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CORPORATE FINANCIAL MANAGEMENT - NOVEMBER 2005

SUGGESTED ANSWERS AND EXAMINER’S COMMENTS IMPORTANT NOTICE When reading these suggested answers please note that the answers are intended as an indication of what is required rather than a definitive “right” answer. In many cases there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated from what might be achieved in the reality of an unseen, time constrained examination. EXAMINER’S GENERAL COMMENTS

• As in previous examinations, Question 1 was generally well answered – better on the whole than the other questions. This may have been because of poor exam technique, but it may also have been because candidates did not prepare sufficiently to be able to answer the longer questions in Section B. Both seem possible: almost all candidates answered three questions from Section B, as required, but many did not do so well, and in many scripts the last answer was poor or incomplete. Any risks that students took in failing to prepare thoroughly had serious consequences: the pass rate this time was about 60%.

• The following is taken from the report following the June 2004 examination, and is still

valid:

Candidates cannot rely on the same questions being set in successive examinations. But the examiner wishes to find what they know rather than catch them out, and some fundamentals of the subject are likely to be frequently examined. Candidates who wish to shine will need to display knowledge, accuracy and a degree of judgment that are out of the ordinary, but students who simply learn the theory and practise calculations should be confident of passing.

1. (a) State to whom the auditors of a company submit their report, and

explain why this is the case. (4 marks) SUGGESTED ANSWER The auditors report to the members – the shareholders – in the Annual General Meeting of the company, and there is a vote on whether to accept the auditors’ report. The purpose of the audit is to confirm that users of the financial statements – including, most importantly, the shareholders who are the owners of the company – can rely on what they say. This is designed to ensure that shareholders have a reliable picture of what the management has done with their money.

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EXAMINER’S COMMENT Most candidates answered this reasonably well, though a number of answers ignored the shareholders completely.

(b) Explain why the net asset valuation method is unlikely to be a good way of valuing a company for an initial public offering of shares.

(4 marks)

SUGGESTED ANSWER The net asset valuation method is likely to give a reliable indication of the value of a company when the assets and liabilities shown in the balance sheet give good estimates of the values of all the company’s assets and liabilities. This is unlikely to be the case where there are important intangible assets that do not appear in the balance sheet. Any company that is a going concern with good prospects for the future is likely to have such assets, representing such things as specialist knowledge, contacts, intellectual property rights and goodwill. A company that is making an initial public offering is likely to qualify. Net asset valuation ignoring such intangible assets is most likely to be suitable where a company’s future prospects are poor and the best option could be to liquidate it. EXAMINER’S COMMENT Most answers identified the fact that information about asset values is likely to omit important intangible assets. Fewer noted that these are likely to be important for a company making an initial public offering.

(c) Explain why, although it does not reflect the time value of money and therefore does not give a good measure of profitability, payback period is widely used by companies in evaluating capital investment projects. (4 marks)

SUGGESTED ANSWER Payback period is based on cash flows that are not discounted. It has the advantage of all cash flow based methods of capital investment appraisal that it avoids variability in definition associated with methods based on accounting profit as a result of the accounting policies that a company adopts. It gives a measure of liquidity, since it shows how long it will take to recover the initial investment from the project cash flows, and therefore focuses on the cash flows that are received first. It therefore provides a measure that is complementary to profitability measures. It is simple to calculate and easy to understand. It is easy to use as a complementary measure to discounted cash flow measures including net present value and internal rate of return. For these reasons it is often used as an initial screening method in conjunction with other methods of evaluation.

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EXAMINER’S COMMENT Most candidates identified simplicity and understandability as characteristics that would encourage its use. Fewer explained the advantage of using cash flows, or the significance of payback in relation to risk. A number of answers wasted time repeating the drawbacks of the payback period.

(d) An investment in the ordinary shares of a large public company gives a return based on the share price, the current dividend and the expected rate of dividend growth, of 12%. An investment in the loan stock of the same company gives a return of 7%. Explain why an investor might be equally happy to invest in either the ordinary shares or the loan stock. (4 marks)

SUGGESTED ANSWER The higher return on an investment in ordinary shares reflects the higher level of risk for the investor, since dividends are not guaranteed, and can only be paid if the company has realised profits, whereas there is a legal obligation on the part of the company to pay interest on debt capital and to repay the principal when it is due. Investors require a higher return when the risk is higher. In considering two investments with different levels of risk and return, it is possible for an investor to consider that each gives an acceptable combination.

