Fundamentals of Financial Management 2078 Board Question Paper

Financial management refers to the managerial discipline tasked with the strategic acquisition, allocation, and oversight of a firm’s capital resources. It guides executives in answering three core operational questions: what long-term assets to acquire (investment decisions), how to raise capital at the lowest cost (financing decisions), and how to distribute cash returns (dividend decisions) to maximize shareholder market value.

An ordinary annuity consists of equal cash flows that occur at the end of each period (e.g., standard bond coupon payments, loan amortization installments). In contrast, an annuity due involves equal cash flows occurring at the beginning of each period (e.g., apartment leases, life insurance premiums). Because cash flows in an annuity due compound for one additional period, its value is always $(1 + i)$ times that of an equivalent ordinary annuity.

Risk in finance refers to the variability or dispersion of actual future returns around the expected return.

• Total Stand-Alone Risk is measured statistically by the variance and standard deviation ($\sigma$) of returns, or by the coefficient of variation (CV) when comparing assets with differing expected returns.
• Systematic (Market) Risk of an individual security within a diversified portfolio is measured by Beta ($\beta$).

Cash break-even point is the volume of sales (in units or currency) required to cover only the cash operating expenses of the firm, excluding non-cash fixed charges such as depreciation and amortization:

$$\text{Cash BEP (Units)} = \frac{\text{Total Fixed Operating Costs} - \text{Depreciation}}{\text{Selling Price per Unit} - \text{Variable Cost per Unit}}$$

It reflects the critical operational survival threshold necessary to avert immediate cash bankruptcy.

A firm prefers issuing a stock dividend (bonus shares) when:

1. Conserving Liquid Cash: The firm has profitable growth projects and needs to retain operating cash for reinvestment rather than distributing cash dividends.
2. Bringing Down High Share Price: The market price per share has grown excessively high; issuing bonus shares increases liquidity and broadens the trading base of retail investors.
3. Signaling Financial Strength: It conveys confidence to the stock market that earnings are permanently capitalized into the equity base.

A firm prepares a cash budget to:

1. Forecast Seasonal Cash Surpluses and Deficits: Identify in advance upcoming cash shortfalls so bank credit facilities (short-term loans) can be arranged proactively.
2. Optimize Short-Term Cash Investment: Direct temporary excess cash balances into interest-bearing marketable securities rather than leaving funds idle.
3. Ensure Financial Solvency: Guarantee sufficient cash liquidity to meet statutory tax obligations, payroll, and debt maturities on time.

Given:

• $\text{Annual Coupon Payment } (I) = 8\% \times 1,000 = \text{Rs. } 80$
• $\text{Par Value } (M) = \text{Rs. } 1,000$
• $\text{Years to Maturity } (n) = 7\text{ years}$
• $\text{Current Market Price } (V_0) = \text{Rs. } 850$

Approximate YTM Formula:

$$\text{Approximate YTM} = \frac{I + \frac{M - V_0}{n}}{\frac{M + V_0}{2}} = \frac{80 + \frac{1,000 - 850}{7}}{\frac{1,000 + 850}{2}} = \frac{80 + 21.43}{925} = \frac{101.43}{925} = \mathbf{10.97\%}$$

(Using 3-weight denominator $\frac{M + 2V_0}{3} = 900$: $\text{YTM} = \frac{101.43}{900} = \mathbf{11.27\%}$).

Given:

• $\text{DOL} = 1.5\text{ times}$, $\text{DFL} = 2.0\text{ times}$
• $\text{Current Net Income} = \text{Rs. } 40,000$
• $\Delta \text{Sales} = +10\%$

Calculations:

1. Degree of Total Leverage (DTL):

   $$\mathbf{\text{DTL}} = \text{DOL} \times \text{DFL} = 1.5 \times 2.0 = \mathbf{3.0\text{ times}}$$

2. Percentage Change in Net Income:

   $$\% \Delta \text{Net Income} = \text{DTL} \times \% \Delta \text{Sales} = 3.0 \times 10\% = +30\%$$

3. New Net Income:

   $$\mathbf{\text{New Net Income}} = \text{Rs. } 40,000 \times (1 + 0.30) = \mathbf{\text{Rs. } 52,000}$$

Given:

• $\text{Annual Demand } (A) = 10,000\text{ units}$
• $\text{Carrying Cost per Unit } (c) = \text{Rs. } 20\text{ per unit/year}$
• $\text{Ordering Cost per Order } (O) = \text{Rs. } 1,000$

