Foundations of Corporate Finance and Financial Analysis

(a) Choice of the Cheapest Alternative

Given:

• Amount needed (usable funds) = Rs 100,000
• Term = 1 year
• Alternative 1: 9% collect (simple) basis
• Alternative 2: 8.4% discount basis
• Alternative 3: 6% add-on basis, equal quarterly payments on initial face value

Alternative 1: 9% collect basis

Face value = Rs 100,000 (borrower receives full Rs 100,000)

Interest = 0.09 × 100,000 = Rs 9,000

Effective rate, $k_1 = \frac{9{,}000}{100{,}000} = 9\%$

Alternative 2: 8.4% discount basis

Interest deducted in advance = 0.084 × 100,000 = Rs 8,400

Usable funds = 100,000 − 8,400 = Rs 91,600

Repayment at year end = Rs 100,000

$k_2 = \frac{8{,}400}{91{,}600} = 9.17\%$

Alternative 3: 6% add-on basis with equal quarterly payments

Interest = 0.06 × 100,000 = Rs 6,000

Total to be repaid = Rs 106,000

Quarterly installment = 106,000 ÷ 4 = Rs 26,500

Outstanding balances during the four quarters = 100,000; 75,000; 50,000; 25,000

Average usable funds = (100,000 + 75,000 + 50,000 + 25,000) ÷ 4 = Rs 62,500

$k_3 = \frac{6{,}000}{62{,}500} = 9.6\%$

Comparison of effective rates

Decision: Alternative 1 is the cheapest. Although its stated rate (9%) is higher than the 8.4% discount rate and the 6% add-on rate, those lower nominal rates understate the true cost — the discount method reduces usable funds, and the add-on method charges interest on the full face value while the loan is repaid in installments, so the borrower has the use of only about 62.5% of the money on average. Hence, Haleshi should choose Alternative 1: the 9 percent loan on a collect basis.

---

(b) Qualitative Factors in Bank Financing vs. Trade Credit

Yes, qualitative factors must be considered, because the effective-cost comparison alone does not capture the full cost and benefit of each source. Trade credit is a spontaneous source that is convenient and requires no negotiation, collateral, or formal agreement, but it carries hidden costs and risks:

1. Loss of cash discount — The real cost of not taking a discount (e.g., 2/10, net 30) is often far higher than any bank rate, so "free" trade credit may actually be very expensive.
2. Supplier relationship — Delaying payment beyond the due date (as Haleshi is doing) damages goodwill and trust with the main supplier, and may lead to refusal of future credit or supplies.
3. Credit standing and reputation — Overdue payables damage the firm's creditworthiness in the market and with lenders, raising the cost of future financing.
4. Flexibility and availability — Bank loans are negotiated, may require collateral and covenants, and take time; trade credit is readily available but limited to the supplier's willingness to extend it.
5. Control and restrictions — Bank financing may impose restrictive covenants on working capital, dividends, and further borrowing, which trade credit does not.
6. Continuity of supply — For a firm dependent on a specialised input (insulation powders), maintaining the supplier's confidence is critical to uninterrupted production; this may outweigh a small interest saving.
7. Size and timing of financing — The amount needed is small (Rs 100,000) and for one year; the administrative cost of arranging a bank loan may be disproportionate, favouring trade credit on convenience grounds.

Conclusion: The quantitative analysis favours Alternative 1 (9% collect basis). However, in the final decision the firm should also weigh the loss of supplier goodwill, possible loss of cash discounts, and the effect on its credit reputation. A balanced decision would be to take the bank loan to clear the overdue Rs 100,000 and preserve the supplier relationship, while negotiating better credit terms for the future.

a. Reasons for using convertibles

1. Lower coupon rate: The conversion option is valuable to investors, so the company can issue debt at a lower interest rate than straight debentures.
2. Delayed equity financing: The company raises debt now and issues equity later only if conversion takes place. This postpones dilution of existing shareholders.
3. Tax advantage: Interest on debentures is tax-deductible, whereas dividends on common stock are not.
4. Favourable when stock price is low: If the company’s stock is temporarily undervalued, it may avoid issuing common stock directly and instead issue convertibles.
5. Less restrictive covenants: Convertible debentures usually carry fewer restrictive covenants than straight debt.
6. Attractive to investors: Investors get fixed interest plus the possibility of capital gain through conversion.
7. Call feature support: A call price of 110 allows the company to force conversion when the stock price rises sufficiently, reducing debt and interest burden.

