Financial Management

A financial plan is a statement of how a firm will raise and use funds to achieve its objectives. It estimates the firm's future financial needs, fixes the amount and sources of finance (debt and equity), and sets out the proposed investment, dividend and working capital policies, usually supported by forecast financial statements and budgets.

The motives for holding cash are:

• Transaction motive: to pay for day-to-day operating expenses such as wages, purchases, taxes and dividends.
• Precautionary motive: to meet unexpected needs and emergencies.
• Speculative motive: to take advantage of unexpected opportunities, such as bargain purchases or favourable price changes.
• Compensating motive: to keep minimum balances at banks that provide services or loans to the firm.

By the CAPM:

$r_s = r_f + \beta (r_m - r_f) = 4\% + 1.5 \times 6\% = 13\%$

The required rate of return on stock X is 13 percent.

Average collection period $= 30 + 40 = 70$ days.

$\text{Accounts receivable} = \frac{\text{Credit sales}}{360} \times \text{ACP} = \frac{18{,}000{,}000}{360} \times 70 = \text{Rs } 3{,}500{,}000$

By purchasing power parity (the law of one price), the same laptop must cost the same in both countries:

$\text{Rs } 120{,}000 = \text{Yen } 160{,}000$

$\text{Rs per Yen} = \frac{120{,}000}{160{,}000} = 0.75$

So 1 Yen = Rs 0.75, or equivalently Rs 1 = Yen 1.33.

Incremental analysis (Rs):

1. Incremental contribution

$\Delta S \times (1 - 0.70) = (7{,}200{,}000 - 6{,}000{,}000) \times 0.30 = 360{,}000$

2. Incremental investment in receivables

Present: $\frac{6{,}000{,}000}{360} \times 45 = 750{,}000$ in receivables, of which $0.70 \times 750{,}000 = 525{,}000$ is investment at variable cost.

Proposed: $\frac{7{,}200{,}000}{360} \times 60 = 1{,}200{,}000$, so the investment is $0.70 \times 1{,}200{,}000 = 840{,}000$.

Increase in investment $= 840{,}000 - 525{,}000 = 315{,}000$

Cost of the additional funds $= 10\% \times 315{,}000 = 31{,}500$

3. Incremental bad debts

$0.025 \times 7{,}200{,}000 - 0.02 \times 6{,}000{,}000 = 180{,}000 - 120{,}000 = 60{,}000$

4. Net benefit

The change gives a positive incremental profit after tax of Rs 187,950, so BTC should change its credit terms from net 40 to net 50.

Expected market return = risk-free rate + market risk premium:

$r_M = 4\% + 8\% = 12\%$

Required return on the stock using CAPM, $r_s = r_f + \beta(r_M - r_f)$:

$r_s = 4\% + 1.5(8\%) = 4\% + 12\% = 16\%$

So the market's expected return is 12% and the stock's required return is 16%.

Average collection period = credit terms + days past due = 40 + 45 = 85 days.

$\text{Daily credit sales} = \frac{9{,}000{,}000}{360} = \text{Rs } 25{,}000$

$\text{Accounts receivable} = 25{,}000 \times 85 = \text{Rs } 2{,}125{,}000$

Under purchasing power parity the same item should cost the same in both countries after conversion:

$\text{Rs } 60{,}000 = \text{Yen } 80{,}000$

$\text{Rs per Yen} = \frac{60{,}000}{80{,}000} = \text{Rs } 0.75$

So 1 Yen = Rs 0.75, or equivalently Rs 1 = Yen 1.3333.

Evaluate the incremental analysis of the proposed change (credit sales Rs 3,000,000 to Rs 3,600,000).

1. Incremental contribution margin

$(3{,}600{,}000 - 3{,}000{,}000) \times (1 - 0.70) = 600{,}000 \times 0.30 = \text{Rs } 180{,}000$

2. Cost of additional investment in receivables (valued at variable cost)

Present: $\frac{3{,}000{,}000}{360} \times 45 = 375{,}000$; at variable cost, $375{,}000 \times 0.70 = 262{,}500$.