EXAMINER’S COMMENT Many answers identified risk as a crucial part of the answer, and concluded that some investors could be happy to invest in shares while others were equally happy to invest in loan stock. Far fewer made the point that the two investments could be equally attractive to a single investor.

(e) A UK-based exporter is expecting to receive US$2 million from a customer in 6 months’ time. It wishes to hedge the foreign exchange risk associated with this payment, and has been quoted the following rates for the US$ against £:

Spot 1.8895 – 1.8905 6 months pm 0.0122 – 0.0125

If the exporter undertakes a forward contract to sell the US dollars that it expects to receive, calculate the sterling amount that it will receive in 6 months’ time. (4 marks)

SUGGESTED ANSWER 6 month forward rate:

1.8773 – 1.8780

Amount received in £: $2.0 million = £1,064,963

$1.8780:£

EXAMINER’S COMMENTS Surprisingly few candidates did this calculation correctly. Common errors included not understanding the significance of the premium, or using the rate for buying dollars instead of selling.

(f) Identify four sources of short term finance for a commercial undertaking (excluding Government funding, grants and donations).

(4 marks) SUGGESTED ANSWER Sources include: bank overdraft, factors, invoice discounters, forfaiters, trade creditors, other creditors including possibly tax creditor.

EXAMINER’S COMMENTS Well answered by most candidates. The main failings were the inclusion of sources of long term finance, or funds arising from long term finance, for example by sales of fixed assets or investments.

(g) A company’s shares have a beta value of 0.8; the risk-free return on an

investment in UK government stock is 5.0%; the market return is 15%. Calculate the expected return on the company’s shares using the capital asset pricing model. (4 marks)

SUGGESTED ANSWER Rs = Rf + β (Rm − Rf)

where Rs = the expected return on the shares

β = the beta factor = 0.8 Rm = the expected return on the market portfolio = 15% Rf = risk-free rate = 5% Rs = 5% + 0.8 (15% − 5%) = 13%

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EXAMINER’S COMMENT There were an encouragingly large number of correct answers to this question. Some answers explained the CAPM, which was not necessary.

(h) It has been argued that the introduction of International Accounting Standards can be expected to increase wealth by reducing the cost of capital and thereby encouraging capital investment. The purpose of accounting standards is to improve the quality of the accounting information provided by financial statements, making it more reliable, more relevant to decision-making and more understandable, and helping users to draw valid comparisons between different companies and different periods of time. Explain why this should reduce the cost of capital. (4 marks)

SUGGESTED ANSWER Good accounting information, which accounting standards help to produce, helps to improve the understanding of users and reduce uncertainty. Reducing uncertainty reduces investor risk. Rational investors trade off risk against return. So improving the quality of accounting information means that investors require a lower rate of return. If companies invest in projects that offer a return greater than the cost of capital, reducing the cost of capital makes more projects worthwhile. Investment increases, and with it shareholder wealth.

EXAMINER’S COMMENT Many answers showed that candidates were struggling with this question, since they relied largely on repeating what the question told them. The point that decision making can be improved with better information was made in many answers, but this did not go far beyond what the question said. The links between the quality of information and risk reduction, and between risk reduction and the return required by investors, and the consequent potential for profitable investment, were made in only a few answers.

(i) Distinguish between a Management Buy Out and a Management Buy In. (4 marks)

SUGGESTED ANSWER In a Management Buy Out, the existing managers buy the company, partly by investing their own equity and partly by taking on new debt. In a Management Buy In, which may be financed in the same way, the new management comes from outside the company.

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EXAMINER’S COMMENT Most candidates knew about Management Buy Outs; fewer knew about Management Buy Ins.

(j) Explain why the executive directors of a company are often rewarded with share options and profit-based bonuses as well as basic salaries.

(4 marks) SUGGESTED ANSWER The agency problem means that the objectives of the management, who are managing the company on behalf of its owners, the shareholders, may be different from those of the shareholders. One way of achieving goal congruence is to reward executive directors and other senior managers if they achieve objectives that match those of the shareholders. Rewards based on profits or share price performance are designed, in part at least, to do this. Another reason given for rewards of this kind is identical to that given for paying high salaries: to attract able managers.

EXAMINER’S COMMENT Most answers identified the significance of motivation. Fewer explained the significance of aligning the interests of directors and shareholders. 2. (a) Micro Parts plc, a computer components company, operates a Just In

Time (JIT) procurement and manufacturing policy. The company is considering introducing an early settlement discount of 2% for credit customers who pay within 10 days. All sales are on credit terms, which are 30 days net and, on average, customers settle within this period. Credit sales are currently £15 million per annum.

