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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 36 EVERTALK PLC

Evertalk plc manufactures mobile phones and operates a mobile phone network. In order to offer the latest hand-held videophone technology the company has borrowed extensively on the international bond market. Unfortunately the new technology has proved to be unpopular with consumers, and sales of new handsets and network subscriptions have been less than forecast. As a result the company’s share price has fallen to only 10 pence, from a high two years ago of 180 pence. Capital investment of approximately £100 million per year is required for the company to continue operating at current levels

– £20 million for the manufacturing division and £80 million for the network division. Approximately 25% of the sales of the manufacturing division are to the network division.

Income Statements for the years ending 31 March 2002 and 2003

£ million

2002 2003

3 Currently 8% interest

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Evertalk’s board of directors has arranged a crisis meeting and is considering three proposals:

(i)A corporate restructuring, in which bonds are converted to equity, and which gives control of the company to the current bond holders.

(ii)Sale of the company’s shares to Globtalk plc, which operates a successful rival mobile phone network, for the sum of £50 million. This deal would be conditional upon Globtalk not taking over the liability for any of Evertalk’s loans.

(iii)Cease trading and close the company.

The restructuring has the following proposed conditions:

(i)Existing ordinary shares will be cancelled and replaced by 100 million new ordinary shares with a par value of 50 pence each. 95 million of these will be given to the existing bondholders in exchange for the cancellation of all existing bonds. The bondholders will also make available £100 million of new 10% fixed rate loans.

(ii)Existing shareholders will be offered one 5% convertible debenture (£100 nominal value) free of charge in exchange for every 1,000 shares they now own. Conversion into new ordinary shares is available at any time during the next five years at a conversion rate of 50 shares for every £100 convertible debenture held.

(iii)5 million new shares will be given to existing participants in the company’s share option scheme in exchange for cancellation of their existing options to purchase 10 million old shares.

Other information:

(i)All existing liabilities have equal claims for repayment against the company’s assets.

(ii)No dividends have been paid on ordinary shares for the last three years.

(iii)Losses may not be carried forward for tax purposes.

(iv)Surplus land and buildings could be disposed of for £40 million in order to repay the bank loan.

(v)The value of receivables, cash, fixed assets and payables represented by the two divisions is approximately equal. 90% of the inventory is represented by the manufacturing division.

(vi)The £300 million bond has been borrowed by the network division, and the £40 million bank loan by the manufacturing division.

(vii)If the restructuring and new investment does not take place, earnings before tax (after interest payments) are expected to stay at approximately the 2003 level. If new investment takes place, forecast earnings before interest and tax are expected to increase by £30 million as a result of some rationalisation of the network division.

(viii)The current market price of ordinary shares is 10 pence, and of debentures £121. The par value and redemption value of each debenture is £100.

(ix)Corporate tax is at the rate of 30%. The risk free rate is 5% and the market return 14%. The equity beta of the company is 1·15, with the manufacturing division equity beta approximately 0·9, and the network division equity beta approximately 1·35.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The company’s analysts believe that market weighted gearing of about 60% equity, 40% debt is appropriate for the entire sector, but currently this cannot be achieved due to the low share price.

(x)Realisable values of assets if not sold as part of a going concern are estimated to be:

(xi)Redundancy and closure costs of approximately £100 million would be payable if the company was closed, all payable before any other liabilities. These costs relate equally to the two divisions. All realisable values and closure values are after tax.

Required:

Acting as an independent consultant prepare a report for the board of directors of Evertalk. Your report should consider the advantages and disadvantages of each of the three proposals, from the viewpoint of each group of existing stakeholders in the company. It should also identify any other strategy(ies) which might be possible for Evertalk plc.

Question 37 SNOWWELL PLC

The managing director of Snowwell plc has received an unsolicited letter from a reputable organisation specialising in the prediction of corporate failure, which suggests that Snowwell has been identified as a probable failing company. The organisation has offered to supply details of the full report on Snowwell for £100,000.

Given the collapse of many companies’ share prices during the last few years, the managing director of Snowwell is concerned that if the contents of the report become public knowledge, Snowwell’s share price could also fall.

