Financial Management Chapter 1 Overview

Chapter 1
FinancialFinancial
Management and
Environment

Learning Objectives
 Describe the nature of financial management.
 Discuss the finance functions.
 Explain value maximization as the objective of
the firm.
 Discuss the agency problem and mechanism of
resolving agency problem.resolving agency problem.
 Identify the basic issues associated with business
ethics and social responsibility
 Define corporate governance and its practice in
Nepal.
 Explain the role and types of financial markets
and institutions.
 Assess the corporate and individual income tax
environment in Nepal.

Nature of Financial
Management
 Effective management of financial resources is the key to the
optimum use of natural and human resources.
 Financial management is concerned with effective
management of financial resources.
 Investment decision, financing decision, current assets Investment decision, financing decision, current assets
management decision and dividend decision belongs to the
purview of financial management.
 Financial management is defined as the decision making
process involving investment, financing, dividend, and
management of current assets of a corporation.
 The study of financial management assists in making these
decisions in a way that contribute to the effective use of
financial resources in a firm.

Functions Of Financial
Management
 Finance functions are carried on to achieve the objectives
of the firm.
 Finance functions are mainly viewed from two
approaches:
Raising of funds and Raising of funds and
 Raising and allocation of funds.
 The second approach is comprehensive and universally
accepted.
 We follow the second approach
 Accordingly, the major functions of financial management
are discussed in terms of the decisions taken by the
financial manager.

1. Investment Decision
 Investment decision, also known as capital budgeting decision, is
the decision regarding investment in long-term investment
proposals.
 Includes the decisions concerned with acquisition, modification
and replacement of long-term assets.and replacement of long-term assets.
 Long-term assets require huge capital outlay… but benefits are
derived over several periods in the future.
 Future benefits are not known with certainty..thus involve risks.
 Estimate and evaluate the expected risk and return of the long-
term investment….. accepted only if it maximizes the
shareholders wealth.

2. Financing Decision
 The decision concerned with the collection of the funds from
appropriate sources.
 The funds can be raised from short-term and long-term sources.
 Financial manager should consider the possibility of the
reinvestment of profit… evaluate debt and equityreinvestment of profit… evaluate debt and equity
 A certain mix of debt and equity may be more beneficial
 A proper balance between risk and return is maintained in an
optimal capital structure that minimizes the cost of capital, hence
maximizes the value of the firm.
 The financial manager should also consider other factors such as
control, ease to repay, forecast of interest rates, government
rules and regulations etc.

3. Dividend Decision
 The decision about allocation of earnings to common
shareholders.
 The net income after paying preference dividend belongs to
common shareholders.
Dividend could be paid in the form of cash or in the form of share Dividend could be paid in the form of cash or in the form of share
of stock.
 The financial manager has three alternatives regarding dividend:
 Pay all earnings as dividends.
 Retain all earnings for reinvestment.
 Pay certain percentage of earnings and retain the rest for reinvestment.
 Must choose among the above alternatives that maximizes the
shareholders wealth.

 Must also be analyzed in relation to the financing decision
because the amount of dividend reduces the amount
available from internal source.
 Should also consider the existing practice of company,
attitude of the shareholders, legal requirements, etc.
 Further, should also decide whether the dividend be paid
in cash or in stock or in cash and stock both.

4. Working Capital Decision
 Decision about the commitment of funds to current assets and
deciding on their financing pattern.
 Current assets investment and financing decision.
 Investment in current assets affects firm's profitability and
liquidity.liquidity.
 Financial manager should achieve a proper trade-off between
liquidity and profitability by maintaining optimal investment in
current assets.
 Financial manager should also consider the financing pattern of
current assets.
 Decision about the use long-and short-term funds.
 It also requires addressing liquidity versus profitability trade-off.

Routine Finance Functions
 Supervision of cash receipts and cash payment.
 Custody and safeguarding cash balances and valuable
papers such as securities, insurance policies,
certificates of property, contract paper, etc.
 Taking care of mechanical details regarding all new
outside financing employed by the firm.
 Maintaining records of firm’s activities which have
financial implications; and
 Timely reporting to facilitate financial decisions.