---

b. Conversion price and conversion ratio

Current market price per share:

[ P_0 = \text{P/E ratio} \times \text{EPS} ]

[ P_0 = 16 \times 2.50 = \text{Rs } 40 ]

Conversion price:

[ P_c = P_0 (1 + \text{conversion premium}) ]

[ P_c = 40 \times 1.20 = \text{Rs } 48 ]

Conversion ratio per Rs 1,000 debenture:

[ \text{Conversion ratio} = \frac{\text{Face value}}{\text{Conversion price}} ]

[ = \frac{1000}{48} = 20.8333 \approx 20.83 \text{ shares} ]

Conversion price = Rs 48 per share
Conversion ratio = 20.83 shares per Rs 1,000 debenture

---

c. Initial conversion value of each debenture

[ \text{Conversion value} = \text{Conversion ratio} \times \text{Market price} ]

[ = 20.8333 \times 40 = \text{Rs } 833.33 ]

Alternatively:

[ \text{Conversion value} = \frac{1000}{1.20} = \text{Rs } 833.33 ]

Initial conversion value = Rs 833.33 per debenture

---

d. New shares issued if all debentures are converted

Total number of debentures:

[ \frac{10,000,000}{1000} = 10,000 \text{ debentures} ]

New shares:

[ 10,000 \times 20.8333 = 208,333.33 \approx 208,334 \text{ shares} ]

Alternatively:

[ \frac{10,000,000}{48} = 208,333.33 \text{ shares} ]

New shares to be issued = 208,333.33 shares, or about 208,334 shares if rounded to whole shares.

---

e. New EPS and retained earnings before and after conversion

Current net income:

[ \text{Net income} = \text{EPS} \times \text{shares} ]

[ = 2.50 \times 1,000,000 = \text{Rs } 2,500,000 ]

Current EBIT:

[ \text{EBIT} = \frac{\text{Net income}}{1 - \text{Tax rate}} ]

[ = \frac{2,500,000}{0.50} = \text{Rs } 5,000,000 ]

Increase in operating earnings = Rs 1,000,000

New EBIT:

[ = 5,000,000 + 1,000,000 = \text{Rs } 6,000,000 ]

Interest on debentures:

[ = 9% \times 10,000,000 = \text{Rs } 900,000 ]

Before conversion:

[ \text{EBT} = 6,000,000 - 900,000 = \text{Rs } 5,100,000 ]

[ \text{Tax} = 50% \times 5,100,000 = \text{Rs } 2,550,000 ]

[ \text{EAT} = 5,100,000 - 2,550,000 = \text{Rs } 2,550,000 ]

[ \text{EPS} = \frac{2,550,000}{1,000,000} = \text{Rs } 2.55 ]

Dividend payout = ( \frac{2}{3} )

[ \text{Dividends} = \frac{2}{3} \times 2,550,000 = \text{Rs } 1,700,000 ]

[ \text{Retained earnings} = \frac{1}{3} \times 2,550,000 = \text{Rs } 850,000 ]

After conversion:

Interest = 0

[ \text{EBT} = \text{EBIT} = \text{Rs } 6,000,000 ]

[ \text{Tax} = 50% \times 6,000,000 = \text{Rs } 3,000,000 ]

[ \text{EAT} = 6,000,000 - 3,000,000 = \text{Rs } 3,000,000 ]

Total shares after conversion:

[ = 1,000,000 + 208,333.33 = 1,208,333.33 ]

[ \text{EPS} = \frac{3,000,000}{1,208,333.33} = \text{Rs } 2.48 ]

[ \text{Dividends} = \frac{2}{3} \times 3,000,000 = \text{Rs } 2,000,000 ]

[ \text{Retained earnings} = \frac{1}{3} \times 3,000,000 = \text{Rs } 1,000,000 ]

Summary table:

Conversion lowers EPS slightly (Rs 2.55 to Rs 2.48) because of dilution, but retained earnings rise by Rs 150,000 as the interest burden disappears.

Innovations in Corporate Finance [2 marks]

Innovations in corporate finance refer to the new financial instruments, techniques, and practices developed to manage risk, raise capital, and create value more efficiently. Major innovations include:

1. Derivative instruments — options, futures, forwards, and swaps used for hedging interest rate, currency, and commodity risks.
2. Securitization — pooling of assets (loans, receivables) and issuing securities against them to raise funds and improve liquidity.
3. Hybrid securities — convertible bonds, preference shares, and warrants that combine features of debt and equity.
4. New financing techniques — venture capital, private equity, lease financing, project financing, and crowdfunding.
5. Financial engineering and structured products — e.g., collateralized debt obligations (CDOs), swaps, and customized risk-sharing contracts.
6. Digital and fintech innovations — online lending, blockchain-based financing, and automated treasury management.

