Overview of Corporate Finance and Financial Management

(a) Effective cost of each alternative

For Alternative 3 the total repayment is Rs 106,000, i.e. Rs 26,500 per quarter. Since principal is repaid in instalments, the borrower has the full amount only at the start. The average usable funds are

$\frac{100{,}000+75{,}000+50{,}000+25{,}000}{4}=\text{Rs }62{,}500$

This matches the standard approximation $\dfrac{2\times m\times I}{P(n+1)}=\dfrac{2\times4\times6{,}000}{100{,}000\times5}=9.6\%$. The exact IRR gives a quarterly rate of about 2.37%, i.e. an APR of about 9.5% and an effective annual rate of about 9.8%. The ranking does not change.

Recommendation: Alternative 1 (9% collect loan) has the lowest effective cost and should be chosen.

(b) Qualitative factors in bank financing vs. trade credit

Yes. Cost alone should not decide the choice. Important qualitative factors are:

• Supplier relationship: Stretching trade credit (overdue payables) can harm the relationship with the main supplier of powders, risk loss of supply, tighter terms or cash-only sales. A bank loan used to clear the overdue Rs 100,000 protects this relationship.
• Cash discounts: Paying early may earn discounts (e.g. 2/10, net 30) whose implicit cost of foregoing is often higher than bank interest.
• Flexibility and availability: Trade credit is spontaneous and informal, with no collateral or covenants. A bank loan needs approval, documentation and a fixed repayment schedule.
• Restrictive covenants and security: Banks may demand collateral, minimum current ratio, dividend limits or other covenants that limit managerial freedom.
• Credit rating and reputation: Late payment lowers the firm's credit standing, while timely bank repayment builds it and eases future borrowing.
• Liquidity and repayment burden: Instalment loans (Alternative 3) strain cash flow more than a single end-of-year payment.
• Growth and stability of supply: A rapidly growing firm needs dependable sources of funds and materials; relying on stretched payables is risky.

A sound decision therefore combines the lowest effective cost with continuity of supply, flexibility and the firm's long-term credit standing.

(a) Reasons for using convertibles

• Lower interest cost: The conversion option is valuable to investors, so the coupon is lower than on straight debt.
• Delayed equity at a higher price: Shares are in effect sold later at a premium over today's price.
• Less immediate dilution: EPS and control are not diluted until conversion.
• Tax advantage: Interest is tax-deductible until conversion, unlike dividends.
• Investor appeal: Investors get the safety of a bond plus equity upside.
• Forced conversion: A call feature lets the company force conversion when the market price exceeds the call price.
• Suitable for growing or risky firms: Funds can be raised when straight debt terms or equity prices are unattractive.

(b) Conversion price and ratio

Current market price $=\text{EPS}\times\text{P/E}=2.50\times16=\text{Rs }40$

$\text{Conversion price}=40\times1.20=\text{Rs }48$

$\text{Conversion ratio per Rs 1,000 debenture}=\frac{1{,}000}{48}=20.83\text{ shares}$

(c) Initial conversion value

$20.83\times\text{Rs }40=\text{Rs }833.33\text{ per debenture}$

(Rs 1,000 face value is 20% above this conversion value, matching the 20% premium.)

(d) New shares if all debentures are converted

$\frac{\text{Rs }10{,}000{,}000}{\text{Rs }48}=208{,}333\text{ shares}$

Total shares after conversion $=1{,}000{,}000+208{,}333=1{,}208{,}333$.

(e) EPS and retained earnings

Present earnings $=2.50\times1{,}000{,}000=$ Rs 2,500,000; the payout ratio is assumed to stay at two-thirds.

Annual interest $=9\%\times10{,}000{,}000=$ Rs 900,000.

Working on a pre-tax basis, existing pre-tax earnings are $2{,}500{,}000/0.5=5{,}000{,}000$.

EPS rises from Rs 2.50 to Rs 2.55 before conversion, then falls slightly to Rs 2.48 after conversion because of dilution, while retained earnings rise from Rs 850,000 to Rs 1,000,000 as interest is no longer paid.

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. The major innovations include:

1. New financial instruments — derivatives (futures, options, swaps), convertible bonds, zero-coupon bonds, floating-rate notes, and hybrid securities such as convertible preferred stock.
2. Securitization — pooling of illiquid assets (loans, receivables, mortgages) and converting them into marketable securities.
3. Structured and project financing — financing designed around specific projects or cash flows, with risk allocated among parties.
4. Venture capital and private equity — specialized funding for start-ups and unlisted firms.
5. Financial engineering and risk management — use of hedging, swaps, and portfolio techniques to manage interest rate, currency, and credit risk.
6. Digital and fintech innovations — online lending, crowdfunding, blockchain-based financing, and automated treasury management.

