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PRIFYSGOL CYMRU UNIVERSITY OF WALES Financial Management and Corporate Finance

LondonSAMExam Paper and Suggested Answer Guides - Full Retake - October 2010

Master of Business AdministrationSeptember 2010

MBA 113 Financial Management and Corporate Finance

FULL RETAKE

7th October 20102.00pm - 5.15pm

Time allowed

Reading and planning 15 minutesWriting 3 hours

This paper is divided into two sections:

Section A – TWO questions ONLY to be attempted.(Each question is for 10 marks)

Section B – TWO questions ONLY to be attempted(Each question is for 20 marks)

Total marks 60

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

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The contents can be used ONLY for the purpose of teaching MBA students for:

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but for NO other purpose.



Section A – TWO questions ONLY to be attempted. (Each question carries 10 marks overall)

Question 1

Risk plays a prominent role in the areas of investment and financing decisions and considerations of risk centre on cost of capital or interest rates. Generally, the higher the risk for an investment or security the greater will be the cost of capital or interest rate.

For these reasons, there are various different risks that must be considered when making financial and investment decisions.

Briefly describe FIVE such risks. (10 marks)

Answer to Question 1

The various risks that must be considered when making financial and investment decisions are as follows:

(i) Business risk is caused by fluctuations of earnings before interest and tax (operating profit). Business risk depends on variability in sales demand, sales price, operating costs, and the amount of operating gearing.

(ii) Financial gearing risk is caused the structure of shareholders' capital plus reserves and either prior charge capital or borrowings or both.

(iii) Liquidity risk represents the possibility that a marketable security may not be sold on short noticefor its market value. If a marketable security must be sold at a high discount, then it is said to have a substantial amount of liquidity risk.

(iv) Interest rate risk is the risk resulting from fluctuations in the value of an asset as interest rates change. For example, if interest rates rise (fall), debenture prices fall (rise).

(v) Purchasing power risk is the risk that inflation (a rise in prices) will reduce the quantity of goods that can be purchased with a fixed sum of money.

(vi) Market risk is the risk that a share price will change due to changes in the stock market atmosphere as a whole since prices of all shares are correlated to some degree with broad swings in the stock market.

(vii) Default risk is the risk that a borrower will be unable to make interest payments or principal repayments on debt. For example, there is a great deal of default risk inherent in the debentures of a company experiencing financial difficulties.

(viii) Currency exchange rate risk is the risk resulting from fluctuations in the value of the domestic currency against other currencies traded in. For example, in the case of UK-based organisations, when the pound strengthens (hardens) exporters face risk of receiving less sterling for invoices denoted in overseas currencies, and when the pound weakens (softens) importers face inflated cost of supplies.

Plus any other sensible risk, such as political risk.

Discussion of ONLY FIVE risks are required.


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Question 2

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In corporate finance, the term bond is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with debenture, loan stock or note.

Briefly discuss FIVE advantages of a company using bonds as a source of long-term financing.(10 marks)


There are many advantages of using bonds as a source of long-term financing:

(i) Low cost. The after-tax cost of bonds is less than that of preference and ordinary share capital. The lower cost of bonds is attributed to the tax deductibility on interest payments, the lower return required by bondholders relative to equity investors, and the relatively low issue costs of bonds. Interest payments are also fixed on most bonds. Thus, bondholders do not share in any excess earnings of the company.

(ii) No dilution of control. Debentures do not carry voting rights, and hence, current shareholders retain their proportionate voting control when bonds are issued.

(iii) Less earnings dilution. The use of bonds may dilute the company's earnings per share less than when issuing shares.

(iv) Financial flexibility. The call provision adds flexibility to the company's financial structure by allowing it to refinance and/or retire bonds before they mature.

(v) Avoids the risk of using short-term debt. Long term maturity of bonds reduces the risk associated with the company's ability to repay old or acquire new short-term debt.

(vi) Inflation hedge. Interest payments and the repayment of principal becomes less of a burden during periods of inflation because the firm is using cash that has less purchasing power to repay its obligations.

Plus any other sensible advantage.

ONLY FIVE advantages are required.




Question 3

Venture Capital is a form of "risk capital". In other words, capital that is invested in a business or project where there is a substantial element of risk relating to the future creation of profits and cash flows. It is normally provided by venture capitalists or venture capital funds.