Proposed: $\frac{3{,}600{,}000}{360} \times 60 = 600{,}000$; at variable cost, $600{,}000 \times 0.70 = 420{,}000$.

$\text{Increase} = 420{,}000 - 262{,}500 = 157{,}500$

$\text{Carrying cost} = 157{,}500 \times 12\% = \text{Rs } 18{,}900$

3. Incremental bad debts

Present: $1.5\% \times 3{,}000{,}000 = 45{,}000$. Proposed: $2\% \times 3{,}600{,}000 = 72{,}000$.

$\text{Increase} = \text{Rs } 27{,}000$

4. Net benefit

Decision: The change gives a positive incremental profit of Rs 80,460, so Sanghrila should change its credit terms from net 30 to net 50.

Social responsibility means the obligation of a firm to act in ways that benefit society as a whole, not only its owners. Besides maximising shareholder wealth, the firm is expected to treat employees, customers, suppliers and the community fairly, protect the environment, obey the law and behave ethically.

The agency problem arises because shareholders (principals) hire managers (agents) to run the firm, and the two groups have different interests. Its main causes are:

• Separation of ownership and control: managers make decisions but shareholders bear most of the risk.
• Conflict of goals: managers may prefer salary, perks, job security and empire building to maximising shareholder wealth.
• Differences in risk attitude and time horizon: managers may avoid risky but profitable projects, or focus on short-term results.
• Information asymmetry: managers know more about the firm than shareholders, so their actions are hard to monitor.

Under the residual dividend policy, the investment is financed first from retained earnings, in line with the target capital structure.

Equity share of the investment $= (1 - 0.40) \times 20 =$ Rs 12 million

Dividend $=$ Net income $-$ Equity needed $= 15 - 12 =$ Rs 3 million

Stock repurchase (buyback) is when a company buys back its own outstanding shares from the market, or from shareholders directly. The shares are then held as treasury stock or cancelled. It is a way of distributing cash to shareholders as an alternative to cash dividends, and it reduces the number of shares outstanding.

Financial management decisions are the major decisions a financial manager takes to create value for shareholders. They are of three or four broad types.

1. Investment decision (capital budgeting). It concerns where to invest the firm's funds: the choice of long-term assets and projects, and the management of current assets. Techniques such as NPV, IRR and payback are used. The aim is to accept projects that earn more than the cost of capital.

2. Financing decision. It concerns how to raise funds, that is, the mix of debt and equity (capital structure). The manager seeks the combination that minimises the cost of capital and maximises firm value while keeping risk acceptable.

3. Dividend decision. It concerns how much of the profit to pay out to shareholders and how much to retain for reinvestment. It also covers the form of payment (cash dividend, stock dividend or repurchase) and the stability of the dividend.

4. Working capital (liquidity) decision. It concerns the day-to-day management of cash, receivables, inventory and short-term financing, so that the firm has enough liquidity to meet its obligations without holding idle funds.

These decisions are interrelated, and together they should maximise shareholder wealth.

Size of profit. Dividends are normally paid out of current or past profits. A firm with large, stable profits can pay higher and more regular dividends. A firm with low or fluctuating profits pays less, because it cannot sustain a high payout. Profit also affects the retention decision: the larger the profit, the more can be both paid and retained.

Liquidity position. Profit is not cash. A dividend is paid in cash, so a firm needs adequate cash and liquid assets. A profitable firm whose funds are tied up in inventory, receivables or fixed assets may have to pay a low dividend or a stock dividend. A firm with a strong liquidity position can pay larger cash dividends.

Investment opportunities. A firm with many profitable projects needs funds for expansion. It will retain more earnings and pay lower dividends, since retained earnings are a cheaper source than new equity. This follows the residual dividend policy. A mature firm with few investment opportunities pays out more of its earnings.

So higher profit and better liquidity support higher dividends, while attractive investment opportunities reduce them.

