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STUDY QUESTION BANK FINANCIAL MANAGEMENT (F9)
1001
Answer 1 PRIVATE V PUBLIC SECTOR OBJECTIVES
(a) Financial objectives
(i) State owned enterprise
(1) The overall objective is commonly to fulfil a social need.
(2) Because of problems of measuring attainment of social needs the
government usually sets specific targets in accounting terms.
(3) Examples include target returns on capital employed, requirement to be
self financing, cash or budget limits.
(ii) Private sector
(1) The firm has more freedom to determine its own objectives.
(2) A capital market quotation will mean that return to shareholders becomes
an important objective.
(3) Traditionally financial management sees firms as attempting to maximise
shareholder wealth. Note that other objectives may exist, e.g. social
responsibilities, and the concept of satisficing various parties are
important.
(b) Strategic and operational decisions
The major change in emphasis will be that decisions will now have to be made on a largely
commercial basis. Profit and share price considerations will become paramount. The
following are examples of where significant changes might occur.
Financing decisions. The firm will have to compete for a wide range of sources of
finance. Choices between various types of finance will now have to be made, e.g.
debt versus equity.
Dividend decision. The firm will now have to consider its policy on dividend
payout to shareholders.
Investment decision. Commercial rather than social considerations will become of
major importance. Diversifications into other products and markets will now be
possible. Expansion by merger and takeover can also be considered.
Threat of takeover. If the government completely relinquishes its ownership it is
possible that the firm could be subject to takeover bids.
Other areas. Pricing, marketing, staffing etc will now be largely free of
government constraints.
FINANCIAL MANAGEMENT (F9) STUDY QUESTION BANK
1002
Answer 2 CAPITAL MARKET EFFICIENCY
The efficient market hypothesis is often considered in terms of three levels of market efficiency.
(a) Weak-form efficiency
(b) Semi-strong form efficiency
(c) Strong-form efficiency.

The accuracy of the statement in the question depends in part upon which form of market efficiency is
being considered. The first sentence states that all shares prices are correct at all times. If correct
means that prices reflect true values (the true value being an equilibrium price which incorporates all
relevant information that exists at a particular point in time), then strong-form efficiency does suggest
that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not
fully consider all information (e.g. semi-strong efficiency does not include inside information). It might
be argued that even strong-form efficiency does not lead to correct prices at all times as, although an
efficient market will react quickly to new relevant information, the reaction is not instant and there will
be a short period of time when prices are not correct.
The second sentence in the statement suggests that prices move randomly when new information is
publicly announced. Share prices do not move randomly when new information is announced. Prices
may follow a random walk in that successive price changes are independent of each other. However,
prices will move to reflect accurately any new relevant information that is announced, moving up when
favourable information is announced, and down with unfavourable information. If strong-form
efficiency exists, prices might not move at all when new information is publicly announced, as the
market will already be aware of the information prior to public announcement and will have already
reacted to the information.
Information from published accounts is only one possible determinant of share price movement. Others
include the announcement of investment plans, dividend announcements, government changes in
monetary and fiscal policies, inflation levels, exchange rates, and many more.
Fundamental and technical analysts play an important role in producing market efficiency. An efficient
market requires competition among a large numb of analysts to achieve correct share prices, and the
information disseminated by analysts (through their companies) helps to fulfil one of the requirements
of market efficiency, i.e. that information is widely and cheaply available.
An efficient market implies that there is no way for investors or analysts to achieve consistently
superior rates of return. This does not say that analysts cannot accurately predict future share prices.
By pure chance some analysts will accurately predict share prices. However, the implication is that
analysts will not be able to do so consistently. The same argument may be used for corporate financial
managers. If, however, the market is only semi-strong efficient, then it is possible that financial
managers, having inside information, would be able to produce a superior estimate of the future share
price of their own companies and that, if analysts have access to inside information, they could earn
superior returns.
.
1003
Answer 3 BASIC DISCOUNTING
(a)

(i)

0.621) (70 0.683) (60
0.751) (50 0.826) (40 0.909) (30
+ +
+ +
= $182

(ii)(30 1.736) + (50 (3.791 1.736)) = $155

(iii)((50 + 60) 0.909) + (70 0.826) + (80 0.751) = $222

(b) (i) $500 5.019 = $2,510

(ii)$500 (5.019 0.870) = $2,183

(iii)$500 (4.772 + 1) = $2,886

(c) (i) $15,000 4.329 = $3,465

(ii)$15,000 (4.329 0.952) = $3,640

(iii)$15,000 (3.546 + 1) = $3,300

(d) (i) $1,500 0.10 = $15,000

(ii)($1,500 0.10) 0.683 = $10,245

(e) $500 0.482 = $1037

(f) ($8 3.791) + ($100 0.621) = $92.43

1004
Answer 4 ELVIRA CO PLC
(a) Payback period
A $100,000/$40,000 = 2.5 years (or 3 years, if cash flows arise at year end)

B After 4 years net position is $120,000-$40,000 = $80,000 negative.
Payback = 4 years + $80,000/$200,000 = 4.4 years

C After one year cash $50,000 negative. Payback = 1 + $50,000/$80,000 = 1.6 years

(b) Accounting rate of return
A Total profit = total inflow total depreciation = 160 - (100-10) = 70
Average profit = 70/4 = 17.5
Average investment = (cost + residual value)/2 = (100+10)/2 = 55
ARR = 17.5/55 = 31.8%

B 40.0%

C 27.3%

(c) Net present value at 15%
A $100,000 + ($40,000 2.855) + ($10,000 0.572) = $19,920
B $120,000 + ($10,000 2.855) + ($212,000 0.497) = $13,914
C $150,000 + ($100,000 0.870) + ($95,000 0.756) = $8,820

(d) Internal rate of return
NPV at 20%

A $100,000 + $40,000 2.589 + $10,000 0.482 = $8,380
B $120,000 + $10,000 2.589 + $212,000 0.402 = $8,886
C $150,000 + $100,000 0.833 + $95,000 0.694 = $770

IRR
A
( ) 380 , 8 920 , 19
920 , 19
15
+ (20 15) = 24%

B
( ) 886 , 8 914 , 13
914 , 13
15
+
+ (20 15) = 18%

C
( ) 770 820 , 8
820 , 8
15
+
+ (20 15) = 20%

Summary
A B C Preferred
Payback (years) 3 5 2 C
ARR (%) 32 40 27 B
NPV ($000) 20 14 9 A
IRR (%) 24 18 20 A
1005
Answer 5 KHAN LTD
(a) NPV and IRR calculations
Promotion method NPV IRR
$ %
Alternative 1 + 3,100 5 or 50
Alternative 2 + 3,470 23

WORKINGS

Alternative 1

(i) Net present value
Cash 20% Present
flow discount value
$000 factor $000
Year 0 (100.0) 1.000 (100.00)
Year 1 255.0 0.833 212.41
Year 2 (157.5) 0.694 (109.31)

Net present value 3.10

(ii) Internal rate of return
NPV = 100 + 255 (1 + r)
-1
157.5 (1 + r)
-2
= 0

Solving this quadratic equation for r to find the internal rate of return (note
it is not likely that you will be required to solve quadratic equations under
exam conditions)

Multiply each side of the equation by (1 + r)
2

100 (1 + r)
2
255 (1 + r) + 157.5 = 0

Using the quadratic formula: x =
2a
4ac) (b b
2

(1 + r) =
100 2
157.5) 100 (4 (255 255
2

=
200
45 255

(1 + r) = + 1.05 r = 0.05 or 5%
or (1 + r) = + 1.50 r = 0.50 or 50%

Thus Alternative 1 has two internal rates of return: 5% and 50%.

1006
Alternative 2

(i) Net present value
Cash 20% Present
flow discount value
$000 factor $000
Year 0 (50) 1.000 (50.00)
Year 1 0 0.833 0
Year 2 42 0.694 29.15
Year 3 42 0.579 24.32

Net present value 3.47

The internal rate of return is estimated using linear interpolation.

Using a 20% discount rate (see above), the cash flow has an NPV of $3,470.

Using a 25% discount rate, the NPV of the cash flow is as follows.

Cash 25% Present
flow discount value
$000 factor $000
Year 0 (50) 1.000 (50.00)
Year 1 0 0.800 0
Year 2 42 0.640 26.88
Year 3 42 0.512 21.50

Net present value (1.62)

Therefore, the IRR (the discount rate that reduces net present value to zero) lies
between 20% and 25%.

IRR 0.
( ) 620 , 1 470 , 3
470 , 3
20
+
+ (0.25 0.2) = 0.234

The internal rate of return is approximately 23%.

(b) Choice of project
The net present value calculations indicate that Alternative 2 is more favourable and
should be undertaken. It has the larger positive net present value and should therefore add
the greater extra amount to shareholders wealth; although it should be noted that there is
relatively little difference between the NPV of the two alternatives.

1007
However, it would be unwise to make the final decision solely on the basis of these
calculations without investigating the risk attached to each alternative and the marketing
and manpower factors that may be involved. For example, the heavy advertising
characteristic of Alternative 1 may have a beneficial spin-off for the companys other
products, or the widespread use of agents with this alternative may again benefit the
promotion of other products imported by Khan Ltd. In terms of the risk aspects, it may be
judged that novelty products generally are high risk short-lived undertakings and that
Alternative 1, which promotes the product for only a single year, may be a less risky
approach than Alternative 2, which appears to extend the life by a further one or two years.
In addition, there are innumerable other considerations which may be relevant to the
decision, such as whether the promotion of this particular novelty product will adversely
affect other products sold by the company.

The internal rates of return of the two alternatives have been ignored in formulating the
decision advice for two main reasons. The first is that Alternative 1 has two internal rates
of return, one above, the other below, the required rate. This conflicting investment advice
clearly indicates that the use of internal rates of return is an unreliable (and unhelpful)
investment decision guide.

The second reason for rejecting the IRR approach is more theoretical, but still valid for
practical decision-making. It is that the decision rule selects between mutually-exclusive
alternatives on the assumption that the opportunity cost of any investments cash flow is
equal to the internal rate of return of that investment.

This can easily be demonstrated to be a fallacious assumption, as the opportunity cost of
cash generated by a project is (or should be) reflected by the firms cost of capital at the
time of generation, certainly not (except by chance) by the internal rate of return of the
generating project.

In these terms the internal rate of return of a project can be seen as little more than an
arithmetic artefact that has little economic rationale behind it, and is therefore an unreliable
decision-making guide. Mr Courts views are important and are commented upon in part
(c) below, including reasons why the payback method was not used to help to reach a
decision.

(c) Comments on Mr Courts views
Mr Court makes two points of note one concerns the payback method of investment
appraisal, whilst the other concerns the relationship between reported profits and
investment decision-making. These two points will be commented upon separately.

(i) The payback method
The payback method of investment appraisal is relatively quick and simple to operate and
understand. It calculates how quickly a projects outlay is recovered from its generated
earnings, usually cash flows, though alternatives are possible.
A number of fairly minor criticisms of the use of payback period can be made, some of which
can be illustrated by the two alternatives under evaluation. On the basis of Mr Courts
remarks, it would appear that Khan Ltd already uses the payback method and therefore has
already set a maximum acceptable payback criterion. Ignoring the problems surrounding the
setting of this criterion, Alternative 1 illustrates two of the methods possible ambiguities: the
definition of outlay (e.g. is it $100,000 or $257,700?) and identifying the start of the payback
period. However, assuming that some sort of discounted payback is used which takes into
account the time value of money, the major fault of the method concerns its failure to
consider the project cash flow that lies outside the payback time period.
1008
Notwithstanding these comments, payback can act as a useful guide to project desirability
when liquidity is a problem for a company and the speed of a projects return is of prime
importance. This may be particularly true where, in addition, the investment opportunities are
relatively small and where it may be felt that a full scale discounted cash flow evaluation is
unnecessary.
However, in the situation given, there is no indication as to the relative size of the two
promotion alternatives to the company as a whole but, on the basis that cash is not in short
supply over the next three years, the firm does not appear to have any liquidity problem.
Thus there would seem to be little evidence to support Mr Courts preference for the payback
method.
One final point is that the supporters of payback claim that the method does attempt to allow
for uncertainty in that it prefers fast payback projects. Such a claim is really unjustified as it
is based on the belief that uncertainty is concerned with the timing of a projects return. This
is somewhat naive.
(ii) Investment appraisal and reported profits
Mr Courts second comment highlights a real problem in that a different approach is used for
investment decision-making (discounted cash flows) from that used for reporting the success
or otherwise of the decisions made (reported profits). Most investment opportunities
undertaken by firms have returns whose generation covers a relatively long time period
(several years). It is one of the tasks of published accounts (and particularly the profit and
loss account) to cut up this continuous stream of wealth generation into a series of time
periods: the accounting year.
It is certainly a powerful argument that, as well as undertaking NPV calculations,
management should also consider the implications for the published accounts of any
investment opportunity especially if the projects are of a substantial size. For instance, if a
particular project had a healthy positive NPV but its acceptance would have an adverse effect
on the published financial accounts, although it would be unwise for the project to be rejected
on these grounds alone, management should make strenuous efforts to ensure that its
investment plans are fully communicated to and understood by the shareholders and the bonds
market in general.
In this case the comment has been made earlier that, although Alternative 2 is the more
favoured on the basis of its net present value, there is really little difference between the
NPVs of the two alternatives. If the acceptance of Alternative 2 would have a substantial and
adverse effect on the companys reported profits, this may well be a legitimate reason in these
circumstances to review the NPV decision.

1009
Answer 6 FIORDILIGI PLC
t
0
t
1
t
2
t
3
t
4
t
5

$000 $000 $000 $000 $000 $000
Labour
Skilled 10,000 0.5 Nil
10,000 0.5 $4.00 20.0 20.0
8,000 0.5 $4.00 16.0 16.0
Unskilled 10,000 2 $2.50 50.0 50.0 50.0
8,000 2 $2.50 40.0 40.0

Materials
Ping 10,000 2 $1.40 28.0 28.0 28.0
8,000 2 $1.40 22.4 22.4
Pang 46,000 0.5 $1.80 41.4
Pong 10,000 1.5 $0.80 12.0 12.0 12.0
8,000 1.5 $0.80 9.6 9.6

Overheads
Variable 10,000 0.5 $1.40 7.0 7.0 7.0
8,000 0.5 $1.40 5.6 5.6
Fixed Rent 2.0 2.0 2.0 2.0 2.0
Rates 1.0 1.0 1.0 1.0 1.0

83.4 100.0 120.0 112.0 96.6 62.6

Revenue 10,000 $18 180.0 180.0 180.0
8,000 $14 112.0 112.0
Costs (as above) (83.4) (100.0) (120.0) (112.0) (96.6) (62.6)
Purchase of plant (60.0)
Resale 6.0

Net cash flow (143.4) 80.0 60.0 68.0 15.4 55.4

Discount factors at 15% 1.000 0.870 0.756 0.658 0.572 0.497

Present values ($000) (143.0) 70.0 45.0 45.0 9.0 28.0

NPV = + $54,000

Therefore, accept.

1010
Answer 7 HULME LTD
(a) Cash flows resulting from manufacture and sale of Champs
Ref to Time 1 Time 2 Time 3 Time 4
workings $000 $000 $000 $000
Machine (150)
Labour (1) (75) (210) (252)
Materials
Alpha (2) (100) (110) (121)
Beta (3) (90) (121) (133)
Overheads (4) (50) (55) (61)

Total outflows (340) (356) (519) (313)
Sales (5) 600 660 726

Net inflow/(outflow) (340) 244 141 413

20% discount factor 1.000 0.833 0.694 0.579

Present value (340) 203 98 239

Net present value = $200,000

On the basis of the estimates given, production of Champs is worthwhile.

Note Time 0 is taken to be the date on which manufacture would commence, i.e.
1 January 19.00; time 1 is 31 December 19.00, etc.

WORKINGS

For explanations of the figures used, see part (b).

(1) Labour cost
$
Year 1 Skilled 25,000 hours @ $3 75,000
Unskilled No cost incurred

75,000

Year 2 Skilled 25,000 ($3 1.2) 90,000
Unskilled 50,000 ($2 1.2) 120,000

210,000

Year 3 Year 2 cost 1.2 252,000

1011
(2) Material Alpha

Current buying price is 50c per kg, rising at 10% per annum.

Time 0 cost 50c 200,000 = $100,000
Time 1 cost $100,000 1.1 = $110,000
Time 2 cost $110,000 1.1 = $121,000

(3) Material Beta

Quantity held is enough for one year.

Time 0 realisable value 100,000 90c = $90,000
Time 1 buying price 100,000 $1.10 1.1 = $121,000
Time 2 buying price 121,000 1.1 = $133,100

(4) Overheads

The only relevant costs are variable overheads, which rise at 10% per annum.

Year 1 cost 100,000 50c = $50,000
Year 2 cost $50,000 1.1 = $55,000
Year 3 cost $55,000 1.1 = $60,500

(5) Sales

The selling price rises at 10% per annum.

Year 1 100,000 $6 = $600,000
Year 2 $600,000 1.1 = $660,000
Year 3 $660,000 1.1 = $726,000

(b) Brief explanations of the figures used
(1) Machine

Although the machine is owned already, it has an opportunity cost if used on
this project, which is the revenue forgone if it is not sold now for $150,000.