Describe FIVE circumstances under which a business might seek venture capital. (10 marks)


Normally it is small and growing firms which need venture capital, although on occasions venture capital can also be used by large and mature companies. The main uses of venture capital are:

(i) for start-up fledgling firms (‘seeding’ finance) who require development finance;

(ii) to bridge the gap between a private company's asset value and eventual stock market quotation on an initial public offer (IPO);

(iii) to invest in an expansion programme for which bank credit is not available, mainly because investment precedes the payoff from 'expected' market growth which brings risk;

(iv) for a management buyout (MBO). An MBO occurs when a team of managers decide to buy part or all of a business enterprise from its owners. Usually the combined available funds of the managers is less (sometimes much less) than the market value of the company they are buying which means they need to obtain 'unsecured' (risky) capital to effect the buyout;

(v) to invest in research and development of the type regarded as a high-risk venture;

(vi) where finance is required and the current share price is below nominal ('par') value.

Plus any other sensible circumstance.

ONLY FIVE circumstances are required.


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Question 4

The main principles of financial management may be applied to most organisations. However, the role of the financial manager may be affected by the type of organisation in which he/she works.

Requirement:

Describe the key characteristics of the financial management function and the role of the financial manager in any ONE of the following types of organisation.

(a) Quoted, high-growth company(b) Quoted, low-growth company(c) Unquoted company aiming for a stock exchange listing(d) Small, family owned business(e) Non profit-making organisation, for example a charity(f) Public sector, for example a government department

Note: You are only required to deal with ONE type of organisation. (10 marks)


The organisations outlined can each cover a very wide range of situations, and some of these will be dealt with in the answer. When considering the role of financial management it is necessary to consider the source of funds, the objectives of the organisation, and the way in which performance is evaluated.

The key characteristics of the financial management function and the role of the financial manager in each of the types of organisation mentioned are outlined below.

(a) Quoted, high-growth company

(i) Strong management accounting function with staff involved in the evaluation of strategic opportunities including expansion of existing businesses, product/market diversification and merger and acquisition work. If the capital structure is changing, then this will demand attention to be given to the determination of the cost of capital.

(ii) A relatively large amount of time may be spent on statutory and listing requirements, particularly if the company is growing by acquisition.

(iii) The demands of growth are likely to impose the need to be constantly developing and adapting management information and accounting systems to meet the needs of the business,

(iv) Strong treasury skills will be required to secure both the short and long-term financing for the company and to contribute to capital structure decisions.

(v) The financial manager must be able to adapt to a continually changing environment and to contribute to the strategic decisions facing the business.


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Answer to Question 4 (continued)

(b) Quoted, low-growth company

(i) The financial management department must be capable of dealing efficiently with the statutory and listing requirements,

(ii) If growth is slow due to market constraints, there is likely to be a higher degree of attention paid to the improvement of profit by means of cost control, and the financial management must be able to select and implement appropriate budgetary and cost control systems and to provide management information in a concise and relevant form.

(iii) If the focus is on cost control, then the finance department itself must be run as effectively and efficiently as possible.

(iv) If the company is growing, albeit slowly, the financial managers must be able to make a significant contribution to the evaluation of strategic opportunities as described above.

(v) If the slower rate of growth means that the company is cash generative, the financial management will be concerned with the best ways in which to use the funds, whether this involves investment in new business opportunities or repayment to shareholders in the form of dividends or a buy-back of shares.

(c) Unquoted company aiming for a stock exchange listing

(i) The financial managers must understand the listing requirements and be able to liaise with the banks and institutions advising on the flotation. They must also be able to provide information on the likely valuation of the shares and to advise on the proposed capital structure of the quoted company.

(ii) If the flotation (Initial Public Offer [IPO]) is being made due to the need for access to a wider pool of funds to finance expansion, then many of the points made in (a) will also be relevant.

(iii) If the purpose of the flotation is to enable the owners to realise the value of their investments then the financial managers must be able to persuade potential investors that the company will be as successful under a new ownership and control structure as it was as a private company.

(iv) The managers must be good at communicating information about the company to the wider public, and must be able to present financial information in a clear and accessible format.

(d) Small, family owned business

(i) The precise role of the financial management will depend to some extent on the position and nature of the company. For instance, is it growing or is it facing competitive pressure and liquidity problems? Different business situations will place different demands upon the financial managers.

(ii) In a small company, the financial manager must be able to turn his or her hand to a much wider range of activities than in a large company. For example, if office staff are absent then he or she may find themselves making up the wage packets, followed by a meeting with the bank to discuss the overdraft, followed by a time of both producing and interpreting the monthly management information. The financial manager must therefore be much more of a generalist and understand the details of a wide range of financial specialism.