Objective of the Corporation:
Value Maximization
 Objective of a firm is what it strives to achieve.
 In the context of financial management, Objective of
the firm refers to the purpose for which the finance
functions are carried out.
 The financial manager takes objective of a firm as a
guideline for financial decisions.
 Value maximization is almost universally accepted
objective of a firm.
 Managers should take decisions that maximize the
shareholder wealth.

 Shareholder wealth is maximized when a decision
generates net present value.
 NPV = PV of benefits – PV of costs.
 Positive NPV creates wealth for shareholders. Positive NPV creates wealth for shareholders.
 We can illustrate the goal of wealth maximization
with this example.
 Suppose a firm invests Rs 10,000 now in a project
that generates cash flow Rs 3,000 each year for five
years. Net present value of the project is Rs 1,372 if
the firm requires 10 percent return on its capital.

 Project like this should be accepted because the net
present value accruing from the project belongs to the
shareholders, hence increases their wealth.
 Investors pay higher prices for shares of a company
which undertake projects with positive net present
value.
As a result, wealth maximization is reflected in the As a result, wealth maximization is reflected in the
market price of shares.
 Share price maximization is considered equivalent to
shareholder wealth maximization because market price
of a firm's stock takes into account
 present and expected earnings per share;
 the timing, duration, and risk of the earnings;
 the dividend policy of the firm; and
 other factors that bear on the market price of the stock.

Arguments for Value Maximization
 Value maximization goal is clear
 Considers the timing of cash flows
 Considers quality of benefits
 Reduces the conflict of interest among
the stakeholders of a firm

Profit Maximization: An Alternative Goal
 According to profit maximization objective, the actions
that increase profits should be undertaken and those
that decrease profits are to be avoided.
 Those who are in favor of profit maximization argue
thatthat
 (i) profit is a test of economic efficiency,
 (ii) it leads to effective utilization of scarce economic resources in
every business firm, and
 (iii) it leads to total economic welfare since it increases the
economic efficiency of every individual firm.
 Therefore, profit maximization is considered as a basic
criterion for financial decision-making.

Objections to Profit Maximization
 However, this goal has been criticized in many
ways. Such as
 The term profit is a vague and conveys different meanings
to different people.
 Benefits received in earlier periods are valuable than
those received in the later period. But, profit maximization
goal ignores the time value and quality of benefits.

Maximizing EPS
 Maximizing earning per share is also advocated as a goal of
financial management.
 It is just an improved version of profit maximization goal.
 It also suffers from a number of drawbacks and cannot be
taken as an appropriate goal of the financial management.taken as an appropriate goal of the financial management.
 It also ignores the timing of cash flows, the business risk, and
financial risks of a firm.
 Finally, it ignores the effect of dividend policy that is one of the
important finance functions.
 The investors would not prefer a company that does not pay
dividend but just maximizes the earning per share.
 So, maximizing earning per share also cannot be taken as an
appropriate goal of financial management.

Profit maximization: Suitable goal for
Small Concerns
 Though profit maximization goal is rejected by
large corporations in present context, it is still
pursued by small sole-trading concerns and
partnership firms.
 Further, it should be noted that profit is an
important variable that affects the price of the
stock and ultimately the value of the firm.

Value Maximization and
Social Welfare
 Value maximization is an appropriate objective
of the firm which also maximizes the wealth of
shareholders.
However, the issues are….. However, the issues are…..
 What about the society?
 Does an attempt by the management to maximize
value of the firm benefit to the society as well?
 The straight answer is yes. How it does, here
are some arguments.

1. Owners of stock are the members of
the society
 Benefits of stock price maximization accrue to the
society because.
 Stockholders are the members of the society, hence
increase in the wealth of members is the benefit of the
society.
 With the increase in the size of shareholders' population
this argument is becoming more forceful.
 For example, in developed countries like the USA,
approximately 50 percent of the household own stocks.
 In Nepal also the number of shareholders is increasing
rapidly.