(2) Labour

In the first year of the project the company will have to pay for extra skilled
labour only, as there is enough surplus unskilled labour to cover the necessary
50,000 hours on the project. As this unskilled labour is paid whether or not the
Champs are produced, there is no relevant unskilled labour cost in year 1 of the
project.

In years 2 and 3 of the project the company will have to pay for extra skilled
and unskilled labour.

1012
(3) Material Alpha

Alpha is used regularly by the company on many projects. If existing inventory
are used to manufacture Champs, the company will have to buy in more
inventory of Alpha for its other projects. The relevant cost of Alpha is thus
always its buying price, which is expected to rise by 10% per annum.

(4) Material Beta

Present inventory of Beta are sufficient for the first years production of
Champs. Since there is no alternative use for Beta within the company, the
opportunity cost of existing inventory is the realisable value of 90c per kg.

After one year present inventory will be exhausted, and the relevant cost of
further supplies of Beta will be the buying price.

(5) Overheads

Fixed costs allocated from head office will be irrelevant to this decision as they
will be incurred whether or not Champs are produced.

Depreciation is irrelevant to a project appraisal based on cash flows.

The only relevant cost is, therefore, the variable overhead.

(c) Factors not included in the calculations which may affect the decision
(i) Availability of more profitable projects
The project has been appraised in its own right, but it should be compared with
alternative uses for the funds employed, particularly if there are constraints on
capital or other resources.
(ii) Scarcity of resources
The calculations assume that there is no scarcity in supply of the resources used on
the project, e.g. that sufficient supplies of Alpha or skilled labour are available at
the prices stated and that the use of them will not affect the quantities available for
the companys normal operations. If there is a scarcity in supply, the opportunity
cost of these resources will include the lost contribution through not using the
resources on alternative projects.
(iii) Risk and uncertainty of estimates
Most of the figures used in the project appraisal are subject to uncertainty. The
decisions might be affected by revised estimates of the following.
(1) The sales price/sales volume relationship. Marketing of the Champ
may encourage others to compete with the new product, leading to
reduced sales, or to reduced selling price, or to a combination of the
two.

(2) The rate of inflation, which could lead to revised forecasts for costs and
the cost of capital.

(3) The length of the project.
1013
(4) Whether head office fixed costs would be unaltered by the new project.
In practice, the addition of a new line is likely to increase fixed costs.
Additional staff may be employed in accounts, despatch or stores, for
example, not directly connected with the new product line, but
ultimately resulting from the increased turnover. The need for
additional storage area may require the utilisation of space which could
otherwise have been sub-let. If so, the rental income forgone would be
treated as a relevant cash outflow.

Other more general possibilities, such as a change of government or a change in
fiscal policy, may affect the profitability of the project.
(iv) Management and labour skills
The calculation assumes that the necessary skills exist for this new project or that
they can be quickly acquired without any teething problems. In practice, this would
be a major factor in the decision.
(v) Technological change
Changing technology may render the Champ obsolete before the end of three years.
Answer 8 BAILEY PLC
(a) Investment appraisal of production of Oakmans
Year 1 2 3 4 5 6 7
$ $ $ $ $ $ $
Contribution before labour costs 139,150 153,065 168,371 92,604 101,865
Labour cost (39,675) (45,626) (52,470) (30,171) (34,696)
Redundancy payments (15,741)
Redundancy payments avoided 20,700
Machine overhaul (79,860)

20,700 99,475 27,579 100,160 62,433 67,169
Tax at 35% (7,245) (34,816) (9,653) (35,056) (21,852) (23,509)
Cost of machine (209,000)
WDAs 18,288 13,716 10,287 7,715 5,786 17,359

Net cash flows (188,300) 110,518 6,479 100,794 35,092 51,103 (6,150)

20% factors 0.833 0.694 0.579 0.482 0.402 0.335 0.279

Present value (156,854) 76,699 3,751 48,583 14,107 17,120 (1,716)

Net present value = $1,690

Conclusion

Bailey plc should, on the basis of the positive net present value, undertake production of
the Oakman. However, the decision is fairly marginal, and the estimate of all variables
should be carefully reviewed to ensure that the decision to produce is correct.
1014
Explanatory notes

(1) Contribution from sales before labour cost

These cash flows have been grouped as they all inflate at 10% per annum. At
current values the cash flow per unit is as follows.

$
Sales price 35
Material and other consumables (8) It is assumed that there is no
Variable overheads (4) change in head office fixed
costs if Oakman is produced
Net contribution before labour cost 23

(2) Labour cost

At current prices the labour cost per unit of 2 hours $3 is included, as the six
employees would not be paid if the Oakman were not produced.

(3) Redundancy payment

This is the payment to the three redundant employees in four years time.

(4) Redundancy payments avoided

If the Oakman were not produced, there would be a payment of 6,000 hours
$3 1.15 to the six employees who would be made redundant. This is avoided
and hence is an incremental cash flow.

(5) Purchase and maintenance of machine

These are the cash flows that will be incurred.

(6) Overhead costs

It is assumed that the overhead costs will be allowed for tax in the year in
which they are incurred.

(7) Taxation

All tax paid on accounting profits is based on the previous years cash flow at
35%.

1015
(8) Writing down allowances
WDA Tax saved Timing
$ $ $
Cost paid at end of first year (t
1
) 209,000
WDA year 1 (52,250) 52,250 18,288 t
2

156,750
WDA year 2 (39,188) 39,188 13,716 t
3

117,563
WDA year 3 (29,391) 29,391 10,287 t
4

88,172
WDA year 4 (22,043) 22,043 7,715 t
5

66,129
WDA year 5 (16,532) 16,532 5,786 t
6

49,597
Proceeds end of year 6

Balancing allowance 49,597 49,597 17,359 t
7

(9) General comments

The production of Oakman has been evaluated by considering the incremental
change in the companys cash flows caused by a decision to produce. These
have been valued at the actual cash flow in each year, after allowing for the
differing effects of inflation on each item. These money cash flows have then
been discounted at the money cost of capital (net of corporation tax).

An alternative would have been to calculate a real discount rate for each cash
stream and discount the un-inflated cash flows at that rate.

(b) Discussion of investment appraisal problems caused by high inflation rates
The existence of high rates of inflation creates problems in investment appraisal by
contributing to the uncertainty attached both to the cash flows themselves and the
appropriate discount rate. It is unlikely that in any investment appraisal situation each cash
flow stream will be affected in the same way by inflation. The budget must predict as
accurately as possible the anticipated level of inflation.

Higher rates of inflation will tend to be more volatile than lower rates, especially as
government action will be directed to reducing them. With different inflation rates
applying to each item (e.g. materials and labour) the value of an investment could be
highly sensitive to changes in those rates. The extent to which the effect of inflation can be
passed on by income increases (e.g. raising product selling price) must also become less
certain as government controls, competitors reactions and the elasticity of demand become
more important.

1016
The conventional treatment of inflation is to discount the anticipated money cash flows at a
money discount rate. This money rate would normally be derived from the so-called
dividend valuation model, to give the shareholders required rate of return and the
required rate of return for other suppliers of capital such as debenture holders. Such a
required rate of return will consist of both a real rate reflecting the time value of money
to the providers of funds, plus an additional return to compensate for the decrease in
purchasing power caused by inflation.

Clearly, with higher anticipated inflation rates, such a money rate will be higher than with
lower rates. However, the company must anticipate such a required rate of return when
evaluating capital projects. With high inflation rates this anticipation becomes more
difficult, as again the expectations of the shareholders as to the effect of inflation on them
will become more diverse. Moreover, with the increased probability of changes in
inflation in the future, the required rate of return is unlikely to be constant over the life of
the project. The company will be faced with increasing uncertainty as to whether it is
acting in the best interests of shareholders by accepting or rejecting a particular project.

Finally, it should be noted that the above comments refer to the problems presented to
investment appraisal by expected or anticipated inflation. The correct treatment in capital
budgeting of unanticipated inflation has so far defied a workable solution, and this
represents a serious gap in the theory of financial decision-making.

Answer 9 STAN BELDARK
(a) Optimal replacement period
The effects of increasing running costs and decreasing resale value have to be weighed up
against capital cost. Road fund licence etc can be ignored, since Stan will always pay $300
per year per car.

The following table is one of the quickest ways to reach an answer.

Running PV Cum PV Resale PV of NPV of Cum EAC
cost of RC of RC value RV car discount
$ $ $ $ $ $ factor $
Life 1 3,000 2,727 2,727 3,500 3,182 5,045 0.909 5,550
Life 2 3,500 2,891 5,618 2,100 1,735 9,383 1.736 5,405
Life 3 4,300 3,229 8,847 900 676 13,671 2.487 5,497

From the above table it can be seen that the optimal replacement period is every two years.

(b) Discussion of investment appraisal and high inflation rates
The existence of high inflation creates problems in investment appraisal by contributing to
the uncertainty attached both to the cash flows and to the appropriate discount rate. It is
unlikely that in any investment appraisal each cash flow stream will be affected in the
same way by inflation. Higher rates of inflation will tend to be more volatile than lower
rates, especially as government action will be directed to reducing them.

With different inflation rates applying to each item (e.g. materials and labour), the value of
an investment could be highly sensitive to changes in those rates. The extent to which the
effect of inflation can be passed on by raising selling prices must also become less certain
as government controls, competitors reactions and the elasticity of demand become more
important. The appraisal procedures must therefore focus more attention on predicting the
effect of inflation on each type of cash flow.
1017

The existence of high rates of inflation will also affect the discount rate used. The
conventional treatment is to discount the anticipated money cash flows at a money
discount rate. This money rate would normally be the yield for shareholders and the
required rate of return for other suppliers of capital such as debenture holders. Such a
required rate of return will be a rate reflecting the time value of money to the provider of
funds, plus an additional return to compensate for the decrease in purchasing power caused
by inflation.

Clearly, with higher anticipated inflation rates such a money rate will be higher than with
lower rates. However, the company must anticipate such a required rate of return when
evaluating capital projects. With high inflation rates this anticipation becomes more
difficult, as again the expectations of the shareholders as to the effect of inflation on them
will become more diverse. Moreover, with the increased probability of changes in
inflation in the future the required rate of return is unlikely to be constant over the life of
the project. The company will be faced with increasing uncertainty as to whether it is
acting in the best interests of shareholders by accepting/rejecting a particular project.

Answer 10 TALEB LTD
Summary showing the optimal replacement policy for Talebs Dot machines
Replacement cycle Annual equivalent net revenue
$000

1 year
2 years
3 years
4 years
8.0
11.1 *
9.8
10.3

* optimal policy

Replacement of the Dot machine every two years results in the greatest annual equivalent net
revenue for the company (i.e. $11,100) and therefore is the recommended replacement policy.

WORKINGS

Annual production/sales (units) 500,000 400,000

$ $
Annual revenue ($0.12 per unit) 60,000 48,000
Less Annual variable costs ($0.04 per unit) (20,000) (16,000)

40,000 32,000

1018
(i) One year replacement
Year 0 Year 1
$000 $000
Machine outlay (60)
Scrap value 40
Running costs (6)
Contribution 40

Net cash flow (60) 74

Net present values = 60 + (74 0.909)

= 7.266

Annual equivalent = 7.266 0.909

$7,993

(ii) Two year replacement
Year 0 Year 1 Year 2
$000 $000 $000
Machine outlay (60.0)
Scrap value 25.0
Running costs (6.0) (6.5)
Contribution 40.0 40.0

Net cash flow (60.0) 34.0 58.5

Net present values = 60 + (34 0.909) + (58.5 0.826)

= 19.227


$11,075

(iii) Three year replacement
Year 0 Year 1 Year 2 Year 3
$000 $000 $000 $000
Scrap value 10.0
Running costs (6.0) (6.5) (7.5)
Contribution 40.0 40.0 32.0

Net cash flow (60.0) 34.0 33.5 34.5

Net present values = 60 + (34 0.909) + (33.5 0.826) + (34.5 0.751) = 24.4865

Annual equivalent = 24.4865 2.487 $9,846

1019
(iv) Four year replacement
Year 0 Year 1 Year 2 Year 3 Year 4
$000 $000 $000 $000 $000
Scrap value 0
Running costs (6.0) (6.5) (7.5) (9.0)
Contribution 40.0 40.0 32.0 32.0

Net cash flow (60.0) 34.0 33.5 24.5 23.0

Net present values = 60 + (34 0.909) + (33.5 0.826) + (24.5 0.751) + (23
0.683)

= 32.6855


$10,311

Answer 11 STICKY FINGERS PLC
(a) No rationing
Present values
Year 0 1 2 3 4
Time t
0
t
1
t
2
t
3
t
4

Discount factor 1 0.870 0.756 0.658 0.572

$000 $000 $000 $000 $000
Project A (1,500) (435) 907 395 172
Project B (2,000) (870) 1,890 1,645 1,430
Project C (1,750) 435 832 921 572
Project D (2,500) 609 680 855 172
Project E (1,600) (435) 151 1,842 1,316

NPV
$000
Project A (461)
Project B 2,095 Therefore, accept all projects with a
Project C 1,010 positive NPV - projects B, C and E
Project D (184)
Project E 1,274

1020
(b) Single-period capital rationing
Project A B C D E
NPV ($000) (461) 2,095 1,010 (184) 1,274
Investment, t
0
($000) 1,500 2,000 1,750 2,500 1,600

NPV/$ $1.05 $0.58 $0.80
Rank 1st 3rd 2nd

Therefore, accept B and
16
10
E.

(c) Single-period capital rationing inflows and outflows, negative NPVs
Using benefit cost ratios
investment Rationed
NPV

Benefit/cost NPV per Ranking
$1 invested
Project A *
Project B $2,095/$1,000 $2.10 2
Project C *
Project D $184/$700 $0.26 **
Project E $1,274/$500 $2.55 1

Notes

* Project A would never be accepted because it has a negative NPV and uses up
funds in the restricted year.

Project C would always be accepted since it has a positive NPV and releases
funds in the restricted year. A total of $700,000 is then available.

** Project D has a negative NPV but releases funds at t
1
.

If project D is accepted, this makes an extra $700,000 available at t
1
. However, in doing
so a negative NPV ( $184,000) is incurred. Thus, it is necessary to examine whether the
extra positive NPV generated by the additional investment finance outweighs this cost.

(1) Available capital = $200,000. Accept projects C, E and 20% B. Total NPV =
$2,703,000.
(2) If D is accepted the available capital becomes $1,400,000 [$200,000 +
$500,000 (from project C) + $700,000 (from project D)]. Accept projects C, D,
E and 90% B. Total NPV = $3,985,500. This is the optimal solution.

(d) Indivisible projects
Possible investment portfolios are
B or C or E or (C and E)

The portfolio which has the highest NPV is C and E requiring an investment of $3.35
million and generating $2.3 million.

1021
(e) Multi-period capital rationing
Note it is not likely that you will be required to solve a multi period capital rationing
situation in exam conditions. It is enough to be aware of the technique that would be used
i.e. linear programming

Let a = the proportion of project A undertaken etc.
Let z = NPV

Sticky Fingers should aim to maximise an objective function

z = 461a + 2,095b + 1,010c 184d + 1,274e

subject to constraints

1,500a + 2,000b + 1,750c + 2,500d + 1,600e 3,000
500a + 1,000b + 500e 200 + 500c + 700d

a, b, c, d, e 1

Non-negativity conditions

a, b, c, d, e 0

Answer 12 ARMSTRONG PLC
(a) Investment decision
t
0
t
1
t
2
t
3
t
4
t
5
t
6
$ $ $ $ $ $ $
Contribution from
new product 30,000 50,000 60,000 122,500 122,500
Contribution forgone
from old product (30,000) (22,500) (4,500) (1,500)
Advertising (14,200)

27,500 41,300 121,000 122,500
Tax at 35% (9,625) (14,455) (42,350) (42,875)
Land (120,000) 160,000
New building (30,000) 25,000
CAs (W1) 420 420 420 420 420 (350)

(150,000) 420 27,920 32,095 106,965 265,570 (43,225)

Discount factor
at 15% 1 0.870 0.756 0.658 0.572 0.497 0.432
Present value
$(150,000) 365 21,108 21,119 61,184 131,988 (18,673)

NPV = $67,091

1022
This NPV does not include cash flows relating to the acquisition of the burnishing machine.
Of the two options for the acquisition, leasing has the lower present value of costs, at $61,981
(see part (b)). Since this is lower than the present value of the benefits from the project
($67,091 above), the project is worthwhile, and should be undertaken.
(b) Financing options (burnishing machine)
(i) Purchase
Present value
$
Purchase price 100,000
Tax saved (W2) (25,996)

74,004

(ii) Leasing
Present value
$
Lease rentals $21,800 (1 + 3.170) 90,206
Tax relief $21,800 0.35 3.791 (28,925)

61,981

The above calculations demonstrate that, at a discount rate of 10%, leasing is the preferred
method of financing the machine. This does not mean, however, that the project is worth
undertaking. As shown in (a) above, the decision must be taken after comparison of the
present value of the cheaper option with the present value of the benefits to be obtained
from acquiring the machine and undertaking the project.

