Meaning of Corporate Finance

Corporate finance is the branch of finance that deals with the financial decisions, activities and problems of a business organisation (a company or corporation). It concerns how a firm raises funds, how it invests those funds in assets and projects, and how it distributes the returns to its owners and other stakeholders.

In other words, corporate finance is the study and management of the three major financial decisions of a company:

1. Investment (capital budgeting) decision — deciding in which long-term assets and projects the firm should invest its funds, and how much to invest.
2. Financing (capital structure) decision — deciding from where and in what proportion the funds should be raised, i.e. the mix of debt and equity.
3. Dividend (profit distribution) decision — deciding how much of the profit should be distributed to shareholders as dividend and how much should be retained in the business.

Thus, corporate finance is mainly concerned with acquiring funds at the lowest possible cost, investing them in the most profitable assets, and distributing the earnings in a manner that maximises the wealth of the shareholders. Its central objective is to maximise the value of the firm or the wealth of its owners, while maintaining a proper balance between risk and return.

Key Features of Operating Lease

An operating lease is a short-term, cancellable lease arrangement in which the lessee uses an asset without owning it. Its key features are:

1. Short duration — The lease period is much shorter than the useful life of the asset. It is usually less than one year or a small fraction of the asset's life.

2. Cancellable at short notice — The lessee can cancel the lease before expiry by giving notice, without heavy penalty. This gives flexibility.

3. No ownership transfer — Ownership of the asset remains with the lessor. The lessee only gets the right to use the asset.

4. No bargain purchase option — The lease agreement does not give the lessee an option to buy the asset at a price lower than fair value at the end of the term.

5. Maintenance and insurance by lessor — The lessor usually bears the cost of maintenance, repairs, insurance and taxes. The lessee pays only rent.

6. Rent is an operating expense — Lease rent is treated as a revenue/operating expense in the income statement. It is not capitalised as an asset and no liability is recorded (under traditional treatment).

7. No depreciation by lessee — Since the asset is not owned, the lessee does not charge depreciation on it. The lessor records the asset and charges depreciation.

8. Equal periodic payments — Rent is generally paid in equal instalments over the lease period.

9. Residual value risk with lessor — The lessor bears the risk of obsolescence and the residual (scrap) value of the asset.

10. Examples — Leasing of computers, vehicles, office equipment, hotel rooms and machinery for a short period.

In short: An operating lease is a short-term, cancellable, service-type lease where the lessor retains ownership and bears the risks of the asset, while the lessee enjoys its use by paying rent treated as an operating expense.

Optimal Capital Structure

Optimal capital structure means that combination of debt and equity in the total capital of a firm at which the cost of capital is minimum and the value of the firm is maximum. At this point, the firm enjoys the greatest benefit of financial leverage — the advantage of using low-cost debt is not yet offset by the rise in financial risk and the resulting increase in the cost of equity.

In other words, it is the debt–equity mix that strikes the best balance between return and risk, so that the overall cost of capital (WACC) is the lowest and the market value of the firm's shares is the highest.

Key features:

• Minimum WACC: The weighted average cost of capital is at its lowest point.
• Maximum firm value: The present value of the firm's earnings is maximised, so shareholder wealth is maximised.
• Balanced risk and return: Use of debt raises EPS, but beyond a point it also raises financial risk; the optimal point lies where the net effect is most favourable.
• Not necessarily 100% debt: Although debt is cheaper than equity, excessive debt increases financial risk and the cost of equity, so the optimum is reached before the debt level becomes too high.
• Dynamic concept: It is not fixed forever; it changes with changes in interest rates, tax rates, business risk and capital market conditions.

Illustration: If a firm's WACC falls from 12% to 10% as debt is increased up to 40% of total capital, and then rises to 11% at 50% debt, the optimal capital structure is the one with 40% debt and 60% equity, because there the cost of capital is minimum and the value of the firm is maximum.

