Professional Documents
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Chapter 20 Questions & Answers
Chapter 20 Questions & Answers
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● 1 Chapter 20: Questions & Answers
2. Minicorp
Minicorp is a mining company. Its mission is to 'maximise profitsfor shareholders whilst
recognising its responsibilities to society'. Itis considering a mining opportunity abroad in a
remote country areawhere there is widespread poverty. The mining work will destroy
localvegetation and may pollute the immediate water supply for some years tocome. The
company directors believe that permission for the mining workis likely to be granted by the
government as there are few people oranimals living in the area and the company will be
providing much-neededjobs.
Identify the likely stakeholders in the company's decision.Consider their possible
objectives and describe three likely conflictsin those objectives.
(10 marks)
5. Breccon Co
Breccon Co introduced a new product, DV, to its range last year.The machine used to mould
each item is a bottleneck in the productionprocess meaning that a maximum of 5,000 units per
annum can bemanufactured.
The DV product has been a huge success in the marketplace and as aresult, all items
manufactured are sold. The marketing department hasprepared the following demand forecast
for future years as a result offeedback from customers.
The directors are now considering investing in a second machinethat will allow the company to
satisfy the excess demand. The followinginformation relating to this investment proposal has
now been prepared:
If production remained at 5,000 units, the current selling pricewould be expected to continue
throughout the remainder of the life ofthe product. However, if production is increased, it is
expected thatthe selling price will fall to $45 per unit for all units sold. Again,this will last for the
remainder of the life of the product.
No terminal value or machinery scrap value is expected at the endof four years, when
production of DV is planned to end. For investmentappraisal purposes, Breccon uses a nominal
(money) discount rate of 10%per year and a target return on capital employed of 20% per year.
Ignoretaxation.
Required:
(a)Calculate the following values for the investment proposal:
Required:
(a)Calculate the NPV and IRR of each project.
(6 marks)
(b)Recommend, with reasons, which project you would undertake (if either).
(4 marks)
(c)Briefly explain the inconsistency in ranking of the two projects in view of the remarks of the
directors.
(2 marks)
(d)Discuss the advantages anddisadvantages of the payback and accounting rate of return
methods ofinvestment appraisal. Note: you are not required to perform anycalculations for these
two methods; if you do, you will not score anymarks for it.
(13 marks)
(Total 25 marks)
7. ARG Co
ARG Co is a leisure company that is recovering from a loss-makingventure into magazine
publication three years ago. The company plans tolaunch two new products, Alpha and Beta, at
the start of July 20X7,which it believes will each have a life-cycle of four years. Alpha isthe
deluxe version of Beta. The sales mix is assumed to be constant.Expected sales volumes for
the two products are as follows:
The selling price and direct material costs for each product in the first year will be as follows:
Incremental fixed production costs are expected to be $1 million inthe first year of operation and
are apportioned on the basis of salesvalue. Advertising costs will be $500,000 in the first year of
operationand then $200,000 per year for the following two years. There are noincremental
non-production fixed costs other than advertising costs.
In order to produce the two products, investment of $1 million inpremises, $1 million in
machinery and $1 million in working capital willbe needed, payable at the start of July 20X7.
Selling price per unit, direct material cost per unit andincremental fixed production costs are
expected to increase after thefirst year of operation due to inflation:
These inflation rates are applied to the standard selling priceand direct material cost data
provided above. Working capital will berecovered at the end of the fourth year of operation, at
which timeproduction will cease and ARG Co expects to be able to recover $1.2million from the
sale of premises and machinery. All staff involved inthe production and sale of Alpha and Beta
will be redeployed elsewherein the company.
ARG Co pays tax in the year in which the taxable profit occurs atan annual rate of 25%.
Investment in machinery attracts a first-yearcapital allowance of 100%. ARG Co has sufficient
profits to take thefull benefit of this allowance in the first year. For the purpose ofreporting
accounting profit, ARG Co depreciates machinery on a straightline basis over four years. ARG
Co uses an after-tax money discount rateof 13% for investment appraisal.
Required:
(a)Calculate the net present value of the proposed investment in products Alpha and Beta as at
30 June 20X7.
(18 marks)
(b)Identify and discuss any likely limitations in the evaluation of the proposed investment in
Alpha and Beta.
(7 marks)
(Total: 25 marks)
8. H Co
H Co is considering purchasing a new machine to alleviate abottleneck in its production
facilities. At present, it uses an oldmachine which can process 8,000 units of Product P per
week. H couldreplace it with machine AB, which is product-specific and can produce20,000
units per week. Machine AB costs $500,000. Removing the oldmachine and preparing the area
for machine AB will cost $20,000.
The company expects demand for P to be 12,000 units per week foranother three years. After
this, in the fourth year, the new machinewould be sold for $50,000. This sale is not expected to
take place untillater in the fourth year. The existing machine will have no scrapvalue. Each P
sells for $7.00 and has a contribution to sales ratio of0.2. The company works for 48 weeks in
the year. H Co normally expects apayback within two years and its after-tax cost of capital is
10% perannum.
The company pays corporation tax at 30% and receives writing-downallowances of 25%,
reducing balance on the investment and any costsincurred in removing the old machine and
installing the new machine.Corporation tax is payable one year in arrears.
Required:
(a)Calculate the net present value for the machine.
9. Quadrant
Quadrant is a highly geared company that wishes to expand itsoperations. Six possible capital
investments have been identified, butthe company only has access to a total of $620,000. The
projects may notbe postponed until a future period. After the projects end, it isunlikely that
similar investment opportunities will occur.
Expected net cash flows (including residual values) are:
Projects A and E are mutually exclusive. All projects are believedto be of similar risk to the
company's existing capital investments.
Any surplus funds may be invested in the money market to earn areturn of 9% per year. The
money market may be assumed to be anefficient market.
Quadrant's cost of capital is 12% per year.
Required:
(a)Calculate the expected Net Present Value for each project, and rank the projects.
(7 marks)
(b)Assuming the projects aredivisible, calculate the profitability index for each project, and
rankthe projects to determine how the money would be best invested. Explainbriefly why the
rankings differ from that in (a) above.
(7 marks)
(c)Now assume the projects are indivisible. Provide advise on how the funds are best invested.
(5 marks)
(d)Explain how uncertainty and risk could be considered in the investment process.
(6 marks)
(Total: 25 marks)
10. Ceder Co
Ceder Co has details of two machines which could fulfil thecompany's future production plans.
Only one of these machines will bepurchased.
The 'standard' model costs $50,000, and the 'de-luxe' $88,000,payable immediately. Both
machines would require the input of $10,000working capital throughout their working lives, and
both machines haveno expected scrap value at the end of their expected working lives offour
years for the standard machine and six years for the de-luxemachine.
The forecast pre-tax operating net cash flows associated with the two machines are:
The de-luxe machine has only recently been introduced to the marketand has not been fully
tested in operating conditions. Because of thehigher risk involved, the appropriate discount rate
for the de-luxemachine is believed to be 14% per year, 2% higher than the discount ratefor the
standard machine.
The company is proposing to finance the purchase of either machine with a term loan at a fixed
interest rate of 11% per year.
Taxation at 35% is payable on operating cash flows one year inarrears, and capital allowances
are available at 25% per year on areducing balance basis.
Required:
(a)to calculate for both the standard and the de-luxe machine:
(i)payback period
(ii) net present value
(14 marks)
(b)Recommend, with reasons, which of the two machines Ceder Co should purchase.
(4 marks)
(c)If Ceder Co were offered theopportunity to lease the standard model machine over a
four-year periodat a rental of $15,000 per year, not including maintenance costs,evaluate
whether the company should lease or purchase the machine.
(7 marks)
(Total: 25 marks)
11. Sludgewater
Sludgewater, a furniture manufacturer, has been reported to theanti-pollution authorities on
several occasions in recent years, andfined substantial amounts for making excessive toxic
discharges into theair. Both the environmental lobby and Sludgewater's shareholders
havedemanded that it clean up its operations.
If no clean up takes place, Sludgewater estimates that the totalfines it would incur over the next
three years can be summarised by thefollowing probability distribution (all figures are expressed
in presentvalues).
A firm of environmental consultants has advised that spray paintingequipment can be installed
at a cost of $4m to virtually eliminatedischarges. Unlike fines, expenditure on pollution control
equipment istax-allowable via a 25% writing-down allowance (reducing balance, basedon gross
expenditure).
The rate of corporation tax is 30%, paid with a one-year delay. Theequipment will have no scrap
or resale value after its expected threeyear working life. The equipment can be in place ready
for Sludgewater'snext financial year.
A European Union grant of 25% of gross expenditure is available,but with payment delayed by a
year. The consultant's charge is $200,000and the new equipment will raise annual production
costs by 2% of salesrevenue. Current sales are $15 million per annum, and are expected
togrow by 5% per annum compound. No change in working capital isenvisaged.
Sludgewater applies a discount rate of 10% after tax on investmentprojects of this nature. All
cash inflows and outflows occur at yearends.
Required:
(a)Calculate the expected net present value of the investment. Briefly comment on your results.
(12 marks)
(b)Outline the main limitations of using expected values when making investment decisions.
(6 marks)
(c)What financial and non-financial criteria will need to be considered when deciding whether
the investment should be made.