Optimal capital structure is the mix of debt and equity at which the firm's cost of capital is lowest and the value of the firm is highest. Its main features are:

• Maximum firm value / minimum WACC: the market value of the firm is highest, and the weighted average cost of capital is lowest at this mix.
• Balance of risk and return: the use of debt raises EPS and ROE through leverage but also raises financial risk, so the optimal mix balances the two.
• Tax advantage with limited distress cost: it takes advantage of the interest tax shield without exposing the firm to heavy bankruptcy costs.
• Flexibility: the firm keeps some unused borrowing capacity to raise funds when needed.
• Solvency and control: the firm can comfortably meet interest and principal payments, and existing owners keep control.
• Suited to the firm's own conditions: it depends on the industry, business risk, size, stability of sales and profits, and asset structure, so it differs from firm to firm.
• Dynamic: it is reviewed and adjusted as conditions change.

Annual demand $D = 3{,}380{,}000$ bags; ordering cost $S =$ Rs 480; carrying cost $H = 20\% \times 600 =$ Rs 120 per bag per year.

(a) Economic order quantity

$EOQ = \sqrt{\frac{2DS}{H}} = \sqrt{\frac{2 \times 3{,}380{,}000 \times 480}{120}} = \sqrt{27{,}040{,}000} = 5{,}200 \text{ bags}$

(b) Total inventory cost

Number of orders $= 3{,}380{,}000 / 5{,}200 = 650$

Ordering cost $= 650 \times 480 =$ Rs 312,000

Carrying cost $= \left(\frac{5{,}200}{2} + 15{,}000\right) \times 120 = 17{,}600 \times 120 =$ Rs 2,112,000

Total inventory cost $= 312{,}000 + 2{,}112{,}000 =$ Rs 2,424,000

(Without the safety stock, the ordering and carrying costs would be Rs 312,000 each, a total of Rs 624,000.)

(c) Reorder point

Weekly usage $= 3{,}380{,}000 / 52 = 65{,}000$ bags

$ROP = 2 \times 65{,}000 + 15{,}000 = \mathbf{145{,}000 \text{ bags}}$

Market value of equity $= 100{,}000 \times 300 =$ Rs 30,000,000. With no tax or signalling effect, the total market value stays the same.

(a) 10 percent stock dividend

New shares $= 100{,}000 \times 1.10 =$ 110,000 shares

$\text{Price} = \frac{30{,}000{,}000}{110{,}000} = \text{Rs } 272.73 \text{ per share}$

(b) 2-for-1 stock split

Shares $= 100{,}000 \times 2 =$ 200,000 shares

$\text{Price} = \frac{300}{2} = \text{Rs } 150 \text{ per share}$

(The par value becomes Rs 50 per share.)

Given: INR 83.22 per USD and NPR 1.60 per INR.

$\text{NPR/USD} = \text{NPR/INR} \times \text{INR/USD} = 1.60 \times 83.22 = 133.15$

The cross exchange rate is NPR 133.15 per US dollar (about NPR 133.152).

Interpretation: To buy one US dollar, one has to pay about Rs 133.15 in Nepalese currency. Equivalently, one Nepalese rupee buys about USD 0.0075. The rate is obtained through the Indian rupee because Nepal's currency is pegged to the INR at NPR 1.60 per INR. If the INR depreciates against the dollar, the NPR also depreciates against the dollar, and imports from the US become costlier for Nepal.

Multinational financial management is the management of the financial affairs of a firm that operates in more than one country. It covers investment, financing, working capital and dividend decisions across borders, while also managing the risks of exchange rate changes, political conditions and differing laws, taxes and markets. Its goal is to maximise the value of the firm as a whole.

Differences between domestic and multinational financial management

Given $S_0 = 1{,}000{,}000$, $S_1 = 1{,}250{,}000$, $\Delta S = 250{,}000$. All assets are at full capacity, so they grow with sales: $A^* = 500{,}000$. Spontaneous liabilities are accounts payable plus accruals: $L^* = 60{,}000 + 50{,}000 = 110{,}000$.

