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

Question 5:

Why do you think investment decisions are important to firms?

Solution to 5:

In organizations, investment decisions are crucial for growth and profitability—impact cash flows—have a long-term impact as many of these decisions are irreversible. Even with limited funds, individuals can obtain impressive returns if the investment is well-planned. A firm's decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm.

Question 6:

a. Critique the usual assumption made in Corporate Finance Literature that the objective of a company is to maximize the wealth of its shareholders. 

b. What potential problems might arise when management of a company is separated from ownership and how could this be resolved. 

Solution to 6 a:

The view that firms (managers) behave as if their goal is to increase shareholder wealth is the shareholder-wealth-maximization principle. While many might agree this principle governs managerial behavior, it continues to arouse intense scrutiny, adoration, and condemnation. We begin by summarizing the economic rationale behind and the welfare consequences of managers pursuing this principle. Numerous writings articulate the principle, including the influential Friedman (1970) and Jensen (2001). Friedman (1970) encapsulates the principle by imploring managers as shareholders’ agents to “conduct the business in accordance with their desires, which will generally be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

The argument that managers should seek to increase shareholder wealth begins with the premise that the society’s resources are scarce. Judicious use of scarce resources implies that resources should be directed toward higher net-value activities. If prices measure opportunity costs and benefits, the net value of an activity can be determined by subtracting the price of resources devoted to an activity from the sales revenues generated by the activity. Because a given activity might involve a multi-period commitment, employing resources that can be used for multiple periods (e.g., plant, property, and equipment), a net present value calculation is often necessary to compare cash inflows and outflows occurring in different periods. This net present value corresponds to the effect of the project on its owner’s wealth. These arguments render the following proposition: Judicious use of society’s resources implies each project’s owners maximize the value of their projects.

Notwithstanding this argument, the shareholder-wealth-maximization principle has been the subject of criticism from many economists, social activists, prominent business executives, and politicians. We divide this objection into four more specific criticisms:

Solution to 6 b:

Separation is, however, not without its disadvantages. These may include slower decision-making and reduced flexibility and agility when responding to change, as well as the principal-agent problem, which occurs when conflicts of interest or incentive arise between those who operate and manage the business The so-called "divorce between ownership and control" happens when the owners of a business do not control the day-to-day decisions made in the business. For example, the majority of shareholders in public companies are not involved in any way with operational decision-making by the companies in which they have invested.

Ownership and Control of a Business:  The owners of a company normally elect a Board of Directors to control the business's resources for them. Often in smaller firms, there is no difference between the Directors and the Shareholders - they are the same person or people. However, when the share ownership of the business becomes more widespread (for example when shares are sold to external investors) the original owners of the business sacrifice some of their control.

Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business. This may lead to conflict between them as different shareholders can have varying objectives. This is known as the principal agent problem.

Dealing with the Divorce between Ownership & Control:  Strategies to deal with the potential conflict between shareholders and managers include:

Ensuring that financial rewards and incentives offered to managers are aligned with shareholder holder interests - e.g. based on the share price, dividends, profits achieved

Implementing suitable corporate governance procedures to ensure shareholders are protected as far as possible (e.g. through non-executive directors, management remuneration committees)

Company legislation ensuring that Directors are accountable for their actions to shareholders.

Question 7:

When it comes to project appraisal, why do small firms in particular find the payback period attractive?

Solution to 7:

The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it's how long it takes for the cash flow of income from the investment to equal its initial cost. This is usually expressed in years. Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting. An investment with a shorter payback period is considered to be better, since the investor's initial outlay is at risk for a shorter period of time. The calculation used to derive the payback period is called the payback method. The payback period is expressed in years and fractions of years.