Marketing surveys have been carried out to try to find which customers would respond to the discount offer. The results suggest that customers who currently account for 70% of the company’s credit sales will take up the offer, and will comply with the requirement to pay within 10 days. The marketing manager believes that introducing a cash discount will increase the company’s sales and market share. He estimates that customers who take up the offer will, on average, increase their purchases by 3%. The remaining 30% of sales will be unaffected by the change. Customers who do not take up the offer are expected to continue to take 30 days on average to pay, and the volume of their business is not expected to change.

The credit manager estimates that, with the expected level of take-up, the offer will lead to the level of bad debts falling from 2% of total credit sales to 1.5% of total credit sales. The company’s post-tax cost of capital is 15%. The company pays corporation tax at 30%. Variable costs represent 60% of sales before discounts.

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REQUIRED

(i) Present calculations to show whether the proposed change will

be profitable. (8 marks)

(ii) Explain the significance of Micro Parts plc’s JIT policies in relation to the evaluation of the proposed change in credit policy. (2 marks)

(b) Describe the actions that a company can take to deal with a forecast

cash shortage. (4 marks)

(c) Discuss the factors that determine a company’s dividend policy. (6 marks)

(Total: 20 marks) SUGGESTED ANSWER 2 (a)(i) Current Situation. £ New Proposal £ Credit sales Bad debts

£15,000,000 2% x £15m = £300,000 £14,700,000

30% of £15m = £4,500,000 103% x 98% x 70% x £15m = £10,598,700 £15,098,700 1.5% x £15,098,700 = £226,480 £14,872,220

Variable costs

60% x £15m = £9,000,000

60% x 30% x £15m = £2,700,000 60% x 103% x 70% x £15m = £6,489,000 £9,189,000

Contribution

= £5,700,000

£5,683,220

Taxation

= £1,710,000 £1,704,966

Post tax earnings

= £3,990,000 £3,978,254

Trade debtors Post tax cost of capital to fund trade debtors

30/365 x £15m = £1,232,876 15% x £1,232,876 = £184,931

30/365 x 30% x £15m = £369,863 10/365 x £10,598,700 = £290,375 £660,238 15% x £660,238 = £99,036

Earnings after cost of funding trade debtors

£3,805,069

£3,879,218

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Conclusion After allowing for the post tax cost of funding the part of the working capital that is affected by the proposed changes, the proposal increases post tax earnings by £74,149 per annum. 2 (a)(ii) Just in Time procurement means that Micro Parts keeps no stocks of raw materials or components. Just in Time manufacturing means that it keeps no stocks of work in progress or finished goods. Micro Parts is also likely to pay its suppliers promptly, as part of maintaining good relations with them. The volume changes arising from the changed credit terms therefore do not affect stocks, and any change in creditors is likely to be small, so that the main effect of the change on working capital is the change in debtors, which is evaluated here. 2(b) Possible actions include: • Accelerating cash inflows from debtors. • Postponing cash outflows by delaying payment to creditors; whilst this is considered to

be a cheap alternative (creditors rarely charge interest), such an alternative increases the risk of insolvency of the firm.

• Postponing capital expenditure (or negotiating extended payment terms with the

supplier). • Reversing past investment decisions, such as selling off non-essential assets. • Rescheduling loan repayments (with the lender’s agreement). • Reducing the level of dividend to be paid. • Deferring tax payments (after discussion with the Inland Revenue). There will be an

interest cost. • Improve stock control to reduce stock levels • Arrange overdraft • Cut or pass dividends 2 (c) Factors affecting a company’s dividend policy could include: • matching dividend policy to the expectations of the company’s shareholders.

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• Following the practice expected by the market for firms in the company’s industry. • Using dividends as a signal to indicate the future prospects of the company - a dividend

cut indicates that the company is – or will be – facing difficulties, and an increase may be taken as evidence of the opposite (see above). A company may increase dividends even though profits have fallen, to demonstrate that the directors are confident that a setback is temporary.

• Dividends may be used as part of a defence against an unwelcome takeover bid. In such

an event, the market may perceive an increased dividend as an indicator of improved future profitability, leading to an increase in the share price. This makes it more expensive for any potential bidder to gain control. When National Power was subject to a hostile bid from a US utility in 1996, it paid a special dividend of £1 per share.

