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REVISION QUESTION BANK FINANCIAL MANAGEMENT (F9)

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Question 1 COMPANY OBJECTIVES

Justify and criticise the usual assumption made in financial management literature that the objective of a company is to maximise the wealth of the shareholders. (Do not consider how this wealth is to be measured).

Outline other goals that companies claim to follow, and explain why these might be adopted in preference to the maximisation of shareholder wealth.

(20 marks)

Question 2 NON-FINANCIAL OBJECTIVES

What non-financial objectives might organisations have? In your answer, identify any stakeholder group that may have a non-financial interest.

(12 marks)

Question 3 STAKEHOLDERS

Private sector companies have multiple stakeholders who are likely to have divergent interests.

Required:

(a) Identify five stakeholder groups and briefly discuss their financial and other objectives. (12 marks)

(b) Examine the extent to which good corporate governance procedures can help manage the problems arising from the divergent interests of multiple stakeholder groups in private sector companies in the UK. (13 marks)

(25 marks)

Question 4 NOT-FOR-PROFIT

Discuss the nature of the financial objectives that may be set in a not-for-profit organisation such as a charity or a hospital.

(8 marks)

Question 5 TAGNA

Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores. In real terms, the company has experienced only a small growth in turnover in recent years, but it has managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid a constant nominal (money terms) dividend for several years and its managing director has publicly stated that the primary objective of the company is to increase the wealth of shareholders. Tagna is financed as follows:

$m Overdraft 10 10 year fixed interest bank loan 20 Share capital and reserves 45 75

FINANCIAL MANAGEMENT (F9) REVISION QUESTION BANK

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Tagna has the agreement of its existing shareholders to make a new issue of shares on the stock market but has been informed by its bank that current circumstances are unsuitable. The bank has stated that if new shares were to be issued now they would be significantly under-priced by the stock market, causing Tagna to issue many more shares than necessary in order to raise the amount of finance it requires. The bank recommends that the company waits for at least six months before issuing new shares, by which time it expects the stock market to have become strong-form efficient.

The financial press has reported that it expects the Central Bank to make a substantial increase in interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in inflation. The financial press has also reported that the rapid increase in consumer demand has been associated with an increase in consumer credit to record levels.

Required:

(a) Discuss the meaning and significance of the different forms of market efficiency (weak, semi-strong and strong) and comment on the recommendation of the bank that Tagna waits for six months before issuing new shares on the stock market. (9 marks)

(b) On the assumption that the Central Bank makes a substantial interest rate increase, discuss the possible consequences for Tagna in the following areas:

(i) sales; (ii) operating costs; and, (iii) earnings (profit after tax). (10 marks)

(c) Explain and compare the public sector objective of value for money and the private sector objective of maximisation of shareholder wealth. (6 marks)

(25 marks)

Question 6 MONOPOLY

An important element in the economic and financial management environment of companies is the regulation of markets to discourage monopoly.

Required:

Outline the economic problems caused by monopoly and explain the role of government in maintaining competition between companies.

(9 marks)

Question 7 EFFICIENT MARKET HYPOTHESIS

Explain the meaning of the term Efficient Market Hypothesis and discuss the implications for a company if the stock market on which it is listed has been found to be semi-strong form efficient.

(9 marks)


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Question 8 DEIGHTON PLC

You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing fittings. It has recently taken over a smaller unquoted competitor, Linton Ltd. Deighton is currently checking through various documents at Lintons head office, including a number of investment appraisals. One of these, a recently rejected application involving an outlay on equipment of $900,000, is reproduced below. It was rejected because it failed to offer Lintons target return on investment of 25% (average profit to-initial investment outlay). Closer inspection reveals several errors in the appraisal.

Evaluation of profitability of proposed project NT17 (all values in nominal terms)

Item ($000) 0 1 2 3 4 Sales 1,400 1,600 1,800 1,000 Materials (400) (450) (500) (250) Direct labour (400) (450) (500) (250) Overheads (100) (100) (100) (100) Interest (120) (120) (120) (120) Depreciation (225) (225) (225) (225) Profit pre-tax 155 255 355 55 Tax at 33% (51) (84) (117) (18) Post-tax profit 104 171 238 37 Outlay Inventory (100) Equipment (900) Market research (200) _____

(1,200) _____

Rate of return = Investment

profit Average =

1,200138 = 11.5%

You discover the following further details:

(1) Lintons policy was to finance both working capital and fixed investment by a bank overdraft. A 12% interest rate applied at the time of the evaluation.

(2) A 25% writing down allowance (WDA) on a reducing balance basis is offered for new investment. Lintons profits are sufficient to utilise fully this allowance throughout the project.

(3) Corporate tax is paid a year in arrears.

(4) Of the overhead charge, about half reflects absorption of existing overhead costs.

(5) The market research was actually undertaken to investigate two proposals, the other project also having been rejected. The total bill for all this research has already been paid.

(6) Deighton itself requires a nominal return on new projects of 20% after taxes, is currently ungeared and has no plans to use any debt finance in the future.


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Required:

Write a report to the finance director in which you:

(a) Identify the mistakes made in Lintons evaluation. (10 marks)

(b) Restate the investment appraisal in terms of the post-tax net present value to Deighton, recommending whether the project should be undertaken or not. (10 marks)

(20 marks)

Question 9 BLACKWATER PLC

Blackwater plc, a manufacturer of speciality chemicals, has been reported to the anti-pollution authorities on several occasions in recent years, and fined substantial amounts for making excessive toxic discharges into local rivers. Both the environmental lobby and Blackwaters shareholders demand that it clean up its operations.

It is estimated that the total fines it may incur over the next four years can be summarised by the following probability distribution (all figures are expressed in present values):

Level of fine Probability $0.5m 0.3 $1.4m 0.5 $2.0m 0.2

Filta & Strayne Ltd (FSL), a firm of environmental consultants; has advised that new equipment costing $1m can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollution control equipment is tax-allowable via a 25% writing-down allowance (reducing balance). The rate of corporate tax is 33%, paid with a one-year delay. The equipment will have no resale value after its expected four-year working life, but can be in full working order immediately prior to Blackwaters next financial year.

A European Union Common Pollution Policy grant of 25% of gross expenditure is available, but with payment delayed by a year. Immediately on receipt of the grant from the EU, Blackwater will pay 20% of the grant to FSL as commission. These transactions have no tax implications for Blackwater.

A disadvantage of the new equipment is that it will raise production costs by $30 per tonne over its operating life. Current production is 10,000 tonnes per annum, but expected to grow by 5% per annum compound. It can be assumed that other production costs and product price are constant over the next four years. No change in working capital is envisaged.

Blackwater applies a discount rate of 12% after all taxes to investment projects of this nature. All cash inflows and outflows occur at year ends.

Required:

(a) Calculate the expected net present value of the investment assuming a four-year operating period. Briefly comment on your results. (12 marks)

(b) Write a memorandum to Blackwaters management as to the desirability of the project, taking into account both financial and non-financial criteria. (8 marks)

(20 marks)


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Question 10 ARR AND PAYBACK

(a) Explain and illustrate (using simple numerical examples) the Accounting Rate of Return and Payback approaches to investment appraisal, paying particular attention to the limitations of each approach. (6 marks)

(b) (i) Explain the differences between NPV and IRR as methods of Discounted Cash Flow analysis. (6 marks)

(ii) A company with a cost of capital of 14% is trying to determine the optimal replacement cycle for the laptop computers used by its sales team. The following information is relevant to the decision:

The cost of each laptop is $2,400. Maintenance costs are payable at the end of each full year of ownership, but not in the year of replacement e.g. if the laptop is owned for two years, then the maintenance cost is payable at the end of year 1.

Interval between Trade-in Value ($) Maintenance cost ($) Replacement (years) 1 1200 Zero 2 800 75 (payable at end of Year 1) 3 300 150 (payable at end of Year 2)

Required:

Ignoring taxation, calculate the equivalent annual cost of the three different replacement cycles, and recommend which should be adopted. What other factors should the company take into account when determining the optimal cycle? (8 marks)

(20 marks)

Question 11 LEAMINGER PLC

Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The machine is essential to the operations of the company. The company is, however, considering whether to purchase the machine outright or to use lease financing.

