BY CA Ummesh sir

CAP-2
FM THEORY

pg. 1 FM Theory
BY CA Ummesh sir

CA cap-2
1. Do not leave any topic as the paper will cover the entire syllabus and almost no

choices

2. Please go through the class notes first..

3. Please go through the past question.

4. Your answer to the problem should include as many working notes as possible.

5. Theory questions will be very simple and straight forward and please don’t

ignore theory and the Misc. topics. It will help in scoring and also clearing the

exams.

6. Time will be a constraint so plan your time well in advance

7. Keep practicing the problems during your preparations. It will give you

momentum and will let you know which problem will take how much time in exams.

8. While preparing for exam note down all the formulae in a sheet and just before

entering the exam revise the formulae for an hour. It will really help you in

solving problems quickly and ensure that you are not stuck mid-way.

9. Try to go through the past question papers and solve them and the feel of the

type of questions asked in the exams.

Thank You………
CA Umesh Bhattarai
FCA,M.COM,BBS.TU Gold Medalist

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BY CA Ummesh sir

BASIC CONCEPT OF F.M

1. Meaning Of Financial Management

Financial management is that managerial activity which is concerned with planning and
controlling of the firm’s financial resources. In other words it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly
to maximize the shareholder’s wealth).
The analysis of these decisions is based on the expected inflows and outflows of funds and
their effect on managerial objectives.
There are three basic aspects of financial management viz., procurement of funds, an
effective use of these funds to achieve business objectives and dividend decision.
Procurement of funds - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby. Where to get the money from?
Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions. - Where to invest the money?
Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. How much to distribute amongst shareholders to keep them satisfied?

2. OBJECTIVE OF FINANCIAL MANAGEMENT

PROFIT MAXIMISATION
It has traditionally been argued that the primary objective of a company is to earn profit;
hence the objective of financial management is also profit maximization. This implies that the
finance manager has to make his decisions in a manner so that the profits of the concern are
maximized. Each alternative, therefore, is to be seen as to whether or not it gives maximum
profit.
However, profit maximization cannot be the sole objective of a company. It is at best a limited
objective. If profit is given undue importance, a number of problems can arise. Some of these
have been discussed below:
i) The term profit is vague. It does not clarify what exactly it means. It conveys a different
meaning to different people. For example, profit may be in short term or long term period; it
may be total profit or rate of profit etc.
ii) Profit maximization has to be attempted with a realization of risks involved. There is a
direct relationship between risk and profit. Many risky propositions yield high profit. Higher
the risk, higher is the possibility of profits. If profit maximization is the only goal, then risk
factor is altogether ignored. This implies that finance manager will accept highly risky
proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.

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iii) Profit maximization as an objective does not take into account the time pattern of
returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if the
returns of proposal A begin to flow say 10 years later, proposal B may be preferred which may
have lower overall profit but the returns flow is more early and quick.
iv) Profit maximization as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society, as
well as ethical trade practices. If these factors are ignored, a company cannot survive for long.
Profit maximization at the cost of social and moral obligations is a short sighted policy.

WEALTH MAXIMIZATION
Shareholders wealth are the result of cost benefit analysis adjusted with their timing and risk
i.e. time value of money.
So,
Wealth = Present value of benefits – Present Value of Costs

It is important that benefits measured by the finance manager are in terms of cash flow.
Finance manager should emphasis on Cash flow for investment or financing decisions not on
accounting profit. The shareholder value maximization model holds that the primary goal of
the firm is to maximize its market value and implies that business decisions should seek to
increase the net present value of the economic profits of the firm. So for measuring and
maximizing shareholders wealth finance manager should follow:
• Cash Flow approach not Accounting Profit
• Cost benefit analysis
• Application of time value of money.

How do we measure the value/wealth of a firm?

According to Van Horne, “Value of a firm is represented by the market price of the company's
common stock. The market price of a firm's stock represents the focal judgment of all market
participants as to what the value of the particular firm is. It takes into account present and
prospective future earnings per share, the timing and risk of these earnings, the dividend
policy of the firm and many other factors that bear upon the market price of the stock. The
market price serves as a performance index or report card of the firm's progress. It indicates
how well management is doing on behalf of stockholders.”

Example: Profit maximization can be achieved in the short term at the expense of the long
term goal, that is, wealth maximization. For example, a costly investment may experience
losses in the short term but yield substantial profits in the long term. Also, a firm that wants to
show a short term profit may, for example, postpone major repairs or replacement, although
such postponement is likely to hurt its long term profitability.
Following illustration can be taken to understand why wealth maximization is a preferred
objective than profit maximization.
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ILLUSTRATION 1
Profit maximization does not consider risk or uncertainty, whereas wealth maximization
considers both risk and uncertainty. Suppose there are two products, X and Y, and their
projected earnings over the next 5 years are as shown below:

Year Product X Product Y

1. 10,000 11,000
2. 10,000 11,000
3. 10,000 11,000
4. 10,000 11,000
5. 10,000 11,000
Total 50,000 55,000

A profit maximization approach would favour product Y over product X. However, if product Y
is more risky than product X, then the decision is not as straightforward as the figures seem to
indicate. It is important to realize that a trade-off exists between risk and return. Stockholders
expect greater returns from investments of higher risk and vice-versa. To choose product Y,
stockholders would demand a sufficiently large return to compensate for the comparatively
greater level of risk.

3. OBJECTIVE OF FINANCIAL MANAGEMENT

The finance manager occupies an important position in the organizational structure. Earlier
his role was just confined to raising of funds from a number of sources. Today his functions
are multidimensional. The functions performed by today's finance managers are as below:-
➢ Forecasting the financial requirement: A financial manager has to make an estimate
and forecast accordingly the financial requirements of the firm.
➢ Planning: A finance manager has to plan out how the funds will be procured and how
the acquired funds will be allocated.
➢ Procurement of fund: A finance manager has to select the best source of finance from a
large number of options available. The finance manager's decisions regarding the
selection of source is influenced by the need, purpose, object and the cost involved.
➢ Investment/Allocation of fund: A finance manager has also to invest or allocate funds in
best possible ways. In doing so a finance manager cannot but ignore the principles of
safety profitability and liquidity.
➢ Maintaining proper liquidity: A finance manager plays an important role in maintaining
proper liquidity. He determines the need for liquid asset and then arrange them in such
a way that there is no scarcity of funds.
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➢ Cash management: A finance manager has also to manage the cash in an efficient way.
Cash is to be managed in such a way that neither there is scarcity of it nor does it
remains idle earning no return on it.
➢ Dividend decision: A finance manager has also to decide whether or not to declare a
dividend. If dividends are to be declared, then what amount is to be paid to the
shareholder and what amount is to be retained in the business.
➢ Evaluation of financial performance: A finance manager has to implement a system of
financial control to evaluate the financial performance of various units and then take
corrective measures wherever needed.
➢ Financial negotiations: In order to procure and invest funds, a finance manager has to
negotiate with the various financial institutions, banks, public depositors in a
meticulous way.
➢ To ensure proper use of surplus: A finance manager has to see to the proper use of
surplus fund. This is necessary for expansion and diversification plan and also for
protecting the interest of shareholders.

4. FINANCIAL DISTRESS
There are various factors like price of the product/ service, demand, price of inputs e.g. raw
material, labor etc., which is to be managed by an organization on a continuous basis.
Proportion of debt also need to be managed by an organization very delicately. Higher debt
requires higher interest and if the cash inflow is not sufficient then it will put lot of pressure to
the organization. Both short term and long term creditors will put stress to the firm. If all the
above factors are not well managed by the firm, it can create situation known as distress, so
financial distress is a position where Cash inflows of a firm are inadequate to meet all its
current obligations.
Now if distress continues for a long period of time, firm may have to sell its asset, even many
times at a lower price. Further when revenue is inadequate to revive the situation, firm will
not be able to meet its obligations and become insolvent. So, insolvency basically means
inability of a firm to repay various debts and is a result of continuous financial distress.

5. DISCUSS THE CHANGING SCENARIO OF FINANCIAL MANAGEMENT IN NEPAL.

Modern financial management has come a long way from traditional corporate finance. As the
economy is opening up and global resources are being tapped, the opportunities available to a
finance manager have no limits. Financial management is passing through an era of
experimentation and excitement as a large part of finance activities are carried out today. A
few instances of these are mentioned as below:-
• Interest rate freed from regulation treasury operation therefore have to be more
sophisticated as interest rates are fluctuating.
• Optimum debt equity mix is possible.

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BY CA Ummesh sir
• Maintaining share prices is crucial. The dividend policies and bonus policies formed by
finance managers have a direct bearing on the share prices.
• Free pricing and book building for IPOs, seasoned equity offering.
• Treasury management.