• High dividend payouts reduce the risk that shareholders may lose all their investment. • The company may restrict dividends in order to finance as much investment as possible

using retained earnings. This avoids issue expenses and the possibility of diluting ownership (with an equity issue) or increased gearing (if the company issues debentures).

• Payment of dividends to the holding company by an overseas subsidiary is a way of

repatriating funds. • There are legal constraints on the level of dividends, designed to reduce the risk of

insolvency: for example, dividends can only be paid out of realised profits. • Apart from legal constraints, a company should in any case consider the effect of

dividend payments on liquidity. • The level of inflation affects the level of dividend which can be paid - companies must

ensure they have sufficient capital to maintain their operating capability. • Dividend payments may be restricted under loan agreements, to reduce the financial risk

to the lender. Banks may formalise these restrictions by covenants. • The company’s gearing level can have an effect on its dividend policy - any reduction in

retained earnings will increase its gearing ratio. • The company may have a large amount of cash that it may wish to return to its

shareholders, especially if its future cash flow predictions are strong. • Since the prime financial objective of a company is to maximise shareholder wealth,

companies should only invest in projects that offer a return greater than the cost of capital. If no such projects are available, funds should be returned to shareholders. This is a residual dividend policy, and is advocated by Modigliani and Miller. The signalling properties of dividends may discourage companies from following this approach rigorously.

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EXAMINER’S COMMENT This question was very popular indeed, but not particularly well answered. Candidates may have been attracted by the discursive parts, which were reasonably well answered. The calculations in Part (a)(i) was not well done on the whole, and hardly any answers were completely correct. Very few answers to Part (a)(ii) were complete. Most said that JIT procurement and manufacturing meant holding no stocks or almost no stocks. Few pointed out the significance of this in relation to the question and the cost of working capital. Even fewer observed what JIT procurement is likely to mean in terms of creditors. 3. (a) Gemrum plc is an acquisitive conglomerate. It specialises in

identifying undervalued companies, which it acquires and then disposes of by selling different parts to the highest bidder. It usually disposes of complete businesses, which the purchasers then integrate into their existing operations with cost savings arising from economies of scope or scale, or by achieving extra benefits by combining the resources of two or more businesses. Less frequently, Gemrum plc disposes of individual assets and closes down businesses or parts of businesses. Gemrum plc has identified Able Medical plc (Able) as a potentially undervalued acquisition target. Able manufactures medical equipment and also operates a wholesale hospital supplies business. Able’s medical product range includes some good products but demand has been hit by intense competition from larger companies in the United Kingdom, the rest of the European Union and the United States of America. The profitability of Able’s hospital supplies business has been severely reduced both by competition and by tougher negotiation by its National Health Service customers in the United Kingdom. The headquarters of both Able’s businesses are in freehold buildings that Able owns in central London.

The following is the summarised balance sheet of Able at 30 September 2005:

£’000 £’000 Freehold property 6,100 Plant and machinery 2,200 Fixtures and fittings 1,300 Vehicles 800 10,400 Current Assets Stocks 1,500 Debtors 3,200 4,700 Current Liabilities Creditors 1,600

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Bank overdraft 500 Tax & national insurance 325 Debenture interest 75 2,500 Net current assets 2,200 Total assets less current liabilities

12,600

10% debentures redeemable 2007

1,500

Net assets 11,100 Financed by: Ordinary share capital (£1 shares)

2,600

Profit and loss account 8,500 11,100

The market price of the 10% debenture stock is currently £105 per £100 nominal.

Gemrum plc is considering the following options: (i) Sale of the freehold land and buildings and disposal of Able on a

going concern basis.

If it did this, Gemrum plc would expect to be able to realise £10 million after selling expenses from the central London offices, and sell the company for £3 million. The purchaser would take over the whole of Able, with its existing businesses, management and capital structure. Gemrum plc would expect to incur costs of £1 million to dispose of Able in this way.

(ii) Sale of the freehold property, and sale of Able’s two businesses to

separate purchasers. If it did this, Gemrum plc would expect to realise a net value of

£10 million for the central London property, as in (i) above. It would redeem the debentures at their market value, and close down the Able head office, with severance costs of £2.4 million. Gemrum plc believes that it could then sell the medical products business for £6 million and the hospital supplies business for £2.5 million. Disposal costs, apart from any expenses involved in selling the freehold property, would amount to £1.2 million.

(iii) Liquidate Able.