Purchasing the machine outright

The machine is expected to cost $360,000 if it is purchased outright, payable on 31 December 2002. After four years the company expects new technology to make the machine redundant and it will be sold on 31 December 2006 generating proceeds of $20,000. Capital allowances for tax purposes are available on the cost of the machine at the rate of 25% per annum reducing balance. A full years allowance is given in the year of acquisition but no writing down allowance is available in the year of disposal. The difference between the proceeds and the tax written down value in the year of disposal is allowable or chargeable for tax as appropriate.

Leasing

The company has approached its bank with a view to arranging a lease to finance the machine acquisition. The bank has offered two options with respect to leasing which are as follows:

Finance Operating Lease Lease Contract length (years) 4 1 Annual rental $135,000 $140,000 First rent payable 31 December 2003 31 December 2002


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General

For both the purchasing and the finance lease option, maintenance costs of $15,000 per year are payable at the end of each year. All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposes in full in the year of payment. Assume that tax is payable one year after the end of the accounting year in which the transaction occurs. For the operating lease only, contracts are renewable annually at the discretion of either party. Leaminger plc has adequate taxable profits to relieve all its costs. The rate of corporation tax can be assumed to be 30%. The companys accounting year-end is 31 December. The companys annual after tax cost of capital is 10%.

Required:

(a) Calculate the net present value at 31 December 2002, using the after tax cost of capital, for

(i) purchasing the machine outright;

(ii) using the finance lease to acquire the machine; and

(iii) using the operating lease to acquire the machine.

Recommend the optimal method. (12 marks)

(b) Assume now that the company is facing capital rationing up until 30 December 2003 when it expects to make a share issue. During this time the most marginal investment project, which is perfectly divisible, requires an outlay of $500,000 and would generate a net present value of $100,000. Investment in the turbine would reduce funds available for this project. Investments cannot be delayed.

Calculate the revised net present values of the three options for the turbine given capital rationing. Advise whether your recommendation in (a) would change. (5 marks)

(c) As their business advisor, prepare a report for the directors of Leaminger plc that assesses the issues that need to be considered in acquiring the turbine with respect to capital rationing. (8 marks)

(25 marks)

Question 12 BASRIL PLC

Basril plc is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the company are limited to $800,000 in the current year. Details of three possible investments, none of which can be delayed, are given below.

Project 1

An investment of $300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms are expected to be as follows:

Year 1 2 3 4 5 Cash flows ($000) 85 90 95 100 95

Project 2

An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs by $140,800 per annum in money terms for the next five years.


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Project 3

An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are expected in current price terms and these are expected to increase by 36% per annum due to inflation during the five-year life of the machines.

Basril plc has a money cost of capital of 12% and taxation should be ignored.

Required:

(a) Determine the best way for Basril plc to invest the available funds and calculate the resultant NPV:

(i) on the assumption that each of the three projects is divisible;

(ii) on the assumption that none of the projects are divisible. (10 marks)

(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed. (3 marks)

(c) Discuss the reasons why capital rationing may arise. (7 marks)

(d) Discuss the meaning of the term relevant cash flows in the context of investment appraisal, giving examples to illustrate your discussion. (5 marks)

(25 marks)

Question 13 LKL PLC

LKL plc is a manufacturer of sports equipment and is proposing to start project VZ, a new product line. This project would be for the four years from the start of year 19X1 to the end of 19X4. There would be no production of the new product after 19X4.

You have recently joined the companys accounting and finance team and have been provided with the following information relating to the project:

Capital expenditure

A feasibility study costing $45,000 was completed and paid for last year. This study recommended that the company buy new plant and machinery costing $1,640,000 to be paid for at the start of the project. The machinery and plant would be depreciated at 20% of cost per annum and sold during year 19X5 for $242,000 receivable at the end of 19X5. As a result of the proposed project it was also recommended that an old machine be sold for cash at the start of the project for its book value of $16,000. This machine had been scheduled to be sold for cash at the end of 19X2 for its book value of $12,000.


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Other data relating to the new product line:

19X1 19X2 19X3 19X4 $000 $000 $000 $000 Sales 1,000 1,300 1,500 1,800 Receivables (at the year end) 84 115 140 160 Lost contribution on existing products 30 40 40 36 Purchases 400 500 580 620 Payables (at the year end) 80 100 110 120 Payments to sub-contractors, 60 90 80 80 including prepayments of 5 10 8 8 Net tax payable associated with this project 96 142 174 275 Fixed overheads and advertising: With new line 1,330 1,100 990 900 Without new line 1,200 1,000 900 800

Notes

The year-end receivables and payables are received and paid in the following year. The net tax payable has taken into account the effect of any capital allowances. There is a one

year time-lag in the payment of tax. The companys cost of capital is a constant 10% per annum. It can be assumed that operating cash flows occur at the year end. Apart from the data and information supplied there are no other financial implications after

19X4.

Labour costs

From the start of the project, three employees currently working in another department and earning $12,000 each would be transferred to work on the new product line, and an employee currently earning $20,000 would be promoted to work on the new line at a salary of $30,000 per annum. The effect of the transfer of employees from the other department to the project is included in the lost contribution figures given above.

As a direct result of introducing the new product line, four employees in another department currently earning $10,000 each would have to be made redundant at the end of 19X1 and paid redundancy pay of $I5,500 each at the end of 19X2.

Agreement had been reached with the trade unions for wages and salaries to be increased by 5% each year from the start of 19X2.

Material costs

Material XNT which is already in inventory, and for which the company has no other use, cost the company $6,400 last year, and can be used in the manufacture of the new product. If it is not used the company would have to dispose of it at a cost to the company of $2,000 in 19X1.

Material XPZ is also in inventory and will be used on the new line. It cost the company $11,500 some years ago. The company has no other use for it, but could sell it on the open market for $3,000 in 19X1.


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Required:

(a) Prepare and present a cash flow budget for project VZ, for the period 19X1 to 19X5 and calculate the net present value of the project. (14 marks)

(b) Write a short report for the board of directors which:

(i) explains why certain figures which were provided in (a) were excluded from your cash flow budget, and

(ii) advises them on whether or not the project should be undertaken, and lists other factors which would also need to be considered. (7 marks)

(c) LKL needs to raise $5 million to finance project VZ, and other new projects. The proposed investment of the $5 million is expected to yield pre-tax profits of $2 million per annum. Earnings on existing investments are expected to remain at their current level. From the data supplied below:

Statement of Financial Position (extract from last year):

$000 Authorised share capital Ordinary shares of 50c each 20,000 _____

Issued ordinary share capital, Shares of 50c each 2,500 Reserves 4,000 10% Debentures (19X4) 2,000 Bank Overdraft (secured) 2,000 _____

10,500 _____

Other information: $000 Turnover 55,000 Net profit after interest and tax 3,000 Interest paid 200 Dividends paid and proposed 800 The 50c ordinary shares are currently quoted at $2.25 per share: The companys tax rate is 33%. The average gearing percentage for the industry in which the company operates is 35% (computed as debt as a percentage of debt plus equity, based on book values, and excluding bank overdrafts).

(i) Calculate and comment briefly on the companys current capital gearing.

Discuss briefly the effect on gearing and EPS at the end of the first full year following the new investment if the $5 million new finance is raised in each of the following ways;

(ii) By issuing ordinary shares at $2 each.

(iii) By issuing 5% convertible loan stock, convertible in 19X4. The conversion ratio is 40 shares per $ 100 of loan stock.

(iv) By issuing 7.5% undated debentures.