 Those who do not directly own stock too have stake in
the stock market.
 They might have their money in the form of life
insurance premium, provident fund, pension fund orinsurance premium, provident fund, pension fund or
mutual fund.
 The companies which manage these funds invest a
portion of their funds in stock. Therefore, an increase in
the price of stocks has indirect positive impact to the
savers.

2. Benefit to consumers
 In an attempt to maximize stock price firms strive
for high quality goods and services at the lowest
possible price.
 They must engage in new product development,
efficient distribution system and courteous service
delivery which ultimately benefits to the consumers.
 In a competitive market, firms prefer cost-cutting
strategy rather than increasing prices, which will
eventually drive price down benefiting the
consumers in the long-run.

3. Benefits to Employees
 Stock price maximization goal does not conflict to the
interest of employees.
 It is sometimes argued that firms exploit employees in
an attempt to earn more profit.
 But in general, firms cannot attract and retain best
brains if they do not pay employees sufficiently.
 Companies that successfully increase stock price also
grow and add more employees.
 Thus, stock price maximization benefits employees in
general.

Managerial Actions to
Maximize Shareholders Wealth
 What types of actions can managers take to
maximize the value or shareholders' wealth?
 Equation 1.1 clearly indicates what managers can do
to maximize the value of a firm.

 Managers should take actions that increase free cash
flows and decrease weighted average cost of capital.
 Free cash flow means funds available for distribution to
all of the company's investors, including creditors and
stockholders.stockholders.
 In order to increase free cash flows the manager should
increase sales revenue, reduce operating costs and
taxes, and decide optimum investment in operation.
 In addition, the managers should speed up the receipt
of cash flows because cash flows received in earlier
periods are more valuable.

 Weighted average cost of capital is affected by the
firm's financing decision and its risk exposure.
 The mangers should set optimum capital structure and
undertake acceptable level of risk.
 Equation 1.1 correctly embodies the return and risk
dimensions of investment.
 Investors assign higher value to a firm which promises
higher return in the form of free cash flows and assign
lower value to a firm which is riskier.
 Therefore, the financial manager should trade-off
between return and risk.


The Role of the Financial
Manager
 What role does the financial
manager have in the firm?
1. Analysis of Financial Aspects of all
DecisionsDecisions
2. Analysis of Financial Condition of the Firm
3. Analysis of Financial Markets
4. Analysis of Risk

The Agency Conflict
 An agent works on behalf of its principal as per
the terms and condition of agency agreement.
 The relation between the agent and principal is
known as agency relationship that is determined
by the contractual agreement between the agent
and principal.
 Agent gets consideration for rendering the
specified services to its principal either in cash or
kind or in both.

 Agency Problem
 The conflict of interest between an agent and the
principal.
 An agent is supposed to work at the best interest An agent is supposed to work at the best interest
of its principal.
 But the agent may work on his/her own interest
rather than that of the principal.
 The conflict between an agent and the principal
takes place because of their divergent interest.

Principal-Agent Relationship in a Corporation
 In corporation - shareholders are owners
 They do not run the corporation by themselves.
 They appoint management to run the corporation and delegate
the decision making authority
 Thus management is the agent and shareholders are the Thus management is the agent and shareholders are the
principals. (Agency Relationship I)
 Creditors are other stakeholders of a corporation.
 Creditors delegate the decision making authority to use their
money in the best way in the business.
 In this case, creditors are the principal and shareholders are
their agents. (Agency Relationship II)

 The finance theory that explains the agency relationship
and the conflict between agent and the principal is known
as agency theory.
 Michael C. Jensen and William H. Meckling propounded this
theory in 1976.

The Agency Conflict I: Shareholders
versus Managers
 Management is supposed to work at the best
interest of the shareholders.
 But the management and the shareholders have
divergent interest:divergent interest:
 Management wants to maximize its own interest and
shareholders want it to work in their best interest by
maximizing their wealth.
 Such conflict does not take place when the owner-
manager owns 100 percent of the ownership of
the corporation.

 The agency conflict results into the
agency costs.
 Monitoring expenditure.
 Structuring expenditures. Structuring expenditures.
 Opportunity costs.
 Mechanism to Reduce the Conflict
 Managerial compensation plan.
 The direct intervention by shareholders.
 The threat of firing.
 The threat of takeover.