(iii) The financial manager must be able to communicate effectively with a wide range of people, including the owners of the business, providers of finance, tax officers and shopfloor workers.

(e) Non profit-making organisation, for example a charity

(i) The fundamental difference between a non profit-making organisation and a commercial business is that resources are allocated not on the basis of cash flow generation, but on the basis of value to those providing the funds. Thus the financial manager will be more concerned with providing an appropriate way of measuring 'value' in the context of the aims of the organisation than with measuring cash flow.

(ii) The financial manager will need to be involved in the fund-raising process, whether this is targeted at individuals, other charitable institutions or various public sector bodies such as the UK Ministry for Overseas Development, the National Lottery or EU funds. This is obviously quite different from the way in which a commercial organisation raises funds in the form of equity and debt.

(iii) Since funds are donated, there is likely to be a strong emphasis on cost control and the efficient use of allocated resources.

(iv) The financial manager must have a good knowledge of the tax law as it affects charities, for example in certain value-add tax (VAT) exemptions and in the recovery of tax on money covenanted in various ways.

(f) Public sector, for example a government department

(i) In terms of expenditure, the work of the financial manager is likely to be similar to that in a non profit-making organisation, the emphasis being on 'value' rather than cash flow. This is likely to demand an understanding of the techniques of cost-benefit analysis.

(ii) Unless the department concerned is the Treasury, the financial manager will have little or no concern with the way in which funds are raised since there is generally a separation in the public sector between sourcing of funds and expenditure.

(iii) Unlike the private organisation where some attempt will be made to look at the longer term, most of the buying in a government department is concerned with the one year timespan and is framed in revenue terms.

There are many other comments in each case.

ONLY ONE type of organisation is required.


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The following financial information relates to Quested Company, a supplier of photographic equipment and film services to the film industry.

Profit and loss accounts for years ended 31 July

2010 2009 2008$m $m $m

Turnover 160·0 145·0 132·0Cost of sales 120·0 105·3 95·7

40·0 39·7 36·3Operating expenses 30·0 26·0 23·5Operating profit 10·0 13·7 12·8Interest 3·6 3·3 3·3Profit before tax 6·4 10·4 9·5Taxation 1·9 3·1 2·8Profit after tax 4·5 7·3 6·7Dividends 1·5 1·7 1·6

3·0 5·6 5·1

Share price at 31 July: $2·70 $5·11 $4·69

Balance sheets as at 31 July2010 2009

$m $m $m $m $m $mFixed assets 45 35Current assetsInventory 36 32Accounts receivable 41 24Cash 1 16

78 72Current liabilitiesAccounts payable 17 11Overdraft 8 1

25 12Net current assets 53 60Total assets less current liabilities 98 95Long-term liabilities10% debentures 2012 13 138% debentures 2017 25 25

38 3860 57

Capital and reservesOrdinary shares (50 cents par) 10 10Reserves 50 47

60 57

Notes: All sales are on credit. Quested currently pays interest on its overdraft at an annual rate of 6%, although this rate is variable.

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Section B – TWO questions ONLY to be attempted. (Each question carries 20 marks overall)

Question 5




Shareholders of Quested Company have been alarmed by the company’s recent announcement that it intends to cut the total dividend for the year. The announcement was released on 1 August 2010, Following the announcement, the company’s share price fell sharply from $2·70 to $2·45 where it has remained.

The Finance Director has collected the following average data for the media sector:

Return on capital employed 12% Inventory days 100 daysGross profit margin 25% Debtor days 60 daysNet profit margin 8% Creditor days 50 daysInterest cover 8 times Current ratio 3·5 timesGearing (debt/equity using book values) 50% Quick ratio 2·5 times

Required:

Using appropriate ratios and financial analysis, comment on the recent financial performance of Quested Company from a shareholder perspective. Clearly identify any issues that you consider should be brought to the attention of the ordinary shareholders. (20 marks)

Question 5 (continued)


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Quested PLC

Discussion of financial performance

It is clear that 2010 has been a difficult year for Quested plc. There are very few areas of interest to shareholders where anything positive can be found to say.