6. STATE THE ROLE OF A CHIEF FINANCIAL OFFICER.

The chief financial officer of an organization plays an important role in the company's goals,
policies and financial success. His responsibilities include:
• Financial Analysis and Planning: Determining the proper amount of funds to employ in
the firm.
• Investment Decisions: The efficient allocation of funds to specific assets.
• Financing and Capital Structure Decisions: Raising funds on favorable terms as
possible.
• Management of Financial Resources such as working capital.
• Risk Management: Protecting assets.

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TIME VALUE OF MONEY

1. NOMINAL INTEREST RATE AND EFFECTIVE INTEREST RATE

The interest rate that is specified on an annual basis in a loan agreement or security (say, in
the case of a bond) is known as the nominal interest rate. Thus, the nominal interest rate is
the simple interest rate (without compounding) which is stated in the face of a security or a
loan agreement.
Usually, there are provisions of compounding of the interest payable on a loan or security. The
compounding may be done monthly, quarterly or semi—annually. When compounding of the
interest payable is done more than once a year, the actual it annualized interest would be
higher than the nominal interest rate and it is called the effective interest rate.
The general formula for calculating effective interest rate (EIR) can be written in the following
form:
EIR = [1 + i/m] nxm – 1, where
i denotes the annual nominal rate of interest,
n denotes the number of year and
m denotes the number of compounding per year.
In the case of annual compounding, m = 1, in quarterly compounding m = 4, and in the case of
monthly compounding, m = 12. The formula given above can be modified to accomplish the
multi-period compounding for any number of years.

2. ANNUITY AND PERPETUITY

S.N Annuity Perpetuity
1 An annuity is a stream of regular Perpetuity is a stream of payments or type
periodic cash flows (either of annuity that starts payments on fixed
payments made or received) for a date and such payments continue forever,
specified period of time. i.e. perpetually. Thus, Perpetuity is a
constant stream of identical cash flows
with no end.
2 Furniture value of annuity can be Perpetuity is a type of annuity which is
computed using compounding never-ending, its sum if future value
technique. cannot be calculated.
3 Examples Example
Recurring Deposit installments paid Dividend on Irredeemable, Preference
to bank. Share Capital.
Life insurance premium per annum. Interest on Irredeemable Debt/Bonds.
Scholarships paid perpetually from an
endowment fund, etc.

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3. EXPLAIN THE RELEVANCE OF TIME VALUE OF MONEY IN FINANCIAL DECISIONS.
Time value of money means that worth of a rupee received today is different from the worth
of a rupee to be received tomorrow or in future, the preference of money now, as compared
to future money is known as time preference for money.
A rupee today is more valuable than a rupee after a year due to several reasons like:-
Risk:- There is uncertainty about the receipt of money in future.
Inflation:- In an inflationary period, a rupee today represents a greater real purchasing power
than a rupee a year later.
Preference for present consumption: - Most of the persons & companies in general prefer
current consumption to future consumption.
Investment opportunities:- Many persons and the companies have a preference for present
money as there are many opportunities of investment available for earning additional cash
flow.
Capital Budgeting:- While arriving at capital budgeting decisions time value of money is one
or utmost important option. In this type of decision money is invested today but return is
realized over a long period of time. Hence to arrive at a correct decision we need to consider
time value of money.

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BOND VALUATION and STOCK VALUATION

1.Treasury Bills
Treasury bills is a short term debt obligation backet by the U.S. government with a maturity of
less than one year. T-bills are issued through a competitive bidding process at a discount from
par, which means that rather than paying fixed interest payments will conventional bonds, the
appreciation of the bond provides the return to the holder.

2.Promised yield and Realized yield

Promised Yield indicates the total rate of return earned on bond if it is held to maturity, lt is
also known as Yield-to-Maturity. This is the rate of return anticipated on a bond if heId until
the end of its lifetime. YTM is considered a long-term bond yield expressed as an annual rate.
The YTM calculation takes into account the bond’s current market price, par value, coupon
interest rate and time to maturity. It is also assumed that all coupon payments arc reinvested
at the same rate as the bond`s current yield. YTM is a complex but accurate calculation of a
bond`s return that helps investors to compare bonds with different maturities and coupons.
Realized Yield is the actual amount of return earned on a security investment over a period of
time. This period of time is typically the holding period which may differ from the expected
yield at maturity, The realized yield also includes the returns that have been earned from
reinvested interest, dividends and other cash distributions.
The realized yield tends to differ from the yield at maturity in scenarios where the holding
period is less than that of the maturity date.
In other words, the security is settled or sold prior to the maturity date given at the time of
purchase. For example, suppose an investor purchases a 10 year bond for Rs. 1,000 that issues
a 5% annual coupon. Furthermore, if the investor sells the bond tor Rs.1,000 at the end of the
first year (and after receiving the first coupon payment), his realized yield would only include
the Rs. 50 coupon payment.

3. Yield to call (YTC) and Yield to Maturity (YTM)

The Yield to maturity (YTM) or redemption yield of a bond or debentures, is the internal rate
of return (IRR, overall interest rate) earned by an investor who buys the bond or debenture
today at the market price, assuming that the bond will be held until maturity, and that all
coupon and principal payments will be made on schedule. Yield to maturity is actually an
estimation of future return, as the rate at which coupon payments can be reinvested at when
received is unknown. It enables investors to compare the merits of different financial
instruments.
The Yield to call (YTC) is one of the variants of YTM. lt is the rate of return if held up to call.
When a bond or debenture is callable (can be repurchased by the issuer before the maturity),
the market looks also to the Yield to call, which is the same calculation of the YTM, but
assumes that the bond will be called, so the cash flow is shortened.

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4. Bond Duration /Macaulay’s Duration
It estimates how many years it will take for an investor to be repaid the bond’s price by its
total cashflows. A bond with a longer coupon will have a shorter duration because more of
the total cashflows come earlier in the form of interest payments.
Duration measures the sensitivity of the bond’s price in relation to the required rate of return
i.e. if a bond has duration of 5 years and market interest rate is increased by 2%, then the
bond price will drop by appx. 10% and vice-versa.

5. Deep Discount Bonds

Deep discount bonds are a form of zero interest bonds. These bonds are sold at a discounted
value and an maturity face value is paid to the investor such bonds, there is no interest payout
during lock in period. When such bonds are sold in the stock market, the difference realised
between face value and market price is the capital gain or YTM.

6. Valuation of compulsorily convertible debenture

The debenture-holders of a Compulsorily Convertible Debenture (CCD) receives interest at a
specified rate for a pre-determined period after which a part or full value of the CCD is
converted into specific number of equity shares. The cash flows resulting in the case of
valuation of CCD are;
- Periodic interest receivable from the company.
- Expected market price of the share received on conversion.
- Redemption amount, if any.
- The value of a CCD is then found out by using the following formula:
𝐽𝑖 𝑚𝑃𝑡 𝑅𝑉
𝐵0 (𝐶𝐶𝐷 ) = ∑𝑛𝑖 (1+𝑘 𝑡
+ (1+𝐾 𝑛
+
𝑒) 𝑑)

Where, B0 (CCD) = Value of a CCD

I = Interest amount receivable per year
Ke = Required rate of return on equity component
m = Number of shares received on conversion
Pt = Share price at the time of conversion
RV = Redemption value. if any
n = Life of the debentures
kd = Rate of discount of debt.
ln the case of partially convertible debentures, the annual interest before conversion and
alter conversion would be different whereas in the case of fully convertible debentures,
there will not be any RV.

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RATIO ANALYSIS
1. Return on Capital Employed
It is obtained by dividing "profit before interest and tax" by 'capital employed'. Capital
employed means equity plus long-term debt. The ratio provides a test of profitability in
relation to long-term funds. It provides insight into how efficiently the long-run funds are
used. Higher the ratio, better it is. Higher ratio indicates more efficient use of capital
employed which helps the firm in being solvent in long-run.

2. Discuss the composition of Return on Equity (ROE) using the DuPont model.
Composition of Return on Equity using the DuPont Model
There are three components in the computation of return on equity using the traditional
DuPont model - the net profit margin, asset turnover, and the equity multiplier. By examining
each input individually, the sources of a company's return on equity can be discovered and
compared to its competitors
(i) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates
for each rupee of revenue.
Net profit margin = Net Income / Revenue (sales)
Net profit margin is a safety cushion; the lower the margin, lesser the room for error. (ii) Asset
Turnover: The asset turnover ratio is a measures of how effectively a company converts its
assets into sales. It is calculated as follows:
Asset Turnover = Revenue /Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e.,
the higher the net profit margin, the lower the asset turnover.
(iii) Equity Multiplier: It is possible for a company with terrible sales and margins to take on
excessive debt and artificially increase its return on equity. The equity multiplier, a measure of
financial leverage, allows the investor to see what portion of the return on equity is the result
of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets / Shareholders' Equity
Computation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three
components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin x Asset turnover x Equity multiplier

3. Explain briefly the limitations of Financial ratios.

The limitations of RA are as below:
• Concept of Ideal Ratio: The concept of ideal ratio is vague and there is no uniformity as
to what an ideal ratio is.
• Thin line of difference between good and bad ratio: The line of difference between
good and bad ratio is so thin that they are hardly separable.