(a) AFN

$AFN = \frac{A^*}{S_0}\Delta S - \frac{L^*}{S_0}\Delta S - M\,S_1\,(1-d)$

$= \frac{500{,}000}{1{,}000{,}000}(250{,}000) - \frac{110{,}000}{1{,}000{,}000}(250{,}000) - 0.08 \times 1{,}250{,}000 \times 0.40$

$= 125{,}000 - 27{,}500 - 40{,}000 = \text{Rs } 57{,}500$

Net income 2024 $= 0.08 \times 1{,}250{,}000 = 100{,}000$; retained earnings added $= 40{,}000$.

(b) Projected balance sheet, 2024 (Rs)

Total assets of Rs 625,000 less the financing available before AFN (Rs 567,500) $=$ Rs 57,500, which equals the AFN calculated in part (a). The AFN would be raised by additional notes payable, long-term debt or new equity.

(a) Expected returns

$E(R_X) = 0.30(10) + 0.40(15) + 0.30(20) = 3 + 6 + 6 = 15\%$

$E(R_Y) = 0.30(30) + 0.40(20) + 0.30(10) = 9 + 8 + 3 = 20\%$

(b) Standard deviations

$\sigma_X^2 = 0.30(10-15)^2 + 0.40(15-15)^2 + 0.30(20-15)^2 = 7.5 + 0 + 7.5 = 15$

$\sigma_X = \sqrt{15} = 3.87\%$

$\sigma_Y^2 = 0.30(30-20)^2 + 0.40(0)^2 + 0.30(10-20)^2 = 30 + 0 + 30 = 60$

$\sigma_Y = \sqrt{60} = 7.75\%$

(c) Covariance and correlation

$Cov_{XY} = 0.30(-5)(10) + 0.40(0)(0) + 0.30(5)(-10) = -15 + 0 - 15 = -30$

$\rho_{XY} = \frac{-30}{3.873 \times 7.746} = \frac{-30}{30} = -1.0$

The returns are perfectly negatively correlated.

(d) Portfolio with 50% in each stock

$E(R_p) = 0.5(15) + 0.5(20) = 17.5\%$

$\sigma_p^2 = (0.5)^2(15) + (0.5)^2(60) + 2(0.5)(0.5)(-30) = 3.75 + 15 - 15 = 3.75$

$\sigma_p = \sqrt{3.75} = 1.94\%$

The portfolio has an expected return of 17.5% with a risk of only 1.94%, far lower than the risk of either stock alone, because of the negative correlation.

(a) Earnings per share

$EPS = \frac{56{,}000}{10{,}000} = \text{Rs } 5.60$

(b) Operating break-even point

Contribution per unit $= 40 - 20 =$ Rs 20

$BEP = \frac{\text{Fixed costs}}{\text{Contribution per unit}} = \frac{100{,}000}{20} = 5{,}000 \text{ units}$

In sales value: $5{,}000 \times 40 =$ Rs 200,000.

(c) Leverages

$DOL = \frac{\text{Contribution}}{EBIT} = \frac{200{,}000}{100{,}000} = 2.0$

$DFL = \frac{EBIT}{EBIT - I} = \frac{100{,}000}{80{,}000} = 1.25$

$DCL = DOL \times DFL = 2.0 \times 1.25 = 2.5$

(d) Effect of a 20% increase in sales

$\%\Delta \text{ net profit} = DCL \times \%\Delta \text{ sales} = 2.5 \times 20\% = 50\%$

Check: Sales 480,000, variable cost 240,000, contribution 240,000, fixed costs 100,000, EBIT 140,000, interest 20,000, EBT 120,000, tax 36,000, net income 84,000. The rise from 56,000 to 84,000 is 50%.

(a) Payback period

Payback period is the time required to recover the initial investment from the project's net cash inflows.

Project X: cash flows are equal, so $500{,}000 / 200{,}000 =$ 2.5 years.

Project Y: cumulative cash flow is 300,000 after year 1 and 500,000 after year 2, so the payback is 2 years.

(b) Net present value at 10%

Project X: the annuity factor for 4 years at 10% is 3.1699.

