讲解 AC3059 Financial Management

AC3059

Financial Management

SECTION A

Answer four questions from this section.

Question 1

Stellar plc reviews its credit policy at regular intervals. Its current policy offers customers a 60 days credit period with a discount of 2% for all payments settled within 30 days. 30%  of  its  customers  take  advantage  of  the  discounting  facility  and  the  remaining customers pay on average in 70 days. Bad debts currently stand at 4% of annual sales. Sales forecast for next year is £1,250,000, assuming this credit policy is maintained.

Two new policy proposals have been put forward by the senior management team. They are as follows:

Proposal 1

The finance  director has  called  for the  policy to be tightened.  He  believes  customers should be offered a discount of 2% on pay settlement within 10 days and the remaining customers not taking advantage of the discount should be offered a credit period of 30 days. It is expected that only 15% of customers would take advantage of the discounting facility and the remaining customers would pay on average in 45 days. Bad debt will fall to 2% and annual sales forecast is not expected to change under this policy. To tighten the policy, the company would incur costs of £30,000.

Proposal 2

The marketing director takes an opposing view and she suggests that the policy should be  relaxed to  attract  more  customers.  She  proposes  that  customers  be  offered  a  3% discount for all payments settled within 30 days. It is expected that 40% of customers would take advantage of the discounting facility. Policy for the remaining customers will be lax and they are likely to pay on average in 90 days. This proposal is likely to be attractive to the market and the marketing team forecast sales will rise by 25% if this policy is introduced. They accept it may attract high risk customers and propose that provision for bad debt be set to 6% of annual sales.

Stellar plc earns a contribution of 25% on sales revenue and its cost of capital has been estimated at 10% per annum.

Assume that 1 year comprises 365 days.

REQUIRED:

Advise Stellar plc, about which of the two proposals, if any, to adopt.  (20 Marks)

[Total: 20 Marks]

Question 2

Supernova plc is in the process of determining its dividend policy for the next four years. Two different proposals have been made to the senior management team: (i) a residual policy, which the company currently follows and (ii) a fixed dividend policy with a growth element.

Below are the details relating to the company’s forecast profit levels (based on current assets, i.e. excluding those from planned reinvested profits) and plans for reinvestment.

Return on the investment levels above are expected to be 10% per annum.

We are currently at the end of year 0, the end of the last financial year for which profits have just been reported and the first period for which the new dividend policy will be operational.

With the first dividend policy, annual dividend payments will be made from the residual income left after all funds required for reinvestment have been taken from the profits earned. At the end of year 4, the forecast PE ratio (ex div) under this strategy is expected to be 14.

The  second  dividend  policy which  has been  proposed by the  finance  director  requires the company to increase its dividends by a fixed percentage of 5% annually, regardless of the profit level. The starting dividend payment for year 0 has been proposed at £60 million. Any earnings not distributed by the firm as a dividend payment will be retained. These retained earnings will not earn any return. These funds can however be drawn upon to make up for any shortfall in reinvestment that may arise in future years.

Shareholders in Supernova plc require a return of 10% on their investment. Ignore taxation.

REQUIRED:

a)   Given  the  information  above  and  assuming  that  all  the  forecasts  above  come  true, calculate the company’s equity value using the first dividend policy.  (7 Marks)

b)   Similarly, calculate the company’s equity value using the second dividend policy assuming that the forecast PE ratio (ex div) at the end of year 4 is expected to be 14.5.  (7 Marks)

c)    Discuss whether or not you believe the PE ratio in part b) above can be higher than that associated with the residual dividend policy in part a).  (4 Marks)

d)   Briefly explain any other factor that you would encourage the company to consider before finalising its dividend policy.  (2 Marks)

[Total: 20 Marks]

Question 3

The Power Shipping Company is a bulk-carrier shipping business registered in Ruritania, the currency of which is the Ruritarian euro (R€). It has noticed the increasing international demand for wheat and wishes to exploit this feature.  It  has  agreed to buy a  British  bulk-carrier  for £40million. Certain specification changes will be necessary first, and delivery and full payment will be made in six months time.

