP_5$) = $8\%$
• Maturity risk premium ($MRP_5$) = $2\%$

Formula:

$$\text{Yield } (r) = r^* + IP_5 + MRP_5$$

Calculation:

$$r = 4\% + 8\% + 2\% = \mathbf{14\%}$$

Final Answer: The yield on the 5-year securities is 14%.

Value of Preferred Stock:

Given:

• Preferred dividend ($D_p$) = $\text{Rs } 15$
• Required rate of return ($r_p$) = $12\% = 0.12$

Valuation Formula (Perpetuity):

$$V_p = \frac{D_p}{r_p}$$

Calculation:

$$V_p = \frac{15}{0.12} = \mathbf{Rs \; 125}$$

Final Answer: The intrinsic value of the preferred stock is Rs 125.

Effective Interest Rate (EAR) Calculation:

Given:

• Monthly interest rate ($r_{\text{monthly}}$) = $3\% = 0.03$
• Number of compounding periods per year ($m$) = $12$

Formula:

$$EAR = (1 + r_{\text{monthly}})^m - 1$$

Calculation:

$$EAR = (1 + 0.03)^{12} - 1 = (1.03)^{12} - 1 \approx 1.42576 - 1 = 0.42576 = \mathbf{42.58\%}$$

Final Answer: The effective annual interest rate on the credit card loan is 42.58%.

Impact of Cash Conversion Cycle (CCC) on Working Capital Size:

• The Cash Conversion Cycle measures the net time lag in days between paying cash for raw materials and collecting cash from customer receivables.
• Direct Relationship: A longer CCC means operating cash remains locked up in inventory and receivables for a prolonged duration, necessitating a larger volume of working capital financing.
• Conversely, shortening the CCC releases liquidity, reducing the firm’s required working capital investment.

Why Cost of Debt is Calculated on an After-Tax Basis:

• Interest payments on corporate debt are a tax-deductible operating expense under corporate tax legislation, creating a valuable tax shield that reduces the firm’s tax liability.
• Consequently, the effective net cost of borrowing to the enterprise is lower than the nominal interest rate paid to debtholders:
  $$\text{After-Tax Cost of Debt} = r_d \times (1 - T)$$

Present Value Computation:

Given:

• Future Value ($FV_5$) = $\text{Rs } 10,500$
• Discount rate ($i$) = $8\% = 0.08$
• Time period ($n$) = $5 \text{ years}$

Formula:

$$PV = \frac{FV}{(1 + i)^n}$$

Calculation:

$$PV = \frac{10,500}{(1.08)^5} = \frac{10,500}{1.469328} = \mathbf{Rs \; 7,146.12}$$

Final Answer: The present value is Rs 7,146.12.

Why Preferred Stock is Called a Hybrid Security:

Preferred stock is termed a hybrid security because it blends legal and financial characteristics of both debt and common equity:

1. Equity Characteristics: No fixed contractual maturity date, non-payment of dividends does not trigger bankruptcy, and dividends are paid out of after-tax profits.
2. Debt Characteristics: Fixed periodic dividend rate, lack of voting rights in normal management, and priority claim over common stockholders upon liquidation.

Core Finance Functions in Modern Business Enterprises:

1. Investment Decision (Capital Budgeting):
   • Involves evaluating and selecting long-term capital assets and investment projects whose expected future cash flows exceed their cost (positive NPV).
2. Financing Decision (Capital Structure Management):
   • Determining the optimal mix of debt and equity capital to minimize the overall Weighted Average Cost of Capital (WACC) while controlling financial risk.
3. Dividend Decision (Profit Allocation):
   • Deciding how much of net corporate earnings should be distributed to shareholders as cash dividends versus retained for internal business expansion.
4. Liquidity / Working Capital Decision:
   • Managing day-to-day current assets and current liabilities to ensure the firm maintains adequate cash liquidity to satisfy obligations without sacrificing profitability.