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• Financial ratios are not independent: The FR's cannot be considered in isolation. They
are inter related but not independent. Thus, decision taken on the basis of one ratio
may not be correct.
• Misleading: Various firms may follow different accounting policies. In such case ratio
companies of may be misleading.
• Impact of Seasonal Factor: Seasonal factor brings boom or recession. Ratios may
indicate different results during different periods.
• Impact of Inflation: Under the impact of inflation, the ratios might not present a true
picture.
• Product line diversification: Due to product line diversification, the overall position of
the firm may differ from position of individual product line.

4. DEBT SERVICE COVERAGE RATIO

The debt-service coverage ratio (DSCR) is a measurement of a firm's available cash flow to pay
current debt obligations. This ratio is important from lender’s point of view and indicate
whether the business can earn sufficient profit to pay periodically interest amount and
principle installment on long term debt.

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COST OF CAPITAL AND CAPITAL STRUCTURE AND LEVERAGE

1. Capital Structure and Financial Structure
It refers to the mix of a firm’s capitalization (i.e. mix of long term sources of funds such as
debentures, preference share capital , equity share capital and retained earnings) for meeting
total capital requirement.
Financial Structure is the entire left-hand side of the balance sheet which represents all the
long-term and short-term sources of capital. Thus, capital structure is only a part of financial
structure.

2. Discuss the major considerations in Capital structure planning.

The major considerations in Capital Structure Planning are:
(a) Risk (b) Cost of capital (c) Control
(a) Risk : Risk is a situation wherein the possibility of happening or non-happening of an
event can be measured. With reference to capital structure planning, risk may be defined as
the variability in the actual return from an investment and the estimated return as forecasted
at the time of capital structure planning. While designing the capital structure the firm tries to
keep the risk at minimum.
(b) Cost of Capital: The cost of capital is the minimum rate of return that a firm must earn on
its investment to satisfy its various investor Cost is thus, an important consideration in capital
structure planning.
(c) Control: The decisions relating to capital structure are taken after keeping the control
factor in mind. For e.g. when equity shares are issued the company automatically dilutes its
controlling.

3. OPTIMUM CAPITAL STRUCTURE

Capital structure is optimum when the value of the firm is maximum and cost of capital
(debits & equity) is minimum and so market price per share is maximum. Which .leads to the
maximisation of the value of the firm.
Optimum Capital Structure deals with the issue of right mix of debt and equity in the long -
term capital structure of a firm. According to this:-
• If a company takes on debt, the value of the firm increases upon a certain point.
Beyond that value of the firm will start to decrease.
• If the company is unable to pay the debt within the specified period then it will affect
the goodwill of the company in the market.
Hence, company should select it appropriate capital structure with due consideration of all
factors

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An optimal capital structure should possess the following features:
• Maximisation of profitability : by using leverage minimum cost.
• Flexibility: structure should be flexible so that company may be able to raise fund or
reduce fund whenever it is required.
• Control: It should reduce the risk of dilution of control.
• Solvency : Excessive debt may threat the solvency of the company.

4. Financial break-even and EBIT- EPS indifference analysis.

Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial
charges i.e. interest and preference dividend.
It denotes the level of EBIT for which firm's EPS equals zero. If the EBIT is less than the
financial breakeven point,
Then the EPS will be negative but if the expected level of EBIT is more than the breakeven
point then more fixed costs financing instruments can be taken in the capital structure,
otherwise, equity would be preferred.
EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm.
The objective of this analysis is to find the EBIT level that will equate EPS regardless of the
financing plan chosen.
(EBIT-I1)(1-T) = (EBIT-12)(1-T)
E1 E2
Where,
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
Alternative 1= All equity finance
Alternative 2= Debt-equity finance.

5. Net Income (NI) Approach

The net income (NI) approach to the relationship between leverage, cost of capital and value
of the firm is the simplest in approach and explanations. This theory states that there is a
relationship between capital structure and the value of the firm and therefore, the firm can
affect its value by increasing or decreasing the debt proportion in the overall financing mix.
Both kd and Ke remain constant and increase in financial leverage i.e., use of more and more
debt financing in the capital structure does not affect the risk perception of the investors.

6. Net Operating Income Approach (NOI)

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According to the net operating income approach, the market value of the firm depends upon
the net operating profit or EBIT and the WACC. The financing mix or capital structure is
irrelevant and does not affect the value of the firm.
Explanation: The market value of the firm is not affected by the capital structure changes.
For a given value of EBIT, the value of firm remains same irrespective of the capital
composition.
It however depends upon the WACC.
Graphical Representation:

Net operational Income Approach.

According to the figure,
Kd & k0 are constant for all leverages. As the leverage increases, ke also increases. But the
increase in ke is such that the overall value of the firm remains same.
Conclusion: As per No. 1 approach, k0 is constant/Therefore, there is no optimal capital
structure. Instead, every capital structure is an optimal one.
Assumptions:
• the WACC remains constant for all leverage.
• kd is always less than Ke
• ke increases as leverage increases.
• kd is constant
• there are no corporate taxes.

7. Traditional Approach
The NI and the NOI approach hold extreme views on the relationship between the leverage,
cost of capital and the value of the firm. In practical situations, both these approaches seem
to be unrealistic. The traditional approach takes a compromising view between the two and
incorporates basic philosophy of both. It takes a mid-way between the NI approach and the
NOI approach. The traditional approach makes the following assumptions: Both kd and ke
tend to rise with increase in financial leverage i.e., use of more and more debt financing in the
capital structure, slowly at first but sharply thereafter.

8. Modigliani – Miller (MM-I) Approach -1958: Without Tax

Modigliani – Miller derived the following three propositions: (i) The total market value of a
firm and its cost of capital are independent of its capital structure. The total market value of
the firm is given by capitalizing the expected stream of operating earnings at a discount rate
considered appropriate for its risk class. (ii) The cost of equity of levered firm is the sum of

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cost of equity of unlevered firm plus risk premium which is given by the following equation:
Kel = Keu + (Keu − Kd) D E (iii) Average cost of capital is not affected by financial decision

9.Modigliani – Miller (MM-II) Approach -1963: With Tax

In 1963, MM model was amended by incorporating tax, they recognized that the value of the
firm will increase or cost of capital will decrease where corporate taxes exist. The value of a
levered firm will be greater than the value of the unlevered firm by an amount equal to
amount of debt multiplied by corporate tax rate. MM has developed the formulae for
computation of cost of capital (Ko),cost of equity (Ke) for the levered firm. (i) Value of levered
company = Value of an unlevered company + Tax Benefit (ii) Cost of equity in a levered
company is given by Kel = KeUL + [(KeUL – Kd)X Debt Equity (1 − Tax Rate)] (iii) WACC in a
levered company (Kol) = Keu(1-t)

10.Write a short note on Pecking order theory of capital structure.

The pecking order theory was first proposed by Donaldson in 1961.The pecking order theory
argues against a target debt/equity ratio. The theory suggests that firms rely for finance as
much as they can on internally generated funds. If not enough internally generated funds are
available then they will move to additional debt finance. It is only when these two sources
cannot provide enough funds to satisfy needs that the company will seek to obtain new equity
finance. One explanation of this ‘Pecking order’ for the supply of finance is issue cost.
Internally generated funds have the lowest issue cost & new equity the highest. Firms obtain
as much as they can of the easiest & least expensive finance, mainly retained earnings, before
moving to the next least expensive debt. Assumptions of pecking order theory: (a) Sticky
dividend policy, (b) A preference for internal funds, (c) An aversion to issue equity shares.

11. Cost of Capital

Cost of Capital is the return expected by the providers of the share capital (i.e. shareholder
lenders and the debt-holders) to the business as a compensation for their contribution to the
total capital. It is also known as Discount rate, Minimum rate of return etc. It can also be
stated as opportunity cost of an investment, i.e. the rate of return that a company would
otherwise be able to earn at same risk level as the investment that has been selected.
Following are the sources of capital;
a. Debt (Bank Borrowing, Long Term Loan, Debentures, Bonds etc.)
b. Preference Shares
c. Equity Shares
d. Reserve and Surplus/ Retained Earnings

12. Flotation cost

Floatation costs are the issue cost such as printing cost of prospectus and application forms,
underwriting commission, brokerage, legal fees, listing expenses and registration fees etc.

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13. Basis Point
Basis Point is the smallest unit in a measure of interest rates which is one hundredth of a
percentage point. Thus one basis point is 0.01% & 100 basis point is 1%.

