College of Administrative and Financial Sciences

Assignment 1
Corporate Finance (FIN201)
Deadline for students: (13/10/2022@ 23:59)

Course Name: Corporate Finance Student’s Name: SARAH ALDOSSARY

Course Code: FIN201 Student’s ID Number: 200037996

Semester: 1st CRN: 13978
Academic Year: 1443/1444 H, Second Semester

For Instructor’s Use only

Instructor’s Name: Dr. Samreen Akhtar
Students’ Grade: /15 Level of Marks: High/Middle/Low

Instructions – PLEASE READ THEM CAREFULLY

 This assignment is an individual assignment.
 The Assignment must be submitted only in WORD format via the allocated folder.
 Assignments submitted through email will not be accepted.
 Students are advised to make their work clear and well presented. This also includes
filling in your information on the cover page.
 Students must mention question numbers clearly in their answers.
 Late submitted assignments will NOT be entertained.
 Avoid plagiarism; the work should be in your own words; copying from students or
other resources without proper referencing will result in ZERO marks. No
exceptions.
 All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered plagiarism).

Submissions without this cover page will NOT be accepted.

Assignment Questions:

True/False ( Marks- 1 x 5= 5 )

1. If shareholders do not like the policies that management pursues, their

easiest solution is to vote in a different board of directors. ( TRUE )

2. The price at which new shares are sold to investors almost always
exceeds par value. The difference is entered into the company's accounts
as additional paid-in capital, or capital surplus. . ( TRUE )

3. Suppose a firm needs fresh capital, but its management does not want to
give up its controlling interest. The existing shares could be labeled Class
A, and then Class B shares with limited voting rights could be issued to
outside investors. . ( TRUE )

4. When securities are priced fairly, then financing at current market rates is
a positive NPV transaction.  ( FALSE )

5. All large corporations have little debt; it is a necessary condition for

maximizing growth.  ( FALSE )

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Essay Questions: - Marks ( 2.5 x 4 = 10 )
Q-1. List four protective covenants that you might be interested in as a
prospective bondholder. Briefly describe why these would be realistic
bondholder concerns. How would a convertible bondholder decide whether
to exercise his rights of exchange? ( Words- 300 to 400 )

( ANSWER )

the 4 protective covenants :

1- limit the amount of dividends regularly given to owners of common shares. If a

corporation pays dividends on a regular basis, it's likely that shareholders are

withdrawing money from it, and what if the company faces a financial crisis? Due to

the absence of excess capital (retained earnings) after dividend payments to

shareholders, the corporation will be unable to repay the bonds.

2- Keep the company's debt-issuance to a minimum. There are requirements that must

be met before the debt can be raised. Too much debt issuance increases the danger to

the current bond holders. If the EBIT/interest ratio is not maintained, more debt

should either not be issued or should not exceed a specified percentage of the

company's total accessible assets as debt. Existing investors are put in danger if the

amount of debt issued exceeds the required proportion, particularly if the additional

debt is subordinated.

3- the maximum amount of additional pay that employees may receive in the form of

bonuses or stock options. The business's free cash flow is of particular significance to

the bondholders. The corporation will become increasingly cash-strapped as more of

these bonuses are given out, which could pose a risk to bondholders.

4- Limit the amount of stock that shareholders can buy back, as this could be another

way for them to keep the company's excess cash to themselves and distribute

relatively little of it to the bond holders.

5- prohibit the ratings provided by the rating agencies from declining without taking the

necessary action to stop it. The subordinate bonds may default as the ratings decline,

giving them the chance to select the assets for the repayment of their debts. Because

of this, the other bond holders who hold debt that is superior to the subordinate debt

will be less protected should the firm run into financial difficulties because they won't

be able to recover the debts using their preferred assets.

How would a convertible bondholder decide whether to exercise his rights of

exchange?

Since the bonds' issuance, it has been known how many shares of common stock a

convertible bond can be converted into. As a result, calculating the current market value

of the stock by the number of shares that may be obtained by exchanging one bond and

comparing the result to the current value of the bond becomes reasonably simple. The fact

that both the bond and the shares are anticipated to offer cash payouts makes the choice

just a little bit more challenging (interest or dividends). Comparing these anticipated cash

flows may increase or decrease a bondholder's likelihood of exchanging. Of course, the

management might be overjoyed to never have to pay back the principal borrowed. This

might affect how they calculate the exchange ratio at first. It is uncertain if students will

understand the distinction between interest and dividends at this time or that management

may consider convertibles to be a type of automatic stock issuance, but they should be

aware of how to draw the comparison in any case.