Economic Order Quantity (EOQ):

$$\mathbf{\text{EOQ}} = \sqrt{\frac{2AO}{c}} = \sqrt{\frac{2 \times 10,000 \times 1,000}{20}} = \sqrt{1,000,000} = \mathbf{1,000\text{ units}}$$

Given:

• $\text{Inventory Conversion Period (ICP)} = 30\text{ days}$
• $\text{Average Collection Period (ACP)} = 40\text{ days}$
• $\text{Payables Deferral Period (PDP)} = 20\text{ days}$

Computations:

1. Operating Cycle (OC):

   $$\mathbf{\text{Operating Cycle}} = \text{ICP} + \text{ACP} = 30 + 40 = \mathbf{70\text{ days}}$$

2. Cash Conversion Cycle (CCC):

   $$\mathbf{\text{Cash Conversion Cycle}} = \text{Operating Cycle} - \text{PDP} = 70 - 20 = \mathbf{50\text{ days}}$$

Significance of Working Capital Management

Working capital management is vital because it manages the immediate cash liquidity required to maintain ongoing business operations without risking bankruptcy:

1. Guarantees Operational Solvency and Liquidity: Ensures the firm possesses adequate cash reserves to meet day-to-day trade payables, payroll, and debt commitments, safeguarding credit ratings.
2. Sustains Smooth Production: A steady supply of raw material inventories eliminates assembly line stoppages and worker downtime.
3. Manages the Risk-Return Trade-Off: Excess working capital creates idle non-earning assets that suppress Return on Assets (ROA), whereas inadequate working capital risks illiquidity. Optimal management balances liquidity and profitability.
4. Strengthens Goodwill and Exploits Trade Discounts: Solvency enables the firm to capture valuable supplier cash discounts (e.g., $2/10, \text{ net } 30$) and build solid supplier goodwill.
5. Provides Crisis Resilience: Equips the firm to weather unexpected economic shocks, supply disruptions, and sudden sales slowdowns.

Loan Amortization Computations

Parameters:

• Loan Principal ($P$) $= \text{Rs. } 300,000$
• Interest Rate ($i$) $= 10\% = 0.10$
• Term ($n$) $= 3\text{ years}$

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a. Amount of Annual Payment (PMT)

$$\text{PVIFA}_{10\%, 3} = \frac{1 - (1.10)^{-3}}{0.10} = 2.48685$$

$$\mathbf{PMT} = \frac{\text{Loan Amount}}{\text{PVIFA}_{10\%, 3}} = \frac{\text{Rs. } 300,000}{2.48685} = \mathbf{\text{Rs. } 120,634.53}$$

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b. Loan Amortization Schedule

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c. Equal Monthly Installment (EMI)

For monthly compounding: $N = 3 \times 12 = 36\text{ months}$, Monthly interest rate $r = \frac{10\%}{12} = 0.8333\% = 0.008333$.

$$\text{PVIFA}_{0.8333\%, 36} = \frac{1 - (1 + 0.008333)^{-36}}{0.008333} = 30.991$$

$$\mathbf{\text{EMI}} = \frac{\text{Rs. } 300,000}{30.991} = \mathbf{\text{Rs. } 9,679.97\text{ per month}}$$

Financial Ratios Analysis (Rs. in Thousands)

1. Accounts Receivable:

   $$\text{DSO} = \frac{\text{Receivables}}{\text{Sales} / 360} \implies 40 = \frac{\text{Receivables}}{1,000 / 360}$$
   $$\mathbf{\text{Receivables}} = 40 \times 2.7778 = \mathbf{\text{Rs. } 111.11\text{ thousand}}$$

2. Current Liabilities (CL): Quick Assets $= \text{Cash (100)} + \text{Receivables (111.11)} = \text{Rs. } 211.11$$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{CL}} \implies 2.0 = \frac{211.11}{\text{CL}} \implies \mathbf{\text{CL}} = \frac{211.11}{2.0} = \mathbf{\text{Rs. } 105.56\text{ thousand}}$$

3. Current Assets (CA):

   $$\text{Current Ratio} = \frac{\text{CA}}{\text{CL}} \implies 3.0 = \frac{\text{CA}}{105.56} \implies \mathbf{\text{CA}} = 3.0 \times 105.56 = \mathbf{\text{Rs. } 316.67\text{ thousand}}$$

4. Total Assets (TA):

   $$\mathbf{\text{Total Assets}} = \text{CA} + \text{Fixed Assets} = 316.67 + 283.50 = \mathbf{\text{Rs. } 600.17\text{ thousand}}$$

