Fundamentals of Corporate Finance 2078 Board Question Paper

Definition of Agency Relationship

An agency relationship exists when one or more persons (the principal) hire another person or entity (the agent) to perform a service on their behalf and delegate decision-making authority to that agent.

• In Corporate Finance: Stockholders are principals who delegate daily operational management to corporate executives and directors (the agents).

Definition of Default Risk

Default risk (credit risk) is the probability that a borrower will fail to make timely payments of contractual interest and/or principal on a debt security when due. Investors demand a Default Risk Premium ($DRP$) to compensate for bearing this risk.

Money Markets vs. Capital Markets

• Money Market: The market for high-liquidity, low-risk, short-term debt securities with original maturities of one year or less (e.g., Treasury bills, commercial paper, certificates of deposit).
• Capital Market: The market for intermediate- and long-term financial instruments with maturities exceeding one year (e.g., common stocks, preferred stocks, corporate bonds, long-term government bonds).

Four Key Responsibilities of a Financial Manager

1. Investment Decision (Capital Budgeting): Identifying and selecting high-return CapEx projects that maximize net present value.
2. Financing Decision (Capital Structure): Determining the optimal mix of debt, equity, and retained earnings to minimize WACC.
3. Working Capital Management: Ensuring liquidity for day-to-day operations and cash flow cycles.
4. Dividend Policy Decision: Deciding the proportion of net earnings to distribute to shareholders versus reinvest.

Calculation of 2-Year Treasury Yield:

• Real risk-free rate ($r^*$) = $3\%$
• Expected inflation: Year 1 = $2\%$, Year 2 = $4\%$
• Average expected inflation over 2 years ($IP_2$) = $\frac{2\% + 4\%}{2} = 3\%$
• Maturity Risk Premium ($MRP$) = $0\%$$r_2 = r^* + IP_2 + MRP = 3\% + 3\% + 0\% = \mathbf{6.0\%}$$ Conclusion: The yield on the 2-year Treasury security is 6.0%.

Calculation of Degree of Operating Leverage (DOL):

• Sales ($S$) = $\text{Rs. } 7,500,000$
• Variable Cost ($VC$) = $\text{Rs. } 4,500,000$
• Fixed Cost ($FC$) = $\text{Rs. } 1,500,000$$DOL = \frac{S - VC}{S - VC - FC} = \frac{7,500,000 - 4,500,000}{7,500,000 - 4,500,000 - 1,500,000} = \frac{3,000,000}{1,500,000} = \mathbf{2.0}$$ Conclusion: DOL is 2.0, meaning a $1\%$ change in sales produces a $2\%$ change in EBIT.

Annual Percentage Cost of Trade Credit (2/10, net 70, 360 days):

$$APR = \frac{\text{Discount } \%}{100 - \text{Discount } \%} \times \frac{360}{\text{Credit Days} - \text{Discount Days}}$$

$$APR = \frac{2}{98} \times \frac{360}{70 - 10} = 0.020408 \times \frac{360}{60} = 0.020408 \times 6 = 0.12245 = \mathbf{12.25\%}$$

Conclusion: The annual percentage cost of trade credit is 12.25%.

Mispricing Arbitrage Profit Calculation:

• Current Stock Price ($S$) = $\text{Rs. } 50$
• Call Exercise Price ($X$) = $\text{Rs. } 35$
• Call Market Price / Premium ($C$) = $\text{Rs. } 10$
• Intrinsic Value of Call = $S - X = 50 - 35 = \text{Rs. } 15$
• The call is undervalued by $\text{Rs. } 15 - \text{Rs. } 10 = \text{Rs. } 5$.
• Arbitrage Strategy: Buy call option for $\text{Rs. } 10$, immediately exercise at $\text{Rs. } 35$ (Total Cost = $\text{Rs. } 45$), and sell share on market for $\text{Rs. } 50$.
  $$\text{Net Arbitrage Profit} = 50 - (35 + 10) = \mathbf{\text{Rs. } 5 \text{ per share}}$$

Price of Television in Japan Under PPP:

• US Price ($P_{\text{USD}}$) = $\text{USD } 1,000$
• Spot Exchange Rate = $110 \text{ Yen / } \text{USD}1$$\text{Price in Japan } (P_{\yen}) = P_{\text{USD}} \times \text{Spot Rate} = 1,000 \times 110 = \mathbf{\yen 110,000}$$ Conclusion: Under absolute PPP, the price in Japan should be 110,000 Yen.

