a. Additional Funds Needed (AFN) for 2025

Given:

• (S_0 = \text{Rs } 40,00,000)
• (S_1 = \text{Rs } 60,00,000)
• (\Delta S = S_1 - S_0 = \text{Rs } 20,00,000)
• Total assets (A^* = \text{Rs } 20,00,000)
• Spontaneous liabilities (L^* = \text{Accounts payable} + \text{Accruals}) [ = \text{Rs } 1,00,000 + \text{Rs } 3,00,000 = \text{Rs } 4,00,000 ]
• After-tax profit margin (M = 10% = 0.10)
• Payout ratio (= 70%), so retention ratio (= 30% = 0.30)

AFN equation:

[ AFN = \left(\frac{A^}{S_0}\right)\Delta S - \left(\frac{L^}{S_0}\right)\Delta S - M S_1 (1 - \text{payout ratio}) ]

Substituting:

[ AFN = \left(\frac{20,00,000}{40,00,000}\right)20,00,000 - \left(\frac{4,00,000}{40,00,000}\right)20,00,000 - 0.10 \times 60,00,000 \times (1 - 0.70) ]

[ = 0.5 \times 20,00,000 - 0.1 \times 20,00,000 - 0.10 \times 60,00,000 \times 0.30 ]

[ = 10,00,000 - 2,00,000 - 1,80,000 ]

[ = \text{Rs } 6,20,000 ]

Therefore, the firm’s additional funds needed for 2025 is Rs 6,20,000.

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b. Pro-forma Balance Sheet of Gandaki Company as of December 31, 2025

Sales increase by (60,00,000 / 40,00,000 = 1.5) times. Since the firm is running at full capacity, all assets and spontaneous liabilities increase proportionally with sales.

Assumption: AFN is financed by notes payable.
(If financed by long-term debt, show it as long-term debt; the total remains the same.)

Working notes:

• Cash (= 2,00,000 \times 1.5 = \text{Rs } 3,00,000)
• Accounts receivable (= 4,00,000 \times 1.5 = \text{Rs } 6,00,000)
• Inventories (= 2,00,000 \times 1.5 = \text{Rs } 3,00,000)
• Net fixed assets (= 12,00,000 \times 1.5 = \text{Rs } 18,00,000)
• Accounts payable (= 1,00,000 \times 1.5 = \text{Rs } 1,50,000)
• Accruals (= 3,00,000 \times 1.5 = \text{Rs } 4,50,000)
• Addition to retained earnings (= 0.10 \times 60,00,000 \times 0.30 = \text{Rs } 1,80,000)
• Retained earnings (= 6,00,000 + 1,80,000 = \text{Rs } 7,80,000)

The pro-forma balance sheet balances at Rs 30,00,000.

Given: Current assets = 120,000 + 500,000 + 380,000 = Rs 1,000,000; net fixed assets = Rs 4,000,000; total assets = Rs 5,000,000. Spontaneous liabilities (accounts payable + accruals) = Rs 400,000. Sales growth = $\frac{7{,}000{,}000-5{,}000{,}000}{5{,}000{,}000} = 40\%$.

(a) AFN at full capacity (all assets grow with sales)

$AFN = \Delta A - \Delta L_{spont} - \Delta RE$

• $\Delta A = 5{,}000{,}000 \times 0.40 =$ Rs 2,000,000
• $\Delta L_{spont} = 400{,}000 \times 0.40 =$ Rs 160,000
• Net income 2026 = 10% × 7,000,000 = Rs 700,000; retained = 10% × 700,000 = Rs 70,000 = $\Delta RE$

$AFN = 2{,}000{,}000 - 160{,}000 - 70{,}000 = \textbf{Rs } 1{,}770{,}000$

(b) Pro-forma balance sheet, 31 December 2026 (AFN raised as notes payable/bank loan)

(c) AFN if fixed assets are at 50% capacity

Sales of Rs 5,000,000 use only half of fixed-asset capacity, so fixed assets can support sales of Rs 10,000,000 and no new fixed assets are needed. Only current assets grow:

• $\Delta A = 1{,}000{,}000 \times 0.40 =$ Rs 400,000

$AFN = 400{,}000 - 160{,}000 - 70{,}000 = \textbf{Rs } 170{,}000$

Operating below full capacity cuts the external funding need from Rs 1,770,000 to Rs 170,000.

Optimal Capital Structure

Optimal capital structure is that combination of debt and equity (debt–equity mix) at which the firm's cost of capital is minimum and the value of the firm is maximum. At this point, the firm enjoys the maximum benefit of financial leverage (tax shield on interest) without exposing itself to excessive financial risk. In other words, it is the debt–equity ratio at which the weighted average cost of capital (WACC) is the lowest and the market value of the firm's shares is the highest. Beyond this point, the rising cost of debt and the increased financial risk (and hence rising cost of equity) push the WACC upward and reduce the firm's value. Hence, the optimal capital structure lies where marginal benefit of debt equals its marginal cost.

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Factors Affecting Capital Structure of a Firm

1. Financial Leverage / Trading on Equity

When the firm earns a return on investment (ROI) higher than the cost of debt, the use of debt magnifies the earnings per share (EPS) and return on equity. A firm with stable and high earnings can afford a higher proportion of debt in its capital structure. This is the most important consideration in designing the capital structure.

2. Stability and Growth of Sales

A firm with stable and growing sales can safely employ more debt because its operating income is predictable and it can meet fixed interest obligations. On the other hand, a firm with fluctuating or uncertain sales (e.g., seasonal industries) should rely more on equity, as fixed interest charges may become burdensome in periods of low sales.

3. Cost of Capital

The capital structure should be designed so as to minimise the overall cost of capital. Debt is generally cheaper than equity because interest is tax-deductible and debt-holders bear lower risk. However, excessive debt increases financial risk and raises the cost of equity. The firm should therefore choose a mix that keeps the WACC at its minimum.

4. Financial Risk and Debt Capacity

Every additional unit of debt increases the firm's fixed financial obligations and the risk of insolvency. The firm must assess its debt capacity — the ability to service interest and principal — before adding debt. A firm with high business risk should keep its financial risk low by using less debt.

5. Control and Dilution of Ownership

Issue of new equity shares dilutes the control of existing shareholders, whereas debt does not dilute control. Hence, owner-managed firms and firms with concentrated ownership often prefer debt to equity to retain control. Conversely, if the firm wants to avoid the risk of losing control to creditors, it may prefer equity.

6. Flexibility and Future Financing Needs

The capital structure should retain the flexibility to raise additional funds in the future without undue difficulty or cost. A firm that has already exhausted its debt capacity may find it hard to borrow in an emergency. Hence, a proper balance between debt and equity should be maintained to preserve financial flexibility.

7. Tax Rate and Tax Shield

Interest on debt is a deductible expense for tax purposes, so debt provides a tax shield that reduces the effective cost of debt. The higher the corporate tax rate, the greater the advantage of debt financing and the more debt the firm can use in its capital structure.

8. Nature of the Industry and Assets

Firms in capital-intensive industries with tangible, marketable assets (e.g., manufacturing) can pledge assets as security and hence use more debt. Service and technology firms with mostly intangible assets have limited collateral and therefore depend more on equity.

