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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Textile expansion

The discount rate may be based upon the company’s weighted average cost of capital (given that assumptions (iii) and (iv) are not violated).

WACC = Ke E +ED + Kd (1 – t) E D+ D

Using the capital asset pricing model Ke may be estimated by

RF + (RM – RF)βe

Ke = 6% + (14% – 6%) 1.2 = 15.6%

Kd is taken as the current cost of loan stock, 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 Crestlee’s financial risk.

These are both significantly different from Crestlee.

Ungearing Canall (assuming debt is risk free and βd = 0)

These are very similar. The ungeared equity beta of the packaging industry will be assumed to be 1.125.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

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%

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. If the project fails there is no risk (the company has a certain failure!).

The other board member is incorrect. If the same discount rate is used throughout a project’s 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 11 HOTALOT

(a)Explanation of terms

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

The alpha value measures the abnormal return on a share. Hotalot’s shares are currently earning 1.5% more than would be expected from the firm’s beta. The average alpha for the market is zero. An investor should buy Hotalot’s shares until the price rises and the alpha falls to zero. The alpha of 1.5% will only be temporary.

(b)Estimation of discount rate

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

1.1+1.25+1.30+1.05

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= 1.175

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

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Hotalot should use a discount rate of 14.43% for the appraisal of its diversification into freezer production.

(c)Risk associated with corporate debt

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

Research by the Bond Investors Association says the default rate in “junk bonds” during the 1980s was running at 11.2%. Between 1980 and 1989, 631 corporate bond issues worth $30.1 billion defaulted.

As Hotalot only pays 9.5% compared with a risk-free rate of 9% we can assume Hotalot debt to have a beta value of 0.06, say

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

33.9217.4(1 0.35)

1.04= βe 33.92+17.4(1-0.35) + 0.06 33.92+17.4(1-0.35)

1.04= βe (0.75) + 0.015

This compares with the previous WACC of 14.43%, which as stated above was overestimated.

(d)Systematic and unsystematic risk

The Capital Asset Pricing Model assumes that shareholders are well diversified, and therefore only concerned with systematic risk. However, Hotalot’s shareholders may not all be well diversified, and may be concerned with the specific risk applicable to Hotalot.

Even well diversified shareholders should not completely ignore unsystematic risk. The total risk of a company, both systematic and unsystematic risk, determines the probability of bankruptcy, which can incur significant costs for equity investors.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Answer 12 BASIC DISCOUNTING

(a)

(i)£30 × 0.909 + £40 × 0.826 + £50 × 0.751 + £60 × 0.683 + £70 × 0621 = £182

(a)Net present value Project 1

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)Internal rate of return

The internal rates of return of both projects must be higher than 15% as both projects have a positive net present value when discounted at 15%. By trial and error the internal rates of return can be found to be as follows.

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———

(c)Investment decision

This example illustrates the conflict which will often be found between the two discounted cash flow appraisal techniques in a ranking decision.

Under the net present value criterion, Project 2 is preferred because it has a higher net present value when the project cash flows are discounted at the cost of capital. On the other hand Project 1 has the higher internal rate of return.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

To decide which method of ranking is correct it is necessary to consider the assumed objective of the firm, which is to maximise the wealth of the providers of finance. Both projects earn more than the required rate of return but Project 2 generates larger cash surpluses in excess of the required amounts than project 1, as can be seen from the net present value calculations. It is these cash surpluses which improve the wealth of the owners of the firm and thus Project 2 is to be preferred to Project 1.

This argument implies that the IRR decision criterion gives the wrong answer in this ranking situation. This can be justified as follows.

Project 1 is relatively more profitable than Project 2, but it is smaller. The two projects are mutually-exclusive, which means that only one of them can be accepted. It is better for the owners of the company to receive the larger cash surpluses from a large adequately profitable project than to receive the smaller cash surpluses from a small very profitable project. Taken to extremes, a return of 10% on £1,000 is better than a return of 1,000% on a penny.

Answer 14 HULME LTD

(a)Cash flows resulting from manufacture and sale of Champs

————

On the basis of the estimates given, production of Champs is worth while.

Note: Time 0 is taken to be the date on which manufacture would commence, i.e. 1 January 19X0; time 1 is 31 December 19X0, etc.

WORKINGS

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

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(1)Labour cost

(2)Material Alpha

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

(3)Material Beta

Quantity held is enough for one year.

(4)Overheads

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

(5)Sales

The selling price rises at 10% per annum.

(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.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(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.

(3)Material Alpha

Alpha is used regularly by the company on many projects. If existing inventory is 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 year’s 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 90p 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 company’s 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.

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