Dean's Office Official Model Question Paper

Answer: Primary Goal: Maximizing the long-term wealth of equity shareholders, reflected in the market value per share of the firm’s common stock. Why Superior: Profit maximization is ambiguous, ignores the timing of earnings (time value of money), neglects cash flows, and disregards the degree of risk and uncertainty associated with earnings streams.

Answer: Agency Problem: The potential conflict of interest between principals (shareholders/owners) and agents (corporate managers), where managers may prioritize self-serving objectives (executive perks, empire building) over shareholder value. Alignment Mechanism: Offering performance-based executive stock option plans (ESOPs) or tie bonuses directly to Economic Value Added (EVA) and share price performance.

Answer:

• Compounding: The mathematical process of converting present cash flows into equivalent Future Value (FV) by adding interest earned on both principal and accumulated interest over successive periods.
• Discounting: The reverse mathematical process of determining the Present Value (PV) of future expected cash flows by stripping away the time value of money at a specified discount rate.

Answer: Net Present Value (NPV): The difference between the present value of future cash inflows generated by an investment project and the present value of initial capital cash outflows:

$$\text{NPV} = \sum_{t=1}^{n} \frac{\text{CF}_t}{(1 + k)^t} - \text{CF}_0$$

Where $\text{CF}_t$ is cash inflow at period $t$, $k$ is the cost of capital, and $\text{CF}_0$ is initial investment outlay. A project is acceptable if $\text{NPV} \ge 0$.

Answer: Internal Rate of Return (IRR): The specific discount rate ($r$) that equates the present value of expected future cash inflows to the initial cash outlay of a project, rendering the Net Present Value exactly equal to zero:

$$\sum_{t=1}^{n} \frac{\text{CF}_t}{(1 + \text{IRR})^t} - \text{CF}_0 = 0$$

Answer:

$$\text{WACC} = w_d k_d (1 - T) + w_p k_p + w_e k_e$$

• $w_d, w_p, w_e$: Target capital structure weights of debt, preferred stock, and common equity respectively.
• $k_d (1 - T)$: After-tax cost of debt, where $k_d$ is before-tax cost and $T$ is the corporate tax rate.
• $k_p$: Cost of preferred stock.
• $k_e$: Cost of common equity / retained earnings.

Answer: Under perfect capital market assumptions with no corporate taxes, no transaction costs, and identical borrowing costs for individuals and corporations, the market value of a firm and its overall cost of capital are completely independent of its capital structure. Leverage does not affect corporate valuation:

$$V_L = V_U$$

(Value of Levered Firm = Value of Unlevered Firm).

Answer:

• Stock Dividend (Bonus Shares): Distribution of additional shares to existing shareholders on a pro-rata basis funded by capitalizing retained earnings; the par value per share remains unchanged.
• Stock Split: Dividing existing shares into a larger number of shares (e.g., 2-for-1 split), reducing the statutory par value per share proportionally without altering total equity or retained earnings.

Answer: Cash Conversion Cycle (CCC): The net length of time in days that elapses from the point a firm pays cash for raw materials until it collects cash from the sale of finished goods:

$$\text{CCC} = \text{Operating Cycle} - \text{Payables Deferral Period (PDP)}$$

$$\text{CCC} = \text{Inventory Conversion Period (ICP)} + \text{Receivables Collection Period (RCP)} - \text{Payables Deferral Period (PDP)}$$

Answer:

• Operating Lease: A short-term, cancellable lease agreement where the lessor maintains the asset and the lease term is significantly shorter than the asset’s economic useful life (e.g., leasing office copiers).
• Financial Lease: A long-term, non-cancellable contractual lease where the lessee assumes maintenance, risks, and economic rewards of ownership throughout the asset’s useful life (e.g., leasing aircraft or heavy factory machinery).