9. Size of the Firm

Large, well-established firms have easier access to capital markets, better creditworthiness and greater bargaining power with lenders; they can therefore use more debt. Small and new firms face difficulty in raising debt and depend more on equity or retained earnings.

10. Market Conditions and Timing

The choice between debt and equity also depends on the condition of the capital market. When interest rates are low and the debt market is favourable, firms prefer debt; when the equity market is booming, they prefer to issue equity. The timing of the issue thus influences the capital structure.

11. Legal and Regulatory Environment

Government policies, SEBON regulations, lending norms of banks and financial institutions, and tax laws affect the availability and cost of debt and equity. Restrictions on debt–equity ratios or on institutional lending may compel the firm to adopt a particular structure.

12. Management Attitude and Risk Preference

The attitude of the management towards risk is a decisive factor. Aggressive, risk-taking managements prefer a debt-heavy structure to maximise EPS, while conservative managements prefer equity to avoid the risk of insolvency. Similarly, the desire to maintain control influences the choice.

13. Retained Earnings and Dividend Policy

A firm with high retained earnings can finance its investment needs internally without diluting control or increasing fixed obligations. A liberal dividend policy reduces retained earnings and forces the firm to depend more on external debt or equity.

14. Nature of Investors and Institutional Norms

The type of investors the firm wants to attract also matters. If investors prefer regular income and safety, preference shares or debt may be used; if they seek capital appreciation and control, equity shares are issued. Institutional norms and the expectations of lenders and rating agencies also constrain the choice.

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Conclusion: The optimal capital structure is not a fixed ratio but a dynamic target that balances the benefits of debt (tax shield, lower cost, leverage) against its costs (financial risk, loss of flexibility, dilution of control). A firm should therefore design its capital structure after carefully evaluating all the above factors so as to minimise the cost of capital and maximise the value of the firm.

TU BBS — Fourth Year — International Financial Management

Given:

• Home country = United States, Foreign country = Germany
• 90-day risk-free rate in the US: $i_{US} = 6\%$ per annum
• 90-day risk-free rate in Germany: $i_{G} = 7\%$ per annum
• Spot rate: $S_0 = USD 1.30$ per euro

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(a) 90-day forward rate

Formula (Interest Rate Parity):

$F = S_0 \times \frac{1 + i_{US}}{1 + i_{G}}$

where the interest rates must be for the same 90-day period.

Step 1: Convert annual rates into 90-day rates

$i_{US} = \frac{6\%}{4} = 1.5\% = 0.015$

$i_{G} = \frac{7\%}{4} = 1.75\% = 0.0175$

Step 2: Substitute into the IRP formula

$F = 1.30 \times \frac{1 + 0.015}{1 + 0.0175}$

$F = 1.30 \times \frac{1.015}{1.0175}$

$F = 1.30 \times 0.997543$

$F = USD 1.2968 \text{ per euro}$

Answer (a): The 90-day forward rate is **$1.2968 per euro** (approximately$1.2970 per euro).

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(b) Is the 90-day forward rate at a premium relative to the spot rate?

Step 1: Compare forward rate with spot rate

$F = USD 1.2968, \qquad S_0 = USD 1.30$

Since $F < S_0$, the forward rate is lower than the spot rate.

Step 2: Compute the forward premium/discount

$\text{Forward premium (discount)} = \frac{F - S_0}{S_0} \times 100$

$= \frac{1.2968 - 1.30}{1.30} \times 100$

$= \frac{-0.0032}{1.30} \times 100$

$= -0.2462\% \text{ (for 90 days)}$

Annualized:

$= -0.2462\% \times 4 = -0.9846\% \approx -0.98\% \text{ per annum}$

Answer (b): No. The 90-day forward rate is not trading at a premium; it is trading at a discount of about 0.25% for 90 days (≈ 0.98% per annum) relative to the spot rate. This is consistent with IRP: the euro is at a forward discount because Germany's interest rate (7%) is higher than the US rate (6%).

a. Conversion ratio

$CR = \frac{\text{Par value}}{\text{Conversion price}} = \frac{1{,}000}{60} = 16.67 \text{ shares}$

b. Conversion value at t = 0

$CV_0 = CR \times P_0 = 16.67 \times 50 = \text{Rs. }833.33$

c. Straight bond value at present

Coupon = 7% of 1,000 = Rs. 70; kd = 9%; n = 5.

$V_B = \sum_{t=1}^{5} \frac{70}{(1.09)^t} + \frac{1{,}000}{(1.09)^5}$

$V_B = 70 \times \text{PVIFA}_{9\%,5} + 1{,}000 \times \text{PVIF}_{9\%,5}$

$V_B = 70 \times 3.8897 + 1{,}000 \times 0.6499$

$V_B = 272.28 + 649.93 = \text{Rs. }922.21$

Summary

Given:

• Annual lease payment = Rs 50,000
• Purchase price = Rs 150,000
• Before-tax cost of debt = 10%
• Tax rate = 40%
• Life = 4 years, no salvage
• Straight-line depreciation
• Discount rate = after-tax cost of debt = 10%(1−0.40) = 6%

Depreciation = 150,000/4 = Rs 37,500/year

a. PV of leasing

After-tax lease payment = 50,000(1−0.40) = Rs 30,000

PVIFA(6%,4) = [1−(1.06)⁻⁴]/0.06 = (1−0.792094)/0.06 = 3.4651

PV of leasing = 30,000 × 3.4651 = Rs 103,953

b. PV of cost of purchasing

PV of depreciation tax shield = 37,500 × 0.40 × 3.4651 = 15,000 × 3.4651 = Rs 51,977

PV of cost of purchasing = 150,000 − 51,977 = Rs 98,023

c. Decision

Purchasing cost (Rs 98,023) < Leasing cost (Rs 103,953), so the machine should be purchased.

Key Features of Multinational Corporations

A multinational corporation (MNC) is a company that owns or controls production or service facilities in more than one country. It operates through a parent company in the home country and subsidiaries, branches or joint ventures in host countries. Its key features are:

1. International operations. The MNC carries on business in two or more countries. It may produce at home and sell abroad, or produce and sell in several foreign countries at the same time.

2. Large size and huge assets. MNCs are among the largest business organisations in the world. They command enormous capital, plant, equipment and manpower, and their annual sales often exceed the national income of many small countries.

3. Centralised control with decentralised management. Strategic decisions — investment, product policy, pricing, finance and expansion — are taken by the head office (parent company), while day-to-day operations are delegated to local managers in each host country.

4. Global outlook and planning. The whole world is treated as one market. The MNC plans production, sourcing and marketing on a global basis rather than a national basis, and shifts resources to wherever returns are highest.

5. Advanced technology and research. MNCs spend heavily on research and development and possess superior technology, managerial skills and marketing expertise, which they transfer to their foreign units.

6. Multiple sources of finance. They raise funds from many countries — equity issues, loans from international banks, bonds in foreign capital markets, retained earnings of subsidiaries and internal transfer of funds between units.

7. Product innovation and strong brand names. They produce a wide range of standardised and differentiated products and enjoy well-known brand names and worldwide distribution networks.

8. Flexible and mobile resources. Capital, technology, managers and even production can be shifted quickly from one country to another in response to cost, market or political conditions.

9. High degree of integration. The parent and its affiliates are linked by ownership, technology, finance and marketing, so that the activities of one unit support the others.

