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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 13 TANTALUS LTD

Tantalus Ltd is considering the selection of one of a pair of mutually-exclusive investment projects. Both would involve purchase of machinery with a life of five years.

The cost of capital is 15% per annum.

Required:

(c)Assuming that the cash flows of both projects are subject to identical levels of risk and

that there will be no problem in raising sufficient funds to finance either project, which

Hulme Ltd is considering the manufacture of a new product, the Champ, to add to its existing range. Manufacture would commence on 1 January 19X0 and 100,000 Champs would be produced and sold each year for three years. The directors of Hulme Ltd expect to be able to charge a price of £6 per Champ during 19X0 and to increase the price during 19X1 and 19X2 in line with increases in the Retail Price Index. The Index is expected to increase in the future at an annual compound rate of 10%.

The following costs are involved in producing Champs.

Labour. Each Champ requires 1/4 hour of skilled labour and 1/2 hour of unskilled labour. Current (1 January 19X0) wage rates are £3 per hour for skilled labour and £2 per hour for unskilled labour. For 19X0 only Hulme Ltd expects to have 100,000 surplus hours of unskilled labour. Whether or not Champs are manufactured, the employees concerned will be retained and paid by the company. All labour costs are expected to increase at an annual compound rate of 20%.

Materials. Each Champ requires 2 kgs of Alpha and 1 kg of Beta. Hulme Ltd currently holds in inventory 200,000 kgs of Alpha and 100,000 kgs of Beta. The inventory of Alpha originally cost £0.40 per kg and has a current realisable value of £0.30 per kg. The current buying price is £0.50 per kg. The inventory of Beta originally cost £0.80 per kg and has a current realisable value of £0.90 per kg. The current buying price is £1.10 per kg. Alpha is used regularly by the company on many products. Beta is used rarely and the only use for the existing inventory, if it is not applied to the manufacture of Champs, is to sell it immediately.

Materials required to manufacture Champs must be purchased and paid for annually in advance. Replacement costs and realisable values of Alpha and Beta are expected to increase at an annual compound rate of 10%.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Overheads. It is the policy of the company to allocate all overhead costs to its various products. The calculated overhead cost per unit for Champs, at current price, is as follows.

1.50

——–

Head office costs and variable overheads are expected to increase in line with the Retail Price Index. The machine required to manufacture Champs was bought some years ago. Its current book value is £90,000, and the above depreciation charge is based on a remaining life of three years at the end of which the machine will have no scrap or re-sale value. If it is not used to produce Champs the machine will be sold immediately for £150,000.

Hulme Ltd has a cost of capital of 20% per annum in money terms.

Assume that all receipts and payments (except costs of materials and machine sale proceeds) will arise on the last day of the year to which they relate.

Assume also that input prices will change annually on 31 December.

Required:

(a)Prepare calculations showing whether Hulme Ltd should undertake production of the

(c)Comment on factors which are not included in your calculations but which may affect

Amble plc is evaluating the manufacture of a new consumer product. The product can be introduced quickly, and has an expected life of four years before it is replaced by a more efficient model. Costs associated with the product are expected to be:

Direct costs (per unit)

Labour:

3.5 skilled labour hours at £5 per hour.

4 unskilled labour hours at £3 per hour.

Materials:

6 kilos of material Z at £1.46 per kilo. Three units of component P at £4.80 per unit. One unit of component Q at £6.40.

Other variable costs: £2.10 per unit.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Indirect costs:

Apportionment of management salaries £105,000 per year. Tax allowable depreciation of machinery £213,000 per year. Selling expenses (not including any salaries) £166,000 per year. Apportionment of head office costs £50,000 per year.

Rental of buildings £100,000 per year. Interest charges £104,000 per year.

Other overheads £70,000 per year (including apportionment of building rates £20,000).

(Note: rates are a local tax on property.)

If the new product is introduced it will be manufactured in an existing factory, and will have no effect on rates payable. The factory could be rented for £120,000 per year (not including rates), to another company if the product is not introduced.

New machinery costing £864,000 will be required. The machinery is to be depreciated on a straightline basis over four years, and has an expected salvage value of £12,000 after four years. The machinery will be financed by a four year fixed rate bank loan, at an interest rate of 12% per year. Additional working capital requirements may be ignored.

The product will require two additional managers to be recruited at an annual gross cost of £25,000 each, and one manager currently costing £20,000 will be moved from another factory where he will be replaced by a deputy manager at a cost of £17,000 per year. 70,000 kilos of material Z are already in inventory and are not required for other production. The realisable value of the material is £99,000.

The price per unit of the product in the first year will be £110, and demand is projected at 12,000, 17,500, 18,000 and 18,500 units in years 1 to 4 respectively.

The inflation rate is expected to be approximately 5% per year, and prices will be increased in line with inflation. Wage and salary costs are expected to increase by 7% per year, and all other costs (including rent) by 5% per year. No price or cost increases are expected in the first year of production.

Corporate tax is at the rate of 35% payable in the year the profit occurs. Assume that all sales and costs are on a cash basis and occur at the end of the year, except for the initial purchase of machinery which would take place immediately. No inventory will be held at the end of any year.