(7 marks)
(Total: 25 marks)
12. Pheonix
Pheonix is considering the purchase of a new machine to makewood-burning stoves. They have
had a market research survey conducted ata cost of $200,000. This predicts demand of 4,000
stoves per annum at aselling price of $750 per stove for 10 years.
The machine will cost $2,000,000, payable in two instalments as follows.
Depreciation of $180,000 per annum over the next 10 years will be provided to write down the
machine to its scrap value.
Use will also be made of some existing equipment which originallycost $150,000, has a book
value of $75,000 and would cost $200,000 toreplace.
Pheonix is currently negotiating the sale of this machine for $100,000.
Variable cost per stove will be $600, and in accordance with thenormal policy $250,000 of fixed
overheads will be apportioned to the newproduct line per annum.
The machine will require its first service one year after purchase,and from then on will be
serviced every year. Each service costs$50,000.
The machine will be brought into use immediately to build upinventory, but the first revenues will
not be received until 31 December20X2. Variable costs are payable annually at the same time
as therevenues are received.
Required:
Calculate the following:
(a)Return on capital employed on an initial investment basis.
(3 marks)
(b)Return on capital employed on an average investment basis.
(1 mark)
(c)Payback period.
(3 marks)
(d)NPV at the company's cost of capital of 15%.
(5 marks)
(e)Internal rate of return of the project.
(3 marks)
(f)The sensitivity of your advice based on the NPV computed in (d) to errors in the estimates of
13. Cloud Co
The following financial information related to Cloud Co:
Other information
(1)Sales for the year to 30 April20X0 were $89m, yielding an operating profit of $8.7m and a
profitbefore tax (after finance costs) of $8.2m.
(2)At the beginning of the year to30 April 20X1 the company bought some new manufacturing
equipment andrecruited six more sales staff.
(3)Sales for the year to 30 April 20X1 were $131m, with an operating profit of $8.5m, and a
profit before tax of $7m.
Required:
(a)Explain the cash conversion cycle (operating cycle) and its significance in determining the
working capital needed by a company.
(4 marks)
(b)Calculate the cash operating cycle of Cloud Co for the years ending 30 April 20X0 and 20X1.
(4 marks)
(c)Using additional calculations, together with your results to part (b) discuss whether or not
Cloud Co is overtrading.
(8 marks)
(d)Explain the different strategies a firm may follow in order to finance its working capital
requirements.
(5 marks)
(e)Suggest ways in which Cloud Comight seek to resolve its current funding problems, and
avoid the risksassociated with overtrading.
(4 marks)
(Total: 25 marks)
14. Hexicon
(a)Hexicon Inc manufactures andmarkets automatic washing machines. Among the many
hundreds ofcomponents which it purchases each year from external suppliers forassembling
into the finished article are drive belts, of which it uses40,000 units pa. It is considering
converting its purchasing, deliveryand inventory control of this item to a just-in-time system. This
willraise the number of orders placed but lower the administrative and othercosts of placing and
receiving orders. If successful, this will providethe model for switching most of its inwards
supplies on to this system.Details of actual and expected ordering and carrying costs are given
inthe table below.
(i)Determine the effect of the new system on the economic order quantity (EOQ).
(ii) Determine whether the new system is worthwhile in financial terms.
(12 marks)
(b)You are required to brieflyexplain the nature and objectives of JIT purchasing agreements
concludedbetween components users and suppliers.
(6 marks)
(Total: 18 marks)
Required:
(a)Calculate the net benefit to the company of taking option 1, the non-recourse factoring
arrangement.
(8 marks)
(b)Calculate the net benefit to the company of taking option 2, offering a prompt payment
discount to customers.
(10 marks)
(c)Recommend which option is the most financially advantageous policy. Comment on your
results.
(7 marks)
(25 marks)
16. Thorne
Thorne Co values, advertises and sells residential property onbehalf of its customers. The
company has been in business for only ashort time and is preparing a cash budget for the first
four months of2006. Expected sales of residential properties are as follows.
The average price of each property is $180,000 and Thorne Cocharges a fee of 3% of the value
of each property sold. Thorne Coreceives 1% in the month of sale and the remaining 2% in the
month aftersale. The company has nine employees who are paid on a monthly basis.The
average salary per employee is $35,000 per year. If more than 20properties are sold in a given
month, each employee is paid in thatmonth a bonus of $140 for each additional property sold.
Variable expenses are incurred at the rate of 0.5% of the value ofeach property sold and these
expenses are paid in the month of sale.Fixed overheads of $4,300 per month are paid in the
month in which theyarise. Thorne Co pays interest every three months on a loan of $200,000at
a rate of 6% per year. The last interest payment in each year is paidin December.
An outstanding tax liability of $95,800 is due to be paid in April.In the same month Thorne Co
intends to dispose of surplus vehicles,with a net book value of $15,000, for $20,000. The cash
balance at thestart of January 2006 is expected to be a deficit of $40,000.
Required:
(a)Prepare a monthly cash budgetfor the period from January to April 2006. Your budget must
clearlyindicate each item of income and expenditure, and the opening andclosing monthly cash
balances.
(10 marks)
(b)Discuss the factors to be considered by Thorne Co when planning ways to invest any cash
surplus forecast by its cash budgets.
(5 marks)
(c)Discuss the advantages anddisadvantages to Thorne Co of using overdraft finance to fund
any cashshortages forecast by its cash budgets.
(5 marks)
(d)Explain how the Baumol model canbe employed to reduce the costs of cash management
and discuss whetherthe Baumol cash management model may be of assistance to Thorne Co
forthis purpose.
(5 marks)
(Total: 25 marks)
18. Toytown
Toytown is a company which distributes and sells a popular toytrain. The company, which is
based in Australia, imports trains from theUSA which it packages and sells in New Zealand and
larger countries inthe Far East. The company is also considering establishing a subsidiaryin
South Africa which would buy products from Toytown and sell withinAfrica.
Toytown reports its results in its home currency. The company paysfor its purchases from the
USA in US dollars, but receives payment forthe goods which it sells in Australasia and the Far
East in localcurrency. All transactions carried out with the subsidiary in SouthAfrica would be in
US dollars. The company generally takes 6 weeks topay its supplier in the USA and receives
payment from debtors within 3months.
Over the last few years the company has found that sales have beenquite predictable and it has
been possible to plan sales levels andpurchases of goods in advance. However, there is
increasing competitionfrom companies in the Far East, which may make this more difficult inthe
future.
Required:
(a)The company is currentlyconsidering whether the foreign currency exposure could be
managed moreefficiently. Describe the following types of foreign currency exposure,giving
examples of how they could impact Toytown, now and in the future:
(i)Economic risk
(ii) Translation risk
(iii)Transaction risk
(6 marks)
(b)Describe the followingapproaches to managing or hedging transaction exposure and
thedisadvantages and advantages of each method:
13 Economic environment
19. PSBR
It has been argued that the United Kingdom Public Sector BorrowingRequirement (PSBR)
should be allowed to increase if a recession isforecast and held in check should the economy
be likely to overheat. Incontrast, the PSBR increased during the 1970s and was held in check
inthe 1980s. The United Kingdom and other countries have been assisted bythe International
Monetary Fund when they have experienced balance ofpayments deficits.
Required:
(a)Explain whether and how the balance of payments and the PSBR are connected;
(7 marks)
(b)Discuss how a major refurbishment of publicly-funded hospital facilities might affect the
PSBR;
(6 marks)
(c)Explain what courses of action are open to a publicly-funded hospital if it finds its funds are to
be reduced.
(12 marks)
(Total: 25 marks)
14 Sources of finance
20. G Brown
G Brown is an established, listed company producing a range ofcentral heating systems for sale
to builders' merchants. As a result ofincreasing demand for its products, the directors have
decided to expandproduction, and therefore to raise more long term finance.
Required:
(a)Discuss the main factors whichshould be taken into account when choosing between
long-term loancapital and ordinary share capital.
(12 marks)
(b)Explain the term 'convertibleloan stock'. Discuss the advantages and disadvantages of this
form offinance from the viewpoint of both the company and investors.
(7 marks)
(c)Discuss the major factors which alender should take into account when deciding whether to
grant along-term loan to the company.
(6 marks)
(Total: 25 marks)
21. Bestlodge
Bestlodge is planning to build production facilities to introduce a major new product at a cost of
$12 million.
The board of directors has already approved the project on thebasis that it will yield a positive
NPV when discounted, over a ten-yearperiod, at the company's market weighted average cost
of capital. Theinvestment is expected to increase profit before interest and tax byapproximately
25%.
No internally-generated funds are available.
The finance director has suggested three possible sources of finance.
(1)A five-year $12 million floating rate term loan from a clearing bank, at an initial interest rate of
10%.
(2)A ten-year €16 million fixed-rate loan from the Euro-currency market at an interest rate of 7%.
(3)A rights issue at a discount of 10% on the current market price.
The company's share price is 170 cents.
The current summarised financial statements are shown below.
Summarised Statement of financial position as at 31 December 20X1
Required:
Prepare a report which discusses the advantages and disadvantagesof each of the three
suggested sources of finance illustrating how theutilisation of each source might affect the
various providers offinance. (Relevant calculations are an essential part of your report.)
Suggest other sources of finance that might be suitable for this investment.
(25 marks)
15 Cost of capital
23. M Co
The directors of M Co are considering opening a new factory tomanufacture a new product at a
cost of $3.0 million. During the last 5years, the company has had 3 million shares in issue. The
current marketprice of these shares (at 31 December 20X8) is $1.45 ex-dividend.