14.Weighted average cost of Capital

Computation of overall cost of capital of a firm involves:
1. Computation of weighted average cost of capital
2. Computation of cost of specific source of finance.
1. Computation of Weighted Average Cost of Capital (WACC): Weighted average cost of
capital is the average cost of the costs of various sources of financing. Weighted average cost
of capital is also known as composite cost of capital, overall cost of capital or average cost of
capital. Once the specific cost of individual sources of finance is determined, we can compute
the weighted average costs of capital by putting weights to the specific costs of capital in
proportion to the. Various sources of firm to the total. The weights may be given either by
using the book value of the source or market value of the sources.
WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Preference + Cost of Preference) +
(Proportion of Debt x Cost of Debt)
For the above formula, we consider some assumptions in order to simplify & make it
calculative. These are:
(i) We consider only three types of capital: Equity, non-convertible & non-cancellable
preference shares and non-convertible & non-cancellable debts so, we have to ignore other
forms of capital. because cost of these forms of capital is very difficult to calculate due to its
complexities. Generally, such types of financing covers a minor part only, so it should be
excluded as it cannot make any material difference,
(ii) Debts include: Long term debts as well as short terms debts (i.e. working capital loan,
commercial papers etc.)
(iii) Non-interest: Bearing liabilities such as trade creditors are not included in the calculation
of WACC. This is done to ensure the consistency in reality. Such type of securities have cost
but such costs are indirectly reflected in the price paid by I the co. at the time of getting the
goods & services.

15. What is meant by explicit & implicit cost of capital?

Explicit Cost
Explicit cost of capital is the rate of return that an entity pays to procure external finance. It is
the discount rate that equates the present value of cash inflows that are incremental to the
taking of the financing opportunity with the present value of its incremental cash outflows. It
is a direct payment made to lenders of finance such as interest on debt funds, dividend on
shares. The explicit costs arise when funds are raised.
Implicit Cost
Implicit cost of capital is the rate of return associated with the best investment opportunity
for the firm & its shareholders that will be foregone if the project presently under

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consideration by the firm is accepted. Implicit costs are those where no actual payment is
made as in case of retained earnings used. The implicit costs arise when funds are used.

16. Business risk and Financial risk.

Business Risk: It refers to the risk associated with the firm's operations. It is uncertainty about
the future operating income. That is, how well can the operating income be predicted ? It can
be measured by standard deviation of basic earning power ratio.
Financial Risk: It refers to the additional risk placed on firm's shareholders as a result of debt
used in financing. Companies that issue more debt instruments would have higher financial
risk than companies financed mostly by equity. Financial risk can be measured by ratios such
as firm's financial leverage multiplier, total debt to assets ratio etc.

17. Leveraged lease.

Under a leverage lease transaction, the leasing company (called the equity participation) and
a lender (called the loan participant) jointly fund the investment in the asset to be leased to
the lessee.
In this form of lease agreement, the lessor undertakes to finance only a part of the money
required to purchase the asset. The major part of the finance is arranged with a financier to
whom the title deeds for the asset as well as the lease retails are assigned. There are usually
three parties involved, the lessor, the lessee and the financier. The lease agreement is
between the lessee and lessor as in any other case. But it is supplemented by another
separate agreement between the lesser and the financier who agrees to provide a major part
say 80% of the money required.
Such lease agreement which will enable the lessor to undertake an expand volume of lease
business with a limited amount of capital and hence it is named leverage leasing.

18. Operating Leverage and Financial Leverage

Operating leverage is defined as the “firm’s ability to use fixed operating costs to magnify
effects of changes in sales on its earnings before interest and taxes.” When there is an
increase or decrease in sales level the EBIT also changes.
The effect of change in sales on the level o f EBIT is measured by operating leverage.
Operating leverage occurs when a firm has fixed costs which must be met regardless of
volume of sales.
When the firm has fixed costs, the percentage change in profits due to change in sales level is
greater than the percentage change in sales.
Whereas, Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT/Operating profits, on the firm’s earnings per share”.
The financial leverage occurs when a firm’s capital structure contains obligation of fixed
financial charges e.g. interest on debentures, dividend on preference shares etc. along with
owner’s equity to enhance earnings of equity shareholders.
The fixed financial charges do not vary with the operating profits or EBIT.
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They are fixed and are to be paid irrespective of level of operating profits or EBIT.

19. Closed and Open Ended Lease

Close ended lease In the closed ended lease, the asset gets transferred to the lessor at the
end, and the risk of obsolescence, residual value etc. remain with the lessor being the legal
owner of the asset. It is also known as "true lease”, "walkaway lease" or "net lease."
Because the lessee has no obligation to purchase the leased asset upon lease expiration, that
person does not have to worry about whether the asset will depreciate more than expected
throughout the course of the lease. So, it is argued that the closed-end leases are better for
the average person.
Open ended lease in the open ended lease, the lease has the option of purchasing the asset at
the end of lease. It is also known as "finance lease."
For example, suppose your lease payments are based on the assumption that a 40,000 new
car will be worth only 20,000 at the end of your lease agreement. If the car turns out to be
worth only 8,000, you must compensate the lessor (the company who leased the car to you)
for the lost 12,000 since your lease payment was calculated on the basis of the car having a
salvage value of 20,000.

******

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DIVIDEND DECISION
1. Dividend
Dividends are that part of the earnings which are distributed to the members of the company
in cash. The balance part of earnings is called retained earnings.
Dividend policy: Each organization has its own policy for dividends and this may change from
time to time as well. Essentially there are two types which a company can adopt:
a. Dividend as long term financing policy: Under this policy earnings are treated as a long
term source of funds and earnings are utilized to finance the expansion programs. When the
firm does not have alternative avenues for investing, then it will distribute the amount as
dividends.
b. Wealth maximization policy: Due to market imperfections and uncertainty, shareholders
prefer immediate returns than long term gains in the form of capital appreciation. High
payouts will result in higher share prices and vice versa. This may result into losing of fourable
alternative investment avenues due to lack of funds.

2. Practical considerations for declaring dividends:

Following are the factors that are looked into before declaring dividends.
a. Liquidity:
b. Repayment of debt obligations, if any:
c. Stability and continuity of profits:
d. Control: The use of retained earnings to finance new projects preserves the company’s
ownership and control. Raising of funds from outside may dilute the ownership
e. Legal considerations: Requirements of Companies Act.
f. Impact on stock market prices:
g. Tax considerations:
h. Desire of shareholders:
i. Form of dividend:

( Refer class note)

******

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SOURCES OF FINANCE
1. American Depository Receipts vs. Global Depository Receipts
Basis of GDR ADR
Difference
1. Meaning The depository receipts in the The depository receipts in the US market is
world market are called GDR. called ADR
2.Voting GDR's donot have voting ADR's may be with or without voting rights.
Right rights.
3. Scope GDR's are traded worldwide. ADR's are traded only in US.
4.Preference GDR's are more preferred due to ADR's provide certain stringent rules to be
their easy operation. followed which make them less preferred.
5.Cost The cost involved in operation of The cost involved in operation of ADR is
involved GDR is less than that of ADR. comparatively high due to annual legal and
accounting costs are much higher.

American depository receipt:- Deposit receipt issued by an Indian company in USA is

known as American depository receipt (ADRs). Such receipt have to be issued in
accordance with the provisions stipulated by the security and exchange commission of
USA. An ADR is generally created by the deposit of the securities of an outsider company
with a custodian bank in the country of incorporation of issuing company. The custodian
bank informs the depository in USA that the ADRs can be issued. ADRs are dollar
denominated and are traded in the same way as are security of U.S. company. ADRs can be
traded either by trading existing ADRs or purchasing the shares in the issuer's home
market and having new ADRs created, based upon availability and market conditions.
When trading in existing ADRs, the trade is executed on the secondary market on the New
York Stock Exchange through Depository Trust Company (DTC) without involvement from
foreign brokers or custodians.
Global Depository Receipts:- Global Depository Receipts are negotiable certificates held
in the bank of one country representing a specific number of shares of a stock traded on
the exchange of another country. These financial instruments are used by companies to
raise capital in either dollars or Euros. These are mainly traded in European countries and
particularly in London.

2. Bridge Finance:
Bridge finance is a short-term loan taken by a firm from commercial banks to disperse
loans sanctioned by financial institutions.
Importance or Need for Bridge finance: Bridge finance as the name suggests bridge
the time gap between the date of sanctioning of a term loan and its disbursement.

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The reason for such delay is due to procedure formalities. Such delays result in cost
overrun of the project. Thus, to avoid such cost over runs, firms approach commercial
banks for short term loans for a period for which delay may occur.

