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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 1 PROGROW

Progrow plc is a company with 350 employees located in Southern England. The company has two main products: a manually operated lifting jack for cars, and a range of high quality metal gardening tools. The products are sold in car accessory shops, garden centres and “do it yourself” superstores.

The company’s production manager has just learned that a new process incorporating new machines could be used in the manufacture of the jacks. The process would require some extra factory space which is currently surplus to the company’s needs (and could not be rented to an external user), and would require 25% less direct labour than current jack production techniques. No expansion in jack production from the current level of 250,000 units per year is proposed. The cost of the new machines would total £535,000, and the machines would require incremental annual maintenance costing approximately £45,000 in current prices. The existing machinery could be sold for £125,000 (after any tax effects including the balancing allowance on disposal). This amount would be received in one year’s time. If the new machines are not purchased, the existing machinery is expected to be kept for a further five years after which time the after tax scrap value is expected to be negligible.

Prices and costs currently associated with the company’s products are:

Incremental annual interest costs associated with the finance of the new machines are £10,000.

As the company is located in a government approved development area, expenditure on any new machinery would be eligible for first year tax allowable depreciation of 50%, with a 25% reducing balance thereafter. The expected working life of the machines is five years, and at that time they are expected to have a scrap value of £40,000.

If the machines are purchased 26 skilled and 24 unskilled workers would be made redundant. Redundancy costs are on average £9,000 for skilled workers and £5,000 for unskilled workers. Twenty of the remaining skilled workers would need to retrain to use the new machines at a cost of £750 per person. These are all tax allowable costs.

As an alternative to buying the new machines the company could use the spare factory space to expand garden tool production. For a capital equipment expenditure of £200,000 the existing annual production of 400,000 garden tools could be increased by 70,000 units per year. Expenditure on this capital equipment is also eligible for 50% first year tax allowable depreciation, and a 25% reducing balance thereafter. This new equipment would have a scrap value of £14,000 after five years.

The managing director of Progrow is concerned that failure to invest in the new jack manufacturing process might lead to the company losing significant market share in the jack market if competitors were able to reduce their prices in real terms as a result of introducing the new process.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)The managing director’s daughter is attending a university degree course in accounting and finance. During a telephone call to his daughter the managing director mentioned the possible alternative investments. She replied that she had learned that:

(i)Net present value is not an appropriate technique to use for strategic investment decisions as it ignores any future options that might occur due to the use of the new machines, or from the expansion of garden tool production.

(ii)The use of betas is suspect, as the capital asset pricing model (CAPM) has significant theoretical and practical weaknesses. She suggested consideration of the arbitrage pricing theory as an alternative to using CAPM.

The managing director has only recently been convinced of the benefit of using net present value, and is left confused by his daughter’s comments.

Required:

Discuss the validity of the comments made by the managing director’s daughter and whether or not the managing director should take them into account in the investment

The company’s ordinary shares are currently trading at £2·20, and the debentures at £105·50. The debenture is redeemable at its par value of £100.

The company’s equity beta is 1·25.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Jetter plc is considering investing in one of three projects. The company has £50 million that is currently earning 5·8% in short-term money market deposits. Any surplus funds after the investment in one of the projects will continue to be invested in the money market.

The company has employed an external consultant to estimate risk/return data relevant to the three projects.

Market standard deviation of returns 6·9%

Risk free rate 6% per annum

Required:

(a)Evaluate which project should be selected. Do not use information provided later in the question requirements in your evaluation.

(b)If it was later calculated that the profitability index for project 2 was 1·3, based upon equal cash inflows of £16 million per year from the project for four years, what does this

(c)Estimate Jetter’s cost of capital prior to undertaking the investment. Briefly discuss (do not calculate) what effect the project selected in (a) is likely to have on Jetter’s cost of capital.

(d)The consultant has suggested that beta estimates should be adjusted by using the formula: [(0·67 × unadjusted beta) + 0·33] in any estimate of required returns.