Determinants of Market Interest Rates:

The quoted market interest rate ($r$) on a debt security is determined by the sum of a base risk-free rate and various risk premia:

$$r = r^* + IP + DRP + LP + MRP$$

1. Real Risk-Free Rate ($r^*$): The theoretical base interest rate on a completely riskless security in a zero-inflation environment.
2. Inflation Premium ($IP$): An average compensation demanded by lenders to offset the anticipated decline in purchasing power over the life of the security.
3. Default Risk Premium ($DRP$): Extra yield demanded by investors to compensate for the possibility that the corporate issuer will default on scheduled interest or principal payments.
4. Liquidity Premium ($LP$): Added yield charged if the security cannot be converted into cash on short notice without significant price loss.
5. Maturity Risk Premium ($MRP$): Compensation required on longer-term bonds to protect investors against interest rate risk and bond price volatility.

“Common Stocks are Riskier than Bonds” — Argumentation:

Yes, I fully agree with the statement.

From an investment perspective, common stocks carry significantly higher financial risk than debt bonds due to three foundational legal and cash flow differences:

1. Subordinated Priority of Claims in Liquidation:
   • In the event of corporate bankruptcy, debtholders possess prior legal claims on corporate assets. Common shareholders are residual claimants who receive compensation only after all creditors and preferred stockholders are paid in full.
2. Contractual Obligation vs. Discretionary Dividends:
   • Bonds represent a legally binding promise to pay fixed coupon interest. Defaulting on a coupon can force the firm into bankruptcy. Common stock dividends, by contrast, are entirely at the discretion of the Board of Directors.
3. Volatility of Cash Flows and Market Prices:
   • Common stock prices fluctuate dramatically based on investor sentiment, macroeconomic shocks, and corporate earnings swings, whereas high-grade bonds exhibit much lower price volatility.

Working Capital Cycle Analysis for Lumbini Company:

Given:

• Inventory Conversion Period ($ICP$) = $35 \text{ days}$
• Accounts Receivable Collection Period ($DSO$) = $30 \text{ days}$
• Accounts Payable Deferral Period ($PDP$) = $25 \text{ days}$
• Annual Operating Outlays = $\text{Rs } 6,000,000$ (360-day year)

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a. Operating Cycle and Cash Conversion Cycle:

• Operating Cycle ($OC$):
  $$OC = ICP + DSO = 35 + 30 = \mathbf{65 \text{ days}}$$
• Cash Conversion Cycle ($CCC$):
  $$CCC = OC - PDP = 65 - 25 = \mathbf{40 \text{ days}}$$

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b. Amount of Financing Required to Support CCC:

$$\text{Daily Cash Operating Outlay} = \frac{6,000,000}{360} = \text{Rs } 16,666.67 \text{ per day}$$

$$\text{Financing Required} = \text{Daily Outlay} \times CCC = 16,666.67 \times 40 = \mathbf{Rs \; 666,667}$$

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c. Managerial Strategies to Reduce the Cash Conversion Cycle:

1. Accelerate Inventory Turnover: Implement Just-In-Time (JIT) inventory management to compress the $ICP$.
2. Speed Up Accounts Receivable Collections: Offer early payment cash discounts (e.g., 2/10 net 30) and automate invoicing to lower $DSO$.
3. Negotiate Extended Supplier Credit: Stretch accounts payable terms ($PDP$) without damaging supplier relationships or incurring credit penalties.

Bond Valuation with Semiannual Compounding: Ragmati Textile Company:

Given Data:

• Par Value ($M$) = $\text{Rs } 1,000$
• Annual Coupon Rate = $10\% \implies$ Semiannual Coupon ($PMT$) = $\frac{1000 \times 0.10}{2} = \mathbf{Rs \; 50}$
• Maturity ($n$) = $7 \text{ years} \implies$ Total periods ($2n$) = $14$
• Required rate of return ($r_d$) = $12\% \implies$ Semiannual discount rate ($r_d/2$) = $6\% = 0.06$

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Valuation Formula:

$$V_B = PMT \times \left[\frac{1 - (1 + r_d/2)^{-2n}}{r_d/2}\right] + \frac{M}{(1 + r_d/2)^{2n}}$$