These innovations help firms reduce cost of capital, manage financial risk, and access wider sources of funds.

Given:

• EBIT = Rs 2,000,000
• Debt to be raised, (D) = Rs 4,000,000
• Corporate tax rate, (T_c) = 35% = 0.35
• Personal tax rate on stock income, (T_s) = 25% = 0.25
• Personal tax rate on debt income, (T_d) = 30% = 0.30
• Required return on equity if all-equity financed, (r_0) = 20% = 0.20

---

(a) Tax advantage of debt under corporate taxes only

When only corporate income taxes are considered, the tax advantage of debt is the interest tax shield:

[ \text{Tax advantage} = T_c \times D ]

[ = 0.35 \times 4{,}000{,}000 ]

[ = \text{Rs } 1{,}400{,}000 ]

Tax advantage = Rs 1,400,000

---

(b) Value of the firm

1. Value of the firm when it remains all-equity financed

[ V_U = \frac{EBIT(1 - T_c)}{r_0} ]

[ = \frac{2{,}000{,}000(1 - 0.35)}{0.20} ]

[ = \frac{2{,}000{,}000 \times 0.65}{0.20} ]

[ = \frac{1{,}300{,}000}{0.20} ]

[ = \text{Rs } 6{,}500{,}000 ]

All-equity value, (V_U) = Rs 6,500,000

---

2. Value of the firm after recapitalization

Using the Miller model with both corporate and personal taxes:

[ \text{Gain from leverage} = \left[1 - \frac{(1 - T_c)(1 - T_s)}{1 - T_d}\right] D ]

[ = \left[1 - \frac{(1 - 0.35)(1 - 0.25)}{1 - 0.30}\right] \times 4{,}000{,}000 ]

[ = \left[1 - \frac{0.65 \times 0.75}{0.70}\right] \times 4{,}000{,}000 ]

[ = \left[1 - \frac{0.4875}{0.70}\right] \times 4{,}000{,}000 ]

[ = (1 - 0.6964286) \times 4{,}000{,}000 ]

[ = 0.3035714 \times 4{,}000{,}000 ]

[ = \text{Rs } 1{,}214{,}286 ]

Therefore,

[ V_L = V_U + \text{Gain from leverage} ]

[ = 6{,}500{,}000 + 1{,}214{,}286 ]

[ = \text{Rs } 7{,}714{,}286 ]

Value after recapitalization, (V_L) ≈ Rs 7,714,286

---

Final Answer

(a) Tax advantage of debt = Rs 1,400,000

(b) All-equity value = Rs 6,500,000
Value after recapitalization = Rs 7,714,286 approximately.

Given:

• Each warrant allows purchase of 3 shares for a total of Rs 60
• Exercise price per share = 60/3 = Rs 20
• Current market price = Rs 18

a. Present theoretical value of warrant:

$V_w = \max[(P_0 - E) \times N, 0] = \max[(18 - 20) \times 3, 0] = \max[-6, 0] = 0$

b. Expected value of stock price 6 months hence:

$E(P_1) = 0.30(15) + 0.40(20) + 0.30(30) = 4.5 + 8 + 9 = 21.50$

c. Theoretical value of warrant 6 months hence:

$E(V_w) = 0.30(0) + 0.40(0) + 0.30(30) = 9$

Venture Capital: Concept and Importance

Concept: Venture capital is a form of long-term equity financing provided by specialised investors (venture capitalists) to new, high-risk, high-growth-potential business ventures — typically start-ups and small firms with innovative products or technology. The venture capitalist invests money in exchange for an ownership stake (equity or convertible securities), and earns returns mainly through capital gains when the venture succeeds and is sold or listed. It is not a loan; the investor shares both the risk and the reward. Funds are usually supplied in stages (seed, early, expansion, bridge financing), with active involvement in management and mentoring.

Importance:

1. Financing for risky ventures — Provides equity funds to start-ups that banks and traditional lenders avoid due to lack of collateral and high uncertainty.
2. Promotes innovation and entrepreneurship — Encourages new ideas, technology and job creation by backing innovative ventures.
3. Managerial and technical support — Beyond money, venture capitalists give strategic advice, networking and monitoring, improving survival and growth.
4. Wealth and employment generation — Successful ventures create jobs, tax revenue and new industries.
5. Bridge for capital markets — Helps promising firms grow to a stage where they can access public markets (IPO) or attract further investment.