10. Ability to influence the economy and policy. Because of their size and mobility, MNCs can affect employment, balance of payments, technology transfer and even government policy in host countries.

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Reasons Why Companies Go Global

Companies expand beyond national borders for the following reasons:

1. To capture new and larger markets. The domestic market may be small or saturated. Going global gives access to a much bigger customer base, raises sales volume and helps the firm achieve economies of scale.

2. To reduce cost of production. Foreign locations may offer cheaper labour, raw materials, land and power. Producing where costs are lowest lowers the average cost and raises profit.

3. To obtain scarce resources and raw materials. Firms go abroad to secure raw materials, minerals, agricultural produce and components that are not available at home in sufficient quantity or quality.

4. To take advantage of government incentives and policies. Many host governments offer tax holidays, subsidies, cheap loans, duty concessions and liberal investment rules to attract foreign investment. Such benefits pull companies abroad.

5. To avoid trade barriers and restrictions. High tariffs, quotas and other protectionist measures in foreign markets make exporting difficult. Setting up production inside those countries helps the firm bypass such barriers.

6. To take advantage of cheap and skilled labour. Differences in wage levels and availability of skilled and technical manpower across countries encourage firms to shift or expand operations abroad.

7. To follow customers and competitors. When major customers or rival firms move into foreign markets, a company may also go global to retain its customers and its competitive position.

8. To diversify risk. Dependence on a single country's market exposes the firm to recession, political instability or currency problems. Operating in several countries spreads and reduces such risk.

9. To exploit technological and managerial superiority. A firm with better technology, brand name or management skill can earn higher returns by using these advantages in countries where local firms lack them.

10. To extend the product life cycle. A product that has reached the maturity or decline stage in the home market may still be new and profitable in developing countries, so the firm moves there.

11. To improve competitiveness and growth. Global operations bring larger scale, wider learning and stronger bargaining power, which help the firm grow and compete with other global players.

12. To earn higher profits. Ultimately, all the above reasons aim at higher and more stable profits than what the domestic market alone can provide.

a. Number of new shares to be issued

$\text{New shares} = \frac{\text{Funds required}}{\text{Subscription price}} = \frac{6{,}000{,}000}{100} = 60{,}000 \text{ shares}$

b. Number of rights required to buy one new share

$\text{Rights per new share} = \frac{\text{Old shares}}{\text{New shares}} = \frac{120{,}000}{60{,}000} = 2 \text{ rights}$

c. Theoretical value of each right

$R = \frac{M_0 - S}{N + 1}$

where $M_0 = 160$, $S = 100$, $N = 2$

$R = \frac{160 - 100}{2 + 1} = \frac{60}{3} = \text{Rs. } 20 \text{ per right}$

d. Theoretical value per share ex-rights

$M_e = \frac{(N \times M_0) + S}{N + 1} = \frac{(2 \times 160) + 100}{3} = \frac{420}{3} = \text{Rs. } 140 \text{ per share}$

(Check: $M_e = M_0 - R = 160 - 20 = \text{Rs. } 140$)

e. Why LFI prefers a rights offering over a cash (public) offer

1. Protects existing control — Shares are sold only to present shareholders in proportion to their holdings, so ownership proportions and voting control are not diluted.
2. Lower flotation cost — No underwriters, prospectus advertising or selling commissions are needed; issue cost is much less than a public issue.
3. Cheaper than a public issue for the firm — The subscription price (Rs. 100) is below market price (Rs. 160), so the shares are easily subscribed and the issue is almost certain to succeed.
4. Keeps the firm's debt–equity position intact — Equity is raised without bringing in outsiders or increasing financial risk.
5. Fair to existing shareholders — The fall in price from Rs. 160 to Rs. 140 is exactly compensated by the value of the rights (Rs. 20), so no shareholder loses wealth.

Only alternatives (ii) and (iii) are reproduced in the question, so they are evaluated here; the chosen alternative is the one with the lowest effective cost among them.

(a) Effective rates

Alternative (ii): 8.5% loan on a discount basis (interest deducted in advance; annual compounding)

For a loan of face value Rs 100, interest = Rs 8.50 and the borrower receives only Rs 91.50.

$\text{Effective rate} = \frac{8.5}{100 - 8.5}\times 100 = \frac{8.5}{91.5}\times 100 = \mathbf{9.29\%}$

Alternative (iii): 6% add-on loan, equal quarterly payments on the initial face value

For Rs 100: add-on interest for the year = Rs 6, total repayable = Rs 106.

$\text{Quarterly payment} = \frac{106}{4} = \text{Rs } 26.50$

The borrower receives Rs 100 and pays Rs 26.50 at the end of each of 4 quarters, so the quarterly rate $r$ solves

$100 = 26.50 \times \frac{1-(1+r)^{-4}}{r}\;\Rightarrow\; \text{PVIFA}_{r,4} = 3.7736 \;\Rightarrow\; r \approx 2.372\%$

(Check: at 2.372%, annuity factor $\approx 3.7736$.)

$\text{Effective annual rate} = (1.02372)^4 - 1 = \mathbf{9.83\%}\quad(\text{nominal } 4 \times 2.37 = 9.49\%)$

Although "6%" looks the cheapest, the add-on interest is charged on the full original amount while the principal is repaid in instalments, so the true cost is about 9.8%.

Decision: Himalya Company should choose the discount loan (ii) among these two, since its effective rate (9.29%) is lower than that of the add-on loan (9.83%). If alternative (i) has a lower effective rate than 9.29%, that one would be preferred.

(b) Other factors in choosing a bank

1. Compensating balance and fees: processing fee, commitment fee, service charges and any minimum balance requirement raise the real cost.
2. Reliability and credit availability: willingness to continue lending in tight money periods and to give emergency credit.
3. Collateral and loan restrictions: security required, covenants and limits on dividends or further borrowing.
4. Bank size and lending limit: whether the bank can meet the firm's growing needs within the NRB single-obligor limit.
5. Range of services: foreign exchange, letters of credit, cash management and advisory services.
6. Flexibility and relationship: ease of renewal or early repayment, and the bank's understanding of the firm's business and management.
7. Interest policy and NRB rules: whether the rate is fixed or floating (linked to the base rate), plus the bank's stability and reputation.

Given:

• 1 U.S. dollar = Yen 125
• 1 U.S. dollar = Peso 10

a. Cross rate of Yen per Peso

$1\ \text{Peso}=\frac{1}{10}\ \text{U.S. dollar}$

$1\ \text{Peso}=\frac{1}{10}\times 125\ \text{Yen}=12.5\ \text{Yen}$

Cross rate: 1 Peso = Yen 12.5

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b. Cross rate of Peso per Yen

$1\ \text{Yen}=\frac{1}{12.5}\ \text{Peso}=0.08\ \text{Peso}$

Cross rate: 1 Yen = Peso 0.08

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c. Cost to Mexican importer in home currency

Total cost of computer = Yen 150,000

Using cross rate:

$1\ \text{Yen}=0.08\ \text{Peso}$

$\text{Cost in Peso}=150,000\times 0.08=12,000\ \text{Peso}$

The computer will cost the Mexican importer Peso 12,000.