The Power Shipping Company is considering the following possibilites in order to deal with the foreign exchange risk associated with the payment:

(i)          A  purchase  of  a  euros  forward  contract  and  at  present  the  six  months

forward rate is at a discount of R€0.0197 per £.

(ii)         An  over-the-counter   option  contract  with  a  six  month  maturity  and  an exercise price of R€1.34. The premium on the contract is R€0.015 per £1.

(iii)       A money market hedge through the use of banks in Ruritania and the UK. At present the interest rates for six months are 3% and 1.5% in Ruritania and the UK, respectively. The company will have to pay a 0.1% administration charge on the sterling value to the bank.

The current spot rate is R€1.33 per £1 and the actual spot rate in six months time materialises to be R€1.3550 per £1.

REQUIRED:

a)   Calculate the total cost in R€ terms of using each of the three options under consideration by the Power Shipping Company. (10 marks)

b)   Comparing  your  outcomes in  part a) with an unhedged position, calculate the hedge gain/loss for each of the three options above.  (5 marks)

c)    Describe the main features of each of the three methods used above to hedge the currency risk. Evaluate the three alternatives and recommend, in your view, the best method the Power Shipping Company should use to make its payment.  (5 marks)

[Total: 20 Marks]

Question 4

Andromeda plc is a UK based company that operates in two industries: vaping, which makes up 60% of the company, and tobacco, which makes up the remaining 40% of the company.  The company is an all-equity company financed by a share capital of 50

million £1 ordinary shares, currently priced at £3.00 each.

The company pays out an annual dividend on its ordinary shares. The dividend payment forecast for next year is £0.42 per share which represents a growth of 1.8% on the current year’s dividend payment. Management plans to maintain this growth rate in dividend levels for the foreseeable future.

Management is currently looking at two capital investment projects, one in each industry:

Management, however, cannot decide what cost of capital to use to evaluate the two projects. The chief executive is keen to use Gordon’s dividend growth model to estimate the overall cost of equity. The finance director is, however, insisting on using the capital asset pricing model (CAPM).

The average industry asset betas for the vaping and tobacco industries are 1.0 and 1.45, respectively. The risk-free rate of interest and the expected return on the market portfolio are currently 4% and 14% respectively.

REQUIRED:

a)   Calculate  the  overall cost of equity at Andromeda plc using Gordon’s dividend growth model. (3 marks)

b)  Calculate the required rates of return for the two industries at Andromeda plc and the company as a whole using the CAPM. (4 marks)

c)   What  are the implications of your results in parts a) and b) above for the two projects  under  consideration  at  Andromeda  plc?  Which  project(s) would you advise Andromeda plc to invest in?  Explain. (8 marks)

d)  Discuss the appropriateness of the CAPM and Gordon’s growth model for estimating publicly quoted companies’ cost of capital?  (5 marks)

[Total Marks: 20]

Question 5

Orion plc is an all-equity company with 240 million shares issued and a current share price of £5.60. Having just received and reviewed its preliminary results for the year ended 31 March 2022, the directors have decided to invest heavily in new technology. This will require immediate long-term financing of £112 million. The funds can be raised by one of two ways, either by a one-for-six rights issue at a deep discounted price of £2.80 per share, or take out a 15 year debenture for the same amount. The debenture will cost £15 million (gross) in interest each year. If the rights issue option is taken the    Price Earnings (PE) ratio is expected to remain at 14 times, while if the debenture issue  option is taken the PE ratio is predicted to decline to 13 times.

For the year to 31 March 2023 the company predicts a substantial growth in operating profits (EBIT) to £180 million based on the benefits of the new investment and the improving trading conditions. Operating profit for the year ended 31 March 2022 was      £120 million. The company does not intend to make dividend payments during the year.

Assume a corporation tax rate of 20%.