Characteristics of Bridge Finance:

• It is short-term loan.
• It bridges the gap between the date of sanctioning the loan and the final
disbursement of loan.
• The rate of interest on such loan is usually high.
• These loans are usually repaid as and when term loans are disbursed.
3. Trading on equity
The term 'equity' refers to the ownership or 'stock' of a company and 'trading' means
'taking advantage of. Hence, the term 'trading on equity' means taking advantage of
equity share capital to borrow funds on reasonable basis. It refers to the additional
profit which equity shares make at the expense of other forms to securities. This
concept is based on the theory that there is a difference among the rates of return on
the various types of securities issued by the company.
When the Return on Investment (ROI) is more than the interest rate then financial
leverage works in favour of equity shareholder and Return on Equity (ROE) will be
even more then ROI.
The policy of trading on equity is followed by a company for the
following three purpose:-
(i) To retain full control over the business.
(ii) To increase the rate of .dividend on equity shares.
(iii) To achieve control on more financial resources by taking maximum
loan/ debt on the basis of minimum owned or equity share capital.
For example the Capital employed is 2,00,000, debt equity ratio is 1:1, interest rate is 10%
and EBIT is 30,000. Here ROI is 15% (30000 / 200000) which is more than interest rate of
10%. This excess return of 5% (15-10) will go to equity shareholders and (ROE) will be
20% (20000/100000).
This excess return earned by equity shareholder due to favourable financial-leverage
position is termed as trading on equity.

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4. Venture Capital Financing
The Venture capital refers to the financing of new high risky venture promoted by
qualified entrepreneurs who lack experience and funds to give shape to their ideas.
The venture capitalists not only invests but also participate in the management of the
venture capital undertaking.
Methods:
a) Equity Financing: Provide fund by way of equity shares. The equity contribution
of venture capital firm doesnot exceed 49% of total capital of venture so that the
effective control and ownership remains with the entrepreneur.
b) Conditional Loan: Under this scheme no interest is paid on such loans.
Conditional loan is repayable in the form of a royalty after the venture is able to
generate sales.
c) Income note: it is a hybrid security which has combine features of interest and
royalty on sales but at low rates.
d) Participating Debenture; Charges interest in three phases, Phase 1 (start up
phase) = No interest , Phase 2 (partial operation) = Nominal interest rate , Phase
3 (High profit) = High level of interest rate.

5. Ploughing back of Profits

Ploughing back of profit is an internal source of finance. It is a phenomenon under
which the company does not distribute all the profit earned but retains a part of it,
which is re- invested in the business for its development. It is thus known as Retained
Earning.
Characteristics:
1. It is a technique of self-financing.
2. It is a source of finance which contributes towards the fixed as well as working
capital needs of the company.
3. Under this phenomenon, a part of the total profit is transferred to various reserves
such as general reserve, reserve for repair and renewal, secret reserves etc.
4. The funds so created entail almost no risk and the control of the owners is also not
diluted.
Advantages:
1. Economical method of financing: Since the company does not depend upon
external sources ploughing back of profit or retained earning acts as, an economical
methods of financing.
2. Helps the company to follow stable dividend policy: The retained earning helps the
company to pay dividend regularly. This enhances the credit worthiness of the
company.
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3. It acts as a shock absorbent: A company with large reserves can withstand the
shocks of trade cycle and the uncertainty of market with ease.
4. Flexible financial structure: It allows the financial structure to remain flexible.
5. Self-dependent: It makes the company self dependent. It need not depend on
outsiders for its financial needs.

6. Foreign Direct Investment (FDI)

Foreign direct investment (FDI) is an investment made by a company or individual in

one country in business interests in another country, in the form of either establishing
business operations or acquiring business assets in the other country, such as
ownership or controlling interest in a foreign company.
Benefits;
a. Increase employment and economic growth
b. Human Resource development
c. Development of backward areas
d. Access latest technology
e. Increase in export
f. Exchange rate stability
g. Improved capital flow
h. Breaks domestic monopoly and creates competitive market

7. Debt Securitization
It is the process of converting mortgage loans together with future receivables into negotiable
securities or assignable debt is called ‘securitization’. The Securitization process involves
packaging designated pool of mortgages and receivables and selling these packages to the
various investors in the form of securities which are collateralized by the underlying assets
and their associated income streams.
Securitization is an off-balance sheet financing technique with the objective of mobilizing
resources at a comparatively lower cost through a wider investor base, by removing loan
assets from the balance sheet of the loan originator.
Securitization actually involves conversion of mortgages into securities which are
tradable debt instruments. The securities, which are backed by the mortgages, are then
freely traded in the market thereby giving rise to a secondary market. In this process,
saver’s surpluses are channelized to meet borrower’s deficits. This also facilitates
interregional and inter-sectorial flow of funds.
Debt Securitization Process:
The steps involved in Securitization process are the following:
(a) A company that wants to mobilize finance through securitization begins by
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identifying assets that can be used to raise funds.
(b) These assets typically represent rights to payment at future dates and are usually
referred to as ‘receivables’.
(c) The company that owns the receivables is usually called the ‘originator’.
(d) The originator identifies the assets out of its portfolio for Securitization.
(e) The identification of assets will have to be done in a manner so that an optimum mix
of homogeneous assets having almost same maturity forms the portfolio.
(f) Assets originated through trade receivables, lease rentals, housing loans, automobile
loans, etc. according to their maturity pattern and interest rate risk are formed into a
pool.
(g) The aforementioned identified and pooled assets are then transferred to a newly formed
another institution called a ‘special purpose vehicle’ usually by way of a trust.
(h) Such trust usually, an investment banker, issues the securities to an investor.
(i) Once the assets are transferred, they are no longer held in the originator’s portfolio.
(j) After acquisition of the assets from originator, the SPV splits the pool into individual
shares or securities and reimburse itself by selling these to investors.
(k) The securities, so issued, are known as ‘pay or pass through certificates’.
(l) The securities are normally without recourse to the originator, thus investor can hold only
SPV for the principal repayment and interest recovery.
(m) In order to make the issue attractive, the SPV enters into credit enhancement
procedures either by obtaining an insurance policy to cover the credit losses or by
arranging a credit facility from a third party lender to cover the delayed payments. To
increase marketability of the securitized assets in the form of securities, these may be
rated by some reputed credit rating agencies.
(n) Credit rating increases the trading potentials of the certificate, thus its liquidity is
enhanced.
(o) A merchant banker or syndicate of merchant bankers will be appointed for underwriting
the whole issue.
(p) The securities have to be sold to the investors either by a public issue or by private
placement.
(q) The pass through certificates before maturity are tradable in a secondary market to
ensure liquidity for the investors.
(r) Once the end investor gets hold of these instruments created out of Securitization, he is
to hold it for a specific maturity period which is well defined with all other related terms
and conditions.

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(s) On maturity, at the end, investors get redemption amount from the issuer along with
interest due on the amount.

8. Commercial Paper:
A commercial paper is an instrument meant for financing working capital requirement. It
represents short term unsecured promissory notes issued by firms which enjoy a fairly high
credit rating. Such a promissory note is negotiable by endorsement and delivery and is issued
at a discount on face value.
The features of a commercial paper are:
• It is a short term instrument for financing the working capital requirement.
• It represents a promissory note, which is negotiable by endorsement and delivery.
• It is a certificate, which acts as an evidence for unsecured corporate debt of short term
maturity.
• The maturity period of commercial paper usually ranges between 90 to 360 days.
• It is issued at a discount and is redeemed at face value.
• It is issued directly by the firm to the investors or through banks.
• Under it the issuer promises to pay the buyer some fixed amount on some future date.
• No asset is pledged against the promise.

9. Seed capital assistance:-

10. Virtual banking and its advantage

Virtual banking refers to the provision of banking and related services through the use of
information technology without direct recourse to the bank by the customer. The advantages
of virtual banking services are as follows:
• Lower cost of handling a transaction.
• The increased speed of response to customer requirements.
• The lower cost of operating branch network along with reduced staff costs leads to cost
efficiency.
• Virtual banking allows the possibility of improved and a range of services being made
available to the customer rapidly, accurately and at his convenience.

11. Agency cost of equity and debt

Agency cost refers to the cost incurred by a firm because of the problems associated with the
different interests of management and shareholder and the information asymmetry that
exists between the principal (shareholders) and the agent (management).
Agency Cost of Equity

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The agency cost of equity arises because of the difference in interests between the
shareholders and the management. As long as the management‘s interests diverge from that
of the shareholders, the shareholders will have to bear this cost. Management may be
tempted to take suboptimal decisions that may not work towards maximizing the value for
the firm. Any measures implemented to oversee and prevent this will have a cost associated
with it. So, the agency costs will include both, the cost due to the suboptimal decision, and the
cost incurred in monitoring the management to prevent them from taking these decisions.
Agency Cost of Debt
The agency cost of debt arises because of different interests of shareholders and debt-
holders. Assume that the management is in favor of the shareholders. If so, the management
can in many ways transfer the wealth to the shareholders and leaving debt-holders empty
handed. Anticipating such activities, the debt-holders will take various preventive measures to
disallow management from doing so. The debt holders may do so in the form of higher
interest rates to protect themselves from the losses. Alternatively they may impose restrictive
covenants.