Solution: Project Evaluation

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Part (a): Payback Period Computation

Project A:

• Year 0: Outlay = Rs. 500,000
• End Year 1: Recovered = Rs. 250,000 (Remaining = Rs. 250,000)
• End Year 2: Recovered = Rs. 250,000 + 200,000 = Rs. 450,000 (Remaining = Rs. 50,000)
• Year 3 Cash Flow = Rs. 150,000

$$\text{Payback Period}_A = 2 + \frac{50,000}{150,000} = 2 + 0.33 = \mathbf{2.33 \text{ Years}}$$

Project B:

• Cumulative cash flows:
  • Year 1: Rs. 100,000
  • Year 2: Rs. 250,000
  • Year 3: Rs. 450,000 (Remaining to recover = Rs. 50,000)
  • Year 4 Cash Flow = Rs. 300,000

$$\text{Payback Period}_B = 3 + \frac{50,000}{300,000} = 3 + 0.17 = \mathbf{3.17 \text{ Years}}$$

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Part (b): Net Present Value (NPV) at $k = 10\%$

Discount factors at 10%: $PVIF_{10\%, 1} = 0.9091,\; PVIF_{10\%, 2} = 0.8264,\; PVIF_{10\%, 3} = 0.7513,\; PVIF_{10\%, 4} = 0.6830$

Project A NPV:

$$PV = 250,000(0.9091) + 200,000(0.8264) + 150,000(0.7513) + 100,000(0.6830)$$

$$PV = 227,275 + 165,280 + 112,695 + 68,300 = \text{Rs. } 573,550$$

$$\text{NPV}_A = 573,550 - 500,000 = \mathbf{\text{Rs. } 73,550}$$

Project B NPV:

$$PV = 100,000(0.9091) + 150,000(0.8264) + 200,000(0.7513) + 300,000(0.6830)$$

$$PV = 90,910 + 123,960 + 150,260 + 204,900 = \text{Rs. } 570,030$$

$$\text{NPV}_B = 570,030 - 500,000 = \mathbf{\text{Rs. } 70,030}$$

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Part (c): Recommendation and Superiority of NPV

• Recommendation: Shikhar Engineering should select Project A because it yields the higher Net Present Value ($\text{Rs. } 73,550 > \text{Rs. } 70,030$) and recovers capital significantly faster (2.33 years vs. 3.17 years).
• Superiority of NPV over IRR:
  1. Reinvestment Rate Assumption: NPV assumes intermediate cash flows are reinvested at the realistic, market-determined cost of capital ($k$), whereas IRR assumes reinvestment at the project’s internal IRR rate, which is frequently unrealistically high.
  2. Scale and Wealth Maximization: NPV directly measures the absolute monetary addition to shareholder wealth ($Rs$), whereas IRR measures a percentage rate that can mislead decisions between mutually exclusive projects of differing scales or cash flow timing.

Solution: Cost of Capital Computation

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Part (a): Component Costs of Capital

1. After-Tax Cost of Debt ($k_d(1 - T)$):

$$k_d = 10\%, \quad T = 25\% = 0.25$$

$$\text{After-tax } k_d = 10\% \times (1 - 0.25) = \mathbf{7.50\%}$$

2. Cost of Preferred Stock ($k_p$):

$$k_p = \frac{D_p}{P_p} = \frac{\text{Rs. } 8}{\text{Rs. } 100} = \mathbf{8.00\%}$$

3. Cost of Common Equity / Retained Earnings ($k_e$):

Using the Dividend Discount Model:

$$D_0 = \text{Rs. } 15, \quad g = 6\% = 0.06, \quad P_0 = \text{Rs. } 250$$

$$D_1 = D_0(1 + g) = 15(1 + 0.06) = \text{Rs. } 15.90$$

$$k_e = \frac{D_1}{P_0} + g = \frac{15.90}{250} + 0.06 = 0.0636 + 0.06 = 0.1236 = \mathbf{12.36\%}$$

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Part (b): WACC on Book Value Weights

$$\mathbf{\text{WACC}} = \mathbf{10.47\%}$$

1. Concept of Trade-Off Theory

The Trade-Off Theory (developed by Kraus and Litzenberger) posits that a firm’s optimal capital structure involves balancing the corporate tax advantages of debt financing against the escalating costs of financial distress and bankruptcy.

