FM Section C
FM Section C
Investment (3,500,000)
NPV 865,434
As, NPV of the project is positive at $865 434 and it is also higher than most likely
outcome at 677296, the project should be considered financially acceptable.
However, the mean (expected) NPV is not a value expected to occur because of
undertaking the proposed investment, but a mean value from undertaking it
many times. There is no clear decision rule associated with the mean(expected)
NPV.
A decision of financial acceptability must also consider the risk (probability) of a
negative NPV being generated by the investment. At 24%, this might appear too
high a risk to be acceptable. The risk preferences of the directors of Copper Co
will inform the decision of financial acceptability; there is no decision rule to be
followed here.
Simulation
One of the main technique on adjusting risk and uncertainty is called simulation
technique. It takes into account of the impact of many variables changing at the
same time and improves risk adjusting process. Therefore, it includes all possible
outcomes in decision making process. Another advantages of simulation is that is
relatively easy to understand and it has a wide variety of applications like
inventory control and component replacement.
Adjusted Payback
If risk and uncertainty are considered to be the same, payback can be used to
adjust for risk and uncertainty in investment appraisal.
As uncertainty(risk) increases, the payback period can be shortened to increase
the emphasis on cash flows that nearer to the present time and hence less
uncertain.
Conversely, as uncertain (risk) decreases, the payback period can be lengthened
to decrease the emphasis on cash flows that are nearer to present time.
Discounted payback adjusts for risk in investment appraisal in that risk is reflected
by the discount rate employed. Discounted payback can be seen as an adjusted
payback method.
MELANIE CO (SEP/DEC 2018)
In most simple accept and reject decisions, IRR and NPV will select the same
project. However, NPV has certain advantages over IRR as an investment
appraisal technique.
SEP-DEC 2019
Scenario 1
If Dink Co chooses to lease the new machine, it would be $58 718 cheaper than
buying it thorough the bank loan.
b)
(i) ROCE can be expressed in a variety of ways, and is therefore susceptible
to manipulation. Although the question specifies average profit to average capital
employed, many other variants are possible, such as average profit to initial
capital, which would raise the computed rate of return.
It is also susceptible to variation in accounting policy by the same firm over time,
or as between different firms at a point in time. For example, different methods
of depreciation produce different profit figures and hence different rates of
return.
Perhaps, most fundamentally, it is based on accounting profits expressed net of
deduction for depreciation provisions, rather than cash flows. This effectively
results in double counting for initial outlay i.e. the capital cost is allowed twice
over, both in the numerator of the ROCE calculation and also in the denominator.
This is likely to depress the measured profitability of a project and result in
rejection of some worthwhile investment.
Finally, because it simply averages the profits, it makes no allowance for the
timing of the returns from the project.
(ii) The continuing use of ROCE method can be explained largely by its utilization
of statement of financial position and statement of profit or loss magnitudes
familiar to managers, namely profit and capital employed. In addition, the impact
of the project on companies financial statements can also be specified. ROCE is
still the commonest way in which business unit performance is measured and
evaluated, and is certainly the most visible to shareholders. It is thus not
surprising that some managers may be happiest in expressing project
attractiveness in the same terms in which their performance will be reported to
shareholders, and according to which they will be evaluated and rewarded.
c)
WARDEN Co
c) (i) Sensitivity analysis is a technique used in investment appraisal to asses the
impact of changes in key variables on the financial viability of the project. It
involves identifying the variables that are most critical to the success of the
project and then testing how changes in those variables affect the outcome of the
appraisal. There are some of the key variables that can be subject to sensitivity
analysis in investment appraisal. They are sales volume, selling price, variable
costs, fixed costs, discount rate. By conducting sensitivity analysis on these
variables, investors can identify the critical factors that determine the financial
viability of the project. This information can be used to informed decisions about
whether to invest in the project, how much to invest, and what level of risk is
acceptable.
