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Justify and criticise the usual assumption made in financial management literature that the
objective of a company is to maximise the wealth of the shareholders. (Do not consider how this
wealth is to be measured).
Outline other goals that companies claim to follow, and explain why these might be adopted in
preference to the maximisation of shareholder wealth.
(20 marks)
What non-financial objectives might organisations have? In your answer, identify any
stakeholder group that may have a non-financial interest.
(12 marks)
Private sector companies have multiple stakeholders who are likely to have divergent interests.
(a) Identify five stakeholder groups and briefly discuss their financial and other objectives.
(12 marks)
(b) Examine the extent to which good corporate governance procedures can help manage
the problems arising from the divergent interests of multiple stakeholder groups in
private sector companies in the UK. (13 marks)
(25 marks)
Discuss the nature of the financial objectives that may be set in a not-for-profit organisation such
as a charity or a hospital.
(8 marks)
Question 5 TAGNA
Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores.
In real terms, the company has experienced only a small growth in turnover in recent years, but it has
managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid a
constant nominal (money terms) dividend for several years and its managing director has publicly
stated that the primary objective of the company is to increase the wealth of shareholders. Tagna is
financed as follows:
Overdraft 10
10 year fixed interest bank loan 20
Share capital and reserves 45


Tagna has the agreement of its existing shareholders to make a new issue of shares on the stock market
but has been informed by its bank that current circumstances are unsuitable. The bank has stated that if
new shares were to be issued now they would be significantly under-priced by the stock market,
causing Tagna to issue many more shares than necessary in order to raise the amount of finance it
requires. The bank recommends that the company waits for at least six months before issuing new
shares, by which time it expects the stock market to have become strong-form efficient.
The financial press has reported that it expects the Central Bank to make a substantial increase in
interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in
inflation. The financial press has also reported that the rapid increase in consumer demand has been
associated with an increase in consumer credit to record levels.
(a) Discuss the meaning and significance of the different forms of market efficiency (weak,
semi-strong and strong) and comment on the recommendation of the bank that Tagna
waits for six months before issuing new shares on the stock market. (9 marks)
(b) On the assumption that the Central Bank makes a substantial interest rate increase,
discuss the possible consequences for Tagna in the following areas:
(i) sales;
(ii) operating costs; and,
(iii) earnings (profit after tax). (10 marks)
(c) Explain and compare the public sector objective of value for money and the private
sector objective of maximisation of shareholder wealth. (6 marks)
(25 marks)
Question 6 MONOPOLY
An important element in the economic and financial management environment of companies is the
regulation of markets to discourage monopoly.
Outline the economic problems caused by monopoly and explain the role of government in
maintaining competition between companies.
(9 marks)
Explain the meaning of the term Efficient Market Hypothesis and discuss the implications for a
company if the stock market on which it is listed has been found to be semi-strong form efficient.
(9 marks)
You are the chief accountant of Deighton plc, which manufactures a wide range of building and
plumbing fittings. It has recently taken over a smaller unquoted competitor, Linton Ltd. Deighton is
currently checking through various documents at Lintons head office, including a number of
investment appraisals. One of these, a recently rejected application involving an outlay on equipment of
$900,000, is reproduced below. It was rejected because it failed to offer Lintons target return on
investment of 25% (average profit to-initial investment outlay). Closer inspection reveals several errors
in the appraisal.
Evaluation of profitability of proposed project NT17
(all values in nominal terms)
Item ($000) 0 1 2 3 4
Sales 1,400 1,600 1,800 1,000
Materials (400) (450) (500) (250)
Direct labour (400) (450) (500) (250)
Overheads (100) (100) (100) (100)
Interest (120) (120) (120) (120)
Depreciation (225) (225) (225) (225)
Profit pre-tax 155 255 355 55
Tax at 33% (51) (84) (117) (18)
Post-tax profit 104 171 238 37
Inventory (100)
Equipment (900)
Market research (200)

Rate of return =
profit Average
= 11.5%
You discover the following further details:
(1) Lintons policy was to finance both working capital and fixed investment by a bank overdraft.
A 12% interest rate applied at the time of the evaluation.
(2) A 25% writing down allowance (WDA) on a reducing balance basis is offered for new
investment. Lintons profits are sufficient to utilise fully this allowance throughout the
(3) Corporate tax is paid a year in arrears.
(4) Of the overhead charge, about half reflects absorption of existing overhead costs.
(5) The market research was actually undertaken to investigate two proposals, the other project
also having been rejected. The total bill for all this research has already been paid.
(6) Deighton itself requires a nominal return on new projects of 20% after taxes, is currently
ungeared and has no plans to use any debt finance in the future.
Write a report to the finance director in which you:
(a) Identify the mistakes made in Lintons evaluation. (10 marks)
(b) Restate the investment appraisal in terms of the post-tax net present value to Deighton,
recommending whether the project should be undertaken or not. (10 marks)
(20 marks)
Blackwater plc, a manufacturer of speciality chemicals, has been reported to the anti-pollution
authorities on several occasions in recent years, and fined substantial amounts for making excessive
toxic discharges into local rivers. Both the environmental lobby and Blackwaters shareholders demand
that it clean up its operations.
It is estimated that the total fines it may incur over the next four years can be summarised by the
following probability distribution (all figures are expressed in present values):
Level of fine Probability
$0.5m 0.3
$1.4m 0.5
$2.0m 0.2

Filta & Strayne Ltd (FSL), a firm of environmental consultants; has advised that new equipment costing
$1m can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollution
control equipment is tax-allowable via a 25% writing-down allowance (reducing balance). The rate of
corporate tax is 33%, paid with a one-year delay. The equipment will have no resale value after its
expected four-year working life, but can be in full working order immediately prior to Blackwaters
next financial year.
A European Union Common Pollution Policy grant of 25% of gross expenditure is available, but with
payment delayed by a year. Immediately on receipt of the grant from the EU, Blackwater will pay 20%
of the grant to FSL as commission. These transactions have no tax implications for Blackwater.
A disadvantage of the new equipment is that it will raise production costs by $30 per tonne over its
operating life. Current production is 10,000 tonnes per annum, but expected to grow by 5% per annum
compound. It can be assumed that other production costs and product price are constant over the next
four years. No change in working capital is envisaged.
Blackwater applies a discount rate of 12% after all taxes to investment projects of this nature. All cash
inflows and outflows occur at year ends.
(a) Calculate the expected net present value of the investment assuming a four-year
operating period. Briefly comment on your results. (12 marks)
(b) Write a memorandum to Blackwaters management as to the desirability of the project,
taking into account both financial and non-financial criteria. (8 marks)
(20 marks)
(a) Explain and illustrate (using simple numerical examples) the Accounting Rate of Return
and Payback approaches to investment appraisal, paying particular attention to the
limitations of each approach. (6 marks)
(b) (i) Explain the differences between NPV and IRR as methods of Discounted Cash
Flow analysis. (6 marks)
(ii) A company with a cost of capital of 14% is trying to determine the optimal
replacement cycle for the laptop computers used by its sales team. The following
information is relevant to the decision:
The cost of each laptop is $2,400. Maintenance costs are payable at the end of each
full year of ownership, but not in the year of replacement e.g. if the laptop is owned
for two years, then the maintenance cost is payable at the end of year 1.
Interval between Trade-in Value ($) Maintenance cost ($)
Replacement (years)
1 1200 Zero
2 800 75 (payable at end of Year 1)
3 300 150 (payable at end of Year 2)
Ignoring taxation, calculate the equivalent annual cost of the three different
replacement cycles, and recommend which should be adopted. What other factors
should the company take into account when determining the optimal cycle? (8 marks)
(20 marks)
Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The
machine is essential to the operations of the company. The company is, however, considering whether
to purchase the machine outright or to use lease financing.
Purchasing the machine outright
The machine is expected to cost $360,000 if it is purchased outright, payable on 31 December 2002.
After four years the company expects new technology to make the machine redundant and it will be
sold on 31 December 2006 generating proceeds of $20,000. Capital allowances for tax purposes are
available on the cost of the machine at the rate of 25% per annum reducing balance. A full years
allowance is given in the year of acquisition but no writing down allowance is available in the year of
disposal. The difference between the proceeds and the tax written down value in the year of disposal is
allowable or chargeable for tax as appropriate.
The company has approached its bank with a view to arranging a lease to finance the machine
acquisition. The bank has offered two options with respect to leasing which are as follows:
Finance Operating
Lease Lease
Contract length (years) 4 1
Annual rental $135,000 $140,000
First rent payable 31 December 2003 31 December 2002

For both the purchasing and the finance lease option, maintenance costs of $15,000 per year are payable
at the end of each year. All lease rentals (for both finance and operating options) can be assumed to be
allowable for tax purposes in full in the year of payment. Assume that tax is payable one year after the
end of the accounting year in which the transaction occurs. For the operating lease only, contracts are
renewable annually at the discretion of either party. Leaminger plc has adequate taxable profits to
relieve all its costs. The rate of corporation tax can be assumed to be 30%. The companys accounting
year-end is 31 December. The companys annual after tax cost of capital is 10%.
(a) Calculate the net present value at 31 December 2002, using the after tax cost of capital,
(i) purchasing the machine outright;
(ii) using the finance lease to acquire the machine; and
(iii) using the operating lease to acquire the machine.
Recommend the optimal method. (12 marks)
(b) Assume now that the company is facing capital rationing up until 30 December 2003 when it
expects to make a share issue. During this time the most marginal investment project, which
is perfectly divisible, requires an outlay of $500,000 and would generate a net present value
of $100,000. Investment in the turbine would reduce funds available for this project.
Investments cannot be delayed.
Calculate the revised net present values of the three options for the turbine given capital
rationing. Advise whether your recommendation in (a) would change. (5 marks)
(c) As their business advisor, prepare a report for the directors of Leaminger plc that
assesses the issues that need to be considered in acquiring the turbine with respect to
capital rationing. (8 marks)
(25 marks)
Question 12 BASRIL PLC
Basril plc is reviewing investment proposals that have been submitted by divisional managers. The
investment funds of the company are limited to $800,000 in the current year. Details of three possible
investments, none of which can be delayed, are given below.
Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an individual
employee basis and would lead to savings in labour costs from increased efficiency and from reduced
absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms
are expected to be as follows:
Year 1 2 3 4 5
Cash flows ($000) 85 90 95 100 95

Project 2
An investment of $450,000 in individual workstations for staff that is expected to reduce administration
costs by $140,800 per annum in money terms for the next five years.
Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are
expected in current price terms and these are expected to increase by 36% per annum due to inflation
during the five-year life of the machines.
Basril plc has a money cost of capital of 12% and taxation should be ignored.
(a) Determine the best way for Basril plc to invest the available funds and calculate the
resultant NPV:
(i) on the assumption that each of the three projects is divisible;
(ii) on the assumption that none of the projects are divisible. (10 marks)
(b) Explain how the NPV investment appraisal method is applied in situations where capital
is rationed. (3 marks)
(c) Discuss the reasons why capital rationing may arise. (7 marks)
(d) Discuss the meaning of the term relevant cash flows in the context of investment
appraisal, giving examples to illustrate your discussion. (5 marks)
(25 marks)
Question 13 LKL PLC
LKL plc is a manufacturer of sports equipment and is proposing to start project VZ, a new product line.
This project would be for the four years from the start of year 19X1 to the end of 19X4. There would be
no production of the new product after 19X4.
You have recently joined the companys accounting and finance team and have been provided with the
following information relating to the project:
Capital expenditure
A feasibility study costing $45,000 was completed and paid for last year. This study recommended that
the company buy new plant and machinery costing $1,640,000 to be paid for at the start of the project.
The machinery and plant would be depreciated at 20% of cost per annum and sold during year 19X5 for
$242,000 receivable at the end of 19X5. As a result of the proposed project it was also recommended
that an old machine be sold for cash at the start of the project for its book value of $16,000. This
machine had been scheduled to be sold for cash at the end of 19X2 for its book value of $12,000.
Other data relating to the new product line:
19X1 19X2 19X3 19X4
$000 $000 $000 $000
Sales 1,000 1,300 1,500 1,800
Receivables (at the year end) 84 115 140 160
Lost contribution
on existing products 30 40 40 36
Purchases 400 500 580 620
Payables (at the year end) 80 100 110 120
Payments to sub-contractors, 60 90 80 80
including prepayments of 5 10 8 8
Net tax payable
associated with this project 96 142 174 275
Fixed overheads and advertising:
With new line 1,330 1,100 990 900
Without new line 1,200 1,000 900 800