The Agency Conflict II:
Shareholders versus Creditors
 Another primary agency relationship is between the
stockholders and creditors.
 This relationship is established through management.
 The interest of the creditors is only in the repayment of
due interest and principal.due interest and principal.
 So, creditors want to protect their interest but on other
hand, stockholders want the management to maximize
their interest at the cost of the creditors.
 The conflict takes place between the shareholders and
creditors due to their divergent interest.

 Creditors lend at a specified interest rate.
 The interest rate is based on the assessment of the
present and expected risk.
 Degree of risk depends largely on investment and
financing decisions.financing decisions.
 The firm's investment decision undertaken by the
managers may bring about changes in the risk
complexion.
 If any new risky investment decision is made, it pushes
up the required rate of return and reduces the value of
the debt.

 Financing decision also hurts the interest of the
creditors
 The firm may need additional financing and raise
further debt capital, which increases the bankruptcy
risk.risk.
 Creditors lend the money at the rate based on:
 The riskiness of the existing asset structure of the firm,
 Expectation concerning the riskiness of future investment
decision,
 The firm's existing capital structure and
 Expectation concerning future capital structure decision.

 Creditors oppose to the investment decision and
financing decision that deteriorate the value of their
investment.
 Risky investment decision and financing decision
especially made to raise new debt capital reduce theespecially made to raise new debt capital reduce the
value of debt by increasing the bankruptcy chance of
the firm.
 These conditions are fruitful only to shareholders,
because their wealth will be maximized at the cost of
creditors.

 Mechanism to reduce conflict
 Creditors protect themselves from the
expropriation by putting restrictive covenants in
the loan agreement.
 Restrictions on repurchase of shares, restructure of capital
structure, dividend policy decision, and to launch risky
projects.
 Make management mandatory to maintain certain level of
working capital.

Business Ethics
 Ethics - moral rules people apply in making decisions.
 Business Ethics – A company's attitude and conduct
towards its employees, customers, community, and
stockholders.
The issue of business ethics has come to the fore in The issue of business ethics has come to the fore in
view of the episodes of
 Violations of securities laws,
 Shading of quality,
 Misrepresenting performance of products,
 Misleading advertisements, etc.

 There are three areas of concern for business ethics.
 How a corporation treats its employees - Such as hiring and firing,
wages and working conditions, and employee privacy.
 How the employees treat the organization - Such as conflict of
interest, secrecy, and honesty in keeping expenses account.
 How the organization treats other stakeholders- Such as
customers, competitors, stockholders, suppliers, dealers and
unions.
 Normal business ethics requires that
 Product and services are safe.
 No unfair business practices such as false claim on advertising.
 Managers be truthful with stockholders, etc.

 What should we do to restrain unethical practices and
promote ethical behavior?
 Appropriate legal and institutions set ups,
 Enforcement of the rule of law and
 Adherence to the principles of good governance, etc. Adherence to the principles of good governance, etc.
 Firm commitment on our ethical values – uprightness and
compassion is the fundamental.
 Once these values guide decisions – the way we treat
our employees, our organization, and our stakeholders –
all will be all right.
 Value guided activities take to the real definition of
ethics.

Corporate Social Responsibility
 CSR - business should be actively concerned with
the welfare of society at large.
 CSR Covers both social and environmental issues,
 CSR is voluntary in nature, and
CSR is about stakeholders. CSR is about stakeholders.
 The concept of social responsibility has
undergone significant changes over periods.
 Charity Principles - The task of more fortunate
individual to assist less fortunate members of
society

 Stewardship principles - The doctrine that business and
wealthy individuals to view themselves as stewards or
caretakers, holding their property in trust for the benefit
of society
Milton Friedman’s Argument - There is one and only one Milton Friedman’s Argument - There is one and only one
responsibility of business: to use its resources and
energy in activities designed to increase its profit so
long as it stays within the rule of game and engages in
open and free competition, without deception and fraud

 Enlightened self-interest concept- The
organization's realization that it is in their best
interest to act in ways that the community
considers socially responsible.
 Operationalizing CSR poses challenges and
requires good judgment and care.
 For example, a firm operating at normal profit margin and
engaging in social responsibility related activities may be
in disadvantageous position – its cost will rise and it will
be unable to compete in the market.