REQUIRED:

a)  Assuming a rights issue of shares is made, calculate:

i.       the theoretical ex-rights price of an ordinary share in Orion plc. (3 marks)

ii.       the theoretical value of the rights for each original ordinary share. (3 marks)

b)  Estimate the price of an ordinary share in Orion plc on 31 March 2023 assuming:

i.       a rights issue was made during the year. (4 marks)

ii.       a debenture issue was made.  (4 marks)

c)   Calculate the breakeven operating profit for a shareholder to be indifferent between the two methods of raising the required long-term capital.  (6 marks)

[Total Marks: 20]

Question 6

Ana is a trainee in the loan department of Sophos Bank plc. Her current responsibilities are to screen small to medium sized businesses that have made loan applications to the bank. As per bank procedures, for this purpose, she is required to use Altman’s Z Score model for private companies in the first screen. Ana then passes on her decisions to her line manager who takes over with the second screen.

Ana  has  just  received  financial  statements  excerpts  of  three  companies  for  the  year ending March 31st, 2023, as presented below.

Lyra Ltd (£000s)   Libra Ltd (£000s)   Leo Ltd (£000s)

Balance Sheet

Assets

Fixed Assets   3,000   2,200   1,800

Less Depreciation   400   300   250

Net Fixed assets   2,600   1,900   1,550

Current Assets

Cash   100      80

Debtors   80   160   160

Stock   300   400   200

Total Current Assets   480   560   440

Current Liabilities

Creditors   80   200   100

Bank Overdraft   -   160   -

Total Liabilities   80   360   100

Net Asset Position   3,000   2,100   1,890

Financed by

Long Term Debt   500   800   590

Shareholder’s Equity   2,500   1,300   1,300

Total Capital   3,000   2,100   1,890

Income Statement

Sales   2,000   600   1,200

Cost of Goods Sold   900   200   600

General Expenses   400   120   230

Depreciation   400   300   250

Earnings before   Interest and Tax   300   -20   120

Interest Expense   50   100   60

Taxable Income   250   -120   60

Tax   5   0   3

Net Income   245   -120   57

Retained Earnings   1000   400   300

Ana is, however, uncertain as to how to proceed. The model she needs to use, she knows is depicted as follows.

Z = 0.72T1  + 0.85T2  + 3.11T3  + 0.42T4  + 1.00T5,

where:

T1 = (Current Assets − Current Liabilities) / Total Assets;

T2 = Retained Earnings / Total Assets;

T3 = Earnings Before Interest and Taxes / Total Assets;

T4 = Book Value of Equity / Total Liabilities; and

T5 = Sales/ Total Assets.

The decision-making process is such that if:

Z > 2.9 – the firm is considered to be in the “Safe Zone”;

1.23 < Z < 2.9 - the firm is considered to be in the “Grey Zone”;

Z < 1.23 - the firm is considered to be in the “Distress Zone”.

a)   For the benefit of Ana, determine the position of the three companies above so that she can pass on her decisions to her manager. (15marks)

b)  Based on your computations above, for any company that is in or close to the distress zone, identify and briefly comment on the core factors that you believe are responsible for this outcome. (3 marks)

c)   For the benefit of Ana, identify two limitations of the approach used at Sophos Bank plc as a basis for screening companies for loan applications. (2 Marks)

[Total: 20 Marks]

SECTION B

Answer one question from this section.

Question 7

The market capitalization of Tesla fell from about $1tr at the beginning of January 2022 to about $330bn at the end of January 2023 in spite of car deliveries increasing by 40% year on year.  Part of the drop was believed to be associated with the fact that Tesla’s

founder sold a substantial holding of shares in Tesla to fund his acquisition of Twitter. How consistent is this evidence with markets being efficient? Explain.

[Total: 20 Marks]

Question 8

In the UK, in much of the second decade of this millennium, median dividend yields for FTSE100 companies exceeded interest rates on government-issued bonds.  How consistent is this evidence with markets being efficient?  Explain.

[Total: 20 Marks]