The year-end receivables and payables are received and paid in the following year.
The net tax payable has taken into account the effect of any capital allowances. There is a one
year time-lag in the payment of tax.
The companys cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Apart from the data and information supplied there are no other financial implications after

Labour costs
From the start of the project, three employees currently working in another department and earning
$12,000 each would be transferred to work on the new product line, and an employee currently earning
$20,000 would be promoted to work on the new line at a salary of $30,000 per annum. The effect of the
transfer of employees from the other department to the project is included in the lost contribution
figures given above.
As a direct result of introducing the new product line, four employees in another department currently
earning $10,000 each would have to be made redundant at the end of 19X1 and paid redundancy pay of
$I5,500 each at the end of 19X2.
Agreement had been reached with the trade unions for wages and salaries to be increased by 5% each
year from the start of 19X2.
Material costs
Material XNT which is already in inventory, and for which the company has no other use, cost the
company $6,400 last year, and can be used in the manufacture of the new product. If it is not used the
company would have to dispose of it at a cost to the company of $2,000 in 19X1.
Material XPZ is also in inventory and will be used on the new line. It cost the company $11,500 some
years ago. The company has no other use for it, but could sell it on the open market for $3,000 in 19X1.
(a) Prepare and present a cash flow budget for project VZ, for the period 19X1 to 19X5 and
calculate the net present value of the project. (14 marks)
(b) Write a short report for the board of directors which:
(i) explains why certain figures which were provided in (a) were excluded from
your cash flow budget, and
(ii) advises them on whether or not the project should be undertaken, and lists
other factors which would also need to be considered. (7 marks)
(c) LKL needs to raise $5 million to finance project VZ, and other new projects. The proposed
investment of the $5 million is expected to yield pre-tax profits of $2 million per annum.
Earnings on existing investments are expected to remain at their current level. From the data
supplied below:
Statement of Financial Position (extract from last year):
Authorised share capital Ordinary shares of 50c each 20,000
Issued ordinary share capital, Shares of 50c each 2,500
Reserves 4,000
10% Debentures (19X4) 2,000
Bank Overdraft (secured) 2,000
Other information: $000
Turnover 55,000
Net profit after interest and tax 3,000
Interest paid 200
Dividends paid and proposed 800

The 50c ordinary shares are currently quoted at $2.25 per share: The companys tax rate is
33%. The average gearing percentage for the industry in which the company operates is 35%
(computed as debt as a percentage of debt plus equity, based on book values, and excluding
bank overdrafts).
(i) Calculate and comment briefly on the companys current capital gearing.
Discuss briefly the effect on gearing and EPS at the end of the first full year following the
new investment if the $5 million new finance is raised in each of the following ways;
(ii) By issuing ordinary shares at $2 each.
(iii) By issuing 5% convertible loan stock, convertible in 19X4. The conversion
ratio is 40 shares per $ 100 of loan stock.
(iv) By issuing 7.5% undated debentures.
(You should ignore issue costs in your answers to parts (ii) (iv)) (14 marks)
(35 marks)
Springbank plc is a medium-sized manufacturing company that plans to increase capacity by
purchasing new machinery at an initial cost of $3m. The following are the most recent financial
statements of the company:
Income Statements for years ending 31 December
2002 2001
$000 $000
Sales 5,000 5,000
Cost of Sales 3,100 3,000

Gross Profit 1,900 2,000
Administration and Distribution Expenses 400 250

Profit before Interest and Tax 1,500 1,750
Interest 400 380

Profit before Tax 1,100 1,370
Tax 330 400

Profit after Tax 770 970
Dividends 390 390

Retained Earnings 380 580

Statements of Financial Position as at 31 December
2002 2001
$000 $000 $000 $000
Fixed Assets 6,500 6,400
Current Assets
Inventory 1,170 1,000
Receivables 850 900
Cash 130 100

2,150 2,000
Current Liabilities 1,150 1,280

1,000 720

7,500 7,120
10% Debentures 2007 3,500 3,500

4,000 3,620

Capital and Reserves 4,000 3,620

The investment is expected to increase annual sales by 5,500 units. Investment in replacement
machinery would be needed after five years. Financial data on the additional units to be sold is as
Selling price per unit 500
Production costs per unit 200

Variable administration and distribution expenses are expected to increase by $220,000 per year as a
result of the increase in capacity. In addition to the initial investment in new machinery, $400,000
would need to be invested in working capital. The full amount of the initial investment in new
machinery of $3 million will give rise to capital allowances on a 25% per year reducing balance basis.
The scrap value of the machinery after five years is expected to be negligible. Tax liabilities are paid in
the year in which they arise and Springbank plc pays tax at 30% of annual profits.
The Finance Director of Springbank plc has proposed that the $34 million investment should be
financed by an issue of debentures at a fixed rate of 8% per year.
Springbank plc uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its
financial statements, Springbank plc uses straight-line depreciation over the expected life of fixed
Average data for the business sector in which Springbank operates is as follows:
Gearing (book value of debt/book value of equity) 100%
Interest Cover 4 times
Current Ratio 2:1
Inventory Days 90 days
Return before Interest and Tax/Capital Employed 25%

(a) Calculate the net present value of the proposed investment in increased capacity of
Springbank plc, clearly stating any assumptions that you make in your calculations.
(11 marks)
(b) Calculate the increase in sales (in units) that would produce a zero net present value for
the proposed investment. (4 marks)
(c) (i) Calculate the effect on the gearing and interest cover of Springbank plc of
financing the proposed investment with an issue of debentures and compare
your results with the sector averages. (6 marks)
(ii) Analyse and comment on the recent financial performance of the company.
(13 marks)
(iii) On the basis of your previous calculations and analysis, comment on the
acceptability of the proposed investment and discuss whether the proposed
method of financing can be recommended. (10 marks)
(d) Briefly discuss the possible advantages to Springbank plc of using an issue of ordinary
shares to finance the investment. (6 marks)
(50 marks)
Question 15 NESPA PLC
Nespa is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three
years. Although the company has an overdraft, it has no long-term debt and its current interest cover is
high compared to similar companies. Its return on capital employed, however, is close to the average
for its business sector. One of its machines is leased under an operating lease, but the company has no
other leasing or hire purchase commitments. The company owns two factories and the land on which
they are built, as well as a small fleet of delivery vehicles. The company does not own any retail outlets
through which to distribute its manufactured output.
Nespa is considering an investment in a new machine, with a maximum output of 200,000 units per
annum, in order to manufacture a new toy. Market research undertaken for the company indicated a link
between selling price and demand, and the research agency involved has suggested two sales strategies
that could be implemented, as follows:
Strategy 1 Strategy 2
Selling price (in current price terms) $800 per unit $700 per unit
Sales volume in first year 100,000 units 110,000 units
Annual increase in sales volume after first year 5% 15%

The services of the market research agency have cost $75,000 and this amount has yet to be paid.
Nespa expects economies of scale to reduce the variable cost per unit as the level of production
increases. When 100,000 units are produced in a year, the variable cost per unit is expected to be $300
(in current price terms). For each additional 10,000 units produced in excess of 100,000 units, a
reduction in average variable cost per unit of $005 is expected to occur. The average variable cost per
unit when production is between 110,000 units and 119,999 units, for example, is expected to be $295
(in current price terms); and the average variable cost per unit when production is between 120,000
units and 129,999 units is expected to be $290 (in current price terms), and so on.
The new machine would cost $1,500,000 and would not be expected to have any resale value at the end
of its life. Capital allowances would be available on the investment on a 25% reducing balance basis.
Although the machine may have a longer useful economic life, Nespa uses a five-year planning period
for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in
the year in which they arise.
Operation of the new machine will cause fixed costs to increase by $110,000 (in current price terms).
Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and
unit variable costs is expected to be 3% per year. For profit reporting purposes Nespa depreciates
machinery on a straight-line basis over its planning period.
Nespa applies three investment appraisal methods to new projects because it believes that a single
investment appraisal method is unable to capture the true value of a proposed investment. The methods
it uses are net present value, internal rate of return and return on capital employed (accounting rate of
return). The company believes that net present value measures the potential increase in company value
of an investment project: that a high internal rate of return offers a margin of safety for risky projects;
and that a projects before-tax return on capital employed should be greater than the companys before-
tax return on capital employed, which is 20%. Nespa does not use any explicit method of assessing
project risk and has an average cost of capital of 10% in money (nominal) terms.
The company has not yet decided on a method of financing the purchase of the new machine, although
the finance director believes that a new issue of equity finance is appropriate given the amount of
finance required.
(a) Determine the sales strategy which maximizes the present value of total contribution.
Ignore taxation in this part of the question. (9 marks)
(b) Evaluate the investment in the new machine using internal rate of return. (12 marks)
(c) Evaluate the investment in the new machine using return on capital employed
(accounting rate of return) based on the average investment. (5 marks)
(d) Critically discuss the relative advantages and disadvantages of internal rate of return
and return on capital employed (accounting rate of return), and comment on Nespas
views on investment appraisal methods. (8 marks)
(e) Discuss TWO methods that could be used to assess the risk or level of uncertainty
associated with an investment project. (8 marks)
(f) Discuss the factors that Nespa should consider when selecting an appropriate source of
finance for the new machine. (8 marks)
(50 marks)
Bread Products Ltd is considering the replacement policy for its industrial size ovens which are used as
part of a production line that bakes bread. Given its heavy usage each oven has to be replaced
frequently. The choice is between replacing every two years or every three years. Only one type of oven
is used, each of which costs $24,500. Maintenance costs and resale values are as follows:
Year Maintenance Resale value
per annum
$ $
1 500
2 800 15,600
3 1,500 11,200

Original cost, maintenance costs and resale values are expressed in current prices. That is, for example,
maintenance for a two year old oven would cost $800 for maintenance undertaken now. It is expected
that maintenance costs will increase at 10% per annum and oven replacement cost and resale values at
5% per annum. The money discount rate is 15%.
(a) Calculate the preferred replacement policy for the ovens in a choice between a two year
or three year replacement cycle. (12 marks)
(b) Identify the limitations of Net Present Value techniques when applied generally to
investment appraisal. (13 marks)
(25 marks)
Question 17 SASSONE PLC
Sassone plc is a medium-sized profitable company that manufactures engineering products. Its stated
objectives are to maximise shareholder wealth and to maintain an ethical approach to the production
and distribution of engineering products. It has in issue two million ordinary shares, held as follows:
Number of shares
Pension funds 550,000
Insurance companies 250,000
Investment trusts 200,000
Unit trusts 100,000
Directors of Sassone 350,000
Other shareholders 550,000


The Managing Director of Sassone plc is considering two items that have been placed on the agenda of
the next Board Meeting:
(1) Complaint by institutional investors
A number of institutional investors complained at the recent Annual General Meeting of the
company that expenditure on environmentally-friendly and socially responsible projects was
at too high a level, resulting in a less than acceptable increase in annual dividend payments.
They had warned that they would vote against the re-appointment of directors if matters had
not improved by the next Annual General Meeting.
(2) Proposal to increase manufacturing capacity
The directors of Sassone plc need to increase capacity in order to meet expected demand for a
new product, Product G, which is to be used in the manufacture of new-generation personal
computers. Product G cannot be manufactured on existing machines. The directors have
identified two machines which can manufacture Product G, each with a capacity of 60,000
units per year, as follows:
Machine One
This machine will cost $238,850 and last for five years, at the end of which time it will have
zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing
by $3,000 per year for each year of operation.
Machine Two
This machine will cost $215,000 and last for four years, at the end of which time it will have
zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing
by $5,000 per year for each year of operation.
Sassone plc expects demand for Product G to be 30,000 units per year in the first year, and to
increase by a further 10,000 units per year in each subsequent year. Selling price is expected
to be $1000 per unit and the marginal cost of production is expected to be $780 per unit.
Incremental fixed production overheads of $10,000 per year will be incurred. Selling price
and costs are all in current price terms.
Annual inflation rates are expected to be as follows:
Selling price of Product G: 4% per year
Marginal cost of production: 4% per year
Maintenance costs: 5% per year
Fixed production overheads: 6% per year

