Financial Management

Meaning of Strategic Plan:

A strategic plan is a comprehensive, long-term roadmap (typically covering 3 to 5+ years) formulated by top executive leadership that defines an organization’s vision, core mission, overriding objectives, and strategic initiatives.

Key Characteristics in Financial Management:

• Guides long-term capital allocation, debt/equity capital structure, and corporate expansion.
• Translates high-level corporate aspirations into operational plans and capital expenditure (CapEx) budgets.
• Integrates internal corporate capabilities with dynamic external market opportunities and threats.

Concept of Risk-Free Rate (Rf):

The risk-free rate (Rf) is the theoretical rate of return attributed to an investment asset that carries zero default risk and zero reinvestment risk over a given investment horizon.

Key Aspects:

• It serves as the absolute baseline floor for calculating expected investment returns and hurdle rates under the Capital Asset Pricing Model (CAPM).
• It reflects pure compensation for the time value of money and expected inflation.
• Empirical Proxy: Short-to-medium-term sovereign debt instruments, such as Nepal Rastra Bank Treasury Bills (e.g., 91-day or 364-day T-Bills), are utilized as the standard risk-free benchmark in Nepal.

Differences Between Operating BEP and Cash BEP:

Basis of Comparison	Operating Break-Even Point (Operating BEP)	Cash Break-Even Point (Cash BEP)
1. Definition	The sales volume where Earnings Before Interest and Taxes (EBIT) equals exactly zero.	The sales volume where operational cash inflows exactly equal cash operating disbursements.
2. Treatment of Non-Cash Charges	Includes non-cash expenses (such as depreciation and intangible asset amortization) in fixed costs.	Excludes non-cash expenses (Depreciation) from fixed costs.
3. Mathematical Formula	Q_BEP = (Total Fixed Costs) / (P - V)	Q_Cash_BEP = (Total Fixed Costs - Depreciation) / (P - V)
4. Magnitude	Always higher than Cash BEP.	Always lower than Operating BEP; represents immediate operational solvency threshold.

Systematic Risk and Real-World Example:

Systematic risk (also termed market risk or undiversifiable risk) is the variability in asset returns caused by macroeconomic and geopolitical forces that simultaneously affect the entire financial market. Because it impacts all companies, it cannot be eliminated through portfolio diversification and is measured by Beta (beta).

Practical Example:

A sudden decision by Nepal Rastra Bank (NRB) to aggressively raise the policy cash reserve ratio (CRR) and statutory liquidity ratio (SLR), coupled with an economic recession and high inflation. This systemic contraction tightens liquidity across the entire banking system, driving up interest rates and depressing stock prices across the NEPSE index simultaneously, irrespective of company-specific managerial excellence.

Definition of Ordering Cost:

Ordering costs are the cumulative administrative, logistical, and processing expenses incurred every single time a purchase order is initiated, transmitted, and fulfilled by a supplier, regardless of the physical quantity ordered.

Typical Components:

• Requisition preparation and purchase order authorization expenses.
• Clerical and communication costs (telephone, electronic data interchange).
• Transportation, receiving, and unloading labor costs.
• Quality inspection and material acceptance verification testing.
• Vendor invoice processing, accounting ledger posting, and payment clearance fees.

Annual Percentage Cost of Non-Free Trade Credit (2/20, net 50):

1. Given Terms:

• Cash Discount Rate (d) = 2% = 0.02
• Discount Period = 20 days
• Net Credit Period = 50 days

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2. Formula & Calculation:

$$\text{Annual Percentage Rate (APR)} = \frac{d}{1 - d} \times \frac{360}{\text{Credit Period} - \text{Discount Period}}$$

$$\text{APR} = \frac{0.02}{1 - 0.02} \times \frac{360}{50 - 20} = \frac{0.02}{0.98} \times \frac{360}{30} = 0.020408 \times 12 = \mathbf{24.49\%}$$

(Using a 365-day year: $0.020408 \times \frac{365}{30} = \mathbf{24.83\%}$).

Concept of Efficient Portfolio with Example:

An efficient portfolio is an investment portfolio that lies directly on the Markowitz Efficient Frontier. It provides:

1. The highest possible expected return for a specified, acceptable level of risk (standard deviation), OR
2. The lowest possible risk for a specified target expected return.

Practical Example:

Assume an investor evaluates three distinct investment portfolios:

• Portfolio A: Expected Return = 14%, Risk (sigma) = 10%
• Portfolio B: Expected Return = 11%, Risk (sigma) = 10%
• Portfolio C: Expected Return = 14%, Risk (sigma) = 14%

Evaluation: Portfolio A is efficient because for the same 10% risk, it yields 14% return versus Portfolio B’s 11% (dominates B), and for the same 14% return, it carries lower risk than Portfolio C (dominates C).

