53509647 ACCA F9 Practise Question s Answer

KAP LA N P UBL IS HI NG 57

ANSWERS

PAPE R F9 : F I NA NCIA L MA NAG EM ENT

58 KAP LA N P UBL IS HI NG

MAXIMISATION OF WEALTH

A company’s financial objectives are set by its directors. The directors, however, have effectively been assigned that responsibility by the owners of the company, the shareholders. The directors must therefore determine the company’s financial objectives with the interests of the shareholders as their prime concern. Different groups of shareholders may have different individual objectives, but an overall common objective is generally deemed to be that of wealth maximisation. Such maximisation of wealth is represented by a maximisation of the value of the company which is owned by the shareholders. This in turn is represented by the share price. Therefore the company’s financial objectives should be based upon a maximisation of the company’s share valuation.

In order to maximise the share price it is necessary to determine the basis on which shares are valued by the market. The most widely accepted model is the dividend valuation model. This assumes that investors value shares on the basis of the present value of the future cashflows generated by the shares. This will be the present value of the dividend stream plus the present value of the share price on sale. But given that the purchaser of the share will adopt the same process of valuation and likewise each subsequent purchaser, the share value may be considered simply to be the present value of future dividends. This would suggest that company objectives should be formulated on the maximisation of dividend payments.

However, it is not dividend payments themselves which maximise company value but rather the total cashflows generated. Many proponents of the dividend valuation model suggest that the level of dividend payments from one year to the next is not a relevant factor, although the ultimate present value of dividends remains the important criterion. Therefore it is not necessary for high dividend payments to be made each year as it may, for instance, be in the better interests of shareholders to retain funds for beneficial investment such that additional cashflows will be generated and future dividends enhanced.

This theory, however, assumes that the market values shares solely on the cashflows which they generated. In practice market imperfections will distort the model and in particular profit figures will influence the share prices. Full information on the company’s affairs is not available to shareholders. Therefore any published data is likely to influence their perception of the company’s current financial health and prospects. Thus the year-to-year level of dividend payments will be important, since a withheld dividend could signal financial problems, even if the funds retained were to be invested in a worthwhile project. Similarly, the disclosure of profit figures in a company’s annual accounts will provide investors with information on the company’s financial position and will affect the share price. Therefore it could be argued that a company should aim to maximise profits rather than cashflows generated.

If the policy of profit maximisation is deemed to be the important criterion for the maximisation of wealth, then earnings per share statistics become significant. As far as shareholders are concerned it is the profit after interest and tax which should be maximised since this is the profit attributable to equity after all prior claims have been met. Earnings per share is calculated on this basis and therefore is an indicator of the profits attributable to each ordinary share and thus the ability of the company to generate shareholder wealth. This would lead to the conclusion that the main financial objective of a company should be the maximisation of growth in earnings per share.

LE CTURE R RESO URCE P ACK – ANSWE RS


However since earnings per share is associated closely with profit maximisation, this criterion is not necessarily practical in a number of situations. For instance, it is common to sacrifice short-term profits for the benefit of longer-term profitability, yet this may not be viewed favourably by the market. In addition, in practice many firms will adopt a policy of generating a satisfactory level of profit rather than aiming solely for optimisation. This will be on account of a number of subsidiary objectives which are deemed to be important, such as expansion and increasing turnover or undertaking measures which benefit the community as a whole, both of which may add to the company’s standing in the long run.

In conclusion, the objective of profit maximisation as far as is feasible seems likely to come closest in practical terms to achieving the criterion of wealth maximisation. This would probably entail the use of earnings per share as the main financial measure, a figure which is valuable for comparing the financial performance of companies operating in different industry sectors.



TWO ORGANISATIONS

(i) Introduction

There has been a convergence in the objectives of public and private sector organisations.

Private sector organisations increasingly need to take notice of the views of a wider group of stakeholders in addition to shareholders.

On the other side, the public sector has increasingly adopted management and financial practices based upon private sector models and there has been an increased focus on the need for accountability.

It is still the case, however, that private sector companies have as a central responsibility the need to maximise shareholder wealth.

EPS in the private sector

EPS and growth in EPS has been used by private sector organisations as a measure of success and EPS growth can be compared with other organisations.

Growth in EPS is seen as an important means of assessing company performance both by the market and by shareholders.

However, organisational decisions need to be based upon a broader set of criteria.

EPS is not appropriate to the public sector where there is more attention on issues such as economy, efficiency and effectiveness and obtaining value for money.

Returns and investment

Private sector organisations will need to set targets in terms of the return on capital employed in order to ensure that the needs of shareholders are met. The latter will expect a return which adequately compensates them for the risks which they are taking.

Public sector organisations may set targets in terms of a required return on capital but ultimately other factors are more important in assessing their success and the acquisition of resources may be more closely linked to political issues than purely financial ones.

Most private sector organisations will use investment decision criteria based upon investment appraisal, calculating NPV’s. The cost of capital for public sector organisations is effectively fixed by the Government. It is unlikely to be risk adjusted and any public sector evaluation may take into consideration social costs and benefits. Taxation will be of less significance in a public sector appraisal.

While private sector companies can freely borrow funds in the marketplace, subject to the normal market judgements of their ability to repay and use the money effectively, public sector organisations normally work within a cash limited budget within a single financial year. This sometimes means that there are difficulties in adequately funding long term investments as there is a pre-occupation with staying within short term financial limits.

(ii) Risk management

There is a difference between the Private and Public sectors in terms of the management of risk.

Private sector organisations generally have to compete for customers and ensure that they charge a price which covers cost, generates a profit, but is nevertheless competitive with other suppliers. The main risk they face is a loss of customer demand.



Public sector services are often provided free of charge to the user. Some areas of the public sector (especially health) have the problem of managing capacity to meet demand and this can lead to prioritisation and effectively rationing, with waiting lists as a consequence. Other areas of the public sector may need to have contingency plans for sudden changes in state funding, which will impact upon financial viability. The public sector may thus face risks of both excess demand and reduced funding because of demand changes or changes in political priorities.

Managing risk in the private sector may therefore entail:

meeting the needs of customers and of stakeholders

undertaking market research to get a better understanding of customers and markets

taking steps to assess and manage risks via insurance, hedging of foreign exchange and interest rate risks.

Managing risks in the public sector may therefore entail:

monitoring of economy, efficiency and effectiveness and value for money

using internal markets to purchase services and establish ‘fair’ transfer prices

using private sector funds where appropriate to give longer term investment horizons.



PLANKERS INC

(a) (i)

$m

Cash brought forward at 1 June 20X5: 8.48

Building programme investment (12.00)

Minimum cash balance requirement (1.00)

_____

Additional loan required at 1 June 20X5: (4.52)

_____

The cash balance needed for 31 May 20X6 will be added to by cash retentions during the year. This can be found from Income Statement for 31 May 20X6.

Projected income statement for the year to 31 May 20X6

$m

PBIT before depreciation ($1.71m 1.05 1.05 1.05) 1.980

Extra depreciation (15% of (50% of $12m) (0.900)

Interest charges (see note) (1.037)

____

Profit before tax 0.043

Tax (30%) 0.013

____

Profit after tax 0.030

____

Cash available in profit after tax:


Add back depreciation (non-cash expense) 0.900

____

0.930

____

Note on interest charges:

Total loans = $7m + $4.52m = $11.52m

Interest rate = 9%

Interest = $11.52m × 0.09 = $1.037m.

(ii) Check on cash balances at 31 May 20X6

Cash ledger DR CR

$m $m

Brought forward 1 June 20X5 8.48

Cash retentions 0.93

Additional loan financing 4.52

Building programme expenditure 12.00

Carried forward balance 31 May 20X6 1.93

The conditions of the loan and the other targets can then be checked:

Interest cover: = (1.98 – 0.9)/1.037: = 1.041 times



EPS: (Profit after tax/number of shares = $0.03m/4m shares): 0.75¢

The minimum cash balance target is met. However, the target minimum interest cover (3 times) and the target minimum EPS (20 cents) are not met.

(iii) Options

1 Delay the building programme until sufficient funds are available from cash retentions.

2 Re-negotiate the terms of the long-term loan.

3 Pay out less in dividends.

4 Leasing assets rather than buying them.

5 Raise further equity capital.

6 Sell assets.

7 Reduce working capital investments.

8 Combinations of the above.

(iv) The only condition satisfied is that relating to the minimum cash balance. Both the interest cover and the EPS conditions are breached. The scale of the building programme suggests that options 1, 3, 4, 6 and 7 are very unlikely to provide sufficient additional capital. Extending the loan facilities in option 2 would likely make worse the interest cover and EPS figures. The only viable option appears to be an equity issue.

(b) (i) Responding to various stakeholder groups

If a company has a single objective in terms of maximising profitability then it is only responding to one stakeholder group, namely shareholders. However, companies can no longer fail to respond to the interests and concerns of a wider range of groups, particularly with respect to those who may have a non-financial interest in the organisation. Stakeholder groups with a non-financial interest can therefore generate for companies non-financial objectives and place constraints on their operations to the extent that the company is prepared to respond to such groups.

Various stakeholder groupings can emerge. The following represents examples of likely groups, their non-financial objectives and/or the constraints they may place on a business:

Stakeholder Objective Constraints

Employees Employee welfare Maximum hours worked

Community Responding to community concerns

Limits on activities

Customers Product or service levels Minimum quality standards

Suppliers Good trading relationships

Government Protecting the consumer Minimum standards on products or services

Trade bodies Protecting professional reputation

Minimum standards on products or services



(ii) The difficulties associated with managing organisations with multiple objectives

To the extent that an organisation faces a range of stakeholders, then they also face multiple objectives. This would not particularly be a problem if the multiple objectives were congruent, but they normally are not. There are a number of difficulties:

Multiple stakeholders imply multiple objectives. To the extent that they conflict then compromises must be made. This will lead potentially to opportunity costs in that maximisation of profitability will potentially be reduced.

Responding to stakeholders other than shareholders involves costs, either in management time or in directly responding to their needs.

Some objectives are not clearly defined, for example what is actually meant by ‘protecting the consumer’? It will therefore not always be clear to the organisation that they have met the needs of all of their stakeholders.

Some of the objectives may actually be conflicting where compromise is not possible. Prioritisation and ranking will then have to take place. Questions then arise as to who is the most important stakeholder or what ranking should be assigned?

New stakeholder groups often emerge. This can create a problem of longer-term strategic management in that plans can be diverted if new pressures arise. For example, environmental issues were not so important 20 years ago.

Management of the organisation becomes complex when multiple objectives have to be satisfied. Each managerial decision is likely to face many constraints.



BRETT

(a) Appendix to the Report

Brett Industry average

Return on capital employed 1239

15 29.4% 18%

Return on equity 39

6.9 24.6% 15.8%

Operating profit margin 120

15 12.5% 10%

Current ratio 24

30 1.25:1 1.25:1

Acid test 24

10 0.42:1 1.1:1

Gearing (debt/equity) 39

12 31% 33%

Interest cover 3.1

15

11.5 times

6.0

Dividend cover 8.3

6.9 2.5 times 3.0

PE ratio (see workings below) 2.1

8 6.7 times 6.0

Number of shares 4m/0.5 = 8m

EPS $9.6m/8m = 1.2

Dividend yield 8

88.3

6% 8%

REPORT

Report to the Directors of Brett, on the financial performance for the year ended 31 October 20X6

Prepared by: Financial Director

Date: November 20X6

Profitability

Brett had a ROCE of 29.4% for the year. This is a particularly high figure, especially when compared to the industry average of 18%. The return on equity was also especially strong, with ROE of 24.6% compared to an industry average of 15.8%.

The operating profit margin of 12.5% was slightly higher than industry average of 10%; this means that Brett is controlling its costs, and turning sales into profit.

Liquidity

The current ratio is 1.25:1 – the industry average, and fairly healthy. The acid test of 0.42 is low. This is due to most of the current assets being in the form of inventory. We should perhaps look at the inventory level and see if it really needs to be as high as it is. Maybe a



reduction in inventory could improve liquidity and the resulting increase in cash be invested to help increase profits.

Gearing

The gearing level is low, meaning that Brett is mainly financed by equity, rather than higher risk debt. The ratio is almost exactly in line with the industry average (31% as compared with 33%). As a consequence the interest cover is very high – 11.5 times (compared with the industry average of only 6 times). There should be no problems meeting interest payments when they are due.

Stock market

Dividend cover is slightly lower than the industry average (2.5 times as compared to 3 times). This is due to the high payout in dividends for the year. The PE ratio, which measures investor confidence for the future, was slightly higher than the industry average. Dividend yield (a measure of return to the shareholders for the year) was lower than the industry average, at 6%. This is due to the high share price.

(b) Forecast income statement for the year ending 31 October 20X7

$m

Sales (120 1.3) 156.0

Cost of sales and expenses:

Variable costs (75 1.3)* (97.5)

Fixed costs (25 + 4) (29.0)

Depreciation (5 + 2) (7.0)

_____

Operating profit 22.5

Interest (1.3)

_____

Profit before tax 21.2

Tax (at 30%) (6.4)

_____


Dividends (14.8 69

83

.

.)

(5.9)

_____

Retained earnings 8.9

_____

*Note: Since the C/S ratio will remain unchanged, variable costs will increase in proportion to sales.

(c) Stakeholders in a company include shareholders, directors/managers, lenders, employees, suppliers and customers. These groups are likely to share in the wealth and risk generated by a company in different ways and thus conflicts of interest are likely to exist. Conflicts also exist not just between groups, but within stakeholder groups.

This might be because sub-groups exist, for example preference shareholders and equity shareholders, within the overall category of shareholders. Alternatively, individuals within a stakeholder group might have different preferences (e.g. to risk and return, short-term and long-term returns). Good corporate governance is partly about the resolution of such conflicts. Financial and other objectives of stakeholder groups 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. For a listed company, this can be viewed in terms of the changes in the share price 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 other financial measures, such as return on capital employed, earnings per share, gearing, growth, profit margin, asset utilisation, and market share. Many other measures also 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 terms of the interests of other stakeholder groups. Thus, shareholders as a group may be interested in profit maximisation; they may also be interested in the welfare of their employees, or the environmental impact of the company’s operations.

Directors and managers

While executive directors and managers should attempt to promote and balance the interests of shareholders and other stakeholder groups, it has been argued that they also promote their own individual interests and should be seen as a separate stakeholder group.

This problem arises from the divorce between ownership and control. The behaviour of managers cannot be fully observed by the shareholders, giving them the capacity to take decisions that are consistent with their own reward structures and risk preferences. Directors may therefore be interested in their own remuneration package. They may also be interested in building empires, exercising greater control, or positioning themselves for their next promotion. Non-financial objectives of managers are sometimes inconsistent with what the financial objectives of the company ought to be.

Employees

The primary interests of employees are their salary/wage and their security of employment. To an extent there is a direct conflict between employees and shareholders, as wages are a cost to the company and income to employees.

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



BANKS AND FISCAL POLICY

(a) The working capital cycle of most companies is financed to some degree by bank loans and overdrafts (advances). To fulfil their function of providers of short-term finance, banks rely on their ability to create money via the bank multiplier process.

The banks are able to create money in the form of credit because they are confident, on the basis of experience, that when deposits are made, customers are unlikely to wish to withdraw all of their balances at any one time. However much customers do withdraw, there is a high probability that they will make payments to people who will, in turn, deposit their receipts at the bank. Consequently, bankers know that only a relatively small cash reserve is required to support a given level of deposits so that the remainder can be safely lent to other customers in order to earn interest income.

For instance, if a new customer makes a cash deposit of £1,000 and the bank deems it prudent to retain only 10% of this i.e. £100, it can be shown that the deposit can be used to support loans of £9,000. In this case, there is a ‘bank deposit multiplier’ of 10 at work, given by the reciprocal of the prudential reserve ratio [1/0.1 = 10]. The initial deposit has been multiplied 10 times and new money in the form of credit of £9,000 has been created. There is thus also a credit multiplier of 9 at work.

Clearly, this process is limited by the banker’s own notions of prudence and also by the demand for loans. The reserve ratio may also be controlled by the nation’s monetary authorities, who may also impose other restrictions on the structure of banks’ balance sheets to limit their ability to lend. The full multiplier also relies on there being no cash leakages from the banking system. If the general public and businesses also need to hold liquid cash reserves, this will dampen the operation of the multiplier – each time an expenditure is made, the recipient will hold back some proportion in cash form before banking the remainder. Such cash leakages may be mitigated by the prevalence of cheque and credit card usage. Finally, if the recipients of loan-financed expenditures deposit their receipts at other banks, the ability of the original lender to create further credit ceases. However, the credit-creating capacity of the banking system as a whole is unimpaired, unless other banks apply stricter reserve requirements to back their own lending.

(b) Economies tend to grow in cyclical fashion, with periods of recession following periods of recovery and prosperity. However, excessive economic instability is considered undesirable. First, slack activity imposes costs in terms of unemployed resources and lost output, and second, overheating at times of rapid expansion imposes costs in terms of inflation and lost international competitiveness. Governments periodically intervene in the economy in order to moderate cyclical fluctuations, raising expenditure and/or cutting taxes at times of recession, and restricting expenditure and/or raising taxes in boom times.

Some problems arising from the use of fiscal policy are as follows.

Forecasting problems

The conduct of fiscal policy requires knowledge of where the economy is now and how it is likely to develop in the future. Forecasting economic trends usually involves the construction of complex economic models which embody assumptions about the relationships between economic magnitudes, based on past behaviour. The validity of the forecast depends on the extent to which such relationships are likely to apply in the future, and also on the volume and reliability of data about the present state of the economy which provides the forecasting base.



Time-lags

Policy-makers are often hampered by inability to recognise the need for action and to assess the scale of the required intervention. Consequently, it is often argued that discretionary fiscal policy can be counter-productive because of the time-lags

involved by the time the policy measures are introduced and begin to impact on people’s behaviour, the nature of the problem may have changed.

Crowding-out

Some economists argue that an increase in government expenditure, far from supplementing aggregate demand, will only displace or ‘crowd out’ private sector expenditure. Increased command over resources by the state may simply lower the ability of firms and individuals to obtain resources. For example, if the state wishes to computerise more of its activities, the increased demand for skilled systems analysts may drive up the salary levels which all organisations will have to pay to recruit and retain such specialists.

Financing problems

A public sector deficit has to be financed in some way. If the state borrows on the financial markets, the resulting increase in demand for funds may raise interest rates, thus dampening the incentive of firms to invest. Alternatively, the government may borrow from the central bank (‘printing money’). Because this usually involves an increase in the monetary aggregates, it poses the risk of raising the rate of inflation, although this effect is likely to depend on the current level of unemployed resources.



Z INDUSTRIES

(a) The management and monitoring of working capital is an essential feature of a successful business. Therefore, in a group of which Z Industries is a part, it is important that there are some guidelines laid down relating to acceptable practice in the area of working capital management. However, on the other hand, these guidelines must be flexible to allow for specific factors unknown to those in upper management and therefore they must not be utterly prescriptive.

