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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

EVA capital employed is based upon the book economic value of capital at the beginning of the relevant period. As there is no information on full adjustments, the book value of shareholders’ funds and medium and long-term debt, plus the value of non-capitalised leases, will be used.

The weighted average cost of capital is estimated using target capital structure:

2000 15% × 0·6 + 9% (1 – 0·35) × 0·4 = 11·34% 2001 17% × 0·6 + 10% (1 – 0·35) × 0·4 = 12·80% EVA 2000 = 56·6 – (233 × 0·1134) = $30·18 million EVA 2001 = 68·9 – (260 × 0·1280) = $35·62 million

Using the EVA measure the company has created significant value in both of the two years, and has apparently performed well.

(b)

If the EVAs for each year of an investment were summed over the entire life of the investment and then discounted, the result, in theory, should equal the net present value of the investment.

(c)Advantages of EVA include:

It measures the value added to an organisation after deducting a charge for the use of capital made by that organisation.

It is based on cash flows and is less easy to manipulate than accounting data.

EVA may be consistent with the objective of maximising shareholder wealth.

EVA can easily be communicated to, and understood by, managers and employees.

EVA may be used to judge performance by managers, and linked to remuneration schemes which reward the creation of value to the organisation.

Disadvantages include:

Calculations of EVA are complicated and require many adjustments to accounting information.

EVA is normally historic. It does not help decide future investments and strategy.

EVA may distort investment by favouring investments with relatively small capital outlays, or relatively short time horizons. Such investments are likely to produce higher EVAs in the near future.

EVA comparisons between companies are not directly valid, unless an adjustment is made for the relative size of companies.

EVA usually relies on CAPM for the estimate of the weighted average cost of capital. CAPM is based upon restrictive assumptions and may not accurately estimate the cost of capital.

EVA is not suitable for young companies or financial institutions.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 40 SHEGDOR

(a)The objectives of transfer pricing include:

The reduction of overall corporate income taxes, primarily by manipulating the transfer price to divert taxable income from high tax countries to low tax countries.

The minimisation of import duties. A low transfer price into a country with import duties will reduce the level of duty paid.

The avoidance of exchange controls or other restrictions such as dividend remittance restrictions. A low transfer price to the parent company might be attempted as an alternative to a dividend payment.

To improve the appearance of the financial performance of a subsidiary. If profits are increased through transfer pricing this might help satisfy any earnings criteria set by lenders to the subsidiary, or make the acquisition of a new loan easier.

(b)(i)

If the transfer price is at fixed plus variable cost:

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(c)

If the transfer price is at fixed plus variable cost, and assembly takes place in Mazila, the likely attitudes of the governments are:

Umgaba: The government of Umgaba would not receive any tax, and would probably try to ensure that any transfer price included an element of profit.

Mazila: Tax is maximised for Mazila, as well as jobs provided by the assembly. The government is likely to regard this favourably.

Bettuna: No tax is received or jobs created as assembly would take place in Mazila. Unless the government offers incentives to attract the assembly there is little it can do.

UK: This is the only situation in which the UK government would receive any tax on the income.

Answer 41 WURRALL PLC

(a)Pro forma accounts

Pro forma income statement for the years ended March 2005–8

£million

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Pro forma Statement of Financial Position 2005–8

(b)

The pro forma accounts are based primarily upon the percentage of sales method of forecasting. This provides a simple approach to forecasting, but is based upon assumptions of existing or planned relationships between variables remaining constant, which are highly unlikely. It also does not allow for improvements in efficiency over time.

Accurate forecasts of sales growth are very difficult. Sensitivity or simulation analysis is recommended to investigate the implications of sales differing from the forecast levels. A constant growth rate of 6% forever after four years is most unlikely.

Cash operating costs are unlikely to increase in direct proportion with sales. The variable elements (wages, materials, distribution costs etc.) could all move at a higher or lower rate than sales, whilst the fixed elements will not change with the value of sales at all in the short run. If the company becomes more efficient then costs as a proportion of sales should reduce.

Unless tax allowable depreciation from new asset purchases exactly offsets the diminishing allowances on older assets, and effect of the increase in assets with sales growth, this relationship is unlikely to be precise. The government might also change the rates of tax allowable deprecation.

4Refinanced with a similar type of loan in 2006

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Assuming a direct relationship between inventories, receivables, cash and other liabilities to sales could promote inefficiency. Although a strong correlation between such variables exists, there should be no need to increase inventory, receivables and liabilities in direct proportion to sales.

Paying dividends as a constant percentage of earnings could lead to quite volatile dividend payouts. Most investors are believed to prefer reasonably constant dividends (allowing for inflation) and might not value a company with volatile dividends as highly as one with relatively stable dividends.

(c)

Free cash flow will be estimated by EBIT(1–t) plus depreciation less adjustments for changes in working capital and expenditure on fixed assets. (N.B. other definitions of free cash flow exist)

The present value of free cash flow for the company after 2008 may be estimated by:

The estimated value of the company at the end of 2008 is £8,883 million. From this must be deducted the value of any loans in order to find the value accruing to shareholders. From the pro forma accounts, loans are expected to total £900 million, leaving a net value of £7,983 million. If the number of issued shares has not changed, the estimated market value per share is 2,4007,983

Based upon this data the managing director’s claim that the share price will double in four years is not likely to occur.