Differences Between Financial Risk and Operating Risk:

Basis of Comparison	Operating Risk	Financial Risk
1. Origin / Source	Arises directly from the company’s business operations and production cost structure (fixed vs. variable operating costs).	Arises strictly from the company’s capital financing choices (the presence of fixed financial debt charges).
2. Relationship with Leverage	Measured by the Degree of Operating Leverage (DOL).	Measured by the Degree of Financial Leverage (DFL).
3. Vulnerability	Variability in Operating Profit (EBIT) due to unexpected shocks in sales volume.	Variability in Earnings Per Share (EPS) and net income available to common stockholders.
4. Avoidability	Inherent to every business enterprise; exists even in 100% unleveraged equity firms.	Completely avoidable by opting for zero debt financing in the capital structure.

Stock Dividend and Comparison with Stock Split:

A stock dividend (or bonus share) is a proportional distribution of additional company shares to existing stockholders without consideration, recapitalizing a portion of retained earnings into paid-in equity capital.

Differences Between Stock Dividend and Stock Split:

Basis of Distinction	Stock Dividend (Bonus Share)	Stock Split
1. Par Value per Share	Par value per share remains completely unchanged (e.g., remains Rs 100).	Par value per share is proportionately reduced (e.g., Rs 100 split 2-for-1 becomes Rs 50).
2. Equity Capital Accounts	Shifts accounting balances: decreases Retained Earnings and increases Common Stock and APIC.	Leaves individual equity account balances unchanged; merely alters share count and par value.
3. Statutory Formalities	Requires adequate accumulated retained earnings or distributable reserves.	Requires no retained earnings; requires an amendment to the company’s Memorandum of Association (MOA).

Calculation of Full Capacity Sales and Target Fixed Asset-to-Sales Ratio:

Given Data:

• Actual Sales = Rs 5,000,000 (Rs 5 million)
• Net Fixed Assets = Rs 1,700,000 (Rs 1.7 million)
• Operating Capacity Utilization = 90% = 0.90

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Part (a): Full Capacity Sales

$$\text{Full Capacity Sales} = \frac{\text{Actual Sales}}{\text{Capacity Utilization}} = \frac{\text{Rs } 5,000,000}{0.90} = \mathbf{\text{Rs } 5,555,555.56}$$

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Part (b): Target Fixed Asset-to-Sales Ratio

$$\text{Target Ratio} = \frac{\text{Fixed Assets}}{\text{Full Capacity Sales}} = \frac{\text{Rs } 1,700,000}{\text{Rs } 5,555,555.56} = \mathbf{0.306 \text{ (or } 30.6\%\text{)}}$$

Reformulation of Shareholders’ Capitalization Account after 20% Stock Dividend:

1. Calculation Details:

• Existing Common Shares: 40,000 shares @ Rs 100 par = Rs 4,000,000
• Stock Dividend Percentage: 20%
• New Shares Issued: $40,000 \times 20\% = 8,000\text{ new shares}$
• Market Price per Share on Declaration Date: Rs 600
• Par Value per Share: Rs 100

Small Stock Dividend Treatment (Market Value Capitalization):

Because a 20% stock dividend is classified as a small stock dividend (<= 20-25%), GAAP requires capitalization at fair market value:

• Total Value Transferred from Retained Earnings:
  $$8,000\text{ shares} \times \text{Rs } 600 = \mathbf{\text{Rs } 4,800,000}$$
• Addition to Common Stock (at Par):
  $$8,000\text{ shares} \times \text{Rs } 100 = \mathbf{\text{Rs } 800,000}$$
• Addition to Additional Paid-in Capital (APIC):
  $$8,000\text{ shares} \times (\text{Rs } 600 - \text{Rs } 100) = \mathbf{\text{Rs } 4,000,000}$$
• New Retained Earnings Balance:
  $$\text{Rs } 5,000,000 - \text{Rs } 4,800,000 = \mathbf{\text{Rs } 200,000}$$

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2. Reformulated Capitalization Account (as of December 31, 2022)

Equity Components	Pre-Dividend Amount (Rs)	Adjustments (Rs)	Post-Dividend Amount (Rs)
Common Stock (48,000 shares @ Rs 100 par)	$4,000,000$	$+800,000$	$4,800,000$
Additional Paid-in Capital (APIC)	$1,000,000$	$+4,000,000$	$5,000,000$
Retained Earnings	$5,000,000$	$-4,800,000$	$200,000$
Total Shareholders’ Equity	$10,000,000$	-	$\mathbf{10,000,000}$

(Note: Total net worth remains unchanged at Rs 10,000,000; the transaction represents an internal recapitalization of equity).

