Fundamentals of Corporate Finance 2080 Board Question Paper

Meaning of Business Ethics

Business ethics refers to the moral principles, values, and standards of conduct that guide organizational decision-making, corporate behavior, and relationships with stakeholders (shareholders, customers, employees, creditors, and society).

Operating Lease vs. Financial Lease

1. Operating Lease: Short-term, cancelable contractual lease; maintenance and insurance are typically provided by the lessor; assets are not fully amortized over the primary lease term.
2. Financial (Capital) Lease: Long-term, non-cancelable lease spanning most of the asset’s economic useful life; maintenance is borne by the lessee; payments fully amortize the asset’s purchase price.

Meaning of Optimal Capital Structure

The optimal capital structure is the precise mix of debt, preferred stock, and common equity that minimizes the firm’s Weighted Average Cost of Capital (WACC) and simultaneously maximizes the market value per share of its common stock.

What is an Operating Plan?

An operating plan provides detailed tactical operational guidance for the enterprise’s functional divisions (marketing, production, logistics, personnel), outlining production targets, unit sales forecasts, and operational cost budgets for the upcoming operating period.

Why Preferred Stock is Called a Hybrid Security

Preferred stock is a hybrid security because it blends debt-like features (fixed dividend payments, priority claim over common equity on liquidation, non-voting status) with equity-like features (no fixed maturity date, omission of dividends does not trigger bankruptcy, dividends are paid from after-tax earnings).

Four Key Reasons for Going Global

1. Accessing New Consumer Markets: Overcoming domestic market saturation.
2. Securing Raw Materials & Natural Resources: Guaranteeing vital inputs at lower cost.
3. Exploiting Low-Cost Production Factors: Benefiting from lower manufacturing wages and operational costs.
4. Geographic Risk Diversification: Mitigating vulnerability to single-country economic downturns.

Definition of Warrant

A warrant is a long-term derivative call option issued directly by a corporation granting the holder the legal right to purchase a specified number of common shares at a stated exercise price within a designated expiration period.

Concept of Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) states that exchange rates between currencies are in equilibrium when their domestic purchasing power at that rate of exchange is equivalent, asserting that identical bundles of goods should sell for the same price worldwide when converted to a common currency (Law of One Price).

Annual Percentage Cost of Stretching Accounts Payable (3/8 net 50, paid on 60th day):

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

$$APR = \frac{3}{97} \times \frac{360}{60 - 8} = 0.030928 \times \frac{360}{52} = 0.030928 \times 6.923077 = 0.214115 = \mathbf{21.41\%}$$

Conclusion: The annual percentage cost is 21.41%.

Minimum Shares Needed to Elect One Director (Cumulative Voting):

• Total Shares Outstanding ($N$) = $320,000$
• Total Directors to be Elected ($D$) = $7$
• Directors Desired to Elect ($d$) = $1$$\text{Shares Needed} = \frac{d \times N}{D + 1} + 1 = \frac{1 \times 320,000}{7 + 1} + 1 = \frac{320,000}{8} + 1 = 40,000 + 1 = \mathbf{40,001 \text{ shares}}$$ Conclusion: A shareholder group must control 40,001 shares to guarantee the election of one director.

Potential Agency Conflicts and Resolution Mechanisms

1. Conflicts Between Shareholders and Managers:

• Nature: Managers may prioritize empire building, personal perquisites, or excessive compensation over maximizing stock price.
• Resolution Mechanisms:
  • Executive stock options tying managerial compensation to long-term stock value.
  • Threat of hostile takeover and proxy fights by activist institutional investors.
  • Direct board oversight through independent non-executive director majority.

2. Conflicts Between Shareholders and Creditors:

• Nature: Shareholders taking speculative, high-risk gambles or issuing equal/senior debt that impairs bondholder safety.
• Resolution Mechanisms:
  • Restrictive loan covenants prohibiting excessive dividend payouts and mandating minimum liquidity ratios.
  • Issuing convertible bonds that grant creditors equity upside participation.

Methods of Issuing Securities in Corporate Finance

1. Public Offering (Initial Public Offering / IPO & FPO): Selling securities to the general public through licensed merchant banking underwriters.
2. Rights Offering (Privileged Subscription): Offering new shares directly to existing shareholders pro-rata at a discounted subscription price.
3. Private Placement: Direct institutional sale of entire security tranches to sophisticated accredited investors (e.g., pension funds, insurance companies).
4. Bonus Shares / Stock Dividends: Capitalizing retained earnings by issuing free proportional shares to existing owners.

Mega Company Lease vs. Buy Analysis:

• Cost of Equipment = $\text{Rs. } 300,000$, Useful Life = 3 years, Salvage = 0.
• Annual Lease Payment = $\text{Rs. } 150,000$ at year-end.
• Pre-tax Cost of Debt ($k_d$) = $10\%$, Tax Rate ($t$) = $40\%$.
• After-tax discount rate $= k_d(1 - t) = 10\%(1 - 0.40) = \mathbf{6\%}$.