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The freehold property would be disposed of on the same terms as in (i) or (ii) above. In addition, Gemrum plc would expect to realise the assets for the following amounts:

£’000

Plant & machinery 800 Fixtures and fittings

nil

Vehicles 500 Stocks 600 Debtors 2,900

Liquidation costs, in addition to severance costs for closure of the head office as in (ii) above, are estimated as £1.5 million. If Able was liquidated, the debentures would be redeemed at their nominal value and not their market value.

REQUIRED

Evaluate the options that Gemrum plc is considering. On the basis of your evaluation, estimate the maximum price per share that Gemrum plc could pay for the ordinary shares of Able if it aims to acquire Able for 70% of its value to Gemrum plc. (16 marks)

(b) Suggest in what circumstances a company may choose to grow by

acquisition. (4 marks) (Total: 20 marks)

SUGGESTED ANSWER 3 (a) Value of Able Medical plc (i) £’000 Land and buildings 10000 Sale of Able as a going concern 3000 Disposal costs (1000) 12000

(ii) £’000 Land and buildings 10000 Sale of medical equipment business 6000 Sale of hospital supplies business 2500 Head office closure (severance) costs (2400) Other disposal costs (1200) Redemption of debt at 105% (1575) 13325

(iii) £’000 £’000 Land and buildings 10000 Plant & machinery 800

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Fixtures and fittings nil Vehicles 500 11300 Current assets Stocks 600 Debtors 2900 3500 Current liabilities Creditors 1600 Bank overdraft 500 Tax and National Insurance 325 Debenture interest 75 2500 1000 12300 Redemption of debentures (1500) Net assets 10800 Head office closure (severance) costs (2400) Other liquidation costs (1500) Net proceeds 6900

Maximum net value (option (ii)) £13.325 million

Maximum price (70% of maximum net value) £9.3275 million

Maximum price per share £9.3275m/2.6m = £3.5875 per share

3 (b) Reasons for growth by acquisition include: • To reduce competition (though in the UK the Competition Commission exists to prevent

this, and larger mergers in EU countries have to be cleared by the EU Commission). • To acquire a new product range or move into a new market. • To obtain tax advantages (possibly by acquiring a loss-making company, whose past

losses can be set against future profits of the combined entity). • To spread risk by diversifying into countercyclical markets or products, so as to stabilise

total sales or profits. • To obtain resources more quickly or cheaply than may be possible through internal

growth. These could include: assets that are undervalued or can be sold off (‘asset stripping’); cash (if the target company is very liquid); access to finance; expert staff; management expertise; technology; access to supplies or production facilities.

• To achieve economies of scale in production, purchasing or marketing.

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• To act as a defence against being acquired itself, either by purchasing the predator company or by making itself bigger and thus harder to take over.

• Using shares as a consideration for a purchase rather than using cash that a policy of

organic growth would require. EXAMINER’S COMMENT This question was answered by very few candidates. Those who tried it did reasonably well. The calculations in part (a) were straightforward: the main errors were errors in calculating the cost of redeeming the debentures; and ignoring the current liabilities in option (iii). 4. (a) A company is expecting to have to pay Euro 10 million to a German

supplier in three months’ time. It has decided to hedge the foreign exchange risk by using currency options. It has purchased a Euro 10 million call option at an exchange rate of Euro 1.45: £1 at a premium of £54,520. If the spot exchange rate of sterling against the Euro in three months’ time is Euro 1.4366 – 1.4389 to 1 pound sterling, calculate the value of the option and the profit or loss that the company makes by buying and using the option instead of buying Euro at the spot rate. (6 marks)

(b) Options are usually a more expensive way of hedging foreign currency

risk than forward contracts or futures. Explain why this is so. (4 marks)

(c) Commonwealth Travel Services plc (CTS) is a UK-based company that

does a lot of business with customers and suppliers in Australia. The Finance Director of CTS expects the exchange rate of the Australian dollar to strengthen against sterling over the next few months. Explain how CTS can use leads and lags to reduce exposure to the foreign exchange risk that it has identified. (4 marks)

(d) Discuss the benefits for a multinational company of raising capital in

the country where it is investing. (6 marks) (Total: 20 marks) SUGGESTED ANSWER 4 (a) Cost of buying Euro 10 million at spot rate in 3 months Euro 10 million/Euro 1.4366:£ = £6,960,880 Cost of buying Euro 10 million by exercising option: Euro 10 million/Euro 1.45:£ = £6,896,552 Saving = value of option £64,328 Cost of option £54,520