12. ‘Loan syndication is one of the project finance services.’ Discuss.

Syndicate means“a group of people or companies who join together

in order to share the cost of a particular business operation for which
a large amount of money is needed”.
Loan syndication is like a teamwork approach in lending money. Instead of one bank giving
all the money to someone who needs a loan, a bunch of banks join together to provide the
funds. This happens when the amount of money needed is too much for just one bank.
Here are some important things to know about loan syndication:
1. Team Formation; One bank, called the lead arranger or agent, is like the team captain.
They organize the group of banks, negotiate the loan terms with the borrower, and
handle the loan on behalf of the team.
2. Many Team Members: Several banks, like teammates, join this group called a
syndicate. Each bank chips in some money, so it's not just one bank taking all the risk.
3. Sharing Risks: Teamwork is all about sharing, right? In loan syndication, the banks
share the risks that come with lending a lot of money. This helps both the borrower
and the banks because if something goes wrong, the impact is spread out.
4. Loan Details: The lead arranger talks to the borrower and decides on things like
interest rates, when the loan needs to be repaid, and other important terms. Then,
these details are shared with all the banks in the syndicate.
5. Flexibility: Teamwork brings flexibility. Borrowers get access to a big amount of
money, and banks get to be part of opportunities they might not handle alone.

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6. Market Trading: Sometimes, banks in the team might decide to sell part of the loan to
other banks. It's like passing the ball in a game. This is done on the secondary market,
where loans can be bought and sold.
7. Big Projects: Loan syndication is used in different areas like business, real estate, and big
projects. It helps spread the risk and make sure there's enough money for important
things, contributing to the stability of the financial world.

Loan syndication is used in different areas like business, real estate, and big projects. It helps
spread the risk and make sure there's enough money for important things, contributing to the
stability of the financial world.

13. Bank Overdraft and Clean Overdraft

Bank Overdraft
Bank Overdraft refers to an arrangement whereby the bank allows the customers to overdraw
from its current deposit account within a specified limit. The overdraft facility is granted
against the securities of assets or personal security as in case of cash credit. Interest is
charged only on the amount actually overdrawn (i.e. debit balance) for the actual period of
use (i.e., for the period the debit balance in current deposit account remains outstanding).
The cost of raising finance by this method is the interest charged by the bank.

Clean Overdraft
Banks may entertain clean advances from those customers, which are financially, sound and
reputed for their integrity. The Banks in this case rely upon the personal security of borrower.
Banks are responsible for ensuring customer's credit worthiness before providing them with
clean overdraft as there is no asset securing the amount of advance. The Banks normally take
guarantee from the persons whom they believe to be credit worthy.

14. Mezzanine debt and Subordinate debt

Mezzanine debt refers to a type of financing that sits between senior debt and equity in the
capital structure of a company. Mezzanine debt is typically used by companies to fund growth,
acquisitions, or recapitalizations.
Mezzanine debt has some characteristics of both debt and equity. It is structured like a loan,
but it is often unsecured and has a higher interest rate than senior debt. Mezzanine debt is
also subordinated to senior debt in the event of bankruptcy, but it ranks above equity in the
capital structure.
Mezzanine debt can take various forms, including convertible debt, subordinated debt, or
preferred equity. The terms of mezzanine debt can also vary widely, depending on the lender
and the company's specific circumstances.
One key advantage of mezzanine debt for companies is that it allows them to raise capital
without diluting the ownership of existing shareholders. Mezzanine debt investors typically
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receive a higher return than senior debt holders, but lower than equity holders, making it an
attractive option for both investors and companies.

Subordinated debt is a type of debt that ranks lower in priority than other forms of debt in
the event of a company's bankruptcy or liquidation. This means that in the event of a default
or bankruptcy, subordinated debt holders are paid back only after senior debt holders have
been paid in full. As a result, subordinated debt carries a higher risk than senior debt and
typically has a higher interest rate.
Subordinated debt can be used by companies to raise capital for a variety of purposes,
including expansion, acquisitions, or refinancing. Subordinated debt can take various forms,
including convertible bonds, preferred stock, or traditional loans with subordination clauses.
Because subordinated debt has a higher risk profile than senior debt, investors typically
demand a higher return to compensate for the added risk. However, subordinated debt can
be an attractive financing option for companies that want to avoid diluting ownership or
giving up control to equity investors.
Overall, subordinated debt is a type of financing that can provide companies with additional
capital while allowing investors to potentially earn a higher return than they would with
senior debt. However, subordinated debt carries higher risk and should be carefully evaluated
by both companies and investors.

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Claim priority at the Time of Liquidation of company;

1. Senior debt
2. Mezzanine debt
3. Subordinated debt
4. Equity

15. Euro convertible bonds Vs. Euro convertible zero bonds.

Euro convertible bond is a Euro bond, a debt instrument which gives the bond
holders an option to convert them into a pre determined number of equity shares of
the company. Usually the price of the equity shares at the time of conversion will
have a call option (where the issuer company has the option of calling/buying the
bonds for redemption prior to the maturity date) or a put option (which gives the
holder the option to put/sell his bonds to the issuer company at a predetermined
date & price).
Euro convertible zero bonds are structured as convertible bond. No interest is
payable on the bonds. But conversion of bonds takes place on maturity at a
predetermined price. Usually there is a five years maturity period and they are
treated as deferred equity issue.
16. Inflation bonds and Floating rate bonds
Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus,
the investor gets ‘interest which is free from the effects of inflation. For example, if
the interest rate is 3 percent and the inflation rate is 6 percent, the investor will get 9
percent in total.
Floating rate bonds, as name suggests, are the bonds where the interest rate is not
fixed and is allowed to float depending upon the market conditions. This is an ideal
instrument which can be resorted to by the issuer to hedge themselves against the
volatility in the interest rates. This has become more popular as a money market
instrument and being issued by the financial institutions.
17. Financial distress and Insolvency
Financial distress is a situation where a firm’s operating cash flows are insufficient to
meet its current obligations (and so the firm must take some kind of corrective
action) financial distress may lead a firm to default on a contract, and it may involve
financial restructuring between the firm, its creditors, and its shareholders in most
cases, the firm is forced to take actions that it would not have taken if it had
sufficient cash flow.
Insolvency is a term which generally means an inability to repay debts stock-based
insolvency occurs when the value of a firm’s assets is less than what is owed on its
debt flow-based insolvency occurs when the firm’s cash flows are insufficient to
cover contractually required payments.

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18. Proxy fight

A proxy fight is like a big argument among a company's owners (shareholders) about
who should be in charge. Some shareholders get unhappy with how the company is
being run, and they want to change things. They try to get other shareholders to vote
for their ideas by using something called a proxy vote, where people can vote even if
they cannot go to the company’s big annual meeting.
Here’s how it usually goes:
a. Concerned shareholders: Some shareholders, often big investors or groups
that really care about certain issues, aren't happy with how the company is
being managed.
b. Proxy statement: These unhappy shareholders write a detailed paper
(called a proxy statement) explaining why they're upset, what changes
they want, and why. They send this paper to all the other owners.
c. Solicitation of proxy votes: The unhappy shareholders then try to convince
other owners to support their ideas. They might talk directly to people,
send out press releases, or use other ways to get their message across.
d. Proxy vote: Owners who can't go to the big annual meeting have a way to
vote from afar (proxy vote). In a proxy fight, the unhappy shareholders try
really hard to get as many votes as possible to back up their plans.
e. Annual meeting: Whether the proxy fight works or not depends on how
many votes the unhappy shareholders get. If they get enough support,
they might get to pick new leaders or make other big changes.
Proxy fights are usually not friendly, and they need a lot of money and legal help.
They're a way for owners to have a say in how the company is run when they feel the
current leaders aren't doing a good job representing everyone's interests.
19. Takeover
A takeover is when one company takes control of another. It's like a strategic move
in business where a company, called the acquiring company, gets a big part or all of
another company, known as the target company. The acquiring company can do this
by buying the shares of the target company, talking about a merger, or doing other
money-related deals.
Takeovers can be friendly or not so friendly:
Friendly Takeover
In a friendly takeover, both companies agree on the deal. The people in charge of the
target company are okay with being taken over, and they work together with the
acquiring company to figure out how it will happen.
Hostile Takeover
In a hostile takeover, the people running the target company don't want to be taken
over. But the acquiring company still tries to get control, sometimes by talking
directly to the owners of the target company.
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Companies might want to take over another company for different reasons, like
wanting to grow in the market, save money by working together, become more
efficient, or get access to new technologies or markets. The whole process involves a
lot of careful checking, getting approval from regulators, and talking things out
between the companies. It's important to know that takeovers can bring big changes
to the companies involved, their workers, and how business works in general.