Importance of Financial Plan

A financial plan is a written statement that estimates the future financial requirements of a business and specifies the sources from which those funds will be raised. It is prepared in advance to match the need for funds with their availability. Its importance can be explained as follows:

1. Ensures Adequate Funds A financial plan estimates in advance how much capital is needed for fixed assets, working capital and future expansion. This prevents both over-capitalisation and under-capitalisation, and ensures funds are available when required.

2. Maintains Balance between Inflows and Outflows It coordinates the inflow of funds (issue of shares, loans, retained earnings) with the outflow (purchase of assets, payment of expenses, repayment of debt). This keeps liquidity sound and avoids a cash crisis.

3. Helps in Raising Funds at the Right Time By forecasting requirements, the firm can approach banks, financial institutions and investors well in advance. It can also choose the cheapest and most suitable source, thereby reducing the cost of capital.

4. Basis for Financial Control A financial plan sets standards and budgets against which actual performance can be compared. Deviations can be identified and corrective action taken, so it acts as a tool of control.

5. Facilitates Coordination among Departments It brings together the plans of production, marketing, personnel and finance into one unified framework. Each department knows how much it can spend, which reduces conflict and duplication of effort.

6. Supports Growth and Expansion A sound plan provides for future capital needs such as new plants, new products or new markets. Without it, growth opportunities may be lost for want of timely funds.

7. Reduces Uncertainty and Risk Unexpected events like price rises, recession or emergency expenditure can be faced better when reserves and contingency provisions are built into the plan. It thus acts as a cushion against business risk.

8. Builds Confidence of Investors and Creditors A clear, realistic financial plan shows that the business is well managed. Banks and investors are more willing to lend or invest, which improves the creditworthiness of the firm.

9. Ensures Optimum Utilisation of Funds It directs scarce funds to the most productive uses and avoids idle or excessive balances. This improves profitability and the return on investment.

10. Helps in Meeting Legal and Policy Requirements Companies must comply with legal provisions on capital structure, reserves and disclosure. A financial plan helps fulfil these requirements smoothly.

Conclusion: A financial plan is thus the foundation of sound financial management. It provides direction, ensures liquidity and profitability, controls expenditure, and creates the confidence needed for the long-term survival and growth of a business.

Cumulative preferred stock is a type of preference share on which, if the company fails to pay the dividend in any year due to insufficient profit, the unpaid (arrear) dividend keeps accumulating. Such arrears must be paid in full to these shareholders before any dividend is paid to the ordinary (equity) shareholders in a later year.

In short, it is a preferred stock carrying the right to receive both the current year's dividend and all past unpaid dividends before equity shareholders receive anything.

Two major reasons for going global market are:

1. To expand the market and increase sales/profit — A firm goes global to find new customers beyond its home country, which raises sales volume, spreads fixed costs over a larger output, and increases profit.

2. To gain competitive advantage and reduce risk — Going global lets a firm exploit lower production costs (cheap labour, raw materials), achieve economies of scale, and diversify markets so that a downturn in one country does not ruin the whole business.

Why Do Firms Issue Convertible Bonds?

A convertible bond is a hybrid security that gives the bondholder the option to convert the bond into a fixed number of the issuing firm's common shares at a predetermined conversion price within a specified period. Firms issue convertible bonds for the following reasons:

1. Lower interest cost (cheaper debt) Because the bond carries a valuable conversion option, investors accept a lower coupon rate than on straight (non-convertible) debt. The firm saves cash interest, which is attractive when its credit rating is weak or interest rates are high.

2. Delayed equity financing at a premium Conversion results in new equity only when the share price rises above the conversion price. The firm thus effectively sells shares in the future at a price higher than today's market price, avoiding the immediate dilution and the low issue price of a direct equity issue.

3. Avoids the negative signal of a stock issue Announcing a new equity issue is often read by the market as a signal that managers believe the shares are overvalued. Issuing convertible debt sends a more favourable signal — management expects the share price to rise — and so meets less price resistance.

4. Tax advantage Interest paid on the bond is tax-deductible, whereas dividends on equity are not. The firm enjoys the debt tax shield until conversion takes place.