Corporate restructuring strategies are the methods a firm uses to change its business portfolio, ownership, or organisational structure to improve performance. Any three are:

1. Merger and Acquisition (M&A) — Two or more firms combine (merger), or one firm purchases another (acquisition), to gain market share, economies of scale, technology, or new markets. Example: a commercial bank acquiring a smaller finance company to expand its branch network.

2. Divestiture (Sell-off) — The firm sells a business unit, subsidiary, or product line that no longer fits its core strategy, raising cash and allowing management to concentrate on core activities. Example: a conglomerate selling its insurance subsidiary to focus on manufacturing.

3. Downsizing (Retrenchment) — Reducing the workforce, closing unprofitable plants, or cutting operating units to lower costs and restore profitability. It is a defensive strategy used when the firm is in a weak financial position.

Other acceptable strategies: spin-off, carve-out, leveraged buyout (LBO), joint venture, strategic alliance, and business process reengineering.

a. Competitive lease rent

Competitive lease rent is the rent determined through open bidding or competitive bidding for the use of a property or asset. Under this system, the lessor invites bids from interested parties, and the highest bidder gets the right to use the asset for a specified period. The rent so determined is called competitive lease rent. It reflects the true market value of the asset because it is fixed by the forces of demand and supply in an open competition. It is commonly used in government land leasing, mining rights, and public property leasing. It ensures transparency, maximizes revenue for the lessor, and eliminates favoritism or underhand dealing.

b. Ethics in financial decision

Ethics in financial decision refers to the moral principles and standards that guide managers while making financial decisions such as investment, financing, and dividend decisions. It means taking decisions that are not only profitable but also fair, honest, and socially responsible. Ethical financial decisions avoid fraud, insider trading, manipulation of accounts, exploitation of shareholders, and tax evasion. Managers should protect the interest of all stakeholders — shareholders, creditors, employees, customers, and society. Ethical behavior builds trust, enhances the firm's reputation, ensures long-term survival, and reduces the risk of legal penalties. Thus, ethics and profitability should go together in sound financial management.

c. Traditional approach

The traditional approach to financial management refers to the early phase of financial management (up to the 1950s) which treated finance as a narrow, descriptive subject. Its main features are:

• It was concerned mainly with raising funds — arranging capital from banks, financial institutions, and capital markets — rather than with the efficient use and allocation of funds.
• It focused on routine, day-to-day problems such as cash collection, payment of bills, maintenance of records, and preparation of financial statements.
• The scope was limited to institutional finance, i.e., the study of financial institutions and instruments.
• Issues like cost of capital, capital budgeting, capital structure, dividend policy, and risk-return analysis were largely ignored.
• The finance manager's role was that of a custodian or treasurer of funds, not a decision-maker.

Because of these limitations, the traditional approach was later replaced by the modern approach, which treats financial management as a decision-making discipline concerned with investment, financing, and dividend decisions aimed at maximizing shareholders' wealth.

Primary Objectives of Corporations

A corporation is a legal entity owned by shareholders and managed by a board of directors. Its objectives can be grouped into two broad categories: financial (economic) objectives and non-financial (social/strategic) objectives.

1. Financial / Economic Objectives

(a) Profit Maximization The traditional and most basic objective of a corporation is to earn maximum profit. Profit is the reward for risk-bearing and the main source of internal financing. It is measured through:

• Gross profit and net profit
• Profit before tax (PBT) and profit after tax (PAT)
• Earnings per share (EPS)

However, profit maximization as a sole objective suffers from limitations — it ignores the timing of returns, the risk involved, and the quality of earnings. It is also a short-term and ambiguous goal.

(b) Wealth Maximization (Shareholders' Wealth Maximization) This is regarded as the supreme objective of a corporation in modern financial management. It means maximizing the market price of the company's shares, thereby maximizing the net wealth of shareholders. It is superior to profit maximization because it considers:

• Timing of cash flows (through discounting)
• Risk of cash flows (through the required rate of return)
• Long-term value creation rather than short-term profit

Wealth maximization is measured by: $\text{Shareholder Wealth} = \text{Number of Shares} \times \text{Market Price per Share}$

(c) Maximization of Value of the Firm The corporation aims to maximize the total value of the firm — the combined value of equity and debt. This is achieved when the firm's Weighted Average Cost of Capital (WACC) is minimized and its Economic Value Added (EVA) is maximized.

(d) Long-Term Survival and Growth A corporation must ensure continuity, stability, and sustainable growth. This includes increasing market share, sales volume, assets, and capacity over time.

2. Non-Financial / Social Objectives

(a) Social Responsibility Corporations must serve the interests of stakeholders — employees, customers, suppliers, creditors, government, and society. This includes fair wages, quality products, environmental protection, and community welfare.

