Introduction to Business Finance

Investment decision is the decision relating to the selection of long-term assets or projects in which the firm's funds are invested, based on their expected return and risk — for example, buying new machinery, expanding plant capacity, or launching a new product. It is also called capital budgeting decision, and it affects the firm's size, profitability, and long-term growth.

Money market instruments are short-term, highly liquid debt instruments with maturities of one year or less. The important ones are:

• Treasury bills (T-bills) — short-term government securities issued at a discount.
• Commercial papers (CPs) — unsecured promissory notes issued by large, creditworthy corporations.
• Certificates of deposit (CDs) — negotiable time deposits issued by banks.
• Banker's acceptances — drafts guaranteed by a bank, used mainly in trade finance.
• Call money / interbank loans — very short-term (often overnight) loans between banks.
• Commercial bills / bills of exchange — short-term trade bills discounted by banks.
• Repurchase agreements (repos) — short-term borrowing backed by securities sold with an agreement to repurchase.
• Money market mutual funds — funds that invest in a portfolio of money market instruments.

We calculate free cash flow (FCF) to measure the cash a firm generates after meeting its operating expenses and necessary investments in fixed assets and working capital. It shows how much cash is available to pay creditors and shareholders, and it is used to value the firm (DCF valuation) and judge its financial health.

Time line:

Year        0            0.5           1.0           1.5           2.0
          ─────┬────────────┬─────────────┬─────────────┬─────────────
Cash flow  −1,000      +50          +50           +50        +50 + 1,000
                      (coupon)     (coupon)      (coupon)   (coupon + face value)

Explanation:

• t = 0: You pay Rs 1,000 to buy the bond → cash outflow of Rs 1,000.
• Semiannual coupon: Annual coupon = 10% of Rs 1,000 = Rs 100, so each 6-month period pays Rs 100 ÷ 2 = Rs 50.
• t = 0.5, 1.0, 1.5: Receive Rs 50 coupon each period.
• t = 2.0: Receive the final Rs 50 coupon plus the Rs 1,000 face value = Rs 1,050.

So there are 4 coupon payments of Rs 50 each, plus the principal of Rs 1,000 returned at maturity.

Percentage return on investment is computed by dividing the return (income or gain) earned on the investment by the amount invested and multiplying by 100:

$\text{Percentage return} = \frac{\text{Return (income or gain)}}{\text{Amount invested}} \times 100$

For example, if Rs 10,000 is invested and Rs 1,200 is earned in a year, the percentage return is $\frac{1{,}200}{10{,}000} \times 100 = 12\%$.

Security Market Line (SML)

The SML is the graphical representation of CAPM. It plots required return (y-axis) against systematic risk, β (x-axis). It is a straight line starting from the risk-free rate Rf on the y-axis and passing through the market portfolio (β = 1, return = Rm).

Required
Return (%)
   |                        SML  (slope = Rm − Rf)
Rm |.....................* (β = 1)
   |                   ./
   |                 ./
Rf |* . . . . . . ./
   |_____________|______________________ β
   0             1

• Intercept = Rf (risk-free rate)
• Slope = market risk premium (Rm − Rf)
• Equation: Ri = Rf + βi (Rm − Rf)
• Points above the line → undervalued (return higher than required); points below → overvalued.

Role of Financial Manager in a Firm [3 marks]

The financial manager is the executive responsible for managing the financial resources of a firm so that its objectives are achieved. The main roles are:

1. Financial planning and forecasting: Estimating the firm's future capital requirements and preparing budgets, cash-flow forecasts and financial plans to meet them in time.

2. Investment (financing) decisions: Selecting the assets in which funds should be invested — evaluating capital projects and deciding the mix of fixed and current assets — so as to maximise return for a given level of risk.

3. Financing decisions: Determining the best mix of debt and equity (capital structure) and choosing the appropriate sources of funds — loans, debentures, shares, retained earnings — at the lowest possible cost.

4. Dividend decisions: Deciding how much profit to distribute to shareholders and how much to retain for reinvestment, thereby affecting the wealth of owners.

5. Working capital and liquidity management: Managing cash, receivables, inventory and payables to maintain adequate liquidity and avoid both idle funds and insolvency.

6. Risk management and control: Identifying financial risks (interest rate, credit, liquidity) and controlling them, and monitoring the firm's financial performance through ratio analysis and other tools.

Conclusion: In short, the financial manager acts as the custodian of the firm's funds — planning, raising, allocating and controlling them — with the ultimate aim of maximising the wealth of shareholders.

Tax liability of Makalu Transport Ltd.

Given:

• Taxable income = Rs 10,000,000 (Rs 10 million)
• Corporate tax rate = 25%

Formula: $\text{Tax liability} = \text{Taxable income} \times \text{Tax rate}$

Substituting: $\text{Tax liability} = 10{,}000{,}000 \times 0.25 = \text{Rs } 2{,}500{,}000$

Tax liability = Rs 2,500,000 (Rs 2.5 million)

Marginal tax rate

The marginal tax rate is the rate of tax applied on the next additional rupee of taxable income. Since the corporate tax rate is a flat 25 percent, the marginal tax rate is also 25 percent.