Charm INC
The new project of Charm Co is expected to have positive Net Present value
which makes the project financially acceptable. This is mainly due to achieving
high-level sales revenue in the first year of the project and in the following years
sales revenue is expected to fall remarkably alongside with production and
operating costs.
b) Net present value is considered number 1 technique for investment appraisal
and there several reasons to support this argument. Firstly, compared to other
investment appraisal methods, such as, ROCE, payback, IRR, it considers time
value of money by taking into account of the impact of interest, inflation and risk
over time. It is also known as an absolute measure of return, as it reflects the
absolute amount of cash flows after taking into account of all cash inflows and
outflows calculation after the impact of nominal interest rate. Unlike ROCE, NPV is
based on cash flows. In real world cash is the king, since cash flows are more
reliable and less sensitive to manipulation. Therefore, investment decisions will
be more effective by the cash flows calculations in NPV rather than Operating
profits in ROCE. Furthermore, it considers the whole life of the project which is
the main disadvantage of payback method of investment appraisal. Payback
technique focuses on only the time period in which initial investment can be
returned.
DUO Co
a) As it can be seen from the positive value of net present value of the new
investment project of Duo Co, it is financially acceptable to invest in the
purchase of new machine to meet increasing demand for its existing
product. In addition to this, the new machine is expected not being able to
meet the last year demand of the product, being capable of producing
100 000 units less, it is also better to invest in more advanced machine to
meet as much demand as possible to increase profitability of the business.
b) Risk and uncertainty are two important concepts in investment appraisal
that refer to the potential for loss or deviation from expected outcomes.
While they are often used interchangeably, they have distinct meanings in
the context of investment appraisal.
Risk refers to the variability of potential outcomes that can be estimated
and measured with the certain degree of confidence. In investment
appraisal, risk is typically associated with known probabilities and can be
quantified using statistical tools and historical data. For example, the risk of
a stock investment can be assessed by analyzing its historical volatility and
correlation with market movements.
On the other hand, uncertainty refers to situations where the probabilities
of potential outcomes are unknown or cannot be reliably estimated.
Uncertainty is typically associated with unpredictable events or factors that
are beyond the control of the investor, such as changes in government
policies, technological advancements , or natural disasters. In investment
appraisal, uncertainty makes it difficult to quantify the potential impact of
these events on the expected returns of an investment.
In summary, risk can be quantified and managed through statistical analysis
and historical data, while uncertainty involves unknown probabilities and
unpredictable events that make it difficult to assess and manage. Both risk
and uncertainty play a crucial role in investment appraisal, and investors
need to consider both factors when making investment decisions.
Sensitivity analysis assess how the net present value of investment project
is affected by changes in project variables. Considering each project
variable in turn, the change in the required variable to make the net
present value zero is determined, or alternatively the change in net present
value arising from a fixed change in the given variable. In this way, the key
or critical project variables are determined. However, sensitivity analysis
does not assess the probability of changes in project variables and is so
often dismissed as a way of incorporating risk into the investment appraisal
process.
Probability analysis refers to assessment of the separate probabilities of a
number of specified outcomes of investment project. For example, a range
of expected market conditions could be formulated and the probability of
each market condition arising in each of several future years could be
assessed.
GORWA Co
Gorwa Co has both fixed interest debt and variable interest rate debt amongst its
source of finance. The fixed interest bonds have ten years to go before they are
redeemed in full and therefore they are considered long-term protection against
an increase in interest rates.
In 20X6, 60% of companies debt was fixed interest in nature, but in 20X7 it had
fallen to 43%. The floating rate debt proportion of the company therefore
increased from 40% to 57% in 20X7. The interest cover rate has declined from
10.7 to 8.4 and this is mainly due to a double increase in variable interest
payments. The debt/equity ratio (including bank overdraft due to its size)
demonstrated a significant increase from 36% to 45%. From the perspective of
increase in interest rates, the financial risk of Gorwa Co has increased and may
continue to increase if the company did not take action to halt the growth of its
variable interest rate overdraft. An increase in interest rates will further reduce
profit before taxation, which is lower in 20X7 than 20X6, despite a 40% increase in
revenue.