(b) Customer Satisfaction Creating and retaining satisfied customers through quality goods, fair pricing, and reliable service.

(c) Employee Welfare and Development Providing safe working conditions, fair remuneration, training, and career growth.

(d) Legal and Ethical Compliance Operating within the legal framework and adhering to ethical business practices.

(e) Contribution to National Development Paying taxes honestly, generating employment, earning foreign exchange, and supporting economic growth.

Summary of Objectives

Conclusion: The primary objective of a corporation is shareholders' wealth maximization, supported by profit earning, growth, and social responsibility. Wealth maximization is the most balanced and rational objective as it harmonizes the interests of all stakeholders.

---

Ethics to be Considered by a Company in Financing Decisions

A financing decision deals with determining the capital structure — the mix of debt and equity — and selecting the appropriate sources of long-term funds. Since financing decisions affect shareholders, creditors, employees, and society, they must be guided by sound ethical principles. The following ethics should be considered:

1. Honesty and Transparency

The company must disclose all material facts about its financing plans honestly to investors. Prospectuses, financial statements, and loan agreements should present a true and fair view of the firm's financial position. Concealing liabilities or inflating assets to obtain funds is unethical.

2. Fairness to All Stakeholders

Financing decisions should balance the interests of shareholders, creditors, employees, and the government. For example:

• Excessive debt may benefit shareholders (through financial leverage) but harms creditors by increasing risk.
• The company should not exploit one group to benefit another.

3. Avoidance of Insider Trading

Directors and managers who possess confidential information about upcoming financing decisions (such as a new share issue or debt restructuring) must not trade in the company's securities for personal gain. This is both illegal and unethical.

4. Full and Fair Disclosure

Before issuing securities, the company must provide complete information regarding:

• Purpose of the issue
• Risk factors
• Use of proceeds
• Financial position and past performance

This enables investors to make informed decisions.

5. Fair Pricing of Securities

Shares and debentures should be priced fairly and rationally, based on the company's intrinsic value. Overpricing securities to raise more funds at the expense of investors is unethical. Underpricing that harms existing shareholders is also unfair.

6. Equal Treatment of Shareholders

In rights issues and bonus issues, all existing shareholders must be treated equally and proportionately. The company should not favour a particular group of shareholders or deny pre-emptive rights.

7. Responsible Use of Debt

The company should borrow only to the extent that it can repay and should not take on excessive debt that endangers the firm's solvency. Deliberately defaulting on debt obligations or using borrowed funds for unauthorized purposes is unethical.

8. Compliance with Laws and Regulations

Financing decisions must comply with the Companies Act, SEBON regulations, NRB directives, and tax laws. Violating legal provisions — such as issuing shares without proper approval or evading taxes — is unethical.

9. Avoidance of Conflict of Interest

Managers and directors should not make financing decisions that personally benefit them (e.g., awarding underwriting contracts to firms they own). Personal interest must be subordinated to the company's interest.

10. Social and Environmental Responsibility

Funds raised should be used for socially beneficial and environmentally sustainable purposes. Financing projects that harm society or the environment (e.g., polluting industries) is ethically questionable.

11. Protection of Creditors' Interest

The company should maintain a safe debt-equity ratio and not dilute the security of existing creditors by issuing additional debt without their consent. Asset substitution — using borrowed funds for riskier projects than agreed — is unethical.

12. Timely Payment of Obligations

Interest on debt, dividends to shareholders, and repayment of principal must be made on time. Delaying or defaulting on payments damages investor confidence and is unethical.

13. Confidentiality

Confidential financial information about the company's financing plans must be kept secret until officially disclosed. Leakage of such information harms market integrity.

14. Accountability

The board of directors must be accountable to shareholders for financing decisions. Decisions should be documented, justified, and subject to review.

Summary Table

Conclusion: Ethical financing decisions build investor trust, market credibility, and long-term sustainability. A company that follows these ethics not only maximizes shareholders' wealth but also fulfils its social and legal responsibilities, ensuring balanced growth of all stakeholders.

Given: old bond Rs 6,000,000 at 15% (15 years left, issued as a 20-year bond); new bond Rs 6,000,000 at 10% for 15 years; call premium 10%; flotation cost new Rs 140,000, old Rs 120,000; tax rate 40%.