Q-2- How do venture capital firms design successful deals? Why it is likely
that venture capital is disbursed in installments, rather than issuing all
necessary funds at once? ( Words- 300 to 400 )

( ANSWER )

Venture capital (VC) is a sort of private equity and financing provided by investors to start-

up enterprises and small businesses with the potential for long-term growth. The majority of

venture capital is often provided by wealthy individuals, investment banks, and other

financial organisations. To make a successful deals there should be :

Excellent Management : Simply said, management is by far the most crucial aspect for astute

investors. VCs invest mostly in the management team's capacity to carry out the company

plan. They are not seeking for "green" managers; rather, they would like leaders who have

developed profitable companies that have provided investors with excellent returns.

Size of the Market: Gaining the interest of VC investors requires proving that the company

will focus on a sizable, addressable market opportunity. VCs typically seek to make sure that

their portfolio companies have a probability of increasing sales worth hundreds of millions of

dollars in order to obtain the huge returns they expect from investments.

Excellent Product with Competitive Advantage : Investors want to put their money into top-

notch goods and services that have a dependable competitive advantage. They look for a

solution to a pressing issue that hasn't already been addressed by competing businesses in the

market. They search for goods and services that clients can't live without because they are

either far superior or far more affordable than anything else on the market.
Evaluation of Risks : It is a VC's duty to assume risk. So it makes sense that they would want

to understand what they are getting into before investing in a young company. VCs will want

to be completely clear about what the business has accomplished and what still needs to be

accomplished as they speak to the founders of the company or read the business plan.

Why it is likely that venture capital is disbursed in installments, rather than issuing all

necessary funds at once?

a) Making payments in instalments lessens the chance that the managers may

mismanage the money. Since they will have less money available at once, they will

need to be more efficient with it and choose investments that have a higher likelihood

of making returns rather than taking on riskier ones.

b) The fact that these businesses could fail at any time and lead VC to lose money makes

investing in them a very hazardous proposition. They therefore invest in the part

rather than everything at once because of the danger involved. Additionally, they set

corporate management targets, and if they meet those milestones, VC funders will

increase their investment. In essence, they are making sure that their investments will

not be wasted.

c) When venture capital is distributed all at once, it is locked into each specific project,

meaning that if the business fails, the venture investor will lose the entire lump sum

sum. As a result, the capital is distributed in instalments to lessen the risk of loss.

d) The capital is distributed by venture capitalists in instalments to minimise the

potential agency issue. If the capital is distributed in one lump sum, the entrepreneur

will feel less obligated to the venture capitalist and less connected to them. As a

result, venture capital is paid out in instalments so that investors feel responsible for

the entrepreneurs' success.

Q-3-

(A)- Calculate the annual value of an interest tax shield under the
assumption that a firm maintains debt at a permanent $1,000,000 level and
rate of 12%. The corporate tax rate is 35%. If there is no chance of
financial distress, how does the value of the firm change as a result of this
debt? 

( ANSWER )

Tax shield = Debt value x Interest rate x Tax

Tax shield = 1000000 x 12% x 35%

Tax shield = $42,000

If there is no chance of financial distress

Change in value due to debt = annual tax sheild / rate of debt.

= 42000/12%

= $ 350,000

SO, the value of firm increases by $350,000 as a result of this debt.

As debt is added to the company's current capital structure, the value of the

company changes. The company can add more projects, and because of the tax

benefits and the generally lower cost of debt than the cost of stock, the cost of

capital also decreases. As the cost of the company's capital is decreased by the

addition of debt, the enterprises become more receptive to projects with

mediocre returns. Debt enhances leverage, broadens the company's asset base,

decreases capital costs, and provides a tax shelter, all of which ultimately raise

the company's worth.

(B)- How are dividends paid and how do companies decide on dividend
payments? Discuss the concept of dividend signaling. ( Words- 250 to 350 )

Dividend signaling is a theory that suggests that a company's announcement of an increase in

dividend payouts is an indication of positive future prospects.

dividends paid through :-

1- Dividends can be thought of as the benefit shareholders receive for holding firm stock.