These innovations help firms reduce financing costs, manage risk better, 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
• Unlevered required return on equity, (r_0) = 20% = 0.20

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(a) Tax advantage under corporate income taxes but no personal income taxes

When personal taxes are ignored, the tax advantage of debt is the present value of the interest tax shield:

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

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

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

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(b) Value of the firm

Value of the all-equity firm:

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

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

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

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

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

Value of the firm after recapitalization:

Using the Miller model with personal taxes:

[ V_L = V_U + \left[1 - \frac{(1 - T_c)(1 - T_s)}{1 - T_d}\right]D ]

[ = 6{,}500{,}000 + \left[1 - \frac{(0.65)(0.75)}{0.70}\right] \times 4{,}000{,}000 ]

[ = 6{,}500{,}000 + \left[1 - \frac{0.4875}{0.70}\right] \times 4{,}000{,}000 ]

[ = 6{,}500{,}000 + [1 - 0.6964286] \times 4{,}000{,}000 ]

[ = 6{,}500{,}000 + 0.3035714 \times 4{,}000{,}000 ]

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

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

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Answer:

• (a) Tax advantage = Rs 1,400,000
• (b) All-equity value = Rs 6,500,000
• Value after recapitalization = Rs 7,714,286
  (If personal taxes are ignored, it would be Rs 7,900,000.)

(a) Present theoretical value of the warrant

Each warrant allows purchase of 3 shares for Rs 60 in total, i.e. Rs 20 per share. At a market price of Rs 18 the warrant is out of the money.

$\text{Theoretical value}=\max(0,\;3\times18-60)=\max(0,-6)=\text{Rs }0$

(b) Expected stock price 6 months hence

$E(P)=15(0.30)+20(0.40)+30(0.30)=4.5+8+9=\text{Rs }21.50$

(c) Theoretical value of the warrant 6 months hence

$E(\text{warrant value})=\text{Rs }9$

Note that the warrant's value at the expected price, $3(21.50)-60=\text{Rs }4.50$, differs from the expected value Rs 9 because the payoff is non-linear.

Concept of Venture Capital

Venture capital (VC) is a form of long-term equity financing provided by specialised investors (venture capitalists) to new, young, or rapidly growing businesses that have strong growth potential but lack sufficient funds, collateral, or a track record to obtain bank loans or issue securities in the capital market.

Key features of the concept:

• Equity or quasi-equity financing — the venture capitalist invests money in return for shares, convertible debentures, or profit-sharing rights, not fixed interest.
• High risk, high return — investment is made in unproven ventures; most fail, so returns come from a few "star" projects.
• Active participation — beyond money, the VC provides managerial advice, technical guidance, market contacts, and strategic direction.
• Exit mechanism — returns are realised not through dividends but through an exit such as an IPO, merger, acquisition, or buy-back by the promoter after 3–7 years.
• Staged financing — funds are released in rounds (seed, start-up, early expansion, bridge) as the venture meets agreed milestones.

Stages of venture capital financing:

Importance of Venture Capital

1. Finances innovation and start-ups — Provides risk capital to entrepreneurs with ideas but no assets or credit history, filling the gap left by banks and the capital market.
2. Promotes entrepreneurship and employment — Encourages new enterprise creation, which generates jobs and develops a culture of self-employment.
3. Supports technological development — Funds R&D-intensive and technology-based ventures (IT, biotechnology, renewable energy), raising national productivity and competitiveness.
4. Bridges the financing gap — Covers the "equity gap" between promoter contribution and bank finance, especially for small and medium enterprises.
5. Professional management support — Supplies managerial, financial, and marketing expertise that new promoters usually lack.
6. Contributes to economic growth — Creates new industries, increases output, exports, and tax revenue, and diversifies the economic base.
7. Develops the capital market — Successful VC-backed firms later list on stock exchanges, deepening the securities market.
8. Reduces dependence on foreign debt — Equity-type funding avoids fixed repayment obligations and foreign exchange burden.
9. Rehabilitates sick units — VC can also be used to revive viable but financially weak undertakings.
10. Institutionalises risk-taking — Creates a formal mechanism to share and manage the high risk of new ventures.