$$\text{Value of Levered Firm } (V_L) = \text{Value of Unlevered Firm } (V_U) + \text{PV of Interest Tax Shields} - \text{PV of Financial Distress Costs}$$

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2. The Two Counteracting Forces

Value of Firm (V)
       ^                           Optimal Capital Structure (Point P*)
       |                                   * (Max Firm Value)
       |                                /     \
       |                             /           \   Loss of value due to
       |       PV of Tax Shield   /                 \  Financial Distress Costs
       |                        /
       |  --------------------/ (Pure MM with Tax)
       |  VU --------------------------------------- (MM without Tax)
       |
       +---------------------------------------------> Debt Ratio (D/V)
                                     D*

1. Interest Tax Shield Advantage: Under tax law, interest on debt is a tax-deductible expense, whereas dividends to equity holders are paid out of after-tax profits. This generates an annual corporate tax saving of $T \times \text{Interest}$, creating an incentive to borrow.

2. Costs of Financial Distress: As debt ratio ($D/V$) increases:

   • Direct Bankruptcy Costs: Legal, accounting, court, and administrative fees during corporate restructuring.
   • Indirect Costs: Lost customer sales due to brand insolvency fears, key employee attrition, suppliers tightening credit terms, and suboptimal asset fire-sales.

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3. Determination of Optimal Capital Structure ($D^*$)

• At low levels of debt, the present value of tax shields dominates distress costs; total firm value rises.
• Beyond point $P^*$ (the optimal debt ratio $D^*$), the marginal cost of financial distress exceeds the marginal tax shield of debt.
• At $D^*$, the firm maximizes its total market valuation and minimizes its Weighted Average Cost of Capital (WACC).

1. Theoretical Comparison

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2. Gordon Model Formulation

$$P_0 = \frac{D_0 (1 + g)}{k_e - g} = \frac{E_1 (1 - b)}{k_e - b \cdot r}$$

• When $r > k_e$ (Growth firm): Retaining earnings ($b \uparrow$) maximizes share price.
• When $r < k_e$ (Declining firm): Distributing 100% earnings as dividends maximizes share price.

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3. Rationale for Dividend Preference in Nepal

1. Information Asymmetry & Signaling: In Nepal’s developing capital market, audited financial statements are often viewed with skepticism. Reliable cash dividends serve as a credible signal of genuine earnings and liquidity.
2. Retail Investor Income Dependency: A significant percentage of domestic retail investors rely on annual cash dividend payouts from commercial banks and telecom for living expenses.
3. Secondary Market Illiquidity: Outside active blue-chip banking and hydropower stocks, many listed stocks suffer from low trading volume, making it difficult to execute "homemade dividends" by selling shares without incurring severe price depression.
4. Agency Cost Mitigation: Distributing free cash flow as dividends prevents corporate insiders and majority promoter groups from expropriating funds for non-value-adding empire building.

Solution: Inventory Management

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Given Parameters:

• Annual Demand ($A$): 30,000 units
• Purchase Price per unit ($P$): Rs. 100
• Ordering Cost per order ($O$): Rs. 450
• Carrying Cost percentage ($C\%$): 15%
• Carrying Cost per unit per year ($C$): $\text{Rs. } 100 \times 15\% = \text{Rs. } 15$
• Working Days per year: 300 days
• Delivery Lead Time ($L$): 6 days
• Safety Stock ($SS$): 200 units

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Part (a): Economic Order Quantity (EOQ)

$$\text{EOQ} = \sqrt{\frac{2 A O}{C}} = \sqrt{\frac{2 \times 30,000 \times 450}{15}} = \sqrt{\frac{27,000,000}{15}} = \sqrt{1,800,000} \approx \mathbf{1,341.64 \implies 1,342 \text{ units}}$$