Required:

(a)Calculate the expected internal rate of return (IRR) associated with the manufacture of

(b)What is meant by an asset beta?

If you were told that the company’s asset beta is 1.2, the market return is 15% and the risk free rate is 8% discuss whether you would recommend introducing the new product

(5 marks)

(c)Amble is worried that the government might increase corporate tax rates.

Show by how much the tax rate would have to change before the project is not financially viable. A discount rate of 17% per year may be assumed for part (c).

(5 marks)

(25 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 16 DARON

The senior managers of Daron, a company located in a European country, are reviewing the company’s medium term prospects. The company is in a declining industry, and is heavily dependent on a single product. Sales volume is likely to fall for the next few years. A general election will take place in the near future and the managers believe that the future level of inflation will depend upon the result of the election. Inflation is expected to remain at approximately 5% per year if political party A wins the election, or will quickly move to approximately 10% per year if party B wins the election. Opinion polls suggest that there is a 40% chance of party B winning. An increase in the level of inflation is likely to reduce the volume of sales of Daron.

Projected financial data for the next five years, including expected inflation where relevant, are shown below.

*A bracket signifies a decrease in working capital:

Tax allowable depreciation will be negligible after 2001 in both cases.

Cash flows after year 2001, excluding tax savings from tax allowable depreciation, are expected to be similar to year 2001 cash flows for a period of five years, after which substantial new fixed investment would be necessary in order to continue operations.

Working capital will remain approximately constant after the year 2001.

Corporate taxation is at a rate of 30% per year, and is expected to continue at this rate. Tax may be assumed to be payable in the year that the income arises.

Daron’s current ordinary share price is 92 centos (100 centos = $1).

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a)Using the above data, prepare a report advising the managers of Daron which, if any, of the three alternatives to adopt. Include in your report comment on any weaknesses/ limitations of your data analysis. Relevant calculations, including:

(i)estimates of the present values of future cash flows from existing operations; and

(ii)the estimated adjusted present value (APV) of diversifying into the hotel industry

should form appendices to your report.

The book value and market value of debt may be assumed to be the same. State clearly any other assumptions that you make. (32 marks)

(Approximately 20 marks are available for calculations and 12 for discussion)

(b)Details of the possible convertible debenture issue for the purchase of the hotel are shown below:

10% $100 convertible debentures 2010, issued and redeemable at par. The debentures are convertible into 60 ordinary shares at any date between 1 January 2002 and 31 December 2004. The debentures are callable for conversion by the company subject to the company’s ordinary share price exceeding 200 centos between 1 January 2002 and 31 December 2004 and puttable for redemption by the debenture holders if the share price falls below 100 centos between the same dates.

Required:

Discuss the implications for Daron if the diversification is financed with convertible

The British Industrial Group plc (BIG), a large conglomerate, is considering acquiring an interest in Bertram Ltd, a private company. You have been asked by the directors of BIG to advise them on the value of Bertram Ltd’s shares.

Bertram Ltd has manufactured domestic appliances since its incorporation in the 1940s. In recent years its management have adopted a policy of maintaining dividend growth at approximately 10% pa. Bertram Ltd’s summarised accounts for the years ended 31 December 19X9, 19X10 and 19X11 are as follows:

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

Produce a report for the directors of BIG which uses three different techniques to value the shares in Bertram Ltd which are to be acquired. In each case describe the circumstances in which the technique is appropriate and state any additional information that you would require.

(30 marks)

Question 18 BIGUN PLC

The acquisition committee of Bigun plc is considering making takeover bids for two competitors, Klein plc and PTT Ltd.

Summarised financial data is given below for the three companies.

Statement of Financial Position s as at 31 March 19X12

1of which £5m cash

2£1 ordinary shares

38% debentures 19X25 – 19X28 currently trading at £80

411% debentures 19X12 – 19X14 currently trading at £110

57 year 10% bank loan

The corporation tax rate is 35%.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Additional information:

(1)The realisable value of inventory is believed to be 90% of its book value.

(2)Land and buildings, with a book value of £4 million were last revalued in 1989.

(3)The directors of the company and their families own 25% of the company’s shares.

Assume that the following events occurred shortly after the above financial information was produced.

7 September – BZO makes a bid for Demast of two ordinary shares for every three shares of Demast. The price of BZO’s ordinary shares after the announcement of the bid is 710 pence. The directors of Demast reject the offer.

2 October – Nadion makes a counter bid of 170 pence cash per share plus one £100 10% convertible debenture 2008, issued at par, for every £6.25 nominal value of Demast’s shares. Each convertible debenture may be exchanged for 26ordinary shares at any time between 1 January 1997 and 31 December 1999. Nadion’s share price moves to 335 pence. This offer is rejected by the directors of Demast.

19 October – BZO offers cash of 600 pence per share. The cash will be raised by a term loan from the company’s bank. The board of Demast are all offered seats on subsidiary boards within the BZO group. BZO’s shares move to 680 pence.

20 October – The directors of Demast recommend acceptance of the revised offer from BZO.

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