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REVISION QUESTION BANK FINANCIAL MANAGEMENT (F9)

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Answer 1 COMPANY OBJECTIVES

Financial management is concerned with making decisions about the provision and use of a firmsfinances. A rational approach to decision-making requires a clear idea of the objectives of the decisionmaker or, more importantly, the objectives of those on behalf of whom the decisions are being made.

There is little agreement in the literature as to what objectives of firms are or even what they ought tobe. However, most financial management textbooks make the assumption that the objective of a limitedcompany is to maximise the wealth of its shareholders. This assumption is normally justified in terms ofclassical economic theory. In a market economy firms that achieve the highest returns for theirinvestors will be the firms that are providing customers with what they require. In turn these companies,

because they provide high returns to investors, will also find it easiest to raise new finance. Hence theso called invisible hand theory will ensure optimal resource allocation and this should automaticallymaximise the overall economic welfare of the nation.

This argument can be criticised on several grounds. Firstly it ignores market imperfections. Forexample it might not be in the public interest to allow monopolies to maximise profits. Secondly it

ignores social needs like health, police, defence etc.From a more practical point of view directors have a legal duty to run the company on behalf of theirshareholders. This however begs the question as to what do shareholders actually require from firms.

Another justification from the individual firms point of view is to argue that it is in competition withother firms for further capital and it therefore needs to provide returns at least as good as thecompetition. If it does not it will lose the support of existing shareholders and will find it difficult toraise funds in the future, as well as being vulnerable to potential take-over bids.

Against the traditional and legal view that the firm is run in order to maximise the wealth of ordinaryshareholders, there is an alternative view that the firm is a coalition of different groups: equity

shareholders, preference shareholders and lenders, employees, customers and suppliers. Each of thesegroups must be paid a minimum return to encourage them to participate in the firm. Any excesswealth created by the firm should be and is the subject of bargaining between these groups.

At first sight this seems an easy way out of the objectives problem. The directors of a company couldsay Lets just make the profits first, then well argue about who gets them at a later stage. In otherwords, maximising profits leads to the largest pool of benefits to be distributed among the participantsin the bargaining process. However, it does imply that all such participants must value profits in thesame way and that they are all willing to take the same risks.

In fact the real risk position and the attitude to risk of ordinary shareholders, loan payables andemployees are likely to be very different. For instance, a shareholder who has a diversified portfolio is

likely not to be as worried by the bankruptcy of one of his companies as will an employee of thatcompany, or a supplier whose main customer is that company. The problem of risk is one major reasonwhy there cannot be a single simple objective which is common to all companies.

Separate from the problem of which goal a company ought to pursue are the questions of which goalscompanies claim to pursue and which goals they actually pursue.

Many objectives are quoted by large companies and sometimes are included in their annual accounts.


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Examples are:

(a) to produce an adequate return for shareholders;(b) to grow and survive autonomously;(c) to improve productivity;(d) to give the highest quality service to customers;(e) to maintain a contented workforce;(f) to be technical leaders in their field;(g) to be market leaders;(h) to acknowledge their social responsibilities.

Some of these stated objectives are probably a form of public relations exercise. At any rate, it ispossible to classify most of them into four categories which are related to profitability:

(a) Pure profitability goals e.g., adequate return for shareholders.

(b) Surrogate goals of profitability e.g., improving productivity, happy workforce.

(c) Constraints on profitability e.g., acknowledging social responsibilities, no pollution, etc.

(d) Dysfunctional goals.

The last category are goals which should not be followed because they do not create benefit in the longrun. Examples here include the pursuit of market leadership at any cost, even profitability. This mayarise because management assumes that high sales equal high profits which is not necessarily so.

In practice the goals which a company actually pursues are affected to a large extent by themanagement. As a last resort, the directors may always be removed by the shareholders or theshareholders could vote for a take-over bid, but in large companies individual shareholders lack voting

power and information. These companies can, therefore, be dominated by the management.There are two levels of argument here. Firstly, if the management do attempt to maximise profits, thenthey are in a much more powerful position to decide how the profits are carved up than are theshareholders.

Secondly, the management may actually be seeking prestige goals rather than profit maximisation:Such goals might include growth for its own sake, including empire building or maximising turnoverfor its own sake, or becoming leaders in the technical field for no reason other than general prestige.Such goals are usually dysfunctional.

The dominance of management depends on individual shareholders having no real voting power, and in

this respect institutions have usually preferred to sell their shares rather than interfere with themanagement of companies. There is some evidence, however, that they are now taking a more activerole in major company decisions.

From all that has been said above, it appears that each company should have its own unique decisionmodel. For example, it is possible to construct models where the objective is to maximise profit subjectto first fulfilling the target levels of other goals. However, it is not possible to develop the generaltheory of financial management very far without making an initial simplifying assumption aboutobjectives. The objective of maximising the wealth of equity shareholders seems the leastobjectionable.


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Answer 2 NON-FINANCIAL OBJECTIVES

Financial statements of any sort are only an expression of organisational activities that can bemeasured. Many of the activities of an organisation cannot be easily measured, nor can its relationswith various stakeholder groups who may have a non-financial interest in the organisation.

Non-financial objectives that may be difficult to measure or express in financial terms include:

welfare of employees and management

health safety leisure and other services

welfare in the broader community

minimisation of intrusion into the community: e.g. traffic

the provision of a service for which no charge is made (e.g. public hospitals). Alsoincluding:

local or regional government services housing education

the effective supply of goods or service (in addition to cost/efficiency issues) suchas:

product or service quality ensuring product or service supply (e.g. vital services) timeliness after sale support customer or user satisfaction

fulfilment of product or service responsibilities: this is a very broad area and wouldcover many of the core activities of a business such as:

leadership in research and development product development

maintenance of standards in goods or service provision maintenance of good business and community relationships employee training and support

support for community activities

minimisation of externalities (e.g. pollution)

fulfilment of statutory or regulatory responsibilities

Whilst it may be argued that many of the objectives expressed have an impact on profitability or costs,they only do so in an indirect manner. Moreover, as with most organisational activities, non financialobjectives crystallise into financial issues given enough time. Thus, for example, poor service provisionwill ultimately lead to loss of customers in a competitive environment.


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The range of stakeholders that may have an interest in an organisations activities are wide and, becauseorganisations have to respond to stakeholder interests, the non-financial responsibilities, and hencerange of objectives, is extended. In this respect, stakeholders create for organisations a range of non-financial issues that have to be addressed. If organisations are responsive then these issues become partof the culture of an organisation and hence part of its broader purpose. Interest in the organisationsactivities from a non-financial perspective can arise even if the stakeholder has a financial relationshipwith the organisation. Thus, the stakeholders who may have an interest might include the following:

shareholders suppliers and trade payables debt holders customers employees pensioners and ex-employees competitors local community broader national and international interests

government regulatory authorities tax authorities special interest groups concerned with pollution, for example

Moreover, many of the stakeholders have common interests and hence stakeholders' groupings canemerge.

Answer 3 STAKEHOLDERS

(a)

The range of stakeholders may include: shareholders, directors/managers, lenders, employees,suppliers and customers. These groups are likely to share in the wealth and risk generated bya company in different ways and thus conflicts of interest are likely to exist. Conflicts alsoexist not just between groups but within stakeholder groups. This might be because subgroups exist e.g. preference shareholders and equity shareholders. Alternatively it might bethat individuals have different preferences (e.g. to risk and return, short term and long termreturns) within a group. Good corporate governance is partly about the resolution of suchconflicts. Stakeholder financial and other objectives may be identified as follows:

Shareholders

Shareholders are normally assumed to be interested in wealth maximisation. This, however,

involves consideration of potential return and risk. Where a company is listed this can beviewed in terms of the share price returns and other market-based ratios using share price (e.g.price earnings ratio, dividend yield, earnings yield).

Where a company is not listed, financial objectives need to be set in terms of accounting andother related financial measures. These may include: return of capital employed, earnings pershare, gearing, growth, profit margin, asset utilisation, market share. Many other measuresalso exist which may collectively capture the objectives of return and risk.

Shareholders may have other objectives for the company and these can be identified in termsof the interests of other stakeholder groups. Thus, shareholders, as a group, might beinterested in profit maximisation; they may also be interested in the welfare of their

employees, or the environmental impact of the companys operations.


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Directors and managers

While directors and managers are in essence attempting to promote and balance the interestsof shareholders and other stakeholders it has been argued that they also promote their owninterests as a separate stakeholder group.