The company pays only one dividend each year (on 31 December) and dividends for the last
five years have been as follows:
M Co currently has in issue $1 million 7% debentures redeemable on31 December 20Y2 at par.
The current market price of these debentures is$83.60 ex-interest, and the interest is payable in
one amount each yearon 31 December. The company also has outstanding a $500,000 bank
loanrepayable on 31 December 20Y7. The rate of interest on this loan isvariable, being fixed at
3% above the bank's base rate which iscurrently 5%.
Required:
(a)Calculate the weighted average cost of capital (WACC) for M Co as at 31 December 20X8
(15 marks)
(b)Explain the terms business riskand financial risk and the significance of each in using an
existingWACC to appraise a future project.
(7 marks)
(c)Briefly advise the directors of MCo on the suitability of using the WACC calculated in (a)
above todiscount the expected cash flows of the project
(3 marks)
(Total: 25 marks)
Note: Ignore taxation
24. Bacchante
Bacchante Co has a capital structure as follows:
The company's current operations are carried out from two locations.
The Oxford factory shows a cash surplus of $1,750,000 on capitalemployed of $27.5 million,
while the Cambridge factory produces a cashsurplus of $640,000 on its capital of $3.5 million.
It is proposed to invest a further $1.5 million in facilities atCambridge which will increase cash
flow by $150,000 to perpetuity.
Required:
(a)Calculate Bacchante's weighted average cost of capital.
(4 marks)
(b)Comment on the proposed expansion.
(6 marks)
(Total: 10 marks)
Ignore taxation.
25. Kingswick
Kingswick Co is an all-equity financed company with a cost of capital of 18.5%.
The risk-free rate is 8% and the expected return on an average market portfolio is 15%.
It is considering the following capital investment projects:
Required:
(a)Calculate Kingswick's beta factor.
(2 marks)
(b)Calculate the CAPM required return for each project.
(7 marks)
(c)Calculate the expected rate of return of each project.
(7 marks)
(d)Show which projects would beaccepted and rejected if they were discounted at the firm's cost
ofcapital, and highlight those projects where an incorrect decision wouldbe made.
(9 marks)
(Total: 25 marks)
16 Capital structure
26. AB Co
AB Co has always been an all equity financed company with a cost ofcapital of 12%. The
finance director has read an article extolling thebenefits of raising debt finance and has asked
you to provide him withadvice as to how AB Co should finance itself for the future. He is
alsointerested in what discount rate he should be using for projectappraisal. In order to assist
you the finance director has helpfullycollected data on four companies which is summarised
below.
Companies C and D operate in the same industrial sector, whilstcompanies E and F both
operate in a different industrial sector which isperceived as more risky than that of C and D.
All four companies and AB Co itself operate in Zee, a country that is at present a tax-free
society.
You also ascertain that debt, which may be assumed to be risk-free, is currently yielding 4% per
annum to investors.
Required:
(a)Comment on the data supplied bythe finance director in relation to the optimal capital
structure of ABCo and advise on an appropriate discount rate for project appraisal.
(15 marks)
(b)Indicate how your advice might change if corporate taxes were introduced into Zee.
(10 marks)
Note: Your answer should address both theories of gearing.
(Total: 25 marks)
17 Financial ratios
Notes
(1)Each P/E ratio is the average for the year.
(2)The increased equity in year 4was partly the result of a share issue which took place at the
beginningof the year. Some of the $20m raised was used to reduce debt.
For the past five years, PDQ Inc has stated its objectives as: 'Tomaximise shareholder wealth
whilst recognising the responsibility of thecompany to its other stakeholders'.
As one of the consultants working on this assignment, you have beenasked to assess whether
the company has achieved its objectives in thefive-year period under review and to discuss the
key factors which havedetermined your assessment.
Required:
(a)to discuss whether the company has met its objectives, based solely on the information
available
(15 marks)
(b)to comment on what other financial information you would need in order to provide your client
with a more accurate assessment.
(10 marks)
(Total: 25 marks)
18 Dividend policy
28. Deerwood
The board of directors of Deerwood Inc are arguing about the company's dividend policy.
Director A is in favour of financing all investment by retainedearnings and other internally
generated funds. He argues that a highlevel of retentions will save issue costs, and that
declaring dividendsalways results in a fall in share price when the shares are traded exdiv.
Director B believes that the dividend policy depends upon the typeof shareholders that the
company has, and that dividends should be paidaccording to shareholders' needs. She presents
data to the boardrelating to studies of dividend policy in the USA, and a breakdown ofthe
company's current shareholders.
She argues that the company's shareholder 'clientele' must beidentified, and dividends fixed
according to their marginal taxbrackets.
Director C agrees that shareholders are important, but points outthat many institutional
shareholders and private individuals rely ondividends to satisfy their current income
requirements, and prefer aknown dividend now to an uncertain capital gain in the future.
Director D considers the discussion to be a waste of time. Hebelieves that one dividend policy is
as good as any other, and thatdividend policy has no effect on the company's share price. In
supportof his case he cites the dividend irrelevancy theory proposed byModigliani and Miller.
Required:
Critically discuss the arguments of each of the four directorsusing both the information provided
and other evidence on the effect ofdividend policy on the share price that you consider to be
relevant.
(25 marks)
29. Predator Co
The board of directors of Predator Co, a listed company, isconsidering making an offer to
purchase Target Co, a private limitedcompany in the same industry. If Target Co is purchased it
is proposedto continue operating the company as a going concern in the same line ofbusiness.
Summarised details from the most recent set of financial statements for Predator and Target are
shown below:
Predator Co 50 cents ordinary shares, Target Co, 25 cents ordinary shares.
2. Minicorp
Stakeholder groups would include:
potential employees, local residents, wider community,environmental pressure groups,
government, company directors/managersand prestige shareholders
Possible conflicts between their objectives would include:
Local residents/ pressure groups Managers/ shareholders
Local damage will have lasting impact on the environment. Localpeople/pressure groups may
consider this unacceptable whilstshareholders may think that provided compensation is paid it is
areasonable consequence.
Company directors/ managers Employees/Pressure groups
Company directors may do only the minimum to comply with anyhealth and safety legislation in
order to save money. Potentialemployees may be desperate for work and un-informed and may
thereforetake risks with their own health. The wider community and pressuregroups will focus on
employee health as a priority.
Shareholders Government
Shareholders will want to see their own wealth increased by wayof a return on their investment.
The government may regard the wealth asbelonging to the country and seek to prevent profits
being taken out.
Note: Again any number of possible conflicts could beidentified here. The scenario
demonstrates the danger of focussing onimproving share wealth to the exclusion of all other
objectives.
5. Breccon Co
(a) (i) Calculation of NPV
7. ARG Co
(a)NPV calculation for Alpha and Beta
(b)The evaluation assumes thatseveral key variables will remain constant, such as the discount
rate,inflation rates and the taxation rate. In practice this is unlikely. Thetaxation rate is a matter
of government policy and so may change due topolitical or economic necessity.
Specific inflation rates are difficult to predict for more than ashort distance into the future and in
practice are found to beconstantly changing. The range of inflation rates used in the evaluationis
questionable, since over time one would expect the rates toconverge. Given the uncertainty of
future inflation rates, using asingle average inflation rate might well be preferable to using
specificinflation rates.
The discount rate is likely to change as the company's capitalstructure changes. For example, if
the company was to fund thisinvestment entirely via debt or equity finance, the gearing of
thecompany will change.
Looking at the incremental fixed production costs, it seems oddthat nominal fixed production
costs continue to increase even when salesare falling. It also seems odd that incremental fixed
production costsremain constant in real terms when production volumes are changing. Itis
possible that some of these fixed production costs are stepped, inwhich case they should
decrease.
The forecasts of sales volume seem to be too precise, predicting asthey do the growth, maturity
and decline phases of the productlife-cycle. In practice it is likely that improvements or redesign
couldextend the life of the two products beyond five years. The assumptionof constant product
mix seems unrealistic, as the products aresubstitutes and it is possible that one will be relatively
moresuccessful. The sales price has been raised in line with inflation, but alower sales price
could be used in the decline stage to encouragesales.
Net working capital is to remain constant in real terms. Inpractice, the level of working capital will
depend on the workingcapital policies of the company, the value of goods, the credit offeredto
customers, the credit taken from suppliers and so on. It is unlikelythat the constant real value
will be maintained.
The net present value is heavily dependent on the terminal valuederived from the sale of
non-current assets after five years. It isunlikely that this value will be achieved in practice. It is
alsopossible that the machinery can be used to produce other products,rather than be used
solely to produce Alpha and Beta.
8. H Co
(a)Initial investment = $500,000 + $20,000 = $520,000
Contribution:
(b)The NPV is greater than zero, suggesting the project should be accepted.
The problem is the payback period = 2 years 1 month (W), which is slightly outside the
company's target payback period.
Working
(W) After two years, cash inflow is $495,960. Another $24,040 isrequired for payback. In the
third year, time to recover investment =24/217 × 12 = 1.3 months.
Despite the project exceeding the normal payback period of twoyears, the project should be
accepted. There is a predicted NPV of$100,850 – a good return on the investment.
One reservation is that the company is purchasing a productspecific machine with a capacity far
in excess of requirement. Theywould be advised to find a cheaper machine with lower capacity,
whichmay give a better return.
