Financial Management & Corporate Finance: Tools, Decisions & Applications

TAKEAWAYS:

• Corporate finance bridges investment decisions (capital budgeting), financing decisions (capital structure), and dividend policy to optimize firm value.
• The Weighted Average Cost of Capital (WACC) is the discount rate for all projects, calculated by blending cost of debt, equity, and preferred stock.
• Dividend policies (stable, residual, or hybrid) impact stock prices and shareholder returns—Nepal’s NEPSE-listed firms often use stable dividends to attract retail investors.
• Working capital management (inventory, receivables, payables) directly affects a firm’s liquidity—e.g., Daraz’s just-in-time inventory reduces holding costs but increases financing needs.
• Financial distress and agency problems (conflicts between managers/shareholders) are real risks in Nepali SMEs, where family-owned businesses dominate.
• Corporate governance (board independence, transparency) is critical for firms like NMB Bank or NTC to attract institutional investors.

1. Core Concepts: What Is Corporate Finance?

Corporate finance is the art and science of managing a firm’s financial resources to achieve its goals. It focuses on three key areas:

1. Capital Budgeting: Deciding which long-term projects to fund (e.g., expanding a Kathmandu retail shop’s warehouse).
2. Capital Structure: How to finance these projects (debt vs. equity).
3. Working Capital Management: Day-to-day financial operations (cash, inventory, credit).

Why it matters:

• Poor capital structure choices (e.g., excessive debt) led to the 2001 financial crisis in Nepal, where many banks collapsed due to non-performing loans.
• Firms like Ncell use corporate finance to balance growth (new 5G infrastructure) with debt sustainability.

2. Capital Structure: The Debt-Equity Mix

Key Definitions

How It Works: The Trade-Off Theory

Firms balance two forces:

1. Tax Shield Benefit: Debt is cheaper than equity (interest is tax-deductible).
2. Financial Distress Cost: Too much debt increases bankruptcy risk (e.g., Global IME’s 2019 collapse due to high leverage).

Visual: Optimal Capital Structure

3. Calculating the Cost of Capital (Worked Example)

Problem: Garudnahani Company issues a zero-coupon bond with:

• Maturity = 10 years
• Current price = Rs 500
• Par value = Rs 1,000
• Corporate tax rate = 40% Calculate the after-tax cost of debt.

Step-by-Step Solution

1. Find the yield to maturity (YTM) for the bond (cost of debt before tax): $$500=\frac{1000}{(1+r{)}^{10}}⟹r=4.14\%$$ (Use financial calculator or Excel: =RATE(10,0,-500,1000))

2. Adjust for taxes: $$\text{After-tax cost of debt}=r\times (1-T)=4.14\%\times 0.60=2.48\%$$

Real-World Tie-In:

• NMB Bank’s 2023 bonds had a similar structure. Their after-tax cost of debt (~3.5%) helped them offer cheaper loans to SMEs.

4. Dividend Policy: How Firms Return Cash to Shareholders

Dividends are cash payments to shareholders. Three common policies:

Visual: Dividend Policy Impact on Stock Price

Trade-off: High dividends please current shareholders but may limit reinvestment.

5. Working Capital Management: Keeping the Engine Running

Working capital = Current Assets – Current Liabilities. Key Decisions:

1. Inventory Management: Balance holding costs vs. stockouts.
   • Example: Daraz uses just-in-time (JIT) inventory to reduce warehouse costs but relies on fast suppliers.
2. Accounts Receivable: Credit terms affect cash flow.
   • Example: Pathao drivers get paid within 3 days, while NTC’s corporate clients get 30-day credit.
3. Accounts Payable: Delaying payments to improve cash flow (but risks supplier relations).

Visual: Working Capital Cycle

flowchart TD
    A["Cash"] -->|"Purchases"| B["Inventory"]
    B -->|"Sales"| C["Accounts Receivable"]
    C -->|"Collections"| A
    D["Accounts Payable"] -->|"Payments"| A

Goal: Minimize the cycle without hurting operations.

6. Financial Planning and Pro Forma Statements

Firms use pro forma financial statements to forecast future performance.

Example: Kathmandu Retail Shop’s Pro Forma Income Statement

Key Takeaways:

• Sales growth drives profit.
• Interest expense rises with debt.
• Retained earnings fund future expansion.

7. Agency Problems and Corporate Governance

Agency Problem: Conflict between shareholders (owners) and managers (agents).

• Example: A CEO might take a golden parachute (Rs 50M exit package) while workers lose jobs.
• Solutions:
  • Board Independence: NMB Bank has 40% independent directors.
  • Performance-Based Incentives: Link CEO pay to stock price (e.g., Nepal Investment Bank’s ESOP scheme).
  • Transparency: NEPSE-listed firms must disclose financials quarterly.

Visual: Agency Costs

8. Financial Distress and Bankruptcy

When a firm can’t meet obligations, it faces:

1. Technical Insolvency: Can’t pay debts as they come due (e.g., Global IME, 2019).
2. Accounting Insolvency: Book value of liabilities > assets.
3. Bankruptcy: Legal process to liquidate or restructure (e.g., Nepal’s 2001 banking crisis).

Prevention Strategies:

• Debt Covenants: Restrict excessive leverage (e.g., NTC’s debt-to-equity < 2:1).
• Diversification: Reduce risk (e.g., NMB Bank’s mix of retail/corporate loans).
• Contingency Planning: Emergency liquidity (e.g., Nepal Rastra Bank’s liquidity support).

In the Real World

1. eSewa’s Capital Structure:

   • Debt: Rs 200M loan from NMB Bank (2023) for digital expansion.
   • Equity: Raised Rs 100M via private investors (e.g., Ant Group).
   • WACC Impact: Lower cost of debt (6% after tax) vs. equity (15%) helps fund growth.

2. Khalti’s Dividend Policy:

   • No dividends yet (retains all earnings for fintech scaling).
   • Residual policy: Invests in AI fraud detection before paying shareholders.

3. NTC’s Working Capital Management:

   • Inventory: Minimal (no physical stock; digital billing).
   • Receivables: 30-day credit to corporates → Rs 5B tied up in 2023.
   • Payables: Delays vendor payments by 60 days to save cash.

4. Nepal Investment Bank’s Agency Solution:

   • ESOP Scheme: Gives employees stock options to align interests with shareholders.
   • Independent Audit: Mandatory for NEPSE-listed firms to reduce fraud.

Exam Tip

1. Memorize WACC Formula: $$\text{WACC}=\left(\frac{E}{V}\times Re\right)+\left(\frac{D}{V}\times Rd\times (1-T)\right)$$

   • Exam trick: Always reconcile E + D = V (total value).

2. Dividend Policy Questions:

   • Compare stable vs. residual policies with real examples (e.g., Everest Bank vs. Daraz).
   • Know the dividend irrelevance theory (Miller-Modigliani) vs. bird-in-hand theory.

3. Working Capital Traps:

   • Over-trading: Sales grow faster than cash flow (e.g., Kathmandu’s 2020 inventory glut).
   • Under-trading: Excess cash hoarding (e.g., Nepal’s SMEs holding 30% idle cash).

4. Agency Problems:

   • Link to Nepal’s corporate governance scandals (e.g., Nepal Bank’s 2018 fraud).
   • Solutions: Board independence, audits, performance-linked bonuses.

5. Numerical Questions:

   • Always show all steps (e.g., YTM calculation, WACC breakdown).
   • Use real numbers (e.g., NPR, NEPSE returns) to avoid memorization.

Final Visual: The Corporate Finance Cycle