This arises from the divorce between ownership and control where the behaviour of managerscannot be fully observed giving them the capacity to take decisions which are consistent withtheir own reward structures and risk preferences. Directors may thus be interested in theirown remuneration package. In a non-financial sense, they may be interested in buildingempires, exercising greater control, or positioning themselves for their next promotion. Non-financial objectives are sometimes difficult to separate from their financial impact.

Lenders

Lenders are concerned to receive payment of interest and ultimate re-payment of capital. Theydo not share in the upside of very successful organisational strategies as the shareholders do.They are thus likely to be more risk averse than shareholders, with an emphasis on financialobjectives that promote liquidity and solvency with low risk (e.g. gearing, interest cover,security, cash flow).

Employees

The primary interest of employees is their salary/wage and security of employment. To anextent there is a direct conflict between employees and shareholders as wages are a cost to thecompany and a revenue to employees.

Performance related pay based upon financial or other quantitative objectives may, however,go some way toward drawing the divergent interests together.

Suppliers and customers

Suppliers and customers are external stakeholders with their own set of objectives (profit forthe supplier and, possibly, customer satisfaction with the good or service from the customer)that, within a portfolio of businesses, are only partly dependent upon the company inquestion. Nevertheless it is important to consider and measure the relationship in term offinancial objectives relating to quality, lead times, volume of business, price and a range ofother variables in considering any organisational strategy.

(b) Corporate governance is the system by which organisations are directed and controlled.

Where the power to direct and control an organisation is given, then a duty of accountabilityexists to those who have devolved that power. Part of that duty of accountability is dischargedby disclosure both of performance in the normal financial statements but also of thegovernance procedures themselves.

The governance codes in the UK have mainly been limited to disclosure requirements. Thus,any requirements have been to disclose governance procedures in relation to best practice,rather than comply with best practice.

In deciding on which of the divergent interests should be promoted, the directors have a keyrole. Much of the corporate governance regulation in the UK (including Cadbury, Greenburyand Hampel) has therefore focused on the control of this group and disclosure of its activities.

This is to assist in controlling their ability to promote their own interests and make morevisible the incentives to promote the interest of other stakeholder groups.


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A particular feature of the UK is that Boards of Directors are unitary (i.e. executive and non-executive directors sit on a single board). This contrasts to Germany for instance where thereis more independence between the groups in the form of two tier boards.

Particular Corporate Governance proposals in the UK which have resulted in the CombinedCode include:

Independence of the board with no covert financial reward

Adequate quality and quantity of non-executive directors to act as a counterbalanceto the power of executive directors.

Remuneration committee controlled by non-executives.

Appointments committee controlled by non-executives.

Audit committee controlled by non-executives.

Separation of the roles of chairman and chief executive to prevent concentration of

power.

Full disclosure of all forms of director remuneration including shares and shareoptions.

The Hampel report has an emphasis not just on whether compliance with bestpractice has been achieved, but on how it has been achieved.

Overall, the visibility given by corporate governance procedures goes some way towarddischarging the directors duty of accountability to stakeholders and makes more transparentthe underlying incentive systems of directors.

Answer 4 NOT-FOR-PROFIT

(a)

In the case of a not-for-profit (NFP) organisation, the limit on the services that can beprovided is the amount of funds that are available in a given period. A key financial objectivefor an NFP organisation such as a charity is therefore to raise as much funds as possible. Thefund-raising efforts of a charity may be directed towards the public or to grant-making bodies.In addition, a charity may have income from investments made from surplus funds from

previous periods. In any period, however, a charity is likely to know from previous

experience the amount and timing of the funds available for use. The same is true for an NFPorganisation funded by the government, such as a hospital, since such an organisation willoperate under budget constraints or cash limits. Whether funded by the government or not,

NFP organisations will therefore have the financial objective of keeping spending withinbudget, and budgets will play an important role in controlling spending and in specifying thelevel of services or programmes it is planned to provide.

Since the amount of funding available is limited, NFP organisations will seek to generate themaximum benefit from available funds. They will obtain resources for use by the organisationas economically as possible: they will employ these resources efficiently, minimising wasteand cutting back on any activities that do not assist in achieving the organisations non-financial objectives; and they will ensure that their operations are directed as effectively as

possible towards meeting their objectives. The goals of economy, efficiency and effectivenessare collectively referred to as value for money (VFM). Economy is concerned withminimising the input costs for a given level of output. Efficiency is concerned with


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maximising the outputs obtained from a given level of input resources, i.e. with the process oftransforming economic resources into desires services. Effectiveness is concerned with theextent to which non-financial organisational goals are achieved.

Measuring the achievement of the financial objective of VFM is difficult because the non-financial goals of NFP organisations are not quantifiable and so not directly measurable.However, current performance can be compared to historic performance to ascertain theextent to which positive change has occurred. The availability of the healthcare provided by ahospital, for example, can be measured by the time that patients have to wait for treatment orfor an operation, and waiting times can be compared year on year to determine the extent towhich improvements have been achieved or publicised targets have been met.

Lacking a profit motive, NFP organisations will have financial objectives that relate to theeffective use of resources, such as achieving a target return on capital employed. In anorganisation funded by the government from finance raised through taxation or public sector

borrowing, this financial objective will be centrally imposed.

Answer 5 TAGNA

(a) Market efficiency is commonly discussed in terms of pricing efficiency.

A stock market is described as efficient when share prices fully and fairly reflect relevantinformation.

Weak form efficiency occurs when share prices fully and fairly reflect all past information,such as share price movements in preceding periods. If a stock market is weak form efficient,investors cannot make abnormal gains by studying and acting upon past information.

Semi-strong form efficiency occurs when share prices fully and fairly reflect not only past

information, but all publicly available information as well, such as the information providedby the published financial statements of companies or by reports in the financial press. If astock market is semi-strong form efficient, investors cannot make abnormal gains by studyingand acting upon publicly available information.

Strong form efficiency occurs when share prices fully and fairly reflect not only all past andpublicly available information, but all relevant private information as well, such asconfidential minutes of board meetings. If a stock market is strong form efficient, investorscannot make abnormal gains by acting upon any information, whether publicly available ornot.

There is no empirical evidence supporting the proposition that stock markets are strong form

efficient and so the bank is incorrect in suggesting that in six months the stock market will bestrong form efficient. However, there is a great deal of evidence suggesting that stock marketsare semi-strong form efficient and so Tagnas share are unlikely to be under-priced.

(b)

A substantial interest rate increase may have several consequences for Tagna in the areasindicated.

(i)

As a manufacturer and supplier of luxury goods, it is likely that Tagna will experience a sharp

decrease in sales as a result of the increase in interest rates. One reason for this is that sales ofluxury goods will be more sensitive to changes in disposable income than sales of basicnecessities, and disposable income is likely to fall as a result of the interest rate increase.


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Another reason is the likely effect of the interest rate increase on consumer demand. If theincrease in demand has been supported, even in part, by the increase in consumer credit, thesubstantial interest rate increase will have a negative effect on demand as the cost ofconsumer credit increases. It is also likely that many chain store customers will buy Tagnasgoods by using credit.

(ii)

Tagna may experience an increase in operating costs as a result of the substantial interest rateincrease, although this is likely to be a smaller effect and one that occurs more slowly than adecrease in sales. As the higher cost of borrowing moves through the various supply chains inthe economy, producer prices may increase and material and other input costs for Tagna mayrise by more than the current rate of inflation. Labour costs may also increase sharply if therecent sharp rise in inflation leads to high inflationary expectations being built into wagedemands. Acting against this will be the deflationary effect on consumer demand of theinterest rate increase. If the Central Bank has made an accurate assessment of the economicsituation when determining the interest rate increase, both the growth in consumer demand

and the rate of inflation may fall to more acceptable levels, leading to a lower increase inoperating costs.

(iii)

The earnings (profit after tax) of Tagna are likely to fall as a result of the interest rateincrease. In addition to the decrease in sales and the possible increase in operating costsdiscussed above, Tagna will experience an increase in interest costs arising from its overdraft.The combination of these effects is likely to result in a sharp fall in earnings. The level ofreported profits has been low in recent years and so Tagna may be faced with insufficient

profits to maintain its dividend, or even a reported loss.

(c)

The objectives of public sector organisations are often difficult to define. Even though thecost of resources used can be measured, the benefits gained from the consumption of thoseresources can be difficult, if not impossible, to quantify. Because of this difficulty, publicsector organisations often have financial targets imposed on them, such as a target rate ofreturn on capital employed. Furthermore, they will tend to focus on maximising the return onresources consumed by producing the best possible combination of services for the lowest

possible cost. This is the meaning of value for money, often referred to as the pursuit ofeconomy, efficiency and effectiveness.