The calculations above have been made at a discount rate of 10%, the after-tax cost of
borrowing from the bank to finance the purchase. This rate is taken to be risk-free and is
the appropriate rate to use for risk-less flows such as those in the two financing options.

WORKINGS

Capital allowances

(1) Building
$
Years 0 to 4 WDA 4% $30,000 1,200

Tax saved 35% $1,200 420

Timing t
1
to t
5

Year 5 Sale proceeds 25,000
Written down value $30,000 5 $1,200 (24,000)

Balancing charge 1,000

Tax effect at 35% 350

1023
(2) Burnishing plant

Tax CAs Tax saved Time Discount PV
WDV at 35% factor
at 10%
$ $ $ $
Cost (t
0
) 100,000
WDA (year 0) (25,000) 25,000 8,750 t
1
0.909 7,954

75,000
WDA (year 1) (18,750) 18,750 6,563 t
2
0.826 5,421

56,250
WDA (year 2) (14,062) 14,062 4,922 t
3
0.751 3,696

42,188
WDA (year 3) (10,547) 10,547 3,691 t
4
0.683 2,521

31,641
WDA (year 4) (7,911) 7,911 2,769 t
5
0.621 1,720

23,730
SV (year 5)

Balancing allowance
(year 5) 23,730 23,730 8,305 t
6
0.564 4,684

100,000 35,000 25,996

Answer 13 COMPOUNDING AND DISCOUNTING
(a) T = p (1 + r)
n
p = present value
r = interest rate
n = number of times compounded
T = terminal value
(i) T = 1 (1 + 0.1)
1
= $1.10
(ii) T = 1 (1 + 0.1)
2
= $1.21
(iii) T = 1 (1 + 0.1)
3
= $1.33
(iv) T = 1 (1 + 0.1)
10
= $2.59
(b) The present value of $T in n years time at r% per annum
p =
n
r) (1
T
+
or T (1 +r)
-n
(i) r = 10%, n = 1, discount factor = 0.909
p = 1 0.909 = $0.91
1024
(ii) r = 10% n = 2 discount factor = 0.826
p = 1 0.826 = $0.83
(iii) r = 10% n = 3 discount factor = 0.751
p = 1 0.751 = $0.75
(iv) r = 10% n = 10 discount factor = 0.386
p = 1 0.386 = $0.39
(c) Year end Cash flow Discount factor Discounted
(r = 10%) cash flow
$ $
1 2,000 0.909 1,818
2 1,500 0.826 1,239
3 3,000 0.751 2,253
4 1,000 0.683 683

NPV = 5,993

(d) Year end Cash flow Discount factor Discounted
(r = 10%) cash flow
$ $
1 1,000 0.909 909
2 1,000 0.826 826
3 1,000 0.751 751
4 4,000 0.683 2,732

NPV = 5,218

(e) Year end Investment Compound interest Compounded
Cash flows factor cash flow
$ $
1 1.00 (1.1)
3
= 1.331 1.33
2 1.00 (1.1)
2
= 1.210 1.21
3 1.00 (1.1)
1
= 1.100 1.10
4 1.00 (1.1)
0
= 1.000 1.00

4.64

Alternatively, using formula:
( )
1 1 +
|
\
|
.
|
|
r
r
n
=
|
|
.
|
\
|

1 . 0
1 1 . 1
4
= 4.641
1025
(f) Year beginning Investment Compound interest Compounded
Cash flows factor cash flow
$ $
1 1.00 (1.1)
4
= 1.4641 1.46
2 1.00 (1.1)
3
= 1.3310 1.33
3 1.00 (1.1)
2
= 1.2100 1.21
4 1.00 (1.1)
1
= 1.1000 1.10

5.10

Alternatively, using formula:
( )
1 1
1
1
+
|
\
|
.
|
|

|
\
|
.
|
|
+
r
r
n
=
|
|
.
|
\
|
|
|
.
|
\
|

1
1 . 0
1 1 . 1
5
= 5.105

(g) Year beginning Investment Compound interest Compounded
factor cash flow
$ $
1 450 (1.08)
4
= 1.3605 612.23
2 525 (1.08)3 = 1.2597 661.34
3 500 (1.08)2 = 1.1664 583.20
4 425 (1.08)1 = 1.0800 459.00
5 350 (1.08)0 = 1.0000 350.00

Terminal value = 2,665.77

(h) (i) 12% per annum nominal 6% per 6 months
Imagine investing $1.00 for 1 year
T = 1 (1 + 0.06)
2
= 1.1236
APR = 12.36%
(ii) 12% per annum nominal 3% per quarter
Invest $1.00 for 1 year
T = 1 (1 + 0.03)
4
= 1.1255
APR = 12.55%
(iii) 24% per annum nominal 2% per month
Invest $1.00 for 1 year
T = 1 (1 + 0.02)
12
= 1.2682
APR = 26.82%
1026
(i) 8% per annum nominal 4% per 6 months
Date Deposit Compound interest Compounded
factor cash flow
$ $
30.06.X1 600 (1.04)
5
= 1.2167 730.02
31.12.X1 600 (1.04)
4
= 1.1699 701.94
30.06.X2 600 (1.04)
3
= 1.1249 674.94
31.12.X2 600 (1.04)
2
= 1.0816 648.96
30.06.X3 600 (1.04)
1
= 1.0400 624.00
31.12.X3 600 (1.04)
0
= 1.0000 600.00

Amount on deposit = 3,979.86

(i) (ii)
(j) Year end Cash flow Discount factor PV Discount PV
$000 10% $000 factor 20% $000
0 (23) 1.000 (23.000) 1.000 (23.000)
1 10 0.909 9.090 0.833 8.330
2 15 0.826 12.390 0.694 10.410
3 5 0.751 3.755 0.579 2.895

NPV = 2.235 NPV = (1.365)

(iii) IRR
Formula IRR ~ A +
N
N N
A
A B
|
\
|
.
| (B A)
IRR ~ 10 +
2 235
2 235 1365
.
. . +
|
\
|
.
|
10 ~ 16% rounded down (see graph)
Graph (for illustration only)
10 12 14 16 18 20
-2
-1
0
1
2
3
NPV
000
Discount
rate %
approx IRR
N
B
N
A
A
actual IRR

1027
Alternatively: Using equal triangles
10 12 14 16 18 20
-2
-1
0
1
2
3
NPV
000
Discount
rate %
X,IRR
C
A
B
D

AB
AC
=
BX
CD
AB = 2.235
AC = 2.235 + 1.365 = 3.6
CD = 20 10 = 10
Substituting:
6 . 3
235 . 2
=
BX
10

BX =
2 235 10
36
.
.

= 6.208
IRR = 10 + 6.208 ~ 16% (rounded down)

(k) Year end Cash flows Discount factors PV
$000 10% $000
0 (50) 1.000 (50.00)
1 10 0.909 9.09
2 20 0.826 16.52
3 30 0.751 22.53

(1.86)

(l) The balance outstanding would be $1,860. In present value terms $50,000 now is worth
$1,860 more than the sum of $10,000 in one years time, $20,000 in two years time and
$30,000 in three years time.
.
1028
(m)
Year end Cash flow Discount PV Discount PV
$000 factor 8% $000 factor 12% $000
0 (33) 1.000 (33.00) 1.000 (33.00)
1 10 0.926 9.26 0.893 8.93
2 20 0.857 17.14 0.797 15.94
3 10 0.794 7.94 0.712 7.12

NPV = 1.34 NPV = (1.01)

Formula
Using IRR ~ A +
N
N N
A
A B
|
\
|
.
| (B A)
IRR ~ 8 +
134
134 101
.
. . +
|
\
|
.
|
4 ~ 10.2% (rounded down)
Graph (as visual aid)

8 9 10 11 12
-1.5
-1
-0.5
0
0.5
1
1.5
NPV
000
Discount rate %
approx IRR

Alternatively
AC
AB
=
CD
BX
AB = 1.34
AC = 1.34 + 1.01 = 2.35
CD = 12 8 = 4
Substituting:
35 . 2
34 . 1
=
4
BX

BX =
134 4
2 35
.
.

= 2.28
IRR = 8 + 2.28 ~ 10.2% (rounded down)
1029
(n) Year end Cash flows Discount factors PV
$ $
0 (1,440) 1.000 (1,440)
1 700
1
1 ( ) + r
700
1
1 ( ) + r

2 900
1
1
2
( ) + r
900
1
1
2
( ) + r

0

Let x = (1 + r)
Then 1,440 +
700
x
+
900
2
x
= 0
Multiply by x
2
1,440x
2
+ 700x + 900 = 0
Compare with ax
2
+ bx + c = 0 and use equation for roots of a quadratic

(note it is not likely that you will be required to solve quadratic equations under exam
conditions)

a = 1,440 b = 700 c = 900
x =
b b ac
a
2
4
2
=

700 700 4 1 440 900
2 1 440
2
( ) ( , )
( , )
=

700 2 382
2 880
,
,

=
+
700 2 382
2 880
,
,
or

700 2 382
2 880
,
,

= 0.584 or 1.07
The value x = 1.07 gives a realistic (i.e. positive) answer
x = 1 + r = 1.07
r = 0.07 i.e. IRR = 7%

(o) Calculate the expected cash flows for each year
Year 1 (0.75 12) + (0.25 10) = $11.50
Year 2 (0.75 13) + (0.25 10) = $12.25
Year 3 (0.75 13) + (0.25 9) = $12.00
Year 4 (0.75 14) + (0.25 8) = $12.50
1030
Year end Expected Discount factors PV
cash flow 14%
$000 $000
0 (30.00) 1.000 (30.00)
1 11.50 0.877 10.09
2 12.25 0.769 9.42
3 12.00 0.675 8.10
4 12.50 + 2 = 14.50 0.592 8.58

NPV = 6.19

NPV @ 14% = $6,190,000

Answer 14 DESPATCH CO
Time Cash 14% factor PV
$ $
0 (12,000) 1 (12,000)
1 10 2,000 5.216 10,432
10 500 0.27 135

(1,433)

As the NPV is negative at 14% the company should not undertake this project.

Answer 15 DISCOUNTED CASH FLOW
(a) (i) Alternative machines
Year 8% Factor Machine 1 PV Machine 2 PV
$ $ $ $
0 1 (10,000) (10,000) (9,000) (9,000)
1 0.926 1,000 926 1,200 1,111
2 0.857 1,600 1,371 1,500 1,286
3 0.794 2,500 1,985 3,500 2,779
4 0.735 2,500 1,838 2,000 1,470
5 0.681 2,500 1,702 2,000 1,362
6 0.630 1,500 945 2,000 1,260
7 0.583 2,500 1,458

225 268

Since both projects have positive NPVs either machine is a good investment. However, the
NPV for machine 2 is slightly higher and this machine should therefore be preferred.
1031
(ii) Comment
Since the difference between the two figures is marginal it may be prudent to carry out a
sensitivity analysis on the result.
The cash flow figures are estimates for several years ahead. A small change in any of these
figures could affect the result to such an extent that machine 1 might be the better investment.
Changes could even lead to the projects having negative NPVs since the values are only small
positive figures. Investments with negative NPVs should be rejected.
(b) Device
$ $
1 (40,000) 0.935 (37,400)
2 29 2,000 12.278 (W) 0.935 22,686

Negative NPV (14,714)

Firm should not produce the device.
WORKING
1
0.07

\
|
.
|
1
1
1.07
29
= 12.278
(c) Crusher
$ $
0 (6,000) 1 (6,000)
3 1,200 1/0.12 1.690 = 6.643 7,972

Positive NPV 1,972

The crusher should be purchased.
Alternatively
Time Cash Time Cash
$ $
3 1,200 is the same as 1 1,200
2
12 . 1
1

Therefore PV of perpetuity = $1,200
2
12 . 1
1

12 . 0
1
= $7,972
Therefore NPV of project = $6,000 + $7,972 = $1,972
1032
(d) IRR
IRR of perpetuity =
investment Initial
inflow annual Equal
100 =
5,000
475
100 = 9.5%
Since the internal rate of return is greater than the return which J can obtain elsewhere, he
would be advised to invest in the scheme.
(e) (i) IRR
Time Cash flow 10% Factor 10% NPV 7% Factor 7% NPV
$ $ $
0 (10,000) 1 (10,000) 1 (10,000)
1 (10,000) 0.909 (9,090) 0.935 (9,350)
2 & 3 4,000 1.577 6,308 1.689 6,756
4 11 3,000 4.008 (W1) 12,024 4.875 (W2) 14,625

(758) 2,031

WORKINGS
(1) @10% DF
111
DF
13
= 6.495 2.487
= 4.008
(2) @7% = 7.499 2.624
= 4.875
IRR = 7% +
2 031
2 031 758
,
, +
|
\
|
.
|
(10 7)%
= 7% + 2.18% ~ 9%
Since the IRR of this project is less than the required rate of return, it should not be
undertaken. Therefore, the ball and crane should not be bought.
(ii) An alternative approach to this problem would be to discount the cash flows at 10%.
Since the project has a negative NPV at 10% (the desired rate of return), the project
would not be accepted.

Answer 16 GERRARD
Net
Year end Machinery Receipts Paper Salary cash flow
$000
0 (50) + (8) = (58.0)
1 (25) + 30 + (8) + (0.5) = (3.5)
2 30 + (8) + (0.5) = 21.5
3 30 + (8) + (0.5) = 21.5
4 30 + (8) + (0.5) = 21.5
5 30 + (0.5) = 29.5
1033
(a) and (b)
Year end Net Discount PV Discount PV
cash flow factors 12% factors 14%
$000 $000 $000
0 (58.0) 1.000 (58.00) 1.000 (58.00)
1 (3.5) 0.893 (3.13) 0.877 (3.07)
2 21.5 0.797 17.14 0.769 16.53
3 21.5 0.712 15.31 0.675 14.51
4 21.5 0.636 13.67 0.592 12.73
5 29.5 0.567 16.73 0.519 15.31

NPV = 1.72 NPV = (1.99)

(c) In view of the projects positive NPV at 12%, expansion is (just) worthwhile.
The IRR of the project is approximately 13% (i.e. half way between 12 & 14%) or
IRR = 12% +
172
172 199
.
. . +
(14 12)% = 12.9%
This gain indicates that the project is worthwhile.

Answer 17 CARTER LTD
(a) (i) Net present value
Time Cash flow 10% factor Present value
$ $
0 (32,000) 1 (32,000)
1 15 5,000 7.606 38,030

Positive NPV 6,030

In view of the positive NPV the project should be undertaken.
.
The internal rate of return is calculated by finding a 15 year cumulative discount
factor as follows.
15 year factor @ IRR =
flow cash Annual
Investment
=
000 , 5
000 , 32
= 6.4
IRR = 13%
The project should be undertaken as the IRR exceeds the cost of borrowing (10%).
1034
(b) (i) Book value of $2,000
This information does not affect the NPV as a book value is not a cash flow.
(ii) Reduced project duration to ten years
Revised NPV calculation
10% Present
Time Cash flow factor value
$ $
0 Net investments (32,000) 1 (32,000)
1 10 Net savings 5,000 6.145 30,725

Negative NPV (1,275)

The reduction in the project duration means that it is no longer worthwhile.
(iii) Changes in allocation and apportionment
This information does not affect the NPV as allocation and apportionment are
arbitrary. The cash flows are unchanged.
(iv) Revised scrap values
With the existing equipment having a scrap value of $2,000 in 15 years time, if the
project is undertaken this $2,000 in year 15 will be forgone.
The NPV will therefore be reduced be reduced by the present value of $2,000
discounted for 15 years.
NPV = $6,030 ($2,000 0.239) = $5,552
The project will still be accepted though the NPV is reduced.

Answer 18 ABC
Project A
Cash flows
Time 0 1 2 3 4 5
$ $ $ $ $ $
Equipment cost (95,000) (95,000) (95,000)
Deluxe net cash inflow (W1) 80,000 80,000 88,000 96,800 106,480
Existing lost cash contribution
(W2) (7,500) (7,500) (8,250) (9,075) (9,985)

Net cash flow (95,000) (22,500) (22,500) 79,750 87,725 96,495
DF @ 17% 1 0.855 0.731 0.624 0.534 0.456
PV (95,000) (19,237) (16,448) 49,794 46,845 44,002
NPV = $9,956
1035
Project B
Time Description Cash flow 17% DF PV
$ $
0 Patent rights (320,000) 1 (320,000)
1 5 Reduction in labour 70,000 3.199 223,930
Expected increase in sales (W3) 27,600 3.199 88,292

NPV = (7,778)

Project C
Time Description Cash flow 17% DF PV
$ $
0 4 Rental (50,000) 1 + 2.743 = 3.743 (187,150)
2 5 IT bureau costs saved 90,000 3.199 0.855 210,960
1 Training (10,000) 0.855 (8,550)
Consultant (5,000) 0.925 (W4) (4,625)
1 Consultant (5,000) 0.855 (4,275)

NPV = 6,360

Projects A and C are worth considering further as they show a positive NPV at the companys required
rate of return.
WORKINGS
Project A
(1) De-luxe net cash inflow
Year 1 2 3 4 5
Demand (units) 10,000 10,000 11,000 12,100 13,310
Net cash inflow (@ $8) 80,000 80,000 88,000 96,800 106,480
(2) Loss of cash contribution on existing project
Year 1 2 3 4 5
Reduction in demand (units)
(15% of demand in W1) 1,500 1,500 1,650 1,815 1,997
Contribution lost (@ $5) 7,500 7,500 8,250 9,075 9,985
Project B
(3) Expected increase in contribution from increased sales
0.8 5,000 + 0.2 3,000 = 4,600 units
Extra contribution = 4,600 $(12 6)
= $27,600 pa
1036
Project C
(4) Discount factor for a flow taking place in six months time
=
17 . 1
1

= 0.925

Answer 19 MOORGATE COMPANY
(a) Ex-rights price
$
4 existing shares $3.00 12.00
1 rights share $2.00 2.00

14.00

The theoretical value of Moorgates shares ex-rights is

5
14.00
= $2.80

(b) Value of right
Value of right = $(2.80 2.00)
= $0.80

One right enables a holder to buy for $2.00 a share which will eventually sell for $2.80.
The value of the right to buy one share is, therefore, $0.80. Four existing shares are
needed to buy one additional share. Thus, the value of the rights attaching to each existing
share is $0.20.