Other information
Sassone plc has a real cost of capital of 8% and uses a nominal (money) cost of capital of 11% in
investment appraisal. The company pays tax one year in arrears at an annual rate of 30% and can claim
capital allowances on a 25% reducing balance basis, with a balancing allowance at the end of the life of
the machines. The company depreciates fixed assets on a straight-line basis over the life of the asset and
has a target before-tax return on capital employed (accounting rate of return) of 25%.
(a) Using equivalent annual cost and considering machine purchase prices and maintenance
costs only, determine which machine should be purchased by Sassone. Ignore inflation
and taxation in this part of the question only. (6 marks)
(b) Calculate the net present value of the incremental cash flows arising from purchasing
Machine Two and advise on its acquisition. (18 marks)
(c) Calculate the before-tax return on capital employed (accounting rate of return) of the
incremental cash flows arising from purchasing Machine Two based on the average
investment and comment on your findings. (4 marks)
(d) Discuss the conflict that may arise between corporate objectives, using the information
provided on Sassone plc to illustrate your answer. (10 marks)
(38 marks)
Question 18 UMUNAT PLC
Umunat plc is considering investing $50,000 in a new machine with an expected life of five years. The
machine will have no scrap value at the end of five years. It is expected that 20,000 units will be sold
each year at a selling price of $300 per unit. Variable production costs are expected to be $165 per
unit, while incremental fixed costs, mainly the wages of a maintenance engineer, are expected to be
$10,000 per year. Umunat plc uses a discount rate of 12% for investment appraisal purposes and
expects investment projects to recover their initial investment within two years.
(a) Explain why risk and uncertainty should be considered in the investment appraisal
process. (5 marks)
(b) Calculate and comment on the payback period of the project. (4 marks)
(c) Evaluate the sensitivity of the projects net present value to a change in the following
project variables:
(i) sales volume;
(ii) sales price;
(iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)
(d) Upon further investigation it is found that there is a significant chance that the expected sales
volume of 20,000 units per year will not be achieved. The sales manager of Umunat plc
suggests that sales volumes could depend on expected economic states that could be assigned
the following probabilities:
Economic state Poor Normal Good
Probability 03 06 01
Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (6 marks)
(25 marks)
Question 19 ARG CO
ARG Co is a leisure company that is recovering from a loss-making venture into magazine publication
three years ago. Recent financial statements of the company are as follows.
Income Statement for year ending 30 June 2005
Turnover 140,400
Cost of sales 112,840

Gross profit 27,560
Administration costs 23,000

Profit before interest and tax 4,560
Interest 900

Profit before tax 3,660
Taxation 1,098

Profit after taxation 2,562
Dividends 400

Retained profit 2,162

Statement of Financial Position as at 30 June 2005
$000 $000
Fixed assets 50,000
Current assets
Inventory 2,400
Receivables 20,000
Cash 1,500

Current liabilities 33,000


9% Debentures 2014 10,000


Financed by:
Ordinary shares, $1 par value 2,000
Reserves 27,000
Retained earnings 1,900


The company plans to launch two new products, Alpha and Beta, at the start of July 2005, which it
believes will each have a life-cycle of four years. Alpha is the deluxe version of Beta. The sales mix is
assumed to be constant. Expected sales volumes for the two products are as follows.
Year 1 2 3 4
Alpha 60,000 110,000 100,000 30,000
Beta 75,000 137,500 125,000 37,500

The standard selling price and standard costs for each product in the first year will be as follows.
Product Alpha Beta
$/unit $/unit
Direct material costs 1200 900
Incremental fixed production costs 864 642

Total absorption cost 2064 1542
Standard mark-up 1036 758

Selling price 3100 2300

ARG traditionally operates a cost-plus approach to product pricing.
Incremental fixed production costs are expected to be $1 million in the first year of operation and are
apportioned on the basis of sales value. Advertising costs will be $500,000 in the first year of operation
and then $200,000 per year for the following two years. There are no incremental non-production fixed
costs other than advertising costs.
In order to produce the two products, investment of $1 million in premises, $1 million in machinery and
$1 million in working capital will be needed, payable at the start of July 2005. The investment will be
financed by the issue of $3 million of 9% debentures, each $100 debenture being convertible into 20
ordinary shares of ARG Co after 8 years or redeemable at par after 12 years.
Selling price per unit, direct material cost per unit and incremental fixed production costs are expected
to increase after the first year of operation due to inflation:
Selling price inflation 30% per year
Direct material cost inflation 30% per year
Fixed production cost inflation 50% per year

These inflation rates are applied to the standard selling price and standard cost data provided above.
Working capital will be recovered at the end of the fourth year of operation, at which time production
will cease and ARG Co expects to be able to recover $12 million from the sale of premises and
machinery. All staff involved in the production and sale of Alpha and Beta will be redeployed
elsewhere in the company.
ARG Co pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in
machinery attracts a first-year capital allowance of 100%. ARG Co has sufficient profits to take the full
benefit of this allowance in the first year. For the purpose of reporting accounting profit, ARG Co
depreciates machinery on a straight line basis over four years. ARG Co uses an after-tax discount rate
of 13% for investment appraisal.
Other information
Assume that it is now 30 June 2005
The ordinary share price of ARG Co is currently $400
Average interest cover for ARG Cos sector is 7
Average gearing for ARG Cos sector is 45% (long-term debt/equity using book values)
(a) Calculate the net present value of the proposed investment in products Alpha and Beta.
(17 marks)
(b) Identify and discuss any likely limitations in the evaluation of the proposed investment
in Alpha and Beta. (6 marks)
(c) Evaluate and discuss the proposal to finance the investment with a $3 million 9%
convertible debenture issue. (8 marks)
(31 marks)
Question 20 BFD CO
BFD Co is a private company formed three years ago by four brothers who, as directors, retain sole
ownership of its ordinary share capital. One quarter of the initial share capital was provided by each
brother. The company has returned a profit in each year of operation as shown by the following
financial statements.
Income Statements for years ending 30 November
2005 2004 2003
$000 $000 $000
Turnover 5,200 3,400 2,600
Cost of sales 4,570 2,806 2,104

Profit before interest and tax 630 594 496
Interest 70 34 3

Profit before tax 560 560 493
Tax 140 140 123

Profit after tax 420 420 370
Dividends 20 20 20

Retained profit 400 400 350

Statements of Financial Position as at 30 November
2005 2004 2003
$000 $000 $000 $000 $000 $000
Fixed assets 1,600 1,200 800
Current assets
Inventory 1,450 1,000 600
Receivables 1,400 850 400

2,850 1,850 1,000
Current liabilities 2,300 1,300 450

Net current assets 550 550 550

2,150 1,750 1,350

Ordinary shares ($1 par) 1,000 1,000 1,000
Reserves 1,150 750 350

2,150 1,750 1,350

BFD Co has an overdraft limit of $125 million and pays interest on its overdraft at a rate of 6% per
year. Current liabilities consist of trade payables and overdraft finance in each of the three years.
The directors are delighted with the rapid growth of BFD Co and are considering further expansion
through buying new premises and machinery to manufacture Product FT7. This new product has only
just been developed and patented by BFD Co. Test marketing has indicated considerable demand for
the product, as shown by the following research data.
Year of operation 1 2 3 4
Accounting year 2005/6 2006/7 2007/8 2008/9
Sales volume (units) 100,000 120,000 130,000 140,000

Sales after 2008/9 (the fourth year of operation) are expected to continue at the 2008/9 level in
Initial investment of $3,000,000 would be required in new premises and machinery, as well as an
additional $200,000 of working capital. The directors have no further financial resources to offer and
are considering approaching their bank for a loan to meet their investment needs. Selling price and cost
data for Product FT7, based on an annual budgeted volume of 100,000 units, are as follows.
$ per unit
Selling price 1800
Direct material 700
Direct labour 150
Fixed production overhead 450

The fixed production overhead is incurred exclusively in the production of Product FT7 and excludes
depreciation. Selling price and unit variable cost data for Product FT7 are expected to remain constant.
BFD Co expects to be able to claim writing down allowances on the initial investment of $3,000,000 on
a straight-line basis over 10 years. The company pays tax on profit at an annual rate of 25% in the year
in which the liability arises and has an after-tax cost of capital of 12%.
Average data for companies similar to BFD Co
Net profit margin: 9% Payables days: 70 days
Interest cover: 15 times Current ratio: 21 times
Inventory days: 85 days Quick ratio: 08 times
Receivables days: 75 days Debt/equity ratio: 40% (using book values)

(a) Calculate the net present value of the proposed investment in Product FT7. Assume that
it is now 1 December 2005. (16 marks)
(b) Comment on the acceptability of the proposed investment in Product FT7 and discuss
what additional information might improve the decision-making process. (7 marks)
(c) BFD Co has received an offer from a rival company of $300,000 per year for 10 years for the
manufacturing rights for Product FT7. If BFD Co accepts this offer, it would not be able to
manufacture Product FT7 for the duration of the agreement.
Determine whether BFD Co should accept the offer for the manufacturing rights to
Product FT7. In this part of the question only, ignore cash flows occurring after the ten-
year period of the offer. Assume that it is 1 December 2005. (6 marks)
(d) As the newly-appointed finance director of BFD Co, write a report to the board which
discusses whether the company is likely to be successful if it approaches its bank for a
loan. Your discussion should include an analysis of the current financial position and
recent financial performance of the company. (16 marks)
(45 marks)
Question 21 AGD CO
AGD Co is a profitable company which is considering the purchase of a machine costing $320,000. If
purchased, AGD Co would incur annual maintenance costs of $25,000. The machine would be used for
three years and at the end of this period would be sold for $50,000. Alternatively, the machine could be
obtained under an operating lease for an annual lease rental of $120,000 per year, payable in advance.
AGD Co can claim capital allowances on a 25% reducing balance basis. The company pays tax on
profits at an annual rate of 30% and all tax liabilities are paid one year in arrears. AGD Co has an
accounting year that ends on 31 December. If the machine is purchased, payment will be made in
January of the first year of operation. If leased, annual lease rentals will be paid in January of each year
of operation.
(a) Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or
lease the new machine. (12 marks)
(b) Explain and discuss the key differences between an operating lease and a finance lease.
(8 marks)
(c) The after-tax borrowing rate of 7% was used in the evaluation because a bank had offered to
lend AGD Co $320,000 for a period of five years at a before-tax rate of 10% per year with
interest payable every six months.
(i) Calculate the annual percentage rate (APR) implied by the banks offer to lend
at 10% per year with interest payable every six months. (2 marks)
(ii) Calculate the amount to be repaid at the end of each six-month period if the
offered loan is to be repaid in equal instalments. (3 marks)
(25 marks)
Question 22 CHARM PLC
Charm plc, a software company, has developed a new game, Fingo, which it plans to launch in the
near future. Sales of the new game are expected to be very strong, following a favourable review by a
popular PC magazine. Charm plc has been informed that the review will give the game a Best Buy
recommendation. Sales volumes, production volumes and selling prices for Fingo over its four-year
life are expected to be as follows.
Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price $25 $24 $23 $22

Financial information on Fingo for the first year of production is as follows:
Direct material cost $540 per game
Other variable production cost $600 per game
Fixed costs $400 per game

Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and
$100,000 in the second year of production. No advertising costs are expected in the third and fourth
years of production. Fixed costs represent incremental cash fixed production overheads. Fingo will be
produced on a new production machine costing $800,000. Although this production machine is
expected to have a useful life of up to ten years, government legislation allows Charm plc to claim the
capital cost of the machine against the manufacture of a single product. Capital allowances will
therefore be claimed on a straight-line basis over four years.
Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which
they arise. Charm plc uses an after-tax discount rate of 10% when appraising new capital investments.
Ignore inflation.
(a) Calculate the net present value of the proposed investment and comment on your
findings. (11 marks)
(b) Calculate the internal rate of return of the proposed investment and comment on your
findings. (5 marks)
(c) Discuss the reasons why the net present value investment appraisal method is preferred
to other investment appraisal methods such as payback, return on capital employed and
internal rate of return. (9 marks)
(25 marks)
Question 23 CAVIC LTD
Cavic Ltd services custom cars and provides its clients with a courtesy car while servicing is taking
place. It has a fleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy
car will cost $15,000. The trade-in value of each new car declines over time as follows:
Age of courtesy car (years) 1 2 3
Trade-in value ($/car) 11,250 9,000 6,200

