QUESTION ONE

Profit Margin

Net Profit
Profit Margin=
Revenue

Telibe ltd Miguel ltd Ethan ltd

2021 2020 2021 2020 2021 2020
Sales 26,500 15,900 450 400 2,100 1,600
Operating Profits 250 280 20 15 40 30
Profit Margin 0.94 1.76 4.44 3.75 1.9 1.88

Miguel has the highest profit margin in both years, ending at 4.44; much higher than Ethan
at 1.9 and Telibe at 0.94.

Stock Turnover

Cost of Goods Sold

Stock Turnover=
Average Stock

Telibe ltd Miguel ltd Ethan ltd

Stock Turnover
2021 2020 2021 2020 2021 2020
COGS 18,200 12,100 340 300 1,500 1,305
Stock 2,100 1,330 80 75 140 135
Average Stock 1,715 665 78 38 138 68
Stock Turnover 11 18 4 8 11 19

By stock turnover, all the three companies had experienced a slump. Comparing the two
years shows that the changes were 42%, 45% and 44% for Telibe, Miguel and Ethan,
respectively, although Telibe and Ethan still had higher turnover times of 11 each, thus
much better than Miguel at 4 times.

Current Ratio

Current Assets
Current Ratio=
Current Liabilities
 Telibe ltd Miguel ltd Ethan ltd
Current Ratio 
2021 2020 2021 2020 2021 2020
Inventory 2,100 1,330 80 75 140 135
Debtors 1,575 920 72 85 105 75
Bank/Cash 1,680 640 5 3 78 104
Total CA 5,355 2,890 157 163 323 314
Creditors 2,750 2,110 85 80 155 146
2 1 2 2 2 2

By the end of 2021, all the three companies were able to cover their short-term debts twice
over as indicated by current ratio values of 2.

Total Debt to Total Assets Ratio

Total Debt
Total debt ¿ total assets ratio=
Total Assets

Telibe ltd Miguel ltd Ethan ltd

2021 2020 2021 2020 2021 2020
Debt 2,750 2,110 85 80 155 146
Total Assets 8,355 5,390 347 288 573 559
Profit Margin 0.33 0.39 0.24 0.28 0.27 0.26

The total debt to total assets ratio shows that of the three companies, Miguel has the best
performance with a lower percentage indication that the company carries less debt compared
to its total assets therefore better solvency.

Basing on the ratios used; the best company for the Franchise is Miguel. In terms of
solvency Miguel is better than Telibe and Ethan. Miguel has the highest profit margin of
4.44. Although Miguel had the lowest turnover rate, it could be due to low revenue levels.
QUESTION TWO:
Part (a)
Net Present Value (NPV) is a method in financial analysis for determining how feasible a
project is. This is determined using projected cash-flows which are a sufficient measure for
justifying an initial investment. A positive NPV indicates that the project is economic. If
there is a mistake in the calculation of NPV, there is an effective reduction in the size of the
investment and this would make the NPV much lower than it would otherwise be. Net
income is considered as a one-time computation while cash flows occur over a period. The
need is to ensure that the discount rate occurs at the same basis with the cash flows, a
phenomenon which cannot be achieved with net income. In technical terms, while it is
possible to use income, it is not appropriate for decision-making. NPV is about future money
and not about profit. It may begin with negative values in the first periods but positive values
occur later.

Part (b)
Operational gearing is also known as operating leverage, describing the relationship between
the fixed costs of a company and its variable costs. A high operational gearing arises where a
firm has higher fixed costs in proportion to its total costs. This high operational gearing will
make the profits to be more sensitive to any changes occurring with sales. It can therefore be
said that operational gearing is the impact of fixed costs on the relationship between sales and
profits. Firms with high gross margins and low variable costs will have higher operational
gearing.

