Fundamentals of Corporate Finance

Meaning of Corporate Finance

Corporate finance is the area of finance dealing with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources.

Key Features of an Operating Lease

1. Short-term Commitment: Primary lease period is shorter than the asset’s economic lifespan.
2. Maintenance Included: Lessor handles routine maintenance, insurance, and taxes.
3. Cancelability Clause: Lessee retains the contractual right to cancel early.

Concept of Optimal Capital Structure

The optimal capital structure is the proportion of debt, preferred equity, and common stock that minimizes the Weighted Average Cost of Capital (WACC), thereby maximizing intrinsic equity share price.

Importance of a Financial Plan

1. Anticipating Financing Deficits: Quantifies Additional Funds Needed (AFN) well before cash crunches occur.
2. Evaluating Strategic Alternatives: Models sensitivity of earnings to sales growth and price competition.
3. Establishing Performance Benchmarks: Sets concrete operational targets for budgeting and divisional accountability.

Cumulative Preferred Stock

A cumulative preferred stock contains a protective stipulation requiring that any omitted or passed dividend payments accumulate as legal dividend arrears, which must be fully settled before common equity dividends can be paid.

Two Major Reasons for Going Global

1. Expanding Customer Sales Base: Tapping into larger foreign consumer markets.
2. Lowering Input Production Costs: Securing cheaper raw materials and competitive manufacturing labor.

Why Firms Issue Convertible Bonds

1. Lower Borrowing Costs: The conversion option acts as a ‘sweetener’, allowing the firm to issue debt with significantly lower coupon interest rates.
2. Delayed Equity Issuance with Reduced Dilution: Shares are effectively sold at a premium above the current market price.

Definition of Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory postulating that in the absence of trade barriers and transportation costs, identical baskets of goods and services will have the same price in different nations when prices are expressed in a common currency.

Cost of Stretching Accounts Payable (1/10 net 40, paid on 50th day):

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

$$APR = \frac{1}{99} \times \frac{360}{50 - 10} = 0.010101 \times \frac{360}{40} = 0.010101 \times 9 = 0.090909 = \mathbf{9.09\%}$$

Conclusion: The annual percentage cost is 9.09%.

Minimum Shares Needed Under Cumulative Voting:

• Total Shares ($N$) = $400,000$, Directors to Elect ($D$) = $7$, Target ($d$) = $1$.
  $$\text{Shares Needed} = \frac{d \times N}{D + 1} + 1 = \frac{1 \times 400,000}{7 + 1} + 1 = \frac{400,000}{8} + 1 = 50,000 + 1 = \mathbf{50,001 \text{ shares}}$$
  Conclusion: 50,001 shares are required.

Managerial Actions to Maximize Shareholder Wealth

1. Investing in Positive NPV Projects: Allocating corporate capital strictly to projects where discounted cash flows exceed initial capital costs.
2. Optimizing Capital Structure: Calibrating the debt-equity ratio to minimize WACC.
3. Disciplined Working Capital Management: Optimizing the cash conversion cycle without risking operational stockouts.
4. Transparent Corporate Disclosure & Ethics: Building credibility with capital markets to eliminate adverse selection discounts on share price.

Advantages and Disadvantages of Long-Term Bonds

• Advantages:
  • Tax Deductibility of Interest: Lowers after-tax cost of debt: $k_d(1 - t)$.
  • No Dilution of Control: Bondholders have no voting rights.
  • Financial Leverage Upside: Excess project returns accrue entirely to common stockholders.
• Disadvantages:
  • Mandatory Fixed Financial Charges: Failure to pay triggers legal insolvency.
  • Increases Financial Risk: High leverage raises cost of equity.

Delta Company Lease vs. Purchase Analysis:

• Cost = $\text{Rs. } 600,000$, Term = 3 years, Salvage Value = $\text{Rs. } 120,000$.
• Annual Lease Payment = $\text{Rs. } 300,000$, $k_d = 10\%$, $t = 40\%$.
• Discount Rate $= k_d(1 - t) = 10\%(1 - 0.40) = 6\%$.

---

a. Cost of Leasing:

• After-tax Lease Payment $= 300,000(1 - 0.40) = \text{Rs. } 180,000$.
  $$PV(\text{Leasing}) = 180,000 \times PVIFA_{6\%, 3} = 180,000 \times 2.67301 = \mathbf{\text{Rs. } 481,142}$$

---

b. Cost of Purchasing:

• Annual Depreciation $= \frac{600,000 - 120,000}{3} = \text{Rs. } 160,000$.
• Depreciation Tax Shield $= 160,000 \times 0.40 = \text{Rs. } 64,000$.
• $PV(\text{Tax Shield}) = 64,000 \times 2.67301 = \text{Rs. } 171,073$.
• $PV(\text{Salvage Value}) = \frac{120,000}{(1.06)^3} = \frac{120,000}{1.191016} = \text{Rs. } 100,754$.
  $$PV(\text{Purchasing}) = 600,000 - 171,073 - 100,754 = \mathbf{\text{Rs. } 328,173}$$

Decision: The machine should be PURCHASED because the net present cost of purchasing (Rs. 328,173) is much lower than leasing (Rs. 481,142).

Hi-Tech Ltd. Warrants Valuation:

• Warrants allow purchase of common shares at specified exercise price.
• Theoretical Value: $\max[0, (S_0 - X) \times N_s]$, where $S_0$ is stock price, $X$ is exercise price, and $N_s$ is shares per warrant.
• Warrants trade at a premium over theoretical value prior to expiration due to speculative leverage and downside protection.

Koshi Company AFN & Pro-Forma Analysis:

• Using standard AFN formula: $AFN = (A^*/S_0)\Delta S - (L^*/S_0)\Delta S - M(S_1)(b)$.
• Step-by-step projection of spontaneous assets and liabilities with proportional balance sheet construction balancing through notes payable.

Multinational vs. Domestic Financial Management

1. Foreign Exchange Risk: MNCs deal with transactions in multiple fluctuating currencies.
2. Sovereign & Political Risk: Exposure to expropriation, currency repatriation controls, and foreign tax regimes.
3. Expanded Capital Sourcing: Access to deep international capital markets (Eurobonds, global equity syndicates).

Comprehensive Analysis of Mergers and Corporate Restructuring

• Strategic rationales, tax considerations, economies of scale, and valuation methodology (DCF vs. market comparables).

Himal Cement Company Long-Term Financing Analysis:

• Evaluating rights offering mechanics, subscription discounts, theoretical right values, and ex-rights share pricing.

Kathmandu Electronic Company Working Capital Options (Rs. 800,000 Needed):

• Comparative evaluation of bank credit line, commercial paper issue, and stretching trade credit.