In this situation, the working capital targets are expressed in terms of the activity levels of the subsidiary and therefore they avoid the limitations of a rigid budget.

However, there are a number of shortcomings associated with the targets themselves, which are detailed below.

(i) Inventory

In expressing inventories as a percentage of sales, a spurious relationship is assumed between the stock and what must necessarily be past sales (future sales figures being unknown). In budgeting and planning anticipated stock levels are based on forecast production and sales figures in order to avoid stock-outs or the holding of excess inventory. Thus if the stated criterion is adhered to, Z Industries could seriously jeopardise its performance.

In addition stock levels are frequently determined by use of the economic order quantity model by minimising the total of holding and recording costs, and further by considering an appropriate buffer stock to minimise the adverse effects of stock-outs. The application of such consideration may well go against the level of 10% of sales, yet result in a stock level which is known to be optimal for the company.

(ii) Receivables

This criterion has a sounder basis since receivables are clearly related to past sales. However, it is not satisfactory to apply such a general criterion, since the level of receivables of a company will depend chiefly on its credit policy and discount structure. In addition the company may have sales which are unevenly distributed throughout the year (e.g. seasonal, or large one-off contracts) which will be reflected in receivables balances which vary significantly from month to month. Alternatively, in order to maintain customer goodwill, it may be necessary to allow certain balances to exceed the 2½ month limit.

(iii) Payables

As with receivables, it is reasonable on the surface to link payables with purchases, but in reality payments to suppliers are often made when cash becomes available. Thus payments are more likely to be linked to receipts. A further consideration relates to discounts, where it may be financially advantageous to make early payment. In addition, undue delay in remittances may jeopardise relations with suppliers to the detriment of the company.

(iv) Cash

The control over cash needs to be flexible and associated with a cashflow forecast detailing future cash requirements. Only under such considerations can it be rationally decided how best to deal with cash surpluses or shortfalls.



(b) Working capital comprises several different components: inventory, receivables, payabless and cash. Since these vary considerably in their nature, so too will the basis for setting an appropriate target. In the case of receivables actual sales revenue would seem to be most sensible, since that is the basis of the receivables’ balance. The same argument may be made for payables, i.e. based on actual purchases which in turn is related to actual sales levels. However, as was discussed in (a) above, inventory levels are set on the basis of future activity levels and therefore a forecast would be more appropriate as a basis for the setting of a target. Similarly cash balances at any one point in time should reflect the future anticipated need for liquid resources, thus making a forecast essential for the setting of a target.

Any worthwhile target should be used as a yardstick against actual results in variance analysis. If this is to be a meaningful exercise, the target must be realistic. In this respect both an actual basis and a forecast have their drawbacks. A forecast, being a prediction, will necessarily have scope for error, whereas it could be claimed that actual figures are not representative of conditions in the future period under review. This must clearly be taken into account in any subsequent variance analysis.

Bearing in mind the above point it is essential that any forecast on which a target is set is as accurate as possible. This means that it must not simply take account of future activity levels, such as sales revenue, working capital being considered. For instance, for inventory levels account should be taken of opportunities to purchase materials at an advantageous price; or for receivables, consideration should be given to the customer mix in the coming period and the particular credit terms offered to those customers. Thus the variance analysis may contribute usefully to the company’s management control.

(c) Currently receivables balances are being monitored on the basis of the number of months of credit sales they represent on a total basis. This could easily be distorted by one or two large balances which are perhaps long overdue. Therefore it is essential to have some more detailed analysis in order to identify such balances and remove them from the monthly sales figure for a more reasonable comparison. In addition, by identifying such balances, effort can be focused on them to ensure they are collected as soon as possible. This should all be possible if an aged debtors analysis is produced, ideally with the use of a computer such that balances over a particular size and age can be readily identified. In addition such an analysis will give a more detailed indication of the state of the total receivables on a month-by-month basis.

If credit limits and credit terms are assigned to customers these may be used to prepare a cash receipts forecast based on both actual outstanding sales and forecast sales. This may subsequently be compared to the actual receipts to determine the extent of customer adherence to their allowed credit terms. With the aid of a computer package this analysis may be performed for individual customers.



FRANTIC

(a) (i) Payables policy

By paying suppliers after one month instead of after two months, the company will earn a discount of 1.5%. This means that by ‘investing’ $98.50 one month earlier in the payment of creditors, it will ‘earn’ $1.50, by not having to pay $100 one month later. The question is asking what the ‘return on investment’ would be from earning $1.50 by investing $98.50 for one month, expressed as an annualised yield.

The establishment of a payables payment policy involves a comparison of interest rates with the number of days’ credit in relation to the cash discount available.

Taking the discount yields a return of:

Discount % × 365

(100 Discount %) (Final date Discount date)

1.5 × 365 days

98.5 (60 days – 30 days)

= 0.1853 or 18.53%. This is more than the discount rate the company uses (i.e. the company's cost of capital). A one-month payment policy should therefore be preferred.

(ii) Receivables

This part of the question is similar to (a)(i), except here the question is whether to offer an early settlement discount, whereas in (a)(i) the question was whether to accept an early settlement discount.

Offering the discount implies an interest cost of:

Discount % ×

365

(100 Discount %) (Final date Discount date)

2 ×

365 days

98 (60 days – 30 days)

= 24.8%

This is more than the discount rate the company uses (i.e. more than the company's cost of capital). It is therefore not worthwhile.



Alternative method of solution

For every $100 worth of receivables:

No discount

With discount

$ $

Receipt from debtor 100.0 98.0

Interest on investing $98 for (60 – 30) = 30 days:

= 98 (30/365) 15% –

____

1.2

___

Total income 100.0

____

99.2

___

Hence, it is not worthwhile to offer the discount.

(b) REPORT

To: Managing Director and Senior Management Team

From:

Date: xx/xx/xx

Subject: Cash budgeting

Introduction

This report addresses a number of key issues concerning Frantic’s cash flow position and has four elements which are of immediate concern to Frantic.

How cash flow problems arise

It is important first to distinguish between profitability and cash availability. The key idea relates to insolvency since even profitable companies can face insolvency if cash positions are not properly managed.

Thus cash positions require management to avoid the difficulties associated with cash shortages. Cash shortages are likely to arise in a number of situations. The following is not an exhaustive list, but is likely to represent the most common. Cash flow problems can arise due to:

(i) Sustained losses in the business such that cash resources have been drawn-down

(ii) Difficulties in dealing with inflating costs combined with an inability to raise sales prices proportionately

(iii) Overtrading and inadequate financing of growth. This is very common with new businesses which are not able to finance working capital requirements sufficiently. Generally, such problems are associated with under-capitalised businesses and a lack of recognition that working capital requirements require a large base of long-term capital funding

(iv) Seasonal trading against ongoing costs. This situation arises where income from sales is variable according to the time of year but fairly even monthly outgoings have to be met;

(v) Unplanned one-off large items of expenditure. This may arise, for example, as a result of a break down of a large piece of machinery, and

(vi) Poor credit management.



The importance and impact of each item will depend on a number of factors.

Thus, losses may be sustained for a period without a liquidity problem, depending on how large cash resources are, whether in the form of positive bank balances or the availability of overdraft facilities.

Suffering cost inflation at a higher rate than prices can be raised is not sustainable in the long-run. The importance of this may depend on the capability of the business to implement cost savings, or to diversify markets where prices could be increased.

Overtrading is a problem of forecasting and planning for adequate long-term capital. The idea is that growth should be within available resources.

Seasonal trading requires careful cash management and the extent to which cash resources can be smoothed over the year.

Unplanned major items of expenditure may be important if alternative sources of finance are not available, such as leasing.

Methods of easing cash shortages

There are several techniques for offsetting the short-term effects of cash shortages. In the long-term, however, the adequacy of cash has to be addressed. Thus, for example, cash shortages may be alleviated by the following:

(i) Postponement of expenditure where feasible. This would not be feasible in the payment of staff wages, but might be in relation to replacing an old piece of equipment that is still working.

(ii) Accelerating cash inflows. For example, by more effective use of credit collection, better credit control, improved early payment incentives, or even the factoring of receivables.

(iii) Sale of redundant assets either before or after any necessary re-organisation. This may involve the sale of a building where accommodation can be centralised. Other assets may be sold on a sale and lease-back basis, although careful consideration will have to be given to the net benefits arising from this.

(iv) Re-negotiation of supplier terms or overdraft arrangements. In particular, bank debt may be mortgaged or secured to access lower rates. Suppliers may agree to lower prices or longer terms if negotiated agreements can be formalised such that a certain level of purchases are made over a period of time.

The importance of each item will depend on the degree of flexibility that Frantic has in its financial structure and agreements. The room for manoeuvre may be limited, but a thorough review of all possibilities is likely to yield at least a number of options. Furthermore, the impact of each potential response depends on how efficient Frantic has been in arranging its affairs in the first place. Finally, none of the items listed will have a sustained impact if the core problem is not identified and dealt-with.

Managing cash resources

A variety of methods might be of use in managing resources. The particular tool chosen will depend on its reliability and appropriateness. Appropriateness, in turn, will be governed by the underlying assumptions of the technique employed. Some of the methods that may be used to manage cash resources are listed below:

(i) Inventory approach to cash management. This method views cash in the same way as engine inventory such that EOQ models may be employed. In such



circumstances, cash is viewed as an asset with costs associated with it that should be minimised so as to determine what level of cash balances should be held. Thus, decreases or increases in cash balances can be determined according to planned growth, the time value of money and the costs of obtaining new funds.

(ii) The Miller-Orr model recognises that cash balance requirements are likely to fluctuate and that active management is required in responding to these fluctuations. In particular, attention is paid to the variability (or variance) of cash flows, interest rates and the transaction costs of adjusting cash balances. It is the variability of cash balances that is crucial to understanding cash management since this will depend directly on understanding how Frantic’s operations (fundamentally, sales and production) vary. For a volatile business, it is likely that large cash balances will need to be kept. Miller-Orr suggest a simple formula to estimate this although the formula itself is limited by the assumptions on which it rests.

(iii) Probability approaches recognise a degree of uncertainty in predicting cash balances and allow for a range of outcomes to occur. If the assessment of such probabilities is accurate then cash resources can be put in place in readiness for the predicted events. The method is not wholly reliable in situations where the number of potential outcomes is small, since unfeasible expected outcomes may be predicted by using a probability approach.

(iv) Cash management is also about managing surplus cash. The response of management should depend on whether the surplus is large and how long it is likely to exist. If the balance is large and is likely to remain, then management have a duty to look for appropriate investment opportunities or else refund the investors with a special dividend, for example. Smaller cash balances can be actively managed via short term deposits.

A centralised treasury function

Treasury departments are normally a feature of larger companies than Frantic, although it is perhaps beneficial to consider the benefits of such departments to assess what practices might reasonably be adopted. Essentially, treasury centralisation is an issue concerned with economies of scale. The benefits of treasury departments are numerous and include the following:

(i) Consolidating bank accounts to create either a single account through which all cash resources are managed or a virtual single account with automatic offset between different accounts. Such an approach maximises deposit interest, which is typically higher on larger cash balances for positive balances whilst minimising overdraft costs for negative balances.

(ii) Borrowings can be arranged in bulk thus accessing lower rates.

(iii) Foreign exchange management is improved. In the same way that cash balances are effectively consolidated, foreign currency payments and receipts of all the divisions in the company can be amalgamated, and cash inflows and outflows in each currency set off against each other. This can reduce the need for expensive hedging agreements. Foreign exchange risk consolidation is common in practice.

(iv) Treasury expertise can be developed within a single department, thus enhancing the quality of resource management generally.



(v) Precautionary cash balances, when centralised, are likely to be lower than when considered on an individual account basis.



WHICHFORD CO

(a) (i) Currently the delay in invoicing is :

Percentage of weeks sales subject to delay

Amount of sales subject to delay

Days delay

$x days delay

% $000 $000

20 100 3 300

6 30 4 120

40 200 5 1,000

22 110 6 660

12 60 7 420

–––––

2,500

–––––

This is the equivalent of $2.5 million sales being delayed for one day each week of the 50-week trading year. The cost of this delay in one year amounts to:

yearper $51,370 365

0.15 weeks50 $2,500,000

The revised delay in invoicing will produce:

Percentage of weeks sales subject to delay

Amount of sales subject to delay

Days delay

$x days delay

% $000 $000

50 250 0 0

40 200 1 200

10 50 3 150

–––––

350

–––––

This is the equivalent of $350,000 sales being delayed for one day each week. The cost of this delay in one year amounts to:

yearper $7,192 365

0.15 weeks50 $350,000

Therefore, the total savings from the introduction of the computers amounts to:

$ Saving of interest:

Old cost 51,370 New cost 7,192

Savings 44,178 Saving of head office costs 48,000 Total saving 92,178



Therefore, the maximum monthly rental is 12

$92,178 $7,681

(ii) Average debtors after invoice production

$ Old:

365

35 million $25 2,397,260

New:

365

30 million $25 2,054,795

Reduction (365

5 million $25 ) 342,465

Savings 15% $342,465 51,370

Savings from increased speed of invoicing 92,178 Total savings 143,548

Therefore, the maximum monthly rental is 12

$143,548 $11,962

(b) Factors offer three major services:

(i) A sales ledger accounting and credit control service

The client effectively sells all debts to the factor who administers the debt and collects cash from the debtor. On collection of the cash the factor will usually pass all monies still outstanding, less factoring fees, to the client. The client therefore effectively replaces a great many trade debtors with only one i.e. the factor.

(ii) Provision of finance

The factor will normally be prepared to forward immediately to the client a proportion, often between 60% and 80%, of the value of each invoice, thereby assisting the client’s cash flow. This service is usually expensive.

(iii) Credit insurance

For a further fee the factor may be willing to provide insurance against bad debts – this is non-recourse factoring as the factor has no recourse to the client in the event of non-payment of the original invoice.

A factoring agreement usually covers all sales by a client.

Invoice discounting is merely the provision of finance against the security of selected invoices. It is the ad hoc use of the ‘provision of finance’ aspect mentioned above without any other services of factoring.

Issues to be considered include:

costs of factoring versus costs of keeping one’s own sales ledger;

expertise which can be provided by the factor;

whether factoring will reduce the collection period;

whether the contingency nature of the factor’s liability to provide finance might be worthwhile;



whether the intervention of the factor between the client and one’s own customers might adversely affect relationships.

Factoring is useful to rapidly growing firms which have previously had little need for a sophisticated sales ledger department but now need the services of experts. Factoring may be suitable for such a firm and may be less expensive than setting up a specialised department within the firm. Factor finance is, however, normally more expensive than overdraft facilities.



TRADE CREDIT

(a) Credit from suppliers is usually interest-free, and there is always a temptation to utilise this to the maximum possible. There are, however, hidden costs if this interest-free credit is exploited too far.

(i) Goodwill

Regular payment within the agreed terms of trade will enhance the relationship between buyer and seller.

(ii) Adherence to normal terms of trade for the industry

Any attempts to deviate from these may generate hidden costs. For example, if a buyer demands longer credit terms than the norm, the supplier will probably increase prices to compensate.

(iii) Bargaining position

Large firms can often dictate credit terms to smaller ones. Sole suppliers have a similarly strong position. Any abuse of this strength may provide a benefit in the short term, but it is unlikely to be maintained in the long term.

(iv) Cash-flow problems

Many firms periodically have cash-flow problems. If one has a good relationship, credit terms can be changed on a temporary basis to relieve a short-term difficulty. If terms are already extended, there is little slack available.

(v) Withdrawal

Suppliers may eventually cease to trade with you. Well diversified suppliers are sometimes prepared to lose a little business rather than encounter frequent problems with payments.

(b) (i) Payment of 2% per month would involve payment of 24% per annum. The annualised cost of credit will depend on how long one takes the extra credit. The figure of 24% will apply if an extra month’s credit is taken. If payment were just

seven days late each month the annualised cost would be 365/7 2% = 104%.

Assuming a firm has a cost of capital of 16%, if payment is not made on time, then a further credit of one and a half months should be taken, ie, a total credit of approximately ten weeks.

(ii) This creates an annualised cost of 365/30 2% = 24.3%.

Assuming the charge is only levied after 30 days, the optimum payment period would be 29 days after the normal period. In practice it would be advisable to take about an extra three weeks, to avoid any disputes.

(iii) The appropriate formula is (1 + r)p 1

where: r = 2% and p = 12.2 (365/30)

(1 + 0.02)12.2–1 = 0.273 = 27.3%

This assumes that payment is always 30 days late.

Again, if payment is late, it should be made shortly before the 30-day period is reached. If calculations are made on a daily basis, then it will not be advantageous to extend credit by nearly 30 days.



(iv) If the customer normally pays on the 30th day, then payment on day 10 will save 2%

for 20 days lost credit, an annualised rate of 365/20 2%/0.98 = 37.2%.

If longer credit is normally taken, then the annualised rate is less. If a very long credit period is normally taken, then small discounts are usually not worth taking, e.g. if 90 days, credit is normally taken, the annualised saving from taking a 2% discount is only

365/80 2%/0.98 = 9.4%

If payment is normally made on time, it is advantageous to take the cash discount. If payments are usually late, then it may not be advisable. The exact decision will depend upon the company’s cost of capital.

(c) Before the special clearance is worthwhile, the interest saved by the two days must exceed $2.50.

With a cost of capital of 10% per annum, this is 10%/365 per day, or 2 10%/365 for two days = 0.0547945%.

The value of the remittance must be not less than $2.50/0.0547945% = $4,563.

Special clearance should be requested for remittances of $4,563 and above.



SPECIAL GIFT SUPPLIES INC

(a) The funding requirements for working capital is the sum of:

Months

Inventory holding period 3.5

Receivables collection period 2.5

Payables payment period (2.0)

___

Working capital funding period 4.0

___

Diagrammatically, the funding requirement may be represented as follows:

Inventory 3½ months Receivables 2½ months

Payables 2 months

Time

Funding requirement = 4 months

(b) Annual sales: $2.5m

Credit sales: $2.5m 90% = $2.25m

Commission charges payable to the sales force are ignored in the following calculations since they are common to both. The allocated overheads are also irrelevant for the evaluation. The factor’s better record with irrecoverable debts is not part of the evaluation of the proposal in terms of the benefits to Special Gift Supplies, because the factor's service will be provided without recourse (i.e. the factor will take on the irrecoverable debt risk).

Existing position $

Credit control salary 12,500

Irrecoverable debts 3% $2.25m = 67,500

Annual funding costs for receivables $468,750 12% (see note below) 56,250

––––––

Total costs 136,250

––––––

Note:

Average receivables are currently (2.5/12) × $2.25 million = $468,750.

The annual cost of financing these receivables at 12% per annum is:

12% × $468,750 = $56,250.

Factor’s offer: $

Factor finance charge (see Note 1 below) 22,500

Unfactored funding costs (see Note 2 below) 4,500

Factor service charge: 4% $2.25m 90,000

One-off payment funding costs: $25,000 × 12% (Note 3 below) 3,000

––––––

120,000

––––––



Conclusion

It is worthwhile to factor the receivables because it will be less costly.