Equal Annual Loan Installment Calculation:

• Loan Amount ($PV$) = $\text{Rs. } 300,000$
• Term ($n$) = 3 years, Rate ($i$) = $10\%$$PVIFA_{10\%, 3} = \frac{1 - (1.10)^{-3}}{0.10} = 2.48685$$
  $$PMT = \frac{300,000}{2.48685} = \mathbf{\text{Rs. } 120,634.49}$$
  Conclusion: Annual payment is Rs. 120,634.49.

Reasons for Corporate Risk Management

1. Debt Capacity Enhancement: Mitigating earnings volatility allows higher safe leverage.
2. Preventing Underinvestment: Protects internal cash flow to fund positive NPV CapEx.
3. Minimizing Bankruptcy Costs: Reduces likelihood of costly legal insolvency and restructuring.
4. Tax Advantages: Flattens income volatility under progressive tax brackets.
5. Comparative Advantage: Hedging financial risks allows management to focus exclusively on core operational excellence.

Preferred Stock: Hybrid Features & Corporate Evaluation

• Hybrid Nature: Fixed dividends and senior liquidation claim like debt; equity accounting, perpetuity, and non-deductible dividends like common equity.
• Advantages to Issuing Company:
  • Preserves voting control of existing common stockholders.
  • Avoids mandatory legal default if dividends are skipped during bad years.
  • Preserves mortgageable physical assets as collateral for senior bank debt.
• Disadvantages to Issuing Company:
  • After-tax cost is higher than debt because preferred dividends are not tax-deductible.
  • Substantial fixed commitment that common shareholders dislike.

Forward Rate Calculations Using Expectations Theory:

Given spot yields: $r_1 = 6\%$, $r_2 = 6.2\%$, $r_3 = 6.3\%$, $r_4 = 6.5\%$.

• a. 1-year security, 1 year from now ($_{1}f_{1}$):

  $$(1 + r_2)^2 = (1 + r_1)(1 + _{1}f_{1}) \implies 1 + _{1}f_{1} = \frac{(1.062)^2}{1.06} = \frac{1.127844}{1.06} = 1.0640 \implies \mathbf{6.40\%}$$

• b. 1-year security, 2 years from now ($_{2}f_{1}$):

  $$(1 + r_3)^3 = (1 + r_2)^2(1 + _{2}f_{1}) \implies 1 + _{2}f_{1} = \frac{(1.063)^3}{(1.062)^2} = \frac{1.201170}{1.127844} = 1.0650 \implies \mathbf{6.50\%}$$

• c. 2-year security, 1 year from now ($_{1}f_{2}$):

  $$(1 + r_3)^3 = (1 + r_1)(1 + _{1}f_{2})^2 \implies (1 + _{1}f_{2})^2 = \frac{1.201170}{1.06} = 1.133179 \implies _{1}f_{2} = \sqrt{1.133179} - 1 = \mathbf{6.45\%}$$

• d. 3-year security, 1 year from now ($_{1}f_{3}$):

  $$(1 + r_4)^4 = (1 + r_1)(1 + _{1}f_{3})^3 \implies (1 + _{1}f_{3})^3 = \frac{(1.065)^4}{1.06} = \frac{1.286466}{1.06} = 1.213647 \implies _{1}f_{3} = (1.213647)^{1/3} - 1 = \mathbf{6.67\%}$$

Financial Forecasting for Fleury, Inc. (20% Growth in 2019):

• Projected Sales = $845,000 \times 1.20 = \text{Rs. } 1,014,000$

a. Pro Forma Income Statement:

• Sales: $\text{Rs. } 1,014,000$
• Costs ($657,000 \times 1.20$): $(788,400)$
• Other expenses ($17,500 \times 1.20$): $(21,000)$
• EBIT: $\text{Rs. } 204,600$
• Interest Expense (constant): $(12,500)$
• Taxable Income: $\text{Rs. } 192,100$
• Taxes (35%): $(67,235)$
• Net Income: $\mathbf{\text{Rs. } 124,865}$
• Dividends ($30\%$ payout): $\text{Rs. } 37,459.50$
• Addition to Retained Earnings: $\mathbf{\text{Rs. } 87,405.50}$

b. Pro Forma Balance Sheet (before AFN):

