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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 4 TROSOFT PTE LTD

(a)

The weighted average cost of capital (WACC) is the effective after tax cost of the different sources of finance used by a company. The costs of the different sources are normally weighted by their market values. WACC is often used to discount the incremental cash flows of an investment in order to estimate the NPV (net present value), the expected change in corporate value resulting from the investment. In order to add value for shareholders it is necessary for the return from an investment to exceed the WACC. WACC is therefore a very useful tool to assist in project evaluation and the measurement of wealth creation. However, it has some problems and limitations. It is sometimes not clear about whether or not to include short-term finance such as overdrafts in the estimate of the weighted average cost of capital and in theory WACC should not be used when:

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

The operating risk of the company changes as a result of the investment.

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

There are subsidised loans or other benefits associated explicitly with an individual project.

In such circumstances the adjusted present value (APV) may be a better technique to analyse investments than the WACC with NPV. APV requires the estimation of the base case NPV of operating cash flows (discounted at the ungeared cost of equity), and, separately, the present value of any financing side effects. It allows more complex financing situations to be dealt with, and the different types of cash flow, with different risks, to be discounted at a rate specific to the individual risk. However, APV also has theoretical and practical problems.

In order to estimate the APV it is necessary to correctly identify all of the financing side effects, and the risk of each individual side effect. This is not an easy task, especially for international investments. APV also relies on some of the unrealistic assumptions of the Modigliani and Miller model (with tax), for example the equation for asset betas used in most APV estimates assumes that cash flows are perpetuities, which is normally not the case.

(b)Report on the proposed Internet auction investment.

The investment will be assessed using both financial and non-financial indicators. It is also important to consider the strategic fit of such an investment, and whether the investment will move the company too far from its core competence.

As the IT infrastructure will require major new investment after six years, the period of the financial evaluation will be six years.

The adjusted present value technique (APV) requires the estimation of the base case NPV of operating cash flows, and, separately, the present value of any financing side effects. Revised financial data:

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Internet auctions project $000

The expected base case NPV is ($2,810,000)

Notes:

(i)The discount rate for the base case NPV should be the ungeared cost of equity, taking into account the risk of the investment. In order to reflect the risk of the investment, the ungeared equity beta of the Internet auction sector will be used.

Assuming corporate debt to be virtually risk free:

Using CAPM

Keu = Rf + (Rm – Rf) beta

Keu = 4% + (9·5% – 4%) 1·035 = 9·69%

10% will be used as the discount rate to estimate the base case NPV.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Other important factors might be:

The accuracy of data. How confident is Trosoft that the forecast sales and costs will occur?

Sensitivity and/or simulation analysis would be useful to investigate the impact of different assumptions on net cash flows.

Has the risk of the venture been accurately assessed? The discount rate of the operating cash flows is based on CAPM, and is subject to its theoretical and practical problems.

Are there new technologies involved in the investment which are not yet fully developed and proven?

What will be the reaction of other Internet auction providers? Will they cut auction listing costs?

Are there alternative investments that would provide a better strategic fit for Trosoft?

Are there existing or possible future government regulations that would affect the investment?

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 5 SLEEPON HOTELS

Report on the proposed theme park investment

The decision to invest in a major project must be evaluated using both financial and non-financial information. From a financial perspective the estimated net present value of the investment will provide an indicator of whether or not the project will create wealth. Non-financial considerations will include the strategic fit of the investment with the company and its future plans.

The estimated net present value is (£140·05) million.

Even if the higher realisable value estimate is used, the expected net present value is still significantly negative.

Notes:

(i)Receipts year 2

Adult admission (6,000) (360) (18) (1·03)2 = 41·25 million Child admission (9,000) (360) (10) (1·03)2 = 34·37 million Food (15,000) (360) (8) (0·3) (1·03)2 = 13·75 million Gifts (15,000) (360) (5) (0·4) (1·03)2 = 11·46 million

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(ii)Capital allowances:

It is assumed that allowances are available with a one year lag.

No balancing allowances or charges have been estimated as the year 5 realisable value of fixed assets has been estimated on an after tax basis.

As the hotel business is successful, it is assumed that allowances may be used as soon as they are available against other taxable cash flows of Sleepon plc.

(iii)Interest is not a relevant cash flow. All financing costs are included in the discount rate.

(iv)The market research is a sunk cost.

(v)Apportioned overhead is not a relevant cash flow.

(vi)Although the company will save money by advertising in its existing hotels, this is not a change in cash flow as a result of the project and is not included in cash flows. (In effect the benefit from the savings is present as there is no cash outflow for advertising).

(vii)Discount rate

The current weighted average cost of capital should not be used. The discount rate should reflect the risk of the investment being undertaken; theme parks are likely to have very different risk to hotels. The cost of capital will be estimated using the risk (beta) of Thrillall plc, as Thrillall operates in the theme park sector.

The market weighted capital gearing of Thrillall is:

Equity 400 × 3·86 = £1,544 m (78·3%)

Debt 460 × 0·93 = £428 m (21·7%)

As the gearing of Thrillall is much less than that of Sleepon, the beta used to estimate the relevant cost of equity will need to be adjusted to reflect this difference in gearing.

Assuming corporate debt is virtually risk free:

Ungearing Thrillall’s equity beta:

Regearing to take into account the gearing of Sleepon:

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The cost of equity may be estimated using the capital asset pricing model.