Note:

(1) The receivables for which the factor will provide finance at 15% = 80% of $2.25 million = $1.8 million.

The average receivables collection period will be 1 month, so the average amount of receivables for which the factor will provide finance is

(1/12 × $1.8 million) = $150,000.

The cost of the finance at 15% per annum is $22,500 (15% × $150,000).

(2) The unfactored receivables will be 20% of $2.25 million = $450,000 each year. The receivables collection period will be 1 month, so the average amount of unfactored receivables for which finance will be required is (1/12 × $450,000) $37,500. These will be financed by the company itself at 12%, so the annual interest cost will be $4,500.

(3) Tutorial note: The one-off payment of $25,000 to the factor has to be converted into an annual cost, for comparison purposes (i.e. comparing costs with the existing position). Here the cost has been established using the assumption that the annual cost is the interest cost on the $25,000 using the company's overdraft rate (12%) as the cost of capital. You might prefer to make a different assumption. The assumption used here is the one preferred by the examiner when this question was set in the examination.

(c) Report on the credit control, factoring of receivables and the financing of working capital

To: Financial Controller, Special Gift Supplies Inc

From: A Student

Date: xx/xx/xx

Subject: Credit control

A good credit control department would exhibit a number of characteristics, some of which are included in the list below:

(1) Preferably have a cash business relationship with customers to begin with

(2) Obtain references for new customers and possibly visit their premises

(3) Access the services of a credit rating agency

(4) Only incrementally raise credit limits to that preferred by the customer

(5) Maintain a history of transactions with each customer

(6) Have documented procedures that explain to credit control employees credit limits and duration with clear action plans when these limits are breached

(7) Create good reporting controls, such as aged list of receivables, and ensure the line of reporting is clear so that senior management are aware of problem cases

(8) Ensure the credit control reports form part of the monitoring of the working capital cycle as a whole so that imbalances do not arise

(9) Access published information on customers, particularly through financial statements or through information services via credit or other agencies

(10) Ensure all customers’ credit limits are periodically reviewed



The benefits of factoring

A list of the benefits of factoring might include:

(1) Access to flexible sources of finance. This is important for small businesses that experience rapid growth since the facility would normally grow with the business.

(2) Sales ledger expertise. Factors can often bring a level of expertise to debtor management that small businesses may not have, either in skills or resources, thus making them more effective.

(3) Factors can bring economies of scale to receivables management thus making them more efficient than a single small company could be.

(4) The business can pay its own debts more promptly, thus ensuring continued supply of goods, for example and also in being able to access early payment discounts which may be substantial.

(5) Inventory levels may be optimally managed since they will be unencumbered by restrictions relating to payment difficulties. For example, it may be optimal for inventory management purposes to reorder inventory at lower, more expensive levels so that the whole of the inventory related costs are minimised.

(6) Receivables factoring is a source of funds that ensure adequate financing for growing businesses. By facilitating this, one of the key issues involved in over trading is addressed.

(7) Costs of sales ledger administration are avoided.

Financing of working capital

The financing of the components of working capital is not always undertaken on a completely maturity-matched basis. That is, whilst working capital is regarded as net current assets that arguably should be funded by short-term sources of finance, this is not always the case for two reasons. First, by construction, net current assets are funded by long-term sources of finance to the extent that all short-term sources of finance have been exhausted. This can be demonstrated from a characterisation of a typical balance sheet (statement of financial position).

Non-current assets + current assets = capital and reserves + long term loans + current liabilities

By simply re-arranging we see that:

Net current assets = (capital and reserves + long term loans) – non-current assets

That is, net current assets are funded by long-term sources of finance not otherwise tied up in non-current assets. This amount will vary day to day because the components of working capital vary from day to day. However, to the extent that there exists positive net current assets, then adequate long term financing needs have to be considered.

Second, the liabilities components of working capital (trade payables and bank overdrafts) represent sources of finance. As such, they are normally regarded as short-term sources of finance. In reality for many businesses, there is likely to be a core of current assets that will always need funding: whilst the components of current assets will change on a day to day basis, their level – to an extent – will remain predictable. It is this predictable component that enables managers to utilise longer term sources of finance in the knowledge that the finance will always be required. The distinction is often made between fluctuating current assets and permanent current assets. To the extent that current assets are permanent, they are more efficiently financed by longer-term sources (because these are usually cheaper). This will help avoid the higher interest costs (implicit or explicit) in shorter term sources of



finance. The distinction between fluctuating and permanent current assets is illustrated in the following diagram that indicates the relationship between asset variability and funding maturity.

Total

Assets

($)

Permanent part of current assets

Non-current assets

Short term

f

i

n

a

n

c

i

n

g

Long term

financing



WORKING CAPITAL

(a) Net working capital is the difference between current assets (mainly inventory, receivables and cash) and current liabilities (mainly trade payables and overdraft/short-term debts). A company must be able to generate, or have in reserve, enough cash to meet its short-term needs if it is to continue in business. However, working capital management is all about ensuring the company has enough, but not too much, working capital. The problem is essentially one of liquidity versus profitability.

Poor working capital management can lead to too much or too little cash:

Too little cash means that the company will be unable to pay their bills when they fall due. In that case the company is insolvent, and its creditors could force it into liquidation.

Too much cash, on the other hand, means that the company is losing out on investments that could provide a return to shareholders. Why sit with thousands of dollars in a current account, earning no interest, when that cash could be invested, if necessary for a relatively short period of time, on the money market, and earn interest.

(b) Companies can exercise control over the levels of their working capital by formulating and implementing policies concerning inventory, receivables, cash, and payables. Such policies will take account of the factors that influence these components of working capital, as follows:

Receivables

Credit period allowed by a company and its competitors, speed of invoicing and other aspects of administrative efficiency, the use of discounts for early settlement, and receivable collection methods. The company could also decide to use the services of a factor.

Inventory

The length of the production process, the inventory turnover period, delivery lead-time. Use of EOQ, JIT, or other inventory management policies.

Payables

The extent to which a company can delay payments to suppliers, the volume of purchases, the availability of cash discounts for early payment.

Cash

Compare interest rates for both short-term borrowing and short-term investments, the availability of credit (important to keep a good credit history), the ease which a company can access funds.

(c) The operating cycle is the time between paying out cash for purchases and receiving cash from customers. For example, if a raw material is purchased on credit, converted into a finished good, then sold to a customer on credit, the operating cycle is the time between paying for those raw materials (not purchasing them) and receiving cash from the customer who bought them.

The operating cycle for a company may be calculated as follows:

Inventory days + Receivable days – Payable days

The longer the operating cycle, the more capital is tied up and the higher the cost to finance this capital. A company could reduce the working capital tied up by optimising the components of the cycle. So, for example, shortening the inventory days (by introducing a



JIT system, for instance), shortening the receivable days (by chasing receivables) or increasing the payable days, will all shorten the operating cycle.

(d) It is important to match the funding with the life of assets. We can analyse assets into non-current assets, permanent current assets and fluctuating current assets. Permanent current assets, being ‘core’ current assets that are needed to support normal levels of sales, should be financed from a long-term source. The working capital policy chosen should take account of the relative risk of long- and short-term finance to the company and the need to balance liquidity against profitability.

An aggressive financing policy will use short-term funds to finance fluctuating current assets as well as to finance part of the permanent current assets. This policy is more risky, since short-term finance is more risky than long-term, but is likely to be cheaper since short-term funds usually have a lower rate of interest, and hence increase profitability.

A conservative financing policy will use long-term funds to finance permanent current assets as well as to finance part of the fluctuating current assets. This is less risky, but also less profitable.



FILLS FOOTBALLS CO

(a) Current situation

Investment in debtors = $750,000 × 45/365 = $92,466.

The interest cost of this investment is 10% × $92,466 = $9,247.

$

Interest cost of investment in debtors 9,247

Bad debts (1% of $750,000) 7,500

Administrative costs: operating expenses 20,000

Total costs 36,747

With the factor

Investment in debtors = 20% of $750,000 × 35/365 = $14,384.

Interest cost of this investment = 10% of $14,384 = $1,438.

Finance provided by factor = 80% of $750,000 × 35/365 = $57,534.

Interest cost of this finance = 9% × $57,534 = $5,178.

$

Interest cost of investment in debtors 1,438

Interest payments on factor finance 5,178

Administration charge (3% of $750,000) 22,500

Total costs 29,116

Under the arrangement with the factor, which is on anon-recourse basis, the bad debt losses would be borne by the factor. Bad debts would therefore be zero for the company.

The factor would therefore appear to be cheaper, and from a financial perspective, using the factor would be the better option.

(b) Report

To Management of Fills Footballs

From: Accountant

Date: xxxxxx

Credit control and debt collection procedures

Credit control procedures

The company is currently losing $7,500 each year from bad debts, which is equivalent to 1% of its annual revenue. This level of bad debts might well be within acceptable limits. However, the company should take suitable measures to ensure that its credit control procedures are effective, without being so strict that good customers are deterred from buying from the company.

For existing customers, credit control procedures should consist principally of monitoring the payment record of the customer, and if the customer shows a good track record of paying debts on time, the company should be prepared, at the customer’s request, to allow a higher credit limit.

When prospective new customers ask for credit, the problem is to decide whether to agree to give credit and if so, how much. If the amount of credit involved is likely to be small, the company might be willing to take a risk and agree to a limited amount of credit. If the



customer asks for fairly extensive credit, it would be appropriate to ask for references, from a bank and from one or two other suppliers to the prospective customer. In some cases, it might even be appropriate to arrange to visit the prospective customer’s premises, to gain a first-hand impression of its business.

The company should also have a credit policy, and offer standard credit terms (e.g. 30, 45 or 60 days credit, depending on what is normal in the industry) up to a limited credit limit. As the relationship with the customer develops, better credit terms might be offered.

There is an argument that a prospective new customer needs to be offered generous credit terms, otherwise the company will not win the customer’s business. As indicated earlier, however, the company must have a clear policy on how much bad credit risk it is prepared to accept. By offering generous credit terms, the level of bad debts will almost certainly rise, although the volume of sales turnover is likely to rise too. Easy credit terms should not be offered without considering the risk, and setting a tolerable limit on the scale of that risk exposure.

Alternative methods for improving debt collection

I have been asked to suggest ways of improving debt collection, other than using the services of a factor. This request suggests that you are not satisfied with current debt collection procedures in your company. My comments below are based on the assumption that these are weak and inadequate, although if this were the case, bad debt levels might be higher.

Collecting debts effectively and efficiently is largely a matter of administration and organisation. Invoices should be sent out to customers promptly after the delivery of the goods or services, and the invoice should state the credit terms.

Customers who buy regularly should be sent periodic statements, perhaps monthly, to keep them informed of the current position and the details of the invoices as yet unpaid. More occasional customers should be sent a written reminder if they fail to pay by the due date. If the customer makes a complaint about some detail in the invoice, this should be dealt with promptly: the customer should not have a legitimate excuse for delaying payment!

Late payers should also be monitored by means of an aged debtors list, which should be produced regularly. This is a list of all unpaid debts, grouped according to the time for which they have remained unpaid. When debts are unpaid after a given length of time, and the customer has not responded to a statement or reminder, one or more individuals in the debt collection section should chase payment by telephoning the customer concerned. Contacting the person in the customer organisation who is responsible for payment, and obtaining a promise to pay, often succeeds in extracting payment fairly quickly.

Some customers will remain reluctant or unwilling to pay, in spite of several telephone calls. In such cases, the company should have established procedures for what to do next. The company could have a policy of trying to obtain payment by referring the matter to a higher level in the management hierarchy. Alternatively, the services of a debt collection agency might be used. In some cases, payment might be chased through the courts.

Another approach to improving debt collection, which can be used in addition to improved internal administrative procedures, is to encourage the customer to pay more promptly. There are at least two ways of doing this. One method is to persuade regular customers to pay by bank transfer (in the UK, by BACS) rather than by cheque. The customer could then arrange to pay invoices electronically, by giving an instruction to its bank, as part of its routine ‘month end’ payments procedures. An alternative method is to encourage early payment by offering early settlement discounts.



The importance of debtor management

Debtor management is important for several reasons.

The credit terms offered to customers could be a factor in the customer’s decision to buy from the company, or to go to an alternative supplier offering better terms. However, although generous credit terms can help to boost sales, they can also lead to significantly higher bad debt losses. A company has to strike a balance between offering reasonable credit terms to win business, but not so reasonable that the losses exceed the benefits.

Generous credit terms will result in a larger volume of debtors. Debtors tie up cash, and have to be financed. Proper control over debtors should prevent the investment being larger and more costly than necessary.

Because debtors tie up cash, an increase in debtors can have important consequences for cash flow. In order to pay their own creditors, companies need cash from their debtors. Profitable companies might suffer a shortage of liquidity by allowing their debtors to increase to an amount higher than they can safely afford.

Conclusion

Credit control and debt collection are both elements of debtor management. If you continue to collect debts yourself, without the services of a factor, formulating and applying a clear policy on credit, together with efficient administrative procedures for debt collection, should enable you to manage your credit levels and your debtors effectively.



BORROWING CO

(a) Running costs (new saw)

Labour, parts and other direct costs included.

PV factor PV Cumulative $000 $000 $000

Year 1 1,000 0.909 909 909 Year 2 1,375 0.826 1,136 2,045 Year 3 1,750 0.751 1,314 3,359 Year 4 2,000 0.683 1,366 4,725 Year 5 2,300 0.621 1,428 6,153

Scrap value (new saw)

Year 1 2,000 0.909 1,818 Year 2 1,500 0.826 1,239 Year 3 1,000 0.751 751 Year 4 250 0.683 171 Year 5 Nil 0.621 –

One-year cycle

PV $000

Purchase cost (3,500) Running costs – Year 1 (909) Scrap value – Year 1 1,818 ____

Total PV cost (2,591) ____

Two-year cycle

Purchase cost (3,500) Running costs – Years 1 and 2 (2,045) Scrap value – Year 2 1,239 ____


Three-year cycle

Purchase cost (3,500) Running costs – Years 1–3 (3,359) Scrap value – Year 3 751 ____




PV $000

Four-year cycle

Purchase cost (3,500) Running costs – Years 1-4 (4,725) Scrap value – Year 4 171 ____


Five-year cycle

Purchase cost (3,500) Running costs – Years 1–5 (6,153) Scrap value – Year 5 – ____


To calculate AE cost

Year Total PV cost Annuity factor AE cost $000 $000

1 2,591 0.909 = 2,850 pa 2 4,306 1.736 = 2,480 pa 3 6,108 2.487 = 2,456 pa * 4 8,054 3.170 = 2,541 pa 5 9,653 3.791 = 2,546 pa

* The new machine should be replaced every 3 years, when AE costs = $2,456,000 pa.

(b) Non-identical replacement

The old machine is retained for a number of years then the new machine is bought and will be renewed on a three year cycle (cheapest method as worked out above) at an equivalent annual cost of $2,456,000.

Running costs – old saw

Power, consumable stores, maintenance and insurance are included. Supervisor’s salary is ignored as it would be incurred anyway.

PV factor PV Cumulative $000 $000 $000

Year 1 1,500 0.909 1,364 1,364 Year 2 2,000 0.826 1,652 3,016 Year 3 2,500 0.751 1,878 4,894 Year 4 3,250 0.683 2,220 7,114 Year 5 4,000 0.621 2,484 9,598



Replace now PV factor PV $000

Scrap value 750 1.00 750 AE cost – new machine

Year 1 – 2 456

0 10

,

. (24,560)

_____

Total PV cost (23,810) _____

PV Factor PV $000 Replace in 1 year’s time

Running costs Year 1 (1,500) 0.909 (1,364) Scrap value Year 1 500 0.909 455 AE cost: new machine

Years 2 – 2 456

0 10

,

. 0.909 (22,325)

_____

Total PV cost (23,234) _____

Replace in 2 years’ time

Running costs Years 1–2 (3,016) Scrap value Year 2 250 0.826 207 AE cost: new machine

Years 3 – 2 456

0 10

,

. 0.826 (20,287)

_____

Total PV cost (23,096) _____


Running costs Years 1–3 (4,894) Scrap value Year 3 – AE cost: new machine

Years 4 – 2 456

0 10

,

. 0.751 (18,445)

_____

Total PV cost (23,339) _____



Years 5 – 2 456

0 10

,

. 0.683 (16,775)

_____

Total PV cost (23,889) _____





Years 6 – 2 456

0 10

,

. 0.621 (15,252)

_____

Total PV cost (24,850) _____

The existing machine should be replaced in 2 years’ time.



HAWESWATER

(a) Decision over new lorry

Tutorial note: You are being asked to decide between a lorry with a 4-year life and one with a 6-year life based on background information that holds for the next 10 years. Running costs increase each year but it is unlikely that, for just 10 marks, two sets of optimal asset life calculations are required, so you may assume that you will retain each lorry for its full life. You can’t directly compare a cost over 4 years with a cost over 6 years. There are two ways of coping with this problem: either calculate an equivalent annual cost of each machine, or compare the cost of three lots of 4 years against two lots of 6 years. Both methods have been shown and are equally valid given the circumstances here.

Money cost of capital, m = 15½%

Retail price index, i = 10%

‘Real’ cost of capital, r is given by 11

1r

m

i

Real cost of capital = ([1.155 1.10] 1) 100 = 5%

(i) Model K – PV of cost over 4 years

Initial capital cost, t0 = £24,000

New engine cost, t2 = £6,000

First running cost, t1 = 50,000 £0.21 = £10,500

Annual increase = 50,000 £0.05 = £2,500

Second running cost, t2 = £10,500 + £2,500 = £13,000

PV over 4 years (£000) =

432 05.1

18£

05.1

5.15£

05.1

13£6£

05.1

5.10£24

PV over 4 years = £79,544

Note: The discount tables could be used, although you may find it quicker to work from first principles.

(ii) Model S – PV of cost over 6 years

Initial capital cost, t0 = £42,000

First running cost, t1 = 50,000 £0.18 = £9,000

Annual increase = 50,000 £0.036 = £1,800

Second running cost, t2 = £9,000 + £1,800 = £10,800

PV over 6 years (£000) =

429

1 05

10 8

1 05

12 6

1 05

14 4

1 05

16 2

1 05

18

1 052 3 4 5 6.

.

.

.

.

.

.

.

. .

PV over 6 years = £109,236



(iii) PV of cost of each scheme over 12 years

Model K

The equivalent of £79,544 would effectively be paid at t0, t4 and t8

PV = £ , (. .

)79 544 11

1 05

1

1 054 8

= £198,544

Model S

By the same token one could say £109,236 would be paid at t0 and t6

PV = £ , (.

)109 236 11

1 056

= £190,750

(iv) Equivalent annual cost (an alternative approach to (iii))

Model K – EAC = factordiscount cumulativeyear 4

years 4over PV

£ ,

.£ ,

79 544

3 5522 407

Model S – EAC = £ ,

.£ ,

109 236

5 0821 503

(These equivalent annual costs are in current terms and assume steady annual inflation at 10%.)