Servicing and parts will cost $1,000 per courtesy car in the first year and this cost is expected to
increase by 40% per year as each vehicle grows older. Cleaning the interior and exterior of each
courtesy car to keep it up to the standard required by Cavics clients will cost $500 per car in the first
year and this cost is expected to increase by 25% per year.
Cavic Ltd has a cost of capital of 10%. Ignore taxation and inflation.
(a) Using the equivalent annual cost method, calculate whether Cavic Ltd should replace its
fleet after one year, two years, or three years. (12 marks)
(b) Discuss the causes of capital rationing for investment purposes. (4 marks)
(c) Explain how an organisation can determine the best way to invest available capital
under capital rationing. Your answer should refer to the following issues:
(i) single-period capital rationing;
(ii) multi-period capital rationing;
(iii) project divisibility;
(iv) the investment of surplus funds. (9 marks)
(25 marks)
Question 24 JERONIMO PLC
Jeronimo plc currently has 5 million ordinary shares in issue, which have a market value of $160 each.
The company wishes to raise finance for a major investment project by means of a rights issue, and is
proposing to issue shares on the basis of 1 for 5 at a price of $130 each.
James Brown currently owns 10,000 shares in Jeronimo plc and is seeking advice on whether or not to
take up the proposed rights.
(a) Explain the difference between a rights issue and a scrip issue. Your answer should
include comment on the reasons why companies make such issues and the effect of the
issues on private investors. (6 marks)
(b) Calculate:
(i) the theoretical value of James Browns shareholding if he takes up his rights;
(ii) the theoretical value of James Browns rights if he chooses to sell them.
(4 marks)
(c) Using only the information given below, and applying the dividend growth model
formula, calculate the required return on equity for an investor in Jeronimo plc.
Jeronimo plc:
Current (1999) share price: $160
Number of shares in issue: 5 million
Current earnings: $15 million
Dividend Paid (cents per share):
1995: 8
1996: 9
1997: 11
1998: 11
1999: 12
(4 marks)

(d) If the stock market is believed to operate with a strong level of efficiency, what effect
might this have on the behaviour of the finance directors of publicly quoted companies?
(6 marks)
(20 marks)
Question 25 PLY, AXIS & SPIN
Food Retailers: Ordinary Shares, Key Stock Market Statistics,
Company Share price (cents)
Current 52 week high 52 week low Dividend Yield (%) P/E Ratio
Ply 63 112 54 18 142
Axis 291 317 187 21 130
Spin 187 201 151 23 211

(a) Illustrating your answer by use of data in the table above, define and explain the term
P/E ratio, and comment on the way it may be used by an investor to appraise a possible
share purchase. (6 marks)
(b) Using data in the above table, calculate the dividend cover for Spin and Axis, and
explain the meaning and significance of the measure from the point of view of equity
investors. (8 marks)
(c) Under what circumstances might a company be tempted to pay dividends which are in
excess of earnings, and what are the dangers associated with such an approach?
You should ignore tax in answering this question. (6 marks)
(20 marks)
Question 26 SME FINANCE
Explain why very Small to Medium-size Enterprises (SMEs) might face problems in obtaining
appropriate sources of finance. In your answer pay particular attention to problems and issues
associated with:
(i) uncertainty concerning the business;
(ii) assets available to offer as collateral or security; and
(iii) potential sources of finance for very new SMEs excluding sources from capital markets.
(12 marks)
Question 27 TECHFOOLS.COM has just issued convertible debentures with an 8% per annum coupon to the value of
$5m. The nominal value of the debentures is $100 and the issue price was $105. The conversion details
are that 45 shares will be issued for every $100 convertible debentures held with a date for conversion
in five years exactly. Redemption, should the debenture not be converted, will also take place in exactly
five years. Debentures will be redeemed at $110 per $100 nominal convertibles held. It is widely
expected that the share price of the company will be $4 in five years time.
Assume an investor required return of 15%.
Ignore taxation in your answer.
(a) Briefly explain why convertibles might be an attractive source of finance for companies.
(4 marks)
(b) (i) Estimate the current market value of the debentures, assuming conversion
takes place, using net present value methods and assess if it is likely that
conversion will take place. (5 marks)
(ii) Identify and briefly comment on a single major reservation you have with your
evaluation in part b(i). (2 marks)
(c) Explain why an issuing company seeks to maximise its conversion premium and why
companies can issue convertibles with a high conversion premium. (4 marks)
(d) Explain what is meant by the concept of intermediation (the role of a banking sector)
and how such a process benefits both investors and companies. (10 marks)
(25 marks)
(a) Describe the methods of raising new equity finance that can be used by an unlisted
company. (8 marks)
(b) Discuss the factors to be considered by a listed company when choosing between an issue
of debt and an issue of equity finance. (8 marks)
(16 marks)
Question 29 ARWIN
Arwin plans to raise $5m in order to expand its existing chain of retail outlets. It can raise the finance
by issuing 10% debentures redeemable in 2015, or by a rights issue at $400 per share. The current
financial statements of Arwin are as follows.
Income statement for the last year $000
Sales 50,000
Cost of sales 30,000

Gross profit 20,000
Administration costs 14,000

Profit before interest and tax 6,000
Interest 300

Profit before tax 5,700
Taxation at 30% 1,710

Profit after tax 3,990
Dividends 2,394

Retained earnings 1,596

Statement of Financial Position $000
Net fixed assets 20,100
Net current assets 4,960
12% debentures 2010 2,500


Ordinary shares, par value 25c 2,500
Retained profit 20,060


The expansion of business is expected to increase sales revenue by 12% in the first year. Variable cost
of sales makes up 85% of cost of sales. Administration costs will increase by 5% due to new staff
appointments. Arwin has a policy of paying out 60% of profit after tax as dividends and has no
(a) For each financing proposal, prepare the forecast income statement after one additional
year of operation. (5 marks)
(b) Evaluate and comment on the effects of each financing proposal on the following:
(i) Financial gearing;
(ii) Operational gearing;
(iii) Interest cover;
(iv) Earnings per share. (12 marks)
(c) Discuss the dangers to a company of a high level of gearing, including in your answer an
explanation of the following terms:
(i) Business risk;
(ii) Financial risk. (8 marks)
(25 marks)
Question 30 TIRWEN PLC
Tirwen plc is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a
15% discount to the current market price of $400 per share. Issue costs are expected to be $220,000
and these costs will be paid out of the funds raised. It is proposed that the rights issue funds raised will
be used to redeem some of the existing debentures at par. Financial information relating to Tirwen plc
is as follows:
Current Statement of Financial Position
$000 $000 $000
Fixed assets 6,550
Current assets
Inventory 2,000
Receivables 1,500
Cash 300

Current liabilities
Trade payables 1,100
Overdraft 1,250


Net current assets 1,450

Total assets less current liabilities 8,000
12% debentures 2012 4,500


Ordinary shares (par value 50c) 2,000
Reserves 1,500


Other information:
Price/earnings ratio of Tirwen plc: 1524
Overdraft interest rate: 7%
Corporation tax rate: 30%
Sector averages: debt/equity ratio (book value): 100%
interest cover: 6 times

(a) Ignoring issue costs and any use that may be made of the funds raised by the rights
issue, calculate:
(i) the theoretical ex rights price per share;
(ii) the value of rights per existing share. (3 marks)
(b) What alternative actions are open to the owner of 1,000 shares in Tirwen plc as regards
the rights issue? Determine the effect of each of these actions on the wealth of the
investor. (6 marks)
(c) Calculate the current earnings per share and the revised earnings per share if the rights
issue funds are used to redeem some of the existing debentures. (6 marks)
(d) Evaluate whether the proposal to redeem some of the debentures would increase the
wealth of the shareholders of Tirwen plc. Assume that the price/earnings ratio of Tirwen
plc remains constant. (3 marks)
(e) Discuss the reasons why a rights issue could be an attractive source of finance for
Tirwen plc. Your discussion should include an evaluation of the effect of the rights issue
on the debt/equity ratio and interest cover. (7 marks)
(25 marks)
Question 31 RZP CO
As assistant to the Finance Director of RZP Co, a company that has been listed on the London Stock
Market for several years, you are reviewing the draft Annual Report of the company, which contains
the following statement made by the chairman:
This company has consistently delivered above-average performance in fulfilment of our declared
objective of creating value for our shareholders. Apart from 2002, when our overall performance was
hampered by a general market downturn, this company has delivered growth in dividends, earnings and
ordinary share price. Our shareholders can rest assured that my directors and I will continue to deliver
this performance in the future.
The five-year summary in the draft Annual Report contains the following information:
Year 2004 2003 2002 2001 2000
Dividend per share 28c 23c 22c 22c 17c
Earnings per share 1904c 1495c 1122c 1584c 1343c
Price/earnings ratio 220 335 255 172 152
General price index 117 113 110 105 100

A recent article in the financial press reported the following information for the last five years for the
business sector within which RZP Co operates:
Share price growth average increase per year of 20%
Earnings growth average increase per year of 10%
Nominal dividend growth average increase per year of 10%
Real dividend growth average increase per year of 9%

You may assume that the number of shares issued by RZP Co has been constant over the five-year
period. All price/earnings ratios are based on end-of-year share prices.
(a) Analyse the information provided and comment on the views expressed by the chairman
in terms of:
(i) growth in dividends per share;
(ii) share price growth;
(iii) growth in earnings per share.
Your analysis should consider both arithmetic mean and equivalent annual growth
rates. (13 marks)
(b) Calculate the total shareholder return (dividend yield plus capital growth) for 2004 and
comment on your findings. (3 marks)
(c) Discuss the factors that should be considered when deciding on a management
remuneration package that will encourage the directors of RZP Co to maximise the
wealth of shareholders, giving examples of management remuneration packages that
might be appropriate for RZP Co. (9 marks)
(25 marks)
Discuss the difficulties that may be experienced by a small company which is seeking to obtain
additional funding to finance an expansion of business operations.
(8 marks)
Question 33 HENDIL PLC
Hendil plc, a manufacturer of electronic equipment, has prepared the following draft financial
statements for the year that has just ended. These financial statements have not yet been made public.
Income statement $000
Turnover 9,600
Cost of sales 5,568

Gross profit 4,032
Operating expenses 3,408

Profit before interest and tax 624
Interest 156

Profit before tax 468
Taxation 140

Profit after tax 328
Dividends 300

Retained profit 28

Statement of financial position $000 $000 $000
Fixed assets 2,250
Current assets
Inventory 1,660
Receivables 2,110
Cash 780

Current liabilities
Trade payables 750
Dividends 300
Overdraft 450

Net current assets 3,050

Total assets less current liabilities 5,300
10% debenture, repayable 2015 1,200


Capital and reserves
Ordinary shares, par value 50c 1,000
Retained earnings 3,100


Hendil plc pays interest on its overdraft at an annual rate of 6%. The 10% debenture is secured on fixed
assets of the company.
Hendil plc plans to invest $1 million in a new product range and has forecast the following financial
Year 1 2 3 4
Sales volume (units) 70,000 90,000 100,000 75,000
Average selling price ($/unit) 40 45 51 51
Average variable costs ($/unit) 30 28 27 27
Incremental cash fixed
costs ($/year) 500,000 500,000 500,000 500,000

The above cost forecasts have been prepared on the basis of current prices and no account has been
taken of inflation of 4% per year on variable costs and 3% per year on fixed costs. Working capital
investment accounts for $200,000 of the proposed $1 million investment and machinery for $800,000.
Hendil uses a four-year evaluation period for capital investment purposes, but expects the new product
range to continue to sell for several years after the end of this period. Capital investments are expected
to pay back within two years on an undiscounted basis, and within three years on a discounted basis.
The company pays tax on profits in the year in which liabilities arise at an annual rate of 30% and
claims capital allowances on machinery on a 25% reducing balance basis. Balancing allowances or
charges are claimed only on the disposal of assets.
Average data on companies similar to Hendil plc:
Interest cover 6 times
Long-term debt/ equity (book value basis) 50%
Long-term debt/ equity (market value basis) 25%