Major Types of Risks Dealt by a Financial Manager

A financial manager faces several types of risks in the course of managing the finances of a firm. The major types are described below:

1. Market Risk

Market risk is the risk of loss arising from changes in market prices such as interest rates, exchange rates, and security prices. It affects the value of the firm's assets, liabilities, and investments. It includes:

• Interest rate risk: Loss due to fluctuations in interest rates, which affects the cost of borrowing and the value of fixed-income securities.
• Exchange rate (currency) risk: Loss due to changes in foreign exchange rates, affecting firms engaged in import, export, or foreign borrowing.
• Equity price risk: Loss due to adverse movements in share prices in which the firm has invested.

2. Credit Risk

Credit risk is the risk that a customer or borrower will fail to repay the amount due on time or in full. It arises from:

• Trade credit extended to customers (accounts receivable).
• Loans and advances given to borrowers.
• Investments in debt securities of other parties.

If debtors default, the firm suffers cash flow problems and possible bad debt losses.

3. Liquidity Risk

Liquidity risk is the risk that the firm will not be able to meet its short-term obligations as they fall due, or will have to borrow at high cost or sell assets at a loss to meet them. It arises when cash inflows do not match cash outflows. A firm may be profitable but still fail if it cannot pay its bills on time.

4. Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, systems, or from external events. It includes:

• Errors or fraud by employees.
• Failure of computer systems or technology.
• Natural disasters, strikes, or accidents.
• Legal and regulatory penalties.

5. Business Risk

Business risk is the uncertainty of operating income (EBIT) caused by factors such as changes in demand, competition, input costs, and general economic conditions. It is inherent in the nature of the business and is independent of how the firm is financed. It has a market-wide (systematic) part, such as a recession, and a firm-specific (unsystematic) part, such as the loss of a key customer; only the latter can be reduced by diversification.

6. Financial Risk

Financial risk is the risk of loss arising from the use of debt (financial leverage) in the capital structure. A highly geared firm must pay fixed interest and principal, which increases the chance of insolvency if earnings fall. It is also called financial leverage risk or default risk.

7. Other Risks

• Inflation risk: Loss of purchasing power of returns due to rising prices.
• Political and country risk: Loss due to political instability, changes in government policy, or country-specific events.
• Tax and regulatory risk: Loss due to changes in tax laws or regulations.

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Important Reasons to Manage These Risks

Financial managers must manage the above risks for the following reasons:

1. To Ensure Survival and Solvency

Unmanaged risks, especially liquidity and financial risk, can lead to default and bankruptcy. Managing them ensures the firm can meet its obligations and continue as a going concern.

2. To Stabilize Earnings and Cash Flows

Risk management reduces the volatility of earnings and cash flows. Stable earnings build investor confidence, support steady dividend payments, and make planning easier.

3. To Reduce the Cost of Capital

Firms with well-managed risks are perceived as less risky by lenders and investors. They can borrow at lower interest rates and issue securities on better terms, lowering the overall cost of capital.

4. To Maximize Shareholders' Wealth

The primary goal of financial management is to maximize shareholders' wealth. By controlling risks that threaten the firm's value, the manager protects and enhances shareholder wealth.

5. To Improve Decision Making

When risks are identified and measured, managers can make better investment, financing, and dividend decisions. They can choose projects with acceptable risk-return trade-offs.

6. To Comply with Legal and Regulatory Requirements

Many laws and regulations require firms to maintain certain liquidity, capital, and disclosure standards. Risk management ensures compliance and avoids penalties.

7. To Gain Competitive Advantage

Firms that manage risks better can take advantage of opportunities, such as entering new markets or investing in new projects, which risk-averse competitors may avoid.

8. To Protect Stakeholders' Interests

Employees, customers, suppliers, and creditors all depend on the firm's stability. Managing risks protects their interests and maintains the firm's reputation.

9. To Avoid Financial Distress Costs

Financial distress brings direct costs (legal fees, administrative costs) and indirect costs (loss of customers, suppliers, and key employees). Risk management helps avoid these costs.

10. To Ensure Efficient Use of Resources

By identifying and controlling risks, the firm avoids wasteful losses and uses its scarce resources more efficiently, contributing to long-term growth.

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Conclusion: A financial manager deals with market, credit, liquidity, operational, business, and financial risks. Managing these risks is essential for the survival, stability, profitability, and growth of the firm, and ultimately for maximizing shareholders' wealth.

Given:

• Additional fund required = Rs 2,000,000
• Current market price per share (cum-right) = Rs 250
• Subscription price = Rs 100
• Existing shares outstanding = 40,000

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a. Number of new shares to be issued

$N_s=\frac{\text{Fund required}}{\text{Subscription price}}=\frac{2,000,000}{100}=20,000$

20,000 new shares must be issued.

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b. Rights required to purchase one new share

Number of rights issued = number of existing shares = 40,000

$\text{Rights per new share}=\frac{40,000}{20,000}=2$

2 rights are required to purchase one new share.

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c. Theoretical value of each right

$R=\frac{M-S}{N+1}$

Where:

• (M) = cum-right market price = Rs 250
• (S) = subscription price = Rs 100
• (N) = rights required for one new share = 2

$R=\frac{250-100}{2+1}=\frac{150}{3}=Rs\ 50$

Theoretical value of each right = Rs 50.

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d. Theoretical value of a share when stock goes ex-right

$P_{ex}=\frac{NM+S}{N+1}$

$P_{ex}=\frac{2(250)+100}{3}=\frac{500+100}{3}=\frac{600}{3}=Rs\ 200$

Alternatively,

$P_{ex}=M-R=250-50=Rs\ 200$

Theoretical ex-right price per share = Rs 200.

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e. Reasons for right issue

1. To raise additional equity capital for expansion, modernization, working capital, or repayment of debt.
2. To protect existing shareholders’ ownership proportion by giving them the first opportunity to buy new shares.
3. Cheaper and easier than public issue because rights shares are issued to existing shareholders, reducing marketing and flotation costs.
4. No dilution of control if existing shareholders exercise their rights.
5. Maintains good investor confidence as the company offers shares at a concessional price.
6. Improves capital structure by increasing equity and reducing dependence on debt.
7. Quick source of funds without lengthy legal and procedural formalities of a public issue.

Given: $S_0 =$ Rs. 10,000,000; $S_1 =$ Rs. 15,000,000; $\Delta S =$ Rs. 5,000,000; profit margin $M = 10\%$; payout ratio $= 70\%$, so retention ratio $= 30\%$. The firm is at full capacity, so every asset grows with sales.

(a) Additional funds needed (AFN)

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

Here $A^*$ is the total of assets that rise with sales (all assets at full capacity), and $L^*$ is the spontaneous liabilities (accounts payable and accruals). Growth in sales is $\Delta S/S_0 = 5/10 = 50\%$, so assets and spontaneous liabilities each rise by 50%.

Addition to retained earnings:

$M \times S_1 \times (1 - 0.70) = 0.10 \times 15{,}000{,}000 \times 0.30 = \text{Rs. } 450{,}000$

$AFN = 0.5\,A^* - 0.5\,L^* - 450{,}000$

With the 2023 balance sheet of Janakpur Textile Company, substitute its total assets for $A^*$ and its payables and accruals for $L^*$. The result is the external financing needed. If it is positive, funds must be raised. If it is zero or negative, retained earnings cover the growth.

(b) Pro-forma balance sheet as of 31 December 2024

Build it step by step:

The AFN from part (a) is the gap between the 2024 total assets and the financing available from spontaneous liabilities and retained earnings. It is entered as new notes payable or long-term debt (or new equity), so that total assets equal total liabilities and equity.

