seminar5materials / P4AFM-RQB_PDF_d08 / P4AFM-RQB-As_d08

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 1 PROGROW PLC

(a)Report on new machine purchase or expansion of garden tool production

From a financial perspective the alternative investments may be compared by using the expected net present values of their incremental cash flows. On this basis expansion of garden tool production would be the favoured alternative as its expected NPV is £277,200, compared with £38,100 from introducing the new jack production process. The two investments have been discounted at different rates as they are of different risk.

Before making a decision we would draw your attention to a number of factors. Investment decisions should not be made purely on financial grounds. In this case the new process will involve making 50 workers redundant which could adversely affect the working relationships and motivation within your company.

Your concern about the possible effect on your share of the jack market may be well founded. If your competitors adopt the new process and are able to cut their prices you could lose market share unless you are able to cut your prices, which will reduce profitability and cash flow. Information is needed on your likely price of jacks if you do not introduce the new process.

The likely future developments in the garden tool markets and jack markets should be considered. If one market is likely to have better future opportunities then this should influence your decision. The likely cash flows after the initial five-year period will be important.

The expected NPVs are subject to a margin of error. As long as the technical specification and reliability of the new jack production process is well proven, the projections for the jack process are likely to be more accurate as you are not expanding sales. The garden tool projections assume that you can sell the extra 70,000 units at the same price, which may not be possible.

A major concern is the lack of any data about the need for extra working capital to accompany the increase in production, or information about whether any additional management or supervisory staff will be required, or if there are incremental overheads associated with the production process. The existing data might under-estimate the cash outflows associated with the expansion.

As both investments produce positive expected net present values might it not be possible to construct an extension to your existing premises in order to create enough space to undertake both? Obviously the cost of this would need to be taken into account, but it might also give the company the flexibility to take advantage of future opportunities.

1001

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Appendix

Incremental cash flows from the introduction of the new jack process

The expected NPV of incremental cash flows from the introduction of the new jack production process is: £38,100

Expansion of garden tool production

Incremental cash flows

Expected net present value is: £277,200

1002

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

For jack manufacture

If the overall beta equity of Progrow is 1.3, and the beta equity of garden tools is 1.018, with garden tools representing 60% of the value of the company, the beta equity of jacks is estimated by:

1.3 = 1.018 × 0.6 + beta equity jacks × 0.4

beta equity jacks = 1.723

WACC = 19.06%× 46,,186536 + 7.6%× 16,,650186 =16%

Apportioned salaries and head office overhead are irrelevant.

Interest costs are not a relevant cash flow as the costs of any financing are encompassed within the discount rate.

(b)Validity of comments

(i)NPV

The managing director’s daughter is correct that NPV does not take into account any future options arising from investment decisions. Such options could lead to additional NPVs and could influence the decision process. The valuation of options from capital investments that might occur in several years time is, however, extremely difficult and is known as real options pricing theory For most companies it is enough to have an awareness of the nature of the possible options that might exist, and to use this qualitative information in the decision process.

NPV is not a perfect method of investment appraisal, but in a reasonably efficient market where the results of the investment decisions of managers (i.e. the expected NPVs) are quickly and accurately reflected in changes in a company’s share price it is a valid technique to use as part of the strategic investment decision process. Non-financial factors are also important.

(ii)Betas

The capital asset pricing model does have theoretical and practical weaknesses. These include:

The basic model is single period whereas most investment decisions are multiperiod.

It is based upon perfect capital market assumptions.

The use of historic data to estimate beta assumes that the future beta will be the same as the past which may not be the case.

The required data may be difficult to obtain. What is the appropriate risk free rate? How can the risk and return of the market as a whole be established?

1005

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Evidence suggests that CAPM does not provide a satisfactory measure of risk against return for small companies, low P/E ratio companies, very high or low beta securities, and the returns in certain months of the year and days of the week.

The model considers the level of return required by shareholders but ignores any preference that they might have for income in the form of dividends and capital gains, which may be subject to different tax treatment.

It assumes that shareholders are well diversified and are only interested in systematic risk.

Other factors besides systematic risk are likely to influence the required returns of shareholders. The arbitrage pricing theory does not suffer from many of the theoretical weaknesses of CAPM, and suggests that the required return is a function of a number of factors, such as interest rates, inflation rates and growth in industrial production. Unfortunately identifying the nature or number of relevant factors is extremely difficult, and the model has not been developed in a form that can be easily applied to aid practical capital investment decisions.

Despite its limitations, CAPM provides a simple and reasonably accurate way of expressing the relationship between risk and return, and offers a practical means of estimating the discount rate to be used in the appraisal of capital investments.

Answer 2 JETTER PLC

(a)

CAPM may be used to estimate whether or not the projects are expected to yield a high enough return relative to their systematic risk.

Beta = Correlation coefficient×project standarddeviation

Marketstandarddeviation

All three projects are expected to generate satisfactory returns relative to their systematic risk. Other things being equal, the project with the highest expected NPV should be selected. However, NPVs cannot be estimated from this data.

It is recommended that investment 2 is selected as it is the largest investment in terms of initial outlay, and also has the largest expected abnormal return.

The investment of any surplus funds in the money market is irrelevant as such investment has an expected NPV of zero (assuming the money market is efficient).