(c) Chairmans views
The chairman is correct. The shareholder should either exercise his rights or sell them
(subject to (d) below).

(i) If he sells all rights
$
Wealth before rights issue
Value of shares 1,000 $3.00 3,000

Wealth after rights issue
Value of shares 1,000 $2.80 2,800
Plus Cash from sale of rights 1,000 $0.20 200

3,000

1037
(ii) If he exercises one half of his rights and sells the other half
$
Value of shares 1,000 $3.00 3,000

Value of old shares 1,000 $2.80 2,800
Value of new shares
4
500
$2.80 350
Cash from sale of rights 500 $0.20 100

3,250
Less Cost of purchasing new shares 125 $2 (250)

3,000

(iii) If he does nothing
$
Value of shares 1,000 $3.00 3,000
Value of shares 1,000 $2.80 (2,800)

Reduction in wealth 200

(d) Shareholder wealth
It is possible that the shareholder, whether exercising the rights or selling them, will suffer
a reduction in wealth.

The above analysis is based on the assumption that the funds to be raised by the new issue
of shares will be invested in the business to earn a rate of return comparable to the return
on the existing funds. The capital market, in valuing the share of Moorgate after the rights
issue, has to make some assumption as to how profitably the new funds are to be used. For
example, if the new funds were squandered the overall return on equity funds would fall,
and the price would drop below the $2.80 calculated above.

Alternatively, if the sales are to be used to finance a highly profitable investment and the
capital market does not initially appreciate this point, then the market in arriving at a price
of $2.80 ex-rights would be undervaluing the share. When the true earning potential of the
company were realised, the share price would rise. However, by then it might be too late
for the shareholder referred to in the question.

If the shareholder exercises the rights in the circumstances just described, he will not lose.
When the shares rise in price he will benefit. However, if at the time of the right issue he
decides to sell the shares, he will lose. The value of his right in the circumstances
described is based on the assumption that the new funds will earn as much as the old.
Later the person who exercises the rights will benefit, when the shares rise in price above
that expected at the time of issue.

1038
Answer 20 GREINER LTD
REPORT

To Mr and Mrs Greiner
From XYZ Ltd
Date Today
Subject Proposed entry onto the Stock Exchange

With reference to your recent enquiry, we set out below information regarding

(a) the necessary steps to be taken prior to obtaining a quotation, and
(b) the methods of raising finance from the market and advice as to which should be used.

(a) Steps prior to obtaining a quotation
(i) Review of current situation
Before approaching the sponsoring brokers, a detailed review of the companys current
situation should be made. This will include consideration of the following areas.
(i) Management. Is there sufficient financial expertise within the company to cope
with the demands of being a public company? The meetings and information-
gathering involved with obtaining a quotation will take up an excessive amount of
your time. It is possible that further staff may be required to aid with the running of
the business during this period.
(ii) Contractual relationships. It may be necessary to formalise trading relationships
with the companys major suppliers and customers, and to review the debt
collection procedure if this has caused problems in the past.
(iii) Directors contracts. The terms of your appointments as directors should be clearly
laid out in the form of service contracts. Prospective shareholders will want to be
sure that remuneration and other benefits are of a reasonable level.
(iv) Accounting systems. These must be in good order to enable management to be
confident of their ability to supply sufficiently accurate information at the required
time.
(ii) Appointment of professional team
The full professional team required to take a company to the market comprises a sponsoring
broker, a reporting accountant and a solicitor. The broker will take overall responsibility for
the co-ordination of the various stages leading up to the quotation. It is important that you
feel confident in the brokers ability to handle the work and that good working relationships
can be maintained before, during and after the flotation.
(iii) Information-gathering and presentation
The sponsor will generally require a long-form report to be prepared by the reporting
accountant. This will provide information to the sponsor about the company and its
prospects. The sponsor will use this report as a guide to the suitability of the company for
flotation, and for the provision of details to be included in the prospectus.
1039
The reporting accountant will thus be obliged to carry out a detailed review of the financial
records of the company and will solicit any other information he may require from yourselves
or your employees.
Once the long-form report has been drafted and agreed upon by all parties, the sponsor will
prepare the prospectus, and preliminary clearance for the quotation will be obtained from the
Stock Exchange.
The finalisation of the prospectus may take several meetings between yourselves and the
professionals; it is essential that all legal requirements are met and that the document is
carefully and accurately worded.
Appended to the prospectus will be the accountants short-form report, containing a profits
record of the company, a balance sheet, and other statements similar in content to those
contained in the annual accounts.
(iv) The final stages
Once the prospectus and other necessary documentation have been completed, they will be
submitted by the sponsor to the Stock Exchange for approval.

(b) Methods of raising equity on the Stock Exchange
There are two main methods.

(i) Placing
This is the most favoured method for small issues, in part because the costs are likely to be
lower than those of an offer for sale.
In a placing the shares are not offered generally to the public but are placed in the hands of a
group of large investing institutions, possibly via an issuing house.
As a placing involves only a limited number of prospective investors, substantial savings may
be made in printing of the prospectus, allotment letters, application forms, etc, as well as in
advertising.
The general cost of a placing of the size being considered will be in the range $50,000
$120,000.
(ii) Offer for sale
This involves the issuing house or broker buying the shares from the directors and selling
them on to the public at a predetermined price.
The offer for sale has to be advertised, under Stock Exchange rules, in a leading newspaper.
Just before the prospectus is made available to prospective investors, the documentation will
be filed with the Registrar of Companies and the company re-registered as a public company.
A press conference will be arranged to promote the company and the flotation and hopefully
gain some favourable press comment which will assist a successful launch of the shares.
Shortly after the prospectus has been made available, permission to deal will be sought from
the Stock Exchange. As soon as this is received, dealings will begin.
1040
You will then be able to realise part of your investment in the company as well as raising the
additional amount of finance required.
The costs of an offer for sale typically range between $200,000 and $500,000.
Where the sale of shares to be issued is in excess of $3 million, an offer for sale is the
method encouraged by the Stock Exchange. This is because an offer for sale gives as large
a number of investors as possible the chance to invest in the security being offered. It
therefore helps to ensure that there is a wide distribution of shareholders and a good
trading market once they have been issued.

For the size of issue involved with Greiner Ltd, however, a placing is strongly
recommended, principally due to the lower costs involved.

Answer 21 MR FIDELIO
All sources of finance to a business fall into one of two categories. The first is equity, the second debt.
The essential difference between the two is that the providers of equity capital become owners of the
business: they participate in running the business, share in the profits and bear the risk. The providers
of debt finance have merely lent money to the firm, they usually have a fixed return and some form of
security over the companys assets. Mr Fidelio and Aida Ltd will have to consider both categories in
their search for the required finance.
There are three significant differences between Mr Fidelio and Aida with respect to their ability to raise
long-term finance. Firstly, Mr Fidelio has no track record to support his request for funds.
Secondly, he does not have very much in the way of mortgageable assets to offer as security for his
loan. Finally, Mr Fidelio wishes to raise a very high proportion of the total funds required. Of the
$250,000 he needs he is only able to provide 20% from his personal resources. No investor would be
prepared to bear so much of the risk of the enterprise without an opportunity to share in the potential
return, i.e. some form of equity would be required. It is equally likely that the providers of such funds
would require some say in the running of the business.
Possible sources of finance for Mr Fidelio are as follows.
(a) Enterprise Investment Scheme
Tax relief is given to individual investors in new equity in unquoted trading companies.
Obviously Mr Fidelio would lose some control of the business and would need to form a
company. In order to retain at least half of the shares Mr Fidelio would probably also need
debt finance.
(b) Venture capital trusts
Tax relief is given to investors in listed investment trust companies who invest at least 70% of
their funds in unquoted trading companies. Hence investment trust companies may provide
equity and debt finances. Again, Mr Fidelio would have to set up a company.
(c) Loan guarantee scheme
In view of the lack of security Mr Fidelio is unlikely to be able to borrow on normal
commercial terms. The loan guarantee scheme provides banks and other lenders with
increased security (the majority of the loan is guaranteed by the government) in return for the
borrower paying an interest premium to the government.
1041
(d) Venture capital funds
$200,000 is probably too small an amount for venture capitalists such as 3i to be interested.
(e) Leasing
Leasing provides an alternative to borrowing to fund the acquisition of fixed assets like plant
and machinery.
(f) Government grants/EU grants
Various grants are available from the above, particularly for high-tech industries (into which
category electronic components may fall). Mr Fidelio should contact the DTI (Department of
Trade and Industry) to see what is available.
Aida Ltd has a major advantage over Fidelio in raising debt finance and that is that it
presumably owns a considerable amount of mortgageable assets. It could raise a fixed
interest loan from an institutional investor such as an insurance company or a pension fund by
giving a mortgage on its property. It is unlikely that such an investor would be prepared to
advance more than 60-70% of the valuation so, if Aida wishes to raise the whole $2 million
this way, it would have to mortgage some of its existing properties as well as the new site.
Alternatively, if Aida were prepared to give up the freehold interest on the site, it could
negotiate a sale and leaseback arrangement with an institutional investor. The ease with
which this sort of arrangement could be set up would depend on the quality of the new site.
However, this type of arrangement is very popular at this time, particularly for the retail
warehouse type of development that Aida is considering.
As far as equity is concerned Aida has a number of options.
(a) Private placing of shares if its articles so allow.
(b) Rights issue to existing shareholders, if they have sufficient funds.
(c) (a) and (b) above maintain the existing limited status of Aida. If neither source of equity
funds is available, Aida could consider becoming a plc and obtaining a listing. Much depends
on the companys size but assuming it is a relatively small (in terms of value), then a listing
on the Alternative Investment Market at the same time as a new issue of shares (e.g. via a
placing) would provide it with the necessary funds. The downside is the cost of listing and
increased scrutiny of the companys activities by external investors and the Stock Exchange.
Answer 22 COST OF CAPITAL
(a) Cost of debt (pre-corporation tax)
(i)
price) market (or proceeds Issue
payment interest Annual
=
100
10
= 10%
(ii)
85
10
= 11.76%
1042
(iii) We need to find the IRR by the following cash flows.
t
0
t
1
t
2
t
3
$(74) $10 $10 $110
By trial and error, NPV of the four cash flows at
25% NPV = $74 + 1.440 $10 + 0.512 $110 = $3.28
20% NPV = $74 + 1.528 $10 + 0.579 $110 = $4.97
kd = 20% +
28 . 3 97 . 4
97 . 4
+
(25% 20%)
= 23%
(iv) As redeemable at current market price, then

100
10
= 10%
(v) Irredeemable

65
5
= 7.7%
(b) Cost of debt (post-corporation tax)
(i) 10% (1 0.35) = 6.5%
(ii) 11.76% (1 0.35) = 7.64%
(iii) We need to find the IRR by the following cash flows.
t0 t1 t2 t3
$(74) $6.5 $6.5 $106.5
(Note This assumes no lag in corporation tax payment.)
By trial and error,
15% NPV = $74 + 1.626 $6.5 + 0.658 $106.5 = $6.646
20% NPV = $74 + 1.528 $6.5 + 0.579 $106.5 = $2.405
k
b
= 15% +
405 . 2 646 . 6
646 . 6
+
(20% 15%)
= 19%
(iv) 10% (1 0.35) = 6.5%
(v) 7.7% (no corporation tax relief on preference share dividend).
1043
(c) Cost of equity
(i) ke =
150
5 . 7
100
= 5%
(ii) ke =
15 165
15
100
= 10%
(iii) ke =
120
) 05 . 0 1 ( 24 +
100 + 5
= 26%
(iv) ke =
10
5 . 1
100
= 15%
(d) Dividend valuation model
(i) No growth, hence Po =
ke
D

=
0.1
50,000 0.10

= $50,000
Per share Po =
0.10
10

= $1.00
(ii) No growth, hence Po =
0.15
500

= $3,333
Per share Po =
1,000
3,333

= $3.33
1044
(iii) Constant growth Po =
g) (ke
) g 1 ( D
0
+

=
0.05) (0.15
(1.05) 1m .10

= $1.05m
Per share S = $1.05
(iv) Po = PV of future dividends
= $0.10 (10,000 3.352) +
0.05) (0.15
(1.05) 10,000 0.10

0.497
= $8,570
Per share 0.86
Answer 23 KELLY PLC
(a) Six-monthly gross redemption yield
This is found as the IRR of the following cash flows.
Initial capital cost Market value $110.43
Interest Nine payments of $7 due half-yearly
Redemption One payment of $100 in nine half-years time
Cash 10% PV 5% PV
flows factor at 10% factor at 5%
$ $ $
Time 0 (110.43) 1 (110.43) 1 (110.43)
Time 19 7.00 5.759 40.31 7.108 49.76
Time 9 100.00 0.424 42.40 0.645 64.50

Net present values (27.72) 3.83

IRR, i.e. six monthly yield 5 +
55 . 31
5 83 . 3

5.6%
1045
(b) Redemption date and effective annual gross redemption yield
Kelly plc will presumably choose the option which minimises the effective cost (based on
similar IRR calculations) of the bond
(i) Redeem 19X8
PV at 10% PV at 5%
$ $
Market value (110.15) (110.15)
Six interest payments of $7 30.49 35.53
One payment of $100 56.40 74.60

Net present values (23.26) (0.02)

IRR = 5%
(ii) Redeem 19X10
PV at 10% PV at 5%
$ $
Market value (110.15) (110.15)
Ten interest payments of $7 43.02 54.05
One payment of $100 38.60 61.40

Net present values (28.53) 5.30

IRR 5 +
83 . 33
5 30 . 5

= 5.8%
Therefore Kelly will redeem the bond in July 19X8. The effective annual gross redemption
yield is (1.05)
2
1 = 10.25%.
(c) Price of debentures on 1 July 19X5
The value at 1 October 19X5 is the present value, at 6%, of two cash flows.
(i) Interest Nine interest payments of $3
plus $3 due on 1 October 19X5.
(ii) Redemption payment $100 in nine half years time.
PV of interest =
|
.
|
\
|

9
1.06
1
1
0.06
3
+ $3.00
= $(20.41 + 3.00)
= $23.41
1046
PV of capital =
9
(1.06)
100

= $59.19
Value at 1 July =
1.0296
59.19) (23.41+

= $80.23
(d) Factors influencing the market price of issued corporate debentures
The market price of a corporate debenture will be equal to the present value of the expected
future interest payments plus the present value of the amount due on redemption. Since the
coupon rate of the bond and the terms for redemption will be known with certainty, the price
is largely a function of the discount rate applied to the future cash flows.
Generally it is agreed that the discount rate used to capitalise an anticipated cash flow stream
is a function of the risk-free rate and a premium for risk. The risk-free rate is often taken to
be the return on government debt. Strictly speaking, government debt is not risk-free; it is
default-free. Whist there is no realistic possibility that the government will not meet its
obligations to pay interest and redemption of capital, there is a risk for the holders of
government debt, since their returns, in real terms, are influenced by the rate of inflation.
Therefore, the required return from a corporate debenture, and hence its market value, is a
function of
the true risk-free rate
a premium for inflation
a premium for risk.
Each of these will now be considered in turn.
(i) The risk-free rate
Even in the absence of risk and inflation, all investors require a return to persuade them to
forgo current consumption in return for future consumption. It is felt that if investors are
prepared to forgo a certain amount of current consumption at a given interest rate, in order to
persuade them to make more funds available it will be necessary to offer a higher risk-free
rate. Therefore it seems likely that the risk-free rate will, in part at least, be a function of
the demand and supply of investment funds. An increase in the demand for funds, e.g.
resulting from a rise in the governments budget deficit, is likely to result in an increase in the
risk-free rate.
(ii) A premium for inflation
The rate of interest which is necessary to persuade investors to forgo current consumption in a
risk-less, inflation-less environment will have to be increased to compensate investors for the
existence of inflation. Therefore the default-free rate (the return on Government bonds) will
be a function of the demand for investment funds and the rate of inflation.
1047
(iii) A premium for risk
For most established companies there is little likelihood of default on either interest payments
or redemption of capital. However, corporate bankruptcy is a possibility and it is likely that
investors will require a premium over the default-free rate to persuade them to invest in
corporate bonds.
The required return from the bond and hence its market value may also be influenced by the
maturity date. Although interest rates vary from time to time, short-term rates are normally
lower than long-term rates (although the reverse may be true if short-term rates are very high
and generally expected to fall in the near future). Therefore the market value of a short-dated
bond would normally be expected to be higher than that of a comparable longer-dated bond.
The coupon rate can also affect the required return. A company may issue bonds with a
coupon rate equal to the current market rate in which case it will issue the bonds at par.
Alternatively, it may reduce the coupon rate and issue the bonds at a discount. The advantage
of the second alternative is that part of the returns to the investor are in the form of capital
gains. This may have tax advantages and could result in low coupon rate, deep discounted
bonds being relatively attractive and hence having a higher market value than equivalent high
coupon rate bonds.
There is one further factor that is likely to influence the required return from, and therefore
the value of, corporate bonds. As has been noted above, the required return from bond is a
function of the return on Government bonds (the default-free rate) and a premium for risk.
There is little doubt that in recent years governments have influenced the default-free rate
through various agencies (notably the Bank of England) as an instrument of macroeconomic
policy. Therefore a final variable is added to the mix in determining the price of corporate
bond. Ultimately the relevant factors are the demand for investment funds, the rate of
inflation, the perceived risk of the corporate borrower and government policy.
Answer 24 REDSKINS PLC
(a) Post-tax weighted average cost of capital
The following calculations are based on the capital structure of the Redskins group which is
deemed to be more appropriate for determining a discount rate to evaluate the projects
available to Redskins plc and its subsidiaries.
(i) Cost of debt
For irredeemable bonds kd =
ue market val interest Ex
T) - (1 Interest