Given: Annual saving (PMT) = Rs 5,000
Time (n) = 5 years
Interest rate (i) = 8% = 0.08

Formula: Future value of ordinary annuity $FV = PMT \times \frac{(1+i)^n - 1}{i}$

Substitution: $FV = 5{,}000 \times \frac{(1.08)^5 - 1}{0.08}$

$FV = 5{,}000 \times \frac{1.469328 - 1}{0.08}$

$FV = 5{,}000 \times 5.8666$

$FV = Rs\ 29{,}333.00 \text{ (approx.)}$

Therefore, Miss Shanta will receive about Rs 29,333 at the end of the 5th year.

(Assumption: deposits are made at the end of each year.)

Step 1: Nepal Bank's effective annual rate $EAR=\left(1+\frac{0.08}{4}\right)^4-1=(1.02)^4-1=0.082432\approx8.243\%$

Step 2: Monthly quoted rate with the same EAR $\left(1+\frac{r}{12}\right)^{12}=1.082432\;\Rightarrow\;1+\frac r{12}=(1.082432)^{1/12}=1.006623$ $r=12\times0.006623=0.0795\approx7.95\%$

Rastriya Banijya Bank must quote about 7.95%, compounded monthly.

Given: purchase price $P_0=$ Rs 1,500, selling price $P_1=$ Rs 1,480, coupon $C=$ Rs 100 received in the one-year holding period.

$\text{Total yield}=\frac{C+(P_1-P_0)}{P_0}\times100=\frac{100+(1480-1500)}{1500}\times100=\frac{80}{1500}\times100=5.33\%$

The coupon income gives a current yield of 6.67%, but the Rs 20 capital loss reduces the total yield to 5.33%.

Given:

• Par value of preferred stock, (P) = Rs 100
• Dividend rate = 10%
• Selling price at par, (P_0) = Rs 100
• Floatation cost = 2.5% of par = Rs 2.50
• Corporate tax rate = 25%

Annual preferred dividend: [ D_p = 10% \times 100 = \text{Rs } 10 ]

Net proceeds per share: [ NP = P_0 - \text{Floatation cost} = 100 - 2.50 = \text{Rs } 97.50 ]

Formula: [ k_p = \frac{D_p}{NP} \times 100 ]

Substitution: [ k_p = \frac{10}{97.50} \times 100 = 10.26% ]

Cost of preferred stock = 10.26%

Why corporate tax is not adjusted: Preferred dividends are paid out of profit after tax, so they are not a tax-deductible expense. Unlike interest on debt, which is deducted before tax and therefore gives a tax shield, preferred dividend does not reduce the company's taxable income. Hence no tax adjustment is made while computing the cost of preferred stock.

Answer (6 marks)

Meaning of fund transfer

Fund transfer means the movement of money from those who have surplus funds (savers, households, businesses) to those who need funds (borrowers, investors, government). In a modern economy this transfer does not happen directly in most cases — it is carried out through financial institutions such as commercial banks, development banks, finance companies, cooperatives, insurance companies and capital market institutions. Hence financial institutions act as the "heart" of the financial system.

Key roles of financial institutions in fund transfer

1. Mobilization of savings (collecting surplus funds): Financial institutions collect scattered small savings from households and businesses through deposits, insurance premiums and unit schemes. In this way idle money is converted into productive capital.

2. Channeling funds to productive sectors: The mobilized funds are lent or invested in agriculture, industry, trade, services and infrastructure. Thus funds flow from surplus units (savers) to deficit units (borrowers/investors).

3. Acting as intermediaries: They stand between savers and borrowers. Savers deposit money and receive interest; borrowers take loans and pay interest. The difference (spread) is the institution's income. This is the classic intermediation function.

4. Pooling and risk diversification: By pooling many small deposits and lending to many borrowers, financial institutions spread risk. A single saver need not bear the full risk of one large borrower.

5. Maturity transformation: Savers prefer short-term, liquid deposits, while borrowers need long-term funds. Banks transform short-term deposits into long-term loans, thus reconciling conflicting maturity needs.

6. Payment and settlement services: Through cheques, drafts, cards, mobile banking and electronic transfer, they transfer funds quickly and safely across places and countries.

7. Reducing transaction costs and information asymmetry: They have specialized staff, credit information and economies of scale, so they can evaluate borrowers better and lend at lower cost than individual savers could.

8. Creating credit and supporting monetary policy: Banks create credit through the deposit multiplier. Central bank uses financial institutions to control money supply, inflation and credit flow.

9. Promoting capital formation and economic growth: By converting savings into investment, they raise capital formation, employment, income and GDP.