 Voluntary socially responsible acts that raise
costs will be difficult to continue.
 Capital market forces also panelize socially
responsible firms.responsible firms.
 For example, suppose Firm A in an industry spends
substantial part of its earnings in social actions, while
Firm B in the same industry concentrates on profit and
stock prices. Naturally, investors prefer Firm B, putting
Firm A at a disadvantageous position in the capital market.

 In practice, it is found that organizations take a wide range of
positions on social responsibility.
 Social obstruction approach – Do as little as possible to solve
social and environmental problems.
 Social obligation approach - Do everything that is required by Social obligation approach - Do everything that is required by
law but nothing more.
 Social response approach - The firm meets its basic legal and
ethical obligations and also goes beyond these requirements
in selected cases.
 Social contribution approach – Firms view themselves as
citizen in a society and proactively seek opportunities to
contribute.

 The idea of social responsibility existed in one
form or other in Nepal as well.
 Donation to religious and educational institutions,
 Contribution to relief funds at the time of natural calamities
 Establishment of memorial foundations.
These trends still continue but there has been These trends still continue but there has been
shift in the form of CSR activities.
 For example, Buddha Air’s CSR is aimed towards assisting
the rural farmers to increase their cereal crops yields
through innovative and appropriate technology transfer,
reduction of cost of production and loss and wastage and
increase in productivity;

Corporate Governance
 Corporate Governance - A set of processes, customs,
policies, and laws that affects the way a company is
directed, administered, and controlled.
 Corporate governance involves balancing the interests of
the many stakeholders in a corporation including itsthe many stakeholders in a corporation including its
shareholders, management, customers, suppliers,
financiers, government and the community as a whole.
 The board of directors and the concerned committees
must follow the principles of corporate governance for the
benefit of corporate stakeholders.
 Good corporate governance balances individual and
societal goals as well as economic and social goals.

 Corporate governance became a pressing issue
following the introduction of the Sarbanes-Oxley
Act, 2002 in the U.S.A. which took effect in
November 2004.
 This act was brought into effect in response to the
financial scandals involving companies such as
Enron, Worldcome, Tycom and Adelphia to restore
public confidence in companies.

 It is not enough for a corporation to
merely be profitable
 It also needs to demonstrate good It also needs to demonstrate good
corporate citizenship through
 Environmental awareness,
 Ethical behavior and
 Sound corporate governance practices.

 Three fundamental values of good governance:
 Accountability – accountability to shareholders
 Openness – Honest dealing within and outside the board
 Probity – Transparency of risk-assessment and decision making
process to shareholders.
 The directors have to frame appropriate policies and
monitor the performance of management in
implementing the policies, and are accountable to
shareholders.

 One basic issue concerning the corporate governance is about
the board structure.
 It is related to have or not to have independent directors in
the board.
 Sufficient independent directors in the board ensure strong
internal control system. For this, the independent directors
must have adequate information to make good decisions, the
ability to put key issues on the agenda, and adequate time to
deal with the central issues they confront.

 The issue of honest dealing within the board is
concerned with mutual confidence among directors in
the board.
 There should be clear understanding among the
directors that nobody shall act for personal gain.directors that nobody shall act for personal gain.
 The board should have strict code of conduct
communicated to and understood by all.
 Similarly, the issue of honest dealing outside the board
is concerned with obeying rules and regulations that
makes the board transparent to outside stakeholders.

 There should be adequate transparency to shareholders
regarding risk-assessment and decision making process.
 While making decisions, board requires having adequate
information, idea generation, and assessment of risks
including strategic thinking, critical questioning and review.
 It also requires a value test to ensure whether the decisions
will be in accordance with the value systems adopted by
corporation.
 Management should be personally responsible for the
accuracy of financial statements and unethical acts that harm
the interest of the stakeholders.