In the Nepali context, venture capital is still at an early stage. The Securities Board of Nepal (SEBON) introduced the Securities Businessperson (Venture Capital Fund) Rules, 2061 (2004), and licensed venture capital funds such as Nepal Venture Capital Fund and Business Oxygen (BO2). Their role is important for financing SMEs, agro-based and IT ventures, and for reducing the heavy reliance of Nepali start-ups on promoter savings and bank overdrafts.

Corporate restructuring strategies are deliberate actions taken by a firm to change its ownership structure, asset base, or organisational form in order to improve performance, create shareholder value, or respond to financial distress. Three commonly used strategies are described below.

1. Merger and Acquisition (M&A)

A merger combines two or more companies into a single entity, while an acquisition is the purchase of one company (the target) by another (the acquirer). The acquiring firm may pay in cash, in its own shares, or through a mix of both. The main motives are synergy (cost reduction, economies of scale, combined market power), diversification into new products or markets, acquisition of technology or brands, and tax benefits. For example, when two commercial banks merge in Nepal under the Bank and Financial Institution Act, the merged entity gains a larger capital base, wider branch network, and lower operating cost per unit. The risk is that expected synergies may not materialise, and cultural or systems integration may fail, destroying rather than creating value.

2. Divestiture (Sell-off) and Spin-off

A divestiture is the sale of a part of the firm — a division, subsidiary, product line, or brand — to an outside buyer, usually for cash. A spin-off, by contrast, separates a unit into an independent company whose shares are distributed to the existing shareholders of the parent, without any cash inflow. Both are contraction strategies used when a unit no longer fits the firm's core strategy, is performing poorly, or is worth more to another owner than to the parent. Divestiture raises cash that can be used to repay debt or fund core operations, while a spin-off lets the parent focus on its core business and allows the separated unit to be valued independently by the market. For instance, a diversified conglomerate may sell its insurance subsidiary to concentrate on banking.

3. Financial Restructuring (Leveraged Recapitalization / Debt Restructuring)

Financial restructuring changes the firm's capital structure rather than its asset or ownership structure. In a leveraged recapitalization, the firm borrows heavily and uses the debt proceeds to pay a large dividend or buy back shares, thereby replacing equity with debt. This increases financial leverage, reduces the free cash flow available to managers (reducing agency problems), and creates a tax shield on interest. Alternatively, a firm in distress may undertake debt restructuring — rescheduling maturities, reducing interest rates, converting debt into equity (debt-for-equity swap), or negotiating with creditors for a haircut. Such steps lower the debt burden, improve liquidity, and help the firm avoid bankruptcy. The risk is higher financial risk: fixed interest obligations raise the chance of default if earnings fall.

Conclusion

Merger and acquisition expands the firm, divestiture and spin-off contract it, and financial restructuring reshapes its capital structure. Each strategy is chosen according to the firm's objective — growth, focus, or survival — and all aim at increasing shareholder value.

a. Competitive Lease Rent

Competitive lease rent is the rent determined through competitive bidding in an open market where several prospective lessees compete for the same property. The lessor invites sealed or open bids, and the highest bidder generally secures the lease. The rent so obtained is called competitive lease rent.

Features:

• It is determined by the forces of demand and supply in the lease market, not by the lessor's discretion.
• It reflects the fair market value of the property at the time of leasing.
• It is generally higher than a negotiated or fixed rent because competition pushes bids upward.
• It requires transparency, public notice, and a well-defined evaluation criterion to be fair.

Importance: It prevents favouritism and underhand dealing, maximises rental income for the lessor, and gives all interested parties an equal opportunity to obtain the lease. It is commonly used for government land, public property, mines, quarries, and commercial premises.

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b. Ethics in Financial Decision

Ethics in financial decision refers to the application of moral principles of right and wrong in the financial choices made by managers — investment, financing, and dividend decisions. A financially sound decision may still be unethical if it harms stakeholders or violates trust.

Key ethical considerations:

• Honesty and transparency: Financial statements and disclosures must present the true position; window dressing and manipulation of accounts are unethical.
• Fairness to stakeholders: Decisions should balance the interests of shareholders, creditors, employees, customers, and society, not only maximise shareholder wealth.
• Avoidance of conflict of interest: Managers must not use insider information or their position for personal gain.
• Social responsibility: Investment and financing decisions should not cause environmental damage or social harm.
• Legal and regulatory compliance: Decisions must conform to company law, tax law, and SEBON/NRB regulations.

Importance: Ethical decisions build investor confidence, protect the firm's reputation, reduce the risk of litigation and regulatory penalty, and ensure long-term sustainability. Unethical decisions such as fraud, tax evasion, or misleading disclosure ultimately destroy shareholder value.