(You should ignore issue costs in your answers to parts (ii) (iv)) (14 marks)

(35 marks)


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Question 14 SPRINGBANK PLC

Springbank plc is a medium-sized manufacturing company that plans to increase capacity by purchasing new machinery at an initial cost of $3m. The following are the most recent financial statements of the company:

Income Statements for years ending 31 December

2002 2001 $000 $000 Sales 5,000 5,000 Cost of Sales 3,100 3,000 Gross Profit 1,900 2,000 Administration and Distribution Expenses 400 250 Profit before Interest and Tax 1,500 1,750 Interest 400 380 Profit before Tax 1,100 1,370 Tax 330 400 Profit after Tax 770 970 Dividends 390 390 Retained Earnings 380 580

Statements of Financial Position as at 31 December

2002 2001 $000 $000 $000 $000 Fixed Assets 6,500 6,400 Current Assets Inventory 1,170 1,000 Receivables 850 900 Cash 130 100 2,150 2,000 Current Liabilities 1,150 1,280 1,000 720 7,500 7,120 10% Debentures 2007 3,500 3,500 4,000 3,620 Capital and Reserves 4,000 3,620


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The investment is expected to increase annual sales by 5,500 units. Investment in replacement machinery would be needed after five years. Financial data on the additional units to be sold is as follows:

$ Selling price per unit 500 Production costs per unit 200

Variable administration and distribution expenses are expected to increase by $220,000 per year as a result of the increase in capacity. In addition to the initial investment in new machinery, $400,000 would need to be invested in working capital. The full amount of the initial investment in new machinery of $3 million will give rise to capital allowances on a 25% per year reducing balance basis. The scrap value of the machinery after five years is expected to be negligible. Tax liabilities are paid in the year in which they arise and Springbank plc pays tax at 30% of annual profits.

The Finance Director of Springbank plc has proposed that the $34 million investment should be financed by an issue of debentures at a fixed rate of 8% per year.

Springbank plc uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its financial statements, Springbank plc uses straight-line depreciation over the expected life of fixed assets.

Average data for the business sector in which Springbank operates is as follows:

Gearing (book value of debt/book value of equity) 100% Interest Cover 4 times Current Ratio 2:1 Inventory Days 90 days Return before Interest and Tax/Capital Employed 25%

Required:

(a) Calculate the net present value of the proposed investment in increased capacity of Springbank plc, clearly stating any assumptions that you make in your calculations. (11 marks)

(b) Calculate the increase in sales (in units) that would produce a zero net present value for the proposed investment. (4 marks)

(c) (i) Calculate the effect on the gearing and interest cover of Springbank plc of financing the proposed investment with an issue of debentures and compare your results with the sector averages. (6 marks)

(ii) Analyse and comment on the recent financial performance of the company. (13 marks)

(iii) On the basis of your previous calculations and analysis, comment on the acceptability of the proposed investment and discuss whether the proposed method of financing can be recommended. (10 marks)

(d) Briefly discuss the possible advantages to Springbank plc of using an issue of ordinary shares to finance the investment. (6 marks)

(50 marks)


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Question 15 NESPA PLC

Nespa is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three years. Although the company has an overdraft, it has no long-term debt and its current interest cover is high compared to similar companies. Its return on capital employed, however, is close to the average for its business sector. One of its machines is leased under an operating lease, but the company has no other leasing or hire purchase commitments. The company owns two factories and the land on which they are built, as well as a small fleet of delivery vehicles. The company does not own any retail outlets through which to distribute its manufactured output.

Nespa is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in order to manufacture a new toy. Market research undertaken for the company indicated a link between selling price and demand, and the research agency involved has suggested two sales strategies that could be implemented, as follows:

Strategy 1 Strategy 2 Selling price (in current price terms) $800 per unit $700 per unit Sales volume in first year 100,000 units 110,000 units Annual increase in sales volume after first year 5% 15%

The services of the market research agency have cost $75,000 and this amount has yet to be paid.

Nespa expects economies of scale to reduce the variable cost per unit as the level of production increases. When 100,000 units are produced in a year, the variable cost per unit is expected to be $300 (in current price terms). For each additional 10,000 units produced in excess of 100,000 units, a reduction in average variable cost per unit of $005 is expected to occur. The average variable cost per unit when production is between 110,000 units and 119,999 units, for example, is expected to be $295 (in current price terms); and the average variable cost per unit when production is between 120,000 units and 129,999 units is expected to be $290 (in current price terms), and so on.

The new machine would cost $1,500,000 and would not be expected to have any resale value at the end of its life. Capital allowances would be available on the investment on a 25% reducing balance basis. Although the machine may have a longer useful economic life, Nespa uses a five-year planning period for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in the year in which they arise.

Operation of the new machine will cause fixed costs to increase by $110,000 (in current price terms). Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and unit variable costs is expected to be 3% per year. For profit reporting purposes Nespa depreciates machinery on a straight-line basis over its planning period.

Nespa applies three investment appraisal methods to new projects because it believes that a single investment appraisal method is unable to capture the true value of a proposed investment. The methods it uses are net present value, internal rate of return and return on capital employed (accounting rate of return). The company believes that net present value measures the potential increase in company value of an investment project: that a high internal rate of return offers a margin of safety for risky projects; and that a projects before-tax return on capital employed should be greater than the companys before-tax return on capital employed, which is 20%. Nespa does not use any explicit method of assessing project risk and has an average cost of capital of 10% in money (nominal) terms.

The company has not yet decided on a method of financing the purchase of the new machine, although the finance director believes that a new issue of equity finance is appropriate given the amount of finance required.


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Required:

(a) Determine the sales strategy which maximizes the present value of total contribution. Ignore taxation in this part of the question. (9 marks)

(b) Evaluate the investment in the new machine using internal rate of return. (12 marks)

(c) Evaluate the investment in the new machine using return on capital employed (accounting rate of return) based on the average investment. (5 marks)

(d) Critically discuss the relative advantages and disadvantages of internal rate of return and return on capital employed (accounting rate of return), and comment on Nespas views on investment appraisal methods. (8 marks)

(e) Discuss TWO methods that could be used to assess the risk or level of uncertainty associated with an investment project. (8 marks)

(f) Discuss the factors that Nespa should consider when selecting an appropriate source of finance for the new machine. (8 marks)

(50 marks)

Question 16 BREAD PRODUCTS LTD

Bread Products Ltd is considering the replacement policy for its industrial size ovens which are used as part of a production line that bakes bread. Given its heavy usage each oven has to be replaced frequently. The choice is between replacing every two years or every three years. Only one type of oven is used, each of which costs $24,500. Maintenance costs and resale values are as follows:

Year Maintenance Resale value per annum $ $ 1 500 2 800 15,600 3 1,500 11,200

Original cost, maintenance costs and resale values are expressed in current prices. That is, for example, maintenance for a two year old oven would cost $800 for maintenance undertaken now. It is expected that maintenance costs will increase at 10% per annum and oven replacement cost and resale values at 5% per annum. The money discount rate is 15%.

Required:

(a) Calculate the preferred replacement policy for the ovens in a choice between a two year or three year replacement cycle. (12 marks)

(b) Identify the limitations of Net Present Value techniques when applied generally to investment appraisal. (13 marks)

(25 marks)


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Question 17 SASSONE PLC

Sassone plc is a medium-sized profitable company that manufactures engineering products. Its stated objectives are to maximise shareholder wealth and to maintain an ethical approach to the production and distribution of engineering products. It has in issue two million ordinary shares, held as follows:

Number of shares Pension funds 550,000 Insurance companies 250,000 Investment trusts 200,000 Unit trusts 100,000 Directors of Sassone 350,000 Other shareholders 550,000 2,000,000

The Managing Director of Sassone plc is considering two items that have been placed on the agenda of the next Board Meeting:

(1) Complaint by institutional investors

A number of institutional investors complained at the recent Annual General Meeting of the company that expenditure on environmentally-friendly and socially responsible projects was at too high a level, resulting in a less than acceptable increase in annual dividend payments. They had warned that they would vote against the re-appointment of directors if matters had not improved by the next Annual General Meeting.

(2) Proposal to increase manufacturing capacity

The directors of Sassone plc need to increase capacity in order to meet expected demand for a new product, Product G, which is to be used in the manufacture of new-generation personal computers. Product G cannot be manufactured on existing machines. The directors have identified two machines which can manufacture Product G, each with a capacity of 60,000 units per year, as follows:

Machine One

This machine will cost $238,850 and last for five years, at the end of which time it will have zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing by $3,000 per year for each year of operation.

Machine Two

This machine will cost $215,000 and last for four years, at the end of which time it will have zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing by $5,000 per year for each year of operation.

Sassone plc expects demand for Product G to be 30,000 units per year in the first year, and to increase by a further 10,000 units per year in each subsequent year. Selling price is expected to be $1000 per unit and the marginal cost of production is expected to be $780 per unit. Incremental fixed production overheads of $10,000 per year will be incurred. Selling price and costs are all in current price terms.