(c)In part (a) of the question, HCo was able to calculate and measure with some degree of
accuracy thenet cash benefits of purchasing the new machine. Several facts wereknown:
● the current machine capacity
● the new machine capacity
● the expected demand
● the current unit contribution.
The forecast NPV of $100,850 should be a reasonable figure that managers can have some
confidence in.
Marketing and IT investment opportunities are more difficult toassess. The future benefits are
difficult to quantify. If a new ITsystem is installed, how can the firm put a value on the benefits to
thestaff and the company? With marketing, if customer perception and theproduct's profile
improve, how can this be measured?
The benefits are often subjective, qualitative and intangible.
It is difficult to use NPV analysis to obtain a meaningful assessment of benefits.
Management will usually be aware of the (high) initial costsassociated with the IT or marketing
decision. The benefits will bedescribed in a report. Often no financial benefit is predicted.
Managers must decide whether the 'improvement in corporate image'and the advancement in
technology are worth the initial costs – asubjective assessment.
9. Quadrant
(a)NPV calculations
Note: Projects A and D are annuities, so it may be quicker to calculate the NPVs as follows:
Project A NPV = –$246,000 + 3.605 × $70,000 = $6,350
Project D NPV = –$180,000 + 3.037 × $62,000 = $8,294
There is a slight difference to the answer above through rounding.Either answer is acceptable.
Note it will make a slight difference tosome of the answers below.
Ranking of projects:
Ranking of projects:
Note 1: At this point there is only $110,000 left to invest. Thiswill therefore be invested into part
of project B. Given that only $110kout of $180k is being invested, the return generated will only
be$1,150 ($1,882 × $110k ÷ $180k)
The rankings differ from (a) because NPV is an absolute measurewhereas the profitability index
is a relative measure that takes intoaccount the different investment cost of each project.
(c)The objective is to select acombination of investments that will maximise NPV subject to a
totalcapital outlay of $620,000. Projects A and E are mutually exclusive, andproject C has a
negative NPV. The following are potential combinationsof projects:
● Best option
Note: It is not possible to combine four projects within theconstraints outlined above, and
expected NPV cannot be increased bycombining two projects.
Accepting projects A, D and F will maximise NPV
This combination will require a total capital outlay of $576,000,and the unused funds will be
invested to yield a return of 9%. Since themoney market is an efficient market, the NPV of funds
invested herewill be zero.
(d)Risk and uncertainty may be considered in several ways. For example:
Adding a risk premium to the discount rate
A premium may be added to the usual discount rate to provide asafety margin. Marginally
profitable projects (perhaps the riskiest) areless likely to have a positive NPV. The premium may
vary from projectto project to reflect the different levels of risk.
Payback period
Estimates of cash flows several years ahead are quite likely to beinaccurate and unreliable. It
may be difficult to control capitalprojects over a long period of time. Risk may be limited by
selectingprojects with short payback periods.
Sensitivity analysis
Sensitivity analysis typically involves posing 'what if' questions.For example, what if demand fell
by 10%, selling price was decreased by5%, etc. Alternatively, we may wish to discover the
maximum possiblechange in one of the parameters before the project is no longer viable.This
maximum possible change is often expressed as a percentage:
This would be calculated for each input individually. The key is to identify the relevant cash flow.
Probability distribution
A probability distribution of expected cash flows may bedetermined, and hence the expected
NPV (EV) may be found together withrisk analysis e.g. best possible outcome, worst possible
outcome,probability of a negative NPV. A more sophisticated measure of risk isto calculate the
standard deviation. This considers the degree ofdispersion of the different possible NPVs
around the expected NPV. Thegreater the spread of outcomes around the expected NPV, the
higher thepotential risk. The coefficient of variation should be calculated tocompare projects.
10. Ceder Co
(a)Evaluation of which model should be purchased
De-luxe model:
The above calculations have assumed that the assets are purchasedon the first day of the
accounting period and that the working capitalis released immediately as each project ceases.
(b)Normally the project with thehighest NPV would be selected. However, as the projects have
unequallives, it can be argued that although the de-luxe has a higher NPV, thisis only achieved
by operating for two more years. If the machines areto fulfil a continuing production requirement
the time factor needs tobe considered.
This is done by calculating the equivalent annual cash flow:
Standard model:
De-luxe model:
As the standard model has the highest equivalent annual cash flow, it is recommended that this
machine be purchased.
Note: Strictly speaking, an adjustment should be made for thedifferent levels of risk associated
with the two projects within theannual equivalent cost calculation. However, this is beyond the
scope ofthe current F9 syllabus.
(c)Lease v buy decision
11. Sludgewater
(a)The expected present value of the fines is equal to:
EV = (0.3 × $1.0m) + (0.5 × $1.8m) + (0.2 × $2.6m) = $0.3m + $0.9m + $0.52m = $1.72 million.
Calculation of the net present value of the investment requirescomputation of the capital cost
plus incremental production costs as setout in the following table:
Notes:
(1)The consultant's charge has already been incurred and (as a committed cost) is therefore
irrelevant to the current decision.
(2)Increased production costs
The negative NPV on the investment in spray painting equipmentexceeds the present value of
the fines which Sludgewater might expect topay. It therefore seems that the project is not viable
in financialterms, and it would be cheaper to risk payment of the fines. However,the company
must accept that to do so might risk incurring the wrath ofboth shareholders and the
environmental lobby.
(b)An expected value is calculatedby using forecast probabilities to weight the values of
alternativeoutcomes and thus compute an arithmetic mean for the overall expectedresult. There
are three main problems with the use of expected valuesfor making investment decisions:
(i)The investment may only occuronce. It is certainly very unlikely that there will be the
opportunityto repeat the investment many times. The average of the anticipatedreturns will thus
not be observed.
(ii) Attaching probabilities toevents is a highly subjective process. In investment
decisions,probability may often be used in relation to sales forecasts derivedfrom market
research. The subjectivity involved in setting probabilitiesmeans that the judgements may be
incorrect, even though the Net PresentValue for the investment may be highly sensitive to
changes in theprobability distribution.
(iii)The expected value does not evaluate the range of possible NPV outcomes.
The limitations of expected values can be demonstrated by means of asimple example.
Suppose that an individual places a $10 bet with acolleague that it will rain within the next 24
hours. The weatherforecast predicts the likelihood of rain with the 24-hour period at 60%.The
expected value of the bet can thus be calculated as: (0.6 * £10)– [0.4 * (£10)] = $2. In
reality, the expected value can never beobserved, because the person will never be just $2
better off, only $10richer or poorer depending on the success of the bet.
(c)On purely non-financialcriteria, it can be argued that Sludgewater has a moral and
communityresponsibility to install anti-pollution equipment as long as the costof installation does
not jeopardise the long-term survival of thecompany.
However, the figures above suggest that the project is notwealth-creating for Sludgewater's
shareholders, because the value of theexpected saving in fines ($1.72 million) is below the
expected cost ofthe project ($2.756 million). The difficulty is that this conclusion isdependent on
the current size of the fines payable, and if they were torise substantially, then the optimal
choice (in financial terms) mightchange. The difference between the expected value of the fines
and thecost of the project is currently just over $1 million. This means thatthe fines would need
to rise by nearly 60% (1/1.72 × 100) before theproject becomes financially worthwhile. Changes
in the size of the fineswould be very difficult to predict as it is a political issue. However,since the
company is a persistent offender, and the green lobby isbecoming more influential, it is not
unreasonable to anticipate that thefines will rise in the future as a result of political pressure.
It would be advisable, from a public relations perspective, for theBoard to consider alternative
and perhaps less expensive anti-pollutionmeasures. It is also possible that the market for this
company'sproducts might increase if it is perceived to be more environmentallyfriendly, and if
customers are sensitive to this. It is even possiblethat the company's share price might benefit
from managers of 'ethical'investment funds deciding to include Sludgewater shares in
theirportfolio.
In addition, the company needs to think about its long-termstrategic objectives, and its stance
on anti-pollution systems inrelation to these objectives. The market positioning of the company
overthe longer term is likely to be affected by decisions made in the shortterm, and so even if
not investing in the project makes short-termfinancial sense, it may be more attractive from a
long-term viewpoint.It is also possible that technological and legal circumstances willchange
over time, and such changes need to be anticipated in currentdecisions.
12. Pheonix
(a) and (b): Return on capital employed
Conclusions: The ROCE can be computed in any number of ways, and sothe results must be
interpreted with care, in particular when drawingcomparisons between different businesses.
(c)Payback period
(d)NPV @ 15%
(f)Sensitivity
(i)the required rate of return
13. Cloud Co
(a)Cash conversion cycle
The cash conversion cycle (operating cycle) is the time betweenpaying out cash for
purchases and receiving cash from customers. Forexample, if a raw material is
purchased on credit, converted into afinished goods, then sold to a customer on credit,
the operating cycleis the time between paying for those raw materials (not purchasing
them)and receiving cash from the customer who bought them.
The operating cycle for a company may be calculated as follows:
Inventory days + Receivable days – Payable days
The longer the operating cycle, the more capital is tied up andthe higher the cost to
finance this capital. A company could reduce theworking capital tied up by optimising the
components of the cycle. So,for example, shortening the inventory days (by introducing a
JIT system,for instance), shortening the receivable days (by chasing receivables)or
increasing the payable days, will all shorten the operating cycle.
