Fundamentals of Corporate Finance

Profit Maximization vs. Shareholder Wealth Maximization:

Annuity Due:

An Annuity Due is a series of equal cash payments occurring at the beginning of each successive period (e.g. lease payments, life insurance premiums). In contrast, an Ordinary Annuity occurs at the end of each period.

Because each cash flow in an Annuity Due earns interest for one additional compounding period:

Yield to Maturity (YTM):

Yield to Maturity (YTM) is the internal rate of return ($IRR$) earned by an investor who purchases a bond at its current market price and holds it until maturity, assuming all coupon payments are promptly reinvested at the same rate.

It satisfies the bond pricing equation:

• If Bond Price $=$ Par Value $\implies \text{YTM} = \text{Coupon Rate}$ (Par Bond).
• If Bond Price $<$ Par Value $\implies \text{YTM} > \text{Coupon Rate}$ (Discount Bond).
• If Bond Price $>$ Par Value $\implies \text{YTM} < \text{Coupon Rate}$ (Premium Bond).

Gordon Growth Model (Constant Dividend Growth Model):

Formula:

Where:

• $P_0$: Intrinsic current stock price.
• $D_0$: Most recent dividend already paid.
• $D_1$: Next expected annual dividend.
• $r_e$: Required rate of return on common equity.
• $g$: Constant annual growth rate of dividends.

Primary Mathematical Assumption: The required rate of return must be strictly greater than the dividend growth rate ($r_e > g$). If $g \ge r_e$, the denominator becomes zero or negative, rendering the model invalid.

Agency Problem:

A conflict of interest arising between the principals (stockholders/owners) and the agents (hired managers/CEOs), where managers may prioritize personal benefits (perquisites, job security, empire building) over maximizing shareholder wealth.

Mitigation Mechanism:

• Performance-based Executive Compensation: Structuring managerial compensation packages tied directly to shareholder value (e.g. Employee Stock Option Plans - ESOPs, performance shares, EVA bonuses) so managerial incentives directly align with stock price appreciation.

Step 1: Calculate Equal Annual Installment (PMT)

Using the Present Value of an Ordinary Annuity formula:

Given:

• Principal $\text{PV} = \text{NPR } 1,000,000$
• Interest rate $i = 10\% = 0.10$
• Duration $n = 4$ years

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Step 2: Loan Amortization Schedule (NPR)

(Note: Minor 2-paisa rounding adjustment in Year 4 payment ensures exact zero terminal balance).

(a) Intrinsic Bond Valuation:

Given:

• Par Value ($M$) = NPR 1,000
• Annual Coupon Rate ($C$) = $8\% \implies \text{Annual Coupon } (I) = 1,000 \times 0.08 = \text{NPR } 80$
• Maturity ($n$) = 10 years
• Required Yield ($k_d$) = $10\% = 0.10$

Bond Valuation Formula:

Calculate discount factors:

Calculate Value ($V_0$):

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(b) Investment Decision:

• Intrinsic Fair Value ($V_0$): NPR 877.11
• Current Market Price ($P_0$): NPR 920.00
• Analysis: The market price (NPR 920) is greater than intrinsic fair value (NPR 877.11). The bond is overvalued by the market.
• Decision: The investor should NOT purchase the bond at NPR 920, because holding it provides an expected return below the required 10% hurdle rate.

(a) Current Intrinsic Stock Price ($P_0$):

Given:

• Current dividend paid ($D_0$) = NPR 25.00
• Constant growth rate ($g$) = $6\% = 0.06$
• Required return ($r_e$) = $14\% = 0.14$

Next year’s dividend:

Current Stock Price:

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(b) Expected Stock Price at Year 3 ($P_3$):

Under constant dividend growth, the stock price grows at the exact same constant growth rate $g = 6\%$:

(Alternatively: $D_4 = 25 \times (1.06)^4 = 31.562 \implies P_3 = 31.562 / 0.08 = \text{NPR } 394.52$)

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(c) Dividend Yield & Capital Gains Yield:

• Dividend Yield: $\frac{D_1}{P_0} = \frac{26.50}{331.25} = 0.08 = 8.0\%$
• Capital Gains Yield: $g = 6.0\%$
• Total Expected Return: $\text{Dividend Yield} + \text{Capital Gains Yield} = 8\% + 6\% = 14\% = r_e$ (Verified).