Calculations for Kathmandu Biscuits Factory:

Part (a): Cash Conversion Cycle (CCC)

Given:

• Inventory Turnover Ratio = 6 times
• Receivables Collection Period (DSO) = 70 days
• Payable Deferral Period (DPO) = 40 days

1. Inventory Conversion Period (ICP):

   $$\text{ICP} = \frac{360}{\text{Inventory Turnover}} = \frac{360}{6} = \mathbf{60\text{ days}}$$
   (Using 365 days: $\frac{365}{6} = 60.83\text{ days}$)

2. Cash Conversion Cycle (CCC):

   $$\text{CCC} = \text{ICP} + \text{DSO} - \text{DPO}$$
   $$\text{CCC} = 60 + 70 - 40 = \mathbf{90\text{ days}}$$
   (Using 365 days: $60.83 + 70 - 40 = \mathbf{90.83\text{ days}}$)

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Part (b): Firm’s Investment in Accounts Receivable

Given:

• Annual Sales = Rs 5,000,000
• Credit Sales Percentage = 80%
  $$\text{Credit Sales} = 5,000,000 \times 0.80 = \mathbf{\text{Rs } 4,000,000}$$

Using Days Sales Outstanding (DSO = 70 days):

$$\text{Accounts Receivable} = \frac{\text{Credit Sales} \times \text{DSO}}{360} = \frac{\text{Rs } 4,000,000 \times 70}{360} = \mathbf{\text{Rs } 777,777.78}$$

(Using a 365-day basis: $\frac{4,000,000 \times 70}{365} = \mathbf{\text{Rs } 767,123.29}$).

Additional Funds Needed (AFN) & Pro Forma Balance Sheet for Karki Furnishing (Pvt.) Ltd:

Given Data (Rs in Millions):

• 2021 Sales (S0) = Rs 2,000 million; 2022 Forecasted Sales (S1) = Rs 3,000 million
• Change in Sales (Delta S) = 3,000 - 2,000 = Rs 1,000 million (Growth g = 50%)
• Total Assets (A*) = Rs 1,200 million (operated at full capacity, so all assets grow with sales: A*/S0 = 1,200 / 2,000 = 0.60)
• Spontaneous Liabilities (L*) = Accounts Payable (100) + Accruals (50) = Rs 150 million
• Non-spontaneous (Notes payable = 50, Long-term debt = 400, Common stock = 300)
• Net Profit Margin (M) = 10% = 0.10
• Dividend Payout Ratio (d) = 60% = 0.60; Retention Ratio (b) = 1 - 0.60 = 0.40

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Part (a): Additional Funds Needed (AFN)

$$\text{AFN} = \left(\frac{A^*}{S_0}\right)\Delta S - \left(\frac{L^*}{S_0}\right)\Delta S - [M \times S_1 \times (1 - d)]$$

$$\text{AFN} = (0.60 \times 1,000) - \left(\frac{150}{2,000} \times 1,000\right) - [0.10 \times 3,000 \times 0.40]$$

$$\text{AFN} = 600 - 75 - 120 = \mathbf{\text{Rs } 405\text{ million}}$$

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Part (b): Pro Forma Balance Sheet for December 31, 2022

All assets and spontaneous liabilities grow by 50% (factor of 1.50). Addition to Retained Earnings = Rs 120 million.

Assets	2021 (Rs M)	2022 (Rs M)	Liabilities & Equity	2021 (Rs M)	2022 (Rs M)
Cash	$100$	$150$	Accounts Payable	$100$	$150$
Accounts Receivable	$300$	$450$	Notes Payable	$50$	$50$
Inventory	$300$	$450$	Accruals	$50$	$75$
Net Fixed Assets	$500$	$750$	Long-term Debt	$400$	$400$
			Common Stock	$300$	$300$
			Retained Earnings $(300 + 120)$	$300$	$420$
			Subtotal Liabilities & Equity		$1,395$
			Additional Funds Needed (AFN)		$405$
Total Assets	$1,200$	$\mathbf{1,800}$	Total Claims	$1,200$	$\mathbf{1,800}$

Risk and Return Calculations for Stock J and Market (NEPSE):