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a. Present Value Cost of Leasing:

• After-tax Lease Payment $= 150,000(1 - 0.40) = \text{Rs. } 90,000$ per year.
  $$PVIFA_{6\%, 3} = \frac{1 - (1.06)^{-3}}{0.06} = 2.67301$$
  $$PV(\text{Cost of Leasing}) = 90,000 \times 2.67301 = \mathbf{\text{Rs. } 240,571}$$

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b. Present Value Cost of Purchasing:

• Initial Cash Outlay $= \text{Rs. } 300,000$.
• Annual Straight-Line Depreciation $= \frac{300,000}{3} = \text{Rs. } 100,000$.
• Annual Depreciation Tax Shield $= 100,000 \times 0.40 = \text{Rs. } 40,000$.
  $$PV(\text{Tax Shield}) = 40,000 \times PVIFA_{6\%, 3} = 40,000 \times 2.67301 = \text{Rs. } 106,920$$
  $$PV(\text{Cost of Purchasing}) = 300,000 - 106,920 = \mathbf{\text{Rs. } 193,080}$$

Decision: The machine should be PURCHASED because the net cost of owning (Rs. 193,080) is significantly lower than leasing (Rs. 240,571).

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c. Why Use After-Tax Cost of Debt as Discount Rate:

Lease payments and depreciation tax shields are contractual, predictable cash flows with risk equivalent to the firm’s debt obligations. Therefore, discounting at the after-tax cost of debt appropriately matches the risk profile.

Alpha Paint Corporation Convertible Subordinated Bond:

• Face Value ($M$) = $\text{Rs. } 1,000$, Coupon = $10\%$, Maturity = 10 years.

• Stock Price ($P_0$) = $\text{Rs. } 200$, Conversion Ratio ($CR$) = 4.

• a. Conversion Price ($P_c$):

  $$P_c = \frac{\text{Face Value}}{CR} = \frac{1,000}{4} = \mathbf{\text{Rs. } 250}$$

• b. Initial Conversion Value ($C_v$):

  $$C_v = CR \times P_0 = 4 \times 200 = \mathbf{\text{Rs. } 800}$$

• c. Initial Conversion Premium:

  $$\text{Premium Amount} = M - C_v = 1,000 - 800 = \mathbf{\text{Rs. } 200}$$
  $$\text{Premium Percentage} = \frac{200}{800} \times 100 = \mathbf{25.0\%}$$

• d. Reasons for Using Convertible Securities:

  1. Lower Borrowing Coupon: Allows issuing debt at sub-market coupon rates.
  2. Deferred Equity Financing: Sells future common equity at a premium ($P_c = 250$ vs. $P_0 = 200$).

Janakpur Textile Company AFN & Pro-Forma Analysis:

• Base Sales 2023 ($S_0$) = $\text{Rs. } 10\text{M}$, Projected 2024 ($S_1$) = $\text{Rs. } 15\text{M} \implies \Delta S = \text{Rs. } 5\text{M}$.
• Operating at full capacity $\implies$ Total Assets ($A^*$) = $\text{Rs. } 3\text{M}$.
• Spontaneous Liabilities ($L^*$) = Accounts Payable ($200k$) + Accruals ($100k$) = $\text{Rs. } 300,000$.
• Profit Margin ($M$) = $10\% = 0.10$, Dividend Payout ($d$) = $70\% \implies b = 30\% = 0.30$.

a. AFN Equation:

$$AFN = \left(\frac{A^*}{S_0}\right)\Delta S - \left(\frac{L^*}{S_0}\right)\Delta S - M(S_1)(b)$$

$$AFN = \left(\frac{3,000,000}{10,000,000}\right)5,000,000 - \left(\frac{300,000}{10,000,000}\right)5,000,000 - (0.10 \times 15,000,000 \times 0.30)$$

$$AFN = (0.30 \times 5,000,000) - (0.03 \times 5,000,000) - 450,000 = 1,500,000 - 150,000 - 450,000 = \mathbf{\text{Rs. } 900,000}$$

b. Pro-Forma Balance Sheet (Dec 31, 2024):

• Assets ($50\%$ growth): Current Assets $\text{Rs. } 1,500,000$, Net Fixed Assets $\text{Rs. } 3,000,000 \implies$ Total Assets = Rs. 4,500,000.
• Liabilities & Equity: A/P $\text{Rs. } 300,000$, Accruals $\text{Rs. } 150,000$, Notes Payable $\text{Rs. } 300,000$, Common Stock $\text{Rs. } 1,500,000$, Retained Earnings ($900k + 450k = \text{Rs. } 1,350,000$), AFN (plug) = Rs. 900,000 $\implies$ Total Liab & Equity = Rs. 4,500,000.