20. Repurchase agreement

A repurchase agreement, commonly known as a repo, is a financial transaction in
which one party sells an asset (typically securities) to another party with a
commitment to repurchase the same or similar asset at a later date. Repurchase
agreements are essentially short-term collateralized loans, often used in money
markets to manage short-term liquidity needs.
Here's how it usually works:
1. Getting Started: One party (let's call them the borrower) agrees to sell
something valuable, like stocks or bonds, to another party (the lender). But,
there's a promise to buy it back at an agreed-upon price on a specific future
date.
2. Backing it Up with collateral: The valuable thing being sold becomes
collateral. It's like a safety net for the lender. If the borrower can't buy back
the item, the lender can sell the collateral to get their money back.
3. Quick Terms and Interest; This deal is short and sweet, usually lasting only a
few days or weeks. Both parties agree on an interest rate (called the repo
rate) as a little bonus for the lender letting the borrower use their money.
4. Common in Money Markets; Big players in finance, like banks and investment
firms, use these agreements to handle their quick money needs. Even central
banks use repos to manage the country's money situation.
5. Playing it Safe; Repos are seen as pretty safe because there's collateral
involved. If things go wrong, the lender can sell the collateral to cover the
costs. Still, like any money deal, there are some risks, especially if the value of
the collateral changes.
6. Big role in finance ; In simple terms, a repurchase agreement is like a short-
term money exchange where one side sells valuable things and promises to
buy them back later. It's a handy tool for handling quick money situations, and
it's considered pretty safe because there's a backup plan with the collateral.

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21. Information asymmetry:

It refers to a situation where one party in a transaction or relationship possesses
more or better information than the other party. This imbalance in access to
information can lead to a variety of issues and challenges in different contexts, such
as markets, negotiations, or contractual agreements.
In simpler terms, it's a scenario where one side knows more than the other, and this
difference in knowledge can impact the dynamics and outcomes of their interaction.
This concept is particularly relevant in economics, finance, and business, where the
availability and quality of information can significantly influence decision-making and
outcomes.

22. Line of credit (LOC)

It is a flexible borrowing arrangement provided by banks and financial institutions,
offering individuals or businesses access to a predetermined pool of funds for
borrowing and repayment as needed. Key features of a line of credit include:
a. Pre-approved Limit: Upon establishing a line of credit, the lender approves a
maximum borrowing amount known as the credit limit. This limit is
determined based on factors such as creditworthiness, income, and financial
history.
b. Revolving Credit: A line of credit operates as revolving credit, allowing
borrowers to repeatedly borrow and repay funds within the specified credit
limit. Repaying borrowed amounts replenishes the available credit, enabling
further use.
c. Interest Charges: Interest is typically applied only to the borrowed amount,
not the entire credit limit. The interest rate may be variable or fixed,
depending on the terms of the line of credit.
d. Access to Funds: Borrowers can access funds from their line of credit through
various means, such as checks, online transfers, or a linked credit card. This
flexibility facilitates effective cash flow management and addresses short-
term financial needs.
e. Purpose of Use: Lines of credit can serve diverse purposes, including covering
unexpected expenses, managing business working capital, making purchases,
or navigating income fluctuations.
Minimum Payments: Borrowers are obligated to make minimum monthly payments,
typically covering both principal and interest. However, they retain the option to
repay the entire balance at any time.
Renewal: Lines of credit are often renewable. Consistent payments and good
standing may lead to the renewal or extension of the credit line after a specified
period.
Lines of credit differ from traditional loans by offering increased flexibility in
borrowing and repayment. They are well-suited for situations involving ongoing or
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uncertain fund requirements and are commonly utilized by businesses for working
capital, individuals for personal expenses, or as a financial safety net for unexpected
needs.

23. Private equity

Private equity is an investment approach focused on privately held companies
or assets not traded on public stock exchanges. Managed by private equity
firms, these funds raise capital from institutional and high-net-worth investors
to invest in various private enterprises.
Key features of private equity include:
a. Investment in private Companies; Private equity targets companies not
publicly traded on stock exchanges, ranging from startups and small to
medium-sized enterprises (SMEs) to larger companies transitioning to
private status.
b. Equity Ownership: Investors in private equity acquire equity ownership in
the companies they support, becoming partial owners with a vested
interest in the company's success.
c. Active Managenment: Private equity firms often play an active role in
managing and enhancing the performance of their invested companies.
This involvement includes providing strategic guidance, implementing
operational improvements, and facilitating financial restructuring.
d. Long-term perspective: Private equity investments typically involve a
longer time horizon compared to public market investments. Investors
may need to wait several years for returns as the private equity firm works
to increase the value of its portfolio companies.
e. Leverage: Private equity transactions frequently incorporate leverage,
where a significant portion of the investment is funded through debt.
While this can amplify returns if successful, it also introduces higher risk.
f. Exit Strategies: Private equity firms plan exit strategies to realize returns.
Common methods include selling the company to another business,
conducting an initial public offering (IPO), or selling to other private equity
investors.
g. Diversification: Private equity offers investors a way to diversify their
portfolios by providing exposure to different investment opportunities
compared to publicly traded stocks and bonds.
It plays a vital role in financing and developing companies, particularly those
requiring capital for expansion, restructuring, or turnaround. Despite the potential
for attractive returns, private equity involves higher risks and is typically considered
suitable for sophisticated investors with a long-term investment horizon.

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24. Spin-off and Carve-out

Spin-Off:
Definition: A spin-off occurs when a parent company separates a subsidiary or
business unit, creating an independent, standalone entity. This new entity
operates autonomously with its own management, financial structure, and
operations.
Ownership: Shareholders of the parent company typically receive shares in the
newly formed spin-off, making them direct stakeholders in both entities.
Objective: Spin-offs are usually undertaken to unlock value, sharpen strategic
focus, and enable each entity to pursue its goals independently.
Carve-Out:
Definition: A carve-out involves selling a minority interest in a subsidiary or
business unit while the parent company retains control. The majority
ownership remains with the parent company.
Ownership: The parent company retains a substantial ownership stake in the
carved-out entity, while a minority stake is often sold to external investors,
frequently through an initial public offering (IPO).
Objective: Carve-outs are commonly executed to raise capital, realize the
value of a subsidiary, or allow the carved-out entity to operate with increased
autonomy while still benefiting from the support and resources of the parent
company.
In summary, a spin-off establishes a fully independent entity with separate
ownership, whereas a carve-out involves selling a portion of a subsidiary while
maintaining control. Both strategies are utilized by companies to streamline
their corporate structure, enhance operational focus, and generate value for
shareholders.

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Overview of Capital Market in Nepal

(Refer class note )

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CAPITAL BUDGETING & INVESTMENT DECISIONS

1. Net Present value and Internal Rate of Return
NPV and IRR Method differ in the following ways :
(1) Under NPV, projects with positive NPV are accepted.
Under IRR, projects whose IRR is more than the cost of project are accepted.
(2) NPV measures both quality and scale of investment.
IRR measures only quality of investment.
(3) NPV provides an absolute measure in quantitative terms.
IRR Provides a relative measure in percentage.
(4) Under NPV, cash flows are re-invested at the rate of cost of capital.
Under IRR, cash flows are re-invested at the rate of IRR.

2. Social Cost Benefit Analysis

Need for Social Cost Benefit Analysis:
• The market price which is used to measure cost & benefit in a project does not
represent social values due to imperfections in market.
• Monetary cost & benefit analysis fails to consider the external positive and
negative effects of a project.
• Taxes and subsidies are transfer payments and therefore are not relevant in
national economic profitability analysis.
• The SCBA is essential for measuring the redistribution effect of benefit of a
project, as benefit going to economically weaker section is more important
than one going to economically fairer section.
• Merit wants are important appraisal criteria for SCBA.

3. Concept of discounted payback period.

Concept of Discounted Payback Period
• Payback period is time taken to recover the original investment from project
cash flows. It is also termed as break even period. The focus of the analysis is
on liquidity aspect and it suffers from the limitation of ignoring time value of
money and profitability.
• Discounted payback period considers present value of cash flows, discounted
at company's cost of capital to estimate breakeven period i.e. it is that period
in which future discounted cash flows equal the initial outflow.
• The shorter the period, better it is. It also ignores post discounted payback
period cash flows.
• It takes care of the time value of money.
4. Desirability factor.
In certain cases we have to compare a number of proposals each involving different
amount of cash inflows. One of the methods of comparing such proposals is to work
out, what is known as the 'Desirability Factor" or 'Profitability Index'. In general

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terms, a project is acceptable if the Profitability Index is greater than 1.

Mathematically,
Desirability Factor= Sum of Discounted Cash inflows .
Initial Cash Outlay or Total Discounted Cash outflows

5. Sensitivity analysis
it is the popular way to find out how the npv of the project changes if sales, labor or
material cost, discount rate or other factors vary from one case to another . it is also
called what if analysis.