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Annual inflation rates are expected to be as follows:

Selling price of Product G: 4% per year Marginal cost of production: 4% per year Maintenance costs: 5% per year Fixed production overheads: 6% per year

Other information

Sassone plc has a real cost of capital of 8% and uses a nominal (money) cost of capital of 11% in investment appraisal. The company pays tax one year in arrears at an annual rate of 30% and can claim capital allowances on a 25% reducing balance basis, with a balancing allowance at the end of the life of the machines. The company depreciates fixed assets on a straight-line basis over the life of the asset and has a target before-tax return on capital employed (accounting rate of return) of 25%.

Required:

(a) Using equivalent annual cost and considering machine purchase prices and maintenance costs only, determine which machine should be purchased by Sassone. Ignore inflation and taxation in this part of the question only. (6 marks)

(b) Calculate the net present value of the incremental cash flows arising from purchasing Machine Two and advise on its acquisition. (18 marks)

(c) Calculate the before-tax return on capital employed (accounting rate of return) of the incremental cash flows arising from purchasing Machine Two based on the average investment and comment on your findings. (4 marks)

(d) Discuss the conflict that may arise between corporate objectives, using the information provided on Sassone plc to illustrate your answer. (10 marks)

(38 marks)

Question 18 UMUNAT PLC

Umunat plc is considering investing $50,000 in a new machine with an expected life of five years. The machine will have no scrap value at the end of five years. It is expected that 20,000 units will be sold each year at a selling price of $300 per unit. Variable production costs are expected to be $165 per unit, while incremental fixed costs, mainly the wages of a maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

Required:

(a) Explain why risk and uncertainty should be considered in the investment appraisal process. (5 marks)

(b) Calculate and comment on the payback period of the project. (4 marks)

(c) Evaluate the sensitivity of the projects net present value to a change in the following project variables:

(i) sales volume; (ii) sales price; (iii) variable cost;

and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)


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(d) Upon further investigation it is found that there is a significant chance that the expected sales volume of 20,000 units per year will not be achieved. The sales manager of Umunat plc suggests that sales volumes could depend on expected economic states that could be assigned the following probabilities:

Economic state Poor Normal Good Probability 03 06 01 Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (6 marks)

(25 marks)

Question 19 ARG CO

ARG Co is a leisure company that is recovering from a loss-making venture into magazine publication three years ago. Recent financial statements of the company are as follows.

Income Statement for year ending 30 June 2005

$000 Turnover 140,400 Cost of sales 112,840 Gross profit 27,560 Administration costs 23,000 Profit before interest and tax 4,560 Interest 900 Profit before tax 3,660 Taxation 1,098 Profit after taxation 2,562 Dividends 400 Retained profit 2,162


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Statement of Financial Position as at 30 June 2005

$000 $000 Fixed assets 50,000 Current assets Inventory 2,400 Receivables 20,000 Cash 1,500 23,900 Current liabilities 33,000 (9,100) 40,900 9% Debentures 2014 10,000 30,900 Financed by: Ordinary shares, $1 par value 2,000 Reserves 27,000 Retained earnings 1,900 30,900

The company plans to launch two new products, Alpha and Beta, at the start of July 2005, which it believes will each have a life-cycle of four years. Alpha is the deluxe version of Beta. The sales mix is assumed to be constant. Expected sales volumes for the two products are as follows.

Year 1 2 3 4 Alpha 60,000 110,000 100,000 30,000 Beta 75,000 137,500 125,000 37,500

The standard selling price and standard costs for each product in the first year will be as follows.

Product Alpha Beta $/unit $/unit Direct material costs 1200 900 Incremental fixed production costs 864 642 Total absorption cost 2064 1542 Standard mark-up 1036 758 Selling price 3100 2300

ARG traditionally operates a cost-plus approach to product pricing.

Incremental fixed production costs are expected to be $1 million in the first year of operation and are apportioned on the basis of sales value. Advertising costs will be $500,000 in the first year of operation and then $200,000 per year for the following two years. There are no incremental non-production fixed costs other than advertising costs.


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In order to produce the two products, investment of $1 million in premises, $1 million in machinery and $1 million in working capital will be needed, payable at the start of July 2005. The investment will be financed by the issue of $3 million of 9% debentures, each $100 debenture being convertible into 20 ordinary shares of ARG Co after 8 years or redeemable at par after 12 years.

Selling price per unit, direct material cost per unit and incremental fixed production costs are expected to increase after the first year of operation due to inflation:

Selling price inflation 30% per year Direct material cost inflation 30% per year Fixed production cost inflation 50% per year

These inflation rates are applied to the standard selling price and standard cost data provided above. Working capital will be recovered at the end of the fourth year of operation, at which time production will cease and ARG Co expects to be able to recover $12 million from the sale of premises and machinery. All staff involved in the production and sale of Alpha and Beta will be redeployed elsewhere in the company.

ARG Co pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in machinery attracts a first-year capital allowance of 100%. ARG Co has sufficient profits to take the full benefit of this allowance in the first year. For the purpose of reporting accounting profit, ARG Co depreciates machinery on a straight line basis over four years. ARG Co uses an after-tax discount rate of 13% for investment appraisal.

Other information

Assume that it is now 30 June 2005 The ordinary share price of ARG Co is currently $400 Average interest cover for ARG Cos sector is 7 Average gearing for ARG Cos sector is 45% (long-term debt/equity using book values)

Required:

(a) Calculate the net present value of the proposed investment in products Alpha and Beta. (17 marks)

(b) Identify and discuss any likely limitations in the evaluation of the proposed investment in Alpha and Beta. (6 marks)

(c) Evaluate and discuss the proposal to finance the investment with a $3 million 9% convertible debenture issue. (8 marks)

(31 marks)


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Question 20 BFD CO

BFD Co is a private company formed three years ago by four brothers who, as directors, retain sole ownership of its ordinary share capital. One quarter of the initial share capital was provided by each brother. The company has returned a profit in each year of operation as shown by the following financial statements.

Income Statements for years ending 30 November

2005 2004 2003 $000 $000 $000 Turnover 5,200 3,400 2,600 Cost of sales 4,570 2,806 2,104 Profit before interest and tax 630 594 496 Interest 70 34 3 Profit before tax 560 560 493 Tax 140 140 123 Profit after tax 420 420 370 Dividends 20 20 20 Retained profit 400 400 350

Statements of Financial Position as at 30 November

2005 2004 2003 $000 $000 $000 $000 $000 $000 Fixed assets 1,600 1,200 800 Current assets Inventory 1,450 1,000 600 Receivables 1,400 850 400 2,850 1,850 1,000 Current liabilities 2,300 1,300 450 Net current assets 550 550 550 2,150 1,750 1,350 Ordinary shares ($1 par) 1,000 1,000 1,000 Reserves 1,150 750 350 2,150 1,750 1,350

BFD Co has an overdraft limit of $125 million and pays interest on its overdraft at a rate of 6% per year. Current liabilities consist of trade payables and overdraft finance in each of the three years.

The directors are delighted with the rapid growth of BFD Co and are considering further expansion through buying new premises and machinery to manufacture Product FT7. This new product has only just been developed and patented by BFD Co. Test marketing has indicated considerable demand for the product, as shown by the following research data.


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Year of operation 1 2 3 4 Accounting year 2005/6 2006/7 2007/8 2008/9 Sales volume (units) 100,000 120,000 130,000 140,000

Sales after 2008/9 (the fourth year of operation) are expected to continue at the 2008/9 level in perpetuity.

Initial investment of $3,000,000 would be required in new premises and machinery, as well as an additional $200,000 of working capital. The directors have no further financial resources to offer and are considering approaching their bank for a loan to meet their investment needs. Selling price and cost data for Product FT7, based on an annual budgeted volume of 100,000 units, are as follows.

$ per unit Selling price 1800 Direct material 700 Direct labour 150 Fixed production overhead 450

The fixed production overhead is incurred exclusively in the production of Product FT7 and excludes depreciation. Selling price and unit variable cost data for Product FT7 are expected to remain constant.

BFD Co expects to be able to claim writing down allowances on the initial investment of $3,000,000 on a straight-line basis over 10 years. The company pays tax on profit at an annual rate of 25% in the year in which the liability arises and has an after-tax cost of capital of 12%.