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c. Traditional Approach

The traditional approach to financial management (also called the traditional view of capital structure) holds that there is an optimal capital structure which minimises the overall cost of capital and maximises the value of the firm. It was developed by writers such as Durand before the Modigliani–Miller theory.

Main propositions:

1. Cost of debt is cheaper than cost of equity because debt carries a fixed, tax-deductible interest and lenders bear lower risk.
2. Use of debt initially reduces the weighted average cost of capital (WACC) because cheaper debt replaces costly equity.
3. Beyond a point, increasing debt raises financial risk, so shareholders demand a higher return and the cost of equity rises.
4. Therefore, WACC first falls, reaches a minimum at the optimal debt–equity mix, and then rises. The firm value is maximum at that point.

Assumptions: Debt and equity are not perfect substitutes; the market is imperfect; investors are rational; and the cost of equity rises only after a reasonable level of debt.

Criticism: It is subjective and lacks a theoretical base for determining the exact optimal point; the behaviour of cost of equity is not precisely defined. Still, it is practically useful because it recognises that a judicious mix of debt and equity can lower WACC and increase firm value.

Primary Objectives of Corporations

A corporation is a legal entity separate from its owners, formed to carry on business for profit. Its objectives can be grouped into primary (basic) objectives and secondary objectives. The primary objectives are:

1. Maximizing Shareholders' Wealth This is the most fundamental objective of a corporation. Shareholders are the real owners who supply risk capital, and the corporation exists primarily to increase the value of their investment. Wealth maximization means increasing the market price of the company's common stock over the long run, through efficient investment, financing, and dividend decisions. It considers both the return and the risk associated with the return, and it reflects the timing of benefits through the share price.

2. Maximizing Profit Profit maximization is the traditional objective of a business firm. A corporation aims to earn the highest possible profit from its operations by increasing sales revenue and reducing costs. Profit is the source of internal funds, a measure of operating efficiency, and the basis for paying dividends. However, profit maximization is often treated as a short-run and narrow objective because it ignores risk, the time value of money, and the wealth of shareholders.

3. Ensuring Survival and Growth A corporation must survive in a competitive environment and grow over time. Survival requires earning at least a normal profit to cover costs and remain in business. Growth means expansion of assets, sales, market share, and productive capacity. Growth helps the firm achieve economies of scale, market power, and long-term stability.

4. Meeting Social and Legal Responsibilities A corporation is a social institution and must operate within the legal framework. It has the primary objective of satisfying legal requirements such as paying taxes, following labour and environmental laws, and protecting consumer interests. It should also contribute to social welfare, employment generation, and community development.

5. Satisfying Stakeholders Besides shareholders, a corporation must satisfy other stakeholders — employees (fair wages and job security), customers (quality goods at fair prices), creditors (timely repayment), suppliers (fair terms), and the government (taxes and compliance). Balancing these interests is a primary objective for long-term sustainability.

In short, the primary objective of a corporation is to maximize the wealth of its shareholders, while earning adequate profit, ensuring survival and growth, and fulfilling legal, social, and stakeholder responsibilities.

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Ethics to be Considered by a Company in Financing Decision

A financing decision deals with determining the mix of debt and equity (capital structure) and selecting the sources of funds. Since financing decisions affect shareholders, creditors, employees, and society, the company must observe the following ethical considerations:

1. Fairness to All Stakeholders The company should not favour one group at the cost of another. For example, issuing excessive debt to benefit shareholders through higher EPS at the risk of creditors is unethical. The interests of shareholders, lenders, employees, and the public must be balanced fairly.

2. Transparency and Full Disclosure The company must disclose all material facts relating to financing—terms of issue, use of funds, risk involved, and repayment obligations—honestly to investors. Hiding facts or giving misleading information to raise funds is unethical.

3. Honesty and Integrity in Prospectus While issuing shares or debentures, the prospectus must contain true and complete information. False statements, exaggerated claims, or omission of material facts to attract investors amount to unethical and illegal practice.

4. Fair Pricing of Securities Shares and debentures should be issued at a fair and justifiable price. Overpricing securities to exploit investors, or underpricing to benefit a favoured group, is unethical. The interest of small and minority shareholders must be protected.

5. Avoiding Insider Trading Directors, managers, and insiders must not use confidential information about financing plans for personal gain. Trading on insider information before a public issue or loan announcement is unethical and illegal.

6. Responsible Use of Borrowed Funds Debt should be used for productive purposes that generate returns sufficient to repay principal and interest. Using borrowed funds for speculative or personal benefit, or taking excessive debt beyond repaying capacity, is unethical as it risks creditors' and employees' interests.