1006

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)

A profitability index of 1·3 on an investment of £40 million implies a present value of cash inflows of £52 million (£40m × 1·3), and a NPV of £12 million ((£40m × 1·3) – £40m).

The discount rate that will produce a present value of £52 million may be found by solving:

1652 = 3·25

Using PV of annuity tables, the discount factor for four years giving a PV annuity value of 3·25 is slightly below 9%.

The beta required to produce a discount rate of 9% is approximately 0·33.

The estimated beta is too high.

(c)The current gearing using market values is:

Equity, 200 million shares × £2·20 = £440 million

The market price of debt is £71m × £105·50£100 = £74·91 million

The cost of equity is estimated to be: 6% + (15% – 6%) 1·25 = 17·25%

The cost of debt may be estimated from the redemption yield of existing long-term debt.

The cost of debt is approximately 6·8%

1007

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Jetter’s cost of capital is 15·73%

The new investment is not likely to alter the gearing of the company significantly, as the investment is financed by internal funds, which, in theory, does not alter gearing but only changes the nature of the company’s assets. The £12m NPV is likely to accrue primarily to the shareholders and might reduce gearing slightly as the value of equity increases.

The risk of the new project appears to be very low (asset beta of 0·33; given the company’s gearing, the equity beta would only be a little higher than this), which will reduce the overall equity beta of the company, and the cost of equity. The overall effect is likely to be a small decrease in the weighted average cost of capital.

(d)

(i)

Betas estimated from standard regression techniques may not provide the best estimate of a company’s true beta. High betas are argued to be overestimated, and low betas to be underestimated. Additionally estimation errors are likely to be greater in small companies than in large companies. Adjusted betas have been suggested to try to reduce estimation errors and produce a more accurate beta. The suggested adjustment lowers betas of more than 1 and increases betas of less than 1.

Project 2 would not have a high enough expected return, and would no longer be the project selected.

(e)

CAPM suggests that a simple linear relation exists between beta and expected return. It may be used to estimate the cost of equity (hence the required rate of return) to be used as part of the discount rate of capital investments. However, CAPM is based upon a series of restrictive assumptions including:

Investors are only interested in the mean and variance of their expected returns

Investors have the same beliefs about the mean and standard deviations of portfolios

1008

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Investors have the same one period time horizon

There are no taxes or transactions costs

Investors can borrow or lend at the risk free rate

No individual investor can influence the market price of a security

Additionally CAPM is an ex-ante model, but the data used in the model are normally ex-post.

Empirical tests of CAPM suggest that company size, market to book value ratios, price earnings ratios, dividend yields and long-term contrarian strategies are to some extent related to expected returns, not just beta. However, there is debate (e.g. by Roll) about whether CAPM can actually be tested.

Another view is that returns are influenced by behavioural bias by investors e.g. bias against companies with low market to book value ratios.

Despite its theoretical limitations CAPM is relatively easy to apply and is widely used in capital investment decisions.

APT is a multi-factor model that assumes that returns on investments are generated by a number of industry and market factors, rather than just within a mean-variance framework. It relies upon less restrictive assumptions than CAPM and allows for the possibility that investors may hold different types of risky portfolios. Unfortunately there is little agreement on what the factors are that explain returns, hence the model is difficult to apply to capital investment decisions.

Answer 3 STRAYER PLC

(a)

Assuming the risk of companies in the printing industry is similar to that of Strayer’s new investment, the beta of the printing industry will be used to estimate the discount rate for the base case NPV. Ungearing the beta of the printing industry:

Using the capital asset pricing model:

Ke ungeared = 5·5% + (12% – 5·5%) 0·706 = 10·09% or approximately 10%

Financing side effects relate to the tax shield on interest payments, the subsidised loan, and issue costs associated with external financing.

1009

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Tax relief:

£5 million 8% loan. Interest payable is £400,000 per year, tax relief is £400,000 × 0·3 = £120,000 per year

£4 million subsidised loan. Interest is £240,000 per year, tax relief £72,000 per year.

Total annual tax relief £192,000 per year.

The present value of this tax relief, discounted at the risk free rate of 5·5% per year is:

£192,000 × 7·541 = £1,447,872

(The tax relief on interest payments allowed by government is assumed to be risk free. The mid-point between 5% and 6% in annuity tables is used. N.B. discounting at a rate higher than the risk free rate could be argued, especially if the company might be in a non taxpaying position in some years.)

Subsidy:

The company saves 2% per year on £4,000,000 = £80,000 but loses tax shield of £24,000. Net saving = £56,000

As this is a government subsidy it is assumed to be risk free and will be discounted at 5·5% per year.

£56,000 × 7·541 = £422, 296

The adjusted present value is estimated to be:

(£1,562,500) + £1,447,872 + £422, 296 – £450,000 = £ (142, 332)

Based upon these estimates the project is not worthwhile.

(b)APV may be a better technique to use than NPV when:

There is a significant change in capital structure as a result of the investment.

The investment involves complex tax payments and tax allowances, and/or has periods when taxation is not paid.

Subsidised loans, grants or issue costs exist.

Financing side effects exist (e.g. the subsidised loan) which require discounting at a different rate than that applied to the mainstream project.

1010