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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 10 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 is marginal i.e. it is small relative to the size of the company. Taken together the two projects are not marginal, but this is not a crucial assumption as long as the costs of debt or equity do not alter because of the size of the financing required.

(ii)All cash flows of the project are level perpetuities. This is unrealistic for “real world” projects, but again makes little difference to the validity of the estimated weighted average cost of capital.

The remaining two assumptions are of more importance:

(iii)The project should be financed in a way that does not alter the company’s 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.

Crestlee’s existing capital structure using market values is:

 

£m

30 million ordinary shares at 380 pence

114.00

£56 million debentures at £104

58.24

 

_____

 

172.24

 

_____

If the two investments are considered as a “package”:

 

£m

New finance being raised

9.275 equity

£56 million debentures at £104

4.725 debt

 

_____

 

14.000 m

 

_____

%

66

34

%

66

34

The company’s 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 company’s existing operations. As the textile investment is an existing operations it is reasonable to assume that it has the same systematic risk. The diversification into packaging could have very different risk characteristics. The company’s existing weighted average cost of capital should not be used as a discount rate for the diversification.

1021

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.

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 βd = 0)

βa

=

βe ×

 

E

 

= 1.3

×

72

= 1.124

E+D(1-t)

72 +168.(1− 033.)

Ungearing Sealalot

 

 

 

 

 

βa

=

1.2 ×

 

138

 

 

=

1.129

 

 

138+13(1− 033.)

 

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

1022

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Regearing for Crestlee’s capital structure

 

βe = βa ×

E + D(1- t)

= 1.125 ×

114 +5824.(1− 033.)

= 1.51

E

114

 

 

 

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

4

= 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.

1023

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Gearing of freezer industry

(MV)

 

 

 

 

 

 

 

 

 

 

Equity

£192m

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt

£40.lm

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

To de-gear industry beta:

 

 

 

 

 

 

 

 

 

 

 

 

 

βu

 

 

 

 

 

E

 

 

 

 

 

 

 

 

 

 

 

 

 

=

 

 

 

 

 

 

βe

 

 

 

 

 

 

 

 

 

 

 

 

 

 

E + D(I T)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

=

 

 

 

 

192

 

 

× 1.175

 

 

 

 

 

 

 

 

 

 

 

192+ 40.1(0.65)

 

 

 

 

 

 

 

 

 

 

 

=

 

192

 

1.175 =

1.035

 

 

 

 

 

 

 

 

 

 

 

 

218

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gearing of Hotalot (MV)

Equity £33.92m

Debt £ 1 7.4m

 

 

To re-gear for Hotalot;

 

 

 

 

 

 

 

 

 

 

 

 

 

βe = βu (1 + (1 – t)

D

) =

1.035 (1 +

74(0.65)

) = 1.38

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

E

 

 

 

33.92

 

 

 

 

 

 

Required return

= Rf + (Rm – Rf)Beta =

 

9% + (16% – 9%)1.38

 

 

 

 

 

 

 

= 9% + (7%)1.38

 

=

 

 

9% + 9.66%

 

=

18.66%

This is the required rate of return for Hotalot’s equity investment in freezers.

 

The WACC required is therefore Ke

 

E

 

+ Kd(l – t)

 

D

 

 

 

E + D

E

+ D

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

18.66%

33.92

+9.5%(1–0.35)

17.4

 

= 12.33 + 2.09 = 14.43%

 

 

 

 

51.32

 

 

 

 

 

 

 

 

 

 

 

 

51.32

 

 

 

 

 

 

 

 

 

 

 

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

1024

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The asset beta (ungeared) is determined by:

 

 

βu

= βe

 

 

E

+ βd

D(1- t)

 

 

E + D (1-t)

E + D(1- t)

 

 

 

βu

=1.175 ×

 

 

192

 

+0.06 ×

 

40(1 0.35)

192+ 40(1-0.35)

192+ 40(1-0.35)

 

 

 

 

 

Re-gear: solve for Be using Hotalot’s gearing:

 

 

βu

= βe

 

 

E

+ βd

D(1- t)

 

 

E + D (1-t)

E + D(1- t)

 

 

 

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

Be

= 1.367

 

 

 

 

 

Ke

= 9% + (16% – 9%) 1.367

=

18.57%

WACC

=18.57%

33.92

+ 9.5% (1–0.35)

17.4

 

 

51.32

 

 

51.32

 

 

 

=

12.27 + 2.09

 

= 14.36%

 

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.

1025

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

(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)

 

 

 

£5,000 ÷ 0.482 =

 

£10,373

(f)

 

 

 

(£8 × 3.791) + (£100 × 0.621) =

 

£92.43

Answer 13 TANTALUS LTD

 

 

(a)Net present value Project 1

 

Year

Cash

Discount

Present

 

 

flow

factor

value

 

 

£

at 15%

£

Machinery

0

(11,120)

1.000

(11,120)

Cash inflows

1–5

4,000

3.352

13,408

Residual value

5

1,120

0.497

557

 

 

 

 

———

Net present value

 

 

 

2,845

 

 

 

 

———

1026

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Project 2

 

 

 

 

 

Year

Cash

Discount

Present

 

 

flow

factor

value

 

 

£

at 15%

£

Machinery

0

(32,320)

1.000

(32,320)

Cash inflows

1–5

10,000

3.352

33,520

Residual value

5

6,020

0.497

2,992

 

 

 

 

———

Net present value

 

 

 

4,192

 

 

 

 

———

(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.

Project 1

 

 

 

25%

Project 2

 

 

 

20%

WORKINGS

 

 

 

 

Project 1

 

 

 

 

 

Year

Cash

Discount

Present

 

 

flow

factor

value

 

 

£

at 25%

£

Machinery

0

(11,120)

1.000

(11,120)

Cash inflows

1–5

4,000

2.689

10,756

Residual value

5

1,120

0.328

367

 

 

 

 

———

 

 

 

 

3

 

 

 

 

———

Project 2

 

 

 

 

 

Year

Cash

Discount

Present

 

 

flow

factor

value

 

 

£

at 20%

£

Machinery

0

(32,320)

1.000

(32,320)

Cash inflows

1–5

10,000

2.991

29,910

Residual value

5

6,020

0.402

2,420

 

 

 

 

———

10

———

(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.

1027

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

 

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 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).

1028

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(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

(2)Material Alpha

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

Time 0 cost

50p × 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 × 90p

=

£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

× 50p

= £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.

1029

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.

1030

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