(b)Cash operating cycle
It is important to match the funding with the life of assets. Wecan analyse assets into
non-current assets, permanent current assets andfluctuating current assets. Permanent
current assets, being 'core'current assets that are needed to support normal levels of
sales, shouldbe financed from a long-term source. The working capital policy
chosenshould take account of the relative risk of long- and short-term financeto the
company and the need to balance liquidity against profitability.
An aggressive financing policy will use short-term funds tofinance fluctuating current
assets as well as to finance part of thepermanent current assets. This policy is more
risky, since short-termfinance is more risky than long-term, but is likely to be cheaper
sinceshort-term funds usually have a lower rate of interest, and henceincrease
profitability.
A conservative financing policy will use long-term funds tofinance permanent current
assets as well as to finance part of thefluctuating current assets. This is less risky, but
also lessprofitable.
(e)Current funding problems
Cloud Co needs to re-organise the funding of its business in a waywhich reduces its
exposure to short-term debt. This could be doneeither by converting the bank overdraft
into a long-term loan or byincreasing the equity investment.
Conversion of the overdraft would alter the overall level offinancial gearing within the
business and so would bring some additionalrisks for both equity investors and suppliers.
Increasing the equityinvestment is the better alternative. The issued share capital is
lowgiven the current level of sales. However, the ability of Cloud to dothis will depend on
whether the existing shareholders are willing toinvest more money or whether new
shareholders could be found.
At the same time, Cloud could look carefully at its current levelsof working capital and aim
to reduce the level of inventory andreceivables as a means of releasing capital. In 2010,
receivables andinventory levels stood at 16.0% and 16.8% of sales value respectively.If
the 2009 levels had been maintained (12.1% and 10.7%), the company'sinvestment in
these two current assets could have been reduced from $43mto $30m, a saving of $13m.
The cash freed up by tighter working capitalcontrols may then provide sufficient capital to
pay for further salesexpansion in the future, without the need to look for additional
outsidefunding.
Additionally the company could restrict further growth in order to avoid overtrading.
Cloud would appear to have exhausted its sources of workingcapital, and any further
increases in sales would therefore place thecompany under a great cash strain. By
reorganising its financing, andincreasing the long-term equity investment, Cloud could
regain access toadditional short-term borrowing, and so avoid the risk of overtrading.
14. Hexicon
(a)Economic order quantity:
(i)
15. Marton
(a)Option 1 – Factoring
16. Thorne
(a)Cash Budget for Thorne Co:
Workings
18. Toytown
(a) (i) Economic risk
Economic risk is the variation in the value of the business (i.e.the present value of
future cash flows) due to unexpected changes inexchange rates. It has a long-term
impact.
For an export company it could occur because:
● the home currency strengthens against the currency in which it trades
● a competitor's home currency weakens against the currency in which it trades.
Toytown would face problems if the Australian dollar strengthensagainst the other
local currencies. The company would then have toconsider either decreasing the profit
margin on products, or increasingthe sales price to maintain profit levels. The second
option couldresult in a loss of sales. The likelihood of this would be increased
ifToytown faced more competition from local companies who are not exposedto the
same risk.
(ii)Translation risk
Translation risk is an accounting risk rather than a cash-basedone. It arises when the
reported performance of an overseas subsidiaryis translated into the home-based
currency terms in order that they canbe consolidated into the group's financial
statements and is distortedbecause of a change in exchange rates.
Unless managers believe that the company's share price will fallas a result of showing
a translation exposure loss in the company'saccounts, translation exposure will not
normally be hedged. Thecompany's share price, in an efficient market, should only
react toexposure that is likely to have an impact on cash flows.
In the case of Toytown, if the subsidiary company wereestablished, a variation in the
Australian dollar to US dollar exchangerate would cause a variation in the reported
valuation of thesubsidiary. For example, if the Australian dollar strengthened
againstthe US dollar, the reported value of the subsidiary would decrease.
Transaction risk is the risk of an exchange rate changing betweenthe transaction date
and the subsequent settlement date, i.e. it is thegain or loss arising on conversion.
This type of risk is primarilyassociated with imports and exports. If a company exports
goods oncredit then it has a figure for receivables in its accounts. The amountit will
finally receive depends on the foreign exchange movement fromthe transaction date
to the settlement date.
Transaction risk has a potential impact on the cash flows of a company. The degree of
exposure involved is dependent on:
● the size of the transaction (is it material?)
● the time period before the expected cash flows occurs
● the anticipated volatility of the exchange rates.
In the case of Toytown, if the Australian dollar strengthensagainst the US dollar during
the six weeks before it pays the supplierfor purchases from the USA, the company will
make a gain. If theAustralian dollar strengthens against local currencies before it is
paidby customers, the company will make a loss.
(b) (i) Leading and lagging
Leading and lagging are means used to alter the time periodbetween the transaction
and settlement dates to avoid exchange ratelosses or increase the likelihood of a
gain.
If an exporter expects that the currency it is due to receive willdepreciate over the next
few months, it may try to obtain paymentimmediately, perhaps by offering a discount
for immediate payment. Thisis leading.
Lagging is an attempt to delay payment if the importerexpects that the currency it is
due to pay will depreciate. This may beachieved by agreement or by exceeding credit
terms.
Strictly speaking this is not hedging the exposure, it isspeculation. The company only
benefits if it correctly anticipates theexchange rate movement.
(ii)Matching
When a company has receipts and payments in the same foreigncurrency due at the
same time, it can simply match them against eachother. It is then only necessary to
deal on the foreign exchange (forex)markets for the unmatched portion of the total
transactions.
Where a firm has regular receipts and payments in the samecurrency, it may choose
to operate a foreign currency bank account. Thisoperates as a permanent matching
process and the exposure to exchangerisk is limited to the net balance on the
account.
The scope for matching is limited unless there are flows in both directions.
Forward exchange contracts are the most frequently used method ofhedging. Such a
contract is a binding agreement to buy or sell currencyat a fixed future date for a
predetermined rate, the forward rate ofexchange.
Advantages are that companies have flexibility with regard to theamount to be
covered and that the contracts are relativelystraightforward both to comprehend and
to organise. The agreement on afixed rate eliminates downside risk.
However there are disadvantages – the company makes acontractual commitment
that must be completed on the due date and has noopportunity to benefit from
favourable movements in exchange rates.They are not available in all currencies.
(iv)Currency options
Options are similar to forwards, but with one key difference –they give the right, but
not the obligation, to buy or sell currency atsome point in the future at a
predetermined date. A company cantherefore exercise the option if it is in its interests
to do so, or letit lapse if the spot rate is more favourable or there is no longer aneed
to exchange currency.
The advantage of options is that they eliminate downside risk butallow participation in
the upside. Options are most useful when there isuncertainty about the timing of the
transaction, or when exchange ratesare very volatile.
However the additional flexibility comes at a price – a premiummust be paid to
purchase an option, whether or not it is ever used.
(c)Factors which Toytown will need to consider include:
● the cost of different options, for example, this would be lower for a forward exchange
contract than for currency options
● the expertise of staff and the capacity of the company's management to arrange and
manage different means of hedging
● whether receipts and payments in US dollars are likely to coincide enough for them to be
matched
● how reliably the company can predict payment dates from customers – they have
control over payment dates to the US supplier
● the likely volatility of exchange rates – the company needs to try to predict them as
accurately as possible
● the availability of different methods – whether all products are available for all
currencies.
If the company does set up a subsidiary as planned, then it may bepossible to match US dollar
transactions if these become stable andpredictable. However, in the early stages of a new
business they arelikely to be less predictable and matching may not be possible.
At the current time the company is able to forecast the timing ofreceipts and payments so
forward contracts are likely to be the mostsuitable method. They should be available in most of
the currencies thecompany deals in and are easy for staff to understand.
If in the future cash flows become uncertain, the company may want to reconsider the use of
currency options.
(d)A forward rate agreement is anover-the-counter agreement between a bank and a customer.
A customer canbuy an FRA to fix the interest rate for a short-term loan starting at afuture date.
The FRA relates to a specific borrowing period. In theexample given in the question the
company can borrow for a period of 6months starting in 2 months time at a simple annual
interest rate of5.0%. This locks the company into an effective interest rate of 5.0%whatever the
market rate.
The company enters into a normal loan but independently organises a forward with a bank:
● interest is paid on the loan in the normal way
● if the interest is greater than the agreed forward rate, the bank pays the difference to the
company
● if the interest is less than the agreed forward rate, the company pays the difference to the
bank.
The FRA:
In this case Toytown is protected from a rise in interest rates,but is not able to benefit from a fall
in interest rates – it islocked into a rate of 5%. The FRA hedges the company against both
anadverse movement and a favourable movement.
19. PSBR
(a)A country's balance of paymentsis the balance between its total imports and total exports.
The levelsof imports and exports include both visibles (goods) and ‘invisibles'(services and
movements of funds).
When imports exceed exports in any period, this is known as a‘trade deficit', and when exports
exceed imports this is known as a‘trade surplus'.
The Public Sector Borrowing Requirement (PSBR) is the amount bywhich government spending
exceeds government revenues in any accountingperiod. If the PSBR is negative it is referred to
as the PSDR (PublicSector Debt Repayment).
During the mid 1980s the UK had a PSDR, but in recent yearsfalling tax receipts and increasing
unemployment benefit payments haveresulted in a significant PSBR.