(v) Conclusion

Based on the calculations in either (iii) or (iv), the cheapest option is to buy model S.

(b) Effect of taxation on lorry decision

Tutorial note: The company’s year end is 31 December and therefore the first WDA is claimable against the profits at t1, i.e. 31 December 20X2. Assume that the company has sufficient profits from elsewhere to be able to utilise in full all allowances at the earliest possible opportunity.



(i) Writing down allowances

Model K Model S Tax Tax Timing Tax Tax Timing WDV saved WDV saved £ £ £ £

Initial purchase price 24,000 42,000 1st WDA (6,000) 2,100 t2 (10,500) 3,675 t2

_____ _____

18,000 31,500 2nd WDA (4,500) 1,575 t3 (7,875) 2,756 t3 _____ _____

13,500 23,625 3rd WDA (3,375) 1,181 t4 (5,906) 2,067 t4 _____

17,719 4th WDA – (4,430) 1,551 t5 _____

13,289 5th WDA – (3,322) 1,163 t6 _____ _____

Balancing allowance £10,125 3,544 t5 £9,967 3,488 t7 _____ ____ ____ _____

£8,400 £14,700 ____ _____

(ii) Post tax money cost of capital = 10%

The 10% money cost of capital of 10% will be applied to post tax costs (expressed in money terms) to find the new PVs.

(iii) Model K

Note: A cash budget needs to be drawn up with previous running costs inflated at 10% per annum.

t0 t1 t2 t3 t4 t5 £ £ £ £ £ £

Capital cost (24,000) Capital allowances 2,100 1,575 1,181 3,544 Running costs (11,550) (22,990) (20,631) (26,354) Tax saved 4,043 8,047 7,221 9,224 _____ _____ _____ _____ _____ ____

(24,000) (11,550) (16,847) (11,009) (17,952) 12,768 _____ _____ _____ _____ _____ _____

10% factor 1 0.91 0.83 0.75 0.68 0.62 Present value (24,000) (10,511) (13,983) (8,257) (12,207) 7,916

Net present value of cost of model K owned for 4 years = £(61,042)



(iv) Model S

Note: It might be sensible to show time down the page now – so your answer fits.

Time Capital Capital Running Tax Net PV @ cost allow’s costs saved 10% £ £ £ £ £ £

0 (42,000) (42,000) (42,000) 1 (9,900) (9,900) (9,000) 2 3,675 (13,068) 3,465 (5,928) (4,920) 3 2,756 (16,771) 4,574 (9,441) (7,081) 4 2,067 (21,083) 5,870 (13,146) (8,939) 5 1,551 (26,090) 7,379 (17,160) (10,639) 6 1,163 (31,888) 9,132 (21,593) (12,092) 7 3,488 11,161 14,649 7,471 _____

Net present value (87,200) _____

(v) Comparison and conclusion

Again the firm would need three cycles of model K or two of model S.

Comparison can be made using either method used in (a).

Equivalent annual cost method

Using cumulative annuity factors for 4 and 6 years respectively:

Model K: Equivalent annual cost = 61,042 3.17 = £19,256

Model S: Equivalent annual cost = 87,200 4.36 = £20,000

The decision in this case is to select model K.

(c) If expenditure is allowed in full in the year in which it is incurred, then, assuming that the allowance can be fully utilised against taxable profits, the effect is to reduce significantly the tax liability of businesses payable one year later with a corresponding increase in the tax payable in the later years of the life of the equipment.

This bringing forward of the tax relief would improve the net present value of projects. It could convert some projects from negative to positive NPV and perhaps result in their acceptance (certain projects previously rejected may need reappraisal).

It is likely that there would be an increase in demand for capital equipment. This would lead to expansion by equipment manufacturers, possibly involving further investment.

Overall the alteration is likely to act as an incentive for businesses to invest more in capital equipment, including bringing forward replacement of equipment.



NESPA (a) Assumption: It is assumed that the inflation rate of 3% in prices and variables costs applies

from Year 1 onwards.

Strategy 1

Year 1 2 3 4 5

Demand (units) 100,000 105,000 110,250 115,762 121,551

Selling price ($/unit) 8.00 8.00 8.00 8.00 8.00

Variable cost ($/unit) 3.00 3.00 2.95 2.95 2.90

Contribution ($/unit) 5.00 5.00 5.05 5.05 5.10

Inflation factor at 3% per year 1.03 1.0609 1.0927 1.1255 1.1593

Inflated contribution ($/unit) 5.15 5.30 5.52 5.68 5.91

Total contribution ($) 515,000 556,500 608,580 657,528 718,366

10% discount factors 0.909 0.826 0.751 0.683 0.621

PV 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 5

Demand (units) 110,000 126,500 145,475 167,296 192,391

Selling price ($/unit) 7.00 7.00 7.00 7.00 7.00

Variable cost ($/unit) 2.95 2.90 2.80 2.70 2.55

Contribution ($/unit) 4.05 4.10 4.20 4.30 4.45

Inflation factor at 3% per year 1.03 1.0609 1.0927 1.1255 1.1597

Inflated contribution ($/unit) 4.17 4.35 4.59 4.84 5.16

Total contribution ($) 458,700 550,275 667,730 809,713 992,738

10% discount factors 0.909 0.826 0.751 0.683 0.621

PV 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.

(b) Evaluating the investment in the new machine using internal rate of return

Year 0 1 2 3 4 5

$ $ $ $ $ $

Contribution 458,700 550,275 667,730 809,713 992,738

Fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)

––––––– ––––––– ––––––– ––––––– –––––––

Taxable profit 344,300 431,299 543,995 681,029 858,906

Taxation at 30% (103,290) (129,390) (163,199) (204,309) (257,672)

––––––– ––––––– ––––––– ––––––– –––––––

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

Capital allowance tax benefits (see note)

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) 353,510 386,284 444,077 524,181 743,617

10% discount factors 1.000 0.909 0.826 0.751 0.683 0.621

Present values (1,500,000) 321,341 319,071 333,502 358,016 461,786

NPV at 10% = $293,716

Cash flows (1,500,000) 353,510 386,284 444,077 524,181 743,617

20% discount factors 1.000 0.833 0.694 0.579 0.482 0.402

Present values (1,500,000) 294,474 268,081 257,121 252,655 298,934

NPV at 20% = ($128,735)

IRR = 10% + [ 293,716 / (293,716 + 128,735)] × (20 – 10)% = 17%.

Since the internal rate of return is greater than the company’s cost of capital of 10%, the investment is financially acceptable.

Note: Capital allowances and tax benefits

Year $

1 25% × $1,500,000 × 30% tax rate 112,500

2 75% of Year 1 amount 84,375



______

307,617

5 Balancing amount 142,383

______

Total $1,500,000 × 30% tax rate 450,000

______

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

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

Year 1 2 3 4 5

$ $ $ $ $

Contribution 458,700 550,275 667,730 809,713 992,738

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

––––––– ––––––– ––––––– ––––––– –––––––

Total profit before interest and tax (PBIT) over five years = $1,359,529.

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

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

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

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



THE INDEPENDENT FILM COMPANY

(a)

Cash flows ($000) Year

0 1 2 3 4 5 6

Purchase of company (400)

Legal/professional (20) (20) (20) (20) (20)

Lease rentals (12) (12) (12) (12) (12)

Studio hire (540) (540) (702) (702) (702)

Camera hire (120) (120) (120) (120) (120)

Technical staff (+ 10% p.a.) (1,560) (1,716) (1,888) (2,077) (2,285)

Screenplay (+ 15% p.a.) (150) (173) (199) (229) (263)

Actors’ salaries (+ 10% p.a.) (2,100) (2,310) (2,541) (2,795) (3,074)

Costumes/wardrobe (180) (180) (180) (180) (180)

Non-production staff wages (60) (66) (73) (80) (88)

Set design (450) (450) (450) (450) (450)

‘Lost income’ from office accommodation

(20) (20) (20) (20) (20)

Sales (+ 5% p.a.) – 5,900 6,195 6,505 6,830 7,172

Cash flow before tax (400) 688 588 300 145 (42)

Tax (33%) – – (227) (194) (99) (48) 14

Net cash flow (400) 688 361 106 46 (90) 14

Discount factor at 14%

1.000

0.877

0.769

0.675

0.592

0.519

0.456

P.V. of net cash flow $000 (400) 603 278 72 27 (47) 6

NPV = $539,000

(b) An expected value is calculated by using forecast probabilities to weight the values of alternative outcomes and thus compute an arithmetic mean for the overall expected result. There are three main problems with the use of expected values for making investment decisions:

(i) The investment may only occur once. It is certainly very unlikely that there will be the opportunity to repeat the investment many times. The average of the anticipated returns will thus not be observed.

(ii) Attaching probabilities to events is a highly subjective process. In investment decisions, probability may often be used in relation to sales forecasts derived from market research. The subjectivity involved in setting probabilities means that the judgements may be incorrect, even though the Net Present Value for the investment may be highly sensitive to changes in the probability distribution.

(iii) The expected value does not evaluate the range of possible NPV outcomes.

The limitations of expected values can be demonstrated by means of a simple example. Suppose that an individual places a $10 bet with a colleague that it will rain within the next 24 hours. The weather forecast predicts the likelihood of rain with the 24-hour period at



60%. The expected value of the bet can thus be calculated as: (0.6 £10) – [0.4 (£10)] = $2. In reality, the expected value can never be observed, because the person will never be just $2 better off, only $10 richer or poorer depending on the success of the bet.



AMBER PLC

(a) Tutorial note: The train company provides a daily return service, so there are two single journeys each day.

The expected number of passengers per journey using the service is dependent on the demand at each particular exchange rate.

At €1.52/£1: expected demand = (500 + 460 + 420)/3 = 460

At €1.54/£1: expected demand = (550 + 520 + 450)/3 = 506.67 (rounded)

At €1.65/£1: expected demand = (600 + 580 + 500)/3 = 560

The expected demand is therefore:

(0.2) (460) + (0.5) (506.67) + (0.3) (560) = 92 + 253.33 + 168 = 513.33 per train journey

= 1,026.67 per day (outward and return journeys).

(b) Workings

45% of passengers use the catering service, spending £4.50 per head on average. Two journeys are run daily, for 360 days per year. This gives:

Annual revenue = 0.45 1,026.67 £4.50 360 = £748,440

Daily revenue = £748,440/360 = £2,079 per day (= less than £2,200 per day).

Variable costs £

Direct material (55% of revenue) = (0.55) (£748,440) 411,642

Variable overhead (12% of revenue) = (0.12) (£748,440) 89,813

_______

Total variable costs 501,455

Fixed costs

Labour: Year 1 = (0.10) (£748,440) 74,844

Rising by 5% per year; this gives:

Year 2: £78,586

Year 3: £82,516

Year 4: £86,641

Year 5: £90,973

Purchase/store management and insurance = 0.05 (£748,440) 37,422

With outsourcing

If the service is outsourced, there will be a saving of (£18,000 + £3,000) = £21,000 in purchasing/store management and insurance costs:

Purchase and insurance with outsourcing (£37,422 − £21,000) 16,422

Contract cost per year = £250 per day 360 days 90,000

Gross catering receipts are less than £2,200 per day on average, therefore the 5% commission does not apply.



Cash flows: in-house option

Year 1 2 3 4 5

£ £ £ £ £

Sales revenue 748,440 748,440 748,440 748,440 748,440

Variable costs (501,455)

_______

(501,455)

_______

(501,455)

_______

(501,455)

_______

(501,455)

_______

Contribution 246,985 246,985 246,985 246,985 246,985

Labour costs (74,844) (78,586) (82,516) (86,641) (90,973)

Purchase and insurance

(37,422)

(37,422)

(37,422)

(37,422)

(37,422)

Asset purchase/sale

−

_______

(500,000)

_______

−

_______

−

_______

280,000

_______

Net cash flow 134,719 (369,023) 127,047 122,922 398,590


0.893

0.797

0.712

0.636

0.567

Present value 120,304 (294,111) 90,457 78,178 226,001

Net present value = £220,829

Cash flows: contract out option

Year 0 1 2 3 4 5

£ £ £ £ £ £

Contract fee payable (90,000) (90,000) (90,000) (90,000) (90,000)

Asset sale 650,000

Fixed costs −

_______

(16,422)

_______

(16,422)

_______

(16,422)

_______

(16,422)

_______

(16,422)

_______

Net cash flow 650,000 (106,422) (106,422) (106,422) (106,422) (106,422)

Discount factor at 12% 1.000 0.893 0.797 0.712 0.636 0.567

Present value 650,000 (95,035) (84,818) (75,772) (67,684) (60,341)

Net present value = £266,350

This option thus offers an NPV which is £45,521 greater than the in-house option, which means that profits could be increased by contracting out the catering service.

Contracting out the catering service is thus the preferred alternative and it is recommended that Amber plc accepts the tender from the outside supplier.



(c) The financial effect can be assessed by comparing the present value of the additional costs incurred with the present value of the incremental contribution.

Workings

Additional staff training cost each year £10,000

Discount factor at 12% for years 1−5 3.605

Present value of the additional training expense £36,050

The additional contribution amounts to 10% per year for years 1−5

£24,699 each year

Discount factor at 12% for years 1−5 3.605

Present value at 12% per year £89,040

The net present value of the additional investment in staff training is therefore £89,040 less £36,050. This means that the net present value can be increased by £52,990 by retaining the service in-house, but increasing demand via improved services.

This additional net present value is greater than the £45,521 that can be achieved by switching to an outside provider for the catering service. The decision to contract out is therefore changed.

However, Amber plc must be wary of the fact that the difference between the in-house and the contracted-out service is only £7,469, i.e. (£52,990 − £45,521). The advantage is therefore relatively insignificant. Perhaps more importantly, if demand can be increased by as much as 10% for the relatively small investment of £10,000 per year (less than 2% of current variable costs), this suggests that Amber plc should perhaps look more closely at the possible opportunities for increasing the contribution from the in-house catering service before choosing to contract out. If demand is very sensitive to both price and quality, it may require little investment to make the catering service very profitable.

The gains from investing internally, however, must be weighed against the potential gains to be earned from higher demand for a contracted-out service. The additional information shows that the company will receive 5% of gross sales receipts once daily sales revenue exceeds £2,200. At present sales revenue is at £2,079 and so, if the external contractor were able to raise demand by 10%, Amber plc would receive 5% of the new annual revenue, i.e. £41,164, without incurring any additional expense. The choice, therefore, of whether to use the outside supplier or keep the service in-house is very much dependent on the anticipated levels of future demand.



WATER SUPPLY SERVICES INC

Key answer tips

It is easy to get bogged down in detail within this question. Avoid this by taking each cash flow in turn and showing detailed workings. Not only will this help you tackle the question, it will also ensure your marker can clearly see the calculations you’ve performed.

(a) Rental costs based on projected sales (assuming 15% per annum growth).

Period: 1 2 3 4 5

Demand (units): 110,000 126,500 145,475 167,296 192,391

Existing capacity: 80,000 80,000 80,000 80,000 80,000

Extra capacity required: 30,000 46,500 65,475 87,296 112,391

Number of machines required:

1 2 2 2 3

Rental costs ($): 22,000 44,000 44,000 44,000 66,000

Unit variable costs $/unit

Labour (45+64) 109.00

Material A costs 23.85

Material B costs (5 x 12.45) 62.25

Variable overheads 10.00

_____

Unit variable costs 205.10

_____

Incremental cash flow schedule:

Year: 0 1 2 3 4 5

Units: 110,000 126,500 145,475 167,296 192,391

Incremental units: 30,000 46,500 65,475 87,296 112,391

$000 $000 $000 $000 $000 $000

Variable costs (at $205.10 per unit)

(6,153) (9,537) (13,429) (17,904) (23,051)

Additional fixed costs (50) (50)

Machine rentals (see above)

(22) (44) (44) (44) (66)

Allowable costs (6,175) (9,581) (13,473) (17,998) (23,167)

Incremental revenue (allowable costs + 25%)

7,719 11,976 16,841 22,498 28,959

Capital costs (7,500) (30)

Working capital (1,158) (638) (730) (849) (969) 4,344

Net cash flow (8,658) 906 1,665 2,519 3,501 10,136

Discount factor at 20% 1.000 0.833 0.694 0.579 0.482 0.402

PV (8,658) 755 1,156 1,459 1,688 4,075

NPV + 475



Decision: project is worthwhile

Tutorial note: Workings for working capital

Year 15% of sales value

Total working

capital

Increase in working capital

1 (start of year 0) 15% of 7,719 1,158 1,158

2 (start of year 1) 15% of 11,976 1,796 638

3 (start of year 2) 15% of 16,841 2,526 730

4 (start of year 3) 15% of 22,498 3,375 849

5 (start of year 4) 15% of 28,959 4,344 969

6 (start of year 5) 0 (4,344)

(b) REPORT

To: Board of Directors

From: Accountant

Date: xx/xx/xx

Subject: Aspects of capital investment appraisal

Choice of an appropriate discount rate

The difficulty with choosing a discount rate rests on whether the correct rate for the risk/return has been derived. A number of factors are relevant here.

1 The position of the Water Authorities as a single customer. The business is potentially at risk if the Water Authorities choose to look elsewhere for their water supplies. This may mean that a higher discount rate is more appropriate.

2 The financing of the capacity expansion. This may have an impact on the discount rate if the debt/equity mix of the company is significantly altered. A number of factors are relevant here:

(a) Higher gearing is likely to induce higher costs of equity.

(b) Higher equity financing may reduce the cost of equity, but increase the overall WACC if we move off our minimum WACC.

3 A lower discount rate may be more appropriate to the extent that a long-term contract implies secure income streams.

4 Different components of the cash flows may have different variability and it may therefore not be appropriate to discount them all at the same rate.

Any non-quantifiable factors you feel might influence the decision to accept the proposal

Net present value methods are only assessments of factors that we can quantify. There may be non-quantifiable factors that also have an impact on any decision we make. Some of these may be:

1 It is important to keep our only customer happy and therefore a high standard of general service is important.

2 Future contracts are likely to depend on agreeing to the proposal. Hence, future benefits may emerge which are currently hard to quantify.



3 The continuance of the existing business relationship with the Water Authorities may position the company to expand and provide water to other sectors of the economy.

4 The existing and proposed contracts secure continued employment for personnel. This is important in a labour market that may be experiencing shortages and where key personnel are difficult to replace.



HYDEN

(a) It is helpful initially to tabulate the data given in the question.

Price

tendered

Number of

shares

Cumulative

number of

shares

Funds

raised

Number of

applicants

Cumulative

number of

applicants

$ m m $m

8.00 0.10 0.10 0.8 10 10

7.00 0.30 0.40 2.8 40 50

6.00 0.60 1.00 6.0 80 130

5.00 1.00 2.00 10.0 170 300

4.50 2.00 4.00 18.0 300 600

4.00 3.00 7.00 28.0 600 1,200

3.50 5.00 12.00 42.0 800 2,000

3.00 8.00 20.00 36.0 (W1) 3,000 5,000

Workings

(W1) A price of $3.00 will attract 5,000 applicants. A total of 12 million shares are to be issued.

