Question

(a) Discuss the FIVE (5) factors, which determine the market price of bonds, (10 marks) (b) Shareholder wealth maximization should be the preferable goal for a firm, by which it proves how firms behave rationally to increase profit. How far do you agree with this statement? Discuss this statement with relevant examples, (10 marks) (c) Discuss the risk/return tradeoff and how it relates to finance, (5 marks) (25 marks) Question 2 (a) What does low working capital say about a company's financial position? (6 marks) (b) Explain any THREE (3) benefits of working capital management. (9 marks) (c) Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? (10 marks) (25 marks)

Answer 1

1A. Following factors determine the market price of bond.
Interest Rates
When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
Inflation
When inflation is on the rise, bond prices fall. When inflation is decreasing, bond prices rise. That’s because rising inflation erodes the purchasing power of what you’ll earn on your investment.
Credit Ratings
Credit rating agencies assign credit ratings to bond issuers and to specific bonds. A credit rating can provide information about an issuer’s ability to make interest payments and repay the principal on a bond.
The Age Of A Bond
The age of a bond relative to its maturity date can affect pricing. This is because the bondholder is paid the full face value of the bond when the bond reaches maturity.
Liquidity
Except for government debt, most bonds are traded over the counter (OTC) and therefore carry a liquidity risk. Unlike the stock market, where investors can easily exit a position, bond investors rely on the secondary market to trade bonds.

1B. Shareholder wealth is measured by the market value of the shareholders’ common stock holdings. Market value is defined as the price at which the stock trades in the market place, such as on the New York Stock Exchange. Thus, total shareholder wealth equals the number of shares outstanding times the market price per share.
The objective of shareholder wealth maximization has a number of distinct advantages.
First, this objective explicitly considers the timing and the risk of the benefits expected to be received from stock ownership.
Second, it is conceptually possible to determine whether a particular financial decision is consistent with this objective.

1C. Risk-Return Tradeoff is the relationship between the risk of investing in a financial market instrument over the expected or potential return from the same. While making investment decisions, one important aspect to consider is what one is getting in return for the investment being made.

2A. If a company has low working capital, it means the company is not having enough liquid funds to meet its short-term obligations. Working capital, also called net working capital, is a liquidity metric used in corporate finance to assess a business' operational efficiency.

2B. Benefits of working capital management
Enhance Profitability
Proper application of working capital management strategy would enhance the company’s profitability in the long run
Improves Financial Health
Working capital management basically deals with the management of cash in an enterprise.
Evades Interruption in Operations
Working capital management involves the use of ratio analysis. Which provides information to managers for planning and executing business operations in the most efficient way.

2C. The cost of debt is less because the interest on debt is a tax-deductible expense.
A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an after tax rate of 6.5 percent.