Profitability

Return on capital employed has declined from 14.4% in 2009, which compared favourably with the sector average of 12%, to 10.2% in 2010. Since asset turnover has improved from 1.5 to 1.6 in the same period, the cause of the decline is falling profitability. Gross profit has fallen each year from 27.5% in 2008 to 25% in 2010, equal to the sector average, despite an overall increase in turnover during the period of 10% per year. Quested plc has been unable to keep cost of sales increases (14% in 2010 and 10% in 2009) below the increases in turnover. Net profit margin has declined over the same period from 9.7% to 6.2%, compared to the sector average of 8%, because of substantial increases in operating expenses (15.4% in 2010 and 10.6% in 2009). There is a pressing need here for Quested plc to bring cost of sales and operating costs under control in order to improve profitability.

Gearing and financial risk

Gearing as measured by debt/equity has fallen from 67% (2009) to 63% (2010) because of an increase in shareholders’ funds through retained profits. Over the same period the overdraft has increased from $1m to $8m and cash balances have fallen from $16m to $1m. This is a net movement of $22m. If the overdraft is included, gearing has increased to 77% rather than falling to 63%.

None of these gearing levels compare favourably with the average gearing for the sector of 50%. If we consider the large increase in the overdraft, financial risk has clearly increased during the period. This is also evidenced by the decline in interest cover from 4.1 (2009) to 2.8 (2010) as operating profit has fallen and interest paid has increased. In each year interest cover has been below the sector average of eight and the current level of 2.8 is dangerously low.

Share price

As the return required by equity investors increases with increasing financial risk, continued increases in the overdraft will exert downward pressure on the company’s share price and further reductions may be expected.

Investor ratio

Earnings per share, dividend per share and dividend cover have all declined from 2009 to 2010. The cut in the dividend per share from 8.5 cents per share to 7.5 cents per share is especially worrying. Although in its announcement the company claimed that dividend growth and share price growth was expected, it could have chosen to maintain the dividend, if it felt that the current poor performance was only temporary. By cutting the dividend it could be signalling that it expects the poor performance to continue. Shareholders have no guarantee as to the level of future dividends. This view could be shared by the market, which might explain why the price-earnings ratio has fallen from 14 times to 12 times.


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Financing strategy

Quested plc has experienced an increase in fixed assets over the last period of $21m and an increase in current assets of $10m. These increases have been financed by a decline in cash ($15m), an increase in the overdraft ($7m) and an increase in trade credit ($6m). The company is following an aggressive strategy of financing long-term investment from short-term sources. This is very risky, since if the overdraft needed to be repaid, the company would have great difficulty in raising the funds required.

A further financing issue relates to redemption of the existing debentures. The 10% debentures are due to be redeemed in two years’ time and Quested plc will need to find $13m in order to do this. It does not appear that this sum can be raised internally. While it is possible that refinancing with debt paying a lower rate of interest may be possible, the low level of interest cover may cause concern to potential providers of debt finance, resulting in a higher rate of interest. The Finance Director of Quested plc needs to consider the redemption problem now, as thought is currently being given to raising a substantial amount of new equity finance. This financing choice may not be available again in the near future, forcing the company to look to debt finance as a way of effecting redemption.

Overtrading

The evidence produced by the financial analysis above is that Quested plc is showing some symptoms of overtrading (undercapitalisation). The board are suggesting a rights issue as a way of financing an expansion of business, but it is possible that a rights issue will be needed to deal with the overtrading problem. This is a further financing issue requiring consideration in addition to the redemption of debentures mentioned earlier.

Conclusion

Ordinary shareholders need to be aware of the following issues.

1 Profitability has fallen over the last year due to poor cost control

2 A substantial increase in the overdraft over the last year has caused gearing to increase

3 It is possible that the share price will continue to fall

4 The dividend cut may warn of continuing poor performance in the future. A total of $13m of debentures need redeeming in two year’s time

5 A large amount of new finance is needed for working capital and debenture redemption



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Appendix: analysis of key ratios and financial information

2010 2009 2008Gross profit margin (%) (40.0/160) 25.0 (39.7/145) 27.4 (36.3/132) 27.5Net profit margin (%) (10.0/160) 6.2 (13.7/145) 9.4 (12.8/132) 9.7Interest cover (times) (10/3.6) 2.8 (13.7/3.3) 4.1 (12.8/3.3) 3.9Earnings per share (cents) (4.5/20) 22.5 (7.3/20) 36.5 (6.7/20) 33.5Dividend per share (cents) (1.5/20) 7.5 (1.7/20) 8.5 (1.6/20) 8.0Dividend cover (times) (4.5/1.5) 3 (7.3/1.7) 4.3 (6.7/1.6) 4.2Price-earnings ratio (times) (270/22.5) 12 (511/36.5) 14 (469/33.5) 14