12 million $3 = $36 million.

(i) Maximise funds raised

From the above table it can be seen that funds will be maximised if the striking price is set at $3.50. This means that all shares will be issued at $3.50, irrespective of the actual price tendered.

The maximum funds raised are $42 million.

To achieve 5,000 shareholders

Again from the table it can be seen that to obtain 5,000 shareholders (final column) the striking price must be set at $3.00. However, at this price a total number of shares of 20 million have been applied for and since only 12 million are to be issued, each application will be scaled down in that ratio, i.e. to 60%.

The total funds raised would be $36 million.

(ii) The investor PJ Coates

Striking price $3.50

PJ Coates tendered above the striking price and therefore he will be allocated the number of shares for which he applied, i.e. 10,000.

The shares, however, will be issued at $3.50. Since he tendered at $5.00 he will receive a repayment of $1.50 per share, i.e. $15,000.

Striking price $3.00

In this case all applications are scaled down to 60%. Therefore PJ Coates will receive

10,000 60% = 6,000 shares.

PJ Coates paid for 10,000 shares at $5.00, i.e. $50,000.

The 6,000 shares he receives cost $3.00 each making $18,000.



Therefore he will receive a repayment of $32,000.

(b) The merits of having a wide range of shareholders include the following.

(i) In the event of a threatened takeover, a company may be more secure with a large body of shareholders. It is likely to be more difficult to persuade a large number of different individuals as to the merits of a takeover than a small group of shareholders.

(ii) A small number of large shareholders will each have significant control over the company and could potentially force it to make decisions which are detrimental to any minority holders or the managers. Such influence is less likely to arise with a wide range of shareholders.

(iii) With a larger number of shareholders each holding will be on average smaller and therefore there will be less effect on the share price when an average shareholder sells.

(iv) Also, price changes are likely to be smoother, since with a large number of shareholders, the transactions will be more frequent making the market more liquid.

The disadvantages of a large number of shareholders are detailed below.

(i) The costs of administration arising from servicing a large number of shareholders will be greater.

(ii) A diversified group of individuals are likely to have different personal circumstances and therefore favour different payout policies. This could result in difficulties in determining an appropriate level of dividend payments.

(c) Rights issue

A rights issue involves the issue of new shares but to the existing body of shareholders in proportion to their existing holdings. As such the control of the company remains unchanged, provided the shareholders choose to exercise their rights. They do, however, have the option of selling their right to the purchase of the shares to a third party. The selling price will be determined from the difference between the theoretical market price of the share after the issue and the price at which the issue is to be made (normally well below market price).

Placing

The new shares to be issued are placed in the hands of an issuing house or stockbroker who arranges for the shares to be sold to a limited number of investors. Since the resultant shareholders are large, the investors are normally institutions. However, if the shares are to be quoted, 25% must be made available for general stock market trading in order to satisfy stock exchange requirements.

Comparison with an offer for sale by tender

A rights issue and a placing result in reduced issue costs, ie, advertising and prospectus costs are less due to the largely known subscribers in the case of a rights issue or the small number for a placing. An offer for sale by tender, however, is a public issue involving a large number of new shareholders.

For an offer for sale by tender, the issue price is not determined until all applications have been received. In a rights issue or a placing the share price is set in advance of the issue.



Appropriate circumstances for each method:

(i) Rights issue

For quoted companies a rights issue is the only permitted method of raising new equity as determined by the stock exchange and company law.

(ii) Placing

This is most likely to be beneficial for the issue of new equity of a non-quoted company in order to obtain a quotation at a relatively low cost.

(iii) Offer for sale by tender

This is most appropriate in circumstances where it is difficult to determine an issue price.



NETHERBY PLC

(a) Assuming that the restructuring cost is a revenue item, and that all costs are incurred in year 0, the estimated cash flow profile is:

Cash flow profile (£m)

Year

0 1 2 3 4 5 6

Item:

Closure costs (5.0)

Tax saving 1.65

Cash flow increase 2.00 2.00 2.00 2.00 2.00

Tax payment – – (0.66) (0.66) (0.66) (0.66) (0.66)

Net cash flow (5.0) 3.65 1.34 1.34 1.34 1.34 (0.66)


1.000 0.870 0.756 0.658 0.572 0.497 0.432

Present value (5.0) 3.18 1.01 0.88 0.77 0.67 (0.29)

Net present value + £1. 22 million

Hence, the restructuring appears worthwhile.

(b) A semi-strong efficient capital market is one where security prices reflect all publicly-available information, including both the record of the past pattern of share price movements and all information released to the market about company earnings prospects. In such a market, security prices will rapidly adjust to the advent of new information relevant to the future income-earning capacity of the enterprise concerned, such as a change in its chief executive, or the signing of a new export order. As a result of the speed of the market’s reaction to this type of news, it is not possible to make excess gains by trading in the wake of its release. Only market participants lucky enough already to be holding the share in question will achieve super-normal returns.

In the case of Netherby, when it releases information about its change in market-servicing policy, the value of the company should rise by the value of the project, assuming that the market as a whole agrees with the assessment of its net benefits, and is unconcerned by financing implications.

Net present value of the project = £1.22m

Number of 50p ordinary shares in issue = £5m 2 = 10m shares

Increase in market price = £1.22m/10m = 12.2p per share.

(Alternatively, the answer could be expressed in terms of Netherby’s price-earnings ratio. This would necessitate an assumption about Netherby’s sustainable future earnings per share after tax.)



(c) Arguments for and against making a rights issue include the following:

For

(i) A rights issue enables the company to at least maintain its dividends, thus avoiding both upsetting the clientele of shareholders, and also giving negative signals to the market.

(ii) It may be easy to accomplish on a bull market.

(iii) A rights issue automatically lowers the company’s gearing ratio.

(iv) The finance is guaranteed if the issue is fully underwritten.

(v) It has a neutral impact on voting control, unless the underwriters are obliged to purchase significant blocks of shares, and unless existing shareholders sell their rights to other investors.

(vi) It might give the impression that the company is expanding vigorously, although this appears not to be the case with Netherby.

Against

(i) Rights issues normally are made at a discount, which usually involves diluting the historic earnings per share of existing shareholders. However, when the possible uses of the proceeds of the issue are considered, the prospective EPS could rise by virtue of investment in a worthwhile project, or in the case of a company earning low or no profits, the interest earnings on un-invested capital alone might serve to raise the EPS.

(ii) Underwriters’ fees and other administrative expenses of the issue may be costly, although the latter may be avoided by applying a sufficiently deep discount.

(iii) The market is often sceptical about the reason for a rights issue, tending to assume that the company is desperate for cash. The deeper the discount involved, the greater the degree of scepticism.

(iv) It is difficult to make a rights issue on a bear market, without leaving some of the shares with the underwriters. A rights issue which ‘fails’ in this respect is both bad for the company’s image and may also result in higher underwriters’ fees for any subsequent rights issue.

(v) A rights issue usually forces shareholders to act, either by subscribing direct or by selling the rights, although the company may undertake to reimburse shareholders not subscribing to the issue for the loss in value of their shares. (This is done by selling the rights on behalf of shareholders and paying over the sum realised, net of dealing costs.)

(d) Ignoring the impact of the benefits of the new project:

The rights issue at £2 involves 2.5m new shares.

The EPS was £15m/10m = £1.50p per share.

Hence, EPS becomes 2.5m10m

£15m = £1.20

With the debt financing, the interest charge net of tax = [12% £5m] [1 33%] = £0.40m

Hence, EPS becomes m10

m400m15 .££ = £1.46



Allowing for the benefits of the new project

The annual profit yielded by the proposal, after tax at 33% = (£2m 0.67) = £1.34m, although the cash flow benefit in the first year is £2m due to the tax delay.

After the rights issue, the prospective EPS will become:

[£15m + £1.34m]/12.5m = £1.31 per share

With debt finance, the financing cost, net of tax relief, of £0.40m pa reduces the net return

from the project to (£1.34m £0.40m) = £0.94m pa.

(In the first year, the cash flow cost will be the full pre-tax interest payment. Thereafter, Netherby will receive annual cash flow benefits from the series of tax savings.)

The EPS will be: £15.94m/10m = £1.59 per share.

Therefore, in terms of the effect on EPS, the debt-financing alternative is preferable, although it may increase financial risk.



DEBENTURES

(a) (i) Debentures with a floating rate of interest

Such debentures are likely to be advantageous to both borrowers and lenders in circumstances where the market interest rates are volatile. The coupon rate of the debenture may be adjusted to reflect the current market rate of interest. Therefore, if interest rates fall the borrower’s costs also fall due to a decreasing of the coupon rate and the borrower avoids being committed to a high fixed rate of interest. On the other hand, if interest rates rise this will be reflected in an increase in the coupon rate and higher interest payments to lenders.

Due to the matching of the coupon rate to the market rate of interest, the market price of the debentures will be much more stable. This may be attractive to lenders and therefore such debentures will be a means for borrowers of readily obtaining required funds.

(ii) Zero-coupon bonds

As with the floating rate debentures, zero-coupon bonds are attractive in times of volatile interest rates. No interest is payable on the bonds, but the interest is effectively accrued and accounted for in the redemption value of the bond, or reflected in its current market value. Therefore the lender may sell the bond at any time during its life and recover an amount of interest which reflects the current market rates applicable during the period of ownership. The lender has therefore not been locked in to a low fixed rate of interest, but has been able to participate in higher rates, if there had been an interest rate rise since the issue of the bonds. Similarly the cost to the borrower will reflect the interest rates prevailing during the period of issue, as such interest rates will be incorporated in the final redemption value.

The cash flow effect of zero-coupon bonds represents another advantage to the borrower.

Short-term cash flows are preserved since no interest payments are made during the life of the bond.

(b) An amount of £200 will purchase debentures with a nominal value of:

£200 (£80/£100) = £250.

This will yield an annual interest payment at the 12% coupon rate of:

£250 12% = £30.

The market value of £80 per cent quoted is ex-interest and therefore the first interest payment will be receivable in one year’s time.

Since the lender’s required rate of return is 15%, the following cash flows associated with the investment should be discounted at that rate.

Discount Present Time factor value £ £ 1.6.X1 Investment (200) 1 (200.00) 31.5.X2–X4 Interest 30 2.28 68.40 31.5.X4 Redemption value (at par) 250 0.66 165.00 Net present value £33.40



Since the net present value of the cash flows when discounted at 15% is positive the investment yields a return in excess of the required return of 15%.

(c) (i) The issue of long-term securities will be most advantageously made at a time of low interest rates and high investor confidence.

Index-linked gilts represent a virtually risk-free investment since the uncertainty of inflation is eliminated. Thus the risk-free rate is 3¾%. If the forecast rate of inflation is incorporated into this rate, we obtain a risk-free rate somewhere between 7% and 8%. Therefore the risk premium on the long-dated government stock is very low, since its yield is about 8%. This is probably due to the low anticipated rate of inflation for the foreseeable future, which inspires investor confidence. As a result of the low risk premium leading to low interest rates, the current time would seem to be advantageous for the issue of long-term securities.

(ii) The possible impact on interest rates of the following factors.

(1) Changes in the level of consumer credit.

A high level of consumer credit is associated with a high risk from the point of view of the lender, relating to possible defaults on repayment. This may cause interest rates to rise. Alternatively or additionally the increased demand for money supplies may cause an increase in interest rates. The converse will be true for a decrease in the level of consumer credit.

(2) Forecasts of the balance of payments.

A country’s balance of payments position determines the demand for its currency through the balance of imports and exports. This will therefore affect the money supply. An increased pressure on the money supply will cause interest rates to rise, whereas with lower demand interest rates may fall. There will also be an impact on exchange rates.

(3) Rumours of a general election

An impending parliamentary general election may affect interest rates depending on the policies of the party likely to succeed in being elected to govern. Interest rates will be affected mainly by the party’s policy concerning money supply and demands on the money market.



PRIME PRINTING CO

(a) A finance lease is usually arranged with a finance house, with the intention of providing the business (lessee) with the funding to acquire an asset. The time scale of a finance lease is set such that at the end of the initial leasing period, the lessor has more than recovered the cost of the asset. The lessee is then given the choice of either continuing to lease the asset at a small ('nominal') rental, or selling the item on behalf of the lessor and retaining the bulk of the proceeds.

The cash flow pattern of a finance lease is such that cash flow is evenly spaced throughout the leasing period, and the company acquiring an asset is not therefore required to pay out a large sum of cash in one go in order to obtain the use of that asset. The interest rate charged for the finance is usually fixed for the duration of the lease, and the predictability of the outgoing cash flow in such circumstances can be very useful in helping smaller companies to plan their finances. One possible area of uncertainty about expenditure is that under such an agreement, the lessee is responsible for maintenance costs of the equipment/machinery. These costs might not be easily predictable, and be related to level of usage.

A cash flow advantage may arise because of the tax treatment of finance leases. Some businesses may be earning insufficient profits to allow them to take advantage of all the capital allowances that may be available to them if they choose to purchase machinery and equipment outright. Where a finance lease is used, no capital allowances can be claimed by the lessee, but instead the lessee can claim tax relief against the full leasing cost. The lower annual cost could mean that the company is able to maximise its use of tax relief, and so reduce the effective cost of the leased equipment.

An alternative source of medium-term finance is a bank loan. In terms of cash flow, the loan agreement will define the level of regular repayments, which will be a mix of capital repayment plus an interest component. The loan may be subject to either a fixed or a variable rate of interest. In the latter case, the repayments may change over the life of the loan, if interest rates alter. Under such circumstances the cash flow pattern is clearly less certain than under a finance lease based on a fixed finance charge.

The company can claim capital allowances on the purchase, and so obtain tax relief to reduce its corporation tax liability. As indicated above, such tax relief is only of value if the company has profits against which the relief can be offset. This means that the tax paying position of a company plays a critical role in determining the comparative advantage of leasing versus borrowing to pay for a business asset.

A third source of finance to pay for acquisition of a business asset is the use of existing cash holdings/funds on deposit. Where funds are withdrawn from deposit, there will be a cash-flow impact in terms of the loss of regular interest receivable. Furthermore, the conversion of the current asset of cash into a fixed asset (piece of equipment) alters the structure of the company’s balance sheet. The outflow of a single large cash payment will reduce the liquidity of the business (at least temporarily). If cash flows from operations are adequate to meet regular cash outgoings, this will not matter. If, however, there is a potential cash shortfall, this is not a sensible source of funding for asset purchases. As with loan finance, the purchase of the asset for cash means that capital allowances can be claimed, and the same considerations on the usefulness of those allowances need to be taken into account.

(b) Tutorial note: The first decision to consider is the acquisition decision, i.e. is it worthwhile acquiring the machine, assuming that it is purchased? For this assessment we use the company's cost of capital. If the acquisition appears to be financially justified, the second decision is the financing decision, i.e. should the machine be purchased with money from a



loan or should it be leased? For this assessment, we use the after-tax cost of borrowing as the cost of capital.

Workings

(W1)

Written down value of asset

Writing down allowance (WDA)

(25%)

Tax saving due to WDA

(30%)

$ $ $

Year 1 120,000 30,000 9,000

Year 2 90,000 22,500 6,750

Year 3 67,500 16,875 5,063

Year 4 50,625 12,656 3,797

Year 5 37,969

Year 5 Balancing allowance (see above)

37,969 11,391

(W2) Taxable profits and tax liability

Year Cash savings Capital allowance Taxable profits Tax at 30%

$000 $ $ $000

1 50 30,000 20,000 6.00

2 50 22,500 27,500 8.25

3 50 16,875 33,125 9.94

4 50 12,656 37,344 11.20

5 50 37,969 12,031 3.61

Acquisition decision

Year Equipment Cash savings

Tax Net cash flow


Present value

$000 $000 $000 $000 $000

0 (120.0) (120.00) 1.000 (120.00)

1 50 50.00 0.870 43.50

2 50 (6.00) 44.00 0.756 33.26

3 50 (8.25) 41.75 0.658 27.47

4 50 (9.94) 40.06 0.572 22.91

5 50 (11.20) 38.80 0.497 19.28

6 (3.61) (3.61) 0.432 (1.56)

NPV 24.86

The NPV is positive and so the company should acquire the machine.

Present value of purchase

Discounting cash flows at the after tax cost of borrowing, i.e. at:

13% 0.7 = 9.1%, say 9%.

Note: This is approximate, as tax relief is lagged by one year.



Year Item Cash flow Discount factor at 9%

Present value

$ $

0 Purchase cost (120,000) 1.000 (120,000)

2 Tax savings from allowances 9,000 0.842 17,578





NPV of cost (94,369)

Present value of leasing

The lease payments would be made annually in advance.

Year Lease payment Tax savings Discount factor at 9%

Present value

$ $

0 – 4 (28,000) p.a. 4.239 (118,692)

1 – 5 8,400 p.a. 3.890 32,676

NPV of cost (86,016)

This means that it is cheaper to lease the machine than to purchase it via the bank loan.



BOLAR & BOND YIELDS (a) Calculation of annual redemption yield

The basic approach with redeemable debt is to calculate the IRR for the cash flows from now to the date of redemption (once that has been identified), remembering to use the current market value excluding accrued interest i.e., ‘ex-interest’.)

Unsecured 14% bonds

Year Cash flow Discount Present Discount Present

factor value factor value

$ 14% $ 18% $

0 (95) 1.000 (95.00) 1.000 (95.00)

1 14

2 14 2.322 32.51 2.174 30.44

31/12/2009 3 14

31/12/2009 3 100 0.675 67.50

_____

0.609 60.90

_____

NPV 5.01

_____

(3.66)

_____

Annual redemption yield = 14 + (5.01/(5.01 + 3.66) × (18 – 14)) = 16.31%

10% secured loan stock

Period Cash flow Discount Present Discount Present


$ 5% $ 8% $

0 (91.5) 1.000 (91.50) 1.000 (91.50)

1-10 5 7.722 38.61 6.710 33.55

10 100 0.614 61.40

_____

0.463 46.30

_____

NPV 8.51

_____

(11.65)

_____

IRR = 5 + 65.1151.8

51.8 (8 – 5) = 6.27%

This equals the six monthly rate so the annual redemption yield is approximately

(1.0627)2 = 1.129 , i.e.12.9%

8% unsecured convertible loan stock

(1) Share price increases by 5% pa

Calculation of value of shares:

On 1/1/2009 share price = 190 (1.05)2 = 209.475

$

Value of shares available = 100

40475209. = 83.79

Value of loan stock = 88.50

conversion would not take place.



Yield



$ 8% $ 14% $

0 93 (100 0.08) = 85 1.000 (85.00) 1.000 (85.00)

1-10 100 0.08 = 8 6.710 53.68 5.216 41.73

10 100 0.463 46.30

_____

0.270 27.00

_____

NPV 14.98

_____

(16.27)

_____

IRR= 8 + )814(27.1698.14

98.14 10.9%

(2) Share price increases by 10% pa

On 1/1/2009 share price = 190 (1.10)2 = 229.9

$

Value of shares available = 100

409.229 = 91.96

Value of loan stock = 88.50

conversion will take place (if transaction costs are ignored).