The ordinary shareholders of Hendil plc require an annual return of 12%. Its ordinary shares are
currently trading on the stock market at $1.80 per share. The dividend paid by the company has
increased at a constant rate of 5% per year in recent years and, in the absence of further investment, the
directors expect this dividend growth rate to continue for the foreseeable future.
(a) (i) Calculate the ordinary share price of Hendil plc, predicted by the dividend
growth model. (4 marks)
(ii) Explain the concept of market efficiency and distinguish between strong form
efficiency and semi-strong form efficiency. (6 marks)
(iii) Discuss why the share price predicted by the dividend growth model is
different from the current market price. (4 marks)
(b) (i) Using Hendil plcs current average cost of capital of 11%, calculate the net
present value of the proposed investment. (14 marks)
(ii) Calculate, to the nearest month, the payback period and the discounted
payback period of the proposed investment. (4 marks)
(iii) Discuss the acceptability of the proposed investment and explain ways in which
your net present value calculation could be improved. (6 marks)
(c) It has been suggested that the proposed $1 million investment could be financed by a new
issue of debentures with an interest rate of 8%, redeemable after 15 years and secured on
existing assets of Hendil plc. The existing debentures of the company are trading at $113 per
$100 nominal value.
Evaluate and discuss the suggestion to finance the proposed investment with the new
debenture issue described above. Your answer should consider, but not be limited to, the
effect of the new issue on:
(i) interest cover;
(ii) gearing;
(iii) ordinary share price. (12 marks)
(50 marks)
Your company has produced a draft guidance manual to assist in estimating the cost of capital to be
used in capital investment appraisal. Extracts from the manual, which includes worked examples, are
reproduced below.
Guidance manual for estimating the cost of capital
(i) It is essential that the discount rate used reflects the weighted average cost of capital of the
(ii) The cost of equity and cost of debt should always be estimated using market values.
(iii) Inflation must always be included in the discount rate.
(iv) The capital asset pricing model or the dividend valuation model may be used in estimating the
cost of equity.
(v) The cost of debt is to be estimated using the redemption yield of existing debt.
(vi) Always round the solution up to the nearest whole percentage. This is a safeguard if the cost
of capital is underestimated.
Illustrative examples:
The current date is assumed to be June 20X0, with four years until the redemption of the debentures.
Relevant data:
Book values($m) Market values($m)
Equity (50 million ordinary shares) 140 214
Debt:10% bank loans $40m, 10% debentures 20X4 $40m 80 85
Per share Annual growth rates
Dividends 24 cents 6%
Earnings 67 cents 9%
The beta value of the company (asset beta) is 11
Other information:
Market return 14%
Risk free rate 6%
Current inflation 4%
Corporate tax rate 30%
Illustration 1 When the company is expanding existing activities:
Cost of equity
Dividend valuation model:
+ g =
+ 0.09 = 0.146 or 14.6%
Capital asset pricing model:
ke = Rf + (Rm Rf) beta = 6% + (14% 6%) 11 = 148%
Cost of debt
To find the redemption yield, with four years to maturity, the following equation must be
Debt is assumed to be redeemed at par value and interest to be payable annually. Estimates
are based upon total interest payments of $80m at 10% or $8m per year
85 =
( ) ( ) ( ) ( )
4 3 2
kd kd kd kd +

By trial and error
At 9% interest
8 3240 = 2592
80 0708 = 5664
9% discount rate is too high.
At 7% interest
8 3387 = 2710
80 0763 = 6104
7% +
44 . 2 14 . 3
14 . 3
2% = 813%
The cost of debt is 813%
Market value of equity $214m
Market value of debt $85m
Weighted average cost of capital:
(CAPM has been used in this estimate. The dividend valuation model would result in a similar
+ 8.13%
= 12.90%
Inflation of 4% must be added to the discount rate.
The discount rate to be used in the investment appraisal is 1290% + 4% = 1690% or 17%
rounded up to the nearest whole percentage.
Illustration 2 When the company is diversifying its activities:
The asset beta of a similar sized company in the industry in which your company proposes to
diversify is 090.
Gearing of the similar company:
Book values($m) Market values($m)
Equity 165 230
Debt 65 60
Cost of equity
The beta of the comparator company is used as a measure of the systematic risk of the new
investment. As the gearing of the two companies differs, the beta must be adjusted for the
difference in gearing.
Beta equity = beta asset
) t 1 ( D E

Beta equity = 090 76 . 0
) 3 . 0 1 ( 60 230

Using the capital asset pricing model:
ke = Rf + (Rm Rf) beta = 6% + (14% 6%) 076 = 1208%
Cost of debt
This remains at 813%
Market value of equity $214m
Market value of debt $85m
Weighted average cost of capital:
+ 8.13%
= 10.96%
The discount rate to be used in the investment appraisal when diversifying into the new
industry is 1096% + 4% inflation, 1496% or 15% rounded up to the nearest whole
Produce a revised version of the draft manual for estimating the cost of capital. Revisions,
including amended calculations, should be made, where appropriate, to both written guidance
note and illustrative examples. Where revisions are made to any of the six guidance notes, or to
the illustrations, brief discussion of the reason for revision should be included.
State clearly any assumptions that you make.
(30 marks)
14 marks are available for guidance notes and 16 marks for illustrative examples.
Question 35 ZENDECK PLC
The finance director of Zendeck plc is considering how to finance a major new expansion of existing
activities. The investment will cost $40 million and is expected to last for five years.
The companys current capital structure is:
$ million
Medium-term floating rate loans 34
11% debentures redeemable July 2007 56
Issued ordinary shares (50 cents par value) 15
Reserves 82

Other information:
(i) The companys current (July 2004) share price ex-dividend is 478 cents, and debenture price
ex-interest is $10780. Each debenture is redeemable at its par value of $100.
(ii) Issue costs of externally financed equity are expected to be 65% of the total raised. There
needs to be a minimum issue of $20 million, otherwise issue costs increase substantially.
(iii) Issue costs of new debentures are estimated to be 35%.
(iv) The equity beta of Zendeck is 115.
(v) The current dividend per share is 364 cents and dividends have grown by approximately 4%
per year for the last three years.
(vi) The risk free rate is 35% per year and the market return is 11% per year.
(vii) The corporate tax rate is 30%.
(viii) Zendeck wishes to maintain its current capital structure.
(a) Estimate the cost of capital of the new investment:
(i) If internal sources of equity are used (retained earnings), and debt finance is
raised by a 75% floating rate bank loan with negligible issue costs;
(ii) If external sources of debt (new debentures issued at par of $100) and equity
are used. New equity may be assumed to be issued at the current market price.
Comment upon your findings and state clearly any assumptions that you make.
(11 marks)
(b) Discuss whether or not the techniques used in part (a) could be applied to unlisted
companies. (4 marks)
(15 marks)
Question 36 OXFIELD PLC
Oxfield plc, a listed industrial company, is considering a major investment. The companys investment
projects team needs an appropriate rate at which to discount the estimated after-tax cash flows for the
investment. Following the companys normal practice this is to be based on the weighted average cost
of capital (WACC).
Figures relating to long-term financing included in the companys most recent Statement of Financial
Position are as follows.
160 million ordinary shares of $0.50 each 80
Share premium account 27
Revaluation reserve 26
Retained earnings 9
7.2% loan stock 67

The loan stock interest for the current year has just been paid. Interest is payable at the end of each of
the next three years, and all of the loan stock is to be redeemed, in cash, at a 5% premium at the end of
three years.
A dividend of 18c per share has just been paid. Dividends have shown an average annual growth rate
of 7% over recent years.
The current share price is 210c and the loan stock has a market value of $97 (per $100 nominal).
The corporation tax rate is expected to be 30% for the foreseeable future.
(a) Calculate the companys WACC. Explain your workings and any assumptions which
you have made. Justify the basis of the weightings which you used. (6 marks)
(b) Explain any criticisms which could be made of using the figure calculated in (a) as the
discount rate for assessing the investment under consideration by the company. (6 marks)
(c) Explain how the capital asset pricing model (CAPM) could be used as an alternative
means of determining a suitable discount rate to be used in the assessment of the
investment. Your explanation should include an outline of the models strengths and
weaknesses. (4 marks)
(d) Explain what would have been the effect, in theory and in practice, on the WACC of the
company having a different debt: equity ratio. (4 marks)
(20 marks)
Timbertops Ltd owns a site in a holiday area of South Wales. Part of the site is a conventional camp
site where pitches are rented by the night to campers and caravaners. Also on the site are a number of
wooden chalets which are rented by the week. Within the site there is an extensive area with attractions
of various types, including rides, a swimming lake, a boating lake and a small zoo. Entry to the
attractions area is included in the rental charges for those staying on the site. Most of the visitors to the
attractions, however, are day visitors who pay a daily charge for entry, which allows access to all the
All of the companys shares are owned by members of the Jenkins family. Since the business started,
only limited expansion of the companys facilities has taken place and that was financed entirely from
profits. The companys directors are now keen to expand the range of attractions extensively since,
they believe, the site will attract more visitors, both residents and day visitors. This expansion will cost
an estimated $1 million.
The most recent financial statements can be summarised as follows.
Income statement for the year ended 31 March 20X9
Turnover 5,011

Operating profit 640
Tax on profit (198)

Profit after tax 442
Dividends (197)

Retained profit for the year 245

Statement of Financial Position as at 31 March 20X9
$000 $000
Fixed assets 1,922
Current assets 280
Liabilities: amounts falling due within one year (270)



Share capital (ordinary share of $1 each) 1,000
Retained earnings 932


These results, including the dividend cover, are broadly consistent with those of previous years. The
company has only a small cash balance but it has no borrowings.
Very recently, one of the shareholders sold her shares to her brother. By mutual agreement the shares
were valued by the companys auditors, strictly on their estimated market value, at $2.75 per share.
(a) Estimate the companys cost of capital, explaining and justifying all workings and
assumptions. (5 marks)
(b) Identify practical possible sources of the $1 million finance required for expansion. For
each possible source you should explain the main issues, both theoretical and practical,
which are likely to be involved, given the companys particular circumstances. (13 marks)
(18 marks)
Question 38 FIZZERS PLC
Fizzers plc is a small listed UK company which makes a range of soft drinks, over 90% sold in the UK
market. The company currently has a cash surplus and the directors are contemplating a major
investment in a plant in the Middle East to supply the local market. The Middle East market, important
for the company, is currently supplied from the UK.
To assess the economic viability of the investment, the finance department needs a rate at which to
discount the projected cash flows from the plant. It has been decided to use the companys weighted
average cost of capital (WACC), deducing the cost of equity through the dividend growth model.
The companys most recent Statement of Financial Position, dated 31 August 20X9, included the
following capital and reserves section.
Called up share capital (ordinary shares of $0.10 each, fully paid) 5,750
Retained earnings 29,750

The Statement of Financial Position also showed that the company had in issue $100 million of 9%
loan stock. This is to be redeemed on 1 September 20Y0 at par. Interest is payable (in arrears) on
1 September each year.
It has been the companys practice to pay a single dividend each year, during September.
Dividends paid per share over recent years have been as follows.
20X4 21.25
20X5 22.50
20X6 22.50
20X7 24.50
20X8 25.00

The 20X9 dividend will be 25.50 cents per share. The companys issued and fully paid share capital
has not altered since 20X3.
At 31 August 20X9 the shares were quoted at $3.35 per share (cum div) and the loan stock at $101.72
(cum interest) per $100 nominal.
The corporation tax rate is expected to remain at 30% for the foreseeable future.
(a) Determine the companys weighted average cost of capital, explaining your workings
and justifying any assumptions which you have made. (9 marks)
(b) Explain why the figure which you have determined in requirement (a) may not be
totally reliable for the purpose for which it has been determined. (5 marks)
(14 marks)

Question 39 BLIN
Blin is a company listed on a European stock exchange, with a market capitalisation of 6m, which
manufactures household cleaning chemicals. The company has expanded sales quite significantly over
the last year and has been following an aggressive approach to working capital financing. As a result,
Blin has come to rely heavily on overdraft finance for its short-term needs. On the advice of its finance
director, the company intends to take out a long-term bank loan, part of which would be used to repay
its overdraft.
(a) Discuss the factors that will influence the rate of interest charged on the new bank loan,
making reference in your answer to the yield curve. (9 marks)
(b) Explain and discuss the approaches that Blin could adopt regarding the relative
proportions of long- and short-term finance to meet its working capital needs, and
comment on the proposed repayment of the overdraft. (9 marks)
(c) Explain the meaning of the term cash operating cycle and discuss its significance in
determining the level of investment in working capital. Your answer should refer to the
working capital needs of different business sectors. (7 marks)
(25 marks)
Question 40 JACK GEEP
Jack Geep will set up a new business as a sole trader on 1 January 2003 making decorative glassware.
Jack is in the process of planning the initial cash flows of the business. He estimates that there will not
be any sales demand in January 2003 so production in that month will be used to build up inventory to
satisfy the expected demand in February 2003. Thereafter it is intended to schedule production in order
to build up sufficient finished goods inventory at the end of each month to satisfy demand during the
following month. Production will, however, need to be 5% higher than sales due to expected defects
that will have to be scrapped. Defects are only discovered after the goods have been completed. The
company will not hold inventory of raw materials or work in progress.
As the business is new, demand is uncertain, but Jack has estimated three possible levels of demand in
2003 as follows:
High Medium Low
demand demand demand
$ $ $
February 22,000 20,000 19,000
March 26,000 24,000 23,000
April 30,000 28,000 27,000
May 29,000 27,000 26,000
June 35,000 33,000 32,000

Demand for July 2003 onwards is expected to be the same as June 2003. The probability of each level
of demand occurring each month is as follows:
High 005; Medium 085; Low 010.
It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making
small purchases. The remaining 90% of sales will be made on two months credit. A 25% discount
will, however, be offered to credit customers settling within one month. It is estimated that customers,
representing half of credit sales by value, will take advantage of the discount while the remainder will
take the full two months to pay.
Variable production costs (excluding costs of rejects) per $1,000 of sales are as follows:
Labour 300
Materials 200
Variable overhead 100

Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears
and variable overheads are paid two months in arrears. Fixed production and administration overheads,
excluding depreciation, are $7,000 per month and are payable in the same month as the expenditure is
Jack employed a firm of consultants to give him initial business advice. Their fee of $12,000 will be
paid in February 2003. Smelting machinery will be purchased on 1 January 2003 for $200,000 payable
in February 2003. Further machinery will be purchased for $50,000 in March 2003 payable in April
2003. This machinery is highly specialised and will have a low net realisable value after purchase.
Jack has redundancy money from his previous employment and savings totalling $150,000, which he
intends to pay into his bank account on 1 January 2003 as the initial capital of the business. He realises
that this will be insufficient for his business plans, so he is intending to approach his bank for finance in
the form of both a fixed term loan and an overdraft. The only asset Jack has is his house that is valued
at $200,000, but he has an outstanding mortgage of $80,000 on this property.
The consultants advising Jack have recommended that rather than accumulating sufficient inventory to
satisfy the following months demand he should not maintain any inventory levels but merely produce
sufficient in each month to meet the expected demand for that month.
Jacks production manager objected: I need to set up my production schedule based on the expected
average demand for the month. I will reduce production in the month if it seems demand is low.
However, there is no way production can be increased during the month to accommodate demand if it
happens to be at the higher level that month. As a result, under this new system, there would be no
inventory to fall back on and the extra sales, when monthly demand is high, would be lost, as customers
require immediate delivery. In respect of this, an assessment of the impact of the introduction of just-
in-time inventory management on cash flows has been made that showed the following:
January February March April May June
Net cash 143,000 (223,279) (7,587) (50,667) 1,843 1,704
flow ($)
Month-end 143,000 (80,279) (87,866) (138,533) (136,690) (134,986)
balance ($)

(a) Prepare a monthly cash budget for Jack Geeps business for the six month period
ending 30 June 2003. Calculations should be made on the basis of the expected values of
sales. The cash budget should show the net cash inflow or outflow in each month and the
cumulative cash surplus or deficit at the end of each month.
For this purpose ignore bank finance and the suggested use of just-in-time inventory
(17 marks)
(b) Assume now that just-in-time inventory management is used in accordance with the
recommendations of the consultants. Calculate for EACH of the six months ending 30
June 2003:
(i) receipts from sales; and
(ii) payments to labour. (6 marks)
(c) Evaluate the impact for Jack Geep of introducing just-in-time inventory management.
This should include an assessment of the wider implications of just-in-time inventory
management in the particular circumstances of Jack Geeps business. (10 marks)
(d) Write a report to Jack Geep which identifies the financing needs of the company. It
should consider the following:
(i) the extent of financing required;
(ii) the factors that should be considered in determining the most appropriate mix
of short-term financing (e.g. overdraft) and long-term financing (e.g. fixed
term bank loan); and
(iii) the extent to which improved working capital management (other than just-in-
time inventory management) might reduce the companys financing needs and
describe how this might be achieved.
Where appropriate, show supporting calculations. (17 marks)
(50 marks)
Question 41 DOE LTD
At a recent meeting of the Board of Doe Ltd, a supplier of industrial and commercial clothing, it was
suggested that the company might be suffering liquidity problems as a result of overtrading, despite
encouraging growth in turnover. The Finance Director was instructed to report to the next Board
meeting on this matter.
Extracts from the financial statements of Doe Ltd for 2002, and from the forecast financial statements
for 2003, are given below.
Income statement extracts for years ending 31 December
2003 2002
$000 $000
Turnover 8,300 6,638
Cost of sales 4,900 3,720

Gross profit 3,400 2,918
Administration and distribution expenses 2,700 2,318

Operating profit 700 600
Interest 125 100

Profit before tax 575 500

Statement of Financial Position extracts as at 31 December
2003 2002
$000 $000 $000 $000 $000 $000
Fixed assets 1,650 1,500
Current assets
Inventory 3,200 2,700
Receivables 2,750 2,000

5,950 4,700
Current liabilities
Trade payables 2,550 1,800
Bank overdraft 2,750 2,300
Other liabilities 500 400

5,800 4,500

Net current assets 150 200

Total assets less current liabilities 1,800 1,700

Capital and reserves
Ordinary shares 400 400
Reserves 1,400 1,300

1,800 1,700

The Finance Director had reported to the recent board meeting that the bank was insisting the company
reduce its overdraft as a matter of urgency. It was suggested that the company could consider factor
finance as an alternative source of funds for working capital investment. The Production Director
insisted that a new machine would be needed to maintain growth in turnover and the Finance Director
agreed to investigate how this might be financed.
The Finance Director has found a factor who would take over administration of the companys
receivables on a non-recourse basis for an annual fee of 10% of turnover. The factor would advance
80% of the book value of debts at an annual interest rate 2% above the companys current overdraft
rate. The factor expects to reduce the average receivables period to 90 days. The company estimates
that Doe Ltd could save $15,000 per year in administration costs. No redundancy costs are expected.
The New Machine
The new machine wanted by the Production Director would cost $365,000 if purchased. The Finance
Director is confident this purchase could be financed by a medium-term bank loan at an annual interest
cost of 10% before tax.
Alternatively, the machine could be leased for $77,250 per annum, payable annually in advance. The
machine has an expected life of five years, at the end of which it would have zero scrap value.
Sales and Costs of New Machine Output
The Finance Director has commissioned research that shows growth in sales of the output produced by
the new machine depends on the sales price, as follows:
Sales price New sales in year 1 Expected annual growth in sales
$70 per unit 10,000 units 20%
$67 per unit 11,000 units 23%

Variable costs of production are $42 per unit and incremental fixed production overheads arising from
the use of the machine are expected to be $85,000 per annum. The maximum capacity of the new
machine is 20,000 units per annum.
Other Information
Doe Ltd pays tax one year in arrears at a rate of 30% and can claim annual writing down allowances
(tax-allowable depreciation) on a 25% reducing balance basis. The company pays interest on its
overdraft at approximately 6% per annum before tax.
Average ratios for the business sector in which Doe Ltd operates are as follows:
Inventory days 210 days Current ratio 135
Receivables days 100 days Quick ratio 055
Payables days 120 days

(a) Write a report to the board of Doe Ltd that analyses and discusses the suggestion that
the company is overtrading. (12 marks)
(b) (i) Determine whether Doe Ltd should accept the factors offer. (7 marks)
(ii) What are the advantages to Doe Ltd of factoring its receivables? (8 marks)
(c) Discuss three ways (other than factoring) by which Doe Ltd might improve the
management of its receivables. (8 marks)
(d) Evaluate whether Doe Ltd should buy or lease the new machine, using an after tax
discount rate of 7%. (Assume that payment for the purchase, or the first lease payment,
would take place on 1 January 2004.) (9 marks)
(e) Calculate the optimum sales price for the output from the new machine. (Taxation and
the time value of money should be ignored.) (6 marks)
(50 marks)
Question 42 FRANTIC LTD
Frantic Ltd is a specialist car manufacturer and is a member of a group of companies that provides a
range of automobile products and services. It is currently facing difficulties in the management of its
working capital and the financial controller of Frantic Ltd is to investigate the situation with a view to
optimising payables payments, inventory ordering and receivables discounts to ease projected cash flow
Payables arise only for engine purchases. Engine suppliers have offered an early settlement discount of
15% if invoices are settled within one month of delivery. If the settlement discount is not taken, normal
payment terms of two months from delivery apply.
Frantic has a budgeted production of 800 cars for the year. The most expensive bought-in components
for the cars are engines. Other components are either made in-house or are minor items which are
bought-in but which do not require special inventory management. Engine purchase prices are subject
to quantity discounts according to the following schedule:
Order quantity Discount
049 units 0%
50249 units 2%
above 249 units 3%

Other details are:
Engine price (before discounts): $1,300
Inventory holding costs per annum
(as a percentage of engine costs): 22%
Delivery costs per order: $1,200
There is zero lead time on engine orders.

The cars are sold at $42,500 each and unit sales are equal to the units produced in each month. 50% of
the cars are made to order and payment is on a cash on delivery basis. The remaining cars are sold to
specialist retailers who take two months credit. Frantic is considering offering the specialist retailers a
2% discount for payments made within one month of sale. It is expected that 75% of the retailers would
take up the offer.
Other factors
A budget forecast is to be prepared for a six month period. Other variable costs (including the other
components) represent 65% of sales value and are payable immediately. Fixed costs are $18,000 per
month for the first three months, rising to $22,000 per month thereafter. The first instalment of $32
million for a major re-tooling operation will be paid in month three of the budget forecast.
Assume that the opening bank overdraft is $25,000 and that there are payables outstanding to the value
of $97,500 which will be paid in the first month of the budget plan. It is expected that receivables
payments of $1,062,500 will be received in each of the first two months.
The companys bank overdraft costs 15% per annum. Assume one month comprises 30 days, that no
opening inventory of engines is held and that production is evenly spread throughout the year.
(a) Calculate:
(i) if it is beneficial for Frantic to change from a two month payment period to a
one month payment period for payables. (3 marks)
(ii) the optimal ordering policy for engines. (6 marks)
(iii) if it is beneficial for Frantic to implement the 2% discount for receivables.
(3 marks)
(b) On the basis of your answer to part (a), and the information given above, prepare the
cash budget for Frantic for each of the next six months. (18 marks)
(c) Write a report to the Managing Director which identifies:
how cash flow problems can arise,
the methods available for easing cash shortages,
the techniques, besides cash budgeting, that could be used to monitor and
manage cash resources, and
the benefits of centralising cash management in a treasury department for
group companies.
(20 marks)
In all of your answers clearly state any assumptions you make.
(50 marks)
Question 43 TNG CO
TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling price of $19
per unit and is purchased for $11 per unit from a supplier, MKR Co. TNG places an order for 50,000
units of product X at regular intervals throughout the year. Because the demand for product X is to
some degree uncertain, TNG maintains a safety (buffer) inventory of product X which is sufficient to
meet demand for 28 working days. The cost of placing an order is $25 and the storage cost for Product
X is 10 cents per unit per year.
TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for cash
settlement within 20 days.
TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365 days.
(a) Calculate the annual cost of the current ordering policy. Ignore financing costs in this
part of the question. (4 marks)
(b) Calculate the annual saving if the economic order quantity model is used to determine
an optimal ordering policy. Ignore financing costs in this part of the question. (5 marks)
(c) Determine whether the discount offered by the supplier is financially acceptable to TNG
Co. (4 marks)
(d) Critically discuss the limitations of the economic order quantity model as a way of
managing inventory. (4 marks)
(e) Discuss the advantages and disadvantages of using just-in-time inventory management
methods. (8 marks)
(25 marks)
Question 44 MARTON LTD
Marton Ltd produces a range of specialised components, supplying a wide range of UK and overseas
customers, all on credit terms. 20% of UK turnover is sold to one firm. Having used generous credit
policies to encourage past growth, Marton now has to finance a substantial overdraft and is concerned
about its liquidity. Marton borrows from its bank at 13% per annum interest. No further sales growth in
volume or value terms is planned for the next year.
In order to speed up collection from UK customers, Marton is considering two alternative policies.
Option one
Factoring on a with-recourse, service only basis, the factor administering and collecting payment from
Martons UK customers. This is expected to generate administrative savings of 200,000 per annum
and to lower the average receivables collection period by 15 days. The factor will make a service
charge of 1% of Martons UK turnover and also provide credit insurance facilities for an annual
premium of 80,000.
Option two
Offering discounts to UK customers who settle their accounts early. The amount of the discount will
depend on speed of payment as follows:
Payment within 10 days of despatch of invoices: 3%
Payment within 20 days of despatch of invoices: 1.5%
It is estimated that UK customers representing 20% and 30% of Martons sales respectively will take up
these offers, the remainder continuing to take their present credit period.
Another opportunity arises to engage in a just-in-time inventory delivery arrangement with the main
UK customer, which normally takes 90 days to settle accounts with Marton. This involves borrowing
0.5m on overdraft to invest in dedicated handling and transport equipment. This would be depreciated
over five years on a straight: line basis. The customer is uninterested in the early payment discount but
would be prepared to settle after 60 days and to pay a premium of 5% over the present price in
exchange for guarantees regarding product quality and delivery. Marton judges the probability of
failing to meet these guarantees in any one year at 5%. Failure would trigger a penalty payment of 10%
of the value of total sales to this customer (including the premium).
In addition, Marton is concerned about the risk of its overseas earnings. All overseas customers pay in
US dollars and Marton does not hedge currency risk, invoicing at the prevailing spot rate, which is
currently US$1.45:1. It is considering the use of an overseas factor and also hedging its US dollar
income on the forward market. Its bank has offered to buy all of its dollar earnings at a fixed rate of
US$1.55:l. Martons advisers estimate the following chances of various dollar/sterling rates of
US dollars per Probability
1.60 0.1
1.50 0.2
1.45 0.4
1.40 0.2
1.30 0.1