One way to hedge against an increase in interest rates is to exchange bank
overdraft into long-term fixed-rate debt. There is likely to be an increase in
interest payments as long-term debt is usually more expensive than short-term
debt. Gorwa Co would also be unable to benefit from a decrease in interest rates
if most of its debt paid fixed rate interest than floating rate interest.
Interest rate option and futures would be an alternative solution to hedge against
an increase in interest rates depending on plans of the company to deal with its
increasing overdraft.
b)
MONEY MARKETS
Explain the role of the money markets and give four examples of money market
instruments.
Answer:
The principal roles of money markets are to:
Transfer money from parties with surplus funds to parties with deficit;
Allow governments and business to raise short-term funds;
Help governments to implement monetary policy;
Determine short-term interest rates.
TAGNA
On the assumption that the central bank makes a substantial interest rate increas
possible consequences for Tagna in the following areas:
i. sales;
ii. operating costs; and
iii. earnings (profit after tax).
Sales
As a manufacturer and supplier and luxury goods, it is likely that Tagna will
experience a sharp decrease in sales as a result of increase in interest rates. One
reason for this is that sales of luxury goods will be more sensitive to changes in
disposable income than sales of basic necessities, and disposable income is likely
to fall as a result of increase in interest rates. Another reason is the likely effect of
interest rate increase on consumer demand. If the increase in demand has been
supported, even in part, by the increase in customer credit, the substantial
increase in interest rate will have a negative effect on demand as the cost of the
customer credit increases. It is also likely that many chain store customers will
buy Tagna’s goods by using credit.
Operating costs
Tagna may experience an increase in operating costs as a result of the substantial
interest rate increase, although it is likely to be smaller effect and one that occurs
more slowly than a decrease in sales. As a higher costs of borrowing moves
through the various supply chains in the economy, producer prices may increase
and material and other input costs for Tagna may rise more than the current rate
of inflation. Labor costs may also rise sharply if the recent sharp increase in
inflation leads to high inflationary expectations being build into wage demands.
Earnings
The earnings (profit after tax) of Tagna are likely to fall as a result of the interest
rate increase. In addition to the decrease in sales and possible increase in
operating costs discussed above, Tagna will experience an increase in interest
costs arising from its overdraft. The combination of these effects is likely to result
in a sharp fall in earnings. The level of reported profit has been low in recent
years and so Tagna may be faced with insufficient profits to maintain its dividend,
or even a reported loss.
UFTIN Co
c) Relevant cash flows
When undertaking the appraisal of investment project, it is essential that only
relevant cash flows are included in the analysis. If non-relevant cash flows are
included, the result of the appraisal would be misleading and incorrect decisions
will be made. A relevant cash flow is a differential(incremental) cash flow, one
that changes as a direct result of an investment decision.
If current fixed production overheads are expected to increase, for example, the
additional fixed production overheads are a relevant cost and should be included
in investment appraisal. Existing fixed production overheads should not be
included.
A new cash flow arising as a result of investment decision is a relevant cash flow.
For example, the purchase of raw materials for a new investment project and net
cash flows arising from the production process are both relevant cash flows.
The incremental tax effects arising from an investment decision are also relevant
cash flows, providing that the company is in a tax-paying position. Direct labor
costs, for example, are an allowable deduction in calculation taxable profit and so
give rise to tax benefits: tax liabilities arising on incremental taxable profits are
also a relevant cash flows.
One area caution is required is interest payments on new debt used to finance an
investment project. They are differential cash flows and hence relevant, but the
effect of the cost of debt is incorporated into the discount rate used to determine
the net present value of the project. Interest payments should not therefore
included as a cash flow in an investment appraisal.
Market research undertaken to determine whether a new product will sell is
often undertaken prior to the investment decision on whether to proceed with
the production of a new product. This is an example of sunk cost. These are the
costs incurred as a result of past decisions, and so are not relevant cash flows.
PINKS CO
(b) Ways to encourage managers to achieve stakeholder
objectives (only FOUR required)
The achievement of stakeholder objectives by managers can be encouraged by
managerial reward schemes.