$NPV_X = 200{,}000 \times 3.1699 - 500{,}000 = 633{,}974 - 500{,}000 = \text{Rs } 133{,}974$

Project Y:

$PV = \frac{300{,}000}{1.1} + \frac{200{,}000}{1.1^2} + \frac{200{,}000}{1.1^3} + \frac{100{,}000}{1.1^4}$

$= 272{,}727 + 165{,}289 + 150{,}263 + 68{,}301 = 656{,}581$

$NPV_Y = 656{,}581 - 500{,}000 = \text{Rs } 156{,}581$

(c) Independent projects

Both have positive NPV (and IRR above 10%), so both X and Y should be accepted.

(d) Mutually exclusive projects

Project Y should be chosen. It has the higher NPV (Rs 156,581 against Rs 133,974), so it adds more to shareholder wealth. It also has the higher IRR and the shorter payback, and it returns more cash in the early years.

(e) Internal rate of return

IRR is the rate at which NPV is zero.

Project X: we need an annuity factor of $500{,}000 / 200{,}000 = 2.5$ for 4 years. The factor is 2.5404 at 21% and 2.4936 at 22%.

$IRR_X = 21\% + \frac{2.5404 - 2.5}{2.5404 - 2.4936} \times 1\% \approx 21.9\%$

Project Y: NPV at 26% is about +Rs 3,730, and at 27% it is about -Rs 3,700.

$IRR_Y \approx 26\% + \frac{3{,}730}{3{,}730 + 3{,}700} \times 1\% \approx 26.5\%$

Both IRRs exceed the 10% cost of capital, which confirms acceptance of both projects when independent.

The agency problem is the conflict of interest that arises when the owners of a corporation (principals, the shareholders) hire managers (agents) to run it and the managers pursue their own interests instead of maximising shareholder wealth.

Main forms

• Shareholders versus managers. Managers may prefer large perks, job security, empire building, excess pay or low-risk projects, instead of projects that maximise share price.
• Shareholders versus creditors. Shareholders may take on riskier projects or pay large dividends after borrowing, shifting risk to creditors.
• Majority versus minority shareholders where a few insiders dominate.

Agency costs include monitoring costs (audits, board supervision), bonding costs (contracts, guarantees) and residual loss (value lost because decisions still differ from the owners' wishes).

Remedies

• Managerial incentives such as stock options and performance-linked pay.
• Monitoring by the board of directors, independent directors and auditors.
• Threat of takeover and the market for corporate control.
• Debt covenants and the discipline of debt.
• Disclosure rules and shareholder activism.

Business ethics is the set of moral principles and standards of right and wrong that guide the conduct of a business and its people in dealing with shareholders, employees, customers, suppliers, competitors, government and society.

It covers honesty in advertising and reporting, fair treatment of employees, product safety, fair competition, avoiding bribery, corruption and tax evasion, protecting the environment, and respecting the law. Ethical conduct builds trust, reputation and long-run value, whereas unethical conduct brings legal penalties and loss of customers.

A firm's investment opportunities strongly influence its dividend policy through the residual dividend idea.

• If the firm has many profitable projects (positive NPV, IRR above the cost of capital), it needs funds. Retaining earnings is cheaper than issuing new shares (no flotation cost), so it pays low or no dividends. Growing firms typically retain most earnings.
• If good projects are few, the firm has surplus cash after financing them and pays high dividends, since retained funds would earn less than shareholders could earn elsewhere.

Under the residual theory, dividends = earnings minus the equity needed for the optimal capital budget. Thus the better the investment opportunities, the lower the payout ratio, and the dividend becomes unstable if investment needs vary. In practice firms smooth dividends and may borrow to avoid cutting them.

Degree of total leverage:

$DTL = DOL \times DFL = 2 \times 2.5 = 5 \text{ times}$

$\%\Delta \text{ net income} = DTL \times \%\Delta \text{ sales} = 5 \times 10\% = 50\%$

Net income increases by 50% if sales increase by 10%.