2010 2009ROCE (%) (10/98) 10.2 (13.7/95) 14.4Asset turnover (times) (160/98) 1.6 (145/95) 1.5Gearing (%) (38/60) 63 (38/57) 67Gearing (with overdraft, %) (46/60) 77 (39/57) 68Growth rates:Cost of sales 120/105.3 = 14% 105.3/95.7 =10%Operating expenses 30/26 = 15.4% 26/23.5 = 10.6%



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Question 6

Jinga Company is considering the selection of one of a pair of mutually exclusive investment projects. Both would involve the purchase of machinery with a life of five years.

Project 1 would generate annual cash flows (receipts less payments) of $200,000; the machinery would cost $556,000 and have a scrap value of $56,000.

Project 2 would generate annual cash flows of $500,000; the machinery would cost $1,616,000 and have a scrap value of $301,000.

Jinga Company uses the straight line method for providing depreciation. Its cost of capital is 15% p.a. Assume that the annual cash flows arise on the anniversaries of the initial outlay, that there will be no price changes over the project lives and that acceptance of one of the projects will not alter the required amount of working capital.

Required

(a) Calculate for each project:

(i) the accounting rate of return (ratio, over project life, of average annual accounting profit to average annual book value of investment) to nearest 1%;

(ii) the net present value;(iii) the internal rate of return (DCF yield) to the nearest 1%;(iv) the payback period to one decimal place;

(12 marks)

(b) State which project you would select for acceptance, if either, giving reasons for your choice of criterion to guide the decision. ( 8 marks)

Ignore taxation (20 marks)


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(a) SUMMARISED DATA

Workingnote Project Project

Criterion reference 1 2(i) Accounting rate of return 1 28% 21.7%(ii) Net present value ($'000) 2 142 210(iii) Internal rate of return 3 25% 20.5%(iv) Payback period (years) 4 2.8 3.2(v) Discounted payback (years) 5 4 5(vi) Annual equivalent benefit ($'000) 6 42.36 62.65

SUMMARISED RANKING

Summary of ranking Best project

(i) Accounting rate of return 1 (ii) Net present value 2 (iii) Internal rate of return 1 (iv) Payback period 1 (v) Discounted payback 1(vi) Annual equivalent benefit 2

WORKING NOTES

1. Accounting rate of return (ARR)

Project 1 Project 2$'000 $'000

Cash flows 200 500Depreciation (see below) 100 263Average accounting profit 100 237

DepreciationInitial investment 556 1,616Scrap value 56 301

500 1,315Annual depreciation 1/5 100 263

Comment

This question allows the Candidate to show knowledge of the various investment appraisal criteria they are likely to encounter in the appraisal exercise.

End of comment


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Annual book value of investment

Project 1 Project 2£'000 £'000Year 1 Opening book value 556 1,616

Depreciation 100 263Year 2 Opening book value 456 1,353

Depreciation 100 263Year 3 Opening book value 356 1,090

Depreciation 100 263Year 4 Opening book value 256 827

Depreciation 100 263Year 5 Opening book value 156 564

556 + 456 + 356 + 256 + 156 = 1,780 1,780/5 = $356

1,616 + 1,353 + 1,090 + 827 + 564 = 5,450 5,450/5 = $1,090

(For an alternative method of calculation see the tutorial comment on the next page.)

Rate of return:

($100,000/$356,000) x 100 = 28%

($237,000/$1,090,000) x 100 = 21.7%

2. Net present value (NPV)Discount rate: 15%

Project 1 Project 2Year £'000 £'0000 Initial outlay (556) (1,616)

1 - 5 Cash flows200 x 3.352 670 500 x 3.352 1,676

5 Residual value56 x 0.497 28301 x 0.497 150

Net present value 142 210

3. Internal rate of return (IRR)Project 1 Project 2£'000 £'000

By trial and errorIst trial: 15%: (see note 2) NPV: 142 210


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Comment

There are different approaches for valuing the ‘Average annual investment’ figure used in the denominator of the ARR equation.

An acceptable approach (which results in a different ARR value) is as follows:

Accounting rate of return (ARR)

Average annual profitProject 1 Project 2$'000 $'000

Cash flows 200 500Depreciation (see below) 100 263Average accounting profit 100 237

DepreciationInitial investment 556 1,616Scrap value 56 301

500 1,315Annual depreciation 1/5 100 263

There is no change to the previous calculation (see Note 2.)