1. Initial investment (outlay)

2. Annual after-tax cash savings (years 1-15)

3. Discount rate

The saving is a fairly certain debt-related flow, so it is discounted at the after-tax cost of the new debt:

$k_d = 10\% \times (1-0.40) = 6\%$

4. NPV of refunding

PV annuity factor (6%, 15 years) $= \dfrac{1-(1.06)^{-15}}{0.06} = 9.7122$

$PV = 181{,}333 \times 9.7122 = \text{Rs } 1{,}761{,}154$

$NPV = 1{,}761{,}154 - 464{,}000 = \text{Rs } 1{,}297{,}154$

Decision: the NPV is strongly positive (about Rs 1.3 million), so it is worthwhile to refund the old 15% bond with the new 10% issue. The large interest saving far outweighs the call premium and flotation costs.

Given:

• Cum-rights market price, (M = \text{Rs }150)
• Subscription price, (S = \text{Rs }100)
• Rights needed to buy one new share, (N = 4)

a. Theoretical value of a right when stock is selling rights-on

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

[ R=\frac{150-100}{4+1}=\frac{50}{5}=\text{Rs }10 ]

Theoretical value of one right = Rs 10.

b. Ex-rights price of one share

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

[ P_{ex}=\frac{4(150)+100}{5}=\frac{600+100}{5}=\frac{700}{5}=\text{Rs }140 ]

Alternatively,

[ P_{ex}=M-R=150-10=\text{Rs }140 ]

Ex-rights price per share = Rs 140.

c. Kapil Sharma’s wealth position before rights offering

Mr. Sharma’s wealth before the rights offering = Rs 200,000.

d. Wealth position after exercising all rights

Number of new shares he can buy:

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

Subscription amount required:

[ 250 \times 100 = \text{Rs }25{,}000 ]

Cash remaining:

[ 50{,}000 - 25{,}000 = \text{Rs }25{,}000 ]

Total shares after exercise:

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

Value of shares at ex-rights price:

[ 1{,}250 \times 140 = \text{Rs }175{,}000 ]

His wealth remains unchanged at Rs 200,000.
If he had sold the rights instead, he would receive (1{,}000 \times 10 = \text{Rs }10{,}000) from the sale of rights, and his total wealth would still be Rs 200,000.

e. Major reasons for using a rights offering

1. Protects pre-emptive rights: Existing shareholders get the first chance to buy new shares, preventing dilution of ownership and control.
2. Lower flotation cost: A rights issue avoids underwriting fees, advertising costs, and other expenses of a public issue.
3. Quick and simple method: It is easier and faster to raise equity capital, especially for small companies.
4. Attractive subscription price: The issue price is usually below the market price, encouraging shareholders to subscribe.
5. Maintains control and capital structure: Existing shareholders can maintain their proportional ownership by exercising their rights.
6. Useful in poor market conditions: When a public issue is difficult or costly, a rights offering can still raise funds from existing shareholders.
7. Rewards loyal shareholders: It gives existing shareholders a chance to increase their investment at a favourable price.

Given: cost Rs 100,000; life 4 years; salvage Rs 12,000; lease Rs 40,000 per year (year end); loan rate 10%; tax 30%.

Annual depreciation = $\dfrac{100,000-12,000}{4}$ = Rs 22,000

Discount rate = after-tax cost of debt = $10\% \times (1-0.30) = 7\%$

(a) Leasing alternative

After-tax lease payment = $40,000 \times (1-0.30)$ = Rs 28,000

$PVIFA_{7\%,4} = \dfrac{1-(1.07)^{-4}}{0.07} = 3.3872$

$PV_{lease} = 28,000 \times 3.3872 = \text{Rs } 94,842$

(b) Borrow and buy alternative

Annual loan instalment = $\dfrac{100,000}{PVIFA_{10\%,4}} = \dfrac{100,000}{3.16987}$ = Rs 31,547

Tax shield each year = 30% × (interest + depreciation). After-tax outflow = instalment − tax shield.

Salvage value: the book value at the end of year 4 is $100,000 - 4(22,000) = 12,000$, equal to the salvage value, so there is no tax on the sale. The inflow of Rs 12,000 has PV = $12,000 \times 0.7629$ = Rs 9,155.

$PV_{own} = 20,511 + 19,734 + 19,024 + 18,376 - 9,155 = \text{Rs } 68,490$

(c) Comparison and decision

Borrowing and buying costs Rs 26,352 less in present value terms. Hence borrow and buy is preferable, because its present value of net cash outflow is lower.

Forms of Market Efficiency

Efficient Market Hypothesis (EMH), propounded by Eugene Fama, states that security prices fully reflect all available information. It has three forms:

1. Weak Form Efficiency Prices reflect all historical price and volume data. Past prices cannot be used to earn abnormal returns. Technical analysis is useless. Only public and private information not yet reflected can give an edge.