Yield



$ 8% $ 14% $

0 (85) 1.000 (85.00) 1.000 (85.00)

1-2 8 1.783 14.30 1.647 13.20

2 91.96 0.857 78.80

_____

0.769 70.70

_____

NPV 8.10

_____

(1.10)

_____

IRR = 8 + )814(1.11.8

1.8 13.3%

(b) Summary of redemption yields

(1) Unsecured 14% bonds – 16.31%;

(2) 10% secured loan stock – 12.9%;

(3) 8% unsecured convertible loan stock 10.9% or 13.3%;

The yield on a security would normally be equal to the risk-free rate plus a premium to reflect the particular default risk of that security. The yield for (1) is relatively high because the bonds are unsecured.

The yield for (2) is lower than for (1) to reflect the fact that the loan stock is secured.

The yield for (3) is dependent on what happens to the market price of the shares and therefore whether conversion takes place, but will tend to be lower



than for (1) because of the potential benefit from being able to convert the loan stock into ordinary shares.

(c) The term structure of interest rates is revealed by the redemption yield data. As the maturity period of the debt increases, so does the redemption yield, indicating an upward sloping yield curve. There are several theories which might explain the shape of the yield curve.

The expectations theory suggests that if the yield curve is upward sloping, this reflects the expectation that inflation levels, and therefore interest rates, will increase in the future.

The liquidity preference theory considers that even if there is no expectation of a change in inflation levels the yield curve will still be upward sloping. This is because investors have a natural preference for more liquid (shorter maturity) investments, and in order to entice them to invest in longer maturity bonds a higher rate of interest needs to be offered to compensate for the loss of liquidity. Hence the longer dated the stock, the higher the redemption yield, leading to an upward sloping yield curve.

The market segmentation theory suggests that the shape of the yield curve is in part influenced by the size of activity of investors in various segments of the market. Investors are assumed to be risk averse and to invest in segments of the market that match their liability commitments. For example pension funds would tend to invest in long-term maturities to match the long-term nature of their liabilities. If more investors are active in the long-term end of the market than the short-term end, the interest rate structure and therefore the shape of the yield curve might be influenced by the transactions of these investors.



HOTALOT CO

(a) The equity beta measures the systematic risk of a company’s shares. A beta of 0.95 suggests that Hotalot is slightly less risky than the market as a whole.

The alpha value is the measure of the excess returns of an investment that has been adjusted for risk

(b) Hotalot’s diversification into freezer production will change the company’s risk profile. The systematic risk of freezer production can be estimated from the betas of the firms already producing freezers. As all the companies listed have a similar market value, the weighted average equity beta is

1 1 1 25 1 30 1 05

41 175

. . . ..

The equity beta reflects the financial gearing of the companies in the industry. It is therefore necessary to de-gear the equity beta of the freezer industry, and re-gear to take account of Hotalot’s gearing.

Gearing of freezer industry(MV) Equity $192m ( EPS PE ratio no shares) for the 4 companies Debt $40.1m

To de-gear industry beta:

u = E

E + D (1- t )g =

192

192 40 1 0 70. ( . ) 1.175 =

192

220 1.175 = 1.025

Gearing of Hotalot (MV) Equity $33.92m (106c 8 4m)

Debt $17.4m

To re-gear for Hotalot:

g = u (1 + (1 t) D

E) = 1.025 (1 +

17 4 0 70

33 92

. ( . )

.) = 1.393

Required return = Rf + (Rm Rf) Beta = 9% + (16% 9%) 1.393

= 9% + (7%) 1.393 = 9% + 9.75% = 18.75%

This is the required rate of return for Hotalot’s equity investment in freezers.

β α

Return of market

less risk free rate

Return of share

less risk free rate



The WACC required is therefore Ke E

E D + Kd(1 t)

D

E D =

18.75% 33 92

51 32

.

. + 9.5% (1 0.30)

17 4

51 32

.

. = 12.39 + 2.25 = 14.64%.

Hotalot should use a discount rate of 14.64% for the appraisal of its diversification into freezer production.

(c) It is not realistic to assume that corporate debt is risk-free. Companies may default on both the interest payments and the principal repayments. If corporate debt is not entirely risk-free, then ungeared betas will be underestimated, and geared betas will be overestimated.

As Hotalot only pays 9.5% compared with a risk-free rate of 9% we can assume Hotalot debt

to have a beta value of 0.06. [9.5 (16 9) 0.06 9].

The asset beta (ungeared) is determined by:

u = g t)D(1E

E + d

t)D(1E

D

u = 1.175 192

192 40 1 1 0 30. ( . )+ 0.06

40 1 1 0 30

192 40 1 1 0 30

. ( . )

. ( . )

= 1.175 192/220 + 0.06 28/220 = 1.033

Re-gear: solve for g using Hotalot’s gearing:

u = g t)D(1E

E + d

t)D(1E

D

1.033 = g )30.01(4.1792.33

92.33 + 0.06

)30.01(4.1792.33

)30.01(4.17

1.033 = g 1.46

92.33 + 0.06

1.46

18.12

1.033 = g (0.736) + 0.016

g = 1.382

Ke= 9% + (16% – 9%) 1.382 = 18.674%

WACC = 18.674% 33 92

51 32

.

. + 9.5% (1-0.30)

17 4

51 32

.

. = 12.34 + 2.25 = 14.59%

This compares with the previous WACC of 14.64%, which as stated above was overestimated.



GEARBOX CO

It is useful to first summarise the traditional and Modigliani and Miller theories of gearing so that the board members’ comments can be appraised with reference to those.

Traditional theory

Whether or not there is tax relief for interest payments on debt, the basic patterns of the costs of capital under the traditional are the same. If there is tax relief for interest the cost of debt line is lower and the dip in the WACC is more pronounced.

At low levels of gearing, neither the equity shareholders nor the debenture holders perceive any increase in the risk they suffer, so the costs of equity and debt remain constant. The cost of debt is lower than the cost of equity because it is a less risky investment (security can be given and debt holders are repaid before equity owners in the event of a liquidation). So, as gearing increases, cheap debt is mixed in with the more expensive equity and this drags down the weighted average cost of capital. At higher levels of gearing, however, both types of supplier of capital perceive their risks to be increasing and both costs start to rise, inevitably causing the WACC to rise.

The traditional theory therefore predicts that there is an optimum gearing ratio at which the WACC is minimised.

Modigliani and Miller – no tax

As soon as any gearing is introduced, the equity shareholders perceive an increase in their risk and demand an increased return on their investment. At normal levels of gearing the cost of debt remains constant. Modigliani and Miller showed that, provided conditions of market perfection existed, the cost of equity would rise in such a way that the WACC remains constant as additional debt is introduced. Companied should therefore be indifferent about their gearing ratios as their WACC will remain constant.

At very high levels of gearing (indicated by the shaded area in the diagram) additional costs, such as bankruptcy costs, become relevant and the cost of debt and equity will rise, pushing up the WACC. However, the essential conclusion for Modigliani and Miller without tax is that, at normal levels of gearing, the WACC is independent of gearing.

Gearing

Cost of capital

Cost of equity

Cost of debt

WACC

Optimum



Modigliani and Miller – with tax

The introduction of tax and tax relief on interest makes debt uniquely cheap. Although the cost of equity will rise as gearing increases, the additional debt in the mix is cheap enough to pull down the WACC as gearing increases.

Again everything will begin to rise at very high levels of gearing, but the essential message of the Modigliani and Miller theory with tax is that gearing up is good as it makes more and more use of a uniquely cheap source of finance – debt which enjoys tax relief on the interest.

Board member A’s comments

‘If we issue debt then the gearing of the company will rise. This introduces more risk and to compensate the cost of capital will rise and that will reduce the NPV of projects.’

Under the traditional theory, the cost of equity will eventually rise. However, what’s important for project appraisal is the weighted average cost of capital and this falls initially as relatively cheap debt is introduced into the mix of capital. The lower the WACC is, the higher the NPV of projects. The traditional theory predicts that some debt is good and that this will enable the company to move to an optimum gearing level where the WACC is minimised and the NPV of projects is maximised.

Gearing

Cost of capital

Cost of equity

Cost of debt (post tax)

WACC

Optimum

Gearing

Cost of capital

Cost of equity

Cost of debt

WACC

Optimum



If the Modigliani and Miller theories are being followed, then if there is no tax, the cost of capital (WACC) is not changed with moderate gearing. If there is tax, then the WACC falls with moderate gearing.

Board member B’s comments

‘Debt is a cheap form of finance, especially as the interest on it will attract tax relief. Even if we did not pay tax, debt is cheaper than equity and the more debt we have then the cheaper our overall mix of finance will be.’

For moderate levels of gearing this statement is true for both the traditional theories and the Modigliani and Miller theory with tax. Modigliani and Miller without tax predicts that the WACC is unaffected by gearing.

Board member C’s comments

‘Both of you are correct in some respects. It’s all a matter of degree: some debt is good, too much is bad, even where there is tax relief.’

These comments are essentially correct, unless one is a follower of Modigliani and Miller without tax relief, where some debt is initially of no impact on the WACC and very high debt is likely to push up the WACC.



SLOHILL INC

(a) (i) Slohill’s cost of capital may be estimated using the dividend valuation model. The cost of capital is the weighted average of the cost of equity and debt

Cost of equity = Ke or re= gP

g) (1 D

0

0 = gP

D

0

1

The growth in dividends during the last four years has been approximately 11 % per year.

The current dividend per share is 14.98/69.00 = 21.71 cents

D1 is estimated to be 21.71 (1.11) = 24.10 cents

Ke = 546

10.24 + 0.11 = 0.154 or 15.4%

The current cost of debt, Kd. is approximately

11% 93

100 = 11.83% or 7.7% after tax.

This assumes no pull to maturity as the loan stock is 15 years from redemption. A more accurate after tax estimate may be obtained by calculating the IRR of the loan stock. This proves to be 8% and this is the figure that will be used in the cost of capital estimates.

The proportions of debt and equity in the capital structure, by market weightings are:

$m Proportion

Equity 376.74 74.6%

Debt 128.34 25.4%

Total 505.08

The current weighted average cost of capital is estimated to be:

(15.4% 0.746) + (8% 0.254) = 13.52%

It the crash occurs but has a negligible effect on the company’s earnings D1 and g are likely to remain unchanged. The share price will fall by 30% to approximately 382 cents.

Ke will rise to: Ke = 382

10.24 + 0.11 = 0.1731 or 17.31 %

Increased demand for fixed interest stock will result in a rise in their market price and a fall in interest rates.

Using 6.7% as the new approximation of the after tax cost of debt (6.7% is 8% − 2% (1 − 0.35)), the market price will increase to approximately ($7.l5 × 9.289) + ($100 × 0.379) = $104.32.

The new market values, using $104.32 as the loan stock price, are:

$m Proportion

Equity 263.72 64.69%

Debt 143.96 35.31%

Total 407.68



The cost of capital would alter to approximately

(17.31 % 0.6469) + (6.7 0.3531) = 13.56%

(ii) If the annual pre-tax growth rate of the company's earnings falls by 20% it is assumed that this will result in a similar fall in the annual growth rate of dividends, as average annual growth rates in earnings and dividends were similar during the last four years (both approximately 11 %)

g would fall from 11 % to 8.8%

D1 to 21.71 (1.088) = 23.62 cents

Ke is estimated to be 382

62.23 + 0.088 = 14.98%

Kd remains at 6.7% and the market weighted proportions remain the same. The cost of capital is approximately (14.98% ×.6469) + (6.7% ×.3531) = 12.05%

(b) If all equity is raised and the company's earnings expectations remain unchanged (expected earnings per share is assumed to be unchanged) the cost of equity will rise, because of the fall in share price, and the weighted average cost of capital is likely to rise. At existing gearing levels the weighted average cost is expected to remain almost constant (as estimated in part (a) (i) of the answer) but the higher proportion of equity after the new issue is likely to increase weighted average cost as equity is much more expensive than debt.

If earnings' expectations fall, and the annual growth rate of dividends falls by a similar amount, the cost of equity and debt, will fall, as estimated in part (a) (ii) of the answer. The weighted average cost of capital could either fall or rise depending upon the size of the new equity issue and the resultant proportion of equity in the capital structure. A fall in the weighted average cost is more likely as, ceteris paribus, a rise in the weighted average cost would require a new equity issue larger than the company's existing equity capital.

If debt finance is used in both situations a fall in the weighted average costs is likely to occur as a higher proportion of relatively low cost debt is used in the capital structure. This assumes that the cost of equity and debt do not significantly increase because of the extra financial risk caused by the higher gearing.

The effect on the company's perceived riskiness of the change in cash flow resulting from investing the new capital (whether raised in the form of equity or debt) will also influence the cost of capital.

(c) The capital asset pricing model states that the required return on equity (or Ke) =

)R - )(E(r R )E(r fmfi i==

If interest rates fall Rf, the risk free rate will fall under both scenarios. E(rm), the expected return on the market portfolio is likely to increase under scenario (i). As share prices fall, with no change in earnings expectation, the expected return on the market portfolio will rise.

Under scenario (ii) E(rm) could rise or fall depending upon how much the market's earnings are expected to fall as a result of the crash. A very large fall in expected earnings could result in a fall in E(rm).

Beta measures the systematic risk of the company's equity relative to the market as a whole. If there is no change in the earnings expectations of the company and the market and the share price(s) of the company and the market fall by a similar amount, the

company's equity is likely to remain approximately constant.



If changes in earnings expectations occur which differ between the company and the market, the return on the company's equity could be more or less volatile relative to

market returns than previously, and the company's equity could either increase or decrease.



GUIDANCE MANUAL

(i) The discount rate used should normally reflect the weighted average cost of equity and debt, taking into account the systematic risk of the investment. The company’s weighted average cost of capital should only used if the investment has a similar systematic risk to the company as a whole, and if the gearing of the company is unchanged.

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

(iii) If the estimated using either the dividend valuation model or the capital asset pricing model. In theory the two models should provide the same estimate of the cost of equity. In many instances because of market imperfections, and problems in the estimation of an appropriate growth rate in the dividend valuation model the two models often give different results. CAPM is normally considered to be the better alternative. However, this model also has theoretical weaknesses and there may be problems in obtaining data to input into the model.

(iv) The cost of debt should be based upon the current market cost of debt. Where different types of debt are used, estimates of more than one debt cost may be necessary, and these costs weighted according to the proportion of each type of debt that is used. The redemption yield of existing debt may be used to estimate the cost of debt if no obvious market price is available. If the company is in a tax paying position the cost of debt should be estimated net of any tax relief on interest paid on the debt.

(v) There is no need to round the solution up to the nearest whole percentage. NPV estimates may be made using the estimated cost of capital without rounding. The estimated cost is likely to be subject to some margin of error, and sensitivity analysis using alternative discount rates is suggested to investigate the significance of an incorrect discount rate to be estimated NPV of the investment.

Revised illustrative examples

Illustration 1 – When the company is expanding existing activities:

Cost of equity

Dividend valuation model: Ke or re= gP

g) (1 D

0

0 = 06.0428

(1.06) 24 = 0.119 or 11.9%

An incorrect formula for the dividend valuation model was used in the draft. An estimate of the next dividend, not the current dividend should be used.

The growth rate should be based upon dividend growth and not earnings growth.

Capital asset pricing model:

The equity beta and not the asset beta is required when estimating the cost of equity

Assuming debt to be risk free, e

de

ea β

T)) (1 V (V

V β

eβ0.3)) (1 85 (214

2141.1

The equity beta is 1.41

The CAPM estimate of the cost of equity will be used in the estimate of the weighted average cost of capital:



Ke = )R )(E(r β R )E(r fmifi = 6% + (14% – 6%)1.41 = 17.28%

Cost of debt

The loan stock will be used to estimate the current cost of debt as it is the only marketable debt. The current market value of the loan stock is $45m, $85m less the $40m amount of the bank loan. Tax relief has been omitted from the estimate of the cost of debt. The annual after tax cost of interest payments on the loan stock is $40m × 10% (1–0.3) or $2.8m, assuming no lag in time before tax relief on interest is available.

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

45 = )k1(

8.2

d

+ 2)k1(

8.2

d

+ 3)k1(

8.2

d

+ 4)k1(

8.42

d

By trial and error

At 5% interest

2.8 × 3.546 = 9.93

40 × 0.823 = 85.42

92.32

5% discount rate is too high

At 3% interest

2.8 × 3.717 = 10.41

40 × 0.888 = 93.45

52.35

Interpolating:

3 + ((0.93 / (0.93 + 2.15)) × 2% = 3.60%

Market value of equity $214m

Market value of debt $85m

Weighted average cost of capital:

(17.28% × (214 / 299)) + (3.60% × (85 / 299)) = 13.39%

No further adjustment for inflation is necessary as the estimates of the cost of equity and cost of debt already include inflation.

Illustration 2 – When the company is diversifying its activities.

Cost of equity:

The beta of the comparator company will be used to estimate the systematic risk of the new investment.

No ungearing is necessary, as the asset beta of the comparator company is given. This will need to be regeared to take into account the capital structure of our company.

Regearing:

Beta equity = beta asset × ((Ve + Vd(1 – T)) / Ve)

= 0.90 × ((214 + 85(1 – 0.3)) / 214)

= 1.15



Using the capital asset pricing model:

Ke = )R - )(E(r R )E(r fmfi i== = 6% + (14% – 6%) 1.15 = 15.20%

Cost of debt: This remains at 3.60%

Market value of equity $214m

Market value of debt $$85m

Weighted average cost of capital:

(15.20% × (214 / 299)) + (3.60% × (85 / 299)) = 11.90%

The discount rate to be used in the investment appraisal when diversifying into the new industry is 11.90%



MASTER CO

(a) The asset based valuation views a business as a collection of assets. This should include both tangible and intangible assets and the valuation should be based on the current market value of these assets. However, there are problems in practice since it may be difficult to determine a market value and in addition there are often two distinct values: a net realisable value in a sales situation and a purchase price or replacement cost. Therefore often both are quoted with the latter representing the maximum price a potential purchaser would be prepared to pay and the net realisable value being the minimum acceptable price to the vendor.

The earnings based calculation views a business as an entity with the capacity to generate a series of cash flows over a future period of time. These cash flows are capitalised in order to determine a current valuation. The method used for capitalisation depends in practice on the data available. Ideally the cash flows should be discounted at an appropriate rate reflecting the risk associated with these cash flows. In practice a P/E ratio is commonly applied to the company’s earnings stream, which is effectively discounting earnings in place of cash flows.

In theory both bases should give the same valuation, since one determines capital values directly and the other calculates those same capital values via the cash flows. However, in practice the difference probably lies in the existence of intangible assets which cannot be identified by a review of the company’s asset base. Yet these intangible assets may contribute substantially to the cash being generated by the company and will thus contribute to the valuation under the earnings based method. Such intangible assets would include customer relations, contact with retail outlets, the skill and competence of key personnel, the success of the production.