Average data for companies similar to BFD Co

Net profit margin: 9% Payables days: 70 days Interest cover: 15 times Current ratio: 21 times Inventory days: 85 days Quick ratio: 08 times Receivables days: 75 days Debt/equity ratio: 40% (using book values)

Required:

(a) Calculate the net present value of the proposed investment in Product FT7. Assume that it is now 1 December 2005. (16 marks)

(b) Comment on the acceptability of the proposed investment in Product FT7 and discuss what additional information might improve the decision-making process. (7 marks)

(c) BFD Co has received an offer from a rival company of $300,000 per year for 10 years for the manufacturing rights for Product FT7. If BFD Co accepts this offer, it would not be able to manufacture Product FT7 for the duration of the agreement.

Required:

Determine whether BFD Co should accept the offer for the manufacturing rights to Product FT7. In this part of the question only, ignore cash flows occurring after the ten-year period of the offer. Assume that it is 1 December 2005. (6 marks)

(d) As the newly-appointed finance director of BFD Co, write a report to the board which discusses whether the company is likely to be successful if it approaches its bank for a loan. Your discussion should include an analysis of the current financial position and recent financial performance of the company. (16 marks)

(45 marks)


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Question 21 AGD CO

AGD Co is a profitable company which is considering the purchase of a machine costing $320,000. If purchased, AGD Co would incur annual maintenance costs of $25,000. The machine would be used for three years and at the end of this period would be sold for $50,000. Alternatively, the machine could be obtained under an operating lease for an annual lease rental of $120,000 per year, payable in advance.

AGD Co can claim capital allowances on a 25% reducing balance basis. The company pays tax on profits at an annual rate of 30% and all tax liabilities are paid one year in arrears. AGD Co has an accounting year that ends on 31 December. If the machine is purchased, payment will be made in January of the first year of operation. If leased, annual lease rentals will be paid in January of each year of operation.

Required:

(a) Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the new machine. (12 marks)

(b) Explain and discuss the key differences between an operating lease and a finance lease. (8 marks)

(c) The after-tax borrowing rate of 7% was used in the evaluation because a bank had offered to lend AGD Co $320,000 for a period of five years at a before-tax rate of 10% per year with interest payable every six months.

Required:

(i) Calculate the annual percentage rate (APR) implied by the banks offer to lend at 10% per year with interest payable every six months. (2 marks)

(ii) Calculate the amount to be repaid at the end of each six-month period if the offered loan is to be repaid in equal instalments. (3 marks)

(25 marks)

Question 22 CHARM PLC

Charm plc, a software company, has developed a new game, Fingo, which it plans to launch in the near future. Sales of the new game are expected to be very strong, following a favourable review by a popular PC magazine. Charm plc has been informed that the review will give the game a Best Buy recommendation. Sales volumes, production volumes and selling prices for Fingo over its four-year life are expected to be as follows.

Year 1 2 3 4 Sales and production (units) 150,000 70,000 60,000 60,000 Selling price $25 $24 $23 $22

Financial information on Fingo for the first year of production is as follows:

Direct material cost $540 per game Other variable production cost $600 per game Fixed costs $400 per game


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Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and $100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. Fixed costs represent incremental cash fixed production overheads. Fingo will be produced on a new production machine costing $800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows Charm plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over four years.

Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. Charm plc uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your findings. (11 marks)

(b) Calculate the internal rate of return of the proposed investment and comment on your findings. (5 marks)

(c) Discuss the reasons why the net present value investment appraisal method is preferred to other investment appraisal methods such as payback, return on capital employed and internal rate of return. (9 marks)

(25 marks)

Question 23 CAVIC LTD

Cavic Ltd services custom cars and provides its clients with a courtesy car while servicing is taking place. It has a fleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy car will cost $15,000. The trade-in value of each new car declines over time as follows:

Age of courtesy car (years) 1 2 3 Trade-in value ($/car) 11,250 9,000 6,200

Servicing and parts will cost $1,000 per courtesy car in the first year and this cost is expected to increase by 40% per year as each vehicle grows older. Cleaning the interior and exterior of each courtesy car to keep it up to the standard required by Cavics clients will cost $500 per car in the first year and this cost is expected to increase by 25% per year.

Cavic Ltd has a cost of capital of 10%. Ignore taxation and inflation.

Required:

(a) Using the equivalent annual cost method, calculate whether Cavic Ltd should replace its fleet after one year, two years, or three years. (12 marks)

(b) Discuss the causes of capital rationing for investment purposes. (4 marks)

(c) Explain how an organisation can determine the best way to invest available capital under capital rationing. Your answer should refer to the following issues:

(i) single-period capital rationing; (ii) multi-period capital rationing; (iii) project divisibility; (iv) the investment of surplus funds. (9 marks)

(25 marks)


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Question 24 JERONIMO PLC

Jeronimo plc currently has 5 million ordinary shares in issue, which have a market value of $160 each. The company wishes to raise finance for a major investment project by means of a rights issue, and is proposing to issue shares on the basis of 1 for 5 at a price of $130 each.

James Brown currently owns 10,000 shares in Jeronimo plc and is seeking advice on whether or not to take up the proposed rights.

Required:

(a) Explain the difference between a rights issue and a scrip issue. Your answer should include comment on the reasons why companies make such issues and the effect of the issues on private investors. (6 marks)

(b) Calculate:

(i) the theoretical value of James Browns shareholding if he takes up his rights; and

(ii) the theoretical value of James Browns rights if he chooses to sell them. (4 marks)

(c) Using only the information given below, and applying the dividend growth model formula, calculate the required return on equity for an investor in Jeronimo plc.

Jeronimo plc: Current (1999) share price: $160 Number of shares in issue: 5 million Current earnings: $15 million Dividend Paid (cents per share): 1995: 8 1996: 9 1997: 11 1998: 11 1999: 12 (4 marks)

(d) If the stock market is believed to operate with a strong level of efficiency, what effect might this have on the behaviour of the finance directors of publicly quoted companies?

(6 marks)

(20 marks)

Question 25 PLY, AXIS & SPIN

Food Retailers: Ordinary Shares, Key Stock Market Statistics,

Company Share price (cents) Current 52 week high 52 week low Dividend Yield (%) P/E Ratio Ply 63 112 54 18 142 Axis 291 317 187 21 130 Spin 187 201 151 23 211


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Required:

(a) Illustrating your answer by use of data in the table above, define and explain the term P/E ratio, and comment on the way it may be used by an investor to appraise a possible share purchase. (6 marks)

(b) Using data in the above table, calculate the dividend cover for Spin and Axis, and explain the meaning and significance of the measure from the point of view of equity investors. (8 marks)

(c) Under what circumstances might a company be tempted to pay dividends which are in excess of earnings, and what are the dangers associated with such an approach?

You should ignore tax in answering this question. (6 marks)

(20 marks)

Question 26 SME FINANCE

Explain why very Small to Medium-size Enterprises (SMEs) might face problems in obtaining appropriate sources of finance. In your answer pay particular attention to problems and issues associated with:

(i) uncertainty concerning the business;

(ii) assets available to offer as collateral or security; and

(iii) potential sources of finance for very new SMEs excluding sources from capital markets.

(12 marks)

Question 27 TECHFOOLS.COM

Techfools.com has just issued convertible debentures with an 8% per annum coupon to the value of $5m. The nominal value of the debentures is $100 and the issue price was $105. The conversion details are that 45 shares will be issued for every $100 convertible debentures held with a date for conversion in five years exactly. Redemption, should the debenture not be converted, will also take place in exactly five years. Debentures will be redeemed at $110 per $100 nominal convertibles held. It is widely expected that the share price of the company will be $4 in five years time.

Assume an investor required return of 15%.

Ignore taxation in your answer.