Corporate Governance in Nepal
 Exercising good corporate governance in
financial institutions in Nepal has been important
because of high concentration of corporate
ownership
 Bank and Financial Institutions Act, 2006 has
made provisions to avoid conflict of interest and
maintain transparency.
 Similarly, Nepal Rastra Bank has also issued
directive regarding codes of conduct for the
directors of banks and financial institutions.

 Nepal Telecom, in its annual report, reports its stance
towards corporate governance as follows:
 Board of Directors with high experience and diverse professional
expertise
 Adoption of transparent procedures and practices Adoption of transparent procedures and practices
 Ensuring compliance with regulatory and fiduciary requirements in
letter and spirit
 High level of disclosures for dissemination of corporate, financial
and operational information to all its stakeholders
 Creation of Audit Committee
 Well-defined corporate structure that establishes checks and
balances and delegates decision making to appropriate levels in the
organization

Financial Environment in Nepal
 Financial environment consists of a set of
components making up the financial
activities.
 These components include
 Financial securities, Financial securities,
 Financial institutions and
 Financial markets.
 The Financial environment in Nepal is also
composed of these components.

1. Financial Securities
 Financial securities represent the evidence of property right or
claim on income and asset of an entity.
 They are financial assets such as common stocks, bonds,
preferred stocks.
 They also include bank deposit accounts, insurance policies, They also include bank deposit accounts, insurance policies,
investment in mutual funds and pension funds etc.
 Among several securities, the shares of common stock are the
most common and popular types of securities in Nepal.
 Shares of common stocks in Nepal were first issued by
Biratnagar Jute Mills and Nepal Bank Limited in 1937.
 Besides common stocks, government securities like Treasury
bills and bonds are other popular types of securities in Nepal.

 The first issue of government bond in Nepal was taken place in
1964.
 Other types of securities such as corporate bonds, preferred
stocks are less common in practices.
 Only a few preferred stocks and corporate bonds are in the Only a few preferred stocks and corporate bonds are in the
market; and municipal securities are yet to come.
 In recent time mutual funds units are emerging as the popular
securities in Nepal.
 Among the short-term securities, Treasury bills issued by
Nepal government are the most popular one in Nepal.
 Thus, there are limited choices of financial securities in Nepal
and the investors are bound to select among these limited
alternatives for investment.

2. Financial Institutions
 Financial Institutions are specialized firms dealing with
financial services and facilitating transfer of funds from
savers to users.
 Financial institutions are the organizations which issue
financial claims against themselves for cash.
 For example, they accept cash on different types of deposit
accounts and issue the certificate of deposit (CD).
 They use cash received on different types of deposit account
to purchase primarily the financial assets of others.
 For example, they may use the cash received on account of CD
to purchase T-bill and corporate bonds.

 Financial institutions facilitate individuals, business
and government to generate the saving and supply
funds to deficit units.
 Financial institutions also work as the intermediaries
between saving units and deficit units of the economy.between saving units and deficit units of the economy.
 Different financial institutions operate in Nepal. They
may be broadly classified as
 (i) depository financial institutions, and
 (ii) non-depository financial institutions.
 The constituents of depository and non-depository
institutions in Nepal are shown in Table 1.1.

Table 1.1 Financial Institutions in Nepal
Types of Financial Institutions
Number of Institutions as of Mid-July
1980 1990 2000 2010 2017
Depository Institutions
Commercial banks 2 5 13 27 28
Development banks 2 2 7 74 40
Finance companies 0 0 45 79 28
Rural/ Microfinance 0 0 7 18 53Rural/ Microfinance 0 0 7 18 53
Non-depository Institutions
Insurance companies 2 5 12 25 28
Provident / pension fund companies* 1 2 2 2 2
Mutual funds 0 0 1 2 10
Total 7 14 113 288 218
* Employee Provident Fund and Citizen Investment Trust; recently the
Parliament has enacted an Act to establish Pension Fund which is yet to be
established.
Source: Banking and Financial Statistics, Nepal Rastra Bank, Mid-July 2017,
Quarterly Economic Bulletin, Nepal Rastra Bank Mid-July 2017 and SEBON
Annual Report 2072/73 B.S.