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Profit by buying and exercising option £9,808 4 (b) A currency future or a forward contract commits the company to buying or selling the foreign currency at the expiration of the contract (unless, as is often the case with a future, the future has been sold in the meantime). An option involves a right, but not the obligation, to buy or sell the foreign currency. A future or forward contract sets the exchange rate at the outset. It removes risk, but leaves no scope for gain if exchange rates move favourably. An option allows the possibility of profit. The combination of removal of downside risk with potential for profit makes an option more valuable. It is therefore more expensive. An option may also be more expensive than a forward contract, which may be for a larger amount and cannot be traded, because it is for a standardised amount, and can be traded. The administrative costs are therefore higher, though they may not be higher than for a future. 4 (c) Leads are advance payments for imports or supplies to avoid the risk of having to pay more in sterling if the Australian dollar appreciates against sterling. Since CTS expects the Australian dollar to appreciate, it can use leads to hedge against the risk of this happening by paying its suppliers early, or by buying in advance the Australian dollars that it will need to pay them. Lags involve slowing down the exchange of Australian dollars into sterling if CTS expects the Australian dollars to be worth more in sterling terms later. CTS can also use lags to hedge against the risk of the Australian dollar appreciating, either by collecting payments from customers later, or by delaying conversion into sterling of the Australian dollars that it receives. Both leads and lags will increase CTS’s working capital requirements, which constitutes a cost of the hedge. 4 (d) Benefits to a multinational company of raising capital in the country in which it is operating could be related to the cost of capital and the mitigation of risk. By matching assets and liabilities – in the form of the capital used to finance them – a company can reduce or avoid translation risk arising from variations in exchange rate between the home currency and the currency of the host country. Political risk, including the possibility of adverse action by the host government, including expropriation of assets, may be reduced if, by having local shareholders or lenders, the company is seen as local rather than foreign.

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Having local investors such as large equity investors or bankers can help in acquiring local knowledge to deal with political and business risks. It may be a requirement of the host government that the company has a local partner who takes an equity stake. Sometimes this will provide capital, and sometimes the equity stake may have to be provided without financial consideration, limiting the benefits to the possible provision of local expertise and contacts. The local reputation of the company and the familiarity of local investors with its business will tend to reduce uncertainty on the part of providers of capital, leading to a lower cost of capital (though this advantage may be offset by market inefficiencies if local capital markets are not well developed). Considerations related to cost of capital also include the opportunity to raise working capital flexibly and economically in the host country. In addition, transaction costs can be reduced by using funds generated from operations in a country to service capital – by paying interest or dividends or repaying principal. Capital may be available on favourable terms from the host government – including possibly grants – to encourage local investment and job creation. If the country in which the company is investing has sophisticated capital markets, the company may wish to use its international reputation to raise funds in these, irrespective of the location of the investment. EXAMINER’S COMMENT Most candidates answered this question, with a reasonable level of success. The calcuation of the costs of buying Euro at the spot rate and with the option, and the profit arising from buying and exercising the option, were generally well done. Few answers calculated the value of the option. The discursive parts were generally satisfactorily or well answered, though not all gave complete or even adequate explanations of the use of leads and lags. In part (c) some candidates gave benefits of being a multinational company rather than answering the question. 5. The directors of Cowdenbeath plc are considering two mutually exclusive

investment projects. The projected cash flows of each project are as follows: Cash flows (£ million)

Project 1 Project 2 Year 0 -13.6 -17.4 Year 1 6.0 5.5 Year 2 7.5 8.6 Year 3 5.0 10.0

It should be assumed that cash flows arise at the end of the year to which they relate.

NOTE: The company’s cost of capital is 10%. Ignore taxation. REQUIRED

(a) Calculate the net present value and internal rate of return of each project.

(6 marks)

(b) Advise the directors of Cowdenbeath plc on which project they should

accept, explaining fully the reasons for your advice. Suggest what other issues could be relevant to the decision. (6 marks)

(c) Prepare a statement presenting and analysing the cash flow

information in such a way as to reconcile the possibly different conclusions that the net present value and internal rate of return methods might lead to, and comment on how it does this. (8 marks)

(Total: 20 marks) SUGGESTED ANSWER 5(a) Calculation of Net Present Values with discount rate of 10% Project 1 Project 2