The financial manager is responsible for acquiring and using funds so as to maximise the value of the firm. The main responsibilities are:

1. Financial planning and forecasting: estimating funds needed and preparing budgets and the financial plan.
2. Investment (capital budgeting) decisions: selecting profitable long-term projects and deciding the asset mix.
3. Financing decisions: deciding the sources of funds and the capital structure (debt versus equity) with the lowest cost and acceptable risk.
4. Dividend decisions: deciding how much profit to pay out and how much to retain.
5. Working capital management: managing cash, receivables, inventory and short-term financing to maintain liquidity.
6. Financial analysis and control: analysing financial statements, costs and performance, and controlling funds.
7. Risk management: handling business, financial, interest-rate and exchange-rate risks, including insurance and hedging.
8. Relations with investors and financial markets, and ensuring compliance with laws and reporting requirements.

Capital structure is the mix of debt and equity used to finance the firm. The main factors affecting it are:

1. Business risk: firms with unstable earnings use less debt.
2. Taxes: interest is tax-deductible, so a high tax rate favours more debt.
3. Financial flexibility: a reserve of borrowing capacity is kept for future needs.
4. Management attitude toward risk and control: aggressive managers use more debt; issuing equity may dilute control, so owners wanting to keep control prefer debt.
5. Growth rate and stability of sales: stable, growing firms can carry more debt.
6. Asset structure: firms with many tangible assets that can be pledged as collateral borrow more.
7. Profitability: highly profitable firms can finance internally and often use less debt.
8. Cost of capital and flotation costs: the cost of each source and the cost of issuing it.
9. Lender and rating agency attitudes: limits on borrowing and loan covenants.
10. Market conditions and timing: interest rates, stock-market state and availability of funds.
11. Industry norms and size of the firm: large firms have easier access to capital markets.

Cash management is the planning, collection, disbursement and investment of a firm's cash so that it has enough cash to meet its obligations while idle balances are kept to a minimum and surplus cash is invested profitably. It involves forecasting cash flows (cash budget), speeding up collections, controlling payments and investing surplus in marketable securities.

Importance of holding sufficient cash

• Transaction motive: to pay wages, suppliers, taxes and other routine bills on time.
• Precautionary motive: to meet unexpected needs and emergencies.
• Speculative motive: to take advantage of bargain purchases or investment opportunities.
• Maintains liquidity and avoids insolvency or default.
• Allows taking cash discounts from suppliers and keeps credit standing and goodwill with banks and creditors.
• Compensating balances may be required by banks.

Too much cash, however, earns nothing, so the aim is an optimum balance.

Contribution per unit = 45 - 20 = Rs 25. Fixed cost = Rs 175,000, of which depreciation (non-cash) = Rs 110,000, so cash fixed cost = 175,000 - 110,000 = Rs 65,000.

(a) Profit (accounting) breakeven point

$Q = \frac{175{,}000}{25} = 7{,}000 \text{ units}$

(b) Cash breakeven point

$Q = \frac{65{,}000}{25} = 2{,}600 \text{ units}$

(c) Operating at 4,000 units

Operating profit = $4{,}000 \times 25 - 175{,}000 = -\text{Rs } 75{,}000$ (a loss, since 4,000 is below 7,000 units).

Cash flow from operations = $4{,}000 \times 25 - 65{,}000 = +\text{Rs } 35{,}000$ (because 4,000 is above the cash breakeven of 2,600 units).

The firm shows an accounting loss but generates positive cash, enough to cover its cash costs and pay bills. So creditors are unlikely to seek liquidation just because it is slow in paying; they would probably wait, as the firm can meet its cash obligations, although continued losses would eventually weaken it.

Given: Euro 1.1215 = $1 and C$1.5291 = $1.

$\text{Euro per CUSD} = \frac{1.1215}{1.5291} = 0.7334 \text{ euro per Canadian dollar}$

Also, $\text{CUSD per euro} = \frac{1.5291}{1.1215} = 1.3634$.

Interpretation: The cross rate is Euro 0.7334 = C$1, i.e. one Canadian dollar buys about 0.73 euro, or one euro buys about C$1.36. It is obtained through the US dollar because the two currencies are quoted against the dollar; if the actual direct euro/Canadian dollar quote differed, traders could make a triangular arbitrage profit.

