Corporate Finance Likely exams Questions and Answers

Nassarawa State University, Keffi

                                                    Faculty of Administration 

                                            Department of Business Administration 

                                            Course:  Corporate Finance  (Bus 813)

                                       Corporate Finance Likely exams Questions and Answers

Question 1

a. In relations to dividend theory, explain briefly (i) bird in hand approach (ii) home-made dividend and (iii) clientele effect 

b. Dividend irrelevancy theory is relevant.  Discuss this argument in relation to the theories 

c. Explain the forms of dividend 

Solution to a:

Bird in Hand Approach:  The bird-in-hand theory says investors prefer stock dividends to potential capital gains due to the uncertainty of capital gains. The theory was developed as a counterpoint to the Modigliani-Miller dividend irrelevance theory, which maintains that investors don't care where their returns come from.

Home-made dividend: What Are Homemade Dividends? Homemade dividends are a form of investment income generated from the sale of a portion of an individual's investment portfolio. These assets differ from the traditional dividends that a company's board of directors distributes to certain classes of shareholders.

Clientele Effect: The clientele effect is a change in share price due to corporate decision-making that triggers investors' reactions. A change in policy that is viewed by shareholders as unfavorable may cause them to sell some or all of their holdings, depressing the share price

Solution to b:

Dividend irrelevancy theory is relevant:  Modigliani and Miller's dividend irrelevancy theory states that dividend patterns have no effect on share values. Broadly it suggests that if a dividend is cut now then the extra retained earnings reinvested will allow futures earnings and hence future dividends to grow.

Solution to b:

Explain the forms of dividend:

i. Cash Dividend: Cash dividends are the most commonly used dividend type. In this type of dividend, the dividend amount is paid by transferring a sum of money. The money can be transferred electronically or through cash and check. When the company declares the dividend, then all the shareholders existing on the date specified by the company are eligible to receive the payment of dividend before the company makes a payment; the company must arrange enough cash to pay off the dividends.

ii. Stock Dividend:  Stock dividends refer to the dividend which is paid by allotting a certain number of shares to the existing shareholders without taking any kind of consideration. The stock dividend is treated differently in two different cases where; the first case is when the company issues less than 25 % of the outstanding shares, then it is treated as a stock dividend, but if the issue is more than 25% of the outstanding number of share, then the same is treated as stock split and nit stock dividend.

iii. Scrip Dividend: A scrip dividend is the type of dividend issued by the company in which the company gives transferrable promissory notes which promise to pay the shareholders the amount of dividend on some later date. The notice issued may or may not be interest-bearing.

iv. Property Dividend: Property dividend is paid using non-monetary items such as assets, inventories, etc., rather than directly paying cash. The company pays this dividend when the company does not have enough cash reserves to pay off dividends. The company has to record this distribution at the fair market value of the asset, and the difference between the fair market value and the asset’s book value is recorded as gain/loss.

v. Liquidating Dividend: The liquidating dividend is the dividend declared by the company usually when the company is in liquidation and the directors decide to pay back to the shareholders their original contribution towards the capital of the company.

Question 2

a. Explain the concept of profit maximization and the criticisms that led to the consideration of wealth maximization as the primary objective of finance 

b. Discuss the roles that financial managers perform in a corporate firm

Solution to a: 

Concept of Profit Maximization:  Profit maximization is considered as the goal of financial management. In this approach actions that increase the profits should be undertaken and the actions that decrease the profits are avoided. The term 'profit' is used in two senses.

• The main focus of profit maximization is on increasing the profit of the company while wealth maximization deals in raising the value of stakeholders in the company. The profit maximization theory is centered around the profit motive while wealth maximization looks at the wellbeing of all stakeholders.

• The risk and its effects on financials of the company are a core part of the wealth maximization process, while there is no focus on risk in the profit maximization theory. Therefore, in practice, profit maximization is not a complete theory in itself while wealth maximization is much more cohesive and inclusive in nature.

• Profit maximization is actually a concept that is basically related to day-to-day business profits. Wealth maximization is a more complex process of increasing the overall wealth of the company that is reflected in the increased price of shares in the market.

Note − Profit maximization does not cover the risk factors associated with finance and operations but wealth maximization does.

Solution to b:

The roles that financial managers perform in a corporate firm:  Financial managers generally oversee the financial health of an organization and help ensure its continued viability. They supervise important functions, such as monitoring cash flow, determining profitability, managing expenses and producing accurate financial information.

Question 3

What is a Bond?  Enumerate five characteristics of bonds 

Solution to question 3:

A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Some of the characteristics of bonds include their maturity, their coupon rate, their tax status, and their callability. Several types of risks associated with bonds include interest rate risk, credit/default risk, and prepayment risk. Most bonds come with ratings that describe their investment grade.

Question 4

a. Enumerate the classes of investment 

b. Briefly explain payback period, internal rate of retun and net present value 

Solution to 4 a:

Growth investments:  These are more suitable for long term investors that are willing and able to withstand market ups and downs.

 Shares:  Shares are considered a growth investment as they can help grow the value of your original investment over the medium to long term. If you own shares, you may also receive income from dividends, which are effectively a portion of a company’s profit paid out to its shareholders.

Of course, the value of shares may also fall below the price you pay for them. Prices can be volatile from day to day and shares are generally best suited to long term investors, who are comfortable withstanding these ups and downs. Also known as equities, shares have historically delivered higher returns than other assets, shares are considered one of the riskiest types of investment.

 Property:  Property is also considered as a growth investment because the price of houses and other properties can rise substantially over a medium to long term period.  However, just like shares, property can also fall in value and carries the risk of losses. It is possible to invest directly by buying a property but also indirectly, through a property investment fund.

Defensive investments:  These are more focused on consistently generating income, rather than growth, and are considered lower risk than growth investments.

Cash: Cash investments include everyday bank accounts, high interest savings accounts and term deposits. They typically carry the lowest potential returns of all the investment types. While they offer no chance of capital growth, they can deliver regular income and can play an important role in protecting wealth and reducing risk in an investment portfolio.

Fixed interest:  The best known type of fixed interest investments are bonds, which are essentially when governments or companies borrow money from investors and pay them a rate of interest in return.

Bonds are also considered as a defensive investment, because they generally offer lower potential returns and lower levels of risk than shares or property. They can also be sold relatively quickly, like cash, although it’s important to note that they are not without the risk of capital losses.

Solution to 4 b:

Payback period: The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point. Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.

Internal Rate of Return: The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does

Net Present Value:  Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment,” says Knight. In practical terms, it's a method of calculating your return on investment, or ROI, for a project or expenditure