Given:

• Amount set aside = NR 300,000
• Bid rate = NR 69.13 per SGD
• Ask rate = NR 69.61 per SGD

When Kapil buys SGD from the bank, the bank sells SGD at the Ask rate.
When Kapil sells SGD back to the bank, the bank buys SGD at the Bid rate.

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a. SGD received on January 16, 2024

[ \text{SGD received}=\frac{\text{NR}}{ \text{Ask rate}} ]

[ =\frac{300,000}{69.61}=4,309.7256 ]

SGD received = SGD 4,309.73 approximately

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b. NR received on January 22, 2024

[ \text{NR received}=\text{SGD} \times \text{Bid rate} ]

[ =4,309.7256 \times 69.13 = 297,931.33 ]

NR received = NR 297,931.33 approximately

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c. Gain or loss in buying and selling SGD

[ \text{Loss}=\text{Initial NR} - \text{NR received} ]

[ =300,000 - 297,931.33 = 2,068.67 ]

Loss = NR 2,068.67

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d. Percentage gain or loss

[ \text{Loss percentage}=\frac{\text{Loss}}{\text{Initial NR}} \times 100 ]

[ =\frac{2,068.67}{300,000} \times 100 = 0.6896% ]

Loss percentage = 0.69% approximately

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e. Bid/Ask percentage spread

Using the usual convention:

[ \text{Percentage spread}=\frac{\text{Ask rate} - \text{Bid rate}}{\text{Ask rate}} \times 100 ]

[ =\frac{69.61 - 69.13}{69.61} \times 100 ]

[ =\frac{0.48}{69.61} \times 100 = 0.6896% ]

Bid/Ask percentage spread = 0.69% approximately

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Final Answers:

Types of Mergers

A merger is the combination of two or more companies into a single entity. On the basis of the relationship between the combining firms, mergers are classified into the following types:

1. Horizontal Merger Two or more firms operating in the same industry, at the same stage of production, and dealing in similar products combine together. For example, the merger of two commercial banks. It eliminates competition, increases market share and market power, and creates economies of scale. However, it may create monopoly and attract legal restrictions.

2. Vertical Merger A merger between firms at different stages of the production–distribution chain, i.e., a firm merges with its supplier or its distributor. When a firm merges with its supplier it is called backward (upward) vertical merger; when it merges with its buyer or distributor it is called forward (downward) vertical merger. It ensures regular supply of raw materials, control over distribution channels, reduces transaction costs, and improves quality control. Its main drawback is that the firm loses flexibility and becomes more rigid.

3. Conglomerate Merger A merger between firms engaged in unrelated business activities, having no common product, market or technology. It is of two types: pure conglomerate (firms completely unrelated) and mixed conglomerate (firms seeking product or market extension). It diversifies risk, utilises surplus funds, and stabilises earnings. However, it demands strong managerial skill and may dilute the core competence of the firm.

4. Market Extension Merger A merger between two firms selling the same product but in different geographical markets. It helps the acquirer enter a new market area without building its own distribution network. For example, a bank of one region merging with a bank of another region.

5. Product Extension Merger A merger between two firms dealing in related but non-competing products, which are sold through the same channels. It widens the product line and increases the customer base. For example, a company producing biscuits merging with a company producing noodles.

6. Circular Merger A special form of product extension merger in which the firms deal in closely related products that can be sold to the same customers through the same outlets. For example, a firm producing shoes merging with a firm producing socks.

7. Reverse Merger A merger in which a private company acquires a public company in order to become publicly listed without going through the lengthy IPO process. The public shell company survives and the private company's shareholders gain control.

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Rationales Behind Mergers and Acquisitions

Mergers and acquisitions are undertaken for a number of motives, which may be grouped as follows:

A. Synergistic (Value-Creating) Motives

1. Operating Synergy The combined firm can operate more efficiently than the two separate firms. This arises from:

• Economies of scale — spreading fixed costs over larger output, reducing average cost.
• Economies of scope — using the same resources (brand, distribution, R&D) for more products.
• Complementary strengths — one firm's weakness (e.g., weak marketing) is covered by the other's strength.
• Increased market power — reduced competition allows higher prices and better bargaining power with suppliers.

2. Financial Synergy

• Lower cost of capital — a larger, diversified firm can borrow at lower interest rates and issue securities at lower cost.
• Better debt capacity — stable combined cash flows support more debt and hence greater tax shield.
• Surplus cash utilisation — a firm with excess cash but few investment opportunities acquires a firm with good projects but insufficient funds.
• Tax benefits — accumulated tax losses of one firm can be set off against the profits of the other; also, gains from asset revaluation may reduce tax liability.

3. Managerial Synergy Superior management of the acquiring firm replaces inefficient management of the target firm, improving performance. This is the basis of the "market for corporate control" argument.

B. Diversification Motives

4. Risk Reduction Merging with a firm whose earnings are not perfectly correlated with the acquirer's earnings reduces the variability of combined earnings, stabilising cash flows and reducing the chance of bankruptcy. However, shareholders can diversify on their own, so this motive benefits mainly managers and creditors.

5. Growth Motive Firms seeking rapid growth find merger cheaper and faster than internal expansion, especially when the industry is mature or entry barriers are high. It also helps overcome scarce resources such as skilled manpower, technology and licences.

C. Financial and Value-Based Motives

6. Undervaluation (Market Timing) When the target firm's shares are trading below their intrinsic value, the acquirer gains by buying it cheaply. Similarly, when the acquirer's own shares are overvalued, it can use them as currency to buy a real asset.

7. Asset Stripping / Value Creation through Restructuring The acquirer may identify a firm whose assets are poorly utilised, sell off unprofitable divisions, and create value from the remaining core business.

8. Hubris Hypothesis Managers sometimes overpay due to overconfidence in their own ability to manage the target better. This is a value-destroying motive.

D. Other Managerial and Strategic Motives

9. Managerial Self-Interest (Agency Motive) Managers pursue mergers to increase firm size, which brings higher salaries, prestige, power and job security. This is an agency problem rather than a shareholder-wealth motive.

10. Defensive Motive A firm may acquire another to prevent itself from being acquired (e.g., buying a firm that would otherwise be a takeover target), or to build a size large enough to deter hostile bidders.

11. Strategic Motive Mergers are used to acquire new technology, patents, brands, distribution networks or to gain access to foreign markets. For example, a Nepali bank may merge to meet regulatory capital requirements and expand its branch network.

12. Regulatory and Policy Compulsion In Nepal, Nepal Rastra Bank has encouraged and sometimes compelled mergers among banks and financial institutions to strengthen the financial sector. Such mergers are driven by regulatory pressure rather than pure market motives.

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Conclusion Mergers may be horizontal, vertical, conglomerate, market extension, product extension or circular in form. The rationales range from genuine value-creating synergies (operating, financial and managerial) to growth, diversification, tax and regulatory motives, and sometimes to value-destroying motives such as managerial self-interest and hubris. A merger is justified only when it increases shareholder wealth.

a. Maximum and minimum subscription price

• Maximum possible subscription price: Rs 250 per share
  If the subscription price is above the current market price of Rs 250, no rational shareholder would subscribe. The rights would have zero or negative value.