Having a high operational gearing means that the firm needs to cover more of its fixed costs
per period, whatever its level of sales. It therefore means that the firm’s operating profits are
sensitive to changes in volume of sales. High operational gearing leads to ‘variability or
volatility of operating profit due to changes in sales volume’. Operating gearing is therefore
a measure of ‘business risk’. Recognising operational gearing as a risk has implications on
managerial decision-making in matters of business financing, capital structure and debt. A
business with high operational gearing has volatile profits which puts a strain on the business.
It means management should be aware of the level of risk before making any decisions for
debt.
There are various strategies that can be undertaken to address high operational gearing. First
is to recognise what impact it is having on the business revenue and profits and to analyse the
associated risks. The strategy is that managers should strive to reduce risk by taking up lower
levels of operational gearing. There does not exist a rule of thumb for fixing high operational
gearing since companies experiencing low levels of business and financial risks may take on
higher levels of operational gearing to improve potential returns when sales are high.

An appropriate strategy is for a company to analyse the variability of its costs while
considering the level of fixed costs according to the nature and industry of its business. A
company must endeavour to achieve low variable costs and a high contribution margin and
then sell a lot of its products in order to make significant profits. This contributory strategy
works to cover the high bill of fixed costs, adding more to attain higher profits.

Another strategy is to adjust the firm’s pricing of its products and services depending on
variations in demand and supply. Firms which work to become market leaders are more
likely to effectively apply this strategy. The strategy remains that firms ought to push for
improvements in the gross margins. The combination of cost and revenue considerations
leads to the strategy of investing in cost of goods sold as a way of supporting revenue
streams. Along the same line of thought, firms need to consider their operating expenses – to
decrease them in proportion to total revenue because in the longrun, they have the same effect
as fixed costs.

As company revenue increases, the need is to invest in those strategies that can reduce costs
and increase revenue. The assignment of managers is to establish which costs are directly
linked to the cost of goods sold and which ones are not. For example sales and marketing,
research and development need to be analysed as to what extent they drive revenue growth or
are a cost. Thus addressing a high operational gearing is not just about bringing costs down. It
is about finding the most appropriate solutions to increase firm efficiency.

Part (c)
The adjusted present value (APV) is an aspect of net present value (NPV) is the net present
value (NPV) of a project whereby it is purely financed under equity. While it is similar to
NPV, APV, it employs the use of equity cost as the rate of discount rather than the WACC.
APV also incorporates tax elements and appropriate for highly leveraged transactions. While
NPV uses weighted average cost of capital, APV employs the cost of equity as the discount
rate. The APV approach is useful in circumstances of analysing the debt effects. Although the
WACC is primarily taken to be the standard approach, it is not the best as the APV
alternative is more versatile and reliable. The APV is most appropriate for analysing existing
assets that can generate future cash-flows, covering the basic problems inherent in the
WACC. It has been established that the APV always works where the WACC cannot as it has
fewer assumptions. There have been fewer errors associated with the WACC and helpful for
managers to analyse the worth of an asset and other associated values.

The approach with APV is to analyse financial data in a separate manner and then add the
ensuing value to the business. This is differentiated from the WACC approach which requires
adjusting the discount rate (or cost of capital) in order to appropriately reflect financial
enhancements. The application of APV involves unbundling the aspects of value and
analysing each one individually. On the other hand, WACC puts together all the financial
side effects in a single discount rate without effectively handling financial side-effects. APV
has proven inexpensive with the advancements in utilisation of spreadsheets and its cost-
effectiveness. APV is also flexible. It can be adjusted to fit any type of valuation as makes
sense to management and according to level of analytical skill. It can also be highly refined
or customized according to tastes and circumstances. APV is utilised basing on the
weaknesses of the WACC. APV is more transparent ad all components are included without
exclusion.

An example of a case requiring the use of APV is where a mature firm has been
underperforming in recent years. Any strategies by management to boost performance have
not yielded required results. The company has rationalised its product line and wishes to
outsource some components in order to improve its operating margin. The idea is to reduce
stock and enhance payables. Some fixed assets are to be sold and working capital would
reduce. There is a strategy to introduce new sales incentives and raise sales, in the process
saving some taxes.

To use APA in this scenario would involve evaluating the business as though it was financed
by equity alone. Noting that the company would not be financed entirely by equity, the value
associated with the financing program would be considered (added or subtracted).
Considering that a positive net effect, then only equity financing would be considered.

Another example of APV is for leverage transactions, including leveraged buyout (LBO).
This is a kind of acquisition whereby a small number of equity investors in a company is
financed by debt. This allows for use of APV as a better approach than the WACC since the
capital structure is bound to change.