1. Tabular Computation:

Year	Market Return Rm (%)	Stock J Return Rj (%)	(Rm - Rm_bar)	(Rj - Rj_bar)	(Rm - Rm_bar)^2	(Rj - Rj_bar)^2	Product of Dev.
2018	$15$	$20$	$+5$	$+4$	$25$	$16$	$+20$
2019	$10$	$15$	$0$	$-1$	$0$	$1$	$0$
2020	$-5$	$5$	$-15$	$-11$	$225$	$121$	$+165$
2021	$20$	$20$	$+10$	$+4$	$100$	$16$	$+40$
2022	$10$	$20$	$0$	$+4$	$0$	$16$	$0$
Total	$50$	$80$	$0$	$0$	$350$	$170$	$225$

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Part (a): Mean and Standard Deviation

• Mean Returns:

  $$\bar{R}_m = \frac{\sum R_m}{N} = \frac{50}{5} = \mathbf{10\%}$$
  $$\bar{R}_j = \frac{\sum R_j}{N} = \frac{80}{5} = \mathbf{16\%}$$

• Sample Standard Deviations (N - 1 = 4):

  $$s_m = \sqrt{\frac{\sum (R_m - \bar{R}_m)^2}{N - 1}} = \sqrt{\frac{350}{4}} = \sqrt{87.5} = \mathbf{9.35\%}$$
  $$s_j = \sqrt{\frac{\sum (R_j - \bar{R}_j)^2}{N - 1}} = \sqrt{\frac{170}{4}} = \sqrt{42.5} = \mathbf{6.52\%}$$

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Part (b): Beta Coefficient of Stock J (beta_j)

$$\text{Cov}(j, m) = \frac{\sum (R_m - \bar{R}_m)(R_j - \bar{R}_j)}{N - 1} = \frac{225}{4} = 56.25$$

$$\beta_j = \frac{\text{Cov}(j, m)}{s_m^2} = \frac{56.25}{87.5} = \frac{225}{350} = \mathbf{0.6429}$$

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Part (c): Required Rate of Return on Stock J using CAPM (Rf = 6%)

$$E(R_j) = R_f + \beta_j [\bar{R}_m - R_f]$$

$$E(R_j) = 6\% + 0.6429 \times (10\% - 6\%) = 6\% + (0.6429 \times 4\%) = 6\% + 2.5716\% = \mathbf{8.57\%}$$

Calculations for Kathmandu Toy Manufacturing Company:

1. Given Data:

• Break-Even Sales Volume (Accounting BEP) = 10,000 units
• Selling Price per unit (P) = Rs 30
• Variable Cost per unit (V) = Rs 18
• Contribution Margin per unit (CM) = P - V = 30 - 18 = Rs 12 per unit
• Cost of Fixed Assets = Rs 80,000
• Useful Life = 5 years (Straight-line depreciation)

$$\text{Annual Depreciation} = \frac{\text{Cost of Fixed Assets}}{\text{Useful Life}} = \frac{\text{Rs } 80,000}{5} = \mathbf{\text{Rs } 16,000\text{ per year}}$$

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2. Fixed Costs Without Depreciation (Cash Fixed Cost):

Using the Accounting Break-Even formula:

$$\text{Accounting BEP (units)} = \frac{\text{Total Fixed Cost}}{\text{CM per unit}}$$

$$10,000 = \frac{\text{Total Fixed Cost}}{12} \implies \text{Total Fixed Cost} = 10,000 \times 12 = \mathbf{\text{Rs } 120,000}$$

$$\text{Fixed Costs Without Depreciation (Cash Fixed Cost)} = \text{Total Fixed Cost} - \text{Depreciation}$$

$$\text{Cash Fixed Cost} = 120,000 - 16,000 = \mathbf{\text{Rs } 104,000}$$

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3. Cash Break-Even Point in Units:

$$\text{Cash BEP (units)} = \frac{\text{Cash Fixed Cost}}{\text{CM per unit}} = \frac{\text{Rs } 104,000}{\text{Rs } 12} = \mathbf{8,666.67\text{ units (or 8,667 units)}}$$

Calculations for Nanglo Bread Company:

1. Given Data:

• Annual Requirement (A) = 100,000 bags @ 50 kg = 5,000,000 kg of wheat
• Purchase Price per kg (P) = Rs 25
• Carrying Cost Percentage = 10% per year
  $$C = 10\% \times \text{Rs } 25 = \mathbf{\text{Rs } 2.50\text{ per kg per year}}$$
• Ordering Cost per order (O) = Rs 500
• Lead Time = 9 days; Safety Stock Requirement = 10 days of consumption
• Daily Consumption (assuming 360 days/year) = $\frac{5,000,000}{360} = \mathbf{13,888.89\text{ kg/day}}$
• Safety Stock Quantity = $13,888.89 \times 10 = \mathbf{138,888.89\text{ kg}}$