5. Common Equity and Total Debt:

   $$\text{ROE} = \frac{\text{Net Income}}{\text{Equity}} \implies 0.12 = \frac{50}{\text{Equity}} \implies \text{Equity} = \frac{50}{0.12} = \text{Rs. } 416.67\text{ thousand}$$
   $$\mathbf{\text{Total Debt}} = \text{Total Assets} - \text{Equity} = 600.17 - 416.67 = \mathbf{\text{Rs. } 183.50\text{ thousand}}$$

6. Return on Assets (ROA):

   $$\mathbf{\text{ROA}} = \frac{\text{Net Income}}{\text{Total Assets}} = \frac{\text{Rs. } 50}{\text{Rs. } 600.17} \times 100 = \mathbf{8.33\%}$$

(a) Stock Valuation for Bishal Electronic

• $D_0 = \text{Rs. } 20$, $g = 5\%$, $k_s = 15\%$.
• $D_1 = D_0(1 + g) = 20 \times 1.05 = \text{Rs. } 21.00$.
• $\mathbf{P_0} = \frac{D_1}{k_s - g} = \frac{\text{Rs. } 21.00}{0.15 - 0.05} = \frac{\text{Rs. } 21.00}{0.10} = \mathbf{\text{Rs. } 210.00}$.
• $\mathbf{P_5} = P_0 \times (1 + g)^5 = 210 \times (1.05)^5 = 210 \times 1.27628 = \mathbf{\text{Rs. } 268.02}$.

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(b) Semi-Annual Bond Valuation for City Bank

• $M = \text{Rs. } 1,000$, Coupon rate $= 12\%$, Semi-annual coupon $I = \frac{12\% \times 1,000}{2} = \text{Rs. } 60$.
• Maturity $n = 10\text{ years} \implies N = 20\text{ semi-annual periods}$.
• Market rate $r_d = 10\% \implies \text{Semi-annual yield } k_d = 5\% = 0.05$.
• $\text{PVIFA}_{5\%, 20} = 12.4622$, $\text{PVIF}_{5\%, 20} = 0.37689$.

$$V_0 = (60 \times 12.4622) + (1,000 \times 0.37689) = 747.73 + 376.89 = \mathbf{\text{Rs. } 1,124.62}$$

• Purchase Recommendation: The intrinsic value is Rs. 1,124.62. Because the bond is trading in the market at Rs. 1,050.00 ($P_0 < V_0$), it is undervalued. Recommendation: Yes, purchase the bond because it yields a return exceeding the required $10\%$.

Cost of Capital Computations for Mega Company

Capital Weights: $w_d = 0.30$, $w_p = 0.20$, $w_e = 0.50$. Parameters: Tax rate $t = 40\%$, Pre-tax debt rate $r_d = 10\%$, Preferred dividend $D_p = \text{Rs. } 12$, Preferred price $P_p = \text{Rs. } 90$, Common dividend $D_0 = \text{Rs. } 15$, Growth $g = 6\%$, Current price $P_0 = \text{Rs. } 180$, New issue price $P_n = \text{Rs. } 150$.

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a. Cost of Each Capital Component

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

   $$\mathbf{k_d} = r_d(1 - t) = 10\%(1 - 0.40) = \mathbf{6.00\%}$$

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

   $$\mathbf{k_p} = \frac{D_p}{P_p} = \frac{\text{Rs. } 12}{\text{Rs. } 90} = 0.1333 = \mathbf{13.33\%}$$

3. Cost of Retained Earnings (Internal Common Equity, $k_s$):

   $$D_1 = D_0(1 + g) = 15 \times (1 + 0.06) = \text{Rs. } 15.90$$
   $$\mathbf{k_s} = \frac{D_1}{P_0} + g = \frac{\text{Rs. } 15.90}{\text{Rs. } 180} + 0.06 = 0.08833 + 0.06 = \mathbf{14.83\%}$$

4. (Cost of New External Equity, $k_e = \frac{15.90}{150} + 0.06 = 10.60\% + 6\% = 16.60\%$).