Extracts from Martons most recent accounts:
000 000
Sales (all on credit)
Home 20,000
Export 5,000 25,000
Cost of sales (17,000)
Operating profit 8,000
Current assets:
Inventory 2,500
Receivables* 4,500
* There are no overseas receivables at the year end.
Note: Taxes and inflation can be ignored in this question.
(a) Calculate the relative costs and benefits in terms of annual profit before tax of each of
the two proposed methods of reducing domestic receivables, and recommend the most
financially advantageous policy. Comment on your results. (14 marks)
(b) Calculate the improvement in profits before tax to be expected in the first trading year
after entering into the JIT arrangement. Comment on your results. (8 marks)
(c) Suggest the benefits Marton might expect to derive from a JIT agreement in addition to
the benefits specified in the question. (6 marks)
(d) Briefly outline the services provided by an overseas factor. (4 marks)
(e) (i) Calculate the maximum loss which Marton can sustain through movements in
the dollar/sterling exchange rate if it does not hedge overseas sales. (2 marks)
(ii) Calculate the maximum opportunity cost of selling dollar earnings forward at
US$1.55:1. (2 marks)
(iii) Briefly discuss whether Marton should hedge its foreign currency risk.
(4 marks)
(40 marks)
Question 45 THORNE CO
Thorne Co values, advertises and sells residential property on behalf of its customers. The company has
been in business for only a short time and is preparing a cash budget for the first four months of 2006.
Expected sales of residential properties are as follows.
2005 2006 2006 2006 2006
Month December January February March April
Units sold 10 10 15 25 30

The average price of each property is $180,000 and Thorne Co charges a fee of 3% of the value of each
property sold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after
sale. The company has nine employees who are paid on a monthly basis. The average salary per
employee is $35,000 per year. If more than 20 properties are sold in a given month, each employee is
paid in that month a bonus of $140 for each additional property sold.
Variable expenses are incurred at the rate of 05% of the value of each property sold and these expenses
are paid in the month of sale. Fixed overheads of $4,300 per month are paid in the month in which they
arise. Thorne Co pays interest every three months on a loan of $200,000 at a rate of 6% per year. The
last interest payment in each year is paid in December.
An outstanding tax liability of $95,800 is due to be paid in April. In the same month Thorne Co intends
to dispose of surplus vehicles, with a net book value of $15,000, for $20,000. The cash balance at the
start of January 2006 is expected to be a deficit of $40,000.
(a) Prepare a monthly cash budget for the period from January to April 2006. Your budget
must clearly indicate each item of income and expenditure, and the opening and closing
monthly cash balances. (10 marks)
(b) Discuss the factors to be considered by Thorne Co when planning ways to invest any
cash surplus forecast by its cash budgets. (5 marks)
(c) Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to
fund any cash shortages forecast by its cash budgets. (5 marks)
(d) Explain how the Baumol model can be employed to reduce the costs of cash
management and discuss whether the Baumol cash management model may be of
assistance to Thorne Co for this purpose. (5 marks)
(25 marks)
Question 46 MERTON PLC
The following financial information relates to Merton plc, a supplier of photographic equipment and
film services to the film industry.
Income Statement for years ended 30 April
2006 2005 2004
$m $m $m
Turnover 1600 1450 1320
Cost of sales 1200 1053 957

400 397 363
Operating expenses 300 260 235

Operating profit 100 137 128
Interest 36 33 33

Profit before tax 64 104 95
Taxation 19 31 28

Profit after tax 45 73 67
Dividends 15 17 16

30 56 51

Share price at 30 April: $270 $511 $469

Statement of Financial Position as at 30 April
2006 2005
$m $m $m $m $m $m
Fixed assets 45 35
Current assets
Inventory 36 32
Receivables 41 24
Cash 1 16

78 72
Current liabilities
Trade payables 17 11
Overdraft 8 1

25 12

Net current assets 53 60

Total assets less current liabilities 98 95
Long-term liabilities
10% debentures 2008 13 13
8% debentures 2013 25 25

38 38

60 57

Capital and reserves
Ordinary shares (50 cents par) 10 10
Reserves 50 47

60 57

Notes: All sales are on credit. Merton currently pays interest on its overdraft at an annual rate of 4%,
although this rate is variable.
Shareholders of Merton plc have been alarmed by the companys recent announcement that it intends to
cut the total dividend for the year. The announcement, which was released on 1 June 2006, also said
that Merton plc is considering expanding into the retail camera market, as a result of which it expects
future share price growth and dividend growth to be at least 8% per year. Following the announcement,
the companys share price fell from $270 to $245 (on an ex dividend basis) where it has remained.
The Board of Merton plc has not announced how it plans to finance the proposed expansion into the
retail camera market, but it believes that the additional capital needed would be at least $19 million. It
also believes that the expansion will generate an after-tax return of 9% per year. The newly-appointed
Finance Director has suggested a rights issue to finance the proposed expansion, but he is concerned
that the recent fall in the companys share price may cause many shareholders to decide against taking
up their rights. Merton plc has not issued any new shares for the last three years.
The Finance Director believes that a rights issue would be a 1 for 2 rights issue at a 20% discount to the
current share price. The rights issue would be underwritten by the issuing house for a fee of $300,000.
The Finance Director decided when taking up his appointment that substantial improvement was
needed in the area of working capital management and asked the factoring subsidiary of a major bank to
provide a quotation for non-recourse factoring. The factor has indicated that it would require an annual
fee of 05% of sales. It would advance Merton plc 80% of the face value of sales at an interest rate 1%
above the current overdraft rate. It expects the average time taken by customers to pay to fall
immediately to 75 days, with a reduction to no more than the average for the sector within two years.
The Finance Director has also been assured that bad debts, currently standing at $500,000 per year,
would fall by 80%. Savings in current administration costs of Merton plc of $100,000 per year would
be achieved as a result of factoring.
The Finance Director has collected the following average data for the media sector:
Return on capital employed 12% Inventory days 100 days
Gross profit margin 25% Receivables days 60 days
Net profit margin 8% Payables days 50 days
Interest cover 8 times Current ratio 35 times
Gearing (debt/equity using book values) 50% Quick ratio 25 times

(a) Using appropriate ratios and financial analysis, comment on:
(i) the view of the Finance Director that substantial improvement is needed in the
area of working capital management of Merton plc; (10 marks)
(ii) the recent financial performance of Merton plc from a shareholder
perspective. Clearly identify any issues that you consider should be brought to
the attention of the ordinary shareholders. (15 marks)
(b) Determine whether the factoring companys offer can be recommended on financial
grounds. Assume a working year of 365 days and base your analysis on financial
information for 2006. (8 marks)
(c) Calculate the theoretical ex rights price per share and the net funds to be raised by the
rights issue, and determine and discuss the likely effect of the proposed expansion on:
(i) the current share price of Merton plc;
(ii) the gearing of the company.
Assume that the priceearnings ratio of Merton plc remains unchanged at 12 times.
(11 marks)
(d) Calculate the ex dividend share price predicted by the dividend growth model and
discuss the companys view that share price growth of at least 8% per year would result
from expanding into the retail camera market. Assume a cost of equity capital of 11%
per year. (6 marks)
(50 marks)
Question 47 ANJO PLC
Extracts from the recent financial statements of Anjo plc are as follows:
Income statements 2006 2005
$000 $000
Turnover 15,600 11,100
Cost of sales 9,300 6,600

Gross profit 6,300 4,500
Administration expenses 1,000 750

Profit before interest and tax 5,300 3,750
Interest 100 15

Profit before tax 5,200 3,735

Statements of financial position 2006 2005
$000 $000 $000 $000
Fixed assets 5,750 5,400
Current assets
Inventory 3,000 1,300
Receivables 3,800 1,850
Cash 120 900

6,920 4,050
Current liabilities
Trade payables 2,870 1,600
Overdraft 1,000 150

(3,870) (1,750)

Total assets less current liabilities 8,800 7,700

All sales were on credit. Anjo plc has no long-term debt. Credit purchases in each year were 95% of
cost of sales. Anjo plc pays interest on its overdraft at an annual rate of 8%. Current sector averages are
as follows:
Inventory days: 90 days Receivables days: 60 days Payables days: 80 days

(a) Calculate the following ratios for each year and comment on your findings.
(i) inventory days
(ii) receivables days
(iii) payables days (6 marks)
(b) Calculate the length of the cash operating cycle (working capital cycle) for each year
and explain its significance. (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. (7 marks)
(d) A factor has offered to take over sales ledger administration and debt collection for an annual
fee of 0.5% of credit sales. A condition of the offer is that the factor will advance Anjo plc
80% of the face value of its receivables at an interest rate 1% above the current overdraft rate.
The factor claims that it would reduce outstanding receivables by 30% and reduce
administration expenses by 2% per year if its offer were accepted.
Evaluate whether the factors offer is financially acceptable, basing your answer on the
financial information relating to 2006. (8 marks)
(25 marks)
Question 48 ARG CO
(a) Included in the receivables of ARG Co is an expected receipt of $500,000 in three months
time. The following exchange rates are available:
Spot 17642 17962
Three months forward 17855 18174

Explain why ARG Co might wish to hedge its expected three-month dollar receipt using
the forward market and calculate the sterling value arising from a forward market
hedge. (4 marks)
(b) Discuss how bills of exchange can be used to reduce the risk associated with the overseas
receivables of ARG Co. (4 marks)
(8 marks)
Question 49 VERTID LTD
In an attempt to recover from the economic recession, Vertid Ltd, a company employing 30 workers in
the UK Midlands, is starting to trade with two foreign countries, Werland and Thodia. Competitively
priced components have been purchased from Werland, with payment of 3,000,000 Werland francs due
in three months time. Goods have been sold to Thodia and receipts of 3,500,000 Thodian pesos are due
to be received in six months time.
The managing director of Vertid is concerned that the company cannot afford to lose money on the two
deals, as the companys poor cash flow situation has been the subject of recent discussions with the
companys bank. Vertids overdraft is currently approaching its agreed limit, and the bank has indicated
that it is unlikely that the overdraft facility will be increased in the near future.
The managing director asked his sales manager for a brief report discussing the likely foreign exchange
risk to be faced when trading with Werland and Thodia. The sales manager has stated that there is likely
to be substantial foreign exchange risk in trading with Werland, but little risk in trading with Thodia,
whose currency is directly linked to the US dollar.
The US dollar in recent months has been quite stable relative to sterling:
Exchange rates
Spot market
290 294 Werland francs per
1.4640 1.4690 $US per
220 228 Thodian pesos per $US
Forward market $US per
3 months forward 0.98 1.15 cents dis
6 months forward 1.70 1.86 cents dis

No forward market exists for the Werland franc or Thodian peso.
Current inflation rates
United Kingdom 3%
US 6%
Werland 12%
Thodia 20%

Current annual interest rates that are available to Vertid
Investing Borrowing
sterling 4.5% 10%
$US 6% 12%
Werland francs 12.5%
Thodian pesos 15%

OTC European currency call options are available for Werland francs at a premium of 25 francs per
with an exercise price of 300 francs per and a three month maturity date.
The managing director of Vertid wishes to develop a strategy for:
(i) protecting against any form of risk that these deals involve;
(ii) financing the overseas trade deals.
You have been asked as a consultant to:
(a) Explain whether or not the views of the sales manager regarding exchange risk are
likely to be correct. (9 marks)
(b) Prepare a report discussing how the managers of Vertid might protect the company
against all of the risks of each of the foreign deals. Relevant calculations should support
your report. (25 marks)
(c) Outline what alternatives might be available to Vertid Ltd to finance the two trade
deals. (6 marks)
(40 marks)
Question 50 GITLOR
At a luncheon meeting the managing director of Gitlor plc has told two of his colleagues, who hold
senior executive positions in different companies, that he has recently obtained from his bank forecasts
of exchange rates in one years time. His two colleagues also work for companies that are heavily
engaged in international trade, and both agree to obtain their own forecasts. The following week the
three again meet for lunch and compare the forecasts made by their banks. These forecasts are shown
$ per Euro per Euro Yen per $ $ per
Bank 1 076 056 120 136
Bank 2 084 064 140 131
Bank 3 100 065 140 154
Current spot rates 088 062 125 142
US UK Euro bloc Japan
Annual inflation rates 3% 2% 3% (1%)
Annual short-term interest rates 325% 475% 418% 001%