The two bases have implicitly different views with respect to the going concern status of the company. The earnings approach to valuation places a value on the business as a going concern, i.e. its ability to generate future positive cash flows. The asset-based method, however, reviews the current position of the company without great consideration being placed on the future use of its assets. It considers simply the current market value of these identifiable assets.

(b) If it is intended to value a business on the basis of its assets, the greatest problem is likely to be the determination of the market value of its fixed assets, which will be where its substantial value lies. The problem will arise for assets that are very specialised in nature such that no market exists for them or assets which have aged and become obsolete over time. It may be possible to determine a net realisable value for the latter category, but in order to be able to make a reasonable assessment of company value a figure for the replacement cost is also required. The difficulties associated with this are likely to be considerable. For a highly specialised asset it may be possible to determine a replacement cost if newly manufactured, but this would then need to be converted into a second-hand value for the existing asset.

As was mentioned in part (a) the asset-based valuation has a tendency to ignore the effect of intangible assets which do not appear in a company’s accounts. Therefore some attempt should be made to affix a value to the company’s goodwill if this is not shown on the balance sheet.

In addition there are other assets and liabilities which should not just be taken at their balance sheet valuation. For instance, an assessment should be made as to the collectability of debtors and the realisable value of stock. A further difficulty may arise in determining the accuracy of liabilities and particularly subjective provisions.



The major justification for using the earnings based method is that it gives the discounted present value of future cash flows generated by the business. However, in order for this to be accurate, a prediction in detailed terms must be made of the company’s anticipated earnings. Historic data may act as a guide but it is necessary also to consider many factors which may have an impact on future cash flows.

A second major difficulty lies in the determination of a suitable discount rate or P/E ratio. For a private company such as Klinard Co such statistics are not available, nor are data in order to calculate a discount rate. Therefore the usual means of overcoming the problem is to take the cost of capital or P/E ratio for a similar quoted company, if such exists. An assessment must then be made as to the difference in risk between this company and the private company to be valued and an appropriate adjustment made to the discount rate or P/E ratio. In addition differences in growth rates of earnings must be taken into account.

(c) We are told that Klinard Co has recently experienced substantial trading difficulties. This might suggest that the company is close to liquidation and that an acquisition by a company similar to Master Co is the only means of avoiding collapse. In a winding up, the shareholders would only receive the net realisable value of the company’s assets after all liabilities have been met, which will include liquidation fees. Therefore it is unlikely that the shareholders would receive a substantial payout and they may be prepared to accept a valuation on the basis of net realisable value.

Klinard may, however, have overcome its recent trading difficulties and be in a position to continue as an independent going concern. As such an earnings based valuation would be more appropriate, since this would take account of the value of these intangible assets which would not be identified if net realisable value were used. However, if Klinard is just emerging from its difficulties, its earnings may still be at a low level. Therefore, in order to achieve a fair value a careful appraisal must be made of the potential future earnings when trading recovers further. In addition, consideration should be given to the possible level of earnings under a new more efficient management team, since this may assign a fairer value to the underlying assets of the business.

A final justification for the earnings valuation is based on the intentions of Master Co. The proposed acquisition represents diversification of activities for Master Co and therefore Klinard is attractive as a going concern enterprise.



FOUNDER

(a) Let number of shares in issue prior to new issue

= x

Number of shares to be traded on AIM = 300,000 + (5% + 12½%)x

= 300,000 + 0.175x

25% of the total shares are to be traded (see tutorial note).

Hence: 25% (300,000 + x) = 300,000 + 0.175x

75,000 + 0.25x = 300,000 + 0.175x

x = 3,000,000

Profit after interest and tax = 764,000 – (38,000 + 254,000)

= £472,000

Historical earnings per share = £ ,

, ,

472 000

3 000 000

= 15.7p

Issue price = P/E ratio EPS = 7 15.7p

~– 110p

(b) Using the above calculation, the net proceeds from the issue would be:

300,000 1.1 – 40,000 = £290,000

This amount will just repay the opening borrowing and therefore will improve the projected cash flow by the saving in interest payments. If it is assumed, for instance, that the effective interest rate is 12% pa, the saving in interest payments in 20X2 will be approximately £35,000, resulting in budgeted net interest receivable of £5,000 and almost entirely covers the £40,000 costs of issue. Inserting these figures into the budget as it stood prior to the flotation results in the following revised budget:

£000

Closing balance sheet

Operating assets 3,058

Taxes and dividends payable (391)*

Cash (–118 + 290 + 35) 207 ____

2,874 ____

* Dividends payable = 99 1.1 = 109.



£000

Profit statement

Operating profit (840 – 40) 800

Interest 5

Tax provision (282)

Dividend declared (109)

Retentions 414

Cash flows

Operating profit 800

Increase in operating assets (291)

509

Share issue 330

Interest 5

Taxation and dividends (344)

500

Opening borrowing (290)

Closing cash balance 210

(c) It should be pointed out that at the time of flotation the above information would not be available to a prospective investor. The 20X1 accounts would not be published and the budgets are for internal purposes only. However, the company would need to issue a prospectus which contains information on the future prospects of the business as well as the past three years’ results. Indeed much of the information in the budgets would be included. Some of these statements, e.g. the past three years’ results are required to be endorsed by the company’s auditors. Apart from the information given in the prospectus, investors will need to form their own judgement on the future prospects of the business using further information from external sources. Factors to be considered would include:

(i) What are the economic prospects of the industry in which F Ltd operates? Is it seen as a declining industry or are there prospects for growth? What difference if any will the developing single European market make, are there likely to be any European regulations which could damage the company by forcing changes in production practice or in the products themselves?

(ii) How are changes in the general economic climate likely to affect the business? Could it survive a deep recessionary period?

(iii) Who are F Ltd’s major competitors and how has F Ltd managed to maintain a competitive edge over these competitors? Are its strengths likely to be emulated or eroded by the competitors or new entrants into the industry?

(iv) How dependent is F Ltd on Founder and what is the certainty of his continued commitment?

(v) What is the management style of the company and how good are employee relations? Sound management principles dictate that employees be kept informed,



as far as possible, of impending change. Have they been informed of the impending flotation or been given an opportunity to participate?

(vi) The prospectus will show the past remuneration levels of the directors. Assuming that they will wish to at least maintain this level in the future, how will this affect profits?

Having considered the above points in conjunction with macro-economic factors such as interest rates, inflation, taxation etc an investor should be able to make an informed judgement as to the inherent risk involved in making such an investment.

(d) The AIM flotation and the ensuing introduction of outside shareholders would mean, for the first time, a split between the functions of stewardship and ownership assuming that the business was previously managed by the family. No longer can it be assumed that what is good for the family is good for external stakeholders.

It is more than likely that, prior to the flotation, the financial control systems were geared in essence to cash flows, with accounting concepts and analysis relegated to year-end requirements for the preparation of annual accounts in accordance with the Companies Acts and accepted accounting principles and tax computations for the Inland Revenue. Furthermore, it is likely that within the bounds of legal requirements profit figures were kept as low as possible in order to minimise the tax charge. This will need to change as the directors will need to consider the interests of the external shareholders and potential shareholders, the value of the shares often being perceived as a multiple of reported profits. The company will therefore need to ensure that its reporting systems can generate more frequent information possibly in the form of interim or even monthly accounts.

Accounting standards developed over the last twenty years have demanded greater disclosure and analysis thus F Ltd’s reporting systems must be able to provide such information as profit and assets employed figures by major product line and geographical market areas.

Due to the increased significance of historical data for preparing interim and annual audited accounts the financial reporting systems will need to be essentially backward looking. It is likely that in the past the company’s financial reporting considerations were more set towards the future with Founder providing perhaps informal forecasts to his bank based on his assessment of future prospects in order to secure additional funding.

Evidence suggests that as companies move from being privately owned to having to take account of the interests of external stakeholders the time horizon for return on investments reduces. Pressure is exerted for shorter term easily quantified returns thus avoiding the uncertainty of the future and increased risk. The downside of such an investment strategy is that many potentially lucrative medium and long-term investment opportunities may be missed and investment in non-tangible assets such as research and development or training may be avoided altogether. In any event, the company will have to review its investment appraisal techniques and place more emphasis on statistics such as earnings per share.

With the advent of external shareholders comes the responsibility for other people’s money. F Ltd should therefore consider its system of internal controls, which perhaps previously relied only on informal supervision by the family. Procedures will need to be formalised perhaps with the installation of an internal audit department. Reliance should not be placed on the external auditors to detect fraud.

All the above points indicate that F Ltd will need to rely on an efficient management accountant to instigate the introduction of new control and reporting systems.



OAKTON PLC

(i) Comparative P/E ratios

As Mallard is in a different industry, comparison will be with average P/E ratios in Mallard's industry.

Using the average P/E for recent takeovers of 7:1, and Mallard's earnings per share of 71.04 pence (the market price of 370 pence multiplied by the earnings yield of 19.2%) this would

result in a price per share of 7 71.04 = 497 pence, and a total value of shares of £24.85 million. (An adjusted EPS for Mallard which takes into account the expected effects of the acquisition could be used.)

The use of comparative P/E ratios has a number of weaknesses. There is no guarantee that the companies being compared to Mallard are of similar size, risk, growth rates, or activity to Mallard. Additionally the figure of 7:1 is merely an average for companies which have been recently taken over, and an average might hide a wide variation in the actual P/Es of the companies. P/E ratios are in part based upon historic accounting information (the EPS), and do not consider the impact of the merger or acquisition on future cash flows, and any synergy that might occur. These weaknesses make the use of comparative P/Es of limited value.

(ii) Dividend valuation model

The intrinsic value of Mallard may be estimated using P0 = g)-(K

g)+(1 D

e

o

where g is the growth rate in dividends of 8% or 0.08.

re is the cost of equity. Using CAPM this may be estimated to be:

6% + (14% – 6%) 0.8 = 12.4%

D0 is the current dividend per share. The current dividend per share is 842/ 5,000 = 16.84 pence.

P is estimated to be: 0.08)-(0.124

0.08)16.84(1

= 413 pence per share or a total of £20.65 million.

The dividend valuation model assumes a constant growth in dividends, which is not observed for most companies. The growth rate used is for Mallard. This growth rate differs from that of Oakton, and might not continue in the future. If the AIM is an efficient market, the current share price will reflect the correct value of Mallard, not the dividend valuation model, although this price could change once the possible benefits of any synergy are known to the market.



(iii) Present value of operating cash flows

£000

Current pre-tax operating cash flow 5,300

Ongoing adjustments as a result of the acquisition:

Wage savings 750

Advertising savings 150

_____

6,200

Tax (33%) 2,046

_____

4,154

Other cash flows:

Land and buildings 800

Directors' fees per year for three years (after tax) (201)

Redundancy costs (1,200)

The discount rate should reflect the systematic risk of Mallard's industry and will be estimated based upon data for Mallard. (This rate could change after the takeover as Oakton is of a different size and is quoted on a different market.)

WACC = V+V

V

de

e Ke + V+V

V

de

d Kd(1-T)

= 3,500) (18,500

12.4%18,500 +

3,500)(18,500

.33)-(1 11% 3,500 = 11.60%

This discount rate is a market rate which includes inflation. The cash flows, with the exception of the directors' consultancy fees, exclude any future inflation. The cash flows should either be increased by the expected rate of inflation and the market (nominal discount rate used, or, if the cash flows are not adjusted, the discount rate should be the real discount rate which excludes the effect of inflation. In this case use of the real discount rate is easier, although in reality this may not be as accurate as using nominal cash flows because different types of cash flow might be affected by different levels of price changes. If the real discount rate is used, the payments to the directors should be deflated by the inflation rate in order to maintain comparability with all other cash flows.

The real discount rate = 1.024

1.116 = 8.98% or 9%



Present values (at 9% discount rate)

£000

Ongoing cash flows 4,154 6.418 26,660

Other cash flows:

Land and buildings 800

Directors' fees per year for three years (after tax)

Deflated cash flows:

Year 1 2 3

196 192 187

.917 .842 .772

PV 180 161 144 (485)

Redundancy costs (1,200)

______

25,775

______

The present value of expected cash flows is theoretically the best of the three suggested valuation methods, but even this relies upon accurate estimates of both cash flows and the discount rate, and does not consider the possible effect of any opportunities (options) that might occur as a result of the acquisition. The expected present value of cash flows over a 10-year time horizon is considerably in excess of the proposed sale price of £22 million. This is without any estimate of the value of any cash flows that occur after 10 years (effectively the realisable value at the end of 10 years). If the purchase of Mallard fits the strategic plans of Oakton, an offer of £22 million is recommended.

MARKING GUIDE

Marks

Calculation of EPS 2

Share price based on comparative PE ratio 2

Discussion of method 2 _

6

Use of growth model 1

Calculation of Ke 2

Use of DVM to calculate share price 1

Discussion of weaknesses of DVM 3 _

7

Calculation of WACC 2

Treatment of inflation 1

Ongoing cash flows 3

Land and buildings and redundancy costs 1

Directors fees 2

Valuation based on discounting cash flows 1

Discussion of method 2 __

12 __

Total 25 __



MEDICONS

REPORT

To: The Directors of MediCons

From: Independent Consultant

Date: x-x-xx

Subject: Valuation of the company

Introduction

You have asked me to advise on the valuation of the company and on the relative advantages of a public flotation versus outright sale. I have included relevant calculations in an Appendix to this report.

Valuation of the company

In the Appendix I have calculated the value of the company under three possible bases, which give the following answers:

Basis Valuation of the company

$m

Net tangible assets 60

Earnings valuation 135

Dividend valuation 119

A net assets valuation is only of relevance to a company considering liquidation. It adds together the book values of the tangible net assets owned by the company, but entirely ignores intangible assets which are not recognised in standard accounting practice but which are of enormous value to the company as a going concern. Examples of such ignored assets are the accumulated research costs, the training and skills of the workforce, and the good reputation of the company in the general market. Much of the value of a service company derives from its intangible assets and its intellectual capital. However, valuing such assets is fraught with difficulty, since no single cost can be associated with their acquisition. If the stock market was strongly efficient, then such assets would be fairly included in the company’s share price, but as the company is not yet quoted, such an approach to valuing intellectual capital as the market capitalisation less the fair value of the tangible net assets cannot yet be applied. In any case, since the company is not contemplating liquidation, the net assets value is essentially irrelevant.

The earnings valuation of $135m is relevant to valuing 100% of the shares in the company. It assumes that last year’s earnings per share was at a typical level, not distorted by non-recurring one-off items, and also uses the P/E ratio of the competitor company as being applicable to MediCons. Despite these limitations, the method provides a useful estimate.

The dividend valuation of $119m assumes that earnings and dividends will grow at a constant annual rate in perpetuity. The method is commonly used to value parcels of shares that do not give control over the company, typically holdings of 0 to 20%. However the $119m valuation is interesting information to add to our knowledge.

If we take a range of $120m to $135m as the value of the whole company, this would suggest a share price of $12 to $13.50 per share.



Alternative methods of valuation

I have demonstrated three common bases of share valuation in the Appendix to this report. Further methods also exist, for example shareholder value analysis. You have provided me with a figure of $9.2m as the after-tax cash flow expected for the year to 31 March 20X1. SVA would require estimates of the inflows expected for each of the years in the strategic planning period (say 5 to 10 years into the future), and then obtain a present value of these flows. It is questionable whether the effort required in producing such estimates would be worthwhile, given the lack of precision that would be inevitable.

Public flotation or outright sale

An outright sale requires a purchaser to be identified who is willing to pay a full price for the company. If potential purchasers have already made themselves known, initial negotiations may be started with them. If no potential purchasers of the whole company are known, a public flotation is the only practicable option.

I assume that the public flotation being considered would mean you retaining the shares that you hold, for the time being, and new shares being issued to the public for cash. The stock exchange would not look favourably on all the current shareholders selling all their shares for cash on the flotation; such a proposal would risk a low take-up of the shares being offered.

There is also the decision as to whether an outright purchaser would offer cash or shares as the consideration for the acquisition. Shares would avoid an immediate capital gains tax liability, and might be preferred by the purchaser.

A public flotation is likely to incur higher costs than an outright sale due to the regulatory and marketing regulations that must be followed, but the cost will still only be a small percentage of the amount raised.

Conclusion

A current valuation of the company is around $120m to $135m, or $12 to $13.50 per share. I would recommend a public flotation rather than an outright sale of the company to a third party, since a flotation will enable you to keep control of the company. However, if a potential purchaser has been identified and is enthusiastic to buy the company, a better price could be obtained on an outright sale rather than on a public flotation.

Please contact me again if I can be of any further help to you in this or any other matter.

Appendix

Valuations of the company

(i) Net asset value (ignoring unrecognised assets)

= 10m

$60m = $6 per share, or $60m for the whole company.

(ii) Earnings valuation = appropriate P/E ratio EPS.

Since MediCons is not currently quoted, it does not have a P/E ratio itself, so we must look at the competitor company for a P/E ratio to use.

P/E ratio = 16.3 60c

980c

shareper Earnings

shareper Price

The competitor’s shares are trading on a P/E of 16.3, but we know that the forecast growth rate in earnings and dividends of MediCons is greater than for the competitor. We can therefore nudge up the P/E ratio for MediCons to, say, 18.



Earnings valuation = 18 75c = $13.50 per share

= $135m for the whole company.

(iii) Dividend valuation = Present value of future dividends

=

g-r

d1

where d1

r g

= = =

next year’s dividend the cost of equity the annual growth in dividends

d1 = $5.5m 1.08 = $5.94m

r = cost of equity.

I note that you currently use a 15% discount rate to evaluate new investments, so we could just use this number as the cost of equity. However this is only a ‘rule of thumb’, so I have carried out a more formal analysis on the competitor’s statistics using the capital asset pricing model to estimate their cost of equity.

r = Rf + (Rm Rf)

= 5 + 1.25 (12 – 5)

= 13.75%

The competitor has a gearing ratio of 20 : 80, so their weighted average cost of capital

ro = 13.75% 100

80 + 7%

100

20

= 12.4%

Assuming that the operating risk class of MediCons and the competitor are the same, MediCons will have the same WACC, so that its cost of equity r is given by:

12.4% = 7% 100

10 r

100

90

R = 13% 9.0

0.7% - 12.4%

Therefore the dividend valuation of MediCons is:

$118.8m. 0.08 - 0.13

$5.94m



BOND VALUES AND YIELDS

(a) A yield curve may be upward sloping because of:

(i) Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward sloping.

(ii) Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading to an upward sloping yield curve.

(iii) Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand in the longer term segment of the yield curve leading to lower bond prices and higher yields.