5. Financing flexibility and lower bankruptcy risk Until conversion, the bond is debt; after conversion, it becomes equity. The firm can therefore adjust its capital structure to changing conditions. If the share price does not rise, the bond simply matures as debt and the firm avoids issuing underpriced shares. The fixed interest obligation is also smaller than on straight debt, reducing financial distress risk.

6. Useful for risky or start-up firms Young, high-growth firms with uncertain prospects and poor credit standing find convertibles attractive: they can borrow at reasonable rates while giving lenders a share in future growth as compensation for risk.

7. Matching with growth opportunities Firms with valuable but uncertain investment opportunities prefer convertibles, since the conversion feature lets them share the upside with bondholders instead of paying a high fixed rate now.

In short, convertible bonds let a firm raise debt cheaply, defer equity issuance to a time when shares are worth more, obtain tax benefits, and keep its financing options open — which is why they are widely used by growth-oriented and financially constrained firms.

Purchasing Power Parity (PPP)

Purchasing power parity is the economic theory that states that in the absence of transportation costs and trade barriers, identical goods and services should cost the same in different countries when their prices are expressed in a common currency. In other words, the exchange rate between two currencies should equal the ratio of the price levels of the two countries, so that a given amount of money has the same purchasing power in both countries.

According to the absolute form of PPP:

$S = \frac{P_d}{P_f}$

where:

• $S$ = spot exchange rate (domestic currency per unit of foreign currency),
• $P_d$ = price level in the domestic country,
• $P_f$ = price level in the foreign country.

Example: If a basket of goods costs Rs 10,000 in Nepal and the same basket costs $100 in the USA, then according to PPP the exchange rate should be Rs 100 per US dollar (Rs 10,000 ÷$100). If the actual rate is Rs 130 per dollar, the Nepali currency is said to be undervalued in PPP terms.

The relative form of PPP states that the exchange rate between two currencies will change by the difference in the inflation rates of the two countries, so that relative purchasing power is maintained over time.

Terms $1/10$, net 40 mean a 1% discount if paid within 10 days; otherwise the full amount is due on day 40. Star Traders skips the discount and pays on day 50, so the credit is used for $50 - 10 = 40$ days beyond the discount period.

$\text{Annual cost} = \frac{d}{100-d}\times\frac{360}{t} = \frac{1}{99}\times\frac{360}{40} = \frac{9}{99} \approx 0.0909$

Annual percentage cost of stretching accounts payable $\approx 9.09\%$.

Paying later than day 40 spreads the same 1% charge over more days, so the annualised cost falls from $\frac{1}{99}\times\frac{360}{30}=12.12\%$ (paying on day 40) to 9.09%.

Under cumulative voting, the minimum number of shares needed to be sure of electing $k$ directors is

$N = \frac{S\times k}{n+1} + 1$

where $S$ = shares outstanding = 400,000, $n$ = directors to be elected = 7, $k$ = directors wanted = 1.

$N = \frac{400{,}000\times 1}{7+1} + 1 = 50{,}000 + 1 = 50{,}001$

A minimum of 50,001 shares is needed to ensure the election of one director.

Maximizing Shareholder Wealth: Managerial Actions of a Financial Manager

The goal of shareholder wealth maximization

Shareholder wealth is maximized when the market price of the firm's common stock rises, since the share price reflects the present value of all expected future returns to owners. The financial manager, as the chief financial decision-maker, should therefore accept only those decisions that increase the firm's value. The three broad decision areas — investment, financing and dividend decisions — plus supporting actions, translate this goal into practice as follows:

1. Sound investment (capital budgeting) decisions

The manager should invest in real assets and projects whose expected return exceeds their cost of capital. Concretely, this means:

• Evaluating projects using discounted cash flow techniques — Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI) — rather than accounting profits or payback alone.
• Accepting all positive-NPV projects, because each such project adds to firm value and hence to share price.
• Rejecting negative-NPV projects, however attractive they may appear in terms of sales growth or prestige.
• Managing existing assets efficiently (inventory, receivables, fixed assets) so that the return on investment is improved.

2. Prudent financing (capital structure) decisions

The manager should choose a mix of debt and equity that minimizes the weighted average cost of capital (WACC) and thereby maximizes firm value.