Cash flows £m PV of cash flows

£m

Cash flows £m PV of cash flows £m

Year 0 -13.6 -13.6 -17.4 -17.4 Year 1 6.0 5.455 5.5 5.0 Year 2 7.5 6.198 8.6 7.107 Year 3 5.0 3.757 10.0 7.513 NPV 1.810 2.220

Calculation of Net Present Values with discount rate of 20% Project 1 Project 2

Cash flows £m PV of cash flows

£m

Cash flows £m PV of cash flows £m

Year 0 -13.6 -13.6 -17.4 -17.4 Year 1 6.0 5.0 5.5 4.583 Year 2 7.5 5.208 8.6 5.972 Year 3 5.0 2.894 10.0 5.787 NPV -0.498 -1.058

Project 1

IRR = 10% + ⎥⎦

⎤⎢⎣

⎡−×

+%)10%20(

0.498) (1.8101.810

= 17.8%

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Project 2

IRR = 10% + ⎥⎦

⎤⎢⎣

⎡−×

+%)10%20(

1.058) (2.2202.220

= 16.8%

5 (b) On the basis of NPV, Project 2 is preferred. On the basis of IRR, Project 1 is preferred. Since NPV is based on discounting project cash flows using the cost of capital, it reflects the surplus that a project offers over the cost of the capital invested, and since the prime financial objective of the company is to maximise shareholder wealth, the project with the largest available NPV should be chosen. Project 2 should therefore be selected. Other issues that should be considered are:

• The level of risk of each project. Projects with higher levels of risk should be evaluated with higher discount rates to reflect the higher return required by rational investors to compensate for risk.

• The effect of accepting either project on the overall corporate risk, which needs

consideration of the correlation of the project cash flows with those of existing activities.

• Intangible benefits, such as the development skills, contacts and reputation, that are

not reflected in the project cash flows.

• The impact of either project on the firm’s corporate strategy. 5(c) Reconciliation of NPV and IRR calculations Consider what the NPV and IRR calculations suggest about the case for investing in the larger project (Project 2). The difference between Project 2 and Project 1 represents the effect of making the extra investment. Year Project 1 Project 2 Project 2 Project 2- Project 2-

– Project 1 Project 1 Project 1 CF £m CF £m CF £m PV £m PV £m (10% (20%

disc rate) disc rate) -13.6 -17.4 -3.8 -3.8 -3.8

1 6.0 5.5 -0.5 -.455 -.417 2 7.5 8.6 1.1 .909 .764 3 5.0 10.0 5.0 3.757 2.894 NPV 0.411 -0.559

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Project 2 – Project 1

IRR = 10% + ⎥⎦

⎤⎢⎣

⎡−×

+%)10%20(

0.559) (0.4110.411

= 14.2%

Comment Comparison using NPV Project 1 is worthwhile because its NPV is positive. Project 2 – Project 1 is also worthwhile because its NPV is positive. On the basis of NPV, it is worth making the extra investment to undertake Project 2 instead of Project 1. Comparison using IRR Project 1 is worthwhile because its IRR is greater than 10%, the Cowdenbeath cost of capital. Project 2 – Project 2 is also worthwhile because its IRR is also greater than 10% - although it is less than the IRR of Project 1. It is therefore worth making the extra investment to undertake Project 2 instead of Project 1. EXAMINER’S COMMENT This question was less popular than questions on capital investment appraisal in recent examinations. Something over half of all candidates attempted it. This may have been because candidates were not sure how to reconcile the NPV and IRR figures in part (c). Part (a) was generally well answered, part (b) was adequately answered by most candidates (though there was a tendency to concentrate on other issues closely related to the calculations in part (a)), and part (c) was very poorly answered. 6. Walker Quick plc (WQ) is a marketing communications company. It is

growing rapidly in a buoyant market. Its unique assets are the skills and experience of its professional staff and its business contacts with a wide range of large companies. It owns almost no assets: it rents its offices, and its computers, vehicles and office fixtures and fittings are leased (they appear in the balance sheet because they are leased under finance leases). Intangible assets such as trade know-how and goodwill are not capitalised or shown in the balance sheet.

WQ’s long term capital, shown in its balance sheet for the year that has just

ended, is shown below:

£m 8% Loan Stock 2007 20.0 Issued Ordinary Share Capital (shares of 25 pence)

8.0

Share Premium Account 18.5 Retained Profits 3.5

The current market price of the ordinary shares is 320 pence. In the year just

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ended, operating profits before interest and tax were £13.44 million. WQ is planning to raise £10 million of new capital by an issue of new ordinary shares, and is planning to do this by a 1 for 4 rights issue at a price of 250 pence per share. It expects the new investment to increase its operating profits by £4 million in the year that has just started. WQ pays corporation tax at 30%. It is the policy of WQ to pay out 75% of its post-tax earnings as dividends.