Required:

(a) Briefly explain why convertibles might be an attractive source of finance for companies. (4 marks)

(b) (i) Estimate the current market value of the debentures, assuming conversion takes place, using net present value methods and assess if it is likely that conversion will take place. (5 marks)

(ii) Identify and briefly comment on a single major reservation you have with your evaluation in part b(i). (2 marks)


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(c) Explain why an issuing company seeks to maximise its conversion premium and why companies can issue convertibles with a high conversion premium. (4 marks)

(d) Explain what is meant by the concept of intermediation (the role of a banking sector) and how such a process benefits both investors and companies. (10 marks)

(25 marks)

Question 28 EQUITY AND DEBT ISSUES

(a) Describe the methods of raising new equity finance that can be used by an unlisted company. (8 marks)

(b) Discuss the factors to be considered by a listed company when choosing between an issue of debt and an issue of equity finance. (8 marks)

(16 marks)

Question 29 ARWIN

Arwin plans to raise $5m in order to expand its existing chain of retail outlets. It can raise the finance by issuing 10% debentures redeemable in 2015, or by a rights issue at $400 per share. The current financial statements of Arwin are as follows.

Income statement for the last year $000 Sales 50,000 Cost of sales 30,000 Gross profit 20,000 Administration costs 14,000 Profit before interest and tax 6,000 Interest 300 Profit before tax 5,700 Taxation at 30% 1,710 Profit after tax 3,990 Dividends 2,394 Retained earnings 1,596 Statement of Financial Position $000 Net fixed assets 20,100 Net current assets 4,960 12% debentures 2010 2,500 22,560 Ordinary shares, par value 25c 2,500 Retained profit 20,060 22,560


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The expansion of business is expected to increase sales revenue by 12% in the first year. Variable cost of sales makes up 85% of cost of sales. Administration costs will increase by 5% due to new staff appointments. Arwin has a policy of paying out 60% of profit after tax as dividends and has no overdraft.

Required:

(a) For each financing proposal, prepare the forecast income statement after one additional year of operation. (5 marks)

(b) Evaluate and comment on the effects of each financing proposal on the following:

(i) Financial gearing; (ii) Operational gearing; (iii) Interest cover; (iv) Earnings per share. (12 marks)

(c) Discuss the dangers to a company of a high level of gearing, including in your answer an explanation of the following terms:

(i) Business risk; (ii) Financial risk. (8 marks)

(25 marks)

Question 30 TIRWEN PLC

Tirwen plc is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15% discount to the current market price of $400 per share. Issue costs are expected to be $220,000 and these costs will be paid out of the funds raised. It is proposed that the rights issue funds raised will be used to redeem some of the existing debentures at par. Financial information relating to Tirwen plc is as follows:


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Current Statement of Financial Position

$000 $000 $000 Fixed assets 6,550 Current assets Inventory 2,000 Receivables 1,500 Cash 300 3,800 Current liabilities Trade payables 1,100 Overdraft 1,250 2,350 Net current assets 1,450 Total assets less current liabilities 8,000 12% debentures 2012 4,500 3,500 Ordinary shares (par value 50c) 2,000 Reserves 1,500 3,500 Other information: Price/earnings ratio of Tirwen plc: 1524 Overdraft interest rate: 7% Corporation tax rate: 30% Sector averages: debt/equity ratio (book value): 100% interest cover: 6 times

Required:

(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:

(i) the theoretical ex rights price per share;

(ii) the value of rights per existing share. (3 marks)

(b) What alternative actions are open to the owner of 1,000 shares in Tirwen plc as regards the rights issue? Determine the effect of each of these actions on the wealth of the investor. (6 marks)

(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to redeem some of the existing debentures. (6 marks)

(d) Evaluate whether the proposal to redeem some of the debentures would increase the wealth of the shareholders of Tirwen plc. Assume that the price/earnings ratio of Tirwen plc remains constant. (3 marks)


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(e) Discuss the reasons why a rights issue could be an attractive source of finance for Tirwen plc. Your discussion should include an evaluation of the effect of the rights issue on the debt/equity ratio and interest cover. (7 marks)

(25 marks)

Question 31 RZP CO

As assistant to the Finance Director of RZP Co, a company that has been listed on the London Stock Market for several years, you are reviewing the draft Annual Report of the company, which contains the following statement made by the chairman:

This company has consistently delivered above-average performance in fulfilment of our declared objective of creating value for our shareholders. Apart from 2002, when our overall performance was hampered by a general market downturn, this company has delivered growth in dividends, earnings and ordinary share price. Our shareholders can rest assured that my directors and I will continue to deliver this performance in the future.

The five-year summary in the draft Annual Report contains the following information:

Year 2004 2003 2002 2001 2000 Dividend per share 28c 23c 22c 22c 17c Earnings per share 1904c 1495c 1122c 1584c 1343c Price/earnings ratio 220 335 255 172 152 General price index 117 113 110 105 100

A recent article in the financial press reported the following information for the last five years for the business sector within which RZP Co operates:

Share price growth average increase per year of 20% Earnings growth average increase per year of 10% Nominal dividend growth average increase per year of 10% Real dividend growth average increase per year of 9%

You may assume that the number of shares issued by RZP Co has been constant over the five-year period. All price/earnings ratios are based on end-of-year share prices.

Required:

(a) Analyse the information provided and comment on the views expressed by the chairman in terms of:

(i) growth in dividends per share; (ii) share price growth; (iii) growth in earnings per share.

Your analysis should consider both arithmetic mean and equivalent annual growth rates. (13 marks)

(b) Calculate the total shareholder return (dividend yield plus capital growth) for 2004 and comment on your findings. (3 marks)

(c) Discuss the factors that should be considered when deciding on a management remuneration package that will encourage the directors of RZP Co to maximise the wealth of shareholders, giving examples of management remuneration packages that might be appropriate for RZP Co. (9 marks)

(25 marks)


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Question 32 SMALL COMPANY FINANCES

Discuss the difficulties that may be experienced by a small company which is seeking to obtain additional funding to finance an expansion of business operations.

(8 marks)

Question 33 HENDIL PLC

Hendil plc, a manufacturer of electronic equipment, has prepared the following draft financial statements for the year that has just ended. These financial statements have not yet been made public.

Income statement $000 Turnover 9,600 Cost of sales 5,568 Gross profit 4,032 Operating expenses 3,408 Profit before interest and tax 624 Interest 156 Profit before tax 468 Taxation 140 Profit after tax 328 Dividends 300 Retained profit 28 Statement of financial position $000 $000 $000 Fixed assets 2,250 Current assets Inventory 1,660 Receivables 2,110 Cash 780 4,550 Current liabilities Trade payables 750 Dividends 300 Overdraft 450 1,500 Net current assets 3,050 Total assets less current liabilities 5,300 10% debenture, repayable 2015 1,200 4,100 Capital and reserves Ordinary shares, par value 50c 1,000 Retained earnings 3,100 4,100


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Hendil plc pays interest on its overdraft at an annual rate of 6%. The 10% debenture is secured on fixed assets of the company.

Hendil plc plans to invest $1 million in a new product range and has forecast the following financial information:

Year 1 2 3 4 Sales volume (units) 70,000 90,000 100,000 75,000 Average selling price ($/unit) 40 45 51 51 Average variable costs ($/unit) 30 28 27 27 Incremental cash fixed costs ($/year) 500,000 500,000 500,000 500,000

The above cost forecasts have been prepared on the basis of current prices and no account has been taken of inflation of 4% per year on variable costs and 3% per year on fixed costs. Working capital investment accounts for $200,000 of the proposed $1 million investment and machinery for $800,000. Hendil uses a four-year evaluation period for capital investment purposes, but expects the new product range to continue to sell for several years after the end of this period. Capital investments are expected to pay back within two years on an undiscounted basis, and within three years on a discounted basis. The company pays tax on profits in the year in which liabilities arise at an annual rate of 30% and claims capital allowances on machinery on a 25% reducing balance basis. Balancing allowances or charges are claimed only on the disposal of assets.

Average data on companies similar to Hendil plc:

Interest cover 6 times Long-term debt/ equity (book value basis) 50% Long-term debt/ equity (market value basis) 25%

The ordinary shareholders of Hendil plc require an annual return of 12%. Its ordinary shares are currently trading on the stock market at $1.80 per share. The dividend paid by the company has increased at a constant rate of 5% per year in recent years and, in the absence of further investment, the directors expect this dividend growth rate to continue for the foreseeable future.