Economy refers to seeking the lowest level of input costs for a given level of output.

Efficiency refers to seeking the highest level of output for a given level of input resources.Effectiveness refers to the extent to which output produced meets the specified objectives, forexample in terms of provision of a required range of services.

In contrast, private sector organisations have to compete for funds in the capital markets andmust offer an adequate return to investors. The objective of maximisation of shareholderwealth equates to the view that the primary financial objective of companies is to reward theirowners. If this objective is not followed, the directors may be replaced or a company may findit difficult to obtain funds in the market, since investors will prefer companies that increasetheir wealth. However, shareholder wealth cannot be maximised if companies do not seek

both economy and efficiency in their business operations.


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Answer 6 MONOPOLY

Many governments consider it necessary to prevent or control monopolies.

A pure monopoly exists when one organisation controls the production or supply of a good that has noclose substitute. In practice, legislation may consider a monopoly situation to occur when there islimited competition in a particular market. For example, UK legislation considers a monopoly to occurif an organisation controls 25% or more of a particular market.

Governments consider it necessary to act against an existing or potential monopoly because of theeconomic problems that can arise through the abuse of a dominant market position. Monopoly can leadto economic inefficiency in the use of resources, so that output is at a higher cost than necessary.Further inefficiency can arise as a monopoly may lack the incentive to innovate, to researchtechnological improvements, or to eliminate unnecessary managers, since it can always be sure of

passing on the cost of its inefficiencies to its customers. Inefficiencies such as these have been seen asmajor problems in state-owned monopolies and have fuelled the movement towards privatisation inrecent years. It has been expected that the competition arising following privatisation will lead to the

elimination of these kinds of inefficiency.Monopoly can also result in high prices being charged for output, so that the cost to customers is higherthan would be the case if significant competition existed, allowing monopolies to generate monopoly

profits.

The government can prevent monopolies occurring by monitoring proposed takeovers and mergers, andacting when it decides that a monopoly situation may occur. This monitoring is carried out in the UK bythe Office of Fair Trading, which can refer takeovers and mergers that are potentially against the publicinterest to the Competition Commission for detailed investigation. The Competition Commission hasthe power to prevent a proposed takeover or merger, or to allow it to proceed with conditions attached,such as disposal of a portion of the business in order to preserve competition.

Answer 7 EFFICIENT MARKET HYPOTHESIS

The term Efficient Market Hypothesis (EMH) refers to the view that share prices fully and fairlyreflect all relevant available information1. There are other kinds of capital market efficiency, such asoperational efficiency (meaning that transaction costs are low enough not to discourage investors from

buying and selling shares), but it is pricing efficiency that is especially important in financialmanagement.

Research has been carried out to discover whether capital markets are weak form efficient (share pricesreflect all past or historic information), semi-strong form efficient (share prices reflect all publiclyavailable information, including past information), or strong form efficient (share prices reflect all

information, whether publicly available or not). This research has shown that well-developed capitalmarkets are weak form efficient, so that it is not possible to generate abnormal profits by studying andanalysing past information, such as historic share price movements. This research has also shown thatwell-developed capital markets are semi-strong form efficient, so that it is not possible to generateabnormal profits by studying publicly available information such as company financial statements or

press releases. Capital markets are not strong form efficient, since it is possible to use insiderinformation to buy and sell shares for profit.

1 Watson, D. and Head, A. (2004) Corporate Finance: Principles and Practice, 3rd edition, FTPrentice Hall, p.35


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If a stock market has been found to be semi-strong form efficient, it means that research has shown thatshare prices on the market respond quickly and accurately to new information as it arrives on themarket. The share price of a company quickly responds if new information relating to that company isreleased. The share prices quoted on a stock exchange are therefore always fair prices, reflecting allinformation about a company that is relevant to buying and selling. The share price will factor in pastcompany performance, expected company performance, the quality of the management team, the waythe company might respond to changes in the economic environment such as a rise in interest rate, andso on.

There are a number of implications for a company of its stock market being semi-strong form efficient.If it is thinking about acquiring another company, the market value of the potential target company will

be a fair one, since there are no bargains to be found in an efficient market as a result of shares beingundervalued. The managers of the company should focus on making decisions that increase shareholderwealth, since the market will recognise the good decisions they are making and the share price willincrease accordingly. Manipulating accounting information, such as window dressing annualfinancial statements, will not be effective, as the share price will reflect the underlying fundamentalsof the companys business operations and will be unresponsive to cosmetic changes. It has also been

argued that, if a stock market is efficient, the timing of new issues of equity will be immaterial, as theprice paid for the new equity will always be a fair one.

Answer 8 BURLEY PLC

(a) Financial desirability

In a real-terms analysis, the real rate of return required by shareholders has to be used. This isfound as follows:

rateinflation1

ratenominal1

+

+1 = (1.14/1.055) 1 = 8%

The relevant operating costs per box, after removing the allocated overhead are (8.00 + 2.00 +1.50 + 2.00) = $13.50. The costs of the initial research etc are not relevant as they are sunk.The set-up cost has already been adjusted for tax reliefs but the annual cash flows will betaxed at 33%.

The NPV of the project is given by:

NPV($) = [PV of after-tax cash inflows] [set-up costs]= 0.15m [20 13.50] (1 33%) PVIFA8.5 2m= 0.65m (3.993) 2m= + 2.6m 2m

= + 0.6m i.e., + $0.6m

Hence, the project is attractive according to the NPV criterion.

The IRR is simply the discount rate, R, which generates a zero NPV i.e., the solution to theexpression:

NPV = 0 = 0.65m (PVIFAR,5) 2mwhence PVIFAR.5= 2m/0.65 = 3.077

To the nearest 1%, IRR = 19%. Since this exceeds the required return of 8% in real terms, theproject is acceptable.


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(b) Sensitivity analysis

A sensitivity analysis examines the impact of specified variations in key factors on theinitially-calculated NPV. The starting point for a sensitivity analysis is the NPV using themost likely value or best estimate for each key variable. Taking the resulting base case

NPV as a reference point, the aim is to identify those factors which have the greatest impacton the profitability of the project if their realised values deviate from expectations. Thisintelligence signals to managers where they should arrange to focus resources in order tosecure favourable outcomes.

Problems with sensitivity analysis include the following:

It deals with changes in isolation, and tends to ignore interactions betweenvariables. For example, advertising may alter the volume of output as well asinfluencing price, and price and volume are usually related.

It assumes that specified changes persist throughout the project lifetime e.g. apostulated l0% change in volume may be projected for each year of operation. Inreality, variations in key factors tend to fluctuate randomly.

It may reveal as critical, factors over which managers have no control, thus offeringno guide to action. Nonetheless, it may still help to clarify the risks to which the

project is exposed.

It does not provide a decision rule e.g. it does not indicate the maximum acceptablelevels of sensitivity.

It gives no indication of the likelihood of the variations under consideration.Variations in a factor which are potentially devastating but have a minimal chance

of occurring provide little cause for concern.(c) Determination of values

The values for which NPV becomes zero are found by calculating the break-even values forthe selected variables. Once determined, these give an indication of the sensitivity of the NPVto changes in these factors

(i) Price (P)

NPV = 0 = 0.15m [P 13.50] (1 33%)(PVIFA8,5) 2mwhence = 0 = [0.15mP-2.025] (2.675) 2m

0 = 0.4P-5.42m-2m0.4P = 7.42mP = $18.55

This means price can drop by [$20 $18.55]/$20 = 7% from the level assumed in the initialevaluation without making the NPV negative.

(ii) Volume (V)

Using a similar procedure:

NPV = 0 = V[20 13.50] ( 1 33%) (PVIFA8,5) 2m

0 = V [17.39m]-2mV = 2m/17.39m= 115,000


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This means volume can drop by [150,000 115,000]/150,000 = 23% from the level assumedin the initial evaluation without making the NPV negative.

The results suggest that the NPV of the project is more sensitive to price variations than tochanges in volume. Since price seems to be the more critical factor, management might planto engage in price support measures like advertising and promotional expenditure. It mightalso attempt to obtain exclusive supply contracts with retailers, although these could violatecompetition regulations. Measures such as these are likely to be costly, in turn reducing the

NPV of the project. It is possible that by making such adjustments, other variables becomemore critical, necessitating further analysis. At this stage, we might infer that, given the

project has a positive NPV of $0.6m, Burley could afford to engage in promotional activitywith a present value marginally below this amount over the lifetime of the project.