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Part (a): Economic Order Quantity (EOQ) in kg

$$\text{EOQ} = \sqrt{\frac{2 \times A \times O}{C}} = \sqrt{\frac{2 \times 5,000,000 \times 500}{2.50}} = \sqrt{2,000,000,000} = \mathbf{44,721.36\text{ kg}}$$

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Part (b): Total Inventory Cost Including Safety Stock

1. Total Annual Ordering Cost:
   $$\frac{A}{\text{EOQ}} \times O = \frac{5,000,000}{44,721.36} \times 500 = \text{Rs } 55,901.70$$
2. Annual Carrying Cost of Normal Cycle Inventory:
   $$\frac{\text{EOQ}}{2} \times C = \frac{44,721.36}{2} \times 2.50 = \text{Rs } 55,901.70$$
3. Annual Carrying Cost of Safety Stock:
   $$\text{Safety Stock} \times C = 138,888.89 \times 2.50 = \text{Rs } 347,222.22$$

$$\text{Total Inventory Cost} = 55,901.70 + 55,901.70 + 347,222.22 = \mathbf{\text{Rs } 459,025.62}$$

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Part (c): Re-Order Level (ROL)

$$\text{ROL} = (\text{Daily Consumption} \times \text{Lead Time}) + \text{Safety Stock}$$

$$\text{ROL} = (13,888.89 \times 9) + 138,888.89 = 125,000 + 138,888.89 = \mathbf{263,888.89\text{ kg}}$$

Comprehensive Capital Budgeting Analysis for City Bank Limited:

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Part (a): Initial Net Cash Outlay (NCO / Initial Investment)

• Machine Purchase Price: Rs 550,000
• Transportation / Transit Cost: Rs 20,000
• Modification Cost: Rs 15,000
• Installation Cost: Rs 5,000 (Note: Receptionist salary is an existing continuing expense and irrelevant).

$$\text{Initial Investment (NCO)} = 550,000 + 20,000 + 15,000 + 5,000 = \mathbf{\text{Rs } 590,000}$$

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Part (b): Annual Straight-Line Depreciation

• Depreciable Asset Base = Rs 590,000
• Estimated Book Salvage Value = Rs 40,000
• Economic Useful Life = 5 years

$$\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}} = \frac{590,000 - 40,000}{5} = \mathbf{\text{Rs } 110,000\text{ per year}}$$

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Part (c): Annual Operating Cash Flow After Taxes (CFAT for Years 1 to 5)

• Annual Pre-tax Operating Cost Savings = Rs 150,000
• Less: Annual Depreciation = Rs 110,000
• Earnings Before Taxes (EBT) = $150,000 - 110,000 = \text{Rs } 40,000$
• Less: Income Tax @ 20% = $0.20 \times 40,000 = \text{Rs } 8,000$
• Earnings After Taxes (EAT) = $40,000 - 8,000 = \text{Rs } 32,000$
• Add back: Depreciation = Rs 110,000

$$\mathbf{\text{Operating CFAT}} = 32,000 + 110,000 = \mathbf{\text{Rs } 142,000\text{ per year}}$$

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Part (d): Terminal Cash Flow (Year 5)

• Actual Cash Salvage Realization = Rs 60,000
• Book Value at end of Year 5 = Rs 40,000
• Taxable Gain on Salvage = $60,000 - 40,000 = \text{Rs } 20,000$
• Tax on Gain @ 20% = $0.20 \times 20,000 = \text{Rs } 4,000$

$$\text{Net Terminal Salvage Inflow} = 60,000 - 4,000 = \mathbf{\text{Rs } 56,000}$$

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Part (e): Investment Decision using Net Present Value (Discount Rate = 10%)

1. Present Value of Annual Operating CFAT (Years 1 to 5):

   $$PV = \text{CFAT} \times PVIFA(10\%, 5) = 142,000 \times 3.7908 = \text{Rs } 538,293.60$$

2. Present Value of Terminal Salvage Cash Flow (Year 5):

   $$PV = \text{Terminal Cash Flow} \times PVIF(10\%, 5) = 56,000 \times 0.6209 = \text{Rs } 34,770.40$$

3. Total Present Value of Cash Inflows (PV):

   $$\text{Total PV} = 538,293.60 + 34,770.40 = \mathbf{\text{Rs } 573,064.00}$$

4. Net Present Value (NPV):

   $$\text{NPV} = \text{Total PV of Inflows} - \text{Initial Outlay} = 573,064.00 - 590,000 = \mathbf{-\text{Rs } 16,936.00}$$

Managerial Recommendation: City Bank Limited should NOT install the intercom system because the project produces a negative Net Present Value of -Rs 16,936, which would reduce shareholder wealth.