End-Term Examination, Spring 2016

_______________________________________________________________________
Course: Corporate Financing Decisions Full Marks: 100
Level: Masters Pass Marks: 60
Program: EMBA, Semester – II Time: 4 hours
_______________________________________________________________________
Candidates are required to give their answers in their own words as far as practicable.
Section A
Attempt any Five questions from Section A (10 X 5 =5)
Q.1 "One of the major issues the managers of the business firms have been facing is
the issue relating to agency relationship". Justify.

Q.2 Indicate whether the following statements are ‘True or False’ and also support
your answer with reasons.

a. The agency problems arise in the business firms due to separation of ownership.
b. Cost of capital is the interest rate at which the firm borrowed the debt capital.
c. Leasing an asset is the alternative source of financing.
d. Receivable financing is a source of long term fund.
e. Repurchase of own shares is an alternative form of dividend.

Q.3 A firm needs Rs 1 million at the end of 10 year from now to replace the existing
machine. In order to have the required fund, the firm is planning to create a fund
contributing a fixed sum of money starting one year from now which earns 12
percent interest annually.

a) What annual amount of contribution should be there to have the required

fund of Rs 1 million?

b) If the firm is thinking of investing single sum today itself instead of

contributing annually to have 1 million at the end of 10 year, what amount
must be deposited at the same interest rate?

c) Instead of depositing annually, if the firm is thinking of depositing

monthly where the interest will be accumulated monthly at the same rate,
what monthly installment should be that?

Q.4 A share of ABC Company is selling for Rs 600 in the market which had just paid
dividend of Rs 20 per share. The dividend is expected to increase by 25 percent
for the coming 2 years then after it is expected to decrease to 20 percent and will

1
 last for next 2 years. The dividend growth rate is expected for the fifth year is 10
percent and will continue for indefinite period. If the required rate of return of the
investors is 15 percent, will it be profitable to hold it at the current price?

Q.5 A Company estimates that as a result of the seasonal nature of its business, it will
require additional Rs 2 million of cash for 2 months of June and July. The
company has the following four alternatives for raising the needed funds.

i) Establish a 1-year line of credit for Rs 2 million with a commercial bank.

The commitment fee will be 0.5 percent per year on the unused portion,
and the interest charged on the used funds will be 10 percent per year.
Assume that the funds are needed only for 2 months.

ii) Forego the trade discount of 2/10 net 70, on Rs 2 million of purchases.

iii) Issue Rs 2 million of 60-day commercial paper at an 12 percent annual

interest rate. The total transaction fee, including a cost of a backup credit
line, on using commercial paper is 0.6 percent of the amount of the issue.

iv) A bank loan can be arranged for the needed fund at 10 percent discount
interest with 20 percent compensating balance of the loan.
Required:
Suggest which is the cheapest alternative for the financing the required
funds showing the cost of each alternative both in rupees and rate.

Q.6 A certain company plans to raise an additional Rs 10 million in new capital during
the coming year to defray the cost of new capital expenditures. The company’s
present financial structure consists of Rs.10 million in 8 percent bonds and
100,000 shares of common stock with a current market price of Rs.100 per share.
The company has the three alternative financing plans in mind (assume no
retained earnings will be available).
Plan A:100 percent common stock
Plan B: 50 percent 12% bonds having the maturity period of 10
years and rest through equity.
Plan C: 100 percent through the bond specify in Plan B
a) Calculate company’s EPS for each financing plan for EBIT level of Rs 2.5
million. The company pays taxes at a rate of 40 percent.
b) Determine the indifference point between plans A and B, A and C, and B and C.
c) On the basis of the information gained in (b), which plan should the company
select? Why?

2
Q.7 A manufacturing Co. needs Rs 2 million. The financial manager is considering
two methods of obtaining this fund: a loan from a commercial bank or a factoring
arrangement. The bank charges 15 percent per annum interest on discount basis. It
also requires a 20 percent compensating balance. The factor is willing to purchase
Co’s account receivables and to advance the invoice amount less a 2 percent
factoring commission on the invoices purchased each month. (All sales are on 30-
day terms). A 20 percent annual interest rate will be charged on the invoice price
and deducted in advance. Also, under the factoring arrangement, Co. can
eliminate its credit department and reduce credit expenses by Rs 5,000 per month.
Bad debt losses of 2 percent on the factored amount can also be avoided.
Required:
i) How much should the bank loan be in order to net Rs 2 million? How
much account receivable should be factored to net Rs 2 million?

ii) What are the computed interest rates and the total annual rupee costs,
including credit department expenses and bad debt losses, associated with
each financing arrangement?

Section B

Attempt any TWO questions from section B (25 X 2 =50)

Q.8 A large-sized chemical company is considering investing in a project that costs Rs

1 million. The estimated salvage value of the project is zero. The tax rate is 40
percent and the cost of capital has been estimated at 12 percent. The company
uses straight line depreciation using 5-year life and the proposed project has Cash
flow before tax (CFBT) as follows:

Year CFBT
1 Rs 400,000
2 500,000
3 650,000
4 250,000
5 450,000
Determine the following:
i) Pay back period
ii) Net present value
iii) Internal rate of return and Modified Internal Rate of Return
iv) Profitability Index

3
Q.9 A Hydro-power Co. is considering acquiring a machine with an expected life of 5
years, costing Rs 5 million including installation and transportation. The
Company has two options whether to borrow and buy on a 10 percent loan from a
commercial bank to be amortized over 5 years or lease the same for five years at a
annual lease payment to be paid at the end of each year. The estimated salvage
value of the equipment is Rs 500,000. The lessor agrees to lease them at a lease
payment that, because of competitive factors, yields an after-tax return to the
lessor of 10 percent. The lease contract stipulates that the lessor will maintain the
machine at no additional charge to Company. If company buys the machine, it
would require spending Rs 100,000 per year to maintain the machine. The
depreciation is to be provided based on the straight line method and Company’s
marginal tax rate is 40 percent.
Required:
a. Competitive annual lease rent
b. Cost of buying
c. Cost of leasing
d. Recommend whether the machine should be leased or purchased.

Q.10 A company is considering whether to refund Rs 10 million, 16 percent coupon,

25-Year bond issue that was sold 5 years ago. Company has been amortizing Rs 1
million of flotation costs associated with the existing bond over the issue's 25-
year life. Co's management is expecting that the company could sell a new, 20-
year issue at an interest rate of 12 percent in today's market. A call premium of 10
percent would be required to retire the old bond and the flotation costs on the new
issue would amount to Rs 0.5 million. Co's corporate tax rate is 30 percent. The
new bond would be issued 2 month before the old bonds are called, with the
proceeds being invested in short-term-government securities returning 8 percent
annually during the interim period. You are called by the management to give
your suggestion regarding the refunding decision of the existing bond.

All the Best!