Answer 9 DEIGHTON PLC

Report submitted to: Finance Director, Deighton plcFrom: An(n) Accountant.

Date: 12th of NeverSubject: Investment Project NT17

The above investment project was rejected by the former management of Linton Ltd, but it appears thatthe evaluation (attached) was flawed. This report identifies these flaws and re-evaluates the proposalwhich appears to be worthwhile. As the market opportunity is still open, I recommend acceptance of the

project.

(i) Mistakes in Lintons evaluation

(1) The initial investment in working capital should be offset by a working capitalrelease in the final year, assuming a constant level of inventory-holding until the last

year.(2) The interest cost, although a cash outflow in reality, should be subsumed in the

overall cost of capital. Lintons evaluation confused the investment decision withthe financing decision. If the project were evaluated by the new owners, Deightonsrequired return of 20% would be the correct rate of discount (assuming no impacton Deightons risk).

(3) No scrap value was shown for either the old equipment, or the new machine at theend of four years.

(4) Depreciation is not a cash outflow: By deducting the depreciation charge, Linton

has double-counted for the capital cost.(5) However, the annual depreciation allowances (WDA) do affect the tax outflows.

These were ignored.

(6) No tax delay was allowed for.

(7) The overhead charge was over-stated. Only half of the amount charged appears tobe incremental.

(8) The market research cost, whatever it relates to, is irrelevant i.e., it is sunk, unless abuyer could be found for the report.


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(ii) Restatement of investment appraisal

In the following solution, the tax allowances in relation to the initial outlay on equipment areevaluated separately. (Other approaches are acceptable.)

The tax-adjusted cost of the capital expenditure can be found by deducting the present valueof the tax savings generated by exploiting the writing-down allowance from the initial outlay.It is assumed that the available allowances can be set off against profits immediately i.e.,

beginning in the financial year in which the acquisition of the asset occurs. This yields fivesets of WDAs as the project straddles five tax years. The solution assumes no scrap values.

YearItem ($000) 0 1 2 3 4 5Allowance claimed at 25% 225 169 127 95 284Written-down value 675 506 379 284 0Tax saving at 33% 74 56 42 31 94Discount factor at 20% 0.833 0.694 0.579 0.482 0.402

Present value 62 39 24 15 38___ ___ ___ ___ ___ ___

Present value of tax savings = 178 i.e., $178,000

The effective cost of the equipment is:

[Nominal outlay present value of tax savings]= [$900,000 $178,000]= $722,000.

The cash flow profile is:

Item ($000) 0 I 2 3 4 5Equipment/scrap (net) (722) 0Sales 1,400 1,600 1,800 1,000Materials (400) (450) (500) (250)Direct labour (400) (450) (500) (250)Inc overheads (50) (50) (50) (50)___ ___ ___ ___ ___ ___

Operating cash flow 550 650 750 450Tax at 33% (182) (215) (248) (149)Working capital (100) 100___ ___ ___ ___ ___ ___

Net cash flow (822) 550 468 535 302 (149)___ ___ ___ ___ ___ ___

Discount factor at 20% 0.833 0.694 0.579 0.482 0.402Present value (822) 458 325 310 146 (60)___ ___ ___ ___ ___ ___

NPV = + 357 i.e., $357,000

Recommendation

Thus, the equipment purchase is acceptable and should be undertaken, although an analysis ofits risk is also recommended.


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Answer 10 BLACKWATER PLC

(a) Calculation of NPV

EV = (0.3 0.50) + (0.5 1.40) + (0.2 2.0)= 0.15 + 0.70 + 0.40 = 1.25 (i.e.) $ 1.25m

To determine the NPV of the project, Blackwater must weigh the present value of the costsincurred i.e. the outlay and the increased production costs, against the benefits in the form ofthe two sets of tax reliefs relating to the increased operating costs and to the writing-downallowance and also the present value of the fines avoided. These are set out in the followingtable.

YearItem ($m) 0 1 2 3 4 5Outlay (1.000)EU grant 0.250FSLs fee (0.050)Increased costs (0.315) (0.331) (0.347) (0.365)Tax saving at 33% 0.104 0.109 0.115 0.120WDA 0.250 0.188 0.141 0.105 0.316Tax saving at 33% 0.083 0.062 0.047 0.035 0.104

Net cash flows (1.000) (0.032) (0.165) (0.191) (0.215) 0.224Discount factor at 12% 1.000 0.893 0.797 0.712 0.636 0.567PV (1.000) (0.029) (0.132) (0.136) (0.137) 0.127

NPV = (1.307), i.e. ($1.307m)

Since the negative NPV exceeds the expected present value of the fines ($1~250m) over thesame period, it appears that the project is not viable in financial terms (i.e. ) it is cheaper to

risk the fines.(b) Memorandum

Memo to: Blackwater plc Main Board.Subject: Proposed Pollution Control Project.From: Lower down the hierarchy.Date: Thatll be the day.

On purely non-financial criteria, it can be suggested that as a regular violator of theenvironmental regulation, our company has a moral responsibility to install this equipment, solong as it does not jeopardise the long-term survival of the company.

But the figures appended suggest that the project is not wealth-creating for Blackwatersshareholders as the EV of the fines is less than the expected NPV of the project. However,this conclusion relies on accepting the validity of the probability distribution, which isdebatable. Not only are the magnitudes of the fines merely estimates, but the probabilitiesshown are subjective. Different decision-makers may well arrive at different assessmentswhich could lead to the opposite decision on financial criteria.

More fundamentally, the use of the expected value principle is only reliable when theprobability distribution approximates to the normal. In this case, it is slightly skewed towardthe lower outcomes. But more significantly, if the distribution itself is examined more closely,it appears to indicate that there is a 70% chance (0.5+0.2) of fines of at least $ 1 4m, which

exceeds the NPV of the costs of the pollution control project. In other words, there is a 70%chance that the project will be worthwhile. It therefore seems perverse to reject it on thesefigures.


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Moreover, given that Blackwater is a persistent offender, and that the green lobby isbecoming more influential, there must be a strong likelihood that the level of fines willincrease in the future, suggesting that the data given are under-estimates. Higher expectedfines would further enhance the appeal of the project.

It is also possible that the company may sell more output, perhaps at a higher price, if it isperceived to be more environmentally friendly and if customers are swayed by this. This maybe less likely for industrial companies although it would create opportunities for self-publicityon both sides. In addition, there may be more general image effects which may fosterenhanced self-esteem among the workforce, as well as increasing the acceptability of thecompany in the local community.

It is even possible that the companys share price may benefit from managers of ethicalinvestment funds deciding to include Blackwater in their portfolios.

Finally, this may be only a short-term solution. As the operating life of the equipment is onlyfour years, we will face a further investment decision after this period, although technological

and legal changes may well have altered the situation by then.Answer 11 ARR AND PAYBACK

(a) Accounting rate of return (ARR) is a measure of the return on an investment where the annualprofit before interest and tax is expressed as a percentage of the capital sum invested. Thereare a number of alternative formulae which can be used to calculate ARR, which differ in theway in which they define capital cost. The more common alternative measures available areaverage annual profit to initial capital invested and average annual profit to average capitalinvested. The method selected will affect the resulting ARR figure, and for this reason, it isimportant to recognise that the measure may be subject to manipulation by managers seekingapproval for their investment proposals. The value for average annual profit is calculated after

allowances for depreciation, as shown in the example below:

If ARR is defined as:investedcapitalInitial

on)depreciati(afterprofitAverage 100

then a project which costs $5 million, and yields average profits of $1,250,000 per year afterdepreciation charges of $500,000 per year, will give an ARR of:

1,250,000/5,000,000 100 = 25%

If the depreciation charged is increased to $750,000 per year as a result, for example, oftechnological changes which reduce the expected life of an asset, the ARR becomes:

1,000,000/5,000,000 100 = 20%

The attraction of using ARR as a method of investment appraisal lies in its simplicity, and theease with which it can be used to specify the impact of a project on a companys incomestatement. The measure is easily understood and can be directly linked to the use of ROCE asa performance measure. Nonetheless, ARR has been criticised for a number of majordrawbacks, perhaps the most important of which is that it uses accounting profits afterdepreciation rather than cash flows in order to measure return. This means that the capital costis over-stated in the calculation, via both the numerator and the denominator. In the numeratorthe capital cost is taken into account via the depreciation charges used to derive accounting

profit, but capital cost is also the denominator. The practical effect of this is to reduce theARR and thus make projects appear less profitable. This might in turn result in some


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worthwhile projects being rejected. Note, however, that this problem does not arise whereARR is calculated as average annual profit as a percentage of average capital invested.