• Minimum possible subscription price: Rs 100 per share
  The shares have a par value of Rs 100. A company cannot normally issue shares below par value. Hence, the minimum subscription price is Rs 100.

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b. Number of shares to be sold if subscription price is Rs 100

[ \text{Number of new shares} = \frac{\text{Funds required}}{\text{Subscription price}} ]

[ = \frac{\text{Rs } 80,000,000}{\text{Rs } 100} = 800,000 \text{ shares} ]

So, 800,000 new shares must be sold.

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c. Number of rights needed to buy one share

[ \text{Rights per new share} = \frac{\text{Existing shares}}{\text{New shares}} ]

[ = \frac{1,600,000}{800,000} = 2 \text{ rights} ]

So, 2 rights are required to buy one new share.

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d. Value of a right

Use the formula:

[ R = \frac{M - S}{N + 1} ]

Where:

• (M) = current market price = Rs 250
• (S) = subscription price = Rs 100
• (N) = number of rights needed for one new share = 2

[ R = \frac{250 - 100}{2 + 1} = \frac{150}{3} = \text{Rs } 50 ]

So, the value of one right is Rs 50.

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e. Ex-rights price

[ P_{\text{ex}} = \frac{N \times M + S}{N + 1} ]

[ = \frac{2 \times 250 + 100}{3} = \frac{500 + 100}{3} = \frac{600}{3} = \text{Rs } 200 ]

So, the ex-rights price is Rs 200 per share.

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f. Shareholder with 2,000 shares before the offering

Before the rights offer:

[ 2,000 \times \text{Rs } 250 = \text{Rs } 500,000 ]

After the rights offer, the shareholder receives:

[ 2,000 \text{ rights} ]

Since 2 rights buy one new share, the shareholder could buy:

[ \frac{2,000}{2} = 1,000 \text{ new shares} ]

But the shareholder does not want to buy additional shares. Therefore, the shareholder can sell the rights.

Value of rights sold:

[ 2,000 \times \text{Rs } 50 = \text{Rs } 100,000 ]

Value of shares after the offer:

[ 2,000 \times \text{Rs } 200 = \text{Rs } 400,000 ]

Total wealth after selling rights:

[ \text{Rs } 400,000 + \text{Rs } 100,000 = \text{Rs } 500,000 ]

This is exactly equal to the wealth before the rights offer:

[ \text{Rs } 500,000 ]

Thus, the shareholder is not harmed by the rights offer. The fall in the share price from Rs 250 to Rs 200 is exactly offset by the value of the rights received. If the shareholder simply lets the rights expire without selling them, wealth would fall to Rs 400,000. Therefore, the shareholder should sell the rights to remain equally well off.

i. Rupee cost of each alternative (Rs. 500,000 needed for 1 month)

(a) Line of credit

• Interest on the used funds for one month: $500{,}000 \times 0.12 \times \tfrac{1}{12} = \text{Rs. } 5{,}000$
• Commitment fee of 1% on the unused part of the line (the whole line for the other 11 months): $500{,}000 \times 0.01 \times \tfrac{11}{12} = \text{Rs. } 4{,}583$

$\text{Total cost} = 5{,}000 + 4{,}583 = \text{Rs. } 9{,}583$

(b) Forgo the 2/10, net 40 trade discount

The discount lost is $0.02 \times 500{,}000 = \text{Rs. } 10{,}000$. Payment is delayed by 30 days (day 10 to day 40). The annualised cost is $\frac{2}{98} \times \frac{360}{30} \approx 24.5\%$.

$\text{Cost} = \text{Rs. } 10{,}000$

(c) Sixty-day commercial paper

• Interest on the paper: $500{,}000 \times 0.09 \times \tfrac{60}{360} = \text{Rs. } 7{,}500$
• Income from investing the idle funds for the second 30 days: $500{,}000 \times 0.06 \times \tfrac{30}{360} = \text{Rs. } 2{,}500$ (earned)
• Transaction fee on the securities: $0.005 \times 500{,}000 = \text{Rs. } 2{,}500$

$\text{Net cost} = 7{,}500 - 2{,}500 + 2{,}500 = \text{Rs. } 7{,}500$

The commercial paper (c) has the lowest rupee cost.

ii. Must the lowest-cost source be selected?

No. Cost is only one factor. Other considerations are:

• Flexibility. A line of credit can be drawn when needed and repaid at any time. Commercial paper is fixed for 60 days and cannot be cut short.
• Risk and availability. Only large, well-rated firms can issue commercial paper. The market may be small or closed to a small printing press in Nepal. A bank line is more reliable.
• Uncertainty of the amount and timing. If the need turns out to be larger or longer than 30 days, a line of credit adjusts easily. Paper does not.
• Relations with suppliers and banks. Forgoing discounts repeatedly can damage supplier credit standing and the firm's reputation. A bank line builds a relationship that helps later.
• Reinvestment risk. The paper's saving depends on earning 6% on the idle funds, and the market rate may change.
• Other conditions. Restrictive covenants, collateral, issue costs and administrative effort differ across sources.

Management should therefore compare the cost with flexibility, certainty of funds, risk and the firm's long-term financing position. The cheapest source is selected only if it is also suitable on these other factors.

Given (Rs million):

• Sales in 2018, (S_0 = 350)
• Net income in 2018, (NI_0 = 10.5)
• Dividends paid, (D_0 = 4.2)
• Increase in sales, (\Delta S = 70)
• Sales in 2019, (S_1 = 350 + 70 = 420)
• Firm operates at full capacity.

Ratios:

[ \text{Profit margin} = \frac{NI_0}{S_0} = \frac{10.5}{350} = 0.03 = 3% ]

[ \text{Dividend payout ratio} = \frac{D_0}{NI_0} = \frac{4.2}{10.5} = 0.40 = 40% ]

[ \text{Retention ratio} = 1 - 0.40 = 0.60 ]

From Magee’s 2018 balance sheet:

• Total assets (A^* = Rs\ 350) million
• Spontaneous liabilities (L^* = \text{Accounts payable} + \text{Accrued liabilities}) [ L^* = 35 + 15 = Rs\ 50 \text{ million} ]

So,

[ \frac{A^*}{S_0} = \frac{350}{350} = 1.0 ]

[ \frac{L^*}{S_0} = \frac{50}{350} = 0.142857 ]

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a. External funds needed using the AFN equation

[ AFN = \left(\frac{A^}{S_0}\right)\Delta S - \left(\frac{L^}{S_0}\right)\Delta S - MS_1(1 - d) ]

Where:

• (M = 0.03)
• (S_1 = 420)
• (d = 0.40)

Substituting:

[ AFN = 1.0(70) - \left(\frac{50}{350}\right)(70) - 0.03(420)(0.60) ]

[ AFN = 70 - 10 - 7.56 ]

[ AFN = Rs\ 52.44 \text{ million} ]

Therefore, Magee’s external funds needed for 2019 is Rs 52.44 million.

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b. Pro forma balance sheet as of December 31, 2019

All figures are in Rs million.

Assets

Liabilities and Equity

Working note:

[ NI_{2019} = 0.03 \times 420 = Rs\ 12.6 \text{ million} ]

[ Dividends_{2019} = 0.40 \times 12.6 = Rs\ 5.04 \text{ million} ]

[ Addition to retained earnings = 12.6 - 5.04 = Rs\ 7.56 \text{ million} ]

[ Retained earnings_{2019} = 100 + 7.56 = Rs\ 107.56 \text{ million} ]

[ Notes payable_{2019} = 50 + 52.44 = Rs\ 102.44 \text{ million} ]

Thus, the pro forma balance sheet balances at Rs 420 million.