Critical evaluation

• Positive side: Financial institutions make fund transfer safe, efficient, diversified and large-scale. Without them, savings would remain idle and investment would be limited to self-finance.
• Limitations / criticisms:
  • They may divert funds to speculative, unproductive or luxurious sectors instead of priority sectors.
  • Financial exclusion: rural, poor and small borrowers may not get access to institutional credit.
  • High interest spread and service charges increase the cost of borrowing.
  • Mismanagement, poor lending and default can create non-performing assets and even bank failure.
  • Concentration of economic power in a few large institutions.
  • Financial crises (e.g., 2008 global crisis) show that weak regulation of financial institutions can harm the whole economy.

Conclusion

Financial institutions are indispensable for transferring funds from surplus to deficit units. They mobilize savings, reduce risk and cost, and accelerate capital formation. However, their role is beneficial only when funds are directed to productive sectors, credit reaches the needy, and strong regulation prevents misuse. Thus the statement is largely true, but its effectiveness depends on sound management and proper supervision.

a. Equal annual installment

$R=P\cdot\frac{i(1+i)^n}{(1+i)^n-1}=10{,}000\times\frac{0.10(1.10)^4}{(1.10)^4-1}=10{,}000\times\frac{0.14641}{0.4641}=\text{Rs }3{,}154.71$

b. Loan amortization table

*The last installment is adjusted by Re 0.01 for rounding. Interest falls each year while the principal portion rises, and the loan is fully repaid at the end of year 4.

a. Average rate of return $\bar r_X=\frac{-18+44-22+22+34}{5}=\frac{60}{5}=12\%,\qquad \bar r_Y=\frac{-24+24-4+8+56}{5}=\frac{60}{5}=12\%$

b. Standard deviation (sample, $n-1=4$)

$\sigma_X=\sqrt{\frac{3664}{4}}=\sqrt{916}=30.27\%,\qquad \sigma_Y=\sqrt{\frac{3648}{4}}=\sqrt{912}=30.20\%$

c. Realised portfolio return (50% X, 50% Y)

2009: $0.5(-18)+0.5(-24)=-21\%$

2013: $0.5(34)+0.5(56)=45\%$

Given:

• Industry constant growth rate, (g = 6%)
• Industry dividend yield (= 7%)
• Last dividend paid, (D_0 = Rs,10)
• Supernormal growth: (50%) this year, (25%) next year, then (6%) forever

Required return: [ r_s = \text{Dividend yield} + g = 7% + 6% = 13% ]

Expected dividends: [ D_1 = 10(1.50) = Rs,15 ] [ D_2 = 15(1.25) = Rs,18.75 ] [ D_3 = 18.75(1.06) = Rs,19.875 ]

a. Terminal value at the end of Year 2

[ P_2 = \frac{D_3}{r_s - g} ] [ P_2 = \frac{19.875}{0.13 - 0.06} ] [ P_2 = \frac{19.875}{0.07} = Rs,283.93 ]

Terminal value = Rs 283.93

b. Value per share of the firm’s stock

[ P_0 = \frac{D_1}{(1+r_s)} + \frac{D_2}{(1+r_s)^2} + \frac{P_2}{(1+r_s)^2} ] [ P_0 = \frac{15}{1.13} + \frac{18.75}{(1.13)^2} + \frac{283.93}{(1.13)^2} ] [ P_0 = 13.2743 + 14.6840 + 222.3577 ] [ P_0 = Rs,250.32 ]

Value per share = Rs 250.32

a. Cost of debt

New bonds are sold at par, so the before-tax cost equals the coupon rate, 8%. $k_d(1-T)=8\%(1-0.40)=4.8\%$

b. WACC

The present capital structure (50% debt, 50% equity) is optimum and is to be maintained. The equity part comes from retained earnings, so no new shares are issued and there is no flotation cost. The cost of equity is the required return: $k_e=\frac{D_1}{P_0}+g=4\%+8\%=12\%$

$WACC=w_d\,k_d(1-T)+w_e\,k_e=0.50(4.8\%)+0.50(12\%)=2.4\%+6.0\%=8.4\%$

Kanchenjunga's WACC is 8.4%. Only projects earning more than this should be accepted for the Rs 30 million investment.

Figures in Rs million. EPS $=140.783/0.9207=$ Rs 152.91 (current) and Rs 101.19 (previous), since 920,700 shares are outstanding.

(EBIT = profit before tax + interest. Book value per share = shareholders' fund / shares.)

f. Conclusion. Financial health has improved overall in the current year.

• Liquidity: the current and acid-test ratios fell slightly but remain comfortable (above 2 and 1.6), backed by large cash balances.
• Debt management: the debt ratio rose a little (54.3% to 57.9%), but interest cover jumped from 48.7 to 109.4 times, so the debt is easily serviced.
• Asset utilisation: total assets turnover is slightly better, but inventory turnover slowed because inventory grew faster than cost of goods sold.
• Profitability: profit margin (7.48% to 9.23%) and return on assets (11.87% to 14.98%) both rose strongly.
• Market performance: the share price rose to Rs 1,600, but EPS grew faster, so P/E fell from 14.8 to 10.5 and market-to-book eased slightly; the shares are priced more cheaply relative to earnings.