Question 8

Write short notes on the following sources of finance:

a) Commercial Paper

b) Factoring 

c) Leasing 

d) Venture Capital 

e) Preference share 

Solution to 8:

a) Commercial Paper: Commercial paper is an unsecured form of promissory note that pays a fixed rate of interest. It is typically issued by large banks or corporations to cover short-term receivables and meet short-term financial obligations, such as funding for a new project.

b) Factoring: Factoring is a type of finance in which a business would sell its accounts receivable (invoices) to a third party to meet its short-term liquidity needs. Under the transaction between both parties, the factor would pay the amount due on the invoices minus its commission or fees.

c) Leasing: Leasing is a major corporate financing strategy used across a wide range of businesses and sectors. At its simplest, a lease is a deal made between two parties, the lessee and lessor, over the use of an asset.

d) Venture Capital: Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions

e) Preference  Shares: Preference shares, more commonly referred to as preferred stock, are shares of a company's stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders.

Question 9:

a) Describe briefly three methods by which a company can raise funds in the capital market

b) State three advantages and three disadvantages for a private company seeking quotation on a stock exchange 

Solution to 9 a:

Retained earnings, debt capital, and equity capital are three ways companies can raise capital. Using retained earnings means companies don't owe anything but shareholders may expect an increase in profits. Companies raise debt capital by borrowing from lenders and by issuing corporate debt in the form of bonds.

Solution to 9b:

Advantages:

i. Creates a market valuation for the business and enables the opportunity to raise capital for expansion, as well as the possibility of realising some of your investment.

ii. Provides access to an acquisition currency and transparency around the value of the business. Listed companies often use their shares, as opposed to cash, to make acquisitions. 

iii. Encourages employee commitment by rewarding them with something of clear value. 

iv. Creates a heightened public profile and improves the ability to attract high calibre board members. 

v. Improves supplier, investor and customer confidence and improves your standing in the marketplace..

Disadvantages: 

i. Accountability and scrutiny. Public companies are public property. As such they are expected to comply with the rules of the markets they populate. 

ii. Undervaluation risk. Issuing shares is not only dilutive but shares can also lack liquidity. This can undermine fundraising and acquisition activity, because there is a lack of demand for the shares. In addition, a lack of demand normally translates into a low share price, so the use of shares as an acquisition currency may also lose its appeal. On the public markets, companies” share prices are not only affected by their own performance, but by the performance of the market and the economy as a whole. 

iii. Cost. The amount of management time and the significant costs associated with a flotation and ongoing listing should never be underestimated. From the process of flotation itself, which can take many months, to the time-consuming administration of regular and constant announcements (interim and final financial results, director dealings in shares, trading updates etc.) there is a lot of activity to manage. It’s quite hands on, labour intensive and time consuming,” says Dr Basirov. So it’s not suitable for every business.

Question 10: 

a) Over the years, share prices of listed companies seem to reflect dividend announcement.  Discuss briefly the factor that influence the dividend policy of a publicly quoted company 

Solution to question 10:

A firm's dividend policy refers to its choice of whether to pay shareholders a cash dividend, how large the cash dividend should be, and how frequently it should be distributed. In a broader sense, dividend policy also encompasses decisions such as whether to distribute cash to investors via share repurchases or specially designated dividends rather than regular dividends, and whether to rely on stock rather than cash distributions. The firm's dividend policy includes two basic components. First, the dividend payout ratio indicates the amount of dividends pay relative to the company's earnings. The second component is the stability of the dividends over time. The expected dividend payout is influenced by many factors such as after tax earnings, availability of cash, shareholders expectation, expected future earnings, liquidity, leverage, return on investment, industry norms as well as future earnings.

Question 11:

What factors that determine the working capital needs of a firm?

Solution to 11:

Factors that determine the working capital needs of a firm 

The Operating Cycle:  The operating cycle is essentially the amount of time it takes your company to invest capital, produce goods or services, and then transform them into revenue. It could be monthly, quarterly, yearly, or an even longer timeline. Understanding the length of the operating cycle gives you an indication of how much capital you need to sustain momentum and how long you have to wait before that initial investment returns as revenue.