Capital Asset Pricing Model (CAPM):

CAPM describes the linear relationship between systematic (undiversifiable market) risk and expected return for assets:

Where:

• $r_i$: Required rate of return on asset $i$.
• $R_f$: Risk-free rate (e.g. Nepal Rastra Bank Treasury Bills).
• $\beta_i$: Systematic risk coefficient of asset $i$.
• $E(R_m)$: Expected market portfolio return (NEPSE Index).
• $[E(R_m) - R_f]$: Market Risk Premium (MRP).

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Security Market Line (SML):

The graphical representation of CAPM:

• X-axis: Systematic risk measured by Beta ($\beta$).
• Y-axis: Required rate of return ($r_i$).
• Y-intercept: Risk-free rate ($R_f$, where $\beta = 0$).
• Slope of SML: Market Risk Premium $[E(R_m) - R_f]$.

Impact of Increase in Market Risk Premium:

When investors become more risk-averse, the Market Risk Premium increases:

• The slope of the SML becomes steeper.
• The required return for all risky assets with $\beta > 0$ increases proportionally to their beta.
• High-beta stocks ($\beta > 1$) experience significantly larger increases in required return than defensive low-beta stocks ($\beta < 1$).

Step 1: Calculate Component Costs of Capital

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

   • Pre-tax cost of debt $k_d = 9\% = 0.09$
   • Tax rate $T = 25\% = 0.25$

     Swipe to see the full formula↔

     $$k_{dt} = k_d(1 - T) = 9\% \times (1 - 0.25) = 6.75\%$$

2. Cost of Common Equity ($k_e$): Using Gordon Growth Model:

   • $P_0 = \text{NPR } 600$
   • $D_0 = \text{NPR } 30$
   • $g = 5\% = 0.05$

     Swipe to see the full formula↔

     $$D_1 = D_0(1 + g) = 30 \times 1.05 = \text{NPR } 31.50$$

     Swipe to see the full formula↔

     $$k_e = \frac{D_1}{P_0} + g = \frac{31.50}{600} + 0.05 = 0.0525 + 0.05 = 0.1025 = 10.25\%$$

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Step 2: Compute Weighted Average Cost of Capital (WACC)

Given target weights:

• Weight of Debt ($w_d$) = $40\% = 0.40$
• Weight of Equity ($w_e$) = $60\% = 0.60$

The firm’s overall weighted average cost of capital is 8.85%.

Cash Conversion Cycle (CCC):

The Cash Conversion Cycle (CCC) measures the length of time in days that elapses between when a company pays cash for raw materials/inventory and when it collects cash from the sale of finished goods to credit customers.

Formula:

Numerical Calculation:

Given:

• $\text{ICP} = 60 \text{ days}$
• $\text{RCP} = 45 \text{ days}$
• $\text{PDP} = 35 \text{ days}$

Kathmandu Electronics takes 70 days to convert operational cash outflows back into cash inflows.

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Two Strategies to Shorten CCC:

1. Accelerate Accounts Receivable Collections: Implement automated electronic billing, offer cash discounts (e.g. 2/10 net 30) for early payment, and enforce strict credit screening to reduce Average Collection Period from 45 to 30 days.
2. Optimize Inventory Turnover via JIT: Implement modern inventory management (Just-in-Time, automated reorder triggers) to avoid overstocking and dead stock, reducing the Inventory Conversion Period from 60 to 45 days without causing stockouts.

Step 1: Discount Factors at 12% Cost of Capital

• Year 1: $1 / (1.12)^1 = 0.89286$
• Year 2: $1 / (1.12)^2 = 0.79719$
• Year 3: $1 / (1.12)^3 = 0.71178$
• Year 4: $1 / (1.12)^4 = 0.63552$

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Step 2: Discounted Cash Flows (PV)

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Step 3: Profitability Index (PI)

• Project Alpha: $\text{PI} = \frac{5,529,720}{5,000,000} = \mathbf{1.106}$
• Project Beta: $\text{PI} = \frac{5,774,655}{5,000,000} = \mathbf{1.155}$

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Step 4: Payback Period (PBP)