• Use debt only up to the point where the tax advantage of interest is not outweighed by financial distress and bankruptcy costs.
• Match the maturity of financing with the life of the assets financed (working capital from short-term sources, fixed assets from long-term sources).
• Keep the firm's financial risk within acceptable limits so that lenders and investors retain confidence.
• Take advantage of favourable market conditions — issue equity when prices are high, borrow when interest rates are low — without diluting owners' wealth unnecessarily.

3. Wealth-oriented dividend decisions

The manager should frame a dividend policy that balances current cash to shareholders with retained earnings for profitable growth.

• Retain earnings when the firm has positive-NPV projects offering returns above the shareholders' required rate; distribute them when such opportunities are absent.
• Maintain stability and consistency in dividend payments to reduce investor uncertainty and support the share price.
• Consider the tax position of shareholders and the signalling effect of dividend changes.

4. Efficient management of working capital and risk

• Maintain an optimal level of cash, inventory and receivables to avoid idle funds and costly stock-outs.
• Manage liquidity so that the firm can meet obligations without distress, while not holding excessive low-return current assets.
• Identify and hedge relevant risks (interest rate, exchange rate, commodity price) so that expected cash flows are protected.

5. Reducing agency conflicts and information asymmetry

• Align managers' interests with those of shareholders through performance-based compensation, stock options and other incentive schemes.
• Reduce agency costs by monitoring, bonding and, where appropriate, using debt as a disciplining device.
• Follow transparent disclosure practices to reduce information asymmetry and lower the cost of capital.

6. Considering stakeholders and social responsibility

Modern finance recognizes that ignoring customers, employees, suppliers, creditors, the government and society ultimately destroys shareholder value. The manager should therefore pursue wealth maximization while respecting legal, ethical and environmental obligations, since such conduct protects the firm's long-run reputation and cash flows.

Conclusion

In short, the financial manager maximizes shareholder wealth by accepting value-adding investment projects, arranging the cheapest suitable mix of financing, adopting a dividend policy consistent with available profitable opportunities, managing working capital and risk efficiently, and reducing agency and information problems — all within a framework of ethical and socially responsible conduct. These actions together raise the market price of the firm's shares, which is the practical measure of shareholder wealth.

Long-term bonds are debt instruments issued by a company to raise large amounts of capital for a long period (usually 5–30 years), on which the company pays a fixed rate of interest and repays the principal at maturity. As a source of long-term financing, they have the following advantages and disadvantages.

Advantages

1. Large funds for a long period: Bonds can raise very large amounts of capital in a single issue, and the money is available for a long duration, which suits heavy, long-gestation projects.
2. No dilution of ownership and control: Bondholders are creditors, not owners. They have no voting rights, so the existing shareholders retain full control over the company.
3. Fixed and tax-deductible cost: Interest is a fixed charge that must be paid whether or not the company earns profit. Moreover, interest is allowed as a deduction before tax, so the effective cost of debt is lower than the cost of equity.
4. Trading on equity (favourable financial leverage): If the company earns a return higher than the interest rate on bonds, the surplus goes to the shareholders and raises their earnings per share.
5. Flexibility and easy repayment: Bonds can be issued in different denominations, with different maturities, and with provisions such as convertibility or a sinking fund. They can also be redeemed early if funds are no longer needed.
6. Retained ownership of profits: Unlike equity, the company does not have to share its profits with bondholders beyond the fixed interest.

Disadvantages

1. Fixed obligation and risk of insolvency: Interest and principal repayment are legal obligations. Failure to pay them can lead to liquidation of the company, so the risk of financial distress is high.
2. Reduced borrowing capacity: Bonds create a prior claim on the company's assets and earnings. This weakens the company's credit position and makes further borrowing difficult or costly.
3. Restrictive covenants: Bond indentures usually contain restrictive conditions — limits on further debt, dividend payments, sale of assets, and maintenance of certain ratios — which reduce managerial freedom.
4. Loss of flexibility in financial planning: Once issued, the fixed interest burden continues even during a recession or a period of low profits, so the company cannot adjust its cost of capital to changing conditions.
5. Costly and time-consuming issue: Issuing bonds requires legal formalities, trustee arrangements, prospectus preparation, and flotation costs, which are higher than for short-term or internal sources.
6. Risk of adverse price movement: If interest rates rise after issue, the market value of the bonds falls, and if the bonds are callable, the company may have to redeem them at an unfavourable time.