(ii)Calculate whether or not your choice of project in (a) above would have altered

(e)Discuss the advantages and disadvantages of using the Capital Asset Pricing Model and

(35 marks)

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 3 STRAYER PLC

The managers of Strayer plc are investigating a potential £25 million investment. The investment would be a diversification away from existing mainstream activities and into the printing industry. £6 million of the investment would be financed by internal funds, £10 million by a rights issue and £9 million by long term loans. The investment is expected to generate pre-tax net cash flows of approximately £5 million per year, for a period of ten years. The residual value at the end of year ten is forecast to be £5 million after tax. As the investment is in an area that the government wishes to develop, a subsidised loan of £4 million out of the total £9 million is available. This will cost 2% below the company’s normal cost of long-term debt finance, which is 8%.

Strayer’s equity beta is 0·85 and its financial gearing is 60% equity, 40% debt by market value. The average equity beta in the printing industry is 1·2, and average gearing 50% equity, 50% debt by market value.

The risk free rate is 5·5% per annum and the market return 12% per annum.

Issue costs are estimated to be 1% for debt financing (excluding the subsidised loan), and 4% for equity financing.

These costs are not tax allowable.

The corporate tax rate is 30%.

Required:

(b)Comment upon the circumstances under which APV might be a better method of

(15 marks)

Question 4 TROSOFT LTD

(a)Discuss the merits and potential problems of using each of the weighted average cost of capital and adjusted present value to aid the evaluation of proposed capital investments.

(8 marks)

(b)Trosoft pte ltd is a Singapore based company specialising in the development of business software. The company’s managers believe that its future growth potential in the software sector is limited, and are considering diversifying into other activities. One suggestion is Internet auctions, and a member of the management team has produced the following draft financial proposal.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Internet auctions project

S$000

Additional information:

(i)All data include the estimated effects of inflation on costs and prices wherever relevant. Inflation in Singapore is forecast to be 2% per year for the foreseeable future.

(ii)The investment in IT infrastructure and the initial working capital will be financed by a 6 year 5·5% fixed rate term loan. Other year 0 outlays will be financed from existing cash flows.

(iii)The Singapore government is expected to give a 1% per year subsidy to the cost of the loan to support the creation of jobs associated with this project.

(iv)Highly skilled IT staff would need to be taken from other activities resulting in a loss of S$80,000 per year pre-tax contribution for three years.

(v)Head office cash flows for overheads will increase by S$50,000 as a result of the project in year one, rising by S$5,000 per year after year one.

(vi)Corporate tax is at a rate of 24·5% per year, payable in the year that the tax liability arises. The company has other profitable projects.

(vii)Tax allowable depreciation on IT infrastructure is 20% for the first year, and straight line thereafter. The IT infrastructure has an expected working life of six years after which major new investment would be required.

(viii)The company’s current weighted average cost of capital is 7·8%.

(ix)The company’s equity beta is 1·05.

(x)The average equity beta of companies in the Internet auctions sector is 1·42.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(xi)The market return is 9·5% per year and the risk free rate 4% per year.

(xii)Trosoft’s capital gearing is: Book value 55% equity, 45% debt

Market value 70% equity, 30% debt

(xiii)The average gearing of companies in the Internet auction sector is 67% equity, 33% debt by market values.

(xiv)The market research survey was undertaken three weeks ago.

(xv)After tax operating net cash flows after year 4 are expected to stay approximately constant in real terms. The royalty payment will remain at S$200,000 in money terms.

(xvi)Issue costs on debt are 1·5%. These costs are not tax allowable.

Required:

Acting as an external consultant you have been asked to prepare a report on the proposed diversification of the company into Internet auctions. The report must include a revised financial analysis. You should use the adjusted present value method for this purpose. Include in your report discussion of other financial and non-financial factors, including real options, that Trosoft might consider prior to making the investment decision. (32 marks)

(23 marks are available for calculations of the APV and 9 marks for discussion)

(40 marks)

Question 5 SLEEPON HOTELS

Sleepon Hotels plc owns a successful chain of hotels. The company is considering diversifying its activities through the construction of a theme park near London. The theme park would have a mixture of family activities and adventure rides. Sleepon has just spent £230,000 on market research into the theme park, and is encouraged by the findings.

The theme park is expected to attract an average of 15,000 visitors per day for at least four years, after which major new investment would be required in order to maintain demand. The price of admission to the theme park is expected to be £18 per adult and £10 per child. 60% of visitors are forecast to be children. In addition to admission revenues, it is expected that the average visitor will spend £8 on food and drinks, (of which 30% is profit), and £5 on gifts and souvenirs, (of which 40% is profit). The park would open for 360 days per year.