• Total Current Assets ($139,000 \times 1.20$) = $\text{Rs. } 166,800$
• Net Plant & Equipment ($375,000 \times 1.20$) = $\text{Rs. } 450,000$
• Total Projected Assets = $\mathbf{\text{Rs. } 616,800}$
• Spontaneous A/P ($62,000 \times 1.20$) = $\text{Rs. } 74,400$
• Notes Payable = $\text{Rs. } 15,000$, Long-term Debt = $\text{Rs. } 144,000$
• Common Stock = $\text{Rs. } 100,000$
• Retained Earnings ($193,000 + 87,405.50$) = $\text{Rs. } 280,405.50$
• Total Projected Liab & Equity = $\text{Rs. } 613,805.50$

c. Additional Funds Needed (AFN):

$$AFN = \text{Total Projected Assets} - \text{Total Projected Liab \& Equity} = 616,800 - 613,805.50 = \mathbf{\text{Rs. } 2,994.50}$$

National Power Rights Offering Analysis:

• Existing Shares ($N_0$) = $1,000,000$, Stock Price ($P_0$) = $\text{Rs. } 500$

• Capital to Raise = $\text{Rs. } 100,000,000$, Subscription Price ($S$) = $\text{Rs. } 400$

• a. Number of Shares to be Sold:

  $$N = \frac{100,000,000}{400} = \mathbf{250,000 \text{ shares}}$$

• b. Rights Required to Purchase One Share ($N_r$):

  $$N_r = \frac{1,000,000}{250,000} = \mathbf{4 \text{ rights}}$$

• c. Value of a Right ($R$):

  $$R = \frac{P_0 - S}{N_r + 1} = \frac{500 - 400}{4 + 1} = \frac{100}{5} = \mathbf{\text{Rs. } 20}$$

• d. Ex-Rights Price per Share ($P_e$):

  $$P_e = P_0 - R = 500 - 20 = \mathbf{\text{Rs. } 480}$$

Destin Corp. Capital Structure Comparison ($t = 40\%$):

• Plan I: 10,000 shares, Debt Rs 90,000 at 10% $\implies$ Interest = Rs 9,000.
• Plan II: 7,600 shares, Debt Rs 198,000 at 10% $\implies$ Interest = Rs 19,800.
• All-Equity: 12,000 shares, Debt = 0 $\implies$ Interest = 0.

a. EPS at $EBIT = \text{Rs. } 48,000$:

• All-Equity: $EPS = \frac{48,000(0.60)}{12,000} = \frac{28,800}{12,000} = \mathbf{\text{Rs. } 2.40}$
• Plan I: $EPS = \frac{(48,000 - 9,000)(0.60)}{10,000} = \frac{23,400}{10,000} = \mathbf{\text{Rs. } 2.34}$
• Plan II: $EPS = \frac{(48,000 - 19,800)(0.60)}{7,600} = \frac{16,920}{7,600} = \mathbf{\text{Rs. } 2.226}$ Conclusion: At $EBIT = 48,000$, All-Equity has highest EPS (Rs 2.40) and Plan II has lowest EPS (Rs 2.226).

b. Break-Even EBIT Levels vs. All-Equity Plan:

1. Plan I vs. All-Equity:
   $$\frac{EBIT(0.60)}{12,000} = \frac{(EBIT - 9,000)(0.60)}{10,000} \implies 10 EBIT = 12 EBIT - 108,000 \implies 2 EBIT = 108,000 \implies \mathbf{\text{Rs. } 54,000}$$
2. Plan II vs. All-Equity:
   $$\frac{EBIT(0.60)}{12,000} = \frac{(EBIT - 19,800)(0.60)}{7,600} \implies 7.6 EBIT = 12 EBIT - 237,600 \implies 4.4 EBIT = 237,600 \implies \mathbf{\text{Rs. } 54,000}$$

Primary Motives Behind Mergers & Four Economic Types

1. Primary Motives:

• Operating & Financial Synergy: Economies of scale, tax shields, and reduced cost of debt.
• Diversification & Growth: Accelerated market entry compared to internal Greenfield expansion.
• Acquiring Intangible Assets & Talent: Proprietary tech patents, brand equity, and skilled management.