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b. Weighted Average Cost of Capital (WACC - Retained Earnings)

$$\text{WACC} = [w_d \times k_d] + [w_p \times k_p] + [w_e \times k_s]$$

$$\mathbf{\text{WACC}} = [0.30 \times 6.00\%] + [0.20 \times 13.33\%] + [0.50 \times 14.83\%]$$

$$\text{WACC} = 1.80\% + 2.67\% + 7.42\% = \mathbf{11.89\%}$$

(a) Major Factors Affecting Dividend Policy

1. Investment Opportunities: Firms with numerous high-NPV capital projects retain earnings rather than paying cash dividends.
2. Legal and Contractual Constraints: Company law restrictions (dividends paid only from realized profits, not capital) and restrictive loan covenants imposed by bondholders/banks.
3. Liquidity Position: Even with high accounting profits, dividends require liquid cash balances.
4. Stability of Earnings: Predictable earnings justify higher and more stable dividend payments.
5. Access to Capital Markets: Firms with easy access to capital markets can afford to pay higher dividends as external funds are readily available.

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(b) Karnali Herbal Company (KHC) Residual Dividend Computation

Given:

• Net Income $= \text{Rs. } 12\text{ million}$
• Capital Investment Budget $= \text{Rs. } 15\text{ million}$
• Target Debt Ratio $= 60\% \implies \text{Target Equity Ratio } (w_e) = 40\%$

Computations:

1. $\text{Equity Capital Required} = 40\% \times \text{Rs. } 15\text{ million} = \text{Rs. } 6.0\text{ million}$
2. $\text{Residual Dividend Available} = \text{Net Income (12M)} - \text{Equity Required (6.0M)} = \text{Rs. } 6.0\text{ million}$
3. $\mathbf{\text{Dividend Payout Ratio}} = \frac{\text{Dividends}}{\text{Net Income}} = \frac{\text{Rs. } 6.0\text{ million}}{\text{Rs. } 12.0\text{ million}} \times 100 = \mathbf{50.00\%}$

Wealth Maximization: Definition and Superiority over Profit Maximization

1. Conceptual Framework of Wealth Maximization

Shareholder Wealth Maximization states that the primary operational objective of corporate financial management is to maximize the market value of the company’s common stock.

$$\text{Total Shareholder Wealth} = \text{Total Outstanding Shares} \times \text{Current Market Price per Share}$$

Because share prices reflect the discounted present value of all expected future cash flows, wealth maximization directly harmonizes management actions with the financial interests of the owners.

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2. Comprehensive Comparison: Why Wealth Maximization is Superior

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3. Resolving Agency Conflicts

Wealth maximization aligns managerial incentives with shareholder interests through performance-linked compensation and equity options, resolving agency dilemmas. Furthermore, socially responsible wealth maximization requires ethical treatment of customers, suppliers, and employees to sustain brand equity.

Probability Distribution Risk and Return Analysis

(a) Expected Return and Standard Deviation

1. Expected Returns:

   • $\mathbf{E(R_A)} = (0.3 \times 5\%) + (0.4 \times 10\%) + (0.3 \times 15\%) = 1.5 + 4.0 + 4.5 = \mathbf{10.00\%}$
   • $\mathbf{E(R_B)} = (0.3 \times 25\%) + (0.4 \times 15\%) + (0.3 \times 5\%) = 7.5 + 6.0 + 1.5 = \mathbf{15.00\%}$

2. Variances and Standard Deviations:

   • Stock A:
     $$\sigma_A^2 = 0.3(5 - 10)^2 + 0.4(10 - 10)^2 + 0.3(15 - 10)^2 = 0.3(25) + 0 + 0.3(25) = 7.5 + 7.5 = 15.0$$
     $$\mathbf{\sigma_A} = \sqrt{15.0} = \mathbf{3.873\%}$$
   • Stock B:
     $$\sigma_B^2 = 0.3(25 - 15)^2 + 0.4(15 - 15)^2 + 0.3(5 - 15)^2 = 0.3(100) + 0 + 0.3(100) = 30 + 30 = 60.0$$
     $$\mathbf{\sigma_B} = \sqrt{60.0} = \mathbf{7.746\%}$$

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(b) Covariance and Correlation Coefficient

1. Covariance between Stock A and Stock B:

   $$\text{Cov}(A, B) = \sum P_i [R_{Ai} - E(R_A)][R_{Bi} - E(R_B)]$$
   $$\text{State 1}: 0.3(5 - 10)(25 - 15) = 0.3(-5)(+10) = -15.0$$
   $$\text{State 2}: 0.4(10 - 10)(15 - 15) = 0.0$$
   $$\text{State 3}: 0.3(15 - 10)(5 - 15) = 0.3(+5)(-10) = -15.0$$
   $$\mathbf{\text{Cov}(A, B)} = -15.0 + 0 - 15.0 = \mathbf{-30.00}$$

2. Correlation Coefficient ($r_{AB}$):

   $$\mathbf{r_{AB}} = \frac{\text{Cov}(A, B)}{\sigma_A \times \sigma_B} = \frac{-30.00}{3.873 \times 7.746} = \frac{-30.00}{30.00} = \mathbf{-1.00}$$
   (Stock A and Stock B are perfectly negatively correlated).