7. Maintaining Trust of Creditors and Lenders The company must honour loan covenants, pay interest and principal on time, and not conceal its true financial position. Deliberate default or fraudulent borrowing destroys trust and harms the credit system.

8. Fair Treatment of Employees and Other Stakeholders Financing decisions such as restructuring, buyback, or heavy borrowing should not be made at the cost of employees' jobs, wages, or welfare. Social responsibility toward workers and the community must be respected.

9. Compliance with Law and Regulations The company must follow the Company Act, SEBON rules, Nepal Rastra Bank directives, and other applicable laws while raising funds. Violating legal provisions for financial advantage is unethical.

10. Avoiding Conflict of Interest Managers and directors must not make financing decisions that benefit themselves, their relatives, or their affiliated firms. Personal interest must be subordinated to the interest of the company and its stakeholders.

11. Long-Term Sustainability over Short-Term Gain Financing decisions should promote the long-term stability and growth of the firm rather than short-term gains achieved through risky or unfair means. Ethical financing builds reputation, reduces cost of capital, and ensures continued access to funds.

Conclusion In financing decisions, a company must balance the goal of wealth maximization with fairness, honesty, transparency, and social responsibility. Ethical financing protects the interests of all stakeholders, maintains the company's reputation, and ensures long-term survival and growth.

Given:

• Old bond outstanding = Rs 6,000,000
• Remaining maturity = 15 years
• Old coupon rate = 15% p.a.
• New coupon rate = 10% p.a.
• Call premium = 10% of old bond = Rs 600,000
• New flotation cost = Rs 140,000
• Old flotation cost = Rs 120,000
• Tax rate = 40%
• Discount rate = after-tax cost of new debt = (10%(1-0.40)=6%)

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1. Annual after-tax interest on old bond

[ 6,000,000 \times 15% \times (1-0.40) = 900,000 \times 0.60 = \text{Rs } 540,000 ]

2. Annual after-tax interest on new bond

[ 6,000,000 \times 10% \times (1-0.40) = 600,000 \times 0.60 = \text{Rs } 360,000 ]

3. Annual after-tax interest savings

[ 540,000 - 360,000 = \text{Rs } 180,000 ]

4. PV of interest savings for 15 years at 6%

[ \text{PVIFA}_{6%,15} = \frac{1-(1.06)^{-15}}{0.06} = 9.7122 ]

[ PV = 180,000 \times 9.7122 = \text{Rs } 1,748,205 ]

5. After-tax call premium

[ 600,000 \times (1-0.40) = \text{Rs } 360,000 ]

6. New flotation cost and its tax shield

Annual tax shield:

[ \frac{140,000}{15} \times 0.40 = \text{Rs } 3,733.33 ]

PV of tax shield:

[ 3,733.33 \times 9.7122 = \text{Rs } 36,259 ]

7. Tax savings on unamortized old flotation cost

Unamortized old flotation cost:

[ 120,000 \times \frac{15}{20} = \text{Rs } 90,000 ]

Tax savings:

[ 90,000 \times 0.40 = \text{Rs } 36,000 ]

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NPV of refunding

[ NPV = 1,748,205 - 360,000 - 140,000 + 36,259 + 36,000 ]

[ NPV = \text{Rs } 1,320,464 ]

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Conclusion

The NPV of refunding is positive at about Rs 1,320,464. Therefore, it is worthwhile to refund the old bond issue, as it increases the firm’s value by approximately Rs 1.32 million.

Given:

• Cum-rights market price per share, (P_0 = \text{Rs }150)
• Subscription price, (S = \text{Rs }100)
• Number of rights required for one new share, (N = 4)

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

[ R = \frac{P_0 - S}{N + 1} ]

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

Theoretical value of one right = Rs 10.

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b. Theoretical ex-rights price of one share

[ P_{ex} = \frac{N P_0 + S}{N + 1} ]

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

Ex-rights price per share = Rs 140.

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c. Kapil Sharma’s wealth position before rights offering

Kapil holds 1,000 shares and Rs 50,000 cash.

[ \text{Value of shares} = 1{,}000 \times 150 = \text{Rs }1{,}50{,}000 ]

[ \text{Total wealth} = \text{Rs }1{,}50{,}000 + \text{Rs }50{,}000 = \text{Rs }2{,}00{,}000 ]

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d. Kapil Sharma’s wealth position after exercising all rights

Kapil has 1,000 shares. Since 4 rights are needed for one new share:

[ \text{New shares he can buy} = \frac{1{,}000}{4} = 250 \text{ shares} ]

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

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

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

[ \text{Value of shares at ex-rights price} = 1{,}250 \times 140 = \text{Rs }1{,}75{,}000 ]

[ \text{Total wealth} = \text{Rs }1{,}75{,}000 + \text{Rs }25{,}000 = \text{Rs }2{,}00{,}000 ]

Thus, Kapil’s total wealth remains unchanged at Rs 2,00,000. Only the form of wealth changes: he holds more shares and less cash.