Average annual investment

= (Capital investment + disposal value)/2

Project 1: ($556,000 + $56,000)/2 = $306,000Project 2: ($1,616,000 + $301,000)/2 = $959,000

ARR

End of comment

27.4%

32.7%

$959,000$263,000 2Project

$306,000$100,000 1Project

=

=

=

=



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15)% - (25 x 172 210

210 15% +

+=IRR

2nd trial: 25%: Project 1 Project 2

Year £'000 £'0000 Initial outlay (556) (1,616)

1 - 5 Cash flows200 x 2.689* 538 500 x 2.689 1,345

5 Residual value56 x 0.328** 18301 x 0.328 99

0 (172)

* Use the formula at the top of the annuity table:

** Use the formula at the top of the present value table:

pv = (1 + r)-n= 1.25-5

= 0.328

IRR: 25%20.5%

4. Payback period (years)Project 1 Project 2

£'000 £'000

Annual cash flows 200 500Initial investment 556 1,616

Payback in years:(556/200) 2.80.8 x 12 = 9.6 2 years, 10 months

(1,616/500) 3.20.2 x 12 = 2.4 3 years, 3 months

2.689 0.25

5-(1.25) - 1

r

-nr) (1 - 1 Annuity

=

=

+=



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5. Discounted payback (years)

Project 1 (£'000) Project 2 (£'000)

DCF Cash PV Cumulative Cash PV CumulativeYear at 15% flow at 15% PV flow at 15% PV

0 1.000 (556) (556) (556) (1,616) (1,616) (1,616) 1 0.870 200 174 (382) 500 435 (1,181)2 0.756 200 151 (231) 500 378 (803)3 0.658 200 132 (99) 500 329 (474)4 0.572 200 114 15 500 286 (188)5 0.497 801 398 210

Discounted payback period Discounted payback periodProject 1 = 4 years Project 2 = 5 years

Note: there is little point in calculating the payback period as a fractional number of years as in discounting the above cash flows we have assumed that they occur at the end of each year.

6. Annual equivalent benefit

Annual equivalent value = Net present value/Annuity for years

Project 1 = $142,000/3.352 = £42,363

Project 2 = $210,000/3.352 = £62,650

For NPVs see Note 2.

(b) On the basis of the information provided project 2 should be adopted as it has the highest NPV.

The reason for using the NPV criterion is that since the company's cost of capital is 15%, acceptance of project 2 will lead to the greatest increase in shareholder wealth. Further, because the projects have equal lives, the annual equivalent benefit calculation also supports this answer.

The reasons for rejecting the other criteria are as follows:

(i) Accounting rate of return fails to take account of the time value of money. It is also a measure of average profitability rather than the increase in absolute wealth. The NPV is better than the accounting rate of return (ARR) method because it focuses on cash flows rather than profits and therefore avoids the understatement of returns caused by double-counting depreciation (deducting depreciation from both the numerator and denominator in the equation).

An advantage claimed for the accounting rate of return method is that it is related to accounting profits, but it is felt that this is outweighed by the disadvantages involved.


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(ii) The payback period ignores both the time value of money and the cash flows after payback and is unsuitable for investment appraisal. An alternative approach is the discounted payback method which looks at the time required for discounted cash flows to repay the initial investment. Although a better approach, this still ignores cash flows after payback.

(iii) IRR does take account of the time value of money, but averages the return over the outlay. It therefore fails to take account of the absolute size of a project's returns. When used asaranking measure it is liable to give incorrect results.

The NPV is superior to the internal rate of return (IRR) approach because if does not suffer from the problem of multiple rates of return due to irregularities in the pattern of cash flows.

Before making a final decision it should be noted that the NPV technique relies on various assumptions (freedom to borrow and lend large amounts of cash at the given discount rate, investor rationality, etc.) and it is important to check that these apply in the case of Jinga. Finally, none of the above approaches have made any allowance for uncertainty of future cash flows.

Fortune knocks but once, but misfortune has much more patience.