The most important criticism of ARR is that it takes no account of the time value of money. Asecond limitation of ARR, already suggested, is that its value is dependent upon accounting

policies and this can make comparison of ARR figures across different investments somewhatdifficult. This may be important in an international company where accounting policies vary

between nations. A further difficulty with the use of ARR is that it does not give a cleardecision rule. The ARR on any particular investment needs to be compared with the currentreturns being earned within a business, and so unlike NPV, for example, it is impossible tosay all investments with an ARR of X or below will always be rejected.

The payback method of investment appraisal is very widely used by industry generally inaddition to other measures perhaps because, like ARR, it is easily calculated andunderstood. The payback approach simply measures the time required for cumulative cashflows from an investment to sum to the original capital invested.

Example:Original investment $100,000Cash flow profile: Years 13 $25,000 p.a.; Years 45 $50,000 p.a.; Year 6 $5,000The cumulative cash flows are thus:End Year 1 $25,000End Year 2 $50,000End Year 3 $75,000End Year 4 $125,000End Year 5 $175,000End Year 6 $180,000

The original sum invested is thus returned via cash flows some time during the course of Year4. If cash flows are assumed to be even throughout the year, then the cumulative cash flow of$100,000 will have been earned halfway through year 4. The payback period for theinvestment is thus 3 years and 6 months.

This approach is useful for companies which are seeking to claw back cash from investmentsas quickly as possible. At the same time the concept is intuitively appealing, as many

businessmen will be concerned about how long they may have to wait to get their moneyback, because they believe that rapid repayment reduces risks. This means that the paybackapproach is commonly used for initial screening of investment alternatives.

The disadvantages of the payback approach are as follows:

Payback ignores the overall profitability of a project by ignoring post payback cashflows. In the example above, the cash flows between 3.5 years and the end of the

project sum to $80,000. To ignore such substantial cash flows is somewhat nave,and as a consequence the method is biased in favour of fast return investments. Thiscan result in investments which generate cash flows more slowly in the early years,

but which are overall more profitable being rejected if the payback system is usedfor investment decisions.

As with ARR the method ignores the time value of money.

The payback method, in the same way as ARR, offers no objective measure of what

is the desirable return, as measured by the length of the payback period.


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(b)

(i)

Discounted cash flow analysis is the term used to describe the technique whereby the value offuture cash flows is discounted back to a present value, so that the monetary values of all cashflows are equivalent, regardless of their timing. The logic for discounting is that the value ofmoney declines over time because of individual time preferences and the impact of inflationin eroding spending power. People value money received sooner rather than later because assoon as cash is received they can increase consumption, or re-invest the capital.

NPV uses discounting to calculate the present value of all cash flows associated with aproject. The present value of cash outflows is then compared with the present value of cashinflows, to obtain a net present value (NPV). If cash out exceeds cash in, then the NPV will

be negative, and vice versa. The size of the NPV is dependent upon the cash flow pattern andthe rate of discount which is applied.

The general rule is that a company will discount the forecast cash flows at a rate equal to itscost of capital. The reason for this is that if a company has an overall cost of capital of, forexample, 12%, it is essential that the rate of return exceeds 12% or the funding costs will not

be covered.

Hence if the cash flows are discounted at the cost of capital and the project yields a positiveNPV, this implies that the return exceeds the cost of capital. When using NPV for investmentappraisal then, a simple rule is applied: invest if NPV is positive, and do not invest if it isnegative.

IRR uses discounting in a slightly different way to determine the profitability of aninvestment. The Internal Rate of Return is defined as the discount rate at which the net

present value equals zero. For example, an investment may yield a forecast NPV of $15,000when the cash flows are discounted at 10%. If the rate of discount is increased, the net presentvalue will fall, and the IRR represents the effective break even discount rate for theinvestment. Suppose, for example, that the IRR is 15%, this figure can then be used toestablish a decision rule for investments. An IRR of 15% means that if the cost of capitalexceeds 15% then the investment would generate a negative NPV. If the company currentlyhas to pay 12% on its investment funds, then it knows that it can afford to see its cost ofcapital rise by 3% before the investment will become financially non-viable. As long as theIRR exceeds the cost of capital, then the company should invest, and so as a general rule, thehigher the IRR the better.

NPV and IRR measures may sometimes contradict one another when used in relation to either

mutually exclusive investments or projects which have multiple yields. An example of theambiguity which can occur when choosing between mutually exclusive decisions is when oneof the investments has a higher NPV than the other, and so is preferable on that basis, but atthe same time it has a lower IRR. When IRR and NPV give conflicting results, the preferredalternative is the project with the highest NPV. In the case of projects with multiple yields,caused by cash flows which change from positive to negative and vice versa on severaloccasions, there may be more than one IRR. In this situation it is once again preferable to use

NPV as the decision criteria.

In conclusion then, although both NPV and IRR use discounted cash flows as a method ofarriving at an investment decision, the results that they generate need to be interpreted withcare, and they do not always yield the same investment decisions. NPV is the preferred

criteria where the two approaches give ambiguous results.


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(ii) If the laptops are replaced every year:

NPV of one replacement cycle = $(2,400) + 1,200/1.14= $(1,347.37)

Equivalent Annual Cost = $1,347/0.877= $1,536.34

If replacement occurs every two years:

NPV of one replacement cycle = $(2,400) + 800/1.142+ (75)/1.14= ($1,850.21)


If replacement occurs every three years:

NPV of one replacement cycle = $(2,400) + 300/1.143+ (150)/1.142+ (75)/1.14= ($2,378.72)


Conclude:

The optimal cycle for replacement is every three years. Other factors which need to be takeninto account are the non-financial aspects of the alternative cycle choices. For example,computer technology and the associated software is changing very rapidly, and this couldmean that failure to replace annually would leave the salesmen unable to utilise the most up todate systems for recording, monitoring and implementing their sales. This could have animpact on the companys competitive position. The company needs to also consider the

compatibility of the software used by the laptops with that used by the in-house computersand mainframe. If system upgrades are made within the main business which render the twocomputers incompatible, then rapid replacement of the laptops to regain compatibility isessential.

Answer 12 LEAMINGER PLC

(a) Purchase outright

2002 2003 2004 2005 2006 2007Outlay/NRV (360,000) 20,000Maintenance (15,000) (15,000) (15,000) (15,000)

Taxation 4,500 4,500 4,500 4,500WDA Tax Effect (W1) 27,000 20,250 15,188 11,391Bal Allowance (W2) 28,172

Cash flow (360,000) 12,000 9,750 4,688 20,891 32,672DF 10 0909 0826 0751 0683 0621

DCF (360,000) 10,908 8,054 3,521 14,269 20,289

Net Present Cost = $(302,959)


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WORKINGS

(1) Writing Down Allowances

Year TWDV WDA Tax Effectb/d 25% 30%

2002 360,000 90,000 27,0002003 270,000 67,500 20,2502004 202,500 50,625 15,1882005 151,875 37,969 11,3912006 113,906

(2) Balancing allowance

TWDV 113,906Proceeds 20,000

Bal Allow 93,906

Tax effect = 93,906 30% = 28,172

Finance lease

Annuity Factor (AF) at 10% for 4 years is 317Thus PV outflows = (135,000 + 15,000)317 = (475,500)PV tax relief = [(150,000 03)317]/11 = 129,682


Operating lease

Annuity Factor (AF) at 10% for 3 years is 2487Thus PV outflows = (140,000)(2487 +1) = (488,180)PV tax relief = (140,000 03)(2487 +1)/11 = 133,140


On the basis of net present value, purchasing outright appears to be the least cost method.

(b)

Each $1 of outlay before 31 December 2003 would mean a loss in NPV on the alternativeproject of $020. There is thus an opportunity cost of using funds in 2002.

Purchasing

Net Present Cost (302,959)Opportunity cost (02 360,000) (72,000)

Total (374,959)

Finance lease



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There is no cash flow before 31 December 2003 in this case and thus no opportunity cost.

Operating lease

Net Present Cost = (355,040)Opportunity cost (02 140,000) (28,000)

Total (383,040)

Thus the finance lease is now the lowest cost option.

All the above assume that the alternative project cannot be delayed.