Annual usage $D = 1{,}250{,}000$ sq yd; ordering cost per order $S =$ Rs 2,000; carrying cost per unit $H = 20\% \times 2{,}050 =$ Rs 410.

(a) EOQ

$EOQ = \sqrt{\frac{2DS}{H}} = \sqrt{\frac{2 \times 1{,}250{,}000 \times 2{,}000}{410}} = \sqrt{12{,}195{,}122} \approx 3{,}492 \text{ sq yd}$

(b) Total inventory cost

Number of orders $= 1{,}250{,}000 / 3{,}492 \approx 358$.

$\text{Ordering cost} = 358 \times 2{,}000 \approx \text{Rs } 715{,}900$

$\text{Carrying cost} = \frac{3{,}492}{2} \times 410 \approx \text{Rs } 715{,}900$

$\text{Total ordering and carrying cost} \approx \text{Rs } 1{,}431{,}800$

(Carrying the safety stock adds $12{,}500 \times 410 =$ Rs 5,125,000, and the purchase cost itself is $1{,}250{,}000 \times 2{,}050 =$ Rs 2,562,500,000.)

(c) Reorder point

Weekly usage $= 1{,}250{,}000 / 52 = 24{,}038$ sq yd. Lead time is 2 weeks.

$\text{Reorder point} = 24{,}038 \times 2 + 12{,}500 = 48{,}077 + 12{,}500 \approx 60{,}577 \text{ sq yd}$

Multinational financial management is the management of the finance function of a firm that operates in more than one country: the investment, financing, working capital and dividend decisions of a multinational corporation (MNC), with the aim of maximising shareholder wealth in a global setting, taking account of exchange rates, differing laws, taxes and political conditions.

Differences from domestic financial management

(a) Expected returns and standard deviations

$E(R_M) = 0.3(5) + 0.4(15) + 0.3(25) = 15\%$

$E(R_N) = 0.3(40) + 0.4(20) + 0.3(0) = 20\%$

$\sigma_M^2 = 0.3(5-15)^2 + 0.4(0)^2 + 0.3(25-15)^2 = 30 + 0 + 30 = 60, \quad \sigma_M = 7.75\%$

$\sigma_N^2 = 0.3(40-20)^2 + 0.4(0)^2 + 0.3(0-20)^2 = 120 + 0 + 120 = 240, \quad \sigma_N = 15.49\%$

(b) Choice of a single stock

Coefficient of variation: $CV_M = 7.75/15 = 0.52$ and $CV_N = 15.49/20 = 0.77$.

Stock N has a higher return (20% against 15%) but much higher risk. Stock M has less risk per unit of return (lower CV), so a risk-averse investor holding a single stock would prefer Stock M.

(c) Covariance and correlation

$Cov(M,N) = 0.3(-10)(20) + 0.4(0)(0) + 0.3(10)(-20) = -60 - 60 = -120$

$r_{MN} = \frac{-120}{7.75 \times 15.49} = \frac{-120}{120} = -1.0$

The stocks have a perfect negative correlation.

Portfolio weights: $w_M = 0.6$, $w_N = 0.4$.

Return

$E(R_p) = 0.6(15\%) + 0.4(20\%) = 9\% + 8\% = 17\%$

Risk (with $r = -1$)

$\sigma_p^2 = w_M^2\sigma_M^2 + w_N^2\sigma_N^2 + 2w_Mw_N\,Cov(M,N)$

$= 0.36(60) + 0.16(240) + 2(0.6)(0.4)(-120) = 21.6 + 38.4 - 57.6 = 2.4$

$\sigma_p = \sqrt{2.4} = 1.55\%$

Check by state: Recession $0.6(5)+0.4(40) = 19\%$; Average $0.6(15)+0.4(20) = 17\%$; Boom $0.6(25)+0.4(0) = 15\%$.

Diversification: Yes. The portfolio risk of 1.55% is far lower than the risk of either stock (7.75% and 15.49%), while the return of 17% lies between the two. The perfectly negative correlation lets the stocks offset each other's fluctuations, so most of the risk is diversified away.