2. Cash is typically used to pay dividends. The business might even choose to pay stock

dividends in the form of additional shares of stock rather than cash.

3- Dividends are one way that a firm can disperse its profits to its shareholders. Dividends

may be paid annually or quarterly.

4- The most typical way to receive a dividend payment is via a dividend check, although it

can also be made in the form of additional stock or cash. On the day of the scheduled

payment, dividends are paid.

Companies decide on dividend payments by :-

1. Earnings Stability: As opposed to businesses that lack earnings stability, organisations with

stable income may afford to have greater dividend payout ratios.

2- Cash flow: Because dividends are often made in cash, a corporation must take its cash

needs into account before announcing a payout. Lower dividends may be declared by a

corporation that lacks adequate liquidity.

3. The Level of Inflation in the Economy: The level of inflation in the economy and dividend

declaration are both related.

4- Impact on Share Prices: One of the key variables influencing share prices is a company's

choice to declare a dividend. According to the conventional method, the market price of a

share is equivalent to the present value of future dividends.

5- The dividend policies of other companies: A company's dividend payments are also

influenced by the dividend policies of other businesses in the same sector.

6- Growth and reinvestment opportunities: Businesses with significant growth potential

require enormous sums of money. As a result, they will turn to paying lower

dividends while keeping greater profits. However, a firm may declare hefty dividends

if it does not need money right away.

Q-4- Discuss how agency problems can develop between shareholders and
bondholders when the firm is experiencing financial distress. Is there a rule
for finding optimal capital structure? ( Words- 300 to 400 )

The agency issues have existed at every level of a corporation from its inception. Agency

issues continue at every level, whether they involve managers and employees, owners and

bondholders, or both. This issue also introduces the conflict of interest issue, which worsens

when the company experiences financial hardship. Bondholders and stockholders both have a

significant impact on how well a firm operates. They participate actively in the organisation.

The bondholders are the company's creditors, whereas the shareholders are people or

organisations with a legal right to ownership of stock. Stockholders are compelled to take on

riskier projects than bondholders because they have a different relationship to the company

and receive distinct rights and financial benefits. Because bondholders gain from keeping it

safe while stockholders gain from taking risks, there is conflict between shareholders and

bondholders. Because management acts as the shareholders' agent, firms frequently carry out

the desires of the shareholders rather than the bondholders.

Both shareholders and stockholders play distinct roles in the corporation, each with unique

rights and improbable responsibilities. Investors in stocks are more willing than investors in

bonds to take on riskier enterprises. Bondholders are more keenly interested in tactics that

will maximise the likelihood that their investment will be recovered. Additionally,

shareholders want higher dividend payouts from corporations than do bondholders.

Bondholders are not permitted to vote at the meeting, although shareholders are. While

interest is paid to holders of debentures whether or not a profit is made, shareholders do not

get a dividend if there is no profit. Bonds frequently have a predetermined duration, or

maturity, after which the bond is repaid, whereas stocks may be outstanding indefinitely but

can also be sold at any time, leading to further conflicts of interest.

When the business is experiencing extreme financial difficulties, managers and owners might

not have the right incentives to approve or reject proposals. When the NPV is positive after

being discounted at the right rate for the project's risk, managers will typically approve

projects. However, in times of financial difficulty and when a lender will still advance

money, it could seem in the managers' or owners' best interests to spend that money in

initiatives with a low chance of success but high potential for success. Naturally, the project's

NPV will be negative if likelihood is taken into account. The point is that the owners would

keep the project's benefits while the lender will be responsible for paying all failure-related

liabilities.

Similarly, even when projects have a positive NPV, managers or owners may be hesitant to

approve them if financial turmoil has driven down the value of debt below its book value. In

this instance, the argument is that the bondholders will "seize" the project's benefits in order

to raise the debt's market value. Because of this, equity holders may receive little to no profit

from the project, which makes them poorly motivated to approve it.
there a rule for finding optimal capital structure : By determining the ratio of debt to equity

that reduces a company's weighted average cost of capital (WACC) while increasing market

value, the ideal optimal capital structure is computed.

A debt-to-equity ratio,, is used to establish the optimal capital structure. Liabilities and equity

make up the ratio equation, thus a business must be aware of both its equity and liabilities,

which include things like loans and other expenses like wages and warranties.

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