REQUIRED

(a) WQ has decided against issuing loan stock as a way of raising new

capital. Suggest possible reasons why it may have excluded this option. (4 marks)

(b) Given that it is raising new equity capital, suggest reasons for WQ’s decision to do this by making a rights issue. (5 marks)

(c) Calculate the theoretical ex-rights share price and the value of the rights for each new share, and for each share held before the rights issue. (4 marks)

(d) Calculate (i) on the basis of the latest results and (ii) in the year that

has just started, allowing for the rights issue and the projected effect on operating profits:

• Pre-tax profits • Profits after tax • Earnings per share • Dividend per share • Interest cover • Capital gearing • Dividend yield (calculated using the current share price)

(7 marks) (Total: 20 marks)

SUGGESTED ANSWER 6 (a)

• WQ has almost no assets to offer as security for a loan.

• WQ’s market may be volatile, which means that its sales and cash flows may be variable, reducing the degree of confidence that it will be in a position to pay interest or repay principal.

• The existing loan stock is due to be repaid in the near future.

• It may not be industry practice in WQ’s sector to provide long term capital in the form

of debt.

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• If WQ is a new company as well as being in a relatively new industry, it will have a

shorter track record, which is also a factor affecting investor confidence.

• Higher risks associated with debt capital, as perceived by investors, mean that the return they require is higher, so the cost of debt capital is high.

6 (b) There is less administrative work, and less cost, associated with a rights issue than with a new public issue of shares. A rights issue is attractive to existing shareholders for the following reasons:

• Existing shareholders can maintain their proportion of the equity by subscribing to the rights issue

• By subscribing, existing shareholders can increase their investment without dealing

costs.

• Existing shareholders may be entitled to take up any rights not taken up by other existing shareholders.

• If shareholders do not wish to take up their rights, they can sell them in the market.

Alternatively, the usual arrangement after the rights issue is for the company to sell in the market any rights issue shares that are not taken up by existing shareholders and to pay to them any premium received over the rights issue price.

6(c) Number of shares in issue before rights issue: £8m/£0.25 = 32 million Number of shares issued in rights issue: ¼ x 32 million = 8 million Number of shares in issue after rights issue 40 million Current value of equity 32 million x 320 pence £102.4 million Amount subscribed 8 million 250 pence £20.0 million Total value of equity after rights issue £122.4 million Theoretical ex-rights share price £122.4m/40million = 306 pence Value of rights for each new share: 306 pence – 250 pence = 56 pence New shares per existing share: ¼ Value of rights for each existing share: ¼ x 56 pence = 14 pence

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6 (d) Latest results First full year

after rights issue

Operating profits £13.440m £17.440m Interest payable £1.600m £1.600m Pretax profits £11.840m £15.840m Taxation at 30% £3.552m £4.752m Profits after tax £8.288m £11.088m Dividends £6.216m £8.316m No of shares in issue 32 million 40 million Earnings per share £8.288m/32 million £11.088m/40 million = 25.9 pence = 27.72 pence Dividend per share £6.216/32 million £8.316/40 million = 19.425 pence = 20.79 pence Debt £20.0m £20.0m Shareholders’ funds Ordinary share capital£8.0m £10.0m SPA £18.5m £18.5m + £18m = £36.5m Retained profits £3.5m £3.5m + £2.772m = £6.272m £30.0m £52.772m Capital gearing £20.0m/£30.0m £20.0m/£52.772m = 66.7% = 37.9% or £20.0m/£50.0m £20.0m/£72.772m = 40.0% = 27.5% Dividend yield 19.425p/320p 20.79p/320p = 6.1% = 6.5% Interest cover £13.440m £17.440m £ 1.6m £ 1.6m = 8.4x = 10.9x

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EXAMINER’S COMMENT This question was attempted by over half of all candidates. Answers to parts (a) and (b) were generally good. The calculations in part (c) were less well done and few were wholly correct. The calculations of profits, earnings and ratios in part (d) were generally incomplete. (It was possible to interpret the information in the question in more than one way, since the company was described as ‘planning to raise £10 million of new capital’, while the 1 for 4 rights issue at an issue price of 250 pence would raise £20m. Credit was given in marking for answers reflecting possible different interpretations of these figures.)

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