Author Unknown



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Question 7 Extracts from the recent financial statements of Zalco Company for years ending 31st July are as follows:

Profit and loss accounts 2010 2009$000 $000

Turnover 15,600 11,100Cost of sales 9,300 6,600Gross profit 6,300 4,500Administration expenses 1,000 750Profit before interest and tax 5,300 3,750Interest 100 15Profit before tax 5,200 3,735

Balance sheets at 31st July 2010 2009

$000 $000 $000 $000Fixed assets 5,750 5,400Current assets

Inventory 3,000 1,300Debtors 3,800 1,850Cash 120 900

6,920 4,050Current liabilities

Trade creditors 2,870 1,600Overdraft 1,000 150

(3,870) (1,750)Total assets less current liabilities 8,800 7,700

All sales were on credit. Zalco Company has no long-term debt. Credit purchases in each year were 95% of cost of sales. Current sector averages are as follows:

Inventory days: 90 days Debtor days: 60 days Creditor days: 80 days

Required:

(a) Calculate the following ratios for each year and comment on your findings.

(i) inventory days(ii) debtor days(iii) creditor days (6 marks)

(b) Calculate the length of the cash operating cycle (working capital cycle) for each year and explain itssignificance. (4 marks)

(c) Discuss the relationship between working capital management and business solvency, and explain the factors that influence the optimum cash level for a business. (10 marks)

(20 marks)


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(a) Sector average Zalco 2010 Zalco 2009

Inventory($’000)

90 days

Receivables($’000)

60 days

Payables($’000)

80 days

In each case, the ratio in 2010 is higher than the ratio in 2009 indicating that deterioration has occurred in the management of inventory, receivables and payables in 2010.

Inventory days have increased by 48 days or 63%, moving from below the sector average to 34 days more than it. Given the rapid increase in turnover of 40% ((15,600-11,100)/11,100) (40%) in 2010, Zalco Co may be expecting a continuing increase in the future and may have built up inventory in preparation for this, i.e. inventory levels reflect future sales rather than past sales. Accounting statements from several previous years and sales forecasts for the next period would help to clarify this point.

Receivables days have increased by 28 days or 46% in 2010 and are now 29 days above the sector average. It is possible that more generous credit terms have been offered in order to stimulate sales. The increased turnover does not appear to be due to offering lower prices, since both gross profit margin of 40% (6,300/15,600, and 4,500/11,100) and net profit margin of 34% (5,300/15,600 and 3,750/11,100) are unchanged.

In 2009, only management of payables was a cause for concern, with Zalco Co taking 13 more days on average to settle liabilities with trade creditors than the sector. This has increased to 39 days more than the sector in 2010. This could lead to difficulties between the company and its suppliers if it is exceeding the credit periods they have specified. Zalco Co has no long-term debt and the balance sheet indicates an increased reliance on short-term finance, since cash has reduced by $780,000 or 87% (780/900) and the overdraft has increased by $850,000 to $1,000,000.

Perhaps the company should investigate whether it is under-funded. It is unusual for a company of this size to have no long-term debt.

days 124 0.95 x $9,300365 x $3,000

Purchases365 x Inventory

=

=

=

days 76 0.95 x $6,600365 x $1,300

=

=

days 89 $15,600

365 x $3,800

Sales365 x sReceivable

=

=

=

days 61 $11,100

365 x $1,850

=

=

days 119 0.95 x $9,300365 x $2,870

Purchases365 x Payables

=

=

=

days 93 0.9 x $6,600365 x $1,600

=

=



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(b) Length of cash operating cycle(Statistics taken from answer part (a))

2010 2009Days Days

In inventory 124 76Payment period (119) (93)

5 (17)Collection period 89 61Cash operating cycle 94 days 44 days

The cash operating cycle or working capital cycle gives the average time it takes for the company to receive payment from receivables after it has paid its trade creditors. This represents the period of time for which the receivables require financing. The cash operating cycle of Zalco Co has lengthened by 50 days in 2010 compared with 2009. This represents an increase in working capital requirement of approximately $15,600,000 x 50/365 = $2.14 million.

(c) Taking steps to improve its working capital management

The objectives of working capital management are often stated to be profitability and liquidity. These objectives are often in conflict, since liquid assets earn the lowest return and so liquidity is achieved at the expense of profitability. However, liquidity is needed in the sense that a company must meet its liabilities as they fall due if it is to remain in business. For this reason cash is often called the lifeblood of the company, since without cash a company would quickly fail. Good working capital management is therefore necessary if the company is to survive and remain profitable.