2. Four Economic Types of Mergers:

1. Horizontal Merger: Combination of direct competitors in the same industry at the same stage of production (e.g., merger between two commercial banks such as Global IME Bank and Bank of Kathmandu).
2. Vertical Merger: Combination of firms operating at different stages of the production/distribution chain (e.g., a garment manufacturer merging with a textile spinning mill).
3. Conglomerate Merger: Combination of totally unrelated business enterprises in completely different industries (e.g., Chaudhary Group operating noodles, hospitality, and banking).
4. Congeneric (Market-Extension) Merger: Combination of related firms in the same general industry that do not offer directly competing products (e.g., a commercial bank merging with a merchant bank or stock brokerage).

Weathers Catering Supply Financing Options (Rs. 2,000,000 for 6 Months):

a. Cost of Each Alternative:

1. Option i (Bank Loan at 9% with 10% Compensating Balance):

   • Gross Borrowing required to yield Rs 2,000,000 net usable funds $= \frac{2,000,000}{1 - 0.10} = \text{Rs. } 2,222,222.22$.
   • 6-month interest $= 2,222,222.22 \times 9\% \times \frac{180}{360} = \text{Rs. } 100,000$.
   • $EIR = \frac{100,000}{2,000,000} \times 2 = 0.10 = \mathbf{10.0\%}$ (EAR $= (1 + 0.05)^2 - 1 = \mathbf{10.25\%}$).

2. Option ii (Discount Loan at 9%):

   • Gross Borrowing $= \frac{2,000,000}{1 - (0.09 \times 0.5)} = \frac{2,000,000}{0.955} = \text{Rs. } 2,094,240.84$.
   • 6-month discount interest $= 2,094,240.84 \times 0.045 = \text{Rs. } 94,240.84$.
   • $EIR = \frac{94,240.84}{2,000,000} \times 2 = \mathbf{9.42\%}$ (EAR $= (1 + 0.04712)^2 - 1 = \mathbf{9.65\%}$).

3. Option iii (Forgo Trade Discount 2/10, net 40):

   $$APR = \frac{2}{98} \times \frac{360}{40 - 10} = 2.0408\% \times 12 = \mathbf{24.49\%}$$

4. Option iv (180-Day Commercial Paper at 9.5% p.a. + 0.5% fee):

   • Interest for 180 days $= 2,000,000 \times 9.5\% \times 0.5 = \text{Rs. } 95,000$.
   • Transaction fee $= 0.5\% \times 2,000,000 = \text{Rs. } 10,000$.
   • Total cost for 6 months $= \text{Rs. } 105,000$.
   • Usable net proceeds $= 2,000,000 - 10,000 = \text{Rs. } 1,990,000$.
   • $EIR = \frac{105,000}{1,990,000} \times 2 = \mathbf{10.55\%}$.

b. Recommendation:

Discount Loan from Frost Finance (Option ii) has the lowest cost (9.42%). However, lowest numerical cost is not the sole criterion; bank flexibility, loan covenants, and rollover risk must be weighed.

Comprehensive Foreign Exchange Analysis:

• Spot Rate: $\text{CAD} 1.05 = \text{USD}1 \implies \text{CAD} 1 = \text{USD}0.9524$

• Six-Month Forward: $\text{CAD} 1.07 = \text{USD}1$

• Japanese Yen: $\yen 80 = \text{USD}1$

• a. Currency Worth: One US dollar buys 1.05 Canadian dollars. Therefore, the U.S. dollar is worth more than the Canadian dollar.

• b. Cost in US Under Absolute PPP:

  $$\text{Cost in US} = \frac{\text{Price in Canada}}{\text{Spot Rate (\text{CAD}/\text{USD})}} = \frac{\text{CAD} 2.50}{1.05} = \mathbf{\text{USD } 2.38}$$

• c. Premium/Discount of US Dollar: In forward market, $\text{USD } 1$ buys more Can$\text{USD}$ ($1.07$ vs. $1.05$). Thus, the US dollar is selling at a forward premium.

• d. Expected Appreciation: The US Dollar is expected to appreciate, and the Canadian Dollar is expected to depreciate.

• e. Cross-Rate in Yen per Canadian Dollar:

  $$\text{Cross Rate} = \frac{\yen / \text{USD}}{\text{CAD} / \text{USD}} = \frac{80}{1.05} = \mathbf{\yen 76.19 \text{ per Can}\text{USD} 1}$$