All costs and receipts (excluding maintenance and construction costs and the realisable value) are shown at current prices; the company expects all costs and receipts to rise by 3% per year from current values.

The theme park would cost a total of £400 million and could be constructed and working in one year’s time. Half of the £400 million would be payable immediately, and half in one year’s time. In addition working capital of £50 million will be required from the end of year one. The after tax realisable value of fixed assets is expected to be between £250 million and £300 million after four years of operation.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Maintenance costs (excluding labour) are expected to be £15 million in the first year of operation, increasing by £4 million per year thereafter. Annual insurance costs are £2 million, and the company would apportion £2·5 million per year to the theme park from existing overheads. The theme park would require 1,500 staff costing a total of £40 million per annum (at current prices). Sleepon will use the existing advertising campaigns for its hotels to also advertise the theme park. This will save approximately £2 million per year in advertising expenses.

As Sleepon has no previous experience of theme park management, it has investigated the current risk and financial structure of the closest UK theme park competitor, Thrillall plc. Details are summarised below.

Thrillall plc, summarised Statement of Financial Position

1,390

––––––

Other information:

(i)Sleepon has access to a £450 million Eurosterling loan at 7·5% fixed rate to provide the necessary finance for the theme park.

(ii)£250 million of the investment will attract 25% per year capital allowances on a reducing balance basis.

(iii)Corporate tax is at a rate of 30%.

(iv)The average stock market return is 10% and the risk free rate 3·5%.

(v)Sleepon’s current weighted average cost of capital is 9%.

(vi)Sleepon’s market weighted gearing if the theme park project is undertaken is estimated to be 61·4% equity, 38·6% debt.

(vii)Sleepon’s equity beta is 0·70.

(viii)The current share price of Sleepon is 148 pence, and of Thrillall 386 pence.

(ix)Thrillall’s medium and long term debt comprises long term bonds with a par value of £100 and current market price of £93.

(x)Thrillall’s equity beta is 1·45.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

Prepare a report analysing whether or not Sleepon should undertake the investment in the theme park. Your report should include a discussion of what other information would be useful to Sleepon in making the investment decision. All relevant calculations must be included in the report or as an appendix to it. State clearly any assumptions that you make.

(Approximately 28 marks are available for calculations and 12 for discussion)

(40 marks)

Question 6 GOTOP PLC

Gotop plc has large subsidiaries in Malaysia and Hong Kong.

The chief accountant at Gotop is concerned about the size of cash bank balances that are held by each of the companies and would like to reduce these balances to make more funds available for capital investment.

The three cash bank balances are currently independent of each other.

Gotop’s chief accountant suggests combining the accounts of all three companies into one UK based account. In order to meet unforeseen needs Gotop has a policy of requiring actual cash balances to be three standard deviations higher than the average cash need.

Required:

(a)Estimate by how much the total balances might be reduced, without altering the current

(b)Briefly discuss possible practical problems of centralising cash balances in this way.

(4marks)

(10 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Question 7 HASDER PLC

Hasder plc currently operates only in the UK, but is considering diversifying its activities internationally into either Europe or East Asia, the latter including several developing economies. Estimates have been obtained of the likely risk and return of investments in these parts of the world, which are expected to vary during different economic states of the UK. After either diversification approximately 30% of the market value of the company would be represented by overseas investments.

Standard deviation of expected returns:

Covariance of expected returns:

Members of Hasder’s board of directors have different views about such diversification.

Director A believes that the company should focus exclusively upon the UK market as it always has, because “overseas investments are too risky”.

Director B believes that overseas diversification will offer the company the opportunity to achieve a much better combination of risk and return than purely domestic investments, and “will open up new opportunities”.

Director C considers that overseas investments are expensive, and overseas diversification will not be valued by shareholders who could easily achieve such diversification themselves.

Director D is in favour of the diversification, but considers East Asia to be a much better alternative than Europe.

Director E is also in favour of East Asia, but suggests that a much higher proportion of the company’s activities should be located there, possibly between 50% and 70%.

Required:

(a)Discuss the views of each of the five directors. Include in your discussion relevant calculations regarding portfolio risks and returns. What other factors might influence the investment decision?

(b)Estimate and explain the implications of the correlation coefficients between:

(i)UK/Europe; and

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