The three senior executives are puzzled by this information.
Prepare a report discussing and analysing the above information, and explaining why the banks
forecasts might differ. Your analysis should include calculations based upon inflation rates and
interest rates.
Discuss in the report the mechanisms influencing future exchange rates and whether or not it is
possible to accurately forecast such future exchange rates, and if so under what circumstances.
(15 marks)
(a) Discuss the advantages of hedging with interest rate caps and collars. (6 marks)
(b) Explain the possible benefits to a company of undertaking an interest rate swap.
(4 marks)
(10 marks)
Question 52 ENDESS LTD
An entrepreneur wishes to undertake a buy-in of Endess Ltd. The entrepreneur will have 60%
ownership of the share capital and other investors, (including some existing management) 40%.
Endess accountant has recently read the valuation chapter in a finance textbook and suggests two
valuations using methods in the book.
Method 1
This is the average of:
(i) the realisable value of the net assets of the company;
(ii) the estimated maintainable profits of the company capitalised at a rate of 16%.
Maintainable profits are to be based upon the average pre-tax profit of the last two years.
Method 2
This requires an agreed normal pre-tax rate of return, in this case 15%, to be applied to the realisable
value of net assets to establish normal profits. These profits are then compared with the expected
average annual pre-tax profits over the next two years. If expected profits are higher, this difference is
regarded as Economic Value Added (EVA) and the price to be paid will be the net assets price plus
three years of EVA.
Endess has supplied the following data from the last two years:
Income Statements year ending 31 March
20X2 20X3
$000 $000
Turnover 1,940 2,175
Cost of goods sold 1,410 1,550
_____ _____
Gross profit 530 625
Distribution costs 85 100
Administrative expenses 120 140
Interest payable 84 78
_____ _____
Profit before tax 241 307
Taxation 70 92
_____ _____
Profit after tax 171 215
_____ _____
Statements of Financial Position as at 31 March
20X2 20X3
$000 $000 $000 $000
Fixed assets
Land and buildings 340 340
Plant and equipment (net) 580 540
_____ _____
920 880
Current assets
Inventory 410 560
Receivables 570 785
Cash 20 15
___ ___
1,000 1,360
Current liabilities
Trade payables 340 430
Overdraft 250 320
Tax payable 50 110
___ ___
640 860
_____ _____
1,280 1,380
_____ _____
Financed by
Ordinary shares (25 cents) 300 300
Reserves 630 730
_____ _____
930 1,030
Term loan (five years) 350 350
_____ _____
1,280 1,380
_____ _____

Additional information
(i) Profit before tax is expected to grow at approximately 10% per year.
(ii) The existing directors who own 95% of the shares declared dividends of $115,000 in the
latest financial year, and $71,000 in 20X2.
(iii) The average earnings yield of AIM listed companies in the same industry as Endess is 12%
per year, and average earnings per share 20 cents.
(iv) The value of freehold land and buildings (never revalued) has fallen by 25% since purchased
due to the recession.
(v) The entrepreneur hopes to be able to pay off all of the companys existing loans.
(vi) Endess cost of equity is estimated to be 18%.
(vii) The replacement cost of plant and equipment is $600,000 but its current realisable value is
(viii) $75,000 of inventory is obsolete and could only be sold for $3,000 as scrap.
(a) Estimate the purchase price of Endess Ltd using each of these two methods. (6 marks)
(b) Acting as an adviser to the entrepreneur, prepare a short report discussing the
advantages and disadvantages of each of these two methods. (4 marks)
(c) Prepare, and critically discuss two additional valuations of Endess for your client, and
give a reasoned recommendation as to what value the entrepreneur should be prepared
to pay. (7 marks)
(17 marks)
Alf Tighs is the managing director of Sutcha and Sutcha plc, a large advertising company. As well as
having entrepreneurial skills in advertising, Alf is also a car enthusiast. In particular he has a passion
for old Italian sports cars and it is this passion that has resulted in a business opportunity for the firm.
At a recent party Alf discovered that Nick Nasom, drummer with the famous rock group Plink Void,
owned a garage that imported Italian sports cars. Furthermore, Nick was keen to sell the business to
give more time for writing rock operas. Alf feels that this is an opportunity not to be missed and that
Sutcha and Sutcha should buy the garage.
Summary financial statements are as follows.
Statement of Financial Position as at 31 December 20X6
$000 Note
Fixed assets
Freehold garage (NBV) 100 1
Pumps, desks, etc (NBV) 8 2

Inventory of Italian sports cars (at cost) 200 3
Shares in British Car Auctions Ltd (at cost) 10 4
Other net current assets 27

Bank loan (50)


Income statement for the year ended 31 December 20X6
$000 Note
Gross profit on garage (excluding car sales) 40
Profit on disposal of cars 100 5
Dividends received from BCA 1
Interest payable (8)


(1) The freehold garage is currently worth $150,000 or could be leased for approximately
$15,000 per annum.
(2) Other fixed assets have a net realisable value of $2,000.
(3) The current inventory of sports cars comprises two vehicles.
(i) 1963 Masoringhi 365 cost $120,000
(ii) 1970 Ferrati Beano 246 cost $80,000

Both models are extremely rare so it is difficult to estimate current value. The last time a
Masoringhi sold was three years ago for $200,000. Unfortunately the classic car market has
been depressed since then. As for the Ferrati Beano, prices reached $500,000 five years ago
but a similar car fetched $130,000 at an auction six months ago.
(4) The BAC Ltd shares are currently valued at $25,000.
(5) The profit on car disposals relates to six cars which Nick sold to rock musician friends over
the last year. In fact the majority of purchases and sales occur with music industry
Like most garages dealing with old sports cars, Nicks firm is unquoted. Some P/E ratios for large
firms in the car industry are given below.
Company P/E Market Business
Volvo 5 4,000 Car manufacturer
Evans Halshaw 13 136 Car dealer and garage services
Lex Service 17 332 Car dealer and garage services
Kwik-Fit 16 287 Exhausts, suspensions, tyres, etc
(Sutcha and Sutcha 20)

Calculate the value of the garage business using the following techniques.
(i) Net book value of assets less liabilities.
(ii) Net realisable value of assets less liabilities.
(iii) Applying a suitable P/E ratio to the earnings of the business.
For each technique detail any reservations you have with the figures used.
(15 marks)
The following are summary financial statements for Associated International Supplies Ltd.
1994 1999
$000 $000
Fixed Assets 115 410
Current Assets 650 1,000
Current Liabilities 513 982
Long Term Liabilities 42 158
Total 210 270
Capital and Reserves 210 270

1994 1999
$000 $000
Sales 1,200 3,010
Cost of sales, expenses and interest 1,102 2,860
Profit before tax 98 150
Tax and distributions 33 133
Retained earnings 65 17

Cost of sales was $530,000 for 1994 and $1,330,000 for 1999.
Receivables are 50% of current assets and trade payables are 25% of current liabilities for both years.
(a) You are a consultant advising Associated International Supplies Ltd. Using suitable
financial ratios, and paying particular attention to growth and liquidity, write a report
on the significant changes faced by the company since 1994. The report should also
comment on the capacity of the company to continue trading, together with any other
factors considered appropriate.
An appendix to the report should be used to outline your calculations. (17 marks)
(b) Explain and evaluate the sources of finance available to small businesses for fixed assets.
(8 marks)
(25 marks)
ACCA Pilot Paper Questions
ALL FOUR questions are compulsory and MUST be attempted
1 Droxfol Co is a listed company that plans to spend $10m on expanding its existing business.
It has been suggested that the money could be raised by issuing 9% loan notes redeemable in
ten years time. Current financial information on Droxfol Co is as follows.
Income statement information for the last year
Profit before interest and tax 7,000
Interest (500)

Profit before tax 6,500
Tax (1,950)

Profit for the period 4,550

Statement of Financial Position for the last year $000 $000

Non-current assets 20,000
Current assets 20,000

Total assets 40,000

Ordinary shares, par value $1 5,000
Retained earnings 22,500
Total equity 27,500
10% loan notes 5,000
9% preference shares, par value $1 2,500
Total non-current liabilities 7,500
Current liabilities 5,000

Total equity and liabilities 40,000

The current ex-div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents
per share has just been paid and dividends are expected to increase by 4% per year for the
foreseeable future. The current ex-div preference share price is 76.2 cents. The existing loan
notes are secured on the non-current assets of Droxfol Co and are redeemable at par in eight
years time. They have a current ex-interest market price of $105 per $100 loan note. Droxfol
Co pays tax on profits at an annual rate of 30%.
The expansion of business is expected to increase profit before interest and tax by 12% in the
first year. Droxfol Co has no overdraft.
Average sector ratios:
Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)
Interest coverage ratio: 12 times

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)
(b) Discuss whether financial management theory suggests that Droxfol Co can
reduce its weighted average cost of capital to a minimum level. (8 marks)
(c) Evaluate and comment on the effects, after one year, of the loan note issue and
the expansion of business on the following ratios:
(i) interest coverage ratio;
(ii) financial gearing;
(iii) earnings per share.
Assume that the dividend growth rate of 4% is unchanged. (8 marks)
(25 marks)
2 Nedwen Co is a UK-based company which has the following expected transactions.
One month: Expected receipt of $240,000
One month: Expected payment of $140,000
Three months: Expected receipts of $300,000
The finance manager has collected the following information:
Spot rate ($ per ): 1.7820 0.0002
One month forward rate ($ per ): 1.7829 0.0003
Three months forward rate ($ per ): 1.7846 0.0004
Money market rates for Nedwen Co:
Borrowing Deposit
One year sterling interest rate: 4.9% 4.6
One year dollar interest rate: 5.4% 5.1

Assume that it is now 1 May.
(a) Discuss the differences between transaction risk, translation risk and economic
risk. (6 marks)
(b) Explain how inflation rates can be used to forecast exchange rates. (6 marks)
(c) Calculate the expected sterling receipts in one month and in three months
using the forward market. (3 marks)
(d) Calculate the expected sterling receipts in three months using a money-market
hedge and recommend whether a forward market hedge or a money market
hedge should be used. (5 marks)
(e) Discuss how sterling currency futures contracts could be used to hedge the
three-month dollar receipt. (5 marks)
(25 marks)
3 Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days credit, although
customers on average take ten days more than this to pay. Contribution represents 60% of
sales and the company currently has no bad debts. Accounts receivable are financed by an
overdraft at an annual interest rate of 7%.
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and
to extend the maximum credit offered to 60 days. The company expects that these changes
will increase annual credit sales by 5%, while also leading to additional incremental costs
equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the
remaining customers taking an average of 60 days to pay.
(a) Evaluate whether the proposed changes in credit policy will increase the
profitability of Ulnad Co. (6 marks)
(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance
of $7,500. The average cost to the company of making deposits or selling
investments is $18 per transaction and the standard deviation of its cash flows
was $1,000 per day during the last year. The average interest rate on
investments is 5.11%.
Determine the spread, the upper limit and the return point for the cash
account of Renpec Co using the Miller-Orr model and explain the relevance of
these values for the cash management of the company. (6 marks)
(c) Identify and explain the key areas of accounts receivable management.
(6 marks)
(d) Discuss the key factors to be considered when formulating a working capital
funding policy. (7 marks)
(25 marks)
4 Trecor Co plans to buy a new machine to meet expected demand for a new product, Product
T. This machine will cost $250,000 and last for four years, at the end of which time it will be
sold for $5,000. Trecor Co expects demand for Product T to be as follows:
Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 25,000

The selling price for Product T is expected to be $12.00 per unit and the variable cost of
production is expected to be $7.80 per unit. Incremental annual fixed production overheads of
$25,000 per year will be incurred. Selling price and costs are all in current price terms.
Selling price and costs are expected to increase as follows:
Selling price of Product T: 3% per year
Variable cost of production: 4% per year
Fixed production overheads: 6% per year

Other information
Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in
arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is
expected to be 5% per year. The machine will be bought on the first day of a financial year.
Trecor Co has a target return on capital employed of 20%. Depreciation is charged on a
straight-line basis over the life of an asset.
(a) Calculate the net present value of buying the new machine and comment on
your findings (work to the nearest $1,000). (13 marks)
(b) Calculate the before-tax return on capital employed (accounting rate of return)
based on the average investment and comment on your findings. (5 marks)
(c) Discuss the strengths and weaknesses of internal rate of return in appraising
capital investments. (7 marks)
(25 marks)