He has also read about various models which use combinations of financial ratios to attempt to predict corporate failure, including a leading business school’s SO model (developed in 2001) which produces a score based upon the following equation:

SO = 3·5S1 + 1·8S2 + 0·25S3 + 0·69S4

where:

S1 = Earnings before interest and tax/market value of equity S2 = Working capital/medium and long term capital employed S3 = Market value of equity/market value of debt

S4 = The present value to infinity of current operating free cash flow/turnover

According to the SO system a company scoring less than 1 has a high probability of failure; a score of 1–2 suggests remedial action is necessary to improve corporate financial performance; and a score of over 2 means that a company has a high probability of survival for at least three years, which is the maximum claimed prediction period for the model.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

The latest summarised accounts of Snowwell plc are shown below:

Statements of Financial Position as at

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Additional information:

(i)The share price of Snowwell Plc is currently 232 pence.

(ii)The current redemption yield on loan stock of similar risk to that of Snowwell is 8%, which is also the current interest rate of the floating rate term loan.

(iii)Snowwell needs to invest approximately £35 million per year to maintain operations at current levels.

(iv)Tax allowable depreciation in 2003 was £38 million

(v)Snowwell’s cost of equity is estimated to be 12%

(vi)Corporate tax is at the rate of 30% per year

(vii)The average gearing of Snowwell’s industry is 50% (measured by the market value of medium and long-term debt related to the market value of equity).

(viii)Snowwell’s turnover is mostly retail sales of high quality jewellery and watches.

Required:

You have been requested by the managing director of Snowwell plc to prepare a briefing document that includes:

(c)A brief discussion of alternative ways of assessing whether or not Snowwell plc is likely

(d)Recommendations as to whether or not Snowwell should take any action based upon your findings in (a) – (c) above and any other relevant information or analysis; (7 marks)

(e)A discussion as to whether or not Snowwell should purchase the full report for £100,000.

(4 marks)

(30 marks)

Question 38 HGT

HGT plc is a UK based multinational company with two overseas subsidiaries. The company wishes to minimise its global tax bill, and part of its tax strategy is to try to take advantage of opportunities provided by transfer pricing.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

The subsidiary in Glinland produces 150,000 graphite golf club shafts per year which are then sent to Rytora for the metal heads to be added and the clubs finished off. The shafts have a variable cost in Glinland of £6 each, and annual fixed costs are £140,000. The shafts are sold to the Rytoran subsidiary at variable cost plus 75%.

The Rytoran subsidiary incurs additional unit variable costs of £9, annual fixed costs of £166,000, and sells the finished clubs at £30 each in Rytora.

Bi-lateral tax agreements exist which allow foreign tax paid to be credited against UK tax liability.

All transactions between the companies are in pounds sterling. The Rytoran subsidiary remits all profit after tax to the UK parent company each year, and the Glinland subsidiary remits 50% of its profit after tax.

Required:

The parent company is considering instructing the Glinland subsidiary to sell the shafts to the Rytoran subsidiary at full cost. Evaluate the possible effect of this on tax and tariff payments, and discuss briefly any possible problems with this strategy.

(10 marks)

Question 39 TOUPLUT PLC

The managers of Toutplut Inc were surprised at a recent newspaper article which suggested that the company’s performance in the last two years had been poor. The CEO commented that turnover had increased by nearly 17% and pre-tax profit by 25% between the last two financial years, and that the company compared well with others in the same industry.

Income Statement extracts for the year $ million

4 After deduction of the economic depreciation of the company’s fixed assets. This is also the depreciation used for tax purposes.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Statement of Financial Position extracts for the year ending

Toutplut had non-capitalised leases valued at $10 million in each year 1999–2001.

Capital employed per the 1999 financial statements was $223 million.

The pre-tax cost of debt was estimated to be 9% in 2000, and 10% in 2001.

The company’s cost of equity was estimated to be 15% in 2000 and 17% in 2001.

The target capital structure is 60% equity, 40% debt.

The effective tax rate was 35% in both 2000 and 2001.

Economic depreciation was $30 million in 2000 and $35 million in 2001.

Other non-cash expenses were $10 million per year in both 2000 and 2001.

Interest expense was $4 million in 2000 and $6 million in 2001.

Required:

(a)Estimate the Economic Value Added (EVA) for Toutplut Inc for both 2000 and 2001. State clearly any assumptions that you make.