The balance of payments and the PSBR are connected by some common economic factors:
(i) Inflation
If a country experiences high levels of demand pull inflation thenone way of seeking to
control this problem is to raise short terminterest rates. This has the effect of reducing
the money supply andhence the demand for goods and services. If this happens the
level ofimports is likely to fall, but also, as the economy slows down, thegovernment
tax revenues will fall.
(ii) Devaluation
If the pound falls in value against other currencies this willmake imports more
expensive and exports cheaper. In the long term theeffect of this should be an
improvement in the balance of paymentsposition.
As imports are more expensive, however, this may also lead tohigher inflation. The
government may seek to control this by eitherraising interest rates or increasing the
tax burden, either of whichwould affect the PSBR.
The World Bank provides assistance in the form of financial aid tocountries with
severe balance of payments problems. The aid is nearlyalways linked, however, to a
devaluation of the currency and an increasein domestic interest rates, both of which
are designed to stabilise thecurrency.
(b)A major refurbishment of apublicly funded hospital could be financed from increased taxation
orreduced spending on other areas of government activity, or by increasinggovernment
borrowing.
Increased taxation or reduced spending on other areas of activitywould not result in an increase
in the PSBR, as it is simply a transferof funds from one part of the economy to another. If the
governmentfinances the major refurbishment from increased borrowing however, thiswould
result in an increase in the PSBR.
(c)A publicly funded hospital thatfinds that its funds are to be reduced must either reduce
itsexpenditure, or increase its income from elsewhere, or undertake acombination of these two.
If neither course of action is undertaken then the hospital willaccumulate an increasing deficit
which may infringe the hospital'soperating regulations.
Expenditure reduction methods include:
(i)Cancelling non-urgentoperations, closing down certain wards for a period of time, or
allowingcertain waiting lists to lengthen. The difficulty with this course ofaction is that
the problems may only be postponed to a future date, andthe result of this policy may
not be acceptable in relation togovernment targets.
(ii) Applying modern managementaccounting techniques aimed at improving the
economy, efficiency andeffectiveness of the services provided.
Income raising methods include:
(i)Generation of income from theprivate use of surplus resources e.g., offering the use
of unused wardsfor private healthcare patients.
(ii) Fund-raising campaigns to provide resources for certain specified projects.
(iii)The sale and leaseback of land and buildings where government regulations
permit.
(iv)Offering ancillary services in hospitals for which people would be expected to pay
e.g. shops, catering services, etc.
20. G Brown
(a) Factors to consider when choosing between debt and equity:
(b) Convertible loan stock provides the investor with the right,but not the obligation, to convert
the loan stock into ordinary sharesat a specified future date and a specified price. The investor
will onlyexercise this option if the market value of the shares is above the'exercise price' at the
specified date. The investor will change statusfrom that of lender to that of owner when the
option to convert isexercised.
The main benefit to the investor is that if the company issuccessful the investor will be able to
participate in that success.This participation is not possible with straight debt. For the
investorthen, convertible loan stock offers the best of both worlds –relatively low risk debt, but
with participation in a successfulcompany. Because of this finance is relatively easily raised.
If the company is successful, the convertible loan stock will beself-liquidating, which can be
convenient for the company. The companymay also be able to negotiate lower rates of interest
or fewer loanrestrictions because of the potential gains on conversion.
Convertible loan stock is often used in takeover deals. The targetcompany shareholders may
find this form of finance attractive if theyare uncertain as to the future prospects of the combined
business. Theinvestors will be guaranteed a fixed rate of return and, if the combinedbusiness is
successful, they will be able to participate in thissuccess through the conversion process.
However, convertible loan stockcan be viewed as part loan and part equity finance, and some
investorsmay find it difficult to assess the value to be placed on suchsecurities.
(c) When deciding to grant a loan, the following factors should be considered:
Purpose of the loan
Lenders will want to know what the loan is for, and the likely returns from the finance provided.
Security
Investors will want to take a charge over the assets of thecompany as security for the loan.
They will ensure that the company hasassets available for security. If not, the interest charged
will behigher.
The ability of the borrower to repay
The finance providers will check the credit history of thecompany as well as forecast financial
statements to ensure theirinvestment is safe. They will use the services of a credit
referenceagency (e.g. Dunn and Bradstreet) who will classify the companyregarding its credit
risk.
The character and integrity of senior managers
Finance providers will want to know that the company is well runbefore investing in a company.
The senior management team should havethe skills necessary to ensure, as far as possible, the
success of theinvestment.
21. Bestlodge
Report
To Managing Director, Bestlodge
From A Consultant
Date Today
Subject Evaluation of financing alternatives for Bestlodge
Contents
(1)Terms of reference
(2)Floating rate loan
(3)Euro currency loan
(4)Rights issue
(5)Alternative sources of finance
(6)Conclusions and recommendations
(1) Terms of reference
The following report will evaluate the impact of each source of finance in terms of its:
(i)cost
(ii) risk
(iii)impact upon other suppliers of capital.
A number of alternative sources of finance are briefly discussed. Iwould be pleased to provide
more details of these upon request. Arecommendation is made on the most suitable of the
sources of financeyou are currently considering.
(2) Floating rate loan
(1) Cost
Debt finance is relatively cheap particularly if the company is ina position to offset the interest
charge against taxable profits.
(2) Risk
The interest rate is variable and it could rise if generalinterest rates move upwards. On the other
hand, if interest rates fall,it ensures that Bestlodge is not left with a high-cost loan. Floatingrate
loans make cash budgeting difficult, but as variation in interestrates tends to be related to
inflation rates the firm should find thatincreases in interest costs are partly matched by
increases in operatingcash flows due to higher inflation.
The loan is only for five years. If the project has not generatedsufficient cash to repay the
principal in this time, a further source offinance will be required. The availability of further funds
in fiveyears' time should be considered.
The loan will, at least initially, substantially increase thefirm's gearing. In book value terms the
likely effect is as follows:
Tutorial note
Other gearing measures would be acceptable. One particularlyuseful approach could be to
calculate gearing on market values of debtand equity.
This increase in gearing is also reflected in the firm's interest coverage:
The acceptability of these increases will largely be determined byindustry standards and the
firm's debt capacity. However, the loanappears to increase significantly the financial risk of the
firm.
The existing loan notes will need to be redeemed in the near future and the firm should consider
how this is to be financed.
(3)Impact upon other suppliers of capital
Equity: The increase in gearing will increase the risks taken by equity holders.
Earnings per share (EPS) is, however, likely to increase. This would also improve dividend
cover.
Debt: The increase in gearing, depending upon the quality of theassets supporting the new loan
and the debt covenants involved, couldincrease the risks of the existing debenture holders.
(3)Euro currency loan
Many of the comments made regarding the above loan are also applicable. In addition,
the following points should be considered.
Although this is a fixed rate loan, any changes in the €/$exchange rate could significantly
affect its cost. The $ appears toweaken on the forward market in the coming year by
approximately
This would increase interest and principal repayments by 6% pa. Ifthis trend continues it
could add significantly to the cost of theloan. For example, if we assume a $ depreciation
of 6% pa, then thiswould increase the actual pre-tax cost of the loan to
7% (1.06) + 6% = 13.42%
(Effect on interest) + (Effect on principal)
This would then be an expensive source of finance. It also addsforeign exchange risk to
the substantial financial risk (gearing) beingtaken by the firm.
(4)Rights issue
To raise $12 million at current market prices the number of new shares required will be
approximately
(1)Cost
As equity holders normally demand higher returns than debtinvestors, this will be a
relatively expensive source of finance. Ifthese returns are not earned, share price would
fall.
Issue costs would probably be larger than the arrangement costs on the debt finance.
(2)Risk
This is permanent finance and will not bring the pressure of early repayment.
A rights issue should substantially reduce the firm's gearing level, from 48.9% to
This represents only a marginal increase over existing EPS. Thismust be contrasted with
the higher returns from the higher riskfinancing strategies
(5) Alternative sources of finance
Note: that the calculation can be done on the value of thewhole equity or on the basis of the
minimum shareholding needed toacquire one extra share:
The chairman is correct. The shareholder should either exercise the rights or sell them (subject
to (d) below).
(1) Take up his rights
Buy the new shares to which he is entitled. He can buy 400 newshares at $3.00, which will
mean investing an additional $1,200 in thecompany.
The investor will now have an investment of 1,400 shares that in theory will be worth $5,600
($4.00 per share).
The value of the total investment has gone up by $1,200, but thisis the amount of the additional
investment he has made to acquire thenew shares, so his wealth is unchanged.
By selling his rights, the investor receives $400, but the valueof his investment is likely to fall by
$400, leaving him no better andno worse off overall.
(3) Buys 200 shares and sells 200 rights
Again his overall wealth is unchanged.
(4) Take no action
If the investor takes no action, the value of his shares is likelyto fall from $4,400 before the
rights issue to $4,000 after the rightsissue. Taking no action is therefore an inadvisable option,
because itresults in a fall in investment value without any offsetting benefitfrom the sale of
rights.
(d) Real circumstances to support the shareholder's claim
Reduction in wealth
It is possible that the shareholder, even though either exercisingthe rights or selling them,
will suffer a reduction in wealth.
The above analysis is based on the assumption that the funds to beraised by the new
issue of shares will be invested in the business toearn a rate of return comparable to the
return on the existing funds.
The stock market, in valuing the shares of Cherry Tree after therights issue, has to make
some assumption as to how profitably the newfunds are to be used.