3. Financial Markets
 Financial markets refer to the market for trading
securities.
 Primarily, there are two types of financial markets:
primary market and secondary market.
 In Nepal, both of these types of markets exist. In Nepal, both of these types of markets exist.
 The first transaction of primary market was taken place
in 1937 when Biratnagar Jute Mills and Nepal Bank
Limited issued shares of common stock for the public.

 The official forum for secondary market trading
started with the establishment of Securities
Marketing Center only in 1976.
 Later on, Nepal Stock Exchange (NEPSE) Limited Later on, Nepal Stock Exchange (NEPSE) Limited
replaced this market in 1993 and formal secondary
market trading in NEPSE started in 1994.
 In recent years, the primary market issues of
securities have been more common among Nepalese
banks and financial institutions due to the
mandatory need of increasing paid up capital.

 Until the recent period, secondary market transactions
in NEPSE incorporate the trading of more than 240
listed securities.
 Secondary market trading has been fully automated.
 The size of the market in terms of number of traders
and volume of trading is still small as compared to that
of the developed markets
 The trading in NEPSE is being facilitated by 50 brokers.
 NEPSE trading is largely dominated by shares of
common stock and the markets for preferred stocks
and bonds are very thin.

 Mostly, the individual investors participate in NEPSE
trading and the participation of institutional investor is
very thin.
 In recent period some developments have taken place
in secondary market transactions which include
 The over-the-counter (OTC) market operation by Nepal Stock
Exchange,
 Establishment of Securities Central Depository Services Company,
and Institutional Credit Rating Agency (ICRA)

Tax Environment
 The taxation policy of government sets the tax
environment of a business firm.
 A business decision that proves to be efficient in the
absence of taxation may be inefficient under tax
environment.environment.
 The financial manager should understand the dynamics
of the tax environment in financial decisions of a firm.

Corporate tax
 Tax to be paid by a corporation on its taxable
income.
 The taxable income of a corporation is calculated
by deducting all deductible expenses, including
depreciation and interest, from revenues.
 Depending upon the nature of the business,
different entities pay tax on taxable income at
different ratios.
 Table 1.2 exhibits the corporate tax rate
applicable in Nepal.

Table 1.2 Corporate Tax Rate in Nepal
Nature of entity Tax Rate
Normal rate 25%
Special industries (mainly manufacturing excluding alcoholic and tobacco
producing industry)
20%
Banks and financial institutions and telecom 30%
Insurance business 30%
Saving and credit cooperatives 20%Saving and credit cooperatives 20%
Other business entity 20%

Average Versus Marginal Tax Rate
 All financial decisions require consideration of tax
effects.
 Average tax rate refers to the percentage of the total
taxable income that is paid out in tax.
 On the other hand, marginal tax rate is the rate
applicable on additional unit of income.
 A clear distinction between average and marginal tax
rate can be observed if there is a progressive taxation
on the corporate income with different ranges.

Capital Gain Tax
 Investment on assets like stock, bonds are examples of
capital assets.
 The gain resulted from sale of stocks and bond is called
capital gain.
For example, if you buy a share of common stock of a For example, if you buy a share of common stock of a
company for Rs 200 and later you sell this for Rs 250,
your capital gain is Rs 50.
 The capital gain is generally taxed at a rate lower than
ordinary tax rate.

 In Nepal, the capital gain tax rate is 5 percent for listed
securities. Thus, if your capital gain is Rs 50, then you
should pay Rs 2.5 (0.05 × Rs 50) as capital gain tax.
 It is generally argued that capital gain tax rate must be
lower than ordinary tax rate.lower than ordinary tax rate.
 There are basically two reasons behind this argument.
 First, lower capital gain tax rate attracts new venture capital which
produces capital gain;
 second, with lower capital gain tax rate, corporations are motivated
to reinvest the earnings which produces capital gain for common
stockholders.

Financial Management Chapter 1 Overview

Financial Management Chapter 1 Overview

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Financial Management Chapter 1 Overview

Similar to Financial Management Chapter 1 Overview (20)

Recently uploaded

Recently uploaded (20)

Financial Management Chapter 1 Overview