Cost of 3% irredeemable bond=
3.00) - (31.60
0.30) - (1 3.00

= 7.34%
1048
For redeemable bonds, to calculate kd it is necessary to compute the internal rate of return of
the after-tax cash flows.
Cash PV PV
flows at 5% at 10%
$ $ $
Time 0 Ex-interest market price (94.26) (94.26) (94.26)
Time 110 Interest (post-tax) 6.30 48.65 38.71
Time 10 Repayment of capital 100.00 61.40 38.60

Net present values 15.79 (16.95)

Cost of redeemable debt = 5% + 5%
16.95) (15.79
15.79
|
|
.
|
\
|
+

= 7.41%
After-tax cost of bank loan = (11% + 2%) (1 0.30)
= 9.10%
Cost of 6% unquoted bonds
The value of the bonds is the present value of the pre-tax cash flows discounted at 10%, i.e.
($6.00 6.145) + ($100 0.386) = $75.47
The after-tax cost is the discount rate which equates the after-tax cash flows to a present value
of $75.47, i.e.
Cash PV PV
flows at 5% at 10%
$ $ $
Time 0 Current value (75.47) (75.47) (75.47)
Time 110 Post-tax interest 4.20 32.43 25.81
Time 10 Repayment 100.00 61.40 38.60

Net present values 18.36 (11.06)

By linear interpolation IRR = 5% +
42 . 29
36 . 18
5%
= 8.12%
Cost of equity = 18% (given)
1049
The market values of the various sources of finance are as follows.
$000 $000
Equity 8,000 1.1 8,800
3% debt 1,400 0.286 400
9% debt 1,500 0.9426 1,414
6% debt 2,000 0.7547 1,509
Bank loan 1,540
WACC =
540 , 1 509 , 1 414 , 1 400 800 , 8
) 540 , 1 0910 . 0 ( ) 509 , 1 0812 . 0 ( ) 414 , 1 0741 . 0 ( ) 400 0734 . 0 ( ) 800 , 8 18 . 0 (
+ + + +
+ + + +

=
663 , 13
981 , 1

= 14.5%
(b) Problems in estimating WACC
(i) Where bank overdrafts are used as sources of long-term finance
Theoretically bank overdrafts are repayable on demand and therefore are current liabilities.
However, it is undoubtedly true that many firms run more or less permanent overdrafts and
effectively use them as a source of long-term finance. Where this is true, a case can be made
for incorporating the cost of the overdraft into the calculation of the weighted average cost of
capital. In order to do this it is necessary to know the interest rate and the size of the
overdraft.
The first of these variables, the interest rate, presents no special problems. Overdraft rates are
known and the quoted rate is the true rate. As with other interest payments, overdraft
interest is an allowable expense for tax purposes and this must be incorporated in the
calculation. Interest on overdrafts fluctuates through time and this presents a problem.
However, it is not a problem unique to overdrafts as other interest rates are also likely to vary.
The particular problem in incorporating the cost of an overdraft into the WACC is
determining its magnitude for weighting purposes. By their very nature overdrafts vary in
size on a daily basis. It would be necessary to separate the overdraft into two components.
The first is the underlying permanent amount which should be incorporated into the WACC.
The second component is that part which fluctuates on a daily basis with the level of activity.
(ii) Where convertible bonds are used as sources of long-term finance
The formula for determining the cost of a convertible bond derives from the basic valuation
model for convertibles which is as follows.
Vc =
kc)n (1
MV
kc) (1
T) - I(1
n
1 t
+
+
+
=

where I = Interest payable
T = Rate of corporation tax
n = Years to conversion
MV = Market value of shares at the time of conversion
kc = Cost of convertible bond
Vc = Market value of convertibles
1050
In principle the calculation of k
c
is a simple IRR computation. In practice the difficulty is in
knowing whether the investor will exercise his conversion right, which will depend upon the
market value of the shares at the time of conversion. Therefore, to compute k
c
requires a
prediction of future share prices which obviously poses severe problems.
(c) Fundamental problems underlying the use of WACC as a discount rate
It can be shown that, in a perfect capital market in which the market value of an ordinary
share is the discounted present value of the future dividend stream, acceptance of a project
which has a positive NPV when discounted at the WACC will result in the share price
increasing by the amount of the NPV. It is this relationship between the NPV and the market
value which is the basis of the rationale for using the WACC in conjunction with the NPV
rule. However, the use of the WACC in this way depends upon a number of assumptions.
(i)
The objective of the firm is to maximise the current market value of the ordinary shares. If
the firm is pursuing other objectives, some other discount rate may be more appropriate.
(ii)
The market is perfect and the share price is the discounted present value of the dividend
stream. Market imperfections may undermine the relationship between NPV and the market
value, and cast doubt upon the usefulness of WACC as a discount rate. Furthermore, if the
market values shares in some other way (earnings multiplied by a P/E ratio), then the link will
also be broken.
(iii)
The current capital structure will be maintained and the existing capital structure is optimal.
(iv)
The risk of projects to be evaluated is the same as the average risk of the company as a whole.
The discount rate has two components, namely the risk-free rate and a premium for risk. The
weighted average cost of capital incorporates a risk premium which is appropriate to the risk
of the company as a whole, i.e. the average risk of all its existing assets and projects. Where a
project is to be considered which has a different level of risk, then the WACC is not the
appropriate rate.
1051
Answer 25 BERLAN
(a) Berlan plc Calculation of cost of capital using traditional approach
(i) Cost of equity
$000
Earnings before interest and tax 15,000
Interest 23,697 16% (3,791)
Profit before tax 11,209

Corporation tax @ 35% (3,923)
Available for dividend to equity 7,286

Dividend per share =
4 500 , 12
100 286 , 7
14.57
Ke =
0
P
D

=
6 86
14.57
= 18.2%
(ii) Cost of debt
31 Dec 19X1 31 Dec 19X2 31 Dec 19X3 31 Dec19X4
Year 0 1 2 3
(105.50) 16(1 0.35) 16(1 0.35) 16(10.35) + 100
The cost of debt is found by discounting the above cash flows, using trial discount rates.
Try 6%
105.5 + (10.4 2.673) + (1 00 0. 84) = 6.3
Try 10%
105.5 + (10.4 2.487) + (100 0.751) = (4.5)
Cost of debt = 6 +
5 . 4 3 . 6
3 . 6
+
(10% 6%) (by interpolation)
= 8.3%
(iii) Cost of capital
$000
Market value of equity = E = 12,500 4 (0.86 0.06) 40,000
Market value of debt = D = 23,697 105.5 25,000
100 65,000

Cost of capital = WACC = (0.18240/65) + (0.08325/65) = 14.4%
1052
(b) Canalot plc
Effect of change in capital structure
Market value
Vg = Vu + Dt
= 32.5 + (5 0.35)
= $34.25m i.e. an increase of $ 1.75m
Tax relief is available on the interest on debt. Hence introduction of debt instead of equity
reduces the companys tax liability. The present value of tax relief to perpetuity is Dt and this
increase in value accrues to the equity shareholders.
Cost of equity
Keg = Keu + (Keu Kd)
E
t) - D(I

= 0.18 + (0.18 0.13)
75 . 1 5 5 . 32
) 35 . 0 1 ( 5
+

= 0.18 +
25 . 29
25 . 3 05 . 0

= 0.1856 i.e. 18.56 an increase 0.56%
The introduction of debt increases the risk faced by the equity shareholders this increase in
risk is referred to as financial risk. This increase in risk results in the equity holders
demanding a higher return on their investment. Hence the cost of equity rises which,
according to Modigliani and Miller (M&M) is at a linear rate.
Cost of capital
WACC = (0.185629.25/34.25) + (0.130.655/34.25)
= 0.171 i.e. 17.1%
a decrease of (1 8 17. 1) = 0.9%

The introduction of debt has three effects:
it increases the cost of equity;
the cost of debt is less than the cost of equity which results in a saving;
tax relief is available on debt interest.
M&M argue that the first two effects cancel out. The net effect of introducing debt is the
benefit of tax relief which reduces the companys overall cost of capital.
1053
(c)
The traditional theory suggests that at low levels of gearing the benefits (i.e. cost of debt <
cost of equity and tax relief) from increasing debt outweigh the disadvantages (i.e. the
increase in financial risk to the equity shareholders) and therefore the average cost of capital
decreases. However, at high levels of gearing the costs start to outweigh the benefits
causing the cost of capital to increase. Hence a U shaped cost of capital curve and an
optimum level of gearing i.e. the level of gearing can directly affect the value of the firm.
This is not based on a theoretical model and no guidance is given as to how to identify this
optimum. Therefore, the theory is of limited practical use although it does suggest that
managers should attempt to achieve a balance between the amount of debt and equity finance
used.
The M&M theory with corporation tax suggests that a company should gear up as much as
possible since the benefits of debt always exceed the cost. This implies a gearing level
approaching 100% which is clearly unrealistic.
The reasons for the model being unrealistic are the assumptions on which it is based and the
costs which are excluded from the model.
(i) The model assumes that:
(1) individuals and companies borrow at the same interest rate for all levels of debt;
(2) personal gearing is viewed by shareholders as equivalent in risk terms to corporate
borrowing;
(3) there are no transaction costs and that information is freely available.
(ii) The model does not take account of..
(1) Bankruptcy costs. At high levels of gearing the probability of bankruptcy occurring
increases and with it the expected cost of bankruptcy which can be a very
significant amount from the shareholders point of view.
(2) Debt capacity. There is a restriction on the amount of debt that a company is able to
raise. Lenders will not be prepared to lend beyond certain levels often determined
by the level of security required for a loan. This capacity will vary from company
to company.
(iii) Personal tax.
In a more recent article Miller argued that when personal tax is taken into account the
introduction of debt has no effect on the value of the firm.
(iv) Tax relief
At high levels of debt the firm may reach a stage where it has insufficient taxable profits
against which to set off debt interest i.e. it would not be able to utilise the tax relief and hence
no cash benefit from introducing more debt. This is sometimes referred to as tax
exhaustion.
1054
(v) Agency costs.
The managers of the company may impose limits on the level of debt in order to suit their
requirements rather than the best interests of shareholders. Similarly providers of debt may
restrict the actions of management.
These costs/restrictions will tend to counteract the beneficial effect (tax relief) of introducing
more debt. The impact of these various costs is to restrict the level of gearing below the 1
00% suggested by the M&M model, indicating again that an optimal level of gearing may
exist.
Answer 26 WEMERE
(a)
The first error made is to suggest using the cost of equity, whether estimated via the dividend
valuation model or the capital asset pricing model (CAPM), as the discount rate. The
company should use its overall cost of capital, which would normally be a weighted average
of the cost of equity and the cost of debt.
Errors specific to CAPM
The formula is wrong. It wrongly includes the market return twice. It should be:
r
j
= rf + (rm. rf)
j

The equity beta of Folten reflects the financial risk resulting from the level of
gearing in Folten. It must be adjusted to reflect the level of gearing specific to
Wemere. It is also likely that the beta of an unlisted company is higher than the
beta of an equivalent listed company.
The return required by equity holders i.e. the cost of equity, is inclusive of a return
to allow for inflation.
Errors specific to the dividend valuation model
The formula is wrong. It should be:
0
1
P
D
+ g
Treatment of inflation as for CAPM.
Again the impact of the difference in the level of gearing of Wemere and Folten on
the cost of equity has not been taken into account.
Revised estimates of cost of capital
CAPM: required return = rf + (r
m
rf) B
j

1055
For Folten

a =
( ) ( )
(
+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )
(
+

d
T 1 Vd Ve
T 1 Vd

assume d = 0, D = 4,400 E = 1.38 1,800 4 (share price no. of equity shares)
= 9,936
Ba = 1.4
) 35 . 0 1 ( 400 , 4 936 , 9
936 , 9
+

= 1.087
For Wemere
D = 2,400, Equity value of $10.6 million,
1.087 =
0.35) - (1 2,400 10,600
600 , 10
+
e
1.087 = 0.872 e
e = 1.25
Cost of equity = 12 + (18 12) 1.25
= 19.5%

WACC = 19.5%
2,400 10,600
600 , 10
+
+ 13(10.35)
2,400 10,600
400 , 2
+

= 17.5%
Dividend valuation model
Folten
Ke =
0
1
P
D
+q
Calculate dividend growth rate:
9.23 (1+g)
4
= 13.03
(1+g)
4
= 1.412
1+g = 1.09
g = 9%
D
1
= 13.03 (1 + 0.09)
= 14.20c
ke =
138
20 . 14
+ 0.09
= 0.193 i.e. 19.3%

Now use Modigliani and Millers theory with tax:

Keg = Keu + (Keu Kd)
E
t) - D(I

1056
Folten
19.3 = Keu + (Keu 13)
936 , 9
0.35) - 4,400(1

Keu = 17.9%
Wemere
Keg = 17.9 + (17.9 13)
600 , 10
0.35) - 2,400(1

= 18.6%
WACC = 18.6%
2,400 10,600
600 , 10
+
+ 13(1 0.35)
2,400 10,600
400 , 2
+

= 16.7%

(b)
Both methods result in a discount rate of approximately 17%. They are both based on
estimates from another company which has, for example, a different level of gearing. The
cost of equity derived using the dividend valuation model is based on Foltens dividend
policy and share price and not that of Wemere. The dividend policy of Wemere (e.g. the
dividend growth rate) is likely to be different.
CAPM involves estimating the systematic risk of Wemere using Folten. The beta of Folten is
likely to be a reasonable estimate, subject to gearing, of the beta of Wemere.
CAPM is therefore likely to produce the better estimate of the discount rate to use. However,
this will be incorrect if the projects being appraised have a different level of systematic risk to
the average systematic risk of Foltens existing projects or if the finance used for the project
significantly changes the capital structure of Wemere.
(c)
Discounted cash flow techniques allow for the time value of money and should therefore be
used for all investment appraisals including that carried out by small unlisted companies. It is
important for all managers to recognise that money received now is worth more than money
received in the future. Discounting enables future cash flows to be expressed in terms of
present value and for net present value to be calculated. A positive net present value indicates
that the return provided by the project is greater than the discount rate.
One non-discounting method accounting rate of return is used because it employs data
consistent with financial accounts, but it is not theoretically sound and is not recommended.
However it does show the impact of a new project on the financial statements and thus likely
impact on users of these statements.
Discounted payback measures how long it takes to recover the initial investment after taking
account of the time value of money. It is a useful initial screening method but should not be
used alone since it ignores cash flows outside the payback period.
A problem for all companies, not only small unlisted companies, is estimation of the discount
rate. This can be partly overcome by calculating the internal rate of return (IRR) i.e. the
discount rate at which the NPV is zero. This provides a break-even cost of capital i.e. a
yield which is then acceptable provided the capital cost of the business could not be lower.
1057
Answer 27 CRESTLEE
(a) The discount rate should reflect the systematic risk of the individual project being undertaken.
Unless the risk of the textile expansion and the diversification into the packaging industry are
the same, their cash flows should not be discounted at the same.
The discount rate to be used should not be the cost of the actual source of funds for a project,
but a weighted average of the costs of debt and equity which is weighted by the market values
of debt and equity. It is possible to estimate an existing weighted average cost of capital for
Crestlee, but the rate cannot be applied to new projects unless the following assumptions are
complied with:
(i) The project should be financed in a way that does not alter the companys existing
capital structure. The net present value investment appraisal method cannot handle a
significant change in capital structure (if such a change occurs the adjusted present
value method (APV) should be used outside of the syllabus.)
Crestlees existing capital structure using market values is:
$m %
30 million ordinary shares at 380 cents 114.00 66
$56 million debentures at $104 58.24 34
_____
172.24
_____
If the two investments are considered as a package:
$m %
New finance being raised 9.275 equity 66
$56 million debentures at $104 4.725 debt 34
_____
14.000 m
_____
The companys capital structure does not change as a result of these two
investments.
(iv) The project should have the same level of systematic risk as the companys existing
operations. As the textile investment is an existing operation it is reasonable to
assume that it has the same systematic risk. The diversification into packaging could
have very different risk characteristics. The companys existing weighted average
cost of capital should not be used as a discount rate for the diversification.
Textile expansion
The discount rate may be based upon the companys weighted average cost of
capital (given that assumptions (i) and (ii) are not violated).
WACC = Ke
E
E + D
+ Kd (1 t)
D
E + D