For example, if the new funds were squandered, the overall returnon equity funds would
fall and the price would drop below the $4.00calculated above.
Alternatively, if the sales are to be used to finance a highlyprofitable investment and the
stock market does not initially appreciatethis point, then the market in arriving at a price of
$4.00 ex-rightswould be undervaluing the shares. When the true earning potential of
thecompany was realised, the share price would rise.
However, by then it may be too late for the shareholder referred to in the question.
If the shareholder exercises the rights in the circumstances justdescribed, he will not lose.
When the shares rise in price he willbenefit. However, if at the time of the rights issue he
decides to sellthe rights, he will lose.
The value of the right in the circumstances described is based onthe assumption that the
new funds will earn as much as the old. Laterthe person who exercises the rights will
benefit, when the shares risein price above that expected at the time of issue.
(e) Alternative methods of issuing equity finance
Placing
A placing is where an issuing house undertakes to find purchasersfor the shares and places the
shares with these clients. Issue costs aremuch cheaper as there are no underwriting costs or
prospectus costs.However, there are limitations on the amount of capital that can beraised using
this method and shares tend to be placed in larger bundles.This will dilute the control of current
shareholders as shares are morelikely to be placed with large financial institutions.
Offer for sale
Shares are sold to an issuing house which then offers the sharesfor sale to the general public
either at a fixed price or by tender. Ifthe sale is by tender then a minimum price is set and the
actual issueprice determined when all of the tenders have been received. The issuesare always
underwritten and this fee is payable to the issuing house andwill vary with the degree of risk
relating to the issue. There is norestriction on the amount of capital that can be raised using
thismethod but issue costs are likely to be higher than a rights issue andexisting control may be
diluted.
A public offer for subscription
Shares are sold directly to the public by the company. Issue costsare likely to be high as the
company must advertise and administer theprocess. Specialist advisors are used to determine
the issue price andunderwriting fees may be high. This method enables a company to access
awider market for funds but they may not have the in house expertise toadminister the process
and the issue costs may be prohibitively high fora relatively small issue of shares.
23. M Co
(a) Calculation of weighted average cost of capital
Definitions:
K = weighted average cost of capital
ke = cost of equity capital
kd – cost of debenture capital
kL = cost of bank loan
E = Total ex-dividend market value of equity
D = Total ex-interest market value of debt
L = Total value of outstanding bank loan
(i)Calculation of ke
Assuming an underlying dividend growth of g per annum, the average growth rate between
20X4 and 20X8 is given by:
g = 6.4%
Assuming that shareholders take past dividend growth as areasonable approximation to future
dividend growth, then using thedividend growth model,
(ii) Calculation of kd
kd is the discount rate which equates the present value of futureincome ($7 per annum) and
redemption ($100) to the current market price($83.60).
The weighted average cost of capital should only be used as thetarget discount rate for
appraising investment opportunities whoseacceptance will not alter the weighted average
cost of capital.
Since the cost of any type of capital can be regarded as afunction of a risk-free rate and a
risk premium, this implies that kshould not be used to evaluate opportunities which have
significantlydifferent risk characteristics from the average risk borne by thecompany prior
to acceptance of the project.
In this context, it is useful to separate the total risk of thecompany into business risk and
financial risk. The business risk is therisk inherent in the nature of the company's
operations. The financialrisk is a function of a company's gearing. For a project to be
evaluatedusing k, its acceptance must not alter the company's overall businessrisk nor
must it alter the financial risk. Therefore, it must be of asimilar nature to existing projects
and it must be financed in such away that the gearing ratio is unchanged and hence the
financial risk isunaltered. In practice may also be used to evaluate small or
marginalprojects whose acceptance is unlikely to alter overall corporate risk.
(c) Advice to directors
The situation outlined in the question if such that the projectbeing considered could hardly
be thought of as marginal. The cost of theproject ($3m) is nearly 70% of the existing
market value of thecompany. In these circumstance k could only be used as a target
discountrate if its business risk were the same as that of existing projectsand it were to be
financed in the same way as existing projects. This isunlikely to be the case, and as a
generalisation it is probably unwiseto use the existing k to evaluate such a major
investment opportunity.
24. Bacchante
(a)x(S = Step)
Therefore:
(1)The proposal's return (IRR) is below current WACC and should be rejected.
(2)Note that current facilities atOxford appear to yield a very low return, though without more
data (e.g.is capital employed at current valuation?) the significance of thisfact is difficult to
evaluate.
Alternatively the WACC could be used to discount the Cambridgeproject:
25. Kingswick
(a)Since Kingswick is all equity financed its cost of capital is the same as its cost of
equity.
Assuming that Kingswick's cost of capital properly reflects its beta factor:
Ke = Rf + β ( Rm – Rf)
therefore:
18.5 = 8 + β(15 – 8)
10.5 = 7β
β = 10.5 ÷ 7 = 1.5
(b) & (c)
(d)If the projects were discountedat the company's cost of capital, 18.5%, then only those with
yield ≥18.5% would be accepted, i.e. the company would accept C, D and E andreject A and B.
Using the firm's cost of capital is clearly wrong because it doesnot allow for the different risks of
the projects. It is simply arequired rate of return given company risk at the time capital cost
isevaluated. The projects where an incorrect decision would be made byusing the firm's cost of
capital are:
Project B a valuable low risk project is incorrectly rejected.
Project E this would be accepted despite the fact that its return is not high enough to
compensate for its high systematic risk.
26. AB Co
(a)The data collected by thefinance director supports Modigliani and Miller's (M&M) theory
ofgearing (see workings below). This states that, in the absence oftaxation, a company's
weighted average cost of capital (WACC) dependsonly on the risk of that company’s
earnings (i.e. the level ofbusiness or earnings risk). In particular the WACC of a company in
thesecircumstances is independent of its capital structure.
If one accepts these results, then AB Co would always be facedwith a WACC equal to its
present WACC of 12%. The downward effect ofissuing cheaper debt finance (at 4%) on the
WACC will always, aspredicted by M&M, be counteracted by an equal and opposite rise inthe
cost of equity. This can be illustrated as follows for AB Co.
Consequently the discount rate that should be used for project appraisal is the WACC of 12%.
This assumes that the projects to be appraised will carry the same business risk as that from the
existing operations of AB Co.
As an alternative to the above analysis it is also necessary toconsider briefly the implications of
the traditional theory of gearing.This is best illustrated in its results by the following diagram.
Under the traditional theory of gearing the initial rise in equityas gearing increases is initially
outweighed in the WACC calculation bythe introduction of cheaper debt finance. Eventually this
effect isreversed and with the influence of bankruptcy risk (see below) even thecost of debt rises
at high levels of gearing. The overall effect is toproduce a WACC that, for some optimal level of
gearing, is a minimum.
If the data collected by the finance director are consistent withM&M purely by chance (i.e. the
traditional theory is that whichactually describes the relationship between WACC and gearing),
then ABCo should issue sufficient debt to attain its optimal gearing level(i.e. lowest WACC). At
optimal gearing the associated minimum WACC willbe an appropriate discount rate for
investment appraisal.
Workings:
(b)Corporate taxes
If corporate taxes are introduced the effect is to produce a costof debt that is lower than the 4%
return required by the providers ofdebt finance. This is on the assumption that companies in Zee
can setinterest payments against profits for the purpose of computing tax, thusobtaining tax
relief on such payments.
M&M predict that the effect on WACC will be as indicated below.
It can be seen that any increase in gearing will produce a lowerWACC. Thus, if one accepts
M&M's hypothesis with corporation tax, ABCo would seek to gear as highly as possible (in
practice investors willset an upper limit on borrowing). An appropriate discount rate forproject
appraisal would be the WACC at the highest gearing level.
Considering the traditional theory of gearing with corporation tax,the effect of tax on the cost of
debt is as described above. However,this will not change the basic result of the traditional theory
(i.e.that there exists an optimal level of gearing) and again the minimumWACC will be used as a
discount rate.
The share issue of $20m at the start of year 4 seems to havedisturbed the favourable trends in
earnings and dividends per share forthat year. However the overall pattern looks very
satisfactory over the 5year period; the company has succeeded in increasing shareholder
wealthas it hoped.
By year 5 the share price stands at $91.2m/8m = $11.40 per share compared with only
$41.6m/6m = $6.93 in year 1.
The other financial stakeholders can see their shares in the company's results as follows:
We can see that payments to employees fell substantially after year3, together with the absolute
number of employees. The average wagesper employee has fallen since year 2, suggesting
that the mix ofemployees is shifting towards less-skilled workers which could bringproblems in
the future.
The loan creditors have received less interest payments in years 4and 5, but this arises purely
because of the reduction in long-term debtmade possible by the rights issue at the start of year
4.
Conclusion
It appears that individual employees have received less of thefinancial benefits accruing to the
company than the shareholders. Whilethe average wages per employee has fallen over the last
four years(suggesting perhaps that certain senior employees have been maderedundant),
dividends per share have risen substantially over the sameperiod.
It is not possible to judge, purely from the information available,whether the company has or has
not met its objectives. The additionalinformation that would be helpful is discussed below.
(b)Other financial informationwhich would be needed to assess more accurately whether the
company hasmet its objectives includes the following:
● What investment possibilities were rejected by management? The analysis above
seemed to show that shareholders did well over the period, but was their return
maximised, i.e. the best possible? To decide this it would be necessary to assess the
alternative courses of action that were rejected during the course of the year; if any of
these would have been more profitable than what was actually decided, then the
shareholders' return was not the maximum possible.