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Part (b): Total Inventory Cost (TIC) at EOQ

$$\text{Total Ordering Cost} = \frac{A}{\text{EOQ}} \times O = \frac{30,000}{1,341.64} \times 450 = 22.36 \times 450 = \text{Rs. } 10,062.31$$

$$\text{Total Carrying Cost} = \frac{\text{EOQ}}{2} \times C = \frac{1,341.64}{2} \times 15 = 670.82 \times 15 = \text{Rs. } 10,062.31$$

$$\mathbf{\text{Total Inventory Cost (TIC)}} = \text{Rs. } 10,062.31 + 10,062.31 = \mathbf{\text{Rs. } 20,124.62}$$

(At EOQ, Total Ordering Cost equals Total Carrying Cost).

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Part (c): Reorder Point (ROP)

$$\text{Daily Usage Rate } (d) = \frac{\text{Annual Demand}}{\text{Working Days}} = \frac{30,000}{300} = 100 \text{ units/day}$$

$$\text{Lead Time Demand} = d \times L = 100 \times 6 = 600 \text{ units}$$

$$\mathbf{\text{Reorder Point (ROP)}} = \text{Lead Time Demand} + \text{Safety Stock} = 600 + 200 = \mathbf{800 \text{ units}}$$

The company must issue a replenishment order whenever inventory drops to 800 units.

1. Concept of Lease Financing

Lease Financing is a contractual arrangement whereby the owner of an asset (the Lessor) grants another party (the Lessee) the exclusive right to use the asset for an agreed period in exchange for periodic rental payments, without immediate transfer of ownership title.

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2. The Lessee’s Evaluation Framework: Lease vs. Buy

When a firm requires productive equipment, it must evaluate whether it is financially advantageous to acquire the asset through a financial lease or borrow funds from a financial institution to purchase the asset outright.

                           Comparative Cash Flow Evaluation
                                          |
        +---------------------------------+---------------------------------+
        |                                                                   |
   Lease Option                                                    Borrow-and-Buy Option
   - Annual Lease Rent Payments (Outflow)                          - Initial Capital Outflow (offset by loan)
   - Tax Shield on Lease Rent (Inflow)                             - Annual Loan Principal & Interest Repayments
   - Zero Depreciation Tax Shield                                  - Tax Shield on Loan Interest (Inflow)
   - Zero Salvage Value (typically)                                - Depreciation Tax Shield (Inflow)
                                                                   - Net Residual Salvage Value at end (Inflow)

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3. Step-by-Step Capital Budgeting Procedure

Step 1: Calculate Net Cash Outflows of Leasing (NAL)

$$\text{Annual Net Lease Outflow} = \text{Lease Rent } \times (1 - T)$$

Step 2: Calculate Net Cash Outflows of Buying

$$\text{Annual Outflow} = \text{Loan Payment} - \text{Interest Tax Shield } (I_t \times T) - \text{Depreciation Tax Shield } (\text{Depr}_t \times T)$$

$$\text{Terminal Inflow} = \text{Expected Salvage Value after tax at year } n$$

Step 3: Determine Appropriate Discount Rate

Because debt cash flows and lease rentals carry low contractual risk, both cash flow streams must be discounted at the After-Tax Cost of Debt:

$$k_d (1 - T)$$

Step 4: Decision Rule: Net Advantage to Leasing (NAL)

$$\text{NAL} = \text{PV of Cost of Buying} - \text{PV of Cost of Leasing}$$

• If $\text{NAL} > 0$: Leasing is financially advantageous.
• If $\text{NAL} < 0$: Borrowing to buy is preferred.