Step-by-Step Calculation:

• Present Value of Annuity Factor:
  $$PVIFA(6\%, 14) = \frac{1 - (1.06)^{-14}}{0.06} = \frac{1 - 0.442301}{0.06} = \frac{0.557699}{0.06} = 9.29498$$
• Present Value of Par Value:
  $$PVIF(6\%, 14) = (1.06)^{-14} = 0.442301$$

$$V_B = (50 \times 9.29498) + (1,000 \times 0.442301) = 464.75 + 442.30 = \mathbf{Rs \; 907.05}$$

Final Answer: The present market value of the bond is Rs 907.05 (selling at a discount because required return 12% exceeds coupon rate 10%).

Loan Amortization Schedule for Jaya Publishing Company:

Given Data:

• Loan Principal ($PV$) = $\text{Rs } 100,000$
• Term ($n$) = $3 \text{ years}$
• Annual Interest Rate ($i$) = $10\% = 0.10$

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a. Amount of Equal Annual Installment Payment ($PMT$):

$$PMT = \frac{PV}{PVIFA(10\%, 3)} = \frac{100,000}{\frac{1 - (1.10)^{-3}}{0.10}} = \frac{100,000}{2.48685} = \mathbf{Rs \; 40,211.48}$$

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b. Loan Amortization Schedule:

Final Answer:

• Annual installment: Rs 40,211.48
• The loan is fully extinguished at the end of Year 3.

Dividend Growth Rate and Future Stock Price: Sagarmatha Company

Given Data:

• Current Stock Price ($P_0$) = $\text{Rs } 360$
• Last Paid Dividend ($D_0$) = $\text{Rs } 24$
• Required Rate of Return ($r_s$) = $12\% = 0.12$

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1. Calculate the Company’s Dividend Growth Rate ($g$):

Using the Gordon Constant Growth Model:

$$P_0 = \frac{D_1}{r_s - g} = \frac{D_0(1 + g)}{r_s - g}$$

$$360 = \frac{24(1 + g)}{0.12 - g}$$

Multiply both sides by $(0.12 - g)$:

$$360(0.12 - g) = 24 + 24g$$

$$43.20 - 360g = 24 + 24g$$

$$43.20 - 24 = 360g + 24g$$

$$19.20 = 384g \implies g = \frac{19.20}{384} = 0.05 = \mathbf{5\%}$$

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2. Calculate Expected Stock Price 3 Years from Now ($P_3$):

Under the constant growth model, the stock price grows at the exact same rate as dividends ($g = 5\%$):

$$P_3 = P_0 \times (1 + g)^3$$

$$P_3 = 360 \times (1 + 0.05)^3 = 360 \times (1.05)^3 = 360 \times 1.157625 = \mathbf{Rs \; 416.75}$$

(Alternative verification: $D_4 = D_0(1+g)^4 = 24(1.05)^4 = 29.172$; $P_3 = D_4 / (r_s - g) = 29.172 / 0.07 = \text{Rs } 416.74$).

Final Answer:

• Dividend growth rate ($g$): 5%
• Expected stock price 3 years from now ($P_3$): Rs 416.75

The Financial Environment and Its Major Components:

1. Concept of Financial Environment

The financial environment encompasses the overarching framework of financial markets, financial institutions, instruments, laws, and regulatory authorities through which capital is mobilized, exchanged, and allocated across an economy.