Share option schemes
The agency problem arises due to the separation of ownership and control, and
managers pursuing their own objectives, rather than the objectives of
shareholders, specifically the objective of maximization of shareholder wealth.
Managers can be encouraged to achieve stakeholder objectives by bringing their
objectives more in line with the objectives of stakeholders such as shareholders.
This increased goal congruence can be achieved by turning the managers into
shareholders through share option schemes. Although the criteria by which
shares are awarded need very careful consideration.
Performance related pay
Part of remuneration of managers can be made conditional upon their achieving
specific performance target, so that achieving performance target can assist in
achieving stakeholder objectives. Achieving a specified increase in earnings per
share, for example, could be consistent with the objective of maximizing
shareholder wealth.
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives is
to reduce information asymmetry by monitoring the decisions and performance
of mangers. One form of monitoring is auditing the financial statements of a
company to confirm quality and validity of information provided to stakeholders.
ASOP Co
COPPER CO
(b) Methods of adjusting for risk and uncertainty
(i) Simulation
Simulation is a computer-based method of evaluating an investment project
whereby the probability distributions associated with individual project variables
and interdependencies between project variables are incorporated.
Random number are assigned to a range of different values of project variables to
reflect its probability distribution. Each simulation randomly selects the values of
the project variables using random numbers and calculates a mean NPV.
BAR CO
Short term finance
Bank overdraft
Advantages include availability ( most companies are offered overdrafts by their
banks) and flexibility( the level of finance automatically adjusts to requirements).
Disadvantages include the risk of bank asking the overdraft to be repaid at short
notice(technically repayable on demand) and exposure to interest risk (overdrafts
are usually at variable interest rates).
Trade credit
Taking trade credit from suppliers is, to some degree, free finance (e.g. if supplier
offers 30 days credit then this represents one-month interest-free credit). Trade
credits are also convenient finance in that there are no issue costs or
arrangement fees.
Disadvantages include the risk of losing early payment discounts, if excessive
credit is taken, risk of credit being refused in the future.
LAFORGE CO
Methods of issuing new equity shares
Right issue
A right issue involves issuing shares to the existing shareholders in proportion to
their existing holding. Right issues are often successful, easier to price and
cheaper to arrange than public issue but the amount of finance raised is limited as
there is a finite amount that shareholders are willing to invest. A right issue would
be mandatory if shareholders have not elected to waive their pre-emptive rights.
Private placing
A private placing is when a company, usually with an intermediary, seeks out new
investors on a one-to-one basis. Share are normally issued to financial institutions
when performing a placing rather than to individuals. This can be a useful source
of new equity for an unlisted company but control of the company will be diluted
as a result. A placing is also cheaper than public issue but only useful for relatively
small issues.
Public offer
If the company is listed it may undertake a public offer whereby shares are
offered to sale for the public at large. This is an expensive way of issuing new
shares as there are significant regulatory costs involved and like the placing,
control of the existing shareholders will be diluted. A public issue will however,
allow very large amount of equity finance to be raised, and will also give a wide
spread of ownership.
Initial public offering(IPO)
If the company is not listed, it can list through the process of an IPO which will
raise equity at the same time. An IPO will be more expensive than a public offer as
there are further regulations having to be complied with, increasing costs.
Consequently, only a large company wishing to raise a significant amount of
finance would consider this option.
(d) Whether LaForge Co should raise finance by reducing its
annual dividend
The director’s suggestion of reducing a forthcoming dividend would raise at most,
$5.6m (70m*0.08) so in itself, would not be sufficient but would provide 22%
($5.6m/$25.48m) of total required. This would reduce the amount of new
external finance needed and also finance costs, but there are further problems
with this suggestion.
Signaling effect
The argument of signaling effect suggests that in the absence of perfect
information( in a semi-strong form of market efficiency), the dividend
announcement will send a massage or a “signal” to the market. Generally, a
reduction in dividend ( such as proposed here) could be interpreted as bad new
by investors and result in a fall in LaForge Co’s share price.