2. Semi-Strong Form Efficiency Prices reflect all publicly available information — historical data, financial statements, dividend announcements, news, and economic events. Fundamental analysis cannot yield abnormal returns. Only insider (private) information can.

3. Strong Form Efficiency Prices reflect all information — public and private, including insider information. No investor, even an insider, can earn abnormal returns. This is the strictest and most ideal form.

Summary: Weak form covers past prices; semi-strong form covers all public information; strong form covers all information including insider knowledge. Empirically, markets are generally found to be weak form efficient, while strong form efficiency rarely holds.

Under the traditional approach, the optimal capital structure is the debt-equity mix at which the weighted average cost of capital (WACC) is minimum and the value of the firm is maximum.

• At moderate debt levels, debt is cheaper than equity and the cost of equity (Ke) rises only slowly, so WACC falls as debt is added.
• Beyond a point, higher financial risk raises Ke (and Kd) faster than the gain from cheap debt, so WACC starts to rise.
• The point where WACC stops falling and begins to rise is the optimal capital structure.

Illustration

A firm has total capital of Rs 10,00,000 and EBIT of Rs 2,00,000. The costs at different debt levels are:

Working

$\text{WACC} = K_d\frac{D}{V} + K_e\frac{E}{V}, \qquad V = \frac{\text{EBIT}}{\text{WACC}}$

For debt of Rs 4,00,000:

$\text{WACC} = 10\%\left(\frac{4,00,000}{10,00,000}\right) + 13\%\left(\frac{6,00,000}{10,00,000}\right) = 4.0 + 7.8 = 11.8\%$

$V = \frac{2,00,000}{0.118} = \text{Rs } 16,94,915$

Conclusion

WACC is lowest (11.8%) and firm value highest (Rs 16,94,915) at debt of Rs 4,00,000, i.e. a 40% debt and 60% equity mix. This is the optimal capital structure; beyond it WACC rises and firm value falls.

Major Types of Leases

A lease is a contractual agreement under which the owner of an asset (the lessor) grants the right to use that asset to another party (the lessee) for a specified period in return for periodic payments. Leases are classified into the following major types:

1. Operating Lease A short-term, cancellable lease in which the lessor retains the risks and rewards of ownership. The lease period is shorter than the useful life of the asset, and the lessee may cancel the lease after giving notice. The lessor is responsible for maintenance, insurance, and taxes. Examples include renting office space, computers, or vehicles. It is also called a "true lease" or "service lease."

2. Financial Lease (Capital Lease) A long-term, non-cancellable lease in which substantially all the risks and rewards incidental to ownership are transferred to the lessee. The lease term covers most of the asset's useful life, and the present value of lease payments equals or exceeds substantially all of the asset's fair value. The lessee bears maintenance, insurance, and tax costs, and usually has an option to purchase the asset at the end of the term. It is a source of medium and long-term financing.

3. Sale and Leaseback An arrangement in which the owner of an asset sells it to a leasing company and simultaneously leases it back for continued use. The seller becomes the lessee and the buyer becomes the lessor. This allows the firm to raise immediate cash while retaining the use of the asset. It may be an operating lease or a financial lease depending on the terms.

4. Direct Lease A lease in which the lessor purchases the asset from a manufacturer or dealer and leases it directly to the lessee. The lessor may be the manufacturer itself or an independent leasing company. The lessee selects the asset and the lessor acquires it for leasing purposes.

5. Leveraged Lease A lease involving three parties: the lessor, the lessee, and the lender. The lessor provides only a part of the purchase price (equity) and borrows the remaining amount from a lender, using the asset and lease rentals as security. The lessor gets the tax benefits of ownership while the lender receives fixed interest. It is common for high-value assets such as aircraft and ships.

6. Leveraged vs. Non-Leveraged (Single Investor) Lease In a non-leveraged lease, the lessor finances the entire cost of the asset from own funds. In a leveraged lease, as noted above, a third-party lender supplies a major portion of the funds.

7. Domestic Lease and International (Cross-Border) Lease A domestic lease is between parties residing in the same country. An international or cross-border lease is between a lessor and lessee located in different countries, often used to take advantage of tax and depreciation differences between nations.

8. Close-End and Open-End Lease In a close-end lease, the lessee returns the asset at maturity with no further obligation. In an open-end lease, the lessee guarantees the residual value and must compensate the lessor if the asset's market value falls below the guaranteed amount.