Solution: Comprehensive Capital Budgeting Analysis

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Part (a): Initial Cash Outlay ($CF_0$)

• Cost of Plant and Machinery = Rs. 4,000,000
• Additional Net Working Capital = Rs. 500,000
  $$\mathbf{\text{Initial Cash Outlay } (CF_0)} = \text{Rs. } 4,000,000 + 500,000 = \mathbf{\text{Rs. } 4,500,000 \text{ (Outflow)}}$$

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Part (b): Annual Operating Cash Flows ($OCF$ for Years 1–5)

• Annual Depreciation:
  $$\text{Depreciation} = \frac{\text{Rs. } 4,000,000 - 0}{5} = \text{Rs. } 800,000 \text{ per year}$$

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Part (c): Terminal Cash Flow ($TCF$ at Year 5)

• Cash Salvage Value: Rs. 600,000
• Book Value at Year 5: Rs. 0
• Taxable Gain on Disposal: $\text{Rs. } 600,000 - 0 = \text{Rs. } 600,000$
• Tax on Salvage Gain (25%): $\text{Rs. } 600,000 \times 25\% = \text{Rs. } 150,000$
• Net After-tax Salvage Value: $\text{Rs. } 600,000 - 150,000 = \text{Rs. } 450,000$
• Recovery of Working Capital: Rs. 500,000 (Tax-free)

$$\mathbf{\text{Terminal Cash Flow } (TCF)} = \text{Rs. } 450,000 + 500,000 = \mathbf{\text{Rs. } 950,000}$$

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Part (d): Net Present Value (NPV) and Profitability Index (PI) at $k = 12\%$

Discount Factors at 12%:

• $\text{PVIFA}_{12\%, 5} = 3.6048$
• $\text{PVIF}_{12\%, 5} = 0.5674$

1. Present Value of Operating Cash Flows:

$$PV(\text{OCFs}) = \text{Rs. } 1,550,000 \times \text{PVIFA}_{12\%, 5} = 1,550,000 \times 3.6048 = \text{Rs. } 5,587,440$$

2. Present Value of Terminal Cash Flow:

$$PV(\text{TCF}) = \text{Rs. } 950,000 \times \text{PVIF}_{12\%, 5} = 950,000 \times 0.5674 = \text{Rs. } 539,030$$

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

$$\text{Total } PV = \text{Rs. } 5,587,440 + 539,030 = \mathbf{\text{Rs. } 6,126,470}$$

4. Net Present Value (NPV):

$$\mathbf{\text{NPV}} = \text{Total } PV - CF_0 = \text{Rs. } 6,126,470 - 4,500,000 = \mathbf{\text{Rs. } 1,626,470}$$

5. Profitability Index (PI):

$$\mathbf{\text{PI}} = \frac{\text{Total } PV}{CF_0} = \frac{\text{Rs. } 6,126,470}{\text{Rs. } 4,500,000} = \mathbf{1.361}$$

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Part (e): Final Recommendation

The proposed plant expansion project is highly acceptable:

1. It yields a substantial positive Net Present Value of Rs. 1,626,470, creating significant economic value for shareholders.
2. The Profitability Index of 1.361 significantly exceeds the acceptance benchmark of 1.00, generating Rs. 1.36 in present value for every rupee invested.

Solution: EBIT-EPS Leverage Analysis

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Part (a): EPS Computation at EBIT = Rs. 2,400,000

At EBIT of Rs. 2.4 Million, Plan 2 generates a higher EPS (Rs. 13.50 vs Rs. 12.00).

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Part (b): Financial Break-Even Point

The level of EBIT where EPS equals zero (covers contractual fixed financial charges):

• Plan 1 (Equity): $\text{Financial BEP} = I = \mathbf{\text{Rs. } 0}$
• Plan 2 (Debt): $\text{Financial BEP} = I = 12\% \times \text{Rs. } 5,000,000 = \mathbf{\text{Rs. } 600,000}$

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Part (c): EBIT-EPS Indifference Point

The EBIT level where both plans produce identical EPS:

$$\frac{(\text{EBIT}^* - I_1)(1 - T)}{N_1} = \frac{(\text{EBIT}^* - I_2)(1 - T)}{N_2}$$

Canceling $(1 - T) = 0.75$ from both sides:

$$\frac{\text{EBIT}^*}{150,000} = \frac{\text{EBIT}^* - 600,000}{100,000}$$

$$\frac{\text{EBIT}^*}{3} = \frac{\text{EBIT}^* - 600,000}{2}$$

$$2 \times \text{EBIT}^* = 3 \times \text{EBIT}^* - 1,800,000$$

$$\mathbf{\text{EBIT}^*} = \mathbf{\text{Rs. } 1,800,000}$$

Verification:

• At $\text{EBIT} = \text{Rs. } 1,800,000$: $\text{EPS}_1 = \frac{1,800,000 \times 0.75}{150,000} = \text{Rs. } 9.00$ $\text{EPS}_2 = \frac{(1,800,000 - 600,000) \times 0.75}{100,000} = \frac{900,000}{100,000} = \text{Rs. } 9.00$ (Equal).