The fundamental objective of the company is to maximise the wealth of its shareholders and good working capital management helps to achieve this by minimising the cost of investing in current assets. Good credit management, for example, aims to minimise the risk of bad debts and expedite the prompt payment of money due from receivables in accordance with agreed terms of trade. Taking steps to optimise the level and age of receivables will minimise the cost of financing them, leading to an increase in the returns available to shareholders.

A similar case can be made for the management of inventory. It is likely that Zalco Co will need to have a good range of stationery and office supplies on its premises if customers’ needs are to be quickly met and their custom retained. Good inventory management, for example using techniques such as the economic order quantity model, ABC analysis, stock rotation and buffer stock management can minimise the costs of holding and ordering stock. The application of just-in-time methods of stock procurement and manufacture can reduce the cost of investing in inventory. Taking steps to improve inventory management can therefore reduce costs and increase shareholder wealth.

Cash budgets can help to determine the transactions needed for cash in each budget control period, although the optimum cash position will also depend on the precautionary and speculative need for cash. Cash management models can help to maintain cash balances close to optimum levels.

The different elements of good working capital management therefore combine to help the company to achieve its primary financial objective.


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Question 8

(a) List the factors which need to be considered when deciding on the investment of short-term cash.(10 marks)

(b) Advise a listed company which has $500,000 surplus of cash for approximately the next 12 months what are the possible ways in which the cash can be used. (10 marks)

(20 marks)


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(a) The main factors include:

(i) Quantity of funds available.

(ii) The length of time for which funds are available. An analysis of the cash budget may indicate that some funds are available for the whole ‘x’ month period whereas other amounts are available only for a much shorter period. The optimum use of funds with different investment periods is likely to differ and the mix of fund quantity and duration may have an impact on the final decision. Investment of short term funds should be designed to ensure the consequences of the investment are largely restricted to the period of surplus, e.g. it would probably be wrong to use short term funds to reduce long term borrowing.

(iii) Certainty of surplus funds and accuracy of cash budget.

(iv) Return on the invested funds.

(v) Risk of, and variability of return from, the investment if held for the full intended duration.

(vi) Possibility and costs of early termination of the investment.

(vii) Risks associated with early termination. A security which provides a fixed, risk free, return if held for the full term may prove risky if terminated early.

(viii) Portfolio of short term investments and short term cash requirements. Ideally a portfolio approach should be used such that the mix of total investment provides for the potential risks and overall cash requirements.

(b) Idle resources generate no income and reduce the return on a company's total capital employed. It is important, therefore, that all assets should directly or indirectly help in the generation of profits, failing which they should be realised and the proceeds distributed to shareholders, or reinvested in a more profitable form. This principle applies to surplus cash also, but the method adopted for re-investing such funds will depend upon whether the surplus is permanent or temporary, In this particular instance, the $500,000 is surplus to current requirements for a period of one year only and therefore appropriate avenues of short-term investment must be considered.

In selecting appropriate investment areas it is important to consider the return offered, the degree of risk, and the extent to which the funds may be withdrawn at short notice. With these factors in mind, it would not be advisable to invest the full amount in any one area, but to have a mixture, selecting some very high liquidity and low returns, and others offering higher returns but requiring stipulated periods of notice or the expiration of a given term, before the principal is repayable.

The principal forms of investment which should be considered are:

(i) Bank deposits with the clearing banks

The rate of interest is generally about 2 per cent below the base rate. In practice, 7 days' notice of withdrawal is required.

(ii) Deposits with merchant banks and branches of foreign banks

Rates of interest and withdrawal terms are similar to those of clearing banks, but are frequently varied; a lot depends upon the size of the deposit and the payments terms involved.

(iii) Discount houses

Discount houses will accept deposits at terms fixed by the London Discount Market Association. Deposits may be accepted with the right of immediate withdrawal (sight deposits), or withdrawals at 7 days' notice which gives a slightly higher return.


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(iv) Short term government securities. These can provide a known fixed return if held for whole intended period (and if government security matures at the end of the period). Can be used for the investment of large sums. Premature termination of loan may be difficult. Premature termination of government security, by sale, may result in loss, or gain, on capital sum if interest rates fluctuate.

Plus any other sensible advantage, such as investment in Certificates of Deposit, commercial paper, local government bonds, etc..


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payment until periods ofnumber n ratediscount r here

n-r) (1 i.e. 1 of valuePresent

Table ValuePresent

==

+


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( )

periods ofnumber n ratediscount r Where

rn -r) 1 - 1 i.e. 1 of annuity an of valuePresent

Table Annuity

==

+

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