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e. Major reasons for using rights offering

1. Protect existing shareholders’ ownership:
   A rights issue gives existing shareholders the first opportunity to buy new shares, so they can maintain their proportionate ownership and avoid dilution.

2. Lower flotation cost:
   Compared with a public issue, a rights offering is usually cheaper because it is sold to existing shareholders and may not require expensive underwriting or wide marketing.

3. Faster and simpler process:
   It is generally quicker and administratively simpler than a full public issue.

4. Raise equity without losing control:
   Since shares are offered to existing shareholders, control of the company is not passed to outside investors.

5. Suitable in poor market conditions:
   When the market is weak and public demand for new shares is low, a rights issue can still raise funds from loyal existing shareholders.

6. Flexible pricing:
   The subscription price can be set below the market price to encourage shareholders to subscribe.

7. Signaling effect:
   If existing shareholders, especially promoters, subscribe to the rights issue, it signals confidence in the company’s future prospects.

Given:

• Machine cost = Rs 100,000
• Life = 4 years
• Salvage = Rs 12,000
• Depreciation (SLM) = (100,000 − 12,000)/4 = Rs 22,000/year
• Lease payment = Rs 40,000/year, end of year
• Borrow rate = 10%
• Tax rate = 30%
• After-tax discount rate = 10%(1−0.30) = 7%

Leasing: After-tax lease payment = 40,000(1−0.30) = 28,000 PVIFA(7%,4) = [1−(1.07)^−4]/0.07 = 3.3872 PV_lease = 28,000 × 3.3872 = Rs 94,842

Borrow and Buy: Loan payment = 100,000 / PVIFA(10%,4) = 100,000/3.1699 = Rs 31,547

Amortization:

• Y1: Interest 10,000; Principal 21,547; Balance 78,453
• Y2: Interest 7,845; Principal 23,702; Balance 54,751
• Y3: Interest 5,475; Principal 26,072; Balance 28,679
• Y4: Interest 2,868; Principal 28,679; Balance 0

After-tax outflows = Payment − 0.30(Interest + Depreciation):

• Y1: 31,547 − 0.30(32,000) = 31,547 − 9,600 = 21,947
• Y2: 31,547 − 0.30(29,845) = 31,547 − 8,954 = 22,593
• Y3: 31,547 − 0.30(27,475) = 31,547 − 8,243 = 23,304
• Y4: 31,547 − 0.30(24,868) = 31,547 − 7,460 = 24,087

PV at 7%:

• Y1: 21,947 × 0.9346 = 20,512
• Y2: 22,593 × 0.8734 = 19,733
• Y3: 23,304 × 0.8163 = 19,023
• Y4: 24,087 × 0.7629 = 18,376 Total = Rs 77,644

Less PV of salvage = 12,000 × 0.7629 = Rs 9,155 Net PV owning = 77,644 − 9,155 = Rs 68,489

Comparison: Owning Rs 68,489 < Leasing Rs 94,842. Net advantage = Rs 26,353. Owning is preferable.

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, each differing in the scope of information reflected in prices.

1. Weak Form Efficiency Prices reflect all historical information — past prices, trading volume, and price patterns. Since past data is already incorporated, technical analysis cannot yield abnormal (excess) returns. Investors cannot "beat the market" by studying charts. However, fundamental analysis may still be useful. Empirical tests (serial correlation, runs test) generally support weak form efficiency in developed markets.

2. Semi-Strong Form Efficiency Prices reflect all publicly available information — historical data plus published reports, earnings announcements, dividend declarations, stock splits, news, and economic indicators. Neither technical nor fundamental analysis can produce consistently superior returns, since prices adjust rapidly to new public information. Only those with inside (private) information could earn abnormal profits. Event studies (e.g., around earnings announcements) largely support this form.

3. Strong Form Efficiency Prices reflect all information — public and private (insider) information. No investor, not even corporate insiders or monopolistic specialists, can earn abnormal returns. This is the most stringent and least empirically supported form, as insiders and institutional investors have been observed to earn superior returns.

Summary

The three forms are cumulative — strong form implies semi-strong, which implies weak form — but not vice versa.