● How did securities markets in general fare over the period? A shareholder should view his
investment in shares in the company in the light of other returns available on similarly
risked securities in the market. If better returns were available elsewhere at no more risk
than the rational risk averse investor should dispose of their shares.
● What was the inflation rate over the period? Growth in money amounts of dividends and
earnings might look less impressive if the trend is deflated by the inflation rate and only
real increases are examined.
● Details of the company's workforce. Why has the payroll cost reduced in the last two
years, by cutting wage rates or by losing high-paid employees? If there has been a formal
programme of rationalisation and redundancies, an assessment of future prospects would
be valuable.
● Volatility of share prices. We are given an average P/E ratio for each year, but how volatile
has this and the share price been during each year? Companies should seek to reduce
volatility by keeping markets informed so that analysts appreciate what the management
are trying to do. This should support the share price.
● Amounts spent on environmental and social issues. A progressive company in today's
business environment recognises its responsibilities to society on top of its other duties.
Projects to ensure the minimum of pollution and support of local communities will serve to
discharge these responsibilities.
● Amounts spent on employee communications and staff welfare would similarly support the
good reputation of the company.
28. Deerwood
Director A believes that investment should be financed byinternally generated funds, including
retained earnings. This implies alow dividend payout or no dividend payout, probably with the
amount ofdividend to be paid being treated as a residual after all investmentfinancing needs
have been satisfied. The residual theory of dividends isbased upon the belief that investors will
prefer the company to retainand reinvest earnings rather than pay dividends s as long as the
returnon reinvested earnings is greater than the return investors could earnon other investments
of similar risk. However if dividends are only paidafter all investment financing needs have been
satisfied, the amount ofdividend paid is likely to fluctuate greatly depending upon the size ofthe
investment budget for the year and the level of after tax earnings.If investors object to
fluctuating dividends, in particular dividendreductions, the cost of equity is likely to be higher for
a company thatadopts a residual dividend payout than a similar company with a morestable
dividend payment pattern. Additionally a residual payout policymight lead to a company
deviating from its target ('optimal') capitalstructure.
Arguments in support of a high level of retentions include:
(i)As the director suggests,raising external finance, especially new equity issues, can
involvesubstantial issue costs which may be avoided by using retained earnings.
(ii) Capital gains may be taxedat a lower rate than dividends causing a positive preference
byshareholders paying a high marginal tax rate for high levels ofretentions. In the United
Kingdom, for example, capital gains anddividends are now taxed at the same marginal rate but
there is annualexemption from tax which could to lead to a positive preference byindividual
shareholders for a high level of retentions.
(iii)New equity issues mightdilute the control of the existing owners of the business; a high
levelof retentions maintains the current pattern of control.
(iv)A faster rate of corporategrowth might be achieved by a policy of retaining a high level
ofearnings (although corporate growth may also be achieved throughacquisitions and external
financing).
The share price of a company will usually fall when the shares aretraded ex div. This is to be
expected as part of the wealth of theshareholder is being paid in the form of a dividend rather
than keptwithin the business. The fall in share price on the ex div date islikely to be
approximately equal to the dividend per share to be paid(assuming that No other factors
influence the share price at the time).
Director B presents some evidence from the USA which suggests thathigh marginal taxpayers
prefer a low dividend payout and that lower ratetaxpayers prefer a relatively high dividend
payout. The implication isthat Deerwood should identify the marginal tax rates of its
shareholdersand adjust its dividend policy accordingly. The analysis of Deerwood'sshareholders
shows that only 36-5% of shares are identified as beingheld by individuals, with an average
holding of about 1,250 shares,although 'nominees' might include some other individuals. More
than 42%of the shares are held by institutions which include both tax payinginstitutions and tax
exempt institutions (e.g. pension funds).Deerwood's investors include individual investors and
institutionalinvestors that are subject to different rates of tax. This could lead toconflicting
desired dividend policies among investors. In suchcircumstances a compromise 'intermediate'
pay-out ratio is sometimessuggested. The US survey, although supportive of a particular
clienteleassociated with a particular dividend yield, might not be directlyrelevant to Deerwood's
home country where the tax system with respect todividends and capital gains may be different
from the US tax system.
Even if a clientele effect does exist there is little evidence thatthe market price of a company is
influenced by its dividend policy.Modigliani and Miller suggest that 'each corporation would tend
toattract itself a clientele consisting of those preferring its particularpayout ratio, but one
clientele would be as good as another in terms ofthe valuation it would imply for firms'. It might
be that Deerwood'sexisting dividend policy has attracted a clientele that is satisfiedwith that
policy, and that the company's market value could not beincreased by changing the existing
policy.
Director C is correct in stating that individuals and institutionalinvestors might require dividends
to satisfy current incomerequirements (e.g. pension payments. life assurance payments). It
isargued that although current income could be 'created' by selling asmall proportion of existing
shareholdings such sales involvetransactions costs and dilute shareholdings, and are not a
satisfactoryalternative to a dividend payout. High payouts are sometimes advocatedin countries
where accounting information, particularly earningsinformation, is poor. In such circumstances
dividends might give anindication of the profitability of companies.
The suggestion that investors prefer a known dividend to anuncertain capital gain is known as
the 'bird in the hand' theory.Dividends are more predictable than capital gains. However, the risk
ofthe company in the long run is determined by the investment andborrowing policies, and not
by the dividend policy, and the company'soverall operating cash flows do not alter with dividend
policy. Thepayment of dividends is not increasing the shareholders' wealth. As longas the
market is efficient the share price will offer a total returnthat is high enough to compensate for
the risk associated with the shareand its' uncertain capital gains'.
Director D supports the view that dividend policy is irrelevant tothe value of a company. The
equation by Modigliani and Miller statesthat a company's value depends upon the expected
future earnings stream,not upon current or future dividends. Dividends do not appear withinthe
equation, and investment, profit, the price at time one, and thecapitalisation rate are all
assumed to be independent of dividend, hencedividend policy is irrelevant. The equation relies
on restrictiveassumptions including perfect capital markets, no transactions costs, agiven
investment policy of the company which is not subject to change,and no taxes. Critics of
Modigliani and Miller argue that marketimperfections and taxes alter this situation and make
dividend policyrelevant to the value of the firm.
However, even when corporate taxes are introduced Black andScholes, and later Miller and
Scholes, with both personal and corporatetaxes argue that dividend policy is irrelevant.
Although there has been agreat deal of research into dividend policy, there is no
conclusiveevidence regarding the impact of dividend policy on share valuation.
29. Predator Co
(a) Net asset valuation
(b) DVM
The average rate of growth in Target's dividends over the last 4 years is 7.4% on a compound
basis.
85 (1+g)4 = 113.1 hence g = 7.4%
The estimated value of Target using the DVM is therefore:
A suitable PE ratio for Target will be based on the PE ratio of Predator as both companies are in
the same industry.
On the basis of its tangible assets the value of Target is $1.4 million, which excludes any value
for intangibles.
The dividend valuation gives a value of around $1.6 million.
The earnings based valuation indicates a value of around $2.5million, which is based on the
assumption, that not only will thecurrent earnings be maintained, but that they will increase by
thesavings in the director's remuneration.
On the basis of these valuations an offer of around $2 millionwould appear to be most suitable,
however a review of all potentialfinancial gains from the merger is recommended. The directors
should,however, be prepared to increase the offer to maximum price.
30. Market efficiency statements
The accuracy of each statement depends on which view of market efficiency is
considered:
The EMH says that share prices are always right.
If 'right' means at a true value – an equilibrium priceincorporating all information available,
then this is mainly true in astrong form efficient market. However, since the reaction to
newinformation would not be instant, there will be a short period even in astrong market when
the price is not 'right'.
In a semi-strong market the price will be fair (reflecting all publicly-available information) rather
than right.
In a weak form efficient market, the price does not include all information.
This is because shares move in a random fashion when new information is made public.
Share prices do not move randomly when new information is announced– they move in a
predictable fashion – up for good news and downfor bad. However they follow a 'random walk'
in that each price changeis independent of the one that went before and it is not possible
topredict the content of the new information without insider information.
In a strong form market, shares would not move just because theinformation had been publicly
announced – the information would beincorporated as soon as the content of the news arose,
e.g. at the pointthe directors decided to embark upon a particular investment.
The only reason prices move randomly is because of the new information contained in
the accounts when they are published.
New information impacting share movements when announced can comefrom a variety of
sources including announcements by management, changesin interest rates or exchange rates,
dividend announcements, etc. In asemi-strong market it is likely that the majority of
informationcontained in the published accounts is already known to the market andtherefore
reflected in the share price. In this case, the share pricewould only react if the published
accounts contained new or unexpectedinformation.
Both technical and fundamental analysis serve no function
In fact the analysts play a key role in reviewing information and communicating it quickly to the
market.
They therefore help ensure the market remains efficient.
technical and fundamental analysis … cannot predict future share price
It is true that, in an efficient market, analysing informationalready in the public domain cannot
help predict the future share price,as the share price will already reflect all the information
beinganalysed.
Corporate fund managers cannot predict share prices either
There is a possibility that fund managers could predict futureshare prices in a semi-strong
efficient market but only if they areoperating with inside information.
Created at 5/24/2012 4:21 PM by System
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