However, the impact of the performance of the economy, and unforeseen significant changes affecting Wurrall plc mean that such estimates are subject to a considerable margin of error.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

It is difficult to comment upon ratios without comparative data for companies in the same industry. The current gearing level, at 42·3%, breaches the covenant limit of 40%, and it is expected to continue to do so in 2005. Whether or not this breaches the one-year covenant is not clear, but would need to be investigated by the company and action taken to reduce gearing if the covenant was to be breached for too long a period. The receivables collection period appears high at 126 days. It is unlikely that credit would be given for such a long period, and the company might consider improving its credit control procedures to reduce the collection period. If this is successful it could also reduce the overdraft and help reduce the gearing level.

Another ratio that would need investigating is the asset turnover. At around one this is relatively low. Unless the industry is very capital intensive, management should consider if assets could be utilised more efficiently to improve this ratio, and with it the return on capital employed.

As previously mentioned, managers might also review the company’s dividend policy. Paying a constant level of earnings could lead to volatile dividend payments which might not be popular with investors, including financial institutions, that rely upon dividends for part of their annual cash flow.

Wurrall proposes to finance any new capital needs with increases in the overdraft. Overdraft finance is not normally considered to be appropriate for long term financing, and the company should consider longer term borrowing or equity issues for its long-term financing requirements.

5EBIT/(shareholders equity plus long term debt). Other definitions are possible

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 42 VADENER PLC

(a)

Group performance may be analysed by using financial ratios, growth trends and comparative market data. Alternative definitions exist for some ratios, and other ratios are equally valid.

Operating and profitability ratios:

It is difficult to reach conclusions about the performance of Vadener without more comparative data from similar companies.

Return on capital at around 30% is dominated by the effect of high profit margins, but the split between divisions is not provided. Asset utilisation is well below 1, which implies relatively inefficient utilisation of assets. Vadener might investigate whether this could be improved.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Liquidity has improved during the last year, and although below some commonly used benchmarks might be satisfactory for the sectors that Vadener is involved with. However, some aspects of working capital require attention. Stock levels have increased from 28% of turnover in 2003 to 33% in 2005, and the collection period for receivables has similarly increased from 114 days to 125 days. Payables have also increased more than proportionately to turnover. Vadener should take action to improve the efficiency of its working capital management.

In contrast operating costs have fallen over the three years from 66% to 62% of turnover, indicating greater efficiency. Gearing appears to be relatively low at around 32%, but comparative data is needed, and interest cover is high at more than eight times in 2005.

Investors do not appear to be entirely satisfied with group performance. The FT market index has increased by 34% between 2003 and 2005, whereas Vadener’s share price has only increased by 26%. With an equity beta of 1·1 Vadener’s share price would be expected to increase by more than the market index. Vadener’s PE ratios are also lower than those of similar companies, suggesting that investors do not value the company’s future prospects as highly as those of its competitors.

The required return from Vadener’s shares may be estimated using the capital asset pricing model (CAPM).

Required return = 5% + (12% – 5%) 1·1 = 12·7%

An approximation of the actual return from Vadener’s shares is the 12% average annual increase in share price plus 4% annual dividend yield, or 16%. The total return is higher than expected for the systematic risk. Given this, Vadener should investigate the reasons why its share price has performed relatively poorly. One possibility is the company’s dividend policy.

Dividends have consistently been more than 50% of available after tax earnings, which might not be popular with investors.

Divisional performance.

The information on the individual divisions is very sparse. All divisions are profitable, but the return from the pharmaceutical division is relatively low for its systematic risk.

Using CAPM to approximate required returns:

The construction and leisure divisions appear to have greater than expected returns (a positive alpha) and the pharmaceutical division slightly less than expected for the risk of the division. The pharmaceutical division has recently suffered a translation loss due to the weakness of the US dollar, and the potential economic exposure from changes in the value of the dollar should be investigated.

From a financial perspective it would appear that the company should not devote equal resources to the divisions, and should focus its efforts on construction and leisure. However, the future prospects of the sectors are not known, nor the long term strategy of Vadener, which might be to expand international operations in the USA or elsewhere.

6It is assumed that the same market parameters are valid for the US based division.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

The strategic use of resources should not be decided on the basis of the limited financial information that is available.

(b)Other information that would be useful includes:

Cash flow forecasts for the group and the individual divisions.

Full product and market information for each of the divisions.

Details of recent investments in each of the divisions and the expected impact of such investment on future performance.

Detailed historic performance data of the divisions over at least three years, and similar data for companies in the relevant sectors.

Competitors and potential growth rates in each of the sectors.

The economic exposure of the US division

The future strategic plans of Vadener. Are there any other proposed initiatives?

How the company’s equal resource strategy will be viewed by investors. The company has performed worse than the market in recent years despite having a higher beta than the market.

(c)A translation loss of £10 million is not necessarily a problem for Vadener plc.

Translation exposure, sometimes known as accounting exposure, often does not reflect any real cash flow changes. It is changes in cash flow that, in an efficient market, will impact on the share price and value of a company. For example, a translation loss might in part reflect a lower home currency value of an overseas factory, but the factory will still be the same and will still be producing goods. It is the impact on the home currency cash flows from the continuing operations of the factory that will affect share price.

However, if the market is not efficient, investors might not understand that there are no real cash flow implications from the exposure, and might be worried about the effect of the translation loss on Vadener, and possibly sell their shares. If this is the case Vadener might consider internal hedges to reduce translation exposure. In most cases this would not be recommended, and companies must also be careful that hedges to manage translation exposure do not adversely affect the efficient operations of the business, or be contrary to hedges that are being undertaken to protect against other forms of currency exposure such as transaction exposure.

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