(b)Explain the relationship between economic value added and net present value. (2 marks)

(15 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Question 40 SHEGDOR

(a)Briefly discuss the possible objectives of transfer pricing strategies used by

(b)Shegdor plc, a UK based multinational company, has subsidiaries in three countries – Umgaba, Mazila and Bettuna.

The subsidiary in Umgaba manufactures specialist components, which may then be assembled and sold in either Mazila or Bettuna.

Production and sales volume may each be assumed to be 400,000 units per year no matter where the assembly and sales take place.

Manufacturing costs in Umgaba are $16 per unit and fixed costs (for the normal range of production) $1·8 million.

Assembly costs in Mazila are $9 per unit, and in Bettuna $7·5 per unit. Fixed costs are $700,000 and $900,000 respectively.

The unit sales price in Mazila is $40 and in Bettuna $37.

Corporate taxes on profits are at the rate of 40% in Umgaba, 25% in Mazila, 32% in Bettuna, and 30% in the UK. No tax credits are available in these three countries for any losses made.

Tax allowable import duties of 10% are payable on all goods imported into Mazila.

A withholding tax of 15% is deducted from all dividends remitted from Umgaba.

Shegdor expects about 60% of profits from each subsidiary to be remitted direct to the UK each year.

Cost and price data in all countries is shown in US dollars.

Required:

Evaluate and explain:

(i)if the transfer price from Umgaba should be based upon fixed cost plus variable cost, or fixed cost plus variable cost plus a mark up of 30%;

(c)Comment upon the likely attitude of the governments of each of the four countries towards the transfer price and assembly location selected in b (i) and b (ii) above.

(3 marks)

(15 marks)

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 41 WURRALL PLC

The board of directors of Wurrall plc has requested the production of a four-year financial plan. The key assumptions behind the plan are:

(i)Historically, sales growth has been 9% per year. Uncertainty about future economic prospects over the next four years from 2005–2008 however implies that this growth rate will reduce by 1% per year after the financial year 2005 (e.g. to 8% in 2006). After four years, growth is expected to remain constant at the 2008 rate.

(ii)Cash operating costs are estimated to be approximately 68% of sales.

(iii)Tax allowable depreciation for the past few years has been approximately 15% of the net book value of plant and machinery at year end This will continue for the next few years.

(iv)Inventories, receivables, cash in hand and “other payables” are assumed to increase in proportion to the increase in sales.

(v)Investment in, and net book value of, plant and machinery is expected to increase in line with sales. No investment is planned in other fixed assets other than a refurbishment of buildings at an estimated cost of £40 million in late 2007.

(vi)Any change in interest paid as a result of changes in borrowing may be assumed to be effective in the next year. Wurrall plans to meet any changes in financing needs, with the exception of the repayment of the fixed rate loan, by adjusting its overdraft.

(vii)Wurrall currently pays 7% per annum interest on its short-term borrowing.

(viii)Corporation tax is expected to continue at its present rate over the next four years.

(ix)For the last few years the company’s dividend policy has been to pay a constant percentage of earnings after tax. No changes in this policy are planned.

(x)Wurrall has borrowed extensively from the banking system, and covenants exist that prevent the company’s gearing (book value of total loans to book value of total loans plus equity) exceeding forty percent for a period of more than one year.

(xi)The company’s managing director has publicly stated that both profits before tax and Wurrall’s share price should increase by at least 100% during the next four years.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

1,104

–––––

The company’s current share price is 210 pence, and its weighted average cost of capital is 11%.

Required:

(a)Produce pro forma Statements of Financial Position and Income Statements for each of

(b)Critically discuss any problems or implications of the assumptions that are made in each

(c)Using free cash flow analysis, evaluate and discuss whether or not the managing director’s claims for the future share price are likely to be achievable. (The operating cash flow element of free cash flow may be estimated by: EBIT(1-t) plus depreciation.)

(10 marks)

(d)Using financial ratios or other forms of analysis, highlight any potential financial

problems for the company during this period. Discuss what actions might be taken with

5The investments yield negligible interest

6Borrowings are scheduled to be repaid at the end of 2006 and will be refinanced with a similar type of loan in 2006.

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