Given:

• Existing shares outstanding = 320,000
• Current market price = Rs 400 per share
• Funds to be raised = Rs 20,000,000
• Subscription price in rights offering = Rs 250 per share

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a. Number of new shares to be sold

[ \text{New shares}=\frac{\text{Funds required}}{\text{Subscription price}} ]

[ =\frac{20,000,000}{250}=80,000 \text{ shares} ]

Answer: 80,000 new shares

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b. Rights required to purchase one new share

One right is issued for each existing share.

[ \text{Total rights}=320,000 ]

[ \text{Rights per new share}=\frac{320,000}{80,000}=4 ]

Answer: 4 rights are required to purchase one new share.

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c. Value of a right

The theoretical value of one right is:

[ R=\frac{M_0-S}{N+1} ]

Where:

• (M_0) = cum-rights market price = Rs 400
• (S) = subscription price = Rs 250
• (N) = number of rights needed for one new share = 4

[ R=\frac{400-250}{4+1}=\frac{150}{5}=30 ]

Answer: Value of one right = Rs 30

Also, ex-rights price:

[ P_{\text{ex}}=\frac{N M_0+S}{N+1} =\frac{4(400)+250}{5} =\frac{1,600+250}{5} =\frac{1,850}{5} =370 ]

So, ex-rights price = Rs 370 per share.

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d. Shareholder’s wealth before and after rights offering

Shareholder has:

• 1,000 shares
• Cash balance = Rs 50,000

Before rights offering

[ \text{Value of shares}=1,000 \times 400 = Rs\ 400,000 ]

[ \text{Cash}=Rs\ 50,000 ]

[ \text{Total wealth}=400,000+50,000=Rs\ 450,000 ]

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After rights offering, if all rights are exercised

Number of new shares the shareholder can buy:

[ \frac{1,000}{4}=250 \text{ new shares} ]

Subscription amount required:

[ 250 \times 250 = Rs\ 62,500 ]

Cash available = Rs 50,000
So there is a cash shortfall:

[ 62,500-50,000=Rs\ 12,500 ]

This Rs 12,500 must be arranged from other sources or by selling some rights.

Total shares after exercising all rights:

[ 1,000+250=1,250 \text{ shares} ]

Ex-rights price = Rs 370

[ \text{Value of shares}=1,250 \times 370 = Rs\ 462,500 ]

Net cash position:

[ 50,000-62,500=-Rs\ 12,500 ]

[ \text{Net wealth}=462,500-12,500=Rs\ 450,000 ]

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Summary Table

Conclusion:
The shareholder’s total wealth remains unchanged at Rs 450,000 before and after the rights offering, provided all rights are exercised. The apparent increase in share value is exactly offset by the cash paid for the new shares.

Given: Plan I (all equity): 210,000 shares. Plan II (levered): 150,000 shares and debt of Rs 22,80,000 at 8%, so interest = 0.08 × 22,80,000 = Rs 1,82,400. No taxes.

$EPS = \frac{EBIT - \text{Interest}}{\text{Shares}}$

(a) EBIT = Rs 5,00,000

• Plan I: $5{,}00{,}000/210{,}000 = \text{Rs } 2.38$
• Plan II: $(5{,}00{,}000 - 1{,}82{,}400)/150{,}000 = \text{Rs } 2.12$

Plan I gives the higher EPS, because at low EBIT the interest burden outweighs the benefit of fewer shares.

(b) EBIT = Rs 7,50,000

• Plan I: $7{,}50{,}000/210{,}000 = \text{Rs } 3.57$
• Plan II: $(7{,}50{,}000 - 1{,}82{,}400)/150{,}000 = \text{Rs } 3.78$

Plan II gives the higher EPS, since leverage magnifies returns when EBIT is high.

(c) Break-even EBIT

Set EPS of both plans equal:

$\frac{EBIT}{210{,}000} = \frac{EBIT - 1{,}82{,}400}{150{,}000}$

$150{,}000\,EBIT = 210{,}000\,EBIT - 210{,}000 \times 1{,}82{,}400$

$60{,}000\,EBIT = 38{,}30{,}40{,}00{,}000 \;\Rightarrow\; EBIT = \text{Rs } 6{,}38{,}400$

Check: $6{,}38{,}400/210{,}000 = 3.04$ and $(6{,}38{,}400-1{,}82{,}400)/150{,}000 = 3.04$.

Below Rs 6,38,400 Plan I is better; above it Plan II is better.

Meaning of Merger and Acquisition

Merger: A merger is a combination of two or more companies into a single company, where one company survives and the other(s) lose their separate legal identity. The assets and liabilities of the absorbed company (or companies) are taken over by the surviving company. For example, when Company A absorbs Company B, only A survives and B ceases to exist.

Acquisition: An acquisition (also called takeover) is a transaction in which one company purchases a controlling interest in another company. The acquired company may continue to exist as a separate legal entity, or it may be merged into the acquirer. The acquirer gains control over the assets, management and operations of the target company by buying its shares or assets.

In short, in a merger two companies join to become one, whereas in an acquisition one company buys control over another.

Concepts of Horizontal, Vertical and Conglomerate Merger

1. Horizontal Merger A horizontal merger takes place between two companies that operate in the same industry, at the same stage of production, and produce similar or competing products. Such firms are direct competitors in the market. The main objectives are to increase market share, eliminate competition, achieve economies of scale, and gain pricing power. For example, the merger of two commercial banks in Nepal, or the merger of two cement companies, is a horizontal merger. Since it reduces the number of competitors, it may raise monopoly concerns and hence attracts regulatory scrutiny.

2. Vertical Merger A vertical merger takes place between two companies that operate at different stages of the same production or distribution chain — that is, between a supplier and a buyer, or between a manufacturer and a distributor. It may be backward integration (merging with a supplier of raw materials) or forward integration (merging with a distributor or retailer). The main objectives are to secure supply of raw materials, control the distribution channel, reduce transaction and inventory costs, and improve coordination. For example, a textile manufacturer merging with a cotton-producing firm, or a brewery merging with a bottle-manufacturing company. Such mergers generally do not reduce direct competition but may create barriers to entry.

3. Conglomerate Merger A conglomerate merger takes place between two companies that operate in unrelated industries or lines of business, with no common production or market relationship. It may be a pure conglomerate merger (totally unrelated firms) or a mixed conglomerate merger (firms seeking product or market extension). The main objectives are diversification of risk, better utilisation of surplus funds, growth without depending on the existing line of business, and use of a strong management team across businesses. For example, a bank merging with or acquiring an insurance company or a hydro-power company. Such mergers do not directly affect competition in any single market.

Growing Need of Mergers and Acquisitions in Banks and Financial Institutions in Nepal

The need for merger and acquisition among banks and financial institutions (BFIs) in Nepal has grown rapidly in recent years due to the following reasons:

1. Excessive number of BFIs and small size: Nepal had a very large number of commercial banks, development banks, finance companies and micro-credit institutions relative to the size of its economy. Most of them were small in capital and could not undertake large projects. Mergers help create larger, stronger institutions.