(c) REPORT

To: The Directors of Leaminger plc

From: A business advisor

Date: December 2002

Subject: Acquiring the turbine machine

Introduction

In financial terms, and without capital rationing, the purchasing outright method is thepreferred method of financing as it has the lowest negative NPV. With capital rationing, afinance lease becomes the preferred method. There are, however, a number of other factors to

be considered before a final decision is taken.

If capital rationing persists into further periods the value of cash used in leasing

becomes more significant and thus purchasing becomes relatively more attractive. Even without capital rationing, leasing has a short-term cash flow advantage over

purchasing which may be significant for liquidity.

The use of a 10% cost of capital may be inappropriate as these are financing issuesand are unlikely to be subject to the average business risk. Also they may alter thecapital structure and thus the financial risk of the business and thus the cost ofcapital itself. This may alter the optimal decision in the face of capital rationing.

The actual cash inflows generated by the turbine are constant for all options, exceptthat under an operating lease the lessor may refuse to lease the turbine at the end of

any annual contract thus making it unavailable from this particular source. On top ofcapital rationing, we need to consider the availability of finance as a continuingsource under the operating lease.

Conversely, however, with the operating lease Leaminger plc can cancel if businessconditions change (e.g. a technologically improved asset may become available).This is not the case with the other options. On the other hand, if the market is

buoyant then the lessor may raise lease rentals, whereas the cost is fixed under theother options and hence capital rationing might be more severe.

On the issue of maintenance costs of $15,000 per annum, this is included in theoperating lease if the machine becomes unreliable, but there is greater risk beyond

any warranty period under the other two options.


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It is worth investigating if some interim measure can be put in place which wouldassist in lengthening the turbines life such as sub-contracting work outside oroverhauling the machine.

Answer 13 BASRIL PLC

(a)

(i) Analysis of projects assuming they are divisible.

Project 1 PV at 12% Project 3 PV at 12%$ $ $ $

Initial investment (300,000) (300,000) (400,000) (400,000)Year 1 85,000 75,905 124,320 111,018Year 2 90,000 71,730 128,795 102,650Year 3 95,000 67,640 133,432 95,004Year 4 100,000 63,600 138,236 87,918Year 5 95,000 53,865 143,212 81,201

NPV 32,740 77,791

Profitability index 332,740/300,000 = 111 477,791/400,000 = 119

Project 2 NPV at 12% = (140,800 3605) 450,000 = $57,584Project 2 profitability index = 507,584/450,000 = 113

The optimum investment schedule involves investment in projects 3 and 2:

Project Profitability Index Ranking Investment NPV

$3 119 1 400 77,7912 113 2 400 51,186 (57,584 400/450)

800 128,977

(ii)

If the projects are assumed to be indivisible, the total NPV of combinations of projects mustbe considered.

Projects Investment NPV

$1+2 750,000 90,324 (32,740 + 57,584)1+3 700,000 110,531 (32,740 + 77,791)

The optimum combination is now projects 1 and 3.


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(b)

The NPV decision rule requires that a company invest in all projects that have a positive netpresent value. This assumes that sufficient funds are available for all incremental projects,which is only true in a perfect capital market. When insufficient funds are available, that iswhen capital is rationed, projects cannot be selected by ranking by absolute NPV. Choosing a

project with a large NPV may mean not choosing smaller projects that, in combination, give ahigher NPV. Instead, if projects are divisible, they can be ranked using the profitability indexin order make the optimum selection. If projects are not divisible, different combinations ofavailable projects must be evaluated to select the combination with the highest NPV.

(c)

The NPV decision rule, to accept all projects with a positive net present value, requires theexistence of a perfect capital market where access to funds for capital investment is notrestricted. In practice, companies are likely to find that funds available for capital investmentare restricted or rationed.

Hard capital rationing is the term applied when the restrictions on raising funds are due tocauses external to the company. For example, potential providers of debt finance may refuseto provide further funding because they regard a company as too risky. This may be in termsof financial risk, for example if the companys gearing is too high or its interest cover is toolow, or in terms of business risk if they see the companys business prospects as poor or itsoperating cash flows as too variable. In practice, large established companies seeking long-term finance for capital investment are usually able to find it, but small and medium-sizedenterprises will find raising such funds more difficult.

Soft capital rationing refers to restrictions on the availability of funds that arise within acompany and are imposed by managers. There are several reasons why managers might

restrict available funds for capital investment. Managers may prefer slower organic growth toa sudden increase in size arising from accepting several large investment projects. This reasonmight apply in a family-owned business that wishes to avoid hiring new managers. Managersmay wish to avoid raising further equity finance if this will dilute the control of existingshareholders. Managers may wish to avoid issuing new debt if their expectations of futureeconomic conditions are such as to suggest that an increased commitment to fixed interest

payments would be unwise.

One of the main reasons suggested for soft capital rationing is that managers wish to create aninternal market for investment funds. It is suggested that requiring investment projects tocompete for funds means that weaker or marginal projects, with only a small chance ofsuccess, are avoided. This allows a company to focus on more robust investment projects

where the chance of success is higher2. This cause of soft capital rationing can be seen as away of reducing the risk and uncertainty associated with investment projects, as it leads toaccepting projects with greater margins of safety.

2 Watson, D. and Head, A. (2001) Corporate Finance: Principles and Practice, 2nd edition, FT PrenticeHall, p.73.

2 Drury, C. (2000),Management and Cost Accounting, 5th edition, Thomson Business Press, p.280


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(d)

When undertaking the appraisal of an investment project, it is essential that only relevant cashflows are included in the analysis. If non-relevant cash flows are included, the result of theappraisal will be misleading and incorrect decisions will be made. A relevant cash flow is adifferential (incremental) cash flow, one that changes as a direct result of an investmentdecision.

If current fixed production overheads are expected to increase, for example, the additionalfixed production overheads are a relevant cost and should be included in the investmentappraisal. Existing fixed production overheads should not be included.

A new cash flow arising as the result of an investment decision is a relevant cash flow. Forexample, the purchase of raw materials for a new production process and the net cash flowsarising from the production process are both relevant cash flows.

The incremental tax effects arising from an investment decision are also relevant cash flows,providing that a company is in a tax-paying position. Direct labour costs, for example, are anallowable deduction in calculating taxable profit and so give rise to tax benefits: tax liabilitiesarising on incremental taxable profits are also a relevant cash flow.

One area where caution is required is interest payments on new debt used to finance aninvestment project. They are a differential cash flow and hence relevant, but the effect of thecost of the debt is incorporated into the discount rate used to determine the net present value.Interest payments should not therefore be included as a cash flow in an investment appraisal.

Market research undertaken to determine whether a new product will sell is often undertakenprior to the investment decision on whether to proceed with production of the new product.This is an example of a sunk cost. These are costs already incurred as a result of past

decisions, and so are not relevant cash flows.Answer 14 LKL PLC

Project VZ

(a) Cash Flow budget and NPV

Inflows: 19X1 19X2 19X3 19X4 I9X5$000 $000 $000 $000 $000

Sales (W1) 916 1,269 1,475 1,780 160Savings, employees

made redundant 42 44.1 46.3Residual valuenew machine 242

Material XNT, savingon cost of disposal 2___ _____ _______ _______ ___

(A) 918 1,311 1,519.1 1,826.3 402___ _____ _______ _______ ___


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Outflows:Purchases (W2) 320 480 570 610 120Sale of old machine

not received 12Labour:Employee promoted 10 10.5 11.03 11.58Redundancy pay 62Materials:Material XPZ, lost

residual value 3Sub-contractors 60 90 80 80Lost contribution from

existing product 30 40 40 36Overheads and

advertising 130 100 90 100Taxation 96 142 174 275___ _____ _______ _______ ___

(B) 553 890.5 933.03 1,011.58 395___ _____ _______ _______ ___IncrementalCash flow (A B) 365 420.5 586.07 814.72 7

WORKINGS

(1)

19X1 19X2 19X3 19X4 19X5$000 $000 $000 $000 $000

Opening receivables 84 115 140 160Add sales 1,000 1,300 1,500 1,800 -_____ _____ _____ _____ _____

1,000 1,384 1,615 1,940 160Less closing receivables 84 115 140 160 -_____ _____ _____ _____ _____

Cash from sales 916 1,269 1,475 1,780 160_____ _____ _____ _____ _____

(2)

Opening payables 80 100 110 120Add purchases 400 500 580 620 -_____ _____ _____ _____ _____

400 580 680 730 120Less closing payables 80 100 110 120 -_____ _____ _____ _____ _____

Cash from purchases 320 480 570 610 120_____ _____ _____ _____ _____


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The net present value of Project VZ

Year Cash Flow PV at 10% P.V.$000 $000

19X1 365.0 0.909 331.819X2 420.5 0.826 347.319X3 586.0 0.751 440.119X4 814.7 0.683 556.519X5 7.0 0.621 4.3_______

1,680.0Less Initial investment (1,640 16) 1,624.0_______

Net present value 56.0_______

(b) Report

3rd October, 19X0To The Board of Directors of LKL plc

From R.U. Tre-Vere, Accounting and Finance team

Preliminary Report Re-The New Product LineI have now prepared the cash flow budget enclosed herewith, and computed the net presentvalue of the project.