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2. Major Components of the Financial Environment:

Components Breakdown:

• Financial Markets: Money Markets & Capital Markets
• Financial Institutions: Depository Banks & Non-Depository Intermediaries
• Financial Instruments: Treasury Bills, Corporate Bonds, Common Stocks
• Regulatory Framework: Central Bank (NRB) & Securities Board (SEBON)

1. Financial Markets:
   • Money Markets: For trading short-term debt instruments maturing in under one year (T-bills, interbank loans).
   • Capital Markets: For issuing and trading long-term debt and equity instruments (stocks, debentures).
   • Primary vs. Secondary Markets: Primary markets raise new capital; secondary markets provide liquidity.
2. Financial Institutions (Intermediaries):
   • Depository Institutions: Commercial banks and development banks that accept deposits and extend credit loans.
   • Non-Depository Institutions: Life insurance companies, pension funds (CIT/EPF in Nepal), and mutual funds that channel institutional savings into capital investments.
3. Financial Instruments (Securities):
   • Legal contracts representing monetary claims (equity shares, corporate bonds, government treasury bonds).
4. Regulatory and Legal Framework:
   • Autonomous regulatory oversight bodies (Nepal Rastra Bank, SEBON) that enforce statutory capital requirements, investor protection laws, and transparent reporting.

Future Value of Ordinary Annuities with Varying Compounding Frequencies:

a. FV of Rs 400 Every 6 Months for 5 Years at 12% Semiannual Compounding:

• Periodic payment ($PMT$) = $\text{Rs } 400$
• Periodic rate ($i$) = $\frac{12\%}{2} = 6\% = 0.06$
• Number of periods ($n$) = $5 \times 2 = 10$$FVA_a = PMT \times \left[\frac{(1 + i)^n - 1}{i}\right] = 400 \times \left[\frac{(1.06)^{10} - 1}{0.06}\right]$$
  $$FVA_a = 400 \times \left[\frac{1.790848 - 1}{0.06}\right] = 400 \times 13.18079 = \mathbf{Rs \; 5,272.32}$$

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b. FV of Rs 200 Every 3 Months for 5 Years at 12% Quarterly Compounding:

• Periodic payment ($PMT$) = $\text{Rs } 200$
• Periodic rate ($i$) = $\frac{12\%}{4} = 3\% = 0.03$
• Number of periods ($n$) = $5 \times 4 = 20$$FVA_b = 200 \times \left[\frac{(1.03)^{20} - 1}{0.03}\right] = 200 \times \left[\frac{1.806111 - 1}{0.03}\right] = 200 \times 26.87037 = \mathbf{Rs \; 5,374.07}$$

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c. Why the Annuity in (b) Earns More Than in (a):

• Both plans involve the identical total cash contribution ($400 \times 10 = \text{Rs } 4,000$ vs. $200 \times 20 = \text{Rs } 4,000$) and identical nominal annual interest rate (12%).
• Reason for Discrepancy: The quarterly annuity makes deposits earlier in the year (after 3 months rather than 6 months). More frequent compounding enables cash flows and interest to earn interest sooner, producing a higher Effective Annual Rate (EAR):
  $$EAR_{\text{quarterly}} = (1.03)^4 - 1 = 12.55\% > EAR_{\text{semiannual}} = (1.06)^2 - 1 = 12.36\%$$

Interest Rate Determinants and Yield Calculations:

Given Data:

• Real risk-free rate ($r^*$) = $2\%$ (constant for 3 years)
• Expected inflation: Year 1 ($I_1$) = $3\%$, Year 2 ($I_2$) = $3.5\%$, Year 3 ($I_3$) = $4.5\%$
• Maturity risk premium ($MRP_3$) = $0.40\%$
• Liquidity premium ($LP_3$) = $0.30\%$
• Default risk premium ($DRP_3$) = $0.60\%$

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a. Average Expected Inflation Rate for 3-Year Period ($IP_3$):

$$IP_3 = \frac{I_1 + I_2 + I_3}{3} = \frac{3\% + 3.5\% + 4.5\%}{3} = \frac{11\%}{3} = \mathbf{3.67\%}$$

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b. Yield on a 1-Year T-Bill:

Treasury securities have zero default risk ($DRP = 0$) and zero liquidity premium ($LP = 0$). One-year securities have zero maturity risk premium ($MRP = 0$):

$$\text{Yield on 1-Year T-Bill} = r^* + I_1 = 2\% + 3\% = \mathbf{5\%}$$

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c. Yield on a 3-Year Corporate Bond:

A corporate bond includes default risk, liquidity risk, and maturity risk:

$$r_{\text{corp}} = r^* + IP_3 + MRP_3 + DRP_3 + LP_3$$

$$r_{\text{corp}} = 2.00\% + 3.67\% + 0.40\% + 0.60\% + 0.30\% = \mathbf{6.97\%}$$

Final Answer:

• a. Average 3-year inflation: 3.67%
• b. 1-Year T-Bill yield: 5.00%
• c. 3-Year Corporate Bond yield: 6.97%

Comprehensive Cost of Capital & WACC: Dhaulagiri Company

Existing Capital Structure (Optimal Weights):

• Debt = $\text{Rs } 40,000,000 \implies w_d = 40\%$
• Preferred Stock = $\text{Rs } 10,000,000 \implies w_p = 10\%$
• Common Equity = $\text{Rs } 50,000,000 \implies w_e = 50\%$
• Total Capital = $\text{Rs } 100,000,000$ | Tax rate ($T$) = $40\%$

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a. Equity Capital Needed to Raise Rs 50 Million:

$$\text{Required Equity} = w_e \times 50M = 0.50 \times 50M = \mathbf{Rs \; 25 \text{ million}}$$

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b. Source of Equity Funding:

If no internal retained earnings are available, all Rs 25 million must come from the sale of new common stock.

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c. Component Costs of Capital:

1. New Debt ($r_d$):

   • Par ($M$) = $1000$, Coupon ($I$) = $1000 \times 9\% = 90$, Maturity ($n$) = $10$
   • Net proceeds ($NP$) = $970 - (2\% \times 1000) = 970 - 20 = \text{Rs } 950$$r_d = \frac{I + \frac{M - NP}{n}}{\frac{M + NP}{2}} = \frac{90 + \frac{1000 - 950}{10}}{\frac{1000 + 950}{2}} = \frac{95}{975} = 9.74\%$$
     $$\text{After-Tax Cost of Debt } r_d(1 - T) = 9.74\% \times (1 - 0.40) = \mathbf{5.84\%}$$

2. New Preferred Stock ($r_p$):

   • Dividend ($D_p$) = $12\% \times 100 = \text{Rs } 12$
   • Net proceeds ($NP$) = $95 - 5 = \text{Rs } 90$$r_p = \frac{D_p}{NP} = \frac{12}{90} = \mathbf{13.33\%}$$

3. Retained Earnings / Internal Equity ($r_s$):

   • $P_0 = 500$, $D_1 = 50$, $g = 6\%$$r_s = \frac{D_1}{P_0} + g = \frac{50}{500} + 0.06 = 0.10 + 0.06 = \mathbf{16.00\%}$$

4. New Common Stock / External Equity ($r_e$):

   • Underpriced by Rs 60 $\implies$ Market Price $= 500 - 60 = 440$
   • Net Proceeds ($P_n$) $= 440 - 20 = \text{Rs } 420$$r_e = \frac{D_1}{P_n} + g = \frac{50}{420} + 0.06 = 0.1190 + 0.06 = \mathbf{17.90\%}$$

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d. WACC Using Retained Earnings ($r_s = 16\%$):

$$WACC_1 = w_d r_d(1 - T) + w_p r_p + w_e r_s$$

$$WACC_1 = (0.40 \times 5.84\%) + (0.10 \times 13.33\%) + (0.50 \times 16.00\%) = 2.336\% + 1.333\% + 8.000\% = \mathbf{11.67\%}$$

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e. WACC When Rs 50 Million is Raised (Using New Equity $r_e = 17.90\%$):

$$WACC_2 = (0.40 \times 5.84\%) + (0.10 \times 13.33\%) + (0.50 \times 17.90\%) = 2.336\% + 1.333\% + 8.950\% = \mathbf{12.62\%}$$

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f. Uses of WACC:

1. Serves as the hurdle rate (discount rate) in Capital Budgeting (NPV/IRR criteria).
2. Benchmarks corporate economic value generation (EVA).
3. Guides optimal capital structure planning.