2. Regulatory capital requirement: Nepal Rastra Bank has been raising the minimum paid-up capital requirement for BFIs from time to time. Many small BFIs could not meet this requirement on their own, so merger became the practical way to comply.

3. Financial stability and risk reduction: Weak and thinly capitalised BFIs pose a risk to the whole financial system. Mergers and acquisitions consolidate weak institutions into stronger ones, reducing the chance of bank failure and enhancing public confidence.

4. Economies of scale and cost efficiency: Merged banks can share branches, technology, staff and administrative systems, which lowers operating cost per unit of business and improves profitability.

5. Competition and globalisation: With the entry of foreign banks and the liberalisation of the financial sector, domestic BFIs must be large enough to compete. Mergers build capacity to compete with big foreign and joint-venture banks.

6. Expansion of branch network and market share: Merger is a faster and cheaper way to expand branches, customer base and market share than opening new branches.

7. Reduction of unhealthy competition: Too many BFIs were competing for the same limited customers and deposits, leading to cut-throat competition. Mergers reduce such unhealthy competition.

8. Improved corporate governance and technology: Larger institutions can afford better management, information technology, risk management and internal control systems.

9. Better access to capital and investment capacity: A larger merged bank can raise capital from the market more easily and finance big infrastructure and industrial projects.

10. Policy and legal support: The Bank and Financial Institution Act (BAFIA) and NRB directives provide a legal framework and incentives (such as relaxation in branch expansion and tax treatment) for merger and acquisition, which has encouraged BFIs to merge.

Because of these factors, merger and acquisition has become an important strategy for consolidation, stability and growth of the banking and financial sector in Nepal.

a. Annual percentage cost of each alternative

i. Forgoing the cash discount (3/10, net 30)

Cost of not taking the discount:

$$k=\frac{d}{1-d}\times \frac{365}{N-D}$$

where (d=0.03), (N=30), (D=10).

$$k=\frac{0.03}{0.97}\times \frac{365}{30-10} =0.030928\times 18.25 =0.5644 =56.44\% \text{ p.a.}$$

So, the cost of forgoing the discount is 56.44% per annum.
If effective annual compounding is used, it is about 74.36%, but the usual BBS treatment uses the simple annualized figure above.

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ii. Bank loan with compensating balance

The firm needs Rs 4.4 million. If it borrows (L), it must keep 12% as compensating balance:

$$L(1-0.12)=4.4$$ $$0.88L=4.4 \Rightarrow L=\text{Rs }5.0 \text{ million}$$

Interest cost:

$$0.15\times 5=\text{Rs }0.75 \text{ million}$$

Usable funds:

$$5-0.12(5)=\text{Rs }4.4 \text{ million}$$

Annual cost:

$$k_b=\frac{0.75}{4.4}=0.17045=17.05\% \text{ p.a.}$$

So, bank financing costs 17.05% per annum.

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iii. Commercial paper

Face value issued = Rs 4.7 million
Net proceeds = Rs 4.4 million
Discount = (4.7-4.4=\text{Rs }0.3) million for six months.

Six-month cost:

$$\frac{0.3}{4.4}=0.06818=6.818\%$$

Annualized cost:

$$k_{cp}=0.06818\times 2=0.13636=13.64\% \text{ p.a.}$$

So, commercial paper costs 13.64% per annum.
If effective annual compounding is used, it is about 14.10%.

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b. Which alternative should Pawlowski select? Why?

The bank loan is more expensive than commercial paper by:

$$17.05\%-13.64\%=3.41\%$$

The firm is willing to pay at most 2% per annum extra for the flexibility of bank financing. Since the extra cost is 3.41%, which is greater than 2%, bank financing is not worth the flexibility premium.

Therefore, Pawlowski should select commercial paper, because it is the cheapest source of financing among the three. Forgoing the cash discount is far too costly.

Even if effective annual costs are used, bank cost is 17.05% and commercial paper cost is about 14.10%, so the difference is about 2.95%, still greater than 2%. The conclusion remains the same.

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c. Qualitative factors Pawlowski should consider

1. Rollover risk: Commercial paper must be rolled over every six months. If credit markets tighten or the firm’s credit rating falls, it may not be able to issue new paper.
2. Credit rating and market access: Only firms with strong credit standing can issue commercial paper easily.
3. Flexibility: Bank financing can usually be drawn as needed and may provide emergency funds, advisory services, and a continuing relationship.
4. Compensating balance: The bank loan requires a 12% compensating balance, which reduces usable funds and liquidity.
5. Supplier relations: Forgoing cash discounts may damage supplier goodwill and future credit terms.
6. Interest rate risk: Rolling commercial paper every six months exposes the firm to rising short-term interest rates.
7. Transaction and flotation costs: Repeated commercial paper issues may involve rating fees, legal fees, and backup line-of-credit costs, which could raise the effective cost.
8. Future financing needs: Maintaining a good bank relationship may be valuable for future long-term or emergency financing.

Thus, although commercial paper is cheaper, Pawlowski should also consider whether it can safely roll over the paper and whether the bank relationship is worth preserving for future flexibility.

a. Amount realized by Nepalese exporter for US Dollar 1,000

A Nepalese exporter receives US Dollar and sells them to the bank. The bank buys US Dollar at the buying rate:

[ \text{Buying rate} = Rs.\ 119.45/\text{US Dollar} ]

[ \text{Amount realized} = 1{,}000 \times 119.45 = Rs.\ 1{,}19{,}450 ]

Answer: Rs. 1,19,450

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b. Amount payable for European Euro 10,000

A Nepalese importer needs European Euro and buys them from the bank. The bank sells European Euro at the selling rate:

[ \text{Selling rate} = Rs.\ 141.16/\text{Euro} ]

[ \text{Amount payable} = 10{,}000 \times 141.16 = Rs.\ 14{,}11{,}600 ]

Answer: Rs. 14,11,600

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c. Profit or loss on converting Rs. 1,00,000 into US Dollar and back into NPR

When converting NPR into US Dollar, the bank sells US Dollar at the selling rate:

[ \text{US Dollar received} = \frac{1{,}00{,}000}{120.05} = 832.9863 ]

When converting US Dollar back into NPR, the bank buys US Dollar at the buying rate:

[ \text{NPR received} = 832.9863 \times 119.45 = Rs.\ 99{,}500.21 ]

[ \text{Loss} = 1{,}00{,}000 - 99{,}500.21 = Rs.\ 499.79 ]

Answer: Loss of Rs. 499.79

This loss occurs because the bank’s selling rate is higher than its buying rate.

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d. Expected inflation rate in the US

Using Purchasing Power Parity:

[ \frac{F}{S} = \frac{1 + \pi_N}{1 + \pi_{US}} ]

Where:

• (S = NPR\ 120.05/\text{US Dollar})
• (F = NPR\ 125.01/\text{US Dollar})
• (\pi_N = 8.5% = 0.085)
• (\pi_{US} = ?)

[ \frac{125.01}{120.05} = \frac{1.085}{1 + \pi_{US}} ]

[ 1 + \pi_{US} = \frac{1.085 \times 120.05}{125.01} ]

[ 1 + \pi_{US} = 1.04195 ]

[ \pi_{US} = 0.04195 = 4.195% ]

Answer: Expected inflation rate in the US = 4.20% approximately.