Conclusion: Long-term bonds are an attractive source of financing because they provide large, long-term funds at a fixed, tax-deductible cost without diluting control. However, they carry a heavy fixed obligation and restrictive conditions. A company should therefore use bonds only when it expects stable and sufficient earnings to cover interest and principal payments.

Given:

• Lease payment = Rs 300,000 per year at the end of each year for 3 years
• Purchase price = Rs 600,000
• Salvage value = Rs 120,000 (book value = cash value)
• Before-tax cost of debt = 10%
• Tax rate = 40%
• Depreciation method = straight-line

After-tax discount rate: [ k_d = 10%(1-0.40)=6% ]

[ \text{PVIFA}_{6%,3} =\frac{1-(1.06)^{-3}}{0.06} =2.6730 ]

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a. Cost of leasing

Lease payments are tax-deductible.

[ \text{After-tax lease payment} =300,000(1-0.40) =Rs\ 180,000 ]

[ \text{Cost of leasing} =180,000 \times \text{PVIFA}_{6%,3} ]

[ =180,000 \times 2.6730 =Rs\ 481,142.15 ]

[ \boxed{\text{Cost of leasing} = Rs\ 481,142.15} ]

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b. Cost of purchasing

Annual depreciation:

[ \text{Depreciation} =\frac{600,000-120,000}{3} =Rs\ 160,000 ]

Annual depreciation tax shield:

[ =160,000 \times 0.40 =Rs\ 64,000 ]

PV of depreciation tax shield:

[ =64,000 \times 2.6730 =Rs\ 171,072.77 ]

PV of salvage value:

[ =\frac{120,000}{(1.06)^3} =120,000 \times 0.8396 =Rs\ 100,754.31 ]

Total PV of benefits:

[ =171,072.77+100,754.31 =Rs\ 271,827.08 ]

Net cost of purchasing:

[ =600,000-271,827.08 =Rs\ 328,172.92 ]

[ \boxed{\text{Cost of purchasing} = Rs\ 328,172.92} ]

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Decision

[ \text{Cost of leasing} = Rs\ 481,142.15 ]

[ \text{Cost of purchasing} = Rs\ 328,172.92 ]

Since the cost of purchasing is lower than the cost of leasing, the company should purchase the equipment.

[ \boxed{\text{The machine should be purchased.}} ]

Net advantage to leasing:

[ =328,172.92-481,142.15 =-Rs\ 152,969.23 ]

A negative NAL also confirms that leasing is not beneficial.

Given: 1 warrant buys 3 shares for a total of Rs 60, so exercise price per share $E = 60/3 =$ Rs 20. Current market price $M =$ Rs 18.

(a) Present theoretical value

$\text{TV} = \max[(M-E)\times N,\,0] = \max[(18-20)\times 3,\,0] = \max[-6,\,0] = \textbf{Rs 0}$

(b) Expected stock price 6 months hence

$E(P) = 0.15(16)+0.20(18)+0.30(20)+0.20(22)+0.15(24) = 2.40+3.60+6.00+4.40+3.60 = \textbf{Rs 20}$

(c) Expected theoretical value of the warrant 6 months hence

$E(\text{TV}) = 1.20 + 1.80 = \textbf{Rs 3}$

(d) No. The market price would normally be above the present theoretical value of Rs 0. The warrant has time left, and the stock may rise above Rs 20 (expected value Rs 3 at expiry), so investors pay a premium for this chance. Leverage adds to the premium, because a small outlay controls 3 shares. The holder's loss is limited to the price paid, while the gain is open-ended. Speculative demand also pushes the price up. So the market price will exceed the theoretical value, and the excess is the warrant premium.