Optimal capital structure under the traditional approach is the debt–equity mix at which the firm's overall cost of capital (Ko) is minimum and the total value of the firm is maximum. The traditional approach assumes that:

1. Debt is cheaper than equity, so a moderate use of debt lowers the weighted average cost of capital (WACC).
2. Beyond a certain point, increasing debt raises the cost of equity (Ke) and the cost of debt (Kd) because of rising financial risk, so WACC starts rising.

Identification: The optimal structure lies in the range where Ko is at its lowest. It is found by calculating Ko at different debt levels; the level giving the minimum Ko (and hence the highest firm value) is the optimum.

Illustration

A firm has net operating income (EBIT) = Rs 2,00,000 and total capital employed = Rs 10,00,000. Cost of equity and cost of debt at different debt ratios are:

Working (sample): At debt = Rs 4,00,000:

$K_o = K_e\frac{E}{V} + K_d\frac{D}{V} = 13.5\%\times\frac{6}{10} + 8\%\times\frac{4}{10} = 8.1 + 3.2 = 11.3\%$

$V = \frac{EBIT}{K_o} = \frac{2{,}00{,}000}{0.113} = \text{Rs }17{,}69{,}912$

Conclusion: Ko is lowest (11.3%) at debt of Rs 4,00,000 (40% debt, 60% equity). Hence the optimal capital structure is 40% debt and 60% equity, where the firm's value is maximum at about Rs 17,69,912.

Major Types of Leases

A lease is a contractual agreement under which the owner of an asset (lessor) grants the right to use the asset to another party (lessee) for a specified period in return for periodic payments. The major types of leases are described below.

1. Financial Lease (Capital Lease) A financial lease is a long-term, non-cancellable lease in which the lessee bears most of the risks and rewards of ownership. The lease term covers a major part of the asset's useful life, and the present value of lease payments equals or exceeds substantially the asset's fair value. The lessor recovers the full cost of the asset plus a return through lease rentals. At the end of the term, the lessee usually gets an option to purchase the asset at a nominal price. It is used mainly to finance plant, machinery, vehicles and equipment. It is also called a capital lease or full-payout lease.

2. Operating Lease An operating lease is a short-term, cancellable lease in which the lessor retains the risks and rewards of ownership. The lease period is much shorter than the asset's economic life, and the total rentals do not cover the full cost of the asset. The lessor is responsible for maintenance, insurance and taxes. The lessee can cancel the lease after giving notice. Examples include leasing of computers, office equipment and vehicles. It is also called a service lease.

3. Sale and Leaseback In this arrangement, the owner of an asset sells it to a leasing company (lessor) and simultaneously takes it back on lease for continued use. The seller thus becomes the lessee. The firm receives immediate cash from the sale while retaining the use of the asset. It improves liquidity and is a popular method of raising finance without losing the use of the asset.

4. Direct Lease A direct lease is one in which the lessor purchases the asset from the 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 buys it and gives it on lease. It is the most common form of leasing.

5. Leveraged Lease A leveraged lease involves three parties: the lessor, the lessee and the lender. The lessor puts in only a part of the funds (equity) and borrows the rest from a lender, using the asset and lease rentals as security. The lessor gets the tax benefits of ownership while the lender gets a fixed return. It is generally used for high-value assets such as aircraft, ships and heavy machinery.

6. Operating Lease vs. Financial Lease — Other Variants Other variants include the closed-end lease (lessee returns the asset at the end with no purchase obligation) and the open-end lease (lessee guarantees a residual value and pays the shortfall if the asset's value falls short). Sale-leaseback and leverage leases are special forms as described above.

Conclusion In short, leases are mainly classified as financial lease and operating lease on the basis of risk, reward and duration, while sale and leaseback, direct lease and leveraged lease are special arrangements designed to meet the financing and tax needs of the parties involved.

Divestiture 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 another party or to its own shareholders. It is the opposite of acquisition: instead of adding businesses, the firm subtracts them. Common forms include sell-offs (sale to an outside buyer for cash or securities), spin-offs (shares of the unit are distributed pro-rata to existing shareholders, creating a separate legal entity), split-offs (shareholders exchange parent shares for shares of the unit), split-ups (the whole firm is broken into several independent companies), and equity carve-outs (a minority stake in the unit is sold to the public through an IPO).

Reasons for divestitures

1. Focus on core business. Firms divest unrelated or peripheral units so that management attention, capital, and other resources are concentrated on the businesses where the firm has a real competitive advantage. Conglomerates that once diversified widely have often reversed course for this reason.