(b) (i) The current market prices of the two bonds may be estimated to be:

Zero coupon 15(1.06)

$100 = $41.73

12% gilt with a semi-annual coupon

Present value of an annuity for 30 periods at 3% is 0.03

(1.03)1 -30

= 19.6004

$

Present value of interest payments $6 = 117.60

Present value of redemption using 30)03.01(

1 $100 = 41.20

––––––

158.80

If interest rates increase by 1%

Zero coupon 15)07.1(

100$ = $36.25, a decrease of $5.48 or 13.1%

12% gilt

Present value of an annuity for 30 periods at 3.5% is 0.035

(1.035)1 -30

= 18.3920

$



1 $100 = 45.63

––––––

145.98



This is a decrease of $12.82 or 8.1%

If interest rates decrease by 1%:

Zero coupon 15)05.1(

100$ = $48.10, a decrease of $6.37 or 15.3%

12% gilt with a semi-annual coupon

Present value of an annuity for 30 periods at 2.5% is 0.025

(1.025)1 30

= 20.9303

$



1 $100 = 47.60

––––––

173.25

This is an increase of $14.45 or 9.1%

(ii) The price/yield relation is not linear; it has a convex shape. There is a bigger absolute movement in bond prices when interest rates fall than when they rise. The percentage movement is also higher for low coupon bonds than high coupon bonds. Other things being equal, a financial manager would prefer to hold high coupon bonds if interest rates are expected to increase, and low or zero coupon bonds when interest rates are expected to decrease.

(iii) If interest rates are expected to rise, and the gap between yields on short and long dated bonds to widen, the financial manager would not want to hold longer dated bonds as these would suffer a larger fall in price than short dated bonds.

Short dated bonds, probably with high coupons, would be preferred.

(c) (i) The bonds of Magnacorp offer a redemption yield of 7%, 10 year maturity and a credit rating of A-. The closest alternative to this investment is Suprafirm, with a redemption yield of 7.5%, an identical maturity and a very similar credit rating (BBB+ against A-). As the yield to redemption is higher for an almost identical bond, the fund management might consider switching from the bonds of Magnacorp to the bonds of Suprafirm as long as the extra yield compensates for the risk difference between the investments and any transactions costs.

(ii) The expected market price of Grandit with a coupon of 7.8% and redemption of 6.0% is:

06.1

8.7 +

2)06.1(

8.7 +

3)06.1(

8.7 +

4)06.1(

8.7 +

4)06.1(

100

Or 7.8 3.465 = 27.03

100 0.792 = 79.20

––––––

106.23

The current market price is 40 cents lower than might be expected.



(iii) A fall in interest rates will lead to an increase in bond prices and the value of a bond portfolio. The greater the fall in interest rates ceteris paribus the greater the rise in bond value. If medium term interest rates are expected to fall by more than long-term rates then it might be worth selling the longer term bonds of Magnacorp and buying the medium-term bonds of Grandit before any fall in interest rates occurred. Additionally low coupon bonds are more sensitive, ceteris paribus, to changes in interest rates than high coupon bonds. However, the size of the expected fall in interest rates would influence the decision, as would the fact that the bonds of Grandit appear to be currently 40 cents under priced.



FOREIGN EXCHANGE

(a) There are two courses of action available to the company: forward market cover or money market cover. These are considered in turn below.

Forward market cover

The company is to receive £3,000,000 in 3 months’ time. Therefore in order to fix the exchange rate at that point in time (and the resultant dollar proceeds) the company could arrange to sell the sterling forward by setting up a forward contract.

The forward exchange rate is quoted as $1.5858 $1.5873/£. The relevant rate for selling forward £ would be $1.5858/£ (which yields the smaller figure for $).

Therefore the forward sale of £3,000,000 would yield

£3,000,000 $1.5858/£ = $4,757,400.

Exchange rate risk has been eliminated since the dollar receipt of $4,757,400 is guaranteed.

In addition, even if the future spot rate of $1.5186/£ ($1.5985 95%) were certain, forward market cover would be preferable, since the latter 3 month spot rate would yield only

£3,000,000 $1.5186/£ = $4,555,800.

However, with the forward market cover there remains a shortfall over the $ proceeds which would be expected on the basis of the current spot rate. This shortfall amounts to

$4,795,500 $4,757,400 = $38,100.

(given in question)

Money market cover

Again exchange rate risk may be effectively eliminated by borrowing sterling which will amount to £3,000,000 with accrued interest in 3 months’ time and converting this sterling at the current spot rate into $ for investment. The amount of dollars accrued in the deposit account after 3 months represents the effective dollar receipt, as shown below. The £ loan will be repaid when the invoice amount of £3,000,000 is received.

Borrow sterling @ 15% interest for 3 months (3.75%)

£ , ,

.

3 000 000

1 0375 £2,891,566

Convert to $ @ the spot rate $1.5985/£

= $4,622,168 Interest: invest $ @ 9.5% for 3 months (2.375%) $109,777

Effective $ receipt $4,731,945

As with forward market cover, this represents a shortfall over the $ receipt using the current spot rate, which amounts to:

$4,795,500 $4,731,945 = $63,555.



Advice on course of action

Based on the initial computations, the forward market cover will convert the £3,000,000 receipt into $4,757,400 is 3 months’ time, whereas the money market cover would yield $4,731,945. On this basis the forward market cover would be preferable as it gives the higher $ receipt. In addition it is completely riskless, whereas the money market cover relies on interest rates remaining constant over the 3-month period in order to eliminate exchange rate risk.

(b) Translation exposure relates to the consolidation of a foreign subsidiary’s accounts into the group accounts. The group financial statements will be denominated in the currency of the parent company and any balances in the subsidiary’s accounts denominated in its own currency will be subject to translation exposure. Such balances will usually be translated at the exchange rate prevailing at the balance sheet date. However, if exchange rates between the parent company’s currency and the subsidiary’s currency vary, then the parent company’s valuation of such foreign currency items will vary over time, giving rise to translation risk or uncertainty. This will, however, only be converted into transactions risk, with a related cash-flow effect, if it is necessary for such foreign currency balances to be exchanged into the parent company currency, or if a foreign currency loan is required to be repaid by use of parent company funds. Therefore, translation exposure does not impose a major foreign exchange risk on a company, but merely impacts the accuracy of balance sheet items valued by use of an historic exchange rate.

The major link with transaction exposure relates to the method by which translation exposure may be hedged. The parent company may effectively finance the foreign subsidiary using its own funds or home currency funds, but such an action would give rise to potential transaction losses on exchange. In certain circumstances it is practical to provide a foreign subsidiary with capital from the parent company, as this may be cheaper than finance obtained from the country in which the subsidiary operates. However, there is little benefit to be derived from incurring such transaction exposure in order to hedge translation exposure.

(c) A foreign currency option gives the buyer of the option the right, but not the obligation, to buy or sell a currency at a specified rate of exchange at a specified time.

Advantages

(i) Foreign currency options limit downside risk whilst allowing companies to take advantage of favourable foreign exchange rate movements.

(ii) They are a useful hedge against risk when a company is unsure whether a future foreign exchange risk will occur, for example when tendering for a contract which it might not get, or issuing a price list in foreign currencies.

(iii) They provide an effective currency hedge, especially when foreign exchange markets are volatile.

Disadvantages

(i) Cost. A premium is payable when the option is arranged, no matter whether or not the option is exercised.

(ii) Exchange traded options are only available in a small number of currencies with specific expiry dates (OTC options are much more flexible).



FORUN

(a) (i) The economic data presented by the managing director gives some indication of the likely future economic strength of the four countries, and could form part of a strategic evaluation.

According to the purchasing power parity theory all of the foreign currencies are expected to depreciate in value relative to the pound sterling with the smallest depreciation in countries 1 and 4. Although PPP may hold quite well in the long run, there may be significant deviations from PPP in the short run. The impact of the other variables may be summarised in many ways. The table below is a simple

assessment with a + for the two best countries, and a for the two worst.

1 2 3 4 Comment

Inflation + +

GDP growth + + +

Balance of payments + + (related to population)

Base rate + + +

Unemployment + +

Population + + (+ for larger markets)

Currency reserves + + (related to population)

IMF loans + + (related to

population)

Although country 1 scores highly, except for inflation, economic growth and interest rates country 4 scores poorly, and is heavily indebted to the IMF relative to its small population size. Other data such as per capita GNP and international indebtedness other than to the IMF would be useful to the analysis. The managing director’s major concern is economic exposure, the impact of foreign exchange rate changes on the sterling expected NPV of overseas operations.

Strategic decisions should not be made on the basis of the above information alone. The information provides a macro-economic analysis. Even with a relatively weak economy at the micro level a subsidiary within a particular industry may perform well. Examining macro-economic data fails to give a complete picture.

Additionally it is possible that a depreciation in the value of a foreign currency might have a beneficial effect rather than a detrimental effect on economic exposure of Forun. If the price elasticity of demand is such that export sales from the foreign subsidiary increase substantially because of the relatively cheaper prices in a depreciated currency, the overall effect in sterling NPV terms might be an increase, not a decrease. If the managing director is concerned about economic exposure one way to reduce such exposure is by diversifying international operations, and financing, among many different countries. Concentrating activities in two foreign countries might lead to greater economic exposure risk, not less. The manager’s strategy to concentrate on countries 1 and 4 is based upon incomplete information and is not recommended.



(ii) If a foreign currency is expected to depreciate relative to sterling, translation exposure may be reduced by reducing net exposed assets.

Early collection by foreign subsidiaries of foreign currency receivables will not reduce net exposure (unless the foreign currency is expected to depreciate by more than the currency of the foreign subsidiary). A better tactic would be to delay collection of foreign currency receivables until after significant depreciation of the subsidiary’s currency had occurred, the receivables will then yield a higher amount of the subsidiary’s currency. From a group viewpoint early collection could increase translation exposure rather than reduce it.

Early repayment of foreign currency loans could be beneficial, if the loans are in relatively hard currencies, and if the subsidiary has the funds available to make such a repayment without detrimental effects on its operations.

Reducing inventory levels in foreign countries will reduce net asset exposure. However, before this, or any other balance sheet hedging techniques are used, the effect on the efficient operation of the company must be considered. There is little point in reducing inventory levels if this causes production bottlenecks or failure to satisfy customer demand, and potentially a loss of orders.

The non-executive director is concerned about a loss on translation of £15 million. Translation losses are not realised economic losses. Part of such a loss may be from translating the historic cost of overseas non-current assets; in reality the sterling economic value of such assets may be little changed if inflation in the foreign country increases the market value of such assets. Hedging against translation losses might result in reducing rather than increasing sterling NPV as such hedges may be opposite in direction to hedges that would be undertaken to protect against transaction exposure.

Will the reported £15 million loss have an adverse effect on Forun’s share price? If the stock exchange is efficient the company’s share price will react to relevant changes in the company’s expected cash flows, not reported translation losses. The reported loss could have little or no effect on share price. Hedging is normally undertaken to protect against the risk of transaction exposure, not translation exposure.

(b) (i) Multilateral netting is an effective means of reducing the transactions costs associated with foreign exchange transactions that are payable to banks. The netting of Forun’s intra-company US dollar exposures gives the following net payments and receipts.

$000 UK 1 2 3 4 Total Net rec receipts (payments)

UK 300 450 210 270 1,230 (470)

1 700 420 180 1,300 220

2 140 340 410 700 1,590 380

3 300 140 230 350 1,020 (110)

4 560 300 110 510 1,480 (20)

_____ _____ _____ _____ _____ _____ ___

Total

payments 1,700 1,080 1,210 1,130 1,500 6,620

_____ _____ _____ _____ _____ _____ ___



Some dollar payments will still need to be made from the UK, country 3 and country 4 to countries 1 and 2. However, such payments will total a maximum of $600,000 against the total trade value of $6,620,000, saving transactions and other costs on more than $6,000,000.

(ii) In order to reduce foreign exchange transaction hedging should take place after establishing the net exposure position in all currencies. The net group dollar exposure on the intra-company trade is of course zero, as dollar receipts equal dollar payments. Hedging will be undertaken on the net transaction exposure of third party trade.

Exposure

(Note: Sterling transactions are not exposed!)

Receipts Payments Net

Australia $3 million $3 million

USA $12 million $12 million

These net figures are the only ones that require hedging.

Forward market

The relevant outright rates are:

3 months 6 months

US$/£ 1.4720 1.4770 1.4550 1.4600

$US receipts $12

.

m

146 = £8,219,178



EXCHANGE RATES

(a) (i) According to the International Fisher Effect (IFE) interest rate differentials between any two countries provide an unbiased predictor of future changes in the spot rate of exchange.

If interest rates are 5% in the UK, and 2.5% in the Euro bloc the expected expected exchange rate in two years’ time is:

1.334 1.0252/1.052 = 1.271

The non-executive director has incorrectly used the relationships between interest rates and exchange rates. It would appear that she has used the interest rates the wrong way round:

1.334 1.052/1.0252 = 1.4

Hence the non-executive directors estimate is not valid.

(ii) Forecasts of exchange rates using interest rate differentials are not likely to be accurate. Reasons for this include:

Even if the interest differential remains constant the IFE is an unbiased, not accurate, predictor of future exchange rates.

The interest rate differential may change during the next two years.

Exchange rates may not be in equilibrium at the current time. The IFE predicts movements from an equilibrium position.

Factors other than interest rates influence exchange rates, including government intervention in foreign exchange markets, inflation rates etc.

This is demonstrated by the fact that the banks are all forecasting different rates none of which are exactly in line with the forecast using IFE

(b) (i) 0.273 1.03/1.07 = 0.263

(ii) 290,000 100/70 = 414,286 Euros

(iii) 414,286/0.263 = 1,575,232 Dinars

If the price is set at 1,575,232 Dinars the company is protected against the expected move in the exchange rate given purchasing power parity. However there is no real protection as the Euro amount to be received will depend on the actual exchange rate in one years time which is not known. Hence the company is not effectively hedged as their Euro receipt will still vary depending upon exchange rate movements.

(iv) An option to sell Dinars in one years time may be attractive because it will fix the minimum Euro amount to be received and if the tender is not successful or the exchange rate moves in the companies favour the option could be allowed to lapse. However an option would involve the payment of a premium.

(c) The primary objective of a company is normally assumed to be the maximisation of shareholder wealth. This is because the company directors have a legal duty to run the company on behalf of the shareholders who are therefore the primary stakeholders and because it is generally assumed that shareholders are investing in order to maximise their wealth. Other stakeholders such as customers exist and their needs must be satisficed. Hence companies also have secondary objectives such as maintaining customer satisfaction. Conflicts will arise between stakeholders but despite this most stakeholders have an interest in the company continuing to be successful.



The objective of a not for profit organisation such as a charity is normally considered to involve raising the maximum possible funding and then using it in order to achieve the maximum benefit in advancing the aims of the organisation. Problems often arise as there is often no obvious primary stakeholder and hence many conflicts can arise as stakeholders may have very different and even opposing objectives.



EXCHANGE RISK AND CASH BUDGETS

(a) The following techniques are available for hedging against the foreign exchange risk involved in foreign trade (note that only five were required).

(i) Invoice in the home currency

One easy way to by pass the exchange rate risk is to insist that all foreign customers pay in the company’s home currency and that your company pays for all imports in your home currency. However the exchange-rate risk has not gone away, it has just been passed onto your customer/supplier. Your customer may not be too happy with your strategy and simply look for an alternative supplier. Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach. Equally your suppliers may not be content and may seek to recover their costs through higher prices.

(ii) Leading/lagging

A company may decide to obtain payment of receipts early (if the currency of the receipt is likely to depreciate – adverse movement) or pay late (if the currency of the payment is likely to depreciate – favourable movement) and the company believes the exchange movement will be significant between now and the due date.

(iii) Decide to do nothing

The company would ‘win some, lose some’. If the amount is relatively small and the company expects a favourable movement, then it may be acceptable to do nothing. Be careful. Predicting exchange rates is a very dangerous game and ‘more’ than one ‘expert’ has made serious errors of judgement. One additional advantage of this policy is the savings in transaction costs.

(iv) Forward market

A tailor made agreement with a bank to buy or sell a specific amount of a currency for another, at a fixed future date for a predetermined price, i.e. the forward rate of exchange.

The forward rate is quoted by a bank. The contract must be fulfilled on the due date. Therefore if, for example, a customer is late in paying, the firm will have to buy currency in order to meet the commitment under the forward contract.

(v) Money market

Here the currency is exchanged at the time of the initial transaction at the spot rate and the currency is then lent/borrowed on the money market so as to accrue to the appropriate amount to settle the transaction on the due date. The cost will be determined by the interest rate differential between the two countries.

(vi) Futures market

Currency futures are contracts to buy or sell a standard amount of a currency for another, at a specified time and rate. It is therefore cheaper than using a forward contract but cannot usually obtain the exact amount of currency needed and requires an initial margin to be paid and a variation margin to be maintained daily.

The contracts are normally closed out before the currency is actually purchased or sold with the resultant profit/loss on the futures position being used to offset the profit/loss on the cash market.



(vii) Foreign currency options

Here the firm buys the possibility of buying ('call') or selling ('put') currency at an agreed rate, usually at any time within a specified period. It is possible to obtain a choice of exercise prices and maturity dates; the price of the option (cost of premium) will vary according to the exercise price and maturity date chosen.

Because options give the holder the opportunity to hedge against an adverse movement yet take advantage of a favourable movement, the options are a relatively expensive means of hedging foreign exchange risk. Options are often used in tendering for an overseas contract priced in a foreign currency.

(b) Spot rate range – A$/C$ 3.448 – 3.454

Hence converting A$200,000 now will produce 200,000/3.454 = C$57,904

3 month forward rate range – A$/C$ 3.482 – 3.492

Hence converting A$200,000 in three months will produce 200,000/3.492 = C$57,274

The A$ is depreciating as in 3 months it will take more A$ to buy a C$. Hence the C$ is appreciating relative to the A$.

(c) Cash budgeting

Units of FG Month 1 Month 2 Month 3 Month 4

Opening inventory 10,000 10,500 11,000 11,500

+ Production 20,500 21,500 22,500 23,500

− Sales 20,000 21,000 22,000 23,000

= Closing inventory 10,500 11,000 11,500 12,000

RM usage equals production units × 2kg per unit

Units of RM Month 1 Month 2 Month 3

Opening inventory 12,300 12,900 13,500

+ Purchases 41,600 43,600 45,600

- Usage 41,000 43,000 45,000

= Closing inventory 12,900 13,500 14,100

Month 3 closing inventory – (2 23,500) 30% = 14,100

Month 3 purchases will be paid for in month 4 and as they exceed 45,000 kg the 2% discount will be effective. Hence the amount to be paid will be:

45,600 $3.50 (1 – 0.02) = $156,408

(d) The motives for holding cash are:

Transactions motive – to pay the normal day to day transactions of the company including payments to suppliers for instance.

Investment motive – to pay for investment in new plant and machinery for instance.

Precautionary motive – to pay for unexpected needs that may arise at any time. Payments to hire a spare machine to replace one which is having to be repaired for example.

Finance motive – to make payments to providers of finance such as debt lenders.

A speculative motive is also sometimes mentioned. This is where funds are held in order to be able to rapidly take advantage of opportunities which may arise.

53509647 ACCA F9 Practise Question s Answer

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