1058
Using the capital asset pricing model Ke may be estimated by
R
F
+ (R
M
R
F
)e
Ke = 6% + (14% 6%) 1.2 = 15.6%
Kd is taken as the current cost of bond, 11% (alternatively a rate could have been
estimated using the redemption yield of the debenture).
WACC = 15.6%
66
/100 + 11% (1 0.33)
34
/100= 12.8%
This is the suggested discounted rate for the expansion.
Packaging diversification
The systematic risk of diversifying into the packaging industry may be estimated by
referring to the systematic risk of companies within that industry. However, the
equity beta is influenced by the level of financial risk (gearing). Unless the market
weighted gearing of Canall and Sealalot is the same as Crestlee, it is necessary to
ungear the equity beta of these companies (to remove the effect of financial risk)
and regear to take account of Crestlees financial risk.
Gearing Canall ($m) % Sealalot ($m) %
Equity 72.0 81 138 91
Debt 16.8 19 13 9
____ ___
88.8 151
____ ___
These are both significantly different from Crestlee.
Ungearing Canall (assuming debt is risk free and d = 0)
a = e
E
E + D(1- t)
= 1.3
72
72 168 1 0 33 + . ( . )
= 1.124
Ungearing Sealalot
a = 1.2
138
138 13 1 0 33 + ( . )
= 1.129
These are very similar. The ungeared equity beta of the packaging industry will be
assumed to be 1.125.
Regearing for Crestlees capital structure
e = a
E + D(1- t)
E
= 1.125
114 58 24 1 0 33
114
+ . ( . )
= 1.51
Ke is estimated to be:
6% + (14% 6%) 1.51 = 18.08%
WACC = 18.08%
66
/100 + 11% (1 0.33)
34
/100 = 14.4%
1059
15% is not an appropriate discount rate for either of these projects. The less risky
textile expansion has an estimated discount rate of 12.8%, and the diversification
14.4%.
(b) The marketing director might be correct. If there is initially a high level of systematic risk in
the packaging investment before it is certain whether the investment will succeed or fail, it is
logical to discount cash flows for this high risk period at a rate reflecting this risk. Once it has
been determined whether the project will be successful, risk may return to a more normal
level, and the discount rate reduced commensurate with the lower risk.
The other board member is incorrect. If the same discount rate is used throughout a projects
life the discount factor becomes smaller and effectively allows a greater deduction for risk for
more distant cash flows. The total risk adjustment is greater the further into the future cash
flows are considered. It is not necessary to discount more distant cash flows at a higher rate.
Answer 28 MUGWUMP LTD
(a) Costs incurred
$
Direct materials 30% of $1,500,000 450,000
Direct labour 25% of $1,500,000 375,000
Variable overheads 10% of $1,500,000 150,000
Fixed overheads 15% of $1,500,000 225,000
Selling and distribution 5% of $1,500,000 75,000

(b) Average value of current assets
$ $

Raw materials
12
3
$450,000 112,500
Work in progress
Materials
12
2
$450,000 75,000
Labour
12
1
$375,000 31,250
Variable overheads
12
1
$150,000 12,500
118,750
Finished goods
Materials
12
1
$450,000 37,500
Labour
12
1
$375,000 31,250
Variable overheads
12
1
$150,000 12,500
81,250
Accounts receivable
12
2
2
1
$1,500,000 312,500

625,000

1060
(c) Average value of current liabilities

Materials
12
2
$450,000 75,000
Labour
50
1
$375,000 7,500
Variable overheads
12
1
$150,000 12,500
Fixed overheads
12
1
$225,000 18,750
Selling and distribution
24
1
$75,000 3,125
(116,875)

(d) Working capital required 508,125

Note It has been assumed that all the direct materials are allocated to work in progress when
production is commenced.

Answer 29 DYER LTD

(a) Long-term effects of policy

(i) Annual profit increase
Old New Increase
position position
$000 $000 $000
Sales (note 1) 2,400 3,960 1,560

Raw materials (note 2) 720 1,080 360
Other variable costs (note 2) 960 1,440 480
Fixed costs (note 3) 600 600

Total costs (2,280) (3,120) (840)

Profit $120 $840 $720

Notes

(1) Increase in sales volume 50%
Increase in sales price 10%
Total revised sales
$2.4m 1.5 1.1 = $3.96m.

(2) Increase caused by volume increase of 50%.

(3) Unchanged.

1061
(ii) Working capital requirement
$000 $000
(1) Raw materials
One months supply 1,080 12 90
(2) Work in progress
One month (1,080 + 1,440) 12 210
(3) Finished goods
One months supply (1,080 + 1,440) 12 210

420
(4) Accounts receivable
70 days credit 3,960 70/360 770

1,280
(5) Accounts payable
One months purchases (90)

Total working capital requirements 1,190

(b) Monthly cash forecast

Basic data
(i) Sales
$200,000 up to July
$220,000 August and September
$330,000 October onwards

(ii) Production
Materials Other
used variable
costs
$ $
June 60,000 80,000
July onwards 90,000 120,000

(iii) Cash costs
Per month
$
Fixed costs 50,000
Less Depreciation (10,000)

Cash costs 40,000

1062
Cash forecast June to December

Month Jun Jul Aug Sep Oct Nov Dec
$000 $000 $000 $000 $000 $000 $000
Sales receipts
Old credit terms 200 200
New credit terms
60% 2 months credit 120 132 132 198
40% 3 months credit 80 88 88

Total receipts 200 200 120 212 220 286

Expenditure
Raw materials 60 90 90 90 90 90 90
Other variable costs 80 120 120 120 120 120 120
Fixed costs 40 40 40 40 40 40 40

Total expenditure (180) (250) (250) (250) (250) (250) (250)

Net inflow/(outflow) $20 $(50) $(250) $(130) $(38) $(30) $36

Opening cash balance 80 100 50 (200) (330) (368) (398)
Closing cash balance 100 50 (200) (330) (368) (398) (362)

(c) Concerning the expansion
Tutorial note: The three important points of examination technique to make here are:
(i) Do not be afraid to state the obvious.
(ii) Think practically about the problem.
(iii) Plan your answer before writing in full.

The main comments could include reference to the following points.

(i) The long-term expansion will increase annual profits by 600% before
considering the cost of financing the increase in working capital required. This
profit increase will be reduced after financing costs are considered.

(ii) During the transitional period there are considerable cash outflows in individual
months and, in spite of a positive cash balance anticipated at the end of May, a
large negative balance is expected at the end of December. Had there been no
change in activity levels or credit terms, etc, the cash balance would be
expected to increase by $20,000 in each month so that at the end of December it
would have reached $220,000. The revised cash balance of a negative
$362,000 is therefore $582,000 lower, and it is this latter figure which is the
true indication of the short-term reduction in liquidity caused by the expansion.

(iii) Therefore, although the expansion is highly profitable, it requires heavy cash
resources to finance the extra working capital. This is especially true over the
first seven months when the new activities produce a substantial increase in
reported profits, but also require additional financing of $582,000.

1063
Answer 30 PUNTER BOOKMAKERS LTD
(a) The reasons for holding cash within the business are primarily the transactions and
precautionary motives. This should enable day-to-day business payments to be met
(primarily the winning customers), and allow for a margin of safety to cope with
unexpected cash needs.

If the finance director carries too high a cash balance, there is an inherent opportunity cost
in the loss of interest, or equivalent return, through its non-investment.

In theory a cash control model could be formulated which is similar to that used in
inventory control. This model would be based on the two basic costs of

(i) holding cash (the opportunity cost)
(ii) procurement of cash (transaction costs incurred in liquidating securities, and the
loss of customer good will if customers cannot be paid promptly).

The model would determine the optimum average cash balance to be held.

The Miller-Orr model is perhaps the derivative most commonly used.

Alternatively, the required cash balances could be determined by the establishment of
required ranges for the values of various cash ratios, e.g. cash to value of bets placed.

The problem with the models outlined above is that they may be of restricted practical
relevance to Punter Bookmakers Ltd, because the cash flows are continuously changing.
Just as with the EOQ inventory control model under uncertainty, one can try to deal with
the problem by estimating the likelihood of abnormally large daily demands for cash where
bets have not been reinsured by referring to the mean and standard deviation of past cash
flows. This presupposes that the cash flows follow a clearly defined statistical pattern,
such as a normal distribution. The finance director could therefore strive to prepare a more
detailed simulation of future periodic cash requirements.
The finance director must also forecast the timing of other payments, such as any capital
investments, renewal of licences, taxation, proposed dividends, loan repayments and
wages.

A computerised model could then be set up (obviously with the necessary help), which
would incorporate the forecast operating cash requirements and interest rates applicable to
financing and investments.

The model could then be used to highlight any long-term deficiencies, but also to allow the
advanced planning of the investment of any surpluses in either short-term or long-term
investments, depending upon the degree of permanency of the surplus envisaged.

The above has adopted a somewhat theoretical approach. Certain practical steps that the
finance director should consider are as follows.

(i) The company should specify that winning bets cannot be collected until a
certain time (perhaps the next day) which would allow cash inflows from other
bets to offset the payments, and would also give more time to consider the
liquidation of securities.

(ii) The operation of a credit system for major clients may smooth out fluctuations,
since any wins could be credited to the account rather than immediately being
paid out in cash.
1064
(iii) The finance director should consider a range of investments for the surplus cash
such that some investments can be liquidated with minimum delay and with
little or no transaction costs. Where there is a lower probability of access to the
funds being needed, longer-term investments can be made.

(iv) The finance director should ensure that he has a safety net available to meet
unexpected demand perhaps through an overdraft facility which can be drawn
upon as a last resort. This means that a good working relationship with the
companys bankers should be developed.

(v) Investments should be managed so that they mature at times where cash
requirements may be high. Thus, large cash balances may be needed around
Grand National time, so perhaps investments should be at a comparatively low
level then, with funds held on deposit to either pay out or to be ready for
reinvestment.

(vi) The risks borne by individual branches can be pooled by operating a centralised
cash account. This should prove helpful unless there is a strong systematic
correlation in bets placed, e.g. where a large number of bets are placed on the
same horse at many branches and there is inadequate reinsurance, the business
would be severely exposed if that horse were to win.

(vii) It is also worth noting that reinsurance may protect profitability, but does not in
itself cover the immediate cash requirements, unless the other bookmakers
settle immediately. Thus the settlement terms when bets are laid off with other
bookmakers must be carefully negotiated.

In summary, a theoretical cash planning model may not be practical because of the
inherent uncertainties within the business. Hence, a flexible approach must be taken to
investment policy, ensuring that sufficient cash is available on short-term deposit to meet
unexpectedly high demand.

(b) The following is a brief summary of the types of securities that the finance director might
choose.

(i) Various types of bank deposits. These will range from high interest cheque
accounts to money market deposits. The differences are largely related to the
minimum deposit, length of deposit required, and conditions attaching to early
recall. If the finance director chooses bank deposits, he may be restricted
substantially by the amount of cash available (for example, money market
deposits at call usually require a minimum of 50,000). The likelihood of early
redemption points towards the use of investment accounts offered by clearing
banks where early redemption is possible, but subject to an interest penalty.

(ii) Negotiable instruments. Most dealing in bills and certificates of deposit takes
place on the secondary market (i.e. the transfer of an existing instrument as
opposed to the purchase of a new, or prime, bill).

Negotiable instruments offer the finance director two distinct advantages,
having regard to the uncertainty surrounding the time for which funds are
available.

(1) An instrument with a first class name, such as a major bank, can be
resold on the market at any time without notice.

1065
(2) The yield will reflect the term for which the instrument is issued.
The main disadvantage is that the price on resale will fluctuate with
interest rates.

(iii) Treasury bills, bank bills and trade bills. These have a nominal value of
5,000 upwards. Bills could be purchased from banks or discount houses, and
the major cost is likely to be the turn between the buying and selling prices
quoted. Most bills can be resold without difficulty but, again, incurring
transaction costs.

(iv) Sterling Certificates of Deposit (CDs). These are negotiable instruments that
entitle the bearer to repayment of the capital deposited, plus the stated interest,
when presented to the issuing bank on maturity. Normally issued for lengthy
periods up to five years, they can be bought and sold on secondary markets
which make them a shorter-term investment. However, the minimum face
value of a CD is 50,000, so these investments may be beyond the scope of the
finance director.

(v) Stock Exchange investments in listed companies. Investment in securities
issued by public companies could be considered. However, this involves a
larger risk and could be considered over-speculative. If this type of investment
were made, care should be taken to mix a well-diversified portfolio in order to
reduce the random risk associated with each individual investment.

In summary, the finance director must consider the trade-off between higher returns
yielded by longer-term investments against the flexibility given by bank deposits and
negotiable instruments. The overall portfolio of investments should comprise
comparatively liquid assets, including some overnight money if the funds at stake are
sufficiently large.

Answer 31 MR COLORADO
(a) Cash forecast to 31 March 19.02
Existing policy

WORKINGS

Current sales $14,500 per month 50% cash $7,250
50% credit $7,250

Purchases (60%) $8,700 takes 2.5% discount. Therefore cash $8,483

Overhead $4,000 per month variable with sales

Budgeted profit and loss items
Nov Dec Jan Feb Mar Apr
$ $ $ $ $ $
Sales 14,500 14,500 14,790 15,086 15,387
Purchases 8,700 8,700 8,874 9,051 9,233 9,418
Overhead 4,000 4,000 4,080 4,162 4,245

1066
Budgeted cash flows under existing policy
Jan Feb Mar
$ $ $
Income
Cash sales 7,395 7,543 7,694
Credit sales
November 7,250
December 7,250
January 7,395

14,645 14,793 15,089

Payments
Accounts payable
December 8,483
January 8,652
February 8,825
Overhead 4,080 4,162 4,245

12,563 12,814 13,070

Net cash flow 2,082 1,979 2,019
Balance brought forward (14,800) (13,088) (11,436)
Add Interest at 2.5% (370) (327) (286)

Balance carried forward (13,088) (11,436) (9,703)

Hence estimated overdraft at 31 March 19.02 = $9,703

Proposed policy

Sales 50% on credit 0.975
Purchases Two months later at 100%

Inventory

Assume the opening balance each month = next three months cost of sales (COS).

Target inventory 1 January = COS (January + February + March).
= $(8,874 + 9,051 + 9,233)
= $27,158
Actual inventory = $18,500
Special purchase = $8,658 paid two months later
January purchases = Special + April COS
= $(8,658 + 9,418)
= $18,076
1067
Budgeted cash flows under proposed policy
Jan Feb Mar
$ $ $
Income

Cash sales 7,395 7,543 7,694
Credit sales
November 7,250
December 7,250
January 7,210
February 7,354

14,645 22,003 15,048

Payments

Accounts payable
December 8,483
January 18,076
Overheads 4,080 4,162 4,245

12,563 4,162 22,321

Net cash flow 2,082 17,841 (7,273)
Balance brought forward (14,800) (13,088) 4,426
Interest at 2.5% (370) (327)

(13,088) 4,426 (2,847)

Hence, estimated overdraft at 31 March 19.12 = $2,847

(b) Comment on figures and method of long-term evaluation of policy
Under the existing policy Mr Colorado has a steadily improving cash position in the next
three months. This must be the case as he makes a gradually increasing profit month by
month. His working capital also increases but this is a linear function of the increase in
activity as far as accounts receivable and accounts payable are concerned, and inventory
remains constant. Thus the steadily increasing cash flow from accounts receivable is more
than sufficient to cover the increased working capital. The net cash flow each month will
steadily increase, with the exception of the one-off reduction in February, caused by the
initial increase in activity and the fact that the higher creditor and overhead costs are paid
earlier than the receipt for the higher credit sales. Nevertheless the net cash flow is
positive. Overdraft interest costs will steadily decline.

Under the proposed policy there is a substantial once-only change in the working capital.
The substantial increase in inventory is paid for in March, which reduced the net cash flow
in that month. More specifically the increase in accounts payable , by not taking the
discount, means no payment at all in February. This, combined with the earlier receipt of
the January credit sales, gives a much improved cash flow in February.

1068
Once the adjustments due to the change in policy have taken place, cash flow will become
positive from April onwards and then steadily increase. However, the April cash flow will
be lower under the new policy as the creditor payment will be higher. Despite the delay in
payment by a further month, it is now without discount and is for purchases required two
months further ahead than the current policy and thus at a higher level.

Both policies give month-end cash balances that are within the bank overdraft limit.