6. Payback Reciprocal
As the name indicates it is the reciprocal of payback period. The reciprocal of the
payback would be a close approximation of the internal rate of return if the life of
the project is at least twice the payback period and the project generates equal
amount of the annual cash inflows. The payback reciprocal can be calculated as
follows:

Payback Reciprocal = 1/ Pay back period

Payback Reciprocal Example

A financial analyst is reviewing a possible investment of $50,000, which will generate

positive cash flows of $10,000 per year. The payback period is 5 years, since cash
flows of $50,000 will accumulate over the next five years. The payback reciprocal is 1
/ 5 years, or 20%. The calculated internal rate of return using this reciprocal is 15% if
the assumed cash flow period is 10 years, and reaches 20% only when the assumed
cash flows cover a period of 30 years.

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TREASURY & CASH MANAGEMENT

1.Different kinds of float with reference to management of cash
The term 'float' denotes a delay or lag between two events.
When a firm receives a cheque, there is usually a time gap between the time the
cheque is written and when it is cleared. This time gap is known as 'Float.' In the
context of cash management the term float is usually used for the following delays:

Despatch of finished Goods to Customer

Billing Float

Preparation of Bill or Invoice

Mailing Float

Receipt of invoice by customer

Credit Period

Payment of amount due under the invoice

Mailing Float
Receipt of Cheque (by the Seller)
Cheque Processing Float
Deposit of Cheque in to Bank

Banking Processing Float.

Credit of Cheque by Bank

Measures are adopted to Reduce various Floats in management of Cash:

Float
• Billing float
• Mailing float (Invoice from seller to customer)
• Mailing float (Cheque from customer) Cheque processing float, Banking
processing float
Measures
• Immediate preparation of bill right on the very date of dispatch of finished
goods.
• Sending the invoice by faster means.
• Concentration Banking & Lock Box System
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2.Enumerate the activities which are covered by Treasury Management.

Treasury Department conducts efficient 'management of liquidity and financial risk is
business. Earlier it was viewed as a peripheral activity conducted by back-office, but
today it plays a very vital role in corporate management.
The major functions of treasury department are as follows:
1. Setting up of corporate financial objective:
(i) Financial and treasury policies,
(ii) Financial and treasury systems,
(iii) Financial aims and strategies.
2. Corporate Finance :
(i) Equity capital management,
(ii) Project finance,
(iii) Joint ventures.
(iv) Business acquisition.
(v) Business sales,
(vi) Equity capital management.
3. Liquidity Management:
(i) Working capital management,
(ii) Money management,
(iii) Money transmission management,
(iv) Banking relationships and arrangements.
4. Funding Management:
(i) Sourcess of fund.
(ii) Funding policies,
(iii) Types of funds,
(iv) Funding procedures.
5. Currency Management:
(i) Exposure policies and procedures.
(ii) Exchange regulations.
(iii) Exchange dealings.
6. Other:
(i) Risk management.
(ii) Insurance management.
(iii) Corporate transaction.

3.Forms of Bank Credit

The bank credit will generally be in the following forms:
• Cash Credit: This facility will be given by the banker to the customers by giving
certain amount of credit facility on continuous basis. The borrower will not be
allowed to exceed the limits sanctioned by the bank.
• Bank Overdraft: It is a short-term borrowing facility made available to the
companies in case of urgent need of funds. The banks will impose limits on the
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amount they can lend. When the borrowed funds are no longer required they
can quickly and easily be repaid. The banks issue overdrafts with a right to call
them in at short notice.
• Bills Discounting: The company which sells goods on credit, will normally draw
a bill on the buyer who will accept it and sends it to the seller of goods. The
seller, in turn discounts the bill with his banker. The banker will generally
earmark the discounting bill limit.
• Bills Acceptance: To obtain finance under this type of arrangement a company
draws a bill of exchange on bank. The bank accepts the bill thereby promising
to pay out the amount of the bill at some specified future date.
• Line of Credit: Line of Credit is a commitment by a bank to lend a certain
amount of funds on demand specifying the maximum amount.
• Letter of Credit: It is an arrangement by which the issuing bank on the
instructions of a customer or on its own behalf undertakes to pay or accept or
negotiate or authorizes another bank to do so against stipulated documents
subject to compliance with specified terms and conditions.
• Bank Guarantees: Bank guarantee is one of the facilities that the commercial
banks extend on behalf of their clients in favour of third parties who will be
the beneficiaries of the guarantees.

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MANAGEMENT OF RECEIVABLES
1.Factoring.
(i) Factoring: Factoring is an arrangement between a firm and a financial institution
under which the firm called the borrower receives advances against its receivables
from the financial institution called the factor. In factoring, receivables are generally
sold to the factor. who charges commission and bears the credit risk associated with
the receivables. It is not just a single service but involves provisions of specialised
services relating to:
1. credit investigation.
2. sales ledger management.
3. purchase of debts.
4. collection of debts.
5. credit protection.
6. Provision of finance against receivables and risk bearing, etc.
The borrower selects various combinations of these functions and makes
arrangement with the factor accordingly. The operation of factoring is very simple
and operates in the following way:
1. The borrower enters into an agreement with the factor on suitable terms and
conditions.
2. The factor then selects the account of the customer that would be handled by it.
3. The borrower sells his account receivable to the factor.
4. The factor provide advance against the account receivables after deducting its
commission and fees.
5. The borrower forwards collection from the customers to the factor and settles
the advances received along with interest on advances.
6. If provided in the agreement, the factor provides for the following allied services.
(i) Credit investigation.
(ii) Collection of debt.
(iii) Sales ledger management.
(iv) Credit protection.
(v) Provision of finance against receivables.
Note: The operation of factoring in India is with recourse i.e. in case of default by the
customer the risk is borne by borrower and not the factor

The benefits of factoring are as follows :

1. The receivables gets easily converted into cash.
2. It ensures a definite pattern of cash inflows from credit sales.
3. It eliminates the need for the credit and collection department and in this way
reduces the cost.
4. It provides flexibility to the borrower as he is ensured of the debt return.
5. Unlike an unsecured loan, compensating balances are not required in this case.
1. Factoring may be considered as a sign of financial weakness.
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2. The cost of factoring sometimes tends to be higher than the cost of other forms
of short term borrowing.
3. While evaluating the credit worthiness of a customer by a factor, it may over
look the sales growth aspect.

2.Importance of 'Credit-rating'.
Answer:
After drawing up the credit policy, a firm has to evaluate the credit worthiness of the
individual customer and also the possibility of bad debt. Credit analysis determines
the degree of risk associated with the capacity of the customer to borrow and his
ability and willingness to pay. For this, firm has to ascertain the credit rating of
prospective customers
Credit Rating: Credit rating is to rate the various debtors who seek credit facility.
Credit rating implies taking decisions regarding individual debtors so as to ascertain
the quantum of credit and the credit period.
This would further involve :-
1. Collection of information about the debtor.
2. Decision Tree analysis of credit granting.

Collection of information about the debtor:

The various sources of information are:-
(i) Past Records: Past records of existing customers prove to be a valuable source of
information to find out the credit risk involved,
(ii) Sales man's Report: Very often the firms depend and decide the credit
worthiness of a customer on the basis of the sales man's report. The sales man
ascertains the potential of the customers and reports accordingly,
(iii) Bank References: Sometimes the banks provide the required information about
the customer and decision is taken after analysing such information,
(iv) Trade References: Information about the customer is also collected from the
persons referred by the customer himself. Such persons giving relevant information
about the customer are the trade references.
(v) Credit Bureau Reports: Useful and authentic credit information is also provided
by credit bureaus of specific industries.
(vi) Published Financial Reports: The financials reports i.e. balance sheet, profit &
loss A/c and others when examined can give valuable information about credit
worthiness of a customer.
(vii) List of Government Suppliers: If a customer's name appears in the list of
Government approved suppliers in agencies like DGS & D or any other reputed
agency, it proves the credit worthiness of the customer.

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(viii) Decision tree analysis of credit granting: Once all the credit information about
the customer (both existing and prospective) is gathered, it has to be thoroughly
analysed to arrive at a decision relating to:
(a) Whether or not to grant credit.
(b) If credit is to be granted, then on what terms and conditions.
The five 'C's of credit which provide a framework for evaluating a customer are:
• Character.
• Capacity.
• Capital.
• Collateral.
• Condition.

4.Accounts receivable systems.

Answer:
• Manual systems of recording the transactions and managing receivables are
cumbersome and costly.
• The automated receivable management systems automatically update all the
accounting records affected by a transaction.
• This system allows the application and tracking of receivables and collections
to store important information for an unlimited number of customers and
transactions, and accommodate efficient processing of customer payments
and adjustments.

5.Factoring and Bills discounting

Basis of Difference Factoring Bill Discounting

Meaning It is management of book It is borrowing from

Bank debt commercial
Parties Factors, clients, debtors Drawer, drawee and payee
Also known as Invoice Factoring Invoice Discounting
Applicable Act No specific Act Negotiable Instruments Act

(Best of Luck)
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