Ke = Rf + (Rm – Rf) beta equity

Ke = 3·5% + (10% – 3·5%) 1·748 = 14·86%

Kd is 7·5%, the cost of the new debt used for the project.

The weighted average cost of capital relevant to the new investment is estimated to be: 14·86% (0·614) + 7·5% (1 – 0·3) (0·386) = 11·15%

11% will be used as the discount rate for the investment.

Other relevant information

The financial projections used in the estimated net present value are subject of considerable inaccuracy. It would be useful to know:

(i)The accuracy of estimates of attendance levels and spending in the theme park.

(ii)The accuracy of price and cost changes.

(iii)Whether or not tax rates are subject to change.

(iv)The accuracy of the estimate of realisable value in year four.

(v)The accuracy of the discount rate estimate. The activities of Thrillall are not likely to be of exactly the same risk as the theme park project.

For a major investment it is unwise to rely on a single estimate of expected net present value. Sensitivity analysis or simulation analysis should be used in order to ascertain the impact on the expected NPV of changes in attendance and other key cash flows. It would be better to undertake simulation analysis, based upon different possible attendance levels, costs, risk, tax rates etc. in order to estimate a range of possible net present values, rather than use a single point value.

A crucial question is what happens to cash flows beyond the company’s four year planning horizon. The year five realisable values are asset values, not the value of the theme park as a going concern. The value as a going concern could be very different from the asset values, and have a major influence on the investment decision.

Will the theme park investment lead to future opportunities/investments (real options), for example in other theme parks or leisure activities? If so the value of such options should be estimated, and should form part of the investment decision.

Strategic and other issues

The strategic importance of the venture to Sleepon must also be investigated, as this may heavily influence the final decision. Sleepon currently runs a successful hotel chain. It might be better to keep to its core competence in hotels rather than diversify into another sector. If new investments are sought are there better opportunities within the hotel sector?

Any final decision must encompass all relevant non-financial factors of which little detail has been provided. Sleepon must be satisfied that it can recruit an appropriately skilled labour force for the theme park, and should thoroughly investigate the competition in the theme park sector, and the likely reaction of competitors if it enters this new market.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 7 HASDER PLC

(a)

It is useful to estimate the return and risk of the two diversification alternatives before examining in detail the views of the directors. The portfolio return is simply the weighted average of the expected returns of the two elements of the portfolio. The portfolio risk may be estimated using the two-asset portfolio theory equation, based upon the expected risk and return of each alternative.

Expected return UK/Europe (0·7) (11·7) + (0·3) (12·3) = 11·88%

Expected return UK/East Asia (0·7) (11·7) + (0·3) (18·6) = 13·77%

The two-asset portfolio equation measures the total risk of the portfolio. This will include some specific or unsystematic risk:

Portfolio risk UK/Europe

[(4·03)2 (0·7)2 + (4·86)2 (0·3)2 + 2(0·7) (0·3) (17·89)]½

σp = 4·20

Portfolio risk UK/East Asia

[(4·03)2 (0·7)2 + (12·26)2 (0·3)2 + 2(0·7) (0·3) (31·98)]½

σp = 5·91

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

It is not obvious from these results which investment is best. As risk increases, so does the expected return. The coefficient of variation, which shows the amount of risk per pound of expected return, would suggest that continuing only in the UK is best. However, the risk/return preferences of Hasder plc would need to be considered before a decision was made, as would strategic and other issues discussed below.

Director A

Director A’s view has merit in that the company would be sticking to its core market and core competence. However, overseas investments are not always too risky. Some overseas investments are less risky than UK investments. If total risk is considered then international diversification can produce risk/return combinations that are not available from investing only in the UK. The benefits of international portfolio diversification might reduce overall risk below that available in the UK, and provide better combinations of risk and return for Hasder. This is the view of Director B who correctly states that international diversification will open up new opportunities.

Director C produces no evidence that overseas investments are more expensive than UK investments. In many multinational companies lower labour and materials costs have been key motives for overseas investments; hence such investments have been cheaper than similar UK based investments.

If the company is investing overseas purely to achieve diversification it is fair to say that in most cases shareholders, by investing in international unit trusts (mutual funds) or similar, could easily, and more cheaply, diversify for themselves. However, some countries do not permit such portfolio investments, and their markets are largely segmented from major Western markets. Segmented markets might include the developing markets in East Asia. Hasder might be able to offer risk/return combinations that are valued by its shareholders if it invests in countries that they could not easily invest in themselves as part of their share portfolios. Investing in segmented markets might also mean that the systematic risk of investments available to Hasder can be reduced, especially if the segmented markets have a low or negative covariance with returns in the UK market.

International diversification might also result in less variability of the cash flows of Hasder, as the markets are not perfectly correlated. This reduction in risk, if recognised by providers of finance, might result in lower financing costs, and a lower cost of capital.

Director D

The summary table shows that investment in East Asia offers a higher potential return than in Europe, but at significantly higher risk. If the coefficient of variation is considered then it is the least favoured alternative.

Director E suggests a much higher proportion of investment in East Asia. If 50% – 70% was invested in Asia, and assuming market values reflected these proportions:

50% – Expected return UK/East Asia (0·5) (11·7) + (0·5) (18·6) = 15·15%

70% – Expected return UK/East Asia (0·3) (11·7) + (0·7) (18·6) = 16·53%

Portfolio risk UK/East Asia

If 50%:

[(4·03)2 (0·5)2 + (12·26)2 (0·5)2 + 2(0·5) (0·5) (31·98)]½

σp = 7·59

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