Clientele effect
Different investors have different needs relating to income or capital growth.
LaForge Co has consistently paid dividends in the past so switching to a
lower/zero payout could alienate some shareholders, resulting in large volume of
share sales. Given the different shareholders that LaForge Co has, this could be a
real issue for them.
Liquidity preference
Generally, it is thought that shareholders, even those who prefer low pay-outs/
high reinvestment, still wish to receive some dividend now as there is a certain
return compared with the more risky and uncertain future dividends or capital
growth.
Recommendation
Given that LaForge Co is a listed company with different shareholders and has
consistently paid dividends in the past, a reduction in dividend could damage
shareholder relations and possibly result in reduced shareholder wealth. This
reduction in dividend is not recommended.
Tinep Co
Discuss the factors to be considered by Tinep Co in choosing to raise funds
(b) via a rights issue.
Rights issue
A right issue raises finance by issuing new share to existing shareholders in
proportion to their holding and there are a number of factors Tinep Co should
consider.
Issue price
Right issues are offered at a discount to the market value. It can be difficult to
judge at what amount the discount should be offered.
Relative cost
Right issue is cheaper than other methods of raising finance by issuing new
shares, such as an initial public offer(IPO), due to the lower transaction costs
associated with right issue.
Ownership and control
As the new shares are being offered to existing shareholders, there is no dilution
of ownership and control, providing shareholders take up their shares.
Gearing and financial risk
Increasing the weighting of equity finance in the capital structure of Tinep can
decrease its gearing and its financial risk. The shareholders of the company may
see this positive move, depending on their individual risk preference positions.
(c) Islamic instruments
Interest(riba) is the predetermined amount, over or above the principal amount
of finance provided. Riba is absolutely forbidden in Islamic finance. Riba can be
seen absolutely unfair from the perspective of borrower, lender and the
economy. For the borrower, riba can turn a profit into loss when profitability is
low. For the lender, riba can provide an inadequate return when unanticipated
inflation arises. In the economy, riba can lead to allocational inefficiency, directing
economic recourses to sub-optimal investments.
Card Co
Discuss whether the dividend growth model or the capital asset pricing
(b) model should be used to calculate the cost of equity.
DGM v CAPM
The dividend growth model calculates the apparent cost of equity in the capital
market, provided that current market price of shares, current dividend value and
also future rate of divided growth are known. While current market price pf
shares and current dividend value are known, it is difficult to find an accurate
future dividend growth rate. A common approach to find future dividend growth
rate is to calculate average historic dividend growth rate and assume that the
future growth rate will be similar. There is no reason why this assumption should
be true.
The capital asset pricing model tends to be preferred to the dividend growth
model as a way of calculating cost of equity as it has a sound theoretical basis,
relating the cost of equity or required return of well-diversified shareholders to
the systematic risk they face through owning the share of the company. However,
finding the suitable values of variables used by the capital asset pricing
model(risk-free rate of return, equity beta and equity risk-premium) can be
difficult.
Wobling Co
b) Discuss the factors to be considered in formulating a trade receivables
management poslicy.
If the company is in monopoly position in the market, it can set freely its
product's price and has an option to sell either for cash or credit. However, if the
company is new in the market or has some large competitors, it should offer
credits to its customers to keep its competitiveness.
In most cases companies have a list of customers who has poor credit rating and
high irrecoverable debt risk.
The Miller-Orr model controls irregular movements of cash by the use of upper
and lower limits on cash balances.
The lower limit has to specified by the firm and the upper limit is calculated by the
model. The cash balances of the firm is allowed to vary freely between two limits
but if cash balances on any day goes outside these limits, action must be taken.
If the cash balances reaches the lower limit it must be replanished in some way by
the sale of some marketable securities or withdrawal from a deposit account. The
size of this withdrawal is the amount required to take the balance back to the
return point.
If the cash balances reaches the upper limit, an amount must be invested in
marketabke securities or placed in deposit account, sufficient to reduce the
balance back to the return point.