Kapil Singapore Tour Forex Calculations:

• NRB Quotes: Bid = NR 69.13 / SGD, Ask = NR 69.61 / SGD. Initial Funds = NR 300,000.

• a. SGD Received on January 16:

  $$\text{SGD Received} = \frac{300,000}{\text{Ask Rate}} = \frac{300,000}{69.61} = \mathbf{4,309.73 \text{ SGD}}$$

• b. NR Received on January 22:

  $$\text{NR Received} = 4,309.73 \times \text{Bid Rate} = 4,309.73 \times 69.13 = \mathbf{\text{NR } 297,931.63}$$

• c. Net Gain or Loss:

  $$\text{Net Loss} = 300,000 - 297,931.63 = \mathbf{\text{NR } 2,068.37 \text{ loss}}$$

• d. Percentage Loss:

  $$\% \text{ Loss} = \frac{2,068.37}{300,000} \times 100 = \mathbf{0.689\%}$$

• e. Bid-Ask Percentage Spread:

  $$\% \text{ Spread} = \frac{\text{Ask} - \text{Bid}}{\text{Ask}} \times 100 = \frac{69.61 - 69.13}{69.61} \times 100 = \frac{0.48}{69.61} \times 100 = \mathbf{0.689\%}$$

Corporate Mergers: Types and Strategic Rationales

1. Types of Mergers: Horizontal, Vertical, Conglomerate, and Congeneric.
2. Key Strategic Rationales:
   • Operational synergies and plant-level economies of scale.
   • Financial synergy through larger debt capacity and lower cost of capital.
   • Tax shield optimization from accumulated carry-forward losses.
   • Accelerated diversification and technological IP acquisition.

Himalayan Herbal Company Rights Offering:

• Capital to Raise = $\text{Rs. } 80,000,000$, Existing Shares ($N_0$) = $1,600,000$, Par = $\text{Rs. } 100$, Market Price ($P_0$) = $\text{Rs. } 250$.

• a. Subscription Price Limits: Maximum $= P_0 = \mathbf{\text{Rs. } 250}$; Minimum $= \text{Par Value} = \mathbf{\text{Rs. } 100}$.

• b. Shares to be Sold ($S = 100$): $N = \frac{80,000,000}{100} = \mathbf{800,000 \text{ shares}}$.

• c. Rights per Share ($N_r$): $N_r = \frac{1,600,000}{800,000} = \mathbf{2 \text{ rights}}$.

• d. Value of a Right ($R$): $R = \frac{250 - 100}{2 + 1} = \frac{150}{3} = \mathbf{\text{Rs. } 50}$.

• e. Ex-Rights Price ($P_e$): $P_e = 250 - 50 = \mathbf{\text{Rs. } 200}$.

• f. Shareholder Holding 2,000 Shares (Sells Rights):

  • Initial Wealth $= 2,000 \times 250 = \mathbf{\text{Rs. } 500,000}$.
  • Sells 2,000 rights at Rs 50 $= \text{Rs. } 100,000$ cash.
  • Stock value after rights $= 2,000 \times 200 = \text{Rs. } 400,000$.
  • Ending Wealth $= 400,000 + 100,000 = \mathbf{\text{Rs. } 500,000}$ (Wealth is completely intact).

Modern Printing Press Short-Term Financing (Rs. 500,000 for June / 30 Days):

• Option a (Bank Line of Credit):
  • Commitment fee on full year $= 1\% \times 500,000 = \text{Rs. } 5,000$.
  • Interest for 30 days $= 500,000 \times 12\% \times \frac{30}{360} = \text{Rs. } 5,000$.
  • Total Rupee Cost $= 5,000 + 5,000 = \mathbf{\text{Rs. } 10,000}$.
• Option b (Foregoing Trade Discount 2/10, net 40):
  • Cash discount lost $= 2\% \times 500,000 = \mathbf{\text{Rs. } 10,000}$.
• Option c (60-Day Commercial Paper at 9% + Reinvestment at 6%):
  • CP interest for 60 days $= 500,000 \times 9\% \times \frac{60}{360} = \text{Rs. } 7,500$.
  • Reinvestment income (July 30 days) $= 500,000 \times 6\% \times \frac{30}{360} = \text{Rs. } 2,500$.
  • Transaction fee $= 0.5\% \times 500,000 = \text{Rs. } 2,500$.
  • Net Rupee Cost $= 7,500 - 2,500 + 2,500 = \mathbf{\text{Rs. } 7,500}$.
• Recommendation: Commercial Paper (Option c) produces the lowest rupee cost (Rs. 7,500).