• Project Alpha Cumulative CF:
  • Year 1: 2,500,000
  • Year 2: 4,500,000 (Remaining = 500,000 out of Year 3’s 1,500,000)

    Swipe to see the full formula↔

    $$\text{PBP}_{\text{Alpha}} = 2 + \frac{500,000}{1,500,000} = \mathbf{2.33 \text{ years}}$$
• Project Beta Cumulative CF:
  • Year 1: 1,000,000
  • Year 2: 2,500,000
  • Year 3: 5,000,000 (Exactly recovered at end of Year 3)

    Swipe to see the full formula↔

    $$\text{PBP}_{\text{Beta}} = \mathbf{3.00 \text{ years}}$$

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Step 5: Final Recommendation & Conflict Analysis

• Recommendation: Since the projects are mutually exclusive, the firm must choose only one. Project Beta has a significantly higher NPV (NPR 774,655 > NPR 529,720) and higher PI (1.155 > 1.106). Therefore, the company should accept Project Beta.
• Conflict between NPV and IRR/Payback:
  • Project Alpha recovers cash faster (front-loaded cash flows, PBP 2.33 yrs) and will have a higher IRR.
  • Project Beta has back-loaded cash flows and generates more total absolute wealth in present value terms.
  • Decision Rule: For mutually exclusive projects, NPV always supersedes IRR and Payback Period because NPV directly measures the absolute addition to shareholder wealth, and assumes reinvestment of cash flows at the realistic opportunity cost of capital ($WACC = 12\%$), whereas IRR unrealistically assumes reinvestment at the project’s own internal rate.

1. Structure of Nepalese Financial Markets:

Nepal’s financial system is bifurcated into two major components:

• Money Market: Governs short-term debt instruments (Treasury bills, commercial paper, inter-bank loans, repo/reverse repo) dominated by commercial banks under NRB supervision.
• Capital Market: Governs long-term securities (common equity, preference shares, debentures, mutual funds), operated by the Nepal Stock Exchange (NEPSE) and regulated by SEBON.

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2. Role of Nepal Rastra Bank (NRB):

• Monetary Policy Formulation: Formulates and implements annual monetary policy using tools such as Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and the Policy Repo Rate to stabilize inflation and preserve foreign exchange reserves.
• Prudential Supervision: Regulates Class ‘A’ Commercial Banks, Class ‘B’ Development Banks, Class ‘C’ Finance Companies, and Class ‘D’ Microfinance institutions, establishing Capital Adequacy Frameworks (Basel III) and Credit-to-Deposit (CD) ratios.
• Payment Systems Regulation: Oversees National Payment Switch, QR-code payment integrations, licensing of Payment Service Providers (PSPs like eSewa, Khalti) and Payment System Operators (PSOs like NCHL).

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3. Role of Securities Board of Nepal (SEBON):

• Securities Market Regulation: Regulates public issues (Initial Public Offerings - IPOs, Right Issues, Corporate Bonds) and approves prospectuses.
• Market Integrity & Investor Protection: Prevents market manipulation, insider trading, and unauthorized syndicate practices on NEPSE; governs merchant banks and stockbroker licensing.
• Specialized Investment Funds (SIF) Regulations 2075: Created the legal framework for domestic Private Equity (PE) and Venture Capital (VC) funds in Nepal.

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4. Key Challenges Faced by IT Startups in Raising Equity in Nepal:

1. Collateral-based Lending Dominance: Traditional banks strictly mandate physical immovable property (land/building) as collateral, making it nearly impossible for asset-light software firms to secure debt.
2. Stringent IPO Profitability Track Record: SEBON historical listing criteria require consecutive years of operational profitability and net worth requirements, barring fast-growing, pre-profit digital technology platforms.
3. Foreign Direct Investment (FDI) Bureaucratic Hurdles: The minimum capital threshold under the Foreign Investment and Technology Transfer Act (FITTA) and multi-tier approval processes between Department of Industry and NRB hinder foreign angel and venture capital inflows.
4. Nascent Secondary Markets for VC Exits: The lack of vibrant secondary trading windows for unlisted shares makes it difficult for early-stage private equity and venture capitalists to achieve profitable exits.
5. Valuation and Intangible Asset Recognition Gaps: Standard accounting and tax practices in Nepal lack structured frameworks for capitalizing software IP, algorithmic assets, and sweat equity.