The cash flows

The principal reason why certain figures were not included in the cash flows is that they areincremental cash flows and only include the income and expenditure which will arise only ifthe project goes ahead.

The following figures were not included in the incremental cash flows:

the feasibility study which cost $45,000 had to be paid out whether or not theproject went ahead;

the depreciation is a non-cash movement item. The cash expended on the assetmoves when it is paid over to the vendor;

the three employees paid $12,000 each would continue to receive that amountwhether or not the project goes ahead;

the cost of the materials XNT and XPZ was paid out some time ago and is nottherefore a relevant cash flow;

the prepayments were already included in the amounts paid to the sub-contractorsand did not require any adjustment to the cash flows. The relevant figures are theactual cash to be paid to them each year, e.g. 19X1 $60,000, and so on.


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The net present value (NPV)

The NPV of the project is a positive $56,000. This indicates, that using our cost of capital10% as our discount rate, the project is wealth creating. However, if the project is consideredto be high risk, then the cash flows will need to be discounted at a higher rate to take this intoaccount.

In addition to looking at the cash flows and net present value, other factors will also need tobe considered such as: servicing and maintenance, reliability of the plant and machinery,availability of spare parts, retraining of operatives, importing and foreign exchange problemsif it is being supplied from another country etc.

Please do not hesitate to contact me should you require further information.

R. U. Tre-Vere ACCA

(c) Project VZ

(i) The companys current gearing

8,5002,000

100 = 23.53%

The current gearing position is on the low side, particularly when compared with the industryaverage of 35%. This provides an indication that the company still has the scope and capacityto attract more debt.

There is however, a large secured bank overdraft, and it is quite likely that quite a highproportion of it represents hard-core debt. It is also most unlikely that the bankers would call

in such a large overdraft at short notice. If the overdraft were included in the gearingcalculation, and treated as debt, the gearing ratio 38.1% is a little above the industry average.

Current earning per share ($000)

EPS5,000

0003,= 60c per share

(ii) Issue of ordinary shares

Number of new shares =

2

5,000,000= 2,500,000 shares

Earnings $000Current net profit after interest and tax 3,000

$000Additional earnings 2,000Less tax at 33% 660 1,340_____ _____

4,340_____

EPS7,500

4,340= 58c per share


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Gearing500,13

000,2 100 = 14.81%

More equity would reduce the gearing further. The gearing in the future would also tend tofall due to increases in reserves via retained earnings.

The scheme would reduce the EPS by 2c per share when compared with current earnings.Other considerations which should be looked at are:

the control factor i.e. those shareholders who currently control the company couldlose control unless they buy some of the shares being offered.

(iii) 5% convertible loan stock

$000Current (as above) 3,000

$000

Plus Additional earnings 2,000Less Loan stock interest at 5% 250_____

1,750Less tax at 33% 578 1,172_____ _____

4,172_____

Undiluted EPS5,000

4,172= 83c per share

The gearing at the time of issuing the convertible loan stock would be:

13,5000007,

100 = 51.85%

This figure would be expected to decrease in future years as a result of ploughing backprofits by way of retained earnings i.e. increasing the equity. On conversion the gearingpercentage should fall quite significantly. This would be affected by the retained earnings,new loans taken out and old loans paid off.

The fully diluted earnings per share i.e. where all the holders convert, would be:

Earnings $4,340 as per scheme (i)

EPSshares7,000

3404= 62c per share

For the period in which the holders cannot or do not convert the undiluted EPS, (providedearnings remain at this level and tax rates do not change), is much greater, at 83c per share asindicated above. If and when the holders convert a dilution of earnings will take place and thecontrol of the company may be affected. If the interest rate is fixed, the company wouldappear to have locked in to quite a low rate compared with the 7% debentures i.e. theconvertibles have a low service cost. The gearing would be well above the current industryaverage, but on conversion would fall well below it.


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An alternative answer using annuity factors is as follows.

$000PV of tax benefits = (225 0893) + (169 0797)+ (127 0712) + (95 0636) + (284 0567) = 6475PV of working capital recovered = 400 0567 = 2268PV of revenue after tax = 1,430 07 3605 = 3,6086Investment in working capital = (400)Investment in new machinery = (3,000)

Net present value = 1,0830

The net present value is approximately $1,083,000

This analysis makes the following assumptions:

(1) The first tax benefit occurs in Year 1, the last tax benefit occurs in Year 5

(2) Cash flows occur at the end of each year.

(3) Inflation can be ignored.

(4) The increase in capacity does not lead to any increase in fixed productionoverheads.

(5) Working capital is all released at the end of Year 5

(b)

Administration and distribution expenses per unit = 220,000/5,500 = $40 per unit

Net revenue from additional units sold = 500 200 40 = $260 per unit

Present value of tax benefits = $647,500

Incremental working capital per unit = 400,000/5,500 = $7273 per unit

Let annual sales volume be SV units

NPV = [SV 260 (1 03) 3605] + 647,500 [7273 SV (1 0567)] 3,000,000 = 0

Hence SV = 3149)-(65611 647,500)-(3,000,000 = 624622,352,500 = 3,766 units

Annual increase in sales volume of 3,766 units will produce a zero NPV

This is 31% (100 1,734/5,500) less than the expected increase in sales volume.

(Note: working capital is assumed to depend on sales volume)


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(c) (i)

The current gearing of Springbank plc = 100 (35m/4m) = 875%Total debt after issuing $34m of debt = 35m + 34m = $69m

New level of gearing = 100 (69m/4m) = 1725%

Current annual debenture interest = $350,000 (35m 01)Current interest on overdraft = 400,000 350,000 = $50,000

Annual interest on new debt = $272,000 (34m 008)Expected annual interest = 400,000 + 272,000 = $672,000

Current profit before interest and tax = $15mCurrent interest cover = 375 (15m/04m)Assuming straight line depreciation, additional depreciation = $600,000 per yearExpected profit before interest and tax = 15 + 143 06 = $233mExpected interest cover = 347 (233/0672)

This is lower than the current interest cover and also assumes no change in overdraft interest.

Thus, Springbanks gearing is expected to rise from slightly below the sector average of100% to significantly more than the sector average. Springbanks interest cover is likely toremain at a level lower than the sector average of four times, and will be slightly reducedassuming no change in overdraft interest.

(ii) Ratio calculations

2001 2002ROCE 1,750/7,120 246% 1,500/7,500 20%

Net profit margin 1,750/5,000 35% 1,500/5,000 30%Asset turnover 5,000/7,120 070 5,000/7,500 067Current ratio 2,000/1,280 156 2,150/1,150 187Quick ratio 1,000/1,280 078 980/1,150 085Inventory days 365 1,000/3,000 122 days 365 1,170/3,100 138 daysReceivables ratio 12 900/5,000 22 months 12 850/5,000 2 monthsSales/working capital 5,000/720 69 5,000/1,000 5Debt/equity 3,500/3,620 967% 3,500/4,000 875%Interest cover 1,750/380 46 1,500/400 375

The return on capital employed of Springbank has declined as a result of both falling netprofit margin and falling asset turnover: while comparable with the sector average of 25% in

2001, it is well below the sector average in 2002. The problem here is that turnover hasremained static while both cost of sales and investment in assets have increased.

Despite the fall in profitability, both current ratio and quick ratio have improved, in the maindue to the increase in inventory levels and the decline in current liabilities, the composition ofwhich is unknown. The current ratio remains below the sector average, however. The increasein both inventory levels and inventory days, together with the fact that inventory days is now53% above the sector average, may indicate that current products are becoming harder to sell,a conclusion supported by the failure to increase turnover and the reduced profit margin. Theexpected increase in sales volume is therefore likely to be associated with a new productlaunch, since it is unlikely that an increase in capacity alone will be able to generate increasedsales. There is also the possibility that the static sales of existing products may herald a

decline in sales in the future.