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(c) Portfolio Return and Risk ($w_A = 0.50, w_B = 0.50$)

1. Portfolio Expected Return ($R_p$):

   $$\mathbf{R_p} = (0.50 \times 10\%) + (0.50 \times 15\%) = 5.0\% + 7.5\% = \mathbf{12.50\%}$$

2. Portfolio Standard Deviation ($\sigma_p$): Because $r_{AB} = -1.00$, portfolio risk formula simplifies to:

   $$\sigma_p = |w_A \sigma_A - w_B \sigma_B|$$
   $$\mathbf{\sigma_p} = |(0.50 \times 3.873\%) - (0.50 \times 7.746\%)| = |1.9365\% - 3.873\%| = \mathbf{1.9365\%}$$

3. Interpretation: Combining these two negatively correlated stocks significantly dampens volatility: while Stock A carries $3.87\%$ risk and Stock B carries $7.75\%$ risk, the 50/50 portfolio risk drops to just $1.94\%$, while yielding a solid return of $12.50\%$. This demonstrates the power of portfolio diversification.

Capital Budgeting Analysis for Lumbini Transportation

Given Parameters:

• Initial Outlay ($I_0$) $= \text{Rs. } 2,000,000$
• Cash Flows: Y1 = 600k, Y2 = 800k, Y3 = 800k, Y4 = 600k, Y5 = 500k
• Cost of Capital ($k$) $= 10\%$

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(a) Payback Period (PBP)

• Cumulative Cash Flows:
  • Year 1: Rs. 600,000
  • Year 2: Rs. 1,400,000
  • Year 3: Rs. 2,200,000
• Initial cost of Rs. 2,000,000 is recovered between Year 2 and Year 3:
  $$\mathbf{\text{PBP}} = 2 + \frac{2,000,000 - 1,400,000}{800,000} = 2 + \frac{600,000}{800,000} = \mathbf{2.75\text{ years (2 years and 9 months)}}$$
  Decision: Because PBP of 2.75 years is less than the benchmark limit of 3 years, the company should run the bus service.

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(b) Net Present Value (NPV @ 10%)

Decision: Because $NPV = +\text{Rs. } 527,870 > 0$, the project creates substantial shareholder wealth. Accept the project.

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(c) Internal Rate of Return (IRR)

• At $k = 10\%$, $NPV = +\text{Rs. } 527,870$. Try higher rate $r = 20\%$:
  • Y1: $600k \times 0.8333 = 499,980$
  • Y2: $800k \times 0.6944 = 555,520$
  • Y3: $800k \times 0.5787 = 462,960$
  • Y4: $600k \times 0.4823 = 289,380$
  • Y5: $500k \times 0.4019 = 200,950$
  • Total PV at $20\% = \text{Rs. } 2,008,790 \implies NPV_{20\%} = +\text{Rs. } 8,790$.
• Try $r = 21\%$:
  • Y1: $600k \times 0.8264 = 495,840$
  • Y2: $800k \times 0.6830 = 546,400$
  • Y3: $800k \times 0.5645 = 451,600$
  • Y4: $600k \times 0.4665 = 279,900$
  • Y5: $500k \times 0.3855 = 192,750$
  • Total PV at $21\% = \text{Rs. } 1,966,490 \implies NPV_{21\%} = -\text{Rs. } 33,510$.

Interpolation:

$$\mathbf{\text{IRR}} = 20\% + \frac{8,790}{8,790 - (-33,510)} \times (21\% - 20\%) = 20\% + \frac{8,790}{42,300} = 20\% + 0.21\% = \mathbf{20.21\%}$$

Decision: Because $IRR = 20.21\% > 10\%$, the project is highly viable. Accept the project.

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(d) Superiority of Evaluation Methods

The Net Present Value (NPV) method is theoretically and practically superior to PBP and IRR because:

1. Direct Measure of Wealth Creation: NPV reports the absolute rupee increase in shareholder wealth.
2. Realistic Reinvestment Rate Assumption: NPV realistically assumes interim cash inflows are reinvested at the firm’s cost of capital ($10\%$), whereas IRR unrealistically assumes reinvestment at the high internal rate ($20.21\%$).
3. Overcomes Multiple IRR and Scale Problems: NPV never produces conflicting multiple rates and reliably selects the better option in mutually exclusive choices.