The Sales Cycle:  Working capital needs can change throughout the year depending on the seasonality of the business. For example, if sales surge around the holidays, the company probably needs to have the most capital on hand in the spring or summer so they can begin stockpiling inventory. The company can expect to have a lot of capital on hand right after the holiday sales seasonLong-Term Goals

Individual Requirements:  Some businesses need more working capital than others because they have to pay specialized taxes, work on extended payment schedules, comply with new regulations, or update technology regularly. As suggested earlier, every business faces unique circumstances that affect how much working capital it needs. Keep in mind that these circumstances can change as companies grow, move into new territory, or adopt new strategies.

Tracking Working Capital through Financial Reporting:  Quantifying your working capital needs is just the first step. More important is tracking how much working capital is on hand while constantly reevaluating how much is necessary. Traditional financial reporting methods don’t make it easy to track this and other financial KPIs or to trust that the data is complete and current. As a result, many companies are quietly struggling to track their working capital as capably as they would like.

Question 12:

Explain the concept of time value of money

Solution to 12 :

Money has time value. In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The difference in the value of money today and tomorrow is referred to as the time value of money.

BONUS:

Meaning of Corporate Finance*

Corporate finance deals with the raising and using of finance by a corporation. It deals with financing the activities of the corporation, capital structuring, and making investment decisions.

Definition of Corporate Finance

Henry Hoagland expresses the view that ‘‘corporate finance deals primarily with the acquisition and use of capital by a business corporation.’’ The term corporate finance also includes financial planning, the study of capital market, money market, and share market. It also covers capital formation and foreign capital. Even financial organizations and banks play a vital role in corporate financing.

Importance of Corporate Finance

1) Helps in decision making

Most of the important decisions of business enterprises are determined on the basis of the availability of funds. It is difficult to perform any function of a business enterprise independently without finance. Every decision in the business is needed to be taken keeping in view of its impact on profitability.

2) Helps in raising capital for a project

Whenever a business firm wants to start a new venture, it needs to raise capital. A business firm can raise funds by issuing shares, debentures, bonds or even by taking loans from the banks.

3) Helps in Research and Development

Research and Development must be undertaken for the growth and expansion of business. Detailed technical work is essential for the execution of projects. Research and Development is a lengthy process and therefore funds have to be made available throughout the research work. This would require continuous financial support.

4) Helps in smooth running of business firm

A smooth flow of corporate finance is needed so that salaries of employees are paid on time, loans are cleared on time, raw material is purchased whenever required, sales promotion of existing products is carried out smoothly and new products can be launched effectively.

5) Brings co-ordination between various activities

Corporate finance plays a significant role in control and coordination of all activities in an organization. For e.g. Production will suffer if the finance department does not provide adequate finance for the purchase of raw materials and meeting other day-to-day financial requirements for smooth running of production unit. Due to this, sales will also suffer and consequently, the income of concern, as well as the rate of profit, will be affected. Thus the efficiency of every department depends upon effective financial management.

6) Promotes expansion and diversification

Modern machines and modern techniques are required for expansion and diversification. Corporate finance provides money to purchase modern machines and technologies. Therefore finance becomes mandatory for expansion and diversification of a company.

7) Managing Risk

Company has to manage several risks, such as sudden fall in sales, loss due to natural calamity, loss due to strikes, etc. The company needs financial aid to manage such risks.

8) Replace old assets

Assets such as plants and machinery have become old and outdated over the years. They have to be replaced by new assets. Finance is required to purchase new assets.

9) Payment of dividend and interest

Finance is needed to pay dividends to shareholders, interest to creditors, banks, etc.

10) Payment of taxes/fees

The company has to pay taxes to the Government such as Income Tax, Goods and Service Tax (GST), and fees to the Registrar of Companies on various occasions. Finance is needed for paying these taxes and fees.