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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Answer 15 AMBLE PLC

(a)Relevant cash flows (£000s)

(iii)Material Z, 72,000 kilos are required in the first year. The relevant cost is 70,000 kilos in inventory, opportunity cost £99,000 plus 2,000 kilos at £ 1.46 giving a total cost of £ 1 0 1,920.

(iv)Only incremental management salaries are relevant, the two new managers plus the replacement deputy manager.

(v)The opportunity rental of £120,000 is the relevant cost.

(vi)Other fixed overhead – the apportionment of rates is not a relevant cost.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Year 1 assumes the company has other profits.

When calculating IRR by trial and error, the use of 0% is a simple calculation, which gives some idea of the next percentage figure to try. As interpolation is usually more accurate than extrapolation the highest available percentage was tried. It was good fortune that this proved precisely correct.)

(b)

An asset beta is the weighted average of the beta of equity and the beta of debt. It reflects the company’s business risk. The difference between the company’s asset beta and its equity beta reflects the company’s financial risk. Only systematic risk is considered in an asset beta.

Using the CAPM, the required return is Rf + (Rm – Rf)Beta.

8% + (15% – 8%) 1.2 = 16.4%

Since the product returns 20%, which is considerably more than the required return of 16.4%, the product should be introduced.

However:

There may be non-financial factors which affect this decision.

The new product may have a higher systematic risk than the company as a whole.

Systematic risk is an appropriate measure only if either the company or the shareholder is well diversified.

The CAPM is subject to criticism, both at the theoretical level, and regarding the practical problems of data collection. The figure of 16.4% calculated, may therefore not be the appropriate rate.

(c)NPV using 17% discount rate

The product will cease to be viable when the NPV of the tax paid increases by £60,000.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The increase in the tax rate from 35% to 50% increases the PV of tax paid by 256 – 179 = £77,000. By interpolation it can be calculated that the PV of tax will increase by £60,000 at a tax rate of just under 47%.

If tax rates rose to 47%, the project would not be viable.

Answer 16 DARON

(a)Report for the managers of Daron

Any recommendation regarding the sale of the company to a competitor for $20 million should be made in the best interests of the shareholders. An offer of $20 million is an 8.7% premium over the current share price.

Estimates of the present values of future cash flows suggest that if party A wins the election the company’s equity value will be $16.3 million and only $7 million if party B wins. In this light the offer of $20m appears very attractive. .

However, these estimates are by no means precise. Inaccuracy could exist due to:

Incorrect inflation estimates.

Errors in sales volume and cost projections.

Inaccurate discount rate estimates.

The assumption of a constant 30% corporate tax rate.

Sensitivity analysis is recommended to analyse the significance of changes in key variables. The cash flow estimates do not incorporate any value for options relating to opportunities that might exist between now and 2006 if operations continue. Nor is there data on the expected realisable value of the company at year 2006. Even if further investment was not undertaken at that time, the present value of the realisable value of land, buildings and cash flow released from working capital needs to be considered. This would increase the above present value estimates.

Appendix 2 shows the financial estimates of the hotel purchase. An APV of $0.56 million suggests that the hotel investment is financially viable. However, this estimate is also subject to many of the possible inaccuracies noted above. The base case NPV is heavily influenced by the realisable value of $10 million in 2001. Future hotel values could vary substantially from this estimate.

Investment in the hotel industry is a strategic departure from the company’s core competence. If the objective is primarily to diversify activities to reduce risk this may not be in the shareholders’ best interest as they can easily achieve diversification of their investment portfolios, through unit trusts or similar investments. As the company is in a declining industry, in the long term diversification may be essential for survival. A medium to long term strategic plan should be formulated examining alternative strategies, and alternative investments which may offer better financial returns than the hotel investment, and/or be closer to the company’s existing core competence.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The estimated APV is the base case NPV plus the financing side effects.

(b)Implications of financing with convertible debentures

Daron’s current gearing, measured by the book value of medium and long term loans to equity is: 1422 or 63.6%

No information is provided about short-term loans which would increase this figure further. A $9 million convertible debenture issue would initially increase gearing to

2223 or 104.5%

a level that involves “high” financial risk especially for a company in a declining industry. The coupon rate of 10%, or $918,400 interest per year would have to be paid for five years or more. Convertible debentures normally carry lower coupon rates than straight debt. Daron can borrow long term from its bank at 10% per year, and the 10% coupon on the convertible appears to be expensive. However, this could be explained by the market seeking a relatively high return because of the size of the loan.

If conversion takes place the gearing level will fall, but this is not possible for at least five years. At the $100 issue price the effective conversion price is $10060 or 167 centos per share

This represents an average share price increase of 12.7% per year over five years, which is possible if market prices in general increase, but is by no means guaranteed.

The existence of the call and put options has potentially significant implications for Daron. The call option allows the company to limit the potential gains made by debenture holders. If the share price reaches 200 centos between 1 January 2002 and 31 December 2004 the company can force the debenture holders to convert, giving maximum capital gains on conversion of 33 centos per share (relative to the $100 issue price). This is a small gain and may not be popular with investors. If the share price falls below 100 centos between the same dates, the debenture holders can ask the company to redeem the debentures at par, forcing the company to find $9 million for repayment of the debentures. If the market price of the shares has only moved by a maximum of eight centos over five years, the company might experience difficulty refinancing the $9 million, leading to severe problems in finding the cash for redemption.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 17 BRITISH INDUSTRIAL GROUP

Report front page

To Directors of BIG plc

From Anne Analyst

Date Today

Subject Valuation of Bertram Ltd

Contents

1Terms of reference

2Dividend valuation

3Price earnings valuation

5Conclusion Appendices

1Terms 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.

2Dividend 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 company’s shares. The size of this adjustment is debatable but some reduction has to be made.

(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.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(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 company’s 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

103.12m20.3m × 15.3m10.3m

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.

3Price 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.

(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.

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