2. Unlocking shareholder value. The market frequently values a division less inside a conglomerate than it would as a stand-alone firm (the "conglomerate discount"). A spin-off or sell-off removes this discount and releases value for shareholders.

3. Raising cash and reducing debt. A sell-off generates immediate cash that can be used to repay debt, fund profitable investment in the core business, or pay dividends — especially useful for a firm that is over-leveraged or short of liquidity.

4. Eliminating negative synergies and cross-subsidisation. When a unit does not fit the parent's strategy, culture, or operations, it may destroy value. Divesting it removes the drag and stops profitable units from subsidising loss-making ones.

5. Correcting strategic mistakes. A firm may have over-expanded, entered the wrong market, or made a poor acquisition. Divestiture is a way to exit and cut losses.

6. Responding to regulatory and antitrust pressure. Competition authorities may require a firm to sell a business as a condition for approving a merger, or may order divestiture of a unit that has become too dominant.

7. Responding to financial distress or takeover threats. A firm facing bankruptcy or a hostile bid may sell attractive units to raise funds quickly or to defeat the bid (the "crown jewel" defence).

8. Better fit with another owner. A unit may be worth more to a buyer that can exploit synergies, so selling it creates gains for both parties.

9. Technological or market change. When a product line becomes obsolete or a market declines, retaining it only drains resources; divestiture allows orderly exit.

10. Improving managerial incentives. In a spin-off, managers of the new firm can be given equity tied directly to its performance, which strengthens motivation and accountability.

In short, divestitures are undertaken to sharpen strategic focus, release unrealised value, generate funds, satisfy regulators, and escape businesses that no longer fit the firm's objectives.

Using MM propositions with corporate taxes:

Given:

• EBIT = Rs 2,000,000
• Value of unlevered firm, (V_U) = Rs 500,000
• Tax rate, (T) = 35% = 0.35
• Cost of debt, (r_D) = 12% = 0.12
• Debt–equity ratio of levered firm, (D/E = 1)

1. After-tax cost of equity for unlevered firm

For an unlevered firm, the cost of equity is the unlevered cost of capital:

[ r_U = \frac{EBIT(1-T)}{V_U} ]

[ r_U = \frac{2,000,000(1-0.35)}{500,000} ]

[ r_U = \frac{1,300,000}{500,000} = 2.60 = 260% ]

After-tax cost of equity for unlevered firm = 260%

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2. After-tax cost of equity for levered firm

Since (D/E = 1), we have:

[ D = E ]

MM Proposition I with taxes:

[ V_L = V_U + TD ]

Also,

[ V_L = D + E = 2D ]

So,

[ 2D = 500,000 + 0.35D ]

[ 1.65D = 500,000 ]

[ D = 303,030.30 ]

Thus,

[ E = 303,030.30 ]

Now, using MM Proposition II with taxes:

[ r_E = r_U + (r_U - r_D)(1-T)\frac{D}{E} ]

[ r_E = 2.60 + (2.60 - 0.12)(0.65)(1) ]

[ r_E = 2.60 + 1.612 = 4.212 = 421.2% ]

After-tax cost of equity for levered firm = 421.2%

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Final Answer

Note: These values are unusually high because the given unlevered firm value, Rs 500,000, is very small compared with EBIT of Rs 2,000,000. If the intended value was Rs 5,000,000, then the answers would be:

• Unlevered cost of equity = 26%
• Levered cost of equity = 35.1%

Given:

• Amount required = Rs 300,000
• Period = 6 months = $\frac{6}{12}$ year = 0.5 year

Alternative I: Mega Bank floating lien loan

Interest rate = 22% p.a.

$$\text{Interest cost} = 300{,}000 \times 22\% \times \frac{6}{12}$$ $$= 300{,}000 \times 0.22 \times 0.5 = Rs\ 33{,}000$$

No additional expenses.

Cost of Alternative I = Rs 33,000

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Alternative II: Terminal warehousing loan

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

$$\text{Interest cost} = 300{,}000 \times 15\% \times \frac{6}{12}$$ $$= 300{,}000 \times 0.15 \times 0.5 = Rs\ 22{,}500$$ $$\text{Total cost} = 22{,}500 + 10{,}000 = Rs\ 32{,}500$$

Cost of Alternative II = Rs 32,500

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Comparison

Alternative II is cheaper by:

$$33{,}000 - 32{,}500 = Rs\ 500$$

Decision: The company should use Alternative II — the terminal warehousing loan, because its total cost for 6 months is Rs 32,500, which is Rs 500 less than Alternative I.