Required:

(a) (i) Calculate the ordinary share price of Hendil plc, predicted by the dividend growth model. (4 marks)

(ii) Explain the concept of market efficiency and distinguish between strong form efficiency and semi-strong form efficiency. (6 marks)

(iii) Discuss why the share price predicted by the dividend growth model is different from the current market price. (4 marks)

(b) (i) Using Hendil plcs current average cost of capital of 11%, calculate the net present value of the proposed investment. (14 marks)

(ii) Calculate, to the nearest month, the payback period and the discounted payback period of the proposed investment. (4 marks)

(iii) Discuss the acceptability of the proposed investment and explain ways in which your net present value calculation could be improved. (6 marks)


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(c) It has been suggested that the proposed $1 million investment could be financed by a new issue of debentures with an interest rate of 8%, redeemable after 15 years and secured on existing assets of Hendil plc. The existing debentures of the company are trading at $113 per $100 nominal value.

Required:

Evaluate and discuss the suggestion to finance the proposed investment with the new debenture issue described above. Your answer should consider, but not be limited to, the effect of the new issue on:

(i) interest cover; (ii) gearing; (iii) ordinary share price. (12 marks)

(50 marks)

Question 34 GUIDANCE MANUAL

Your company has produced a draft guidance manual to assist in estimating the cost of capital to be used in capital investment appraisal. Extracts from the manual, which includes worked examples, are reproduced below.

Guidance manual for estimating the cost of capital

(i) It is essential that the discount rate used reflects the weighted average cost of capital of the company.

(ii) The cost of equity and cost of debt should always be estimated using market values.

(iii) Inflation must always be included in the discount rate.

(iv) The capital asset pricing model or the dividend valuation model may be used in estimating the cost of equity.

(v) The cost of debt is to be estimated using the redemption yield of existing debt.

(vi) Always round the solution up to the nearest whole percentage. This is a safeguard if the cost of capital is underestimated.

Illustrative examples:

The current date is assumed to be June 20X0, with four years until the redemption of the debentures.

Relevant data:

Book values($m) Market values($m) Equity (50 million ordinary shares) 140 214 Debt:10% bank loans $40m, 10% debentures 20X4 $40m 80 85

Per share Annual growth rates Dividends 24 cents 6% Earnings 67 cents 9%

The beta value of the company (asset beta) is 11


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Other information:

Market return 14% Risk free rate 6% Current inflation 4% Corporate tax rate 30%

Illustration 1 When the company is expanding existing activities:

Cost of equity

Dividend valuation model: PD + g =

42824 + 0.09 = 0.146 or 14.6%

Capital asset pricing model: ke = Rf + (Rm Rf) beta = 6% + (14% 6%) 11 = 148%

Cost of debt

To find the redemption yield, with four years to maturity, the following equation must be solved.

Debt is assumed to be redeemed at par value and interest to be payable annually. Estimates are based upon total interest payments of $80m at 10% or $8m per year

85 = ( ) ( ) ( ) ( )432 188

18

18

18

kdkdkdkd +++++++

By trial and error At 9% interest 8 3240 = 2592 80 0708 = 5664 _____ 8256 9% discount rate is too high.

At 7% interest 8 3387 = 2710 80 0763 = 6104 _____ 8814

Interpolating:

7% +44.214.3

14.3+ 2% = 813%

The cost of debt is 813%

Market value of equity $214m Market value of debt $85m

Weighted average cost of capital:

(CAPM has been used in this estimate. The dividend valuation model would result in a similar answer.)


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148% 299214 + 8.13%

29985 = 12.90%

Inflation of 4% must be added to the discount rate.

The discount rate to be used in the investment appraisal is 1290% + 4% = 1690% or 17% rounded up to the nearest whole percentage.

Illustration 2 When the company is diversifying its activities:

The asset beta of a similar sized company in the industry in which your company proposes to diversify is 090.

Gearing of the similar company:

Book values($m) Market values($m) Equity 165 230 Debt 65 60

Cost of equity

The beta of the comparator company is used as a measure of the systematic risk of the new investment. As the gearing of the two companies differs, the beta must be adjusted for the difference in gearing.

Ungearing:

Beta equity = beta asset )t1(DE

E+

Beta equity = 090 76.0)3.01(60230

230 =+ Using the capital asset pricing model:

ke = Rf + (Rm Rf) beta = 6% + (14% 6%) 076 = 1208%

Cost of debt

This remains at 813%

Market value of equity $214m Market value of debt $85m

Weighted average cost of capital:

1208% 299214 + 8.13%

29985 = 10.96%

The discount rate to be used in the investment appraisal when diversifying into the new industry is 1096% + 4% inflation, 1496% or 15% rounded up to the nearest whole percentage.


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Required:

Produce a revised version of the draft manual for estimating the cost of capital. Revisions, including amended calculations, should be made, where appropriate, to both written guidance note and illustrative examples. Where revisions are made to any of the six guidance notes, or to the illustrations, brief discussion of the reason for revision should be included.

State clearly any assumptions that you make.

(30 marks)

14 marks are available for guidance notes and 16 marks for illustrative examples.

Question 35 ZENDECK PLC

The finance director of Zendeck plc is considering how to finance a major new expansion of existing activities. The investment will cost $40 million and is expected to last for five years.

The companys current capital structure is:

$ million Medium-term floating rate loans 34 11% debentures redeemable July 2007 56 Issued ordinary shares (50 cents par value) 15 Reserves 82

Other information:

(i) The companys current (July 2004) share price ex-dividend is 478 cents, and debenture price ex-interest is $10780. Each debenture is redeemable at its par value of $100.

(ii) Issue costs of externally financed equity are expected to be 65% of the total raised. There needs to be a minimum issue of $20 million, otherwise issue costs increase substantially.

(iii) Issue costs of new debentures are estimated to be 35%.

(iv) The equity beta of Zendeck is 115.

(v) The current dividend per share is 364 cents and dividends have grown by approximately 4% per year for the last three years.

(vi) The risk free rate is 35% per year and the market return is 11% per year.

(vii) The corporate tax rate is 30%.

(viii) Zendeck wishes to maintain its current capital structure.


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Required:

(a) Estimate the cost of capital of the new investment:

(i) If internal sources of equity are used (retained earnings), and debt finance is raised by a 75% floating rate bank loan with negligible issue costs;

(ii) If external sources of debt (new debentures issued at par of $100) and equity are used. New equity may be assumed to be issued at the current market price. Comment upon your findings and state clearly any assumptions that you make. (11 marks)

(b) Discuss whether or not the techniques used in part (a) could be applied to unlisted companies. (4 marks)

(15 marks)

Question 36 OXFIELD PLC

Oxfield plc, a listed industrial company, is considering a major investment. The companys investment projects team needs an appropriate rate at which to discount the estimated after-tax cash flows for the investment. Following the companys normal practice this is to be based on the weighted average cost of capital (WACC).

Figures relating to long-term financing included in the companys most recent Statement of Financial Position are as follows.

$m 160 million ordinary shares of $0.50 each 80 Share premium account 27 Revaluation reserve 26 Retained earnings 9 7.2% loan stock 67

The loan stock interest for the current year has just been paid. Interest is payable at the end of each of the next three years, and all of the loan stock is to be redeemed, in cash, at a 5% premium at the end of three years.

A dividend of 18c per share has just been paid. Dividends have shown an average annual growth rate of 7% over recent years.

The current share price is 210c and the loan stock has a market value of $97 (per $100 nominal).

The corporation tax rate is expected to be 30% for the foreseeable future.

Required:

(a) Calculate the companys WACC. Explain your workings and any assumptions which you have made. Justify the basis of the weightings which you used. (6 marks)

(b) Explain any criticisms which could be made of using the figure calculated in (a) as the discount rate for assessing the investment under consideration by the company. (6 marks)


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(c) Explain how the capital asset pricing model (CAPM) could be used as an alternative means of determining a suitable discount rate to be used in the assessment of the investment. Your explanation should include an outline of the models strengths and weaknesses. (4 marks)

(d) Explain what would have been the effect, in theory and in practice, on the WACC of the company having a different debt: equity ratio. (4 marks)

(20 marks)

Question 37 TIMBERTOPS LTD

Timbertops Ltd owns a site in a holiday area of South Wales. Part of the site is a conventional camp site where pitches are rented by the night to campers and caravaners. Also on the site are a number of wooden chalets which are rented by the week. Within the site there is an extensive area with attractions of various types, including rides, a swimming lake, a boating lake and a small zoo. Entry to the attractions area is included in the rental charges for those staying on the site. Most of the visitors to the attractions, however, are day visitors who pay a daily charge for entry, which allows access to all the attractions.