The evaluation of the long-term effect of the alternative credit policies must be made by
considering the net cash flow effect in terms of Mr Colorados cost of capital (finding the
NPV of each policy). This exercise is justified as consistent with the objective of the firm
to maximise shareholder wealth. The change in working capital is a cash flow effect on
the firm. The change in receipts from accounts receivable and payment to accounts
payable is similarly an annual cash flow. The policies can thus be regarded as any other
decision, and evaluated by discounting the cash flows they produce.

Answer 32 WORRAL LTD
(a)
(i) Increase long-term loans by $300,000
Cost of loan = Grandus cost of debt

=
75 82
12
.

= 14.5%

Cost of bank overdraft = 11 + 2

= 13%

Effect on current ratio =
300 3,293
4,874

= 1.63

(ii) Offer cash discount
$
New accounts receivable level
No discounts (2,684 0.5) 1,342,000
Cash discount (2,684 0.5
107
14
) 175,589

1,517,589
Old accounts receivable level 2,684,000

Reduction in accounts receivable 1,166,411

There will be a corresponding reduction in the overdraft adjusted by the amount
of cash discounts given.

1069
Total reduction in overdraft will be 2,684 0.5
107
93
0.97

= $1,131,419

The effect on the current ratio =
1,131,419 3,293,000
1,166,411 4,874,000

= 1.72

Annual cost of discount scheme = $30,000

Saving in overdraft interest = 13% 1,131,419

= $147,084

(iii) Non-recourse factoring company
$ $
Reduction in accounts receivable 2,684,000

Reduction in current liabilities
Advances 2,684,000
Less Commission (2% 9,182,000) (229,550)

2,454,450

Effect on current ratio =
2,454,400 3,293,000
2,684,000 4,874,000

= 2.61

Annual cost of factoring
$000
Commission (9,182 2%) (229.55)
Interest (2,684 14%) (375.76)
Saving in overdraft interest (1,650 13%) 214.50
Saving in bad debts (9,182 1%) 137.73
Saving in credit management 135.00

(118.08)

Recommendation

Each of the three suggestions will increase the current ratio to above the average of 1.6.
However, increasing long-term loans achieves this aim by only a small margin. Factoring
increases the ratio to well over 2 and is the most beneficial in this respect.

Considering the annual cost of each alternative, the long-term loan option substitutes a cost
of 14% for one of only 13% and is obviously not beneficial.

1070
The factoring arrangement has a net cost of $118,080 per annum and therefore is unlikely
to be as attractive as the cash discount option. Not only does the latter achieve the desired
current ratio but also an annual net saving of $117,000.

(b) Other ways of obtaining finance using accounts receivable as security would include the
following.
(i) A short-term loan or overdraft on the back of trade accounts receivable .

(ii) Selected invoices could be sold, or discounted, to a factoring company or
finance house. The company will receive a percentage (usually up to 90%) of
the invoice value. When the debt is collected the money is paid back to the
factor or finance house.

(iii) On the sale of goods a bill of exchange may be drawn up and accepted by the
buyer as his means of payment. The seller can then discount the bill (i.e.
receive a percentage in cash) with a third party.

Answer 33 DIRE PLC
Existing level New level Difference
$ $ $
Accounts receivable
12
3
5m 0.9
12
2
5m 0.9
= 1,125,000 = 750,000 375,000

Inventory
12
4
3m
12
3
3m
= 1,000,000 = 750,000 250,000

Accounts payable
12
2
3m 0.8
12
2
2
1
3m
= 400,000 = 625,000 225,000

Total reduction in working capital 850,000

Interest saved
$
Working capital 850,000 0.1 85,000
Reduced interest payable on loan 200,000 (0.1 0.07) 6,000

91,000

1071
Answer 34 MOORE LTD
(a) DCF appraisal
Assume that the new policy is implemented at t = 0. This affects anything invoiced at t = 1
onwards.

Existing scheme
1 2 3
$ $ $
Accounts receivable
1 month 2,000 2,000
2 months 7,800
Accounts payable (6,000) (6,000)
Administration (1,000) (1,000) (1,000)

(1,000) (5,000) 2,800

New scheme
1 2 3
Accounts receivable $ $ $
1 month 98% 60% 11,000 6,468 6,468
2 months 37% 11,000 4,070
Accounts payable
To cover sales (6,600) (6,600)
Extra to boost inventory (1,200)
Administration (1,150) (1,150) (1,150)

(1,150) (2,482) 2,788

Incremental CF (150) 2,518 (12)
DF @ 1% pcm 0.99 0.98 98
PV (149) 2,468 (1,176)

NPV $1,143

NPV > 0. Therefore, new scheme better.

(b) Profits
Old scheme New scheme
$ $
Sales 120,000 132,000
Cost of sales (72,000) (79,200)

Gross profit 48,000 52,800
Administration (12,000) (13,800)
Bad debts (2,400) (3,960)
Discounts (1,584)

Profit before interest and tax 33,600 33,456

1072
This would indicate that the old scheme is better, in contradiction of the result in (a). The
reason for this discrepancy is that the P&L approach ignores the timing of the cash flows
and the change in working capital. The difference in profit of $144 (or $12 pcm) reflects
the cash flows from month 3 onwards but not the transition to get there.

(c) Cash operating cycle
Before After
months months
Accounts receivable period
(0.2 1 + 0.78 2) 1.76
(0.6 1 + 0.37 2) 1.34
Inventory period 2.00 2.00
Accounts payable period (1.00) (1.00)

Length of cycle 2.76 2.34

New scheme will reduce the length of the cycle.

(d) Working capital in one year
Old scheme
$
Accounts receivable = 0.2 + 10,000 + 0.78 100,000 2 = 17,600
Accounts payable = 1 6,000 = 6,000
Inventory = 2 6,000 = 12,000
Cash balance = 20,000

Current ratio =
000 6
20,000 12,000 17,600
,
+ +
= 8.27
Quick ratio =
6,000
20,000 17,600 +
== 6.27

New scheme

Accounts receivable = 0.6 11,000 + 0.37 11,000 2 = 14,740
Accounts payable = 1 6,600 = 6,600
Inventory = 2 6,600 = 13,200
Cash (W1) = 22,248

Current ratio =
6,600
22,248 13,200 14,740 + +
= 7.6
Quick ratio =
600 6
248 22 740 14
,
, , +
= 5.6

Both current and quick ratios are lower under the new scheme.

1073
WORKINGS

Either

(1) Use figures from (a)

Cash balance = 20,000 150 + 2,518 (10 12)

= $22,248

or

(2) Do a basic CF statement
$
Cash balance under old scheme 20,000
Difference in profit (144)
Movement in accounts receivable 2,860
Movement in accounts payable 600
Movement in inventory (1,200)
Adjustments for discounts for last month of sales that should not
have gone through P&L a/c for first year 2% 60% 11,000 132

22,248

Answer 35 WAGTAIL LTD
(a) Optimal batch size
s = 4,000
h = $15
f = $30 + 5 $9* = $75

* The opportunity cost of the employees time is the revenue forgone, i.e. $(5 + 4) =
$9, not merely the contribution. If the employee were producing, revenue would be $9,
i.e. enough to cover his $5 wages and also to provide a contribution of $4.

Optimal batch size =
h
2fs

=
15
4,000 75 2

= 200 units

1074
(b) Quantity discount decision
The annual cost of B becomes relevant. To take the discount, the batch size would be
increased to only 400. Any larger figure would increase the total of holding and order
costs, since the formula gives 200 regardless of price.

(i) Order size = 200; Price = $24
$
Holding cost h
2
Q
= $15
2
200
1,500
Ordering cost f
Q
s
= $75 20 1,500

3,000
Cost of B 4,000 $24 96,000

Total cost 99,000

(ii) Order size = 400; Price = $(24 0.24) = $23.76
$
Holding cost h
2
Q
= $15 200 3,000
Ordering cost f
Q
s
= $75 10 750

3,750
Cost of B 4,000 $23.76 95,040

Total cost 98,790

(iii) Conclusion

Wagtail Ltd should take up the discount by adopting a batch size of 400 as this
results in a net saving.

Answer 36 TIPEX LTD
(a) Reorder quantity
Mean monthly demand = 7 (from symmetry of distribution)
Mean annual demand = 7 12 = 84

EOQ =
h
2fs
=
0.2 280
84 15 2

= 45 = 7 (to nearest whole number)

This implies 12 orders per annum.

1075
(b) Reorder level
Lead time is one month. Therefore average demand in lead time is 7 units. A reorder level
of 7 corresponds to no buffer inventory. Reorder levels of 7 and upwards will be
considered.

ROL B No of units Prob- Expected Annual Total
short ability annual holding annual
stock-out cost cost cost
7 0 1 0.20 0.53 12
2 0.10 $40
3 0.03
4 0.01

0.53 $254.40 $0 $254.40

8 1 1 0.10 0.19 12 1
2 0.03 $40 $56
3 0.01

0.19 $91.20 $56 $147.20

9 2 1 0.03 0.05 12 2
2 0.01 $40 $56

0.05 $24.00 $112 $136,00

10 3 1 0.01 0.01 12 3
$40 $56

0.01 $4.80 $168 $172.80

The total expected cost is minimised for a reorder level of 9 units.

Answer 37 ORION PLC
(a) Optimal order size
Annual demand s = 2,800 250

= 700,000 items

Holding costs per unit per annum h = $0.1715 + 0.15 $1.19 = $0.35

Fixed costs per order f = $12.25

1076
Optimal order size x =
h
2fs

=
0.35
700,000 12.25 2
= 7,000 items

(Orders should be placed every 2
1
/2 days, 100 times a year)

(b) Discounts
(i) Total annual costs with orders of 7,000
$
Purchase price 700,000 $1.19 833,000
Holding costs 3,500 $0.35 1,225
Reorder costs 100 $12.25 1,225

Total 835,450

(ii) With orders of 20,000
$
Purchase price 700,000 $1.18 826,000.00
Holding costs 10,000 ($0.1715 + 0.15 $1.18) 3,485.00
Reorder costs 35 $12.25 428.75

Total 829,913.75

The optimal order size is therefore 20,000 items.

(c) Minimum discount acceptable
Let the reduced price be P.

The annual costs if inventory is ordered in batches of 20,000

= $428.75 + 10,000 ($0.1715 + 0.15P) + 700,000P

= $2,143.75 + 701,500P

For the discount to be acceptable

$2,143.75 + 701,500P < $835,450

701,500P < $833,306.25

P < $1.187892

This is a discount of 0.2c or 0.18%.

1077
(d) Reorder level
Lead time = 2 days
Average demand in lead time = 2 2,800 = 5,600
Standard deviation =
2 2
400 400 + =
2
400 2 = 565.685

= 565.685
= 5,600 R
z
2%

From tables z = 2.05

Buffer inventory = 565.685 2.05 = 1,160

Reorder level = 5,600 + 1,160 = 6,760 items

Answer 38 THREE SMALL UK COMPANIES
There is some evidence that foreign exchange markets are efficient (in the context of the efficient
markets hypothesis) when foreign exchange rates are allowed to float freely. However, there are very
few examples of currencies that are allowed to float freely in response to economic forces; where a
floating exchange rate exists it is normally in the form of a managed float (or dirty float) where a
government intervenes in the foreign exchange market to influence the price of its currency. Even if an
efficient foreign exchange market exists the manager of company one would be engaging in a risky
strategy. The effect of changes in the exchange rate on the companys export transactions depends
upon the strength of sterling relative to the currencies in the countries to which company one exports. It
is possible that sterling could rise in value against all of these currencies simultaneously, and losses be
made on the export sales due to exchange rate changes. The company might not be able to sustain such
losses until more favourable exchange rate movements occur. Hedging, although it involves costs, can
limit foreign exchange losses (if any) to a known amount.
Company two only trades within Europe. It might be thought that, as imports are contracted to be paid
for in sterling, there is no foreign exchange risk with such transactions. Risk, however, does still exist,
as is explained for company three.
The answer with respect to company twos exports will depend upon whether or not the UK uses the
Euro or continues to use $. At the time of writing the UK is choosing to remain outside Euroland.
Alternative answers are:
(i) If the UK joins the European single currency
The company will not face exchange risk in dealing with other countries participating in the
Euro. However the Euro itself of course floats against all other world currencies. Hence if the
company exports outside Euroland, it will face foreign exchange risk.

1078
(ii) If the UK does not join the Euro
The value of sterling can fluctuate against the Euro. Substantial foreign exchange gains or
losses could occur on the companys export transactions.
Although company three is not engaged in foreign trade, exchange rate changes are still likely
to be relevant to the company. One form of foreign exchange risk is economic exposure,
which relates to the effects of unexpected changes in exchange rate on future cash flows.
Changes in exchange rates might affect the companys competitive position. If exchange rate
movements make foreign competitors products cheaper, company three could lose sales to
such foreign competitors. Additionally, although the company is not directly engaged in
foreign trade, if it purchases components from other UK companies such components might
contain imported materials. If exchange rates change, this could directly affect the price
company three has to pay for components, even though these are purchased from UK
suppliers. There are several other ways in which exchange rate change could affect company
three. Exchange rate changes are not irrelevant to this company.
Answer 39 FOURX LTD
(a) Buying and selling rates
(i) Buying francs
Francs will be bought at 9.725 Ff/$. Ff 2,000 will cost
725 . 9
000 , 2
= 205.66
(ii) Selling francs
francs will be sold at 9.735 Ff/$. Ff 100 will provide
735 . 9
100
= 10.27
(b) Spot and forward rates
Note Remember ADDIS (Add discount; therefore subtract premiums).
Forward buying rate = 9.725 0.015
= 9.710
Francs received = 200 9.710
= Ff 1,942
1079
(c) Forward market cover
Forward buying rate (as in (b)) = 9.710 Ff/$
Cost of machine =
710 . 9
000 , 150