Conclusion: These types differ mainly in lease duration, cancellability, transfer of risks and rewards of ownership, number of parties involved, and tax treatment. The choice among them depends on the lessee's financing needs, tax position, and the nature of the asset.

Divestiture

Divestiture (also called divestment or demerger) is the process by which a firm sells, spins off, or otherwise disposes of a part of its business — a subsidiary, division, product line, or brand — to focus on its core operations. It is the opposite of acquisition: instead of adding businesses, the firm sheds them. Divestiture may take the form of a sell-off (sale to another firm), a spin-off (shares of the unit distributed to existing shareholders, creating a separate legal entity), an equity carve-out (partial sale through an IPO), or a split-up (the whole firm broken into separate companies).

Reasons for Divestitures

1. Focus on core business. A firm may find that a division is unrelated to its main line of business and diverts managerial attention. Selling it allows management to concentrate on activities where it has real competence and competitive advantage.

2. Reverse synergy / negative value. The unit may be worth more to another owner than to the current parent. If the parts are worth more than the whole, a sell-off or spin-off creates value for shareholders.

3. Need for funds. Divestiture raises cash that can be used to repay debt, finance profitable investment in the core business, or fund an acquisition. It is a quick source of finance when other sources are costly or unavailable.

4. Poor financial performance. A persistently loss-making or low-return division drags down the firm's overall profitability and share price. Divesting it improves financial ratios and investor perception.

5. Strategic restructuring. Changes in the competitive environment — deregulation, globalization, technological change — may make an old business obsolete. Divestiture is part of restructuring the firm's portfolio to match the new strategy.

6. Reduction of risk and debt burden. Divesting a risky or highly leveraged unit lowers the parent's overall business and financial risk and improves its creditworthiness.

7. Regulatory and legal compulsion. Government orders under competition (antitrust) law may require a firm to divest a business to prevent monopoly or to approve a merger. Courts may also order divestiture during bankruptcy or settlement.

8. Management and agency reasons. Divestiture may be used to correct earlier over-expansion or empire-building by managers, to remove a unit whose management is weak or incompatible with the parent's culture, or to defend against a hostile takeover by making the firm leaner.

9. Better fit with another owner. A unit may have greater strategic value to a buyer in the same industry (e.g., a supplier or competitor) that can exploit economies of scale, so selling it maximizes total value.

Conclusion. Divestiture is thus a deliberate portfolio-adjustment decision. Firms divest to sharpen strategic focus, unlock hidden value, raise funds, cut risk, and comply with legal requirements — all aimed at increasing shareholder wealth.

Given: EBIT = Rs 2,000,000; $V_U$ = Rs 500,000; $T = 35\%$; $K_d = 12\%$; $D/E = 1$ for the levered firm.

1. Unlevered firm

With no debt, $V_U = \dfrac{EBIT(1-T)}{K_{eU}}$, so

$K_{eU} = \frac{2,000,000(1-0.35)}{500,000} = \frac{1,300,000}{500,000} = 2.60 = 260\%$

2. Levered firm (MM Proposition II with taxes)

$K_{eL} = K_{eU} + (K_{eU} - K_d)(1-T)\frac{D}{E}$

$K_{eL} = 2.60 + (2.60 - 0.12)(1-0.35)(1) = 2.60 + 2.48 \times 0.65 = 2.60 + 1.612 = 4.212$

Result:

The cost of equity rises with leverage because shareholders demand a higher return for bearing greater financial risk. (The very high rates arise from the figures given in the question.)

Given: Loan required = Rs 300,000
Period = 6 months = $\frac{6}{12}$ year = 0.5 year

Alternative I: Floating lien loan from Mega Bank

Interest rate = 22% p.a.
No additional expenses.

[ \text{Interest} = 300{,}000 \times 22% \times \frac{6}{12} ]

[ = 300{,}000 \times 0.22 \times 0.5 = Rs\ 33{,}000 ]

Cost of Alternative I = Rs 33,000

---

Alternative II: Terminal warehousing loan

Interest rate = 15% p.a.
Warehouse charge = Rs 10,000 for 6 months

[ \text{Interest} = 300{,}000 \times 15% \times \frac{6}{12} ]

[ = 300{,}000 \times 0.15 \times 0.5 = Rs\ 22{,}500 ]

[ \text{Total cost} = \text{Interest} + \text{Warehouse charge} ]

[ = 22{,}500 + 10{,}000 = Rs\ 32{,}500 ]

Cost of Alternative II = Rs 32,500

---

Comparison

Alternative II costs Rs 500 less than Alternative I.

Decision: The company should use Alternative II — terminal warehousing loan, because it has the lower total cost for the 6-month period.