All of the companys shares are owned by members of the Jenkins family. Since the business started, only limited expansion of the companys facilities has taken place and that was financed entirely from profits. The companys directors are now keen to expand the range of attractions extensively since, they believe, the site will attract more visitors, both residents and day visitors. This expansion will cost an estimated $1 million.

The most recent financial statements can be summarised as follows.

Income statement for the year ended 31 March 20X9

$000 Turnover 5,011 Operating profit 640 Tax on profit (198) Profit after tax 442 Dividends (197) Retained profit for the year 245


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Statement of Financial Position as at 31 March 20X9

$000 $000 Fixed assets 1,922 Current assets 280 Liabilities: amounts falling due within one year (270) 10 1,932 Share capital (ordinary share of $1 each) 1,000 Retained earnings 932 1,932

These results, including the dividend cover, are broadly consistent with those of previous years. The company has only a small cash balance but it has no borrowings.

Very recently, one of the shareholders sold her shares to her brother. By mutual agreement the shares were valued by the companys auditors, strictly on their estimated market value, at $2.75 per share.

Required:

(a) Estimate the companys cost of capital, explaining and justifying all workings and assumptions. (5 marks)

(b) Identify practical possible sources of the $1 million finance required for expansion. For each possible source you should explain the main issues, both theoretical and practical, which are likely to be involved, given the companys particular circumstances. (13 marks)

(18 marks)

Question 38 FIZZERS PLC

Fizzers plc is a small listed UK company which makes a range of soft drinks, over 90% sold in the UK market. The company currently has a cash surplus and the directors are contemplating a major investment in a plant in the Middle East to supply the local market. The Middle East market, important for the company, is currently supplied from the UK.

To assess the economic viability of the investment, the finance department needs a rate at which to discount the projected cash flows from the plant. It has been decided to use the companys weighted average cost of capital (WACC), deducing the cost of equity through the dividend growth model.

The companys most recent Statement of Financial Position, dated 31 August 20X9, included the following capital and reserves section.

$000 Called up share capital (ordinary shares of $0.10 each, fully paid) 5,750 Retained earnings 29,750

The Statement of Financial Position also showed that the company had in issue $100 million of 9% loan stock. This is to be redeemed on 1 September 20Y0 at par. Interest is payable (in arrears) on 1 September each year.


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It has been the companys practice to pay a single dividend each year, during September.

Dividends paid per share over recent years have been as follows.

Cents 20X4 21.25 20X5 22.50 20X6 22.50 20X7 24.50 20X8 25.00

The 20X9 dividend will be 25.50 cents per share. The companys issued and fully paid share capital has not altered since 20X3.

At 31 August 20X9 the shares were quoted at $3.35 per share (cum div) and the loan stock at $101.72 (cum interest) per $100 nominal.

The corporation tax rate is expected to remain at 30% for the foreseeable future.

Required:

(a) Determine the companys weighted average cost of capital, explaining your workings and justifying any assumptions which you have made. (9 marks)

(b) Explain why the figure which you have determined in requirement (a) may not be totally reliable for the purpose for which it has been determined. (5 marks)

(14 marks)

Question 39 BLIN

Blin is a company listed on a European stock exchange, with a market capitalisation of 6m, which manufactures household cleaning chemicals. The company has expanded sales quite significantly over the last year and has been following an aggressive approach to working capital financing. As a result, Blin has come to rely heavily on overdraft finance for its short-term needs. On the advice of its finance director, the company intends to take out a long-term bank loan, part of which would be used to repay its overdraft.

Required:

(a) Discuss the factors that will influence the rate of interest charged on the new bank loan, making reference in your answer to the yield curve. (9 marks)

(b) Explain and discuss the approaches that Blin could adopt regarding the relative proportions of long- and short-term finance to meet its working capital needs, and comment on the proposed repayment of the overdraft. (9 marks)

(c) Explain the meaning of the term cash operating cycle and discuss its significance in determining the level of investment in working capital. Your answer should refer to the working capital needs of different business sectors. (7 marks)

(25 marks)


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Question 40 JACK GEEP

Jack Geep will set up a new business as a sole trader on 1 January 2003 making decorative glassware. Jack is in the process of planning the initial cash flows of the business. He estimates that there will not be any sales demand in January 2003 so production in that month will be used to build up inventory to satisfy the expected demand in February 2003. Thereafter it is intended to schedule production in order to build up sufficient finished goods inventory at the end of each month to satisfy demand during the following month. Production will, however, need to be 5% higher than sales due to expected defects that will have to be scrapped. Defects are only discovered after the goods have been completed. The company will not hold inventory of raw materials or work in progress.

As the business is new, demand is uncertain, but Jack has estimated three possible levels of demand in 2003 as follows:

High Medium Low demand demand demand $ $ $ February 22,000 20,000 19,000 March 26,000 24,000 23,000 April 30,000 28,000 27,000 May 29,000 27,000 26,000 June 35,000 33,000 32,000

Demand for July 2003 onwards is expected to be the same as June 2003. The probability of each level of demand occurring each month is as follows:

High 005; Medium 085; Low 010.

It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making small purchases. The remaining 90% of sales will be made on two months credit. A 25% discount will, however, be offered to credit customers settling within one month. It is estimated that customers, representing half of credit sales by value, will take advantage of the discount while the remainder will take the full two months to pay.

Variable production costs (excluding costs of rejects) per $1,000 of sales are as follows:

$ Labour 300 Materials 200 Variable overhead 100

Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears and variable overheads are paid two months in arrears. Fixed production and administration overheads, excluding depreciation, are $7,000 per month and are payable in the same month as the expenditure is incurred.

Jack employed a firm of consultants to give him initial business advice. Their fee of $12,000 will be paid in February 2003. Smelting machinery will be purchased on 1 January 2003 for $200,000 payable in February 2003. Further machinery will be purchased for $50,000 in March 2003 payable in April 2003. This machinery is highly specialised and will have a low net realisable value after purchase.

Jack has redundancy money from his previous employment and savings totalling $150,000, which he intends to pay into his bank account on 1 January 2003 as the initial capital of the business. He realises that this will be insufficient for his business plans, so he is intending to approach his bank for finance in the form of both a fixed term loan and an overdraft. The only asset Jack has is his house that is valued at $200,000, but he has an outstanding mortgage of $80,000 on this property.


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The consultants advising Jack have recommended that rather than accumulating sufficient inventory to satisfy the following months demand he should not maintain any inventory levels but merely produce sufficient in each month to meet the expected demand for that month.

Jacks production manager objected: I need to set up my production schedule based on the expected average demand for the month. I will reduce production in the month if it seems demand is low. However, there is no way production can be increased during the month to accommodate demand if it happens to be at the higher level that month. As a result, under this new system, there would be no inventory to fall back on and the extra sales, when monthly demand is high, would be lost, as customers require immediate delivery. In respect of this, an assessment of the impact of the introduction of just-in-time inventory management on cash flows has been made that showed the following:

January February March April May June Net cash 143,000 (223,279) (7,587) (50,667) 1,843 1,704 flow ($) Month-end 143,000 (80,279) (87,866) (138,533) (136,690) (134,986) balance ($)

Required:

(a) Prepare a monthly cash budget for Jack Geeps business for the six month period ending 30 June 2003. Calculations should be made on the basis of the expected values of sales. The cash budget should show the net cash inflow or outflow in each month and the cumulative cash surplus or deficit at the end of each month.

For this purpose ignore bank finance and the suggested use of just-in-time inventory management. (17 marks)

(b) Assume now that just-in-time inventory management is used in accordance with the recommendations of the consultants. Calculate for EACH of the six months ending 30 June 2003:

(i) receipts from sales; and (ii) payments to labour. (6 marks)

(c) Evaluate the impact for Jack Geep of introducing just-in-time inventory management. This should include an assessment of the wider implications of just-in-time inventory management in the particular circumstances of Jack Geeps business. (10 marks)

(d) Write a report to Jack Geep which identifies the financing needs of the company. It shoul

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