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Part (d): Management Recommendation for EBIT = Rs. 3,000,000

• If EBIT is projected at Rs. 3,000,000, it is substantially above the indifference point of Rs. 1,800,000.
• Whenever $\text{EBIT} > \text{Indifference Point}$, the plan with higher financial leverage (Plan 2 - Debt) magnifies returns to equity shareholders, producing superior EPS:
  • $\text{EPS}_1 = \frac{3,000,000 \times 0.75}{150,000} = \text{Rs. } 15.00$
  • $\text{EPS}_2 = \frac{(3,000,000 - 600,000) \times 0.75}{100,000} = \frac{1,800,000}{100,000} = \mathbf{\text{Rs. } 18.00}$
• Strategic Advice: Select Plan 2 (Debt Financing) to maximize EPS, provided the firm’s business operating risk is stable and cash flows comfortably cover the annual interest burden of Rs. 600,000 (Interest Coverage Ratio $= \frac{3,000,000}{600,000} = 5.0\times$).

1. Classification of Current Asset Needs

A firm’s total current asset requirements consist of:

1. Permanent Current Assets: The baseline minimum amount of cash, receivables, and inventory required to sustain operations through all economic seasons.
2. Fluctuating (Temporary) Current Assets: Additional current assets accumulated to meet seasonal, cyclical peaks in demand.

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2. The Three Working Capital Financing Approaches

                      Working Capital Financing Strategies
                                       |
    +----------------------------------+----------------------------------+
    |                                  |                                  |
Hedging (Matching) Strategy         Conservative Strategy              Aggressive Strategy
- Fixed & Permanent assets         - Fixed, Permanent, and part       - Fixed assets funded long-term;
  funded with Long-Term debt;        of Temporary assets funded        Permanent and Temporary
  Temporary funded short-term.       with Long-Term capital.           assets funded short-term.

A. Hedging / Maturity Matching Approach

• Principle: Each asset is financed with a debt instrument of corresponding maturity.
• Permanent assets and fixed capital are financed with equity and long-term debt; temporary seasonal surges are financed with short-term bank credit.
• Risk-Return: Balanced moderate risk and moderate profitability.

B. Conservative Approach

• Principle: The firm finances all fixed assets, all permanent current assets, and a portion of temporary seasonal current assets using permanent long-term capital and equity.
• Short-term bank borrowing is used sparingly during peak seasonal spikes.
• Risk-Return: Lowest liquidity risk, but lower return on equity due to higher interest carrying costs of long-term funds during idle seasons.

C. Aggressive Approach

• Principle: The firm finances not only temporary seasonal assets but also a significant proportion of permanent current assets with short-term debt (revolving bank lines, commercial paper).
• Risk-Return: Highest potential profitability due to cheaper short-term borrowing costs, but carries severe refinancing and interest rate volatility risk.

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3. Impact of Nepalese Macroeconomic Constraints

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4. Strategic Recommendations for Nepalese Finance Executives

• Adopt a Hedging/Slightly Conservative Stance: Avoid excessive short-term debt for permanent operations.
• Optimize Cash Conversion Cycle (CCC): Accelerate accounts receivable collection via dynamic electronic discounting and negotiate disciplined credit terms with regional suppliers.
• Diversify Working Capital Facilities: Establish syndicated non-funded facilities (letters of credit, bank guarantees) across multiple stable Class ‘A’ banks to mitigate single-lender liquidity crunches.