= 15,448
(d) Money market cover
Note This involves
(i) investing that amount of foreign currency to accumulate to the required
sum to be paid at the required date
(ii) buying that amount of foreign currency in (i) in the spot market, and
(iii) borrowing sufficient funds in the UK to buy the foreign currency in (ii).
Invest
025 . 1
150,000 Ff
= Ff 146,341
Buy Ff 146,341 in the spot market for
725 . 9
341 , 146
= 15,048
Borrow 15,048 and repay in three months time
15,048 1.0275 = 15,462
The cost using money market cover (15,462) is very similar to that using forward market
cover (15,448). These hedges eliminate the uncertainty of what is to be paid.
1080
Answer 40 STORACE PLC
(a) Sterling receipts
(i) Price in sterling = 100,000
(ii) Invoice price in dollars = 100,000 1.11
= $111,000
Exchange rate in three months time (spot rate)
= 1.20 1.09
Therefore, received is between 92,500 and 101,835
(iii) Invoice in dollars $111,000
Forward rates
Spot 1.1100 1.1100
Three months pm (0.0120) (0.0115)
______ ______
Three months forward 1.0980 1.0985
______ ______
Sell dollars forward at $1.0985 to 1
Receive 101,047
(b) Report comparing methods of invoicing
To Storace plc
From Gluck & Co, Chartered Accountants
Date 3 January 19X0
Re Methods of invoicing export order
You have asked us to advise on the best method of invoicing one of your foreign clients,
Jacquin Inc. Three methods are under consideration.
(1) Invoice in sterling.
(2) Convert the sterling price into dollars at the current spot rate, invoice in dollars and
convert the dollars into sterling at the spot rate prevailing on receipt of the dollars
three months hence.
(3) Invoice in dollars and sell the dollars forward at the three month forward exchange
rate.
Our calculations in Appendix 1 show the expected sterling receipts resulting from each of the
three options. In summary they are as follows.
(1) 100,000
(2) Between 92,500 and 101,835
(3) 101,047
1081
In general, the objective in deciding on the method of invoicing foreign clients should be to
minimise exchange rate risk, i.e. the potential losses suffered by the company as a result of
movements in the exchange rate between the date of invoice and the date of payment. Stated
simply, if your company wishes to speculate on the foreign currency exchanges, there are
easier ways of doing it than exporting goods to foreign customers.
Given this objective the obvious answer is to invoice in sterling which completely eliminates
any exchange rate risk from the view point of the selling company. By invoicing in sterling
and thereby guaranteeing the sterling receipt three months hence, Storace plc will pass on the
exchange risk to the foreign customer, Jacquin Inc. The management of Jacquin Inc will
then have to decide whether to buy the 100,000 needed to meet the invoice in the forward
market or wait until the payment date and buy in the spot market. However, it may not be
prepared to accept the risk. Therefore it is possible that your client may not be prepared to
accept a sterling invoice. If you wish to keep the business you may have to invoice in the
currency of your foreign client. In these circumstances the choice is between options (2) and
(3).
Option (3), to cover your position in the forward market, is also riskless provided your client
pays on the due date. Indeed, since the dollar is trading at a premium in the forward market,
i.e. the market expects the value of the dollar to rise, it is possible for your client to make a
profit of 1,047 by using this method of invoicing as compared with invoicing in sterling.
However, if your client defaults on payment for whatever reason, you will still have to honour
your contract to deliver $111,000 three months hence.
Another option is to invoice in dollars and convert the dollars at the spot rate prevailing in
three months time. Depending on the strength of the dollar at that time, you could receive
between 92,500 and 101,835. Compared with option (3) this gives a potential gain of 788
if the exchange rate moves to $1.09, and a potential loss of 8,547 if the rate moves to $1.20.
These figures assume that management expectations of the future spot rate are correct.
Conclusions
Ultimately the choice must depend on the commercial considerations affecting your company.
Although invoicing in sterling is the simplest solution, it is unlikely to lead to a sale. The
choice is therefore between options (2) and (3). Under option (2) there is a chance that only
92,500 will be received, which could mean that a loss is made on the sale of the machine.
Therefore, you will probably prefer the certain 101,047 given by a forward contract. To
protect yourself against the possibility of a delay in payment by Jacquin Inc, I would suggest
that you consider using an option date forward contract where delivery can take place
between two dates rather than on a single date. You will receive less than 101,047 because
the contract rate will be less favourable from your point of view, but the difference will not be
great.
(c) Implications of a major export drive
If the company decides to engage in a major exports sales drive, there are four decisions to be
made in which corporate financial management will have a major role to play.
(i) Choice of organisation
A company can sell its product in a variety of ways abroad, e.g. direct to customers or agents,
via a branch or department established in that country or via a subsidiary company established
in that country.
1082
(ii) Financing branches/subsidiaries
Overseas branches/subsidiaries will require financing. Financial managers will need to
consider both the cost of funds and exchange risk (e.g. whether a loan to finance a subsidiary
should be taken in sterling or a foreign currency).
(iii) Protecting against exchange risk on receipts
This is the subject of part (a) of the question and can be covered by dealing in the forward
markets as explained in part (b).
(iv) Assessing creditworthiness of overseas customers
A company may experience more problems in assessing the creditworthiness of overseas
customers than of domestic customers. The risk of default by an overseas customer can be
insured against via the Export Credits Guarantee Department. The ECGD also gives banks
guarantees on cash advanced against such insurance policies, thus providing a company with
the means to finance increased working capital requirements resulting from overseas sales.
Answer 41 OMNIOWN PLC
(a)
A forward rate agreement (FRA) involves fixing the future interest rate now for the
$5m. It involves an agreement tailor-made to the companys requirement in terms of
amount and dates. Once an FRA has been entered into Omniown must pay interest
at the agreed rate. The rate offered will depend on the markets current perception
of future interest rates. The FRA is based on a notional principal i.e. it is
independent from the underlying loan which should be arranged separately. It would
protect the firm from rate increases but if the actual rate fell below the forward rate
the company would not benefit from this decrease i.e. it would still have to pay the
rate per the forward rate agreement.
The mechanics of an FRA are that if actual rates are in excess of the rate per the
FRA, the bank will compensate the company by the amount of the excess. Similarly,
if actual rates are below the agreed rate the company pays the difference to the bank.
There is no initial premium payable on an FRA. FRAs can normally be arranged for
up to two years into the future.
Interest rate futures are contracts of standard amounts and for standard periods of
time running from a limited number of dates. They are therefore less flexible than
an FRA but are similarly binding on both parties. For Omniown protection against
interest rate increases could be achieved by selling futures contracts now. As
interest rates rise the value of futures contracts will fall. Hence Omniown can buy
back the contracts at a lower price and make a profit. This profit should compensate
the company for the increase in interest rates though this profit is unlikely to match
perfectly the additional interest costs incurred. Interest rate futures involve payment
of a small initial margin.
1083
An interest rate guarantee (or cap) is an option which enables the treasurer to fix a
maximum interest rate for a period in the future but if the rate falls the treasurer can
choose not to use the option and take advantage of the lower rate. Because of this
additional benefit of taking advantage of lower rates options tend to be more
expensive: they involve payment of a premium in advance at the time the contract is
entered into.
In this case the option would be to guarantee rates at their existing level and because
it is a short-term option, the premium is likely to be fairly high unless the market
expects rates to fall.
(Tutorial note: the premium would be lower if the guaranteed rate were higher than
existing rates e.g. 16%.)
Answer 42 BRITISH INDUSTRIAL GROUP
Report front page
To Directors of BIG plc
From Anne Analyst
Date Today
Subject Valuation of Bertram Ltd
Contents
1 Terms of reference
2 Dividend valuation
3 Price earnings valuation
4 Asset valuation
5 Conclusion
Appendices
1 Terms of reference
This report makes three estimates of the value of Bertram Ltd. The usefulness of these
valuations depends upon the size of stake you intend to take in the company, and the
relevance of each valuation will be discussed.
It is vital to appreciate that valuation is not an exact science and the final price paid will be a
matter of negotiation. These figures simply provide boundaries for discussion.
Also included are details of further information required to increase confidence in the figures
provided.
2 Dividend valuation
(i) Valuation
This approach works on the basis that the value of the share is equal to the present value of
future dividends calculated at a rate of return which reflects the risk of the share returns.
As detailed in Appendix 1 this gives a valuation of $2.29 per share. This figure falls
considerably if we make an adjustment to the cost of equity to reflect the non-marketability of
the private companys shares. The size of this adjustment is debatable but some reduction has
to be made.
1084
(ii) Suitability
This technique is suitable if you believe that the value of a share is equal to the present value
of future dividends. It is particularly appropriate if you intend to take a minority interest as it
bases value on the cash returns you could expect to earn.
It is not as appropriate for a controlling interest as you would then be in a position to
influence future dividend policy. However, it could be argued that as this approach
simulates a market value for Bertram if it were a listed company, then it gives a guide to
what you would have to pay to acquire the firm. If you did use these figures for a controlling
interest, you could adjust upwards the price you would be prepared to pay for the net of tax
gain you could generate on the surplus warehouse. This figure is detailed in Appendix 4 as
$4.34m.
(iii) Further information
Further information would be useful to substantiate the estimates of future dividends and the
cost of equity.
To verify a growth rate of 10% in dividends it would be useful to have details of past
dividends, more detailed sets of accounts to explain the nature of the extraordinary items, and
details of the companys future strategy to maintain this growth rate in current economic
circumstances. As earnings growth has reduced over the last two years, forecasts of future
earnings would be useful.
General economic data on interest rates, forecast inflation, the prospects of the domestic
appliances industry and the results of other firms in this sector would also be helpful.
Growth in dividend over the last two years has actually averaged 12% and this could cast
doubt on the 10% figure. A Gordon growth rate estimate, return on shareholders funds
multiplied by the retention rate
103.12m
m 3 . 20

15.3m
m 3 . 10

also gives a slightly more optimistic estimate of 13.25%.
To verify the suitability of the cost of equity employed, further details of the size, operating
gearing, products and markets of the listed companies from which the 16% has been derived
would be helpful. The basis of calculation (dividend valuation or CAPM) would also be of
interest.
3 Price earnings valuation
(i) Valuation
This approach works on the basis that the value of a business depends on its future earnings
potential. Current earnings are taken as an indicator of earnings potential and anticipated
growth rates and risks are embodied in the PE multiple.
As detailed in Appendix 2 this gives a valuation of $4.06 per share. This figure is
substantially reduced to $3.045 following adjustments for non-marketability. Once again the
size of this adjustment is debatable, but some reduction must be made.
1085
(ii) Suitability
This technique is suitable if you believe that the value of a business depends upon its future
earnings potential. It is most suitable for a majority interest as with a controlling interest you
would have control of the assets and therefore earnings.
If you were to take a controlling interest it could give a rough indication of value as once
again it could be considered as a simulated market price. It is probably more suitable than a
dividend-based estimate in these circumstances as earnings are less easy to manipulate. If it
were used to estimate the price for a controlling interest, the net of tax gain on the surplus
warehouse could be added to the above figures.
In using this approach it is essential that the earnings figure and the PE multiple adopted are
realistic.
To verify the earnings figure most of the information already requested to support the
dividend valuation approach would be helpful.
In addition, more detail on the extraordinary items is essential. As significant and growing
amounts are involved for three consecutive years, it is legitimate to question if they are truly
extraordinary, or if they are simply being used to massage reported earnings. It could well be
prudent to base our valuation on earnings after extraordinary items, resulting in a total value
of $91.8m on a PE ratio of 6. Directors salaries may also need to be classified as
distributions rather than expenses.
Further information on the size, operating gearing, products and markets of the listed
companies from which the PE ratio has been derived would be helpful. It would also be
useful to know how extraordinary items have been dealt with in calculating their multiples.
4 Asset valuation
(i) Valuation
The above approaches value the company by attempting to assess the value of its future
earnings stream. An asset valuation approach takes the view that a collection of assets is
being bought and that this needs to be managed to achieve future earnings. There is no
guarantee that existing managers will stay and therefore future earnings could be in doubt,
whereas asset value is relatively certain.
As detailed in Appendix 3 this gives a valuation of $1.59 per share. Note that this is after
deducting the present value of the debenture obligations that the firm is carrying.
(ii) Suitability
Asset valuation is usually regarded as most suitable for a controlling interest as minority
holders would not be in a position to realise asset values. The figure presented could be
viewed as a break-up value of the business (net realisable value) and the minimum the owners
are likely to accept, or a cost of setting up the business from scratch (replacement cost) by
buying individual assets.
1086
Whichever view is taken it must be remembered that goodwill is excluded from these figures.
Much here will depend upon the companys past trading record, its market position, the
quality of its management and the likelihood of their remaining after the takeover as well as
your own managerial skills in the domestic appliances business. Although various procedures
are available to value goodwill (e.g. a super profits approach), they are very subjective and the
price you are prepared to pay on top of asset value is a matter of judgment and negotiation. It
is worth noting, however, that asset value is considerably below the PE ratio valuation.
Asset values are subjective and further independent verifications of the fixed asset figures
would be welcome, particularly in the light of the current state of the property market. Details
of any disposal costs would also be helpful.
The figure included for net current assets is very much a guess and a detailed breakdown of
their composition would be useful. Details of raw materials, work in progress and finished
goods would be particularly helpful, especially when taking a net realisable value view of the
business, as inventory is often of little value on disposal.
5 Conclusion
(a) Valuation
As stated in the introduction, the figures provided are estimates and should be considered a
framework for negotiation.
If you are able to take a majority stake, asset value will most likely form the minimum
valuation. Even so, the existing owners of Bertram are unlikely to sell without considering
future earnings potential.
For a minority interest the PE ratio approach applied to the earnings after extraordinary items
would probably give the most realistic valuation as it avoids the problems of estimating future
dividend growth.
It should be appreciated that you are likely to pay a higher price per share for a controlling
interest than for a minority stake.
(b) Further information
Much of the necessary further information has already been requested. However, several
other items also need to be considered.
(i) Is the acquisition of Bertram for strategic reasons or is it purely an asset-stripping
investment? In the former case synergistic effects would need to be considered in
more detail; in the latter case, asset values are more pertinent.
(ii) Are the directors of Bertram likely to defend the acquisition? This could lead to a
higher price.
(iii) What is the quality of the management team of Bertram and how easily could they
be replaced by BIGs existing staff? It is only through the management team that
you can secure future earnings.
1087
Appendix 1
Dividend valuation
Using the constant growth approach
D
o
= $5m
k
s
= 16%
g = 10%
Po
=
g k
g) (1 D
s
0
+

=
0.10 0.16
0.10) 5m(1
+

= $91.67m
Price per share =
shares 40m
91.67m

= $2.29 per share
If the cost of equity were increased by (say) 25% to reflect the non-marketability of the private
companys shares, these figures would reduce to
Po
=
10 . 0 20 . 0
m(1.10) 5

= $55m in total and $1.375 per share
Appendix 2
Price earnings ratio valuation
PE ratio = 8.00
Earnings before extraordinary items = $20.30m
Market value = 20.30m 8.00 = $162.40m
Price per share =
shares 40m
162.40m
= $4.06
If the PE ratio were reduced by (say) 25% to reflect the non-marketability of the private companys
shares, these figures would reduce to
$20.30m 6 = $121.8m in total and $3.045 per share
1088
Appendix 3
Asset based valuation
$m $m
Market value
Land and buildings 25.000
Plant and equipment 31.000
Estimated market value net current assets 46.375 (note 1)

102.375
Less Market value of debt 33.804 (note 2)
Value of warehouse not required 5.000 (note 3)

(38.804)

63.571

Net value per share
m 40
571 . 63
= $1.59 per share
Notes
(1) Net current assets valued at 50% of book value. This is very much a guess and much will
depend upon their make-up.
(2) Present value of debenture holders claim is the present value of future interest and principal
payments at market interest rates
$m
Interest payments $30m 0.14 3.170 13.314
Principal payment $30m 0.683 20.490

33.804

(3) You will not require the warehouse. Therefore, it should not be purchased but left for the
existing owners to dispose of. Alternatively, you could pay $5m more which could be
recouped by a subsequent sale.
Appendix 4
Value of surplus warehouse
$m
Proceeds from sale 5.00
Less Tax 0.33 $(5m 3m) (0.66)

4.34

1089
Answer 43 TWELLO PLC
(a)
(Tutorial note: a wide range of ratios can be calculated, but time will restrict the number
which can be done. Major ratios should be calculated, and presented in logical groupings.)
19X5 19X6 19X7 19X8
Profitability:
ROCE 22/118 25/165 40/149 54/171
18.6% 15.2% 26.9% 31.6%
Operating profit margin 22/742 25/859 40/961 54/1,028
2.96% 2.91% 4.16% 5.25%
Total asset turnover 742/222 859/268 961/299 1,028/334
3.34 3.21 3.21 3.08
Liquidity:
Current ratio: 76/104 94/103 1031/50 101/163
0.73 0.91 0.69 0.62
Acid Test: 33/104 48/103 54/150 49/163
0.32 0.47 0.36 0.30
Payables days 32 days 25 days 32 days 32 days
Financial Gearing: debt/equity 25/118 25/165 67/149 65/171
21% 15% 43% 38%
Earnings per share 26.0c 28.3c 38.3c 51.7c
P/E Ratio 11.5 12.4 11.5 10.1
With such limited information, a complete analysis is not possible. However, the following
observations can be made.
Profitability: this would have to be compared with other companies in a similar
business. However, ROCE does appear to be high and rising.
Profit/sales appears low, but one would need to compare this with Twellos competitors.
Again, it is improving, which reduces any concern.
Asset turnover has fallen from 3.34 to 3.08 which is not encouraging. Without knowing the
industry it is not possible to determine how serious this is, but if the business only produces
3% 5% return on sales, it requires a much higher asset turnover.
Liquidity: both Current ratio and Acid test appear to be low. Nevertheless, Twello has lived
with these figures for four years without the share price suffering. The slight deterioration in
both these ratios should not be allowed to continue. The trade accounts payable were further
studied because of the low ratios, but accounts payable appear to be being paid promptly.
Financial gearing appears not to be excessive although it has increased. EPS has risen in each
of the last three years, quite substantially in the last two. This is encouraging. The share
price has risen steadily, but it would have to be compared with the market generally, and the
segment in particular, before any opinions could be expressed. The P/E ratio has fallen over
the period.
The interest payable exceeds the interest receivable by $5m and $6m in the last two years.
Comparing the amounts invested with the amounts borrowed, it would be worth investigating
further to see if the policy of having both borrowings and investments is sound.
1090
Overall it is difficult to draw any firm conclusions as to Twellos financial health. Whilst its
liquidity and return on sales ratios might appear weak for a manufacturing company, they
could be normal for a retailer.
(b) Other information
(1) Twellos business.
(2) Comparable figures for similar companies.
(3) Share price movements in company sector for 19X58.
(4) Price level changes for 19X58.
(5) Cash flow statements.
(6) Current cost accounts.
(7) Chairmans statement regarding future plans.
(8) Directors shareholdings and details of any management share option scheme.
(9) Details of any developments since the last accounts.
(10) Details of labour relations in Twello.
(11) Age and experience of management team.
(12) Information regarding the market in which Twello operates.
(c)
Deep discount bonds are bonds offered at a substantial discount to their nominal value.
Advantages accrue to both the company and the investor.
Company advantages
(1) Low interest rate is paid.
Investor advantages
(1) They are likely to remain in issue for their full life, an early call being unlikely.
(2) Gain on redemption may be treated as a capital gain, with tax advantages. Some tax
authorities amortise the discount and treat this amount as taxable income.
(3) Yield to redemption can be calculated more accurately, as the annual interest
received is less (therefore the uncertainties of reinvestment returns are less).
Zero coupon bonds are the extreme deep discount bond.
1091
The redemption yield of a 4% bond issued at $50 and redeemed in 17 years time is found by
solving for r in the following:
$50 = 4 4 4 ............. 4+100
+ + +
1+r (l+r)
2
(l+r)
3
(1 + r)
17

Try 11 % discount rate:
PV of an annuity of $4 for 17 years is $4 7.549 $30.20
PV of $ 100 in 17 years time is $1 00 0. 170 $17.00

Total $47.20
Issue ($50.00)

NPV (2.80)
Try 8 % discount rate:
PV of an annuity of $4 for 17 years is $4 9.122 $36.49
PV of $ 100 in 17 years time is $100 0.270 $27.00

Total $63.49
Issue ($50.00)

NPV 13.49
Redemption yield = 8% + 13.49
3% = 10.5 %
13.49 + 2.80
1092

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