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The decrease in the receivables ratio is an encouraging sign, but the interpretation of thedecreased sales/working capital ratio is uncertain. While the decrease could indicate lessaggressive working capital management, it could also indicate that trade payables are lesswilling to extend credit to Springbank, or that inventory management is poor.

The gearing of the company has fallen, but only because reserves have been increased byretained profit. The interest cover has declined since interest has increased and operating

profit has fallen. Given the constant long-term debt, the increase in interest, although small,could indicate an increase in overdraft finance.

Ratio analysis offers evidence that the financial performance of Springbank plc has beendisappointing in terms of sales, profitability and inventory management. It may be that themanagement of Springbank see the increase in capacity as a cure for the companys declining

performance.

(iii)

Since the investment has a positive NPV it is acceptable in financial terms. The dangerhighlighted by the analysis of recent financial performance is that existing sales may generatea declining contribution towards meeting interest payments in the future. However, sensitivityanalysis shows the proposed expansion is robust in terms of sales volume, since a 31%reduction in forecast sales is needed to eliminate the positive NPV. The proposed expansion istherefore acceptable, but the choice of financing is critical.

Springbank should be able to meet future interest payments if the cash flow forecasts for theincrease in capacity are sound. However, no account has been taken of expected inflation, and

both sales prices and costs will be expected to change. There is also an underlying assumptionof constant sales volumes, when changing economic circumstances and the actions ofcompetitors make this assumption unlikely to be true. More detailed financial forecasts are

needed to give a clearer indication of whether Springbank can meet the additional interestpayments arising from the new debentures. There is also a danger that managers may focusmore on the short-term need to meet the increased interest payments, or on the longer-termneed to replace the machinery and redeem the debentures, rather than on increasing the wealthof shareholders.

Financial risk has increased from a statement of financial position point of view and this islikely to have a negative effect on how financial markets view the company. The cost ofraising additional finance is likely to rise, while the increased financial risk may lead todownward pressure on the companys share price. The current debentures represent 54% offixed assets and after the new issue of debentures, this will rise to 73% of fixed assets. Theassets available for offering as security against new debt issues will therefore decrease, and

continue to decrease as fixed assets depreciate.

No information has been offered as to the maturity of the new debenture issue. If thematching principle is applied, a medium term maturity of five to six years is indicated.However, the 10% debentures are due for redemption in 2007 and it would be unwise to havetwo significant redemption calls so close to each other.

On the basis of the above discussion, careful thought needs to be given to the maturity of anynew issue of debentures and it may be advisable to use debt finance to meet only part of thefinancing need of the proposed capacity expansion. Alternative sources of finance such asequity and leasing should be considered.


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(d)

Financing the investment by an issue of ordinary shares could offer several advantages toSpringbank plc. Gearing would fall to 47% (35/74), less than half of the sector average of100%, rather than increasing to significantly more than the sector average. Interest coverwould increase to 58 (233/04) from 375, compared to a sector average of 4. The financialrisk faced by the company would thus be reduced, making it a more attractive investment

prospect on the stock market. This could have a positive effect on the companys share price.

Ordinary shares do not carry a commitment to make regular payments such as interest ondebt, giving Springbank plc a degree of flexibility in rewarding shareholders in financialterms. This must be balanced against the common desire of shareholders for a regular andincreasing dividend.

Ordinary shares are permanent capital since they do not need to be repaid. Springbank plcwould thus avoid the need to find funds for redemption that would arise if it issueddebentures.

Because the fixed assets of the company would increase but its burden of long-tem debtwould be unchanged, Springbank would find it easier to raise additional debt in the future.This could be useful when the need arises to redeem the existing debentures in 2007.

Answer 16 NESPA PLC

(a)

Strategy 1

Year 1 2 3 4 5

Demand (units) 100,000 105,000 110,250 115,762 121,551Selling price ($/unit) 800 800 800 800 800Variable cost ($/unit) 300 300 295 295 290Contribution ($/unit) 500 500 505 505 510Inflated contribution ($/unit) 515 530 552 568 591Total contribution ($) 515,000 556,500 608,580 657,528 718,36610% discount factors 0909 0826 0751 0683 0621PV of contribution ($) 468,135 459,669 457,044 449,092 446,105

Total PV of strategy 1 contributions = $2,280,045 or approximately $2,280,000

Strategy 2

Year 1 2 3 4 5Demand (units) 110,000 126,500 145,475 167,296 192,391Selling price ($/unit) 700 700 700 700 700Variable cost ($/unit) 295 290 280 270 255Contribution ($/unit) 405 410 420 430 445Inflated contribution ($/unit) 417 435 459 484 516Total contribution ($) 458,700 550,275 667,730 809,713 992,73810% discount factors 0909 0826 0751 0683 0621PV of contribution ($) 416,958 454,527 501,465 553,034 616,490

Total PV of strategy 2 contributions = $2,542,474 or approximately $2,542,000

Strategy 2 is preferred as it has the higher present value of contributions.


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(b)

Evaluating the investment in the new machine using internal rate of return:

Year 0 1 2 3 4 5$ $ $ $ $ $

Contribution 458,700 550,275 667,730 809,713 992,738Fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)

Taxable profit 344,300 431,299 543,995 681,029 858,906Taxation at 30% (103,290) (129,390) (163,199) (204,309) (257,672)

241,010 301,909 380,796 476,720 601,234

CA tax benefits 112,500 84,375 63,281 47,461 142,383

Profit after tax 353,510 386,284 444,077 524,181 743,617

Cash flows (1,500,000) 353,510 386,284 444,077 524,181 743,61710% discount factors 1000 0909 0826 0751 0683 0621

Present values (1,500,000) 321,341 319,071 333,502 358,016 461,786NPV at 10% = $293,716

Cash flows (1,500,000) 353,510 386,284 444,077 524,181 743,61720% discount factors 1000 0833 0694 0579 0482 0402

Present values (1,500,000) 294,474 268,081 257,121 252,655 298,934NPV at 20% = ($128,735)

IRR = 10 + [(10 293,716) / (293,716 + 128,735)] = 17%

Since the internal rate of return is greater than the companys cost of capital of 10%, theinvestment is financially acceptable.

(c) Evaluating the investment using return on capital employed:

Annual depreciation charge = 1,500,000/5 = $300,000

Year 1 2 3 4 5Inflated contribution 458,700 550,275 667,730 809,713 992,738Inflated fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)

Depreciation (300,000) (300,000) (300,000) (300,000) (300,000) Annual PBIT 44,300 131,299 243,995 381,029 558,906

Average investment = 1,500,000/2 = $750,000

Average annual accounting profit = 1,359,529/5 = $271,906

Return on capital employed = 100 (271,906/ 750,000) = 36%

Since the return on capital employed is greater than the hurdle rate of 20%, the investment is

financially acceptable


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(d)

Internal rate of return (IRR) is a discounted cash flow investment appraisal method thatcalculates the discount rate which causes the net present value of an investment to becomezero. An investment project is acceptable if it has an IRR greater than the cost of capital of theinvesting company. It uses cash flows rather than accounting profits in the evaluation of aninvestment project. It also takes account of the time value of money, the concept that thevalue of a given sum of money decreases over time due to the opportunity cost of selectingone investment rather than the best available alternative. IRR considers all cash flows over thelife of an investment project and always gives correct advice, provided that investment

projects being compared are not mutually exclusive.

Return on capital employed (ROCE) is also called accounting rate of return. Unlike IRR,ROCE uses average annual accounting profit before interest and tax in the evaluation ofinvestment projects, expressing this as a percentage of the amount of capital invested. Thedecision as to whether a project is acceptable is made by comparing project ROCE with atarget ROCE, such as a companys current ROCE.

The problem with using accounting profit rather than cash flow is that only cash flow islinked directly to an increase in company value. ROCE also ignores the time value of money.Because it averages accounting profit over the life of the project, the amount of profit in agiven year is irrelevant; ROCE therefore ignores the timing of accounting profits.

ROCE also suffers from definition problems as there are several definitions in common useand so care must be taken to ensure comparisons are made using identical definitions. Capitalinvested can be defined as initial capital invested or average capital invested, but otherdefinitions are met in practice.

Both IRR and ROCE offer a relative measure of return in percentage terms, a feature that is

seen as attractive to managers who may have difficulty in interpreting the absolute measure ofvalue offered by net present value. A relative measure of return ignores the size of the initialinvestment, however, and so should not be relied on as a sole measure of investment worth.

Academically, IRR is preferred to ROCE because it takes account of the time value of money,uses cash flows, and compares the return on investment projects with t

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