Part 1: Additional funds needed (Star Trading Company)

From the balance sheet: total assets (all fully utilised) = Rs 200,000; spontaneous liabilities = accounts payable 35,000 + accruals 20,000 = Rs 55,000 (notes payable is not spontaneous). $S_0 = 400{,}000$, $S_1 = 600{,}000$, $\Delta S = 200{,}000$.

(a) AFN equation

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

$= \frac{200{,}000}{400{,}000}(200{,}000) - \frac{55{,}000}{400{,}000}(200{,}000) - 0.10(600{,}000)(0.30)$

$= 100{,}000 - 27{,}500 - 18{,}000 = \text{Rs } 54{,}500$

(b) Projected balance sheet, 2024 (assets and spontaneous liabilities grow by 50%)

Part 2: Himalaya Company

(a) 20% stock dividend

New shares = $100{,}000 \times 20\% = 20{,}000$, so shares outstanding rise to 120,000. The amount capitalised is at market price: $20{,}000 \times 600 =$ Rs 12,000,000, of which par is $20{,}000 \times 100 = 2{,}000{,}000$ and the rest, 10,000,000, goes to share premium.

Price without signalling effect: the market value is unchanged, so

$P = \frac{600 \times 100{,}000}{120{,}000} = \text{Rs } 500$

If there is a signalling effect (investors read the stock dividend as management's confidence in future earnings), the price may fall by less than expected, i.e. settle above Rs 500; if investors see it as a gimmick or a lack of cash, the price may drop below Rs 500.

(b) 2-for-1 stock split

Shares double to 200,000 and par value halves to Rs 50. Common stock stays at Rs 10,000,000, share premium Rs 5,000,000, retained earnings Rs 35,000,000, total equity Rs 50,000,000 (no change in the accounts). The market price should fall to about $600/2 =$ Rs 300 per share.

(a) Payback period

Payback period is the time required for a project's cash inflows to recover the initial investment. It is a simple liquidity and risk measure but ignores the time value of money and cash flows after payback.

Project S: equal inflows of 400,000, so $1{,}000{,}000/400{,}000 =$ 2.5 years.

Project L: cumulative inflows are 500,000 (year 1), 900,000 (year 2), 1,200,000 (year 3), so payback $= 2 + \frac{100{,}000}{300{,}000} =$ 2.33 years.

(b) Net present value

NPV is the present value of expected cash inflows (discounted at the cost of capital) minus the initial investment. A project with NPV greater than zero adds value.

Project S: PV annuity factor (10%, 4 years) = 3.1699

$NPV_S = 400{,}000 \times 3.1699 - 1{,}000{,}000 = 1{,}267{,}948 - 1{,}000{,}000 = \text{Rs } 267{,}948$

Project L:

$PV = 500{,}000(0.9091) + 400{,}000(0.8264) + 300{,}000(0.7513) + 600{,}000(0.6830) = 1{,}420{,}326$

$NPV_L = 1{,}420{,}326 - 1{,}000{,}000 = \text{Rs } 420{,}326$

(c) Internal rate of return

IRR is the discount rate that makes the NPV of a project equal to zero (the present value of inflows equals the investment).

Project S: need annuity factor $= 1{,}000{,}000/400{,}000 = 2.5$. At 21% the factor is 2.5404 and at 22% it is 2.4937, so

$IRR_S \approx 21 + \frac{2.5404 - 2.5}{2.5404 - 2.4937} \approx 21.9\%$

Project L: at 28% NPV is about +Rs 1,300 and at 29% about -Rs 15,600, so $IRR_L \approx 28.1\%$.

(d) Independent projects: both have NPV greater than zero and IRR greater than the 10% cost of capital, so accept both.

(e) Mutually exclusive projects: choose Project L. It has the higher NPV (Rs 420,326 against Rs 267,948), the higher IRR (28.1% against 21.9%) and the shorter payback (2.33 against 2.5 years), so there is no conflict among the criteria.